Media Highlights

"Economic outcome would be the same with a concession"

30 January 2011

The government has decided to change the method of exploitation of the pre-salt layer, the huge oil reservoir hidden under the salt layer of the sea, throughout the Brazilian coastline. Instead of the concessions system, the regulatory framework anticipates the production sharing system. As a result, part of the so-called profit oil, which is the oil found, minus the cost of exploitation, goes to the government.

The specialist on the matter Luiz Antonio Lemos, of Campos Mello Advogados, believes that, from a technical viewpoint, the country could, in theory, obtain the same economic results without changing the form of exploitation. “In theory, everything that the government will obtain with the production sharing system could also be obtained with the concessions system. Legally speaking, the same effects are possible,” he says.

In the interview, granted to the magazine Consultor Jurídico, at the office of Campos Mello in Rio de Janeiro, Luiz Antonio Lemos and attorney Marcelo Romanelli de Oliveira explained how the exploitation systems work. They also talked about the comparative study prepared by Lemos and his team at the request of BNDES. Lemos and his team studied the models adopted by 11 countries, including Brazil.

Lemos believes that the choice made by the Brazilian government ultimately created a unique system. “For us it is a mystery if it will be a successful model,” he said. Among the reasons for the doubts is the fact that Brazil has maintained a single operator, namely Petrobras, which will be awarded, at least, 30% of the blocks. “The more operators there are, the more companies to assume the exploration and production risks,” he explains.

Another distinguishing characteristic of the system created in Brazil are the royalties. “The PSA [Production Sharing Agreement] anticipates the appropriation of the wealth by the Government, which is entitled to part of the oil production. Royalties are typically associated with the concession system. In the PSA, there is the part of the production that goes to the Government, plus the royalties,” he says. In addition, the country will incorporate Pré-sal Petróleo S/A (PPSA), the government-owned company that will manage the exploration work.

The specialist also addressed the changes in the environmental aspect. According to Lemos, the concession system transfers the responsibility for the activity to the concessionaires. In the production sharing system, there is a Government company reaping the benefits. “No matter how much anyone argues that the company is not responsible, the hard fact is that it is,” he concludes.

One discussion that might end up in Court is the change in the form of distribution of the royalties. Former Brazilian President Luis Inácio Lula da Silva vetoed the article that established the distribution of the royalties among all municipalities, even non-producing municipalities. However, despite the veto, specialists say that the change might be discussed. “There will surely be a loss, since other states and municipalities will be entitled to a piece of the cake, which were not originally entitled to it,” explains Marcelo Romanelli de Oliveira.

Born in Rio de Janeiro, Luiz Antonio Lemos graduated from the Law School at the Federal University of Rio de Janeiro (UFRJ) in 1982. A partner in the infrastructure area at Campos Mello Advogados, Lemos carries with him the experience with several projects in the field of oil and gas. His curriculum includes advisory services provided not only to Brazilian companies, but also to U.S., Norwegian, Venezuelan and Japanese companies. He has also advised Petrobras in projects such as the construction and operation of the Bolivia-Brazil pipeline. When asked about the role played by Petrobras in the new regulatory framework, the attorney has no doubt that the company will be a key element for the country’s development. “Petrobras had already been imposing very high levels of local content in services and equipment. In this sense, it will be a major development driver.”

Marcelo Romanelli de Oliveira graduated from the Law School at Universidade Candido Mendes and has a master’s degree in Oil & Gas Taxation, from the Centre for Energy, Petroleum and Mineral Law and Policy – CEPMLP, at Dundee University, in the United Kingdom. He was recently hired to work in the Energy and Infrastructure practice area at Campos Mello Advogados, Rio de Janeiro.

Read the interview

ConJur — You and your team prepared a study on regulatory models in the field of oil exploration, at the request of BNDES. How was that?

Luiz Antonio Lemos — We studied the models that were successful and the models that failed. The idea was to determine exactly which mistakes were made, the government policies or the legal and regulatory definitions that impacted the economic development of the associated segments. The North Sea is an interesting example. England and Norway were benefited by the prospect of oil production in the area. Norway developed its supply chain brilliantly, to the point that, today, the largest companies in the entire world in the oil, equipment and services segment, originate from the country. Up until the 1960s Norway was a farm-based, underdeveloped country, but with an excellent cultural and educational foundation. They managed to turn the country into a cutting-edge economy, with the best HDI [Human Development Index] in the world. England, on the other hand, which had a similar prospect of production and reserves, did not manage to develop its oil industry with the same intensity.

ConJur — How many countries were included in this study?

Luiz Antonio Lemos — We studied the regulatory models of 11 countries, including Brazil. We researched the historic, economic and social framework, to better contextualize the models. There are, basically, four kinds of systems: the concession system, the service-based system, the production sharing system, and the system that we will refer to as “joint venture”, which is the model adopted in Venezuela. The concession and production sharing systems are the most important. The service-based system is common in countries such as the Middle East. Mexico, for instance, selected the service-based system, which is totally public. The model is inefficient. Norway, in turn, adopted a form of concession system. Each country had a historic reason for the choice. If we examine the origin of the concession system, we find it to be an extremely aggressive and invasive system in regards to the countries that received the foreign investments during the initial period.

ConJur — And did these countries react to this aggression?

Luiz Antonio Lemos — They began to react in the early XX century, until the 1950s, and created their own systems in order to defend themselves. However, the concession changed as well. Like every system, it was gradually enhanced and, today, it is perhaps the prevailing system. We prepared this study and delivered it to BNDES for its appreciation. Naturally, the decision concerning the selection of the system was not the bank’s. But it was used as a subsidy for the decision. From our technical viewpoint, it would be enough to enhance the concession system.

ConJur — Would you call it a successful system?

Luiz Antonio Lemos — Yes. The example of its functionality and success is unequivocal. We ended the 1990s with one company. Today, there are 72 companies engaging in oil exploration in Brazil. This has a multiplying effect in terms of the generation of jobs, technology, resources. The number of service companies that developed during this period is massive. The production of oil and gas increased significantly. However, from a political viewpoint, the government needed to establish a change. This PSA [Production Sharing Agreement] bears no resemblance with other PSA models existing worldwide.

ConJur — And can this model work?

Luiz Antonio Lemos — It is much different from any model that we have seen to date, it is unique, for good and for bad. We have no idea if it will be a successful model. This is due, basically, to two important reasons. First of all, because, historically, the production sharing system was conceived in poor countries, lacking technology and financial and human resources. And it had two main characteristics from the legal viewpoint. One was that the contracts were not dependent on any additional regulation, they were effective on their own. That is to say, they rely on a protective shield within the host country with which the local legislation, supposedly, does not interfere. This is an important aspect to attract foreign capital, investors and the major companies in the segment. The second aspect is, evidently, that they dilute the interests of the operators in such countries. The higher the number of operators, the more companies there will be to assume the risk inherent to the exploration and production.

ConJur — In the case of Brazil, with the pre-salt regulatory framework, Petrobras will be the only operator.

Luiz Antonio Lemos — Petrobras will be the only one. That alone is a major difference. In addition, in Brazil, there cannot be a contract that is independent from the country’s legislation. Another characteristic of our system are the royalties. The PSA already provides for the appropriation of wealth by the Government, which gets part of the production of the oil. The royalties are typically associated with the concession system. In the PSA, there is the part of the production that goes to the Government, plus the royalties. That is a heavy burden for the investors. And there is, further, a third element that concerns us, from the perspective of the market, which is the organization of the company to compensate for the power of Petrobras. The Government has incorporated PPSA [Pré-Sal Petróleo S/A], the company that represents the Government in the production sharing. It will have a great deal of power in the operating committee, which will decide everything, but without the risk inherent to the activity. It is a bit contradictory. If I do not have to deal with the risk inherent to the activity, I cannot have the power of veto, like they do, or the majority of the members of the committee. For the market participants, this appears odd. Naturally, the Government must have influence in the activity, but it must not be absolute.
ConJur — Considering all these aspects, will it be beneficial for the companies to engage in oil exploration under the production sharing system in Brazil?
Luiz Antonio Lemos — It is possible that the issue of the financial return be deemed secondary as compared to interests such as the supply of their own market, for instance. For example, China has already loaned 10 million dollars to Petrobras and will lend even more, simply because it needs oil. The matter of the barrel value is a relative one to them in light of the greater priority, which is the supply of their domestic market. This is not the business reasoning of a typical company in the segment, which seeks financial return. Any company in the segment will calculate the share of oil to be left to the government, the royalties that will be payable, the investments necessary, and add all this up to determine if it will or will not obtain financial return. It is possible that the return will not be appropriate and we will miss out on the opportunity to attract other investors, being limited to those that are not interested in the activity, but rather in their own market. This is bad, since the oil segment is extremely complex. The pre-salt area requires a technology that not even Petrobras has at this point. The more experienced companies that come to Brazil, the better it will be for us. Over the past 10 or 11 years Petrobras expanded considerably because of the experience gained from the other companies on the market. It is quite common practice in the oil industry to work in association with others.

ConJur — Why is that?

Luiz Antonio Lemos — Because it is a high-risk field. There is no use owning 100% of the block, because you will also have to assume 100% of the risk. The ideal share is 30 or 40%. If there is any problem with the block, the company will share the risk with the others. Petrobras will be able to do this with the companies that come to Brazil, thus reducing its risk exposure and increasing its interest in other areas abroad. Much of the international expansion of Petrobras was due to this. It was highly beneficial to the company.

ConJur — But with this change in the regulation of the pre-salt areas, Petrobras will have to own 100% of certain blocks, correct?

Luiz Antonio Lemos — Not exactly. Actually, the government may, when defining the bid process, establish that a certain block will be 100% owned by Petrobras. If the company does not agree, a bid will be held, in which case Petrobras will own, at least, 30%, which is the lawful percentile for a company to act as operator. Naturally, it may participate, alone or in a consortium with other companies, in view of acquiring additional interest. The problem for Petrobras, which I believe is very risky, is one of the criteria adopted for the bid process.

ConJur — Which criterion?

Luiz Antonio Lemos — There is cost oil and profit oil. Cost oil is everything that is associated with the cost of the investment made in the block. Anything that is generated beyond that is known as profit oil. The government will establish the minimum profit oil that it wants. If the government determines the minimum and the company produces much more than that it will be great. But it is possible that this will not happen. According to the logic of the companies engaging in the segment, they know how far they can go. But it is not the same logic, for instance, of government-controlled companies, which have interests other than merely the economic aspect of return.

ConJur — Would you please exemplify that?

Luiz Antonio Lemos — The risk is that China, for instance, will offer an absurd percentile of oil to the government and that Petrobras be forced to follow. It is already bound to, since it will own, at least, 30%. It may not obtain the expected return, since, in the event of an absurd offer, the government will take that lion’s share of the profit oil. It is the best offer to the government that will prevail. Petrobras itself may suffer huge losses, since it is a mixed-economy company, albeit with a corporate perspective, with its shares traded on the stock market.

ConJur — Are there other countries that adopted both the concession and the production sharing systems simultaneously?

Luiz Antonio Lemos — In Russia, there is also the concession and the PSA. There, the production sharing did not work. They understood that the system to be adopted in locations offering greater difficulty, or in which the companies lacked interest in the block should be the production sharing system. It is the opposite situation of Brazil. Here, since the wealth is clear, the geological risk is small. The production sharing system is best for the government. In Russia, because the risk is greater, the production sharing system was adopted, while here in Brazil, the production sharing system is adopted because the risk is smaller. This system is adopted for opposite reasons in each Country. Each has a different view of the system.

ConJur — What do you believe should have been improved in the concession model?

Luiz Antonio Lemos — When I mentioned the success of the concession it was because its main characteristic is its adaptability. It has adapted quite well to the many countries in which it was adopted, adjusting to the historic peculiarities of those locations. That is why it is a successful model. There is not a specific rule. For instance, in terms of revenues, I believe we have lost a great deal of time. We could already have earned a lot of money by way of a bonus in anticipation of the future wealth that will be generated. We would already have money available, which would be important. The country cannot afford to lose time.

ConJur — Didn’t this bonus exist before?

Luiz Antonio Lemos — It did. However, the advantage of the bonus under the concession system is that it is variable, being dependent on the offer. A minimum bonus value may be established and the sky’s the limit. A few minor adjustments to the legislation would be enough, which would not require the approval of the Brazilian Congress. In regards to the royalties and the special interest, for instance, there is already a proposal for the calculation of the value based on volume or profitability. If the problem was that the wealth might be so huge that the volume would not represent the proper appropriation of this wealth, it would be enough to change the criterion to the profitability criterion. This could be done by way of decree. And this would settle the revenue issue.

Marcelo Romanelli de Oliveira — Basically, the same financial outcome would be possible with both the production sharing system and the concession system.

Luiz Antonio Lemos — Actually, the production sharing system has the purpose of controlling the production system. But, in Norway, on at least two occasions, the king issued a decree determining the suspension of the production on account of adverse situations on the international market in terms of oil. They stopped producing. If the problem is controlling the pace of production, there are means to do this. We need only enact a specific law to address such cases. A specific law already exists concerning the supply of the domestic market. A new law could be drafted to define the pace of production of this oil, even in light of the larger volume that will be produced with the pre-salt layer. This could be done over time, even because it will take time for this production to start coming in. Legally speaking, it is possible to have the same effects.

ConJur — So, the change had political motivations?

Luiz Antonio Lemos — The issue was subject to a much more political than economic bias. But the consequences associated with this choice are theoretical. I do not criticize the production sharing system. The system might work. However, we will only know this in the future, since we have created a different system and will have to learn to live with it. We did not take the proper advantage of the international experience. We are starting from scratch. We might reap huge benefits, but we might also face problems. Only time will tell if the choice was right or not. The examples I am giving are merely possibilities that might have happened with the concession system, from a strictly technical viewpoint.

ConJur — The environmental issue gained even more prominence after the recent leak in the Gulf of Mexico. People are inquiring about the extent of the protection of the environment – or the lack thereof – in oil exploration field.

Luiz Antonio Lemos — This problem is not exclusively related to the oil industry. All infrastructure activities in Brazil face difficulties with this today. The preliminary license for these projects is crucial. There was a time when the applications for environmental licenses were filed after the agreements resulting from bids. This happened in the energy industry as a whole. The company would win the bid and be denied the license, which has happened before. Nowadays, a company must obtain a preliminary license in order to bid on anything. As a result, the risk has been somewhat mitigated. Even so, there is this whole procedure, involving installation licenses and, later, operating licenses. The situation with BP, in the Gulf of Mexico, was emblematic. It showed, beyond a doubt, that no matter how many technologies we develop for deepwater oil exploration, there is always a risk of an operating or equipment failure. In a situation like that, and in Brazil something like this might even be worse, since it is farther from the coast, it is much more crucial to have control in this process, to avoid environmental damage.

ConJur — Is there any difference among the systems in terms of the environmental aspect?

Luiz Antonio Lemos — There is a huge difference. The concession system transfers the responsibility for the activity to the concessionaires. They are the owners of the product. The government may even be held liable, but it has the right of recourse. In the production sharing system, however, there is a Government company, PPSA, which, according to the Brazilian Constitution, is environmentally liable, since it earns the economic benefit. No matter who says that the company is not liable, the fact is that it is. I believe this change in the production sharing system, in a certain way, increased the exposure of the Brazilian government to the environmental risk. Naturally, under the concession system, despite the direct liability of the concessionaires, the Government would not be able to avoid a certain responsibility to help and demand explanations from the companies in case of another environmental disaster.

ConJur — The Government is also responsible for the inspection and even for the grant of environmental licenses. In light of this risk, which will be greater even for the Government itself, is it expected that the environmental agencies and bodies will be stricter in granting the licenses?

Luiz Antonio Lemos — I believe these are independent issues. Our environmental awareness, today, is much different than it was 30 years ago. I worked at Petrobras. Back then, the environmental matter was not relevant. We were not concerned about what would happen to Lagoa Rodrigo de Freitas. Today, there has been a change in behavior. The world is concerned, Brazil is involved in this process and society has been more cautious. Naturally, this reflects on the bidding process. The bodies involved have more responsibilities. They must take certain precautions. The requirements for the procurement of licenses are increasingly strict. On the other hand, we note that the environmental bodies, especially Ibama, are lacking in human resources. They will have to make considerable investments. If there is a prospect of greater development, they will have to be prepared to provide timely assistance.

ConJur — Is there a strictness in the grant of these licenses?

Luiz Antonio Lemos — It is not a matter of strictness. Generally, there are considerable delays in the grant of the license. Often due to the volume of work, but also to unpreparedness, and to the requirements presented.

ConJur — The regulatory agencies in Brazil tend to be strongly criticized for their inefficiency. Does this happen with ANP?

Luiz Antonio Lemos — ANP is an agency that is still in formation, although it has existed for 10 or 11 years. At the beginning, it had a very good technical staff, but, since they were temporary, it was forced to let them go and hire employees through public contest. This caused a certain loss in terms of the agency’s technical quality. But I believe it has been restored. Its autonomy, on the other hand, has been quite reduced, especially with the advent of the pre-salt layer. But, undoubtedly, it has accumulated a wealth of knowledge, and is the repository of the country’s geological information. This is very important, since, in the past, this was entrusted exclusively to Petrobras. Today, the agency has an excellent database and a very good knowledge level of the basins. The big challenge facing the ANP is perhaps the decision as to which PSA model should be adopted.

ConJur — Even now that the system has been defined, can the model of the agreement make all the difference?

Luiz Antonio Lemos — Yes.

Marcelo Romanelli de Oliveira — In fact, the industries are anxiously awaiting this agreement, even in light of the inconsistencies in the bill of law. The idea is that some of the flaws found in the law will be corrected. That is the general hope.
ConJur — Is this change in the regulation liable to discussion in Court?
Luiz Antonio Lemos — All of this is liable to discussion. I personally believe that the system per se will not be questioned, except for the matter of the royalties and the loss of revenues. The purpose of the royalties is precisely to offer financial compensation for the industry’s activities performed in the states and municipalities where the blocks are located. There is no doubt that, wherever oil-related activities are performed, a number of social and economic problems will arise. The loss of revenues is a major concern, which is likely to end up in Court.

ConJur — Despite the former Brazilian President’s veto of the change in the distribution of the royalties to all municipalities, will there be a loss anyway?

Marcelo Romanelli de Oliveira — He vetoed it and proposed a new form of distribution, in which the loss will not be as bad as before the veto. But the loss is inevitable, since other states and municipalities were included in the distribution, which were not included before.

ConJur — In the experience of your team, especially with the foreign market, from which countries are the companies that are coming to Brazil in view of engaging in exploration?

Luiz Antonio Lemos — All of them. Brazil is a hot item now. I am speaking of the vision of the oil companies that carry out the operation. But, when we consider the industry around this activity, service providers, equipment suppliers, the inflow of these companies in the country is growing steadily. There is a beneficial side of the pre-salt layer that is apparent now. The companies are moving to establish in Brazil. The tendency is that the issue of the local content be a determining factor.

ConJur — The infrastructure that will have to assembled, not only to extract the oil, but the supply chain as a whole, is massive. Is the country prepared for this kind of industrial boom, to meet this demand?

Luiz Antonio Lemos — No. There are major difficulties. We lack both engineers and technicians. There is the matter of the schedule of investment obligations within the scope of the concession agreements. Many blocks, within the pre-salt area, are subject to the concession system. And there are deadlines to be met. There is also the matter of the industrial gap, because we still do not have companies. We are developing a number of research centers, precisely to begin producing appropriate equipment for our reality. But we are not prepared. We will surely face numerous difficulties, including in terms of technical resources, human resources, financial resources. We are lacking in every aspect.

ConJur — And how is the legal market in the field of oil and gas? Are there few specialized professionals in this area?

Luiz Antonio Lemos — There is no doubt about it. But this is a worldwide issue. At some point in the 1980s and early 1990s, the oil market was not attractive. Even because there was a recession in Brazil and, abroad, nothing very significant was happening. There was a period when the field was not interesting to the people graduating from school. There are very good professionals from my age up, and much younger professionals. There is a gap in between these periods that also generated a gap in the qualification of professionals with experience in this segment. The normal situation is to have people of all age groups, in order to set a proper development path. On top of all this, the segment expanded remarkably. High-quality professionals are hard to find. Most of the professionals who work with me were my interns, because it is hard to find qualified people on the market.

Source: Consutor Jurídico