John UWAJUMOGU Transaction Advisory Services Partner EY NIGERIA

Capital is much more supportive of green energy, while it is harder to harness capital for new oil projects.

John UWAJUMOGU Transaction Advisory Services Partner EY NIGERIA

Survival of the efficient

October 18, 2021

John Uwajumogu, transaction advisory services partner at EY Nigeria, talks to The Energy Year about how the crisis has encouraged a rapid energy transition in Nigeria, trends in consolidation and finance restructuring, and how gas utilisation is advancing in the country. EY offers assurance, advisory, tax and transaction advisory services worldwide.

In what ways has the crisis encouraged a rapid energy transition, and how is it taking place?
We often hear the term “the new normal” and how to operate in a reality characterised by an environment of low oil prices. It is a very similar scenario to the one we had in the last oil shock, which at the same time was a replica of the previous one. This phenomenon is cyclical and tends to happen every five years. We have to ask ourselves: How is this different from the last time?
One thing that is different and is gaining momentum is the conversation surrounding the energy transition, which has intensified. Plans that were a decade away from implementation have moved to the forefront. Prior to the pandemic, some of the majors such as BP, Shell and Total were already moving away from crude oil and into cleaner fuels and renewables. Energy transition efforts have been substantially intensified. At the same time, capital is much more supportive of green energy, while it is harder to harness capital for new oil projects. At the end of the day, people gravitate towards where the capital is, which is gas and renewables.
So, Nigeria needs to recognise the energy transition, looking at how it will take place and its possible impacts. With the world moving away from crude, Nigeria has to look into diversification within and without oil. Like coal, crude oil has many more applications and it will not go away anytime soon. Nigerian operators have to think about the future of the market and how to transform. Alternatives are already in place such as natural gas displacing diesel and PMS [premium motor spirit] for transport and to power industries. For example, companies such as Seplat Energy are investing heavily in gas. Firms need to think about how to build a more diverse and robust business to be able to withstand the energy transition.

What elements are important for adapting to and thriving in today’s market conditions?
It all boils down to capital and operational excellence. You have to become a low-cost producer and look at the key value drivers: people, processes, systems, your contracts and how you manage your contracts and supply chain. Further questions emerge: Are you maximising synergies? Are you using digital technology to extract value and generate cost efficiency and improved production? Operational excellence is key in this environment because you have to be a low-cost producer.
Secondly, capital excellence is also important. In an industry that requires high levels of capital, the ability to access funding at an affordable rate is a key value driver. It allows you to withstand shocks. Weak companies with weak balance sheets will fall while you can opportunistically acquire weaker competitors, grow your portfolio and create more resilience. Hence, portfolio optimisation is key, and this involves resilience.

Is the low price environment incentivising consolidation in the sector?
Indeed, we are on the verge of another period of consolidation. What may happen is that well-funded companies with strong balance sheets might start acquiring smaller competitors and increase their acreage. The economics of the industry favour scale because of infrastructure requirements. If you can run your cost through massive production volumes, you gain. Moreover, those companies with strong balance sheets and good governance, able to attract institutional investors, will be able to pick up the pieces of small companies that are crumbling. As for the IOCs, these will mostly go into deep offshore while local operators will grow larger in the onshore terrain, filling in the gaps left behind by major IOCs.

How would you assess Nigerian hydrocarbons companies’ relations with banks, and what debt and loan restructuring strategies are they adopting?
In Nigeria we have witnessed what many call “creative destruction,” where weak companies fell while stronger companies succeeded. In essence, that is the underlying driver of capitalism: the efficient allocation of resources to the most efficient users. Market forces drive resources to those operators who are more efficient. And it is precisely the banks playing the role of allocating capital. They are intermediaries sitting between investors and businesses.
When analysing the current scenario, we see that companies are heavily leveraged. Loans were given when oil prices were much higher, and many of them were reserve-based lending, so the value of the reserves determines their capacity and the amount they are qualified for. So, if prices drop significantly, the company is not worth as much and the loans have not gone down as much. In fact, over the years, they were given more loans.
A lot of Nigerian businesses are in a place where their ability to manoeuvre, survive, redefine and optimise is restricted because they cannot obtain financing for the investments required to succeed, whether that is digital technology or finding new reserve sources or funding their capital. For this reason, a lot of the operators will have to refinance and restructure in order to have the optimal capital base to make the right investments and set a course toward success.

 

What hurdles are marginal field bidders encountering and what are their desired profiles?
The big money, international money, is not looking at crude oil. It is looking at gas infrastructure and renewables. Crude oil exploration and production is not the sweet spot for international energy money anymore, which means that attracting investment will be difficult. In addition to this, it will be key for companies to demonstrate they are successfully developing the governance structure and have credible technical capacity.
Oil and gas is complex and capital intensive, which means that you may spend a lot of money digging a hole in the ground and find nothing. This is the fear, and more so when it comes to non-producing marginal assets.
Another hurdle is the fact that many companies have no institutional history of running an oil and gas asset. You need to be able to show a good production profile in order to be considered. Hence, only those who can partner with the right technical allies, demonstrate a strong institutional and governance setup, showcase skill in making investments and carry out a certain level of diagnostics and due diligence on the asset for investors will be in a position to attract financing.
Once you’ve become a preferred bidder and have been awarded an asset, you have to pay your signature money. It is then that you can conduct your technicals to ascertain the attributes of your asset. But by then you have already committed a substantial amount of money. If you look at the first indigenous fields awarded, some of them should have exhausted their reserves, but they have continued and increased daily production. This means that these fields have plenty of potential, and are ready to be drilled and exploited.

Does the solution to creating value addition in crude oil lie in the downstream sector?
There is a disconnect in the narrative about Nigeria, which is said to be a mono economy. Most government revenue and foreign exchange currency, about 90%, comes from the export of oil. But if you look at the composition of GDP, you find oil accounts for 9%. So why the disconnect? The answer lies in the downstream sector.
The country has not domesticated its oil and gas industry despite efforts with local content laws. It has not built links between E&P and the export of oil in terms of domesticating other parts of the value chain that complement the industry. In other words, the oil comes out and it is exported. Even most of the equipment used is imported. Foreign investors come in and fund E&P but the benefits are exported. This means that the benefits to the economy are minor compared to what is sent out and in turn, the benefits are not spread throughout the economy.
What the country needs is to get into value-adding processes like refining and petrochemicals to make sure most value addition to crude oil is done domestically.
At present, the GDP gap is driven by the downstream sector because we do not refine here, but this is bound to change. The government is revamping the existing refineries, in addition to encouraging the construction of modular refineries. Yet, it is the Dangote Refinery that will change the whole downstream landscape.
Still, the government has to change the policies in place to make the environment a market-driven one, so that market forces can direct affairs. This means a complete deregulation of the industry. As long as there are price caps, access and participation will be limited. This process will come with its hurdles, as it will initially be highly inflationary, so they will need to come up with measures to alleviate the initial impact.

What does the modular refinery phenomenon tell us about the current state of the market?
Modular refineries are just a reflection of the stage of our economy in that, other than Dangote, nobody has the financial power to build a large refinery. Also, the policy doesn’t encourage that. If you are building a refinery, the margins are usually razor thin. That’s why you don’t see a lot of modular refineries up and running. In a price-capped environment, it’s hard to make money given the high capital cost of setting up a refinery with thin margins, especially when you have NNPC disrupting the market. The reason companies like Niger Delta or Waltersmith contemplated developing a modular refinery was that they produce crude oil in situ. In addition, there is no other refinery close by. So, those who set up a modular refinery did it because they had the feedstock, they refine it on location and they feed it into the market where there is a huge supply gap.

What challenges does gas utilisation face in Nigeria, and how is the sector advancing?
The economics of gas are quite different from those of oil, as it requires huge, ready-made transportation infrastructure which is not yet in place. On the other hand, crude can be stored and you can either play the long game, or quickly bring it to market. Gas doesn’t lend itself to that strategy as it can only be stored under specific and expensive conditions and can only be transported through specialised transportation schemes. Moreover, you have to use it as you produce it, which means that every plan for gas has to be end-to-end, going from production to consumption. If not, somebody loses money.
The economics work when the infrastructure has been built and there is an industrial base ready or available demand. In Nigeria, our industrial base is low and we do not have the retail market for gas. To this, we must add the fact that the current regulatory environment is not incentivising, which hampers potential investment. What’s more, parts of the value chain are still regulated – for example transportation, which is controlled by the government. Pricing is also regulated.
Despite the obstacles, there are projects coming on line that aim to make gas availability a reality. The OB3 pipeline will connect the east and west, allowing a huge aggregation capacity that can be taken to major consumption clusters. The markets here are isolated and there is no pipeline linking all three clusters. But that will change with OB3 as it will aggregate the gas, and route it so that there are opportunities for local distribution companies to tie into those major trunklines. In addition to this, the AKK pipeline will also be a huge advance, having a knock-on effect in making gas widely available. At the end of the day, pipelines are the best means of transporting gas, and are cheaper.

In what ways can deregulation, decentralisation and decapitalisation bridge the gaps in the power sector in this country?
Three things are needed for Nigeria’s electricity supply: deregulation, decentralisation and decapitalisation. The industry is highly regulated and in such a way that it creates dependencies that are unsustainable. Generation companies sell to the distribution companies [DisCos] via a transmission companies, and the DisCos sell to the end user. In a way, whatever happens downstream impacts the upstream, but ironically, they do not have any commercial arrangement with each other. If the DisCo doesn’t collect, generating companies don’t get paid. The system in Nigeria doesn’t work because not only does the single buyer model not provide accountability, now they have to acquire credit enhancements and guarantees from the government.
We have 30,000 MW of capacity but we are only moving 7,000 MW or less. There are huge liquidity issues, and a lot of reform without tactical benefits. The answer is to deregulate, decentralise and decapitalise. Firstly, you set up electricity markets in each state, and each state decides whether to roll out a full competitive market allowing citizens to choose their service providers. The generation companies would then be able to cultivate the market and find their customer base. This also allows the market to innovate.
On the other hand, DisCos must have the liberty to innovate and sub-franchise, bringing in different energy mixes. In this way, they are more in control of their network, locating energy, gas-fired plants or solar close to injection points so that losses are minimised. Decentralising the grid is essential.
As a result, you will have some states producing more power than they need and some less. Investment will gravitate to some more than others, becoming competitive, and the national grid can then be a network to balance supply and demand across states and sales across states. In turn, decapitalisation would happen because one would be looking for the optimum mix. The opportunities for participation would be unlimited. Anyone could set up an IPP and sell power for instance, while hydro dams in some states could start being utilised.

To what extent could the rise in electricity tariffs rebalance the business of DisCos?
The service-based tariff the government has come up with helps solve the liquidity challenge DisCos have had. Now they can’t claim the tariff is not cost-reflective because tariffs have jumped 50%. Electricity bills have gone up significantly. Now they can get the money and make the right investments and use their resilience, networks and systems to make investments in technologies and improve their networks. Hopefully the new tariff will bring the required investment in the market.

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