Wednesday, May 30, 2007


Petrobras (PBR), the national oil company of Brazil, is the most undervalued public major oil company (outside of Russia) on the basis of proven reserves of oil and natural gas. Petrobras is unique in the oil major universe in that it not only has a low valuation on the basis of proven reserves, but also has strong prospects for increasing oil and gas reserves and production. Further, Petrobras is the first oil major to move significantly into ethanol distribution and production. These factors are discussed in more detail below.

Valuation Comparison Chart:
Ticker: Company Name
Proven Reserves
Proven Reserve to Production (R/P)(years)
Probable & Possible Reserves
Enterprise Value (US dollars)
Standardized Measure (from 10-K 2005 -- PBR has not published its 2006 10-k as of 6/07)
Standardized Measure (proved)/Enterprise Value

PBR: Petrobras (Brazil) [E&P: 90% 05 income];
11.775 BBoE (17% gas, 83% oil);
15.4 years;
$109Bn (YE 05 prices of oil and gas -- 06 values not available at 5/07)
Standardized Measure/Enterprise Value: 1.01x

PTR: PetroChina[E&P: 100% 05 income, Marketing: minimal inc Refining: loss]
19.56 BBoE (41% gas, 59% oil)
18.4 years
$175.2Bn (YE Chinese Prices)
Standardized Measure/Enterprise Value: 0.88x

China Ntnl Offshr Oil Co [E&P 100% 05 Income]
2.36 BBoE (68% oil)
5.6 years
$25.2Bn (YE Chinese Prices)
Standardized Measure/Enterprise Value: 0.73x

Sinopec (China)[E&P: 70% 05 income, Marketing 15%, Chem: Refin: 15% loss]
3.362 BBoE (14.7% gas, 85.3% oil)
10.6 years
$44.1Bn (YE Chinese Prices)
Standardized Measure/Enterprise Value: 0.54x

[65% 05 income E&P, 22% ref & marketing]
13.37 BBoE (42% gas, 58% oil and NGL’s) reserves exclude oil sands
9.0 years
$99.2Bn (YE prices of oil and gas) (55% of standardized measure in US/Can/EU)
Standardized Measure/Enterprise Value: 0.25x

(Note: the figures above are dated as the market capitalization values are from mid 2006 and the reserve valuations are from year end 2005).

Petrobras operates in three main divisions: 1) Upstream: PBR develops oil and natural gas reserves mainly off the coast of Brazil, 2) Downstream: PBR refines and markets petroleum products mainly in Brazil, and 3) Ethanol: the Company distributes and exports ethanol.

PBR Upstream Operations Analysis:

Petrobras derived approximately 90% of its net income from its upstream operations (Exploration and Production) according to its latest annual report (05). PBR produced an average of 1.77mbpd of oil -- out of a world average production of approximately 86 mpd of oil -- and expects to produce 1.919 mbpd of oil in 2007, as new projects come on line offsetting existing declines in existing oil fields.

Petrobras has good prospects for increasing oil and natural gas reserves on offshore Brazil as the company can explore more fully the Campos Basin, and then move down to the Santos Basin, to the south, of a similar geographic size to Campos (although the geology obviously differs). The Campos Basin is 100,000 square miles but has had significantly less exploration than the Gulf of Mexico, which produces a similar quantity of oil -- GoM produced approximately 1.8 mbpd of oil in 2005 while Campos produced approximately 1.7 mbpd of oil in 2005 -- and further exploration is promising. There is high interest from majors in all blocks offered in Campos for the purposes of oil and gas exploration.

Petrobras has a very large amount of territory to explore off the coast of Brazil -- as a comparison, the country is approximately the same size as the United States ex Alaska. Although Petrobras does not explicitly state that it hasn't fully explored the Amazon basin, the author has not seen anything that shows that PBR has spent a large amount of funds exploring this area. Note that most large offshore oil deposits occur in basins in a near proximity to rivers -- Campos and Santos basins notwithstanding, as these are not close to rivers (note that this last statement concerning is this author's opinion only, and the author is not a petroleum geologist).

Historically, the government of Brazil has awared Petrobras the vast majority of territory claims on offshore Brazil, and this is expected to continue in the intermediate term -- all blocks are opened by the Brazilian government to bids to cooperate with Petrobras and only one block is independently produced by a firm other than PBR -- although this could change as the Brazilian government has moved towards opening up the oil sector. Note however that most Brazilian domestic oil firms besides PBR do not currently have the capital to compete with PBR -- Petrobras estimates that in 2005 it developed more than 98% of Brazil's oil and gas reserves, according to its Annual Report filed with the SEC.

Oil Field Analysis:

Over 90% of Petrobras' reserves are located in the Campos Basin, 50 miles off the coast of Brazil, in deepwater (over 1000 meters). PBR's major fields in the Campos Basin are reported as follows:

Campos Basin:
Field Name: Estimated Size (oil barrels): 2006 Production Notes:
1a. Marilin 1.229 Billion 414,200 bpd Largest Field to date, peaked in 2002 at 586,312 barrels per day
1b. East Marlin see Marlin above 160,000 bpd 09 (0 now) Extension of the Marlin Field
1c. South Marlin see Marlin above 430,186 bpd 11 (185,740 now)
2a Barracuda 1.229 Billion 169,903 bpd Connects with Caratinga listed below
2b Caratinga connects w/ Barracuda above 141,198 bpd Both Caratinga and Barracuda have not peaked
3a. Albacorra N/A 114,878 bpd Peaked in 1998 at 199,800 bpd
3b. East Albacorra N/A 61,000 bpd Under development
4. Espadarte N/A 24,500 bpd Under development
5. Roncador N/A 84,000 bpd Under development

Petrobras' largest discovered field to date has been the Marlin field, which contains an estimated 1.7 billion barrels of remaining oil. This field has been in decline since 2002, from 586,312 bpd of production to 414,200 bpd currently. In the immediate area of Marlin are the East Marlin and South Marlin fields, which are forecasted to combine to produce a combined 590,200 barrels of oil in 2008. These two fields are forecasted to more than offset the projected declines from the main Marlin field in the near term.

Santos Basin:
Field Name: Estimated Size (oil barrels): 2006 Production Notes
1. Jubarte 600MBoe 180,000 (2011) Mainly heavy oil
2. Tupi 1.7 BBoe to 10 BBoe (initial) No Production time frame as of 6/2007

The Santos Basin has only been relatively lightly explored to date (mid 2007), although the basin lies in close proximity to Sao Paolo and therefore is a very good prospect to be developed economically. The largest potential discovery was made in October 2006 when PBR's partner UK's BP Group PLC discovered light oil in the Tupi field, initially estimated at between 1.7 to 10 BBoE, however, PBR later reported in 2.07 that it is too early to estimate the economically recoverable reserves of the Tupi discovery.

Notes on Petrobras' SEC vs SPE Reserves:

Petrobras' SPE stated oil reserves stand around 12Bn barrels of oil -- in comparison with its SEC stated reserves of slightly under 10 billion barrels. The significance of this fact is that SPE allows for the reporting of more "probable" oil reserves -- oil reserves that are commercially produceable with less than 90% certainty -- compared to SEC oil reserves guidelines, which mandate only proven (90% certainty) reserves are reported. Note that 12 billion barrels of oil are very large numbers -- in comparison, KMG -- the national oil company of Kazakhstan, reports approximately 8 billion barrels of oil in proven reserves according to the Baker Institute for Energy Studies (Kazakhstan is one of the hottest areas of the world for investment into the oil sector).

PBR Ethanol Production:

Petrobras is the world's largest distributor and exporter of ethanol fuel, exporting approximately 60% of global exports of ethanol. PBR has since 1980 purchased ethanol from Brazilian farms and distributed it for Brazil's own use and for export. Ethanol is at mid-2007 a relatively low percentage of overall net income, at less than 5% ($R189M/$R4.2Bn) of total 1Q 07 net consolidated income. Petrobras intends to expand its exports of ethanol from 850m litres in 2007 to 3.5bn litres a year by 2011 (367% total growth). Petrobras forecasts that ethanol will be Brazil's top commodity export in 2017, overtaking soya -- estimates are that ethanol will contribute $US24Bn to the Brazilian economy in 2015 (up from $US6Bn currently).

Petrobras is entering the production of ethanol by purchasing sugar fields -- integrating its distribution and marketing functions in the ethanol industry -- which may improve margins. Overall, Petrobras is forecasted to significantly improve profits going forward from ethanol fuel, although E&P will remian the largest segment for Petrobras in terms of profitability over the medium term.

Risk: Is Petrobras at Risk Due to Its Exposure to Deepwater Oil Production?

The largest risk to Petrobras is its deepwater oil and gas exposure: deepwater production is more expensive than onshore oil production, and deepwater production tends to undergo faster peak times and stronger declines. These factors are partially mitigated by Petrobras positive prospects, and overall undervaluation based on existing reserves, with faster depletion rates -- the standardized measure takes into account development costs.

Tuesday, May 22, 2007

Banking Institutions Valued By Net Tangible Assets

Banking Institions mainly derive their revenues and income from three sources: 1. net interest spread between assets and liabilities, 2. fees, and 3. Trading. Large Banking Institutions nowadays have several operating divisions accross several financial service areas but this general rule income derived from net interest spread, fees and trading generally holds. Bank of America, for example, reports its results in three divisions: 1. Consumer and Small Business Banking, 2. Corporate and Investment Banking, and 3. Wealth and Investment Management. BofA derives the largest percentage of its income from Net Interest Margin and Fees, and only in Investment Banking does the third catagory "trading" comprise a relatively large percentage of income (besides fees and net interest margin) -- trading as defined as gains on trading and holding of equities, bonds, options and other investments in its trading division.

Note further that a Bank is generally not a hedge fund so trading is presumably -- although perhaps not always -- a large percentage of income (but note that trading is a very large source of income for many if not most investment banks). Also note that the Wealth and Investment Management mainly accrues income from annual fees on assets under management, typically around 0.5% to 1.5% of total assets.

It follows from that the total amount of tangible assets on the bank's balance sheet -- generally to a banking institution, mainly investments and loans -- is a key source from which revenue and income is derived. It follows, with cavaets and exceptions (explored in detail below), that the size of a banking institution can be approximated by the value of the tangible assets on its balance sheet.

Which Banking Institution Boasts the Largest Tangible Asset Base?

From the above discussion, it is interesting to compare the largest publicly held banking institutions worldwide in terms of assets, as the size of the asset base has a large effect on profitability. A comparison of the largest publicly held banks worldwide at 5/07 shows some surprises in terms of which Banks are the largest (to a US based analyst), as shown below:

Largest Banking Institutions Listed By Tangible Assets:

Ticker; Company Name; PE (TTM/Proj); Tangible Assets; Price/Book Value; Price/Tangible Assets; Market Capitalization
DB; Deutsche Bank; 9.2/10.0; $2.20Tr; 1.60x; 3.4%; $74.9Bn;
BCS; Barclays; 10.4/9.7; $1.8Tr; 2.36x; 5.2%; $94.4Bn
ING; ING; 9.6/9.3; $1.58Tr; 1.76x; 6.2%; $96.8Bn
AZ; Allianz; 9.6/9.0; $1.46Tr; 1.34x; 6.5%; $94.5Bn
UBS; UBS; 13.5/10.7; $1.90Tr; 2.92x; 6.5%; $125Bn
CS; Credit Suisse; 9.2/10.5; $1.03Tr; 2.09x; 7.3%; $74.9Bn
ABN; ABN AMRO; 14.4/14.7; $1.18Tr; 2.65x; 7.5%; $88.7Bn
HBC; HSBC; 13.0/10.7; $1.68Tr; 1.99x; 12.8%; $215.8Bn
JPM; JP Morgan; 11.7/11.1; $1.30Tr; 1.53x; 13.8%; $179Bn
RY; Royal Bank of Canada; 15.9/na; $496Bn; 3.52x; 14.2%; $70.3Bn
C; Citigroup; 13.1/10.9; $1.84Tr; 2.24x; 14.7%; $271.1Bn
BAC; Bank of America; 10.9/9.7; $1.39Tr; 1.72x; 16.3%; $227.5Bn
WBK; Westpac (Australia); 15.5/13.6; $222.5Bn; 3.35x; 18.7%; $41.7Bn
WFC; Wells Fargo; 14.3/12.1; $482Bn; 2.63x; 25.1%; $121Bn

Notes on the above chart: in $US, at exchange rates as of 5/07, listed in ascending order of market capitalization/asset base, source: company SEC filings, and yahoo finance.

Surprising: Deutsche Bank Holds the Largest Asset Base:

Deutsche Bank at 3/07 posted assets of $2.20Trillion, significantly larger than Citigroup, which held assets of $1.84 Trillon at 12.06 -- that is, at an exchange rate of 1.35 Euro/Dollar, Deutsche Bank holds almost 20% more tangible asset than Citigroup. Deutsche Bank also holds 58% more assets than Bank of America. However, Deutsche Bank's profitability is significantly lower than Bank of America and Citigroup, and the market capitalization of Deutsche Bank is only $US74.9Bn compared to $227.5Bn for Bank of America and $271.1Bn for Citigroup. Why is the profitability of Deutsche Bank so much lower than Citigroup and Bank of America when DB posts a significantly higher asset base?

Deutsche Bank and Bank of America Operating Results Analysis:

It is clear that Bank of America and Citigroup are returning a much higher rate on their asset base than Deutsche Bank. In order to answer the conundrum of Deutsche Bank's relative low performance, a comparision by operating division is utilized here.

Bank of America 2006 Operating Performance by Division (Source: 2006 10-K)(note: Bank of America reports in three operating divisions)

I. Global Consumer and Small Business Banking: Assets: $382.4Bn; Return on Assets(06): 2.92%
2006 2005 2006 2005
Revenue: $41.7Bn $28.4Bn Net Income: $11.2Bn $7.0Bn

II. Global Corporate and Investment Banking: Assets: $689.3Bn, Return on Assets(06): 0.99%
2006 2005 2006 2005
Revenue: $22.7Bn $20.6Bn Net Income: $6.8Bn $6.4Bn

III. Global Wealth and Investment Management: Assets: $137.7Bn; Return on Assets(06): 1.74%
2006 2005 2006 2005
Revenue: $8.0Bn $7.3Bn Net Income: $2.4Bn $2.3Bn

2006 2005 2006 2005
Total Rev:$72.4Bn $56.3Bn Total Net Inc: $20.4Bn $15.7Bn

Deusche Bank 2006 Operating Performance (source: 2006 20-F, Euro/US$ exchange rate of 1.35)
(note: DB reports in two main divisions)

I. Corporate and Investment Banking Division: Assets: $1.37Bn; Return on Assets(06): 0.58%
2006 2005 2006 2005
Revenue: $25.2Bn $21.5Bn Net Income: $7.94Bn $6.42Bn

II. Private Clients and Asset Management Division: Assets: $166.9Bn; Return on Assets(06)1.56%
2006 2005 2006 2005
Revenue: $12.4Bn $11.5Bn Net Income: $2.6Bn $2.35Bn

2006 2005 2006 2005
Total Rev:$37.6Bn $33.0Bn Total Net Inc: $10.5Bn $8.77Bn

Discussion of DB and BAC 2006 Operating Performance:

The two most striking differences in operating performance between Deutsche Bank and Bank of America is 1) the low return on Assets in DB's Corporate and Investment Banking Division compared to the counterpart at BAC -- DB accrues only approximately half of BAC's return on assets, and 2) DB does not boast a strong retail banking and credit card network, but BAC does -- and BAC receives a return on assets of an incredible 2.73% on its retail and credit card banking division.

Credit Cards Have Largely Driven Bank of America's Improved 2006 Performance:

BAC's credit card division, according to the Company's 2006 10-K, returned an unbelievable 3.94% on assets in 2006. BAC's credit card division profits -- reported within BAC's Consumer and Small Business Division -- were $5.64Bn in 2006 (28% of total BAC company net income) on credit card assets of $143.2Bn. BAC credit card net income was up 442% from 2005. BAC explains that some of this growth was due to the merger with MBNA and some was due to organic growth, but does not elaborate further in its 10-K. However, it can be inferred with resonably certainty that pricing and/or organic growth was strong for BAC in 2006 as in 2005 the credit card division returned 1.57% on assets, growing to the abovementioned 3.94% in 2006.

Deutsche Bank contrasts with BAC, in that DB does not focus on credit cards, due in part to its historical lack of focus on consumer banking. DB was originally created over 80 years ago to finance trade between large German and International corporations -- and has never focused on consumer retail banking. Therefore credit cards are not a large source of income for DB and not likely to become one in the near future, as DB does not mention credit cards in its investment presentations and only mentions "credit cards" in passing reference 10 times in its 2006 annual report with the SEC.

Reasons for Low Return on Assets for Deutsche Bank's Corporate and Investment Banking Division:

DB funds its corporate banking activities mainly from both money markets and customer deposits, while Bank of America funds its corporate banking activities mainly from low interest cost deposits. As mentioned above, DB lacks the retail presence of Bank of America. This is significant as Bank of America has a significant source of low cost funding from retail banking accounts, on which they pay a low interest rate.

Bank of America maintained approximately $700Bn of deposits worldwide, representing nearly 100% of assets in its corporate and investment bank, while DB maintained $US550M of deposits worldwide, approximately 42% of assets in DB's corporate and investment bank. It remains the subject of another post if DB is generating an acceptable rate of return from its mix of deposits and money market funding, but it is clear that under similiar interest rate conditions it won' t match the returns on assets of Bank of America.

Note also, provisions for loan losses at Bank of America and DB are approximately equal and do not account for the differences in returns on assets.


As analysed in this post, the difference in how the assets are funded and in what activities makes a difference in the profitability of the firm. Still it is a useful analysis to determine how, more exactly, the banking institutions derive income. In the case of Bank of America and Deutsche Bank, the differences in profitability mainly stem from the sources of funding (deposits vs money markets) and credit cards. Deutsche Bank remains interesting as an investment due to its high amount of assets that represent earning power and its relatively low market capitalization currently (5/07). Bank of America's credit card division should be closely watched as it is a major determinant of future income.

Friday, May 18, 2007

Insurance Companies Valued By Net Tangible Assets

Insurance companies derive income mainly from two sources: 1) income derived from policy sales -- insurance policy and annuity sales -- and 2) income derived from their investment portfolios. The insurance business has been described by Warren Buffett (who knows the insurance business extremely well) in his legendary annual reports as follows (here paraphrased): an insurer collects funds from policy holders, invests those funds, and then over time pays claims to policy holders from its received funds. And, as usually over time competition drives the sum of payments for claims to equal or exceed the total amount of funds received from policy payments (ie the "Combined Ratio" tends to trend towards 100), the rate of return on the funds is a key driver of the overall earnings for an insurance company.

The Significance of a Large Investment Portfolio to Market Capitalization for Insurance Companies:

The larger the investment portfolio compared to the market capitalization of the insurer may mean that the insurer is undervalued, with caveats (caveats are discussed below). That is, an intelligent investor would like to see a large sum of tangible assets and net assets (assets-liabilities) on the balance sheet compared to the market value of the firm for a possible value investment.

Note that on the balance sheet of insurance companies, most of the tangible assets of an insurance company will be the insurer's investment portfolio, while on the liabilities side, the main liabilities will be estimated future claims by policy holders and debt. Valuation of the asset side is relatively straightforward -- as most of the investment portfolio is invested in bonds, which are written at cost or at market value. The liability side of the insurance company is the larger source of uncertainty, as the estimate of future liabilities is the assessment of the insurer's actuary and may be different depending on low probability events ("acts of God") and possible miscalculations by the actuary. But note that generally the larger the firm, the better the law of averages works for the valuation of the liabilities side. For example, more confidence can generally be placed on AIG's future expected policy claims (liabilities) vs a sub-$50M asset insurance company.

Caveats -- mentioned above -- concerning this measure of the assets to market value of the insurance firm include:
A. Whether the insurer is gaining market share, (that is, an insurance company with a declining market share may not be an attractive investment even if it has a large and profitable investment portfolio)
B. has a quality credit rating --lower rated insurers should sell at a lower multiple than higher rated insurers
C. has estimated its future policy claims appropriately, (the investor does not want to see too many "surprises" in policy claims)
D. has written appropriate policies -- is pricing risk appropriately.

Analysis of the Largest Insurance Companies Worldwide:

An analysis of the largest publicly held insurers (including life and P&C and excluding reinsurance only)-- shows that there is a large discrepancy between the largest insurers in terms of price to tangible assets, but less of a discrepancy in price to tangible book value, as shown in the following chart (companies listed from lowest to highest price/tangible assets):

Ticker; Company;P/E (Hist/Proj); Tangible Assets ($US); Price/Book Value; Market Cap/Assets; Market Capitalization
ING; ING; 9.6/9.3; $1.58Tr; 2.08x; 6.2%; $96.8Bn
AZ, Allianz; 9.6/9.0; $1.46Tr; 2.28x; 6.5%; $94.5Bn
MET; Metlife; 8.6/11.5; $527.5Bn; 1.76x; 9.6%; $50.8Bn
PRU ; Prudential; 14.9/12.7; $454.3Bn; 2.03x; 10.5%; $47.9Bn
AIG; AIG; 12.6/10.4; $869.8Bn; 2.02x; 21.5%; $187Bn
ACE; Ace Ltd; 8.2/8.6; $65.0Bn; 1.65x; 31.3%; $20.4Bn
CB ; Chubb Corp; 10.0/9.0; $50.2Bn; 1.65x; 44.0%; $22.1Bn
LFC; China Life; 10.2/22.4; $69.4Bn; 2.56x; 51.0%; $35.4Bn

Discussion of the Largest Insurance Companies' Asset Values:

A few figures are striking from the above chart. First, the total assets of the German based Allianz and the Netherlands-based ING are huge -- larger than AIG in the United States (AIG is the largest insurer in the US) by a significant margin -- Allianz holds tangible assets of $US1.46 Trillion at current Euro/Dollar exchange rates compared to AIG's $US869.8Bn in tangible assets. In other words, Allianz holds 68% more tangible assets than AIG, and ING holds a similar number of assets as Allianz.

Discussion of the Significance of the Higher Asset Values at AZ and ING vs AIG:

The first observation concerning the higher asset numbers is that AZ and ING are much more levered (hold more liabilities to equity) than AIG -- AZ is levered at 21.8x assets to equity, ING is levered at 29.0x assets to equity, while AIG is levered at a much lower 8.6x assets to equity. In other words, if AIG was levered at the same level as ING (29.0x), AIG would hold an incredible $2.9 Trillion of assets. Note also that AIG's net equity value (assets minus liabilities) is approximately $100Bn compared to $70.2Bn for Allianz; AIG on this measure can be considered a larger company.

However it would not be straightforward for AIG in the above example to add a very large sum of tangible assets. Note that these are the two ways in which insurance companies gain assets, by selling either 1. insurance policies and/or 2. annuities (it is generally not the case that an insurance company will borrow money from the bond market or banks only to invest in bonds). In order for AIG to gain the number of assets of either Allianz or ING, AIG would have to either 1) underwrite a sum total of 70% more insurance policies than AIG currently has on its books and fund these policies from debt, and/or 2) sell a very large number of annuities. It would likely be very difficult to gain an incredible $700M of new policies for any firm, at an acceptable risk/pricing profile.

It follows that, the high value of tangible assets reflects that both AZ and ING are huge firms, which dominate their respective country's insurance markets and the EU. Further, one could say that the tangible assets that both AZ and ING are most likely "quality" -- meaning assets in which the companies can derive increased earnings from investment earnings -- although the high leverage places more importance on the soundness of the company's respective underwriting policies and liability and interest rate management policies.

Do the Higher Asset Values of AZ and ING Mean that they are Undervalued?

It is argued here that both AZ and ING are somewhat undervalued, compared to the large insurance universe. The price/tangible book value of AZ and ING are equivalent to AIG at approximately 2x, but the assets are as mentioned above higher, leading to higher earnings leverage with more variability. The S&P credit rating of AZ and ING are AA- and AA respectively, compared to AIG's AAA rating -- so all insurers have very strong ratings, although it is possible AZ is in line for a credit upgrade with a few more quarters of strong profitability. The European economies are improving currently (mid-2007) with reforms instituted.

Lower Differences in Price/Tangible Book Value in the Large Insurance Universe:

The second salient feature of the above is that the differences in the price/tangible book value is less dramatic than the price/asset values. Possibly an interpretation of this is that the market will give limited credit to a higher risk profile -- more asset leverage. Further, all the large insurers listed above have many analysts following them, so the likelihood of hidden value between the firms is less.