Oil, Euphoria and the Future of Brazil

Fernand Braudel Institute of World Economics Associated with the Fundação Armando Alvares Penteado Rua Ceará 2•São Paulo, Brazil 01243-010 Phones (5511) 3824-9633/3214-4454 Cell 84015270 Fax 3825-2637 [email protected] / www.braudel.org.br / www.normangall.com

The Politics of Potential and Limitation

Norman Gall

Talk at the Center for Latin American Studies, University of Chicago, March 31, 2011.

Norman Gall is executive director of the Fernand Braudel Institute of World Economics and editor of Braudel Papers, the Institute’s newspaper of research and opinion.

The 25 years since the end of two decades of military rule in 1985 has been called the best phase of Brazil’s history, with consolidation of democracy, stopping decades of chronic inflation and major gains in social justice. These 25 years coincide with what may be a climax of human development that accelerated during the six decades after World War II. Prodigious advances occurred on a planetary scale in longevity, nutrition, productivity, communications, logistics, science, public health, scholarship and many other fields of endeavor. Middle-class patterns of consumption have been proliferating throughout the world. The challenge today is to sustain these advances. Democracy, stability and rising consumption gave Brazilians a benign view of their prospects. The Global Attitudes Survey of Washington’s Pew Research Center last year found Brazilians more satisfied with economic conditions than the citizens of any of 22 countries except the Chinese. Some 77% think Brazil will become, or already is, a world power, although that concept remains vague. Brazil indeed may be a special case. Visiting Brasília in 1976, Takeo Fukuda, soon to become prime minister of Japan, told his hosts: “After the oil crisis, it has become clear that resources are limited. This is a big event in the history of mankind. Your country is a power in the 21st Century –a resources power.” 1 This kind of talk became woven into protocol in other countries’ diplomacy with Brazil. Yet the talk is coming true. Brazil’s cornucopia of resources has come to life as booming commodity exports –iron ore, soybeans, beef, poultry, cellulose and many others—in which Brazil is a world leader. Guided by Embrapa, the government agricultural research institute, application of new techniques transformed the rolling cerrado scrub forests of Brazil’s Central Plateau, an area the size of the Great Plains of the United States, into one of the world’s most productive farming regions. Yet the richest resource may be water. Brazil is endowed with 13% of the world’s fresh water supply. A Beijing-based member of our Institute, Arthur Kroeber, editor of the China Economic Quarterly, said at one of our seminars last month that the biggest limitation on China’s long-term development is water. He added that China hopes to import water from Brazil in the form of 2

agricultural products. Meanwhile, Brazil will have to overcome looming shortages of water supplies for its own cities, thanks to mismanagement and a lack of public investment. 2 The idea of Brazil as a “resources power” was reinforced by a new frontier in petroleum discovery, among the last of such frontiers on this planet. In 2006 Petrobras, the state-controlled oil company, and its private partners were drilling 7,000 meters below the surface of the South Atlantic, penetrating ancient sediments that lie beneath a beds of salt more than 2,000 meters thick, to find the fossilized remains of green microbes that lived 130 million years ago, when dinosaurs still roamed Brazil’s continental interior. Trapped beneath massive salt structures, these microbe fossils were transformed by heat, pressure and time into the supergiant field of Tupi, since renamed Lula, one of the world’s biggest oil and gas discoveries of recent decades. In all, discoveries of 10 giant fields have been announced so far in the deep waters of the Santos Basin. Brazil is now the world’s biggest market for goods and services in the offshore oil industry and Petrobras the biggest single buyer. Some analysts say that Petrobras may spend $1 trillion 3 in coming years in capital and operating costs of deep-water projects, a sum equal to half of Brazil’s GDP for 2010, in by far the biggest industrial undertaking in Brazil’s history. Petrobras’s annual capital spending for the current decade, at more than $45 billion , is much more in constant dollars than NASA’s yearly budget in the 1960s, 4 when the United States was preparing to send a man to the moon. Petrobras’s five-year, $224 billion investment program is the biggest in the oil industry today, generating 10% of all of Brazil’s fixed capital investment. The petroleum industry always has been risky, both physically and financially, but less so when companies can achieve vertical integration, controlling the flow of production, transportation, refining and marketing. John D. Rockefeller’s Standard Oil trust achieved integration in the early years of the industry, as did the majors –Exxon, Shell, Chevron and a few others—until the OPEC revolution of the 1970s greatly reduced their control of reserves. Since its creation in 1954 as an incarnation of nationalist fervor, Petrobras developed spectacularly. With its offshore discoveries since the 1970s, Petrobras now stands alone as the world’s most highly-integrated major oil company, dominating its large national market with government support and with privileged access to huge reserves in deep waters of the Campos and Santos basins. Yet in deep waters it still must overcome daunting problems of geology, technology, logistics, safety, finance, politics, human resources, corporate governance and strategies of economic development that still must be solved as Brazil grasps the opportunities of a new era. Within the limits of this talk, I can focus only on a few key aspects of this complex subject. So in what follows I will touch upon the politics, geology, logistics, industrial supplies and finance before reaching some general conclusions about what may lie ahead for Brazil. Politics. President Luiz Inácio Lula da Silva called these discoveries a bilhete premiado, a winning lottery ticket. The pre-salt euphoria bred in the political class the illusion of limitless resources on the horizon. Proposing legislation to create a new institutional framework governing these discoveries, Lula’s cabinet ministers said they promise “extremely low exploration risks and great profitability.” Lula’s successor as Brazil’s president, Dilma Rousseff, supervised drafting of the new legal framework while chairing the Petrobras governing board before entering the 2010 election campaign. Furious Congressional debate on the new institutional regime focused almost entirely on distribution of royalties among states and municipalities, neglecting the governance and technical issues posed by deep-water exploration and production. As a signature gesture while these debates were proceeding, Brazil’s Congressmen raised their basic salaries by 62% to US$204,000, one of the world’s highest legislative salaries. 5 In her inaugural address as president, Dilma called the pre-salt discoveries “our passport to the future” but warned against “hasty spending that reserves for future generations only debts and desperation.” Nevertheless, the new production-sharing regime fortifies a politically- 3

protected state capitalism with broad discretionary powers and little transparency. A reinforced Petrobras monopoly would reduce chances for competition and spreading risk among several companies. The new laws oblige Petrobras to become the operator, with a 30% minimum stake, of all exploration blocks in “strategic” deep-water areas embracing 149,000 km 2, an obligation that would overburden Petrobras’s already stretched manpower, financial and technical capacities. All operating decisions, including contracting of personnel, suppliers and service providers, would be subject to veto by political appointees in a new state company, PetroSal Petróleo, created to supervise these ventures. Geology. The salt beds in the Santos Basin are very thick, in some places reaching 5,000 meters. They are plastic, mobile and heterogeneous, containing different kinds of salt, shifting position as drilling proceeds. They cover geological formations with petroleum potential that stretch far into the South Atlantic at even greater depths. These formations would not be accessible today without recent developments in seismic probes and in processing seismic data. “Drilling into the pre-salt reservoir presents daunting challenges,” Petrobras engineers observed at the Offshore Technology Conference (OTC) in Houston. 6 “Of all these challenges, salt creeping is the most common and difficult to manage.” The salt beds are unstable and can engulf the drill bit and collapse the casing that encloses the drill pipe. The oil emerges from the reservoir very hot into a cool environment at only 4 0 centigrade, congealing as wax to clog the pipe unless special chemicals are added and the pipe is continuously lubricated. The instability of salt beds impedes horizontal drilling to increase recovery from reservoirs immediately below the salt. This is just one of the problems involved in developing these resources. Engineering and logistics. “In the pre-salt discoveries, we have two kinds of logistical problems,” Petrobras President José Sérgio Gabrielli explained in an interview. “The first is about people, which is a problem of distance. In the Campos Basin, currently our main producing area, we transport more than 60,000 people to the platforms 150 kms. offshore by helicopter. But the pre-salt clusters in the Santos Basin can be 300 kms. away, too far for large- scale helicopter transportation. So we first have to reduce the number of people working on the platforms by intensifying automation. We have to build offshore platforms midway between the coast and the pre-salt discoveries to serve as logistical hubs with sleeping quarters, so that workers arriving aboard boats can be distributed by helicopter to the operating rigs and platforms after overnight stays on the logistical hub. The second logistical problem is the delivery of supplies to offshore operations. You need transportation of chemicals, machines, electricity. We probably will have specialized platforms dedicated to generating electricity and others to mix chemicals for drilling fluids.” 7 One difficulty of creating these hubs is assuring enough stability in rough seas to permit efficient mooring, landing and departure of ships and helicopters. “Everyone thinks it’s easy, but it isn’t,” said José Formigli, Petrobras’s manager of pre-salt operations. “And what’s the price? We even were offered the use of aircraft carriers as hubs. But aircraft carriers have the bad habit of swerving from side to side. They have thin hulls that they need for speed, so when they stop forward motion they sway and helicopters can’t land on them.” 8 The Petrobras strategy would automate all operations where possible, reducing the number of workers at sea. In the Santos Basin, bases for large fleets of helicopters and support ships should change the ecology of the seashore, with the port city of Santos becoming a new managerial hub for offshore development. Guilherme Estrella, Petrobras’s director of exploration and production, imagines 50 platforms harvesting the initial discoveries, each consuming 100 megawatts of electricity, totaling 5,000 megawatts of capacity generated by 200 gas-fueled turbines, equal to the consumption of Greater São Paulo, a metropolis of roughly 20 million inhabitants. Supplies. As of 2009, Petrobras dominated the world market for deep-water floating production systems (FPSOs), mainly converted supertankers that receive, store and offload oil and gas from the seabed. Petrobras operates 23 of the 49 FPSOs in service worldwide, along 4

with 10 of the 17 semi-submersible production platforms used globally. 9 By 2020, Petrobras operations would absorb 58 more drilling rigs (costing more than $600 million each), 45 more production platforms and more than 300 supertankers and support ships. Over the next few years Petrobras is expected to order 330 turbine-generators, 610,000 valves, 10,000 kilometers of subsea electrical cables (umbilicals)], 17,000 kms. of flexible tubing (risers), 4.8 million tons of steel, thousands of pieces of complex subsea equipment. All this would involve 68 million man-hours of engineering and a billion hours of construction and assembly labor. 10 Gabrielli warned of “critical areas, strangulation” in the supply chain. “One of them is drilling rigs. A rig takes three or four months to drill a well through 2,000 meters of water. A converted supertanker, which becomes the hub of a production system, uses 15 or 20 wells. So with one rig it takes four years to create a production system. Rigs are critical and Brazil doesn’t produce them. We also lack subsea systems, tubing to connect the ocean floor to the surface. Today we have the whole world’s production capacity contracted and we need more. We must advance in the area of large turbo-compressors, which are floating electricity generators. We are talking about gigantic quantities of equipment. Each system produces from 100,000 BD to 180,000 BD. So if we are going to meet our production goals by 2020, we need 41 of these systems. Each system costs about $3 billion. To operate, each one needs an average of five support ships. So we are talking of 200 support ships of different kinds (tugs, anchor handling, firefighting boats, etc.). To meet our goals, we will need many more tankers, each with 1.1 million barrels capacity, to transport all this.” 11 Finance. In September 2010, Petrobras raised $70 billion in new capital, the largest stock floatation in financial history. Of this, $45 billion was government money, including $16 billion from its sovereign wealth fund and the BNDES (the National Bank for Economic and Social Development), raising the federal stake in Petrobras from 40% to 48%. As part of this circular transaction, the finance ministry borrowed R$30 billion [$18 billion] to lend to BNDES so BNDES could buy Petrobras stock. The $45 billion was returned to the Treasury to pay for exploration rights ceded to Petrobras of pre-salt blocks supposedly containing 5 billion barrels of recoverable oil near the first discoveries. These transfers formed part of complex maneuvers to balance Brazil’s fiscal accounts for 2010, reducing the net inflow of funds for Petrobras to roughly $25 billion, still huge. Some analysts say that Petrobras may have to raise even more capital in a few years. Conclusion. Can Petrobras achieve all this? Politicians, managers and technicians face these risks with a courage bordering on temerity. The pre-salt discoveries have bred myths of their own. These myths of unlimited resources hide disturbing questions. Does Brazil really need to invest in pre-salt development at this speed and scale? Will these accelerated investments create distortions of their own? Are these investments in oil more important to the future of Brazil than more investment to correct enormous deficiencies in public education, ports, airports, electricity generation and transmission, communications, basic sanitation and transport infrastructure? While Brazil’s deep-water oil resources are a major target in the worldwide search for new reserves, Petrobras may have to move more slowly and cautiously in overcoming limitations in financial, technical and manpower capacity. These efforts are being undertaken in an environment blessed until recently by low inflation and 7.5% economic growth in 2010. When Lula took office in 2003, he had the wisdom to recognize that Brazil’s people would not accept a return to chronic inflation. But now Brazil may face a subprime crisis of its own. Lula’s popularity was based on a huge consumption boom, contributing to his 80% approval ratings as he left office on January 1. The consumption boom was fueled by big increases in government employment and salaries as well as a tripling of transfer payments, including the Bolsa Familia program that pays small monthly sums to mothers to keep their children in school. The transfer payments and a big increase in formal employment 5

contributed to the lifting of some 29 million Brazilians out of poverty. These Brazilians are enjoying the fast growth of consumer credit to buy domestic appliances, computers, motorcycles, cars and new homes, with personal loans growing by 26% yearly since 2003, at interest rates exceeding 40% that now absorb more than 20% of monthly income of indebted families. Let me tell you a story that about the enormous changes that have taken place in Brazil. On March 18, 1912, a small coastal steamboat left Rio de Janeiro, carrying a team of public health specialists on a voyage of exploration into the expanses of Brazil’s drought-stricken Northeast. After 18 days on horseback crossing the thick, spiny bush of the caatinga, the travelers reached the town of São Raimundo Nonato in the state of Pìauí, where two of the researchers, Arthur Neiva and Belisário Pena, appraised the human condition: 12 Rare was the individual who knew that Brazil exists. Piauí was one country, Pernambuco another, and so with other states. Government for these pariahs is a man far away who gives orders. The existence of this government is known because the man sends his agents each year to collect taxes. When we ask these people if these lands (Piauí, Pernambuco, etc.) are linked to each other, forming a nation, they say they don't understand this. To them we were gringos, lordaços (foreign lords). Illiteracy embraces more than 80% of the people. Life is reduced to raising pigs, chickens, a few scrawny cattle, the vicissitudes of the drought, waiting for rain, and nothing more. After the winter rains comes malaria. Between the old and new towns of São Raymundo, there is a natural basin that floods during the rains, leaving water in stagnant pools during two or three months of drought as epidemic malaria spreads. The water is detestable, salty, taken from a filthy ditch dug beside the bed of a small stream, where people fill their buckets. Why not dig a well, lined with stones and covered, and draw the water using a pump? “It’s not worth the trouble” is the answer. “People are used to this, and it does no harm.”

I was very moved when I first read this report 20 years ago while doing field research on the cholera epidemic in Latin America, so last year I visited São Raimundo to get a clearer idea of Brazil’s progress over the past century. In those earlier days, life expectancy at birth of Brazilians was around 30 years, roughly the same as in India, against roughly 75 years today. In 1900 Brazil’s population was only 17 million, against nearly 200 million today. So modern times have come to Brazil. By appearances, modernization even has reached the sertão, a corruption of the word desertão, or “big desert,” coined by early Portuguese settlers of this vast region in the 16 th and 17 th centuries. The people of the sertão, no longer forsaken by government, now are bathed in public transfer payments and subsidies. There are modern hotels, paved roads, air conditioning, wi-fi internet and many clinics and commercial enterprises. São Raimundo is still poor and isolated geographically, but nearly everyone has a cell phone and three times as many motorcycles as cars registered, with sales of motos tripling over the past three years. The town’s mayor, Padre José Herculano Negreiro, tells me that people are alive to opportunity, migrating to cut sugar cane in the plantations of São Paulo State and to work as maids and on construction sites in Brasília and Vitoria, bringing back savings that they invest in improving the family home and buying the good things of life. Yet back home there is mass underemployment, with scores of young men in yellow mototaxi T-shirts idling around the plaza of São Raimundo, waiting for customers, and scores of barber shops and beauty salons empty of patrons. Backward areas of Brazil still depend on government jobs, not least in towns like São Raimundo, one of thousands of municípios that get nearly all their revenue from federal transfers with little effort to collect local taxes. After a decade of stability, public finances threaten to burst out of control. Fears of inflation are reviving. In a far-ranging interview with the newspaper Valor Econõmico, President Dilma swore: “I will not allow inflation to return to Brazil,” adding: “I don’t believe that inflation in Brazil is [caused by] demand.” Although the government announced budget cuts totaling R$50 billion [US$30 billion], Dilma insisted: “There is no inconsistency between cutting R$50 billion from the budget and transferring R$55 billion to the BNDES to guarantee financing of our investment program.” 13 6

There are two problems with these promises. (1) The announced budget cuts are from the 2011 budget, which by Brazilian practice is a vague statement of intentions. Federal spending actually is rising beyond the expansive levels of 2010. (2) Government spending in Brazil is protected by legal guarantees and deeply embedded public policy, with little room for discretionary cuts. Beyond this, Dilma recently announced big increases in transfer payments in the Bolsa Familia program. Helpless before laxity in the finance ministry, as public spending and credit keep expanding, the central bank seeks once more to curb demand by raising real interest rates to the highest levels among major economies, sucking in hot money and making it harder for the government to service its debts. In 2010 Brazilian hedge funds increased their assets under management by 23% to $248 billion , rising to 12% of GDP. 14 A widening current account payments deficit is aggravated by an overvalued currency distorted by huge inflows of foreign money. This is an old story. The future will be shaped by how Brazil’s leaders and its people adapt to new realities. I wish them well. I am a Brazilian myself. But now disturbances appear on the horizon.

1 Quoted in Norman Gall, “The Rise of Brazil,” Commentary. January 1977/p45. 2 Roberto Rockmann, “Especial Água: Segurança na fonte,” Valor. March 22, 2011. 3 Steve Robertson & Thom Payne, Global Offshore Prospects. London: Douglas-Westwood, presentation February 17, 2011/p29; Joe Leahy, “Brazil: Platform for growth,” Financial Times . March 15, 20111. 4 Wikipedia, NASA Budget. Updated February 20, 2011. 5 Erica Fraga, “Salário de congressistas é maior que em países ricos,” Folha de São Paulo. December 18, 2010/pA4. 6 I Alves et al, Pre-Salt Santos Basin: Well Construction Learning Curve Acceleration. OTC 20177, May 2009. 7 Recorded interview with Gabrielli, October 30, 2009. 8 Cláudia Schuffner, “Petrobras já planeja novo gasoduto e dez plataformas no pré-sal,” Valor. December 27, 2010/A3. 9 Douglas-Westwood, The World Deepwater Market Report 2010-2014. Pp91& 97. 10 Booz&co., Agenda de Competitividade da Cadeia Produtiva de Óleo e Gás Offshore no Brasil. August 2011/p82-86 11 Cristiano Romero, “Licitação acelerada do pré-sal pode levar à desindustrialização,” Valor. December 6, 2010/A16. 12 Arthur Neiva and Belisário Pena, "Viagem cientifica pelo Norte da Bahia, sudoeste de Pernambuco, sul do Piauhí e de norte a sul de Goiaz," Memórias do Instituto Oswaldo Cruz (8) Rio de Janeiro: 1916/p184. 13 Claudia Safatle, “Dilma vai adotar regime de concessões para aeroportos,” Valor. March 17, 2011/pA6. 14 “The buys from Brazil,” The Economist. February 19, 2011/p81.