US embassy cable - 05CARACAS2934

C O N F I D E N T I A L SECTION 01 OF 05 CARACAS 002934 
 
SIPDIS 
 
NSC FOR CBARTON 
ENERGY FOR CDAY, DPUMPHREY, AND ALOCKWOOD 
 
E.O. 12958: DECL: 08/11/2015 
TAGS: EPET, EINV, VE 
SUBJECT: GOV HYDROCARBON POLICY: UNDERLYING ASSUMPTIONS 
 
REF: A. CARACAS 02387 
     B. CARACAS 02443 
     C. CARACAS 02596 
     D. CARACAS 02807 
 
Classified By: Economic Counselor Andrew Bowen for Reason 1.4 (D) 
 
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SUMMARY 
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1.  (C) GOV hydrocarbon policy is driven by ideology, oil 
prices, and, to a lesser extent, production levels.  The 
basic contours of the GOV's hydrocarbon policy are the 
maximization of state control over reserves, the maximization 
of state revenues, and the use of oil as a significant tool 
in advancing the GOV's foreign policy goals.  Whenever there 
is a collision between these goals, the maximization of 
revenues is the first objective to go by the wayside. 
President Chavez appears to believe oil prices will not only 
stay high but continue to climb.  Even assuming he is 
correct, we believe the GOV will face declining production 
levels in the short to medium term.  The decline stems from 
three broad factors: inadequate maintenance, a decline in 
PDVSA's administrative abilities, and a degradation of 
PDVSA's and, to a certain extent, the private sector's 
operational abilities  It is not clear at what point the 
decline will start to squeeze the GOV fiscally.  Septel will 
cover Post's views on GOV options if the decline begins to 
cause fiscal problems, including the possible role of IOCs. 
END SUMMARY. 
 
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WHAT IS GOV HYDROCARBON POLICY? 
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2.  (C) The basic contours of the GOV's hydrocarbon policy 
are the maximization of state control over reserves, the 
maximization of state revenues, and the use of oil as a 
significant tool in advancing the GOV's foreign policy goals. 
 The GOV intends to maximize its control over reserves in 
part by forcing migration of companies with operating service 
agreements (OSAs) to mixed or joint venture companies in 
which PDVSA will have majority control by the end of the year 
(See Reftel A).  The GOV's goal, as reported in Reftel B, 
appears to be the conversion of all of the OSAs, the four 
strategic associations, and the exploration contracts into 
joint venture companies, with PDVSA exercising control.  The 
resulting joint ventures would be subject to a 30 percent 
royalty rate and a 50 percent income tax rate.  The GOV will 
also maximize its control over reserves by ensuring under its 
"Siembra Petrolera" strategic development plan that new oil 
projects will be controlled by PDVSA and in many cases 
involve national oil companies (NOCs) from countries friendly 
to the GOV (Reftel C). 
 
3.  (C) The GOV has attempted to maximize state oil revenues 
by claiming companies with OSAs owe substantial back taxes 
and are subject to a 50 percent tax rate rather than a 34 
percent rate (Reftel D).  Both the maximization of state 
control and revenues are in line with Ministry of Energy and 
Petroleum (MEP) Vice Minister Bernard Mommer's books and 
articles.  Mommer is personally leading the negotiations to 
migrate the OSAs to joint venture agreements.  The GOV, under 
its Petroamerica program, has aggressively used sweetheart 
oil deals to increase its influence in the Caribbean, 
Central, and South America. 
 
4.  (C) COMMENT: It is obvious that the three main prongs of 
GOV hydrocarbon policy directly collide with each other. 
Whenever there is a collision, the maximization of revenues 
is the first objective to go by the wayside.  Sweetheart oil 
deals such as Petrocaribe have a direct impact on the bottom 
line.  In addition, the uncertainty the GOV has raised by 
ignoring the sanctity of contracts has had an impact on 
foreign investment in the sector.  That said, Venezuela, with 
its huge reserves, is too rich a prize for IOCs and NOCs to 
abandon.  END COMMENT 
 
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PRICE, RESERVES, AND IRRATIONAL EXUBERANCE 
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5.  (C)  Although the GOV's hydrocarbon policies are not 
economically efficient or rational at first glance, they are 
not illogical if you make certain basic assumptions.  If you 
assume that oil prices will only continue to go up, then the 
maximization of revenues and production are not as key as 
they normally would be.  This is particularly true if the 
GOV's political goals of reordering society and expanding its 
influence in the hemisphere are considered to be more 
important than economic goals.  If oil prices are high and 
continue to rise, then the GOV does not have to worry as much 
about inefficiencies in PDVSA or even declines in production. 
 Rising oil prices will still continue to provide the GOV 
with sufficient levels of income for its social programs and 
foreign policy objectives. 
 
6.  (C) President Chavez has stated publicly that he believes 
prices will continue to rise for a number of reasons (Reftel 
C).  The obvious question is whether he really believes it. 
The answer appears to be yes.  Dr. Hugo Hernandez (strictly 
protect), President of Constructores Electricos Industriales, 
an oil services company, and a PDVSA external director until 
January 2005, told Petroleum Attache (PetAtt) that he had a 
conversation with Chavez approximately seven months ago. 
Chavez was firmly convinced that oil prices could only rise 
in the future.  He based his view on increased world demand, 
Saudi Arabian production capacity, and his belief that the 
United States would draw down the SPR.  When Hernandez 
pointed out that ever increasing oil prices flew in the face 
of history, Chavez remained unconvinced.  Hernandez believes 
Chavez's advisors have convinced him that prices can only go 
one direction in the foreseeable future: up.  (COMMENT: 
Hernandez is a rarity in present day Venezuela: a realist who 
has managed to maintain excellent ties with both the GOV and 
the opposition.  An attorney by training, he sat on the 
commission that drafted the current hydrocarbon law.  His 
departure from the PDVSA board does not appear to be the 
result of a rift with the Chavez administration, but rather 
to the expiration of his term.  He told PetAtt that he never 
wanted to sit on the board in the first place.  Hernandez's 
service company counts both PDVSA and Chevron as major 
clients.  END COMMENT) 
 
7.  (C) The other key assumption that the Chavez 
administration is making is that Venezuela's reserves, 
combined with high prices, basically put the GOV in the 
driver's seat when it comes to dealing with the IOCs, NOCs, 
and service companies.  This assumption has a great deal of 
merit to it.  As Chavez noted in his Siembra Petrolera speech 
this month, the Faja region of Venezuela contains reserves of 
236 billion barrels.  Although these reserves are heavy or 
extra heavy in nature, advances in technology have made the 
development of the Faja commerically feasible.  Ali Moshiri, 
President of Chevron Latin America Upstream, told Economic 
Counselor (Econcons) and Petatt on September 23 he believes 
the Faja has the potential to be a "Saudi Arabia type" 
development.  According to Moshiri, the Faja could have a 
production level of 1.5 million barrels per day within five 
years if it were developed correctly.  Moshiri said it is 
hard to find another major development that has less 
political risk.  In addition, no other potential major 
development has Venezuela's geographic advantages.  According 
to Moshiri, the Faja offers the possibility of relatively low 
cost production and low transportation costs.  In addition, 
there is no question that the petroleum is actually there. 
Moshiri noted it was only a question of "punching holes".  He 
also noted Venezuela, despite all of the recent problems, 
still gave Chevron its highest profit margins in the world. 
To put it simply, Venezuela's reserves make it too important 
for IOCs or NOCs to ignore.  As service company executives 
recently pointed out to Econcons and Petatt, the GOV knows 
that even if 2 or 3 IOCs or NOCs leave Venezuela, it will 
still have close to 30 companies that are willing to stay. 
 
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THE KEY IS PRODUCTION 
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8.  (C) Assuming the GOV's assumptions about production and 
companies' willingness to stay in Venezuela, come what may, 
in order to have access to reserves are true, the one factor 
that could be the GOV's Achilles heel is production. 
Obviously, you have to extract hydrocarbons from the Earth in 
order to take advantage of high oil prices.  Although the new 
Faja blocks offer an incredible opportunity for the GOV and 
oil companies, they will not begin producing for at least 
five years.  In addition, Moshiri specifically noted the 
blocks have to be developed properly if they are to produce 
1.5 million barrels a day.   The key questions are what is 
PDVSA's ability to produce presently and is that ability 
degenerating. 
 
9.  (C) Although PDVSA is currently claiming a daily 
production level of 3.3 million barrels, conventional wisdom 
among our private sector contacts is that production is 
hovering between 2.4 to 2.6 million barrels.  Of this amount, 
IOCs account for 1.2 million barrels, or roughly 45 percent. 
Chevron's Moshiri believes the IOCs could easily raise their 
production level to 1.5 million barrels a day with little or 
no additional investment.  He also believes that production 
is currently between 2.6 to 3.0 million barrels.  Former 
PDVSA director Hernandez told PetAtt he saw internal PDVSA 
documents that showed production of 3.0 to 3.1 million 
barrels.  (Comment: Hernandez harshly criticized PDVSA 
throughout his discussion with PetAtt.  It is hard to believe 
that he would exaggerate production figures given the rest of 
his comments.  End Comment)  Moshiri has an explanation for 
the divergent figures that makes sense.  He stated PDVSA 
production figures have fluctuated on a daily basis.  He 
believes PDVSA lower management regularly highlights high 
production figures and downplays poor figures.  This would 
explain Hernandez's firm belief that PDVSA is producing 3.0 
million barrels a day.  It also raises the question of 
whether senior PDVSA and GOV officials are receiving true 
production figures. 
 
10. (C) Conventional wisdom also holds that PDVSA production 
is declining.  PetAtt has yet to speak to anyone in the 
industry outside of the GOV or PDVSA who does not believe 
that PDVSA production is declining.  Production declines are 
due to three broad factors: inadequate maintenance, a serious 
decline in PDVSA's administrative abilities, and a sharp 
decline in PDVSA's and to a certain extent the private 
sector's operational abilities. 
 
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MAINTENANCE PROBLEMS 
-------------------- 
 
11. (C) According to generally accepted wisdom, Venezuelan 
production capacity falls by 20 to 25 percent per year.  This 
decline is due to the heavy nature of Venezuelan crude as 
well as the age of many of the wells.  As a result of these 
two factors, producers must use gas or steam injection in 
order to bring the crude to the surface.  This requires 
constant maintenance on the part of operators.  Private 
sector experts have been unanimous in stating that PDVSA has 
not carried out the necessary maintenance to maintain 
production levels let alone increase them.  In addition, 
numerous contacts have stated they believe the reservoirs in 
Lake Maracaibo and in the East are in poor shape due to 
inadequate maintenance by PDVSA.  Even Moshiri, who is 
generally an optimist, has stated the reservoirs are in poor 
condition.  He went so far as to state PDVSA did not maintain 
the reservoirs even before the strike.  If this is true, it 
is hard to imagine what condition they are in after the GOV 
fired 18,000 of PDVSA's most technically proficient employees. 
 
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ADMINISTRATIVE CHAOS: MALEVOLENCE OR INCOMPETENCE 
--------------------------------------------- ---- 
 
12. (C) PDVSA's administrative problems start at the top and 
reach into every facet of the company's operations. 
Hernandez described PVSA as "ungovernable".  He said there 
were numerus tensions within the board when he served as 
diector and they have only increased since his deparure. 
He said board members have reached the poin in meetings 
where they almost come to blows.  Acording to Hernandez, the 
company has divided itelf into a series of cliques that war 
among themslves.  He said approximately 30 percent of PDVSAemployees ar 
e "political".  He said this was a conervative 
estimate and thought that it was closerto 50 percent.  The 
remaining 50 percent of the mployees are resentful of the 
changes in PDVSA an sometimes engage in passive resistance. 
Hernandz said "problem employees" are frequently moved. 
13.  (C) Halliburton executives in Maracaibo toldEconcons 
and PetAtt they believe their biggest poblems are 
administrative in nature rather than oerational.  The 
executives said they are not sur if PDVSA is making life 
difficult for them as part of a strategy or if it is just the 
result of incompetence.  Service company executives in 
Maracaibo complained about constant turnovers among senior 
PDVSA managers and their frequent inability to find PDVSA 
managers who were willing to make basic decisions.  PDVSA 
managers are often moved without warning and the executives 
complained they were frequently forced to start projects over 
again once an executive had been moved. 
 
14.  (C) A lack of legal expertise among PDVSA managers and 
attorneys has also created difficulties for service 
companies.  Halliburton executives described PDVSA attorneys 
as "young, inexperienced, and radical".  The executives said 
their biggest worry was contracts, particularly in the 
assignment of risk.  PDVSA typically tries to use 
standardized contracts in all situations.  This frequently 
translates into contracts that do not fit the unique demands 
of a project.  For instance, PDVSA attorneys frequently ask 
for guarantees that would be appropriate for the construction 
of a warehouse but wholly inappropriate for an oil services 
project.  Tenders have also caused companies problems. 
Several service company executives in Maracaibo said tenders 
frequently looked like cut and paste jobs from old contracts. 
 In addition, companies often do not receive adequate 
information in order to draft rational proposals.  Baker 
Hughes executives stated they repeatedly asked for detailed 
information on the Maracaibo Lake reservoir in order to make 
a proposal.  PDVSA refused to provide them with the 
information.  The executives complained that PDVSA is 
becoming increasingly secretive.  Mark Handin (strictly 
protect), general manager of Tidewater, a marine services 
company, said his company submitted tenders for the same 
project three times but the contract was never awarded.  He 
blamed the situation on the fact that no one in PDVSA wants 
to make a decision. 
 
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OPERATIONAL PROBLEMS 
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15.  (C) Conversations with private sector executives in 
Maracaibo indicate that operational problems can be traced to 
a lack of experience and training on the part of PDVSA 
personnel as well as labor problems.  Oscar Romero (strictly 
protect), president of Wood Group Gas Turbines, said a senior 
PDVSA official stated 42 percent of PDVSA's work force had 3 
to 5 years experience.  According to Jose Toro Hardy, a 
former PDVSA director, the average level of experience before 
the strike was 15 years.  Romero said PDVSA frequently sent 
an unusually large number of employees to supervise his 
firm's projects.  It was clear that the additional personnel 
were being sent to Wood Group's shops in order to be trained. 
 Wood Group employees were frequently required to explain all 
aspects of a job to the "supervisors".  Wood Group now has a 
contract that includes a training component.  Baker Hughes 
executives said they have not had any problems with radical 
PDVSA employees but said they were frequently inexperienced 
and asked to do projects well beyond their levels of 
competence.  One of the executives speculated that PDVSA 
would have excellent engineers in five to ten years since the 
current crop of young engineers were being exposed to 
projects normally reserved for more senior engineers. 
 
16.  (C) New PDVSA labor regulations as well as increasingly 
radical "parallel" unions will also have an impact on 
production.   PDVSA's new employment system, the 
Democraticization of Work System (SISDEM), which began on 
July 1, requires contractors  and service companies to hire 
new employees for union jobs from a PDVSA employment pool. 
Pool operators select all of the new employees but the 
companies have a right to reject the selections.  In 
addition, contractors that use union labor for specific 
projects will now have all of the jobs staffed by SISDEM 
employees.  Under the previous system, the union in question 
selected 60 percent of the employees and the company selected 
40 percent.  The new system has caused tremendous 
difficulties for companies.  Tidewater's Hardin said his 
company used to use their ability to select 40 percent o the 
workers to select key positions such as capain and chief 
engineer for their ships.  Tidewate selected personnel who 
were certified and had rceived training from Tidewater.  The 
company nowhas to worry about whether the personnel it 
entrsts with millions of dollars of equipment actuallyknow 
how to perform their jobs.  Land service companies also have 
their share of problems.  The biggest problem facing them at 
present is finding qualified drivers who know how to 
transport expensive equipment safely.  One IOC executive 
based in Maracaibo said the time to transport a rig has 
increased from two to eight days as a result of SISDEM. 
17.  (C) New radical unions also appear to be a problem for 
companies. According to Romero, a radical, non-certified 
"union" came to his company in May and claimed to represent 
his work force  The union bussed in outside agitators and 
chained the doors to his shop.  The union made extravagant 
promises to the Wood work force and a portion of the 
employees backed the union.  Romero used family connections 
to have the police come and reopen his shops.  The 
overwhelming majority of his work force went back to work 
without causing problems but Romero believes that radical 
outside "unions" will become more active in the future and 
target international companies. 
 
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CONCLUSION 
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18.  (C)  Based on PDVSA's  poor administrative controls, 
lack of technically capable operational personnel, poor labor 
regulations, as well as the effects these issues have on key 
contractors, we believe PDVSA's portion of Venezuelan 
hydrocarbon production will continue to decrease in the short 
to medium term.  Despite the Faja's great potential, we do 
not believe that it will be developed with sufficient speed 
or skill to mitigate PDVSA's production decline.  The 
question is not whether the production decline will have an 
impact on GOV finances but when.  The answer to that question 
depends on both oil prices and the rate of decline.  Septel 
will address the policy options the GOV has once production 
declines create pressure on the GOV budget. 
Brownfield