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Brazil's targets need to be realistic and practical

Petrobras’ new chief executive, Maria das Graças Foster, has already made her mark at the Brazilian company. The former chemical engineer has said Brazil can become a leading oil producer, but must temper its expectations, saying targets need to be ‘realistic and practical’

The heady days at Petrobras when Brazil’s former president Luiz Inacio Lula da Silva hailed the company’s pre-salt oil discoveries as a “gift from god” and its former chief executive Jose Sergio Gabrielli travelled the world touting an ever-brighter future for Brazil’s oil future are over.

Brazil’s oil ambitions received a much-needed reality check this month. State-run Petrobras has said that developing the billions of barrels of oil off the country’s coast is going to take longer and cost more than it has previously predicted.

Maria das Graças Foster, Petrobras’ new chief executive, took her first five-year business plan on the road in June in a bid to bridge the company’s growing credibility gap.

Petrobras has a well-deserved reputation as a deep-water technological and operational leader. But confidence in the company’s ability to deliver on its production and spending targets has eroded, as observers believe the firm has consistently over-promised and under-delivered.

Graças Foster, who trained as a chemical engineer, has made no attempt to sugar-coat the company’s record. “Exploration and production planning based on aggressive targets have proved themselves since 1999 to be unrealistic,” she told investors during a June presentation in London.

And she has provided the evidence. In 2003, for instance, the company forecast that it would be producing 2.2 million barrels a day (b/d) of oil by 2007. At the end of 2011, Petrobras recorded production of 2.022m b/d of oil.

It is not only in the upstream where the company’s projections have proven overly optimistic. The start up of the Abreu e Lima refinery, which Petrobras is building alongside Venezuela’s state-oil company PdVSA, has been delayed by at least three years, and costs have spiralled. In 2005, Petrobras said the refinery would cost around $2.3 billion, but seven years later that investment is now seen topping $20 billion.

After taking the helm at Petrobras earlier this year, Graças Foster forced the company to take a collective look in the mirror. “One of my first actions was to review in great detail the oil and gas production curve for 2012. The exploration and production area were told to be realistic and practical.”

That meant basing projections on the company’s experiences developing projects to date rather than hopes for what would be achievable. The process was then applied to all projects out to 2020. The result of that review is a plan that looks markedly different from those presented in recent years.

Under the 2011-2015 business plan, the company was projected to be producing more than 3m b/d in 2015, an increase of more than 1m b/d from 2011, and 4.91m b/d in 2020. The 2012-2016 plan envisions production of 2.5m b/d in 2016, a far more modest, though still sharp increase of 500,000 b/d from 2011. The new plan also cuts the 2020 production outlook by 17% to 4.2m b/d, though this is still ambitious, as it will more than double current oil output over the next decade.

Managing output

Gas production has taken a back seat under the current plan. Petrobras says it will need to do further tests before it is able to determine, for instance, how much associated gas from pre-salt projects will be sent to market and how much will have to be reinjected to manage oil output. But with gas included, the current plan calls for production of 5.7m barrels of oil equivalent a day (boe/d) by 2020.

During certain months in the latter half of this decade, the difference in projected production between the two plans is 1m b/d. Assuming oil prices of around $100 a barrel, that is a difference in cash flow of as much as $3bn a month.

At the same time as new barrels are now seen as slower to come on stream, costs are also expected to be higher. The previous plan put spending from 2011-2015 at around $224bn. The new plan envisions the company investing $236.5bn from 2012 to 2016.

The bulk of this – around 60% or $141.8bn – will go towards the exploration and production business. That will please the company’s international investors, who have long complained about the company’s heavy spending in less-profitable domestic refining and marketing.

Nevertheless, refining and marketing will still account for more than a quarter of spending as increasing the country’s ability to meet its own fuel needs remains a priority for Petrobras’ largest shareholder, the Brazilian government.

While Graças Foster could be commended for her forthrightness in addressing Petrobras’ challenges, the market was in no mood to extend any such goodwill. The company’s New York-listed shares fell to $18.35 a share when the plan was announced – a level not seen since the financial crisis. Indeed, the shares are now trading at levels lower than they were when the Lula pre-salt discovery was made in mid-2006.

There is little doubt over Petrobras and Brazil’s resource potential. As the company points out, 63% of deep-water discoveries around the world in the past five years have been made offshore Brazil. But even with a dose of realism from Graças Foster, there are still questions over Petrobras and Brazil’s ability to deliver on its resource promise.

The most contentious issue is over Brazil’s local content policy. The government requires around two-thirds of all goods and services provided to the oil industry to be produced in Brazil. It is central to the government’s hopes of ensuring that the benefits of the oil bonanza are felt throughout the Brazilian economy.

And Graças Foster has championed this policy, making it central to the company’s strategy to the point that it is now part of Petrobras employee evaluations.

“The policy of local content frequently appears as the big villain that justifies all project delays, especially in exploration and production areas. Such a generalisation is not supported by facts,” she said during a recent visit to London, instead placing the blame at the feet of international suppliers.

Brazil’s domestic oil and gas services industry has made great strides. Major international suppliers have set up shop in the country and are already planning to expand. Subsea specialist Technip, for instance, now employs 2,700 people in the country. Rolls Royce, GE, Aker Solutions and other major international technology firms have also expanded operations in the country.

Brazilian companies have also taken advantage of the new opportunities. Brazilian tycoon Eike Batista has expanded capacity at his oil services company OSX. So far, OSX has only won contracts with Batista’s upstream oil company OGX, but looks well-placed to land work with Petrobras and other international players in the future.

Despite this, Brazilian industry is struggling to meet the demands of the country’s booming oil sector. A Credit Suisse analysis showed, for instance, that under-capacity at Brazil’s shipyards has led to longer delays at Petrobras’ projects, which have generally relied on local suppliers. The average delay at those international projects (which involve international suppliers) averaged around 1.7 months, compared with 11.6 months at Petrobras projects.

Petrobras plans to add 33 new domestically built drilling rigs from 2016 to 2020, placing an enormous strain on Brazil’s shipyards. Meanwhile, demand for subsea pipelines is set to rise by more than 300% over the next five years and demand for subsea trees will increase by 165%. Perhaps the biggest challenge will be hiring and training the more than 120,000 new personnel the industry will need.

Many remain sceptical that even with the new, more conservative, targets, Brazilian industry will be able to meet the oil sector’s demand in the timeframe currently envisioned. While strong local content is vital to the sector’s long-term sustainability, developing it could come at a short-term cost.

Another issue that has put Petrobras at the centre of a tug-of-war between the government and its minority shareholders are domestic fuel prices. Here, Graças Foster appears to have won a victory for the company’s minority shareholders and Petrobras’ bottom line.

Stability

Petrobras has kept domestic fuel prices stable for the past several years, despite the international oil market’s volatility. It did so largely at the behest of the government, which feared that an increase in domestic fuel prices could slow economic growth and stoke inflation. But as international prices have remained elevated and Petrobras has been forced to increase imports to meet soaring demand, losses in the refining and marketing business have mounted. In the first quarter of this year alone Petrobras’ downstream unit lost $2.6bn.

The company realises this is unsustainable. “In the long-run we are moving towards international product prices – this is a fundamental assurance,” chief financial officer Almir Barbassa said. On 25 June, Petrobras raised fuel prices for the first time since 2006. Gasoline prices went up by 7.83%, while diesel prices rose by 3.94%.

That should help put the company on a firmer financial footing. But a move towards international price parity is essential to the company’s plans. As are long-term Brent oil prices of around $90 a barrel, which the company has used in its forecast. A sustained fall below this level, even with higher fuel prices, could force a major rethink of the company’s plans.

There is also mounting concern over accelerated decline rates in the Campos basin, which still contributes around 80% of Brazil’s oil production. Credit Suisse said that Petrobras may have taken its eye off the ball around 2007 as it started to move resources from the Campos to the Santos basin, where the major pre-salt discoveries have been made.

Production from Roncador field – Brazil’s largest producer – declined at a rate of 11% last year, to 321,000 barrels of oil equivalent a day (boe/d). And the apparent decline rate at the Marlim field, Brazil’s third-largest producer, was 21%. The field now produces 254,000 boe/d. Petrobras has said that it expects its maturing fields to see decline rates at between 7-10%.

New fields have made up for these declines, but if higher-than-expected decline rates persist, it will make it that much more difficult for Petrobas to reach future production targets.

Petrobras has put increased operational efficiency in the Campos basin at the centre of its exploration and production programme over the coming years. It says that efficiency has fallen from 89% in 2008 to just 72% in the first quarter of 2012. To stem this decline, the company plans to spend $5.1bn in the hopes it will be able to gradually push efficiency back to 90% by 2016.

All of these issues are likely to affect Petrobras’ international partners. Foreign oil companies have lined up to grab their share of Brazil’s offshore oil bonanza. Although Petrobras dominates the industry, major foreign players such as BG Group, Repsol, Sinopec, Statoil, Chevron, Shell and others have established strong positions in the country.

BG in particular has put Brazil at the centre of its portfolio. The company plans to spend around $30 billion in the country by 2025 developing the Lula, Guará, Iara and Carioca pre-salt discoveries, among others. BG has said that its discoveries hold reserves net to the company of between 4bn and 8bn barrels of oil equivalent (boe) and it is targeting production of 600,000 boe/d by 2020, nearly matching its global 2011 production. The company, though, is reliant on Petrobras and Brazilian industry to realise these plans.

Brazil has generally welcomed foreign investors. Chevron, however, was pilloried earlier this year after a leak at the Frade field. The 2,400 barrel spill was soon brought under control. Nevertheless, the incident sparked a public backlash against the company. And a government prosecutor brought charges against the company that claimed the US supermajor was liable for more than $20bn in damages and threatened senior executives with long-term prison sentences. Those charges were eventually dropped, but the incident has left a sour taste with foreign operators.

Brazil still holds some of the largest opportunities for the industry and companies from around the world are keen to enter the play. Foreign operators, though, have started to grow impatient over the slow pace of new acreage offerings.

The 11th and 12th licensing rounds have been delayed since 2006, when the government halted all new acreage offerings after the first major pre-salt discovery so that the country could draft a new regulatory framework. Most of that has since been put in place, with the only major remaining dispute being over how the government will disperse billions of dollars in oil royalties among Brazil’s states. Rio de Janeiro and other oil producing states want to take the lion’s share of those royalties, while other states want them to be shared more equitably. A resolution has not yet been reached.

Although this has been a source of concern for foreign operators keen for new pre-salt acreage, the delay is not the worst thing for Petrobras. New regulations require Petrobras to operate all new pre-salt projects with a minimum 30% stake. That will ensure more of the spoils fall to the government, but if Petrobras was forced to take on a raft of new exploration projects in the near future it would only exacerbate the capacity problems that have already plagued the company.

Although Graças Foster has brought Petrobras and Brazil’s oil ambitions back down to earth, the future still looks bright. The country has the reserves base to propel it to a top-five oil producing country - that may happen in 2020, it could take longer, but there is little doubt that it is on its way, and a dose of hard-headed realism from the top is only going to help it get there.

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