Petroleo Brasileiro SA, also called Petrobras (NYSE:PBR) (NYSE:PBR.A), has made great strides in improving its operations through better capital allocation. I believe the shares could be worth $15 if the current strategy is maintained. However, given the recent change in government, I believe Petrobras may revert to its past value-destroying practices, such as subsidizing fuel prices in Brazil and misallocating Petrobras’ capital, causing the shares to trade closer to their book value of $5.26 per share.
This article will cover Petrobras’ Q4 results, its current capital allocation strategy, and the potential risk the new government’s administration poses.
Petrobras is an integrated energy company based in Brazil and under the control of the Brazilian government. Its primary focus is exploring and producing oil and gas in offshore fields within Brazil. In 2021, Petrobras produced 2.8 million barrels of oil equivalent per day, 83% of the production being oil. Additionally, Petrobras has reserves of 9.9 billion boe, with 85% being oil. Furthermore, Petrobras operates 12 refineries in Brazil with a total capacity of 1.9 million barrels per day. Petrobras also distributes refined products and natural gas throughout Brazil.
Q4 Earnings Results
During Q4 2022, Petrobras benefited from higher oil prices, positively impacting its financial performance. Petrobras’ refining segment also performed well, despite concerns regarding product pricing. Additionally, Petrobras demonstrated strong free cash flow and reduced debt levels. However, a proposed change to the dividend policy introduces political risk that could escalate with the new administration.
Petrobras reported an adjusted recurring EBITDA of BRL 75.5 billion, up from BRL 62.5 billion the previous year due to higher oil and gas prices. However, the adjusted EBITDA for exploration and production decreased from BRL 61.1 billion to BRL 57.6 billion. Total production volumes also fell from 2,704 mboe/d to 2,646 mboe/d due to maintenance and interventions and the decommissioning of Marlim platforms, resulting in a decline in full-year production to 2,684 mboe/d from 2,774 mboe/d in the previous year .
Petrobras also reported a reduction in its net debt to EBITDA ratio from 1.1x in Q3 2022 to 0.6x in Q4 2022, well below its target of 1.5x. Petrobras also plans to increase investments in its core assets, particularly in the presalt, while divesting non-core assets.
Capital allocation improvements
Before 2014, Petrobras invested over $40 billion annually in projects that destroyed value. However, the company has steadily decreased its annual capital expenditures since then.
Petrobras plans to increase payouts using stronger cash flows from higher oil prices instead of making value-destructive investments.
The company also intends to invest only $78 billion over the next four years, with 83% of its spending directed toward high-return exploration and production (E&P) segments and 10% toward historically value-destructive refining.
Petrobras will invest in low-cost pre-salt fields (67%) while divesting lower-quality upstream and downstream assets to improve its portfolio quality.
Although Petrobras has a dominant position in offshore Brazil and has strengthened its competitive position by discovering significant oil and gas resources in the presalt, its refining operations lack a distinguishable competitive advantage. Plans to divest nearly half of Petrobras’ refining capacity and continued investment in its exploration and production operations should improve returns.
The board of directors approved a dividend payout of BRL 2.75 per share, slightly lower than the previous quarter’s BRL 3.35. The dividend payout follows the existing policy of distributing 60% of free cash flow. However, the board recommended retaining BRL 0.50 as an extraordinary dividend reserve for the current quarter.
Lula vows to use Petrobras as Brazil’s piggy bank
The Brazilian government’s controlling stake in Petrobras poses a risk to its investment strategy. The government’s decisions may not align with shareholder interests, leading to investments in economically disadvantageous projects that benefit the country instead. The recent election of Luiz Inácio Lula da Silva as Brazil’s president could jeopardize these plans, as Petrobras may return to high spending and domestic fuel subsidies. During Lula’s previous administration, Petrobras overspent and suffered from fuel price controls, which put Petrobras in a precarious financial position. Lula has vowed to use Petrobras as a vehicle for national development.
Specifically, I see four specific mismanagements during Lula’s previous administration.
- Operation Car Wash: This massive corruption scandal implicated Petrobras executives, politicians, and construction companies. The scheme involved bribes and kickbacks in exchange for contracts, and it is estimated that Petrobras lost billions of dollars as a result. I suggest reading this article for more details on the scandal. But it could be summarized in this quote from Wikipedia:
Originally a money laundering investigation, it expanded to cover allegations of corruption at Petrobras, where executives allegedly accepted bribes in return for awarding contracts to construction firms at inflated prices.
- Intervention in fuel pricing: Lula da Silva’s administration was criticized for interfering in Petrobras’ fuel pricing policies, which hurt the company’s profitability and led to fuel shortages in the country.
- Increased debt: Lula’s government encouraged the company to take on more debt that eventually was used to fund the bribery discovered in Operation Car Wash.
- Misallocation of capital: During Lula’s first administration, a significant amount of capital was invested in refineries even though subsidizing fuel prices made the refining business, at best, a break-even business. For instance, in the 2010 Strategic Plan, Petrobras allocated 73.6 billion to invest in refineries, almost as much as the total capex planned to be deployed from 2023 to 2027, of which just 10% will be invested in refineries.
Petrobras’s primary risk is the possibility of a fall in oil and gas prices, which can harm its profitability and limit the development of its reserves. Additionally, the narrowing refining margins may also pose a threat to downstream profitability. Although the risks of high prices and the need to subsidize the domestic market have largely subsided, with Lula’s recent victory, there has been an increase in domestic political risk. Additionally, past corruption scandals, such as Operation Car Wash, have highlighted poor governance practices and the potential for financial misconduct.
If Petrobras continues with the Strategic Plan 2023-2027, the shares could be worth $15 based on a DCF valuation. The Strategic Plan entails reducing debt, investing in high-return assets such as pre-salt, reducing capital expenditure to low-return refining assets and returning 60% of free cash flow to shareholders.
The main assumptions of the DCF are:
1. Brent Oil prices of $105 in 2023 and converging to a long-term price of $62
2. Oil Volume to increase by 4% annually for the medium term
3. I allocated capex following the allocation of the Strategic Plan. I assumed that the capital deployed in E&P would have a ROIC above 20% while the capital allocated to refining to be closer to the cost of capital of 11%.
4. Cost of Capital of 11.0%, this is based on an unlevered beta of 0.95 for integrated oil companies and a 200bps premium for Brazil.
However, as mentioned above, there is a high risk that the new government will mismanage the company’s capital as in the past when the same administration was in place. I could easily see the company divesting its capital for projects benefiting the country, not the shareholders and subsidizing domestic fuel, causing leverage to increase. In this scenario, the shares could easily trade below their book value of $5.26 per share.
Lula served as President of Brazil from January 1, 2003, to January 1, 2011. As it is demonstrated below, ROE gradually decreased due to the mismanagement I mentioned above.
This time around, I think Petrobras’ ROE would, at best, cover the cost of equity of 13.8%.
Petrobras has an unparalleled advantage due to its access to low-cost presalt reservoirs. The company has shifted towards disciplined spending and deleveraging, focusing on high-quality assets and increasing diesel production to meet the growing demand for refined products in the domestic market. Recent price revisions by the government and the divestment of half its refining capacity should help stem losses and high-grade the portfolio. The implementation of the current strategy values shares at $15.
However, despite abundant resources, the company has struggled to increase production and faces government control that could result in financial or strategic decisions that benefit the country but harm shareholders. The recent election victory of Luiz Inácio Lula da Silva may lead to a return to past excessive spending and value-destroying projects, causing shares to trade below the book value of $5.26.