The
statue of Cristo Redentor dominates the Bay of Rio de Janeiro. It is no exaggeration to say that Petrobras
dominates the Brazilian economy to the same extent. President Dilma Rousseff said as much a few
days ago.
There is no question that, besides being a symbol of
Brazilian technological prowess, Petrobras has been a locomotive for the
economy and a major contributor to federal and states coffers. It has now been revealed that its contribution
exceeded the boundaries of the law. The
question is, what’s next?
The inquiry into the “Lava Jato” scandal ( who got paid off, paid himself or passed on
money to its favorite political party) will go on. But in my view there are two certainties and
one hope: 1) Petrobras will survive, as its demise would trigger the fall of
the government and a deep confidence crisis within the country, 2) Such
survival will necessitate a drastic reduction in subsidies shouldered by the
company, and 3) the need for governance reforms may be taken seriously.
Petrobras has still not released audited 3Q14
financials. Worse, it has been unable –
and in my view reluctant – to quantify the overvaluation of its assets which
resulted from corruption.
In truth, it is no easy task, but Petrobras could
have taken a first step: do you count as bribery the actual stuffing of
suitcases with bank notes? Since the
“cut” has been put at 3% of the value of big constructions contracts[1],
it would amount to R$4.06 billion; or do you consider the amount by which the
book value of projects completed by firms under investigation exceeds fair
market value, in which case it reaches R$61.4 billion[2].
Two pieces of information have yet to be given
proper relevance: 1) although Petrobras has often been a cash cow for Brazilian
governments, the organized bribery scheme is viewed to have started in earnest
in early 2004, one year into the first term of President Lula, the leader of
the PT[3],
and 2) by not picking the R$4.06 billion, the management of Petrobras
acknowledged that the bribery scheme was substantially bigger.
In their defense, management said that other
factors, such as currency devaluation and lower oil prices also contributed to
the loss of value. Indeed. Illegal cartel behavior by Brazilian E&C
firms inflated contract values, but it is not yet clear whether Petrobras
management colluded with its contractors.
Perhaps the biggest factor has been the policy set by former
President Lula to impose a high minimum “local content” threshold of 50% to 80%
in major projects. I recall that in
years past, as a result of this anti-competitive policy, Petrobras has had to
cancel several offshore platform tenders when the bids that were submitted were
double the maximum acceptable price.
In the end, it is of little economic importance to
Petrobras whether some of its assets are permanently impaired because of
dishonesty or economic factors; they have to be marked down. If it takes a R$61 billion write down, the
company will cut its net worth by 17%, a serious but hardly fatal blow[4].
I am convinced that the company will survive, but what
to make of its current share price? It depends
on the answers to the following questions:
-
Will Petrobras be allowed to operate as
a for profit-corporation, able to
achieve profitability and credit parameters in line with its international peers?
-
Will oil prices improve so that its huge
oil and gas reserves can be economically extracted?
-
Will Petrobras shareholders be so
diluted as to make buying shares unattractive at current prices?
I think that the answer to the first question is
yes, at least for the next two years.
Clearly, it would be a disaster for the government if Petrobras were to
go bankrupt; it would badly affect local pension funds, and the standing of
Brazil in the financial markets and as a destination for FDIs would
suffer. Finally, Brazil doesn’t have the
money to support Petrobras if the latter is forced to operate at a loss, an it
is acting accordingly. The fact that
Petrobras has not passed on the drop in crude oil prices to gasoline buyers is
clear proof of that.
Anticipating oil prices is a trickier
proposition. I would expect oil demand
not to drop over time, even if the US and Europe demand is flat. On the supply side, production will be driven
by marginal finding and lifting costs and by national budgetary needs. At $45/barrel, only Saudi, Gulf and Russian producers
make an operating profit; half of US shale production is viable and Brazil is
probably somewhat under breakeven[5].
At $45/barrel, none of the large producing countries meet their budgetary needs[6]. My view is that the 2mm-2.5mm bpd of
overproduction will be absorbed by year end 2015 and afterwards, we may range
around $70-$75 for a while, barring geopolitical events.
What is the value of Petrobras today, and does it
offer any margin of safety?
Its enterprise value (market value + debt – cash)
today is $148.6 billion. To value its
refining division, 1) I assume that Petrobras will be given the freedom to make
a decent profit and 2) I use US refiner Valero as a benchmark with a 30%
haircut[7];
I get $14.5 billion. I value the
distribution division at 12 times net profits[8]
or $11.3 billion. Finally, I value the
Gas & Power division at 10 times net profits, or $7.5 billion. Assuming no value for other assets, by
difference, the upstream is worth $115.3 billion. I assigned that value to proven reserves
only, potential reserves and resources being assessed at zero.
As a result, the 16 billion barrels of proven
reserves are valued today at $7.2 each. 41% of these reserves fall in the ultra deep
category and are more expensive to exploit; if they are also taken out, the
rest, 9.44 billion barrels, is valued $12.2/barrel.
IF
oil prices rise to the $70-$75 by next year AND IF the government lets Petrobras operate according to
international standards, it is an undemanding valuation.
That said, 2015 is likely to be rough on
shareholders. In its latest presentation,
management projected to end the year with $8-$12 billion in cash. That may be
optimistic, and indeed they made no secret that dividends could be cut. Also, at 9/14, Net Debt/EBITDA was a whopping
4.63x. This is hardly compatible with an
investment grade rating, and Petrobras needs such a rating to finance its
investment program; a capital increase is thus possible.
My sense is that dividends will be reduced and
perhaps cut, and that a capital increase is likely if markets are receptive;
they could be if Petrobras announced a thorough management cleanup, a new
energy policy, and if such capital increase were combined with a dilution of
the government stake.
I bought some shares. I expect a rough ride with some likely share
dilution. The upside however is at least
100%.
[1]
Awarded between 1/04 and 9/14 to E&C firms under investigation for
fraud and cartel behavior.
[2]
Same contracts as above.
Represents the difference between
R$88.6 billion of negative variance and R$27.2 billion of positive variance.
[3]
Who had been vehemently against the partial privatization of Petrobras
and who never considered Petrobras as a company truly belonging to all its
shareholders.
[4]
Particularly if it makes profits again.
[5]
Petrobras stated that they were profitable at $40 or $45, but that price
probably doesn’t cover SG&A expenses.
[6]
Not an issue in he US.
[7]
To account for possible differences in complexity and pricing freedom.
[8]
Taking a rough average of last three year profits before tax, applying
the corporate tax rate of 25%.
