When analyzing an ADR like the Argentine oil giant YPF (NYSE:YPF), understanding the country where it operates is key. Argentina's involvement in this state-run company is substantial. Consider that all of YPF's operations, properties, and customers are located in the country, making its business to a large extent dependent upon economic conditions prevailing there.
It's not only the economic situation, but also how often the country's laws and policies change, that generates major distortions to the company's operations. YPF was nationalized two years ago, and now the impact of the government's actions are even more significant to the company than ever before.
Argentina and its influence on YPF
YPF is Argentina's biggest company in size, geographic reach, and capitalization. The company is responsible for a third of Argentina's oil production and is also the market leader in fuels, with about 58% volume share. Argentina also holds the third-largest reserves of shale gas in the world at 802 trillion cubic feet, and YPF claims much of it.
There are three critical areas where Argentina's policies and government actions affect YPF the most: production, prices, and trade.
When YPF was nationalized, the expropriation law declared all operations involving hydrocarbons of public interest, making them subject to price and quantity intervention. However, the nationalization aimed at one main objective: to attain energy self-sufficiency. The only way to do so was increasing production and developing Argentina's huge shale oil and gas formation, Vaca Muerta.
This increased focus on production has paid off for YPF, as production has increased for five consecutive quarters. During the first quarter of 2014, gas production grew 10% over Q1 2013, and oil production grew 7.8%.
This is significant considering that most of YPF's oil- and gas-producing fields are mature, and these type of fields hold declining reserves and production. In fact, before the government took action, production declined by 8.4% in 2011 and 0.6% in 2012 in terms of barrels of oil equivalent per day.
Argentina has a long history of high inflation and unorthodox fiscal and monetary policies. Still, we must admit that the way the current government has dealt with inflation is unique. In 2007, the government had the most clever of ideas: shaking up the country's statistics office and pressuring it to produce rosier numbers! After that, inflation figures lost credibility. Without a clear inflation index for reference, price increases accelerated.
For YPF and any other company in Argentina, it became difficult to plan ahead not knowing how prices and wages would change. Oil unions are quite strong in the country, and they agitated for payment increases that surpassed the real inflation rates for many years, reducing YPF's profitability. The Argentine annual official consumer price index increased 10.8% in 2012 and 10.9% in 2013, but real inflation in those years was around 25% and 30%, respectively.
To put this into context, YPF's average production costs rose from 65.5 pesos per barrel of oil equivalent (boe) in 2011 to 113.5 pesos/boe in 2013. That's a huge cost increase, and it owes primarily to inflation alone. With such price-growth inertia, inflation expectations are hard to temper, and oil unions know how to pressure for wage increases. Recently, they signed a 30% increase valid for nine months -- that's tough.
Nonetheless, this year the government aims to force salary adjustments to remain below nominal price increases, helping companies' finances in real terms. This strategy is working, but mostly because prices are growing faster than wages. Real salaries dropped a steep 10% in Q1 2014. Activity levels in sectors like automotive and manufacturing are dropping, so unions would rather take the adjustment and avoid losing jobs. In the oil and gas industry, however, activity is not slowing down, and unions can easily keep their salaries from deteriorating by halting production and blocking roads in order to force salary negotiations, as they have done in the past.
Regulations on foreign trade
The implementation of export duties, other taxes, and import regulations has also made doing business in Argentina difficult for YPF. The law establishes that when the West Texas Intermediate crude-oil price exceeds $80 per barrel, YPF can collect only $70 per barrel, while the remainder is withheld by the Argentine government as an export tax. Oil companies seeking to export crude oil or liquefied petroleum gas must first demonstrate that domestic demand for such product is satisfied, which is complicated in a country that is not self-sufficient.
In addition, local authorities must pre-approve any import of products and services to Argentina as a precondition to granting importers access to the foreign exchange market to pay for such imported products and services. This restriction generates costly delays in operations. Most of YPF's drilling equipment and maintenance parts are imported. In addition, in the first four months of this year, YPF imported about 120,000 cubic meters of refined fuel to meet domestic demand at an average price of $892 per cubic meter. However, YPF is not affected too severely, as the company has a direct line with government authorities that eases operations.
Given the restrictions and regulations in Argentina, investing in YPF carries its risks. The company has experienced a nationalization and extensive intervention in the market, and other policies also indirectly affect YPF. Nonetheless, the growth potential is there, and it could be argued that the worst has passed for YPF. It is hard to foresee more tightening of government policies, as there is not much more room to maneuver. More restrictions on foreign trade would only bring retaliation, and inflation figures seem to have found a ceiling, considering that activity levels have started to suffer.
YPF's production will continue to grow nonetheless, and demand for fuel in the country (which is fairly inelastic relative to activity swings) should remain within healthy levels. The growth in oil and gas production will eventually allow some exports. When this happens, the restrictions on foreign trade could be reviewed. Why? The aim behind these measures was to protect the domestic market.
Having the government's wink on your side has its perks, and YPF does. Even though the company might not benefit from a drop in salaries in real terms, it should be able to transfer the rise in costs to retail prices. Gasoline retail prices rose 55% in the last 12 months, and price increases are now being performed on a more consistent basis; there have been four so far this year. The government agreed to allow these frequent price rises.
However, the current administration will have to leave office in 18 months. When that happens, the country could face a shift in policies. Even YPF's CEO, who was especially appointed by the president, could lose support and be removed. At least for now, YPF is handling the "Argentina" factor well.
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