Since the Argentine government stated that it would proceed with expropriating control of the country's largest oil product, YPF S.A. (YPF) from its Spanish parent Repsol YPF S.A. (REPYY.PK), there have been howls of outrage and condemnation throughout the media in the U.S, Europe and the UK. It has seen many journalists, political and economic commentators, business representatives and government officials portray it as a fundamental attack on free market capitalism and the global economic system by a misguided and ideologically corrupt government. This has seen a multitude of economic and political threats made against Argentina across the economic and political spectrum.
However, despite these protests and threats, the Argentine government has proceeded with the nationalization and last week, after overwhelming approval from the Argentine senate and congress, President Cristina Fernández de Kirchner enacted the YPF nationalization and oil and gas self-sufficiency law. With this process now officially complete there has yet to be any concrete action taken against Argentina and furthermore, the government has softened its rhetoric as it seeks the necessary foreign investment to access the country's vast energy deposits. All of which indicates that the rationale behind the expropriation was one of economic expediency rather than ideology.
With the expropriation of YPF now complete, the company's shares are split between the Argentine government, holding 26.03%; the Eskenazy families Petersen group, 25.46%; the Argentine provincial governments, holding between them 24.99%; and Repsol (REPYY.PK), with 6.43%. The remaining 17% is distributed between smaller institutional and non-institutional shareholders and will continue trading on the Buenos Aires and New York stock exchanges. A key reason driving the government's nationalization of YPF was the need to increase oil and gas production to address growing energy trade deficit.
As a result, during and after the process of nationalizing YPF, the Argentine government has been approaching foreign oil majors seeking investment in YPF so as to access the vast shale oil reserves identified in the Vaca Muerta (Dead Cow) region in southern Argentina. It is estimated that there are oil reserves of over 23 billion barrels in this region, but because of its geological structure and geographical location it will require substantial investment to access those reserves. The Argentine government has estimated the required annual investment to be at least $25 billion over the next ten years, which it is unable to fund itself, especially because it is unable to access international credit markets since its 2002 credit default.
This, as discussed in my article "What Does Argentina's Impending Expropriation of YPF Tell us?," requires Argentina to seek investment from foreign oil companies that are already operating in Argentina or are willing to do so. Recently Argentine Planning Minister Julio De Vido approached Brazil's government controlled oil company Petrobras (PBR), which operates an subsidiary in Argentina Petrobras Argentina SA (PZE), regarding investment in YPF. Planning Ministry officials have also met executives from ConocoPhillips (COP) to discuss potential investments and outlined plans to contact other foreign oil majors, including Exxon (XOM) and Argentina's fourth largest oil producer Chevron (CVX), to seek further investment.
The Chinese have also expressed interest in investing in the Argentine oil industry and possibly even YPF. During the lead-up to the nationalization of YPF, CNOOC (CEO) expressed an interest in making a takeover offer for the company, just as Sinopec (SHI), which already has substantial investments in Argentina, was reputedly finalizing a takeover offer for YPF. With all of this activity, large oil reserves and a rising oil price that is now well over $100 a barrel, it is inevitable that the Argentine government will find investors to allow it to realize its goal of returning Argentina to being a net energy exporter. This will be despite the protests and outrage voiced as a result of its expropriation of Repsol's controlling interest in YPF.
Against this background, Repsol has threatened legal action against Argentina, as well as stating that it will take legal action against any company that invests in YPF. The company has also publicly stated that it is seeking $10.5 billion in compensation from the Argentine government for the expropriation of almost its entire share of the company. However, at this time it seems unlikely that President de Kirchner will consider compensation anywhere near that amount, with Argentina's deputy economy minister, Axel Kicillof stating; "were not going to pay what they say." However, lately there have been some signs of this attitude softening, possibly as the government seeks to create an environment more conducive to attracting investment in the Argentine oil industry.
Never the less, it is likely the Argentine government will compensate Repsol though I believe it will be for substantially less than the amount sought. At the end of 2011 YPF's financial statement gave the book value of Repsol's 57.43% holding in the company as $5.35 billion. If the Argentine government were considering compensating Repsol based on the book value of the 51% holding that was expropriated, it would constitute an offer of around $4.75 billion.
Spanish officials have heavily criticized Argentina for its expropriation of YPF and threatened a strong response as part of a wide range of economic and political sanctions against Argentina. But to date the only concrete action taken has been Spain decreasing its multimillion dollar imports of Argentine bio-diesel. The only other significant impact of the nationalization has been Standard and Poor's downgrading of Repsol's credit rating to BBB-. This has occurred because YPF accounted for a significant portion of Repsol's production and accordingly the loss of YPF will see a significant impact on its finances and cash flow.
The Spanish government has also commenced lobbying other members of the European Union to take action against Argentina. If the EU were to impose trade sanctions on Argentina it would have a significant effect on the Argentine economy, because the European Union is Argentina's second largest export market after Brazil. In 2011 the EU accepted Argentine exports of $13.8 billion, which is 16% of Argentina's total 2011 exports of $84.3 billion. In effect any sanctions by the EU against Argentina could have a significant impact on Argentina's exports and economy, but I believe that any clear cut tangible action by the EU is highly unlikely.
To date the Spanish Foreign Minister Jose Manuel Garcia-Margallo has stated that his EU counterparts have been sympathetic and supportive of countermeasures against Argentina, especially if they government doesn't fully compensate Repsol for YPF. However, it is unlikely that the EU will take any material action against Argentina, because in order to do so it would be up to the European Commission to decide on the form of that action and they would need to the support of the World Trade Organization (WTO) to implement it. Furthermore, the EU at this time is particularly preoccupied with getting its own house in to order, especially with regard to vexing sovereign debt and domestic economic as well as political issues.
The U.S and Mexico have also heavily criticized Argentina's expropriation of YPF, but yet again neither country is either able to or likely to take concrete action against Argentina. In addition, both are also distracted with their own economic and political problems. Mexico is managing a range of economic, political and social problems of its own that are affecting its security situation, key export markets and energy industry. This includes Mexico being subjected to substantial pressure from Brazil to reduce its volume of auto exports to that country as it seeks to protect its own economy and push ahead with its own economic nationalist agenda.
The U.S has already implemented a series of trade sanctions and measures against Argentina. These measures have included voting against multilateral loans and revoking trade preferences for Argentina, because the country has failed to pay arbitration awards to two U.S. companies. To date these actions appear to have had little effect on Argentina and I believe it is highly unlikely that they will because the country has little to lose in this respect as it is already treated as an international economic pariah since its 2002 debt default. Therefore, it appears that any sanctions undertaken by either Spain or the EU would have any significant effect on Argentina. Furthermore, Argentina has a long history of failing to pay settlements stemming from international trade disputes as well as having more cases pending with the International Center for Settlement of Investment Disputes than any other country. It also still owes members of the Paris Club, an unofficial network of finance officials from 19 of the world's largest economies, $9 billion as a result of the debt default.
I believe that President de Kirchner has pragmatically weighed up the risks and rewards associated with the expropriation of YPF and gambled that other than international disdain, discomfort and strong rebukes, there would be no material consequences for Argentina. It is also important to appreciate that within Argentina itself the decision was particularly popular with the takeover of YPF supported by up to 74% of the population polled. All of which further affirms that President de Kirchner's actions are driven by pragmatic political and economic exigencies, rather than anything more than cursory ideological attachment to Peronism, socialism or nationalism. This can be hard to believe when the strong history of oil nationalism in Latin America is considered, but when the economic considerations are taken into account I believe that it becomes evident.
The economic and political need becomes apparent when it is considered that from 2004 to 2011 Argentina's oil production declined by almost 20%, with YPF accounting for much of this decline. In addition, prior to the Vaca Muerta find the company's proven reserves of oil had also fallen substantially over the past few years, primarily due to a lack of exploration. This lagging production was problematic not only for meeting consumer demand but also for the country's economy because the shortfall in oil production led to a rapid rise in imports affecting the balance of trade for a country that is overwhelmingly reliant upon maintaining a trade surplus. Energy imports in 2011 increased by 100% from the previous year, to $9.4 billion, thus negating a large part of Argentina's trade surplus. For a country that cannot tap international credit markets as and when required it is overly reliant upon a trade surplus to inject foreign capital into the economy and prevent a balance of payments crisis.
However, this drop in production can be directly attributed to domestic oil prices being capped initially at $42 per barrel and now $55 per barrel, thus limiting profitability from domestic consumption. Furthermore, any oil exported at a price in excess of this cap, is punitively taxed at 100% in a global market where oil has been trading at around or over $100 per barrel since March 2011. This further reduces the incentive to invest in exploration and increased production.
None the less, even if the Argentine government were to either substantially increase the cap or remove it to incentivize greater production, energy prices in Argentina would increase substantially. This would have a significant impact on the economy and standard of living in a country where 30% of the population is living under the poverty line. This could have the potential of triggering a popular political backlash, strikes and riots in an electorate already fearful of another economic collapse after 2001. The flip side is, if the government is unable to raise production and move back to an energy trade surplus, further downward pressure is applied on the already plunging Argentine currency and the specter of a balance of payments crisis arises. This would again have flow on effects for the cost of living, creating unpopularity for the incumbent government and potentially creating further political and economic crises.
Therefore, the reasoning behind President Kirchner's decision becomes clearer - nationalize YPF and wear the ire of Repsol, Spain and the international community but ultimately have greater control over energy production, the balance of trade and the economy. While the pressing economic and political needs to proceed down the path of nationalization certainly doesn't justify the government's actions it does explain them. But the next question is where to from here because these actions only further reinforce the boom and bust cycle in which Argentina finds itself trapped. Ultimately Argentina needs to bite the bullet and embark on a program of structural economic reform, but this is not palatable to the majority of the major political parties or an electorate still fearful of another economic crisis. All of which is directly contributing to the ongoing high degree of political risk associated with investing in Argentina.
Ultimately, this will make the degree of investment risk to too high for many investors to accept and accordingly they should avoid investing in Argentina. But for those investors willing to tolerate this risk, opportunity and value certainly abound. They can choose to invest directly through the Buenos Aires stock exchange the Bolsa de Comercio de Buenos Aires (BCBA), through the 18 Argentine companies with American depositary receipts (ADRs) listed on U.S exchanges or through the only Argentine exchange traded fund available, the Global X FTSE Argentina 20 (ARGT).
Even YPF has rebounded by around 20% since hitting a bottom of $12.48 just over 2 weeks ago as uncertainty swirled around the company's future. There may even be further gains in YPF's share price, as its production should lift now that the matter of control has been settled. Even so shareholders not be expect a substantial recovery or that dividend payments will recommence as the government will seek to use the company to further their own political and economic agenda rather than maximize shareholder value.
For those investors willing to accept this risk they will find tremendous potential upside, although they will need to correctly time their entry point and be capable of coping with high levels of political and economic volatility. These investors would also be prudent to thoroughly research the proposed investment, its industry and the economic and political environment before investing. They should also seek to ensure that the risk-reward equation is firmly in their favor, with an adequate risk premium to justify the degree of risk by seeking out companies with a high earnings yield. Currently a number of Argentine ADRs have double digit earnings yields with some exceeding 20%, including Petrobras Argentina, Telecom Argentina (TEO), Banco Macro (BMA), and Grupo Financiero Galicia (GGAL).
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.