How change is challenging the Brazilian energy sector

How change is challenging the Brazilian energy sector

Naki Mendoza
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After years of crisis, the Oil & Gas sector appears to be the driving force behind Brazil's economy in the aftermath of the election of Jair Bolsonaro as President. In an election that has seen a categorical rejection of the Establishment, the energy industry very much wishes to maintain its status quo

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The populist wave has now officially swept over Brazil. Second round voting on October 28 confirmed what had been apparent for the prior three weeks, but really the past few months – Jair Bolsonaro will be the next president of Brazil. He is radical, controversial, and fiercely nationalist. His traits have earned him the nickname the “Tropical Trump.” He embraces authoritarian tendencies. A former army captain, Bolsonaro praises the strength and order of Brazil’s former military dictatorship. He has run afoul with defenders of civil rights for his incendiary views on women, ethnic minorities, and the gay community. Bolsonaro’s victory shifts Latin America’s largest country hard to the right, upending four consecutive presidential wins by Brazil’s leftist Workers Party. Like the U.S. and Mexico in their last elections – and many other parts of the world – that shift was underpinned by anti-establishment fervor. Bolsonaro is a self-described law-and-order leader, whose mandate is to arrest the corruption, profligate spending, and breakdown in societal values that he believes flourished under the status quo, contributing to Brazil’s deepest recession and rampant drugs and violence in its cities.

But while his election bodes poorly for democracy and human rights, it is less clear how his law-and-order mantra will translate into economic policy, specifically for energy. What is certain, however, is that he inherits a very favorable energy picture – booming production, committed investments, and a calendar of auctions to continue marketing international interest in Brazil’s world-class geology. If Bolsonaro’s election represents a rejection of establishment principles, an exception should be made for energy policies to allow the sector to continue its recent gains.

Cautious optimism in the markets

Despite being Latin America’s largest economy, economic issues, including energy, were never the driving force of Bolsonaro’s agenda. Financial markets and industry investors have responded with cautious optimism to his ascent, likely for two reasons. First, as a “Tropical Trump” he espouses his own nationalist “Brazil-first” ideology that emphasizes putting the country’s financial house back in order through a pro-business approach of austerity and privatization. Bolsonaro has tapped a top campaign advisor, Paulo Guedes, to lead his economic team. Guedes will likely occupy a “super finance minister” position and be entrusted to shepherd pro-market policies while the president oversees a broader governance agenda. He is a member of the University of Chicago fraternity of economists that capital markets tend to favor because of their orthodox, by-the-book policies to tackle debt and budget deficits, the latter now pushing 10 percent of Brazil’s gross domestic product.

 

Second, Bolsonaro’s views on energy and the economy are a relief from the proposals put forward by candidates previously in the running. Ciro Gomes of Brazil’s Democratic Labor Party called for an outright reversal of the policies that have opened Brazil’s oil sector to foreign investment, before losing in the first round. Fernando Haddad, Bolsonaro’s runoff opponent, was the chosen candidate of former president Lula da Silva for the Workers Party (PT), whose state-intervening policies are credited with hobbling the economy and setting the stage for a massive corruption and money laundering scandal.

Brief anatomy of a Crisis

Under Lula da Silva, Brazil struck its most prolific bounty of black gold. In 2007, oceans of oil and gas with the potential to transform the economic fortunes of Brazil were discovered miles below the sea floor trapped beneath a thick layer of salt. With its newfound wealth, da Silva and the PT party in power suspended bid rounds for oil blocks and devised new rules that gave the state a bigger cut in the “pre-salt” assets. The new laws required state-owned Petrobras to be the sole operator of pre-salt oil blocks and maintain a minimum 30 percent investment share in these massive projects. To boost domestic industry, regulators also required higher percentages of local content to service oil projects. The restriction of competition created a system that incentivized corruption and under-the-table dealings. The Lava Jato (“Car Wash”) scandal unraveled a complex web of kickbacks and payoffs in which contractors colluded to inflate prices for a dominant customer – Petrobras – and shoveled profits to corporate officers and politicians.

Industry Renaissance

Since its nadir, Petrobras and Brazil’s oil and gas sector at-large have reversed course and regained steady footing over the past three years. Outgoing President Michel Temer has pushed through market-oriented reforms, but moves to revamp the sector in response to the Lava Jato fallout were underway before he took office. Legislation in 2016 stripped Petrobras of its pre-salt monopoly, allowing foreign investors greater stakes and operating control in pre-salt plays. Local content rules were eased, freeing up value and efficiencies in project supply chains. A favorable tax scheme for imported parts and equipment for offshore projects was extended until 2040. And Brazil’s oil regulator, the National Petroleum Agency (ANP), established a consistent calendar of upstream bid rounds, giving industry predictability and regularity in planning investments.

Over the past 13 months, Brazil has held five bid rounds for upstream acreage, including three tenders for pre-salt assets. International investors have been bullish on the offerings. The five auctions licensed 68 blocks and collected over 21 billion reals ($5.7 billion) in signing bonuses. They are projected to generate an additional $80 billion in investments and $334 billion in tax revenues, according to ANP. While Brazil’s economy continues to be hobbled by low growth and stagnant productivity, the energy sector and the investment it is attracting have been a salient bright spot.

 

Pro-market reforms are critical because of the prolific resources that are in play. The sheer volumes of Brazil’s pre-salt reserves and the geological characteristics of the reservoirs make them one of the hottest oil and gas assets in the world. A single well from the pre-salt Lula field, Brazil’s largest-producing oil field, averages between 20,000 and 30,000 barrels per day of output, compared to 10,000 b/d on average in the U.S. Gulf of Mexico, according to Brazil’s main oil industry association. With their significant flow rates, deepwater projects in Brazil are breaking even under $40 per barrel. Already a top-ten global producer at around 3.2 million b/d of total output, Brazil’s energy forecasting agency predicts that production will double by 2026. By then it could one of the world’s five-leading oil exporters.

Between nationalist instinct and pro-market ideology

The openness of Brazil’s energy sector was up for debate in the election. With energy, continuity of the status quo is a good thing. At a minimum, a predictable schedule of competitive bid rounds should be maintained. Three more auctions are slated for 2019, including another offering of pre-salt blocks. Geopolitics are also working in Brazil’s favor to continue reaping the benefits of foreign oil investment. Brazil’s continued opening could come just as Mexico, a rival for deepwater oil investments, closes itself off. President-elect Andrés Manuel López Obrador, himself a populist, though left-leaning, has already halted bid rounds for new blocks for the next two years. Industry capital flows to the markets of least resistance and greatest certainty. The sustenance of market-oriented upstream openings position Brazil to cash in on both accounts.

But Bolsonaro has also indicated interventionist leanings, particularly around Petrobras and how far he is willing to go to unshackle the company. The state-led firm is saddled with one of the highest levels of debt in the international oil industry. It has embarked on a massive $21 billion divestment program to pay down debt. The question of whether to privatize more of the state giant or cling to it as a state strategic resource has exposed contradictions between his pro-market ideology on the campaign trail and his nationalist instincts. Divisions are emerging within Bolsonaro’s inner circles on how to manage state resources. Though Guedes is a pro-market advocate who favors private sector participation in industry, he is reportedly contending with factions of military advisors who advocate guarding state companies for strategic purposes. In a tension between open investment policies and a nationalistic military mindset, Bolsonaro’s sympathies may well prove to be with the latter, with negative implications for the energy sector.

Bolsonaro has been mercurial on market openings in the past. As a congressman he repeatedly voted in favor of maintaining Petrobras’s monopoly on oil and gas production. And when a trucker strike over rising diesel prices grounded Brazil’s economy to a halt in the spring, Bolsonaro backed the truckers who faced an alignment with international market prices for fuel. Sentiments against free and open markets have also percolated in Bolsonaro’s views against China. He has been openly critical of the rising tide of Chinese investment in Brazilian infrastructure and resources. Chinese national oil companies, for example, are investors in Libra, Brazil’s largest pre-salt field, positions they acquired through open-market mechanisms of competitive and transparent bid rounds.

 

The sale of Petrobras assets will gain increasing traction early on in Bolsonaro’s administration, particularly with natural gas infrastructure. Industry and government joined forces late in the Temer administration to devise a national gas initiative aimed at developing a more competitive and holistic domestic gas market. The plan called for privatization and third-party access to Petrobras-owned pipelines, processing facilities, and import terminals, to allow the company to focus on its core pre-salt development priorities. A national bill stalled in Congress in the election year, but will likely revive in the year ahead as global LNG markets continue to grow and public policies favor lower carbon sources, raising the appeal of natural gas.

An increasingly controversial process of privatization

A push to privatize more of Petrobras stock may be more difficult to achieve. Beyond the leanings of his advisors, such bold reforms would also require equally bold legislative action and political deal-making, which Bolsonaro lacks a strong track record to lean on. In nearly three decades as a congressman, Bolsonaro only presented two proposals that went on to become law.

Brazil’s energy industry and its many gains in recent years appear to have avoided a sharp turn with the election of Jair Bolsonaro, controversial as he is. His economic stance on the campaign trail suggests a more orthodox approach for business that bodes better for the energy sector than the alternatives in the presidential election. But nationalist leanings should temper optimism in any sector. The present picture for energy in Brazil, a driving force of its economy, is favorable. In an election that staunchly rejected the establishment, the energy industry would be content with the status quo.