Brazil's state-run energy giant Petroleo Brasileiro S.A., or Petrobras ( PBR - Analyst Report ) announced first quarter 2012 earnings of R$9.2 billion or R$0.71 per share, compared with R$11.0 billion or R$0.84 in the year-earlier quarter.

The company reported net income of US$5.2 billion or 40 cents per ADR, down form the year-ago quarter result of US$6.6 billion or 51 cents per ADR. Quarterly earnings per share also missed the Zacks Consensus Estimate of 65 cents.

The company’s results were hurt by rising operating costs and impairment charges.

Petrobras’ net operating revenues of R$66.1 billion (US$37.4 billion) was up 21.5% from the first quarter 2011 level. The result also beat our projection of $35.8 billion, reflecting improved prices level along with a lift in production.

Segmental Performance

Upstream: Total oil and gas production during the first quarter of 2012 reached 2,676 thousand oil-equivalent barrels per day (MBOE/d), up from 2,670 MBOE/d in the previous quarter and 2,629 MBOE/d in the same period of 2011.

Compared with the first quarter of 2011, Brazilian oil and natural gas production increased 1.9% to 2,430 MBOE/d, while international production came in at 246 MBOE/d (up slightly from 244 MBOE/d in the year-ago period).

During the first quarter of 2012, the average sales price of oil in Brazil increased 18.6% from the year-earlier period to U.S.$111.56 per barrel. Average sales price of international oil was up 14.4% year over year, reaching U.S.$99.99 per barrel. Regarding natural gas, average international sales price increased 23.2% from the first quarter of 2011, while domestic price was up 5.8%.

This pushed up the upstream (or exploration & production) segment profit by 33.4% to R$12.4 billion.

Lifting cost per barrel (or cost to produce each barrel of oil) moved up 14.1% in Brazil to U.S.$12.98, while overseas costs hiked 35.0% to U.S.$7.63.

Downstream: During the first quarter, Petrobras’ downstream unit incurred a net loss of R$4.6 billion, compared with a loss of R$94 million a year ago. This was due to the company’s inability to cope with the rising oil costs, a higher level of imports during the period and a poor sales mix.

Though the Brazilian government came up with a decision to hike domestic fuel prices during late 2011, it was not enough to offset Petrobras’ refining losses.

Refining costs per barrel in Brazil were down (by 5.7%) at U.S.$4.27. Internationally, it dropped 32.0% to U.S.$3.27. Petrobras exported an average of 720,000 barrels of oil per day, 14.1% higher than the comparable quarter last year.

Capital Spending & Balance Sheet

During the three months ended March 31, 2012, Petrobras’ capital investments totaled R$18.0 billion. At the end of the quarter, the company had cash and cash equivalents of R$39.9 billion and net debt of R$164.1 billion. Net debt-to-capitalization ratio was approximately 24%.

About the Company

Headquartered in Rio de Janeiro, Petrobras competes with other established integrated energy firms like ExxonMobil Corp. ( XOM - Analyst Report ) , PetroChina Co. Ltd. ( PTR - Analyst Report ) and Royal Dutch Shell plc ( RDS.A - Analyst Report ) . The company’s activities include: exploration, exploitation and production of oil from reservoir wells, shale and other rocks, and refining, processing, trade and transport of oil and oil products, natural gas and other fluid hydrocarbons, in addition to other energy-related activities.

We believe that continued demand growth in Brazil, together with all the new investments and acquisitions, will fuel Petrobras’ medium-term earnings outlook. Additionally, we expect the company to benefit from its expertise in deepwater operations and its huge recent discoveries.

However, we remain on the sidelines give the company’s exposure to the volatile oil and gas fundamentals, which are expected to impact profitability. Moreover, Petrobras’ huge investment requirements, operational hindrances and international business risks also add to our negative sentiment.

Hence, we expect Petrobras to perform in line with the broader market and maintain our Neutral recommendation on the stock.