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By Allen Good

Petrobras (NYSE:PBR) is in a tough spot. Refining losses and production guidance misses have reignited long-standing investor concerns about government influence, investment outside exploration and production, and the company's ability to execute its ambitious growth plans. We believe the concerns about the production guidance miss may be overly focused on the short term, though long-term execution risk remains. Additionally, the refining losses will be a headwind over the next few years. Furthermore, we believe shifting offshore dynamics relating to new Brazilian oil and gas laws have weakened Petrobras' ability to benefit from its world-class discoveries.

2012 Production Growth Is Set to Rebound, but Long-Term Risks Remain
Last year's domestic oil production of 2,022 thousand barrels per day missed guidance of 2,100 mb/d (plus or minus 2.5%). However, the miss was not resource-related (geological) but operational in nature, as equipment issues resulted in greater downtime for repairs in the Campos Basin. Planned and unplanned maintenance downtime resulted in reduced production of 67 mb/d (33 mb/d unplanned); production otherwise would have come in at the lower end of guidance. Production was also hurt by a delay in new wells because of late arrival of rigs from international shipyards. This is more concerning to us, considering future production targets and required rigs.

While Petrobras has not provided production guidance for 2012, probably hoping to avoid a replay of 2011, volumes should rebound. The firm anticipates that the ramp-up of previously installed floating production, storage, and offloading units should add about 211 mb/d to full-year production volumes. Meanwhile, plans call for the installation of 414 mb/d of oil production capacity additions in the second half of the year, contributing to 2012 volumes while setting up for a strong 2013. Additionally, fourth-quarter production already marked signs of recovery, posting the highest production volumes of the year as negative production impacts from stoppages on Marlim fell from third-quarter levels (-24 mb/d from -79 mb/d). However, demonstrating what a poor year it was, 2011's production high in December of 2,084 mb/d was below the 2,122 mb/d in December 2010.

As we saw in 2011, production targets are just that--targets. The miss in the first year of a decade-long plan does not inspire confidence, but we hesitate to emphasize one year. At the same time, delays in rig deliveries, which partially contributed to the miss, raise the issue of execution. Petrobras plans to not only double production over the next decade, but also enable the creation of an oil and gas service industry in Brazil. Local content requirements driving such desires could lead to excessive cost inflation as well as project delays. While the recent rig tender with Sete Brasil and Ocean Rig secures attractive, if not even below market, day rates for Petrobras, we think it carries greater on-time delivery risk as the rigs will be built in shipyards that do not yet exist, potentially offsetting the benefit derived from the lower rates. We risk our production forecast to account for such delays.

We Expect More Refining Losses Even With Improving Asset Quality
Perhaps the most glaring issue of 2011 was the refining segment's accelerating losses. The fourth quarter registered the largest losses despite product price increases (gasoline 10%, diesel 2%) because of higher-cost imports due in part to depreciating currency. For the full year, U.S. price realizations in reais (proxy for import prices) increased 29% compared with a rise in Brazilian price realizations of 6%. At the same time, demand increases, particularly in gasoline, outpaced supply growth, forcing Petrobras to rely on higher-cost imports to supply the domestic market. While the currency depreciation prompted the sharp acceleration of losses in the fourth quarter, the underlying drivers are likely to remain in place for the next couple of years as the gap between domestic demand and production endures. Additional refining capacity will not be added until 2013, when the first stage of the 230,000 mb/d Abreu e Lima refinery is brought on line. In 2014, capacity will increase with the addition of the second phase in January and the startup of the 165,000 mb/d first phase of the Comperj refinery. Even with these additions, Petrobras estimates a supply deficit of almost 400 mb/d in 2015 in its most recent capital plan. As a result, assuming current conditions hold, we expect Petrobras will record refining losses through 2014 and potentially beyond.

As a result of its downstream positioning, Petrobras is losing its leverage to higher oil prices despite oil constituting 83% of total production. Refining losses during the fourth quarter outweighed the gains of the exploration and production segment, leaving earnings before interest, taxes, depreciation, and amortization slightly lower from the previous year despite a 26% rise in Brent prices. Full-year results tell a similar story, with total EBITDA rising an anemic 5% against a 40% rise in Brent prices. The fourth quarter merely accentuated a trend that has been in effect since 2009. Theoretically, the integrated model is operating as it should, with upstream gains/losses offsetting downstream losses/gains. In Petrobras' case, it has worked too well, with refining losses swamping upstream gains. Additionally, its current refining configuration does not allow Petrobras to capture the crude differentials with its downstream, another benefit of integration. Instead it is exporting lower-quality crude (at a discount) and importing higher-value refined product to sell at a loss. Granted, this balance will tip in the coming years as production and upstream earnings grow while high-complexity refining capacity is added. In the short term, though, we expect pain to continue with increases in production potentially being offset by refined product demand growth calling for greater imports. Meanwhile, currency depreciation similar to that of the fourth quarter could add to losses.

In light of fourth-quarter results, it's difficult to argue that Petrobras needs to increase investment in refining capacity to reduce reliance on imports. While ceding market share and allowing foreign suppliers of refined products in the Brazilian market would make sense, it is unlikely to happen. As a result, Petrobras will maintain its near 100% market share and need to keep pace with a rapidly growing economy. However, while the increased refining capacity of 1,460 mb/d by the end of the decade should nearly eliminate the need for imports, little is likely to change the pricing dynamics of the Brazilian refined product market. We expect Petrobras to maintain its policy of not passing international price volatility on to the Brazilian market. As a result, in times of volatility Petrobras is likely to see downstream losses.

The additional refining capacity should also better align the upstream and downstream segments by increasing processing of heavier discount crude from offshore Brazil and enabling greater capture of those discounts.

Meanwhile, the higher-quality refineries should operate at lower costs and deliver wider margins thanks to improved yields than Petrobras' older facilities. Ultimately, though, we think the high cost of the refineries is likely to result in returns below the cost of capital. We think this is particularly true of the first refinery to be built, Abreu e Lima, where estimates imply a lofty cost of $65,000 per capacity barrel. However, costs should come down with subsequent refineries Comperj (330 mb/d including petrochemical production) and Premium I (600 mb/d) and II (300 mb/d). A recently announced delayed startup of the first stage of the Comperj refinery will probably increase costs, though.

Regulatory Changes and Non-E&P Investment Will Weigh on Long-Term Returns
In addition to the concerns regarding production growth and refining losses, we see two significant factors that will affect Petrobras' long-term performance. First, Petrobras is liable to match potentially economically unattractive future presalt bids as part of the government mandate that it be operator in all new presalt licenses. Second, Petrobras plans significant investment in strategic projects that carry lower returns.

The presalt oil discoveries prompted the Brazilian government to change its existing oil and gas laws. Two new provisions will have the most impact for Petrobras. First, Brazil will move from a concessionary regime to requiring production-sharing contracts for future presalt exploration licenses. Contracts will be awarded to companies that submit bids with the highest government share of profit oil. This will result in a higher entry cost for Petrobras and any other national or international oil company interested in unlicensed presalt exploration blocks. Second, Petrobras will be installed as a 30% operator in all these licenses, requiring it to match the terms of any outside bidder for its interest. This provision could prove especially costly for Petrobras if a national oil company that regards returns as a secondary concern submits an especially aggressive bid. The requirement to act as operator also threatens to stretch Petrobras too thin as it looks to develop its more attractive fields. The one saving grace could be that as operator, Petrobras can control the development timelines, though it remains to be seen what final contract terms will hold.

Perhaps the most discussed concern regarding Petrobras focuses on the firm's annually updated five-year investment plan. We tend to agree this should be a major point of consternation for any Petrobras investor. With its most recent investment plan for 2011-15, Petrobras sought to address the issue of non-E&P capital spending largely by pushing out planned refinery construction. As a result, E&P spending increased to 57% of the total budget from 53%. However, ultimately the postponed spending will occur. Additionally, the portion of E&P spending is well below levels of the past decade as Petrobras looks to funnel proceeds from capital raises and increased cash flow from offshore production into catching up on its refining capacity deficit. Meanwhile, Petrobras will invest in segments with historically poor returns to serve the growing energy demand in Brazil. Consequently, we think the increasing portion of total capital employed, relative to historical allocations, flowing to lower-return businesses will result in structurally lower companywide returns.

Our fair value estimate implies an enterprise value/EBITDA multiple of 6.5 times our 2012 EBITDA forecast of $42.8 billion. Our 2015 domestic production forecast is based on a 10% haircut to Petrobras' most recent outlook. Also, following fourth-quarter results we forecast losses for the refining segment in 2012, 2013, and 2014, given the gap between domestic and international prices and the likely need for continued imports. We forecast the refining segment will return to profitability 2015 as imports decline and domestic prices fully incorporate recent increases in international oil prices.

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Source: Petrobras's Tantalizing Growth Comes With Baggage