Brazil Faces the Oil Curse

Ever since the Brazilian state energy company Petrobras struck oil in giant fields deep below the floor of the Atlantic, the mood in the normally sedate Brasília has been practically euphoric. In 2007, this chronically energy-deficient nation confirmed it had hit the energy jackpot. President Luiz Inácio Lula da Silva donned overalls and a hard hat and helicoptered out to an offshore drilling platform to dip his hand in oil, like a Hollywood idol leaving a footprint in the sidewalk. A seminar last week in the capital kicked off with the national anthem. "We still do not know exactly how much oil is in the pre-salt layers," intoned keynote speaker Dilma Rousseff, Lula's chief of staff. "We have strong evidence that God is Brazilian."

After years of trial and error—probing 7,000 meters below the ocean's surface, past the rock and sand seabed, and on through the thick crust of salt on the South American coastal shelf—Brazilian oil engineers found staggering quantities of crude oil. Just the proven reserves in three different areas of the so-called pre-salt cache total some 9 billion to 15 billion barrels, the largest find in the Western Hemisphere in more than three decades. But that may be just the beginning. After drilling scores of test wells, the experts now reckon the pre-salt reserves sprawl over 149,000 square kilometers, an area half the size of Italy, and could contain up to 80 billion barrels of oil. Not the heavy, low-grade crude stuff Brazil currently fetches from the sandy layers in its existing offshore wells, but light, sweet crude, the prize of hydrocarbons. "Brazil drew a winning lottery ticket," said Lula.

And the potential for self-destruction that goes with it. As many nations have discovered, drilling oil generates money but not necessarily development. Economists call it Dutch disease, after the affliction that hit the Netherlands in the 1960s, when a natural-gas bonanza in the North Sea overwhelmed the small economy with dollars and foreign investment, inflating the value of the guilder, which gutted Dutch exports and crippled national industry. Mostly, though, this is a poor nation's problem. Three decades after oil started flowing in Nigeria, a study by the International Monetary Fund revealed, per capita income had fallen slightly, but the number of people living on $1 a day or less practically doubled, from 36 million to 70 million, between 1970 and 2000. Venezuela pumped nearly 3 million barrels of oil when Hugo Chávez came to office in 1999. A little more than a decade later, Venezuela pumps 800,000 fewer barrels a day, the once stellar oil company PDVSA is a government cash box, poverty is little changed, and Chávez is entrenched in power as never before. It's no different in the Andes, Central Asia, or the Middle East, where oil fuels tyrants and leaves a deep stain of poverty and backwardness.

Can Brazil avoid the curse? Until just a few years ago, the question would have seemed ridiculous. Brazil, after all, has won a reputation as an exemplary steward of its energy bounty. The country is already the world leader in renewable energy, with 80 percent of its electricity grid generated by hydropower plants. Half the national fleet of passenger cars runs on clean-burning ethanol distilled from sugar cane, a world benchmark. Before "pre-salt" was even part of the working vocabulary, topnotch geologists, experienced engineers, and pioneering investment plans had already turned Petrobras into one of the world's most profitable oil companies and the leader in deep-water prospecting. Last year Brazil gained energy independence, producing 2 million barrels per day from 14 billion barrels in proven reserves, enough to cover domestic demand for the first time. Now, with the new Atlantic discoveries more than doubling proven reserves in just three fields, and due to start producing by 2013, experts expect Brazil to become a net exporter of oil, natural gas, and byproducts. Mines and Energy Minister Edison Lobão reckons the oil will make Brazil the seventh or eighth-largest producer in the world.

If any developing nation could handle this windfall, Brazil would be it. The reasons Brazil is rising so fast as an oil power are in large part the same set of reasons it has surged to the front lines of the emerging markets: economic stability, a resilient democracy with respect for the rules of the free market, and leaders with a penchant for looking beyond the day after tomorrow. All this has drawn capital and foreign businesses and lifted Lula to the status of global superstar. No international gathering is complete without this hirsute former union man, a "responsible leftist," who champions the poor and scolds the elite but also combats inflation, breaks bread with executives, and scrupulously pays the country's debts.

Lately, though, the rich world's favorite emerging-market leader—"There's my man," Barack Obama exclaimed at the G20 summit in London in April—has become a little less predictable. At least since last year, when Petrobras confirmed the size and potential of its deep-sea oil reserves, the Lula government has taken on a marked swagger. Long before a single drop of this deepest oil was recovered, the government was already warring with states and towns over their share of the take. Bureaucrats declared how pre-salt largesse would be the salvation of the poor, while others waxed ebullient about paving the country with highways and bridges, and over the coming petrochemical-industrial complex. Now it seems that energy politics in Brazil are about to take a hard turn to the left. In August the Brazilian government announced its new regulatory model for the oil system. The proposed law, which must still pass Congress, where it may undergo an overhaul, is an abrupt departure from a system that many in the global energy business have come to know and respect. More troubling, what's fueling the shift appears to be something only too familiar: the official appetite for command and control.

Brazil's current arrangement in the oil industry relies on competition and private initiative: drilling contracts are farmed out to private investors, who assume the risk and pay royalties. By contrast, the new system calls for production sharing—a method favored by autocratic governments like Venezuela—which centralizes decision making and leaves bureaucrats to pick winners. Instead of dozens of companies bidding for exploration rights, the master of the pre-salt reserves will be state capitalism. Though most of its stock is publicly traded, Petrobras is controlled by the government, and the new rules governing the blue-water oil frontier will only make that bond tighter. The Brazilian energy giant will be the sole operator in the fields. (The new law will not alter old contracts in the shallower, post-salt fields, or the 28 percent of pre-salt wells already auctioned.) Private companies may bid, but only if they partner with Petrobras, which has a guaranteed 30 percent stake in all wells. Brasília has also created a new wholly owned state company, Petrosal, which will put up no risk capital but will oversee all new drilling contracts in the pre-salt province, retaining half the seats on the board of future prospecting consortiums, and, more significantly, veto power.

The bill took the energy market aback. Its critics argued that the existing concession system is one of the world's best. Voted in by constitutional amendment in 1997, a sweeping oil-reform bill ended Petrobras's monopoly and shook up the cloistered oil market. The bloated state company—nicknamed Petrosaurus—shed tens of thousands of redundant workers, sold most of its stock to the public (the government remains the biggest shareholder), and opened the market, forcing Petrobras to compete for drilling contracts with the world's top energy companies. "The end of the monopoly gave a new life to the company," says Adriano Pires, head of the Center for Brazilian Infrastructure, a think tank. "Petrobras became more efficient and broke record after record. Under the new rules, that is now at risk." So, too, may be the potential gain from private investors, who are likely to balk at entering a forced partnership with Petrobras or putting up money in a deep-sea drilling operation where bureaucrats call the shots.

Brazilian officials have a ready defense. Bolstering Petrobras, says company president José Sergio Gabrielli, will help save money by creating an economy of scale for services and equipment spread over 800 kilometers of open ocean, and by standardizing procurement practices across the industry. More pointedly, Brasília argues, by taking the reins of the industry the country will be able to avoid drilling too much oil too fast, safeguarding the nation's strategic energy reserves and inoculating the economy against the oil curse that could flood the Brazilian market with investment, send the real soaring, and price the country's goods out of the world market. Besides, the government argues, why should Brazil share the wealth? "The only reason to keep a concession system is if a country is not certain it will find petroleum," President Lula says. "But when we know that the oil is there, and that oil is a state resource, why should we grant concessions?"

Critics answer that the current law offers all the same protection, without the risk of rewriting the industry rules. Authorities, they say, already have the power to determine which blocks of the pre-salt reserve to auction and which to withhold from the market for future exploration. They also can invoke existing contractual clauses to quickly boost the official cut of oil revenues under extraordinary circumstances, as in the case of a sudden windfall from pre-salt finds. "The law is clear, transparent, and encourages competition, which ensures greater efficiency," says David Zylbersztajn, a former head of the National Oil Agency, the national regulator, who oversaw the first auction for exploration rights in Brazil's pre-salt blocks in 2000. "It was under the current law that the pre-salt oil was discovered in the first place."

More than oil is behind the government's abrupt slide to the left. Brazil's presidential election is still a year away, but already the political class is prospecting for hearts and minds. Lula has labeled the new oil regulatory bill as "urgent," a measure that requires Congress to vote on the measure within 45 days, upstaging all other legislative business. Tellingly, he also has anointed chief of staff Rousseff, his preferred candidate for succession in 2010, as the propagandist in chief for the new oil law. For all Lula's popularity, Rousseff is struggling in the polls, trailing a distant second behind São Paulo Gov. José Serra. Talking up Petrobras and the country's fabulous oil finds at events soaked with pomp and patriotism cannot hurt. "Oil is something that's easy to see and simple for voters to comprehend," says Pires. "Petrobras is like the national football team. It's a symbol dear to all Brazilian hearts and one that few politicians dare criticize openly."

By that logic, the new regulatory law will probably pass, perhaps with only minor adjustments. The stakes for Brazil are high but perhaps not fatal. No one expects Latin America's biggest economy to succumb to Dutch disease. But the renewed spasm of state control and retronationalism that the oil law represents could take its toll. "What we're seeing is the revival of ideas that we thought had been reduced to historical footnotes, that foreign capital is bad and that bureaucrats know how to manage the country better than business and industry," says Mailson da Nóbrega, a former finance minister. "This is not going to derail Brazil, but it will slow us down." The real risk for this rising emerging market is not one of collapse, but of missed opportunity—the oldest Brazilian curse.