Petrobras: Balancing Risk and Opportunity in Brazil's Oil Industry

Petróleo Brasileiro S/A - or simply called Petrobras - is the leading player in oil and gas production in Brazil. The majority-state-owned company has a net revenue of R$ 452 billion (approx. USD$90bn), outputs approximately 2.77 million barrels of oil equivalent per day, and is a publicly-listed company traded on the New York Stock Exchange (NYSE:PBR), Nasdaq  (NASDAQ:PBR), and the London Stock Exchange (LSE:0KHP), and several others. Despite its relevance to the global energy markets and its considerable growth potential, investors’ sentiment towards Petrobras usually contains extra grains of salt. The company is often embroiled in domestic wrangles and power struggles that shed uncertainty about its corporate governance and was at the centre of a major corruption scandal involving high-rank Brazilian policymakers in 2015.

After the election of Lula da Silva as president, markets again reacted badly due to a perceived high potential for undesired political influence over the appointment of Petrobras’ Board of Directors, for changes in its dividend distribution, and a revision of the company’s pricing policy (which currently follows a parity with international import prices). One year later, a scanning of those three issues and of the newly appointed Board might still prove revealing of Petrobras' future and better prepare investors to hedge against associated risks.

Currently, the State-owned Companies Act (2016) prohibits figures with a potential conflict of interest due to previous positions inside public administration from being appointed to the Board for a period of 3 years after leaving the previous function, which is also endorsed in Petrobras’ statute. A Bill reducing the “quarantine” period to 1 month is stalled in the Upper House of Congress since 2022, prompting many to wonder if the Bill’s approval could be pushed to ensure greater coalition support in times of political turbulence. Despite being a possible strategy, it is far from being the likely one. A Supreme Court decision has already suspended the proposed 3-year quarantine period of the Bill, and 3 of the government’s 6 appointees were confirmed on the Board despite alleged concerns about their ties with partisan politics. However, other bills and reforms are among Lula's top priorities with Congress, making it unlikely that he would create an unnecessary conflict with the Upper House over Petrobras, especially when  opposition forces are strengthened.

Acting as Petrobras's CEO is Jean-Paul Prates, who has vaguely commented on the possibility of changing the dividend distribution policy, but both Lula’s and Bolsonaro’s defence for greater taxing in dividend yield distributions likely does little to appease markets. Still, a recent judicial attempt of halting Petrobras’s dividend distribution shed even more uncertainty about how alternative ways of interference - ones that do not even involve the Board’s discretion - can be overreaching, indicating a high likelihood of taxation in the future.

The potential for a change in the company’s policy of maintaining parity with international oil prices also cannot be discarded, as key figures inside the Board have signalled they desire its revision. Nevertheless, in a continued scenario of high oil prices due to external shocks, the Board is likely to be interested in retaining a part of Petrobras’ profitability by not announcing major changes in the parity policy for the near future.

While the prospects for stable dividend yield distributions and insulation from rent-seeking dynamics appear less optimistic, posing increasing risks for investors, Brazil's potential to become a major player in clean energy production presents an opportunity. Petrobras is actively exploring cutting-edge technologies in renewable energy markets, such as wind-powered energy and green hydrogen production, which could enhance its long-term profitability. While the company’s issues span across multiple incumbencies and require careful assessment of long-term tolerance for loss, the most risk-appetite investors can still find creative ways to offset the balance and - with some stroke of luck - profit from the undertaking.

Photo credit: Global Business Outlook

Brazil-China: Trade Relations and their Impact on Commodities

Brazilian President Lula's recent trip to China has stoked tensions between Brazil and the West. From both a geopolitical and financial point of view, Lula’s actions surrounding the trip represent a marked change from his predecessor Bolsonaro. Where Bolsonaro had backed ally President Trump’s aggressive rhetoric on foreign policy, Lula is not only trying to reestablish Brazil’s role in global diplomacy, but is also toeing a more neutral line in the developing cold war between China and the US. Lula seems to be aligning himself with the other BRICS (Brazil, Russia, India, China, and South Africa) nations, but due to rivalries between the member nations, it is the bilateral economic deals that will have a more visible effect on the world, rather than empty foreign policy promises. 

Alongside 240 Brazilian business leaders, Lula headed to China for the inauguration of former Brazilian President Dilma Roussef as head of the New Development Bank, a multilateral development bank established by the BRICS to help fund infrastructure projects in developing countries. This set the financial tone for the rest of his visit, in which 15 deals worth about $10 billion were signed between Brazil and China. China has long been Brazil’s largest export market and Lula wants to leverage this relationship to help with the reindustrialization of Brazil. With US companies leaving Brazil, the symbolism of Ford seeking to sell its plant to BYD cannot be understated. This coupled with talks between BRICS to dethrone the dollar as the currency for international trade will come as a blow to Biden, though it is unlikely that China will want the Yuan to become an international currency. Lula’s comments surrounding the Russo-Ukrainian war sparked more controversy in the West after he offered to join China in mediating peace talks while also placing partial blame for the conflict on the US. 

Overall, Lula’s visit is most surprising as it marks a shift in Brazilian foreign policy, though this is only surprising when looking at the policies of his predecessor. Indeed, Lula is known to be a staunch leftist and had started cultivating a relationship with China in his previous presidency, so we can assume that this relationship will only be strengthened under his administration. President Xi has made it clear that Brazil is a key part of his plans of challenging US global hegemony, and this is shown by bilateral trade increasing by 10.1% from 2021 to 2022. A key commodity being sold by Brazil is beef, as China has a huge demand for it with 55% of their imports coming from Brazil and 10% of Brazil’s sales being to China. However, Brazil is also a key part of the iron, soybean, and crude petroleum markets. In addition to this, Brazil was the single largest recipient of Chinese FDI in 2021. This is part of Xi’s plan of integrating Brazil into the Belt and Road initiative, to increase China’s influence in Latin America, so we can expect trade to grow in coming years. 

The markets for each of Brazil’s main commodities, beef, soybeans, and crude petroleum could change drastically by the end of the year. Both beef and soybean sales are interconnected. Soybeans are instrumental for feeding beef cattle with cattle feed making up 18% of soybean sales in the US and 52% of the oil gathered from soybeans are used in the food industry. With growing demand for beef from China opening up, we can expect beef sales to increase through restaurants reaching pre-pandemic levels of demand and pushing soybean prices up as restaurants need more oil for frying food, while farmers will need more soybeans to feed growing cattle numbers. While some feared stricter controls on cattle rearing in the Amazon with the election of a left leaning President, Lula has been unwilling to change his predecessor's profitable policies. While Lula has talked about placing people and nature in front of profits, this philosophy has not yet reached the agricultural sector, but this does not necessarily mean it will enjoy projection for the rest of his term. For now the only thing which has stopped the flow of Brazilian beef has been cases of mad cow disease, but suspensions were normally lifted within a few months of being placed.

Iron ore makes up the largest portion of Brazil’s exports and its price shifts are harder to predict. In the short term, prices will increase as China opens back up. As it eases its coronavirus policy and its real estate sector gradually recovers, it is likely that demand for iron will increase from Brazil’s main trading partner. However, as the markets recover their supplies from India and Brazil, it is likely by the end of the year that prices could decrease. There is even the chance that Russian and Ukrainian supplies flood back into the market, which could drastically change the price of iron ore but it is unclear if a peace settlement can be reached anytime soon.

Cry For Me Argentina: What the current soybean rally tells us about climate change and food security

Soybeans are a fundamental commodity for the global food chain. While only a tiny fraction of the crop is used directly for human consumption, soybeans are a crucial component of animal feed, and as such indirectly significant for human consumption. This means that soybeans can have a substantial impact on food prices in general. For this reason, the out of season increase in price of soybean futures (ZSH3: CBOT) and exchange-traded funds (ETFs) like the Teucrium Soybean Fund ($SOYB: NASDAQ) could be a potential warning sign of how climate change might adversely impact global food security. This is because many analysts are associating the increase in price to the ongoing summer drought in Argentina and Brazil – two key exporters, accounting for half of global supply of soybeans. Cultivation of the crop in Brazil occurs traditionally in the state of Rio Grande do Sul, whereas in Argentina cultivation is spread across the Argentine Pampas and the province of Santiago del Estero.

Reuters reported on January 12 2023 that up to 90-per-cent of the expected harvest in Rio Grande do Sul will be wiped out in the absence of heavy rainfall – this lack of rainfall in Rio Grande do Sul was also highlighted in the latest agroclimatic monthly report published by the Brazilian Meteorological Institute. Likewise La Bolsa de Cereales (Buenos Aires’ grain exchange) reports that in the event of a severe drought the country will miss its expected harvest by 12.5 megatons, while a mild drought would dampen this loss to  seven megatons. According to the same report, the impact of this dry winter could be a reduction of two per-cent of the value of Argentina’s entire agricultural industry this year. The impact this has had on futures is not so pronounced, however. Since December 1 2022 the value of ZSH3 futures contracts maturing in March 2023 increased 3.75 per cent from $1,489.40 to 1,435.60, peaking at $1,546.40 on January 17 2023. Likewise in the same timeframe, $SOYB has risen a modest 1.48 per cent from $27.05 to $27.45, finding resistance at $28.50 on January 12 and January 17 2023. 

In the context of near-record global inflation over the last year and a summer drought in South America, it is difficult to pinpoint the exact causal mechanism of the higher-than-average prices of soybean futures. However, the arid weather conditions in Argentina and Brazil have sprung short-term supply shocks which could be driving this out of season rise in soybean prices. Furthermore, other grain ETFs focussing on different crops, such as wheat ($WEAT) and maize ($CORN) are seemingly returning to pre-covid price fluctuations, although they are still dealing with spillover from the Russian invasion of Ukraine. In the long-term, increasing temperatures and decreasing rainfall will potentially reduce supply. Nevertheless, the impact on price remains unclear. Whether climate change will impact harvest cycles, and by extension price fluctuations, or if harvest cycles and price fluctuations occur with the same seasonality as they have done, thus far, remains to be seen. 

The untimely nature of this modest increase in soybean prices and the timing of the droughts in Argentina and Brazil do raise concerns for the long-term supply and price of grains in the context of deteriorating climate change. Both in Argentina and Brazil, average temperatures have increased by over 1 degree celsius since records began in the 1930s. Although historical rainfall data for Brazil is not as readily available, the decrease in average rainfall in Argentina since record-keeping began has been around 50mm/year. 

Whilst the recent links between extreme climate events, crop cycles, and commodity prices are cause for concern in the long-run, we ought to be prudent in overstating the negative impacts on crop prices and food security. Yield gaps – the difference between attainable/expected yield and actual yield – in economically developed countries exporting barley, maize, soybeans, and wheat have been decreasing as total output has marginally increased. Other environmental and physiological concerns impacting crop health – such as disease and crop resilience – have also been improving yields with the help of new technologies. 

In summary, the current supply-side issues will probably make for a very expensive year for soybean futures and, because of the crop’s use in animal feed and oils, probably will have some impact on supermarket shelves too. The impact of the current drought could well be corrected if inflation subsides or indeed, if a recession occurs. But this remains to be seen. With this and next week’s forecasts pointing to some rain in Junín, Buenos Aires – one of the larger soybean pastures in the province – and  Rio Grande do Sul in Brazil, there is still hope that some of the South American soybean harvest can be rescued.