Petroleo Brasileiro SA, Brazil's state-controlled oil company, said first-quarter profit fell 38 percent as oil prices dropped and costs rose.

Net income dropped to 4.13 billion reais ($2.05 billion), or 88 centavos, from 6.68 billion reais, or 1.52 reais, in the year-earlier quarter, Petrobras Chief Financial Officer Almir Guilherme Barbassa said today. Net sales rose 8.4 percent to 38.98 billion reais.

While Petrobras hasn't raised Brazilian gasoline and diesel prices for 20 months, aviation fuel, fuel oil and naphtha fell along with an 8.3 percent slide in world oil prices. Meanwhile, the cost of oil platforms, labor, steel pipe and other goods and services are soaring. Petrobras' operational costs climbed 58 percent to 6.68 billion reais in the quarter.

``Costs are rising and the company doesn't raise prices to cover them,'' said Luiz Otavio Broad, oil and gas analyst with Agora CTVM, Brazil's largest stock brokerage. ``Some of the cost increases are inevitable, but it's not doing enough to maintain profitability.''

Broad, who has a ``buy'' recommendation on the stock, expected net income of 5.3 billion reais and sales of 38.7 billion reais.

Expansions

Barbassa also said the board approved a 2-for-1 stock split on the company's American depositary receipts.

According to a statement sent to U.S. and Brazilian regulators, after the split, each ADR will represent two Brazilian shares of Petrobras, down from four currently.

Costs were boosted by pension costs of 1.04 billion reais, higher exploration fees and the company's new U.S. refinery.

On April 11, Brazilian president Luiz Inacio Lula da Silva, told investors they had to accept the government's plan to use the company to promote its economic development goals. Lula spoke at an event where Petrobras signed a contract with a Rio de Janeiro shipyard.

Lula won election for the first time in October 2002 on a platform promising to revive Brazil's ship-building industry. Petrobras is spending $2.5 billion to build 26 tankers and support ships in Brazil.

Cash Flow

The government has also moved to have Petrobras expand its electricity generation capacity and gas-pipeline system to reduce the chance of energy shortages. The gasoline and diesel- price freeze has helped control consumer-price inflation, and laws requiring Petrobras to use alternative fuels -- a quarter of all gasoline sold in Brazil is made up of ethanol -- have helped farmers.

``Management needs to pay more attention to costs,'' said Felipe Cunha, an oil and gas analyst with Banco Brascan SA in Rio de Janeiro. ``We are skeptical about the possibility of a substantial recovery in operational cash-flow margins in the quarter.'' Cunha has an ``outperform'' rating on Petrobras stock.

Barbassa said the company has no reason to increase prices of its main products, such as gasoline and diesel fuel, because the trend for prices doesn't justify it.

``We don't change our domestic fuel prices on every fluctuation in world prices,'' he said in an interview. ``I see no reason to raise or lower prices right now.''

Refining Margins

Earnings before interest, taxes depreciation and amortization, or Ebitda, the most common measure of the company's ability to generate cash from operations, dropped 22 percent to 11 billion reais from 14.1 billion reais a year earlier.

Broad expected Ebitda of 11.4 billion reais, or 29 percent of expected sales. Cunha expected Ebidta of 11 billion reais, or 28 percent of sales.

``Petrobras can make the company leaner,'' Broad said. ``They aren't doing this.''

Margins may remain lower than in the past as the company moves to expand abroad, Barbassa said. Commercial refining margins at its Pasadena refinery will be lower than in Brazil as the company does not have its own source of crude oil and will buy from the market, including Petrobras.

Its fuels-trading businesses will also have lower profit and cash generation margins than its Brazilian operations, he said.

Value of the Real

``Investors approve (of) our efforts to expand,'' said Paulo Roberto Costa, head of refining at Petrobras, in an interview at company headquarters. ``Margins on trading are lower but if we want to expand we have to go into these businesses.''

Oil prices averaged $58.23 a barrel in the quarter, compared with $63.48 a year earlier.

Petrobras' domestic oil and gas production rose 3 percent from a year earlier. The company produced 1.8 million barrels a day compared with 1.75 million last year. Total world output climbed 1 percent to 2.31 million barrels a day.

A decline in the value of Brazil's real against the dollar also boosted financial costs, reducing the local-currency value of dollar-denominated oil and fuels exports. Currency exchange- related losses were 736 million reais compared with a gain of 270 million reais in the year-earlder period.

Brazil's real averaged 2.11 to the dollar in the first quarter of 2007, 3.7 percent less than the 2.19 to the dollar average a year earlier.

Petrobras stock has fallen 9 percent this year, the eighth- worst performer on the Bovespa index of the 60 most-traded stocks on the Sao Paulo stock exchange. Petrobras is also the most heavily weighted stock on the index, which has gained 14 percent since Dec. 31.