Petrobras 2014 Q3 Preview: Corruption Investigations To Cloud Improvements In Key Business Drivers

Petrobras (NYSE:PBR) is expected to announce its unaudited financial results for the third quarter on December 12, after a delay of more than a month, primarily because of ongoing investigations into the alleged bribery and corruption scandal that has hit the company. We expect a focus on the potential impact of the ongoing probe to overshadow improvements in the company’s key business drivers such as net upstream production and downstream margins. Apart from that, we also expect lower crude oil prices and the depreciation of the Brazilian Real against the U.S. Dollar to weigh on the company’s financial results. ^[1]

Petrobras is a vertically integrated oil and gas company, which operates in both the upstream and downstream segments of the industry. The Brazilian multinational energy giant is one of the largest companies in Latin America by annual sales revenue. Its operations account for a large majority of the total oil and gas production in Brazil. Last year, Petrobras’ average daily oil production in Brazil was 1,931.4 thousand barrels per day (MBD), an estimated 90.9% of Brazil’s total oil production. We currently have a $14/share price estimate for Petrobras, which values it just above 10x our 2014 diluted EPS estimate of $1.37 for the company.

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Impact Of Corruption Investigations

Despite several new discoveries, rising upstream production and an improving downstream outlook due to lower crude oil prices and higher domestic petroleum product prices, Petrobras’ stock price has declined sharply over the past couple of months. Most of this erosion in shareholder value could primarily be attributed to investor concerns arising from ongoing investigations into a corruption scandal that has hit the company. One of Petrobras’ former executives has alleged that the company systematically overpaid construction companies hired on contract work and that the excess funds were kicked back to politicians from the ruling party and its allies. The prosecutors claim that almost $4 billion was skimmed off from overpriced contracts with the state-owned oil giant and distributed to Rousseff’s Workers’ Party and its allies in the Congress. However, the overall financial impact of these investigations on Petrobras could be much higher because of the ongoing delay in publishing its audited financial results. ^[2]

Credit ratings firm, Moody’s, recently lowered Petrobras’ baseline credit assessment, which reflects the standalone financial strength of the company excluding any extraordinary support from the Brazilian government, to Ba1 from Baa3. This basically implies that analysts at Moody’s see substantial credit risk in Petrobras without the extraordinary support from the Brazilian government. The global credit ratings firm attributed the change in its stance to corruption allegations and related investigations that have triggered the auditors, in this case PricewaterhouseCoopers (PwC), to delay the signing off on the company’s third-quarter financial statements. Moody’s believes that this delay, which already restricts Petrobras’ access to the debt capital markets, could potentially lead to a covenant breach, which would significantly increase the company’s financial risk since it depends largely on debt financing to fund its 5-year, $220 billion capital expenditure plan. We currently estimate that Petrobras might have to write down about $4 billion worth of assets that were systematically overpaid for previously, and will be looking forward to more details on the potential financial impact of ongoing investigations during the earnings conference call. ^[3]

Higher Upstream Production

Based on the monthly production figures reported by Petrobras, we estimate the company’s net hydrocarbon production to have grown by almost 9% y-o-y during the third quarter, primarily driven by the development of its hydrocarbon reserves in the Campos and Santos basins, located off Brazil’s southeast coast. Petrobras’ upstream production is expected to grow significantly in the coming years as it continues to develop its pre-salt reserves. Between 2014 and 2018, Petrobras plans to invest $153.9 billion in the exploration and production of hydrocarbons in Brazil. It plans to invest a lion’s share of this amount ($112.5 billion or 73%) in the development of existing proved reserves, with more than 64% of that going into the development of pre-salt reserves. ^[4]

Currently, production from pre-salt reserves accounts for just around 27% of Petrobras’ total oil production, but the company plans to increase this figure to 53% by 2020. Petrobras recently announced that oil production from fields operated by it in the pre-salt areas of Campos and Santos Basins, which averaged just 302 MBD last year, hit a record level of 640 MBD on October 28. The company plans to grow its average daily crude oil and natural gas liquids production by 5.5-6.5% y-o-y this year. However, given the progress made so far, we have factored in a 5% y-o-y increase in its total upstream production for the full year. ^[5]

Thicker Downstream Margins

Petrobras’ downstream operations in Brazil have been under considerable pressure over the past few years. According to our estimates, the company’s refining, marketing, and distribution EBITDA margins have declined significantly from around 14% in 2009 to -1.4% in 2013. This has been primarily because of the sharp increase in global crude oil prices over the same period and lower price realization by the company for its refined products sales in Brazil due to government regulations.

Up until recently, since January 2012, Petrobras was selling gasoline, diesel, and other refined petroleum products in Brazil at a sharp discount (around $10-15 per barrel on average) to international prices. This is because the Brazilian government did not allow the company to pass on higher input costs to its end consumers. The government’s reluctance in allowing the price of petroleum products to be increased can be attributed to its policy focused on controlling inflation. Gasoline and diesel are heavily weighted in the country’s benchmark IPCA inflation rate. However, the recent decline in crude oil prices is a big positive for Petrobras’ downstream operations since it reduces the cost of importing refined petroleum products for the company. ^[6]

In addition, last month, Petrobras was also allowed to increase its wholesale petroleum product prices for the first time in more than 11 months. The company increased prices of gasoline and diesel by 3% and 5%, respectively, excluding federal and state taxes. ^[7] Furthermore, Petrobras also initiated the start-up of the new RNEST refinery last month. Located in Northeastern Brazil, RNEST is designed to process 230 MBD of crude oil to produce 162 MBD of low sulfur diesel (10 ppm) along with LPG, naphtha, bunker fuel, and petroleum coke. Once the refinery is completely up and running, the company’s reliance on imported refined petroleum products would shrink significantly. We believe that this new refinery start-up combined with the increase in domestic fuel price and the recent decline in global crude oil prices will help improve its downstream margins significantly in the short to medium term. ^[8]

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1. Clarification on disclosure schedule of information on the third quarter of 2014, investidorpetrobras.com [↩]
2. Former Petrobras Director Says Graft Scheme Widespread In Brazil, reuters.com [↩]
3. Moody’s Lowers Petrobras’ Baseline Credit Assessment; Global Ratings Affirmed, moodys.com [↩]
4. Aggregate Production From The Pre-Salt Layer Reaches 343 Million Barrels, investidorpetrobras.com [↩]
5. Petrobras Third Quarter 2014 Operational Performance, investidorpetrobras.com [↩]
6. Brazil’s Petrobras Raises Gasoline Prices 3%, Diesel 5%, reuters.com [↩]
7. Prices Readjustment, investidorpetrobras.com [↩]
8. Abreu e Lima Refinery initiates Atmospheric Distillation Unit start-up procedure, investidorpetrobras.com [↩]