Five Keys to Understanding Brazil’s Petrobras Scandal

SMITH BRAIN TRUST -- Arrests and resignations have kept Petrobras in the news while a criminal investigation unfolds, but don’t assume a gloomy forecast for Brazil’s state-controlled oil company. “My overall answer for Petrobras is, I’m very optimistic about the company,” says Paulo Prochno, a strategy professor at the University of Maryland’s Robert H. Smith School of Business.

Prochno reads newspapers like everyone else, but the São Paulo native also has a background in engineering and business that allowed him to do consulting for Petrobras prior to the scandal. He gained additional insights about the company while teaching executive education courses with Petrobras participants in Brazil. “The company has very strong capabilities,” he says. “This is what I see looking from the outside, but I also know quite a few people there.”

Making sense of the Petrobras saga requires a certain amount of historical perspective. The Financial Times published a timeline in February 2015 that traces the story as far back as 2007. That’s when Petrobras explorers first discovered massive oil deposits in the ultra-deep waters off the coast of Rio de Janeiro — enough to double Brazil’s reserves and turn the country into an energy superpower.

Contractors lined up to help Petrobras cash in on the find, and money started flowing into the personal accounts of company leaders to ensure generous contracts. In one high-profile case, investigators caught the former Petrobras director of services with nearly $24 million in bribe money stashed in a Monaco account.

Overall, the ongoing investigation has led to 80 arrests and put previously untouchable powerbrokers on alert. Even Brazilian President Dilma Rousseff, who served as Petrobras chairwoman from 2003 to 2010, remains vulnerable. Prochno shares five keys for keeping the Brazilian telenovela in context.

1. Cronyism Hurts in One Way, Not the Other 

Unlike ExxonMobil, Shell and other multinational oil companies, Petrobras is publicly traded but government controlled. This means politicians, not shareholders, get the final say on who fills board seats. “It’s not a merit-based process,” Prochno says. “It’s based on who you know.”

Political favors are traded until each stakeholder group in Brazil’s multiparty system has the loyalty of one, two or three executives. Something similar happens when those executives consider bids for lucrative contracts. “If you look at the top companies, they’re all interrelated,” Prochno says.

Still, government officials don’t just give Petrobras jobs to stooges with no oil and gas experience — such as somebody’s unqualified brother-in-law. “Usually they try to get people from inside,” Prochno says. “It’s not that they would appoint somebody who has nothing to do with the company in a top management position there.”

So the cronyism does not hurt Petrobras in terms of sticking the company with incapable partners. Instead, the corruption means inflated contracts with money siphoned into the pockets of senior leaders and perhaps politicians. (Investigators are still considering whether bribery money was used to fund elections.)

“Brazilian construction companies have had very strong capabilities,” Prochno says. “So it’s not a problem with the quality of work, but it’s overpriced.”

2. They’ve Got the Know-how

All the cronyism at the top of Petrobras has left the company’s midlevel managers carrying the weight of daily operations. Generally, Prochno says they do a good job.

He recalls one conversation with an engineer who had been at Petrobras for more than 30 years. “It doesn’t matter who’s at the top,” the engineer told Prochno. “We know our job. We know what to do.”

The confidence stems partly from the national oil company’s near monopoly on Brazilian talent. “They hire only the best,” Prochno says. “They have very hard entrance examinations. They hire lower-level talent when people are fresh out of college, and then people move up.”

Petrobras also invests heavily in research, which has focused on deep-water exploration and extraction because most of Brazil’s reserves are trapped below the Atlantic seabed. “If you think about deep-water exploration, they’re probably the leading company with technology in that area,” Prochno says.

If the scandal can force Petrobras to address its governance problem at the top — which has weighed down the company for years — then Prochno says its long-term prospects will be better than ever. “If you talk to good people inside Petrobras, which is probably 98 percent or 99 percent of the company, they’re happy that this is going on,” he says.

3. What They Need Is Cash

What the company has lacked since the deep-water discovery of 2007 is cash. “For the exploration of those pre-salt reserves, it does require a huge investment,” Prochno says.

One option would have been to share access to the oil with a multinational partner such as Shell, but Brazil opted instead to give exclusive rights to Petrobras. "When pre-salt was discovered, the government changed the law and determined that for the fields in the pre-salt area, only Petrobras could be the operator," Prochno says. "Foreign companies can be investors but not operators."

The policy made sense when oil prices hung near $100 per barrel. Petrobras had cash reserves and assets that could be divested to focus on the big prize. “They had to do some rearrangement of their portfolio, given the size of the investments needed,” Prochno said.

But the landscape changed when U.S. companies started ramping up their fracking operations. Oil prices dropped, shrinking Petrobras's margins and making the cronyism at the top more obvious. The one-two punch left Petrobras with its first primary budget deficit in more than a decade in 2014, forcing the company to scale back its forecasts.

One response has been a Senate proposal that would allow foreign companies to operate in the pre-salt area. The vote, originally scheduled for this week, has been delayed to allow discussion. "Analysts think it's likely the bill will pass, even with opposition from government," Prochno says.

Despite the setbacks, Prochno says the long-term prospects for Petrobras remain positive -- although the margins for error have shrunk. “If the world goes into a crisis, and the price of oil drops to the $40 level for 10 years, then there’s a problem to explore those huge reserves that they found,” Prochno says. “But all oil companies would be subject to the same external factors.”

4. Fracking Has Risks, Too

To reach the reserves below the Atlantic seabed, Petrobras crews must travel 200 miles off the coast of Rio de Janeiro — nearly the distance from Boston to New York. Then they must run pipes through more than one mile of water, another mile of rock, and then another mile of salt. In some places the oil is buried more than four miles below the surface. 

Petrobras already has pulled off the engineering feat with its initial pre-salt wells (shown in this Petrobras video and described on this Petrobras page). But many political, economic and engineering risks remain.

Prochno says Petrobras takes encouragement from the knowledge that every form of energy extraction -- not just deep-water drilling -- comes with its own sets of challenges. U.S. frackers, for example, must operate closer to places where people live, which raises environmental scrutiny. Fracking is also expensive from an engineering perspective. 

"It's hard to put fracking against pre-salt as direct competitors," Prochno says. "Though, of course, both have an influence on supply and thus prices." He says the break-even point for pre-salt oil is about $50 per barrel when transportation costs are inclcuded. The numbers vary widely for fracking, from as low as $25 per barrel to as high as $70 per barrel, because the complexities of each site are unique.

"Things are not always black and white," he says. “But if somebody’s going to die first, it might be the frackers.”

5. Brazil Still Belongs

While some people see Petrobras’s recent struggles as a sign of Brazilian failure, Prochno takes the opposite view. “This whole story, I think it’s very positive for Brazil,” he says.

Cronyism has plagued Petrobras since its founding in 1953, but only recently have well-connected powerbrokers needed to worry about arrest and prosecution. Prochno says the shift shows progress in a country where democracy is still young. “That’s a very good signal,” he says. “That shows a maturity of the judicial system in Brazil.”

He says Brazil still belongs in the BRICS with Russia, India, China and South Africa, and U.S. investors who focus too much on Asia make a mistake. “Brazil is still a story of growth,” he says.

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