The Future of the Oil and Gas Sector in Latin America is Now
The year of 2014 marked the beginning of an unprecedented worldwide crisis in the oil and gas industry triggered by the downward turn of the crude oil market cycle. By the end of 2015, the international crude benchmark Brent had dropped from its 2014 high of US$115/bbl to below US$35/bbl. In this scenario, international oil companies 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.
This crisis in the oil and gas sector also highlighted the structural and macroeconomic problems faced by several countries across Latin America. Nations such as Bolivia, some Brazilian states, Ecuador, Mexico, Peru and mainly Venezuela have fiscal and budget policies that are dependent on energy commodities,2 and faced major macroeconomic challenges as a direct result of the chain reaction caused by falling oil prices. In Venezuela, the economic instability started in 2014 has taken on serious political dimensions and now, in 2018, the country faces the biggest humanitarian crisis in its history amid the rise of extremist political leaders.
During these times of hardship, 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.
Therefore, despite all the ills caused, the crisis served to push the envelope on much-needed legal and regulatory changes, especially after the election of pro-business governments all over the continent. One such example was the reformulation of the local content policy in Brazil after years of controversy between the main players of the sector and government, resulting in remarkable satisfaction of the private sector in the country.
Now that oil prices seem to be recovering from the 2014 crash and investments in alternative sources of renewable and non-renewable energy are gaining momentum, oil and gas companies need to innovate to stay competitive in soaring markets such as Mexico and Brazil.
The success of the bidding rounds taking place in these two countries together with the respective governments' efforts to encourage investment are the sign that Latin America is able to, once again, stand in the spotlight of the O&G industry.
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 negative 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.
However, with the stabilisation of international indicators for oil prices, the industry's recovery on the continent seems to have potential to outpace even the most optimistic forecasts. Once again, the Brazilian example is due for analysis. The new government that emerged from the impeachment of populist President Dilma Rousseff reversed many of the negative regulations and laws mentioned above, established an ambitious calendar of bid rounds (by 2019 over 10 rounds will have taken place) and, opposing the failure of the above-mentioned rounds, broke successive income records from signature bonuses for the granted areas.
Thus, as important regulatory and legislative developments take place in Latin American countries country aiming at maintaining the momentum of growth in production rates and direct government incomes, the unprecedented success of the latest bid rounds proves the strength of the continent in attracting investment from the largest players in the industry.
Now, as the E&P projects become increasingly complex and capital intensive, the most pressing challenge for Latin American governments is to modernise regulation and live up to a fast-maturing market environment, in order to consolidate their respective positions as a global flagships in the energy commodities business.
Where to place bets as the future approaches
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. Now that the insufficient implementation of populist development policies by means of poorly oriented state interference has been exposed as the main cause of the serious hardship that Latin American countries faced, the emergence and strengthening of new political currents are a remarkable opportunity for action.
The political tide in many Latin American countries has begun to change after increased dissatisfaction from its populations and market agents. The policymakers seem to have realised the window of opportunity to take corrective measures, and are now prioritising economic and regulatory reforms aimed at breaking the over-reliance on commodities and positioning their economies to withstand other cyclical and abrupt global shifts, which will surely continue to happen in the future.
Therefore, the initial paradox created during the crisis provided a new way of thinking about the future of the oil and gas sector in Latin America – a way that effectively ensures such future. In order to participate in the ascension of the oil and gas sector in Latin America, it is fundamental for players to promote 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. To that end, strategic guidelines of state actions oriented towards continued macroeconomic stabilisation must be established and observed. The value of this opportunity is highlighted by the growing willingness in new Latin American governments to reopen the markets and establish dialogue with foreign investors.
An example of such willingness in recent past year is Mexico, which ranks 11th worldwide and second in the Latin American and Caribbean region for oil producing, and nevertheless has 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 it softened some post-bidding rules in order to keep a grip on investments and respond more efficiently to investors' claims and necessities in the oil and gas environment. Since then, the bidding rounds in Mexico have attracted a variety of investors and major oil and gas companies seeking to expand their exploration acreage in an attractive environment. The growth of interest in the country has been so expressive that the government recently decided to postpone the next bid rounds, initially planned for 2018, until early 2019 in order to allow the large number of interested companies to plan their participation properly.
One example of policy change following bidding rounds was the significant reduction of local content requirements, as mentioned above, when the government recognised the unfeasibility of the required high standards, particularly for deepwater 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 and since 2018 the main oil producer in the continent (surpassing Mexico), the regulatory and legislative developments over the last two years have been impressive and seem to have put the country on the definitive path to success. Now, the pre-salt law allows oil companies – other than Petrobras – to operate pre-salt projects, even though the state company still holds the preference rights to the operation. Moreover, the local content policies were reviewed, leading to reduced and more flexible commitments by the oil and gas companies, reducing the unreasonable burden previously established, and generating interest in the upcoming bidding rounds. 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. The 'Repetro' regime, a special customs regime aiming to reduce the taxes levied on exploration and production of oil and gas in Brazil, has been extended until 2040, which was one of the greatest concerns of the oil and gas companies operating in Brazil. Finally, the natural gas market has been undergoing promising developments: the consumption of natural gas has been growing exponentially owing to the continuous implementation of regas-to-power projects; the de facto Petrobras monopoly over several parts of the value chain is coming to an end and relevant business opportunities are attracting major investments; and the gas regulation is set to undergo complete reformulation to accommodate the new business environment. The overall perception is that Brazilian authorities are finally taking many significant steps towards the improvement of market regulation and, although there are still many issues that need to be addressed in the near future to ensure a constant growth of the oil and gas industry, the Brazilian market position is now stronger than ever before.
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., Argentina, Brazil and Venezuela) and strong criticism of previous governments' ideologies. These up-and-coming governments have actively sought more dialogue and a closer relationship 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 high-quality legal advice 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 continuous 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 capita3 higher than that of China and the Middle East.
Economic and political measures are being taken, and the region is finally moving faster, 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 moment, the timely participation of investors is crucial to ensure that this direction of state intervention is consolidated in an effective manner. A specialised view on Latin America indicates that participation is feasible, even beyond the reasons given here. The potential of Latin America, more than ever, calls for smart business decisions in order to secure the bright future of the oil and gas industry here.
1 Giovani Loss is a partner at Mattos Filho, Veiga Filho, Marrey Jr e Quiroga Advogados.
2 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.
3 World Bank, available at http://data.worldbank.org/indicator/NY.GDP.MKTP.KD.ZG.