Finance review

Historically Tullow has primarily been funded through a combination of operational cash flow, portfolio management and reserve based debt facilities.

The scale of our current exploration portfolio, exploration success and associated appraisal together with the fast-track development of two world-class basins in Ghana and Uganda have resulted in a number of important operational and financial strategic decisions being taken in 2009 and 2010.

These will enable the Group to continue to grow and underpin the business with an appropriate capital structure. Key decisions include:

• Continued operational focus on the development of Jubilee Phase 1 in Ghana, the commercialisation of the Lake Albert Rift basin in Uganda and a high-impact exploration drilling programme;
• Raising £402 million of equity and extending the reserve-based lending debt facility to US$2 billion in the first quarter of 2009, and adding a Corporate debt facility of US$250 million in December 2009;
• Taking a decision to pre-empt the sale of Heritage’s Ugandan assets and then working to farmdown our interests to 33¹/₃% by bringing in partners to deliver a unified and accelerated basin development plan; and
• Raising a further £925 million of equity in January 2010 to facilitate the Uganda pre-emption and then, after the farmdown, to provide substantial financial flexibility for the foreseeable future.

From a financial perspective, these decisions allow Tullow to bridge the gap between the Group’s current cash and profit generating ability and more significant production and cash flow in the future. This starts with Jubilee Phase 1 production in the fourth quarter of 2010.

Key financial metrics
	2009	2008	Change
Cash operating costs are cost of sales excluding depletion, depreciation and amortisation and under/over lift movements. Net debt is cash and cash equivalents less financial liabilities net of unamortised arrangement fees. Interest cover is earnings before interest, tax, depreciation and amortisation (EBITDA) charges and exploration written-off divided by net finance costs. Gearing is net debt divided by net assets.
Production (boepd, working interest basis)	58,300	66,600	-12%
Sales volume (boepd)	48,350	55,000	-12%
Realised oil price (US$ per bbl)	60.0	73.6	-18%
Realised gas price (pence per therm)	39.3	52.4	-25%
Cash operating costs per boe (£) 1	7.28	5.90	+23%
Operating cash flow before working capital per boe (£)	15.8	21.3	-26%
Net debt (£ million) 2	718	400	+80%
Interest cover (times) 3	6.3	17.8	-11.5 times
Gearing (%) 4	47	31	+16%

2009 financial results

2009 financial results were down compared with the record results recorded in 2008 primarily because of the following:

• Production volumes were down as expected by 12%;
• Lower oil and gas prices and the impact of Sterling weakness on Dollar-based costs;
• Exploration write-offs were £174 million lower in 2009, but this was more than offset by asset disposal proceeds that were £233 million higher in 2008; and
• An IAS 39 charge of £37 million in 2009 compared with a credit of £43 million in 2008.

Production, commodity prices and revenue

Working interest production averaged 58,300 boepd, 12% lower than 2008, due to natural decline in mature fields and deferred production due to the reallocation of capital to development projects and high-impact exploration. Sales volumes averaged 48,350 boepd, representing a decrease of 12%, also driven by changes in the proportion of sales arising from Production Sharing Contracts (PSC).

On average, oil prices in 2009 were lower than 2008 levels reflecting the global economic downturn. Realised oil price after hedging for 2009 was US$60.0/bbl (2008: US$73.6/bbl), a reduction of 18%. Tullow’s oil production sold at an average discount of 2% to Brent Crude during 2009 (2008: 4% discount).

UK gas prices in 2009 were significantly lower than 2008 levels. The realised UK gas price after hedging for 2009 was 39.3 pence/therm (2008: 52.4 pence/therm), a reduction of 25%.

Lower commodity prices and lower sales volumes were partially offset by the weakening of Sterling against the US Dollar, which averaged approximately GBP£1:US$1.55 in 2009 compared to GBP£1:US$1.90 in 2008. Overall revenue decreased by 16% to £582.3 million (2008: £691.7 million).

Operating costs, depreciation and impairments

Underlying cash operating costs, which exclude depletion and amortisation and movements on under/overlift, amounted to £155.1 million; £7.28/boe (2008: £143.9 million; £5.90/boe). In absolute terms cash operating costs increased by 8%, principally due to the significant weakening in Sterling during the period which materially affected the cost in Sterling terms of the underlying US Dollar cash operating costs. Cash operating costs on a per barrel basis increased by 23% above 2008 levels, also impacted by the decrease in production volumes during the year.

Depreciation, depletion and amortisation charges before impairment charges for the year amounted to £223.2 million; £10.54/boe (2008: £198.4 million; £8.14/boe). The depreciation rate for 2009 was also materially affected by the weakening of Sterling when compared to 2008. The Group has also recognised an impairment charge of £8.1 million; £0.38/boe (2008: £26.3 million; £1.08/boe) in respect of the Chinguetti field in Mauritania.

At the year-end the Group was in a net overlift position amounting to 148,000 barrels. The movements during 2009 in the overlift position compared with 2008 and stock movements during the year have given rise to a charge of £6.3 million to cost of sales (2008: credit of £6.4 million).

Administrative expenses of £49.5 million (2008: £43.0 million) include an amount of £11.3 million (2008: £7.9 million) associated with IFRS 2 – Share-based payments. The increase in total general and administrative costs is also due to the continued growth of the Group during 2009 with staff numbers increasing by 24% to 669 people.

Exploration cost written-off

Exploration costs written-off were £52.8 million (2008: £226.7 million), in accordance with the Group’s ‘successful efforts’ accounting policy, which requires that all costs associated with unsuccessful exploration are written-off in the income statement. This write-off is principally associated with exploration activities in Côte d’Ivoire, new ventures activity and licence relinquishments. In 2008, Tullow undertook a fundamental review of its exploration portfolio following the decision to focus on fast-tracking its discoveries in Ghana and Uganda coupled with a more selective high-impact exploration programme. This resulted in significant write-offs in respect of interests in Mauritania, Suriname, Tanzania and Trinidad and Tobago.

Derivative instruments

Tullow continues to undertake hedging activities as part of the ongoing management of its business risk and to protect the availability of cash flow for reinvestment in capital programmes that are driving business growth.

At 31 December 2009, the Group’s derivative instruments had a net negative mark-to-market value of £11.1 million (2008: positive £49.3 million). This is principally due to the increase in the oil price from the beginning of 2009.

While all of the Group’s commodity derivative instruments currently qualify for hedge accounting, a pre tax charge of £37.2 million (2008: credit of £42.9 million) has been recognised in the income statement for 2009. The charge is principally due to a combination of Brent forward oil prices strengthening during the year and reduced volatilities, with a consequent reduction in the time value of the oil derivative instruments for Tullow. This was only partially mitigated by a credit for time value on gas derivative instruments arising from UK gas prices, which weakened during the year.

Commodity hedging summary

At 3 March 2010 the Group’s commodity hedge position to the end of 2012 was as follows:

Hedge Position
	2010	2011	2012
Oil Hedges
Volume – bopd	14,500	11,000	7,000
Current Price Hedge – US$/bbl	81.66	83.55	84.68
Gas Hedges
Volume – mmscfd	29.45	10.43	4.31
Current Price Hedge – pence/therm	42.00	45.98	47.06

Operating profit

Operating profit amounted to £95.1 million (2008: £299.7 million), a decrease of 68%. The reduction was principally due to lower commodity prices and sales volumes and less profit relating to portfolio management activities, partly offset by lower exploration costs written-off during 2009.

Gearing, financing costs and interest cover

The net interest charge for the period was £37.6 million (2008: £43.3 million) and reflects the increase in net debt levels during 2009 offset by an increase in interest capitalised during the year on qualifying assets, principally due to the Jubilee phase 1 development in Ghana.

At 31 December 2009, Tullow had net debt of £718.3 million (2008: £400.3 million), while unutilised debt capacity was in excess of US$620 million. The Group’s gearing was 47% (2008: 31%) and EBITDA interest cover has decreased to 6.3 times (2008: 17.8 times).

Taxation

The tax charge of £1.8 million (2008: £73.1 million) relates to the Group’s North Sea, Gabon, Equatorial Guinea, Ghanaian and Mauritanian activities. After adjusting for exploration costs and profit on disposal of subsidiaries, the Group’s underlying effective tax rate is 3% (2008: 26%). The reduction in the effective tax rate is principally due to the recognition of tax losses available for utilisation against future revenues from Ghana.

Dividend

The Group has significant opportunities to increase shareholder value by continuing to invest in its portfolio of assets, principally in Ghana and Uganda, and the Board feels that it is appropriate to maintain the final dividend at the 2008 level. Consequently the Board has proposed a final dividend of 4.0 pence per share (2008: 4.0 pence per share). This brings the total payout in respect of 2009 to 6.0 pence per share (2008: 6.0 pence per share). The dividend will be paid on 21 May 2010 to shareholders on the register on 16 April 2010.

Summary cash flow
	2009 £m	2008 £m
Revenue	582.3	691.7
Operating costs	(161.4)	(137.5)
Operating expenses	(42.4)	(35.4)
Cash flow from operations	378.4	518.8
Working capital and tax	(203.4)	(8.0)
Capital expenditures	(757.4)	(460.4)
Investing activities	11.8	288.7
Financing activities	457.8	(151.7)
Net (decrease)/increase in cash and cash equivalents	(112.7)	187.4

Operating cash flow; focused capital investment

Reduced commodity prices and lower sales volumes led to an operating cash flow before working capital movements of £373.5 million (2008: £518.8 million), 28% lower than 2008. This cash flow together with the equity placing proceeds helped facilitate 2009 capital investment of £757.4 million in exploration and development activities, payment of dividends and servicing of debt facilities.

Based on the current estimates and work programmes capital expenditure for 2010 is forecast to be £990 million. Approximately 40% of this investment will be for exploration and appraisal and the remainder will be on development and production activities. Tullow’s activities in Ghana and Uganda will comprise approximately 60% of the anticipated 2010 capital outlay.

Balance sheet

Total net assets at 31 December 2009 amounted to £1,525.9 million (31 December 2008: £1,309.2 million), with the increase mainly as a result of the 9.1% share placing in January 2009, currency translation adjustments and hedge movements.

Net assets decreased by £32.7 million in the year due to the movement of the hedge reserve in accordance with IAS 39 – Financial Instruments: Recognition and Measurement. A reduction in net assets (foreign currency translation reserve) of £125.8 million resulted from the strengthening of Sterling against the US Dollar from US$1.45 to US$1.60 in the year. As a consequence, underlying US Dollar denominated assets decreased in Sterling value terms at the year end.

Portfolio management

During 2009 Tullow completed the sale of the Chachar field in Pakistan for US$7.5 million (£4.8 million), received final consideration from the sale of the Hewett-Bacton interests and farmed out an interest in the Guyane Maritime licence in French Guiana to Shell and Total.

In October 2009, Tullow commenced a transparent farmdown process to sell a proportion of its interests in Blocks 1, 2 and 3A in the Lake Albert Rift Basin in Uganda. The purpose of this process was to bring in an experienced and like-minded partner with downstream expertise to commence an accelerated basin-wide development plan. The process gained strong interest from a number of major international and national oil companies who visited the dataroom and operations and made representations to the Government of Uganda.

On 23 November 2009 Heritage Oil plc, Tullow’s partner in the basin, announced that it intended to sell its entire interests in Uganda. On 17 January 2010, Tullow chose to exercise its right of pre-emption on this transaction and formal request for Government consent for the assets to be transferred to Tullow was submitted on 2 February 2010. The acquisition price for these interests is up to US$1.5 billion.

Tullow is now working closely with the Government to gain approval for the pre-emption of the Heritage interests in parallel with the farmdown process which is now at an advanced stage. Two new potential partners have been identified, CNOOC and Total and it is expected that each partner will take a one third interest in each of the three blocks. Presentations by all parties have recently been made to the relevant Ugandan authorities and Tullow expects the transactions to be signed by the end of April 2010. This will result in a unified partnership with considerable experience and financial capability to enable Uganda to become a significant oil producing nation.

Long-term funding

In March 2009 Tullow finalised arrangements for US$2 billion (£1.28 billion) of new debt, structured in the form of secured reserve-based lending facilities with a seven-year term. In December 2009 this was supplemented with a new US$250 million (£160 million) revolving credit facility. Tullow raised £402 million in a placing of ordinary shares in January 2009 and in January 2010 the Group raised an additional £925 million in a further placing of ordinary shares. Together with the anticipated proceeds from the Ugandan farmdown process, this funding significantly strengthens the balance sheet as Tullow seeks to:

• Maintain a US$500 million (£320 million) per annum exploration programme and develop longer-term exploration options;
• Accelerate development in Uganda across a unified basin with new partners; and
• Progress activities in Ghana with accelerated appraisal of the Tweneboa discovery and initiate subsequent phases of the Jubilee development.

Accounting policies

UK listed companies are required to comply with the European regulation to report consolidated statements that conform to International Financial Reporting Standards (IFRS). The Group’s significant accounting policies and details of the significant accounting judgements and critical accounting estimates are disclosed within the notes to the financial statements. The Group has not made any material changes to its accounting policies in the year ended 31 December 2009.

Presentational currency

With effect from 1 January 2010 the Group will present its financial statements in US Dollars. The Group has decided it is now appropriate to change the presentational currency from Sterling as the majority of the Group’s activities are in Africa where oil revenue and costs are Dollar denominated.

Liquidity risk management and going concern

The Group closely monitors and manages its liquidity risk. Cash forecasts are regularly produced and sensitivities run for different scenarios including, but not limited to, changes in commodity prices, different production rates from the Group’s portfolio of producing fields and delays in development projects. The Group normally seeks to ensure that it has a minimum ongoing capacity of US$500 million (£320 million) for a period of at least 12 months to safeguard the Group’s ability to continue as a going concern.

Following the placing announced in January 2010, the planned portfolio activity and with the US$2 billion (£1.28 billion) financing already secured in March 2009, the Group’s forecasts and projections show that there is significant capacity and financial flexibility for the 12 months from the date of the 2009 Annual Report and Accounts.

After taking account of the above, the Directors consider that the Group has adequate resources to continue in operational existence for the foreseeable future. Accordingly, they continue to adopt the going concern basis in preparing the 2009 Annual Report and Accounts.

Risk management

Effective risk management is critical to achieving the Group’s strategic objectives and protecting its people and reputation. The management of key risks has been assigned to individual Executive Directors and senior managers. The principal risks and uncertainties facing the Group, their potential impact and the mitigation strategies developed are detailed in the risk management section.

Risks to 2010 performance

In common with other companies in the oil sector, Tullow is exposed to commodity price risk, the delivery of major projects and ensuring safe operations in all locations. The Board determines the specific key risks for the company and required mitigation plans and reviews delivery on a regular basis. Risks for 2010 include delivery of Jubilee first Oil, completion of the Uganda pre-emption and farm-down, and maintaining an adequate hedging programme.

Capital market relationships

Tullow takes great pride in achieving top quartile and best practice performance in investor relations and capital market communications. In 2009, senior management participated in over 200 investor meetings in the UK, Europe and North America and presented at 13 capital market conferences and hosted investors and sell-side analyst events in the UK.

There was strong news flow during 2009 which resulted in positive TSR of 99%, the 14th best performance in the FTSE 100 index and in the top quintile in Tullow’s comparator group. We were also recognised for good disclosure with an award for the Most Effective Overall Annual Report in the FTSE 100 for our 2008 Annual Report.

As part of our ongoing strategy to improve shareholder relations, Tullow commissioned the Rivel Research Group to undertake an independent Investment Community Perception Study in December 2009. The study’s preliminary findings were received in February 2010. The full report will be presented to the Board in April. Initial findings confirmed the high level of respect the investment community has for the Tullow management team and the Group’s strategy. It has also identified specific strategic challenges for the Board to consider and communicate on during 2010. In addition the study demonstrated a high approval rating for the effectiveness of Tullow’s Investor Relations programme, which provides open and transparent disclosure and good access to Tullow executive management.

Financial strategy and outlook

Tullow’s financial strategy is to ensure the Group has a strong and well funded balance sheet. This means having the capacity to undertake a significant and growing activity set through a combination of operating cash flow and an appropriate mix of debt and equity funding, supplemented by selective acquisitions and divestments.

The outlook for 2010 is very positive for Tullow. First oil from Jubilee in the second half of 2010, the Group’s equity fund raising and the successful completion of the Ugandan farmdown will all ensure that Tullow is adequately capitalised to fund its growth strategy.

Ian Springett
Chief Financial Officer