Venezuela's Oil Privatization Fuels Wealth

by Torres, Plaz & Araujo

During a five-day period last month, US$2.1 billion entered Venezuela as a result of the State’s decision to open petroleum activities to the public. Until four years ago, the State held a monopoly in this sector.

In 1976, through the creation of Petróleos de Venezuela C.A. (PDVSA), the Venezuelan government took control of the hydrocarbon industry. Since then, PDVSA has monopolized the entire Venezuelan oil and gas industry. PDVSA is the second most profitable oil company in the world and its worldwide presence is substantial. Despite its considerable success—due in large part to its relative independence from government intervention—PDVSA could no longer preserve its monopolistic system and simultaneously maintain its role as one of the leaders in the international oil market.

PDVSA is a corporation worth more than US$100 billion. PDVSA has refineries in the United States, the Caribbean, Germany, Sweden, Belgium, and the United Kingdom. It also conducts important activities in Japan, China and other East-Asian countries, and owns 100% of Citgo Petroleum Corporation, which has more than 15,000 gas stations throughout the United States.

Politically, economically and strategically, Venezuela is arguably one of the most important oil countries in the world. It has reserves sufficient to support more than 200 years of production at a rate of 6 million barrels per day. Half of Venezuelan territory rests on sedimentary basins. It is estimated that the Orinoco Basin alone contains more than 1.3 billion barrels of oil. Given that the world’s oil reserves are 1.2 billion barrels, one could reasonably conclude that Venezuela has the potential to become the richest country on earth if it adopts and implements intelligent administrative, cultural, juridical, industrial and social policies.

"Venezuela views the opening of its petroleum industry, or Apertura Petrolera, as a means of taking greater advantage of its privileged position in the oil world."

Recognizing this potential for wealth and considering PDVSA’s priorities, the State has decided to open the oil market to all private entities, both domestic and foreign. Should the government fail to do so, expansion opportunities and financial flexibility would be lost and substantial amounts of reserves would have to wait approximately 35 years to be exploited. Venezuela views the opening of its petroleum industry, or Apertura Petrolera, as a means of taking greater advantage of its privileged position in the oil world.

Private entities will be able to participate in the operation of fields, exploration, production, transportation and marketing of oil, gas and their derivatives. In addition, they will have business opportunities in refineries, petrochemicals not reserved by the 1976 law, gas, domestic commercialization of hydrocarbons, marine activities, outsourcing and information.

Under Article 5 of the 1976 law, there are three agreements that can be signed by private entities and one of PDVSA’s affiliates in order to pursue the activities mentioned above. The first, an operating agreement, typically has a duration of 20 years and does not require congressional approval, except in some unusual cases. The private entity must participate in a competitive bidding process. The company that bids the highest wins the specific area and becomes a contractor and operator of PDVSA’s affiliate responsible for that area.

For its services, the operator receives a fee equivalent to the qualified production multiplied by the value per barrel, f.o.b. Venezuelan port of export, less some specific costs attributable to PDVSA. The income tax to be paid is the same charged to any other private company: 34% on net income. To date, operating agreements for 33 areas have been assigned to private companies.

It is important to mention that anyone interested in petroleum sector investment can participate. By investing in SOFIP, an investment entity of PDVSA, the private individual, company or third party can indirectly participate as an investor in the Third Round “Marginal Fields.” Under this program, SOFIP can invest in the capital markets and obtain funds necessary to own up to 10% of the business in each area.

The second type of agreement, known as a strategic association agreement, requires the approval of both chambers of Congress for its execution. Strategic association agreements, the first of which was granted for the purpose of exploiting the enormous gas reserves belonging to Paria’s Peninsula, are complex and interesting. Several of these agreements have already been approved by Congress, and aim to facilitate the extraction and upgrading of heavy oil into commercial grades at local facilities. Under this type of agreement, the private entity is a partner with PDVSA’s affiliate and can dispose of its quota of the business as it sees fit. An income tax of 67.7% on net income, plus a royalty of 16 2/3%, must be paid.

The third type of agreement, known as a risk exploration agreement or a profit sharing agreement, also requires the authorization of both chambers of Congress Nevertheless, the process has been fast and successful to date. In this type of agreement, the private company offers a PEG value to compete for the bid; the highest PEG wins the bid. PEG is the participation level that the State would have in the business.

The private entity receives one or several areas that are supposed to contain the higher API grades of petroleum; it must then explore at its own risk. If the private entity finds petroleum, it forms a partnership with PDVSA’s CVP, which is allowed a maximum share of 35%. If the prospective financial return makes sense for the CVP, the PDVSA affiliate’s share is increased proportionally. The income tax is 67.7% plus a royalty of 16 2/3%; this royalty could be reduced at the discretion of the government in cases of economic necessity. The PEG is paid over operating revenue plus joint revenue less royalty and operating costs, before income tax.

Venezuela expects to obtain more than US$55 billion in the next ten years solely from activities executed by private companies participating in the three agreements previously discussed. Coupled with the actual income generated from the privatization of former public activities, this private investment will constitute a significant fiscal contribution to Venezuela.

Venezuela’s decision to open its petroleum industry to private investment and involvement presents a unique opportunity to overcome past mistakes. However, there is a strong sense that the opportunities presented now might be easily lost. The Apertura Petrolera must serve as the impetus for Venezuela to create incentives for its industrial base, adjust its overall institutional complex and promote social improvement which will benefit future generations.

The law firm Torres, Plaz & Araujo is located in Caracas, Venezuela. Its practice areas include taxes, corporate, foreign investment, labor, banking, securities and litigation.