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Volumetric Production Payments An Effective Monetization Strategy IPAA Private Capital Conference 19 January 2006 Presented by: Paul Riddle Managing Director.

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Presentation on theme: "Volumetric Production Payments An Effective Monetization Strategy IPAA Private Capital Conference 19 January 2006 Presented by: Paul Riddle Managing Director."— Presentation transcript:

1 Volumetric Production Payments An Effective Monetization Strategy IPAA Private Capital Conference 19 January 2006 Presented by: Paul Riddle Managing Director Energy & Power Corporate Finance Wachovia Securities

2 2 | Wachovia Securities Topics for Discussion What is a volumetric production payment (VPP) How is the VPP upfront payment determined VPP risk and responsibility allocation between purchaser and seller Accounting and tax treatment Rating agency views Reasons to sell a VPP Pioneer Natural Resources case study Volumetric Production Payments – An Effective Monetization Strategy

3 3 | Wachovia Securities What is a Volumetric Production Payment? A Volumetric Production Payment or VPP is a limited term overriding royalty interest in oil and gas reserves. – A VPP is free and clear of all operating costs, capital expenditures and taxes The VPP entitles the purchaser to receive scheduled production volumes from specific lease interests. The VPP guarantees the purchaser a first priority on production from these specified lease interests. – The VPP is recourse only to these specified lease interests and not to the seller’s other assets The Bankruptcy Code provides special protection to VPPs in the event of a seller’s bankruptcy. – The VPP is recognized as a separate property interest (not part of the seller’s bankruptcy estate). Volumetric Production Payments – An Effective Monetization Strategy

4 4 | Wachovia Securities Sample VPP Volumetric Production Payments – An Effective Monetization Strategy PDP VPP Volume  volume purchased under the VPP. PDP Operating Cost Volume  producer retains enough volumes to cover all operating costs, basis volatility and taxes. PDP Cushion Volume  serves to provide reliability of production volumes. Size of cushion is based on the production profile’s predictability. Reserve Tail  reserves remaining at the end of the VPP term (will be owned by the VPP seller along with PDNP, PUD and all other upside potential).

5 5 | Wachovia Securities How is the VPP Upfront Payment Determined? Upfront Payment = Discounted present value of projected VPP cash flow VPP Cash Flow = (VPP volumes) x (Projected realized sales price based on NYMEX forward curve less a hedgable basis) Discount Rate = Weighted average of the forward LIBOR curve hedged over the term of the VPP plus a credit spread Volumetric Production Payments – An Effective Monetization Strategy

6 6 | Wachovia Securities How is the VPP Upfront Payment Determined? (Continued) Volumetric Production Payments – An Effective Monetization Strategy

7 7 | Wachovia Securities VPP Risk / Responsibility Allocation VPP Seller VPP Buyer Volumetric Production Payments – An Effective Monetization Strategy Reserve Risk Production Risk Price Risk Offtake Risk Hedge Exposure Interest Rate Exposure Operations Pays Operating Costs and Taxes Subject Reserves Encumbered Until VPP Volumes Are Produced

8 8 | Wachovia Securities GAAP Accounting Treatment VPP Reserves – Removed from annual disclosure of proved reserves – Removed from “Standardized Measure of Discounted Future Net Cash Flows” – VPP transaction would be recorded as a sale of reserves in the analysis of reserve changes VPP Production – Not included in the Company’s reported production volumes in the analysis of reserve changes – Can disclose production subject to a VPP in operating data, but the data would need to be footnoted to identify volumes subject to a VPP – Disclosure of VPP production would allow investors to calculate the Company’s true economics on a per unit of production basis Volumetric Production Payments – An Effective Monetization Strategy

9 9 | Wachovia Securities GAAP Accounting Treatment (Continued) Balance Sheet – Credit “Deferred Revenue” which is a long-term liability Income Statement – Company recognizes VPP production revenue as VPP production occurs. VPP production revenue is categorized as “Oil and Gas Sales Revenue.” – Value of VPP production revenue is determined by the average of the cash advanced per unit of production (provides a stable, predictable hedged revenue stream) – Company continues to recognize appropriate “Operating Expenses” and “Depletion” for VPP reserves Volumetric Production Payments – An Effective Monetization Strategy

10 10 | Wachovia Securities GAAP Accounting Treatment (Continued) Cash Flow Statement – The initial proceeds received upon the sale of a VPP are generally reflected as “Cash Flow from Investing Activities” in the cash flow statement – As the reserves are produced and delivered under the VPP, “Cash Flow from Operations” is reduced in the cash flow statement > The reduction in “Deferred Revenue” is noted in the non-cash adjustments Volumetric Production Payments – An Effective Monetization Strategy

11 11 | Wachovia Securities Other Accounting Issues FAS 133 Impact – The Company does not mark-to-market gains or losses on hedge contracts associated with the VPP FIN 46 Impact (related to Special Purpose Entity) – The VPP purchaser consolidates the entity for accounting purposes – The entity purchasing the VPP must have multiple assets Volumetric Production Payments – An Effective Monetization Strategy

12 12 | Wachovia Securities Tax Treatment The Internal Revenue Code treats a VPP as debt for federal income tax purposes (as if it were a mortgage loan on the property) Federal Income Tax over the life of the transaction remains the same independent of commodity prices Tax treatment of expenses (including DD&A) is unchanged State taxes are typically due when production occurs If VPP reserves have no upside potential and only a nominal tail, then transaction could be treated as a sale for tax purposes Volumetric Production Payments – An Effective Monetization Strategy

13 13 | Wachovia Securities Rating Agencies Rating agencies generally treat VPPs as debt, but recognize the following benefits: – Locks-in current attractive production economics to ensure repayment – Self liquidates – Cannot be accelerated based on the seller’s financial condition – Only recourse to underlying property and not to the Company When determining a VPPs impact on ratings, agencies are concerned about the shifting of risk and whether the use of funds is debt holder friendly: – High amount of risk shifted to the VPP purchaser?Positive – Repurchase senior or pari passu debt?Positive – Repurchase junior debt or stock or fund a dividend?Negative – Reinvest in activities that create asset value and/or add cash flow?Positive Volumetric Production Payments – An Effective Monetization Strategy

14 14 | Wachovia Securities Requirements to Sell a VPP Must own domestic reserves – VPP treatment as separate property is based on U.S. law PDP must have predictable production profile – provides confidence in scheduling VPP production – Reduces cushion requirements – Reduces production risk = reduces cost Ability to hedge or otherwise lock-in components of basis Must have use of funds… – Acquisitions and other investment opportunities – Refinance higher cost capital (retire debt or share repurchase) Volumetric Production Payments – An Effective Monetization Strategy

15 15 | Wachovia Securities Reasons to Sell a VPP – Summary 1) Efficient way to hedge large quantities of production for long durations 2) Selling a VPP locks-in current attractive production economics on “top line” of income statement 3) The sale of a VPP can change the production profile of declining assets to flat (or increasing) 4) The sale of a VPP has advantages to selling the asset outright 5) Because of its flexibility, a VPP can be very competitive versus debt instruments based on advance rate and cost-of-capital 6) The sale of a VPP has advantages to forming an MLP or royalty trust Volumetric Production Payments – An Effective Monetization Strategy

16 16 | Wachovia Securities Reasons to Sell a VPP – Hedging Efficient way to hedge large quantities of production for long durations – No potential for margin deposits (losing liquidity when prices go up) – No FAS 133 mark-to-market impact on income statement – Effectively matches hedges to production profile of assets – Removes hedge counterparty credit risk – Does not use hedge counterparty credit (VPP purchaser is hedging its own volumes) > VPP purchaser with higher credit rating is able to obtain longer, more favorable hedges – Producers can assign underwater hedges to a VPP > Up front payment is net purchase price (net of impact of assigned hedge) > Frees up margin deposits or LC requirements > Hedge losses are not recognized until volumes are produced Volumetric Production Payments – An Effective Monetization Strategy

17 17 | Wachovia Securities Reasons to Sell a VPP – Removes Earnings Volatility Selling a VPP locks-in current attractive production economics on “top line” of income statement – VPP production still recognized on income statement as “Oil & Gas Sales Revenue” as volumes are produced – Each unit of production receives the average price paid per UOP over the life of the VPP – No FAS 133 impact! – No changes to “Operating Costs” or “Depletion” necessary Volumetric Production Payments – An Effective Monetization Strategy

18 18 | Wachovia Securities Reasons to Sell a VPP – Ability to Change Production Profile of Asset The sale of a VPP can change the production profile of declining assets to flat (or increasing) – VPP reserves and production are removed from public Company disclosures – Asset profile becomes more attractive to public market or in a sale Volumetric Production Payments – An Effective Monetization Strategy VPP Sold

19 19 | Wachovia Securities Reasons to Sell a VPP – Attractive Alternative to Asset Sale The sale of a VPP has advantages to selling the asset outright – Keep 100% of asset’s upside potential (including upside from future technologies) – Sale of a VPP is not a taxable event – Maintain operational control (no disruption for field level employees) – Size VPP to amount of desired proceeds only Volumetric Production Payments – An Effective Monetization Strategy

20 20 | Wachovia Securities Reasons to Sell a VPP – Attractive Alternative to Asset Sale (Continued) Anatomy of an asset… Volumetric Production Payments – An Effective Monetization Strategy Reserve Tail  heavily discounted by PV discount rate Upside  probabilistic discounting reduces purchase price for timing risk and likelihood for success VPP Volume  Not risked; Banks (VPP) are most aggressive bidders with lowest rate-of-return hurdles and ability to hedge large volumes (strong balance sheet) Operating Cost Volume  No money for this

21 21 | Wachovia Securities Reasons to Sell a VPP – Flexible Source of Leverage Because of its flexibility, a VPP can be very competitive versus debt instruments based on advance rate and cost-of-capital Volumetric Production Payments – An Effective Monetization Strategy Lowest Cost-of- Capital (Increase Collateral) Highest Advance Rate (Stretch Collateral) Borrowings are non-recourse to seller VPP purchaser cannot accelerate repayment based on financial condition of the VPP seller No financial covenants Lower up front costs Able to raise capital at a tighter spread-to-LIBOR than senior secured bank debt (and usually more capital as well) Credit quality is improved due to bankruptcy remoteness from the seller’s bankruptcy estate Structural Flexibility (General) Able to raise significantly more leverage on PDP reserves on a senior secured basis than bank debt Allows for acquisition of reserves without significant equity component (and favorable accounting treatment if VPP is in place before the acquisition)

22 22 | Wachovia Securities Reasons to Sell a VPP – Attractive Monetization Strategy Versus MLP/Royalty Trust The sale of a VPP has advantages to forming an MLP or royalty trust – Does not trigger a taxable event – Does not create significant overhead/reporting responsibilities – Lower up front costs – Banks likely buy at lower discount rate than public MLP/royalty trust markets – Ease/speed/certainty of execution with one counterparty Volumetric Production Payments – An Effective Monetization Strategy

23 23 | Wachovia Securities After analyzing strategic alternatives to unlock the value of its reserves (royalty trust, MLP, outright sale), Pioneer chose to monetize its reserves through a VPP structure. The transactions were a coordinated effort of Wachovia’s Energy & Power Corporate Finance Group, in-house technical staff, Structured Asset Finance Group and Derivatives Group. By monetizing reserves through the VPP structure, Pioneer was able to lock in commodity prices (with no mark-to- market exposure) and accelerate the return of cash at a low discount rate while retaining control and all upside. – The VPPs monetized approximately 2% (20.5 MMBOE) of Pioneer’s total worldwide reserves for approximately 8% of its enterprise value – The VPPs monetized Pioneer’s reserves for over $29.00 / BOE ($23.00/ BOE net of operating expenses) as compared to a market valuation of $7.16 / BOE at the time Monetizing the reserves allowed Pioneer to complete its targeted debt reduction and stock repurchase programs. Close Date:January 26, 2005 WS Role:Wachovia provided or arranged all capital and derivative contracts. Product:Aggregate VPPs of $593 million  $317 million 8-year VPP on Pioneer’s Spraberry field crude oil production  $276 million 5-year VPP on Pioneer’s Hugoton field natural gas production Wachovia VPPs — Pioneer Natural Resources Company Volumetric Production Payments – An Effective Monetization Strategy

24 24 | Wachovia Securities Public Equity Market Reaction to the Pioneer VPPs Pioneer’s stock price closed up 6.17% the day of the announcement (versus a gain of 0.04% for the S&P 500), representing an increase in market capitalization of approximately $325 million. PXD Stock Price at $36.28 at VPP Announcement PXD Stock Price at $38.52 after 1 st Trading Day Volumetric Production Payments – An Effective Monetization Strategy

25 25 | Wachovia Securities Public Equity Market Reaction to the Pioneer VPPs (Continued) Research analysts reacted positively to the VPP transactions: – Moody’s Investors Service: > “We view the VPP’s as a monetization of 20.5 MMBOE of future production, with certain contingent obligations, but at very attractive up-cycle forward five-year and seven-year prices” > “Viewed another way, they nicely hedge the comparatively higher Spraberry and Hugoton production costs underlying the VPP volumes and arbitrage the gap between spot and long-dated forward prices” – Raymond James: > “By selling reserves through these VPPs, the company is capturing the value of its long-lived assets using current robust commodity prices” > “The VPPs and buybacks (stock buyback) show Pioneer's commitment to boosting shareholder value, and we view them very favorably” – Merrill Lynch: > “Pioneer is taking advantage of high commodity prices to monetize a very stable, low risk asset” > “We think it makes sense given that Pioneer’s reserves are currently valued under $7.00/BOE” (VPP was effectively sold for $23.00/BOE) Volumetric Production Payments – An Effective Monetization Strategy

26 26 | Wachovia Securities Selected Structured Transactions $548,700,000 Oil / Gas Volumetric Production Payment Securitization ¸ Sole Arranger December 2005 $317,400,000 Volumetric Production Payment in Spraberry Oil Field ¸ Sole Arranger January 2005 $143,400,000 Investment in Volumetric Production Payment ¸ Sole Senior & Preferred Capital Provider August 2004 Irish Ocean L.P. Volumetric Production Payments – An Effective Monetization Strategy $275,500,000 Volumetric Production Payment in Hugoton Natural Gas Field ¸ Sole Arranger January 2005

27 27 | Wachovia Securities THE INFORMATION YOU ARE RECEIVING HAS BEEN SUPPLIED TO WACHOVIA CAPITAL MARKETS, LLC BY SOURCES DEEMED RELIABLE. THIS INFORMATION IS BEING FURNISHED BY WACHOVIA CAPITAL MARKETS, LLC SOLELY FOR USE BY PROSPECTIVE SELLERS OR INVESTORS OR BUYERS AND IS NOT TO BE REPRODUCED OR USED FOR ANY OTHER PURPOSES. WACHOVIA CAPITAL MARKETS, LLC MAKES NO REPRESENTATION OR WARRANTY WITH RESPECT TO THE ACCURACY, ADEQUACY, USEFULNESS OR COMPLETENESS OF THE INFORMATION PROVIDED. WACHOVIA CAPITAL MARKETS, LLC MAKES NO REPRESENTATION OR WARRANTY AS TO THE ACCURACY OR COMPLETENESS OF THIS INFORMATION AND SHALL HAVE NO LIABILITY FOR ANY REPRESENTATION (EXPRESSED OR IMPLIED) CONTAINED IN, OR FOR ANY OMISSIONS FROM, THIS INFORMATION OR ANY OTHER WRITTEN OR ORAL COMMUNICATIONS TRANSMITTED TO THE RECIPIENT IN THE COURSE OF ITS EVALUATION OF THIS INFORMATION. PROSPECTIVE SELLERS OR INVESTORS OR BUYERS ARE NOT TO CONSTRUE THE INFORMATION PROVIDED AS LEGAL, ACCOUNTING, BUSINESS OR TAX ADVICE. EACH PROSPECTIVE SELLER, INVESTOR OR BUYER SHOULD CONSULT AN ATTORNEY, BUSINESS ADVISOR AND TAX ADVISOR AS TO LEGAL, BUSINESS, TAX AND RELATED MATTERS. SELLERS OR INVESTORS OR BUYERS MAY DISCLOSE TO ANY AND ALL PERSONS, WITHOUT LIMITATION OF ANY KIND, THE TAX TREATMENT AND TAX STRUCTURE OF THE TRANSACTION(S) CONTEMPLATED HEREIN AND ALL MATERIALS OF ANY KIND (INCLUDING OPINIONS OR OTHER TAX ANALYSES) THAT ARE PROVIDED TO IT RELATING TO SUCH TAX TREATMENT AND TAX STRUCTURE. HOWEVER, ANY SUCH INFORMATION RELATING TO SUCH TAX TREATMENT OR TAX STRUCTURE IS REQUIRED TO BE KEPT CONFIDENTIAL TO THE EXTENT NECESSARY TO COMPLY WITH ANY APPLICABLE FEDERAL OR STATE SECURITIES LAWS. WACHOVIA SECURITIES IS THE TRADE NAME FOR THE CORPORATE AND INVESTMENT BANKING SERVICES OF WACHOVIA CORPORATION AND ITS SUBSIDIARIES, INCLUDING WACHOVIA CAPITAL MARKETS, LLC, MEMBER NASD, NYSE AND SIPC AND WACHOVIA BANK, NA. Disclaimer


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