Ana Luiza Cruz Vizaco June 24 2013 Exploration in pre-salt layer: historic development and dreams of independence Karim Vakil & Cruz Vizaco Advogados | Energy & Natural Resources - Brazil Ana Luiza Cruz Vizaco Energy & Natural Resources IntroductionRoyaltiesBidding roundsCommentIntroductionInvestment in the Brazilian oil and gas industry began over 60 years ago, when the government became aware that there was great potential for the exploration of such natural resources in the country.This perception resulted in a number of developments, including the creation of Petrobras, which was made responsible for all activity related to the commercial exploration of such commodities, as they are considered part of the country's assets. The significance of this development was highlighted in a speech by then-President Getúlio Vargas, who declared that Petrobras would make Brazil's economic independence possible.In 1997, more than four decades after the creation of Petrobras, Brazil opened up the oil and gas sector, broke part of Petrobras's monopoly and allowed foreign players to participate in the exploration and production processes. From then on, both Brazilian and foreign companies were able to participate and help in the development of local activities related to the oil and gas industry.By this point, Petrobras had become one of the largest and richest oil companies in the world. Investments originating from the private and public sectors, as well as local and international institutions, boosted the economy and marked Brazil as one of the most important centres of oil and natural gas production.However, the best was yet to come: the discovery of oil in Brazil's pre-salt layer. Following this discovery, demand rapidly increased. The existence of new, substantial reservoirs of high-quality oil provoked huge interest from all over the world, with global demand for the commodity ever increasing, especially in China and India, and even in Brazil itself.Exploration in the pre-salt layer is expected to help Brazil to continue its ascent as one of the biggest oil producers in the world. As a result, the government suspended the rounds containing offshore blocks in order to list and organise the future concessions of blocks that would be offered.RoyaltiesAs a consequence of government action, three different regimes now guide the exploration and production of oil and natural gas in Brazil, as follows:Concession agreements - these are applicable to the post-salt layer and the areas of the pre-salt layer tendered before the regulatory restructuring. The concessionaires pay royalties equivalent to 10% on their production. However, in the largest fields, companies holding a concession must also pay a special participation fee of up to 40% of the field's net revenue. The larger the profit, the higher the percentage will be.Production sharing agreements - these are applicable to the areas recently discovered to contain oil in the pre-salt layer. No special participation fee applies, only royalties equivalent to 15% of the total production.Onerous assignments - in 2010, the government executed the mega-capitalisation of Petrobras so that it would have the resources to sustain the exploration of oil in the pre-salt layer. In parallel with the initial public offering (which raised $70 billion for Petrobras), the government transferred fields containing an estimated production capacity of 5 billion barrels to the company. No special participation fee is due, just royalties.Many market specialists have argued that by providing onerous assignments, the government has created a scenario in which Petrobras focuses its investment efforts on fields inside the regime, without paying much attention to mature fields, due to the efficiency of the former. As a result of these concerns, the National Agency for Oil, Natural Gas and Biofuels (ANP) recently intervened and notified Petrobras that the company must present plans to increase production in mature fields as well.According to recent media reports in a national newspaper, the production of oil will double in 10 years, but monetary compensation will rise by only 55% in the same period.Controversy has also emerged regarding the distribution of royalties (for further information please see "Division of royalties causes friction between states"). The federal states that are not involved with any phase of exploration and production wish to benefit from the financial results of royalties, which are expected to increase considerably in future. Royalties on oil and natural gas were introduced back in 1953, during the same period as Petrobras's incorporation, when the intention was to offer a partial return on investment to states involved in the production of oil and natural gas, providing compensation for all damages suffered locally.As it is hard to achieve agreement on a political level, the Supreme Court will be responsible for defining if adjustment in the distribution of royalties should be applied.Bidding roundsEleventh roundMay 2013 saw a number of important events and releases, such as the 11th oil and gas bidding round (for further information please see "Agency announces 11th oil and gas bidding round"). After more than five years without offering any areas in deep waters, ANP hosted the 11th round in mid-May, covering 289 blocks distributed in 11 sedimentary basins.Local authorities were expecting to collect R3 billion in investments to fulfil the minimum exploratory programme demanded by ANP. A total of 64 companies participated, and 30 consortiums (18 foreign and 12 national participants) won concessions across the 11 basins. Furthermore, 142 blocks were taken in concession, totalling investments of at least R7 billion in the exploration phase.The biggest bonus paid for a single block was that bid by the consortium formed by Total E&P (holding 40%), Petrobras (holding 30%) and BP (holding 30%) for the Foz do Amazonas Marítimo 57 block, which amounted to R345.9 million. Signing bonuses totalled approximately R2.82 billion (around USD1.32 billion) - the best result in the history of the rounds.Furthermore, for the first time in local history, British company BG applied as an operator. Total and Exxon were eager to win, while Brazilian OXG and Queiroz Galvão increased their participation in deep-water fields.Twelfth roundKeeping in mind the extraordinary results of the 11th round, and given the proximity of upcoming presidential elections, the government recently decided to bring forward the first tender involving pre-salt layer areas under the new production sharing agreement regime to the second half of October 2013.For this round, only the Libra area (in the Santos Basin) will be offered, with possible reserves containing from 8 to 12 billion barrels of oil equivalent (the biggest reserve offered in a single tender worldwide, constituting up to 80% of all proven reserves with oil in Brazil). The new field is estimated to be twice as big as the Lula field (formerly known as the Tupi field), which was the first discovered in the pre-salt area and motivated the adjustments in the regulatory framework.Government sources affirm that the tender could raise up to R9 billion in signing bonuses (more than three times that of the 11th round) and investment to develop Libra could vary between $250 billion to $500 billion in the long term.In light of the above, ANP believes that only major players will participate in this tender, including Asian companies. It has also informed potential parties that the company offering the highest profit percentage will be the winner - in the sharing agreement regime, the company (or consortium) can claim profit for the activity (after deducting investments and production costs), which will be divided with the union (which remains the owner of the oil).Under the existing regulation, Petrobras will be the operator, with a minimum participation of 30% in the consortiums. The expectation is to have a percentage of 73% or 74% offered to the union.CommentBoth history and recent events demonstrate that investment in the Brazilian oil and gas industry has increased significantly since acknowledgement of the sector's existence in the country, and is likely to continue to do so in future.However, local protectionist politics interfere in this market more than they should and the guidance of Petrobras is often seen to grant the government free rein. These concerns, added to a constant eagerness for the financial benefits that this industry can bring, have led to much internal discussion and may diminish the safety of investment indexes in Brazil. The war on royalties, for example, generates yet more instability and may result in the suspension of a large amount of investment essential to national development.Moreover, according to a comment made by Statoil's chief executive officer, Helge Lun, in a recent interview: "Without efficiency there is no oil." Lun argued that efficiency should begin with a good regulatory framework, stipulating goals and a deadline for when subsidies should be ended. However, he argued that it is also essential to create a culture of competitiveness between those who receive money from the government. He further argued that the only way to follow through the task of exploration and production is to invest in intelligence, technology and innovation. He added that large oil companies are transforming themselves into organisations pre-occupied with productivity gains and risk management.It is true that Petrobras has always participated in and financed research centres in the country. For example, the Centro de Pesquisas Leopoldo Américo Miguez de Mellow (Petrobras's research arm responsible for developing systems and equipment) has allowed Petrobras to consolidate and expand its activities into the global energy sector; indeed, Petrobras is famed worldwide for its know-how in relation to the exploration of oil in deep water and runs the biggest research and development centre in Latin America.In practical terms, Petrobras has reduced by 45% the costs for drilling the pre-salt layer since 2008. The company has also reduced the time taken for drilling, after becoming better acquainted with the areas and using new and adjusted technology.With regard to the economic independence commented on by Vargas in 1953, Petrobras has plans to replace the light oil imported at present. Furthermore, it later intends to be a bigger exporter of both the commodity itself and its high-added-value derivatives. As the oil of the pre-salt layer is of a higher quality, the company may sell the commodity with fewer discounts, resulting in a greater return in investments and contributing to the development of production and an increase in exports.Brazilians view Petrobras with great pride, for good reason, but the country faces many other adversities in the oil and gas exploration and production industry that may jeopardise investment in the country. If these obstacles can be overcome, the industry could create even more benefits to society in the long run.For further information on this topic please contact Ana Luiza Cruz Vizaco at Karim Vakil & Cruz Vizaco Advogados by telephone (+55 21 8151 0018) or email ([email protected]).