Ecopetrol: A Second Look At The Geopolitical Threat

Funding thesis

Ecopetrol S.A. (NYSE:EC) is Colombia’s nationwide oil firm (or NOC) and likewise the most important firm within the nation. The federal government owns 88.49% of the inventory. The 11% float is traded in Colombia and on the NYSE through ADR itemizing.

The funding story is straightforward and is a trade-off between two components:

• On the constructive facet, Ecopetrol is at the moment one of the vital discounted oil producers, and its massive dividend stands out relative to different NOCs too.
• The detrimental is the geopolitical danger related to Colombia’s new, leftist president. The priority is that the federal government could push the corporate into unprofitable initiatives to meet social goals, or could in any other case take actions towards the curiosity of minority shareholders.

Because the valuation facet is pretty apparent, the article focuses totally on the geopolitical side. My thesis is that the political danger priced into the inventory is exaggerated for 3 causes:

1. President Petro has a minority in Colombia’s congress, so coverage modifications are solely potential through broad coalition constructing. Nonetheless, the broader the coalition, the smaller the modifications from the established order will be.
2. To meet the social features of his agenda, Mr. Petro will want vital authorities income to finance the spend. So relatively than killing the proverbial “golden goose” (that’s, Colombia’s hydrocarbons sector) by means of aggressive environmental reforms, a extra logical selection could be to keep away from disrupting the earnings potential of Ecopetrol and relatively go for symbolic “fast wins” on the environmental entrance.
3. At a macro stage, Colombia’s sovereign credit score default swaps (or CDS) and the spreads on Ecopetrol’s personal USD listed debt counsel that geopolitical danger perceptions could have peaked in October.

If the presumably extra refined bond market is appropriate, the fairness market ought to comply with and re-rate Ecopetrol’s shares larger. Within the meantime, buyers can profit from the huge dividend.

Firm background

Ecopetrol is Colombia’s NOC. Its separation from the federal government started in 2003, when the company ceded its administrative position as hydrocarbons regulator to the Nationwide Hydrocarbons Company. The preliminary public providing was in 2007, when Ecopetrol’s frequent shares have been listed on the Colombian Inventory Alternate. The American Depositary Shares have been listed on the NYSE in 2008.

Lately, Ecopetrol has expanded past Colombia. In 2017, the corporate entered into Mexico, the place it obtained curiosity in two offshore blocks. In 2018, Ecopetrol entered the Brazilian pre-salt oil area, in partnership with different NOCs and majors. In 2019, Ecopetrol additionally began operations within the Permian by means of an alliance with Occidental Petroleum (OXY). In 2021, the corporate bolstered its advertising and marketing presence in Asia by means of a brand new buying and selling entity in Singapore.

As a snapshot, EC produces about 700,000 boe/d and its refining capability can soak up half of that. The corporate additionally owns vital electrical transmission infrastructure. The transmission enterprise could have probably been “pushed” onto the corporate by the federal government, however nonetheless it appears to generate good ROE:

The Permian operation is changing into extra distinguished, and Ecopetrol can also be increasing its advertising and marketing presence in Texas:

In my opinion, the truth that Ecopetrol now has materials U.S. property, which might theoretically be focused in lawsuits, might additionally act as an vital assure for Ecopetrol’s minority shareholders.

Valuation concerns

At 2.2x ahead earnings and a 15+% dividend yield, Ecopetrol appears to be like fairly enticing from a valuation perspective:

Ecopetrol can also be one of many few power shares on the market that’s down year-to-date. A comparability to the S&P 500 power sector (XLE) is sufficient to present this has nearly all the pieces to do with the presidential election and never a lot with oil costs:

In comparison with the Majors, Ecopetrol trades at fairly a reduction:

The low cost is bigger relative to the 2 U.S. Majors, ExxonMobil (XOM) and Chevron (CVX); the European ones, Whole (TTE), Shell (SHEL) and BP (BP) have a smaller premium over EC, maybe as a result of with the latest windfall taxes, Europe can also be perceived as politically dangerous for power firms.

Infamously although, NOCs commerce at decrease multiples. When the federal government is a majority shareholder, there’s at all times a danger that nationwide priorities could come into battle with the pursuits of minority shareholders. Ecopetrol’s valuation is consistent with the metrics of different NOCs:

The NOC panel contains firms from different international locations present process political turmoil equivalent to Petrobras (PBR). The state of affairs in Argentina (YPF) can also be not excellent. Nonetheless, Ecopetrol’s dividend nonetheless stands out.

In comparison with how the market valued it within the latest previous, Ecopetrol additionally appears to be like discounted:

Trailing EBITDA multiples have been within the 4x to 6x vary. The upper ratios in 2021 have been pushed by the unusually low 2020 outcomes. Nonetheless, the two.5x ratio in place now’s unusually low; it solely briefly touched that time earlier than in March 2020 throughout the peak COVID lockdowns and OPEC+ worth struggle.

In the meantime, the corporate is reporting document earnings:

9-month EBITDA YTD equals the prior two fiscal years mixed.

As a high-level goal, I believe the inventory worth might ultimately return to the March-April ranges, implying a 50% to 100% upside from right here. Such repricing would additionally convey the valuation metrics extra consistent with their historic norms. Nonetheless, that won’t occur earlier than the market will get snug with the political state of affairs.

Reassessing the geopolitical danger

A typical narrative within the media has been that Petro, a former guerrilla and Colombia’s first leftist president, could be very negative for the nation’s oil sector:

To cite from the article:

Even if crude is Colombia’s primary export, Petro vows to be hostile towards the oil and fuel business and has pledged to cease awarding new exploration contracts. He allegedly desires to show Ecopetrol, the nation’s major petroleum producer and largest firm of any variety by income, right into a wind and photo voltaic supplier. As Bloomberg studies, the Colombian authorities, owns 85% of Ecopetrol, so there’s little to cease Petro from undertaking this.

The selloff within the Colombian peso, CDS spreads and equities with publicity to Colombia are all per the narrative. I’ve additionally personally heard a few tales about expats transferring their funds overseas.

Nonetheless, in my opinion these narratives are a nasty take. They search the journalistic sensationalism and ignore the fact that what a politician (Petro) desires is not at all times what they get.

Successful elections is not governing

To be clear, the purpose is not that Petro would not need to implement the agenda he has campaigned on. I do not know what he actually desires, however I’m completely satisfied to imagine that his platform displays his targets. The purpose is, nevertheless, that after elected politicians step into workplace, their incentives change. Voters decide incumbents much less so on their platform and extra so by means of the prism of the voters’ personal financial well-being. If you cannot pay your payments or afford groceries, you blame the man in cost. This places some strain on politicians to drop much less prudent features of their platforms as soon as voters understand them as being in cost.

Actually, a political science research, suggestively entitled “Neoliberalism by Shock in Latin America,” discovered systematic proof that left-leaning Latin American politicians have a tendency to maneuver to the best on coverage throughout their time period. The research concludes that, finally, neoliberal (unpopular) insurance policies work finest for constituents and that’s exactly why elected officers have the incentives to pursue such insurance policies. One higher identified instance is maybe the Peruvian presidential election in 1990, which was received by populist Alberto Fujimori towards the conservative Mario Vargas Llosa. As soon as in workplace, Fujimori pivoted to the best and “stole” a lot of Vargas Llosa’ platform, successfully implementing neoliberal reforms. The underside line is that, trying throughout the area, the arrival of a leftist chief in workplace does not mechanically suggest a Venezuela state of affairs. Actually, what went on in Venezuela appears to be far more of an exception than the rule.

Political establishments matter too

Coverage making does not occur in a vacuum both. Colombia’s “Congreso”, has two chambers, not in contrast to the Home and Senate within the U.S. Neither of those our bodies are managed by Petro’s occasion, which in flip implies that the legislative course of can solely transfer ahead with a broad successful coalition behind it. In different phrases, the system has quite a lot of “veto gamers”, who because of the distribution of political energy and coverage preferences, can block modifications from the established order. Petro must keep away from any veto gamers blocking him, however that can naturally drive coverage in direction of the middle.

That is precisely what appears to have occurred with Colombia’s tax reform, which underwent just a few months of negotiations:

On 6 October 2022, the financial commissions of Colombia’s Senate and the Home of Representatives authorized the tax reform invoice. Now the modified invoice will likely be mentioned in second debate by the plenary of each homes earlier than it may turn into regulation.

The tax reform authorized in first debate contains a number of modifications, agreed between the Authorities and a bunch of congressmen, primarily based on the preliminary feedback to the tax reform invoice submitted by the Colombian Authorities on 8 August 2022.

Petro isn’t Chavez and does not mechanically get what he desires. Quite the opposite, his place might be extra much like that of Joe Biden, who has to barter his agenda with Congress.

So what’s politically potential?

A report from Colombia Threat Evaluation, a geopolitical danger consultancy targeted on the nation, tried to rank Petro’s proposals by precedence (for Petro) and the probability they might be accepted:

Whereas Colombia Threat Evaluation categorized tax reform (which already handed as famous) as a “fast win,” Petro’s extra radical proposals associated to the oil and fuel business are deemed unlikely to go with out radical modification. Quoting from Colombia Threat Evaluation (my emphasis):

Petro’s insurance policies relating to the extractive sector are a few of his most contentious proposals. His imaginative and prescient for ceasing oil exploration and banning fracking addresses his goal to assuage local weather change and promotes extra sustainable power sources; nevertheless, it isn’t lifelike. Contemplating the numerous burdens his administration will confront inside the first weeks of the 100 days, Petro will likely be unlikely to sort out a sector that gives vital funding, which means he’ll possible backtrack on his marketing campaign rhetoric to keep away from financial fallout. The speedy power transition he had proposed earlier is more likely to cutoff essential funding for his quite a few social applications.

Colombia Threat Evaluation brings up an excellent level; specifically, that the federal government’s “purse” can even act as constraint. If Petro have been to hurry and kill the “golden goose” that oil and fuel is for Colombia’s financial system, in addition to scare off international funding within the course of, his budgetary receipts will fall critically and thwart the social features of his agenda (which, naturally includes spending extra money):

The struggle in Ukraine has pushed the worth of a barrel previous 100 USD, which has created a large windfall for Ecopetrol, taxes, and royalties, even with oil costs at the moment reducing. Petro should be significantly savvy in figuring out his finances and monetary framework when factoring in oil manufacturing, costs, the tempo of the power transition, and regulation of oil exploration permits. With out these cautions, Petro will likely be unable to ship on his various social applications and marketing campaign guarantees resulting from a scarcity of presidency funds.

For Petro, then, the optimum play could also be to keep away from radical power reforms and go as an alternative for extra symbolic environmental coverage wins, with the intention to protect the income producing energy of the power sector and channel it into the social reforms, which finally will decide his recognition. Subsequently, regardless of the rhetoric, ceasing oil exploration could also be politically unattainable:

Colombia Threat Evaluation additionally cautions on drawing parallels with Chavez:

Though his opposition loves to match Petro to Chavez, Chavez did have overwhelming assist in contrast to Petro, making their political realities vastly totally different. Chavez additionally had laborious assist from the army and PDVSA, which managed the Venezuelan financial system. Petro won’t have the identical authority and deal with over the financial system with Ecopetrol. Though Petro’s base desires to see heads on a spike, and shortly, Petro must straddle each ideological camps to advance any legislative modifications.

Petro’s appointment as finance minister of José Antonio Ocampo, a centrist economist who did not marketing campaign for Petro throughout the election, can also be seen as indication that Petro will not attempt to “rock the boat” on financial and power coverage an excessive amount of. From Colombia Threat Evaluation once more:

Petro’s appointment of José Antonio Ocampo as Minister of Finance alerts a shift in Gustavo Petro’s financial imaginative and prescient that implies a better allowance and reliance on the extractive sector and free commerce. They hope to keep away from affecting the funding local weather and macro-financial stability, particularly contemplating Petro’s strained relationship with the non-public sector and commerce associations.

In abstract, Petro, constrained by Colombia’s finances and authorized framework, can have a relatively slim path forward:

With Petro’s proposed coverage to stop oil exploration, Colombia is more likely to exhaust its present reserves in six to seven years, which means the nation will possible expertise a doubling in fuel costs with heavy implications for a rustic with such a big poverty fee. To lighten this influence and the federal government’s dependence on extractives, Petro is more likely to encourage different sectors to extend productiveness. Nonetheless, this will likely be something however a easy transition as most authorized mines–together with the fracking pilots and open-pit mining–have strong authorized instances to again their operations, which is almost definitely to lead to a plethora of complicated, prolonged authorized battles for Petro. To keep away from being slowed down in his first 100 days within the extractive sector, Petro is more likely to goal extra straight-forward features of the sector, equivalent to unlawful mining, the place he can cooperate with the non-public sector. Petro will possible go a mining and carbon tax, which is able to increment prices for these depending on carbon to speed up a phasing out of the power supply.

Some authorities statements already counsel Petro could have settled on defending the “purse” first; based on recent reporting:

Colombia is concentrating on a 15% enhance in crude oil output by utilizing “enhanced restoration” applied sciences to make the most of larger power costs, even because it pushes to decarbonization, Minister for Mines and Vitality Irene Velez stated.

Speculating about political incentives is inherently subjective, however my private feeling is that the camp which equates Colombia to Venezuela is exaggerating fairly a bit.

The tax reform

The tax reform, which was finally authorized (after modifications) on November 17, did certainly enhance taxes on the extractive industries:

Corporations receiving earnings derived from the event of sure extraction actions of non-renewable assets needs to be topic to a everlasting CIT surtax which is able to range between 0% to fifteen% for oil firms (complete CIT fee between 35% to 50%) and between 0% to 10% for coal mining firms (complete CIT fee between 35% to 45%). The relevant surtax fee could be decided primarily based on a calculation that considers the typical mining/oil costs inside the 10 years previous to the yr during which the surtax is set and the typical worth of the product within the yr during which the calculation is made…

Earnings derived from the sale of pure fuel will likely be not topic to the CIT surtax…

Royalties paid for the exploitation of non-renewable assets will likely be not deductible for earnings tax functions…

The tax reform repeals the 5 years accelerated amortization for investments in exploratory actions carried out between 2017 and 2027 in addition to the motivation credit score for oil, fuel and mining investments.

Extractive industries are at all times taxed at excessive charges, so I personally do not discover 50% CIT fee to be extreme, even with non-deductible royalties; we’ve examples of upper windfall tax charges from Europe. I additionally do not see Ecopetrol as the first goal of those reforms, however relatively non-government owned entities. The federal government owns 88% of Ecopetrol, so even with 0% tax fee, it will nonetheless be gathering the overwhelming majority of Ecopetrol’s distributions.

So is that this actually in regards to the 12% minority curiosity? I extremely doubt it. The minority piece is sort of small from Colombia’s perspective, so it’s in all probability not well worth the hassle. Ecopetrol, as identified, can also be quickly increasing exterior of Colombia and within the Permian particularly. The corporate has loads of U.S. primarily based property that might in all probability be focused by authorized motion if Colombia disregards Ecopetrol’s company bylaws defending the minority stake.

Lastly, it’s even possible that the tax reform contributes to Colombia’s total fiscal stability:

The reform seems fiscally accountable. It raises income to cut back the deficit, which rose to nearly 8% of GDP in 2020 on the again of pandemic spending. This yr, deficit will fall to five.6% of GDP and may proceed to say no. If the fiscal rule mandated by regulation is revered, the deficit will fall to 4.6% in 2023.

For Ecopetrol’s minority shareholders, extra tax means much less dividend, however, in the long term, a extra fiscally secure Colombia will likely be a constructive issue.

The macro view

The bond market is steadily stated to be a extra refined weighing balance of macro dangers. So let’s look first at Colombia’s 5-year credit score default swap charges:

The CDS fee in late October was about 400 bps, however has come all the way down to 265 bps since then. It means that, for now, the bond market’s danger perceptions could have peaked.

Ecopetrol itself additionally has a number of bond points registered with the NYSE. I seemed on the 6.875% USD-denominated notes due in April 2030. The choice-adjusted unfold additionally means that October could have marked the height danger perceptions:

To disentangle the geopolitical element from the selloff in power, I additionally calculated a relative unfold, pairing Ecopetrol’s notes to Oxy notes with the identical credit standing BB+ and likewise maturing in 2030:

The conclusion is just about the identical. For greater than a month now, the geopolitical danger notion embedded in bond costs has been declining.

The height in October in all probability is not random both. It coincides with the board of directors drama, when Carlos Cano, the longest serving board member was elected as head of the board. It turned out that Petro hadn’t been consulted, so inside 24 hours, Cano’s election was revoked and he was changed by Saul Kattan, a brand new board member simply nominated by Petro.

The markets reacted very negatively, however looking back, this agrees with my evaluation. Since Petro is constrained from making substantive modifications to the power sector, will probably be vital for him to assert symbolic victories with the intention to appease his base and present he’s in management. To my understanding, Mr. Cano remains to be on the board, and the board head, now Mr. Kattan, does not have many particular powers. So Petro’s tantrum over this was in all probability for home political consumption.

Presumably, Petro’s administration did not anticipate the market response both, as a result of the president’s tweet (in Spanish) shortly after reaffirmed in essence the EC company bylaws and their safety for minority shareholders (my emphasis):

1. Ecopetrol configures its board of administrators like every other firm based on the shareholding, and the vast majority of shares belong to the State.

2. The brand new board of administrators is made up of people that have already elevated the worth of firms equivalent to EEB and ETB.

3. The rights of minority shareholders will at all times be revered.

4. The directive of the President of the Republic for the motion of his representatives within the new board of administrators is to extend the worth of Ecopetrol.

So possibly an excessive amount of ado for nothing, and that’s the reason CDS and Ecopetrol spreads have come down significantly because the incident.

To conclude the macro assessment, let’s additionally check out the assessments of Moody’s and Fitch:

Moody’s:

Ecopetrol’s Baa3 rankings proceed to mirror the corporate’s standing as Colombia’s main oil and fuel producer, accounting for over 60% of the nation’s manufacturing and near 100% of the provision of oil merchandise, as effectively its massive energy transmission enterprise in Colombia and different international locations in Latin America. Moreover, Moody’s assumes excessive chance of assist from the Authorities of Colombia (Baa2 secure) and a reasonable default dependence between the 2 entities; this evaluation ends in a three-notch uplift of Ecopetrol’s senior unsecured score to Baa3 from its Ba3 (standalone).

Fitch:

Fitch Rankings has affirmed Colombia’s Lengthy-Time period Overseas Foreign money Issuer Default Score at ‘BB+’. The Score Outlook is Secure.

Colombia’s rankings mirror the nation’s monitor document of macroeconomic and monetary stability underpinned by an impartial central financial institution with an inflation concentrating on regime and a free-floating forex.

The Gustavo Petro administration pledges to spice up social expenditures with key reforms in healthcare, pensions and different areas. Petro’s administration additionally seeks to remodel Colombia’s financial system by decreasing its dependence on extractive industries whereas specializing in renewable power, probably ending new oil exploration and banning fracking, which if carried out might create uncertainties for the sector and undermine funding.

The president was capable of develop a working majority within the congress by attaining alliances with many center-left and leftist events. In consequence, Petro has handed vital tax reform inside his first few months in workplace, which is anticipated to yield revenues of 1.3% of GDP in its first yr and assist fund pledged will increase to social expenditure.

Coverage uncertainties are anticipated to stay over the approaching yr. Petro’s reform agenda throughout 2023 is anticipated to shift to deal with the doubtless controversial pension reform. Nonetheless, the Petro administration has pledged to stick to Colombia’s fiscal and financial framework, adhering to the independence of the central financial institution and the up to date fiscal rule.

This is an earlier assessment from Fitch, after the congressional elections at the start of the yr:

Sunday’s Congressional elections noticed no single bloc acquire greater than 15.6% of the seats within the Senate or 19.6% of the Home of Representatives, based on preliminary outcomes…A fragmented Congress makes consensus-building essential to go laws, no matter who wins the presidency. This helps our view that Colombia’s broad coverage framework will stay intact as a result of institutional checks and balances are more likely to stop coverage radicalization. An impartial central financial institution and autonomous judicial system can even present checks and balances to the chief.

Neither evaluation suggests motive for panic, and Fitch additionally highlights Colombia’s institutional constraints as a coverage moderation issue.

Conclusion

Ecopetrol’s sound working efficiency and closely discounted valuation make the corporate a powerful deep worth prospect. The one issue miserable the valuation is the notion of geopolitical danger related to Colombia’s new president Gustavo Petro and his environmental agenda.

Nonetheless, the institutional constraints prevailing in Colombian politics, in addition to Petro’s incentives as a now elected official, counsel that the issues over the federal government impairing Ecopetrol’s long-term profitability and appearing towards the minority shareholders could also be overblown.

From a macro perspective, the bond and CDS markets additionally counsel that we could have already seen the height geopolitical danger perceptions. Because the fairness markets comply with bonds in repricing the danger, Ecopetrol’s shares ought to rerate larger too.

Editor’s Be aware: This text was submitted as a part of In search of Alpha’s Prime 2023 Choose competitors, which runs by means of December 25. This competitors is open to all customers and contributors; click here to seek out out extra and submit your article in the present day!