Big Oil, State Oil, Statoil

I appreciate that this is a blog about Emerging Markets, but it never hurts to reference a Developed Market success story, especially if it serves to show where a great opportunity has been missed.

I am a great admirer of Statoil. It is hard to imagine a better managed State Owned Enterprise (SOE) anywhere in the world. Here in Canada, Norway and Statoil are regularly invoked as the ideal models for Government handling of oil resources. Invariably, the people making that invocation then go on to propose a course of action diametrically opposite to that taken by Norway, underling just how hard it is the emulate them.

I mention this because Brazil and Petrobras have been showing us how not to do it.

Former President Fernando Henrique Cardoso started reforming Petrobras as part of the Real Plan. Its balance sheet was cleaned up to reduce Sovereign risk; product pricing was made more transparent to reduce subsidies; foreign capital was allowed to participate in exploration and production more.

These reforms helped to raise Petrobras’s efficiency and profitability, which in turn led to improved tax and dividend payments to the Government. Positive feedback meant that the improvements at Petrobras helped reduce Brazil’s country risk perceptions, lowering the cost of capital for Brazil and thus Petrobras. Although the company never rivaled Statoil in terms of efficiency, it was slowly moving in the right direction.

The discovery of the pre-salt resource changed all that.

Former President Luiz Inácio Lula da Silva (Lula) immediately took the resource nationalism route. All farther auctions were suspended, Petrobras was named the sole producer with mandated minimum participation in every field, and local content rules were set extremely high. Foreign Oil companies, including the ones who had been instrumental in developing Norway’s North Sea Assets, were reduced to mere sleeping partners.

I would doubt that would work in an advanced economy, so in a country renowned for its inefficiency and the “Gasto do Brasil”, he was being over optimistic – or worse. Petrobras had a well-deserved reputation for delivering projects late and over budget. Brazilian ports were at capacity, and the Government was dragging its feet over infrastructure expansion.

Several local firms had expanded capacity in anticipation that the auctions would lead to increased demand. By cancelling the auctions, the Government cancelled that demand, sending several firms to renegotiate with creditors, and others to put farther expansion plans on hold, so much for trying to promote local content.

The Government also carried out a “capital increase” to fund the development of the pre-salt, structured in such a way as to reduce minority shareholders participation in the company. Nothing compared to Chavez or Christina certainly, but enough to make many investors nervous, and starting a long period of underperformance by the stock, a core holding in Brazilian retirement funds.

Whilst we have been waiting for the auction process to restart, several things have happened.

1) Anecdotally, corruption at Petrobras has increased. We don’t know this, given the lack of prosecutions, but most political commentators in Brazil refer to it, and there have been several high profile corruption cases.

2) Petrobras’s Capex budget has continued to rise, needing more and more borrowing to fund it.

3) Finally, the company has gone back to surreptitiously subsidizing fuel sales, importing diesel at the world price and reselling it at the lower local price, in a vain attempt to keep inflation within the official targets. Over the last two years, the refining division has lost something in the order of $20 Billion on the subsidy. Compare this the Norway having some of the highest domestic gas prices anywhere.

So we have a country that abandoned its hard won reputation for pragmatism and reform. It has arbitrarily changed the rules after the event, disadvantaged its partners, and is now spending large quantities of money to suppress inflation, rather than deal with the root causes. How is that working out?

The October auction was expected to have 40 or so of the world’s oil majors attend, but in the end only 11 showed up, dominated by Asian SOEs that tend to be less price sensitive. When that many major firms walk away, and those firms that do participate are not technological leaders, you have a problem.

Petrobras is considered tapped out. Although total debt/ Equity is not excessive yet, it has been rising faster than its peers, and its current plans would make it very highly leveraged at a time when country fundamentals are weakening and demand for EM debt is under pressure. Perversely, it was probably helped by the poor auction result, given that it would have been even more stretched by any higher bids. It will have to fund the majority of the R$15 Billion signing bonus from the auction

Explore more PBR Data at Wikinvest

Explore more PBR Data at Wikinvest

The $20 Billion in lost profits by the refining division represents several billions in lost corporation and sales taxes to the Government, farther contributing to the deterioration in the Government balances. It is hardly surprising Moody’s downgraded Brazil and Petrobras within a day of each other in early October.

The lack of participation at the auction represents several billion in lost revenue, although we cannot quantify that.

And then there were this summers riots. The Government was forced to promise that more of the profits from the Libra field would be spent on education and social services to appease the masses.

One just hopes those profits stop being eroded by higher capex and higher debt service costs, after all, if Norway can do it….