18th October, 2004
Venezuela: Royalty rise raises risk perceptions

Published by Oxford Analytica
©Copyright 2004 Oxford Analytica Ltd. All rights reserved.

"SUBJECT: Implications of President Hugo Chávez's announcement on October 10 that royalties on oil production in the Orinoco belt would rise from 1.0% to 16.67%.

SIGNIFICANCE: The announcement, Chávez's first significant move since his victory in August 15 recal referendum, does not look favorable to international oil companies. It raises the question whether the expected continuity in oil policies will be maintained.

ANALYSIS: On October 10, during his television programme 'Alo Presidente!', President Hugo Chávez announced that his government would end tax exemptions on oil production from the Orinoco heavy crude belt, in effect increasing the tax rate on international oil companies active in the area from 1.0% to 16.67%. The royalty increase applies only to companies working in the Orinoco Belt - among them, ExxonMobil, ChevronTexaco and ConocoPhilips of the United States, French TotalFinaElf and Norvegian Statoil - and relates to the specific terms of the Orinoco Belt contracts.

Orinoco Contracts. The oil field in Orinoco is among the largest in the world, with estimated reserves of some 235 billion barrels of heavy crude. The project to turn the heavy tar-like Orinoco crude into synthetic oil began to be implemented only in the late 1990s. However, international companies were reluctant to invest, given the substantial field and technological risks involved. Oil companies did not have a clear idea of the eventual profitability to be gained from producing large quantities of extra-heavy oil and then upgrading it. Furthermore, the price of Venezuelan oil basket was then around 10 dollars per barrel. As a result, the government was forced to make significant concessions on both royalties and income tax to attract international investment.

However, the companies are reported to have been much more successful than initially anticipated, making a very good return on their investments, in particular through upgrading. Their results have been further enhanced by the dramatic rise in oil prices: with the Venezuelan basket now around 42.67 dollars per barrel, the oil from the Orinoco Belt is priced at between 24-32 dollars. Even if the field risk still exists, the technological risk is far more under control.

The royalty issue. The strategic association contracts signed in the 1990s established a temporary 1% royalty. This rate was supposed to be maintained until such time as the projects would become economically profitable; the contracts stipulated that, thereafter, the royalty would then be established at 16.67%

· The recovery of investment was initially estimated to require nine years, with prices between 18-20 dollars per barrel. However, in the light of current oil prices, recovery has proved to be much quicker.

· In Venezuela, 16.67% is still a preferential level: in 2001, a decree raised royalty rates from 20% to 30%. Foreign investors have criticised the law as excessively restrictive, but investors interest has not faded.

Chávez has used an option left open by the terms of the contracts - a strategy facilitated by the fact that the increasing need for oil reserves has made international oil companies ready to accept tougher conditions of exploitation. He also knows that he can raise royalties without creating real problems for companies that have enjoyed years of extraordinary windfall oil profits. In this respect, it can be assumed that the government has evaluated the risk attached to the move and considered that, given the combination of high prices and Venezuela's location and reserves, companies are not likely to leave the country because of the royalty adjustment. This calculation may prove to be right.

Limited impact? Some analysts have argued that this decision, taken unilaterally, has sent a negative message to international oil companies, which are concerned by sudden changes in the rules of the game. However, while the timing and form of the announcement may have taken international companies by surprise, the decision itself almost certainly did not:

· It was clear from the original contract terms that his option could be exercised at any time.

· One company was already negotiating an extension of its exploration zone, offering voluntarily to adopt the 16.67% royalty rate in exchange.

Oil companies are thus expected to accept the decision without protest, as they acknowledge the fact that the Energy Ministry was empowered to take such a decision by the terms of the original contracts.

Relations between the state and the international oil companies involve an ongoing, complex negotiating process. Oil companies will probably try, in the coming weeks and months, to negotiate some compensatory measures in their favour - possibly the extension of exploitation rights or capital ownership. However, high oil and gas prices and Venezuela's large reserves continue to make the country an attractive investment destination. Some international oil companies have demonstrated clear interest in new heavy oil ventures, despite the fact that the fiscal regime would be less favourable than that in effect for the existing strategic associations.

Political announcement: The fact that the decision was announced on the president's popular television programme indicates that Chávez wanted to maximise the political benefits of the royalty rise. The announcement in front of a national audience allowed Chávez to appear to be defending national interests against multinational companies. He has good reasons for wishing to do so: some of his 'nationalist' supporters have recently denounced what they call a clandestine plan to privatise state oil company PDVSA. They claim there are plans to weaken PDVSA through reorganization, and to offer generous contracts to international oil companies. Chávez thus needed to send a clear message to his supporters that he was defending national interests.

This measure also had an additional political side effect: in early October, Ali Rodriguez, president of PDVSA, was apparently pressing for an increase in oil prices on the domestic market, because the retail business is said to be facing problems of profitability. Chávez opposed this measure, for social reasons. The public differences between the two men may have been reduced by the royalty increase, which Rodriguez has been seeking since 1995.

Political risk perceptions. International oil companies may have voluntarily agreed on this measure, especially in the context of complex negotiations. If Chávez decide to make a blunt public announcement, this may in part be due to the fact that any leak of the content of negotiations would have weakened its political effect (…).

CONCLUSION: Oil companies originally signed contracts which stipulated that the recent royalty increase would be implemented when investments had been recovered. As such, the companies involved will not withdraw, despite irritation over the handling of the announcement. Chávez's unorthodox style will be tolerated as long as oil prices remain high".