Brazilian Auction Raises Concerns, Not Interest

Despite the fact that 40 companies were expected to attend, only a handful actually registered for the upcoming oil auction in Brazil, and the lackluster reaction worries many South American investors. However, it could prove rewarding for another region, writes MoneyShow's Jim Jubak, also of Jubak's Picks.

What if they gave an oil auction in Brazil and nobody came?

Things aren't quite that bad-yet-for the highly-touted deep ocean oil discoveries off the coast of Brazil, but the October 21 auction for the Libra field-estimated to hold eight billion to 12 billion barrels of oil-is shaping up as a near disaster. Only 11 companies registered for the auction last month-instead of the expected 40-and majors such as Chevron (CVX), ExxonMobil (XOM), and BP (BP) all failed to sign up.

This is quite a turnaround from the heady days of 2007, when discoveries deep under the South Atlantic were said to be about to turn Brazil into the Saudi Arabia of Latin America.

The auction news isn't good for investors in Brazil's Petrobras (PBR), but it could well be a boon for China and Chinese oil companies such as PetroChina (PTR) and CNOOC (CEO).

The reason for the lack of enthusiasm for the auction is a result of policies put in place by the Brazilian government after the 2007 discoveries. By law, Petrobras has to be the sole operator of any field and gets a 30% stake in all of these deep sea finds. The government will retain ownership of the oil-unlike in the more common concession model, where the bidding companies own the oil. In the current system, companies make money by selling a share of the oil produced; in the concession model, the winning bidders own the oil and pay a royalty to the government.

There seem to be a couple of features to this system that especially worry the big international producers. First, besides all the risk in bidding for a relatively unproven field, the government will charge a $6.8 billion signing bonus on the winning bidders. That seems high, the majors say, considering that only one exploratory well has been drilled at Libra. Second, the majors worry that Petrobras won't have the capital or the engineering resources to support its role as sole operator. The company already has a capital budget of $237 billion for the five years that end in 2017-a huge burden for a company required by the Brazilian government to import fuel at international prices, and then sell it for a loss on the domestic market.

Although international majors have shown limited interest in the auction, Chinese (and Indian, and Malaysian, and Colombian) state-owned oil companies have all entered bids. For these bidders, securing supply is the goal-and high prices and high risk matter relatively little.

A bad auction-low prices and few bidders-will put more stress on Petrobras and raise more questions about its capital spending budget.

Full disclosure: I don't own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund, I liquidated all my individual stock holdings and put the money into the fund. The fund did not own shares of any company mentioned in this post as of the end of June. For a complete list of the fund's holdings as of the end of June see the fund's portfolio here.