Brazil’s state-run oil company, Petrobras, had its investment grade cut by Moody’s, aggravating uncertainty over whether it will be up to the Brazilian government to back up the oil giant. In the case of a bailout, Brazil’s fiscal tightening and primary surplus target may be abandoned entirely.
From black gold to junk
In many ways the Brazilian government has run Petrobras the same way it has run the country: with heavy spending and poor planning. The country, however, appeared to be getting back on track. Brazil’s new economic team has successfully started to appease investors by curbing spending and raising interest rates. Petrobras, on the other hand, has experienced an unprecedented reputational decline with a massive corruption scandal and debt of over $135 billion.
After Moody’s downgrade of Petrobras by two notches, the company’s bonds, which were already being traded at nearly junk value, plunged by over 6 percent on Wednesday (February 25). The sell-off is due to continue as other credit rating agencies follow suit and cut the company’s investment grade sooner rather than later.
Among the reasons behind the downgrade is Petrobras’s failure to present audited third-quarter results due to difficulties in assessing the impact of the corruption scandal on the company’s assets. It was later announced that the writedowns would be included in the company’s annual financial statement, but that these would not be released before the end of May – a month after the deadline.
By failing to submit timely audited results, Petrobras risks a technical default and payment acceleration. The company’s violation of IFRS rules, which leaves investors in the dark, can be subject to litigation in the near future, and consent solicitation for more flexibility does not seem like a viable option given the number of bondholders involved.
Presenting annual results before the end of April therefore seems like the only way to avoid major losses. There is, however, no concrete evidence that the deadline will be met.
Between a rock and a hard place
A potential default at this point would be no spectator game, and the Brazilian economy would likely be dragged down. A bailout would compromise the country’s sovereign debt rating, increase the costs of borrowing and hamper economic recovery.
Brazil ended last year with a fiscal crisis, rampant inflation and zero growth. In response, the new economic team has implemented an adjustment package and laid out a primary surplus target of 1.2 percent of GDP for 2015. Adjustment will however be rendered unachievable if the government is to cover Petrobras’s more than $50 billion in debt.
Furthermore, after closing 2014 with a historic current account deficit, Brazil is especially vulnerable to fluctuations in investment flows. Petrobras accounts for about 10 percent of investment in the country. Given that many institutional investors are contractually forbidden from holding bonds that are not rated investment grade, inflow is due to decrease.
The Brazilian government has however declared that no bailout is being planned at the moment, and President Dilma Rousseff justified the downgrade as a lack of information about the company’s potential to recover. On its assessment, however, Moody’s also downgraded Petrobras’s baseline credit, the company’s intrinsic financial strength without government support, thus highlighting Petrobras’s inability to survive on its own.
Closed for business
The slowdown of the country’s biggest company affects the Brazilian economy on multiple levels. Petrobras’s $16 billion cut in its ambitious $220 billion investment plan has already impacted the production chain, as contracts with suppliers and service providers have been discontinued.
In a domino effect, Brazilian banks with loan exposure to the oil and gas industry may be imperiled as companies are not able to service their debts. Goldman Sachs estimated that Brazilian banks have over $40.2 billion in exposure to the oil and gas industry. Banco do Brasil, the country’s largest bank in terms of assets, for instance, has 7.4 percent of outstanding loans to the sector.
While it remains cut out from financial markets, Petrobras is exploring new possibilities to finance its debt. The company has announced a $13.7 billion asset sale for 2015 and 2016. Bank of America Corp. has however estimated that a $20 billion asset sale, together with a $25 billion capital expenditure reduction, is necessary if leverage is to be substantially reduced.
In sum, the pervasive effects of a default would turn the most promising source of wealth for the Brazilian people into one of its heaviest burdens by preventing the country from resuming growth. It is even questionable now whether the choice of economic policy is still in the hands of the country’s economic team, or if this year will simply witness the consequences of a decade of costly malfeasance. In any case, it seems fair to conclude the state-controlled company Petrobras became a company in control of the state.
