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On Aug 19, 2013, we downgraded Brazilian state-run energy giant Petroleo Brasileiro S.A., or Petrobras (PBR - Analyst Report) to Underperform from Neutral.

Why the Downgrade?

Petrobras’ erratic earnings trend have been a drag on its near to medium term outlook. We also remain concerned by Petrobras’ huge investment requirements and the possibility of heightened state interference.

Detailed Analysis

Headquartered in Rio de Janeiro, Petrobras is the largest integrated energy firm in Brazil. The company’s activities include: the exploration, exploitation and production of oil from reservoir wells, shale and other rocks, and in the refining, processing, trade and transport of oil and oil products, natural gas and other fluid hydrocarbons, in addition to other energy-related activities.

On Aug 12, Petrobras reported lower-than-expected June quarter profits, owing to decreased liquids realizations and weak production. Earnings per ADR came in at 46 cents, against the Zacks Consensus Estimate of a profit of 51 cents. The company’s refining segment continues to bleed losses even after the recent decision by the Brazilian government to allow it to raise diesel and gasoline prices.

Petrobras has embarked on an ambitious investment program for the 2013-2017 period, totaling a massive $236.7 billion. This is expected to substantially increase the company’s leverage and deteriorate its credit metrics during the current downturn in the economic cycle. Additionally, the increasing capital intensity of its operations may result in reduced returns going forward.

In Sep 2010, Petrobras raised R$120.4 billion ($70 billion) in the biggest global share issue in history. Following the share sale, the Brazilian government boosted its stake in Petrobras, now controlling approximately 63% of the voting power. This has led to investor skepticism regarding heightened state interference in the company.

Finally, Petrobras’ deep-sea pre-salt reserves include fields that are located at water depths of more than 2,000 meters, and then a further 5,000 meters below sand, rocks and salt – making exploration technologically complex, challenging and expensive. As such, the success of these projects remains uncertain and bears a great financial risk.

Stocks That Warrant a Look

While we expect Petrobras to perform below its peers and industry levels in the coming months and see little reason for investors to own the stock, one can look at Carrizo Oil & Gas Inc. (CRZO - Snapshot Report), Abraxas Petroleum Corp. (AXAS - Snapshot Report) and Range Resources Corp. (RRC - Analyst Report) as good buying opportunities. These domestic upstream energy operators – sporting a Zacks Rank #1 (Strong Buy) – have solid secular growth stories with potential to rise significantly from current levels.

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