Weak Fundamentals Underpin Cautious Stance On Petrobras

W e maintain a cautious stance on Brazilian state-owned oil company Petrobras over a multi-month time horizon due to the company's relatively weak fundamentals , meaning that it could weigh on the performance of Brazil's benchmark Bovespa equity index ( see 'Regional Equity Strategy', August 27 ) . While we anticipate that the firm will benefit from the development of Brazil's massive subsalt oil reserves in the long term, our Oil & Gas team believes that the short-to-medium term will be challenging for Petrobras. This is underpinned by our view that a 2010 law specifying that the company hold a 30% stake in all subsalt developments will remain a major cost burden for the firm , caps on domestic oil prices will continue to weigh on the profitability of the firm's downstream segment , and a weak real may keep the cost of servicing US dollar denominated debt elevated ( see 'Petrobras: Structural Weaknesses Prompt Cautious Stance', September 6 ).

We believe that only a fundamental change for the company, such as sustained real appreciation, an amendment of the 2010 oil law, or signs that the Brazilian government is willing to allow Petrobras to increase domestic fuel prices substantially in order to improve the profitability of the firm's downstream segment would see the stock sustain a break through trendline resistance around BRL20.0, marking the end of its long-term downtrend ( see chart above). With growth likely to slow in H213, and poor balance of payments dynamics to persist, we believe that a sustained rally is in the real unlikely in the coming months, in line with our average forecasts of BRL2.1450/US$ this year, which implies further weakness from the year-to-date average of BRL2.1119/US$, and BRL2.2000/US$ next year ( see 'BRL: Weakness Here To Stay', August 9). Furthermore, given that a general election is coming up in October 2014 and President Dilma Rousseff continues to face public protests on a number of issues, including government transparency and the sub-par quality of public services, we believe the current government will not have the political capital to expend to change the 2010 oil law. Similarly, with inflation remaining elevated, we believe the administration is unlikely to allow substantial fuel price hikes that would alleviate the pressure on Petrobras's downstream segment. While our Oil & Gas team believes that a fuel price hike could be on the cards in the coming months, our core view remains that it is unlikely to make a significant dent in the wide spread between domestic and international fuel prices ( see 'Petrobras Facing A Real Problem', August 29). As such, until we see more concerted efforts on the part of company officials to address these issues, as well as greater support for such a change from the Brazilian government, we maintain our cautious outlook on the stock.

Potential For Short-Term Gains

Downtrend Remains Unbroken
Brazil - Petrobras Share Price, BRL (Weekly)

W e maintain a cautious stance on Brazilian state-owned oil company Petrobras over a multi-month time horizon due to the company's relatively weak fundamentals , meaning that it could weigh on the performance of Brazil's benchmark Bovespa equity index ( see 'Regional Equity Strategy', August 27 ) . While we anticipate that the firm will benefit from the development of Brazil's massive subsalt oil reserves in the long term, our Oil & Gas team believes that the short-to-medium term will be challenging for Petrobras. This is underpinned by our view that a 2010 law specifying that the company hold a 30% stake in all subsalt developments will remain a major cost burden for the firm , caps on domestic oil prices will continue to weigh on the profitability of the firm's downstream segment , and a weak real may keep the cost of servicing US dollar denominated debt elevated ( see 'Petrobras: Structural Weaknesses Prompt Cautious Stance', September 6 ).

Downtrend Remains Unbroken
Brazil - Petrobras Share Price, BRL (Weekly)

We believe that only a fundamental change for the company, such as sustained real appreciation, an amendment of the 2010 oil law, or signs that the Brazilian government is willing to allow Petrobras to increase domestic fuel prices substantially in order to improve the profitability of the firm's downstream segment would see the stock sustain a break through trendline resistance around BRL20.0, marking the end of its long-term downtrend ( see chart above). With growth likely to slow in H213, and poor balance of payments dynamics to persist, we believe that a sustained rally is in the real unlikely in the coming months, in line with our average forecasts of BRL2.1450/US$ this year, which implies further weakness from the year-to-date average of BRL2.1119/US$, and BRL2.2000/US$ next year ( see 'BRL: Weakness Here To Stay', August 9). Furthermore, given that a general election is coming up in October 2014 and President Dilma Rousseff continues to face public protests on a number of issues, including government transparency and the sub-par quality of public services, we believe the current government will not have the political capital to expend to change the 2010 oil law. Similarly, with inflation remaining elevated, we believe the administration is unlikely to allow substantial fuel price hikes that would alleviate the pressure on Petrobras's downstream segment. While our Oil & Gas team believes that a fuel price hike could be on the cards in the coming months, our core view remains that it is unlikely to make a significant dent in the wide spread between domestic and international fuel prices ( see 'Petrobras Facing A Real Problem', August 29). As such, until we see more concerted efforts on the part of company officials to address these issues, as well as greater support for such a change from the Brazilian government, we maintain our cautious outlook on the stock.

Long-Term Technical Picture Still Has A Way To Go
Brazil - Petrobras Share Price, BRL (Monthly)

Potential For Short-Term Gains

Despite our cautious multi-month outlook on Petrobras, we believe that a constructive technical picture indicates potential for some near-term upside for the stock. Indeed, the equity is heading higher after bouncing off trendline support around BRL15.0 in recent trading, and the MACD looks poised to cross to the upside. In addition, improved investor sentiment towards Brazilian equities in recent trading has seen the benchmark Bovespa equity index sustain a break through a key area of resistance around the 52,500 level, potentially presaging further gains. Moreover, the company remains relatively cheap from a valuations perspective, as its price-to-book and price-to-earnings ratios of 0.7x and 8.1x respectively remain below the 10-year averages of 1.6x and 8.7x. As such, we believe that Petrobras could head higher to test resistance around BRL19.0 in the coming weeks, although weak fundamentals mean that a more sustained rally is off the cards for now.

Constructive Technicals Highlight Potential For Short-Term Gains
Brazil - Petrobras Share Price, BRL & MACD (Daily)

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