¿Is Colombia just not for Super-Majors? ¿Will the others come?

“Strategy failures are generally failures in confronting reality” (Magretta). A successful national hydrocarbon strategy necessitates monitoring and anticipating external trends, so that strategies, policies, and contractual/fiscal terms and incentives can be adjusted and properly realigned. Colombia has taken bold steps to improve its level of E&P activity; but are they bold enough?

The current external forces (Porter’s industry forces and those of the macro environment) are rapidly evolving. The most notorious and relevant among them are: (1) the looming tangibility of a medium-term resource scarcity scenario while energy demand continues to grow, setting the stage for a potentially severe supply/demand imbalance, (2) the recent consolidation of super-majors, (3) the consequent raising of internal barriers – only the select few may aspire access to significant conventional reserves, and (4) the irruption of transnational NOC’s as aggressive competitors.
While energy demand grows exponentially, fueled by the compounded vegetative and economic growth, the legendary global supply capacity peak seems now within reach. According to Matthew Simmons1, the world’s 14 largest fields based on current output, account for 20% of total petroleum production and are on average 44 years old.
Dissatisfaction with recent exploration results is rampant and super-majors are failing in organic growth. Again according to Simmons2, they spent 150 billion dollars in capital between 1999 and 2002, only to see their collective output grow from 13.1 to 13.7 MMboe/d (1.5% CAGR). Between production decline replacement and such modest growth, their capital cost per barrel should be in the order of 8 $/boe. Since they are already vertically integrated and conglomeratic diversification attempts have always failed, a logical strategic response is to consolidate to at least enjoy further economies of scale. However, these eventually exhibit diminishing returns.
Since super-majors cannot deliver on production rate growth, they are aiming once again at ROCE (return on capital employed). This drives them to focus on areas of high materiality at low unit costs (e.g., Persian Gulf, FSU) and stop seeking growth or even divest from areas of low materiality and high unit costs (e.g., the Sub Andean basins). Let’s keep in mind that over 2/3 of the planet’s conventional oil reserves sit around the Persian Gulf. Thus, our more humble basins seem to be falling out of super-major favor.

A market made of independents and transnational NOC’s

The Sub-Andean basins would thus be left as a strategic interstice, which should open an attractive window of opportunity for independents and transnational NOC’s.
Independents are more “expensive,” because they must command higher rates of return:
They have a higher cost of capital: higher cost of debt and higher cost of equity (higher systematic volatility due to higher operational and financial leverage)
They are not integrated (vertically diversified)
They are not as well diversified geographically
They require higher premiums to cover for idiosyncratic and especially, for surface risks
This is not all bad for the governments. Despite being a little more expensive, independents have virtues too: a little less arrogance, more flexibility, less slothfulness, faster decision making, and more modest materiality thresholds (they will aim at what may appear to be smaller targets and may end up discovering giants too).
Transnational NOC’s on the other hand, may have strategic supply motivations that often trump any theoretical cost of capital considerations. They also have a competitive upper hand, since deals can be struck government-to-government. However, the host government’s aim is to grant the E&P rights to the companies that not only value the state’s assets the most, but also that add the most value to them (licensing is never an outright sale). Some of these transnational NOC’s are excellent, some acceptable, and some very poor. The question then is: if a given foreign NOC’s were ineffective and inefficient operationally, or incompetent in managing environment and social concerns in its country of origin, why would it perform better in ours? Conversely, what are the attractive competencies that our NOC possesses that can be leveraged and would be welcome in other countries?

Do governments know their new market?

In any case, if investment in E&P by independents and foreign NOC’s is not only badly needed but also desired, the exercise for a government boils down to a strategic marketing problem:
What are our goals with respect to production, reserve replacement, refinery inputs, exports, absolute rent development and government capture, social development, etc.?
Which profile of investor do we need for each type of project?
Do we know our “customers,” their motivations, needs, fears, constraints, deal-breakers, etc.?
How do we make ourselves attractive to them?
What differentiates our country from its competitors, both favorably and unfavorably?
Do we compete regionally or globally?
What will our value proposition to our customers be?
How will we position our country in the perceived prospectivity vs. government take continuum?
Will we change our contractual and fiscal terms (“price” signals) gradually for a trial-and-error approach, or drastically to act as a stimulus?

The Colombian Case

Colombia has understood that it has a serious problem of declining production and decided to act accordingly. Many excellent signals have been sent to the market: (a) the creation of the ANH, (b) the phasing-out of the Association Contract, which very adversely affected materiality and the risk/reward ratio, and (c) an administration that is willing to listen to its market. Besides, a history of transparency, respect for contracts, and strong political institutions provides an aura of low political risk, at least of the regulatory kind. Ecopetrol should emerge strengthened and more independent, and may even consider taking its well-recognized competencies to foreign ventures. On top, there seems to be an inflection point regarding the war on narco-subversion and a surge in the population’s optimism (sometimes, a self-fulfilling prophesy).
The recent changes would seem a priori spectacular when one understands the formidable political constraints. But will they suffice? There is always the risk that the changes may not be drastic enough so as to create the necessary stimulus.
For contrast, the U.K. North Sea, the U.S. Gulf of Mexico and Argentina, at one time deliberately positioned themselves aggressively, with a very low government take relative to their decent perceptions of prospectivity. Their government take rivaled those of Nicaragua, Portugal, South Africa, etc., all countries with low or non-existing prospectivity. Those countries understood that 45% of a lot is much better than 90% of not much. Argentina (Figure 1) then saw in the ‘90s its production grow by 70% while its reserves also grew (the curious 1990 drop in reserves is due to making YPF’s reserves honest prior to its privatization). Another striking contrast is the Burgos basin straddling south Texas and north Mexico (Figure 2). While Texas recovers 80% of OGIP with a 40% government take, Mexico recovered only 20%, but with a 100% government take. Who generated and captured more rent?
Back to Colombia, the provision to capture windfall at higher oil prices would be reasonable if a strong stimulus were not needed, or if Colombia didn’t have to counteract a still very negative perception of its security and stability issues (perception always trumps reality). Also, as the draft stands, there is a very high level of agency supervision that may seem rather intrusive, maybe a remnant of the Association Contract culture. Binding international arbitration (impartial and away from biases and conflicts of interest) is still not available.
Can Colombia afford to miss this political window of opportunity during the current administration to make more aggressive changes? What if the current signal to the market does not adequately stimulate investment?

(1) Simmons, M.R., 2002, “The World’s Giant Oil Fields, Hubert Canter newsletter #2002/1, M. King Hubert Center for Petroleum Supply Studies, Colorado School of Mines
(2) Simmons, M.R., 2003, “Consolidation in oil and Gas,” Offshore Technology Conference Presentation