Brazil: Pre-Salt: A New Legal Framework for the Oil Industry in Brazil*

Last Updated: 17 January 2011
Article by Bruno De Luca Drago

Within the last three years, Brazilian society has been involved in a major debate pertaining to the current legal framework of the oil and gas industry in light of the recent findings of large amounts of oil and natural gas off the Brazilian coast. These findings made by the state owned oil giant, Petrobras, at the end of 2006, lie under an extensive salt layer extending 500 (five hundred) miles across the central-southern seashore (being named the "Pre- Salt" area.)

Based on the current findings and the technical studies these oil and natural gas reservoirs present huge potential for new findings, with expectation of being one of the world's largest oil reservoir ever. In addition to the sheer volume, the quality of the oil, considered a light crude oil with high commercial value, and the fact that the reserves found so far indicate that the exploitative risks are considerably low, have motivated the Government to rethink the Brazilian oil regime, which has promoted a debate in society.

Following the finding, the Government, through the Ministry of Mines and Energy, commenced an evaluation of possible changes to the legislation in place. It created an Inter-Ministerial Commission to propose alternatives for the development of the Pre-Salt exploitation. The idea behind such an approach was to adapt the legislation to the new paradigm in the exploitation of oil and gas, and to increase the Government take in future entrepreneurships, while ensuring that the contracts in progress are fully respected. As a result of this intense government activity, three legislative bills were presented by the Federal Executive Branch to the Brazilian Lower House in September 2009, all of them already approved by the Congress and sanctioned by the President.

The intended main pillar of the new oil and gas legal regime is the Law No. 12351/10, which aims to regulate the exploitation and production of oil, gas and other hydrocarbon fluids under the regime of production sharing in the Pre-Salt (and other strategic areas) and to create a Government Social Fund with the purpose of serving as a regular source for financing social projects. This law also introduces amendments to the former Brazilian Oil Legislation1 to ensure consistency with the new proposals.

The current model of contracts available for the exploitation of oil and gas, according to the Brazilian Federal Constitution and Brazilian Oil Legislation, was one of the major reasons that the Government felt reform was needed. This model concession agreement was initially designed for a system where exploitation risks were considerably high. Under this model, the grantee carries on the exploitation and production activities under its own account and pays the Federal Union a subscription bonus, royalties, and special participations, while maintaining ownership of all hydrocarbons produced.

Evaluations of the Pre-Salt reservoirs suggest an area with considerably low risks of exploitation, which is one of the main reasons considered by the Government to propose a new model of contracts, based on the sharing of the production. Under this regime, in case of commercial findings the contracted party would be reimbursed from costs incurred in the exploitative activity through results of production (cost oil). The exceeding oil and gas produced (profit oil) would be shared between the Federal Union and the contracted party. The contracted party would keep the risks of the exploitation and development activity.

The Law No. 12351/10 also reflects the Government's will to strengthen the economic and financial power of Petrobras. According to the new legislation, Petrobras shall be the operator2 for all the oil blocks contracted by the Federal Union under the regime of production sharing. Accordingly, Petrobras shall participate in all the consortiums to be formed with, at least, thirty percent equity.

In this respect, the new legislation sets forth that the Federal Union, through the Ministry of Mines and Energy, may execute production sharing agreements either directly with Petrobras or through a public bidding procedure, under the modality of auction. Moreover, the new legislation also provides that Petrobras may be contracted directly to perform exploratory studies for the assessment of the energetic potential of the Pre-Salt and other strategic areas. Finally, another aspect introduced in the legislation is that Petrobras is entitled to participate in public biddings, which could extend its minimum participation in the consortiums.

Similarly, Law No. 12276/10 (one of the approved LB), also aimed to strengthen Petrobras' power to the extent it authorized the Federal Union to assign to Petrobras the research and extraction activities of oil, gas and other hydrocarbons of the Pre-Salt area not previously granted to third parties, dismissing the requirement of public bidding, subject to a payment which may be effective through government bonds. The model to be followed under these circumstances is total risk assumption by Petrobras with ultimate ownership of the volumes of oil and gas produced up to five billion barrels oil equivalent (BOE). Hence, an exception to the production sharing model. The onerous assignment contract grants to Petrobras the exploration rights of certain areas for the price of almost US$ 43 billion3.

In order to raise funds for paying such exploration rights and to assure their financial needs in the exploitation of the Pre-Salt areas, Petrobras performed a record public offer with the capitalization of more than US$ 69 billion. As per an authorization from Law No. 12276/10, the Federal Union subscribed shares from Petrobras at the public offer, paying for them with government bonds.

With respect to the public bidding required in cases where Petrobras is not directly contracted by the Federal Union, the new regulatory regime also provides for some additional mandatory elements, such as minimum local content, which shall be observed by bidders and the value of the subscription bonus. Moreover, the criterion for awarding an agreement to a bidder, under the proposed regime, is the highest offer of profit oil to the Federal Union. Foreign companies participating in public biddings will also be required to incorporate a local company, under the Brazilian laws, in case they are awarded a contract.

It is also of interest to note that the former regulatory regime did not regulate the commerce of oil, gas and other hydrocarbons fluids, which is precisely what is regulated by the new Law No. 12304/10. In this regard, the newly created national oil company shall be allowed to contract Petrobras without a proper public tender process, as a commercial agent for the oil, gas and other hydrocarbon fluids produced and owned by the Federal Union. The revenue that arises out of such commercialization shall be deposited in a to-be-created Social Fund.

This national oil company will be created for the purpose of governing the production sharing agreements and the agreements for the marketing of the hydrocarbon fluids, owned by the Federal Union. In this regard, Law No. 12304/10 authorizes the Executive Branch to create a public company, so called Empresa Brasileira de Administração de Petróleo e Gás Natural S.A. - Pré-Sal Petróleo S.A. (PPSA). This new public company is to be formed by common shares totally owned by the Federal Union and will represent the latter's interests in the consortiums to be created.

In this respect, the corporate structure proposed for the exploitation of the Pre- Salt area is the consortium, which will be formed by Petrobras and the new national oil company in the case of direct contracting of Petrobras, and also by the awarded tender(s) in case of contracts to be granted under public biddings, whereby Petrobras shall be named the operator of the agreement. Moreover, an Operating Committee composed of representatives of all the public and private companies involved shall be created to manage the consortium, having the PPSA the casting vote in case of deadlock.

The royalty distributions among the States was the most polemic issue regarding the new regime. The Congress has approved a controversial amendment to the law equally distributing among all States and Municipalities the royalties from the production of oil and natural gas. Such amendment was a huge defeat for the States with oil production which used to receive most of the royalties distribution. Nevertheless, the former Brazilian president approved the law vetoing the section regarding royalties distribution, matter which is currently under discussion by the Congress under a separate bill.

Despite the Government optimism, there are several controversial legal issues being raised concerning the proposed regime. Just to mention a few, the mandatory participation of Petrobras on all oil concessions as operator and with a minimum interest, the direct contracting of Petrobras to perform exploratory studies for assessment of the reservoirs potentials and the assignment of the activities of research and extraction of oil, gas and other hydrocarbons, irrespective of public biddings. As well as the interpretation of some scholars, that the Brazilian Constitution does not permit the exploitation of hydrocarbons under the model of production sharing agreements.

Footnotes

* By Bruno De Luca Drago and João Luis Ribeiro de Almeida, partners of the oil and gas department of Demarest e Almeida Advogados, respectively located in São Paulo and Rio de Janeiro, and Guilherme Veloni, associate of the oil and gas department of Demarest e Almeida in Rio de Janeiro.

1 Law No. 9478/97.

2 Responsible for the conduct and execution, direct or indirectly, of all the activities of exploitation, assessment, development, production and termination of the exploiting and production premises.

3M Conversion rate used in the article: US$ 1.00 / R$ 1.72.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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