My Foolish colleague Stephen Simpson has certainly provided investors with a wellspring of sage advice regarding Brazilian energy behemoth PetroleoBrasileiro
Stephen's thesis at the time was that Petrobras was attractively valued, trading at more than a 50% discount to the average multiple of competitors such as PetroChina
While the stock has had a great run since that time and the valuation discount has indeed narrowed, Petrobras still trades at a significant markdown to its competitors, at around 7.4 times 2006 First Call estimates of $12.36, a 30% discount to the average multiple sported by its peers.
Guess what? (Drumroll, please).... I believe this discount will continue to close, and that shares of Petrobras remain attractive at these levels.
What are the reasons -- aside from my bullishness about emerging market stocks in general, and energy stocks in particular -- for my optimism? Simply put, I like Petrobras because the company is the dominant player in energy production and refining in Brazil, has the second-largest amount of proven reserves in Latin America, and should continue to show strong production volume growth.
Don't get me wrong, investing in Petrobras isn't without hazards (which I'll address later), but I believe that the potential rewards far outweigh the possible risks. Let's take a look, shall we?
Market dominance in Brazil
Petrobras pretty much is the energy industry in Brazil. The state-owned company's launch of a new major offshore platform (P50) in the first quarter of 2006 should make Brazil completely self-sufficient in oil production by end of the year -- and all the production is owned by Petrobras. Similarly, Petrobras owns 11 refineries within the country, with a throughput of 2.1 million barrels/day, representing roughly 98% of Brazil's total refining capacity. It should be noted that currently 80% of the company's refining needs are met through Petrobras' own domestic production, a percentage that is likely to increase as the company upgrades its refineries to handle the heavier crude that represents the majority of its production.
While these two operating segments contribute the vast majority of the company's earnings (97% as of the end of 2005), Petrobras also runs some 7,000 gas stations around the country (21% market share) and is in the process of beefing up its power generation operations from its currently installed base of 2,400 megawatts (MW) to more than 5,000 MW over the next few years.
Of course, having a virtual monopoly in a country is only beneficial if the economy remains sound, but Brazil's certainly seems to be. The Brazilian National Confederation of Industry (CNI) recently upped its 2006 GDP growth rate to 3.7% from 3.3%, thanks to increased strength in manufacturing. Growth is also expected to accelerate next year to 4.5%-5% (according to Brazil's Finance Ministry), powered by declining interest rates, a strong real, and strong domestic demand.
Not too shabby an outlook, eh? Now, let's take a gander at Petrobras' reserve situation.
As I stated previously, Petrobras has the second largest proven reserves in Latin America -- behind only Venezuela's state-owned PDVSA (and that country is not exactly a good investment play at the present time) -- with roughly 10.6 billion barrels of oil-equivalents (BOE) as measured by SEC guidelines. This translates into roughly 13-plus years worth of domestic output, at the company's current production level of 2.28 million BOE per day.
Furthermore, while 80% of its proven reserves lie in large, adjoining fields in the Campos Basin, there remain many other areas that Petrobras is just beginning to develop. A prime example of these further opportunities is the Espirito Santo Basin, where a newly discovered field is estimated to contain some 280 million barrels of light crude.
In all, the company has over 40 different exploration and production projects under development in Brazil, and Petrobras continues to snap up new properties -- grabbing some 60%-80% of all fields offered by the Brazilian government over the past three years.
After a rough 2004, which saw Petrobras' production fall 3.1%, the company rebounded strongly, reporting that its average daily domestic production grew by some 12.8% in 2005. While production growth isn't likely to continue at such a rapid clip -- it slowed to a mere 10% in the first quarter of 2006 -- the company's proven reserves coupled with a recently increased capital expenditure plan (to $87 billion between 2007 and 2011) should allow the company to hit its target of average annual production growth in the neighborhood of 6%, well above the industry mean.
I want to make two additional quick points: First, Petrobras' expertise in deepwater E&P allows it to have one of the lowest production costs (before the government's take) in the industry, at $5.73/barrel. Secondly, the company is using incredibly conservative numbers for its projections, assuming a Brent price of $45/barrel in 2006 and a mere $25/barrel in 2008.
Hmmm, can anyone say upside potential?
Of course, no investment is without risk, and Petrobras does have a few ... let's look at three of them.
Among the risks facing the intrepid souls investing in Petrobras is the specter of government meddling. While the price controls previously imposed on the company were abolished in 2002, the Brazilian government has been known, from time to time, to "nudge" the company into granting discounts to certain politically important constituencies, especially in an election year.
Another concern is that Petrobras' debt is virtually all dollar-denominated, not a problem in today's environment with a strong real and a weak dollar, but....
A third problem is that Petrobras makes up a third of the weighting of the MSCI Brazil Index. This means that if investors panic and want to sell Brazil, then shares of Petrobras will get dinged, regardless of the underlying performance of the company.
Some serious concerns, no doubt about it.
That being said ...
Despite these risks, I believe that long-term investors -- those capable of stomaching a certain amount of volatility -- should take a look at shares of this emerging market giant. It's seldom that you find an energy company with the combination of high reserves and strong production growth that trades at a markdown to its peers.
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Fool contributor Will Frankenhoff is enjoying his time writing for The Fool more than reading The Financial Times, rooting for the N.Y. Giants, or pondering the vagaries of life (pretty unsuccessfully up to this point). He welcomes your feedback. He does not own shares in any of the companies mentioned above. The Fool has a disclosure policy.