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%.

Ce qui est bon pour la “goose” est bon pour le “gander”

Mafalda[1]

 

Over the last few weeks, a scandal without precedent has been engulfing Brazil.  I am referring to the so called petrolão at the center of which stands Petrobras.

Several years ago, a large vote buying scheme, the so called mensalão, threatened to bring down the Lula government.  But as a top Brazilian jurist noted recently, the mensalão amounted in total to R$170 million (US$65 million) while just one Petrobras executive is being asked to return R$250 million (US$95 million) in skimmed money.

The petrolão not only involved corrupt executives pocketing huge amounts of money but a well organized conspiration aimed at channeling 2% to 3% of the value of large investment contracts to the political parties in power, the PT, PMDB and PP.  Whether all the monies received by these parties were used for political purposes or partly appropriated by individuals remains to be seen. 

This couldn’t have worked without the complicity of the country top engineering and construction firms.  The inquiry into the petrolão soon unveiled the anti-competitive practices of these firms as they colluded to raise the value of contracts and take turns in winning them.

As Petrobras executives and their acolytes were offered reduced sentences for their cooperation, it came to light that the same corrupt practices extended to capital intensive sectors controlled by the state such as electric generation and railways.

Clearly, the most serious issue for Brazil is that its economic model has turned out to be fraught with inefficiencies, waste and corruption.  Since the extent of this scandal is yet to be determined, I will stick to Petrobras.

For many years, Petrobras was the cash cow of the state.  It was not unusual for it to make investments which were not the best use of its capital; it often “deworsifed” in fields where it didn’t have a particular expertise; more than one politician or ex-government official got his pension, or part of it, paid or complemented by Petrobras.

To get it into shape, President F. H. Cardoso partially privatized Petrobras in 2000[2].  He succeeded in the face of huge opposition, particularly from the PT and its leader, Mr. Lula da Silva.  The Cardoso administration even considered changing the company name to Petrobrax to dramatize the hoped for break with the past.

And for several years, it worked.  Thanks to its technical expertise and tighter management, the company made major offshore discoveries and achieved a good level of profitability.  These discoveries were made even more valuable by the global commodity boom.

The prospects of a highly profitable Petrobras, while welcome by minority shareholders didn’t go down well with President Lula; he publicly lamented that so much of Petrobras money was distributed to foreigners in the form of dividends.  Before the end of his second mandate, his government engineered a highly controversial capital increase, the purpose of which being to increase government control over the company.  Ironically, despite the bad press this operation received, the government didn’t succeed in gaining a two thirds majority of the voting common share capital.

Greater control over the company, both at the corporate level and via new offshore oil and gas legislation proved disastrous.  Petrobras was saddled with huge investment obligations which were beyond its financing and management capacities.  As a result, it embarked on a massive debt raising program while consistently missing its production commitments[3].  The new legislation also took away Petrobras’ ability to prioritize its offshore investments, giving that authority to a newly formed government agency.

Over the last years, global liquidity, rock-bottom interest rates and high oil prices let Petrobras borrow huge sums of money, and that pactole attracted the attention of many: as the French humorist Sasha Guitry once said, “I can resist everything except temptation”. The old practice of placing well connected people within the Petrobras hierarchy took a more ominous turn: as top executive positions - division heads – were allocated among the various political parties within the government coalition, it was just a (very) small step to use this connection to siphon money out.

The solution to this catastrophic situation is to privatize Petrobras, the French way.

Manolito may think he can’t speak French, but when it come to economic culture and policy, translating French into Brazilian Portuguese is very easy.

I have always been impressed by how France and Brazil converged in that regard: both countries have a strong centralized government and administration, large public sectors, share a vision of economic dirigisme[4] mixing interference with subsidized financing; finally, both like to nurture national champions.

Now, both know that politics and national oil champions shouldn’t mix. 

For many years, Elf Aquitaine was the French national oil champion, and that brought it rewards, such as the award of foreign oil concessions. In the early 1990s, it was very close to the government and often played an active role in French foreign policy in the Middle East and Africa.  In part, this was due to its history as Elf was born from the merger of two government agencies[5].  By comparison, the second largest oil company, Cie Française des Pétroles (later renamed Total) played second fiddle; Total was also run by a no-nonsense CEO who knew how to keep some distance with the French government. 

In 1994, all hell broke loose, when the press revealed that billions of dollars had been siphoned from Elf and spent on payments to African, European and French politicians as well as executive “perks”.  The story ended badly for Elf.  Its executives were brought to court and jailed, and it was absorbed by Total in 2000. 

Brazilians will immediately see a pattern here.

Mindful of the dangers of letting politicians too close to very rich companies, Total was privatized in a way which could and should apply to Petrobras.  The basic idea was that the company would be run as a major publicly held company by professional managers not state appointees.  To that end, the state would sell its majority stake down.  At the same time, steps would be taken to ensure that it would remain an effective national champion.

The initial step was to assemble a nucleus of stable, long term French institutional investors.  In the case of Petrobras, these institutions exist and include major pension funds, large banks and insurance companies.  They could hold 10% to 15% of the common shares[6].  The government would retain a large minority ownership and the balance of the shares would be allocated to retail and institutions both domestic and foreign.

The second step entails the state selling most of his shares in the company but retaining a golden share to veto such major decisions as change of control, bankruptcy or the sale of entire divisions such as refining, exploration, etc.  Total went public in 1991 with the French government holding a 30% stake.  That stake was gradually reduced to 1% by 1996.

Golden shares were declared illegal by European courts in 2003.  But there is little risk of a similar ruling in Brazil.  Indeed, given Brazilian politics and sensitivities, and the size of the financial commitments, I think that a golden share is necessary to facilitate a true privatization.  

It would be a monumental fight, but given the staggering and pervasive degree of corruption within the company and the threat to democracy that control of Petrobras clearly entails, a real privatization of Petrobras is not only feasible but crucial.

Ask any international oil company, it will tell you that Total is still very much the French national champion, that in large international project tenders, it enjoys the full backing and lobbying of the French administration.  But it is professionally run and Division Heads are not allocated among the Socialist, Green or other political party.

Little translation from French to Portuguese is needed; if the French can do it, so can the Brazilian.

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[1] - Manolito, did you know that my mother was a French translator?  I know French too; I know how to say “Papa” in French.

  - Really? OK, how do you say it?

  - Papa.

  - Ah, that’s easy, it’s the same.

  - Easy? The same?  No way, the trick is to think in French! Try to say “Papa” but thinking it in French! Go ahead! Let’s see? Go ahead!

  - It’s useless! I’ll never be able to speak that damn language.

[2]  However, he couldn’t overcome broad resistance to an effective privatization with the state losing control over the company.

[3]  In fairness, a Lula inspired policy raising local content for heavy  offshore equipment and machinery contributed to Petrobras’ delays and cost overruns.

[4]  Faith in government economic development planning, and generally a “government knows best” belief.

[5]  The Régie Autonome des Pétroles and the Société Nationale des Pétroles d’Aquitaine.

[6]   This percentage is suggested given the huge size of Petrobras and the likelihood that a true privatization would make it much more valuable.