EXXONMOBIL'S ASSESSMENT OF CHALLENGES TO THE OIL

UNCLAS SECTION 01 OF 04 LAGOS 000096 SIPDIS SENSITIVE BUT UNCLASSIFIED - HANDLE ACCORDINGLY SIPDIS DOE FOR GPERSON, CGAY TREASURY FOR ASEVERENS, SRENENDER, DFIELDS COMMERCE FOR KBURRESS STATE PASS USTR FOR ASST USTR FLISER STATE PASS TRANSPORTATION FOR MARAD STATE PASS OPIC FOR ZHAN AND MSTUCKART STATE PASS TDA FOR NCABOT STATE PASS EXIM FOR JRICHTER STATE PASS USAID FOR GWEYNAND AND SLAWAETZ E.O. 12958: N/A TAGS: EPET ENERG PGOV NI SUBJECT: EXXONMOBIL'S ASSESSMENT OF CHALLENGES TO THE OIL AND GAS SECTOR LAGOS 00000096 001.2 OF 004 Sensitive But Unclassified; Business Confidential; Handle Accordingly ¶1. (SBU) Summary: Nigeria's ambitious plans for increasing natural gas production could be hampered if the challenges facing the companies leading this enterprise are not resolved. The major challenges are underfunding of joint venture (JV) projects by the Nigerian National Petroleum Corporation (NNPC),pressure on the companies to fund greenfield refineries, local content legislation, caps on company operating margins, gas taxation legislation, the pricing provisions of the Gas Master Plan, and terms of Production Sharing Agreements. End Summary. Nigeria's Goals for the Oil and Gas Industry -------------- ¶2. (SBU) In a business issues briefing, ExxonMobil Production executives told Pol Econ Chief that Nigeria has a number of political goals that impact on the company's ability to operate: 1) stimulate economic growth, alleviate poverty, create jobs, and grow the tax base; 2) develop local capacity and diversify the economy; 3) build gas and electric power infrastructure to attract non-oil investment; 4) build a self sufficient refining and chemical sector; (Note: Currently Nigeria has only 150,000 bd of nominal refining capacity. Only the Port Harcourt refinery is operating. The Warri and Kaduna refineries are not operating. End Note) and 5) grow Nigeria's share of the OPEC quotas. Goals of the Oil and Gas Industry in Nigeria -------------- ¶3. (SBU) Within this general framework, the Nigerian oil and gas industry has the following additional objectives: 1) increase production to 4.0 mbd by 2010; 2) achieve national reserves of 36 gb by 2007, and 40 gb by 2010; 3) eliminate routine gas flaring by 2008; 4) increase gas revenue to approximate oil revenue by 2010; 5) increase local content of oil and gas sector inputs to at least 45 percent by 2006, and to 70 percent by 2010; and 6) achieve and maintain world class safety and health standards. Underfunding is Major Impediment to Reaching Goals -------------- -------------- ¶4. (SBU) ExxonMobil believes it will play a major role in meeting Nigeria's goals and achieve industry goals as well. However, company executives believe, there are major impediments to meeting those goals: 1) The government's time frames are unrealistic; 2) joint venture (JV) funding by the Federal Government of Nigeria (FGN) is seriously deficient; 3) even the alternative funding mechanisms ExxonMobil routinely uses to supplement FGN JV funding are insufficient to meet the government's ambitious national objectives. Oil production from any given field declines by 10 percent each year. Therefore, joint venture partners must invest additional amounts over the initial investment each year merely to maintain current production. To increase production, even more additional capital needs to be invested. ¶5. (SBU) The FGN has under-funded JV operations since 1996, ExxonMobil claims. Although Nigerian National Petroleum Company (NNPC) contributions to JV funding have increased over time, they have not kept pace with ExxonMobil's investment needs or requests. This means that ExxonMobil must compensate for the FGN investing less than its LAGOS 00000096 002.2 OF 004 agreed-upon share. In 2006, the shortfall between the amount needed and the amount provided by the NNPC was approximately USD 1 billion. ¶6. (SBU) To bridge the gap, ExxonMobil has been successful in using non-equity sources to fund priority activities. In 2005, ExxonMobil managed to raise over USD 2G of non-equity funding. The mechanisms for doing so varied. In the Yoho project, ExxonMobil provided up front funds, which were then repaid in crude oil. In the NGL II project, the company borrowed from banks. In the Satellite Primers project, the company was successful in obtaining bank financing at a low interest rate. ¶7. (SBU) ExxonMobil works from extensive JV funding projections. These projection show that the funds planned to be provided by the NNPC will not be sufficient to meet production objectives. The funding shortfalls are so significant that they will delay projects. As projects are delayed, both production and reserves will decline, flare elimination will be deferred, and revenue to the Federal Government from the oil and gas industry will decrease. Pressure to Fund Greenfield Export Refineries -------------- ¶8. (SBU) Since 2003, when the Federal Government of Nigeria proposed to deregulate the downstream sector by privatizing its three oil refineries, ExxonMobil, like other international oil companies (IOCs),has been pressured by the FGN to invest in these refineries. In 2005, NNPC proposed additional regulations pursuant to the Petroleum Act. The new regulations would require the IOCs to refine in country some proportion of crude oil produced. A bill has been introduced and is being considered by the National Assembly requiring that 50 percent of crude oil be refined domestically. The bill also requires that equity crude be refined in country, and imposes severe penalties of up to $4 bbl for non-compliance. ¶9. (SBU) To help the FGN understand the costs involved in taking over one of the refineries, the upstream majors, including ExxonMobil, Shell, Chevron and Total, participated in a feasibility study with the NNPC. The study assessed the legacy environmental issues, security, regulatory environment, and manpower problems that are associated with the refineries. The study concluded that the cost for a 200 kbd single train refinery would be USD 4.3G. Because refining at best yields only the most marginal of profits, the IOCs will not take it on, the executives said. Local Content Legislation -------------- ¶10. (SBU) Since the return to democratic rule in 1999, the country has intensified efforts to promote local content development. The company supports those efforts and has been working to incorporate best practices from its worldwide operations into the process. The FGN's stated objective is to retain in-country an increasing percentage of the annual oil and gas industry investment (approximately USD 10 G) and have set local content targets of 45 percent by 2006, and 70 percent by 2010. The NNPC has created a Nigerian Content Division which works to assure that every contract over USD 500,000 has the requisite percentage of Nigerian content. Contracts can take from 18-24 months to negotiate. The Nigerian Content Requirements slow the process even further. ¶11. (SBU) The National Assembly has had three bills on the LAGOS 00000096 003.2 OF 004 Nigerian Content issue under consideration. The Chairman of the Senate Committee on Upstream Petroleum Resources, Senator Lee Ledogo Maeba's bill, called the Nigerian Content Development Bill of 2005, has been through two readings and is scheduled for third reading early in February. The bill, which made it through second reading before the industry became aware of it, contained in its original form several punitive provisions, including criminal penalties for CEOs, for non-compliance. An IOC industry group proposed a harmonized bill that eliminated objectionable elements from the Chairman's bill. One provision the group succeeded in having removed from the original bill related to the creation of a monitoring board; the industry prefers monitoring through the NNPC be continued. (See septel) Caps on Company Operating Margins -------------- ¶12. (SBU) Nigeria has had a series of Memoranda of Understanding through which it provides incentives to the IOCs to increase crude oil exports and encourages investments in exploration and development. The current MOU was signed in 2000 for the purpose of creating incentives for investment when oil prices are low, ExxonMobil executives said. ¶13. (SBU) Clause 2.6 of the MOU states that the Minister of Petroleum shall advise of any change in applicable margins when crude oil prices exceed USD30 bbl. Because oil prices have been high, the industry expected that their operators' margins would increase under the MOU. However, the NNPC decided instead to cap the operators' margins at USD 30 bbl. Once the price of oil rises over USD 40 bbl, the Petroleum Profits Tax controls. ¶14. (SBU) The industry agreed in January 2005 to pay its 2004 taxes in accordance with the margin cap, with the understanding that an Inter-Ministerial Committee (IMC) would be constituted for the purpose of renegotiating the MOU. The IMC was set up in May 2005, and set a target of August 2005 to conclude negotiations. A revised MOU was planned to become effective on January 1, 2006. ¶15. (SBU) However, the talks stalled. The Minister of Petroleum confirmed that the FGN is willing to share upside benefits in exchange for increased work by the IOCs in the onshore, shallow water areas. However, the Ministry of Finance has insisted on keeping the margin cap at USD 30 bbl and only increase fiscal costs to USD 5 bbl. Pending Taxation Legislation -------------- ¶16. (SBU) There are two competing gas tax bills currently under consideration by the National Assembly. One bill, drafted by the NNPC, removes existing gas incentives, has higher tax rates, and would adversely impact gas development, according to ExxonMobil. According to ExxonMobil's analysis, a large percentage of Nigeria's gas reserves would not be developed if this bill passes. A second bill, drafted by the Federal Internal Revenue Service (FIRS),would be acceptable to ExxonMobil if modified. The FIRS bill was introduced in December 2005 and passed the House without input from the industry. However, at the request of ExxonMobil, the Senate Finance Committee considered modifications proposed by the industry. The companies are seeking grandfathering for existing projects. Downstream Gas Act -------------- LAGOS 00000096 004.2 OF 004 ¶17. (SBU) The Downstream Gas Bill, introduced by the NNPC to create a legal and regulatory framework, including a Regulatory Commission, for natural gas, would, in its original form, require the industry to move gas into the domestic market either "free of cost at the flare" or at a negotiated price. The bill allows prices to be set below the market price, and would make it difficult, if not impossible, for the IOCs to earn a profit. ExxonMobil is part of an industry group that is engaging with the Senate on this issue. Public hearings on the bill have been held by the House of Assembly and the Senate (see Septel). NNPC Gas Master Plan -------------- ¶18. (SBU) The NNPC released the Gas Master Plan (GMP) in October 2005. Phase One of the plan includes sector diagnosis and concept development while Phase Two of the plan establishes the gas pricing framework. The objective of the plan is to grow the Nigerian economy by maximizing the multiplier effect of gas. It mandates that gas be supplied to the domestic sectors of the economy, sets a low price for gas to strategic domestic sectors, and gives suppliers a 15 percent rate of return. However, the single low price does not reflect the costs inherent in the diversity of sources from which the gas is drawn. Some areas have small reserves that must be linked, creating higher costs, while gas drawn from a single large reserve will have lower associated costs. ExxonMobil and the rest of the industry believe that the open market approach, rather than the approach included in the GMP, is the best way to incentivize economic gas supply. ¶19. (SBU) President Obansanjo has already intervened in the gas price discussion, raising the price from USD 0.05 to 0.10 per cubic meter of gas. However, the underlying assumption, that is that every company can make a 15 percent profit at this low price, is incorrect, ExxonMobil pointed out. Deepwater Gas Rights Under PSAs -------------- ¶20. (SBU) ExxonMobil has a production sharing agreement (PSA) with the National Petroleum Investment Management Services (NAPIMS),a division of NNPC, to produce gas from the Bonga field. The PSA provides that ExxonMobil, as contractor, has the right to participate in production of the gas on behalf of the leaseholder. After it is produced, the Bonga gas is delivered to NNPC's JV partner Shell Production and Development Company (SPDC),in which Shell, Total and Agip all participate. SPDC then sells the gas to Nigeria Liquified Natural Gas (NLNG). Proceeds from the sale are shared between NNPC (55 percent) and SPDC (30 percent). No compensation is paid to the PSA contractor. ¶21. (SBU) ExxonMobil interprets the PSA as providing that the company has a split share with NAPIMS in the gas produced. NAPIMS, however, believes that it has full, not partial, ownership of the Bonga gas. This underlying dispute has not yet been resolved. However, an interim agreement between ExxonMobil and NAPIMS which provides that the proceeds of gas sales are paid into an escrow account has been reached. NAPIMS has said that, while it is willing to allow ExxonMobil to share in the proceeds of the sale of the gas, it will do so only if ExxonMobil concedes that it has no rights under the Production Sharing Agreement to the gas itself. ExxonMobil has received no revenue from the Bonga project, which has been flowing since December 2005. BROWNE