The Day Brazil Ended, or a Lesson in Mortgaging your Future with Oil

Brazil ended on June 8, 2007, even though nobody knew it at the time. Even more striking, the country rode a high until 2013, when growth started to falter and the country slipped into a deep recession. It was another “chicken flight”, euphoria quickly leading to a reality check that indeed, a chicken cannot fly. The year 2007 brought a lot of good news, but they were the foundations of the Brazilian demise. Growth was high, inflation low, and Petrobras, its national oil company, discovered huge oil reserves off the Southeast coast. Since then, the government has mortgaged the country’s future on a supply of oil income that is a fraction of the bets placed by all levels of government. Rio de Janeiro’s governor and many municipalities, for instance, simply spent away all oil proceeds, using temporary income to generate permanent liabilities, a disaster waiting to happen. It did. Rio is bankrupt, as are many municipalities counting on oil royalties as the main source of income. The idea of a wealth fund to use volatile oil royalties to smooth the business cycle? Brazilian institutions are short-termist to the extreme, and tomorrow was always the problem of the next cycle of politicians, whose jobs would be to postpone the inevitable crash. Well, there is no postponing the crisis in Brazil today. Opportunities squandered, and incompetence abounds.

In hindsight, we forgot one simple rule: do not give too much money and power to incompetent and corrupt institutions. A combination of hybris, incompetence and graft was inevitable, even though we still act as it was unexpected.

Nothing represents hybris like a small event in an executive education classroom in 2012. I was teaching Financial Management to Petrobras executives. In one class I mentioned the reasons why the stock was underperforming at the time, and that the company did not have the managerial capabilities to pull off its massive investment plan, a staggering USD 224 billion of pure arrogance disguised as a national development plan. At the time, everybody believed that massive investments would turn a local oil company into the largest oil company in the world in the span of less than one generation. One executive just lost it, screaming that the markets were colluding in bringing the stock price down, that the company was the most valuable in the world, and that Exxon and BP were afraid of Petrobras, as it was the only company with a future in terms of oil reserves. He left the classroom to complain that a professor could not see what was the simple plain truth, that Petrobras was the future and the other oil companies were the past. Right.

The graph above shows the performance of Petrobras’ stock, with a negative 60% return since 2012 and over 90% decline since that fatidic day in the idles of 2007. Mind you, I have taught dozens of classes at the company and its executives are usually competent, intelligent, conservative, and a pleasure to deal with, but the angry executive outburst was due to a pervasive feeling around the company at the time, that its reserves represented the future of the nation, and the company would be the most valued company in the world. Not in the oil sector. The entire world.

There is one theory in development economics called  resource curse, its main idea being that countries endowed with too much natural resources find it more difficult to develop due to incompetent and corrupt institutions. Even though I find the theory lacking in predictive power, it provides the best description for what happened in Brazil in the last 10 years. The chain of events is relatively simple:

• Petrobras discovers huge oil reserves.
• The country rides the commodity boom.
• Corrupt politicians entrench themselves in the company.
• Managers devise obscene investment projects.
• Government forces Petrobras to invest in areas in which the company has no expertise, at one time managing the building of four new refineries, simultaneously.
• States and municipalities use income from royalties like they are never-ending, creating permanent expenses on volatile resources.
• Government directs federal royalties to education and health, also creating permanent expenses based on volatile resources.
• Petrobras managerial incompetence cannot push forward its investment projects, even though the company claimed that there was no operational risk in getting oil from the Pre-Salt.
• Oil crashes. And Petrobras with it, even though the company would be in this mess regardless of the movements in oil prices.
• Petrobras fires thousands of employees.
• A gigantic semi-state owned company called Sete Brasil is on the brink of bankruptcy.
• Government decides to tear down contracts with energy utilities, subsiding forced down prices to the tune of tens of billion of Reais.
• Myriad of subsidies disbursed to many companies in different sectors. Cronyism at its best.

When the business cycle changes and the government is forced to rebalance all its crazy projects, the economy crashes. The state of Rio de Janeiro, who rode the oil wave like no other, is bankrupt.  Ignorance, incompetence, greed, cronyism and arrogance. The basis of it all, oil reserves that should have been kept in the ground. Petrobras is the most indebted oil company in the world, and probably does not have enough cash flow to survive without being bailed out by the government. Mortgaging a country’s future based on a dirty energy source. Well done, Brazil. If only we never discovered the pre-salt reserves. And now a fight between an incompetent government and corrupt politicians to decide who gets to run the mess left behind. It is far from over. Resource curse. It fits.