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Capex plunges

A temporary break in electoral activity has not brought about the expected revival in oil sector investment. Instead, capital spending has slipped, while the government's ambivalent relationship with foreign companies has led to clashes with investors and delays in approving new projects, reports Robert Olson

President Hugo Chávez' successful campaign against the recall referendum called against him last August and his subsequent landslide victory in October's regional elections were heavily reliant on new social programmes using billions of dollars provided by Petróleos de Venezuela (PdV).

On top of its normal tax and dividend payments, the state-owned oil firm says it spent $1.7bn last year funding these initiatives, as well as contributing a further $2bn to a special development fund set up by the government to back infrastructure and housing construction. The heavy social spending took its toll on the company, which struggled to find enough cash to invest in its own operations in the first half of the year.

Capex set to jump

Félix Rodríguez, who, until recently, was PdV's upstream chief, admitted in August that the firm had spent only 20% of its $3.3bn upstream capital budget over the first half of 2004. The prevailing opinion, however, was that capital investment would jump at the end of the year once the need to fund the government's electoral initiatives had passed.

Instead the anticipated rise in capital spending failed to materialise. The central bank reported that the measure of economic activity in the oil sector in the fourth quarter of 2004 – which largely ignores the effect of oil prices and instead measures production volumes and capital spending – was the single worst three-month period of Chávez's nearly six years as president, with the exception of episodes of prolonged labour disruptions in 2002 and early 2003.

Given the stagnation in oil production volumes, the fall in oil industry activity appears to be largely due to plunging capital investment, which portends further declines in oil production in 2005 unless PdV can dramatically boost investment.

This is unlikely. The Chávez government faces national legislative elections late this year and a presidential vote in 2006, meaning PdV and its resources will certainly be once again put to the service of the government. PdV officials have already said that the company's social spending is to double in dollar terms this year ahead of the legislative vote.

The drop in capital expenditure in Venezuela's oil industry has more to do with a longer-term structural shift in capital spending patterns than one-off electoral events. The completion of the multi-billion dollar 190,000 barrels a day (b/d) Hamaca heavy-oil upgrader in October 2004 was undoubtedly the biggest factor in the sharp fall in capital spending reported by the central bank compared with the same period a year earlier, when thousands of workers would have been building the giant upgrader.

Looked at differently, the data underscore the vital role played by projects awarded to private-sector companies in the 1990s in sustaining capital investment in the oil industry following severe cuts in PdV's investment budget under Chávez. Over Chávez's first five years, it would have been impossible to make up for the catastrophic losses in oil production capacity at PdV's own operations without the output that was being added by billions of dollars in investment in four heavy-oil upgraders and 33 marginal oilfield reactivation contracts signed.

These projects are now all but completed. The 75,000 b/d ConocoPhillips-backed Corocoro oilfield is the only significant new production capacity that is certain to be added by a private-sector company in the near future. At the same time, output from the marginal oilfield reactivation projects, which pump over 0.5m b/d of Venezuela's oil, is expected to start declining.

PdV's inability to meet its growing capital investment burden, as well as the social spending plans imposed by the government has not helped relations with foreign investors. The government has announced that it plans to force some marginal field investors to renegotiate their contracts as they are "no longer good business" for the state.

Plans blocked

ConocoPhillips found its development plan for Corocoro blocked for two months until the US firm agreed to pay higher royalties on its output than had been contemplated by the original risk-sharing contract governing the field. The government has once again said it might change the shareholding of Shell's long-delayed Mariscal Sucre liquefied natural gas (LNG) project and may even split it into two or three separate projects (see box).

For now, most foreign investors have kept a low profile, but the increase in royalties on the four heavy-oil upgrading projects has stirred ExxonMobil into action. The major has been pushing for a meeting with the government to roll back a decision to raise royalties unilaterally on heavy-oil output to 16.67% from the 1% stipulated in the contract governing its 120,000 b/d Cerro Negro heavy-oil upgrader.

Although talks are planned, the oil minister, Rafael Ramírez, has already declared that the increase in royalties is "non-negotiable". The government says the royalty increases and contract renegotiations are justified because the price of oil is now far above the levels contemplated when the contracts were drawn up.

Sources close to ExxonMobil say the major is prepared to haul the Chávez administration before an international arbitration tribunal in a bid to reverse the government's decision, although the likely angry reaction from the government to any such challenge would jeopardise the status of a planned $2.5bn ethylene cracker ExxonMobil has been seeking to build in the east of the country.

Risk reappraised

The unilateral royalty increases have made firms take a second look at the risks surrounding investing in Venezuela. ConocoPhillips saw its share price knocked back by investors after the Corocoro project was delayed, spurred by concerns the company is already over-exposed to Venezuela, where it has 10% of its upstream capital invested, according to Deutsche Bank. With the local courts solidly in the government's control and recourse to international bodies forbidden in new contracts, firms worry they are at the mercy of the government.

Much of the risk stems from the unsustainable macroeconomic and fiscal structure the government has adopted. Public spending has risen to 30.89% of GDP from 18.8% in 1998. Should the government find itself short of cash, foreign oil companies could easily become the target of an administration unwilling to cut spending or devalue the currency in an election year. Because foreign companies now produce 1.1m b/d of the country's total output of 2.6m b/d yet pay substantially lower taxes and royalties on their production than does PdV, the fear is not unjustified. Federal government workers' salaries and debt payments alone are budgeted this year at $15.2bn, far above the $12.3bn the entire oil industry paid in taxes, royalties and dividends in 2004 when oil prices reached record highs.

Yet where some investors see risk, others see opportunities. Executives argue that while existing projects may be vulnerable to renegotiation, new ventures should be protected because they will be in compliance with the tough fiscal terms of the 2001 Hydrocarbons Law.

Having accepted the government's investment terms, Total is pushing ahead with its proposed plans to expand its Sincor extra-heavy-oil project. The company hopes it can reach a deal with the government by the end of the year that would permit a multi-phase expansion of the upgrader, costing an eventual $5bn. "We can have confidence in our relationship with the government as well as PdV," Total's boss, Thierry Desmarest, said during a visit to Caracas in February.

A minority partner

The terms of the 2001 Hydrocarbons Law mean that PdV will have a majority stake in any new upstream production, but senior government officials, including the deputy oil minister, Bernard Mommer, a critic of previous deals with foreign firms, say they would be happy with PdV continuing as a minority partner in the upgrader itself. Such a step would reduce the share of the capital expenditure PdV would have to bear, as the upgrader makes up the bulk of the upfront investment.

Total has also committed to test steam-assisted gravity drainage (SAGD) technology in the Orinoco heavy-oil belt in order to meet the government's demand that recovery rates in the area be raised. The four existing projects rely on cold production, which recovers less than 10% of the oil in place. SAGD, which is used in Canada's oil sands, involves pumping steam into a horizontal well to reduce the viscosity of extra-heavy crude, thereby increasing well productivity. Moreover, the natural gas used to generate the steam could come from the fields itself, where some 200m cubic feet a day (cf/d) is flared because of a lack of suitable infrastructure to take it to market.

To mitigate risk and make the project more manageable, Total hopes to gradually raise production at the Sincor upgrader by debottlenecking and expanding the facility, eventually leading to a doubling of the plant's capacity to 400,000 b/d of extra-heavy crude. The first phase of the project, which would take the existing upgrader up to 240,000 b/d, could be completed within three years of the project being approved.

Total is also examining the possibility of expanding its investment in the Jusepin field, which it operates under a marginal field contract from PdV. The firm has discovered a number of new reservoirs deep below the main field that could allow output to be raised to 60,000 b/d from around 35,000 b/d with $150m in new spending. The firm, along with its partner BP, is talking to the government and PdV about how the new reserves could be developed.

Shell and ChevronTexaco are also both keen to build new heavy-oil upgrading projects and both have made multi-billion dollar proposals to the government. Neither firm is keen to discuss the details of its proposed investments, which, together, would probably reach $10bn, but the promise of reserves with a 30-year life span is highly attractive to embattled Western majors, struggling to replace output from traditional areas with new reserves.

Some oil executives worry, however, that new directives from the powerful planning ministry could sharply increase the costs of proposed new heavy-oil projects. To promote the industrial development of the interior of the country, the ministry is pushing for all new heavy-oil upgraders to be sited within the Orinoco heavy-oil belt itself, just as it is pushing PdV to build new refineries several days' sailing time up the Orinoco River, despite the huge losses such an investment would entail.

Planners acknowledge the reduced profitability of remotely located plants, but claim the losses to PdV outweigh the benefits of industrialising an impoverished part of the country. Existing operators in the heavy-oil sector worry that the proposed extension of this policy to the heavy-oil sector would rob the existing operators of the opportunity to take advantage of economies of scale at their existing facilities at the port of José, which many say are necessary to offset the heavy tax burden imposed by the government's energy tax policy.

New competitors

Adding to the concerns of Western firms' executives has been the emergence of an explicit government policy favouring companies from states the Venezuelan government is seeking closer ties with. In many cases, the favourites are state-owned companies, which are able to compromise on investment terms to meet the strategic goals of their governments.

State-backed firms from China, Brazil and India have all been offered new upstream investment opportunities ranging from marginal oilfield reactivation contracts to new heavy-oil ventures. Unlike Western firms, these companies can bring to the bargaining table gestures of diplomatic support for the Chávez government, which feels itself increasingly under pressure from the US.

But while Petrobras can help PdV with the offshore and deep-water operating expertise that it lacks, it is not clear whether Chinese state-owned firms, for instance, possess the technology needed to handle extra-heavy crude, especially once the Venezuelan government's policy of pushing for higher recovery rates and the employment of novel hydrocracking techniques to produce synthetic crude is taken into account.

No concrete deals

As such, despite the wave of announcements from state-owned companies, the initiatives put forward by PdV remain simply "agreements to study" and "letters of intent". Yet the same can be said for many of the big spending plans boldly stated by Western firms. No concrete deals have been signed and the devil, as always, is in the detail.

It is worth noting that the Chávez administration has only seen one small project through from concept to production – Total's 100m cf/d Yucal-Placer gasfield – since taking power five years ago. Meeting the challenge of the simultaneous drop in PdV's production capacity along with that built by Western firms in the 1990s demands a much faster pace of deal-making.

LNG: two steps forward, one step back
THE COUNTRY'S enormous potential as a natural gas exporter remains untapped, blocked mainly by shifting policy priorities in recent years. However, some progress was made last year. A series of exploration wells drilled by ChevronTexaco, the operator of the Orinoco Delta Platform block 2, turned up what appears to be a major gasfield. Statoil and Total plan to drill their first exploration wells on nearby block 4 later this year. ChevronTexaco is so confident in the size of its discovery that basic engineering on a liquefied natural gas (LNG) plant has begun.

The Loran/Manatee field discovered by ChevronTexaco is said to hold 5-7 trillion cubic feet (cf) of gas. The bulk of the field lies in Venezuelan waters, with the remainder stretching north into Trinidad and Tobago's block 6b, in which the major is a 50% partner. The discovery is helping to restart stalled talks between Venezuela and Trinidad over a cross-border field unitisation treaty. At the same time, ChevronTexaco is planning further drilling in Venezuela's block 3, where it is also the operator, in the hopes of adding further reserves.

The major has been keen to announce its willingness to proceed with an LNG plant regardless of the status of Venezuela's other proposed LNG project, which has long been seen as providing the necessary infrastructure for the Delta Platform ventures. Despite the long history of the Shell-backed Mariscal Sucre LNG project, which was first conceived in the 1980s, ChevronTexaco may yet become the first company to develop Venezuela's gas export potential.

Shell says the Mariscal Sucre LNG project is progressing. They point to a joint statement with PdV in February that committed both companies to proceed with the development of the 6-10 trillion cf of gas lying off the northeast coast of the Paria peninsula that has been the basis of Venezuela's gas-export dreams for two decades.

Despite the public commitment, government policy toward the project appears to be less than certain. The government of Hugo Chávez has invited in new investors such as Petrobras and officials in the energy ministry have said the project could be divided into two upstream packages and a liquefaction plant, or even that the whole venture could be scrapped and a bidding round for the offshore acreage put in its place. The policy indecision is threatening Shell's timetable for the project, which calls for LNG exports to the US to begin in 2009.

ChevronTexaco may yet experience the same sort of turbulence. Some Venezuelan officials are already grumbling about the rock-bottom price the US firm paid for block 2 in the January 2003 bidding round. ChevronTexaco bid $19m in the auction, which the government insisted on holding even while PdV remained paralysed by an anti-government strike. Earlier talk of sending gas to Trinidad is being downplayed, with the Chávez administration now saying that a "few years" of early production at most will be permitted to be sent to Trinidad for liquefaction.

Downstream: re-focussing on Latin America
UNCERTAINTY about the government's feelings towards PdV's US refining assets and talk of closer ties with China have triggered speculation that a divestment of its US refineries is imminent. Although President Hugo Chávez said in Argentina in February that the government's plan is to divest assets in the northern hemisphere and invest in the Latin American downstream sector, officials later said there are no plans to completely withdraw from the US, while indicating certain asset divestments are possible.

The worsening state of relations between Caracas and Washington is adding fuel to the fire. Chávez has threatened to cut off oil supplies in the face of US aggression, while the US government has stepped up its own rhetoric, describing Chávez as a "negative force" in Latin America.

Much of the Venezuelan government's dissatisfaction with Citgo, PdV's US downstream subsidiary, centres on the perception that the long-term supply contracts between the two shift profits out of Venezuela to the US, where income tax rates are lower. While former PdV managers deny this, the government says its own studies have shown a systematic transfer of profits from the parent company to the refining subsidiaries, which Chávez condemned as Venezuela "subsidising" the US.

However, a recent debt-swap carried out by Citgo has lifted the covenants that restricted PdV's ability to cancel the contracts. New supply arrangements are being worked out that will resolve the government's grievances.

Despite the strident criticism of the Citgo supply contracts, the government has forced PdV into other business deals that make little economic sense. Chávez's desire to cement diplomatic ties with China led to a shipment of 0.95m barrels of heavy Boscan crude to PetroChina at the end of January, at the unheard-of discount of $30 a barrel to the price of US benchmark WTI, according to documents obtained by Petroleum Economist. At least two more cargoes were sold at similar prices in February.

PdV also recently opened two filling stations in Argentina in partnership with that country's new state-owned energy firm, Enarsa, where market leader Repsol YPF has reported that government pricing restrictions led to negative marketing margins in fourth-quarter 2004. Ivan Orellana, Venezuela's Opec governor and a PdV board member, defended the deals saying the government is willing to accept losses in return for "strategic political gains".

One initiative that appears to be gaining momentum is a nascent downstream partnership with Russia's Lukoil. The Russian major is seeking access to US refining assets to supply its Getty-branded filling stations in the US northeast and talks are under way between PdV and Lukoil over a processing agreement that would see the Russian firm sign a long-term supply contract for Urals crude with Citgo in return for a refined products supply deal for its filling stations. Lukoil is also reportedly interested in PdV's German refining assets, which the Venezuelan government is keen to sell as almost no Venezuelan crude finds its way across the Atlantic because of poor market conditions. PdV tried to sell its interest in the Ruhr Oel joint-venture with BP to Russia's Alfa Group last year, but negotiations broke down over price issues.

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