By Welter Benicio

Much has been said about the oil & gas industry in Brazil and its frustrations. Despite the impressive yearly capital expenditure of more than 40 billion USD in the last 2 years, there’s plenty of criticism and disenchantment with an industry (and a region) that was the players’ darling until recently. Distortions in the macroeconomic, regulatory and political environments are frequently seen in the nuclei of many analyses and are constantly described as the causer of the existing problems.

Nevertheless caution is recommended when a lot is at stake. Common sense indicates that the extremes are never a good starting point for a rationale and the actions that follow it. Therefore any analysis fully biased to the negative side may look suspicious. On the other hand (lawyers will love it!), no one can deny that expectations have been frustrated due to the postponements of large investments, difficult project executions marked with delays and cost overruns, earnings below the expectations accompanied by meager cash flows and a myriad of other bad experiences in the middle, providing fuel to rich analysis and explanations. Frequently, the root causes appointed for the under achievements are the hindrances mentioned above. Yet, the micro world, almost always neglected by all, has its share in the responsibility for the mishaps.

Micro world here is the world of transactions that is characterized locally by asymmetry of information, adverse selection, imperfect contracts, risk allocation and incentives, high bargaining, coordination and monitoring costs and pre / post contractual opportunism. It’s clear that this world and its distortions have an influence in the status quo and ignoring them or not addressing them will result in prolonged frustrations and continued losses by all stakeholders.

The small stones

Risks are inherent to life and even more so to business. That’s an axiom! Foreseeing variances, reasonably pricing them and their likelihood to happen, in addition to mastering them should be part of any set of skills of any organization performing any task under agreed rules. And thanks to a competitive (but imperfect, to the sorrow of economists!) market, there are limits in the contingencies one can add to the transaction prices, to provide protection against the undesirable variances. So a combination of reserves, in the form price contingencies, and the mastering of events is required. The problem appears when these reserves are not enough for cost variances arising from unexpected bumps in the road that are, unfortunately, prolific in our local industry.

In order to set the context: how many of you have faced bitter surprises due to fiscal or regulatory issues that were not anticipated in O&G in Brazil? Do local content calculations or paperwork for customs remind you of difficult days? Have you spent nights awake because the sub-supplier of choice is not coping with the commitment and unforeseen costs showed up? Or have you contracted a sub-supplier just to learn later on that you are in the middle of a forced negotiation (hold up) that is unavoidable, will reduce profit margins and will force you to do the same with your customer, but with much lower chances to succeed? If you are operating locally and none of the above happened to you, consider yourself lucky or else (food for thought: managing operations in the drilling rigs, 20 years ago, we used to say that something was bound to be wrong when everything was going right…).

Whereas we concur that in some segments of our local industry the mentioned risks are lower, we observe struggles in some others, mainly in those where the players are less vertical (offshore module fabrication by OEM’s, for example) or that have started localization programs recently (packaging and assembly of rotating equipment, for example). Whereas we encounter a mature business model and solid local setups for the manufacturing of major subsea equipment (trees, manifolds and wellheads), we observe challenges in the fabrication of special modules for the topsides of production vessels, for example. These modules, that are too specific and small for the shipyards but large and heavy enough to require special transportation, have their fabrication, erection and assembly contracted with small shops that are fully aware of their limitations, sometimes not visible to their customers, but that accept price, terms and conditions beyond their capacity and capabilities giving cause to future strained relationships, de-motivation, hold-up, cost increase, delays, forced negotiation or other sort of opportunistic behavior.

The problem, one may say, is related to the use of imperfect supplier selection processes and contracts that lack the correct aligning incentives that could make the parties to converge to common goals. Or more, that the incentives are creating adverse selections of sub-suppliers (choices that are the opposite of the desired ones), increasing the chances of disputes, de-motivation and ultimately cost variations and delays. Based on that, anyone could argue that everything would be solved with the correct contract wording, sufficient and efficient coordination, information gathering and monitoring processes and structure (supply chain and project management skills), assuming, obviously, that there are viable alternatives in the market to be contracted for the work and, obviously, that the context these transactions are part of are favorable. At this point, we must keep in mind that this context is a result of the factors mentioned in the first paragraph combined with the reflexes of the contracting / procurement policies adopted by the end users with their huge bargaining power…I leave it to the reader to judge how favorable this context is and how efficient the negotiations are in the first tier (with end users).

Anyhow, the situation of the specific modules has a high likelihood to end up in cost deviations caused by increased coordination and monitoring of the works in the field (project management and site supervision), replacement of sub-contractors, forced contractual variations and penalties for delays and other sanctions that can not (and in some cases should not) be transferred to the “tiny equity/balance sheet shops” sub-contracted for non-core works. The situation, that can result in deadlocks, disputes and mediation in escalating levels, is one example of escalating transaction costs, most of the time above the estimations, that haunts the oil and gas industry in the country.

Cleaning the pathway

The case of the module fabrication is only one example and (before I am exasperatedly criticized) I know that it does not (statistically) suffice as the support to my argument that is (just to remind the reader) that something else other than the visible distortions in the macroeconomic, regulatory and political frameworks is affecting our local oil and gas industry and shares the responsibility for the status quo. This “something else” shows its face as distortions at the level of transactions and is constantly giving origin to escalating transaction costs, disputes, delays and other undesirable events that sprout in a fertile ground. Having said that I can affirm, without hesitation, that there are other cases in other segments that face challenges at the transaction level just as in the example adopted. Try the risk allocation in contractual negotiations for example. Reality indicates that an efficient contract is only achievable when the risk allocation follows the bargaining power and capacity of the parties. The ones more capable should hold more risks. In order to help you understand this statement, I ask you to name a contractor that would assume the risks of unexpected (and undesirable) costs of subsea intervention activities for recovering parts and components that have to be repaired or replaced under warranty? What about a contract that does not clearly exclude, cap or clearly outline the risks and costs associated with the recovery of damaged reservoirs, or costs to recover the environment due to spill, blowouts, uncontrolled emissions and soil contamination? Or still, a contract where a new technology is being developed, to be tested in the field, but that includes penalties for performance and delays due to a failing prototype? These examples may seem drastic and extreme, but I’m sure the reader has a clear idea of how these risks should be dealt with. The problem is that efficiency in risk allocation is most always neglected during negotiations and the result is a contract that will give rise to de-motivation, disputes, opportunistic behavior, among other issues, following the popular wisdom that what is born deficient will likely end the same way. Another area that certainly has cases that support the central idea of this text refers to the clarity on the scope of work prior to commencing the work, or even before contract signature, and the clarity on the criteria for work acceptance. And we could go on and on, in an investigation and reporting that would only confirm my thesis. What to do then?

Macroeconomic, political and regulatory distortions are highly visible and are being constantly debated whereas contracts are negotiated in private, when and if they are negotiable! Opportunistic behaviors are self determined actions and cannot be foreseen unless there is a track record, a public history by the agent (if the history is too rich, it is expected that it be ousted by the other players or competent authorities, or both). Nevertheless, improvements in the processes and agreements reached in the privacy of meeting rooms can be achieved. Some useful tips are:

Contract limitations and bounded rationality – despite the multitude (actually infinite) of events that can occur during the execution of a contract and that are out of the original scope, a simpler wording is always preferable to a vast collection of terms and conditions. It seems that human brain, that is limited (bounded) in its rationality, is much more efficient at foreseeing the low side of things and we are always tempted to be deterministic (like it was possible). However, the inclusion of far too many provisos will mostly increase the chances of future disputes. As relational contracts (a relationship frame with goals and objectives) are not always possible, keeping simplicity as a guiding principle during negotiation and contract construction will always pay off;

“It’s not all but it’s quite a lot about the incentives” – be careful with what you incentivize, but do make use of incentives as a limiter of post-contractual nasty behaviors. Assuming these behaviors are associated with cultural and organizational aspects or that result from distorted moral values is naïve. They are always (ok, 99% of the cases!) a result of the contract terms and conditions, how they were negotiated, its incentives and enforceability. Alignments when objectives seem conflictive are not easily established but will improve future motivation. The use of risk/reward sharing for example is rarely seen, but could make fixed price contracts more palatable;

“With great power comes great responsibility” – no one could imagine that Spider Man, the movie, could teach valuable lessons to the oil and gas community in Brazil. But yes, instead of accepting the game of pushing the risks to the “other’s backyard” during a negotiation, the parties should discuss them and allocate them according to their bargaining power, capacity and capabilities. The ones that can more should take more risks: simple (and efficient) as that!

Adverse selection – there’s no free lunch! Someone will pay the bill, somehow. Selecting partners that at first seem a cheap choice can be the recipe for future headaches. Whilst we understand that there are regulations in this market that end up having a high degree of influence on who’s going to do what, the choices available to be contracted must be thoroughly assessed, from all angles, and I firmly believe that by doing that the cheapest alternatives will be discarded early in the selection process;

Respecting changes is a pre-requisite for successfully managing them – the Brazilian oil and gas market is complex and full of challenges for some players, not friendly and treacherous for some others but it is too big and full of opportunities to be ignored. The ones that succeed here are those whose level of respect for change (a decision to operate in the country in this case) is high, leading them to work hard on information gathering, talent selection and preparation.

Like any other NOC dominated market, the Brazilian oil and gas market has its idiosyncrasies. It is a highly technological market driven by the challenges of exploiting offshore ultra-deep water reserves (pre or post-salt). Despite all frustrations and challenges mentioned above, Brazil walks steadily to become one of the largest producers of hydrocarbons in the world in the next 5 to 6 years (average of more than 5 million barrels of oil equivalent per day) and it’s clear to most players in the market that the distortions need to be addressed and quickly, as the global competition for resources is fierce: the recent movement by the government of Mexico in the direction of making that prolific country more friendly to foreign investors, for example, will represent an additional challenge to a market that is already full of them. Unfortunately, not all distortions are highly visible as mentioned before. It does not mean however that they cannot (or should not) be discussed in the proper forums (industry associations, workshops, etc.) and actions to improve them, specially the ones in the world of the transactions, should not be implemented. After all, the litany of complaints and frustration is long being heard, always giving notice on something wrong beyond the political, economic and regulatory world in the land of samba.