Brazil's Case Against Chevron Oil Nationalism In Disguise

| About: Chevron Corporation (CVX)
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The winds of oil nationalism are once again blowing through Latin America, with regional governments seeking to expropriate control of productive energy assets at the expense of foreign-owned private producers. This nationalism is manifesting itself in different forms, the most extreme examples being Venezuela's and Bolivia's wholesale nationalization of the oil industry. We can now add to this the politicized and systematic interventionist policies of Argentina's Kirchner government, as well as the softer targeted manipulation of legal and environmental standards by the governments of Peru and Brazil. Despite these differences in application, they are still following the time-honored tradition of encouraging foreign owned energy companies to invest the required assets to locate and initiate production. But then, once the oil is flowing, they seize control of the companies' facilities and hand them over to government owned and operated monopolies, as we have seen with Argentina's expropriation of 51% of Repsol's (OTCQX:REPYY) controlling interest in Argentina's largest oil company YPF S.A. (NYSE:YPF).

However, there is now a new twist as Latin American governments are not only relying on expropriation, but also manipulating their legal and regulatory systems to lend an air of legitimacy to their actions. The region's state-owned oil monopolies have also evolved into publicly traded listed companies, while the state retains majority ownership. This hybrid model has allowed them to more effectively compete in global energy markets against private corporations and dressed up government control, lending it an air of liberal economic legitimacy.

A significant problem has emerged for these hybrid entities, though -- due to the degree of government interference in their operations, they have lost the efficiency and flexibility of privately owned energy companies. This has created issues directly related to operational efficiency and profitability, with these hybrid companies being beaten in the race to exploit new oil and gas reserves in the region. This is particularly apparent in the case of Brazil's state majority owned oil giant Petrobras (NYSE:PBR), which is causing the Brazilian government to lose direct control of oil reserves and consequently receive reduced oil-derived revenues. This has driven the change in tactics to a more subtle approach that is reliant on legal and economic manipulation rather than outright expropriation.

It is this change in tactics that I believe has been misunderstood by foreign energy companies operating in the region, and is seen as a distinct but refined elevation in the degree of country risk facing foreign investors. A telling example of this change is the actions taken by the Brazilian government as a result of two minor oil leaks at Chevron's (NYSE:CVX) Brazilian oilfields in November 2011 and March 2012. These have seen Chevron not only fined and officially sanctioned, but subjected to criminal and civil actions brought by Brazilian federal prosecutors as well.

Chevron is one of the world's largest publicly traded energy companies and has invested heavily in Latin America with operations in Venezuela, Colombia, Argentina and Brazil. Despite Chevron Venezuela pumping the most oil and gas of Chevron's Latin American operations, it is Brazil where it has made its greatest investments. Chevron's key investment focus in Brazil has been the development of the Frade field and the Papa-Terra field. The Frade field, which is among the largest deepwater heavy oil projects in the world, is one of Chevron's biggest capital investments to date. Chevron has also revealed that the Papa-Terra project, on completion, will be the company's largest investment in Brazil.

It is easy to understand why Chevron has been investing heavily in Latin America and, in particular, Brazil. It is now estimated that over one-fifth of the world's oil reserves are located in Latin America, and Brazil is believed to have oil reserves of at least 50 billion barrels on top of proven reserves of 14 billion barrels. Despite the large reserves and Chevron's significant investment, Chevron Brazil only contributed 1.2% of the company's net oil production and 0.6% of net gas production in 2011. This is approximately $1.3 billion of revenue for a company that reported $253.7 billion in 2011.

But as a result of the Brazilian government's actions this investment is now at risk, and Chevron stands to lose more than its investment. Chevron's troubles commenced on Nov. 7, 2011, with an oil leak at an appraisal well in the Frade field, approximately 230 kms off the coast of Rio de Janiero. The leak is claimed to have been around 2,600 barrels in volume, far less than the major environmentally damaging oil leaks of the Exxon Valdez, which was around 257,000 barrels, or BP's (NYSE:BP) Macondo oil leak in the Gulf of Mexico, which was estimated at 4.4 million barrels.

Despite the small amount of oil that leaked, which dissipated and swept out to sea, the Brazilian government and in particular the federal prosecutor's office responded in a particularly heavy-handed manner, levying fines totaling $110 million and initiating criminal and civil actions seeking damages of $11 billion. Since that leak, Chevron experienced an additional oil leak in the Frade field on March 4, 2012, which caused Chevron to temporarily halt production. As a result of this second leak, Brazil's federal prosecutor's office commenced a second action against Chevron, seeking an additional $11 billion in damages. The action was also broadened to prevent Chevron and its driller Transocean (NYSE:RIG) from operating in Brazil, transferring Brazilian profits overseas, obtaining government backed finance and moving equipment from Brazil.

All of this is an extensive setback for Chevron because of the considerable time and resources it has invested in developing its interests in Brazil. The second suit now leaves Chevron exposed to $22 billion in damages plus other unquantified direct and consequential financial losses from lost production, maintenance costs, legal fees, lost revenue and non-financial impacts such as reputational damage.

It appears that while there has been a legitimate accident, which has caused some environmental damage, the Brazilian government, and in particular the federal prosecutor's office, has acted oppressively. If we are to compare both of the current spills and the proposed damages to what was one of the largest oil spills in history, the BP Macondo spill in the Gulf of Mexico in 2010, this overreaction becomes apparent. For the Macondo oil spill, BP is said to be facing up to $30 billion in damages, which with 3.4 billion barrels of oil spilled is $8,800 for each barrel of oil. However, in Chevron's case, with a total of $22 billion sought in damages for approximately 6,000 barrels of oil spilled, it comes out to around $3.7 million per barrel.

Furthermore, Brazil's oil regulator has admitted that it believes Chevron was not negligent in the drilling of the well that caused the November 2011 oil spill. This will certainly assist Chevron in the defense of its case and further substantiates my view that the current criminal and civil action is a vast overreaction. Yet the prosecutor is continuing with both the criminal and civil legal action against Chevron. So far it seems that despite Chevron's substantial investment in Brazil, a country which has typically been seen as pro-foreign investment, it has experienced substantial detriment so far as a result of what are seen as minor leaks.

The legal actions in Brazil, while a response to a legitimate environmental incident, seem blown out of proportion and driven by political interference -- and is certainly the result of emerging Brazilian oil nationalism. It also appears that Chevron failed to correctly measure the degree of country risk and the significance of this oil nationalism, therefore leaving it exposed to punitive government action driven by political and economic agendas.

It is my opinion that the real reason for such an overzealous reaction is to increase government control of oil reserves, reduce competition for Petrobras -- which is 54% Brazilian government owned -- and maximize the government's oil revenues. This has included introducing legislation that gives Petrobras a distinct advantage of other oil companies operating in Brazil. This legislation includes making Petrobras the sole operator of oil fields where licenses haven't been sold or allocated, and being able to explore any oil field defined by the Brazilian government as a strategic asset, thus preventing open exploration by other oil companies. The legislation also grants Petrobras a minimum 30% stake in joint ventures that bid for exploration licenses, essentially forcing the bidders to take Petrobras on as a joint venture partner. All of this increases government control and gives Petrobras a commercial edge over its competitors.

Furthermore, larger oil spills by Petrobras in Brazil have resulted in comparatively little to no action being taken. For example, in 2010 Petrobras reported 57 oil leaks that released a total of 4,201 barrels of oil into the ocean, marginally more than Chevron's November 2011 and March 2012 leaks combined. Yet it received significantly smaller fines, which in total came to only $43 million, equating to a fine of $10,235 per barrel.

There have also been accusations that there are those within the Brazilian political and economic elite who want to use this oil leak as a tool to totally shut out foreign resource companies from operating in Brazil. I don't believe this for two reasons. First, it would be an economic mistake because despite Petrobras being one of the largest publicly traded energy companies in the world, it doesn't have the scale or capacity to develop Brazil's offshore oil reserves alone. It has been estimated that $600 billion of investment is needed over the next few years to get Brazil's newly discovered offshore oil fields into production.

Second, the Brazilian offshore deepwater oilfields are particularly difficult to extract oil from and require specialist technology. This is not only because of the depth and the pressure at which the drills operate, but also due to the salt shifts that occur during drilling and because the oil is extremely hot as it exits the reservoirs and must pass through wellheads that are only a few degrees above freezing. Accordingly, to access these reserves Brazil will require the assistance of foreign companies such as Chevron that have the expertise and assets to invest in these types of projects.

Third, there is significant motivation for Brazil to become a key oil exporter on a global scale. It is here where we start to see the political motivations that I believe Chevron overlooked and are motivating the legal action and adverse publicity against Chevron. It boils down to Brazil seeking complete economic and political control of its biggest foreign income producing assets, as the country positions itself to fulfill its ambition of becoming a global power.

Petro-dollars will also allow Brazil to complete the development process that began with defeating hyperinflation in the mid-1990s, make Brazil energy self-sufficient, give the country ready access to hard currency and boost national savings -- all of which will reduce the countries exposure to the vagaries of the global economy. This is extremely enticing for Brazil because it was the oil shocks of the 1970s that brought rapid economic development in that decade to a sharp halt. Finally, oil would add to Brazil's global status, allowing it to assert itself as a global power and giving it even greater political and economic power on the world stage.

So where does this leave Chevron? The civil damages brought by the Brazilian government in proportion to Chevron's revenue and net income are extremely damaging as they represent over 9% of Chevron's 2011 revenue and 82% of that year's net income. Obviously, if Chevron were to pay these damages should a judgment be awarded against them, there would be a significant financial impact on the company. But it is unlikely that Chevron would pay any such judgments and would seek to have the judgment overturned on appeal. Even if Chevron was forced to comply with a judgment against it, it would only initially be enforceable in Brazil until the Brazilian's were able to legally apply for it to extend to other jurisdictions.

It is estimated that Chevron's total Brazilian oil assets are worth around $4.1 billion. Therefore, in a worst-case scenario, Chevron could declare its Brazilian unit bankrupt and leave the Brazilian government to seize those assets. Chevron's U.S. and global assets, which are in other legal jurisdictions, would be beyond the reach of the Brazilian government. It would seem that despite Chevron misjudging the risks of operating in Brazil, the company has employed a sensible risk mitigation strategy by compartmentalizing its operation and minimizing the assets that it has exposed in Brazil.

It is my opinion that to the detriment of its shareholders, Chevron has failed to adequately assess the changing degree of political risk in Brazil. Also, Chevron hasn't given sufficient regard to the risk/reward equation. Based on full-year 2011 production figures, Brazil only accounts for an estimated 1.2% of Chevron's net crude oil production and 0.6% of its net natural gas production. This equals approximately $1.2 billion of Chevron's $253.7 billion 2011 revenue, yet the company is now facing two incidents with a total direct financial impact in excess of $42 billion. This is more than 35 times the revenue Chevron generates from its Brazilian business. This has obviously had an impact on Chevron's stock price, which has dropped by around 8% since the second damages action was commenced and Chevron stopped its Brazilian operations.

If I were a Chevron shareholder, I would not be overly concerned by the situation in Brazil as I believe the long-term impact on Chevron will be relatively minor. I have formed this opinion because the company has a number of strategies at its disposal to mitigate any financial impacts, if a judgment is awarded against it. As we have already seen with Chevron's management of the $18 billion Ecuadorean judgment against it, the company has successively delayed payment of damages through lodging multiple legal appeals and raising issues relating to jurisdiction and the Ecuadorian court's conduct. Furthermore, we are seeing a gradual softening of the Brazilian case against Chevron as the Brazilian courts have started to recognize the excessive nature of the damages sought. Even in a worst-case scenario Chevron would only need to declare its Brazilian operation bankrupt and take a one-off hit for the $4 billion of assets in the country.

I believe that Brazil will be the long-term loser, especially if an adverse judgment is brought against Chevron. Already, these actions have seen other foreign oil majors become cautious about investing in Brazil, and Chevron has hinted that the future of its Brazilian operation hinges on the outcome of the criminal and civil actions against it and its employees. Overall, any adverse judgment against Chevron will most likely see Brazil lose access to the much-needed capital and expertise required to access its deepwater oil reserves. Sadly, while the short-term economic benefits of oil nationalism may be very attractive to the Brazilian government, the long-term outcome can only be declining energy production, decreased foreign investment and unrealized economic potential.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.