Private equity in Latin America
Current investment environment in oil and gas is encouraging
Daniel Chavez, McDermott Will & Emery LLP, Houston
According to a recent survey conducted by EY, fundraising activity by private equity firms focused on the oil and gas sector will continue to grow in the coming years. The survey shows that while most of these investments will target North America, Latin America as a region is expected to experience the largest increase in investment over this period. Which country will attract the bulk of these private equity funds will depend on the number of new projects available but, more importantly, on the overall investment environment in each country.
An attractive destination for private equity investments
Despite the disappointing performance of some of the region's economies in the last couple of years, Latin America continues to be an attractive destination for private equity investors looking for acceptable returns in relatively stable emerging markets. During the past decade, robust economic growth in the region as a whole, civil stability and sound policy-making have created solid investment opportunities in Latin America, and strong macroeconomic fundamentals support the region's continued growth prospects.
The oil and gas industry is one of the most attractive for private equity firms active in Latin America. The region holds some of the world's largest reserves of hydrocarbons but has historically lacked the capital and infrastructure needed to exploit those reserves, thus creating enormous opportunities for private equity investors. A recent report by PricewaterhouseCoopers noted that the oil and gas industry offers investment opportunities that involve a wide range of capital requirements, risk exposure, expected returns, and exit opportunities, therefore accommodating investors with very different sizes and investment profiles.
The upstream sector involves the greatest amount of risk and capital requirements and has traditionally attracted a small number of very large firms, which typically invest through direct acquisitions or by sponsoring experienced management teams that can build and operate successful exploration and production companies. The midstream sector, on the other hand, offers lower returns but also steady low-risk cash flows, which make it the most popular sector for private equity investors. In addition to the potential for extraordinary returns, investment opportunities in the oil and gas industry are often the only ones large enough for some of the bigger private equity firms.
An improving regulatory environment for private equity funds and investors in the major Latin American markets also contributes to this trend. On the fundraising side, ongoing efforts by local regulators to ease the restrictions for institutional investors have resulted in increased private equity allocations by pension funds and insurance companies. Restrictions on foreign investments in the region are gradually disappearing. With the exceptions of Argentina, Cuba, and Venezuela (where tight exchange controls and reporting requirements continue to hinder foreign investment), all Latin American countries have eliminated exchange controls, as well as minimum stay and reserve requirements.
Lastly, capital markets in Latin America continue to develop, thereby providing investors a greater supply of securities, larger sources of funding and additional exit strategies that were not available before (outside of Brazil and Mexico). For instance, the integration in 2011 of the stock exchanges of Chile, Colombia, and Peru in what is called the Latin American Integrated Market has created the second biggest market of Latin America in market capitalization, behind Brazil's BM&FBOVESPA.
Oil and gas investment opportunities
This year, after more than 70 years of state monopoly in the oil and gas industry and against the backdrop of decreasing production, Mexico finally undertook a sweeping energy reform which opened its entire oil and gas industry to private investors. These reforms are expected to attract an additional $20 billion of foreign direct investments a year, increase oil production in Mexico from 2.5 million to 3.7 million barrels per day by 2025, and almost double natural gas production to as much as 10.4 billion cubic feet per day.
In the upstream sector, the Mexican government has concluded the process known as "Round Zero" by which it reserved certain oil and gas fields for exclusive development by Pemex, the national oil company, alone or in partnership with private companies, and has announced a list of approximately 160 new fields which will be bid out to private exploration and production companies during the first quarter of 2015 in what is called "Round One."
Not surprisingly, the international oil and gas majors are already lined up to enter the Mexican market through joint-ventures with Pemex in order to develop some of the most attractive conventional and deep-water fields. This will leave ample room for independent E&P companies and private equity-backed teams to participate in Round One. An example of this is the recent $525 million capital commitment made by private equity firms Riverstone Holdings LLC, Encap Investments, and Infraestructura Institucional (I2) to a new firm called Sierra Oil & Gas, which will become the first independent E&P company in Mexico.
While the new upstream opportunities have attracted most of the media coverage, the energy reforms will also create a significant amount of investment opportunities in the midstream and downstream sectors. Gas transportation, which is one of the few sectors that was open to private participants prior to the reforms, will remain a key area of focus since the country's pipeline network is still lagging and could become a serious bottleneck for the entire industry if it remains underdeveloped.
Pemex and the Comisión Federal de Electricidad (CFE), the state-owned utility, have laid out plans to build natural gas pipeline projects worth between $23 billion and $38 billion in the coming years. In addition, the energy reforms will allow private investment in natural gas gathering and storage facilities, which will represent significant opportunities for infrastructure firms in the coming years. According to ICF International, the gas pipeline sector will require investments of between $10 billion and $15 billion through 2020, while gas storage, gathering and processing will require an additional $8.5 billion to $15 billion.
Brazil's oil and gas sector continues to drive the country's growth and is expected to remain the main target for foreign private investment projects in the region. These investments will focus mainly on the country's deepwater pre-salt basins, which have reached record production and productivity levels after only eight years of being discovered. Production from fields operated by Petrobras, the national oil company, in the pre-salt area has exceeded 500,000 barrels per day and is expected to reach approximately 6.7 million barrels per day by 2020.
Brazil held its first auction for pre-salt oil fields in October 2013 under a production sharing regime, but investors are wary of the requirements to make Petrobras the sole operator with a 30% stake in all fields in the area. The upstream oil sector in Brazil has been dominated by Petrobras and the international oil majors, however, private-equity backed companies, such as Barra Energia, have started to build interesting portfolios in recent years. On the other hand, the natural gas market continues to be led by domestic companies, which leaves ample opportunities for private equity investors to participate in that sector.
Colombia has been experiencing an oil boom for nearly a decade and continues to be one of the most attractive countries in the region for oil investment. Since 2003, the country has carried out several, largely successful, public bidding processes to award development rights to exploration and production fields. Unfortunately, the lack of significant new onshore discoveries has caused the country's reserve to lag behind rising production levels.
The government's efforts to develop deepwater and unconventional fields have not been very successful, as evidenced by the lack of interest in the unconventional fields offered during this year's bidding round. Nevertheless, private equity groups continue to be active in the country's oil and gas industry. As an example, earlier this year, Darby Private Equity, together with two co-investors, acquired a $385 million stake in OCENSA, Colombia's largest oil pipeline responsible for moving almost 60% of the country's crude oil, after Advent International's acquired a larger share of the same pipeline ($1.1 billion) in 2013. Also last year, London-based Capital International Private Equity Fund (CIPEF) and US firm Acon Investments acquired Vetra Energía, one of the largest independent oil producers in Colombia for a combined total of $247.5 million.
Recent criminal attacks on oil infrastructure assets and community blockades of oil installations have given some investors pause, but the government hopes to resolve the underlying conflicts in the near future, as they continue to make progress in the peace talks with the rebel groups.
Argentina boasts some of the world's largest shale oil and gas deposits in the Vaca Muerta formation and in the recently discovered Agrio formation, both of them located in the Neuqen basin. Vaca Muerta holds approximately 27 billion barrels of technically recoverable oil and 802 trillion cubic feet of technically recoverable shale gas. Chevron, the largest player in the Vaca Muerta region, has announced plans to drill more than 300 wells in the area in partnership with YPF, the national oil company. This is a vote of confidence for the country and is also good news for the few small companies who have land holdings in the basin which will benefit from the major's drilling plans.
However, recent incidents such as the government's expropriation of YPF from Spanish firm Repsol in 2012 and the country's default on its bond payments earlier this year have kept away from the country all but the most aggressive of investors. The government has taken some steps to incentivize foreign investment, including a reduction in the oil export taxes and a proposed new hydrocarbons law. Nevertheless, the fear of price controls in the industry and the prospects of a change of government in 2015 are likely to delay the inflow of any significant amount of private capital until 2016.
Remaining challenges
Despite enjoying an increasingly favorable regulatory environment in the region, private equity investors still face significant challenges in Latin America, including dealing with overprotective and complex land use and property regimes, lack of infrastructure, and higher levels of operational, health, and safety risks.
With the notable exception of Chile and Uruguay, where the levels of perceived corruption are comparable to those of developed countries such as the United States or Japan, rampant corruption is still a major concern for investors in Latin America in spite of recently enacted anticorruption legislation in Brazil, Mexico, and Peru.
Another important obstacle for foreign private equity investors is the prevalence of slow, inefficient, and sometimes corrupt judicial systems in Latin America. While private contracts are generally upheld, judicial disputes are lengthy and cumbersome, which has promoted the use of international arbitration in cross-border transactions. Nevertheless, enforcing such arbitral decisions can be costly and problematic in some countries.
To be fair, these challenges are no different from, and in most cases no worse than, those encountered by investors in other emerging markets. But, just as in other emerging markets, investors looking to enter the oil and gas sectors in Latin America need to understand these challenges and seek partners and advisors with country-specific presence and experience who can help them mitigate the risks involved.
About the author
Daniel Chavez is a partner in the Houston office of McDermott Will & Emery LLP. His practice focuses on private equity, energy, natural resources and infrastructure transactions in Latin America. Chavez previously served as managing director and general counsel for a private equity firm specializing in investments in Latin America, the Middle East, and Africa, and prior to that he was senior counsel for AEI, an international energy company which owns and operates energy infrastructure assets in emerging markets.