Brazil Oil Battle Goes International

By Marin Katusa, Chief Energy Investment Strategist

A $10.6 billion lawsuit against Chevron (N.CVX) and rig contractor Transocean (N.RIG) for a small oil spill has shone a spotlight on how Brazil's internal battle over oil revenues is threatening its ability to attract oil and gas investors, just as the country is looking for tens of billions in investments to develop its massive deepwater oil reserves.

The spill involved less than 3,000 barrels of crude… not enough to create an oil slick on the surface of the water. There was no visible impact on local coastlines. Yet prosecutors are gunning to fine Chevron and rig operator Transocean $10.6 billion and kick both companies out of Brazil. The fine would represent $3.6 million for each barrel of oil spilled. For comparison, the vastly more devastating Deepwater Horizon oil spill in the Gulf of Mexico forced BP to book more than $40 billion in losses, which represents just $8,160 per barrel spilled.

The size of the fine is nonsensical until one delves a bit deeper into the situation and realizes it has more to do with Brazilian politics than with Chevron or Transocean. Over the last ten years new technologies have unlocked huge oil reserves in Brazilian waters. Known as "sub-salt reserves" because they lie underneath thick layers of salt deep within the ocean floor, these deposits are already known to hold between 50 and 200 billion barrels of oil, and there is much ground left unexplored.

Ever since the discovery of these sub-salt reserves, the Brazilian government has been deliberating about how to distribute its pending oil wealth. The result of that debate is a proposed change to the tax regime that would see oil revenues distributed more evenly across Brazil's states instead of remaining primarily in the three coastal states that lay claim to the offshore deposits. The change has been approved by the senate and will be debated in Congress next year.

Brazil's oil-producing states stand to lose billions of dollars from the redistribution plan. They are fighting back, using any means at their disposal. This relatively small spill at Chevron's Frade project provided an opportunity to howl over the potential costs to clean up from an oil disaster, another angle in their effort to convince the federal government to leave oil revenues in their home states (even though the November 7 spill was nothing close to a "disaster").

The problem is that the plan is backfiring. The potential to be hit with such a massive fine for such a small oil spill is an enormous red flag to foreign oil companies and investors, which don't care about the domestic political backdrop and only see the skewed risk-reward balance. If investors get scared away and Brazil can't find the money to develop its sub-salt oil, no one in Brazil will get any oil revenue. Wagner Freire, a former director of Petrobras, described the situation well in a quote to Reuters:

The situation is extremely worrisome. Not only does there seem to be almost no technical basis for the lawsuit, the political overtones are the latest example of the enormous steps backward the industry is taking.

Sub-Salt Riches: Everyone Wants A Cut

The Santos, Campos, and Espirito Santo basins that host these sub-salt deposits stretch across an 800-kilometer-long belt off the coast of southeastern Brazil. The technology to "see" these deposits through the salt did not exist until the early 1990s, and it has taken from then until now for engineers to figure out how to drill through 2 km of water, 2 to 7 km of rock, a formation covering the salt usually made of shale or calcium carbonate, and then through thousands of meters of unstable, shifting salt – all from a rocking ship. Engineers describe it as akin to drilling into jelly. Even once the drill reaches the oil the challenge is not over, because the oil is mixed with sand and is very thick because of the low temperatures.

Having finally found solutions to these challenges, Brazil's state oil company Petrobras recently started producing from its first sub-salt deposit. If things go as planned and this marks the beginning of a groundswell of sub-salt production, these offshore deposits will transform Brazil's oil sector.

By tapping into these reserves, Brazil has the potential to leapfrog upwards in the global oil reserves and production standings, from fifteenth place to fifth. The leap will be very costly: Petrobras, which has a 30% stake in all sub-salt concessions, is planning to spend $224 billion on sub-salt work by 2014. In return, the company expects to more than double production, going from its current rate of 2.8 million barrels of oil equivalent per day (boepd) to 6.4 million boepd in 2020. The increase will derive almost exclusively from sub-salt work – at present sub-salt oil provides less than 2% of Petrobras' production, but by 2020 it will account for 40% and will enable Brazil to export 2 million barrels of oil per day. The oil industry will grow from about 10% of Brazil's GDP to 25%.

The effort will represent one of the biggest private-sector investment programs in history: total costs are estimated at roughly $1 trillion over the next ten years. The payout, however, will also be massive. As is so often the case when it comes to money, the prospect of this payout sparked this battle between Brazil's states, which all want a piece of the pie.

Under the current oil regime, much of this tax money would stay in the states where the projects are located, which are Sao Paulo, Rio de Janeiro, and Espitio Santo. However, in mid-October the Brazilian Senate voted in favor of a proposal to change the regulations so that tax revenues are distributed more widely across the country, redistributing royalties away from the oil-producing states and toward non-producing states. The reform is expected to cost Rio de Janeiro alone US$2.42 billion in 2012 and US$4.23 billion in 2013.

Not surprisingly, Rio is not happy about the proposed changes. Rio says it needs the tax money to the address environmental impacts that will accompany development and to pay for the World Cup and the Olympics.

The Chevron-Transocean Fine

With all of this background in hand, the proposed Chevron-Transocean fine makes a bit more sense. Most of the loud lamenting over the spill has come from the governments of oil-producing states; and the lawsuit was filed in Campos, the Rio de Janeiro town with the most to lose from the regulatory changes. Reading between the lines, it become clear: The suit is more intended as a message from Rio to the federal government that the state will need piles of money to regulate and clean up after sub-salt projects, so the feds better not mess with Rio's pending tax windfall.

That explains why the fine amount is so ridiculously large by any measure – Rio de Janeiro simply wants to send as big a message as possible. Chevron and Transocean are the unlucky teenagers, stuck getting the brunt of their parents' frustrations over their marriage problems. And a big message it is: $10.6 billion represents more than 700% of Chevron's $1.5 billion net capital investment in Brazil.

That's the kind of risk-reward ratio that will scare plenty of foreign investment away. The lawsuit will drag on for years and, without any evidence of environmental damage, it is unlikely that the fine will actually be levied. Regardless, the situation is sure to give investors pause when it comes to spending their money in Brazil, if for no reason other than the fact that domestic battles are translating into uncertainty in oil and gas regulations. Both the governor of Rio de Janeiro and the state's minister for mines and energy have said they will initiate legal proceedings to stop the redistribution amendment if Congress votes it in, and a prominent senator from Rio promised to paralyze the country in defense of Rio's royalties. When oil and gas companies are assessing a country to decide whether the risks are worth the potential reward, political battles like these over oil regulations are precisely the kind of thing they note and avoid.

It is worth quoting Freire, the former Petrobras director, again:

Cases like this will chase away the Exxons and Shells that have the know-how to create a competitive and efficient oil industry. Petrobras can't do it on its own.

In addition, Brazil has not offered any offshore acreage since the ninth licensing round in 2007 while it sorts out this revenue debate. Protracted delays are not a good way to build momentum in the offshore oil sector – excitement builds when new rounds of bidding lead to exploration investments and then to new discoveries, which boost prices on the next round of bidding.

Foreign investors are also taking note of other government initiatives to capitalize on sub-salt oil. For one, Brazil has made Petrobras the sole operator for new sub-salt discoveries and legislated a 30% stake for the state company in any project in the area. This reduces competition and raises costs; it also leaves Petrobras vulnerable to becoming overstretched. The Brazilian government has also set up a 100% government-controlled company that will have the power of veto over investment decisions in each block. And the sub-salt revenue debate has ignited nationalistic feelings around oil in Brazil. The slogan "O petroleo e nosso," meaning "The oil is ours," is a common sighting in Rio.

The bottom line is that oil has become very political in Brazil – prosecutors and politicians alike want to gain public support from oil-industry attacks. In all likelihood, nothing will happen to Chevron or Transocean. What will happen is that investors will get scared and Brazil as a whole will lose out.

[A triple threat jeopardizes much of the world's oil supplies, threatening to skyrocket gas prices to $5 a gallon and beyond. But investors who get positioned in energy now won't care – and may well make out better than those who got into gold 10 years ago. A free report details the story.]

Additional Links and Reads

Oil: Iran's Hormuz Strait Threats Could Wreak Global Economic Havoc (Forbes)

We dedicated the last issue of our Casey Energy Opportunities newsletter to Iran, where the intersection of nuclear power ambitions, sectarian passions, and global oil supply control points is creating a volatile and dangerous situation. In it we described Iran's geographic weapon: that almost 40% of the world's daily oil needs pass through a narrow waterway that runs along Iran's south coast. The next day, oil prices spiked after an Iranian MP and member of the National Security and Foreign Policy Committee told the Iranian Student News Agency that his country was preparing to hold exercises to close that waterway, which is known as the Strait of Hormuz.

Oil Tumbles Most Since September as OPEC Raises Output Ceiling (BusinessWeek)

Just two days after oil prices spiked based on Iran's Strait of Hormuz threat, they tumbled after the Organization of Petroleum Exporting Countries (OPEC) decided to raise its official production ceiling. Even though the cartel increased its ceiling from 24.845 to 30 million barrels per day, actual production will remain little changed because OPEC has already been producing 30 million barrels a day for more than a year. Regardless, traders wanted to see OPEC restrict production to keep supplies tight and prices high even if Europe slides into a recession.

Cameron International Settles with BP on 2010 Oil Spill Claims (Washington Post)

Cameron International – the maker of the blowout preventer that failed to stop the massive Deepwater Horizon oil spill in the Gulf of Mexico – agreed to pay BP $250 million in exchange for indemnity against claims related to the Oil Pollution Act and environmental damage. The settlement does not indemnify Cameron against other fines, penalties, and claims and is not an admission of liability. Cameron is the fourth company to settle with BP and contribute to the restoration fund, which shows BP is making good progress in moving past the accident. However, the British oil major still remains at odds with Halliburton, the contractor responsible for cementing the well's casing and plug, and with Transocean, owner and operator of the $500-million Deepwater rig.

Shipping Oil to Asia? The Route's East, Not West (Globe and Mail)

Canada's oil sands need more outlets. Production from the oil sands is set to increase substantially over the next few years, and the pipelines that carry crude south to storage tanks and refineries in the United States are nearing capacity. As such, Canada needs new pipelines. The main routes in question are south – the infamous Keystone XL pipeline – and west, to the Pacific coast so that oil can be loaded onto tankers and shipped to Asian markets.

This editorial argues for an interesting alternative: to get Canada's oil to Asia, ship it east. By reversing certain existing pipelines and in the longer term building a new line from Montreal to an Atlantic port, not only would Alberta's oil reach the ocean – and therefore Asia – and Eastern Canada could start relying on domestic crude instead of imported oil.

Russian Oil Rig Search: Hopes Fade for Survivors (BBC)

As the easy oil deposits in the world are drained, oil producers are required to work in more difficult regions every day. News that a drilling rig being towed to a new location capsized in the icy seas 200 km off Sakhalin Island is a reminder that oil exploration is not only becoming more and more expensive, the need to work in extreme environments and with massive and highly complex technologies means oil production is also becoming more dangerous. The Kolskaya rig sank on Sunday with 67 people on board. By Monday, 14 survivors had been rescued and 14 bodies recovered, but hopes were fading that any of the other 39 people would be found alive in the high seas.

Coal Demand to Grow by 600 000 t/f over Next Five Years, IEA Warns (MiningWeekly)

In its inaugural Medium-Term Coal Market Report 2011, the International Energy Agency predicted that infrastructure bottlenecks and an expected shift to lower-quality deposits could push coal prices upward over the next five years, during which time demand is expected to increase by 600,000 tonnes per day. That is a rapid rate of increase, but it's actually slower than it has been: from 2000 to 2010, coal demand grew by 700,000 tonnes per day.