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Business Risk and Investment Grading Essay

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Updated: Dec 27th, 2021

Introduction

Project financing is vital in ensuring the success of a firm. Du Pont and PDVSA are in the process of financing a new project which will result in the establishment of a new entity referred to as Petrozuata. There are various sources available for the firms to use in funding the project. These include loans from private organizations and banks. Alternatively, the firms can finance the project externally by issuing corporate bonds through the capital market. Conoco and Maraven have agreed to sponsor the intended project until it is complete. In addition, these firms will also finance other unexpected costs which may occur before the completion of the project. The parent companies DuPont and PDVSA have got different credit ratings. DuPont is rated AAA while PDVSA is not rated. For rating agencies to effectively rate a company, a qualitative evaluation of the firm is conducted (Moody’s Investor Service, 2009, p.10). Some of the issues considered include the firm’s competitiveness and market share amongst other quantitative factors (Kronwald, 2010, p. 3). Credit rating serves in providing information that is not publicly available to the investors (Kronwald, 2010, p. 3). A firm’s credit rating is important in the process of making decisions related to capital structure. DuPont rating (AAA) indicates that the firm’s creditworthiness is high. This means that it is easy for the firm to pay off its debts without any challenges. In addition, it depicts that the firm is a potential investment destination since the default risk is low (Kronwald, p. 3).

Several risks would limit Petrozuata from obtaining investment grades. In assessing the probability of Petrozuata investment being graded, the rating agencies would assess several issues which include its financial projections, construction risks, business risks, and technical reserves. These risks can be classified as pre-completion risks, post-completion risks, sovereign risks, and financial risks.

Resource Risk

At its inception, Petrozuata entered into a purchase agreement with Conoco in which Conoco would buy the first batch of syncrude. Despite there being a guarantee from DuPont, Conoco was not obligated to purchase the firm’s syncrude during its scheduled refinery downtime. In addition, there is no guarantee that the firm will be successful in its oil exploration. Despite this, the firm will be required to pay off its debt obligation even in the event of a reduction in oil price. This means that there is a high degree of uncertainty about the investment which would make investors reluctant to purchase the project bond.

Sovereign risk

Sovereign risk depicts the probability with which a country can default payment of internationally borrowed funds (Peter, Grandes, 2005, p. 4). Venezuela is characterized by a high degree of political instability. For example, the Venezuelan government can influence the outcome of the project making it difficult for rating agencies to grade the project. For example, Petrozuata may be required to sell its syncrude to another entity apart from Conoco thus breaching the purchase agreement. In addition, the government can order Conoco’s syncrude payment diversion from the intended revenue waterfall. Because rating the bond is dependent on price, the intended rating can be effected upon the government imposing controls on the foreign exchange rate or changing royal and tax rates.

About exchange rate risk, Petrozuata tax liability and operation expenses would be increased upon bolivar’s appreciation compared to the dollar-denominated revenues. In addition, grading Petrozuata’s investment would be challenged by increases business risks in Venezuela such as a decline in local contractors and supplier’s creditworthiness. This would further be made worse by the increased fragility within the domestic country’s financial sector coupled with a high degree of volatility within the country’s labor market (Esty, 2002, p.8).

Post completion risks

Despite the project being faced with numerous risks, the financial risk seems to be relatively low. The firm projected its syncrude price per barrel to be $12.87 which was relatively low compared to that of Maya which was set at $18.62(Esty, 2002, p.10). The low price per barrel has the potential of attracting potential customers hence increasing its financial returns. On the other hand, the operating costs of the project upon its completion are relatively low. The projected costs include well servicing -15%, maintenance materials-8%, overhead and labor-38%, and utilities-13%. In addition, finding and development costs were relatively low, that is $0.25 per barrel. This is low compared to other competitors such as Athabasca which is a Canadian project whose finding and development cost averaged $1.13 per barrel. The median price of finding and development within the petroleum industry was established at $4.96 per barrel. In addition, the project’s cash operating cost was $3.19 per barrel in 2001. Again, this was way below the industry median and that of Athabasca which averaged & 8.55 and $9.36 (Esty, 2002, p.10)

Upon the project being completed, there is a high probability of there being a fluctuation in oil prices. One of the factors that might result in oil price fluctuation is the inflation rate. Increment in the rate of inflation will have the effect of increasing the price of implementing the project. This will make it to be an unstable investment vehicle. In addition, oil prices will be affected by global fluctuation in oil demand. For example, due to an increment in the price of oil, individual and institutional consumers will search for alternative sources of energy. This will have the effect of reducing the market value of the bond. The resultant effect is that the bond will not be attractive to the investors.

Conclusion

Because PDVSA is being established by being sponsored by Conoco and Maraven which and does not have well-established creditworthiness, it would be difficult to grade the investment. Difficulty in grading the investment is increased by the numerous risks which are associated with Venezuela where the project is being undertaken. For example, the country has a high degree of risk about sovereign risk and financial risk. This affects the rating since the government is the only shareholder of the project. The probability of default by the government is high due to its political instability thus reducing investor confidence. Grading the investment will also be affected by pre-completion and post-completion risks. Some of the pre-completion risks relate to a lack of resources and changes in technology. Technology change would result in an increment in the project’s completion cost. On the other hand, if oil exploration does not bear fruits, the project will come to a halt.

Reference List

  1. Esty, B. 2000. Petrolera Zuata, Petrozuata. California: Harvard Business School.
  2. Kronwald, C. 2010. Credit rating and the impact on capital structure. Marienstr: Grin Verlag.
  3. Moody’s Investor Service. 2009. Moody’s rating symbols and definitions. New York: Moodys.
  4. Peter, M. & Grandes, M. 2005. How important is sovereign risk in determining corporate default premia: a case of South Africa. New York: International Monetary Fund.
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