Rebalancing oil contracts in Venezuela.

• Author: Garcia, Julian Cardenas

1. INTRODUCTION II. THE REGULATORY HYDROCARBON REGIME IN VENEZUELA AND ITS CURRENT MAJOR ISSUES A. The Establishment of a Legal Framework Based on State Control 1. The Takeover of Upstream Operations and Windfall Profit Tax (2005-2008) 2. The Takeover of Service Companies and the Windfall Profit Tax Reform (2008-2011) B. Imbalances in the Contractual Framework for Mixed Companies 1. Controls over Management and Oil Sales 2. Contractual Restrictions of Investors' rights in Light of BITs III. METHODS OF AWARDING CONTRACTS AS A SOURCE OF BALANCE IN THE VENEZUELAN'S PETROLEUM CONTRACT REGIME FOR ORINOCO BELT PROJECTS A. The Tender of the Carabobo Area 1. The Inflexibility of the Original Contractual Conditions 2. The Incentives Granted and the Auction Results. B. The Practice of Direct Negotiation of the Junin Area Blocks 1. Incentive Mechanisms Granted through Direct Negotiation 2. Most Favored Nation (MFN) Clause towards Orinoco Belt Projects IV. CONCLUSION I. INTRODUCTION

   This Article is based on research of the regulatory framework for oil contracts in Venezuela, conducted during visits to Caracas in July and August 2009 and January 2010. (1) The study included reviewing Venezuelan legislation, petroleum contracts, and interviewing Venezuelan government officials, international oil companies (IOC) executives based in Venezuela and experts in the Venezuelan case. (2) Initially, the research concentrated on assessing the impact of the Carabobo tender on the contractual conditions for oil ventures in Venezuela. This was for two reasons: 1) The 2009-2010 auction of the Carabobo Project, located in the Orinoco Belt, was highly relevant to the pattern of Venezuelan oil contracts to exploit the vast reserves--estimated at 127.9 billion barrels--of heavy crude oil, (3) and 2) the reduction of the government's bargaining power when oil prices collapsed in 2008, and foreign investment in new projects was vital to increase oil production. (4)

   Based on the dates for the tender approved by the Venezuelan Ministry of the People's Power for Energy and Petroleum (MPPEP) in early 2009, the research was conducted first in Caracas during a period that permitted observation of the auction's outcome, scheduled for August 14, 2009. (5) Nevertheless, on July 28, 2009, the Minister of Energy and Petroleum and President of Petroleos de Venezuela S.A. (PDVSA), Rafael Ramirez, announced the halt of the bidding process "without providing new dates." (6)

   The delayed auction thwarted the initial attempt to assess the overall consequences for the contractual regime, but it brought new elements to light: 1) the existing contractual imbalances, which have limited the presentation of bids, (7) 2) the instability of the fiscal regime with the introduction and reform of new taxes, 3) the simultaneous implementation of both competitive bidding and direct negotiation to award contracts, (8) and 4) the shift in the government's position towards approving economic incentives, providing greater substantive investment protection rights, and granting access to international arbitration to encourage the participation of foreign companies. (9)

   To improve the understanding of Venezuela's current oil-sector investment framework, Part II of this Article reviews the major issues of the Venezuelan hydrocarbon legal regime. This review will demonstrate that during a period in which the government has increased its oil-sector control, the government's overbearing position has created contractual imbalances, which should be assessed in light of the investor's rights under Bilateral Investment Treaties (BIT). Given the evolving negotiations between oil companies and the Venezuelan government, Part III of this Article will show how the heavy crude oil projects awarded after the February 2010 Carabobo Area tender, and the existing practice of directly assigning blocks in the Junin Area, also in the Orinoco belt, have led to a new balance in the contractual conditions which, if respected, might contribute in an influx of investment in the Venezuelan oil sector.

2. THE REGULATORY HYDROCARBON REGIME IN VENEZUELA AND ITS CURRENT MAJOR ISSUES

   Les investisseurs doivent comprendre qu'un regime trop protecteur de leurs droits ne sert pas necessairement leurs interets. Des clauses garantissant trop les seuls interets des investisseurs risquent de susciter des reactions brutales de la part des gouvernements futurs. (10) ... l'equilibre est la regle d'or, et une nouvelle inegalite ne doit pas remplacer une ancienne. (11) The applicable legislation for oil contracts in Venezuela has undergone a constant and accelerated reform in the last decade. (12) One feature of the reform was its abrupt rupture with the previous regime, known as the Apertura Petrolera [Oil Opening], implemented throughout the 1990s. (13) The Apertura allowed foreign direct investment under attractive financial terms and provided a contractual protection regime that included fiscal stabilization clauses, choice of external law, and the government's consent to international arbitration. (14) This preferential treatment was seen as inconsistent with the aims the current administration and declared incompatible with its nationalization regime. (15)

   The reversal of the Apertura led to a legal framework in which the Venezuelan government has sought to increase both the government's profit share and its control over the oil industry, which will be addressed in Section A. Further, a new model contract for Mixed Companies (incorporated joint ventures) was established to govern the participation of foreign investors in the oil sector. (16) Hence, Section B reviews the terms of the model and seeks to identify possible imbalances which will be reviewed in light of investment protection rights under BITs.

   1. The Establishment of a Legal Framework Based on State Control

      The current legal regime regulating hydrocarbons in Venezuela is based on a policy that sought to recover "full petroleum sovereignty." (17) The reform started with the 1999 approval of a new Constitution, which reaffirmed state ownership and control over hydrocarbons and PDVSA. (18) A new Organic Hydrocarbons Law (OHL) was enacted in 2001 (19) and partially reformed in 2006. (20) The OHL defined the government's operational control of the oil industry, increased its quota of fiscal income, and created the contractual framework for Mixed Companies (MCs). (21) Some analysts pointed out that such reform could be applied only to new investors or investments based on the two principles of non-retroactivity, under Article 24 of the Venezuelan Constitution and sanctity of contracts. (22) Nevertheless, various factors gave the Venezuelan government powerful incentives to impose the new regime on prior agreements. These factors included a contract design based on a low-price scenario, the obsolete bargain created at the conclusion of the private investment cycle of the oil opening and also a regressive oil tax framework, which did not include contingencies for oil price increases. (23)

      1. The Takeover of Upstream Operations and Windfall Profit Tax (2005-2008)

         During a period of increases in oil prices beginning in 2005, the Venezuelan government faced the opportunistic dilemma that the net economic benefit of reneging on its contracts was greater than the net benefit of complying with those contracts. (24) The government's initial steps were to unilaterally raise royalty rates and income taxes and create a new extraction tax, affecting the value of foreign investments. (25) Then, the government reneged on thirty-two operating agreements, two risk-exploration and profit-sharing agreements, and later forcibly renegotiated four association agreements for production of heavy crude oil operating in the Orinoco Belt. (26) The agreements were declared illegal, and the government insisted on adapting them to the new 2001 OHL. (27) In particular, on May 1, 2007, the government sent an ultimatum to IOCs involved in the association agreements. (28) The ultimatum stated that if the IOCs did not accept the new scheme, the authorities would take control of their operations and threatened to pay book value for expropriated assets. (29) Indeed, the execution of forced renegotiation compelled IOCs to agree to a re-allocation into a model of Joint Ventures with PDVSA as the majority shareholder. (30)

         Notwithstanding the high risk of conflict, most companies accepted the new terms and decided to stay in Venezuela, partly in hopes of securing new opportunities. (31) However, ExxonMobil and ConocoPhillips resorted instead to international arbitration, seeking compensation for the expropriation of their assets. (32)

         a. Windfall Profit Tax Introduction 2008

         Later, as a result of a further increase in oil prices that reached $147/barrel in July 2008, the Venezuelan government sought greater profits by approving the Law on the Special Contribution on Extraordinary Prices in the International Hydrocarbons Market. (33) This law established a new windfall profit tax called Special Contribution that should be added to the fiscal regime of royalties and taxes set forth in the OHL. (34) The Special Contribution tax reached 50% when oil prices reached $70/barrel, and up to 60% when the price exceeded $100/barrel in a given month. (35) The tax is paid by exporters of natural or upgraded liquid hydrocarbons and derivative products. (36)

         After the implementation of these measures, one could expect the end of the reform process. The government, however, approved more interventions, which increased state control over the oil sector. The Venezuelan government continued acting based on its assumption that its huge onshore reserves of crude oil, the country's low geological risk, and the lack of opportunities for big upstream projects in other oil-rich countries, gave the government a strong bargaining position with foreign companies. (37)

      2. The Takeover of Service Companies and the...