The Fuse

Brazil: Debt, Scandal, and the Risks of Resource Nationalism

by Nick Cunningham | September 17, 2015

Standard & Poor’s recently slashed Brazil’s credit rating into junk territory, knocking it down to a “BB+” rating with a “negative” outlook. The move meant Brazil’s sovereign debt is no longer investment grade, a dramatic reversal for a country that put the “B” in BRIC, the group of rapidly expanding economies and emerging global powers that became the darlings of international investors just a few years ago.

Poor leadership, overhyped resource nationalism, and bad luck have all played a role in the country’s disappointing turn.

How did Brazil get to this point? How could the country that lifted millions out of poverty, weathered the 2008-2009 financial crisis better than most, and posted years of blistering growth rates transform into a floundering nation with a shrinking economy, mounting debt, and one of the worst political corruption crises in decades? Poor leadership, overhyped resource nationalism, and bad luck have all played a role in the country’s disappointing turn.

Dwindling Revenues

In its latest downgrade, S&P blamed political paralysis for the bulk of the uncertainty that Brazil faces. “The political challenges Brazil faces have continued to mount,” S&P said in a statement. “The negative outlook reflects what we believe is a greater than one-in-three likelihood of a further downgrade due to a further deterioration of Brazil’s fiscal position.”

Downgrades from Fitch and Moody’s, two other important credit ratings agencies, are likely forthcoming. If one of the other agencies does downgrade Brazil’s credit rating into junk territory, it could spark a selloff of Brazilian bonds, as major pension funds are required to hold only investment grade assets.

The effects of the downgrade, along with the ongoing recession and worsening fiscal position, are showing evident in Brazil’s currency. As of mid-September, the real is trading near 3.90 to the dollar, a 12-year low. In fact, the real has lost more than 40 percent of its value so far this year.

The political problems stem from fighting over the budget, which has undergone several downward revisions as revenues continue to disappoint. The government announced $17 billion in fresh austerity measures on September 14 in response to the S&P downgrade, in the form of tax hikes and spending cuts intended to erase the deficit. The measures could be difficult to implement, given the political gridlock, but the government of President Dilma Rousseff is desperate to restore confidence.

Pre-Salt Failing to Live Up to Hype

It wasn’t supposed to be this way.

In 2007, the country’s state-owned oil company Petrobras announced the discovery of the Tupi field, an offshore oil field beneath a thick layer of salt (known as the presalt). The discovery of 5 to 8 billion barrels of recoverable oil, located 18,000 feet below the sea surface, changed the trajectory of the nation. The field has since been renamed the “Lula” field, in honor of former President Luiz Inácio Lula da Silva.

Three years later, the company made another discovery—the Libra field, which could turn out to be an even larger find with an estimated 8 to 12 billion barrels of oil. These two fields, along with a handful of other discoveries, kicked off a gold rush. As recently as 2013, Brazil predicted that its oil production would more than double to 4.9 million barrels per day by 2020. Brazil was emerging as a global power, underpinned by a rapidly expanding oil industry.

libra oil field

Operation Car Wash

But tapping the presalt has proven to be difficult and expensive, and oil production has only ticked up modestly.

Now, Brazil has more immediate concerns. A massive corruption scandal involving Petrobras could head off any chance that the company had of turning its presalt basin into a major source of production, at least for the foreseeable future.

A major investigation that blew up last year unveiled a wide-reaching scheme, in which Petrobras contractors would overcharge the oil company for work, then kickback bribes to company executives and even the ruling Workers’ Party. The scandal has rocked the country’s economy and political establishment, with officials at the top of both Petrobras and the government implicated. The scandal has also threatened President Dilma Roussef’s legacy in nationalizing Petrobras.

Dubbed “Operation Car Wash,” the investigation could cost Petrobras at least $17 billion, but the indirect costs are likely to be far worse for the company and the country. In addition to the sovereign debt downgrade, S&P also lowered Petrobras’ credit rating into junk territory, the second agency to do so.

“We find that the ongoing investigations of corruption allegations against high-profile individuals and companies—in both the private and public sectors and across political parties—have led to increased near-term political uncertainty,” S&P wrote, as reported by the FT.

Over the next five years, Petrobras actually expects to see its oil output stay flat or decline, erasing the once ambitious dreams of doubling output.

The scandal, low oil prices, and a massive debt load have weighed down Petrobras. The company’s second quarter profits were down 90 percent in the second quarter from the same period a year earlier. The most indebted oil company in the world finally came to grips with its problems in June 2015 when it dramatically lowered its production forecast for 2020. The company decided to slash capital expenditures by 41 percent over the next five years compared to its previous spending plan. That will translate to a projected 2.8 mbd of oil in 2020, a jaw-dropping revision from a year ago when it expected to produce 4.2 mbd by 2020. It is also a glaring figure given the fact that Brazil produced 2.9 mbd in 2014. In other words, over the next five years, Petrobras actually expects to see its oil output stay flat or decline, erasing the once ambitious dreams of doubling output.

But the more austere budget plan from June could already be obsolete. To cut its debt load and raise cash, Petrobras announced plans earlier this year to divest itself of $15.1 billion worth of assets between 2015 and 2016, followed by $42.6 billion in further asset sales in 2017 and 2018. However, with oil prices still hovering around $45 per barrel, the company has realized that it will be unable to raise as much money as it would like from its holdings, as low oil prices will push down asset values. Nobody wants to buy what Petrobras is selling.

That means more budget cuts will likely be needed, and the asset sales will likely be postponed, according to Reuters. In June, Petrobras also issued $2.5 billion in 100-year bonds, which have since lost 15 percent of their value as the company’s fortunes have failed to improve.

On September 14, Petrobras’ chairman announced that he is taking a leave of absence, just months after he was elected by the government to take over the company’s board. Without much explanation, the move raised questions over confusion and disorder in the company boardroom.

Little Relief in Sight

The country’s GDP could shrink by as much as 2 percent this year. Since Petrobras is Brazil’s largest source of investment, the company’s austerity drive alone could account for a loss of 1 percentage point of GDP growth.

“Brazil is the country of the future…and always will be.”

For the Brazilian government, options are few. With high levels of debt, there is little room for increasing public spending. Inflation is already above the central bank’s target and the currency is depreciating, so easing monetary policy would be risky. Making matters worse for both Petrobras and Brazil is the fact that oil prices are not expected to recover in the near term.

There is an old cliché about South America’s largest economy: “Brazil is the country of the future…and always will be.” With the vast presalt discoveries between 2007 and 2010, Brazil had finally hoped to shake off its stigma of never living up to its potential. But with the explosive Petrobras scandal over the past year, along with the difficulty of extracting oil from the presalt and the collapse of oil prices, Brazil is falling short of expectations yet again.