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The World's Most Exciting Market – Until They Spoiled it

Over the past year, Brazil has established itself as one of the most exciting markets in the world for investors. Its Bovespa stock index is up 55% this year. And the discovery of the huge new Tupi oil field off its east coast has led some investors to refer to Brazil as the "New Saudi Arabia."

Brazil had clearly become the new "must-play" market for investors.

And then they had to go and spoil it all.

As promising a market as Brazil had become, it was the discovery of the massive Tupi oil field off of the country's east coast – that really transformed Brazil into an investor's dream. The oil and natural-gas reserves are located beneath heavy salt beds in deep offshore water. These reserves are 23,000 feet to 26,000 feet down, a depth that wasn't even accessible until recently.

These Tupi reserves appear to contain at least 60 billion barrels of oil, worth $4 trillion at today's prices. Tupi oil is expected to start hitting the market in 2011 or 2012. When that happens, it will revolutionize Brazil's economy and its shift its balance of payments.

The exploration of the Tupi oil fields had been carried out by the Brazilian oil company Petroleo Brasileiro SA (NYSE ADR: PBR) – more commonly referred to as Petrobras – in partnership with some of the international majors. The contracts call for the Brazilian government to receive royalties on any oil found.

Brazil is now one of only three top oil-producing countries to not assert state ownership of its oil reserves. Canada and the United States are the others.

This was very reassuring for the international oil majors. They're used to dealing with fruitcake kleptocratic regimes in Venezuela, Angola, Nigeria and most of the Middle East. As a result, the Tupi deposits generated real excitement both among oil companies and among international investors in general. The feeling was that Brazil was about to end its two centuries of failed economic hopes. Fueled by oil revenue and additional economic activity, Brazil appeared ready to claim its true destiny as a wealthy country.

Unfortunately, it wasn't to be.

Although there are several reasons for this, a key culprit is the election scheduled for next year. Incumbent Brazilian President Luis Inacio "Lula" da Silva can't run again. But he'd very much like to choose his successor. The most likely candidate: current Chief of Staff Dilma Rousseff.

Rousseff was put in charge of devising a scheme to capture more of the Tupi oil revenues for the Brazilian government and, nominally, the Brazilian people. Tales were spun of how the new revenue would finally eliminate Brazilian inequality, and bring its poorest citizens up to Western living standards.

The new system announced this month reflects this aspiration. A new state oil company, Petrosal, would be created to manage the reserves. Petrobras – aided by outside investor capital – would carry out production. And Petrosal and the outside investors would share the output.

This plan will imbue Petrosal with a lot of power. The company would control half the votes on the operating consortium. And it would have veto rights over production and capital expenditures.

The revenue would be managed by a new state fund. The fund would devote this new cash to poverty relief, education and infrastructure.

In the meantime, the existing royalty system would remain in place. Under this system, outside investors would pay both royalties and a production share. In one acknowledgement of marketplace realities, concessions already granted would not be torn up.

There are two major problems with this system. First, it makes life much more difficult and less profitable for oil companies wanting to invest in the Tupi oil field. Had Brazil torn up existing contracts, I believe the oil majors would have left. In the past two years, the world's Big Oil firms already saw existing agreements torn up in Nigeria and Venezuela. There's just no point investing large amounts of money under such risky conditions.

As it is, the new Brazil agreement applies only to new contracts. So I believe the oil companies will probably put up with this new system – at least as long as oil prices remain high. It's not as if these firms have a lot of alternatives right now.

However, given how expensive it will be to extract this oil, if market prices drop, it may end up being difficult to attract Big Oil players.

The more dangerous problem is this fund, which is little more than a huge pool of money that politicians can play with.

As I mentioned, Brazil's economy has been one of the world's best performers. This year, in the face of a worldwide recession, Brazil's gross domestic product (GDP) is expected to decline only 1%, according to the forecasting panel of The Economist magazine.

Inflation is 5% and the budget deficit is only 2.8% of GDP – both excellent figures in this difficult year. Brazil's monetary policy is an example to the world, with short-term interest rates still at 8.65%, well above the inflation rate.

But this money pool plan puts that performance at risk.

Brazilian public spending is already 35% of GDP, very high for such a poor country. State bureaucrats have feather-bedded contracts guaranteed to them under the 1988 constitution. So this "slush fund" will just fuel Brazilian corruption, diverting still more of that country's economy into the pockets of politicians, their friends and favoured interest groups.

It's no use for Brazilian spin-doctors to point out that Norway and Alaska have funds of this nature. Norway and Alaska have small populations and relatively un-corrupt political cultures. This fund must inevitably represent at least 3%-5% of Brazilian GDP. And it will be mostly wasted, spent without the market having any say as to its use or destination.

I've been watching Brazil for more than 30 years; since I began travelling there for the merchant bank Hill Samuel [now part of Lloyd's Banking Group PLC (NYSE ADR: LYG)] in the late 1970s. It's a maddening country: Just when you think the Brazilian authorities have finally got their act together, and that the country is ready to achieve the enormous economic growth predicted for it since at least 1900, something unexpected and foolish goes wrong.

This appears to have happened again. And that's a real pity – for Brazil's citizens, and for global investors.

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The Permanent Wealth Investor assembles high-yielding dividend stocks, profit plays on gold and specially designated "Alpha-Bulldog" stocks into high-income/high-return portfolios for savvy investors. Hutchinson's strategy is tailor-made for periods of market uncertainty. But the real beauty of this approach is that it can work in any kind of market – even those dominated by the bulls or the bears.

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  1. Tomás Rosa Bueno | September 17, 2009

    Dear Martin,

    you forgot to mention that the existing royalty-paying scheme was based on *risk*: we don't know whether there's any oil down there. If you want us to drill and find out, at the risk of drilling a dry well, we'll do it, at a price. The risk is ours, the bigger share of profits should be ours too.

    There's no risk involved in subsalt drilling. The thing is practically a 500 x 80 miles lake of oil. Anywhere you drill you'll hit oil. Therefore, there's no reason to keep giving the bigger share of the profits to companies which will not be risking anything.

  2. Government=Politicians not 'the people' or 'the poor' | September 18, 2009

    This scam of having government intervention in the economy to help the poor has been exploited for decades by socialist-democrat-populist politicians to lever political power in their favor, this has been demonstrated several times in serveral scenarios by history to have lead these countries with a lot of 'poor people' to be poorer if not poorest, this system based on 'politics in the name of the poeple or poor' has, does not and will never work to generate wealth or 'common wealth'. The thing is that the poor keeps voting for this socialist scam…I guess the 'poor' is not that smart huh..

  3. Bob Lundy | September 19, 2009

    Totally agree with #2 comment above. Note that none of these socialist-left leaning countries were as poor as China after the Cultural Revolution. Good thing their government didn't allow poor voters to elect the politicians. Ultimately the government wised up and went capitalistic, and look at where they are now. Even the Chinese are trying to teach proper Capitalism to Mr. Obama!

  4. Kevin Beck | October 1, 2009

    This sounds just about par for the course: A major stream of riches is available for the citizens of the country, and the government has to stick its nose in the middle and muck it all up. If only they would learn….

  5. sage | October 8, 2009

    alot of sour grapes in the comments here – typical of the north atlantic anglo-judeo populace.

    also, martin is full of bais & shit.

    finally, the govt. of alaska non-corrupt – my ass, lol

    suck on eggs you monkeys. the oil is ours, you're welcome to assist in it's development for a fee/compensation consumerate w/ your effort & risk. dont like it, go to russia. pradators not welcome.


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