! 1! Writer Frank P. Neuhaus Founder and director of imanagementbrazil Ltda. São Paulo, Rio de Janeiro - Brazil

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1 New local content rules for the Brazilian offshore oil exploration sector and the challenges for the next decades in the ultra- deepwater pre- salt layers Writer Frank P. Neuhaus Founder and director of imanagementbrazil Ltda. São Paulo, Rio de Janeiro - Brazil Photos & Illustrations imanagementbrazil Ltda. istudiobrazil, Brazil The Economist, September 213 1st. quarter of 214 Preface The Brazilian government, together with the national energy giant Petrobras, the governmental owned development bank BNDES and the National Petroleum, Gas and Biofuel Agency ANP, has changed the rules of the so called local content related to all offshore exploration activities, including the pre- salt fields. The new rules particularly refer to the high technology sector with lower Local Content requirements - whereas on the other side not so specialized services and technologies will be committed to more stringent Local Content requirements. It is the official opinion that the exploration and exploitation of the pre- salt oil fields will include a new wave of technology developments to the benefit of national companies participating in the value chain. Otherwise, all parties concerned are well aware of that technical requirements of the future demand so far unknown expertise. Thereof, Petrobras adopted adjusted Local Content Rules to attract foreign suppliers of very specialized and sophisticated niche technologies working with lower criteria "Made in Brazil". In short, technologies with highly specialized and sophisticated engineering will require lower Local Content percentages, whereas ready available technologies are more demanding. The new rules applicable to the pre-salt exploration concept define that the Local Content will be reduced from 55% to 37%. This revised L.C. concept will become effective for certain licenses for the LIBRA exploration field. submarine X-mas tree 7 % 85 % flowlines/ risers 56 % 8 % submarine automation systems 2 % 5 % project management for construction and engineering 34 % 6 % logistic support 15 % 5 % basic engineering 5 % 9 % 9 % detail engineering 9 % present local content future local content 1 Source: ANP, National Petroleum, Gas and Biofuel Agency, Rio de Janeiro, Brazil, October 213

2 According to a director of CBIE (Brazilian Center of Infrastructure), Petrobras will direct its focus on exploration and exploitation of oil. The new rules offer the chance for Petrobras to develop the pre- salt oil fields with attracting sophisticated international know- how and reduced obligations for local social developments. Even so Local Content is very important for the development of the national value chain, but it can not mean that further development is hampered by such interest. When Ms. Graça Forster, became President and CEO of the company in February 212 (see also Coffee Break - Historical change of management culture at Petrobras and indications for suppliers, Oct. 213), she started a program to promote productivity and high, international standards thus closing the gap with the leading petroleum producing companies of this world for Petrobras. Particularly in the field of the very challenging pre- salt oil formations, development of specialized international technology developments is required. Reaching the pre- salt formation which is located approximately 7. meters below the water surface, first a water layer of 2. meters has to be passed. In the second step, a rock- and sand formation of 1.5 meters will be drilled reaching the salt area covering the pre- salt formation. Depending on the drilling field, the salt area represents an additional challenge of 2.5 meters. Finally, the pre- salt oil layer is reached after a journey of up to max. 7. meters heading the Earth core. It is vital for the success of the national Brazilian project to open the technological competition and calling international suppliers and technology leaders of several disciplines to settle in Brazil, looking for partnerships or buy- in local companies. It is vital for the success of the national Brazilian project to open up the local market for international suppliers and technology leaders in several disciplines and to convince them to set up an office or a partnership with local companies. The high Local Content requirements for basic and detailed engineering emphasize a policy to develop projects under Brazilian leadership. These requirements make it mandatory that international companies seeking market entrance develop an own strategy that enables them to participate in such projects. On the other hand the revised L.C. requirements explain the strong need of Petrobras for most demanding international engineering and construction expertise in order to safeguard productivity, financing, and time limits. But what is the total scenario in Brazil - what does it mean to explore and make the ultra- deepwater oil layers economically feasible? Brazil is attempting to be the 6th. largest oil producer all over the world. This is the prediction of the International Energy Agency in November 213; the agency attaches great attention to Brazil. Between 227 and 235 the country will achieve the peak of the ultra- deepwater oil fields thus representing one third of the total global oil production. In order to achieve such a challenging goal, a huge capital injection as well as technological development will be required. The project is so large that it must be compared w i t h i n t e r n a t i o n a l s p a c e exploration projects. It means, i n t e r n a t i o n a l t e ch n o l o g y companies as well as financial investment firms and funds are floating into Brazil now and during the next years. It is a global understanding that during the next two decades, Brazil will be the protagonist of the energy market, unconventional gas exploration will also contribute to that goal, following the World Energy Outlook 213, published in London on November 12, 213. The report forecasts that the national oil production in Brazil of 2 million barrels per day today will be tripled rocketing up the production to 6 million barrels per day extracted from 7. meters bellow the Atlantic Ocean in 223. Strategically Brazil is an independent oil producer without any commitment to OPEC and, therefore, of vital interest for numerous countries in Asia, foremost China, USA and Europe. Together with enormous modifications in the national oil ultra- deepwater pre- salt layer 2

3 The next 12 years will require a total investment of US $ 5 billion and an average of US $ 9 billion per year until INTERNATIONAL ENERGY AGENCY, NOVEMBER 213 Rodrigo Vaz, director of the oil & gas department of the consulting company IHS in Brazil, observes that the opening up of the new fields requires gigantic numbers of 63 thousand tons of structural steel, 7.8 kilometers of floating flexible pipelines, 1.5 wet x-mas trees, 52 thousand tons of steel pipes and 75 thousand tons of submarine equipments. Today, Petrobras runs the 4th. largest CAPEX- program in the World. This business and investment plan forecasts until 217 plus 48% deepwater drilling rigs (today Brazil has 4 under operation), plus 68% FPSOs (the todays number is 5 in operation), plus 86% of wet x- max trees rocketing- up the operation scale to 1.74 submerse installations, plus 172% of subsea flow lines and plus 143% of umbilical points in ultra- deepwater environments. In this very moment, almost 7% of all heavy duty helicopter services available in the World are operating in Brazil. It is not surprising that only the Brazilian oil and gas sector is larger than any other Latin American countries BIP. The national shipyards capacity is challenged. Considering today s capacities, it is not sufficient to meet the requirements of Petrobras. As a consequence local content ambitions cannot be accomplished in the near future. Considering all semi-submersible ultra-deep-water exploration platforms and FPSOs under construction for Brazil, less than one third is built under Brazilian flag with local wharfs. Almost all present projects in this sector are for old oil fields in Brazils shallow waters. These fields are of lower productivity but still rich with oil. Be aware shallow water in Brazil is not to be mistaken with shallow in other regions. By now Petrobras is the most e x p e r i e n c e d d e e p - w a t e r o i l exploration company in the world. The technological history of the company is very impressive: 1977: Enchova field started its production at 2.63 meters. 1988: The Marimbá oil field 3.32 meters. Early this century Petrobras drilled to 4.34 meters depth for the second stage of Roncador field. market, the gas market too will be subject to profound changes. Together with the large shifts in the national oil market, the gas market will be submitted to profund changes either. Until 223, the national gas production will multiplied by the factor five confirming Brazil among the self- sufficient and independent gas consumers of our Globe. These figures seem to be very optimistic, thereof, the IEA is not getting tired to remind all parties concerned that a lot of capital, technology, and market rules are required to achieve the goal. Particularly in the case of macro-economic rules the agency emphasizes the challenging obligation for the national oil giant Petrobras to participate with a minimum of 4% in all consortia active in the ultra-deep-water fields. The annual average of required investments is estimated to be approx. US$ 9 billion per year. The bulk of this investment has to be raised by Petrobras. The company is considered as one of the two most professional state owned oil companies globally, together with the Norwegian oil company Statoil. The local content requirements are causing a large tension to the the national suppliers chain. Brazil has not developed a strong and solid base of suppliers yet. The lack among the very large suppliers of the industry and the small local companies is considerably high. The increase of oil and gas production in Brazil depends on very large and complex technological developments and intense capital investments beyond everything seen in the sector and higher than in the Middle East and Russia. -INTERNATIONAL ENERGY AGENCY, NOVEMBER 213 3

4 All these fields were so-called post-salt formations, but considering the international standard just deep-water fields. Especially in the beginning Petrobras considered these fields to be shallow-water-fields. The first time ever industrial exploration of ultra-deep-water fields began in 27 when Petrobras drilled the presalt field Tupi with 7. meters depth in the Bacia de Campos. Today this field is named Lula. The pre-salt oil field in Brazilian ultra-deep-water was discovered by a national prospection team of Petrobras in July 25, the Parati field. One year later the discovery of the Tupi field encouraged rising expectations that Brazil was up to something new without example, hidden under a huge layer of salt and rocks, far way out in the Atlantic Ocean. Today it is internationally confirmed that the Brazilian pre-salt oil fields are good for at least 9 billion barrels. A promise which starts to become reality. On 21 st October 213 the gigantic ultra-deep-water drilling field Libra (located in the Bacia de Santos, Sate of Rio de Janeiro) was auctioned. It is the first field of the pre-salt layer and the largest oil field of Brazil so far. The reserves are estimated to be 12 billion barrels. The field was sold to a consortium of Brazilian, Chinese, and European companies for a price of US$ 7,5 billion and 35 years of exploitation rights. The winning consortium is constituted among Brazil, China and Europe which was quite surprising the rise of two European companies. In order to exploit the Libra field at the envisaged production rate of 1,4 million barrels per day nothing less than 12 up to 18 platforms, including FPSOs, are required. That will be almost half the present national oil production including all offshore operations in Brazilian waters right now. It is planned that 6 up to 9 vessels will operate in the Libra field, such as pipe layers, cable layers, module handling and well intervention vessels, supplier vessels, diving support vessels, offloading units and deep-water lowering vessels. Libra was only the first of several other fields that will be submitted to auction in the course of the next few years. The consortium s partners have to meet a great challenge: Roughly US$ 5 billion must be invested. The first barrel will be extracted in 217. The huge investment made it necessary for the Partners in the consortium to join forces. The partners are Petrobras of Brazil, the Anglo-Dutch Shell, French Total, and both Chinese CNOOC and CNPC. All protagonists of the 1 % worldwide oil markets are keenly observing how the group under the leadership of 1 % Petrobras will make that oil shoots out of the wells. Shell and Total, well known for their 4 % project management ability, contribute a high degree of financial security management, thus 2 % reducing the risk for Petrobras. Both Chinese partners have no experience in deep-water exploration. 2 % The new geopolitical scenario. It has to be observed that several geopolitical factors will affect the energy market much faster than the production start up in Brazil. The USA is rapidly Petrobras Shell Total CNOOC developing the non-conventional gas and oil CNPC production. The country will move from an importer to an exporter by 22. With that the oil price might stagnate or rise insignificantly. Prospects are that the price will level off at US$ 8, - per barrel by 221. However, this is not a threat for the ultra-deepwater oil fields because the production cost are estimated to be around US$ 3, -/barrel. Opportunity and risk for the oil companies. No doubt, the Libra contract under PSC terms presents an opportunity to find access to important oil resources. Whilst there is a potential of several billion barrels the risks associated therewith are substantial, as usual. To start with, the amount of the bonus, which cannot be recovered under the cost in oil (as is common in the industry), is unusually high. The only factor for decision on the bidding winner is very complex, with provision for correction related to the Brent price and to exchange fluctuations of the Brazilian currency, and tied as well to the production 4

5 of each of the field s wells. The is no provision for inflation correction of the investment, to be recovered after a long period of time, but there is still time for ANP to introduce the relevant important provision. The uncertainty related to the actual reserves to be found is also a major issue, considering the wide range of investments it may require and the associated cost of capital. The duration of 35 years for the contract is another restraint, if we consider the time for evaluation of discoveries, the time for deciding on the viability of its development, the production build-up, and the actual recovery of reserves. Considering the experience with similar projects in Brazil the investors may need much more time for the project. Many a company may wish to be the administrator in such a project, but leaving this to Petrobras, a company with longstanding experience in similar projects, may actually be advantageous, particularly if the partners in a consortium are not very homogeneous. If you wish to get a foot into this business with almost unlimited possibilities in Brazil you may need assistance to overcome the manifold trade barriers of the local content. As management consultants, based in São Paulo, we have the required expertise and experience and with our connections we will find a way that will benefit you. Such success would benefit the companies, the industry as a whole and ultimately the country. (FN) The uncertainty related to the actual reserves to be found is also a major issue, considering the wide range of the investments it may require and the associated cost of capital. - WAGNER FREIRE, BRAZIL, OCTOBER 213 5

6 Fact Sheet: Brazilian Petroleum in the World 1 Venezuela Saudi Arabia Canda Iran Iraque Quwait UEA Russia Libia Nigeria USA Quatar China Brazil 297,6 265,9 173,9 157, 15, 11,5 97,8 87,2 48, 37,2 35, 23,9 17,3 15, Proofed reserves by country (in billion barrels per day); in the case of Brazil, the shallow water and deepwater fields are accounted Saudia Arabia Russia USA China Canada Iran UAE Quwait Iraque Mexico Venezuela Nigeria Brazil 11,5 1,6 8,9 4,2 3,7 3,7 3,4 3,1 3,1 2,9 2,7 2,4 6, Production by country in 22 (in million barrels per day); in the case of Brazil, the shallow water and deepwater fields are accounted 1ANP, National Petroleum, Gas and Biofuel Agency, Rio de Janeiro, Brazil, October 213 6

7 3, Evolution of Brazilian reserves (in billion barrel) 28,4 28,5 22,5 15, 7,5 11,2 2,8 18,1 14,7 15,3 14,2 12,1 12,8, proofed total Franco (Brazil) Libra (Brazil) Iara (Brazil) Barda Rash (Iraque) Shaikan (Iraque) Sapinhoá (Brazil) 7.4 Carcará (Brazil) Júpiter (Brazil) Johan (Norway) The 1 major descoveries in the World (estimated reserves in place since 28 (in million barrels equivalent of petroleum) 7

8 7, R² =,9811 6,5 5,25 5,2 5,5 3,5 3, 1,75 2, 2,3 2,5 1,3,,5, (E) 22(E) 222(E) 227(E) Evolution of Brazilian Oil production (in million barrels per day) Total Rational Trend Line (5th. degree with R2 factor.9862) Proofed Petroleum Reserves Production Petroleum 6 % offshore onshore 9 % offshore onshore 94 % 91 % 8

9 Production by country in 22 (in % of global production); in the case of Brazil, the shallow water and deepwater fields are accounted; in the case of Angola, the deepwater fields are not accounted Nigeria 3 % Venezuela Angola 4 % 3 % Mexico 4 % Saudi Arabia 16 % Saudi Arabia Russia USA Brazil China Canada Iran UAE Quwait Iraque Mexico Venezuela Nigeria Angola Iraque 7 % Quwait 7 % Russia 15 % UAE 5 % Iran 5 % Canada 5 % China 6 % USA 12 % Brazil 9 % 9

10 Fact Sheet: Ambitious Plan - Fortune in the Brazilian Atlantic Petrobras production and investment plan, the 4th. largest CAPEX program worldwide in this moment, forecasts to double the domestic production of oil and gas by the end of this decade, despite the fact that growth rates were low in recent years. 7, Domestic production of Oil & gas by Petrobras (in million barrels per day) floating average trend line 6,5 5,3 Growth Figures: % per year % per year 5,2 5,5 3,5 1,8 1,8 2, 2,1 2,3 2,4, (E) 222(E) 227(E) Source: Credit Suisse, Brazil, 212 The Brazilian petroleum exploration campaign is one of the largest CAPEX programs in the World in this moment, comparable only to the Chinese high speed train with a rail network of 25. kilometers and a total estimated investment of billion US$ 3 until the year 22, the Qatar Project incorporating infrastructure, logistic and the sport complex for the Soccer World Cup 222 projecting a total investment volume of billion US$ 25 and the Brazilian oil and gas exploration campaign mainly in the ultra- deepwater offshore fields in the Atlantic pre- salt layer with a total estimated investment of billion US$ 27 until the beginning of the next decade. This Brazilian investment campaign will generate a lot of opportunities US$ 4 billion will be necessary for the construction, operation and further services for the investment expansion and maintenance in order to safeguard the ambitious plan of Petrobras until 22; the investments in the oil and gas sector in Brazil will represent 2% of the total BIP of the country until 22; in 27, the sector represented 1% and today, it is responsible for 12% of the overall Brazilian BIP; the total additional headcount is estimated with two million people; as of today Petrobras approved 6. registered suppliers, this figure will increase by at least 5% during the next three years. 1

11 Petrobras intends to install a gigantic production scheme until 22. As a precondition they have to solve several obstacles in the value chain of their suppliers, a problem on which they have to work constantly today (units) 116 until 22 (units) The FPSOs stationed in the offshore production area in the Brazilian Atlantic Ocean are serving as floating refineries, separating oil, gas, water, sand and other debris. The mayor problem: only three out of 13 equipment and service categories required for the construction of platforms can be contracted locally. The chances for engineering, operation services, and construction companies are tremendous, even when considering the local content obstacles today (in km) 28.2 until 22 (in km) The flexible submersible pipelines connected with the wet subsea trees are transporting the extracted oil from the bottom the FPSO operating on the sea level. The hitch: So far only two national companies are qualified to operate under the ultradeep-water pre-salt conditions. New production units and expansion of production capacity was envisaged but the available quantity will remain approx. 3% below the demand of Petrobras. The chances for investors are good if decisions are taken in good time today (units) until 22 (units) The wet subsea tree (wet x-mas tree) is a complex construction of valves controlling the oil and gas extraction from the presalt oil layers hosted on the seabed operating 2. meters below sea level. The number of projects announced will double the output of these devices until 22, but the overall demand is three times as high during the same period. The chance for investors is very good, especially under the new and reduced local content terms

12 12 today (units) until 22 (units) Petroleum tankers will transport the output from the FPSOs to the on-shore off-loading terminals. This refers particularly to the ultra-deep-water pre-salt layer oil fields far way out in the Brazilian Atlantic Ocean. The task for offshore supply vessels is pipe laying, cable laying, module handling, well interventions, ROV and dive robot operations, material supply, FPSO installation and offloading support as well as helicopter support for far away operations. The bottleneck here is national capacity. Brazilian wharfs can handle five large vessels at the same time, whereas Petrobras need the capacity of nine vessels at a time, expanding to 2 ships to be serviced simultaneously by 22. The semi-submersible free-floating drilling platforms realize the well drilling down to pre-salt layer. The total range of the drilling columns is 7. meters, challenging the Atlantic free water, rocks, and semi-solid salt layers. The problem here: Of eight specialized shipyards in Brazil only three are in a position to build platforms. This sector has enhanced potential to invest into wharfs under construction. The steel will be used with wharfs and for subsea equipment. The itch: Brazilian steel is 3% more expensive compared with world market prices. Until today Brazils production of non-corrosive special steel is insignificant. However, the oil extracted from the pre-salt layers is highly corrosive because of its higher than average content of CO2 and lead today (units) 289 today (units) 1,5 57 today (in million tons) 12 until 22 (units) until 22 (units) 3,9 until 22 (in million tons) 12

13 Brazils investment campaign in favor of the ultra-deep-water oil exploration areas is hampered by numerous obstacles, which make it difficult to turn invested capital into a successful cash flow. Here are some of the most obvious reasons responsible for the reduced competitiveness in the supplier value chain of oil and gas. The majority of all companies active in the oil and gas sector in Brazil are small and mid-size companies with very low export volume, thus indicating low competitiveness % none- exporters 76 % exporters Facts - out of the 24% of exporting companies 8% export less than 1% of the total production - the average annual turnover is million R$ 83-65% invoice less than million R$ 25 per year - the average headcount is 241 employees 3 The total tax burden for the manufacturing value chain is extremely high - by international standards. Don t forget to add the local content burden. The figures here depict the inflation of local prices compared with that of selected countries: 2 1 4,5 2,8 5,6 2,8 1,6 2,4 6,2 2,5 26,7 7, 3,4 UK Norway South Korea China Brazil additional Brazilian taxes (IPI, PIS, COFINS, ICMS), (in%) comparabel additional charges (in %) income tax on salary (in %) valves: 1% - 2% compared to China basic engineering: 1% - 15% compared to The Netherlands heat exchangers: 4% - 7% compared to Europe production pipes: 4% - 9% compared to Japan maritime metal sheet work: 4% - 6% compared to China steel for offshore industry: 25% - 4% compared to Asia pumps: 1% - 35% compared to USA 13

14 67 % Conclusion 7 % superior engineering basic technologies 26 % technicians A mayor obstacle for Brazil s oil industry is the lack of well-trained, qualified personnel. The 185 categories in the national oil and gas market lack approx. 28. professional staff, which has to be trained and educated by 215. No doubt, Brazil definitely will increase its oil production within the next decade. Furthermore, it is doubtless that Brazil s oil and gas industry will be a mayor player on a global scale. However, it is very doubtful that the country will reach the envisaged output of 5,2 million barrel/day by 22. The most pessimistic forecast predicts a maximum of 4,1 million barrel/day by 22 which is 21% below the present business plan of Petrobras. The company has an excellent track record of technological achievements, especially for deep-water exploration. Unfortunately the company s record of achievements falls behind their plans. Considering all aspects and the applicable local content an output of 4,4 million barrels/day seems realistic. The factor that the Brazilian government does not allow to adjust the national price compared with imported combustibles and derivates causes problems for the operational cash flow of Petrobras. But this is the source for such ambitious investment campaigns. It seems that the free cash flow of Petrobras will stay negative during a prolonged period of this decade. The country has to use the present chance of the ultra-deep-water salt oil fields exploration to improve its current revenue. Therefore, we think that within short large-scale changes of the fiscal regime as well as substantial investments in an education plan will be put into effect. Frank P. Neuhaus Managing Director imanagementbrazil Ltda. R. Marechal Deodoro, floor CEP São Paulo/ Brazil Tel. São Paulo: Tel. Rio de Janeiro: Mobil: Hans J. Zeese Managing Director BoaVista Executive Consultants Rosenheimer Str. 139 / 1 floor Munich / Germany Tel.: Fax: Mobil: