Attention, Barrelheads: Petrobras Shares Are on Sale

David Fessler
by David Fessler, Energy & Infrastructure Strategist, The Oxford Club

Attention, Barrelheads: Petrobras Shares Are on Sale

by David Fessler, Energy and Infrastructure Expert

Friday, July 30, 2010: Issue #1313


A touchy subject these days, I know - even with cleanup crews in the Gulf successfully removing much of the spilled oil from the water.

But I don't want to talk about U.S. oil in today's article. Instead, we're going to head south to check in on a company that has gained increasing international attention over the past several years, having made some of the world's largest oil discoveries in recent decades.

We're heading to Brazil and the offices of oil and gas conglomerate, Petroleo Brasileiro (NYSE: PBR) - or Petrobras, as it's more commonly known...

Right off the bat, the company faces a problem: most of Brazil's offshore oil is located between layers of salt nearly seven miles below sea level. As you can imagine, extracting and producing this oil in an economical way is a daunting task.

But Petrobras engineers and geologists think outside the box. The company has invented and perfected both seismic and drilling techniques along the way. And the initial risks now look like they're going to pay off in a big way.

Or are they? Let's take a look at the potential hazards and rewards for Petrobras...

Petrobras' Underground Oil Bonanza

Four years... $224 billion.

That's how much money Petrobras plans to spend on development of its offshore oil fields and onshore refining facilities between now and 2014.

This massive sum alone should be an indication of how much oil is down there and the level of Petrobras' optimism. The current figure puts the "official proven reserves" at six billion barrels of oil, but some believe there could be 10 times more than that.

Frankly, I think even that number could be on the low side. I believe Petrobras has enough potential reserves (whether undiscovered or unannounced) to become the next Saudi Arabia of oil. Time will tell.

For now, though, the company's other offshore fields are already churning out oil to the tune of nearly two million barrels a day. And there are many offshore areas that it hasn't even explored yet.

That's the good news. Now for the bad...

Hello, Government... Goodbye, Common Sense

While history is littered with examples of failures from nationalized oil and gas investments (Venezuela, Russia, and Nigeria to name a few), Petrobras isn't one of them.

Brazil formed Petrobras back in 1953, under the leadership of then-President Getulio Vargas. It remained a legal oil monopolist in the country until 1997.

Today, it's the largest company in Latin America by market capitalization ($158 billion) and in revenue ($92 billion in 2009). It's also the fourth-largest energy company in the world.

But the Brazilian government still has the biggest piece of Petrobras firmly under its management. In fact, all the unexplored oil blocks that Petrobras once had under its control have reverted to the Brazilian government.

Perhaps most importantly, though, the government holds 55% of voting control in Petrobras... despite only owning 33% of the shares.

And now it's making a grab for even more control. It's utilizing a controversial plan that would grant Petrobras production rights for up to five billion more barrels in return for more shares - and thus, more authority.

The question is: Why would the government bother? Do its officials know something that the general public doesn't in terms of the estimated amount of oil sitting beneath Brazilian waters?

Perhaps. But the short-term reason is that it sees a potential cash windfall that it intends to direct toward social programs that it wants to implement.

Three Reasons Why Petrobras Could Soar Over the Next 12 to 18 Months

Not surprisingly, when the government announced that it planned to grab more control of Petrobras, investors began fleeing the company in droves.

Once a high-flier in the oil industry, Petrobras shares are down 25% since the beginning of 2010. The stock is trading at a significantly discounted price/earnings ratio to the likes of ExxonMobil (NYSE: XOM).

However, I believe investors' fears about the government's moves are overblown, not to mention fresh concerns over deepwater drilling. Once both subside, Petrobras shares could see significant upside from here, perhaps as much as 50% or more in the next 12 to 18 months.

Here are a few reasons why:

  • The company plans to boost its production output by 9.4% per year, doubling production output to 3.9 million barrels per day by 2020. (It currently produces around 2.5 million barrels per day.) That's a significantly better growth rate than all the other big producers.
  • At 38%, Petrobras boasts the second-highest gross margins in the oil and gas industry. This is a key measure of profitability and by way of comparison, Exxon Mobil's margins are running at about 29%, which is the average for the overall industry.
  • Petrobras notched up trailing 12-month sales of $190 billion and annual sales growth north of 18%. It's only a matter of time before the stock price catches up to these numbers.

Petrobras Isn't All About Oil...

But lest you think Petrobras is all about oil... it's not...

  • It has operations all over the globe, with exploration or production efforts underway in 27 different countries on every continent.
  • The company operates 112 production platforms, more than 8,000 service stations, 16 refineries and 10 thermoelectric power generation facilities.
  • It's also branching out into biofuels - big business in Brazil - and plans to spend nearly $3 billion on their development in the next three years.

Tasked with balancing Brazilian government interests, the need for huge amounts of capital, and fleeing shareholders, CEO Jose Sergio Gabrielli certainly has his work cut out for him in the months ahead.

But if you're looking for a bargain in the oil patch, take a closer look at Petrobras. It's a consistent over-achiever relative to its peers and its shares are currently selling at fire-sale prices.

And if you can handle a little stock market volatility, plus the ups and downs of the oil sector in particular, you could be richly rewarded a year or two from now.

Good investing,

David Fessler

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