Alexis Solis Cansino GLOBAL STRATEGY 000130502 AUTUMN 2015 Session 11: Managing Government Relations Tuesday October, 27" 2015 Inrropuction Oil has a profound effect on Russia's economic health: the dependency that Russia has on oil, in extreme situ like now, is exacerbated exponentially, revenues account for over 50% of the direct income of the government. ‘Wherever oil goes today, that’s where Russia goes ions ‘The Russian oil marker is characterized as high risk for potentially high rewards. High risks include (but are not limiced to) obsolete and poor infrastructure; foggy and obscure governmental (and subsequently economic) policies; unreliable Russian geologic studies, etc. Prosem StaTeMENT ‘The valuation process firms experience when looking to acquire a company is very complex, but when a company, especially a foreign one, makes the conscious decision to enter another foreign market it is even more complex and tricky. In this case three western oil firms (che neophyte Philbro; the legacy Mobil; and, the middle weight Conoco) all have to determine if and how they want to enter the newly open Russian Oil marker. ‘Western (primarily from the United States) oil firms realize that (at the time of this case) che US is lacking in oil reserves and will need petroleum for their huge economy, hence there are incredible opportunities to earn enormous sums of money in Russia. Geologic experts believe that Russia has the Sth largest supply of oil and the largest nacural gas reserves in the world and they need money. Russia is the world’s largest single producer of crude. Philbro, Mobil, and Conoco have to negotiate all of these issues and include them into their valuation to determine if there is value in Russian oil. Anatysis- Conoco 1. ~ Develop a political risk analysis of Russia at the time of the case, using the three methods in Exbibits 1a, 3 and 4 of the “Note on political risk analysis” COUNTRIES IN TROUBLE. POLITICS (41/50) Being near a superpower or troublemaker Authoritarianism Longevity of regime Generals in power ‘War! armed insurrection ECONOMIES (17/33) High inflation High and rising foreign debt as a proportion of GDP. Raw materials as a high percent of exports SOCIETY (7/17) Pace of urbanization Ethnic tensionAlexis Solis Cansino GLOBAL STRATEGY 000130502 AUTUMN 2015 TOTAL: 65/100 BERI'S METHOD INTERNAL CAUSES OF POLITICAL RISK Political fractionalization +5 Ethnic fractionalization +5 Coercive measures required for retaining power +3 Mentality (xenophobia, nationalism, corruption or nepotism) +2 Social conditions (population density and wealth distribution) +5 Radical left +2 EXTERNAL CAUSES OF POLITICAL RISK Importance to hostile major power +5 Negative regional influences +4 SYMPTOMS OF POLITICAL RISK Societal conflict (demonstrations, strikes, street violence) +4 Instability (on-constitutional changes, assassinations, and guerrilla wars) +5 TOTAL: 40/70 2, How important is the acquisition of Russian oil toa Western oil firm? How would you value the worth of this acquisition?” Any business venture can be valued using different approaches. Financially, any project is worth taking if its Net Present Value (NPV) is positive. However, the Net Present Value requires knowing the furure cash flows, which of ‘course, ate unknown at the time where the investments have to be made It also involves knowing the interest rate at which the future cash-flows are going to be discounted. Since such rate includes so many factors (mainly, different types of risks) ic is quite dificult ro calculate with extreme precision. Therefore, NPV valuation is impredse but it grants a guideline. Using probability cheory and statistics, a distribution of possible NPVs can be obtained and even an average (expected value). This adds more information so we can take an informed decision of whether to take the project or not. At 4.625 million exported barrels per day (just behind the Saudi Arabian exports of 6.880 million barrels per day and ahead of the American exportsof 2.500 million barrels per day) Russia was ranked second in total oil exportsac the end of 2013. Therefore the access o a part of the Russian oil market proved to be highly important, bur there was no way of knowing this (with certainty) in the 1980's. Despite all chis, some intuition In terms of Business Administration, the project is worth taking if it adds value to the company. Once again, the concept of “value” can be ambiguous but we can summarize it by saying that itis anything that helps the company gain a sustainable competitive advantage. 3. Evaluate the strategies undertaken by Conoco. Is it wise? Why?” First, a firm evaluated how important the investment in Russian oil was to its overall corporate strategy. Phibro, Conoco, and Mobil valued this investment differently, probably due co the relative size of each firm. Conoco represented a new entrant into the oil/gas industry, indicating that it was a smaller competitor compared to others and relied heavily on new ventures to maintain profitability as it lacked the scale and breadth of operations that would allow it co act defensively in the internacional oil/gas marker.Alexis Solis Cansino GLOBAL STRATEGY 000130502 AUTUMN 2015 Conoco saw investing in Russia as a component of their competitive strategy; Russia's oil production historically outperformed that of the United States’ and was often the world leader in oil production. Provided that Conoco had no other alternatives at that time, they had to act on the opportunity to start operating in Russia and be prepared to take on the associated risks. The risks taken on by Conoco extended beyond the macroeconomic trends of the oil/gas industry. During the Sovier cra, operations at Russian oil fields were based on maximizing production, as opposed to pumping at an “optimal rate.” This practice is risky for foreign investors because drilling was not managed in a sustainable way, drastically reducing the roral amount of recoverable oil and positioning the firm ro succeed only in the short run, Furthermore, Conoco faced the possibility of tying up their costly resources and assets in Russia; the Polar Lights contract comprised of the pipeline infrastructure and development/maintenance of rigs on vitgin fields. Conoco also faced a multitude of taxes for operatingand exporting in Russia, With nearly 70% of revenue generated from a single barrel of oil funneled directly to the Russian government, a firm investing in Russian oil was forced ro ‘operate on below-industry average margins. All of this was taking place ina global environment that was experiencing a decreasing demand and stagnating consumption. Conoco was initially subject co taxes and environmental conditions, but later received an exemption. This exemption was shaky on the grounds that Russia's political support and legal enforcement of contracts was not as sophisticared and lacked the integrity of United States’ systems, generating some doubr over how long the exemptions would last or how well the contracts would be supported. Because of the inherent political, economic; legal, and environment risks associated with venturing into Russian oil, Conoco had to rake some measures to hedge their investments. Conoco had a more protected and practical approach, in che sense that it rested the wacers of Russian oil developing a network and experience in the industry before ic fully committed to any type of contract on the scale of Polar Lights. Conoco's approach is the most financially viable RECOMMENDATIONS 4, How might Conoco protect or hedge their investments in the Russian oil sector? Hedging a project can be made through several ways. The most general statement that we can make here is that Conoco would have co make sure all of the critical contracts were in place before making the investment. Such contracts include: government licenses, operating and maintenance cost contracts, credit (Financing) contracts, construction and exploration contracts, exportation and sales contracts, and finally, financial risk management contracts (financial derivatives and others). Of these contracts the most important are government licenses and financial risk management due to the unreliable Russian government and due to the fact that oil is one of the most important traded commodities around the globe