A Few Thoughts on Brazil E&P, Repsol and BG

Energy, Global Economy, On the cover, Sin categoría

This article was published in Spain’s Cotizalia on o8-06-2010

Eight months ago I wrote from Rio de Janeiro saying how wrong most analysts were in their estimates of development costs of the pre-salt discoveries in Brazil, and time has proved us right. Facts now show between 25 to 30% less than the $40/barrel estimated by consensus. Despite this, the market is not reflecting the incremental value of these reserves in the involved companies’ stocks (Petrobras, Repsol, BG and Galp).

For example, BG Group trades at a 25% discount to its NAV (Net Asset Value), despite being one of the most benefited from the discoveries in Brazil (with holdings of between 25% and 30% in the most attractive blocks, BMS- 9 and 11), showing excellent LNG trading results and being a clear takeover target. Even if we accept the valuation of its remaining assets at “conglomerate” multiples, BG Group at £10.5/share does not reflect in any way reflect the intrinsic value of its Brazilian assets in Tupi, Guara, Carioca, Iara, which, at $77/bbl would be worth about $16 billion. And BG is the only group exposed to Brazil able to finance its development with own free cash flow.

Part of the blame for the loss of interest in Brazil comes from the delay of Petrobras to complete its capital increase ($20-30 billion) and the lack of new information about the pre-salt assets and the improvements achieved.

In this comes Repsol, and says they cannot wait any longer. And it will IPO (or sell to a third party) 40% of its E&P assets in Brazil. Repsol, as Galp and Petrobras, does not swim in free cash flow and thus seeks to raise cash to finance the development program of the fields and diversify into other areas. For Repsol, unlike for BG, Brazil represents too large a percentage of its total E&P assets.

How much are these assets worth? Analysts estimate between $5 to $10 billion, or $8/bbl at the top end of the range for assets that to this day are undeveloped. It seems an excessive price, when BG’s Brazilian reserves are valued at $ 3/bbl, in Petrobras at $3.4/bbl and Galp at $2.8/bbl.

Additionally, Repsol’s assets are the most exposed to changes in the Petrobras development program. If developing the Franco area is the Petrobras focus after Tupi, then Guara + Carioca will not be starting up until 2020, which would severely impact the NPV of the Repsol assets, and put at risk any value above $2-3/bbl.

But let us not forget that out of these companies, two (Galp and Petrobras) are semi-state-owned, and therefore “not for sale”, the third, BG, is a very large leading independent global gas explorer and producer, so maybe Repsol Brazil is the only option for third parties to participate in the pre-salt opportunity. Additionally, the transaction multiples we have seen recently have reached up to $12/bbl (proven and probable reserves). Therefore, it is not surprising that the $8/bbl figure mentioned before would be more than acceptable in a private transaction.

However, it is more difficult to think that an IPO will reach the same valuation from day one due to market risk, the fact that the assets no longer provide an aggressive exploration potential (most of the discoveries have been announced already), and that the market would bear the risk of the previously mentioned delays or difficulties in the development schedule of the assets. And we have seen in Pacific Rubiales or OGX that the attractiveness for the stock market of pure exploration assets is diluted when these move into production. But it is worth bearing in mind the “scarcity value” of Repsol Brazil for other international oil companies, as Petrobras will be the only beneficiary of the new licenses in the country.

The IPO of Repsol Brazil, if it happens, would be great news. To begin with, because it would crystallize value and would allow investors to choose the part of the integrated group that interests them the most, without having to take the risk of refining, which terrifies me, or Argentina. But it is also a double-edged sword. If the listed subsidiary fails in the secondary stock market, it will de-rate the Repsol stub agressively. It is inevitable to see the “de-rating” of the parent when the subsidiary goes public, but even more if it loses value, and this has been seen in 100% of the cases of spin-offs, IPOs, or rearrangements of divisions priced “greedily”. Repsol Brazil also has to compete for investor interest against BG, Petrobras, which trades at a 15% discount to its peers, and OGX, its largest competitor in Brazil as a “pure play” in E & P.

For now, the commitment to crystallize value, re-organize the company and reduce the conglomerate discount has made Repsol trade at a deserved 11% premium over its peers (ENI, Total, Shell, OMV). For Repsol it is now time to make its Brazilian division a “must own” stock for investors. And that has to come from a good pricing and solid catalysts.

In Memory of Matt Simmons

Energy, Global Economy, On the cover, Sin categoría

This article was published in Spain’s Cotizalia.com on 08/12/2010

Last Monday I received a short email from Matt Simmons’ institute. Mr. Simmons, oil guru, visionary of clean energy and author of one of the most fascinating and controversial books of the recent past, “Twilight In The Desert”, had passed away at the age of 67 years old. I was shocked.

For those of us who study oil and energy, Matt Simmons was always an essential reference to understand the complex world of energy. To me, he was an amazing personality and an absolute master in his field. Matt was humble, open, always ready to discuss different theories and innovations in the field of energy, and what’s most important, always interested in other people’s opinions. Matt didn’t speak from an altar to share his wisdom. He engaged in dialogue and open debate. And listened. Patiently. To everyone.

His loss is immense but his legacy is outstanding. Let me centre this article on some of his many achievements.

On one side, his analysis of the oil fields in Saudi Arabia was groundbreaking not only for the wealth of detail and clarity of the arguments, but also because it was the first time that someone had questioned official information with solid data. It might seem strange to my readers, but before “Twilight In The Desert” no one really questioned the official figures of reserves provided by the producing countries. Only a few years before Matt’s book Newsweek was warning of an “oil glut” based on precisely those official numbers!. Today, all of us who study oil and gas try to make an effort to challenge official numbers and study the issues that might impact the figures of proven and probable reserves in countries like Saudi Arabia, Iran, Iraq, Brazil, Russia, etc. Thanks to Matt Simmons we are all a lot more cautious with predictions of new production and, most of all, in estimating decline curves. And this caution has proven to be right when, delay after delay and revision after revision, we can all see that global oil production does not reach the 89mboepd mark even counting with Iraq and Tupi.

It is true that some of the predictions of “Twilight in the Desert” have been delayed, mostly due to the global recession’s impact on oil demand. But even the Kingdom of Saudi Arabia is now showing an unusual level of transparency and recognizing the need to preserve current reserves and monitor the declines of Ghwar, Khurais or Khursaniyah.

Many have criticized the “Peak Oil” theory, but reality has proven that supply issues are only growing and even those who criticize the theory must admit that it has been essential to help promote innovation and alternatives. Even the IEA admits that the “deficit of discoveries” is so large that the world will need investments of $26 trillion to replace consumed reserves by 2030.

But Matt Simmons also left us a tremendously interesting analysis of the opportunities provided by shale gas when analysts and companies said it was uneconomical at $10/mmbtu. Matt was proven right when he mentioned that costs would drop aggressively and proving that profitability of shale gas in Marcellus, Barnett or Haynesville was solid at $4.5/mmbtu.

Mr Simmons’ analysis of the new paradigm of natural gas as a clean, abundant and profitable source of energy and his studies of other alternative sources were also essential for the US administration’s advances in energy policy.

The last time I spoke with Matt Simmons he came for a chat at my fund. We spoke about the challenges of the electric car as a viable alternative to traditional vehicles, the difficulties to develop a coherent and sustainable energy policy in the US and the Macondo oil spill, where Matt was right as well when he warned of a much worse spill at a time when most analysts and experts still spoke of 5-10kbpd. His last comments to me were about the work he was doing on alternative energies that would be efficient and viable without massive subsidies. I am sure his team will continue the good work.

To all my readers, I recommend you to read or re-discover “Twilight in the Desert”, and if you can, read some of his papers from the Ocean Energy Research Institute in Rockland, Maine. I will remember the chats and debates and his lively and open personality, and as soon as I can, I will enjoy a wonderful Maine lobster in his memory. Rest in Peace.

European utilities and the value trap

Energy, Europe, Global Economy, On the cover

(This article was published on Cotizalia in Spanish on July 22nd 2010)

“Welcome to the banana republic.” These are words of RWE’s chief financial officer (the second-largest German utility) after learning of the German government’s intention to impose a tax on nuclear power stations of € 2.3bn pa. Nearly 15% of the net profit of the two major companies are to be “seized” by the government. Snip.

The European electricity sector is again the worst performing sector in 2010, down 20%. This already occurred in 2008 and 2009 due to the weight of the five major integrated companies, which have all the features of what is called a “value trap”:

1. The returns of the companies are “seized” when governments need money. Indeed, from Germany to Italy (the cynically called “Robin Hood tax”), power companies are perceived by governments as public service entities, available to tap the capital market to make huge investments in the long term, but not allowed to generate returns above what governments consider “adequate”, which is a paltry 8% ROACE on average. At the end of the day, the governments think, they can always make capital increases (more than € 16bn in 2009) and start all over again. A sector where companies invest hundreds of billions per annum for 25 year projects but where the rules of the game change every four or five.

2. Run To Stand Still. Part of the huge number of mergers and acquisitions that we have seen between 2004 and 2007 came from the objective of these groups, several semi-state owned, seeking to generate returns outside their country because the profits in their home market will always be limited. But then the results end up being as disappointing as the domestic. Look at EDF (France), which has spent €60bn on acquisitions, to generate no added net income whatsoever, or Endesa-Enel, GDF-Suez, a story of additions through acquisitions that have always delivered lower ROCE, or E. On, whose net profit is very similar to that of 2007 after acquiring billions of dollars in assets. Funny that the sector is not cheaper on 2 year forward multiples than it was in 2008, when it’s 40% lower.

3. One sector that is only optically cheap. The sector trades at an average of 6.7x times 2012 EBITDA and dividend yield of 6.7%. It seems very attractive to those seeking an investment in the “long term”, right? Careful. The EBITDA multiple is actually closer to 8.5 times if “clean” estimates, removing the free CO2 permits, are applied. And more importantly, after the wave of M&A and re-gearing, the WACC has increased, something that companies do not acknowledge. And be careful with the estimated dividends. First, because we have already seen cases (Enel, National Grid, SSE, etc.) in which the dividend is paid by the investors themselves through capital increases disguised as “opportunities for growth”. But also remember that such a capital intensive sector needs to maintain a pristine credit rating to access the bond market. With returns confiscated and an average 3x Net Debt/EBITDA, the sector does not generate enough free cash flow to undertake the committed investments, pay dividends and reduce debt.
In addition the sector has delivered the keys to the reserve margin management and investment decisions in new generation capacity to their governments, who are delighted to see overcapacity, and the industry, with the risk of seeing no growth, prefers to invest in the hope that someday they will be remunerated for the investments.

A sector is also a reflection of its managers. Except for honorable exceptions, it’s worth highlighting the low quality of management teams, with a history of investing billions at the peak of the cycle and then selling at the lows, and their poor exposure to the share price (minimal ownership of directors in the shares). At last, after all, how can the investor trust a manager who owns almost no shares in their own company, is incentivised to buy anything that moves to “grow”, and having to invest long term, have a such a poor long term track record?. Additionally, I would highlight the low interest that governmets have in the share price of their own investments, not aligned with the minority holders.

It is interesting to see in this environment that the worst performing stocks are the most recommended by analysts (EDF, E. On, GSZ, EDPR) all over 80% of “buy” recommendations. I always say it: In a bull market you don’t need analysts and in a bear market you don’t want them. The only ones that are doing well are the ones showing financial discipline, focused on return on capital employed (ROCE) and “anti-government rebellion”. And if you like the sector and want value, play short-term securities which are targets for predators or in the process of restructuring, or transmission companies, BUT only those which offer a higher dividend to that of the yield of corporate and government bonds, because if not, you are subject to the risk premium of the equity market without the required returns. The rest is waste of money. We continue to warn about it.

Careful: The Five Risks Of Big Oil

Energy, Global Economy, On the cover, Sin categoría
(This is a November update of an article published in Cotizalia in Spanish)

I have read several analysis reports recommending to buy large integrated oil companies versus the market because they have underperformed. Careful.

Yes, in the last weeks the market has risen considerably and the brokers dust off the “Buy” recommendation machine and recommend laggards. I have nothing against it. But I, just in case, would list the reasons why Big Oil, as stocks, generate more risk than return.

1) Big oil is not a good way to play the oil price. The average price realization of their basket of crudes has fallen inexorably to stand at an average of $65-68/barrel, while oil contracts and licenses underpinning the future growth are very restrictive in terms of taxes and profit sharing between the producer and the company (production sharing contract). Moreover, most of Big Oil’s mid-term growth is heavily weighted to gas. This has led to most of Big Oil to generate returns of 33% in “legacy assets” and much lower, close to 15% on new projects. Therefore, to reinvest cash generated at 33% in projects that generate 15% returns destroys shareholder value, even if it’s a decision of business survival.

2) An industry that invests 33% of its capitalization to replace less than 100% of its reserves. One reason why the sector “does not work” is that multiples seem cheap (PE 8.5 x, Dividend yield 6%), but what really matters is the cash flow generation in a sector as capital-intensive as this one. Free cash flow yield has fallen year after year from 7% in 2003, with oil at $30/barrel to a very poor 3.6-3.8% in 2010 with oil at $80/barrel. Since depreciation of assets is still lower than the capital invested, the real PE (the “Economic PE”) is much higher, close to 9.5x … no longer so cheap, right? If we add that such investments can hardly replace the reserves consumed, it adds to the sector problem: “running to stand still”.

3) Diversification does not add value (to shareholders.) Another typical argument is that mega oil companies are trading at prices far lower than their sum of parts. As we have discussed other times, the conglomerate discount of about 30% is justified when the generation of returns of some of the parts is much lower than the core business. For example, one of the major listed companies invests 15% of their capex in areas (refining and power) that generate a return on capital employed of 5.5%. Then it is justified that the valuation of such activity does not add up, but substracts to the remainder of the valuation of other activities.

4) Lots of reserves does not mean value. The valuation of big oil based on reserves is not valid, unless the company, like E&Ps, was for sale. If, in addition, it appears that these companies do nothing more than buy new reserves to replace those consumed, the value of the conglomerate does not exceed $4/barrel (proven and probable) until they start generating cash. That is the reason why Big oil trades on traditional PE multiples, EV/DACF and free cash flow yield.

5) Beware of dividends. The last argument is that Big Oil pay a great dividend. Right. But it is also true that since the fall of free cash flow we have discussed, much of that dividend is paid with additional debt. So it is difficult to see that dividend as increasing in US$ terms, unless we consider that debt is too low. And at first glance, it seems like it. With 20-30% debt to capital (equity) on average, companies seem to have very little debt. But if we add working capital requirements, and turn to the equation “free cash-capex-dividend “, it is difficult to be positive, as these enormous dividends are not sustainable in a cyclical environment. Additionally, with a Free Cash Flow yield at around 3.6-3.8% for 2011 for US and Euro names and heavy requirement to ramp up capex on exploration, high dividends should not be considered as sacred.

Integrated oil companies appear attractively valued on 12-month forward P/Es relative to the market. However, once we adjust for the sector’s under-depreciation, they no longer look as attractive. The 12-month forward P/E adjusted for under depreciation shows US and European majors trading above historical norms relative to the market. As I mentioned before, the adjusted 12m forward P/E of Euro Big Oil, for instance, at 9.2x, is in line with that of the market, not 20% cheap, as the unadjusted number suggests.

In my opinion, Big oil does not provide defensiveness vs market turmoils. So, you can only buy for the very short term. A typical case of “value trap” of stocks that seem cheap, but they are not. After a 17% stock market crash in 2010, the surprise is that they are not cheaper looking at forward estimates. I am more interested in “restructuring story” stocks such as Repsol (July 2010), so disliked by my readers and by analysts and, like the national team, rocking, driving value through the simplification of business, or in independent explorers. In my opinion, to invest in oil, it seems obvious, we must invest in companies that have real exposure to oil. Or not invest at all. Washed down hybrids are only a waste of capital and a headache.