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Investors See Petrobras Peril of Ignoring BP Oil Drilling Spill

Jose Sergio Gabrielli, ceo of Petroleo Brasileiro SA
Jose Sergio Gabrielli, chief executive officer of Petroleo Brasileiro SA, speaks during an interview at company headquarters in Sao Paulo on April 30, 2010. Photographer: Paulo Fridman/Bloomberg

Lucia Rodriguez Ilaria figured it would be easy to get a big crowd together in Brazil’s largest city to demonstrate against BP Plc, the company responsible for the largest oil spill in U.S. history. The June 12 event in Sao Paulo was part of Worldwide Protest BP Day, an event organized in 52 cities across five continents that aimed to start a boycott of BP products. About 350,000 people signed on for the protest on Facebook.

In Sao Paulo, eight people showed up for the rally at Ibirapuera Park, Bloomberg Markets magazine reports in its September issue.

“I don’t think they’ll care until there’s a wake-up call, like if it happened off the coast of Rio de Janeiro tomorrow,” says Rodriguez, 26, a translator and organizer of the Sao Paulo event.

As the failure of the protest makes clear, few Brazilians are in the mood to rail against the dangers of the deep-water oil drilling that’s at the root of the Gulf of Mexico disaster.

That’s because Petroleo Brasileiro SA, Brazil’s state-controlled oil producer, does little else. Ninety percent of Petrobras’s domestic production comes from beneath the waters of the Atlantic Ocean. The company in 2009 pumped 20 percent of all the oil drawn worldwide from water deeper than 1,000 feet (300 meters), more than any other oil company, according to data compiled by PFC Energy, a consulting firm.

Exxon Mobil Corp. was second with 13 percent.

Out of Poverty

President Luiz Inacio Lula da Silva says Brazil is relying on the deep-water oil to raise the nation of 191 million people out of poverty. Geologists estimate that just one recent strike, in a field called Tupi, contains 5 billion to 8 billion barrels of oil, worth $600 billion at the Aug. 2 price.

The Brazilian government owns 56 percent of the voting shares of Petrobras and 32 percent of the total shares. The company has budgeted $108 billion during the next five years to expand production, mainly from offshore fields. About $25 billion of the cost will be funded through a new share issue, originally scheduled for July and now postponed until September.

Investors nervous about the share issue have driven Petrobras’s stock price down 21.5 percent since the beginning of the year, to 32.68 reais ($18.71) on Aug. 2. They are concerned that a large stock sale will dilute earnings per share, says Eric Conrads, a hedge fund manager at Mexico City-based Armada Capital SA.

Investors are also worried about an elaborate oil-for- shares swap designed to guarantee that the government maintains control of the company.

Oil-Share Swap

Under the deal, the government will hand over to Petrobras the rights to as many as 5 billion barrels of publicly owned oil -- all of them still under the Atlantic -- in exchange for enough shares to maintain or exceed its current stake. Uncertainty about the price the government will put on that oil -- the in-the-ground price could be anywhere from $5 to $10 per barrel -- has made investors wary.

“There’s still a lot of questions in the air on the transaction,” says William Landers, who oversees about $8 billion in Latin American stocks at BlackRock Inc. “I think that is why Petrobras continues to underperform.”

Investors also complain that the government, eager to fill its coffers with oil revenue, is exerting too much control over Petrobras.

“The stock did phenomenally well when it was being run with private-company-type objectives and management being largely depoliticized,” says Christopher Palmer, who oversees $5 billion as head of global emerging-market stocks at Gartmore Investment Management Ltd. in London.

Rating at Risk

Gartmore owned more than 6 million Petrobras shares as of mid-July, according to data compiled by Bloomberg.

One reason Petrobras needs to sell equity is that a large increase in debt would put the company’s investment-grade rating at risk. Standard & Poor’s cut Petrobras one level to BBB-, the lowest investment grade, in June 2009 on concern the investment program was too big. The company’s debt-to-equity ratio is currently nearly 32 percent.

Petrobras Chief Executive Officer Jose Sergio Gabrielli says the company needs to keep it below 35 percent to avoid a new downgrade.

Gartmore’s Palmer says that Petrobras ignores the lessons of the BP spill at its peril.

“One of the things you wouldn’t want as an investor, a politician or a voter is for Petrobras to rush into this,” he says. Much of Brazil’s oil is trapped beneath layers of salt deposited eons ago miles below the floor of the Atlantic.

These “pre-salt” formations, geologists and engineers say, are far more difficult to access than the oil in BP’s Macondo well that’s polluting the Gulf of Mexico.

‘To the Moon’

“Going down into the pre-salt is like going to the moon,” Palmer says. “They need to take a step back from this and say, ‘Are we going at the right pace?’”

Several oil-producing countries have adopted new precautions. On May 27, U.S. President Barack Obama imposed a six-month ban on the launch of new deep-water facilities, halting work on 33 rigs. When a federal court struck down the ban, Obama reinstated it on July 12, using different criteria.

Norway on June 23 removed four exploration blocks in the Norwegian Sea from a licensing auction while it studies the causes of the Gulf disaster.

Lula, who will leave office on Dec. 31 after serving two four-year terms, has no plans to slow down the pace of drilling.

“Pre-salt exploration will allow us to invest in education, the environment and fighting poverty,” Lula said last September.

Very Deep Drilling

Brazil’s Senate voted 44-6 on June 9 to give Petrobras access to new areas in 7,000 feet of water, where high pressure and low temperatures at the seafloor make it difficult to do oil-well repairs.

BP’s Macondo well is in 5,000 feet of water about 40 miles (64 kilometers) out to sea.

Petrobras, founded in 1953, spent its first two decades as a refiner of imported oil, since its efforts to find oil and gas on land largely failed. Then, the company discovered the offshore Campos Basin in 1974.

The company now does deep-water drilling in Brazilian waters and in the Gulf of Mexico and West Africa.

The potential windfall from Tupi, one of the biggest finds ever in the Americas, has emboldened Lula to increase the government’s stake in Petrobras and reverse the opening of Brazilian oil drilling to foreign companies that took place in the late 1990s.

BP in Brazil

San Ramon, California-based Chevron Corp, Madrid-based Repsol YPF SA and The Hague-based Royal Dutch Shell Plc are now producing oil in Brazilian waters. Soon to join them: BP. In March -- a month before the Gulf oil spill -- the British company agreed to buy eight offshore exploration blocks from Oklahoma City-based Devon Energy Corp. as part of a $7 billion purchase of Devon’s offshore assets in Brazil, the Gulf of Mexico and Azerbaijan.

Last year, Lula introduced legislation, which has yet to pass, that would make Petrobras the operator of all new pre-salt oil fields and reduce the role of foreign companies to financial investors in projects in which Petrobras calls the shots.

Meanwhile, local politicians are fighting over how to divide up what they hope will be tens of billions of dollars in future revenues from the oil fields. All Brazilian states share royalties whether they produce oil or not. In early March, the lower house passed a bill that would increase the royalties for non-oil-producing states by as much as 26 percent.

Rio Protest

More than 80,000 people filled downtown Rio on March 17 on a rainy afternoon to protest the bill. Rio de Janeiro state, which produces 68 percent of the country’s oil and natural gas, has the most to lose from any changes in the royalty structure. Further action on the bill has been delayed until after the October presidential elections.

Given the public enthusiasm for Petrobras’s deep-water projects -- or at least the money they’ll bring in -- it’s hard to find a politician who doesn’t back more drilling. Carlos Brizola, a Brazilian lower-house representative who led a committee this year that wrote a bill establishing new oil laws boosting government control of the industry, says there’s “no chance” Brazil will impose an Obama-style moratorium.

“Petrobras has consolidated its know-how and technology,” Brizola says. “No company can offer better safety than Petrobras.”

Brazil’s regulator, the Agencia Nacional do Petroleo, or ANP, set up an emergency committee to review the response to the Macondo spill and is working with oil companies operating in Brazil to step up inspections at oil fields.

Lula’s Reassurance

“We’ve been working together to prevent this from happening at our blocks,” ANP Chief of Staff Luis Eduardo Duque told an oil conference in Rio de Janeiro on June 1.

Lula, while inaugurating a new deep-water well at the Espirito Santo basin in July, said BP cut corners “to do it cheaper” at its Macondo well. “In Brazil, we will not allow something like this to happen,” he said.

Whatever precautions they take, the Brazilians will suffer from the aftereffects of the Gulf disaster. Since the April BP spill, insurers have been charging 50 percent more for policies covering rigs in deep waters, Moody’s Investors Service said on June 3.

“Without question you’re going to see higher costs and a slower pace of development,” says Ted Harper, who helps manage about $6.8 billion in assets at Frost Investment Advisors in Houston.

282 Fatalities

The oil workers union, the Federacao Unica dos Petroleiros, says Petrobras’s safety record is hardly pristine. The union says it has documented 282 fatalities among Petrobras staff and contract workers during the past 15 years in accidents at oil rigs and refineries.

The company responds that it has the lowest fatal accident rate of any oil company in Latin America.

Petrobras has also suffered 27 oil rig blowouts since 1980, two of them in the past 10 years, according to a presentation by Otto Luiz Alcantara Santos, a trainer from the International Association of Drilling Contractors.

In 2007, it took six weeks to plug a leaking well on land near the Espirito Santo Basin on Brazil’s eastern coast. The leak was finally plugged via a relief well of the kind being drilled in the Gulf, says Santos, who trains Petrobras staff in well control.

The most recent offshore blowout was in 2009 and was caused by an explosion in an offshore well in the Sergipe Basin. No one was killed, and Petrobras was able to plug the well in just two days by injecting fluids into the piping that remained after the explosion -- a technique that failed in the Gulf.

No Risk Aversion

“Like in aviation, you can’t completely eliminate risk,” says Fernando Siqueira, the president of the Association of Petrobras Engineers. “If an airplane crashes, you can’t shut down all aviation.”

To help fund its ambitious deep-water plans, Petrobras wants to raise a total of $58 billion from investors through stock and bond sales. The first step is the share sale set for September, which hedge fund manager Conrads says is likely to be postponed again.

“September is a month before the election, and it may become a very politicized topic,” he says. “I’m not sure it will happen this year.”

The oil-for-shares part of the plan involves government-owned petroleum reserves that now reside in the untapped pre-salt Franco field in the Santos Basin off the coast of Rio, 3.7 miles below the seafloor in waters 7,181 feet deep.

The Franco Field

It’ll take about five years to start producing at the field, with initial production projected at 50,000 to 100,000 barrels a day, says Hugo Repsold, an exploration and output manager at Petrobras.

Franco, which holds an estimated 4.5 billion barrels in recoverable reserves, won’t be enough. The government is still deciding what other petroleum blocks it will include in the transaction.

Investors say Petrobras shares are languishing because no one knows what the Franco field oil is worth -- partly because the infrastructure needed to drill it hasn’t been built. The government commissioned an independent assessment of the reserves by energy consulting firm Gaffney, Cline & Associates Ltd. That report has been delayed until late August.

“It’s a political drama,” Gartmore’s Palmer says. “You think something is a plan, then it’s not a plan. It could be looking like a Gazprom,” a reference to the state-controlled Russian gas and oil company.

BlackRock Says Buy

Yet when all is said and done, Petrobras looks like a buy, BlackRock’s Landers says.

“It will be one of the few companies around the world with growing reserves and the capability to do this type of drilling,” he says.

And absent a Gulf-style disaster, one thing is clear: the Brazilians will keep drilling.

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