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Chavez increases royalties on heavy crude operators

By Miguel Octavio

10/10/04 - President Chavez announced today that he was increasing oil royalties to the heavy oil projects from 1% to 16.66%. These projects are Petrozuata, Hamaca, Cerro Negro and Sincor. These are all projects in which heavy crudes are transformed into synthetic fuels. These four projects produce a combined total of about 500,000 barrels a day today, but production is expected to reach 800,000 barrels within the next two years, with each project producing roughly having 200,000 barrels a day. Venezuela’s state oil company PDVSA is a minority partner in all of these projects.

Three years ago, Venezuela’s National Assembly approved a new hydrocarbons bill, that increased all royalties from oil exploitation to 16.6% but in Venezuela, laws can not be applied retroactively, so it did not apply to projects approved before the law. In general, at current levels of oil prices, this should not be a problem for these projects, most of which were planned assuming West Texas Intermediate prices of US$ 15 per barrel. They were all given a 1% tax for the first nine years of the production as an incentive to start them. Before these projects came into existence, there were no similar projects in Venezuela.

Most of these projects were built using debt issued in US dollars by the projects themselves. Bonds were issued which were guaranteed by the company’s partners until the projects met certain technical specifications of actual production. Many of the bonds are of the sinking fund type, in which after a certain date, they pay not only interest on the principal, but also part for the principal. This structure is used whenever investors may find that it is hard to look down the line to the maturity of the bond.

As an example, the Cerro Negro 2009 bond has a coupon of 7.33% per year, but has returned principal since three years ago at a rate of 6% per semester, so that only 70% of its principal is still outstanding. It currently has a yield of 5.75%, which is quite attractive given worldwide interest rates. Another project, Petrozuata, has a bond maturing in 2017 which pays no principal until 2008 and has a coupon of 8.22%. I consider this bond to be one of the most attractive fixed income investments in Venezuela.

While it is reasonable, given current oil prices, to increase the royalty to this level, I am not comfortable with the way it has been done. First of all, these were contracts signed by PDVSA in which that royalty percentage was negotiated. Second, it would seem more reasonable to negotiate it with the companies, establishing a sliding schedule in case prices go down in the future. Third, I understand that all of the projects are looking to expand their operations in Venezuela; maybe this could have been negotiated rather than imposed, as it does not send the best signal to investors looking for new oil deals in Venezuela.

The biggest problem in my mind with the decision is one of competitiveness; Canada and Venezuela have the biggest heavy oil reserves in the world. These projects are similar to much larger projects in Canada such as Suncor, which have found a way to exploit these heavy crudes. In Canada, according to the Suncor report, the royalty is 1%, which is probably the reason why PDVSA negotiated that rate when the projects were started. Note that there are royalties and there are taxes, in both countries the royalty was 1% until today. Suncor as a company pays an effective tax rate of 36% which is probably similar to Venezuela’s. Thus, Canada is more attractive from that point of view.

I am not in a position to know or evaluate at this time whether this hurts Venezuela’s competitive advantage in heavy crudes or not. There are other issues to consider such as production costs. These projects make use of natural gas, which is cheaper in Venezuela, so that may be an advantage. Financially at current oil prices the decision should not affect any of the projects as they were planned for much lower oil prices. The one affected the most is Hamaca, which only came on line recently, the rest have benefited for quiet a while of the lower royalty.

In any case, you read The Devil’s for free and today you get, also for free, two investment recommendations: If you are aggressive buy Suncor stock (NYSE:SU), the company’s cash flow is fantastic and if oil prices stay high it will keep going up. If you just want income, buy Petrozuata’s 2017 bond with a coupon and yield of 8.22% for the next 13 years and you start getting back you principal in 2008. Benefit from the Devil’s Excrement, not this one, the real one!

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