How Brazil Squandered Their “Winning Ticket” By Attempting To Re-nationalise Oil Production

In 2006, exploration in Brazil’s Campos Basin discovered pre-salt, an ultra-deep geological layer known to harbour high-grade oil. The announcement was greeted with euphoria. Politicians said the discovery would launch a new era for the country. The former president, Lula da Silva, described the pre-salt layer as a “winning ticket” for Brazilians.

Now, ten years later, the country is in an economic and political crisis. Unemployment has reached 12 million people. In the oil industry, bad decisions by the government turned the supposed benefits of the pre-salt discovery into a fiction. There has been a haemorrhaging of private investment, and research and innovation have dwindled, while engineers trained in Brazil’s best universities can instead be found manning newsstands or running small businesses.

Who Stopped The Black Gold?

Brazil’s journey from euphoria to failure is best understood through the oil industry’s regulatory framework over the last quarter of a century. Until the mid-1990s, the Brazilian constitution provided that oil exploration and production would be monopolised by the federal government, legally called “The Union”. This monopoly would be exercised on The Union’s behalf by Petrobras, the state energy company created in 1954.

In 1995, a constitutional amendment was approved, enabling private companies – Brazilian and foreign – to submit competitive tenders for Brazil’s oil. Two years later, in 1997, Brazil established the concession agreement. This scheme provided such companies with the right to explore oil in the country if they offered payments or royalties to The Union via a bidding process. Today, Brazilian exploration fields pay on average 10 per cent of their output through this concession scheme.

These reforms brought about significant results. The oil and gas sector increased from 2.7 per cent of Brazil’s GDP in 1997 to 10.5 per cent in 2005. While the Brazilian economy grew by 14.2 per cent between 1998 and 2004, the oil industry grew by 318 per cent. This meant the expansion of jobs and opportunities for Brazilians. Under the pressure of competition, Petrobras began to master technology for drilling offshore in deep waters.

It was in this context that pre-salt was discovered in 2006. The oil and gas potential in this layer outran any other in Brazil: indeed, it was the largest discovery in the Western Hemisphere for decades.

It was at this point that President da Silva’s government made a fateful, and political, decision.

The Policy That Confirmed Brazil's Fate

On 22 December 2010, Act No. 12,351 established a new model known as “production sharing contracts” aimed at increasing state control over production in the pre-salt area. It outlined new terms for the sharing of a percentage of the oil between producers and The Union. In addition, Petrobras would be guaranteed at least a 30 per cent share in every auction of pre-salt blocs, meaning that foreign companies could only act as part of a consortium with the Brazilian oil giant.

The intervention also regulated the operational decisions of consortia. PPSA, a state-owned company with the purpose of representing the Brazilian government in sharing contracts, would have half of the votes in the consortias’ main decision-making body, as well as the casting vote and veto power on decisions.

These changes severely limited the role of private capital in the pre-salt block – there being little point competing for a contract when Petrobras was guaranteed such a large share. In the auction for the Libra oilfield, considered the most attractive, there was only a single bid: a consortium formed by Petrobras, Shell, Total, CNOOC and CNPC. With no one to bid against the consortium, the block was sold off at its minimum price – not least since the auction notice stated that 41.65 per cent of any surplus oil would be handed over to the federal government.

As investment evaporated, it rapidly became clear the introduction of the sharing model had proved to be one of the biggest strategic failures in Brazilian history. Yet political discussion surrounding it was shut down. Any proposals to correct the distortions of the sharing model were described as “entreguista” (allowing foreign domination over Brazilian assets) or “neoliberal”, mainly by politicians of the Workers’ Party (the party of presidents da Silva and Dilma Rousseff) but also by the Federação Única dos Petroleiros (Single Federation of Oil Workers), which has strong ties to the Workers’ Party.

Petrobras’ monopoly on operations also hindered any need for reform within the company. The absence of these changes is now cited as one of the causes of the current Brazilian economic crisis: the lack of competition removed the need for the company to invest in technological innovation. Making matters even worse, the same government which introduced the unsuccessful changes was implicated in a huge corruption scandal involving Petrobras, with millions spent in kickbacks and fraudulent contracts.

The discovery of pre-salt could have represented to Brazil what the Ekofisk oil field represents to Norway: the beginning of a new development cycle, bringing prosperity to the country. It could have meant success and professional opportunities for Brazilians among the network of companies involved in oil production, ranging from the sale of goods to sophisticated offshore engineering.

This week, Brazil’s new government has announced that it will be easing many of the restrictions on foreign involvement, in order to attract investment. But it comes after a decade of self-inflicted damage. The changes that followed the discovery of pre-salt drove away investment, reduced jobs and brought the production of oil back to the level of the 1970s. A failed government that led the country to the brink of bankruptcy also made Brazil’s “winning ticket” a fiction.

This piece was first published on the Foundation for Economic Education and has been republished here with permission.