Wednesday, November 5, 2014

Chile is not an oil producing country, but has a story of success and failure to tell

In the last decades there are several factors which led to a decrease in gas and oil production in Chile. Certainly, the depletion of conventional resources in the Estrecho de Magallanes, which historically has been the place where oil and gas activity have taken place in the country, initially onshore and subsequently offshore, is one.

The petroleum activity in the southern region dates back to 1945 with the discovery of the first deposit. In 1950, the National Petroleum Company (ENAP) was created with the aim of engaging in exploration and production of oil. In Chile, both the underground gas and petroleum belong to the State, and ENAP has the right to engage in exploration and production activities of both oil and gas.
The peak in oil production occurred in 1982 with 55,000 barrels per day (b/d) of crude oil, what drop to 18,000 b/d in 2012. For natural gas, this peak was in 1973 with 22 million cubic meters (considering the reinjection), and fell to 3.75 million cubic meters per day by 2010.
In the early 1970s, when onshore production starts to decline, ENAP launch and offshore oil exploration and production project in the Estrecho de Magallanes. This program helps to revert the downturn in oil production, and in 1982 the country reached its peak in oil production. However, since then, ENAP resources to invest in exploration and production activities were dwindling. It did not invest in new technology or exploration wells, with 120 wells drilled in 1982, between 2000 and 2005 ENAP drilled only five wells. And thus, domestic oil and natural gas production was mainly determined by the existent wells rate of decline. At that time, was the belief that the area of Magallanes is an area already depleted. With this idea ENAP start looking for alternative oil sources to secure the country´s supply.
ENAP was gradually losing relevance in the domestic oil supply, with declining levels of production, rising domestic demand, and an oversize cost structure not adjusted to the levels of production. Thus, adding the inefficiencies of a poorly managed company, it confronted increasing levels of debt and decreasing resources to invest in exploration and production. The way foresaw to revert the declining domestic production was to internationalize the company, launching an investment program in oil exploration and production abroad. This program was leaded by SIPETROL, a new subsidiary of ENAP, as the vehicle to engaged in oil exploration and production in Argentina, Ecuador and Egypt. Also, gradually the State of Chile opens the sector to private investment.
The private companies that want to participate in oil and gas exploration and production, are allowed to do it in a consortium with ENAP, alone or with other companies, where a concession known as Special Contracts for Exploration and Exploitation of Hydrocarbons (CEOP) was needed from the government. The CEOPs establish a set of conditions for investments in exploration, production and infrastructure, for operation, in the number of wells to be drilled and the participation of the private company, the participation of ENAP and the State in the recovered oil and gas, and a time period to carry the required program. The first CEOPs were given in 1977, attracting new investment in oil and gas exploration and production. However, they were not enough to turn around the downward trend in exploration and production. Next, by the end of the 2000 decade and early 2010 new CEOPs have been granted, and in 2010 the region starts to notice a slight improvement in the proven oil and gas reserves and production. Nevertheless, well below the reserves and production of the beginning of the decade. Further, for a long period has existed a plan to open new offshore and onshore areas for CEOPs, with an offshore area that goes from the coast of Valparaiso to Chiloe, more than 1300 miles long if you take a straight line.

To succeed Chile in turning around the decline in oil and gas production, it must be bolder in improving the business environment, the contract framework, and in opening new areas for oil and gas exploration and production to attract more investment and new technologies. The risks of the oil industry are diverse and extensive. And usually, in the developing world, more than the geological risk, the greatest risks are over the ground, on issues related with the regulatory framework, rule of law, enforcing contracts, proper prices which take into account the costs and risks of the activity.

Another important aspect, which mainly affects the incentives to attract private investment to the Magallanes Region, is the generalized subsidies that exist for natural gas consumption. The natural gas household prices in the region are US$ 1.3 per million of BTU, plus the value added from the distribution cost, and this is below the production costs of new wells.

The region is home to approximately 160,000 people, and most of them live in the regional capital, the city of Punta Arenas. In 2013 residential natural gas consumption in the region reached 184 million cubic meters. However, the national capital, the city of Santiago, with a population of 7 million, in 2013 reached residential natural gas consumption of 248 million cubic meters. Thus, the Magallanes Region, with a population that is 2.3% of the population of Santiago, has a level of natural gas consumption equal to 74.2% of what is consumed in the national capital. It can be claimed that Santiago has a much warmer weather than Punta Arenas. Yes, that is true! But, what if we compare the per capita level of natural gas consumption in Magallanes, with that, for example, of Minnesota, USA? No one can claim that Minneapolis has warmer winters Punta Arenas. In Minnesota the per capita consumption of natural gas for residential customers is about 666 cubic meters, while in Magallanes this figure reaches 1150 cubic meters. By both comparisons, the level of natural consumption in Magallanes is very high!

The heavily subsidized natural gas price, which makes no difference in the poverty status of the beneficiaries, has encouraged an increasing use of natural gas, and has led the current administration to ask the Chilean Congress, in the 2015 Finance Act, to allocate US $ 92.5 million to subsidize the natural gas price in the region for the year 2015. This translates into a subsidy of $ 578 per person per year. As reference, in 2012 the Government of Chile spent on grants and bonds to reduce poverty US $ 517 million, of which US $ 156.6 million were used to ensure what has been called the ethical family income that is aimed at the poorest families. A total of 220,795 families were benefitted by this grant, receiving US $ 709 per household or US $ 177 per person (assuming a family of four). This huge distortion encourages consumption but create a negative incentive to attract new private investments in the sector. Instead of this generalized subsidy, the authorities should lock for a more focused subsidy that tackles the poor. This is a highly politicize issue in the region, where exist the belief that this gas is for their own and domestic consumption.

Given the uncertainties and prospects for oil and natural gas exploration and production in the region, METHANEX, a methanol producer and the main natural gas consumer in the region, have confirmed that it withdraw gas exploration in Magallanes and that it has dismantled two of the four production trains it has in the region. METHANEX was an important factor to enable large investment in exploration and production of natural gas for the region, but given the uncertainties surrounding property rights to dispose freely of the produced natural gas, at a reasonable price, and because of the better prospects for this activity in other regions of the world, the role of METHANEX as an investment enabler has been seriously diminished. Having adequate prices in the foreseeable future that cover the costs and risks of the sector is crucial and essential to attract new investments, but this is something that is not happening in Magallanes.

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