Bond investors should think twice before subscribing to Premier Oil’s (PMO) retail bond offer which is due to close tomorrow (6 Dec). They should ask themselves whether the 5% coupon represents adequate compensation for the risks involved in the oil and gas exploration and production business.

The £1.6 billion cap, whose paper is due to begin trading on the London Stock Exchange’s (LSE) Order Book for Retail Bonds (ORB) on Wednesday (11 Dec), is issuing the bond to diversify its $1.4 billion of net indebtedness away from bank borrowings. The firm’s main bank facility is due for refinancing in 2015.

Premier will use the expected £100 million of proceeds to finance the development of already discovered reserves in order to boost existing output. Discovered reserves include those contained within the firm’s two key North Sea development projects of Solan and Catcher, with expected output from the latter key to achieving its medium-term target of 100,000 barrels of oil equivalent per day (boepd).

Risk and reward

While the bond’s bi-annual distributions compare favourably to the forecast 1.9% dividend yield on the equity, higher coupons attached to safer companies can be found elsewhere on the ORB. Prospective bond investors will note Premier is struggling to meet production targets from its existing assets, a factor behind the poor performance of the equity.

The firm has downgraded this year’s output guidance twice in the past five months, with an initial production target of 65,000 to 75,000 boepd first cut to 63,000 (11 Jul) and then reduced again by up to 10% to 57,000 to 59,000 boepd (23 Oct). Prospective investors in the bonds will know it is the future cashflows from production that will pay the coupons.

Those with an appetite for risk will note the company’s exciting long-term prospects, including the development of its operated Sea Lion discovery offshore the Falkland Islands, and promising exploration sites in Indonesia, Norway, Pakistan and Mauritania among others. The company’s exploration track record this year has been good with six of the seven wells drilled in the first half succeeding, including a significant discovery in Norway.

While the exploration potential could generate much upside for equity investors, bond investors need to analyse whether 5% is adequate compensation. They should ask whether this coupon is big enough to cover the risk that further disappointments from existing production significantly hit cashflows, or the company fails to make sufficient new discoveries to replenish reserves.

Creditor ranking

The offer is the first under the firm’s £500 million Euro Medium Term Note Programme, established last month (18 Nov) to enable it to issue retail or wholesale notes in various markets and currencies. The debt is unsecured, but classed as senior so investors stand ahead of other creditors if the company goes bust, but there is no guarantee of the original investment being returned.

The bond is guaranteed by several of Premier’s subsidiaries, a list of which can be found in its prospectus at: www.londonstockexchange.com/prices-and-markets/retail-bonds/newrecent/pmo1-2020prospectus.pdf. The prospectus flags how exploration is costly and Premier also describes competition in the market for equipment and assets as intense.

The bond, which is also being made available to wholesale investors, is the second issue from the oil and gas industry since the start of the month.It follows the re-opening of EnQuest 5.50% 15 February 2022 (ENQ1:ORB) earlier this week (2 Dec) (see Fixed-income focus, Shares, 28 Nov).

Verdict

Premier Oil offers 5% for funding a risky business while higher coupons attached to safer companies can be found elsewhere on the ORB