China National Petroleum Corp. (CNPC) and Petrobras have signed an agreement defining the proposed structure of joint ventures that envision: CNPC buying 20% of Petrobras’ unfinished Complexo Petroquímica do Rio de Janeiro (Comperj) refinery project; and 20% of a group of the Campos Basin’ giant, but ageing, offshore Marlim Cluster oilfields.
The agreement is being hailed by Petrobras as proof that it is keeping its promise to the government and private shareholders to cut its massive debt. As a result it can now raise capital for its giant, new and most-promising offshore projects by selling or finding partners for older and less lucrative assets such as petrochemical plants and fuels-distribution networks. The government, and many industry observers, also hailed the accord as proof that the efforts to simplify and reduce the cost of regulation are working to attract the necessary international capital to help pull the sector and the national economy from a four-year slump
If the deal is completed it will be both the largest ever and only active foreign investment in the country’s refining sector. It will also rank as the biggest-ever overseas commitment to help Petrobras raise output and extend the productive life of older under-financed heavy-crude fields that still account for much of Brazil’s output. The neglect of these older areas of the Campos Basin has severely limited the expected boom in crude output and tax revenue from the astoundingly productive oil and gas flows from its massive pre-salt developments. The Marlim Cluster comprises four active fields which are all 100% owned by Petrobras: Marlim, Voador, Marlim Sul and Marlim Leste.
It will be a big deal for Petrobras if CNPC ultimately decides to invest the several billion dollars it would need to spend to help its partner complete the 80% built, 165,000 b/d Comperj project — halted after corruption-related cost overruns left a nearly US$15 billion hole in Petrobras’ balance sheet — and rework the fields in the nearby Marlim Cluster. While the countries 15 refineries can theoretically process 2.18 million b/d of crude, actual production is lower and cannot service the expected growth in domestic fuels demand. Petrobras’ already owns or directly controls nearly 98% of Brazil’s refining capacity which is more than when its legal monopoly on domestic refining ended in 1997. Even with huge annual investments, that reached US$45 billion in 2013, the combination of Petrobras new refinery investments and government fuel-pricing controls resulted in nearly US$50 billion in losses. Since then investment has more than halved. Without new players in the refining market, Brazil will either have to import more diesel, gasoline and supplies of bottled liquified petroleum gas (LPG) — used by most Brazilians to cook their food — or reduce crude exports by forcing Petrobras to slash investment in developing new offshore production and maintaining existing fields.
Investors still face very major obstacles
Unfortunately, the CNPC-Petrobras agreement is far more significant for what it says about the enormous political and economic risks of investing in Brazil’s fuels market and Petrobras failure to find buyers for its non-core assets than it is for any potentially real, or ground-breaking importance a successful deal would be. Without major legal and regulatory reform there is little chance that CNPC, or any other company besides Petrobras, will be able to justify spending the necessary capital sums to enter a Brazilian fuel-production business that is almost guaranteed to make losses rather than profits. With the Comperj/Marlim agreement only preliminary — and major obstacles to a realistically profitable investment — Petrobras is still a long way from getting the funds from CNPC. It has completed few asset sales and has only raised US$4.8 billion — or less than 25% of the US$21 billion 2017-2018 asset-sale target — so far.
The biggest obstacle to a final deal is the government’s fuel price controls. After ending Petrobras’ legal monopoly on exploration, production and refining in 1997, Brazil hoped to see a boom in both new, non-Petrobras upstream and downstream investment. Instead, however, it took nearly four years for the government to control a destructive history of hyperinflation — with energy prices making up about a 25% of the consumer price index and sometimes more for the country’s poorest citizens — to finally let Petrobras set domestic fuel prices based on world markets for crude and its own financial interests. In 2001, Spain’s Repsol bought 30% of a major Petrobras refinery in Brazil’s south. Its optimism was soon tested by the 2002 currency and debt crisis sparked by fears that Luiz Inácio Lula da Silva’s (a.k.a. Lula) Partido dos Trabalhadores’ (PT) would win the presidency and follow through on more than a decade of promises to default on Brazil’s foreign debt and limit the opening of its oil and fuels market.
Lula won but, once he took office in January 2003, his economic policies were far more moderate than anyone expected. He did, however, immediately end Petrobras freedom to set fuel prices as it saw fit. From then until mid-2016 — a period that saw oil prices soar to nearly US$150 a barrel in 2008, back below US$50 a barrel in 2009, up to about US$120 a barrel in 2011, and below US$30 a barrel in early 2016 — there was no predictable relationship between the world crude prices and the domestic price of refined products.
High oil prices enabled Petrobras to swallow much of the enforced government subsidies to the fuel consumers by simply reducing its large and growing profit margin on output from projects designed to be economic when oil prices were low to cover the declining refining margins. But that soon failed. It was hoped that the 2007 discovery of more than 30 billion barrels of high-quality light-crude reserves in offshore pre-salt fields off Rio de Janeiro would fund Brazil’s move to become a developed nation. The government — which is Petrobras’ controlling shareholder — used the expected pre-salt bonanza to more than double Petrobras investments both new projects but also shipyards, petrochemicals, biofuels, and giant new export-oriented refineries. At the same time the government demanded that Brazil restrict foreign and other non-Petrobras companies from invest in the new ‘strategic’ resources. It and its coalition partners also saw the benefits of increasing domestic control of the oil business and concentrating major investments with Petrobras. This made it easier to control the growing amounts of bribery, kickbacks and contract fixing opportunities that came through the increased political interference in the industry.
With the price of fuel unable to cover the cost of crude, Repsol sold its Brazilian refinery stake back to Petrobras in 2010 for about US$850 million, which was mainly accumulated debt on its investment. Venezuela’s President Hugo Chavez was willing to let PDVSA subsidise oil sales and other loss-making oil projects to expand his country’s influence and regional anti-American crusade. In the end, however, he reviewed the losses he would probably suffer as a result of Brazilian fuel-price controls and corruption-fuelled cost-overruns on his long-promised US$8 billion share for a 40% stake in Petrobras’s US$20 billion Abreu e Lima Refinery in Brazil’s Northeast — the most expensive refinery every built — and ultimately pulled out of the project. Petrobras ultimately lost about US$20 billion at the time on subsidies before they were ended in 2016. The losses on Abreu e Lima and Comperj have cost Petrobras about US$35 billion and the massive corruption that inflated the projects price helped among other things to: wipe more than US$300 billion from Petrobras’ market value; drive its debt above US$120 billion which was the largest of any publicly traded company; and contributed to turning Brazil’s 2014-2017 recession into the worst in the country’s history.
With Petrobras reeling from the vast corruption scandal, its debt nearly out of control and losses mounting as oil prices dropped again, the government of President Michel Temer — that succeeded Lula’s PT successor and Petrobras’ former chair, Dilma Rousseff, who was then impeached and removed from office in 2016 — finally set Petrobras free to set wholesale refinery gate fuel prices as it saw fit. That freedom only lasted two years and the devastating June 2018 national lorry-drivers’ strike cut off fuel and food supplies to many cities and forced reduction of public transit services.
To end the strike the government acceded to the strikers’ demands to re-impose political controls on fuel prices. Diesel prices in particular had soared in recent months as Congress failed to pass measures to limit spending and cut its soaring debt. This was expected to reach 100% of GDP which is the highest of any developing nation except Venezuela. The failure to pass the controversial budget controls in the run up to this month’s general elections — a situation made more difficult as a result of tax reductions designed to help cut fuel prices — caused the Brazilian Real to plunge to a record low against the US$ in recent months. This exaggerated the local-currency rise in fuel costs which were pegged by Petrobras to the dollar-denominated world price for crude.
Neither candidate in this week’s second round presidential election has been willing to risk promising a return to free-market pricing for fuel. This raises the risk that any company investing in the downstream sector could easily face a situation where political pressure results in it having to sell fuel at a loss. Jair Bolsonaro has promised to liberalise the economy and expand the sale of state assets, including Petrobras’ non-core and money-losing businesses, but his commitment to free-market principles is far from certain. While his PSL party has been one of the strongest supporters of the Temer government’s oil-market opening, for most of his nearly 30-year career in Congress, the former army captain has largely supported nationalist and state-directed economic development. These are still popular with many in the military whose 1964-1985 dictatorship is openly admired by Bolsonaro and it the source of several of the men he has said he plans to pick to head key ministries.
Brazil and China: mutual fear and loathing
This all raises serious questions about whether or not CNPC or any other company will be able to justify any Brazilian refinery investment. Until Brazil passes legislation —either preventing government interference in fuel-price decisions, or requiring the government and not refinery investors to pay the full cost of any direct or implicit domestic fuel subsidies — any new refinery deal faces serious political and economic risks. Even if CNPC decides to go ahead with its Comperj/Marlim investments there is little to suggest that it will necessarily spark a rush of new, non-Petrobras investment in Brazilian refineries.
China and its state-owned companies have a long history of making investments for political rather than profit-oriented reasons. The 20% stake may appear relatively small and, according to Petrobras’ statement, also includes access to new production. Therefore — together with CNPC’s existing E&P investments in the country — it could, depending on the direction of prices, allow it to own enough Brazilian crude to simply reduce their profit share to cover any lower refinery returns imposed by the government. That, in turn might only become a real issue if CNPC cannot get a better price by exporting its Brazilian crude output to China. It was the expected losses on the Abreu e Lima Refinery contract clauses — requiring PDVSA to commit a set amount of its own output to supply the refinery and sell the resulting fuel in Brazil — that led to Chavez pulling out of the agreement.
China, may, however, be willing to accept losses on Comperj refinery because it will gain: increased influence with Petrobras; preferred access to new Petrobras-led oil-production projects to help supply the Chinese market; and a market for its rapidly growing oil service sector companies. This will enable it to better compete for Petrobras contracts with more traditional US and European suppliers. That assumes, however, that Chinese oil executives are willing to set aside their history of frustration with Brazil’s tax and labour regulations and the deep, if largely hidden, mutual suspicion and even contempt that Brazilian and Chinese leaders and executives share for each other.
Brazilians fear that the erosion of their strategic independence might result in too much dependence on Chinese investment. There is often justifiable anger that China is not as open to its agricultural and industrial exports, such as soybeans and aircraft, as Brazil is to Chinese imports. China has not only surpassed the US as Brazil’s largest trading partner but has replaced the US’ former role as the biggest existential threat to Brazilian economic independence.
For their part, the Chinese, when caught in unguarded moments, often express contempt for: Brazilian rules and regulations that they consider excessive and costly; and for a population they not infrequently consider lazy, economically backward and uncultured. Nearly every major Chinese major non-oil heavy industrial investment in Brazil has been an economic failure. Its companies and government has never been shy to break promises to make major capital investments — in everything from steel mills and mines to shipyards and electronics factories — if Brazil is unable to satisfy their demands. With Brazil being neither as open or legally transparent as the US or Europe, or as compliant as African dictatorships, Brazil has always been a difficult place for China to do business.