VZCZCXRO9179
RR RUEHRG
DE RUEHSO #0121/01 0631311
ZNR UUUUU ZZH
R 041311Z MAR 09
FM AMCONSUL SAO PAULO
TO RUEHC/SECSTATE WASHDC 8987
INFO RUEHBR/AMEMBASSY BRASILIA 0142
RUEHRG/AMCONSUL RECIFE 4312
RUEHRI/AMCONSUL RIO DE JANEIRO 9042
RUEHBU/AMEMBASSY BUENOS AIRES 3437
RUEHAC/AMEMBASSY ASUNCION 3684
RUEHMN/AMEMBASSY MONTEVIDEO 2864
RUEHSG/AMEMBASSY SANTIAGO 2684
RUEHLP/AMEMBASSY LA PAZ 4071
RUCPDOC/USDOC WASHDC 3253
RUEATRS/DEPT OF TREASURY WASHDC
RHMFIUU/DEPT OF ENERGY WASHDC
RHEHNSC/NATIONAL SECURITY COUNCIL WASHDC

UNCLAS SECTION 01 OF 04 SAO PAULO 000121 
 
SIPDIS 
SENSITIVE 
 
STATE PASS USTR FOR KDUCKWORTH 
STATE PASS EXIMBANK 
STATE PASS OPIC FOR DMORONSE, NRIVERA, CMERVENNE 
STATE PASS NSC FOR ROSSELLO 
DEPT OF TREASURY FOR LINDQUIST 
DEPT OF ENERGY FOR CGAY, RDAVIS 
 
E.O. 12958: N/A 
TAGS: ECON ENRG EFIN EINV BR
SUBJECT: OUTLOOK FOR BRAZILIAN NATURAL GAS MARKET POSITIVE 
 
REF: 08 Sao Paulo 31 
 
SENSITIVE BUT UNCLASSIFIED--PLEASE PROTECT ACCORDINGLY 
 
¶1.  (SBU) Summary:  Brazil's Congress has passed natural gas 
legislation that would create specific roles for production, 
distribution, and commercialization of natural gas.  The original 
bill, passed by Brazil's lower house in August 2007 and then with 
revisions in the Senate on December 3, clarifies private access to 
Petrobras natural gas pipelines, which should improve the investment 
climate and overall competitiveness of the sector.  The bill is the 
result of intense cooperation across the public and private sector 
and expectations are that the bill will be signed into law by the 
President this year.  This bill comes at a time of falling demand 
for natural gas, (due to a decline in industrial production courtesy 
of the financial crisis and heavy rainfall feeding hydro-electric 
reservoirs reducing the need for gas-fired power plants), as well 
the need to reform the pricing structure of natural gas which 
adjusts much more slowly than oil resulting in market imbalances. 
As a result of this fall in demand, the GOB contemplated a 
significant reduction in natural gas imports from Bolivia, but 
retracted its decision after further consideration of its contract 
terms.  With the current excess supply, as well as potential natural 
gas production from the pre-salt discoveries, Petrobras is analyzing 
the creation of an export platform to transform Brazil into a 
regional natural gas exporter.  End Summary. 
 
Natural Gas Legislation Based on Industry Consensus 
--------------------------------------------- ------ 
 
¶2.  (U) The Government of Brazil (GOB) introduced ordinary 
legislation to differentiate natural gas from petroleum in 2007 and 
was approved by the Chamber of Deputies (lower house) in August 
¶2007.  Debates and revisions ensued until the Senate approved its 
version of the bill on December 3, 2008.  The bill fills a legal gap 
on regulation of natural gas, which was previously addressed as a 
chapter in the Petroleum Law.  The legislation defines the upstream, 
midstream, and downstream functions, as well as pipeline usage, 
construction of LNG terminals, and distribution pipelines. 
Improving the business climate, the bill creates stable rules of 
access for private investors to Petrobras' pipelines that would 
facilitate investments in gas production and transport.  New gas 
pipelines would also be developed via concessions, which would 
provide additional guarantees and increase competition for the 
private sector.  Currently, Petrobras holds a near monopoly over the 
country's existing pipelines and negotiates terms on a case-by-case 
basis, so private investors are hesitant to produce natural gas to 
supply the domestic market. 
 
¶3.  (SBU) One new area of coverage is the inclusion of state-level 
regulators in the process.  Carlos Montagna, Director of Natural Gas 
Supply for Comgas, Brazil's largest gas distributor, told Econoff 
that the lack of clear federal natural gas laws has allowed state 
regulators freedom to interpret the application of federal law.  The 
new legislation defines various consumers, but delegates to 
Brazilian state authorities the ability to segment the market into 
free consumers that could purchase natural gas directly from private 
sector importers or producers, and regulated consumers that must buy 
from a state distributor.  According to Montagna, natural gas 
intensive industrial consumers want to become "free" to buy directly 
from the source to avoid the fees and state taxes associated with 
state distribution agents.  Montagna expects that the Sao Paulo 
market will officially open in 2011, removing the monopoly for 
distribution and commercialization currently held by state 
government distributors.  Montagna told Econoff that Rio de Janeiro 
had already instituted this "free market" program this year. 
 
¶4.  (SBU) Montagna participated in the discussions leading to the 
December vote, where he said the Senate brought together many 
associations and agencies, including Petrobras and the Brazilian 
Association of Natural Gas Distributors (Abegas), to come to a 
balanced result.  Perhaps more delicate, Montagna opined, would be 
the process of reconciling differences between federal and state 
 
SAO PAULO 00000121  002 OF 004 
 
 
laws because it is a federal law but involves state-level 
distribution.  Though Montagna believed the legislation is 
technically unconstitutional because Brazil's constitution grants 
the central government a monopoly over gas transportation (via 
Petrobras), he stated that the legislation as written is preferred 
to none at all. 
 
Pricing Imbalance Remains Problem 
--------------------------------- 
 
¶5.  (SBU) The new legislation will go a long way in improving the 
investment climate for natural gas, but does not correct the 
inefficient pricing structure for natural gas.  Unlike gasoline, 
diesel, and butane, the retail price for natural gas is adjusted 
quarterly.  Montagna explained that this quarterly lag is closer to 
a six month lag on international prices because Comgas' wholesale 
cost for Bolivian gas is readjusted every three months based on a 
basket of petroleum product prices over the previous six months. 
The system creates a sizeable deficit when international oil prices 
have rapid swings and the distributor cannot adjust.  In December, 
Comgas was paying USD 9 per million BTU and selling for USD 7.20 per 
million BTU, which created a deficit of USD 225 million over that 
quarter.  Data from Abegas shows that natural gas prices climbed 40 
percent from September 2007 to 2008, but not enough to cover the 
difference between what Comgas pays and then must charge for natural 
gas.  As a result, the state of Sao Paulo energy and sewage 
regulator (ARSESP) approved an extraordinary price readjustment for 
Comgas and another Sao Paulo distributor in December 2008 for 
industrial, commercial, and vehicular natural gas consumers. 
 
¶6.  (SBU) The current structure also means that despite the decline 
in oil prices, natural gas prices in Brazil do not yet reflect the 
decline in oil prices.  Montagna complained that natural gas prices 
in Brazil are currently uncompetitive, especially with fuel oil, 
which has a much lower price at the moment because it readjusts 
weekly based on oil prices.  Montagna indicated that some of Comgas' 
more flexible industrial customers had started taking advantage of 
lower fuel oil prices.  Montagna expected the substitution to be 
temporary, at least in the state of Sao Paulo (the largest 
industrial natural gas consumer), because the state environmental 
agency is very proactive and industrial customers do not have the 
permits for higher emissions that result from burning fuel oil 
instead of natural gas. 
 
Financial Crisis and Rainfall Slow Demand 
----------------------------------------- 
 
¶7.  (SBU) Demand for natural gas is down by approximately 20 
percent, primarily due to a comparable decline in industrial 
production.  (Note: Industrial production fell by 19.8 percent in 
the last quarter of 2008 compared to the same period in 2007.  End 
Note.)  According to Abegas, Brazil's industrial sector comprised 52 
percent of natural gas consumption in 2008.  Montagna clarified that 
December, January, and February are seasonally lower natural gas 
consumption months, but that the collective furloughs, particularly 
for the pulp and paper and auto industries, have had a profound 
effect on natural gas consumption. 
 
¶8.  (U) In addition to industrial consumers that power directly from 
natural gas, Abegas calculated that gas-fired power plants comprised 
27 percent of natural gas demand in 2008.  Gas-fired power plants 
are turned on during drought periods and to reduce demand for 
hydropower to allow reservoirs to refill.  While the 2008 demand 
increased by 150 percent over 2007 because of low reservoir levels 
for hydroelectric generation, the GOB powered down more than 10 
gas-fired power plants due to ample rainfall so far in 2009.  As of 
the last week of February, reservoir levels nationwide were at 73 
percent of capacity. 
 
Rethinking Bolivia 
------------------ 
 
¶9.  (SBU) Facing a sudden abundance of natural gas at the close of 
 
SAO PAULO 00000121  003 OF 004 
 
 
2008, the GOB announced that Petrobras should cut imports from 
Bolivia by more than a third, sparking Bolivian President Evo 
Morales to immediately send representatives to Brasilia.  Within a 
week, the GOB backtracked on its decision and returned imports to 
approximately 24 million cubic meters per day (MMm3/d).  According 
to press statements, the reduction to 19MMm3/d would have cost the 
Bolivian government USD 600 million in lost revenue from January to 
April.  Despite political pressure, Montagna pointed to the 
take-or-pay contract as the underlying rationale for not reducing to 
their originally announced 19mm3/d.  Under its contract with 
Bolivia, Brazil must buy on average 24.8MMm3/d over the year, and a 
monthly average of no less than 19MMm3/d.  Montagna stated 
decreasing now would only result in an increase later in the year to 
avoid paying for natural gas Brazil did not import, and the decision 
to keep an extra four gas-fired power plants online would put 
approximately 1,000 megawatts into the system. 
 
¶10.  (SBU) Bolivia has limited pipeline capacity to Argentina, its 
only other export market, preventing a dramatic increase in natural 
gas exports there.  For its part, Argentina pays more for Bolivian 
natural gas, but Bolivia had not been meeting its contract terms 
with Argentina for some time.  The La Paz Econoff noted that even if 
Argentina wanted Bolivia to fulfill its contract, the lack of 
progress on expanding the pipeline south remained a bottleneck. 
Without an alternative market, the fiscal impacts of a reduction in 
Brazilian imports on Bolivia's economy would have been devastating. 
Bolivia's tax structure is based on production volumes, and while 
Bolivian states would be anticipating tax revenues at the contracted 
production rate, they would instead receive revenues on actual 
production.  Another bottleneck in Bolivia, limited storage 
capacity, would mean a decline in production without any place to 
store excess production. 
 
Future Demand Growth Likely 
--------------------------- 
 
¶11.  (SBU) Montagna underscored that domestic production and demand 
outlook remained positive despite the recent slump.  He pointed to 
the timeline for the LNG terminals as an example and stated that the 
LNG terminal in the state of Rio de Janeiro should be completed in 
the first half of this year.  Similarly, Montagna told Econoff that 
natural gas development for production at Mexilhao is on track, and 
Tupi and other pre-salt developments are making progress.  The 
environmental licensing that had delayed Mexilhao was resolved, with 
production for this year expected to be about 3 to 4MMm3/d and up to 
8MMm3/d in 2010.  He also pointed to the recently formed group that 
Sao Paulo State has put together, including state level agents that 
should speed up the process of bringing new natural gas discoveries 
on line.  The group was formed in Novembe 2008 and will start 
working in March. 
 
¶12.  (SBU) Comgas has a relatively good picture for future demand 
growth based on requests for incoming supply contracts.  Montagna 
outlined Comgas' revised projections for industrial demand, 
increasing from the 1.5MMm3/d to 6MMm3/d by 2012, a more than 
fourfold increase over current consumption.  Despite the economic 
crisis, Montagna expects Comgas' demand to be stable this year due 
to its emphasis on building residential access.  Comgas last year 
began using a new technology that allows distribution pipelines to 
be installed below sidewalks (versus streets), at two-thirds of the 
cost.  Comgas also offers credit lines for low income residents to 
replace electric showers with gas heaters, which Montagna hopes will 
also expand their residential customer base. 
 
Gearing Up for Exports? 
---------------------- 
 
¶13.  (SBU) Petrobras announced on February 10 its intention to 
invest in infrastructure to become a natural gas exporter. 
According to the press statement, Petrobras' strategy would be to 
liquefy and then stockpile excess natural gas capacity to then 
export to the Southern Cone, United States, and Europe.  According 
to Petrobras' Director of Gas and Energy, Graca Foster, the company 
 
SAO PAULO 00000121  004 OF 004 
 
 
plans to extend its contract with Bolivia which currently expires in 
2019, indicating that Brazil could become an export platform for 
Bolivian natural gas.  These plans include two liquefied natural gas 
terminals and an additional liquefaction plant with an initial 
capacity of 10MMm3/d to be built near the merger of gas pipelines 
from Minas Gerais, Rio de Janeiro, and Sao Paulo states.  Indeed, 
Petrobras engineers told Rio Econoff that the company plans to use 
offshore floating LNG facilities for Tupi and other pre-salt fields. 
 Petrobras' plans to export could provide an additional incentive to 
begin developing these facilities. 
 
Comment 
------- 
 
¶14.  (SBU) The chances that President Lula will sign the new natural 
gas legislation are high given the GOB's interest in pursuing reform 
of the sector.  While the legislation does not treat the issue of 
improving the pricing system for natural gas, this legislation will 
still strengthen the investment climate for natural gas as it 
regularizes access to pipelines and allows the private sector 
greater freedom in setting supply contracts.  This legislation 
should lead to increases in domestic production that will augment an 
already over-supply of natural gas from Bolivia due to lower 
industrial demand and an abundance of rainfall.  These factors will 
position Brazil to begin thinking about its role as a potential 
regional exporter for the additional domestic production that will 
come online from the pre-salt discoveries as well as re-exporting 
imports from Bolivia.  End Comment. 
 
¶15.  (U) This cable was coordinated/cleared by Embassies Brasilia 
and La Paz and with Consulate Rio de Janeiro. 
 
WHITE