Petrobras Proposed Solution

FUQ‐04‐2010 Original: April 10, 2010

Proposed Solution

Petrobras in Nigeria: Valuation of the Agbami Oil Field

This case was prepared by Nikita Agarwal, Jacob Anjilivelil, Mahesh Damodaran and Jesse Schwarz for the Advanced Topics in Corporate Finance course under the supervision of Professor Campbell R. Harvey and was written as a basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation.

Copyright © 2010 – all rights reserved. The Fuqua School of Business, Duke University, 1 Towerview Drive, Durham, NC 27705, USA. http://faculty.fuqua.duke.edu/~charvey/Cases/index.htm

Proposed Solution of Petrobras in Nigeria: Valuation of the Agbami Oil Field FUQ‐04‐2010

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Case Synopsis

David Passami, the VP of strategy for Petrobras Nigeria has to make an important decision. Statoil has made a $1bn bid for Petrobras’s 13% share in the Agbami (Nigeria) project. Petrobras has been in Nigeria since the past 10years and has invested $500mn in the country. Petrobras is going to start seeing oil revenues this year (2008) but there are many uncertainties associated with the projected cash flows. The idea is for students to evaluate the cash flows after putting tangible values to the uncertainties as well as to strategically analyze the options available to Petrobras at this point. Students are required to make a recommendation as to which option they would select and support their recommendation with reasons.

Objectives of the Case

By working through this case, students should develop an understanding of the political, economic, and social context around a strategic investment decision in an emerging market. Specifically, the case requires an analytical look at a specific industry (oil) in which major upfront costs are made with revenue and cash inflows expected 8-10years after the capital investment. The case asks students to evaluate both the explicit and implicit risks associated with a project or investment, complete a break-even analysis, analyze selling out versus staying invested in a project and understand the role of the cost of capital in analyzing financial returns.

Primary objectives of this case include:

• Risk assessment of the oil industry • Risk assessment of the political, economic, and social environment in Nigeria • Valuing Petrobras's share in the Agbami project through a NPV analysis • Identifying the key uncertainties associated with staying invested in the Agbami project • Evaluating the effect of each uncertainty through a sensitivity analysis on the value of the

Agbami project • Strategic recommendation on whether Petrobras should stay invested in the Agbami project

supported by adequate qualitative and quantitative analysis Why Oil? Oil is an incredibly significant commodity. Oil is deeply ingrained into our culture as it was the driving force (and still is in the developing regions of the globe) behind industrialization. There is no country or area in the world today that can insulate itself from problems in the oil market. Oil affects every nation on earth with no exceptions. Oil is remarkably pervasive in society and can be found in a multitude of commodities. It is a misconception that oil is merely present in petroleum fuel for cars. Oil is used for heating homes, running electric power plants, fertilizers and pesticides and a whole variety of plastics. In fact 1/3 of all oil consumed in America is for stationary uses, such as industries, businesses and residencies. It has also grown into a huge factor in international trade. Primary energy fuels represent 3.3% of total world GNP, with oil making up 2/3 of that. In addition, oil represents 7% of world exports. Overall, oil now fulfills many important roles: Key global commodity, political bargaining chip, economic catalyst or, as the Gulf War showed us, excuse for military aggression. In any of these roles, oil is undoubtedly very important.


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Why Nigeria? Nigeria is the most populous country in Africa, the eight most populous country in the world, and the most populous country in the world in which the majority of the population is black. It is listed among the "Next Eleven" economies, and is a member of the Commonwealth of Nations. The economy of Nigeria is one of the fastest growing in the world, with the International Monetary Fund projecting a growth of 9% in 2008 and 8.3% in 2009. It is the 2nd largest economy in Africa. Nigeria's economy depends a lot on it's oil wealth which is found abundantly in the Niger Delta. However, as is the case with many emerging economies, Nigeria still suffers from many political, social and economic issues which make it an interesting case topic. Risk Identification and Mitigation There are several risks and uncertainties Passami needs to consider before making his decision to sell out to Statoil or not. These risks can be divided into four generalized categories:

1. Project risks – those risk factors that directly impact the production of oil and affect the cost of capital 2. Market risks – those factors impacting the oil market as a whole 3. Sovereign risks – risks facing any business operation in Nigeria

Below is an in depth analysis of these risk factors as well as potential mitigating factors.

Project risk: General Risks Specific Risks Agbami Mitigating Factors

Sovereign

Currency

Direct currency risk: Exchange rate andcurrency fluctuations can directly impact thevalue of goods and services sold. Indirect currency risk: Macroeconomicpolicies can cause the local currency todevalue which has a secondary effect.Massive devaluation can cause major unrestin the country.

Oil sold in USD which takes a big bite out ofthe risk premium. All transactions regardingthe export of oil take place in dollars. Thereremains some risk, as Petrobras exports toother countries and the dollar can move up ordown against their currency. However, thesemovements are rather stable and there areadequate derivative markets through whichsuch currency risks can be hedged.

Expropriation Direct: The government can seize assets

Diversion: The government can divert exports

Creeping: The government can alter itstaxation policies

Direct: Oil projects are capital intensiveprojects in which large capital investmentsare made get projects up and running. Thegovernment can seize some of the PSOs andsell oil in the thriving black market. Currently$10bn worth of oil barrels are stolen everyyear from the Niger Delta for illegal tradewhich has a corrupting effect on securityservices and institutions.

Creeping: The government can alter itstaxation policies by increasing taxes(currently at 85%), can increase the royaltiescollected (currently at 18.50%) or can


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decrease the profit allowance (currently at16%) which would have a negative impact onPetrobras's revenue in Agbami.

Diversion: There seems to be very little riskof the government diverting exports.

Though it is unlikely that Petrobras will exitNigeria even if taxes and royalties increase,the government would not want to antagonizePetrobras or any foreign oil investor in thecountry through direct or creepingexpropriation. The Agbami and other oilprojects contribute to the economic prosperityin Nigeria with $55bn in oil earnings flowinginto the treasury in 2007 and an estimated$76bn expected in 2008. A rationalgovernment decision maker would not wantto change policies that could negativelyimpact these inflows into the state’s coffers.

Commercial International partners

Are any international partners involved in thisproject that lend credibility to the project andthat could give Petrobras and Agbami astronger hold in the region?

Petrobras has partnered with U.S. oil giantChevron and Statoil in the Agbami project.Texaco has a technical sharing agreementwith them. Many other international oilcompanies have made investments in theregion. Petrobras has internationalcommercial partners in the Agbami projectwhich gives them a stronger hold in theregion.

Involvement of Multilateral Agencies

Is any multilateral agency involved in theproject which lends support to the project andbenefits from the project proceedingsmoothly?

Since 2008 the Nigerian government hasbegun to demonstrate political will toimplement market-oriented reforms urged bythe IMF, such as to modernize the bankingsystem, to curb inflation by blockingexcessive wage demands, and to resolveregional disputes over the distribution ofearnings from the oil industry. It appears asthough the government would work towardsresolving any oil field related conflicts thatmay arise in the region.

Sensitivity of Project to wars, strikes, terrorism

Sensitivity of the project to civil unrest andstrikes that could affect the ability ofemployees to carry on their daily work. Oneway to think about this is: is this project moresensitive to war and terrorism that otherprojects undertaken in Nigeria?

The Agbami project is not so vulnerable tostrikes since it is a capital intensive projectwith many foreign employees that bringexpertise of the offshore oil industry.However, the project is vulnerable to civilwar and terrorism. Agitation for betterresource control in the Niger Delta has led todisruptions in oil production. Competition foroil wealth has fueled violence between


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innumerable ethnic groups, causing themilitarization of nearly the entire region byethnic militia groups as well as Nigerianmilitary and police forces. Offshore terroristattacks have been rare but recently speedboatriding gunmen navigated more than 100km ofopen sea in darkness to attack Shell’s giantBonga vessel, forcing the company to shut200,000 b/d of oil production. Agbami is as sensitive to war, strikes andterrorism as any other oil field in the region.Though there is civil unrest in the region, oilwealth has increased the GDP of the country(though income inequality has increasedsimultaneously). The government has themost incentives to maintain peace andstability in the region.

Sensitivity of Project to natural disasters

Natural disasters are unexpected suddenevents which impacts with such severity thatit is usually disastrous and uncontrollable.

Nigeria is exposed to natural disasters like oil spillage, drought and the most common of all, flood. However, the Agbami project is not more sensitive to such natural disasters as is any other project in the region.

Operating Resource Resources include availability of inputs and

raw materials required for production. Though Daewoo had brought the FPSO toAgbami in 2007, the FPSO had not yet comeonline and the field is still awaitingproduction. Aside from this resource beingactivated, Agbami has all the resourcesrequired for oil drilling.

Technology Technology refers to the technological

challenges required for ongoing and sustainedproduction.

Deepwater projects are more technologicallychallenging than onshore projects.Technological risks are low as Agbami doesnot involve any new offshore technology.Petrobras brings the technical expertise andexperience in deep water.

Financial Probability of default

Default refers to the inability to make debtpayments or to come up with adequatefinancing for completion of a project.

Petrobras has financed it's investment inAgbami through available cash and has nottaken on any leverage. There is the small riskthat the other partners of the Agbami projectmay run into a cash crunch delaying drillingand production. However, given that majorinvestments have already been made into theproject by large experienced partners, itseems unlikely that coming up with financeswill be an issue.


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Political risk insurance Political risk insurance is a type of insurance

that can be taken out by businesses, of anysize, against political risk — the risk thatrevolution or other political conditions willresult in a loss.

Petrobras has insurance in place protectingthem against all political risks.

Market Risks General Risks Specific Risks Mitigating Factors

Price Volatility The oil market is among the most volatilecommodity markets in the world. As a general trend, falling oil prices affect theeconomies of various oil producing nationsthat depend largely on oil income.

Nigeria became a member of the OPEC in 1971; as a member, it is somewhat shielded from major fluctuations in oil prices by the OPEC which controls supply and demand to maintain global oil rates. However, even the OPEC cannot shield countries from a drop in oil prices caused by a major recession / slowdown in world economies.

Market Demand Nigerian crude is of light, sweet quality forwhich there is a large market demand.

Nigeria is an important oil supplier to the United States. Over half of the country’s oil production is exported to the United States (see exports below) and the light, sweet quality crude is a preferred gasoline feedstock. Consequently, disruptions to Nigerian oil production impacts trading patterns and refinery operations in North America and often affect world oil market prices.

New market entrants

Oil upstream and downstream activitiesrequire a substantial capital investment aswell as expertise and experience in theindustry. There a big barriers to entry for newmarket entrants.

Petrobras’s expertise in off-shore drilling set them apart from new entrants that are still mastering the technology needed for such off-shore drilling techniques.

Sovereign Risks

General Risks Specific Risks Mitigating Factors

Political instability and corruption

The country has only re-achieved democracy status (in 1999) after 33 years of military rule.The current President of Nigeria is unwell andthere are underlying strains of political unrestready to erupt in the country. There isgrowing unrest as few individuals benefitfrom the oil wealth of the country adding tothe income inequality.

The chance of return to military rule seem remote in Nigeria as the country has made rapid strides towards development and progress in the past decade. It has successfully dealt with many of the political and economic issues it faced.

Currency exposure An unstable home currency createsuncertainty, hindering ability to make

All transactions regarding the export of oilbeans take place in dollars. There remains


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business decisions. A strengthening currency will weaken export demand, while aweakening currency will improve exportdemand.

some risk, as Petrobras exports to othercountries, and the dollar can move up or down against the currency of these countries. However, these movements are rather stable and there are adequate derivative markets through which such currency risks can be hedged.

Expropriation The government can seize assets, divertexports, or alter its taxation policies.

Nigeria’s economy depends largely on it’s oil wealth and it would not be in the best interest of the country or its leaders to antagonize oil companies by expropriating.

Valuation: We created a pro-forma for Petrobras in Nigeria till the date 2024 in order to value the company’s Agbami project. Since Petrobras is going to start seeing revenues from Agbami in the year 2008 and the normal life of an offshore project is 16 years (not including the years invested in drilling and exploration), 2024 seemed like a good time period over which to project cash flows. Our pro-formas used the income statement ratios of Chevron in Agbami and adjusted Petrobras’s income and expenses proportionately. The changes in working capital as suggested in the case are 0 for the purpose of the NPV analysis. The capex figures, as mentioned in the case, are $7bn amortized over 17years. Since there is no debt for financing the operations, there is no interest expense. Based on the above cost of capital analysis, we obtained a cost of capital of 16.69% for the project factoring all sovereign, operating and financial project risks.

In order to evaluate the downside potential that a fall in oil prices can have on the Agbami project, different production schedules can be used which will result in different revenue figures. The Texas State Government oil price projections are more bearish and give a worst case scenario that can be used to get a range of values for Petrobras. The oil prices using futures are more optimistic. Students can also come with a 3rd in-between oil price schedule which averages the worse case and best case scenarios. We have also created a break-even price of oil (option 4 in the production schedule tab of the excel solution). Using the Texas State Government oil price projections, as well as base case profit allowance (16%), royalty (18.50%) and tax figures (85%) we obtain a net present value of $618million. Given the offer price of $1bn from Statoil, it seems like accepting Statoil's offer is the best option in this case. However, students should consider the intangible value of relationships in the future on which there is an associated premium that is difficult to quantify (Relationships section on page 9 of the case). The Agbami opportunity gives Petrobras an opportunity to partner with the big players like Chevron and many others in the future. Exhibit 11 displays the world’s deepwater opportunities that could be potential opportunities for Petrobras. The value of the relationships though hard to quantify is larger than the ($1bn-$618mn) $372mn premium that Statoil is offering. Additionally, this is a worst case scenario of oil prices and making a decision on the basis of this scenario alone would be incorrect. Using an average oil price projections, as well as base case profit allowance (16%), royalty (18.50%) and tax figures (85%) we obtain a net present value of $1.049billion. Given the offer price of $1bn from Statoil and the fact that David is willing to consider an offer price of up to 10% below that of the true


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value ($944.51mn in this case) of its stake in Agbami, it seems like Statoil has made a substantial offer in this case. Again, students should consider the intangible value of relationships in the future on which there is an associated premium that is difficult to quantify (Relationships section on page 9 of the case). Additionally, this is an average scenario of oil prices and does not consider more optimistic oil prices based on futures prices. Using an optimistic oil price projections, as well as base case profit allowance (16%), royalty (18.50%) and tax figures (85%) we obtain a net present value of $1.481billion. Given the offer price of $1bn from Statoil and the fact that David is willing to consider an offer price of up to 10% below ($1.332bn in this case) that of the true value of its stake in Agbami, it seems like Statoil has made a very low bid for the Petrobras share in Agbami. This is without considering the intangible value of future relationships so in the optimistic oil price scenario, Petrobras should not accept Statoil’s offer. In order to evaluate the uncertainty that a change in royalty (currently @ 18.50%) can have on the present value of the Agbami project, students can adjust these numbers to create different scenarios. In the event of creeping expropriation, the Nigerian government might increase their taxes (currently at 85%) or decrease the profit allowance figures (currently at 16%). We have created a drop down menu to allow for different royalty, profit allowance and taxes on the A break even analysis can be done to determine how low oil prices need to be in order to make the project futile for Agbami. This has been done (oil price scenario 4) in the solution. Though not required, students can find an expected value of the field factoring in all uncertainties and assigning equal probabilities to each scenario. Real Options Analysis There are 3 potential options available to Passami at this point in time: Option 1: Stay invested in Agbami and Nigeria (recommended) The NPV analysis yields different values for Petrobras’s share in Agbami based on the fact that there are many uncertainties around the price of oil in the future as well as the drilling costs, royalties, production schedule taxes and profit sharing allowance. One option available to Passami is to reject the Statoil offer and stay invested in the Agbami project. The advantages of doing so are:

• Through the newly formed partnership with Chevron and Texaco, Petrobras can make many more global oil investments. As mentioned in the case, these are valuable relationships for Petrobras. Students should consider the intangible value of relationships in the future on which there is an associated premium that is difficult to quantify (relationships section on page 9 of the case as well as exhibit 11 showing potential deepwater opportunities).

• The Brazilian and Nigerian government can continue to share a good working relationship and Petrobras could continue to establish itself as a premier player in deepwater production.

• Though the recent attack by the MEND on a deep-water oil facility is alarming, Nigeria has come a long way in curbing ethnic and political unrest and has made much progress in the past decade. The government is also trying to implement the market-oriented reforms urged by the IMF showing the desire for progress and economic upliftment.

• The key reasons for entering this project were the sweet quality of oil and the transportation costs and those had not changed.


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• Staying invested in the project would also be keeping with the long term objectives of the company which are to accelerate out-of-Brazil expansion plans.

Option 2: Selling Petrobras’s share to Statoil Using the average and bearish oil price forecasts, it seems to make sense for Petrobras to sell their share to Statoil. From a pure numbers perspective, Statoil has made a good offer for Petrobras’s share in Agbami. There are many advantages for Petrobras to exit Agbami and eventually Nigeria.

• Though the country has progressed in the past decade, it still struggles with political and economic instability. The attack by the MEND is a reminder of the past violence that the country has seen.

• Petrobras has been invested 10 years in Agbami and is still to see revenues from oil. Exiting at this point would prevent any further capital investments into the project.

• Statoil is already a partner in the Agbami project and selling out would be a seamless process. Maybe, Petrobras could negotiate a higher acquisition amount with Statoil.

• The cash flows from the project are shrouded with uncertainty and given the bearish news from the US unemployment, a recession could majorly affect prices of oil, demand for oil and in turn revenues.

Option 3: Looking for additional potential buyers of Petrobras’s share in Agbami The only advantage of this option over accepting Statoil’s offer is that Petrobras might be able to get a much higher price for their share in Agbami. However, finding a new acquirer might be a time consuming process. Additionally, selling out to a new partner would require approvals from the existing partners of the project which may be hard to get.

Documents

Petrobras Proposed Solution