We need to find a way in which we can all agree on what needs to be done, knowing beforehand that we will all need to give up some things for projects to be viable.

Ernesto DÍAZ Latin America WOOD MACKENZIE

Measures to ensure Vaca Muerta’s success

August 28, 2017

Ernesto Díaz, Wood Mackenzie’s regional director in Latin America, talks to TOGY about the differences between developing projects in Vaca Muerta and the Permian Basin, what factors affect the viability of Argentinian projects and how the services sector is key to the development of unconventional resources. In April 2017, research and consultancy firm Wood Mackenzie released a detailed study on the development of Vaca Muerta.

• On shale development: “You do not need very low production costs to make this resource profitable in Argentina. You need to improve productivity and keep reducing costs, making development sustainable in time, but you do not need to develop a cost structure such as the one in the United States to make the resources profitable. This is positive because Argentina is never going to be able to develop that type of cost structure.

• On activity in Vaca Muerta: “As long as we can achieve attractive levels of productivity, investment will come along and we will be able to launch large-scale projects. There are several projects for massive play development, which are currently being analysed. By the end of 2017, we will probably have news on one or two additional ones.”

Most TOGY interviews are published exclusively on our business intelligence platform TOGYiN, but you can find the full interview with Ernesto Díaz below.

What are the challenges in attracting US and Canadian small and medium-sized E&P companies to Argentina?
Wall Street loves the Permian. Today, when investors in the United States and Canada look into projects, be it through equity funds or hedge funds, they are interested in projects that will be developed within the United States or Canada. If you offer a project in a foreign country, the investors do not like it because it represents uncertainty and risks.
I believe it is difficult for the US independents, many of whom are currently struggling to make money in US shale, to land in the local market. They do not have the financial support they need to develop the projects and Argentina cannot offer them the financing they need.
Today, we are all relying on profitability. There is no other option. The companies, especially those in the United States, are not aiming at strategic projects. They want profitability, accelerated return of investment, to pay their debts with the banks and to keep finding investors.
We no longer have the scenario with investors in Vaca Muerta that we had three or four years ago, when they focused on strategic projects. This is still the case, but only for large companies such as Shell or ExxonMobil. Those types of operators are already in Argentina. The rest that might be able to come in are playing a different game.

Is Argentina still a risky place in which to invest?
In reality, any country besides the United States is currently a risk for investors. In the United States there are currently very low profitability margins and numerous competitors. Even so, the funds and companies prefer to bet in a safe scenario in the current environment, which is why they stay there.
They believe that by staying there they can limit the uncertainty. Even though they have reduced margins, many of them still manage to maintain profitable activity. They would rather stay in the United States than come to a country such as Argentina, where they might have a larger profitability margin, but with larger uncertainties.
Regardless, I believe Argentina is still a very interesting investment option. We have factors that make the possibility of investing here quite attractive, but we are evidently competing with other projects that, given the current situation, are considered safer investments. Today, Vaca Muerta competes with the Permian Basin.

How does Vaca Muerta’s attractiveness compare to that of the Permian Basin?
Vaca Muerta is an excellent investment opportunity, but when you come into Argentina and you find yourself competing in the current environment, as an investor you are not completely convinced.
The well productivity of Vaca Muerta is comparable with the best plays in the United States. That, combined with a cost structure that has been decreasing and now lies within acceptable ranges, which we hope to maintain for the rest of 2017 and 2018, together with the low entrance fees due to the pricing per acre – four or five times lower than in the United States – makes Argentina an interesting option for investors.
On the downside, there are several other factors that make this country unattractive for investors, such as the local political risks and the global oil market scenario. We expect the average Brent price to be around USD 50 per barrel in 2017 and 2018, but the price will face downward pressure in 2018, especially in the first half of the year. There is some uncertainty around the US onshore supply and OPEC’s willingness to extend production cuts beyond Q1 2018.

What are the major hurdles to the development of Vaca Muerta’s shale gas resources?
Between pilot projects and already developing projects in Vaca Muerta, only 16% of the play’s total surface is being explored. This is very low, when compared to plays in the United States.
As you start going further away from the places where there is consolidated infrastructure, where you can connect to the gas network and where services companies operate, you start needing more investment. For gas exploration, as you go further away from the gas pipelines, you have to consider a different type of investment. It is not easy. I believe that the projects that are being carried out in this period and the ones that will be launched between 2017 and 2018 can still rely on the current infrastructure. For the rest, there will be serious bottlenecks if the required investments in infrastructure are not addressed now.
It’s quite surprising that this scenario was not even on the map until recently. Up until 2016, everyone was venturing into gas projects without a second thought. Today, this is no longer the case. The entire industry is starting to ask itself if it is worth continuing to grow the gas portfolio, considering the large competition that exists.
There is a lot of gas currently being produced in Bolivia and Brazil is no longer buying the same quantities from that country. Bolivia has always had issues encouraging exploration, so it will eventually run out of gas. But currently, it is exporting a lot of it.
LNG costs USD 3.43 per million Btu on average in the United States and we expect it to be around USD 3.27 per million Btu on average in 2018. You then have to consider an additional USD 1-2 for regasification and transport to Argentina. There is also the LNG contracted in Chile and renewable resources in Argentina. The local market will become increasingly competitive. Today, not all gas projects in Argentina are viable or make complete sense.

What will happen in 2021 when the natural gas price incentive ends?
When this moment comes, you have to consider a completely different landscape and type of investment. It will start looking a lot more like shale investments in the US, as they are massive development projects that require a higher level of competition from services providers and larger infrastructure. When that moment comes, the rules of the game are going to change.
For now, there is still the price incentive and the necessity to quickly start gas projects, especially tight gas ones, to ensure gas pipeline capacities. We will see some bottleneck problems, but I am sure we are going to have several gas projects.
The government has opted for a strategy where diversification is key, and through which it is encouraging the use of alternative energy sources, which I believe is the wise thing to do. The problem is being able to establish what comes first and what comes second, because timing is everything for long-term investments.

How will a focus on Vaca Muerta’s unconventional resources affect the development of other sectors?
When you start encouraging the creation of gas projects, on top of other sources of energy, you will start having more bottleneck problems in the gas pipelines, and even the risk of leaving conventional businesses unattended. Every time you encourage one specific thing, you stop encouraging something else, unless you make an effort to encourage everything, which is usually not possible.
The government made a decision to encourage just one part, which was a wise decision, considering that Vaca Muerta needs to be developed. To achieve this, millions of dollars in investments are needed. If the government did not start now, it was going to be very difficult to start further down the road, so it needed to do this.
As long as the government is aiming for future growth, I believe it is important to deregulate the market, encourage and promote competition. In Argentina we are also seeing a trend of decreasing inflation, which should be positive when considering opex, variable and labour force costs, all of which are not paid in dollars, but instead in local currency.

What regulatory changes are needed to boost the development of natural gas projects?
To start with, there has to be the possibility of having long-term contracts for gas exploration and development. We need to start by regulating this. Parties should be able to sign contracts freely, they need to have the possibility of having long-term contracts, we need to start developing the financial markets and support all initiatives through financing. If you do not have solid financing and capital markets, the industry will never take off.
All of those aspects are necessary. Once you are able to ensure all of them, and considering that demand peaks will always exist, you need to start thinking about the infrastructure needed to import and export the product. You need to be able to do both at competitive prices. To do this, you need to keep costs under control.
Attracting competition and bringing new investments will be a direct result of having the possibility to import and export. Markets have to be more transparent and more liquid at a national level, otherwise big investments are never going to come. You cannot expect big gas investors to come, considering these are always long-term investments, only to supply a domestic market. With the cycles we experience in Argentina, gas demand is 130 mcm [4.59 bcf] in winter and drops down during the summer.


What adjustments must be made for the financial sector to become more involved in the energy industry?
To start with, we would need to be able to make long-term contracts between private parties. There would also need to be market deregulation, specifically for gas and electricity purchases. I believe this is the correct approach to attracting investment. Investors that are interested in coming here will ask for financial guarantees, and in the case of the Argentinian market, these guarantees are represented by long-term contracts. This will activate financing, which will in turn enable the development of long-term projects.

What were the results of Wood Mackenzie’s research on Vaca Muerta’s productivity?
We made a comparative analysis with analogous scenarios in the United States, especially in the Permian. When comparing the different types of wells, we discovered that the productivity levels of Argentina, regarding the tight and shale development in the country, were very similar to the best wells in the Permian and in the United States.
This means that you do not need very low production costs to make this resource profitable in Argentina. You need to improve productivity and keep reducing costs, making development sustainable in time, but you do not need to develop a cost structure such as the one in the United States to make the resources profitable. This is positive because Argentina is never going to be able to develop that type of cost structure. There are much fewer wells in Vaca Muerta than in the United States, so it is difficult to foresee a completely accurate trend.
Considering that in the next two years we would be able to maintain or even reduce the current cost level while increasing productivity, combined with the cost per acre in Argentina, we believe that producing from Vaca Muerta can be highly profitable. We also have to consider the incentives for gas pricing, as well as the measures the government is implementing regarding productivity agreements, import cost reduction and other tax exemptions.
All these changes arose after Argentina’s market opened to the rest of the world, after we lifted the traps and allowed capital imports. These measures have been very positive, and have led to a cost reduction, but we believe that productivity and costs are the key drivers that really make resources highly profitable.
You also have to consider what actions you need to take to attract foreign investments, and this is mostly a result of how Vaca Muerta is able to compete with other projects in an international industry context that is not the best we could hope for.

How important is an efficient services sector for the development of shale projects?
If we are able to develop the services sector, it will not only enable us to reduce costs, but also increase operational efficiency and improve operational capabilities. If you have to contact the services provider and wait for it to co-ordinate the delivery every time you need a replacement part or need to conduct maintenance on a facility, that ultimately results in project delays and an impact on costs.
Unconventional and conventional operations are very different. For unconventionals, you need the supplies, spare parts and services to flow, because if they come to a halt, the productivity of the entire project is affected. You will always have wells that go as planned, and others that do not, but at a project level, you need to have a well-oiled machine. Otherwise, you will have negative impacts in costs and productivity. This is something Argentina still does not have.
In the United States, a very important issue is water. They even have regulatory frameworks for water treatment, which increases production costs. We still do not have this problem in Argentina. Some projects are lucky enough to be in conditions that allow them to access water more easily than others.

What are the main problems that the domestic oilfield services sector faces?
The main problem in Argentina, which has an impact on costs and efficiency, is sand management. We need to become more efficient when handling sand. We need to find a way, perhaps by integrating vertically with operators, to make sand logistics more efficient when transporting it to the well, taking into account the quarry location, sand storage points and transportation routes. We need to make all of these aspects more efficient to be able to deliver larger volumes to the wells and prevent delays in operations.
We also need to have equipment availability, be it for exploration or completion. We also have to address the aspect of better practices. We need to keep learning from and incorporating the latest technologies used in the United States.
We need to find ways to shorten the learning curve. In this aspect, information-sharing plays a key role. We need to find an effective way for operators to share information, so that they can each learn from the advances the others are making. We need to not only learn from what is being done in the United States, but also from what other companies in Argentina are doing. These are all measures that are either already being implemented, or are expected to be implemented soon.

What has been the impact of the Vaca Muerta framework agreement signed in January 2017?
It has been very positive and in the right direction, but limited in practice. The signals are positive, but there is still a long way to go. You have to take into account that there are no oilfield services unions in the United States. They solve problems by performing singular agreements between companies and contractors or employees. This is not the case in Argentina and it will never be.
The unions have to understand that the context of the unconventionals sector is very different and that we are handling a very different resource than we were in conventional exploration. The resource changed and so did the context, and so will the way we operate. Unions have to be somewhat sensitive, they need to understand that it is not a matter of being flexible, but rather that this is a very different type of operation. This is like going from operating a well that will provide you with oil and gas for the next 20 years, to becoming an operator of a Toyota car factory.
In this adjustment process, the role of the unions is fundamental. We can’t play games and wait for companies to let go of equipment or reduce investments so that we can come in and negotiate new conditions. I think that Neuquén province was able to realise that this situation is very different, and that it needs to be addressed as soon as possible.
We should not wait for investments to be withdrawn, equipment to be taken back or for activity to stop before we do something about it. We are not talking about an exchangeable currency, with which you can speculate. If we allow this to move forward with these precepts, we will leave the industry at a halt for many years.
This needs to be understood and addressed with a discussion between all the parties involved – the federal and provincial governments, unions and operators. We need to find a way in which we can all agree on what needs to be done, knowing beforehand that we will all need to give up some things for projects to be viable.

Do Argentina’s provinces compete for investment?
Yes, absolutely. As you might imagine, incentives are allocated unevenly. Even this can be proposed as an improvement. This is a four-legged negotiation with all provinces: The federal government, provinces, unions and operators in each province have to move forward with the negotiations.
I believe the federal government is willing to help, be it with incentives, tax deductions, import facilitation and any other factor that is under their control. Provinces also need to do their part as well. They need to aim to attract investment and create jobs. Unions need to adapt to the new reality and understand that investments are only possible if there is a certain level of productivity. Operators need to make investment commitments, taking into consideration the current context of maintaining or even increasing current production, if the conditions allow for it.
This dynamic, which started in Neuquén, should be replicated in all provinces. If we are able to reach these basic agreements between the parties, companies will be able to operate with a profit and competition will start to increase. You will be able to choose the company that offers the best conditions, based on this basic agreement, which will attract more investment. All this will create a virtuous cycle, which will be positive for everyone. We are still working on these basic agreements, province by province, union by union.

How regionally competitive is Argentina’s hydrocarbons industry?
It all depends on the growth strategies and portfolios of each operator. There is no single answer for this question. Today, there are three big projects in Latin America: the E&P bidding rounds in Mexico, the divestments of Petrobras in Brazil and Vaca Muerta in Argentina. Depending on the operator, you might see more interest in Peru, Ecuador and Venezuela as well, even though for many, Venezuela is currently in standby.
Venezuela has unmeasurable reserves, which is why everybody is always analysing that country. Nobody is currently considering entering this market, as they are waiting to see how the internal situation develops. Bolivia needs to improve its terms regarding exploration agreements, because it is currently not attractive and is not bringing in private investments. Mexico, Brazil and Argentina are the top actors right now, while in second line you have Peru, Ecuador and Colombia.

How should cost and productivity be addressed to facilitate the development of Vaca Muerta over the next five years?
Currently, everything that could impact development is directly related to productivity. This is the most important aspect. We have to keep the current cost structure, aiming to reduce it, if possible. We have to maintain or increase well productivity, as we have been doing so far.
As long as we can achieve attractive levels of productivity, investment will come along and we will be able to launch large-scale projects. There are several projects for massive play development, which are currently being analysed. By the end of 2017, we will probably have news on one or two additional ones.
The important thing for Argentina right now is figuring out what conditions we want to be in when that moment comes. If you do not start working right away to improve productivity, when the moment of a more favourable international context comes, you are not going to be in optimal conditions to take advantage of the opportunities the market will provide.
Let us not forget that the gas incentive will be in place up until 2021. That is another reason why you have to be very productive and disciplined regarding costs, so that when 2021 comes and the incentive is taken away, you will still have the basic conditions that allow you to be profitable. You will have to work hard on the cost and productivity aspects, because starting in 2021, you will not know what the international context might be like.
You cannot control the demand and supply context, you cannot tell beforehand what OPEC or the United States will do, or how prices will evolve.

What other elements will impact Vaca Muerta’s development during this period?
There will also be economic and political shifts that can affect investment positively or negatively, not only for the oil and gas industry, but for the Argentinian economy in general. Regarding macroeconomic measures, we need inflation to keep decreasing. If inflation is kept out of the equation, cost structures will be simplified and more focus can be placed on productivity.
We also need to work on bureaucratic issues that currently govern the creation of companies in Argentina, and the contractual aspects as well. Federal, provincial and municipal governments need to support the infrastructure.
The national government recently opened a tender for the extension of the railway from Bahía Blanca to Añelo. This will take some time, as it needs considerable investment, but it is a project that we desperately need to start. It relies on the support of the public sector to be successful, because if it relies only on the work of the private sector, it will face some difficulties.
In the short term, I believe we have to focus on the productivity aspect, while in the mid and long term we should shift our focus to infrastructure. You also need to consider a series of additional factors, such as relationships with neighbouring countries and working to make projects feasible for oil and gas imports and exports.

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