Petrobrás of Brazil and the Cost of Capital How do you estimate the cost of capital for a multinational enterprise in a global industry – in this case oil – – which is based in an emerging market?
Petrobrás of Brazil and the Cost of Capital •
Petróleo Brasileiro S.A. (Petrobrás) was the national oil company of Brazil • • •
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Petrobrás was an integrated oil and gas producer which was publicly traded but 33% of its ownership shares were still owned by the Brazilian government The company was not internationally diversified in its operations, as all of its current oil and gas operations were Brazilian when it went public in 2000 As a result of its lack of diversification, and being considered relatively risky as a result of Brazil’s economic history, Petrobrás has a significantly higher cost of capital than most other major oil and gas companies all over the world
Petrobrás’s cost of capital Oil and gas are priced and traded globally in U.S. dollars Most major multinational oil and gas producers as of January 2002 all had a cost of capital which was between 7.6% and 9.0% -- but Petrobrás’s was 15.0% • One of the major determinants of the company’s higher cost of capital was Brazil’s high sovereign risk • •
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Sovereign risk • •
Sovereign risk is the market’s assessment of the risk associated with the government’s willingness and ability to repay U.S. dollar-denominated debt Brazil’s sovereign risk had been as high as 24% and as low as 0.4% over the past decade
Petrobrás’ WACC:
Case Questions 1. Why do you think Petrobrás’s cost of capital is so high? Are there better ways, or other ways, of calculating its weighted average cost of capital? 2. Does this method of using the sovereign spread also compensate for currency risk? 3. The final quote on “one’s view on the direction of the broad Brazilian market” suggests that potential investors consider the relative attractiveness of Brazil in their investment decision. How does this perception show up in the calculation of the company’s cost of capital? 4. Is the cost of capital really a relevant factor in the competitiveness and strategy of a company like Petrobrás? Does the corporate cost of capital really affect competitiveness?
Exhibit 1 Petrobrás Suffers an Uncompetitive Cost of Capital
Exhibit 2 The Brazilian Sovereign Spread (December 1997 –August 2005)
Petrobrás’ WACC:
Case Questions 1.
Why do you think Petrobrás’s cost of capital is so high? Are there better ways, or other ways, of calculating its weighted average cost of capital? • •
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Most of the major multinational oil firms are treated equally, with comparable costs of capital and assessments of their earning potential. Petrobrás, however, was a Brazilian oil company which was distinctly domestic in its activities. Even major oil companies like PDVSA, a Venezuelan oil company (not discussed in the case), were considered of lower relative risk and possessed a lower relative cost of capital because of the magnitude of their export sales. Petrobrás was a Brazilian oil company producing for Brazilian markets. There is good argument that the company‟s cost of capital should not be “burdened” by the additional charges of the Brazilian sovereign spread when calculating its cost of debt and equity. It is operating in a global industry which has a global price, in U.S. dollars, and a global market, which could potentially be accessed for sales if the company wished. There are obviously a multitude of different ways to calculate the company‟s cost of capital, but most methods would require some additional risk premium being added to in some way compensate investors for the perceived risk of Brazilian political or country risks (not particularly currency risks).
Petrobrás’ WACC:
Case Questions 2.
Does this method of using the sovereign spread also compensate for currency risk? •
The sovereign spread is technically the international debt markets‟ opinion of the creditworthiness of the Brazilian government when borrowing U.S. dollar-denominated debt. This is not the same thing as currency risk.
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The credit analysis would in principle reflect the market‟s opinion of the Brazilian government‟s capability to earn or generate U.S. dollar hard currency earnings in order to repay the debt, which may or may not be directly related to changes in the value of the Brazilian reais itself.
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The fact that Petrobrás‟ share price had shown a high correlation with the EMBI+ sovereign spread for Brazil, is however, a very interesting factor.
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As long the spread is used by investors in calculating the company‟s cost of capital, it would seem to be reflecting changes in the exchange rate, regardless of its theoretical validity.
Petrobrás’ WACC:
Case Questions 3.
Is the cost of capital really a relevant factor in the competitiveness and strategy of a company like Petrobrás? Does the corporate cost of capital really affect competitiveness? • •
This argument is consistent with the market‟s opinion that Petrobrás is a Brazilian company first and an oil company second. If investors wish to invest in a firm of its character they must therefore have bullish expectations on the potential of the Brazilian equity market more than a positive opinion on the possibilities of the global or even Brazilian oil markets.
Petrobrás’ WACC:
Case Questions 4.
Is the cost of capital really a relevant factor in the competitiveness and strategy of a company like Petrobrás? Does the corporate cost of capital really affect competitiveness? •
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The cost of capital is always a factor in considering a company‟s competitiveness. For a company like Petrobrás, operating in one of the world‟ most capital-intensive industries, the cost of capital is considered critically important. Theoretically, the company will only undertake new investments which are expected to possess rates of return which exceed the cost of capital; the higher the cost of capital, the fewer potential investments which can be considered and the fewer potential investments likely to be undertaken. A final note. Although students of finance are clearly and consistently taught that the cost of capital, specifically the cost of equity, is important to the ability of a company to compete, there are also those who argue (convincingly sometimes) that the cost of equity is a „paper -cost‟, and therefore is not as material as the cost of debt which is an actual cash outflow which must be paid on a regular basis. Equity cost is largely that calculated through methods like CAPM, where the cost is actually and expected return, not a contractual cash flow commitment.
Petrobrás of Brazil and the Cost of Capital Petrobrás’s stock performance appears more highly correlated to the Brazilian equity market and credit spreads based on historical trading patterns, suggesting that one’s view on the direction of the broad Brazilian market is important in making an investment decision on the company. If the historical trend were to hold, an improvement in Brazilian risk perception should provide a fillip to Petrobrás’s share price performance. “Petrobras: A Diamond in the Rough,” JPMorgan Latin American Equity Research, June 18, 2004, p. 26-27.
Exhibit 1 (Mini Case Appendix) The Brazilian Reais/U.S. Dollar Spot Rate, 1998 –2005
