THINK TANK

EVENT: A US federal court yesterday confirmed an order freezing 315 million dollars in a bank account held by Venezuelan state oil company PDVSA, in the context of its contractual dispute with ExxonMobil.

SIGNIFICANCE: With global demand supporting oil prices close to 100 dollars per barrel, developments in Venezuela (claiming the world’s largest oil reserves with its heavy oil) can exert an impact on the global picture and will be closely watched.

ANALYSIS: The Venezuelan hydrocarbons sector has been undergoing a period of substantial change. In 2006, foreign investors were obliged to surrender their majority equity stakes in and control of conventional oil operations, and enter into ‘empresas mixtas’ controlled by state oil company PDVSA. Similar action on the four major heavy oil upgrading projects in the Orinoco Belt followed in 2007.

In May 2007, PDVSA took over operational control of the four heavy oil projects, valued in excess of 30 billion dollars. The six foreign oil company investors were given until late June to reach agreement on PDVSA taking a 60% stake in these projects. Chevron, BP, Total and Statoil accepted the deals on offer, while ExxonMobil and ConocoPhillips refused, opting to negotiate for compensation . The book value of ExxonMobil’s 41.7% stake in the Cerro Negro project was about 750 million dollars at the time but their fair market valuation is perhaps three times this sum.

Asset freeze. Having failed to reach agreement with Caracas on the value of its Cerro Negro assets, in September 2007 ExxonMobil filed a request for arbitration with the International Centre for Settlement of Investment Disputes (ICSID) in Washington. Thereafter, on February 7 the company announced that it had secured court orders in the United States, United Kingdom, Netherlands and the Netherlands Antilles freezing up to 12 billion dollars of PDVSA’s assets (including 315 million dollars in a US bank account) in these jurisdictions, thus preventing PDVSA from selling or transferring assets.

These latest legal moves, to prevent assets being transferred to jurisdictions beyond the reach of enforcement of any future arbitration award, appear to have surprised PDVSA, although not the industry, which expects ExxonMobil to take a tough line on contractual issues.

Consequences. A number of consequences are likely:

Ø Country risk will increase – the price of Venezuela’s dollar-denominated bonds has already fallen – and PDVSA’s borrowing costs will rise.

Ø If these orders are sustained, PDVSA’s ability to dispose of/transfer assets in the normal course of business will be severely impaired, with potential buyers, investors and partners moving very cautiously until these matters are resolved.

Ø This could force PDVSA to use the cash flow and asset base of its US subsidiary, Citgo (whose assets are not attached) to fund its activities, potentially ‘hollowing out’ Citgo.

Ø With PDVSA expected to appeal, this could be a long and expensive process; arbitration hearings alone could take 3-4 years.

Ø Were ExxonMobil to win a major arbitration award and recover full compensation, the four companies that settled – reportedly at less than half their stakes’ estimated market value – may be tempted to review their agreements and call for equal treatment.

Ø ConocoPhillips, with assets whose net book value reached 4.5 billion dollars, could follow a similar path, although it currently appear to be taking a more conciliatory approach.

Ø ExxonMobil probably warned the US government of its planned course of action, which will undoubtedly exacerbate already severely strained bilateral relations. Caracas has accused Washington of being behind the ExxonMobil lawsuit, and President Hugo Chavez has halted oil sales to ExxonMobil and threatened to cut off supplies to the United States (though this appears impracticable).

Hydrocarbon production. Reliable published statistics on oil production are scarce. Although the Central Bank reported that crude oil production fell by 5.3% in 2007, high-end production claims by the Venezuelan authorities – around 3.3 million barrels per day (b/d) – contrast with much lower estimates from the IEA (International Energy Agency) and Cambridge Energy Research Associates (around 2.3 million b/d). Some reports suggest that Venezuelan crude production has declined by nearly 30% since Chavez took office in 1999.

Other evidence tends to support the view that production is falling:

ü Last year, PDVSA said it needed nearly 200 rigs but, at the end of the year, only some 70 were active – and the number of wells drilled declined by some 30% between 2001 and 2005.

ü Venezuela, along with Iran, consistently opposes any increase in OPEC production and reacts to modest falls in the oil price by advocating production cuts. While unwelcome to consumer countries, this is an entirely logical stance for a producer unable to maintain its output.

Investment burden. Venezuela now directly controls all conventional and heavy oil production, with foreign investors allowed at most a 40% stake in oil exploration, development and production. However, there are costs attaching to this policy:

Þ One estimate suggests that foreign investment is as much as 6 billion dollars below the level anticipated under the national strategy.

Þ Foreign investors will have to be compensated for their lost equity. Where there is disagreement, arbitration and even court action could persist and possibly discourage new foreign investment.

Þ Some important foreign investors have left the country and despite Venezuela’s obvious resource attractions, may not return under the current regime. With the international oil industry struggling to replace production, the loss of oil production in Venezuela last year will not be quickly forgotten.

Þ Remaining foreign investors are likely to resist investment beyond necessary maintenance and contractual obligations. Total recently signed heavy oil study agreements with PDVSA to appraise reserves and examine a production project – a relatively low-cost way of keeping an option open.

Þ PDVSA will have to bear at least 60% of all future oil investments – a challenge that will increase if anticipated moves to take a similar level of control in the gas industry transpire.

PDVSA priorities. With continuing high oil prices, a conventionally managed PDVSA could probably meet its investment needs largely from its own resources. However, non-oil demands are rising, with reports of a new structure being introduced, with seven new subsidiaries covering agriculture, services, industrial, naval, communal gas, engineering and construction, and urban development.

PDVSA had 48,000 employees in 1998-99, just under 75,000 in late 2007, with 110,000 forecast by end-2009. Working directly through PDVSA allows the government to re-direct oil revenues to meet domestic and foreign policy objectives within the company, without checks and balances or external scrutiny. This makes it difficult for PDVSA to maintain the necessary focus on its core business. Even a modest reduction in oil prices will have a significant impact on PDVSA’s revenues. Unless prices continue to rise, revenues will fall. PDVSA may lack funds to meet its ’stay in business requirements’, let alone grow production and invest in major new developments.

With oil revenues accounting for an increasing percentage of national income, the future of the country becomes ever more closely tied to oil production. This is falling and the political imperatives now driving PDVSA’s non-oil priorities run the risk of accelerating this decline.

CONCLUSION: There is a significant risk that headline numbers on economic performance supported by high oil prices could be masking serious challenges to Venezuela’s longer-term viability. Any modest downward pressure on the oil price could force Chavez to make difficult choices between domestic social spending, international commitments and hydrocarbon investment. The ratcheting up of ExxonMobil’s dispute with PDVSA would intensify these potential dilemmas.