What happened at Petrobras?

Petrobras, the national oil company, was once a proud symbol of Brazil’s emergence and a driver of national economic growth. Then, after years of bad results, the company was rocked by a blockbuster corruption scandal. Now, Petrobras’s new leadership is working to get the company’s finances back in order, but will their efforts be enough?

There is a saying that the most profitable business in the world is a well-run oil company, and the second-most profitable business is a poorly run one. Well, according to that logic, Brazil’s Petrobras defies categorization. It is a state-owned oil company, essentially a monopoly, in one of the biggest countries in the world, and yet it has been losing money for years. How is this possible?

Recently, much has been written about the role of corruption in Petrobras’s downfall. Indeed, a historic and unprecedented investigation known as Operation Car Wash, or Lava Jato in Portuguese, has unearthed the greatest corruption scandal ever seen in a democracy. The numbers are staggering: 1-3% of the value of every single contract with the company diverted to bribes, adding up to some 2 billion dollars. 179 people charged and 93 convicted so far, with the sentences totaling over 1,000 years in prison. Tens of thousands of jobs lost, both among company employees and employees of the many contractors that depend on the company.

And yet, this massive level of corruption doesn’t even begin to explain the dire state of the company’s finances. Last year, Petrobras had to write down 15 billion dollars due to “poor planning, declining oil prices, unrealized refinery project goals and excess costs.” The company is 150 billion dollars in debt, the highest level in the global oil industry. At its worst moments, some 85% of its market capitalization simply vanished as the stock price plummeted from highs in the 60-dollar range to lows of just over 3 dollars per share (the stock price has now recovered somewhat, to around 9 dollars per share). A US lawsuit alleges that the company misled investors, causing them to lose some 200 billion dollars in shareholder value since 2008. The company may yet have to recompense investors for their losses in addition to paying a 1.25 billion dollar settlement related to a separate investigation by the US Department of Justice.

Clearly, the 2 billion dollars lost to bribes is not enough to explain all of this. So what else happened at Petrobras?

The answer is a mixture of mismanagement, bad investments, and costly price controls in which the government effectively forced the company to lose money. All of this, in turn, stems from a deeper underlying pathology in Brazil in which state-owned companies are regarded as tools that can be used and manipulated at will for political ends, even if this is unprofitable or illegal. Because of this, Petrobras was treated like some sort of national petty cash box used to fund the political priorities of the moment, rather than as a business that needed to operate independently and profitably in order to survive. The results of this mentality, which created the conditions for corruption and mismanagement to thrive, have clearly been disastrous. If the company is to get back on its feet and succeed in the future, both its direct financial and underlying political problems will need to be addressed.

Strangling the goose that laid the golden egg

Although much has been made of the Petrobras case, it is important to note that corruption is hardly new to Brazil. Throughout the country’s history, institutionalized impunity has been the norm rather than the exception. Indeed, the payment of bribes and kickbacks, along with a whole litany of other crimes, has been business as usual in the government and big Brazilian companies for as long as anyone can remember. Beyond its direct costs, corruption is so damaging because of the culture that it fosters: One in which anything goes as long as powerful people benefit, whether financially or politically, and regardless of the consequences. This mentality has also been the norm throughout Brazilian history, and it has prevented the country from fulfilling its vast potential for hundreds of years.

What changed in recent years, however, was the amount of corruption, the scale and the audacity of it, and the Petrobras case exemplifies this shift (although the company is by no means alone, and allegations abound of similar schemes at other state-owned companies, such as Eletrobras). The reason for this sudden increase in corruption stems from the political and economic changes that Brazil experienced in the 2000s. Along with Brazil’s economy, the ambitions of the country’s political leaders to raise their international profile grew exponentially during this time. This created the conditions for the subsequent boom in investments and, consequently, the boom in the level of corruption.

It is all so ironic considering that when Luiz Inacio Lula da Silva, of the leftist Workers’ Party, became president in 2004, he vowed to bring an end to this type of politics as usual. In retrospect, it looks more like his desire was not so much to end the political corruption machine, but rather to take control of it to his benefit. It became abundantly clear that Lula was not above using the old tactics of patronage to solidify and amplify his power when the Mensalão congressional vote-buying scandal came to light during his first term as president. Although his chief of staff was imprisoned for paying monthly allowances to members of congress in exchange for their support of the president’s agenda, Lula denied knowing about it.

A weaker president may not have been able to get away with this denial, but Lula had the soaring Brazilian economy on his side. Brazilian voters gave him the benefit of the doubt and reelected him despite the scandal. Lula remained in office, happily continuing to take credit for Brazil’s booming economy even though it had a lot more to do with the orthodox economic policies set by his predecessor, Fernando Henrique Cardoso, and a global commodities boom in which Brazil profited tremendously from selling things like oil and iron ore to an ever-growing China. Then came perhaps the most important factor in creating the conditions for corruption to proliferate at Petrobras: The discovery of the pre-salt offshore oil fields near Rio de Janeiro, which were estimated to hold some of the biggest oil reserves in the world.

These fields represented a chance for Brazil to become one of the world’s most important oil producing nations. However, they were also perhaps the greatest challenge ever encountered in the business of oil exploration. Located up to 300 km offshore and in ultra-deep waters, the reserves are located beneath layers of water, rock, and salt, each of which is a couple of kilometers deep. To reach the oil, drilling equipment would have to reach some 5 to 7 kilometers down. Nothing of the type had ever been attempted. It required the development of entirely new technologies, from new floating platforms and rigs that could withstand conditions so far out in the open ocean, to drills that could reach so many kilometers underwater and underground, to pipes capable of withstanding the crushing pressure of water at those depths. All of it had to be invented and no one had any idea how to do it. Exploring the pre-salt fields had the potential to be incredibly lucrative, but it would require a massive and unprecedented amount of investment.

Meanwhile, in line with his populist tendencies, Lula made keeping the pre-salt finds out of international hands a priority. He passed laws regulating that Petrobras was to be the sole operator of any pre-salt activities, thereby excluding private companies from other countries from getting involved (and preventing them from sharing the burden of the required investments). He also passed strong protectionist measures dictating that large percentages of the equipment and parts used in the exploration of the fields would have to be manufactured in Brazil. Both of these measures maximized the amount of money the Brazilian government would have to direct towards Petrobras, drastically increasing the company’s vulnerability to corruption.

The combination of revenues from the booming Brazilian economy with the pre-salt discovery and Lula’s nationalistic regulations led the company to embark on a wildly ambitious program of investments unprecedented in scale, not only in Brazil but globally. The history of Petrobras under Lula is one of superlatives: To develop the pre-salt and grow the company, Petrobras embarked on the biggest corporate capital expenditure program the world: By investing some 225 billion dollars, Brazil spent more on developing these oil fields than NASA spent on the Apollo missions to the moon. Soon, to raise even more money, the company orchestrated the greatest share offer ever, selling 70 billion dollars worth of shares on both Brazilian and international stock markets.

At the time, it seemed like Brazil and Petrobras were on top of the world. The Brazilian oil boom was expected to last for 30 years. Brazil was on its way to becoming a global superpower, and no amount of money seemed unreasonable to make that happen. How naïve those predictions seem in retrospect.

The results of this explosion of money are well documented. The boom in investments, coupled with the long-standing practices of systemic corruption in Brazil and the Workers’ Party’s embrace of this system led to equally unprecedented and superlative amounts of corruption. This created a sort of feeding frenzy among well-placed politicians and connected members of the business community: everybody wanted a piece of the Petrobras pie. It was a positive feedback loop that soon got out of control. That’s when things started to get ugly. People got sloppy. In the midst of this massively complex undertaking, unqualified executives were routinely appointed as political favors. Huge amounts of money were spent on investments that made no sense, just to extract bribes or rally political support. Even when investments did make sense, their prices were wildly inflated to raise the amounts of money paid out in kick-backs. Protectionism and poor infrastructure raised the cost of doing business. The losses started piling up.

And then came Dilma.

Dilma Rousseff, Lula’s handpicked successor, certainly looked good on paper. Whereas Lula, a former factory worker with no higher education, had risen to national prominence by leading a labor union, Dilma was a trained economist who had previously served as energy minister and chair of the Petrobras board. She was expected to bring a technocratic approach to the job of president and to take especially good care in the area of energy policy. Unfortunately, she differed from Lula in other ways as well, and these proved to be her undoing. Whereas Lula had been pragmatic, a wily politician willing to be ideologically flexible, Dilma was a former Marxist guerilla with a very specific and uncompromising worldview.

While Lula benefitted from the global commodities boom, during Dilma’s presidency, the world economy turned, leaving her in a much more challenging environment. China’s demand for Brazilian commodities slowed down, creating a recession. Meanwhile, after years of record levels of government spending, unsurprisingly, inflation was becoming a problem. Brazil was facing that horrible two-headed type of economic crisis, stagflation.

At that point, the cultures of corruption and mismanagement intersected with the culture of misguided and ideologically motivated government interventionism. Dilma decided that the best way to tackle inflation and help struggling Brazilian consumers would be to keep domestic fuel prices artificially low, on Petrobras’s dime. So while billions in company funds were being diverted to corruption, while the company was taking out huge loans for its massive investments, while the  bottom line was suffering due to slowing demand for its oil exports, Petrobras was forced to subsidize the cost of fuel in Brazil, selling gas at below market prices and covering the difference.

Needless to say, this created huge losses. For years, the company had to do this, losing money in not just one but two ways. Profits were foregone directly by selling gas at a price much lower than the market rate. In addition, because Brazil’s domestic refineries were unable to keep up with demand, Petrobras had to import additional fuel, paying high international market prices and then selling at a 20% discount. This led to losses of some 17 billion dollars between 2011 and 2014.

Meanwhile, the company’s unprecedented investment spree was failing to bear fruit. Huge sums of money were funneled into often unprofitable ventures. Probably the most egregious example is the purchase of the Pasadena refinery in Texas, a transaction personally approved by Dilma when she was energy minister and chair of Petrobras. It was a decrepit, hundred-year-old facility valued at 50 million dollars, but the Brazilian government paid one billion dollars for it. A plant at the poorly maintained facility, which has long violated safety and pollution regulations, recently exploded.

There are many other examples: Refineries were built in remote or inaccessible areas where there was insufficient transportation infrastructure, and the company made bad investments in non-core businesses such as fertilizers, biofuel and petrochemicals. Such projects were undertaken not because they represented promising businesses, but rather because in addition to generating bribes and kick-backs, they were supposed to create jobs and shore up support among the Workers’ Party base.

Although it could reasonably be argued that a state-owned company in a poor country does indeed have the responsibility to create jobs, the way in which this was done at Petrobras was completely unsustainable. Too much money was spent too quickly, on projects that were too untenable, without any sense of strategy or regard for long-term consequences. In this way, the company’s resources were quickly exhausted, allowing the company to essentially be looted for political gain. By the time the Lava Jato investigation came around and began shedding light on the scheme, the company had been gutted. All of the previous years’ gains, the new jobs, the potential for future growth, the optimism, it was all gone, just like that.

Can Petrobras be saved?

Petrobras’s new CEO, Pedro Parente, who was appointed by the new government of Michel Temer, recently announced a 5-year recovery plan that mostly revolves around getting the company’s finances in order. This will be done by cutting capital expenditures by 25%, to 74 billion dollars, and divesting some 36 billion dollars in assets that are not related to the company’s core oil business. Another key part of the company’s recovery plan relates to new policies on the domestic pricing of fuel. The company’s new leadership has vowed that the government will no longer interfere in business decisions.

Meanwhile, Parente has painted the company as a victim of corruption, arguing that the company itself should not be liable for any damages since it did not benefit, but was rather hurt by the corruption. By this logic, the only things that need to be done are to root out and remove corrupt individuals, while the company’s new leaders sort out its financial problems.

However, if the company truly is to make a comeback, this will certainly not be enough. The root cause of all the trouble is not merely financial mismanagement, but rather the long-standing mentality that Petrobras and other state-owned companies can be looted for personal or political gain. If this is not addressed, then all the other efforts to right the ship will have been in vain and it is only a matter of time before another corruption scandal emerges.