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Why Petrobras Will Continue to Struggle

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Brazilian oil and gas giant Petrobras (NYSE: PBR  )  on Tuesday released its fourth-quarter and full-year 2013 financial results. Although the company's fourth-quarter profit fell 19% on a year-over-year basis, the decline was less than forecast. However, apart from that there is not much to cheer about for the company. Petrobras, which is the world's most indebted oil company, is expected to continue to struggle if it is not allowed to raise domestic fuel prices in line with the global standard.

Petrobras' problems
Petrobras, which is majority owned by the Brazilian government, has been struggling over the past few years as it has been forced to sell diesel and gasoline below market prices. Only a few years ago, Petrobras was seen as one of the best investments in the oil and gas sector, given Brazil's vast offshore oil resources. However, over these years the company has struggled to boost its production and instead has had to import fuel due to Brazil's badly managed energy policy.

Subsidized fuel prices, with a rising middle class, have meant that the demand for diesel and gasoline has been rising in Brazil over the past few years. In fact, last year, demand for diesel and gasoline grew faster than the overall economy. Petrobras's refinery capacity, however, has not kept pace with this rising demand. As a result, the company has been importing fuel, even though Brazil has vast offshore oil reserves.

The imported fuel is sold at 20% to 25% discount to the market price. Not surprisingly, Petrobras's downstream division has seen mounting losses over the past two years. A weaker Brazilian real vis-à-vis the dollar last year accentuated the losses for Petrobras.

Mounting debt
The loss-making downstream business has forced Petrobras to borrow. The company saw its net debt rise 50% in 2013, ending the year with net debt of R$221.6 billion. Petrobras has a net debt/adjusted EBITDA ratio of 3.5 now. Other oil majors such as ExxonMobil (NYSE: XOM  ) and Chevron (NYSE: CVX  ) have also seen their debt levels rise as they invest heavily. However, their debt levels are nowhere near those of Petrobras.

Moreover, the debt woes will continue for Petrobras if the downstream business continues to lose money. Petrobras was allowed to raise prices in November last year. However, the price increase was more than offset by the depreciation of the Brazilian currency. The only solution for Petrobras is to charge market price for gasoline and diesel. But that looks unlikely.

Election year
The Brazilian economy has struggled since 2011. Last year, the economy grew just 2.3%. In 2012, the growth was a meager 1%. At the same time, inflation has remained stubbornly high. In 2010, it seemed that Brazil had put behind the hyperinflation era of the 1990s. However, inflation worries have resurfaced in the last two years. In such an environment, it is not likely the Brazilian government will allow Petrobras to raise diesel and gasoline prices further, let alone move them toward the global standard. Also, this is an election year in Brazil. Elections are expected to take place in October this year. It is highly unlikely that the government will allow a price rise as it seeks reelection.

What does it mean for Petrobras? It means more losses down the road. The company imported less oil products in 2013, as it produced more domestically. However, this was achieved by running its refineries at 97% of capacity, a level seen by experts as dangerously high. Of course, Petrobras has been expanding its capacity, but these will take a while to come online. Until then, Petrobras will have to import fuel to fill in the gap. And if the price for imported fuel doesn't move toward the global standard, Petrobras will continue to struggle.

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Varun Chandan

I have a Master in Finance degree from IE Business School in Madrid. I use the top-down approach when it comes to investing. I like to analyze macroeconomic factors and how they impact individual companies.

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