Evaluation of Political and Regulatory Risks in the Oil Industry

Abstract

The objective of this study was to determine the best way to quantify the political and regulatory risks in the oil industry. To analyze if these risks should be included in the cash flow or quantified in the WACC (weighted average cost of capital), we used real case studies of exploration and production (E&P) and refining in Latin America. The oil industry is a good case study for this type of analysis because it is more susceptible to government interventions. Our findings indicate that, in general, changes in oil rules cause only small increases in the country risk and beta (therefore in the WACC) but generate great volatility in the cash flow. Although the political and regulatory risks are considered market risk (i.e. have the potential to affect the whole economy) and should be quantified in the WACC equation, our results indicate that the option to insert these risks directly in the cash flow produce better results when compared to adding a spread in the WACC.