* Political battle over royalties threatens to slow sector
* Deepwater oil auctions on hold until deal reached
* Brazil hopes to become major oil exporter by 2020
By Raymond Colitt and Brian Ellsworth
BRASILIA/RIO DE JANEIRO, Oct 3 (Reuters) - Brazil's government is racing to forge a deal in Congress this week that it hopes will prevent a lengthy legal and political battle over its huge offshore oil reserves.
Brazil's states and cities have been quarreling for years over how to distribute the expected multi-trillion-dollar windfall from one of the world's biggest recent oil finds. Former President Luiz Inacio Lula da Silva called the so-called "subsalt" fields, discovered in 2007, "a gift from God" that could make Brazil a rich country.
President Dilma Rousseff's government is now trying to defuse the arguments by offering a cut of its own take in future royalties from the fields. Officials are confident Congress will approve the government proposal in coming days or weeks.
"We're at ease. The interested sides are hard at work ... and by the looks of it, they're forging a quite significant majority," Gilberto Carvalho, general-secretary of the president's office, told Reuters.
Yet some leading politicians are still balking at the proposal or threatening legal action. The final outcome is up in the air at a time when Rousseff's relationship with Congress has been poisoned by budget cuts and other problems.
At stake is Brazil's plan to become one of the world's largest suppliers of oil outside of OPEC and to ensure revenue to finance improvements in infrastructure, health programs and education, which are crucial to entering the ranks of developed nations.
The final outcome will have major implications for state oil company Petrobras (PETR4.SA)(PBR.N), and possibly for multinational energy companies such as Italy's (ENI.MI) and Norway's Norsk Hydro (NHY.OL), who have expressed interest in helping Brazil develop the fields. ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^
Graphic of oil discoveries: link.reuters.com/fyh84m
Factbox on Brazil oil finds [ID:nN23274907] ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^>
So far Brazil is pumping only a small fraction of the subsalt fields and requires tens of billions of dollars to develop the remaining reserves.
An agreement on distributing oil revenues is needed for the government to go ahead with a planned auction next year for the rights to develop the vast oil fields.
The so-called subsalt region is believed to hold more than 50 billion barrels of oil buried under a thick layer of salt. At current prices that would be about $4 trillion in revenue.
Failure to reach agreement on the bill would spark a drawn-out legal battle, potentially stalling fresh investments for several years. Without a compromise, Congress would almost certainly overrule last year's veto by Lula of a law that would have distributed more revenue to non-producer states.
The three largest oil producing states -- Rio de Janeiro, Sao Paulo and Espirito Santo -- are keen to uphold the veto.
Sergio Cabral, governor of Rio de Janeiro, said he would go all the way to the Supreme Court to ensure his state's oil income. Losing it would generate a political backlash for him and President Dilma Rousseff, Cabral warned.
"The electoral tragedy in Rio would be dramatic," said Cabral, wary of losing cash before hosting the 2016 Olympics.
Rio de Janeiro pumps the vast majority of Brazil's roughly 2 million barrels per day of crude.
Cabral proposes hiking a separate oil excise tax, which state oil company Petrobras in turn has said would violate existing contracts and force it to go to court.
New framework legislation passed last year heightened state control over the subsalt region and made state-led oil company Petrobras (PETR4.SA). But private investors can still take a stake of up to 70 percent in joint-ventures.
Mauricio Pedrosa, a partner with asset management group Queluz Asset in Rio de Janeiro, said any changes to existing contracts would be a blow to the company.
"If the royalty agreement alters existing contracts it could affect Petrobras' cash flow. It's another risk factor for the company," said Pedrosa, who helps manage around 300 million reais ($158 million in assets).
The proposal by Rousseff's administration would cut the federal government's cut of royalties by almost a third and distribute that to non-producer states [ID:nS1E78D28F]. Producer states like Rio de Janeiro would see a small cut.
The offer was rebuffed by some players, particularly by municipal governments, which would see the biggest losses.
"We don't understand why the government is punishing the municipalities. We are the ones who suffer the economic and social effects of oil operations," said Riverton Mussi, mayor of the city of Macae -- the country's main oil hub.
Mussi, who estimates Macae would lose a quarter of its annual budget under the government's plan, also said he would defend his city's oil income in court.
"Right now this debate is holding hostage the whole development of the sector," said Latin America analyst Christopher Garman of the Eurasia consultancy in Washington.
(Additional reporting by Jeferson Ribeiro; Editing by Bob Burgdorfer)