Petrobras Scandal Casts Cloud Over Brazil’s Prospects

 

IISS Strategic Comments

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Petrobras scandal casts cloud

over Brazil’s prospects

 

Brazil’s state oil company Petrobras is engulfed in the biggest corruption scandal in the country’s history, with many top figures both from the company and from the ruling Workers’ Party implicated in a vast kickback scheme. Following the chief executive’s resignation in February, the fallout from the scandal is overshadowing the second term of President Dilma Rousseff, who was re-elected by a narrow margin in October.

In addition to causing upheaval in the top echelons of the company, the scandal has severely damaged its finances and prospects. Petrobras, which is 60% controlled by the government and is listed on the Sao Paolo, New York, Buenos Aires and Madrid stock exchanges, is heavily indebted and has struggled for years to cope with political interference in its operations. The present crisis is seriously impeding its ability to finance the massive capital spending that it needs to undertake in order to meet ambitious oil-production targets.

Meanwhile, hundreds of thousands of protesters demonstrated across Brazil on 15 March to voice their anger at the president, whose government is overseeing an economic slowdown and imposing austerity measures to restore the public finances.

Kickbacks
The scandal first came to light in March 2014 when a senior executive, Paulo Roberto Costa, was arrested on charges of money-laundering. In a plea bargain, he revealed that for years, the company’s executives and senior government officials had conspired in a scheme that involved inflating prices in Petrobras contracts and pocketing 3% of the value. While the extent of the corruption is still unclear, analysts estimate that as much as $20 billion was stolen.

In January 2015, the assets of Jose Sergio Gabrielli, who was chief executive from 2005 to 2012, were frozen by court order. His successor, Maria das Gracas Silva Foster, resigned on 4 February, along with five other Petrobras executives. A close friend of the president, Foster appears not to have had any involvement in or prior knowledge of the scheme.

The scandal is spreading across Brazilian industry and politics. Twenty-three of Brazil’s largest engineering and construction firms have been banned from bidding for Petrobras contracts because of their alleged involvement. Rousseff herself was president of the Petrobras board of directors from 2003 to 2010, although she too was apparently unaware of the scheme. But members of the Workers’ Party, which she heads, are facing charges. On 16 March, its treasurer, Joao Vaccari, was charged with corruptly soliciting donations from Petrobras executives. And on 19 March, Brazil’s Federal Audits Court said it would investigate whether Petrobras board members mismanaged the company. To date, 34 politicians – almost all from the Workers’ Party or the Brazilian Democratic Movement Party, the biggest party in Rousseff’s ruling coalition – have been implicated. In total, more than 80 people have been charged in connection to the scandal.

Troubled finances
The scandal is causing severe financial repercussions for a company that was already facing challenges in meeting ambitious goals. In 2013, the company had annual revenues of $140.7bn, profits of $10.9bn, and by mid-2014 it had net borrowings of about $110bn. Under its corporate plan, it intends to invest more than $40 billion annually over five years in order to double oil production capacity. However, its ability to finance this programme is increasingly questionable.

Citing the debt burden, the ratings agency Moody’s Investors Service on 24 February downgraded Petrobras debt to Ba2 ‘junk’ status, assessing it as below investment grade. Other major agencies – namely Standard and Poor’s, and Fitch – had previously assigned it the lowest investment grade rating of BBB minus. Lowering to junk status prevents many institutional investors from holding a company’s debt, forcing up borrowing costs.

Petrobras share prices have fallen from $72 at their height in 2008 to around $6 per share. Although the share-price decline is also linked to the company’s longer-term financial and operational struggles, as well as the recent decline in global oil prices, markets have reacted with a sharp sell-off following each announcement about the scandal or the company’s failure to produce audited financial statements. While oil prices have dropped by 30% since November, Petrobras shares are down 50%.

The inability of Petrobras to calculate its losses from the corruption scheme has prevented it from publishing audited financial results for the third quarter of 2014, as well as for the full year. If Petrobras does not release audited statements soon, it will be in technical default and could be blocked from international capital markets.

To put its finances in order and restore the confidence of international investors, Petrobras has said it will not issue any new foreign debt this year and has announced plans to sell assets and cut capital spending by $16bn.

In common with those of other international oil companies, Petrobras’s revenues from foreign sales have been hit by falling oil prices. However, in the domestic market, the price fall has a silver lining for Petrobras. Government controls on fuel prices generated losses for Petrobras in previous years when oil prices were high. But retail prices in Brazil are now above international import prices, yielding a profit for the company.

However, this will not be enough to counter its problems. Some analysts are speculating that Petrobras may need a government bailout. This, in turn, could damage Brazil’s sovereign debt rating. Officials say the government has no plans to inject new capital into Petrobras. However, it has already taken indirect measures to boost the company’s liquidity. In addition, it appears that the government plans to keep domestic fuel prices at their current rates, which are on average 30–40% higher than international import prices.

Belt-tightening at Petrobras, while necessary under the current circumstances, could damage the company’s longer-term prospects. Though oil production has been flat over the past four years, the company has discovered extensive reserves off Brazil’s shores, known as the ‘pre-salt’. Petrobras has repeatedly had to revise down its growth projections, and the 2014 target to double production to more than four million barrels per day by 2020 now looks highly optimistic. In order to reach such an ambitious goal, Petrobras plans to bring 31 production units online by 2020, including 13 that are contracted to be built in Brazil.

However, the bar on dealing with many construction companies leaves few qualified suppliers in a country with strict local contractor rules. Those rules had been eased somewhat over the last few years, but still pose a major constraint to acquiring oil equipment and services at competitive rates in Brazil. Whether the government will further relax its quotas remains a key question. With important drilling plans scheduled over the next three years, any delay in meeting supply contract obligations could further endanger the company’s production targets.

While the corruption scandal marks a new chapter in Petrobras’s fall from grace, it comes after years of problems tied to excessively political management of the company. After the discovery of the pre-salt reserves in 2007, then-president Luiz Inacio Lula da Silva introduced legislation that increased government control over Petrobras, which had been partially privatised almost ten years earlier. The law increased the government’s stake in the company and made Petrobras the sole operator with a minimum 30% stake in all pre-salt blocks. These regulations put a tremendous financial and operational burden on Petrobras and severely limited foreign oil-company participation in exploration and production in Brazil. Other government-imposed decisions, such as fuel subsidies, local contractor rules and the building of expensive refineries in the poor, sparsely populated northeast for economic development purposes, further undermined Petrobras’s ability to manage its finances and projects effectively.

It remains unclear whether the company will gain more independence from the government in strategic decision-making. The new Petrobras chief, Aldemir Bendine, who was previously head of Banco do Brasil, the largest public bank in the country, has close personal ties to the president. On the positive side, however, he is an outsider in the oil industry and immune from any allegation that he might somehow be involved in the kickback scheme. His experience with financial markets in Brazil and abroad will also be an asset.

The government has decided to revamp the Petrobras board of advisers, removing political appointees. Guido Mantega stepped down as chairman and has been temporarily replaced by Luciano Coutinho, president of the BNDES development bank. The more market-friendly Murilo Ferreira, CEO of Brazilian mining firm Vale, is expected to take over as chairman pending his confirmation on 29 April.

Economic and political effects
The state-led approach undertaken by both the Lula and Rousseff administrations extends more widely than the oil sector. Brazil’s economic policies over the last decade have been characterised by high public spending, increasing debt and protectionist trade policies. Meanwhile, little has been done to improve the country’s poor infrastructure and inadequate education system.

Such policies have become problematic as Brazil contends with an increasingly hostile global economic environment. Growth in China, Brazil’s largest trading partner, has slowed, reducing demand and prices for Brazilian commodity exports. Foreign capital flows to emerging markets have declined. The economy is expected to contract this year. The Petrobras scandal will make matters worse by cutting spending by a major domestic company. The effects on the construction industry could have even greater repercussions for the wider economy. Many major Brazilian construction firms that were expected to execute the country’s infrastructure plans, including for the 2016 Olympic Games, can no longer access capital markets because of alleged corruption. Even if the government steps in to help Petrobras, it can do little to support the construction industry.

Brazil’s new finance minister, Joaquim Levy, is imposing unpopular austerity measures to balance the budget and safeguard the country’s investment grade status. He is cutting public spending, reducing pension benefits and raising taxes. However, these reforms, while improving economic health in the longer term, will stifle growth in the short term. Economic growth averaged 2% between 2011 and 2013.

Anger over the corruption scandal, coupled with the economic slowdown, is undermining Rousseff’s popularity. If any of the funds allegedly kicked back to members of the Workers’ Party are linked to her campaign contributions, she will face much greater damage to her credibility. Already some opposition figures are calling for her impeachment.

Although impeachment is highly unlikely, political fallout from the scandal could drag on. As more people are charged with corruption and are offered plea bargains in exchange for information, the list of alleged offenders will likely grow. Rousseff will have to choose either to stand up to corruption or to abandon members of her own party. Either way, she faces a difficult second term.

Volume 21, Comment 8 – March 2015

 

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