The oil market is entering a period of structural volatility amid upstream underinvestment and extreme uncertainty over long-term demand. Brent seems to be heading towards $100 per barrel, but even if it breaches that threshold how long might it stay there?

Carbon Tracker has warned that oil’s surge towards triple digits presents a “stranded asset trap” in the event that demand falls quickly in the 2030s. If the rally prompts a wave of upstream investment into long-cycle oil projects that are rendered uneconomic before recouping their investment, investors might waste $500bn.

The think tank suggests companies “avoid locking in high-cost, long-cycle projects” and instead focus on short-cycle projects that can ramp up production quickly “to meet elevated short-term demand”.

This is already happening. Investors are showing renewed interest in alternative oil provinces such as Brazilian onshore, where national oil company (NOC) Petrobras is actively relinquishing its monopoly.

The Presidente Bernardes refinery of Brazilian state-run oil company Petrobras, in Cubatao, Sao Paulo state, Brazil, in November 2021. (Photo by Nelson Almeida/AFP via Getty Images)

“Small scale is enough for great returns”

Petrobras’s onshore oil production has slumped over the last decade from 187,000 barrels of oil per day (b/d) in 2010 to 96,000 in 2020, and falling. The NOC is instead focusing on abundant opportunities in Brazilian offshore, which dwarf the atomised onshore segment.

Petrobras’s strategic retreat from the onshore segment is giving rise to a new wave of independent players dedicated to acquiring and revitalising mature assets with productive life left in them. These include PetroReconcavo, 3R Petroleum, Petro Rio and Petro-Victory Energy, among others.

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“Brazil’s onshore oil production has been in decline due to a lack of investment,” says Ben Leith, director at Gneiss Energy, which was recently appointed as exclusive financial advisor to Petro-Victory. Brazil is dotted with ageing wells drilled 30 or 40 years ago using unsophisticated 2D seismic data that are producing only tens or hundreds of barrels per day.

These small wells can be “massively ramped up” through “simple workovers” that can deliver positive cash flow and a return on investment in a matter of weeks or months, rather than the several years typical of larger upstream plays.

“You don’t need scale. Small scale is enough for great returns,” Leith says. “Operating costs are low, there is no big government take through PSC [production sharing contracts], just a flat royalty in the range of 5–10% plus Brazilian corporate income taxes of 25%.”

Also, a large amount of promising underexplored acreage is located in areas adjacent to legacy wells, offering the possibility of “easy, short-term, low-risk, low-capital development opportunities”, Leith adds.

The small scale of the opportunity means big players in Brazilian upstream oil such as Shell, BP or Equinor aren’t competing for acreage. The fact that wells are vertically drilled into conventional resources also means redevelopment is less capital-intensive than shale oil, which requires fracking.

The gas play

The retreat of Petrobras, accompanied by a deregulation push, is creating opportunities in the natural gas space too.

The government is legislating to break up the NOC’s monopoly on gas distribution, which rendered it virtually impossible to get well head gas to market in the absence of widespread pipeline infrastructure.

“You can’t have a simple gas-to-wire [gas-fired power generation connected to a grid or demand source] arrangement like you have in other countries, because Petrobras owns the monopoly,” Leith said. “It has been extremely difficult to get Petrobras involved in putting in gas infrastructure. That is completely opening up with the new gas law.”

Stranded gas will be much easier to monetise under the new rules; for example, by piping it to a nearby industrial user or using it to generate power that is injected into the local distribution network.

Onshore sites with significant volumes of gas at the well head will soon be able to plot a route to market, flipping the calculus on these molecules from costly ESG liability – previously this gas was vented or flared rather than sold – to additional source of revenue.

Worries: politics and asset inflation

Despite the new opportunities in onshore oil and gas, the investment case remains beset by uncertainty. Brazil’s deregulation agenda, and particularly the generous royalty regime that is spurring onshore investment, are the hallmark of President Jair Bolsonaro – who is facing an uphill battle for re-election.

Polls suggest ex-president Luiz Inácio ‘Lula’ da Silva might be swept back into office in October 2022. If that happens, the investor-friendly regulatory conditions favouring upstream investment might come under review.

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In some instances, onshore operators are counting on further royalty reductions on licence renewal, but this is out of their hands and subject to political risk, according to a market source. “There is always the chance that these more favourable rates don’t come through, or that royalties go the other way, or even that renewals aren’t authorised,” the source added.

Awareness of the Brazilian onshore opportunity has been growing for some time and there are already signs too that asset prices are inflating, leading to speculation of a bubble. Shares in 3R Petroleum have more than doubled since the company debuted on the Brazilian stock exchange in November 2020.

The Brazilian onshore market “hasn’t peaked yet, but anyone not already established in-country on the ground could be getting in towards the top of the market," a regional market expert says. "Retail investors are particularly at risk.”

Still, many investors see a “tremendous upside” and are gobbling up assets from Brazil’s national petroleum agency ANP. Returns could be spectacular if market tightness persists into the late 2020s, experts say.

The overall size of the opportunity is barely a drop in the global oil market. Even if Brazil were to recoup its 2010 onshore production rate of ~225,000 b/d, it would still account for less than 0.3% of worldwide oil production – which is expected to soar by more than six million b/d to surpass 100 million b/d in 2022.

Since oil demand shows no signs of abating this decade, investment will keep flowing into supply-side opportunities that can pay off before then. For those able to secure suitable assets under the right regulatory terms, the pay-off could be handsome, regardless of how quickly the world transitions away from oil.

This is an abridged and updated version of an original deep dive first published by the Energy Flux newsletter in August 2021. Read the full-length original here: