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Noel Maurer : Old evil vendepatria
PDVSA saves new socialist PDVSA!


On the turn of the New Year, the International Chamber of Commerce (ICC) awarded ExxonMobil $907.6 million in its dispute with PDVSA over the Venezuelan government's nationalization of its interest in the Cerro Negro project in the Orinoco oil belt. The press has been pretty quick to call it a victory for PDVSA, considering that the company initially claimed that its investment was worth $12 billion. Exxon, they say, received only book value for its investment, and Chávez has run away with the store.

Is that true? My job here is to argue that it's not. Exxon received from PDVSA what it was contractually entitled to get. The standard used by the ICC was the market value of the assets, not book value. The assumptions used to calculate that market value, however — chief among them estimates of the expected future price of oil — were limited by a clause in ExxonMobil's 1998 association contract that effectively put a ceiling on the value of the company's investment.

In the words of Steven Bodzin: “So for all the rhetoric about how the Old PDVSA sold out the patria etc. etc., the only reason the New PDVSA was able to do so well in arbitration was because of clever bargaining by the Old PDVSA?”

I'm going to briefly walk through the Orinoco value chain. Then I'll briefly describe some key features of the Cerro Negro contract. Finally, we'll run some numbers.

Let's start with Cerro Negro. The project is in the Orinoco oil belt — but keep in mind that until 1956 it was actually called the Orinoco tar belt. (The “faja bituminosa del Orinoco.”) The crude oil there is “extra heavy,” meaning that its specific gravity exceeds that of water. At room temperature, the stuff is gunky and practically solid. Put it into a beaker and turn it upside down; the oil will stick.

That creates a bit of problem in terms of transporting the stuff. There are three solutions. The first is to heat the stuff up and sent it out in special ships. That's expensive and really own done for oil intended to be made into asphalt. The second is to mix the extra-heavy gunk with lighter crudes and export it. Venezuela's “Merey” blend is a mix of 61.8% gunk and 38.2% lighter “Mesa” crude. (That's nice, because it means you can calculate a market price for the gunk.) The third is to build an “upgrader,” where you partially refine the gunk, mix it with a diluent and then export the resulting “synthetic crude.”

The Cerro Negro project covers 115 square miles and includes an upgrader. Its costs, therefore, are not low. The cost to get the extra-heavy crude out the ground isn't that high. Wikileaks documents indicate that it is around $4 per barrel, but it isn't as though that number is top secret: Bernard Mommer, formerly the People's Vice-Minister for Hydrocarbons and currently the Bolivarian Republic's representative on OPEC's Board of Governors, estimated them at $3.60. Upgrading costs, on the other hand, is significantly more expensive: Mommer reported them to be $9 per barrel. That comes to a total production cost of $12.60 per barrel of syncrude.

Production costs aren't the only costs, of course. In 2002, the Bolivarian Republic hiked royalties from 1% to 17%. In 2006, it hiked them again, this time to 33%. That same year, it raised the income tax rate from 34% to 50%. Taxes and royalties, therefore, are very substantial.

When Hugo Chávez Both converted the Cerro Negro oil extraction project into a majority-PDVSA joint venture in May 2007, ExxonMobil rejected Venezuela's (undisclosed) compensation offer and went to arbitration. It went to arbitration in two forums: the ICC and ICSID. The ICC arbitration was based on ExxonMobil's association agreement, which established the Cerro Negro venture between ExxonMobil (41.67%), PDVSA (41.67%), and BP (16.66%). Article 15 , “Consequences of Certain Governmental Actions,” stated that Exxon could take PDVSA to arbitration if PDVSA refused to “restore the economic benefit that the foreign party would have received had the discriminatory action(s) not occurred.”

What were the lost economic benefits? Well, at the prevailing oil price for Venezuelan blends in 2007 (and assuming a 9% nominal discount rate and 2% inflation) Exxon would have earned an average of $325 million per year (nominal), with a net present value of $3.0 billion. That's a lot more than $907.6 million! So was Exxon robbed?

Well, no. The first (and minor) point is that in 2007 it was far from clear that high oil prices were going to last. When ExxonMobil signed the contract in the late 1990s, Venezuelan oil was bouncing around $16 per barrel. So it is possible that Venezuelan lawyers might have persuaded the arbitration panel to use a lower oil price, under the assumption that prices might have crashed. If that had been the case, I would unhesitatingly call the $907 million result a victory for the Revolution.

The nice thing, however, is that we don't need to resort to hair-splitting. Article 15 of the association agreement tells us the price the arbiters had to use:

… after the first period of six consecutive months during which the price of Brent crude oil is in excess of the threshold price [$27 in inflation-adjusted 1996 dollars], Lagoven CN [PDSVA's subsidiary in the Cerro Negro venture] will not be required to compensate any foreign party for any discriminatory action(s) with respect to any fiscal year in which the average price of Brent crude oil is in excess of the threshold price, and such foreign party received net cash flow commensurate, after taking into account the effect of the discriminatory action(s), with a reference price for the production produced by the parties that bears at least a reasonable relationship, adjusted for quality and transportation differences, to the threshold cash flow for such fiscal year.

Translation: the highest possible oil price that can be used to value damages in the event of expropriation is $27 per barrel in 1996 dollars, or $37.50 in 2007 dollars. Moreover, that's the highest price — Venezuela, after all, doesn't sell Brent but rather lower-priced blends. That price can be marked down to adjust “for quality and transportation differences.” E.g., the arbiters can pick a lower one.

Ah hah! Brilliant! When Brent traded at $37.50, Mesa crude traded at around $32. At $32 per barrel (adjusted for 2% inflation), Exxon would have expected to earn an average of $95 million per year through 2035. At a nominal discount rate of 9%, that would value ExxonMobil's investment at $865.8 million. It only takes a little tweaking of the discount rate or oil price to get us to the figure that the ICC finally came up with. 

What does this imply for the results of the upcoming ICSID arbitration ? Damned if I know. That arbitration is against the Bolivarian Republic, not PDVSA. So Article 15 doesn't apply. Rather, the relevant document is the bilateral investment treaty that defines what the Venezuelan government can and cannot do. Moreover, it is possible that ExxonMobil will be able to argue not only that the 2007 expropriation was illegal, but that the big royalty and tax hikes the year before were also illegal under the Netherlands-Venezuela bilateral investment treaty. My gut feeling is that Venezuela is going to win, but I'm not sure why exactly I suspect that will be the case.

To sum up, then, this case was not a victory for the Bolivarian Republic. Rather, it was a victory for the PDVSA negotiators who wrote Article 15 of the association agreement back when the plain old Republic of Venezuela invited foreign companies in to develop the Orinoco oil belt. ExxonMobil got basically the maximum that it could have expected to get. So what was that initial  $12 billion claim all about? Well, as Michele Bachmann would mispronounce , nothing but chutzpah.

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Noel Maurer is an associate professor at the Harvard Business School in the Business, Government and the International Economy (BGIE) unit. Maurer earned his Ph.D. from Stanford University in 1997. Between 1998 and 2004 he worked as an assistant professor in the Department of Economics at ITAM, a university in Mexico City. Petroleumworld does not necessarily share these views.

Editor's Note: This commentary was originally published by The Power and the Money, on Jan. 05, 2011. Petroleumworld reprint this article in the interest of our readers.

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