Petrozuatas Use of Debt Financing

International Financial Management

Ricky Chen Anna Pakman James Tobin Janie Wang

Agenda
Timeline Introduction to international debt and debt ratings Description of the PDVSA and Conoco joint venture Petrozuatas debt rating Debt financing: 144A Bonds Project financing: advantages and disadvantages Three types of project financing risks The aftermath: Duponts 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

Petrleos de Venezuela (PDVSA)
(49.9% Interest)

Conoco Incorporated (USA)

(50.1% Interest)

Petrolera Zuata

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 Venezuelas interior Transportation of the oil to coast via pipeline Transportation of oil to refineries along the US Gulf Coast

The Joint Venture (contd)

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, Moodys, Fitch

Debt Ratings (contd)

AAA highest possible rating D Default <BBB junk bonds Venezuela
Long term: B Short term: B
Bond Rating Grade Moody's Aaa Aa A Baa Ba, B Caa/Ca/C C Standard & Poor's AAA AA A BBB BB, B CCC/CC/C D Investment Investment Investment Investment Junk Junk Junk Risk

Lowest Risk
Low Risk Low Risk Medium Risk High Risk Highest Risk In Default

Petrozuatas 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

Petrozuatas debt rating (Contd)

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 predetermined 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 Commercial Bank Debt Rule 144A Project Bond Paid-in Capital (incl. shareholder loans) Operating Cash Flow Total in million $450 $1,000 $445 $530 $2,425 % 18.6 41.2 18.4 21.9 100%

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 isnt 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 TransAtlantic 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 billiontoo much for any one firm to handle

Duponts 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 Duponts debt Spinning off Conoco would help it be an industry leader, which was impossible under Dupontconflicted with Duponts 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?