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Petrobras (PBR), a major producer and seller of oil and oil products, has been increasing its production to meet its year-end production target. However, the company has been suffering from low operating margin growth, which might result in reduced operating cash flows. A reduced operating cash flow could result in difficulties paying down the debt it has accumulated.

Production - A significant revenue driver

In September this year, the production of oil by Petrobras averaged at 1.979 million barrels per day, or mbpd. The production of crude oil and natural gas is expected to increase over the fourth quarter ending in December of this year as the company is bringing two production units, P-61 and P-62, into operation by the end of December. The P-61 is a Tension Leg Wellhead Platform, or TLWP, and was put into service in the Papa Terra fields in offshore Brazil. A TLWP is an oil and gas producing unit, which is secured by piles driven into the sea floor. The P-62 is a FPSO and will be put in service in the Rancador oil field located in offshore Brazil. A FPSO is a floating vessel used for offshore processing and storage of hydrocarbons. Additionally Petrobras has scheduled P-58, a FPSO that will be stationed at Parque das Baleias for oil and gas production. Parque das Baleias is located in the Campos basin in offshore Brazil. The production of oil and gas is thus expected to grow moderately to around 2 mbpd by the end of this year, which is in line with Petrobras' planned production output guidance.

Chevron (CVX), a major player in oil exploration and production, has increased production during the third quarter ending in September of this year. The production increased by 2.7% during the third quarter to around 2.9 million barrels of oil equivalent per day, mboepd, over the third quarter of last year. Chevron is currently focusing on deep water exploration for increasing production of oil and natural gas. In October of this year, the company received two permits from the Australian government to explore the Great Australian Bright. This water depth of the basin extends from around 150 meters to around 3700 meters.

Another oil and gas producer that is looking to increase its oil and gas production is Exxon Mobil (XOM). In the first nine months of this year, the company spent around $33 billion to boost oil and gas production. Exxon's third quarter production this year grew by 1.5% year over year, to around 4 mboepd, in comparison to the third quarter of last year. With increased focus on deep water exploration, the company successfully bid for two oil blocks with a gross acreage position of 750,000 in Brazil. In addition to this, the company recently acquired a 30% stake in the Arouwe block in offshore Gabon.

Managing Debt

While there is growth in production over the last three quarters, Petrobras has experienced increasing debt. The following table shows the trend of the company's net debt and debt paying capacity over the last three quarters of this year:

Time Period

First Quarter 2013

Second Quarter 2013

Third Quarter 2013

Net Debt ($ million)

74,820.00

79,563.00

86,542.00

EBITDA ($ million)

8,211.00

8,928.00

5,937.00

Cumulative EBITDA ($ million)

8,211.00

17,139.00

23,076.00

Annualized EBITDA ($ million)

32,844.00

34,278.00

30,768.00

Annualized Net Debt/EBITDA

2.28

2.32

2.81

The increase in the Annualized Debt/EBITDA ratio occurred due to the reduction in EBITDA during the third quarter ending in September of this year. The company's operating margin reduced 8% quarter over quarter. We believe that the following parameters will contribute significantly to Petrobras' future debt paying capacity.

While Petrobras will be able to increase its oil and gas production due the above mentioned production units coming into operation, the company will also benefit from the reduced cost due to the completion of maintenance on a number of production units. Petrobras also concluded maintenance on production units P-26 and P-35, both of which are located in Marlim oilfields. Marlim is located in the northeastern part of the Campos basin in offshore Brazil. In addition to these, there is the forthcoming maintenance completion of P-51 located in the Marlim Sul oilfields in the Campos basin. The completed maintenance is expected to reduce the cost of operations for Petrobras, resulting in a better operating margin.

While being able to strengthen its production volumes, Petrobras might experience some margin compression due to its U.S. dollar debts. Petrobras has around 63% of its total debt of around $112.5 billion in U.S. dollars. The U.S. dollar debt rose from around 55% during the first quarter. This is a significant amount of debt in an environment where the U.S. dollar is appreciating against the Brazilian currency. The following chart shows the movement of the Brazilian Real against the U.S. dollar:

(click to enlarge)Source: XE

As can be seen from the chart, the U.S. dollar appreciated over the Brazilian Real over the last year and is still 9% higher than the USD/BRL of November of last year. With debt in U.S. dollars, an appreciation of U.S. dollars against the Brazilian Real could increase Petrobras' debt burden.

Another pressure point on Petrobras' operating margin is the increase in imports of oil and oil products. The net crude oil and oil product import by Petrobras during the financial period from January to June of this year was 400 mbpd, which increased to 408 mbpd during the financial period from January to September of this year. According to the EIA, the consumption of oil and oil products in Brazil will continue increase more than its production through next year. This is as shown in the chart below:

(click to enlarge)

Source: EIA

So, we expect imports of oil and oil products to increase in the coming quarters. As discussed above, the combination of Brazilian Real depreciation and increase in imports could decrease the company's EBITDA. This is because the same amount of Brazilian Real will import less oil and oil products, resulting in more cost to buy similar levels of imports. This might further increase Petrobras' Annualized Debt/EBITDA ratio.

Formulating the price

As we discussed in our previous article, the import parity of around 30% is causing Petrobras a loss in revenue from the sale of oil and oil products. Import parity is the price of domestically produced goods that is set equal to the imported good. In other words, the imported price of oil in Brazil will be derived by adding the market price of oil, the tariff imposed, and the transportation cost to Brazil. Since fuel sales constitute around 40% of the company's revenue, a high import parity erodes the company's operating income. In October this year, Petrobras proposed a pricing formula for both diesel and gasoline, and it is awaiting the approval of its Board of Directors to implement the same. This pricing mechanism will better reflect the changes in international oil prices. We believe that this pricing formula could reverse the company's declining revenue from the sale of gasoline and diesel.

Debt levels can still be controlled

Petrobras has been in line with its scheduled production increase over three quarters of this year. The production will grow in the coming months as a number of production units are becoming operational in the fourth quarter. However, the Brazilian currency's depreciation and the increasing imports may take a toll on Petrobras' operating margin. To reduce this impact on its operating margin due to imports, Petrobras is in the process of formulating a pricing mechanism that would reflect the international prices of oil, resulting in reduced losses on the sale of gasoline and diesel.

We believe Petrobras is taking definitive steps toward increasing its operating margins, which will enable it to manage its debt more effectively. Petrobras has a price-to-sales, or P/S, ratio of around 0.79. Looking at the company's strong revenue generation potential due to better pricing, we expect the P/S ratio to decrease in the coming quarters. We believe that Petrobras' strong and improving operations will provide better growth in the coming quarters. Our recommendation on this stock is a buy.

Source: Can Petrobras Keep Ahead Of Its Debt?