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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.

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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

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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

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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

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Project Financing Vs Corporate Financing

Direct Financing Project FinancingCriteria [On Balance Sheet] [Off Balance Sheet]

Corporate structure Corporate structureOrganisation -Large businesses Cash flows only from

Cash flows from different Project assetsassets are mingled

Control & Control vested in Stringent monitoringMonitoring management, Investors’

role minimalRisk Allocation Full recourse Limited/Non- recourse

Diversified across Contractual arrangementsassets for risk distribution

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Project Financing Vs Direct Financing

Financial Easy/fast Difficult and timeFlexibility consuming, highly

structuredFree cash flow Can be freely Must follow cash waterfall

used. Commingled and allocated as per Corporate Policy Cash Flow Sweep

Debt Contracts Lenders seek Lenders recourse to allrecourse all assets project assetsTypically unsecured Secured

Debt capacity Seen in entirety Only out of project assetsplus Credit support fromother sourcesHigh leverage Possible

Direct Financing Project FinancingCriteria [On Balance Sheet] [Off Balance Sheet]

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Project Financing Vs Direct FinancingDirect Financing Project Financing

Criteria [On Balance Sheet] [Off Balance Sheet]

Bankruptcy Costly and time consuming Cost of resolving financialFinancial distress can be avoided distress lower, BankruptcyBeneficial to lenders as they have ‘remote’, more risky to access to entire asset lenders

Transaction Lower HigherCosts

Agency Cost Equity Investors exposed Agency cost for FCF reducedManagement Incentive project Incentive can be tided to PFSpecific is difficult Closer monitoring by investorAgency Cost Greater Under investment mitigated

Agency cost lower

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MARKET IMPERFECTIONS

PROJECT FINANCE CORPORATE FINANCE

Transaction CostPf has higher cost

Higher structuring cost to set up project company (lawyers, independent consultants, financial advisors etc)

Harder to obtain operating synergy as project may be economically independent

Lower structuring Cost

Easier to obtain operating synergy

Distress CostUnclear advantage

Less threat of risk contamination (isolate losses at the project level)

Little benefit from co coinsurance

Greater threat of risk contamination

Greater potential for co insurance

TaxesPf 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 CostPF has higher information cost

Better information about project assets and cash flows (more transparent)

Greater disclosure can be costly from a competitive perspective

Less information on multiple, Co mingled assets and cash flows

Agency costUnclear advantage

Little managerial discretion (more discipline can be value enhancing)

Restrictions on use of cash flows

Little risk of under investment (projects have limited investment needs)

Better defense against sovereign interference (expropriation and hold up)

Greater managerial discretion- depends if discretion is beneficial

Greater risk of leverage induced under investment

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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

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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.

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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

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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

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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?

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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

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Exhibit 5a Estimated Project Economics for the Azeri, Chirag, and Deepwater Gunashli Fields

Oil price (assumed) $10.00 $15.00 $20.00 $25.00Production costs a 4.00 4.00 4.00 4.00Transportation costs

b3.00 3.00 3.00 3.00

Gross profit 3.00 8.00 13.00 18.00AIOC cost recoveryc 1.50 4.00 6.50 9.00Pre-tax profit 1.50 4.00 6.50 9.00AIOC share d 1.05 2.80 4.55 6.30Azerbaijani taxes

e0.26 0.70 1.14 1.58

After tax profit to AIOC 0.79 2.10 3.41 4.72

Total available to AIOC for cost recovery and profitf $2.29 $6.10 $9.91 $13.72

Source: Casewriter estimates based on public information.aProduction costs are assumed higher than BP Amoco’s world average of $3.05/bbl (Amoco Corp., Form 8K, 8/12/98).bThe PSA contemplates transportation costs to the Mediterranean of $3.00/bbl (Ramco Energy Prospectus, 3/10/97, p. 40).

cThe PSA allocates 50% of gross profit for cost recovery (Ramco Energy Prospectus, 3/10/97, p. 40).dInitially, there is a 70/30 split between AIOC and SOCAR (Ramco Energy Prospectus, 3/10/97, p. 40).eThe Azeri tax rate for the AIOC is 25% (Ramco Energy Prospectus, 3/10/97, p. 47).

f 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.

Project Economics (per barrel)

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Exhibit 5b Estimated Production Volumes for Azeri, Chirag, and Deepwater Gunashli Project

Average Daily Production CapitalProduction (millions of Expenditures

Year (barrels of oil) barrels per year) ($ millions)

1998 $1,9001999 Early Oil Complete 100,000 36.5 $1,000

2000 100,000 36.5 $1,0002001 100,000 36.5 $1,1002002 200,000 73.0 $1,000

2003 Stage 1 Complete 200,000 73.0 $1,5002004 Stage 2 Complete 400,000 146.0 $1,5002005 Stage 3 Complete 600,000 219.0 $1,000

2006 800,000 292.02007 800,000 292.02008 800,000 292.02009 800,000 292.02010 800,000 292.02011 800,000 292.02012 700,000 255.52013 700,000 255.52014 700,000 255.52015 600,000 219.02016 600,000 219.02017 600,000 219.02018 500,000 182.52019 500,000 182.52020 500,000 182.52021 300,000 109.52022 200,000 73.02023 0 0.0 0.0

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Average Production CAPEXCAPEX (millions) $10.00 $15.00 $20.00 $25.00 Discount Factor $10.00

Year Bbl/Day barrels/yr ($ millions) $2.29 $6.10 $9.91 $13.72 10% $2.29

1998 $1,900 1.000 1999 Early Oil Complete100,000 36.5 $1,000 83.59 222.65 361.72 500.78 0.909 75.99

2000 100,000 36.5 $1,000 83.59 222.65 361.72 500.78 0.826 69.082001 100,000 36.5 $1,100 83.59 222.65 361.72 500.78 0.751 62.802002 200,000 73.0 $1,000 167.17 445.30 723.43 1001.56 0.683 114.18

2003 Stage 1 Complete200,000 73.0 $1,500 167.17 445.30 723.43 1001.56 0.621 103.802004 Stage 2 Complete400,000 146.0 $1,500 334.34 890.60 1446.86 2003.12 0.564 188.732005 Stage 3 Complete600,000 219.0 $1,000 501.51 1335.90 2170.29 3004.68 0.513 257.35

2006 800,000 292.0 668.68 1781.20 2893.72 4006.24 0.467 311.942007 800,000 292.0 668.68 1781.20 2893.72 4006.24 0.424 283.592008 800,000 292.0 668.68 1781.20 2893.72 4006.24 0.386 257.812009 800,000 292.0 668.68 1781.20 2893.72 4006.24 0.350 234.372010 800,000 292.0 668.68 1781.20 2893.72 4006.24 0.319 213.062011 800,000 292.0 668.68 1781.20 2893.72 4006.24 0.290 193.692012 700,000 255.5 585.10 1558.55 2532.01 3505.46 0.263 154.072013 700,000 255.5 585.10 1558.55 2532.01 3505.46 0.239 140.072014 700,000 255.5 585.10 1558.55 2532.01 3505.46 0.218 127.332015 600,000 219.0 501.51 1335.90 2170.29 3004.68 0.198 99.222016 600,000 219.0 501.51 1335.90 2170.29 3004.68 0.180 90.202017 600,000 219.0 501.51 1335.90 2170.29 3004.68 0.164 82.002018 500,000 182.5 417.93 1113.25 1808.58 2503.90 0.149 62.122019 500,000 182.5 417.93 1113.25 1808.58 2503.90 0.135 56.472020 500,000 182.5 417.93 1113.25 1808.58 2503.90 0.123 51.342021 300,000 109.5 250.76 667.95 1085.15 1502.34 0.112 28.002022 200,000 73.0 167.17 445.30 723.43 1001.56 0.102 16.972023 0 0.0 0.00 0.00 0.00 0.00 0.092 0.00

$10,000 $10,364.5 $27,608.6 $44,852.7 $62,096.7 $3,274.2

NPV -$4,162.1

Net Profit to AIOC ($ perBarrel)

AIOC Cash flows (US$ Millions)Price per Barrel

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Sensitivity Analysis Discount Million $Rate $2.29 $6.10 $9.91 $13.72

7% ($3,602) $3,815 $11,232 $18,6498% ($3,832) $2,839 $9,510 $16,1809% ($4,016) $2,003 $8,022 $14,040

10% ($4,162) $1,285 $6,733 $12,18011% ($4,277) $668 $5,614 $10,55912% ($4,366) $137 $4,640 $9,14213% ($4,433) ($321) $3,790 $7,901

$10.00 $15.00 $20.00 $25.00Price Per Barrel

Project returns in terms of NPV

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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

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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

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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

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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?

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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

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• 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

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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

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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?

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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

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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

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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?

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• 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

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Your Vote

Pros and ConsPros and ConsPros and Cons

Yes/NoYes/NoYes/No

COMBINATIONCORPORATE FINANCE

PROJECT FINANCE

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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?

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• 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

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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

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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?

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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)

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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,TechnologicalCost and Management

No Yes No

When to use project finance? Motives

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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)

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