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On Mar 21, 2013, we upgraded Brazil's state-run energy giant Petroleo Brasileiro S.A., or Petrobras (PBR - Analyst Report) to Neutral from Underperform. Our new investment thesis is supported by a Zacks Rank #3 (Hold).

Why the Upgrade?

The Rio de Janeiro-headquartered company’s latest quarterly results came in better than the year-ago period and matched the Zacks Consensus Estimate. We are also encouraged by the increase in pump fuel prices that is expected to boost Petrobras’ margins. Given its strong pipeline of development projects and impressive exploration successes, Petrobras’ long-term outlook seems compelling.

Detailed Analysis

On Feb 4, Petrobras reported fourth quarter profit of R$7.7 billion or R$0.59 per share, compared with R$5.0 billion or R$0.39 in the year-earlier quarter. Earnings per ADR came in at 58 cents (1 ADR = 2 shares), above the year-ago profit of 44 cents and in line with the Zacks Consensus Estimate. Results were driven by higher financial gains and lower taxes.

The recent decision by the Brazilian government to allow Petrobras to raise diesel prices – the second time in six months – is a long term positive for the company. The move would not only boost the state-run energy major’s margins but also cut its import losses.

Additionally, we expect the company to benefit from its expertise in deep-water operations, its massive new discoveries (which could double its resource base) and the growing domestic refined products market.

However, we remain concerned by Petrobras’ declining production trend. The huge investment requirements and the possibility of heightened state interference add to the negative sentiment.

Stocks That Warrant a Look

While we expect Petrobras to perform in line with its peers and industry levels in the coming months and advice investors to wait for a better entry point before accumulating shares, one can look at EPL Oil & Gas Inc. (EPL), Range Resources Corp. (RRC) and Stone Energy Corp. (SGY) as good buying opportunities. These domestic oil and natural gas explorers – sporting a Zacks Rank #1 (Strong Buy) – have solid secular growth stories with potential to rise significantly from current levels.

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