3 Key Trends Driving Our $11 Per Share Price Estimate For Petrobras

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We recently revised our price estimate for Petroleo Brasileiro Petrobras (NYSE:PBR), also known as Petrobras, to $11 per share, which is around 14.5x our 2015 full-year diluted earnings per share (EPS) estimate of $0.76 for the company. 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 crude oil production in Brazil was around 2,034 thousand barrels per day (MBD), more than 90% of Brazil’s total oil production.

Petrobras holds a large base of proved hydrocarbon reserves in Brazil, a vast majority of which (almost two-thirds) are located in large, contiguous and highly productive fields in the offshore Campos Basin. This allows the company to optimize its infrastructure and limit costs associated with the exploration, development, and production of these hydrocarbon reserves. In addition to exploration and production of hydrocarbons, Petrobras also operates substantially all of the oil refining capacity in Brazil and distributes refined products through its own retail network and to other fuel wholesalers. Like other integrated oil and gas majors, the company is also involved in the production of petrochemicals. Below, we discuss the four key trends that are driving our current price estimate for Petrobras.

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Rising Pre-salt Production

A bet on Petrobras is essentially a bet on the development of pre-salt reserves offshore Brazil. 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. Most of the growth in Petrobras’ net proved reserves in recent years has come on the back of large pre-salt discoveries. Today, pre-salt deposits contribute more than 30% to the company’s total net proved reserves. Production from these ultra-deepwater reserves has grown significantly over the last few years. Just eight years after the first pre-salt discovery in 2006, Petrobras reported that gross oil and natural gas liquids production from pre-salt reserves, which averaged around 300,000 barrels per day in 2013, reached a record level of 800 MBD on April 11th 2015. [1]

As the chart above shows, the figure has been growing at an increasing pace of late. It rose from a monthly-average rate of just around 300 MBD in February 2013 to 715 MBD in April this year. And Petrobras continues to maintain a strong focus on the development of these reserves despite significant headwinds from lower crude oil prices, ongoing corruption investigations, and the strengthening of the U.S. Dollar against the Brazilian Real. The company plans to invest a lion’s share (more than 60%) of its net capital investments on the development of these reserves. As of now, it has several new floating production units under construction, while production from some of the recently-started ones is being ramped up. These projects are expected to help Petrobras meet its production growth target of 3.5-5.5% for this year. We currently forecast the company’s total net hydrocarbon production in Brazil to grow from around 2.28 million barrels of oil equivalent per day (MMBOED) in 2014 to 3.26 MMBOED by the end of our forecast period, primarily driven by the ramp-up of production from pre-salt reserves. [2]

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) from 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, because of the change in the global supply/demand equation for crude oil, with a faster than expected non-OPEC supply growth, primarily driven by tight oil development in the U.S., and a slower than expected growth in global demand, benchmark crude oil prices declined sharply last year and continue to remain low currently. This has led to a sooner than expected convergence in international and domestic refined petroleum prices for Petrobras. [3]

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. [4]

Slower Capital Investments

Controlling capital expenditures while maintaining modest cash flow growth prospects is the highest priority for Petrobras right now, primarily due to the changed crude oil price environment. With a deteriorated image and downgraded credit ratings after the unfolding of the corruption scandal in Brazil, raising fresh capital has become significantly more difficult for Petrobras. Therefore, the company is trying to meet as much of its investment needs as possible through cash flows from operations and divestments. (See: Petrobras’ Cost of Capital Set To Rise After Moody’s Downgrade)

According to the cash flow plan outlined by the company during the 2015 first quarter earnings call, it expects to invest around $29 billion in its operations (all divisions combined) this year, and divest assets worth around $3 billion. This gives us a net investment figure of around $26 billion for the year, most of which (around 87%) is expected to be spent on the Brazil Oil and Gas division. Our forecast for the Net Capex as % of Brazil Oil and Gas EBITDA is based on the same assumption. In 2016, Petrobras plans to divest assets worth more than $10 billion, so that’s driving the sharp drop in our estimate of the metric for that year. Beyond that, it is just a function of the projected recovery in crude oil prices, cash flow growth, and continued pace of capital investments. [5]

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Notes:
  1. Oil and Natural Gas Production on April, investidorpetrobras.com []
  2. Petrobras 2014 20-F SEC Filing, sec.gov []
  3. Brazil’s Petrobras Raises Gasoline Prices 3%, Diesel 5%, reuters.com []
  4. Petrobras starts up unit at Rnest refinery, ogj.com []
  5. Petrobras 2015 1Q Earnings Call Presentation, investidorpetrobras.com []