Strategic Choices Crucial To Foreign Upstream Ventures

A primer on exploring abroad-Part I

Richard A. Wasteneys
Andersen Consulting
Houston

Oil and gas companies of many sizes have recently considered investing for the first time in exploration and production (E&P) ventures outside their home countries. Some companies already involved in foreign E&P have broadened their focus to include countries or regions that they had previously avoided or ignored.

A detailed examination of the basis on which a company decides to pursue foreign upstream ventures will often make clear the best way of implementing the company's strategy. Furthermore, the way a company decides the issues that follow is likely to drive its investment program and budgets for a number of years.

For many companies, encouragement to look outside traditional areas of activity derives from market forces that became apparent in the mid-1980s. They include:

• Improving contract terms. There was a slow but general improvement in contract terms offered in many traditional producing countries, mainly in reaction to the reduced E&P investment caused by persistent weakness of crude oil prices.
• Limited domestic opportunities. Managements of companies domiciled in mature E&P provinces, as well as those in countries that remained net importers of oil, recognized the difficulty of increasing or replacing reserve values in their home countries. In the U.S., this trend was mitigated to some extent by the lower operating costs that accompanied low crude prices and by the benefits resulting from improvements in E&P technology.
• Opportunities in former socialist countries. The collapse of the Soviet Union and subsequent political and economic reform in other socialist countries led to the opening of large, geologically attractive areas formerly closed to international investment.
• South American opportunities. World-class discoveries made in Colombia's sub-Andean region, followed by the reopening of Venezuela's upstream sector to foreign investment, led a number of companies to rethink their South American strategies.
• Privatization. Privatization of Argentina's YPF, the dramatic success of which initiated a general trend toward divestiture and privatization of other national oil companies, put into play considerable exploration acreage previously controlled by state companies.

About this series

The two-part series beginning here addresses companies that have made the decision to invest in upstream activities in countries not their own. Its purpose is to help them anticipate and deal effectively with risks and other issues common in foreign upstream operations.

This week's article focuses on the strategic thinking upon which companies, whether integrated or independent, should base decisions to explore in foreign countries. Next week's article, part of OGJ's Managing Independent Oil & Gas Companies special report, provides a practical guide for implementing the strategy.

This material is intended to help not only companies going outside their home countries for the first time but also experienced international explorers that may be redirecting their geographic or economic focus as a result of changing economic or political conditions worldwide.

New realities

The initial euphoria resulting from these events has been tempered by new realities.

A few of the countries that recently opened their upstream sectors to foreign investment have proved to be extremely difficult places in which to do business for political or logistical reasons. The improvements in contract terms in some of the traditional producing countries have been rolled back as a result of increasing crude oil prices and the almost feverish interest the industry has shown in their exploration areas. Some of the countries in which the potential size of discoveries is the greatest now impose fiscal terms that verge on the prohibitive. Furthermore, opportunities being offered to private-sector investors in some countries are limited to the most technically challenging and capital-intensive.

Despite these new realities, many companies continue to find foreign exploration attractive, either to diversify their asset portfolios or to offset poor or declining domestic opportunities for reserve replacement and growth. In addition, a few companies still have foreign strategies driven by a need for direct access to crude oil, either for use in swap transactions or for direct importation into their home countries.

However, today's complex economic landscape requires that strategic choices of this magnitude be made more carefully than ever. No matter how attractive an opportunity may appear, it should be pursued only after careful evaluation of the most accurate information available on all of its aspects: strategic, geologic, economic, and political. In particular, how well an investment fits a company's portfolio of existing assets, and especially the company's tolerance for risk, must be realistically assessed.

Defining key objectives

Before beginning the process of identifying and ranking opportunities, it is worthwhile to examine issues that flow from the decision to "go foreign."

Is the company going outside its traditional areas of activity primarily because its return on domestic risk investment is inadequate? If so, it will likely be indifferent to the exportability of foreign production if it can be sold profitably in the host country's domestic market.

The company may also be indifferent to the risk of finding natural gas rather than crude oil if it is willing to participate in the midstream or downstream investments necessary to maximize the value of a gas discovery. A strategy unconstrained by such elements can considerably increase the number of areas in which the company would consider investing.

Conversely, if a company is vertically integrated or has other commitments which demand that it have the right to export its share of foreign crude oil production, it may avoid investing in countries that are themselves net importers of crude oil. A company determined to remain a "pure" explorer and producer may hesitate to invest in gas-prone areas where the wellhead price for gas is substantially below the international price for comparable fuels. A strategy including such constraints would eliminate certain countries or basins from consideration.

Another strategic issue consists of setting objectives that realistically take into account the company's key capabilities and limitations, which can determine the type of investment opportunity the company should pursue. This decision will affect such factors as the size of the budget required, the size and skills of the staff needed, the probable delay between first investment and first production, the kinds of partners that will be acceptable, and the geographic areas in which the company must develop expertise.

Broadly speaking, the alternatives are:

• Giants (world-class oil or gas fields). In addition to potentially large rewards, the pursuit of this alternative usually entails: (a) relatively onerous economic terms (e.g., Venezuela, Colombia); (b) high levels of geological or operating risk (e.g., Falklands, deepwater marine areas); (c) exceptional political and economic risk (e.g., certain parts of the former Soviet Union); or a combination of these. The cumulative costs of reaching the production stage in such areas may be beyond the reach of many independents. Realistically, areas such as these should be considered the playgrounds of majors or consortia of large independents. It must be admitted that promoters and small independents have occasionally succeeded in leading plays of these kinds. The ability to farm out to an experienced and well-financed operator at an early stage is critical to the success of this approach. This is becoming increasingly difficult to do, however, as there are few countries today that will award attractive acreage to a bidder lacking clearly demonstrable financial and technical resources.
• "String of pearls." This strategy would concentrate on areas likely to contain numerous fields of less than giant size but large enough to add significant value to a company's asset portfolio under the contract terms and operating conditions prevailing where they are found (e.g., Argentina, Egypt). Such opportunities are more numerous, less risky, and likely to carry more reasonable contract terms than the areas where giant fields can be found. The competition for these opportunities is likely to become more intense, however, as more companies gain the confidence to pursue them.
• Incremental production or enhanced recovery contracts. The absolute geological risk in such contracts is clearly less than that in exploration contracts, but so is the potential return. The operational and economic risks are still substantial, but these can be mitigated to some extent in contract negotiations. The reliability of the engineering, production, and cost data on which a company bases its proposal is critical, as is the negotiation of a baseline production curve realistic enough to allow a reasonable profit. The kinds and magnitude of the environmental problems the company inherits, and who has ultimate responsibility for them, can make or break such a venture.
• Marginal field contracts. A number of national oil companies have offered packages of their marginal fields to the private sector (e.g., Ecuador, Venezuela). The risks are similar to those for incremental production contracts, but the room for a reasonable profit may be considerably less. Most national oil companies have historically set performance targets entirely in volumetric terms; as a result, many of their fields and wells have been produced beyond their economic limits. This risk may be offset in some countries by the possibility that significant reserves and productive capacity have been left behind due to a lack of access to modern production technology. A rigorous engineering and economic evaluation based on accurate data is critical to a successful project. The environmental risks of such contracts are comparable to those attaching to incremental production or enhanced recovery contracts.

Foreign E&P capability

A company that intends to participate in foreign ventures in a systematic way should begin by deciding two key questions.

The first of these is whether it intends to act as operator in some or all of its foreign ventures. The second is whether it intends to generate its own foreign plays and prospects or to rely primarily on opportunities offered by competitors or promoters.

The answers to these questions will determine, among other things, the size and capabilities of staff required and the size of the overhead budget dedicated to foreign activity.

Operate or not?

Few companies insist on operating all of their foreign ventures, and there is no inherent advantage in either operating or not operating. The decision should be based primarily on the company's existing capabilities and on its willingness to develop capabilities it may not possess.

The decision to act as operator in even a small percentage of its ventures, however, requires that a company make certain commitments.

Operators must possess certain technical, financial, and political expertise beyond those needed in domestic operations. Most such capabilities can be either developed in-house or outsourced. They include the following:

• The ability to generate prospects, and to evaluate externally generated opportunities, in several areas of the world. Some companies have tried to play a single geographic niche, but this has usually been found to limit diversification of both risk and opportunity excessively.
• The capacity to manage operations in technically and logistically challenging areas. Each foreign operation inevitably needs considerable support from the operator's home office. This requires a home-office staff experienced in foreign operations and logistics. Staff members must be capable of providing routine technical, accounting, and administrative support, arranging and tracking the logistics of critical equipment and materials, and either hiring or outsourcing specialized personnel for the foreign operation.
• Cost-control and audit procedures specifically designed or adapted for foreign operations.
• Sufficient organizational depth (in-house and outsourced) to staff one or more foreign operations with competent key people. (This does not imply that all key people working in a foreign operation should be expatriates.)
• Ability to identify the exit point in an E&P project. Even after the most rigorous evaluation of an opportunity, optimism can take control once the commitment is made to proceed with the investment. A competent operator must have the self-discipline, as well as the resources for economic and technical analysis, to determine when the original play concept has been conclusively disproved. Nothing is more destructive to the success of an exploration strategy than the futile insistence on additional investment once this point has been reached.

What it takes to do business abroad

Operators need:

Ability to generate prospects and evaluate opportunities

Capacity to manage operations in challenging areas

Cost-control and audit procedures designed for foreign operations

Sufficient organizational depth

Ability to identify the exit point in an E&P project

Nonoperators need abilities to:

Evaluate foreign opportunities offered by potential partners

Evaluate partners that may be operators

Negotiate international farm-in agreements, joint operating agreements, and accounting procedures

Monitor operator's performance

Perform or outsource joint-venture audits

Nonoperator capabilities

Nonoperators in many cases rely on their operating partners for many of these capabilities. Except for completely passive investors, however, nonoperators must possess certain core capabilities of their own if they are to manage their participation in foreign joint ventures prudently. These include:

• The ability to evaluate foreign opportunities offered by potential joint-venture partners or promoters from technical, economic, and political points of view.
• The ability to evaluate the competence and experience of joint-venture partners that might act as operators.
• The ability to negotiate international farm-in agreements, joint operating agreements, and accounting procedures.
• The ability to monitor an operator's performance effectively, including the technical, financial, and political aspects. This includes being competently represented at budget and operating committee meetings and knowledgeably evaluating the operator's proposed work programs and budgets.
• The ability to perform or outsource competent joint-venture audits. Even the most ethical and competent operators make errors in charging costs. Audits performed by experienced professionals will more than recover their costs over time and can identify serious problems such as malfeasance or concealed violations of the Foreign Corrupt Practices Act (FCPA).

Prospect development

The ability to generate a steady flow of new prospects requires a substantial staff. Corporate downsizing has made such a staff more difficult than before to justify, with the result that many companies now form ephemeral special-purpose teams comprised of varying combinations of permanent staff and external consultants. A team formed to evaluate a particular set of opportunities might be dissolved when its work is done and its members dispersed to new teams working in other areas.

Not all companies capable of acting as operators in overseas ventures generate all of their own plays or prospects, but they usually generate a significant percentage of them. The reasons for this are economic as well as strategic.

A company that is able to charge part of its home-office overhead to joint ventures finds it easier to justify the cost of maintaining a new-ventures group of the size and competence required.

The opposite is equally true. A company whose strategy is not to operate usually relies on prospects generated by potential joint-venture partners or promoters of known competence and integrity. Since it cannot charge any of its overhead to joint ventures, it tries to keep the number of permanent staff as small as possible consistent with meeting its performance objectives.

In-house advantages

Advantages of in-house prospect generation are:

• Control of the deal. The company that originates a play usually handles acreage selection and acquisition and negotiates contract terms with the host government. The unique understanding of the venture that it develops as a result can be a significant advantage in negotiating farm-out terms with potential partners.
• Consistency with corporate objectives. In-house teams are likely to generate prospects which are consistent with the company's strategy and performance objectives.
• Farm-in evaluation capabilities. The same teams generating prospects usually possess most of the knowledge and skills needed to evaluate competently the opportunities submitted by competitors and promoters.
• Reciprocity. Companies generating and farming out high-quality prospects are the ones most likely to be approached by other generators of high-quality opportunities. Over time, such companies may develop symbiotic relationships with other companies in whose work they have confidence and whose integrity they respect.

In-house disadvantages

Disadvantages of in-house prospect generation:

• The "not-invented-here" syndrome. In-house teams can become convinced of their superiority, even in light of mediocre results. When this happens, they are inclined to reject ideas and interpretations generated by outsiders, including those of joint-venture partners whose competence may equal their own.
• Sheer numbers. Unless a company elects to limit its efforts to one or two geographic areas, maintaining the in-house expertise needed to generate prospects in multiple geographic areas and basins can require large professional and technical staffs and support systems. The team approach can reduce this tendency significantly, particularly if a company develops a stable of consultants with specific geoscientific or geographic expertise rather than keeping all such experts on its full-time payroll.

Identifying, ranking opportunities

The criteria a company uses in identifying and ranking upstream opportunities should be determined primarily by the company's strategy.

A company that approaches foreign investment with the primary objective of developing profit centers, for example, might give more initial weight to geological criteria. A company interested in exporting its share of production would probably screen its opportunities according to market considerations before delving into geological factors.

Market criteria should be related to company strategy. Regardless of what "targets of opportunity" a company may be offered from time to time, it should concentrate on areas in which the available opportunities fit its strategic objectives. The gross criteria on which these areas are selected may include exportability of crude oil, proximity to certain markets, and the probability of discovering fields of a size range compatible with the company's strategic objectives.

Once a list of target countries or areas has been selected, it can be further refined by evaluation and ranking of prospective basins based on purely geological criteria. These normally include probability and timing of hydrocarbon generation and accumulation, anticipated field size, likelihood of gas vs. oil discoveries, anticipated oil quality, and other exploration risks.

Economic considerations form the third criterion. It is an unpleasant fact of life that even the largest fields can be rendered marginal by poor contract terms. A realistic economic evaluation should be based on modeling economic and contractual terms for the most likely anticipated field sizes. It should also include such criteria as creditability of local taxes in the company's home country; pricing of oil and gas, both for sale and for tax and royalty calculations; ability to repatriate profits; freedom from exchange controls; availability of transportation and export infrastructure for production from the contract area; existence and attractiveness of a local market for gas and gas derivatives; and opportunities for private-sector participation in generation and sale of electrical power.

A company with a large asset portfolio and an ambitious budget should consider evaluating all of the criteria discussed above as part of a portfolio management system. Such systems now have the capability to evaluate investment opportunities on either a stand-alone basis or as part of an asset portfolio.

The more sophisticated systems are capable of modeling geological, engineering, economic, and other types of risk and generating economic evaluations that take these into account. Geological and other risk factors can be input directly or generated by a petroleum-systems model.

Currency risk

The potential importance of currency risk to project economics in certain countries deserves separate discussion.

It can be critical for companies selling their production in the local market in countries in which the currency is not freely convertible or in which the U.S. dollar exchange rate is volatile. The currency of payment denominated in the contract with the host country can greatly affect the company's ability to finance the project.

If possible, the price the company receives for production sold locally should be tied to the export price (denominated in U.S. dollars) of comparable crude oil or products, or to the avoided cost of importing crude oil or products. It is also possible in some cases to negotiate a central bank guarantee of convertibility (as well as of dollar availability) for payments made in local currency.

An E&P company selling electrical power generated by a hydrocarbon-fueled plant, rather than selling the hydrocarbons themselves, may find it more difficult to negotiate payment in dollars. It may be possible to arrange to be paid in crude oil or refined products which can be exported for dollars if the government has access to these.

If not, a central bank guarantee of convertibility may be the only alternative.

Political risk

Although assessment of political risk may seem subjective, hard data and competent professional advice are available. Key questions to which a company should seek answers include:

• How stable has the country been historically, and how stable is the current regime?
• How stable have the terms of oil and gas contracts been over time, and to what extent have they been respected by the host government?
• To what extent have taxes or other fiscal terms grown more onerous over time ("creeping nationalization")?
• If exports rely on a pipeline which crosses a neighboring country, are the host country's relations with that country reasonably good?
• Is the acreage in which the company is interested the subject of a boundary dispute with another country?
• Are personal and operational security serious problems, either in the country or in the company's specific area of interest? If so, can these be controlled or reduced to a manageable level?

Strategy and early steps

The early steps that a company must take when contemplating new international involvement also relate to strategy. They depend on whether the company is a prospect generator or intends to farm in to other companies' ventures, as well as on whether it prefers to act as operator or allow a partner to operate.

The choice between generating prospects and farming in raises several issues.

Farming in

In the case of foreign opportunities, farming in entails more than a simple evaluation of the deal and the geology of the prospect or play being promoted. You must decide whether a particular opportunity fits your strategy, portfolio of upstream assets, and tolerance for risk.

Unless you are prepared to base your evaluation entirely on the information provided by the promoting company, you must do your own due diligence in a number of areas. You should, for example:

• Build a comprehensive economic model based on the best information available and update it with the results of your own due diligence. Use the model to identify areas of economic exposure that may not be obvious initially. This model should include economic runs for 100% of the working interest and for the percentage of interest and other farmout terms being offered.
• Develop a detailed understanding of the terms of the contract under which the acreage is held. Are all working-interest owners jointly and severally liable for all contract obligations? Are there acceptable provisions for impartial arbitration of disputes with the host government or its agencies? Is there a meaningful force majeure clause? Does the host government have to approve work programs and budgets? Can the host government oblige the joint venture to execute programs or make expenditures that may be contrary to the interests of the participants? Are tax and royalty rates fixed for the life of the contract? Does the host government or the national oil company have a back-in right in the event of a commercial discovery, and if so, how is its share of costs paid or recovered?
• Determine the viability of the contract terms under the laws of both the host country and your company's home country. One imperative here is the avoidance of double taxation, but other considerations may be equally critical. In certain parts of the former Soviet Union (FSU), for example, it is extremely important to establish whether the agency with whom the promoting company has contracted actually has the power to deliver what is promised under the contract. It is also essential to determine whether any provincial or local government exercises authority over any part of your contract or operation.
• Understand and plan for the work and expenditure obligations to which you will be committed during each phase of the contract, and be aware of the degree to which foreign project costs usually exceed those of domestic projects.
• Determine the farmor's suitability as a joint-venture partner and as an operator if it has ambitions in this direction. Is the farmor able to meet its financial obligations, both during and after any carry provided in the farmout? Will the normal financial and decision-making demands of a foreign operation overtax its technical, managerial, or financial resources? Does it have general foreign experience or experience in the host country or operating environment in question? If the company is acceptable as a partner, but not as an operator, is its management willing to concede the operatorship to a better-qualified partner?
• Understand the relationships of the promoting company in the host country. Is its position there heavily dependent on personal relationships that may disappear with a change of government? Are its relationships reasonably cordial? Has it antagonized important stakeholders, either in its negotiations or in previous operations?
• If your company is U.S.-based, determine whether a relationship with this partner is likely to create FCPA problems.
• Establish the quality and completeness of the data on which the promoting company's geological interpretation is based.

There are numerous instances in which maps provided by host-country agencies or state companies omit key dry holes or seismic lines. This is often because the missing data are in the hands of a rival agency or state company.

• Examine the terms on which participation is offered to your company, including:

1. The amount of the "promote" and the extent to which it affects your company's project economics vs. the farmor's, especially if the farmor will be the operator.
2. The extent to which your interests and the promoter's are likely to diverge during the life of the venture.
3. Your company's rights and obligations under the farm-out agreement and the joint operating agreement. What percentage of the total working interest can make operating decisions and approve work programs and budgets? Are there clearly defined sole-risk, nonconsent, and audit provisions? What are the provisions for cash calls and other financial obligations? What are the default provisions? Is there a mechanism for removal of the operator by a majority of the nonoperators?

Issues for operators

An operator initiating a foreign venture must deal with many of the same issues a farmee must address. However, the operator approaches these issues with considerable power to shape their outcome.

A company that elects to act as operator assumes a special burden of diligence in its own self-interest and also because the quality of its work will largely determine its ability to obtain joint-venture partners.

The quality of the technical and economic work that results in the new prospect is obviously the cornerstone on which eventual success must be built. In addition, the skill and diligence with which the application or bid is made and with which the final contract is negotiated are critical. They will affect the profitability of any discovery as well as the efficiency and the degree of difficulty of the entire operation.

Diligence to be performed prior to making an initial visit to a host country should include research of sources commonly available on-line or in print, including:

• CIA Country Reports.
• Economist Intelligence Unit country profiles.
• International Energy Agency statistics on production, consumption, imports, and exports of hydrocarbons and generation and consumption of electrical power.
• Barrows' summaries of contract terms for the country under consideration.
• Petroconsultants' periodic maps and reports of international E&P activity.
• Petroconsultants' comparisons of economic terms for given field sizes in host countries under consideration.
• Internet search for petroleum-oriented, financial, or political news relevant to the country in question.
• Contacts with the economic section of the host country's embassy or consulate.
• Contacts with the section of your home country's foreign ministry that deals with the host country.
• Contacts with competitors that have experience in the host country. Most companies will share information that does not compromise their own competitive position.
• Headquarters offices of oil field service companies you might expect to use in your proposed operations. Many have branch offices in oil-producing countries and can be useful sources of information on local operating problems and conditions.

Next week

The second part of this article covers some of the more common procedures under which acreage is awarded and contracts are negotiated. It concludes with a guide to initiating operations in a foreign country and identifies some of the issues to be addressed.