Petrobras Earnings Preview: Lower Oil Prices To Offset Higher Upstream Production, Thicker Downstream Margins

Petrobras (NYSE:PBR) is scheduled to announce its 2015 first quarter results on May 15. We expect lower crude oil prices to weigh significantly on the company’s upstream earnings. Benchmark crude oil prices have fallen sharply since June of last year on rising supplies amid slower demand growth. The average Brent crude oil spot price declined by more than $54 per barrel or 50% year-on-year during the first quarter. However, we expect higher net upstream production, primarily driven by the growth in pre-salt production, and thicker downstream margins, to partially offset the impact of lower oil prices on the company’s overall performance.

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 2,033.6 thousand barrels per day (MBD), more than 90% of Brazil’s total oil production. We currently have a $13/share price estimate for Petrobras, which values it at around 17x our 2015 full-year diluted EPS estimate of $0.76 for the company.

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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 10.7% y-o-y during the first quarter, primarily driven by the development of its hydrocarbon reserves in the Campos and Santos basins, located off Brazil’s southeast coast. The company recently provided its monthly hydrocarbon production update, according to which, its total net oil and gas production from Brazil increased to 2,610 thousand barrels of oil equivalent per day (MBOED) during the first quarter, up almost 12.6% over the year-ago quarter. Petrobras’ domestic crude oil production grew by 11.8% from 1,922 thousand barrels per day (MBD) in 1Q 2014 to 2,149 MBD during the first quarter of 2015. Most of the growth in production came from increased development of the company’s pre-salt reserves offshore Brazil. Its operated production from pre-salt reserves in the Santos and Campos Basins stood at 672 MBD in the month of March, up more than 70% from last year. ^[1]

The expression “pre-salt” refers to an aggregation of rocks that hold hydrocarbon reserves and are located in ultra-deep waters in a large portion of the Brazilian coast. It is called “pre-salt” because the rock interval ranges under an extensive layer of salt, which can be as much as 2,000 meters thick. The term “pre-” is used because these rocks were deposited before the salt layer and are therefore older. The total depth of these rocks can be as much as 7,000 meters from the surface of the sea. Petrobras plans to invest a lion’s share (more than 60%) of its net capital expenditure on the development of these reserves, which are expected to contribute more than 50% to its net production by the end of this decade. The chart below shows how the company’s crude oil production in Brazil has trended since the beginning of 2013. ^[1]

Source: Petrobras’ Operational Highlights

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 -0.9% in 2014. This has been primarily because of 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. ^[2]

In addition, Petrobras also began crude oil processing at the new RNEST refinery in December last year. 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. The company also initiated the start-up of the second crude oil processing unit at RNEST in March this year and expects to commission it by the end of this month. Once the refinery is completely up and running, Petrobras’ 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. However, the positive impact from these factors is likely to be partially offset by increased demand for petroleum fuel products in the domestic market due to the growth in passenger vehicle fleets. This is because higher domestic demand means an increased need for costlier imported fuel to replenish that, which ultimately weighs on the company’s operating margins. ^[3]

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1. Oil and Natural Gas Output for March, investidorpetrobras.com [↩] [↩]
2. Brazil’s Petrobras Raises Gasoline Prices 3%, Diesel 5%, reuters.com [↩]
3. Petrobras starts up unit at Rnest refinery, ogj.com [↩]