BP Amoco (A) & (B) Policy Statement on Project Finance (A) Applying Project finance concept for Structuring Decision (B)
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Issues • • • • • •
Finance Organization Structure Project Finance Concepts Cost and benefits of PF Decision on Corporate Finance/Project Finance Oil Industry economics Type of Projects Basics (Development, Exploration, Refining, Marketing, Power Plants)
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Case A Discussion Issues • What is Project Finance? How does it differ in Corporate Finance? Exhibit 6A,B & C. • What are the cost and benefits of PF? (BPA perspective – generalize with caution. • According to Bill Young, when should BPA use Project Finance? • How and why does project finance create value? • Which assets are most suitable for PF? Investment as portfolio problem. 3
What prompted the merger of the two arc rivals?
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• Belief that success in capital intensive Oil and Gas Industry was becoming increasingly dependent on scale. • Scale and Synergies • See Case page 3. “The best investment opportunities, in terms of rates of return on capital employed, will be ones that, because of location and complexity, will be available only to companies with greatest financial resources.” “The risks are high and capital cost enormous – as are the potential riches if a huge oil field is discovered. Only well capitalized firms – big enough to afford the time, money and risk required to play poker game can hope to thrive. “
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How did Business units took up Capex at BPA combined? • Lets understand how finance group was integrated. Pg 3
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• Biz units proposed and valued investments using corporate WACC • Finance group determined the best way to finance proposed investment and executed the approved transactions • Centralized Finance structure retained to provide better mgmt of cash, risk and financial execution. • Disadvantage: Decision impacting financing opportunities were made at business unit well before finance group have opportunity to provide inputs to improve the decisions • Finance group had two distinct customers: Business Units and Sr Mgmt and Shareowners 7
How was finance function organized at BPA? • See: Integration of the finance group Case P3 & Exhibit 4.
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Defining Project Finance • How is PF defined • Refer P4
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Suggested Definition • PF involves creation of a legally independent entity financed with non recourse debt for the purpose of investing in a industrial asset, Usually with a limited life. • Lets understand the features 10
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Corporate Finance v/s Project Finance
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What are differences and variations? • See Exhibit 6 A, B and C
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• 6A Typical corporate finance transaction • 6B Incorporate Joint Venture common in power and petrochemical biz Project Finance (e.g. suitable for power projects)- Low- moderate Project Completion Risk
• 6C Unincorporated Joint ventures Project Finance (e.g. Suitable for Oil Field Development) – High Project Completing Risk 13
Project Financing Vs Corporate Financing Criteria Organisation
Control & Monitoring Risk Allocation
Direct Financing Project Financing [On Balance Sheet] [Off Balance Sheet] Corporate structure -Large businesses Cash flows from different assets are mingled Control vested in management, Investors’ role minimal Full recourse Diversified across assets
Corporate structure Cash flows only from Project assets Stringent monitoring
Limited/Non- recourse Contractual arrangements for risk distribution 14
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Project Financing Vs Direct Financing Direct Financing Project Financing [On Balance Sheet] [Off Balance Sheet]
Criteria Financial Flexibility
Easy/fast
Free cash flow
Can be freely used. Commingled and allocated as per Corporate Policy
Difficult and time consuming, highly structured Must follow cash waterfall
Cash Flow Sweep
Debt Contracts
Lenders seek recourse all assets Typically unsecured
Lenders recourse to all project assets Secured
Debt capacity
Seen in entirety
Only out of project assets plus Credit support from other sources High leverage Possible15
Project Financing Vs Direct Financing Criteria
Direct Financing [On Balance Sheet]
Project Financing [Off Balance Sheet]
Bankruptcy
Costly and time consuming Financial distress can be avoided Beneficial to lenders as they have access to entire asset
Cost of resolving financial distress lower, Bankruptcy ‘remote’, more risky to lenders
Transaction Costs
Lower
Higher
Agency Cost
Equity Investors exposed Management Incentive project Specific is difficult Agency Cost Greater
Agency cost for FCF reduced Incentive can be tided to PF Closer monitoring by investor Under investment mitigated Agency cost lower 16
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MARKET IMPERFECTIONS
PROJECT FINANCE
CORPORATE FINANCE
Transaction Cost Pf has higher cost
Higher structuring cost to set up project company (lawyers, independent consultants, financial advisors etc)
Lower structuring Cost
Easier to obtain operating synergy Harder to obtain operating synergy as project may be economically independent Distress Cost Unclear advantage
Less threat of risk contamination (isolate losses at the project level)
Greater threat of risk contamination Greater potential for co insurance
Little benefit from co coinsurance Taxes Pf has higher taxes
Less ability to use interest tax shields and net operating losses
Greater ability to use interest tax shield and net operating loss
Information Cost PF has higher information cost
Better information about project assets and cash flows (more transparent)
Less information on multiple, Co mingled assets and cash flows
Greater disclosure can be costly from a competitive perspective Agency cost Unclear advantage
Little managerial discretion (more discipline can be value enhancing)
Greater managerial discretion- depends if discretion is beneficial
Restrictions on use of cash flows
Greater risk of leverage induced under investment
Little risk of under investment (projects have limited investment needs) Better defense against sovereign interference (expropriation and hold up)
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Where did BP and Amoco used PF more often?
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• Used in any of divisions • Most frequently in down stream business, particularly for petrochemical plants and power generation. • Why? • With regard to upstream where did it used more often? – Development & Exploration – Production – more often
• What has been the past financing structures? – See e.g. of BP and Amoco on pg 5 19
Project Finance used as important risk management tool • Risk Sharing • Transfer of risk to other parties that can bear and manage risk more cheaply and effectively • Large investment for several years requires partners
• Risk Mitigation (Reduction) • Through Structuring and participation of Multilateral agency
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Why is risk management valuable? • Way to reduce the cost of market imperfection • Cost reduction leads to investment – AOIC only possible thru PF. • Risk mgmt solves under investment problem (agency problem-Manager v/s Owners, performance compensation) – Expected Cost of Financial Distress = Cost of Default * Probability of Default – PF reduces the probability default and limits cost of default by sharing, mitigations etc. 21
How project finance can help eliminate costly lower tail outcomes? • Investment as a Portfolio Problem – Under investment by sponsor: adding a risky project on balance sheet – Lost Sales – Under investment by related party – Lost interest tax shield – Endangered human capital 22
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Which assets can be PF assets? • • • •
Relative Size Relative Risk Relative Tangibility Positive Return Correlation – with corporate assets
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What is the Policy Statement of BP Amco ? • See case p8S
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What are the Cost and Benefits of PF ? • BP Amoco(A) Case p 6,7
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• COSTS • Higher fees and Interest rates/Spreads • Increased time • Reduced Flexibility • Increased Information Disclosure (Compromise on Privacy/ Confidentiality)
• BENEFITS • • • • • • • •
Sharing of Risk Risk Management Put Option (if walk away) Expand Firms debt capacity Interest Tax shield Tax Holidays (if separate entity required) Better risk allocation with various parties Suitable for high risk, first time investments, new industries etc. Partners bring the needed know how 26
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Project Finance Benefits • How valuable is PF as walk away put option? – PF structure limited BP’s exposure to downside risk – BP A paid Price in form of higher interest rates and loan fees – Can u Value the put option? P 7, Para 3
• BP Amoco (A) Case Exhibit 7 • Is put option exercisable? – Depends • Ability prior to project completion • Willingness
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Policy Statement on PF: Exceptions • Use internal funds to fund investment – Exception 1: Mega projects – Exception 2: Projects in Politically volatile areas – Exception 3: JV with heterogeneous partners
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Project Evaluation • How were the project proposals that met the one of the three criteria's of PF were processed further? • See p 10
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Financing Development of Caspian Oil Fields (B)
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Case B: Discussion Issues • Why does BPA view Project finance as holding a walk away put option? • When is the put option valuable? • How attractive is AOIC opportunity? What is your assessment of risk and return? • What was the AOIC’s Finance strategy for Early oil Project? How should BPA finance its share of full filed development project? • Is your answer consistent with BPA new policy statement on Project Finance? • How should LUK Oil finance its portion of Full filed development? How does this affect BPA’s Decision? 31
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How attractive is the AOIC Investment Opportunity?
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AOIC opportunity is attractive as • Separation of Financing and Investment Decisions • Corporate WACC / Project WACC is lowered • Managerial risk aversion tackled (r u clear what does this mean?)
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Capital Budgeting Practice in BPA • Separation of financing and investment decision at BP AMCO and its impact on Investment decisions. P 3 – Potential for lost investment opportunities • Corporate WACOC being used by BP to evaluate projects, but Sr Management makes judgments at required rates of return for different biz units P 10 • Managerial Risk Aversion with mega project P 8 – A qualitative concept
• The Magnititude of Distress Case P 8 – Large enough to cause material harm – Sr management views distress as costly- even small hits are considered very costly 36
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Exhibit 5a Estimated Project Economics for the Azeri, Chirag, and Deepwater Gunashli Fields Project Economics (per barrel) $10.00 $15.00 $20.00 $25.00
Oil price (assumed) Production costs
a
Transportation costs Gross profit c AIOC cost recovery Pre-tax profit d AIOC share
b
e
Azerbaijani taxes After tax profit to AIOC
4.00
4.00
4.00
4.00
3.00 3.00 1.50 1.50 1.05
3.00 8.00 4.00 4.00 2.80
3.00 13.00 6.50 6.50 4.55
3.00 18.00 9.00 9.00 6.30
0.26 0.79
0.70 2.10
1.14 3.41
1.58 4.72
$2.29
$6.10
$9.91
$13.72
Total available to AIOC for cost recovery and profit
f
Source: a b c d e f
Casewriter estimates based on public information.
Production costs are assumed higher than BP Amoco’s world average of $3.05/bbl (Amoco Corp., Form 8K, 8/12/98). The PSA contemplates transportation costs to the Mediterranean of $3.00/bbl (Ramco Energy Prospectus, 3/10/97, p. 40). The PSA allocates 50% of gross profit for cost recovery (Ramco Energy Prospectus, 3/10/97, p. 40). Initially, there is a 70/30 split between AIOC and SOCAR (Ramco Energy Prospectus, 3/10/97, p. 40). The Azeri tax rate for the AIOC is 25% (Ramco Energy Prospectus, 3/10/97, p. 47). Includes the AIOC cost recovery plus the after-tax profit to AIOC, but excludes certain bonus payments due to SOCAR. This number is approximately equal to the free cash flow AIOC could expect to receive per barrel. 37
Exhibit 5b
Estimated Production Volumes for Azeri, Chirag, and Deepwater Gunashli Project
Year 1998 1999 Early Oil Complete 2000 2001 2002 2003 Stage 1 Complete 2004 Stage 2 Complete 2005 Stage 3 Complete 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023
Average Daily Production (barrels of oil)
100,000 100,000 100,000 200,000 200,000 400,000 600,000 800,000 800,000 800,000 800,000 800,000 800,000 700,000 700,000 700,000 600,000 600,000 600,000 500,000 500,000 500,000 300,000 200,000 0
Production (millions of barrels per year)
36.5 36.5 36.5 73.0 73.0 146.0 219.0 292.0 292.0 292.0 292.0 292.0 292.0 255.5 255.5 255.5 219.0 219.0 219.0 182.5 182.5 182.5 109.5 73.0 0.0
Capital Expenditures ($ millions) $1,900 $1,000 $1,000 $1,100 $1,000 $1,500 $1,500 $1,000
380.0
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Average
Production CAPEXCAPEX (millions)
Year
1999
2003 2004 2005
Bbl/Day
1998 Early Oil Complete 100,000 2000 100,000 2001 100,000 2002 200,000 Stage 1 Complete 200,000 Stage 2 Complete 400,000 Stage 3 Complete 600,000 2006 800,000 2007 800,000 2008 800,000 2009 800,000 2010 800,000 2011 800,000 2012 700,000 2013 700,000 2014 700,000 2015 600,000 2016 600,000 2017 600,000 2018 500,000 2019 500,000 2020 500,000 2021 300,000 2022 200,000 2023 0
barrels/yr
AIOC Cash flows (US$ Millions) Price per Barrel $15.00 $20.00 Net Profit to AIOC ($ perBarrel) $6.10 $9.91
$10.00 ($ millions)
36.5 36.5 36.5 73.0 73.0 146.0 219.0 292.0 292.0 292.0 292.0 292.0 292.0 255.5 255.5 255.5 219.0 219.0 219.0 182.5 182.5 182.5 109.5 73.0 0.0
$2.29
$1,900 $1,000 $1,000 $1,100 $1,000 $1,500 $1,500 $1,000
$10,000
$25.00 Discount Factor
$10.00
$13.72
10%
$2.29
1.000 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386 0.350 0.319 0.290 0.263 0.239 0.218 0.198 0.180 0.164 0.149 0.135 0.123 0.112 0.102 0.092
75.99 69.08 62.80 114.18 103.80 188.73 257.35 311.94 283.59 257.81 234.37 213.06 193.69 154.07 140.07 127.33 99.22 90.20 82.00 62.12 56.47 51.34 28.00 16.97 0.00
83.59 83.59 83.59 167.17 167.17 334.34 501.51 668.68 668.68 668.68 668.68 668.68 668.68 585.10 585.10 585.10 501.51 501.51 501.51 417.93 417.93 417.93 250.76 167.17 0.00
222.65 222.65 222.65 445.30 445.30 890.60 1335.90 1781.20 1781.20 1781.20 1781.20 1781.20 1781.20 1558.55 1558.55 1558.55 1335.90 1335.90 1335.90 1113.25 1113.25 1113.25 667.95 445.30 0.00
361.72 361.72 361.72 723.43 723.43 1446.86 2170.29 2893.72 2893.72 2893.72 2893.72 2893.72 2893.72 2532.01 2532.01 2532.01 2170.29 2170.29 2170.29 1808.58 1808.58 1808.58 1085.15 723.43 0.00
500.78 500.78 500.78 1001.56 1001.56 2003.12 3004.68 4006.24 4006.24 4006.24 4006.24 4006.24 4006.24 3505.46 3505.46 3505.46 3004.68 3004.68 3004.68 2503.90 2503.90 2503.90 1502.34 1001.56 0.00
$10,364.5
$27,608.6
$44,852.7
$62,096.7
$3,274.2 NPV
-$4,162.1
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Project returns in terms of NPV Sensitivity Analysis Discount Rate 7% 8% 9% 10% 11% 12% 13%
$2.29 ($3,602) ($3,832) ($4,016) ($4,162) ($4,277) ($4,366) ($4,433)
$6.10 $3,815 $2,839 $2,003 $1,285 $668 $137 ($321)
$9.91 $11,232 $9,510 $8,022 $6,733 $5,614 $4,640 $3,790
$10.00
$15.00 $20.00 Price Per Barrel
Million $ $13.72 $18,649 $16,180 $14,040 $12,180 $10,559 $9,142 $7,901 $25.00
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Project Risks • Industry Risk – Price p7 – Reserve p7 – Construction Cost overruns p2
• Transportation Risk – Northern and western pipes not long term solution p 6 – MEP could cost from $ 2.6 to 4 bn p 3 – Other cheaper routes have problems 41
Cont • Financial Risk – Asian/Russian Crisis spread to emerging market p6 – May be difficult for partners from emerging markets to rise capital given their debt ratings and financial positions see Ex 1 – Usually difficult to raise money for investment in emerging markets – “Every thing stopped in Russia” Its is becoming increasing difficult to open credit lines for Russian projects : A Project finance banker. – AIOC MIG financing was incomplete even with multilateral support 42
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Cont.. • Political Risk – – – –
Unstable situation in Azerbaijan: p 2 Very high political risk quote p3, 4 Leadership in question: Aliyev,76 sick p 5 Weak property rights: dispute owner ownership of oil p6 – Caspian is lake, its oil should be under international law – Legal rules, Bankruptcy, Corporate law is either new and untested or non existent p6 – Exhibit 3 Statistic on Caspian and AIOC Member country 43
How do BP and Amoco finance the deals? • Should it refinance Amoco’s Share of Early Oil Project? • How to finance Full Filed Development Project? • What was financing strategy in Early oil project? 44
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Financing Options • First Decision: To Refinance or Not ( is refinance Attractive?) See Case p 158 • Second Decision: How to finance full filed development ( Analyze case fact, P158-9) – Dual financing (BP internal funds + Amoco MIG) – Project Loan (Join AOIC member MIG) – Entirely using internal funds as BP did for Early oil Project 45
• BP and Amoco both held 17% each in the project (total 34%) • BP used general corporate funds • Amoco with other four partners raised $400 mn of project finance with assistance from two multilateral agencies 46
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Three Possible strategy • JV : unincorporated entity – Aliyey’s desire to have diversified set of equity investors from superpower
• Staging: – Value of Fixed v/s Staged investment – Stock v/s flow project assets (Mines v/s Toll Road) – Stock assets need staged investment (Mines)
• Agency Debt – Funds from IFC and EBRD Multilateral Institute can reduce the political risk – Less likely to expropriate the project – Other projects rely on Agency funds – Azerbaijan depends on financial assistance
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Staged v/s Fixed Investment Project Assumptions • Two projects requires $12 bn over 3 years • Two scenarios: – Fixed investment must occur every year – Staged investment occur only if good outcomes till date
• Project payoffs(Cash flow if invest) – Good state = 10 bn with ½ probability – Bad State = 0 bn with ½ probability 48
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• Staged investment is worth more – 43%, ($ 1.75- (-$ 3.25)) / $ 12.0)
• Flexibility (abandonment option adds value) • Staged investments when u can learn something about demand, revenue cost or risk – – – –
Do you learn something valuable? Can u stop investment? What are the costs? Are multiple projects like phases of single project? What is the cash flows correlation across phases? 51
Two Types of Projects • Stock type – Fixed resource depleted over time, mines, oil fields, forests
• Flow type – Use of assets to generate value, Power plant, pipelines, telecommunications systems, toll roads
• Different risk and Pre sell capacity 52
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Have BP and AMCO used different Financing Strategy? Why?
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• It was not mega project either for BP or Amoco – See A case exhibit 2 (AIOC investment share as % of total asset)
• But Amoco might have perceived slightly greater risk and therefore Project financed • BP used internal funds 54
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How should be the Full field development Project be Financed? • What is investment in Full filed development? • What is the Policy? • What are exceptions from Corporate Finance? 55
• How mega is the project? – As % of Balance Sheet size – As Portfolio of related project exposure in Caspian
• What is the extent of Risk Esp. Political? • What is the JV Feature? Heterogeneous or homogenous Partners? See Exhibit 1 56
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Your Vote PROJECT FINANCE
CORPORATE COMBINATION FINANCE
Yes/No
Yes/No
Yes/No
Pros and Cons
Pros and Cons
Pros and Cons
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Put option • Will BPA consider AOIC Investment through PF as Walk away put option? • Can BPA (afford to) exercise? • Do you think walk away option would be the motivation for using PF?
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From Other Partners’ View • Say LUK Oil (see Exhibit on its Financial Position) • What is the share of LUK oil • What kind of finance would suit the partners ? • Can LUK Oil finance its share on Corporate Finance? 59
• Would LUK Oil using project finance affect the BPA’s Financing decision?
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• If BPA uses PF it can negotiate better terms for whole project then the weaker partners can do. • BPA may be compelled to use PF due to heterogeneous partners in JV • Else accept the Lenders covenants / bargain done by weak partners 61
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What happened? (2001) • The pipeline was routed through BTC, Turkey as US wanted to avoid other route • Lot of negotiation - Turkish government offered guarantee for cost if escalation beyond $2.4 bn • AOIC – MIG negotiated for the PF from multilateral agencies • First phase used combined financing strategy similar to early oil • BPA continues to avoid PF but non homogeneous partner exception causes to use PF 63
Sum UP. Learning Issues • Why BPA view project finance as a holding a walk away put option? • When is this put option valuable? • How attractive is the Caspian Oil Field Investment? What r risks? • Staged v/s Fixed / Stock v/s Flow type Projects • What was finance strategy for Early Oil Project? • How should BP Amoco finance the oil fields? 64
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• Is your answer consistent with BPA policy statement? • How will LUK oil Finance its 10% share of Full filed development Project? • Why might project Finance make more sense then Corporate Finance for LUK oil? How will LUK oils decision affect BP Amoco’s decision? • Who the partners are and what percent of project they hold can have manor impact on project performance (Cost, revenues, expropriation risk) 65
When to use project finance? Motives
BP Amoco
Dhobal
MP Toll Road
Size of Investment
Yes/ may be
No
No
Regulatory Suitability
No
Yes
No
Funds Requirement
No
No
Yes
Risk (Political)
Yes
No (Low Risk)
No
Heterogeneous Partners Need
Yes
No
No/ NA
Completion Risk
No
Yes
No
Staged Investment
No
Focused Yes
Focused Yes
Tax Benefits
No
Yes
NA
Distress Cost effect on Sponsor
Yes
No
No
Need to Know Independent Performance and Control
Yes
Yes
Yes
Transaction Cost lowering
No/ May be
No
No
Supply Risk
NA
NA
NA
Market Risk
NA
Yes/ may be
NA
Operating Risk, Technological Cost and Management
No
Yes
No
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TO Do • Can u develop a project proposal and proposed structuring 20-25% • Quiz (on assigned pre readings)25-30% • Evolved Pedagogy • Also read Indian cases • MDF Case on Data server
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Course Themes • Theme 1: Introduction, Project Appraisal and Finance, Structuring (2 Session) • Theme 2: Project Appraisal: Techno, Market feasibility, DPR preparation (2 Sessions) • Theme 3: Project Valuation and Cash Flow Modeling, Financial feasibility(2 Sessions) • Theme 4: Risk Management (1 session) • Theme 5: Project Structures (1 session) • Theme 6: Financing the Project and Innovation and Sum up (2 Session) 68
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