The 3 Biggest Threats to Petrobras' Success

With the massive offshore fields of Brazil ready to take off, Petrobras (PBR -0.88%) is in the middle of one of the worlds most ambitious growth plans over the next several years. The company is set to spend $237 billion to develop its huge finds at home and completely change its face. Despite the promise that Petrobras may hold, investors may give pause before loading up on shares. Let's look at three pressing issues that could drag on Petrobras' profitability.

A government mandated loss?
Sometimes being half national oil company, half public enterprise brings some pretty cushy government perks when it comes to doing business. On the flip side of that equation, that government intervention can also bring some headaches. The most visible example of this rough situation is the company's refining and marketing segment. In Brazil, gasoline prices are set by the national government to help curb inflation. Also, as the government's go to oil company, Petrobras is responsible for imports of crude and finished petroleum products for the entire country. This means that Petrobras can sustain some hefty losses if the price for imported products is greater than what they can sell for. 

Source: Petrobras Investor Presentation (Note: Prices on chart are denoted in Brazilian real, which is about 2.3 reais per U.S. dollar)

This past quarter, the refining and marketing segment of Petrobras suffered a $1.82 billion loss, which is actually a vast improvement over the $5.1 billion loss refining and marketing took back in the second quarter of last year. The biggest reasons for the improvement have been from a combination of fewer imports, lower purchase prices for imports, and increased price levels on the domestic front. As long as Petrobras is unable to set prices on gasoline that are indicative of market conditions, it is very likely that the refining arm of the company will continue to be a major drag on the bottom line. 

Where going local goes wrong
There are lots of social merits behind the idea of buying local. For Petrobras, though, the government mandates on production and locally manufactured equipment has led to some additional financial burdens. Depending upon the type of drilling or exploration, Petrobras needs to source between 30% and 70% of its equipment from Brazilian manufacturers. This has led to several cost overruns and scheduling delays as the country has had a difficult time meeting the needs of Petrobras. Last year, Diamond Offshore (DO) executives stated that a single rig's day rate increases by $40,000 by being in Brazil thanks to these mandates. This is a 10%-15% premium for the 10 rigs that Diamond has operating in the region, and these costs are of course deflected onto Petrobras.

With Petrobras responsible for a 30% working interest in every well that will be drilled in the pre-salt basin, the high costs to get all of the infrastructure up and running to make this massive oil field productive will put an immense burden on capital expenditures, which ultimately will take away from returning that operational cash to investors. 

Doubtful debt situation
Overall, when you look at the balance sheet of Petrobras, the company's debt-to-capital ratio of 42% isn't of great concern. While the company is more debt-levered than some of its peers in the integrated major category, it's not so egregious that it should be too much concern.

Source: S&P Capital IQ

If you dive deeper into the company's debt structure, though, you will find something that is a little bit more alarming. Of the $102 billion that the company has in debt outstanding, 86% of it was issued in a foreign currency. What this means for the company is that the amount to pay off that debt is both influenced by the interest rate as well as any changes in the foreign exchange between now and the date of repayment. To give a little perspective, 26% of the company's debt outstanding is based on U.S. dollars versus Brazilian reais. While foreign exchange rates can fluctuate as much as the market over the course of a day or so, looking at the inflation rates between the two countries shows that Brazil has, on average, an inflation rate 4% higher than that of the U.S. over the past several years. This means that the total Petrobras will need to pay back that loan will be the interest rate plus that 4% tacked on top.  

The uncertainty associated with debt in foreign dollars could significantly affect the way that the company can repay its debt. Again, Petrobras is a company that straddles the fence between government ownership and publicly traded company. So it is very unlikely that the company would ever go under because of these debt problems, but it could certainly have a big affect on the rate of return on an investment.

What a Fool believes
For integrated majors to move the needle in terms of production, it takes massive amounts of capital and a certain degree of difficulty that the smaller producers simply cannot handle. In a study by Ernst & Young earlier in the year, three of the four integrated majors surveyed had reserve replacement costs above the industry-wide average, with BP paying the most at 3.7 times as much as the average to replace every barrel of produced oil. The potential to move the needle in terms of production is certainly there for Petrobras, but the question still remains whether it can do it in a way that will benefit shareholders.