Petrobras Facing A Real Problem
BMI View: We take a cautious short-term stance toward Brazilian state-oil company Petrobras , noting that the recent sell-off of the real will only exacerbate both the company's rapidly rising net debt burden and the losses of its downstream segment. Moreover, while we expect the government will ultimately hike fuel prices over the coming months to ease investor concerns, we are sceptical that this will be sufficient to close the gap between domestic and international fuel prices.
While we believe Petrobras has substantial long-term potential, highlighting that it is well positioned to benefit from Brazil's coming sub-salt boom, we hold a cautious short-term stance on the state-owned company. First, we highlight that between Q109 and Q113, Petrobras' net debt has more than tripled, increasing from US$21.8bn to US$74.8bn, and its financial obligations are only likely to continue mounting. Namely, on the back of a 2010 change to Brazil's oil law, the company is required to operate and hold a 30% stake in all subsalt areas, implying that it will face a heavy upfront financial burden to develop the country's resources over the coming years. As of Q113 the company was already highly leveraged, with debt-to-equity at 73.3%, and we believe the company's debt position will only continue to deteriorate over the coming quarters as it pushes forward with its ambitious development projects.
|Exposed To BRL Sell-Off|
|Brazil - Net Debt (LHS) & Debt By Currency, %|
Moreover, this will only be exacerbated by continued real weakness. After a sharp 15.6% sell-off in the year-to-date, BMI's Brazil Country Risk analysts expect the Brazilian currency will remain near current levels over the coming years, averaging BRL2.19/US$ between 2013 and 2017 - well below Petrobras' own BRL1.85/US$ projections. This suggests substantial currency risk given that as of Q213, 61% of the company's debt was dollar-denominated. Indeed, while recently implemented hedge accounting may smooth the impact of exchange rate volatility, given our expectations for prolonged currency weakness, this suggests that debt servicing costs will be a significant drag on the country's margins.
|Brazil - Debt To Equity|
Second, the government's decision to maintain domestic price controls on fuel in an effort to stem inflation will continue to have a highly detrimental effect on the company's margins. As Petrobras does not have sufficient refining capacity to meet domestic demand, even operating at 99% capacity utilisation as of H113, this has forced the company to purchase refined fuels at globally competitive prices and sell them at a loss, weighing on the downstream segment's margins. In recent quarters there has been some progress toward closing the gap, including a pick-up in refining capacity and several domestic price hikes resulting in a 21.9% net increase in diesel prices and 14.9% bump in gasoline prices since June 2012. However, the differential between foreign and domestic prices is still considerable - with the Wall Street Journal reporting a 30% difference between domestic prices and foreign prices in August 2013. Moreover, we believe this is only likely to be exacerbated by the sell-off of the real, as this implies that the country's dollar-denominated refined fuel imports are rapidly becoming more expensive.
|Investors Growing Cautious Toward Petrobras|
|Brazil - Petrobras vs Sovereign 5 Year CDS (LHS) & Spread (RHS), bps|
Fuel Hike On The Horizon?
Despite the currency's rapid fall, thus far, the government has denied reports by local news sources of impending fuel price hikes. That said, we believe a few factors suggest an increase in domestic gasoline and diesel prices is more likely than not in the coming months.
First, we highlight rising pressure to ensure that Petrobras' debt rating, which has recently been cut from a stable to a negative outlook by Standard & Poor's, is not downgraded. We have already seen investors growing increasingly cautious of Petrobras on the back of slower than expected progress in the upstream sector and a rising debt burden - reflected in a rapid widening of the spread between Petrobras' five year credit default swap (CDS) and the government's 5 year contract. If the company's debt is downgraded, this could further spook investors, making it even more expensive for the Brazilian company to borrow at a critical time in its attempts to develop its subsalt resources.
Second, inflation in Brazil, while still elevated, has begun to ease, falling within the upper bound of the central bank's target band, at 6.3% y-o-y in July. This suggests that the government may be more willing to hike prices. However, given the real's significant depreciation in recent weeks, we caution that the risks to our Country Risk team's 6.2% average inflation forecast for this year lie to the upside.
Finally, we believe that the October 2014 general election is still far enough off that the government will be able to hike fuel prices without damaging its prospects too much. Indeed, while given recent widespread social unrest we cannot rule out a more cautious stance by the government, if it plans to increase fuel prices any time before the election, we believe it will do it in the coming months rather than wait.
Given the above factors, we ultimately expect the government is more likely than not to increase fuel prices in the coming months. That said, we note that questions remain as to whether this will be sufficient to both fully mitigate the impact of the falling real and continue to close the gap between domestic and international fuel prices. Namely, even local sources have been hinting at no more than a 10% price hike, which would be insufficient to bring domestic prices into parity with international ones. While we could see a series of price increases, we believe it that as the election nears, the window for action is narrowing fast. As such, for now, we maintain a cautious stance toward Petrobras.