Brazil: Petrobras on the right track, and investors think so too
Recent comment in the mainstream and financial media on Petrobras’ level of indebtedness, the unprofitability of its refining and marketing business in Brazil, the technical difficulties of extracting oil and gas from the pre-salt basins and various legal problems miss the point. The company performed well during H114 and is on track towards achieving its planned doubling of production to 4.2m barrels of oil per day (bpd). As production from the pre-salt basins is increased, the company’s cash flows should improve.
It is easy to find evidence of the challenges facing Petróleo Brasileiro SA (Petrobras), Brazil’s listed (but predominantly state-owned) gigantic oil company. In late July, the ratings agency Moody’s Investors Service suggested that the company’s credit metrics would deteriorate until 2016, after which time, higher production should boost cash flow. Moody’s highlighted how the increase in production will depend on greater output from the massive pre-salt basins off the south-eastern coast Brazil: the oil is at extremely great depths and is difficult and expensive to extract. Financial journalists have long focused on government policies preventing Petrobras from lifting the prices of (significantly imported) diesel and gasoline to bring them in line with international prices. The result is that Petrobras’ very substantial refining and marketing (R&M) business segment is unprofitable. Ahead of the October 2014 general election, a congressional inquiry has been examining Petrobras’s purchase – apparently at a grossly inflated price – of a refinery in Pasadena, Texas, in 2006 when President Dilma Rousseff, who is seeking re-election in October, was chair of the Petrobras board. There have also been allegations of corruption in relation to the construction of the Abreu e Lima refinery in Northeastern Brazil. Earlier this year, Paulo Roberto Costa, a senior Petrobras executive, was arrested as a result of a major police investigation into money laundering. Without prejudice to the various allegations and police investigations, it is the case that corruption allegations (and congressional investigations) involving Petrobras have become par for the course in general election years in Brazil, when the opposition is on the attack.
However, the share price of Petrobras tells another story. The price of the approved depository receipts (ADRs) that are listed on the New York Stock Exchange (NYSE) reached an all-time high of a little over US$70. In the wake of the global financial crisis, the ADR price slipped from around US$40 in early 2010 to a nadir of about US$11 in March 2014. Since then, the price has recovered to US$18. As we explain below, Petrobras and its management have been performing well through H114. The results for the first six months of the year were published on 8 August 2014.
As chart 1 shows, the company’s cash holdings (including small positions in government bonds) slipped from US$32.8bn at the end of June 2013 to US$30.1bn at the end of 2013. However, the cash position had slipped to US$19.75bn at the beginning of 2014. Cash generated from operations amounted to US$10.5bn in H114, and the company’s net raisings from global bond markets (i.e. proceeds from issues of new bonds less payments for maturing bonds) amounted to US$19.6bn. This amount included the US$5.1bn that Petrobras raised from European investors and the US$8.5bn raised in North America early in 2014. Petrobras also generated US$1.1bn from divestments. Cash from these sources amounted to US$31.1bn. The cash was applied to capital expenditure (US$17.2bn) and dividends (US$3.9bn). As is indicated by Moody’s, Petrobras still needs to raise money from bond investors, and particularly those that are based outside Brazil.
| Chart 1: Cash Flows - Summary (US$mn) | ||
| H113 | H114 | |
| Adjusted cash at beginning of period [1] | 23,732 | 19,746 |
| Cash generated from operations | 15,281 | 10,394 |
| Capital expenditure [4] | -20,418 | -17,185 |
| Divestments [5] | 1,542 | 451 |
| Change in investable securities | -96 | 604 |
| Net cash flow | -3,691 | -5,736 |
| Proceeds from long-term financing [2] | 29,672 | 27,341 |
| Repayments | -13,993 | -7,699 |
| Dividends paid | -1,386 | -3,916 |
| Other [3] | -1,494 | -394 |
| Adjusted cash at end of period [1] | 32,840 | 30,130 |
| 1. Includes holdings of government bonds | ||
| 2. Includes US$5.1bn raised in Europe in January 2014 and US$8.5bn raised in North America in March 2014 | ||
| 3. Mainly impact of exchange rate changes on cash and cash equivalents | ||
| 4. Capex was down for both E&P and R&M relative to H113. | ||
| 5. Divestments were boosted in H113 by sale of African assets | ||
| Source: Petrobras | ||
And the absolute amount owed by the company to bond investors continues to grow. As chart 2 shows, total debt rose from US$114.2bn at the end of 2013 to US$139.7bn at the end of June. The latter number is inflated by the general softness of the Brazilian Real through the first half of this year.
| Chart 2: Petrobras Debt Summary (US$mn) | |||
| Maturity | 31-Dec-13 | 30-Jun-14 | Change |
| 2014 | 8,001 | 7,671 | -330 |
| 2015 | 7,266 | 6,767 | -499 |
| 2016 | 12,692 | 13,162 | 470 |
| 2017 | 8,679 | 12,314 | 3,635 |
| 2018 | 16,051 | 18,673 | 2,622 |
| 2019 or later | 61,547 | 81,025 | 19,478 |
| Total | 114,236 | 139,612 | 25,376 |
| NB US$68,112mn of the debt is floating rate BRL and US$ denominated debt amount to US$28,143mn and US$96,340mn respectively. | |||
| Source: Petrobras | |||
However, other data published by Petrobras in its half-year report identifies a number of positive trends. As noted above, the company’s paper is seen as an attractive opportunity by global investors: indeed, the vast majority of the debt is denominated in foreign currencies. Over the course of the first six months of the year, Petrobras extended the maturity profile of its debt. The percentage that matures in 2019 or later has increased to 58%. Floating rate securities account for just under half of the outstanding debt. Petrobras should gain a partial benefit from a fall in bond yields over the long term: conversely, it is not fully exposed to a rise in bond yields.
The slippage in capital expenditure from US$21.67bn in H113 to US$18.1bn (i.e. including the cash payment of US$17.2bn plus an increase in amounts payable to suppliers of US$905m) may seem anomalous for a company that is committed to roughly doubling its production from the current level of just over 2.0m bpd to 4.2m bpd in 2020. However, almost all of the reduction is accounted for by a drop in capital expenditure in Petrobras’ currently unprofitable R&M business segment and in its operations outside Brazil. The details are shown in chart 3.
| Chart 3: Capital Expenditure Summary (US$mn) | ||
| H113 | H114 | |
| Exploration & Production | 11,809 | 11,739 |
| Refining & Marketing [1] | 7,106 | 4,128 |
| Gas & Power | 1,189 | 1,132 |
| All Others [2] | 1,561 | 1,091 |
| Total | 21,665 | 18,090 |
| 1. Including transportation | ||
| 2. Drop is mainly due to 47% fall in capex outside Brazil to US$554mn | ||
| Source: Petrobras | ||
Net income slipped from US$6.7bn in H113 to US$4.8bn in H114. This was partly due to the softness of revenues in US$ terms, although they were higher by 12% relative to the earlier period in Real terms. Costs of sales were US$1.22bn higher than they had been in H113, thanks in part to the impact of the slippage in the currency on the costs of imports. Much of the deterioration in profitability was taken by the R&M business segment, which posted an operating loss of US$5.8bn – in part because of the official requirement that it sell imported gasoline and diesel at a loss: the government’s cap on retail prices is a measure to protect household budgets from some of the ravages of inflation. However, Petrobras is a vertically integrated operation, and most of its other business segments are profitable. The profits from outside Brazil slipped from US$1.67bn in H113 to US$485m in H114: this was the result of Petrobras having sold foreign assets since the earlier period. Crucially, the exploration and production (E&P) segment, which plays a central role in the company’s planned expansion, lifted its operating profit from US$14.2bn in H113 to US$14.25bn in H114. The details are shown in chart 4.
| Chart 4: Income Statement (US$mn) | ||
| H113 | H114 | |
| Sales revenues [1,2] | 71,914 | 71,404 |
| Cost of sales [3] | -53,428 | -54,647 |
| Gross profits | 18,486 | 16,757 |
| Selling expenses | -2,383 | -2,397 |
| General/admin. Expenses | -2,489 | -2,240 |
| Exploration | -1,225 | -1,454 |
| R&D | -624 | -520 |
| Other taxes | -232 | -278 |
| Other operating costs [4] | -911 | -2,696 |
| Operating profit [5,6] | 10,622 | 7,172 |
| Net finance expense | -1,019 | -495 |
| Profits from associates | 266 | 343 |
| Profit-sharing | -321 | -282 |
| Net income before income tax | 9,548 | 6,738 |
| Income taxes | -2,879 | -1,963 |
| Net income | 6,669 | 4,775 |
| Minority interests | 181 | -270 |
| Profits attributable to shareholders | 6,850 | 4,505 |
| 1. Total sales volumes in H114 were 3% higher, overall. | ||
| 2. Sales revenues were up 12% in BRL terms. | ||
| 3. Cost of sales was 15% higher in BRL terms in part because of higher import costs. | ||
| 4. H114 boosted by Voluntary Separation Incentive Plan (US$1,005mn), higher write offs of dry wells (US$512mn), and areas returned to the ANP (US$222mn). | ||
| 5. The contribution of the various Business Segments are: | ||
| E&P | 14,231 | 14,255 |
| R&M | -5,009 | -5,793 |
| Gas & Power | 998 | 627 |
| Biofuel | -72 | -60 |
| Distribution | 888 | 652 |
| International | 1,665 | 485 |
| Corporate/Other | -2,079 | -2,994 |
| 10,622 | 7,172 | |
| 6. Savings in relation to operating costs under the PROCOP program were US$2.1bn, or 39% more than expected in H114. | ||
| Source: Petrobras | ||
As is the case with the company’s discussion of its debt profile, Petrobras’s explanation for the rise of expenses is a source of encouragement about the general direction that the company is headed. Other operating costs soared from US$911m in H113 to US$2.7bn in H114. However, the latest figure included US$1.0bn arising from the Voluntary Separation Incentive Plan – a scheme to pare headcount in an orderly way (and one that focuses mainly on older workers). In H114 there were also higher write-offs of dry wells (US$512m) and areas returned to the Agência Nacional do Petróleo, Gás Natural e Biocombustíveis (ANP), the government agency that regulates the energy industry. These are essentially one-off costs. Petrobras noted that cost savings under its long-term program to boost efficiency amounted to US$2.1bn in H114 achieved, or 39% more than expected. In short, the decline in profits could have been a lot worse.
The US$4.78bn in net income that was achieved in H114 needs to be considered in the context of total equity, which rose from US$149.1bn at the end of December 2013 to US$164.5n at the end of June this year. The firm’s return on equity in the first six months of this year was around 6%, having been 10% in the previous corresponding period. We would assess that the slippage in profitability is only temporary. Given the payment of the dividend to shareholders, that appears to be the view of the Petrobras management as well.
Meanwhile, the company’s balance sheet remains reasonably strong. As chart 5 shows, total debt of US$139.7bnn is less than equity (including shareholders’ funds, retained earnings etc.). Total assets rose during the first six months of the year from US$321.4bn to US$363.4bn. Current assets have risen by US$12.85bn to US$65.5bnn, while current liabilities have slipped by US$1.06bn to US$32.16bn. The growth in trade receivables and inventories over H114 appear reasonable for a company that is lifting its output.
| Chart 5: Balance Sheet (US$bn) | ||
| 31-Dec-13 | 30-Jun-14 | |
| Cash | 15,868 | 26,397 |
| Marketable Securities | 3,885 | 3,739 |
| Trade receivables | 9,670 | 10,630 |
| Inventories | 14,225 | 16,984 |
| Other current assets | 9,007 | 7,752 |
| Investments | 6,666 | 7,114 |
| Property, plant & equipment | 227,901 | 253,955 |
| Intangibles | 15,419 | 16,326 |
| Other non-current assets | 18,782 | 20,495 |
| Total Assets | 321,423 | 363,392 |
| Trade payables | 11,919 | 12,509 |
| Current debt | 8,017 | 10,685 |
| Taxes payable | 4,950 | 5,020 |
| Other current liabilities | 10,340 | 5,953 |
| Non-current debt | 106,308 | 129,025 |
| Deferred taxes | 9,906 | 12,737 |
| Pension/medical benefits | 11,757 | 13,105 |
| Other non-current liabilities | 9,103 | 9,889 |
| Total liabilities | 172,300 | 198,923 |
| Equity | 149,123 | 164,469 |
| Total Equity and Liabilities | 321,423 | 363,392 |
| Memo Items: |
||
| Retained earnings etc. | 41,156 | 56,389 |
| Total debt | 114,325 | 139,710 |
| Current assets | 52,655 | 65,502 |
| Current liabilities | 35,226 | 34,167 |
| Source: Petrobras | ||
In summary, both equity and bond investors believe that Petrobras is on track to develop its massive pre-salt reserves so that the increase in production of oil and gas easily compensates for declines at its longer-established projects. We agree. Production from the pre-salt basins now amounts to 0.5m bpd, which is three times the level of 2012 and one quarter of the current total. Cashflow in the short term should be boosted by further divestments of non-core assets: press reports in late July indicated that Petrobras was close to selling its (remaining) 40% stake in gas distributor Gasmig to a partnership comprising the Minas Gerais power utility Cemig and Spain’s Gas Natural Fenosa. Profits in the coming six months should benefit from further progress with the management’s programme to boost productivity and to cut costs. In her comments to shareholders about the H114 result, Chief Executive Officer Maria das Graças Silva Foster noted that the company “remains committed to adjusting Brazilian prices for oil products with those in the international market in order to achieve the Net Debt/EBITDA and leverage targets within the limits and deadlines” set by the Board in late 2013. It is possible that Petrobras will have greater scope to set retail prices for gasoline and diesel after the forthcoming general election.
- Shares up, Silva up
Petrobras shares in New York hit a 52-week high of US$19.32 on 27 August after the company announced it had found more gas and light oil at its second extension well. The ultra-deepwater well, 3-BRSA-1244-SES/3-SES-182, or Moita Bonita-3, is located in the Sergipe-Alagoas Basin, 82kms off the coast of Sergipe. Meanwhile in Brazil, the company's share price rose 4.6% to R$22.8 as polls put Marina Silva ahead of Dilma Rousseff in the presidential race. Silva has promised fiscal reform and less intervention in state companies.
- What could go wrong for Petrobras?
The planned growth of Petrobras is based on the assumption that the profits and cashflow from its massive pre-salt reserves of oil and gas are sufficient to offset the impact of declining output from its long-established fields. An obvious question is: what are the main risks to this optimistic view?
In his presentation of the Petrobras second quarter results, Almir Guilherme Barbassa, the company’s chief financial officer, noted that the lifting costs for the pre-salt oil is US$9 per barrel – although this figure should fall as production volumes grow. Excluding the cost of the infrastructure, production from the pre-salt reserves should be profitable provided that the price of oil remains above US$45 per barrel. Including additional facilities to evacuate gas, that figure rises to around US$50 per barrel.
The US Energy Information Administration (EIA) released its latest Short-Term Energy Outlook (STEO) on 12 August. The EIA expects that, globally, supply of and demand for oil will remain broadly balanced. It envisages surplus oil production capacity of 2.1m bpd on average in 2014 and 2.7m bpd in 2015. The EIA noted that unplanned disruptions to supply remained at a high level of about 3.2m bpd in July, of which Libya accounted for one third.
The EIA noted that the North Sea Brent crude price slipped by around US$5/barrel (/b) in July to US$107/b. July was the 13th consecutive month in which the price of North Sea Brent crude remained in a fairly narrow band of US$107-US$112/b. The EIA estimates that the average crude oil price, by this yardstick, should be US$108/b in 2014 overall, and US$105/b through 2015. The EIA anticipates that the West Texas Intermediate (WTI) crude oil price in the US will be US$7/b lower than the North Sea Brent crude price through the second half of 2014, and US$9/blower in 2015.
In short, Petrobras’ pre-salt oil can be extracted at a cash profit unless a crisis in the global economy (for instance, as a result of dislocations within China’s financial system) causes oil prices to fall by more than one half. Of course, if the global price of crude oil were to fall to, say US$60 per barrel, the impact on Petrobras’ return on equity would be adverse.
If problems in China’s financial system represent one wildcard (albeit an indirect and geographically remote one), another wildcard is much closer. This is the possibility that supply of oil and gas (and other products) in Southern South America increases greatly as a result of the development of the shale deposits at Argentina’s Vaca Muerta formation. Obviously, this could have an impact on prices across the sub-region.
For now, we would suggest that the unknowns associated with the development of Vaca Muerta are considerable. One is the likely output. Press reports indicate that the second phase of the project, which began in April 2014 and may require total investments of US$16bn by YPF and Chevron, will result in production of 50,000 bpd of oil and 3.0m cubic metres per day of gas. With output from Petrobras pre-salt reserves rising to a new record of 546,000 bpd on 13 July, we would conclude that the Brazilian company will remain the pre-eminent supplier in the region.
A separate question is: to what extent will the oil and gas produced from the Vaca Muerta formation actually reach customers outside Argentina? There are early indications that it will be sold mainly to producers of petrochemicals and other products within the country: in essence, the various protagonists see import substitution as a major objective of the development of shale oil and gas in Argentina.
The bottom line is that a precipitous slide in the market price of the oil and gas extracted by Petrobras from the pre-salt reserves is a possibility, but not a probability. Given the performance of the company’s share price in 2014, and investment appetite for the bonds that Petrobras has issued, we would conclude that many other observers are sanguine about the company’s plans. We are confident that the development of Vaca Muerta will not pose problems for the Brazilian company.
- WTI discount to Brent widens
WTI for October delivery closed at US$93.4/b on the New York Mercantile Exchange on 26 August, the lowest close since 14 January last. Meanwhile Brent crude for October delivery was trading at US$102.65/b on the ICE Futures Europe exchange in London. Spreads between WTI and Brent are widening on expectations of falling fuel prices in the US, thanks to its growing shale supplies. US production hit 8.5m bpd in July, the most since April 1987, according to the EIA’s 12 August monthly Short-Term Energy Outlook.