Vaca Muerta, a chimera or a real treasure?
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The Macri government, in Argentina, has to decide whether it is appropriate to develop hydrocarbon deposits at all costs, or to focus on more valid long-term solutions

Since the first oil discovery in 1907, Argentina has suffered from volatile energy policies determined by domestic politics. Populist energy policies during the Kirchner-Fernández presidencies (2003-2015) culminated with the 2012 expropriation of Repsol-YPF, which had discovered the vast Vaca Muerta shale play. However, the promises of rapidly increasing unconventional oil and gas production failed to materialize and the imbalances of the energy sector became economically unsustainable. The Macri presidency has made energy reform the hallmark of its economic policy, addressing simultaneously supply and demand weaknesses. While during the last year his government has delivered an impressive set of policy measures, including a reduction in consumer energy subsidies and an agreement to foster the development of Vaca Muerta, the only partially successful efforts to accelerate the slow development of the Neuquén basin risk disappointments on the delivery of promises in the short term.

Vast unconventional reserves

In 2011, Repsol-YPF confirmed the existence of vast unconventional oil and gas resources in Vaca Muerta, an oil and gas formation in the Neuquén basin, southern Argentina, with a shape and size similar to Belgium. Vaca Muerta is the second-largest shale gas and fourth-largest shale oil reservoir in the world, and since its discovery it has raised the expectations of successive governments to replicate the shale revolution going on in the United States and Canada. While the country hold other conventional and unconventional reserves, Vaca Muerta plays the dual role of compensating declining conventional production and pioneering shale exploration and production that can be extended to other areas of the country. At the time of its discovery, oil and gas production had been falling for almost a decade and energy imports were rapidly increasing for the first time in 20 years. The president Fernández cabinet saw the development of shale gas as a simple solution to a serious energy crisis without having to adopt unpopular measures to harness energy demand growth, like the reduction of high consumer subsidies. However, in spite of generous subsidies to oil and gas production, both continued to decline. Oil production was still falling in 2016 to 1991 levels, while gas production only started to increase in 2015 and by 2016 had reached 2000 levels. Unconventional exploration proved more demanding than expected, and while Argentina is arguably the third country after the United States and Canada to have developed unconventional exploration and production, it lags well behind in terms of wells drilled and, more importantly, production costs. Vaca Muerta is compared to such a prolific play as Eagle Ford, but production costs roughly double those in the United States. The players are mainly YPF and a few international oil companies, that are waiting for better domestic (production subsidies) and global conditions (a rise in oil prices) to improve before intensifying the pace of final investment decisions. This has no similarity to the myriad of small and medium companies that developed the United States’ shale basins in a much more competitive ecosystem and that initially benefitted from high oil and gas prices. High production costs in a global low price environment and domestic political uncertainty explain the reluctance of foreign companies to scale up investments in Vaca Muerta. Until recently, final investments have been modest, with shale oil and gas production slowly increasing but unable to compensate for the decline in conventional fields with the exception of gas during the last two years. However, the election of a new president committed to economic reform has changed the Argentinean energy landscape and has renewed interest in developing the country’s vast unconventional oil and gas reserves.

Volatile energy policies

Hydrocarbons constitute 85 percent of the energy mix in Argentina, and are key to electricity generation, representing around two thirds of electricity generation and installed capacity. Like in other economic policy areas, energy policies have been historically subjected to political interests and radical shifts in their orientation from one presidency to another. In the 1990s, president Menem adopted market friendly measures, including the deregulation of the energy sector, privatization of state-owned energy companies like YPF, and the liberalisation of foreign energy trade. These measures were reversed during the severe 2001 economic crisis: public utility tariffs were frozen, dollar contracts with utilities converted to devalued pesos and export taxes re-enacted. These and other interventionist measures were intended to be temporary, but the Kirchner-Fernández presidencies maintained and even extended them during the fast economic recovery that followed the crisis. During their mandates, the energy sector became the largest recipient of subsidies. Consumer electricity subsidies, initially intended to reduce poverty, were not reduced but increased with economic recovery, becoming the hallmark of Kichners’ Peronist energy policies. On the supply side the principal measure was the 2012 expropriation and nationalization of Repsol-YPF after its Vaca Muerta discovery. By that year economic growth had stalled and, representing around 3 percent of GDP, energy subsidies were no longer fiscally sustainable. In order to accelerate oil and gas production, the government introduced another policy swing, easing some restrictions like export controls and setting wellhead oil and gas prices above global market prices. A special plan, "Plan Gas," was devoted to develop gas exploration and production through subsidized prices until 2017. In 2015 a support price for oil companies was introduced to offset falling international oil prices, the so-called "barril criollo." The period of low prices in global oil and gas markets continued longer than expected, making these measures increasingly costly. Aware of the need to attract foreign investment to develop the country’s unconventional resources, the Congress also agreed to compensate Repsol with US$5 billion in bonds for the expropriation of YPF. Nevertheless, the nationalization of Repsol-YPF demonstrates how Argentinian politics had led in the recent past to a lack of respect for the rule of law and property rights.

Shifting politics

This lack of consistency in Argentinian energy policies goes beyond the political will of different governments, and remains an obstacle to a sustained and incremental development of the country’s shale oil and gas resources. The volatility of economic policies in the country has been related to the characteristics of its political system: hyper-presidentialism, competitive federalism, delegative democracy and powerful trade unions make a complex institutional mix. This uniqueness has led the country to pendular economic policy-making and to alternate cycles of accelerated development followed by periods of prolonged stagnation. In particular such an institutional configuration raises the question of whether the deep energy reforms initiated during the first year of the Macri mandate will be politically sustainable over enough time to unleash the potential of Argentinian unconventional reserves. Since his election in December 2015, president Macri has made energy policy one of the drivers of economic reform. The energy minister, Mr. Aranguren, is a respected energy sector professional. Until 2015 he was the president of the Argentinian branch of Royal Dutch Shell and one of the most vocal critics of Peronist energy policies. A few months later having entered office his department enacted an abrupt reduction of consumer gas and electricity subsidies to arrive at "sincere" prices ("sincerar precios"), the euphemism the new government is using to avoid the unpopularity of price increases. The measure was criticized by the opposition, and even partially suspended by the courts. However, minister Aranguren has perseverated, and has been quite successful in reducing subsidies and their fiscal burden. The substantial decrease in electricity and gas demand experienced in recent months is the first sign of the effectiveness of governmental policies in balancing the energy market. From the supply side, Mr. Aranguren’s department has also been very pro-active. His main achievement has been a comprehensive agreement announced last February to foster the development of the country’s hydrocarbon reserves. First, it has extended the "Plan Gas" until 2020, but restricted the minimum price offered to producers to US$7.5 per mBTU, still above global market prices but available only to new wells in the Neuquén basin and setting a roadmap for a progressive price reduction. The agreement also provides for the gradual elimination of the "barril criollo," setting a starting price of US$59.4/barrel for oil from the Neuquén basin and US$48.3 from the San Jorge basin, with prices decreasing monthly to converge with international (WTI) prices by the end of 2017. The export taxes on crude oil and products in place since the 2002 devaluation are lifted. The government hopes that oil and gas prices will tend to increase over the next years while local producers will be able to reduce production costs, thus allowing the full eliminateion of support prices. It has also launched several initiatives to increase competition and transparency in the retail market, like fostering information on gasoline prices among consumers. Perhaps more importantly in terms of policy time consistency, the agreement was designed in an inclusive manner, with the participation of the federal government, the Neuquén provincial government, as well as the oil and gas companies and labour unions. It includes the "flexibilisation" of labor conditions in the costly Vaca Muerta non-conventional fields, as well as other measures to improve productivity and converge towards North American exploration and production costs. Such a concession from a powerful oil workers’ union has been interpreted as a promising sign of a more attractive labor environment that could be extended to other basins and the whole energy sector. For instance, a similar agreement is being negotiated for the San Jorge basin, home of Cerro Dragón, the country’s largest oil field. The agreement also includes the commitment of the Neuquén provincial government not to increase taxes and to invest in transport infrastructures to improve logistics and factor productivity. If successful, the government could even project energy reform as an institutional template for other structural reforms.

Vaca Muerta: dead or alive?

The ambitious and comprehensive energy reforms adopted by the Macri presidency to attract foreign investment in the oil and gas sector, especially the Vaca Muerta agreement, have renewed the interest of some companies in developing its reserves. An increase in investment in exploration and production over the next years is likely to follow such policy improvements. In exchange for the above-mentioned facilitating measures, the agreement includes the commitment by the main players (state-owned YPF and Pan American Energy (PAE) from Argentina, and international companies like Chevron, Shell, Dow and Total) to increase investments in Vaca Muerta to US$ 5bn in 2017 and US$ 15bn annually thereafter. Since then, new investments have been announced. YPF has subscribed three agreements over the last months: in February a US$ 300m project with Shell; in March another US$ 500m MoU with PAE, Wintershall and Total; and in April a third one with Schlumberger for US$ 400m. But the most significant project announced to date is the one by the Italian-Argentinian Techint Group to invest US$ 2.3bn between 2017-1019. However, and notwithstanding the last reforms, the development of the country’s unconventional oil and gas reserves faces several challenges: low oil prices in a context of tough competition over market shares; a slowly evolving oil and gas domestic regulatory framework with structural productivity problems (lack of infrastructure, competition and labor flexibility); and the sustainability and consistency of the current policies over sufficient time to allow incremental investment to unleash the country’s shale oil and gas production. It is no coincidence that in spite of the recurrent announcements of big investment projects in Vaca Muerta since the expropriation of Repsol-YPF and the enormous potential of the field, until now just two out of 17 concessions have started production. In fact, most of the infrastructure and activity is concentrated in Loma Campana, the first play to be massively exploited in Vaca Muerta by YPF and Chevron since 2013. In order to reduce costs, most of the new investments are concentrated there, or in contiguous areas like Bandurria Sur. In any case, the development of Vaca Muerta is an incremental process that will require time. A recent and optimistic report by IHS (Vaca Muerta Insight Series: Supply Scenarios for Argentina's Energy Future) pointed out that Argentinean shale gas could be able to supply domestic demand by 2040, with exports being more difficult to envisage but also possible under sustained optimal policies. In particular, the report finds that Vaca Muerta gas is more attractive than oil, suggesting break-even prices below the “Plan Gas” price of $7.50 per mBTU, especially in the most prolific areas. It also highlighted, however, that to materialize, such a scenario requires an annual investment of US$8 billion until 2040, a challenging amount for a country that received less than US$5 billion in foreign investments for the whole economy in the first nine months of 2016, a total 50 percent less than in the same period a year earlier. While promising, the outcome will not replicate the United States’ shale revolution. There will be no Saudi Argentina. On the other hand, several policy measures implemented by the new presidency, namely the support to wellhead prices, depend upon the international price context. The recovery of the oil price could take longer than expected by the government, increasing the burden of supporting wellhead prices and therefore complicating the fiscal and political sustainability of energy reforms. If the increase in unconventional exploration and production turns out to be slower than expected, restrictive demand-side policies are to remain a key element of Argentinian energy policy to contain consumption and maintain convergence towards international energy prices. These are politically costly measures and the current president needs to prove they will be sustained over time. His government stance has been pragmatic, negotiating inclusive agreements and sequencing adjustments in a gradual manner. In this way, it has been able to revive interest in Vaca Muerta, where to date production increases have been elusive and modest. There is no doubt that these are the kind of policies that attract foreign investors, but the Macri presidency could learn from his predecessors about the risks of raising expectations and failing to deliver on the promises of a shale windfall. A realistic and incremental approach could be more credible and effective over the medium term than a premature shale rush under a yet inadequate domestic and global environment. Perhaps more importantly, the Macri government will have to decide whether it is advisable to develop Vaca Muerta at any price (literally) or concentrate on more efficient measures in the long term than continue to subsidize wellhead prices.