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BP Amoco (B)

The B case presents an interesting natural experiment involving two firms from the same industry financing the same asset in two different ways. The B case provides an opportunity to apply the new policy statement to a real investment decision. Why might a project and a sponsoring firm be worth more when the project is separately incorporated and financed with non recourse debt (project finance) than when it is jointly incorporated and financed with corporate debt (corporate finance). BP and Amoco joined the Azerbaijan International Oil Consortium (AIOC), an 11-firm consortium that was developing oil fields in the Caspian Sea at a cost of $10 billion.

BP Amoco (B)

British Petroleum/Amoco the firm should use project finance instead of corporate finance for new capital investments. BPA always use corporate finance except in the case of a) mega projects b) projects in politically volatile areas, and c) joint ventures (JVs) with heterogeneous partners. BP would use project finance as a risk management tool to isolate project risk and limit the potential collateral damage a failing project could inflict on the parent corporation.

BP Amoco (B)
1) How attractive is the Caspian Oil Field investment opportunity? Are the returns commensurate with the risks? 2) What was AIOCs finance strategy for the Early Oil Project? Should BP Amoco use project finance, corporate finance, or a combination of the two to fund its share of the Full Field Development Project? 3) Is your answer consistent with BP Amocos new policy statement on the use of project finance? 4) How will LUKoil finance it 10% share of the Full Field Development Project? Why might project finance make more sense than corporate finance for LU Koil? How will LUKoils decision affect BP Amocos decision?

BP Amoco (B)

For the sponsor, the question is whether the benefits, outweigh the costs. For a large, high-rated sponsor like BPA (it is AA-rated and has $85 billion in assets, Exhibit 3), the benefits of co-insurance are approximately zeroit is not going to default or experience significant distress costs. The expected costs of providing co-insurance and of getting contaminated could be significant depending on the size of the project and the leverage. If these deadweight costs are large enough, the sponsor may forgo investment even if the project has a positive NPV on its own. Riskier projects and projects whose cash flows are negatively correlated with the sponsors cash flows are more likely to need co-insurance. and equity invests the remaining $25.

BP Amoco (B) The managers job is to decide whether to invest using corporate finance or invest using project finance, or not at all. 1) No investment: The sponsor is worth $100, the debt is worth its face value of $30, and the equity is worth $70. There is no possibility of default. 2) Corporate-financed Investment: Debt holders will invest only $75 for the project (the expected value of the corporate debt given its $85 face value 3) Corporate-financed Investment: Debt holders will invest only $75 for the project (the expected value of the corporate debt given its $85 face value 4) Project-financed Investment: The sponsor invests $57.5 into the project and raises $42.5 of new project debt (with a face value of $85)these are their expected values

BP Amoco (B)
Investment in large, risky assets can increase deadweight distress costs, which assets are most suitable for project finance and why. Asset characteristics are exogenous and that the project structure is endogenous. Project finance is used as a risk management tool, four characteristics Relative size, Relative risk ,Positive return correlation, and tangibility Make it more likely that a sponsor will benefit from using project finance. Financial distress is costly, that expected distress costs increase as the probability of distress increases, and that total firm risk is a reasonable proxy for probability of distress.

BP Amoco (B)

BP Amoco (B)
Where subscript S refers to sponsor and s P refers to project: CFP = project cash flows CFS = sponsor cash flows WP and WS are the proportion of total value in each asset; WP and WS are standard deviation of cash flows for each asset, and Var (CFP) and Var (CFS) are the variance of cash flows for each asset.

Then total, combined variance is given by the formula for two random variables.

BP Amoco (B)
The manager must compare the all-in costs (assuming value is the same) with and without the investment. The deadweight distress costs associated with corporate-financed investment are higher than the deadweight distress costs under the no investment scenario [Var(CFS) < Var(CFS + CFP)] The manager is more likely to pick the project-financed or the no investment alternatives. Total combined variance using corporate finance, Var (CFP + CFS), increases as the: 1) relative size of the project, WP, increases; 2) project risk, Var (CFP), increases; or 3) cash flow correlation, Corr (CFP, CFS), increases

BP Amoco (B)
Project finance is more appropriate for large and risky projects, where both variables are measured relative to the sponsor, which is essentially what the BPA policy statement says. The policy cites mega projects and risky projects (i.e. projects in volatile countries) as two exceptions to the corporate finance only policy. High, positive correlation typically implies some similarity between the two assets (i.e. they are from the same or related industries), which is beneficial in terms of asset management. Yet high, positive correlation between the assets increases total combined risk and increases the potential for risk contamination. Low or negative correlation, on the other hand, has the benefit of reducing total risk, but runs the risk of managerial inefficiency The merger literature shows that diversifying acquisitions destroy value compared to related acquisitions , most sponsors and projects are in the same line of business.

BP Amoco (B)
Sponsors can benefit by using project finance for large, risky assets. Substantial costs associated with structuring projects (i.e. writing contracts), it is reasonable to assume that contractual feasibility and contractual completeness are critical elements of success. Long-term contracts work better with tangible assets because there is relatively less uncertainty about future outcomes. Managers need greater flexibility to respond to rapidly changing conditions. Large, tangible, risky assets make the best candidates for project finance, particularly when they have returns that are positively correlated with the sponsors existing assets. The threat of risk contamination can result in under-investment in positive NPV projects. The project generates cash flows in emerging market currencies, the major risk involves unknown quantities or reserve risk, or the project has long-term price uncertainty in an illiquid or infrequently traded commodity), organizational risk management becomes an attractive alternative to financial risk management with derivative contracts.

BP Amoco (B)

Financing Development of the Caspian Oil Fields The first section explores the concept of risk sharing and project finance as a walkaway put option on project assets. Section two analyzes the opportunity to invest in the Full Field Development Project. the economic returns and the potential risks; a quick and highly simplified valuation analysis shows the investment opportunity looks quite attractive. Part one reviews the financing strategy used for the Early Oil Project to show the importance of staged commitments.

BP Amoco (B)
Section 1: Project Finance as a Form of Risk Sharing Total exposure would be if a firm financed the project by itself using corporate finance ($100m). Using an equity joint venture with two partners ($50m each), and using an equity joint venture with four partners ($25m each). The relationship between incremental distress costs and investment size is positive and convex. The distress costs associated with a single firm making a large investment are greater than five times the distress costs associated with five firms making 20% investments in the same asset. Larger investments may require debt finance and a greater increase in leverage. As described in most corporate finance textbooks (e.g. Brealey and Myers, 2003, pp. 497-498), the relationship between distress costs and leverage is positive and convex (so that the relationship between firm value and leverage is concave). Larger projects inject more volatility into reported cash flows.

The relationship between the cost of external finance and cash flow volatility is

BP Amoco (B)
How Attractive is the AIOC Opportunity?

Separation of financing and investment decisions: This organizational structure reflects Modigliani and Millers assumption that financing and investment decisions are independent and separable.
Independence between groups and the sequencing (business unit to finance group) creates the potential for lost opportunities (p. 3) in reality. Corporate weighted average cost of capital (WACC): BP uses a single corporate WACC (p. 10) for all of its investment proposals. Recall that it is a diversified firm with assets in oil, gas, petrochemicals, power, etc. They use the corporate WACC to evaluate projects. But senior managers makes a series of judgments at the deal approval stage based on the NPV and IRR.

BP Amoco (B)

Managerial risk aversion: Mega is the size where senior management begins to feel uncomfortable.
The magnitude of distress costs: BP defines mega projects as those that are large enough to cause material harm. For a firm with $55 billion in assets, a loss of $3 billion or approximately 5% of total assets ( =$3 billion /$55 billion). Would cause material harm to the Companys balance sheet and debt capacity.

BP Amoco (B)
Political risks Unstable situation in Azerbaijan: coups, wars, etc. (p. 2). Very high political risk (quotes p. 3, p. 4). Leadership in question: Aliyev, 76, is sick (p. 5) Weak property rights: dispute over who owns the oil (p. 6). Legal rules, bankruptcy, corporate law is either new and untested or nonexistent (p. 6). Exhibit 3 provided statistics on the Caspian and AIOC Member Countries. Azerbaijan rates 33.4 out of 100 on the Euromoney country risk scale compared to 94.5 and 90.9 for the United States and Japan, respectively.

BP Amoco (B) Financial Strategy Why BPA formed an unincorporated joint venture, staged the

commitments, and brought in the IFC and EBRD.


The mixture of project finance and corporate finance and why BP and Amoco chose different structures. Financing the Early Oil Project A JV equity structure was attractive to BP and Amoco because funds were provided on a several basis (p. 3) and, therefore, the

financially stronger partners were not obligated to carry the weaker


partners. Not all partners are equal, and not all capital contributions are equal.

BP Amoco (B)

DCF models with capital expenditures spread over multiple years future expenditures are made regardless of intermediate outcomes. Staged investment is worth 42% more [($1.75 - (- $3.25)) / $12.0]. The ability to stage allows the investor to learn something about demand, revenue, costs, risk, etc. The concept of stock type projects and flow type projects. A fixed resource that is depleted over time such as mines, oil fields, and forests whereas the latter requires use to generate value such as toll roads, power plants, pipelines, and telecommunications systems.

Flow type projects are more difficult to stage because you must spend the entire amount before you can learn much about underlying demand. Some risk can be mitigated if a wholesale market exists and you can pre-sell capacity (i.e. a company agrees to buy all or part of the projects output), yet this approach does not work with retail demand.

BP Amoco (B)

The use of agency funds from IFC and EBRD. As multilateral institutions can reduce risk, especially political risk. The AIOCs financial strategy and structure. Why BP and Amoco might have chosen different investment strategies. Both used project finance for mega projects. For BP, with $55 billion in assets, a 17% share of the AIOC, $1.7 billion (17%*$10.0B=$1.7B). Was not mega because it was less than its $3 billion threshold (p. 8). On the other hand, Amocos 17% share did constituted a mega investment (defined as $2 billion, p. 8) relative to its $33 billion in assets. Differences in opinion on the level of perceived risk in Azerbaijan. Amoco must have perceived slightly greater political risk than BP. How should BPA finance its investment in the Full Field Development Project?

BP Amoco (B)

Financing the Full Field Development Project The total expected cost of the Full Field Development Project is $8 to $10 billion, with BPA expected to contribute $2.8 to $3.4 billion (34.1%*$8.1 billion, p. 4) The expected cost of the first stage of the Full Field is $2.6 to $3.1 billion, of which BPA will have to contribute $1 billion (34.1%*$3.0 billion, p. 4). BPA should use corporate finance unless one of three exceptions exists. In the A case, BP considered $3 billion (p. 8) mega; $3 billion is approximately 5% of BPs total assets ($3B/$55B) A case (Exhibit 2). 5% of total assets for the combined BP Amoco ($85B, B case Exhibit 1) is approximately $4.5 billion. Not even the total investment in the Full Field Project would be considered mega.

BP Amoco (B)

All the investments in the Azerbaijani area should be viewed as a single project. Terms of political risk, the outcome of one investment in the area will affect the outcomes of the rest. the outcomes are highly positively correlated, and the corresponding diversification benefits will be low.
JV with Heterogeneous Partners: Heterogeneous means financially weaker or smaller partners which might be forced to use project finance. The deal contains public (Unocal, Hess, etc.) and government-owned companies (Statoil, Lukoil, etc.). Debt ratings on the members range from AAA (Amoco) to unrated (LUKoil, etc.). Finally, firm size ranges from $92.6 billion in assets (Exxon) to $100 million

BP Amoco (B)
Project finance is a tool that some companies can use to reduce the opportunity cost of leverage-induced underinvestment. For LUKoil, project finance may be the only way it can raise the funds necessary to develop its reserves. The companys total investment in the project equals $1 billion (10% of $10B), which is 25% of its current total assets ($1B/$3.9B in assets.

Exhibit 5B, that it costs $10 billion to develop 4.5 billion barrels of oil, LUKoil will need approximately $24 billion [($10B/4.5B bbls)*10.7B bbls of reserves] to develop its 10.7 billion barrels of reserves (Exhibit 1).
How LUKoils need to use project finance will affect BPAs financing decision? BPAs fear is that the weaker partners might structure a deal that somehow affects the non-participating partners or jeopardizes the consortiums ability to finance future stages.

BP Amoco (B) There is a third option for BPAa mixture of both, as was used for the Early Oil Project. as of January 2002. BPA has still not finalized the financing structure for the Full Field Development Project. It will likely be some sort of mixed strategy. Because project finance is best suited for large projects (measured in both a relative and an absolute sense). Firms use project finance for three primary reasons. The first reason is to reduce the deadweight costs associated with financial distress and encourage investment in large risky assets (risk management). This motivation applies to firms like BPA. Project finance reduces the opportunity cost of leverage-induced underinvestment debt overhang]. Finally, for relatively safe (low-risk) assets, firms can also use project finance to mitigate costly agency conflicts over free cash flow.

BP Amoco (B)
What Happened? Seven members of AIOC (SOCAR, BP, Statoil, Amerada Hess, Unocal, Itochu, and TPAO) began discussions with the Turkish Government for a 1,730 km pipeline that would run from Baku through Tblisi to a new export terminal in Ceyhan (the BTC pipeline). The sponsors originally expressed reservations about the pipeline route in light of shorter, lower-cost alternatives. US Government successfully lobbied the oil companies in favor of the BTC pipeline because it wanted to avoid alternative routes through Iran or Russia. The seven sponsors finalized a deal in October 2000. The government responsible for all expenditures exceeding the $2.4 billion construction cost. They are speaking with a range of multilateral agencies, export credit agencies, and commercial banks about financing the pipeline

BP Amoco (B)
As for the Full Field Development Project, development of the Azeri field (the first phase) began in August 2001. The estimated cost for this phase remains at approximately $2.6 billion. The consortium still plans to develop all three phases, but has pushed back completion from first quarter 2004 to early 2005. AIOC is presently negotiating a project financing of approximately $500 million with a portion of the funds to come from multilateral agencies and a portion from commercial banks.

BP Amoco (B)
Exhibit TN-7A The Value of Staged Investment

BP Amoco (B)
Exhibit TN-7B The Value of Staged Investment

BP Amoco (B)
Exhibit TN-7C The Value of Staged Investment

BP Amoco (B)
Exhibit TN-7D The Value of Staged Investment

BP Amoco (B)
Exhibit TN-4E Investment as a Portfolio Problem

BP Amoco (B)
Exhibit TN-8 Project Finance Matrix

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