HONDURAN GOVERNMENT DIALOGUE WITH OIL INDUSTRY

C O N F I D E N T I A L SECTION 01 OF 04 TEGUCIGALPA 000134 SIPDIS SIPDIS NOFORN STATE FOR EB/ESC, WHA/EPSC, WHA/PPC, EB/CBA, AND WHA/CEN STATE FOR D, E, P, AND WHA STATE FOR S/ES-O MMILLER AND MSANDELANDS TREASURY FOR AFAIBISHENKO STATE PASS AID FOR LAC/CAM NSC FOR DAN FISK COMMERCE FOR MSELIGMAN AND WBASTIAN STATE PASS USTR FOR AMALITO E.O. 12958: DECL: 01/21/2017 TAGS: EPET ENRG PREL BBSR NI VE HO SUBJECT: HONDURAN GOVERNMENT DIALOGUE WITH OIL INDUSTRY CONSTRUCTIVE BUT INCONCLUSIVE REF: REF: TEGU 0098 AND PREVIOUS Classified By: AMB Charles Ford for reasons 1.4 (b,d) ¶1. (C/NF) Summary: The January 18 talks in Salvador between oil industry representatives and a GOH delegation led by Minister Counselor for Legal Affairs Enrique Flores Lanza reportedly made significant progress. The GOH put two alternatives on the table and the affected oil companies have undertaken to respond constructively to those proposals by January 23. The GOH agreed to the talks when a rigorous GOH analysis suggested the new state-run import scheme would not save Honduras any money, while incurring significant legal risks and sending a strong anti-investment message. Industry concerns over inventory "confiscation" were reportedly resolved at the table, and talks now center on USD 0.01 to 0.02 per gallon margin reductions each on imports and handling costs. Post considers it highly significant that Flores Lanza has reportedly been convinced of the poor risk/reward ratio of continuing to pursue a strategy of nationalizing imports. If accurate, this would be one of the most important defections of this year-long process, and could open the way to a breakthrough in the talks. The proposed negotiated solution is not optimal, but it might be the best obtainable under the circumstances, and it avoids several far-worse alternatives. End summary. ¶2. (C/NF) On January 19, EconChief had an extended meeting with Presidential advisor on fuels Arturo Corrales, who presented his statistical analysis of the current offers and a comprehensive review of the current state of negotiations with the international oil companies (IOCs). On the ConocoPhillips offer, Corrales noted that the final version of that offer contained two significant changes: the inclusion of a hefty price premium for product delivered to the southern port of San Lorenzo, and a clause making the new offer a package deal rather than a la carte. The consequence, Corrales said, was an "unbalanced offer" in which a low-ball headline price for super unleaded gasoline delivered to the Atlantic ports was compensated by higher prices for other products and other ports. Modeling this offer using empirical data from 2004 through 2006, Corrales determined that the Conoco offer would have cost Honduras USD 3.43 million more in imports in 2004, and saved it USD 2.9 million in 2005 and USD 6.2 million in 2006. The net savings overall, he says, is therefore only USD 2 million per year on average, on a total import bill of more than USD 650 million (that is, less that 0.3 percent savings). Given the numerous assumptions implicit in his model, Corrales dismisses this as "within the statistical margin of error" and therefore is confident in saying that overall the new deal would not really save Honduras any money at all. ¶3. (C/NF) Corrales presented this analysis to Minister of the Presidency Yani Rosenthal on Tuesday, January 16 and a convinced Rosenthal urged the President to consider these results. President Zelaya sent the lead GOH official on the fuel issue, Minister Flores Lanza, to receive the same briefing and report back. After several hours of detailed review, Flores Lanza reported to the President that Corrales was correct. Following the extensive discussions with Ambassador earlier that day, Lanza's conclusion reportedly convinced Zelaya to dispatch Corrales and Flores Lanza to Salvador for talks with the IOCs. According to Corrales, Flores Lanza -- long one of the staunchest supporters of this poorly-planned scheme to nationalize fuel imports -- was persuaded by the evidence and has now switched his position to one of seeking an accommodation with the IOCs, as long as such a deal delivers the needed political victory for the President. ¶4. (C/NF) In the meantime, the GOH is no longer convinced that an exclusive contract with ConocoPhillips makes sense. The GOH's own analysis reveals that savings will be TEGUCIGALP 00000134 002 OF 004 negligible, and Zelaya has expressed concerns about the reliability of a partner with no investment on the ground in Honduras. Post has made it clear that ConocoPhillips is a first-class company, and that we have no doubts it would fully honor its contract, if signed. However, to avoid the possibility of lawsuits from other companies or breaches of international treaties, any GOH contract with ConocoPhillips should not infringe upon the rights of existing investors. Given the potential legal conflicts with existing investors (as vividly demonstrated last week by the GOH's announced intention to take over privately-owned fuel storage facilities),the GOH appears to be considering carefully whether the meager (or zero) savings from an exclusive contract with ConocoPhillips is worth the negative political consequences a state takeover of the sector would entail. ¶5. (C/NF) In Salvador, in a series of separate meetings on January 18, Corrales delivered his presentation to each company and initiated a negotiation based on technical and financial factors, while also reminding the companies of the political context. Flores Lanza was reportedly calmly supportive and incisive, and offered the companies two options: buy their fuel imports from Conoco and maintain all their other downstream operations; or present the GOH with alternatives to the current plan that deliver similar or greater savings than the bid solicitation would deliver. According to press remarks, Shell is considering the first option, while Texaco and Esso told EconChief that they prefer the second. ¶6. (C/NF) Corrales said he would grade the companies' degree of constructive engagement in these talks as: Texaco A , Shell B , and Esso D. Texaco and Shell each brought senior officials, listened politely, asked probing questions, admitted their role in perpetuating this problem, and agreed to consider the GOH offer and propose a compromise by Tuesday. Texaco representatives told EconChief on January 18 that the talks were more open than previous meetings had been, and that both sides seemed genuinely engaged. Esso, on the other hand, was represented by a public relations person, and reportedly opened their meeting by literally banging on the table and demanding a USD 0.10 per gallon immediate price increase. Despite such provocations, Corrales and Lanza remained focused and continued talks for several more hours. At EconChief's urging, Esso's Country Manager said on January 21 that he was going to contact Flores Lanza to reaffirm that while talks got off to a rocky start, Esso remains optimistic and seeks a mutually acceptable outcome. ¶7. (C/NF) The talks, while quite technical, basically focused on three elements: financial losses on inventories caused by the sudden change in sales prices; changes to the import pricing formula; and the proposed "onshore" price adjustments. The first issue, initially presented as a potential deal-breaker and likely impetus for legal suits over "confiscation," was essentially resolved at the negotiating table "in about three minutes," according to Corrales. Of the eight lempira price reduction that affected inventories, he explained, about six came from changes in the international price or changes to the Honduran price calculations by shifting from a 22 day rolling average to a 10 day rolling average (thus bringing forward last week's sharp drop in international prices). These are largely price adjustments that would have occurred anyway over the next 10 days (when the next inventory deliveries were to be made). Thus, the financial losses on inventories to the importers are limited to 10 days of losses, which Corrales estimated at about USD 150,000 per company. (On January 21, Esso told EconChief it estimated these losses at approximately USD 200,000.) Corrales dismissed this as a minor issue made to seem major for bargaining purposes. Such a relatively small loss, he said, could be recovered by the companies by slightly tweaking the pump prices over the coming weeks. Corrales told EconChief (and Esso later confirmed) that this TEGUCIGALP 00000134 003 OF 004 arrangement was accepted in principle by both sides at the bargaining table, thus removing the inventories issue as an obstacle to a settlement. ¶8. (C/NF) The second issue under discussion is the import price, which is currently based on Platt's Gulf Posting prices with slight adjustments. The new proposal eliminates the adjustments, and instead offers a fixed premium based on product and delivery port. The net change according to the GOH is close to zero, proving that current import prices are basically "fair" and that price gouging is not taking place. Esso argues that the new formula will cost it an additional USD 0.035 per gallon (a figure not supported by the spreadsheets produced by Corrales). Corrales replies that the net impact is very sensitive to the weights applied (such as product mix and delivery port) as well as to the specific premium given in each case. He is confident Esso's alleged loss could be minimized or eliminated by massaging the weights in the revised formula. Esso has agreed to consider this offer carefully and produce a proposal. ¶9. (C/NF) The third issue under discussion is the array of non-standard "onshore" costs, including a credit for leakage, a guaranteed margin for the importer, inspection costs, and others. These fees and costs currently total USD 0.113 per gallon, but the GOH calculates that they should be reduced to between USD 0.05 and 0.06 per gallon. This reduction would include shifting a portion (about USD 0.004 per gallon) of late fees to the importers in recognition that some demurrage is the fault of the companies, whereas currently 100 percent is attributed to the GOH. It also proposes equally sharing the costs for product inspections (about USD 0.0015 per gallon),since those inspections benefit both the companies and the GOH equally. The largest reduction would be the elimination of the guaranteed profit margin for importers (USD 0.045),which was inserted into the formula by Honduran oil importer DIPPSA to make it more competitive with the IOCs. All participants reportedly agree that fee is not justifiable, and Esso even objected to it as "unethical" in a letter to the GOH several years ago when the fee was first imposed. (Comment: DIPPSA's former owner Jose Lamas likely saw the writing on the wall last year and realized that without this guaranteed margin enhancement DIPPSA would be worth far less to a buyer and might even fail. He therefore sold it promptly to Henry Arevalo, who then sold 50 percent to IOC Trafigura. The loss of this margin likely negatively impacts DIPPSA earnings and therefore valuation. We can't imagine Trafigura will be pleased to learn it has bought into a depreciating asset. End Comment.) ¶10. (C/NF) As a result of the Salvador talks, this negotiation -- which only a week ago threatened arrests, confiscations, and lawsuits -- is now focused instead on a USD 0.02 margin reduction on imports and a USD 0.01 to 0.02 margin reduction on fees. The GOH will attempt to resolve the former using formula weights, and the latter will be negotiated. In exchange for this deal, the companies would remain in the country doing business, would not have to contemplate a mutually assured destruction policy of international lawsuits, and would win what they have most sought: a reform to the current unsustainable pricing formula and a broader liberalization of the sector. This liberalization would be codified in a GOH document with specific steps and milestones, beginning January 2008. ¶11. (SBU) Post has been working closely with the World Bank to identify resources to support the GOH's announced intention to move over the medium term towards a liberalized fuels market. The World Bank has already done a study of the Honduran fuels market and has identified an expert who could come to Honduras to advise the GOH on next steps. This would fit with Zelaya's professed intent (as confirmed to Ambassador) to establish a firm timeline with concrete steps towards such a market opening, which the GOH prefers to call TEGUCIGALP 00000134 004 OF 004 "competitiveness" instead of "liberalization." In a January 18 meeting at the World Bank, Minister of the Presidency Rosenthal was presented this option by World Bank officials. Rosenthal, who is no longer the lead official on the fuels topic, took the offer on board and promised to get back to World Bank staffers in "a couple of weeks." ¶12. (C/NF) Comment: Post considers it highly significant that Flores Lanza has reportedly been convinced of the poor risk/reward ratio of continuing to pursue a strategy of nationalizing imports. His continued support has been one of the primary reasons for President Zelaya's reluctance to follow his own instincts to abandon this scheme and instead seek lower prices through a market-based reform. In his public remarks just prior to the Salvador meetings, Minister Flores Lanza had again begun referring to the GOH seeking a legal way to compel Texaco to allow use of its storage facilities. Lanza had made similar comments on January 13, raising the spectre of expropriation (as reported by Post on January 14). Since that time, the GOH has told Post that no expropriation is being invoked, but rather a pre-existing clause in the GOH contract with DIPPSA (which the GOH argues also covers Esso's joint venture storage facility with DIPPSA). Because no such clause exists in Texaco's contract, any GOH move to take over those facilities would have required some other legal justification. If a deal were struck with the IOCs, this plan to seize storage facilities would likely be abandoned as unnecessary and counterproductive. If Flores Lanza has finally accepted the need for a negotiated exit strategy, this would be perhaps the most important defection of this entire process, and could open the way to a breakthrough in the talks. ¶13. (C/NF) Comment continued: We are also very pleased to see that the mutual suspicion between Flores Lanza and Corrales appears to have lessened, as Flores Lanza reportedly now accepts both that the numbers are persuasive and that Corrales is not a mouthpiece for the IOCs. According to Corrales, Flores Lanza was favorably impressed that Corrales was just as demanding with the IOCs in the El Salvador talks as he had been with the GOH over the previous weeks. Both Corrales' objective mathematical analysis and Flores Lanza's influence with the President will be needed for any negotiated settlement to be accepted by the GOH. ¶14. (C/NF) Comment continued: The proposed negotiated solution is not optimal, but it might be the best obtainable under the circumstances, and it avoids several far-worse alternatives. The status quo is neither politically sustainable nor financially justifiable. A short-term win for Zelaya in exchange for a medium-term overhaul of the sector serves the interests of investors and the GOH alike. To IOC grumbling about these margin reductions, the GOH responds that this will only be a USD 0.01 to 0.02 and only last for one year, whereas the IOCs benefited from the padded USD 0.045 margin adjustment for several years. Finally, Esso (and presumably the other IOCs as well) understands that if it refuses to negotiate flexibly and creatively, and in the end is nevertheless forced to accept a GOH takeover of the fuel import sector, its credibility will be damaged in the eyes of all governments in the region. With an increasingly populist wind blowing throughout the region, this would be an invitation to similar moves by other governments elsewhere in the hemisphere. A negotiated solution that champions market-based reforms, on the other hand, would send a positive message to consumers throughout the region while defending the long-term enlightened interest of the IOCs. End Comment. Ford FORD