Advanced Corporate Finance

Brandon Julio, Spring 2012

Petrolera Zuata, Petrozuata C.A.

Students:
Kausik Ash |
Javier Echave |
Trang Ho |
Sarah Nash |
Ayse Zeynep Saka |
Raj Sambasivan |

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 Advanced Corporate Finance
Brandon Julio, Spring 2012

1a Financing of Orinoco Basin

The generally understood criterion for using project finance to fund a project and Petrozuata's compliance
comparison are as below;
- Legally independent company = Once the project was completed, Petrozuata would become a stand-
alone entity, with the sponsors warranty coming to an end
- Non-recourse debt = at completion the project debt would also become non-recourse to the sponsors.
- Sponsor holding most of the equity are also suppliers/customers = Conoco would purchase the first
104,000 BPCD from Petrozuata upon production,
- Single purpose capital asset = While the project was an integrated facility of production, transportation
and refining, the main purpose was to sell syncrude.
- Finite life = Petrozuata had a life time of 35 years.
In light with the above, Petrozuata's financing was fit for project financing.
1b Costs and benefits of using project finance
Under the benefits of using project finance the following can be listed; it is cheaper to fund Petrozuata as
project than in comparison to PDVSA to do it internally because PDVSA is rated as B whereas Dupont is
rated as AA-; it is easier to secure an undisrupted cashflow for the project; PVSA plans further projects to
fund such a Sincor. Since it would have been also possible to fund the project internally, choosing project
finance takes a lot more time to structure, which is one of the disadvantages. Additionally the high fixed
costs of the project financing was another disadvantage for the deal.
1c Affects of project finance on cost of capital

2a Petrozuata's risks
The sponsors creditworthiness: Conoco and Maraven were subsidiaries without publicly-traded debt;
therefore the parent companies' creditworthiness was considered structuring the deal; however there was
no security against Dupont for example spinning-off or selling Conoco during the project period.
The project economics: Petrozuata had to meet its debt obligations even if the oil prices went down it was
important to consider the projects vulnerability to oil price declines
Venezuela's sovereign risk: the government could take actions such as imposing foreign exchange controls,
change the structure of revenue waterfall, or sell syncrude to an entity other than Conoco. Additionally, an
appreciation of the Bolivar could cause increase in operating expenses as well as tax-liability to its dollar
denominated revenues. Finally, Venezuelan business risks could realize related to creditworthiness of local
contractors, fragility of the financial sector and the volatility of labor market.

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2b Deal structure to bear the risks and the option of internal financing
The deal structure was made so that Petrozuata would be classified as a private company and not be
bound by the regulations facing public companies. Finding partners with extensive know-how and high
crude oil marketing capacity, the risks on the creditworthiness were lowered. Additionally, the forecasted
syncrude oil price at completion was $12.87 per barrel which was well below the current Maya price of
$18.62 per barrel. In case of internal financing, PDVSA would have had to bear all the risks together with
Conoco and Maraven.

3 Leverage ratio of financing / Sensitivity analysis

According to the case, in order for Petrozuata to get an investment grade rating, it would need to have a
base case DSCR of 1.8-2.0x and its DSCR under various stress cases would need to exceed 1.5x. Based on
the given assumptions in the model (as is), Petrozuata would be able to increase its leverage to 70%
without violating the base case DSCR requirement of 1.8x.
Leverage Ratio DSCR IRR
50% 2.47x 21.3%
60% (Proposed Level) 2.08x 25.3%
70% 1.80x 32.5%

4 Changes is the valuation methodology

For the base case, we altered the six fundamental assumptions as follows:
Variable As Our Rationale
Given Alterations
Initial oil $12.25 $14.25 Average Maya price over the past 5 years; This assumption is still
price conservative as it is only 89% of the expected $16.00/barrel price
of Maya expected in the next few months.
Avg. annual 2.5% 0% The average Maya price was relative consistent for the 10 year
change in oil period of 1986-1996 ($14.27) vs. the most recent 5 year period of
price 1991-1996 ($14.25). Both of these averages are lower than the
average for 1982-1996 ($16.57), so the assumption of 2.5% annual
growth seems aggressive.
VZ Govt. 1.0% 16.67% According to the case (p.3), the royalties paid by operating
royalty rate subsidiaries of PDVSA are 16.67%.
Initial 60% 60% Same as given.
Leverage
Market Risk 7.5% 7.0% Utilizing the market risk premium listed in Exhibit 11.
Premium
Country Risk 0.0% 6.67% Utilizing the country risk premium listed in Exhibit 11.
Premium

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In addition, we noted that the asset beta, risk-free rate and tax rate were different from the values given in
the case, so we altered these to be consistent with the case [asset beta: 0.6 → 0.38 (Exhibit 11 – p. 21),
risk-free rate: 6.81% → 5.60% (Exhibit 11 – p. 21 – COULD ALSO MAKE A CASE FOR THE 10 or 30YR.
TREASURY IN EXHIBIT 10b) and tax rate: 34% → 67.7% as an operating subsidiary of a state-owned
enterprise) – NOT SURE IF THIS LAST ONE IS FAIR, BUT FOR THE SAKE OF CONSISTENCY WITH THE ROYALTY
PAYMENTS (and since we don’t have info. On the municipal/state taxes for a non-state-owned enterprise),
I CHANGED THIS METRIC TO THE HIGHER TAX RATE.
As Is Our Alterations
Leverage Ratio DSCR IRR DSCR IRR
50% 2.47x 21.3% 0.97x 12.1%
60% (Proposed Level) 2.08x 25.3% 0.81x 15.1%
70% 1.80x 32.5% 0.69x 21.0%

Based on these alterations, Petrozueta would only be able to have a leverage ratio of 27% to achieve the
minimum base case DSCR required to be eligible for an investment grade rating. Additionally, at this level,
Petrozueta’s NPV would be negative.

Thoughts of cost of capital methodology?

5 Advantages and disadvantages of agency debt, bank debt and Rule144A bonds
Using bank debt, Petrozuata could draw on its credit line as needed, matching its cashflows. However they
were short in maturities, had restrictive covenants and were limited in size. If it was required to be covered
by PRI, which was highly likely, this structure would make the deal much more expensive and it could take
12 to 18 months to arrange it. Using public bonds on the other hand would provide longer maturity, fixed
interest rates, more flexible covenants and larger amounts of borrowing. However public bonds would
have to be raised in lump sum amounts to the extent that the excess funds would create negative carry. As
another alternative Rule144A bonds had all the advantages of public bond, plus they are faster to acquire
(6 months) and require less initial and ongoing disclosure. The main disadvantage of Rule144A bonds in
addition to the ones same as public bonds, only qualified institutions were able to get it, which meant less
liquidity for the issuance and Petrozuata would needed investment-grade rating. Given the speed and
flexibility of the process, Rule144A bonds were the most appealing financing.

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6 Weakest link in the project?

The weakest link in the project was the project's debt capacity, minimum debt service coverage ratio and
the break-even oil price. The project team estimated the projects nominal break-even price to be $8.63 per
barrel in 2008, the year of the highest forecasted debt service. According to the historical data of crude
prices, the average Maya price/barrel on full data sample was $16.57, on 10 years up to 1996 $14.27 and
on 5 year up to 1996 $14.25. Additionally the lowest price in the full historical data was $8.14 per barrel.
All these prices were in general higher than the projects break-even oil price; therefore the project should
have received the investment grade rating.

7 Sensitivity analysis on project economics

In addition to the alterable parameters in the valuation model, other variables that we would want to test
for sensitivity to verify the projects’ economics include:

• FX sensitivity [revenue: USD; costs: debt = USD/EUR (for international bonds or 144As) but operating
costs = VEF]: The model has an inflation adjustment (Calculations – Column H: “Inflation Adjustment”)
but it is not possible to do sensitivity analysis on this variable.
• Financing structure: A portion of the construction financing ($530 million) is expected to come from
operations. How will the project be impacted / what contingency plans have been formulated if
operability is delayed? If initial production levels are lower than expected?
• Subsidiary Designation: At the federal level, PDVSA (a state-owned enterprise) is subject to a 34%
corporate income tax rate and its subsidiaries are subject to both a 16.67% royalty as well as a 67.7%
income tax. Both PDVSA and its subsidiaries are not subject to state or municipal government taxes.
From the case write-up, it is unclear if there is a % ownership threshold to qualify as an operating
subsidiary and/or if non-recourse holdings are treated as operating subsidiaries, but if the government
changes its definition or if PDVSA’s share falls below the ownership threshold, if this exists (esp. as
PDVSA’s 49.9% stake will decrease after the raising of additional equity funds), this could change
Petrozueta’s tax rate, royalty payments and potentially make it subject to state and municipal taxes.
• Interest Rate: The model’s interest rate on debt ranges from 8.41-8.54% through 2022. Since 144As
take up to 6 months to complete, it would be worth exploring the potential variability in interest rates
that could be looked in at issuance. Additionally, there is a possibility that a portion of the required
debt would be bank debt (uncovered: 7.50%-8.75%; covered: 10.5-11.75%) or provided by
development agencies. The impact of these possibilities could be further explored.

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• Negative carry: If Petrozueta issues a 144A or (less likely) a public bond, it would be a drag on earnings,
as the proceeds would be received in a lump sum and the re-investment rate until these funds would
be required by operations would be lower than the coupon rate. This impact could be further
explored.

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