For the most part, investing in one of the international oil and gas majors these days is about a trade-off between a fairly predictable stream of dividends and share buybacks and sluggish production growth. Well-known companies like Exxon Mobil (NYSE:XOM), Chevron (NYSE:CVX), BP (NYSE:BP), and Royal Dutch Shell (NYSE:RDS.A) will, for the most part, consider themselves lucky if they grow production much more than 3% or 4% a year over the next decade.

SEE: Oil And Gas Industry Primer

On the flip side of that equation is Petrobras (NYSE:PBR). With its privileged access to Brazil's huge offshore pre-salt deposits, Petrobras could lead the world's major energy companies with 10% annual production growth over the next decade. But while Petrobras is highly likely to deliver high levels of production growth, Petrobras doesn't enjoy the same reputation as Exxon Mobil or Chevron in per-barrel profitability or returns on capital. What's more, the ongoing interference of the Brazilian government looms over the stock. All of that said, it looks like investors are too worried about the bad things that could happen relative to the good things that probably will happen – setting these shares up as a potentially significant bargain in the space.
Big Opportunities, But At What Cost?
Depending upon the calculation process you use, Petrobras's reserves range from about 13 billion barrels to over 16 billion barrels, with much of that in the form of good-quality crude oil. Adding in probable reserves, Petrobras has access to an enormous amount of oil off the shore of Brazil.

SEE: Investing In Brazil 101
The question is how much Petrobras will actually earn from those rich deposits. Brazilian law mandates that Petrobras be the sole operator of pre-salt and other strategic reserves, with a minimum stake of 30%. At the same time, Brazilian law also mandates local content in the exploration and production process – ranging from 37% during exploration to up to two-thirds in development. 
These rules create both challenge and opportunity. While it would appear to give Petrobras a huge stake in the reserve base, it also conceivably commits the company to huge capital outlays to develop those reserves virtually irrespective of the economics. The mandate for Petrobras to be the sole operator in all cases may be revoked/repealed, but there remains the risk that Petrobras will be facing enormous capital outlays and balance sheet expansion in the coming years to comply.
Likewise, the local content rules create some challenges. While it seems that there are ways for proven international companies like Cameron (NYSE:CAM) and FMC Technologies (NYSE:FTI) to work within the rules, there is a risk that Petrobras will be forced to used less experienced and/or less cost-competitive vendors and service providers to comply with these rules.
Downstream Arguably The Bigger Risk
Although I don't believe investors should ignore the risk that Petrobras's upstream activities take quite a while to generate solid returns on investment, the downstream business looks like the bigger year-to-year threat.
Petrobras operates 12 refineries with over 2 billion barrels per day capacity, but the government interferes heavily in the pricing mechanisms for the fuel the company produces. As a result, Petrobras has little choice but to operate unprofitably at times. It also doesn't help at all that this segment generates about 40% of its revenue in U.S. dollars, but 90% of its costs are in dollars – making currency a major factor in the financial performance.
The Bottom Line
I am cautiously optimistic that Petrobras has seen the worst in terms of its reported earnings. Unfortunately, reported earnings aren't necessarily the relevant metric for investors. While energy investors certainly do value production growth, they also consider the cost of that growth, and I am concerned that Petrobras is going to face very large investments (and debt-fueled balance sheet expansion) just to get the ball rolling with these offshore developments.
Though I think the full-cycle profitability and returns will be worthwhile, Petrobras doesn't have the best reputation on the Street for its operational skill. With relatively new management in place, the company must show better execution to really unlock the value in the shares.
Assigning the right premium for Petrobras is no easy task. Most international majors trade around 4x to 5x forward EBITDA. Petrobras, though, has historically traded a little higher and on that basis I think a multiple of 6x is not unreasonable. That would suggest a fair value of about $20 today, and substantial value in the shares, but it's worth mentioning again that if Petrobras's return on investment and per-barrel profitability doesn't improve as expected, that premium multiple is likely to vanish. A 5x multiple would still suggest the stock is undervalued, but much lower than that and the stock is better avoided than bought.
Disclosure – As of this writing, the author owns shares of Cameron.

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