The Country of the Future?

In 1960 the Gross Domestic Product per capita of South Korea was US$158.  By 2016 it had grown to US$27,539.  Over the same period, the numbers for Brazil were US$210 and US$8,650[1]. 

Adjusting for purchasing power parity doesn’t change the picture much. Over the 1990-2017 period, and in constant US dollars of 2011, the results were US$11,633-US$35,938 for South Korea and US$10,345-US$14,103[2] for Brazil.

Discounting the drag caused by its much larger population and looking at overall country GDP data, Brazil still underperformed: over the 1960-2016 period, its GDP grew from US$15.2 billion to US$2.05 trillion (+13,453%) while South Korea’s grew from US$4 billion to US$ 1.53 trillion (+38,576%).

Fast forward to 2018.  Brazil is in the last stages of the biggest corruption scandal of its history, the so-called Lava Jato/Car Wash, which sent a former president and many political leaders from the left, right and center to jail; for the first time in years, active and retired military leaders are raising their voices to warn against further institutional and judicial drift; crime and personal security are foremost among the population’s concerns; and a key presidential election is less than two months away.

What next?  Is the wheel about to turn, and if so, which way?

Two polls reveal the true dimension of the next president’s challenge:

§  92 % of Brazilians believe that the judicial system treats the rich better than the poor, and
§  As recently as August 22, former president Lula, who remains in jail for corruption, led voting preferences with 39%[3].

In September, two events shook the already atypical presidential campaign: 1) former president Lula was ruled ineligible and his party, the PT, named Fernando Haddad as his replacement, and 2) Jair Bolsonaro, the rightwing candidate who was running second to Lula, was the victim of an attempt on his life and will remain hospitalized for several weeks.

Most candidates have a familiarity deficit with the population.  As of September 9, the following table shows that less than 1/3 of the population knew the main candidates “very well” and about half knew them “very well” or “a little”:
 

	Geraldo Alckmin	Jair Bolsonaro	Ciro Gomes	Fernando Haddad	Henrique Meirelles	Marina Silva
Knows very well	30%	29%	25%	17%	13%	27%
Knows a little	29%	23%	29%	21%	19%	32%
TOTAL	59%	52%	54%	38%	32%	59%

Source: Datafolha.

The PT and Fernando Haddad face a challenge: how to make the candidate from Sao Paulo nationally known without having him appear as a mere stand-in for Lula.

The other candidates face another kind of challenge: better known because they have been in politics longer and/or have already ran for the presidency, they also represent the “political establishment” which many voters distrust.

A relatively new comer on the national stage, Bolsonaro is now enjoying a rise in sympathy for having been stabbed, but over the next few weeks his ratings will likely suffer from diminished exposure and his inability to campaign in person.

The absence of a clear leader in the polls also reflects voters’ indecision:  55% of respondents declared themselves set in their choices vs. 80% in 2010 and 2006 and 70% in 2002 and 2014[4]. 

Political cleavages and history make it difficult to imagine the right or the left easily uniting behind one candidate in the second round.  Bolsonaro and his small party, the PSL, haven’t much in common with Alckmin and his traditional center coalition; the PT has historically refused to join any coalition that it didn’t lead, and Ciro Gomes so far has not been welcome. This also leaves Marina Silva, the best presidential candidate from the left in my view, out in the cold.

Can we make the outlook hazier for investors? Sure we can!

There is evidence that voters are ambivalent regarding needed economic reforms.  While Alckmin appears set to privatize many the state-owned enterprises, unions have often gone to court to block past privatizations, congress has been loath to let go of its patronage, and the public appears reluctant to see Petrobras privatized, even after the massive scandal that nearly bankrupted the company.

Apart from the PT, party discipline is weak in Brazil, making governing difficult and reforming very difficult.  This is unlikely to change this time around.  Even if Haddad wins, there will inevitably be tensions between him and Lula and their respective followers as the new leader seeks to establish himself[5].

More importantly, the diverging economic paths followed by Brazil and South Korea over the last 50 years reflect profound differences in history and culture.  These two factors are powerful and resilient, and not limited to these two countries.  For a while, leaders can overcome them, as FH Cardoso did in Brazil or Kemal Ataturk did in Turkey, but the forces to undo or blunt deep reforms are strong, ever present, and in the end often overwhelming.

The operating horizon for traders and even most investors in emerging countries is short; in Brazil, not everything is negative.

For example, the Lava Jato scandal is fresh in every memory and one can expect governments and politicians to be more careful with public assets for the foreseeable future.

Most candidates must realize that they lack broad popular support and that further dividing the population once in office would be a national disaster and politically risky.  With Lula absent from the ballots and Bolsonero in the hospital, it is close to 60% of the voters’ first choices which are gone or in jeopardy.

The presidential elections will be decided by October 28 at the latest.  While the race is wide open, it wouldn’t surprise me if Fernando Haddad, with the well-organized support of the PT and of Lula himself, were to reach the second round and face Jair Bolsonaro.  If he failed, it could be because Ciro Gomes rallied more of traditional voters from the Left.

In a second round, the outcome of a Bolsonaro/Haddad or Bolsonaro/Gomes race is a toss-up at this stage.

These are two among several scenarios, though unless the campaign dynamics change appreciably, they are the most likely for me. 

Brazilian stocks are not off-limit in the absolute, but either current prices fall further to reflect the inherent risks of this election or any buying decision should be delayed until after the second round is over, in my view.

The future always appears unclear, but the past is not and is as good a guide of things to come as any.  Days of Future Passed as the Moody Blues would say.     

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[1]  Source: World Bank, Trading Economics.

[2]  Source: World bank

[3]  Source: Datafolha.

[4]  Source: Datafolha.

[5]  A good example of unhelpful tensions between a former president and his anointed successor was on display in Colombia between Alvaro Uribe and Juan Manuel Santos.

Southern Winds

Finance Minister Levy is leaving his post by year end.  If so, he will have lasted just one year.

Almost a year ago, soon after his nomination, I wrote[1] that while he was highly qualified for the job and would “find some initial freedom of action… [which] could last a couple of years..,[his] remedies and policies.. are the exact opposite of what the PT wants and what President Rousseff has supported in the past. I also wrote that Brazil needed to make profound reforms which “are political in nature and go far beyond the competency of the Minister of Finance”.
 

My misgivings were proven valid even sooner than I expected.  Minister Levy didn’t receive the political backing from his president nor from the PT in congress.  As a result, he could only raise some taxes but couldn’t significantly cut public spending.  The last straw was the government refusal to hold the line at 0.7% for the 2016 primary budget surplus.

 

Nelson Barbosa, currently Planning Minister and a traditional proponent of active government intervention in the economy, will replace him.  He will get along better with President Rousseff but I don’t think that it will mean better decision-making.

Ravaged by corruption scandals, economic recession and depressed commodity prices, the future looks bleak for Brazil.  The political opposition is by and large clean (perhaps because it didn’t have access to the levers of power) but weak and lacking grassroots organization.

Further south, the winds are beginning to blow in another direction.  Mauricio Macri was elected president of Argentina and wasted no time in liberalizing the foreign exchange regime via a dirty float system.  He also cut taxes on the main grain exports which got him the exporters’ agreement to bring back, daily, some $400 million of grain export proceeds.  Finally, Finance Ministry’s and the Central Bank’s teams look very good.

I have no doubt that the Argentine recovery will be rocky at times: undoing several years of ill-advised policies takes time and is politically difficult; the opposition is well organized and deeply resentful of its loss; finally, the world economies are still weak.

But Macri has a number of factors in his favor, besides having adopted good policies and chosen good people:  Argentina is smaller than Brazil, with a population of 44 million vs. 206 million; its population is better educated and economically less unequal; last but not least, he was clear in his campaign as to what his policies would be and voters, in their majority, backed him.

In Venezuela, the heirs to Hugo Chavez have suffered a heavy defeat in the latest congressional elections.  Clearly, the population is unhappy with the abysmal performance of the economy.  External pressure is also mounting for the regime to respect human rights.  More than anywhere else in the region, low commodity prices are shaking political and economic foundations.

Elsewhere in South America, commodity prices are forcing government to revise their policies, although with distinct flavors.

 

The education, social and political reforms which the Bachelet government wanted to carry out have faced fiscal realities: the money is not there; the haste with which they were introduced met a pushback from both moderate politicians and a population facing other priorities.

In Colombia, where oil accounts for half of exports, the government is scrambling to raise tax revenues, ease oil and gas permitting, hold inflation in check with a more aggressive monetary policy and, at last, intervention in the foreign exchange market.  The wild card is the peace process with the FARC: the rebels are increasingly isolated as their foreign backers are short of funds (Venezuela) or considering a change in strategy (Cuba).

In conclusion, the implosion of the hard commodity markets has wrecked havoc in South America.  Populist policies have run out of money and change is forced upon these countries.  The choice is between liberalization, repression and chaos.

Argentina has chosen liberalization, Venezuela has chosen repression, Brazil is heading towards chaos.  Chile and Colombia are so far sticking to a middle of the road regime of open economies and politics.  If the prices for oil, copper and iron ore weaken further in 2016, the pressure will rise further on governments to “do something”.  The more unpopular they are, the harder it will be for them to heed to moderation and rationality.

Optimists will say that a cycle of populism in ending in South America, and that the example of Argentina will favorably influence its large neighbor to the north, Brazil; that Chileans and Colombians are unlikely to turn their backs on two decades of social and economic progress; that Chavismo has lost the legitimacy, credibility and financial means to rule as it wishes.

Pessimists will argue that economic and political liberalism is a foreign concept in South America and that voters not so much want that as an interventionist government largely financed by buoyant commodity prices.

Let me be a guarded optimist.  I do believe that most people aspire to a better life for their families and themselves, greater freedom and pride in their country.  In Latin America, they will also have realized that much of the government bonanza of past years was due to external factors (China’s appetite), not bureaucratic excellence; they have also seen the true cost of government largesse.  For all the above, I think that a new cycle is starting, first in Argentina. 

2016 promises to be interesting.

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[1]  12/7/14 Brazil’s uncertain future post.

Iguacu Falls, (Part Two) - an exercise in fiction

In Salvador, an early morning thunderstorm washed away torn paper posters, empty soda bottles, as well as an odd assortment of abandoned sneakers, broken wood sticks and debris of the violent confrontations from the previous day. Now and then, an armored police van could be seen speeding silently down empty avenues, lights flashing.

This scene was repeated, with minor variations, in many large cities.  But in the heart of Brazil’s manufacturing, the so called ABC Region outside the city of São Paulo, TV crews were beaming back scenes reminiscent of Apocalypse Now: an acrid haze from still burning tires floated in the streets; blackened wrecks of police cars and buses haphazardly dotted the urban landscape; rows of shops with broken windows and gaping doors added to the vision of destruction and irreality.

TV viewers were served non-stop images of violence from the day before, of interviews with victims and of seemingly deserted cities.  Shocked by the extent of the destruction, many businesses had not opened and, by and large, people had decided to stay home.

Despite the endless televised group discussions and opinionated pundits, viewers were still struggling to make sense of what they had seen: massive crowds surging between concrete city blocks like the sea at high tide, companies of red shirted militias, some on foot others riding motorcycles, giving chase to straggling demonstrators.  But two videos held viewers in their seats: one of a policeman, his clothes set on fire, slowly crumbling to the ground in a silent scream, the other of a police squad, beating two men senseless with their clubs, long after these had stopped moving.  Had the police put their lives on the line in defending the safety of the citizenry or had they behaved like thugs?

The government seemed just as shocked and dumbfounded as the public.  The presidential office had released no communique so far, while the Interior Ministry had condemned the violence and declared a state of emergency.

The main opposition party had been divided as to how to react.  But on September 23rd, the leaders of the PSDB came out with a unified message that President Dilma  Rousseff should resign or be impeached, recalling the words of former PMDB icon, Ulysses Guimaraes, back in 1992 when then President Collor was himself under threat of impeachment for corruption:” He thinks he still he is president, but he no longer is”.

Attuned as ever to where power was shifting, and conscious of its own weakened position as a result of the indictment of several of its most prominent members, the PMDB issued a communique calling for “ the voice of the people to be heard, and for politicians to respect it”.

Fearing an imminent vote of impeachment, the PT and its allies called for “an immediate popular show of support in favor of democracy and against the rabid forces of oppression”.

Soon, thousands of armed milicias petistas and sympathizers took to the streets in Brasilia, encircling the seat of government, the Planalto , as well as the Brazilian Nacional Congress, ostensibly to protect both.  When Vagner Freitas and a handful of CUT followers stormed the news set of TV Brasilia to denounce a presumed coup, the temperature rose by several degrees.

In Goianias, São Paulo, Rio, Salvador, and elsewhere, supporters of the government in place occupied or blocked access to strategic centers of power or industry.  Having been widely criticized for the use of excessive force, federal and local police forces stood by.

The 23rd came and went.  On the 24th, public employees unions called for a general strike.  They were soon followed by those of Petrobras, Banco do Brazil, as well as those of the likes of CSN, Usiminas, GM, Ford and Fiat.

On the 25th, air traffic controllers joined the movement.  The country had ground to a halt.  The PT had effectively broken into several factions, the more extreme being the more vocal, the PMDB was not sure whether to make effective its dominance of the governing coalition, and the opposition was, as usual, divided and not ready to govern.

Brazil slowly drifted into chaos, as basic services were no longer provided, private industry was on strike, the supply chains of commerce were no longer functioning, and the streets were no longer safe.  Change needed to come, and it did on the 26th.

Iguacu Falls, (Part One) – an exercise in fiction

It had been a hot summer, in more ways than one.  China had made the biggest headlines; its vital economic signs, as could be inferred from its periodic statistical releases, were worse than most pundits had expected; in private, many wondered whether 2015 GDP growth could be flat or even negative rather than settling around the +6.9% or so trumpeted in public..

The dizzying gyrations of the Shanghai stock market, the increasingly erratic government interventions, and finally industrial catastrophes like the explosion at the Tianjin port frayed nerves around the world.

A still slow growing U.S., a convalescent Europe and a teetering China were wrecking havoc for many commodity dependent countries.  Low oil prices had hit Colombia hard, but Brazil had fared worse.

The country of the future and likely to remain so, as skeptics had dubbed it, Brazil had hugely benefitted from the commodity boom which started in 2003.  Indeed, it had been able to finance a generous social program and ambitious oil and gas related investments without difficulties and without needing to correct glaring structural economic weaknesses.

The discovery of huge offshore oil and gas reserves had triggered a renationalization of sort at Petrobras, had encouraged the federal government to intervene more than ever into various sectors of the economy, and as was to be discovered later, had given birth to institutionalized corruption on a scale never seen before.

The Great Recession of 2008, the profound change in investor sentiment and the uncovering of the Petrobras corruption scandal gave birth to the biggest crisis that Brazil had experienced in three decades.  Petrobras, weighed down by huge debts contracted to carry out the government’s pre-sal ambitions, came close to debt restructuring; the international financial markets effectively closed to Brazilian borrowers; the abrupt economic slowdown cut federal tax revenues while public spending was only slightly reined in, leaving the country with a flat to negative budget primary balance.

But most of all, the petrolao scandal tore apart the political system, leaving Brazil with either a weak presidential or parliamentary regime, depending whom you talked to.

During her reelection campaign, President Rousseff and the Workers Party (PT), had scoffed at the necessity of budgetary cuts; likewise, by delaying cash outlays and having Congress amend the budgetary Law, the government had avoided more immediate trouble.

Now, President Rousseff had to backtrack on her promises, which proved difficult as her own party strenuously opposed spending cuts and the population was ill prepared to accept them anyway.

Against this ominous background of incipient economic, institutional and financial crisis, the government blindingly stuck to its authoritarian ways in nominating a new president of the House.  This backfired badly, and its political ally, the PMDB, managed to elect one of its own, Eduardo Cunha, to the job.  With PMDB member Renan Calheiros already holding the presidency of the Senate, the government had dealt itself an incapacitating blow.

The PMDB quickly made it known that it no longer was a junior partner of the PT, and Eduardo Cunha made it known that the Legislative Branch had responsibilities and powers equal to the Executive’s.  Bewildered, frustrated, the PT dragged its feet when called upon to vote for painful measures, leaving President Rousseff in a weakened position to negotiate the support of the PMDB.  The politics of Brazil became very complicated, with a weakened Executive, a powerful Legislative with no mandate to govern, and a divided, ineffective, opposition.

Yet matters were getting much worse.  Continuing revelations by the investigating magistrates, leaks and plea bargaining by a slew of suspects further destabilized the various branches of government.   The presidents of both the House and the Senate were formally investigated for corruption, along with a number of senators, congressmen and former governors from the parties that had formed the governing coalition, namely the PT, PP and PMDB.

Fighting for his political life, Eduardo Cunha opened his own House inquiry into suspected malversations at the National Bank of Economic and Social Development  (BNDES), as a means of pressuring the government into letting him off the hook.  The Executive and the Legislative were now at loggers head, despite being led by the same political coalition.

As September came, further revelations of mishandling of funds surfaced: billions lent by BNDES to Cuba, Venezuela and others in support of the same engineering and construction companies that were already suspected of corruption, and with similar results: overbilling and (credit) losses in the billions.  Worse, former President Lula, the highest profile politician in Brazil and  the PT leader, was formally indicted of influence peddling.

His response was immediate and virulent: on September 17, in Sao Bernardo do Campo, flanked by thousands of PT and United Workers’ Central (CUT) members waving red flags and giant portraits of him, former President Lula denounced the hidden agenda of the opposition, ridiculed PSDB leader Aecio Neves’ “pathetic attempt to clear his way to the next presidential elections”, and threatened that any attempt to put him under preventive custody would be “opposed by the Brazilian people”.

Standing to his right, Wagner Freitas, president of the CUT, remained impassive. Yet all of the members of the press in attendance remembered his fiery declarations, a month before, when talks of impeaching President Rousseff were growing:

-“ what is coming to Brazil today is intolerance…. We are the defenders of a national project to bring better conditions to all, and this means, right now, getting down in the street, and digging in, weapon in hand, in case they want to overthrow President Rousseff.  Any attempt against democracy, the lady [Dilma Rousseff] or President Lula, we will be the army that will confront those bourgeois in the street.”

Like the mythical straw that broke the camel’s back, the indictment of President Lula, after the long string of revelations at Petrobras, Eletrobras and most recently at the Federal Railway System, struck a raw nerve in the population.

Brazilians were already suffering from high inflation, negative growth and accelerating layoffs most visibly in the automotive, oil and gas and related sectors. Yet while they were facing hard times, midlevel managers and politicians admitted to having stolen tens of millions of dollars.

There were no institutions to believe in anymore.  Even the Judicial Branch, which had gamely exposed the misdeeds, was resented for ruining the national mood, and the common man still doubted very much that the miscreants would spend significant time in jail anyway.

A huge wave of popular anger and despair spread throughout the country.  Just like in March, calls for a nation-wide day of protest rose spontaneously.  On September 20th, a huge protest march was to assemble in Brasilia to “throw the bums out”, and a massive sit-in was to start in front of the Planalto until the President resigned.  Another demonstration would gather in front of President Lula’s residence any many more would spring up around the country.

Meanwhile, both the PT and the CUT decided to organize counter-demonstrations against what they viewed as politically orchestrated efforts to unseat the President.  Some on the fringes of these organizations were eager to “retake the streets” and viewed the Venezuelan, motorcycle mounted, milicias bolivarianas, as a worthy model; after all, these had succeeded in dispersing and discouraging popular demonstrations.  There had been casualties among the population but no militia has been prosecuted.

The PSDB was ambivalent about the marches.  Neves and his associates viewed them as genuinely popular, and a wave to surf on politically, especially since their party didn't have the kind of structure and manpower the PT had.  But they also realized that this limited manpower wouldn't allow them to control mass demonstrations should they get out of control.  If that happened, the PSDB would be held responsible.

In the end, Neves publicly supported the forthcoming demonstrations and marches but advised PSDB members to attend individually and not in representation of the party.

September 20th was hot, especially in Brasilia when temperatures rose to 98F at midday.  According to police estimates, over 8 million people descended in the streets nationwide.  Some 50,000 police personnel were deployed to contain any violence.  Unfortunately, by the end of the day, confrontations between opposing movements had degenerated into deadly violence.  Accounts vary as to who started, but in the end, the excesses of a few thousands triggered massive and often uncontrolled popular reactions.  Police attempts at mob control often became desperate efforts to save their own lives, and live ammunition was used.

In all, there were 120 deaths and some 2,000 casualties that day.  Brasilia declared a national state of emergency and a 9pm curfew.  September 21st came, and with it, a new future.

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.