Brazilian Pre-Salt Legal Framework
Submitted by Aaron Ball and Paula Galhardo, Looper Reed & McGraw, P.C. (Houston)

I. Introduction

Recent discoveries in the so-called "pre-salt" area may place Brazil amongst the largest oil producers in the world, as the region may contain up to 50 to 80 billion barrels of oil and gas. Current forecasts envisage that sometime between 2014 and 2024 Brazil will become the world's fifth largest economy and São Paulo its fifth wealthiest city.

In order to regulate the new wealth resulting from the pre-salt discoveries, last year President Luiz Inacio "Lula" da Silva unveiled four bills (the "Pre-Salt Bills") describing how the yet to be realized pre-salt windfall will be spent. If enacted, these new laws would govern not only the pre-salt area (excluding those areas already under concession), but also to certain "strategic" areas such as the Campos, Santos, Espírito Santo and São Francisco basins. This article briefly summarizes the Pre-Salt Bills.

II. New Regulatory Framework

A. Bills

On August 31, 2009, President Lula submitted four bills to Brazil’s lower house, the Chamber of Deputies, describing administration of pre-salt development and how the yet to be pre-salt oil revenues will be spent. The Pre-Salt Bills represent a significant departure from the existing, concession-based system. Instead of competition, the Pre-Salt Bills will centralize decision making and leave bureaucrats to select "winners" in the process (including indirectly through the designation of certain areas as strategic "Petrobras only" and, therefore, 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 wells. A new state agency, Petro-Sal, will control all drilling contracts and exercise veto power over all consortiums.

Brazilian officials, including Mr. Lula's favored successor and chief minister, Dilma Roussef, argue that the location of so much oil in the pre-salt area has eliminated the geological risk normally borne by oil companies in a concession model. This, they say, justifies the government receiving a larger piece of the proverbial pie in oil revenues. Opponents of this position (not surprisingly composed of Brazilian opposition parties and oil companies) argue that this could have been accomplished by altering existing laws and, for example, increasing royalty rates. They argue that the pre-salt fields are difficult and expensive to develop because of their depth and distance from shore, pointing to three recent and highly publicized dry holes drilled by ExxonMobil, the BG Group and Petrobras. Industry is also concerned that the Lula government is abandoning a transparent and respected system for the development of hydrocarbons in favor of a complex, government controlled scheme---especially in a country where public corruption is a recurring problem.

The Pre-Salt Bills have been approved by Brazil's lower house. The next step is Senate approval. Brazilian lawmakers returned from vacation on February 2, 2010. Senate leadership previously agreed to vote sometime during the first two weeks of February (by February 16th) on at least three of the four Pre-Salt Bills. This did not happen. Although President Lula has requested the Senate make the Pre-Salt Bills a top priority, party wrangling, constitutional issues, and the imminent presidential election may derail prompt passage. Delays in the enactment of any legislation could also impede development. One senior oil executive recently said that "[w]ith the nebulosity right now, I don’t think we could make [an investment] decision."

As mentioned above, the pre-salt proposals are divided into four different bills:

1. Assignment to Petrobras of free pre-salt acreage in consideration for the Brazilian government’s subscription for Petrobras shares;
2. Production Sharing Agreements ("PSAs") for the pre-salt and other strategic areas;
3. Incorporation of a state oil company, "Petro-Sal", to manage the Brazilian government's interests in PSAs; and
4. A "Social Fund" to manage revenues from PSAs.

Below is a summary description of each of the Pre-Salt Bills:

1. BILL 5941/2009: Assignment to Petrobras of free pre-salt acreage in consideration for the Brazilian government’s subscription for Petrobras shares.

Under Bill 5941, the Brazilian government will inject the financial equivalent of 5 billion barrels of oil into Petrobras to ensure it has the capital to remain the dominant player in the Brazilian market. Specifically, the Brazilian government will be allowed to assign pre-salt acreage directly to Petrobras (without a bid round) containing a maximum of five billion barrels of oil equivalent of reserves (around to fifty billion dollars). Reserves will be estimated and valued "in place" as 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, according to the bill, must be effected in treasury securities - and to finance investment. Minority shareholders will be entitled to (though most likely will not be financially able) 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 from such acreage does not yield five billion barrels of petroleum equivalent Petrobras will be granted additional acreage to reach the five billion barrels of oil equivalent and production in excess of five billion barrels, the excess will belong to the Brazilian government.

2. BILL 5938/2009: PSAs for the pre-salt and other strategic areas.

Pursuant to Bill 5938, PSAs will apply only to the pre-salt area and to other areas deemed "strategic" by a newly-formed government agency, Petrosal (described in greater detail below). The concession system that has been used by Brazil for exploration and production will be valid only for the areas (called "blocks") that were already auctioned.

PSAs are defined in Bill 5938 as a "regime of exploration and production of oil, natural gas and other fluid hydrocarbons" whereby oil companies (contractors) will be granted rights to explore for, develop and produce petroleum reserves, at their cost. In the event of a commercial discovery, costs incurred will be reimbursed to oil companies through an entitlement to production referred to as "cost oil." The remaining petroleum, after deduction of cost oil, is considered "profit oil". This profit oil is shared between the contractor and the Brazilian government in the percentages set forth in the PSA.

Under Bill 5938, the Brazilian government may award a PSA to Petrobras as sole contractor without holding a licensing round or it may tender blocks to other contractors, provided that Petrobras must possess a minimum 30% interest. Petrobras may bid alone or in a consortium to increase its participating interest beyond the minimum 30% interest.

On the PSAs awarded to Petrobras without a tender, the National Board of Energy Policy (Conselho Nacional de Política Energética – CNPE) 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 that offers the Brazilian government the highest percentage of "profit oil" will win the auction. The winning company in the auction process must pay ten percent (10%) of royalties and a fee called Special Participation ("Participação Especial" – PE) that varies from zero to forty percent (40%). The PE is distributed between the states and municipalities where the oil and gas is located as determined by National Petroleum Agency ("Agência Nacional de Petróleo" – ANP).

Under all PSAs, the contracted company will engage in the exploration at its own risk. In case of success, 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.

3. BILL 5939/2009: Incorporation of a state oil company, Petro-Sal, to manage the Brazilian government’s interests in the PSAs.

Pursuant to Bill 5939, a public company would be organized as a corporation under the aegis of the Ministry of Mines and Energy for purposes of managing PSAs. Although a party to the PSAs, the corporation, dubbed "Petro-Sal," (though it will, according to Petrobras CEO Gabrielli, soon be renamed as it conflicts with the name of an existing Brazilian company) will not take up any risk or responsibility for costs of oil and gas exploration activities. However, as a party to the PSA, Petro-Sal 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.

Petro-Sal, among the roles mentioned above, will be responsible for the following:

(i) conducting the management, audit, and fiscalization of petroleum activities performed under PSAs;
(ii) authorizing bidding processes related to the exploration and production of pre-salt areas;
(iii) representing the Government, through the operational committees, in consortiums incorporated for the execution of PSAs; and
(iv) representing the Government in case of unitization in the pre-salt and strategic areas.

Bill 5939 limits the size of Petro-Sal to the maximum of 130 employees, most of which will be hired by civil service exam (except its Directors, which will be appointed by the Government). This limit was put in place in an effort to stem the growth of another government bureaucracy (though in Brazil, like all countries, they tend to get bigger no matter what).

4. BILL 5940/2009: A Social Fund to manage revenues from PSAs.

Bill 5940 proposes the creation of an oil wealth fund (a "Social Fund") to manage Brazilian government revenues from PSAs, including share of signature bonuses, that is set by the government, royalties and government receipts from the sale of profit oil. The ostensible objective of the Social Fund is to maintain financial stability and to fund programs dealing with poverty, education, culture, science, technology and the environment. The "financial stability" aspect of the Social Fund is to avoid what the economists call "Dutch Disease." Named after an economic crisis in the Netherlands following a natural gas discovery, "Dutch Disease" occurs when the ingress of a great amount of foreign capital into a country generates a strong domestic currency, weakening the domestic industrial sector.