Brazil, Petrobras, and Leverage.

Brazil, Petrobras, and Leverage.

by Lushfun

Hopefully Brazil makes it out of the path it is upon today, but my sense it is unlikely. What is happening is something similar to Russia when western sanctions went into effect and credit refinancing became unavailable for oil producers and other firms as a whole. The difference is that Russia had reserves which could be used to do the refinancing in order for those firms to not implode, and drag the rest of the industrial chain that is reliant upon them into dire straits. What also makes a difference is the amount of leverage those firms had, Lukoil and Rosneft combined had less than half the debt that Petrobras has today, while production was probably larger per firm while reserves are probably similar per firm. Even if one compares Petrobras to Conoco Phillips which produces similar amounts but probably has less reserves, there is a quick realization of the difference in debt burden.

As we speak Petrobras owes somewhere in the ballpark of about 130 billion dollars in debt, around 75% of it is denominated in dollars, 5% in euros and rest in reais. The problem is not the debt per se, but the maturity waterfall. Starting next year around 16-17 billion has to be paid back annually, it is likely that refinancing would be costly from a paying rate if it was available say at 8 or 9+ percent but it is also likely it is not available as questions regarding the validity of books and sustainability of cash flow at current oil prices will make underwriting unlikely.

The impact on Brazil at large just from this one company is not to be understated. If your commodity exports fell in value due to prices and your external reserves are under pressure due to debt maturities there may be an issue with meeting the regular import and export requirements if there is a mismatch that forces you to go insolvent with the outside world by having a shortage of external currency to CLEAR your transactions. Hence the isolvency issue arising in the future say a year or two from now. Note that I didn’t even bring up issues regarding Brazil sovereign debt itself nor other firms such as Oi or Braskem which themselves have issues.

Devaluation is a symptom of attempts by the government at large to create an environment where the purchasing power of the public is re-directed to pay-down or refinance debt to both internal and external holders by freezing the aggregate purchasing power EXCEPT for the transitional amounts. The mistake longer term is that this creates lack of trust for the home currency and reinforces foreign funding since the devaluation in home currency would be looked at as a undeniable fact of life. My rationalization of reis strengthening in light of investigation into corruption schemes is the fact that it will force some cure into the public breach of trust by the government at large. It would be better if companies that cannot survive their debt fail and be essentially given to the bond holders at large once they do, this would prevent a external debt crisis in the future and allow the government to simply reshape the fiscal constraints in regards to these companies to regain their lost equity. In regard to Petrobras at least. Most of these assets are worth 2, 3 or even less times than they were when the debt was taken on, even if you discount current equity to zero. Even Petrobras is probably worth half to two-thirds of its’ debt load or probably around 80 billion in my view in regards to today and possibly foreseeable future.

The long term problem of government attempts to shape how debt is pushed outward while control of desirable institutions is kept is that it expends a very real ‘financial trust’ that creates harsher costs for every actor that needs capital other than the favored institutions. Longer term even if local lenders swap into shares the debt waterfall maturity problem does not go away neither for the company or the country as a whole. The marginal impact of paying tens of billions of dollars in a month would eliminate a lot of reserve power needed longer term to operate in a global context.

Why is this dangerous? Considering the overall situation I’ll provide an example. Imagine you are a miller of grain into flour and everyone around you is going bankrupt (competition wise). Your bank requires higher rates of interest for the equipment you have financed and the grain you buy on the world market with U.S. dollars. Everyone around you whom provides you with a service or machinery is in a similar situation and requires higher prices for their products and in a sense you have to buy some of those services & goods to operate. You in turn will require higher prices for flour to break-even, as the market buys less products as a whole because the economy is declining you need higher margins for lower volume of goods for the survivors to compensate the marginal destruction of capital that occurred in the system. Now imagine the whole supply and production chain reeling from similar winds and having capital needs that are being closed by the market refocusing on larger actors. Top down you have structural problems in regards to necessity to change the big companies for them to remain alive, but bottom-up you are sending a cyclical message as those companies with leverage get wiped out and those without capital run out of product or machinery to operate. In a sense business becomes costlier, volumes implode, margins collapse, supply chain destruction permeates, and access to raw materials if they are external becomes questionable if you have no foreign exchange outside the country. This creates a push for those that do to take them out from the bottom and pressures those at the top to close that venue. In a sense something that Argentina experienced. Mistake in focusing the direction of credit is that once the cycle in that particular industry turns against you, all credit is at risk since what was focused will not be paid back in risk-adjusted terms, nor in greater purchasing power. Thus one industrial overexpansion garners an overall industrial over contraction. The way out is not forcing credit availability since that will never flow evenly to where it is needed, but to allow the most solvent firms to survive and allow the break up of the most inefficient and insolvent. The problem is that whom decides whom is insolvent or inefficient and generally the financial sphere wants those to survive because those are the ones whom owe it credit.

How fast things occur? Well that depends on maturities and if they bunch up in certain months this year and next. How much of ‘hot money’ leaves, this is money that is in funds or by international or institutional investors parked in stocks, bonds, etc. in Brazil’s markets. Essentially hot money is foreign deposits of foreign investors that a country would be returning that they invested into the country. According to IMF, reserves are ~360 billion with convertible currencies ~333 billion for January 2016. If one goes to the bcb Chapter V.28 External Indebtedness indicators there is more clarity. If one goes to line 31 you gain some scope of how fast things really occur. Over 2015 debt service over exports rose from 39.1% to 64.6% coming in at 66.1% for January 2016. You could say a 50% growth a year, perhaps over this year it goes to 100%. You could take line 31 of debt service over goods and service exports that grew at a 66% clip over a year so you would end up with ~90% using that number. These are the actual flows into the country, the reason I look at them and not other things is because if you have to pay in foreign currency for maturities and your service costs do not go away you are limited to your reserves and the number between your left over flows. Currently reserves more or less match external debt. However, I am going to give some food for thought.

Imagine a following scenario over the course of the year, maturities of short term external debt at around 55 billion dollars, hot money outflows of say another 50 billion dollars, with balance of trade outflows of say another 45 billion, and you roughly halve the reserves from 330 to 180 billion dollars. A year later you’re left with 30 billion. So roughly two years of reserves currently. But since markets are forward discounting mechanisms, and politicians are presently rationalizing people the later tend to distribute reserves in such a fashion that the former generally are overoptimistic about what is currently happening.

In 2009 Brazil instituted a 2% fee on foreign investment capital on entry, what happened most likely is some of that issuance moved abroad. What they do not capture is the credit shifts in regards to these aspects. Imagine if you issued capital abroad and then lent it to your own firm from the subsidiary that is not wholly owned. Theoretically if the company defaults the subsidiary would become the holding company and take over the parent since it is owned by other non-related investors. I know very unlikely but imaginative scenario, however at that point the capital base of the country flips and those foreign claims you thought you had on paper are no longer yours{from a country view} from every legal stand point the foreign entity{that may have same owners} is now the owner of this firm and you essentially exported capital since you are forcing it to flow where the people that own it cannot allow it for their livelihood depends on it.

How does any of this matter? Well if you gradually clamp down on foreign exchange reserves and companies that need to use them cannot, they will attempt to front run the event. Ergo the miller above will likely shift his available capital at least partly to finance his future grain buys, however he will try to do so with credit to himself so that capital is not ‘frozen’ in the country and he can no longer use it. Thus over a period of time the country incentivizes more capital to be brought out while associated credit tied to said capital brought in, which in the long run will make flows more unstable. Precisely what they are attempting to regulate away.

Be well, dear reader and look into the sky, the clouds are good.

http://gulfnews.com/business/economy/brazil-s-debt-king-1.1634986

http://en.mercopress.com/2016/02/25/moody-s-downgrades-brazil-s-sovereign-debt-to-junk-territory

http://www.zerohedge.com/news/2016-03-04/real-soars-6-month-highs-after-former-brazilian-president-lula-detained

http://www.reuters.com/article/brazil-corruption-petrobras-debt-idUSL2N15V17W

http://www.bcb.gov.br/?INDICATORS

http://www.bcb.gov.br/pec/Indeco/Ingl/IE5-28i.xlsx