03-04-2020

Paulo Valois Pires – Partner at Schmidt Valois Miranda Ferreira & Agel

An explosive combination of two external factors totally outside the control of the oil companies determined the most significant drop in oil prices of the last 17 years: the controversy between Saudis and Russians over the increase in oil production combined with the outbreak of the coronavirus.

These two factors were crucial for a significant drop in the barrel price, generating, on the one hand, an excess of supply and, on the other, a profound shrinkage in demand due to the downturn of economic activity. This explosive combination caused Light Sweet Crude Oil to plummet, within 30 days, from USD 53.78 on February 20 to approximately USD 25.00 on March 20 of this year.

One may say that oil companies are used to and work with price volatility, but not all are prepared for such a profound adjustment if the crisis continues over time.

At these times, the economics of projects are put to the test since no one intends to continue a project or production system if relevant costs are above the oil selling price or if the NPV is negative and without a perspective of recovery in the forecasting horizon.

Such fine-tuning has been taking place since last year in the exploration and production of US shale and other jurisdictions, with substantial losses for operators, many of which are currently under financial restructuring or judicial reorganization.

The current crisis brings with it legal and economic consequences on contracts and operations underway, particularly in the E&P sector.

A first helpful reflection stems from that old legal adage: “the agreement is good when everyone signs it, but it has to be even better when the parties remember to enforce it .”

Therefore, it is precisely at this moment that clauses of force majeure, hardship, and material adverse change, amongst others, come into play, to re-establish the contractual balance, or even to justify their termination.

This situation is even more delicate for ongoing operations during the so-called “interim period” between signing and closing. Mainly because the assets were priced considering a curve with the average Brent price between USD 50.00 – USD 60.00/bbl, or more.

Interim periods can be challenging because a series of unfortunate events may occur during the handover of operations and satisfaction of the conditions precedent. If the closing does not happen by unpredictable events beyond the control of the parties, as seems to be the case, an issue to be analyzed is the return of financial deposits to purchasers of assets or equity stakes.

The solution lies in negotiating more realistic economic and financial thresholds. But if negotiations involve the NOCs, the discretionary powers granted to negotiators are restricted, due to the control and supervision to which NOCs are subject, following the example of Petrobras itself.

The unexpected plunge in oil prices affects loans and the raising of funds through other debt instruments. This is the time to assess whether the collaterals are sufficient to ensure the payment of principal and interests. In other words, is there a need to strengthen the pledged volumes? Do the guarantees offered constitute rights in rem, strict sensu, or do their execution still depend on regulatory and other approvals?

The answers to such questions are crucial when the proven reserves serve as the underlying asset to secure financings backed by oil production. Such a statement is true in Brazil.

Companies outside the big oil circuit were compelled to implement RBLs, prepayments, and mezzanine structures to finance their acquisitions under the Petrobras divestment program.

However, from the crisis, opportunities arise for some.

According to an article recently published by the Financial Times, at times like these, companies that hold terminals and storage capacity can benefit from buying oil at depreciated prices, betting on the increase of the price curve in the futures. Such growth will come up either because of the commodities cycle itself or by a reduction in supply aggravated by the abandonment of uneconomic projects and the suspension of exploratory campaigns.

Where is Brazil in all this? Profoundly affected at this moment like any other oil-producing country, a situation that will require companies to review their strategic planning.

There will be an immediate impact on ongoing divestment processes until the outlook is brighter. Here, as in other countries, projects with lower profitability lose strength in the short term as a result of a natural selection within the companies’ portfolio.

As an example, in Petrobras’ current business plan, the projects count on positive NPV in a resilience scenario with Brent spinning between USD 45.00 and USD 50.00/bbl. According to the state-owned company, the breakeven of the pre-salt production development is in the range of USD 35.00 – USD 45.00/bbl.

Looking back on operations closed a few months ago, there is no doubt that Petrobras and other companies have benefited from the sale of assets and equity stakes at much higher levels than at the present moment.

However, upsides tend to be much limited from now on, in “strange times” like this, in the best expression coined by a Brazilian writer Erico Veríssimo.

But the opportunities are still there for investments with a medium-term view.