Industry Trend Analysis - Modest Growth Forecast Remains Intact - APR 2017

BMI View: Efforts to strengthen the financial stability of Petrobras will ensure upstream improvement and encourage private sector participation. The Brazilian recovery will be held back by less robust sector reforms and sustained oil price weakness.

The Brazilian oil sector continues on its path toward improvement despite weakness in the external environment. Nearly three years after the 'Lava Jato' scandal broke open, national oil company (NOC) Petrobras is accelerating efforts to strengthen its financial performance and secure long-term growth. Since taking the helm of Petrobras in May 2016, CEO Pedro Parente's more reformist agenda has helped stabilise the fallout from the scandal, improving investor confidence via a more pragmatic upstream strategy ( see ' Reforms Test Upstream Recovery ' , November 2 2016).

Though sustained oil price weakness and a high debt load persist, we believe Brazil holds considerable upside potential. This is led by a continued focus in deepwater acreage where both the NOC and private partners are expanding exploration and development efforts ( see 'Deepwater Potential Luring In Drillers', January 9).

Notably, an improving regulatory environment will attract international investment suggesting a stronger showing at this year's upstream licensing rounds. In 2017, one round is confirmed and another is under consideration in presalt basins, making them the first auctions in the area since 2013.

Deepwater Luring In Investors
Map Of Brazilian Offshore Basins
Note: Libra is the only existing Production Sharing Contract. Source: Petrobras, BMI

As the overwhelming leader within the sector, Petrobras' efforts to deleverage will provide the most benefits over the next several years. Operating over 80% of the Brazilian upstream, we believe the reduction of the NOC's heavy debt load will free up capital for upstream investment, supporting our forecast for 3.7% y-o-y production growth through 2021.

Growth Momentum Picking Up
Brazil - Total Liquids Production, 000 b/d
e/f = BMI estimate/forecast. Source: ANP, BMI

Recent efforts include a USD5bn oil-for-loan financing deal with the China Development Bank which will reduce the NOC's reliance on debt-financing and support its efforts to expand in deepwater. In exchange, Petrobras will supply an estimated 100,000b/d to Chinese firms, solidifying China's dominance of the Brazilian export market.

Petrobras also issued USD4bn in 5- and 10-year notes on the international markets to extend maturities and free up working capital. After spiking at 8.3% in November 2016, yields on Petrobras' bonds rallied to just over 7.0% in January, offering a window for the NOC to issue the notes. Petrobras will buy back up to USD2bn of existing bonds maturing between 2019 and 2020, lowering their short-term obligations by just under 18%.

Near-Term Hurdles Becoming Smaller
Petrobras Debt Distribution By Maturity, USDmn
Note: image refelcts pre-issuance debt distribution. Source: Bloomberg

Upstream Challenges Remain

Though we remain optimistic with respect to growth, our production forecast is less bullish than that of Petrobras due to enduring above-ground obstacles. Namely, continued declines in economic activity have resulted in a hesitancy towards additional reforms at the municipal level in an effort to close large fiscal deficits, including within key oil producing regions.

In December, the state of Rio de Janeiro - responsible for approximately 70% of national crude production - voted to abolish a law that reduces taxes on purchases of oil and gas equipment, thereby raising costs while reducing profitability. Producers in portions of the Campos and Santos basins including Shell, Total, Statoil and Repsol, will now pay a combined USD1.2bn in additional taxes per year as a result of the change.

In addition, repeated legal setbacks have undermined the advancement of Petrobras' divestments - a key component of their long-term investment strategy. Most recently, on January 31, a Brazilian court order forced the NOC to suspend the sale of its petrochemical companies Suape and Citepe, a deal worth an estimated USD385mn. This follows similar delays targeting the sale of the Tartaruga Verde and Bauna oilfields to Karoon Gas in late 2016.

Finally, sustained oil price weakness will limit Petrobras' ability to invest upstream. Though prices have stabilised in the wake of the OPEC/non-OPEC supply cut announcement on November 30, we caution that inconsistent compliance and continued output gains from non-participants will cap upward momentum over 2017 ( see ' Fundamentals Aligning To Support Price Growth ', January 9). This will undermine efforts to increase investments, supporting our more modest output forecast.