Caracas Chronicles

“Just that something so good just can’t function no more.”

Love Will Tear Us Apart (Again) – Joy Division (1979)

As Venezuela’s oil industry sinks deeper and deeper into an unprecedented crisis, the need has never been greater for clarity on what specifically we need to do to turn it around.

Well, we have a plan. A far-reaching Eight Point Plan to bring vitality back to Venezuela’s hydrocarbon exploration and production sector.

Is this plan innovative?

Not at all.

Just the opposite: we take pride in being unoriginal, because there’s no need to reinvent the wheel here. Instead, we put forward proven reforms. Reforms that have been shown to work. And not in Norway and Canada, either, but right here in our region.

Our Benchmarks: Brazil, Colombia and Mexico

Over the last 17 years Colombia and Brazil have grown their oil production by 40% and 150% respectively.  In contrast, Mexico and Venezuela have seen production decrease by 30% and 35% respectively.

So how have they done it, exactly? What reforms have Colombia and Brazil, and more recently Mexico, undertaken to put their oil industries on a path to high performance?

Mexico is already doing something about it. They’ve broken the 75-year-old Pemex monopoly and have opened the hydrocarbon industry to private sector investment.

Venezuela, by contrast, is committed to the same old self-destructive path.  As a result, today Brazil produces more oil than Venezuela (2,581mbd vs. 2,328mbd); a shocking state of affairs given the fact that Venezuela holds 20 times the reserves of Brazil. Twenty times!

So how have they done it, exactly? What reforms have Colombia and Brazil, and more recently Mexico, undertaken to put their oil industries on a path to high performance? And what can we learn?

Let’s see…

1. Moving on from the Petroleum Activities Reserva Dogma

The most important sector of our economy is still dominated by a historic event that happened in…41 years ago.

When the current regime went to rewrite the constitution in 1999, the Constituent Assembly decided, in a grand gesture, to give Constitutional status to the Oil Nationalization, a 1975 event carried out by, of all people, Carlos Andrés Pérez. This was per se utterly unnecessary… and to make things more confusing they did it wrong.

This rhetorical flourish has opened a rather shy but intense debate among lawyers.

The constituyentes included a vaguely drafted four-liner within the Exposición de Motivos (the official forword) of the Constitution, not even as a proper article.

Se le otorga rango constitucional a la nacionalización petrolera, pero al mismo tiempo establece la posibilidad de continuar en convenios de asociación con el sector privado siempre y cuando sean de interés para el país, y no desnaturalice el espíritu, propósito o razón de la nacionalización petrolera.

It says that the oil nationalization is granted constitutional status but the state may enter into association agreements with the private sector as long as it is in the country’s interest and they do not denaturalize La Nacionalización’s “spirit, purpose or reason”. One couldn’t get vaguer or than that.

This rhetorical flourish has opened a rather shy but intense debate among lawyers. Many have concluded that it wasn’t the 1975 Ley de Nacionalización that was made constitutional but the “principles” that animate it: the organization of the sector, the administrative framework and the modalities under which the “private sector” may participate in the oil business.

Does it make sense to keep this small but massively important clause in our Constitution? It’s so clumsily worded, it’s subject to any numbers of interpretations. And guess who the ultimate responsible of interpreting constitutional precepts is? Yes, the most politicized judicial institution we’ve ever had: the Supreme Court’s Constitutional Chamber.

La Nacionalización was incredibly important, a game-changing event for the country. However, it was an excess to try to freeze it in time and saddle future generations with a system that isn’t suited to changing circumstances.

Although the 1975 Oil Nationalization established a strict “reserve” over the activities across the whole hydrocarbons chain (from exploration and production to refining and retail) the current Chavista Hydrocarbons Law allows non-state parties (including international oil companies) to own a refinery. What? Wasn’t the Oil Nationalization included in the Constitution?

The current state of law on this point is deeply confused.

It’s time to rethink this entire state reserve debate. We can hear the hackles about “PDVSA privatization” a mile away, but it’s really not about that.

To be clear, we strongly agree that the Republic must own the natural resource (as happens all around the world, except the U.S.) We also agree Venezuela should keep its own national oil company, like all successful countries in the region do. 

La Nacionalización was a game-changing event for the country. But it was an excess to try to freeze it in time and saddle future generations with a system that isn’t suited to changing circumstances. It is expedient for Venezuela to have a national oil champion, but not under terms and principles frozen in time 41 years ago.

How to move forward? Well, by looking at how other countries in the region have dealt with similar situations. Mexico’s 2013 Energy Reform started with a Constitutional amendment that clearly established the basis, reach and limit of the participation of oil companies into the country’s energy (including hydrocarbons) sector.  If Mexico — a country whose entire self-understanding was built around the 1938 nationalization — could do it, so can we.

What’s needed is a constitutional amendment that excludes confusing references to the 1975 oil nationalisation while making it clear that the State reserves for itself hydrocarbon activities (from exploration and production to refining and retail) and that it retains the right to assign those activities to others.  

2. Segregating the functions of the State and the National Oil Company

Imagine a baseball game where the umpire gets to make the rules and is also the manager of one of the teams. Does that sound fair to you?

Bizarrely, this is how our oil sector has been run for the last few years, putting the rule-maker and umpire (the ministry) in the hands of the same person who runs the biggest team: PDVSA.

This is one — of many — reasons foreign partners have retrenched and stopped investing in Venezuela, and why output is now declining so fast.

In our system, the Minister of Petroleum and Mining, in charge of making energy policy, enforcing energy regulations, is also in charge of running the national oil company. How can the other teams — the private oil and gas companies — expect to earn a fair return for their capital when the industry is regulated by their main partner (or competitor)? It’s a classic conflict of interest.  

This is one — of many — reasons foreign partners have retrenched and stopped investing in Venezuela, and why output is now declining so fast.

The arrangement never made any sense. It’s not just the conflict of interest, it’s the fact that it treats being CEO of one of the biggest oil companies in the world as a part time job. Ni Superman. However, and regrettably, we see this pattern of one person running multiple important institutions across the State. It is a matter of quantity and quality: you need more people and good people to run each of these institutions properly.

What have our benchmark countries done? They’ve clearly segregated the three roles. The minister makes energy policy, the CEO of the National Oil Company runs the business and an autonomous agency implements policy and regulates the industry. The result is an industry run by full time, competent professionals that enables a level playing field where all companies can compete, partner and participate.

To make things worse at home, cash flow generated by PDVSA directly funds public spending in sectors that have nothing to do with hydrocarbons. We’re not even talking only about the state grabbing PDVSA cash to spend on social programs, we’re talking about PDVSA itself acting like a social spending ministry – another good reason to segregate the functions of the State and the National Oil Company.  

What would we need to do?  Simple. It is a political and common sense decision to be taken by the ruling political class: recruit qualified managers to lead each of these key institutions in our hydrocarbon industry; and limit PDVSA’s scope to what it should be: oil and gas.  

3. Launching the Agencia Venezolana de Hidrocarburos

In Colombia it is known as the Agencia Nacional de Hidrocarburos (ANH), in Brazil as the Agencia Nacional de Petróleo (ANP) and in Mexico as the Comisión Nacional de Hidrocarburos (CNH). Their role is similar: to implement the energy policy defined by the ministry and regulate the industry.

What does energy policy implementation mean? It means helping define the fiscal regime for the industry and running the licensing rounds that award acreage to execute exploration, appraisal and production activities – remember our first point where the State reserves petroleum activities but can assign them to others?  Well, this is an example of assigning those petroleum activities to third parties. This has worked tremendously well in Brazil and Colombia and is behind their increases in production. Mexico is following this path as we write this article.

To work, agencies like these need to be autonomous (really autonomous) and have enough power to issue regulations that outlast the political cycle.

What does regulating the industry mean? It means making sure that operators, state-owned and private alike, deliver on their committed activities (e.g. drill X wells, shoot Y seismic or develop the field to have first oil by Z date) and comply with operational, safety and fiscal rules. And it means penalizing them if they fail to comply. In Brazil for example, the ANP fines Petrobras, just like they would do with any other company, when they fail to comply with regulations.

To work, agencies like these need to be autonomous (really autonomous) and have enough power to issue regulations that outlast the political cycle. Ideally the agencies should be self-funded: the fines and licensing fees they raise should be enough to cover their costs.

These agencies also keep a database of all contracts that have been signed, production, operations, costs, accidents, fines, laws and regulations related to the hydrocarbon industry. They hold public consultations on any changes to laws or regulations they are responsible for. In many cases, the regulatory agency’s team tours the world to promote the country’s hydrocarbon industry and more importantly tour the country itself to maintain direct contact with the industry’s stakeholders: the people.

4. Making state participation an option, not an obligation

Article 22 of Venezuela’s hydrocarbon law (a.k.a., the oil law) requires that the State keep a majority stake in any “empresa mixta” in the industry.

Las actividades primarias… serán realizadas por el Estado, ya directamente por el Ejecutivo Nacional o mediante empresas de su exclusiva propiedad. Igualmente podrá hacerlo mediante empresas donde tenga control de sus decisiones, por mantener una participación mayor del cincuenta por ciento (50%) del capital social, las cuales a los efectos de esta Ley se denominan empresas mixtas. Las empresas que se dediquen a la realización de actividades primarias serán empresas operadoras.

The gas law allows but does not require State participation. So why not change the oil law to mimic the same lines?

This nationalistic approach has become a bottleneck now that both the State and PDVSA are virtually broke. When the time to invest comes, PDVSA simply does not have the financial resources to pay its share. As a consequence, projects get put on hold and production eventually declines.  

Is there a better way? There sure is. And it’s at hand: the gaseous hydrocarbon law (aka the gas law) allows but does not require State participation. So why not change the oil law to mimic the same lines? This is how the high-performing countries in the region do it: their National Oil Companies have the option but not the obligation to participate.

Colombia goes further in this direction: there the sector is completely open to private investment without restrictions of any kind. For example, the biggest oil field in Colombia, known as Cusiana, was discovered by BP in the 90s. BP operated it until the license expired and the field was handed off to a Joint Venture with participation of Ecopetrol, Colombia’s  National Oil Company.

In Mexico, on the other hand, the industry was completely nationalized from 1938 until just last year, when major constitutional reform was implemented that effectively break the Pemex monopoly, reinventing the rules for the whole industry. This was in response to the same challenges we face: declining production due to underinvestment. Since 2015 Mexico begun running a number of licensing rounds where Pemex has had the option but not the obligation to participate, either by itself or as part of a consortium with other privately owned oil & gas companies.

Does it work? Well, let’s look south. Brazil is almost a clinical case study of how liberalization boosts production, while state control hampers it. The country opened its upstream sector in 1998. Since then participation by private oil companies has increased hand-in-hand with production.

Then, in the early 2000s Petrobras discovered the pre-salt: a massive accumulation of oil offshore near the states of Rio de Janeiro and Sao Paulo. The left-wing PT, which ran Brazil for much of the last decade, decided to take the nationalistic step of passing a new law to regulate the pre-salt by limiting operatorship exclusively to Petrobras and establishing that the company had to at least hold a 30% stake in all pre-salt licenses.

How’s that gone for them?

Production increased on the back of the 1998 apertura until Petrobras’ finances became strangled by corruption and low oil prices, slowing down development and production in the pre-salt. Since the enactment of the pre-salt law, only one bidding round for one area (Libra) has been called: all the way back in 2013.

In response to this slowdown, the pendulum has swung the other way. The law that forces Petrobras to be the sole operator of the pre-salt is about to be removed in hopes of boosting investment and production.

The trend is pretty clear: when it comes to implementation of the petroleum activities, let the private sector do the heavy lifting and have the option, rather than the obligation, of State participation.

5. Staging Round Zero

All our benchmark countries have kept their National Oil Companies, and we also advocate keeping ours. But for the national company’s dominance to begin to recede, there has to be a moment when you take a fresh look at who keeps which bits of territory. To decide what acreage the national company keeps and which one they release for licensing by the AVEH later on.

In Colombia, Brazil and Mexico, the regulatory agency did a “License Round Zero”.

This round was about defining the licenses that the national company would hold onto and the commitments they would take on in terms of operational activities in such licenses.  

Round zero has proven to be a fundamental step to level the playing field and hold the NOC accountable for their solely-owned operations

From this point forward, the national company would be subject to the same rules as any other oil & gas company. For example, they would pay royalties for the production from each license.

To make sure the national company didn’t just keep all its existing acreage, the agencies set minimum work obligations that the company would commit to deliver. The idea was to force the national company to choose what it would keep and what it would release to become “open” acreage available for transparent and competitive license rounds later on by the regulatory agency.  

Round zero has proven to be a fundamental step to level the playing field and hold the NOC accountable for their solely-owned operations (“esfuerzo propio”).  Which brings us to…

6. Documenting PDVSA’s ‘Esfuerzo Propio’

PDVSA’s opacity is legendary. The company doesn’t report the status of its operations, production, costs, much less any accident or spill or any relevant event or detail that, as a state-owned company, it is bound by law to disclose on a regular and open basis.

Because they borrow in international markets, they’re forced to disclose some financial details, but their disclosures are usually late and always incomplete. The result is a bit of a black box.

Running an oil operation without an “esfuerzo propio” contract is a bit like living in a Gran Mision Vivienda apartment without a title. If you don’t have title you don’t have an asset.

Opacity is especially bad when PDVSA carries out operations on its own, without any partner and without a specific ‘title’ to a given area or basin. These are the so-called “esfuerzo propio” operations — or its solely-owned operations.

Some of the richest oil fields in Venezuela are run under this kind of black-box “esfuerzo propio” setup. There is no contract for areas such as El Furrial, Jusepin, Tia Juana, and others. Following international best practice, “esfuerzo propio” operations should have a legal framework just as “Empresas Mixtas” do.

Again, the region is far ahead of us in this regard: Brazil, Mexico and Colombia have special yet clear regimes for their National Oil Companies’ “esfuerzo propio” operations. All it takes is a relatively simple administrative change to define contracts per area and make these easier to oversee by the regulatory agency – so the NOC is held accountable for its obligations.

Crucially, this would also allow PDVSA to monetize these areas by selling part of their stake to third parties. Running an oil operation without an “esfuerzo propio” contract is a bit like living in a Gran Mision Vivienda apartment without a title. If you don’t have title you don’t have an asset: you can use it, but you can’t sell it or mortgage it. It’s dead capital. Why on earth should PDVSA continue to impose such restrictions on itself?

7. Holding transparent and competitive license rounds

The next step our benchmark countries took was to have their newly created hydrocarbon regulatory agencies plan and run licensing rounds to award acreage for exploration and production activities.

What does a licensing round need to succeed? Transparency and attractive terms.

What does a licensing round need to succeed? Transparency and attractive terms.

Picture the Teresa Carreño Theater packed with people and press broadcasting the round on Live TV.  The head of the agency says that we will be auctioning block X, companies stand up to line up, hand over a CD with the bidding parameters (for example, number of commitment wells, cash bonus and/ or incremental royalty to be paid for production) and in a matter of minutes someone clicks a button and boom!

The auction results are shown on a big screen, the winner rejoices (or not if it overpaid relative to the next bidder) and the losers can’t hide their disgust. There are no shady bilateral meetings or manila envelopes changing hands. The risk of corruption is minimized and the country as a whole benefits from the competitive nature of the contest as it maximizes investment. PDVSA can participate if it wants to and can afford it, just like any other company. Bidders can create partnerships through joint bidding agreements to diversify risk and share costs.

Of course, for the license to be successful it needs to combine prospective acreage being offered (that shouldn’t be a problem in a resource rich country such as Venezuela) and attractive terms – that means competitive government take relative to other investment alternatives such as Mexico, Colombia and Brazil.  

Get this wrong and the round can be a bust. Last year Brazil held ANP Round #13, and of 88 offshore exploration blocks only two were awarded at the minimum price – an embarrassing failure. Since then, the Brazilian government and ANP have been working to improve terms to become more competitive. Which brings us to…

8. Making the government take competitive

We live in a competitive world where capital is scarce and opportunities are plentiful. If we want to attract capital, our terms have to be attractive. Just having tons of reserves is not enough anymore.   

Right now, Venezuela’s petroleum fiscal regime is uncompetitive. It’s not just the myriad operational and foreign exchange constraints that dissuade private companies from investing serious bucks in Venezuela. You could fix all that overnight, and major investment would still not materialize because our fiscal stance is just not competitive.

One very general concept used by International Oil Companies in benchmarking fiscal regimes is what’s called “Government Take”. This concept includes all the mechanisms the country has put in place to capture some of the rents generated by hydrocarbon operations.

There are all kinds of ways governments tax oil and gas, from royalties and corporate income tax to windfall taxes and bonuses, local content commitments and indirect taxes. Venezuela seems to have them all. In fact, in terms of “Government Take” Venezuela is one of the least attractive countries in the world!

Venezuela’s hydrocarbons law stipulates effectively a royalty of 30% for crude oil and an income tax rate of 50%. Brazil on the other hand takes a royalty of 10% to 15% and income tax rate of 34%.

This isn’t entirely arbitrary: after all, investors in general don’t have to spend a penny on exploration activities in a country that’s awash in oil — not true for gas though, where there is plenty of underexplored acreage particularly offshore.

However, the capital expenditures needed in Venezuela can be very high. For example, making the Orinoco’s Oil Belt extra-heavy crude oil sellable requires either an ‘upgrader’ or huge quantities of ‘diluent’ (i.e. products such as naphtha or light crude oil) need to be produced or imported to ‘blend’ with the extra-heavy oil. Both options cost a lot of money, which added to high government take results in a low return or even loss-making business for the private company.

For example, Venezuela’s hydrocarbons law stipulates effectively a royalty of 30% for crude oil and an income tax rate of 50%. Brazil on the other hand takes a royalty of 10% to 15% and income tax rate of 34%. Broadly, both countries’ assets are similarly appealing to potential investors from a pure field value and development point of view: fields are large and prolific but cost-intensive and complex. Which country do you think is going to attract more investment?

Even our gas law is more competitive with a royalty of 20% and an income tax rate of 34%. The solution is simple: simplify and lower taxes to become more competitive.

Another problem is that Venezuela uses a one-fiscal-model-fits-all approach that doesn’t take into consideration the type of oil field, its complexity and cost-structure. This is not ideal for a country that has considerable variety in oil fields: some of them are mature, some declining, some with lots of gas and others with extra heavy oil, some onshore and others offshore. It doesn’t have to be this way: Mexico, for instance, is now applying different contract types, each adapted to a given type of field.

Let’s get the Ministry of Petroleum and Mining and the to be created AVEH sort this out.

The Way Forward

Let’s review the scoreboard. Our call is for an eight point reform agenda:

1. Moving on from the Petroleum Activities Reserva Dogma
2. Segregating the functions of the State and the National Oil Company
3. Launching the Agencia Venezolana de Hidrocarburos
4. Making state participation an option, not an obligation
5. Staging Round Zero
6. Documenting PDVSA’s ‘Esfuerzo Propio’
7. Holding transparent and competitive license rounds
8. Making the government take competitive

These eight reforms, implemented together, would have a  profoundly transformative effect.

Such an agenda cannot be carried out overnight. Once real political will for reform is in place, we believe it will at least take two to three years to implement them and see initial results in terms of increased participation and investment in the industry able to start to reverse the production decline.

Our proposals touch only on the exploration and production sector. It does not address equally urgent and relevant issues further downstream, such as the status of refineries, upgraders, pipeline system and gas & power generation, transmission and distribution. The list of issues to address is vast. We didn’t even touch on the exchange regime mess we have in Venezuela or the worrying lack of specialized workforce in Venezuela. We also didn’t touch on the commercial and technical feasibility of the new Orinoco’s Oil projects as they were originally conceived. We have some proposals that make them work. We will also be elaborating on this on a separate piece.

Like a good sancocho, these changes take time and cannot be rushed. The upshot is that revenues from the hydrocarbon industry, though fundamental to the country, will not be in a position to “rescue” Venezuela in the short term. But if Colombia, Brazil and hopefully Mexico, eventually did it, so can we.  

We hope tomorrow’s policy-makers do care about the country’s future and therefore take a good hard look at how the hydrocarbon industry is run in the most successful countries in the region. If they take a close look, they’ll quickly realize the magnitude of the opportunity that Venezuela is wasting every day it doesn’t implement reform.