It’s painfully simple. With most places around the world ground to a halt amid the covid-19 crisis, the global demand for the world’s most popular energy source – oil – has plummeted. Brazil is no exception. This is far from ideal for state-owned Petrobras, but it’s also concerning for small and medium-sized businesses in the oil sector having to adapt to this new paradigm.
More than 160 million barrels of crude oil are stranded at sea around the world right now. That’s because widespread lockdowns and business closures around the world have caused the demand for petrochemical products to plummet. Less planes, trains and automobiles in usage during this pandemic is having serious knock-on effects on the oil sector. The industry is producing too much oil for a world that can’t use it.
US oil prices turned negative for the first time in history in mid-April, and while there has been a slight improvement since, prices are continuing to fall by more than 20% since the start of the year.
In Brazil, the oil price crisis is also making waves. Latin America’s largest economy is also the region’s biggest oil producer. Brazilian oil projects are being suspended or delayed, regulations have been issued to ease obligations for oil companies and state governments are collecting less in royalties because oil businesses aren’t making their forecasted profits. The price of oil in Brazil for the past month is barely covering the overhead costs of most upstream projects in the country.
State-owned oil company Petrobras has reduced its 13 domestic refineries to varying levels of operation in response to the reduced oil demand. It’s lessened its output by 200,000 barrels per day to try to cope. Consider too that the company is sitting on US$80 billion of net debt – one of the highest debt loads of any oil company in the world.
The crash of global oil prices combined with other effects of the covid-19 pandemic (reduced workforces as a result of state-backed lockdowns across Brazil, for example) has contributed to the highest level of capital flight in Brazil’s history. Foreign investors are not as confident about Brazil as they were before covid-19, its oil industry included. The forecast is concerning and poses problems for domestic producers. “For Brazilian companies, competing with current prices in the international market is difficult and it demands sacrifices that may become even harder to bear if prices stay as low as this for long,” says one GC in Brazil’s oil industry who wishes to remain anonymous.
The activities most affected by the pandemic have been investments in exploration and production – this includes companies directly doing the exploration as well as service providers within their supply chains. These upstream activities are most at risk, given the surplus of crude oil already above ground at present. Petrobras has reportedly had to postpone several offshore oilfield sales within the last month alone, due to low pricing and demand. “In the short term, we are already seeing a postponement of E&P investments, a hibernation of production units – which also means a decrease in hydrocarbon production – and an overall reduction in fuel and gas consumption,” says Machado Meyer Advogados partner Daniel Szyfman.
Midstream activities – most obviously storage and shipping – are in high demand at present, to handle the surplus oil not being sold. But there are only so many storage units available in Brazil and indeed the world. Predictions are placing June as the month when the world will run out of oil storage if demand does not rise.
Many consider Brazil’s short-term economic outlook gloomy and, as Schmidt, Valois, Miranda, Ferreira, Agel Advogados partner Paulo Valois Pires explains, the economic viability of oil projects is being put to the test. “No one intends to continue a project or production if costs are above the selling price, or if the net present value is negative with no signs of recovery on the horizon,” he says.
The Brazilian National Petroleum Agency (ANP) has put on hold plans to launch new exploratory areas. While postponement in normal times might provide more time for business analysis and greater competition at the auction, the covid-19 crisis means companies – both local and international – are doing all they can to keep up with their fiscal responsibilities, so may not have the means to compete at all in auctions soon. For Brazil’s economy, less investor interest spells bad news for the country’s road to economic recovery, which has been a good news story over the past five years. Boosting foreign investment in Brazil’s energy sector has been President Jair Bolsonaro’s game plan, but the ensuing crisis creates complications. ANP’s postponement of new auctions might also further encourage oil companies to sit tight and postpone or cancel deals they are considering.
But Brazil’s oil and gas regulator has made moves to encourage market activity too. Just last Monday, the ANP issued new rules for companies to more easily decommission and abandon mature oil and natural gas fields, in the hope of generating about US$5 billion in investment over the next five years. The rules are part of a series of reforms that aim to reduce bureaucracy and make the once state-monopolised oil and gas sector more business-friendly and attractive to the private sector. By making abandonment and decommissioning processes quicker, investors are no longer tied to fields for so long and can reallocate money elsewhere.
The ANP has also extended certain exploratory and production deadlines for projects that have been interrupted by the covid-19 pandemic. The Brazilian oil regulator must continue to work alongside all authorities – federal, state and municipal – to respond quickly to the ever-evolving situation, says Mattos Filho, Veiga Filho, Marrey Jr e Quiroga Advogados partner Giovani Loss. He says companies must also communicate with the authorities on how they think the sector can best survive the pandemic. “As the economic and health issues progress, there is no magical formula: companies and government will need to keep studying and discussing the best way forward, considering we are all in the same boat. Communication is key in these difficult times,” says Loss.
The bigger the better?
It’s the small and midsize companies that may face the most difficulties within the industry, as they may not have the liquidity to ride this wave of low revenues. “For the short term, activities will be reduced drastically, and companies will aim for strong cost reductions,” says Mattos Filho’s Loss. These businesses may find it difficult reducing their activities, but larger companies will probably have more leverage to cut short-term activities while not hurting their bottom line. “Long term, most projects won’t be cancelled as they tend to be the ones in which the economics have already considered potential oil pricing setbacks,” adds Loss.
While most Brazilian insurance policies exclude losses resulting from pandemics and banks are hesitant to lend at present, companies must take advantage of the measures introduced to help stay afloat during this time – from tax payment extensions to national insurance contribution cuts, companies can capitalise on these moves to cut their spending. Reserve-based lending – loans made against and secured by oil and gas fields or a portfolio of assets – is also a more viable option following the ANP’s 2019 institution of clearer rules for sale and purchase agreements using this kind of financing.
Even if companies do stay afloat for the time being, what condition they will be in once pricing returns to normal is still up for debate. “Financing is currently in short supply, and small and medium-sized companies are threatened. Many of them, unfortunately, will expire along the way,” says our anonymous GC. “Even the larger companies, like Petrobras, are likely to see their investment plans compromised and, in some cases, their levels of debt and financing commitments will merit a close watch.”
Petrobras is not in the healthiest position right now – it announced last week it was scrapping its 2020 debt reduction target (it now aims to end 2020 with the same gross debt as it ended 2019, US$87 billion).
Appetite for the refineries and oilfields Petrobras wants to divest is low at present; depending on when that appetite returns, the likelihood of it meeting its revised debt target remains questionable. The oil giant may choose to put more assets up for sale than originally intended to cope with the aftermath of the crisis. Valois Pires is confident that in the mid-to-long term, there will be “opportunities for companies that intend to explore the pre-salt potential and acquire shallow water, midstream and gas-related projects from Petrobras.”
Petrobras is at a critical juncture but so too is the US oil and gas industry, says Tauil & Chequer Advogados in association with Mayer Brown partner Alexandre Chequer, which could spell good news for Brazil. “The crash of shale combined with the current global oil glut may trigger low oil production in the near future – in such a case, the US may become a net oil importer,” he says. “Oil prices would then become higher and countries like Brazil will benefit greatly from a significant increase of investments. Major investors will be wary of US shale and we should see a major move of capital to offshore exploration and production around the world.”
Meanwhile, Machado Meyer’s Szyfman highlights how there has been a spike in domestic demand for liquefied petroleum gas, though he adds that this is mostly due to consumers’ fear of perceived shortage, “not because of macroeconomic or market fundamentals.”
What should legal do?
The new paradigm Brazilian oil companies face means legal teams are involved in the management strategy of their businesses now more than ever before. “Governance needs to be assured and at the same time it is necessary to rethink, question and readapt it,” says one GC. “The current model of your company may no longer be the most appropriate to deal with the ongoing situation this sector is facing.”
GCs must oversee several issues related to business continuity matters, such as handling the workforce, the pandemic’s impact on contracts (including the use of force majeure), disputes strategy, tax and insolvency matters. “We expect this will all be the focus until social distancing restrictions are lifted or reduced… shortly after that, companies will eventually be doing business again,” says Szyfman. But there will be an aftermath, he warns. “We expect there will be a ‘legacy’ of legal issues associated with covid-19, particularly in terms of disputes and debt reorganisations.”
Renegotiating debts and revising financial agreement conditions – including covenants and waivers – will be especially important for small and medium oil companies that need to preserve cash fast to respond to the reduced demand for oil and subsequent profit losses. At listed oil companies, GCs will need to pay particular attention to fluctuations in the share price and subsequently provide transparent and frequently updated communication to shareholders and the public.
The devil is in the detail. Reviewing all contracts is high on the list of priorities for many oil company legal teams right now, as they make tough decisions on how to cut costs and make up for the losses endured in the current crisis. “[Legal teams] are reviewing contracts to re-establish the contractual balance or even to justify [project] terminations,” says Valois Pires. “We believe this trend, together with finance restructure work, will continue this year until the recovery of the oil prices.” Unfortunately, that end is not yet in sight.