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Slower, lower, weaker: Brazil under Rousseff

Brasilia’s political crisis is deepening. Is there still hope for energy investors?

BRAZIL’S president Dilma Rousseff has suffered some blows lately – but none as stunning as that in April, when the lower house of congress voted overwhelmingly for her impeachment. The decision has tipped Latin America’s largest economy, and one of its most important oil producers, into its worst political crisis in decades and sets up a long and ugly period for the country. “It’s not the beginning of the end. We’re at the beginning of a fight – a long, drawn-out fight,” Rousseff, the former guerrilla fighter, declared after the vote.

Besieged by a faltering economy and an epic corruption scandal at Petrobras, Rousseff now sees her political fate rest with Brazil’s upper house. Given the wide margin of victory for her political oppo­nents in the lower house, not to mention the president’s pitiful 10% approval rating, the Senate is widely expected to push ahead with impeachment hearings. That would see Rousseff sidelined for as long as six months while the proceedings take place.

Cast into political exile, her credibility would be hammered. She may never find her way back to power.

It is a turn of events few would have bet on when Rousseff easily swept to re-election victory just 18 months ago. But her coun­try’s problems since then have mounted inexorably.

Brazil’s finances tanked along with com­modity prices, plunging the country into its worst recession for a century. The economy contracted by 3.8% in 2015, and the IMF expects a similar decline this year. Infla­tion has surged and the real has crumbled against the dollar. Brazil’s credit rating has been cut to junk status and the low oil price has sapped government budgets in Rio and other states along the coast that had grown used to a booming offshore industry. Petro­bras’s $30bn a year in capital spending was an important growth driver in these regions, filtering through shipyards, engineering firms, financial services companies and the broader economy. Its 40% spending cuts have hit hard.

There is nothing Rousseff could have done about commodity prices. She had no control over China’s slowing economy or America’s booming shale industry. But she spent heavily before the bust and left barely a cushion to absorb it. Since the downturn hit, she has been slow to react to the eco­nomic fallout or take measures to restore government finances.

Then there is the corruption. Over the course of 2015, the Lava Jato – Carwash – corruption scandal laid bare the ugly busi­ness of Brazil’s political graft.

The scheme uncovered was crude and one of the oldest sorts of rackets around. Petrobras executives conspired with major engineering and construction firms to skim a few percent off the top of contracts and used the ill-gotten gains to live lavishly and curry political favour.

What lies beneath

The vast sums in­volved in Brazil’s oil boom inflated the fraud. Billions of dollars were siphoned from con­tracts to build refineries, offshore platforms and other major projects. A newly embold­ened judicial branch has uncovered all this crookedness with glee. Hardly a day goes by that a new member of Brazil’s political or business elite is linked to the scandal.

The speaker of the lower house, Eduardo Cunha, faces allegations of perjury, bribery and money laundering. Marcelo Odebrecht, the founder of one of the country’s largest companies and a key Petrobras contractor, is serving 19 years in jail after his company was ensnared in the corruption crackdown. Brazilians have long known many of their leaders were corrupt. Now they know the gory details.

Among the many surreal aspects of this political drama is that Rousseff’s impeach­ment has nothing to do with the corruption scandal. Even though she was chair of Petro­bras’s board during many of the Lava Jato years, no evidence has emerged to link her with the scandal or show she knew what was going on. She has denied having any knowledge of the scheme. Instead, she has been accused of illegally using funds from the central bank to plug holes in the budget – a sign of economic mismanagement that’s almost trifling compared with the systemic graft machine that was running at the core of Brazil’s elite institutions. Still, she has been unable to get out from under the shroud of economic decline and corruption.

Replacing the racket?

If Rousseff goes down – as looks most likely – vice president Michel Temer of the Brazilian Democratic People Movement (PMDB), which was in a coalition with Rousseff’s Worker’s Party until abandoning the partnership in late March, will likely assume the presidency until elections in 2018.

This prospect has brightened investors’ spirits. Many like the fact that Temer has spoken about deep structural reforms he would make to right the economy. In Octo­ber last year, he and the PMDB announced plans to cut public spending, prioritise private investment over that by the state, and reform bloated pension schemes – all measures necessary to recalibrate the gov­ernment’s finances and restore the value of the real, which has fallen by 40% over the past two years.

He has also had soothing words for oil executives. Much of Brazil’s oil legislation was put in place nearly a decade ago, when oil prices were rising and Brazil was a place oil companies wanted to be. Today, cash is scarce in the industry and Brazil’s upstream has lost its lustre. Rousseff’s administration has been slow to realise that – resisting many industry reform efforts. Temer, by contrast, seems to have grasped the new landscape.

Temer’s PMDB party has pushed for legislation that would end rules that require Petrobras to own at least 30% and operate all pre-salt projects. It is a financial and op­erational burden that has weighed down the state-controlled oil company and undoubt­edly slowed the development of the coun­try’s deep-water reserves.

Temer has also talked at length about re­ducing the steep local content requirements that have driven up costs for deep-water projects and which, for years, have been a constant source of complaint for many for­eign operators.

Driven to debt

Temer is seen as playing a more hands-off role at Petrobras. He is very likely to allow the company to take deeper cost-cutting measures – including unpop­ular layoffs. Critically, he is also likely to allow the company a freer hand in setting fuel prices. For years, the Rousseff admin­istration has forced Petrobras to cap petrol prices well below the cost it was paying to import them, losing the company billions of dollars. The plunge in international crude prices has taken the sting out of the policy, but it was a major contributor to the $130bn debt that now cripples the company’s ability to develop new projects.

That debt is Petrobras’s most pressing problem. And it has been made even worse by the destruction in the real’s value. Most of the company’s debt is dollar-denominat­ed, while most of its sales are in real – so the 40% fall in the value of the real over the past two years is roughly equivalent to a 40% rise in debt. That makes macroeconomic reforms as important to Petrobras as any energy-specific reforms.

In response to the deteriorating financ­es, Petrobras needs to slim down, which will mean slower production increases over the next couple of years. The company lopped 300,000 barrels a day – roughly equal to two pre-salt production vessels – off its 2016 production outlook, to 2.2m b/d. The 2020 output goal has fallen from 4.2m b/d to 2.8m b/d. If the low oil price continues, those figures could be cut yet again.

Optimism that change might be coming for Petrobras has supported the company’s stock price in recent months. Its US-traded shares fell below $3 in February. But as the impeachment effort gained steam so too did the shares. By late April the shares had more than doubled to $7.20 a piece – a tenth of their value in the heady days of pre-salt ex­citement in early 2008, but a remarkable rise nonetheless.

But how realistic and achievable is the reform agenda?

Temer would take office under the most difficult circumstances. He is personally not well known to the public, and those that do know him don’t particularly like him. He is hardly more popular than Rousseff, with a disapproval rating of nearly 60%; and a recent Datafolha poll found that just 2% of voters favour him in the 2018 general elec­tions. To top it off, he has been implicated in the Lava Jato corruption scandal himself, and could have a cloud of legal uncertainty hanging over his head (Temer denies any wrongdoing).

More broadly, Temer would be leading a deeply damaged institution, requiring complete structural reform. From the out­side, Brazil’s political elite has lost nearly all credibility with the public. Sixty percent of the country’s 594 congressional members have been convicted or accused of serious crimes. Protests have coalesced on the de­spised Rousseff, and the battle to unseat her, but that shouldn’t be taken as support for anyone else.

Internally, Brazil’s Congress has been riven and hardened by the impeachment process. Rousseff and her supporters have repeatedly accused her opponents of trying to turf her out in a coup. “I’m not comparing the coup here to the military coups of the past, but it would be a breaking of the dem­ocratic order of Brazil,” she said in March. “[The coup] will have consequences. Maybe not immediately, but it will leave a deep scar on Brazilians’ political life.” Self-serving as this reading of events is, it isn’t all wrong.

Given this situation, a prolonged period of embittered infighting and policy paralysis seems more likely than a re-energised effort to push through a deep – and in the case of pension reforms and welfare spending deep­ly unpopular – reform agenda.

Rudderless

For the energy business, a bright side is possible. Some analysts think Temer would take up pre-salt reform soon after taking office – a swift move to sew up relatively easy legislative victories. Opposi­tion to the reforms has weakened in recent months, with some in the Worker’s Party coming around to the notion that changes are needed to reinvigorate foreign invest­ment. So lifting the pre-salt restrictions could be among the first measures taken this summer if Temer takes over the presidency.

If Rousseff stays in office, the fate of pre-salt reform is harder to read. She may take a harder line against reform to shore up her left-leaning base of support. Alternatively, she could see pre-salt reform as a relatively easy measure to demonstrate that she is still able to govern.

If that is the case, the first pre-salt bid round in many years could come as soon as next year. At today’s oil prices such an auction would struggle to attract investors. But if it coincides with a re-balancing in the market, and an uptick in prices, in 2017, it could start to put Brazil back on the map for oil investors.

An enduring political crisis, though, will take its toll on the industry. It would add to the certainty about who is running the country, who is making energy policy and who is at the helm of Petrobras.

Without knowing who’s in charge, it will be next to impossible for investors to predict the direction the country is going to move on critical policy decisions. That will make it difficult for companies to put big bets on Brazil’s energy industry.

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