This article was published in Spain’s Cotizalia on o8-06-2010

Eight months ago I wrote from Rio de Janeiro saying how wrong most analysts were in their estimates of development costs of the pre-salt discoveries in Brazil, and time has proved us right. Facts now show between 25 to 30% less than the $40/barrel estimated by consensus. Despite this, the market is not reflecting the incremental value of these reserves in the involved companies’ stocks (Petrobras, Repsol, BG and Galp).

For example, BG Group trades at a 25% discount to its NAV (Net Asset Value), despite being one of the most benefited from the discoveries in Brazil (with holdings of between 25% and 30% in the most attractive blocks, BMS- 9 and 11), showing excellent LNG trading results and being a clear takeover target. Even if we accept the valuation of its remaining assets at “conglomerate” multiples, BG Group at £10.5/share does not reflect in any way reflect the intrinsic value of its Brazilian assets in Tupi, Guara, Carioca, Iara, which, at $77/bbl would be worth about $16 billion. And BG is the only group exposed to Brazil able to finance its development with own free cash flow.

Part of the blame for the loss of interest in Brazil comes from the delay of Petrobras to complete its capital increase ($20-30 billion) and the lack of new information about the pre-salt assets and the improvements achieved.

In this comes Repsol, and says they cannot wait any longer. And it will IPO (or sell to a third party) 40% of its E&P assets in Brazil. Repsol, as Galp and Petrobras, does not swim in free cash flow and thus seeks to raise cash to finance the development program of the fields and diversify into other areas. For Repsol, unlike for BG, Brazil represents too large a percentage of its total E&P assets.

How much are these assets worth? Analysts estimate between $5 to $10 billion, or $8/bbl at the top end of the range for assets that to this day are undeveloped. It seems an excessive price, when BG’s Brazilian reserves are valued at $ 3/bbl, in Petrobras at $3.4/bbl and Galp at $2.8/bbl.

Additionally, Repsol’s assets are the most exposed to changes in the Petrobras development program. If developing the Franco area is the Petrobras focus after Tupi, then Guara + Carioca will not be starting up until 2020, which would severely impact the NPV of the Repsol assets, and put at risk any value above $2-3/bbl.

But let us not forget that out of these companies, two (Galp and Petrobras) are semi-state-owned, and therefore “not for sale”, the third, BG, is a very large leading independent global gas explorer and producer, so maybe Repsol Brazil is the only option for third parties to participate in the pre-salt opportunity. Additionally, the transaction multiples we have seen recently have reached up to $12/bbl (proven and probable reserves). Therefore, it is not surprising that the $8/bbl figure mentioned before would be more than acceptable in a private transaction.

However, it is more difficult to think that an IPO will reach the same valuation from day one due to market risk, the fact that the assets no longer provide an aggressive exploration potential (most of the discoveries have been announced already), and that the market would bear the risk of the previously mentioned delays or difficulties in the development schedule of the assets. And we have seen in Pacific Rubiales or OGX that the attractiveness for the stock market of pure exploration assets is diluted when these move into production. But it is worth bearing in mind the “scarcity value” of Repsol Brazil for other international oil companies, as Petrobras will be the only beneficiary of the new licenses in the country.

The IPO of Repsol Brazil, if it happens, would be great news. To begin with, because it would crystallize value and would allow investors to choose the part of the integrated group that interests them the most, without having to take the risk of refining, which terrifies me, or Argentina. But it is also a double-edged sword. If the listed subsidiary fails in the secondary stock market, it will de-rate the Repsol stub agressively. It is inevitable to see the “de-rating” of the parent when the subsidiary goes public, but even more if it loses value, and this has been seen in 100% of the cases of spin-offs, IPOs, or rearrangements of divisions priced “greedily”. Repsol Brazil also has to compete for investor interest against BG, Petrobras, which trades at a 15% discount to its peers, and OGX, its largest competitor in Brazil as a “pure play” in E & P.

For now, the commitment to crystallize value, re-organize the company and reduce the conglomerate discount has made Repsol trade at a deserved 11% premium over its peers (ENI, Total, Shell, OMV). For Repsol it is now time to make its Brazilian division a “must own” stock for investors. And that has to come from a good pricing and solid catalysts.