The oil industry of the world is largely privatized and uses the US dollar as its exchange currency. Since oil companies require large capital to function, they are reliant on credit, debt balance and management, investors, and banking transactions to remain in profit. American, European, and even Asian companies such as Shell, British Petroleum, Noble Affiliates, PetroChina, Ocean Energy, and others are looking to expand into oil-rich countries and acquire rights for drilling and selling oil in them. Petrobras of Brazil is one of the largest oil and gas companies in the world and is effectively owned by the Brazilian government, which controls 33% of its total capital and 55% of voting shares (“Our history,” 2017). Petrobras was created under the premise of energy security. It is effectively a monopoly within the Brazilian state with extensive and exquisite premium rights for oil extraction and site development projects. However, this kind of monopoly ends up hurting the image of the company, resulting in a higher cost of capital, reduced attractiveness for the investors, and increased debt (Cavalinni, 2017). To reduce the weighted cost of capital (WACC), improve the debt situation, and attract additional investors, Petroleo Brasileiro S.A must diversify its holdings by acquiring smaller companies operating in the domestic markets where it wishes to expand, and privatize some of its assets to raise money to pay the debt.In only 3 hours we’ll deliver a custom Petrobras of Brazil and the Cost of Capital essay written 100% from scratch Get help
Background of the Company
Petrobras was founded in 1954 as a government monopoly set to protect the country’s oil assets from foreign conquest. The leader of Brazil, Getulio Vargas, was a communist and a nationalist who held to those political beliefs. Under the slogan “O petróleo é Nosso”, which translates to “The Oil is Ours,” he promulgated the establishment of Petrobras and a new course towards economic independence (“Our history,” 2017). Ever since, it managed to become one of the largest companies in the world, and a leading expert in deepwater technology, which allows for excavating and acquiring petroleum from the depths of the ocean. The company established a new world record for deep-sea levels of oil exploration, reaching a depth of almost 2 km below the sea level (“Our history,” 2017).
Although the company is called a monopoly in the Brazilian oil market, it is not strictly such. In 1997, the Brazilian government lifted the monopoly rule and allowed foreign investment and companies to enter the country to explore its oil fields. Shell, PetroChina, BP, and others, who are the direct competitors of Petrobras, have entered Brazil. However, their activities are highly regulated by the National Petroleum Agency, which exists to ensure that the government’s interests are not threatened by foreign exploration (“Our history,” 2017).
Petrobras and the Cost of Capital
One of the major problems of Petrobras is its high cost of capital. Unlike the majority of other major oil companies, such as Exxon, Shell, PetroChina, BP, and others, its cost of capital is extremely high. While the rest have their cost of capital bounce between 6 and 9 %, Petrobras’ cost of capital has been firmly above 9% since 2002 (“Petroleo Brasileiro,” 2017). The company lacks an international presence, which is preventing it from accessing other markets with cheaper capital. At the same time, the fact that 92% of the company’s oil shares are located in Brazil, paints it as a strictly Brazilian enterprise rather than a multinational conglomerate that most other companies are. As such, it is highly dependent on the political and economic situation in Brazil. For the past 15 years, Brazil suffered from high inflation, currency depreciation, market instability, and political upheaval. These sovereign risks affect the company’s cost of capital, as any foreign investors would require a higher premium in return for their investments into the company (Cavalinni, 2017). They fear the high operational risk, and without such incentives are reluctant to invest in an undiversified company.
While Petrobras realized the flaw in its strategy and embarked on a journey for diversification, these efforts are not enough. Its expansion was aimed at other Southern American markets, which share similar market risks and are connected to Brazil both politically and economically, which did little to improve the company’s standing in the eyes of investors. The purchase of Pecom and an exchange agreement with Repsol-YPF did not improve the situation with WACC, but only worsened it because Petrobras now had to shoulder the debts acquired by Pecom (Royce, 2002).
Although the weighted capital of Petrobras can be calculated in several ways, changing the formula would do little to help the company due to the inherent risks of investing in Brazilian-based companies. All investors are aware of the country’s political and sovereign risks, and demand higher rates of return on their investments.
Can Sovereign Spread Compensate for Currency Risk?
Sovereign spread stands for the difference between bond yields from governmental bonds issued by both Brazil and the USA (“Yield spread,” n.d.). As it stands, the US bond has a better sovereign rating and greater creditworthiness, at least when compared to Brazil. In addition, the US dollar is used as a benchmark currency around the world, for all exchange and trade purposes. Brazil’s current creditworthiness is uncertain, as it is affected by high levels of external debt, its political instability and low rates of economic growth, and other related factors. At the same time, currency risk and sovereign spread are two different things. Currency risks stand for the chances that the value of the Brazilian currency would fluctuate in comparison to the US dollar (“Yield spread,” n.d.).Academic experts
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In this case study, Petrobras’ share price is viewed in the context of Brazil’s sovereign spread. The investors use it to assess the company’s cost of capital, over the country’s exchange rates, and currency risks. Therefore, it could be said that in a way, the sovereign spread does compensate for the currency risks, despite them being two different matters in the context of this case study.
The attractiveness of the Brazilian Market and the Calculation of Capital Costs
The WACC is often used to calculate the return of invested capital – a very important feature for financial analysts who make recommendations for investments to potential investors. Petrobras as a company primarily located in Brazil is forced to suffer for economic imperfections of its home market. The current formula for WACC calculation is (Debt/capital) x kd x (1 – Tax rate) + (Equity/capital x ke) (“What is cost of capital, “ n.d.). As it is possible to see, some of the most important numbers in this formula for Petrobras are the Debt, and the cost of equity (ke). The company has accumulated large amounts of debt, which contributes to its high WACC. In addition, the ke is influenced by country risks relative to the risk-free rates. The Brazilian base portfolio influences the ke by contributing to its enlargement. The situation for the company would be even worse for the investors operating under the global NYSE portfolio.
The Cost of Capital in Petrobras’ Competitive Strategy
The cost of capital is important for any capital-intensive industry, and the oil industry is considered one of the most capital-intensive in the world, enough to define regional and even global economic strategies. Any large for-profit company needs to consider its cost of capital, as it is one of the primary defining factors for foreign and local investment. Thus, it is very important for Petrobras. However, at the same time, it is not the only factor to define the company’s competitive strategy. According to Michael Porter, the nature of the industry, the corporate strategy, and the external environment also play an important role (“Porter’s five forces,” n.d.).
Petrobras was founded to be the largest oil company in Brazil, to achieve broader political and economic objectives than simply profit. It exists to protect the national interest and complement the energy security of the country. In addition, it enjoys certain favors, subsidies, and guarantees that it would no longer enjoy if it stopped being a primarily Brazilian oil giant. Assessing the relative benefits of a low WACC in comparison to the benefits received from the government would be paramount to the company’s competitive strategy (“Our history,” 2017).
Potential Privatization Prospects for Petrobras
As it stands, there are two ways that Petrobras could improve its WACC and attract more investments at a better interest return rate. The company could either privatize its pre-salt oil assets, or invest in small foreign companies in economically and politically stable countries such as the US, Europe, and certain countries in the Middle East (Rapoza, 2016). Either would help drop the percentage of assets in Brazil and help it feel more like a multinational company than a Brazilian oil giant that is affected by every whim of volatile Brazilian politics. In theory, it would help drop the WACC and improve the company’s image among the investors. However, in order to succeed in dropping the WACC to the level where Petrobras could compete with the likes of Exxon and BP, the company would have either to sell many of its assets or purchase a greater amount of assets in other countries. Considering the great amounts of debt that the company accumulated, the former would be a better solution (Rapoza, 2016).
Transaction Risks of Petrobras
Transaction risk is one of the most common currency risks, and it is present in Petrobras’s case. The country’s currency is considered to be the 7th most unstable currency in the world, according to the FXCM report of 2015 (Cavalinni, 2017). Although the situation around the Brazilian Real is more stable than it was in 1999, when the country had changed from fixed to float currency rates, it still represents a risk for foreign investors. There are two kinds of currency risks, one of which is associated with the exchange rates falling, and the other – with rising too high. High exchange rates, especially when the prices in Brazil remain the same they were before, are dangerous for Petrobras, as the company would lose profit when converting dollars to Reals. At the same time, while low exchange rates would certainly attract investors and offer profit to Petrobras on the local market, they also mean that the country’s economy is experiencing depression. In addition, low exchange rates make it difficult for Petrobras expand into foreign markets, as the reverse conversion from Reals to dollars would mean the loss of profit (Cavalinni, 2017).
Recommendations for the Company
As it stands, the large amounts of debt accumulated by Petrobras prevent its WACC from falling down. It would continue to remain such due to the specifics of Petrobras as a company – it is a government-controlled oil giant in an unstable region, with no funds to pay the debt, let alone expand anywhere outside of the impoverished South American region. The strategy employed by Mexican companies, which involves purchases of small domestic companies in the US and Europe would not be profitable, as they would increase Petrobras’ debt even more while the contributions to its image would be slim. The majority of its assets would still remain in Brazil, and it would not make much difference if the total percentage of its Brazilian assets would fall from 92 to 85 or even 80%. Alternatively, Petrobras could try selling its assets in order to make itself a “less Brazilian” oil giant and raise funds to pay for the debt (Rapoza, 2016). However, in so doing, it would cease to be the oil monopoly it once was. Should that happen, Petrobras’ point of existence would become moot, as it was founded solely to protect Brazil’s national interests and assure its energy security. Therefore, there are only two choices left for Petrobras – either sell a good portion of its assets and expand into foreign markets, becoming yet another “for-profit” oil company, or hold on to what it currently has, and hope for oil prices to rise. It all comes down to how much does its mission of “O petróleo é Nosso” is really worth.15% OFF Get your very first custom-written academic paper with 15% off Get discount
Cavalinni, L. (2017). The risks of investing in Brazil. Web.
Our history. (2017). Web.
Petroleo Brasileiro SA Petrobras. (2017). Web.
Porter’s five forces. (n.d.). Web.
Rapoza, K. (2016). Why Brazil’s Petrobras should ‘privatize’ its pre-salt oil assets. Web.
Royce, K. (2002). Analysts, investors react to Petrobras-Pecom deal. Web.
What is cost of capital? (n.d.). Web.Get your customised and 100% plagiarism-free paper on any subject done for only $16.00 $11/page Let us help you
Yield spread. (n.d.). Web.