PETROLERA ZUATA, PETROZUATA C. A.

CASE ANALYSIS

ALTERNATIVE MODELS OF FINANCING THE ORINOCO BASIN:Entire project as Project finance

Pros:• PF reduces Information cost significantly. Separation of projects from the sponsoring firm facilitates initial credit decisions allowing creditors to analyze the project on a stand-alone basis. With segregated cash flows and dedicated management, there is little room for the kind of intentional or judgmental misrepresentation. These improvements reduce asymmetric information costs and can lower a project’s cost of capital

• PF also reduces cost of financial distress. Project finance adds value by reducing the probability of distress at the sponsor level and by reducing the costs of distress at the project level. This cost is offset though by the benefit of coinsurance wherein the project cash flows might prevent the parent from defaulting.

• There is probability of getting investment grade bonds.• Higher debt capacity will be possible, which gives higher flexibility to operate and which also enables them to get incremental tax shield.

• It reduces Corporate taxes paid. Petrozuata will pay income taxes at the rate of 34% and royalty rates at the rate of 1% for the first nine years of operations and no municipal taxes compared to Maraven’s conventional on-balance sheet financing, its income tax rate would be 67.7% and its royalty rate would be 16.67%.

Cons:• Increase in transaction cost as Conoco and Maraven spent more than 5 years and millions of dollar in advisory fees to negotiate this deal.

Entire project as Corporate finance

Pros:• In this financing method cost of transaction reduces significantly, which occurs in Project financing.

• High cost of political risk insurance may increase interest rate associated with debt. So leverage through PF would be costlier, as Venezuela has a rating of B.

• Chances of Negative carry if we opt for issuing government bonds. So investment gains would be lower and higher interest rate payment would lead to loss.

Cons:• High Information cost• High cost of financial distress• If project financed internally, the risks were to be borne by PDVSA and home government.

• Also banks providing capital to PDVSA would charge higher interest rate for high risk.

• There is lesser scope of foreign direct investment in the project through JVs etc.

SUGGESTIONS: Project financing the entire venture is a better option.

1. POLITICAL RISK: Risk associated with downfall of Venezuelan government & unpredictability of government to abruptly change tax rate or royalty.

2. EXCHANGE RATE RISK: With Venezuelan economy developing, risk of interest rate fluctuation is there as currency Bolivar would appreciate against Dollar, which would increase expenses & tax liability of project as against to revenue which would be in dollar, hence reducing profitability of project.

3. OIL PRICE VOLATILITY: Oil prices have been fluctuating in a high range if $8.14 to $37 per barrel, hence risk of price volatility is high.

DEAL STRUCTURE TO MINIMIZE THESE RISKS

SOME OF THE OPERATING RISKS INVOLVED IN PETROZUATA

1. Inclusion of PRI: This insurance given by US ExIm bank, IFC, OPIC, EDC etc., that increase the lending rate by 300bps to 10.5 - 11.75 %.

2. To mitigate sovereign risks, one of the key features was the decision to keep oil revenues out of the country. Conoco as the purchaser would deposit US dollar proceeds with a trustee in NY who would then disburse the cash. This also eliminated exchange rate risk as the revenues and debt service were both denominated in dollars.

3. High debt coverage ration of 1.35X is the bare minimum requirement.4. To account for price volatility low breakeven point of $8.63 per barrel is set that is achievable with

market rate $14.27.5. Cash waterfall or Payment priority to account for high risks. Priorities were, 1st to 90 day operating

expenses account, then to project’s debt obligation, then to debt service reserve account for 6 months, lastly to equity holders.

The IRR for the project comes to 26% when the leverage ratio is 60%, hence for the project to be attractive to the sponsors the cost of equity should be lower than 26%On calculating the Ke for various years given the cash flow to equity, we find that the cost of equity is around 22.8% on an average and goes above IRR only for the initial years (upto 2006) when the D/E ratio is very high.Hence as a sponsor the leverage of 60% gives us adequate returns.

EXPECTED RETURNS TO SPONSORS

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Leverage of 60%:The DSCR remains well above 2.0x during the initial years and also the IRR is 26% which is much higher than the average cost of equity (22%).Even with the variability in cash flows due to price or currency rate fluctuations, the project will be in the condition to service it’s debt hence it is an investment grade project.Leverage of 50%:The DSCR increases and remains about 2.5x during the initial years on decreasing the leverage to 50% hence being a safe investment project. But the IRR decreases to about 22% which is very close to the cost of equity hence being of no advantage for the sponsors to invest in this project.Even with the variability in cash flows due to price or currency rate fluctuations, the project will be in the condition to service it’s debt hence it is an investment grade project.Leverage of 70%:The DSCR decreases considerably and is sometimes below 1.8x (assuming cost of debt to be 10% which is optimistic hence the DSCR might reduce even further if cost of debt increases with leverage) making the project risky to invest in though it still remains above the minimum requirement of 1.35x, also the IRR increases to about 29% with the increase in leverage making it lucrative for the sponsors.Since the project cash flows might vary with price or currency fluctuations, a leverage of 70% will not get the project an investment grade.Hence 60% seems to be optimal leverage ratio.

EFFECT ON DSCR AND IRR WITH CHANGE IN LEVERAGE

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DIFFERENT SOURCES OF DEBT Development Agencies and

BanksPros:

• Draw on credit line, matching the cash inflows and outflows

• Reliable option when nowhere else to turn toCons:• Short maturities, serious risk in case of constructional delays

• Restrictive covenants• Variable interest rates, Limited size of loans • Majority of remaining debt would require PRI, taking cost to ceiling

• Time and cost of arranging sufficiently required “covered” debt

Public Bond MarketPros:

• Time and cost savings (no “covered” debt requirements)

• Long maturities of greater than 10years• Fixed interest rates• Fewer and more flexible covenants• Larger loan size availableCons:• Funds to be raised in lump sum with investment rate for remaining cash lesser than borrowing rate

• “Emerging market” unreliability in terms of creditworthiness – making it difficult to succeed in public debt markets

144A Bonds MarketPros:

• Time and cost savings (no “covered” debt requirements)• Long maturities of greater than 10years• Fixed interest rates & private bonds could provide high value of debt of $1.4 bn.

• Fewer and more flexible covenants• Additional speed advantage of underwriting within 6 months due to non requirement of initial disclosure/ less disclosure to the SEC

• Better scope of investment as, Venezuelan financial condition is improving and hot bond market leading to higher chances of getting large fund

• Partnership with Dupont company improves creditworthy image of Petrozuela Cons:

• “Emerging market” unreliability in terms of creditworthiness – both Venezuela and PDVSA had sub investment grade ratings

• Required continued financial, political stability of Venezuela

• Required continued “hotness” of the bond market for sustainability

SUGGESTIONS:Getting debt through 144A bonds is a

better option to finance this project.

Year Price Percentage variation from forecast price-25% -20% -10% 0% 10% 20% 25%

2001 $ 13.86 -1.86 -1.97 -2.19 -2.42 -2.64 -2.86 -2.97

2002 $ 14.21 -1.92 -2.03 -2.26 -2.49 -2.72 -2.95 -3.07

2003 $ 14.56 -1.70 -1.80 -2.00 -2.21 -2.41 -2.62 -2.72

2004 $ 14.93 -1.69 -1.79 -2.00 -2.20 -2.40 -2.60 -2.71

2005 $ 15.30 -1.58 -1.67 -1.86 -2.05 -2.24 -2.43 -2.52

2006 $ 15.68 -1.66 -1.76 -1.96 -2.16 -2.36 -2.56 -2.66

2007 $ 16.07 -1.63 -1.72 -1.92 -2.11 -2.31 -2.50 -2.60

2008 $ 16.47 -1.69 -1.79 -1.99 -2.20 -2.40 -2.60 -2.70

2009 $ 16.89 -1.96 -2.08 -2.31 -2.55 -2.78 -3.02 -3.13

2010 $ 17.31 -1.85 -1.96 -2.18 -2.40 -2.62 -2.85 -2.96

2011 $ 17.74 -1.80 -1.91 -2.12 -2.34 -2.55 -2.77 -2.88

2012 $ 18.19 -2.39 -2.54 -2.82 -3.11 -3.40 -3.68 -3.83

2013 $ 18.64 -2.92 -3.10 -3.45 -3.80 -4.15 -4.50 -4.67

2014 $ 18.64 -2.59 -2.75 -3.06 -3.37 -3.68 -3.99 -4.14

2015 $ 18.64 -2.30 -2.44 -2.71 -2.99 -3.26 -3.54 -3.67

2016 $ 18.64 -2.23 -2.36 -2.63 -2.89 -3.16 -3.42 -3.56

2017 $ 18.64 -44.33 -46.98 -52.26 -57.55 -62.83 -68.12 -70.76

2018 $ 18.64 -37.93 -40.19 -44.71 -49.23 -53.75 -58.27 -60.53

2019 $ 18.64 -35.68 -37.81 -42.05 -46.30 -50.54 -54.79 -56.91

2020 $ 18.64 -32.92 -34.84 -38.69 -42.54 -46.40 -50.25 -52.17

2021 $ 18.64 -34.84 -36.87 -40.94 -45.01 -49.08 -53.15 -55.19

2022 $ 18.64 -2.92 -3.09 -3.43 -3.77 -4.11 -4.46 -4.63

SENSITIVITY ANALYSIS

Assumptions:1. Forecast price of Syncrude much

lower than Maya (base 1998: Syncrude $12.87 – Maya $18.62)

2. Assuming the production of oil to be constant. So taking only minimum guaranteed production in the contract i.e. 104,000 BPCD

Conclusion:DSCR drops below the required 1.8X in extreme cases of 20-25% variation in price for 6 years even when it is around 1.6x, and then is almost always above 2.0X. Hence price fluctuation is not a major concern. Therefore, the project should get an investment grade rating.

The above points support that the project will receive an investment grade.

Stable Revenue

•Conoco guaranteed to buy all the output that Petrozuata would produce for the next 35 years •The sensitive analysis also shows that maintaining the DSCR of 1.8x is achievable

Stable Cost

•Except labor costs, all costs are also under long-term contracts

No extra debt

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

Completion Tests

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

WILL THE PROJECTS BONDS RECEIVE INVESTMENT GRADE RATINGS?

WOULD YOU INVEST IN THE PROJECT’S BONDS?Yes we should invest in such Project’s bonds, primarily because• The DSCR is well above 1.8x and the sensitivity analysis also does not indicate any red flags, hence the bonds will get any investment grade.

• It is sensible to invest in the bonds since the rate is fixed and the sponsors will pay any extra costs incurred.

• Also the data shows that investment in project bonds are increasing over the years and project bonds have a high spread over treasury rates, indicating that the attractiveness of project bonds is increasing.

THANK YOU!