Brazilian Oil Dreams Get Sobering Reality Check

Wed, Jul 11, 2012 - 8:51am

Stories of doubles, five-baggers, or even tenfold returns abound in the resource sector. These successes are exactly why we play the game: The discovery and development of a new oilfield or gas basin can create immense value, and being part of a story like that is extremely satisfying, not to mention financially rewarding.

However, the potential for big resource returns can all too easily make investors forget just how risky the sector really is. Investors are not the only ones who get caught up in the hype - an exciting discovery can turn normally conservative CEOs and geologists into starry-eyed daydreamers waxing poetic about grand possibilities and great riches. As a story out of Brazil recently reminded us, even the world's most successful investors can get carried away by dreams of resource riches.

That is precisely what happened to the richest man in Brazil. Eike Batista earned his formidable wealth in the resource sector, starting with a gold-trading firm and moving into precious-metals mining before branching out into oil and gas. His empire is now contained within the EBX Group, a conglomerate of five public companies with the same majority owner: OGX is an oil and gas explorer and producer; MPX is an energy entity that generates power, mines coal, and produces natural gas; MMX is a mining company with operations in Brazil and Chile; LLX is a logistics company focused on resource-sector needs; and OSX is an offshore oil and gas service provider that also builds ships and constructs ports.

OGX is the firm that propelled Batista into the headlines in late June. Just months after CEO Paula Mendonca reassured investors that the company was on track to meet its targeted production volumes at its nascent Tubarao Azul field, OGX admitted that the first two wells at Tubarao are only pumping out half of their expected production. Since Tubarao is the company's first producing operation, the downgrade forced OGX to slash its 2016 production guidance in half.

The market responded in kind, cutting OGX's value in half. The fall was the biggest anyone at the Sao Paulo stock exchange can remember, erasing R$16 billion - US$7.9 billion - of value in just two days.

There are many lessons to draw from such an investment calamity, but all of them harken back to one primary fault: OGX overpromised and underdelivered. Blame undoubtedly goes to OGX's management team, but questions remain. Why didn't an incredibly successful and experienced chairman like Eike Batista provide better counsel? Why did the company set itself up for failure by promising the moon?

The answer to both questions is the same: they thought they could do it. OGX's concessions in Brazil and Colombia contain resources totaling a whopping 10.8 billion barrels of oil equivalent (boe); and everyone at the company, including Batista, let themselves believe they could develop those reservoirs with nary a stumble and would soon be pumping out barrels and barrels of oil.

If it had worked out as planned, OGX might still be worth R$50 billion (US$25 billion). But it is never easy to develop any kind of natural resource, and even though the Campos Basin - where OGX kick-started its development efforts - is in relatively shallow waters and does not present any specific technical challenges (it is not a sub-salt deposit, like so many of Brazil's offshore barrels are), it proved more difficult to tap than the company expected.

A management team with more temperance would have incorporated the potential for setbacks in its outlook, which would have meant more modest production targets. Had that been the case, the company's share price wouldn't have rocketed skyward the way it did, but perhaps OGX would have met - or even bettered - its oil guidance.

Instead, what we got was a dramatic reminder that even highly experienced resource investors can all too easily forget the litany of risks inherent in moving a resource project from potential to reality. Developing resource deposits is very difficult. Just about the only guarantee is that something will go wrong.

Eike's Oil Endeavor

Batista had already created $20 billion in shareholder value in the mining arena before he set foot in the energy sector. He took that step in 2005, creating OGX as his vehicle to participate in Brazil's burgeoning offshore oil industry. OGX snapped up a raft of offshore concessions, gaining ownership of almost five billion barrels of oil. Based on that resource, the company managed to raise US$3.3 billion in its IPO in 2008, a record in Brazil at the time.

That Eike was able to raise so much in OGX's public debut even though the company had not yet produced a drop of oil speaks to the excitement Batista and his team stirred up around the company. They spoke glowingly of OGX's future as Brazil's largest oil producer and emphasized that OGX's offshore concessions were not overlaid by a layer of salt, which was supposed to mean that the oil would be easy to access.

Batista and his management team at OGX took turns telling the markets just how much oil OGX would churn out. CEO Mendonca predicted repeatedly that the Tubarao field in the Campos Basin alone could produce as much as 80,000 barrels per day (bpd). Batista loved to tell whoever would listen that OGX would be pumping 730,000 bpd by late 2015. By 2019 the company was aiming for 1.4 million bpd.

It all sounded fantastic, but when it comes to output forecasts, the proof is in the pudding: Geologists and CEOs can talk about potential production rates until their throats are dry, but the only way to know what a field will really produce is to drill some production wells, open the taps, and see how quickly the black gold comes out. And since OGX did not produce a drop of oil until January of this year, investors had no way of knowing whether OGX's forecasts were realistic. They just had to wait for production data.

In January OGX produced its first oil, pumping from its initial Tubarao production well. Excitement over the long-awaited moment lifted the company's share price above R$18. Just six weeks ago, after several months of production but before the company released any real data about Tubarao, Mendonca publicly reaffirmed that OGX would be producing 40,000 to 50,000 bpd from four Tubarao wells by 2013. His confidence suggested that things were going well, but investors must have sensed trouble: OGX's share price slid to R$10 by mid-June.

Those investors who fled the stock were right to follow their gut instincts - things were not going well. On June 26 OGX revealed that its first two Tubarao wells are currently producing just 10,000 barrels of oil equivalent per day (boepd), half of what Mendonca said they would pump in their early days. Since wells decline with time, OGX has now projected these wells will produce just 5,000 boepd over their producing lifespans, far below the 10,000 -13,000 boepd originally forecast.

By the end of 2013 Tubarao will now be producing just 20,000-25,000 boepd, not the 40,000-50,000 bpd Mendonca estimated just weeks ago. By the end of 2015 Tubarao was supposed to be spitting out 730,000 boepd; now OGX expects less than half that volume.

The news had two instant ramifications. First, OGX's future cash flows were slashed. Fitch now projects OGX will book earnings before interest, tax, depreciation, and amortization (EBITDA) of $2 billion in 2015, down from a forecast of $6 billion before the Tubarao production revision.

Second, the company lost all credibility with investors. Analysts with Bank of America Merrill Lynch put it well when they wrote that the production downgrade "puts into question all the assumptions behind the company's growth program." In short: No one has any reason to believe any of OGX's production predictions... and since OGX grew into a R$58-billion company based completely on its future production potential, much of the company's value evaporated alongside its credibility.

OGX is now down 62% since the beginning of the year. Its market capitalization stands at R$20 billion. The company has deep pockets - its bank account is well stocked and Batista's remains very healthy despite losing $11 billion on paper in recent weeks - and so it will likely survive. But it will never forget the lesson it learned in 2012: never underestimate the challenges of resource development.

And OGX investors will never forget the sting of a resource investment gone terribly wrong. For Batista, who lost more than every other OGX investor combined, the lesson is that pumping hydrocarbons is not the same as mining metals. Mining has its many challenges, but exploration drilling and metallurgical testing can determine with reasonable certainty where a gold deposit lies, how much gold it contains, how difficult it will be to blast apart the rocks and collect the ore, and whether the gold can be separated from the other minerals to produce an economic product. Obstacles to mine development and operation are still aplenty, ranging from water in the rock formation that causes wall collapse to politicians in the country who want more money, but defining an orebody is easier than outlining an oil reservoir.

While OGX's drastic downgrade will certainly scare some investors away from energy, that doesn't change the fact that the sector is poised to be the next great bull market. We have to face it, most of the easily extracted oil is gone, and the only way to meet the world's energy demands will be by harvesting gas and oil in reservoirs trapped miles beneath the earth and sea. For investors, the trick is finding companies that can do this consistently and profitably; but doing that requires extreme due diligence on every potential investment... otherwise you run the risk of getting stuck with an OGX.

As one infamous quote put it, a geologist looking for an oil reserve is akin to a blind man in a dark room looking for a black cat that may or may not be there. If you manage to find the cat, you still have to figure out how it behaves... but you're still completely blind.

With oil reserves, the resource is a liquid under immense pressure from a mixture of gases, and the reservoir holding this liquid-gas balancing act has to remain under high pressure or wells will run dry. Maintaining pressure requires a sealed unit; while exploration drilling and geophysical surveys provide some information about reservoir size and pressure, there is no way to be sure the reservoir does not connect to an adjacent reservoir or some other kind of geologic formation that will impact production.

That is precisely what happened at Tubarao. When flow rates declined much more rapidly than anticipated, OGX geologists reassessed their data and concluded that natural fractures connect the reservoirs feeding the first two wells. With two wells pumping from a joint system, pressures in the reservoirs decreased double-time.

Whether this will happen to every Tubarao well is yet to be seen, but it is certainly possible. And Tubarao is just one of the fields OGX is developing - if OGX has been equally optimistic in projecting production flows from its other oil and gas fields, the company and its remaining investors could be in for many more unpleasant surprises. And this from a reservoir that was not even supposed to be that hard to develop! Most of Brazil's vast hydrocarbon wealth is contained in reservoirs that lie underneath deep waters and shifting salt formations; by contrast Tubarao is in shallow waters and outside of the salt zone. In addition, OGX operates in a country with fairly good oil infrastructure and reasonable, well-defined levels of government take. Just imagine how much harder it can be when the geology gets complex, the environment is harsh, and the fiscal rules of the game change under your feet.

Such is the nature of the oil and gas game. The days when one could drill a simple, shallow well into the Texan soil or Saudi Arabian sand and be rewarded with gushing flows of black crude oil are over. Today's oil discoveries are in increasingly challenging reservoirs that demand evermore sophisticated technologies to unlock.

The inescapable truth is that developing a successful new oil project becomes more difficult with every passing day. The result is that every investor who fails to appreciate this new reality will see an investment sideswiped by an unexpected geologic complexity, or a greedy government that takes a bigger piece of the pie, or a lengthy but ultimately fruitless battle for permits that relegates a promising project to the history books, or some similar obstacle that stops a project in its tracks.

This does not mean that oil and gas is a hopeless investment landscape! It means that every energy-investment decision requires careful due diligence and that investors have to take every company promise with a grain of salt. The rising risk barometer also makes it even more important for investors to temper their greed - it is better to sell too early, locking in a small or mid-sized gain, than to wait too long and lose it all.

The energy exploration and production landscape is becoming more difficult to navigate every day. Without a guide you could easily get lost, regardless of how many gains you've booked already - for proof of that, look no further than Eike Batista.

Additional Links and Reads

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