Welcome to Thunderdome!

You remember the movie[1], Thunderdome with its ghoulish MC and his famous opening line: “Two men enter, one man leave!”

Well, Thunderdome just moved North, except that we are no longer talking about Max and Master Blaster, but Greece and Germany.

For the last few months, the new Greek government, elected on an anti-austerity platform, has showed no interest in abiding by the existing multilateral agreement under which private creditors were bought out at a massive loss (≈77%) to them, or negotiating a new reform program with the other eurozone countries, the IMF and the ECB.

Instead, the basic Greek game plan has been to play chicken, betting that the prospects of a Greek default would scare the other Eurozone members into caving in, while periodically demanding WWII reparations from Germany and flying its prime minister to Russia.

The Greeks have some excuses, for while Finance Minister Schauble has taken a clear and firm line, his French counterpart has kept zigzagging, one day asking them to come up with serious proposals and the next insisting that Greece couldn’t leave the currency union.

The result, so far, is that Greece is expected to default on its IMF loan repayment today, its banking system is essentially shut down and confidence in its government (as measured by money flows) is at its lowest level among locals and foreigners.  Much worse, by now Greece’s economy has shrunk even more than Chile’s did in the early 1980s, yet it has nothing to show for it while by 1986, Chile enjoyed a nationalized but functioning banking system, a sustainable private pension program, globally competitive non-traditional export industries, a balanced budget and foreign debt reduction programs which met their objectives and attracted new investments.  Its GDP also grew by 6%.  And unlike Greece, Chile had not received any multilateral financial assistance in solving its financial crisis.

The new Greek government has planned a referendum for July 7^th, yet has lacked the honesty to set the choice right for voters: it is not between economic austerity and flexibility, but between staying within the eurozone and leaving it. 

Greece’s “intellectual” allies decry the imposition of reforms and spending cuts, yet Greece has already gone through the pain for no benefit.  The UK, with its much criticized austerity policies, is doing better than most of continental Europe for two reasons: a) its austerity policies were devised so that everyone carried his fair share and b) capital is not blind and will go where it has a chance to prosper.

Another bugaboo is the excessive burden of the Greek debt: creditors should (again) take a loss to make it bearable.  But what is the real burden if interest rates are rock-bottom, interest payments are partly deferred[2], and principal repayments extend 30 to 50 years in the future[3]?  Besides, Greece has a primary budget deficit, that is before even paying interest on its debts.

At this stage, it is difficult to predict what will happen in the next weeks and months.  Perhaps another lifeline will be cast to Greece. 

But all parties realize that by getting in deeper, creditors are becoming hostages to their debtor.  Private creditors took a whopping 77% loss just three years ago!  The new sovereign creditors are on the hook for close to €250 billion, of which France alone gathers it is owned over €42 billion.  Already, in the last go around, Finland demanded collateral to back its bilateral loan while Cyprus, Slovakia, Ireland, Portugal and Spain stepped out of the EFSF.  Greece has already asked for a haircut from its eurozone partners, while providing scant details as how it will repay the rest.

More fundamentally, even if a new Greek government were to adopt better economic policies and the population were to agree to drastic changes in such areas as taxation, pensions, public sector employment, privatizations, etc. it remains to be seen if Greece can really share the same currency with the likes of Germany, unless it is to receive permanent subsidies.

Can a country, whose holders of its sovereign debt lose 77% of their investment, really be part of the second most important reserve currency system in the world?

Bound to the euro currency, it can only regain productivity the very hard way: by cutting wages. Likewise, the euro linkage hampers its tourism industry (18% of GDP[4]) as it competes with the likes of Croatia, North Africa and Turkey.

As the core economies of the eurozone regain their health, the gap with Greece will grow.  As explained above, the debt burden is NOT the essential problem of Greece.  Rather, it is its lack of competitiveness.  Not sharing the same currency with the stronger economies is politically and economically the only way out, even if it is unpalatable in the short run.  Recurring eurozone wealth transfers are a no go. 

In the short term, Greece may not want to leave.  If it stays, I expect Germany and others to leave, eventually.

Welcome to Thunderdome! “Two countries enter, one country leave!”

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[1]   Mad Max Beyond Thunderdome.

[2]   Up to 2022, interest on €34.6 billion of EFSF facilities is capitalized and then paid over the 2023-2042 period.

 [3]   €142 billion owed to the Eurozone countries via the European Financial Stability Facility (EFSF) mature between 2023 and 2053 and carry interest at the rate of about 1.5% p.a. The IMF loans amount to €25 billion and carry interest at rates varying between 3% p.a. and 4% p.a.; €7 billion are due this month and the rest at intervals until 2024.  Another €95 billion represent traded sovereign bonds which were already subjected to a 77% haircut.  Furthermore, of these €95 billion, the ECB holds €27 billion.  However, the ECB bought these bonds at below market prices and has agreed to repay that discount to Greece.  Finally, there are €53 billion of bilateral loans from other Eurozone countries which carry interest at a rate of 3 month Euribor + 0.5%p.a. for an all-in rate barely above 0.5% p.a. (the spread was repeatedly reduced from an original level of 3% p.a.).

[4]   The importance of tourism is understated by this percentage given the very high contribution of the public sector to GDP.

The comeback kids

If you have been reading this blog for several years, you know that competitive swimming has been my favorite activity after investing.  Actually, it helped me keep my balance during the stress filled period from 2007 to 2009.  When you swim, your mind is focused on your strokes, your times, how you “feel the water” and nothing else.  By the time practice is over, any stress you may have brought to the pool has disappeared and you are ready for another day.

Lately, my attention has been drawn to the efforts of past champions, from the business and swimming worlds, to make a come-back.  Both fields are very competitive, staying on top is difficult as trailblazers, by breaking records, make the seemingly impossible possible and keep moving the goal posts.   Staying on top is as difficult for leading companies as it is for elite swimmers, and once they slip, coming back is terribly hard.  For all, aging is the ultimate debaser of idols.

Four champions are battling gamely, and given their track record, their efforts are worth watching closely.

Grant Hackett is the greatest long distance swimmer of all times, having won silver or gold medals in the 200m, 400m, 800m and 1500m free at world and Olympic venues.  At age 34, after taking a six year break from competition and with the benefit of only six months of intensive practice, he qualified for the Australian 4x200m relay at this summer World Championships and finished third in the 400m free at the Australian Nationals.  And he did so in world class times.

It is one thing to come back in the 50m or even the 100m free past age 30 (Anthony Irvin, at 33, is a rare example of success), but it is altogether different in the 200m and even more so the 400m.  It simply never happened before.  When Vladimir Salnikov of the USSR capped his great comeback in Seoul by winning gold in the 1500m he was 28 years old, he had not dropped swimming for 6 years and he certainly had practiced for more than 6 months prior.

In a way, Hackett is so atypical as to have little predictive value for others.  He continues to enjoy an exceptional fitness level and a huge physiological advantage thanks to a lung capacity in excess of 13 liters[1].  Finally, those six years away from elite swimming seem to have rekindled his love for the sport.

The case of Michael Phelps is more complex.  The greatest all around swimmer ever, Phelps shares with Hackett the mental fortitude required for top level performance.  While Hackett has exceptional fitness, Phelps has great feel for the water.  Both swimmers worked very hard on their conditioning, with Hackett enjoying  a natural edge there; as a result, Phelps has to train harder to regain his top form, a cruel challenge when you are pushing 30.  Finally, Phelps never took more than 1-1.5 full years off and I think that it shows in the mental freshness area.

So far this year, his times have been unimpressive, and while his coach puts that on a heavy work load, one would assume that his competitors are in the same situation, yet performed better.  Phelps must now get back to the grind to catch up with his peers (Lochte, Clary, Cseh) and push back younger, fresher, upcoming rivals (le Clos, Hagino, Seliskar).

I wouldn’t bet against Phelps, particularly if he focuses on one or two races (100 fly, 200 IM), but he will need great mental strength to repeat as #1.  Success is possible but will only be achieved the (very) hard way.

In the business world, two companies are also fighting to get back on top.  Petrobras is one.

Its new management team is finding much fat to cut.  For example, it discovered that its PR department employed 1,146 people; this compares with 45 at Vale[2][3].  More generally, Petrobras has over 446,000 employees vs. 94,000 at Shell, yet Shell had revenues of US$421 billion in 2014 vs. US$144 billion at Petrobras[4]. 

I have long sustained that Petrobras is like Ali Baba’s cave, full of treasures or at least a bric à brac of valuable assets.  The new management team has announced a divestiture program of at least US$13.7 billion.  That should not be too difficult to achieve.  Indeed, it probably should be expanded in order to make the company more manageable and efficient.

But a successful turnaround will depend on factors beyond the company control.  To wit:

-1Q2015 showed a marked improvement in earnings before interest and taxes, largely as a result of the lifting of the government mandated freeze on diesel and gasoline prices.  Hopefully, this hands off policy on the part of the government will continue even if unemployment rises and the economy contracts;

-Company gross debt expressed in Brazilian reales rose 14% q-o-q to a whopping R$400 billion as a result of currency depreciation. So far in 2Q15, the real has appreciated, but a swing back the other way is always possible;

-Despite a large downward revision, 2015 capex are expected to exceed operating cash flows (US$29 billion vs. US$25 billion) for the eighth year in a row.  The company should unveil its new medium-term plan next month.  We will see how much leeway the government, as controlling shareholder, will allow the company.

-After Congress made some positive noise about revising the onerous local content rules and the requirement that Petrobras be the lead operator in new pre-salt projects with a 30% equity stake, President Dilma Rousseff publicly came down against those sensible proposals;

-Finally, Petrobras operates in a country which is struggling with well known problems, the solutions to which are socially unpopular and politically difficult;

In sum, everybody knows what it will take for Petrobras to regain its former health, and some welcome remedies (most importantly the freedom to price oil derivatives) are already in place.  But the crux of the problem is political in nature, and unfortunately the President is no free-market believer and even if she were, she would have a hard time leading the way after losing control of her own party.

Imagine Michael Phelps being limited to five morning swim and two dry land practices per week, at venues to be decided on a weekly basis by the Baltimore municipal council[5].  He could still make the C and perhaps the B finals on the Arena Grand Prix circuit, but he wouldn’t stand a chance to make it to Rio in 2016. 

Petrobras won’t be another PDVSA but it won’t stand a chance to emulate Total.  Where, in between, will it settle is still in doubt.

A world leader in iron ore mining,Vale shares some of the same pains with Petrobras.  A national champion, Vale was greatly pressured by then President Lula to use its bountiful cash flows to invest in new projects, whether or not those fell within its area of expertise.  Unlike Petrobras, Vale was a privately controlled entity, yet the conflict with the government got so severe that its CEO had to resign and a new one, more politically attuned, was appointed.

But the damage was done, with investments in fertilizers, non-ferrous and precious metals, coal and lower grade iron ore.  To be fair, the commodity boom of the last decade made capacity expansions very tempting particularly since the alternative - share buybacks and big dividend increases – was anathema to the government.

As Chinese demand for iron ore fell and prices swooned 60% from their highs, miners scrambled to slash operating costs, renegotiate capex-related contracts and divest from non-core assets.  By their nature, mining projects are long-term and very expensive, so that cancelling them midway makes little sense.  As in the oil sector, being the lowest cost producer is the name of the game.  A global production cutback would raise ore prices and operating costs, and it would give some breathing space to high cost producers.  So far, the most efficient miners have chosen to raise production to lower costs and flush out their weaker competitors (Chinese and some Australian).  Besides, it is unclear the extent to which China would salvage its iron ore industry.  So are the short/medium terms prospects of the Chinese economy. 

Unlike Petrobras, Vale is reasonably lean and well managed.  It has divested assets and continues doing so.  It is cutting costs.  Its survival is thus not in question.  But for the reasons mentioned above, it will be some years before it returns to a high degree of profitability. 

Both Petrobras and Vale are suffering from unfavorable commodity dynamics, weakening export markets as well as political and economic crises at home.  French readers who see similarities between present day Brazil and France in the Hollande-Ayrault years will be correct, except that the situation in Brazil is much worse.

I think that Hackett will do great this summer at World, flirting with 1’ 46” flat on the 200m free and making Australia the favorite to win gold in the 4x200m relay.  Phelps won’t be there; he may have it in him to win gold in Rio, in either the 100 m fly or the 200 IM, but for the first time, I think that his challenge may be more mental than physical.

Petrobras has rebounded from a scary bottom and will “make it”, but I must say that I have lowered my expectations; B finals at best. As for Vale, A finals but no medals.  Both should do better in 2020 in Tokyo.

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[1]   As per Hackett, it didn’t decrease in the six years since his retirement. Sydney Herald Tribune April 2, 2015.

[2]   Folha de Sao Paulo May 17, 2015.

[3]   Also, this number includes PR employees of the holding only, and  none at subsidiaries like BR  Distribuidora.

[4]   In case you think that the recent devaluation of the Brazilian real distorted the comparison, the numbers were US$467 billion vs. US$145billion in 2012.

[5]   I know, he and Bob Bowman are moving to Arizona, but this is to make a point!

Petrobras: out of the ICU, not having a real good time yet

Petrobras finally released its audited 4Q and full year 2014 financial statements yesterday.  Today, it held its conference call with analysts.  In more ways than one, the company is out of the ICU, but a long way from regaining its form of the mid 2000s.

New CEO Aldemir Bendine and his team can take credit for avoiding the brick wall.  Like Freddie Mercury of his favorite rock band Queen, he surely pleads, with his controlling shareholder, the Brazilian State: “Don’t stop me now!”  Would President Dilma Rousseff be more receptive if he wore white denim jeans, a wife-beater and Addidas track shoes?  We’ll never know.

Tonight im gonna have myself a real good time

I feel alive and the world it’s turning inside out Yeah!

I’m floating around in ecstasy

So don’t stop me now don’t stop me now

‘Cause I’m having a good time having a good time
 

As I expected in my two previous posts[1], the company booked a small “corruption” charge based on the 3% bribes skimmed off a variety of contracts and a large impairment charge.  I thought that the former would be north of R$4 billion and the latter a maximum of R$61 billion.  The final, audited numbers, were R$6.2 billion and R$44.6b billion respectively.

The direct and indirect cost of corruption was probably higher than the R$6.2 billion number because 70% of the impairment was due to massive cost overruns at the Comperj and Abreu e Lima refineries, and it is hard to explain that away by blaming sheer incompetence alone.  But the official version looks better and doesn’t change the company fundamentals[2].

Another decision of the incoming management which I expected was cutting dividends for the time being.

I’m a shooting star leaping through the skies

Like a tiger defying the laws of gravity

I’m a racing car passing by like Lady Godiva

I’m gonna go go go

There’s no stopping me

I also feel comforted in my belief that the choice of a financially savvy top management, rather than a technical one, was the correct choice.  For now and the next few years, the key challenges are financial.  This is clear when one considers the following:

-In 2014 the company generated gross cash flows from operations of US$27 billion yet spent US$35 billion in capex, paid US$6 billion in interest, US$4 billion in dividends, US$10 billion in debt maturities and raised US$31 billion in new financing;

-Last year its gross debts rose to US$132 billion as a result of net new borrowings and the weakening of the real (80% of the debts are denominated in foreign currencies).  Given that the real has devalued another 12% since year-end, the financial pressure has risen even further;

-The company has debt maturities ranging between US$16 billion and US$27 billion in each of the next four years.

I’m burning through the sky yeah!

Two hundred degrees

That’s why they call me Mister Fahrenheit

I’m trav’ling at the speed of light

I wanna make a supersonic man out of you

 Solving these problems will call on the obvious financial skills of management, but also on the cooperation of Petrobras’ controlling shareholder, especially if it is mostly passive.  There is clear progress on those fronts:

-The company was facing a financing gap of US$13 billion this year[3], which has already been filled with a combination of Brazilian and Chinese bank loans;

-2015 capex have been cut from US$35 billion in 2014 to US$29 billion (for now);

-A preliminary divestiture program of around US$14 billion over the 2015-2016 is being implemented;

-Mr. Bendine has stated that he has the approval of his government to sell liquids domestically at price parity with international markets;

-New board members from the private sector are expected to join at the end of this month, among them Mr. Murilo Ferreira the CEO of Vale SA who will become chairman of the board;

-Finally there are talks in Congress in Brasilia to bring more flexibility to the minimum content rules and to drop the requirement that Petrobras take a 30% stake in all new pre-salt projects and operate them.

Don’t stop me now

I’m having such a good time

I’m having a ball

Don’t stop me now

If you wanna have a good time

Just give me a call

But shareholders shouldn’t uncork the champagne and sing “We are the champions” just yet (or perhaps ever).

Right now, Brazil is still reeling from the magnitude of the petrolão scandal, and the combination of popular anger, judicial activism and political rivalries will ensure that corruption will be held in check and government meddling will be scrutinized by the press.  Then what?

A recent opinion poll showed that, while angry with the corruption at Petrobras, a majority of Brazilians is against its privatization; if this sentiment can’t be changed, sooner or later the same lethal combination of corruption and incompetence will return.

Finally, one shouldn’t forget that the oil and gas industry is going through a period of low prices which may last longer than expected and cause operational and financial damage.  Depending on what management is willing and allowed to do, it may find itself in a tight corner again.

Don’t stop me

Don’t stop me

Don’t stop me

Hey hey hey!

Don’t stop me

Don’t stop me

Ooh ooh ooh (I like it)

Have a good time, good time

Don’t stop me

Don’t stop me

Ooh ooh alright

In my post of 1/29/15, I disclosed that I had bought some shares (PBR).  The price was then US$6.40 and I thought that it had the potential to at least double.  Since then, I bought some more and haven’t changed my views.  Its closing price today is US$9.40.

In my post of 2/6/15 I suggested that Petrobras wouldn’t be privatized[4], losing the opportunity to emulate Total of France but also avoiding the ghastly fate of PDVSA.  If I am right, Petrobras is a two to three year trade. If I am wrong and it is privatized ... 

Don’t stop me now (‘cause I’m having a good time)

Don’t stop me now (‘cause I’m having a good time)

I don’t wanna stop at all

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[1]   Of 1/29/15 and 2/6/15.

[2]   Besides, digging deep into the cost overruns would have taken much longer, delaying the publication of the audited financials for no greater benefit to the company.

[3]   Based on the following reasonable assumptions:  US$60/bbl, 2.8mm boe/d production and R$3.10/US$.

[4]   As Vale was for example, where a majority of voting shares is in the hands of private investors.

Brazil: Is Mae West in and Raul Prebisch out?

Although Argentine, the economist Raul Prebisch has had a huge influence on Brazilian economics, and indirectly on its political system.  His essential belief was that less developed countries were in a structurally disadvantaged position vis-à-vis developed ones because of the lower value added of their exports.  The proposed remedy was import substitution and economic integration (don’t import engine blocks from the US or Germany, build up plants locally to manufacture them for regional markets).

This policy choice carried with it an increased role for governments in setting priorities, promoting “national champions”, protecting these from “unfair” foreign competition via loans at subsidized rates and high import duties.  Import substitution failed[1] but bloated bureaucracies and intrusive politicians survived.

Over the years, governments and bureaucrats found themselves at the command of powerful economic levers, capable of making or breaking companies, extending huge loans at well below market rates to a happy few, and calling on favors from these grateful recipients.

The commodity boom of the 2000-2008 period proved a bonanza for Brasil.  It also coincided with the arrival to power of the PT which, more than any party, believed in income redistribution, government intervention and patronage while being wary of foreign investment and the free markets ethos.  So much money! So much power!  So much temptation!   

The results, by now, are not pretty.  The Petrobras scandal revealed widespread corruption, “institutionalized” corruption as one witness characterized it. Corruption has also been uncovered in the electric utilities sector; other sectors are reported to be next.

In fairness, Raul Prebisch is not the only one to blame.  History is another factor when power is concentrated, either at the seat of central government, or in vast countries, in the hands of governors far removed from the capital.  In such systems, there are few checks and balances and temptation is rampant. 

As Mae West once said, “I generally resist temptation, unless I can’t resist it.”  The solution to Brazil’s governance problems is simple, although its implementation won’t be easy: REDUCE TEMPTATION by reducing government role in the economy.  Besides Petrobras, the federal government controls the largest long term lenders as well as key infrastructure sectors.  Via BNDES loans and equity investments, it exerts a huge influence on the largest privately held industries and utilities. 

Perhaps because it is in a tight financial situation, Brazil is initiating some welcome changes.  Finance minister Levy has already announced that BNDES should return to its original mission and stop subsidizing large companies which can easily tap the financial markets.  The board of directors of Petrobras will soon replace political appointees with private sector candidates.  A relaxation of local content legislation seems inevitable[2].  So is the requirement that Petrobras lead all new offshore exploitation projects and own at least 30%.  The PT will likely fight tooth and nails against privatizations (the ultimate solution to reducing temptation) and these may have to wait until a new government is elected.

It will be a tough road.  Indeed, the continuous stream of revelations, the extent to which politicians and prominent companies exchanged bribes, and the sheer magnitude of the money which was wrongfully appropriated may trigger such revulsion that peaceful progress is by no means assured. 

Still, the alternative is economically and politically much worse.  As Mae West also said, “between two evils, I always pick the one I never tried before.”

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[1]  In fairness, Prebisch wasn’t happy with the results either.

[2]   Legislation whereby large construction contracts, particularly in the oil and gas sector, must include 50% to 80% of locally sourced goods and services.

Petrobras v.1.01.1: a estatal lite?

Petrobras has a new CEO, Aldemir Bendine.  It also has five new division heads, including a new CFO, Ivan Monteiro who held the same position at Banco do Brasil.  The state chose the CEO with little regard for minority shareholders, and it chose the division heads with little regard for the CEO.

Market reaction has been negative, and understandably so.  Many had hoped for a name that would galvanize investors and employees alike and offer a new framework for state controlled national champions.  That didn’t happen.  We still have a state company, the question is, will it be the lite version?

In retrospect, the choice of Mr. Bendine shouldn’t have surprised.  After all, the PT and its leader had been dead set against the privatization of Petrobras in 2000, and Dilma Rousseff, while an economist herself, is no Milton Friedman devotee.  She also must worry about the petrolão corruption scandal and want a “friend” at the helm of the company.  Finally, it seems that a number of well known private sector CEOs were not interested in leading Petrobras through a potentially acrimonious restructuring, a global oil crisis, and a huge corruption scandal all at the same time, while having to also defer to government priorities.

On a more positive note, Mr. Bendine does have the experience of managing a very large business organization, Banco do Brasil, which was not the case of some of his  predecessors (Mr. Gabrielli, 2005-2012, was an economist; Mr. Dutra, 2003-2005, was a geologist and politician).  He has experience doing right for his company while dealing with political interference, as Banco do Brasil shareholders fared better under his leadership than those who bought the broad Ibovespa Index.  Finally, it could be argued that Petrobras is facing greater challenges in the financial than in the technical area, and Mr. Bendine knows about finance.

Add to that Mr. Bendine's reported fondness for the rock group Queen, and I think we have  a man with the potential to surprise those who expect bland bureaucratic loyalty.

Now what?  I expect that Mr.  Bendine will soon present his recovery plan.  I expect dividends to be cut, and that fresh capital could be raised if the stock price starts to recover.  But the keys to success lie in the hands of the government: will Petrobras be allowed to operate as a for-profit corporation, pricing its products accordingly, investing within its means, and rewarding its shareholders (more or less) in line with international benchmarks? 

I think that the government has little choice but to oblige as long as Petrobras is in recovery mode which will take a couple of years. 

Investors are also awaiting the release of the audited quarterly and annual financials of Petrobras. There is much discussion as to whether the asset write-down will be $2 billion, $20 billion or more.  Except for its indirect impact on income taxes, the magnitude of the write-down has little impact on the company’s cash flow generation.  Refineries, drilling platforms, pipeline networks won’t be any more or less productive whether their book value is 100, 90 or 70.

As I suggested in a previous post, I suspect that the government policy of imposing very high minimum local content will have resulted in larger write-downs than outright bribery did. Sure, if the corruption component turns out to be very high, it will be bad news for people involved and will result in costly and lengthy litigation for Petrobras.  But I don’t think that it will do much to the next two years’ cash flows.

In conclusion, Petrobras is not going to be privatized, it is not going to turn into a South American Total.  Rather, it may morph into an estatal lite, not too free, not too efficient, not too shareholder friendly, but not a new PDVSA either (although it was on that track until the petrolão blew open).

Investors must focus on what really matters: not the size of the asset write-downs, not even the new management team, but the government policy and actions.  If I am right, Petrobras stock is now priced as if it is the next PDVSA[1].

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[1]  I also assume that global oil prices will return to $70/barrel ± $10 within the next two years.

Petrobras reborn?

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%.

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[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%.