Since my last Ecopetrol (EC) update there have been news stories publicizing an extraordinary event; Colombia's Ecopetrol surpassed Brazil's Petrobras (PBR) by market cap on Tuesday 15th May 2012, to become the largest company in South America. At the time of writing this article, Petrobras had resumed its dominant position with a market cap of $128 billion compared to Ecopetrol's $120 billion. In addition, since that update Ecopetrol's share price has fallen by 10%, with the company now trading at around $58. However, the company has still risen by 31% from the start of 2012, compared to Petrobras which has plunged by 23% during the same period to be trading at around $20. I have been bullish on Ecopetrol for some time and I still believe that it is a solid investment opportunity for investors seeking exposure to Latin America's oil boom. The question for investors is whether Ecopetrol still continues to be a credible investment, which is superior to Petrobras, for those investors seeking exposure to the Latin American oil boom.
In my last update my argument as to why Ecopetrol is a compelling investment opportunity centered on the company's consistently strong financial performance, increasing production and growing sales volumes. All of which was achieved while keeping a firm control on costs. For the first quarter 2012 Ecopetrol reported solid financial results, which in comparison to the same period one year ago saw a 24% rise in revenue, a 26% rise in revenue and 58% increase in the company's cash holdings and production rose 8%. Whereas, for the same period Petrobras reported a 32% fall in revenue, a 16% fall in net income and a 3% rise in production.
Ecopetrol's ongoing strong financial performance has seen the company develop one of the highest profit margins in the industry at 24%, which is superior to Petrobras' 9%, Exxon's (XOM) 8% and Chevron's (CVX) 11%. The company is also successfully converting this profit margin into a solid return on equity of 38%, which is one of the highest in the industry and superior to Petrobras' 12%, Exxon's 25% and Chevron's 23%.
However, as with any company there are risks when investing in Ecopetrol and in its case the key risk is primarily the company's lack of oil reserves, particularly in comparison to other major oil companies. Further to this, the company's exploration and production can be potentially hampered by the twin effects of Colombia's poor internal infrastructure and volatile security environment. Nonetheless, despite these risks, investors have continued to flock to the company pushing it to a new 52 week high of $67.92 on 1st May 2012. For investors seeking exposure to the Latin American oil boom it then becomes necessary to determine whether Ecopetrol at its recent highs still represents a credible investment opportunity, particularly in comparison to Petrobras. Therefore, it is critical to understand Ecopetrol's risks and to determine their materiality, likelihood and impact, particularly in comparison to Petrobras.
A key reason for Ecopetrol's relentless upward march in value is the ongoing strength of the Colombian economy. By the end of 2011 Colombia's GDP had grown by 5.9%, which was the highest in Latin America and the country had a first quarter 2012 GDP growth rate of 5.1%, exceeding expectations. In comparison, since reporting a GDP growth rate of 7.5% in 2010, Brazil's economy has slowed considerably reporting GDP growth of only 2.7% for 2011. It is also predicted that the country's economic growth will slow further in 2012.
This is highlighted by the Brazilian central bank's IBC-Br economic activity index, which is seen as a proxy for gross domestic product, which by the end of March 2012 had contracted by almost 1% since the end of 2011. The strength of Colombia's economy is further indicated by the performance of Colombia's main stock index, the Indice General de la Bolsa de Valores de Colombia (IGBC), which has increased in value by 13% since the end of 2011. In comparison for the same period the Brazilian stock index the BOVESP (^BVSP) has fallen by 10% and the Dow Jones Industrial Average (^DJI) has remained almost unchanged having risen by 1%.
As a result of this vigorous economic growth the Colombian peso has rallied strongly against the U.S. dollar and is up 8% in value so far in 2012. It is likely that the Colombian peso will continue to rise in value through 2012 because of Colombia's ongoing strong economic growth and domestic consumption. This will force the Colombian central bank to keep interest rates high in order to keep a lid on inflation and cool domestic demand, attracting additional foreign capital, further causing the peso to rise. Currently the Colombian central bank has set the national rate at 5.25%, and there is pressure to raise the national rate with fears the economy is becoming overheated. This rally in the Colombian currency makes Ecopetrol's U.S dollar denominated debt cheaper to service reducing interest costs. It has also caused the company's assets to appreciate in value as well as being beneficial for pushing up the value of its dollar denominated American Depositary Receipts (ADRs).
In stark contrast, the Brazilian government has embarked on an economic program aimed at increasing economic growth for an economy that is slowing rapidly. This substantial slowdown in the Brazilian economy can be partly attributed to the government's previous policy of hiking up interest rates to a high of 12.5% in 2011, in an attempt to cool an economy driven by booming commodities demand and domestic consumption. However, it is arguable that the government has moved too quickly and aggressively because these high interest rates have caused domestic consumption to stall and in combination with a slowing Chinese economy and a deepening European financial crisis has almost brought economic growth to a halt. As a result of the slowing economy, lower amounts of foreign capital being injected into the country and a concerted government policy of pushing the value of the Brazilian currency, the Brazilian real has fallen in value by 6% against the U.S. dollar this year.
In reaction to the slowing economy the Brazilian government has moved to lower the official interest rate to stimulate economic growth, with the national rate dropping from its 12 month high of 12.5% to 9%. The depreciating real, while good for Brazilian exporters is bad for stock prices denominated in dollars such as Petrobras' NYSE listed American Depositary Receipts (ADRs). The weaker real has also seen the interest costs associated with the company's $76 billion in dollar-denominated debt become more expensive. Furthermore, if the real were to plunge substantially further it may lead to issues with debt covenants.
Another key contributor to Ecopetrol's success, which has drawn the investors to the company, is that despite owning 88% of the company the Colombian government has taken a hands-off approach to managing the company. This is in stark contrast to the Brazilian government which systematically interferes in the operations of Petrobras and essentially uses the company as a tool for managing economic policy. This has obviously attracted the ire of investors leading to its further price drops.
The Colombian government has also implemented a wide range of economic policies aimed at making the economy more investor friendly in an effort to attract and retain foreign investment. All of which has seen a gradual deregulation of the economy and a more liberalized free-market approach being implemented. This approach has seen foreign direct investment ('FDI') in Colombia rapidly increase and for the first quarter 2012 when compared to the same period last year is up by 30%. The government's liberalized economic policy is illustrated by the country having one of the lowest number of economic protectionist measures in place in Latin America. As measured by Global Trade Alerts Colombia has seven protectionist measures compared to Brazil's 88.
The Colombian government has also taken the view that private shareholders in the company should be the first to benefit from its ongoing successes. Therefore, despite the Colombian finance ministry accounting for a significant portion of Ecopetrol dividends in their budget, the government has asked Ecopetrol to delay paying the government dividend until 2013 and give preference to private shareholders. The government has taken this approach as a means of giving the company a boost in short-term capital and also helping to stem inflation caused by the rising value of the Colombian peso.
The Colombian government's liberalized economic management and hands-off approach to managing Ecopetrol is in distinct contrast to the Brazilian government's hands-on management approach with Petrobras. It is this approach which has seen the company's board implement policies that have contributed to destroying value rather than enhancing it. Furthermore, the Brazilian government has imposed demands on Petrobras to use locally produced goods and services in preference to imports for the exploration and production of oil. All of which, has seen Petrobras subjected to constant government interference leading to a loss of operational flexibility, rising costs and flattening production. The government intervention also contributes to Petrobras being unable to pass on higher oil prices to consumers in Brazil primarily due to the government's ongoing control of gasoline prices. This includes at this time the government's refusal to raise gasoline prices because of its policy of promoting domestic economic activity.
Unlike Brazil, the Colombian government sets gasoline prices in accordance with the global oil price, allowing Ecopetrol to still benefit from the rising global oil prices even for oil production that is directed to domestic consumption. The Colombian government has established a taxation regime and price setting formula that sets gasoline prices at a higher level than many other countries as a means of retaining greater oil production for the lucrative export. At this time gasoline in Colombia is around $5 per gallon, compared to a U.S average of $3.80 and Venezuela's 3 cents per gallon.
It is clear that Ecopetrol is well positioned to profit from the ongoing and spectacular growth of the Colombian economy, but there are a number of risks that may affect its ability to hit new highs and continue to deliver investor value. Firstly the company only has proven reserves of 1.8 billion barrels of oil compared to Petrobras' 15 billion or Chevron's 11 billion. This lack of reserves becomes an even greater concern when it is considered by many analysts that Colombia's oil reserves are approaching a natural ceiling. However, I don't believe that Colombia is approaching a natural ceiling, firstly because only 30% of the country has been explored for oil, primarily due to limitations created by the volatile security situation and poor transport infrastructure. Secondly during 2011, Colombia's provable oil reserves grew by 10% to 2.3 billion barrels and thirdly since the start of 2012 there have been a series of oil discoveries in Colombia by Ecopetrol and other companies including Gran Tierra Energy (GTE) and Apco Oil and Gas (APAGF).
Ecopetrol has also embarked on an aggressive exploration program in order to address this lack of provable reserves having acquired 62 million acres of land for exploration. The company has also increased its exploration budget for 2012 by 8% to $1.4 billion, which makes up 17% of the company's capital expenditure. Based on this ongoing exploration program, Ecopetrol over the next eight years has, based on previous exploration success rates, projected an increase its reserves by 224% to 5.8 billion barrels. This exploration program has also seen for 2012 42 exploratory wells focused on near field exploration in known oil fields. It also seems likely that Ecopetrol will experience further success in its exploration program with a technical exploratory success rate of 48%. The company has discovered oil in 2012 announcing the discovery of hydrocarbons in the Tisquirama Este-1 exploratory well, located in the municipality of San Martin, Cesar. This adds to the nine successful exploratory wells drilled in 2011.
The next risk facing Ecopetrol is whether the current level of capital expenditure is sustainable. The company currently generates sufficient cash internally to cover its planned capex for 2012. By the end of 2011 internal cash available for capex expenditure had risen by a healthy 50%. Ecopetrol's profitability should also grow as a result of the capex program, because in addition to funding the growing exploration program, capex is also being used to increase production of higher margin premium quality products, as well increase efficiency and transportation capacity. This is to be achieved by firstly completing the upgrades of the Cartagena and Barrancabermeja refineries increasing the capability to utilize more low cost heavy crude oil in the production of high value add products such as gasoline and LPG. Secondly oil transportation capacity is to be lifted to 250,000 barrels daily through improving existing oil pipelines and the construction of a new pipeline.
The other major risk that has the capability to significantly impact on production, transportation and costs is the Colombian security situation, which is obviously a risk that is not faced by Petrobras. There are a multitude of armed groups operating in Colombia from organized criminal gangs, neo-paramilitary groups and the two main left-wing insurgent groups the Fuerzas Armadas Revolucionarias de Colombia ('FARC') and the Ejército de Liberación Nacional ('ELN'). Both the FARC and ELN have a strong presence in the oil rich departments of Cauca, Antioquia, Meta, Caqueta, Putumayo and Cesar.
FARC have been actively involved in attacks on Colombia's oil pipelines and in 2011 were blamed for 84 pipeline attacks. The increasing volume of attacks on Colombian oil pipelines can be primarily attributed to firstly the vulnerability of the oil pipelines as they run through remote territory which is difficult to secure and in which both the FARC and ELN operate. Secondly, in 2011 the Colombian government changed how oil and gas royalties are managed and distributed. In the past royalties were paid to local government officials and mayors in the regions where the oil is being pumped. However, in June 2011 Colombian Congress approved the implementation of a sovereign wealth plan and an agreement on how to best distribute the royalties.
This sees all royalties collected by the central government and then distributed according to the agreement. Of the royalties collected 30% are retained in a sovereign wealth fund held outside of Colombia, denominated in dollars. This was established as a means of reducing the impact of oil and gas earnings on the Colombian peso. From the remaining royalties only 25% are then distributed to local and regional governments in the departments where the oil and gas fields are operating, with the remainder being allocated to other budgetary requirements. These changes have been initiated as a means reducing corruption, increasing accountability and ensuring the greatest social and economic benefit from the royalties.
All of which has motivated these armed groups to switch from kidnapping mayors and local government officials for ransom, to directly attacking the pipelines as a means of extorting money from the oil companies operating in Colombia. It has also seen the kidnapping of oil workers and attacks on well-heads as a means of increasing the pressure to pay protection money. This is a critical risk for Ecopetrol, because Colombia's poor roads and lack of rail infrastructure, makes oil pipelines the only means of transporting oil from the inland oil fields to coastal ports. However, unlike smaller oil companies operating in Colombia such as Gran Tierra Energy, Ecopetrol's production is geographically diversified reducing its dependence on single pipelines.
For all of the reasons discussed it is clear that investing in Ecopetrol is not risk free, although neither is investing in Petrobras. However, the risks are of a very different nature between the two companies. From a valuation perspective, Petrobras appears quite compelling as it is trading at a 20% discount to its book value and has an earnings yield of 13%, indicating that it is deeply undervalued by the market.
Whereas Ecopetrol is trading at a 371% premium to its book value and has an earnings yield of 8%, which would indicate that it is marginally over-valued. But, any investment in Petrobras comes with substantial baggage because of the Brazilian government's ongoing economic intervention, increasingly populist economic and social policies which as seeing the company being used as a source of revenue and as an economic policy tool. Over the short-term as investors have seen this has only resulted in the destruction of company value. All of which is causing the company to fail in converting its profit margin of 12% into a credible return on equity.
The performance and valuation of both companies is representative of the economic effectiveness of their respective government's economic policies, which are diametrically different. At this time these two companies, like the Brazilian and Colombian economies represent very different investment opportunities, with very different value drivers for investors. Petrobras is essentially an investment in the company's massive proven oil reserves and a calculated gamble on its future ability to access and profit from those reserves. But at this time the company's baggage will impede the delivery of value to investors and any recovery in the value of the stock. If oil prices drop any further it is likely that there will be a further drop in the company's share price. Conversely, investing in Ecopetrol is an investment in the proven ability of its management team to continue driving margins and profitability, while taking a calculated risk that the company can maintain cost effective production and increase its oil reserves.