When in 2007, Petrobras, Brazil’s National Oil Company (NOC), and the Federal Government announced the discovery of a large ultra-deep offshore oil province, the pre-salt, the country became euphoric. The new resources would be Brazil’s passport to the future, claimed the then-president Luiz Inácio Lula da Silva. The pre-salt would provide revenues to be channeled to education and science as well as increase industrial demand for the drilling rigs and platforms which would be manufactured mostly in Brazil due to stringent local content laws. Almost ten years later, euphoria has been replaced by despair.
The overall economy endured two years of deep recession, and the forecast for the oil sector has disappointed. Rather than the close to 5 million barrels per day (mmbd) of production by the end of 2017 predicted by the government in 2010, Brazil will finish the year with 3.4 mmbd. Worse yet, with the fall of oil prices, each barrel generates lower rents predicted when many of the “go ahead” investment decisions were taken, decreasing both the profitability of companies operating in Brazil and the government’s finances. On top of that, Brazil’s supply chain, particularly the shipyards, proved unable to fulfill the high local content targets that had been projected.
This shortfall resulted in higher capital costs (CAPEX), delivery delays that affected the cash flow of projects, and fines for failing to reach minimum local content contractual clauses.
By themselves, all of these issues would be challenging, but the discovery of a major corruption scandal involving Petrobras drove Brazil’s oil industry to a “perfect storm” situation, one that resulted in 2016 in the impeachment of President Dilma Rousseff, a former Minister of Energy and Lula da Silva’s handpicked successor.
Now the waters have calmed, the worst has passed, and a cautious optimism is in the air. Recent policy decisions signal that Brazil wants to be back in business, with new bidding rounds, the end of Petrobras’ legal monopoly in the pre-salt fields, more flexible local content legislation, and a stronger corporate governance against corruption in the country’s leading oil company. Petrobras’ own financial troubles led it to a divestiture program that is strengthening the domestic competitive environment, both upstream and downstream. This article reviews recent key decisions designed to attract new investments and put Brazil’s oil sector back on track to being a hot spot for the global oil and gas industry.
Petrobras' divestment will strengthen the competitive environment
Petrobras had the monopoly on upstream operations in Brazil from its creation in 1953 up to 1995, when Congress passed a constitutional amendment that introduced competition into the industry. However, the opening of the oil sector became effective only after a new legal framework was passed in 1997 and the National Petroleum Agency (ANP), a new regulator, conducted the first bidding round for exploratory areas several years later. Notwithstanding that its monopoly legally ended almost 20 years ago, Petrobras still dominates Brazil’s oil sector with 81 percent of the national oil and gas production, according to ANP’s latest statistical yearbook. Petrobras’ longstanding investment program in deep offshore capabilities and intimate knowledge of Brazil’s geology gave the national oil company (NOC) a natural advantage in open bids. Private competitors frequently preferred to associate with Petrobras rather than try to outbid it during oil auctions. Petrobras’ leading domestic position may have been achieved by merit but had the unwelcome consequence of perpetuating a relatively closed market with a government-run company with monopsony power. Without strong competitive constraints, and driven by a political agenda intent on boosting investments in Brazil and subsidizing gasoline prices (the latter during Rousseff’s tenure), Petrobras accumulated an unsustainable level of debt, about $100 billion by 2015, making it the world’s most indebted oil company. The new administration has speeded efforts to raise capital to pay its debt through a sizeable divestment plan, one that aims to raise an additional $19.5 billion between 2017 and 2018 alone (as disclosed in the Petrobras Business and Management Plan 2017-2021). The most significant deals have been the selling of Petrobras’ share (66 percent) in the pre-salt Carcará area (block BM-S-8) to Statoil for $2.5 billion and a substantial strategic alliance with Total, with a value of $2.2 billion, that includes the transfer of 35 percent of its stake and the operation of the Lapa field (block BM-S-9) to the French company. The divestment program also includes selling assets in the midstream and downstream, and Petrobras is eager to find partners to share the cost of completing two of its refinery investments, Comperi in Rio de Janeiro and Abreu e Lima in Pernambuco, projects that were plagued by cost overrun and corruption scandals. Currently, Petrobras completely dominates the downstream in Brazil by having 100 percent ownership of all refineries. This monopoly position made the company more vulnerable to politically determined price setting during Rousseff’s administration, as all losses were borne by the state company.
New investment rounds under more attractive conditions
Following the discovery of the pre-salt, the government crafted specific legislation applying to fields located in this large formation, introducing production-sharing agreement contracts where Petrobras had the monopoly on operation and a minimum 30 percent stake. The changes were heavily criticized by industry stakeholders, including the Brazilian Institute of Petroleum (IBP), an association that represents oil operators. Only one field was ever auctioned following this arrangement, Libra, which was acquired at the minimum price by a consortium of Petrobras (40 percent), Total (20 percent), Shell (20 percent), CNPC (10 percent) and CNOOC (10 percent) in 2013. Oil companies will now be able to operate in the pre-salt, and last November, President Michel Temer (who rose to power after Rousseff’s impeachment) sanctioned a law (13365/2016) which ended Petrobras’ legal monopoly. The law still grants Petrobras preferential treatment as the NOC will have the option to say, for each block offered in the pre-salt, if it wants to be an operator with a minimum 30 percent stake or not. This political compromise effectively allows the government to put pre-salt areas out to bid again, as Petrobras’ investment and operational capacity have been a major limitation. In the old model Petrobras would have been forced to pay, even if it did not want to, 30 percent of a signature bonus and all the investment in exploration and development. Another key recent change was a modification to the local content requirements in bidding rounds. Local content clauses have been adopted since the first bidding round and are part of Brazil’s strategy of using the growth of the oil industry to stimulate the development of its supply chain. However, due to the industry lobby and a strong industrial policy mindset during the Worker’s Party (PT) tenure, local content became one of the points of contention in Brazil’s oil industry. It moved from an incentive to become mandatory, with high minimum targets and hefty fines when companies failed to comply. Furthermore, local content requirements became more rigid over time, with a schedule of 90 items (from cathode protection to wet Christmas tree), each with its own national requirement percentage. For example, in a notable case, BG drilled a dry well in the block S-M-508, in the Santos Basin, and had to pay an additional R(Reais)$192 million in 2015 (approximately $64U.S. million) as a fine for using only 15.42 percent of local content in its total investments when the contractual minimum was 55 percent. In addition to fines, another direct cost of the policy comes in the form of delivery delays when production is postponed because FPSO platforms are still being finished in Brazilian shipyards, an issue that has hit Petrobras hard and resulted in its failing to reach production targets. A peripheral issue at first, IBP and consultants linked to oil operators started to see in Brazil’s local content requirements a barrier for the future growth of the sector. Even among Petrobras’ executives there was a sense that Brazil’s local content policies went too far and imposed a heavy burden on the NOC. After more than a year of deliberations that involved multiple ministries and governmental agencies, an Executive committee decided on March 29, 2017 to cut local content requirements by half, make it no longer a bid criterion, and simplify the compliance process. Now, rather than having to follow a detailed list of about 90 items, oil operators will have targets divided by “macro-segments.” For offshore fields, exploration was set to 18 percent and the development phase was divided into well construction (25 percent), subsea equipment (40 percent), and production platform (25 percent). The decision was met with strong criticism by business associations such as the Brazilian Machinery Builders´ Association (Abimaq) and the politically powerful Federation of Industries of São Paulo (FIESP), but this action signals the government’s intent to attract new upstream investments in the coming rounds. For the current year, the Executive is preparing to hold four bidding rounds, with an initial forecast of raising $3 billion in signature bonuses. The 14th Round, following the concession system, will put to bid 291 exploratory blocks from 9 different sedimentary basins including 10 ultra-deep offshore blocks in the Santos Basin. The 4th Marginal Fields Round, also in the concession system, will offer 9 onshore areas and is targeted to medium and small operators. For the pre-salt, following the production-sharing regime, 2 rounds have been announced. The first is a unitization round that will be made of 4 areas in the pre-salt region that border previously awarded fields where discoveries have been made. Finally, in November, the government wants to put to bid 4 prospects located in the broader pre-salt polygon. The National Energy Policy Council, a committee headed by the Ministry of Energy, also announced last April 11 a calendar of future bidding rounds totaling 10 between 2017 and 2019. The intention is to bring predictability to the Brazilian oil and gas market and a steady flow of investments in exploration.
Cleaning up the house
This ambitious calendar of bidding rounds seems to be overly optimistic considering challenging oil prices and Brazil’s own political issues, particularly the ongoing corruption investigations. Widely reputed to be one of the best NOCs in the world, Petrobras was at the center of a major corruption scandal that sent to jail many of its former directors and senior managers, executives of supply companies, and the elite of Brazil’s political class, including the former Speaker of the House (Eduardo Cunha) and minister of Finance (Antonio Pallocci). In short the scandal, known by Brazilians as Petrolão, was a kickback scheme that used Petrobras’ investment program to fuel political campaigns and private bribes to politicians and Petrobras’ executives. Operationally, the scheme worked by a collusion of suppliers, oil company executives and politicians responsible for selecting employees for senior management positions within Petrobras. First, suppliers got together in a cartel that held regular meetings to bid rig the oil company. Corrupt executives of Petrobras would accept having to pay overcharged prices in their procurement activities in exchange for kickbacks that varied from 1 percent to 3 percent and were paid in the form of transfers to offshore bank accounts in Switzerland and campaign donations to parties of the ruling coalition, led by the Worker’s Party (PT). More than $2 billion exchanged hands in the form of bribes originating from contracts of Petrobras. It is important to note that the scandal was centered on the procurement practices of Petrobras and did not include the regulator’s activities (ANP), bidding rounds or private oil operators. The Petrolão has been a watershed moment in Brazilian politics. The scandal was first discovered during the course of a money laundering investigation led by the Federal Police which got momentum with the wide use of plea bargains to gain the collaboration of those involved in the scheme. The first to cooperate with the Justice was a former downstream director of Petrobras, Paulo Roberto Costa, opening a Pandora’s box to the business and political class. The extent of damages to Petrobras is now well documented. Many employees were purged (with some former directors still in jail), and the company is receiving back part of the money illegally deposited in offshore bank accounts. Just one former senior executive, Pedro Barusco, returned to Petrobras $100 million he had accumulated in a Swiss bank account. More recently, 77 executives from the large Brazilian business group Odebrecht struck a deal with prosecutors and provided testimonies about the illegal activities of the company with politicians in Brazil and abroad. The full effects of the revelations on Brazil’s political system are still hard to predict. Within Petrobras, the current government strengthened the corporate governance of the company to reduce the potential for corruption and the role of political pressure in the appointment of directors. Another key decision was to adopt a clear and predictable price-setting policy, with monthly adjustments to the price of its refined products. Perhaps more effective in the long-run, a more competitive Brazilian oil and gas industry may be a more resilient and long-lasting mechanism to check government interference and recent changes are moving Brazil in this direction. The revelations made in the Petrolão scandal may also help politics in Brazil become cleaner and the country institutionally stronger, a key factor in turning resource wealth into a blessing.