Petrobras: Unfulfilled potential - FT.com Fuel subsidies have thwarted the Brazilian state oil company's ambitions to become a global power Diminishing returns: investors blame state intervention for wiping more than $200bn off Petrobras's value since 2009 Pharaoh's motel in the industrial outskirts of São Paulo is typical of Brazil's 5,000 secretive "love hotels" found in the suburbs of big cities. Just visible from the 10-lane highway that runs to the coast, rows of secluded, air-conditioned lodges offer the usual combination of round beds and thematic quirks - in this case, murals of Cleopatra and a selection of hieroglyphs. However, Pharaoh's biggest, and perhaps dirtiest, secret is locked away in one of the back rooms: a diesel-guzzling generator. Like other remote hotels cut off from the main gas system, it runs on a generator at peak times to avoid expensive electricity tariffs, taking advantage of diesel prices that are kept artificially low in Brazil. Petrobras Is it environmentally friendly? No, but we've got to make a living," says José Marchi, the motel's manager. Six years after an oil discovery that promised to transform Brazil, the nation's energy policy is in disarray. And for investors who bought shares in Brazil's state-controlled oil company Petrobras in 2010 as part of its $70bn equity offering - the world's biggest share issue - Pharaoh's is a telling example of where a big chunk of that cash has gone. Since January 2011, Petrobras's refining division has posted a total net loss of R$39.7bn ($18.3bn), equivalent to the gross domestic product of Honduras. It funds the country's de-facto fuel subsidies enjoyed by motorists, industry and anyone with a generator. It is the most toxic aspect of growing state intervention in the industry, which investors blame for destroying more than $200bn of Petrobras's value since 2009, turning one of Brazil's best hopes for future growth into a financial time bomb. "The government has been strangling the capacity of the company at a time when it most needs cash," says Adilson de Oliveira, a professor at the Federal University of Rio de Janeiro. But for the government to admit it has made mistakes is not going to be easy. Investors, bewitched by the company's vast offshore reserves, are still prepared to try their luck with Petrobras. Confident that Petrobras's state controllers will not let it reach breaking point, shares have rebounded 20 per cent since an eight-year low in July. However, as shown by the decision this month by Moody's, the rating agency, to downgrade the company, time is running out for the government to change its course. The next few months will prove crucial for Petrobras, which will be watched by emerging markets as a test of whether the state capitalist model embraced by many after the financial crisis is sustainable. The game-changer for the company based in Rio de Janeiro came in 2007 with the first pre-salt discoveries. Lying in the seabed off Brazil's southeast coast beneath a layer of salt up to 2km thick, the reserves were estimated to contain at least as much as the near-60bn barrels of oil found in the North Sea. "It's a gift from God," Luiz Inácio Lula da Silva, Brazil's then president, exclaimed at the time. Brazil was now an oil power. Emboldened by the financial crisis and a loss of confidence in market-based capitalism globally, the government set about the task of bringing Petrobras back under greater state control. In December 2010, Congress passed an onerous regulatory framework requiring Petrobras to be the sole operator of all new pre-salt blocks with a minimum 30 per cent stake. Strict national content rules were also introduced to limit the use of foreign equipment and services. "The discovery of pre-salt suddenly changed the way the government viewed the company," says Prof Oliveira. They began to see that Petrobras could be a source of enormous revenue for the government and an instrument for industrial policy. As oil prices began to creep up towards $100 per barrel at the end of 2010, the government prevented Petrobras from passing on the higher prices to the domestic market to help contain inflation. Since then Petrobras has been forced to import as much as 215,000 b/d of petrol and diesel to meet domestic demand, and sell it at a loss - currently about 20 per cent less than the total cost on an import parity basis, according to Brazil's Itaú BBA bank. Unlike fuel subsidies in countries such as Venezuela or India, the Brazilian practice is neither official nor, according to some, even legal. Instead it is the result of a private deal among politicians to run parts of the listed company at a loss for the good of the country. "Each month the board meets and weighs up the short-term profitability of the company against the country's needs," says a former senior executive at the company. The prospectus for Petrobras's 2010 rights offer makes no explicit mention of the government pricing practices that would help wipe out the equivalent of about 30 per cent of the total capital raised. According to a partner at one of Brazil's biggest law firms, this omission could be grounds for a lawsuit. Petrobras declined to comment, as did Guido Mantega, Brazil's finance minister and also Petrobras's chairman. The country's energy ministry responded by saying oil companies in Brazil are free to set their own prices. Since Maria das Graças Foster, a technically-minded Petrobras veteran, took over as chief executive in February last year, the company has negotiated several moderate price increases. But with inflation still around 6 per cent, further rises are not guaranteed. If there are no more fuel price increases by the end of 2014, Petrobras will need another capitalisation to reach its net debt to earnings target ratio of 2.5 times, which is crucial to maintaining its investment grade rating, says Itaú BBA's Paula Kovarsky. Based on the current exchange rate of R$2.20 to the dollar, Petrobras would need to raise R$75bn, but if the currency weakened to R$2.50 to the dollar it would need more than R$100m, she adds. Petrobras might have avoided the quagmire by increasing production. But its output has been stagnant or in decline since early 2012, largely because the government held no oil auctions between 2008 and 2013 as it wrangled over the division of royalties. In the second quarter last year, Petrobras posted its first quarterly loss in 13 years of R$1.35bn. A sharp depreciation in the Brazilian real swelled the value of its dollar-denominated debt, raising import costs. Ms Graças Foster has sought to appease minority investors by hiring the company's first genuinely independent director in April and introducing an aggressive cost-cutting plan that aims to save R$34bn by 2016. However, such moves have done little to distract from the more than $200bn in shareholder value that Amec, Brazil's investor association, recently estimated had been destroyed since Petrobras announced its share offering in August 2009. For Petrobras's investors, the discovery of pre-salt has been a curse, not a blessing. Members of Brazil's leftist ruling Workers" party (PT) have developed a stock response to such complaints. "Our party serves Brazil, not speculators," said Wellington Dias, the leader of the PT in the Senate, in March. Owners of ethanol plants across the country disagree. Caps on the country's petrol prices have made it harder to sell the biofuel to motorists, accelerating the demise of the industry. Given the size of Petrobras, its profitability is also clearly in the country's interests, analysts say. If it cannot stop bleeding cash it will be harder to raise capital for its $237bn five-year investment plan - a plan that will drive economic growth and create thousands of jobs. "They have these enormous resources but they are in this transition period and there are a lot of questions about how they are going to get from here to there in delivering on production growth, rigs and local content," says Thomas Coleman, an analyst at Moody's. Moody's cut Petrobras's foreign and local currency debt ratings from A3 to Baa1 this month, reflecting its increasing leverage. The company's total adjusted debt (debt including off-balance sheet items such as equipment leases) has grown from less than $40bn in 2008 to $185bn by the middle of this year, according to rating agencies, making it one of the world's most heavily indebted oil companies in absolute terms. However, it is places such as Caju in Rio de Janeiro, where the government's interventionist policies face their strongest test. Three years ago, the working-class neighbourhood in the city's derelict port region was known for two things: drugs gangs and being home to one of the country's biggest cemeteries. However, after Petrobras hired EEP, Brazil's newly formed shipbuilder, in 2010 to renovate Caju's Inhaúma shipyard, the region is now a hub for the country's resurgent maritime industry. By imposing strict national content regulations, Brazil plans to use the pre-salt discoveries to revive its shipbuilding industry, which has been in decline since the 1970s. The contentious rules that cap foreign provision of equipment and services are responsible for increasing the costs of some gear by between 30 and 50 per cent, says Itaú BBA's Ms Kovarsky. Others complain of the regulations" bureaucracy; it takes as long as three weeks to calculate the national content of one offshore drill. But Fernando Barbosa, head of EEP, says Kawasaki, the company's Japanese technology partner, would not have taken an equity stake in the group otherwise. The company plans to expand to Africa next year. The industry's rigorous pre-salt regulations are also regarded as a big obstacle and the reason why many international oil companies such as Exxon and BP have not come forward to bid for the country's long-awaited Libra field. Only 11 companies have signed up for next week's auction, mainly state-run groups from China and elsewhere in Asia. "The poor turnout took the PT by surprise," says Prof Oliveira. "They imagined international oil companies would be desperate to get into Brazil but the world has changed since 2008," he says. The shale gas revolution in the US, combined with promising oil prospects in Mexico and west Africa, means Brazil will have to work harder to attract private sector companies. As Libra has shown, if Brazil does not make itself more investor-friendly it risks simply becoming a pawn in the geopolitical strategies of Asian states rather than the great oil power it dreamt of back in 2007. "Brazil cannot simply go ahead just selling oil blocks to the Chinese," says Mr de Oliveira. Something has to change. Ethanol: Sun sets on South America's "biofuel Silicon Valley" For the families of Sertãozinho, the towering neoclassical gates at the entrance to the small farming town are a painful reminder of its glorious past, writes Samantha Pearson. In 2008 the community of 100,000 became the centre of Brazil's booming ethanol industry - the country's so-called "biofuel Silicon Valley." Wedged between Brazil's most fertile cane fields about four hours" drive north of São Paulo, Sertãozinho attracted multibillion-dollar investments in ethanol plants and was enjoying China-like growth rates. To celebrate its newfound status, the town splashed out R$300,000 on its grand new entrance and spent another R$2.5m on a 57m-high statue of Christ the Redeemer that easily dwarfed Rio de Janeiro's. The town did not know, however, that its fate had already been sealed more than 600 miles away with Petrobras's discovery of vast offshore oil reserves. Sertãozinho is now largely deserted. Brazil's de facto petrol subsidies have made it difficult for ethanol producers to compete at the pump. In Brazil most cars are built with flex-fuel engines, allowing drivers to choose whether to fill up with petrol or ethanol. While Brazil's sugar and ethanol plants have also been hit hard by the global financial crisis, the government's cap on petrol prices accelerated their demise. More importantly, uncertainty over future petrol prices has dissuaded investment in the industry, says Adhemar Altieri, a director at Unica, the Brazilian sugar and ethanol association. When the price of your competitor can be adjusted at a whim there is too much unpredictability. It becomes difficult to ask someone to pursue the industry with any passion," he says. While 30 plants were built in 2008 in the centre-south region, there are no plans to construct any more mills. Mr Altieri adds: "We're not looking for guarantees but we need to know what the government wants. Where does ethanol fit in to their plans? After many of Sertãozinho's ethanol factories shut down, the town's unemployment rate surged. "I remember the day I lost my job as it was exactly six months after my wife gave birth to our second child," says José Totoli, a former metalworker at an ethanol factory, as he leaves the town's crowded jobcentre. He had just been interviewed for a part-time job as a security guard, he says.