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Brazil’s Oil and Gas Exploration and Production Regimes: An Overview

23 March 2012
Mayer Brown Article

Since 1997, the exploration and production (E&P) of oil and gas in Brazil has been driven by a federally regulated concession system. This highly successful program was bolstered in 2010, when the Brazilian Congress approved legislation that set forth general rules and principles for a production sharing contract regime intended to control petroleum exploration and production activities in the nation’s pre-salt coastal shelf and other government-designated “strategic” areas.

The legal framework for Brazil’s new production sharing contract regime is formed by three legislative articles:

  • Law no. 12,351, which regulates the exploration and production of oil and gas in the pre-salt and strategic areas of Brazil;
  • Law no. 12,304, which authorizes the creation of Pré-Sal Petróleo S.A. (PPSA), a national entity chartered to govern the Federal Union’s production sharing agreements and to manage marketing contracts for state-owned petroleum products; and
  • Law no. 12,276, which authorizes the “onerous assignment” of exploration rights from the Federal Union to Petrobras, for the purpose of capitalizing Petrobras.

Thus, exploration and production activities in Brazil are currently governed by two legal frameworks: the concession contract regime (concession regime) and the production sharing regime (PSA regime). The prevailing regime to be applied to an individual E&P project is determined by the relevant petroleum deposit’s geographic location.

Some claim that a third framework—the onerous assignment regime—has been put in place exclusively for Petrobras, to allow for the recent capitalization of Petrobras. In the context of this exclusive framework, Petrobras signed a contract with the Federal Union to explore up to five billion BOE in designated pre-salt areas.

To varying degrees, both the concession regime and the PSA regime allow for the acquisition of exploration and production rights by any company that meets certain requirements as established by Brazil’s National Agency of Petroleum, Natural Gas and Biofuels (ANP). Such acquisitions may be direct (through participation in the bidding rounds conducted by ANP) or indirect (through the acquisition of participating interests in blocks previously assigned to companies), subject to the approval of ANP.

Although properly approved by the Brazilian Congress, the PSA regime has not been tested, as there have not been open bidding rounds for the pre-salt and strategic areas thus far. The main problem delaying the start of the PSA regime open rounds is the debate among states of the Brazilian Federation regarding the sharing of petroleum revenues (mainly royalties). However, there is considerable political pressure to initiate the first pre-salt open round of bidding in 2012.

The Concession Regime

The concession regime has been in effect since 1997, pursuant to Law no. 9,478 (the Concession Law). The regime is based on the execution of concession contracts awarding oil and natural gas exploration and production rights and obligations in exploration blocks offered during the bidding rounds regularly conducted by ANP.

Access to the bidding rounds is open to any company or consortium that meets the legal, technical and financial requirements established by ANP. Operators have to qualify to operate onshore, in shallow or deep waters, depending on their prior operating experience. The criteria used by ANP
to determine the winning bidders are based on a formula that considers the amount of signature bonus, the minimum exploratory program and the local content offered by each bidder. The criteria vary from one bidding round to another.

The concession contract is entered into by ANP and the oil companies (concessionaires). In addition to payment of a signature bonus offered during the bid round, the concession contract determines the payment of: (i) a retention fee that is proportional to the size of the concession area retained; (ii) royalties equal to 10 percent of the production of oil and natural gas; and (iii) special participation for blocks with high levels of production or profitability.

Under a concession contract executed with ANP, a company or consortium has the obligation to perform a minimum exploration program within the area of each block, at its own cost and risk, and owns the production in case of success. A concession contract provides for two distinct phases:

  1. The exploration phase, which usually lasts no more than seven years and may be divided into two periods, the second of which is optional. During the exploration phase, the concessionaires are obliged to perform all activities contemplated by the minimum exploratory program, including conducting seismic works and possibly drilling at least one exploratory well. The exploration phase also includes the appraisal of a discovery, if any.
  2. The production phase, which usually lasts up to 27 years and may start only after completion of all activities contemplated by the minimum exploratory program. The production phase must begin with a declaration of commerciality after completion of the appraisal of a discovery by the concessionaires. This phase of the concession contract also includes all development activities necessary prior to actually starting the production of oil or natural gas.

According to Article 26 of the Concession Law, ownership of the oil and gas produced becomes the concessionaire’s property once the hydrocarbons pass through the measurement point. Prior to passing the measurement point, the oil and gas reserves belong to the Federal Union (Article 3 of the Concession Law).

The assignment or transfer of the concession contract, fully or partially, is permitted under Article 29 of the Concession Law, provided that the assignee fulfills the technical, financial and legal requirements set forth by ANP in the concession contract and the bid tender rules. Thus, ANP’s prior approval is required before the assignment can actually go into effect.

The assignment may materialize as an actual assignment of participating interest from oneconcessionaire to another or, indirectly, by means of a corporate transaction in the level of the concessionaire’s interest. Thus, the sale of the control or merger, amalgamation or other corporate transaction may trigger a need for the concessionaire to request ANP’s approval. Further, ANP may require a performance guarantee if it considers that the concessionaire does not have sufficient assets to guarantee its obligations under the concession contract.

To date, ANP has approved hundreds of requests for assignments of concession rights, both to existing concessionaires and newcomers and also in connection with corporate transactions (i.e., indirect transfers). In fact, due to the lack of bidding rounds during the past several years, assignments of concession rights have increased substantially because farm-in deals have been the only way for companies to start or increase their portfolios in Brazil.

Unlike the pre-salt rounds, nothing should prevent the government from authorizing ANP to promote the next concession rounds. In fact, the E&P industry in Brazil is concerned with the lack of concession bidding opportunities over the last three to four years.

The PSA Regime

According to the PSA Law, the new regime will only apply to fields located within Brazil’s pre-salt areas and such other areas as the federal government may eventually designate as “strategic.” Essentially, the PSA regime provides that an oil company contractor will conduct exploration and production activities at its own risk and expense. In case of commercial discovery, the contractor will have the right to be reimbursed for properly incurred E&P costs (cost oil) and will receive a percentage of the profits generated by the project (profit oil). The contractor’s share of project profits will be defined in the production sharing contract.

The cost oil is the share of production costs that the contractor is entitled to recover (in case of a commercial discovery) for costs it incurred and investments it made during exploration, appraisal, development, production and abandonment activities. The terms, conditions and limitations of the cost oil will be set forth in the production sharing contract.

The profit oil is the share of production profits to be divided between the Federal Union and the contractor, and it represents the difference between the total volume of production and the share of cost oil, royalties and special participation. The division of the profit oil, as well as other conditions related to it, will also be defined in the production sharing contract.

According to Article 4 of the PSA Law, Petrobras will be appointed as the sole operator responsible for the execution, directly or indirectly, of all project-related exploration, appraisal, development, production and abandonment activities. As the project’s operator, Petrobras will hold a minimum participating interest of 30 percent in each new block within the pre-salt and strategic areas. The remaining 70 percent interest may be contracted with other companies under competitive bid rounds. As a consequence, these companies will have to form a consortium with Petrobras and PPSA, the non-operating entity created in 2010 by Law no. 12,304 to act as the federal government’s representative in production sharing agreements. Petrobras may also compete, by itself or under a joint bidding arrangement, to increase its 30 percent participating interest by up to 100 percent.

The main roles of PPSA are to manage and supervise production sharing agreements and to represent the government in project operating committees. PPSA has the right to appoint half of an operating committee’s members, including its chairman, who will have veto power.

Similar to the concession regime, exploration activities under the PSA regime will be developed at the sole cost and risk of Petrobras and its joint-venture partners.

In addition to royalty payments, the PSA regime also establishes the payment of a signature bonus. Unlike the concession regime, the value of signature bonuses under the PSA regime will be determined in advance by the relevant production sharing agreement. It will not, however, be among the criteria used to determine the winners of a bid round.

The criteria used by ANP to determine winning bidders during the PSA regime’s bidding rounds will be based exclusively on the highest share of profit oil offered by the competing companies to the government.

The PSA Law also created a social fund to be maintained with the revenues of the pre-salt production. The purpose of this social fund is to ensure a permanent benefit to the country by means of investments in projects to reduce poverty and to promote development in key areas such as education, science and environmental sustainability, including mitigation of climate changes.

Although the general rules and principles of the PSA regime are set forth in the PSA Law, many controversial issues will have to be defined in the context of the production sharing contract. For instance, it is still unclear how much control Brazil’s federal government, through PPSA, will have in the day-to-day management of E&P operations. Other key features of Brazil’s PSA regime, such as sole operatorship by Petrobras, may not seem very reasonable to operators or investors.

Petrobras as Sole Operator

A big part of Petrobras’s offshore E&P success over the past several years is explained by the fact that it has partnered and shared experience with other leading international oil companies. The legislators’ selection of Petrobras as the sole operator for E&P projects in all pre-salt and strategic areas, however, raises many concerns and may not be good for the country, for the E&P industry or for Petrobras itself.

From a national perspective, for example, Petrobras may not have the ability to move all projects forward in a desirable time frame. As big as it has become, moreover, Petrobras may not have the financial and human resources necessary to handle all of its pre-salt projects at the same time. Given its size, too, Petrobras may be an unwilling or inefficient operator of some smaller pre-salt projects that may be better suited in scale to an independent oil company.

According to the PSA Law, Petrobras may not transfer operatorship to other oil companies, however well qualified to operate they might be. Likewise, removal of Petrobras as a project’s operator will apparently not be possible under the PSA regime. And the strength and effectiveness of ANP’s regulatory authority over Petrobras remains to be seen.

Moreover, Petrobras’s appointment as sole operator without a public tender raises questions regarding the legality and constitutionality of such legal provision. Brazilian courts may be obliged to rule on this issue if the PSA Law is questioned.

Finally, Petrobras’s minimum 30 percent participating interest in all pre-salt areas, although probably intended as a blessing by the legislators, may be a curse in some cases. This could be true, for instance, in situations in which a particular deposit promises a less-than-favorable return on investment and would not normally receive bid offers in a more competitive environment.

The geological potential of the pre-salt areas has been widely announced by the specialized media in Brazil and abroad. However, the fiscal and contractual terms to be published in the first pre-salt open bidding round and the production sharing contract model will be crucial factors in the oil industry’s evaluation of Brazil’s pre-salt frontier.

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