09 April 2020

An explosive combination of two external factors completely out of oil companies’ control – the controversy between Saudi Arabia and Russia over the increase in oil production, combined with the covid-19 outbreak – have led to the most significant drop in oil prices in 17 years.

By Paulo Valois Pires, partner at Schmidt, Valois, Miranda, Ferreira, Agel Advogados

These two events were crucial factors behind a significant drop in the oil barrel price, generating on the one hand an excess of supply and on the other, a profound reduction in demand due to the downturn of economic activity. The combination caused light sweet crude oil to plummet within 30 days, from US$53.78 on 20 February to about US$25 on 20 March.

One might 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 economic viability of projects are put to test, since no one intends to continue a project or production if costs are above the oil selling price or if the net present value (NPV) is negative and without a sight of recovery on the horizon.

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

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

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

For that reason, it is precisely at this moment that clauses of force majeure, hardship, and material adverse change, among 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 US$50 and US$60 per barrel 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 due to unpredictable events beyond the control of the parties, as seems to be the case, an issue to be analysed 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 national oil companies (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. This is true in Brazil. Companies outside the big oil circuit were compelled to implement reserve-based lending (RBL), prepayments, and mezzanine structures to finance their acquisitions under the Petrobras divestment programme.

However, from the crisis, opportunities arise for some.

According to an article recently published by the Financial Times, in situations 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 future. Such growth will come up either because of the commodity 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. It is 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 will 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 US$45 and US$50 per barrel. According to the state-owned company, the breakeven of the pre-salt production development is in the range of US$35 and US$45 per barrel.

Looking back on operations that 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 more limited from now on, in “strange times” like this, an expression coined by a Brazilian writer Erico Veríssimo.

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