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Petrobras is struggling to meet its production targets while no new acreage in the subsalt region has been auctioned off for companies to explore. (Photo: Wharton)
Monday, March 25, 2013
Special Reports

Nationalism Threatens Brazil Oil


Will resource nationalism spoil Brazil’s big oil future?


LATINVEX SPECIAL

Knowledge@Wharton  

The announcement in 2007 that oil company Petrobras had made a giant oil find off Brazil’s southeast coast was a reason for euphoria in South America’s biggest country. With estimated recoverable reserves of between five and eight billion barrels of oil, the so-called “Tupi” find was the biggest anywhere in the world for almost a decade and the biggest in the Americas since the Cantarell field in Mexico in 1976.

More promisingly, the strike was set to be the first of many. Tupi confirmed that below a subterranean layer of salt that stretches for hundreds of kilometers off Brazil’s coast there lies oil, and lots of it, with estimates ranging from 50 to 150 billion barrels.

Such large volumes of so-called “subsalt” oil will, when tapped, propel Brazil up the list of the world’s oil producers -- and in doing so, turn an economy that was once vulnerable to the sudden spike in the price it had to pay for oil imports into an exporter. Petrobras itself is targeting raising its daily production from around two million barrels currently to 5.2 million by 2020.

The country’s president at the time, Luiz Inácio Lula da Silva, joked that the Tupi find was proof of the old saying that God is a Brazilian. The oil is a “passport to the future,” in the words of Lula’s successor, Dilma Rousseff. Petrobras was set to eclipse rivals like Exxon and Shell. There was talk of Brazil’s joining the OPEC oil cartel.

But that mood of euphoria has long since faded. The Tupi find – now renamed the “Lula Field” – has started production, as have other subsalt finds made in the Santos basin. But Petrobras is struggling to meet its production targets, while raising the money required to develop the existing subsalt finds has made it the most indebted company in the world. Meanwhile, no new acreage in the subsalt region has been auctioned off for companies to explore. Most of the huge bonanza -- perhaps more than 70 percent of it -- remains waiting to be discovered.

Much of the blame for this delay has been laid at the government’s door. Critics accuse it of overreach. After the magnitude of the subsalt region became clear, the government set out to boost state control over the sector in what was another example of the resource nationalism that has spread across the world during the current Chinese-driven commodity super-cycle. This had two consequences. One was a time delay in furthering development of the subsalt region. After the Tupi find, the government quickly suspended auction rounds in which it offered new acreage for exploration to oil companies. It set out to rewrite the country’s oil laws. Given how slowly the machinery of Brazilian government move, this process took several years for drafting and then passage through the congress.

When the time new legislation was finally passed last year, Brazil had changed from its traditional concession regime where companies paid royalties on oil extracted, to a production-sharing agreement framework for all future subsalt regions when they come up for auction. In the future, in these areas companies will be paid by the government for lifting the oil, which will remain the property of the Brazilian nation.

The government also decided to make publically listed, but state-controlled, Petrobras the main instrument of its greater control. The new legislation stated that in the subsalt region, Petrobras will take the development lead. All future exploration blocks in the subsalt region will have the company as exclusive operator, and the company will hold a minimum 30 percent stake in each block. Essentially, all rigs in the subsalt would be run by Petrobras.

STANDARD REGULATIONS, OR RESOURCE NATIONALISM?

For officials, the new legislation made sense. “The concession regime was correct for a Brazil where there was a high risk in exploring for oil. But in the subsalt [region], you have lots of oil and low exploration risk. All around the world, in these situations you use production-sharing agreements instead of concessions,” says Haroldo Lima, the former director-general of Brazil’s energy regulator ANP (National Petroleum Agency), who sat on the committee that designed the new legislation.

Limasays that the decision to make Petrobras the only operator in the subsalt region was done so as to tap its geological and operational knowledge of the region. But critics of the new legislation argue that even worse than the delay in bringing it into law is the resource nationalism at its heart, which they claim will hamper the development of a major natural resource. “Brazilian politicians felt they had finally hit the jackpot and that everything was in their favor and that they could dictate the terms to the industry,” says Norman Gall, director of the Fernand Braudel Institute in São Paulo. “But there is no way Petrobras can be the operator of all new deep water concessions with a minimum 30% stake.” 

For Gall and other critics, what the government has demanded of Petrobras is too much. The subsalt region, with its ultra-deep-waters and large area, is being compared to the North Sea oil fields, which took dozens of companies decades to develop. “Petrobras does not have the money or people to do this on its own. Brazil wants to do what nobody has ever done in ten years, with a manpower skill base that has not yet been developed,” notes Gall.

The debate over whether Petrobras can on its own operate such a vast region will be brought into sharper focus when Brazil holds the first auction rounds for subsalt exploration blocks under the new legislation in November. Then, the appetite among international oil companies to participate as junior partners with Petrobras will be tested for the first time.

The government is expecting strong interest, especially from growing oil consumers in Asia -- principally China, who will act as essentially an investor in Petrobras-led consortias. But even if these consortias materialize, the new laws will still be responsible for slower development, say critics. “The new framework is not conducive to having multiple companies trying to develop a deep-water oil frontier, which is technically difficult to do,” says Christopher Garman, a director at Eurasia Group and its lead analyst on Brazil. “The Government has implemented a model that essentially guts competition in the upstream sector. It took the decision that it is going to limit the development of this tremendous resource to the operational and financial constraints of one company. It is a recipe for a much slower pace of development, for a slower cycle of investment.”

Even Lima, now retired from the ANP, is having second thoughts about the wisdom of burdening Petrobras with such responsibility in the subsalt region. “The first auction rounds under the new legislation for subsalt blocks will be this year. Then we will see the level of interest by companies to be junior partners. But it is possible we will have to revisit the legislation if it is seen that Petrobras is being overburdened.”

TOO LATE FOR REFORM?

But to do so will be politically costly. The bills that redesigned the country’s oil legislation were sent to congress in August 2009. The final piece of the new framework was only passed late last year and is now the center of a constitutional dispute that could end up before the country’s supreme court. Reopening such troubled laws to re-examination could further delay efforts to tap the subsalt.

The government will also be unwilling to reform the legislation until it absolutely has to make an admission of error. “The person most identified with the new oil framework is President Rousseff,” says André Pereira César of the CAC political consultancy in Brasília. “She oversaw the committee that designed the changes. She was chairwoman of Petrobras when it passed, so any change to the new law now would be an admission of error that the critics she dismissed were right. Therefore, it is hard to envisage any move to alter the new laws until at least after her re-election campaign next year.”

That would coincide with the litmus test for the new system – whether Petrobras succeeds in delivering on the aggressive growth projected for Brazilian oil production from 2015 onwards. But rather than rewrite the new laws, a possible solution could be to allow a level of flexibility in interpreting them so that no rewrite is required, says Felipe Monteiro, a professor of strategy at INSEAD and a senior fellow at Wharton's Mack Center for Technological Innovation.

“You have to read it with the Brazilian context in mind,” he says. “Laws can be written one way and implemented in another. I think the intention by leaving everything for Petrobras was to put in a gatekeeper. But the way it is going to be implemented is what we have to look at. I wouldn’t be surprised that we will still see Petrobras outsourcing much of its operational responsibility, or doing it in conjunction with others. We need to see if there will be flexibility on the monopoly, whether Petrobras settles into a role of just overseeing it.”

Such an approach would be helped by the fact that the new legislation is only written into ordinary law. Brazil will not need to go through the complex process of amending its constitution to revise its oil sector as is required in Mexico.

ENERGY MARKET REVOLUTION

Such flexibility might become all the more necessary because, since the announcement of the Tupi find, the global energy market has undergone a revolution. In 2007, there were few exploration opportunities for international oil companies. If the Brazilian government was filled with hubris, it was at least based on an accurate assessment of a global oil sector with limited opportunities for companies.

But since then, the U.S.-led revolution in tight oil and shale gas has changed the global picture. The U.S. is cutting back on energy imports as capital is being redirected towards exploration in North American basins. “The technical revolution in tight oil and shale has exacerbated the impact of the bad decisions Brazil made in designing its new oil legislation,” says Eurasia’s Garman. “The government was correct that it had leverage over the oil companies in 2007. But now, the environment is very different. The oil companies are not as interested in Brazil as they were. The government does not have as much leverage as it had.”

The U.S.’s experience with its shale and tight oil revolution offers the Brazilian government a worrying contrast to its own approach to subsalt development. The U.S. energy revolution occurred very quickly, in part because it had many different companies competing with each other in trying to figure out the best way to tap unconventional resources. These advances are now being brought to other parts of the world with the potential to pressure the price of oil. This has potentially serious consequences for Brazil, as the subsalt reserves are expensive to develop. “Technology is changing. In the U.S., new technology of shale and tight oil could alter the oil price. It could drop, and this would be a problem,” says Lima.

The questions being raised about Brazil’s new oil framework is a demonstration of the weakness of the country’s congress, which ushered them into law with little debate, say critics. The government’s proposals were passed with little discussion as to their consequences. “The congress barely debated the demands the new legislation would place on Petrobras. Instead, the most intense discussions centered on the division of royalties between Brazil’s states and municipalities,” notes Gall. “This is the result of a lack of knowledge about a key sector. In the U.S. congress, they have specialized committees on energy with their own professional staff, and both members of the committees and the staff become experts in the field. In Brazil, there is a central advisory group to the senate – very bright people, very well paid – but apparently, they do not have much influence.”

Meanwhile, just as the politicians are placing the huge burden of developing the subsalt on Petrobras’s shoulders, they are financially undercutting its ability to do so. The company is currently obliged to sell imported gasoline at below cost as the government keeps prices down in a bid to contain creeping inflation. With demand from a rapidly expanding car fleet outstripping supply from Brazilian refineries, this is costing Petrobras billions of dollars each year and caused it to post its first quarterly loss in 13 years last year, further undermining its ability to execute what is the world’s biggest corporate investment plan -- to spend $236.7 billion, much of it borrowed, by 2017.

The government’s pricing policy could also prove another barrier to attracting foreign investment to the subsalt sector. “Investors are concerned that if they do not have freedom in the pricing of what they are selling, what else could happen? The government has no intention of breaking contracts or not getting foreign investment. But these controls are having a negative indirect impact on investment,” notes Monteiro.

A successful auction round of subsalt exploration blocks in November could, after all the delays, inject some new momentum into Brazil’s subsalt oil play. But the auction round will only bring closer the real moment of truth – the moment when Petrobras tries, on its own, to develop one of the biggest new oil frontiers in the world. For the company and its masters in government,much is riding on whether it can prove the doubters wrong.

Republished with permission from http://www.knowledge.wharton.upenn.edu -- the online research and business analysis journal of the Wharton School of the University of Pennsylvania.

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