Petrobras’ controlling shareholder is the Brazilian government, not the ADR holder. If Petrobras focuses on maximizing the government’s valuation of the shares, how would this affect its discount rate for Pecom? (I am looking for a qualitative answer here)


Drilling South: Petrobras Evaluates Pecom

João Nogueira Batista, Chief Financial Officer of the Brazilian firm Petrobras, reflected on Gros’s words as he prepared for a Board of Directors meeting in July 2002. The main item on the Board’s agenda was the proposed acquisition of an Argentinean firm, the Perez Companc Group, or Pecom.2 The acquisition would significantly increase Petrobras’s oil and gas production and add to its oil reserves. It would also provide the mainly Brazilian-based Petrobras with considerable foreign interests. Petrobras would have access to Pecom’s management team, which had worked in most of the major Latin American countries and under different operating environments, enhancing Petrobras’s ability to manage an international portfolio.

Recent corporate governance changes meant that Petrobras now had more independence from the Brazilian government, and some managers were eager to explore new opportunities for the company, including the possible acquisition of Pecom. Others were more cautious. General elections would be held in a few months, and one of the leading candidates for president, Luiz Inácio Lula da Silva of the Workers’ Party, did not fully support Petrobras’s increasing autonomy. If Lula won the election, Petrobras’s new structure and its strategy could be challenged. At the same time, the acquisition of Pecom would give Petrobras’s even more weight and could increase the company’s already substantial contribution to the Brazilian economy.

Batista had spent the previous weeks debating the merits of the acquisition and how to value Pecom with his team. There had been numerous discussions on the cost of capital for the acquisition, and especially on how to incorporate country risk given the current economic upheaval in Argentina. Uncertainty over the appropriate discount rate to use in a cash flow model led some team members to advocate other approaches to the valuation, such as multiples. It was Batista’s responsibility to present these different perspectives to the Board. The uncertainties inherent in valuing Pecom were bound to give rise to interesting discussions at the forthcoming Board meeting.


Petrobras was created as a symbol of Brazil’s natural wealth under the slogan “the oil is ours,” in 1953. It was incorporated as a mixed-capital company3 with a government-granted monopoly for all crude oil and gas production, refining and distribution in Brazil. Petrobras’s official monopoly ended in January 2002, when the Brazilian government deregulated domestic prices for crude oil and oil products.

Petrobras’s first discoveries were made onshore in the Northeast of Brazil in the 1950s and 1960s. In the mid 1980s, when the giant deepwater pools in the Campos Basin were discovered and developed, the profile of the company started to shift upstream toward exploration, development, and production.

Upstream and Downstream Activities4

By 2001, almost 50 years after its inception, Petrobras had become a fully integrated oil and gas company. Petrobras was the seventh largest publicly traded oil and gas company in the world based upon proven reserves, the largest Brazilian corporation, the third largest Latin American corporation, and the 185th largest global company, by 2001 consolidated revenues.

In Brazil, Petrobras had a dominant position in both upstream and downstream activities. The company’s combined oil and gas production was 1,621 tbpd and it had proven reserves estimated at around 9.3 billion boe.5 (

Exhibit 1

provides selected oil and gas data for Petrobras and other oil companies.) Most of the firm’s proven reserves were located in very deep waters (more than 400 meters) and Petrobras was the world’s pioneer in deep water oil exploration and production. Furthermore, with approximately 60% of its reserves undeveloped, Petrobras had a large pool of assets to engender long-term production growth.

In downstream activities, Petrobras was the fifth-largest refiner in the world among traded companies, with a virtual monopoly in the Brazilian downstream business. It owned and operated 11 out of 13 refineries in Brazil, accounting for 98.6% of the Brazilian refining capacity. Petrobras also owned the largest oil distribution company in Brazil.

Exhibits 2 and 3

show the organization of the firm’s main activities within its corporate and management structures.

The Restructuring of Petrobras6

Until the late 1990s, the Brazilian government owned 84% of the voting shares of Petrobras and the Brazilian President appointed the company’s Board and its executive directors. For many years, there was a market perception that several governments had used Petrobras as a tool to contain inflation7 or to advance development policies for specific industrial groups. Beginning in 1997, Petrobras became more independent of the government. Responsibility for appointing the Board shifted from the Brazilian president to Petrobras’s shareholders, and the government was allowed to sell up to 34% of its voting shares in the capital markets. The government lifted restrictions on the ownership of shares by non-government entities and permitted foreign ownership of shares (see

Exhibit 4

for major changes in the ownership and governance of Petrobras). In August 2000, Petrobras was listed on the NYSE through an ADR Level II program, and in July 2002 it was listed on Latibex, the euro market for Latin American equity shares.8 The shareholder structure of Petrobras is shown in

Exhibit 5.

Another significant change affected Petrobras’s financing strategy. Petrobras had played a key role in the government’s fiscal policy. It was the largest Brazilian taxpayer, as well as the largest distributor of dividends and royalties. Petrobras’s net profit represented almost 25% of the overall primary surplus of the consolidated public sector, or roughly 1% of the Brazilian GDP. Petrobras’s capital expenditures were included in the government’s budget and the company’s investments and indebtedness were therefore subject to restrictions tied to the country’s fiscal policy. From July 2002 on, The International Monetary Fund, or IMF, no longer considered Petrobras’s investments part of the government’s budget, thus removing any restrictions to its financing strategy.

Along with the changes in its ownership and control, Petrobras streamlined its management structure and implemented new management policies. The changes included the adoption of a new long-term strategic plan, the introduction of business units, the integration of some subsidiaries into the company as divisions to promote synergies and minimize functional overlaps, and the introduction of performance targets. Under the leadership of the current CEO, Francisco Gros, the company defined the role and responsibilities of the Board and the executive directors, created committees to advise top management, and issued guidelines for corporate governance, best practices and ethical conduct.

The main objective of these changes was to transform Petrobras into a state-owned company able to compete with the same agility and freedom as a privately owned corporation. These changes appeared to be paying off. Statistical studies indicated that from 1999 to 2001, Petrobras migrated from a typical Brazil-risk stock, trading in close correlation with country risk, to something closer to a global oil company, reacting more to swings in crude oil prices. The market capitalization of Petrobras almost tripled during this period.

Exhibit 6

provides data on the company’s stock price history .

In 2001, on a consolidated basis, Petrobras’s net revenues were $24.5 billion (see

Exhibit 7

for Petrobras’s financial statements). The company planned capital expenditures amounting to $28.2 billion through 2005, with 45% directed to exploration and production and 23% to international projects (not including potential acquisitions). The company’s adjusted net debt of $11.1 billion gave a debt-to-total-capital ratio of 38%. Of the company’s financial debt, 88% was denominated in foreign currency.

Petrobras’ Strategy

Some analysts judged that the recent changes in Petrobras’s ownership and control and its new emphasis on a more flexible and responsive management structure put Petrobras in a different league from state-owned Latin American oil companies such as Pemex and PDVSA (see

Exhibit 8

for key statistics on Petrobras and other Latin American oil companies). Alexandra Strommer, a J. P. Morgan senior analyst, explained:

Petrobras had a very peculiar position within the oil industry. The company could not be considered a typical Latin American oil company like PDVSA or Pemex because it was already much more market-oriented and had more of a private-company mentality. Also, it was not a net exporter, focused on the external markets, but very much Brazil-centric. Additionally, despite its size, Petrobras did not seem to fit among the major oil companies, since it was not really global, even though it has a sizable integrated structure.9

While Petrobras was not yet a global oil company, it was committed to geographic diversification. Petrobras’s stated objective was to build a portfolio of upstream assets in Latin America, the Gulf of Mexico, the Caribbean, and West Africa. The common theme behind that geographic focus was for Petrobras to leverage its deepwater expertise acquired in the Campos Basin. Moreover, since 95% of Petrobras’s upstream reserves were exposed to the risks of a single country, Brazil, the company had a strong strategic rationale for enlarging its international activities. The acquisition of an Argentinean company was in line with Petrobras’s strategy of expanding outside Brazil.


The origins of Pecom went back to 1946, when the Perez Companc family incorporated the firm as a shipping company. However, it was only in 1960 that the company got involved in the oil business. Gradually, Pecom developed an appetite and skills for the oil industry and, in 1990, the company gained its first major oil concession. In 1994, Pecom took another important step when it started operations in Venezuela and then expanded into Brazil, Bolivia, Ecuador and Peru. In 1998 Pecom was consolidated as a vertically integrated energy company. The firm listed its shares on the Buenos Aires Stock Exchange in January 2000 and launched an ADR program on the New York Stock Exchange. Pecom’s corporate structure is shown in

Exhibit 9.

Upstream and Downstream Activities10

Pecom’s exploration and production activities were its main cash source, with drilling accounting for 69% of its adjusted EBITDA. Pecom’s proven developed and undeveloped reserves were estimated around one billion boe.11 About 42% of Pecom’s total reserves were in Argentina, and 58% were in operations in five other South American countries. Pecom forecast that its total production in 2005 would reach 400 tbpd, with most of this coming from outside Argentina.

Pecom’s downstream activities included refining operations in Argentina and Bolivia. Although these interests represented just 7% of Pecom’s adjusted EBITDA as of December 2001, refining was a key part of Pecom’s long-term strategy, representing an important link in the business value chain. Petrochemicals represented 8% of Pecom’s adjusted EBITDA in 2001. It had the region’s largest capacity for styrene and polystyrene production, and was a leader in Argentina in these products. In addition, Pecom had over a one-third share of the fertilizer market in Argentina. Among Pecom’s other activities were its investment in TGS, the largest transporter of natural gas in Argentina, and interests in the generation, transmission, and distribution of electricity in Argentina. Pecom operated 75% of the country’s high-voltage power transmission system, and had an exclusive license to serve both the residential population and commercial firms in the central and southern Buenos Aires metropolitan area.

Pecom and the Financial Crisis in Argentina

Like many oil companies with hard, bankable assets, Pecom opted for relatively low-cost dollar borrowings in the 1990s, on the assumption that its primary products – crude, gas, and refined products – would remain priced in dollars (see

Exhibit 10

for Pecom’s exposure to the domestic market and export opportunities). In July 2001, for instance, Deutsche Bank, a commercial bank, led a syndicate of banks to underwrite Pecom’s four-year, $220 million unsecured floating rate note with a 9.3% all-in cost, substantially below the 16% Argentine sovereign bonds.12

In January 2002, however, the Argentine government abandoned its Convertibility Law, which fixed the Argentine peso at exactly one U.S. dollar and opted for a “pesification” of the economy. All U.S. dollar-denominated deposits in the financial system were converted at a rate of 1:1, while all U.S. dollar-denominated debts incurred in the Argentine financial system were converted at a rate of 1.40:1. The government decided to compensate financial institutions for the difference with a bond that had not yet been issued in July 2002. Firms that had incurred debt in U.S. dollars abroad were forced to cancel them through the open exchange rate market. On July 15, 2002, the U.S. dollar was quoted at AR$3.58

The financial crisis in Argentina had a severe impact on Pecom. Less than 10% of Pecom ́s loans, and none of its foreign bond debt, were covered by the pesification. Pecom still faced mostly dollar- based debts, but revenues from some of its commercial agreements denominated in dollars and adjusted per the U.S. producer price index were converted into pesos at a 1:1 rate, and indexation was eliminated. These peso revenues were far below world market prices since domestic prices did not rise at the same rate as the devaluation. Pecom also faced a pending export tax that could be levied on up to 40% of the company’s Argentine oil export revenue. In March 2002, Pecom held $231 million in cash and short term investments and its debt and other financial obligations to the end of the year amounted to $840 million (see

Exhibits 11a and 11b

for Pecom’s debt profile). Pecom’s vice chairman, Oscar Vicente, painted a grim picture of Pecom’s situation: “I have half or less of the pesos I need to buy the dollars I have to pay. A group like Perez Companc is not viable in this situation.”13

Although the medium- and long-term business view was still promising, the short-term scenario had put the company at a crossroad. Pecom and its external advisors had been working on different alternatives since the end of 2001, without a clear or easy solution. The company owned sound assets, but it could not simply divest selected assets without jeopardizing its longer-term growth prospects (see

Exhibit 12



, and


for Pecom’s actual and estimated financial statements). Simultaneously, the local banking system was in crisis and international bankers were reluctant to increase their exposure to an emerging market company. Pecom’s management and shareholders had to come up with a solution before they were out of cash or credit. A senior analyst from Merrill Lynch explained:

It is necessary to look at whether the company really does have the cash flow to continue to endure the crisis. Whatever the long-term cash-flow generation capability of the company, the ability to meet its debt maturities and interest payments is key to preserving equity value.14

Petrobras’s Proposed Acquisition of Pecom

The acquisition of Pecom by Petrobras offered the Argentinean firm a solution to its current financial problems and it was in line with Petrobras’s strategy of geographic diversification. It was not clear, however, if the acquisition would be feasible. The deal would require regulatory approval, Argentina was in the midst of a financial crisis, and Brazil faced economic challenges of its own. Many Brazilians feared that the crisis would spread to their country, and were concerned about the fiscal deficit and the continuing depreciation of the Brazilian Real against the U.S dollar (see

Exhibit 15

for average monthly exchange rates). There was also considerable political uncertainty in Brazil because of the upcoming general elections in October 2002. Some businesses feared that the leading candidate for president, Luiz Inácio Lula da Silva of the Workers’ Party, would change Brazil’s existing economic and legal framework if elected president. A roll back of privatization, or at least a freeze on it, were among the Workers’ Party’s proposals, and it was not clear what impact this might have on Petrobras.

Batista therefore faced a demanding task in evaluating the proposed acquisition of Pecom. The transaction initially envisioned by Petrobras’s CEO Gros and Batista covered Petrobras’s purchase of 58.6% of the total capital of Pecom from the Perez Companc family and the Perez Companc Foundation. In a separate transaction, Petrobras would also acquire 47.1% that the Perez Companc family held in Petrolera Perez Companc.15 Batista and his team prepared pro forma consolidated figures to detail the increases in oil and gas reserves and refining capacity that would be gained, and to show how the acquisition would affect debt and income (see

Exhibits 16a

for Pro Forma Operating Figures and

Exhibit 16b

for Pro Forma Financial Data).

Valuation Approaches

Batista had emphasized the need to build a cash flow model and run sensitivity analysis in the valuation of Pecom. The most complex issue confronting Batista was how to account for country risk in the cost of capital. Latin America’s long tradition of economic and political instability exposed companies to a myriad of risk factors, including currency devaluation, repatriation, capital controls, and expropriation, but these risks changed over time and varied from country to country. Over the last decade, both Argentina and Brazil had embraced reforms backed by the International Monetary Fund (IMF) and the World Bank. Measures such as exchange rate stabilization, freer capital flow mechanisms, lower import tariffs to encourage trade, and privatization of state-owned companies were put into practice to pave the way toward integration with global economies.17 Argentina, however, was again in financial crisis, and determining the appropriate country risk premium to use for the Pecom valuation proved challenging for Batista and his team.

Country risk premiums were most commonly derived from J. P. Morgan’s Emerging Market Bond Index (EMBI), which measured the spread between external sovereign debt instruments of emerging markets with U.S. Treasury Bills of similar duration. As shown in

Exhibit 17,

Argentina and Brazil had similar country risk premiums up to mid-2001. By 2002, Argentina’s country risk had increased so much that some team members argued that incorporating this risk premium into the discount rate for the Pecom valuation was problematic (see

Exhibit 18

for sovereign risk premiums and market valuation indicators). They suggested that the cost of capital could instead be derived from current analyst estimates of the weighted average cost of capital for oil companies, including Petrobras and Pecom (see

Exhibits 19a



for cost of capital estimates


, or from cost of equity estimates for different countries, including Brazil and Argentina (see

Exhibit 20).

Other team members, though, questioned how relevant such estimates were to the Pecom valuation.

The uncertainty about the country risk premium and the appropriate cost of capital to use in a cash flow model led Batista and his team to consider other valuation approaches in their analysis. They compared the valuations of selected companies, examining their multiples on a range of variables including reserves, EBITDA, cash flow and earnings (see

Exhibit 21)

. BOE multiples were another common valuation measure used in the oil industry, and

Exhibit 22

provides information on the BOE multiples for recent transactions. BOE multiples, however, did vary considerably across transactions, and also according to the location of reserves, as shown in

Exhibit 23.

In analyzing the different market-based valuations, team members debated which companies were most comparable to Pecom and which transactions could usefully be compared to the proposed acquisition.

Funding Strategy

Another point the board would raise was the question of Petrobras’s financing strategy for the acquisition. Funding the acquisition with cash, securities, or a combination of both would be a sensitive matter. Petrobras was a well-recognized name, but market conditions were deteriorating by July 2002. Raising local funds meant paying high local interest rates with maturities shorter than 3 years. International markets were virtually closed to corporate bonds coming from emerging markets.18 Finally, floating equity at that point could send a troublesome signal regarding Petrobras’s current price truly reflecting its inherent equity value, thus jeopardizing the market expectation that Petrobras could lower its cost of capital, and consequently boost future results and market performance.19

As Batista organized his notes for the Board meeting, he reflected on the issues he and his team had discussed in the previous weeks. Was the Pecom acquisition a sound opportunity to increase Petrobras’s diversification, or was it a risky venture during an unsettled time? The price offered for Pecom would at least in part determine the answer, and Batista wanted to be sure that his valuation of Pecom provided the Board with the information it needed to make a decision.