Restructuring National Oil Companies: The Obligations and Cost of Emerging NOCs

SummaryThe fall in oil prices since mid-2014 has profoundly changed the prospects for national oil companies (NOCs). If, as seems likely, prices remain low for a number of years, investors will be far more cautious, international oil companies will see reduced cash flows, and many exploration projects will be put on hold or cancelled. NOCs, and the oil and gas industry as a whole, must reconsider their strategies. This will have an impact on the ambitious plans that some emerging producers had nurtured for national participation in the petroleum sector, forcing them to refocus on an affordable strategy for developing upstream capabilities. Governments of emerging and prospective producer countries, and their NOCs, need to understand the cost of various NOC roles, and how these can be financed at different stages of developing the resource base. This will enable them to formulate clear and appropriate strategies for the future.The current environment offers an opportunity for governments to refocus their efforts on defining a mandate that supports their national vision and priorities. This requires an evaluation of the resource base, national capabilities (including those of the NOC) and possible revenue streams, so that the NOC can be tasked with a role it can execute and the state can afford. Governments must approve clear revenue streams for NOCs. NOCs should focus on costs, as well as on strong accounting and reporting standards. Governments and NOCs should be strategic about capacity-building, so that efforts and scarce resources are dedicated to building the right skills and using them on the job.IntroductionMajor oil and gas discoveries during the last decade opened new energy frontiers in East Africa and offshore West Africa, as well as in the Caribbean and the Mediterranean. These regions saw a surge of exploration interest from International oil companies of various sizes. However, the fall in oil prices since mid-2014 has profoundly changed the prospects for NOCs. If, as seems likely, prices will remain low for a number of years, NOCs, and the oil and gas industry as a whole, must reconsider their strategies and ambitions. Investors will be far more cautious, international oil companies will see reduced cash flows, and many exploration projects will be put on hold or cancelled. Companies are focusing on developing reserves rather than exploring for new ones. This will have an impact on the ambitious plans that some emerging producers had nurtured for national participation in the petroleum sector, forcing them to refocus on an affordable strategy for developing upstream capabilities.Domestic aspirations in countries with recent discoveries are still strong. However, many national oil companies were created, or existing ones restructured, to take on greater responsibility for exploiting new-found reserves. Some of these NOCs were called on to develop operator capabilities. As an operator, an NOC has legal authority to explore for and produce petroleum resources in a given field. In practice this requires the company to have the capability to propose a development plan, raise money and manage a large project, including supervising international partners and contractors. Given those very high expectations, along with a need to demonstrate to the public an ability to exploit reserves efficiently and transparently, some governments have tasked NOCs with roles they cannot play because of limited capabilities.There is often a mismatch between available finance in emerging producer countries and national aspirations for the extent of NOC activities in the early stages of development. The current environment offers an opportunity for governments to refocus their efforts on defining a mandate that the country can afford. This paper examines the cost of various NOC roles in new or prospective producer countries and how they can be financed at different stages of developing the resource base. Governments of emerging producer countries, and their NOCs, need to understand what is possible today in order to develop clear and appropriate strategies for getting to where they want to be tomorrow.Range of Roles for Emerging NOCsMany emerging producer countries have established NOCs to ensure national participation in the petroleum sector, beyond simple collection of license payments, royalties and taxes. For some countries (Uganda and Timor-Leste, for instance) the establishment of the NOC is quite new. Emerging producers with NOCs established decades ago must now consider how to restructure them to achieve current objectives. The Tanzania Petroleum Development Corporation (TPDC) was incorporated as early as 1969. The National Oil Corporation of Kenya (National Oil) and the Empresa Nacional de Hidrocarbonetos (ENH) of Mozambique were created in 1981; Suriname’s Staatsolie in 1980; the Ghana National Petroleum Corporation (GNPC) in 1983; and the National Petroleum Corporation of Namibia (NAMCOR) in 1991.Over the years, the mandate of these NOCs has changed, usually alternating between a focus on the upstream and the downstream depending on whether promoting new exploration or securing adequate supplies of refined products was more important at the time. For some governments the objective is for their NOC to become an upstream operator. In principle, relying too much on International Oil Companies (IOC) may not be in the national interest since they may not invest as much in developing local human capital and infrastructure. An NOC operator would be expected to transfer more revenue to the Treasury than an International oil company (IOC). Governments also look to established peers, such as Brazil or Malaysia, whose success they attribute to their capable and internationalized NOCs. In many emerging producer countries, petroleum laws provide the NOC with a legal right to take on operator responsibilities for fields;A problem arises when these national priorities are not implemented because they are well above the capabilities of the NOC. Moreover, a lack of clear policy directives or capacity in government institutions can lead the NOC to assume a role in the petroleum sector without a political mandate. NOCs succeed when governments are clear about the role they are meant to play and are committed to both supporting them and keeping a watchful eye over them. NOC roles and resources in four key stages of resource development, this section outlines typical NOC roles and the human and financial resources deployed to carry them out at four key stages in resource development.NOC roles and resources in four key stages of resource developmentThis section outlines typical NOC roles and the human and financial resources deployed to carry them out at four key stages in resource development (see Figure 1). The range of practice (actual spend and manpower) for each role is discussed, with a particular focus on the first two stages. But it is important to note that these may not be optimal. First, the analysis of NOC financial and human resource deployment is largely based on data from the period 2010-14, when high oil prices and strong exploration activity led to a significant growth in NOC ambitions. During this period of high oil prices and strong exploration activity NOC ambitions grew significantly. Most NOCs have since seen their budgets cut as a result of falling oil prices and slowing upstream activity from the fourth quarter of 2014. Second, many NOCs have not relied on manpower mapping exercises to clarify what resources and skills are needed to execute the role assigned to them. The impact of a continuing era of low prices on NOCs at each of these stages is also considered.Stage 1Before commercial discoveryStage 2After discovery, before productionStage 3Early production or small reserve baseStage 4Large-scale or long-term production

Stage 1: Before commercial discoveryRolesDuring the exploration phase the NOC’s role is usually to represent the state in the upstream through minority stakes in licenses awarded to IOCs. NOCs in these instances hold an equity stake, usually between 5 per cent and 20 per cent, which is most often carried financially by the IOCs, at least until discoveries are made and sometimes until production begins. As such, the oil companies that are majority shareholders handle the costs of exploration and development, and sometimes that carried cost is refunded through the revenues of first oil. Governments may grant the NOC a guaranteed minority stake through the petroleum law, or the NOC may be left to negotiate its stake with International oil companies. Many NOCs in the early stages of developing the resources are also tasked with a ‘governance role’. This may involve promotion of the acreage, collection and management of geological data, licensing and/or monitoring IOCs activities.Human resourcesNOCs in the pre-discovery phase vary considerably in the size of their workforce, ranging from less than a dozen upstream experts to 50 or even more. Differences in terms of levels of exploration activities and concessionaire responsibilities explain much of the variation in scale of companies. PetroSeychelles, for instance, which handles promotion for the Seychelles, has a staff of 11. Exploration interest there only restarted in 2012, after the last exploratory well was drilled in 1995. But the small size of the NOC is also attributable to its self-restraint. In contrast, the National Oil Company of Liberia (NOCAL), which has overseen three licensing rounds since 2009, expanded its staff from 37 in 2010 to 146 in 2014. An executive of the company estimated the share of staff involved in carrying out the governance role to be three-quarters of the total.However, this increase in staff was not warranted by the workload in the upstream and became too costly, especially as payments from new contracts signed were delayed by slow ratification. President Ellen Johnson Sirleaf said that ‘despite the obvious decline in revenue that began in late 2013, NOCAL continued hiring staff at an alarming rate with exorbitant benefits, resulting in the current wage bill of over $7 million (US) per annum. In August 2015, following the Board of Directors’ recommendation, NOCAL addressed the funding crisis by laying off more than 80 per cent of its workforce, reducing it from 162 to 43 (including three vice presidents and its CEO). It now has an interim three-man senior management team along with some technical staff, who were given short-term contracts, renewable every two months. Other companies also expanded their workforce, spurred by ambitions to develop upstream operator capabilities.NAMCOR of Namibia, for instance, doubled its staff to 99 between 2013 and 2014. The increase was not attributable to its governance role: while the company advises the ministry and handles data management on behalf of the government, it is not the concessionaire, and exploration activity is limited. Several NOCs have a significantly larger workforce because of their downstream activities. Uruguay’s Administración Nacional de Combustibles, Alcoholes Portland (ANCAP), which has a workforce of 2,837 people, operates a refinery and has a dominant national position in the marketing of products. But the company also nurtures upstream ambitions, and established an exploration and production training centre in 2014.Investing in capacity building in Stage 1 allows the NOC to prepare for a greater operational role at a later stage. Similarly, allowing it to take a majority stake in a license in the pre-discovery stage, with a view to conducting seismic studies and eventually farming out part of the stake to a qualified operator, offers greater opportunities to build skills. But these strategies are risky. The country can gain more if the projects succeed, but it will lose more if they fail. At this stage the risk that a project (or all projects) will fail is greater, so a decision to invest very heavily in NOC engagement is much more perilous.FinanceDay-to-day operating expenses, including capacity-building and training are the greatest cost for NOCs in Stage 1 because their share of costs in projects is usually carried during this exploration phase. The issues of high spend on developing capacity in the upstream in countries without a proven resource base will certainly come to the fore if exploration activity does not yield expected results. In the short term activity levels will drop, as drilling program are put on hold. And in the long term those NOCs cannot be guaranteed future work in the upstream without an established reserve lifespan. Sources of finance are also limited because there are no upstream revenues from production. Most pre-production NOCs rely on government funding, for everything from initial start-up capital to emergency lending in times of trouble and for this reason, budgeting can be uncertain.Funds periodically dry up as more pressing development priorities divert public money from the high-risk and uncertain prospects of the petroleum sector. Disruptions to budgetary allocations have prompted some NOCs to lobby government to do things differently. In a number of African countries, the fuel import mandate and the levy on the sale of petroleum products were devised as means of generating some revenues for the NOC outside the government budget. Some NOCs received as much as a third of their revenues this way. Even though downstream and retail businesses are cyclical and often produce low profit margins, they can contribute a big chunk of finance to the small budgets of Stage 1 NOCs. Naturally, in countries where the downstream is regulated and the NOC bears some or all of the expense of subsidies for petroleum products, downstream activities are not profitable. In Uruguay, for instance, ANCAP is not authorized by the state to pass on fuel cost increases to domestic consumers, and the NOC has had to take on debt to offset losses. However, as its full name indicates, ANCAP’s business is relatively diversified.Stage 2: After commercial discovery, before productionRolesAfter discovery, new opportunities appear. The range of practice begins to widen with respect to the NOCs’ role, with some stepping back from governance functions and commercial ambitions growing. Indeed, some NOCs transition away from responsibilities related to their governance role. For the National Oil Corporation of Kenya, for instance, recent discoveries significantly increased its administrative burden. It is currently transferring its previous governance role to the state. After discoveries, most NOCs continue to hold minority stakes that are financially carried by IOCs partners, but some begin to build more ambitious commercial agendas.They may seek to increase their stakes or acquire stakes in new licenses as oil flows. For example, in 2009 GNPC increased its interest in the recently discovered Jubilee field to 13.75 percent (10 percent carried, 3.75 percent equity participation), with the help of a commercial loan from the World Bank. Some NOCs and governments see an even bolder future than minority stakes. In a number of countries, NOCs have been given somewhat vaguely phrased mandates to operate in the upstream. For instance, TIMOR GAP is ‘entrusted with the development of business activities for upstream exploration and production’ and TPDC is to undertake Tanzania’s commercial aspects of petroleum in the upstream.Human ResourcesShifting the focus to commercial and upstream activities requires the development of a different set of skills. Discoveries in Kenya brought a major change in the role of National Oil. The majority of its manpower was in the downstream and new capacity was required in the upstream. Building on a technical upstream team of 20-25 people, the company recruited a further 34 people, who were sent on postgraduate oil and gas courses abroad. Ghana’s GNPC is another example. As the technical and business adviser of the Ministry of Energy (it was de facto regulator for the sector) during a period of active exploration work in 2000, with its own commercial activities outside the petroleum sector, the company had a staff of 900. In 2002, as a result of the government’s decision to focus on its core upstream business, it scaled down to fewer than 100 staff. The workforce increased again after oil discoveries were made, rising twofold from 117 employees in 2008 to over 250 in 2013.FinanceAfter discoveries NOCs often continue to rely on government allocations for their regular running costs, along with whatever revenues they already had: import mandates, levies, downstream sales and/or data sales. Depending on the licensing terms, some NOCs begin to pay their share of operating costs (‘backin participation’) once reserves are commercially proven. National Oil in Kenya is contemplating a variety of finance mechanisms to fund its minority stake in proven fields. These include shareholder loans, reserve-based lending and partially floated bonds. GNPC also illustrates this type of financial and operational flexibility. Owing to its minority equity stake in fields in the development phase, it was estimated to have investment requirements of over $1 billion over the next 10 years: a study carried out by the World Bank in 2013 expected GNPC’s investment requirements to average over $200 million annually during the peak years of 2014-17, considering costs associated with the simultaneous development of the TEN and Sankofa fields. GNPC structured its deals to allow for capital requirements to be financed by oil company partners as needed.It would then agree to a smaller share of future output. This is essentially a carried interest. For those NOCs seeking to increase their equity participation, access to equity and debt markets improves in Stage 2. External finance empowers NOCs to generate additional revenues and execute a more ambitious program. However, it can be difficult to attract financing at good terms at this stage. This difficulty is compounded today by lower oil prices, which decrease the value of oil assets. Financial markets are also more risk-averse than previously and this may become increasingly the case as rates start to rise. As always, contracting debt also increases risks for both the company and the state for a revenue stream that often remains small or uncertain. The risk of proved discoveries being shelved or delayed indefinitely is greater now than before. Governments will need to be realistic about what their countries can afford.Stage 3: Early production or small reserve baseRolesWhen countries enter the production phase, many NOCs rethink their corporate business strategy. Some NOC operational ambitions may grow and therefore so would their workforce. Some maintain governance roles after production begins, but most emerging producer NOCs today are required to transfer regulatory and licensing responsibilities to the state.Human resourcesThe size of the workforce in Stage 3 depends, of course, on the roles and activities of the NOC, and also on its history. Staatsolie is a well-established, vertically integrated small-scale Surinamese operator, with a workforce of 1,046. It is active in exploration in shallow waters, produces 17,000 barrels of crude oil per day, refines 15,000 bd, and markets, sells and transports crude and refined products. It also has a governance role and handles the assessment of the hydrocarbon potential, promotion of acreage and monitoring of IOCs’ activities on behalf of the state. Nevertheless, in Staatsolie’s case, the team responsible for the governance role is kept deliberately small, at 10 people; four geoscientists, two people working on finance and business, a data engineer, a data technician, a secretary and the manager. The annual budget for this department is $820,000.FinanceNOCs with small production volumes have been much harder hit by the fall in oil price since 2014 than NOCs in Stages 1 and 2 (whose countries benefit from lower fuel import costs). They are more at risk in the lower oil price environment than established, larger producers, as they are more likely to have a concentrated portfolio, maybe just one asset, which may not be viable at lower price levels. Lower prices have an impact on these producers’ revenues and cash flows. They also negatively affect asset value, threatening project viability in some cases and reducing the NOCs’ capacity to raise funds on the capital markets. In this context lenders may require greater securities for loans. These factors contribute to limit investment in projects and capacity development. GNPC is one such NOC negatively affected by the drop in prices. Its $700 million prepayment facility from March 2014 was cut back to $350 million in 2015 because allocated cargoes could no longer meet repayment debt service obligations.Operations in Ghana are also affected, Operators are cutting expenditure, slowing planned activities, reducing exploration activity beyond minimum work obligations, and cutting non-petroleum projects such as capacity-building activities. Indeed, in certain fields, the low oil price regime undercuts the scenarios which underpinned development plans. On the other hand, operational costs may fall over time as demand for industry-specific inputs falls. And GNPC’s own exposure to capital costs relative to that of IOC operators is limited because its interest is carried or is a small participating interest. GNPC also sees opportunities in the relinquishment of licenses by IOCs operators, as it hopes to acquire stakes of these licenses under better terms. However, these opportunities depend on the NOC’s ability to secure the necessary finance. If low oil prices persist, access to and the cost of funds on financial markets will become increasingly problematic for new producers. NOCs will need the skills to make the most of cost reductions in the service sector and to negotiate finance under good terms.Stage 4: Large-scale or long-term productionRolesWhen countries enter the large-scale production stage, the opportunities and challenges NOCs face in terms of human resource development and access to capital are significantly distinct from the previous stages. A key difference is that these NOCs can factor scale and time of production into their decision making, whereas planning for NOCs in previous stages involved a large degree of uncertainty about the resource base. This new horizon can justify the development of upstream operator capabilities by the NOC.Human resourcesRamping up the right skills to take on the operatorship of fields is a common challenge. A typical operator producing 100,000 barrels per day requires about 100 technical staff. As the resource base matures and evolves, the focus of expertise for those staff will also change. In the exploration phase the skills focus will be on geology and geophysics; during development it will be on drilling and completion experience. Later production stages will demand reservoir and production skills. In addition to technical staff, the operator will need accountants, marketers, economists and other administrative staff. Statoil is illustrative of larger operators. It needed 14 years to acquire the skills to become the major operator it is today. During that period, it hired 8,000 staff and it took eight years to turn a profit. Others have had head starts, Sonangol P&P, the upstream subsidiary of Sonangol, took three years to move from operatorship of very small fields to a complex field in Angola (Block 3). The parent company had already been active in the upstream for many years, building its skill base to carry out the concessionaire role when its subsidiary moved to become an operator. Sonangol P&P also benefited from its parent company’s revenue stream, and was supported by external consultants.FinanceWhile NOCs in large-scale producing countries potentially have access to much greater financial resources than those in earlier stages, their financial situation is by no means universally comfortable. Broadly speaking, NOCs with government budget allocations continue to struggle financially, while those able to retain earnings from upstream sales can more easily secure the level of finance required for capital expenditure program. Companies in between, such as GNPC, can hold on to a defined percentage of earnings from sales and transfer the remainder to the state. They are financially constrained but benefit from greater predictability for planning purposes. Finding the right balance is a common challenge, as too much autonomy for NOCs can lead them to abuse public funds for pet projects, while too much state control inhibits their commercial drive and ability. In an era of persistent low oil prices, the ambitions of large producers will be affected too.

With a reduced revenue stream and other pressing budget priorities, governments may lack the patience to continue investing in the petroleum sector through the downturn. This also affects NOCs that retain earnings: there is the risk that the government may ask for increased dividends. Even in good times, most NOCs have had to supplement their revenue through partnerships with International oil companies and through deals on financial markets, where they must compete with private oil companies. They must reassure investors about risk and reward. And this is more difficult today than during the period 2010-14.Expenditure on capacity building and training and development
• NOCAL’s manpower training budget for 2013-14 was $8 million, for a staff of 146, this amounts to $54,794 per employee and represents 28 percent of the company’s total expenditure.
• TPDC spent $2.49 million on training for a staff of approximately 11,036 which amounts to $18,459 per employee per year.
• Before prices fell GNPC planned to spend $34 million per year to develop its capacity (starting from 252 employees, with plans to grow).
• ANCAP spent $40.89 million on training for 2,031 employees across its various activity sectors; this amounts to $20,142 per employee receiving training and $14,412 per employee.Recommendations for Emerging NOCsNational participation in the development of the country’s resource base is an important goal for emerging producers. However, as shown above, during Stages 1 and 2 (and even in Stage 3) of the development of the petroleum sector, many NOCs lack the resources to fulfill their mandate and struggle to participate in a meaningful way in operations (or in their oversight). Others pursue ambitious strategies that are neither affordable nor directed by government. How can the efforts of NOCs are refocused on a mandate that their countries can afford and that will give them the best chances of fulfilling it.Governments need a clear view of what different NOC roles cost and there is no one-size-fits-all plan. The resources and time needed for various roles will depend on the capacity of the NOC and on the capacity and depth of the government and the country’s pool of workers. Are there a capable state administration and an effective legislative framework that allows for effective regulation of the industry? The resources required for an NOC to carry out an effective governance role (concessionaire or managing data) depend to a large extent on the level of petroleum activity in the country. In any case, they are greater than the resources required for a non-operator NOC without a governance role, which can carry out its mandate (e.g. overseeing the carried minority interest) with a very limited staff and budget.Government and the NOC should choose a role for the NOC that it can realistically play, and one that the government can afford Key to this is shaping ambitions and a mandate around the size of revenues reasonably extractable from the resource base. It may very well be that the resource base is not big enough to justify the costs of developing a technically competent operator. There is much focus in emerging producer countries about the petroleum sector’s potential to generate revenues, but it is also a capital-intensive industry.The fall in oil price and slowing exploration program combine to create a difficult environment for the financing of NOC budgets and many NOC ambitions will need to be factor in and spending should closely match company strategy. Lower oil prices also present an opportunity for NOCs to drive new levels of efficiency, focus on their mandate and, in doing so, and become better performing companies. Improved accounting and financial disclosure, as well as risk management, are also beneficial. They are critical, of course, for the NOC’s greater accountability to the state. But the state must also develop its own capacity to police the NOC. Early stage accountability is key, and the state needs to be able to increase its oversight of the NOC as the sector and the operator grow.Governments and NOCs should be strategic about capacity-buildingHaving identified their human-resource needs, almost all the NOC executives surveyed for this study pointed to skills shortages as a key factor holding back their growth strategy. Training is a high priority:
• NOCAL’s manpower training budget for 2013-14 was $8 million, for a staff of 146.35 this amounts to $54,794 per employee and represents 28 per cent of the company’s total expenditure.
• TPDC spent $2.49 million on training for a staff of approximately 11036 which amounts to $18,459 per employee per year.
• Before prices fell GNPC planned to spend $34 million per year to develop its capacity (starting from 252 employees, with plans to grow).37
• ANCAP spent $40.89 million on training for 2,031 employees across its various activity sectors; this amounts to $20,142 per employee receiving training and $14,412 per employeeConclusionMost emerging producer countries wish to see their NOCs play a strong role in the upstream sector, eventually competently overseeing IOCs and, one day, competing with them at home and abroad. But governments must first look carefully at what such a role entails in practice, in order to assess the capacity and finance required and to determine whether that role brings value to the country. This assessment must be repeated over time, as the resource base develops. In addition to the context provided by the stages of development of the resource base, governments and NOCs must consider the impact of the market context on NOC roles and strategies. The fall in oil prices, and the prospect of prices remaining ‘low’ for some years, are causing IOCs to focus their activities on the highest-quality/lowest-cost projects.They are also reducing the scope of capital expenditure to match their lower expectations of cash flow and financial capacity. The new NOCs need to adjust their plans and ambitions to the new realities of price and competition for investment. In this context, emerging NOCs and governments will need to have realistic investment terms. They will also benefit from building collaborative relations with IOCs (in order to better understand the market and their investors), as well as from keeping their house in order, ease of doing business, good governance, transparency and accountability all contribute to making a country more attractive to investors and its NOC a better partner.

Car Finance – What You Should Know About Dealer Finance

Car finance has become big business. A huge number of new and used car buyers in the UK are making their vehicle purchase on finance of some sort. It might be in the form of a bank loan, finance from the dealership, leasing, credit card, the trusty ‘Bank of Mum & Dad’, or myriad other forms of finance, but relatively few people actually buy a car with their own cash anymore.

A generation ago, a private car buyer with, say, £8,000 cash to spend would usually have bought a car up to the value of £8,000. Today, that same £8,000 is more likely to be used as a deposit on a car which could be worth many tens of thousands, followed by up to five years of monthly payments.

With various manufacturers and dealers claiming that anywhere between 40% and 87% of car purchases are today being made on finance of some sort, it is not surprising that there are lots of people jumping on the car finance bandwagon to profit from buyers’ desires to have the newest, flashiest car available within their monthly cashflow limits.

The appeal of financing a car is very straightforward; you can buy a car which costs a lot more than you can afford up-front, but can (hopefully) manage in small monthly chunks of cash over a period of time. The problem with car finance is that many buyers don’t realise that they usually end up paying far more than the face value of the car, and they don’t read the fine print of car finance agreements to understand the implications of what they’re signing up for.

For clarification, this author is neither pro- or anti-finance when buying a car. What you must be wary of, however, are the full implications of financing a car – not just when you buy the car, but over the full term of the finance and even afterwards. The industry is heavily regulated in the UK, but a regulator can’t make you read documents carefully or force you to make prudent car finance decisions.

Financing through the dealership

For many people, financing the car through the dealership where you are buying the car is very convenient. There are also often national offers and programs which can make financing the car through the dealer an attractive option.

This blog will focus on the two main types of car finance offered by car dealers for private car buyers: the Hire Purchase (HP) and the Personal Contract Purchase (PCP), with a brief mention of a third, the Lease Purchase (LP). Leasing contracts will be discussed in another blog coming soon.

What is a Hire Purchase?

An HP is quite like a mortgage on your house; you pay a deposit up-front and then pay the rest off over an agreed period (usually 18-60 months). Once you have made your final payment, the car is officially yours. This is the way that car finance has operated for many years, but is now starting to lose favour against the PCP option below.

There are several benefits to a Hire Purchase. It is simple to understand (deposit plus a number of fixed monthly payments), and the buyer can choose the deposit and the term (number of payments) to suit their needs. You can choose a term of up to five years (60 months), which is longer than most other finance options. You can usually cancel the agreement at any time if your circumstances change without massive penalties (although the amount owing may be more than your car is worth early on in the agreement term). Usually you will end up paying less in total with an HP than a PCP if you plan to keep the car after the finance is paid off.

The main disadvantage of an HP compared to a PCP is higher monthly payments, meaning the value of the car you can usually afford is less.

An HP is usually best for buyers who; plan to keep their cars for a long time (ie – longer than the finance term), have a large deposit, or want a simple car finance plan with no sting in the tail at the end of the agreement.

What is a Personal Contract Purchase?

A PCP is often given other names by manufacturer finance companies (eg – BMW Select, Volkswagen Solutions, Toyota Access, etc.), and is very popular but more complicated than an HP. Most new car finance offers advertised these days are PCPs, and usually a dealer will try and push you towards a PCP over an HP because it is more likely to be better for them.

Like the HP above, you pay a deposit and have monthly payments over a term. However, the monthly payments are lower and/or the term is shorter (usually a max. of 48 months), because you are not paying off the whole car. At the end of the term, there is still a large chunk of the finance unpaid. This is usually called a GMFV (Guaranteed Minimum Future Value). The car finance company guarantees that, within certain conditions, the car will be worth at least as much as the remaining finance owed. This gives you three options:

1) Give the car back. You won’t get any money back, but you won’t have to pay out the remainder. This means that you have effectively been renting the car for the whole time.

2) Pay out the remaining amount owed (the GMFV) and keep the car. Given that this amount could be many thousands of pounds, it is not usually a viable option for most people (which is why they were financing the car in the first place), which usually leads to…

3) Part-exchange the car for a new (or newer) one. The dealer will assess your car’s value and take care of the finance payout. If your car is worth more than the GMFV, you can use the difference (equity) as a deposit on your next car.

The PCP is best suited for people who want a new or near-new car and fully intend to change it at the end of the agreement (or possibly even sooner). For a private buyer, it usually works out cheaper than a lease or contract hire finance product. You are not tied into going back to the same manufacturer or dealership for your next car, as any dealer can pay out the finance for your car and conclude the agreement on your behalf. It is also good for buyers who want a more expensive car with a lower cashflow than is usually possible with an HP.

The disadvantage of a PCP is that it tends to lock you into a cycle of changing your car every few years to avoid a large payout at the end of the agreement (the GMFV). Borrowing money to pay out the GMFV and keep the car usually gives you a monthly payment that is very little cheaper than starting again on a new PCP with a new car, so it nearly always sways the owner into replacing it with another car. For this reason, manufacturers and dealers love PCPs because it keeps you coming back every 3 years rather than keeping your car for 5-10 years!

What is a Lease Purchase?

An LP is a bit of a hybrid between an HP and a PCP. You have a deposit and low monthly payments like a PCP, with a large final payment at the end of the agreement. However, unlike a PCP, this final payment (often called a balloon) is not guaranteed. This means that if your car is worth less than the amount owing and you want to sell/part-exchange it, you would have to pay out any difference (called negative equity) before even thinking about paying a deposit on your next car.

Read the fine print

What is absolutely essential for anyone buying a car on finance is to read the contract and consider it carefully before signing anything. Plenty of people make the mistake of buying a car on finance and then end up being unable to make their monthly payments. Given that your finance period may last for the next five years, it is critical that you carefully consider what may happen in your life over those next five years. Many heavily-financed sports cars have had to be returned, often with serious financial consequences for the owners, because of unexpected pregnancies!

As part of purchasing a car on finance, you should consider and discuss all of the various finance options available and make yourself aware of the pros and cons of different car finance products to ensure you are making informed decisions about your money.