Proposals for a new petroleum regime in Brazil 1

Ever since the announcement of the Tupi discovery in November 2007, the eyes of the international oil industry have been firmly fixed on Brazil. This mega-field of 5 to 8 billion barrels of oil opened up an entirely new petroleum province, dubbed the “pre-salt” because its reserves are located beneath a thick layer of salt offshore Brazil. The pre-salt is widely expected to contain 50 to 100 billion barrels of oil, and promises to transform Brazil into one of the world’s leading petroleum producing nations.

The Brazilian Government responded quickly to the Tupi discovery by withdrawing a number of blocks in the pre-salt region from its ninth licensing round which was held in December 2007. Shortly afterwards, it announced a major review of Brazil’s petroleum licensing regime. After almost two years of deliberations, President Lula announced on 31 August 2009 his Government’s proposals for major changes to the country’s petroleum laws.

It was decided early on that Brazil would not seek to renegotiate existing petroleum concessions, even in the most prolific regions. The new regime will only apply to unlicensed acreage in the pre-salt region and other areas that may be classified as strategic by the Federal Government.

The Government has put forward a suite of four proposals:

• Use of production sharing contracts (PSCs), rather than the existing concessionary regime, in the pre-salt and other strategic areas. Petrobras, the State controlled oil company, will be granted operatorship and a participating interest of at least 30% in all PSCs.
• Creation of a new State oil company, dubbed Petro-Sal, to manage the State’s interests in the PSCs and the hydrocarbons produced.
• Grant of certain unlicensed pre-salt acreage to Petrobras in consideration for the State’s subscription for additional Petrobras shares.
• Creation of a federal social fund to manage the nation’s revenues from PSCs.

Production Sharing Contracts

Brazil will adopt a production sharing model for the pre-salt and strategic areas whereby oil companies, referred to as the “Contractor”, are granted the rights to explore for, develop and produce petroleum reserves, at their cost. The costs that the Contractor incurs are reimbursed by the State through an entitlement to production, referred to as “cost oil”. The PSC stipulates a maximum percentage of total production that may be characterised as cost oil, although, if a development is successful, the Contractor would expect to recover all of its historical costs over the term of the contract. The remaining petroleum, after deduction of cost oil, is referred to as “profit oil”. This is shared between the Contractor and the State in the percentages stipulated in the PSC.

Under the proposed Brazilian model, the Government may award PSCs to Petrobras as sole Contractor without holding a licensing round or it may tender blocks to other oil companies, provided that Petrobras must be the operator with a minimum 30% interest. Petrobras may bid alone or in a consortium to increase its participating interest beyond the minimum specified in the tender protocol.

Where PSCs are awarded to Petrobras without a tender, the Government will agree the profit oil split with Petrobras. Where PSCs are tendered, the bidders will specify a profit oil split, subject to a minimum percentage for the State that will be specified in the tender protocol. The company or consortium that bids to give the biggest share to the State will be granted a PSC for that block and Petrobras must match the profit oil split proposed by the winning bidder in respect of its mandatory operating interest. The tender protocol may specify that this percentage will vary in relation to the economic efficiency, profitability or volume of production or variations in the prices of oil and/or gas.

The Contractor will also be required to pay a signature bonus that is set by the Government, royalties and, in the case of onshore blocks, 1% of the value of production to landowners.

The attractiveness of this regime to independent oil companies will depend on a number of factors that are still unclear:

• Prospectivity of the blocks that will be tendered, as opposed to those granted directly to Petrobras.
• Maximum cost oil percentage.
• Minimum State share of profit oil and terms of the profit oil split; including whether this will vary according to production volumes, oil price, profitability or return on capital invested.
• Term of the PSCs (subject to a maximum of 35 years stated in the Government’s proposal).
• Minimum Petrobras participating interest, which may be increased beyond 30% by the relevant tender protocol.
• Minimum exploration programmes, required signature bonuses and royalty rates.

The switch to PSCs was widely anticipated by the industry, but the preferential treatment of Petrobras role may come as some surprise, given that it is treated no differently from other companies under the existing concessionary regime. Its predominance may worry oilfield service companies and suppliers investing in the region, who will become increasingly dependent on a single major client. However, Petrobras already has a leading role in the Brazilian market because of its local knowledge and deepwater expertise, so many international oil companies would elect to work with them in any event.

It is worth noting that the Government’s preferential treatment of Petrobras may be challenged on constitutional grounds, even if approved by Congress. By creating privileges for one private company and not offering those same privileges to other companies, there is a risk that the new law may violate the constitutional principles of “free competition” and “equality”.

Role of Petro-Sal

Petro-Sal will be a wholly State-owned company responsible for managing the State’s interests in the PSCs and the commercialisation of hydrocarbons produced therefrom. It will not operate or hold a participating interest, so it will not assume any risk or responsibility for costs of petroleum activities. However, Petro-Sal will be a party to the PSC and will nominate half of the members of the operating committee, including its president. It will therefore have voting rights and a power of veto over all significant decisions relating to activities conducted under the PSCs.

Although it is common for State oil companies to have wide ranging powers of veto in production sharing arrangements, the Government has recently emphasised that the switch to PSCs will allow them to increase control over the flow of oil production for political reasons. This may cause some concern for foreign investors who will want some comfort that their investments in exploration and development will not be frustrated because of conflicting Government interests. However, this is part of the political risk equation that exists in all petroleum activities. Even in concessionary regimes, the Government must usually approve field development and production plans and can effectively delay production if they wish.

Petro-Sal will be funded, in part, by management fees set out in the PSCs and a share of the signature bonuses. Petro-Sal will need to acquire a high level of technical competence to carry out this role, starting from zero. In a human resources market where Petrobras will be expanding aggressively, it may prove difficult for this new State oil company to attract and retain the necessary skilled personnel.

Direct Grant to Petrobras

Under the new proposals, the Government may grant pre-salt acreage directly to Petrobras containing a maximum of 5 billion barrels of oil equivalent of reserves. The reserves will be estimated and valued “in place” in accordance with international oil industry practice, as independently certified.

The value of the reserves transferred to Petrobras in this way will be used by the Government to capitalise Petrobras. The Government will subscribe for additional Petrobras shares up to the value of the reserves. Minority shareholders will be entitled to exercise “tag-along” rights, allowing them to pay an equivalent cash value to subscribe for additional shares in proportion to their existing shareholdings. It is not entirely clear whether these cash funds will remain with Petrobras to further capitalise the company and finance development of the additional acreage or whether it may be repaid to the State, resulting in a smaller capital increase. The former alternative would kill two birds with one stone, reducing the need for Petrobras to return to the market for additional financing. Not all Petrobras shareholders will exercise their tag-along rights, so the Government will also increase its percentage participation in the company.

The proposed law provides for the new shares to be paid for in federal debt bonds, which will be used by Petrobras to pay for the transfer of additional reserves. This mechanism avoids minority shareholders in Petrobras having to approve the valuation of the reserves and has been widely criticised in Brazil for side-stepping corporate governance safeguards.

Petrobras will carry out petroleum activities in these areas at its own risk and cost and will take ownership of all production from these areas up to five billion barrels. If it cannot produce five billion barrels from the areas initially transferred, it will be granted additional acreage and, if it produces in excess of five billion barrels, the excess will belong to the State.

The capitalisation of Petrobras and associated direct grant of reserves to Petrobras may raise constitutional issues. The Brazilian Constitution says that the State is the owner of petroleum reserves in the ground and that the right to develop and produce these reserves can be transferred to companies through tendered concessions. It does not envisage the unilateral transfer of acreage that has been proposed. There is therefore a risk that this mechanism will be challenged even if the law is passed in Congress.

Creation of Federal Social Fund

The final Government proposal is to create a fund to manage its receipts from PSCs, including its share of signature bonuses, royalties and receipts from the sale of profit oil. The proposed objectives would be to maintain financial stability as well as to fund programmes dealing with poverty, education, culture, science, technology and the environment. The fund would be managed in accordance with Government policy, under congressional supervision, and it is worth noting that the proposals expressly contemplate the possibility that this fund may be used for the State to acquire direct paying interests in PSCs.

The distribution of petroleum revenues in Brazil is a political hot potato. Revenues are currently shared between the Federal Government and its various organs, producing states and municipalities, in different proportions depending on whether they come from royalties, signature bonuses, special participations (a concessionary charge on profits from oil production) or other taxes. It is proposed that the existing royalty regime should be maintained, but that special participations would be abolished in the new PSC model. This has already attracted criticism from politicians of Rio de Janeiro, the largest petroleum producing state in Brazil, which would lose out on its revenues from the special participation. The Government did not want to interfere with the distribution of royalty revenues, but expects this to be the subject of intensive congressional debate. Many in Brazil are suggesting that, since the pre-salt reserves lie up to 300 kilometres from the coast, the entirety of revenues should go to the Federal Government.

Under the PSC regime, the largest source of Government revenues should be from its share of profit oil, which would go to the social fund, which would be controlled by the Federal Government. Since the Federal Government would also control which areas are characterised as “strategic” and subject to the PSC regime, there would therefore be a temptation for the Government of the time to expand the scope of the PSC regime to maximise the revenues under its direct control.

This topic, in particular, risks delaying congressional approval of the new proposals. The Government is trying to pass this legislation under an emergency procedure, which would restrict congressional debate, but politicians from different states and municipalities have conflicting interests, so many expect the political process to be protracted and bitterly fought. With elections next year, opposing parties are likely to use this debate for political capital, so a speedy resolution is unlikely.

The uncertainty created by any delays in the political process will discourage international investment in the Brazilian oil industry and could delay commencement of production of the pre-salt reserves. That said, the lure of these reserves is probably sufficient to attract the necessary investment in Brazil, even on the less favourable terms envisaged by these legislative proposals. It is therefore to be hoped that these political and constitutional issues are addressed in a timely manner.