Hybrid approach to debt-equity structure
A DATA-DRIVEN APPROACH DELIVERS ACTIONABLE INSIGHTS AND
HELPS DRIVE PRUDENT DECISION-MAKING ON THE OPTIMAL DEBT-EQUITY MIX
PATRICK NG, REAL CORE ENERGY, HOUSTON
GEOFFREY WONG, IAM LEGACY, HONG KONG
WHETHER THE OIL PRICE will be $80 or $50 by 2020, two
challenges are here to stay. They are: 1) reduce variability, and
2) create a finance program that can weather “lower for longer”
oil price scenarios.
In our previous article in the December 2016 issue of OGFJ
(“Operating profitably with $50 oil”), we demonstrated how
alpha-seeking portfolio adjustment works. While pruning a
portfolio can enhance return on the edge, adjustment in itself
may not suffice to move the needle. By extension of the hybrid’s
bottom-up, highly granular, asset-level well economics modeling
and top-down portfolio simulation, we illustrate how a data-driven approach delivers actionable insights and helps drive
prudent decision-making on the optimal debt-equity mix. When
coupled with improved acreage and margins, the hybrid helps
reduce variance and strengthen execution.
First we simulate the universe of portfolios with different weights
of the underlying assets. Figure 1 shows the expected return
and volatility of portfolios. Next, express the incremental gain
in return with respect to volatility as pseudo capital-market
line, and finally determine the optimal debt-equity mix.
We equate reducing variability to narrowing the spread of returns. It can be accomplished by upgrading acreage and, or
adjusting portfolio allocation. While portfolio adjustment can
do only so much, heavy lifting will come from more impactful
acquisition which often requires financing.
The key is lower cost of capital. More concretely, quantify
how the weighted average cost of capital (WACC) varies with
debt/equity ratio. For the purpose of illustration (Figure 2), we
use a reference interest rate of 2.5% and equate the cost of equity
to the expected return of portfolio.
As evident in Figure 3, for rates higher than 8%, there is no
tangent portfolio for the underlying assets. When there is no
tangent portfolio, borrowing works for borrower, but is sub-op-timal for lender. Within the pseudo capital-market line sweep
on positive rates (solid lines), there exist viable portfolios along
the efficient frontier. For each suitable reference rate, there is