BP Amoco Case

8/3/2019 BP Amoco Case

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Why should a company

segregate the cash flows from a

particular business, and make it self financing?Group Members

Swapnil Potdukhe (89) Shraddha Ghag (117)

Rashi Jain (100) Vrinda Mohan (142)


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British Petroleum Amoco Corporation

UK based worlds3rdlargest Oil & Gasgiant

Operations in 70countries

56,000 employees

CEO Sir John Browne

Assets $ 54.6 bn.

Revenues $ 71.3 bn.

Profits $ 4.1 bn. (1997)

US based worlds6rdlargest Oil & Gasgiant

Operations in 25

countries 43,000 employees CEO H Lawrence Fuller Assets $ 32.5 bn. Revenues $ 31.9 bn. Profits $ 2.7 bn. (1997)


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In spite corporate rivalry, both agreed to a $48billion merger in 1998 to form BP Amoco

to create financial synergies required to fundcapital intensive projects.

Cost saving of $2 billion annually Complementary commercial strength BP in

upstream operation , Amoco in downstream

Sustainable long term growth & strong competitive

return Debt to capitalization ratio-30% , target pay-out

ratio 50%


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Global HQ in London with Sir John Browne (BP) as CEOH Lawrence Fuller (Amoco) & Peter Sutherland (BP) asnon exe co-chairman

Finance Group: CFO: John Buchanan (BP) Treasurer: David Watson (BP)

Head Specialized Finance: Bill Young (Amoco)

Both companies had highly centralized financefunctions with preference for corporate financing overproject financing.


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Goal: To work out new financing policy for the merged

entity.

Process: Watson & Bill sought opinion of finance

executives of both the firms regarding their takeon project finance vis--vis corporate finance.

BP sparingly used project finance Amoco too, believed in corporate finance more.

But they sometimes used project finance.


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Long term financing of the project in which lenders are totally relianton the assets and cash flows of that project for interest and loanrepayment

Fund projects off balance sheet and cash flows are separatedfrom parent company

The financier usually has little or no recourse to the non-

project assets of the borrower or the sponsors of the project A special purpose entity is created with limited liability which

borrows funds directly and pledges its assets and cash flows tosupport the loan, thereby shielding other assets owned by a projectsponsor from the detrimental effects of the project failure

Project financing has been most commonly used in theextractive mining, transportation, telecommunication andenergy industries.

Component of debt is very high


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Firms bear deadweight costs (DWC) when they invest in

and finance new assets. DWCs result from marketimperfections. They include:

Agency costs and incentive conflicts

Asymmetric information costs

Financial distress costsTransaction costs

Taxes

Sponsors should use project finance whenever the DWC are

lower than their corporate finance counterparts

To manage risks more effectively and more efficiently.


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The Capital Structure is irrelevant as long as thefirms investment decisions are taken

Then why do corporations:

Set up independent companies to undertake megaprojects and incur substantial transaction costs

Finance these companies with over 70% debtinspite of the projects typically having substantial

risks and minimal tax shields


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- Symmetric risks including: market risk (quantity), market risk (price),input or supply risk, exchange, interest and inflation rate risks, reserverisk, throughput risk. Exposures to symmetric risks causes largerpositive and negative deviations from the expected outcome.

- Asymmetric risks including: environmental risk, expropriation risk.These risks cause only negative deviations in the expected outcome.

- Binary risks including: technology failure, full expropriation,counterparty failure, regulatory risk, force majeureThese risksincrease the probability that an asset ends up worthless.

In practice, projects have relatively low asset risk allowing a high debt

capacity. The use of leverage introduces financial risk which allowequity-holders to capture unlimited upside once debt claims have beensatisfied


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Financing vehicle Similarity Dis-similarity

Secured debt Collaterized with aspecific asset

Recourse tocorporate assets

Subsidiary debt Possible recourse tocorporate balance

sheet

Asset backedsecurities

Collaterized and non-recourse

Hold financial, notsingle purposeindustrial asset

LBO / MBO High debt levels No corporate sponsor

Venture backedcompanies

Concentrated equityownership

Lower debt levels;managers are equityholders


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Project Finance (PF)v/sCorporate Finance (CF)


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Project finance allows firms:

to minimize the net costs associated with marketimperfections such as:

- incentive conflicts,- asymmetric information,- financial distress,- transaction costs,- taxes.

to manage risks more effectively and moreefficiently.


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Project Finance Corporate Finance

Purpose: a single purpose capital asset,usually a long-term illiquid asset. The

project company is dissolved once the

project is completed. No growthopportunities.

A legally independent project: the

project company does not have access

to the internally-generated cash flowsof the sponsoring firm and vice versa.

The investment is financed with non-recourse debt. All the interest and loanrepayments come from the cash flows

generated from the project.

Project companies have very high

leverage ratios, with the majority of

debt coming from bank loans.

A company invests in many projectssimultaneously.

The investment is financed as part ofthe companys existing balance sheet.The lenders can rely on the cash flowsand assets of the sponsor companyapart from the project itself. Lendershave a larger pool of cash flows fromwhich to get paid. Cash flows and

assets are cross-collateralized. Publicly traded firms have typical

leverage ratios of 20% to 30%.


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Project finance reduces costlyagency conflicts:-Conflicts between ownership and control- Conflicts between ownership and related parties- Conflicts between ownership and debtholders

Project finance reduces information costs (asymmetricinformation). Project finance reduces costly underinvestment, in

particular leverage-Induced underinvestment.

Project finance, as a organizational risk management tool,reduces the potential collateral damage that a high riskproject can impose on a sponsoring firm, i.e., riskcontamination. It also reduces the costs of financialdistress and solves a potential underinvestment problem


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Project company is dissolvedonce the project gets completed.No future growth opportunities. Cash flows of the project areseparated from cash flows of

sponsors. The single discreteproject enable lenders to easilymonitor project cash flows.

The verifiability of CFs isenhanced by the waterfallcontract that specifies howproject CFs are used.

Company invests in manyprojects and possessesmany growth opportunities.

Cash flow separation isdifficult to accomplish incorporate finance. Projectcash flows are co-mingledwith the cash flows fromother assets makingmonitoring of cash flowsdifficult.

The verifiability of cashflows is difficult.


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Monitoring mechanisms include:

Managerial discretion is constrainedby extensive contracting. Claims oncash flows are prioritized throughthe CF waterfall.

Concentrated equity ownership

provides critical monitoring, Theunique board of directors andseparate legal incorporation makesmonitoring more simple andefficient.

High leverage both the amount andtype (maturity); Bank loans provide

credit monitoring.

Traditional monitoring mechanismsinclude:

Takeover market

Product market

Reputation

Staged investment

Leverage: high debt service forcesmanagers to disgorge free cashflows.

Creditors rights: lenders threat toseize collateral and threat ofliquidation to deter borrowers

opportunism.


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Problem of Hold Up & Expropriation

Standard Approach Project Finance ApproachVertical Integration Joint Ownership

Long term contracts, withcontract duration increasing with

asset specificity.

High Level of Debt

To avoid Expropriation To avoid Expropriation

High Visibility Multilateral lenders

High Leverage Joint Ownership


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Problem - Debt/Equity holder conflict in distribution of cashflows, re-investment and restructuring during distress. High

leverage can lead to risk shifting and underinvestment

Standard Approach Project Finance ApproachStrong debt covenants allow bothequity/debt holders to better

monitor management

Concentrated ownership ensuresclose monitoring and adherence

to the prescribed rulesTo facilitate restructuring,concentrated debt ownership,less classes of debtors, and bankdebt, are preferred. Bank debt is

much easier to restructure thanbonds

Opportunities for risk shiftingdo not exist because the cashflow waterfall restrictinvestment decisions.


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Problem- .Insiders know more about the value of assets inplace and growth opportunities than outsiders. Asymmetricinformation increases monitoring costs andincreases cost ofcapital (equity is more costly than debt).

Standard Approach Project Finance ApproachDisclosure Segregated cash flows enhancetransparency, which decreases

monitoring costsAnalyst-relationship Segregation eliminates the need toanalyze other corporate assets orcash flows. Creditors can analyze theproject on a stand-alone basis.Signaling Project structure reserves thesponsors debt capacity/ flexibilityto fund higher risk projectsinternally


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Debt Overhang: Firms with high leverage, risk averse managersand asymmetric information have trouble financing attractiveinvestment opportunities. This leads to under investment inpositive NPV projects due to limited corporate debt capacityas new debt is limited by covenants.

tandard Approach Project Finance ApproachUse of secured debt, senior bankdebt, new equity (raised at adiscount).

Non recourse debt in an independent entity

allocates returns to new capital providers

without any claims on the sponsors balance

sheet.

This preserves scarce corporate debtcapacity and allows the firm to borrow more

cheaply than it otherwise would.

Project finance is more effective than

secured debt because it eliminates recourse

back to the sponsoring firm.


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A high risk project can potentially drag a healthy corporation

into distress. Short of actual failure, the risky project canincrease cash flow volatility, the expected costs of financialdistress, and reduce firm value. Conversely, a failingcorporation can drag a healthy project along with it.

Standard Approach Project Finance ApproachHedging, or foregoing the project(under-investment)

Exposes losses only to the extent ofequity commitment

Sponsors can share project risk withother sponsors. Pooling of capital

reduces each providers distress costdue to the relatively smaller size ofthe investment and therefore theoverall distress costs are reduced

Reduces the probability of distressboth at sponsors and project level.


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Tax: An independent economic entity allows projects toobtain tax benefits that are not available to the sponsors.When a project is located in a high-tax country and theproject company in a lower tax country, it may be beneficialfor the sponsor to locate the debt in the high tax country.

Location: Large projects in emerging markets cannot befinanced by local equity due to supply constraints. Investmentspecific equity from foreign investors is either hard to get orexpensive. Debt is the only option and project finance is theoptimal structure.

Heterogeneous partners: Financially weak partner needs project finance to

participate.

The bigger partner is better equipped to negotiate termswith banks than the smaller partner and hence has toparticipate in project finance.


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Overall Advantage to BP Amoco from projectfinance can be explained by 2 charts


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Example: BP AMOCOThe Corporate Finance Model

ProjectCost = $1 billionPartner A25% share Partner B35% share

BP Amoco

BusinessUnits Cash Managementand Money MarketInstruments

Short-term Financing: Commercial paper Bank loansTreasuryGroup

OperatingCash Flow

$400m

40% ofCash Flow

$250m $350m

25% ofCash Flow

35% ofCash Flow

Long-term Financing: Bonds Equity


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Example:BP AMOCOThe Project Finance Model

Banks

Partner B35% share

BP Amoco

Treasury Group(40% share) Business Units

payback+interest

$300 millionsecured loan

40% of operatingcash flow

Partner A25% share

ProjectCost = $1 billionEquity = $400 millionDebt = $600 million144A A BondMarket

$300 millionsecured loan

payback+ Interest

$100 millionequity

$140 millionequity $160 millionequity

International Org.overnmentuppliersontractors


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Total Investment = $2 Billion Corporate Finance (Exhibit 6A) Project Finance (Exhibit 6B) Project Finance (Exhibit 6C)

BP Amoco (Investment) 0.8 0.32 0.32BP Amoco Subsidiary(DV=60%) - - 0.48

BP Amoco (Own Resources likeBusiness Units) 0.56 0.224 0.224

BP Amoco Debt (Proportionedto its DV=30%) 0.24 0.096 0.096

Partner A 0.7 0.28 0.7

Partner B 0.5 0.2 0.5

Direct Debt (DV=60%) - 1.2 -


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Total Returns = $4 Billion Corporate Finance (Exhibit 6A) Project Finance (Exhibit 6B) Project Finance (Exhibit 6C)BP Amoco (Investment) 1.6 1.528 1.528BP Amoco Subsidiary - - 0.072

BP Amoco (Own Resources likeBusiness Units)

1.576

1.5184

1.5184

BP Amoco Debt (Proportionedto its DV=30%) 0.024 0.0096 0.0096

Partner A 1.4 1.337 1.4Partner B 1 0.955 1

Direct Debt - 0.18 -Return on own Equityemployed for BP Amoco 281% 678% 678%


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Investment Share

BP Amoco: 40%Partner A : 35%Partner B : 25%

Project is viable for only 1 year

Initial Investment is $2 Billion and Operating profit is$4 Billion

Corporate Loans at 10% p.a. while project loans 15%

p.a.

All numbers used are in $ Billion


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BP Amoco should use internal corporate

funds to finance new projects except in threeparticular circumstances

In most situations, costs outweighed thebenefits for BP Amoco


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Mega Projects

Projects large enough to

harm companysearnings, debt ratings,

and in the extreme case

survival

Senior Management

begins to feel

uncomfortable about thesize and level of risk

Projects in Politically

Volatile Areas

High degree of political

risk: War, Strikes,Sabotage, Lack of

property rights, direct or

creeping expropriation,

or currency

inconvertibility

Host country less likelikely to take or tolerate

hostile action against

project

Commercial lenders

would lend only if MLAs

like EBRD and ADB or an

ECA was involved

Joint Ventures with

Heterogeneous Partners

Host governments or

their agencies could beparticipants in the project

without the will to use or

lack of large funds

Partners with weak

balance sheets couldnt

raise the requiredamounts on their own

Negotiate with lenders by

itself rather than letting

weaker partners

negotiate which would

give BP Amoco more

leverage in decisions

Exceptions


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Business Unit

Quantify the incremental costs and benefits of using project finance

A project with positive NPV using a pre-determined corporate WACC and assuming debt-

to-capitalization ratio of 30%

Specialized

Finance Team

Various financial structures using an incremental cost analysis

Estimate incremental, after-tax cash flows associated with fees, interest, and principal

payments and discount these cash flows at the firms marginal cost of debt Financing NPV was generally negative

Finance Group

Financing NPV when combined with investment NPV and other possible benefits, the

result could be positive

Recommend project finance and seek approval for chosen structure


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No. In our view BP Amoco should use projectfinance as far as possible instead of corporatefinance for its downstream or upstreambusinesses alike.


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Risk associated with projects in Oil & Gasindustry is very high.

Huge investments in the initial stages with noguaranteed returns.

BP Amocos revenues & net profit declined by~26% & ~46% respectively on a Y-o-Y basis in1998.

Capital expenditure is very high ~$10 billion.It also has long term debts above $10 billion.


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BP Amoco doesnt have substantial cash reservesto fund projects in the range of $0.5-2.0 billion.

Most of its current assets are in the form ofaccounts receivables which mainly would beused for paying back the current liabilities.

BP Amoco also pays substantial part of its profitsto its share holders in the form of dividends, acrash crunch may occur if corporate finance isused and the investment required issubstantially high.


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BP Amoco already has a high debt to capitalratio compared to Royal Dutch Shell & Exxon.

Any further debt for providing corporatefinance may not be appreciated by themarket.

Any loss or abandonment of the new projectwould have a direct recourse on BP Amoco asa whole and can impact its marketcapitalization.


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Thank You

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BP Amoco Case

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