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reflections

Oct 22, 2013 | 01:01 GMT

5 mins read

Brazil: An Inauspicious Start to Pre-Salt Auctions

(Stratfor)
It can be difficult to separate the important from unimportant on any given day. Reflections mean to do exactly that — by thinking about what happened today, we can consider what might happen tomorrow.

More than five years after Brazil discovered massive oil reserves thousands of meters underneath the sea floor, the country's prospects of imminently becoming an economic and energy power are fading. On Monday, Brazil hosted its first auction of one of these fields, now known as pre-salt fields, but the event was met with skepticism and unrest. The inauspicious beginning shows how Brazil's geopolitical constraints have tempered once-promising expectations and how the country will have to focus on its domestic affairs.

Back in 2007, Brazil was in a state of euphoria. A consortium led by state-controlled Petrobras discovered the Tupi field in the pre-salt layer, a geological formation off the continental shelf of Brazil's coast that holds significant hydrocarbon resources. The Brazilian economy was growing by more than 6 percent per year, and there was a widespread feeling that Brazil would become a global energy and economic power. The country's largest companies were rapidly expanding and exerting their economic heft regionally and internationally. In a moment of hubris indicative of the era, former Brazilian President Luiz Inacio Lula da Silva famously remarked that the Tupi discovery proves that "God is Brazilian." 

This shift was on full display Monday as Brazil's National Petroleum Agency auctioned off the Libra bloc, which is expected to contain some 8-12 billion barrels of technically recoverable reserves, potentially doubling the country's total proven reserves and rivaling Tupi as the country's largest field. However, the auction had a lukewarm turnout; only 11 firms participated, compared to 71 firms in the previous conventional auction. The auction was further tainted by a strike involving members from Petrobras' workforce that eventually required military intervention to ensure order.But now the mood in Brazil is dramatically different. Since 2010, both oil production and economic growth have stagnated as demand for fossil fuels has grown. Companies that were once excited about the discovery of pre-salt fields are now complaining about the unfavorable conditions of the new regulatory regime, which was drafted in 2008 and 2012. Oil workers and civilians claim the government is effectively selling out the country to foreign interests. Whereas it once appeared to be on the verge of becoming a major energy player, Brazil now is struggling to increase oil production at home.

The field was ultimately auctioned off to a consortium composed of Petrobras (40 percent), Royal Dutch/Shell (20 percent), France's Total (20 percent), China National Petroleum Corp. (10 percent) and China National Offshore Oil Corp. (10 percent). Notably, the consortium's was the only bid made, and it offered the government the bare minimum of profits — 41.65 percent — under the new production-sharing regime. Given that no one firm should shoulder the entire 70 percent stake available, the "auction" was simply a way for firms to buy into a consortium to develop a pre-salt field. And since this was the first such auction under the new regulatory regime, it was also seen as a way to gauge the viability of the new system.

Neither a complete success nor failure, the auction demonstrates the ongoing constraints faced by Brasilia. On one hand, the country needs investment and foreign partners if it wants to increase hydrocarbon production. Pre-salt is simply too risky and expensive for Petrobras to develop alone, but the risks and the price tags have discouraged many firms from participating in pre-salt projects. On the other, the government wanted to keep Petrobras at the forefront of the technological frontier. It also wanted to support local industries and use the proceeds from the energy sector to fund its ambitious investment plans in education, health and infrastructure.

Ultimately it was these imperatives that led to the creation of the new regulatory system. The system ensured that Petrobras would have at least a 30 percent stake in every project; that it would be the primary operator; that firms would buy between 37 percent and 55 percent of their materials locally; and that proceeds would be tied to health and education investment. Moreover, Brasilia set a $7 billion signature bonus, making upfront costs extremely high. Unsurprisingly, these restrictions made participation costlier and riskier, forcing firms to either abstain from participation, as all U.S. firms did, or form into consortia to divide up the risk associated with the project.

Combined with changing global economic developments, the new regulatory environment has forced the country's major economic players to reconsider their plans for expansion. Investment abroad was formerly a significant lever for Brasilia, but Petrobras spent much of the past few years divesting its assets in Argentina, Peru, Colombia and the Gulf of Mexico to help finance its ambitious $237 billion investment plan. Rather than exerting its influence regionally, Brazil is reinvesting its money back home.

Brazil meanwhile had hoped to become a significant exporter of fossil fuels. But in order to maintain fuel subsidies, Brasilia forced Petrobras to import refined petroleum products and sell them at a loss. As a result, exports of crude oil have fallen, while imports of refined product have increased. Since the 2007 pre-salt discovery, Brazil's energy trade balance has actually worsened as Brasilia has tried to prioritize maintaining social stability at home through subsidies.

The nationwide protests in July 2013 and the Oct. 21 pre-salt auctions are somewhat foreboding. The country's challenges have come into focus this year in a way that was disguised by the prosperity of the 2000s. Development is not something that happens overnight; it is a long process requiring political and economic sensibility and skill. As the past six years have demonstrated, the pre-salt reserves will not propel the country into a new role as an economic and energy power. But at least they offer the country a way to continue the slow process of maturing into a stronger and more stable economy.

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