Why Brazil Struggles to Produce More Oil

Brazil floats on a sea of oil. So why have its oil stocks sunk so badly?

It is nearly six years since initial discoveries of vast oil reserves buried under a thick layer of salt beneath the seabed off Brazil’s coast. State-controlled Petroleo Brasileiro, or Petrobras, is sole operator, with a minimum 30% stake in all so-called “pre-salt” projects. In a recent study from Harvard’s Kennedy School, Brazil ranks fourth in the world in terms of the potential to boost oil output this decade.

Yet Petrobras’ stock price is now pretty much where it was back in October 2006, lagging both the Brazilian market and the U.S. exploration-and-production sector.
Even starker is the case of OGX Petróleo e Gás Participações, part of Brazilian tycoon Eike Batista’s stable of companies. OGX went public in June 2008, and has lost about two-thirds of its value in U.S. dollar terms. Petrobras’s stock has done even worse in that period, and both have performed about as well as Argentina’s YPF YPF +0.70% —incredible given YPF has been renationalized.

Despite their overall performance, both Petrobras and OPX saw their stocks beating the market handily at various points in recent years. Petrobras did very well in 2007 and 2008 as the magnitude of pre-salt oil became clear. Similarly, OGX’s ambitious production targets, alongside rising oil prices, sustained a rally from 2009 to mid-2011.

But hype has succumbed to reality. OGX is finding it tougher, and costlier, than expected to develop its reserves. It slashed output estimates in June, touching off a rout in the stock and a change of chief executive. Petrobras, meanwhile, has cut output targets while expanding its already huge capital-expenditure budget.

Roger Tissot, an energy consultant focused on Latin America, says “Brazil has been oversold”, referring to the hype around its potential. Despite rich oil resources, government policy limits the deployment of foreign capital and expertise, slowing development and raising costs he says.

Petrobras’s stock took a big knock in 2010 amid a complex and dilutive equity raise that boosted the state’s ownership in the company. Heavy local-content requirements—as Brazil’s government seeks to boost local industry—also embed inefficiencies in Petrobras’s development spending.

Little wonder Petrobras’s unit costs have jumped. Its average replacement cost for each barrel of oil equivalent of reserves over the past five years is just over $24, according to consultancy IHS Herold. That is higher than for Western oil majors, as well as state-controlled oil company PetroChina PTR -1.82% . Moreover, the trend in Petrobras’s costs has been upward.

Matt Portillo, analyst at investment bank Tudor, Pickering, Holt & Co., says foreign companies involved in discovering the pre-salt reserves, such as the U.K.’s BG Group, BG.LN -1.12% have been a better investment. BG has benefited from the excitement around discoveries but has also monetized their potential, and reduced development risk, by selling stakes in them to other companies.
Across the border, Colombian companies such as state-controlled Ecopetrol EC -1.57% and Pacific Rubiales have seen their stocks perform much better than Brazilian rivals. Like Brazil’s, Colombia’s oil industry has been transformed in recent years, with production growing at 6.5% a year since the low point of 2003. That upturn coincides with a more stable security situation in the country, but also with new policies to encourage foreign investment in oil and gas.

TPH’s Mr. Portillo estimates Colombian barrels typically offer a net present value of $20 to $30 each, or double what Brazilian barrels offer. Better fiscal terms are one reason. But a better business environment all round also helps. Colombia ranks third in the World Bank’s index for ease of doing business in Latin America and the Caribbean, compared with 26th for Brazil.

Big oil strikes often fuel stock-market exuberance. But resources in the ground aren’t the same as free cash flow, as investors in Brazil are discovering for themselves.

WSJ