Petrozuata’s Use of Debt Financing

International Financial Management

Ricky ChenAnna PakmanJames TobinJanie Wang

Agenda

• Timeline• Introduction to international debt and debt ratings• Description of the PDVSA and Conoco joint venture• Petrozuata’s debt rating• Debt financing: 144A Bonds• Project financing: advantages and disadvantages• Three types of project financing risks• The aftermath: Dupont’s sale of Conoco and state of

Petrozuata today• Q&A

Timeline

1976 1997 1998 1999

Venezuelan government nationalizes interests of oil companies and forms PDVSA

Petrozuata was

formed

Dupont sold Conoco and first set of cost overruns

Second cost overruns

The Case of Petrozuata

Petrolera Zuata

Conoco Incorporated

(USA)

Petróleos de Venezuela (PDVSA)

(50.1% Interest)

(49.9% Interest)

The Partners - PDVSA

• Currently 4th largest oil company in the world

• State-owned and formed through the nationalization of other companies’ assets (Mobil, Exxon, etc)

• Despite government instabilities, PDVSA has a strong track record

The Partners - Conoco

• Subsidiary of Dupont (USA)

• Has operations in over 200 countries

• Known for expertise in technology and extraction processes

The Joint Venture

• Petrozuata was formed in 1997 by PDVSA and Conoco

• Three key components– Production of heavy oil from a new field in

Venezuela’s interior– Transportation of the oil to coast via pipeline– Transportation of oil to refineries along the

US Gulf Coast

The Joint Venture (cont’d)

• Estimated $2.425 billion in costs

• Conoco (50.1%) and PDVSA (49.9%) together invest $975 million

• Remainder $1.450 billion to be financed through debt

Why International Debt?

• In liquid markets, greater availability of capital

• Diversification effects similar to that of diversifying portfolios

• But there are risks - – Illiquid markets– Foreign Exchange Risk

Debt Ratings

• An evaluation of the possibility of default by a bond issuer

• It is based on an analysis of the issuer's financial condition and profit potential

• Main providers: S&P, Moody’s, Fitch

Debt Ratings (cont’d)

• AAA – highest possible rating

• D – Default• <BBB – junk bonds• Venezuela

– Long term: B-– Short term: B

Bond Rating

Grade Risk

Moody'sStandard &

Poor's

Aaa AAA InvestmentLowest

Risk

Aa AA Investment Low Risk

A A Investment Low Risk

Baa BBB InvestmentMedium

Risk

Ba, B BB, B Junk High Risk

Caa/Ca/C CCC/CC/C JunkHighest

Risk

C D Junk In Default

Petrozuata’s debt rating

• Conoco was rated single A

• PDVSA was rated single B– ‘Junk Bond’ (it is state-owned company)

• Its target is to get a BBB rating

• How?

Crude Oil Price

Petrozuata’s debt rating (Cont’d)

• Conoco guaranteed to buy all the output that Petrozuata would produce for the next 35 yrs (priced in $)

• All costs (ie: water, electricity and gas) are also under long-term contracts, except labor (but it only represented a small fraction of total cost)

• Conoco & PDVSA guaranteed to pay project expenses, including any unexpected cost overruns

• The project passed six completion tests (to make sure that the project can produce syncrude at pre-determined quantities and qualities)

stable revenue + stable cost + no extra costs BBB

Debt Financing

• High leverage ratio (60%)– Bank debt, the traditional source of debt and

Rule 144A project bonds

Sources of Funds   in million %

 

Commercial Bank Debt $450 18.6

Rule 144A Project Bond $1,000 41.2

Paid-in Capital (incl. shareholder loans) $445 18.4

Operating Cash Flow $530 21.9

Total $2,425 100%

What is Rule 144A bond

– Is a relatively new security gaining popularity– Has greatly increased the liquidity of 144A

bonds– Can waive the time consuming SEC registration

process (implied it is less expensive to issue Rule 144A bond compared to other types of bonds)

– Can only be sold to professional investors

(at least has $100 million in investible assets)

Project Financing

• Popular in emerging markets• Often involves syndicates• Project is separate from legal and financial

responsibilities of investors• Used for large investments that are long-term and

singular (cannot be commingled)• Cash-flow from third parties is predictable • Projects and their lives are finite• Petrozuata used project financing to pay down large

debts without the owners being accountable for deficits

Three types of risk

• Precompletion risk– No operations = no cash flow coming from

the investment

• Postcompletion risk– Occur when project is operating and effect

the cash flows

• Political risk– Macroeconomic events in Venezuela

Why Project Finance?

• Project finance holds less risk for the partners in the joint venture than simply financing it themselves – too expensive– local governments offer loans to develop oil fields

• Protects the companies from bankruptcy risks because they have limited responsibility– the project is regarded as legally independent – equity returns are increased and the companies’

own debt capacity isn’t used up.

Why not Project Finance?

• Project finance seems perfect as it allows the company to rid itself of responsibility and increase equity returns– However, it eliminates co-insurance and

diversification benefits within the company so the free lunch is a myth.

• High legal costs associated with the setup

• Difficult to exit syndications

Another example

• British Petroleum: North Sea and Trans-Atlantic Pipeline– Constructed to move oil from the North Slope of

Alaska to the northern most ice- free port- Valdez, Alaska

– Joint venture between BP, Standard Oil of Ohio, Atlantic Richfield, Exxon, Mobil Oil, Philips Petroleum, Union Oil and Amerada Hess

– Cost: $1 billion—too much for any one firm to handle

Dupont’s sale of Conoco

• Dupont purchased Conoco in 1981 after high oil prices hurt profits during the 1970s

• Dupont decided to sell Conoco in 1998, shortly after the Petrozuata deal, when oil prices were at their lowest levels in a decade

• The sale lowered Dupont’s debt• Spinning off Conoco would help it be an

industry leader, which was impossible under Dupont—conflicted with Dupont’s strategic positioning

The Aftermath

• Benchmark price of crude oil falls $5 per barrel over 6 months

• Inflation in Venezuela causes interest rates to jump from 25% to 70%

• Cost overrun for Petrozuata is announced

Were Investors Correct?

• Petrozuata encountered some of the types of risk mentioned earlier

• Cost of project increases by $553 million

• The costs ended up being covered by sponsors

• Petrozuata is able to produce larger quantities than expected

• Investors made the right choice

Where Are They Now

• Conoco has merged with Philips Petroleum and is the 3rd largest integrated energy company

• PDVSA is starting to collect oil from some newly found sources despite a worker strike at the end of 2002

• Petrozuata is making new contracts and continues to run well they still have an their B rating

Q&A

• Any questions?