FT BeyondBrics: Repsol close to bond deal – and then?

FT BeyondBrics, January 24 2014

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As Argentina’s economy enters crisis mode with the peso crumbling, nobody is watching more closely than the management of Repsol and its shareholders.

On January 29 the Repsol board will meet, as it does on the last Wednesday of every month. On the agenda will be the finer details of a proposal by the Argentinian government to compensate Repsol for having nationalised its controlling stake in Argentina’s biggest oil firm, YPF, in May 2012.

It has taken the best part of two years and a great deal of acrimony to get this far, with Repsol at first suing Argentina for $10.5bn, Argentina accusing Repsol of environmental transgressions, and various odd proposals for resolution being made and rejected, sometimes with Mexico appearing as a middleman. But Repsol is now considering an offer understood to be $5bn of 10-year bonds, carrying a coupon between 8.25 per cent and 8.75 per cent, as full and final compensation for the loss of its holding in YPF.

Repsol’s official position was last made public in a comment by its chairman Antonio Brufau before Christmas, saying he expected significant progress in the first few weeks of this year. Clearly, recent events may change the thinking – but beyondbrics understands that negotiations are well advanced, potentially within a couple of weeks of resolution, though it is possible Repsol may then choose to put proposals to shareholders before formally accepting them.

Some of these points are technical, such as a grace period before which the bond will begin paying interest; while a five-year grace period has been reported, Repsol is thought to be arguing for two years. There is also the question of guarantees: ensuring that payment is in the right currency (that is, dollars and not pesos), agreeing on the coupon, and – an increasingly pressing issue – establishing what recourse there would be in the event of an Argentinian default.

Others are legal, such as ensuring that none of the various law suits that have been suggested in either direction can raise their head again once the bonds are transferred to Repsol.

But once the bonds are in Repsol’s hands, and if there is no lock-up period involved as part of the deal, the question will turn to a simple one: what to do with them.

An initial temptation would be to sell, instantly. Investors have been fleeing both Argentina’s bonds and its currency, causing both to decline in value through January as doubts have risen about the country’s ability to pay future debts. Argentina’s history, with its 2001 debt default, do not help investor sentiment when the country wobbles, and investors are becoming concerned about the approximately $149bn of outstanding bonds issued by the federal government. There was a single day, January 10, when the price of Argentina benchmark bonds maturing in 2017 slipped 4.6 per cent to 87 cents on the dollar, and although asset prices appear to have stabilised since, there is still a clear risk of volatility. Foreign currency reserves have fallen below $30bn, an eight-year low following a 30 per cent decline last year, and analysts expect the figure to fall further; since Argentina has around $8bn of bond payments and interest due in 2015 alone, those numbers are beginning to look precarious.

Rating agencies have been concerned for some time. Standard & Poor’s downgraded Argentina to CCC+ in September on the back of increasing legal risks, and in particular a US lawsuit over debt the Argentine government maintains in default, which S&P said “could result in the interruption of payments on bonds currently under New York jurisdiction”. That’s one of a host of lawsuits Argentina faces – there are about 50 involving the country before the International Court for the Settlement of Investment Disputes, more than involve any other country – and it’s also not the whole problem. “In addition to the importance of the lawsuit to Argentina’s creditworthiness,” S&P said last month, “[the] rating remains limited by a track record of unsustainable macroeconomic policies that have led to an economic environment marked by high inflation and a de facto dual exchange rate system. A decreasing level of international reserves, limited access to funding, and growing macroeconomic imbalances will continue to increase the risks of drastic policy corrections if these distortions are not addressed on time.”

That said, there is another side to the argument. Argentina has not missed a payment since its debt restructure in 2005; Argentine debt was one of the best performers in the world last year, delivering a 19 per cent return; and the stock market has been performing well. “You never say never, but at the moment I don’t see what the trigger is for a default,” says David Rees, emerging market analyst at Capital Economics, speaking before the peso’s huge fall on January 23. “The big risk at the moment is that court cases start flaring up again, but they appear to have been kicked into the longer grass for the moment.” Rees notes that the government has started talking about negotiating a repayment schedule settlement with the Paris Club, a group of creditor nations, to whom it owes more than $9.5bn. Success there would move towards so-called “external financial normalisation” – that is, being able to borrow in the international debt markets like other countries, something it has not been able to do since 2002.

Rees also argues that President Cristina Fernandez “appears to be one the way out,” and that consequently, “the outlook is probably improving a little bit for Argentina, particularly if we get a government coming in who are a little bit more market friendly.”

Repsol’s decision on what to do when it gets the bonds will have other elements to it too. Although lock-ups on the debt are not understood to be central to discussions, it is possible Argentina would offer incentives to Repsol not to sell immediately, perhaps fearing the impact of such a large amount of its paper appearing on the markets. Then there is the question of what Repsol would get for its paper: selling $5bn of debt exposed to a troubled Latin American economy is easier said than done, and some think that it might only clear the market at as little as 75 cents on the dollar compared to the bonds’ notional value.

Keeping hold of the debt would be problematic too, and would at the very least need considerable hedging and other risk management work. “It is the riskiest financial position I’ve ever seen an industrial company take on,” says one observer. “We’ve seen companies take on comparable industry or asset risk, but not financial risk like this.” Another observer, a banker, remarks: “We would never take $5bn naked financial risk to Argentina as a bank. Certainly no company should do it.”

Also in the mix is Repsol’s debt and liquidity position. Had the YPF nationalisation happened a few years ago, it would probably have killed the company, but Repsol has diversified well in recent years and dramatically improved its financial position by the sale of its LNG business to Shell which, alongside a stake in another smaller business to BP, brought in $4.3bn, as well as shedding other commitments and non-consolidated debt. On January 2, the date the Shell deal was completed, Repsol said its net debt had been reduced by $3.3bn. Bond issues in 2013 improved the liquidity of the company too.

The bonds from Argentina would appear to boost that further and create ammunition for acquisition so the company can diversify once again – outside Argentina, one assumes – but it has to be remembered that the $5bn of instruments Repsol will receive is still less than the $7bn YPF is valued at in Repsol’s books, and the accounting treatment around this will have an impact on decisions around redemptions and spending too.

For example, when Santander analyst Jason Kenney crunched the numbers in December, modelling a $5bn bond with an 8.75 per cent coupon starting annually from the fourth quarter of 2015, he concluded there would be a write-down in 2015 reported earnings, assuming a €1.7bn item in the first quarter with associated tax effects, all because of the difference between the bond value and Repsol’s stated net book value for its YPF stake.

In short, nothing is straightforward, and nothing is finalised either. But one thing is certain: Repsol will want this completed so it can move on to other things. Resolving it is something all parties will gain from.