With commodities, and oil prices in particular, getting hit hard, it seems a little premature to be buying an energy company. Especially one based in Argentina. Currencies are getting crushed right now, meaning risk aversion is taking an especially hard toll on emerging market stocks. So, fully aware that this stock will probably trade down further, and will be subject to terrible volatility, I am dipping my toe into the water (or oil) so to speak and buying a little YPF.
Company: YPF Sociedad Anonima, ADR ticker YPF
Price per Share: $35.41
Market Value: $13.5BB
Dividend Yield: 9.0%
Ownership: 57% Repsol
25% Petersen Energia (The Eskenazi family in Argentina)
Note: YPF reports financial in Argentine pesos, but as a USD investor I have converted these amounts to dollars. Ownership is in “D” Shares. A, B, and C shares are held by the Argentine government and local provincial governments, in amounts less than 1% but with regulatory oversight benefits.
YPF is Argentina’s largest energy company. It produces and owns approximately 50% of Argentina’s oil and gas supplies, and also owns significant downstream assets. Namely, refining and marketing assets, as well as a petrochemicals business. To put some numbers around these, here is a breakdown of 2010 revenue and EBITDA (earnings before interest, taxes, depreciation and amortization):
2010 Revenue (USD) 2010 EBITDA
Exploration & Production $5.9BB $2.7BB Refining & Marketing $9.4BB $1.0BB
Chemicals $1.0BB $0.25BB
Consolidated $11.3BB $3.8BB
I know, the revenue numbers don’t add up. That is because they sell significant quantities of oil and natural gas to their refiners, which get eliminated in consolidation. The EBITDA figures should be close, with only the corporate overhead slightly lowering the sum of the segment results.
Generally, YPF reserves are 55% in oil, and 45% in natgas (on an energy equivalent basis). Total reserves are 531MM barrels of oil, and 2.5 TCF (trillion cubic feet) of natural gas, aggregating 982MM barrels of oil equivalent (BOE).
Downstream, YPF has three 100% owned refineries, and a 50% stake in Refineria del Norte co-owned with Petrobras (PZE). It also owns 1,600 YPF branded retail service stations, 31% of all service stations in Argentina. Petrochemicals is the smallest segment.
Repsol of Spain (REPYY.PK) purchased 97.5% of YPF Argentina in 1999. Two years later, Argentina experienced an economic crisis, de-pegged their peso from the dollar, and as a result its currency got crushed. The 1.0 dollar peg turned into a nightmare for Argentines, as the peso fell to a 4.0 ratio virtually overnight. With the cost of imported oil 4x as high as it was before the de-pegging of the peso, the Argentine government severely regulated policies on the selling of oil and gas.
Specifically, Argentine energy companies were forced to give priority to domestic demand for oil and gas, via their Argentine Hydrocarbons Law. “The needs of the local market must be taken into account when authorizing long term natural gas exports.” Oil exports also must be approved by the Argentine Secretariat of Energy too. And if refiners continue to demand more oil than is produced by YPF, they must sell it at local (low) prices. The political risk factors are high here.
Given the difficulty of selling natural gas and oil at international markets prices, it comes as no surprise that Repsol, as owners, spent little on developing hydrocarbon reserves. In fact, they let fields mature, milked YPF for dividends, and invested little in the business.
For YPF’s exports, if international oil prices (WTI) are above $60.90 a barrel, then the company can only collect $42 USD a barrel. The rest goes to the government, whether oil is $150 or $80 a barrel. If oil is between $45.00 and $60.90 a barrel, then YPF pays a 45% withholding tax, so that at say $55 a barrel, they get $35.75 a barrel. To illustrate, here is a table of WTI oil compared to what YPF nets in export revenue after paying taxes:
WTI Oil Price
To me, this clearly shows that as oil falls, it doesn’t really matter to YPFs export revenue. That is, until oil falls below $60 a barrel. This is important to consider as oil prices fall from $100 to $80, it doesn’t really impact the company’s top line.
Where YPF is Today
Given the limited investment returns in exploring for hydrocarbons, supply from YPF and from other Argentine producers fell dramatically from 2001 to 2010. On the flip side, with low prices, demand for gasoline and energy have been high in Argentina. In fact, natural gas production declines have meant that natgas imports have gone from zero (ie self sufficient), to over 300MM mcf per month last year. Paying Bolivia over $7 per mcf, paying YPF $2 per mcf and covering the difference is creating larger and larger government subsidies. Merrill Lynch estimates that energy subsidies have increased from $2.1BB in 2006, to over $12BB in 2010! Political support for higher hydrocarbon pricing is now a fiscal reality in Argentina today. Increasing government budget deficits will mandate change.
So, what I think is generally interesting about YPF is that, while pricing is terrible, government regulation cannot get any worse. The company’s average natgas price in 2010 was a mere $2.15 per mcf, and its average oil price was just a tad over $45 a barrel. With WTI still well over $80, and regulation likely lessening in Argentina, there is substantial upside to this stock as pricing improves.
The ownership structure is also moving in the right direction. Repsol has been selling down its stake in YPF, the last one being in May to the Eskenazi family of Argentina. Having a local owner with 25% of YPF stock can only make a positive difference to the regulatory environment. Management will benefit from Repsol’s oil producing expertise too, and now punitive energy policies will be less likely when it is seen as a company owned locally. In fact, USD revenue per barrel increased from $47.50 to $55.30 in the first half of 2011 compared to first half of 2010. And gas pricing improved from $2.07 per MMBTU to $2.25 per MMBTU despite an 11% decline in Henry Hub prices.
YPF is now spending significantly more resources on developing mature fields to prevent further production declines. I do anticipate a higher capex number prior to production hitting the P&L, but I think the market understands the lag here. 2010 was quite notable for the fact that its reserve replacement ratio got back to 100%, ie they replaced all the reserves that they produced in 2010. That hasn’t been the case for years. Natural gas production may continue to decline, but oil production probably looks to remain steady.
The second quarter was awful. A strike impacted production at the company’s Santa Cruz field (which is 29% of the company’s crude oil output). So, while TTM EPS was $3.32, there was perhaps 21 cents per share in strike impacts and a roughly $50mm charge for exploration expense. Factoring these out would improve forward EPS to the $3.60-3.70 a share.
In case you are wondering, EPS the last 3 years has been $3.12 in 2008, $2.50 in 2009, and $3.77 in 2010. Revenue has grown slightly from $11.0BB to $11.3BB. FCF per share, which I define as CF from Operations less Capex, has averaged $3.46 a share over the past 3 fiscal years. That is slightly higher than reported EPS which averaged $3.32 over that time frame, indicating pretty clean books.
Downside on the Stock
No question, oil price declines and market fear send YPF reeling. The stock was off 10% just last week. This could continue. While it is very hard to look at YPFs trading history, as it was largely illiquid for most of the 2000s, I would suggest that in a panic tape, the stock could trade down to a low of 7x earnings. That would be a low $25.50 a share.
Oil production likely will be flat in 2012, but a decline there, another strike, worsening government regulation, could be factors. But more than anything, as the dollar rallies amidst European’s debt crisis, the peso likely continues to fall. In 2009 the stock fell by 50% from peak to trough, and a similar fall would imply a stock in the $25-27 range. Valuations simply won’t matter in a banking / liquidity crisis, and I do suggest any purchases be tempered with the thought of adding more at lower levels.
Using $26 as a target, that implies down 25% and is quite realistic truth be told. But if you receive dividends of roughly $3 per ADS, then a one year downside scenario looks much better. Using $26 plus $3 of dividends gives me a one year downside risk of 16%.
Upside on YPF
YPF was trading over $56 earlier this year, and is already down almost 40% from its peak. It pays out 90% of its net income in the form of dividends, which should provide some downside protection as just noted. But looking at forecasts for EPS (or more correctly EPADR), they range from $4-6 for 2012. Given that Q1 EPS was $1.12, that is pre-strike, it’s conceivable that 2012 EPS would be roughly $4.50, just on a run-rate basis.
Production may remain flat, but when you are likely to see higher oil and gas prices, it’s worth noting that 100% of the increase in pricing falls to the bottom line. Higher production means higher production costs. The incremental impact of higher pricing is 100% to the bottom line. Fortunately this is a low cost producer, with production costs running between $15 and 17 per barrel the last few years. If only they could sell in an unregulated market.
But using street forecasts of $5.00 to nearly $6.00 in EPS next year, easily adds up to a $55-60 stock again. With $3 at least in dividends, $60 is quite attainable, for upside of 74%.
Other Upside to the Story
Most of the improvement here in the near term will be improved pricing and perhaps some improvement in production on the E&P side. However, in December 2010, YPF announced a non-conventional shale gas play in its Lomo Lata field. Potential reserves could total 4.5 TCF, which is a lot considering total gas reserves today are 2.4 TCF. I have no clue if any of this will come to pass, but I don’t think you as a shareholder are attributing any value to these probable/possible reserves. There is also a shale oil play of 150mm BOE in the northern part of the Lomo Lata field. In all the company has 19mm undeveloped net acres in Argentina. The potential there with today’s technology has to be meaningful. $15 of profit per barrel on 150mm barrels of oil is future value of $2.25BB in additional market cap, or $6 a share.
Quick Note on Currency
Currency risk is different than you might expect. The company’s cost structure is about 2/3s in pesos, so you are short pesos there. With revenue tied both to international markets and Argentine regulation, it’s tough to say exactly the currency exposure there. But generally, you are more long dollars as oil is priced and sold in USD’s worldwide. So, being long this stock doesn’t imply you are really long pesos. In fact, a strong dollar probably helps you more than hurts you here. Inflation in Argentina is a bigger issue in my opinion.
The Eskenazi family bought stock starting in early 2008. They paid $38.50 a share, adjusted to the low $30s including the dividends they have received since. I honestly don’t know much about the Eskenazi empire, but it is one. They are a billionaire family in Argentina and probably very helpful in negotiating oil and gas prices locally. They did borrow half the $1.3BB that they invested in the company in May, but that is far less than what a private equity firm would borrow.
Also, Eton Park, former Goldman star Eric Mindich’s hedge fund, recently bought 13mm shares of Class D stock for $500mm. My math is that they paid around $38.50 a share. They also have options to buy more at $43 a share. Soros also recently initiated a position in Q2 this year, probably paying in the $40s. I like owning this with other smart holders, at similar to lower prices on the equity.
One thing to note too. This likely isn’t going to be a takeover by Exxon (XOM) or another multinational. Too much political risk. And the share structure, whereby the government owns A, B, and C shares, also means that ownership of over 15% of the company has to be approved by said government entities.
As far as a sum of the parts, given the ownership structure and its size, it’s probably not terribly useful. You could back of the envelope say E&P is worth 6x EBITDA, R&M and Chemicals 4x EBITDA. That would imply a $50 stock, but is highly generalized. There is a ton of information on wells, regions, assets, etc in their 20-F, it’s a good read. Take note of the risk factor section too.
With the markets in turmoil, there is a storm to ride out here near term. Keep a little dry powder. But the risk reward, down 16%, up 74%, is firmly in your favor. I suggest buying some now, and doubling down between $28 and $30. People need oil and gas, and regulatory regimes that suppress market fundamentals never last. They may hang on for a few years, but eventually the market will win.
Disclosure: I am long YPF, and may buy more.