Sometimes back in 2002, Brazil’s national oil company referred to as Petrobras experienced a period that saw its cost of capital shoot up by 6% more than the average of other companies. When a company operates on a high cost of capital, there are bound to be problems when seeking its competitive business advantage (Ogier, Rugman, & Spicer, 2004). The expected return of capital has to exceed the cost of capital, and that was not the case at Petrobras (Ogier et al. 2004). Therefore, to address this, it was important to assess the cost of capital, currency risk as well as risk considerations such as operational and transactional risk, and the recommendations thereof.
Background
The problem facing Petrobras was attributed to lack of diversification following its equity listings on the New York Stock Exchange. The government had 55% of the voting shares and 33% of the total capital (Petrobras Mini Case, n. d.). The company managed to reduce the dependency that Brazil had on imported oil, but there was a drawback to this in the sense that it failed to diversify bearing in mind it was given the same premiums and risk factors like other companies. Therefore, it emerged that the organizational competitive advantage was at risk due to the high cost of capital.
Financing
In diagnosing the challenge facing the company, it is important to look at why its cost of capital is so high. At first, one of the reasons it was high was because Petrobras’ share price had indicated a high correlation with the Emerging Markets Bond Index (EMBI) and the sovereign spread for Brazil that had been around 0.84 for a while (Petrobras Mini Case, n. d.). Petrobras share price had been inversely correlated with Brazil’s reais averaging at around -0.88 between the 2000 and 2004 period (Petrobras Mini Case, n. d.). At the same time, the sovereign spread did not have an opportunity that would see it compensate for the currency risk. In the first place, Brazil had a strong history of economic instability, currency devaluations and depreciations, and high inflation. Therefore, the country’s sovereign spread had been volatile and high (2,400 basis points (24%). Sometimes it could go down to 400 basis points (Petrobras Mini Case, n. d.). In the case of Petrobras, with the Brazil’s sovereign spread being at 400 basis points, for example, the cost of dollar debt stood at 9% even if the credit spread was at 1.0% (Petrobras Mini Case, n. d.). That cost was way high than the debt considering other companies were paying an average of around 5%. In essence, it was difficult for the sovereign spread to compensate for currency risk. At the same time, one apparent thing that came out in the company’s cost of capital was the fact that it affected its competitive advantage considering that its return of capital was higher than the cost of capital (Ogier et al. 2004). That means the company was limited in its quest to expand and make more investments.
Operational Risk
On the same breadth, the process of addressing the situation would also have been explored through the privatization of its assets. One of the assets that the company could have utilized was its pre-oil assets that were under its control. In fact, out of the 20 biggest pre-oil fields in Brazil, the company was said to control 17 (Rapoza, 2016). Therefore, the privatization of these assets would have helped it to reduce the operational risk that was increasingly becoming a reality. In fact, there was the thinking that was it not for the fact that it is a government company, it would have laid off thousands of workers (Rapoza, 2016). Therefore, the privatization of these assets would have saved the company that kind of pressure and reduce its operational risk in the process. Of critical importance, Petrobras was also facing transaction risks that were working against it. One of them emanated from the country’s currency that was pretty much volatile and facing periods of fluctuations. Another risk was the sovereign spread that was also volatile.
Recommendations
In the process of helping the company recover from the current situation, one of the things that it would have done was to explore opportunities for reducing its debt and operational risk. It was evident that the higher the operational risk, the more matters would have worsened. Another thing that would have helped the company was to review its management structure. Here, there was the need to have proper management that has persons highly competent and skilled in navigating such matters (Bevins, 2015). Another thing useful for the company would have been to offset some of the assets that would have helped reduce the high debt it was currently facing. Such assets included BR Distributors and its fuel station business as well as its Braskem stakes. Finally, the company would also have employed the use of analytical tools that help in forecasting and analyzing its management functions.
In conclusion, it is evident that Petrobras was facing an uphill task of addressing the cost of capital that had derailed its progress. Issues such as lack of diversification had been some of the contributory factors that had caused the high cost of capital. Despite efforts to bring it down, it was still high, and one of the things was due to the high correlation with the country’s EMBI and the sovereign spread for Brazil that had been around 0.84 for a while. However, this would have been addressed by privatizing some of its pre-salt oil assets as well as off-setting some assets. Still, it would have streamlined its management.
- Bevins, Vincent. (2015, January 28). Brazil’s economy hurt by unknown cost of Petrobras’ corruption. Los Angeles Times. Retrieved 08 June, 2017 from http://www.latimes.com/business/la-fi-ff-petrobras-scandal-20150129-story.html.
- Petrobras Mini Case. (n. d). Petrobras of Brazil and the Cost of Capital – Mini Case.
- Ogier, T., Rugman, J., & Spicer, L. (2004). The real cost of capital: A business field guide to better financial decisions. Harlow: Financial Times/Prentice Hall.
- Rapoza, K. (2016). Why Brazil’s Petrobras should ‘privatize’ its pre-salt oil assets. Forbes. Retrieved 08 June, 2017 from https://www.forbes.com/sites/kenrapoza/2016/06/20/why-brazils-petrobras-should-privatize-its-pre-salt-assets/#1ae6acf91331
