Policy Statement free essay sample

The British Petroleum Company p. l. c. (BP) and Amoco Corporation (Amoco) had a long history of competitive encounters. This rivalry continued into the 1990s in a variety of locations ranging from the United States to the North Sea to, more recently, the Caspian Sea—a region that had opened up to exploration by Western oil companies following the breakup of the Soviet Union in 1991. In describing this rivalry, one analyst wrote: Azerbaijan was an early battleground for BP and Amoco as these two companies competed for the oil riches of this newly independent country. During the period from 1990 until 1994, BP and Amoco were the two major players in the Azerbaijan oil rush. This competition extended to their respective governments, each of which was trying to support its country’s commercial interests via BP and Amoco. 1 Despite their historic rivalry, BP and Amoco agreed to a $48 billion merger in August 1998. Following shareholder approvals in December, they began the process of integration, which involved placement decisions for hundreds of executives and creation of a new organizational structure. Within the Finance Group, BP’s John Buchanan and David Watson retained their positions as chief financial officer and treasurer, respectively. Bill Young, a 20-year Amoco veteran, became head of a unit known as Specialized Finance with responsibility for advising the company’s business units on project structuring, project finance, leasing, and other asset-backed transactions. Shortly after the merger, in March 1999, Da vid Watson asked Bill Young to prepare a recommendation on when and in what circumstances the firm should use external project finance instead of its own internal, corporate funds to finance new investments. One challenging aspect of this assignment was the perception that BP and Amoco had somewhat different philosophies regarding project finance. To some observers, particularly those outside the firm, Amoco was viewed as more willing to use project finance than BP. Young isagreed with this characterization, though he acknowledged that he had little information on BP’s financial policies prior to the merger. Only well-capitalized firms that are big enough to afford the time, money, and risk required to play in this poker game can hope to thrive. Because the stakes are so high, finding that â€Å"elephant† of an oilfield has become the industry’s obsession. 3 Besides the need for scale, analysts cited potential cost savings of $2 billion annually and complementary commercial strengths—BP in upstream operations and Amoco in downstream operations—as reasons for the merger. In addition, executives highlighted â€Å"sustainable long-term growth† and â€Å"strongly competitive returns† as corporate objectives. In terms of financial polices, they said the new firm would have a target debt-to-capitalization ratio of 30% and a target pay-out ratio of 50% of mid-cycle earnings. 5 As a result of the merger, BP Amoco became one of the world’s three â€Å"super-majors† along with Exxon and Shell (see Ex hibit 3). Integrating the Finance Group Shortly after consummating the merger, management began the process of integrating the two companies. Both companies had highly centralized finance functions, although BP did have regional finance offices in Asia and the United States. Both companies also tended to separate investment and financing decisions, and had organizational structures that reflected this approach. The business units valued proposed investments using the corporate weighted-average cost of capital (WACC), while the Finance Group determined the best way to finance proposed investments and executed approved transactions. Management decided to retain the centralized finance structure because it provided better cash management, risk management, and financial execution. One of the perceived disadvantages of this centralized structure was that decisions impacting financing opportunities were often made at a business unit level before the Finance Group had an opportunity to provide input, thereby creating on occasion the potential for missed opportunities and sub-optimal financing solutions. Given this structure, the Finance Group had two distinct groups of customers for its services, the business units and senior management/shareholders. To achieve the benefits of centralization without creating too much of an information gap between the business units and the Finance Group, management retained BP’s central office in London to service the business units in Europe, Africa, the Middle East, and the Former Soviet Union. BP’s existing office in Singapore would provide financial services and support for business units in Asia/Pacific while the U. S. -based finance staffs were consolidated in Amoco’s Chicago headquarters with responsibility for supporting business units in the Americas. CFO John Buchanan and Treasurer David Watson ran the Finance Group, which consisted of three major divisions (Exhibit 4 shows the organization chart for the new Finance Group). Treasury Operations handled cash management, including short-term debt. Corporate Services managed all debt and equity at the parent level, as well as shareholder relations. Business Services had five major responsibilities: financial skills 3 This document is authorized for use only by Ashok Kumar Malhotra until August 2012. Copying or posting is an infringement of copyright. [emailprotected] harvard. edu or 617. 783. 7860. 201-054 BP Amoco (A): Policy Statement on the Use of Project Finance (training), business insurance, financial engineering, banking projects, and specialized finance. Bill Young, head of Specialized Finance, led a team of nine finance professionals based in London. Similar teams existed in Singapore and Chicago. All maintained close contact with the business units in the geographic areas and helped shepherd transactions through the headquarters approval process, financial negotiation, and closing. The Assignment As part of the integration process, David Watson asked Bill Young to review existing policy and recommend when and in what circumstances the firm should use project finance to fund new capital investments. Young knew this request was not just a matter of intellectual curiosity because the company invested heavily in fixed assets. In fact, BP and Amoco together had spent more than $10 billion per year on capital expenditures in each of the last three years. Expenditures of this magnitude were common among the major oil companies because their key assets, oil and gas reserves, were continually depleting (see Exhibit 5). By one estimate, total capital spending on exploration and development for the entire industry could reach $1. 4 trillion in the decade leading up to 2005. 6 This assignment was also important because project finance was a well-established financial structure in the oil and gas industry, and many firms had used it successfully in the past. Knowing the importance of the assignment, Young sought assistance from Mike Wrenn from the America’s Finance Group in Chicago and Adam Wilson from Specialized Finance Group in London (see Exhibit 4). The team began by defining project finance: Project finance is the financing of a project which is arranged in such a way that lenders are totally reliant on the assets and cash flows of that project for interest and loan repayment, as opposed to â€Å"corporate finance,† where the lenders are not reliant upon any one project and can rely on the cash flows and financial strength of the entire corporate entity. While this definition was not perfect, because there was often some form of partial or temporary recourse to the project’s sponsors such as a completion guarantee, it captured the critical distinction between corporate finance and project finance. Exhibit 6A presents a typical corporate transaction while Exhibits 6B and 6C present possible project finance structures. Exhibit 6B shows an incorporated joint venture, which was more common in petrochemical and power projects. The unincorporated joint venture structure shown in Exhibit 6C was more common for BP Amoco’s upstream businesses (i. . exploration and production projects). Under the project finance structure, a special purpose entity with limited liability borrowed funds directly and pledged its assets and cash flows to support the loan. With few exceptions, the lenders had no recourse to the project’s beneficial owners, often called sponsors. The use of internal funds, on the other hand, implied the use of the corporation’s balance sheet to obtain the debt and equity needed to finance its share of a project. It also implied that all corporate assets and cash flows could be used to repay debt. The next step in the process was to limit the scope of the assignment by considering the types of investments that could utilize project finance. Although BP Amoco could use project finance in any of its divisions, it used project finance most frequently in the downstream businesses, particularly for petrochemical plants and power generating facilities. Project finance was more often appropriate for power plants because they were discrete, non-core assets; had, at least historically, cash inflows and outflows set by long-term contracts; and had lenders familiar with project finance. According to Adam Wilson: This document is authorized for use only by Ashok Kumar Malhotra until August 2012. Copying or posting is an infringement of copyright. [emailprotected] harvard. edu or 617. 783. 7860. BP Amoco (A): Policy Statement on the Use of Project Finance 201-054 The market expects developers to use project finance for power projects, and you can’t underestimate the importance of pr ecedent. The existence of investor clienteles familiar with power plants tends to improve their valuation. The project finance structure also facilitates a sell-down of our position if and when we choose to do so. With regard to the upstream businesses, the focus would be on production rather than exploration assets because banks were reluctant to lend on a project basis until reserves were proven and capable of production. After defining project finance and bounding the scope of their assignment, the team conducted a series of meetings with executives from both organizations to understand their positions on project finance. Historically, BP had used project finance only sparingly based on a belief that the disadvantages in terms of costs, time, and rigidity outweighed the advantages in terms of risk management. Young’s interviews led him to believe this position remained an accurate assessment of the views held by most BP executives. BP executives recalled only limited applications of project financing in recent memory. Examples included the financing of the North Sea Forties Field in the early 1970s. This deal, however, was more of a corporate financing because BP remained obligated to the lenders for all interest and principal, but could use the project financing structure as a tool for reshaping debt repayment obligations in line with project economic performance. Another example was the Kaltim Prima Coal Mine project in Indonesia. Here BP chose to use project finance as a way to manage Indonesian exposure. More recently, BP, as the operator of the Cusiana and Cupiagua oil fields in Colombia, had worked with partners to create a financial structure that facilitated project financing for the export pipeline. Ecopetrol, the state oil company, and some of the other sponsors, subsequently used this structure to raise project funds for the pipeline. BP, nevertheless, chose to fund its share of the pipeline using internal funds. According to Young, Amoco also preferred corporate finance even though it had used project finance on occasion. In the early 1980s, Amoco used project finance for the $1 billion Ok Tedi gold and copper mine in Papua New Guinea. It also used project finance for a variety of international joint ventures in the petrochemicals industry to accommodate partners who were unable to finance their shares through corporate borrowings. More recently, Amoco and others had financed the $1 billion Atlantic Liquified Natural Gas (LNG) plant in Trinidad and Tobago on a project basis because certain critical partners did not want to have such a large investment on their balance sheets. In contrast, Amoco, which was investing $600 million of internal funds to develop the offshore gas fields that would eventually supply the plant with natural gas, was prepared to finance its share of the LNG plant entirely with internal funds. The Atlantic LNG financing was widely syndicated in the bank loan market, and perhaps this fact accounted for the perception that Amoco was an advocate of project finance. The New Policy Statement on Project Finance Following these meetings, the team concluded that BP and Amoco shared a common preference for using internal funds to finance capital expenditures, and that the combined firm should prefer internal funds as well. To justify this recommendation, the team carefully assessed the costs and benefits of using project finance they had discussed with their colleagues. This document is authorized for use only by Ashok Kumar Malhotra until August 2012. Copying or posting is an infringement of copyright. [emailprotected] harvard. edu or 617. 783. 7860. 201-054 BP Amoco (A): Policy Statement on the Use of Project Finance The Costs of Using Project Finance When asked to describe the merits of project finance, Bill Young jokingly replied, â€Å"The only people who prefer project finance are the ones who’ve never done a deal using project finance. Without much hesitation, he cited four disadvantages of project finance: it cost more, took longer to arrange, restricted managerial flexibility, and required greater disclosure. To begin with, non-recourse project debt cost more than otherwise equivalent corporate debt due in part to greater risk and in part to greater leverage. Lenders typically demanded up-front fees ranging from 50 to 200 basis points of the amount financed and interest rate spreads ranging from 100 to 400 basis points over LIBOR de pending on project type, location, and maturity. In contrast, BP Amoco would expect to pay slightly less than LIBOR for short-term borrowings under bank lines or through commercial paper programs, or 80 to 120 basis points over equivalent maturity treasuries for long-term, fixed-rate bonds (including fees). The ability to raise cheaper corporate funds was the direct result of having a strong balance sheet and lots of excess debt capacity. Prior to the merger, BP and Amoco had senior unsecured debt ratings of AA and AAA, respectively. Besides the direct financial costs, project finance involved substantial third-party costs. Financial advisors, selected to help structure the financing, charged advisory fees on the order of 50 to 100 basis points of the amount eventually raised. Sponsors also had to pay for engineering reports certifying the quality of project design, the feasibility of the project schedule, and, in the case of oil and gas projects, the existence of hydrocarbon reserves. In addition, they had to pay legal fees incurred in structuring operating contracts and crafting loan documentation. While some of these costs would also be incurred in a corporate deal, the incremental cost associated with project finance could add an additional 100 basis points or more in fees, according to Mike Wrenn. Structuring a project-financed deal, particularly a multi-party deal, took considerably longer than structuring a comparable corporate-financed deal. Decisions that could be made internally in a matter of days by only a handful of people, took significantly longer in a project-financed deal because more independent parties were involved in the process. Adam Wilson estimated that using project finance added a minimum of our to six months to a deal, and considerably more if one of the multilateral lending agencies was involved. Incremental time not only reduced a project’s NPV, it could also result in a missed opportunity. A third disadvantage of project finance was the loss of managerial flexibility. The loan documentation imposed an extensive set of operating and reporting r equirements on borrowers. These provisions restricted the sponsors’ ability to change design, admit new partners, dispose of assets, or respond to any number of contingencies that invariably arose over the course of a project’s life. As Young put it, â€Å"I think of corporate finance as a way to avoid the inflexibility associated with project finance. When you sign a project finance deal, you have to live with a giant stack of documents full of provisions that hinder your ability to respond to a changing environment. † A final factor weighing against the use of project finance was the occasional need to disclose proprietary information to lenders. For example, there could be tax or royalty reductions, or commitments to ancillary infrastructure investments intended to support the project that neither the owners nor the host governments wanted in the public domain. Yet lenders needed this information to make credit decisions. Depending on the size of the deal, there could be scores of lenders involved, many of whom would have banking relations with BP Amoco’s competitors. Despite the use of confidentiality agreements, the potential for leakage was troublesome. 6 This document is authorized for use only by Ashok Kumar Malhotra until August 2012. Copying or posting is an infringement of copyright. [emailprotected] harvard. edu or 617. 783. 7860. BP Amoco (A): Policy Statement on the Use of Project Finance 01-054 The Benefits of Using Project Finance The basic assumption behind the team’s analysis was that BP Amoco was a portfolio of exploration, development, refining, and marketing assets. With less than perfect correlation among its various assets, it was able to eliminate idiosyncratic risks through diversification. Because it was particularly skilled at assessing business risks, had a strong balance sheet, and had a vertically in tegrated business model, it was more efficient to hold the assets collectively than individually. However, there might be instances in which it made sense to finance investments individually on a project basis. In these instances, project finance created value by improving risk management. Whereas risk management could take several forms—risk sharing, direct risk reduction, hedging (reducing a risk by giving up the opportunity for a gain), and insurance (reducing a risk by paying a premium)—the benefits were typically associated with risk sharing and risk reduction. In terms of risk sharing, the project structure limited BP’s exposure to downside risk. In essence, BP exchanged downside exposure for a price in the form of higher interest rates and loan fees. According to Wilson, using project finance was tantamount to buying a â€Å"walk-away† or put option for the project. Exhibit 7 presents this framework: the combination of holding an underlying asset (a project) and buying a put option on that asset created a payoff function that resembled a call option on the underlying asset. When BP Amoco used corporate finance, the firm was exposed to the full range of outcomes (NPVs); when it used project finance, it sacrificed some of the upside in exchange for truncating the downside. Such downside protection could be extremely valuable in certain settings. Whether the benefits of risk sharing outweighed the incremental structuring costs was the real question. In deciding whether to make this exchange, BP had to consider both the price of the walk-away option and its willingness to exercise the option. For investments in its core businesses, BP was better equipped than most lenders to assess and bear the risks. As a result, it was not likely to get favorable, or even fair, pricing on the put option. Unlike a financial option with continuous prices, the downside scenarios in the investment business tended to be discrete events with highly uncertain, if not unknown, distributions. In these instances, history did not give you a good indication of the magnitude of potential losses or the probability of occurrence. Valuing such an option was not easy, and even informed parties could disagree on how much it was worth. The value of the walk-away option also depended on BP Amoco’s ability and willingness to exercise it. Prior to project completion, the ability to walk away from a loan could be constrained by support obligations and completion guarantees. Only after an independent third party certified completion, usually defined in terms of both financial and operational characteristics, did the loan become non-recourse to the sponsors. Although BP Amoco could walk away at this point, it might be reluctant to do so for several reasons. For example, it might not be wise to abandon a project that was an integral part of a larger development, thereby turning over a key asset to a bank group. Alternatively, a sponsor might be reluctant to abandon a proprietary asset. Would the Walt Disney Company really abandon a theme park and let project lenders control Mickey Mouse and other Magic Kingdom characters? Finally, default could tarnish the firm’s reputation and jeopardize important relationships with host governments, international agencies, and bankers. Such actions could preclude the firm’s ability to gain access to or finance future projects. To the extent BP was either unwilling or unable to walk away, the put option had no value. In addition to risk sharing, project finance had other benefits even though Young believed most of them were illusory or non-existent, at least for BP Amoco. Five such benefits came to mind. Some argued that project debt, particularly when accounting rules did not require project assets or liabilities to appear on the sponsor’s balance sheet, expanded a firm’s debt capacity. Of course, this 7 This document is authorized for use only by Ashok Kumar Malhotra until August 2012. Copying or posting is an infringement of copyright. [emailprotected] harvard. edu or 617. 783. 7860. 201-054 BP Amoco (A): Policy Statement on the Use of Project Finance assertion was true only to the extent that investors and rating agency analysts did not â€Å"see through† the financial statements and recognize continuing obligations to pay. Another supposed benefit of project finance was that it generated additional interest tax shields because projects had a igher leverage ratios than sponsoring firms: the typical project had a debt-tovalue ratio of 70% compared to 30% for a firm like BP Amoco. The difference in leverage existed, in part, because firms, but not projects, needed the flexibility and excess debt capacity to invest whenever attractive opportunities arose. Yet BP Amoco viewed its investments and payment obligations on a consolidated basis even if they were pro ject financed. Thus, the decision to finance a given asset with 70% debt simply displaced corporate borrowing capacity. As a result, the total amount of debt did not depend on particular financial structures. Besides, equivalent debt tax shield benefits could be obtained by careful choice of project ownership vehicles and intra group financing structures. In those instances where the firm could take on more leverage using the project finance structure, the incremental interest expense (and potential distress costs) usually outweighed the incremental interest tax shields, which meant that using project finance could reduce firm value. That said, there were other debt-related factors such as tax arbitrage, risk transfer, or managerial incentives that could easily off-set the benefits of incremental interest tax shields. Third, there might be tax benefits associated with reduced rates or tax â€Å"holidays† that made particular transactions attractive—host governments were often more willing to make one-off concessions to project companies than to make full-scale policy changes. Yet these benefits usually had a greater influence on site selection than on the choice between corporate and project finance. Fourth, some argued that the project resulted in better risk allocation among the various parties to a deal. This argument rested on the assumption that you could not replicate or get pricing credit for the same allocation of responsibilities in a corporate-financed deal. Except for political risk—one of the key exceptions discussed below—this assumption appeared untrue. For example, BP could sign a fixed-price, turnkey construction contract, thereby transferring completion risk to an experienced contractor, regardless of how it financed the deal. Finally, some firms used project finance for high-risk projects such as first-time investments in new industries, markets, or technologies. Here, project finance created value by introducing an added level of discipline to the process and by providing access to partners with greater or different previous experience. With the exception of investments in new countries, this rationale was not a major consideration for BP Amoco. Instead, it relied on its accumulated experience and largely restricted its investments to core assets, thereby limiting the technological and markets risks associated with new projects. The Exceptions Based on the team’s assessment of these costs and benefits, they were recommending that BP Amoco use internal corporate funds to finance new projects except in three very particular circumstances: 1) mega projects; 2) projects in politically volatile areas; and 3) joint ventures with heterogeneous partners. While other companies might weigh the costs and benefits differently and, therefore, reach different conclusions, the costs clearly outweighed the benefits in most situations for BP Amoco. This document is authorized for use only by Ashok Kumar Malhotra until August 2012. Copying or posting is an infringement of copyright. [emailprotected] harvard. edu or 617. 783. 7860. BP Amoco (A): Policy Statement on the Use of Project Finance 201-054 Exception #1: Mega Projects Mega projects were those that were large enough to cause â€Å"material† harm to the company’s earnings, debt rating, and, in the extreme, survival. Quantifying material harm was not easy to do. Instead, it was a more qualitative concept. Wilson defined mega as the size â€Å"†¦where senior management begins to feel uncomfortable about the size a nd the level of risk. † Prior to the merger, Amoco viewed investments of $2 billion and up as potential candidates for project finance; executives from BP estimated the number at closer to $3 billion. The key issue here was one of relative size and the firm’s ability to hold a diversified portfolio, a concept that would surely change following the merger. In deciding whether a project qualified as mega, it was important to define it correctly. Many oil and gas developments proceeded in phases over several years. Whereas the first phase might not exceed a given threshold, the total investment across all phases could. In the event BP Amoco elected to use project finance, it would require a much smaller and more diversifiable investment (compare the $400 million investment in Exhibits 6A to the $160 million investment in Exhibits 6B and 6C). Exception #2: Projects in Politically Volatile Areas Projects exposed to a high degree of political risk, broadly defined as war, strikes, sabotage, lack of property rights, direct or â€Å"creeping† expropriation, or currency inconvertibility, were candidates for project finance because they benefited from the presence of outside lenders. The logic was that host governments would be less likely to take or tolerate hostile action against the project because such action could jeopardize access to future credit from the international financial community. In the most risky countries, commercial lenders would not even consider lending unless one of the multilateral lending agencies (MLA’s) or an Export Credit Agency (ECA) was involved in the deal. Given their roles as development lenders and as lenders of last resort to highly-indebted countries, MLAs such as World Bank Group, the European Bank for Reconstruction and Development (EBRD), and the Asian Development Bank (ADB) helped deter sovereign interference. Thus, they reduced the level of risk by reducing the probability of default. For this reason, MLA participation was said to confer a â€Å"halo effect† on projects. Even in high-risk countries, however, relative size remained a critical factor in deciding whether to use project finance. According to Adam Wilson: The threshold for what constitutes mega in the United States or Cana da is much higher than the threshold in an emerging country. For big projects in developed countries, we would prefer to use internal funds or to share the project with a wellcapitalized partner before using use project finance. At the same time, we would prefer to finance small and medium-sized projects in even the riskiest places using our own corporate funds. The problem with using project finance was that outside lenders often required some form of political risk insurance (PRI), and the market for PRI in high-risk markets was very thin. As a result, it was expensive to buy, which created another factor arguing against the use of project finance. Exception #3: Joint Ventures with Heterogeneous Partners In certain joint ventures, BP Amoco might find it necessary to use project finance, even if unjustified on other criteria, as a way to manage the financial needs of partners with weaker credit capabilities. For example, host governments or their agencies sometimes wanted to participate in 9 This document is authorized for use only by Ashok Kumar Malhotra until August 2012. Copying or posting is an infringement of copyright. [emailprotected] harvard. edu or 617. 783. 7860. 201-054 BP Amoco (A): Policy Statement on the Use of Project Finance projects, yet did not want to use or did not have large amounts of funds available. At other times, partners with weaker balance sheets could not raise the required amounts on their own. In these instances, the project structure became the price of admission for BP Amoco to participate in the project. In other cases, BP Amoco might participate in a project financing so that it could negotiate with lenders rather than letting weaker partners negotiate for the group as a whole. Because BP Amoco’s ability to make decisions could be compromised by partner debt covenants, it wanted as much say in the negotiations as possible. Project Evaluation If a particular project met one or more of these criteria, then it would be a candidate for project finance. Because the internal finance organizations and project approval processes were similar at both firms prior to the merger, they decided to retain a similar system in the new organization. The new process was designed to quantify the incremental costs and benefits of using project finance. After a business unit determined a project had a positive NPV using the pre-determined corporate WACC assuming a debt-to-capitalization ratio of 30% (the â€Å"investment† NPV), it would forward the project to the Specialized Finance team, which would then assess various financing structures using an incremental cost analysis. They estimated the incremental, after-tax cash flows associated with fees, interest, and principal payments, and discounted these cash flows at the firm’s marginal cost of debt for a comparable maturity. This â€Å"financing† NPV was typically negative. But when combined with the â€Å"investment† NPV a nd other possible benefits described above, the result could be positive. In these instances, the Finance Group could recommend using project finance and seek approval for the chosen structure. Conclusion: Preparing for the Presentation As he put the finishing touches on his presentation, Young wondered why the public perception of differences between the BP and Amoco existed. In particular, he thought of a recent comment made by an analyst at the Center for Global Energy Studies in London shortly after the merger. At the time, both companies were participating in the Azerbaijan International Operating Company (AIOC), an 11-firm joint venture created to develop oil fields in the Caspian Sea. The analyst wrote, â€Å"The BP-Amoco merger consolidates the ownership of AIOC a little bit†¦ The two will be speaking with one voice, whereas perhaps they haven’t always been in the past. 8 Bill Young saw things differently: â€Å"Contrary to the public view that we were on opposite ends of the project finance/corporate finance spectrum, we discovered that we really were reasonably wellaligned in our views and philosophies. † His team, and the colleagues with whom he had discussed his recommendations, seemed to concur with the idea that BP Amoco should use corporate funds to finance new investments except in very special circumstances. Elaborating, he said: It’s likely that project finance will continue to be used sparingly at BP Amoco.