Paper Money and Energy Demand, Part 3

Spanning the energy investing landscape for companies with a competitive edge, one cannot ignore the state-controlled national oil companies (NOCs) trading on major exchanges. Production from NOCs accounts for the lion’s share of world production, dwarfing production from majors like Exxon, Shell, and BP. Many NOCs — including Saudi Aramco, Petroleos de Venezuela, and Kuwait Petroleum Corp. — are also key members of OPEC and are not open to foreign investment.

But Brazil-based Petroleo Brasileiro S.A. (PETROBRAS) is not a member of this group, and is highly profitable despite its smaller size. The Brazilian government owns 57% of the shares, while 27% trade as ADRs on the NYSE under the ticker symbol PBR:

PETROBRAS: A Newly Capitalist National Oil Company

The history of PETROBRAS dates back to 1953, when it began operating as a 100% government-owned enterprise with oil production of 2,700 barrels per day (bpd). Up until 1995, the company held a government-granted monopoly on the upstream (exploration and production) and downstream (refining and marketing) oil market in Brazil. This, combined with price controls on oil and refined products, was clearly not leading to the kind of increases in living standards enjoyed by most Western economies over this 41-year period.

Government-granted monopolies always lead to inefficiency, complacency, and shortages. With no competition, the incentive to reinvest profits for future growth was virtually nonexistent, and PETROBRAS was selling into a highly subsidized market. To complicate things even further, the Brazilian government overprinted several different fiat currencies until they lost all value, leading to one bout of hyperinflation after another. This type of monetary environment was hardly conducive to maintenance or expansion projects; who in their right mind would invest hard-earned capital — with its present purchasing power — in return for an increasingly worthless stream of future earnings? Just like bonds, the value of capital investments can be completely eroded by high inflation:

But the late 1990s marked a significant turning point for the oil and gas exploration and production (E&P) business in Brazil. In 1995, the Brazilian constitution was amended to open up investment to international companies. Market reforms continued until 2002, when prices for crude oil and refined products were completely deregulated (other than long-term natural gas supply contracts signed years ago).

Since 2002, crude and refined product prices received by PETROBRAS have been indexed to international prices, while natural gas remains an underdeveloped market. Hydroelectric plants generate about 83% of Brazil’s electricity, versus only 4% from gas-fired power plants — just one indication that PETROBRAS’ gas production yields very low, if any, profits.

The First-Mover Advantage in Unexplored Territory

Along with deregulation came a change in management philosophy from complacent and bureaucratic to aggressive and focused on achieving high returns on investment. PETROBRAS is a fully integrated oil company with assets including oil and gas reserves, fleets of drilling rigs and oil tankers, along with a collection of refineries, pipelines, and service stations.

But the most interesting achievement resulting from free market reforms is the announcement earlier this year that Brazil had reached the stage of oil self-sufficiency (i.e., the country produces more than enough oil to fulfill domestic demand).

PETROBRAS is the single greatest contributor toward this national goal of oil self-sufficiency — not counting decades of sugarcane ethanol subsidies from the government. The company has really “made hay” with its endowment of the choicest petroleum asset in the country: the prolific Campos Basin. The company has locked in the lion’s share of attractive lease acreage within this basin, and with years of accumulated deepwater drilling experience has really ramped production in time to benefit from the surge in oil prices since 2002. According to the EIA, Brazil (which extends only marginally beyond PETROBRAS) produced oil at a rate of 1.7 million barrels per day over the first nine months of 2006, representing 8% compound annual growth over the past 10 years:

Viewed in isolation, this red chart of Brazil’s crude oil production certainly provides Peak Oil skeptics plenty of ammunition for the case that aggressive investment and advanced technology can yield impressive production growth. But look at the same chart superimposed onto historical production trends from Saudi Arabia, Iran, and Venezuela.

Production from each of these OPEC members is subject to a high degree of political risk and Iran and Venezuela in particular have not exactly fostered the type of economies that reward investment in oil infrastructure. So when you hear the argument that all it takes is a little investment to bring life back to declining basins, remember that the vast majority of the world’s oil is not produced by highly efficient, capital-replacing enterprises like Apache Corp. or Devon Energy Corp. Rather, these regimes realize that they have little incentive to invest heavily and potentially kill the high profit margin environment they currently enjoy:

Aggressive Production and Investment Plans

Back to the realm of ROI-focused companies — PETROBRAS discovered the highly prolific Campos Basin in 1974 and production commenced in 1977. As of September 2006, the Campos Basin yields 1.47 million barrels of oil (and NGL) per day, or 76% of Brazil’s total daily production. Located about 90 miles off the coast near Rio de Janeiro, the basin’s production has long been dominated by PETROBRAS:

source: PETROBRAS

Shell is the only foreign company currently operating in Brazil (producing 50,000 barrels per day in the Campos Basin), and Chevron is expected to bring its 120,000 bpd Frade project online over the next year. But foreign participation in recent production license auctions has been mostly limited to acquiring ownership interests in PETROBRAS-operated projects. Perhaps this reflects the lack of foreign attraction to non-Campos properties. If this is the case, Brazil may, in fact, be approaching peak oil production within the next five years.

PETROBRAS was a pioneer in deepwater oil production, and has reached the stage at which about 70% of its oil production is derived from fields more than 1,000 feet under the ocean surface. This would not be the case if cheap and easy-to-find crude were plentiful in shallow water or on land. So this growth plan, outlined in a company presentation, depends heavily on the deepwater:

source: PETROBRAS

Will PETROBRAS Produce Cash or Consume Cash?

Free cash flow (FCF) can be thought of as the amount of money that can theoretically be paid out as a dividend to shareholders each year. But almost all companies pay only a portion of this sum out as a dividend. The remainder can go toward share repurchases, debt repayment, or funding growth initiatives. It all depends on how aggressively the management team chooses to pursue growth opportunities. Conservative management teams allocate a very high proportion of free cash flow toward dividends, share repurchases, and debt repayment; these are different ways to return capital to shareholders.

Conversely, a more aggressive management team that views its company as a “growth” company will allocate very little or nothing toward dividends, share repurchases, and debt repayment. Instead, it reinvests cash flow into future growth projects. If the management team wants to be even more aggressive, it may tap into outside capital by taking on more debt or issuing more stock. If the opportunity is truly great, and requires quick action to establish a market presence, then piling on balance sheet leverage is often the right decision. It just raises the risk profile — and the expected return — to a far higher level.

The most common calculation of free cash flow is operating cash flow minus capital expenditures. Divide this amount by diluted shares and you have FCF per share. Over the past four years, ExxonMobil’s cash from operations has grown much faster than capital expenditures. This reflects the conservative nature of its management team, which appears to doubt the sustainability of high oil and gas prices. Otherwise, it would be far more aggressive about ramping up capital expenditures — expenditures that will fund growth in reserves, hydrocarbon production volume, and, ultimately, profits:

State-controlled companies PetroChina and PETROBRAS have also generated billions in cash from operations, but they have been far more aggressive about reinvesting this cash into future growth. Partly compelled by government pressure and partly driven by the profit motive, they are making a bigger bet that high prices are here to stay. PETROBRAS plans on spending $87 billion over the next five years, with more than half being dedicated to E&P. This kind of commitment will be necessary for the company to achieve its goal of reaching 2.4 million barrels per day by 2011:

source: PETROBRAS

So considering the huge size of these investments, will PETROBRAS consume cash or produce cash? It depends on both the future trajectory of oil prices and continued success in deepwater drilling projects. If the next four years look anything like the last four (since the 2002 deregulation of Brazilian energy prices), then the company is making investments that will yield impressive long-term earnings for shareholders. Eight times earnings for a company with a diversified asset base and a high growth profile seems like a pretty good prospect from a risk-reward perspective.

Good investing,

Dan Amoss, CFA
October 20, 2006