Ecopetrol Has Performed Well, Despite A Difficult 2015

| About: Ecopetrol S.A. (EC)

Summary

Ecopetrol makes it through a difficult year with strong operating cash and barely a dent on its liquid resources.

The company enjoys continuingly robust EBITDA margins, relying on the strength of its refining and midstream segments and a lower Colombian peso.

The balance sheet remains conservatively leveraged.

Ecopetrol is well-positioned to weather the slump in oil and gas prices.

Ecopetrol SA (NYSE:EC), the Colombian oil and gas giant, recently reported its fourth quarter 2015 and full year 2015 financial results. The company's financial performance for 2015 was solid, despite a brutal operating environment for oil and gas companies. Latin American oil and gas giants recently have gotten a bad rap. Each company is very different, operating in different countries and under vastly different political regimes, and their challenges are distinct and have different root causes.

The challenges confronting Brazilian oil and gas giant, Petroleo Brasileiro SA (NYSE:PBR), are well known, and the most noteworthy given the scale of the company and the fact that Petrobras was a darling of "BRIC" enthusiasts only a few months ago. In recent years, the company took up gigantic debts in the aftermath of the euphoria triggered by the discovery of its giant, but challenging and expensive to develop, pre-salt oil fields. The company has also been haunted by corruption allegations associated with its procurement practices. Petrobras has tremendous resources and market depth and is likely to survive the present crisis, but the explosive nature and wide scope of the problems that have been exposed now threaten to topple the Presidency of Dilma Rousseff and expose the former president of Brazil, Luiz Inácio Lula da Silva, to possible criminal charges.

Petroleos de Venezuela SA is also highly indebted, but unlike Petrobras is likely headed to a default within the next 12 months. The Venezuelan giant has been chronically mismanaged since the onset of the Hugo Chávez regime, who fired its top brass and largely replaced management with political cronies with few technical skills to operate a major oil and gas enterprise. The nationalization of key assets of the company's business partners and other oil and gas operators in the country of course did not help the company's long-term situation.

The difficulties of PEMEX, the Mexican oil giant, are altogether different. The challenges facing PEMEX are a combination of financial, legal, and geological factors. The company has struggled to replace production and reserves brought on by the steady decline of its giant shallow-water Cantarell field, and has taken up considerable debts, revamped Mexico's legal framework for oil and gas, and opened up the Mexican oil and gas exploration and production market to foreign partners in an attempt to reverse its declining production. The jury is still out as to the success the company will have in this regard, although the recent collapse in oil prices has certainly not helped in this regard.

Among Latin America's oil and gas giants, Ecopetrol stands out. Ecopetrol is a conservatively run company, and its recent financial performance is satisfactory. And yet, S&P rates the debt of Ecopetrol just a notch above junk. This is in my view not justified. The risk premiums assessed against the company's securities appear excessive. On the basis of balance sheet solidity, financial performance, and operational expertise, Ecopetrol is a Latin America blue chip company, and the likelihood of a default is remote. The market's hesitancy with respect to Ecopetrol appears related more to global concerns about the market for oil and gas, concerns about Petrobras (with which Ecopetrol gets unfairly lumped together), and somewhat exaggerated fears concerning Colombia-related country risks, rather than any identifiable Ecopetrol-specific company weaknesses.

Because Ecopetrol is such a large enterprise, this article will be supplemented by three separate articles. This first article will review the company's consolidated performance. A second article will review the company's reserves and its oil and gas exploration activities. A third article will focus on its large refinery operations, and on the controversy concerning the Reficar refurbishment cost overruns. A fourth article will review the company's midstream and transportation activities, will explore the company's relationship with its largest stockholder, the government of Colombia, and will address the issue of country risk.

Background

Oil and gas giant Ecopetrol is among the top four integrated oil and gas companies in Latin America, and among the top 50 oil and gas companies in the world. It generates over 60% of the oil and gas production in Colombia, where it is headquartered, but also has exploration and production activities in Brazil, Peru, and in the U.S. Gulf of Mexico. Ecopetrol also has substantial refinery operations in Cartagena and Barrancabermeja, Colombia, and has substantial misdstream assets consisting of a near monopoly of the pipeline and multi-product pipeline network in Colombia.

The largest shareholder of Ecopetrol is the government of Colombia. Its board of directors consists of a mix of independent directors and high-ranking members of the country's presidential cabinet and other presidential appointees. Historically, Ecopetrol has generated 10% to 15% of the government's funding, derived in large part from the company's dividend payments. With over 400,000 private shareholders in Colombia and abroad, its common shares are a staple of the country's pension and retirement programs. The company's close relationship with the government of Colombia, and its prominence in the country's affairs, is complex, but offers external investors a stability, a preferential legal framework, and a degree of transparency that perhaps would be lacking in an enterprise of the company's scale that did not enjoy the government's explicit backing and a broad ownership base across the country's middle class.

2015 - A Tough Year for the Oil and Gas Industry Across the Globe

2015 was a brutal year for the oil and gas exploration and production industry across the world. The valuations of oil and gas companies were slashed in tandem with the price for a barrel of oil, with U.S. non-integrated producers, and in particular shale-focused producers, having a particularly difficult time during a year that has left many companies teetering on the edge of bankruptcy. Other Colombia-focused oil producers, such as Pacific Exploration and Production Corp. have also experienced financial distress. The price of oil dropped in fairly consistent fashion throughout the year, jeopardizing high cost and high leverage players.

Ecopetrol shareholders have not been immune to the negative market sentiment pervasive throughout the global oil and gas industry. As can be seen in the graph below, the price of Ecopetrol's common stock tracked in fairly consistent fashion the drop of the price of oil. On March 18, 2016, the common shares were priced at USD$8.75 per share.

EC Chart

Ecopetrol prices its crude production for the export markets in accordance to a basket of crude indices that varies with export destinations. This basket consists primarily of the Brent and Maya indices. As can be seen, these indices experienced considerable pricing deterioration in 2015 relative to a year earlier.

Ecopetrol: Price of Crude References

As can be seen below, the company's effective prices for crude, derivative products, and natural gas suffered during 2015. Ecopetrol's basket for crude showed an annualized price of USD$43.9 per barrel, for a price deterioration of 49.8% compared to the year before. The company's 2015 basket price for products and natural gas likewise decreased 41.9% and 7.3%, respectively, on an interyear basis.

Ecopetrol: Average Sales Price

Needless to say, Ecopetrol's revenues were significantly negatively affected for 2015. As discussed below, although 2015 was far from a bumper year for the company, its financial performance was nonetheless satisfactory and demonstrated a considerable degree of resiliency.

Sound Financial Performance in a Difficult Year

For Ecopetrol, 2015 was a difficult year. The company saw its operating profits slashed 89%, to 1.46 trillion Colombian pesos ("COP") (approx. USD$473.8 million) from 14.45 trillion COP (approx. USD$4.7 billion) the year before. The company saw an overall net loss for the year of 3.1 trillion COP (approx. USD$1 billion).

This loss was however a result of asset impairments, triggered by lower oil and gas prices. In the 4th quarter of 2015, Ecopetrol recognized 6.3 trillion COP (approx. USD$2.05 billion) in impairments. In this regard, it should be noted that Ecopetrol reports under International Financial Reporting Standards (IFRS) as applicable in Colombia, not under U.S. generally accepted accounting principles (GAAP). Under IFRS, impairment losses can be reversed once market conditions turn more favorable, except in the case of goodwill impairments. Under GAAP, these reversals are never permitted. Thus, when the price of oil recovers, Ecopetrol can be expected to report massive paper gains as it reverses some of its prior impairments.

Asset impairments aside, for 2015 the company achieved profitability of 2.4 trillion COP (approx. USD$781 million). EBITDA and margins were strong, and, as discussed below, cash flow was satisfactory. The company achieved EBITDA of 18.09 trillion COP (approx. USD$5.89 billion). EBITDA margins shrank marginally and remained healthy, from 37.2% in 2014 to 34.7% in 2015.

The table below highlights key data from the company's most recent financial reports.

Summary of Ecopetrol's Consolidated Financial Results

Healthy Cashflow

Ecopetrol's cash position was more or less stable through 2015. The operating environment for the year was extremely poor, and yet the company burnt through only a relatively thin sliver of its existing cash pile, without resorting to significant external financing or asset sales. This is an enviable achievement for many companies in the oil and gas industry, particularly companies focused on U.S. shale, for many of which 2015 was a year that witnessed a struggle for liquidity as operating cash vanished and credit lines were pulled.

Ecopetrol's cash burn rate on the other hand appears sustainable. The company's opening cash balance for 2015 was 7.62 trillion COP (approx. USD$2.48 billion). Its closing cash balance for the year was 6.55 trillion COP (approx. USD$2.13 billion), or a decrease of 1.07 trillion COP (approx. USD$348 million). The company's cash burn rate in 2015 was in fact slightly less than the annual burn rate for 2014, which saw a net cash decrease of 1.19 trillion COP (approx. USD$386 million).

The preceding currency conversions are based on the current exchange rate, and not as of the date that the company's expenses were incurred, and are therefore for purposes of illustration only. In fact, as discussed below, the COP-USD exchange rate varied widely between 2014 year-end and 2015 year-end, with a tendency towards a sharp COP depreciation. It should however be kept in mind that the company's expenses are largely denominated in COP, and not USD. Although the company does have USD-denominated debt, its export revenues are obtained in USD and so there is a "natural" (i.e., non-bank intermediated) hedge in place.

Ecopetrol in any event collected less COP-denominated operating cash in 2015 than in 2014. In 2015, the company collected 10.41 trillion COP (approx. USD$3.39 billion), compared to 16.6 trillion COP (approx. USD$5.39 billion) the year before. The apparent shortfall in operating cash in 2015 did not cause the company to deplete its cash position. Rather, the company simply paid out less in dividends in 2015 than in 2014. For 2015, the company paid out 5.49 trillion COP (approx. USD$1.79 billion) in dividends, as opposed to 12.51 trillion COP (approx. USD$4.01 billion) the year before. The difference between these two numbers more or less accounts for the operating cash shortfall. Other inputs in the company's statement of cashflows were largely stable between the two years, despite significant differences in operating environments.

Conservative Balance Sheet

Ecopetrol has a healthy balance sheet. In addition, the company faces no material refinancing risk until 2019.

With a current ratio of 1.15, Ecopetrol can comfortably meet its obligations due within 12 months as they come due, without resorting to external financing or asset sales. Aside from its liquid assets on hand, the company as has been discussed benefits from a healthy cash flow from operations. Although cash flow deterioration from a harsh operating environment in 2015 affected its ability to pay dividends at prior levels, the company's overall liquid position and its ability to meet its business needs and external obligations was not affected. Between 2014 and 2015, its liquid assets decreased by only 2.6%.

Ecopetrol has long-term debts of 60.32 Trillion COP (approx. USD$19.6 billion). In 2015, the company's long-term liabilities in COP increased 35.7% compared to the prior year. Total assets increased by 11%. Current liabilities increased by only 3.6%, with total liabilities increasing however by 26.8%. The disproportionate and seemingly large increase in long-term debt in COP is however not due to the issuance by the company of any significant new debt, but of currency fluctuations that are naturally hedged by the company's USD export revenues. Approximately 65% of the company's long-term debts are denominated in USD, and during the year the COP depreciated with respect to the USD.

Even after the asset impairments recognized in 2015, the equity position of the shareholders in the company's books remains robust. During 2015, the shareholders' equity position in the company decreased by 9.7%, and as of year-end stood at 43.356 trillion COP (approx. USD$14.1 billion). The company's total liabilities to equity ratio (including non-controlling interests) stands at 1.65, indicating moderate leverage. This ratio is a deterioration from the prior year's levels, which stood at a more conservative 1.28.

A snapshot of key items from the company's balance sheet is included in the table below.

Ecopetrol: Balance Sheet

The company generated 18.09 trillion COP (approx. USD$5.89 billion) in EBITDA in 2015. The company's debt to EBITDA ratio (as calculated by the company) stood at 2.9. This is a relatively conservative ratio. However, the company now seeks to further improve that ratio, in order to preserve or even improve its investment grade ratings despite a persistently depressed oil and gas pricing environment. Accordingly, the company is seeking cost savings of 1.6 trillion COP (approx. USD$520.8 million) for 2016, with a view towards maintaining a debt to EBITDA ratio no worse than between 3.8 and 4 times in 2016. This is in addition to the 2.8 trillion COP (approx. USD$911.5 million) cost savings achieved in 2015.

Ecopetrol has no significant debt maturities until 2019, and therefore no significant refinancing risk until then. The company's debt maturity schedule is set forth in the table below.

Revenues in Dollars, Costs in Colombian Pesos

Ecopetrol enjoys an advantage that its integrated oil and gas company peers operating in other regions of the world might envy under current market conditions. Its revenues are mostly denominated in USD, the currency at which the company sells or benchmarks the bulk of its products, while its costs are largely denominated in COP.

The drop in the international price of oil and gas and their derived products had a significant impact on the company's overall revenues for 2015. The company's total revenues for that year were 52.09 trillion COP, compared to 65.97 trillion COP for 2014, for a decrease of 21%. When measured in USD at rates prevailing as of the close of 2015 and 2014, respectively, the decrease appears sharper. At the exchange rates prevailing as of those two dates, total revenues fell from USD$27.8 billion to USD$16.4 billion, or a decrease of 40.9%.

Indeed, between 2015 and 2014, the COP to USD exchange rate worsened considerably. In 2014, the average exchange rate for the company was 2,000 COP per USD$1. In 2015, the average exchange rate was 2,743 COP per USD$1, reflecting an average depreciation of 37.15%.

The current COP to USD exchange rate, at 3,069 COP per USD$1 as of March 19, 2016, is even lower than the average exchange rate prevailing in 2015. The graph below details the historical USD to COP 5-year exchange rate, which indicates a trend towards continuous COP depreciation.

USD to COP exchange rate

USD / COP - Forex Chart

Ecopetrol is export-oriented and receives considerable revenues in USD. In 2015, the company exported the bulk of its overall production. Of a total of 1,005.9 mboed in crude oil, derivative products, and natural gas sold by the company in 2015, 618.6 mboed, or 61.5% of sold volumes, were oriented towards the export market and priced in USD.

Because Ecopetrol receives its revenue streams largely in USD or at prices established in reference to the USD, the stronger dollar boosts its revenues when measured in COP even if the company's USD effective price per barrel has decreased. The company's costs are on the other hand largely incurred in COP, meaning that they are lower when measured in USD if the USD is strong. Because the value of the COP in USD terms is correlated to the price of oil (despite the continuous depreciation of the COP that has been witnessed over the years), the COP acts as a natural hedge for Ecopetrol against low oil prices in international markets.

The impact of this natural hedge can be seen in the company's 2015 financial performance, and in particular in its margins. For that year, the company exhibited an EBITDA margin of 34.7%, a slight decrease from the prior year's EBITDA margin of 37.2%. The company's extraction, refining, and midstream margins however all improved. The weak COP lightened the company's cost burden as compared to earlier periods.

In 2015, Ecopetrol achieved a 17% reduction in average cost per well, decreasing average drilling days in all its fields and reducing well interventions by 20%. The company's lifting cost per barrel decreased USD$3.84 per barrel, from USD$11.2 to USD$7.4 per barrel, or a 34% reduction. The company attributes this decrease 70% to FX moves and 30% to increased efficiencies.

In 2015, the company exhibited strong refining margins, which significantly improved in 2015 as compared to 2014. The gross refining margins at the company's Barrancabermeja facility increased 15%, from USD$14.6 per barrel in 2014 to USD$16.8 per barrel in 2015. Operating cash cost per refined barrel similarly decreased 39.5% on an interyear basis, from USD$7.2 to USD$4.4 per barrel. Approximately USD$1.63 of these savings directly relate to the depreciation of the COP.

The company's midstream margins also increased in 2015. The company's pipeline average daily transportation volumes increased by 2%, from 1205 kbd to 1232 kbd. Transportation costs per barrel decreased from USD$4.03 per barrel in 2014, to USD$3.37 per barrel in 2015, or a decrease of 16%. According to the company, USD$1.28 per barrel of this difference is attributable to the depreciation of the COP (tax increases and other factors, balanced however by increased efficiencies, would have otherwise increased the transportation cost per barrel). Overall, EBITDA from midstream activities increased an impressive 71%, from 4.5 trillion COP (approx. USD$1.47 billion) in 2014 to 7.7 trillion COP (approx. USD$2.5 billion) in 2015.

Dividends

Ecopetrol paid out 5.49 trillion COP (approx. USD$1.79 billion) in dividends in 2015, as compared to 12.51 trillion COP (approx. USD$4.01 billion) the year before. The company however recently announced that it would pay no dividends for the fourth quarter of 2015. This suspension is part of its program to conserve cash and bolster its balance sheet in order to satisfy the demands from credit agencies and preserve or enhance its investment grade rating.

Ecopetrol's dividends are a substantial source of income for the government of Colombia, Ecopetrol's major shareholder. The pressure on the company to resume dividend payments as soon as practicable should therefore be heavy.

Ecopetrol is a consistent dividend payer. The payouts since 2009, relative to the price of its common shares, are set forth below.

EC Chart

Conclusions

2015 was a harsh year for Ecopetrol and other oil and gas producers. However, Ecopetrol performed well under the circumstances. Although the company registered losses for 2015, if non-cash asset impairments are ignored, the company achieved profits of approximately USD$781 million (based on current exchange rates). EBITDA for the year remained robust, at approximately USD$5.89 billion. EBITDA margins were strong, at 34.7%.

The company's cash position was virtually unchanged from year to year, despite the absence of significant intervening indebtedness or asset sales. Cash from operations remained strong for 2015, at approximately USD$3.39 billion, compared to approximately USD$5.39 billion the year before. The apparent shortfall in operating cash in 2015 is accounted for by reduced dividend payment levels in 2015 as compared to the year before.

Ecopetrol's balance sheet remains strong, despite the grumblings of certain credit rating agencies. The company has ample liquid resources and no current need to resort to outside financing or asset sales to fund its business operations. It is conservatively leveraged, with no significant refinancing risk until 2019.

Ecopetrol enjoys certain key advantages over its competitors solely focused on the upstream sector. Ecopetrol has substantial refining and midstream activities, which buttress its profitability in periods of commodity price weakness.

In addition, the company's cost base is largely priced in COP. Its revenues are largely USD sourced or priced in reference to the USD. The COP has historically been correlated with the price of oil and other commodities. Hence, even if its USD revenues decrease because of the lower price of oil and gas products in international markets, the impact on the company is muted by foreign exchange movements when those revenues are translated into COP. In addition, the company's cost burden in USD is lightened, given that the bulk of the company's expenses are incurred in COP.

The impact can be seen in bolstered margins throughout the company's operations, despite reduced USD denominated revenues. In 2015, Ecopetrol's costs per barrel fell in extraction, refining, and transportation. That is perhaps a key ingredient in the "secret recipe" of the company's surprisingly stable EBITDA margins for 2015 as compared with 2014.

Although the company has announced some asset sales for 2016 in order to bolster its balance sheet and preserve or enhance its investment grade rating, the assets in question are incidental and of secondary importance to its business. Unlike other oil and gas producers, Ecopetrol is not being forced to strip bare its asset base at the bottom of the downward cycle for oil and gas in order to survive.

Ecopetrol cancelled dividends for the fourth quarter of 2015. However, as the price of oil stabilizes at higher levels, the company can be expected quickly to resume dividend payments.

Supporting Documents

  1. Reporte_4Q-2015InglesVF.pdf
  2. Results-presentation-4T-2015.pdf

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in EC over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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