Petrobras Is A Great Stock But For Later

Summary

• Petrobras is a great stock on paper combining many favorable investment positives.
• Unfortunately, its stock price will likely lag its NOC peers over the coming quarters due to political risks until the Brazilian election later this year.
• I see better risk-reward elsewhere for the time being.

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Investment Thesis

Petrobras (NYSE:PBR) is a near-perfect investment on paper. It’s dirt cheap, cash generative, highly distributive, and growing. Off paper though, is a different story. The company is unfortunately under political scrutiny from the current government as well as from the leading challenger. There is a lot of scary chatter that would significantly lower company profitability if materializes. I’m not a buyer of the stock today despite my view that the odds of these risks playing out are very low. I see a cyclical opportunity in emerging markets and NOC stocks and believe that these names will move materially higher over the 12 months. Petrobras’s stock price will likely be capped by political uncertainty over this period. I see better risk-reward elsewhere for the time being.

Petrobras is Perhaps the Best Investment On Paper

Petrobras combines several mouthwatering investment characteristics and at the forefront for me is how well it capitalizes from the current macro-cycle. My readers will be familiar with my macro framework of higher growth, higher commodity prices, and lower commodity supply. I will provide a brief summary here, please read the linked articles for more detail. I expect higher oil prices for longer and think that Western producers are well-positioned (see here and here) but that NOCs (National Oil Champions) are positioned even better (see here and here). Oil supply has not matched oil demand forecasts. Fluctuating profitability in times of depressed oil prices has increased investor demand for profitability over growth and ESG concerns have put long-term production investments at risk. Now, we’re at a time of decreasing energy supply and increasing energy demand. This bodes well for oil producers and especially for non-Western ones that tend not to be as concerned about ESG. I believe that Petrobras will benefit from a strong cyclical swing.

Petrobras is ridiculously cheap. Almost the entire global fossil fuel complex is very cheap as is emerging markets but Petrobras is in a class of its own. The company trades at 2.7x NTM (next twelve months) EBITDA, 3.4x NTM P/E, and just 2.3x NTM CFPS (cash flow per share). Needless to say, these are very low multiples but I’ve added a comparison table below to both supermajors as well as other NOCs to showcase my point, nevertheless. Petrobras is unarguably cheap.

Petrobras is a shareholder’s dream in turns of distributions. The company produces loads of cash and distributes it generously. It targets to return 60% of surplus cash (operating cash flow – investments) to shareholders. Consensus DPS (dividends per share) forecast for 2022 is $1.95 or an ~18% yield. If the company performs as it has been without interference, it should be able to pay out its price in dividends in 5 to 6 years.

Petrobras offers growth in addition to returns and low valuation. The company highlighted the opportunity in its recent Petrobras day presentation. Petrobras has a lot of unexplored reserves and plans to bring 15 FPSOs (floating production storage and offloading) online in 6 fields by 2026 with the potential for more. This excess capacity is rare among fossil fuel producers and I believe that it will differentiate Petrobras over the coming years.

To summarize, we have a high and growingly cash-generative asset here offered at a very attractive price that I believe will be a cyclical winner over the coming years.

There is a Lot of Bad and Ugly that Comes With the Good

As good as Petrobras is on paper, it’s bad off of it. The company looks great by most measurable KPIs but it's plagued by the political situation in Brazil where it’s stuck in a political tug of war. The leftist candidate Luiz Inácio Lula da Silva is leading in the polls for the 2022 Brazilian election and isn’t friendly to Petrobras. Brazilian people are facing inflationary pressures like in many other emerging markets and like in other emerging markets, rising energy prices are a key factor. Using Petrobras to subsidize energy prices is among leftist chatter. Using Petrobras to increase employment could also be in the cards. Petrobras will face a lot of headline risks at the very best and could face very material risks in a grey-sky-scenario.

Brazil or Petrobras are unfortunately no strangers to such policies. The government used Petrobras to subsidize prices between 2011-2014 during which Petrobras lost ~$40 bn due to the policy. The company has also historically been exploited with CapEx overruns. This was demonstrated in Operation Car Wash, perhaps the biggest corruption scandal ever. A repeat of this would more than offset all of the aforementioned investment positives.

The market chatter focuses on the risk (or eventuality with the current poll numbers) of Lula’s presidency but Bolsonaro hasn’t been a friend to Petrobras recently either. Bolsonaro replaced the market-friendly head of Petrobras with an ex-military man earlier this year. The replacement came on the back of Petrobras’ price hikes and the commentary by the ex-Petrobras boss unearthed the expected truth of government pressure to contain price hikes. Bolsonaro’s comments about Petrobras are scary, to say the least, and range from being against dividends to privatization. Petrobras seems like it will remain under pressure even in the case of Bolsonaro’s presidency, particularly considering my aforementioned expectations of higher oil prices for longer which should continue to cause inflationary pressures.

Quantifying the Risk is Difficult but Petrobras is in Better Shape Today Than it Was Before

To present a balanced argument I want to comment on what I think often goes overlooked; the changes in Brazilian regulation make burdening interventions in state-owned companies much more difficult today. Operation Car Wash changed things in Brazil which were quickly put in law. The State-owned Company Act 13,303/2016 made interfering in Petrobras difficult. Petrobras then quickly changed its bylaws to adapt to this new regulation by adding a clause that forces the Brazilian Government to reimburse Petrobras for any losses that may result from Government obligations that require the company to operate differently than what market prices would imply. The reimbursement is to be paid in the same fiscal year and will be defined by the Minority Committee. The laws would fully protect Petrobras if applied.

We’ve seen this law put to the test already. Petrobras cut prices during the 2018 Brazil truckers' strike. The company went on to recover most of the losses from the government. This was a much shorter and less encapsulating price cut than the one being proposed today but is a datapoint, nevertheless.

Given the inefficiency in using Petrobas to subsidize prices as Petrobras isn’t a monopoly anymore, and the regulation protecting any interference and personal liability of any interfering management, and the difficulty in changing regulation and the time required, my base case is that the political rhetoric doesn’t come to pass.

I’m on the Sidelines Nevertheless

I like Petrobras and am bullish on the company over the long term and think that headline risks have made the stock price very attractive despite having a low probability of materializing. However, I expect stronger returns from Petrobras’ peers in underlying emerging markets and fossil fuel factors over the more immediate term than I expect from Petrobras. I believe that 2022 will see a lot of inflows into these areas but due to the Brazilian election uncertainty, Petrobras is unlikely to perform. In my opinion, Petrobras’s share price won’t be able to move higher while other similar NOCs will despite its lower valuation and better dividend yield. Moreover, other NOCs bear less political risk. I’m on the sidelines on Petrobras for now and could buy as a chase the laggard play if my expectations of an upward move in the sector in which Petrobras doesn’t participate play out.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of BP, OMVJF, LUKOY either through stock ownership, options, or other derivatives. 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.