Oil on Troubled Waters

Last May, the Brazilian national oil company Petrobras had to scrap its plan to sell a $200 million, 15-year bond as the 2002 election campaign warmed up. Not even political risk insurance was enough to tempt investors into the deal. Many investors, burned by their experiences in Argentina, were panicking over the rise of Luiz Inácio Lula de Silva, the Workers Party presidential candidate. A year later, with Lula now installed as president, investors were falling over themselves for slice of a $400 million, five-year bond offering from Petrobras shorn of credit enhancements and risk mitigation features. This was the first time since the 1990s that Petrobras could raise money in the international market with a plain vanilla bond.

Bear Stearns, bookrunner on the March 2003 bond, launched it at $200 million and quickly doubled its size after attracting nearly $700 million in orders, even though many economists remained cautious about the new Brazilian government’s policies and the abilities of the new top management at Petrobras. Its new president and chief financial officer are both political appointees with no prior business experience. Uncertainty in the oil markets as American and British troops advanced on Baghdad didn’t deter buyers either. The bond, which features a three-year put and was sold largely to Brazilian investors, even priced 380 basis points tighter than the sovereign’s 2008 bond. If investors decide not to exercise the put, the coupon steps up from an initial 9% to 12.375% for the final two years of the bond’s life. “This transaction was basically brought to market on an unsecured basis at the same level as where the PRI bonds are trading,” says Jorge Cantonnet, head of Latin America for Bear Stearns. “This is a tremendous coup for Petrobras to accomplish this.”

Petrobras is certainly among the world’s best-run state oil companies, but the success of its bond is also due to the fact that Latin American oil companies are currently one of the most attractive emerging market issuers. This is just as well, because oil companies want to issue around $10 billion in debt this year. Oil, like gold, is the commodity of the moment, a safe haven for international investors. Emerging market bond funds have received record inflows so far this year and Petrobras is riding high, thanks to this renewed appetite for risk. The rise in oil prices is an added bonus. The price of Brent crude oil has climbed steadily from a low of $17 a barrel last year to $28.63 at the end of March.

Regional Standout

Latin America’s oil companies have built reputations as some of the most sophisticated and experienced issuers in the emerging markets. Companies like Petrobras and Petróleos de Venezuela SA (PDVSA) and Petróleos Mexicanos (Pemex) are the largest companies in their respective countries. Some are elite institutions with outstanding management teams. Petrobras even listed on the New York Stock Exchange in 2000 in a $4 billion ADR issue, and last year was among the most profitable oil companies in the world with a return on equity of 27%. However, as the fate of PDVSA illustrates so graphically, these companies also share some serious problems.

PDVSA was until recently one of the slickest issuers in the international capital markets.Today, PDVSA is a shell of its former self. The government of President Hugo Chávez has purged thousands of technicians and managers and installed political stooges in senior posts. PDVSA is struggling to raise output after a devastating national strike at the beginning of the year and may be further hit if the government defaults later this year as many fear. PDVSA is an extreme case, but all state-owned companies, particularly those operating in the critical oil industry, are subject to meddling from politicians who decide their investment budgets, set their domestic prices and pack their payrolls with political supporters. They face formidable political opposition to reform, with the result that in many cases their finances are a mess, a problem that afflicts Pemex in particular. And when a vitally important company such as a stateowned oil producer is ailing, it does not bode well for the country as a whole.

For the moment, investors are more than willing to give President Lula da Silva and Petrobras’s new bosses the benefit of the doubt, confident that it will continue to operate as a for-profit enterprise, free to set prices in line with market forces. The company has longed to issue long-term bonds in the international capital markets for years without the need for any complex enhancements. Until the new March bond, all but one of its bonds included some kind of risk mitigation device. Almir Barbassa, executive manager for corporate finance at Petrobras, says, “We are very happy. It seems that Petrobras has improved its credit in the eyes of the market in the last three years.We hope to be able to issue longer plain vanilla bonds, with seven and 10 year tenors.” Petrobras’s ambitions don’t seem so farfetched since spreads on Brazil’s benchmark C bond collapsed to around 850 basis points in April from a high of 1,892 basis points last October, and analysts expect a further drop in Brazilian bond yields.

Bear Stearns’ Cantonnet argues that, “The success of this [March] issue has less to do with oil and more to do with Brazil. I think that you will see continued appetite for Brazil. Oil is important, but if you did not have an improving view of Brazil [the bond] would have been impossible.” Curtis Mewbourne, executive vice president and portfolio manager at Pimco, the world’s largest emerging market fund manager, agrees. He evaluates public sector companies based on sovereign risk rather than their industry risk. “When we analyze these oil companies, whether they are quasi-sovereign or corporate, the driving concern from our side is the sovereign risk. For the government-owned or governmentguaranteed companies, the individual business issues are secondary.”

PDVSA’s troubles throw the vulnerability of state-owned oil companies into sharp relief. With the conflict in Iraq over and oil prices easing, PDVSA will struggle to return to full production capacity. Its ability to collect on oil sales has been drastically impaired since the government fired around 13,000 employees, including personnel in its invoicing and collections departments. PDVSA is unlikely to make any investments this year to upgrade installations or replace depleted reserves. José Barrionuevo, head of emerging markets strategy at Barclays Capital, warns that Venezuela’s oil exports could fall by nearly 20% $17.23 billion this year.

Political Freedom

It is not surprising then that there are observers with misgivings about Brazil’s incoming administration. Alexandra Parker, an oil and gas analyst at Moody’s Investors Service, says Petrobras may be a listed company, but as the state owns a majority of its voting shares, it is definitely not free from political interference. “Petrobras is facing government interference in its operations. Since the petroleum sector was deregulated in January 2002, market [oil] prices [dictate] domestic prices. After the huge currency devaluation in Brazil last year and the increase in international oil prices, the government limited the increase in petroleum prices in Brazil to control inflation,” she says.

The appointment of José Eduardo Dutra as Petrobras’s president and José Gabrielli as CFO calls into question the quality of management at of Petrobras. Dutra is a former Workers Party senator and a geologist, while Gabrielli is an academic. Neither has the extensive private sector or capital markets experience of the previous management team. But Barbassa, a long-term Petrobras executive, insists that little will change. “The management has changed but we do not expect that there will be different goals for the company.Petrobras will keep investing in the growth of production and that is it. That is the main target,” he says.

Ted Helms,Petrobras’s general manager in New York, says, “We are in the process of updating our strategic plan. For the most part it will continue to focus on increasing production, which should lead Brazil to becoming self-sufficient in oil.” The company has a capital expenditure plan of $31.7 billion between 2001 and 2005, with $15 billion earmarked for exploration and production.Petrobras executives says the company plans to raise about $1.5 billion-$2.0 billion a year from the capital markets to finance the program, with most of the remainder coming from cashflow.

Aiming to Export

Barbassa says Petrobras is on track with its ambitions to become an oil exporter, “About 25% of our business comes from outside Brazil and we are becoming more and more of an international company.We are producing 6 million barrels of oil a day and the market is looking at Petrobras as an improving credit risk.” Moody’s rated Petrobras Ba2, two notches below investment grade. Petrobras exported 439,000 barrels of oil per day last year, nearly 50% more than in 2001 and reduced oil imports by one-third to 542,000 bpd last year. Unfortunately, pretax income has dropped for two years in succession, falling to $3.37 billion last year, half as much as in 2000. Last year’s 35% devaluation of the real and a 19% drop in revenues did not help. Although its total debt load of $14.7 billion has not risen substantially in dollar terms, leverage shot up to 90% in 2002 as the currency slid. The equity market’s view of the company is heavily colored by politics. Petrobras stock fell to $8.57 in October, days ahead of the presidential elections, only to rebound by 68% to $14.42 in mid-April.

Mexico’s state-owned monopoly, Pemex, tapped the international markets in March, two days after Petrobras, with a €750 million, seven-year bond leadmanaged by BNP Paribas and JP Morgan. The bonds were priced to yield 6.87%, about one percentage point lower than its previous euro-denominated, seven-year bond issued in July 2000. Pemex’s investor following has strengthened since Mexico won investment grade status from all three ratings agencies last year. Says Gerardo Vargas, managing director for financing and treasury at Pemex, “We have a very strong foothold in the investment grade [investor base]. They made up to 80% of our [January] bond issue.” Pemex issued a $750 million, five-and-a half year issue led by Lehman Brothers and Morgan Stanley in January 2003. Boston-based fund manager Grantham Mayo Van Otterloo makes little distinction between sovereign risk and Pemex.Tom Cooper, a portfolio manager at Grantham, which manages $1.9 billion in emerging market debt, says, “We like Mexico because it is an improving investment grade credit and we like Pemex because it is primarily a sovereign credit. The high oil prices are also an added bonus.”

Debilitating Weakness

This strong endorsement from the market serves Pemex well in the short term, but it may not remain the market’s darling forever.With the war in Iraq winding down, oil prices will likely fall.This will affect nearly all oil companies, but the inability of Pemex to reinvest its own profits is a debilitating weakness. Pemex must transfer nearly all its income to the government, leaving little over to invest in discovering new reserves or boosting production capacity. This is why Pemex is struggling to maintain output and is unable to add to its depleting reserves. Its total hydrocarbon reserves dwindled to 52.9 billion barrels of proven, probable and possible reserves in 2002 from 69 billion barrels in 1998. Pemex is still one of the world’s largest oil company, producing approximately 3.2 million bpd of crude oil and 4.5 billion cubic feet of natural gas.Yet in 2002, Mexico had to import 11% of its natural gas, 26% of its gasoline and 20% of its fuel oil needs.

There is little chance that the private sector can play a significant role in Mexico’s oil sector as it has in Brazil or Argentina, which privatized Yacimientos Petrolíferos Fiscales (YPF) in a $3 billion IPO in 1993. In 1938, Mexico’s President Lázaro Cárdenas nationalized the oil industry dominated by American and British interests, and the state monopoly remains enshrined in the constitution to this day. Pemex needs to invest more than $10 billion a year in exploration and production to maintain its current levels of production. It has had to issue debt to do this. According to Moody’s, its total debt rose to $19.1 billion last year from $17.2 billion at the end of 2001. Vargas says the company plans to raise between $7 billion and $8 billion in debt this year. Of this, $2.5 billion will come from the international debt capital markets and a further $1 billion is to come from a debut medium-term note issue on Mexico’s local bond market. The remainder will come from commercial banks and export credit agencies

Upping E&P

Vargas recognizes that the company needs to invest more of its own resources in exploration and production. “Up until now we have been developing fields in shallow water on the continental shelf and eventually we have to go to deeper water and that will require substantial investments. That is why the tax regime needs to be addressed,” he says.

President Vicente Fox hopes to lessen the government’s dependence on Pemex by increasing general tax revenues. Says Vargas, “We do not think that the company is over leveraged yet, it is something that we pay close attention to.We are aware of [increasing debt] and that is why we have been lobbying for a tax regime change.” But Pemex has been waiting for this relief for the past two years and Fox has a tough job ahead pushing through these tax reforms. Congress shot down his tax plans in 2002.

In the meantime, Pemex hopes to develop its natural gas reserves by attracting private sector capital through so-called multiple service contracts. Instead of awarding many individual contracts to develop oil refining and exploration projects, Pemex plans to award fewer contracts to service providers who can provide all the services. Vargas says this means private capital will develop the natural gas sector in Mexico without bogging Pemex down in more debt. He says the company will also gain from what he calls, “a transfer of technology from these companies to Pemex.” He hopes that Pemex will be able to learn how to run refineries more efficiently. Pemex had hoped to award its first multiple service contracts in the first quarter of this year, but suspicious politicians insist on scrutinizing each deal.

Private Help?

Progress with multiple service contracts depends on the unlikely chance of Fox winning over members of the opposition Institutional Revolutionary Party (PRI) in Congress to his cause. If the PRI sweeps local elections in July, the party would likely block further reforms of Pemex and the oil and gas industry. Indeed, the emergence of a hostile opposition majority in Congress could well paralyze Fox’s reform agenda for the remainder of his presidency. If so, the financial health of Pemex will continue to suffer, perhaps affecting its long term viability and thus threatening Mexico’s ability to continue pumping oil at current rates.

Friction in Mexico’s Congress pales in comparison to the tumult at PDVSA.The dramatic deterioration of PDVSA has proved how vulnerable state-owned companies are to political interference, no matter how strong their management record. Juan Fernández, president of Gente del Petróleo, PDVSA’s worker’s union and a former PDVSA finance executive until the government fired him in January, says the government considers Venezuela’s oil industry,”a weapon of the revolution rather than an instrument of wealth for Venezuelans.”

Daily Difficulties

The national strike slashed PDVSA’s output to around 500,000 bpd from 2.8 million bpd, pushing the government closer to default on its $29.8 billion in local and international debt. PDVSA is the economy’s cornerstone, and the government gets nearly half its annual $16 billion in revenues from the oil industry. Although the government claims oil output had returned to almost 2 million bpd at the end of March, Deutsche Bank estimates output is nearer 1.7 million bpd. The day-to-day operations of the company have also been severely compromised by the sacking of around 13,000 employees. Unless PDVSA returns to normal soon, oil prices remain firm and the political crisis is resolved, the government will struggle to make $9.40 billion in debt service payments due this year.

Thomas Coleman, an oil and gas analyst at Moody’s, says a breakdown of basic operations poses a threat to PDVSA’s ability to continue to pay its approximately $7 billion in long term debt. Moody’s changed its rating criteria in 2001 to allow certain companies and banks to be rated above their sovereign ceiling. It rated PDVSA above Venezuela’s country ceiling but downgraded the company to Caa1 in February, in line with the sovereign. The level of collateralization on bonds issued by PDVSA Finance, an offshore funding vehicle, is as high as 20 times debt service, but its invoicing system is in disarray so dollar payments are not flowing into the offshore account on a timely basis. Investors say PDVSA has suffered too much from political interference and would not contemplate buying its debt.Violet Osterberg, managing director at Pacific Life Insurance Company in California, who manages a $1.9 billion portfolio, says, “The political risk in Venezuela is too high. The reward just doesn’t seem to be there for that risk.”

However dire PDVSA’s predicament, or the risk inherent in lending to Latin America’s public sector, no oil company is likely to be exiled from the capital markets forever. Oil is a valuable, dollar- priced, exportable commodity that makes it an attractive investment option. It is no coincidence that Petrobras was able to borrow in international markets well before the Brazilian government could. In Argentina, Pecom Energía was the first issuer to return to the international capital markets after the 2001-2002 crisis with a $32.8 million one-year bond issue led by ABN Amro Bank in March. LF