Round 5: Can Brazil Keep Oil Companies Interested?

Abstract: Brazil's Round 5 auction of deep offshore properties lacks the allure of high returns like those from the prolific Campos basin. Is there anything the country can do to make these leases more attractive?

Analysis: August 18, Brazil will conduct its fifth auction of deep offshore drilling concessions. In early auctions, bidders envisioned high returns in the range of those from the prolific Campos basin. Disappointing results have hammered down that optimism. So Round 5 will likely attract fewer bidders and lower bids. And it may take improved contract terms, lessened taxes, and a better regulatory climate to get even those.

In 1997, Brazil decided to open its offshore deep oil prospects to exploration by international oil companies (IOCs) and other private oil companies. Brazil counted on the private companies to increase investment, speed development, and move the country faster toward its long-time goal of energy self-sufficiency. To deal with the private companies, the government of Brazil created a new bureaucracy--the National Petroleum Agency (ANP). The Brazilian national oil company, Petrobras, was left in place to conduct business (almost) as usual, though a few of its properties were transferred to ANP and included in the first round of bidding offered to the private oil companies in 1998--called Round 0.

ANP set up royalties and taxes based on the hugely successful Campos basin, which includes the giant Roncador field. Exploration there exceeds a 25 percent success rate, and three fields discovered in the basin between 1984 and 1996 have reserves of over a billion barrels each. In 2001, the Campos basin produced 1.2 million barrels of oil per day and 722 billion cubic feet of gas. Production averaged 500 million barrels of oil with gravity greater than 22 API.

International oil companies jumped at the chance when Brazil opened the Campos, Santos, and Espirito Santo basins--collectively known as the salt basin--for exploration. From then until 2001, offshore Brazil became one of the premier focus areas for exploration by major IOCs as well as independents and local Latin American oil companies. Through farmouts by Petrobras and licensing rounds by ANP, many thousands of square kilometers were set up for exploration. The four licensing rounds subsequent to Round 0, the farmout of Petrobras properties, have resulted in more than 40 licensees exploring 113 blocks extending over 123,420 square kilometers.

However, results since Round 0 have fallen short of the early Campos basin promise. Of 102 wells drilled in the salt basin from 1998 through 2002, only two were declared commercial, yielding a five-year success rate of two percent. This is nowhere near the return producers get in deepwater Gulf of Mexico, Nigeria, and Angola. These regions enjoy the following percentage success rates in exploration and commercialization, respectively: GOM--30 percent and 16 percent; Nigeria--62 percent and 16 percent; and Angola--70 percent and 63 percent.

Quality of the discoveries has also been lower than expected. The fields are smaller--less than 500 million barrels--and lie outside the Campos system, many in deep frontier regions. In addition, the oil is heavier--less than 20 degrees API. In deepwater Brazil, the "prize of Big Oil" has yet to be realized. Make no mistake, most of the leases are just emerging from exploration and entering the drilling phase. So there could be major fields yet to come. But so far, in both the Round 0 blocks and the ANP licensing blocks, nothing very promising has turned up. The results of drilling campaigns over the next two to three years will be what Stephen P. Thurston of ChevronTexaco referred to in a talk before the 2003 Offshore Technology Conference last May as "a very significant litmus test" for the long-term vitality of Brazil's deepwater development. But for now the rewards of taking the risk offshore Brazil don't measure up to the rewards being earned through investment in the Gulf of Mexico, and offshore Nigeria and Angola.

Preparing for Round 5
There are already signs of a downturn in interest. Round 4 resulted in lower bonus bids and an increase of farmout activity. In the face of this, can Round 5 restore an impetus that will sustain or increase interest?

Nobody can say for sure, but as Thurston said in his OTC talk, there could be a stimulus from improvements Brazil can make to the terms and conditions of licensing.

Thurston, working with Thomas Bard, also of ChevronTexaco, suggested that improvements in the technology of dealing with heavy oil and better ways of upgrading and refining the oil, can also help, but will take awhile. Help right now is more likely to come from contracts that ease the terms and conditions explorers must meet.

Deal Sweeteners
With smaller basins, heavier oil, and low commercial success rates, Brazil apparently has little choice but to look for ways to sweeten its auction terms to have a chance of competing with the GOM, and offshore Nigeria and Angola.

The ANP has already changed some of its contracts, but Thurston and Bard suggest more can be done to overcome the following problems:

  • Brazil has a complex tax regime with high upfront indirect taxes on transactions and investment rather than on revenue. These are not typical in other deepwater venues and erode value over a 20- to 30-year oil and gas project life.

  • In addition, Brazil has a tiered Special Participation Tax that sets production tax levels for onshore and offshore less than 400 meters deep, and offshore deeper than 400 meters. These provisions make no allowance for water deeper than 1,000 meters or for heavy oil. Both factors cause substantially higher exploration and development costs.

  • Few local sources of oilfield support services and machinery are available to private oil companies in Brazil. So private oil companies must import their own--an expensive process. At least the import of machinery for use in oil exploration and production is duty-free under a Temporary Admissions Regime, called REPETRO. But REPETRO is not a permanent exemption: It has to be renewed periodically, an uncertainty that troubles IOCs. A similar problem is a value-added tax, which can be imposed by Brazilian states. One recently proposed by Rio de Janeiro state would impose an 18 percent sales tax. This caused Petrobras to say that, if the tax passed, it would cancel two proposed offshore platforms.

  • There are other factors as well, such as low bureaucratic staffing levels, procedures that thwart efficient operations, and plodding regulatory rules, which add to potential investors' frustrations.

    So, the promise of Big Oil in deepwater offshore Brazil has yet to be realized by the many IOCs, independents, and other companies working there now. If Brazil is to attract investment at a level that will move it toward self-sufficiency, easing the terms and conditions of its contracts and improving regulatory and tax climates seem to have the best chance of helping. We'll see what Round 5 brings.