Latin America: the true flywheel will be a new policy

Latin America: the true flywheel will be a new policy

Francisco J. Monaldi
The area, which has always possessed a huge energy potential, has in recent years exhibited a disappointing performance, especially in terms of production of crude oil production. The true growth opportunity is in a clear administration, efficient and based on strengthening investment

The Americas, North and South, concentrate the largest hydrocarbon resource endowment outside of the Middle East. The Western Hemisphere has 33 percent of the world’s proved oil reserves, while the Middle East holds 47 percent. The geological potential is enormous, but the remaining resources are largely unconventional (shale and extra-heavy oil) or in deep waters, so costs and risks are higher and tech­nol­ogy/ knowhow more crucial.
In the US and Canada, which hold 13 percent of the world’s proved oil reserves, high oil prices fueled an energy revolution with substantial increases in oil and gas production. During the last ten years, oil production increased 73 percent, from 9.9 million barrels a day (mbd) in 2005 to 17.1 mbd in 2015. In contrast, in Latin America, with 20 percent of the proved oil reserves, oil production declined 7.2 percent, from 11.1 mbd to 10.3 mbd, and the region lost more than two percentage points of the world market share. That is a remarkably poor performance, given that it happened during the largest oil price windfall in history. Using alternative measures of resource endowments, the same inescapable conclusion arises: the region’s oil industry generally wasted a tremendous opportunity to grow.
Latin America’s striking underperformance was largely the result of production declines in three countries: Mexico, Venezuela, and Argentina, and was partly compensated for by production increases in Brazil and Colombia. However, even Brazil, the star performer of the last two decades, has recently underperformed, and its national oil company is in a serious predicament.
The recent oil bust has hit the Latin America oil industry very hard; both investment and production have been falling rapidly throughout the region. The decline in production in 2016 could reach as high as 400 to 500 thousand barrels a day, a dramatic 4 to 5 percent fall in just one year, with Venezuela and Mexico again the highest drops. However, it is important to stress that even though the troubles in the Latin American oil industry were made much worse by the collapse in oil prices in 2014, the problematic trends predate it. The oil price boom had been hiding unsustainable trends that are now painfully clear.

The geological potential of #LatinAmerica is huge, but many resources are #non-conventional with higher #costs and #risks

If its geology is so attractive and prices were so favorable for more than a decade, what has been the source of the region’s oil industry blues? The answers lie in the dysfunctional politics of oil, the cycles of resource nationalism, and the mismanagement of national oil companies.

The cycles of short-sighted resource nationalism have been a recurrent feature of the oil industry in the region, damaging the long term potential of the sector. During the boom years, 2003-2014, Argentina, Bolivia, Ecuador, and Venezuela, forcefully renegotiated contracts and/or nationalized the oil sector. Mexico remained a closed and inefficient state monopoly, missing a great opportunity to attract private investment to its oil industry. Although Brazil did not change contracts retroactively, it made future deep-water projects much less attractive. Even in Colombia, the only relevant oil producer that did not worsen contract conditions, the overall policy environment turned less welcoming to oil investors. Thus, to an extent, foreign investors were victims of the price boom and their own success in increasing production and reserves, particularly in oil exporters.
In turn, as a result of the problematic trends facing the oil industry in the region, a new wave of liberalization began to surface even before the oil price collapse; and as expected, these trends significantly strengthened with the financial troubles faced by countries and their NOCs after the bust. However, the reputational costs of the highly volatile institutional frameworks would make it even harder to attract investment and develop the region’s full potential.
Another key reason for the region’s underdeveloped oil industry has to do with the inefficiency, underinvestment, and corruption which have plagued its dominant players: the national oil companies (NOCs). Brazil, Mexico and Venezuela produce 3 out of 4 barrels in the region and contain more than 90 percent of its reserves, so what happens in these three countries is crucial for understanding the future of the world oil supply. Their NOCs are the largest in the region and among the largest in the world. PDVSA (Venezuela), Pemex (Mexico), and Petrobras (Brazil) are currently in deep financial trouble, made worse by the oil price fall, but they were all on an unsustainable path long before it happened. PDVSA was gutted by Hugo Chávez after he fired most of its senior management and technical staff. Since then, production has been declining, despite having by far the largest oil reserves in the region. Pemex, until recently an oil monopoly, underinvested for decades, which led to a sharp reserve decline and eventually to a production collapse starting in 2005. Overstaffing, corruption, and politicization have been historical problems for Pemex, as they are now, to an unparalleled extent, for PDVSA. Petrobras long a symbol of national pride for Brazil, one of the few NOCs capable of operating deep-water projects, has been involved in a spectacular corruption scandal that has rocked the country’s political system.

Venezuela. The colossal basket case

In Venezuela, a successful opening of the oil sector paradoxically helped to create the conditions that led to oil nationalization; while the stagnation of the industry, in turn, is restoring pragmatism to deal with the decline. In the 1990s, facing low oil prices, recurrent fiscal crises, and significant investment needs, Venezuela opened the oil sector to private investment in the riskier and less profitable projects. This was a major departure from the nationalization in 1975, which had made state-owned PDVSA the monopoly producer. The opening attracted significant investments by major international players, including Exxon, Shell, BP, Chevron, Total, and Eni, leading to a substantial increase in production of more than one million barrels per day (equivalent to more than 40 percent of current production levels).
In 1998, Hugo Chávez was elected president with a resource nationalist rhetoric, just when prices bottomed out, but he did not change the existing oil deals until 2005, after all major investments had been made and prices had swung up significantly. The protracted and confrontational expropriation process that ensued significantly increased the government-take on profits. It also affected Venezuela’s reputation and attractiveness, delaying all major new investments and generating very high opportunity-costs in terms of foregone future production. Lately, as production faltered and the regime became desperate for more revenues, realism pushed the government to offer investors better terms and guarantees. Although investors continued to be very cautious, the change in the Venezuelan government’s attitude was palpable. The pragmatism - better described now as desperation—has become more obvious after the price collapse because of the urgent need to increase investment and production.
PDVSA, which had been considered one of the best run NOCs in the world, suffered a massive setback in 2003 when Chávez fired most of its management and technical staff, as a result of a power struggle that led to a massive oil strike. Since then, the company has never fully recovered. It has a limited pool of qualified human resources and was able to avoid production collapse by relying heavily on foreign contractors and joint-venture partners in a favorable price environment. Nevertheless, the number of employees grew three-fold, while the production per-employee rapidly fell to its lowest level in history (to levels similar to Pemex’s). Moreover, production operated alone by Pdvsa has collapsed by more than half since its peak in 1998, and has only been partly compensated by the JVs with foreign partners.
The government has over-extracted resources from PDVSA. The company’s financial debt increased from $3 billion in 2006 to $44 billion today and debts with suppliers are above $20 billion. The company has also been  borrowing heavily from the Central Bank to cover operational expenses in domestic currency. Overall, the situation of PDVSA—critical even before the price collapse - is now desperate, unless oil prices go back up. Only a major overhaul of the company and an intensive use of partnerships with the private sector can reverse its decline.

Latin America's striking underperformance was largely the result of production declines in three countries: Mexico, Venezuela and Argentina, and was partly compensated for by production increases in Brazil and Colombia

Mexico. Production collapse brings reform, price collapse accelerates it

Mexico was an exception to the liberalizing trend in the 1990s. Historical and ideological reasons can help explain this exceptionalism, but the major factor behind the lack of reform is that Mexico’s production kept increasing without significant new investments. The giant oil field of Cantarell, which produced more than two million barrels a day at its peak (or close to two thirds of the country’s production), allowed the government to over-tax and conceal the significant inefficiencies of the national oil monopoly, Pemex. The future costs of the lack of investment were not perceived by the political leadership and even less by the general public, so there was no rush for reform.

Once Cantarell’s production started to collapse in 2005, the need for reform became clearer, but high oil prices made it initially less urgent. However, as Pemex capital expenditures increased five-fold but barely slowed declining output, the case for reform became much stronger. Cantarell’s production has declined more than 85 percent from its peak. With Peña Nieto’s election, institutional gridlock eased, and reform was finally passed. Mexico, as Venezuela in the past, is opening the riskier and/or marginal projects, some of which require large investments and complex technology. Pemex kept most of the proved reserves and all the high rent low risk areas, and so far, the first bidding round of oil areas has had limited impact. Few attractive areas have been assigned, and some bids have been unrealistically high, generating uncertainty over the magnitude of investments that will actually materialize. In December of 2016, the auction of deep-water areas is set to take place. This would be by far the most relevant event yet in the oil opening; there are high expectations that the upstream reform would finally prove meaningful with the allocation of areas with high potential to major oil companies.
In contrast to Venezuela, Mexico is building a much more robust institutional framework to support reform. It is also much more integrated into the world economy than its South American neighbors. These factors might deliver a longer life for the investment cycle. However, if the incentives for expropriation appear in the future, high oil prices, major discoveries, and high sunken investments; one cannot discard the possibility of a partial reversion to reform, especially given the enduring strength of nationalistic ideology in Mexico. In fact, the popular leftist presidential candidate Lopez Obrador has threatened to halt the reform if elected in 2018.
In 2015, Pemex for the first time had a loss before taxes, and it had to massively cut investments. As an indication of the extent of the cut, the number of oil rigs in operation fell from 44 in January 2015 to just 16 in July 2016 (a 64 percent decline). Rating agencies downgraded Pemex debt, and  the government had to inject capital to Pemex to enable pay for suppliers and pensions. It also improved its fiscal regime to limit further financial strain and changed the leadership of the company with a mandate to cut costs, sell assets, and partner with private companies. The new CEO Jose A. Gonzalez Anaya, a highly respected economist, has moved swiftly to take advantage of the opportunities given by the new legal framework and move the reform further than initially planned, concentrating Pemex’s limited investment capacity in the most profitable areas, while partnering, transferring, or selling non-core assets. However, the challenges of Pemex reform remain formidable, particularly for a weak lame-duck president like Peña Nieto.

In contrast to Venezuela, Mexico is building a much more robust institutional framework to support energy reform. In Mexico is also much more integrated into the world economy than its South American neighbors

Brazil. Still the country of the future?

Even though Brazil is still a net importer of oil, it has increased its production more than fourfold over the last two decades, matching the production levels of Mexico and Venezuela. That success is in large part the result of the liberalization of the oil industry in the 1990s, when Petrobras, the national oil company, was partially privatized and the petroleum sector opened to foreign investment. As a net importer, the country was eager to maximize its production and, until recently, did not focus on extracting fiscal rents. However, the discovery of massive deep offshore reserves, began to change governmental incentives. In contrast to its South American counterparts, Brazil did not nationalize or force contract renegotiations. However, it did increase the government take for future offshore projects. It required Petrobras to be the operator and established an ambitious policy of increasing the local content of investments. Moreover, the participation of private shareholders in Petrobras was diluted when the government exchanged oil reserves for equity in the company, in a move that many analysts considered a form of expropriation.
Thus, even though Brazil had been considered a model of oil regulatory policy, the effects of its success and the prospect of becoming a net oil exporter also induced a milder version of resource nationalism. This has already had negative implications for investment and production, which have not reached their targets during the last few years. Petrobras investment plan of 2014 forecasted production at 4.2 million barrels a day by 2020. The last investment plan reduced that forecast to 2.8 million barrels a day, and it may have to revise it down further.

The corruption scandal involving Petrobras dealings with its contractors, a result of the politicization of the local content program, has been a big blow for the company and for the government, which still is having significant consequences related to investment. Most of the main local contractors were involved. In early 2016, Petrobras’ market capitalization collapsed to less than 10 percent of its peak value in 2008.
There were some mild signs that the Rouseff administration was moving back to a more pragmatic stance, particularly after the lack of investors’ interest in the last offshore auction and given the recent oil price collapse. After the Rouseff impeachment process started, the interim president Michael Temer signaled that he will support a reform of the legislative framework to give a larger role to the private sector in deep-waters and revise local content rules. Still, as Brazil becomes a net exporter and the federal and regional governments face a fiscal crisis, the risks of fiscal pressure over the oil sector might increase.

The oil industry in Latin America could have a bright future, given that it has the largest resource base aoutside of Middle East, but in addition to dysfunctional policies, there are other riscks to conside: as, in the short term, the low oil price

The future of the Latin American oil industry

Latin America has been more prone to cycles of resource nationalism and liberalization than other regions in the world, possibly due to the combination of factional democracies, weak rule of law, and high inequality. Given the right circumstances, resource nationalistic ideologies could come back. After a cycle of significant investment that adds substantial production and reserves, changing the rules may become tempting again. Conversely, a prolonged period of low oil prices could induce further pragmatism and liberalization. In general, net importers or countries that have both declining production or reserves and a portfolio of high-risk projects would be pressed to be more open. Institutions that encourage governments to take longer-term approaches, which limit their ability to opportunistically renege on deals, could moderate the effects of such volatile incentives. Independent regulatory agencies, as well as progressive and effective fiscal and contractual regimes that properly tax windfall profits, would be helpful to attract private investment. A pragmatic nationalist perspective requires substantial participation of the private sector to help develop the frontier and unconventional resources, utilizing a strong regulatory framework that both captures rents and provides incentives to develop the sector to its full potential.
NOCs are likely to remain major players in the region, as they are in almost all significant oil producing developing countries; but if they are not significantly reformed, the region’s potential will remain underdeveloped. They have to be restructured to concentrate on the lower risk profitable upstream areas and partner, or exit altogether, non-core areas and frontier developments. Their corporate governance has to be strengthened, providing them with financial and operational autonomy, but guaranteeing more accountability and the existence of a hard budget constraint. Having private shareholders is not a panacea, as the Petrobras case shows, but it could still be a useful mechanism to discipline management and limit politicization.
The oil industry in Latin America could have a bright future, given that it has the largest resource base outside of the Middle East, but in addition to dysfunctional policies, there are other risks to consider. In the short term, the key risk is a continued low oil price environment that makes high cost projects uncompetitive. In the longer term, the regional oil industry, along with the rest of the world, faces the risks generated by climate change and the policies to mitigate it, as well as the potential displacement of oil as the lead transportation fuel. Oil dependent countries, like Venezuela and Ecuador, could face an existential challenge if they do not change path. Other countries like Argentina, Brazil, Colombia and Mexico, although less affected, also might suffer due to the economic importance of the oil sector and their NOCs.

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