José Virgílio Lopes Enei, partner of Machado Meyer Sendacz e Opice Advogados, charts six decades of development in Brazil’s oil and gas legal framework, from the abolishment of the state monopoly and concession regime, to the proposed pre-salt reform
 
 
It was not until the early 1940s that Brazil made its first commercial oil discovery in an onshore area in the north-eastern region of Brazil. After that, while production of oil was increasing in a slow pace, the “petroleum is ours” slogan, under the Getúlio Vargas Presidency, was the best expression of a nationalist generation that ultimately prevailed in 1953 with the creation of Petrobras and the establishment of a governmental monopoly for all exploration and production activities in the oil and gas industry.
 
The legal monopoly in favour of Petrobras, which lasted for 44 years, served its purpose. It enabled the creation and growth of the largest company in Brazil, one of the first true Brazilian multinationals, which now has the most advanced technology in deep water oil production.
 
The world has changed dramatically in the last few decades and Brazil has followed the trend. The scope of governments worldwide has generally shifted from direct entrepreneurship to regulation. The monopoly of Petrobras was officially abolished in 1995 by a constitutional amendment that was only made effective in 1997 by the so-called Oil Law, which allowed private companies to compete with Petrobras in exploration and production activities, among others. Congress was convinced that, just like in other sectors, the oil and gas industry in Brazil, its consumers, and even Petrobras, would be better off by free competition, subject to proper regulation.
 
Despite the legal monopoly being extinguished, Petrobras has never lost its dominant position in the local industry. Nevertheless, the opening of the market enabled Brazil to host a massive wave of foreign investments, which contributed not only to the economic development and stability of the country, but which also brought state-of-the-art technologies for the oil and gas industry that might not be available to Brazil otherwise.
 
In recent years, the opening of the market has also enabled the entrance of small and medium-size companies, with local or foreign capital, in the exploration and production industry, spreading the benefits and knowledge of the industry to a wider investing community, fostering stronger competition and contributing to the creation of new jobs and local suppliers in Brazil.
 
This new competitive environment, governed by the Oil Law, was based on concession agreements for the exploration and production of specified onshore and offshore blocks, granted by the federal government, represented by the national petroleum authority (ANP), after a transparent bidding procedure to which any company, including Petrobras, or a consortium of companies, could participate, being assured the same bidding rules and opportunities.
 
Following a rigorous technical, financial and legal qualification analysis, the selection procedure carried out by ANP has traditionally been the best combination of signing a bonus proposal (upfront payment consideration for the awarding of the concession), minimum investment commitment and level of local content requirement.
 
The awarded concessionaire would then have freedom to carry out its exploration and production activities, becoming the owner of the oil and gas produced, subject to the obligations set forth in the concession agreement, including minimum investments, local content, and a defined term for showing commercial viability of its discoveries and commencing its actual production. In addition to regular Brazilian taxes applicable to economic activities in general (amounting to one of the heaviest tax burdens in the world), the government would also be entitled to certain government takes, including the above-mentioned signing bonus, royalties of 5 per cent or 10 per cent over gross production revenues as set forth in applicable law and bidding documentation and a special participation ranging up to 40 per cent over net production profits in the case of extraordinary profitability and/or production.
Production and reserve figures - the pre-salt areas
 
Since 1999, the ANP has conducted 10 bidding rounds, which resulted in the awarding of approximately 730 concessions of oil and gas exploration and production blocks, either onshore or offshore.
 
Based on these concessions, Brazil has recently become self-sustainable: the volume of oil produced in Brazil - approximately 2 million daily barrels for the first six-month period of 2009 - exceeds its domestic consumption. However, most of the oil production in Brazil is made of heavy crude oil, which is not the same quality of oil consumed for the most part in Brazil. In addition, Brazil does not have sufficient refinery capacity to refine all its production.
 
By the end of 2008, proven oil reserves in Brazil were equal to 14 billion BOE (barrels of oil equivalent). The vast majority of reserves are located in deep and ultra-deep waters.
 
Brazil has recently discovered promising oil reserves in pre-salt depths, between 5,000 and 7,000m below the sea surface, in an offshore area of approximately 150,000km² within the Espírito Santo, Campos and Santos Basins in the states of Espírito Santo, Rio de Janeiro and São Paulo. This area and its promising reserves are deemed to constitute a new frontier for the production of oil and gas in Brazil - called the pre-salt.
 
Approximately 28 per cent of such pre-salt area has already been granted under ordinary concessions, including the Tupi, Iara and Parque das Baleias blocks. Only these three blocks are expected to raise our proven reserves by an additional 23.5 billion BOE within the next years. The pre-salt area already granted under concession is also expected to double our daily oil production by 2020, turning Brazil into a strong net exporter of oil.
 
A further 72 per cent of the pre-salt area is yet to be awarded. Official estimates made by the government assume that the full pre-salt area should reveal oil reserves of at least 50 billion BOE.
 
The proposed pre-salt reform
 
In spite of the great success achieved by the concession regime throughout more than a decade after the end of the old monopoly of Petrobras, and the reliable and stable framework accomplished by it, the government believes that the promising oil and gas reserves discovered in the pre-salt area require a radical reform in the oil and gas legal framework.
 
According to the government, the exploration risk in the pre-salt areas is so low that the concession regime would be completely unsuitable. Although the government takes could be substantially increased for new concession agreements to account for such lower risk or higher profitability potential without disrupting the concession regime, the government still contends that this would not be enough. According to the government, it is not just an economical concern. The government must strategically control the investments and production pace, and essentially have a much closer involvement in the exploration and production activities. Nevertheless, as indicated below, the reform seems to be mostly driven by political motives, as this stronger control could also be achieved under the concession regime.
 
Indeed, the rationale underlying the proposed reform resembles a lighter version of the nationalistic movement that implemented the state monopoly many decades ago. This approach might seem a little old-fashioned for the international community, but it appears to be still very popular among Brazilian voters, who will vote for a new president and new governors in the October/November 2010 elections.
 
Bearing this context in mind, on 31 August 2009, the government officially presented four bills of laws to the Congress, and asked for a fast track/urgency legislative procedure.
 
Production sharing contracts (PSCs)
 
The main bill of law introduces the PSCs for all blocks not yet awarded within the pre-salt area or such other strategic areas to be later defined as such. The existing concession agreements will be respected and new concession agreements might still be granted for blocks outside the pre-salt and such other strategic areas.
 
Under the proposed PSC regime, Petrobras would be the sole and mandatory operator, and would be assured a minimum 30 per cent participation in the consortium ultimately awarded with the PSC contract over any pre-salt block.
 
Petrosal - a 100 per cent government-controlled entity to be created pursuant to a separate bill of law - would also have a mandatory participation in the PSC consortium, so as to represent the interests, and appropriate the share of the government, in the production of the relevant oil field. Private parties or Petrobras itself would be entitled to participate in a bidding procedure to bid for the remaining participation in the PSC consortium, the winner being the entity willing to surrender the largest participation stake in the consortium to Petrosal. Nevertheless, the share of Petrosal would be calculated over the net production, that is, the production remaining after a certain share is set aside to cover all the eligible and verified exploration and production costs. Petrosal’s share, however, would not exclude royalties, but only the royalties would be distributable to the federative states and municipalities according to the current laws.
 
The fact that the federal government may ultimately retain 100 per cent of the government share in the PSC contracts might also explain why it is proposing this reform so strongly, considering that the concession regime would require it to share most of the royalty and special participation revenues with the states and the municipalities.
 
Petrobras capitalisation
 
Another bill of law intends to authorise the federal government to make equity contributions to Petrobras, and therefore potentially dilute private investors in the company, in the form of the assignment of oil reserves to Petrobras, without a bidding procedure. Such oil reserves, up to the limit of 5 billion BOE, would be priced at market value.
 
However, in order to simplify the procedure and avoid the complexities of an equity contribution in kind, the government would first make equity contributions to Petrobras in the form of government debt bonds (which may be easily priced at market value), and such debt bonds would be immediately used by Petrobras to pay for the oil reserves being assigned to it.
 
This virtual equity contribution in kind, at a market price for the oil reserves that may not be easily determined, may be viewed as detrimental to private investors in Petrobras. On the other hand, the various prerogatives that the main bill of law intends to assure to Petrobras - such as the right to be the sole operator of all the pre-salt blocks, the 30 per cent minimum participation in all PSC contracts, the status of preferential trader of all the oil and gas production attributed to Petrosal, or the right to be contracted for technical studies by the regulator or the government without a bidding procedure, etc - are not being computed in that equity valuation, and therefore might be deemed in contradiction to the free competition regime applicable to Petrobras since 1997.
 
The sovereign fund
 
Finally, the last bill of law proposes the creation of a sovereign fund, which would accumulate part of the revenues attributed to the federal government, as represented by Petrosal. The fund proceeds would be invested in low-risk permitted investments, according to investment policies aiming at a suitable profitability, and only the income derived from such investments would be eligible for social destinations, so as to preserve the principal amounts allotted to the fund for the benefit of future generations.
 
Challenges and opportunities
 
It is still premature to assume that these bills of law will be approved without substantial changes, but there is certainly a good chance that the government political base is able to do so. The fast track procedure was lifted, but the bills of law are still moving fast.
 
Petrobras will certainly have a very strong role in the pre-salt exploration and production. Nevertheless, irrespective of the legal prerogatives that may eventually be granted to it by the new legislation, there is going to be plenty of opportunities for local and international private parties, including service providers and oil companies making alliances with Petrobras or competing with it.
 
The pre-salt prospects are huge, but so are the challenges. The pre-salt may require investments in excess of US$300 billion in the next two decades, and will present great technology challenges. Such challenges will require collective efforts from a large investor community.
 
In a global scenario that may still face cyclical crisis in the near future, and where countries compete for investments, Brazil would be better off by a legislation that raises attractiveness to its pre-salt projects. If the legislation to be ultimately enacted does not achieve this goal, it should at least provide stable rules and predictability so that each investor may properly assess the risks and potential rewards of embracing these pre-salt opportunities.
 
(Latin Lawyer 01.02.2010)
 
(Notícia na Íntegra)