Doing E&P business abroad - entailed risks and the importance of ethical practices

From these plots, one can notice that the relation of world proved reserves to annual supply has been kept around 35 years over the past 5 years, which means that reserves have been fully replaced through new discoveries. But, this has been reached through extensive work in order to offset the depletion of the large, mature, low-cost fields. Analysts say that the gap between demand and supply is narrowing since the spare capacity to resume production from shut-in wells has been under one million barrels per day during much of 2004 and 2005, which is not enough to cover any interruption of supply.

In addition, the US and the world economy are growing steadily and the Asian demand for crude oil is even growing at a faster pace, which stresses the need for investments in exploration. So, the combination of depleted mature fields and heated demand for oil has prompted western oil companies to go abroad looking for a more balanced portfolio encompassing exploration, appraisal, and production assets.

Establishing and structuring business abroad

There are a few strategies used the most by oil companies to incorporate new assets into their upstream portfolio. These strategies are roughly described below. It should be pointed out that the most convenient strategy for a given scenario would depend upon various factors such as regulatory and legal environment, acquisition fee, cost recovery, profit sharing philosophy, and so on.

Bidding for concession licenses in hydrocarbon licensing rounds - Petroleum regulatory agencies of certain countries organize licensing rounds from time to time so that pre-selected oil companies can compete for onshore and offshore exploratory licenses through an auction system. Although the biddable signature and production bonuses are low, the license winner should be prepared to comply with a minimum exploratory work program whose chances of striking oil/gas are also low. In addition, the fiscal and regulatory regime in the host country should be very well understood beforehand so as to allow proper tax planning with respect to royalties, petroleum customs law, income tax, and earnings repatriation.

Signing a Production Sharing Agreement with the host government - Unlike a concession, which by its legal nature is a type of a lease agreement, under a Production Sharing Agreement (PSA) the state hires the international oil company (investor) as a contractor to perform the exploration/development/production work at its own expense and own risk. In this sense, no license to explore the subsoil is granted by State and a conventional service contract with mutually agreed provisions is signed between client (state) and contractor (oil company). The oil company is compensated with a percentage of the produced petroleum and the state also receives a part of the measured production; the conventional tax system is replaced by the production sharing philosophy. Some oil companies prefer to invest under a PSA in countries with economies in transition to avoid the risks of a constantly changing tax system.

Farm-in to exploration licenses - A farm-in takes place when 1) one company acquires an interest in an exploration or production license by paying some of the past or future costs of another company that relinquishes part of its interest, or 2) when one company drills wells or performs activities on another company’s lease to earn an interest in or acquire that lease. The risks are not as high as the previous strategy since the company acquiring an interest may take benefit of preliminary reservoir evaluation from the drilling of a wildcat or exploratory wells. For example, ExxonMobil Corp. recently took a farm-out from Providence Resources PLC, Dublin, to earn an 80% interest in the Dunquin prospect offshore Ireland, and will be funding a 2D seismic data shoot.

Acquire shares of immature fields - This strategy considers that a company enters into an agreement to acquire all shares of another company that holds interest in a promising prospect. Like the farm-in strategy, this arrangement allows oil companies to secure possible and probable reserves with significant up-side potential by paying a given acquisition fee. From the former licensee standpoint, this fee should reimburse all the exploratory costs and licensing bonuses and should offer a premium for the risk originally taken. An example is Norsk Hydro’s acquisition of all shares held by a subsidiary of the EnCana Corp. for a discovery in the Chinook field, offshore Brazil. Hydro will pay the EnCana subsidiary $350 million on a debt-free basis.

Acquire shares of mature fields - This strategy considers that a company takes on the shares of a depleted field where the production has already declined. In this context, the interested company should be capable of applying sophisticated techniques of reservoir recovery and/or drilling additional multilateral and sidetracking wells so as to extend the field life. Proved reserves can be replaced through this strategy provided that the reservoir recovery factor is increased significantly. Companies that are strong on managing complex reservoirs and on improved oil recovery (IOR) may benefit from this strategy. The life of some mature fields in the North Sea has already been extended through this acquisition strategy.

Another issue that companies must address is determining the most convenient corporate structure to be set up abroad. The three most common structures for business enterprise are establishing a subsidiary, establishing a partnership with a local company, or setting up a joint venture company. Establishing a subsidiary involves larger investments and requires that the foreign company is well advised on the country and state business and labor laws. It is more suitable for situations where the chances of success are high to justify that investment.

Before committing to high start up costs, it may be more sensible to enter into an agreement with another company through a joint venture or a limited partnership. This strategy has the advantage of complementing competences and sharing the risks. Preferably, the chosen partner company should have experience in doing business locally.

Some companies prefer to set up a joint venture rather than a partnership since the former is for limited purpose and a specific period of operation. After the purpose is completed, bills are paid, profits (or losses) are divided, and the joint venture is terminated. On the other hand, partnerships are more wide-ranging and subjected to disputes if dissolved. It should be pointed out that some countries require that the company established is partially owned by a local company.

What to expect from emerging markets

As any other business, the decision to invest in a given asset abroad should be based upon an economic analysis through which oil companies evaluate potential additions to their investment portfolio. This decision-making process will vary from company to company since it is dependent on the company’s strategy and its willingness to take on less or more risks. Early cost and return estimates are usually the basis for investment decisions, allowing the screening of potential projects and the definition of business strategies. Inaccurate early estimates may lead to lost opportunities and lower than expected returns.

The way companies rank their business risks and opportunities usually adopts discounted cash flow analysis so that economic indexes can be worked out properly (NPV, IIR, payback time, etc.). Risks are usually assessed by means of sensitivity analysis combined with Monte Carlo simulation and decision trees. Regulatory and political uncertainties are roughly estimated since they are usually based on a short-term track record, not reflecting the likelihood of sudden changes.

These uncertainties are magnified in countries with emerging markets, since they may have relatively unstable governments and less established markets and economies. A country that offers a politically and socially stable environment to do business will allow a sustainable investment strategy. Preferably, the host country should have a long-term political stability, security, a modern infrastructure, and a big consumer market.

Quite recently, Bolivia, whose proven reserves of natural gas total 48.7 trillion cubic feet, passed a new hydrocarbon law in May 2005 which imposed a new 32% tax on production of petroleum on top of the existing royalties of 18%. This measure came as a consequence of manifestations and protests that took place across the country claming for nationalization of the country’s hydrocarbon resources.

Many foreign investors and oil companies such as BP France’s Total, Repsol of Spain, and Petrobras of Brazil, that have been pumping money into Bolivia’s gas industry since 1996, threatened to freeze any new investment in the country and resort to international arbitration if negotiations reach a dead-end. Recently elected President Evo Morales, who based his campaign on a promise to nationalize the exploration and production of hydrocarbons in Bolivia, said that Petrobras should turn two refineries it owns in Bolivia back to Bolivian control. This is a typical example of how things can change rather quickly in a country where income disparities undermine social and political stability.

Another example is the current situation in Nigeria. Since early 2003, militants from the “Movement for the Emancipation of the Niger Delta” have been attacking facilities in that country run by France’s Total, Italy’s Agip, and Royal Dutch Shell. They started a campaign of sabotage and kidnapping of oil companies installations and employees, fighting for more local control over the Niger River Delta, where most of Nigeria’s 2.4 million barrels a day are produced. They recently held foreign employees of Royal Dutch Shell and Agip hostage and threatened attacks on the region that would destroy Nigeria’s ability to export oil.

Analysts say that the violence is part of growing regional rivalry to succeed the current Nigerian president and should escalate until next year elections. These past incidents have cast a shadow over the investments policy of international oil companies in Nigeria, the world’s eighth largest oil exporter. This example shows how social issues and inequality in wealth distribution may affect the foreign investment flow in developing countries.

The situation in Bolivia and Nigeria emphasizes the importance of upfront risk assessment and constant updating of the portfolio status before relevant investments are sunk and become unrecoverable. Most importantly, those circumstances show that investments in assets and facilities should be accompanied by a social and environmental awareness policy. In short, paying royalties and income taxes are not enough to assure a successful and long-lasting relationship with local communities and the government.

Understanding regulatory risks

Regulatory risk may be defined as the risk associated with the potential for laws related to a given industry to change and impact relevant investments. Compliance with regulatory requirements and ethical conduct standards should be a major concern of the managing board of any company in order to prevent litigation and reputation damage and meet shareholder accountability demands. Companies should be prepared to handle unexpected situations that may compromise a long-term policy of investment and turn prospective profits into unrecoverable losses.

Fiscal regimes associated with the exploration and development of oil and gas fields are many times a source of misunderstanding and should be defined in a simple and unambiguous fashion. When taking part in a competitive licensing round or farming in to exploration licenses, all investors (oil companies) look for a fiscal model that allows early paybacks, whereas licensors aim at early revenues. Governments usually make three main levies on oil and gas activities: 1) direct taxes levied on company income, 2) indirect taxes levied as an import duty on a company’s tangible supplies or as a service tax on services hired, and 3) petroleum levies specific to oil extraction activities. This involves the full understanding of signature and production bonuses, royalty and field-based special participation taxes, recovery cost policy (for sunk costs in the exploration and appraisal phases), profit sharing philosophy (the rationale behind the estimate of the profit oil), and indirect taxation on goods and services.

The tax system should be made clear for potential investors from the start so that they can assess the risks in bidding for exploration and development contracts. For example, the fiscal model currently adopted in Brazil is described in Figure 2. Despite the larger number of petroleum levies and taxes, the Brazilian fiscal framework is similar to the model adopted by other nations, and is regarded as economically attractive by worldwide investors.

The petroleum customs law of some countries allows a tax exemption on goods imported for petroleum operations. Companies should make sure that they fulfill the conditions beforehand and that the goods to be imported are eligible for tax exemption according to the Inland Revenue Department of these countries.

The legal requirements of the host country with respect to the procurement policy should be also well understood. The government of some countries requires that a competitive public tender take place for the majority of equipment and materials of the upstream supply chain. So, direct negotiation with a given supplier/contractor is not allowed; a public bid opening date is set for this purpose. This arrangement makes for a longer bid process since complaints, questions, and answers are shared among tenderers throughout the process.

This arrangement is also subject to disputes before the award if a bidder files a protest or objections against the tender’s outcome. So, supply contracts of long-lead equipment (gas compressors, wet Christmas trees, gas turbines, windlasses and winches, cranes, etc., and the EPCI of risers, flowlines, host platform) should go through a public tender in some countries. In addition, contracting procedures dictated by the authorities of these countries usually favor one lump sum turn-key contract with a prime contractor, to the detriment of other contracting strategies.

Moreover, with increased frequency and importance, some regions of the world are demanding an increased use of local industry and workforce in the construction and operations of oil development projects. These local content requirements may result in the use of subcontractors with arguable capabilities who are not familiar with the standards and requirements of performance with respect to quality, safety, and productivity. Therefore, the risks associated with the use of an undeveloped local industry for engineering, supply, and construction purposes, should be understood prior to defining the project execution plan or the acquisition of shares in a given enterprise.

The importance of maintaining high ethical standards

The petroleum industry is regarded as ‘one of the world’s least ethical industries’. Public opinion worldwide is that oil companies work in a self-serving fashion and that they do not care about conservationism and social responsibility. The image oil companies portray does not reflect recent efforts. Studies indicate that the major oil companies have been gradually improving their global ethical performance in terms of corporate governance, transparency, ethics, environmental management, and corporate social responsibility.

The environmental policy of some countries, supported by the narrow-minded thinking of local environmentalists, has been a critical issue impacting the oil industry in the past years. For example, the prohibitions against drilling in the eastern Gulf of Mexico and offshore Florida has kept oil companies from initiating exploratory work in this region.

Every major oil company has been concerned about its public image and the industry as a whole is keen to discuss conservationism to remediate their image as greedy oil and gas producers. Some countries, backed by the outcry of the international community, have set up stringent environmental laws whose compliance by oil companies has impacted the time frame of their projects.

This scenario stresses the importance of conducting business abroad with correctness and full awareness of the surrounding environment. So, a strong HSE (health, safety, and the environment) program, including environmental certifications for projects and conservationist policies, is a must for any international oil company. In addition, oil companies should avoid litigation by employees and disputes with the county/state, as well as raising unnecessary controversies in the media. A positive track record always eases the relationship with local authorities and draws sympathy from the host country population.

Managing the risks in international ventures

In light of what has been discussed, Figure 3 illustrates the factors that may impact the international business of E&P oil companies. It is stressed that being successful entails creating social and economic values within the host country and keeping a “good neighborhood” policy with the communities and local governments.

Political and regulatory instability are also ‘hard to handle’ issues. Companies are advised to screen potential countries and favor those offering lasting socio-economic stability with well-established institutions and a fair distribution of wealth and incomes. This makes them less susceptible to political and social uprisings.

For the purpose of mitigating the business risk, most oil companies have engaged partners with local business experience, and advisors with expertise in the fiscal framework of the selected country. When there is no tax treaty between the investor and host country, double taxation on company profits may be avoided through company affiliations. Specific-purpose joint ventures are the most common business structures used by oil companies provided the right partners are found, i.e., those that share the same goals and vision.

Broadly speaking, oil companies should balance their portfolios regarding the size of their upstream assets and corresponding stage of development. It is well known that the size of the field to be developed has a significant impact on oil companies’ profitability in terms of payback periods. The larger the assets, the higher the expenditures, the longer it takes to see first oil and a payback period. So, to reduce their financial risk exposure, oil companies are advised to spread the venture risk by balancing the size of their field assets and spreading out the three main phases (exploration, field development, and production) among them.

Concluding remarks

International enterprises are challenging and risky to implement. Risks should be taken on and mitigated using a common sense balancing approach where the interests of investors are balanced with the need to leverage the well-being of the population of host countries. E&P companies should always enforce ethical practices and conduct business fairly so as to ensure long lasting support from the host government and population.

About the authors

José Ferrari Jr. [[email protected]] is a visiting scholar for the engineering and project management group of University of California Berkeley. He is currently on leave from Petrobras -Petroleo Brasileiro SA where he serves as a senior advisor of floating system engineering and has worked in various capacities since 1985.

Robert Bea [[email protected]] is a professor at University of California Berkeley’s department of civil and environmental engineering. He has over 48 years of experience in engineering and management of design, construction, maintenance, operation, and decommissioning marine systems. He has been teaching at UC Berkeley since 1989.

DISCLAIMER: The views expressed in this article are those of the authors and do not necessarily represent the opinions of their organizations.