Overview of the situation
Petrobras (NYSE:PBR) is a Brazil-based integrated oil and gas company with majority of its operations in two segments - Exploration and Production; Refining, Transportation and Marketing. Over the recent years the business model of Petrobras was pretty simple - borrow to pursue capex and maintain oil production volumes in expensive offshore locations, and then use oil revenues to subsidize refining operations. With regards to refining, the Brazilian government forces to import fuel products and sell those at below international prices. Recently, Petrobras got some relief as the government did not yet adjust domestic fuel prices in line with the depressed international levels.
At the moment Petrobras is getting squeezed on all sides - oil price is down, Brazilian Real depreciated against the US dollar by 20%, corruption scandal is in full swing and at the same time Petrobras is entering the main stage of its huge capex program.
Offshore E&P is the sector where you want to be the least at this stage, given its high breakeven oil price. But Petrobras has 87% of its oil production coming from deep- and ultra-deepwater offshore areas with over $200bn capex program approved to grow these areas further. Its problems are exacerbated by one of the lowest efficiency levels in the energy sector with regular cost overruns, corruption cases and massive and growing debt pile. All this makes the company among the worst positioned oil majors with regards to the low oil price environment. I would like to show why there remains very little value in the common equity of Petrobras and restructuring, in combination with government bailout, may be the only way forward.
Complete lack of credibility from the management and corruption
Lose-lose scenario with the corruption charges and excessive contracts' price:
The highly publicized corruption scandal related to construction contracting had initial estimates pointing to the embezzlement of BRL 10bn, however more recent estimates suggest it may have surpassed BRL 25bn mark. The firm made announcement that it had blocked payments of 23 contractors, as they are involved in the investigation of the scandal being led by Brazilian prosecutors. Amongst the contractors are a number of big names, including Odebrecht Construction, Skanska AB, Techint, Andrade Gutierrez, Camargo Correa and Galvao Engenharia. A cartel of construction companies allegedly colluded and artificially raised the price of public contracts assigned to Petrobras and used bribes to win the said contracts.
- The suspension of payments means these construction companies will not be allowed to do business with Petrobras and bid on the new contracts. As a result Petrobras has a limited number of construction firms it can work with to complete its multibillion spending plan, which in turn would drive the construction costs even higher.
- Brazil has never sent anyone to jail for a capital markets crime in its entire history, which means the minor management shakedown is the most likely outcome of the current investigations.
- As a result the management of the company with the same poor ethics is there to stay as well as the high contracting costs.
On top of the currently developing corruption story, Petrobras has a long history in this area:
- In March a Petrobras former refining head, Paulo Roberto Costa, was arrested for taking $400 million from the company to make political donations.
- There's an investigation into Petrobras' $1.25 billion purchase of an oil refinery in Texas in 2006. The deal was a disaster and led to a $500 million write down.
- Authorities in Brazil, the Netherlands, and the US are looking into $100 million in alleged kickbacks Petrobras gave to SBM Offshore NV, a Dutch vessel making company.
Guidance from management has no value. The guidance provided by the Petrobras management makes no sense on a regular basis, where the results are always over-optimistic with failure to come even close to the guided projections. This was noted by the multiple analysts covering the stock.
Petrobras was persistently giving 7.5% growth guidance for 2014 even when this target assumed the unbelievable 7% MoM growth for December. Obviously, such growth did not materialize with the December production showing 4.8%, where the 2014 total domestic production came at 5.3% vs. the 7.5% target.
The company has another ambitious target for 2015 production growth at 8%, where I would take half of this figure as the optimistic scenario, particularly given its extremely poor track record of delivering growth, managerial issues and disruptions related to the ongoing investigations. To confirm this ROIC stands at 3.7% and return on assets at 3.4% for 2013FY.
Petrobras's P-36 platform sinking in 2010 due to cutting corners on safety:
There is plenty of promises from the management in terms of the upcoming growth of production that is intended to cover debt interest payments (we looked into their credibility earlier). But do you know much revenue growth Petrobras generated over the past 3 years on the back of the $114bn capex during that period?....None!
Source: Petrobras data
Such staggering growth coupled with the projected 2.7% return on asset for 2014 shows that company is just chewing cash with complete lack of results and makes me highly skeptical about its ability to deliver any meaningful growth in the future.
Domestic fuel subsidies
Brazilian government's 50.2% shareholding and total control of the company's destiny is another major problem for Petrobras. The company derives 40% of its revenues from diesel and gasoline, where prices are set by the government. Under the unofficial agreement, Petrobras is forced to import fuel (priced in dollars) and sell it domestically in local currency. Given the current political and economic situation, the government's interest is to keep fuel prices low to solve the fiscal and inflationary headwinds. As a result Petrobras is forced to subsidize low prices for consumers and had a whooping loss of BRL 18.4bn from those activities just for 2013 with the BRL 63bn of losses accumulated since 2011!
Some relief was given to the company with the announced raise for subsidized refinery gate prices for gasoline by 3% and diesel by 5% in November 2014. As a result the company should at least temporarily eliminate its losses in the refining operations.
But the beneficial price mismatch would almost certainly not hold for long:
- RNEST refinery is finally coming on stream and will reduce diesel imports by half, which ironically hurts Petrobras since it caps the benefit from domestic diesel prices being 42% above international.
- Government discusses the return of the CIDE tax on fuels, which would lead to lower price at the refinery. There are no clear rules about the fuel price policy, but the stated goal is fuel price parity and inflationary pressure would most certainly lead to a large domestic fuel price reduction, and hence closing the existing large gap to international prices.
The economics of Petrobras are not functional at the prevailing oil price
Petrobras had a lifting cost including production taxes of $32.8 per barrel for the 1st half of 2015 but the pre-salt areas, which account for 30% of existing output and where most of the upcoming capex is intended - have $45 lifting cost according to the company data.
For some reason most analysts and observers tends to miss a huge point - there is capex per each barrel of oil in addition to the lifting costs! This capex also needs to be accounted for to get the full picture of economics behind the output. Hahn and Passell in their 2010 research paper estimated the capex per barrel of offshore oil at $17-20 (Barclays estimated industry-wide cost of $20-22 per barrel). Even assuming those costs declined by 25% over the past 4 years, given the "poor" contracting practices and low efficiency of Petrobras with their deep- and ultra- deepwater E&P projects - $15 of capex per barrel would be a very optimistic estimate. This derives us a pre-salt breakeven cost per barrel at $60 in a good case scenario.
But the realized oil selling price for Petrobras is significantly below the benchmark Brent price. During the 1st half of 2014 the average Brent price was at $108.9 per bbl vs. the domestic selling price at $98.5 and international at $86.0 per barrel. In previous years the picture was similar and this implies the price realized by Petrobras has close to $10 discount relative to Brent benchmark.
The bottom line is that at the current Brent price Petrobras would be selling its oil for $40-50 when the breakeven price for its pre-salt projects is $60. Brent needs to go above $75 to provide some commercial viability for the planned $200bn capex program since at that level of Brent the selling price for Petrobras's crude would be around $65-68. This compares to the breakeven price of at least $60 per barrel but additionally we need to account for the company's cost of capital which is at least 10% or $6 per barrel. As a result Brent at $75 would merely cover the company's cost of capital and permit the servicing of debt in light the optimistic cost projections.
Announced Capex and its inefficiency
The official budget for the five-year investment plan stands at the sky-high $207 billion, where $176 billion is already approved and mostly contracted with suppliers. This translates into $42bn a year annual capex over the next 5 years. Such spending is in stark contrast with the company's EBITDA.
Cash shortfall for 2015
A pile of debt needs to be raised over 2015 and onwards to finance the approved capex program, where my simple cash flow estimates imply a funding gap of $28bn only for 2015 on the back of $55 Brent, 4% production growth and assuming refining remains staying profitable on the back of the government support.
Source: author's estimates, Petrobras data
There are plenty of capex related issues that make the funding gap even worse:
- Hardly any cuts can be done to capex in 2015 because of the nature of the contracts and high cancellation charges
- Petrobras's capex is linked to USD since majority of its work is contracted to international companies and most of the revenue is linked to BRL, which creates further trouble on the back of 20% Brazilian real devaluation over the last 6 months.
- Even assuming the $31 billion cut in the five-year capex plan, the annual reduction would be only $6 billion a year.
Even if Petrobras somehow shelters its cash shortfall for 2015, this does not change the underlying fundamentals because the company would be spending $60-65 dollars per barrel via borrowing to make the revenue of $40-50 per barrel, given the prevailing oil price. At the same time viewing Petrobras as a call option on the oil price with $75 strike does not offer much value because of the fairly short time to expiration.
Further sources of liquidity are limited for Petrobras:
- Assuming that the government will not decide to sell E&P assets in Brazil (either Campos or Santos), there are no other assets that have significant value and can be sold in the short term to raise cash. Outside of Brazil, E&P assets in the Gulf of Mexico can be a candidate but Petrobras already tried unsuccessfully selling those before.
- Petrobras is looking into the possibility of securitizing receivables. The idea would be to sell BRL 7.3 billion (or $2.8bn) worth of receivables that Petrobras holds from Eletrobras, due to the fuel supply to thermal plants. This may offer a bit of extra breathing space but not solving the root cause of the problem.
Growing debt pile
What Petrobras is essentially doing at the moment is borrowing more and more to invest into the deep- and ultra-deepwater projects with negative IRR.
Debt Maturity schedule in BRL:
Source: JPMorgan, Petrobras data
The company has around $126 billion debt load, the largest among the publicly-traded oil companies and more than double what it was at the start of 2011. There is plenty of debt maturing in 2015-2018, with the lowest maturity in 2015 being at the still heavy $19.3bn. Over half of the debt has a floating rate where the current weighted average interest comes to 4.5% with the projected cost of $5.9bn to service this debt in 2015.
Petrobras needs a very strong balance sheet and good access to financial markets to handle such load at the current oil price and obviously none of those are present at the moment. It has around a year to improve its cash flow position and net debt/EBITDA to access international capital markets at reasonable cost - my estimate for net debt/EBITDA for 2015 is at 5.5-6x (and growing further), where 5 year USD senior bonds currently trade close to 7.2% yield. Those numbers are too high to handle for the company.
- On top of the above mentioned debt, Petrobras has $13bn pension and medical benefits liability and $7bn de-commissioning liability, which should not be counted out.
- Additionally there are 5.6bn of outstanding preferred shares, which rank more senior in the capital structure than common and amount to $20bn.
- 70% of the company's debt is dollar denominated, which makes the debt servicing costs a lot higher following the recent close to 20% BRL's depreciation against the dollar. At the same time most of the company's revenues are denominated in BRL, which leads to significant worsening in the debt servicing capacity.
USD/BRL exchange rate:
Source: Thompson Reuters
Realistically, I don't see who would be willing to lend to Petrobras at the rate of interest that would make the debt servicing cost prudent for the company. The jump in 5 year CDSs for USD denominated debt to 490bps may be a good reflection of the poor state of affairs at the company and its inability to borrow at any reasonable rate in the open market.
Petrobras CDS for 5 year USD Senior unsecured debt:
The main problem for Petrobras is if oil price does not improve by over 50% - the whole upcoming capex program would simply equal to cash. Brazilian government may appear to be the only candidate to finance the firm's debt given the current oil price and may need to fully nationalize the company to avoid its default. With the net debt/EBITDA ratio moving to the 5-6x territory in 2015 and strongly negative free cash flow in the foreseeable future, I do not see how PBR shares would avoid further collapse.
Value of PBR stock... or lack of it
The company may appear attractive only based on the proven reserves valuation, but because the cost of getting those barrels to the market is so high and efficiency is poor - this would not be the optimal choice to value the company in its current state. Having billions of oil reserves in the ultra deepwater locations where extraction costs are higher than price of oil does not help much and Brazilian government owns half of Petrobras and unwilling to execute a fire sale of those reserves. Additionally, this approach has very limited applicability for Petrobras with capex funding and debt servicing being of primary concern at this stage.
On the back of the $60 breakeven price of pre-salt oilfields and given the required rate of return to service interest payments, Petrobras can only be saved by Brent going back above $75 because there is $7-10 discount for the realized oil selling price vs. Brent. With the price below that level my valuation for Petrobras is quite simple - the stock would continue its bleeding as debt pile mounts and the company burns through its cash over the next 12-24 months. No catalyst is even required since Petrobras is shooting itself in the foot by pursuing its offshore capex program. Continued chaos in the company would drive CDS prices and yields higher fully shutting Petrobras out of the capital markets and driving its stock down.
The next 6-18 months potential scenarios are:
1) Government supports the refinancing of debt maturing in 2015-16 and the company continues its cash burn - but because the economics of the production is so poor, the value of common equity would get eroded further as the company gradually burns through more cash.
2) Petrobras borrows at 7% or higher in the open market initially, and runs out of cash in 2016 because the cost of debt would go even higher on the back of further massive cash shortfall and no one to lend.
3) Government allows further decline of shares so that it can exercise its control and nationalize the company for cheap, which may be a very comfortable scenario for Brazil as a country. Simply reducing domestic fuel prices may be enough to kill Petrobras balance sheet.
Assume binomial outcome with 30% probability of oil being at $75 or above and 70% probability - holding below that level over the next 2 years. Also assume that in the good case scenario the price would reach the analyst consensus target at $11.3 per share, or alternatively in the low case scenario Petrobras would go to restructuring with common shareholders being wiped out, particularly in light of the 5.6bn of outstanding preferred shares worth $20bn. This probability-based valuation suggests $3.39 per share price target and implies 48% downside.
I would like to underline that at the moment most of the brokers are modelling Petrobras's stock based on $75-85 price per barrel in the future, likely because of the investment banking relations with the firm and not feeling comfortable to announce that Petrobras is heading towards bankruptcy/restructuring. The reality is that oil price stands over $10 below their projected values even for the 2 year forward futures.
Risks to the thesis: unlikely case of government keeping the domestic gasoline and diesel prices far above the international levels, oil price increasing above $75 and holding there.
Petrobras needs oil price above $75 simply to have a chance of turning into the sustainable operation and keep up with the debt servicing costs and committed capex. Investors may try speculating that oil price may rebound in such and such period but at the moment everyone needs to accept the reality of Dec 2015 Brent trading at $58 and Dec 2016 at $64 and judge the perspectives of the hugely indebted Petrobras with very high breakeven oil price from there. The company is unlikely to go belly-up completely but the potential restructuring with the involvement of Brazilian government may leave very little for the common shareholders.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.