Equity Research YPF Macro play? Maybe not anymore... Argentina goes into default, but that could change in 12 months... As of last night, Argentina effectively went into an odd type of default which, while not as drastic as other such situations we ve seen in the past, has taken away some investor confidence on a massive reduction in Argentina s country risks in the near term. We believe Argentina s macro picture is not likely to derail on the default, and believe that, in 12 months, the country might be back to global capital markets. YPF has been seen as a key macro play. We see a demanding valuation now. Over the course of the last months, YPF s shares have rallied significantly as investors seem to have elected it as one of the strongest re-rating candidates in the event of a normalization of Argentina s credit. While we understand the flow case for the stock we ve found it hard to make a strong argument for the name on country risk alone. YPF could offer more value. But shale success or more cash flow is needed. Raising our target to recognize some shale value. Still a Neutral for us. After a full review of recent shale data and of YPF s recent track record. We are raising our target for the stock to $34/ADR from $23/ADR to better capture its higher 2013 reserves and some $6/ADR of value for its shale assets. Still, we are keeping our Neutral rating unchanged. We see no real upside to our revised target and still see more value risk in YPF s shale story than the market seems to see. Valuation: $34/ADR Our target is based on a sum of the parts valuation of YPF where we value its reserves and resources under a long term oil price of $80/b, its downstream assets assuming long term EBITDA of $10.8/b, and where we attach a valuation of $6/ADR to YPF s shale assets assuming the acreage is worth $200/sq. km. Valuation 12/2012 12/2013 12/2014E 12/2015E 12/2016E RoIC (EBIT) % 15.1 12.1 14.5 15.2 14.8 EV/EBITDA 2.5 5.0 4.0 3.3 3.2 P/E 7.2 16.5 12.0 9.4 10.0 Net dividend yield % 1.1 0.4 0.0 0.0 0.0 Latin America Oil, Gas & Petrochemicals Company Note 31 July 2014 Rating 12m Price Target Price RIC: YPF.N, BBG: YPF US Trading Data and Return Forecasts Neutral US$34.00 US$35.38 (ADR) 52-wk range US$38.91-15.89 Market cap. US$13,915m Shares o/s (m) 393.3 Free float 16% Avg. daily volume('000 Shares) 2,438 Avg. daily value (US$ m) 81.4 Forecast price appreciation -3.9% Forecast dividend yield 0.0% Forecast stock return -3.9% Stock Performance (US$) 60.0 40.0 20.0 0.0 31-Jul-11 31-Oct-11 31-Jan-12 Gustavo Gattass Brazil Banco BTG Pactual S.A. gustavo.gattass@btgpactual.com +55 21 3262 9299 Andres Cardona Colombia - BTG Pactual andres.cardona@btgpactual.com +574 356 7421 30-Apr-12 31-Jul-12 31-Oct-12 31-Jan-13 Price Target (US$) Stock Price (US$) Rel. MerVal (US$) 30-Apr-13 31-Jul-13 31-Oct-13 31-Jan-14 30-Apr-14 31-Jul-14 200 160 120 80 40 0 Financials (ARSmn) 12/2012 12/2013 12/2014E 12/2015E 12/2016E Revenues 67,174 90,113 150,395 199,946 207,175 EBITDA 16,032 21,296 37,953 48,955 53,739 Net Income 3,902 5,125 9,480 12,120 11,373 EPS (ARS) 9.92 13.03 24.10 30.82 28.92 Net DPS (ARS) 0.77 0.83 0.00 0.00 0.00 Net (debt) / cash (12,357) (21,177) (36,049) (46,354) (57,526) Source: Company reports, Bovespa, BTG Pactual S.A. estimates. / Valuations: based on the last share price of the year; (E) based on a share price of US$35.38, on 31 July 2014. ANALYST CERTIFICATION AND REQUIRED DISCLOSURES BEGIN ON PAGE 23 Banco BTG Pactual S.A. does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.
31 July 2014 page 2 It s a macro play, isn t it? It is better than before... In a sense, yes. But not really worth more, in our view. Over the course of the last months, as Argentina unwound a number of its past points of attrition with international capital markets (paying Repsol for the take-over of YPF, settling past debts with the Paris Club...) we ve seen YPF rally strongly. When talking to investors we sensed interest in the stock coming from three fronts: A belief that Argentina s actions could lead it to regain access to global capital markets and with it to comfortably stabilize its economy; A belief that Argentina s stabilization could lead to a relevant reduction in country risks and appetite for equity in the country; and A belief that since YPF had traded at higher values in the past it was a prime candidate for a significant rally should this play out. Argentina s failure to reach an agreement with the country s holdouts of its 2005 and 2010 bond renegotiation put a stop to this positive trend, but we do not believe that it will de-rail Argentina s macro picture. In 12 months we believe this may be settled. Still, in spite of our somewhat benign belief of what is to come on the macro front, we don t really share the belief that, from a valuation point of view, YPF stands to gain a lot of value from a reduction in perceived country risk. We have no doubt that YPF could still be worth a lot more than it is today. Yet, we believe that such additional value stems not from a reduction in discount rates but rather from... A potential increase in domestic crude and gas realizations that is not offset by significant additional taxation or a reduction in downstream profitability; A stronger level of success in the company s shale oil appraisal in the Vaca Muerta area over the coming years; or Exploration and appraisal success elsewhere (in other shale or tight reservoirs) that generates substantial value for the company. Argentina s unwinding of its credit challenges does not change the fact that YPF is still a company with a small reserve life (6 years) and a new shale play that, while appealing, has not shown strong enough signals of economic appeal. It has also not changed the fact that the company s strategy has significantly changed favoring more aggressive spending to try turn around production and appraise the shale even before crude and gas prices reach international parity. All in, our Neutral rating is unchanged here. There is definitely room for solid and lasting upside. But we believe the market is hoping to see it from a front that might not stand up to the test of time.
31 July 2014 page 3 In summary... Over the course of the last 10 months, YPF s stock has rallied significantly on the back of a successful farm out agreement in its shale and an excellent performance of the new management on fuel prices and production that was further supported by a string of positive news in Argentina s macro front. As we talked to investors we saw appetite for the stock as a macro play and something that could recover past highs. Chart 1: YPF s share price and some of the recent key events ($/ADR) 55.0 50.0 45.0 40.0 35.0 30.0 25.0 20.0 15.0 10.0 5.0 Re-float at $41 Expropriation CVX agreement Strat. plan Gas px agreement REP compensation Holdout ruling De-valuation + CVX presentation YPF ($/ADR) Key events Source: Bloomberg and BTG Pactual Whilst we believe that some of the rally is justified in light of all that the company s management has accomplished, we tend to believe that (i) YPF does not offer significant upside from here from just a reduction of perceived risk in the country; and that (ii) its valuation already demands much from either higher hydrocarbon prices in Argentina or higher value for its shale acreage. We believe that the sovereign credit picture is more likely to be sorted out in twelve months than not. But we also believe that in the aftermath of that event, inflation might still be a large enough concern to prevent relevant price increases to crude and gas prices that could support a real re-rating of YPF s assets. And we also believe that YPF s shale, while appealing, is not yet something investors should pay up for. In this report, we have revisited YPF s investment case in light of (i) the relevant improvements we ve seen in domestic fuel pricing; of (ii) much of what YPF has been able to accomplish with Chevron in its Vaca Muerta appraisal; and of (iii) the rally that
31 July 2014 page 4 the stock has seen in value. We are reiterating our Neutral rating believing that valuation could be seen as demanding in light of all the variables we see. Table 1: BTG Pactual s forecasts for YPF $m 2010 2011 2012 2013 2014 2015 2016 Brent ($/b) 80.2 111.5 111.7 108.8 106.9 100.0 90.0 End FX rate 4.0 4.3 4.9 6.5 9.3 9.7 10.2 Production (kboed) 533 488 484 493 567 597 615 EBITDA 3,730 3,383 3,524 3,879 4,589 5,138 5,386 Net income 1,480 1,283 858 934 1,146 1,272 1,140 EPADR ($) 3.76 3.26 2.18 2.37 2.91 3.23 2.90 Net debt 1,323 2,629 2,514 3,248 3,872 4,755 5,635 ROIC (%) 38% 28% 18% 14% 18% 20% 19% Our forecasts assume additional improvement in profitability and a stemming of falling ROIC, but some realization gains are needed for that. Strong growth this year is driven mostly by the acquisitions of Apache s assets and one of Petrobras stakes in a field. Our forecasts are unchanged from our latest update in early July. However, have revisited our sum of the parts valuation for the company and decided to explicitly consider some value for the company s shale acreage in our target price for the stock along with an increase in our downstream valuation of the business in light of management s success in dealing with currency devaluation. Table 2: BTG Pactual s Sum of the Parts Valuation of YPF Cap. '14 EV/ Value Value Capacity Unit Multiple Unit EBITDA EBITDA ($m) ($/ADR) Comment Assets E&P 1,579 mboe 6.5 $/boe 3,733 2.8x 10,294 26.2 Proven developed 799 mboe 12.9 $/boe 3,733 2.8x 10,294 26.2 Year end 2013 reserves Proven undeveloped 254 mboe 0.0 $/boe 0 n.m. 0 0.0 Year end 2013 reserves Probable (estimate) 526 mboe 0.0 $/boe 0 n.m. 0 0.0 BTG Pactual estimate Dow nstream 325 kbd 17.1 $/bd 1,112 5.0x 5,559 14.1 Multiple on 2014 EBITDA of $11.6/b Shale assets 11,778 sq. km 200.0 $k/sq. km 0 n.m. 2,356 6.0 CVX deal at $200k/km2 and carries at $700k/km2 Apache asset 135 mboe 4.3 $/boe 236 2.5x 583 1.5 At aquisition cost (-) Corporate (292) 6.0x (1,750) (4.4) (-) Net debt (3,248) (8.3) Updated the net debt (-) Aquisition cost (583) (1.5) Net asset value 13,211 33.6 Our target is thus up to $34/ADR from $23/ADR. We have based it on our revised sum of the parts model for the company which can be seen in the table above. Some may say it is a conservative valuation for the stock in light of (i) our assumption that YPF s undeveloped reserves add no value to the company; and (ii) our low valuation of $200k/sq. km for YPF s Vaca Muerta acreage. But we believe that these conservative assumptions are still reasonable in light of the most recent data that we have. While we will look at this in more detail as we go through the company s revised investment case, we would summarize our more cautious approach on the value of YPF s assets and shale monetization potential through three key points: We believe that inflationary concerns could delay a migration of crude and gas prices to international parity levels, and that when they get there YPF s existing concession contracts could allow Argentina s provinces to claw back much of the potential upside we perceived some years ago;
31 July 2014 page 5 We believe that YPF s very high cost of developing much of its undeveloped reserves has been leading to a relevant deterioration in the company s return on invested capital and that this fundamentally changes YPF s upside relative to its past highs; and We believe that while much of what YPF found in its shale appraisal efforts has been encouraging, there are also a number of small bits of data (reservoir heterogeneity, and the most recent farm outs) that make the application of optimistic multiples to its acreage a very risky proposition. As we flagged above, YPF could still offer relevant upside from here and we believe that its management is working hard to turn that into a reality. But we do not believe that the data and balance sheet of the company lend themselves to a quick conclusion that the stock might be worth a lot more than it is worth now on the back of lower country risks alone.
31 July 2014 page 6 The bull case... In a sense, we see three pillars for the bull case on YPF. Before we jump into our own investment case for the stock, we have attempted to outline each of these pillars and their supporting facts as we see them. In the next section of this report we look why we are not that keen on the stock in spite of the positive picture that the pillars paint for the stock s investment case. The historical value and what has changed case... One of the simplest, and yet most focused on, arguments that we hear from investors asking us about YPF s appeal is that the stock (i) used to trade at much higher prices than it does now, during the Repsol-YPF years; in spite of the fact that (ii) now management seems to be achieving much more than Repsol-YPF was able to in the past. The chart certainly supports the share price part of that argument... Chart 2: YPF s share price and some of the recent key events ($/ADR) 55.0 50.0 45.0 40.0 35.0 30.0 25.0 20.0 15.0 10.0 5.0 Re-float at $41 Expropriation CVX agreement Strat. plan Gas px agreement REP compensation Holdout ruling De-valuation + CVX presentation YPF ($/ADR) Key events Source: Bloomberg and BTG Pactual As can be seen in the chart, since YPF s refloating in early 2011, at a price of $41 and until noise over the company s potential expropriation started to become loud in February 2012, YPF s stock trade between $35-45, which the stock is only now reaching in spite of a fairly strong performance from the mid-teens since the fourth quarter of 2013.
31 July 2014 page 7 We believe that the achieving more view is also be supported by some facts... Fuel price improvements with consistent government support and consent In both automotive fuel prices (gasoline and diesel) and natural gas (Dec/12 agreement), this has been the case of late and we do not dispute that. Chart 3: Gasoline price (P$/liter) vs. the Argentine Peso (P$/US$) Chart 4: YPF s gas price ($/boe) and government incentives ($m) 210 35 350 190 170 150 130 110 90 70 May-11 Aug-11 Nov-11 Feb-12 May-12 Aug-12 Nov-12 Feb-13 May-13 Aug-13 Nov-13 Feb-14 May-14 30 25 20 15 10 5 0 Expropriation 300 250 200 150 100 50 0 Gasoline Arg. peso "Expropriation" Source: Argentina s Energy Secretariat and Bloomberg Gas price ($/boe) Incentive ($/boe) Incentive ($m) Source: Company reports Production growth in oil and gas, with some reserve growth YPF s new management and their focus on stronger E&P spend have been able to increase production and to bring about the first relevant increase in reserves in a while. Chart 5: YPF s production (consolidated and operated) in kboed 550 500 450 400 350 300 Chart 6: YPF s reserves (mboe) 1,200 1,053 982 953 952 954 1,000 800 426 445 422 422 364 600 400 537 531 530 590 627 200 0 2009 2010 2011 2012 2013 Consolidated Operated Oil Gas Source: Company reports and Argentina s Energy Secretariat Source: Company reports A successful farm out agreement with a major oil company that helped fund the appraisal of its shale acreage The agreement with Chevron (CVX) that was announced at the end of 2012, and which has been followed by some others.
31 July 2014 page 8 Chart 7: YPF s shale and tight gas production (kboed) 30.0 25.9 23.9 25.0 20.0 13.6 15.0 9.8 8.6 10.0 5.0 7.9 9.4 4.2 5.4 6.4 0.0 1Q13 2Q13 3Q13 4Q13 1Q14 Chart 8: Rigs in operation in the shale acreage 25 23 23 20 19 15 15 12 10 5 0 1Q13 2Q13 3Q13 4Q13 1Q14 Oil Gas Rigs Source: Company reports Source: Company reports In many ways, the lower share price in spite of improving conditions argument is a fair one. As we ll see below, we believe it fails to focus on three other points that are equally important and somewhat of an offset to the argument. But for now, let s move from this one to the two other bullish arguments that we often hear for the stock and which make up the bull case trinity, in our view. The free price case for Argentina s E&P... The structural case for YPF, which is less of a novelty, but still something that is used with some recurrence, is that YPF still under-earns on its assets by a significant amount in light of oil and gas price controls that are either imposed by Argentina s government, or a result of tenuous pressure from the government over oil and gas producing companies. Chart 9: YPF s oil price vs. Brent over time ($/b) 120 100 80 60 40 20 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Chart 10: Gas price realizations vs. Asia LNG prices ($/boe) 20.0 18.0 16.0 14.0 12.0 10.0 8.0 6.0 4.0 2.0 0.0 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 YPF crude Brent YPF gas LNG to Asia Recalculating YPF s historical results under the assumption that it might have captured Brent prices for its oil production and $7.5/mbtu for its gas production instead of the actual realized prices leads to a significant re-rating of its earnings and
31 July 2014 page 9 cash earning over the last years. In 2013, we d see some $7.0bn EBITDA and some $2.9bn in earnings relative to the $3.8bn and $0.9bn reported. Chart 11: YPF s quarterly EBITDA at international oil and gas prices ($m) 2,500 2,232 1,988 2,000 1,826 1,837 2,058 1,500 1,000 500 925 907 1,170 878 997 0 1Q13 2Q13 3Q13 4Q13 1Q14 Rep. EBITDA ($m) Int. pricing ($m) Chart 12: YPF s EBITDA and earnings at international oil prices ($m) 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 6,961 2009 2010 2011 2012 2013 Full EBITDA Rep. EBITDA Full earnings Rep. earnings 2,906 We really have little or no arguments against this case, but we believe that here too is a catch that the simulations shown above fail to capture properly and which could lead to somewhat different conclusions over just how much upside there really might be in YPF s earnings in the event that oil and fuel prices were really left in the hands of the market in Argentina. The hidden value of the shale case for YPF... Lastly, we believe that investors see in YPF the potential for much more value that is not yet recognized in the company s reserves, through the potential that Argentina s shale, and YPF s large acreage position in the play, offers. While the play is still being appraised, YPF s farm outs of some relevant positions in the play over the last years have fueled a strong belief that there is value to be captured there. YPF believes it has some 12,000 sq. km of acreage that is exposed to the Vaca Muerta shale. Partnership agreements signed to date cover only some 640 sq. km but have allowed it to fund some $790m of its own investments in the play, and to effectively get some $40m in cash for the sale of part of that acreage to another player although this only happened in one of the farm outs. As the bull argument goes, the appraisal of the play, along with improvements in drilling and completion costs associated with the natural learning process involved in breaking in a new play, could unlock significant value for the 12m sq. km acreage position and generate significant value for the company given its current $17.4bn enterprise value.
31 July 2014 page 10 Figure 1: YPF s shale acreage in Vaca Muerta and areas with farm out agreements and company reports While this is indeed a possibility, as we ll, again, see below, we believe there is not enough evidence to support this belief at present. On the contrary, we believe the data that is available suggests that using any blanket value for the valuation of the entire acreage position could lead to gross misrepresentation of its current market value. The economic appeal argument here needs more support, in our view. Table 3: YPF s shale deals (announced) to date Payment Carry Net area Parner Date Stake ($m) ($m) (sq. km) Comments Chevron (I) Dec-12 50% 40 600 198 Now on 2nd phase Bridas Dec-12 50% n.a. n.a. 92 MoU > No deal DOW Mar-13 50% 0 122 23 Convertible for now Pluspetrol Feb-14 50% 217 0 1,242 "Apache" deal Petronas Feb-14 n.a. n.a. n.a. n.a. MoU still Chevron (II) Apr-14 50% 0 70 100 Capex of $140m
31 July 2014 page 11... and why we are cautious in spite of it. In summary, our caution can traced to four points... We believe the New YPF is a more risky proposition for equity investors and not necessarily comparable in value to Repsol s YPF of the past; We believe that under free market conditions YPF costs may be higher than they are now, thus diminishing the upside to an international price case; We believe that without the shale, there is no upside for YPF s stock, and we see reasons to be cautious on the shale value still; and We believe that the macro story that investors seem to be hoping for in Argentina offers as much upside as risk here. In this section, we look at these points in more detail. The historical value and what has changed argument... While there is no disputing that YPF s stock traded at higher prices at a time where raising domestic fuel prices was a much tougher proposition for the company, we believe that other things changed in the company and which could offset some of the fuel pricing success. In particular we d flag YPF s (i) dividend yield; and its (ii) return on invested capital (ROIC). Chart 13: YPF s Payout ratio vs. peers and its dividend yield (%) 300% 18% 16% 250% 15% 200% 11% 11% 12% 150% 9% 8% 7% 8% 9% 100% 6% 50% 4% 5% 3% 0% 1% 1% 0% 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 EC PBR YPF YPF's Yield (RHS) Chart 14: YPF s ROIC vs. its peers (%) and its EBITDA in dollars ($bn) 70% 4.0 60% 3.5 50% 3.0 40% 38% 2.5 30% 28% 2.0 20% 18% 14% 1.5 10% 1.0 0% 0.5 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 EC PBR YPF YPF EBITDA ($bn RHS) After Argentina s devaluation in the early noughties, Repsol was able to keep the company with (i) a fairly stable EBITDA; (ii) one of the highest ROIC s in the peer group; and (iii) with a strong enough pay out to have a very appealing dividend yield when it was re-floated, in spite of Argentina s low and controlled fuel and crude prices. Even with the new management, EBITDA is not much higher than in the past. But those Repsol traits have given way to a new management focus: that of growing production. In spite of the fuel price increases, dividend payout is now minimal making yields irrelevant, EBITDA has not grown much in dollars, and YPF has seen a
31 July 2014 page 12 massive deterioration in its ROIC. The choice for growth could be very appealing if oil prices are freed locally or if the shale proves to be high return. But those are doubts. The argument for YPF under international prices... The case for YPF under free market prices is, mathematically, not hard to make. But we find it harder to argue for with confidence in light of three key unknowns: (i) how much more royalties might increase in the event that prices are freed; (ii) how much downstream profitability might fall if prices are freed; and (iii) if oil prices will still be as high as they are now when prices are allowed to float. Table 4: YPF s renegotiated royalty rates and additional cost disclosure in fillings Province Date Royalty Additional charge comments Neuquen 2008-09 15% "...the parties agreed to make adjustments up to 3% in the event of an extraordinary income" Mendoza 2011 15% "...the parties agreed to make additional adjustements in the event of extarordinary income" Santa Cruz 2012 15% No comments in YPF's fillings regarding additional payments Salta 2012 15% "...cos. w ill recognize an additional payment...... w hen conditions of extraordinary income are verified" Chubut 2013 15-16% No comments in YPF's fillings regarding additional payments Source: Company reports and BTG Pactual The three points may or may not be relevant. YPF s disclosure does not allow us to confidently say how much higher royalties might be if prices are freed for good. Downstream profitability is also a question as we tend to believe that YPF s high profitability in its refining unit (no longer disclosed since 2013) could be in some way related to the country s uncommon fuel and crude pricing conditions. Chart 15: Refining (downstream from 13) profitability vs. Ecopetrol ($/b) 12.0 10.0 8.0 6.0 4.0 2.0 0.0 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 (2.0) (4.0) R&M Downstream EC's R&M Chart 16: BTG Pactual s oil price forecasts vs. Brent futures ($/b) 115 108 110 106 105 102 100 95 112 112 109 90 107 100 85 90 80 80 75 2010 2011 2012 2013 2014 2015 2016 Historical BTG Pactual Futures The crude call is perhaps the hardest one to make. While our forecasts assume that crude will trend lower over the coming years, we understand that small geopolitical shifts can keep prices at higher levels, so we understand that investors are likely to have very different expectations on this front. But even so, even the most bullish investors don t expect fuel price conversion in Argentina in the coming quarters. And how does this all stack up to? In the chart below we ve shown what YPF s earnings would have looked like in 2013 if it were able to capture Brent prices in its
31 July 2014 page 13 crude and $7.5/mbtu in its gas production. Later we show how such a value might change if it faced (i) quality discounts on its crude; (ii) lower crude prices; (iii) a $4/boe drop in refining profitability and (iv) a 3% higher royalty rate. Chart 17: 2013 earning sensitivity to different free market scenarios 3,500 3,000 2,500 573 2,000 894 1,500 1,000 2,906 224 260 500 934 955 0 2013A "Parity" Quality adj. Oil to $90/b Royalties +3% Ref -$4/b Adjusted Assuming Parity with no other offsetting adjustment, we d see YPF s earnings be some three times what it made in profits in 2013 pointing to a P/E of some 4.9x, which is appealing. If we run all of our adjustments, YPF would then see only 3% higher profits and a P/E of 15.1x. There is certainly a value argument that one can make, but it is one that could crumble in the face of some known risks. Signs of caution over the shale story Yet, perhaps the most relevant concern that we have over YPF s investment case has to do with (i) its shale investments; (ii) the hope that is associated with them and (iii) the data we have on the asset to date. In our view, it is very hard to see YPF as an appealing investment if one does not consider that its Vaca Muerta shale will be a success. But what we see in the recent data brings more concern than excitement. While there is much more we could discuss based on the data we have over YPF s Vaca Muerta probes, here we summarize our point: while (i) 221 wells were drilled with falling well costs; (ii) the reservoirs were found to be more complicated than expected; and (iii) we believe that some recent deals do not yet condone an appealing value case for the asset. YPF has seen ample drilling in the shale. In the Vaca Muerta shale alone, we ve seen YPF move from having two producing wells in 2010 to having 221 producing wells at the end of June. Drilling and completion times have fallen and with them YPF has reported a reduction in vertical well costs from some $11m to some $7.5m. More drilling is happening and is planned, but there is much data to work with.
31 July 2014 page 14 Chart 18: YPF s shale wells in Vaca Muerta and elsewhere 300 269 250 200 181 150 100 70 221 34 147 50 1 8 50 0 2 22 2009 2010 2011 2012 2013 Jun-14 Chart 19: Avg. vertical well drilling time in Vaca Muerta (days) 80 75 68 70 62 60 54 24 34 50 23 48 40 23 19 30 20 44 41 39 10 31 29 0 2010 2011 2012 2013 6M14 Vaca Muerta Other shale Drilling Completion Still, the data that was gathered in the primary area of the Vaca Muerta probe, the Loma Campana concession, has led YPF to understand that reservoir conditions are very different even across fairly small areas. Shale are known for having sweet spots, but we were hoping to see more homogeneity in reservoir conditions in the Vaca Muerta shale that YPF has been working on. Figure 2: YPF s sweet spot and other areas in Loma Campana Figure 3: Average oil and gas production in different areas (boed) 400 350 300 250 200 150 100 50 0 Month 1 Month 2 Month 3 Month 4 Month 5 Month 6 Loma Campana LLL East Struc. complex Sweet Spot Source: Company reports And running the risk of going too geophysical on the average reader, we believe that YPF has also found that the shale is not only heterogeneous horizontally, i.e. over an area, but also vertically, i.e. within different layers of the reservoir. This vertical heterogeneity lends itself of very different levels of efficacy within a single well for YPF s fracking efforts in wells (as it may be hard to see in the figures below). This difference in vertical reservoir conditions could turn into an impediment or a major problem for an eventual development of the shale using the horizontal wells that are so common elsewhere. Since at present it is not possible to map the vertical conditions of the reservoir without trying to frack it, YPF cannot know if a horizontal well will work or not until it drills and fracks.
31 July 2014 page 15 Figure 4: Fracking efficacy in one of YPF s horizontal wells Figure 5: Good and bad reservoir layers for fracking Source: Company reports Source: Company reports Lastly, we would point to YPF s own shale farm outs with Chevron to support our case that one should not pay much for the shale assets just yet. Since the end of 2012, YPF has announced six agreements with energy players for shale farm outs, of which four turned into actual contracts of some sort. Of these, two have happened with Chevron, one in December 2012 and the other in April 2014. We look at the Chevron agreements in particular because we tend to believe that Chevron s exposure to the results of the shale tests could make it a more qualified investor in the play than the others. And what we see that is curious. Back in 2012, Chevron agreed to pay YPF some $200k/sq. km for access to its first shale farm in, along with commitments to carry YPF on about $3m/sq. km of investments. Table 5: YPF s shale deals with Chevron CVX payments Value $m Work. Int Carry/Prft Total ($k/km2) Comments First deal (Dec/12) 600 640 1,240 3,241 50% Loma Campana - 395km2 Capex commitment 600 600 1,200 3,038 More than 100 w ells by 1Q14 Premium 0 40 40 203 Paid in excess of YPF capex Sec. deal (Apr/14) 70 70 140 700 50% Narambuena - 200km2 Capex commitment 70 70 140 700 9 w ells in four years Premium None None None None No premium this time In April 2014, after drilling and testing more than 100 wells in the play, it committed to further investments in the Loma Campana area of some $800m with no carry for YPF s interest in the field. At that time YPF announced it had entered into another agreement with Chevron over the Narambuena area, but this time Chevron was to pay nothing for access and it would carry some $700k/sq. km of investments only. We don t dispute that YPF s shale can still prove to be a very appealing and valuable asset for the company with lower drilling costs and more technological breakthrough leading to a more appealing set of economics for the play. But we would argue that the transactions that have taken place to date lead us to see it as appealing, but not very valuable just yet.
31 July 2014 page 16 Our macro concern: Inflation and the Petrobras risk In our view, most YPF investors own the stock as a macro play on Argentina. Hoping for an eventual reintegration of the country into the global capital markets, we believe these investors see YPF as a potential beneficiary of falling risk perception and demanded equity returns. As we point out above, we believe the value case for YPF is not as sound as these investors believe it to be, yet we see another macro risk. In our minds, Argentina s difficulty of accessing international capital markets, and the country s need to shore up its hydrocarbon trade accounts, has led to a very benign relationship between YPF and the Argentinean government. YPF s success in maintaining its dollar-denominated operational cash flow through stronger domestic fuel prices is, in our view, evidence of that. Assuming that the country wide financial hardship eases, we fear that that could be something that changes, as we have seen happen in Brazil with Petrobras. There, in spite of a consistent history of government-priorities-taking-precedence-over-cashflow-generation, capital markets have been willing supporters of the company s investments on the back of expected sovereign support. Should a similar benign picture come into being for YPF, we fear that Argentina s government might resort to similar expedients as Brazil does to combat what might emerge as its lingering macroeconomic issue after it regains access to capital markets: inflation. It could be that our concerns are overdone and that capital markets never come to be as forgiving with YPF as they are with Petrobras. But it is a risk.
31 July 2014 page 17 Valuing YPF When talking to investors about YPF we often get very diverse views. Some energy focused investors seem to see potential upside in the stock stemming from (i) an eventual re-rating of crude and gas prices in Argentina; or (ii) the confirmation and eventual unlocking of significant value from its shale assets. Generally, we see greater optimism with the latter than the former amongst them, though. Other investors seem to see in YPF an appealing macro play and seem to believe that it trades at low multiples that are bound to re-rate in the event that Argentina s macro woes dissipate. We generally hear this argument from macro funds rather than energy focused investors, and we understand that equity inflows into Argentina could push valuations higher in some scenarios. But we believe that in general, YPF s stock is not undervalued given its existing cash flow generation and reserve base i.e. we don t buy the multiple expansion argument and that at present, one could argue that some value is already being attributed to the shale assets. We understand the shale offers significant value potential, but we don t think investors should pay up for it just yet. In this section of the report, we look at YPF s valuation under different valuation approaches. We also look at the drivers behind our $34/ADR target for the stock and try to put it in context with the other names in our coverage. Significant changes in the realization prices that YPF might be able to get in Argentina could change our valuation significantly, but we do not see much upside from country risk alone. How does it compare, in theory? While all companies are unique in their own ways, we often look for parallels in the investment cases or conditions of different companies to better gauge the parameters for relative valuations. Reserve life, oil price leverage, production growth and resource potential are some of the key points that we look at. And within LatAm s integrated oil group, we see YPF as more similar to Petrobras than Ecopetrol. Table 6: Comparing and contrasting LatAm s integrated oil companies YPF Petrobras Ecopetrol 1P reserve life (years) 6.0 years 15.4 years 8.1 years Unrecognized resources Vaca Muerta Pre-salt Enhanced rec.? BTG 2013-15 CAGR (%) 10.9% (w ith acq.) 9.6% 2.2% Oil price leverage Low Low High Low profitability? Underearning E&P Underearning Ref. Market prices Potential for change? Yes Yes No Payout as a driver? No No Yes On those parameters YPF s similarity to Petrobras is large... Both have struggling legacy production assets that require very high investments to curb their strong production decline; Both have relevant new plays that can become significant drivers for production growth in the future: YPF s Vaca Muerta and Petrobras pre-salt;
31 July 2014 page 18 Both are currently under-earning on their businesses YPF on E&P and Petrobras on refining with the potential for change in 2015; Both, at present, are stocks with low payouts which are not the a relevant support driver for their current valuations; and Both at present have seen recent rallies that capture rising expectations that value accretive change is becoming more likely. Ultimately, we d argue that Petrobras still offers more than YPF does at present in light of (i) the larger reserve life that it has; and (ii) the fact that its new, growth supportive, play has been further tested and has been, for now, showing good profitability. Brazil s pre-salt is some years ahead in appraising relative to YPF s Vaca Muerta shale, and showing strong economics to date. Multiple valuations YPF s financials, and in particular its adoption of the dollar as its functional currency, lead to some distortion on the company s financial results. In light of that, we have focused our valuation comparisons on cash earnings rather than earnings or EBITDA. As can be seen below, YPF is cheaper than its peers, but not far from where Petrobras trades at present. Table 7: YPF s valuation relative to its peers YPF PBR EC XOM OXY PTR CEO 2014 P/E 12.3x 8.6x 11.9x 12.7x 13.8x 12.7x 8.8x 2015 P/E 11.1x 6.7x 12.9x 13.2x 14.1x 12.2x 9.2x 2014 P/CE 3.8x 4.7x 7.3x 8.6x 6.9x 5.5x 4.2x 2015 P/CE 3.8x 3.8x 7.2x 8.5x 7.0x 5.1x 4.2x Note: YPF s cash earnings are adjusted for their FX gains and FX driven deferred taxes. Petrobras by its capitalized interests. Arguably, increased realization prices in Argentina could lead to relevant improvements in the company s earnings and cash earnings. But we do not believe that a reduction in country risk alone would be sufficient to bring about a strong rally given where Brazil s Petrobras (PBR) and China s CNOOC (CEO) are trading at present, especially considering how much smaller YPF s reserve life is. SEC s PV10 calculation Another interesting valuation comparison is to look at where the group trades relative to the standardized valuation of its proven reserves that is disclosed in each company s annual report. In our view, these provide a better valuation benchmark than EV to reserve figures as they account for (i) realization prices; (ii) cost of development of undeveloped barrels and (iii) time value of money. And here too, what we see is a curious picture for YPF that, once more, stands in the face of investor perception that a reduction in country risk alone could drive significant value upside for the stock. As this standardized valuation approach always reflects the value of reserves under a 10% discount rate for all the companies, YPF would have to be trading at a deep discount to its peers to justify the claim.
31 July 2014 page 19 Table 8: EV to Standardized Proven Reserve Valuations at 10% (PV10) ratios YPF PBR EC XOM OXY PTR CEO EV ($m) 17,411 204,277 75,077 451,685 81,481 346,111 93,988 PV10 ($m) 9,452 196,361 39,097 219,945 40,166 256,225 64,255 EV/PV10 (x) 1.84x 1.04x 1.92x 2.05x 2.03x 1.35x 1.46x YPF s low reserve valuation is, in part, a function of the prevailing crude and gas realization prices in the country, but also, in part, related to the high development cost of its reserves, further discussed below. We understand that this valuation is somewhat handicapped by low domestic crude and gas prices, but again, we see in the multiple not enough of a discount to warrant a country risk rerating argument. One could argue here that this valuation ignores the potential value, or value destruction, of one s downstream assets. To try to adjust for that, we show below an adjusted EV to PV10 valuation. Here we have considered that non E&P assets are worth 5x their 2013 EBIT. This adjusted valuation allows one to better understand why Petrobras EV/PV10 ratio is so low. But it does not put YPF in the value radar. Table 9: Adjusted EV to PV10 ratios YPF PBR EC XOM OXY PTR CEO EBITDA (2013) 3,879 26,717 14,834 74,893 14,629 57,254 21,951 E&P 3,055 40,697 14,006 68,885 12,647 47,513 22,456 All else (inc. debt) 824 (13,980) 828 6,008 1,982 9,741 (505) "All else" ($m) 4,946 (83,881) 4,970 36,048 11,892 58,445 (3,032) "Net" EV ($m) 12,465 288,158 70,106 415,637 69,589 287,666 97,020 Net EV / PV10 (x) 1.32x 1.47x 1.79x 1.89x 1.73x 1.12x 1.51x Our own sum of the parts valuation We set our target using a sum of the parts valuation that breaks up YPF s value into three key parts: (i) its E&P assets; (ii) its downstream assets; and (iii) our own valuation of the value of the company s shale acreage. To that, we add the value of YPF s newly acquired Apache assets and subtract both the cost of its overhead and its debt at acquisition costs. Table 10: BTG Pactual s Sum of the Parts Valuation of YPF Cap. '14 EV/ Value Value Capacity Unit Multiple Unit EBITDA EBITDA ($m) ($/ADR) Comment Assets E&P 1,579 mboe 6.5 $/boe 3,733 2.8x 10,294 26.2 Proven developed 799 mboe 12.9 $/boe 3,733 2.8x 10,294 26.2 Year end 2013 reserves Proven undeveloped 254 mboe 0.0 $/boe 0 n.m. 0 0.0 Year end 2013 reserves Probable (estimate) 526 mboe 0.0 $/boe 0 n.m. 0 0.0 BTG Pactual estimate Dow nstream 325 kbd 17.1 $/bd 1,112 5.0x 5,559 14.1 Multiple on 2014 EBITDA of $11.6/b Shale assets 11,778 sq. km 200.0 $k/sq. km 0 n.m. 2,356 6.0 CVX deal at $200k/km2 and carries at $700k/km2 Apache asset 135 mboe 4.3 $/boe 236 2.5x 583 1.5 At aquisition cost (-) Corporate (292) 6.0x (1,750) (4.4) (-) Net debt (3,248) (8.3) Updated the net debt (-) Aquisition cost (583) (1.5) Net asset value 13,211 33.6 Below, we have further highlight we go about their valuation.
31 July 2014 page 20 YPF s E&P assets (excluding the shale acreage) E&P reserves are, by design, finite assets that one has to continuously grow through exploration and develop before they can generate cash. They are also exposed, in Argentina, to somewhat convoluted pricing mechanics. Over the last years, YPF has been able to capture between $13 and $17/boe of EBITDA on its E&P business, which we see as translating into some $10-14/boe of cash earnings. As of the end of 2013, YPF had 799mboe of proven reserves that had already been developed and an additional 254mboe of proven reserves that have not been developed. While YPF s own 20F shows a standardized valuation of $9.4bn for those reserves, our own valuation points to some $10.3bn in value, implying some $6.5/boe of value for the barrels relative to the $5.4/boe of earnings they are generating now. As we see it, value is, at present, concentrated on YPF s developed reserves where we ve captured both a reasonable level of cash generation at present and the positive impacts that we see from an improving mix in gas sales from the company as more and more of those sales capture the benefits of Argentina s gas price incentive program. Our valuation, however, has a very uncommon trait. We find no value in YPF s undeveloped reserves given (i) the very high cost of development that the company points to in its 20F, of $29/b; and (ii) our assumption that those barrels might not be able to capture oil prices of more than $80/b because of Argentina s low oil prices and our assumption that over time, oil prices trend down even if price controls wane. Because of this odd trait, we have assigned no value to some 526mboe of 2P reserves that we believe YPF might carry in its books. Higher up front oil prices could change our valuation picture for the reserves considerably, but at present we believe they are a fair representation of the risks and rewards that Argentina s E&P space offers. If and when prices are freed, oil prices may be lower. YPF s downstream assets YPF s downstream business is composed of some 325kbd of refining capacity, a country wide chain of service stations and some chemical assets that are integrated in their refinery systems. Until the end of 2012 YPF reported each of these businesses separately, but as of 2013 it chose to consolidate their disclosure under a single downstream unit. We gauge and forecast the results of this unit based on the company s EBITDA generation per barrel of oil that goes into their refineries. Over the course of the last three years the company has been able to capture between $10 and $13/b of EBITDA and our valuation of the asset of $5.6bn assumes a 5x multiple on an EBITDA generation that considers $10.8/b of unit results. For some, our 5x multiple might seem low, but with the very high profitability of this unit, we have aimed somewhat lower than we usually do on the valuation to capture the potential for lower profitability in the event that prices in Argentina are freed in the future. Whilst it could be that downstream profitability is unchanged even if upstream profitability rises, we would not make that bet here.
31 July 2014 page 21 The value of YPF s shale assets The last part of our asset valuation for YPF represents our own try to assign value to the company s shale acreage that have not been turned into reserves as of yet. With some 11.8 thousand net square kilometers of acreage that it has not yet farmed out to any partner, we have little doubt that there is some value that the company might be able to capture if it wanted to divest of this asset. The challenging question is just how much that value might be. As we flagged above, we believe that (i) YPF s shale investments to date have confirmed it to be an interesting play to continue to appraise; but (ii) not yet one where there is a clear and appealing economic equation. We believe that this equation might yet be found and in that hope lays our valuation of the acreage now. But to reflect the doubt, we have assigned a value of $200k/sq. km to the net acreage in the belief that Chevron s bid for the asset back in 2012 might be a good reflection of what its potential value might be today. As we flagged above, Chevron s second farm in with YPF included no payment at all for the acreage and a carry value that implied only $700k/sq. km. Table 11: YPF s shale deals with Chevron CVX payments Value $m Work. Int Carry/Prft Total ($k/km2) Comments First deal (Dec/12) 600 640 1,240 3,241 50% Loma Campana - 395km2 Capex commitment 600 600 1,200 3,038 More than 100 w ells by 1Q14 Premium 0 40 40 203 Paid in excess of YPF capex Sec. deal (Apr/14) 70 70 140 700 50% Narambuena - 200km2 Capex commitment 70 70 140 700 9 w ells in four years Premium None None None None No premium this time The remaining assets and liabilities For the remaining assets, we have simply assumed (i) Apache s assets are worth what YPF paid for them net of the re-sale value it got by transferring part of the assets to Pluspetrol; and (ii) YPF s own year-end 2013 net debt position. We have lowered our valuation by some $4.4/ADR to account for YPF s corporate overhead costs, at a multiple of 6x.
YPF 31 July 2014 page 22 YPF Income Statement (ARSmn) 12/2009 12/2010 12/2011 12/2012 12/2013 12/2014E 12/2015E 12/2016E Revenue 34,320 44,162 56,697 67,174 90,113 150,395 199,946 207,175 Operating expenses (ex depn) (22,330) (29,569) (42,730) (51,142) (68,817) (112,442) (150,991) (153,436) EBITDA (BTG Pactual) 11,990 14,593 13,967 16,032 21,296 37,953 48,955 53,739 Depreciation (4,832) (5,273) (5,466) (8,129) (11,237) (18,813) (23,062) (24,813) Operating income (EBIT, BTG Pactual) 7,158 9,320 8,501 7,903 10,059 19,139 25,893 28,926 Other income & associates 0 0 0 0 1,101 3,000 858 0 Net Interest (1,264) (300) (255) 662 3,188 5,540 (4,985) (7,525) Abnormal items (pre-tax) 0 0 0 0 0 0 0 0 Profit before tax 5,894 9,020 8,246 8,565 14,348 27,679 21,766 21,401 Tax (2,408) (3,230) (2,950) (4,663) (9,269) (18,150) (9,325) (9,579) Profit after tax 3,486 5,790 5,296 3,902 5,079 9,530 12,440 11,821 Abnormal items (post-tax) 0 0 0 0 0 0 0 0 Minorities / pref dividends 0 0 0 0 46 (50) (320) (448) Net Income (local GAAP) 3,486 5,790 5,296 3,902 5,125 9,480 12,120 11,373 Adjusted Net Income 3,486 5,790 5,296 3,902 5,125 9,480 12,120 11,373 Tax rate (%) 41 36 36 54 65 66 43 45 Per Share 12/2009 12/2010 12/2011 12/2012 12/2013 12/2014E 12/2015E 12/2016E EPS (local GAAP) 8.86 14.72 13.47 9.92 13.03 24.10 30.82 28.92 EPS (BTG Pactual) 8.86 14.72 13.47 9.92 13.03 24.10 30.82 28.92 Net DPS 12.45 11.30 14.15 0.77 0.83 0.00 0.00 0.00 BVPS 48.01 48.41 47.63 79.48 122.65 175.13 205.94 234.86 Cash Flow (ARSmn) 12/2009 12/2010 12/2011 12/2012 12/2013 12/2014E 12/2015E 12/2016E Net Income 3,486 5,790 5,296 3,902 5,125 9,480 12,120 11,373 Depreciation 4,832 5,273 5,466 8,129 11,237 18,813 23,062 24,813 Net change in working capital 0 0 0 0 0 0 0 0 Other (operating) 0 0 0 0 0 0 0 0 Net cash from operations 8,318 11,063 10,762 12,031 16,362 28,293 35,182 36,186 Cash from investing activities (5,603) (8,624) (12,278) (16,403) (22,344) (45,007) (47,842) (50,087) Cash from financing activities (4,897) (4,444) (5,565) (303) (326) 0 0 0 Bal sheet chge in cash & equivalents 929 382 (1,066) 3,286 5,966 (2,092) 9,695 8,828 Balance Sheet (ARSmn) 12/2009 12/2010 12/2011 12/2012 12/2013 12/2014E 12/2015E 12/2016E Cash and equivalents 2,145 2,527 1,461 4,747 10,713 8,621 18,316 27,144 Other current assets 5,897 7,187 9,547 10,966 17,295 29,698 31,772 32,831 Total current assets 8,042 9,714 11,008 15,713 28,008 38,319 50,089 59,975 Net tangible fixed assets 27,993 31,567 39,650 56,971 93,496 138,448 163,228 188,502 Net intangible fixed assets 4,248 5,308 4,741 7,265 14,091 21,109 21,109 21,109 Investments / other assets 0 0 0 0 0 0 0 0 Total assets 40,283 46,589 55,399 79,949 135,595 197,876 234,426 269,586 Trade payables & other ST liabilities 5,857 7,639 11,915 12,856 20,312 30,722 32,868 33,963 Short term debt 4,679 6,176 8,113 5,004 8,814 0 0 0 Total current liabilities 10,536 13,815 20,028 17,860 29,126 30,722 32,868 33,963 Long term debt 2,140 1,613 4,654 12,100 23,076 44,670 64,670 84,670 Other long term liabilities 8,726 12,121 11,982 18,729 35,153 53,606 55,889 58,581 Total liabilities 21,402 27,549 36,664 48,689 87,355 128,997 153,427 177,214 Equity & minority interests 18,881 19,040 18,735 31,260 48,240 68,879 80,999 92,372 Total liabilities & equities 40,283 46,589 55,399 79,949 135,595 197,876 234,426 269,586 Company Profile: YPF Sociedad Anonima (YPF) is a limited liability company. In 1999 Repsol acquired approximately 99% of YPF, but selling down to 54% of the company in the early part of this decade, it saw 51% of the company's shares expropriated by Argentina's government in 2012 with no compensation payment up front. This year Argentina paid Repsold for its "acquisition" with long term bonds. YPF is the leading integrated oil and gas player in Argentina and it operates in the exploration, development, production, refining, processing, trading, and transportation of crude oil, oil products, natural gas, and other fluid hydrocarbons. Financial ratios 12/2012 12/2013 12/2014E 12/2015E 12/2016E EBITDA margin 23.9% 23.6% 25.2% 24.5% 25.9% Operating margin 11.8% 11.2% 12.7% 12.9% 14.0% Net margin 5.8% 5.7% 6.3% 6.1% 5.5% RoE 15.6% 12.9% 16.2% 16.2% 13.1% RoIC 15.1% 12.1% 14.5% 15.2% 14.8% EBITDA / net interest -24.2x -6.7x -6.9x 9.8x 7.1x Net debt / EBITDA 0.8x 1.0x 0.9x 0.9x 1.1x Total debt / EBITDA 1.1x 1.5x 1.2x 1.3x 1.6x Net debt / (net debt + equity) 28.3% 30.5% 34.4% 36.4% 38.4% Source: Company reports and BTG Pactual estimates. Valuations: based on the last share price of that year(e) based on share price as of 31 July 2014