LONDON, June 27 The scale of Brazil's offshore oil reserves should be bringing a bonanza to service and equipment companies. Instead, dominant national company Petrobras' negotiating tactics and government demands are combining to squeeze industry margins.
Oil service companies - suppliers of everything from rigs to teams of engineers - cite issues in Brazil for contributing to a spate of earnings disappointments. The trend continued on Thursday as Subsea 7 warned it will miss its 2013 profit forecast due to cost overruns on its Brazil project.
"Certainly Brazil for many players this year has been softer than they had expected," Glynn Williams, partner at oil services private equity fund Epi-V, told Reuters.
There are unique difficulties of doing business in Brazil, Subsea 7 Chief Executive Jean Cahuzac said in explaining cost increases of between $250 million and $300 million at its Guará-Lula project, offshore Brazil.
"It is partly due to the project, but to a great extent it is due to the Brazilian environment," he said. "It's more difficult to work in Brazil, it's a more complex situation because of local content, the administration ... the tax."
Yet the scale of Brazil's offshore oil and gas ambitions make it a hard place for international contractors to ignore.
The country's giant 2006 oil discovery, where Petrobras is principle operator, hailed a rush into Latin America's largest economy by oil service companies, whose expertise and equipment allows oil companies to explore and develop fields.
Some 27 percent of all deep- and ultra-deep offshore wells drilled in the last two years were in Brazil, according to data from research company IHS.
So for European contractors such as Subsea 7, Saipem , Aker Solutions and Technip, offshore Brazil has become a crucial operating centre, accounting for 15 percent of Subsea 7's first-quarter revenue, for example.
But in recent months, companies which grew fat on years of strong oil prices in which drillers fell over each other to secure their scarce services, have found themselves facing tight-margin contracts in which they carry a large chunk of operational risk.
Strict local content rules and a rapid increase in labour costs have also taken their toll.
Saipem, Aker and Subsea 7 have issued profit warnings this year, with Brazilian activities partly to blame.
At the end of last year, Petrobras vowed to cut costs by 32 billion reais ($15.4 bln) between 2013 and 2016, responding to a decline in output, a government fuel-price freeze, soaring prices for offshore projects and rising debt.
The net effect was to put at risk its $237 billion five-year investment plan, the world's largest corporate spending program.
Yet Petrobras remains dominant in Brazilian drilling as it is responsible for 90 percent of the country's offshore output. That gives it a strong hand when it comes to negotiations.
Petrobras demands an additional discount from suppliers who have already offered the most competitive price through a tender process, an industry source told Reuters.
"When pricing material some percentage has to be added on for the discount they will always ask of the bid winner, even though it's a bid where the lowest price wins," said the source who spoke to Reuters on condition of anonymity.
The source said Petrobras had also been cutting back on new projects. "Now that they are out of money ... Petrobras has cancelled and postponed new opportunities, even the small ones".
In a statement, Petrobras outlined how suppliers compete for contracts, but did not comment on whether it asks for discounts on top of a price proposed in the tendering process.
Neither did Petrobras say whether its stance towards contractors had shifted since it launched its cost-saving drive.
"In our management of suppliers, we encourage the technological development of the companies in a manner that meets the demands of Brazilian industry," the company said.
Recent pressures on oil service companies are a contrast with previous times, when data shows investors believe they have captured much of the value from the strong oil price.
The Thomson Reuters global oil services index performed twice as well as the Dow Jones index of the world's top 30 oil companies over the past three years, rising some 53 percent compared with 27 percent.
But this year the services sector has been shaken by a number of disappointments.
Saipem's two profit warnings in the past six months have wiped out 12 billion euros ($15.5 billion) of shareholder value since the stock peaked in September 2012.
Norway-based Aker also warned of lower profits due to cost overruns and project delays and has seen its stock slump by a third this year.
Investors and analysts highlight issues in working and negotiating with Petrobras, whose debts of $97 billion make it one of the world's most indebted publicly listed companies.
"It's much easier in Brazil to get into a confrontational relationship with Petrobras if you're not careful, because they do not have the ability to react so fast to changes of scope," said Charles Whall, energy portfolio manager at Investec Asset Management, referring to the way demands of a project may change as it is carried out.
One issue is the sharing of risk, with Petrobras eager to shift responsibility for operational issues on to the contractor, industry insiders say - a key issue given the depth and geological complexity of Brazil's "subsalt" oil deposits, where work can be unpredictable and contractors have been more exposed to risks than in other areas of the world.
Subsea 7 said sharing the risk of deepwater subsalt projects with Petrobras was different to other similar projects around the world and said it will not add orders until a new business model can be negotiated with Petrobras.
"This (working in the subsalt) is all on the forefront of technology in terms of water depths ... and there has been some learning curve, the cost of which has not been equitably distributed between contractor and operator," Whall said.
A lack of other growth markets has created fierce competition in recent years for European oil services companies.
While U.S. firms Schlumberger and Halliburton Co have been tied to the growth of shale in the United States, European contractors have been left battling for work in places like West Africa and Brazil where most new opportunities have been found.
"If you haven't got the right contracts in West Africa, if you haven't been in the first wave of Brazilian contracts, then you've really suffered relative to the rest," Whall said.
The other problem has been strict local content regulation, exacerbated by the rising cost of labour, particularly among engineers and other skilled oil services jobs.
Aker CEO Per Harald Kongelf partly blamed local content rules for disappointing first-quarter earnings.
But as one of the remaining high-growth markets, contractors will find it difficult to pull out, according to Bob Fryklund, energy analyst at IHS.
"Brazil is still top of the heap right now," he said.
($1 = 0.7637 euros) (Additional reporting by Jeb Blount in Rio de Janeiro; Editing by Andrew Callus and David Holmes)