Libra Auctions - Maximizing Fiscal Revenues Vs Ensuring Commercial Viability

Last week the Brazilian government opened the much awaited auction of the pre-salt Libra off-shore oil field in the South Atlantic to lukewarm response from global oil majors. Its 8-12 bn barrels of recoverable oil lie under a 2 km thick layer of salt beneath the seabed and is estimated to eventually produce 1 million barrel per day, or nearly 50% of Brazil's current production. It is the first of a series of proposed auctions to develop large off-shore oil discoveries made in recent years.

The US oil majors were not among the 11 firms which registered, far lower than the 40 bids expected by the Brazilian government. State owned oil firms, from China, India, and Malaysia, dominated the list of registrants. The demanding terms of the auction is said to have put off competition. The FT writes,

The government was charging a signing bonus of R$15bn ($6.6bn) for the winning group. Petrobras, which is required to take a minimum stake of 30 per cent in all blocks in the pre-salt fields, will need to spend at least R$4.5bn on the signing bonus. The bidding groups will compete on how much of the so-called “profit oil” in the production-sharing contract they are willing to allocate to the government beyond the state’s minimum share of 40 per cent. All told, the total “government take” will be 75 per cent, including the amount from the signing bonus, income tax and the 40 per cent of profit oil. The winning bidder will be able to use up to half of the value of gross production per month to cover the cost of development of the field for the first two years of the contract, after which this will be reduced to 30 per cent.

The auctions being held under the country's new oil field development policy places further restrictions, most notably the operational control of the field,

The auction will be the first under the country’s 2010 production-sharing agreement through which the government has sought to increase its control over the country’s newly discovered reserves. Under the model, the government will award rights to explore and produce oil at Libra to whichever company or group that promises to give the largest share of its output from the field to the Brazilian government... Petrobras will also automatically take a minimum stake of 30 per cent in the winning consortium and become the sole operator of the field, controlling exploration and production.

The initial response raises questions about the strategy being pursued for the development of the pre-salt fields, discovered in 2006-07 and easily the largest oil find in South America in decades. Apart from the restrictive conditions, two other factors may have muted investor enthusiasm. One, this is part of the $237 bn five year (2013-17) investment plan being implemented by Petrobras, the largest corporate capital expenditure plan ever. The scale of its planned deep-water drilling operations have never been attempted by any oil firm before. Two, despite positive drilling results till date, the technological challenges associated with extracting oil from under the sheet of salt is likely to be formidable. Both these factors exacerbate the risks associated with the project.

Clearly the Brazilian government views the pre-salt oil fields as a cash cow to be milked to maximize the country's fiscal gain. In fact, the one-time signing fee itself is seen as too steep in comparison to similar international agreements. In addition, by making Petrobras as the sole operator for these fields, the external investors will remain "sleeping partners" of the state-owned firm. The decision has given currency to the perception that the government plans to use Petrobras as an instrument to exercise operational control. The long history of expropriation of privately held assets too would not have been lost on investors. 

The government has resorted to the production-sharing agreement, as against a concession model, since the exploration risk (possibility of finding oil) is lower in the pre-salt area. Under the production sharing contract, the government retains ownership of the resource and the operator is allowed to profit from selling a share of the oil. In a concession contract, the company owns the resource but returns a share to the state through taxes and royalties. 

Governments, like Brazil, seeking to leverage foreign capital and technology to exploit natural resources face the difficult dilemma of balancing between maximizing its windfall revenues and allowing the commercial viability of the development project. Unfortunately, immediate financial gain and populist considerations predominate in such decisions. This undermines the long-term financial viability of the project and reduces the attraction for foreign and domestic private investors. The pre-salt oil fields, where the government effectively appropriates 75% of the output and uses Petrobras to exercise operational control, is only the latest example of this trend.  

Update 1 (12/22/2013)
Mexico has amended Articles 27 and 28 of its Constitution to allow contracts between the government and private companies to share profits from the extraction (also refining, transporation, storage, and distribution) of the country's rich on-shore and off-shore (off Gulf of Mexico) oil and gas deposits. The country's oil industry was nationalized in 1938 and in 1960 a constitutional change assigned full control to Pemex, which today contributes nearly a third of the country's budgetary resources. The FT writes,

Other promising hydrocarbon deposits in Mexico, particularly in shale beds and deepwater wells, remain untouched because Pemex lacks the technology and financial capacity to profitably extract from these sites. While Mexico’s energy production remained stalled, other countries with the assistance of the private sector have learned to develop hard-to-reach resources efficiently, with less pollution and risk.

The government estimates the reform will lower energy prices, create over 2m jobs over the next decade, strengthen Pemex by making it compete on equal grounds with private companies, and provide Mexico with needed funding to invest in long-term infrastructure projects. Under the legislation, a new Mexican sovereign fund will be created, operated by an appointed independent board, to manage royalties and make investments in the country.

The reform will allow private investment through various schemes: profit sharing, production sharing, or in the form of licences. Mexico will benefit from new technology and financial and human capital to exploit its abundant energy deposits, not to mention the royalties it will receive. Foreign and domestic private investors will benefit from entering a market with plentiful energy resources.