As it awaits government approval, the Cairn-Vedanta deal hangs perilously in the balance. The deadlock stems from an old dispute over royalty payments, but has nonetheless shaken investor confidence

Contrary to popular belief, the Cairn-Vedanta deal is not shrouded in layers of complexity. Elements of its financing structure admittedly convey sophistication, marrying debt, equity and capital markets, but the deal in its essence is straightforward.

On 16 August last year, Edinburgh-based Cairn Energy signed an agreement that would give 51-60% of its Cairn India subsidiary to UK mining giant Vedanta Resources. To satisfy India’s takeover regulations and complete the US$9.6 billion deal, Vedanta, through its Indian subsidiary, iron ore producer Sesa Goa, would offer Cairn India’s minority shareholders ₹355 (US$8) per share for up to 20% of the shares of Cairn India.

Based on the subscription in the open offer, Cairn Energy would then give up between 40% and 51% of its ownership to Vedanta so that the mining company would enjoy majority control. On top of that, Cairn’s promoters would be paid an extra ₹50 per share as non-compete fees.

“The structure kept moving from trying to do an offshore transaction to trying to do an onshore transaction and worrying about the regulatory approvals that may be required at each stage,” says Uday Walia, a partner at S&R Associates who advised Cairn Energy on the deal.

“We explored several options and finally decided on the option which was possibly the simplest and the cleanest. We sell shares of Cairn India, which will trigger the Takeover Code. That will become an obligation of Vedanta and Vedanta will then need to fund the open offer, and an overseas Vedanta entity will buy the shares from Cairn.”

Not so easy

Sadly for Cairn’s CEO, Bill Gammell, and Vedanta’s founder and chairman, Anil Agarwal, the sale has been a painful experience, mired in scuffles that have extended its deadline from 15 April to 20 May. Indian authorities have argued that government consent is mandatory in a deal where ownership of the country’s national oil and gas assets is being transferred.

Walia says this is unreasonable. “Our contention is we’re not transferring the interest, because we’re not selling the interest held by Cairn India and its subsidiaries in these production sharing contracts,” he says. “We’re only selling shares at the top level, so the operator remains the same. There’s no need for Cairn to come to the government for consent.”

The deal hinges dangerously on the outcome of an old dispute over royalty payments between Cairn India and its state-owned partner, Oil and Natural Gas Corporation (ONGC). The government is torn over whether to give the deal a green light and address the tussle over royalties later, or whether to settle the issue first.

Indian petroleum and natural gas minister Jaipal Reddy said on 6 April that a committee of ministers would discuss the transaction and aim to respond with a “quick” report, although he added, “I cannot indicate a time frame”.

Exploiting the deal

ONGC’s resentment over royalties has bubbled quietly for years. Contractual obligations have forced it to pay 100% royalties on the production of crude in an oil block in Rajasthan operated by Cairn India, in which ONGC holds only a 30% interest.

The block was initially operated by Shell India. In 1997, Cairn India sold half of its Bangladeshi interests to Shell and obtained an interest in Shell’s Rajasthan block as part of the deal. Then in 2002, Cairn India acquired the rest of Shell’s interest in Rajasthan for around US$7.5 million, giving it total control of the area.

The arrangement dates back to the time when oil exploration in India was just beginning. To attract big oil companies, the Indian government offered to cover all royalty payments on any discoveries. However, if the foreign explorer made a commercial discovery, the government, in the shape of ONGC, would have the right to back in for 30%. In essence, the government was encouraging foreign companies to bear the exploration risk.

In 2004, Cairn discovered a huge oilfield giving ONGC the chance to claim 30%, which meant Cairn’s stake was reduced to 70%. ONGC obtained 30% interest in eight out of 10 blocks in Rajasthan but it remained liable for 100% of all royalty payments.

As part of this arrangement, the Indian government casually promised to compensate ONGC for 70% of the royalties. Unfortunately, this was only a verbal agreement, which the government has not honoured.

Riding high in Rajasthan: Cairn discovered US$4 billion of oil reserves on an oil block it had bought for just US$10 million.
Riding high in Rajasthan: Cairn discovered US$4 billion of oil reserves on an oil block it had bought for just US$10 million.

“The government not compensating ONGC is just one of those things that happens a lot in the Indian oil and gas sector,” explains Alok Deshpande, a research analyst specializing in oil, gas and petrochemicals at Elara Securities (India). “You’ll see a similar trend with oil marketing companies. They are never compensated by the government on time. It’s not as if the government does not want to compensate ONGC, it’s just that the processes and decision-making are so slow that typically these things get delayed.”

Deshpande describes the agreement as “peculiar”, but says the contract is to blame for its lack of clarity. Most contracts signed since the introduction of the New Exploration Licensing Policy (NELP) are more clearly drawn.

“Cairn was one of the companies that came to India and took the job at a time when India was not very readily giving out exploration acreages,” notes Deshpande. “Most of the acreages at the other pre-NELP blocks were owned by ONGC and Oil India. It’s not that private players have more control now, but they have more specific and precise norms when operating a block.”

ONGC slowly realized that paying royalties on Cairn’s behalf was a burden it could not shoulder for much longer. So for the state-owned company, Cairn’s offer to sell its stake to Vedanta was a godsend – and the perfect opportunity for ONGC to renegotiate the terms of its production sharing contract.

ONGC hopes the royalties it currently pays can be designated as capital expenditure. The company maintains that it should be able to recover all the capital it has spent before it shares any profits with the government.

By contesting the terms of the antiquated production sharing contract, ONGC is effectively threatening to derail the Cairn-Vedanta deal. The Indian government’s willingness to consider this question now has enraged proponents of the deal. However, solving the royalty issue could greatly benefit the Indian government, which plans to sell 10% of ONGC in the next couple of months. If ONGC’s royalty obligations are reduced, its value would improve dramatically.

Amending the contract is a long and laborious task, which requires parliamentary approval. “In the UK, we actually increased our tax on oil companies in the last budget,” says Piper. “It’s quite easy to change the terms in the UK. But in India, these production sharing contracts are actually laws, which makes it very difficult and I think the chances of this being changed fundamentally are pretty slim. Of course, if they did change, the value of Cairn would be lower, there would be a material change on the deal. Vedanta, I would have thought, would walk away.”

According to Walia, ONGC is arguing that it has the right of first refusal on the sale of Cairn India’s assets and that in order for it to waive this right, Cairn India must settle the royalty dispute in ONGC’s favour. “That’s just wrong,” says Walia. “You can’t do that. I’ve lost complete faith in the government.”

Uday Walia Partner S&R Associates

Bets both ways

Any company dealing with a commodity as precious as oil often finds itself walking a political tightrope. Adding fuel to the fire, Cairn seeks to entrust one of India’s most productive oil blocks – and potentially billions of dollars worth of crude oil – to Vedanta, an oil virgin with a somewhat troubled history in the country.

Many say the government’s concerns over this deal are legitimate and in the national interest. India relies heavily on oil imports, bringing in 80% of its oil requirements. The Rajasthan oilfield produces about 20% of India’s oil and it could produce more.

Although the wait for government approval has been excruciating, many believe the deal will eventually go through. Some analysts argue that Cairn simply started on the wrong foot.

“I don’t think it is right to say that the government is blocking the deal,” says Piper. “Cairn Energy thought, because it’s a corporate deal, not an asset deal, they didn’t require government approval. The process has been elongated rather than blocked so that the government has the time to properly assess the deal. And I think they’ll give approval shortly. But there is due process that needs to be undertaken. And because Cairn didn’t involve the government directly from the get-go, the timelines have just been lengthened.”

The deal may be what India needs to encourage more investment in the oil and gas industry. Vedanta cannot boast crude expertise, but it is heavily involved in resources and familiar with the economic and business climate in India. Moreover, Vedanta is to retain Cairn India’s management team, geologists and engineers. The expertise will therefore stay in place, which could give the government the reassurance it needs to bestow its blessing.

Auspicious precedent?

It could be in India’s best interests to propel Cairn and Vedanta to the finish line for a variety of reasons. From a legal perspective, the financial structure and funding of the acquisition would set a new benchmark for Indian deals. Although the share purchase agreement is straightforward, Vedanta’s success in tapping the global liquidity market is a significant commercial accomplishment. The company reached out to banks and other institutions that could tap the debt, equity and capital markets to amass the war chest needed to acquire an entity, which is virtually of the same market capitalization and itself.

“You’re effectively balancing a number of financings, all of which need to be on a certain funds basis. In other words, the conditionality of the funding needs to be the same, otherwise you’re subject to the weakest link,” says Sanjeev Dhuna, a partner at Allen & Overy, which advised Vedanta. “They all need to work in the same way and they all need to be done at the same time. Otherwise you have a problem because you have a funding gap. So you’re effectively negotiating three or four financings at the same time.”

Few transactions have combined all these dimensions. “This was one of the most challenging deals I’ve ever worked on,” says Dhuna. “It commanded every single brain cell to come up with solutions.

“The backdrop is also important because deals like this are getting done in a context where global liquidity is still constrained and global M&A in the US and Europe has significantly reduced,” adds Dhuna. “The financing used an innovative structure since it gives access to the global debt, equity and bond markets and allows the company to optimize their sources of capital.”

Sanjeev Dhuna Partner Allen & Overy

From a general investment perspective, approving this deal could serve the Indian government well, particularly following ONGC Videsh’s failure to buy Imperial Energy in the UK and the embarrassing brawl between the Ambani brothers over gas pricing. For the most part, global oil majors have shied away from India and the death of this deal could kill their interest altogether. Despite the contractual clarity achieved in the NELP era, Indian contracts still lag far behind when compared to those signed between exploration and production (E&P) players and governments globally.

Deshpande says the only way to ensure a level playing field is to deregulate petrol prices. “If a global oil major wants to come to India, the basic variable which it needs to know is the price it is going to get for its product. If it is not clear about something as simple as that, why would it come and bid?”

“Crude is a cyclical commodity and it will come down to maybe US$75-80 a barrel and that is probably the time the government should really put its foot down and say that diesel prices will not be regulated – it’ll be fee pricing,” he says.

According to Deshpande, India is also missing out by failing to offer E&P players a level playing field to set up a host of businesses including refineries and retail outlets. “If you take Shell, Total or Exxon Mobil – all these big players go into countries or continents where they can be present across the entire oil value chain,” he says. “This is not possible in India today. When rules keep changing every five years, they don’t want to take a chance because E&P is a very long process.”

Alok Deshpande Research Analyst Elara Securities India

At the crossroads

Cairn is in an enviable position. It bought the Rajasthan oil block for US$10 million and went on to discover US$4 billion worth of oil. This achievement may well fuel increased international interest in India’s geology. Yet Cairn’s success belies some inherent problems in the sector.

“Fundamentally, do big oil companies like the rocks in India?” asks Piper. “Not really. And up until very recently is there an active gas market? Not really. And, is it easy to do business in India? Well, I’m not sure. You put them all together and people have just decided there are better places to spend their time.”

But this could change: “I think Cairn needs to just do what it’s been doing, which is just be straight, give all the information they need, keep absolutely focused on the deal completion and just keep putting pressure in the right way on the government to come to a decision,” says Piper. “This deal is slowing production increases on the block. So it’s in everyone’s interest, including India’s, to get it sorted out, get the field producing more oil and everyone’s happy.”

Nathan Piper Equity Analyst RBC Capital Markets

The events that have unfolded over the past eight months are not typical to India, argued a lawyer associated with the Cairn-Vedanta transaction, who requested anonymity. “Look at the difficulties faced by Dubai Ports in the US during the P&O transaction,” he said. “Even though investors may encounter similar problems here, people who are bullish enough will just take that risk and do it. India is too important a market to ignore.”

Whatever the government’s decision, its handling of the Cairn-Vedanta drama will reverberate throughout corporate India and affect India’s efforts to project itself as a stable, sensible place for oil and gas companies to operate. It could open the floodgates to foreign investment, or reinforce the stereotype of a bureaucracy that stands in the way of commercial gain.

Walia has already drawn some glum conclusions: “The unfortunate lesson from this is if you’re in the infrastructure sector, or oil and gas or telecom – any of these important sectors that has direct contact with the government – your exit is going to be fraught,” he says.

“Any changes in the contract and you need to go back to the government and it can impose whatever conditions it sees fit. Courts in this country are going to continue supporting the government and allowing it to behave in a capricious and arbitrary manner. I don’t think it’s acceptable. You can’t on the one hand say you want additional investment when you are in effect dragging your feet over consent in a matter where no consent is required in the first place,” Walia laments.

But despite the problems that have arisen, neither side has given up on the deal. “Cairn and Vedanta continue to work with the government of India to secure the necessary consents and approvals,” Gammell says.