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Case study made by: Ana-Maria Pase Dan-Gabriel Grigorescu Sergiu Alexandru Dragan
In 1975, the company finalizes one of its biggest challenges: the Trans-Alaska pipeline system, which was, at the time, the largest civil engineering project attempted in North America.
In 1987, BP becomes a fully privatized company, the British government having sold its last shares.
John Browne, who had been on the board as managing director since 1991, was appointed group chief executive in 1995.
In 1998, with stiff competition in the energy industry setting off a string of prominent mergers, BP and Amoco joined to form BP Amoco. Other important strategic moves followed and these included the expansion of the group by taking over ARCO, Castrol and Aral.
20th Century: Major long-term projects in Russia, the Gulf of Mexico, North America, Azerbaijan, Indonesia. In 2000, BP unveiled a new, unified global brand. Its identifier was a green, yellow and white sunburst, symbolizing energy in all its dynamic forms. To further strengthen this commitment, it created a new unit, BP Alternative Energy, devoted to making from all the various types of low-carbon energy solar, wind, natural gas, bio-fuels a viable, large-scale and profitable business. We might say BP has become an organization that embodies energy in all its many forms.
Off the coast of Louisiana, Amoco explorers found the first off-shore oil field in the mid 1940s. The companys research department followed on with some extraordinary breakthroughs, such as Hydrafrac, a hydraulic well fracturing process that increased industry production worldwide, and PTA, a chemical used in the production polyester fibres. By the end of the century, it was the largest natural gas producer in North America, with a reach that stretched well beyond its home continent: exploration in 20 countries, production in 14 countries.
Standard Oil Company (Indiana) was officially renamed Amoco Corporation in 1985. In 1998, Amoco and BP announced that they had merged, combining their worldwide operations into a single organization. Overnight, the new company, BP Amoco, became the largest producer of both oil and natural gas in the US. At the start of the new millennium, Amoco service stations in the United States were rebranded BP, although Amoco gasoline continued to flow from the pumps.
Question 1
Project Finance is a technique in which the financing of a project is totally dependent on the future contracts which will be signed and cash-flows that will be generated by that independent project company. The creditors will have to rely exclusively on the assets and profits of the project company in order to recuperate their loans and interest. Therefore, most of the funds are provided by banks (or a syndicate of banks) and not from internal sources.
In CF, the company initiating the project has unlimited liability regarding debt repayment. On the other hand, on a PF basis, the project company has only limited liability concerning its debts, meaning that the risk is limited solely to the projects own assets and cashflows.
PF has a narrower field of use than CF. While the latter can be implemented in just about any rational investment on which the company decides, PF can only be used on large-scale projects (especially those who have a long life span).
Question 2
In Bill Young and his teams opinion, CF is to remain the principal method of financing future investments at BPAmoco. However, they consider that PF could be chosen under the following particular scenarios: Mega Projects, meaning those projects so massive in size (financial requirements) that could jeopardize the well-being of the company as a whole.
Projects in Politically Volatile Areas, referring to those projects which are exposed to an increased political risk. Indeed, in these cases, the transfer of risk towards outside lenders was a major advantage deriving from the use of PF.
Joint Ventures with Heterogeneous Partners, meaning those situations when BP-Amoco needed to step in directly so as to compensate the insufficient financial capabilities of some of its partners.
Question 3
How and why does project finance create value? Hint: Think in terms of market imperfections. What are the costs associated with taxes, financial distress, information, incentives conflicts (agency), transaction, etc., and how does project finance increase or decrease the costs associated with these imperfections.
Time cost since PF takes longer than CF to arrange: Decisions are delayed This, in turn, leads to a lower project NPV Opportunities could be missed all together because of the extra-time needed Loss of managerial flexibility because of the strict requirements placed on operations and reporting. This made adapting to changes during the projects lifetime much more difficult for its sponsors. High risk in using PF of leaked information due to the fact that greater disclosure is needed in this type of financing than in the case of using company funds exclusively.
Additional tax benefits could be generated by PF for particular projects, when certain governments could be prepared to offer reduced/no taxes in order to attract investments to their countries. PF also generates value by better allocating the risk of the project between all the parties involved. PF provides a lot of benefits for companies who engage in first-time investments (high risk involved). PF combats information asymmetry on the markets and thus creates value by making them more transparent.
Question 4 Do you agree with the recommended policy? Which parts? Is anything missing?
Further to the assessment of choosing PF versus CF, the assigned team concluded that corporate funds for new projects were more popular than external funds among both companies before the merger, and that it should continue to remain as such for the combined firm, BP-Amoco.
Additionally, project finance would be used solely in three very particular circumstances, as already mentionned:
Mega projects Project in politically volatile areas Joint ventures with heterogeneous partners
Considering the above, we do not fully agree with the recommended policy, as per the following arguments:
Question 5 Study Exhibit 7. How is project finance like holding a portfolio of call options on project assets? How is corporate finance like holding a call option on a portfolio of assets?
By examining exhibit 7, we are able to draw some conclusions as to how PF might affect the overall corporate entity when it is utilized. As described above, using PF, each sponsor has limited liability towards the project; its liability is concentrated to the funds he has initially brought into the project.
Therefore, each project which is financed through PF can be thought of as a single callable option. If the project doesnt go well, the company can simply walk away, incurring a loss, which is limited to the initial funds it has invested in the project. Therefore, a project-based company can consider its overall project portfolio as a sum of callable options, the initial investment representing the premium on the call option. This representation serves many purposes, but the main one is that the company is able to mitigate the risk of default.
In the case of corporate finance such a thing is not possible. If the company decides to invest in certain projects using internal funds, it has sole ownership of both assets and liabilities resulting from the new investments. Therefore, the company will gain all the potential profits but will also incur all the losses, without any option to walk away, if the investment decision wasnt a sound one. The only actual call option the firm has is to declare bankruptcy and discontinue its operations. Thus, in the case of CF, the company has a portfolio of assets/projects, on which it can exercise a single global option: to operate or not.
After having discussed the above, the stand which Bill Young and his team took, regarding project finance for BP Amoco is somewhat understandable, since except on the three circumstances described, they do not see a plausible risk of default given the size and financial strength of BP Amoco.
We consider that the separation between the two types of NPV was founded on a largely arbitrary statement that the ideal debt-tocapitalization ratio of the company should be 30%. To sum up, we believe that the merits of PF were grossly underestimated. Even in the three exceptional cases presented, its use could ultimately be rejected in favor of internal funds because of questionable corporate beliefs.