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Industry reform continues, but at snail's pace

Foreign investment in the energy sector of most Latin American countries is dropping, even as it soars in the rest of the world. The region cannot afford such a slow-down, writes Robert Olsen

LATIN American governments are fond of pointing out how under-explored their countries are. However, private-sector investors seem less concerned about the attractions of virgin geology than about the toxic brew of poor exploration results and restrictive government regulations and there is a danger that countries throughout the region will fail to attract the investment they need to prevent output from falling.

The doors to investment in Latin America's energy sector were thrown open in many countries in the 1990s, amid a region-wide drive to reform national economies in response to financial crises. The results are well known: billions of dollars in foreign investment poured into the region and oil and gas output soared in countries such as Venezuela, Colombia and Argentina. Brazil's opening of its upstream acreage set off a scramble amongst international firms to gain access to acreage near the big discoveries being made by Petrobras, the state-controlled incumbent.

A decade later, poor exploration results in some countries and a shift in regional politics away from the reforms of the 1990s have led to more sober assessments of Latin America's attractiveness to private investors. Governments that strove to accommodate foreign companies in Argentina and Brazil have been replaced with administrations with different agendas.

Brazil has yielded a number of major finds, but almost all of them have been made by Petrobras. Big discoveries in Colombia, such as the Cusiana oilfield, have turned out to be the exception rather than the rule – although the country's upstream regulator hopes that improved licence terms brought in last year will change this.

Political turmoil and a lengthy tax dispute have discouraged investment in Ecuador, leaving the privately owned $1.4bn OCP pipeline operating at half of its 450,000 barrels a day (b/d) capacity. Venezuela, the biggest reserves holder in the region, has altered the investment regime to the detriment of private investors.

These disappointments are causing a decline in energy sector investment in most parts of Latin America, yet the region can scarcely afford an investment slow-down. Mexico is grappling with the decline of its giant 2.6m b/d Cantarell oilfield while Argentina is suffering from gas supply shortages. Brazil is becoming worried that it could join its neighbour unless gas supplies are quickly developed.

Even Venezuela, which is cash rich because of high oil prices, could face nationwide electricity shortages this winter because of under-investment in the largely state-owned electricity industry. In the long term, the government of Hugo Chávez could also be undermining the main source of its funding because insufficient state funds are being reinvested in the oil sector. 

Tightening investment terms

One factor that has impeded investment has been the unwillingness, or inability, of many countries to provide a stable framework for investment. Much of this instability is caused by the perception that foreign investors reaped massive profits in the 1990s at the expense of local consumers and governments. Governments elected in the wake of region-wide discontent with reform at the beginning of the decade have themselves invoked these feelings to justify the tightening of investment terms and the imposition of greater state control over the industry.

The tightening of investment terms in many Latin countries has coincided with growing supply problems, especially in the Southern Cone. Gas-rich Argentina has been grappling with a serious energy crisis since its economy began to recover in 2003. The Bolivian authorities were forced to impose energy-rationing measures in September after unusually cold weather led to an unexpected surge in demand for gas and electricity. With pipeline bottlenecks restricting gas flows, just as they are in Argentina, supplies to industrial customers in Bolivia are being curbed to ensure sufficient supply to households.

The continuing political crisis in Bolivia, which has seen two presidents resign in two years and paralysed investment in gas pipelines and exploration, has had wider implications for the region. Both Argentina and Brazil had been counting on Bolivia to supply rising demand in their domestic markets. The sudden collapse of export plans from Bolivia has exposed flaws in the long-term energy policies in both countries.

The gas-supply crunch in Argentina mirrors the situation in many other parts of Latin America. Investment in infrastructure and reserves has not kept up with demand and investors are reluctant to spend because returns are too low. The government's attempts to blame the shortage on foreign investors have done little to stimulate interest in fresh capital spending.

Similarly, Ecuador, Bolivia and Venezuela have seen investment levels tumble as foreign companies either lack opportunities to invest or are reducing spending because of political uncertainty. Meanwhile, many of the region's state-owned oil firms are unable to invest sufficient capital in their operations as well as keep up with the state's voracious cash demands. Pemex, for example, has racked up enormous debts while trying to increase investment and simultaneously pay for a third of the government's budget.

Courting China and India

Latin American governments are aware that the foreign investors that have traditionally supplied the capital for developing the region's energy resources are reluctant to commit to new investments in the region. To counteract this trend, China and, to a lesser extent, India, are being courted by Latin American countries as an alternative source of investment. Both countries' energy imports are surging and there is a perception that these countries' national oil companies are willing to pay more for access to energy reserves than Western corporations.

Venezuela has made the greatest effort to attract Chinese investment, offering China's state-owned firms preferential access to new extra-heavy-oil upgrading projects, as well as other upstream opportunities. But these efforts have, so far, not yielded investment commitments from China and there are considerable doubts among Western executives in the country that China's desire to secure long-term energy will outweigh the high costs imposed by Venezuela's restrictive oil and gas sector legislation.

Other countries are limited to encouraging Chinese firms to compete alongside Western investors for new acreage. Indeed, efforts by former Ecuadorian president Lucio Gutierrez to offer four oilfields to Chinese firms generated considerable controversy in the country and the plan was eventually dropped. Furthermore, despite the considerable speculation about China's growing involvement in Latin America's energy sector, Beijing's initial steps have been modest, with China's energy corporations largely confining themselves to acquiring assets that Western firms have been more than happy to divest.

Ecuador, whose unpredictable politics have deterred many Western firms, has become a favourite destination for Chinese investors. Sinopec picked up ConocoPhillips' 14% stake in block 16 in late 2003 and the country's biggest investment in the region came in September when Andes Petroleum, a consortium formed by the three major Chinese state-owned oil companies, bought EnCana's assets in the country for $1.4bn. However, China's purchase of existing assets will do little to help Ecuador raise investment, reserves and output in the long run.

Similarly, announcements of huge investments by China in Brazil and Argentina have so far led to nothing. The Gasene pipeline, which will link Brazil's southern natural gas fields with the northeast of the country, was supposed to have been built by Sinopec with funds provided by Eximbank, China's state-owned export credit bank. The pipeline was to be the centrepiece of China's commitment of $5bn in investment in Brazilian infrastructure in order to ensure supplies of raw materials for its growing manufacturing base. But as the cost of the pipeline ballooned, from $1.1bn to $2.3bn, China's willingness to back the project has cooled.

Market-friendly governments have dealt with the situation differently. Colombia and Peru have responded to the shortage of upstream investment by improving terms for foreign companies. Policymakers have taken longer-term views of the situation, recognising that improving investment terms now makes it more likely that the decline in their oil production will be reversed. Peru says its investment terms are the second-most flexible and attractive in the world, while Colombia has been signing an increasing number of upstream contracts since liberalising its contract terms just over a year ago.

Some countries with left-of-centre governments are also trying to move along with reform, if at a more gradual pace. Brazil has also held firm with its opening of its oil and gas sector, and tentative steps are being taken to broaden the role of the private sector in the downstream gas business. The government has proposed legislation that would force Petrobras to grant access to its gas-pipeline network, which would help stimulate private-sector investment in gas production.

Even Argentina, which has battered investors with price controls and threats of boycotts over the last two years, has begun to look at creating incentives to investment, provided companies agree to associate with its new state-owned oil and gas company, Enarsa.

Political wrangling

And Mexico, whose constitution bans foreign involvement in the oil and gas business, is making tentative steps towards allowing foreign investment, although much depends on the outcome of next year's elections. Political wrangling between the president and the Congress has ensured that fiscal reforms designed to alleviate Pemex's crushing tax burden have been scuttled and there is little optimism that President Vicente Fox's proposal that the constitution be amended to allow privately owned companies to explore for and produce non-associated gas will pass because of political differences with the parties that control Congress.

Nevertheless, the high oil-price environment of recent years has had a dampening effect on the willingness of other countries to relax investment terms. Venezuela has decided that it can fund much of its 2006-12 business plan by itself. State-owned PdV will account for the bulk of the $22bn that has been budgeted for adding capacity in the conventional oil sector over these years. Foreign companies will be restricted to developing the most challenging parts of the Orinoco extra-heavy oil belt, while the more promising blocks in the area are being reserved for joint ventures between PdV and companies associated with governments Venezuela is courting, such as China, Russia, Spain and Iran.

Venezuela: a special case

Venezuela is a special case, however. The country's extensive reserves and the majors' need to replenish their own dwindling portfolios are motivation enough to overcome the difficult fiscal and operating environment being imposed. Western investors are trying to form partnerships with the favoured companies that have been invited by the Chávez government to take a lead in developing the heavy-oil resources. Chevron has agreed to partner Repsol-YPF – one of the companies granted preferred access to the extra-heavy oil belt because of Venezuela's desire for closer diplomatic ties with Spain – to build a huge 400,000 b/d heavy-oil project. Other companies are also studying partnerships with some of the state-owned firms that have been invited to participate in the heavy-oil block by the government, such as Petrobras and Russia's Gazprom.

Other countries, such as Bolivia, which has proposed a massive increase in upstream taxes, are facing considerable resistance from investors. Under pressure from large anti-foreign investment demonstrations earlier this year, the government proposed a series of new taxes that would effectively place a 50% royalty on all gas produced in Bolivia, a measure denounced by investors as confiscatory.

The impasse has already led to a significant drop in investment, but the political climate makes it extremely difficult for the government to arrive at a negotiated solution. In contrast, investors are reacting cautiously but favourably to Ecuador's announcement that it would seek the renegotiation of all upstream oil production contracts in order to boost the state's revenue from oil output.

Ecuador: legal disputes

Some investors in Ecuador, such as Occidental Petroleum, are hoping to resume investment, once they have settled legal disputes and negotiated new, more stable investment conditions. "Occidental wants to resolve its conflicts in Ecuador ... We are open to renegotiating a settlement over [sales tax] rebates and exchanging ideas with [PetroEcuador] to improve the economic conditions of block 15," says Occidental's vice-president of legal affairs, Daniel Almaguer.

Over the long term, investors in Latin America expect reform to continue, if at a gradual pace. There are considerable doubts, for instance, that PdV can single-handedly achieve Caracas' goal of lifting oil production capacity to 5m b/d.

The firm has already taken on heavy social-spending commitments, which are expected to total over $4bn this year and oil output has not yet fully recovered from the December 2002 strike by PdV management that almost completely shut the company down. Despite government claims that output stands at 3.3m b/d, international market observers, such as the International Energy Agency, say Venezuelan production is no more than 2.7m b/d and some local experts claim it may have fallen to as little as 2.5m b/d because of underinvestment in new capacity.

Nevertheless, PdV claims it will add 1.834 million b/d of conventional oil-production capacity over the life of the plan. This figure, however, is at odds with past experience in Venezuela. Between 1991 and 1997, PdV and its private-sector partners spent $34bn to add 0.915m b/d of new production capacity and while much of this capacity was in marginal oilfields that were more costly to develop, PdV's claim that it can add double this amount of capacity for $12bn less, at a time when upstream costs are rising, lacks credibility.

Bolivia may well come around to the view that it will also benefit from foreign investment once it sees that it is being left behind. But for this to occur, political changes are necessary. Two main factors were at play when Latin America opened up its oil and gas sector to foreign investment in the 1990s: the demands of international lenders, such as the International Monetary Fund (IMF), that state-dominated sectors be opened up to private investment as a condition for financial assistance; and the need to attract foreign capital and expertise to develop national energy resources.

Harsh medicine

However, the influence of the IMF in the region has waned with the stabilisation of most countries' economies and the emergence of politicians willing to confront the agency and the harsh medicine it prescribes. Yet the need to attract foreign capital into the energy sector throughout Latin America is probably greater than it was in the 1990s.

In part, the problems now facing governments and upstream operators are a consequence of the way in which the oil and gas sectors were opened in the first place. The reforms that opened up the upstream oil and gas sector to foreign investment were by and large imposed from above by governments seeking to escape fiscal pressures instead of following the emergence of a national consensus over energy policy. As such, when the political fortunes of those who backed the opening waned there were few obstacles to curbing or even dismantling the policies put in place in the 1990s.

The abandonment of reform by many countries over the last five years has not been accompanied by any long-term planning, the consequences of which are now being felt in Argentina and to a lesser extent Brazil. The threat of an energy crisis in these countries is prompting a more serious approach to energy planning, just as the shock in neighbouring Chile over Argentina's unilateral cuts in gas supplies has prompted a national debate over energy policy. The Chilean government is planning to build a liquefied natural gas (LNG) receiving terminal in order to diversify its sources of energy supply and some members of Congress have proposed a bill that would force the country to source no more than 80% of its energy imports from any single country.

In response to the disruption of their plans to import Bolivian gas, Argentina, Chile and Brazil have begun to talk with Peru about building a $2bn pipeline to connect Peru's gasfields with the energy-hungry south. The proposed Peruvian pipeline is to form part of a broader South American Energy Ring that would eventually interconnect the entire continent, which the leaders of Peru, Chile, Argentina, Brazil and Uruguay agreed to in June.

A final deal is unlikely before Peruvian President Alejandro Toledo steps down in 2006 and a shift leftward in Peruvian politics cannot be discounted given the general unhappiness with Toledo's liberal policies. But the international agreement is a sign that the region's governments are beginning to try to adopt an integrated long-term strategy to dealing with their energy-supply problems.

Camisea success

Peru's unlikely rise to the role of gas provider to the Southern Cone stems from the successful development of the country's 8.7 trillion cubic feet Camisea gasfield. Meanwhile, the emergence of export demand for Peruvian LNG has brought foreign investors back to the country. PeruPetro, the national upstream agency, expects to sign 17 exploration contracts this year, and major regional players such as Petrobras and Repsol-YPF have been bolstering their positions in the market.

But with Peru's gas in private hands and Mexico ready to purchase Peruvian LNG doubts remain whether there is enough gas in the country to satisfy the LNG ambitions of the private sector and the energy needs of the Southern Cone. Finding investors willing to back such a project could be difficult given the unpleasant experiences of many regional players in Argentina and Bolivia in recent years.

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