______ 1-7(22 Series Editor: _ - - - - ssues Rachel English 'IThe World l3ank Group - Energy Note No. 6 September 1995 Deregulation and Reform of Petroleum Markets From Monopolies to New Regulated Markets Eleodoro Mayorga-Alba Introduction International oil markets have evolved significantly, and a competitive market has emerged that is setting internationally accepted prices for crude and refined products. in many developing countries, structural reform of petroleum markets has become a critical component of macroeconomic hiberalization policies. The role of the govemment in -the petroleum sector is being redefined, -and markets are being deregulated (Le., state interventions such as special treatments of state-owned oil companies, price controls, and restrictions to trade are being removed, and monopolies are being broken up). Increasingly, the private sector is participating in more competitive petroleum markets. If it is to be successful, such structural reform must be accompanied by minimal but effective "new-style" regulation. Drawing on the recent experiences of several Latin American and Caribbean (LAC) and Sub-Saharan African (SSA) countries, this note reviews the -successes and problems of implementing structural reform and "new- style" regulation and proposes some general lessons. Exploration and Production Deregulation should start upstream, introducing competition in the local crude oil market and thus attracting capital to exploration and production (E&P) activities. Exploration Although national laws typicaly confer to the state ownership of hydrocarbon reserves, the licensing of exploration blocks is a common policy worldwide that allows governments to pass the responsibility for high-risk investments to private companies. Except for Brazil, Venezuela, and Mexico (and, until recently, Ghana), most governments have opened prospective basins to exploration by private companies; competition over risk capital is recognized globally. Production The development of oil discoveries, which requires large capital outlays, is typically financed by private operators under E&P contracts. Basically two types of contract are used: the "Indonesian type" of production sharing contracts (PSCs), where the operation assumes all risks and investments; and joint ventures, involving large-scale state participation in the E&P investments. _ _ __ - continued on next page Energy Note No. 6 Joint ventures are now rare, since states cannot afford the high level of investment required. In Nigeria (and, to a certain extent, Colombia), where state enterprises are still involved, they are finding it difficult to raise financing to maintain a high equity participation in the development of oil fields. Under more recent E&P contracts - usually PSCs - the oil and gas produced belong to the producer and can be freely sold either locally or abroad. Contractual prices are set as "fair-market values" in direct reference to international prices. In Argentina and Peru, the elimination of state oil production monopolies and the healthy proliferation of independent suppliers of crude to local refineries marked a turnig point for the success of sector reforms. Procurement and Refining Openng procurement of crude oil and products to competition is more difficult to accomplish, but it is critical to successful reform. It requires facilitating access to domestic markets to qualified importers and exporters of crude oil and products, thus obliging local refineries to face competition. Most LAC and SSA refineries need to be upgraded or to be closed if they cannot be operated economicalRy. Where governments persist in delaying such reform, the technical and environmental gap between these refineries and the intemational industry will continue to widenm Changing Pricing Deregulation downstream requires adequate industry facilities and a change in and Taxation pricing policy. To attract new entrants into a market, product prices - before taxes - have to be set by the market in line with economic border prices, and the taxation regime must not discriminate between local and foreign suppliers. Several LAC -and SSA countries have used transitory pricing formulas to simulate import-export parity prices during a short period before prices are deregulated fully. Temporaiy Protection Protected operations, such as uneconomic refineries operating under cost-plus systems, must adapt or disappear. A large number of small hydroskimming refineries in Central America and SSA are generating significant losses to their economies. Such protectionism, even for security reasons, is no longer justified. Where investments for-improving existing facilities make economic sense, temporary (explicit or implicit) tax protection could be granted. This has taken place recently in Kenya and in Cameroon, as part of World Bank adjustment programs. Distribution and Marketing Downstream reform can proceed even further down the supply chain into the retail market and result in competing wholesale distributors and retail outlets. Such reform is possible even in small markets if transport is freed, conmmon-carrier principles are introduced, and mininal safety and environmental regulations are respected. Key Conditions Certain key conditions need to be met to achieve reform in the retail market: * transport and storage facilities must be sufficient to cope with the demand; * requirements for investors to enter the market must be simplified; minimal regulations must be enforced regarding product quality and safety and environmental standards, including liabilities for all agents in the supply chain; and * prices need to reflect differences in regional transport costs and market size. Eontinued on next age Energy Note No. 6 Different Starting Points Structural refonn of retail markets typically starts from different situations in LAC in LAC and SSA and SSA countries. In LAC, national enterprises constructed and operated terminals and product lines with little regard to economic criteria. The margins allowed in these facilities are now being reviewed, and the next step - to ensure the long-term sustainability of the reform - is to provide for competition on a permanent basis by privatizing these facilities. In SSA, however, most distribution and retail facilities are already owned by private companies but are operated under cost-plus pricing agreements that are reflected in the fuel prices administered by the state. SSA countries have to design carefully the steps required to introduce economic pricing, before removing state price controls, to ensure that private operators remain in the market. Pricing and Institutional Issues A good understanding of the vast interests of the petroleum industry and a well- defined and -articulated political commitment are essential for structural reform Prices usually need to be corrected, a new regulatory framework put in place, and certain key conditions met during a transition period to ensure that a truly competitive market is established. Price Liberalization in Honduras The price liberalization taking place in Honduras, an oil-importing country close to a large oil market, provides insights into the typical stages of a deregulation process. After a first phase in which procurement was opened to competition that brought the closure of the Texaco refinery, the government introduced a price formula reflecting import parity values and generous margins for terminal and retail operators. Hence, in the last three years, investments in terminals have risen to US$30 million, and today this small market (18,000 barrels/day) has four importers. Honduras now faces the difficulties of establishing a minimal regulatory framework and a skilled agency to move ahead toward full market deregulation. Ensure Correct Price Product prices and margins need to provide correct signals to producers and -Signals -consumers. Price -distortions, such as subsidies and taxation, need to be reviewed. Subsidies on household fuels, for example, have proved extremely costly to economies. Household consumers are better served by plentiful resources and several suppliers competing in a level market. Policies should therefore encourage substitution of modern fuels and favor direct -subsidies.' In addition, downstream taxation must not differentiate between local and foreign supplies or between fuels.2 As regional integration progresses, cross-border prices wil become increasingly harmonized, and hence fewer products wil be smuggled. Introduce Minimal Minimal regulations need to be put in place: Regulation * policy formulation responsibilities and regulatory functions need to be assigned to different agencies; * barriers to enter the local market need to be abolished (in particular, unnecessary legal and administrative procedures to build and operate new facilities); * open access needs to be introduced to monopolistic facilities (such as marine terminals, storage facilities, and pipelines) through nondiscriminatory tariffs; and * quality standards need to be set for products that take into account the market characteristics and maximize the number of supply sources. continued on next page Energy Note No. 6 Reform of the Petroleum Market in Chile Chile provides an excellent example of the separation of policy and regulatory responsibilities into different government agencies and of the elimination of barriers to competition. Empresa Nacional Administradora del Petroleo (ENAP) continues to own all the refineries and most of the common storage facilities but operates them on a commercial basis. Since the mid - 1970s, barriers to the downstream segment have been aboiished, and facilities have been run by qualified operators with open access under nondiscriminatory rules. Create Conditions for It takes time - depending on the location of the country, the size of its market, and Competition the overall macroeconomic program - to create the minimal conditions for competition. It also takes time for a market to react to new competitive conditions. During the transition, the following features are important: * a certain number of players must be ready to operate (the number depends on the size of the market); * relations with private companies need to be handled sensitively by the government. Quahfied operators should prove their financial and technical capacity, be liable for environmental and safety regulations, and keep a minimum security stock; and * a regulatory entity must be established to monitor the market and to react rapidly to any deterioration of product quality or noncompetitive behavior. Regulation of the Petroleum Market in Mali In Mali, difficulties observed in reforming the oil market resulted mainly from problems in implementing an adequate regulatory framework The lack of skills and the poor monitoring role of the regulatory agency have created an uneven playing field, giving national marketing an unfair advantage over international operations. Problems include tax evasion; lower standards of product quality and safety (e.g., caused by the proliferation of illegal "smali pumpse); and insufficient security stocks. Such deficiencies in the regulatory environment have allowed some 15 national retailers to undercut the prices of the four multinationals operating in the country. Without a level playing field, ensured by a transparent and efficient regulatory agency, the reform process will not succeed. The author is a Scnior Petroleum Economist, Industry and Energy Department. ' See forthconiing Energy Note, "The Impact of Energy Policies on the Urban Poor," by Douglas Barnes. 2 In Peru, fuel oil carries an indirect tax of nearly 78%. This has meant that heavy industries such as cement are importing nontaxed coal despite the large Petroperu fuel oil surpluses. South Africa is another case in which the coal supplies do not completely include the environmental costs. The case of differential taxation applies also in favor of natural gas or alcohols in other markets. Industry and Energy Department Vice Presidency for Finance and Private Sector Development Energy Issues is produced by the Energy Practice Management Office, which seeks to disseminate information about recent and ongoing energy activities of the World Bank Group. For further information, contact the Energy Practice Manager, Rachel English, G-5055, The World Bank, 1818 H Street NW, Washington DC 20433 or fax (202) 522 3004. Printed on recycled paper.