Ecopetrol's Second Quarter Results Indicate A Disappointing Year Ahead For Investors

| About: Ecopetrol S.A. (EC)
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For some time I have been extolling the virtues of Colombia's Ecopetrol (NYSE:EC) as the preferred investment for investors seeking exposure to Latin American oil. While the company's oil reserves are substantially less than the other oil majors operating in the region such as Petrobras (NYSE:PBR), the company has consistently delivered for investors. But the company's second quarter results while impressive year-on-year, leave little to be impressed by on closer scrutiny. This can be attributed to many of the major risks faced by the company materializing over the last 6 months, including production disruptions and a declining oil price.

Recent financial performance was disappointing

Second quarter revenue compared to the first quarter declined by 9% to $9.2 billion and for the same period net income fell by 14% to $2 billion. The company's EBITDA was also down by 7.5% to $4 billion down, along with its EBITDA margin dropping by 4% to 45%. Ecopetrol's balance sheet also weakened with cash and cash equivalents falling by 27% to $3.7 billion and long-term debt rising by 5% to $5.6 billion.

The decline in revenue and profitability can be partly attributed to the falling oil price. This saw Ecopetrol receive an average price over the second quarter of $101 per barrel of oil equivalent ('BOE'), which is a 9.4% decline from the previous quarter. It is also the lowest average price received by Ecopetrol since the third quarter of 2011, as the chart illustrates.

source data: Ecopetrol Second Quarter Results, Index Mundi, Bloomberg

The company also hasn't been able to compensate for the lower average oil price by expanding production in the second quarter as planned. Overall production only grew by 2.5% to an average of 762,000 barrels of oil equivalent per day ('BOEPD') as the chart shows.

(click to enlarge)

The bad news doesn't stop at falling revenue and EBITDA, Ecopetrol's total cost-of-goods-sold ('COGS') for the second quarter increased by 8% to $5.2 billion. This saw the company's COGS to revenue ratio rise by 4% to 58% as illustrated by the chart.

source data: Ecopetrol 2011 to Second Quarter 2012 Results.

But in comparison to the other oil majors including Chevron (NYSE:CVX), Royal Dutch Shell (RDS.A), Petrobras, BP (NYSE:BP) and Exxon (NYSE:XOM), Ecopetrol is still one of the lowest cost producers as the chart below illustrates.

source data: Ecopetrol Q2 2012 results, Chevron UBS Global Oil & Gas Conference presentation, Shell 2012 Investor Fact Sheet, BP Group Results Q1, Exxon 1Q12 Earnings Presentation.

The company still has a fair valuation and strong performance metrics

Despite these disappointing results Ecopetrol's share price is up by 28% in value for the year to date, although it has fallen by around 2% since my last update on 21st May 2012. In fact when compared to the performance of its peers the company has been a standout performer for the year-to-date outperforming the other oil majors.

Ecopetrol has outperformed the Amex Oil Index (^XOI) which is down by 4%, its South American peer Petrobras which is down by 22%, and Chevron the only oil major with significant operations in Latin America, which is down by 1%. The company has also outperformed the Global X FTSE Colombia 20 ETF (NYSEARCA:GXG), in which Ecopetrol is the largest holding and is up by 15% for the same period.

source: Yahoo Finance

Even at its current price, Ecopetrol still presents as compelling value in comparison to its peers with a 2013 forward price-to-earnings-ratio of 11 coupled with a solid return on equity of 35% along with a double digit profit margin of 24%. These performance metrics are superior to its peers as illustrated in the chart below.

source data: Ecopetrol Q2 2012 results, Chevron UBS Global Oil & Gas Conference presentation, Shell 2012 Investor Fact Sheet, BP Group Results Q1, Exxon 1Q12 Earnings Presentation.

A further consideration for investors is whether further Ecopetrol stock will be issued given that the Colombian government is still holding 88.5% ownership of the company. Ecopetrol currently has the authority to issue another 10% of its shares, after gaining board and regulatory approval, but in 2010, 2011 and so far in 2012 it has made the decision not to.

Whether it will do so in 2013 is unknown, because neither the company nor have the Colombian government made any announcements on this matter at the time of writing. It would seem unlikely given that the company is holding a healthy amount of cash and cash equivalents totaling $3.7 billion. But investors should be aware that if there is a further issuance of Ecopetrol shares, it will more than likely have a negative short-term impact on the company's share price.

However, the primary drivers of whether Ecopetrol will continue to deliver value for investors still comes down to three key factors. Firstly, the outlook for the oil price, secondly whether the company is able to grow its proven reserves and thirdly, whether the company can increase production while controlling costs.

Macro outlook

The global macro outlook and the outlook for oil are complicated and extensive subjects in themselves and there is insufficient space here to do them justice. However, in the past I have written that despite demand falling there will be supply side constraints primarily due to geopolitical issues in the Middle East.

This still holds weight for some analysts, but the price for oil has dropped markedly. It has fallen predominantly because of falling demand triggered by the European financial crisis and China's self induced economic slowdown. This has seen China's economic growth fall to its lowest level in three years, with the country reporting a second quarter 2012 GDP growth rate of 7.6%.

For these reasons, as illustrated by the chart below, the oil price fell by around 14% bottoming in June 2012 at around $96 and $82 per barrel of Dated Brent and West Texas Intermediate ('WTI') respectively. However, it has now recovered to be trading on the 30th July 2012, at around $108 and $90 per barrel of Dated Brent and WTI respectively.

source data: Index Mundi, Bloomberg

The U.S Energy Administration expects oil prices to remain steady at current levels until mid-next year. Citigroup has cut its 2013 forecast for Dated Brent to $99 per barrel and West Texas Intermediate to $85, which is lower than the current prices.

However, it is likely that Ecopetrol's average basket price per barrel of oil will fall for during the remainder of 2012. This will see revenue fall and the company's EBITDA decrease unless the company is able to reduce costs and increase production.

Ecopetrol needs to boost its low proven reserves

The company's proven reserves of 1.8 billion barrels is the lowest of the oil majors as the chart below illustrates.

sources: Ecopetrol Q2 2012 results, Chevron UBS Global Oil & Gas Conference presentation, Shell 2012 Investor Fact Sheet, BP Group Results Q1, Exxon 1Q12 Earnings Presentation.

However in comparison to other oil companies operating in Colombia, such as Pacific Rubiales (PEGFF.PK), Petrominerales (OTCPK:PMGLF) and Gran Tierra Energy (NYSEMKT:GTE), Ecopetrol has the lion's share of proven reserves, as the chart below illustrates.

source data: Ecopetrol Q2 2012 results, Pacific Rubiales , Petrominerales' Exploring Beyond Corporate Presentation July 2012' & Gran Tierra Energy Inc AGM Presentation June 2012.

Of further concern is that at the current rate of production of 762,000 BOEPD, Ecopetrol's existing reserves will only be sufficient for a further six and half years of production. This if anything underlines the urgency and resources that Ecopetrol's management needs to dedicate to resolving this risk for investors.

Opportunities for building reserves

Ecopetrol has established a strong exploration program in an effort to boost its low proven reserves. As part of its exploration program Ecopetrol has acquired 62 million acres of land for exploration and in the second quarter 2012 also recently acquired six new blocks for exploration off the U.S. Gulf Coast. It has also commenced offshore drilling on the Colombian Caribbean coast in an effort to diversify and boost its exploration efforts. Based on its previous exploration success rate, with a technical exploratory success rate of 48%, Ecopetrol has projected an increase in proven reserves by 224% to 5.8 billion barrels.

Since the start of 2012, Ecopetrol has also been investing heavily in developing the Cano Sur field in the central eastern Colombian department of Meta. Ecopetrol acquired 100% control of the field when it purchased Royal Dutch Shell's 50% share in February 2011.

Earlier in July 2012, Ecopetrol confirmed the presence of hydrocarbons in the field, which bodes well for a significant increase in proven reserves. The company also discovered oil earlier this year in the Tisquirama Este-1 exploratory well, located in the municipality of San Martin, Cesar.

Another factor that augurs well for Ecopetrol to grow its reserves is that because of poor infrastructure and the decade's long civil conflict, only 30% of Colombia has been explored for hydrocarbons. It should also be noted, that despite some analysts claiming that Colombia has reached its natural ceiling for oil reserves the country's provable oil reserves in 2011 grew by 10% to 2.3 billion barrels. All of these factors augur well for Ecopetrol being able to grow its existing reserves, although disappointingly to date the company has yet to make a significant discovery.

It has also been speculated as to whether Ecopetrol should consider boosting its reserves through the acquisition of one of the smaller producers operating in Colombia such as Petrominerales or Gran Tierra. This seems an unlikely approach, with Ecopetrol having already made considerable investments to acquire 100% control of its exploration and production assets in Colombia and expand into offshore drilling.

I believe this is also unlikely because the Colombian government is seeking to boost daily national production to 1 million BOEPD with Ecopetrol playing a key role in this through increasing its reserves. Therefore, the policy appears to be one of using Ecopetrol to drive increased production by adding to its proven reserves through successful exploration.

Overall, while I am confident that Ecopetrol will be able to add to its proven reserves, this is an issue that management needs to urgently address in order to maintain investor confidence.

Ecopetrol has been unable to significantly lift production

Colombia has been unable to meet its goal of increasing national daily production to 1 million primarily due to production disruptions caused by an increase in the intensity of the civil conflict. This has also affected Ecopetrol, which only recently reduced its 2012 production target of 800,000 BOEPD by 2.5% to 780,000 BOEPD. This is a result of the escalating intensity of guerilla attacks by the Fuerzas Armadas Revolucionarias de Colombia ('FARC') on well-heads, pipelines and other oil infrastructure.

However, given the surge in guerilla attacks, this revised target may even be overly ambitious. Particularly when it is considered that Ecopetrol was only able to increase production for the second quarter by 2.6% to 762,000 BOEPD as the chart shows.

source data: Ecopetrol Q1 2011 to Q2 2012 results

These FARC attacks have particularly focused on disrupting the northern Cano Limon-Covenas and the south western Trans-Andean pipeline. The increased intensity can be attributed to changes in the royalty payment system and the FARC seeking to reaffirm its presence in traditional strong-holds along the Venezuelan border and south central Colombia.

If Ecopetrol is unable to significantly increase production and along with a lower average oil price, it is likely that revenue and net income will continue to fall throughout the second half of 2012. Based on current oil price forecasts along with the revised production target an optimistic view is that revenue for the remainder of 2012 will fall by around 10%. I would also expect costs to remain at current levels because of increased operational costs relating to transport and maintenance created by disruptions to Ecopetrol's oil pipelines. This I believe will continue to impact the bottom-line for the remainder of 2012 and may even affect the first-half of 2013.

Bottom line

Despite Ecopetrol's management dressing up the company's second quarter results as an improvement, it is clear that the company has failed to deliver for investors. This can be attributed to a number of factors that are beyond the company's control, including Colombia's fluid security situation and falling oil prices. It is also clear that management needs to address the issues concerning the lack of proven reserves and disrupted production if they are to retain investor confidence. For all of the reasons discussed I believe that investors should be bracing themselves for a less than stellar full year result.

However, there are still many positive aspects to the company for investors. These include firstly, Ecopetrol's healthy dividend yield of 5%, which is significantly higher than many of its peers. Secondly, the Colombian government, unlike its Brazilian counterparts management of Petrobras, has taken a "hands off" approach with Ecopetrol despite being the majority owner. This has allowed management to focus on growing value for investors and to put their interests ahead of its majority owner.

Thirdly, Ecopetrol has a strong and experienced management team, which historically has delivered strong returns for investors. Evidence of this can be found in the company's return on equity, which at 35% is one of the highest in the industry.

But with a depreciating oil price combined with low proven reserves, high exploration costs and increasing production disruptions because of the worsening security situation, I believe the company's ADRs are fairly priced at around $57. Therefore, investors shouldn't expect any further appreciation in value until their is a significant and sustained rise in the oil price and Ecopetrol is able to adequately address the risks discussed.

Disclosure: I am long EC, PBR, GTE.