SELECTED FINANCIAL AND OPERATING INFORMATION

S-25

(1)           Pre-tax.

OPERATING AND FINANCIAL REVIEW AND PROSPECTS

You should read the following discussion of our financial condition and results of operations together with our Audited Financial Statements, which can be found in our Report on Form 6-K furnished to the SEC on February 26, 2014 and our related amendment on Form 6-K/A furnished to the SEC on March 10, 2014, which are incorporated by reference in this prospectus supplement.   

Overview

We earn income from:

·          domestic sales, which consist of sales of oil products (such as diesel, gasoline, jet fuel, naphtha, fuel oil and liquefied petroleum gas), natural gas, ethanol, electricity and petrochemical products;

·          export sales, which consist primarily of sales of crude oil and oil products;

·          international sales (excluding export sales), which consist of sales of crude oil, natural gas and oil products that are purchased, produced and refined abroad; and

·          other sources, including services, interest income from investments, share of profit of investees, foreign exchange variation and inflation indexation gains on financial instruments.

Our expenses include:

·          costs of sales (comprised of direct labor expenses, operating costs and purchases of crude oil and oil products); property, plant and equipment maintenance and repairs; depreciation and amortization of fixed assets; depletion of oil fields; and oil and gas exploration costs;

·          selling (which include expenses for transportation and distribution of our products), general and administrative expenses;

·          research and development and other operating expenses; and

·          interest expense, inflation indexation and foreign exchange variation losses on debt and other financial instruments.

Fluctuations in our financial condition and results of operations are driven by a combination of factors, including:

·          the volume of crude oil, oil products and natural gas we produce and sell;

·          changes in international prices of crude oil and oil products (denominated in U.S. dollars);

·          related changes in the domestic prices of crude oil and oil products (denominated in reais) ; 

·          the demand for oil products in Brazil and the amount of imports required to meet the domestic demand;

·          fluctuations in the Brazilian real (the “ real ”) vs. U.S. dollar exchange rates and, to a lesser degree, other currencies, as set out in note 34.2.2 (c) to our Audited Financial Statements; and

·          the amount of production taxes from our operations that we are required to pay.

The profitability of our operations in any particular accounting period is related to the sales volume of, and prices for, the crude oil, oil products, natural gas and biofuels that we sell and the relationship of these prices to international prices.  Our consolidated net sales in 2013 totaled approximately 1,384,616 thousand barrels of crude oil equivalent, representing U.S.$141,462 million in sales revenues, compared to 1,385,917 thousand barrels of crude oil equivalent, representing U.S.$144,103 million in sales revenues in 2012, and 1,355,309 thousand barrels of crude oil equivalent, representing U.S.$145,915 million in sales revenues in 2011.

As a vertically integrated company, we process most of our crude oil production in our refineries and sell the refined oil products primarily in the Brazilian domestic market.  Therefore, the price of oil products in Brazil has a more significant impact in our financial results than crude oil prices.  International oil product prices vary over time as the result of many factors, including the price of crude oil.  Over the long term, we intend to sell our products in Brazil at parity with international product prices, however we do not adjust our prices for gasoline, diesel and certain other oil products to reflect short-term volatility in the international markets.  As a result, our downstream margins may be significantly different than those of other integrated international oil companies within a given financial reporting period due to material rapid or sustained increases or decreases in the international price of crude oil and oil products, or in the real  vs. U.S. dollar exchange rate.

The average prices of Brent crude, an international benchmark oil, were approximately U.S.$108.66 per barrel in 2013, U.S.$111.58 per barrel in 2012 and U.S.$111.27 per barrel in 2011.  In December 2013, Brent crude oil prices averaged U.S.$110.81 per barrel. However, due to the devaluation of the real  throughout the year of 2013, the average price of the Brent crude, when expressed in reais , went from R$217.47 per barrel during 2012 to R$234.52 per barrel during 2013.

In November 2011, we announced price increases at the refinery gate (the wholesale price we sell to distributors) of 10% for gasoline and 2% for diesel to partially adjust to higher international oil product prices. During 2012, we announced further price increases at the refinery gate totaling 7.8% for gasoline and 10.2% for diesel when compared to December 31, 2011 prices. The effect of these price increases to retail customers was partially offset by the reduction by the Brazilian federal government of the CIDE tax rate for gasoline and diesel, that currently is reduced to 0% for both oil products. During 2013, we announced further price increases at the refinery gate totaling 10.9% for gasoline and 19.6% for diesel when compared to December 31, 2012 prices.

                In November 2013, our board of directors announced our diesel and gasoline pricing policy. Such policy aims at achieving the following principles and objectives:

·          Ensure that our indebtedness and leverage ratios return to the limits established under our 2013 - 2017 Business and Management Plan no later than December 2015, considering the growth of our oil production and the application of our diesel and gasoline pricing policy;

·          Achieve, in a compatible time period, an alignment between Brazilian and international diesel and gasoline prices; and

·          Prevent transferring the volatility of diesel and gasoline international prices to the domestic consumer.

During 2013, approximately 75.3% of our sales revenues were derived from sales of oil products, natural gas and other products in Brazil, compared to 69.7% in 2012 and 67.8% in 2011.          

(1)   Net average price calculated by dividing sales revenues by the volume for the year.

Effect of Taxes on Our Income

In addition to taxes paid on behalf of consumers to federal, state and municipal governments, such as the Domestic value-added tax ( Imposto sobre Circulação de Mercadorias e Serviços , or ICMS), we are required to pay three principal charges on our oil production activities in Brazil: royalties, special participation and retention bonuses.

These charges imposed by the Brazilian federal government are included in our cost of goods sold. In addition, we are subject to tax on our income at an effective rate of 25% and a social contribution tax at an effective rate of 9%, the standard corporate tax rate in Brazil. 

For further information related to income taxes, other taxes payable, deferred income taxes and a reconciliation between income taxes calculated by applying a statutory tax rate and our tax expense, see note 21 to our Audited Financial Statements.

Exchange Rate Variation

Our functional currency is the real  and our presentation currency is the U.S. dollar. Therefore, we maintain our financial records in reais , and translate our financial statements into U.S. dollars for presentation purposes based on the average exchange rates prevailing during the period or at the balance sheet date, pursuant to the criteria set out in IAS 21 – “The effects of changes in foreign exchange rates.”

When the real appreciates relative to the U.S. dollar the effect is to generally increase both revenues and expenses when expressed in U.S. dollars.  When the real  depreciates relative to the U.S. dollar the effect is to generally decrease revenues and expenses when expressed in U.S. dollars.

From 2003 to 2011, considering the average exchange rates prevailing throughout the year, the U.S. dollar depreciated against the real  each year, except for 2009. In 2013, the U.S. dollar appreciated 10.4% against the real , compared to an appreciation of 14.3% in 2012 and a depreciation of 5.1% in 2011.

Fluctuations in exchange rate have multiple effects in our results of operations in reais . The relative pace at which our total revenues and expenses in reais  increase or decrease with the exchange rate, and its impact upon our margins, is affected by our pricing policy in Brazil.  When the real appreciates against the U.S. dollar and we do not adjust our price in Brazil, our margins generally improve. When the real  depreciates against the U.S. dollar and we do not adjust our prices, margins generally decline.

                The foreign exchange variations on foreign-denominated assets and liabilities of entities for which the real  is the functional currency are recorded in profit or loss, while the foreign exchange variations on the translation of foreign subsidiaries are recognized in other comprehensive income in shareholders’ equity. As our net debt denominated in other currencies increases, the negative impact of a depreciation of the real  on our results and net income when expressed in reais  also increases, thereby reducing the earnings available for distribution. Note 32.2.2(c) to our Audited Financial Statements provides further information on our foreign exchange exposure related to assets and liabilities.

                Effective mid-May 2013, we designated cash flow hedging relationships in which (a) the hedged items are portions of our highly probable future monthly export revenues in U.S. dollars, (b) the hedging instruments are portions of our long-term debt obligations denominated in U.S. dollars, and (c) the risk hedged is the effect of changes in exchange rates between the U.S. dollar and Petrobras’ functional currency, the real . Both long-term debt obligations (hedging instruments) and future exports (hedged items) are exposed to the Real/U.S. dollar foreign currency risks at their respective spot exchange rate. Cash flow hedge accounting permits that gains and losses arising from the effect of changes in the foreign currency exchange rate on the hedging instruments not be immediately recognized as profits or losses, but rather in other comprehensive income in shareholder’s equity and then reclassified from equity to profit or loss in the periods during which the hedged transactions occur. See notes 3.3.6 and 34.2.2 to our Audited Financial Statements for further information about our cash flow hedge.

            To the extent that our indebtedness in long-term debt obligations denominated in U.S. dollars continues to increase, we will only be able to create additional cash flow hedging relationships with such additional debt if we are capable of increasing our production, and subsequently, our highly probable future monthly export revenues in U.S. dollars.

Exchange rate variation also affects the amount of retained earnings available for distribution by us when expressed in U.S. dollars.  Amounts reported as available for distribution in our statutory accounting records are calculated in reais  and prepared in accordance with the IFRS and they may increase or decrease when expressed in U.S. dollars as the real appreciates or depreciates against the U.S. dollar.                  

RESULTS OF OPERATIONS

The differences in our operating results from year to year occur as a result of a combination of factors, including primarily: the volume of crude oil, oil products and natural gas we produce and sell; the price at which we sell our crude oil, oil products and natural gas and the relationship of this price to the international prices; the level and cost of imports and exports needed to satisfy our demand; production taxes; and the differential between Brazilian and international inflation rates, adjusted by the depreciation or appreciation of the real  against the U.S. dollar.

The table below shows the amount by which each of these variables has changed during the last three years.  Production volumes presented in this table are prepared in accordance with Society of Petroleum Engineers (SPE) criteria, which are the criteria we apply to analyze our operating results:

(1)   Non-consolidated companies in Venezuela and, as from June 2013, companies in Africa, as set out in note 10 to our Audited Financial Statements.

(2)   Amounts were converted from bbl to cubic feet in accordance with the following scale: 1 bbl = 6 cubic feet.

(3)   Based on year-end exchange rate (U.S.$/ real ).  

(4)   Based on average exchange rate for the year (U.S.$/ real ). 

Virtually all of our revenues and expenses for our Brazilian operations are denominated and payable in reais . When the U.S. dollar strengthens relative to the real , as it did in 2013 and 2012 (with an appreciation of 10.4% and 14.3%, respectively), revenues and expenses decrease when translated into U.S. dollars. The appreciation of the U.S. dollar against the real  affects the line items discussed below in different ways. As a consequence, the following comparisons between our results of operations in 2013 and in 2012, and between our results of operations in 2012 and 2011, are impacted by the depreciation of the real  against the U.S. dollar during that period. See note 2 to our Audited Financial Statements for the year ended December 31, 2013, for more information about the translation of real  amounts into U.S. dollars.                                                                                          

Results of operations—2013 compared to 2012

Sales Revenues

Sales revenues decreased by 2% to U.S.$141,462 million from U.S.$144,103 in 2012, driven primarily by foreign currency translation effects (the appreciation of the U.S. dollar against the real ). Excluding foreign currency exchange effects, local currency sales revenues increased by 8%, primarily driven by:

·       Higher oil product prices in the domestic market mainly derived from adjustments in gasoline and diesel prices, higher electricity prices and impact of the appreciation of the U.S. dollar (10%) on oil product prices that are adjusted to reflect international prices;

·       A 4% increase in domestic oil product sales volumes, mainly of diesel (5%), gasoline (4%) and fuel oil (17%), offset by lower crude oil export volumes (43%), attributable to lower production levels and higher feedstock processed.

Cost of Sales

Cost of sales increased by 1% to U.S.$108,254 million from U.S.$107,534 million in 2012, due to:

·       A 4% increase in domestic sales volumes of oil products, met by higher oil product output from our refineries;

·       An increase in natural gas imports volumes to meet thermoelectric demand and higher crude oil import volumes attributable to the increase in feedstock processed in our refineries, along with the impact of the appreciation of the U.S. dollar on our unit costs;

·       Increased crude oil production costs, attributable to the higher number of well interventions and to the production start-up of new systems, which are still not producing in full capacity;

·       Excluding foreign currency translation effects, the local currency cost of sales was 11% higher in 2013.

Selling Expenses

Selling expenses were relatively flat in 2013 (U . S.$4,904 million) when compared to 2012 (U.S.$4,927 million) expressed in U.S. dollars. Excluding foreign currency translation effects, local currency selling expenses were 10% higher in 2013, primarily as a result of higher freight expenses, driven by increased domestic sales volumes.

General and Administrative Expenses

General and administrative expenses decreased by 1% to U.S.$4,982 million in 2013 from U.S.$5,034 million in 2012. Excluding foreign currency translation effects, local currency general and administrative expenses increased by 9%, mainly as a result of higher employee compensation expenses arising from the 2012 and 2013 Collective Bargaining Agreements.

Exploration Costs

Exploration costs were 26% lower in 2013 (U.S.$2,959 million) when compared to 2012 (U.S.$3,994 million), primarily due to lower write-offs of dry or sub-commercial wells. A breakdown of exploration costs by nature is set out in note 15 to our Audited Financial Statements.                                                                                                

Research and Development Expenses

Research and development expenses remained relatively flat in 2013 (U.S.$1,132 million) when compared to 2012 (U.S.$1,143 million).

Other Operating Income and Expenses

The 47% decrease in our net other operating expenses in 2013 when compared to 2012 (U.S.$ 2,237 million vs. U.S.$4,185 million) is attributable to gains on disposal of assets, including the disposal of 50% of our interest in assets in Africa and of block BC-10, as set out in note 10 to our Audited Financial Statements.

Net finance income (expense)

Net finance expense was U . S . $2,791 million in 2013, a U . S . $865 million increase compared to 2012, resulting from:

·        Lower finance income compared to 2012, when we benefited from the positive impact of gains on disposal of government bonds (National Treasury Notes – B Series) and interest income over judicial deposits (U . S . $1,280 million);

·        Higher finance expense due to higher debt; and

·        The settlement of certain of our tax debts and disputes through our participation in the federal tax settlement program (REFIS).

The increase in net finance expense was partially offset by lower exchange variation losses (U . S . $1,636 million) attributable to the extension of our cash flow hedge accounting, reducing by U . S . $5,924 million the impact of foreign currency effects on our finance expenses. For further information about our cash flow hedge accounting, see notes 3.3.6 and 34.2.2 (a) to our Audited Financial Statements.

Income taxes

Income taxes were U.S.$984 million lower in 2013, when compared to 2012, due to the lower income before taxes and the impact of different jurisdictional tax rates applied for companies domiciled abroad, attributable to the disposal (and loss of control) of assets in Africa.

Exploration and Production

Exploration and Production (E&P) net income decreased by 17% in 2013, when compared to 2012, primarily due to a decrease in crude oil and NGL production (2%) resulting from the natural decline of fields (slightly offset by the production start-up of new systems), higher equipment depreciation costs, increased freight costs for oil platforms, higher employee compensation costs and higher well interventions and maintenance costs.

Higher domestic crude oil prices (sale/transfer, when expressed in reais ), lower write-offs of dry or sub-commercial wells and a gain on the disposal of our total interest in block BC-10 partially offset this decrease in net income.

The spread between the average domestic oil price (sale/transfer) and the average Brent price increased to U.S.$10.47/bbl in 2013 from U.S.$6.98/bbl in 2012.

Refining, Transportation and Marketing

Refining, Transportation and Marketing (RTM) purchases crude oil from E&P and imports oil to blend with our domestic oil.  Additionally, RTM purchases oil products in the international markets to meet excess product demand in the domestic market.  Those purchases are made at international prices, either from E&P or from international markets, and the products are sold in Brazil at a price that we expect will converge to international prices in the long run. For some of our products, mainly gasoline, diesel and residential LPG, however, the prices in Brazil can lag the international markets. Depending on the impact of this lag effect, RTM’s earnings may differ from international refining margins.

In 2013, our RTM segment net losses decreased by 30% when compared to 2012, reflecting the diesel and gasoline price adjustments in the domestic market beginning in June 2012, and the higher feedstock processed in our refineries, reducing the share of oil product imports in our sales mix, partially offset by higher crude oil acquisition/transfer costs (when expressed in reais ). 

Gas and Power

Our Gas and Power segment net income decreased by 27% in 2013 due to higher LNG and natural gas import costs necessary to meet higher thermoelectric demand. This decrease was partially offset by higher thermoelectricity generation and higher average electricity prices, mainly attributable to lower water reservoir levels of hydroelectric power plants located in Brazil (caused by low rainfall), and thus increased difference settlement prices.

Biofuel

Biofuel net losses increased by 4% in 2013, driven by lower biodiesel average sales prices (which fell by 11% compared to 2012). These net losses were partially offset by a decrease in our share of losses from ethanol investments, attributable to increases in ethanol, electricity and sugar sales volumes, as well as the higher average sales prices of ethanol and electricity.

Distribution

Our Distribution segment net income decreased by 4% in 2013 compared to 2012. Excluding foreign currency translation effects, local currency net income for our distribution segment increased due to a 7% increase in the average trade margins and a 4% increase in sales volumes. This increase was partially offset by higher selling and administrative expenses.

Distribution sales volumes increased in the fourth quarter of 2013, however we lost market share in 2013 (37.5%) when compared to 2012 (38.1%) due to a shift in our sales mix in order to achieve higher margins.

International

Our International segment net income increased by 140% due to gains on disposal of assets in accordance with PRODESIN, our divestment program, mainly in Africa and in the United States, and to the recognition of tax credits in the Netherlands. Lower exploration costs and write-offs of wells also had a positive impact. This net income increase was partially offset by lower crude oil and NGL production.

See note 30 to our Audited Financial Statements for further information regarding our business segments.

Results of operations—2012 compared to 2011

                A comparison of our 2012 and 2011 results of operations can be found in our annual report on Form 20-F for the year ended December 31, 2012, filed with the SEC on April 29, 2013 and incorporated by reference herein.

The Brazilian Ministry of Planning, Budget and Management controls the total amount of medium and long-term debt that we and our Brazilian subsidiaries can incur through the annual budget approval process.  Before issuing medium and long-term debt, we and our Brazilian subsidiaries must also obtain the approval of the National Treasury Secretariat.  Borrowings that exceed the approved budgeted amount for any year also require approval of the Brazilian Senate.  All of our foreign currency denominated debt, as well as the foreign currency denominated debt of our Brazilian subsidiaries, requires registration with the Central Bank.    

However, the issuance of debt by our non-Brazilian subsidiaries, including PifCo and PGF, is not subject to registration with the Central Bank or approval by the National Treasury Secretariat. All issuances of medium and long-term notes and debentures require the approval of our board of directors.

Sources of Funds

Our Cash Flow

In 2013, the resources needed to fund our capital expenditures (U.S.$45,163 million) and payment of dividends (U.S.$2,656 million) were met by cash flow from operations (U.S.$26,289 million), net proceeds from long-term financing (U.S.$16,021 million), cash provided by the disposal of assets (U.S.$3,820 million), as well as a reduction in our balance of government bonds with maturities of more than 90 days (U.S.$6,334 million).

Net cash provided by operating activities in 2013 increased by 4% in local currency (excluding the foreign currency translation effect), as a result of increases in diesel and gasoline prices in the domestic market during 2013 and the increase in outputs of refined products (6%), which contributed to a reduction in oil product import volumes. These effects were partially offset by the impact of the depreciation of the real  on import costs and by lower crude oil export volumes. When translated into U.S. dollars, cash provided by operations decreased from U.S.$27,888 million in 2012 to U.S.$26,289 million in 2013. 

Proceeds from long-term financing, net of repayments, totaled U.S.$16,021 million in 2013, an increase of U.S.$6,935 million when compared to 2012. The principal sources of long-term financing were the issuance of six series of U.S. dollar bonds totaling approximately U.S.$11 billion in the capital markets in May 2013, and long-term financing from foreign and Brazilian financial institutions.

Proceeds from disposals of assets throughout 2013 totaled U.S.$ 3,820 million. These divestments were the result of our PRODESIN divestment program, with the majority of the proceeds coming from the disposal of 50% of our interest in operations in Africa (through the formation and partial sale of a joint venture combining our African assets) and the disposal of our interest in block BC-10, located in Brazil.

The uses of cash were primarily for capital expenditures and investments in operating units, which totaled U.S.$45,163 million in 2013 compared to U.S.$40,706 million in 2012. Higher expenditures in E&P (U.S.$5,200 million), including U.S.$2.6 billion related to acquisition costs of rights over the Libra block in the pre-salt area, were largely responsible for the increase.

Payment of dividends during 2013 totaled U.S.$ 2,656 million.

As of December 31, 2013, our balance of cash and cash equivalents amounted to U.S.$15,868 million, compared to U.S.$13,520 million as of December 31, 2012. Our balance of government bonds with maturities of more than 90 days decreased from U.S.$10,212 million as of December 31, 2012 to U.S.$3,878 million as of December 31, 2013.

Short-Term Debt

Our outstanding short-term debt serves mainly to support our working capital and our imports of crude oil and oil products. As of December 31, 2013, our total short-term debt amounted to U.S.$3,654 million and the current portion of our long-term debt amounted to U.S.$3,118 million, compared to U.S.$3,666 million and U.S.$2,795 million as of December 31, 2012, respectively.                                                                                       

Long-Term Debt

Our outstanding long-term debt consists primarily of securities issued in the international capital markets, funding from development banks (such as the BNDES), loans from Brazilian and international commercial banks and amounts outstanding under facilities guaranteed by export credit agencies and multilateral agencies.  The non-current portion of our total long-term debt amounted to U.S.$106,235 million as of December 31, 2013, compared to U.S.$88,484 million as of December 31, 2012.  This increase was primarily due to funding from the domestic and international banking markets and from the issuance of U.S. dollar bonds. These financial resources will be used primarily for the development of projects related to oil and gas production, for the construction of vessels and pipelines, as well as for the construction and expansion of industrial plants.  See note 17 to our Audited Financial Statements for a breakdown of our debt by source and other information. 

Included in these figures at December 31, 2013 are the following international debt issues:

(*) Petrobras fully and unconditionally guarantees the notes issued by PGF and PifCo.

(**) On January 14, 2014, PGF issued four tranches of notes totaling U.S.$5.09 billion (after expenses) (€3.05 billion and £600 million aggregate principal amounts of guaranteed senior notes).

(1) Issued by PifCo on September 27, 2006 in the amount of ¥ 35 billion, with support from Petrobras through a standby purchase agreement.

(2) Floating rate equal to a three-month U.S. dollar LIBOR plus 1.620%.

(3) Issued by PifCo on December 9, 2011 in the amount of €1.25 billion.

(4) Issued by PGF on October 1, 2012 in the amount of €1.3 billion.

(5) Floating rate equal to a three-month U.S. dollar LIBOR plus 2.140%

(6) Issued by PifCo on December 9, 2011 in the amount of €600 million.

(7) Issued by PGF on October 1, 2012 in the amount of €700 million.

(8) Issued by PifCo on December 12, 2011 in the amount of £700 million.

(9) Issued by PGF on October 1, 2012 in the amount of £450 million.

Off Balance Sheet Arrangements

As of December 31, 2013, we had no off-balance sheet arrangements that have, or are reasonably likely to have, a material effect on our financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.                                                                                  

Uses of Funds

Capital Expenditures and Investments

We invested a total of U.S.$48,097 million in 2013, a 12% increase, when compared to our investments of U.S.$42,949 million in 2012. Our investments in 2013 were primarily directed toward increasing oil and gas production, as well as modernizing and expanding our refineries. Of our total capital expenditures in 2013, U.S.$27,566 million was invested in exploration and development projects in Brazil.

The following table sets forth our consolidated capital expenditures for each of our business segments for 2013, 2012 and 2011:

On February 25, 2014, we announced our 2014-2018 Plan, which contemplates total budgeted capital expenditures of U.S.$220.6 billion from 2014 to 2018, U.S.$206.8 billion of which is for projects already being implemented or under a bidding process, while U.S.$13.8 billion is for the portfolio under evaluation with projects that are still in the planning phase of development and subject to further approvals by our management . 

We expect that U.S.$153.9 billion of the capital expenditures in our 2014-2018 Plan will be directed towards exploration and production segment in Brazil, totaling U.S.$162.9 billion when also considering our activities abroad. Our capital expenditure budget for 2014, including our project financings, is U.S.$42.4 billion.

We plan to meet our budgeted capital expenditures primarily through internally generated cash, issuances in the international capital markets, structured facilities and project finance loans, commercial bank loans, divestments and other sources of capital.  Our actual capital expenditures may vary substantially from the projected numbers set forth above as a result of market conditions and the cost and availability of the necessary funds.

Dividends

Interest on capital will be indexed based on the SELIC rate from December 31, 2013 to the date of payment, which will be voted on at our 2014 annual general shareholders’ meeting.

(1)          Excludes U.S.$35,308 million related to our pension and medical benefits obligations, which are partially funded by U.S.$22,735 million in plan assets and U.S.$7,133 million related to our provision for decommissioning costs. Information on employees’ postretirement benefit plans (including the expected maturity analysis of pension and medical benefits, set out on note 22.5 (c) to our Audited Financial Statements), and on the provision for decommissioning costs are set forth in notes 22 and 20, respectively, to our Audited Financial Statements.

(2)          Includes accrued interest, short-term debt and long-term debt (current and noncurrent portions).

(3)          Amounts assume that the counterparty would not fulfill certain precedent conditions in the agreement.

Critical accounting policies and estimates

Information about those areas that require the most judgment or involve a higher degree of complexity in the application of the accounting policies that currently affect our financial condition and results of operations is provided on note 4 to our Audited Financial Statements (comprising oil and gas reserves, depreciation and impairment; pension and other post-retirement obligations; contingent liabilities and provisions; derivative financial instruments and hedge accounting). Certain information about dismantling of areas and environmental remediation, as well as pension and medical benefits, are set out below and additional information about our accounting policies and new amendments and standards are provided on notes 3 and 5 to our Audited Financial Statements. Further information on impairment of assets is provided on note 14 to our Audited Financial Statements. Additionally, we have expanded the discussion of some of the items addressed in the financial statements for certain topics.

The accounting estimates we make in these contexts require us to make assumptions about matters that are highly uncertain. The aforementioned notes address only those estimates that we consider most important based on the degree of uncertainty and the likelihood of a material impact if we used a different estimate.  There are many other areas in which we use estimates about uncertain matters, but the reasonably likely effect of changed or different estimates is not material to our financial presentation.

Dismantling of Areas and Environmental Remediation

Under various contracts, permits and regulations, we have material legal obligations to remove equipment and restore the land or seabed at the end of operations at production sites.  Our most significant asset removal obligations involve removal and disposal of offshore oil and gas wells and production facilities worldwide.  We accrue the estimated discounted decommissioning costs (for dismantling and removing these facilities) at the time of installation of the assets.  We also estimate costs for future environmental clean-up and remediation activities based on current information on costs and expected plans for remediation.  Estimating asset retirement, removal and environmental remediation costs requires performing complex calculations that necessarily involve significant judgment because our obligations are many years in the future, the contracts and regulation have vague descriptions

of what removal and remediation practices and criteria will have to be met when the removal and remediation events actually occur and asset removal technologies and costs are constantly changing, along with political, environmental, safety and public relations considerations.  Consequently, the timing and amounts of future cash flows are subject to significant uncertainty.

In 2013, our provision for decommissioning costs decreased by U.S.$2.30 billion due to the annual revision and to payments of decommissioning made.

We reviewed and revised our estimated costs associated with well abandonment and the demobilization of oil and gas production areas. As a result, for 2013, there was a U.S.$0.9 billion decrease in the amounts related to the revision of the provision, attributable to:

a)  a U.S.$1.63 billion decrease attributable to an increase in our risk-adjusted discount rate (from 2.31% p.a. at December 31, 2012 to 3.03% p.a. at December 31, 2013) used for discounting future obligations to present value; and

b) a U.S.$0.7 billion decrease attributable to revised abandonment estimates, which incorporate recent technologies and procedures in the industry, including the adoption of the light workover technique to abandon part of offshore wells.

Those effects were partially offset by a U.S.$1.21 billion increase attributable to the devaluation of the real  in relation to the U.S dollar (from R$ 2.0435 in December 31, 2012 to R$ 2.3426 in December 31, 2013).

Petrobras regularly conducts studies to incorporate the most recent technologies and procedures to optimize the abandonment of areas, considering industry best practices and previous experiences with respect to costs incurred.

For more information about the annual changes in the decommissioning provisions, please refer to note 20 to our Audited Financial Statements.

Pension and Medical Benefits

                Changes in actuarial assumptions, including changes in the discount rate used, may significantly impact our pension obligations. Nominal discount rates (before adjustments for inflation) for our pension plans Petros and Petros 2, and for our health care plan (AMS) have increased from 9.35%, 9.35% and 9.42% in 2012 to 12.88%, 12.97% and 12.90% in 2013, respectively, following an increase in interest rates in Brazil. See note 22.5 (c) to our Audited Financial Statements for a sensitivity analysis of the impact of a 100 basis point change in actuarial assumptions over our pension obligations.

Research and Development

We are deeply committed to research and development as a means to extend our reach to new production frontiers and achieve continuous improvement in operations.  We have a history of successfully developing and implementing innovative technologies, including the means to drill, complete and produce wells in increasingly deep water.  We are one of the largest investors in research and development among the world’s major oil companies, and we spend a large percentage of revenues in research and development.  Our Brazilian oil and gas concession agreements require us to spend at least 1% of our gross revenues originating from high productivity oil fields on research and development, of which up to half is invested in our research facilities in Brazil and the remainder is invested in research and development in Brazilian universities and institutions registered with the ANP for this purpose.

In 2013, we spent U.S.$1,132 million on research and development, equivalent to 0.8% of our sales revenues, while in 2012, we spent U.S.$1,143 million, equivalent to 0.8% of our sales revenues, and in 2011, we spent U.S.$1,454 million, equivalent to 1.0% of our sales revenues.

Our research and development activities focus on three main goals:

(1)           Expansion of our current businesses through the:

(a) discovery of new exploratory frontiers through comprehensive, basin-scale geological and geophysical investigations of Brazilian frontier areas, both onshore and offshore, and implementation of innovative seismic processing and inversion algorithms;

(b) enhancement of oil and gas final recovery by the use of innovative sea water, CO ₂ and polymer injection systems;

(c) enhancement of the pre-salt production systems and its reservoirs’ final recovery by intensive usage of compact subsea solutions, injection systems and the capacity enhancement of the new pre-salt FPSO units;

(d) development of new or enhanced subsea production systems and equipment for deep and ultra-deep waters based on compact subsea oil/water/gas separation, sea floor produced water re-injection, improved gas-lift technology, sea floor oil boosting and gas compression and a new generation of electrical submersible pumps;

(e) optimization and development of drilling and production solutions for unconventional reservoirs, shale gas, gas hydrates, coal bed methane, tight gas and shale oil, by geophysical investigations of the Brazilian onshore frontier areas and well design optimization through cost effective and currently available technologies;

(f) optimization of our natural gas logistics and final usage, through the development of solutions for offshore and stranded gas, such as chemical conversion, compression and subsea to shore, and the optimization of our onshore assets;

(g) application of available up-to-date logistic technologies to improve our integrated offshore operations;

(h) optimization of the Brazilian oil and derivatives supply and the exportation of oil and its derivatives;

(i) development of technologies and mixing devices to optimize the refining processes for pre-salt oils, such as desalter operation, and;

(j) development of technologies to enhance the flexibility of middle distillates or gasoline, in order to meet market demands;

(2)           Providing a mix of products compatible with the energy demands of the future through the:

(a) development of new fuels, lubricants and special product formulations such as podium diesel and podium gasoline;

(b) development of new technologies for petrochemical activities such as catalyst systems for polypropylene and ethylene production from olefins and polystyrene and polyester (raw materials and polymers) from both fossil and renewable sources;

(c) optimization of our ammonia and urea production plants through advanced real-time process control optimization and development of new technologies for urea based fertilizers and ruminant feedstock, through mixed fertilizer formulations with micronutrients;

(e) development of competitive second generation biofuel production processes, which use residual biomass as feedstock, through biochemical and thermochemical routes such as pyrolysis and gasification, and;

(f) optimization of our thermoelectric power plants, with emphasis on operation and maintenance cost reduction, and research and development on renewable energy technologies, such as concentrated solar, photovoltaic and wind power;                                                                    

(3)           Ensuring that our activities are environmentally sustainable. We aim throughout our entire business to:

(a) reduce water consumption and the volume and toxicity of wastewater discharges, by the selection and development of new chemical products and formulations and by water re-use increase through an extensive portfolio of primary, secondary and tertiary treatment routes;

(b) reduce our emissions of air pollutants, CO ₂ and other greenhouse gases based on intensive re-injection of CO ₂ into our production reservoirs, selection and development of technologies for pollutants abatement and carbon capture storage and sequestration;       

(c) increase the energy efficiency of our processes and products through research and development in combustion, heat transfer processes and advanced thermal cycles;        

(d) prevent and mitigate the environmental impact of our activities through extensive offshore research in deepwater biodiversity characterization and the development of innovative operation standards, and;

(e) ensure the integrity, safety and reliability of all our industrial facilities, by the development and implementation of new materials and process equipment, online process and equipment integrity monitoring and diagnosis, inspection techniques, new process tuning systems, advanced control tools, real-time optimization and simulators for design and process analysis.

In the three-year period ended December 31, 2013, our research and development operations were awarded 97 patents in Brazil and 139 overseas. Our portfolio of patents covers all of our areas of activities.

We have operated a dedicated research and development facility in Rio de Janeiro, Brazil since 1966.  As a result of its expansion in 2010, this is one of the largest facilities of its kind in the energy sector and the largest in the southern hemisphere, with laboratories especially dedicated to pre-salt technologies.  As of December 31, 2013, this facility had 1,959 employees, 91.3% of which are exclusively dedicated to research, development and basic engineering.

We also have several semi-industrial scale prototype plants throughout Brazil that are in proximity to our industrial facilities and that are aimed at scaling up new industrial technologies at reduced costs.  In 2013, we conducted research and development through joint research projects with more than 100 universities and research centers in Brazil and abroad and participated in technology exchange and assistance partnerships with several oilfield service companies, small technology companies and other operators. 

Trends

We plan to continue expanding all segments of operations in our target markets in accordance with our 2014-2018 Plan.  In support of this goal, we plan total capital expenditures of U.S.$220.6 billion over 2014-2018, U.S.$206.8 billion of which is for projects already being implemented or under a bidding process, while U.S.$13.8 billion is for the portfolio under evaluation with projects that are still in the planning phase of development and subject to further approvals by our management.  Of this total, approximately 70% is in the exploration and production segment (Brazil and abroad), where constant investment in exploration and development is needed to exploit newly discovered resources and offset natural declines in production from existing fields as they mature .