The Brazilian government hasn’t made a decision on adjusting the price Petrobras uses to sell gasoline and diesel to distributors, Mantega said today at an event in Sao Paulo. Petrobras subsidizes imported fuel as part of a government policy to control inflation, and a weaker exchange rate increases the cost of selling imported fuel in Brazil.

Many in the market say that fuel price hikes might vary between 5-10%, but the research team at Itau says that’s not enough. Here is from their latest note:

“Something has to give! This is the main argument from those trying to make a positive case for Petrobras, or justify a neutral position on the name from a risk-management standpoint. The balance sheet is becoming increasingly stretched as the currency quickly heads toward the market’s BRL 2.50/USD target, leaving the government no option other than to allow an increase in diesel and gasoline prices. Assuming no price increase, Petrobras will spend around BRL 900 million per month on imports going forward, driving the net debt/EBITDA to 4.2x by the end of 2014 and net debt/total capital to 46%.

With the help of our macro team, we outline the potential impacts of a price increase on the economy, showing that the government really is between a rock and a hard place. A 10% increase in diesel and gasoline prices represents a 27-bp spike in the IPCA this year. A reduction in PIS/COFINS to net the impact of a gasoline increase at the pump would cost approximately BRL 4 billion, reducing the primary surplus by 0.1% of GDP (from a 2.3% target), which is not insignificant given that meeting the fiscal target already seems very difficult. This does not include the indirect impact of higher diesel prices on the entire production value chain, which could add about 10 bps over a more extended period of time. Add to that the risk of street protests and truck driver strikes, or a possible backlash from the mayors of cities like São Paulo or Rio, who are calling for the reestablishment of the CIDE tax on gasoline to fund a reduction in public transportation tariffs.

The alternative would be a dramatic capex reduction or another capital increase. We find it highly unlikely that Petrobras will be exempted from the obligation of bidding the minimum 30% for Libra. Any discussion will be related to pre-salt bid rounds after 2015. Petrobras could replicate the Sete Brazil model to unload its balance sheet from the construction of the FPSOs. However, credit agencies are likely to consider this a capital lease. In the absence of a price increase, Petrobras would need a capital increase of BRL 117 billion until the end of 2014 to bring the net debt/LTM EBITDA indicator back to 2.5x, causing another massive dilution of minority shareholders only three years after the “biggest capitalization ever”.

We take a rational approach, assuming a 10% increase in both diesel and gasoline prices in 4Q13. The acceleration of the BRL depreciation has added considerable pressure and urgency to the decision. As we write this note, the discount of diesel and gasoline prices to international import parity is at 30%. For those willing to buy on the back of a price increase, however, we note that a 10% hike in diesel and gasoline prices at this point is far from enough, and should not be taken as another step toward parity. Instead, we take it as a palliative step, with some hope that the BRL will appreciate or oil prices will fall. Assuming a price increase in 4Q13, our EBITDA 14 number stands at BRL 83 billion and the earnings at BRL 35 billion, implying a net debt/EBITDA14 of 3.5x by year-end.

We take the opportunity to roll over Petrobras’ fair value to YE14, at BRL 23.6/PETR4 / USD 18.5/PBRA (from BRL 24.2/PETR4 and USD 22.0/PBRA) and reiterate our market perform recommendation. Our model incorporates Itaú BBA’s new macro scenario, the hedge accounting, a 10% increase in fuel prices and a postponement of international parity from 2015 to 2017. We see Petrobras trading at 6.8x P/E14, implying a 12% discount to our selected comps. The absence of a price increase would expand our P/E14 estimate significantly, to 8.9x, resulting in a 16% premium to the same group of companies. In the end, this is a political decision, and political decisions are hard to anticipate. There is always the hope of additional increases to follow the first one, but this would mean a likely further deterioration in the balance sheet before that. And, given the current macro conditions, committing to a price increase formula might be too risky.”

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