Petrobras: Slowly Righting The Ship

BMI View: Petrobras registered net income of US$11bn in 2012, representing a 45% y-o-y decline i n net income. Although Petrobras ' results ha ve disappointed investors, particularly over the last two quarters , the state-owned company's most recent financial s reinforce CEO Maria das Gra ç as Silva Foster's assertion that the company is undertaking critical reform - with falling top-line production numbers at least partially due to much-needed maintenance at the country's most important producing fields. In addition, several key challenges, including imbalances in the company's downstream segment appear to be abating . Moving forward, we are less bearish on Petrobras than consensus, precisely because we had less bullish earnings expectations for its earnings after the company announced its sweeping reform agenda and a US$236.5bn re-investment pla n.

In terms of its financial health, Petrobras continues to be plagued by problems that are largely beyond its control: a weakening real , as well as the ' Custo Bras il ' , and a domestic fuel pricing regime that - despite recent signs of government flexibility - continues to render the company ' s downstream segment not only unprofitabl e, but also acts as a drag on its overall fiscal health. This limits the company's ability to invest in raising oil production, especially in terms of monetising its subsalt resources.

However, Brazil ' s massive hydrocarbon s po tential, combined with strong initial inte rest from some of the world ' s largest exploration and production ( E&P ) companies in the country ' s upcoming 2013 licensing round , point s to a decidedly positive future. As such, we remain bullish on Brazil ' s long-term outlook.

Nevertheless , o ver the short- to- medium term we retain our cautiously optimistic view on Petrobras, as the company continues to target the right areas of reform despite its underwhelming earnings and production results in 2012 . Looking ahead, t he most important questions surround its ability to successfully influence the Brazilian government ' s policies , which is currently causing an unsustainable expense for Petrobras , as well as its own company-wide commitment to pursuing internal reform , which favour s long-term growth over short-term profit. Indeed, market sentiment has worsened since the company's reform agenda was announced, placing additional pressure on the company to perform in the near term.

Some of the main themes that can be extracted from Petrobras' year-end 2012 results are :

  • A 1% drop in global crude oil and natural gas liquids ( NGL ) production, with Brazilian domestic production declin ing 2% year-on-year (y-o-y) . A lthough production did begin to rebound in the last quarter of 2012 , it was insufficient to reverse the negative annual trend . The loss of production was due primarily to field maintenance, part ly because of the Operating Efficiency of the Campos Basin initiative (PROEF), and the shutdown of production at the Frade field . However, s hort-term production losses due to upgrades and maintenance support a n improving production picture over the longer term and therefore provide the basis for our supportive medium- and long-term view .

  • Rising E&P investment, as per Petrobras ' current reform agenda which calls for US$236.5bn in investment through 2016 . Specific investment in 2013 include s a US$47.8bn allocat ion to upstream activit y in Brazil.

  • Brazilian government policies will continue to constrain growth over the coming years, despite their decidedly negative impact on the Brazilian oil and gas sector . This is despite recent fuel price increases in the second half of 2012 and in early 2013 . Indeed, while we view these increases as recognition that such policies are unsustainable, the Brazilian downstream sector remains significantly disto rted, p lacing considerable downward pressure on Petrobras' balance sheet.

  • Market sentiment became increasingly negative towards Petrobras in the second half of 2012 - although we believe that the fundamentals of the company ' s reform agenda w ill remain supportive of a broader technical uptrend . Indeed, on February 15 we initiated a bullish view on Petrobras in our Asset Class Strategy, highlighting the possibility of a technical bounce.

2012 Production Falls, But Efficiency Gains Will Support Long-Term Growth

As Brazil's primary oil producer, Petrobras' falling output in 2012 led to declines in overall Brazilian production; this hit a 22-month low in August ( see our online service, October 5 2012, 'Brazilian Oil Production Plunges To 22-Month Low'). The state-owned company attributed much of this decline to scheduled maintenance at producing fields, particularly in the critical Campos Basin. As such, Petrobras' domestic production averaged 1.98mn barrels per day (b/d) in 2012, compared to 2.0mn b/d in 2011, equivalent to a 2% decline (y-o-y).

The PROEF is a key component of Petrobras' US$236.5bn investment plan, which was announced several months ago. The PROEF will see US$141.8bn, or about 60% of the US$236.5bn earmarked for investment over the next five years, invested in replacing ageing platforms and production systems with new generation equipment, with the goal of raising the Campos Basin's operating efficiency from 72% in Q112 to 90% - as measured in terms of actual output compared with potential production ( see 'Petrobras To Breathe Life Into Campos Basin', August 1 2012).

Although the PROEF has contributed significantly to the fall in production, it is a clear example of the trade-off between long-term growth and short-term profit. This distinction is one component of our cautiously optimistic view on Petrobras over the short-to-medium term. Indeed, these maintenance stoppages and equipment upgrades are already starting to produce results; the efficiency of the Campos Basin Operational Unit fell to 67% in April 2012, but subsequently rose to 78% in December on the back of maintenance and upgrades. Such investment is critical to the long-term future output of the company and country. As such, we have not been particularly rattled and have not put too much stock in consensus reaction to the company's production figures for the second half of 2012; nor were we surprised by the figures.

Looking ahead, we anticipate growth in production from Petrobras, as well as the country more broadly. Indeed, six new platforms will enter operation in H213, although the company's maintenance stoppages will continue into 2013.

Waiting For A Rebound
Brazilian Crude Oil and NGL Production ('000 b/d)

Rising E&P Capex Required For Long-Term Production Increase

Petrobras allocated a larger proportion of its total investment to E&P activit y in 9M 12 than it did in 2011 . In addition to overall investment rising from BRL 72.5bn (US$36.9bn) in 2011 to BRL 84bn (US$42.7bn) in 2012, its allocation of that investment into E&P activit y rose substantially from 47% of total investment to 51% . This trend is expected to continue into 2013, with an increasing amount of money directed towards E&P.

Increasing E&P Investment
Petrobras' 2011 & 2012 Investment Allocation (in %)

Included in this increased E&P investment are orders for 21 production platforms and 30 drilling rigs, which will be delivered and come online through 2020, enabling total Brazilian production to increase steadily over our forecast period. In 2013, Petrobras expects six new platforms to enter operation in the Sapinhoá, Baúna and Piracaba, Lula Nordeste, Papa-Terra, and Roncador fields. These will begin contributing to production growth in H213. We are currently forecasting that 2012 production of 2.9mn b/d will increase to 4.3mn b/d by 2017, and rise further to 6.2mn b/d by 2022.

E&P Investment Is Key To Production Growth
Brazilian Proven Oil Reserves & Production, 2001-2022

We have consistently highlighted a number of different Brazilian government policies which have been weighing on Petrobras ' operations. These include domestic policies which can be referred to in sum as the ' Custo Brasil ' ( or the ' Brazil cost '), as well as an unsustainable domestic gasoline pricing regime.

Local requirements, which set a minimum local c ontent restriction on capital of 60% , and a 65% local labo u r for ce requirement, are placing considerable pressure on oil sector servi ces and contributing to growing lifting costs ( the cost of production per barrel after drilling is complete d ) . The result has been equipment shortages and delays to the develop ment of new fields, while output has fall en from more m ature fields ( see ' Structural Weaknesses Affecting Petrobras ' Production ' , June 13 2012 ). Indeed, Petrobras cited both rising operational costs - due to rising personnel expenses as a result of the 2012 Collective Bargaining Agreement - and the increasing cost of maintenance as the two main forces driving down the company ' s earnings.

Beyond rising costs, these local content requirements have limited Petrobras' ability to access the cutting edge technology and skill sets required when undertaking deepwater production in Brazil , where some of the most promising discoveries have been made in recent years. Importantly, these costs also affect international oil companies (IOCs) , and , consequently, the Brazilian business environment. Indeed, t hese policies are also having a knock-on effect on Petrobras' partners. Oilfield service providers such as Saipem and Aker Solutions have recently cited Brazil as an area of weakness on their balance sheets, as costly content and labour requirements hit their margins.

Lifting Cost - Brazil (in US$/bbl)
2012 2011 % change
Source: Petrobras
Excluding production taxes 13.92 12.59 11
Including production taxes 33.83 32.52 4

One of the most adverse government policies remains its domestic fuel pricing regime. As we have long highlighted, part of the Brazilian government's strategy to curb inflation has been the maintenance of price controls on domestic fuel. As the country ' s only downstream player, as well as having insufficient refining capacity, Petrobras is therefore forced to purchase gasoline for consumption at world prices and then sell it on domestic markets , where prices are, on average, 20% l ower ( see 'Pricing And Operational Reforms Critical To Petrobras' Success ' , July 17 2012 ).

Petrobras' CEO has consistently emphasised the importance of fuel price parity, and successfully negotiated fuel price increases with the government in the past six months, marking the first time prices have been changed since 2006. In June 2012 , prices were increased for diesel and gasoline by 10% and 8% , respectively , Further changes in January 2013 led to an additional readjustment of 5.4% for diesel and 6.6% for gasoline. Nevertheless, t hese increases have been insufficient to bring prices into parity with those on the international market, leaving losses in the company ' s downstream segment as the biggest challenge to the company's overall financial health ( see 'Regulatory Challenges Constrain Huge Long-Term Potential ' , September 19 2012 ).

Weakening Equity Performance

Petrobras' stock performance has disappointed in recent quarters on the back of souring market sentiment towards the company, given the well-known challenges it must overcome. As previously mentioned, we have not been particularly rattled by Petrobras' earnings in Q312 and Q412, as many of the dynamics affecting its results have been linked to long-term trends that we have been highlighting for some time.

As such, we believe that the fundamental story of reform, so long as a credible commitment to such an agenda remains in place, will strengthen Petrobras' equity performance. Indeed, as already mentioned, on February 15 we initiated a bullish view on Petrobras in our Asset Class Strategy, highlighting the possibility of a technical bounce.

Significant Upside Potential
Petrobras Share Price, BRL
Petrobras' 2012 Operating Results: Financial Highlights (in BRLmn)
FY2012 FY2011 % Y-o-Y change
Source: Petrobras
Revenue 144,103 145,915 -1
Adjusted EBITDA 27,632 37,322 -26
Consolidated Net Income 11,034 20,121 -45
Capital Expenditure 42,949 43,164 0
Exploration & Production 35,644 37,036 -4
Refining, Transportation, and Marketing -17,453 -8,461 106
Gas & Power 1,102 2,521 -56
International 1,961 2,122 -8
Distribution 1,425 1,195 19
Biofuel -128 -165 -22
Corporate -4,937 -4,809 3

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