Petrobras: A tale of two halves

Pre-salt finds in Brazil offer a once-in-a-century opportunity for the country to boost its coffers and tackle pressing social problems. If balanced with interests from other stakeholders, the oil will indeed be transformational. However, the mere thought of the money is already proving tempting for politicians, who risk smothering the golden goose with bickering and heavy-handed intervention. Brazil is sitting on some of the most promising oil discoveries in the world and the government is determined its national champion, Petrobras, should benefit. However, cack-handed interventions in fund raising and technical uncertainties are beginning to undermine investor enthusiasm for the stock in the short term.

”The petrol is ours!” The rallying cry of Brazilian nationalists when petrol was first pumped from offshore fields in the 1950s still echoes in Brazil. Only now it has been appropriated by a new generation eager to stake a claim to the country’s fast-growing proven reserves. So far, the country’s oil reserves are concentrated in three areas: Tupi, in the Santos Basin, and nearby Iara and Guara. Together, they contain between 9.1bn and 14bn barrels of oil equivalent, according to official estimates from Petrobras.

That could be just the start. Early in the process, the managing director of the National Agency of Petroleum (ANP), Haroldo Lima, announced that there could be as much as 33bn barrels-worth of oil still unexploited, and was quickly slapped down by Petrobras. More recently, Márcio Rocha Mello, president of the Brazilian Association of Petroleum Geologists, went much further. He estimates there may be much more in the pre-salt layer and has devised a figure of up to 100bn barrels available.Even staying within Petrobras’ more modest forecasts, increases in production from existing fields promise to be significant. Petrobras president Sérgio Gabrielli has said that the company will be able to up its production from 2.5m barrels of oil and natural gas equivalent per day to 3.9m per day in 2014 and 5.4m per day by 2020. The new finds, however, catapult Petrobras further up the league of energy companies. It became the world’s fourth largest energy company at the end of last year, up five places in a single year, according to Washington-based consultancy PFC Energy. It is already the largest company in Latin America by market capitalisation at $149bn.

Naturally, the long-term story looks profoundly appealing to investors especially as the finds are in a jurisdiction which has regulated its oil industry mostly fairly. However, excitement is increasingly tempered by a growing anxiety that the country’s oil supplies will become a political football.

Politicians are already jockeying to divvy up the oil spoils and pushing for the jobs bonanza to remain within Brazil and not bring in foreign workers or oil majors. The government is rewriting the rules; making Petrobras the lead in all development of the country’s fields and planning to change the tax structure from a royalty-based regime to a production-sharing one. Equally, the challenges in successfully exploiting the deep sea pre-salt deposits are daunting. Over the next five years, Petrobras estimates it will need to spend as much as $220bn in capital expenditure to develop the discoveries, trapped five to seven kilometers beneath the waters under shifting layers of salt. The difficulties inherent in deep water drilling, brought into relief by the BP Gulf of Mexico disaster, are also weighing on investors’ minds.

These considerations continue to exert pressure on the value of Petrobras shares, which slid by 16.17% in a 12-month period to close at BRL32.04 ($18.10) on July 31st this year, compared with the performance of the Bovespa index, which is up 23.93% over the same period. A number of foreign investors have sliced Petrobras positions in consequence. William Landers, fund manager at BlackRock, which has some $8bn of investments in Latin America, believes a number of issues are reducing visibility and adding risk for Petrobras investors. These include how much the government will pay for reserves, and whether there are more surprises, he says. “Up to one year ago, Petrobras was seen as a clean company. Regulatory uncertainties and the large equity offering make us more careful with the stock,” says Landers.

Even normally buoyant analysts have been split. At the end of July, some 61.11% had a buy recommendation on Petrobras common shares, while a full 33.33% had a sell recommendation with the balance of analysts having the company under review.

The most immediate issue is the government’s role in raising capital for Petrobras’ massive capital expenditure plans. The former is selling Petrobras the rights to extract 5bn barrels of oil at a price per barrel yet to be determined. The embryonic nature of exploration means that the cost of extraction is difficult to estimate and the size of the area needed for Petrobras to recover this quantity is unknown, which has led to fears of over-charging by the government. Petrobras will then carry out an equity issue, which may bring in $25bn, with the government paying for its stake through a bond issue and diluting minority shareholders that do not participate.

Petrobras and the country’s governing political party, the ANP, have strived to prove that the pricing process for the 5bn barrels is transparent. Both have hired international consultants to oversee the process: Petrobras brought in the respected DeGolyer & MacNaughton, while more recently the ANP contracted Gaffney, Cline & Associates. The government has also promised that it will provide further exploration areas if insufficient oil is found in those areas it initially designates.

Ahead of the pricing, fund managers are operating in the dark. “If the price is $5 per barrel, we would consider that decent and fair; if it is more than $6 per barrel, the deal starts to look pricey,” says Rafael Sales, partner and co-portfolio manager at Constellation Asset Management in São Paulo. He points out that the whole process of extraction could last years, bringing in the risk of operating in very different markets.

Late valuations
Meanwhile, Walter Mendes, chairman of the Association of Investors in Capital Markets (AMEC) in São Paulo, worries that the ANP has left the valuation to the last moment and fears it will be rushed to allow the equity offer to get under way in September, before elections. “This is a very short period for an evaluation and the market has some doubts that it can be done so quickly,” he says. Mendes adds that the range most commonly being discussed is $3 to $8 with some predicting as much as $10 per barrel, which he describes as “extremely expensive”.

The planned equity offering is also controversial. The government says the deal is separate from the sale of oil, but investors see the two as related and see the government using the proceeds from the sale of the 5bn barrels to underwrite its share in the equity offering.

“Any fifth grader can look at this deal and tell you that the government is trading oil for shares. It’s a very significant danger not just for Petrobras but capital markets as a whole,” says Mauro Cunha, head of equities at Mauá Sekular Investimentos in São Paulo. Brazilian legislation dating back to 1976 clearly states that every time there is a rights’ issue where one shareholder contributes with assets not cash, this needs to be approved by the other shareholders, he notes. Cunha adds that the delays are reducing the strategic value of the oil and that new finds, such as those in the North Sea, threaten to steal some of the thunder from Brazil.

Mendes would like to see minority shareholders consulted more closely on the equity deal and believes they should be able to decide whether the deal gets the green light. “We would like minority shareholders to vote on this issue in the General Assembly and the controlling shareholder, that is the government, should abstain from voting,” he says. That has not happened. Mendes says the share price tumble shows just how much the government plans are deflating investor interest. “The uncertainty related to the deal is the reason the stock has suffered so much,” he says.

“The government has not chosen the best way to raise capital,” avers Sales. It is interested in enlarging its position in Petrobras and seems to be quite comfortable in diluting minority shareholders, he adds. He believes that the best way to raise capital would be to farm out some exploration areas to international players but concedes that this might not be politically feasible. All this impacts Sales’ view of the value of shares. Currently trading at an average of eight to nine times earnings, Petrobras shares are aligned with other oil majors. If the government charges a high price for the five billion barrels, those ratios could spike up to a pricey 11 to 12 times earnings, Sales says.

The other area of concern comes from the deepwater disaster in the Gulf of Mexico, which has raised a red flag over deep water drilling and emergency procedures worldwide. “We are not discussing sufficiently what has been going on and how it applies to Petrobras. People don’t want to talk about this, but we need to,” believes Claudio Andrade, fund manager at the boutique asset manager Polo Capital in Rio de Janeiro, which has some BRL2bn in assets under management. Investors have been too focused on capital raising and the pre-salt discoveries, he believes.

Although Petrobas has a good safety record today, it has not always been so. The company was responsible for a leak in Rio’s picturesque Guanabará Bay that spilled 800,000 litres of crude oil in 2000 and the next year the sinking of its P-36 platform killed 11 people. The disasters seemed to have acted as a spur for the company to clean up its act. Today, Brazil has some of the best safety legislation in the developing world, says Sales. Petrobras is possibly the best deepwater drilling company globally, agrees Mendes. Moreover, deepwater may prove to have some positive effects on Petrobras. In the short term, the disaster could help reverse the trend for increases in prices for equipment related to deepwater drilling.

Longer-term effects
The longer-term effects are likely to be less benign with stricter safety and environment regulations imposed across the board. Petrobras has said that it will review its safety procedures once a conclusive report on the cause of the accident is released. Meanwhile, the ANP is set to review safety procedures at oil companies under its remit and has solicited information on well-control systems and asked to see companies’ emergency plans.

The other issue is the government’s insistence on locally-sourced materials, which is likely to prove a constraint in the development of the pre-salt area, but is in line with the political demand to spread the benefits of the discoveries and is non-negotiable in an election year. Petrobras’ demand for steel alone in 2020 could constitute up to 25% of Brazil’s current production, putting enormous strain on the local industry and driving up prices. “Availability of equipment is certainly a concern especially with requirements that 60%-70% of content is sourced locally. This is very tough,” says Sales. The Brazilian oil services and equipment industry is not as developed or as efficient as some in Asia, he notes.

It is not clear whether Brazil can meet these ambitious targets and it is already proving a headache for foreign companies eager to provide services to Petrobras, says Sales. These foreigners are seeking to persuade the government to water down the targets on domestic sourcing, he adds. Firms such as Baker Hughes, Transocean and Halliburton, which have or are establishing offices in Brazil, are eager to curry favour with the government but say they need more time to find local content, he says.

The inauguration of a new government may lead to further upheaval. If opposition leader José Serra, who heads the PSDB party, wins, he may seek to alter regulations. “Under the previous PSDB government political interference in Petrobras was much, much lower, and performance improved a lot as the company focused on profitability,” notes Mendes. Senior PSDB figures have said that they do not like the shape of the current deal, but Serra has remained curiously quiet, notes Mendes. However, if the government pushes ahead with the capitalisation the deal may be too far progressed to turn back. Change may not be appreciated by investors anyway. Cunha admits to feeling nervousness about the “new government and the possibility of them doing things in a slightly different way,” now that so much has been decided.

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