Since Brazil's financial markets hit their nadir in 2002, with the real tumbling and sovereign spreads ballooning, the Petrobras story has been one of exceptional progress and some luck.

The Brazilian macro story has improved beyond measure. Ted Helms, general manager of Petrobras' New York office, points out that just five years ago, Brazilian sovereign bonds spiked to as high as 2,300bp over equivalent US Treasuries because of the uncertainties surrounding President Lula's election. Today, the average yield spread on Brazilian dollar bonds over US Treasuries is 125bp.

Senior managers at Petrobras have earned a reputation as hard-nosed and successful negotiators. And capital market conditions are much stronger for oil companies because commodity prices and international liquidity stand at record levels. That has helped Petrobras build $6 billion in cash reserves. Consequently, the number of debt issues out of Petrobras is declining, giving issues a scarcity value. When it does tap markets, Petrobras can pick between bank loans, capital markets and project finance deals.

"We are doing fewer deals. And for the deals we are doing, we are seeing much lower costs and simpler structures," notes Helms. Banks have been offering credit without seeking security and forfaiting, as was the case in the past, but relying on the creditworthiness of Petrobras. "Some of these old structures were very cumbersome. In these deals, inevitable changes that occur during construction would often require a waiver from lenders. New deals are much more flexible," he says. Petrobras is already using the new environment to renegotiate some of its outstanding loans, including those for platform P-51.

Corporate or project debt?

Now that banks accept, and even lionise Petrobras, the firm is changing the way it looks at project financing. Keywords are price and diversification. When the company considers whether to use a corporate or project finance structure, getting the best terms from either market is a focus, says Helms. Public markets are a visible and straightforward benchmark to decide which structure to use, he says, adding that for the most part, the loan, debt and project finance markets have been moving more or less in lockstep.

"They are starting to use project finance structures only where there is a good reason to, such as risk sharing," notes Clarence Tong, senior vice-president of project finance Americas at Mizuho Corporate Bank in New York. "That's because Petrobras can finance a whole project finance deal rather than resorting to a joint venture," he adds. "The decision on structure is now purely commercial," agrees Reginaldo Takara, analyst at Standard & Poor's in São Paulo. "Originally, one of the key motivations for Petrobras to use project finance deals was to move debt off its balance sheet as there were limitations on the company's debt, which was consolidated in government accounts. That no longer applies," he notes.

When it studies project finance deals, Petrobras also looks at different structures including owning, chartering, or owning in partnership with companies in or outside of Brazil. No model predominates. "This is a real and live discussion within Petrobras and there's no easy answer," says Roldão Freitas, structured finance manager at Petrobras in Rio de Janeiro. The essence is that Petrobras always tries to cut its costs, he says: "Whatever we do, whatever partnership we engage in, it is aimed at reducing costs."

The best illustration of its search for value is seen in the contracts to build six floating drilling units, all signed in the last twelve months. Petrobras had decided that it needed these for long-term production targets through 2015 and beyond. It wanted to charter four rigs capable of operating at depths of up to 2,000 meters, and two at up to 2,400 meters. It signed deals with four of Brazil's largest construction companies: Construtora Norberto Odebrecht; Petroserv; Queiroz Galvão; and Schahin Engenharia. The four companies will each build one of the rigs that operate up to 2,000 metres. On successful delivery, they will be awarded long contracts of seven years extendable for another seven years. Schahin Engenharia and Queiroz Galvão will each build one of the rigs that operates up to 2,400 metres with contracts of five years, extendable for another five.

Risk management

The award of these long contracts removes much of the renewal risk, notes Isaac Deutsch, executive director, structured and corporate finance for Latin America, at WestLB in New York. That was crucial, enabling operators to raise financing and take on the building and completion risk, he adds. "Petrobras understood the necessity for private contractors to secure competitive financing terms so that the suppliers could go back and give Petrobras good terms. It was an intelligent process," says Deutsch.

"Recent project financing transactions involving new contracts shift construction, operational and asset residual risks to the operators and to the banks, which now lend to the operators and not to Petrobras. In most of these transactions, after the contract term, there may be a balloon payment of 15-20% where the loan is not fully amortised. That risk will be mitigated by contract renewal or asset collateral value, "he notes.

Contracts vary substantially. In some, the shipbuilder stands behind the contract enabling lending banks to look at the shipyard's rating to determine loan pricing, says Tong. In other cases, it's not as clear-cut. The contract may provide for damages for delay and provide compensation linked to performance bonds that represent some 5-15% of the contract or simpler letters of credit. If operators have not received a guarantee from the shipyard, they have put in their own credit enhancement.

Petrobras is not closely monitoring the building process itself but protects itself against time over-runs by instigating the charter agreement only on delivery of the platform and an acceptance test, says Tong. In the event of an over-run, Petrobras retains the right to cancel the contract. The average cost per platform is some $500 million with a ratio of 80% debt to 20% equity, the latter held by the operators.

The syndicated market has found this kind of structure acceptable as evidenced by the placement of the tranches to date, says Tong. Distribution of the operators' deals is taking place at the wholesale level through big tickets of $50 million and more.

The deal not only shifts risk to suppliers and lenders but guarantees supply of floating units at a time when the market is stretched. Demand from oil companies has allowed international suppliers to jack up rates. For example, in the last two years, a typical daily rental rate for a platform has shot up from some $300,000 to $500,000, according to Tong. Not only that but international operators have moved units to capture the highest rates. As a direct result, Petrobras lost a couple of platforms, which it found highly disruptive, says Tong.

Unsurprisingly, Petrobras is keen to secure its own floating vessels in case rents continue to head north. At the same time, the deals show that Petrobras is looking to boost sourcing from local suppliers, with whom it can develop close relations. For now it is very dependent on US companies: some 80% of the vessels in Petrobras' fleet are American, owned by companies such as Global Santa Fe and Diamond Offshore, says Tong.

Old-style Petrobras borrowing

Compare these new contracts to older project finance deals and it's clear just how much has changed. In early 2000, Petrobras typically borrowed through commercial banks using the export credit agencies, often JBIC and NEXI, to provide support and credibility.

In the case of the fundraising for the development of large fields, such as Barracuda-Caratinga, the balance was tilted much more in favour of the banks. "They were supposed to be project finance deals, but they weren't. They had full recourse to Petrobras as a company, but many of the disadvantages of the controls that go into a project finance deal," says Helms. Increasingly, creditors recognised that Petrobras support was sufficient without needing the addition of project finance structures.

From 2003-05, a time of improving credit for the company and Brazil overall, Petrobras actively reduced and finally ended the involvement of insurers. As credit and lending markets continued to bend towards borrowers, margins for banks were becoming wafer thin. Bankers say that in 2003, commercial banks would lend to Petrobras without coverage at some 400bp over Libor. Two years ago, that had slipped to around 100bp-plus.

Today, the figure is less than 100bp and can be as low as 40-50bp over, a margin which has little attraction.
Given this, the new contracts worked to the advantage of all. Petrobras is able to pass on completion and some operational risk. Suppliers, armed with a long contract from Petrobras, are able to raise the funds from banks. Banks that are hungry for yield are able to charge some 125bp over Libor to these suppliers by accepting some of the residual risk.

"Petrobras is taking less risk in these contracts. It provides a long-term contract to be used by suppliers as an asset to negotiate financing, leaving it less and less construction and performance risk," sums up S&P's Tanaka. Petrobras is very savvy in responding to the needs of the market, adds Deutsch.

What next?

The coup that Petrobras has scored with these contracts is surprising given global trends. The international market for service providers in the oil industry has tightened, says Gretchen French, an analyst at Moody's in New York: "Now, oil companies are having to pay more for lump sum contracts and service companies are taking on less risk." It's not only in upstream projects, although it has been particularly noticeable in offshore deals as the search for oil moves into deeper waters. That said, the level of cost increases has probably passed the inflection point and price rises are likely to flatten.

The other question is whether this is the peak of two cycles: high commodity prices and global liquidity in financial markets. It remains to be seen how easy it will be for Petrobras to replicate the structure of this deal in other upstream projects, let alone in mid- and downstream ones.

One of the first tests of its clout with suppliers is the renegotiation of two platforms, P-55 and P-57. The bidding processes were cancelled as offers came in much higher than Petrobras expected, says Petrobras' Freitas.

After this rebuff, the firm has gone back to the drawing board to re-evaluate the projects and see how it can best produce from the field. The lowest bid is of around $2 billion, much higher than the final cost for P-52, which was recently concluded for $1.1 billion, he adds. Contractors have pricing power and are seeing how far they can exercise it, reasons Helms. That's in large part because of the dynamics of the oil industry: the after-tax cash flow from P-52 is expected to repay investment less than a year, points out Helms. He declined to reveal what Petrobras had expected the bids for P-55 and 57 to be.

The upstream business particularly lends itself to such non-recourse deals, supported by Petrobras or third parties, notes Helms. It is much more problematic to structure similar deals for downstream activities, particularly extensions to existing refineries. They are more typically funded through Petrobras borrowing.

However, a new refinery in the north-east of Brazil, which is being planned with Venezuelan state national PDVSA, may lend itself to project financing. It is in the early stages and could be complicated by the political risk associated with Venezuela, a theme on which Helms declined to be drawn. Petrobras is also discussing financing for the pipelines Gasene (from Campos bay to the north-easterly state of Bahia) and the 670km natural gas pipeline Urucu Manaus, located in the Amazon region.