Petrobras Sticking With Investor-Friendly Plans for the Moment

Strategist

Allen Good

Despite turnover in top management, Petrobras appears to be sticking to the same key elements of its investor friendly strategic plans—notably reduced leverage, disciplined capital spending, and modest production growth—that have righted the ship in recent years. The strategy is literally paying dividends as Petrobras has increased payouts with stronger cash flow from higher oil price thanks to its variable distribution plan, instead of plowing it back into value-destructive investment. 

After years of overspending and a poor record of delivery, Petrobras is slowly regaining investor trust by keeping a lid on spending and reducing leverage. Although spending is expected to grow during the next few years, the increase brings total investment back to 2020 plan levels. Also, total investment of $78 billion compares favorably with the $45 billion it was spending annually before 2014. 

Also, 83% of that spending will go toward high-return E&P segment, with only 10% going toward historically value-destructive refining. That investment will flow toward the low-cost presalt, which, combined with divestment of lower-quality upstream and downstream assets, should improve Petrobras' portfolio quality over time. 

Presalt volumes will continue to grow, becoming 78% of total production by 2027 compared with 76% in 2022, while total volumes will grow to 3.1 mmboe/d, net of divestments, from 2.6 mmboe/d expected in 2023. 

With this plan, Petrobras expects to generate $180 billion to $210 billion in cash during the next five years assuming oil prices of $85 in 2023 falling to $65/bbl by 2027. It also could pay out $75 billion to $85 billion in dividends under its latest dividend policy. 

These plans could quickly change, however, given the election of Luiz Inácio Lula da Silva. He oversaw much of the value-destructive investments of the past and has made comments suggesting dividends should be curtailed and renewable and downstream investment increased. As such, the most recent investment plans presented by management are at risk. Investors should be cautious.

Business Strategy & Outlook

As an integrated oil and gas firm, Petrobras derives revenue and profits from both upstream and downstream operations. However, Petrobras' economic moat has historically emanated from its exploration and production activities, thanks to the company's dominant E&P position in offshore Brazil. After more than 50 years of operations in Brazil, Petrobras accumulated the majority of the country's oil and gas assets, along with unrivaled knowledge of the region and significant offshore operating experience. 

The company's competitive position was bolstered over a decade ago with the discovery of significant oil and gas resources under a salt layer (presalt) in existing offshore concessions. Petrobras' early entry into the previously underestimated and overlooked area created a commanding position in some of the largest discoveries in recent decades. Pre salt volumes have steadily grown to comprise 76% of 2022 production.

On that alone, Petrobras would seemingly have a moat. While we expect returns to improve given recent strategic actions and exceed our estimated cost of capital at our midcycle price assumption of $60/bbl, we do not have sufficient confidence that excess normalized returns will more likely than not be positive 10 years from now. The lack of confidence results from past government involvement in investment decisions and the potential for future involvement creating a substantial threat of material value destruction that prevents us from awarding Petrobras a narrow moat rating. 

The discovery of the presalt reserves prompted the government to push Petrobras to invest in lower-returning assets, particularly refining, as a way to build out domestic infrastructure and create jobs. In addition, the government mandate to supply the domestic market and Petrobras' inability to pass along international prices have resulted in increasing downstream losses and sagging returns. When the new refinery projects fell behind schedule and ran over budget, Petrobras took $17 billion in impairment charges, ensuring future returns will fail to meet the cost of capital.

The E&P business also faced new challenges as the government revised existing oil and gas laws so that Petrobras would have to participate in future offshore licenses at less attractive financial terms. It also made poor capital-allocation decisions; combined with the fall in oil prices, this resulted in another $17 billion in impairment charges. Petrobras took an impairment charge of $13 billion in early 2020 related to E&P assets as management revised its long-term price deck to $50/bbl from $65/bbl.

Although the government hasn't ceased intervention, revisions to domestic product pricing will ensure closer tracking of international prices and avoid the large losses of the past, when government-controlled prices meant Petrobras subsidized the domestic market when oil prices were high. The new system will likely prevent the large profits realized when oil prices fell, but will bring more stability to the segment. However, we see the past capital-allocation miscues as too large to overcome. Meanwhile, government intervention that results in value destruction always remains a possibility. Also, the domestic refineries have no distinguishable competitive advantage, in our view, leaving Petrobras without a moat on its inability to generate excess returns. 

Plans to divest nearly half of Petrobras' refining capacity, along with continued investment in its E&P operations, should result in improved returns and tip the scale toward a narrow moat. Finding buyers for the refineries, however, has proved difficult. Assuming the divestments occur and the E&P segment continues to grow while demonstrating cost improvement, and the government continues to demonstrate a hands-off approach, we would likely revisit our no-moat rating. 

Though emissions abatement, low-carbon technologies, and renewable fuels are garnering more attention from Petrobras, management has committed only a fraction of capital ($4.4 billion by 2027) to sustainability projects. Petrobras' business model remains focused on oil and gas production, which should be a safe bet given we do not foresee a material decline in global oil and gas demand over the next decade. Also, the renewables space entails risk of lower returns and is highly competitive, therefore a focus on core oil and gas business should not detract from Petrobras' prospects. However, the new government has suggested Petrobras increase investment in renewable power and this remains a risk to Petrobras' future returns. 

We have incorporated environmental, social, and governance (ESG) risk into our moat evaluation, but no risk is material or probable enough to cause material value destruction in the next 10 years. A carbon tax is likely to be implemented and will increase the price of end products to consumers, which will likely erode demand, but not in the near term. 

While Petrobras lacks longer-term emissions targets, it plans to reduce carbon intensity through improved efficiencies, biorefining, zero routine flaring, and emissions offsets from carbon capture and storage (CCUS) as Petrobras targets reinjection of 80MM ton CO² by 2025. Petrobras has a relatively low upstream carbon intensity compared with its peers at 15.1 kg CO2e/boe (2022) and has set a target of 15 kg CO2e/boe by 2025 (a 32% reduction from 2015 levels) and to be maintained until 2030. However, about 90% of emissions from oil and natural gas occur during combustion (scope 3), which falls outside the company’s control.

Oil spills are an ever-present risk for oil companies operating offshore and can be devastating to a firm’s value, as BP’s Macondo incident in the Gulf of Mexico shows. With nearly all its production offshore, Petrobras is highly exposed to this risk and has experienced previous oil spills. Oil companies regularly cause spills, but most are immaterial in size and associated fines and cleanup costs are manageable. Large spills such as Macondo are very rare and do not factor into any of our scenario modeling. 

Petrobras also experienced strained relations in areas where indigenous peoples and traditional communities have objected to oil and gas developments and exploration, particularly in more isolated parts of the Amazon rainforest. Social unrest, protests, and sabotage can cause delays or disruptions, higher costs or concession disputes. However, a delay or disruption of any one project remains manageable and is unlikely to materially affect the value of Petrobras.

Finally, Petrobras was embroiled in Operation Car Wash, a largescale corruption and money-laundering scandal, since 2014. Its most material litigation was settled in 2018, including a major lawsuit initiated by investors and claims by the U.S. Department of Justice and Securities and Exchange Commission. President Bolsonaro ended the investigation in February 2021, and Petrobras has implemented management safeguards to prevent widespread fraudulent transactions and combat corruption. Despite more explicit governance structures, corruption remains a risk at Petrobras.

None

Economic Moat

Petroleo Brasileiro

Petróleo Brasileiro SA engages in oil and gas exploration, production, and distribution activities. It operates through the following segments: Exploration and Production; Refining, Transportation, and Marketing; Gas and Power; and Corporate and Other Business. The Exploration and Production segment involves crude oil, natural gas liquids, and natural gas exploration, development, and production. The Refining, Transportation and Marketing segment involves refining, logistics, transportation, trading operations, oil products and crude oil exports and imports, and petrochemical investments. The Gas and Power segment includes transportation and trading of natural and liquefied natural gas, the generation and trading of electric power, and the fertilizer business. The Corporate and Other Business segment comprises the financing activities not attributable to other segments including corporate financial management, and central administrative overhead and actuarial expenses. The company was founded on October 3, 1953 and is headquartered in Rio de Janeiro, Brazil.

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Petróleo Brasileiro S.A. represents a rare investment that's simply and fundamentally undervalued based on its cash flow potential. The company's share price has been punished some by Brent crude prices dropping towards $75 / barrel. Petrobras' improved balance sheet enables it to focus cash towards shareholder returns, making it a profitable holding.

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