Latin American Approach to Oil And Gas Lacks Structure

March 2012, Vol. 239 No. 3

Jeff Share, Editor

Though unconventional plays are remaking the face of the North American oil and gas industry, we dare not overlook our neighbors to the south. Although activity in Latin America varies from country to country because of political situations, economics and resources, oil and gas development is the essential ingredient needed to improve the standard of living of their citizens – both in terms of the comforts they provide and the revenues they earn.

Jose Valera is a partner in the Houston office of Mayer Brown’s Energy practice. He focuses his practice on domestic and international energy transactions, and has more than 25 years of legal experience representing oil, gas, and electric energy companies throughout the United States, Central America, South America, Africa, Asia, and the Caribbean. In this interview, Valera discusses the future of Latin America’s oil and gas industry. He can be reached at jvalera@mayerbrown.com.

P&GJ: What factors are working to make Latin America a growing force in the oil and gas industry?
Valera:
Countries in Latin America vary greatly in the way they develop their oil and gas resources. Some countries take a nationalistic approach and barely engage private sector companies (Mexico) or offer bare-minimum incentives through mandatory associations or other arrangement with state-owned enterprises (Venezuela, Ecuador, Bolivia). The industry in all these countries lacks adequate managerial capacity, capital and technology; and production and reserves are generally declining.

Argentina for about a decade now has stunted E&P activity by regulating prices at consumer levels and taxing exports, with a resulting very low net-back price at the wellhead. The timing for the development of shale gas discoveries in Argentina is uncertain. On the other hand, Brazil, Colombia and Peru have maintained openness to the private sector under competitive terms and production and reserves in all such three countries are increasing.

P&GJ: How is domestic use of natural gas and oil increasing and is it being encouraged by governments?
Valera:
Domestic use of oil and gas is increasing as a direct result of economic growth and policies directed at increasing the use of natural gas. Argentina has the largest consumption of natural gas per capita in Latin America, and is a leader in the development of vehicular natural gas infrastructure. But because domestic E&P is adversely affected by government policies, an increasing share of natural gas comes from imported LNG.

Other countries are also quickly adopting VNG and developing gas distribution networks. The government of Peru was very supportive of the development of the Camisea gas field, which now allows for the use of natural gas in the Lima metropolitan area, for power generation and for LNG exports. Brazil, Colombia and Ecuador view natural gas as necessary to lessen dependence on variably hydro resources for electric generation.

Chile produces very little natural gas and imports LNG to support gas-fired power generation. Mexico produces natural gas but in insufficient quantities. In order to satisfy the demand for power generation and industrial and residential use, Mexico imports pipeline gas from the U.S. and LNG.

P&GJ: How has the development of shale and other unconventional fuel sources changed the energy picture and is it stronger for gas or oil?
Valera:
Shale gas has been discovered, most notably in Argentina, Chile and northern Mexico, but not developed yet in any commercial sense. It would be a surprise to see major unconventional gas production before 2020 in Latin America. The unconventional fuel source of more importance is ethanol. Brazil is the leader in ethanol production and consumption in Latin America, particularly of the sugar-based variety. Brazil’s consumption of ethanol is now so high that it has to import ethanol from the U.S. to satisfy demand.

P&GJ: Where are the hottest plays right now?
Valera:
The hottest play right now has to be the pre-salt offshore Brazil. Brazil now produces more than 2.5 million boe/d and is poised to become a large oil exporter. But to develop the pre-salt is expensive and technically very challenging. The players that venture into the pre-salt are relatively few. Shale gas in Argentina has the potential to become a hot play if government policies change to encourage it. The oil sands in Venezuela are abundant but not being developed to their true potential due to restrictive government policies. And of course there is Mexico, if the country decides to open up.

P&GJ: Are countries encouraging outside investment, and what are some of the challenges outside companies need to be aware of in working there, both financially and physically? Is Colombia still dangerous?
Valera:
All countries in Latin America are open to outside investment to one degree or another, but not all offer competitive terms and give comfort to investors that the rules are going to be maintained and contracts respected. The biggest challenge is politically driven resource nationalism which affects existing contracts.

In recent years Bolivia, Ecuador and Venezuela forced new terms under explicit threat of nationalization. Another challenge is populism, which distorts markets. Colombia is substantially safer now than it was ten or more years ago. This situation has undoubtedly contributed to the impressive increase in E&P activity in Colombia. The number of outside players in Colombia has also gone up.

P&GJ: What is your perspective on how the LNG market will work in Latin America regarding both imports and exports?
Valera:
Argentina, Brazil, Chile and Mexico import LNG. Only Peru exports LNG. Imports in Argentina, Chile and Mexico are on an upward trajectory. Peru is unlikely to export more in the foreseeable future than it does today given unsatisfied domestic demand. All increased production will probably remain in the domestic market. Colombia, Uruguay and Central America could turn into importers of LNG. By some estimates, Brazil could revert its LNG trade and turn itself into an exporter with a leading floating LNG project. Venezuela exporting LNG is a long shot.

P&GJ: What are the prospects for new pipeline construction? Can you talk about any specific projects on the drawing boards?
Valera:
I’m not aware of any likely new cross-border pipeline projects. Most new pipeline projects are in-country. There are such gas pipeline projects in Peru, Colombia, Bolivia, Brazil, Venezuela and Mexico.

P&GJ: What are your thoughts of the Venezuelan oil and gas industry with Hugo Chavez still at the helm?
Valera:
It’s an industry that has stagnated and become very inefficient. The national oil company, PDVSA, is also a government instrument for social policy and government financing. PDVSA controls the industry but it is not run as a business. Under the oil law, outside investment has to come in under a 60/40 joint venture which PDVSA controls. The outside investor has to carry PDVSA.

Add to that ever-increasing taxes and royalties, unpaid or nationalized contractors, and Chavez demanding that disputes be handled only in his local courts, and you see a picture of high risk and not much upside. PDVSA’s costs are high and domestic prices for fuels are one of the lowest in the world due to subsidies. The single largest source of government revenue is the export sale of crude oil. This is an oil republic that doesn’t even maximize its own oil resources.

P&GJ: What have been the effects of nationalization in Bolivia, and is this a situation that could occur elsewhere?
Valera:
The effects of the nationalization in Bolivia have not been good. Bolivia painted itself into a fiscal corner, placing a large bet on its natural gas resources. The problem is that after it coerced outside investors into changing their contracts into service agreements and putting YPFB in control, YPFB did not deliver. True exploration is almost nil. Production is flat. Reserves are shrinking. Downstream infrastructure has not kept up with demand growth and Bolivia now imports a wide array of fuels that it then resells domestically under heavy subsidized prices.

The nationalist policy has been very costly. Bolivia has only two export markets for its natural gas: Argentina and Brazil. Both have resources that could be developed to a point of substituting imports from Bolivia. If Bolivia loses its gas export markets it would be catastrophic for its treasury. Bolivia has historically refused to sell gas to Chile and even allow for the transport of Bolivian feed gas through Chile for a now-doomed LNG project. Prospects are not good unless the government introduces profound changes.

P&GJ: Is Brazil and Petrobras still the leading operator in South America, and what is their focus on today?
Valera:
Petrobras is the most successful operator in South America. Ninety percent of its production is in Brazil and that is its focus. Recent legislation requires that Petrobras be the operator of all new areas in the pre-salt region, and that it carry a mandatory minimum 30% working interest. Its existing areas offshore Brazil are demanding what is probably the largest expenditure of capital in offshore resources of any other company in the world. Petrobras had 12.873 billion boe of proved reserves as of Dec. 31, 2011. It had an average production of 2.6 million boe in 2011.

P&GJ: What role does the petroleum industry play in the economic development of South American countries?
Valera:
It varies by country. What is clear is that large government revenues by themselves do not guarantee development. Few would seriously argue that Venezuela will become a developed country under current policies despite its immense resources and government revenues. What matters is what the government does with its revenues and the opportunity given to the private sector to grow itself.

Brazil is poised to deflect the resource curse and I hope it does. The change in legislation there I alluded to earlier aims, in part, at nurturing local industry and creating funds with oil revenues to be spent by the government on development programs. It remains to be seen how this money will be spent and what the results will be, but if done smartly it could have a profound effect in the standard of living of all Brazilians.

Ultimately, governments create the conditions for development, as opposed to being the direct agents for development. Some countries have taken the position that the government has to maximize revenues by squeezing and restricting the participation of the private sector and redistribute revenues on social programs. This is a dubious recipe for development. Other countries are taking a different approach, spending smartly and not forsaking the market economy.

P&GJ: What have been the effects of forced conversion of oil contracts into service contracts in Ecuador?
Valera:
It has not been a great start. The forced conversion of contracts into service contracts had the effect of removing incentives for outside investors to risk and spend capital in Ecuador. The expectation, then, is that Petroecuador has to fill the void in order to continue adding reserves and at least maintain production.
Much like Bolivia, this is not yet happening in Ecuador. Managerial capacity, available capital and technology are sorely lacking. The government is borrowing heavily from China, which lends billions on a no-questions-asked-basis so long as it is repaid in oil. This gives the appearance that the government is flush, but it masks a long-term problem of sustainability.