Buy, Sell or Hold: Dump Petroleo Brasileiro S.A.(NYSE ADR: PBR) Before Its Stock Gets Drilled

At first glance, Petroleo Brasileiro S.A. (NYSE ADR: PBR), or Petrobras, looks like a quality investment...

But looks can be deceiving - and in the case of Petrobras, surface-level success is hiding some serious blemishes.

No doubt, Petrobras is one of the top five major energy companies in the world. And the offshore discoveries made off the coast of Brazil over the past few years have been remarkable.

However, these reserves, while large, present problems of their own. The oil they hold will be costly and difficult to extract, and legal red tape and government interference are further complicating matters.

Additionally, new sources of shale oil are proving more reliable and convenient than such precarious deepwater drilling operations

So it's time to sell Petroleo Brasileiro S.A. (NYSE ADR: PBR) (**), before the only thing getting drilled is its stock.

Into the Deep

Deepwater drilling is hard enough to begin with. Imagine what it takes to force high-pressure/high-heat fluids into chilled production equipment sitting on the ocean floor.

That's no easy task. And in Brazil's case, it's made even more challenging by a thick layer of salt sitting above the oil.

The Carioca field, for instance, is 170 miles offshore, more than 6,000 feet below the surface of the water, and trapped beneath a shelf of salt 500 miles long and 125 miles wide.

The trouble is, it's beyond both Brazil's and Petrobras' capacity to fully fund or provide the level of drilling expertise to carry out these projects. So they must rely on international experts and new, unproven technology to make these deepwater fields productive.

This is a risky strategy - not to mention an expensive one.

The first wells drilled in the exploration cost as much as $100 million each. Petrobras' development plans for 2011-2015 include $224 billion in total investments to fund 688 projects.

Legal Minefield

As if these headaches weren't enough, Petrobras was thrown another curveball in December.

That's when federal prosecutors in Brazil sued Chevron Corp. (NYSE: CVX) and Transocean Ltd. (NYSE: RIG) for $11 billion over a November oil leak that is estimated to have been 3,000 barrels.

The lawsuit also includes a demand for Transocean's drilling operations in the region to stop - permanently. This has real ramifications, since Transocean provides 10 of the 61 drilling rigs in the area. These rigs are some of the largest, deepest drilling on the planet, and they are in high demand worldwide. So they will be very difficult to replace.

Furthermore, situations like these scare away other oil majors with the capital and expertise needed to develop these fields. The fear is that Brazil is going to become another Venezuela. Big Oil hasn't forgotten how their expensive capital investments in Venezuela turned out.

And if you're an energy investor, you don't want to be exposed to challenging offshore fields where you risk losing everything if a prosecutor decides to attack your investment.

Furthermore, Brazil has a payout structure that rewards the state for higher prices. This sliding pay scale puts a cap on the returns of an oil and gas company. The risk-to-reward ratio in Brazil is higher than in most locations around the world.

It is time to reevaluate the risk of being invested in Brazil. Big Oil is watching the legal case, and will take into consideration the cost of doing business going forward.

Action to Take: Sell Petroleo Brasileiro S.A. (NYSE ADR: PBR) (**).

Petrobras is in a touchy situation. It is tasked with developing Brazil's offshore assets while its own government attempts to financially exploit the deep pockets of the investors who are needed to develop the projects.

Before the shale revolution in the United States, Brazil was the most logical place from which to expect a significant increase in production. Today, would you rather invest $100 million per well and risk a hostile national partner who takes a larger percent of the cut as prices increase, or would you prefer to invest $4 million to $6 million per well while owning the production?

It is time to sell Petrobras at market. The shale revolution is going to change the oil and gas markets significantly. Brazil's development plans are the most obvious victim of the coming changes.

The lawsuit by Brazil's Federal Prosecutor is a sign of the real business conditions in Brazil, and of things to come. There is easier oil to develop in the world.

(**) Special Note of Disclosure: Jack Barnes has no interest in Petroleo Brasileiro S.A. (NYSE: PBR).

About the Writer: Columnist Jack Barnes started his career at Franklin Templeton in 1997. He started out in the company's fund-information department - just as the Asian contagion infected the Asian tiger countries.

Barnes launched his own shop, RIA, in 2003, just as the second Gulf War was breaking out. In early 2006, after logging a one-year return of nearly 83%, Forbes named Barnes the top stock picker in its "Armchair Investors Who Beat the Pros" competition. His two audited hedge funds generated double-digit returns in 2008.

Barnes retired to the beach in the summer of 2009, and continues to write from there. He's now the author of the popular blog, "Confessions of a Macro Contrarian," and his "Buy, Sell or Hold" column appears in Money Morning on Mondays. In his BSH column last week, Barnes analyzed CARBO Ceramics Inc. (NYSE: CRR).

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