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Spotlight: Surety bonds - The evolving energy sector

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Surety bonds can offer companies across various industries a method of managing their liquidity challenges. Post looks at the rapidly changing energy sector and how surety guarantees are a potential solution for managing risks if companies are unable to meet contractual obligations.

Currently, in all aspects of life, we are searching for some assurance from a very uncertain world. From thousands of workers across the UK wondering when they will once again return to the workplace, all the way down to our children considering whether or not their crucial, life-changing exams will take place this year.  

The impact of Covid-19 has been vast. The International Monetary Fund has reported that Britain’s economy contracted by 10% in 2020 and predicted that activity in Britain and the European area is not likely to reach pre-Covid levels until 2022.  

So, how do business sectors continue to grow, develop, and prosper amid such ambiguity?  

The energy sector, for one, is feeling the pinch of change.  

A report by the International Energy Agency, Global Energy Review 2020, shows that countries “in full lockdown are experiencing an average 25% decline in energy demand per week and countries in partial lockdown an average 18% decline”.  

Growing demand for security  

It’s not just usage effecting the energy sector, because those companies in the business of exploration and development of oil or gas reserves, drilling or offshore wind power are also impacted.  

Large scale operations within this sector are reliant on fast, efficient supply chains which are being adversely impacted by staff and material shortages. These supply chains are, therefore, becoming harder to plan, organise and predict.  

As Graham Mitchener, practice leader – surety and builders warranty, Willis Towers Watson Australia, explains in an article published on the global advisory and broking website, this unpredictable nature is building demand for security.  

“It’s a truism that, in a buyers’ market, insurers or sureties will treat ‘what they don’t know as a positive’. In the current market it is the opposite: their approach is now treating what they don’t know as a negative. There is widespread fear of incurring losses.” 

This uncertainty or ‘fear’ has led those operating within the energy sector to consider how they manage this risk. Should a business in the energy sector be unable to meet contractual obligations due to the pandemic, or any other reason, who is accountable?  

The surety bond is one potential solution.  

Andrew Evans, head of surety, UK and Ireland, at Liberty Mutual Surety, describes this as a “three-party arrangement between a contractor or business (the principal), the project (the obligee), and the surety. The bond guarantees that the principal completes all contractual obligations to the obligee – and if the principal can’t fulfil the obligations, the surety is responsible for ‘making things right’”. 

New requirements for an evolving energy sector 

It’s not just uncertainty in the market that is pushing energy companies to consider different ways it can provide security within contracts. The energy sector is evolving in many different ways, and some of these changes are providing the perfect scenario for surety bonds.  

One such shift is the movement of ‘major’ oil companies in oil-producing basins, like the North Sea. As major oil companies have started to migrate away from the area in search of more profitable locations, smaller outfits begin to swoop in, explains Tim Clarke, managing director, energy division, Marsh JLT Specialty.  

“As with any mature producing basin like the North Sea, once it gets towards the latter end of that cycle, from say the 1980’s to another 25 years, it’s usually the case the smaller, independent companies come in to manage the assets. ‘Majors’ are after the big fields, and they have the large overheads and the margins are smaller.” 

But the UK government, which is responsible for the use and exploration of this area, is dealing with a different kind of business when the major companies step out. The challenge, of course, is that the smaller companies simply do not have the same size balance sheet as the major companies, therefore driving up risk and concern for the government – where primary concern lies with the taxpayer.  

Take an example from 2018, when ‘majors’ BP and Shell received approval for their 50-50 joint Shetland venture. An agreement like this, between two significantly sized companies, can leverage security in the form of a parental company guarantee.  

This kind of security simply isn’t available to smaller companies.    

“Outside of the major oil companies there is still tremendous financial backing, but their balance sheets are smaller and they can’t lean on the PCG to satisfy their decommissioning security obligations. So, they need to come up with an alternative form of security. The key driver is the government requiring the oil companies to, individually, provide such security to ensure that, in the event of early abandonment, it’s not the taxpayer that pays,” adds Clarke.  

Surety minds the gap  

In steps surety. The first port of call, and possibly the default reaction in instances like this is to pay a visit to the bank manager. However, getting a line of credit as insurance against problems or hold-ups requires cash being stacked behind the arrangement. And, in the current climate, not all businesses want to use cash in this way, or indeed have the cash required for the security. 

Surety bonds are able to release this money, instead of tying it up and rendering it useless for growth and development. Put simply, surety has become an option that works far better than a letter of credit because companies can still access cash in a way that wasn’t previously possible with a bank agreement. 

Another important element of this migration away from areas like the North Sea, that requires consideration from an insurance perspective, is the legacy that is left behind. There is, it would appear, no such thing as a ‘clean break’. A major company will still be accountable should there be any issues with the new owners of the licence after they moved on. And, with smaller companies unable to provide a PCG, a surety bond between the incoming and outgoing can fill yet another gap.  

“The final piece is that the US majors like Marathon Oil, Chevron, Conico Oil have pretty much gone now, and ExxonMobil are about to go. Demand is high because there is so much up for grabs. When they leave the North Sea they want to make sure they’re not going to get pulled back in with any legacy credit problems – because you never get off the licence.  

“If one company sells a licence to another and there are issues 20 years later the prior owner is still involved. They will always want to make sure that the new company is in good shape,” insists Tim Clarke, managing director, energy division, Marsh JLT Specialty. 

But it’s not just about viability, it’s also about mitigating risk. For energy companies operating in uncertain times, it makes complete sense to free up capacity with banks where possible.  

“Our clients have a better understanding today of what is available, from a risk management point of view. It makes sense to have some risk with banks and some with insurers – don’t have all your eggs in one basket.”  

Cash reserves pressure  

It’s also true that the pandemic has mounted pressure on cash reserves for businesses. Naturally, projects have slowed down, spending has reduced and decision-making has been cautious.  

An October 2020 report by the Office for National Statistics showed that almost two-thirds (64%) of UK businesses were at risk of insolvency in the month of September 2020. Nearly half (43%) of companies at that point had less than six months cash reserves. In these unpredictable times, holding on to cash is paramount.  

Even those that have managed to survive with government-backed schemes such as furlough and the coronavirus business interruption loan scheme, will be increasingly reliant on banks to loan money and financially support growth into the future. 

Paul Smith, head of construction at global insurance and risk management firm, Gallagher, explains: “Using a surety bond rather than a bank guarantee can free up those working capital facilities, leaving the principle to use the bank facilities for other means to grow the business and invest in research and development, for instance.”  

This would appear to strengthen the case for those in the energy sector looking to spread dependency away from banks, and towards alternative suppliers and providers.   

“With surety bonds, businesses are not using up credit with banks for things that they don’t need to – debt for instance, banks are really good at managing. Use insurers for guarantees, surety bonds and all the things that we’re good at,” says Andrew Evans, head of surety, UK and Ireland, at Liberty Mutual Surety.

And, the energy sector is one that will require substantial investment over the next few years if various energy transition milestones, targets and ambitions are to be met.  

Energising transition with major investment  

While the pandemic may well have slowed down energy consumption and created a level of demand for security among those investing in projects, one area that is seemingly growing is energy transition – the switching from fossil fuels to renewable energy sources.  

“The energy sector is wide ranging. There’s the normal business performance side of things and then there’s energy transition, like wind farms off the North Sea, helping us to move away from fossil fuels. This means huge amount of engineering work and if you listen to all of the European government plans, it’s coming,” explains Evans. 

According to provider of strategic research into energy transition, BloombergNEF, global investment in renewable energy capacity increased by 2% last year, despite Covid-19’s grip, while 80% more companies reportedly set science-based decarbonisation targets in 2020 than in 2019.  

Couple this with the United Kingdom of Great Britain and Northern Ireland’s Nationally Determined Contribution report, which commits £12bn investment to create and support up to 250,000 highly-skilled green jobs in the UK, and unlock three times as much private sector investment by 2030. 

On a global scale, if as a collective we are to reach the targets of the Paris Agreement, we must shift energy investments to low-carbon energy sources and reach a total of $131tn by 2050, according to a report by the International Renewable Energy Agency, published in March 2021.  

Evans confirms: “The capacity for banks will be needed for investment so they need someone else to provide guarantees, I believe, because the banks can’t do it all by themselves.” 

There is no doubt that the energy sector is in a cycle of change. From mounting pressure for us all, personally to be more responsible with usage all the way down to oil companies decommissioning platforms and businesses battling with unpredictable supply chains.  

And, changing landscapes require alternative solutions, which is where surety bonds can clearly add significant value.  

Whether it is to help companies to add that level of security to contracts during a very uncertain time, or whether it supports businesses to use banks in the most appropriate way while cash reserves are low, as a solution, surety bonds may never have been so relevant.  

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