WHesterN Hemisphere

EVENT: Reports on August 14 suggested imminent changes to the legal and regulatory frameworks for the exploration and production of new offshore oil reserves.

SIGNIFICANCE: The recent discoveries, which could boost Brazil's petroleum reserves by upwards of 50 billion barrels, led the government to order the withdrawal of 'pre-salt fields' from the last licensing round. Since then, vigorous debate has ensued on the best model for efficient and profitable exploration and production of these potentially large, but extremely challenging, new reservoirs.

ANALYSIS: The announcement of the pre-salt discoveries -- accumulations found in ultra-deep waters of 5,000-7,000 metres and underneath a 2,000 metre layer of salt -- was immediately followed by the withdrawal of all blocs in and surrounding the pre-salt cluster from the National Petroleum Agency's (ANP's) November licensing round. These blocs accounted for 41 out of 321 exploratory blocs originally offered:

• State-controlled oil company Petrobras's CEO, Sergio Gabrielli, reasoned that a different set of parameters should apply as bidding to acquire rights to these blocs was "akin to buying a 'winning' lottery ticket" ( see BRAZIL: String of pre-salt finds boosts oil optimism - July 4, 2008). Gabrielli suggested that a production-sharing contract was preferable to the concession contract currently in place.
• In contrast, other oil and gas companies, including Petrobras's current partners in pre-salt blocs -- BG, Shell, Repsol, ExxonMobil, Hess, Petrogal-Galp and Partex -- argued that the current concession contract offers the flexibility the government needs to increase its 'take' while not increasing risk perceptions, a key element to the financing of such costly exploration projects.

Analysts were quick to point out that if the government followed Gabrielli's idea of decoupling the pre-salt exploration regulatory framework from that of the other basins and, moreover, adopting a production-sharing contract for the pre-salt cluster, a new state oil company would be needed to administer these assets.

Inter-ministerial commission. On July 18, President Luiz Inacio Lula da Silva created an inter-ministerial commission to study petroleum exploration in the pre-salt area. Its mandate is to "study and propose the necessary changes to the legislation with respect to oil and gas exploration and production in the recently discovered petroleum areas". The group, which has 60 days to produce its recommendations, includes Mines and Energy Minister Edilson Lobao, Cabinet Chief Dilma Rouseff, Planning Minister Paulo Bernardo, Finance Minister Guido Mantega, Gabrielli, National Development Bank President Luciano Coutinho and ANP Director Haroldo Lima.

Rising confusion. The commission first met on July 28. According to an interview with Lobao, the group agreed that it would not comment on its discussions before concluding its deliberations and drafting its recommendations. However, Lobao acknowledged that the group had reviewed oil and gas exploration models currently in place in countries including Russia, Venezuela, the United States, Iran and Norway, and said that a second meeting was scheduled for August 12. It is unclear whether this meeting took place; however, on the same day, comments by Lula to the National Students Organisation (UNE) led to speculation that the government was closer to making a decision than originally anticipated:

• Of particular relevance was Lula's defence of a change to the Petroleum Law of 1997, which ended Petrobras's monopoly on exploration and production of hydrocarbons and allowed private entities -- domestic and foreign -- to participate in the sector.
• According to Lula, "the pre-salt riches cannot stay in the hands of half a dozen companies ... and must be used to bring a solution to the millions of poor people". He went on to ask for the students' support for his cause -- a reenactment of the 1940s "the petroleum is ours" campaign that led to the creation of Petrobras.

Exaggerated reaction? Lula's comments provoked strong negative reactions; Lobao added to the controversy by publicly commenting that he interpreted Lula's words to mean that a new state company, in the mould of Norway's Petoro, would be created. He went further by saying that Lula had instructed him and Rouseff to secure support for this new company among political leaders. Nevertheless, the decisions taken thus far appear less alarming:

• The government has indicated that a final decision on the model to be adopted will not be made public until after the November municipal elections.
• The rules and regulations pertaining to the blocs that have been already awarded will be honoured as per current contracts.
• No new blocs will be awarded to either Petrobras or other companies until a new regulatory and fiscal framework for the pre-salt cluster is adopted.

However, it appears that commission members support the adoption of a mixed framework -- one for pre-salt reserves following either a production-sharing or service contract; and another, the existing concession contract, for all other basins. The production-sharing (or service) contract would be administered by the new state oil company, an entity that the government also hopes will administer a new national fund to invest the new riches in social and educational programmes and initiatives.

Arguments against. The overall response to these ideas has been extremely critical. It is widely agreed that the state should receive a larger share of the eventual revenues from the pre-salt production, that a sovereign fund would allow the government to invest funds in much needed areas, and that the government should have the ability to determine whether oil or products should be exported. However, almost no one outside the political sphere supports the creation of a new state oil company. There are strong arguments against it:

• The nationalist rhetoric is misplaced, as the current Petroleum Law specifies that all hydrocarbons belong to the state, and that the state must maintain control of Petrobras. Consequently, there is no need to change the law to reaffirm what is already clear.
• The existing concession contract could offer the flexibility necessary. Jean Paul Prates, secretary for energy and international relations for Rio Grande do Norte state, notes that the current concession contract includes a signature bonus, an area retention payment, royalties ranging from 5-10% and a special participation fee applied only to extremely productive or profitable fields. He proposes changes to the royalties to range from 0% (for very small, marginal fields) to 25% (for pre-salt fields) in addition to adjusting the special participation fee to ensure that the bulk of revenues accrue to the state. Although these changes would require congressional approval, he claims that securing support would be easy.

By contrast, this will certainly not be the case for the creation of a new state oil company and introduction of a production-sharing contract:

• This type of contract is difficult to draft and administer. Moreover, a new state oil company automatically implies that a new agreement between the federal, state and municipal governments which now share the royalties would have to be negotiated. Producing states and municipalities will not hand over their share without a fight.
• Creating a new state oil company requires qualified personnel and access to capital. To date it is suggested that the government would issue bonds or other financial instruments using future pre-salt production as collateral. It is unclear how successful these papers would be -- particularly the discount factor charged by the financial sector given that this new company's assets would be in only one country and one field that is yet to produce oil.

CONCLUSION: There will be changes to the current regulatory and fiscal framework for oil and gas exploration and production. However, although radical ideas are being mooted as if they were already decided and close to implementation, the final decision is likely to be made only after much thought, dialogue and deliberation.