Petroleo Brasileiro SA Petrobras

Petrobras' second-quarter earnings soared compared with the year before, largely on higher oil prices and record oil production, further capitalizing on the high-price environment. Debt was steady, but management still nearly doubled the dividend from first-quarter levels.

Why it matters: Petrobras already benefits from high oil prices given its oil-dominant portfolio, but it's good to see it's delivering higher production as well. A record 2.7 mmb/d during the quarter and 2.6 mmb/d during the first half, outpacing the midpoint of its full-year guidance of 2.5 mmb/d, means it further capitalizes on higher prices. Unlike peers, though, it's not delivering the same downstream earnings boost or reducing debt. Total debt fell slightly to $70.8 billion from $71.2 billion in the first quarter, as lower financial debt offset an increase in leases. Achieving its $65 billion target through 2030 is a priority for cash flow.

The bottom line: Our no moat rating and $19.80 fair value estimate are unchanged, leaving shares trading at a slight discount. Petrobras should continue to do well with higher oil prices, which will support dividends and debt reduction to its targeted range. However, with the benefits of Middle East disruptions now accruing more to refiners, Petrobras looks disadvantaged relative to peers given its smaller footprint and inability to fully capitalize on international refining benchmarks. Still, it's unlikely to see the price caps that drove losses in the past when oil prices were high, while higher utilization and diesel yields leave it a net beneficiary in the current market.

We are increasing our fair value estimate to $20.60 per share from $19.80 after updating our model with the latest financial results, strategic plan guidance, and latest oil prices. Higher oil prices since our last update drove most of the increase.

Our fair value estimate corresponds to a forward enterprise value/EBITDA multiple of 2.8 times our 2027 EBITDA forecast of $67.8 billion. The low multiple reflects the uncertainty of future oil prices and the risk of government intervention.

We derive our fair value estimate using Morningstar's standard three-stage discounted cash flow methodology. This methodology derives a terminal value using our assumptions for long-term earnings growth and return on new invested capital. This valuation methodology also more explicitly incorporates our moat rating, which reflects how long we expect a given firm to deliver excess returns on invested capital from a discounted cash flow analysis.

We expect steady production growth throughout our forecast, reaching 3.3 mmboe/d by 2028, slightly below management’s guidance of 3.4 mmboe/d, but within its plus/minus 4% range, and holding there through 2030. We model per-barrel operating costs to remain in check as lower-cost presalt volumes maintain a large portion of production over time.

We now forecast the refining segment to remain profitable through our forecast period, but to decline from recent high earnings levels. However, if oil prices remain high and domestic fuel price controls are reinstituted, the segment could perform much worse and incur large losses. Conversely, it could do much better if demand remains strong and the government maintains its market-based pricing policy.

In our DCF model, we assume Brent oil prices of $90 in 2026 and $88 in 2027. Our long-term oil price assumption is $65. We assume a weighted average cost of capital of 9.9%.

Despite a high-quality asset base, Petrobras lacks a moat because past missteps in capital allocation, driven by government intervention, have weighed on returns.

After more than 50 years of operations in Brazil, Petrobras accumulated most of the country's oil and gas assets, with unrivaled regional knowledge and extensive offshore operating experience.

The company's competitive position strengthened nearly 20 years ago with the discovery of significant oil and gas resources beneath a salt layer (presalt) within existing offshore concessions. Petrobras' early entry into the previously underestimated and overlooked area created a commanding position in some of the largest discoveries in recent decades. Presalt volumes have steadily grown, now comprising nearly 80% of production.

On that alone, Petrobras would seemingly have a moat. While we expect returns to improve given recent strategic actions, they do not exceed our estimated cost of capital at our midcycle price assumption of $65/bbl. We also do not have sufficient confidence that excess normalized returns will more likely than not be positive 10 years from now. The lack of confidence results from past government involvement in investment decisions and the potential for future participation, creating a substantial threat of material value destruction that prevents us from awarding Petrobras a narrow moat rating.

The discovery of the presalt reserves prompted the government to push Petrobras to invest in lower-returning assets, particularly refining, to build out domestic infrastructure and create jobs. In addition, the government mandate to supply the domestic market and Petrobras' inability to pass along international prices have increased downstream losses and sagging returns. When the new refinery projects fell behind schedule and ran over budget, Petrobras took $17 billion in impairment charges, ensuring future returns will fail to meet the cost of capital.

The E&P business also faced new challenges as the government revised existing oil and gas laws, requiring Petrobras to participate in future offshore licenses on less attractive financial terms. It also made poor capital-allocation decisions; combined with the fall in oil prices, this resulted in another $17 billion in impairment charges. Petrobras took an impairment charge of $13 billion in early 2020 related to E&P assets as management revised its long-term price deck to $50/bbl from $65/bbl.

Although the government hasn't ceased intervention, revisions to domestic product pricing will ensure closer tracking of international prices and avoid the large losses of the past, when government-controlled prices meant Petrobras subsidized the domestic market when oil prices were high. The new system will likely prevent the large profits realized when oil prices fell, but will bring more stability to the segment. However, we see past capital-allocation miscues as too large to overcome. Meanwhile, government intervention that destroys value remains a possibility. Also, the domestic refineries have no distinguishable competitive advantage, in our view, leaving Petrobras without a moat and unable to generate excess returns.

With most new investment going toward its high-return E&P operations, Petrobras’ returns could tip the scale toward a narrow moat. We consider Petrobras’ upstream position to be high-quality, given its low operating costs and attractive returns on new investments. The company estimates its portfolio breakeven at $25/bbl, and new projects deliver IRRs of 23%. Investment is also increasing in refining, including expanding capacity, where management expects returns of 15%, but still holds the risk of returns impairment that occurred in the past.

Though emissions abatement, low-carbon technologies, and renewable fuels garner more attention from Petrobras, management has committed $13 billion or 12% of total spending by 2030 to sustainability projects. Petrobras' business model remains focused on oil and gas production, which should be a safe bet given we do not foresee a material decline in global oil and gas demand over the next decade. Also, renewables entail the risk of lower returns and is highly competitive. Therefore, a focus on the core oil and gas business should not detract from Petrobras' prospects. However, the new government has suggested that Petrobras increase investment in renewable power, and this remains a risk to Petrobras' future returns.

Petrobras' spending remains focused on its prolific presalt position, which should drive attractive production growth over the next few years.

Higher spending does not mean Petrobras' profligate ways are returning as it continues disciplined, focused spending on the highest-quality assets with deleveraging and dividends with surplus cash flow a priority.

The large downstream losses of the past will not be repeated thanks to price policy revisions by the government and divestment of refining capacity, which should result in a high-grade the portfolio.

Government control implies financial or strategic decisions benefit the country but could harm shareholders. It also results in an incestuous relationship, as the past corruption scandal demonstrates.

With Lula's return as president, Petrobras will resume subsidizing domestic fuel prices, incurring large losses in the process.

The large shareholder payouts of recent years are over as the new government directs Petrobras to curtail dividends and increase investment.