At the surface, the oil industry might appear impervious to the cleansing efforts of responsible investors. But if we drill deeper, it is clear that integrating environmental, social and governance (ESG) analysis into investments – and engaging with companies – can deliver both a better financial return and a public good. In the latest Spectrum Audra Stundziaite, Senior Credit Analyst, and Jaime Gornsztejn, Associate Director, Hermes EOS, at Hermes Investment Management, discuss how ESG analysis and engagement with Petrobras and Pemex, the Brazilian and Mexican state-owned oil giants, enabled them to pinpoint risks and subsequently work constructively with the companies to help improve their financial performance.
Oil poses more than a few headaches for ESG investors. Besides the obvious high carbon content of petroleum products, the industry as a whole has accrued a reputation as risky across a range of ESG measures. For credit investors, however, oil companies are a significant presence, as they are the largest debt issuers in the global high-yield market, accounting for approximately 16% of notional debt. With so much at stake, it would be short-sighted to abandon the oil field to disengaged industry participants. Credit investors, like shareholders, need to discuss ESG concerns with oil firms if the industry is to improve. In turn, companies like Petrobras and Pemex, the Brazilian and Mexican state-owned oil majors, are heavily reliant on credit markets for financing and should be compelled to engage with bondholders.
Aware of the importance of ESG risk – to credit valuations returns and society – we assess them as part of our fundamental analysis of issuers . Both Petrobras and Pemex have attracted our attention for several reasons. Petrobras and Pemex – ranked 10th and 8th respectively in terms of global oil production – benefit from substantial scale, low costs of production and implicit government support.
In addition, the two oil giants have boosted their performance and reputations by embarking on material strategic refurbishments. Following sustained engagements with investors, including Hermes, Petrobras and Pemex have made rapid improvements in their financial, operational, corporate governance, environmental and sustainability measures.
Petrobras: Cleaning up after the car wash
Petrobras ranks as Brazil’s number one corporate entity and among the largest integrated oil firms globally.
The company began ramping up production from 2008 after making major oil discoveries in offshore pre-salt fields. To exploit its discoveries, Petrobras more than quadrupled its borrowing levels over the next five years to a peak of about $140bn in 2014, compared to just $30bn previously. In the process, the company increased its leverage ratio from one-times to five-times. While Petrobras has eased off the debt-pedal somewhat since 2014, its current borrowings of roughly $114bn mark it out as the largest constituent of the Global High Yield Index.
With leverage rising faster than production, mounting interest costs put extreme pressure on Petrobras’ cash flows by 2015, ahead of the $12bn in principal payments it was due to pay in 2016. Unfortunately, the Petrobras debt squeeze coincided with slumping oil prices and, to the further dismay of investors, a major corruption scandal flowing into the public domain.
As far back as 2012, Hermes’ stewardship and engagement team EOS has pressed for board changes at Petrobras that would see the independent directors take up the two seats reserved for minority shareholders that were not closely linked to the government. Historically, the Brazilian government had stacked the Petrobras board by appointing nine of the 11 seats and allowing minority shareholders – including state-controlled pension funds – to vote for the remaining two.
However, in 2013, after a period of intense negotiations, Hermes EOS and a group of international investors were successful in seeing their two independent director nominees elected to the Petrobras board. By the 2015 AGM, at the height of the Car Wash scandal, the Brazilian government itself put forward independent board directors in lieu of the traditional state appointees.
In addition, Petrobras’s new corporate strategy, which was revealed in September 2016, emphasises debt reduction and focuses on targets that include:
- Reducing leverage to 2.5-times by the end of 2018;
- Selling $21bn of assets by the end of 2018;
- Pursuing partnerships and joint ventures, which are projected to reduce capex burdens by 25% by 2021;
- Increasing cash flows by improving efficiency and reducing headcount; and
- Reducing accident rates.
Petrobras still has some work to do but these initiatives have already struck paydirt, as demonstrated by the following achievements:
- Leverage has declined from 5-times in the second quarter of 2016 to 3.15-times a year later;
- Free cash flow has been generated for the last five consecutive quarters; and,
- Moody’s upgrading Petrobras debt from B3 up to B1 with positive outlook.
Strategic turnaround combined with substantially strengthened corporate governance resulted in Petrobras spreads rallying despite the overall weakness in the energy sector (see figure 1).
Figure 1. Petrobras has outpaced the energy and broad high-yield markets this year
Source: Barclays Live as at 11 August 2017
Pemex: Seeking sustainability
North of the Brazil border, Mexico’s Pemex – or Petróleos Mexicanos – has experienced some of the same problems as Petrobras, namely: high debt levels and government interference in its commercial operations. Unlike Petrobras, it is wholly owned by the government.
Unfortunately for investors, ESG concerns entered the frame. They included: Pemex’s significantly below-par record on workers’ safety, and a poor environmental management history that featured numerous oil spills and leaks. To discuss these matters, we asked Hermes EOS to initiate conversations with Pemex. To its credit, the company was keen to take up the dialogue.
In particular, our discussions with the company’s sustainability team in May 2017 went some way to reassuring us about its commitment to better ESG practices. From this engagement, it was clear that Pemex was aware that it needed strong ESG performance to attract discerning investors in global debt markets. With the Mexican energy sector undergoing deregulation, Pemex can focus more on expansion and less on supporting the federal budget. Best-practice management of its operations will enable it to become more competitive.
The company has made some progress in lifting workforce health record to industry standard, citing a recent workplace safety campaign that mandated ‘zero tolerance’ for risky behaviour. Moreover, labour safety and carbon-emission-reduction targets have been published in its five-year business plan ending in 2021.
These actions to date augur well for Pemex, but we will continue to monitor the company against its stated ESG targets. We would certainly consider moving to an above-benchmark position in Pemex debt if it reduces ESG risks as planned – assuming, of course, the group’s credit profile remains stable and valuation sensible.
Oil continues to be a vital resource for global society: despite the growing popularity of electric cars and the long-term threat of fossil-fuel deposits becoming stranded assets, demand for the resource is likely to increase in the coming decades. For credit investors, knowledge of oil companies is essential, as they are the largest debt issuers in the high-yield market.
However, understanding their credit attributes is not enough. As demonstrated by the case studies above, the performance of both Petrobras and Pemex are driven by improving ESG dynamics, strongly supported by engagement, as well as traditional credit risks. By drilling deep into these companies, we identified non-financial aspects which could be improved to benefit the bottom line and therefore investment performance. ESG integration and engagement helped fuel the change.