The philosophy behind the policy on managing financial risk is to guide decisions on risk transfer and is sustained by actions based on capital discipline and debt management. These actions are:

Produce cheaply - capital discipline ensures competitive costs for all products sold in the market;
Future investments are decided on a realistic basis by seeking a balance between profitability, growth and the strategic compliance of the project portfolio on the one hand, while preserving the liquidity and solvency of the Company's balance sheet and creating the essential conditions for sustainable growth, on the other;
Prudent management of debt, seeking to match the operational cash flows with debt amortizations, taking into account amounts, currencies, maturities and indexes, and consequently reducing the risk of insolvency.

Other important characteristics in risk management are:

Integrated management of market risks that quantifies total exposure, identifies natural hedges and acts on net Company exposure, while avoiding isolated initiatives on the part of the Business Units that do not contribute to the optimization of corporate risks;
Respect for the concepts of market efficiency and diversification. Petrobras is aware that it operates in some of the most liquid markets in the world where the possibility of systematically predicting prices is very limited. As a result, the Company's risk management is focused on avoiding extremely adverse events rather than minimizing oscillations in results, cash flow, etc.;
The highest standards of transparency in disclosing the Company's potential exposure.

The risk assessment of the financial feasibility of the Company's strategic plan is based on probability analysis of projected cash flows for a two-year period. The economic-financial projections are up-dated annually in conjunction with the review of the strategic plan.

The model used for quantifying risk (Cash Flow at Risk) considers the variations in key factors that have the most impact on cash generation - namely, prices, amounts (production and markets), foreign exchange and interest rates.

In essence, cash balances are projected under an infinite number of scenarios involving the principal risk factors using Monte Carlo Simulation analysis. The cash balance is estimated for the intended confidence level and then periods in which the balance may be lower than the minimum, analyzed.

Among the alternatives that could be adopted for preserving the minimum predetermined cash balance are financial derivatives, additional funding and optimization of the disbursement profile.

Transactions using derivatives are not limited to the processes described above, but are also important tools for protecting transactions and in the matching of assets and liabilities.

Because of this, Petrobras’ risk management policy aims at contributing to an appropriate balance between company growth and return objectives and its level of exposure to risk, whether inherent to its activities themselves, or resulting from the context it operates in, in such a manner as for, through the effective allocation of its resources - physical, financial, and human - Petrobras may achieve its strategic goals.

To manage oil and oil byproduct market risks, based on the premise of only considering the net consolidated exposure to oil and oil byproduct price risks, operations involving derivatives are generally limited to protecting the results of specific short-term transactions (up to six months).

Future contracts, swaps, and options are used in these hedges. These operations are always tied to those that are carried out in the physical market. From January to December 2005, hedge operations were carried out for 23.30% of the total marketed volume (imports and exports).

Attending to specific business conditions, we undertook, exceptionally, a long-term hedge operation, which is still active, involving the sale of sales options for 52 million barrels of WTI oil, in the 2004 to 2007 period.

This operation aims at establishing price protections for this amount of oil to guarantee minimum margins for Barracuda/Caratinga Project financers to cover debt servicing. Petrobras Energía S.A - PESA., a company controlled indirectly by Petrobras, also uses derivative financial instruments to mitigate its exposure to oil and oil byproduct market risks.

For the period of January to December 2005, PESA had covered a volume of 7.3 million barrels of oil.

A considerable part of the Company's total debt and future operational cash flow is in dollars or strongly indexed to the dollar.

For this reason, Petrobras does not have an excessively large exposure to foreign exchange risk.

Depending on a case-by- case basis, the use of derivatives is limited to mitigating exposure in relation to other currencies such as the Euro and the Yen.

The company doesn't currently uses derivative financial instruments to manage its exposure to interest rate fluctuations. These are only used by its indirect controlled company Petrobras Energía S.A. (PESA).

The interest rate risk that the Company runs depends on its long-term debt and, to a lesser degree, short-term debt as well. Floating rate debt in foreign currency is subject principally to fluctuations in Libor, and debt in Reais at fluctuating rates of interest is subject principally to the long term interest rate (TJLP), periodically announced by the Brazilian Central Bank. Currently, the Company does not employ derivative instruments to manage its exposure to fluctuations in interest rates. The only exception is the Company's indirect subsidiary Petrobras Energía Participaciones S.A. (Pepsa), which uses various financial derivative instruments to reduce certain exposure to interest rate volatility.

Derivative instruments

The Company uses derivative and non-derivative instruments to implement its overall risk management strategy. However, by using these instruments, Petrobras exposes itself to credit and market risk. Credit risk is the failure of the counterparty to perform under the terms of the derivative contract. Market risk is the adverse effect on the value of the financial instrument that results from a change in interest rates, foreign exchange rates or commodity prices. Petrobras addresses credit risk by limiting its counterparties in such financial derivative instruments to first class financial institutions. Market risk is managed by the Company's executive officers.

The Company does not hold or issue financial instruments for trading purposes.

Credit risk is assessed through a new credit analysis system called Credit Flow, and two Credit Commissions have been created: the Supply and Natural Gas and Energy commissions. These commissions are forum where several aspects related to granting and administering credit are discussed.

In 2005, the company increased the final premium paid for the main policies – large fire/operational risks, oil risks, and named risks. The premium was raised from $25.2 million, in 2004, to $29.3 million, a 16% increase. However, in the period, the insured asset value grew 23%, from $26.6 billion to $32.6 billion.

Most of Petrobras’ risk is reinsured in the international market. As a result, the company has, both in Brazil and abroad, a permanent policy of divulging the risk management quality and practices.

Relevant information, such as incidents, incident causes, and the improvements that were introduced are informed quickly and transparently to the insurance market.

Because of the investments that it has made in Health, Environment, and Safety (SHE), as well as in Quality, Petrobras, as other major oil companies have done, takes on an expressive parcel of its own risk, including by increasing deductibles, which may go as high as a $40 million.

As part of this policy, the Company does not insure against lost profits neither does it insure wellhead controls nor the pipeline network.

Platforms, refineries, and other facilities are covered by large fire/operational risk and oil risk policies. Cargo movement is protected by transportation policies, while vessels are covered by hull and engine policies. Civil liability and environmental risks, as per the case, are covered by one or more policies. Projects and facilities under construction are insured against engineering risks through policies hired by Petrobras or by the contractors.

For effective insurance, the company's assets are evaluated considering replacement costs, calculated by Petrobras and/or by classification associations. Once the maximum likely damage has been calculated for each facility, this value serves as the base for the establishment of the maximum compensation limit for the large fire/operational risk policy, currently at $720 million.

Most activities carried out abroad are insured or re-insured by Bear Insurance Co. Ltda. A captive insurer headquartered in Bermuda, Bear does not retain risk, as it passes it on in full to the market.