Brazil needs more oil – these guys will give it to them

On 5 October, nearly 150 million eligible voters will cast their votes in the Brazilian election. Pundits believe it is hard to call, and reckon it will go to a second round of votes (25 October).

That’s all well and good, you may say, but why should I care about Brazilian politics?

Well, an important election can often jolt the markets. It’s something I talked about in greater detail a few months back.

So far, the investment strategy of ‘buying election markets’ has worked pretty well: India is up 25%, Indonesia 21% and Turkey 10%. So far the Brazilian market has shown an 8.6% gain.

I’ve found a great way for us to potentially profit from Brazil’s election… though this is not a direct play on the Brazilian stock market. I’ve found a company in Singapore with a large, growing business in a booming Brazilian market.

What does Singapore have to offer Brazil?

A few years back, Brazil was a poster child for emerging markets. The economy grew by an average of 4.6% between 2007 and 2010. But over the last three years, growth has dropped to a more lacklustre 2.1%.

There’s a lot that Brazil needs to get right if it’s going to get back to its glory days. But it goes without saying that with a population of more than 200 million, it will be essential to sort out the country’s long-term demand for oil and gas.

Petróleo Brasileiro SA (Petrobras), the national oil and gas company, is targeting a production increase of 7.5% this year. But the long-term target is to more than double production – to 5.2 million barrels per day (bpd) – by 2020. To achieve that ambitious target, Brazil needs to boost its deep-water drilling projects. This means it’s going to need a lot of new oil rigs.

I believe I’ve found the perfect company to help it out with this – Keppel Corporation. Let’s take a look.

Keppel has what Brazil needs

Keppel Corporation (KEP:SP) is one of the largest conglomerates in Singapore. Its business can be divided into three divisions: offshore and marine, infrastructure, and property. The bulk of its earnings (56% of revenues) come from offshore and marine.

The company is a world leader in rig building, and so is well placed to capitalise on Brazil’s increased demand for rigs. It has established Brazilian shipyards, which account for about 20% of Keppel’s offshore and marine revenue in the first half of 2014.

Keppel has a robust record in Brazil, with six newly built submersibles on track. These special rigs are designed for exploration and drilling as well as development drilling.

What about competition?

Chinese-made rigs are the closest competitors. But there are three reasons Keppel Corp should continue to enjoy a bright future in the Brazilian market.

China’s rigs are cheaper… but Keppel’s are better

Firstly, Chinese rigs are a lot of hassle. While the construction cost is about 20% cheaper for Chinese-built rigs, the need to add another $20m-$30m due to project mismanagement and installation of additional equipment makes that advantage less obvious.

Secondly, Keppel has more than 30 proprietary designs for the project. China, on the other hand, buys most of its designs from third parties. Given the technical difficulties that go with exploration in deep water, tailor-made rigs have a distinct advantage.

Thirdly, Keppel has a different customer profile. About 85% of the Chinese-made rigs are built ‘speculatively’, meaning without having a firm contract lined up for the rig once it is ready. Keppel’s rigs are mainly built for the needs of specific customers. So Keppel doesn’t normally compete directly with the Chinese companies for the same types of customers.

Global demand for rigs looks robust. Slower spending from ‘supermajors’ (big Western oil and gas companies) will be offset by increased demand from exploration and production companies in emerging markets, such as CNOOC (China), PEMEX (Mexico), and Petronas (Malaysia) – not to mention the booming exploration market off the coast of Brazil.

A structural rig replacement cycle will also spur demand for new rigs. More than half of the working rigs in the world are above the normal retirement age of 30 years. Old rigs are required to complete regulatory surveys, which is said to cost the owners up to $30m to keep the rigs qualified for operation.

Keppel is trading on a price/earnings ratio of 12.2 times 2015 earnings, with a dividend yield of 4.0%. And to sweeten the deal, the Singapore dollar is fairly strong against the US dollar, reflecting Singapore’s safe heaven and ‘Switzerland of Asia’ status. It has only depreciated 0.5% against the greenback, which, after the Hong Kong dollar, makes it one of the strongest currencies in the world.

My ‘buy election markets’ strategy has performed well so far. Can Keppel keep the run going?