Oil in Latin America

The good oil boys club

The Latin American and Caribbean region consists of several oil producing nations such as
Mexico, Colombia, Trinidad and Tobago, Venezuela, Ecuador and Brazil amongst others. In 2015
the region was responsible for producing 13% of world oil output thus making it an important
cog in the world oil market. According to the U.S. Energy Information Administration (EIA), the
region boasts two of the top 12 largest oil producers in 2015 with Venezuela and Brazil ranking
11th and 9th respectively. Venezuela produced over 2.6 million barrels per day while Brazil
produced in excess of 3.1 million barrels per day. Venezuela also has some of the largest proven
oil reserves with data showing it has a massive 24.8% of the worlds proven reserves. With this
magnitude of production and potential it is evident that the crude oil industry plays a significant
role in the economies of Latin American countries. This notion is further supported by World
Bank data that concluded that since 2010 until 2014 Ecuador oil revenues contributed in excess
of 10% to the countrys GDP. The crashing of the oil price in 2014 also produced downgrades in
economic ratings by international rating agency Standard & Poors (S&P) for countries like Brazil
and Venezuela, reflecting the importance of the oil sector to the regions economy. Given that
the oil industry is so vital to the Latin American economy, it is glaringly important that the right
levels of capital investments are necessary to keep the industry in good health.

The issue of foreign capital investment in Latin America has always been a very precarious topic
due to the historical nature of resource nationalism felt by its citizens. Many countries such as
Brazil, Mexico and Venezuela have chosen to go the route of the state maintaining very high
stakes in their petroleum industries which some countries are now finding out was to their own
detriment. The world oil market has been quite open to foreign capital investments for a very
long time and this is evident by the large amount of foreign investors present in North America
which is one of the largest oil producers in the world. On the bright side however, it is clear that
Latin America has finally woken up and has seen that given the mobility of capital and the
choices present to investors, they will have to be a little more investor friendly to sustain the
long term future of the oil industry. Foreign capital investments are even made more necessary
as Latin American governments are finding it increasingly difficult to fund the industry
themselves. Countries like Mexico, Brazil and Venezuela who are the largest producers in the
region have significantly cut back budgetary allocations to the oil industry. Ages of
mismanagement has done the region no favours and with the colossal fall in oil prices over the
last three years, the mask that was being held up by prices over $100 per barrel has now fallen
off and it is no wonder that the repercussions of such mishandlings are now coming to the fore.

The reality of conforming to the current world oil market has finally set in as the region
continues to see production fall by millions of barrels per year. Mexico has taken the lead in
opening itself to large scale foreign capital investments. However, its initial effort to engage
foreign investors did not go according to plan as only a very small number of fields that were
auctioned were snapped up by investors. Major contributing factors might have been the fact
that even though they attempted to add some level of privatization, they were still hell-bent on
maintaining a tight level of control which many investors will not find very attractive. These
mind-sets need to be overcome if investors are going to feel completely at ease such that at no
point in time will they be forced out of the country before their contract expires. The lesson to
be learnt from this is that petroleum contracts must be made to suit both parties and not just
the owner of the resource as there is a high chance that resources could be left unexplored if
the government is too demanding. This lesson seems to have seeped through to the rest of
Latin America as even the once hard-line Venezuela is now seeking to lure investors back to
their shores. Brazil is also making great considerations in this regard albeit with the very
conservative mind-set of still wanting to keep their industry partly nationalized.

For the Latin American region, there are plenty of options available for consideration to
countries that are willing to invite investors to their borders. The subject of economic rent and
its collection to the state could repay further examinations by governments looking to promote
the oil industry. Economic rent is the excess value of a natural resource after all necessary cost
inclusive of the opportunity costs are deducted from the revenues arising as a result of the
selling of the natural resource. In an efficient scheme, that excess revenue is eligible for
government taxation without affecting the ability of the investor to cover its costs. In attracting
investors and collecting rent, Latin American governments might choose to approach investors
from one of the several options listed below:

Bonus bidding scheme: This is where the government could choose to auction an oil field with
the winning bidder required to make a large upfront lump sum payment based on the fields
potential and expectations of monetary value. This is the only sum that is paid to the
government with no earnings accruing to the government over the life of the resource. Backed
up with taxes and royalties, this is ideal for a country where there are very high potential. With
less potential in a field, this scheme is not optimal. The advantage to the government is that if
the exploration proves futile then they would have already been paid as well as they would
have transferred all the risk to the investor. The downside of this deal is that if the field is way
more productive than was expected then the government would have made way less than they
could have.

Royalty bidding scheme: This option is where investors try to woo the government with the
highest royalty rate in order to be awarded the license. In this case the investor is secured by
the fact that royalties are only realized by the government (paid) if a discovery is made that will
result in production. The disadvantage to the investor is that royalties begin payment by
producers once the viable field is discovered and long before profits begin generating. For the
government this means once it is known there are viable oil reserves then the earnings start
flowing whether or not the producer is efficient in its production.

Net profit sharing bidding: This is where the bidder who bids the highest share of potential
profits with the government is awarded the contract. Therefore rent is only realized when
profits are made, it is the general consensus that there is likely to be less disincentives with a
profit based scheme. This type of bidding can take different forms such as a profit oil share,
profit gas share, resource rent tax etc.

Work programme bidding: The oil company will make a bid to carry out exploration for a
specific time period which means the government is secured by the fact that some exploration
will take place even though they are not paid an upfront bonus. The explorer is comforted by
the fact that the bid they make is on the premise of the potential of the area, the available
technology and the expected value of the resource. The explorer is usually given enough time
to carry out a thorough exploration. If the work programme is to be optimised then it should
follow the design that the next step is based on the result of new information garnered from
the previous steps. Most countries around the world apply this method as it usually maximizes
their interest. This scheme would suit countries with smaller oil resources.

Hybrid Scheme: The government may also choose to use a mixture of the above mention
bidding processes with a combination of other policies such as income tax, production tax and
special taxes etc. The Australian government has chosen what is considered a progressive
system which consist of a resource rent tax plus income tax.

In its negotiations, a government may also discuss issues relating to domestic market
obligations that the foreign oil company will have and the cost at which it will supply the
domestic market. Negotiations must decide on the ideal percentage of local content policy
where materials, financing etc. must be from the country in question. It will need to decide if
the country will take the revenue from the new foreign capital investments and invest it into an
oil fund where the income received from that fund can be used in the short term while the
principal acts as a capital fund. It will need to iron out at what rate resources are to be depleted
and what is the driving force for that depletion rate, such as preserving oil resource for future
generations or taking cash now and investing the proceeds. Governments must also be a little
more pragmatic about pricing policy due to the uncertainty around the oil prices.

The long term interest of the region must be taken into account by respective governments to
finally eliminate the resource curse (countries with large oil/gas reserves sometimes exhibit
lower growth than in those with no oil/gas) which has plagued the region for decades. Mexico
has taken a commendable step; however that is just the first of many necessary steps to see
the region maximize its full potential from its un-bounding levels of petroleum reserves. If these
steps are taken efficiently then before too long the Latin American region shall take its rightful
place as a major oil producing hub.

Therefore I am recommending that the respective governments within Latin America consider
which of these approaches would best fit their countrys oil profile when engaging potential
investors. The bonus bidding scheme complimented with resource rent tax and royalties would
be ideal for countries with large oil prospects while for smaller prospects, the work programme
bidding scheme should be considered. Governments can also apply a hybrid of taxes and
bidding schemes which are coined to ensure the country maximizes its potential. It is therefore
clear that no single approach will solve the regions issues and that the approach considered
ideal for one country might not be ideal for another country.