Will Higher Domestic Prices Squeeze Petrobras' Profits?

Brazil just announced higher inflation levels, pushing Petrobras to deal with a tougher financial scenario.

Apr 16, 2014 at 5:04PM

Brazilian oil giant Petroleo Brasileiro, better known as Petrobras (NYSE:PBR), is facing a new domestic challenge. Local consumer inflation accelerated last month to its fastest monthly pace since 2003, beating all forecasts. According to the local statistics agency, IBGE, the country's consumer price index increased 0.92% compared with a 0.69% rise in February. As a consequence, the annualized inflation figure rose to 6.15%, the highest level since July and way above the annualized February figure of 5.68%. This is not good.

The financial impact
Unfortunately, this new data made analysts take a closer look and review the year-end inflation figure, revising it upward. The Central Bank of Brazil's latest weekly economist survey raised the outlook for 2014 annual inflation to 6.35% from 6.3% in the previous week.

Petrobras could suffer from this worsening climate, as the rising inflation figures could push the central bank to continue raising interest rates. The company still needs to cover its financial needs for the year, and part of this financing is done locally through so-called "infrastructure notes."These are basically debt notes issued domestically in local currency. In fact, the company announced that it is considering selling $1.35 billion of these instruments.

Petrobras has raised $25 billion this year, and that is not enough, given its investment requirements and a series of setbacks that have so far characterized this year. For example, a contractor recently dropped a 2.3-kilometer steel pipe 5,900 feet down into the Atlantic Ocean, costing $2 million for the pipe alone. If you add in the delays in Petrobras' offshore developments, this fumble gets quite expensive. Petrobras will probably approach the local markets and issue euro- and British pound-denominated global bonds as well. Last month the company completed an offering of $8.5 billion global notes denominated in dollars.

Brazil's monetary authority has performed nine consecutive increases in its interest rate, the Selic, since May 2013. It now sits at 11% compared to a record low of 7.25% in April 2013. This diminishes Petrobras' ability to finance itself at low financial cost domestically.

Are domestic gasoline prices an issue?
Petrobras' prices for diesel and gasoline have increased 8% and 4%, respectively, since Nov. 30, 2013. This is part of a new pricing policy mechanism for oil products that the government put in place, establishing price bands -- a price-controlling method that establishes a price floor and cap -- and two price increases per year of 4% to 8% each.

The main problem is that the company will not disclose any details about when and by how much it will raise domestic fuel prices, which are currently below international prices.

This is not good news for investors, as a big component of profitability is, of course, retail prices. It's especially important considering that Petrobras' production has been stagnant since 2011. Total domestic and international oil and natural gas production in 2013 averaged 2,539 mbbl/day, dropping slightly from 2,598 mbbl/day in 2012. Production for this year will probably remain near these figures, given that no major changes in capacity have been made so far. Now, given growing inflation in a presidential election year, the most likely scenario is that the government will put pressure on Petrobras to keep fuel prices flat. Let's not forget that the company has very close ties with the government, and any plans to modify the current pricing will likely be discussed with government officials. Flat gasoline prices would help keep inflation levels under control and avoid voter discontent, but they would also hit Petrobras' income in real terms.

Bottom line
This inflation scenario puts Petrobras in a tricky situation, as the company will have to deal with increasing interest rates and strong pressure from the government to keep its prices flat. The company has problems of its own, mostly related to having zero growth in output since 2011 and increasing costs to develop its promising offshore ventures.

In macroeconomic terms, Brazil's inflation levels are still healthy and manageable. Many analysts point out that this spike in inflation levels is related to a record-high drought that affected many Brazilian states, driving up the prices of potatoes, tomatoes, and beans, which all have a high weight in the inflation rate. Inflation could cool down a bit as soon as this price disturbance moderates.

One thing is clear, however: Domestic prices cannot continue to grow at these rates for the rest of the year. If this continues, the central bank will probably have to take action, reducing the supply of reals and/or raising interest rates even more.

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Louie Grint has no position in any stocks mentioned. The Motley Fool recommends Petroleo Brasileiro S.A. (ADR). Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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