Brazil has long been known as a country with vast potential. When it first became a republic in the 1800s, Brazil did so in an atmosphere of euphoric optimism. Brazilians have, at times, held an overly optimistic view of their government’s ability to guide the country in the right direction.

Recent discoveries in the presalt area place Brazil among the largest oil producers in the world. Current forecasts envision that sometime between 2014 and 2024 Brazil will become the world’s fifth largest economy and S?o Paulo the fifth wealthiest city.

In private conversations, Brazilians temper optimism over presalt with caution. They are aware of the country’s failure to live up to politicians’ expectations in the past. Presalt wealth, and how the government plans to use it, will be a crucial test of Brazil’s moral fiber and forever mark its destiny.

Presalt

Dubbed “presalt” because they lie beneath a layer of salt, the presalt layers are geologic formations that hold one of the largest reserves of medium to light oil and gas in the world. The area spans 500 miles (805 km) along the coast of Brazil (from the state of Espirito Santo to Santa Catarina), 186 miles (300 km) off the coast of Rio de Janeiro, and 15,000 ft (4,572 m) below the ocean bottom depths of up to 6,000 ft (1,829 m). Nearly half the size of Italy, it includes offshore fields such as Tupi, Guard, Bem-Te-Vi, Carioca, Jupiter, Sugar Loaf, and Iara. The entire presalt layer is estimated to hold reserves of 50 to 80 Bbbl of oil. If estimates prove correct, Brazil potentially could become the sixth largest oil-producing country in the world.

To accelerate and expand E&P of presalt layers, Petrobras hatched an aggressive investment plan to double Brazil’s production to 3.5 MMbbl/d by 2012. The Brazilian government currently projects total capital expenditures for the 2010-2014 period at US $224 billion. Brazil is banking on what it considers the virtual certainty of presalt wealth. Evidence supports the fact that oil-rich fields exist and foreign companies are reporting early success. However, it remains to be seen if the government’s regulations of the presalt will allow the country to fulfill that promise.

Regulations

Since 2009, former President Luiz In?cio Lula da Silva has been trying to pass new regulation for the presalt area. On Aug. 31, 2009, he submitted four bills to Brazil’s lower house, the Chamber of Deputies, describing administration of presalt development and how future presalt oil revenues will be spent. These bills were passed in 2010 and represent a significant departure from the existing concession-based system. Instead of competition, the presalt bills centralize decision-making and leave bureaucrats to select winners in the process (including indirectly through the designation of certain areas as strategic “Petrobras only,” therefore being government-controlled). These winners will be selected largely based on the amount of money they turn over to the government. Further, private companies will be allowed to bid, but only if they partner with Petrobras, which will have a 30% stake in all presalt wells. A new state agency, Pr?-Sal Petr?leo SA (PPSA), will control all drilling contracts and exercise veto power over all consortiums.

Presalt regulation consists of three main parts. The first is Law 12,276/ 2010: Capitalization of Petrobras. The goal of this law is to capitalize and strengthen Petrobras’ power by injecting the financial equivalent of 5 Bbbl of oil into the company. Specifically, the Brazilian government is authorized to assign “non-granted” presalt acreage directly to Petrobras (without a bid round) containing a maximum of 5 Bbbl of oil and natural gas equivalent of reserves (approximately $50 billion).

Reserves will be estimated and valued “in place” per international oil industry practice and independently certified. Prospective reserves transferred to Petrobras will be used by the Brazilian government to capitalize Petrobras through the subscription of shares up to the value of the reserves. Resources accumulated in the capitalization will be used to pay for the transfer – which must be affected in treasury securities – and to finance investment. Minority shareholders will be entitled (though might not be financially able) to exercise “preferential” rights, allowing them to pay the equivalent cash value to subscribe for new shares in proportion to their existing shareholdings. Petrobras will pay for the assignment with federal debt bonds.

Petroleum activities in such acreage will be carried out by Petrobras at its own risk and cost. If production does not yield 5 Bbbl of petroleum equivalent, Petrobras will be granted additional acreage to reach the 5 Bboe, and any production in excess of that will belong to the Brazilian government.

The second part of the presalt regulation is Law 12,351/2010: Production Sharing Agreements (PSAs) for Presalt and Other Strategic Areas and Social Fund. This law regulates E&P of oil, gas, and other hydrocarbon fluids under the regime of PSAs. Pursuant to Law 12,351, PSAs will apply only to the presalt area and to other areas deemed “strategic” by PPSA. The concession system that has been used by Brazil for E&P will be valid only for the blocks that already were auctioned.

PSAs are defined in Law 12,351 as a “regime of exploration and production of oil, natural gas, and other fluid hydrocarbons,” whereby oil companies will be granted rights to explore, develop, and produce petroleum reserves at their cost. In the event of a commercial discovery, costs incurred will be reimbursed through an entitlement to production referred as to as “cost oil.” The remaining petroleum, after deduction of cost oil, is considered “profit oil.” This is shared between the contractor and the government in the percentages set forth in the PSA.

Under Law 12,351, the Brazilian government can award a PSA to Petrobras as sole contractor without holding a licensing round, or it can tender blocks to other contractors, provided that Petrobras possess a minimum 30% interest. Petrobras can bid alone or in a consortium to increase its participating interest beyond the minimum. On the PSAs awarded to Petrobras without a tender, the National Council of Energy Policy will determine the profit oil split with Petrobras. Bidders on tendered PSAs will indicate their proposed profit oil split at equal to or higher than the minimum percentage set forth in the tender documents as the Brazilian government’s share. The bid offering the Brazilian government the highest percentage of profit oil will win the auction. The winning company in the auction process must pay royalties and a fee called Participa??o Especial (PE, or Special Participation) that varies from 0% to 40%. Under all PSAs, the contracted company will engage in exploration at its own risk. If successful, the contracted company will be reimbursed in oil production for the exploratory investments and development of production and for production operational costs. The excess material /oil will be allotted as established in the PSA. The final part of the legislation is Law 12,304/2010: Incorporation of State Oil Company, PPSA, to Manage Government Interests in PSAs. This law creates PPSA, a public company organized as a corporation under the aegis of the Ministry of Mines and Energy for the purpose of managing PSAs. Although a party to the PSAs, PPSA will not take up any risk or responsibility for costs of oil and gas exploration activities. However, PPSA will nominate half of the members of the respective operating committee, including its president, and will have voting rights and power of veto over all decisions relating to activities conducted under the PSAs. PPSA also is responsible for:

Conducting the management, audit, and fiscalization of petroleum activities performed under PSAs;

Authorizing bidding processes related to the E&P of presalt areas;

Representing the government through operational committees in consortiums incorporated for the execution of PSAs; and

Representing the government in case of unitization in the presalt and strategic areas. Although the Brazilian presalt shows great potential, foreign investors in the market must be aware of possible complexity created by the new regulatory framework in what already is a highly regulated sector in an equally well-regulated economy.