Brazil's Oil Euphoria

Petrobras’s offshore bonanza may transform the country -- if oil prices hold and the company can extract the crude from beneath kilometers of salt and rock.

By Jeb Blount and Adriana Brasileiro
Bloomberg Markets, May 2009

It was a Sunday morning in August 2006 when Gilberto Lima broke the bad news to Mario Carminatti, executive manager for exploration at Petroleo Brasileiro SA, Brazil’s state-controlled oil company. The company’s quarter-billion-dollar bet on a new offshore oil field was a bust.

Years earlier, Petrobras’s study of the geological formations beneath Brazilian territorial waters had indicated there was oil -- lots of it. So the company spent $240 million drilling a test hole in the seabed more than 300 kilometers off the coast of Rio de Janeiro state.

All the drillers found, said Lima, Petrobras’s general manager for exploration, was water, salt and rock.

“I told Gilberto, ‘That’s impossible,’” Carminatti recalls. “‘Tell them to look again.’ It was one of the worst days of my life.”

It turned out that the drilling crew had sunk the wrong probe through the test hole. When they took a new sounding, they changed their minds about the presence of oil.

They also changed Brazil.

What the Petrobras geologists discovered was a pool of petroleum, now called the Tupi field, that the company says may hold 5-8 billion barrels of oil and gas. That would make it the largest strike in the Americas since Petroleos Mexicanos, Mexico’s state oil monopoly, found its Cantarell Field in 1976.

Tupi is just one of several “elephant” finds of more than a billion barrels each. If they pan out, they may make Brazil the world’s fourth-largest oil producer after Saudi Arabia, Russia and the U.S. It’s now 13th, according to London- based BP Plc, which ranks countries by production.

Oil Euphoria

In the wake of the discovery, there was euphoria in Brazil. Citizens literally danced in the streets of Rio de Janeiro at 2008’s Carnival parades to celebrate the find, with one float named “The Black Gold That Comes From the Sea.” President Luiz Inacio Lula da Silva said the flood of oil money would allow the government to attack poverty among Brazil’s 191 million people, 24 percent of whom live on less than $3 a day.

Then the world economy hit a wall, and the price of oil sank to $32 on Dec. 12 from a peak of $147 on July 11. Even though prices have recovered somewhat -- they stood at $48.4 on March 30 --investors are now wondering whether Tupi will be a bonanza or a case of misguided national celebration.

Petrobras shares fell 45.2 percent to 28.78 reais on March 30 from their peak in May 2008.

Deep-Water Leader

Rio-based Petrobras leads the world in deep-water oil drilling; it operates dozens of fields in Brazil, Africa and the Gulf of Mexico. “At $140 a barrel, or even $70, you could make lots of money,” says John Ditierri, who manages $7 billion of developing nation stocks for Emerging Markets Management LLC in Arlington, Virginia. “At $20 or $30, it’s not worth anything.”

Ditierri won’t say whether his firm owns Petrobras shares.

Analysts say Brazilian officials shouldn’t underestimate the technical challenges of extracting oil from Tupi, no matter what happens to the price of crude. The field, in Block BM-S-11, lies 340 kilometers (210 miles) from the Brazilian coast beneath 2 kilometers of water and 5 kilometers of sand, rock and salt.

“Much of their planning is based on the assumption that they can use the same technology they are using to produce oil offshore today and that they will only need to make minor adjustments,” says Rio-based Sylvie D’Apote, a director at Cambridge Energy Research Associates Inc., or CERA, in Cambridge, Massachusetts. “If that turns out not to be true, costs are likely to rise a lot.”

Brazil could also be hampered by a surge of economic nationalism, says Adriano Pires, a former member of the national petroleum agency board and head of Centro Brasileiro de Infra Estrutura, a Rio-based energy and infrastructure research group.

Government-Controlled

Though the government owns 40 percent of the total stock and 58 percent of the voting shares of Petrobras, Energy Minister Edison Lobao wants to form a new state-owned corporation to take control of the offshore oil reserves.

Creating a new state company would let the government keep out foreign oil companies, which now have a big stake in some of Brazil’s offshore oil fields, usually through partnerships with Petrobras. In 2007, Lula’s National Energy Policy Council temporarily blocked the sale of new licenses for the exploration blocks around the Tupi site.

Petrobras’s government-controlled board has approved an ambitious agenda for exploiting Tupi and other new offshore fields. In January, the company announced a five-year, $174.4 billion capital spending plan, which represents a 55 percent increase over the 2008-12 budget it supplants. The company says the new spending will let it increase production 52 percent, to 3.66 million barrels a day, which would make Brazil the second- largest producer in the hemisphere, after the U.S.

‘A New Era’

“Tupi really marks a new era for Petrobras,” Chief Executive Officer Jose Sergio Gabrielli told Bloomberg News in July. “It will transform the company, and Brazil, forever.”

To follow through on the five-year plan, Gabrielli will have to borrow tens of billions of dollars in international markets. Each dollar decline in the price of oil cuts $500 million a year from Petrobras’s cash hoard, Chief Financial Officer Almir Barbassa says.

With crude at $47 a barrel, the company will generate about $120 billion in cash through 2013, Gabrielli says, meaning it will have to borrow $54 billion to finance the rest of its five- year plan. That’s more than five times the $10.6 billion of bonds and loans the company has coming due through 2023, according to data compiled by Bloomberg.

The price of five-year credit-default swaps linked to Petrobras’s bonds jumped 2.55 percentage points to 3.49 percentage points on March 30 from a low of 0.94 percentage points on May 19, 2008, according to CMA Datavision in New York.

Loan From China

That means it cost $349,090 to insure $10 million of the company’s debt against default.

Gabrielli is looking to China for cash. Petrobras and China Development Bank Corp. agreed on Feb. 19 to a $10 billion loan that Petrobras would pay back with future oil output. Final terms were still under negotiation as of mid-March.

“Capital is tough today, but the Chinese are willing to pay,” says Jorge Pinon, an energy fellow at the University of Miami and former head of BP’s operations in Latin America. “If they prepay, you can get the capital to begin the process.”

The oil price shock was just one link in a chain of bad news for the Brazilian economy. Gross domestic product shrank 3.6 percent in the fourth quarter of 2008, the worst quarterly result since at least 1996, according to the national statistics agency. Industrial output slumped 17.2 percent in January from a year earlier after a 14.8 percent drop in December, the worst downturn since 1992.

A record 756,694 Brazilians lost their jobs in December and January as companies cut output to adjust to falling demand.

Interest Rates Lowered

On March 11, the central bank cut the benchmark lending rate by 1.5 percentage points to 11.25 percent in an effort to stimulate growth. Only aggressive action to reduce borrowing costs will save Brazil from a deep recession this year, former central bank President Gustavo Franco says.

“This crisis is exceptional, and it’s having a much worse impact on the real economy than we imagined,” says Franco, who now runs Rio-based money management firm Rio Bravo Investimentos.

One bright spot: As of March 30, Brazil’s Bovespa stock index was up 8.3 percent for 2009 compared with an 10.8 percent drop in the Bloomberg World Index of equities.

Stable Nation

“Brazil has political stability, it has solid macroeconomic fundamentals compared with other emerging markets, and the central bank has a lot of fat to burn in terms of interest rates,” says Luiz Maria Ribeiro, who manages $1.2 billion in offshore funds at London-based HSBC Holdings Plc’s Brazilian unit. “That’s a positive outlook for equities.”

Officials are convinced the country’s economic future after the recession wanes will still lie offshore, beneath the Santos and Campos basins, which cover an area that’s bigger than California and stretches from Santa Catarina state in the south to Espirito Santo state in the north.

Petrobras has been extracting oil and gas from the Campos Basin since 1977, and the area now represents 85 percent of the company’s Brazilian output. Development of new Campos fields nearly doubled Brazil’s total oil production to 2.4 million barrels a day last year from 1.4 million barrels in 1998.

The Tupi find is in the Santos Basin, to the southwest of Campos. It makes Santos one of the major offshore exploration regions in the world.

Foreign Investors

U.S.-based Exxon Mobil Corp. and Hess Corp.; The Hague- based Royal Dutch Shell Plc; Madrid-based Repsol YPF SA; Reading, England-based BG Group Plc and others are exploring there under concessions from Brazil.

Santos is also home to Mexilhao, the country’s largest offshore gas field.

The block that Exxon Mobil operates in partnership with Hess and Petrobras just south of Tupi may hold another 8 billion barrels of oil, says Luiz Lemos, a partner at TozziniFreire Advogados, a Rio-based law firm that represents foreign energy companies with projects in Brazil.

Tupi is in a part of the Santos Basin known as the pre-salt cluster, so called because the oil is trapped beneath a 2- kilometer-thick layer of salt. Other big finds in the cluster include fields named Guara, Iara and Jupiter.

Ancient Lake

As Petrobras geologists explain it, the oil buried under the salt comes from the remains of a 130-million-year-old lake. The lake was formed as Africa and South America, once part of a supercontinent dubbed Gondwana, slowly separated, sending the lake and its rich layer of organic sediments to the bottom of what became the Atlantic Ocean, where they were gradually covered with sea salt.

Pressure, heat, time and the shifting of tectonic plates turned the sediment into oil.

The layers of salt and oil-bearing rock extend beyond the Tupi pre-salt cluster and run 800 kilometers along the Brazilian coast near Sao Paulo and Rio, some of it beneath existing Petrobras oil fields.

Petrobras’s P-34 production platform in the Campos Basin has been sucking oil out of pre-salt formations since September.

The whole pre-salt region may contain as much as 100 billion barrels of oil, says Marcio Mello, head of Brazil’s Petroleum Geologists Association and president of geology consulting company HRT Petroleum.

When the oil price was $147, it was worth almost $15 trillion to Brazil’s economy; at the $48 March 30 price, the number is nearly $5 trillion.

$600 Billion Expense

Zurich-based UBS AG estimates that exploiting the pre-salt region will take an investment of more than $600 billion in ships, drills, pipes and other equipment over more than two decades.

“It’s not a stretch to compare what Petrobras is doing with our U.S. space program,” says Tad Patzek, chairman of the petroleum and geosystems engineering department at the University of Texas at Austin. “I’m a little skeptical of talk that they can do it at $35 or $40 a barrel.”

To get to the pre-salt oil, Petrobras will have to sink tons of equipment to depths where the water pressure would crush a sinking ship like a soda can. When oil as hot as 100 degrees Fahrenheit (38 degrees Celsius) suddenly meets pipes rising through extremely cold water on the ocean bottom, paraffin, a waxy substance in the oil, can solidify and block the pipes.

Instability

Also, the instability of the salt layer makes horizontal drilling, which lets wells reach out to different parts of an oil deposit from a single location, very difficult. “If they have to drill all their wells vertically, the costs will increase,” says Sophie Aldebert, director of Latin America energy at CERA. “And without horizontal drilling, they may also not be able to maximize output.”

The movement to control global warming also presents an obstacle. Tupi, where Petrobras is scheduled to begin testing output May 1 and start production on a pilot basis in 2010, contains large amounts of carbon dioxide, a greenhouse gas that under Brazilian law can’t be released into the atmosphere.

Petrobras will get rid of the gas by reinjecting it into the wells, which is a good way to help maintain pressure, says Ricardo Luis Beltrao, Petrobras’s general manager for oil production research and development.

Getting workers and equipment to and from the offshore platforms is another logistical challenge. Helicopters can’t cover the 340-kilometer distance to Tupi and other offshore sites and back without running out of fuel.

The company may build floating storage and helicopter landing facilities the size of aircraft carriers between the shore and the oil platforms, says Guilherme Estrella, Petrobras’s head of exploration and production.

No Insurmountable Problems

Petrobras engineers and geologists are confident they can resolve the technical problems presented by pre-salt wells. “There are no insurmountable technical challenges facing us in Tupi -- none,” says Antonio Carlos Pinto, the manager of pre- salt production engineering. “A lot of what people say is totally wrong.”

For Patzek, the technical challenges are less of an issue than the financial ones. “We already know what the problems are with high-temperature, high-pressure offshore environments,” he says. “It means a lot of expensive steel, safety measures and a lot of expensive equipment. If they can keep their costs down or at the current level, they will do fine.”

Like Pemex in Mexico, Petrobras started life as a flag- waving assertion of national sovereignty. It was created by a 1953 decree issued by President Getulio Vargas, who helped popularize the political slogan of the day, “O petroleo e nosso”: “The petroleum is ours.”

Late Bloomer

Yet as late as the early 1990s, Petrobras was ridiculed by former Brazilian finance minister Roberto Campos as “the world’s largest oil company without any oil.” On the date of its birth, Oct. 3, 1953, Petrobras was producing just 2,700 barrels of oil a day, all from onshore fields. It would take until 2005 for Petrobras and Brazil to become net oil exporters.

Until 1997, Petrobras was largely owned by the state and had a monopoly on Brazilian production and refining. That year, in the wake of one of the country’s periodic financial crises, exploration was opened to foreign companies, a dozen of which now operate on Brazilian territory.

To compete, Petrobras management overhauled the company by putting a freeze on most hiring, taking on partners, listing the company on the New York Stock Exchange, reaching out to nongovernmental investors and subjecting operations to new financial controls.

Global Oil Company

Petrobras as of mid-March operated in 28 countries, and in 2008 it was the most-traded non-U.S. company on the NYSE, according to Petrobras. Within six months of the Tupi announcement, the preferred shares that investors usually buy had nearly doubled in value in both Sao Paulo and New York, and the company was the world’s fifth largest by market value -- bigger than General Electric Co. or Microsoft Corp.

Billionaire investor George Soros doubled his holdings in Petrobras in the fourth quarter of 2008, making his 1.45 percent stake in the company the largest single holding of his $21 billion Soros Fund.

With the government in control of almost 60 percent of voting shares, Lula says he still considers Petrobras part of Brazil’s national patrimony. “Petrobras is the mother of our industrial development,” he said in September. He has vowed that oil development will continue apace, even in the face of the economic crisis.

Not a Dollar Less

“There will be no cuts in Petrobras projects, not a single dollar,” Lula said at a forum for Brazilian governors in Recife on Dec. 2. He has made more than $5 billion available to Petrobras and its suppliers from state-controlled banks to back up his promise and start the company on its $174 billion spending spree.

The non-governmental shareholders who own 77 percent of Petrobras preferred stock and 42 percent of the common shares will have to forgo profits so that Petrobras can exploit the Tupi field and Brazil can meet its economic development goals, Lula says.

“The oil belongs to 190 million Brazilians, and we will show everyone that the oil is ours,” Lula, a former labor leader, told a meeting of Brazil’s metalworkers union in August.

Petrobras’s entanglement with the political establishment runs deep. Five of the eight members of its board of directors are government officials, and a sixth is a former army general. The chairwoman, Dilma Rousseff, is also Lula’s chief of staff.

Election Issue

He’s grooming her to succeed him as president in elections to be held next year. Rousseff is in charge of the government’s Accelerated Growth Program, a public-private investment plan to boost housing, create jobs and build infrastructure projects that has highlighted Petrobras’s activities as the government’s own.

The current front-runner in the race for President is Sao Paulo state Governor Jose Serra, who was favored by 43 percent of voters surveyed in a poll conducted by Brazil’s Sensus Polling in February. Rousseff scored just 13.5 percent.

Like many oil-rich emerging-market countries, Brazil uses its petroleum wealth to provide social benefits. Petrobras raised gasoline, diesel and cooking gas prices only twice in the 30 months ended in May 2008, and the increases did not capture even a small percentage of the rise in crude oil prices during that period. The government says the goal was to control inflation.

Inflation Buster

Petrobras hasn’t cut gasoline or cooking oil prices since petroleum prices dropped, which allows it to recover some of the forgone profits.

Petrobras has also built or taken over most of the country’s natural gas-fired power plants to help the government meet electricity demand during times when drought reduces hydroelectric output. Lula ordered Rousseff, his former energy minister, to make sure that the electricity shortages and rationing that hurt his predecessor, Fernando Henrique Cardoso, never happen on his watch.

With trillions of dollars at stake in Tupi and other pre- salt fields, Energy Minister Lobao has attracted widespread support for his plan to increase state control of the oil finds. In November 2007, all unleased exploration areas in the region were pulled from the Energy Policy Council’s lease auction.

No deep-water leases have been offered for sale by the National Petroleum Agency since, and future offshore auctions, which used to happen once a year, have yet to be announced.

Lula has said that all existing oil concessions and leases owned by Brazilian and foreign companies will be honored under any new system.

Chevron Disappointed

“Like everyone else, we would be very interested in being in Brazil,” George Kirkland, who oversees San Ramon, California-based Chevron Corp.’s exploration program, said in a March 10 meeting with analysts in New York. “We were very disappointed a year ago when that leasing round was delayed. We’ve got to have the opportunity to get in there.”

Investors are eager for Petrobras to get beyond the political posturing and start drilling. “This is a fantastic opportunity for them,” says Navaneel Ray, lead energy analyst and fund manager at TIAA-CREF Investment Management LLC in New York. “The world’s oil service and equipment companies have empty order books. Brazil is about the only good news for them. Petrobras has a lot of leverage to cut prices.”

As of Dec. 31, TIAA-CREF, which manages $363 billion, owned $152 million of common shares of Petrobras through U.S.-traded American depositary receipts, according to filings with the U.S. Securities and Exchange Commission.

New Refineries

Petrobras says it will have full-scale production under way at Tupi and surrounding deep-water fields by 2013. By 2020, it expects output of 5.73 million barrels a day. The company also plans to build at least five new Brazilian refineries, expand its petrochemical operations and continue exploration and production abroad.

“It’s more important than ever, in this moment of international economic problems, to press forward,” CEO Gabrielli told shipyard workers at the launching in October of the company’s $1 billion P-51 floating oil platform, the first such vessel built entirely in Brazil.

Brazil’s coast is dotted with shipyards building platforms that will pump oil from fields 300 kilometers out to sea. In mid-March, a production ship was on its way from Singapore to the Tupi well, where it was to capture the field’s first test oil. Drill ships are scattered beyond the horizon, looking for more of the black gold that Brazilians hope will finally live up to its promise.

Jeb Blount is a Bloomberg News reporter in Brasilia. jblount@bloomberg.net; Adriana Brasileiro is in Rio de Janeiro. abrasileiro@bloomberg.net.

		Email this article Printer friendly format