Will new rules dim Brazil's presalt promise?

Seven years ago, Brazil's state-owned oil company, Petrobras, and several foreign partners, including Exxon and Britain's BG Group, discovered a huge bounty of oil in a new oil province known as the presalt, approximately 300 km (186 mi) offshore from Santos in southeast Brazil.

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Ken Hurwitz
Attorney at Law

Seven years ago, Brazil's state-owned oil company, Petrobras, and several foreign partners, including Exxon and Britain's BG Group, discovered a huge bounty of oil in a new oil province known as thepresalt, approximately 300 km (186 mi) offshore from Santos in southeast Brazil. The oil is 7 km (22,965 ft) below the South Atlantic, under a thick bed of salt. Geologists estimate that the new find contained 50 to 123 Bbbl of recoverable oil, greater than the proven reserves of Mexico and the North Sea combined.

In 2010, driven by a desire to have the state tightly control the new bounty, Brazil altered its existing legal framework for exploration and production from presalt resources, while grandfathering in concession arrangements already in place. Legislation was enacted placing Petrobras and a new state-owned entity, Pre-Sal Petroleo S.A. (PPSA), at the epicenter of the high-stakes opportunity, potentially pushing aside investment by non-Brazilian oil companies, and, some have claimed, at the same time diminishing competition and sacrificing exploration and extraction efficiency. A strong impulse toward state-directed capitalism resolved into aggressive local content requirements. The new regulatory regime also promoted social welfare goals by channeling government takes of profits from offshore oil revenues into educational, cultural, social, health, and environmental programs. Whether these reforms will benefit or will compromise efficient development of the presalt, evade easy answers, but the Brazilian offshore oil sector might be headed in the wrong direction.

Legal commentators tend to focus on the fact that, for presalt resources, Brazil replaced its long-established concession system with a production-sharing arrangement. Under a concession system, the host country sells title to its hydrocarbon rights to the highest bidder, which is given exclusive rights to explore within a given area, at its sole cost and risk. Title to any oil produced vests in the winning bidder at the wellhead, with the attendant right to sell and export the oil, in exchange for royalties paid to the government on the oil produced. Brazil's concession system set royalties at 10%, along with a requirement to pay higher special participation fees if a large volume of oil is produced.

In form, production-sharing arrangements are fundamentally different because the host government retains title to the mineral resources in the tendered area, but gives the winning consortium the exclusive right to explore and produce the oil, again at its own risk and cost. If the field is viable, the consortium receives, up to a cap, an in-kind payment to reimburse its exploration and production costs—"cost oil." The remaining oil—"profit oil"—is divided between the government and the consortium in accordance with the production-sharing agreement, but the government share must be no less than approximately 40%. The government is paid through its share of profit oil and the payment of a signature bonus and royalties; the consortium sells the cost oil and its share of profit oil to realize a return on its investment.

At first blush, the concession system and production-sharing contracts appear different because of their distinct arrangements as to the ownership of hydrocarbon resources and the distinct nomenclature delineating how and in what amount consideration flows between the government and the consortium. However, the differences in ownership structure, and in particular the retention by the government of the mineral resource in a production-sharing contract, are largely symbolic, primarily serving a political function. The fiscal terms of concession arrangements and production-sharing contracts can be adjusted to yield identical outcomes. So what is truly behind the Brazilian reforms?

The overriding goal appears to be to fortify Petrobras as one of the world's leading national oil companies and to establish Brazil as a major player on the international energy stage. The degree of control vested in Petrobras and PPSA over presalt resources is nothing short of staggering. Brazilian law now requires that Petrobras hold no less than a 30% equity stake in any consortium that bids on a production-sharing contract block, and Petrobras has the right to increase its stake above this level. Petrobras may even be awarded blocks without having to participate in formal bidding.

The new law also provides that Petrobras must be the operator in every production-sharing contract block, relegating other oil companies to merely holding a financial stake (unless Petrobras contracts with a company to conduct operations). Moreover, other consortium members will be unable to exert significant influence on operating committees, which control budgets, declarations of discoveries, exploration work, development programs, and other key management decisions—because the PPSA will have the right to nominate half of the consortium's operating committee members, notwithstanding the individual company's percentage stake in the consortium. The government also decreed that up to 70% of the equipment and supplies to develop the presalt, including rigs and FPSOs, must be nationally produced.

It is possible that, in the long run, Petrobras' commanding role will discourage international oil company participation in exploring and producing the presalt resource. Early indications point in this direction. While the May 2013 auction for exploration rights, which employed the concession model, yielded record bids from both national and foreign companies, yielding 12 winning companies, the first presalt auction under the new rules in October 2013 produced only one bidder, a consortium of Petrobras (40%), Shell and Total (20% each), and two Chinese firms, CNPC International and CNPPC International (10% each). The paltry competition might mean that efficiency has not been optimized. It is also concerning that Petrobras, by acting as operator for every presalt block, will be spread too thin, and be forced to concentrate its resources on the most promising blocks and neglect other blocks containing substantial reserves. Finally, the demanding local content requirements probably signal higher costs, since Brazilian firms will not have to meet competition from around the world.

The bottom line is that Brazil's presalt oil reserves will clearly be a boon for Brazil. But questions linger. Do the benefits outweigh the costs of diminished competition? Time will tell.

The author

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Ken Hurwitz is a graduate of the University of Pennsylvania Law School and the Wharton School. He practices energy and environmental regulatory law, representing clients in the oil and gas production, transportation, and marketing sectors. He is a recognized authority on offshore safety, operation, and environmental regulation.

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