Brazil's Petroleum Sector Resumes Licensing Activities

Summary

Brazil has issued its first new energy concessions since 2008. The May 14-15 11th Oil and Gas Licensing Round marked the end of a half-decade during which the exploration of newly auctioned blocks was on hold while the South American country revised the laws that govern its energy sector. While the licensing round was the country's most successful auction to date, it was only the prelude to a more important event, the Nov. 28 auction of pre-salt oil deposits under the country's new regulatory system. This auction will include four times the estimated reserves involved in the May auctions. New laws aside, growth in Brazil's energy sector will be determined by oil companies' perceptions of the new production-sharing agreement system and by Petrobras' ability to finance and carry out its ambitious and expensive expansion plans.

Analysis

In 2006, Brazil announced the Western Hemisphere's largest oil discovery in 30 years in the pre-salt layer off the coast of Rio de Janeiro. The pre-salt areas in the Santos and Campos basins are estimated to contain between 50 billion and 100 billion barrels of oil equivalent, which contains both oil and natural gas, an amount equivalent to three years of total global oil consumption.

The discovery of the Tupi oil field (now called Lula oil field) with its estimated reserves of 6.5 billion barrels of oil equivalent prompted former President Luiz Inacio Lula da Silva to begin a process to reform the sector's regulatory system. While regulatory reforms were underway, the country did not license new pre-salt blocks for exploration and production; the last offshore auction occurred in 2007. These reforms included creating a new state-owned company called Petro-Sal and a social fund, transferring exploration and production rights to Petrobras, and devising a new framework for royalty distribution.

Most of the external pagenew regulatory frameworkcall_made was passed in 2010. The only outstanding issue was royalty redistribution reform, which proved external pagehighly contentiouscall_made. This reform shifted royalty revenues away from producing states like Rio de Janeiro and Espirito Santo toward non-producing states. Though President Dilma Rousseff eventually signed the royalty bill into law in mid-March 2013, paving the way for the recent licensing round, the legality of the bill -- particularly pertaining to whether the royalty redistribution will apply to existing contracts -- is being adjudicated in the Supreme Court. November's auction is expected to proceed. But if the court strikes down the bill, the auction could be delayed while the reform is amended.

This week's round raised approximately $1.4 billion in signing bonuses (paid up front upon winning the concession), well above amounts raised in all previous concession rounds in Brazil. The licensing guarantees billions of dollars of investment to meet minimum exploration commitments. This auction was unique in that most new exploration blocks were located in the northeastern frontier basins of Foz do Amazonas and Barreirinhas, which share similar geological characteristics to Africa's Gulf of Guinea, where major oil discoveries have been made.

The estimated reserves of these blocks totaled around 9 billion barrels of oil equivalent; a substantial amount, if not quite on the level of the amount of oil to be offered in the November pre-salt auction. Satisfying Brazil's attempt to attract bids from larger energy companies, a wide array of international, regional and domestic energy companies including ExxonMobil, BP, Chevron, Total, Ecopetrol, OGX and of course, Petrobras, won blocks.

While the 11th round was a success, it was just the latest round of the old regulatory system. A much more important indicator of how the sector will fare going forward will be the November auction of pre-salt blocks under the new production-sharing system.

From 1997, when Petrobras' monopoly ended and private investment was allowed in the energy sector, until 2007, the country's regulatory system was based on the concession model. This essentially meant that international oil companies could participate in auctions, pay a signature bonus and royalties, and own 100 percent of subsoil minerals in their blocks. This model proved very effective for the high-risk, high-cost areas off the coast of Brazil, where the country needed to shift exploration and production. Since the discovery of the pre-salt reserves, the risk and cost factors have decreased. Discovery rates in the pre-salt regions are upward of 80 percent, and pre-salt break-even costs have fallen 45 percent to $35 to $40 per barrel. This meant Brazilian policymakers felt they could reasonably exact more revenues from oil production without disincentivizing investment.

This has led legislators and regulators to create a new system to manage the pre-salt reserves, namely the production-sharing agreement. This system allows the state to retain full ownership over the subsoil reserves, placating nationalist sentiment regarding the discovery while compensating international oil companies for their expenses ("cost" oil) and granting them a percentage of profits ("profit" oil). In addition to high domestic content requirements, which require firms to use a certain percentage of Brazilian inputs, the new system also requires that Petrobras must be the operator and must have at least a 30 percent stake in every pre-salt operation.

Two main questions emerge out of the regulatory shift. The first is whether international oil companies will respond enthusiastically even though they will now be able to book only a smaller percentage of the total reserves. For example, if the company is allocated 20 percent of profit oil, it can book only 20 percent of the total proven reserves. That said, some 80 percent of the world's oil reserves are in countries with either production-sharing or mixed systems. Thus, the pre-salt auction in November will be a referendum on how the oil companies view other legislation such as domestic content requirements and stipulations regarding Petrobras' ownership and operatorship.

The second is whether Petrobras will be able to keep up with foreign investor interest. Since by law Petrobras must own 30 percent of every block and must be the main operator, the firm must raise a large amount of capital to be able to expand.

Petrobras is currently two years into an ambitious $237 billion dollar investment plan from 2012-2016. The company invested nearly $43 billion in 2012, putting it on pace to achieve its investment goals. To raise capital, Petrobras has done three things.

First, it has pressured the government to approve additional fuel price hikes to bring Brazil's energy prices closer to international norms. Petrobras, which bears the brunt of the government's price controls on fuel, succeeded in getting the government to external pageraise gasoline and diesel pricescall_made in late June 2012 and in January 2013 and on diesel prices in July 2012 and March 2013. Second, it has begun to sell off some international assets, such as those in the Gulf of Mexico and in Argentina, to cut costs. And third, the company recently began its 2013 financing plan by offering six bonds totaling about $11 billion, the largest emerging market bond offerings in history.

The company intends to raise some $20 billion in debt in 2013 and another $20 billion in 2014. Investors have responded favorably, with orders totaling $40 billion in the first 2013 offering. More than just financing, if Petrobras hopes to keep up with investor interest in the upcoming pre-salt auctions, it must also have the institutional capacity to manage all of these projects simultaneously.

All of these reforms will grant Brazil more control over the country's energy sector. The resumption of auctions will allow Brazil to be able to better cover its domestic energy needs. These developments may help Brazil move toward being a significant net exporter, but in the short term, expanded production will still primarily be used to satisfy fast-growing domestic demand.

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