Brazil oil and gasRealities in a new frontier

Introduction

Over the past 25 years, by exploiting its vast natural resources and huge labor pool and by taking advantage of large and well-developed agricultural, mining, manufacturing and service sectors, Brazil has become Latin America’s leading economic power, rapidly expanding its presence in global markets. The national oil company, Petróleo Brasileiro or Petrobras, was created in 1953. The monopoly enjoyed by Petrobras ended in 1997 with the constitutional change that liberalized the oil and gas sector, partially privatized Petrobras and opened the oil and gas sector to private and foreign competition.

More recently, the discovery of several potentially huge fields in the “pre-salt” layer of the deepwater offshore, beginning in late 1997 in the Santos basin and since then extending into the neighboring Campos and Espiritu Santo basins, has opened a new frontier, bringing both tremendous opportunities and daunting challenges. These pre-salt discoveries have triggered a reassessment of the Brazilian regulatory model and a restructuring of the Government’s role in the industry, bringing uncertainty for investors seeking to efficiently exploit the opportunities. The Brazilian Government is looking to:

1. Attract the international capital to fund the development of these complex resources.

2. Create a national development fund for infrastructure, education, housing and social services.

3. Build a strong, technologically sophisticated domestic oilfield services (OFS) industry.

Managing the complex interdependencies between these objectives will determine how successful Brazil will be in fully exploiting its pre-salt deepwater reserves potential.

1Brazil oil and gas: realities in a new frontier

Source: International Energy Database, US Department of Energy,accessed 10 September 2010.

000

b/d

crude/condensate NGLs Other liquids

Brazilian oil production3000

2500

2000

1500

1000

500

02000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Source: International Energy Database, US Department of Energy,accessed 10 September 2010.

Brazilian natural gas production (marketed production)

bcf

600

500

400

300

200

100

02000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Brazilian oil and natural gas reserves

Source: International Energy Database, US Department of Energy,accessed 10 September 2010.

billi

on b

oe

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

oil natural gas16

14

12

10

8

6

4

2

0

Market overview

DemandBrazil is the world’s tenth-largest energy consumer. Domestic oil demand in 2009 totaled ~2.5 million b/d and growth over the next 20 years is expected to be approximately 1.9% per year, with oil demand in 2035 expected to reach about 4.0 million b/d. (In contrast, over the 2010-2035 period, global oil demand growth is expected to average about 0.9% per year.1) Unique to Brazil is the prominent role of biofuels (primarily ethanol) in the oil demand mix. As a result of rapidly growing crude oil and biofuels production, Brazil is now self-sufficient in oil, with a growing role for oil exports.

Natural gas demand in Brazil was about 650 bcf in 2009. Gas demand growth of about 4.3% per year is expected over the next 20 years. (Global gas growth is forecast to be about 1.3% per year over the period.2) Demand growth will be met by increasing domestic production as well as by increased gas imports, both in the form of pipeline gas (primarily from Bolivia) and liquefied natural gas (LNG).

Production and reservesDrilling activity has increased sharply over the past five years in Brazil and as a result both production and reserves have increased dramatically. More than 93% of Brazil’s oil reserves are located offshore, while about 80% of the country’s natural gas reserves are offshore. The waters off the state of Rio de Janeiro (which include most of the prolific Campos and Santos basins) account for about 80% of Brazil’s oil reserves and about 45% of Brazil’s natural gas reserves. In 2009, about 90% of the country’s oil production and 70% of its natural gas production was offshore.3

1 International Energy Outlook 2010, US Department of Energy, 27 July 2010.

2 Ibid.3 “Energy Country Profiles: Brazil,” IHS Global Insight, September 2010.

2 Brazil oil and gas: realities in a new frontier

While the recent gains in Brazilian production and reserves have been substantial, more important is the role that new production is expected to play in the future. Conventional long-term forecasts of oil supply and demand see new production from Brazil as the single largest source of new oil supply outside of the OPEC countries over the next 20 – 25 years.4

The domestic giant: PetrobrasPetrobras currently accounts for about 95% of Brazil’s national oil and gas production. Its production is expected to continue rising steadily in the next few years, with most of the production growth over the short term to come from the planned addition of new production modules to fields in the Campos Basin that are already in production, as well as from more recent discoveries in the basin. Longer-term growth will come from the pre-salt cluster in the Santos Basin. Under its most recent five-year investment plan (2010 – 2014), Petrobras expects to spend more than US$224 billion (an average of almost US$45 billion per year) with more than half of its total investment dedicated to upstream. The new regulatory framework has allowed a recapitalization of Petrobras through a public share offering and a federal government grant of approximately 5 billion barrels of reserves in unlicensed pre-salt acreage (the “rights” offering) in return for an increased stake in the state oil company.

4 International Energy Outlook 2010, US Department of Energy, 27 July 2010.

Integrated companiesPetrobras was the nation’s sole oil producer until August 2003, when Shell became the first international company operating a field to start production. Although Petrobras lost its monopoly over oil exploration and production with the 1997 constitutional change, many companies still choose to partner with the state oil company. Its partners and competitors in the Brazilian upstream include many of the world’s largest international oil companies (IOCs). In early 2009, the Agência Nacional do Petróleo, Gás Natural e Bicombustíveis (ANP) estimated that as many as 36 foreign companies were involved in upstream activities in Brazil.5

Like other oil-producing countries, Brazil is also attracting increased interest from Asian investors. Chinese national oil companies (NOCs) have been slower to enter the market but are starting to catch up following the signing of a strategic cooperation agreement in April 2010 that could pave the way for Sinopec to acquire part of Petrobras’ interests in two blocks and for Sinochem to take stakes in certain upstream operations.

Other domestic playersAnother emerging trend is the heightened activity of privately owned domestic companies. The activities of local companies, apart from Petrobras, were once limited to participation in incremental oil production projects in mature onshore basins, but newcomers like OGX Petróleo e Gás and the mining giant, Vale, are now investing in offshore exploration as well.

Downstream oil and alternative fuelsWhile Petrobras lost its monopoly over the domestic downstream market and for the importation of crude oil and refined products in January 2002, it nonetheless remains the dominant player. Petrobras owns or has an interest in 11 of Brazil’s 13 refineries and has four additional refineries under construction or in advanced planning. It accounts for approximately 98% of Brazil’s refining capacity and its product distribution subsidiary (BR Distribuidora) accounts for about 35% of Brazil’s domestic product distribution market. Notably, many of the international integrated majors have been gradually

5 Nelson Narciso, Filho, ANP Director, “The Oil and Gas Industry in Brazil: The Role of the Regulator,” May 2009.

Source: International Energy Outlook 2010, US Department of Energy, 27 July 2010.

conventional oil unconventional oil/other liquids

Brazil Canada US Russia Caspian All other NOPEC (net)

mill

ion

b/d

-5.0

-4.0

-3.0

-2.0

-1.0

1.0

2.0

3.0

4.0

5.0

6.0

0.0

Expected changes in non-OPEC oil supply: 2008–2035

Market overview continued

3Brazil oil and gas: realities in a new frontier

withdrawing from the Brazilian downstream retail market. Of the majors, only Shell is actively growing its retail presence in Brazil.

Brazil’s alcohol fuels program dates to the mid-1970s and the aftermath of the first world oil price shock, with Brazil’s ethanol policy designed to reduce oil dependence and leverage its surplus sugar cane production capacity. Brazil is the world’s second-largest producer of ethanol and its largest exporter. All gasoline sold in Brazil contains at least 20-25% ethanol and a majority of the country’s vehicle fleet can operate on essentially any blend of ethanol and gasoline. In August 2010, Brazil’s largest producer/distributor of ethanol, Cosan and Shell announced a US$12 billion joint venture for the supply, distribution and sale of transportation fuels through their combined distribution and retail networks.

Transaction activityInterest in Brazilian oil and gas has increased dramatically in recent years, particularly as the pre-salt potential has grown. With three major pre-salt deals, including two involving the Chinese NOC, Sinochem, transaction activity in 2010 totaled more than 22 billion.

In the chart below, “downstream” transactions include refining, marketing and petrochemicals, while “other” deals include midstream, oilfield services and gas distribution transactions.

The Gulf of Mexico spill effects on Brazil

With Brazil being the next major growth center for the offshore industry, it is important that the lessons from the Gulf of Mexico spill are learned both in terms of prevention and also in terms of incident response. As the industry moves inexorably into deeper and deeper waters, it will have to come to grips with the possibility that the technical difficulties of dealing with a major spill one mile under the surface may be exacerbated or require a totally different approach at a two-mile depth or deeper. Brazil’s regulations on platform safety, largely put in place after the country’s own rig disaster in 2001, are believed to be among the most advanced in the world. The ANP recently announced a review of safety systems and contingency strategies in light of the Gulf spill, given that the development of the prolific sub-salt area in ultra-deepwater at high pressures presents a new series of technical challenges, potential dangers and environmental risks.

Source: “Herold M&A Transaction Database,” IHS Herold Inc., accessed 15 October 2010.

Brazilian oil and gas M&A activity$25

$20

$15

$10

$5

$0

deal

val

ue (U

S $

billi

on)

num

ber o

f dea

ls

25

30

35

20

15

10

5

02000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

upstreamdownstreamalternative fuelsothernumber of deals

4 Brazil oil and gas: realities in a new frontier

Opportunities, challenges and risks

• Recent successful share offering but with greater state ownership. The recent successful share offering gives Petrobras the necessary funding for the first phase of its aggressive development plan. In addition, the rights offer adds substantial acreage and potential reserves to the asset base, adds to long-term production growth and increases the company’s operational flexibility by broadening its development options. However, in the recent share offering, the Government bought almost two-thirds of the shares. As a result, the Brazilian Government now directly or indirectly controls 64% of all Petrobras common shares and about 48% of all shares, including preferred shares. The free float of Petrobras shares is now down to about 52%, as opposed to 60% before the share offering.

• Political stability and geopolitics. The positive business implications of the political stability of the Lula years and the prospects of political continuity with his successor, Dilma Rousseff, will likely offset any worries that foreign policy objectives and/or ideology (e.g., strengthened relationships with Venezuela) could be detrimental to or conflict with commercial objectives. Similarly, the Government has pledged to use the new oil revenues for the public good.

• Tax and regulatory structure. The current fiscal structure, which applies to existing discoveries, is a tax/royalty regime. The regime operates through three mechanisms: (1) a flat royalty, typically of 10%; (2) a “special participation tax” (SPT), which is a sliding-scale levy set with reference to field location, field vintage and field production; and (3) a corporation tax levied at 34%. While the intention is that this regime will be ultimately superseded with a Production Sharing Contract (PSC)-based system for newly licensed acreage, the PSC system has yet to be passed into law and it does not appear that this will be applied to the resource that forms the transfer of rights. The exact terms to be applied when valuing the 5 billion boe transfer are unclear, although it appears likely that the existing tax/royalty system will be used, but without the application of SPT.

• Local service, labor and infrastructure constraints. There are existing bottlenecks in equipment and skilled personnel availability, which are not expanding in step with acreage and production growth targets. The high local content provisions of the rights offer (55% through 2016 and 65% through 2019) will further reduce the flexibility to import equipment and manpower. Importantly, existing rig tenders are running a year behind schedule and Petrobras’ implied drilling plan for the rights offer areas could lead to significant mid-term rig shortages.

• Investment requirements. The scale of the required investment in Brazil’s infrastructure is enormous, with estimates approaching almost US$1 trillion over the next 10 years. Almost half of the required investment is expected to be dedicated to oil and gas, including exploration and development of the massive pre-salt resources, expansion and upgrading of the country’s refining and petrochemical sector and expansion of the energy transportation and distribution infrastructure. The numerous large and complex projects will present huge opportunities for suppliers and partners. However, the potential cost and execution risks are large as well.

• Technical challenges, production logistics and operational risks. The best prospects lie in ultra-deepwater, essentially at the technology frontiers. The water depth challenges are further complicated by high pressures and low temperatures and by the difficulties in drilling through the thick salt layer and by the high CO2 content in many of the reservoirs. In addition, there are gas monetization and transport issues, such as moving gas to shore rather than flaring, as well as issues with Floating Production Storage and Offloading (FPSO) unit logistics. Similarly, the recent spill in the Gulf of Mexico highlighted some of the risks in deepwater that will need to be mitigated through the implementation of operational best practices and leading incident response procedures.

The positive drivers of the Brazilian business dynamic going forward are Brazil’s political and economic stability, expected massive investments in local and national infrastructure, particularly in oil and gas, and huge partnership/supplier opportunities. However, as noted by IHS Global Insight6, as well as other analysts, there are some potential pitfalls. These include:

6 IHS Global Insight, Inc., “IHS Global Insight Report: Brazil Energy,” September 2010.

5Brazil oil and gas: realities in a new frontier

How can Ernst & Young help?

Our Global Oil & Gas Practice consists of a network of more than 8,300 professionals with extensive experience working in the oil and gas industry. Our professionals have experience serving a wide range of companies — independent exploration and production companies, oilfield services companies, independent refiners, major integrated corporations and national oil companies.

Our Global Oil & Gas Centers, like the professionals in our Global Oil & Gas Practice, are strategically located in areas that allow us to best serve the needs of the industry. In addition to our Houston, London, Moscow and Bahrain Centers, we have several Satellite Centers located around the globe, including in Aberdeen, Calgary, Cape Town, Beijing, Perth, Rio de Janiero, Singapore and Stavanger.

Our service offerings particularly relevant to the Brazilian oil and gas industry include:

• Statutory accounting and compliance services, including external audit and other assurance-related services such as HSE services, climate change and sustainability reporting services; accounting advisory services; and fraud investigation and dispute services

• Tax planning, advisory and compliance services, including in-bound tax compliance services; transaction tax services; and tax-efficient supply chain advisory services

• Transaction advisory services, including partnership planning and optimization; portfolio planning and evaluation services; strategic financing assessments; transaction due diligence; asset valuation and business modeling; and transaction integration services

• Performance improvement and risk management advisory services, including internal audit services and internal controls design and evaluation; business process innovation, transformation and governance; project life cycle management services and Project Management Office (PMO) implementation and operation; as well as strategic risk assessment, management and remediation.

Our deep industry focus helps Ernst & Young make a difference. It allows us to help companies in the oil and gas industry meet their goals and compete more effectively.

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How Ernst & Young’s Global Oil & Gas Center can help your businessThe oil and gas industry is constantly changing. Increasingly uncertain energy policies, geopolitical complexities, cost management and climate change all present significant challenges. Ernst & Young’s Global Oil & Gas Center supports a global practice of over 8,000 oil and gas professionals with technical experience in providing assurance, tax, transaction and advisory services across the upstream, midstream, downstream and oilfield service sub-sectors. The Center works to anticipate market trends, execute the mobility of our global resources and articulate points of view on relevant key industry issues. With our deep industry focus, we can help your organization drive down costs and compete more effectively to achieve its potential.

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