Filling up the future

GEOLOGICAL structures of vast antiquity are more often called on to bolster the arguments of atheists than enlisted as tokens of a deity’s existence—let alone his nationality. But the deep Cretaceous salts which trap oil in rocks off Brazil’s coast are “strong evidence”, in the words of President Dilma Rousseff, “that God is Brazilian.” It is not a new conceit, but it has rarely been a more apposite one. The pré-sal (“below the salt”) oilfields look set to generate wealth on a scale that could transform Brazil’s economy.

Before the pré-sal finds, which started in 2007, the country’s total proven and probable reserves were 20 billion barrels. Conservative estimates for the total recoverable pré-sal oil now come in at 50 billion barrels: a little less than everything in the North Sea, all in the waters of one country. Optimists expect three times as much. “In the pré-sal area, our exploration has a success rate of 87%, compared with a world average of 20% to 25% for the industry,” says Sergio Gabrielli, the president of Petrobras, Brazil’s state-controlled oil company.
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The first shipment of pré-sal oil, 1m barrels from the Lula field (formerly known as Tupi), set sail for Chile in May. Petrobras is producing 100,000 barrels a day from the pré-sal, a third of it from the remarkably productive Lula test well (see map). By 2020 Petrobras expects to be pumping 4.9m barrels each day from Brazilian fields, 40% from the pré-sal, and exporting 1.5m: at the moment the country falls a little short of self-sufficiency. Today Brazil is the world’s 11th-largest oil producer. By 2020 it should be in the top five.

Becoming an oil exporter could complete the development process that began with the conquering of hyperinflation in 1994. Because the country’s previous period of economic development was brought to an end by the oil shocks of the 1970s, self-sufficiency in energy looks more than usually enticing to Brazilians. Plentiful hard currency looks good, too; it is just nine years since the country last had to borrow from the IMF to stabilise its currency. Petro-dollars will boost national saving—currently just 16% of GDP—creating room for Brazil to upgrade its decrepit infrastructure. And oil would add pleasingly to the geopolitical heft of a country keen to assert itself as a global power.

The possible missteps, though, are legion. Huge, technically challenging projects tend to run late and over budget everywhere. Last year’s disaster in the Gulf of Mexico is a grim reminder of the risks in such “ultra-deep” drilling projects. And countries with big oil finds are prone to an ominous list of economic ailments: capital absorption (the diversion of funds from other worthwhile investments); Dutch disease (oil exports pushing the currency to a level that hurts other industries); and reform fatigue (governments’ unwillingness to tackle structural economic problems when they can see vast wealth on the horizon).

Since the pré-sal was discovered Brazil’s politicians have talked much less about reforming burdensome tax and labour laws. The corrupting tendency of oil is worrying in a country where the president has had to sack five ministers since taking office in January over accusations of illicit enrichment. Without a lot of care, oil might block development as much as spur it on. In the 1970s, looking at what its oil reserves might mean for Venezuela’s future in terms of waste, misallocated money and corruption, a former hydrocarbons minister, Juan Pablo Pérez Alfonso, did not thank a providential god; the country’s oil, he said, was but “the devil’s excrement”.

A key to success in the pré-sal is Petrobras. The company’s older offshore fields are deep enough that it already accounts for 22% of the world’s deepwater production. The pré-sal should give it the know-how to become the world leader in “ultra-deep” drilling, too, opening new possibilities for it off Africa (where the geology is similar) and beyond.

A moonshot under the ocean

But it is an extraordinary technical challenge, and not just because of the depth, and thus the pressure, at which the drills must operate (see diagram). New seismic techniques are needed to see what’s going on. The salt shifts during drilling. The oil comes out of its reservoirs very hot, and must then pass through wellheads that are only a few degrees above freezing. It is mixed with corrosive gases.

The dozens of floating production platforms required, which cost billions of dollars each, will be an uncommonly long way out to sea. Lengthy pipelines will have to be laid along the sea floor for the fields’ gas (flaring it is illegal, as well as a waste). Oodles more platforms will be needed to act as way-stations for helicopters ferrying personnel out and back. The distances would also hamper the response to a disaster. Mr Gabrielli has warned that more needs to be done to prepare for such a Deepwater-Horizon-style catastrophe, not just by Petrobras, but by the government and armed forces, too.

Pedro Cordeiro of Bain & Company, a consultancy, says all this makes developing the pré-sal a national commitment comparable to that of the Apollo programme. In terms of cost it is actually a good bit larger. Apollo cost less than $200 billion in today’s dollars; the total bill was a few percent of America’s annual GDP at the time. Ten years’ aggressive development of the pré-sal could take a trillion dollars, around half of Brazil’s 2010 GDP.

The lion’s share of the pré-sal investment will come through Petrobras. Last year it raised $25 billion in cash with a share offer plus the rights to 5 billion barrels of pré-sal in an oil-for-shares swap with the government. It will be borrowing another $47 billion in the next few years, and plans to raise $14 billion more by selling assets. It is already engaged in nearly 700 projects costing more than $25m each, mostly to do with the pré-sal, and it has plans for $224 billion in capital expenditure from 2011 to 2015. This will account for a tenth of Brazil’s gross fixed-capital formation over the next few years. Petrobras claims that exploiting the pré-sal will make it a bigger company than Exxon Mobil well within the decade.

For most of this year, though, the company’s share price has been falling. There are two linked concerns: overstretch and political interference. The oil-for-shares swap means the government now owns more of Petrobras than it did before the share offering (48%, up from 40%). It has always held a majority of voting shares.

The government’s role does not stop there. In the 1990s Petrobras was part-privatised and the system for allocating oil concessions was liberalised: concessions were to be sold at auctions in which any company, Brazilian or foreign, could bid equally. For the pré-sal, that model has been torn up. A new state enterprise, Pré-Sal Petróleo, will own all pré-sal deposits and can veto projects it deems not in the national interest. Future pré-sal concessions will be auctioned to consortia which must include Petrobras as their operator, with a stake of at least 30%. Once a consortium has pumped enough to cover its costs, what remains must be shared with the state: winning bids will usually be those that hand over more of this “profit oil”.

The oil is ours

Luiz Inácio Lula da Silva, Brazil’s president at the time, justified these 2010 changes on the basis that “you offer risk-sharing contracts when there is risk. In the case of the pré-sal, we are sure.” This is a bit blithe. Mr Gabrielli has recently started emphasising the distinction between “exploration risk”, which seems low for the pré-sal, and “development risk”, which is high. And it is not obvious that a winning recipe needed more than tweaking. Brazil taxes oil relatively lightly. If the government felt it was underselling a close-to-sure thing it could have raised taxes on companies operating in the pré-sal. That would be a lot simpler than cost-plus calculations, which Norman Gall of the Fernand Braudel Institute, a São Paulo think-tank, expects to cause endless legal disputes. Adriano Pires, a Brazil-based energy consultant, says the changes to the regime have fed a perception of regulatory risk. He points to Lula’s worrying resurrection of a slogan from state-monopoly days: “The oil is ours.”

Compared with lumbering state-run oil firms like Mexico’s Pemex and Venezuela’s PDVSA, treated as cash cows and employers of last resort, partially privatised Petrobras is fit and strong. Colombia’s Ecopetrol is already following the Petrobras model, having placed some of its shares in the stockmarket, and Mexican politicians talk of similar steps. But navigating Brazil’s mixed economy is never easy, for companies or their leaders. Earlier this year a posse of shareholders cobbled together by the government ousted Roger Agnelli, president of the privatised mining company Vale, who had laid off workers in the credit crunch against Lula’s wishes and showed an excessive zeal for investment abroad.

So far Mr Gabrielli has handled such tensions rather niftily. But minority shareholders complain that the government is forcing the company to make uneconomic decisions. There are doubts as to whether it needs four new refineries when there is excess capacity abroad, and if so whether it makes sense to put two of them in the north-east, which pleases politicians but does not best serve markets. Then there is the purchase of supertankers from Brazilian yards with costs almost twice those of South Korea’s. The government, concerned about inflation, regularly stops Petrobras from putting up petrol prices in line with rising world prices. Mr Pires calculates it has lost at least 9 billion reais ($4 billion) in the past eight years as a result.

Such tricks may end up weakening the firm’s capacity to use its development expertise elsewhere. “By letting in competitors and letting Petrobras go abroad, [Brazil] created a real national champion,” says Sarah Ladislaw of the Centre for Strategic and International Studies, a think-tank. She thinks Petrobras’s recent decision to pull out of projects in Cuba, citing domestic commitments, may be evidence of overstretch. “Folks respect Petrobras and don’t want to see it pull back internationally to be hamstrung at home.”

Perhaps the biggest challenge for Petrobras will come from the strict local-content requirements the government is imposing on pré-sal projects. The government intends to make these progressively more demanding, applying them to the entire supply chain. By 2017 they may reach as high as 95% for some parts of it. The oil-and-gas supply chain, broadly defined, accounts for 10% of Brazil’s economy now. By 2020 its share should grow to 25%, say analysts.

Jobs for the boys from Brazil

The policy is meant to stop foreign suppliers from gouging Petrobras and its partners as they buy hardware by the $100 billion. It is also meant to stimulate domestic industry. “This is a very important demand pull on the Brazilian economy,” says Mr Gabrielli. “We think it will respond.” If it does, the benefits will be not only in quantity, but quality: a study by IPEA, a government-funded think-tank, found that Petrobras’s domestic suppliers were more technologically advanced and productive than the average Brazilian firm, and paid higher wages and more taxes.

New oil-and-gas service companies are already springing into being, providing everything from undersea electrical cabling to industrial quantities of popcorn (light, cheap and biodegradable, it can be thrown overboard to simulate the evolution of oil spills). A high-tech hub is forming around Cenpes, Petrobras’s research centre in Rio de Janeiro: leading service firms, including Baker Hughes, GE and Schlumberger, are building laboratories close by. The area will be the southern hemisphere’s largest research complex, says Petrobras. In the state of São Paulo, the port city of Santos will be transformed into a managerial hub, with bases for fleets of helicopters and support ships.

Nevertheless, forcing Petrobras and its partners to buy Brazilian, and international companies to locate themselves there, will push up costs and cause delays. According to Booz & Company, a consultancy, Brazilian suppliers to the oil and gas industry charge 10-40% more than world prices. Part of the problem is a scarcity of staff. Brazil’s labour market is already so tight that employers complain about a “labour blackout”. Petrobras itself is unlikely to suffer: it gets hundreds of applicants for each job. But its suppliers will struggle.

According to a wide-ranging study of the pré-sal’s impact by Mr Gall, most workers starting courses at Prominp, a government-funded trainer for the oil and gas industry, needed remedial Portuguese and arithmetic lessons before they could read manuals or carry out simple calculations. Many dropped out and quite a few who finished their training were still of too low a standard to work in the industry. When Aker Solutions, a Norwegian oil-services company, explained weak results in August, it cited an overspend in Brazil caused by “too many inexperienced people”.

The attempt to stimulate supply-chain industries is in part a way to offset the Dutch-disease damage of high exchange rates. Some of the inconvenient strength of the currency is down to high real interest rates which attract footloose foreign capital. But soaring commodity exports are another factor (see chart). Brazil is the world’s largest, or second-largest, exporter of iron ore, soyabeans, sugar, ethanol, coffee, poultry and beef. The commodity boom has led to a big improvement in Brazil’s terms of trade—and hard times for Brazilian industry. Imports, mostly of manufactured goods, have grown even faster than exports, and the country’s current-account balance is now negative. Though the economy grew by 7.5% in 2010, and is forecast to grow by more than 3% this year, industrial output, long flat, is starting to fall.

Local-content rules for the oil industry may help, but are of little comfort to, say, dressmakers, who are unlikely to become part of Petrobras’s supply chain. And they may have unintended consequences beyond reducing the oil industry’s efficiency. Less spending outside Brazil by Petrobras and friends will reduce demand for foreign currency—thus pushing the real higher than it would be otherwise.

One way to counter Dutch disease is to raise productivity in the rest of the economy. Brazil is planning a fund to invest a good part of pré-sal revenues along these lines. Its aims, as yet ill-defined, include education, culture, science and technology, environmental sustainability and poverty eradication. Bain & Company, asked by Brazil’s national development bank to analyse the lessons of similar funds in Norway, Chile and elsewhere, said such spending could be worthwhile, provided clear targets were set and the money was professionally managed (not something the government’s penchant for appointing placemen makes likely). It also recommended spending on the sort of infrastructure that would benefit other industries and help to lower the cost of exports, such as roads and ports. With 60% of all of Brazil’s industrial investment currently in the oil and gas industry, according to the National Petroleum Industry Organisation, a trade body, that could be a welcome fillip.

But the sovereign fund may end up with little to invest in anything. A ferocious battle is being waged in Congress between the coastal states, which have in the past received most of the royalties from offshore oil, and the rest, which want a share. Until a solution is found, in the supreme court if need be, there can be no new pré-sal auctions. The answer will probably involve the federal share shrinking, which will be bad for the fund and its chances of strategic investment. State revenues, whichever the state, will go straight into current spending.

Still going Dutch

Made in Brazil

Tony Volpon of Nomura Securities, an investment bank, points to the disturbing possibility that Brazil could already be suffering from the Dutch disease associated with success in the pré-sal—without yet enjoying any of the benefits. “Brazil’s growing current-account deficit is similar to big investments in a company with present negative cashflows, but excellent earnings prospects,” he says. Most of the assets Brazilians hold abroad are low-yielding, such as treasury bonds; foreigners’ assets in Brazil earn much more. For a commodity exporter like Brazil, those growth expectations can only be met by large current-account surpluses.

Running the numbers, Mr Volpon reckons that the current strength of the real implies Brazil’s current account switching to surplus in a few years and its trade surplus increasing by 20% or so year on year. Only the pré-sal, he thinks, can possibly justify such high expectations. If Petrobras disappoints by not producing oil quickly enough, it will find it difficult to go on attracting the foreign cash Brazil, and Petrobras, need. In consolation, though, the real would fall, providing a natural remedy for Dutch disease, and giving the rest of the economy time to breathe.

Mr Gabrielli, whose company plunges drill bits into the bowels of the Earth with a precision measured in centimetres, seems confident of steering a course that threads its way between the dangers of damaging haste and disappointing delay. For him, the providence invoked by Ms Rousseff lies not only in where the oil was found, but also when. “God hid it until Brazil was strong enough to cope,” he says with a laugh. It will soon become clear whether Mr Gabrielli is right.

Correction: In our article on Brazil’s new oilfields we stated incorrectly that the country now has a trade deficit. We meant to say that the current account is now in deficit. Brazil posted a trade surplus of $25.4 billion in the first ten months of the year. Apologies for the error.