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Chavez surprised international oil companies

From Stratfor

Oct. 18, 2004 - On Oct. 10, Venezuelan President Hugo Chavez surprised international oil companies (IOCs) by announcing on his weekly radio broadcast that he was increasing royalties -- from 1 percent to 16.66 percent -- paid to the state by companies involved in heavy crude production in the Orinoco Tar Belt.

Chavez noted that higher world oil prices justified the increase, as oil companies were earning substantially higher profits. Using the spicy Bolivarian rhetoric that he favors, Chavez also called the increase "an act of justice and sovereignty'' for Venezuela.

Chavez's decision reveals several things:

(1) The Venezuelan government is anxious to get its hands on a greater share of oil revenues, despite record high oil prices.

(2) Chavez recognizes that his political control could be undermined if he loses the support of the lower classes, putting pressure on the budget to increase social spending.

(3) Signed contracts with the Venezuelan government are meaningless when they get in the way of Chavez's political agenda.

(4) IOCs -- and their financiers -- will be reevaluating their investments in Venezuela, and could face similar problems in other oil producing countries.

The affected companies -- including France's Total, Norway's Statoil, the UK's BP and U.S. companies ConocoPhilips, ChevronTexaco and ExxonMobil -- signed strategic association contracts in the mid-1990s for the production in the Orinoco belt. Those companies extract and upgrade extra-heavy crude, resulting in about 500,000 bpd of synthetic crude. The lower tax rates and royalties associated with the initial contracts were designed to offset the high investment costs needed to set up the upgrading and conversion process for this type of production.

The decision does not come as a complete shock, for a couple of reasons. First, Chavez has long railed against what he sees as sweetheart deals afforded foreign oil companies in Venezuela, and has taken steps for redress in the past - most notably the 2001 Hydrocarbons Law. Second, Caracas had hinted specifically that future investments in the Orinoco Tar Belt would be subject to higher royalties, and that the current terms would likely be renegotiated at some point.

Foreign companies knew the increase was coming, though they did not know exactly when it would happen. The salient point is that Chavez acted quickly and unilaterally in imposing the increase, which his energy minister said would take effect immediately, rather than seeking to negotiate new terms as the companies had expected. Sources with two foreign oil company told Stratfor that the increases came without warning, and that they are angered more by the way it was carried out than by the substance of the decision.

So far, the affected foreign investors have said publicly only that they are studying the matter, and they are very unlikely to actually pull out of the projects. Nevertheless, the decision is a rude wakeup call for oil companies, as well as other foreign corporations that are active or considering investments in Venezuela.

Moreover, this will not be a one-time event in Venezuela.

Milking the Cash Cow

Venezuela's state finances -- long in shambles -- recently have been on the mend as a result of capital controls and high oil prices, as evidenced by a September debt rating upgrade by Moody's. However, the country's tax regime is still very weak, its foreign debt high (around $22 billion), and budget demands are growing rapidly.

Chavez is looking to shore up his support among the Venezuelan masses through expansive social outlays, while simultaneously rebuilding the country's shoddy military apparatus, including plans for large equipment purchases from Russia. That takes money which -- considering the tattered state of the Venezuelan economy, endemic tax evasion and rampant government corruption -- Caracas doesn't have.

The fiscal pressures on the government are substantial and rising. Shortly before the August referendum vote, Chavez lowered the value-added tax (VAT) from 16 percent to 15 percent. While this may have helped shore up popular support in the short term, it stuck the government with yet another fiscal problem, especially as Chavez cannot realistically revert back to the higher VAT. Tax evasion is a systemic problem, particularly as nearly half of Venezuelan workers are involved in an informal economy that doesn't capture income taxes.

Moreover, the government also continues to pay huge sums to "missions" to feed the poor and hold their loyalty, as well as expensive subsidies for basic staples, including food and gasoline. With the economy faltering and poverty, malnutrition and starvation levels on the rise, the need for social outlays rises as well.

Financially, something has to give. In the two weeks before Chavez raised the strategic association royalty rates, Venezuelan officials floated an idea to raise domestic gasoline prices, which are currently so low that one U.S. dollar is enough to fill the gas tank of a small sedan. This trial balloon crashed immediately, however, with even Chavistas warning the president that raising local gasoline prices could trigger massive riots. That was no idle warning: a similar move in 1989 led to an entire week of rioting in which some 300 Venezuelans were killed and several thousand injured.

Venezuela's Falling Star

With oil production in Venezuela heading down, not up, the one way of raising revenues is to take a bigger piece of the international oil pie. The increased royalties would translate into an estimated $776 million of additional government revenues annually -- a huge windfall, compared to current estimated revenues of around $46 million. But given the fiscal burdens carried by Caracas, this is not likely to be enough, meaning more surprises are yet to come.

The Orinoco decision was the first time since 1958 that any Venezuelan head of state has unilaterally changed terms of a signed contract. In doing so, Chavez has damaged his hopes of attracting foreign direct investment (FDI) into oil and other sectors. Foreign companies in Venezuela can expect similar decisions, such as temporary or permanent ad hoc tax increases.

However, oil companies will remain a focal point for the government. Those in strategic associations are now paying a 34 percent corporate tax rate; under the new Hydrocarbons Law, royalties can be set between 20 and 30 percent and taxes at 50 percent. And that implies Chavez could hike taxes even further, possibly to an effective tax rate as high as 80 percent. Even with oil prices at their current rates, above $50 a barrel, this would wipe out the hefty profit margins oil companies enjoy and discourage companies from making large new investments in Venezuela, despite the country's sizeable conventional and bitumen reserves.

These changes will be couched in nationalistic rhetoric, and may indeed be part of a larger, longer-term plan. In announcing the oil tax increase, Chavez said: "Today, we are starting the second phase of the true nationalization of PDVSA and of Venezuela's oil, aiming for full petroleum sovereignty." Such language is bound to make IOCs nervous about their current investments and even more cautious about sinking new funds into the country.

Companies engaged in the strategic associations aren't likely to pull out of Venezuela altogether. However, the business case for significant up-front investments in new production -- including expansions in the Orinoco Tar Belt -- will not look nearly as strong. Companies likely will raise the levels of acceptable rates of return for new investments to account for (1) the recently raised tax rates and (2) risk that other tax rates will be hiked as well. The cost of obtaining outside financing for new projects will also go up, due to higher perceived risk. The result will be a decline in new investment that will speed the fall of Venezuela's reputation as a reliable oil producer.

Contract? What Contract?

It would be a mistake to assume that this is only a Venezuelan phenomenon. Other oil-producing countries are looking at the growing revenues of their IOC guests and reconsidering the fairness of past agreements. As oil prices continue to hit record levels, the temptation for governments to dip their ladles into the IOCs' gravy bowl well might prove too much to resist.

The president's office in Chad -- a rising African oil producer -- issued a statement in September complaining that the government is getting short shrift in this high-price environment. "The sale price of Chadian oil is less than 20 dollars. But the barrel price is $50 on the international market today," the statement read. "This practice puts considerable strain on the meager resources Chad expects of its oil." The government receives a 12.5 percent royalty for every barrel produced in the country, and it conceivably might begin exploring ways to increase its oil revenues.

Kazakhstan has done more than hint at changes. There, the government is actively trying to muscle in on the Kashagan oil field, has harassed various foreign companies (unfairly, in the companies' views) over late tax payments, and is considering legislation to raise tax rates on oil producers and implement new production-sharing contracts that give the state a minimum share in revenues, without taking on any cost of production or operations.

Russia, too, is awash in political uncertainty that fundamentally alters the basis for investment decisions.

The Kremlin recently commissioned the German firm Dresdner Kleinwort Wasserstein to do a market valuation of Yukos subsidiary Yuganskneftegaz. The result was an underwhelming valuation of $10.4 billion -- a discount of almost 40 percent from most market estimates, which have ranged recently between $15.7 and $18.3 billion. The reason for the discount in DKW's view: political risk.

And who can argue? The overriding theme of the Yukos affair is that politics trumps economics (not to mention ethics) in big-time business decisions in today's Russia. By the end of this year, Yukos will have paid off its debt obligations (in back taxes and fines) to the government through the year 2000. Riding the wave of high global oil prices, the company conceivably could meet all of its other debt obligations for back taxes for 2001-2003 by the end of 2005, negating the need to sell off large chunks of the company. But that hasn't stop Moscow from moving forward with the sale of Yuganskneftegaz through the Russian Federal Property Fund: The Russian Justice Ministry announced Oct. 15 that the valuation of Yuganskneftegaz had been completed, thus opening the way to its sale. While the actual value of the company is open to debate, this is clearly a political rather than business decision.

With oil prices at their current levels, IOCs have some luxury in taking on new projects. But they also have choices. States such as Venezuela that move too aggressively to change the terms of investment or Russia, which promise frequent earthquakes of political risk -- could be in for a rude awakening if they are shunned for more "friendly" shores.

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