On Tuesday 24 June 2014, the Brazilian government unexpectedly granted new oil and gas production rights to Petroleo Brasileiro S.A., the state-run oil company better known as Petrobras. The rights in question relate to four fields in the Santos basin ‘pre-salt’ cluster: huge oil and gas reserves located under a thick layer of salt at depths of around 7,000 metres offshore Brazil. In 2010, Petrobras was granted exclusive rights to produce up to five billion barrels from the Búzios, Entorno de Iara, Florim and Nordeste de Tupi fields, in return for the issue of US$42 billion in shares to the Brazilian state. Its exploration of these fields has since revealed that the reserves far exceed five billion barrels, and last week mines and energy minister Edison Lobão announced that Petrobras would be awarded the right to produce remaining reserves from these areas under a production sharing regime. The additional volumes are estimated at between 10 and 15 billion barrels.

The announcement has taken the market, and even members of Petrobras’ board of directors, by surprise; coming without warning at a time when most of the country is focused on the World Cup. This timing may not be a coincidence! The terms of the deal are unusual and have been criticised by a number of analysts, with Petrobras’ share price falling on the news.

Terms of the deal

The Production Sharing Agreement (PSA) will have a duration of 35 years and Petrobras will be entitled to between around 51.5% and 53.5% of profit oil, depending on the field. This is less than the 58.35% that Petrobras and its consortium partners are entitled to under the only other pre-salt production sharing agreement signed to date; for the 8 to 12 billion barrel Libra field that was auctioned last year. It was not clear what proportion of total production will be available for recovery of Petrobras’ costs, nor what costs will be recoverable under the PSA, considering that some of the development costs would inevitably have been incurred in the production of the first five billion barrels already awarded.

Most controversially, Petrobras will be required to make advance payments totalling R$15 billion between 2014 and 2018, even though first production of additional volumes is not expected until at least 2021. These required payments come at a time when Petrobras’ cash flow is already stretched by its US$220 billion four-year investment plan, and when the government is forcing it to sell refined oil products for less than it is paying to import them. Critics have suggested that these payments are motivated by the government’s need to plug a short-term budget deficit and its desire to extract Petrobras profits up front, rather than sharing in dividends with minority shareholders.

The government and Petrobras’ management have been at pains to stress that this is a good deal for Petrobras, but many financial analysts are sceptical. Perhaps more worrying than the financial terms is the way the deal seems to have been imposed by the government behind closed doors, despite the clear conflict between the government’s interests and those of Petrobras’ minority shareholders. The deal was reportedly announced without having been discussed at a board meeting, with two of Petrobras’ three independent directors stating that they learnt of the agreement through a securities filing.

Consequences for the Brazilian oil industry

Many other oil companies will be disappointed not to have had the opportunity to bid for these valuable reserves. However, federal law no. 12351/2010, which introduced the production sharing regime for pre-salt acreage in Brazil, does expressly permit the government to directly contract Petrobras as an alternative to awarding PSAs pursuant to a bidding round. This strategy makes some sense, in so far as it relates to acreage that Petrobras will be developing anyway, to produce the first five billion barrels acquired in 2010. Petrobras should benefit from synergies and be incentivised to maximise recovery levels following this new award. However, the government could have required the relinquishment and rebidding of certain fields, given that the first five billion barrels are likely to be available from the Búzios field alone, or it could have auctioned minority stakes while maintaining Petrobras as operator, as it did for Libra.

Unfortunately, this decision seems to be part of a wider trend for this government to seek to concentrate the Brazilian oil industry in the hands of Petrobras. The PSA law already required Petrobras to operate all newly awarded pre-salt blocks with a minimum 30% stake. Petrobras certainly has unrivalled expertise in the development of these technically challenging pre-salt areas, but there is concern that no single company has the organisational capacity to simultaneously develop so many projects of this scale. This concern is exacerbated by the cash flow issues described earlier and recent project delays, which have caused Brazilian oil production to stagnate over recent years, notwithstanding unprecedented exploration successes.

It is unclear how Petrobras will finance the additional investment demands of this project, but its CEO Maria das Graças Foster has ruled out bringing in partners or issuing further shares. Petrobras is already highly leveraged, so Ms. Graças Foster suggested that it may raise up to US$11 billion in asset sales over the next five years. To date, Petrobras has been reluctant to reduce its upstream activity in other areas in Brazil, even in mature onshore basins. It is to be hoped that its growing pre-salt demands will encourage Petrobras to offload some of these assets to independent players who will focus on further development and maximising recovery. If Brazil is to maximise the benefits of its oil riches and avoid Petrobras bottlenecks, it should also resume competitive bidding and reconsider Petrobras’ position as sole operator in the pre-salt. The state oil company already has plenty on its plate!