Ordem E Progresso

Brazil, as always, continues to fascinate and excite. This week they took several steps forwards and several steps backwards; to be honest I am still trying to count how many in each direction.

Petrobras, the State owned Oil Company held a board meeting where they raised gasoline and diesel prices 4% and 8% respectively. This is good, as far as it goes. These changes should add $3.7Bn to EBITDA and $2.3Bn to net income according to Merrill Lynch.

Unfortunately they didn’t bring the domestic prices up to international parity, so the large amounts of fuel Brazil imports is still being sold at a discount – about an other 8% for gasoline and 15% for diesel, again according to Merrill.

Apart from the direct effect this has on Company and Government revenues, it has serious knock on effects to other industries, such as the domestic ethanol industry - Brazilian cars are able to run on any mixture of ethanol or gasoline.

Ethanol for fuel is a genuine green industry in Brazil, since it uses sugar cane rather than corn. Sugar cane requires basically no fertilizer (derived from oil) to grow, and can yield multiple harvests a year. Brazil has established itself a world leader not only in the production of ethanol, but also the technology that allows vehicles to be so flexible. Having encouraged huge amounts of private capital into the industry, the Government is now pulling the rug out from underneath them by crushing profitability. As a result, Private Investors are going to demand even bigger subsidies from the state development bank (BNDES) to invest in Brazil in future – hence the heavy participation of BNDES in the recent airport auctions.

Net-net, the Government is handicapping its own financing abilities AND discouraging investments at the margin, hindering economic growth.

The board also failed to specify how and when farther adjustments would be made, only that they hoped to do it over the next 24 months. This was a great opportunity for the Government to show that they were in control of the situation, and they blew it.

Petrobras was recently downgraded, and S&P has the country on negative watch. I would argue that these failures to take decisive action make a Sovereign downgrade inevitable, possibly as soon as the next review in early 2014. Should the Government continue to run such incoherent policy, a second downgrade after the elections cannot be ruled out.

I, however, still think that a second downgrade would be unlikely and a serious over reaction. As much as the Government’s policies are incoherent, they are in no ways a return to the idiocy of the pre-Real Plan days. Losing investment grade would be a major blow to national prestige and seriously undermine the Government’s credibility. When push comes to shove, I believe that the Government will do just enough to stop things getting out of control.

They have also made it clear that they recognize the effect their policies are having on Petrobras’s Balance Sheet, and its ability to fund its huge investment program. Out have gone the platitudes that Petrobras is fine, in has come the recognition of the speed with which debt is now rising and the rapid deterioration of debt metrics; The company is talking more seriously of Net Debt/ EBITDA below 2.5X, whilst it is currently over 3.1X and set to rise farther.

Barring a Sovereign crisis, and there are absolutely no rational reasons why Brazil should have one even under the current mismanagement, we are probably approaching the point of maximum pessimism. My guess, and I emphasize guess, is that it should occur during the first half of 2014. Once the World Cup starts, things will coincidently get better slowly, as the competition proves not to be a disaster, and any back up in US 10 year yields due to Fed Tapering proves to be muted; Current 10 year yields are 2.82, up from 1.62% a year ago. That is already quite a significant de facto tightening, so it's hard to see Janet Yellen trying to push rates up much farther.

There was an other development that got much less attention, but which could be very significant in the long run, if it is followed up; Brazil actually jailed corrupt Senators!

One of the causes of this summer’s riots was frustration with the politicians who had been found guilty of bribery and corruption but were able to keep themselves out of jail through complex legal wrangling. The cynical view on the street was that it would “all end in pizza”, a Brazilian term meaning the bad guys would get away with it again. Now it seems the Supreme Court has had enough too, and has sent the most visible and important members to prison – José Dirceu and Jose Genoino – along with several others.

This may be just a one-off sop to appease the rioters, and once they get bored it will be back to business as usual, but there is a very strong movement to increase transparency in Government that appears to be having an effect. I am under no illusion that Brazil will suddenly become as corruption free as Canada, but every journey starts with a single step.

Such is Progresso!