| | | | | | Ecopetrol S.A. | Sell (US$8.8 price target) |
Luiz Carvalho, Analyst, luiz.carvalho@ubs.com, +55-11-2767 6606
| UBS Research THESIS MAP | a guide to our thinking and what's where in this report | | PIVOTAL QUESTIONS | Q: Can Ecopetrol grow production and reserves in the short term? No. Ecopetrol changed c80% of its management in 2016 to implement changes in the company's strategy. We believe its focus has changed to profitability, however, we also believe the effort from new management will only be able to partially offset declines but won't present significant production growth within the next 5 years and especially because we still see reserves life at low levels (~6y). more Q: How relevant will oil prices be to Ecopetrol going forward? Oil prices are extremely important to Ecopetrol's valuation. The company's E&P segment is 100% exposed to oil prices. At the current oil prices, E&P EBITDA represents close to 50% of the company's total EBITDA. Since the company follows international prices, every change of US$5/bbl in the long-term Brent oil estimate means an impact of ~US$0.8/share. In the past few years, the company's share price correlation with the Brent price has been ~0.97. Ecopetrol SA – Reserve increase visibility remains low | UBS VIEW | We believe Ecopetrol's focus is changing towards profitability. However, in our view, the new management's efforts to increase reserves won't be revealed in the short term and reserves levels are key to production sustainability and cash generation. | EVIDENCE | As of 2015, the company reported 1.849bnboe of net reserves; considering the company's production from 2015, that means ~7 years of its reserves life. The company's exploratory activity has dropped significantly over the past few years so 2016 and 2017 exploratory efforts will only be translated into reserves after 2020. The company reported 2016 reserve levels at 1.598mn boe, a 14% drop compared to 2015 which we believe indicates a sign of difficulty in improving reserves figures. | WHAT'S PRICED IN? | Given the lack of capex focus on E&P until 2016, we believe investors aren't pricing in any relevant increase in reserve figures in the coming years, similar to our view. | UPSIDE / DOWNSIDE
SPECTRUM
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Value drivers | Production 2020 (kbd) | LT Oil Prices ($/B) | Transp. Growth (%) | Capex 2020 plan | Ref. Utilization (%) | $12 upside | 760 | 80 | 5% | $3.1b | 80% | $8.8 target | 715 | 70 | 4% | $3.3b | 70% | $5.3 downside | 670 | 60 | 2% | $3.5b | 60% |
| COMPANY
DESCRIPTION | Created in 1951, Ecopetrol is a publicly-owned Colombian company that operates in the production, refining and transportation of oil and gas, as well in petrochemical activities. |
Ecopetrol S.A. | UBS Research |
| PIVOTAL QUESTIONS | return ↑ | Q: Can Ecopetrol grow production and reserves in the short term? UBS VIEW No. Ecopetrol changed c80% of its management in 2016 to implement changes in the company's strategy. We believe its focus has changed to profitability, however, we also believe the effort from new management will only be able to partially offset declines but won't present significant production growth within the next 5 years and especially because we still see reserves life at low levels (~6y) for the coming years. EVIDENCE Company reported its 2016 reserves at 1.598mn boe, a 14% drop compared to the 1.849mn boe figure from 2015. Lack of capex focus on E&P until 2016 should be responsible to little (or no) reserves additions until 2020. WHAT'S PRICED IN? Investors currently price in ~19x EV/Reserves multiple. While considering the metric under last year's reserve number, the company was trading at 16x. |
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Ecopetrol: Reserves remain a concern Ecopetrol announced this week its 2016 reserves figure at 1.598mn boe, a 14% drop compared to 1849mn boe in 2015. This confirms our concerns on reserves life (at only 6.8y) and consequently the company’s ability to sustain production levels. Besides the decrease from 2016 production, lower oil prices during the year significantly impacted reserves figures (202mn boe). On this front we see room for upside considering UBS' estimate for Brent prices in 2017 is US$60/bbl, however, it is too soon for paying it upfront. Figure 1: Oil price ($/bbl) | | Figure 2: Reserves changes | 
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| Source: Company reports, UBS, Bloomberg | | Source: Company data, UBS |
On reserves additions by exploratory successes, we recognize the company's efforts on E&P focus; however, results from this front won't likely help before 2020. The company guided that it would lower capex in 2017 by ~50% compared to 2015, with a greater focus on E&P. In 2014-16, only 59% of total capex was allocated to E&P, but in its 2020 plan, 90% of capex will go to this segment. Therefore, given the change in capex mix and greater focus on E&P we are adjusting our capex figures in line with company's guidance. Figure 3: Capex recent focus on E&P | 
| Source: Company reports, UBS |
Valuation changes Given Ecopetrol's track record of high capex spending, we were previously assuming capex 5% higher than company's new guidance until 2020 and 9% higher on perpetuity, but considering the aforementioned guidance change, we are now using company's guidance of ~US$3.25bn until 2020. For the long term we are using the company's estimate of US$4.25bn under US$70/bbl assumption (UBS also estimates US$70/bbl LT oil price). This adjustment in capex is responsible for adding US$1.3/sh to our price target, as it is DCF-derived and on perpetuity it has a strong impact. Figure 4: Capex estimates – Old vs New (US$bn) | 
| Source: UBS estimates |
On the production front, according to Ecopetrol's strategic plan, production growth will come from two fronts: 1) Inorganic growth from buying operating assets with reasonable 2P reserves. For these potential deals, the company will use its targeted available cash generation until 2020 of US$4.8bn (cash generation under US$50/bbl assumption). The main focus is Colombia, Brazil and Mexico. 2) Improvement in recovery factors at major fields. The company also plans to drill infill wells using ~US$6bn in capex until 2020. However, we are still below company's guidance of reaching 760kbd production in 2020 (6% above the expected 715kbd 2016 figure). Ecopetrol’s estimated growth breakdown foresees that 49kbd will come from successful exploration; this is more than the 45kbd net growth from 715kbd to 760kbd, and as mentioned above we do not expect current exploratory assets to deliver growth before 2020. At the same time, we prefer to be conservative and do not include any acquisitions in our model; rather, we consider improvement in recovery factor will only partially offset declining rates. Figure 5: Company's breakdown for reaching production target in 2020 | 
| Source: Company data, UBS |
We are raising our production growth forecast from a 1.5% decline per year to 0.8% decrease per year until 2020. From 2020 onwards we consider flat production assuming exploratory success will start delivering results. This change adds US$0.5/sh to our PT. Figure 6: Old vs new production curve | | Figure 7: Valuation sensitivity to production growth | 
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| Source: UBS estimates and company data | | Source: UBS estimates |
As a result of these improvements to our model, we are improving our PT from US$7/share to US$8.8/share. Figure 8: Old vs. new PT | | Figure 9: Old vs. new financials | 
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| Source: UBS estimates | | Source: UBS estimates |
Ecopetrol S.A. | UBS Research |
| UPSIDE / DOWNSIDE SPECTRUM | return ↑ | 
Value drivers | Production 2020 (kbd) | LT Oil Prices ($/B) | Transp. Growth (%) | Capex 2020 plan | Ref. Utilization (%) | $12 upside | 750 | 80 | 5% | $3.2b | 80% | $8.8 target | 715 | 70 | 4% | $3.3b | 70% | $5.3 downside | 670 | 60 | 2% | $3.5b | 60% |
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Upside (US$12): In our upside scenario we consider a production of 750kbd in 2020, long-term oil prices at US$80/Bbl, transportation growth of 5%, a capex of US$3.2bn in 2020 and a refinery utilization of 80%. Base (US$8.8): In our base case scenario we consider a production of 715kbd in 2020, long-term oil prices at US$70/Bbl, transportation growth of 4%, a capex of US$3.3bn in 2020 and a refinery utilization of 70%. Downside (US$5.3): In our base case scenario we consider a production of 670kbd in 2020, long-term oil prices at US$60/Bbl, transportation growth of 2%, a capex of US$3.5bn in 2020 and a refinery utilization of 60%. Ecopetrol S.A. | UBS Research |
| COMPANY DESCRIPTION | return ↑ | Market Cap | US$18.5bn | Shares Outstanding | 2.056m (ADR) | Industry and outlook | Integrated Oils | Region | Americas | Website | www.ecopetrol.com.co |
Created in 1951, Ecopetrol is a public-held Colombian company that operates on production, refining and transportation of oil and gas, as well on petrochemical activities. Industry outlook We believe Ecopetrol's focus is changing towards profitability. The company has presented relevant improvements during 2016. However, we believe new management's efforts to increase reserves won't be revealed in the short term. Therefore, we prefer to wait for its 2016 reserves report and more details and results to emerge from its 2017 exploratory campaign before revisiting our outlook. |  Source: Company data, UBS estimates |
| | | | | | | Forecast returns | Forecast price appreciation-2.3% | Forecast dividend yield2.2% | Forecast stock return-0.1% | Market return assumption7.0% | Forecast excess return-7.1% |
| Valuation Method and Risk Statement Our PT is based on DCF, with a 2017E UBS Brent price of US$60/bbl and long-term estimate of US$75/bbl.
Risks for oil companies include: 1) commodity prices and domestic refinery gate prices for gasoline/diesel; 2) exploration risks associated with the business; 3) worse-than-expected drilling results; a 4) steep increase in market risk aversion.
Required Disclosures This report has been prepared by UBS Brasil CCTVM S.A., an affiliate of UBS AG. UBS AG, its subsidiaries, branches and affiliates are referred to herein as UBS. For information on the ways in which UBS manages conflicts and maintains independence of its research product; historical performance information; and certain additional disclosures concerning UBS research recommendations, please visit www.ubs.com/disclosures. The figures contained in performance charts refer to the past; past performance is not a reliable indicator of future results. Additional information will be made available upon request. UBS Securities Co. Limited is licensed to conduct securities investment consultancy businesses by the China Securities Regulatory Commission. UBS acts or may act as principal in the debt securities (or in related derivatives) that may be the subject of this report. This recommendation was finalized on: 23 February 2017 02:23 AM GMT. Analyst Certification: Each research analyst primarily responsible for the content of this research report, in whole or in part, certifies that with respect to each security or issuer that the analyst covered in this report: (1) all of the views expressed accurately reflect his or her personal views about those securities or issuers and were prepared in an independent manner, including with respect to UBS, and (2) no part of his or her compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by that research analyst in the research report. UBS Investment Research: Global Equity Rating Definitions 12-Month Rating | Definition | Coverage | IB Services | Buy | FSR is > 6% above the MRA. | 45% | 29% | Neutral | FSR is between -6% and 6% of the MRA. | 39% | 27% | Sell | FSR is > 6% below the MRA. | 15% | 16% | Short-Term Rating | Definition | Coverage | IB Services | Buy | Stock price expected to rise within three months from the time the rating was assigned because of a specific catalyst or event. | <1% | <1% | Sell | Stock price expected to fall within three months from the time the rating was assigned because of a specific catalyst or event. | <1% | <1% |
Source: UBS. Rating allocations are as of 31 December 2016.
1:Percentage of companies under coverage globally within the 12-month rating category.
2:Percentage of companies within the 12-month rating category for which investment banking (IB) services were provided within the past 12 months.
3:Percentage of companies under coverage globally within the Short-Term rating category.
4:Percentage of companies within the Short-Term rating category for which investment banking (IB) services were provided within the past 12 months. KEY DEFINITIONS: Forecast Stock Return (FSR) is defined as expected percentage price appreciation plus gross dividend yield over the next 12 months. Market Return Assumption (MRA) is defined as the one-year local market interest rate plus 5% (a proxy for, and not a forecast of, the equity risk premium). Under Review (UR) Stocks may be flagged as UR by the analyst, indicating that the stock's price target and/or rating are subject to possible change in the near term, usually in response to an event that may affect the investment case or valuation. Short-Term Ratings reflect the expected near-term (up to three months) performance of the stock and do not reflect any change in the fundamental view or investment case. Equity Price Targets have an investment horizon of 12 months. EXCEPTIONS AND SPECIAL CASES: UK and European Investment Fund ratings and definitions are: Buy: Positive on factors such as structure, management, performance record, discount; Neutral: Neutral on factors such as structure, management, performance record, discount; Sell: Negative on factors such as structure, management, performance record, discount. Core Banding Exceptions (CBE): Exceptions to the standard +/-6% bands may be granted by the Investment Review Committee (IRC). Factors considered by the IRC include the stock's volatility and the credit spread of the respective company's debt. As a result, stocks deemed to be very high or low risk may be subject to higher or lower bands as they relate to the rating. When such exceptions apply, they will be identified in the Company Disclosures table in the relevant research piece. Research analysts contributing to this report who are employed by any non-US affiliate of UBS Securities LLC are not registered/qualified as research analysts with FINRA. Such analysts may not be associated persons of UBS Securities LLC and therefore are not subject to the FINRA restrictions on communications with a subject company, public appearances, and trading securities held by a research analyst account. The name of each affiliate and analyst employed by that affiliate contributing to this report, if any, follows. UBS Brasil CCTVM S.A.: Luiz Carvalho; Julia Ozenda. Company Disclosures Company Name | Reuters | 12-month rating | Short-term rating | Price | Price date | Ecopetrol SA | EC.N | Sell | N/A | US$9.01 | 22 Feb 2017 |
Source: UBS. All prices as of local market close.
Ratings in this table are the most current published ratings prior to this report. They may be more recent than the stock pricing date 5.UBS AG, its affiliates or subsidiaries expect to receive or intend to seek compensation for investment banking services from this company/entity within the next three months. 6a.This company/entity is, or within the past 12 months has been, a client of UBS Securities LLC, and non-investment banking securities-related services are being, or have been, provided. 6b.This company/entity is, or within the past 12 months has been, a client of UBS Securities LLC, and non-securities services are being, or have been, provided. 7.Within the past 12 months, UBS Securities LLC and/or its affiliates have received compensation for products and services other than investment banking services from this company/entity. 16.UBS Securities LLC makes a market in the securities and/or ADRs of this company. Unless otherwise indicated, please refer to the Valuation and Risk sections within the body of this report. For a complete set of disclosure statements associated with the companies discussed in this report, including information on valuation and risk, please contact UBS Securities LLC, 1285 Avenue of Americas, New York, NY 10019, USA, Attention: Investment Research. Ecopetrol SA (US$) 
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Date | Stock Price (US$) | Price Target (US$) | Rating | 2013-11-22 | 41.79 | - | No Rating | 2016-08-15 | 8.47 | 6.5 | Sell | 2016-11-28 | 8.16 | 7.0 | Sell | 2016-12-21 | 9.2 | 7.5 | Sell | 2017-01-24 | 9.52 | 7.0 | Sell |
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