It has been over three months since I last provided an update on Petrobras (PBR) (PBR.A) in which I explained how Petrobras was on track to deliver double-digit returns for years future. The nearly $1.15 interim dividend was paid in December, and we can probably expect another dividend announcement as soon as Petrobras prepares to release its annual results.
Meanwhile, the company is trying to become more transparent as it will likely change its dividend payment schedule rather than announcing dividends on an “ad hoc” basis at times: the third quarter dividend was increased several weeks after the initial dividend announcement. Moreover, the market seems less frightened by the political situation in Brazil. The Brazilian government has been relatively quiet on the Petrobras front and I suspect tax payments by the oil giant
Net debt will now decline rapidly thanks to the price of oil and further divestments
For a review of the third quarter results, I would like to refer you to my October article in which I discussed the company’s free cash flow profile. Adjusted free cash flow generated in the third quarter of last year was just under $6 billion. And although the company pays dividends, net debt will continue to decline rapidly based on the current price of oil and further divestments.
Let’s first talk about the impact of the oil price on the free cash flow result. The nearly $6 billion in free cash flow was generated in a quarter when the price of oil averaged just below $73.5 a barrel. As Petrobras is a Brazilian producer, its oil is sold based on the price of Brent oil rather than the price of WTI oil. The price of Brent oil is currently trading at just over $93 a barrel, about 30% higher than the average oil price received during the third quarter.
This means that if the price of Brent oil increased by 30%, the margins generated by Petrobras would have probably doubled. It is not easy to make a firm prediction here because not all oil is exported and Petrobras uses part of its production for domestic purposes. But in any case, we can expect Q4 and Q1 results to be significantly stronger than Q3 results.
Moreover, the price of natural gas in Brazil is also on the rise. As I explained in this article on Alvopetro (OTCQX:ALVOF), a local Brazilian gas producer, the price of natural gas has jumped around 50% and this should also benefit Petrobras (although oil obviously remains the most important driver for cash flow).
Net debt at the end of 2021 is unlikely to be materially lower than net debt at the end of the third quarter, as Petrobras completed the payment of an exceptionally high dividend during the quarter. Petrobras paid 42.4 billion BRL in dividends in December and applying the USD/BRL exchange rate of 5.75 mid-December, the dividend cost Petrobras nearly $7.4 billion. So don’t expect big changes when it comes to net debt.
That being said, Petrobras has made some additional divestments since announcing its third quarter results. At On February 1, he received $475 million in cash of Equinor (EQNR) and the company has indicated that it will attribute this cash inflow to the results of the fourth quarter. Additionally, he signed a contract to sell the Potiguar cluster on January 31. $110 million was prepaid in cash with an additional $1.04 billion in cash due upon closing of the transaction.
And on the total debt situation, it’s important to note that Petrobras throws both lease debt and finance debt onto a single pile. As you can see from the image below, financial debt was only $37 billion on a gross basis and approximately 40% of the total reported gross debt of $60 million consisted of lease debt. This is important because my third quarter free cash flow earnings calculation already includes lease payments. So the company essentially generates $6 billion in free cash flow per quarter, including the gradual repayment of lease debt.
The $37 billion represents the gross financial debt. Petrobras also had just under $11 billion in cash on its balance sheet, meaning its net financial debt at the end of the third quarter was approximately $26 billion. I expect net debt to be just under $25 billion at the end of calendar year 2021 and further down to under $20 billion by the end of Q1 (of course , this is subject to changes in the working capital position and the timing of the next dividend which I anticipate will be in April).
The key takeaway is that net financial debt has been aggressively reduced over the past decade and Petrobras is now in a position to generously reward its shareholders. This is all the more true as net financial debt is now less than 1x free cash flow based on oil at $75. Indeed, a very healthy balance sheet and an even greater reduction in net debt would not make much sense because a little leverage is not a bad thing.
The 2022-2026 plan promises to be solid and rather conservative
This means that the company’s official outlook for the 2022-2026 period may actually be too conservative. As you can see below, Petrobras expects to generate $175 billion in operating cash flow, of which $50-60 billion will be needed for capital expenditures, while another $50 billion were reserved for depreciation and lease payments.
This means that there is $60 billion to $70 billion available for distributions to shareholders. That’s the theory. In my calculation, the $6 billion in quarterly free cash flow should translate to $120 billion in free cash flow after taxes, leases and capital expenditures.
It sounds like a huge difference, but the difference is easy to explain because my quarterly free cash flow result of $6 billion is based on a Brent oil price of just under $75 a barrel. Meanwhile, Petrobras is using much lower oil prices: $72/barrel for 2022 and a drop to just $55/barrel in 2025.
This indeed means that the official guidelines are quite conservative. And even using $65/barrel versus $55/barrel for 2025 and 2026 could have a major impact. The sensitivity analysis below confirms my calculations. At $70 Brent and a USD/BRL exchange rate of 5.25, operating cash flow is likely to be around $29.5 billion. After deducting capital expenditures and lease payments, we will be north of $20 billion in free cash flow.
This means that Petrobras will likely surprise on the upside over the next few years. The base case scenario using Petrobras’ price essentially means that the company will pay nearly $10/ADR in dividends over the next five years. Not only do I think there’s a substantial upside there, but we could also see Petrobras’ conservative pricing as a political hedge. This mitigates the impact of potential changes on the political front as Petrobras could be viewed as a political plaything.
Either way, I still have the vast majority of my position in Petrobras which I started buying in the $7 range last year. I have already received north of $2/ADR in dividends and expect another $10-15 over the next five years. That being said, due to the rising stock price and overweight Petrobras in my portfolio, I sold some stocks by selling call options which then ended up in the money. That’s not to say I don’t believe in Petrobras anymore as the numbers back up my thesis, it’s just a portfolio management decision and if I wasn’t already overweight Petrobras I would be buying more at these levels. I also sold some of my PBR shares to buy the PBR-A shares which are currently trading at a discount of around 10%.