By Allison Fedirka
Editor’s Note: This is the second piece of a three-part series examining the impact of declining oil prices in Latin America. Click here to read part one.
Summary The challenges in the oil industry in Brazil and Argentina stem from long-standing business and policy practices in the oil sector, not from declining oil prices. In both countries, the underlying causes of these problems predate the fall in prices in late 2014. Oil companies would have faced financial challenges and unrest would have occurred regardless of fluctuations in international oil prices.
Last week, we discussed why Mexico has been able to deal well with plummeting oil prices. We also explained that the country’s ability to meet its financial obligations while avoiding major public unrest makes it an outlier among major oil-producing countries in Latin America. This week, we will look at two countries where financial challenges facing oil companies, as well as social unrest connected to the oil industry, are only tangentially related to lower prices: Brazil and Argentina.
Petrobras is the most powerful oil company in Brazil. But well before the drop in oil prices, the company was setting itself up for financial trouble. For years, the company engaged in massive borrowing and unprofitable activities. For example, Petrobras is mandated to hold a 30 percent share in pre-salt fields and to buy a certain amount of input materials from domestic producers, who do not always sell at competitive prices. Also, up until 2014, the company had to sell imported refined gasoline at a loss on the domestic market to keep domestic fuel prices low and avoid inflation. As a result, Petrobras’ refining division lost about $14 billion over several years. Petrobras is currently the world’s most indebted oil producer and one of the world’s most indebted non-financial companies. It owes about $130 billion to banks, bondholders and other creditors.
The decline in oil prices exacerbated Petrobras’s pre-existing tenuous financial situation. Approximately 75 percent to 80 percent of the company’s debt is denominated in U.S. dollars, while the company earns revenue in the Brazilian currency, the real. Between the depreciation of the Brazilian real and drop in oil prices, the company’s ability to pay off short-term debt diminished. At the end of February, Petrobras took a $10 billion loan from the China Development Bank to help make payments totaling $12 billion due this year. The decline in oil prices also poses challenges to pre-salt development in the medium term. In 2015, Petrobras said the break-even price for pre-salt development was $45 to $52 per barrel. OPEC put the price closer to $55 and, for ultra-deepwater development, $60 to $80 per barrel. Shell bought some oil assets in Brazil this year and believes by the end of the year oil will reach a break-even price close to the Petrobras estimates. Petrobras’ 2016 business plan sees oil selling at $45 per barrel.
Over the last two years, the company has not only cut back on investment but also implemented divestment plans, a decision that cannot be attributed solely to oil prices. Much of Petrobras’ divestments were planned before the drop in oil prices. In February 2014, the company’s 2014-2018 Business and Management Plan called for divestments ranging from $5 billion to $11 billion. The plan, consisting primarily of asset sales, was part of a greater financial strategy aimed at reducing leverage, preserving cash and focusing on priority investments, like oil and gas production in areas of high productivity and return in Brazil. The latest version of the divestment plan calls for the sale of $15 billion worth of assets that are not core assets or controlling shares. To date, it has been difficult for the company to find buyers willing to purchase the assets at the desired prices.
Three factors serve as obstacles to the planned asset sales, none of which are related to oil prices. First, the absence of core assets and controlling shares makes many of the items less desirable. Second, the high level of bureaucracy in Brazil deters some investors. Third, Petrobras is the epicenter of the Lava Jato corruption scandal that is shaking the nation. Lava Jato made headlines in late 2014, though initial investigations date back to March of that year. The company had a $17 billion write-down due to graft and overvalued assets in its annual financial results for 2014. Additionally, Brazil’s national industrial policies left the domestic economy very exposed to any changes in Petrobras’ activity. While oil revenue only accounts for 2.3 percent of Brazil’s GDP, the oil industry accounts for 13 percent of GDP due to the high local content rules that heavily integrate domestic industrial development and activity with the oil sector. Up to 70 percent of Petrobras’ capital expenditure went to the local economy. When the scandal broke, the economy was deeply impacted as contracts were nullified, suspended or revised. Major projects involving oil rigs as well as infrastructure were stalled as the government investigated involved companies, including many major companies in Brazil. Economists estimated that this scandal alone would cause the economy to contract by 2 percent to 2.5 percent.
The Lava Jato scandal also intensified pre-existing, anti-government sentiments in parts of the Brazilian public. The domestic unrest currently observed in Brazil dates back to June 2013. This marked the start of mass public marches against the government over public spending and corruption. At the time, the grievances were primarily related to excessive spending for World Cup preparations and stadiums instead of public programs that would improve education and healthcare. The Lava Jato scandal made headlines shortly after President Dilma Rousseff barely won the 2014 elections with 51.64 percent of the popular vote. News of the scandal intensified the anger of an already politically charged public. Therefore, corruption in the government, which also happened to involve the national oil company, served as the impetus of social unrest in Brazil, not lower oil prices.
Argentina is a more nuanced case than Brazil. Yes, there were oil workers protesting oil prices and the potential impact on employment. However, these events are still only indirectly related to international oil prices and would have occurred regardless of the price of oil. Two important factors explain why. First and foremost, the previous government severely intervened in and manipulated pricing and production in the energy sector. The Mauricio Macri government needed to take measures to normalize this sector because the previous policies were financially unsustainable. The Argentine Budget Association and the country’s Energy Institute estimate that nearly 3 percent of GDP has been devoted to subsidizing domestic energy consumption. Second, this type of behavior by oil workers is a fixture in the sector in Argentina.
Argentine oil prices have not aligned with international prices for over a decade. This is due to government intervention in the oil industry, including setting domestic prices. Right now, oil in Argentina is some of the most expensive in the world – $67.50 per barrel for light crude (Mendanito) and $55 per barrel for heavy crude (Escalante) – while international prices hover just over $40 a barrel. This was not the case prior to the plummet in prices. For 10 of the past 12 years, Argentine oil was priced well below international oil. The government officially started setting domestic oil prices at the end of 2007. At this time, the government set the domestic price at $42 per barrel while international prices were over $100.
At first glance, it would seem low oil prices would offer the government the opportunity to bring domestic oil prices back in line with international ones. This is much more easily said than done. Provinces that produce oil tend to rely heavily on the sector for royalties and employment. Also, oil workers are some of the most active and have some of the most powerful unions in the country, holding strikes regularly over the last decade. In the past, these strikes have caused gasoline shortages throughout the country. Prior to oil prices dropping, government intervention in the sector was aimed at giving financial incentives to oil companies to ensure enough oil was sold on the domestic market to meet demand at prices that did not aggravate inflation. It also set up a framework to incentivize companies to keep producing enough oil and investing enough money to ensure royalties and employment were not put at risk.
While Macri now faces the reverse scenario in oil prices of his predecessor, he must confront many of the same problems. Since taking office, Macri has started incrementally increasing gasoline prices. This is a delicate move given that he also does not want to stimulate further inflation. Oil companies still cannot fully adopt international price schemes without compromising employment levels and royalties. In January, oil workers threatened strikes and mobilizations in an effort to ensure workers were not suspended or fired. Their demands did not result in marches or strikes with the size and intensity of years past. But once again, the government finds itself paying up to $10 extra per barrel to prop up oil prices in the country. In addition to continuing production stimulus programs for this year, the government is also in the final stages of signing an agreement to pay oil companies at least $1.2 billion in overdue stimulus payments from previous years.
As for investments, Argentina may be one of the few places where low oil prices do not strongly discourage potential investors. Much of this can be attributed to the new government. The Macri government managed to settle Argentina’s debt with bond holdouts, which in turn will allow the country to return to capital markets. Macri’s reforms have also started loosening up capital controls and foreign exchange restrictions, which businesses tend to view in a positive light. He is also making efforts to reduce government intervention in the business sector and create a more predictable and transparent regulation environment. All of these moves will greatly change the investment landscape in Argentina, as they will remove significant obstacles that previously discouraged investment.
Brazil and Argentina stand out as Latin American oil producers whose challenges in the oil industry and social unrest are only tangentially related to oil prices. In the case of Brazil, Petrobras’ financial troubles were developing years before the drop in oil prices. The country’s social unrest dates back to 2013 and stems from public dissatisfaction with corrupt government practices. In Argentina, complications arising from oil prices are the result of the government fixing oil prices well out of sync with international markets for nearly a decade. The level of unrest seen in the Argentine oil industry is not exceptional in that it is consistent with workers’ behavior in recent years and by no means more intense. As we will see next week, there are other countries in Latin America where lower oil prices have directly spurred public unrest, threatening to topple governments.