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The Wall Street Journal: Why Some Think Repsol Stock May Be Too Rich

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By KEITH JOHNSON
November 6, 2006; Page C1

MADRID — Spanish-Argentine oil company Repsol YPF SA is an outlier among European oil companies.

Its international expansion has been a series of misadventures in Argentina, Bolivia and Venezuela. The recent slump in oil prices and the steady rise in costs are pinching its already weak profitability. On top of all that, it is having more trouble than its rivals replacing what it produces with fresh reserves of oil and natural gas.

So why has Repsol’s stock risen 16% in the past eight weeks?

The short answer: Everyone thinks it is up for sale. Repsol has been assailed by talk of a possible takeover bid by a big oil multinational or a European rival flush with cash after years of high crude prices. The thinking is that Repsol, despite its small size, is appealing because of its still-impressive refining operations.

In the past few months, companies such as BP PLC, Royal Dutch Shell PLC and Italy’s ENI SpA all have had to issue public denials that they were looking at Repsol, after a surge of market speculation.

Despite the rampant speculation, investors might want to be wary. Repsol faces a triple-witching hour that threatens to push its shares back to earth. Its shares trade at about 10.3 times estimated 2007 earnings, making its stock more expensive than its peer group at a 10.1 average ratio. Shares of huge oil majors such as Total SA and Exxon Mobil Corp. trade at an average multiple of 9.9.

Many analysts, at Citigroup and Merrill Lynch, for instance, have become bearish on the stock. Citigroup rates the stock a “hold” and has a target price of €21 ($26.71). Merrill Lynch has a “neutral” rating.

Repsol stock closed at €26.65, up 47 European cents in Madrid trading Friday. Repsol American depositary receipts closed at $33.87, up 31 cents.

Repsol got a vote of confidence from a big Spanish construction firm, but that isn’t good news for other investors thinking of piling in. Last month, Spanish builder Sacyr Vallehermoso SA spent about €1.8 billion to acquire a 6% stake in Repsol, and it controls an additional 4% through derivatives. Late last month, Sacyr said it wants to acquire at least 20% of Repsol to form a core of Spanish shareholders.

Repsol Chairman and Chief Executive Antoni Brufau welcomed Sacyr’s move, saying that a stronger group of core shareholders could protect the company from a hostile bid. La Caixa, a savings bank, holds a 14% stake, so core shareholders could control as much as 43.9% of the company if Sacyr is allowed to invest up to the revised legal limit of 29.9% without being obliged to launch a full bid.

As the possibility of a takeover of Repsol recedes, so does the upside potential of its stock. Recent bearish reports by Société Général and Cheuvreux said the chance of a takeover bid diminished after Sacyr’s arrival.

Some investors in Spain believe Repsol, with its flanks covered against a hostile bid, might be drawn into the restructuring of the Spanish energy sector. Prime Minister José Luis Rodríguez Zapatero is eager to create a Spanish national champion in energy. For more than a year, the Spanish government has battled to keep German power giant E.On AG from snapping up Endesa SA, Spain’s biggest utility. This weekend, the Spanish government finally removed most of the conditions it imposed on E.On’s bid, partially clearing the way for the German takeover, after the European Union threatened to take Spain to court.

Repsol is small by global standards in an industry where scale is important. Repsol needs to boost investment in research and exploration — the group isn’t replacing the reserves of oil and gas that it extracts — but it needs a partner or a merger to help shoulder the costs. Because oil companies around the world are fighting for a limited number of new oil and gas fields, costs to survey, explore and develop new finds are still high despite a recent fall in oil prices. Repsol hasn’t ruled out a deal with a midsize company that could give it more muscle.

Merrill Lynch in a recent report highlighted “substantial risk” for investors as Repsol mulls a merger or acquisition in a “competitive” mergers-and-acquisitions market “where both price and risk are high.”

Repsol acknowledges that talk of a possible takeover helped boost its share price, but insists investors are now looking at fundamental strengths. “The market had been seriously undervaluing Repsol’s assets,” says Miguel Martinez, head of planning and investor relations for Repsol.

Still, many analysts consider Repsol’s underlying business to be fraught with problems. The company faces operational challenges ranging from dwindling reserves to increased competition for its oil-refinery arm. Most of Repsol’s oil and gas reserves are in Brazil, Argentina and Bolivia. The latter two countries have created political headaches that threaten Repsol’s investments in the region.

At the end of October, Repsol renegotiated its gas contracts with Bolivia so that South America’s poorest country takes a bigger chunk of earnings from Repsol and other foreign companies. In May, Bolivian President Evo Morales sent in the army to nationalize the country’s gas fields, and obliged companies such as Repsol to agree to new contracts under which the tax rate will rise from 18% to between 50% and 82%, depending on the size and age of the fields. Repsol says the terms will provide a stable investment climate, and other multinationals, such as Total, BG Group PLC and Petroleo Brasileiro SA, reached similar deals to keep operating there.

Repsol is trying to boost exploration and production in other areas, especially the Gulf of Mexico and North Africa. But the cost of exploration and production, exacerbated by a shortage of engineering specialists, makes it hard for all oil companies, including Repsol, to find new sources of oil and gas at reasonable prices.

“Everybody is in the same boat, but some of us are closer to the water than others,” says Mr. Martinez of Repsol.

Even its crown jewel, its refining arm, has lost some of its luster this year, part of the refining sector’s cyclical nature. Repsol is different than many other oil companies because it relies more on refining oil and selling it to motorists than on finding crude. Last year, Repsol announced a $3 billion plan to upgrade refinery capacity at a time when thirst for refined products like gasoline and diesel had made the business suddenly profitable.

The profit Repsol made by refining each barrel of oil reached $10 last year, much higher than the historical average. This year, due to a combination of falling crude prices and a gradual recovery in global refining capacity, Repsol’s profitability from refining slipped to $7 a barrel. That is a bigger hit to the company’s profitability, in relative terms, than the recent fall in oil prices.

Write to Keith Johnson at [email protected]

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