On April 16th, the Government of Argentina moved to nationalize a portion of YPF Sociedad Annima (YPF), the country's largest oil and gas company. Some form of nationalization has been expected for some months as the government has stepped up its criticism of YPF and its majority shareholder Repsol over lack of investment, but a full nationalization was not expected.
The situation regarding investment is more somewhat more complex than Argentina has made it out to be, as is often the case. YPF has in fact been investing heavily in its business. From 2005 to 2011, the company reinvested 1.57x the rate of depreciation. In 2010 and 2011, the rate was 1.66x and 2.25x, respectively, showing investment has been increasing. Even at the height of the recession in 2009, the company reinvested 1.16x the rate of depreciation.
Digging a little deeper, we can analyze the percentage of net income reinvested in the business. Most businesses need to reinvest above the level of depreciation to keep a business healthy and given the unique change in oil prices over the period this would be especially true of an oil and gas company. On this score, YPF's performance is more spotty. While the overall reinvestment rate of 54% over the period is adequate, a number of years individually were quite low. Some of this can be explained by the recession which created a great deal of uncertainty, but YPF is also helped by a major capital plan for 2011 with investment well in excess of net income.
Overall YPF was probably investing as much as should be expected of a company, especially in 2010 and 2011. On the other hand it is true that even with this level of spending, production had been in decline. In 2011 alone, production declined 8.3% from prior year. However, based on YPF's reinvestment rate, it is not clear that decline was due to starving the business of capital.
The question then is what drove the nationalization, especially in light of the recent ramp up in investment which should have satisfied the government. It is possible that the nationalization was driven more by financing cash flows rather than investing. Since 2005, YPF has made ARS 33.8 billion of dividend distributions or roughly at the level of net income over the period. However, in recent years, the dividend has been supported mostly by increased borrowing since a large portion of net income has been reinvested in the business .
The majority of borrowing has in all likelihood taken place through the domestic Argentinean banking sector. Since a large portion of the dividends were distributed to foreign stakeholders that has implied a net demand for foreign currency - in the last year alone, around $750 million worth based on Repsol's (OTCQX:REPYY) roughly 60% stake. While the amount may not seem large, in relationship to the country's dwindling foreign exchange reserves of some $47 billion (assuming this number can be trusted), the figure is not trivial. More important was likely the signal that YPF was sending by distributing dividends out of the country using proceeds from borrowings from the domestic banking sector, itself probably starved of dollar liquidity and reliant on central bank reserves.
The important lesson in my view is that investors in companies such as YPF are not free to run the company as they choose - either operationally or financially. The economic decision to not reinvest a large portion of cash flows was likely the right one in Argentina because of price controls. There may not have been enough projects that justified investment at the prices set by government. The situation reversed itself somewhat in recent years due to programs such as Gas Plus and Petroleum Plus which allowed for some increased realizations and also likely due to government pressure. Still, it is clear that Repsol was ultimately not all free to dividend out net income let alone depreciation. When businesses are growing or stable, it is easy to be friendly to foreign shareholders. But, when trying to extract the most value as possible out of a declining asset, foreign and even domestic shareholders have to watch out for government intervention. In my view, this fact should inform decision making for foreign investors based on the life cycle of a firm, especially in emerging markets (EEM).