Oil Investment Project

Introduction

The case study is an analysis of an oil investment project between two companies that plan on sponsoring the project: Conoco Inc. (A US-based, highly experienced oil company) and PDVSA (a Venezuelan-based oil firm). These two organizations plan on starting the project Petrolera Zuata which will possibly result in the manufacture of crude and refined oil in Venezuela. The company plans on utilizing equity funds from their sponsors and market bonds i.e. specifically the 144 A-type. The risks inherent in cash flow projections and operating costs are good indicators of whether this firm can be able to get an investment-grade rating and whether the project will result in substantial benefits. (Esty, 2002)

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Pre-completion risks

The pre-completion risks for technology are quite low. Both companies possess the right technologies for oil drilling and refining. Also, the fact that the project’s technologies were given a green light by leading overseas consultants Stone and Webster mean that risks are minimal here. (Esty, 2002)

In terms of the availability of oil, it is necessary to acknowledge that this will be low risk because there is an excess of resources. First, the site chosen for drilling oil will be more than the production capacity for the said project by far since it has a capacity of 21.5 billion barrels worth of crude. Consequently, the two firms will be in a position to sell off those excesses. Furthermore, gas, water, and electricity use for the project will come from Petrolera Zuata itself. An assessment of PDVSA indicates that it has 35 yrs experience in proven reserves so this is a bonus. Consequently, these two factors will not inhibit its investment grading and this implies that there will be low risks (Esty, 2002)

Legal issues that may represent some risk to the company will be a moderate risk. Firstly, the two companies are from two separate countries and there will be differential liabilities because of those differences. Second, PDVSA is a public company and needs to pay royalties to the government; it must meet its corporate tax obligations and also needs to cover its income taxes. Furthermore, the project is a 35-year contract that will involve granting Conoco’s shares to PDVSA for free after the period. However, because the former company is a majority shareholder, then its high credit rating may improve prospects for investment grading. (Tofalis, 2008)

Post completion

Demand risk is rather high in this project because oil prices keep fluctuating. Expenditure has been set at a steady value yet that is not sufficient enough to cushion the firm during periods of dwindling oil prices. Consequently, demand risks may bring substantial challenges to the firms. However, price risks have been mitigated by setting a modest price per barrel for their syncrude. The project’s choice of $12.87 is much lower than the existent Mayan price which was $18.62. The company was still safe even after the price went down by as much as two dollars. (Esty, 2002). The low price projections made by the company will protect it against demand risk thus one can say that demand risk is low.

Input and output involved in setting up the company will also be substantially affected by certain external factors. For instance, the firm’s estimates have all been made in terms of dollars and as the country’s history in the nineties has shown, their currency markets are frequently interrupted by the Venezuelan government hence indicating that there are extensive losses that could result from such actions in the future. The input, output, and currency risks are high so total post-completion risks are high.

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Sovereignty risks

There are four major sovereignty risks that this firm is currently going to deal with as it continues with operations. First of all, the company is being formed between an American-based and Venezuelan-based firm. The project will be susceptible to government tariffs as well as investment policy rules on foreign companies and this is a high risk.

Secondly, business conditions in Venezuela are not favorable – high risk and this will significantly diminish their credit rating. For example, there are frequent instances in which the labor market has fluctuated and this can happen again. Furthermore, the country’s financial sector is not as robust as it should be for a project of such magnitude. Petrolera Zuata plans on using the services of local contractors to construct their downstream and upstream pipelines. However, experience has shown that most local firms tend to have weak financial backings and may disappoint. (Esty, 2002).

Government action may be another serious sovereign risk as well – it is high risk. In the past, it has not refrained from interfering with tax rates by public companies and royalty rates as well. Currently, Petrolera Zuata is covered by the La Apertura strategy. Nonetheless, it is not definite whether or not this may continue to be the case, especially after elections take place in 1998. Since half of the project will be sponsored by a government-owned company, the government may decide to seize assets. Another president may choose to enact different rules that will affect the company negatively. Also, alterations could be made to the recipients of the crude. Because currently, Contoco is counting on the fact that it will be entitled to crude drilled in the designated area. However, the government could change tactics and force the crude to go to be sold to another party and this may ruin the arrangement. (Tofallis, 2008)

Foreign exchange risks are a real problem here because the government has previously entered this market – high risk. In ten years, the government was able to do so twice. This goes to show that it can repeat the same thing. The projected revenues, demand costs, and price costs for the crude have all been estimated in dollars and this would limit the company’s ability to maneuver once interferences occur. (Esty, 2002)

Financial risks

Perhaps the types of risk with the most serious implications for this company are financial ones. For sources of capital, the project is counting on equity funds from its sponsors and this accounts for 530 million dollars, the major strength of this strategy is that guarantees have been instated and a thorough execution plan exists. (Esty, 2002)

Another advantage is that the cost of the equity for the firm has been estimated at 20.97 percent. This means that the company will have to pay its shareholders returns at this rate. Conversely, the WACC or the Weighted average cost of capital for the firm has been placed at 12.29 percent. (Esty, 2002) This implies that for every dollar invested into the project, a value of 8.68% is being created. If the reverse were true then the company would not be creating value but would be shedding it. One can therefore say that the investment is a good idea because it will not result in diminishing value but will increase it (Eugene, 1997). Therefore in conclusion financial risks are low and this could give the company a high rating.

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Conclusion

The investment into Petrolera Zuata should not be made because post-completion risks are high. Pre-completion risks and financial risks are low but sovereignty risks are very high. In other words, there is a fifty-fifty risk spread between the four types of risks analyzed. This is too dangerous for the sponsors of the project. Furthermore, Venezuela as a country has a relatively low credit rating and will therefore dilute the high credit rating for the US-based firm. This means that it does not deserve an investment grade.

References

Esty, B. (2002). Petrolera Zuata. Harvard Business School, 299-012: (1-22).

Eugene, F. (1997). Industry costs of equity. Financial economics journal 43(2), 158.

Tofallis, C. (2008). Investment volatility. Operational research 197(3), 1358.

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