The energy industry is very capital-intensive. Projects often require an initial investment of billions of dollars to extract oil and gas, upgrade bitumen, refine crude oil, transport oil and gas products, or generate and distribute power.
An upcoming LNG export project, LNG Canada, is expected to be the largest private sector project in Canada’s history at an estimated $40 billion.
Annual combined investment in new and existing Canadian oilsands projects often exceeds $20 billion per year and peaked about $33 billion in 2014 before global oil prices dropped substantially.
Overall, capital expenditure in Canada’s upstream oil and gas sector exceeded $40 billion in 2017.
When a company decides to build a large-scale project, it needs to arrange funds to pay for the project. While the company may have excess cash generated internally from current operations or from asset sales, typically the company also needs to raise additional funds in the capital markets.
The primary external sources of capital funds that the company may use are equity, debt or some combination of the two.
The overall blend of equity and debt financing that a company uses across all lines of its business is called its “capital structure.”
The cost to the company of each source of capital is a key determining factor in capital structure decisions and has significant implications for the profitability of individual projects and the overall business.
Both industry specific, and overall economic market conditions can influence the availability and cost of capital. Capital structure is commonly expressed as a percentage of equity to total capital and of debt to total capital, or as a total debt to total equity ratio.
The capital structure of a company affects its financial risk level. As more debt is used, the company’s financial risk rises by increasing the likelihood of the company not being able to meet its financial obligations, including required debt payments.
Therefore, the higher the company’s operational risk profile, the less debt it is likely to use in its capital structure.
Upstream companies tend to use more equity in their capital structure, as these companies typically possess higher operating or other business risks, whereas pipeline and electricity companies typically use relatively more debt in their overall capital structure, as these companies tend to carry lower business risk in the energy space.
Capital from equity sources comes from selling shares to shareholders, generally by issuing new common shares on public stock exchanges or through private placements. If the company has never issued shares on a stock exchange before, it is considered an Initial Public Offering (IPO).
Common shares give the purchaser direct ownership in the company, including profits from all of its projects. The company decides when and how much of its profits to retain inside the company versus to distribute to shareholders in the form of dividends or share repurchases:
• Dividends are the most common way shareholders are compensated by the company for investing in common shares. Dividends may be paid on a regular schedule, for example quarterly, or on an ad hoc basis. Pipeline and utility companies tend to have relatively stable operating cash flows, and thus typically pay a steady stream of dividends. Upstream oil and gas companies tend to have more variable operating cash flows, due in part to more exposure to commodity price risk and exploration or other technical risks, so dividend payments may be less certain.
• Share repurchases, or buybacks, are when the company uses its excess cash to buy back a certain amount of shares from investors either at current prices on the stock exchange or by using a tender process offering premium prices. The intended effect of buybacks is to increase the company’s share price and increase the proportionate share of profits for remaining shareholders going forward, since fewer shares are outstanding. Upstream oil and gas companies tend to use share buybacks more frequently than pipeline and utility companies, when they have large but sporadic cash receipts due, for example, to major projects coming online.
- National Energy Board
