UNN-31 THE SEARCH FOR OIL IN DEVELOPING COUNTRIES A Problem of Scarce Resources And Its Implications for State and Private Enterprise Prepared At the Request of THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT W. J. LEVY, I N C_ NEW YORK THE SEARCH FOR OIL IN DEVELOPING COUNTRIES A Problem of Scarce Resources And Its Implications for State and Private Enterprise Prepared at the Request of THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT W. J. Levy, Inc. 30 Rockefeller Plaza New York 20, New York November 1960 THE SEARCH FOR OIL IN DEVELOPING COUNTRIES A Problem of Scarce Resources And Its Implications for State and Private Enterprise Table of Contents Page INTRODUCTION AN\D SUMMARY 2 Summary 6 What Exploration Involves 6 Technical Capability and Judgment 6 Capital Costs and Foreign Exchange Requirements 7 Continuing Cash Drain 9 Financial Implications for Underdeveloped Areas 9 Problems under Government Monopoly 10 Private Participation in National Oil Programs 12 THE NATURE OF OIL EXPLORATION 18 Inherent Problems 18 Risk and Uncertainty 18 Capital Investment to Establish Production 22 Colombia 23 Expenditures in Nigeria 24 i Table of Contents Page THE NATURE OF OIL EXPLORATION (cont'd) Continuing Financial Requirements 25 Rocky Mountain Area 26 Canadian Oil Industry 27 Results of Maturing Oil Operations 29 Role of Private Enterprise 32 Bearing the Risk 32 Guatemala 34 Turkey 35 Libya 38 Financing Oil Operations 41 Foreign Exchange 44 PROBLEMS AND ISSUES OF GOVERNMENT OIL MONOPOLY 48 Technological Capabilities 48 Centralization of Judgment 50 Capital Requirements 51 Foreign Exchange 53 Pricing Policy 54 'Brazil 57 Establishment of Petrobras 57 ii Table of Contents Page PROBLEMS AND ISSUES OF GOVERNMENT OIL MONOPOLY (cont'd) Brazil (cont'd) The Problem Facing Petrobras 58 Financial Resources 60 Operating Profits 62 Reinvested Dividends 65 Receipts from Import Duties and Excise Taxes 66 Long-Term Debt 67 The Build-up of Funds -- Effect of Inflation 67 The Application of Funds 69 Working Capital 69 Gross Fixed Assets 70 Petrobras Operations, 1954-1959 72 Prospects for Closing the Oil Gap 76 U.N. Estimates 77 Petrobras Expansion Plans 78 0The Problem Ahead 80 Mexico 83 Establishment of Pemex 83 Early Problems 85 Table of Contents Page III. PROBLEMS AND ISSUES OF GOVERNMENT OIL MONOPOLY (cont'd) Mexico (cont'd) Postwar Developments 88 1947-1954 89 1955-1959 94 Financial Concomitants 97 Prices and Profits 98 Long-Term Debt 101 Contributions to Government Revenue 101 Balance of Oil Trade 102 Reorganization in 1959 103 IV. COOPERATION BETwEEN STATE ENTERPRISE AND PRIVATE COMPANIES 111 Argentina 115 Postwar Developments 116 Drilling Activity 117 Reserves and Production 118 Refining 119 The Oil Balance in 1958 121 Why Production Lagged 122 iv Table of Contents Page IV. COOPERATION BETWEEN STATE ENTERPRISE AND PRIVATE COMPANIES (cont'd) Argentina (cont'd) Development Program, 1959-1964 124 How These Goals are to be Met 126 Early Results 130 Bolivia 133 YPFB Operations 133 The 1955 Oil Code 136 India 139 Government Activity in Oil 139 Recent Policy 142 APPENDIX A: Argentine Production Contracts with Private Companies APPENiDIX B: Statistical Tables v PREFACE The following study was commissioned by the International Bank for Reconstruction and Development in order to provide a source of useful information to the governments of its underdeveloped member countries which might be formulating their policies in the field of petro- leum development. The study has been prepared solely on the responsibility of the author and does not purport to be an official statement of the views or policies of the International Bank. vi CHAPTER I INTRODUCTION AND SUfARY - 1 - CHAPTER I INTRODUCTION AND SUMMARY 1. Oil development is an objective that is closely linked with national economic goals in many parts of the world. This is apt to be especially true of countries that are striving for rapid industriali- zation and diversification of their economies and for improvement in living standards. 2. The energy needs of these countries -- for light, heat, and power -- must now be met in large measure by petroleum imports. And oil requirements can be expected to mount rapidly, along with econo- mic advance. Thus, the cost of oil supplies looms large; if it has to be met mostly in foreign exchange, it may seriously impinge on a na- tion's balance of payments and thus adversely affect its ability to import capital equipment and other essential goods. In consequence, the discovery and exploitation of a country's own oil potential is often looked to as a major aim and requirement of national develop- ment programs. 3. To many of these countries, the active participation of government in oil operations appears attractive. The reasons are many and varied -- reflecting diverse historical, political, and economic circumstances. In many countries, it is the urge of nationalism that inspires government oil operations; in others, a socialistic approach. And where state sovereignty over sub-soil resources is established by law, there is a tendency for oil operations to be vested in a govern- ment entity. 4. A range of problems confronts the operations of the state oil entity, however. These derive, in part, from the inherent nature of oil operations -- for example, the very great capital requirements that are involved and the need for vast technological capabilities and skilled manpower. Among developing countries, the resources that can be mus- tered for an exploration program are likely to be inadequate as com- pared with the magnitude of the job. People with the necessary training and experience are generally few; facilities and technical knowledge are extremely limited; capital is scarce and at the same time desperately needed for many competing projects. 5. The problems of a government oil entity also stem, in part, from its inevitable character -- for example, centralization of judg- ment and susceptibility to political pressures. Thus, notwithstanding -2- the participation in many instances of very able and dedicated per- sonnel, difficulties in achieving national objectives have marked vir- tually every state oil effort. 6. An alternative approach to development of national oil poten- tial would be through the participation of private enterprise. This has been the course followed in many countries. In practice, private parti- cipation takes many forms -- the opening of national areas to private operations, private operations side-by-side with government enterprise, and joint ventures between private companies and the state. To develop- ing countries "private" means, in effect, "foreign private", since lo- cal capital is very limited and without access to technical knowledge and skills. Foreign companies, on the other hand, are in a position to bear the risks as part of internationally diversified operations, can provide the capital resources that are required, and can bring tech- nical competence and trained manpower to the task. 7. As against this background of urgent need and limited nation- al capabilities, the search for oil in developing countries can involve important issues of policy and critical problems of performance. There is the need for oil to meet essential energy requirements. And where geological prospects are at all favorable, there is the possibility of providing for some part at least of those requirements out of indige- nous resources. This study focuses on the basic question that is posed -- is it appropriate and practical for government in such coun- tries to undertake exploratory operations, or would development be fur- thered by the efforts of private industry? We do not consider the separate case of countries with established production and export oper- ations; nor do we consider state operations in refining and marketing -- all of which involve somewhat different questions. We thus limit our inquiry to the interests of developing countries in exploring their potential oil resources -- and the roles that state or private enter- prise can effectively take on. 8. In this connection it is interesting to note that by far the largest part of world oil operations is financed and conducted by pri- vate enterprise,* and private industry is especially active in explora- tion over undeveloped but primising areas. At the same time, govern- ment oil operations are found in a large number of countries, probably more than thirty in one form or another.*" But while the list of * Oil operations within the Soviet bloc are excluded from this study. ** Included here are government operations in established producing areas, as well as state refining, and to a lesser extent, state mar- keting enterprises. These are beyond the scope of this study, as noted above, but are touched upon peripherally in subsequent chap- ters. -3- GOVE?NMENT 5HARES IN WORLD OIL OPERATIONS, 1959 Production Refinery Runs (Thous. of (Thous. of Bbls. Daily (Per Cent) Bbls. Daily) (Per_Cent World, outside Soviet bloc 16,643 100.0 17,269 100.0 Private 16,001 96.1 16,3SS 94.9 State 642 C 9 SS1 5.1 Mexico 290 287 Argentina 110 140 Brazil 65 95 Austria 44 29 Colombia 27 33 Egypt 18 23 Chile 17 24 French Sahara 15 ... Gabon 12 Yugoslavia 11 24 All others 33 226a Note: Data are in large part estimated. Government equities in pro- duction and refining refer to home countries only. British Petroleum and Compagnie Francaise des Petroles are not included as state enterprises. Although shares in each are held by their respective governments, state participation is based on a financial interest, and does not involve any privileged com- mercial position nor interference in business decisions. a Of which: Italy, 63; Spain, 45; Uruguay, 23 -- among others. Sources: U.S. Bureau of Mines, Oil and Gas Journal, and annual reports of state oil companies. government oil operations is extensive, the aggregate volumes of pro- duction and refining that are carried out under state auspices are small in comparison with private operations. It is difficult to arrive at precise figures because of the multiplicity of government under- takings and the often complex arrangements involved in joint operations with private industry. However, the table above presents a reasonable approximation of government production and refinery runs in 1959. In -4- neither instance do state operations account for more than 5 per cent of world totals, exclusive of the Soviet bloc. 9. In considering the problems of exploration in developing countries, we have organized this study into three major parts. Chap- ter II begins with a discussion of problems inherent in the search for oil -- the risks of exploration; the importance of experienced per- sonnel, technical comrpetence and diversity of judgment to successful operations; the financial requirements, in capital and foreign ex- change, to establish production; and the continuing cash deficits that must be expected as operations are built up. Chapter III then treats with instances of government monopoly where all the problems of oil develo?:ment devolve on the State oil entity. Chapter IV turns to countries where private participation has been accepted to supplement state operations, to illustrate how private enterprise functions in different environments under arrangements that are compatible with the policies of the respective governments. 10. Where instances of government oil operations are cited, these are not intended as separate critiques. In the first place, there is usually not enough information available on the workings of state oil entities, especially with respect to their financial accounts, for a comprehensive comparison of expenditures with results. And in any case, it is not the success or failure of a state enterprise to per- form according to plan that is most significant. Far more fundamental is the question of policy -- what course holds out greatest promise for national oil development? 11. A decision to vest the search for oil with government or to accept the participation of private enterprise can have far-reaching consequences, not only for the success of the exploration program it- self, but also for the effective use of the nation's technical and financial resources in its economic development. It is our hope that this study will contribute to an understanding of the problems of exploration in developing countries, and will help in the determina- tion of policy by their governments. What Exploration Involves 12. To begin with, the search for oil is fraught with uncertainty. For every successful wildcat, there are many more dry holes. There are instances where favorable prospects have been intensively worked over, without success. There are instances where unpromising regions, long ignored, have yielded improbably rich reserves. And there are areas, thoroughly prospected and abandoned, that have subsequently turned out to be productive when a later well was drilled from a slightly different location or to a slightly greater depth. 13. In any country, production potential will ultimately depend on the extent of its oil resources. But since results of exploration are unpredictable, success in the search for oil would depend in large measure on the scope of an exploration effort. The broader the search over likely locations, the better the chances of discovery. Further- more, since "likely locations" are a highly subjective matter, it is important that as many judgments as possible enter into the choice of exploratory areas and drilling sites. Finally, the greatest possible competence in pursuing an oil search is obviously desirable -- which means drawing upon the experience, methods, and technology that derive from exploratory operations over the years and under diverse conditions in all parts of the world. Technical Capabilitv and Judgment 14. A state enterprise charged with the responsibility for explo- ration tends to be at some disadvantage in each of these respects. Depending largely upon nationals for its scientific and technical per- sonnel, it has difficulty in recruiting the number and variety of skilled people who are required to carry on the search. Training takes time, and experience can be gotten only through repeated exposure. Nor is a government oil entity as well situated to benefit from the cross- fertilization of knowledge as the many companies that regularly engage in world-wide operations. The state enterprise may call upon foreign consultants and even foreign operating personnel for assistance in the government's exploration program; but technical aid on an ad hoc basis, however valuable, is no real substitute for continuous charting of a course that assures maximum returns to the country's exploration effort. 15. In charting that course, the state enterprise would not only be handicapped by shortage of technical personnel, but all its choices - 6- and decisions must inevitably reflect one centralized judgment. The oil search does not then benefit from separate perspectives and evalua- tions, as when many groups are competitively engaged in exploration. In Turkey, for example, some 20 private concerns are participating in the oil search together with the Government, including two major in- ternational oil companies whose recent experiences testify to the un- certaAnties inherent in exploration and the importance of diverse judg- ments. One is now discontinuing operations, having drilled 11 unsuc- cessful wells and spent a total of t2O million on its ventures.* The other has just brought in a 1,200-barrels per day wildcat, the country's most prolific discovery. It is through such multiplicity of exploration efforts that a country may be assured of a comprehensive assessment of its oil prospects. 16. Decisions of a state enterprise are also inevitably susceptible to political considerations. In particular, it becomes difficult to justify large and continuing expenditures on unsuccessful drilling. But many dry holes are typically the price that must be paid in the course of a successful search. An alternative is for the government oil entity to concentrate on development drilling in relatively proven areas. As a result, the discovery of new reserves tends to receive lower priority than the build-up of current production -- which could seriously inhibit national oil development over the long run. 17. Beyond these problems, there is a basic question as to the practicable scope of a government exploration program. As already noted, chances of success are increased by the broadest possible probing of prospective areas. At the same time, however, costs of exploration are huge and can weigh heavily upon government budgets. Hence the dilemma: A maximum effort would hold out the greatest promise of success, but could also threaten losses which govern- ment may ill afford; while A modest effort could limit potential losses, but would also unduly expose the exploration program to the vagaries of chance. Capital Costs and Foreign Exchange_Reauirements 18. The financial requirements of an exploration program must be * Significantly, the company's expenditures over the five years were just about equal to Government outlays on exploration during the 20 years, 1935-1954, when oil development was vested in a state entity. - 7 - considered from several standpoints. First of all, there are the very large capital outlays involved in the search for oil. Recent experience (outside the United States and the Soviet bloc) suggests that expendi- tures to establish production have averaged almost $2,000 per barrel per day. This figure encompasses widely varying costs among countries and even among regions within a country; and it obviously cannot be used as a measure of potential capital costs for any country's exploration program which would depend on its unique geological conditions. But it is useful as a rough indication of the magnitude of investment in- volved. On this basis, the capital costs of building up crude oil producibility of, say, 50,000 barrels per day would run to $100 mil- lion -- apart from large additional investment for transportation, pro- cessing, etc., which could add up to another $150 million. 19. Furthermore, there can be very substantial foreign exchange costs wherever exploration equipment has to be obtained from abroad. In the early stages and until production is built up, therefore, the exchange drain is apt to be pyramided as imports of equipment are added to continuing imports of oil. A country looking to national oil devel- opment for a larger measure of self-sufficiency would thus have to sub- sume a heavy exchange burden in the interim. 20. The instances of Guatemala and India illustrate these finan- cial difficulties. In Guatemala, for example, where more than 30 companies are engaged in the search for oil over two-thirds of the national territory, expenditures aggregated 820 million during 1957- 58 -- the first two years of operations and before extensive drilling had even begun. These outlays amounted to more than 10 per cent of Government income from all sources. It is clear that the State, on its own, could hardly mount an exploration program of comparable pro- portions. 21. In India, the Government had set a goal of self-sufficiency in crude oil production by the end of the Third Plan in 1966. This would require a build-up of producibility of more than 200,000 barrels per day beyond existing potential. Reserves to support that production will have to be discovered, with perhaps 400,000 square miles of prospective sedimentary basin within which exploration could be pursued. Con- sidering these, the Minister of Mines and Oil stated before Parliament: But large-scale oil exploration programme must be undertaken involving expenditure of great amounts of foreign money in a comparatively short time if we have to attain the target . . . Government have, there- fore, decided to invite foreign oil explorers to join in the quest for oil in India . . . Continuing Cash Drain 22. Even after successful discovery of reserves and establishment of production, the build-up of production is likely to involve a finan- cial drain over a prolonged period. Not only have facilities to be provided, but reserves must be replaced in the course of production, and still further reserves proved up to sustain a rising level of opera- tions. It is common experience in new producing areas for cash outlays to exceed cash receipts for many years. For example, in both the Rocky Mountain region of the United States and in Canada -- both relatively young oil provinces -- exploration and development in the postwar decade have absorbed significantly larger amounts than the funds generated by oil and gas production. In Colombia, where substantial results are being achieved in terms of crude oil reserves and producibility, ex- penditures have aggregated more than $950 million, more than one-quarter of which remains to be recovered. 23. The figures do not imply that oil development in these areas has been unprofitable. To the contrary, the substantial funds that are being committed to exploration and development reflect relatively favor- able results. But while the margin on operations may be profitable from an accounting standpoint, the cash balance is still adverse. Financial Imolications for Underdeveloned Areas 24. Thus, in looking to the development of its potential oil re- sources, a country has to consider the initial capital outlays with attendant risks, the early foreign exchange costs, and the continuing cash drain that may persist for a considerable time. For most countries, especially those in the process of economic development, the financial concomitants of an extensive government exploration program would strain their financial resources to the utmost. Any major commitment of pub- lic funds to the search for oil would have to be at the expense of other vital undertakings, and with the possibility that a large part of that investment might prove. futile. 25. The urge to better living standards is impelling among under- developed areas today. This means expansion of educational facilities and health services. It involves construction of housing and transport. And it requires industrial diversification, to increase productivity and raise national income. All these have to be done, and quickly -- the world being impatient for progress. But capital is scarce, and foreign exchange a continuing problem. -9- 26. Withal, development of national resources should play an im- portant role. Energy requirements are bound to mount rapidly in these areas. And for most countries, oil will have to supply the larger part of their needs. As an alternative to petroleum imports, indigenous production may hold out great promise. But the promise of exploration can be a siren's lure. If undertaken by government, it must inevitably be at the expense of other critical projects. Funds allocated for edu- cation, transportation, or a power plant would be securely invested. Funds allocated to the search for oil would be risked on uncertain ven- tures. 27. This certainly does not imply that a country need forego ex- ploration. Nor does it imply that government must never engage in exploration. Where prospects are favorable, there would be every rea- son for as extensive an oil search as possible, to be pressed as rapidly as possible. The basic question is how best to probe the country's re- source potential, then develop the reserves that may be discovered; and where government operations are determined upon as a matter of set pol- icy, what responsibilities a state enterprise can reasonably be expected to undertake. Problems under Government Monopoly 28. When the entire responsibility for national oil development is committed to a government oil entity, its operations are likely to be beset by chronic capital stringency. Typically, the government enter- prise will have been endowed with a patrimony -- an initial capitaliza- tion, valuable rights over public land and resources, and perhaps title to extant facilities. It may also be granted added financial support -- an annual stipend deriving from certain tax receipts, and the right to raise funds by borrowing. Given these, it is anticipated that the state oil entity will, in turn, pay specified taxes to the government and earn a return on the social capital that is being invested; and that funds for continuing development will be generated through operations. 29. But the large and continuing requirements of an oil program typically exceed the financial resources of a state enterprise. In consequence, government subvention is inevitably required. This takes many forms -- tax abatement, special loans, preferential exchange rates, and sometimes high price supports so as to augment revenues. All these, of course, are real costs, in that they have to be borne by the economy and represent the hypothecation of income that might have been allocated to other purposes. While the patrimony of a state enterprise is an ob- viously identifiable charge against the government's oil operations, indirect assistance tends to be concealed and is less frequently counted as a cost. Thus, it becomes difficult for the nation to evaluate the results of government oil operations against the resources committed. - 10 - 30. The experience of Petroleos Mexicanos (Pemex) is especially noteworthy in this respect. Having taken over a going industry, Pemex began with the advantages of established production and extant faci- lities. On the other hand, Pemex suffered the loss of export markets after expropriation; a heritage of low domestic product prices cut into its revenues; and it faced especially acute personnel and technological difficulties at a time when private industry was certainly not disposed to help it along. In course, it made substantial progress in building up oil and gas production and in expanding processing facilities. By the end of 1953, however, at the time when a major financial reorgani- zation was begun and domestic product prices were being raised, Pemex had incurred a substantial cumulative deficit; it was heavily in arrears on tax payments to the Mexican Government, and outstanding debt was some seven times its net worth. 31. Other countries that are unable to afford continuing financial support on a large scale have been forced to restrict drastically the scope of their government oil effort. This was the experience, for example, in Turkey until 1954, in Bolivia until 1955, and in Argentina until 1958, so long as the full burden of operations devolved on a state enterprise. In Chile, the Presidential Address to Congress on May 21 of this year referred with pride to the national petroleum industry, but suggested that it was a serious mistake to reject the assistance of foreign capital for the development of Chilean petroleum resources in view of the country's limited financial capabilities.* 32. Where the activities of a government oil entity extend into refining, or even marketing, difficult issues of policy are apt to arise. .A basic question involves the budgeting of capital expenditures as among exploration, production, and refining. Refining, because it promises visible results most quickly, tends to get priority. And as refining capacity is built up, the fastest possible development of local crude oil producibility in proven areas may be emphasized. Exploration, on the other hand, being riskier to begin with and not likely to yield any cash flow for a considerable time in any case, may then be starved for funds. 33. In Brazil, for instance, Petroleos Brasileros (Petrobras) has gone a long way toward building up refining capacity to meet national product requirements; and development has obviously been pushed in the producing fields of Bahia, possibly too rapidly in view of recent salt invasion. But its exploration effort has been limited, compared with the expanse of prospective area that remains to be explored. * Fortnightly Review, Bank of London and South America, Ltd., June 13, 1960, p. g01. 34. This does not imply a criticism of any government oil entity for its accent on refining and related operations. As a matter of fact, it is probably a political imperative for any state enterprise with lim- ited financial resources. But discovery of the nation's oil potential inevitably suffers when the oil search is restricted to a government oil entity which does not and probably cannot sustain an adequate explora- tion program. 35. There is also a closely related question as to local petroleum product prices. In come countries, national policy is directed toward low energy costs, at large or for preferred consuming groups. As a re- sult, operating income of the government oil entity would be adversely affected and its ability to generate funds for reinvestment impaired. This is most likely to be the case after substantial production has been established, or is taken over from private industry. In Mexico, the pri- vate oil industry had developed a sizable export trade, over and above domestic requirements. Internal prices, regulated by the Government, involved a considerable subsidization of local consumption. This pol- icy was continued after expropriation in 1938, and the burden of sub- sidy became progressively more onerous as Pemex's margin for export dwindled. The Government is now adjusting internal prices so as to im- prove the earning capacity of Pemex, along with a major reorganization of Pemex's financial structure. 36. Alternatively, income of the government oil entity may be de- liberately enhanced by a policy of high internal prices, particularly during early stages of development. These may be sustained through im- port restrictions and duties on crude and/or refined products originat- ing abroad. In the event, it is the economy as a whole that is subsi- dizing government oil operations through its energy costs. There may also be considerable incentive to perpetuate high internal prices. When the state has invested heavily in exploration and production, there is bound to be strong incentive to produce at capacity so as to provide a return on government investment. In consequence, local markets may be required to absorb this oil even though alternative supplies could be available at lower cost. So long as foreign exchange considerations are pressing, the advantages of such preference may counter-balance any in- creased costs. But state oil operations can thus lead to continuing re- straints and restrictions that deprive the country's energy sector of flexibility and result in perpetuation of a high-cost structure. Private Participation in National Oil Programs 37. In contrast with instances of government monopoly, many coun- tries have encouraged the participation of private capital. This re- flects a desire to enlarge the scope and speed the pace of local oil - 12 - development beyond what could reasonably be expected of a government oil entity itself. 38. For most developing countries, private participation would prob- ably mean foreign participation. Neither the technical resources nor the trained and experienced personnel for extensive oil operations are likely to be found within the country. And the volume of saving is too limited to provide a sufficient flow of local capital. Furthermore, local inves- tors are likely to be hesitant about committing funds in the risky busi- ness of exploration. On the other hand, established oil companies are constantly looking to expand and diversify production in order to meet growth in oil consumption. Existing operations generate internally a substantial part of the capital that has to be reinvested in the contin- uing search for new reserves. And wide experience with exploration in many parts of the world 'and under diverse geological conditions can be brought to bear in each new venture. Significantly, too, the interna- tional oil industry embraces a large and increasing number of firms from many countries that may be expected to compete aggressively in the search for oil. 39. The question of foreign investment may pose ideological or po- litical issues in some countries. But it is significant that many coun- tries have arrived at a modus operandi for such private participation; and are convinced that they have not thereby compromised either national or social objectives. ho. Effective cooperation between government and industry depends upon arrangements that are conducive to the interests of both. From the government point of view, diligence on the part of operating companies in exploration and in developing such reserves as are proven would be the foremost consideration. The state would then expect to benefit both from the oil that is locally produced and from tax revenues contributed by the industry. 41. From the standpoint of private industry, there would be essen- tial prerequisites to investment. These include foreknowledge of company obligations and rights during all phases of operations, security with respect to arrangements that are entered upon, and an expectation of fa- vorable returns if the venture is successful. Furthermore, where a gov- ernment oil entity and private enterprise operate side-by-side, incen- tives for investment would depend on non-discriminatory treatment of pri- vate capital. 42. Arrangements differ from country to country, reflecting the in- dividual political orientation and economic conditions of each. What stands out is the ability of private enterprise to accommodate opera- tions to national oil policy and contribute to national oil development when circumstances are favorable for investment. - 13 - 43. In some countries, vast tracts have been opened to exploration on the basis of concessions awarded in competitive bidding. Typically, the terms of concessions set standards of performance, along with tenure for reexploration and .exploitation- and provision for-periodi, relinqyli3h- ment of acreage. The state receives rental payments (and may win sub- stantial bonuses where prospects are unusually attractive), royalties on subsequent production, and income tax payments when profitable opera- tions are established. Guatemala and Libya are instances where virtually all exploration is being undertaken by private enterprise, a large num- ber of companies having embarked on extensive oil search under the countries' liberalized petroleum codes. Bolivia and Turkey are instances where selected acreage has been reserved to government operations, with private companies undertaking responsibility for exploration over other areas. It is noteworthy, too, that in the French Sahara where the early search was largely sponsored by various State organizations, the Govern- ment has encouraged private investment so as to achieve the most com- prehensive development of the area's potential. In each case, the scope of exploration that is provided by the participating companies goes far beyond what the country could possibly undertake on its own. 44. In other countries, private participation is sought through contractual arrangements with the government oil entity. In Colombia, for example, where both state and private operations are underway, Em- presa Colombiana de Petroleos (Ecopetrol) has engaged private companies to work a large part of its producing area, including secondary recovery operations, and to conduct further exploration. Payment is in the form of a share in production, so that costs are in effect covered by proceeds from operations. In Argentina, where the constitution provides that oil resources are the inalienable property of the State, the Government has turned to contracts with private companies as a means both of broaden- ing the scope of exploration and speeding the pace of oil development. In proven areas, drilling by Yacimientos Petroliferos Fiscales (YPF) is augmented by contracting out additional wells to a large number of firms. Exploration and development of extensive areas are also being undertaken by private operators under arrangements whereby they advance the costs and bear the risks, with payment contingent upon successful establish- ment of production and provided for out of the value of oil that is sub- sequently recovered. 45. Still other arrangements set up joint operations between govern- ment and private enterprise. In Iran, for instance, the private part- ners in such joint ventures with the state entity advance the costs of exploration and carry the risks of failure. If the oil search proves successful, they will be reimbursed for previous investment, the National Iranian Oil Company (NIOC) and companies sharing equally there- after in the costs of development and in the profits on production -- with the companies further subject to a 50-per cent tax on their share - 14 - of profits. Elsewhere, there are instances where government shares in costs (and risk) as well as in profits; and where government has an op- tion to take on an interest if the venture proves successful. Details vary, in large part according to the presumed potentialities of indivi- dual undertakings. It should also be noted that joint ventures may have different implications, depending on whether production is consumed internally or moves into export -- and we do not consider here the po- tential problems that may arise for such export operations, particularly during a period of world oil surplus. 46. While the form of private operations differs from country to country, it is apparent that private enterprise can make a major con- tribution to national oil development. Private enterprise then bears the risks of failure that are inherent in exploration. Essential capital is made available. A country is thus relieved of the burden of investment; in effect, it covers amortization and the return on investment over time in the price of its oil supplies. Foreign exchange requirements are largely subsumed in the course of private investment. If operations are suc- cessful, foreign exchange savings from the replacement of imports by indigenous production would more than cover any repatriation of industry profits (or even such capital as is not reinvested). Experience, methods, and equipment developed in the course of far-flung operations are brought into a country's oil program. And diversification of judgment provides greater promise of success. In sum, the scope of oil operations within the country is extended and the pace stepped up through private operations, far beyond what most countries could possibly undertake on their own. 47. For any country looking to its oil potential, the critical problem is how to mobilize the financial and technical resources now so as to develop its petroleum resources for the future. To vest oil development in a government monopoly would mean risking scarce capital, and would inevitably limit the national oil effort, even if results were favorable. Where a country is determined upon state operations as a matter of national policy, these could be undertaken on a scale commensurate with the financial and technological capabilities of the - 15 - government oil entity, and within the compass of an overall oil program. Private enterprise, on the other hand, could provide the breadth to oil operations that is so essential for successful development. - 16 - CHAPTER II THE NATURE OF OIL EXPLORATION - 17 - CHAPTER II THE NATURE OF OIL EXPLORATION 1. It is the very nature of oil operations that sets the problem. To begin with, results of exploration are inevitably uncertain. At the same time, initial capital requirements are large. Thus, heavy finan- cial outlays are incurred at considerable risk. Beyond these, very substantial and continuing investment is required if oil is found -- first, to develop production; then, to replace reserves as they are drawn down; and further, to expand reserves and facilities to keep pace with mounting oil requirements. In consequence, even a successful oil effort is likely to involve a prolonged cash drain before current re- venues from production begin to cover current expenditures. Inherent Problems 2. These being inherent in the search for oil, they must be faced up to in the course of any exploration program -- whether by private enterprise or government entity. In the sections following, we draw upon the experience of private oil operations by way of illustration. In course, the role of the international oil industry emerges: Bearing the risks of exploration; Providing technical competence coupled with diversified judgments; and Financing capital requirements, in large measure out of reinvested earnings. We then turn in the next chapter to the implications for government oil operations. Risk and lncertaintv 3. Oil exploration is an undertaking that requires costly effort, but promises uncertain rewards. At the outset, the geologist can seek out likely source beds. From a study of the earth's formation and a reconstruction of geological history, he must judge whether these would have been conducive to the creation and accumulation of oil. The geo- physicist can test gravitational force, the transmission of shock waves, and electrical resistivity to judge the nature of structures buried far below the surface. But even with the most advanced techniques and pro- fessional competence, the most that can be said is that oil-bearing conditions would seem to be present in an area. Thereafter, the drill must probe from selected locations to specified depths; and many wells may have to be completed before oil is found, or the search is abandoned. 4. The record is marked with evidence of the uncertainty that ac- companies the search for oil. Persistent and costly exploration, backed up by advanced technical skills and proven managerial competence, has been carried out in promising areas, and turned out futile. In Ecuador, two major oil companies pursued the search from 1938 to 1950, when operatibns were suspended without success. In the interim, $47 million had been spent on their exploration efforts. In Peru, some 12 companies obtained exploration rights in the Sechura Desert under the 1952 petroleum law. Between 1953 and 1956, 22 wells were drilled at an estimated cost of $20 million, but no commercial production was established. In the Eastern Hemisphere, in Denmark one company drilled six dry holes and spent almost $10 million in an unsuccess- ful search for oil that ended in 1954. Nevertheless, in early 1957 another company began a $5 million drilling program in that country. Prolific structures have gone undisturbed for years until one group ventured where others had passed by. A leading producing company in the Middle East gave up the first opportunity for a concession in Kuwait, on the judgment that prospects were not especially favorable, Kuwait subsequently turning out to be the most prolific oil area in the Persian Gulf. East Texas was poorly regarded by most of the leading oil companies in the United States until an independent opera- tor stepped in and completed an unusually productive wild- cat. And there have been instances of striking success in areas that had been worked over previously and then abandoned. But for every Burghan, Ghawar, or Agha Jari there are many more determined efforts that result only in dry holes. - 19 - AUSTRALIAN OIL REQUIREMvENTS AND DRILLING ACTIVITY, 1951-1959 Oil Requirements (Thousands of Barrels Daily). Wells Drilled 1959 211.3 36a 1958 195.7 18 1957 185.4 ... 1956 178.1 28 1955 157.1 36 1954 133.3 5 1953 118.4 2 1952 114.8 ... 1951 116.3 3 a Estimated. Sources: World Oil; Petroleum Information Bureau (Australia). 5. The case of Australia (and Papua) is particularly indicative. Oil requirements have been rising rapidly (see table above). At present crude and product imports come to around 230,000 barrels daily, at a cost of about $220 million per year.* To aid in the search for indige- nous oil, the Government is underwriting drilling costs of approved stratigraphic and "off-structure" wells, geophysical surveys and related activities up to a total of about $4.5 million annually. In addition, the Government gives Australian residents, including companies con- trolled abroad, full remission of tax on any income invested in ex- ploration. 6. By itself, the record of past exploration is far from en- couraging. One company, drilling in Western Australia several years ago, found oil in its first exploratory well. Ten addi- tional wells were drilled in the same geological trend at a cost of around $10 million; all were dry. Unable to establish production in commercial quantities, the company had to consider these expenditures as a loss. The same company went on to drill another 14 wells in Western * Of this, roughly 24,000 barrels daily represents crude imports re- fined in Australia for re-export abroad; from mid-1958 to mid-1959 these exports were valued at about $36 million. - 20 - Australia through mid-1958. In all, some At40 million was spent without success. Another three companies have carried on joint exploration in Papua for some 22 years, at a cost of 070 million, with only a few scattered oil shows resulting. One of the part- ners has recently suspended operations; the other two are continuing to drill, however. Results have been equally disappointing for other companies. All told, more than $140 million has been spent on exploration in Australia and Papua, as yet without positive results. 7. Despite past failures, however, individual companies continue to see prospects that warrant the risk. Currently, 35 different con- cerns, including many foreign companies, sometimes in partnership with local firms, are engaged in the oil search; and a strong resurgence of drilling activity is underway. It has been estimated by the Government that nearly $22.5 million will be spent on exploration in 1960. 8. Thus, there is inevitable risk involved in any exploration program. For given geological conditions, the chances of discovering oil will depend on how the search is carried forward. Scientific and technological strides are constantly being made in the course of exploration in various parts of the world. These can contribute significantly to the effect- iveness of the oil search, provided that advanced tech- niques are brought to bear. Equipment and methods, however, are only as good as the men who put them to use. Trained personnel are thus required in a wide range of skills -- with actual ex- perience being of greatest importance. With these, the more varied the perspectives and opinions that are given play, the greater the assurance of success. In sum, an impressive combination of science and its machines, of men and their experience, and of diversified judgments is essential in the exploration for oil. 9. These factors do not lend themselves to easy documentation. And in contrast, the financial requirements of oil exploration can be detailed at length (as in the sections following). Nonetheless, they must be recognized as basic to any successful oil program. - 21 - Capital Investment to Establish Production 10. A rough idea of the investment required in oil operations can be gotten from figures compiled by the Chase Manhattan Bank.* At the end of 1955, for examxple, net investment in property, plant and equip- ment of the petroleum industry outside the United States and Soviet bloc was estimated at $12.8 billion. By the end of 1958, investment had grown to $22.6 billion. In three years, net additions to capital had aggregated almost $10 billion. 11. These figures cover the range of industry activity, from ex- ploration and production through refining, transport and marketing. Fcr exploration and production alone, net investment rose from $3.4 billion in 1955 to $7.0 billion in 1958 -- an increase of P3.6 billion, account- ing for some 36 per cent of total net investment by the oil industry in the three-year period. 12. Setting these additions to net investment against the build-up in production, we can get an approximation of the average cost of find- ing and developing a barrel of crude oil.";'- World production (again outside the United States and Soviet bloc) rose from 6.8 million bar- rels daily in 1955 to 8.8 million barrels per day in 1958 -- an increase of 2 million'barrels per day. Thus, expenditures to establish produc- tion average out at some $1,800 per barrel per day.;."-;'- 13. These figures, of course, subsume widely different experiences among regions and countries. The average encompasses a substantial build-up of production from prolific proved reserves in the Middle East, where relatively small additional investment may have been required. On the other hand, it also encompasses expenditures in widely scattered parts of the world where no production at all was forthcoming. Even within a country or geographical area, results can vary widely. The fig- ures'are useful, therefore, only as an indication of the magnitude of in- vestment involved in establishing and expanding crude oil production. Obviously, they cannot be used as a measure of potential capital costs in any country's exploration program, where its oiwn unique geogolical con- ditions (and the play of chance) will govern. * The special problem of foreign exchange costs involved in a countryts exploration effort we defer for later consideration. ** Additions to net investment do not, of course, include those expend- itures, in particular the cost of drilling dry holes, which are ex- pensed against current income rather than capitalized. **e- Additional expenditures for refining, transport and marketing facil- ities amounted to $3,100 per barrel per day. - 22 - Colombia 14. The experience of Colombia provides a useful illustration of the capital outlays involved in establishing a significant volume of production. In recent years, the oil search in Colombia has begun to yield substantial results in terms of proved reserves and crude oil producibility. (See table below.) COLOMBIAN CRUDE RESERVES AND PRODUCTION, 1950-1959 Year-End Reserves Production (Millions of (Thousands of Barrels Daily Years' Barrels) Total Private Statea Supply 1959 750 147 120 27 14 1958 700 128 99 29 15 1957 650 125 95 30 14 1956 650 121 90 31 15 1955 580 108 76 32 15 1954 570 111 78 33 14 1953 550 110 74 36 14 1952 470 106 68 38 12 1951 450 105 66 39 12 1950 400 93 93 ... 12 a Government production began in 1951 upon the automatic reversion to the State of a privately-held concession at the end of its 30-year life. Sources: World Oil; Petroleum Press Service. In 1950, reserves were estimated at 400 million barrels, and supported production of 93,000 barrels daily by the several companies operating there. In 1951, a privately-held concession reached its 30-year ter- mination and reverted to the State. Total production of 105,000 bar- rels daily was thus divided between private operations (66,000 barrels daily) and government (39,000 barrels daily). In the years following, - 23 - government production gradually tapered off.- Private development, meanwhile, provided an 87-per cent build-up of reserves, to 750 mil- lion barrels in 1959; and an 82-per cent increase in production, to 120,000 barrels per day. 15. Underlying these broad results was a very large capital in- vestment by the several companies -- reflecting individual judgments with varying degrees of success. One major oil company spent at least $76 million through 1955 on exploration in areas which yielded production of only 500 barrels daily. Since 1955, the same company has invested an additional $25 million without finding a commercial discovery. In the more successful Barco operations, scme $60 million were spent over a period of 13 years, during which time approximately 100 wells were drilled before the first oil was produced for sale. In the nearly four decades from the start of commercial production in Colombia in 1921 to 1957, crude oil output aggregated some 790 million barrels. Net additions to reserves amounted to 650 million barrels. During the same period, it is estimated that oil companies spent more than $950 million on exploration and production -- more than one- quarter of which has not yet been recovered. Expenditures in Nigeria 16. The case of Nigeria is another example of the capital re- quirements of a successful oil exploration program. One operator, a Shell-BP combine, has spent $168 million on exploration since initiat- ing operations just prior to World War II; $50 million of this was ex- pended in 1959. The first commercially-producible oil was discovered in 1956 and production began on a very limited scale in 1958. Oil out- put is expected to climb to about 35,000 barrels daily this year, and to perhaps 90,000 barrels per day by the mid-1960's. But at best, the company does not expect yearly cash receipts to cover cash expenditures before 1964. And, according to company estimates, it will be during the 1970's at the earliest before the accumulated deficit can be wiped out. * A large portion of the producing area that reverted to the State is now worked by private companies with whom Ecopetrol (the government oil entity) has contracted to undertake secondary recovery operations and to conduct further exploration and development; payments to the operators takes the form of a share in production. - 24 - Continuing Financial Requirements 17. The risks that are inherent in exploration for oil and the very large capital investments that are normally required to establish production both stand out in the record. What is less commonly ap- preciated is the fact that substantial outlays must be maintained after a commercial discovery has been achieved. This continuing investment has to create the facilities -- wells, gathering lines, storage tanks, etc. -- through which production potential can be realized.- It has to finance the exploration program by which reserves are replaced -- in order to sustain current production. Finally, it has to provide a pro- gressive expansion in reserves and facilities -- if production opera- tions are to remain viable and grow along with the rising trend of oil requirements.- ** 18. In consequence, the successful oil effort is likely to in- volve a prolonged cash drain, before current revenues from production begin to cover current expenditures. Only in the case of a really pro- lific find can it be anticipated that the cash flow from production will exceed expenditures in the short run. 19. This rather striking fact is illustrated in the experience of relatively young producing regions where exploration has been suc- - Development costs are typically large, even set against the huge outlays incurred in early exploration; and may actually exceed ex- ploration costs as operations are expanded. In Canada, for example, outlays for development were around 50 per cent of exploration costs during the 12 years following the Leduc discovery in 1946. (See below.) In the United States, where oil operations are more mature, development costs of all oil and gas producing companies were estimated at $2.6 billion in 1956 as against exploration costs of $2.3 billion. The same has held true in other years for which data are available. C.f., Joint Survey of the American Petroleum Institute, Independent Petroleum Association of America and Mid- Continent Oil and Gas Association. The need for sustained investment is not a problem peculiar to the oil industry. Indeed, it characterizes any capital-intens.e opera- tion. What is unique to oil is the accompanying element of risk which lasts throughout the life of the enterprise. Even so-called "development" drilling to exploit "proven" reserves may result in a proliferation of dry holes. And the continual need to extend the resource base through the search for oil in new pools and new areas may involve as much uncertainty as the initial exploration effort. - 25 - cessful, and has been accompanied by a build-up of reserves and of out- put. Producing operations in such regions can be favorably regarded. Yet the comoanies involved have had to sustain substantial cash deficits for a considerable span of years, and production revenues are still falling short of current outlays. Rocky Mountain Area 20. The Rocky Mountain area of the United States, for example, is a relativelyi new producing region that has witnessed significant growth in the postwar period. At the war's end, proved reserves were estimated at slightly under one billion barrels. Since then, intensified explora- tion has been carried on by a large number of companies over an exten- sive area embracing nine states.* In course, gross additions to re- serves came to some 3.3 billion barrels by 1957. 21. At the same time, productive capacity of the area was being rapidly developed. In 1947, production amounted to 189,000 barrels per dal?, with reserves constituting about 15 y-ears' supply at the current rate of output. By 1957, production had been built up to 630,000 bar- rels dnily, with reserves constituting abcut 12 years' supply. Re- serve-to-production ratios fluctuated within a range of 11 to 16 years over the period, depending on the vagaries of year-end reserve esti- mates and the 77eqr-to-year pace of production. On the whole, there was a slight downward trend in the reserve ratio. (See Table B-1 ap- pended.) Meanwhile, the average rate of gain in production was 12.8 per cent per year. 22. Thus, the very substantial success of an extensive and di- versified exoloration effort was being converted into actual production in quick time. Under the circumstances, the value of crude oil (and natural gas) output was bound to advance sharply. In 19L7, value of production came to 310.8 million; by 1S57, it had mounted to 580 mil- lion. Over the eleven years, value of production totalled $3,282 mil- lion. 23. At the same time, however, costs of exploration and develop- ment were huge. The search for oil had to be continuously pressed, in order to replace the reserves drawn dowJn in the course of production and to build up the resource base so it could sustain a rising trend in output. Of the 3.3 billion barrels gross additions to reserves, 1.5 billion barrels were required merely to offset current withdrawals; - Colorado, Idaho, Montana, Nevada, North Dakota, South Dakota, Utah, Wyoming and part of western Nebraska. - 26 - ROCKY MOUNTAIN AREA ESTIMATED CASH EXPENDITURES AND INCOME, 1947-1957 Millions of Dollars Value of Production 3 282 Crude oil 3 Natural gas 113 Cash Expenses 1),250 Cash Position -968 Source: Appendix Table B-2. 1.8 billion barrels constituted net additions to reserves and supported the expansion in producibility. Further, the favorable results of ex- ploration required substantial outlays in order to develop productive potential. 24. Reflecting these, cash outlays of the companies operating in the Rocky Mountain area rose from $96 million in 1947 to $666 million in 1957, and aggregated $4,250 million for the period. Significantly, cash outlays actually exceeded the value of oil and natural gas produc- tion by almost one billion dollars over the years. (See above and Table B-2 appended.) What is noteworthy here is that a cash deficit position has occurred and persisted in the course of oil operations that have been in fact unusually successful. In time, the funds generated by current production will begin to cover current expenses, and then yield a surplus; but it is manifest that exploration and development outlays can exceed the value of current production for a prolonged period. Canadian Oil Industry 25. The record of Canadian oil development presents much the same picture. Comprehensive reserve estimates are not available before l°5o, but in that year reserves were estimated at 1.2 billion barrels. In the seven years following the widespread oil search by a host of companies, large and small, resulted in gross additions to reserves of 3.4 billion barrels. Of these, 1.1 billion barrels offset with- drawals; 2.3 billion barrels constituted a net addition to reserves, which aggregated 3.5 billion barrels by the end of 1959. - 27 - CANADIAN PETROLEUM INDUSTRY ESTIMATED EXPENDITURES AND INCOME, 1947-1958 Millions of Dollars Value of Production 2,551 less Royalty Payments 321 Cash Income 2,230 Exploration Costs 2,216 Development Costs 1,147 Production Expenses 510 Total Outlays 3,874 Cash Position -1,643 Source: Appendix Table B-4. 26. Meanwhile, production was being rapidly expanded, from 130,000 barrels per day in 1951 to 510,000 barrels daily in 1959. The average rate of growth in production came to 18.6 per cent per year. In course, the reserve-to-production ratio was drawn down from 29 years' supply in 1950 to 19 years in 1959. (See Table B-3 appended.) Thus, the Canadian oil industry experienced a period of rapid growth follow- ing the initial major discovery at Leduc in 1946. 27. The financial concomitants of this growth are documented by the Canadian Petroleum Association. Cash income -- the value of oil and natural gas production less royalty payments -- rose rapidly as operations expanded, from $18 million in 1947 when commercial output was just beginning to $369 million in 1958. For the 12 years, cash in- come aggregated $2,230 million. 28. At the same time, however, the industry's cash outlays con- sistently ran ahead of its cash income. (See above and Table 3-4 ap- pended.) In the earlier years (1948-1954) when the oil search was still in its early stages and discovery of reserves was a first concern, annual exploration costs alone exceeded the cash receipts from opera- tions. Subsequently, exploration costs continued to rise, to replace the reserves that were being drawn and to add further to the reserve base that was required to support a rising trend in production. 29. Meanwhile, annual development costs were also mounting, to establish the increased producibility. Thus, the combination of ex- ploration and development costs, together with production expenses, kept total cash outlays well ahead of cash income. Over these 12 years of Canadian oil operations, exploration costs amounted to $2,216 million. - 28 - Development costs came to $1,147 million -- half again as much as was spent on the oil search itself. Production expenses were 510 million. Together, these outlays of $3,874 million exceeded cash income by $1,643 million. 30. Nor has the industry's annual cash deficit been eliminated as yet. Projections for the ensuing five years indicate that the ex- cess of expenditures over receipts will persist through 1962.* By then, the cumulative deficit will have mounted to around 'W"2 billion. Only in 1963 -- more than 15 years after the beginning of Canada's major oil development -- is the industry as a whole likely to realize a cash surplus for the first time. Many more years will elapse before the accumulated deficit of past years will be recovered. 31. In sum, the Canadian experience, like that of the Rocky Mountain area, provides a dramatic illustration of the continuing financial requirements that are involved in the subsequent develop- ment of a successful exploration effort. Initial investment in the oil search must be multiplied many times; thus, a cash drain may per- sist over a prolonged period, before income from operations begins to cover the necessary cash outlays. Results of Maturing Oil Operations 32. As oil operations mature, proceeds from production can be expected to cover the industry's expenditures and yield a cash surplus. Even then, however, the cash throw-off is likely to be modest compared with either the total value of production or the magnitude of continu- ing expenditures.x-* 33. This is illustrated in the experience of the U.S. oil and gas producing industry. In the postwar period, crude oil production advanced at the rate of slightly better than 4 per cent per year. Gross additions to reserves have served to hold the nation's reserve- - These projections include the anticipated income from proposed gas exports, as well as somewhat higher development and utilization costs associated with stepped-up gas production. In the case of prolific oil-bearing areas -- where production costs are low and replacement of reserves is not a problem -- the situa- tion would, of course, be different. A substantial cash surplus may then be realized comparatively soon. - 29 - to-production ratio at around 12 y-ears' supply.' Natural gas produc- tion advanced at about twice the rate of crude oil production. But this rapid expansion in natural gas output has been supported by a considerable drawing down of previously-established reserves, so that the reserve-to-production ratio has declined from over 30 years' sup- ply at the war's end to around 22 -ears at present. 34. The cash flow position of the U.S. petroleum industry can best be appreciated against this background. Comprehensive estimates of outlays and income for the industry as a whole are available for selected years, the most recent being 1956.,- 35. Exploration expenditures in the United States amounted to around $2,325 million in 1956. Development costs were even larger, t.2,648 million. Together, these outlays summed to 44,973 million. The value of oil and gas production came to $7,320 million. With pro- duction costs of 'ii2,030, the cash income of the industry as a whole was $5,290. The difference between outlays and income thus amounted to a cash surplus of $317 million -- equivalent to 6 per cent of cash income and around 6.5 per cent of exploration and development expendi- tures. 36. Much the same picture is presented if one turns to a source- and-use analysis of company accounts. Data are available covering the operations of 25 U.S. oil companies for the period 1948-1959.**, In the twelve years, additions to gross investment of these companies amounted to el8.6 billion. (This excludes sizable expenditures on ex- ploration, such as the cost of dry holes, that were charged off as ex- penses.) Internal sources included i12.4 billion of depreciation al- lowances and $10.9 billion net income, for a total of $23.3 billion. Thus, internally generated funds exceeded capital outlays by -4.7 bil- lion. Significantly, gross income of the 25 companies aggregated +120.6 billion over the years, so that the excess of internal funds over capital requirements amounted to less than 4 percent of gross income. * Gross additions to reserves include revisions of earlier reserve estimates and extensions of established fields, as well as new discoveries. Joint Survey of the American Petroleum Institute, Independent Petroleum Association of America and Mid-Continent Oil and Gas Association. See Table B-5 appended for details, and data for earlier years. The group includes both independent producing companies and in- tegrated producer-refiners. Major international companies are ex- cluded, since their foreign and domestic operations cannot be segregated in sufficient detail. See Table B-6 appended. - 30 - 37. The experience embodied in these figures on the cash flow and source and use of funds for the U.S. oil industry points up sharply the continuing financial requirements associated with even well-estab- lished production operations. Where the industry is attempting to keep pace with expanding oil requirements, exploration and development ex- penditures will be in a rising trend. As noted earlier, the rising trend in outlays is likely to be especially marked over a considerable period during the early years of development, exceeding the cash re- ceipts from current production. As the ind-ustry matures, funds gene- rated in the course of operations may be expected to cover annual out- lays, but the margin of surplus is likely to be modest until the pace of expansion begins to fall off and the industry moves toward liquid- ation of previously proven reserves. 38. There is, of course, no implication to be drawn from these figures on the flow of funds as to the profitability of the oil opera- tions. The rising trend in expenditures is obviously directed toward increasing subsequent production, with the expectation that future re- turns will yield an acceptible margin on the investment that is being made. What is significant are the pervasive financial demands that are incurred in the development of oil production. 39. The preceding sections have drawn on experiences from many parts of the world -- where wildcat operations are pursued in the hope of discovering new oil sources; where the productive potential of newly-established petroleum reserves is being developed; and where a viable industry is engaged in maintaining and expanding its resource base and increasing its producibility to meet future requirements. They illustrate the problems inherent in oil exploration and develop- ment: The risk involved in a search for oil; The technology, skill and experience, and diversity of judgment that together increase the chances of success; The heavy initial investment that must be incurred; and Where exploration is successful and development proceeds, the continuing financial requirements to develop, maintain, and expand production -- which can result in a cash deficit for a prolonged period, and which is likely to absorb the larger part of funds generated in the course of operations even after production is well established. As noted earlier, these are problems common to oil operations, and would have to be faced in course of an oil program whether undertaken by pri- - 31 - vate enterprise or government entity. Against this background, we consider, in the sections following, the operations of private enter- prise. We then turn, in the next chapter, to the implications for government operations. Role of Private Enterprise Bearing the Risk 4o. A basic function of private enterprise in undertaking in- vestment is that it bears the risk of failure, while anticipating the rewards of success. Nowhere is this so clear-cut as in the search for oil. As noted previously, the whole history of the oil industry -- embracing a hundred years of exploratory efforts, and ranging from the Western to the Eastern Hemisphere, from the Arctic to the Tropics -- attests to the willingness of individual companies to commit huge sums in uncertain ventures, provided that there is promise of oil and pro- vided that the economic and political climate is conducive to invest- ment. Thus, the business of exploration goes on in the face of uncer- tainty. Should efforts prove futile, the investor expects to have to bear the costs. 'Where efforts come to fruition, the private company hopes that the returns will compensate for the money invested, the period of waiting, and the risks incurred. 41. Since uncertainty is inherent in the search for oil, and the incidence of failure is high relative to success, the rate of re- turn -- on the average and over time -- must provide the inducement for continuing capital investment. But the profit expectations that underlie exploration in far-flung corners of the globe are not based on a single judgment or even a consensus. In each instance they re- flect an individual company's evaluation of oil-bearing potential and production prospects. Thus, the world-wide explorations of the inter- national petroleum industry encompass the individual decisions of a large and growing number of firms. 42. Competition within the industry provides the spur to the search for oil. A continuously rising trend in consumption requires that new oil resources be found and developed. And in anticimation each company within the industry must seek to protect the adequacy and distribution of its reserves and productive potential. This competi- tion for position underlies the industry's willingness to assume the risks of exploration. What is -more, it brings into play two factors that are essential to a successful search for oil -- diversification of judgment based on individual decisions and technical competence drawn from wide experience. - 32 - 43. The first, diversification of judgment, is essential if prospects are not to be rejected or pursued on the basis of a single evaluation, especially since evaluation of oil-bearing potential rests on so many geological and geophysical considerations, each subject to a multitude of interpretations. It is the very multiplicity of judg- ments within the oil industry that provides the broad scope and in- tensive effort entering into world exploration. 44. The second, technical competence, reflects the training and experience that is built up only in the course of repeated operations in many areas and under all possible conditions. World-wide operations of the petroleum industry add up to a technical encyclopedia, whose "learning" is carried over to exploratory ventures wherever they are undertaken by the many companies making up the industry. Past failures, as well as successes, have contributed to that fund of knowledge; and each new area that is opened to exploration benefits from previous ex- perience. There may be no way of assessing the cost of that experience or placing a value on it; bDut it is obvious that the effectiveness of the oil search that is being carried on in the far reaches of the world depends in large part on technical competence that the industry has de- veloped over a considerable length of time and in the course of exten- sive exploratory efforts, with access to and continued contacts with world-wide developments. 45. Many instances can be cited by way of illustration. The ones noted below pertain to countries that have only recently been opened to exploration by private enterprise. Previously, restrictive legislation in these countries had effectively deterred private operations. Sub- sequently, the countries' petroleum codes were liberalized with a view toward encouraging private investment and stimulating the pace of the oil search. In noting these cases, we do not here attach any signifi- cance to the specific terms of the legislation that has been adopted. Chapter IV will deal extensively; with the many and diverse ways in which private operations are now being carried on in accordance with national oil policies. What is significant is the entry of private firms, subsuming the risks of exploration, providing the basis for an extensive oil search, and applying all kinds of technical competence in the effort, as supported by continual contact with progress made anywhere in the world. The contribution of private enterprise in these cases has to be measured according to the investment and physical ef- fort being made; it is probably too soon to appraise final results in terms of oil discovered or reserves proved up. - 33 - Guatemala 46. Until recently, the oil potential of Guatemala, a country of 42,000 square miles, had received but scant attention. Some pre- liminary exploratory work was carried out in the late Thirties and in the early postwar period. But in 1949 Guatemala decreed that 60 per cent of the capital in oil ventures within the country had to be Guatemalan; the international oil companies, considering this to be an impracticable condition, withdrew. 47. Exploration was virtually at a standstill in the early 1950's. Then, in 1955, Guatemala turned to a new policy that was more conducive to foreign investment as a means of reviving oil operations. Under the new petroleum code, a company may obtain an exploration concession that covers up to one million acres. The exploration concession is valid for 6 to 10 years. Surface fees are set, and minimum annual expenditures on exploration are required. Upon discovery of oil, an exploration concession may be automatically converted to exploitation status, but production rights are limited to 500,000 acres. Such rights extend for 40 years, with one 20-year extension. Once production rights are granted, output must begin within three years. 43. Fiscal provisions of the 1955 law call for payment of sur- face fees on acreage under concession, royalties on production, and an income tax -- together adding up to not less than 50 per cent of a company's net income. Deoletion allowances may be taken on a cost or a percentage basis. If the latter, depletion is limited to 27 per cent of gross income after royalties, up to 50 per cent of net income (before depletion). 49. Response to the new law was immediate. In fact, many over- lapping applications were received and considerable negotiation was required before leases were assigned. Eighteen companies were awarded exploration leases in 1956; another eight, in 1957-1958. By mid-1959, concessions had been granted to more than 30 companies. Together, these concessions cover more than 11 1/2 million acres, or two-fifths of the national territory. The area being explored embraces virtually all of the northern province of Peten, bordering on Mexico and British Honduras, together with coastal and off-shore acreage along the Carib- bean. 50. The concessionary regions, particularly in the north, are densely wooded jungle areas with few roads. A six-month rainy season further complicates the problems of exploration. Nevertheless, the oil search has been pressed forward. In 1957, fifteen operators jointly sponsored an aerial magnetometer survey covering 10 million acres. - 34 - Subsequently, most have carried out geological and geophysical surveys in their own concessions. The first wildcat well was drilled about 25 miles from the Caribbean coast in January 1958. In December 1959, a second company spudded a well along the coast. Four more companies be- gan drilling in 1959. One well has encountered a show of oil thus far. 51. It is estimated that altogether some $20 million was spent by oil companies in Guatemala in 1957-1958 and perhaps an additional $12 million in 1959. Obviously, an even higher rate of expenditures will have to be incurred before the country's oil ootential is fully explored. Results up to now have been somewhat disappointing, and individual com- panies may well reconsider their exploration programs as a result. Nevertheless, while the sums thus far invested in Guatemalan oil explo- ration are not unusually large, compared with outlays that have been incurred elsewhere or with what may yet be spent in Guatemala, it is noteworthy that oil company expenditures in 1957-1958 amounted to more than 10 per cent of the Government income from all sources. Thus a major exploration program was launched -- on a scale considerably beyond the countryts own financial resources. The capital requirements (and foreign exchange) being provided by the various private companies, the risk of failure is theirs alone. Meanwhile, the equipment, methods and experience that are brought to the oil search and the diversification of judgment in pursuing it are of incalculable value in probing the nation's oil potential. Turkey 52. According to Turkey's Institute of Mineral Research and Ex- ploration, the country has over 46,ooo square miles of sedimentary area (including the present producing areas) that are regarded as highly favorable to the discovery of oil, and another 63,000 square miles c:? generally favorable sedimentary conditions. These compare with a total national area of 296,000 square miles. 53. The search for oil in Turkey began in 1933 with the estab- lishment of the Petroleum Exploration and Exploitation Administration, a state agency. The first well was spudded a year later. In 1935 govern- ment oil operations were reorganized under the Mineral Research and Ex- ploration Institute (MTA), which was responsible for state oil activity until 1954.* * A Government agency, Petrol Ofisi, distributes petroleum products along with private marketing companies. It accounts for about one- third of total volume; its product requirements have been met by im- ports under long-term arrangements with a private supplier. - 35 - 54. Between 1935 and 1954, MTA spent about 420-24 million on oil exploration. (It may be noted that outlays over the 20 years were about the same as private investment in Guatemala in the first two years of operations, while the area involved in Guatemala was only about two-fifths of that regarded as most favorable in Turkey.) Geological surveys were undertaken. Wells were drilled in several promising areas; and some oil was discovered in southeastern Turkey near the Syrian border -- at Raman in 1940 and Garzan in 1950. In all, an es- timated 65 million barrels of reserves were proved by 1954. Produc- tive capacity was built up to around 6,000 barrels daily. However, output did not exceed 1,000 barrels daily (all from the Raman field) because of inadequate refining and transport facilities.* 55. Meanwhile, population growth coupled with postwar indus- trial development was leading to sharp gains in oil consumption. By 1954 demand was 20,000 barrels per day. Refined product imports were required to meet virtually all of this dema'nd, at a cost of about o40 million. This drain on scarce foreign exchange holdings, together with urgently needed imports of machinery, posed a serious problem, and one which threatened to become progressively worse as petroleum demand mounted. 56. The need for a more rapid and efficient investigation of Turkey's oil potential thus became evident. In the words of a later Government bulletin: 8- the rate of progress in this field was very slow because of the impossibility of meeting with a limited budget the requirements of exploration, calling for large investments, obtaining experienced workers, and importation of special material, etc In 1952, the Government announced its decision to encourage private initiative and investment. To this end, a liberal petroleum code was drafted and adopted in 1954. 57. As amended in 1955 and 1957, Turkey's petroleum law provides for a 6-10 year exploration period, with drilling to begin within five years and to proceed with due diligence. Half the acreage must be sur- rendered on conversion to production status. Exploitation leases are granted for 40 years, with one 20-year renewal permitted. Drilling In 1954, Turkey had only a single refinery of 1,400-barrels daily capacity, operated by MTA. **- Turkish State Petroleum Administration, Bulletin No. 1, "Petroleum Law and 1956 Petroleum Activities in Turkey," p. 5. - 36 - must begin within six months and commercial production within three years. A company is limited to a single lease of 375,000 acres in any of the nation's nine established districts. Fiscal provisions call for a 50:50 sharing of profits between company and government, with a de- pletion allowance equal to 27 1/2 per cent of gross income up to 50 per cent of net income. 58. In anticipation of the new law, four companies began prelim- inary geological investigation in 1953. Upon enactment of the law, these were joined by three more in taking out exploration permits. The following year, applications were accepted for exploitation leases. Twelve companies were granted concessions, largely in southeastern Turkey, but also in Thrace and elsewhere. Additional awards followed. By the end of 1959, 20 companies held leases on some 40,000 square miles. After considerable preliminary work, the first company well was drilled in late 1956. Since then, more than 40 additional explor- atory wells have been completed at a cost of about M70 million. The first successful well was completed in July 1960. It has been fol- lowed by a favorable stepout completion and a second wildcat strike elsewhere. 59. Meanwhile, state oil operations were reorganized. MTA was replaced by a joint stock company, Turkish National Petroleum Company (TPA0), owned 51 per cent by the Government and the rest by private Turkish business interests. TPAO took over the Raman and Garzan fields and the Batman refinery. The refinery's capacity was expanded at a cost of around $7 million to 7,000 barrels daily, and this pennitted expansion in output from the producing fields, including initial pro- duction from Garzan. Drilling was stepped up, with 36 wells completed in 1955-1958 as against 22 in 1951-1954. New oil was found in a step- out at Garzan in 1958. By 1959, national oil production was increased to 7,300 barrels per day. 60. After a prolonged period of disappointment, exploration in Turkey is now beginning to show more promising results. It took four years and 39 dry holes before oil was discovered in commercial quan- tities. Then one company found oil on its fourth try. Another firm was successful in its second attempt. At about the same time, how- ever, a third company decided to withdraw, having invested ~20 million and drilled 11 dry holes. These experiences illustrate dramatically the importance of a large and diversified approach to the search for oil. 61. In course, other of the companies operating in Turkey -- or in Guatemala -- may withdraw from the search. The experience of these countries is obviously not adduced as proof that an exploration effort, even on a substantial scale and including a large number of different - 37 - firms, will guarantee success. WThat does emerge, however, is the com- plex and costly effort involved in probing a country's oil potential, if only to test how promising it may or may not be.- Libya 62. The United Kingdom of Libya was established by the United Nations in 1951 from the former Italian colonial territories in North Africa. The country comprises three provinces -- Tripolitania in the northwest, Cyrenaica in the east, and Fezzan in the southwest. In all, the national area encompasses 676,000 square miles. Its subsurface re- sembles and is largely an extension of that found in the French Sahara. 63. The oil possibilities of the region aroused only minor in- terest in prewar and early postwar years. Early in the 1950's, however, the situation changed abruptly. First, there were the initial successes in Algeria which gave rise to speculation as to the oil potential of the entire Sahara desert. Then, in 1953, the Libyan Government adopted a Minerals Law under which exploration permits could be obtained; and in- dicated that it would enact supporting legislation conducive to private oil investment. Before the end of the year several major oil companies had commenced preliminary geological surveys. 64. In 1953-1954 Libya set about drafting a petroleum code whichi would define the conditions for award of concessions. An invitation was extended to interested companies to draw up a suggested law in detail. As the Minister of Finance stated at the time: "We have taken this step Besides exploration, private industry is to assist in building up Turkish refinery capacity. Two plants are proposed. One, of 20,000 barrels-per-day capacity, will be constructed jointly by Caltex and the Turkish Government. Caltex will finance construction of the $26 million plant, holding an initial 49-per cent interest. It will operate the refinery for 10 years, then sell its interest to the Government. Caltex will supply the refinery's crude requirements at competitive prices to be marketed by the Government distributor, Petrol Ofisi, replacing imported products. This refinery is sched- uled for completion early in 1962. The second plant, a 65,000-bar- rels-per-day refinery at Mersin on the south coast, will be built by international companies that market in Turkey. It is to cost $50 million and is expected to go on stream in 1961. Following upon this refinery investment, the country can look forward to self-suf- ficiency in its product requirements and a commensurate reduction in foreign exchange costs, whatever the outcome of the exploration effort. - 38 - with the knowledge that we can place this most important matter in the hands of the oil companies with full confidence that they will appreciate that it is in their interests as well as Libya's that a fair, reasonable and workable law be produced.""- 65. The petroleum code was adopted in mid-1955. In the law, four petroleum zones are established, two in the northern half of the country bordering on the Mediterranean and two in the land-locked southern region. Provisions for the southern zones are .nore liberal, reflecting inevitably higher costs of operations there. 66. Under the law, exploration and production rights are granted simultaneously. Concessions run for 50 years, with one 10-year renewal permitted. Maximum acreage that may be held by a comnpany is specified for each zone. Minimum annual expenditures are required. These begin at $10.88 per square mile in the first year and increase to $43.51 per square mile after 8 or 12 years, depending on the zone. Provision is also made for the relinquishment of from two-thirds to three-quarters of the original acreage gradually over ten years. 67. Fiscal obligations include a minimum bonus of $1,400, surface fees, royalties and income tax. Once an export level of 15,000 barrels per day has been attained for 30 days, the total of surface fees, royalties and income tax must add to 50 per cent of a. company's net income; tax payments in excess of 50 per cent oI' net income are refunded. Exploration and intangible drilling costs, costs of non-commercial wells, and the costs of initiating a company's Libyan operations may either be ca-pitalized or expensed. Investment may be amortized at a rate not exceeding 20 per cent yearly, and 10 per cent yearly after four years or after exports of 15,000 barrels daily have been reached. Depletion allowance may be taken equal to 25 per cent of gross income up to 50 per cent of net income (before depletion). 68. With passage of the petroleum code in 1955, applications for concessions were prompt, many of them overlapping one another. In Tripolitania 55,000 square miles were available; applications aggregated 130,000 square miles. A similar situa.tion existed with respect to Cyrenaica. Most were settled by negotiation, a few by Government decision. In all, 47 concessions were issued to 12 companies in 1955. The following year, an additional 15 concessions were awarded to these companies. Since 1957 a further 21 concessions have been granted, with six new comipanies among the recipients. By April 1960, the 18 companies, including all of the major internationals, held exploration rights on some 435,000 square miles, or more than three-fifths of the national area. * Oil Forum, Mid-November, 1954. - 39 - 69. It is noteworthy that concessionary arrangements have been negotiated on terms more favorable to the Government as appreciation of the country's oil potential has grown. A principal change has been with regard to depletion allowances. Beginning in late 1957, the Government indicated that the amount of depletion taken should in fact be expended on exploration. Some variation of this provision appears in five agreements. Subsequently, the Government insisted on the complete elimination of depletion allowances in respect of new conces- sions. And while the Government bound itself to honor the provisions of extant agreements, it has been able to effect the voluntary surrender of depletion on certain existing concessions. 70. Further modifications were introduced in the concessionary arrangement with an affiliate of ENI, the Italian state oil entity, in late 1959. ENI undertook to pay a 17 per cent royalty, instead of the statutory 12 1/2 per cent. The company also foregoes depletion allow- ances. If oil is discovered in com7nercial quantities, the Government has an option to participate in ensuing operations up to a 30-per cent equity.* ENI may then recover up to 30 per cent of its expenditures prior to the participation of Government in the company's operations. Government rights under the Petroleum Law are not otherwise effected. Then, in a concession awarded in April 1960 to Ausonia Mineraria, a private Italian firmn, the cormapany agreed to a 17-per cent royalty on production up to 15,000 barrels daily and also waived depletion allow- ance. However, there is no option for Government participation, as in the case of ENI. 71. The first Libyan wildcat well was spudded in April 1956. After five more exploratory wells, oil was discovered in commercial quantities early in 1958. In that year, a total of 30 wildcpts was completed; of these, two were successful. Drilling has been stepped up even more sharply in 1959-1960. Seven companies have rigs in operation. More than 25 successful wells have now been completed. The gre2ter number of these are in the erea due south of the Gulf of Sirte -- the most distant less than 200 miles from the coast. Several others are in western Libya, near the Tunisian border. The most importent find is the Zelten field, where two wells each brought in production in excess of 15,000 barrels per day. Production from this field is scheduled to begin as soon as a pipeline can be laid to the coast. Elsewhere, a group of smaller American companies have developed potential production of at least 24,000 * Other examples of joint company-Government participation are discussed in Chapter IV, along with some of the problems raised by such arrangements. - 40 - barrels daily in their Dahra field in the Sirte basin. One well alone was tested at 12,000 barrels per d2y. In view of the generally rapid progress of drilling activity, it should be noted that any summary of well completions or producing capacity is apt to be outdated almost immediately. 72. Behind these results was a prodigious flow of private capital into an early exploration effort. One company alone -- Standard Oil (N.J.) -- had spent in the neighborhood of $25 million by mid-1959. It is estimated that the 18 companies together invested some $150 million in Libyan operations during 1957-1959.* Capital outlays of at least $160 million Pre programmed for 1960. 73. Although the striking discoveries in Libya stand in sharp contrast to the somewhat disappointing results in Guatemala and Turkey, the three countries were faced by a common set of problems in getting an exploration program underway. Turning back just five years, there was virtually no oil search going on in any of the countries. While each contained large sedimentary areas that might be conducive to oil forma- tion, the existence or extent of oil deposits was highly uncertain. Local financial, technical and organizational resources were obviously inadequate for any significant exploration effort. In consequence, each of the countries chose to encourage private investment in exploration by adopting a liberal petroleum code. The terms of concessions were obviously designed to encourage company oper2tions -- reflecting the risks that would be involved.*- For their part, the governments looked forward to an extensive assay of their national oil-bearing potential, and rapid development of production if prospects warranted. And in each case, a large number of companies took up the initiative, providing the financial and technical means for the exploration effort. Financing Oil Operations 74. As noted earlier, the flow of capital required to finance oil operations is prodigious. Funds must first be committed to the costly search for reserves. Where successful, subsequent investment has to be * Petroleum Times, March 11, 1960. ** As noted previously, reference to the liberalized petroleum codes of these countries does not imply that any specific arrangement can or should be taken as a. model for use elsewhere. Private oil operations today are conducted under a variety of terms that accommodate the interests of both government and industry. These are discussed in detail in Chapter IV. - 41 - made to develop resources and facilities. Finally, replacement and expansion involve a continuing input of capital. 75. Private financing of these operations is provided within the internetional oil industry. Funds generated in the course of established operations provide for replacement and expansion. They also flow into the exploration of new areas; and they support the development of resources and construction of facilities until these can become self- financing. PRIVATE FOREIGN LONG-TERM CAPITAL INVESTMENT, 1954-1957 Per Cent Accounted for Millions of by U.S. Oil Company Dollars Direct Investment U.S. Oil Companies, Direct Investment 4,040 t All U.S. CompFnies, Direct Investment 8,890 45 Gross Outflow, 8 Main C;pital-Supplying Countriesa 17,340 23 a United States, United Kingdom, France, BelEium, Luxembourg, Netherlands, Germany (Federal Republic) and Switzerland. Includes capital flotations, security purchases and extensions of credit as well as direct investment. Sources: U.S. Department of Commerce and United Nations, The Inter- national Flow of Private Capital, 1956-1958. (See Table B-7 appended.) 76. While world-wide statistics on private oil investment are not available, an appreciation of its magnitude can be gotten from the capital flows of U.S. oil companies. Between 1954 and 1°57, direct foreign investment by U.S. oil companies averaged more than $1 billion per year. This represented some 45 per cent of total direct investment by all U.S. firms. It constituted almost a fourth of the gross outflow of private long-term capital from the eight mairn capital-supplying countries. (See table above.) 4 2 - 77. Significantly, this flow of funds into long-term investment accounted for 72 per cent of the companies' total foreign earnings in 1954-58. The ratio of new investment to earnings would naturally tend to be lower then average in areas of established operations where the build-up of reserves and productive capacity is already advanced. In Venezuela, for example, additions to net investment (including bonus payments for new concessions in 1956-57) came to 58 per cent of earnings. On the other hand, the flow of capital into newly developing areas tends to exceed by far the earnings derived from oil operations. In Canada, additions to net inve tment were more than four times the rate of earn- ings. (See table following.) Thus, world-wide operations of the industry enable companies to draw on their earnings in established areas to finance exploration and development elsewhere. FOREIGN OPERATIONS OF U.S. OIL CCMPANIES: EARNINGS AND NET INVESIMENT, 195h-1958 Per Cent of Millions of Dollars Earnings All Foreign Areas Earnings 6,540 Additions to Net Investment 4,690 72 Canada Earnings 300 Additions to Net Investrnent 1,35o 458 Venezuela Earnings 2,290 Additions to Net Investment 1,320 58 Note: Additions to net investment abroad include reinvestment of retained earnings plus new capital outflow. Source: Table B-8 appended. - 43 - Foreign Exchange 78. At the same time, the flow of private investment in the course of international oil operations serves to supplement national funds in capital-short countries end to provide essential foreign exchange for machinery and equipment imports where international payments positions might otherwise be adversely affected. Two general cases can be distinguished. First, countries where exploration and development are being vigorously pursued, requiring 2 large input of capital resources for a considerable period before the returns on production begin to pay off. Once the industry has matured, the return on invested capital is a debit against the countryts external accounts, but is more than offset by exchange credits eerned through current production and savings on oil imports. A second case is that of consuming areas where oil prospects are perhaps less favorable but where the exchange cost of oil imports is large and thus impels a. nation to seek a greater measure of self-sufficiency in its oil balance. 79. Canada provides a striking example of how private foreign investment in a young and expanding oil industry provides essential capital and foreign exchange during the period of development. As shown in the table above, direct investment in Cpnada on the part of U,S. oil companies totalled $1,350 million between 1954 and 1958 -- compared with earnings of $300 million. This direct oil investment constituted almost 50 per cent of the total direct long-term flow of foreign capital into Canadian industry. (See Table B-9 appended.) It offset more than 20 per cent of Canada's exchange deficit in its current account. Meanwhile, income from oil investment, which is a debit in the current account, was a minor item. Thus, the international oil industry not only provided an essential flow of capitel to augment Canada's own financial resources and speed the pace of development, but contributed substantially to the country's balence of payments in the process. 80. Where exploration is successful and production is built up, income from investment could, of course, eventually constitute a larger debit in a country's external accounts than the credit from capital inflow. But then, foreign exchange earnings from current production (and savings on oil imports) would tend to offset this. The role of oil in the balance of payments of Venezuela, Iraq and Iran is illustrative. (See Tables B-10, 11, and 12 appended.) In the case of Venezuela, for example, the f.o.b. value of oil exports ranged between $1,560 and $2,570 million a year during 1954-1958. Investment income of all foreign-owned oil companies ranged between $450 and $890 million, Meanwhile, long-term capital flows were minor, except in 1956 and 1957 when bonus payments were made on account of new concessions. - 44 - Netting these, Venezuela earned a favorable balance in the neighborhood of $1 billion a year (exclusive of bonus payments). And this does not include expenditures by the oil companies in local currencies. Similarly, Iraq and Iran realized export earnings which exceeded invest- ment income by a considerable margin. In the case of Iraq, the favorable balance mounted to $271 million by 1958; for Iran, to $316 million. Significantly, more than half of the value of oil exports from these countries accrued back as a net credit in their balance of payments. 81. Turning to consuming areas, the problems of investment and foreign exchange become somewha.t more complicated. To the extent that oil supplies are drawn from abroad, foreign exchange costs can weigh seriously on the country's balance of payments. In consequence, nationa.l policy may be directed toward a greater measure of self- sufficiency -- in refining, and in crude production if the resource potential is regarded as favorable. But it is precisely at this point that netiona.l oil policy faces alternatives of far-reaching consequence. 82. As a point of departure, we may consider what is involved in meeting oil requirements of, say, 100,000 barrels daily. The investment in production and subsequent facilities required to support that level of consumption might approximate $500 million.* But the greater part of this investment would probably have to be made in foreign exchange -- at lea.st in the case of less developed countries tha.t would have to import most of the required machinery end equipment. And meanwhile, foreign currency outlays for oil imports would continue until substan- tial production was established. If the country were to attempt to go it alone, domestic capital resources and current foreign exchange eernings would have to bea.r the burden of oil development. On the other hand, where oil investment is provided by the private international industry, the capital and foreign exchange costs are borne externelly. The country itself does not have to carry a large capita.l burden. Nor does it have to set aside funds from its limited export earnings to cover equipment imports. In effect, it provides for the amortiz2tion and return on the capital invested in oil operations over time through the prices paid for its oil products. 83. In brief, an oil program designed to achieve greater self- sufficiency inevitably involves very large capital investment. As noted previously, the initial ca.pital requirements may often strain the * Taking $5,0oo per barrel daily as a rough average -- for production, refining, and distribution facilities. financial and budgetary resources that are available internally. And the period of capital investment can be an extended one, with a prolonged period before the cash flow from oil operations catches up with cash expenditures. Further, foreign exchange requirements may actually increase for a considerable time, as industrial equipment for local operations is imported, the while oil imports continue until the program toward self-sufficiency catches up with the trend in oil consumption. 84. How these problems are reflected in government oil operations is reviewed in the next chapter. - 6 - CHAPTER III PROBLEMS AND ISSUES OF GOVERNMENT OIL MONOPDLY CHAPTER III PROBLEMS AND ISSUES OF GOVERNMENT OIL MONOPOLY 1. As was noted in Chapter I, government activities differ widely in their scope and take many diverse forms. We consider here the problems and issues that arise where a state monopoly is established over a substantial sphere of the country's oil operations. In the chapter following, we review the various ways in which govern- ment oil activities are carried on along with private operations -- either side-by-side or in joint ventures. 2. When a government entity is charged with the entire responsibility for national oil operations, the many inherent problems associated with oil activities devolve upon it. These include mobili- zation of competent technical and management personnel; procurement of necessary equipment and construction of facilities; and most important, carrying through the difficult and hazardous search for reserves. For these, financial resources, including both capital and foreign exchange, have initially to be provided and then sustained. Withal, the determination of objectives and priorities, the allocation of budgets, and all operational decisions are based on a single set of judgments centralized within the goverrment oil entity -- but inevitably susceptible to broad political considerations of the government itself. 3. Further, these problems are likely to be all the more difficult, the earlier the stage of national oil development. This would especially be the case among under-developed countries that are simultaneously trying to improve agricultural productivity, diversi>-- industry, broaden educational opportunities and otherwise expand social services. Technical and financial resources then tend to be severely limited and subject to urgent and competing demands from many economic sectors. In consequence, means are almost inevitably inadequate to the task, as set for the government 3il entity. Technological Capabilities 4. An obvious problem is that of assembling competent personnel to carry out the oil program. Such personnel would include, first, the top administrative echelon, then the scientific and technical specialists having both requisite training in their fields and the experience that is so essential to effective performance. - 48 - 5. At the outset, there is the difficulty in recruiting management to handle the complexities of organizing and directing a government oil entity. Especially where a new government organization is being launched on a large scale, administrative people have to be found for whom there are usually attractive employ- ment opportunities in private enterprise (not only among oil companies but in a range of industrial and commercial fields). In many instances, rates of remuneration in government service tend to be considerably lower than in private industry, so that it is hard to get the kind of top management that would guarantee effective operations. And to boost salaries to a sufficiently attractive level is apt to lead to awkward disparity between pay scales of operating personnel and civil servants in the political areas of government. 6. What is more, where the top administrative posts in the state oil entity are filled by political appointment, the choice of manage- ment personnel may be limited. And competent people may be deterred from taking on the assignment by the uncertainty of job tenure in a political framework. 7. The government oil entity often runs into further difficulties in staffing its operations. Invariably it is obliged to rely largely on nationals. Indeed, such a policy is often among the very objectives of the government program. And in the long run, the policy can be expected to up-grade employment opportunities, insofar as successful oil operations would provide more jobs in a wide range of occupational classifications. But it takes time and exposure to develop the number of technically trained people that are required to launch and direct oil activities. 8. In the interim, the availability of technicians is circum- scribed. Thus, skilled personnel are likely to be scarce if not completely unavailable, and the burden on these commensurately heavy. In many instances, these few may be required to discharge responsibili- ties for which they are not yet fully prepared -- which would be as unfair to the individual as it is unfortunate for the organization. 9. Further, the government organization often finds itself out- side the main stream of technological progress. At least, it is not likely to participate so directly in the world-wide proliferation of newly acquired knowledge or methods. These difficulties are, of course, usually appreciated. A common recourse is to enlist the aid of foreign technicians, usually on a consulting basis. But the consultant, however competent, is no real solution to a basic personnel problem. His stay is brief. He can only make recommendations, which may or may not be accepted by others. The point is that responsibility for decisions does not and cannot rest with him. _ i.9 _ Centralization of Judgment 10. This leads to the basic question, whether the centralization of judgment that is inherent in a government oil monopoly is the best means to successful oil operations. It is not just the possibility of political intrusion into *perations that should be rigorously oriented toward maximum effectiveness. The problem goes much-deeper. It would still exist, even if the government oil entity were set up as a quasi-independent body with safeguards against outside interference. It would exist as well under private operations if one company alone exercized a monopoly in operations over wide areas. 11. The question can be put most cogently with respect to exploration: Is centralized judgment conducive to success in the search for oil? In the preceding chapter we noted how diversified perspectives among many companies, each spurred by competitive con- siderations, have contributed to the effectiveness of world-wide exploration. In contrast, the government oil entity is almost inevitably forced to be circumspect in its approach. In a country of vast prospective but untested areas, it may require a very large-scale exploration program to assess the true potential and disclose the most promising acreage. The official who commits public capital has to consider the many dry holes that could result, the prolonged period of apparently fruitless search -- and the consequent effect on his budget and future appropriations. On balance, intensified development of proved areas may be regarded as the more attrac-tive decision, because it promises immediate pay-off in increased production at the rate of hundreds or thousands of barrels per day, despite the nation's long- run need for millions of barrels of added reserves. 12. In the review of various government oil operations (in this chapter and the next), there will appear repeated instances where the emphasis has been on development drilling as opposed to inherently risky exploration activity. From the standpoint of government organizations constrained by limited budgets, this may well have been the reasonable path to pursue. But it provides a sharp contrast to the instances cited in Chapter II, where countries that provided an opportunity for private operations were able to attract a large number of companies -- individually assessing prospects and then exploring various areas that each regarded as promising. 13. It is noteworthy that in the one instance where government has made a major contribution toward successful exploration -- the French Sahara -- the search was not confined to the efforts of a single state organization. Early exploration was undertaken in separate areas by three different entities -- the Bureau de Recherches de Petrole (BRP), - 50 - the Compagnie Francaise des Petroles (CFP),* and CREPS. The last- named company is a joint operation in which four different French Government agencies together hold 60 per cent, along with the Royal Dutch/Shell Group (35 per cent) and various French financial interests (5 per cent). Capital Requirements 14. In the preceding chapter we emphasized the inherent role of capital in oil operations -- bearing the risk, and financing the period of waiting, from the time investment is initiated until it pays for itself in the value of increased production. Where private enter- prise provides capital for exploration, these are recognized and accepted as functions of investment. IWJhere government enters upon oil operations, however, these functions involve knotty problems of public policy. 15. Capital is today a scarce factor in virtually every country that is looking toward the development of its own oil resources. At the same time, these countries generally face urgent budgetary demands for other economic and social undertakings -- ranging from education to internal transportation, from measures to improve agricultural pro- ductivity to attempts at industrial diversification. In many of these areas, financing has to come from public capital. Costs are great, and the rewards will be measured only in terms of general economic progress -- increased productivity and better standards of living in the future. Thus, government budgets are strained, and foreign aid is often required to sustain national development programs. 16. Added to these, the search for oil can impose an awesome financial burden. Considering the uncertainty that attaches to explora- tion, there is always a danger that scarce capital diverted from other pressing needs will be dissipated in unsuccessful ventures. The cost of one dry hole, for example, may have paid for the construction and staffing of several schools'. And even where the search for oil is successful, the costs of development are likely to mean continuing cash deficits for many years, at a time when government budgets are not able to procure essential services. Thus, a decision to embark on govern- ment oil operations goes beyond the normal commercial considerations on which private investment is based. 17. In this regard, there are three points worth stressing. First, * In which the French Government has a share-holding interest, but which otherwise operates as a commercial enterprise. - 51 - the very substantial capital requirements for a major exploration effort. In Guatemala, as noted previously, the first two years of search by more than 30 private companies involved outlays that amounted to more than 10 per cent of Government revenues from all sources; and these merely financed the beginnings of an exploration program which, by the way, may well prove to be unsuccessful. For most countries, an all-out effort would mean expenditures on a far larger scale than their national budgets could support. 18. Second, the alternative is apt to be a more modest effort in which resources are allocated to exploration by dint of sacrifice else- where. But where prospective areas are vast, chances of success are increased by thorough survey and extensive testing. A limited program, constrained moreover by the single judgment of one government organiza- tion, can hardly be expected to yield the best results. Government exploration in Turkey, for example, was carried out with expenditures that over 20 years added up to just about what private companies committed in the first two years of early search in Guatemala. Sub- sequently, the Government moved to admit private capital so as to enlarge the scope of exploration, the while maintaining a limited program of oil operations by its state entity. Similarly, India has recently invited the participation of private capital in expanding the oil search over its extensive sedimentary basins, alongside the Govern- ment's Oil and Natural Gas Commission. (See Chapter IV.) 19. Third, where government seeks to maintain oil operations ex- clusively through a state entity, social costs are likely to run considerably higher than the nominal patrimony. In the review of government operations further along in this chapter, indirect sub- sidization is a common experience. It may take the form of tax exemption for the government oil entity, or even tax delinquency where payments to the state are specified. In either event, the government, in effect, is supporting oil operations out of current revenue. Government loans to its state oil entity invariably carry lower interest charges than the entity, or even the government itself, would have to pay in the nationts money market. Domestic prices may be deliberately built up to buoy the government oil entity's earnings so that consumers are in effect providing indirect support to state operations.* 20. These, and many other devices, are probably inevitable, in order to maintain the government oil program. And per se, they may be justifiable in terms of the oil policy that a country has chosen. They raise a basic problem, however, in that the true costs of government operations are to a considerable extent concealed; hence it becomes * The issue of internal pricing -- whether high to support oil opera- tions or low to subsidize consuming groups -- is discussed below. - 52 - difficult for the nation to assess or evaluate results. Foreign Exchange 21. A major impetus to government oil operations often stems from the need to conserve foreign exchange balances. For many countries, petroleum imports constitute the largest single debit in their balance of payments. Construction of local refinery capacity would enable them to substitute lower-cost crude oil imports for more expensive finished products. And where oil prospects are promising, the development of local production would provide a further measure of self-sufficiency. 22. But the process of oil development itself involves heavy foreign exchange costs. Equipment, facilities, installations -- all or a large part of these may have to be obtained abroad. In consequence, foreign exchange outlays are apt to rise in this early period, when such imports are added to the continuing importation of the nationts oil requirements. As notecl previously, the international oil industry largely provides its own foreign exchange in the very act of investing. In many instances, indeed, the international flow of oil capital becomes a significant credit item in a country's balance of payments; and repatriation of investment in subsequent years is offset by ex- change savings from established oil operations. 23. In contrast, a government oil entity that is charged with full responsibility for national oil development must cope with the foreign exchange difficulties that so often cumulate until operations are firmly established. To some extent, foreign credits from suppliers of materiel may ease the burden, but these are usually for relatively short term. And for countries just embarking on oil operations, the annual rate of investment by the state entity is likely to be large relative to its total assets, which naturally would tend to limit the amount of credit it might expect to obtain. In MAexico, for example, where oil operations are long established, Pemex has been able *to obtain a substantial volume of outside financing. In Brazil, where Petrobras is still in a relatively early stage of oil development, the problem is more acute. 24. In some countries foreign exchange costs might appear somewhat less burdensome because the government has established a preferential exchange rate for the state oil entity. In Brazil, for example, Petroleos Brasileros (Petrobras) enjoys a substantial advantage with respect to its imports (100 cruzeiros to the dollar, as against a free rate of about 185 cruzeiros). But this obviously is another form of indirect assistance and should reasonably be considered as part of the social cost of government oil operations -- in this instance, the cost - 53 - being carried by the nation's export industries. Pricing Policy 25. Finally we would note the issue of pricing as it bears on the problem of capital availability. On the one hand, there is the incentive to maintain internal product prices at a relatively high level so as to bolster cash earnings of the state oil entity and provide funds for reinvestment. This is most likely to be the case during early stages of oil development, when financial requirements for expanding operations are especially large. In Brazil, for example, prices of petroleum products are based on import parity plus a relatively heavy import duty -- ranging up to 150 per cent of c.i.f. values. Locally refined products are subject to an excise tax, for which Petrobras is liable, but the excise tax is considerably less than the import duty. Thus, the consumer pays the full duty in his price; the difference between duty and excise accrues to Petrobras and carries over into net profits. In practice, more than 40 per cent of Petrobrast earnings has derived from this price build-up. 26. High internal prices may, of course, result from other than a deliberate policy of maximizing profits as a source of capital funds. A state which has made a large and continuing investment in exploration and production has an obvious incentive to expand production at the fastest possible rate once producibility has been established. In this respect, the desire of a state entity to realize a return on its capital outlays may be no different from that of a private company. But while production of a private company is determined by competitive marketing, government is in a position to direct its production into local consumption channels. In course, the state oil entity would be concerned with the price it receives for its crude oil and with a product price level that supports its crude prices. In the event that alternative oil supplies are available at more advantageous terms, preference for "national" oil would tend to increase the country's total energy costs. By the same token, there could be loss of flexi- bility in the future development of the country's energy sector. 27. On the other hand, internal prices may be deliberately depressed so as to subsidize various consuming interests. Such a course may ultimately serve to deny the state oil entity the ability to provide for future needs. The Mexican oil monopoly, Petroleos Mexicanos (Pemex), for example, had a heritage of low prices that carried over from the time when the Mexican oil economy was oriented to the export trade. Thus, the oil industry was called upon to keep local energy costs low as a stimulus to industrial growth, trans- portation, and living standards. In course, the margin of Mexican - 54 - oil exports was progressively narrowed until operations were entirely devoted to meeting internal requirements. Yet the low price structure was maintained. Pemex estimates that it subsidized local consumption to the extent of $43 million in 1957 -- equivalent to almost 14 per cent of its total revenues. Significantly, Pemex showed little profit or even operating losses during this period and was severely restricted in its investment program. Only recently, following a sharp increase in local prices, has Pemex been able to project any significant net earnings. THE OIL BALANCE IN ARGENTINA, BRAZIL AND MEXICO 1954 AND 1958 (Thousands of Barrels Daily) Argentina Brazil Mexico 1958 Demand 260 225 269 Refinery Runs 228a 137 261 Production 98b 52 274 Net Imports 179 178 4 Crude 129 92 Products 50 86 4 1954 Demand 176 159 201 Refinery Runs l53C 6 221 Production 81d 3 234 Net Imports 120 167 (29) Crude T72 7 IY) Products 48 160 (16) Note: Figures in parentheses denote net exports. a YPF, 136; private, 92. b YPF, 88; private, 10. c YPF, 104; private, 49. d YPF, 67; private, 14. Sources: YPF; Petrobras; Pemex; U.S. Bureau of Mines. - 55 - 28. These are the problems that together, in part, and in various combinations confront government oil operations. Rpnging from access to technology and competent direction to provisions of huge sums of capital and foreign exchange, they are particularly weighty for countries whose limited resources are hard-pressed to meet a host of urgent development needs. In consequence, performance of state oil entities has typically fallen short of national objectives. In the table above, the oil balance in Argentina, Brazil and Mexico is shown for 1954 and 1958, marking a span of years during which each country vested the greater part of its oil operations in its state organization.* In each case there was a substantial expansion in local refinery runs, and each country was able to achieve increased levels of production. But none of the countries was able to keep pace with its rising level of petroleum consumption. Thus, oil imports in 1958 were larger than four years earlier. 29. In the following sections of this chapter, we review the cases of Brazil and Mexico in some detail. The experience of these two countries is particularly indicative of the problems and issues of government monopoly in oil. Brazil represents a relatively young oil operation, where geological prospects are promising but where virtually all phases of activity have had to be developed by the state oil entity -- from the discovery of reserves to the installation of refining capacity. In contrast, government operations in Mexico began with expropriation of a large and relatively prosperous industry in 1938, whose production was not only sufficient to meet internal requirements but also supported a substantial export trade. (The case of Argentina is reviewed in Chapter IV, along with other instances where a national policy of exclusive government operations has been modified to permit private participation.) * The table leads off with 1954 for two reasons -- the special difficulties of immediate postwar operations were past, and it was the first complete year of Petrobras activity. It terminates with 1958 because that year marked a transition in Argentine policy from exclusive dependence on government exploration to participation by private capital. - 56 - Brazil 30. Brazil's oil potential first attracted attention just prior to World War II. A state entity, the Conselho Nacional do Petroleo (CNP), was established in 1938 to initiate exploration and development.- CNP made Brazil's first commercial oil discovery the following year in the State of Bahia, along the coast northeast of Rio de Janeiro. Develop- ment of production was exceedingly slow, however. At the war's end, output was 200 barrels per day; by 1953, it increased to only 2,400 barrels daily. 31. CNP built and operated a small refinery near the Bahia pro- ducing fields. In 1953, this plant had a capacity of 5,000 barrels per day. Private refineries, which could be owned only by native- born Brazilians, had a total canacity of 22,300 barrels daily in 1953. Establishment of Petrobras 32. Whether private enterprise should participate in exploration and production was vigorously debated in the early postwar years. The Constitution of 1946 did, in fact, allow for such private parti- cipation through companies domiciled in Brazil. Enabling legislation was never enacted, however. Instead, in 1953 the Government con- firmed a policy of state oil development. A new operating entity, Petroleos Brasileros (Petrobras), was created. CNP was reorganized as a supervisory agency directly responsible to the President. As such, CNP reviews the operations of Petrobras. It also sets product prices, controls distributors' margins, and allocates import licenses. 33. Petrobras, in turn, received all the operating assets of CNP -- the Droducing fields at Bahia, the small refinery there and a partially constructed refinery at Cubatao, and the Government's fleet of tankers. Petrobras was to receive additional capital to support expansion of its operations through a participation in receipts from certain import and excise taxes, a share in the profits of private refineries, and reinvested dividends. According to law, at least 51 per cent of the ownership of Petrobras must be in the hands of the Federal Government. The remaining shares are held largely by * Minority participation in CNP was permitted for private Brazilian investors.. -57- states and municipalities, with some private capital subscribed by native-born Brazilians. 34. In its operations, Petrobras was given a monopoly over petro- leum and natural gas production, and over the transport of crude oil and products by pipeline. Petrobras also received exclusive rights to all new refinery construction. The private refineries could con- tinue to operate, but were not allowed to enlarge their capacities beyond what had been authorized as of June 30, 1953. Petrobras was authorized to obtain a majority interest in the private refining companies through purchase of outstanding stock, when and if it chose; but to date Petrobras has not exercised this right. Finally, Petro- bras was given a monopoly for acquisition of tankers for the transport of domestic crude and petroleum products. Privately-owned tankers used in specialized transportation of Brazilian oil were exempt from the monopoly; however, such vessels could not be replaced by their private owners when retired. 35. Marketing of petroleum products was the one phase of oil operations that was left almost entirely to private enterprise. The major marketing firms in Brazil are subsidiaries of international companies. Each of these is reouired to distribute a share of local refinery output under a formula set by CNP. Thus, Petrobras, and the private refineries, are assured of product outlets. CNP issues import licenses for the balance of each marketing company's product requirements. Entry by Petrobras into broad marketing operations could be achieved with CNP approval. At present, Petrobras has a limited participation. It sells fuel oil directly for electric power plant consumption. It also imports and distributes liquified petro- leum gases. tnd since 1958, Petrobras has been receiving licenses from CNP for the larger part of Brazil's fuel oil import require- ments, which it resells to the marketing companies for distribution. The Problem Facing Petrobras 36. When Petrobras was established, the nation's dependence on oil imports presented an acute problem. In 1953; some 137,000 barrels daily were being consumed. But local crude output constituted less than 2 per cent of demand. Loc2l refining accounted for less than 5 per cent. In consecuence, vi-rtually all of Brazil's oil requirements had to be met through product imports. (See table below.) The result was a heavy foreign exchanage drain. Oil imports cost the country about Z227 mil- lion in 1953 -- and represented 17 per cent of the total import bill. 37. The immediate need, then, was to narrow the gap between oil re- quirements and domestic supplies. Furthermore, the problem was one that threatened to grow apace. Over the early postwar period, oil consump- - 58 - BRAZILIAN OIL BALANCE, 1953 (Thousands of Barrels Daily) Domestic demand 137 Refinery runs 6 Crude production 2 Imports 135 Crude oil _T Refined products 131 Sources: Petrobras; U.S. Bureau of Mines. tion in Brazil had increased at an average rate of about 16 per cent per year. And while this rate was to slow somewhat in the years after 1953, to around 11 per cent per year, national oil requirements would still be mounting by around 20,000 barrels daily each year. 38. To reduce the impact of petroleum imports on Brazil's inter- national payments would call for a tremendous effort. An obvious need was for expanded refining capacity. This would, at the outset, re- duce the cost of imported oil by substituting crude for more expensive refined products. And while substantial investment would be involved -- together with outlays of scarce foreign exchange for equipment -- the country could look forward to subsequent exchange savings on its oil imports. 39. An effective long-range solution to Brazil's oil imbalance, how- ever, would depend on intensive development of local production. In 1953, Brazil was still essentially a new oil area. Proved reserves were prob- ably on the order of l0-0 million barrels* -- the eouivalent of two years' consumption. Production, as noted earlier, amounted to only 2,h00 barrels daily. 4o. WIhat is even more important, the effort going into explora- tion and development was minimal compared with the task at hand. In all, 65 wells were completed in 1953, of which only six were exploratory. All drilling was confined to the Reconcavo basin in Bahia -- an area of around * Trade sources estimated Brazil's reserves at 50 million barrels in 1953; Petrobras set the figure at 150 million barrels as of the end of 1954. - 59 - 3,000 square miles. The prospective sedimentary basins of Brazil, ac- cording to petroleum geologists, encompass more-than a million square miles.* 41. Obviously, a vastly expanded exploration effort would have to be mounted if the gap between consumption and production were to be closed. Not only would the number of wells drilled have to be multi- plied many times over, but the search for oil would have to spread out to the relatively inaccessible inland basins, such as those along the upper reaches of the Amazon and Parana Rivers. This would mean costly surveys, substantially higher drilling costs, and, if inland pro- duction were successfully established, further large outlays for trans- port and other facilities. 42. This, then, was the oil problem facing Brazil when Petrobras was established. With the grant of exclusive rights to oil develop- ment, Petrobras was assigned a tremendous responsibility. To meet that responsibility, technical and professional personnel would have to be recruited and then matured through experience. Specialized eauip- ment would have to be procured and facilities established. Above all, huge capital funds would have to be mustered to support so large an effort. Financial Resources 43. Among the major sources upon which Petrobras could draw for its financial requirements would be its earnings from current operations, its participation in receipts from taxes on petroleum product imports and locally-refined products, and additional new capital provided by the Government. We consider first the flow of funds from these sources over the period since October 3, 1953 when Petrobras was established. We then turn to the uses to which these funds were put. Finally, we review the physical performance of Petrobras to date and consider the program that still lies before it. 44. A summary of Petrobrasr sources of funds over the six years of its operations is presented in the table following. This shows that new investment, beyond its original capitalization, accounted for almost 40 per cent of the total financial resources available to Petrobras. The largest single source was receipts from import duties and excise taxes, alone constituting 30 per cent of the total. In addition, an increase in * The Sedimentary Framework of Brazil, report before the Fifth World Petroleum Congress, June 1959. Petrobras has recently indicated, however, that it considers only about one sixth of this area as potentially oil-bearing. - 60 - PETROPRAS -- SOUIRCES OF FUNDS, OCTOBER 3, 1953 - DECEMBER 31, 1959 Millions of Per Cent of Cruzeiros Total Internal 17,852 42.3 MET=Tned earnings 15,074 3L77 Depreciation and depletion 1,735 4.1 Provisions for miscellaneous reserves 1,0o43 2.5 External 2)4,335 57.7 Original capitalization h,000 9O5 New capital 16,630 39.4 Reinvested dividends 2,539 6 eO Receipts from import duties and excise taxes 12,598 29.9 Receipts from private refineries 1,390 3.3 Other 103 0.2 Long-term debt 3,705 8.8 Long-term obligations representing contributions by proprietors of cars, boats and planes 1,755 4.2 Other long-term obligations 1,950 4.6 TOTAL SOURCE OF FUNDS 42X187 100.0 Source: Petrobras. long-term debt accounted for another 9 per cent, including obligations representing contributions by proprietors of vehicles which were deposi- ted with Petrobras by the Government. 45. In all, about three-fifths of the company's funds were derived from external sources. This, of course, reflects a basic problem of establishing oil operations -- that very substantial and continuing in- vestment is required before such operations can reasonably be expected to be self-sustaining. 46. Among internal sources of funds, depreciation and depletion was a minor item, since Petrobras is still in the early stages of its operations. On the other hand, retained earnings amounted to 36 per cent of the total financial resources available to Petrobras. However, for reasons discussed below, a major part of the company's reinvested - 61 - profits should probably be regarded as investment of social capital, rather than as coming from current operations. Cperating Profits 47. Progressive expansion of Petrobras operations provided the company with an expanding flow of internally-generated funds. Two aspects of this flow of funds are noteworthy, however. First, the rate of profits was relatively high, especially in recent years, owing in large part to the structure of product prices within Brazil. Second, the rising trend in profits also reflected the progressive inflation that characterized the entire national economy -- so that the increase in the real value of cruzeiro earnings was considerably less than the growth of nominal profits. The impact of inflation is considered fur- ther in a later section in connection with the year-to-year build up in the company's financial resources. PETROBRAS -- PROFIT AND LOSS STATEMENT, 1955 - 1959 (Millions of Cruzeiros) 1959 1958 1957 1956 1955 Gross revenue (including marine freight) 41,702 24,870 15,959 9,594 4,666 Costs 28 370 17,104 11,254 6,777 3 644 Gross operating profit 13 332 7,766 4,705 2,ol7 1 2 Add: Other income 428 177 184 66 70 Total 13,760 7,943 4,889 2,883 1,092 Less: General expenses 4,283 2 556 i 1,029 921 Net Profit 9,477 5,387 3,744 1,854 171 Net profit as a per cent of gross revenue 22.7% 21.7% 23.5% 19.3% 3.7% Source: Petrobras. 48. The above table shows how gross revenue of Petrobras rose sharply after 1955 (the first year for which published income data are. - 62 - available). By 1956, net profits constituted 19.3 per cent of gross revenue, with even better showings in recent years. 49. As noted earlier, the entire output of Brazilian refineries is taken for distribution by private marketing companies, with refinery prices set by CNP. The basis of such prices is import parity -- f.o.b. prices at the Caribbean together with transport costs to Brazil, plus the import duty or "sole tax". Local refineries are liable for an excise tax on their product output (also called "sole tax"), but the excise tax is considerably less than the import duty. Thus, the dif- ference between import duty and excise tax constitutes a measure of protection for Brazilian refinery operations. 50. What the refinery protection means to Petrobras can be illustra- ted by considering its refinery output during 1959. (See table below.) The spread between duty and excise ranged from 95.5 cruzeiros per barrel for heavy fuel oil to 218.6 cruzeiros per barrel for kerosene. Ap- plied to Petrobras refinery output, the build-up of product prices thus provided additional receipts of Cr$ 3,898 million from its re- fining operations. This was equivalent to 11 per cent of total income from sales of locally-refined products (Cr$ 24,590 million). Further, the entire amount of refinery protection would naturally be carried down to net profits -- where, in fact, it accounted for more than two- fifths of Petrobras earnings (Crt 9,477 million). PETROBRAS' INCON7T FROM PROTECTION OF LOCAL REFINING OPERATIONS, 1959 Sole Petrobras C.I.F. Sole Tax on Local Refinery Refinery Value Ta x Locally- Production Output (Cruz./ on Refined Differ- (Cruz./ (Mil. (Mil.bbl.) bbl.) Imports Products ence bbl.) Cruz.) (Per Cent of c.i.f. value) Gasoline 8.4 443.0 150 112.5 37.5 166.1 1,395.5 Kerosene 1.6 h37.1 100 50 50 218.6 349.7 Gas Oil 5.5 431.7 80 40 40 172.7 949.8 Fuel Oil 12.6 272.8 70 35 35 95.5 1,203.1 28.1 364.1 138.7a 3,898.1 a Average, weighted by refinery yield. Sources: Petrobras; Brazilian Government. - 63 - 51. It is, of course, not uncommon for consuming countries to pro- vide protection to local refining as a means of supporting investment in such facilities. It would appear, however, that the extent of refinery protection in Brazil is considerably greater than is usually afforded. On a Der-barrel of output basis, Petrobras realized an average of around 139 cruzeiros as a result of the product price build-up. Converted to dollars at the free market rate of exchange, this would come to some $0.94 per barrel.* This compares, for example, with refinery protection ranging from 010.20 to $o.40 per barrel in countries such as South Africa, India, Japan and Australia. 52. It is clear, therefore, that a major part of Petrobras profit- ability cannot be regarded simply as earnings from operations. Behind it is a deliberate policy of public support. Not that such a policy warrants criticism per se.- Government subsidy of "infant"f industry is common practice in developing countries. In particular, foreign exchange controls, tax policy, and price supports are usual means of assisting newly-developing industries. 53. But the implications of such financial support are worth noting. If excise taxes were set at the same rate as import duties, the added receipts would accrue as Government revenue. Then, if the Government turned over such sums to Petrobras, the transfer would clearly represent a subscription of public capital. Alternatively, product prices could be lowered, in which case consumers would benefit at the expense of Petrobras earnings. Thus, it is not just "commercial" profits that have constituted the company's internal flow of funds, but also a measure of support provided through higher prices paid by consumers and/ or Government revenues that are foregone. 54. It may also be noted that the profitability of Petrobras opera- tions in recent years has undoubtedly been enhanced by the relatively favorable terms at which its supplementary crude requirements could be purchased abroad. 8** Considering the world oil surplus, substantial dis- counts below posted price would have been available. An-d while Petrobras * Taking the mid-year quotation of 147.75 cruzeiros to the dollar. At the preferred rate of exchange accorded to Petrobras, the dollar value of refinery protection would be even greater. *-* As noted earlier, the other extreme in pricing policy that subsi- dizes local consumption has the effect of depriving a government oil entity of potential earnings as a source of funds for essential investment. In 1959, for example, Petrobras refinery runs were at the rate of 95,0oo barrels daily; production amounted to 65,ooo barrels daily. Hence, net crude imports came to 30,000 barrels per day, or slightly more than 30 per cent of the company's crude input. - 64 - does not report its crude supply arrangements, Argentine and Uruguay tenders are openly bid. During the last year or so Argentina and Uru- guay met their crude requirements at discounts ranging between 20 and 50 cents per barrel. 55. These discounts would be indicative of the general terms at which Petrobras' crude imports could be obtained, even though precise prices would vary according to the specific crude involved.* Petrobras would thus benefit from discounts on its crude imports which serve to enlarge further the margin between crude costs and product realization on that volume of refining that involves purchased crude.*'* 56. Finally, we would note that under Brazilian law Petrobras is free from all income tax on reinvested earnings until 1962. Thus, for fiscal reasons alone, there was a strong incentive to plough back a major share of profits to finance expanded operations. Over the years, re- tained earnings of Cr$ 15,074 million constituted almost 75 per cent of net profits. Reinvested Dividends 57. Remaining profits of Cr$ 5,559 million were paid out as divi- dends to the Federal Government and the several state and municipal *- It should be noted that only a limited quantity of Bahia crudes can be run in Petrobras refineries because of its wax content. In con- sequence, Petrobras exports the remaining volume, largely under arrangements by which Bahia crude is sold in exchange for purchases of more suitable crudes. But relative prices in such arrangements would tend to reflect the advantageous terms at which foreign crudes are generally available. - Since 1958, Petrobras has been receiving licenses from CNP for the larger part of Brazil's fuel oil imports. Substantial discounts on Caribbean fuel oil would have been available during this period of surplus. In view of the formula by which internal prices are set, however, it would appear that Petrobras would have had little incen- tive to purchase its fuel oil imports below posted price. Alterna- tively, Petrobras might have been in a position to take the advan- tage in the form of lower prices for the crude it purchases or higher prices for the Bahian crude it exports. In either case, the value of the import licenses would be converted into an increased margin between the companyts net crude costs and product realiza- tion. - 65 - entities that are participating shareholders.* In turn, Cr$ 2,539 million of these dividends were reinvested in Petrobras, constituting 46 per cent of dividend payments. In recent years, over half of divi- dend payments by Petrobras have been returned to the company via rein- vestment. PETROBRAS -- NET PROFITS, DIVIDENDS PAID OUT AND REINVESTED, 1955 - 1959 (Millions of Cruzeiros) Net Profits Dividends Paid Out Dividends Reinvested 1959 9,477 2,068 1,059 1958 5,387 1,494 773 1957 3,744 1,107 605 1956 1,854 788 102 955 171 102 20,633 5,559 2,539 Source: Petrobras. Receipts from Import Duties and Excise Taxes 58. The most important source of Petrobras' funds has been the company's share in Government receipts from specified import duties and excise taxes. According to law, 15 per cent of the sole tax on imported and locally-refined petroleum products accrues to Petrobras as new capital. In 1958 (the latest year for which detailed data are available), such proceeds amounted to Cr$ 2,064 million. In addition, Petrobras participates in the duties on imported vehicles, which amounted to Cr$ 418 million during 1958. Together, the funds realized through receipts from import duties and excise taxes have aggregated Cr$ 12,598 million since Petrobras' inception -- and have constituted 30 per cent of the company's total sources of funds. * In addition, some 5.o5 per cent of earnings have been set aside for profit sharing by employees and directors, the minimum required by law. - 66 - 59. Another source of Petrobras capital has been its receipts from private refineries. Those which operate under concessionary grants from the Government (of which there are three) must pay Petrobras a charge equal to 9 per cent of the c.i.f. value of their individual crude imports and 50 per cent of their net profits on products refined from imported crude. In addition, all private refineries must transfer to Petrobras the profits earned on refining operations beyond capacity authorized as of mid-1953. Petrobras receipts from private refineries aggregated Cr$ 1,390 million through 1959. Long-Term Debt 60. About 11 per cent of Petrobras funds has derived from long-term borrowing. When Petrobras was established, it was designated as re- cipient of deposits which vehicle owners are obliged to make. Such funds amounted to somewhat more than Cr$ 400 million per year between 1954 and 1957, aggregating Cr$ 1,755 million at the end of 1959. The deposit provision was rescinded in 1958. Petrobras then turned to the private capital market and floated some Cr$ 1,950 million of long-term loans.* The Build-Up of Funds -- The Effect of Inflation 61. Thus far we have considered the aggregate availability of funds over the first five years of Petrobras operations. The table following shows how these increased progressively, from Cr$ 1,657 million in 1955 to Cr$ 14,973 million in 1959. As noted earlier, virtually uninterrupted inflation during the period tended to buoy Petrobras earnings. At the same time, however, the purchasing power of Petrobras funds was being eroded. 62. This can be illustrated by contrasting the rising trend of avail- able funds as expressed in current cruzeiros with deflated figures measured in 1955 cruzeiros.-I-X, Between 1955 and 1956, for example, funds available to Petrobras increased from Ci'$ 1,657 million to Cr$ 3,339 million, an increase of Cr$ 1,682 million in current cruzeiros. - In 1958-1959, also, Petrobras first sold preferential shares to private subscribers, netting Cr$ 103 million. a- Current cruzeiros adjusted for annual changes in the wholesale price index (excluding coffee). - 67 - PETROBRAS -- FLOW OF FUNDS IN CURRENT AND DEFLATED CRUZEIROS, 1955 - 1959* (Millions of Cruzeiros) 1959 1958 1957 1956 1955 Retained earnings 7,409 3,893 2,637 1,066 69 Depreciation and depletion 638 394 279 252 161 Receipts from import and excise duties 4,186 2,482 2,153 1,300 936 Receipts from private refineries 389 560 404 37 ... Reinvested dividends 1,059 773 605 102 off Long-Term obligations 822 1,146 416 473 446 Other 470 288 234 109 45 Total 14,973 9,536 6,728 3,339 1,657 VALUE OF FUNDS IN 1955 CRUZEIROS 6s562 5,970 4,820 2,734 1,657 * Adjusted for annual changes in the wholesale price index (excluding coffee). Source: Petrobras. But measured in 1955 cruzeiros, 1956 funds amounted to Cr$ 2,734 million -- an increase of Cr$ 1,077 million over the preceding year. In effect, a third of the gain was wiped out by the inflation of internal prices. And the effect of continuing inflation became more severe each year. By 1959, the purchasing power of Petrobras funds of Cr$ 14,973 million was only Cr$ 6,562 million in terms of 1955 cruzeiros. 63. The dollar equivalents of available funds are not easily deter- mined because multiple exchange rates are involved. But dollar value would be of considerable importance because a large part of machinery and equipment purchased by Petrobras had to be imported and paid for in foreign exchange. In connection, it is noteworthy that the free market rate for the cruzeiro declined even more sharply during this period than - 68 - its internal purchasing power.* While the rate applicable to petroleum goods imports was generally more favorable for Petrobras than the free rate, it tended to reflect movements in the free market rate. It is clear, therefore, that the "real" capital available to Petrobras for investment was progressively eroded by external devaluation and by internal inflation. The Application of Funds 64. In view of the limited financial resources with which operations had to be conducted, the distribution of Petrobras investment among ex- ploration and development, refining, and other operations would be quite significant. And the results achieved, matched against expenditures, would provide a measure of the company's resource utilization in coping with imbalance in the national oil economy. Unfortunately, however, published financial statements of Petrobras do not report either total outlays or the amounts allocated to various functions. 65. An indication of the amounts spent by Petrobras to maintain and expand its operations can be gotten from its annual reports, however. By comparing consecutive year-end balance sheets, we can determine the interim build-up of assets. These include changes in working capital as well as in the several categories of fixed assets. Working Capital 66. The use of funds by Petrobras from its inception through 1959 is summarized in the table following. What stands out is the unusually high proportion that entered into working capital (38 per cent). Some build-up in current balances was to be expected as operations expanded. Considering the substantial capital requirements involved in boosting refinery capacity to the level of petroleum consumption and in attempts to increase crude oil producibility, however, a maximum allocation of funds for essential investment could be expected. The very great increase in working capital would seem, therefore, to be a further reflection of inflationary pressures within the Brazilian economy. - The free market rate went from 76 cruzeiros to the dollar in 1955 to 204 cruzeiros to the dollar in 1959. At the same time, the wholesale price index in Brazil rose from 149 in 1955 to 340 in 1959 (1953 = 100). - 69 _ PETROBRAS -- USES OF FUNDS OCTOBER 3, 1953 - DECEMBER 31, 1959 Millions of Cruzeiros Per Cent of Total Capital Assets from NPC 3,125 7.4 Additions to Property, Plant and Equipment 21,537 51.1 Working Capital 16,225 38.4 Other 1,300 3.1 42,187 100.0 Source: Petrobras. Gross Fixed Assets 67. Changes in gross fixed assets provide a further indication of the uses to which the remaining funds available to Petrobras were put. It should be noted that total expenditures would probably be substantial- ly greater than the increase in fixed assets shown in the balance sheet since not all costs are normally capitalized. This might be most sig- nificant with respect to costs of drilling non-productive wells, which are usually written off against current income. Also, additions to gross fixed assets would understate expenditures to the extent that there were property retirements. 68. Within these limitations, it appears that a substantial alloca- tion of funds was to the production effort. Two categories -- "explora- tion and: drilling equipment" and "exploration, drilling and other costs" -- account for 35.1 per cent of additions to gross fixed assets during 1955- 1959. (See table below.) As noted, these would understate actual ex- penditures to the extent that certain costs are not capitalized but are charged against current income. 69. A large amount of investment is also reflected in categories that include outlays on refinery expansion. In particular, "incomplete construction" is believed to include expenditures on a new plant at Rio de Janeiro and on expansion of capacity at Mataripe and Cubatao, none of - 70 - PETROBRAS -- ADDITIONS TO GROSS FIXED ASSETS, 1955 - 1959 Millions of Per Cent of Cruzeiros Total Exploration and drilling equipment 799 3.7 Exploration, drilling and other costs 6,698 31.h Industrial plant and equipment 1,964 9.2 Incomplete construction 6,733 31.5 Marine and other transport equipment and installations 2 ,660 12.5 Other equipment 1,281 6.0 Realty 1,237 5.8 All other -10 .. 21,362 100.0 Source: Petrobras. which had been completed by the end of 1959. Together with "industrial plant and equipment", these account for 40.7 per cent of additions to gross fixed assets.* 70. Finally, the substantial increase in transportation assets -- amounting to 12.5 per cent of the total -- reflects the addition of four newly-built 33,000 dwt tankers to the Petrobras fleet in 1958-1959. (Another three are currently under construction.) 71. With respect to actual investment, as against the increase in gross fixed assets, Retrobras is quoted to the effect that 63 per cent goes for exploration and development, 19 per cent for refining, and 5.7 per cent for tankers.-E* There is no indication, however, as to the period to which such allocations apply -- whether the entire span of Petrobras operations or a more recent pattern of expenditure. In any case, it would appear that the largest share of investment has, in fact, gone into the program to expand crude oil output. This, of course, is the area where the gap between national production and consumption is most acute. * Besides refineries, other industrial installations -- e.g., synthetic rubber and fertilizer plants --- would be included here. iH* Journal do Commercio, December 10, 1958. - 71 - Petrobras Operations, 1954-1959 72. Over the six years Petrobas' capital outlays brought about a significant expansion in its operations. The first task Petrobas set itself was a build-up of Brazilian refinery capacity. As noted earlier, private refineries were allowed to continue operations but not to expand their plants beyond that authorized in 1953. Based on prior authorizations, privately-owned capacity was increased by 30,000 barrels per day -- from 22,000 barrels daily in 1953 to 53,000 barrels in 1959. At the same time, Petrobras undertook a major construction program. The small refinery at Mataripe in Bahia was expanded to 10,000 barrels per day. The partially-constructed installation at Cubatao, inherited from CNP, was completed and then enlarged; by 1959, its rated capacity was 94,000 barrels per day. All told, Petrobras capacity was increased by almost 100,000 barrels per day -- from merely 5,000 barrels daily in 1955 to 104,000 barrels daily in 1959. 73. A second task facing Petrobras was the need for rapid expansion of crude output. This, however, was to prove more difficult. 74. During the first three years of Petrobras operations, its drilling effort was even more limited than that of CNF immediately pre- ceding. Petrobras drilled an average of about 54 wells annually during 1954-56, compared with 65 by CNP in 1953. While the development of Bahia production continued to receive priority, a slightly larger number BRAZILIAN REFINERY CAPACITY AND RUNS TO STILLS, 1953 - 1959 (Thousands of Barrels Daily) 1959 1958 1957 1956 1955 1954 1953 Refining capacitya 156 152 114 111 102 87 27 Petrobras 10 T100 7-0 65 7 T7 - Private 53 52 44 46 47 42 22 Crude runs 151 137 123 108 71 6 6 Petrobras 97 -87 73 -T7 -ST NA NA Private 53 52 50 42 30 NA NA a At end of year. b CNP. Sources: Petrobras; Oil and Gas Journal. - 72 - of exploratory tests were drilled. These included several deep tests in the Amazon and Maranhao basins. Meanwhile, geological and seismic surveys were initiated in these areas and in Parana and Sergipe- Alagoas. 75. A marked upturn in Petrobras drilling occurred in the next two years. There were 79 completions in 1957 and 118 in 1958.*t By far the greatest increase was in exploratory tests, which come to account for almost a third of total wells. An increasing number of these were drilled in rank wildcat areas, 20 in 1957 and 26 in 1958. 76. Results were generally disappointing outside Bahia. Only 7 of 96 exnloratory wells in the first five years of operations were successful, and these were all in Bahia. In development drilling, on the other hand, about 80 per cent of all completions yielded commer- cial quantities of oil or gas. PETROBRAS EXPLORATION AND DEVELOPMENT DRILLING, 1954 - 1958 CNP 1958 1957 1956 1955 1954 1953 Total well completions 118 79 47 60 56 65 Oil 8 ° 7 33 X 9 Gas 2 2 1 5 3 4 Dry holes 36 31 13 27 24 8 Exploration 34 29 8 10 15 6 Oil 3 -3 2.. .. Gas 1 1 .. DryT holes 30a 26b 7 1a Development 84 50 39 50 41 59 Oil 77 39 33 Gas 1 2 . 5 3 4 Dr holes 6 9 6 18 9 4 a Including one oil show in non-commercial quantities. b Including four oil shows in non-commercial quantities. Source: American Association of Petroleum Geologists. * Comparable data are not yet available for 1959. A further substantial increase in well completions is indicated, however. - 73 - BRAZILIAN CRUDE OIL RESERVES AND PRODUCTION, 1953 - 1959 1959 1958 1957 1956 1955 195S 1953 Crude oil reserves (Millions of barrels) 620 480 418 311 255 150 50a Production (Thousands of barrels daily) 65 52 28 11 6 3 2 a Industry estimate; other reserve data from Petrobras. Sources: Petrobras; Oil and Gas Journal. 77. The intensive development of Bahian fields was reflected in the reserve position of Petrobras. Crude reserves were increased by about h70 million barrels -- from 150 million barrels in 1954 to 620 million in 1959. The major additions accompanied accelerated well completions in 1957-1959. And, as no major new field discoveries were made, the in- crease in reserves in effect represented extensions of the Bahia oil- fields. 78. In terms of production, the development program of Petrobras resulted in a sharp increase over the six years -- from 2,400 barrels daily in 1953 to 65,000 barrels daily in 1959. By far the larger part of the increase in production occurred in 1957 and 1958. 79. The increasing quantity of crude produced from Bahia presented Petrobras with something of a problem. Because of' its wax content, this crude has not been suitable for local refining operations, at least until specialized facilities could be installed. In conseouence, Petrobas has had to export a portion of its limited crude production -- 30,000 barrels per day in 1959. (See following table.) Recently, Petrobras entered into several arrangements with private international oil companies whereby it sells Bahian crude in exchange for purchases of imported crude of more appropriate quality.* * Under one such contract, for example, Standard Oil (N.J.) is reported to be buying 28 million barrels of Bahian crude from Petrobras over a period of 3 years -- averaging 25,000 barrels per day. Petrobras, in turn, would purchase 80 million barrels of Venezuelan crude from Jersey Standard over 6 years -- averaging 36 500 barrels per day. In return for these import supply rights, Petrobras probably receives a better price for its Bahian crude than it could otherwise obtain in a world crude oil market characterized by general over-supply. - 74 - PRODUCTION AND PLACEMENT OF BAHIA CRUDE, 1955 - 1959 (Thousands of Barrels Daily) Petrobras Production Refineries Exports 1959 64.6 34.4 29.7 1958 51.8 26.0 22.6 1957 27.7 26.3 (C.3 1956 11.1 10.1 . . 1955 5.5 5.1 ... Source: Petrobras. 80. In evaluating the accomplishments of Petrobras, one must cer- tainly take account of the difficulties it faced in the first five years of operations. Nevertheless, set against the expanding dimensions of Brazil's oil economy, the results would probably have to be counted as disappointing. What was achieved, in terms of additions to reserves and production, was too limited even to reduce the nation's import gap. Thus, Brazil still faced as large an imbalance between its oil requirements and supplies in 1959 as existed in 1953. (See table below.) BRAZILIAN OIL BALANCE, 1953 - 1959 (Thousands of Barrels Daily) 1959 1958 1957 1956 1955 1954 1953 Domestic Demand 233 225 193 195 177 159 137 Refinery Runs 151 137 123 108 71 6 6 Crude Production 65 52 28 11 6 3 2 Imports (net) 168a 178 168 188 166 165 135 Crude oil _M 92 9 X 5 -7 5 Refined products 82 86 70 93 105 158 131 Note: Includes stock changes. a Estimated. Sources: Petrobras; U.S. Bureau of Mines. - 75 81. By 1959, Brazilian petroleum consumption had grown to 233,000 barrels daily. This was some 95,000 barrels per day larger than in 1953. Refinery runs, at 151,000 barrels daily, met about 65 per cent of local demand as opposed to less than 5 per cent in 1953. Refined product imports were thus reduced to 82,000 barrels daily, compared with 131,000 barrels daily in 1953. 82. Crude production, at 65,0oo barrels daily, met two-fifths of Brazilts refinery requirements. And while this represented a substan- tial improvement over the 1953 level, it left the country with a rising. trend in crude oil imports. By 1959, net crude oil imports amounted to 86,000 barrels per day. 83. Together, net crude and refined product imports amounted to 168,000 barrels daily in 1959, compared with 135,000 barrels daily in 1953. The cost to Brazil came to $221 million. This represented 16.1 per cent of the nation's total import bill -- only a slightly smaller proportion than in 1953. 8h. The limitations on the contribution that Petrobras was able to make toward Brazilian oil development were probably inevitable in view of the terms and conditions under which it operates. Adequate develop- ment of the country's oil potential together with construction of refining facilities would have required an enormous capital investment, not just at the outset but continuing and increasing as energy needs mounted. With private companies excluded from the oil search and from refinery expansion, the full burden of these heavy capital requirements, as well as technical and managerial demands, fell entirely on Petrobras. 85. Petrobrast access to capital resources was necessarily limited, however. The infusion of social capital was substantial, both through direct Government subscription of tax receipts and reinvestment of divi- dends, and indirectly through favorable pricing for Petrobras refinery output. But Petrobras' call on Government financing had always to be considered against a background of other urgent economic and social needs. Prospects for Closing the Oil Gap 86. Closing the gap between Brazilian production and consumption is thus still a distant goal. And a stepped-up rate of capital investment will have to be achieved, if national self-sufficiency is to be realized. - 76 A PROGRAM FOR SELF-SUFFICIENCY: CAPITAL OUTLAYS AND IMPORT EXPENDITUPES TO MEET BRAZILIAN OIL REQUTREMENTS, 1955 - 1965- (Millions of Barrels) Capital outlays 2,410 of which: Foreign exchange 1,440 Crude and product imports 1,250 Total oil costs 3,660 of which: Foreign exchange 2,690 ' Consumption is assumed to rise at an annual rate of 9.5 per cent over the period, from 150,000 barrels daily in 1954 to 390,000 barrels per day in 1965. Source: UN Economic Commission for Latin America. Energy Development in Latin America. U.N. Estimates 87. An appreciation of the effort that would be required was in- cluded in a study by the Economic Commission for Latin America, covering the 10-year period 1955-1965. The ECLA assumed that oil consumption in Brazil would increase at an average rate of 9.5 per cent per year, and would reach 390,000 barrels per day in 1965. It then estimated the capital outlays that might be involved in achieving self-sufficiency by 1965, together with the cost of oil imports in interim years. It also estimated what portion of these expenditures would have to be met in foreign currencies. 88. Capital outlays to achieve self-sufficiency in crude and product output -- at 390,000 barrels daily in 1965 -- were projected at $2.4 billion, of which $1.4 billion in foreign exchange. Crude and product imports over the 10-year period, until self-sufficiency was attained, were estimated to cost $1.3 billion, all in foreign currencies. The total cost of the program, then, would be $3.7 billion, with $2.7 billion in foreign exchange outlays. 89. It should be noted, of course, that some of these capital costs have already been met, insofar as Brazilian production and refining have advanced from the 1954 levels that were taken as the base of BCLA Dro- jections. But by far the greater part of the increase in reserves and - 77 - production, as well as major refinery construction, remains to be accomplished. Thus, the rate of capital investment that will be re- quired if Brazil is to achieve self-sufficiency by 1965 is likely to be every bit as high as the ECLA figures suggest. Petrobras Expansion Plans 90. It is interesting to compare these ECLA estimates with the ex- pansion program that Petrobras has set for itself. In 1957, Petrobras adopted certain targets to be achieved by 1961. These included production of 110,000 barrels per day, enough to meet about one-third of anticipated demand.* Refining capacity was to be increased to 280,000 barrels daily; with existing privately-owned capacity of 50,000 barrels per day, this would enable Brazil to fill its product requirements. Sizable additions were to be made to Petrobras' tanker fleet, which would amount to 561,000 tons by 1961. 91. Production of 110,000 barrels per day by 1961 represents an increase of some 100,000 barrels daily over 1956 output (11,000 barrels daily). By 1959, production has been built up to 65,ooo barrels per day. Thus, Petrobras has been able to expand crude oil output by around 55,000 barrels per day in the first three years of its development plan -- a little more than half the target set for itself. 92. But, as noted previously, all of the expansion in production has come from the Bahia fields. Petroleum technologists suggest that it may not be possible to step up production at Bahia much further on the basis of present reserves without danger of too rapid depletion. And further substantial additions to reserves in Bahia are considered un- likely because of the physical limits of the basin. In fact, Petrobras has recently cut back output somewhat, apparently because of salt in- vasion occasioned by too-rapid rates of withdrawal. 93. Outside Bahia results have been disappointing. So far, no commercial deposits of crude oil have been found. But even if oil had been found, or were to be found in the near future, problems of develop- ment and transport would be formidable, as the areas of search are, for the most part, jungle areas far inland from coastal centers of population * Significantly, Petrobras was then contemplating oil consumption of some 330,000 barrels per day by 1961, as against the ECLA Drojection of 390,000 barrels per day by 1965. The Petrobras projection has since proved to be somewhat overstated. - 78 - and industry. Huge investments and a considerable time lag would thus be required to bring any newly-discovered oil to market. 94. Petrobras' ability to meet its crude production goal by 1961 would therefore seem doubtful at best. This is not to suggest that Brazil's oil prospects would appear poor. To the contrary, the country's prospective sedimentary basins encompass an area of 750,000 square miles, only a very small portion of which has been tested. The oil potential of this vast area will be known only after extensive exploration. And meanwhile, even if the first results of such an oil search should turn out to be favorable, the risk of repeated and prolonged failures will be great. 95. In its refining program, construction of an additional 230,000 barrels per day beyond 1956 capacity was implied. By the end of 1959, Petrobras has added 45,000 barrels per day to its refining installations. The bulk of the projected increase, then, would have to come in 1960 and 1961. At nresent, Petrobras is building a 42,000-barrels-per-day exten- sion to its Mataripe refinery and a 15,000-barrels-per-day extension to the Cubatao plant. A completely new 90,000-barrels-per-day refinery complex near Rio de Janeiro is also under construction. Within the capacities being installed are special facilities to process Bahia crude. These additions, which are to be completed in 1960, would bring total capacity to within 40,000 barrels daily of the 1961 goal. Meanwhile, consideration is being given to construction of a 45,000-barrels-daily plant 300 miles north of Rio de Janeiro and a 25,000-barrels-daily re- finery in the south, where present facilities do not satisfy local re- quirements. 96. Whether Petrobras will realize its target of 330,000 barrels daily of refinery capacity by 1961 is not certain. Some lag beyond the target date seems likely merely from the fact that construction takes time and some of the needed facilities have not yet been started. Never- theless, self-sufficiency in product requirements will probably be attained upon completion of facilities now under construction, in view of a somewhat less rapid growth in demand than had been anticipated. 97. With respect to the Petrobras tanker program, it is significant that the bulk of construction and additions to the fleet comes at a time when there is an unprecedented surplus of world tonnage, and tanker rates are unusually depressed. In 1958, a CNP review of Petrobras opera- tions criticised the proposed purchase of seven 33,000 dwt tankers as - 79 - "superfluous and uneconomic."* Petrobras' reply emphasized the savings on foreign exchange that could result from the use of its own fleet; and pointed out that construction costs would be amortized in 6 1/2 years. Apart from these issues, the commitment of scarce capital to a tanker program illustrates the knotty question of resource allocation which Petrobras faces. 98. Inevitably, the hypothecation of funds to shipbuilding im- pinges on the financial resources available for exploration. And it is just this latter area where delays in national oil development are critical. Significantly, the cost of Brazilian net oil imports from 1955 to 1959 amounted to $1,266 million, compared with the $1,250 million projected by the ECLA for the ten years from 1955 to 1965. This, of course, points up the fact that delays in meeting the national oil deficit mean higher foreign exchange costs in the long run. The Problem Ahead 99. It is precisely here that Petrobras faces an uncomfortable dilemma. So long as private capital is excluded from the oil search, results depend entirely on the effort that Petrobras can muster. With limited capital resources, Petrobras must ration its funds among alter- native functions, the most risky being production operations. Within its production program, it must decide how much will be allocated as between development and exploration; and for exploration, as among alternative areas and sites. 100. To skimp on the exploration budget in favor of projects that promise more immediate and secure returns could buttress the company's income position in the short run. But it would threaten the country's future crude position. Yet to expend sufficient funds on exploration The CNP report (October 4, 1958) was critical of Petrobras planning in several respects -- including over-expansion of refinery capacity, too high fuel oil yields, excessive fuel oil prices, and improper conser- vation practices. Petrobras, in turn, defended its decisions, and a Special Commission appointed to investigate CNP charges generally agreed with the position taken br Petrobras. Lacking detailed infor- mation, we would not presume to discuss the various points at issue. In any case, the focus here is on the inherent problems involved in government oil operations, as they confront Petrobras in its program to cope with the Brazilian oil imbalance, and it is in this context only that the tanker construction program is considered. - 80 - might deprive other operations of essential capital. And there is no guarantee of success in the exploration effort. As the sole agency responsible for such decisions, Petrobras would inevitably bear the onus for "1ost" capital -- even though in the long run, repeated failures may be the price paid for a successful exploration program. Thus, there is a constant danger that the exploration effort -- upon which future Brazilian oil supplies basically depend -- will suffer by virtue of the allocation of scarce capital resources to projects promising more immediate and more certain results. 101. Turning to the cost of the 1957-61 program, Petrobras estimates it at $900 million, implying average annual outlays of $180 million. In 1959, the funds available to Petrobras came to some Cr$ 1,973 million. About a third was taken up in working capital. Allowing for the preferential exchange rate on Petrobras purchases abroad and for exploration costs that may have been expensed, it would appear that the scheduled program involves financial outlays perhaps half again as large as those that Detrobras was able to sustain in 1959. 102. In its expansion program, Petrobras is charting the course of operations that have only recently come into being. Its industrial undertakings alone (refineries, etc.) involve commitments that are many times larger than existing assets. To raise additional funds, and foreign exchange, beyond the sources on which Petrobras has drawn in the past (retained earnings and new capital from the Government), the company is turning to long-term credits. These are being sought largely from foreign equipment manufacturers. The proceeds from such loans would go to cover a portion of the cost of refinery expansion and of imported equipment to step up exploration. How successful Petrobras has been in securing foreign loans is not known. Scattered announcements suggest that perhaps $120 million may have been raised thus far.*, 103. It is important, in this context, to distinguish the conditions under which Petrobras seeks access to foreign capital from those under which private enterprise finances its world-wide operations. As was stressed previously, a major part of the capital requirements of the inter- national oil industry are financed internally. And where additional funds have to be raised from outside, the profitability of established opera- tions provides security against the loans or equity that is subscribed. Thus, the greatest risks -- such as exploration ventures into new and uncertain areas -- are in effect subsumed within the companies' diversi- fied operations. * As noted previously, Petrobras floated Cr$ 1,950 million in long-term debt in 1958-1959, when the Government stopped turning over deposits of motor vehicle owners. - 81 - 104. Beyond these capital commitments for refinery construction and equipment imports, Petrobras will have to incur very substantial explor- ation costs a.s the search for oil spreads out from Bahia to more remote prospecting a.rea.s. An unusual stroke of good fortune could turn up huge reserves, leading to a, rapid build-up of production. Or repea.ted failure could eat up the company's financial resources and threaten its very liquidity. Even if the nation's oil resources prove to be a.bun- dant, the period of explora.tion and development -- during which finan- cial requirements will exceed the value of oil extracted -- is likely to be considerable. 105. Significantly, the production goal that Petrobras has set for 1961 would still meet only perhaps two-fifths of the na.tion's crude oil requirements at tha.t time. Thus the program that Petrobras is able to undertake is obviously a limited one -- whether mea.sured against the trend in petroleum consumption, or a.gainst the exploration effort tha.t would be required to probe Bra.zil's va.st potential. 106. A critica.l problem for Brazil, as for many other countries of rapidly mounting oil requirements, is one of timing -- how to mobilize the technical and financial means now and in the yea.rs immediately ahea.d in order to develop the country's resources for the future. Judging from past performance, if Petrobras has to shoulder the entire burden -- even straining to the utmost its financial and technical capa.bilities -- it may not be able to bridge the ga.p between Brazil's consumption and production. - 82 - Mexico 107. In contrast to the youthfulness of the oil industry in Brazil, commercial oil operations in Mexico began as early as 1901. Rapid development ensued, sparked by strong competition among a number of private producers. By 1921 output amounted to more than half a million barrels per day, and the country ranked as the world's second largest oil producer. Mexican crude and refined products were a major source of supply for European oil markets. Domestic demand absorbed only a small fraction of Mexican output. 108. Mexican oil production began to decline after 1921 and by the end of the decade amounted to only one-fifth of its earlier peak, or about 108,000 barrels per dav. A number of factors were responsible. For one, rapid expansion of production in the preceding years may have been at fault. It apparently led to salt water invasion of some key producing fields, notably in the Golden Lane near Tampico. It also tended to reduce the amount of recoverable reserves in other of the older fields. And while drilling continued at a fairly intensive pace in the 1920's, additions to reserves were generally disappointing. Meanwhile Mexican production costs were rising at a time when Venezuela was becoming increasingly attractive as a source of low-cost crude. 109. Output recovered somewhat in the 1930's, although under the influence of the recession capital expen.litures were generally cut bacK. Labor difficulties and an atmosphere of legal uncertainty as to the future of private oil operations in Mexico also tended to discourage investment. 110. In March 1938, Mexico nationalized its oil industry by expro- priating the producing, refining, and marketing properties of the major private companies. These properties, which accounted for more than 90 per cent of Mexican productive capacity, were turned over to a newly- formed state entityn Petroleos Mexicanos (Pemex). Since then Pemex has gradually absorbed all the producing and refining operations left in private hands -- by purchase, on expiration of lease, or by law (1959). Establishment of Pemex 111. In 1937, the year immediately preceding nationalization of the oil industry, Mexican oil production amounted to 128,000 barrels daily. Of this, 118,000 barrels per day, or roughly 92 per cent, was refined in Mexico. - 83 - MEXICAN OIL BALANCE, 1937 (Thousands of Barrels Daily) Production 128 Refinery Runs 118 Domestic Consumption 62 Exports (net) 64 Crude oil 20 Refined products 4L Domestic consumption accounted for 62,000 barrels daily, or about half of local production. On balance, 6b,000 barrels per day were exported; more than two-thirds of this was shipped out as refined products. Actual exports were slightly larger, the difference being accounted for by a small quantity of product imports for areas remote from loca.l refineries. 112. What Pemex inherited, then, was a large, going oil operation that not only met internal requirements, but supported a significant export trade. To conduct these operations and build for the future, Pemex was conceived as a public corporat-on, or independent government a.gency, with no private equity. As such, it w7as anticipated that Pemex would pay the same general taxes applicable to private business opera.tions.* These included, among others, import duties and income taxes. 8* In a.ddition, Pemex was to act as collection agency for gasoline consumption taxes, to be passed on to the Government. * This philosophy is forcibly stated by the Director General (1946-58): "... the Mexica.n people have a right to expect that exploitation of petroleum resources produce greater revenues for the national trea.sury in order that the State can meet its increasing expenses and improve public services. That is to say, it is not the State that ought to come to the aid of Pemrex, but Pemex that must -- and easily can -- contribute in greater degree to public finances." Antonio J. Bermudez, Doce Anos al Servicio de la. Industria. Petrolera Mexicana., 1960, p. 271. 8* Seminario judicial de la federacion, vol. 88, pp. 1h36-1W43. Pemext liability for income taxes appears to have been rescinded at a later date. - 8h - 113. An August 19L0 Amendment to the 1938 law added new fiscal responsibilities.* The Government was to receive 3 per cent interest on its investment in Pemex (to be charged as an operating expense) plus royalties to be fixed each year by the Government at a figure between 10 and 35 per cent of Pemex production. After these charges and other costs of production had been met, nret earnings were to be distributed as follows: 20 per cent to a reserve fund for expansion; 60 per cent to the Federal Government and 20 per cent to labor. The law also provTided that the Government might put its interest and royalty receipts back into Pemex as new capital. llh. Finally, in l9!d a new law xy required Pemex to reimburse the Goverrment for iL..demnification payments on account of expropriation, which the Governmlent had carried up to that time. These payments we-re to be given prec,edence over interest and royalties. To meet them, Pemex was to set aside 10 per cent of- gross revenues less ta-.es. 115. Government oil activity in Mexico was thus launched on the basis of an established industr3y. It was presumed that operations would be largely self-financin;, throuvh depreciation reserves and retained earnings. Beyond these, Pc.mex was expected to cover indemnification payments and interest on its patrimony out of current revenues, and further contribute to the national treasury via royalties and income tacr. Early Problems 116. The earlyr problems of Pemex were largely those of maintaining operations. It inherited substa-ntial producing and refining capacity, but the transition to government ownership was to involve difficulties of management, technology, and economic orientation. At the outset, the diverse organizations and facilities of almost a score of private companies had to be brought together. This would require a plan of coordination and would inevitably taKe some time. Meanwhile, Pemex would have to cope with a severe shortage of skilled personnel. Since the expropriation decree had been abruptly promulgated, there was an immediate and pressing need for trained Mexicans to assume vacated positions. Nationalization did not find Mexico completely unprepared, of course. As a, matter of policy, the oil companies had long been * Diario oficial, December 31, 19L0. F Diario Oficial, December 2, 194b. - 85 - training Mexican personnel for administrative and technical posts. In addition, the Government had limited experience with oil operations through the activities of the National Petroleum Administration.* 117. But these hardly prepared Pemex for the vast and complicated problems of management with which it was confronted. Indeed, these problems were not to be confined to the period of transition. As a state entity, Pemex has undoubtedly been constrained in its personnel policie's; rigorous regard for the economies of operation would ine-itably be tempered by pressure to sustain employment, even where it might mean less than optimum utilization of its labor force. And Pemex has had chronic difficulty in its management and technical staffing. This difficulty is described tersely by a former Director General of Pemex:e- * .. salaries are better at the lower levels than for those more highly qualified.... In the last 12 years, no less than 500 professionals, of diverse activities, left the industrv for other better paying jobs. ... the crisis of e4xpansion which has affected the company has manifested itself also in terms of skilled personnel -- the rapid development of its operations has required a greater number of skilled workers in less time than it takes to train them. 118. In addition to being short of trained personnel, Pemex found itself effectively cut off from access to new developments in oil tech- nology. Prior to nationalization the Mexican oil industry had as a matter of course benefitted from the relatively free flow of technical knowledge which characterizes the world-wide operations of the inter- national oil industry. But once their properties were taken over, the international companies were understandably reluctant to lend technical assistance. It was not until 1948 that Pemex was able to enlist the * This agency had a long and checkered history. Established in 1925, it had been engaged in both production and refining in competition with private companies, and had also regulated domestic prices of oil products. Converted to semi-private but wholly Mexican-owned status in 193M, as Petromex, it was reestablished as a government operation in 1937. It had production of around 16,000 barrels daily and operated a small topping plant when Pemex took over Mexican oil activities. As* Antonio J. Bermudez, op. cit., p. 207. - 86 - services of a foreign oil company in Mexico (see below).- In the meantime the new state entity was left largely to its own technological resources. 119. A second set of problems derived from the economic orientation of the Mexican oil industry. As noted earlier, half the nation's petroleum production was exported in 1937, as either crude or refined products. The country's five refineries had been desi-gned for that export trade. Thus, they were located at tidewater, with straight-run distillation facilities for high fuel oil and low gasoline yields. MEXICAN OIL BALANCE, 1937 AND 1946 (Thousands of Barrels Daily) 1946 1937 Production 135 128 Refinery runs 122 118 Domestic consumption 115 62 Exports (net) 17 64 Crude oil 9 20 Refined products 8 44 Sources: Secretaria de Ecoriomia, Compendio estadistico; Bermudez, op. cit.; U.S. Bureau of Mines. 120. Following nationalization, foreign mark.et outlets of the inter- national companies that had been operating in Mexico were lost, and exports dropped off sharply. Some trade was arranged in Europe, in large part on a barter basis, but this was interrupted by the outbreak of war. In " Earlier, in 1944, the Export-Import Bank had authorized a $10 million credit for the construction at Atzcapotzalco of a 36,000-barrels-daily high octane gasoline refinery. The U.S. Government classified this as a war project to provide Mexico with aviation gasoline for hemispheric defense. The plant was completed in late 1946. - 87 - consequence, oil operations in the early years after nationalization were essentially limited to meeting domestic demand. Initially this meant some reduction in the over-all level of operations until gains in domestic consumption could offset reduced exports. Beyond this, Pemex production and refinery runs were to be held back by technical difficulties, particularly in regard to refinery location and product mix, which, as noted earlier, had been designed primarily to meet external requirements. 121. The loss of export markets severely impinged on the industry's income -- not only by reducing the paysical volume of sales but also by elimina.ting its most prof'itable markets. Long before expropriation the Mexican Government had established a policy of low internal petroleum prices as a stimulant to industrial development, transportation and living standards. Thus, the export operations olf private industry were called upon to subsidize petroleum consumption within the country. Prices continued to be held down under Pemex. With the loss of e-port outlets, Pomexc thus was 'aced with a more than proportionate decline in income a x a sharp limitation on its ability to generate internal funds for reinvestment. 122. In the early years, then, Pemex found itself in a very difficult position. To overcome immediate problems and initiate a vigorous develop- ment of the nation's oil reserves, Pemex w,ould need a heary influx of imported equipment and technical skills. But wartime eouipment shortages, and the disfavor of the oil companies, to pethLer with a scarcity of capital funds, held t]he oil development effort to a minimum. Well completions avera2ged only 29 per year in 1938-19L46, as compared with 86 per year in 1933-37. And little was done in the way of enlarging or modernizing rec ineries. Postwar Developments 123. By 19L6 a rising trend in domestic constumption had permitted a recovery in production and refining to pre-nationalization levels. (See table above.) A number of long-range problems now presented themselves in clearer perspective, however. Oil activities in 19h6 were almost completely dependent on the facilities taken over by expropriation. Those facilities were now eight years older. As the postwar period began, Pemex was t,ius faced with the urgent need for replacement and moderniza- tion of its productive and refinery capacity merely to sustain operations. 124. A second problem was to be posed by the postwar expansion in Mexican oil consumption. Between 19L6 and 1959 demand for petroleum products increased at an average rate of almost 7 per cent per year. This meant that oil consumption more than doubled over the 13-year period, increasing by about 12,000 barrels daily, on average, each year. - 88 - 125. Consequently, even though the Mexican oil industry was already relatively mature at the war's end, enormous capital expenditures would be required of Pemex in the years ahead. First, replacement and modern- ization of existing installations would call for sizable investment. Then, additions to productive capacity to keep pace with rising demand and provide for future growth would mean even larger expenditures, that would continue and mount as consumption increased. Cash outlays were certain to exceed cash income for many years; and a heavy inflow of' new capital would be needed to meet the cash drain. In this, Pemex' financial requirements would not be dissimilar from those of a relatively new oil operation. 126. The postwar activities of Pemex di-ide naturally into two periods. Through 1954, Pemex was chiefly concerned with initiating a substantial program of exploration, development and modernization to make up for the long wartime years of neglect. After 1954, the major problem would be to expand productive and refining capacity so as to rmeet Mexico's rising energy requirements. 1947-1954 127. The first task Pemex set itself was to step up exploration and development. During this period, when Pemex faced great difficulty in obtaining capital and equipment, private participation was still permitted. First, Pemex attempted to interest Mexican nationals in exploration and development rights, with compensation to take the form of a share in production. Only one such contract was signed, however, and it was never carried out. In 1948, Pemex entered into an agreement with Cities Service, a, U.S. cornpany whose Mexican subsidiaries had. not been nationalized. The concessionary rights of these subsidiaries were relinquished, and in return, Cities Service agreed to undertake drilling operations under Pemex direction. Cities Service was to provide tech- nical and administrative staff and assist in acouiring equipment. The corapany was to have the right to purchase 50 per cent of an-y newly discovered oil at an agreed price somewhat below Gulf Coast quotations. 128. In 1949 Pemex signed two agreements with an American group organized as the Mexican Independent Corrpany (CIMA).* The areas covered were on the Isthmus of Tehuantepec and offshore in the Gulf of Mexico. Under both contracts, CITA was given rights to explore and drill for oil and gas until a fixed number of structures had been developed, or for 12 years inland and 15 years in the Gulf. The company was to pay all * American Independent Oil Company, Signal Oil and Gas and Edwin L. Pauley. - 89 - expenses, but would be reimbursed if successful out of 50 per cent of gross production. CDMA was to receive additional payment of 15-18 per cent (depending on the area) for up to 25 years. A separate contract was later concluded with Edwin L. Pauley, conferring similar rights in north- eastern Mexico.* (These operations resulted in gas discoveries on the Isthmus in 1950 and in the northeast in 1958, and an offshore oil dis- covery in 1959.) 129. Pemex also entered into drilling agreements with several other American and locally-organized groups. These contractors were paid on a fee basis. 130. In 1959, however, a new oil law wa.s adopted with two major ob- jectives. The first wa.s expropriation with compensation of the remaining small private ventures that were operating under pre-1938 concessions. The second was an affirmation of Government policy prohibiting any new contracts with private companies tha,t called for payment on other than a fee basis. This, in effect, ruled out any further contracts of the type negotiated with CIMA in 1949. 131. Pemex itself increased the pace of drilling as soon as wartime shortages of equipment were overcome. From an average of less than 30 wells per year in 1938-1946, completions rose to more than 200 by 1950 and to 300 by 1952. A substantial number, close to two-fifths of all wells completed over the period, was drilled to locate new oil reserves. Pemex wa,s quite successful in its exploration effort; about 40 per cent of al1 exploratory well completions resulted in new discoveries of oil or natural gas. In subsequent reorganization of these ventures, Signal withdrew and Petrofina entered. In 1958, Pauley took over sole responsibility for operations. Offshore operations are now yielding about 6,000 barrels daily; a 35,000-barrels-daily link with Pemex pipelines is being built. The price Pemex pays for the oil has reportedly been adjusted downward in reflection of the current world crude situation. - 90 - PEMEX -- EXPLORATION AND DEVELOPMENT DRILLING, SELECTED YEARS, 1938-1954 1938-1946 1954 1952 1950 1948 Average Total well completions 293 307 223 82 29 Oil 193 169 11 ( 44 16 Gas 9316 17 (1 Dry holes 100 122 87 38 13 Exploration 121 111 100 24 4 Oil 39 3 1 Ga.s 18 8 6 3 ( Dry holes 6h 68 57 17 3 Development 172 196 123 58 25 Oil ( 3 -7 ( Ga.sl ( 136 8 11( 37 15 Dry holes 36 54 30 21 10 Sources: American Association of Petroleum Geologists; Bermudez, op. cit. 132. It is noteworthy, however, that drilling activity wa,s largely concentrated in established area.s. More than three-fifths of all wells drilled between 1947 and 1954 were located within the Tampico basin, Mexico's oldest and most prolific producing zone. Another quarter wa,s located in the Isthmus and Tabasco region, which also had some estab- lished production. A modest drilling program was centered in north- ea.stern Mexico, which emerged as an important potential ga,s producer during this period. And a, small amount of drilling wa.S also carried out in Lower California and a.round Vera Cruz, both of which were rank wild- cat areas. 133. The drilling program of Pemex led to substantial increases in re- serves and production during these years. Proved reserves were more than doubled between 1946 and 1954. Most of the build-up was accounted for by extensions and revisions of the older producing fields in the Tampico and Isthmus zones. Important oil discoveries were made in Tabasco in 1951 and 1954 and in Tampico in 1952. The latter established produc- tion 35 miles south of the prolific Golden Lane and suggested good - 91 - MEXICAN OIL AND GAS RESERVES AND CRUDE OIL PRODUCTION, SELECTED YEARS, 1946-1954 1954 1952 1950 1948 1946 Crude oil reserves (Millions of barrels) 1,750 1,525 1,300 850 800 Production (Thousands of barrels daily) 234 211 198 164 135 Natural Gas Reserves (Billions of Cubic Feet) 1,994 1,572 1,401 NA NA Sources: Pemex; World Oil, Oil and Gas Journal. oil potential for the entile area. in between. This possibility was later confirmed. Another notable drilling success was the initial discovery of oil in the Angostura field near Vera Cruz in 1953. 134. Several important gas discoveries were also made during this period -- in the northeast and on the Isthmus. By 1954 natural gas reserves amounted to 1,994 billion cubic feet. 135. While production did not expand quite as much as reserves, Pemex was able to boost output at an average annual rate of almost 7 per cent over the eight-year period. Virtually all of this increase came from the Tampico zone, which still accounted for more than 85 per cent of Mexican oil production in 1954. However, a considerable volume of Tampico production, as well as Isthmus and Tabasco crude, came from wells drilled by Pemex after 1946. 136. The second major effort of Pemex was modernization and e xpa.nsion of refineries. Between 1946 and 1954, 66,000 barrels daily were added to processing capacity, bringing the total to 243,000 barrels per day. Major additions were made to the Cuidad Madero refinery at Tampico, raising its capacity from 57,000 to 78,000 barrels daily. A new 30,000-barrels-per-day plant was constructed at Salamanca, north of Mexico City, to supply the oil needs of the surrounding a.rea. A 7,000-barrels-daily plant wa.s installed at Reynosa, nearby the newly-discovered northeastern oil and gas fields. - 92 - MEXICAN OIL BALANCE, 19h6 AND 195L (Thousands of Barrels Daily) 1954 1946 Production 234 135 Refinery runs 221 122 Consumption 201 115 Exports (net) 29 17 Crude oil 13 9 Refined products 16 8 Sources: Pemex; Bermudez, op. cit.; U.S. Bureau of Mines; World Oil. 137. By 195$, Pemex had thus made considerable progress toward provid- ing for Mexico's postwar oil requirements. While consumption had risen to 201,000 barrels daily, production of 23h,000 barrels per day yielded a small margin for export. Refining facilities had been updated and new plants located closer to centers of consumption. Distribution facilities had been improved, with Tampico fields linked to Mexico City by crude oil and natural gas pipelines and to Salamanca. by a crude oil line. 138. Serious problems remained, however. Distribution channels were still inadequate, so that product imports were required to supply isolated areas. These being high in unit cost compared with the value of crude oil or heavy fuel oil exports, a narrow margin of net exports wvould not be enough to prevent an adverse exchange balance. Indeed, a Combined Working Party* in 1951 concluded that Mexico might become a net importer within a few years. Much additional investment would be necessary to translate newly-discovered gas reserves of the Northeast and Isthmus regions into marketable energy. Drilling operations would have to be stepped up further to keep productive capacity in line with increasing consumption; and the search for oil would have to spread out with more attention to newer areas such as the northeast, Vera Cruz and Tabasco. - A joint group of experts representing the International Bank for Reconstruction and Development and the Nacional Financiera of Mexico. - 93 - 1955-1959 139. Considering the capital requirements that these objectives would entail, it is interesting to note the order of priority that Pemex adopted. The refinery program was accelerated; total drilling tended to level off; and exploration activity yielded to development. 140. As the following table shows, Pemex refinery capacity wa.s increased by more than 100,000 barrels daily between 195L and 1959. The bulk of this came early in the period, with completion of a 48,000-barrels- per-day addition to the Atzcapotzalco (Mexico City) plant, and smaller additions to the refineries at Salamanca, northwest of Mexico City, Ciudad Madero, and Arbol Grande, near Tampico. Later, 60,000 barrels daily were a.dded to the capa.city at the refinery at Minatitlan on the Isthmus. 141. Additions to refinery capacity far exceeded the growth in refined product demand during the four-year period, as witness the trend in refinery runs. In part, the sharp increase in new facilities was designed to provide for future needs; in part, to permit the retirement of inefficient equipment. While precise figures on retirements are not available, it is known that at least 36,000.barrels daily of obsolete capacity were dismantled at the Ciudad Madero, Arbol Grande and Minatitlan plants, once new units had been installed. 142. Exploration and development drilling continued to. increase until 1956, when some 400 wells were completed. Thereafter, however, drilling activity levelled off. There was a marked empha.sis on development a.ctivity; and the number of exploratory wells declined, accounting for about a quarter of all completions a.fter 1955, as against two-fifths in 1951-1954. PEMEX -- REFINERY CAPACITY AND CRUDE INPUTS, 1954-1959 (Thousands of Barrels Daily) 1959 1958 1957 1956 1955 1954 Refinery capacity 357 328 322 320 290 243 Crude runs 287 261 243 238 232 221 Sources: Pemex; Oil and Gas Journal. - 94 - PEMEX -- EAPLOPAITORY AND DEVELOPMENT DRILLING, 1951-1959 1951-1954 1959 1958 1957 1956 1955 Average Total well completions 389 319 389 L02 330 306 Oil 277 270 20 223 717) Gas 20 35 68 44 38) 184 Dry holes 91 94 116 135 104 122 Exploration 81 76 108 113 114 122 Oil 3T 10 -17 27 27 39 Gas 8 7 19 24 18 11 Dry holes 39 59 74 62 68 72 Development 303 303 281 289 216 18h Oil T47 270 190 :9o 160 ) Gas 12 28 49 20 20) 134 Dry holes 52 35 42 73 36 50 Sources: Pemex; American Association of Petroleum Geologists. 143. At the same time, the location of drilling activities shifted somewhat toward newer producing areas. Tampico, where more than three-fifths of all drillinng was concentrated prior to 1955, accounted for less than half in 1955-1958. The southern zone -- Isthmus-Tabasco regions --was now the focus for 35 per cent of all drilling activity, especially in Tabasco where several important new fields had been discovered in 1951 and 1954. Drilling was also stepped up in the Northeast and around Vera Cruz. 144. There were a number of significant discoveries in this period, as well as extensions of older fields. In 1956 Pemex located a new producing zone in the Poza Rica area of Tampico. Several other important finds were made in the Tampico region in 1955-1957; these established the producing potentia.l of the New Golden Lane, first located in 1952. Three oil fields were found in Tabasco in 1957 and 1958 Elsewhere, drilling activity was turning up an increasing volume of gas reserves -- in the Northeast, near Vera Cruz, and along the Isthmus. By 1959, crude oil reserves had increased to 2,700 million barrels. Gas reserves had grown to 8,100 billion cubic feet -- four times the 1954 figure. - 95 - PEMEX -- CRUDE OIL AND NATURAL GAS RESERVES, 1954-1959 1959 1958 1957 1956 1955 1954 Crude oil reserves (Millions of barrels) 2,700 2,510 2,066 1,750 1,500 1,750 Natural gas reserves (Billions of cubic feet) 8,100 7,500 6,540 2,770 2,470 1,994 Sources: Pemex; Oil and Gas Journal; World Oil. 145. Crude oil production increased but modestly, however, from 234,000 barrels daily in 1954 to 290,000 barrels daily in 1959. With internal consumption rising more rapidly, the export margin was narrowed. By 1957, refined product imports exceeded exports of crude and products by 6,000 barrels per day; and for the first time in its history Mexico had an adverse balance in its oil trade. This was repeated in 1958; preliminary figures for 1959 suggest that growth in consumption slowed, and a small export bplance was_reestablished. - 146. On the other hand, output of natural gas tripled between 1954 and 1959, reaching 329 billion cubic feet in the latter year. This expansion was made possible by the important gas discoveries of the period, and the construction of absorption plants for processing gas produced with crude oil at Reynosa, in the northeast, and at Ciudad Pemex on the Isthmus. A start was also made on a pipeline network to link the northeastern and Isthmus fields with major energy-consuming centers. In 1955, Pemex began exporting natural gas across the frontier to the United States; these shipments amounted to 51 billion cubic feet in 1959. Greater production from Pemex' substantial gas reserves awaits construction of pipeline facilities. 147. Summarizing postwar developments, it would appear that Pemex has accomplished much by the way of developing Mexican oil and gas resources and improving physical installations, though how this perform- ance stacks up against the country's oil potentipl 2nd how costly it has been is not known. Progress was e.specially marked in the early postwar period when Pemex was able to build on established facilities. In recent years, however, oil operations were barely able to keep pace with national requirements, so that an industry which had once supported substantial export sales is now faced by a precarious balance between production and consumption. Part of the difficulty is owing to deficiencies in internal transport and distribution. But future _ 96 - availability may also be affected. by recent cutbacks in exploration activity, reflecting continuous problems of financing Pemex's ambitious undertakings. MEXICAN OIL BALANCE, 1954-1959 (Thousands of Barrels Daily) 1959 1958 1957 1956 1955 1954 Production 290 274 253 258 250 234 Refinery runs 287 261 243 238 232 221 Consumption 269 258 249 235 212 201 Exports (net) 13 -4 -6 18 25 29 Crude oil NA ... 7 17 13 Refined products NA -4 -13 ... 10 16 Sources: Pemex; Bermudez, op. cit.; U.S. Bureau of Mines; U.S. Depart- ment of Commerce. Financial Concomitants 148. It is difficult to construct an integrated picture of Pemex's financial position over the years of government oil operations. Pemex did not publish any balance sheets, for example, between 1948 and 1958. However, scattered data and statements provide a basis for rough analysis of the sources and uses of funds, profitability, and financial relationships between Pemex and the Government. 149. Through 1958, the two major sources of financing for Pemex's capital investment were its depreciation reserves and long-term borrowing. Neither earnings nor new capital made any significant contribution. (See table below.) It should be noted, however, that Pemex probably covered a sizable amount of exploration expenditures -- e.g., dry holes that were not capitalized -- though current expenses charged against gross revenues. 150. Considering the scope of fixed assets with which Pemex started out, and the scale of its operations, depreciation reserves established - 97 - out of gross revenues provided a continuing support for capital expendi- tures. But such reserves would have had to cover the cost of replacing extant capacity. Normally, expansion of net assets would be financed, at least in part, out of retained earnings. By law, 20 per cent of net income was to be set aside in a reserve for expansion. But Pemex has reportedly suffered operating losses, or shown minimal earnings at best, over the course of years. FINANCING CAPITAL INVESTMENTS OF PEMEX, 1947-1957 Millions of Pesos Per Cent of Total Reserves 3,116 51.1 Debt 2,998 48.8 New Capital 24 a 6513b 100.0 a Less than 0.5 per cent. Source: Bermudez, op. cit. Prices and Profits 151. During 1955-1958, for example, aggregate earnings (after payments to Government on account of expropriation debt) apparently amounted to no more than 6 per cent of gross revenues. In Brazil, it will be recalled, Petrobras earnings ranged up to 24 per cent of gross revenue in the same years. A major factor holding down Pemex profits was the relatively low prices received for its oil products. 152. As noted earlier, the Government initiated a policy of low oil prices prior to nationalization when exports were the main source of industry income. This policy was maintained after Pemex was established and export sales declined to at most a marginal operation. As a result, the Mexican oil economy itself had, in effect, to subsidize low-cost energy, while Pemex was hard pressed to generate internal funds for reinvestment. Thus, regardless of operational performance, Pemex was bound to face serious financial problems on the basis of pricing policy alone. 153. As the table below shows, gasoline prices in Mexico were considerably below those in other Western Hemisphere countries except - 98 - RETAIL GASOLINE PRICES IN SELECTED COUNTRIES, 1957-1958 (U. S. Cents Per Gallon) Mexico, D.F., Mexico (80 oct.) 22.7 (Nov. 30, 1958) Ciudad Bolivar, Ven. (reg.) 11.4 (Oct. 22, 1957) New York, U.S.A. (reg.) 31.7 (Dec. 15, 1957) Buenos Aires, Arg. (80 oct.) 32.6 (Nov. 26, 1957) Rio de Janeiro, Brazil (reg.) 40.1 (July 1, 1958) Santiago, Chile (75 oct.) 30.9 (May 13, 1958) Source: U.S. Bureau of Mines. for Venezuela. The margin on Pemex's lowest grade of gasoline (Mexo- lina), which accounted for the bulk of sales, was especially small. And Pemex's retail sales of kerosene, diesel fuel and residual fuel oil were at prices below cargo quotations at the Caribbean and U.S. Gulf. PETROLEUM PRODUCT PRICES -- RETAIL IN MEXICO CITY AND CARGO SALES IN CARIBBEAN, JUNE 1958 (U. S. Cents Per Gallon) Mexico City Cargo Sales Retail less Caribbean and Retail Direct Tax U.S. Gulfa Gasolmex (90 oct.) 27.3 24.3 10.042 Supermexolina (80 oct.) 22.7 19.7 8.917 Mexolina (70 oct.) 16.7 13.7 8.792 to taxis, buses, etc. 10.6 7.6 8.792 Kerosene 4.55 4.55 8.625 Diesel fuel 4.85 4.85 8.375 Residual fuel oil 2.63 2.63 5.36 a Low of Plattts. Sources: Bermudez, op. cit.; U. S. Bureau of Mines; Platt's Price Ser- vice. - 99 - PEMEX -- FINANCIAL STATENENTS, 1958 AND 1959 (Millions of Pesos) 1959 1958 Current Assets 2,134 1,742 Gross Fixed Assets 10 016 8,418 Oil and gas wells 1,928 Plant and equipment 7,428 6,269 Other 213 221 Less Depreciation 4,o83 3,201 Total Assets and Liabilities 8,o68 6,959 Current Liabilities 1,223 1,405 Long-Term Debt 1,292 1,920 Due Federal, State and Local Governments ... 449 Reserves and Contingencies 3,406 2 844 For exploration 997 9 For replacement of equipment and installations 1,708 1,220 Other 701 642 Net Worth 2 146 342 Certificates "A" X7 7 Certificates "B" 1,764 .. Total 2,321 557 Less Deficits of Previous Years 215 215 Plus 1959 Profit 40 . Source: Pemex. 154. Moreover, certain consumers, such as the National Railways, taxis, bus lines, and residents of what were considered economically depressed areas, benefitted from special discount prices. Subsidization of these sales, plus the losses incurred on product imports sold below cost,' are estimhated to have cost Pemex around 538 milli6n pesos in 1957. This represented some 14 per cent of total revenues in that year -- and - 100 - is a measure of the profits that Pemex might have realized under a more favorable price structure. Long-Term Debt 155. Unable to generate internal earnings to finance investment, Pemex was obliged to borrow heavily in order to obtain essential capital. Its 1958 balance sheet shows outstanding debt of 1,920 million pesos. In addition, some 449 million pesos were due Federal, state and local governments. Together, these came to 2,369 million pesos. (See table on previous page.) 156. Equity for 1958 was shown at 557 million pesos. But net worth was reduced to 342 million pesos by virtue of cumulative deficits of 215 million pesos. Thus, outstanding debt was some seven times Pemexts net worth. The weakness of Pemex's fin^ncial position in 1958 is underscored by the changes effected in its 1959 accounts as a result of a finencial reorganization discussed below. Thus, net worth was increased by 1,804 million pesos and debt reduced by 1,077 million pesos in 1959, these adjustments reflecting a major subvention by Government. (See paragraph 166.) Contributions to Government Revenue 157. As noted earlier, it had been anticipated that Pemex would be able to make substantial contributions to the Government as a result of its operations. It is of intere-t, therefore, to review actual performance in this respect. In 1952, for example, Pemex payments to the Goverrnment, exclusive of direct taxes on gasoline sales and import duties, apparently came to somewhat under $35 million -- equivalent to around 45 cents per barrel of crude oil produced. Venezuelan Govern- ment revenues from private oil operations amounted to 74 cents per barrel of production in that year. 158. In 1957, Government oil revenues were reported at $63 million, but these appear to include gasoline sales taxes. If allow- ance is made for estimated gasoline taxes, the actual contribution of Pemex to Government revenue would appear to be in the neighborhood of about 30 cents per barrel of oil produced. This compares with 89 cents per barrel in Venezuela. Payments by Pemex would normally include reimbursement of the expropriation debt indemnified by the - 101 - Government, royalties, and 3-per cent interest on government capital. But since, as has been noted, Pemex has been in arrears in its tax payments, it is not clear whether 1957 taxes, as reported, include full liability. 159. In any case, it would appear that Government proceeds from State oil operations have been quite modest. In part, of course, this is a reflection of Mexicots oil resources base, which is considerably less favorable than in Venezuela. More strikingly, it illustrates once again the severe financial straits in which Pemex found itself as a result of Government pricing policy for petroleum products sold by Pemex. Balance of Oil Trade 160. One final aspect of Pemex operations is of interest -- the effect on Mexico&s balance of oil trade. Foreign earnings have obviously been in a declining trend, reflecting the narrowing export potential. Meanwhile, product imports to serve isolated market areas have involved relatively high unit costs, compared with the unit value of crude and fuel oil exports. On balance, Mexico showed a deficit in its oil trade even in 1954-1956 when the volume of exports slightly exceeded the volume of imports. (See table following.) In 1957, when Mexico had to import more oil than it exported for the first time, the trade deficit rose to $39 million. And while that figure has since been reduced, the balance of trade remains adverse. (These data exclude, of course, foreign exchange costs for material, equipment and other imports connected with oil operations.) - 102 - MEXICAN PETROLETPM TRADE, 1954-1958 Volume Value Exports Imports Balance E I Balance (Thousands of Barrels Daily) (Millions of Dollars) 1958 31.9 31.h 0.5 28.5 53.5 -25.0 1957 44.4 48.2 -3.8 38.5 77.5 -39.0 1956 65.o 46.4 18.6 h5.1 72.1 -27.0 1955 70.8 44.3 26.5 44.5 68.9 -24.4 1954 63.8 34.4 29.4 37.2 55.0 -17.8 Source: Antonio J. Bermudez, Doce Anos al Servicio de la Industria Petrolera. Export and import volumes as given by Senor Bermudez differ somewhat from data from trade sources used elsewhere in the text. However, the differences are minor; and figures on volume and vplue shown are believed to be consistent. Reorganization in 1959 161. Against this background, it became increasingly evident that the financial structure of Pemex was weak. By the end of 1958, tax payments to the Government were some $36 million in arrears; and there was a sharp drop in exploratory drilling. Clearly, a financial crisis was inevitable in view of Pemext long history of inadequate profits and capital stringency. 162. In consequence, a major reorganization of Pemex operations was begun in late 1958. Key measures included the following: Increase in product prices, designed to eliminate subsidies of consumption by Pemex; Consolidation and capitalization of past debt; Consolidation of tax liability, with funding of past taxes due; Recourse to foreign loan capital, to finance major projects that could be expected to be self-liquidating; An internal economy campaign to achieve improvements in operating efficiency. - 103 - PETROLEUM PRODUCT PRICES IN MEXICO CITY JUNE 1958 AND DECEMBER 1958 AND CARIBBEAN -- U.S. GULF, DECEMBER 1958 (U.S. Cents Per Gallon) Cargo Sales Retail - Mexico City Caribbean and Dec. June U.S. Gulf 1958 1958 Dec. 1958 Gasoline Gasolmex (90 oct.) 30.3 27.3 10.250 Supermexolina (80 oct.) 24.2 22.7 9.125 Mexolina (70 oct.) 16.7 16.7 9.00 Kerosene 4.55 4.55 9.504 Diesel fuel 9.40 4.85 9.254 Residual fuel 3.54 2.63 4.76 a Low of Platt's. Sources: Pemex; Bermudez, op. cit.; Plattts Price Service. It should be noted that while Pemex was to turn to outside borrowing for a major part of its c;pital requirements, a thorough reorganiza- tion of its own finances would probably be a necessary condition to any substantial volume of new loans. 163. The first change thet was effected involved internal product pricing. In November 1958 Pemex raised the prices of its high grade gasoline by 3 cents per gallon and its medium grade gasoline by 1.5 cents per gallon. The price of Mexolina, the lowest quality gasoline, was left unchanged, but Pemex announced its intention to gradually retire this product beginning in 1959. Pemex also began to relieve itself of the subsidies incurred by supplying taxis and buses at discount. 164. Then in December the price of diesel oil was almost doubled, bringing it a fraction above Caribbean-U.S. Gulf quotations. Residual fuel oil prices were raised by a third. However, these remained below Caribbean-U.S. Gulf quotations, as did the price of kerosene, which was left unchanged. - 104 - PEMEX -- SALES VOLUME AND REVENUES, 1955-1960 Sales Volume Sales Revenuea (Millions of Barrels) (Millions of Dollars) 1960 NA 489b 1959 NA 395 1958 89.9 330 1957 91.6 314 1956 93.5 292 1955 89.7 256 a Apparently includes gasoLine consumption taxes collected by Pemex. b Estimated. Source: Pemex. 165. These price increases, affecting a major part of Pemex sales, could be expected to result in substantial improvement in operating revenues, and potentially in net profits. As is shown in the table above, Pemex revenues rose steadily during 1955-1958, then advanced sharply in 1959. Perhaps twTo-thirds or more of the 1958-1959 gain was owing to higher product prices; the rest reflected increased consumption. An even larger gain was anticipated for 1960, when the elimination of Mexolina gasoline would be completed. Significant- ly, however, net income of Pemex has shown only modest gains -- as exploration expenses have apparently been stepped-up substantially and payments to the Government increased on account of interest and taxes. 166. A second area of reform involves the debt structure of Pemex and its tax obligations to the Government. Unpaid taxes and royalties and bonds of the Nacional Financiera had cumulated to some $140 million. In May 1960, the Federal Government granted Pemex an extraordinary contribution designed to ease this debt burden. According to Govern- ment decree: First: The Ministry of Finance and Public Credit shall proceed to contribute 1,770 million pesos to the patrimony of Petroleos Mexicanos. This capital contribution shall be in the nature of an extraordina.ry allocation and shall constitute preferred patrimony enjoying retirement rights. The funds thus provided shall in consequence be considered as distinct from the patrimony derived from contributions referred to in Article 3 of the Organic Law of Petroleos Mexicanos. - 105 - Second: Petroleos Mexicanos shall devote the proceeds from the above mentioned contribution for the exclusive purpose of liquidating various debts to be designated by the federal government through the Ministry of Finance and Public Credit. Third: For accounting purposes, Petroleos Mexicanos will make whatever adjustments are necessary so that the foregoing operations will appear on the books as of December 31, 1959. Fourth: Petroleos Mexicanos shall pay the Ministry of Finance and Public Credit a guaranteed return of 8% per year, payable monthly, on the unretired portion of the capital contribution. Fifth: The capital contribution referred to in point No. 1 will be retired gradually by means of partia.l payments effected by Petroleos Mexicanos in the measure that its financial situation so permits in the judgment of the Ministry of Finance and Public Credit. In consequence, Pemex is obligated for interest ppyments on the newly consolidated debt, but is relieved of repayment of principal until such time as its financial position may be better able to permit debt retirement. 167. At the same time, the various tax liabilities of Pemex have been consolidated. Pemex will now pay 12 per cent of its gross revenue to the Federal Government. If this single tax rate had been in effect in 1957, government revenues from Pemex operations would have come to around $38 million, or about 41 cents per barrel of oil produced. This compares with Venezuelan Government revenues of about 89 cents per barrel. (See paragraph 156 above.) 168. On the basis of anticipated sales for 1960, tax payments will come to $59 million. "Interest on permanent credits" is expected to add another $12 million. (See table following.) 169. Considering these, Pemex looks forward to a, net profit of $41 million in 1960, compared with less tha.n $3.5 million in 1959. Thus, the combined effects of higher internal prices and the elimination of unprofitable low-grade gasoline, together with consolidation of tax and debt payments, could ease the immediate financial strains to which Pemex has been subject. - 106 _ PEMEX -- ESTIMATED PROFIT AND LOSS STATEMENT, 1960 (Millions of Dollars) Gross Revenue Domestic sales 462 Export sales 27 Total 7 Less: Costs 325 Gross operating profit 164 Add: Other income 2 Total 166 Less: General expenses 54 Net profit before payments to Government 112 Less: Payments to Government Interest on permanent credits 12 Taxes (12 per cent of gross revenue) 59 Net profit 41 Source: Pemex. 170. On the other hand, cash requirements of the Pemex program continue to exceed the interna.l generation of funds by a. wide margin. Net profits of $41 million would represent less than a. quarter of anticipated capital requirements in 1960. The remainder will derive from foreign and domestic loans. 171. According to Government directive, Pemex may borrow outside only for specific projects that are expected to generate funds with which to meet interest and repayments within a fixed length of time. By the end of 1959, Pemex had arranged for $112 million of such credits, earmarked principally for pipeline and petrochemical projects. In addition, 100,000 barrels daily capacity is being added to the Ciudad Madero refinery and increases are planned for the Minatitlan and Salamanca plants. This should permit further dismantling of obsolete capacity, chiefly at Tampico. - 107 - PEMEX -- ESTIMATED CASH FLCW, 1960 (Millions of Dollars) Sources Net profits 41 Foreign and domestic loans 133 Deficit 2 Total Sources 176 Uses Replacement of major and minor installations 15 Equipment replacement and purchases 18 Miscellaneous new projects 143 Total Uses 176 Source: Pemex. 172. Beyond these, an ambitious drilling program is scheduled for 1960. Pemex plans to complete 600 wells this year, comppred with 390 in 1959 and an average of 360 per year in 1955-1958. It is possible that an increase in dry hole and intangible expenses occasioned by stepped-up drilling in 1959 explains the modest net profit of that year ($3.2 million), despite the substantial rise in product prices and revenues. And the drilling program for this year will obviously involve a much greater cash outlay. 173. On balance, it would appear that the current financial position of Pemex has been strengthened considerably as a result of the reorgani - zation begun late in 1958. Sales--revenues' have benefitted from the long overdue increases in product prices. And Pemex has received a sizable infusion of new social capita.l. Together with foreign borrowing, this involves very large deferred obligations, however. 17h. Beyond this, improvements in internal operating efficiency are obviously needed, as witness inclusion of this problem among the major goals of the Pemex reorganization. According to the company's president*, Pemex plans to cut costs through changes in administration * Petroleum Week, January 9, 1959. - 108 - and personnel and by revision of purchasing methods and contracting procedures. How far Pemex would be able to Eo in this direction remains to be seen, particularly in view of the special considerations arising from its status as a state entity. 175. The big question ahead is whether Pemex can accomplish in the future what could not be done in the past -- namely, generate earnings to provide an adequate return on the public and private capital that is being so heavily committed, and, equally important, to permit the accumulation of funds to serve as the basis for sustained expansion. - 109 - CHAPTER TV COOPERATION BETWEEN STATE ENTERPRISE AND PRIVATE COMPANIES - 110 - CHAPTER IV COOPERATION BETWEEN STATE ENTERPRISE AND PRIVATE COMPANIES 1. As against the exclusive policy of government oil operations discussed in the preceding chapter, and illustrated in the case of Brazil and Mexico, nearly every other country that has state oil opera- tions has found it advantageous to accept the participation of private enterprise under arrangements that are compatible with its ownl national oil policies. The impetus stems from a desire to enlarge the base of exploration -- technologically and financially -- and speed the pace of local oil development beyond what could be expected of a government organization itself. 2. In developing countries, it is perhaps inevitable that private participation would in large measure be foreign participation, at the outset at lea.st. Many of the difficulties confronting a government oil entity would also inhibit local, private enterprise. Scientific and technical competence, trained and experienced personnel could not be found within the country to undertake an oil search on the scale required. 3. Furthermore, the volume of saving that could be drawn upon in developing countries is extremely limited. And local investors are likely to be hesitant about committing funds for so risky a venture as exploration, especially since other, more secure opportunities will be open to local capital. On the other hand, established oil companies with large and increasing crude requirements are in a position to diversify their risks by participa.ting in exploration over widely dis- persed regions. At the same time, they bring to such ventures the facilities, methods, and experience that can only be put together in the course of repeated operations under varying geological conditions. L. Major international oil companies may naturally be expected to play a prominent role in the search for oil. They have to provide constantly larger supplies to sustain their world-wide operations; these same operations generate the siza.ble funds that are required for exploration. Furthermore, economic and politica.l considerations en- courage them toward diversification of production. These companies are also likely to be present suppliers of crude or refined products in the various developing countries. However, this does not mean that priva.te participation in a nation's oil program need or should neces- sarily involve the major oil companies alone. They have no monopoly on - 111 - the finding of oil -- either in ability or fortune. And an ever in- creasing number of firms from many countries is engaged in the business of exploration. 5. The question of foreign investment may well raise ideologi- cal or political issues in some countries. These are obviously beyond the province of this study, which treats only with the economic aspects of oil development. On the other hand, it is significant that included among the examples in this chapter are countries that have arrived at a modus operandi for private, foreign participation in their oil develop- ment; and would feel strongly that in doing so, they have not compro- mised either their national or social orientations. 6. Finally, it should be emphasized that such participation, by its very terms, is limited in tenure. Upon completion of contract or concession, a going oil operation reverts to the country -- to be con- tinued under state or private auspices, according to the dictates of national policy. In the interim, the country can count on training and experience in oil operations, which are so essential to effective per- formance; and can apply its own limited financial resources to the many vital efforts for which foreign capital could not so easily be found. 7. Arrangements with private companies differ widely from coun- try to country. Diverse historical circumstances and political perspectives, exploration prospects and marketing conditions -- all these bear upon the relationships that are established between govern- ment and the oil industry. 8. From the standpoint of the government, diligence on the part of operating companies in searching for and developing oil reserves is a primary consideration. The country needs and looks for a maximum contribution from its own oil resources to its energy requirements and its economic progress. At the same time, the country may ensure that it receives financial contributions in keeping with the value of such resources as may be discovered and developed. There are also essential prerequisites to private investment. These include foreknowledge of company rights and obligations during all phases of operations, secu- rity with respect to arrangements that are concluded, a, clear-cut understanding as to managerial prerogatives, and the possibility of attractive compensation for risk and effort if the oil search should prove successful. 9. In view of these considerations, it is noteworthy that a. variety of ways have been found by which the interests of government and industry have been accommodated within the framework of national oil policies. - 112 - Argentina for many years had reserved virtually all exploration and production to a state organization. Despite considerable expansion of reserves and pro- duction, demand grew at a still more rapid rate. In consequence, import requirements and foreign exchange costs continued to mount. In 1959, the Government turned to private industry to supplement the State effort. Exclusive and autonomous rights of the State over national oil resources were reaffirmed. Private p rticipation was to be on the basis of contracts with the government oil entity. In course, a program of oil exploration and developments has been launched that holds forth promise of early self-sufficiency for Argentina. The Bolivian national oil effort began with an expec- tation that the country's oil potential could lead to significant levels of production and export; it foundered for lack of financial resources. In 1955, a petroleum code was adopted, permitting private explo- ration in untested areas. Producing regions were reserved to the Sta.te entity (YPFB) for development; private enterpr ise may drill in these regions under special arrangements. India, with small production and rapidly mounting oil requirements, faces a critical need for the quickest possible development of its oil potential. Prospec- tive oil-bearing areas are vast in extent, but exploration has barely "scratched the surface"t. Under the Industrial Policy Resolution of 1956, India re- served all future oil development to the government sector of the economy. At the same time, a wide range of economic and social programs involved urgent and competing demands on the nation's scarce capital and foreign exchange resources. Thus, the government's Oil and Natural Gas Commission was limited in the scope of its effort by the financial and technical re- sources at its disposal. In late 1959, following extensive study and review -- without deroga.ting from the role of the ONGC -- the Government broadened its policy to invite the participation of private compa- nies in oil exploration on terms and conditions to be negotiated. A number of companies have expressed interest but the outcome of these negotiations is not yet known. - 113 - 10. The desire to extend the scope and speed the pace of national oil development through private participation is the one common feature among all these arrangements. In other respects, they differ widely. te review these instances in greater detail in the sections following in order to point up the potential role of private investment under varying conditions of government policy and oil prospects. We would emphasize that the specific examples noted are intended as illustrations of the variety of arrangements found -- and not as models suitable for repro- duction elsewhere. - 114 - Argentina 11. Yacimientos Petroliferos Argentinos (YPF) was established as the State oil entity in 1922. Government oil operations date back even earlier, however, to 1907 when oil was first discovered by a government team drilling for water in the Comodoro Rivadavia basin. Private oil companies entered the oil search beginning in 1916. In the years fol- lowing, private production was built up at a considerably more rapid rate than YPF production, so that by 193I private operations yielded 24,000 barrels daily and YPF operations 1)4,000 barrels daily. 12. After 1934, a, series of governmental restrictions on acreage available to private companies limited their exploration and development activities, and private production went into a gradual but almost un- interrupted decline. YPF output, on the other hand, continued to in- crease. At the war's end, YPF was producing about 39,000 barrels of crude oil daily; the private companies, 17,000 barrels per day. 13. All of Argentina's crude output in 1946 was processed inter- nally. YPF had refining capacity of 43,000 barrels daily, slightly in excess of State production. Private refineries, of which there were eight, were rated at 56,000 barrels per day. These processed domestic crude to the extent available, supplemented by crude oil imports. ARGENTINE OIL BALANCE, 1946 (Thousands of Barrels Daily) Domestic demand 118 Refinery runs 80 Crude production 56 Imports 62 Crude oil 21 Refined products k2 Source: U.S. Bureau of Mines. 14. Argentine oil consumption in 1946 amounted to 118,000 barrels per day. Two-thirds of these product requirements were met by local - 115 - refineries, leaving about 40,000 barrels per day to be imported, largely fuel oil from the Caribbean. Domestic production amounted to roughly half the nation's oil needs and 70 per cent of refinery runs, leaving 20,000 barrels per day of crude imports. Crude and product imports together thus came to 60,000 barrels daily. Postwar Developments 15. This imbalance between petroleum supplies and requirements, with consequent imports, was to be a major economic problem throughout the postwar period. The oil gap was already formidable in 1946. Re- finery capacity would have to be increased. And oil production would have to be doubled just to approximate 1946 consumption. 16. But even larger demands were to be made on the Argentine oil industry by rapid growth in national energy requirements over the years ahead. Because the country has virtually no indigenous coal supplies, the burden of expanding energy needs had to be met by oil. Thus, oil consumption rose at an average rate of almost 7 per cent per year. By 1958, demand totalled 260,000 barrels daily, or more than twice the 1946 level. 17. To meet these urgent energy needs, the Argentine oil industry would have ha.d to expand rapidly. It had favorable oil prospects before it, as suggested by extensive proved and semi-proved acreage and attrac- tive wildca.t areas. But a number of serious problems had also to be met. Initially, increases in production and in the reserves necessary to support them were to be held back by the world-wide scarcity of drilling equipment, arising out of wartime dislocations and inevitable delays in reconversion. When equipment became more available, it still had to be imported and thus required considerable outlays of scarce foreign exchange. 18. Argentine oil development was also to require very large capital expenditures. These were bound to strain the capabilities of any single company, and, indeed, to tax the nation's resources. Fur- ther, the need for skilled manpower would pose a problem in expanding local operations. 19. For its oil development, Argentina. elected to confine the pr oduction effort to the state entity, YPF. As a result of this policy, private companies were not able to acquire any new acreage. Nor were the services and technical know-how of private drilling or construction firms sought. YPF was thus dependent upon its own technical resources, and upon the funds which it could generate from within its own opera- - 116 - tions or could secure from the State. Only in refining and marketing were private companies allowed to participate in Argentine oil develop- ment. Drilling Activity 20. As noted earlier, YPF's drilling effort was retarded in the immediate postwar years by a scarcity of equipment. It wa.s not until 1952 that the prewar level of well completions was surpassed. There- after, progress was more rapid. As the following table shows, total well completions rose from 242 in 1954 to 362 in 1958 -- for a gain of 50 per cent. The emphasis was clearly on development wells, which accounted for five-sixths of the total and all of the increase in well completions. The number of exploratory wells actually declined over the period. On the average, only a.bout 45 exploratory wells were drilled each year -- and these included step-out wells as well as wildcats. By way of comparison, some 50-60 exploratory wells were drilled anmually in the late 1930's. YFF -- EXPLORATION AND DEVELOPMENT DRILLING, 19L4 AND 1954-1958 1958 1957 1956 1955 1954 1944 Total well completions 362 307 272 222 242 103 Oil and gas 332 275 7 T 173 171 NA Dry holes 30 32 44 48 71 NA Exploration 33 35 51 48 54 38 dil and gas 1 22 217 12 NA Dry holes 15 13 25 31 42 NA Development 329 272 221 173 188 65 Oil and gas 3 1T 202 253 19 Dry holes 15 19 19 17 29 NA Source: American Association of Petroleum Geologists. 21. In the ea.rly postwar years, YPF confined its exploration and development activities almost entirely to the Comodoro Rivadavia basin, the oldest and most a.ccessible producing area. Later, increasing atten- tion wa.s given to the newer and more remote oilfields in Neuquen, - 117 - Mendoza, and Salta Provinces. However, the Comodoro Rivadavia fields still a.ccounted for half of total well completions in 1954-1958. 22. Only scattered data. are available on private drilling during this period. These suggest, however, that there wa.s virtually no ex- ploratory activity, owing to restrictions against acquiring new acreage. Also, development drilling was limited, apparently, to such wells as might help, at least in part, to offset declining production. In con- sequence, priva.te production drew down a.ccumulated reserves, and output continued in a declining trend. Reserves and Production 23. The results of YPF's drilling program are reflected in its additions to reserves and production. Unfortunately, YPF publishes re- serve figures only occasionally, so that additions to reserves cannot be regularly determined. However, estimates of Argentine reserves are available in industry journals. And while these are obviously no better than informed guesses, we are obliged to take such figures a.s an indica- tion, a.t least, of the postwar trend. ARGENTINE CRUDE RESERVES AND PRODUCTION, 1946 AND 1954-1958 (Thousands of Barrels Da.ily) 1958 1957 1956 1955 1954 19h6 Crude oil reservesa 1)000 750 450 350 300 300 Production 98 93 85 84 81 56 YPF 72 77 70 7 39 Private 10 13 13 14 14 17 a. Millions of barrels. Sources: Oil and Gas Journal; World Oil. 24. These show Argentina's crude reserves rising from 300 million barrels in the yea.rs imrediately following the war to 1,000 million bar- rels at the end of 1958. While this is a sizable gain, it is noteworthy tha.t the number of new field discoveries announced by YPF was small. - 118 - And all but one of the discoveries was adjacent to an older producing area -- the exception being the initial discovery at Tierra del Fuego in 1950. It is noteworthy too, that the bulk of additions to reserves came in 1957 and 1958, precisely at the time when exploratory activity was tapering off. This suggests that additions to YPF reserves represented for the most part extensions to previously discovered fields. Appar- ently, no major new oil province and very little in the way of new oil resources were proved over these years. Obviously, YPF's emphasis was on development drilling that promised to yield most immediate results in terms of crude production. 25. The result of this effort was an expansion in crude produc- tion a.t the rate of about 7 per cent per year. By 1958, YPF was produc- ing 88,000 barrels da.ily, or slightly more than twice its 1946 volume. But with internal consumption rising rapidly and private production falling off, Argentine crude availability actually lagged behind the growth in demand. For YPF, lack of capital to develop producibility to the fullest and to link remote productive areas with refining centers was a continuing problem.- Refining 26. YPF embarked on a program of refinery expansion early in the postwar period. By 195L, capacity had been boosted from L3,000 to 131,000 barrels per day. But this, in turn, emphasized the need for in- creased crude production. After 1954, additions to refining were small, while YPF, as noted, intensified its drilling efforts. At the end of 1958, YPF refinery capacity amounted to 144,000 barrels per day, more tha.n three times that of 19b6. Refinei7f runs advanced in line with capacity, and amounted to 136,000 barrels daily in 1958. 27. Meanwhile, private refining capacity had been virtually un- changed over the postwar deca.de. But as YPF refining outlays were being cut back, private construction took over. The occasion was a, marked improvement in the "climate" for foreign investment in Argentina, after many years during which there was, at best, little concern over favor- able conditions for priva.te enterprise.** The result was installation of some 30,000 barrels per day of a.dded capa.city in 1957 and 1958, which contributed substantially to local output of petroleum products. This private investment took place as import requirements continued to rise * Both were to receive high priority under YPF contracts with private firms when the new development program was formulated. 7- See the "Prebisch Report", October 24, 1955. - 119 - ARGENTINE REFINING CAPACITY AND CRUDE RUNS, 1946 AND 1954-1958 (Thousands of Barrels Daily) 1958 1957 1956 1955 1954 1946 Refining capacity 236 211 196 189 186 99 YPF 14h4 138 138 131 131 43 Private 92 73 58 58 55 56 Refinery runs 228 210 169 161 153 80 YPF 136 126 106 109 104 NA Private 92 84 63 52 49 NA Sources: U.S. Bureau of Mines; Oil and Gas Journal. in the fa.ce of a 10-year effort to close the gap -- and presaged a. new oil program under which YPF would turn to priva.te enterprise for capital and technologica.l assistance in achieving national goals. ARGENTINE OIL BALANCE, 1958 (Thousands of Ba,rrels Daily) Domestic demand 260 Refinery runs 228 Crude production 98 Imports 179 Crude oil 129 Refined products 50 Sources: U.S. Bureau of Mines; Oil and Gas Journal; World Oil. - 120 - The Oil Balance in 1958 28. Argentine petroleum requirements reached 260,000 barrels per day by 1958. Despite the increases in production, domestic crude accounted for less than 40 per cent of consumption, as compared with about half in 1946. The gap, far from na.rrowing, had widened signifi- cantly. 29. With respect to refined products, there was some improvement over the period. By 1953, Argentine refineries met about 88 per cent of product requirements as aga.inst 84 per cent in 1946. 30. The net effect wa.s increased dependence on oil imports. As the following table shows, these amounted to 179,000 barrels per day in 1958, or three times as much as in 1946. Refined product imports had just about stabilized, consisting of 30,000 barrels per day fuel oil and 20,000 barrels per day light products. But crude oil imports rose sharply, from 21,000 barrels daily in 1946 to 129,000 in 1958. 31. In 1958, the annua,l oil import bill amounted to $200 million. This constituted 25 per cent of all exchange earnings, and exceeded the over-all deficit in the country's balance of payments. ARGENTINE OIL IMPORTS, 1946 AND 1954-1958 (Thousands of Barrels Daily) 1958 1957 1956 1955 1954 1946 Crude oil 129 114 82 79 72 21 YPF 54 47 35 38 38 NA Private 75 67 47 41 34 NA Refined products 50 58 79 64 48 41 YPF 23 26 3 27 13 NA Private 27 32 45 47 35 NA Total Imports 179 172 161 143 120 62 Value (Millions of Dolla.rs) 250 280 200 200 149 NA Source: U.S. Bureau of Mines. - 121 - Why Production La.gged 32. Argentina's increasing dependence on foreign oil could not be attributed to a deficiency in the country's resource base. Now that early results of the current development program ha.ve begun to take shape (of which more la.ter), it is clear that the resources were there to support a. considerably greater rate of production than was achieved. But even without the advantage of hindsight, it is evident that the effort YPF was able to mount wa.s limited by the means a.t its disposal, and inadequate to the job of exploration and development that had to be done. The Argentine policy of limiting exploration and development to the state oil entity thus imposed an inordinate burden on YPF. 33. As noted earlier, the declining producibility of existing concessions made it impossible for private companies even to mainta.in their crude output in the postwar yea.rs. Nor were they in a position to contribute financially or technically to the Argentine oil effort, since no new a.creage was opened to them for prospecting. 3b. For YPF, this meant first of all enormous capital require- ments. These could be met in part from funds generated within its operations -- depreciation allowances and retained earnings. YPF could also turn to the Government for financial assistance, through subsidies or loans. 35. To our knowledge, no financial statements have been made publicly available by YPF. Hence, we are unable to determine the sources of capital funds, or the investments to which capital wa.s com- mitted. However, scattered references to YPF finances have appeared in the Argentine press from time to time. These indicate that YPF had sizable operating deficits throughout much of the postwar period. In fiscal 1957-1958, YPF's operating deficit was reported to be $88 million -- apparently the la.rgest element in the over-all budgetary deficit of the Government, next to the state railways. YPF also apparently suf- fered from a, severe cash shortage, a,t least in 1957 and 1958. Other state enterprises, such as the railways, fell behind in their payments to YPF for fuel deliveries. And YPF in turn was deficient in its pay- ments to the Government on account of ga.soline taxes and otherwise a.ssumed a growing burden of debt to finance current operations. 36. It should be noted, of course, that the entire Argentine economy was characterized by capital shorta.ge in this period. And the Government budget had to cope with a wide range of financial demands. Indeed, it is likely that a substantial amount of disinvestment may have occurred in various economic sectors under the Peron Government. - 122 - 37. Against this background, it is not surprising that YPF1s financial resources were inadequate to the task set for it. As one indication, the five-year oil development program that has now been launched in conjunction with private participation calls for investment of between $1.5 and $2.0 billion. The entire Government budget in 1958 amounted to less than $900 millionl 38. Further, the foreign exchange demands of stepped-up YPF oper- ations were bound to be great. Much of the necessary equipment would have ha.d to be imported. In fact, the limited development effort under- taken between 1954 and 1958 probably involved increasing outlays for imported equipment that may have amounted to as much a.s $40 million per yea.r. But the oil production that might have resulted from even greater use of imported equipment would not ha.ve been achieved for some time. Meanwhile, rising oil demand would be paralleled by rising oil imports. Thus, the drain on available exchange, which was itself a major factor in prompting national oil development, would be intensified as develop- ment got under way. 39. These problems were reflected in YPF operations in many ways. They explain the concentration on drilling of development wells in es- tablished oilfields, as contrasted to exploratory activity in wildcat areas. Even so, production could not be expanded fast enough to keep pa.ce with growth in oil requirements. 40. Significantly, the build-up in reserves to around one billion barrels in 1958 would. probably have supported higher levels of produc- tion. But where YPF was able to find new reserves, it was unable to exploit production potential fully. For every successful discovery means heavy investment for development wells, gathering facilities and pipelines. Thus, potentially important discoveries in the Andean pro- ducing areas in 1951-1953 were still shut-in a.s late as 1958 for lack of a.dequa.te transport. And an initial wildcat discovery in Tierra del Fuego in 1950 remained undeveloped for lack of follow-up investment. Finally, vast promising acreage remained even to be tested. 41. In sum, YPF experience clearly posed a basic issue of na- tional oil development. Maximum development of the country's resources held out promise of providing at least a. large measure of internal energy requirements. For this, the pace of development would obviously have to be accelerated. But the immediate cost of such development, in capital and foreign exchange, would be huge; the returns could only be realized over future years. It was an appreciation of these that led in mid-1958 to the adoption of a comprehensive oil program whereby private capital, technical skills and personnel could join in the Argentine oil effort. - 123 - Development Program, 1959-1964 42. Argentine national policy relative to petroleum resources was established as early as 1922. It was reaffirmed in the law of 1958, under which the present development program was established: Article 1. -- Deposits of solid, liquid, and gas- eous hydrocarbons existing in the territory of the Argentine Republic and those of its submarine platform are the exclusive, imprescriptible, and inalienable property of the National State . . . Article 2. -- Activities of the Nationa.l State connected with the study, exploration, exploita- tion, industrializa.tion, transportation, and com- mercialization of the said hydrocarbons shall be in cha.rge of Yacimientos Petroliferos Fiscales, Gas del Estado, and Ya.cimientos Carboniferos Fiscales, which for that purpose will enjoy full autonomy, as well a.s the powers established in its organic regulations, and will exercise those powers throughout the National Territory. Article 3. -- Rights enjoyed by private individ- uals up to May 1, 1958, on the above mentioned deposits and a.ctivities, shall be respected. Article 4. -- The granting of new concessions on hydrocarbon deposits referred to in the present law is hereby forbidden throughout the National Territory, as well as the signing of any other contract, whatever its denomination, containing clauses prejudicial to the Nation's economic independence or which might prejudice in any other manner the Nation's self determination. 43. Under the plan adopted in 1958, Argentina hopes to solve its oil problems within the span of about four years. Broadly, the goa.l is for self-sufficiency by the end of 1961. (See table below.) This would then involve production and crude runs of more than 300,000 barrels daily. It is hoped that further increa.ses in production after 1961 would yield a crude oil surplus for export. 44. To a.ttain these goals, development of established producing areas is being accelerated. As noted earlier, the bulk of YPF invest- ment in recent years ha.s gone to such area.s. Nevertheless, it is believed that a considerably greater production could be obtained - 124 - ARGENTINE OIL PRODIJCTION, IMPORTS AND DOMESTIC DEPTAND, 1958 AID 1959 AND YPF FORECASTS, 1960 - 1964 (Thousands of Barrels Daily) YPF Forecasts Actual 1964 1963 1962 1961 1960 1959 1958 Crude production 377 346 314 264 184 122 98 Imports (Exports -) -65 -44 -25 13 88 150 179 Domestic demand 312 302 289 277 272 266a 260 a. Estimated. Sources: YPF; World Petroleum; Oil and Gas Journal. through more intensive drilling -- in the older Comodoro Rivadavia fields a.s well as in the Andean producing zones. Second, a comprehen- sive evaluation of Argentina's oil potential in other a,rea.s is to be made. Taken together, these efforts are expected to provide the re- serves and producing wells to sustain output in 1961 at more than triple the 1958 rate. 45. Third, to overcome the transportation bottleneck that has hampered expansion of production in the interior producing areas, a, number of long-distance pipelines are being built. These will carry crude, refined products ancd natural gas to major cities and ports. In addition, several shorter lines are to facilitate the delivery of Comodoro Rivadavia output to the coast for tanker transport to Buenos Aires. 16. Finally, the development program calls for expansion and modernization of refinery operations. Self-sufficiency in product out- put by 1961 would entail a 40 per cent increase in refining capacity -- from about 230,000 barrels daily at the end of 1958 to 325,000 barrels per day in 1961. 47. These undertakings would obviously require sharply increased investment in all phases of Argentine oil operations. In the words of President Frondizi:* * Sta.tement prepared for World Petroleum, July 1960. - 125 - YPF, using the means at its disposal, has carried out a task that merits the commendation and thanks of the Argentine people. But the economic and financial situation did not permit giving YPF the financia.l resources necessary to a solution of the problem, within the time the situation demanded. At best, in three or four years, YPF would be able to produce enough to cover just half of consump- tion. It was necessary, therefore, to make a. grea.t deci- sion. We wholeheartedly supported YPF, and com- plemented its activities with private operations. Thus, a major role has been assigned to foreign capital, which is cur- rently participating with YPF in a wide range of oil development activ- ities. The various tasks being undertaken by YPF and by private enterprise are noted below. How These Goals Are to be Met )8. Development of proved oil fields in the Comodoro Riva.davia basin is being directed by YPF, aided by credits from equipment sup- pliers and by foreign drilling contractors to be paid on a. fee basis. YPF itself plans to drill some 3,545 wells in the Comodoro Rivadavia, area in 1960-196h. This compares with a total of 1,580 wells drilled by YPF in all areas in the previous six years. Private contractors are to drill another 3,650 wells under YPF direction. By mid-1960, contracts had been let for 2,130 wells to be completed in four years. In addi- tion, private contractors are to service operating wells and complete others under YPF direction. 19. Elsewhere, on proved, semi-proved, and rank wildca.t a.creage, YPF ha.s a.rranged for private venture capital to search for, develop and produce oil.* Four major contra.cts have been concluded, providing for the development of various promising areas: Pan American Internati6na.l, a subsidia.ry of Stand- ard Oil of Indiana,-is working over 1,545 square miles in the general area. of the Comodoro Riva- davia Ba.sin. The a.greement calls for the drilling of 50 wells in the first year and 100 additiona.l ' Major provisions of ea.ch are described in Appendix A. - 126 - wells in the second year. YPF will pay $1.59 per barrel for all oil produced, sixty per cent in dollars, the rest in pesos. After five years, the price may be adjusted to reflect fluctuations in world market prices. The contract extends for 15 years, with a 5-year renewal at the option of the company. Carl M. Loeb, Rhoades & Company is developing proved and semi-proved acreage -- approximately 100,000 acres in Mendoza Province and 1,200,000 a.cres in the Comodoro Rivadavia. basin, as jointly selected with YPF. The company will provide all necessary financing, estimated on the order of k;l00 million. The company will recover its out- lays through receipt in pesos a.t the rate of 50 per cent of the value of crude produced; plus a "benefit" in dollars of 20 per cent of the value of crude produced from each productive structure for 20 years from the time development is begun. (The "benefit" may be reduced down to 15 per cent, depending on rates of production and the value of the crude; and upon agreement between the company and YPF, a single payment may be made representing profit on the area's productive po- tential.) Standard Oil (N.J.) concluded a contract covering 1,850rsquare miles in Neuquen Province. The agreement is to run for up to 30 years at the company's option, with the acreage progressively reduced during its duration. The company is com- mitted to expenditures of at least $23 million in the first six years. YPF will pay (in pesos) $1.83 to $1.75 per barrel of crude oil produced, depending on the rate of output, with the price further adjusted to fluctuations in the inter- national price of oil. Tennessee Gas Transmission is developing some 5,400 square miles in Tierra del Fuego under a contract that runs from 3 to 25 years at the companyts option. Minimum expenditures of $10 million are required in the first three years. Initial production will be delivered to YPF in exchange for the use of existing installations; thereafter,,YPF will pay $1.77 per barrel, the - 127 - price to be adjusted in line with changes in posted prices for crude oil in world markets. 50. Two additional contracts were concluded covering the explora- tion and development of wildca,t acreage. Union Oil Company is operating on more than 6,100 square miles of virtually untested area in Santa Cruz and Chubat Provinces in the vicinity of the Comodoro Rivadavia basin. A 5-year exploration period is set, during which the company undertakes to spend at least $8 million. If oil is discov- ered, a 15-year production period is provided, with a 5-year renewal at the company's option. YPF will pay $1.90 per barrel for crude oil pro- duced, sixty per cent in dollars; and the price may be adjusted monthly to reflect changes in world crude oil postings. Royal Dutch/Shell has a contract covering 11,500 square miles of wildcat territory in Buenos Aires and Rio Negro Provinces, the area to be progres- sively reduced over the duration of the contract. A 10-year exploration period is set, to be fol- lowed by a 20-year production period, although production is to begin earlier if possible. The company is committed to a schedule of minimum exploration expenditures, with some $28 million involved over 10 years. Outlays will be reim- bursed out of production if exploration proves successful, the crude to be valued in line with international price. Thereafter, 10 per cent of subsequent production accrues to YPF, until the aggregate value adds up to $b.2 million, after which half is to be turned over to YPF and half retained by Shell "as compensation for the explo- ration and production investments, risks, inter- ests, and profits." 51. There are several significant features common to each of these contracts: The companies undertake to finance all costs of exploration, and bear the risk of failure. Where production is established, title to the oil is vested with YPF. - 128 - For oil produced and delivered to YPF, the compa- nies are to be paid a. flat fee per barrel or a. percentage of its value; in one instance, payment is to take the form of a share of the oil produced. In all instances, however, payments will be made out of the newly established production. 52. According to YPF estimates, the private companies will drill a total of about 1,350 wells in their respective development zones by 1964. Added to the activity scheduled in the Comodoro Rivadavia. basin, this means that a grand total of over 8,500 wells is projected for the period 1960-1964. In contrast, there were 6,900 wells completed in all of Argentina in the preceding 50 years of oil operations! 53. In addition to the agreements already signed, YPF is solic- iting bids for exploration and development of virtually the entire central and northern part of the country, much of which is rank wildca.t area.. About kOo,000 square miles or L0 per cent of the national terri- tory is involved. Several bids have been received; these have specified minimum expenditures of $32 million in ten years. At latest report, YPF is holding these areas open for further bidding. 5L. The construction of long-distance pipelines is being under- taken by foreign engineering firms, by oil companies producing in estab- lished fields, and by private financial interests. Long-term financing is to be arranged by the builders. Some costs in Argentine pesos are to be met by YPF through capital raised locally. 55. At least five major pipeline projects are included in the program. First, twin 1,000-mile gas and products lines have been built under contract to link the Salta, producing area with the Buenos Aires market; these were completed in late 1959. Construction costs of around $200 million were a.dvanced by the contracting firms, to be repaid by YPF over a six-year period. Second, a. 670-mile products line is to run from Mendoza, to Buenos Aires. Third, a. 390-mile, 4h,000 barrels daily, crude pipeline is to be laid from Neuquen to the coast a.t Bahia Blanca.. In addition, an 80-mile crude line in the Comodoro Rivadavia region is to tie in production with port facilities. This line wa.s completed in early 1960, permitting the new production developed by Pan American to be brought to refineries. Finally, construction of a 1,000-mile, 30-inch, gas pipeline from Comodoro Rivadavia to Buenos Aires is now open for bidding; it is expected to cost $300 million and to get under- way in 1961. Other pipelines are tentatively planned, depending upon * the success in establishing production in the various zones opened to private exploration and development. - 129 -- 56. As for refinery expansion, YPF plans to boost the capacity of its existing plants by means of long-term equipment purchases abroad, and by construction contracts with foreign concerns. By late 1961, ad- ditional capacity of 28,000 barrels daily is scheduled for YPF refin- eries. Two private firms, Esso and Shell, are also to expand their Argentine plants. Esso's capacity is to be increased by 2b,000 barrels daily in 1961; Shell's capacity, by 35,000 barrels daily in 1962. Early Results 57. Operations under YPF's development program have only recently gotten underway. Thus it is too soon to assess results against the goals projected. However, even the early progress must be counted as encouraging. In 1959, crude production to YPF account rose 30 per cent above 1958 to an average of 11L,000 barrels daily. This increase largely reflected the stepped-up drilling activity of YPF and private contractors in the Comodoro Rivadavia basin. 58. Meanwhile, Pan American had completed 91 development wells on its acreage in the Comodoro Rivadavia area in 1959, with-productive ca.- pacity of more than 25,ooo barrels daily. These wells were largely shut in, until completion of a pipeline in April 1960. Pan American drilled another 76 development wells and 6 wildcat wells in the first half of 1960 and has further stepped up crude deliveries to YPF. Production by Loeb, Rhoades group, vhich completed 21 wells in Mendoza in the first half of 1960, is expected to average about 16,000 barrels daily in 1960. Tennessee Gas, which has brought in 11 oil wells, including one major discovery, began delivery of oil to YPF from its wells in Tierra del Fuego in July. All told, it is estimated that the private companies may be turning over as much as 70,000 barrels per day by the end of 1960. This compares with total Argentine production of under 100,000 barrels daily in 1958. Significantly, YPF has achieved self-sufficiency in its own crude requirements by the first quarter of this year; and with open- ing of the pipeline bringing Pan American production to YPF, it was in a position to supply part of the requirements of private refineries as well. 59. Elsewhere on wildca.t acreage, YPF announced a discovery in Rio Negro in April 1960. Union Oil ha.s completed a 365-barrels daily well in one section of its tract. Esso, which has so far concentrated its efforts on exploration, has drilled one successful well in five attempts. Shell expected to drill its first wildcat well late in 1960.. 60. From recent press reports it would appear that the very rapid pace at which development work is being undertaken, coupled with tight- ness in government credit, is causing YPF temporany financial difficul- - 130 - ties. It has been indicated that some refinancing of the private drill- ing contracts in the Comodoro Rivada.via basin may be negotiated to strengthen YPF's current cash position. And YPF is reported to be con- sidering a broadening of the explora.tion program by granting new devel- opment contracts along the southern bank of the Conodoro Rivadavia basin, which ma.y provide advance payment of royalties.* 61. Apart from immediate financia.l stresses that may be involved, there are important long-range implications for YPF in the private in- vestment that is being undertaken. First, Argentine oil development is underway on a far broa.der scale and at a. much faster pace than if it were limited by the fina.ncial resources available to YPF. The oil search is being extended over a greater area. Development of proved and semi-proved acreage is being speeded; and pipeline construction will provide outlets for the new producing fields. Thus, resources as a source of national wealth will be more quickly converted into national in- come. Refinery expansion will permit nationa.l oil re- quirements to be met by local output of petroleum products, probably within two years. Second, a, substantial part of total capital requirements will be provided by private investment. In exploration, the risk of unsuccessful ventures will not fall on YPF; and the cost of failure will not bear upon YPF's limited financial re- sources. Priva.te outlays a.re to be reimbursed out of the proceeds of expanded operations, so that the pri- vate investment is essentially self-liquidating. At time of final writing the exa.ct policy to be followed by the Argentine Government is uncertain. Within Argentina. there are indications of differences of opinion as to the respective roles of YPF and contra.cting companies in developing these areas. - 131 - During the prolonged period when expenditures on the Argentine oil program are bound to exceed re- ceipts, the cash drain will be subsumed by priva.te investment. YPF's budget will not be encumbered except to the extent of its own undertakings -- which can now be focused on projects promising the most rapid payout. Third, the foreign exchange position of the Argentine oil economy should benefit considerably. The inevitably large foreign exchange costs of the development program are being provided for, in large measure, in the course of private investment. Subsequently, as the private outlays are being re- imbursed, foreign exchange costs will be offset by savings on oil imports. By 1964 these savings may approximate $400 million, while foreign exchange payments on drilling and production contracts a.nd refinery and pipeline construction are not ex- pected to exceed $160 million in that year. 62. Finally, there is the important contribution of trained and experienced personnel, of techniques and methods, that follows with the entry of private firms into Argentine oil development. Cross- fertilization of knowledge and approach, drawn from wide and long exper- ience in international oil operations, should ensure a high level of competence. 63. In sum, it would appea.r that private participation in Argen- tina.'s oil program should contribute decisively to the goal of national self-sufficiency. * * These genera.l conclusions should not be construed as judgments on in- dividua.l contracts between YPF and the various companies. The emphasis here is on the potentialities for private participation in national oil development, not on specific forms. Indeed, the very perspective of this chapter is toward the many and diverse ways in which private enterprise can and does make a, contribution under varied conditions and circumstances. - 132 - Bolivia, 64. In Bolivia, national oil operations got underway largely on the basis of private producing properties taken over in the late 19301s. As domestic oil requirements were small, it was hoped that substantial oil exports could be developed to provide relief from chronic foreign exchange difficulties. But a rapid build-up of production proved too large a task for the state oil entity. The Government therefore turned to private industry to stimulate oil development. 65. Oil operations in Bolivia. da.te back to 1921. In that year Standard Oil Co. (N.J.) obtained a, 55-year concession on 2.5 million acres in the southern part of the country near the Argentine border. Later, the company relinquished 70 per cent of this acreage. Jersey Standard drilled 31 wildcat wells in the 15 years to 1936; about half of these were producers. Oil was discovered at Bermejo along the Argentine border in 1922. Two more discoveries followed in 1926 -- at Camiri and Sanandita further north. Commercial production began in 1931. 66. In 1936 Bolivia created a state oil entity, Yacimientos Petroliferos Fiscales Bolivianos (YPFB). The followina year the Boli- vian properties of Jersey Standard were expropriated and turned over to YPFB, which wa.s given a. monopoly over all oil development in the coun- try.'F 67. At the time of expropriation, Bolivian oil production amounted to less than 1,000 barrels per day and came almost entirely from the Camiri field. Output from other fields was held back by the lack of transport facilities. The small quantity of oil that was pro- duced was consumed locally, and wa.s supplemented by refined product imports. YPFB Operations 68. Under YPFB management, Bolivian oil development proceeded slowly. In the postwar years to 1954, an average of only about 8 wells a, year were drilled. YPFB stepped up its drilling somewhat after 1954, completing an average of 27 wells a year in 1955-1958. Crude oil re- serves were gradually built up -- from 20 million barrels in 1949 to 45 million in 1954; they have since been doubled to 90 million barrels. Two new fields were discovered -- Guairay, an extension of the Camiri field, in 1947; and Toro, an extension of the Barmejo field, in 1955. ' Jersey Standard valued its investment in Bolivia at the time of ex- propriation at close to $7 million. The Government paid the company an indemnity of $1,750,000 as full settlement in 1942. - 133 - 69. Cruide oil production, however, lagged under YPFB operations. Output of 1,000 barrels daily was not reached until 1945; in 1954, crude production amounted to only 4,700 barrels per day. Thereafter, output rose more rapidly and amounted to 9,400 barrels daily in 1958. 70. YPFB built four small refineries, all completed before 1951, with a total capacity of 12,300 barrels per day. The largest (5,800 barrels daily) is at Cochabamba; the others are at Sucre (4,000 barrels per day), and at the oil fields of Camiri (2,000 barrels per day) and Sanandita (500 barrels daily). Much of this capacity went unused, how- ever; YPFB's runs to stills amounted to only 6,500 barrels daily in 1958. The low level of refinery throughput was occasioned by a slower growth in product demand than had been anticipated when the refineries were built. YPFB -- EXPLORATORY AND DEVELOPYENT DRILLING, 1946-195b AVERAGE AND 1955-1958 19h6-54 1958 1957 1956 1955 Average Total well completions 33 24 25 21 8 Oil and gas 23 19 20 19 Dry holes 10 5 5 2 Exploratory wells 9 5 4 2 2 Oil and gas 2 2 2 2 Dry holes 7 3 2 Development wells 24 19 21 19 6 Oil and gas 21 17 18 17 Dry holes 3 2 3 2 Source: American Association of Petroleum Geologists. 71. YPFB also constructed a relatively extensive pipeline network to link its meager production with the scattered refineries and consum- ing centers; also to permit shipments to Argentina and to Chile via tanker. In 1949 a crude line was completed linking the Camiri field with refineries at Sucre and Cochabamba. This pipeline was extended to La Paz in 1955, and to Santa Cruz in 1957. In the latter year, the Bermejo field was joined to the network. A second line -- from the Camiri field south to the Argentine border -- was completed in 1955. Finally, in 1958, a $12 million, 100-mile line over the Andes to the - 134 - Chilean port of Arica was constructed with the financial and technical assistance of a. major international oil company. However, this line's 6,000-barrels-per-day capacity is reported to have been idle for some time for lack of production. 72. What YPFB produced, in the way of crude and refined products, was adequate to meet the country's domestic oil needs, at least after 1954. But petroleum consumption was retarded by low levels of indus- tria.l activity and sparse use of motor transport. The slow advance of domestic oil requirements made it possible to export some oil. .A far more rapid expansion of petroleum production and exports was needed, however, to help diversify the economy and to provide badly-needed foreign exchange earnings. BOLIVIAN OIL BALANCES, 1954 AND 1958 (Thousands of Barrels Daily) 1958 195b Production 9.4 4.7 Refinery runs 6.5 4.3 Domestic demand 5.7 4.3 Exports 3.7 0.3 Crude oil 3.3 0.2 Refined products 0.4 0.1 Sources: YPFB; U.S. Bureau of Mines. 73. The slow pace of Bolivian oil development was largely a result of YPFB's acute shortage of investment funds. A more intensive exploration and development program would have required substantial fi- nancial resources. Funds generated from YPFB's own operations were necessarily small by virtue of the low level of activity. They were, in fact) even more restricted because of relatively low product prices. -What dapital funds were available came largely from the Government. But these were also extremely limited; in fact the Bolivian Government was itself in need of substantial foreign aid during much of the postwa.r period. 74. As early as 1952, the Government began moving in the direc- *tion of a more liberal policy toward foreign oil companies as the only - 135 - practical means of more rapid oil development. During the next few years, foreign companies were offered acreage on a lease basis from YPFB. One company, an American independent, took a 35-year lease on 920,000 acres in 1954. To overcome the reluctance of most oil companies to enter the Bolivian oil search without clearly defined rights, the Government adopted a new petroleum code in 1955. The 1955 Oil Code 75. Under the 1955 oil code, Bolivia is divided into four petro- leum zones. The first three are open to private foreign investment under the terms established in the law. The fourth zone, which includes all acreage under production when the law wa.s adopted, is reserved to YPFB. Private companies may participate in Zone IV under terms to be negotiated with YPFB. Parts of Zone I and IV are reserved for develop- ment under terms established by a. mixed Bolivian-Brazilian commission. (See below.) 76. Exploration rights are valid for 4 to 10 years, depending on location, with minimum expenditures and maximum acreage specified. Ex- ploitation leases run for 40 years and involve certain drilling obliga- tions. Surface fees are payable during exploration and production. During production, surface fees together with royalties and a 30 per cent income tax, are to add to 50 per cent of net income. If they fall short, a surtax is imposed. If they exceed 50 per cent of net income, the excess is credited a.gainst future taxes. A depletion allowance is permitted equal to 27 1/2 per cent of the gross value of production, up to 50 per cent of net income before depletion. 77. The first company to enter Bolivian oil operations under the new law wa,s the Bolivian Gulf Oil Co., which leased L million acres in newly-opened area.s in 1956. Gulf also made an agreement with YPFB covering operations on 3 1/2 million acres in the YPFB zone and agreed to finance half the costs of the $12 million pipeline a.cross the Andes to the Pacific. Five more companies, including a subsidiary of the Royal Dutch/Shell group, took out concessions in 1957; this brought the area under priva,te lease to 15 million acres. Another four applications were approved in 1958, covering L 1/2 million acres and bringing the number of foreign oil companies operating in Bolivia, to 11.* 78. Geologica.l and geophysical survey teams have been active on this acreage since 1957; at present there are more than 20 teams con- Several of these operators represent groups of oil companies; in all, more than 20 companies are involved in Bolivian operations. - 136 - ducting operations. Several wildcat wells have already been drilled and more are underway, all in the YPFB zone.* While results so far have been generally inconclusive, no let-up in activity appears to be indi- cated. In fact, drilling is expected to be pushed more intensively in 1960. Two producing wells have been brought in by private companies. One, in November 1959, is located in the YPFB zone less than a half-mile from Argentina's Madrejones field; the second, in September 1960, on privately-held acreage northwest of Santa Cruz. 79. Through the end of 1959 the companies are reported to have spent about $55 million in the search for oil, $25 million in 1959 alone. An increasing tempo of capital expenditures is planned for 1960. These expenditures, all of which preceded the first show of oil, compare with YPFB capital outlays of $38 million in 1957-1958, of which $10 million was raised via foreign loans. 80. Bolivia ha.s also sought to get exploration going on the 8.6 million acres reserved for joint Brazilian-Bolivia.n development under a 1938 treaty resolving the boundary dispute between the two countries. In 1957 an agreement was reached whereby the northern 60 per cent of the area would be developed by YPFB, and the southern 40 per cent by private Brazilian companies. e Four Brazilian private concerns have so far been accepted by the Brazilian Government to explore in its reserved area. It appears, however, the Brazilian Government has ruled out any associa.- tion of foreign risk capital in these ventures and will not help them to secure any necessary foreign exchange. An anomalous situation has thus developed: Bolivia is prepared to accept private foreign participation in its oil program; Brazil, with reserved rights to explore and develop certain border areas, cannot operate through its national oil entity, and the several private Brazilian groups may not ally themselves with foreign companies that would appa.rently be acceptable to Bolivia. 81. Finally, YPFB has sought foreign credits to help finance its own efforts. The U.S. Government has recently cleared a "Point Four" industrial credit of $2,700,000, apparently for purchase of equipment. In addition, it will finance a study of the YPFB organization and opera- tions, together with the long-term prospects of development based on proved and potential reserves. * In addition, four wells were drilled on the early 1954 lease without achieving commercial production. In 1957, the operator sold his rights to a group of U.S. independents who are now drilling their third wildcat. ** Petrobras is excluded, as Bolivian law prohibits operations by con- cerns associated with foreign governments. - 137 - 82. Thus, Bolivia has moved in several directions to strengthen its na.tional oil program. Extensive new areas have been opened to search by priva.te companies, who provide a source of exploration capital that YPFB sorely lacked. Within its reserved areas, YPFB ha.s a.vailed itself of private capital and technology so a,s to speed development. Meanwhile, credits obtained from both private and Government sources should help YPFB improve its physical facilities. It is still too early to predict results; but the activities taking place now allow a, much more extensive testing of prospects than YPFB could have ever handled by itself. - 138 - India 83. In India, rapidly rising oil requirements have greatly con- tributed to the acute foreign exchange burden on the nation. With little indigenous production, imports to support domestic oil con- sumption have accounted for perhaps 40 per cent of India's balance-of- trade deficit in recent years. Yet the country contains promising petroliferous regions, vast in extent but largely untested. India's decision to grant exploration and production rights to private companies was announced in November 1959. This marked a significant shift in national policy which since 1956 had pointed to a virtually exclusive role for the Government in all new oil development. 84. In the early years following India's independence (1947), a limited exploratory and production effort was carried out by two private companies. Assain Oil Company, a subsidiary of Burmah Oil Company, was responsible for all of India's oil output (about 5,000 barrels daily in 1950), which came from a field discovered in 1890. Assam Oil subsequently located two major fields in the postwar years -- at Nahorkatiya in 1953 and at Moran in 1955 -- but production was largely shut in pending construction of transport facilities. In 1953 Stanvac obtained exploration rights over some 10,000 square miles with- in the Bengal Basin; the Government holds a one-fourth interest in this venture. Thus far, drilling has been without success. 85. Private companies also conducted all refining and marketing operations in India. The three major marketers, Burmah-Shell, Caltex and Stanvac, established refineries in the 1950's at Government request. A major consideration was the need to reduce the foreign exchange cost of imported oil supplies. These now have a total capacity of 103,000 barrels daily, equal to roughly 85 per cent of Indian oil requirements. Government Activity in Oil 86. In 1956 the Indian Government's Industrial Policy Resolution defined spheres of government activity in industry. Petroleum opera- tions were listed among those industries whose future development would be the exclusive responsibility of the State. To quote from the Resolution: All new units in these industries, save where their establishment in the private sector has already been approved, will be set up only by the State. This does not preclude the expansion of existing privately- - 139 - owned units, or the possibility of the State securing the cooperation of private enterprise in the establish- ment of iiew units when the national interests so require . .. Wherever cooperation with private enter- prise is necessary the State will ensure, either through majority participation in the capital or otherwise, that it has the requisite powers to guide the policy and control the operations of the undertaking. Thus, while the expansion of existing private ventures or the coopera- tion of private enterprise in the establishment of new ventures was not ruled out, the major impetus in oil development was to come from the State. 87. To implement this policy, the Oil and Natural Gas Commission (ONGC) was established. In addition to advising the Government on oil matters and supervising private operations, the ONGC was to engage actively in exploration, production and refining. With the assistance of foreign personnel and equipment, the ONGC has undertaken a variety of exploratory activities. During 1958-1959, 28 teams carried out geological and geophysical surveys. Wells have been drilled in the Punjab area, at Baroda and at Cambay. Several successful wells have been brought in at Cambay, and Ankleswar, where tests are continuing. 88. The Indian Government also set up a joint venture with the Assam Oil Company to develop and work the newly-discovered Assam reserves. Oil India Private Limited is owned one-third by the Govern- ment; two-thirds by the Assam Oil Company. It is constructing a 260- mile pipeline to Gauhati, Assam, where the Indian Government will build and operate a 15,000-barrels-daily refinery. A 460-mile ex- tension will take Assam crude on to a 4O,OOO-barrels-daily plant, also government-owned, at Barauni. 89. The decision to erect government refineries raised prospects of state entry into marketing operations as well. In June 1959 a new State Corporation, the Indian Oil Company, was established to handle retail distribution of products. 90. While results of the Government's initial exploratory effort can, on the whole, be regarded as encouraging, what is most striking is how much remains to be done. Even in the northeast, the one area where production has been established, the full scope of possible oil deposits is as yet undetermined. A systematic search remains to be carried through before the potential producibility of the Upper Assam Valley will have been tested. The underlying structure is known to be complex, so that further exploration is apt to be difficult and costly. At Cambay, potential producibility will not be determined until the - 140 - various structures are more completely tested and offset wells posi- tioned. Beyond these a vast sedimentary area encompassing perhaps 400,000 square miles has yet to be opened to systematic investigation and exploration. 91. Given the uncertainty that is inevitably associated with the search for oil and considering the extensive areas that are regarded as promising in India, it would follow that the broadest possible ex- ploratory effort should be encouraged -- to minimize the risk of indi- vidual failures and maximize the chances of discovering and developing the nation's potential resources. Exploratory operations, and sub- sequent oil development, would also have to be carried forward as rapidly as possible if the results were to contribute to India's economic growth in the crucial years immediately ahead. 92. All this would require a very large staff of scientific and technical personnel with a huge amount of equipment, far beyond what India has at its disposal. In addition, the financial requirements would be enormous. Capital expenditures would mean a continuing budgetary drain -- first, to discover oil; then, to develop production; and subsequently, to replace and also add to reserves so as to keep up with growing demand. Furthermore, foreign exchange costs would be multiplied in the early years of an oil program, as imports of special- ized equipment and material are added to the imports of crude oil and products. 93. During the period covered by India's third five-year plan (1961-1966), economic development is tentatively expected to involve outlays of equivalent to $21 billion -- as against the $14 billion currently programmed -- and requiring external aid in the amount of perhaps $1 billion a year. The amount that can be allocated by the Government to oil development falls far short of the outlays required for an all-out effort. 94. The critical problem for India is therefore one of timing. To attempt it all within the public sector would mean drawing on a very large part of the country's scarce resources which then would not be available for urgent needs in other areas -- and at the risk that all or much of the investment in exploration might prove futile. By per- mitting private initiative in oil development, on the other hand, India would know that where exploration ends in failure, the loss would be taken by the cdmpany. Where there is success, the Government real- izes an immediate gain -- through its share in the income from pro- duction, through tax receipts, and in foreign exchange savings. Thus, private investment could be the means for stepped-up oil exploration now, in India's critical years. - 141 - Recent Policy 95. A growing awareness of the problems posed by confining the oil development effort to the State led the Indian Government on the basis of extensive study and review to modify the national oil policy in late 1959. As the Minister of Mines and Oil stated in Parliament: But large-scale oil exploration programmes must be undertaken involving expenditure of great amounts of foreign money in a comparatively short time if we have to attain the target of producing about 14 million tons (280,000 barrels daily) of crude oil by 1966. Government have, therefore, decided to invite foreign oil ex- plorers also to join in the quest for oil in India, subject to mutually acceptable terms for exploration and also a.ssuring that such arrange- ments with foreign oil explorers fall generally within the ambit of India's Industrial Policy Resolution. With a view to creating these con- ditions the Government have finalised their new Petroleum and Natural Ga.s Rules and they are being published immediately. 96. The Petroleum and Natural Gas Rules, 1959, set up standard provisions which may be included in exploration licenses and exploita- tion leases. According to the Rules, exploration rights are ordinarily to run for four years, with possible extensions for two 1-year periods. Exploitation rights a.re ordinarily to run for 20 years; no extension is mentioned. Surface fees are to be paid to state governments, unless exceeded by the royalty in which case only the royalty need be paid. The royalty, a.lso payable to state governments, is to equal 10 per cent of the gross value at the wellhead of all production. 97. The Rules are apparently meant to be flexible, and most major conditions of private operation are left open to negotia.tion. A number of companies -- U.S., British, French, Italian and Japanese -- are reported to have expressed interest and are currently discussing explo- ration terms with the Government. However, it is too soon to assess the - 142 - role that private enterprise may take on within India's oil development program. 98. Meanwhile, private participation will in no way derogate from the functions of the ONGC. In a.d.dition to continued drilling in exist- ing areas, government geological, gravity and seismic crews plan to operate over a 2,859-square mile area in the 1960-61 field season. A primary object is the "systematic and thorough investigation of the country's sedimentary basins which, from the geological point of view, deserve exploration for petroleum." Such extension of basic knowledge as to the nation's oil potential is, of course, essential to an effec- tive oil search; it will obviously have to be carried forward on an even greater scale. 99. What the future ma.y hold remains to be discovered. But if private investment can be brought into exploration to supplement ONGC operations, India can hopefully look forward to a much larger effort toward closing the oil gap than it could ever muster itself. 100. At the same time, it should be noted that the impending entry of Government into refining and marketing, especially if it were to in- volve discriminatory or exclusive privileges for the new entities, could make for difficult relations between Government and industry. The coun- try faces two knotty problems in these areas. First, the imbalance between refinery yields and inland consumption. Kerosene and diesel re- quirements are especially large, and growing rapidly; gasoline needs are relatively small, and increasing slowly if at all. In consequence, projected refinery expansion could lead to very great gasoline surpluses with serious middle distillate shortages. Second, oil consumption in India, is thinly spread, whether on a per capita. or per square mile basis. And this leads inevitably to fairly high distribution costs. If Government refining and marketing activities are pla.nned in isola.tion, ha.ving regard only to the furtherance of individual State projects, the private companies could find their operations seriously circumscribed. * It should also be noted that India is receiving substantial help from the Soviet bloc for its State oil program. This includes long term loans from Rumania. ($11 million) for the Gauhati refinery, and from the U.S.S.R. ($21 million) for the projected Barauni refinery. Also, some 4$69.3 million ha.s been allocated, out of the 1,500-million rouble loan extended by the U.S.S.R., for exploration and drilling over the period of the Third Plan. And India has contracted to im- port Soviet kerosene and distillates, with payment in rupees, to re- place products that have been brought in by the private refining and marketing companies. - 143 - This would undoubtedly affect the decision of these -- and probably other companies as well -- to devote large resources to the search for oil in India. On the other hand, problems of product imbalance and of distribution offer a, distinct opportunity for collaboration between Government and industry on matters of common interest. 101. The sections above have traced out the experience of various countries in accepting the pa.rticipation of private enterprise alongside State oil operations. As noted previously, these arrangements ha.ve not been cited a,s necessarily appropriate to other areas. To the contrary, the emphasis of this chapter is on the diversity of forms that have been negotiated. Thus, private participation differs from country to country -- depending on historical, political, and economic circumstances in ea.ch instance -- but the common objective is to extend the scope and speed the pace of local oil development beyond what could be accom- plished through the resources of the government oil entity itself. 102. It is a.pparent from the examples cited that private enter- prise is able to operate in many different environments, under terms that are consistent with the policies of the respective governments. At the same time, effective colla.boration in nationa.l oil development de- pends on the scope and opportunities that are permitted to private oper- ations. Especially in the search for oil, private capital would obviously expect that it be offered reasonable a.ccess to a.ttractive acreage, under conditions that provide adequate incentives to invest- ment. It is not uncommon for selected areas to be reserved to State operations, for example, in regions where production is under way or productive potential is fairly well established. But substantia.l pri- vate expenditures in the risky business of exploration are unlikely unless acreage with encouraging prospects is opened to search on a non- discriminatory basis. - 144 - APPEIDIX A Argentine Production Contracts with Private Companies - 145 - APPENDIX A Argentine Production Contracts with Private Companies 1. In this Appendix, we review the terms of exploration and pro- duction contracts entered into between YPF and several private com- panies, pursuant to the oil development program that was launched in 1958. Pan American International 2. The first of these -- in effect since mid-1958 -- is with the Pan American International Oil Company, a subsidiary of Standard Oil Company of Indiana. It covers about 1,545 square miles in the general area of the Comodoro Rivadavia basin and is valid for 15 years, with a 5-year renewal optional on the part of the company. The agreement calls for the drilling of 50 wells in the first year and 100 addi- tional wells in the second y2ear. Production is to be maintained at the maximum efficient rate. In addition, an 80-mile crude pipeline is to be built to deliver the oil to YPF at Comodoro Rivadavia. 3. YPF is to pay Pan American $1.59 per barrel produced and delivered. Sixty per cent, or $.95 per barrel, is to be paid in U.S. dollars, the rest in pesos. After five years, the price may be ad- justed to reflect fluctuations in world market prices. (The method of determining the adjustment was left to subsequent negotiation.) 4. Under this agreement, Pan American has been granted certain preferential rights to supply Argentine crude imports, effective after three y,ears -- provided, however, that in competitive bidding the company offers price, means of payment, delivery, and other terms which match those of other possible suppliers. Volume under the pre- ference is limited to one-third of Argentina's 1957 crude imports, which were 114,000 barrels daily. Loeb, Rhoades 5. A second contract calling for the development of proved and semi-proved acreage was made with Carl M. Loeb, Rhoades & Company. The first areas jointly selected include more than 100,000 acres in Mendoza Province and 1,200,000 acres in the Comodoro Rivadavia basin. An Operations Committee representing the company and YPF will plan and - 146 - carry out development, production and transport projects. The company will provide all necessary financing, which is estimated on the order of $100 million. 6. Once production has begun, Loeb, Rhoades is to recover its expenses through receipt in pesos of 50 per cent of the value of the crude oil produced, determined in accordance with world market prices, plus delivery costs to Argentina. This value is defined as "the ex- penditure which at that moment would have had to be made to import the respective substance into Argentina". Any dispute as to this value shall be decided by arbitration. 7. In addition, the company is to receive a "benefit for par- ticipating in the development of production" of 20 per cent of the value of the crude oil produced. This payment is to be made in U.S. dollars. It is to be calculated separately for each productive structure and is to be limited in each case to 20 years from the date on which full development of the structure has been attained. The percentage may be reduced by 1/4 of 1 per cent for every 5,000 barrels daily of production above 25,000 barrels daily and/or for every $ 25 above $2.50 in the cost of imported crude, but is not to be less than 15 per cent. If the company and YPF agree on the reserves recoverable from an area, a single payment representing profit on that area's potential production may be made. 8. Payment for the construction of transport facilities, in- cluding pipelines, is to be made through 20-year, 5-per-cent bonds, issued by YPF. Standard Oil (N.J.) 9. Some 1,850 square miles of proved and semi-proved acreage in Neuquen Province are covered in a third contract -- with a subsidiary of Standard Oil (New Jersey). The agreement is to run for up to 30 years, at the company's option. The acreage is to be reduced to half the original size in six years and to one-quarter in ten years. 10. Expenditures of at least $23 million are required in the first six years. If reserves and markets support production of 25,200 barrels daily, another $24 million is to be spent (on reduced acreage) during the next four years. If not, investment is reduced propor- tionately to the level of production. During the final 20 years, investments must be adequate to complete exploration and development of areas then remaining. 11. Production shall be maintained at the maximum economic rate. All oil, except that required for operations, shall be delivered to - 147 - YPF until national self-sufficiency is attained. YPF will pay Esso Argentina each month the peso equivalent of $1.83 per barrel daily for up to 12,600 barrels daily; $1.79 per barrel daily for up to 25,200 barrels per day; and $1.75 per barrel daily for over 25,200 barrels daily. Adjustments are to be made in line with fluctuations in the international price of petroleum. This is defined as follows: . . . the international price of petroleum corresponding to any given six-month period (January-June and July- December), shall be the arithmetic mean of the posted prices during the immediately preceding six-month period, at ports of loading in Venezuela, the Persian Gulf and the South of the United States of America (Gulf Coast), of petroleum of gravity and specifi- cations equivalent to those of the petroleum pro- duced in the contract area. The price of petroleum for each of the three zones shall be a single price representing the arithmetic average of the prices corresponding to the said zone. 12. After Argentine crude oil production reaches the point of self-sufficiency, Esso Argentina has two alternatives with respect to further production from its area. It may continue to produce nor- mally at the maximum efficient producing rate. In this case, YPF will sell the surplus oil to Esso, presumably for use in Essols Argentine refining and marketing operations. Beyond this, Esso may export the excess at a mutually acceptable price, paying YPF the difference between the proceeds of sale and the fee the company ordi- narily receives, plus transport and other charges. Alternatively, the company may cut back production, the duration of the contract being lengthened six months for every period of restricted output of the same duration. 13. Esso Argentina is also to spend up to $23 million to construct a 390-mile pipeline from Neuquen Province due east to Bahia Blanca on the Atlantic coast. It will be reimbursed in U.S. dollars plus 5 per cent interest over a 30-year period. Construction is to begin when the company decides it is economically feasible unless YPF requires an earlier start. 14. A special feature of this contract relates to refining and marketing operations of the company in Argentina. It provides that the company shall not be limited to a market position lower than that held during May 1957-April 1958.*' To meet its refinery requirements, i Reported to have been around one-sixth of Argentine product sales. - 148 - the company will purchase from YPF a share of any available surplus crude proportionate to Esso's market position. Beyond that, the company may meet its refinery needs by crude imports under "reason- ably competitive conditions". The contract adds: In order to determine reasonable competitive con- ditions, the terms under which Esso obtains trans- portation and crude petroleum from its respective suppliers will be subject to annual review by the competent State agency for the purpose of confirming that the freight rates obtained are comparable to market rates for similar transportation, and that the price and sale conditions of the crude petroleum are comparable to the prices and conditions charged for assured long-term supply of crude of similar quality and quantity. Tennessee Gas Transmission 15. A fourth contract involving proved and semi-proved acreage was made with the Tennessee Gas Transmission Company. It covers 5,400 square miles in Tierra del Fuego at Argentina's southernmost tip. It is valid for from 3 to 25 years, at the company's option. The company is to spend a minimum of $10 million in the first three years, in- cluding $4 million for exploration. Another $3 million must be invested if operations continue beyond the third year. 16. If Tennessee Gas has not invested $20 million by the end of the sixth year, the acreage will be reduced to between 200 and 1h00 square miles, depending on exploration results. If $20 million has been spent by the end of the sixth year, only 20 per cent of the original acreage must be surrendered then and another 20 per cent of the original acreage after four more years. 17. The first 504,000 barrels are to be delivered to YPF in exchange for the use of existing installations. YPF payments to the company will start 16 months after the next 220,500 barrels are delivered. The price is set at $1.77 per barrel of crude oil produced and delivered, and is to be adjusted in line with changes in posted prices for crude oil in world markets. 18. If YPF should elect not to take all the oil Tennessee Gas pro- duces and this causes the company to decrease its deliveries by 567,000 barrels or more, the company has two alternatives. It may cut back production and extend the life of the contract at the rate of one month for each 567,000 barrels not taken by YPF. Or, it may produce - 149 - the oil for export by YPF or the company. If the company is authorized to export the oil, it guarantees that the price obtained will yield YPF a minimum profit of $.24 per barrel. 19. Tennessee Gas is to complete construction of an oil pipeline and submarine loading line for YPF on a 2-year credit without interest. Union Oil Company 20. Two additional producing agreements were signed. These cover wildcat areas rather than proved or semi-proved acreage. The first was made with Union Oil Company of California. It calls for exploration and development of more than 6,100 square miles of virtually untested area in Santa Cruz and Chubut Provinces in the vicinity of the Comodoro Rivadavia basin. A 5-year exploration period is established. If oil is discovered in commercial quantity, a production period is to run for 15 years. The company may obtain a 5-year renewal on the same terms and conditions. 21. Union Oil undertakes to drill diligently, spending a minimum of $8 million during the exploration period. If one of the areas is found to be productive, minimum expenditure is increased by $3 million; if both, by $6 million. Union Oil may terminate the contract at any time after the first two years, but it shall be under obligation to finish the individual jobs which it may have begun and to pay YPF the difference between its expenditures and $5 million. 22. Oil is to be produced at the maximum efficient rate and is to be delivered to YPF at Comodoro Rivadavia via one or two pipelines constructed by the company. The company has the option of repurchasing production in excess of Argentine requirements. 23. YPF will pay the company $1.90 per barrel of oil produced and delivered. Payment will be 60 per cent in U.S. dollars; the rest in pesos. Monthly adjustments will be made in per-barrel payments to reflect changes in posted prices for crude oil in world markets. Royal Dutch/Shell 24. A second wildcat area is covered under an agreement with the Shell Production Co. of Argentina, a subsidiary of the Royal Dutch/ Shell group, which produces, refines and markets in Argentina. The contract covers 11,500 square miles in Buenos Aires and Rio Negro Provinces. This area is to be reduced to 70 per cent of original acreage within three years, to 50 per cent within five years, to 25 - 15o - per cent within seven years, and to 10 per cent within ten years. 25. A 10-year exploration period is established. The production period is to run for 20 years from expiration of the 10-year explora- tion period, but production is to begin earlier if possible. The company may terminate the contract at any time, provided minimum ex- penditures have been made or the unspent balance is paid to YPF. 26. The Shell Company undertakes to spend a minimum of $2.8 million in the first two Wears, $5.6 million in the following three years, $8.4 million in the subsequent three years, and if justified, $11.2 million in the final two years of the exploration period. All told, minimum outlays on exploration of $28 million are anticipated. 27. When a likely structure has been found, drilling is to be carried forward under a jointly agreed-upon development program. The company will construct and operate a pipeline if it is economically and technically justified. 28. A quantity of oil equal in value at the international price to the company's direct and indirect expenses including amortization shall be refined and marketed locally by Shell subsidiaries; the proceeds will repay the company for its expenditures. The inter- national price to be used in establishing the value of the crude oil is to be determined on the basis of posted prices for similar Venezuelan crudes plus AFRA or other mutually agreed-upon freights to Buenos Aires. Ten per cent of the remainder of production is to be turned over to YPF until such time as its value at the international price adds up to `4.2 million. Of the balance, half is to be turned over to YPF and half is to be retained by Shell "as compensation for the exploration and production investments, risks, interests, and profits." 29. The marketing position of the Shell subsidiary in Argentina is to be protected.* So long as Shell's Argentine crude production is inadequate to its refinery requirements, the company may import any deficiency, subject to the prices paid being competitive with prices obtainable under other long-term agreements. If there are effective offers for long-term supplies to the Government at lower prices, these are to be taken into consideration. If there is surplus national production, Shell is to meet its deficiency by purchasing YPF crude supplies at a price guaranteeing Shell a "reasonable profit."' When the amount of oil produced and retained by the company exceeds the needs of the Shell subsidiaries for maintaining their percentage of e Specified in the contract as 20 per cent of domestic sales. - 151 - of the domestic market, the excess is to be sold to YPF at the current international price, or it may get permission to export such crude. - 152 - APPENDIX B Statistical Tables - 153 - APPENDIK B LIST OF TABLES B - 1 Crude Reserves and Production in the Rocky Mountain Area of the United Sta.tes, 1947-1957 B - 2 Estima.ted Cash Expenditures and Income of Rocky Mountain Oil and Natural Gas Producers, 1947-1957 B - 3 Canadian Crude Reserves and Production, 1950-1959 B - 4 Estimated Petroleum Industry Expenditures and Income in Western Canada, 1947-1958 and 1959-1963 Projected B - 5 U.S. Oil and Gas Producing Industry: Estimated Expenditures a.nd Receipts, Selected Years B - 6 Cash Flow of 25 U.S. Oil Companies in Domestic Operations, 1948-1959 B - 7 Gross Outflow of Private Long-Term Capital from the Main Capital-Supplying Countries, 1954-1958 B - 8 U.S. Oil Companies Ea.rnings Abroad and Net Investment, 1954-1958 B - 9 Oil Investment in Canada's Balance of Payments, 1954-1958 B - 10 Oil in Venezuelats Balance of Payments: Transactions of Foreign-Owned Oil Companies, 1954-1958 B - 11 Oil in Iraq's Balance of Payments: Transactions of the Oil Sector, 1954-1958 B - 12 Oil in Iran's Balance of Payments: Transactions of the Oil Sector, 1955-1959 - 154 - TABLE B - 1 CRUDE RESERVES AND PRODUCTION IN-THE ROCKY MOUNTAIN AREA* OF THE UNITED STATES, 1947-1957 Year-End Reserves Production (Millions of (Thousands of Yearst Barrels) Barrels Daily) Suppl.y 1957 2,790 630 12 1956 2,474 597 11 1955 2,250 530 12 1954 2,303 456 14 1953 1,843 390 13 1952 1,727 305 16 1951 1,292 297 11 1950 1,069 261 11 1949 1,074 222 13 1948 1,047 224 13 1947 1,003 189 15 1946 994 Average Millions of Annual Barrels Increase Net Additions to Reserves 1946/57 1,796 9.8% Production 1947/57 1,498 12.8% Gross Additions to Reserves 1946/57 3,294 * Includes the States of Colorado, Idaho, Montana, Nevada, North Dakota, South Dakota, Utah, and Wlyoming, and part of aestern Nebraska. Source: Paper presented at the 44th Annual Meeting of the American Asso- ciation of Petroleum Geologists in Dallas, Texas, March 17, 1959. - 155 - TABLE B - 2 ESTIMATED CASH EXPENDITURES AND INCOME OF ROCKY MOUNTAIN OIL AND NATURAL GAS PRODUCERS, 1947-1957 (Millions of Dollars) Value of Production Cash Crude Natural Cash Position Total Oil Gas Expense (Deficit-) 1947/57 3282 3,169 113 4.250 -968 1957 580 558 22 666 -86 1956 502 484 18 684 -182 1955 435 419 16 615 -180 1954 371 358 13 600 -229 1953 305 296 9 487 -182 1952 227 218 9 373 -146 1951 218 211 7 272 -54 1950 191 186 5 180 11 1949 171 166 5 146 25 1948 174 169 5 131 43 1947 108 104 4 96 12 Source: Paper presented before the 44th Annual Meeting of the American Association of l'etroleum Geologists in Dallas, Texas, March 17, 1959. - 156 - TABLE B - 3 CANADIAN CRUDE RESERVES AND PRODUCTION, 1950-1959 Year-End Reserves Production (Millions of (Thousands of Years' Barrels) Barrels Daily) SupDly 1959 3,497 510.3 19 1958 3,166 453.4 19 1957 2,874 498.1 16 1956 2,849 462.6 17 1955 2,510 354.7 20 1954 2,208 263.2 23 1953 1,845 221.6 23 1952 1,680 167.3 28 1951 1,377 130.5 29 1950 1,203 Average Millions Annual of Barrels Increase Net Additions to Reserves 1950/59 2,294 12.6%, Production 1951/59 1,118 18.6% Gross Additions to Reserves 1950/59 3,412 Source: Canadian Petroleum Association. _ 157 - TABLE B - 4 ESTIMATED PETROLEUM INDUSTRY EXPENDITURES AND INCOME IN 4ESTERN CANADA, 1947-1958 and 1959-1963 PROJECTED (Millions of Dollars) Value of Production, Less Exploration Development Production Total Oil and Royalty Cash Income- Costs Costs a Expenseb Outlay Natural Gas Payments Income Outlay 1947 16.4 5.9 3.1 25.4 21.2 3.3 17.9 -7.5 1948 49.5 12.0 4.9 66.4 38.4 5.6 32.8 -33.6 1949 106.5 32.4 12.1 151.0 62.5 7.8 54.7 -96.3 1950 103.9 57.5 16.4 177.8 86.3 10.8 75.5 -102.3 1951 146.1 77.4 20.1 243.6 122.7 14.9 107.8 -135.8 1952 187.0 114.2 25.8 327.0 148.0 18.5 129.5 -197.5 , 1953 188.9 100.5 31.7 321.1 205.2 25.8 179.4 -141.7 D 1954 248.4 87.3 37.0 372.7 249.4 31.3 218.1 -154.6 1955 255.1 168.1 52.0 475.2 311.7 39.2 272.5 -202.7 1956 297.6 162.4 90.2 550.2 415.6 52.1 363.5 -186.7 1957 314.1 169.5 112.4 596.0 468.2 58.5 409.7 -186.3 1958 302.7 160.1 104.4 567.2 421.6 52.7 368.9 -198.3 1947-1958 (Total) 2,216.2 1,147.3 510.1 3,873.6 2,550.8 320.5 2,230.3 -1,643.3 1959 250.0 155.0 110.8 515.8 483.6 55.4 428.2 -87.6 1960 310.0 162.8 166.8 639.6 554.1 62.6 491.5 -148.1 1961 320.0 174.8 206.6 701.4 635.6 70.4 565.2 -136.2 1962 330.0 204.3 160.2 694.5 762.0 81.6 680.4 -14.1 1963 340.0 153.2 169.1 662.3 813.5 87.2 726.3 +64.0 a Does not include outlays for pipelines beyond the field gate. b Includes gas utilization costs. Source: Canadian Petroleum Association. T.iBLE B - 5 U.S. OIL <.JD GAD PRODUCING INiJUSTRY: -ST'I1jl..TED EXPNIL)ITURZS AAlL RECEIPTS, SELECTEV YEARS (Millions of Dollars) 1956 1955 1953 1948 OUTLAiYS 4,973 4,632 4,375 2.629 Exploration Costs 2,325 2,183 1,956 1111 Dry holes 909 774 797 462 Othera 1,416 1,409 1,159 649 Levelopment Costsb 2,648 2,449 2,419 1,518 Producing dells 1,959 1,826 1,762 1,058 Equipment 477 426 483 362 CASH I1TCOME 5,290 5,033 4,398 3,832 Value of oil and natural gas production 7,320 6,872 6,471 5,044 Less: Production Costs 2,030 1,839 2,073 1,212 AET CASH SURPLUS +317 +401 +23 +1,203 a Includes lease acquisition, geological and geophysical, other miscel- laneous and overhead. b Includes overhead, not shown separately. Source: Joint survey of the American Petroleum Institute, Independent Petroleum Association of America and Mid-Continent Oil and Gas Association. - 159 - TABLE B - 6 CASH FLOW OF 25 U.S. OIL COMPANIES* IN DOMESTIC OPERATIONS, 1948-1959 (Millions of Dollars) Uses of Funds Additions Sources of Funds to Gross Internal Net Depreciatiog External Gross Total Investment Dividends Funds Incomea & Depletion Funds Incomea 1948/59 23.023 4.4 23.289 10.912 12.377 -266 120.589 1959 2,153 1,682 471 2,455 987 1,468 -302 12,977 1958 2,048 1,585 463 2,276 841 1,435 -228 12,206 1957 2,380 1,908 472 2,514 1,070 1,444 -134 12,776 1956 2,466 2,015 451 2,389 1,075 1,314 77 11,926 1955 2,241 1,829 412 2,218 1,010 1,208 23 11,037 1954 2,018 1,648 370 1,917 873 1,044 101 10,147 1953 2,027 1,672 355 1,874 897 977 153 10,067 1952 1,920 1,575 345 1,718 832 886 202 9,349 1951 1,650 1,328 322 1,696 908 788 -46 8,793 1950 1,225 932 293 1,429 791 638 -204 7,553 1949 1,330 1,071 259 1,272 669 603 58 6,767 1948 1,565 1,309 256 1,531 959 572 34 6,991 * Excludes the major international oil companies, as separate data on their domestic operations are not readily available. a From all operations, domestic and foreign; that from foreign operations is relatively small. b On all investments, domestic and foreign. As most foreign investments of these companies are of recent origin, amounts charged to depreciation and depletion are believed to be relatively small. Source: Chase Manhattan Bank. TABLE B - 7 GRO3, OUTFLO J OF PRIV,tTE LONG-TER1M4 CtV?ITAL* FROM THE 1i.IN CtYPITAL-SUPPLYING COUIYTRIES, 1954-1958 (Millions of Dollars) 1958 1957 1956 1955 1954 United States 3,293 3,920 3,420 1,91 1,628 Retained earnings 755 1,017 974 899 644 Net outflow 2,538 2,903 2,446 1,019 984 United Kingdoma 533 755 557 364 585 Continental lestern Europe NA 1,025 1,155 1 874 Belgium-LuxembourgD NA 150 160 170 70 Francec NA 457 540 494 490 Germany (Fed. Rep.) 262 185 75 61 54 Netherlands NA 103 59 157 60 Switzerlandd NA 130 321 260 200 TOTAL NA 5,700 5,132 3,424 3,087 Of Tdhich: DIRECT INVESTvL'NT BY U.S. OIL COMP,aNIES 702 1,696 1,397 572' 371 * Includes capital flotations, security purchases and extensions of credit as well as direct investment. a Net figures. Entries for all years include only part of the retained profits of U.K. companies operating abroad. b Net private capital rnovements, long and short term. c Includes estimates of French jrivate contribution to capital. formation in the overseas franc area. d New issues on the Swiss capital market plus net transactions in out- standing securities. Sources: United Nations, The International Flow of Private Capital, 1956-1958; U.S. Department of Commerce. - 161 - T.ABLE B - 8 U.S. OIL COMPANIES K,RNINGS ABROAD .iND NET INVESTirENT, 1954-1958 (Millions of Dollars) 1954-58 1958 1957 1956 1955 1954 All Foreign Areas Earnings 6,539 1,307 1,623 1,406 1,239 964 Additions to Net Investmnent 4,688 702 1,696 1,397 520 373 Canada Earnings 295 66 95 75 44 15 Additions to Net Investment 1,350 257 378 328 172 215 Venezuela Earnings 2,291 384 613 526 426 342 Additions to Net Investment 1,318 122 768 353 44 31 Note: Additions to net investment abroad include reinvested earnings plus new capital outflow. Source: U.S. Dept. of Commerce. - 162 - TABLE B - 9 OIL INVESTMENT IN CANADA'S BALANCE OF PAYMENTS, 1954-1958 (Millions of Canadian Dollars) 1954-58 1958 15 1956 19SS 1954 Goods and servicesa -5.005 -1.085 -1,424 -1,366 _698 -432 Merchandise: exports 22,897 4,890 4,909 4,837 4,332 3,929 Merchandise: imports -24,572 -5,o60 -5,488 -5,565 -4,543 -3,916 Investment income: credit 769 166 154 142 160 147 Investment income: debit -2,602 -586 -587 -523 -483 -423 of which: U.S. OIL COMPANIES -96 -38 -38 -26 -4 10 Other (net) -1,497 -495 -412 -257 -164 -169 Capital movements 5.005 1,085 1,424 1,366 698 432 Direct lona-term investments in Canada 2,356 450 514 583 417 392 of which: U.S. OIL COMPANIES 1,124 222 317 269 132 184 Other long-term investment (net) 2,535 723 788 844 -7 187 Short-term capital (net) 114 -88 122 -61 288 -147 Note: No sign indicates credit; minus sign indicates debit. a Includes donations. Source: International Monetary Fund. Balance of Payments Yearbook. TABLE B - 10 OIL IN VENEZUELA'S BALANCE OF PAYMENTS: TRANSACTIONS OF FOREIGN-OiNED OIL COMPANIES, 1954-1958 (Millions of U.S. Dollars) 19587 1956 1955 1954 Exports (f.o.b.)b 2,309.8 2,569.6 2,o86.0 1,791.2 1,563.5 Imports (f.o.b.) -257.1 -396.3 -237.5 -135.1 -122.4 Transportation and insurance -19.1 -36.2 -20.5 -14.2 -11.4 Investment income -504.9 -886.7 -681.5 -551.6 -454.4 Other service -189.7 -179.6 -157.4 -103.3 -70.5 Capital 68.6 802.9 384.7 -19.9 -21.4 Net errors and omissions 1.8 0.2 5.4 -0.9 -0.5 Total 1,409.4 1,873.9 1,379.2 966.2 882.9 Note: No sign indicates credit; minus sign indicates debit. a Preliminary. b Includes government exports of royalty oil received in kind. Source: International Monetary Fund. Balance of Payments Yearbook. - 164 - TABLE B - 11 OIL IN IRAQ'S BLAiNCE OF PiiYMENTS: TRANSACTIONS OF THE OIL SECTOR, 1954-1958 (Millions of U.S. Dollars) 1958 1957 1956 1955 1954 Exports and re-exports (f.o.b.) 522.9 320.3 439.3 473.5 436.4 Imports (c.i.f.) -27.9 -29.0 -20.7 -17.4 -16.2 Investment income -223.7 -136.8 -192.8 -206.5 -191.8 Salaries remitted abroad -0.8 -1.2 -1.1 -1.1 -1.1 Capital movements Royalty adjustment 12.6 7.0 ... ... Charge in accrued royalties due ... ... ... 29.8 5.6 Other (including errors and omissions) -12.2 13.9 -1.0 -14.4 -10.5 Sub-total 270.9 174.2 223.7 263.8 222.3 Advance to Iraqi Government -(net) ,,-. . 1,4 .. Total 270.9 174.2 223.7 262.4 222.3 Note: No sign indicates credit; minus sign indicates debit. Source: International Monetary Fund. Balance of Payments Yearbook. TABLE B - 12 OIL IN IRAN'S BALANCE OF PjiYMENTS: TRANSACTIONS OF THE OIL SECTOR, 1955-1959 (Millions of U.S. Dollars) Solar Years Ending March 20 1959 1958 1957 1956 1955 National Iranian Oil Company Exports (f.o.b.) of oil, including bunkers 4.1 6.8 6.5 12.4 13.6 Imports (c.i.f.) -17.7 -21.4 -8.8 -4.9 -2.0 Services (net) -7.5 -5.6 -7.9 -1.0 -1.0 Foreign assets (increase 0) 0.2 -O.4 3.4 0.3 -3.5 Total -20.9 -20.6 -6.8 6.8 7.1 Oil Consortium Exports (f.o.b.) 574.9 505.6 382.9 221.4 76.1 Imports (c.i.f.) -65.1 -63.8 -43.1 -9.0 -1.9 Investment income -244.9 -207.8 -140.7 -79.8 -18.5 Capital and net errors and omissions 54.2 22.0 -18.0 -6.1 -25.3 Total 319.1 256.0 181.1 126.5 30.4 Settlement under 1955 oil agreement -7.0 -7.0 -7.0 Pan American Petroleum Corp. payment 25.0 ... ... ... Total 316.2 228.4 167.3 133.3 37.5 Note: No sign indicates credit; minus sign indicates debit. Source: International Monetary Fund. Balance of Payments Yearbook. - 166 -