Petrobr6s of Brazil and the Gost of Gapitcl
'letrobrris
standsout in termsof deepwaterte:chnology. . .
but currentlylagsin theareaof costof capital.Webelieve
, that in the long term, if petrobr1s is to becoimea,cotmpet-
ttive player in what loolcsto be thefuture int und,erwater
fuel exploration, it would be headedin the right direction
by expandinginternationally,secu.ringitspresencein the
Golden Trianile, and lowenng iis costof aapital
acquiredentity.We'veseenother savvyLatin companies
(i.e., Cemex via its Spanishsubsidiary Valenciana)do
this successrutt:;;::"r:::;^^,ion
Makes Senseat the
Right Price," Morgan StanleyEquity
Research,January18,2002,p. 4
Petr6leo Brasileiro S.A. (Petrobrris)was an integrated
oil and gascompanyfounded in 1954by the Brazilian gov-
ernment asthe national oil companyof Brazil. In 1997,the
Brazilian governmentinitiated a number of major privati-
zation effortq including Petrobrds. The company was
listed in S5o Paulo in 1997,and on the New york Stock
Exchange(NYSE: PBR) in 2000.Despite the equity list-
ings, the Brazilian government continued to be the con-
trolling shareholder,with 33% of the total capital and
55% of the voting shares.As the national oil company of
Brazll, the company'ssingular purpose was the reduction
of Brazil's dependencyon imported oil. A side effect of
this focus,however,had been a lack of international diver-
sification.Many of the company,scritics arguedthat being
both Brazilian and undiversified internationalv resurted
in an uncompetitivecost of capital.
lrleedfor Diversiftcation
ln2D2,Petrobr6s was the largest companyin Brazil, and
the largestpublicly traded oil companyin SouthAmerica.
It was not, however, international in its operations.This
inherent lack of international diversification was clearlv
ffi ;;5"rd;"ffiffi;ffi* c*tffi
mffim mm
160/o
14o/o
120/o
1lYo
8.5%
8To
60/o
4Vo
2Yo
0o/o
gQ
^$d.t* *$\"t*
al.o"t"'
""N
WACC reduction could be immediate.If peffobrdi
were to acquire one of the North American indepen-
dents-which we estim;ateon averagehave aWACC in
the range of 6o/" to 8o/o--it ,":;rt- raise debi-ot tn",
acquired.companyand subsequentlylower itsWACC in,
the short term. Petrobrascould even cancelsome of its
own debt and./or issue new debt through the newly
apparentto international investorqwho assignedthe com-
pany the samecountry risk factors and premiums they did
all other Brazilian companies.As shown in Exhibit 1, the
result wasa cost of capital in 2002thatwas 6% higher than
all others.The equity strategistsand markets considered
this a distinct competitive disadvantage.
Petrobrds embarked on a globalization strategy,with
several major transactions heading up the process.In
December z}}t,Repsol-YpF of Argentina and petrobr6s
concludedan exchangeof operating assetsvalued at $500
million. In the exchange,Petrobrdsreceived 99% interest
in the Eg3 S.A. service station chain, while Repsol-ypF
gained a 30o/ostake in a refinery, a L}yo stake in an off-
shore oil field, and a fuel resale right to 230 service sta-
tions in Brazil. The agreement included an eight-year
guaranteeagainstcurrencyrisks.
In October 2002,Petrobr6spurchasedpercz Companc
(Pecom)of Argentina. Pecomhad quickly come into play
following the Argentine financial crisis in January 2002.
Although Pecom had significant international reserves
and production capability,the combinedforces of a deval-
ued Argentine peso, a largely dollar-denominated debt
portfolio, and a multitude of Argentine government regu-
lations that hindered its ability to hold and leveragehard
currency resources,the company had moved quickly to
find a buyer to refund its financial structure. petrobr:{s
took advantageof the opportunity. pecom's ownership
had been split betweenthe owning family and foundation
(58.6%), and public flotation (the remaining 4L.4o/o).
-8:8./;-*--
&90/d***-- 9.0 %*--*-9 :00/d-
a""- 6.N\
t-t". --.."""-."" **t""*
 the
fuIl actually operatedin the world, was consideredto have
Petrobr6shad purchasedthe controlling interest-the currency. Once that company listed
family' dollar as its functional
58.6Yointerest-outright from the the dol-
on its sharesin a U.S.equity market like the NYSE'
In the following iht"" years' Petrobrds focused more accepted'
of its debt (and the debt it had Iarization of its capital costsbecameeven
restructuring *o"h
in its But what was the cost of capital-in dollar terms-for
acquired via the Pecom acquisition) *d investing bouts
a Brazilian business?Brazil has a long history of
owrrgrowth.Butplogressinrevitalizingitsfinancialstruc- instability, and currency
dis- with high inflation, economic
ture had come stowly,and by 2005there wasrenewed
its equity devaluationsand depreciations(dependingon the regime
cussion of a new equity issuanceto increase
of de jure). One of the leading indicators of the global mar-
capital.l But at what cost?What wasthe company'scost
ket-'sopinion of Brazilian country risk was the sovereign
capital? the
spr"ad, the additional yield or cost of dollar funds that
over
Gostof CapitalandCountryRisk Brazilian governmenthad to pay on global markets
borrow
and above that which the U.S.Tieasury paid to
Exhibit 1 presentsthe cost of capital of a number of major Brazilian sov-
dollar funds.As illustrated in Exhibit Z,the
oil and gas companies across the world' including volatile over the
petrobr6s in2002.ihi, ,o.parison could occur only if all ereign spread had been both high and
as low as 400
this past-decade.2The spread was sometimes
capital costswere calculatedin a commoncunency;in 2'400
markets had fasis points (4.0%),asin recentyearg or as high as
case,the U.S. dollar. The global oil and gas during the 20O2 financial crisis in
basis points Q4%),
lonjbeen considered"dollar-denominated,"and any com- devalued then floated' And that
it which the reais was first
puo:yop"rating in these markets, regardlessof where

Tr ;#iti." S"*t"ign SpreaO(December1997-August2005)

0verU.S.
BasisPointSpread
2,400
2,200
2,000
1,800

1,400 i*-**-"
'1,200

1,000
-*---^-^-*-'^
t
:
1t
800
.'.,.'.'...-'----.-.'l
i
600

400

200 Dec-O4
Dec-98 Dec-99 Dec-O1
Dec-97

Global - Brazil

quoted by Latin Focus,http://www.|atin-focus'com/|atinfocus/countries/

Source:JPMorgans EMB| + Spread,as
August 2005'
brazilbisPrd.htm,

funding (not debt, in that project

lBy 2005,the company,sfinancial strategywas showingsignificant diversification-Total corporate
st"rtrrpf was well balanced:uonas,$+ billion; nNpEs (bonds issuedunder
finance is nonrecourseto the companyafter operational finance,$5 billion; other, $4 billion'
tinion; project
the auspicesof a Brazilian economi. a"u"ropol"ot ag"rr"y;, $g
in its Emerging Market Bond Index Plus
zThemeasureof sovereignspreadpresentedin Exhibit 2 is that calculatedby JPMorgan
*idely usedmeasureof country risk by practitioners'
(EMBI+) index.This ir'in"ioti
 was merely the cost of debt for the governmentof Brazil.
How was this sovereign spread reflected in the cost of
debt and equity for aBrazilian companylike petrobr6s?
One approachto the estimationof petrobrds,scost of
debt in U.S.dollar terms,k$0,was to build it up-the gov-
ernment of Brazil's cost of dollar funds adjustedfor a pri_
vate corporate credit spread:
kl = U.S.Treasuryrisk-freerate+
Braziliansovereignspread+
Pehobr6scredit spread
kl = 4.000X+ 4.000%+ 1.000% -- 9.000%
If the U.S.Tieasury risk-free rate was estimatedusing
the Treasury 10-year bond rate (yield), a base rate in
August 2005 could be 4.0oh. The Brazilian sovereign
spread, as seen in Exhibit Z, appearedto be 400 basis
points,or an additional 4.0o/o.Even if petrobr6s'scredit
spreadwasthen only L.0%,the company,scurrent costof
dollar debt would bego/o.Thiscost was clearly higher than
the cost of debt for most of the world,s oil majors, who
were probably paying only 5% on averagefor debt in late
2005.
Petrobr6s'scost of equity would be similarly affected
by the country risk-adjusted risk-free rate of interest.
Using a simple expressionof the Capital Asset pricing
Model (CAPM) to estimatethe company'scost of equity
capital in dollar terms (k$"):
kl = risk-freerate* (gr"*o* x marketrisk premium)
= 8.ooo%
+ (r.rox 5.soo%)
=14.05Yo
This calculation assumedthe same risk-free rate as
used in the cost of debt previously, with a beta (NySE
basis)of 1.L0and a market risk premium of 5.500%.Even
with these relatively conservative assumptions (many
would argue that the company,sbeta was actually higher
or lower, and the market risk premium to be 6.0% or
higher),the company,scost of equity wasl4yo.
Finally, the corporate cost of capital,WACC, could be
calcul'atedas follows:
WACC = (oeUt/capital)x t! x (r - Tax rate)+
t-
x t')
(Equity/capitar
Assuming a long-term target capital structure of one-
third debt and two-thirds equity, and an effective corporate
tax rate of 28"/" (after specialtax concessions, surcharges,
and incentives for the Brazilian oil and gas industry),
Petrobriis'WACC wasestimatedat a little over l_1,.5%:
WACC = (0.333x 9.000%x0.72) +
(0.667x L4.050"/")= ll.529o/o
So, after all of the efforts to internationally diversify
the firm and internationalize its cost of capital, why was
Petrobrds' cost of capital still so much higher than its
global counterparts?Not only was the company'sWACC
high comparedto other major global players,but this was
the same high cost of capital used as the basic discount
rate in evaluatingmany potential investmentsand acqui-
sitions.
A number of the investment banking firms that cov_
ered Petrobrdsnoted that the company'sshareprice had
shown a very high correlation with the EMBI + sovereign
spread for Brazil (shown id Exhibit 2), hovering around
0.84 for a number of years. Similarly, petrobrds, share
price was alsohistorically correlated- inversely-with the
Brazilian reaisAJ.s.dollar exchangerate. This correlation
had averaged-0.88 over the Z00L1004period.Finally,the
questionof whether Petrobrdswasconsideredan oil com-
pany or a Brazil.ian company was also somewhat in
debate:
Petrobrds'sstockperforrnanceappearsrnorehighly cor-
relatedto theBrazilian equity marketand creditspreads
based on historical trading patterns, suggesting that
one'sview on the direction of the broad Brazilian mar_
ket is important in making an investmentdecisionon the
conxpany.If the historical trend were to hold, an
improvementin Brazilian risk perception should pro-
vide a filhp to Petrobrds'sshareprice performance.
-"Petrobrds: A Diamond in the Rough,,'
IPMorgan Latin American Equity Research,
June18,2004,p.2G27.
Gase0uestions
1. Why do you think Petrobri{s' cost of capital is so
high? Are there better ways,or other ways,of calcu-
lating its weighted averagecost of capital?
2. Does this method of using the sovereignspread also
compensatefor currencyrisk?
3. The final quote that "one,s view on the direction of
the broad Brazilian market" suggeststhat potential
investorsconsiderthe relative attractivenessof Brazil
in their investment decision.How does this percep-
tion show up in the calculationof the company,scost
of capital?
4. Is the cost of capital really a relevant fuctor in the
competitivenessand strategy of a company like
Petrobr6s?Does the corporate cost of capital really
affect competitiveness ?