The Rising Influence of Rising Affluence

[DewDiligence]

Politics, Not Deep Drilling, Pose Biggest Risk for Petrobras

[Nothing new here, but this write-up succinctly states the predicament for Petrobras investors.]

http://online.wsj.com/article/SB10001424052748703597204575483551475422226.html

›SEPTEMBER 13, 2010

The latest revision to the prospectus for Petroleo Brasileiro SA's $65 billion offering of common and preferred stock highlights the risks of the kind of deepwater-offshore drilling the new capital will fund. But the bigger risk may be political.

The mother lode of oil off Brazil's coast threatens to reintroduce politics into the management of the oil giant, which is controlled by the Brazilian government but has been ably managed on a commercial basis.

The prospectus stresses that 53% of the $224 billion the company has budgeted for capital expenditure through 2014 will go toward exploration and production, and this is focused on deepwater drilling. Petrobras is already the world's largest deepwater player, with 22% of global deepwater production in 2008, far ahead of No. 2 Exxon Mobil's 14% share. Petrobras will be drilling at depths beyond any current wells, so obtaining the oil will be difficult enough, and the risk of accidents and leaks could be significant.

Although the government holds about 30% of the company's capital and 55% of its voting shares, Petrobras has operated largely independently, especially since 2002, and Brazilian law had been loosened to allow partnerships with foreign oil firms. The prospect of an enormous revenue stream—with more than 14 billion barrels of oil equivalent, or BOE, of proven reserves and the potential for as much as 35 billion BOE—could bring the company back under tighter political control.

For one thing, as the prospectus points out, Brazil's congress is considering enacting rules for the exploration and production of oil and gas that might make Petrobras the exclusive operator in all unlicensed pre-salt areas—areas of rock under thick salt deposits—comprising about 10.7 million hectares. This envisions having Petrobras assume about a one-third interest in any public bids for such licenses, meaning it would retain a pre-eminent position in all drilling activities.

However, the company cautions that any new rules, and an agreement under which the company is allocated five billion barrels of deepwater reserves in exchange for issuing $42.5 billion worth of stock to the government, may be challenged by Brazilian courts—a wild card in evaluating the company. Some investors have complained that the company is paying too much for the fields.

In addition, the state of Rio de Janeiro's tax on exploration and production activities—enacted in 2003 but not enforced—could require Petrobras to pay the state about $6 billion per year.

Brazil's presidential elections in October will introduce another uncertainty [see #msg-51011758 and #msg-44866628 for more on this]. The candidate with a wide lead in the polls, Dilma Rousseff, is generally seen as having more leftist views than current President Luiz Inácio Lula da Silva, though she has his support.

Nor are the political risks limited to Brazil. While the majority of the company's investments are there, 44% of its international production and reserves are in Argentina, which levies export taxes on oil and gas sales that have been detrimental to operations. An additional 20% of international investments are in Bolivia, which in 2009 prohibited private ownership of the country's oil and gas reserves, complicating Petrobras's investment value there.

As Petrobras is used as an instrument of national policy, either by design or through economic evolution, it stands to become politicized. The danger is that it moves closer to Petróleos Mexicanos or Petróleos de Venezuela SA, the national oil companies of Mexico and Venezuela respectively, which have been tapped to promote a variety of social causes.

While shares of Petrobras have recently performed well in relation to major oil-company peers, the stock's movements will become increasingly volatile due to its being a relatively pure oil play, the potential risks of its new deepwater exploration and production emphasis, and the greater risk that the company's independent operating philosophy and financial behavior may be altered by politics.‹