Description

With Oil prices bouncing around the $70-$80 range, a mixed short-term economic outlook that is at best uncertain, and a long-term shortage of investment, the near-term outlook for E&P equities is very tricky. Instead of skimming the final few percentage points from well-known names in the case that oil prices rise in the short term or collecting a dividend that won't offset a capital decline if oil prices fall in a weakening economic environment, one might be better off betting against the political risk of Columbia and buying the deeply discounted Ecopetrol (EC: US).

Situation

EC is the ADR for the Colombian national company. It is 80% owned by the national government and 20% owned by minority shareholders. Pre-pandemic, with Brent crude averaging around $60/bbl, EC traded in the high teens to mid-20s. In 2022, with Brent averaging over $100/bbl and EC posting its best results in the company's history, EC fell 50% as former Marxist guerrilla Gustavo Petro was elected the country's first-ever leftist leader.

Petro ran on a platform of big social spending, currency devaluation, and militant environmentalism, pledging to ban fracking, stop oil exploration, and transition Colombia to an economy based on tourism. At the current price (roughly $10.0 per share), EC trades around levels the stock settled at during the COVID when oil tumbled and just above the range the company traded at during 2016 when Brent crude went under $30/bbl.

Is the outlook under Petro so negative that the company should be priced at levels only seen during the most negative global pricing environments for their products? Probably not.

What Has Changed with Petro

Although Petro talked a big game during his campaign, what politicians can achieve, as opposed to their preferences, is always more constrained than most investors' price into a stock. Though there have been several proposals, the negative changes which became law as of November 3rd, 2022, are:

• Oil companies operating in Colombia must pay additional taxes on their net income. Specifically, companies will be taxed an extra 5% when international oil prices are between $67.3 and $75/bbl, 10% from $75 to $82.2, and 15% above that. Management of EC has noted that this tax increase is a disappointment but by no means debilitating, raising the firm's effective tax rate from ~35% to ~50% in the worst-case scenario. This year's expected impact is 5%, given the ten-year price average used to calculate the tax.
• Colombian oil companies will no longer be able to deduct royalty payments from their income statement.
• Fracking is no longer permitted in Colombia, and the government will no longer offer new exploration contracts. However, existing exploration contracts will be honored, and of 207 exploration contracts awarded, only a bit more than half are currently active, meaning there is some "underutilized" inventory. EC engages in no fracking in Colombia, EC has fracking operations in the US, and management does not believe EC wells lend themselves to fracking.
• But not all the changes have been bad; there have also been some positive changes. For years, the government has used the FEPC (Fuel Price Stabilization Fund) to subsidize domestic fuel pricing effectively. Around 4B USD has been included in the 2023 budget (according to a recent conference call) to reimburse Ecopetrol for its contribution to that program. Additionally, over the summer, the government agreed (and I think it is still the understanding) that the FEPC balance would be reduced instead of the government receiving dividend payments for its 80% holding.

Many have been concerned that Petro would become a strong man, hold onto power for years (think Chavez), and bring the country down in flames with his Marxist leanings. This is not only unrealistic (Petro has no friends in the military, the control of which is a minimum necessity to pull a Chavez) but also shows a lack of effort on the part of investors to understand the Columbian political system and the constraints it puts on politicians:

• Although term limits on Presidential candidates in Columbia have gone back and forth between one and two terms (currently one term) in the last decade, the constitutional court has been active in limiting efforts to change the system to allow for multiple terms, pushing back at every turn, even when the effort in the early 2000s where the goal was to allow the president to run for a second term.
• To take a run at another constitutional amendment allowing more than one term, Petro would need control of the legislature and the judiciary. Given that traditional political parties increased their representation (and traditional parties tilt conservative), it is unlikely that the distribution of political power in congress has shifted sufficiently to allow Petro to try and put together the coalition necessary to push for a change to the presidential term limits.

Valuation

Based on the above analysis, assuming that oil prices do nothing and average $70 a barrel, a value north of $15 a share and more likely in the roughly ~$20.0 per share range seems a reasonable bet. We can triangulate this value utilizing the following three methods:

• DCF
  • Assume stable sales at expected 2022-year-end levels, with a favorable 2022 3Q2022 EBITDA margin of 47% going forward.

• EBITDA Exit Multiple of 5.0x
• Assume roughly flat CapEx off of the 2022 base, which is in keeping with company comments.
• Forecasted and Terminal Discount Rate of 10%
• No Terminal Growth Rate
• Multiples Valuation
• Assumed 30% and 40% EBIT and EBITDA Margins represent historical margins.
• 2023 Forecast Revenue
• 6x and 5X EBIT and EBITDA Multiples
• Normalized Valuation
• 30% EBIT Margins
• 2023 Revenue

Areas of Concern Valuation:

• The DCF scenario assumes no further growth in production; this is at odds with what management is suggesting will happen but not at odds with the production fade in recent years. The firm appears to be struggling to maintain flat production. Growth could happen, and management is targeting growth, but the bet should probably be that it won't.
• As noted in the intro paragraph, now is a tricky time for oil equities. $70 a barrel for valuation does not seem an egregious level to value the company, but a downside exists should oil fall out of bed.   One source of investor protection in this scenario is a strong dividend, which makes the dividend from most oil E&Ps look pedestrian. Investors buying today can look forward to collecting an already-announced 10% dividend on 4/11/2023, with more likely to come this year.

Catalyst

• Fading concerns about Politcal Risk.
• Flat to rising oil prices.
• Special dividends.