Petrobras (PBR) is the American Depository Receipt (ADR) for the shares of the national oil company of Brazil. Despite the fact that PBR is in the process of tapping the largest oil field in the west, the share price has done very little except go down in the past year.
A little background: Each ADR represents two common shares of the Brazil-listed Petrobras stock. At current exchange rates of 1.62 BRL for 1 USD , one can multiply the Brazilian per share data by 2 and divide by 1.62 to get relevant ratios for the ADR.
PBR shares have been lagging the overall energy sector and are down 11% YTD while the price of oil and most other energy stocks are up dramatically. The shares of Exxon Mobil (XOM) are up 10% YTD and up 36% from a year ago. I feel there is a good opportunity for a pairs trade by going long PBR and short XOM at these levels, based on the future production and earnings growth for PBR and the lack of production and earnings growth for XOM. For the purpose of this article, I will focus only on the upstream operations of both companies. They both have downstream operations, but those have only a marginal impact on the companies' performance.
Long Case for PBR
Part of the underperformance of PBR can be attributed to production of oil and NGL being slightly below the 2.1 million barrels per day (mbpd) forecast by the company. Actual oil and NGL production was 2.044 mbpd, up only slightly from 2.03 mbpd in Q4 2010. Income was up 42% from a year ago, but on a per-share basis, income was down 4% due to the massive share issuance late last year to pay for investments in the Santos Basin Pre-Salt Area -- the largest oil find in the western hemisphere, which requires major investments before any oil is recovered. When production begins in the Pre-Salt, PBR’s production will increase by 370,000 bpd in 2015 and rise to 600,000 bpd in 2017.
PBR has not given guidance after 2017, but given the size of the field, production should increase every year for the foreseeable future. These investments have resulted in proven oil reserves climbing to 16 Billion Barrels. This results in the reserve/production ratio at 18.4 years. Currently, PBR trades at 8x trailing earnings, 1.1x Book Value, and has a liquids/natural gas ratio of 86/14 (86% of oil equivalent production is liquids while 14% is natural gas).
The risks associated with PBR include that its majority owner is the government of Brazil, so investors are concerned that any future success of the company will be more the success of the state than of the investors. Also, PBR does not have the strong historical performance history that XOM has. These, along with the fact that it is an emerging market company, are among the reasons the shares trade at a discount to other energy companies.
Short Case for XOM
Exxon Mobil recently reported earnings of $10.6 Billion, up from $6.3 Billion a year ago and $9.25 Billion last quarter. Production volume was up 10% from last year; however, this production increase was entirely from increases in production of natural gas, while production of oil and NGL were flat from last year. Natural gas prices have been exceptionally low recently, so they are not as big an earnings driver as oil or NGL production. XOM is investing a lot in capex just to keep oil production flat and increase natural gas production. If natural gas prices begin to increase, my investment thesis will have to be revisited, based on XOM’s industry leadership in natural gas production.
XOM trades at 11x earnings and 2.5x book value. According to XOM’s 2010 10-K, it has 24.8 Billion Barrels of oil equivalent reserves, resulting in a reserve/production ratio of 15.5 years, and its liquids/ natural gas production ratio is 50/50.
Exxon is a very well-managed company with a reputation for being able to bring a project to completion on time and on budget. For that reason, the company trades at a significant premium to its peers. That being said, my investment thesis is mostly based on PBR being undervalued, not so much that XOM is significantly overvalued. I have chosen to short XOM because I have no special knowledge about the future price of oil or natural gas, and I would like to hedge the commodity exposure inherent in the PBR position. I do think XOM is getting expensive at these prices and will underperform PBR over the next few months.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in PBR and/or a short position in XOM over the next 72 hours.