Brazil's investment environment: does the reward outweigh the risk?

February 2017 | Evelina Pagkalou

Brazil is trying to transform into an attractive market to both upstream and downstream investors—and success is likely despite challenges

Recent changes in Brazil’s pre-salt operatorship regulation and fuel pricing at the refineries have helped highlight the prospect of attractive returns in the local upstream and Brazilian refining industries. The country’s investment environment is still challenging; complex regulations, economic turmoil, and the unstable political climate elevate the risk of doing business in Brazil. Nevertheless, EI expects that the combination of recent regulatory changes, the impressive size of the Brazilian pre-salt oil reserves, and their low breakevens that touch USD35/bbl will be enough to incentivize upstream operators and lead to over 2 MMb/d of pre-salt oil production by 2025 in a USD70/bbl oil world. The downstream refinery industry also has the potential to see traction, thanks to the undersupply of existing refinery capacity versus local product demand. Yet due to the risk associated with refining lead time, growth in the downstream will heavily depend on the government continuing to pursue market-friendly policies for an extended period of time.

Upstream industry status-quo overhaul

For upstream operators, Brazil has been a hotspot this decade. The country’s high-productivity pre-salt resources have proven to have high initial production rates, shallow decline rates, and low water breakthrough. In the last 4 years, production from pre-salt has already surpassed the 1 MMb/d mark, with wellhead breakevens resting as low as USD35/bbl. Costs have decreased as Petrobras, the preeminent pre-salt operator, has developed a better understanding of the time, technology, and money necessary to properly develop a pre-salt field.

Exhibit 1: Costs on pre-salt projects have been decreasing as the technology and understanding of the geological layer matures

Source: Petrobras

The pre-salt reserves are vast. The Santos basin, where all the major pre-salt fields are found today, was estimated by ANP to hold over 5.6 billion barrels of oil of proved reserves at the end of 2015. Petrobras alone is expected to deploy an additional 18 FPSOs in its offshore pre-salt region by 2020.

Until recently, the pre-salt story was a Petrobras story; a local law stipulated that only Petrobras could operate the pre-salt fields. Yet Brazil’s pre-salt operatorship law (Bill 131/2015) was overhauled in October, in an effort started by the previous government and finished by Michel Temer’s administration. The regulation overhaul opened up the country’s pre-salt resource through two access routes for E&P companies. First, fields that Petrobras is not interested in developing become directly available to other players through an auction. Second, operators can now also directly purchase fields from Petrobras that the NOC is not interested in developing or operating anymore.

Given Petrobras’ inability to successfully develop all its pre-salt due to its mounting debt, which stood at USD126 Bn as of Q2 2016, the opening up of pre-salt to operators other than Petrobras presents a considerable number of attractive asset acquisition targets. On top of potential new fields that will be auctioned by the government, the company has laid out an ambitious divestment program. It has already sold ~USD4.6 Bn in upstream assets out of USD15.2 Bn in the 15/16 plan and has announced plans to sell an additional USD19.5 Bn for the 17/18 period, although it is not specified what part would be E&P.

Downstream industry margins

Brazil has a complicated and much publicized refinery industry. Theoretically, it could be called an economically promising market, as the country lacks adequate refining capacity despite its rising demand for refined products and availability of feedstock. Delays in the construction of additional refinery capacity by Petrobras have resulted in Brazil being long on crude but short on products, despite the economic recession. In 2016, the demand for light and mid-distillates surpassed available conversion capacity by more than 1.1 MMb/d, while oil and NGL production exceeded distillation capacity by 0.3 MMb/d. Yet while the market has not been regulated since 1997, the ownership of the logistic infrastructure by Petrobras had previously effectively discouraged competition. Before the recent economic crisis, it was common for Petrobras to align its product pricing with government policies, further complicating new market entries.

Nevertheless, as of October 2016, Petrobras, the owner of the vast majority of refinery capacity in Brazil, announced that it will price its fuels closer to international market rates instead of adhering to artificial prices in line with policy objectives set by the Brazilian government. The alignment with government directives has previously cost Petrobras billions per year. Even if the new pricing plan results in margin losses in the near term, a move towards market-driven pricing removes a lot of the risk associated with doing business in refining in Brazil both for Petrobras and for new entrants. In addition, it is anticipated that as pre-salt resources are further developed, the resulting high availability of feedstock will make Brazil even longer on crude and potentially improve local margins.

Petrobras’ divestiture program could include refineries if there is interest, and it also includes its fuel distribution network, the largest one in Brazil. The company has also expressed interest in attracting capital from external stakeholders to finish the Comperj and Rnest refineries.

Challenging investment and labor environment

While investment opportunities have multiplied with policy changes and Petrobras’ divestiture program in both upstream and downstream, Brazil’s unstable political environment and regulations could make things more challenging as new players move in.

The current government was not elected by popular vote. Once the election cycle comes around, a potential new leadership could reverse the recent regulatory changes, introduce new rules or processes that may further complicate business, or the country may undergo a wave of reforms in response to the recent political upheaval, which could create an unstable investment environment. The risk is not immediate. It took the government almost 6 years to change the royalty structure even with voting majority, and it usually takes about 2 years to introduce and approve regulations. Yet even a pause in the current effort to liberalize energy markets would be costly to future oil investment in Brazil.

Additionally, at a local level, Brazil’s regulations still tend to favor unions and obstruct profit-seeking operations—a significant setback for foreign operators. First, Brazil is an expensive location to hire foreign employees due to the fees and taxes paid to the government. While local labor is comparatively economic, any activity heating up like before 2012 could result again in capacity constraints of local personnel. On top of this, existing regulations make it complicated to hire both local and foreign workforce. Due to a system of laws that overwhelmingly protects the employee, Brazil is also home to a high number of labor claims—nearly 3 million in 2010 alone.

Lastly, the local content clause is still an active requirement for the upstream industry. Adherence to the law means operators are required to partly use local OFSE providers that will most likely not be the most cost-efficient, increasing the risk to profitability. And after the recent political scandals, many of the local suppliers and service providers formerly used by Petrobras have been blacklisted and are currently under investigation for corruption, or are already bankrupt. This lack of available cost-effective providers presents an added challenge for operators. Nevertheless, the government has announced it intends to relax minimum local content rules to assist pre-salt development so the impact of the clause is expected to be minimized.

Does the reward outweigh the risks?


While entering Brazil independently—not as part of a joint venture with Petrobras—and adjusting to the country’s challenging rules and regulations may seem daunting, access to pre-salt resources is still a unique opportunity. The pre-salt resources have relatively low breakeven prices, long lives, and with the current budget crisis, both Petrobras and the Brazilian government are willing to share profits with external players.

It is EI’s expectation that pre-salt will end up being developed even under low prices, thanks to already sunk capital; the Lula field is already producing 700 kb/d with 2 more phases under way. In a USD 70/bbl Brent scenario, pre-salt would dominate offshore balances and help increase Brazil’s oil production by 60% by 2030; in the next 10 years, pre-salt production is expected to surpass 2 MMb/d, compared to 1 MMb/d in 2016.

Exhibit 2: We project that this high risk, but high reward market will result in development of pre-salt, as the resource is too cheap not to be developed

EIA STEO, Energy Insights GLSM

As local legacy production declines, we expect the state of Rio de Janeiro and the federal government to have an additional incentive to motivate operators to develop the pre-salt fields. Any kind of federal or regional incentives will further increase the expected profit margins for upstream operators. Overall, the government has proved it is actively seeking to help pre-salt development. For those reasons, we expect that A&D activity will only increase going forward, turning Brazil’s upstream sector into an attractive, and active, investment arena.

Some companies have already decided the risk is worth it. Statoil acquired interest in the Santos basin, including a significant part of the Carcará, for USD2.5 billion. Statoil estimates the recoverable volumes to be 700–1,300 MMboe and has already begun discussions with Petrobras regarding cooperation on future endeavors in the Campos and Espírito Santo basins. Shell has also announced that it plans to invest USD10 billion in the next five years, on top of the USD30 billion it has already invested in Brazil.


The refinery industry is not as clear-cut of a potential investment target, as it is plagued more heavily by profitability uncertainty.

Even though the conditions are there to turn refining in Brazil into a profitable business in the near future, returns are more dependent on regulatory changes and the refining cycle, and thus the risk is still high. We therefore expect that the government and Petrobras will need to maintain a prolonged period of political stability and market-friendly climate before Brazil’s downstream can be considered a sought-after investment. For now, expectations are that distillation and conversion capacity will increase faster than demand, but still not fast enough to satisfy local product demand.

Exhibit 3: Refinery Imbalance

Source: Petrobras

Nevertheless, we believe the regulators are moving in the right direction. Brazil downstream is a market that should be closely monitored in the upcoming years as a source of potential opportunities, especially as margins get squeezed in more mature markets.


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About the author

Evelina Pagkalou is a senior analyst with Energy Insights in McKinsey's London office.