The expropriation that wasn't

  Kevin Drum and Dan Drezner wonder why the oil companies would get back into Venezuela after the way Hugo Chávez treated them the first time around.  The answer is simple:  Chávez didn’t treat them badly.  When oil prices head back up, they’ll do fine even if he plays the same movie all over again. 

“What???” you say?  How can that be?  Simple.  Between 2004 and 2006, the Bolivarian Republic of Venezuela expropriated the marginal surplus generated by the run-up in oil prices.  It did not, however, reduce the revenues of the oil companies.  They took home about $10 a barrel when the contracts were signed in the late 1990s, and they took home about $10 a barrel in 2008.  In fact, some of the companies that had signed service contracts under the old regime received more money under the Bolivarian regime than they would have under the original rules.

So why not get back in?  It isn’t like there are a whole lot of places around the world for the oil companies to invest in, especially not on-shore.  Most oil reserves are closed to the majors, and political risk is everywhere, including Alaska under its radical socialist governor.   The companies have little chance of enjoying the upside from a return to high prices, but with estimated costs of $6-$7 a barrel, Venezuela is still a good bet. 

Details and money graph below.

In the 1990s, Venezuela opened its oil industry to foreign investment.  The first contracts in 1991 and 1992 were “operational service agreements” signed to take advantage of marginal fields that PDVSA didn’t want to develop itself.  In essence, the 1991-92 agreements pledged PDVSA to purchase the output from the marginal fields for a fixed price of $12-$14.  The oil cost between $4 and $7 per barrel to extract, and the concessionaires faced an income tax of 34%.

In 1997, PDVSA signed a second wave of operational service agreements.  These were a little more complicated.  Basically, the concessionaire kept everything (subject to income taxes) until it broke even, after which PDVSA’s share would slowly rise to 70 percent. 

At the same time, Venezuela signed a different set of contracts to open up the Orinoco oil belt.  Under these “association agreements,” PDVSA took an equity stake between 40% and 47% in the projects.  The resulting joint venture would then pay the 34% income tax and a royalty of 1% on production.  The royalty rate, however, would rise to 16.7% in either ten years or after the project reached a pre-set level of profitability, whichever came first.  

Chávez changed the rules in 2004, when he upped the royalties to 16.7%.  That change, however, affected only one of the four Orinoco association agreements.  In 2005, the income tax rate on all foreign ventures went up to 50%, and the Orinoco royalty jumped to 30%.  In 2006, the government abolished the operational service agreements, replacing them with joint ventures in which the government charged a 33.3% royalty and in which PDVSA took a 60% stake, in addition to income taxes.  The Orinoco agreements were placed under the same framework, only PDVSA took even higher stakes, averaging 78%.  (PDVSA paid some compensation for its upped stake in the projects.)  This last change was what the Bolivarian government called “nationalization.”

Chevron, B.P., Total, and Statoil accepted the change; Chevron and Exxon left and took Venezuela to arbitration.  Chevron later backed down.  Exxon did not, and continues to threaten Venezuela at ICSID.

The above sounds very bad for the oil companies, but when you calculate the net effect on their revenues, Chávez’s changes had the net effect of expropriating the marginal revenues that the Orinoco companies would have received from the big run-up in oil prices.  Their net revenue per barrel remained basically unchanged.

The effects of the new rules on the companies governed by operational service agreements are a little more complicated.  Projects initiated under the 1991-92 rules benefitted from the changes, at least as long as oil stayed above $80 a barrel:  they moved from an effective marginal tax rate of 100% to an effective rate of 87%.  Some of operational service agreements initiated under the 1997 rules didn’t do as well, depending on how much money they had already made for their owners.  Perversely, the more money they had already made, the more likely they were to benefit from the Bolivarian revolution.  The reason for that perversity is simple:  under the old system, marginal tax rates rose along with cumulative profitability, and the new rules cut the maximum marginal rate.

In short, Chávez’s great oil expropriations weren’t.  Expropriations.  They were tax hikes, and in this, they were not at all unlike Bolivia’s putative gas nationalization.

It surely would have been better for everyone to have specified a set of progressive taxes and royalties to cover the unforeseen contingency of super-high oil prices, but the net effect would not have been different.  So why not get back in now that the oil price is low?  The oil companies won’t enjoy any future boom, but they are also unlikely to find themselves truly nationalized.

The big mystery is neither why Chávez changed the concession agreements, nor why the oil companies appear willing to re-enter the Venezuelan market now that he appears to be changing them back.  Nor is it a mystery why most of the majors decided not to pursue the options available to them against Venezuela. 

Rather, the big mystery is why Exxon went to the mattress against the Bolivarian Republic.  It isn’t clear to me that they will be able to win.

Thoughts?  Greater knowledge? 

Comments

[Peter]

"So why not get back in now that the oil price is low? The oil companies won’t enjoy any future boom, but they are also unlikely to find themselves truly nationalized."

Compared to the Middle East, there's also much less chance of terror attacks against the oil infrastructure or of complete societal collapse. I'm sure that the executives of every oil company operating in Saudi Arabia have nightmares about what will happen if/when the House of Saud falls and Taliban-style fundamentalists take over. Whatever forms of turmoil might arise in Venezuela, it's 100% certain that they'll never be of remotely the same magnitude.

[Noel Maurer]

The amazing thing about Saudi Arabia is that its national oil company, Saudi Aramco, is as good as any of the international majors. Amazingly enough, there /aren't/ any western execs operating in the Saudi oil industry.

Truly astounding accomplishment on the part of the Saudis. PDVSA might have been moving that way, but pre-1998 Venezuelan governments opened the industry to international collaboration in order to attract capital faster. (To be fair, there is a good case that this was the right thing to do, although the Orinoco contracts gave the majors far too much of the upside in the event of an oil price spike. Which no one expected, of course, but still.)

Then came the big strike of 2002. PDVSA shot itself in the head during that strike, and in the aftermath the Chávez administration stripped the company of a lot of its technical expertise and ability. That, combined with an rather astounding lack of cash, is why Chávez has to invite the majors back in now. PDVSA just can't expand production on its own.