Venezuela’s Hydrocarbons Policy: From Service Contracts to Joint Ventures

VHeadline.com oil industry commentarist Oliver Campbell writes: On April 10, Venezuelan Vice-Minister for Energy and Petroleum, Dr. Bernard Mommer, gave a talk to a packed house at the Bolivar Hall in London which was sponsored by the Venezuelan Embassy in London, The Anglo-Venezuelan Society, and The Windsor Energy Group.

The title of the talk was “The fundamentals underlying Venezuela’s hydrocarbon policy” … but a better title would have been “The development of the Service Contracts from 1992 to the present day” since some 80% of the time was dedicated to this topic.

Dr. Mommer started by remarking that Venezuela was a “power house” with oil reserves, when those from the Orinoco Belt were included, greater than Saudi Arabia’s. This made the country an important player in the world oil market. He continued by saying it is natural every country wants to get the most out of its natural resources. This meant Venezuela had constantly to assess its oil business and make changes to the rules of the game if this was necessary.

He then turned to the main theme of his talk which was to explain why the Service Contracts, entered into as part of the “apertura” or opening up of oil production to the multinationals in the 1990s, had been an extremely poor deal for the country. Of the 32 contracts, 14 had produced losses, others had paid no income tax, and the government take from others had been less than 50%. 

The Vice-Minister went on to explain the essentials of the new model for the Joint Ventures which supplanted the former Service Contracts. PDVSA will have a majority shareholding of at least 60%, royalties are set at 30%, and income tax at 50%.

All but two of the companies, ENI of Italy and TOTAL of France, agreed to “migrate” to the new JV model which came into effect on April 1, 2006.  Talks are taking place on the compensation to be paid, but it will not include payment for loss of future earnings (“lucro cesante”)

The companies which accepted the change were consulted and apparently agreed to the new conditions without too much arm twisting. An interesting departure from the norm for such joint ventures is that the minority partners must sell their equity oil, at market prices, to PDVSA which will then market the oil. It was not said whether some deal could be made whereby PDVSA would sell the oil on to the minority partners’ clients rather than its own customers.

Following certain rationalization, the 32 previous contracts will be reduced to 22 joint ventures. In most cases the minority partners will be the operators but, through PDVSA’s majority shareholding, the government will call the shots and maintain control.

The good news for potential investors was that newcomers would be welcome provided they were willing to accept the conditions of the new model. He also emphasized the technology foreign investors could contribute would be a positive factor for their acceptance.

During the question and answer session following the talk, a listener asked if a guarantee could be given that the conditions in the model would not be changed. Dr. Mommer replied no government anywhere could give such an undertaking since nobody could foresee how circumstance would change in the future. The questioner could hardly have expected a different reply. However, it does show the concern foreign investors have about the goal posts being subsequently moved.

Back in January 2005, in an article I wrote on the marginal fields, I noted the average cost of production under the Service Contracts in 2002 was $12 a barrel. This meant half the production cost more, and in one case it reached $23 a barrel. The average cost in 2005 exceeded $14 a barrel, and I fully agree with Dr Mommer the country was getting a poor deal and something had to be done to bring the costs down. The creation of joint ventures seems to be an excellent solution.

However, I question two assertions made by Dr. Mommer:

a) that the companies operating the Service Contract were oil companies and not contractors, and

b) that the Service Contracts signed by previous governments were illegal.

The norm is that an E&P (exploration and production) company becomes the owner of all or, if it has a partner, of a predetermined percentage of the oil it produces i.e. it acquires what is known as equity oil. However, the Service Contract operators never had any right to the oil produced which always belonged to PDVSA. They were paid in three parts: Operating Fee, Capital Fee and Stipend (the profit element) i.e. a typical contract arrangement. The fact some of the remuneration may have been linked to the oil price does not turn the contractors into oil companies.

I believe any good lawyer could successfully argue the income tax rate of 34% applicable to non-oil companies, and adopted since the contracts’ inception in 1992, was the correct one.

Why did it take the government from 1998, when it came into power, till 2005 to determine the contractors were oil companies and so subject to the 50% income tax rate?

The long time taken to come to this conclusion certainly adds no credibility to its case. The fact is the companies were taken by surprise when obliged to pay the additional income tax backdated to 2002, the date the new Hydrocarbons Law with the 50% tax rate came into effect.

The same holds true for the assertion the contracts were illegal.  Why did it take seven years to decide this?

In the Anglo-Saxon world the position is quite clear and I quote: “No Parliament may be bound by a predecessor or bind a successor.” I doubt the position is different in Venezuela, so I fully agree the present administration had every right to change the economic conditions of the Service Contracts.

I also fully endorse Dr. Mommer’s statement that there can be no guarantee the terms in the present model will last any particular length of time.  Any oil companies which believed the previous conditions were written in stone would be commercially naive and I certainly don’t think they are. They are hard headed enough to know if the cake becomes bigger the government will want a larger slice.

However, it is one thing not to be bound by the decisions of previous governments, but quite another to allege the contracts they signed were illegal. Once a government questions the legality of the actions of a previous government it can only mean the lawyers will have a field day.

There is talk of indicting the oil ministers and presidents of PDVSA who approved the contracts. However, if the National Congress did not object to their being signed, its members must also be implicated in the illegality. I find it hard to believe the Venezuelan court would find this to be the case.

The international press has exaggerated the concern about the change to service contracts.

One paper stated there were “fears that Venezuela will nationalize the oil industry.”  This would be difficult as the country needs both the capital and know-how that foreign companies provide. As far as I know, it is not on the cards and certainly Dr. Mommer did not mention it. The word he used several times was “control” stressing the Oil Ministry wants to know exactly what is going on. He affirmed that, with the Service Contracts, PDVSA had adopted a “hands-off” policy and not been on top of the high costs’ problem.

So I believe the minority partners will have to get used to more control than hitherto. Some may also have to accept their profit margin will go down. Even so, I think the average return will be satisfactory, if not as high as the partners would wish. The following figures, based on averages, give an idea of the profit the companies could make.

* I have assumed a 33% rate to be conservative since there is talk this may be the final rate. 

My estimated cost of $8 per barrel looks high when compared with the average of $3 for other crude oils, but most of the crude oils produced by the joint ventures are from marginal fields with heavy oil which require costly secondary recovery methods.  The $8 compares with the average of $12 in 2002 and about $14 in 2005.

With a $40 sales price, the partners’ profit starts at some $9 per barrel and   rises to $16 when the sales price reaches $60 a barrel. This is not a bad result for them. It is an eminently satisfactory one for the country.

Some might even call it a “win-win” situation.

It is regrettable the change to joint ventures was handled with such a lack of tact that it soured relations with some companies. The aggressive attitude of “take it or have the fields confiscated” need not have been aired in the press. This ultimatum, as indeed it was, should have been kept for the negotiating table. Neither should SENIAT’s constant threats to impose large fines if the companies did not pay the back taxes have made the headlines. Both aspects created unnecessary friction and were possibly why ENI and TOTAL decided not to accept the joint venture alternative.

In brief, the government was right to change the modus operandi so the country obtained a better deal. The choice of Joint Ventures is a good, practical solution, and the foreign partners will still obtain a reasonable return on their investment. It is doubtful any back taxes were owed since it needs some imagination to sustain the operators of the Service Contracts were in fact oil companies. 

The assertion the Service Contracts were illegally signed by previous governments is open to serious question.

Changing the economic conditions so the country got a better deal was long overdue.

Dr. Mommer was actively involved in negotiating the new Joint Ventures and is to be commended for doing a good job.