WHesterN Hemisphere

An Oxford Analytica In-depth Analysis published on July 4, 2008

EVENT: Indications of further large offshore hydrocarbons deposits have been found near the giant offshore Tupi field, Petrobras CEO Jose Sergio Gabrielli announced on July 2.

SIGNIFICANCE: A string of significant oil discoveries and a buoyant agriculture sector -- capable of delivering food and bioenergy -- solidifies Brazil's position as an emerging global powerhouse. However, realising this potential will require long-term financial and human resource commitments as well as much coordination from all levels of government and the private sector.

ANALYSIS: Since November 8, 2007 when Brazilian state-controlled oil company Petrobras announced the discovery of a new oil frontier -- the pre-salt reservoirs -- with the finding of significant deposits in the Tupi field, a string of other discoveries followed (see BRAZIL: Hydrocarbons potential poses major challenges - November 20, 2007). The success rate for exploration in the pre-salt area has been 100% -- something unprecedented in high-risk oil exploration. To date, Petrobras and partners have drilled seven exploratory wells in six different fields (two wells in Tupi and one each in Parati, Carioca, Bem-te-Vi, Caramba and Jupiter), and are currently drilling three wells in three separate fields - Guara, Iara and a re-entry into Jupiter.

Key insights

• The string of recent offshore discoveries will add billions of barrels to Brazil's reserves, changing the country's -- and region's -- energy equation.
• Realising the potential of those new reserves will pose a series of challenges and will require long-term stability and growth.
• Fears of future changes to the terms of oil licensing rounds may heighten uncertainty and the difficulty of financing costly developments.
• Equipment and refining investments will need to be substantially expanded, representing a further challenge to Petrobras's efficiency and investment capacity.

The potential addition to Brazil's reserves is substantial. However, realising this potential will pose a range of challenges. These are:

• technical, due to the nature of the reserves;
• logistical, due to the materials, equipment, and infrastructure requirements;
• concern human capital, due to the rapid expansion implications for skilled labour needs;
• financial, due to the significant investments necessary; and
• political, given the pressures inherent on the mixed capital ownership structure of Petrobras and the delicate balance between the corporate and public interests. 

Moreover, the long-term stability and economic growth needed to fulfil this promise will be challenged by short-term pressures resulting from high oil prices, tightness in adequate refining capacity, and domestic and international energy markets.

Pre-salt prospects. The original Tupi discovery, located in the BM-S-11 bloc in the Santos Basin, and operated by Petrobras (65%), in partnership with UK BG (25%) and Portuguese Petrogal-Galp Energia (10%), suggested the existence of 5-8 billion barrels of very light oil, of 28 API, and considerable volumes of associated gas:

• As predicted, the pre-salt cluster, an area spanning approximately 15,000 square kilometres where accumulations are found in ultra deep waters of 5-7,000 metres and underneath a 2,000-metre layer of salt, holds much promise.
• Petrobras and partners (including BG, Repsol YPF Brasil, Petrogal-Galp, Shell and Partex) drilled wells in five other fields. Results have been deemed successful and tests are being conducted to assess the specifics of each reservoir. In addition, three new exploratory wells are currently being drilled.

Industry impact. The first and most noticeable impact of these discoveries was the withdrawal of all blocs in and surrounding the pre-salt cluster from the November 27, 2008 National Petroleum Agency's licensing round. The reasoning, set out primarily by Petrobras Chief Executive Officer (CEO) Sergio Gabrielli, was that acquiring rights to these blocs was akin to buying a "winning" lottery ticket. The government agreed and ordered the removal of 41 out of 321 exploratory blocs originally offered for bids. Following this decision a vigorous debate among many industry players and the government ensued. At stake is the question of what resource development model is best suited for the Brazilian oil and gas sector given these new circumstances. The positions were clearly outlined in a Senate hearing that took place on June 4:

• Petrobras's position, as explained by Gabrielli, is that current concession contracts -- which include royalties, taxes and a special participation paid on highly productive wells -- were designed for, and suited to, the previous scenario of high exploration risks, low financing capacity, medium-sized fields and low oil prices (averaging less than 20 dollars/barrel).
• By contrast, the current situation of the pre-salt cluster is one of low exploration risks, high financing capacity, large fields and high oil prices. Consequently, according to Petrobras, a new model that delivers greater returns to the State is needed.
• Originally, Gabrielli suggested that Brazil adopt a production-sharing contract, as in countries such as Colombia, Turkey, Nigeria, China and India. Critics were quick to point out that, if this system were adopted, given the mixed-capital nature of Petrobras, Brazil would need to create another state oil company to deal with the government's take. Since then, Gabrielli has toned down his position, still suggesting that a change is necessary, but backing away from defining the type of contract that should be adopted.

Other industry players -- represented by Joao Carlos de Luca, CEO of Repsol YPF Brasil and president of the Brazilian Oil, Gas, and Biofuels Institute, the industry's lobby association, of which Petrobras is also a member -- defended the position that the current concession structure is adequate and that changes could be introduced by adapting the "special participation" clause. Their fear is that changes in the contract will increase uncertainty and thus heighten risk and the difficulty in financing what are certain to be very costly developments. To date no decision has been taken on this complex and difficult issue. Given what is at stake, taking time to understand the issue and allow for an open debate before making any decisions can only be interpreted as a constructive and sensible way to proceed. Consequently, it is unlikely that the next licensing round will take place before the last quarter of 2008, or even early 2009.

Petrobras impact. Apart from the repercussions of these finds on Brazil, the effects they are having on Petrobras itself are significant. Although the company was already in high gear prior to the new discoveries -- with market capitalisation going from 14 billion dollars in 2003 to 300 billion this year -- in the last twelve months its stock more than doubled ( see BRAZIL: Buoyant Bovespa maintains strong potential - February 12, 2008). A work programme that targeted an increase in production (domestic and international) from 2.3 million barrels of oil equivalent/day (boe/d) in 2007 to 3.5 million boe/d in 2012 and forecast levels of 4.15 million boe/d by 2015 is now being completely revamped. In terms of production from Brazil's offshore areas, without including the pre-salt cluster, the estimates were for 1.79 million b/d in 2007 to increase to 2.42 million b/d by 2012.

Equipment implications. To meet these targets -- which are likely to be replaced by even more aggressive ones -- the company has quietly been purchasing and contracting drilling rigs and vessels ( see INTERNATIONAL: Offshore drilling faces constraints - June 30, 2008). In addition to the 35 drilling rigs owned and leased in 2007, 29 others have been contracted for delivery up to 2012. Another 28 rigs are expected to be leased up to 2017, bringing the total to 57 new drilling rigs. In addition, the company is planning to contract 40 drilling ships and semi-submersible drilling platforms capable of operating in deep and ultra-deep waters. Of that total, plans are for the first twelve units to be contracted internationally and to be received by 2012, giving time for the Brazilian shipbuilding industry to mobilise so it can produce the remaining 28 vessels needed for delivery between 2013 and 2017. The addition of tankers, supply and other vessels will bring the total to 175 within a few years.

In broader terms, Petrobras's plans dovetail with President Luiz Inacio Lula da Silva's national economic development programme. Apart from the increased need for materials and supplies, there are few sectors as labour-intensive as shipbuilding. In tandem with the news coming from Petrobras, at the end of May, Lula launched a "naval industry" plan that forecasts orders for 146 units -- all related to oil, gas, and environmental monitoring activities -- budgeted at approximately 5 billion dollars. In addition to the jobs created during the construction phase, it is expected that thousands will be needed to run and maintain these vessels. However, although this is unquestionably a great opportunity for the country, currently the educational system is failing to deliver qualified labour. Clearly, industry's capacity to gear up at the speed Petrobras and the government expect will be inexorably linked to investments and attention being paid to the entire education system.

Refining. The refining side of the equation could prove to be the weak link. Brazil's total refining capacity reaches 1.98 million barrels per day (b/d) (with utilisation rates averaging 90%), in addition to the 281,000 b/d coming from Petrobras's US, Argentine and Japanese refineries. Thus far, this amount has fallen short of meeting the country's specific needs. The situation is unique. Although in theory Brazil is self-sufficient in oil production, producing and consuming approximately 2.2-2.3 million b/d, its refining park is antiquated and set for processing the light crude it used to import from the Middle East. That means that Brazil still needs to import light oil and sell heavy oil, and it imports diesel and exports gasoline:

1. Ethanol strategy. Brazilian consumption of diesel has increased substantially in the last year, owing to economic growth and the preponderance of road transport. Combined with high oil prices, this caused Brazil to register a 2.75 billion dollar deficit in its petroleum import accounts in the first quarter of 2008 alone -- a 627% increase year-on-year. This context may help explain why Petrobras is content to keep the domestic price of gasoline (a product it exports) relatively low:
   
   
   • Arguments that prices have increased substantially if the appreciation of the real is considered offer only a partial explanation.
   • The real has appreciated in relation to the dollar by a factor of 2.0 from 2003 to 2008, while oil has appreciated by a factor of 3.7 during the same period.
2. Keeping domestic prices fairly low does help economic stability. On the other hand, low prices encourage consumption, and in this case, serve to compound pressures. However, Petrobras is depending on ethanol producers, who have no other significant markets and must sell their product at a discount to gasoline, to make up the difference. This way Brazil's light passenger fleet consumes more ethanol than gasoline, and Petrobras is able to sell its surplus to international markets (although little goes to the United States, as its refining park is not able to deliver product to strict US specifications).
   
   
3. Refining expansion. The numbers must be considered in the full context of Petrobras's overall financial balance: despite refining woes, the company posted net profits of 6.9 billion reais (4.3 billion dollars) in the first quarter of 2008, up 68% year-on-year. Nevertheless, this is a delicate situation. Should international markets, particularly the buoyant US ethanol market, open to Brazilian product, Petrobras might have to deal with this refining shortfall sooner than it would like ( see NORTH AMERICA/BRAZIL: Ethanol key in fuel market - July 20, 2006). This situation arises from a lack of planning and forward investments in refining, although Petrobras is far from alone among oil companies that did not see the shortages coming.
   
   To compensate, the company is planning a very aggressive programme of upgrade and construction of new refineries. The objective is to be able to supply all of the Brazil's product needs and to set the country as a refined product exporter; as Lula recently declared, Brazil is unlikely to join OPEC as it does not plan to become a crude exporter. Moreover, as Gabrielli recently pointed out, Petrobras is unique in its class as its revenues are 85% dependent on the domestic market. However, these are early days, and it is still unclear which investments will come to fruition. Several refinery projects have been announced:
   
   
   • Comperj. This integrated petrochemical project in Rio de Janeiro will involve total investments of 8.4 billion dollars, with Petrobras responsible for 4.6 billion. Output will reach 150,000 b/d of heavy oil from Marlin, Campos Basin.
   • Pernambuco. This project involves Petrobras in partnership with Venezuelan state oil company PDVSA, with total investments of 4.1 billion dollars, of which 2.4 billion will come from Petrobras. Output will reach 200,000 b/d -- 60% from Petrobras and 40% from PDVSA -- producing diesel and liquid petroleum gas (LPG) for the northeastern markets.
   • Rio Grande do Norte. A new plant to produce gasoline and improve the quality of other oil products (aviation fuel, diesel, and LPG), which will start in 2010.
   • Ceara. A study with the state government plans for construction of a 300,000 b/d refinery to start in 2014.
   • Maranhao. A study with the state government plans for construction of a 600,000 b/d refinery to start in 2013.

CONCLUSION: There is no doubt that the energy equation in Brazil, and consequently in the Americas, has shifted. Nonetheless, development will take time and success will require all agencies involved to stay focused and to make all investments necessary in a timely manner. Moreover, Petrobras will have to become increasingly efficient if it wants to expand in all fronts simultaneously. However, the pragmatism that forced Brazil to look at energy development from a strategic resources perspective now appears likely to pay off.