Investment Thesis 01/10/2014
The honeymoon after the initial offshore presalt discoveries in 2007 proved to be a high point for Petrobras investors. Since then it has been downhill. Increased government intervention, a dilutive capital raise, an overly ambitious investment program, and ongoing downstream losses have driven the stock price to new lows, while production is at the same level it was in 2009.
The upstream segment is finally headed in the right direction, though. While we don't see significant improvement in 2014, Petrobras is improving productivity across all of its segments and aims to deliver cost reductions of $8 billion per year over the next four years. Importantly, oil production is set to increase after likely bottoming in late 2013 thanks to new project startups and improved operations in the Campos Basin.
Future risks remain, however. Changes to Brazilian oil laws that install Petrobras as operator with at least a 30% stake in all future presalt fields could pressure future returns and further increase execution risk as Petrobras risks spreading itself too thin and is forced to match bids by overly aggressive national oil companies to maintain its stake.
The downstream segment will continue to be a drag in 2014, as an inability to charge market prices results in another year of losses. Price increases have been more frequent of late, but a new mechanism to align domestic and international prices will unlikely result in a meaningful change from the prior system, in our opinion. Also, with elections in 2014, the government may be less willing to pass along higher fuel costs to consumers. Petrobras will suffer as a result.
We expect domestic and international prices to eventually converge, but the outlook remains bleak. Petrobras plans to construct almost 1.5 million barrels a day of refining capacity during the next decade. Budget overruns mean the new refineries are unlikely to ever generate sufficient returns on capital. Management may cancel future refinery projects unless returns are met. However, with the government involved with future capital allocation decisions, we think those projects could ultimately move forward regardless.
Economic Moat 01/10/2014
As an integrated oil and gas firm, Petrobras derives revenue and profits from both upstream and downstream operations. However, Petrobras' economic moat has historically emanated from its E&P activities thanks to the company's dominant exploration and production position offshore Brazil. After more than 50 years of operations in Brazil, Petrobras accumulated the majority of the country's oil and gas assets along with unrivaled knowledge of the region and significant offshore operating experience. The company's competitive position was bolstered several years ago with the discovery of significant oil and gas resources under a salt layer in existing offshore concessions. Petrobras' early entry into the previously underestimated and overlooked area created a commanding position in some of the largest discoveries in recent decades. As a result, the company has the potential to double its reserves and production during the next 10 years.
A key element of an E&P firm's moat is the quality of its assets, and with its oil-dominated presalt exposure, Petrobras' position is unmatched by other large international integrated firms that are increasingly relying on natural gas to replace reserves. Given the staggering reserve estimates of the presalt fields, Petrobras’ moat appeared unquestionable.
However, increasing government involvement in investment decisions has jeopardized future returns to the point where we think Petrobras no longer earns a moat. We cannot forecast that excess normalized returns will more likely than not be positive 10 years from now. In addition, we see continued substantial threat of major value destruction. As a result, we do not believe Petrobras continues to earn an economic moat.
In short, the discovery of the presalt reserves prompted the government to push Petrobras to invest in lower-returning assets, particularly refining, as a way to build out domestic infrastructure and create jobs. In addition, the government mandate to supply the domestic market and Petrobras’ inability to pass along international prices have resulted in increasing downstream losses and sagging returns. Also, the new refinery projects are largely behind schedule and over budget, ensuring future returns will fail to meet the cost of capital. Once operational, profitability will still be subject to government price controls.
Given the increase in the size of the E&P business and its higher returns, Petrobras may earn a moat as historically the higher returning upstream segment has resulted in companywide excess returns. However, we believe future offshore projects may see returns threatened thanks to increasing regulation in the awarding of exploration licenses and local content requirements. Of particular note is the government’s requirement that Petrobras be operator and hold a 30% interest in all future presalt fields. However it must match partners’ bids on fiscal terms, potentially risking future returns. Combined with the increase in capital in lower returning businesses, a moat is unwarranted at this time.
We are maintaining our fair value estimate of $21 after updating our forecasts based on the latest quarterly results. Our fair value estimate implies an EV/EBITDA multiple of 7.4 times our 2014 EBITDA forecast of $30 billion. Though expensive based on its forward multiple, Petrobras trades at a steep discount to our DCF-derived fair value estimate. While fraught with risks, most notably a dilutive equity issuance, Petrobras shares are compelling at our Consider Buying price, as improving upstream operations in 2014 and the eventual waning of downstream losses mean the worse is likely over.
After slightly lower domestic oil production in 2013, we expect steady growth between 3% and 5% in 2014-16, slightly below management's guidance of 4% to 6%. Domestic natural gas volumes should see growth as well as infrastructure is added to send gas onshore. International production remains flat throughout our forecast period. We think Petrobras' latest production forecast is more realistic, but we continue to risk its targets to arrive at our forecast.
We forecast losses for the refining segment in 2014-17, given the gap between domestic and international prices and the need for continued imports (at international prices) that will likely persist over the next few years. Strengthening domestic currency or falling oil prices could reduce downstream losses.
In our discounted cash-flow model, our benchmark Brent oil prices are based on Nymex futures contracts for 2014-16. For oil, we use $105 per barrel in 2014, $100 in 2015, and $95 in 2016. Our long-term oil price forecast for 2017 is $100. Our DCF valuation uses an exit multiple of 6.5 times and a cost of equity of 12%.
Petrobras' primary risk lies with the possibility that oil and gas prices will fall, damaging profitability and preventing economical development of reserves. Meanwhile, a rapid increase in international oil prices would produce outsized losses for the refining segment. Exploration risk associated with presalt discoveries is minimal, but the relatively new play can present operational and engineering challenges, which may lead to higher costs. With its concentration of production in Brazil, Petrobras for the most part avoids geopolitical risk. Petrobras' development plan could be limited by constraints on financing or lack of available equipment. A stretched balance sheet means another equity issuance has become a risk.
With the Brazilian government owning a controlling stake, any decisions made about directors, management, and even strategy ultimately will benefit the state, potentially putting shareholder interests second. Expect no change in the situation, as Brazilian law requires the government to own a controlling stake in Petrobras. The company is up-front about this, as it discloses in its filings that the Brazilian government may pursue its agenda through Petrobras, damaging financial performance. While the arrangement may prove to be beneficial to Petrobras in the administration of resource policy, it is possible that government officials will view the company as a means to enact social or economic policy or generate government revenue. Government policy toward Petrobras, as well as management, may change with each administration. Shareholders must keep in mind that the Brazilian government's interests could supersede shareholders' and the company's, risking returns. In the most recent share offering, the government subscribed to additional shares, increasing its own and its affiliates' ownership in the company to approximately 48%, from 40% previously.
Maria das Gracas Silva Foster was recently named CEO, replacing Jose Sergio Gabrielli de Azevedo. Foster has been with Petrobras for 31 years, previously serving as director for gas and energy. Foster's appointment was followed by a number of other new management hires in key positions and creation of other positions designed to better manage Petrobras' development activities. Foster has been at the helm for only a few months, but she appears to be already having an impact. In addition to the new personnel, she has been up-front about Petrobras' past failures, particularly with regard to meeting production goals. Under her leadership, Petrobras also dramatically revised its production growth forecast. While we appreciate the honesty, we think her true test will be hitting the targets and improving operations. Convincing the government of the need to revise domestic prices should be first on her list, though.
Petrobras is a Brazil-based integrated energy company controlled by the Brazilian government. The company focuses on exploration and production for oil and gas in Brazilian offshore fields. Production in 2012 was 2.6 million barrels of oil equivalent a day (83% oil), and reserves stood at 12.8 billion BOE (85% oil). Petrobras operates 12 refineries in Brazil with a capacity of 2 million barrels a day and distributes refined products and natural gas throughout Brazil.
Thanks for informative post. I guess you just have to be patient. If we get a flare up in the Middle East or somewhere else, hopefully the market will view the PBR more favorably. Right now, PBR trades for about 50% of Book Value. Good luck
Book value I'd a work of fiction. What is presal worth? What is book value of refineries that cost 10x more to build because of corruption and cost overruns? Lula dictated the price of the presal. A man with no oil background. Sergio Gabrielli, Lula's buddy the CEO of Petrobras now hides in the NE of Brazil as a consultant the Jacque Wagner, Gov of Bahia. Like the CEO of Chevron taking a job in Havana for Fidel's brother.....
Sentiment: Strong Sell