What it means
Oil and gas companies often need cash today to drill wells, but their main asset is hydrocarbons that will only be produced over the coming years. In a VPP, an investor buys the right to a defined quantity of that future output, such as a set number of barrels per year, and pays the producer a lump sum now.
The producer then delivers that volume to the investor as it is produced. The arrangement is described as volumetric because it is tied to a quantity, not a dollar amount.
The investor takes the price risk on the oil or gas delivered, because the value of the barrels may rise or fall. The producer, in turn, keeps the cost risk of getting those barrels out of the ground, and usually must keep operating the field.
VPPs are usually structured so that the investor's right is treated as a sale of a share of the reserves instead of a loan, though the accounting and tax treatment depends on the exact terms and on local rules. Finance teams therefore take advice before deciding whether to show the proceeds as debt or as deferred revenue.
The structure also often involves a special-purpose vehicle, a separate legal entity set up to hold the rights. Pricing is based on the present value of the expected future volumes.
The lender estimates the volume, forecasts the net price after production costs, and discounts the stream back at a rate that reflects risk. A higher discount rate, lower expected prices or doubts about reserves all reduce the upfront payment.
Producers like the structure because it can offer cheaper funding than ordinary borrowing and because repayment in kind means that if production disappoints, the obligation is limited to the volume actually produced, depending on the contract. Investors like having an energy-linked asset with a defined delivery schedule.
The risks include falling output, operating failures and uncertain reserve estimates. Producers also give up future production and may have fewer volumes available to sell at high prices.
In practice
Real-world examples.
Example
A mid-sized gas producer needs $2,000,000 to drill two additional wells. Rather than borrow at a high rate, it sells a VPP to an investment fund and delivers a fixed number of cubic feet each month. The wells pay for themselves, and the fund receives gas rather than interest.
Example
A bank wants energy exposure but does not want to own operating assets. It buys a VPP from a small oil company, receiving fixed barrels delivered to a pipeline over four years. The bank sells those barrels on the market and carries the price risk, which it hedges with futures.
Example
A producer's chief financial officer reviews the accounts after signing a VPP and notes that the $2,000,000 proceeds are shown as deferred revenue, released as barrels are delivered. The auditors agree after reviewing the contract terms.
Formula
Calculation
Upfront payment = Sum of (Expected net value of volume in each year / (1 + discount rate)^year)
A producer agrees to deliver 55,000 barrels in year one and 60,500 barrels in year two. The expected net value is $20 per barrel after production costs. Year one value = 55,000 x $20 = $1,100,000, and year two value = 60,500 x $20 = $1,210,000. At a 10% discount rate, the present values are $1,100,000 / 1.10 = $1,000,000 and $1,210,000 / 1.21 = $1,000,000. The investor would therefore pay an upfront amount of $1,000,000 + $1,000,000 = $2,000,000.Case study
Seen in the real world.
Saltmarsh Energy is an illustrative, fictional oil producer with proven reserves but a stretched balance sheet. Banks were unwilling to lend more against its fields, so the finance director explored selling a VPP covering 150,000 barrels over three years.
An investor valued the barrels using a forecast net price of $20 and a discount rate of 12%. After allowing for the risk that wells could underperform, the parties agreed an upfront payment of about $2,400,000.
Saltmarsh used the cash to drill two wells that raised output by 20%. In this fictional case the VPP gave the company funds without adding conventional debt, but the finance director was careful to ensure enough production remained to cover operating costs.
Watch out
Common mistakes.
- Treating a VPP as a plain loan, when its treatment depends on contract terms and can differ for accounting and tax.
- Forgetting that delivering barrels to the investor means giving up revenue that would otherwise be earned later.
- Ignoring reserve risk, since the value of the deal depends on the producer actually being able to deliver the promised volumes.
Questions
People also ask.
Who bears the price risk?
The investor does, because it receives physical barrels or gas whose market price can rise or fall after the deal is struck.
What happens if production falls short?
The outcome depends on the contract, which may limit the producer's obligation to volumes actually produced or may require make-up deliveries later.
Is a VPP only for oil and gas?
It is most common there, though similar volume-based structures are used in mining and other commodity sectors.
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