Brazil plans massive unitization for its pre-salt basin discoveries

Drilling in offshore Brazil Photo courtesy of Pride International

This article will provide an economic analysis of unitization agreements and the ways in which regulation can smooth colliding interests among acreage neighbors. This exercise entails understanding the key characteristics of the economic environment where these contracts are signed, such as the asymmetry of information among neighbors, the uncertainties regarding the reservoir properties and the dynamics during its life cycle.

Another important point covered by this article is the role of regulation in the unitization of licensed and non-licensed acreage. While the excessive competition problem persists, but to a lesser extent, there is scope in understating the appropriate allocation mechanism, given the potential negotiation costs.

We find that the appropriate regulation of unitization agreements should minimize negotiation costs and the disinformation games, typical in asymmetric information environment, by pre-selecting mediators or their characteristics in case of negotiation failure, timing of negotiation should be as soon as a trespassing reservoir is identified, and the more so the more complex are the reservoir geological features. The allocation of non-licensed acreage should account for the trade-off between the negotiation costs with a different licensee and the exploratory bias of the incumbent company, neighbor to the non-licensed area.

In Brazil, the economic regulation of unitization agreements is efficient in minimizing the negotiation costs, but there is room for improvement given the absence of an economic trigger, which would enable the use of common infra-structure by a group of small reservoirs, turning them into commercially viable ventures. With regard to non-licensed areas, the regulation does not favor explicitly the incumbent company, but the latter seizes, from the auction program in place, an important competitive advantage. In an environment where reservoir characteristics are complex and very uncertain, this implicit advantage may be preferable given the potentially high negotiation costs.

The regulation in place

Since the early commercial years of oil and gas exploitation, both industry and society have understood the need for unitization agreements: they solve the problem of excessive competition for the common resources among companies. The logic of fluids migration in the reservoir incentivizes excessive drilling by the operators of a common reservoir, which is deleterious to its primary recovery capacity. Without the natural energy of the reservoir, its recovery factor can decrease abruptly, with the need to employ increasingly costly energy to maintain oil production.

This common perception is not applied to the regulation of these agreements and its imposition by national law or contract may not be sufficient to minimize other (very) relevant cost, the negotiation cost. There are some important aspects of the economic environment where these agreements take place that affect importantly the negotiation process and therefore can contribute to a longer and contentious negotiation process or shorter and straightforward agreements.

Typically, the national regulations impose unitization agreements under a geological or, in some cases, an economical trigger. The timing of the agreement – if it must be signed before or after production starts – and whether the share of gains and costs should be fare is also object of regulation. Finally, when unitization encompasses non-licensed acreage, the authority may start a licensing procedure. (See table for examples.)

Best regulation

The parties to a unitization agreement are asymmetrically informed about the reservoir's features and dynamics. However, as production starts, the actual characteristics of the reservoir become common knowledge as more information is elicited from the day-to-day activities. Also, the parties will probably interact in another moment in the future via consortia or contracts in the international secondary E&P market where contracts like farm in and farm out are celebrated between oil companies. They may be numerous, quite heterogeneous, and risk averse.

In the following, we discuss the implications of these characteristics in regulation design.

Information asymmetry

In bilateral bargaining, as is the case of unitization agreements, the private signals that parties have on the reservoir characteristics are strategic variables, treated as confidential. Depending on the contract, this is because the omission of information can favor one company in detriment to the other. This mutual understanding leads each party not to reveal what it knows about the reservoir and incentives a disinformation game that increases the negotiation costs and leads to a partition of rights and obligations that would be different if information were common knowledge.

One example of this disinformation game is the mere choice of the mediator in case of negotiation failure. Suppose A and B engage in a negotiation and there is only a biased mediator available, who would favor A's perception of the reservoir's characteristics. Because A does not want to reveal its information in order to gain a larger share in the unitization agreement, it will pretend to favor the use of the mediator, engaging in ‘prosperous-like' negotiations, but never actually closing the deal.

Similarly, a number of mediators may be available and one has to be chosen. Company A, aware of the information revealing imbedded in its mediator's choice, will be incentivized to chose a mediator that would not reveal crucial information to B. However, B takes that into account when it observes A's choice. In equilibrium, each company will propose a mediator that would be the least informative about its private signs, even if this implies a worse or less-skillful mediator.

From a welfare perspective, the disinformation game that the parties to a unitization agreement engage in reduces the net gains from the agreement itself, since other mediators would be chosen if there were common knowledge between parties.

One way out this game is, besides the imposition of a deadline to the negotiations by regulation, the choice of a mediator – or its characteristics - before hand in case of negotiation failure. This prevents that new information, gathered privately by the companies, from altering the incentives they have to efficiently explore the common reservoir.

Timing of agreement

We saw that the distribution of information among players is crucial to the efficient exploration of the reservoir. The more common the knowledge about the reservoir – and its mutual understanding among parties – the less the scope for strategic use of information. Suppose the degree of uncertainty is high but homogenous among parties once the trespassing reservoir is identified, but this uncertainty reduces as parties invest in its identification. Then it is expected that the latter can give quite different interpretations about the reservoir, as geologists start making calls about its characteristics.

As different interpretations can reduce the pace of negotiations, there is scope for the government to mitigate its effects by simply imposing unitization as soon as a trespassing reservoir is identified, especially in a complex geologic formation. Another possibility is to foresee redeterminations of shares once more information is revealed.

Correlated information

Given that parties' signals about the reservoir are correlated, the information problem faced by the mediator can be considerably reduced. A straightforward way to trigger parties to reveal their information is to punish the ones that report very disparate information from what was revealed by others.

Uncertainty and risk aversion

The above mechanism can be quite harmful for risk averse parties, as they are not aware whether their signal is an indicator or not of the distribution. As a consequence, parties would not be willing to join an exploration project with such rules.

If the formula does not distribute costs on the same way it distributes revenues, there is scope for productive inefficiency and contentious calls for renegotiation, given that parties can individually have incentive to increase the development costs beyond the desirable level. For instance, one of the companies can propose excessive drilling if it is favored in the cost-sharing formula by this activity.

The profit-sharing formula has an extra advantage that, besides leading companies to sort among themselves the accountancy issues, its incentive structure reduces the need for extensive checking and cross-checking of the investments' decisions. Finally, the profit formula facilitates adaptations to entry or exit of companies, something relevant given the intense acreage secondary market.

Hold-up of investments

The hold-up problem is possible whenever there is scope for opportunistic behavior, where parties try to extract from others the value of assets already invested. While this possibility is not mitigated by proper regulation, there is waste of business opportunities. If verifiable, regulation should punish such strategies.

Number of companies

The higher the number of companies involved in the negotiation, the higher the cost of negotiation. This can be due to lack of individual clear understanding of common goal and even free-riding among parties.

Company heterogeneity

The more the companies are heterogeneous with respect to its stake on the reservoir. Sometimes, small companies pretend to have small stakes to participate on cost only once production starts, as determinations are due.

Multimarket contact. The dynamic interaction of oil companies in different jurisdictions implies that reputation in the international market can be an important coercive device against opportunism. Therefore, the bigger the company, the lesser scope for government to be concerned that unitization negotiations would deviate much from international practice.

Unitization in non-licensed areas

The problem of excessive competition persists, though to a lesser extent, when the part of the trespassing reservoir is non-licensed: there is at least one company interested in maximizing the profits from its acreage and not necessarily from the reservoir as a hole. Therefore, there is scope for government intervention.

The allocation of the non-licensed area can be of two forms: attribute favoritism to the incumbent company, the one that found out that its reservoir trespasses its acreage to non-licensed area, or propose a competitive tender or auction of the area. We identified a trade-off between these options, which is the negotiation costs versus the bias in the exploratory program of the company.

On the one hand, favoring the incumbent can be preferable when the reservoir is potentially very complex or the contracts between government and companies are of a different nature, which would be the case of tax and royalties contracts unitized with production-sharing ones. Such negotiations could be contentious and quite long, which would be deleterious to society. On the other hand, the preferential treatment to the incumbent company can change its exploratory efforts to the borders of its acreage in an effort to enhance its area.

Unitization in Brazil

The national regulation obliges unitization agreements as soon as a trespassing reservoir is identified. However, there is no economic trigger to unitization, which would enhance exploration activities in mature or marginal areas and decrease development costs.

Also, the negotiations should start up to 10 days after notification, which would minimize the asymmetry of information between parties. Still, there is regulatory flexibility for the extension the negotiation phase if the environment is sufficiently complex. The national regulator also is pre-elected the mediator in case of negotiation failure, which avoids its strategic use during negotiations.

With regard to non-licensed areas, the regulation does not explicitly favor the incumbent company, as the regulator is obliged to license the neighbor acreage by auction. However, the auction format commonly used in Brazil does not favor information sharing across rival companies during the auction. In an environment where the incumbent company seizes a strong information (and therefore competitive) advantage against the others, it puts that company in a preferable position to win the auction.

An illustration of the importance of information in auctions of this type is the persistent strong presence of the former state monopoly, Petrobras, in the Brazilian market. From all the licensed blocks since liberalization in 1997, Petrobras won 50%, including 70% of those without partnerships.

To put this all in perspective, the significant changes in the regulatory framework that have been proposed and the complexity of the pre-salt basin and its scale, it is likely that the current licensing regime, with the implicit advantage given to better-informed companies, will reduce the (seemingly) huge negotiation costs of the unitization agreements. OGFJ

References

Asmus, D. and Weaver, J. (2006). "Unitizing Oil and Gas Fields Around the World: A Comparative Analysis of National Laws and Private Contracts"

Libecap, G.D. and L.L. Smith (1999). "The Self-Enforcing Provisions of Oil and Gas Unit Operating Agreement: Theory and Evidence." Journal of Law, Economics and Organization

About the author

Brazil's new profit-sharing system

On Aug. 30 Brazilian President Luiz Inácio Lula da Silva announced a new development model for the exploration and production of petroleum in Brazil's offshore "pre-salt" region, which includes the largest oil discovery in the Americas in three decades and the biggest estimated oil and natural gas volume under evaluation worldwide.

The development model, which still needs to be ratified by the National Congress in order to be enacted, includes: a new production-sharing system for contracts; a new public company for pre-salt contract agreement and administration; and a new social fund for investment in education and mitigating poverty.

The production-sharing system introduced in the new development model reflects a change in Brazil's standing from an oil importer to a self-sufficient global energy producer and is a major change from the previous concession model.

The Brazilian government believes that the profit-sharing system will continue to offer excellent investment opportunities to external parties.

The region refers to a 500 mile-long area roughly 170 miles off the coast of Brazil. It is estimated to hold more than 50 billion barrels of oil equivalent.

Production-sharing system

The first tenet of the new development model involves Brazil's shift from a concession model to a production-sharing system for the award of new contracts.

Under this system, Brazil's state-controlled oil company Petrobras will be the operator of all E&P contracts in the pre-salt layer. Interested parties can seek contracts through a partnership agreement. The shared contracts may be entered into directly with Petrobras or by open bidding, and Petrobras will receive a minimum participation of 30% of the costs incurred and profits obtained in the business. In addition, the National Treasury will become a partner of the companies investing in the exploration, sharing the profits and receiving part of the oil.

The production sharing system will apply to new contracts signed for fields in approximately 72% of the pre-salt currently interpreted area. Previously awarded contracts – which involve roughly 28% of the pre-salt region – will remain unchanged.

Public company created

The government's new model also includes the creation of a public company responsible for controlling and monitoring the cost of exploration and production of pre-salt and the administration of sharing contracts.

This company will represent Brazil in the consortia and operating committees to be created for directly managing different sharing contracts and monitoring all E&P activities.

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