At current oil prices, many would say that you should stay away from the sector. That attitude, I would argue, would be the reason why taking a deeper look at the sector may be worthwhile as there might be some interesting opportunities. One of such opportunities I believe to be is YPF Sociedad Anonima (NYSE: YPF), the Argentinean national oil company offering an upside of 60% with a target price of $26.00/ADR.
As you might know by now, I like to understand the value of a company by its economic spread (ROIC - WACC); generally, I would focus on the ROIC leg of the equation, but in the case of YPF, the current political changes in Argentina may also have a significant effect on the WACC side of the equation. While there are many factors that will enhance the business economics in the coming years, such as the increase of horizontal wells in Vaca Muerta as those are more profitable than vertical wells, I believe that there are two main catalysts that will drive the stock price in the next 12 months - those are the local oil price and the de-risking of Argentina.
YPF is 51% owned by the Argentinean government and is the second largest gas producer and fourth largest crude oil producer in Central and South America. Under the oil operation, the entire production and 3rd party crude is refined at its refineries and 89% of those products are sold domestically (84% at domestic prices and the rest at international prices). 55% of the exported oil is sold at international prices while the remaining includes export taxes as well. YPF owns 143 production concessions and exploration permits, 56 at 100%. Its most important concession is Vaca Muerta where it has a concession on 12,000 sq. km. YPF's production represents 41% of Argentinean oil production and 33% of gas production. In the gas business, YPF produces, purchases, imports and sells in the domestic market (55% residential, 27% industrial and 18% to power plants). Half the refining capacity of Argentina is owned by YPF, specifically 55% of both gasoline and crude processing, 58% of diesel and 34% of gas stations in the country.
Argentina is home to the third largest shale resource globally following the United States and China. Most of these resources are located in Vaca Muerta, the basin of Neuquen. Estimates indicate that the technical recoverable natural gas is 308 Tcf and 16.2 billion barrels of oil (source: EIA/ARI World Shale Gas and Shale Oil Resource Assessment May 17, 2013). As it is demonstrated in the table below, Vaca Muerta has among the best shale basin properties; it has a high concentration of organic material (TOC) and it has among the thickest areas increasing the probability of finding oil.
The government has used the company for its political agenda. Those actions can be seen indirectly in the sub-optimal capital allocation of the cash generated by YPF - investing in refinery capacity expansion rather than accelerating the development of Vaca Muerta. More direct actions were witnessed post 2001 default where price control changed the role of the energy sector in the country. Those price controls caused the local oil prices to be lower than the international oil prices, which discourages foreign investments in the sector and encourages energy companies to pay higher dividends. This led reserve life in the country to decrease from 24.6 years in 2004 to 8.0 years in 2008, and production to decline from +800k barrels per day to around 650k barrels per day in the same time frame. This also caused Argentina to change from a net exporter to a net importer of oil. Simultaneously, natural gas has followed the same path, but the effect is worse as the imports are at $11 or 18/mmbtu when imported from Bolivia or through vessels, respectively. They have tried to encourage natural gas production by offering $7.5/mmbtu for every incremental production of natural gas in the country which has picked some traction in increasing production.
I believe that the last hope for Argentina, and not just for YPF, to become a relevant energy producer and even exporter is Vaca Muerta. But it is difficult for Argentina to develop the massive basin of Vaca Muerta without foreign investments. Those investments are right on the Argentinean borders waiting for political change in the country.
Price of Oil
Similar to every energy company, the share price performance is dictated by the price of a barrel of oil. Despite the local oil price in Argentina being fixed (currently at $67.5/barrel), I do not think local governments would allow the oil price to converge to international prices as those provinces need the royalties and do not want to discourage international investments in the sector. Even with the new president, the new revisions should be limited this year, as it has already been lowered from $77 to $67.5 in January of this year. Please keep in mind that YPF sells its oil at $60/barrel, as it has a mixture of lower quality oil and, as detailed above, some of the oil is sold at international prices. The current stock price reflects the market's assumption that local oil prices would decrease to $35/barrel by the third quarter of the year.
De-risking of WACC
Needless to say, Argentina is a risky country to invest in due to many factors ranging from its import controls among other constraints in the domestic market to its track record in dealing with the capital markets (e.g. Holdouts). I calculate the current WACC required to invest in Argentina to be 14%. However, the new elected president, Macri, seems pretty pro-market which is reflected specially in his administration filled with former executives and CEOs of large private enterprises. I expect that under his administration, the perceived risk to invest in Argentina should decrease. For every 100 bps compression in the Argentinean CDS, WACC should tighten by 60 bps; I have used a WACC of 11% (500 bps compression in CDS).
Sum of Parts
I valued YPF by parts, upstream, downstream, Vaca Muerta and deducted the net debt. The details are as follows:
Upstream - $11.70/ADR and the main assumption is a long-term oil price of $40 and a cost per barrel (excluding SG&A) of $30.
Downstream - $6.67/ADR assuming an EBITDA margin of 10% (100 bps in margin = $1.8/ADR). In recent years, margins have been bouncing around 7-11%. As the government owns the control of YPF, and YPF has half the refining capacity of Argentina, the government will continue to utilize YPF's refineries for its political motives rather than to increase the value for the company.
Vaca Muerta - $16.40-29.10; of this, $6.00 have been crystallized through the JV with Chevron (NYSE:CVX). As more JVs roll into operation, the value of Vaca Muerta should converge to the upper limit. The lower limit is the case where Chevron is the only JV and the rest of Vaca Muerta is developed organically. The latter scenario is very unlikely as they have several deals in progress such as with Exxon Mobil (NYSE:XOM), American Energy Partners and Repsol (OTCQX:REPYY).
Risks to Valuation
I believe the three main risks to the valuation are:
- The international oil prices - Any further decrease in international oil price would further pressure the government into revising the local oil price.
- Local oil prices - Macri's policy may be more aggressive and be able to convince the producing provinces and oil unions to converge the oil price with the international price.
- Macri's policy - As we have seen through history, not all presidents are able to keep their campaign promises as they realize the reality to implement those measures are tougher than they expected. If Argentina does not deal with the holdouts, it is improbable that the international financial markets will open to Argentina.
Note: Here you can find my previous articles about investing in LATAM. If you would like to read about a specific LATAM company, please let me know.
Disclosure: I/we 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.