Petrobras (PBR)

Derivative transactions

SFAS 133 requires that an entity recognize all derivatives as either assets or liabilities in the balance sheet and measure those instruments at fair value. Accounting for derivative transactions requires us to employ significant judgment to arrive at assumptions to compute fair market values which are used as the basis for recognition of the derivative instruments in the financial statements. Such measurement may depend on the use of estimates such as estimated future prices, long term interest rates and inflation indexes, and becomes increasingly complex when the instrument being valued does not have counterparts with similar characteristics traded in an active market.

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In the course of our business we have entered into contracts that meet the definition of derivatives under SFAS 133, certain of which have not qualified to receive hedge accounting. For the majority of these contracts, the estimates involved in the calculations for the fair value of such derivative instruments have not been considered likely to have a material impact in our financial position had we used different estimates, due to the majority of our derivative instruments being traditional over the counter instruments with short term maturities.

However, the estimates and assumptions used are critical to the determination of the mark to market value on one long term gas price contract that was signed in October 2002, with a gas producer and which constituted a derivative financial instrument under the requirements of SFAS 133. This contract was signed in connection with the long term contract to buy gas (“The Gas Supply Agreement” or “GSA”) to supply thermoelectric plants and for other uses in Brazil. The Natural Gas Price Volatility Reduction Contract (the “PVRC”), with maturity in 2019, was executed with the purpose to reduce the volatility of price under the GSA. The volume covered by the PVRC represents approximately 43% of the anticipated volume under the GSA.

Under the PVRC contract we recognize mark to market gains or losses according to the increase or decreases of the derivative’s fair value. Considering that there is no market quotations for natural gas for such a long duration as that of the PVRC, the fair value was calculated based on simulation using a mean reversion model developed by us. The most significant model assumptions at December 31, 2004 include starting prices of crude oil of US$ 39.53 per barrel, an average fuel oil basket (i.e., the price index of the GSA) of US$ 23.58 per barrel and a volatility of crude oil of 25% a.a. Other parameters of the model, including the long run average of crude oil, fuel oil spread to crude, correlations and inflation indexes were estimated based on historical averages.