Petrobras: A Brazilian Oil Value Play
by Tony D'Altorio, Investment U Research
Wednesday, September 22, 2010
Brazilian oil giant Petrobras ADR (NYSE: PBR) is about to break a record.
At September's end, it plans to issue an estimated $75 billion in new shares. About $32 billion will come from minority shareholders and the rest from the Brazilian government in exchange for the rights to 5 billion barrels of offshore oil at about $8.50 a barrel.
The 5 billion barrels of oil are from Brazil's pre-salt fields, so called because they lie under miles of seawater, rock and a tough layer of salt.
Early estimates suggest they may hold as much as 100 billion barrels worth. If so, that would dwarf the country's current reserves and put it on production par with Russia.
International oil company executives liken the fields to the North Sea discoveries in the 1970s in their potential to transform the industry. And Ali Moshiri, president for Africa and Latin America at Chevron (NYSE: CVX), may have summed it up best in saying, "Brazil is the future for the oil industry."
So why would Petrobras want to give up even a portion of such an amazing cache?
It expects the deal to strengthen its balance sheet, while also allowing it to borrow - yet keep - its debt-to-equity ratio below 35%, the threshold for its investment grade rating.
Yet despite the enormous potential, investors seem to have little faith in the company.
Can Petrobras Develop its Pre-Salt Fields?
Some question whether Petrobras can develop the area at all. Others don't like how the Brazilian government, which owns about 40% of the company, changed the rules regarding the pre-salt fields...
From the late 1990s, when Petrobras lost its monopoly, Brazil's oil industry thrived under a concessions system. During that time, the government put parts of the pre-salt region out to concessions before it realized exactly what it had.
So Petrobras, along with foreign companies like ExxonMobil (NYSE: XOM) and Royal Dutch Shell ADR (NYSE: RDS.A), began developing the fields.The new regulations, however, require production sharing agreements for all future development. And a new state company, with veto power over all operation matters, will oversee such ventures.
Petrobras will take at least 30% of any project and will lead operations in all of them. The government, at its discretion, can also grant the business licenses for any field.
Brazil claims the new rules will ensure that most of the pre-salt oil profits stay in the country. But critics argue that it could have achieved the same result by simply imposing higher taxes on foreign oil companies.
Regardless, qualms about the new rules have sent Petrobras' stock down about 25% off its value this year. Brazil's main index, meanwhile, is only down 2%.
Petrobras: At Risk or in Reach?
Investors think the plan puts far too much pressure on Petrobras to develop the fields. They're also questioning its ability to meet ambitious targets under its $224 billion investment program for 2010 to 2014.
- For one thing, it is hard to keep costs down with only one operator.
- Similarly, it's difficult to nourish and develop a local offshore supply and services industry with only one buyer.
- Adding to the problem, Petrobras has issues finding qualified workers. More deepwater projects will just exacerbate that situation.
Perhaps it should advertise in Louisiana...
Of course, the BP oil spill has renewed concerns about Petrobras attempting to operate successfully at such depths and in untested conditions. Fortunately, that is a non-issue according to the Eurasia Group's Christopher Garman: "Petrobras' expertise [in deep waters] is top of the field. Regulations on what blowout preventers are required are as tough or tougher than anywhere in the world, and environmental regulations are probably more stringent than they are in the U.S."
Why Investors Can't Do Much Better Than Petrobras
What it really comes down to is cost. And Petrobras says it can pump oil from these fields at $45 a barrel, comfortably below today's price of about $75.
And keep in mind that it should easily achieve its goal of 4 million barrels of oil per day from its existing fields. Since it's already producing about 2.5 million daily, that kind of growth rate will put other large oil companies to shame.
Also, with CEO Sergio Gabrielli at the helm, it averages an 18% annual sales growth. Its 38% gross profit margin easily beats out Exxon's 29% for the industry's second highest.
Book building for the stock issuance began on September 3rd and won't end until the 20th. Expect some heavy shorting during this time, as firms try to drive the issue price down.
But when they do, that just makes it an even better deal.