Cash Cameleon
No oil and gas market in Latin America has been more active than
Brazil in recent years. In the last two years alone there have been
over $6 billion of financings dedicated to the development of
offshore oil and gas fields and related projects. At the center of
this financing activity is one of the world's largest integrated
oil and gas concerns: Petrobras. To understand the various
financing techniques which have been utilized, and will be
utilized, in the Brazilian market, one need not look further than
Petrobras.
This article examines the different financing techniques that Petrobras has used in recent transactions to further its exploration and development activities. It also looks ahead, and suggests what type of financing techniques are likely in the future and the general prospects for the Brazilian oil and gas market.
A look back: quasi project financings
In the late 1990's, Petrobras faced enormous challenges. On the one hand, as a state-owned entity it was responsible for the development of the hydrocarbon resources of Brazil, and as such had a mandate to expand oil and gas production and develop promising new fields under difficult physical conditions.2 On the other hand, Petrobras was hampered by regulatory and budgetary constraints imposed by Brazil's fiscal austerity program, the Real Plan, including limitations on public expenditures and Central Bank restrictions. At the same time, Petrobras was facing a less certain future, with the opening up of the hydrocarbon sector in Brazil and the onset of competition from foreign oil companies. To meet these challenges, Petrobras was intent on moving forward with the development of the Campos Basin fields and increasing domestic oil production, but needed to do so in a manner which was consistent with existing legal and financial constraints. Against this backdrop, Petrobras began developing the Campos Basin projects: five large offshore projects which received financing from multiple equity and lending sources within a limited time period.3
In simplest terms, the Campos Basin projects were structured as hybrids of a project financing transaction and a corporate credit, hence the term ?quasi project financing?. While the projects were not true project financings, as the lenders generally had full recourse to Petrobras, they also strayed in many important respects from the basic corporate financings on which Petrobras had relied in the past, in that they utilized complex structures and multi source lender arrangements to achieve Petrobras' objectives. The quasi-project financings of the late 1990's in Brazil are best understood by examining the objectives that they were intended to accomplish; objectives that were articulated by Petrobras but defined by the circumstances in which Petrobras found itself in the late 1990's. Each of the Campos Basin projects was pursued in a similar manner: Petrobras approached its lenders with a defined set of objectives and, based on those objectives, the lenders developed, and later presented to Petrobras, financing structures intended to achieve such objectives.
Petrobras goals
Petrobras' primary goals in developing the Campos Basin projects were three-fold: to limit its aggregate funding commitments, to keep the financings off-budget for Brazilian budgetary purposes and to achieve off-balance sheet treatment under Brazilian generally accepted accounting principles.4
Petrobras needed to minimize its own funding commitments to the projects, which it did by maximizing third party lender participation and having other investors lend funds in the form of pseudo equity. Petrobras, which remains controlled by the Brazilian government, was constrained from incurring significant new indebtedness as a result of the government's adoption of the Real Plan. This situation was compounded by the fact that Petrobras needed to make, and was making, significant capital expenditures in connection with the Brazil-Bolivia pipeline. With the international capital markets basically closed to Petrobras, and compounded by the fact that Petrobras needed to make, and was making, significant capital expenditures in eam activities, Petrobras found itself in need of raising a substantial amount of funds in a limited time frame for a number of promising projects. By structuring projects with high debt to equity ratios, and having third party investors provide additional funding in the form of pseudo equity, Petrobras was able to minimize its direct funding obligations for these projects.
Next, it was important that the financing for each of the projects be considered off-budget for Brazilian budgetary purposes. Because Petrobras' capital expenditures are included in the Brazilian government's budget, Petrobras could not include in its budget large capital projects, such as those in the Campos Basin, without adversely affecting the state's fiscal situation. This required that the projects be excluded from Petrobras' capital budget and that Petrobras not be directly liable for the repayment of debt under the financing. In order to achieve this objective, not only was Petrobras limited from acting as a co-borrower under the terms of the financings, it was also limited from acting as a guarantor to secure repayment. Any kind of keep-well or support arrangement involving Petrobras also had to be carefully scrutinized from a budgetary and accounting perspective to ensure that Petrobras was not, in effect, providing a guarantee of the indebtedness.
Finally, the last objective, and one that was closely related to achieving off-budget treatment, was to structure the financing so that it was off-balance sheet under generally accepted Brazilian accounting principles. The financings for each of the Campo Basin projects were structured carefully so that the leases were characterized as operating leases for accounting purposes, rather than finance leases, and as such were not included on Petrobras' balance sheet as a liability. In addition to the over-riding budgetary and accounting concerns, Petrobras' desire to minimize incremental tax and other costs also affected the transaction structure utilized for these projects. In particular, by taking advantage of the Repetro regime,5 Petrobras was able to decrease the sales and social contributions taxes payable on any lease or rental payments made pursuant to the offshore structure.
Resulting structures
With Petrobras' key objectives in mind, the lenders in these transactions worked with Petrobras to develop workable structures; the result was the utilization of multiple variations of the offshore leasing structure, developed and modified to take advantage of beneficial tax and customs regimes. Typically, an offshore special purpose vehicle was created in a jurisdiction which was not classified as a tax haven under Brazilian law.6 This vehicle was owned by equity participants and Petrobras (or an affiliate of Petrobras), and was the borrower of funds from a variety of different lending sources, including the capital markets,7 commercial banks, export credit agencies and the Brazilian development bank BNDES. The special purpose vehicle (either directly or through an onshore special purpose vehicle)8 purchased equipment and services and made development expenditures. All of the equipment, services and other assets were in turn rented or leased to Petrobras for its use in developing the relevant project, and in exchange Petrobras made rental or lease payments to the special purpose vehicle, which payments were used to finance the indebtedness. Through the use of this structure, and the inclusion of other features such as offshore accounts, the ability of lenders to obtain in kind (e.g. crude oil) payment in certain circumstances, the use of support arrangements and the pledging of assets, Petrobras was able to successfully complete these Campos Basin financings while achieving its basic objectives.
The product
Although the quasi project financing structures provided Petrobras with sufficient capital at a crucial time for development and satisfied Petrobras' basic financing objectives, that capital came at a considerable cost. The reality of these structures was that they provided few of the benefits of a limited recourse financing, while retaining most of the burdens. With a few notable exceptions, the various risks of these projects, whether it be completion, marketing, operating/reserve or political risk, were borne by Petrobras and were generally not allocated to the other debt and equity participants. Despite the fact that the lenders generally had recourse to Petrobras, the complexity of these projects created other problems for Petrobras. First, they were comparatively costly sources of funding, as the pricing reflected the complexity and the documentation and legal risks associated with these structures, rather than the fact that Petrobras remained responsible for most project risks. Second, these transactions required a long lead time, and resulted in significant transaction costs. Finally, as each of the structures varied somewhat and involved different participants, it was impracticable for Petrobras to realize efficiencies and economies of scale in subsequent projects.
Today's projects: enhanced Petrobras credits
As the Campos Basin projects were being completed, a number of events were in process that would provide Petrobras greater flexibility in structuring future projects. First, in August 2000 Petrobras was successfully listed on the New York Stock Exchange, and although it remained majority owned by the Brazilian government, for the first time Petrobras' shares were being listed and traded in the United States. In anticipation of its US listing, Petrobras adopted and published financial statements using United States generally accepted accounting principles. These developments had a number of positive repercussions for Petrobras' future financing plans. Investors could now compare Petrobras much more easily to other industry majors, and could gain confidence in Petrobras' financial condition. Perhaps even more importantly, a wealth of information regarding Petrobras was made available publicly, facilitating diligence by private sector institutional and other lenders, insurers and guarantors. Third, the Brazilian economy was enjoying a period of growth and relative stability, and oil prices were rising; a development which benefited Petrobras, since recent regulatory changes allowed it to take advantage of international oil pricing. Finally, Petrobras had gained a great deal of experience in structuring and executing complicated financings and significant international exposure through the success of the Campos Basin projects, most particularly with foreign rating agencies, which would play a crucial role in future Petrobras financings.
Petrobras objectives
The Campos Basin projects were fairly costly for Petrobras and, despite their cost, did not allow Petrobras to reduce its risk exposure or take advantage of any of the other touted benefits of a limited recourse project financing. Understanding that it was already bearing the bulk of the risk associated with these projects, Petrobras determined to seek structures which would provide it with a lower overall cost of funding, through an ?enhanced corporate credit?. By providing lenders and bondholders with a more overt Petrobras credit, Petrobras hoped to increase the speed of project implementation and lower transaction costs. Petrobras was also interested in improving the economic terms of its financings, both by lengthening maturities and receiving higher investment ratings on its external indebtedness (and thus lower cost financings).
PRI-backed bonds
Following its listing on the New York Stock Exchange, Petrobras once again turned to the capital markets as a potential source of funding, this time through an offshore financing subsidiary, Petrobras International Finance Company (PIFCo). PIFCo was originally created in 1997 in order to purchase oil and oil related products from suppliers abroad and sell them to Petrobras on a deferred basis, thereby fostering imports. In mid-2001, as part of a strategy to enhance access to financing sources (and in particular the capital markets), Petrobras effected a unique debt offering through PIFCo in order to finance oil purchases and repay short term indebtedness. The PIFCo bond offering was designed to take advantage of a recently announced change by Moody's in how it would evaluate corporate credits located in emerging markets, where Moody's indicated that there are certain mechanisms and circumstances which could permit the rating of a security to pierce the relevant sovereign ceiling. In short, Moody's indicated that the credit ratings of such securities would not be automatically limited by the rating of the sovereign's securities. Moody's provided a blue print for the type of credit enhancements that would protect security holders against an inconvertibility event or other transferability restrictions, and that could result in a security being rated higher than the rating of the relevant sovereign debt securities, including the existence of offshore reserve accounts and letters of credit or political risk insurance.9 The PIFCo offering included many of these features. First, Petrobras established an ample reserve account, sufficient to cover six months of interest on the bonds, to specifically cover the period of time between when a claim under the political risk insurance was made, and when insurance payments would be available. Second, the bonds were backed by a political risk insurance policy, designed to mitigate the risks associated with inconvertibility or non-transferability of amounts which Petrobras has agreed to pay in the event that the Brazilian government institutes limitations on the convertibility of Reais into Dollars.10 The political risk insurance was designed to commence as soon as the claim was processed (approximately when the reserve account would be diminishing) and cover the next 12 months of interest. Third, Petrobras entered into a standby purchase agreement, pursuant to which Petrobras agreed to purchase from noteholders any unpaid principal, interest and other amounts due under the notes in the event of a PIFCo default. The reserve account, coupled with the political risk insurance, covered an eighteen month period ? the same eighteen month period which Moody's estimated was the maximum length of duration of an inconvertibility event. In addition, during the occurrence of an inconvertibility event, the terms of the bonds provide that the maturity of any principal amounts due will be extended eighteen months
The PRI-backed bond offering was a pivotal transaction for Petrobras and PIFCo ? and Petrobras obtained very attractive pricing, particularly when comparing it to its earlier financings. The reasons for the use of PIFCo as an issuer were two-fold: it resulted in payments on the bonds being exempt from withholding tax and it permitted the financing to remain off of Petrobras' debt budget. Further, the existence of Petrobras' obligations under the standby purchase agreement meant that there was no negative connotation to PIFCo acting as the issuer, as the PIFCo offering was able to obtain the same ratings as if it were a Petrobras offering. The first PIFCo offering, in what will be a series of PIFCo debt offerings, was underwritten by UBS Warburg and was priced above the sovereign ceiling; rated at Baa1 by Moody's.11 The high rating from the rating agencies was attributable to a number of factors, including the availability of political risk insurance to cover the inability to convert Reais into Dollars and/or the inability to transfer Dollars to the trustee in order to make required payments on the bonds. In addition to obtaining the benefit of a political risk insurance policy, holders of the bonds had the practical equivalent of a Petrobras guarantee through the standby purchase agreement.
The PRI-backed bond offering illustrates Petrobras' increasing sophistication when it comes to developing and using complicated financing techniques to further its corporate objectives. The PIFCo underwritten debt offering combines the benefits of capital markets financing with favourable pricing obtained through various credit enhancements. The success of this structure, from both Petrobras' perspective and that of the international markets, is demonstrated by the fact that this offering was the first time that Petrobras was able to pierce the sovereign ceiling. Rather than accepting whole cloth complex structures presented by various potential financing sources, Petrobras took a much more active role in structuring the PRI-backed bond offering. As a result, Petrobras received less costly capital, utilized a transparent structure that can easily be replicated for future financings and provided lenders and bondholders with the ultimate comfort of a Petrobras support obligation.
A look forward: more sophisticated and varied structures
The key to understanding the financing techniques that are likely to be utilized in future Brazilian oil and gas financings, is understanding Petrobras' development as an experienced and knowledgeable sponsor of such projects and the challenges that Petrobras and other sponsors will face as the market evolves. As Petrobras has matured as a project sponsor and borrower, so too have the opportunities for investment in the oil and gas sector in Brazil. The techniques that will be successful in future financing transactions will mirror the needs and objectives of Petrobras and other market participants.
What sorts of financing techniques will we see in the Brazilian oil and gas sector in the future? In all likelihood, we will not see a return to the types of structures that were utilized in the Campos Basin projects. They were too costly and too cumbersome, and they reflected the unique circumstances in which Petrobras found itself in the late 1990's. Rather, we are likely to see Petrobras continue to rely on ?structured? corporate credits, with credit enhancements designed to achieve an investment grade rating. For other market participants that are just now beginning to develop and exploit hydrocarbon reserves, we are likely to see a variety of financing techniques employed, from limited recourse financings to traditional corporate credits, depending upon the commercial objectives and financial condition of such participants. Set forth below are a few of the financing techniques that we will undoubtedly see in this market in the future.
Securitizations
The success which other state-owned oil companies in Latin America have had with securitization transactions involving oil receivables was surely a significant factor in Petrobras' recent decision to securitize certain of its export receivables. PEMEX, PDVSA and Ecopetrol have all had very successful experiences with securities offerings involving oil export backed securities. In each of these transactions an offshore, bankruptcy remote vehicle was established as the issuer, in a somewhat complex structure which provided bondholders with the ability to look to the issuer's oil receivables (or, in the case of Ecopetrol, future production rights) in the event of a default. The confidence of investors and the international markets was evidenced by the strength of the ratings which these transactions received, all of which pierced the sovereign ceiling in their respective jurisdictions. The recently announced $750 million bond issuance by Petrobras, backed by oil exports, demonstrates that, despite the fact that Brazil is a net importer of oil, Petrobras can securitize its exports. In fact, Petrobras is actually Brazil's largest exporter, exporting products such as bunker fuel, heavy oil and certain refined products, a point that investors obviously came to accept. Through this recent securitization, Petrobras demonstrated to the investment community that, among other things, it was able to address exchange control issues such as inconvertibility and non-transferability.
The benefits to Petrobras of this new transaction structure are significant: from a risk management and balance sheet perspective, the transaction is superior to that which Petrobras has utilized in the past, while simultaneously achieving strong economic terms and longer maturities. The bond issuance was at an all-in cost of less than 8% for 10-year bonds, the lowest yield of any Petrobras debt issuance with a similar maturity. As a result, Petrobras has already announced that it plans to launch another similarly sized export-backed securities offering next year, due to the success of the recent offering.
Complex offshore financing structures
The creation of PIFCo, and the need for continued development and expansion of offshore fields, has also led Petrobras to consider other financing alternatives. One strategy which Petrobras is currently working on is the development of an offshore financing structure which could be easily replicated for a variety of different projects, and which could be utilized to attract multiple financing sources. Although still in the process of being created, the PIFCo offshore financing structure is being developed with a focus on equipment financings, and is expected to be utilized for the first time in the Marlim Sul transaction through an export credit agency led financing. Basically, through a complex array of transaction documents, PIFCo (or a subsidiary) will purchase equipment from various countries utilizing funds12 from a variety of export credit agencies and commercial bank lenders.13 The equipment is then rented to another Petrobras subsidiary which then sub-charters the equipment to Petrobras under an already existing sub-charter agreement relating to the underlying deepwater platform on which the equipment is to be placed. Although the structure is designed to maintain the financing off-balance sheet and off-budget for Petrobras under Brazilian accounting standards in a manner which is fiscally efficient, the structure of the lending arrangements replicates an unsecured financing with Petrobras and is designed to obviate the need for complicated intercreditor or security arrangements.
True limited recourse financings
Despite the opening of the Brazilian oil and gas market to further private investment, a number of exploration and production projects and related infrastructure (eg, pipelines, terminals, etc.) will still be developed with Petrobras as an equity partner. These projects will be the best candidates for securing true, limited recourse project financing. Examples of this are already being seen in the power sector (Araucaria, TermoRio, etc.), as well as in high profile petrochemical projects (Rio Polimeros). The strength and importance of these projects strategically, coupled with a strong role for Petrobras as an equity sponsor, will make them very desirable from a project financing perspective.
Traditional corporate financing techniques and local funding options
In projects where Petrobras is not a participant, the joint venture partners are most likely to utilize traditional corporate financing techniques rather than complicated highly structured project financing structures. Although there are benefits to utilizing project financing structures, such structures may be too expensive and time consuming to pursue for non-Latin American oil companies. Although not always the case, oil company majors participating in these projects tend to finance their overseas operations and activities off their own balance sheet ? using project financing techniques for situations where there is a strong Brazilian partner, preferably Petrobras. Another alternative for financing is through local financing options such as the Brazilian capital markets, pension funds and BNDES, which have been successfully used in the past. Although today these funding sources are in the early stages of development, they are likely to provide a reliable source of funding as the Brazilian economy matures.
Outlook for Brazil's oil and gas market
In recent years, financing Latin American oil and gas projects, particularly in the international capital markets, has been a significant challenge. The outlook for today's market is not much different. Clearly, only the strongest and best conceived projects will attract international financing. Despite this general environment, Brazil's oil and gas sector is better positioned than most Latin American markets to attract foreign investment and international lending. The success of the Campos Basin projects and the various licensing rounds that have been held have attracted a large number of participants, particularly foreign oil companies, to the Brazilian market. The Agência Nacional do Petróleo (ANP), which regulates the industry, is generally viewed as a credible and transparent regulator. In addition, the government's programs to expedite and subsidize (through favourable BNDES financing) the development of thermal generating projects should result in significant opportunities for companies engaged in the production, supply or delivery of natural gas. In comparison to some of the other Latin American markets, these factors make the Brazilian oil and gas market very attractive from an investment and financing perspective.14
This is not to suggest that the financing market will not be a challenging one. First, there are the political and regional issues: the potential fallout from the situation in Argentina and the uncertainty resulting from the upcoming Brazilian elections. Second, there is the issue of electricity reform, and how that market will develop. Third, there are the recent management changes at Petrobras, which are likely to heighten investor concerns, if for no other reason than change carries with it uncertainty. Finally, foreign investment may also be somewhat affected by the Petrobras monopoly on domestic refining capacity and related infrastructure projects. Notwithstanding these issues and the other more general challenges facing Brazil and the region as a whole, the Brazilian oil and gas market is surely poised to continue its role as the region's most active and exciting market for oil and gas projects. n
Footnotes
1 Francesca Lavin is a senior associate, and Richard Cooper is a partner, at the international law firm of Cleary, Gottlieb, Steen & Hamilton. The firm represents a number of Latin American oil and gas companies in connection with their financing activities, including PDVSA, Pemex, Ecopetrol and Petrobras, and has worked on a number of oil and gas projects in Brazil.
2 The Campos Basin fields are among the deepest underwater oil and gas fields in the world, and Petrobras has become a recognized leader in deep sea exploration and production activities.
3 The projects characterized as the ?Campos Basin projects? include Albacora, Barracuda and Caratinga, Cabiúnas, Marlim, and Espadarte, Voador and Marimbá.
4 A secondary objective was to structure the projects so they were off-balance sheet for US generally accepted accounting principles, an objective that proved more elusive to achieve.
5 Repetro is a customs regime established in late 1999 which provides the same beneficial treatment to synthetic exports as is afforded to actual physical exports. The regime allows an export to an offshore vehicle, which is then leased back to a Brazilian person, exemption from sales taxes and social contribution taxes, without the exported item ever leaving the country.
6 Brazilian law classifies certain common offshore jurisdictions (such as the Cayman Islands) as tax havens, and imposes Brazilian federal income and withholding tax on payments involving such jurisdictions. By law, a tax haven is statutorily defined as a jurisdiction that taxes the income of its residents at a maximum rate of less than 20%. The existence of this law, and the negative tax treatment attributed to payments to and from offshore entities in such jurisdictions, makes their use impractical and costly.
7 The Marlim transaction is an unique example of the variety of financing sources which were utilized in the Campos Basin projects. The project was able to access both international and local capital, in large part due to the fact that the Marlim field was the largest producing oil field in Brazil. In addition to the $200 million of financing which Petrobras received from BNDES and the $200 million of equity contributions, Petrobras was also able to raise $500 million in the international capital markets and another $395 million in the Brazilian capital markets. Following the success of the Marlim transaction, however, Petrobras found the capital markets virtually closed for the remainder of the Campos Basin projects.
8 In certain instances, such as the Marlim transaction, a consortium structure was utilized rather than a special purpose vehicle.
9 Moody's announced a shift in its ratings policy, saying it would consider rating borrowers higher than the sovereign ceiling when they meet three criteria: sound creditworthiness, including ?external support mechanisms,? the probability that there would not be a generalized moratorium in the event of default by the government, and the borrower's access to foreign exchange. Key to Moody's policy are certain assumptions regarding the potential duration of an inconvertibility event, which Moody's believes is, as a general rule, not likely to last more than eighteen months.
10 The political risk insurance policy did contain certain limitations, such as policy payment limits (the policy was limited to the amount in Dollars that corresponds to one year of scheduled interest on the bonds) and time limits (if an inconvertibility event continues for longer than 18 months, a default may occur on the bonds and the bondholders may be required to accept Reais rather than Dollars). In addition, the political risk insurance did not cover the following events: (i) bona fide, non-discriminatory measure of general application, of the type normally taken by governments in the public interest, (ii) devaluation or fluctuation of the Reais/Dollar exchange rate and (iii) any breach by Petrobras, including its failure to deposit the appropriate Reais into the relevant account.
11 In September 2001, Moody's assigned a Ba1 long term rating to Petrobras ? three notches higher than the sovereign rating, and only one notch below investment grade. According to Moody's, the upgrade was a result of Petrobras' ?substantial assets and revenues, its dominant position in Brazil's petroleum sector, the integrated nature of its operations, its sizeable hydrocarbon reserves, and its strong prospects for oil production growth?. Then why is Petrobras ?one shy of the grade? when it comes to attaining an investment grade rating? Moody's states that it is because Petrobras' foreign currency convertibility risk is ?relatively high, due to the company's net importer status and the fact that much of its debt is Dollar-denominated?.
12 With the reachback programs of many export credit agencies, PIFCo (or its subsidiaries) would be able to purchase equipment prior to the completion of the transaction documents and the financing, and can then still receive funds from the relevant export credit agency upon demonstration that the equipment meets the applicable ECA guidelines.
13 The structure would be developed in a manner such that the senior lenders could be from a variety of different sources: commercial lenders, bondholders, export credit agencies or other multilateral institutions.
14 Contrast this situation to other Latin American markets. In Venezuela, foreign investors are still very wary of the Chavez administration and the recent changes to the hydrocarbons law were not well received by the investment community. In Mexico, upstream activity (with the exception of a possible gas licensing round) is still closed to private and foreign participation for the near future. In Colombia and Peru, although the atmosphere for foreign investment is more favorable, security concerns still make many foreign investors hesitant to participate.
Contact:
Cleary Gottlieb Steen & Hamilton,
1 Liberty Plaza, New York. Telephone: 212 225 2000.
This article examines the different financing techniques that Petrobras has used in recent transactions to further its exploration and development activities. It also looks ahead, and suggests what type of financing techniques are likely in the future and the general prospects for the Brazilian oil and gas market.
A look back: quasi project financings
In the late 1990's, Petrobras faced enormous challenges. On the one hand, as a state-owned entity it was responsible for the development of the hydrocarbon resources of Brazil, and as such had a mandate to expand oil and gas production and develop promising new fields under difficult physical conditions.2 On the other hand, Petrobras was hampered by regulatory and budgetary constraints imposed by Brazil's fiscal austerity program, the Real Plan, including limitations on public expenditures and Central Bank restrictions. At the same time, Petrobras was facing a less certain future, with the opening up of the hydrocarbon sector in Brazil and the onset of competition from foreign oil companies. To meet these challenges, Petrobras was intent on moving forward with the development of the Campos Basin fields and increasing domestic oil production, but needed to do so in a manner which was consistent with existing legal and financial constraints. Against this backdrop, Petrobras began developing the Campos Basin projects: five large offshore projects which received financing from multiple equity and lending sources within a limited time period.3
In simplest terms, the Campos Basin projects were structured as hybrids of a project financing transaction and a corporate credit, hence the term ?quasi project financing?. While the projects were not true project financings, as the lenders generally had full recourse to Petrobras, they also strayed in many important respects from the basic corporate financings on which Petrobras had relied in the past, in that they utilized complex structures and multi source lender arrangements to achieve Petrobras' objectives. The quasi-project financings of the late 1990's in Brazil are best understood by examining the objectives that they were intended to accomplish; objectives that were articulated by Petrobras but defined by the circumstances in which Petrobras found itself in the late 1990's. Each of the Campos Basin projects was pursued in a similar manner: Petrobras approached its lenders with a defined set of objectives and, based on those objectives, the lenders developed, and later presented to Petrobras, financing structures intended to achieve such objectives.
Petrobras goals
Petrobras' primary goals in developing the Campos Basin projects were three-fold: to limit its aggregate funding commitments, to keep the financings off-budget for Brazilian budgetary purposes and to achieve off-balance sheet treatment under Brazilian generally accepted accounting principles.4
Petrobras needed to minimize its own funding commitments to the projects, which it did by maximizing third party lender participation and having other investors lend funds in the form of pseudo equity. Petrobras, which remains controlled by the Brazilian government, was constrained from incurring significant new indebtedness as a result of the government's adoption of the Real Plan. This situation was compounded by the fact that Petrobras needed to make, and was making, significant capital expenditures in connection with the Brazil-Bolivia pipeline. With the international capital markets basically closed to Petrobras, and compounded by the fact that Petrobras needed to make, and was making, significant capital expenditures in eam activities, Petrobras found itself in need of raising a substantial amount of funds in a limited time frame for a number of promising projects. By structuring projects with high debt to equity ratios, and having third party investors provide additional funding in the form of pseudo equity, Petrobras was able to minimize its direct funding obligations for these projects.
Next, it was important that the financing for each of the projects be considered off-budget for Brazilian budgetary purposes. Because Petrobras' capital expenditures are included in the Brazilian government's budget, Petrobras could not include in its budget large capital projects, such as those in the Campos Basin, without adversely affecting the state's fiscal situation. This required that the projects be excluded from Petrobras' capital budget and that Petrobras not be directly liable for the repayment of debt under the financing. In order to achieve this objective, not only was Petrobras limited from acting as a co-borrower under the terms of the financings, it was also limited from acting as a guarantor to secure repayment. Any kind of keep-well or support arrangement involving Petrobras also had to be carefully scrutinized from a budgetary and accounting perspective to ensure that Petrobras was not, in effect, providing a guarantee of the indebtedness.
Finally, the last objective, and one that was closely related to achieving off-budget treatment, was to structure the financing so that it was off-balance sheet under generally accepted Brazilian accounting principles. The financings for each of the Campo Basin projects were structured carefully so that the leases were characterized as operating leases for accounting purposes, rather than finance leases, and as such were not included on Petrobras' balance sheet as a liability. In addition to the over-riding budgetary and accounting concerns, Petrobras' desire to minimize incremental tax and other costs also affected the transaction structure utilized for these projects. In particular, by taking advantage of the Repetro regime,5 Petrobras was able to decrease the sales and social contributions taxes payable on any lease or rental payments made pursuant to the offshore structure.
Resulting structures
With Petrobras' key objectives in mind, the lenders in these transactions worked with Petrobras to develop workable structures; the result was the utilization of multiple variations of the offshore leasing structure, developed and modified to take advantage of beneficial tax and customs regimes. Typically, an offshore special purpose vehicle was created in a jurisdiction which was not classified as a tax haven under Brazilian law.6 This vehicle was owned by equity participants and Petrobras (or an affiliate of Petrobras), and was the borrower of funds from a variety of different lending sources, including the capital markets,7 commercial banks, export credit agencies and the Brazilian development bank BNDES. The special purpose vehicle (either directly or through an onshore special purpose vehicle)8 purchased equipment and services and made development expenditures. All of the equipment, services and other assets were in turn rented or leased to Petrobras for its use in developing the relevant project, and in exchange Petrobras made rental or lease payments to the special purpose vehicle, which payments were used to finance the indebtedness. Through the use of this structure, and the inclusion of other features such as offshore accounts, the ability of lenders to obtain in kind (e.g. crude oil) payment in certain circumstances, the use of support arrangements and the pledging of assets, Petrobras was able to successfully complete these Campos Basin financings while achieving its basic objectives.
The product
Although the quasi project financing structures provided Petrobras with sufficient capital at a crucial time for development and satisfied Petrobras' basic financing objectives, that capital came at a considerable cost. The reality of these structures was that they provided few of the benefits of a limited recourse financing, while retaining most of the burdens. With a few notable exceptions, the various risks of these projects, whether it be completion, marketing, operating/reserve or political risk, were borne by Petrobras and were generally not allocated to the other debt and equity participants. Despite the fact that the lenders generally had recourse to Petrobras, the complexity of these projects created other problems for Petrobras. First, they were comparatively costly sources of funding, as the pricing reflected the complexity and the documentation and legal risks associated with these structures, rather than the fact that Petrobras remained responsible for most project risks. Second, these transactions required a long lead time, and resulted in significant transaction costs. Finally, as each of the structures varied somewhat and involved different participants, it was impracticable for Petrobras to realize efficiencies and economies of scale in subsequent projects.
Today's projects: enhanced Petrobras credits
As the Campos Basin projects were being completed, a number of events were in process that would provide Petrobras greater flexibility in structuring future projects. First, in August 2000 Petrobras was successfully listed on the New York Stock Exchange, and although it remained majority owned by the Brazilian government, for the first time Petrobras' shares were being listed and traded in the United States. In anticipation of its US listing, Petrobras adopted and published financial statements using United States generally accepted accounting principles. These developments had a number of positive repercussions for Petrobras' future financing plans. Investors could now compare Petrobras much more easily to other industry majors, and could gain confidence in Petrobras' financial condition. Perhaps even more importantly, a wealth of information regarding Petrobras was made available publicly, facilitating diligence by private sector institutional and other lenders, insurers and guarantors. Third, the Brazilian economy was enjoying a period of growth and relative stability, and oil prices were rising; a development which benefited Petrobras, since recent regulatory changes allowed it to take advantage of international oil pricing. Finally, Petrobras had gained a great deal of experience in structuring and executing complicated financings and significant international exposure through the success of the Campos Basin projects, most particularly with foreign rating agencies, which would play a crucial role in future Petrobras financings.
Petrobras objectives
The Campos Basin projects were fairly costly for Petrobras and, despite their cost, did not allow Petrobras to reduce its risk exposure or take advantage of any of the other touted benefits of a limited recourse project financing. Understanding that it was already bearing the bulk of the risk associated with these projects, Petrobras determined to seek structures which would provide it with a lower overall cost of funding, through an ?enhanced corporate credit?. By providing lenders and bondholders with a more overt Petrobras credit, Petrobras hoped to increase the speed of project implementation and lower transaction costs. Petrobras was also interested in improving the economic terms of its financings, both by lengthening maturities and receiving higher investment ratings on its external indebtedness (and thus lower cost financings).
PRI-backed bonds
Following its listing on the New York Stock Exchange, Petrobras once again turned to the capital markets as a potential source of funding, this time through an offshore financing subsidiary, Petrobras International Finance Company (PIFCo). PIFCo was originally created in 1997 in order to purchase oil and oil related products from suppliers abroad and sell them to Petrobras on a deferred basis, thereby fostering imports. In mid-2001, as part of a strategy to enhance access to financing sources (and in particular the capital markets), Petrobras effected a unique debt offering through PIFCo in order to finance oil purchases and repay short term indebtedness. The PIFCo bond offering was designed to take advantage of a recently announced change by Moody's in how it would evaluate corporate credits located in emerging markets, where Moody's indicated that there are certain mechanisms and circumstances which could permit the rating of a security to pierce the relevant sovereign ceiling. In short, Moody's indicated that the credit ratings of such securities would not be automatically limited by the rating of the sovereign's securities. Moody's provided a blue print for the type of credit enhancements that would protect security holders against an inconvertibility event or other transferability restrictions, and that could result in a security being rated higher than the rating of the relevant sovereign debt securities, including the existence of offshore reserve accounts and letters of credit or political risk insurance.9 The PIFCo offering included many of these features. First, Petrobras established an ample reserve account, sufficient to cover six months of interest on the bonds, to specifically cover the period of time between when a claim under the political risk insurance was made, and when insurance payments would be available. Second, the bonds were backed by a political risk insurance policy, designed to mitigate the risks associated with inconvertibility or non-transferability of amounts which Petrobras has agreed to pay in the event that the Brazilian government institutes limitations on the convertibility of Reais into Dollars.10 The political risk insurance was designed to commence as soon as the claim was processed (approximately when the reserve account would be diminishing) and cover the next 12 months of interest. Third, Petrobras entered into a standby purchase agreement, pursuant to which Petrobras agreed to purchase from noteholders any unpaid principal, interest and other amounts due under the notes in the event of a PIFCo default. The reserve account, coupled with the political risk insurance, covered an eighteen month period ? the same eighteen month period which Moody's estimated was the maximum length of duration of an inconvertibility event. In addition, during the occurrence of an inconvertibility event, the terms of the bonds provide that the maturity of any principal amounts due will be extended eighteen months
The PRI-backed bond offering was a pivotal transaction for Petrobras and PIFCo ? and Petrobras obtained very attractive pricing, particularly when comparing it to its earlier financings. The reasons for the use of PIFCo as an issuer were two-fold: it resulted in payments on the bonds being exempt from withholding tax and it permitted the financing to remain off of Petrobras' debt budget. Further, the existence of Petrobras' obligations under the standby purchase agreement meant that there was no negative connotation to PIFCo acting as the issuer, as the PIFCo offering was able to obtain the same ratings as if it were a Petrobras offering. The first PIFCo offering, in what will be a series of PIFCo debt offerings, was underwritten by UBS Warburg and was priced above the sovereign ceiling; rated at Baa1 by Moody's.11 The high rating from the rating agencies was attributable to a number of factors, including the availability of political risk insurance to cover the inability to convert Reais into Dollars and/or the inability to transfer Dollars to the trustee in order to make required payments on the bonds. In addition to obtaining the benefit of a political risk insurance policy, holders of the bonds had the practical equivalent of a Petrobras guarantee through the standby purchase agreement.
The PRI-backed bond offering illustrates Petrobras' increasing sophistication when it comes to developing and using complicated financing techniques to further its corporate objectives. The PIFCo underwritten debt offering combines the benefits of capital markets financing with favourable pricing obtained through various credit enhancements. The success of this structure, from both Petrobras' perspective and that of the international markets, is demonstrated by the fact that this offering was the first time that Petrobras was able to pierce the sovereign ceiling. Rather than accepting whole cloth complex structures presented by various potential financing sources, Petrobras took a much more active role in structuring the PRI-backed bond offering. As a result, Petrobras received less costly capital, utilized a transparent structure that can easily be replicated for future financings and provided lenders and bondholders with the ultimate comfort of a Petrobras support obligation.
A look forward: more sophisticated and varied structures
The key to understanding the financing techniques that are likely to be utilized in future Brazilian oil and gas financings, is understanding Petrobras' development as an experienced and knowledgeable sponsor of such projects and the challenges that Petrobras and other sponsors will face as the market evolves. As Petrobras has matured as a project sponsor and borrower, so too have the opportunities for investment in the oil and gas sector in Brazil. The techniques that will be successful in future financing transactions will mirror the needs and objectives of Petrobras and other market participants.
What sorts of financing techniques will we see in the Brazilian oil and gas sector in the future? In all likelihood, we will not see a return to the types of structures that were utilized in the Campos Basin projects. They were too costly and too cumbersome, and they reflected the unique circumstances in which Petrobras found itself in the late 1990's. Rather, we are likely to see Petrobras continue to rely on ?structured? corporate credits, with credit enhancements designed to achieve an investment grade rating. For other market participants that are just now beginning to develop and exploit hydrocarbon reserves, we are likely to see a variety of financing techniques employed, from limited recourse financings to traditional corporate credits, depending upon the commercial objectives and financial condition of such participants. Set forth below are a few of the financing techniques that we will undoubtedly see in this market in the future.
Securitizations
The success which other state-owned oil companies in Latin America have had with securitization transactions involving oil receivables was surely a significant factor in Petrobras' recent decision to securitize certain of its export receivables. PEMEX, PDVSA and Ecopetrol have all had very successful experiences with securities offerings involving oil export backed securities. In each of these transactions an offshore, bankruptcy remote vehicle was established as the issuer, in a somewhat complex structure which provided bondholders with the ability to look to the issuer's oil receivables (or, in the case of Ecopetrol, future production rights) in the event of a default. The confidence of investors and the international markets was evidenced by the strength of the ratings which these transactions received, all of which pierced the sovereign ceiling in their respective jurisdictions. The recently announced $750 million bond issuance by Petrobras, backed by oil exports, demonstrates that, despite the fact that Brazil is a net importer of oil, Petrobras can securitize its exports. In fact, Petrobras is actually Brazil's largest exporter, exporting products such as bunker fuel, heavy oil and certain refined products, a point that investors obviously came to accept. Through this recent securitization, Petrobras demonstrated to the investment community that, among other things, it was able to address exchange control issues such as inconvertibility and non-transferability.
The benefits to Petrobras of this new transaction structure are significant: from a risk management and balance sheet perspective, the transaction is superior to that which Petrobras has utilized in the past, while simultaneously achieving strong economic terms and longer maturities. The bond issuance was at an all-in cost of less than 8% for 10-year bonds, the lowest yield of any Petrobras debt issuance with a similar maturity. As a result, Petrobras has already announced that it plans to launch another similarly sized export-backed securities offering next year, due to the success of the recent offering.
Complex offshore financing structures
The creation of PIFCo, and the need for continued development and expansion of offshore fields, has also led Petrobras to consider other financing alternatives. One strategy which Petrobras is currently working on is the development of an offshore financing structure which could be easily replicated for a variety of different projects, and which could be utilized to attract multiple financing sources. Although still in the process of being created, the PIFCo offshore financing structure is being developed with a focus on equipment financings, and is expected to be utilized for the first time in the Marlim Sul transaction through an export credit agency led financing. Basically, through a complex array of transaction documents, PIFCo (or a subsidiary) will purchase equipment from various countries utilizing funds12 from a variety of export credit agencies and commercial bank lenders.13 The equipment is then rented to another Petrobras subsidiary which then sub-charters the equipment to Petrobras under an already existing sub-charter agreement relating to the underlying deepwater platform on which the equipment is to be placed. Although the structure is designed to maintain the financing off-balance sheet and off-budget for Petrobras under Brazilian accounting standards in a manner which is fiscally efficient, the structure of the lending arrangements replicates an unsecured financing with Petrobras and is designed to obviate the need for complicated intercreditor or security arrangements.
True limited recourse financings
Despite the opening of the Brazilian oil and gas market to further private investment, a number of exploration and production projects and related infrastructure (eg, pipelines, terminals, etc.) will still be developed with Petrobras as an equity partner. These projects will be the best candidates for securing true, limited recourse project financing. Examples of this are already being seen in the power sector (Araucaria, TermoRio, etc.), as well as in high profile petrochemical projects (Rio Polimeros). The strength and importance of these projects strategically, coupled with a strong role for Petrobras as an equity sponsor, will make them very desirable from a project financing perspective.
Traditional corporate financing techniques and local funding options
In projects where Petrobras is not a participant, the joint venture partners are most likely to utilize traditional corporate financing techniques rather than complicated highly structured project financing structures. Although there are benefits to utilizing project financing structures, such structures may be too expensive and time consuming to pursue for non-Latin American oil companies. Although not always the case, oil company majors participating in these projects tend to finance their overseas operations and activities off their own balance sheet ? using project financing techniques for situations where there is a strong Brazilian partner, preferably Petrobras. Another alternative for financing is through local financing options such as the Brazilian capital markets, pension funds and BNDES, which have been successfully used in the past. Although today these funding sources are in the early stages of development, they are likely to provide a reliable source of funding as the Brazilian economy matures.
Outlook for Brazil's oil and gas market
In recent years, financing Latin American oil and gas projects, particularly in the international capital markets, has been a significant challenge. The outlook for today's market is not much different. Clearly, only the strongest and best conceived projects will attract international financing. Despite this general environment, Brazil's oil and gas sector is better positioned than most Latin American markets to attract foreign investment and international lending. The success of the Campos Basin projects and the various licensing rounds that have been held have attracted a large number of participants, particularly foreign oil companies, to the Brazilian market. The Agência Nacional do Petróleo (ANP), which regulates the industry, is generally viewed as a credible and transparent regulator. In addition, the government's programs to expedite and subsidize (through favourable BNDES financing) the development of thermal generating projects should result in significant opportunities for companies engaged in the production, supply or delivery of natural gas. In comparison to some of the other Latin American markets, these factors make the Brazilian oil and gas market very attractive from an investment and financing perspective.14
This is not to suggest that the financing market will not be a challenging one. First, there are the political and regional issues: the potential fallout from the situation in Argentina and the uncertainty resulting from the upcoming Brazilian elections. Second, there is the issue of electricity reform, and how that market will develop. Third, there are the recent management changes at Petrobras, which are likely to heighten investor concerns, if for no other reason than change carries with it uncertainty. Finally, foreign investment may also be somewhat affected by the Petrobras monopoly on domestic refining capacity and related infrastructure projects. Notwithstanding these issues and the other more general challenges facing Brazil and the region as a whole, the Brazilian oil and gas market is surely poised to continue its role as the region's most active and exciting market for oil and gas projects. n
Footnotes
1 Francesca Lavin is a senior associate, and Richard Cooper is a partner, at the international law firm of Cleary, Gottlieb, Steen & Hamilton. The firm represents a number of Latin American oil and gas companies in connection with their financing activities, including PDVSA, Pemex, Ecopetrol and Petrobras, and has worked on a number of oil and gas projects in Brazil.
2 The Campos Basin fields are among the deepest underwater oil and gas fields in the world, and Petrobras has become a recognized leader in deep sea exploration and production activities.
3 The projects characterized as the ?Campos Basin projects? include Albacora, Barracuda and Caratinga, Cabiúnas, Marlim, and Espadarte, Voador and Marimbá.
4 A secondary objective was to structure the projects so they were off-balance sheet for US generally accepted accounting principles, an objective that proved more elusive to achieve.
5 Repetro is a customs regime established in late 1999 which provides the same beneficial treatment to synthetic exports as is afforded to actual physical exports. The regime allows an export to an offshore vehicle, which is then leased back to a Brazilian person, exemption from sales taxes and social contribution taxes, without the exported item ever leaving the country.
6 Brazilian law classifies certain common offshore jurisdictions (such as the Cayman Islands) as tax havens, and imposes Brazilian federal income and withholding tax on payments involving such jurisdictions. By law, a tax haven is statutorily defined as a jurisdiction that taxes the income of its residents at a maximum rate of less than 20%. The existence of this law, and the negative tax treatment attributed to payments to and from offshore entities in such jurisdictions, makes their use impractical and costly.
7 The Marlim transaction is an unique example of the variety of financing sources which were utilized in the Campos Basin projects. The project was able to access both international and local capital, in large part due to the fact that the Marlim field was the largest producing oil field in Brazil. In addition to the $200 million of financing which Petrobras received from BNDES and the $200 million of equity contributions, Petrobras was also able to raise $500 million in the international capital markets and another $395 million in the Brazilian capital markets. Following the success of the Marlim transaction, however, Petrobras found the capital markets virtually closed for the remainder of the Campos Basin projects.
8 In certain instances, such as the Marlim transaction, a consortium structure was utilized rather than a special purpose vehicle.
9 Moody's announced a shift in its ratings policy, saying it would consider rating borrowers higher than the sovereign ceiling when they meet three criteria: sound creditworthiness, including ?external support mechanisms,? the probability that there would not be a generalized moratorium in the event of default by the government, and the borrower's access to foreign exchange. Key to Moody's policy are certain assumptions regarding the potential duration of an inconvertibility event, which Moody's believes is, as a general rule, not likely to last more than eighteen months.
10 The political risk insurance policy did contain certain limitations, such as policy payment limits (the policy was limited to the amount in Dollars that corresponds to one year of scheduled interest on the bonds) and time limits (if an inconvertibility event continues for longer than 18 months, a default may occur on the bonds and the bondholders may be required to accept Reais rather than Dollars). In addition, the political risk insurance did not cover the following events: (i) bona fide, non-discriminatory measure of general application, of the type normally taken by governments in the public interest, (ii) devaluation or fluctuation of the Reais/Dollar exchange rate and (iii) any breach by Petrobras, including its failure to deposit the appropriate Reais into the relevant account.
11 In September 2001, Moody's assigned a Ba1 long term rating to Petrobras ? three notches higher than the sovereign rating, and only one notch below investment grade. According to Moody's, the upgrade was a result of Petrobras' ?substantial assets and revenues, its dominant position in Brazil's petroleum sector, the integrated nature of its operations, its sizeable hydrocarbon reserves, and its strong prospects for oil production growth?. Then why is Petrobras ?one shy of the grade? when it comes to attaining an investment grade rating? Moody's states that it is because Petrobras' foreign currency convertibility risk is ?relatively high, due to the company's net importer status and the fact that much of its debt is Dollar-denominated?.
12 With the reachback programs of many export credit agencies, PIFCo (or its subsidiaries) would be able to purchase equipment prior to the completion of the transaction documents and the financing, and can then still receive funds from the relevant export credit agency upon demonstration that the equipment meets the applicable ECA guidelines.
13 The structure would be developed in a manner such that the senior lenders could be from a variety of different sources: commercial lenders, bondholders, export credit agencies or other multilateral institutions.
14 Contrast this situation to other Latin American markets. In Venezuela, foreign investors are still very wary of the Chavez administration and the recent changes to the hydrocarbons law were not well received by the investment community. In Mexico, upstream activity (with the exception of a possible gas licensing round) is still closed to private and foreign participation for the near future. In Colombia and Peru, although the atmosphere for foreign investment is more favorable, security concerns still make many foreign investors hesitant to participate.
Contact:
Cleary Gottlieb Steen & Hamilton,
1 Liberty Plaza, New York. Telephone: 212 225 2000.
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