TEMPERATURE RISES FOR STRATEGIC ASSOCIATIONS

C O N F I D E N T I A L SECTION 01 OF 05 CARACAS 001445 SIPDIS SIPDIS ENERGY FOR CDAY, DPUMPHREY, AND ALOCKWOOD NSC FOR DTOMLINSON E.O. 12958: DECL: 05/18/2016 TAGS: EPET ENRG EINV VE SUBJECT: TEMPERATURE RISES FOR STRATEGIC ASSOCIATIONS REF: A. CARACAS 00910 ¶B. 2005 CARACAS 03654 CARACAS 00001445 001.3 OF 005 Classified By: Acting Economic Counselor Shawn E. Flatt for Reason 1.4 (D) ¶1. (C) SUMMARY: The National Assembly on May 16 approved amendments to the Organic Hydrocarbons Law (OHL) that raise income taxes on the strategic associations from 34 to 50 percent and introduced a 33.3 percent extraction tax. It appears that the six international oil companies (IOCs) that are partners in the strategic associations have very little in the way of legal remedies to combat the tax increases. The BRV appears to be angling for majority control of the associations. Two company representatives told us that a decrease in their equity in the associations is not acceptable under any circumstances. The BRV also appears interested in forcing the companies to use vapor injection to increase recovery rates. PDVSA may buy out Italian oil company ENI's interest in its Exploratory Round field. END SUMMARY -------------- BRIEF OVERVIEW OF THE STRATEGIC ASSOCIATIONS -------------- ¶2. (U) The four strategic associations: Sincor (Total 47 percent, PDVSA 38 percent, Statoil 15 percent); Petrozuata (ConocoPhillips 50.1 percent, PDVSA 49.9 percent); Hamaca (ConocoPhillips 40 percent, Chevron 30 percent, PDVSA 30 percent); and Cerro Negro (ExxonMobil 41.67 percent, PDVSA 41.67 percent, BP 16.67 percent) extract extra-heavy crude oil from the Faja region and upgrade it at four facilities in Jose. Petrozuata is a publicly listed corporation and the rest of the associations are partnerships. Under the original terms of the agreements, the strategic associations paid a one percent royalty and a 34 percent income tax. In September 2004, the BRV unilaterally raised the royalty rate to 16.67 percent. -------------- NEW TAXES FOR THE STRATEGIC ASSOCIATIONS -------------- ¶3. (C) The National Assembly approved a bill on May 16 that raised the income tax rate for strategic associations from 34 to 50 percent. The bill also created a new 33.3 percent "extraction tax" which is applied to the value of the hydrocarbons extracted from a field and is calculated on the same basis as a royalty. The BRV reserves the right to reduce the extraction tax to 20 percent. The extraction tax will apply to PDVSA and joint ventures as well as the strategic associations. Companies may deduct the amount that they pay in royalties from the extraction tax. Thus, strategic associations will pay a royalty and the difference between the extraction tax and the royalty rate. The result is a de facto royalty rate that is higher than the 30 percent stipulated in the Hydrocarbons Law. The widely respected partner of a local Venezuelan law firm that specializes in energy law told Petroleum Attache (Petatt) on May 16 that she believes the BRV decided to seek the extra three percent when the oil companies with Operating Service Agreements (OSA) acquiesced in an additional 3.33 percent royalty over and above the 30 percent royalty during the migration to joint ventures (Reftel A). (NOTE: The bill also created a 30 percent royalty rate that would be applied to the associations with the option of lowering the rate to 20 percent. Given the extraction tax, this amendment is basically irrelevant. END NOTE) ¶4. (C) The bill also established an export registration tax that is equivalent to .1 percent of the value of all hydrocarbons exported from Venezuelan ports. In order to comply, the seller must supply the Energy Ministry with the CARACAS 00001445 002.2 OF 005 volume, API, sulfur content, and destination of shipments prior to sailing. (COMMENT: We have yet to find someone who understands the rationale behind this tax. The BRV has repeatedly stated the tax is not designed to raise revenue and PDVSA is the principal exporter of hydrocarbons in Venezuela. Assuming that the strategic associations are migrated to joint ventures in which PDVSA holds a majority stake, PDVSA or one of its affiliates will control crude exports. END COMMENT) ¶5. (C) According to the partner at the Venezuelan firm, the strategic associations do not have a legal basis to fight the income tax increases or the new extraction tax. An ExxonMobil executive also told Petatt on May 17 that his firm did not believe it had a legal basis for opposing the tax increases. The attorney stated, however, that each of the strategic association agreements has some form of indemnity clause that protects them from tax increases. Under the clauses, PDVSA will indemnify the partners if there is an increase in taxes. However, in order to receive payment, a certain level of economic damage must occur. In order to determine the level of damage, the indemnity clauses contain formulas that, unfortunately, assume low oil prices. Due to current high oil prices, it is highly unlikely that the increases will create significant enough damage under the formulas to reach the threshold whereby PDVSA has to pay the partners. The attorney speculated that even if the damage threshold was met, she believed the IOCs would be loathe to ask PDVSA for payment. ¶6. (C) Despite the tax increases, it appears that the strategic associations still offer a sufficiently lucrative rate of return for the IOCs. Klaus Nusser, a former senior PDVSA finance official, told Econoff on April 27 that he did a sensitivity analysis on Cerro Negro and Sincor to review the change in internal rates of return (IRR) as a result of tax and royalty increases. According to Nusser, oil prices would have to drop below USD 35 per barrel for the companies to earn less than a 15 percent IRR, even with 30 percent royalty and 50 percent income rates. -------------- THE REAL ISSUE IS EQUITY -------------- ¶7. (C) Under the OHL, the model for future investment in Venezuela is a joint venture in which PDVSA has at least a 51% stake. The joint venture under the OHL is subject to a 30 percent royalty rate, a 50 percent income tax rate, and the new extraction and exportation taxes. As is clearly indicated by the forced migration of the Operating Service Agreement fields and the recent changes in the tax and royalty structures for the strategic associations, the BRV wants to apply the OHL model to existing investment as well as future investments. A special National Assembly commission that is investigating the Apertura (the internationalization and privatization of the Venezuelan petroleum sector) issued a report in early May that specifically requested that the executive branch "revoke any agreement that prohibits the BRV from controlling the operations in the Faja". At this point, the strategic associations meet all of the model's requirements except the joint venture structure with majority control held by PDVSA. ¶8. (C) It is not clear how great a stake the BRV will want to take in the strategic associations. Although the OHL mentions a minimum stake of 51 percent, the BRV forced companies with Operating Service Agreements to migrate to joint ventures in which PDVSA had at least 60 percent stake. In one case, the BRV took an 80 percent stake in a joint venture. What is clear is that that some companies will not accept a dilution of their equity. A senior Chevron executive told the Ambassador on May 16 that his company will CARACAS 00001445 003.2 OF 005 not accept a dilution of its equity. He stated Chevron would not accept a dilution under any circumstances even if it was offered a significant expansion in its strategic association's acreage and production. He claimed Chevron is not interested in investing significant sums in Venezuela due to legal uncertainties. The executive stated his greatest fear is that the BRV would offer Chevron a major project in the Faja since it would be difficult for Chevron to turn the project down. The ExxonMobil executive also told Petatt on May 17 that his company is not interested in expanding its strategic association's operations and that it would not consider a dilution of its equity. ¶9. (C) A Statoil executive told Petatt on May 18 he believes the BRV will seek to secure at least 51 percent equity in the strategic associations. He stated there was a variety of incentives the BRV could offer including increased production. When Petatt raised the possibility that some companies may not be interested in increasing investment, the executive acted surprised but admitted that was possible. He speculated that the BRV would engage in negotiations with the companies over the issue of equity but declined to speculate on what would occur if no agreement was reached. (COMMENT: Although he did not specifically say it, Petatt came away with the impression that Statoil is still interested in expanding Sincor and that it would be willing to give up equity in order to do so. The official implied that increased production would also be an option that Statoil would be willing to explore. As reported in Reftels, Statoil has maintained a good working relationship with the BRV and definitely would like to see a major expansion at Sincor. END COMMENT) -------------- ACREAGE AND RECOVERY RATES -------------- ¶10. (C) Two additional factors further muddy the waters for the strategic associations: acreage and recovery rates. The National Assembly report harshly criticized the Sincor strategic association for using more acreage than it was allotted and overproduction. The report called for the executive branch to limit that acreage for each strategic association to 250 square kilometers. The Statoil executive believes the BRV will make this adjustment to the associations' acreage in the next six months. ¶11. (C) According to the Statoil executive, a reduction in acreage would also force the strategic associations to increase their recovery rate in order to maximize the use of their upgraders. (NOTE: Recovery rate is the amount of oil in place that will be produced from a reservoir. END NOTE) The National Assembly report harshly criticized the recovery rate for the associations, which currently is somewhere between 7 and 10 percent. The report blamed the low recovery rate in part on the vast amounts of acreage that the associations have. The Statoil executive stated there was truth to this, since large amounts of acreage allow the companies to rely on natural flow, which is the cheapest way to extract crude. He agreed that restricting the acreage would force companies to rely on technology to raise the recovery rate for the smaller area. ¶12. (C) Both the National Assembly report and the BRV have stated the strategic associations must raise their recovery rates. The report encourages the executive branch to demand that the companies increase in a "significant and immediate manner" their recover rate. The report notes that Sincor and Petrozuata agreed to use steam injection in order to raise the recovery rate of their respective fields when they secured congressional approval for their respective projects. ¶13. (C) Forcing the strategic associations to use steam CARACAS 00001445 004.2 OF 005 injection in order to raise recovery rates creates a whole new set of problems. The Statoil executive noted that although there are technologies that are promising, none of them have been tried in Venezuela. As a result, the introduction of these technologies would require a significant testing period. The executive also admitted that the introduction of steam injection would require a significant amount of investment. Given the legal uncertainties surrounding Venezuela, it is difficult to imagine that the companies will be enthusiastic about making these investments. In addition, a local analyst has pointed out that the recent downgrading of the association's bonds by rating agencies and a sharp drop in their bond pricing will make it difficult for the associations to obtain financing. Finally, the analyst noted that prices for materials and contract labor are also substantially higher than when the strategic association projects were constructed. (COMMENT: Increased financing, materials, and labor costs also reduce the attractiveness of significant expansions in the current strategic associations' operations as well as new greenfield projects. END COMMENT) -------------- TIMING -------------- ¶14. (C) Up until this point it appeared that the BRV would seek to migrate the strategic associations to the OHL model before turning its attention to the Exploratory Round projects. However, the ExxonMobil executive told Petatt that the BRV may be trying to migrate both groups in tandem. According to the executive, PDVSA is negotiating to buy Italian oil company ENI out of the Corocoro project (ConocoPhillips 32.5 percent, PDVSA 35 percent, ENI 26 percent, and OPIC, 6.5 percent). By purchasing ENI's share, PDVSA would have majority control of the project. It is not clear if PDVSA is also negotiating to purchase ENI's 30% stake in the Golfo de Paria Este project. -------------- CARROTS AND STICKS -------------- ¶15. (C) Assuming that the BRV's goal is to migrate the strategic associations to joint ventures with PDVSA holding a majority stake, the obvious question is how are they going to do it. If the BRV wanted to maintain good relations with the IOCs, it could offer them a variety of incentives in order to migrate. The two incentives that first come to mind are additional investment opportunities and additional production. Based on the paragraphs above, it is clear that at least some of the IOCs are not sure if they are interested in either, due to the current level of uncertainty in Venezuela. Another option is for the BRV to purchase the additional equity in the strategic associations. However, given the sheer size of the projects, it is hard to believe that the BRV would be willing to pay the vast sums required. The fact that the BRV was unwilling to pay OSA companies cash for lost value during their migration also does not bode well for an outright purchase. In the case of the OSAs, the best the companies could hope for was a voucher to be used for future investment. Bonds or tax credits could also be options but it is not clear that the companies would find these particularly attractive unless they were liquid. ¶16. (C) On the stick side, a partner at a multinational law firm told Petatt on May 18 that the BRV has a number of options. It could, as it did in the OSA migrations, use tax audits to make life quite uncomfortable for the IOCs. In addition, the BRV could bring a suit alleging that the strategic association agreements violate Article 22 of the OHL that specifically reserves the exploration, production, and marketing of hydrocarbons to the State. The BRV would have to argue that prior congressional approval (as well as a CARACAS 00001445 005.2 OF 005 Supreme Court decision in the case of the Exploratory Round fields) were somehow invalidated by the OHL. The BRV could then argue that it was merely regularizing the agreements. Another option would be the closing of a loophole in Article 57 of the OHL that allows the strategic associations to have equity oil and market their production on the grounds that syncrude is not a natural hydrocarbon for the purposes of the OHL. According to Venezuelan attorneys, President Chavez could do this via presidential decree. If the BRV closed the loophole, the associations would have to sell all of their output to PDVSA or one of its affiliates. (COMMENT: It is not clear what impact this would have on the associations' long term supply contracts. END COMMENT) -------------- COMMENT -------------- ¶17. (C) Given the BRV's track record and the OSA migration, we expect them to enter into negotiations with the IOCs. At some point, when the negotiations do not proceed as quickly as the BRV likes or go in the preferred direction, we expect the BRV to begin wielding a stick. One possible determining factor in terms of deadlines is the coming elections in December. We believe a speech in which President Chavez announced that the BRV was reclaiming title to all of the country's reserves is too enticing to put off until after the elections. We would also note that the BRV's brinkmanship has been remarkably successful. Beginning in September 2004 with the increased royalty for the strategic associations until the recent forced migration of the OSAs, the Chavez administration has achieved all of its goals. High oil prices as well as the fact that it is difficult for IOCs to secure access to reserves has set the stage for the success of these tactics. However, as Kaiser Wilhelm and Hitler can attest, brinkmanship is successful only if you know when to stop. The question now is whether the BRV knows its limits or not. BROWNFIELD