Despite the most potent economic boom in a generation, and the massive offshore pre-salt deposits off the coast of Brazil, two factors currently hold back cross-border private project finance opportunities in the countrys oil and gas sectors: the willingness of BNDES, the countrys state-run development bank, to carry so much of the funding burden, and the propensity of sponsors to draw on plentiful foreign sources of corporate debt.

The Brazilian government pumped BNDES full of capital during the crisis of 2008 and 2009 to stave off depression and get the bigger projects going, and Petrobras, the state-owned operator with rights to most of the offshore heavy crude, is finding that it has much better access to cheap debt and equity overseas than it found before.

Petrobras used to do a lot of project financing, says Marcelo Viveiros de Moura, partner in charge of private finance at law firm Pinheiro Neto in Rio de Janeiro. They did all the pipelines and all the major oil field financings through project finance. But today we are not seeing so much done this way, and they are self-financing or going through BNDES. The international corporate financing markets are more attractive at the moment. Thats what were seeing in our practice.

But few believe that either BNDES largesse or the overly favourable debt market conditions will exist forever. There are long-term pressures on both, but there are plenty of opportunities at the margins that will exist even before they change. Most notably, in the construction of rig ships, and in the new Brazilian ship industry, launched at the behest of government prodding.

Despite the challenges, we think offshore Brazil will continue to attract the great majority of the oilfield services industry with potential markets of roughly $17 billion for subsea equipment, $24 billion for SURF and installation, $26 billion for floating production and $37 billion for deepwater development drilling, says Sergio Monaro, head of project finance, Brazil, at HSBC.

Drill-ships drive debt deals

Shipyards will be the main target for new investment for years to come, with lucrative possibilities for well-organised new entrants such as OSX. Competitive financing from BNDES/FMM will help their competitive position versus international yards, as will alliances with several leading Asian players such as Hyundai, Samsung, and Keppel, says Monaro. On the supply chain, established suppliers of key equipment (subsea/drilling equipment, valves, compressors) are already well-placed to manage local content and benefit from future growth. There will certainly be a very positive spillover of the E&P investments done primarily by Petrobras to the whole local supply chain.

Stephen Hood, a partner at Davis Polk in Sao Paulo, says that the proliferation of joint ventures in the oil and gas sectors in Brazil means that project finance opportunities should continue to abound in the short term. He cites the example of Embraport, a project that his firm is working on, which will be used to export ethanol and is owned by Odebrecht and Dubai Ports.

The choice of financing route will depend ultimately on how much the controlling corporation wants on its balance sheet, he says. Like with any project financing, theres some limited sponsor shareholder support going on. But when you have a joint venture like that youre very typically going to see some project finance, because the shareholders dont want it on their balance sheet. That is a phenomenon independent of the international scenario regarding Brazilian credit, Hood says. Very good opportunities exist to make loans to the drilling services companies, including Odebrecht, OGX, Queiroz Galvao, which is very aggressive, and Schahin.

He, though, like Moura, is sceptical that Petrobras will be able to continue to finance all of its needs through corporate debt and the state. It seems to be difficult for Petrobras to do all of that financing at a corporate level. There is the question of whether they can continue to meet all of their needs through a combination of government injection and capital markets. I think they have a preference to do that but the simple scale should make it difficult, says Hood.

Life after BNDES

Brazils government has moved to rein in BNDES activities, as the dictates of pro-cyclical policy finally take hold in Brasilia during an economic boom. And most believe, sooner or later, that interest rates will come up in dollar investor host countries. My feeling is that that the current situation will change, because I dont think you can have BNDES financing everyone and access to cheap money abroad forever, says Viveiros de Moura. Though the companies are getting it today, at a certain point in time there will be a need for structured project financing again.

We [the commercial banks] have the ability to assess projects, says Louis Bazire, at BNP Paribas. But the question is where can we get the funding. Where can I find reais for 10, 15, 20 years? Do we think that some stage that the project bonds market will happen or not in Brazil? People are working hard on it, but first of all, the secondary market for bonds in Brazil is very narrow.

In the years since the unfolding of the financial crisis, large Brazilian companies that can issue corporate bonds abroad have consistently raised records amounts of cash in this way. However, smaller companies forced to rely on real-denominated bonds have little access. At the end of last year, the government and BNDES announced the first of a set of measures to boost the secondary market for real-denominated Brazilian bonds, but this has yet to be effective.

This makes underwriting quite complicated, says Bazire, On the one hand, for banks its quite complicated, you have a firm take, and you have the risk of finding it difficult to sell. On the other side, there are not so many incentives for a pension fund or the usual suspects in this kind of market to buy project bonds, because if you have 30 years of reais in pocket, you can take that to the Treasury. The first step is having the vanilla bond market getting more fluid, in reais, which is more important. Odebrecht is doing much more of its financing in dollars, where bond markets for its kind of credit are very liquid.

The Brazilian government wants more and more built in Brazil, this will lead sponsors to switch from dollars to reais, says Bazire. Petrobras has a strong funding base in reais. Will Petrobras choose to finance those projects or do the acquisitions in reais or in dollars? The Brazilian government has placed local production restrictions on potential vessel operators to help the budding shipping industry, limiting the type of cross-border procurement that will take place. But they cant all be built in Brazil, says Hood. Some will be, some will be built in Korea and Singapore mainly, and some in Abu Dhabi as well.

Monaro lists the 70%+ local content requirements and what they imply for construction costs, alongside long-term funding concerns and technological hurdles as the three main challenges facing oil and gas in Brazil in the coming years. The minimum local content tends to add more complexity to the current financing structures, which have been so far primarily based on international funding. Further in-depth analysis will be needed to assess the pre-completion risks, especially those related to cost overruns and delayed start ups, on the local shipyards, says Monaro. From a financial point of view, BNDES (and local commercial banks) should also play a critical role in the financing of local content, which will also entail additional work on tying up the various elements of the security package under an inter-creditor agreement with traditional lenders such as ECAs and international banks.

The most recent notable deals for HSBC have been a $1.5 billion bond for Odebrechts Norbe VII & IX, a $575 million bank loan for Queiroz Galvaos Alpha Star, the $1.05 billion bank loan for Odebrechts ODN 1 & 2, a $470 million bank loan for Odebrechts ODN Tay. It is also working on a $700 million project bond for two unnamed mid-water drillships.

In the ultra-deep water space, most of the projects have been financed in the international bank loan market (usually under an ECA-covered tranche), given their greenfield nature and associated pre-completion risks. So far the contractors have been international reputable shipyards, which also can count on additional refund guarantees, such as the ones provided by the Korean agencies. Post-completion, most of these projects can be refinanced in the international capital markets through project bonds, which represent another important alternative to funding at competitive rates, Monaro says.

Mid-water units are rarely newbuilds and are mostly financed based on historical track record of performance. These units are usually updated/enhanced to meet the technical requirements of charterers. Given their lack of completion risk, project bond structures can really be considered an important source of refreshed refinancing for the older bank loan alternative, he says.

Hood, who has just joined David Polk from Mayer Brown, and is currently based in New York, sees a long upward curve and is likely to return to So Paulo soon. Theres a limited number of banks these days that seems to have the appetite for project finance. The limited number and the limited amount that banks can provide will stimulate more project bonds.

Banks dominate the end of the wave

But bank loans, with heavy ECA presence, still predominate. Recent deals in oil and gas include Petroservs closing of the $720 million debt financing for its Catarina ultra-deepwater semi-submersible drill-ship, which has a 10-year charter with Petrobras. The deal, which closed in July, included a $460 million ten-year commercial bank tranche arranged by Banco Itau-BBA (co-ordinator), ING, Santander, Socit Gnrale, Standard Chartered and WestLB. Rounding out the debt total were two $130 million direct loans from Kexim and Giek/Eksportfinans. The ship is being built in South Korea and is scheduled for delivery in 2010.

Petrobras has been the source of two recent financings for floating production, storage, and offloading vessels. In July, a consortium led by SBM closed a $1 billion financing for the Cidade de Paraty FPSO. The debt has a tenor of ten years and what SBM calls competitive pricing. The sponsors of thevessel are SBM Offshore (50.5%), Queiroz Galvao Oleo e Gas (20%), Nippon Yusen Kabushiki Kaisha (17.5%) and Itochu (12%), The venture holds a charter for a field in the Santos Basin, operated by a joint venture of a joint venture of Petrobras (65%), BG Group (25%) and Galp (10%).

The mandated lead arranger group includes bookrunners ABN Amro, DNB-Nor, Mizuho, Natixis, SMBC, and Standard Chartered, ING Bank as co-ordinator, BTMU as facility agent, Rabobank as documentation agent, CIC, DBJ and Nordea. And, Guara MV23 a Netherlands-based company set up by MODEC, Mitsui & Co. and Mitsubishi Corporation closed an $812 million 12-year facility with BTMU and SMBC to back construction of anFPSOto service the Guara field offshore Brazil for Petrobras, BG and Repsol Sinopec. JBIC is providing $487.2 million. SMBC and BTMU, as coordinating banks, are providing $82.4 million each. ING and Mizuho also took $55 million each and Societe Generale provided $50 million.

Despite the possibility of a consumer credit crunch in Brazil, and risks of overheating leading to inflation, most analysts view Brazil as long-term growth positive, especially because of the existence of the offshore oil projects. GDP grew by 7.6% in 2010 and is expected to grow at a slower, but healthier, pace this year.