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Summary

  • A case of inattentional blindness.
  • Petrobras has gone from darling to cursed (or invisible).
  • A catalyst, and how much worse? Risks and Valuation.

I always found so amusing that experiment of a bunch of basketball players, passing a ball to each other. The subject needs to count the number of passes. What follows is most shocking (click before reading on!! https://www.youtube.com/watch?v=vJG698U2Mvo

All the while a gorilla suited person has been walking about and guess what…most subjects didn't even notice! If you are like me you suffer "inattentional blindness".

This a serious enough "condition" so that at least we keep it in mind. It can be fatal while driving for example (please beware of cyclists…!). For investing it is also crucial as it can lead both to excessive risk taking but also to neglected, attractive investment opportunities.

At the moment I feel Petrobras is one such gorilla walking about, invisible to almost all; nobody cares any more. I think it got to this point via a combination of "cry-wolf" syndrome, poor execution and career risk. This is how it became invisible, victim of inattentional blindness.

Petrobras used to be everybody's oil company darling, from the moment they announced their first pre-salt oil discoveries in 2006 (the largest discovery since US Cantarell in the Gulf of Mexico, the new frontier, the best operator globally given size and growth potential, unique expertise…you name it). Besides that was the heyday of the BRIC domination theme. I mean, it ticked every box in the manual to become a hot story. And so it did.

However the Global Financial Crisis (GFC) struck in 2008 and investment outflows weighed the most on liquid Emerging Market names. Next, before you knew it they had all rebounded sharply. At some point though, investors changed their mind about Petrobras.

Indeed as years passed, Petrobras failed to deliver. There was too much promising, and too much crying wolf about the risk of missing out when volumes and reserves were delivered. Meanwhile capex continued its growth unabated. The latest strategic plan for example targets c. $220bn for 2017-2018. That is around the GDP of Chile and the Philippines, and greater than that of Peru and Czech Republic. What's more, that is more than what is invested annually in any EM country except for the BRICs, South Korea and Indonesia. So huge capex and nothing in return.

Unfortunately that was not the only problem. Downstream, which contributes a massive portion of costs (and capex), had become a heavy drag. Although PBR is free to set product prices, inflation considerations for Brazil seemed to have taken precedence over company profits time and again. Minorities interests weren't that well aligned after all (the Brazilian government controls voting shares and the Board of Directors is full of ministers and government officials with little skin in the game).

Lastly PBR undertook a massive rights issue in 2010, not only dilutive but very likely insufficient for investment needs, all else equal. After all the government contributed no cash but oil barrels rights instead. So who was going to pay for Exploration and Development then?

The consequence was that performance suffered. When eventually EM also fell out of favour things didn't get any easier for PBR share price. Soon enough it became difficult for any fund manager to risk her career and justify a long term active investment in it. Over time all that was left was ETFs and "tracking error" driven investment. Petrobras had gone full circle. It became an "obvious to all" very bad investment.

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But sooner or later when things are taken for granted new info is neglected. Which brings us to today.

There are a couple of points that I find deserving of renewed attention. One is a trigger, so that investors' interest can be drawn to the name once again; sort of like the "eye of Sauron" when someone puts the magic ring on. The other one relates to the limited scope for things to get a lot worse (both in sentiment and fundamentals).

Volumes trigger:

Firstly I think it is worth to point out that volumes for pre-salt have been growing very nicely. Despite this being a new frontier for exploration and development, with all kinds of new challenges (temperature, pressure, corrosion, logistics…), PBR managed to grow from 0 to 300kbpd in only 7 years (February 2013), a record time if compared with the North Sea (9 years) or the US in the Gulf of Mexico (17 years). Production now stands at 412kbpd ( +37% yoy) with 21 producing pre-salt wells only, which attests their very high productivity (20-30kbpd per well). The road map for 2014 includes 5 new platforms and a total of 22 new wells. At the current rate that would add c. 550kbpd gross in pre-salt (post ramp up).

The bottom line is that Petrobras seems to be one of the best volume (11% CAGR to 5.2mmbpd by 2020 vs 2.5 today) and reserves growth stories globally. And there is relatively good visibility about where it will all come from. PBR has created a PTTEP or a Repsol from scratch since 2006. Plus they target 1mmbpd, or a CNOOC, by 2017. Furthermore within pre-salt they target more than a CNOOC + Repsol + PTTEP or 2.1mmbpd by 2020!!

This additional volume and reserves growth should at long last reverse perception towards execution which has disappointed frequently over the last few years (almost no growth to both), despite the huge capex committed (c. $110bn for E&P alone!)

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Pre-salt is taking off and adding plenty of reserves (100% success rate in 2013) and volumes. It just needed some time to pan out, it couldn't happen overnight. And the larger the pre-salt portion of volumes the greater the impact on overall growth. This is one catalyst that should draw investors' attention to Petrobras once again.

On the other hand, how much worse can it get…?

If something cannot go on for ever it will stop (Stein's Law). This is one useful way of thinking when building an investment case. I mean, volume growth is great and all, but is that going to show up in profits and flow to minorities at long last?

I found it very interesting that in the last strategic plans for Petrobras (link) some rather specific and simple targets have been given, again. But this time and taken together they make sense IF AND ONLY IF the main issues plaguing Petrobras are resolved. No more silly games. And that should be good for minorities. To wit:

1.- Maintenance of investment grade (and they spell out a Net Debt/(Net Debt + Equity) target <35% and Net Debt/Ebitda < 2.5x from 2015 onwards - still small breach in 2014 though).

2.- No new equity issuance.

3.- Convergence of oil product prices with international levels .

4.- Partnerships and businesses restructuring/divestments.

The 4 Strategy points taken together with the planned capex and the current balance sheet have very clear implications starting today (especially looking at the recent historic operating earnings numbers):

*Petrobras' Net Debt is planned to grow to c. R$380bn (from R$220bn today, +(9.1+60.5)*2.3 ). Because of the leverage constraints (0.35 Net Debt/(Net Debt + Equity) this implies that PBR expects Shareholders Equity to grow by 105% or 15% CAGR, until 2018 (interestingly, Warren Buffet focuses on Book Value growth as a performance measure not affected by market moods…). And this doesn't include dividends (4-7% additional). This would be minorities' share price return if there is no de-rating nor re-rating and excluding dividend (let me stress this one). It is trading at 0.46xPBV currently so some re-rating is very possible if good execution starts to take place.

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* Also Petrobras is expecting to generate c. $182bn of operating income (and c. $237bn EBITDA) over the period (net of dividends). That means an annual average of c. $36bn. Without this income, capex plans will not be possible for the given leverage (or even at all…). This compares very aggressively with the recent few years in the c. $ 15-25bn level (gross of dividends). So the company is hinting clearly at some mighty profitability improvement. But, seriously ? Can this be under management control?

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*Point 3 EXPLICITLY mentions oil product convergence as a target set by the Board of Directors (as per an internal policy approved on 29th November 2013). Point 3 is the answer to Petrobras' Strategy Conundrum. Refining is the swing division. If losses are no more, then there are c. $10-15bn additional operating profits to be had (+60-100% from current levels). Then there is enough to fund investment and growth (almost even without additional volumes!). If refining even got to earn some return on investment then the upside is even greater. And yes, this is under management (and Board of Directors') control indeed.

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I think this is VERY SIGNIFICANT. Never before had the whole strategy depended on such an explicit point so much. And never before had Petrobras been so close to running out of road. Refining losses were never that large. The company has little credibility left. New CEO Ms. Silva Foster (February 2012) should be well settled by now and well aware of it all. If they fail to deliver on such straightforward point even the country will struggle without Petrobras' investment.

Risk:

The main risk is of course oil prices (although energy is a staple that is burned no matter what unlike most other cyclical commodities/industries; plus geopolitics is typically a tailwind for oil).

Although perhaps not… Surely if oil weakens and E&P profits are under pressure then Refining losses will reverse providing a nice offset (the Strategy Plan would still be at risk I guess). This seems a rather asymmetrical risk to me, i.e. less business downside vs. upside.

One other risk is that populism and inflation concerns continue to dominate. The ongoing drought in Brazil and the related power rationing and expensive spot electricity won't make things any easier. But if Petrobras continues to waste time, disappoints, and things don't change then the whole strategy plan is a big fat lie. I think that would have serious negative implications for the credibility of the country as a whole.

Valuation:

Lastly, valuation is never enough to change perception (and direction) of things. To me it is similar to the ski jump slide, a measure of the length and incline, of potential energy that will be unleashed by some trigger (also a measure of the resistance that additional bad news need to overcome to make the share price even cheaper).

Current valuation is a good reflection of the last few years of disappointing execution on volumes and reserves, terrible alignment with minorities in relation to refining losses and extremely unpopular Brazil and Emerging Markets thematic. One could say that the ski jump slide has gotten truly daunting (good!) and fundamentals and sentiment have much upside and perhaps little additional downside.

At 7xPE trailing (4.6x PE14), 0.46xPBV for a 10% ROE14 and 4%-7% dividend yield, with a strong catalyst and getting to the end of the road, I really feel Petrobras has never looked so pretty. And yet, it is invisible to most!!

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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Petrobras: Invisible In Plain Sight