Bet on a recovery in this oil giant

This Brazilian oil company has been quietly restoring the business to profitability, says Matthew Partridge.


Just don't ask about the car wash
(Image credit: alffoto)

The recent general election that unexpectedly resulted in a hung parliament and the ongoing debate over Brexit is causing a lot of political uncertainty in Britain. However, our problems are nothing compared to what's been happening in Brazil for more than a year.

Last year, President Dilma Rousseff was impeached and replaced with her then vice-president, Michel Temer. Now Temer is facing allegations of corruption and he could still be impeached by Brazil's National Congress. Even if he survives this, his approval ratings are at rock-bottom thanks to an unpopular austerity programme. So regardless of what happens to him in the near term, the country is likely to have another president by the time next year's elections, scheduled for October 2018, are done.

This political turmoil has had a negative impact on Petrobras, the Brazilian oil company. After surging to a peak of over $12 a share nine months ago, shares in the company's American depositary receipts (ADRs essentially the way that the firm's Brazil-listed shares are traded on the New York Stock Exchange) have fallen by a third to around $8.

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The fact that oil prices have recently fallen to $45 per barrel hasn't exactly helped matters, but fundamentally this is because investors are concerned about the extent to which the firm, which is partly owned by the Brazilian government, will be affected by this political chaos. Petrobras is deeply implicated in the sprawling set of corruption allegations known as Lava Jato, or Operation Car Wash, that are at the heart of Brazil's crisis. For example, Petrobras's former chief executive is reportedly under investigation for allegedly taking $907,000 in bribes from a German construction company.

Still, it's important not to overstate Brazil's recent problems. The possibility of another impeachment crisis comes at an inconvenient time for Brazil, but it's a far cry from last year where there were fears that pro-Rousseff protests could turn violent. Independent economic forecasts still expect the Brazilian economy to grow this year, after two years of sharp contractions, with 2.2% growth projected for 2018. Note that national debt levels of 70% of GDP are lower than the equivalent for other major economies, including both the US and UK, and should give the government room for a modest stimulus if needed.

Similarly, despite the political turbulence, Petrobras's current management has quietly been getting on with the task in hand of restoring the company to profitability. This has included selling unproductive assets, settling an investor lawsuit and cutting costs. The firm has also changed its pricing policy for petrol and diesel to ensure that its prices are updated more frequently, at least once every 30 days, so they are in line with world prices. Earnings before interest taxes and amortisation (Ebitda) are rising and the balance sheet has been strengthened.

In my view, the firm's attractive valuation more than compensates for the risks. Petrobras trades at nearly a 40% discount to its book value (the value of its assets minus its liabilities) and on a price/earnings ratio of just over seven times the average of analysts' forecasts for 2018. This compares extremely favourably to the large oil giants, with BP, Chevron, ExxonMobil and Shell all trading at greater than the value of their net assets. So I suggest that you buy Petrobras (NYSE: PBR) at £1.25 per $0.01 with IG Index at the current price of 783.2 (IG's minimum is £0.24). I'd set a stop-loss at 383.2, which gives us a potential downside of £500. I'm not going to set a specific target for when to take profits, but I'll review the situation in six months' time in any case.

How our trades are doing

In addition to our new trade on Petrobras, we have six open trades. Five of these are long positions and one is a short.

The longs are: gold (issue 832), pub chain Mitchells & Butler (834), construction firm John Laing (836), Virgin Money (838), a challenger bank and IG Group (846), the holding company that owns the spread-betting firm IG Index. Of the six, John Laing is now the most profitable, making a paper profit of £170 (if you had followed my recommendations to bet at £4 per 1p). My gold trade is also £168 in the black, while IG Group is making a small profit of £25. Unfortunately, the other two long trades, as well as the short on Ocado, aren't doing so well.Virgin Money has fallen from 318p to 268.1p, which means that we are £149.70 in the red. Mitchells & Butler has also fallen to 231.7p, making a loss of £72.88. Ocado has risen 53p since we tipped it, which means that you would have lost £212. This means that overall, our longs are making a current profit of £115.82, while our short is losing £212. Of course, we have to remember that the previous positions that we've closed have made net profit of £402, so we're still well ahead overall.

I'm going to keep all six of the positions open. The three winning trades aren't a difficult decision, but even Virgin Money and Ocado are still worth persisting with. In the case of Virgin Money, I think the underlying business model is strong and the company is undervalued, so its decision to shelve a bid for Co-op Bank doesn't worry me.

Similarly, I'm convinced that Ocado's price surge is only temporary. This seems to be driven by Amazon's takeover of Whole Foods, with rumours that it could follow this by making a bid for Ocado. However, the reason for taking over Whole Foods seems to be to use the bricks and mortar stores as collection points for online purchases. Since Ocado only operates online, there is little point in Amazon buying it indeed, Amazon's entry into online groceries could badly damageOcado.

Dr Matthew Partridge

Matthew graduated from the University of Durham in 2004; he then gained an MSc, followed by a PhD at the London School of Economics.

He has previously written for a wide range of publications, including the Guardian and the Economist, and also helped to run a newsletter on terrorism. He has spent time at Lehman Brothers, Citigroup and the consultancy Lombard Street Research.

Matthew is the author of Superinvestors: Lessons from the greatest investors in history, published by Harriman House, which has been translated into several languages. His second book, Investing Explained: The Accessible Guide to Building an Investment Portfolio, is published by Kogan Page.

As senior writer, he writes the shares and politics & economics pages, as well as weekly Blowing It and Great Frauds in History columns He also writes a fortnightly reviews page and trading tips, as well as regular cover stories and multi-page investment focus features.

Follow Matthew on Twitter: @DrMatthewPartri