Petrobras Prioritizes Increased Spending Over Dividends in Latest Strategic Plan 

Director

Allen Good

With its latest five-year plan, Petrobras meaningfully increased spending levels as it incorporates investments for the energy transition. While the latest plan is by no means a return to the profligate spending of a decade ago that first placed Petrobras in jeopardy, it is—along with a reduction in the payout ratio—a departure from the capital discipline of the last few years that resulted in a healthier balance sheet and large shareholder payouts.

Petrobras expects to spend $102 billion during 2024-28, an increase from $78 billion in the 2023 to 2027 plan. Positively, high-return exploration and production projects garner the bulk of investment, but their share falls to 72% of the total from 83% previously. 

A greater portion of investment is going toward the refining segment, including biofuels, and the gas and low-carbon energies segment. The latter includes renewable power such as wind and solar, which marks their introduction into the investment plan. While part of the company’s energy transition strategy, their expected returns are much lower. Expected returns are 23% for new E&P projects, but only 14% and 8%, for refining and gas and low carbon, respectively. 

Investing in renewable power is a misstep for integrated oil companies, in our view, given the lack of potential for competitive advantage and low returns. That said, Petrobras is investing less than 10% of its budget in low-carbon energies, while also focusing on carbon capture, hydrogen, and biofuels, which fit more with integrated oil’s core competencies. As such, investors are unlikely to punish Petrobras like they have some global integrated peers, who are investing more in renewable energy. The risk is that Petrobras further increases investments in these areas and returns suffer. 

Although Petrobras retains some flexibility in the spending plan, the greater spending comes with a higher oil price outlook than previously. As such, lower-than-expected oil prices could put spending or the balance sheet at risk. Alternatively, management could reduce its payout ratio further, after reducing it to 45% from 60% earlier this year, likely in anticipation of the higher spending.

Business Strategy & Outlook

As an integrated oil and gas firm, Petrobras derives revenue and profits from 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 nearly 20 years 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. Presalt volumes have steadily grown to comprise nearly 80% of production.

On that alone, Petrobras would seemingly have a moat. While we expect returns to improve given recent strategic actions, they do not exceed our estimated cost of capital at our midcycle price assumption of $60/bbl. We also 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, 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 a portion of 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 a relatively small amount of capital ($11.5 billion by 2028) 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 the 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 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, or  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 large-scale 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 US Department of Justice and Securities and Exchange Commission. Former President Jair 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 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 covers the activities of exploration, development, and production of crude oil, natural gas liquid, and natural gas, for the primary purpose of supplying its domestic refineries. The Refining, Transportation, and Marketing segment refers to refining, logistics, transport, and trading of crude oil and oil products activities as well as exports of ethanol. The Gas and Power segment represents the activities of logistic and trading of natural gas and electricity, transportation and trading of liquefied natural gas, generation and electricity by means of thermoelectric power plants, as well as holding interests in transporters and distributors of natural gas. The Corporate and Other Business segment includes corporate items related to corporate financial management, overhead related to central administration, and other expenses; and other businesses such as distribution of oil products abroad (South America) and the production of biodiesel and its co-products. The company was founded on October 3, 1953 and is headquartered in Rio de Janeiro, Brazil.

Prosafe has signed a contract extension with Petrobras Netherlands B.V. (‘Petrobras') for the provision of the Safe Notos semi-submersible vessel for safety and maintenance support offshore Brazil. The original three years and 222-day firm period was due to complete in July 2020, but the extension will result in operations through to mid-November 2021. The contract extension allows for up to 30 days for 5-yearly class renewal inspections. Total value of the contract amendment including the extension is approximately USD 28.7 million. The Safe Notos, a technologically advanced and efficient Dynamically Positioned (DP3), harsh environment semi-submersible safety and maintenance support vessel, can accommodate up to 500 persons with extensive recreation facilities. In addition with a large capacity open deck area and telescopic gangway, the Safe Notos provides Petrobras with 300 tonne lift capability. Jesper Kragh Andresen, CEO of Prosafe says: “Prosafe is pleased that an agreement has been found to extend the Safe Notos throughout almost all of 2021 at a premium rate compared to recent auctions. The Safe Notos has performed extremely well since commencing operations with Petrobras in December 2016, and we look forward to the continued operations.” Prosafe is a leading owner and operator of semi-submersible accommodation vessels. The company is listed on the Oslo Stock Exchange with ticker code PRS. For more information, please refer to www.prosafe.com Stavanger, 9 November 2020 Prosafe SE For further information, please contact: Jesper K. Andresen, CEO Phone: +47 51 65 24 30 / +47 907 65 155 Stig Harry Christiansen, Deputy CEO and CFO Phone: +47 51 64 25 17 / +47 478 07 813 This information is subject to the disclosure requirements pursuant to Section 5-12 the Norwegian Securities Trading Act

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