Since 2014, the oil and gas industry has faced a worldwide crisis, triggered by unprecedented steep drops in global oil prices. In this scenario, international oil companies have cancelled or put on hold several E&P projects that are not as profitable at depressed oil prices or that are located in risk sensitive jurisdictions, such as many countries in Latin America. Therefore, companies have been exiting Venezuela and putting projects on hold in Peru, Colombia and Brazil.
Additionally, the current crisis in the oil and gas sector has highlighted the structural and macroeconomic problems faced by several countries across Latin America. Countries such as Bolivia, some Brazilian states, Ecuador, Mexico, Peru and mainly Venezuela have fiscal and budget policies that are dependent on energy commodities, and now they face major macroeconomic challenges as a direct result of the chain reaction caused by the falling oil prices.
During these times of crisis, one of the clearest lessons for Latin America is that the pre-existing macroeconomic volatility, lack of infrastructure and weak legal and regulatory framework can be especially damaging to the development of the O&G industry, which relies on legal certainty and a favourable environment for its investments.
In any event, the deep crisis affecting Latin America has accelerated much-needed changes, especially with the election of pro-business governments in Argentina and Peru and major street protests that have weakened populist governments in Brazil and Venezuela, which has even led to the impeachment of Dilma Rousseff in Brazil. Also, the oil prices are starting to stabilise and many Latin American countries, especially Brazil and Mexico, hold large plays that international oil companies cannot otherwise access in other emerging markets.
What led the O&G sector in Latin America into its specific challenges?
In the early 2000s, leftist-populist governments were elected to office in most Latin American countries. Of course, the economy of Latin American countries has for the most part been dependent on the export of commodities in the energy, mining and agricultural sectors. The boom of commodities prices, led by Chinese demand starting around early 2008, caused an unprecedented inflow of dollars into Latin American economies.
With abundant money from commodity exports, the populist governments became increasingly lax with respect to the macroeconomic basis that the 1990s liberal governments had created and which later allowed for unprecedented economic growth when commodity prices boomed. Although the ever-growing inflow of money from commodity exports mitigated the problems arising from the governments’ willingness to relax important fiscal and budgetary rules, it immediately, in some countries, caused evident Dutch disease, especially in Venezuela and Argentina, where the governments placed high subsidies on utilities and saw a growing de-industrialisation. This was led by inflation that had not been seen since the 1980s, and growing unemployment rates. However, these governments were able to hide the growing problems while commodity exports were still on the rise.
Therefore, a serious vicious cycle was set in many Latin American countries for nearly a decade, with growing interference in the economy, changes in the legal framework to the detriment of foreign investors and populist policies allowing the ruling parties to entrench themselves in power.
During that time, in Brazil we saw the publication of a new set of laws and regulations applicable to the promising pre-salt area, which re-established a de facto monopoly by Petrobras, created a production sharing regime, created a new state-owned petroleum company (PPSA), set more stringent local content policies and changed the tax and royalties rules. All of this occurred after a decade of extremely successful oil and gas policies that attracted dozens of foreign oil companies to the country, and allowed the creation of dozens of independent Brazilian oil companies.
When the commodity bubble burst in late 2014, all of the socio-economic problems caused by the populist governments came to light. Argentina, Venezuela and Brazil suffered the most, with economic recession, growing unemployment and inflation. Of course, when commodity prices plummeted, so did the interest of foreign investors in the countries. For instance, the first pre-salt bid round in Brazil was a fiasco, and the 13th bid round for exploratory play was the worst ever recorded.
Paving the way for the future
The reasons given above were fundamental to Latin America experiencing such profound macroeconomic and socio-economic impacts from the changes in oil (and other commodities) prices. The insufficient implementation of populist development policies by means of poorly oriented state interference is the main cause of the serious situation that Latin American countries currently face. Such crisis has strongly affected the O&G industry in these nations, on top of the global pricing crisis.
Fortunately, the political tide in many Latin American countries has begun to change after increased dissatisfaction from its populations. The policymakers now have a window of opportunity to take corrective measures, prioritising economic and regulatory reforms aimed at breaking the over-reliance on commodities, and to position their economies to withstand other cyclical and abrupt global shifts, which will surely continue to happen in the future.
Therefore, what apparently creates a paradox actually does create a new way of thinking about the future of the O&G sector in Latin America – a way that effectively ensures such future. Securing the future of the O&G sector means promoting joint efforts with governments in order to consolidate regulatory and economic policies that are friendlier towards the investor and express commitment to the sustainable growth of the Latin American countries, taking advantage of strategic guidelines of state actions oriented towards continued macroeconomic stabilisation. Recently, new Latin American governments have shown a willingness to re-open the markets and establish dialogue with foreign investors.
An example of such willingness in the past year is Mexico, which ranks 10th worldwide and first in the Latin American and Caribbean region for oil producing and, nevertheless, experienced declining production and exports rates in recent years. These declines in crude oil exports have led to increases in imports, and have negatively affected the balance of trade. To reverse this trend, the federal government promoted a reform in the energy sector that was approved in December 2013, declaring that oil and gas exploration and production were strategic activities, and promoted private investment in the hydrocarbon industry. In July 2015, Mexico conducted its first public bidding for oil exploration rights since the announcement of energy reform in 2013, and despite initial mixed results, the government did not stand still and softened some post-bidding rules in order to keep a grip on investments and respond more efficiently to investors’ claims and necessities in the O&G environment.
One example of policy change following bidding rounds was the significant reduction in local content requirements, as mentioned above, when the government recognised the unfeasibility of the required high standards, particularly for deep-water operations. This has proven crucial to the government’s intention to develop the sector in harmony with foreign investors, especially now that more bidding rounds have been announced for the coming years and are highly anticipated.
In this sense, it is essential to strengthen the practice of dialogue and cooperation with public authorities within the standards of compliance to anti-corruption rules, especially when it comes to the development of legislation and regulatory frameworks. From a governmental perspective, it is a growing trend that the industry’s appeals are heard and a cooperative dialogue is consolidated. For example, recent political changes in major countries like Argentina, Mexico and Brazil, where the changes in policies arose mainly from industry appeals and created fairer and more efficient modalities for contribution of the private sector to the development of the local economies.
In Argentina, the recently elected government has already announced strategic plans to tackle the energy deficit and reduce the impact of subsidies on the public budget. In that regard, the Argentinian Energy and Mining Ministry aims to suspend the government’s utility bill subsidy system, including renewable energy, in the energy matrix to reduce dependence on hydrocarbons, develop nuclear energy and increase domestic production of hydrocarbons through foreign investment, leading to new opportunities and the opportunity for development of the energy market.
In Brazil, the largest Latin American economy, some regulatory authorities have been acting in favour of a fair tax and royalties regime, in response to the O&G sector’s appeals. This includes opposing the intentions of some politicians to increase income by elevating the payment of royalties (government’s mandatory participation in production) by E&P companies. Also, the pre-salt law will probably change to allow oil companies – other than Petrobras – to operate pre-salt projects. Moreover, there are indications that the new government will make the local content policies more flexible, which has unreasonably burdened oil and gas concessionaires. Brazil has also taken initial steps to set up a new legal framework for the natural gas midstream sector, in order to end Petrobras’ de facto monopoly of such sector. Petrobras has also put forward a divestment programme, in order to reduce its enormous debt with the sale of various strategic assets, from downstream to upstream.
Another relevant fact that makes the possibility of dialogue and cooperation between the private sector and public authorities even more feasible is the increasing specialisation of Latin American law firms and the growth of the corporate law market, providing top-quality legal counselling. This means, in a more practical sense, that a high-profile investor will be more equipped to deal with the legal mishaps of the investments and will be adequately counselled in dealing and dialoguing with the public authorities, mainly regarding compliance rules and proper suggestions within the local legal systems’ framework of possibilities for regulation, and economic matters for legislation proceedings. Understanding the local culture, regulations, processes and requirements is key to avoiding pitfalls when investing in Latin America.
It is fundamental to note that the main Latin American governments are going through a time of political overhaul (e.g., in Argentina, Brazil and Venezuela) and strong criticism of previous governments’ ideologies. These new governments have actively sought more dialogue and relations with the private sector. In order for investors to follow this emerging political trend and strengthen the commitment to certain local development requirements and open dialogue with regulatory and economic institutions, being able to count on a high quality of legal counselling will be important in laying the foundations for a solid future for the Latin American oil and gas industry, especially in this time of recovery.
After all, it is no secret that countries are in an endless battle to attract foreign investment. Implementing these strategies to help boost their development is a solution that works particularly well for the private investor. And although each country has different social and political environments, most offer an exceptional workforce and economic incentives, which provide opportunities for investors and businesses. Notwithstanding its problems, Latin America has one of the fastest GDP growth rates in the world and a GDP per capita higher than that of China and the Middle East.
Economic and political measures are being taken, and the region is moving slowly, even on a collective level, towards a more stable future with steadier macroeconomics and politics. For example, Mercosur, which aims to promote free trade and the fluid movement of goods, people and currency between South American countries, is now a consolidating reality that will surely strengthen the region in the face of the international market with regard to rates and tax dynamics.
At this time, the participation of the investor is crucial to ensure that this direction of state intervention consolidates in a timely and effective manner. A specialised view on Latin America indicates that participation is feasible, even beyond the reasons given here. The potential of Latin America alone calls for reasonable intervention in order secure the future of the O&G industry here.
- It is estimated that, collectively, these countries draw about one third of their revenues from energy commodities. ‘Latin America in 2015: Manufacturing Aces, Commodity Bases and Basket Cases.’ Wharton University of Pennsylvania (published 9 January 2015). Available at http://goo.gl/2KTIrV.
- World Bank, available at http://data.worldbank.org/indicator/NY.GDP.MKTP.KD.ZG.