With continuing concern about the impact of a Chinese economic slowdown on the global economy and the flow on effect this will have on commodities, we are seeing the prices of commodity stocks pushed down. Yet it is my opinion that while this will have an impact on the revenue of basic materials providers such as Brazil based Vale (VALE), Australia based Rio Tinto (RIO) and U.S based Cliff Natural Resources (CLF), the effect on oil and gas producers will be more muted. I believe that the impact on oil prices will be less severe due to some positive signs emerging that indicate the economic outlook for the U.S and eurozone economies is improving as well as the ongoing demand for energy, which is now an essential requirement of all modern and emerging economies.
We are also seeing supply-side constraints emerge for oil that will offset any dip in demand through 2012. At the time of writing Brent Crude is trading at around $126 per barrel, which is a 17% increase in price since the end of December 2011. When this is considered in conjunction with increasingly positive growth signs in many Latin American economies when compared to the U.S, the eurozone and Japan, I am of the view that it is time to consider further investments in Latin American commodities companies. Since hitting a 2012 high of $32.12 in February, Petrobras (PBR) has dropped by 16% to now be trading at around $27. This I believe represents a buying opportunity for risk tolerant investors and in this article I will explain why.
Petrobras is Brazil's largest company and an integrated global energy company that operates oil and natural gas exploration, production, refining, transportation and distribution businesses across the Americas, Africa, Europe, and Asia. Interestingly the company also operates a bio-fuel production business. With a market cap of $176 billion, it is the sixth largest publicly traded integrated oil and gas company.
Petrobras' financial results for both the fourth quarter and full year 2011 were disappointing. For the fourth quarter 2011 the company reported a 1% fall in revenues to $35 billion and a 20% fall in net income to $2.7 billion. In addition, for the same period its balance sheet marginally weakened, despite cash and cash equivalents rising 6% to $19.6 billion, because long-term debt increased by 8% to $74.7 billion. Petrobras also reported a disappointing full year 2011 result, with revenue of $134.8 billion and a net profit of $18 billion, which is a 5% drop from 2010's reported net profit.
There were also a number of other key positive take outs from Petrobras' 2011 report, including:
- They have an increased reserve replacement ratio of 148%, which has lifted production life to 18 or 19 years.
- Compared to 2010 the company has seen an increase of 9% in sales to the Brazilian market.
- The company as an exploration success index of higher than 50%, which has contributed significantly to reserves in both oil and natural gas.
However, when we look at Petrobras' key performance indicators compared to its competitors the company appears to be lagging in almost all aspects as the table below shows.
Debt to Equity Ratio
Based on the PEG ratio, Petrobras has worse growth prospects than its key competitors, while the other major Latin American oil and natural gas producer Ecopetrol has the best growth prospects. Although Petrobras has the second highest profit margin of the five companies it is still 10% lower than Ecopetrol's, but higher than Chevron's, BP's and Exxon's. The company is also delivering a particularly disappointing return on equity, which is the lowest of the four other companies and substantially lower than Ecopetrol's 32% return on equity which is the highest in the integrated oil and gas industry.
However, I do like Petrobras conservative balance sheet with a debt to equity ratio of only 0.40, though this is still higher than Ecopetrol's, Exxon's and Chevron's but around the same as BPs. This conservative debt to equity ratio does bode well for the degree of investment risk undertaken when investing in Petrobras, as it means its operations are predominantly funded by equity rather than debt. This means either an increase in interest rates or a drop in revenue due to a declining oil price should have little effect on Petrobras, nor should the company experience any discomfort with regard to debt convents should its stock price drop substantially.
Overall the low profit margin and return on equity does not bode well for Petrobras' future revenue and net income growth. However investors should remember that other than the PEG ratio the other indicators are lagging indicators and do not necessarily provide a leading prediction of the company's future performance. To get a good feel for the company's future performance I believe it is important to get a feel for its forward valuation and determine whether at current prices, combined with consensus future earnings, it is expensive in comparison to its competitors.
With a current trading price of around $27 and a forecast consensus 2012 EPS of $3.10, Petrobras has a forward PE of 9. In addition, it has been forecast that Petrobras' 2012 revenue will rise by 12% to $151 billion. Ecopetrol, Petrobras' main South American competitor is trading at around $61 with consensus 2012 EPS of $4.60, giving it a forward PE of 13. It has also been forecast that Ecopetrol's revenue in 2012 will fall by 7% to $34.7 billion, all of which makes it expensive in comparison to Petrobras. When we look at U.S based oil and gas companies Petrobras continues to look cheap except when compared to Chevron. Chevron, which by market cap is the fifth largest company in the integrated oil and gas industry, has consensus 2012 EPS of $12.92, which with a current trading price of around $106, gives it a forward PE of 8. It is also forecast that Chevron will see a 21% increase in 2012 revenues to $286 billion.
BP, which by market cap is the fourth largest company in the integrated oil and gas industry, has a consensus forecast 2012 EPS of $6.60, which with a current trading price of around $46, gives it a forward PE of 7. Analysts have also forecast a 1% drop in 2012 revenues to $372 billion. Finally there is the world's largest publicly traded oil company Exxon, which with a trading price of around $86 and forecast 2012 consensus EPS of $8.24 has a forward PE of 10. Analysts haave also forecast that Exxon's 2012 revenues will fall by 13% to $492 billion.
Based on these forward valuations, Petrobras is cheap in comparison to Ecopetrol but equal to Chevron, BP and Exxon. Given theat BP is stilll dealing with fallout from the Deepwater Horizon oil spill and Chevron is grappling with the recent oil spill and its fallout in Brazil, Petrobras a this time appears to be a superior investment based on these forward valuations.
I also quite like Petrobras' dividend yield of around 4% (after foreign withholding tax is deducted from payments), which is a solid yield for an oil and gas producer and is similar to BP's 4% and higher than Ecopetrol's 3.5%, Chevron's 3% and Exxon's 2%. The total dividend yield is made up of two components a dividend payment and a distribution of interest on shareholders' equity (ISE), which is an alternative form of payment to shareholders. Essentially the ISE payments are not guaranteed and may vary from payment to payment and year to year.
In 2011 Petrobras had a cost of goods sold (COGS) of $93 billion, which as a percentage of total revenue is 69%. This is inferior to Ecopetrol's 2011 COGS of $20.8 billion which is 56% of total revenue, but superior to BP's COGS of $318 billion, which is 84% of total revenue. It is also equivalent to Chevron's COGS of $163.5 billion, which is 69% of total revenue and Exxon's COGS of $304 billion, which is 70% of total revenue. Overall, Petrobras' is producing oil and gas at an equivalent cost to its competitors except Ecopetrol, which is a lower cost producer.
Currently there is significant concern regarding the hard landing of the Chinese economy and the effects this will have on the global economy. A Chinese economic slowdown will cause global ripple effects and energy producers such as Petrobras will not be immune. China is the second largest economy in the world and its share of global GDP reached almost 15% on a PPP basis in 2011. The IMF estimates that the impact of Chinese demand on the world's largest economies has more than doubled over the past decade.
The IMF has predicted that China's GDP growth rate for 2012 will be 9%, which is lower than the 9.4% average for the first 3 quarters of 2011, yet many economists are predicting that China's GDP growth for 2012 will be under 9%, with S&P predicting that Chinese GDP growth will be 8.2%, although they have described this as a soft landing. A deteriorating outlook for Chinese imports would send commodity prices into a tailspin and see a drop in global energy demand, all of which will have an impact on both basic materials producers such as Vale and BHP Billiton (BHP) as well as oil and gas producers like Petrobras.
Despite the negative view on the Chinese economy and the impact that a Chinese economic slowdown will have there are some signs that in my view should see oil prices remain steady. These include signs of some progress in resolving Europe's long-running sovereign debt crisis and a tightening global supply picture in view of the geopolitical fallout over Iran's alleged nuclear ambitions have been keeping oil prices at elevated levels.
Over recent months the price for Brent crude has risen by 13.77% since August 2011 to be trading at the time of writing at $125.26 per barrel as the table below shows.
Table 1: Brent Crude per barrel
*As at the 25th March 2012
Therefore, despite the impact that Chinese economic slowdown is perceived to have on the demand commodities, I believe that the price of oil will continue to rise. I have formed this opinion due to supply-side constraints caused by the ongoing political instability in the Middle East, continued tensions over Iran's nuclear ambitions and Chavez's ongoing reactionary and nationalistic political rhetoric.
Over the long-term the price of oil will in my view continue to rise as energy is an essential part of any developed or developing economy and demand for energy around the world will continue to grow as developing countries mature and populations grow. Exxon recently published an outlook report that highlights this growth, projecting that global energy demand will be around 30% higher in year 2040 than it was in 2010.
I also believe that when investing in a Brazilian company it is important that investors understand there is an additional degree of country risk that can and will impact on the performance of their investment. In summary while Brazil is one of the more stable Latin American countries it still has problems with corruption, lack of transparency with governmental, judicial and law enforcement bodies as well as economic and sovereign risk. Transparency International has rated Brazil as 73rd out of the 184 countries it analyzes on its Corruption Perception Index, which is well behind the U.S which was rated 24th. Brazil has also been given an OECD country risk rating of 3, on a scale of 0 to 7, with 0 being the least risky and 7 the most risky.
However, Brazil has an S&P BBB international credit rating, which is above the minimum investment standard of BBB- and was upgraded by S&P in November 2011 from BBB- on the basis of "the current government's growing track record of prudent macroeconomic policies." Furthermore the international community has expressed a strong degree of confidence in Brazil through awarding it the right to host the 2014 FIFA World Cup and 2016 Olympics. This bodes not only well for the perception of reduce country risk but when coupled with Brazil's forecast 2012 GDP growth rate of 3.6%, increased domestic demand for basic materials and commodities such as oil and gas, all of which bodes well for Petrobras. If you wish to read further details on Brazil's level of country risk please refer to my article 'Vale a Solid Mining Investment for 2012'.
A key plank in Petrobras' growth strategy that makes me particularly bullish on the company is its continuing focus on growing its resources and production base while pushing to reduce costs, which will place it in a strong position to capitalize on rising oil prices. At the time of writing Petrobras had made a number of key discoveries that added to its reserves including:
- The discovery of a new high quality oil accumulation in ultra deep waters in the pre-salt of Santos Basin. The discovery was found during drilling of well known as Carcará, 232 km off the coast of São Paulo State, with sampling confirming the presence of oil of approximately 31º API, in reservoirs 5,750 meters deep.
- The confirmation of good quality oil in the area referred to as Tupi Northeast, in the Santos Basin Pre-Salt.
Finally, I believe at its current trading price Petrobras is undervalued by the market as it has an earnings yield of 13%, which is more than five times the current risk free rate. When allowing for the accepted additional risk premium for investing in Brazil of 2% combined with the generally accepted equity risk premium of 4% on top of the risk free rate of return of 2%, Petrobras would be fairly valued with an earnings yield of around 8%. However, at 13% the company is still undervalued by the market at its current trading price.
For all of these reasons I believe that at this time Petrobras represents a solid investment opportunity for risk tolerant investors. Despite some of its competitors having stronger performance indicators, I believe that Petrobras' is cheap based on both its forward valuation and earnings yield and that its stock price has already been punished by investors for its poor 2011 performance. I also believe that despite the slowdown in Chinese economy, oil prices will continue to rise through 2012 and that Petrobras is well positioned to capitalize on any increase in the oil price.