The Petroleum Royalty Reduction in Venezuela. Short Comments on Recent Projects.
Submitted by Carlos Bellorin, IHS (London)

"(…) it has to be considered that the legislation on hydrocarbons
is one of the most important in the country, after the Constitution,
because it must regulate, clearly and accurately, one of the foundations
of the Venezuelan economy and society."

Hydrocarbons Organic Law preamble/justification (Exposición de Motivos)

Synopsis

After the oil price collapse in 2008, Venezuela introduced a series of fiscal incentives in order to attract foreign investment for the development of the country's heavy oil projects in the Orinoco Oil Belt. Among these incentives, a unique royalty reduction mechanism was established. This article will briefly explain the background of the royalty reduction mechanism and its application in two recent agreements.

Background

On 1 January 2002, ¹ the current Hydrocarbons Organic Law ² entered into force which dramatically changed the legal hydrocarbons framework in Venezuela that was previously governed ³ by the Hydrocarbon Law of 1943 ⁴. Among several other changes to the legal regime introduced by the new Hydrocarbons Law, the royalty rate was raised from 162/3% to 30%.

In order to add flexibility, Article 44 of the Hydrocarbons Law provides a mechanism to lower the royalty rate from 30% to a floor of 162/3% in the case of mature fields or Orinoco's Oil Belt extra-heavy oil fields. These projects would need to prove that the exploitation is not commercially viable under the "regular" (30%) rate. The provision also states that the regular rate could be entirely or partially reinstated "until reaching again 30%, when it is demonstrated that the commerciality of the deposit may be kept with said reinstatement."

In 2006,⁵ a further amendment to the Hydrocarbons Law raised the royalty reduction floor from 16^2/3% to 20%. The other conditions for the royalty reduction were untouched by the amendment.

Article 44 of the Hydrocarbons Law currently reads as follows:
"The State shall have the right to a participation of 30%, as royalty, of all hydrocarbon volumes extracted from any deposit. In the event that it is demonstrated to its full satisfaction that a mature deposit or a deposit of extra-heavy oil from the Orinoco Belt cannot be commercially exploited with 30% royalty stipulated in this Law, the National Executive may reduce said royalty up to a limit of 20%, in order to attain commercial exploitability, but it is also to be empowered to reinstate said royalty, either in whole or in part, until reaching again 30%, when it is demonstrated that the commerciality of the deposit may be kept with said reinstatement."

Royalty Reduction Provision

It was not until the oil price collapse in 2008 that a royalty reduction was considered for projects that were currently under negotiation at the time. These projects, consisting of Mixed Companies ⁶ formed between PDVSA (the Venezuelan national oil company) and foreign companies ⁷, are an important element of Venezuela's oil industry strategic plan which seeks to raise the country's oil production from 2.3-3.2 to 4.9 million barrels per day. This goal was initially established in PDVSA's Oil Production Business Plan (Orinoco´s Project) 2005-2012.

In late 2009, the royalty reduction mechanisms for extra-heavy oil projects in Orinoco's Oil Belt were finally agreed and included in the framework provisions and presented to potential investors.

The second half of this article demonstrates how the royalty reduction mechanism has been applied in two different cases. The first case demonstrates how the royalty reduction applies to projects that are awarded through a competitive bidding process, and the second case demonstrates how the reduction is applied to a project that involves State-to-State negotiation. It is important to note that a reduction to the "extraction tax" ⁸ was paired in both cases with the royalty reduction.

1. 2009-2010 Carabobo’s bid round.

The Orinoco's Oil Belt Carabobo bid round ⁹ (the Bid Round) terms and conditions, known as "Guidelines for the Selection of Shareholders for the Mixed Companies" (the Guidelines), were subject to a long negotiation process. The Bid Round was originally launched on 30 October 2008, its first Guidelines draft was issued on 2 December 2008 and it was not until 30 November 2009 that the definitive Guidelines were agreed and the Bid Round was ready to commence. On 28 January 2010, the offers were submitted and the bid winners were announced on 10 February 2010.¹⁰

It is understood that the Bid Round's National Assembly Agreement Model accompanying the Guidelines stipulates that the National Executive through the Ministry of Energy and Petroleum "shall grant" to the Mixed Company the reduction of the royalty and extraction tax according to the Hydrocarbons Law, when certain conditions are met. Basically, the reductions must be granted once the basic engineering studies of the project have been concluded and the revised cash flow projections have been adjusted (on the basis of the new engineering study results), which indicates that the investment cannot be recovered in a period equal to or shorter than seven years from the start of commercial production of upgraded crude oil.¹¹

The royalty and extraction tax are of temporary application and apply upon the commencement of commercial production of upgraded crude oil and until such time as the Mixed Company has recovered its investments. In this event, the royalty and oil extraction tax must be reinstated to their "regular" rates.

2. Russian-Venezuelan Agreement for the Development of Junín 6.

Almost in parallel to the Carabobo's Bid Round, the Venezuelan and the Russian government, the latter in representation of a consortium of five Russian-based companies, began negotiating the conditions to establish a Mixed Company for the development of the Junín 6 area also in the Orinoco's Oil Belt. On 2 June 2009, an Energy Cooperation Agreement was published in the Official Gazette No. 39,191¹² where Venezuela and Russia manifested their intentions to carry out joint energy projects, in particular the development of Junín 6. On 23 November 2009, the Energy Cooperation Agreement Approbatory Law was published in the Official Gazette.¹³ Annex I to this agreement set-up the framework conditions that will govern the Junín 6 project, establishing for the first time "special conditions" for its economic viability. Among the special conditions was the possibility to reduce the royalty rate.

According to Annex I Article 4(a), the Mixed Company ¹⁴ activity will be oriented to reach an Internal Rate of Return (IRR) of 19% that will allow for a seven year investment payback period counted from the first commercial production of upgraded crude oil.

Article 4(b) states that the Mixed Company will review its business model once the basic engineering studies of the project are finalized using Class 3 estimated costs. If the cash flow projections of the Mixed Company show that it will not be able to recover its investments in the estimated period (seven years), the National Executive through the Ministry of Energy and Petroleum must grant the reduction of the royalty and extraction tax according to the Hydrocarbons Law. As well, the royalty and extraction tax reduction are of temporary application until the Mixed Company recovers its total investments.

“Ventaja Especial”

In order to guarantee a fiscal take of at least 50% gross profits, a "shadow tax" provision is included in the Mixed Company agreements. The shadow tax is one of the "ventajas especiales" ("special advantages") in favour of the Republic, referred to in the Hydrocarbons Law. The shadow tax is triggered in case the fiscal take does not reach at least 50% of gross profits after applying royalties, taxes and other levies. In this case, the Mixed Company must pay the difference between this threshold and the fiscal take.

For this reason, an extra paragraph in the "shadow tax" provision in the new agreements was included. The provision establishes that in case the Ministry chose to reduce the royalty rate and the extraction tax, the "ventaja especial" will be subject to an "adjustment in order to ensure that it does not neutralize, in whole or in part, such reductions."

Conclusion

The two royalty reduction mechanisms, briefly explained in this paper, represent only one of the fiscal incentives established in the agreements signed with foreign partners for the development of new projects in the Orinoco's Oil Belt in conjunction with PDVSA.¹⁵ It is understood that other companies¹⁶ that agreed to participate in other Orinoco's Oil Belt projects received similar benefits, including, of course, the royalty reduction option.

For some specialists, a direct interpretation of the Hydrocarbons Law shows a very rigid and inflexible regime. For the author of this article(only), if the Venezuelan government honours the fiscal incentives included in recent deals, then the regime will show to be flexible enough to retain and to receive the much needed foreign investment. The problem again will be the volatility of the oil prices and if it can stay in a "safe zone" for both governments and foreign oil companies.

As we explained, the royalty reduction applicability is linked to the project's economic horizon in a certain timeframe for both cases. So, in consequence, this reduction may or may not be applicable depending on the behaviour of the oil prices. In any case, the royalty reduction option included in recent agreements gives flexibility and even some progressiveness to a regime initially thought as inflexible. Despite the aggressive rhetoric against foreign capitals, it seems that the current government understood the importance of the private participation in Venezuela's main industry and the lesson that complexity inhibits flexibility.¹⁷ What happens next is still to be seen.

Recent Development

On 15 April 2010, the National Assembly Agreements authorizing the formation of two Mixed Companies (MC) between the Corporacion Venezolana de Petroleo (which is PDVSA's affiliate known as the CVP) and the awarded companies of the Carabobo bid round’s Projects 1 and 3 were published in the Official Gazette No.39,404. These Agreements contain the royalty reduction mechanism as explained in section (1.-) of this piece and are the materialization of the "Agreement Model" we referred to in the same section.

The Agreements, which are akin to a preliminary version of the MC contracts, also contain the following paragraph believed not to be included in the “Carabobo Guidelines” final version. The following is a brief of such paragraph:

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For Income Tax effects: 1) the MC investments in assets for the development of hydrocarbons primary activities (according to the Hydrocarbons Law Article 9: exploration, exploitation, gathering, transportation and initial storage) will be entirely deducted in the fiscal year they are incurred, while the upgrading investments incurred will be deducted during a 10 year period using the straight-line method; and 2) the net operative losses incurred by the MC in any fiscal year could be carried forward to be deducted in anyone of the 10 subsequent fiscal year from the fiscal year in which they had been incurred.

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The views expressed in this paper are the sole responsibility of the author and do not necessarily represent the views of IHS or any its employees, associated companies or affiliates.

¹ The 2001 Hydrocarbon Organic Law was actually a Decree-Law since it was passed on 13 September of 2001 by means of an "Enabling Law" which authorized the President of the Republic to legislate over several areas over a limited period of time.
² This law only governs the liquid hydrocarbons and the associated natural gas activities, since Venezuela has an independent and different legal framework which regulates the non-associated natural gas industry, consisting basically, in the Gaseous Hydrocarbons Organic Law of 1999 and its Regulations of 2000.
³Although the Hydrocarbon Law of 1943 laid-out the basic legal framework, other Laws, acts "with force and rank of Law" and Supreme Court of Justice (currently Supreme Tribunal of Justice) decisions were also part of the set of provisions governing the hydrocarbon industry in Venezuela.
⁴ The Hydrocarbon Organic Law of 2001 also repealed the 1955 and 1967 amendments of the Hydrocarbon Law of 1943, the Concessions Reversion Law of 1971 (commonly known as the “Nationalization Law), the Law which Reserved to the State the Exploitation of Petroleum Derivatives of 1973, the Organic Law which Reserved to the State the Industry and Commerce of Hydrocarbons of 1975, and the Law which Opened the Domestic Market of Gasoline and other Fuels Used in Motorized Vehicles of 1998.
⁵On 24 May 2006, the Hydrocarbon Organic Law was partially amended and re-published in the Official Gazette No. 38.443. Briefly, the amendment had the effect of: a) including the associated natural gas under its scope of application; b) eliminating the definition bitumen; c) establishing a new "extraction tax"; d) establishing the procedure for the "Mixed Companies" formation; e) establishing an investment requirement towards an Indigenous Development Project equal to 1% of the pre-tax profits; and f) setting the petroleum production marketing procedure.
⁶The "Mixed Company" figure is defined by the Hydrocarbons Law as the company in which the state has control over the decisions as holder of a participation above 50% of the capital, carrying out hydrocarbons primary activities (exploration, extraction, gathering, initial transportation and storage of hydrocarbons). The Mixed Company as defined in the Hydrocarbons Law has a very special regime and in the opinion of L.E Andueza is "where private investors and the State share participation in a company that does not qualify as a State company (in "Legal Regime Applicable to the Mixed Companies of Article 22 of the Venezuelan Organic Law" published in OGEL (2) 2008 www.ogel.org)
⁷Usually, 60%-40% participation in favour of PDVSA.
⁸ This tax is actually 1/3 (33.33%) of all produced hydrocarbons. In practice, functions as an "additional royalty" of 3.33% for the Orinoco's Oil Belt extra-heavy oil projects since the royalty (30%) can be deducted. For practical reasons, if the royalty is reduced the extraction tax must be reduced as well. The Hydrocarbons Law establishes that the extraction tax could only be reduced up to 20%.
⁹The Carabobo Bid Round was the first to be launched by Venezuela in 12 years. Consequentially, the round is also the first one to be carried out by the current administration and under the terms of the current Hydrocarbon Organic Law.
¹⁰ Ultimately, two out of three projects offered were awarded, known as Carabobo 1 and Carabobo 3. No offers were received for the right of developing Carabobo 2.
¹¹The projects include the construction and operation of upgrading facilities in order to upgrade half of the estimated production of between 400-480 thousand barrels per day to obtain approximately 180-220 thousand barrels per day of  32º API of crude oil. Then the upgraded production must be blended with the rest of extra-heavy oil production to obtain about 360-460 thousand barrels per day of blended crude oil with a gravity oscillating between 16-22º API.
¹² On 14 July 2009, an amendment protocol to the Cooperation Agreement was re-published in the Official Gazette No. 39,220 due to a "major" clerical error. The error consisted of that the area to be exploited in the Orinoco's oil belt jointly by Venezuela and a Russian consortium was demarcated as Carabobo 1 Centre and Carabobo 1 North (Carabobo 1) despite the fact that these areas were being offered in the Carabobo’s Bid Round. The amendment protocol corrected this error indicating that the area was in fact Junín 6.
¹³ It is understood that the Russian Duma ratified this Agreement on 18 September 2009.
¹⁴ The Mixed Company was called PetroMiranda in honour of Francisco de Miranda, a Venezuelan independence hero that also participated in the French Revolution and in the Revolutionary Wars of the United States of America. He was also a member of the Russian diplomatic mission in London at the order of Empress Catherine II (the Great) of Russia. It is said that he was also one of the favourite lovers of the Empress.
¹⁵ In both cases, more specifically, PDVSA's affiliate "Corporacion Venezolana de Petroleo" ("CVP") which is 100% owned by the national oil company and it has been used as the corporate vehicle in the Mixed Companies formed with foreign partners.
¹⁶To the date, 8 April 2010, namely: Petrovietnam (Junín 2), ENI (Junín 5) and CNPC (Junín 8).
¹⁷ Henry Kissinger. “Diplomacy”. Simon & Shuster, New York (1994).