State meddling warrants bigger Petrobras discount

June 30, 2010

By Rob Cox and Christopher Swann

Petrobras has taken a beating of late. But don’t blame it all on BP. While the Brazilian energy giant is deep in the deepwater business, its technical prowess at ferreting out hydrocarbons trapped in Davy Jones’ Locker is world class. What’s questionable is the firm’s ability to withstand the Brazilian government’s designs to make it an instrument of social policy, as highlighted by its planned massive stock sale and spending program.

Ever since Brasilia floated the monster Petrobras recapitalization, of some $82 billion in total, almost a year ago, the nation’s flagship stock has lagged the BOVESPA index. This year, the shares have fallen 30 percent, twice as much as industry rivals such as Exxon Mobil and Royal Dutch Shell. The labyrinthine complexity of the plan hasn’t helped matters. Even now, Brazilian officials have still to color in key details of the deal.

What shareholders do know is that the government will endow Petrobras with around 5 billion extra barrels of oil — a big boost to current proven reserves of some 15 billion barrels. What they don’t know is how many shares the government will expect in return. Estimates of how much Petrobras will pay range as high as $10 a barrel of reserves, a price that would equate to a $50 billion transfer of value from the company to the state.

Whatever the case, a dilution of minority shareholders appears inevitable. If the government values its extra reserves at $5 a barrel — a conservative estimate — it will demand $25 billion in new stock. Since the government owns around a third of Petrobras, private investors would need to stump up some $50 billion of new cash to avoid dilution.

Even if two-thirds of private shareholders participate in the follow-on offering, that could leave the government sopping up the unsubscribed shares, bringing its direct stake to around 40 percent. While it already controls a voting majority, an increase in state ownership would hardly send a positive signal to global capital markets.

That’s especially true given heightened concerns about the company’s shareholder value bona fides stemming from its recent capital expenditure plan. Petrobras last week unveiled a plan to step up investment in the low-return refining business — from around $43 billion over five years to a whopping $74 billion through 2014. This rightly set off alarm bells given the company’s poor experience in downstream businesses.

The suspicion is that Petrobras is creeping away from its core competency as a deepwater exploration and production pioneer to satisfy government desires to create jobs through the inefficient construction and operation of refineries. Based on its projected capital spending, Barclays Capital estimates Petrobras will be paying around twice as much as rivals when measured by its increase in so-called throughput refining capacity.

That’s why even after factoring in the massive amounts of new oil Petrobras will have to exploit — and taking into consideration that oil prices have risen — the company’s projections for returns on capital haven’t budged from around 14 percent a year ago.

True, Petrobras has much to warrant the envy of oil executives worldwide. Not only does it operate a monopoly in one of the world’s fastest-growing major nations, it is on track to nearly double its output over the next decade. Only Iraq could aspire to such growth. And Brazil’s recent political stability — a rare commodity in the troubled world of oil — also gives some succor to investors worried about the state’s intentions.

That may explain why, even with the stock’s recent underperformance, Petrobras trades at around eight times this year’s earnings, according to Thomson Reuters estimates. That’s in line with Norway’s national champion Statoil, as well as Chevron. And that’s before factoring in the sale of so much new stock, which would make Petrobras look considerably more expensive than its peers.

The company’s conflicted hybrid status — part government agency and part private company — has now been more clearly exposed by its upcoming share offering. With a chunky dilution now on the cards, combined with a big investment in low margin (though high employment) refining operations, investors could be forgiven for chipping away further at Petrobras shares.

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