The Next Oil Giant

From Fortune, a big story on the Brazilian oil industry:

Since BP's (BP) disastrous Deepwater Horizon accident in the Gulf of Mexico last April, the risks of offshore oil drilling have been a hot topic. One place it isn't questioned much is Brazil, whose oil production industry is one of the fastest-growing in the world because of vast new deepwater oil reservoirs discovered in the past five years. The largest finds are in the Santos Basin, which, at nearly 200 miles off the coast of Rio, is much farther offshore than even Campos. The mega-fields there lie more than three miles below the ocean's surface, underneath a salt layer in the crust of the earth some 6,000 feet thick. The technical and logistical challenges of drilling in these areas are immense.

Together, the so-called pre-salt reserves off the coast of Brazil have been put at 50 billion to 100 billion barrels or more -- potentially a deepwater Kuwait. Vast amounts of money and manpower are being mobilized for what is shaping up to be a historic investment boom. Foreign oil-services companies like Schlumberger, (SLB) Halliburton, (HAL) and GE (GE) are rushing to set up offices. It has been estimated that offshore oil and gas could be as much as a $1 trillion industry for Brazil over the next decade. And as political unrest in the Middle East drives up crude prices, the value of a stable new supply of oil from Brazil is magnified.

The company spearheading all this activity is Petrobras (PBR). By every measure the energy giant is already one of the world's most important corporations -- and it stands to grow vastly more influential. Last year Brazil's biggest corporation ranked No. 54 on Fortune's Global 500 list of the world's largest companies; in its most recent fiscal year revenues jumped 32% to $121 billion. Excluding wholly state-owned oil companies such as Saudi Aramco or NIOC of Iran, Petrobras is the fifth-largest oil company by production (2.15 million barrels a day in 2010) and the third-largest in market capitalization ($240 billion). By the end of the decade, Petrobras is likely to pass Exxon Mobil (XOM) to become the largest publicly traded oil company in reserves and production. It also has the respect of its peers, coming in seventh in its category on this year's list of the Most Admired Companies.

Developing the pre-salt assets is a daunting task. For starters, it will be mind-bogglingly expensive. In its five-year plan through 2014, Petrobras has committed to invest $224 billion, much of it on platforms, rigs, and other infrastructure for pre-salt production. (It's also building five new refineries.) To help fund the effort, last year the company conducted the largest share offering in world history when it sold $70 billion worth of new stock to investors. It plans to sell up to $40 billion in bonds by 2014.

Scrounging up investment capital is only part of the challenge. Critics argue that the government's mandate to make Petrobras the lead operator in the development of all fields in the pre-salt area -- rather than leave it open for bidding from international companies -- puts too much pressure on the company and will prove an inefficient approach to developing the area. It's unclear whether the industry supply chain can grow fast enough to meet the production targets Petrobras has outlined. And there is always the possibility that an offshore accident will throw the whole operation into chaos . . .

For decades Brazil was considered hydrocarbon-poor. The country didn't produce enough crude to meet its own demand -- much less to export -- until five years ago. That's a big reason Brazil developed its sugar-cane ethanol industry. (Virtually every car on the road in the country can run on either gas or ethanol, and pretty much every fueling station offers both. Petrobras is investing $3.5 billion in biofuels through 2014.) Early on, Petrobras took its search for reserves offshore and expanded overseas. While the vast majority of its output today is in Brazil, the company has a presence in 28 other countries, including large-scale operations in the Gulf of Mexico. It produces a quarter of the world's deepwater offshore oil.

The Brazilian oil equation changed in 1997 when the government amended the law to allow foreign oil companies to bid for the right to explore blocks offshore. The competition led to new discoveries. Then improving seismic technology enhanced the ability of the oil companies to "see" through the salt layer in the earth's crust. The first major pre-salt field in the Santos Basin was discovered in 2006.

The industry is keeping a watchful eye on how Petrobras develops those ultra-deepwater fields. "It's the frontier," says David Knapp, chief energy economist for the Energy Intelligence Group in New York, who points out that the geology off the coast of Angola, across the Atlantic from Brazil, is almost identical. "It is seen as a bellwether for potential future development in similar areas at similar depths."

Petrobras has been drilling in the pre-salt fields and has even been producing some oil. But the activity so far has mostly been to verify reserves and get a handle on the technical challenges. There are contaminants in the pre-salt oil that make it highly corrosive, so Petrobras has been working on new alloys for its drilling equipment. And the salt layer is softer than rigid rock, which means that solidifying drilled wells is more difficult and expensive.

Production is expected to ramp up aggressively. The company's strategic plan calls for doubling its total hydrocarbon production rate by the end of the decade, from 2.7 million barrels a day in oil and oil equivalents to 5.4 million. That will require huge investments in infrastructure. "The main constraint we have is the capacity of the supply chain to meet our needs," says Gabrielli.

Consider the company's rig situation. Petrobras has 14 ultra-deepwater drilling rigs -- far short of what it needs. By 2012 it will have added 20 rigs that are now either under construction or being used by other companies. After that there's no supply. The shipyards in Singapore and South Korea that build most of the world's offshore drilling devices are maxed out. So Petrobras is helping create a rig-building industry at home. It is awarding contracts worth a total of about $18 billion to four Brazilian shipyards to supply 28 rigs starting in 2014.

Gabrielli says Petrobras assumes that oil will fluctuate between $65 and $85 a barrel through 2020. To some that estimate might sound low. But the CEO says that he expects strong demand in countries like China, India, and Brazil to be counterbalanced by slower demand in mature markets like the U.S. and Europe. "We don't see why the price is going to be skyrocketing," he says. Gabrielli says the breakeven price for pre-salt oil from the Santos Basin should be $40 a barrel and could go lower as the operations scale up.

Who will buy that oil? It makes sense geographically for the U.S. to be a big customer -- tankers going north from Rio to the petroleum infrastructure of the Gulf Coast don't have to cross an ocean or go through a canal. In 2010 the U.S. purchased about 260,000 barrels a day of petroleum products from Brazil. The Chinese are likely to be aggressive buyers too. Last year China replaced the U.S. as Brazil's biggest trading partner. And in 2009, when credit markets were still tied up, the China Development Bank loaned Petrobras $10 billion in exchange for the right to buy up to 200,000 barrels of oil a day for 10 years at market prices. "They are going to be important customers," says Gabrielli. "The Chinese put a value on the strategic relationship."