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Africa's new energy frontier: The promise and the peril
International oil companies seeking to develop East Africa's hydrocarbon resources must align their commercial expectations with the political realities in their host countries.
The strategic oil and gas landscape is entering a transition phase. Faced with limited access to resources (around 60% of global hydrocarbon deposits are held by national oil companies that offer no equity access to international oil companies [IOCs]), and with costs on the rise, IOCs have shifted their focus to exploration in new frontier areas over the past few years, including East Africa. These exploration efforts have led to significant finds. The challenge now for IOCs is to move "beyond the drill bit" to monetize these assets through development and production of the newfound reserves.
This process goes beyond the application of below-ground technologies, project management, and capital to access molecules; these are elements that IOCs, especially the largest, are expert at managing. An equally significant challenge for IOCs is to navigate the above-ground risks associated with investments in frontier areas. Everything from contract type to hydrocarbon policy to regulations will be shaped by the needs and desires of host governments, IOCs' partners in these ventures. The domestic political, financial, economic, and environmental pressures that the host government faces will drive its external behavior toward IOCs. Thus, the key to commercial success for investors in these frontier areas is IOCs' ability to anticipate how stakeholder demands will evolve and how these changes will shape the investment environment.
East Africa: the new energy frontier
East Africa has emerged as a major new frontier for oil and gas in the past half-decade, and the region is increasingly attracting the attention of large IOCs. Significant deepwater gas fields have been discovered off the shores of Mozambique and Tanzania. Cumulative discovered reserves in deepwater Mozambique's Rovuma and Mamba basins total around 20 billion barrels of oil equivalent, higher than those of either Angola or Nigeria; gas finds in the Tanzania deepwater have been more modest (cumulative discovered reserves total around 5 billion barrels of oil equivalent) but nonetheless are significant. Meanwhile, onshore exploration has yielded oil finds of commercial quantity in Uganda, with reserves estimated at around 2.5 billion barrels (the fourth-largest oil reserves in sub-Saharan Africa). There have also been discoveries in neighboring Kenya, which aspires to be East Africa's first oil exporter by mid-decade. Large onshore hydrocarbon deposits are also thought to exist in Ethiopia and Eritrea, although exploration in those locales has lagged. (See map below.)
The discovery of hydrocarbon resources on this scale in East Africa not only has whetted the appetite of IOCs, it is generating domestic expectations as well. Despite the nascence of the sector and significant production and export challenges (including a dearth of hydrocarbon infrastructure), government and populations-at-large nevertheless anticipate massive financial windfalls. Moreover, they are determined to develop the sector in a way that drives the wider economy and boosts living standards. Visions of wealth on the scale of the Persian Gulf states may not yet have set in, but the discovery of hydrocarbon resources is regarded as a springboard to economic prosperity.
These hopes and expectations are, in turn, shaping the investment environment that IOCs face. Government ambitions, and the pressure that is felt from below, are guiding national hydrocarbon policies and the legal and regulatory structures that are being put in place to underpin them. The key to success, for governments and investors alike, will be to align the commercial expectations of the IOCs with the political imperatives of host states. Experience so far suggests that this will pose challenges, as well as significant above-ground risks for investors. (See figure below.)
At the state level, host governments are intent on achieving more than just the monetization of assets from their partnerships with IOCs. Indeed, contract terms thus far have been relatively favorable to investors, with the undiscounted government take in the 70-80% range. This is no surprise; host states in frontier provinces, lacking the institutional wherewithal and the investment capital to find and develop resources, traditionally offer favorable terms to attract exploration. Further along in the production cycle, contracts are likely to become more onerous as the law of the obsolescing bargain takes hold: once investors have significant fixed assets in place with long amortization periods, (re)negotiating leverage shifts in favor of the host government.
Nevertheless, even in this exploration and early development phase, host governments across East Africa have pushed a hard bargain, seeking to determine the pace of production as well as demanding that companies invest in and develop mid and downstream infrastructure. A case in point is Tullow Oil's experience in Uganda. The company, along with partners Total and CNOOC, recently reached a deal to develop its onshore finds after a three-year standoff with the government over terms. Uganda's government insisted that the development plan include a 60,000-barrel-per-day refinery, an export pipeline via Kenya, and a power station in Uganda's main oil-producing region. The government also demanded a say in the pace of future production, indicating that it is seeking a slower ramp-up than its IOC partners prefer. Reports that Tullow may be seeking to divest some of its interests in Uganda in favor of focusing on assets in Kenya, which is seen as having a less onerous investment regime, illustrate the potential pitfalls if a host government pushes its partners too far.
Insistence on "local content provision"
Striking a balance between economic needs and commercial terms plays out in another key area: so-called "local content provisions," by which host governments earmark a portion of a project's work to be performed by indigenous companies. East African states are not alone in seeking to use their hydrocarbon resources to generate ancillary economic benefit and boost employment; local content demands are a feature of many producing provinces, from Brazil to Iraqi Kurdistan. The key is for governments to establish provisions that promote the development of their resources, not the retarding of it. This has not always been easy to achieve, particularly where qualified domestic human resources have been inadequate to allow targets to be met, or where the capacity of the sectors involved was insufficient. Difficulties in accommodating all stakeholders' objectives have been a key driver in protracted debates around hydrocarbon legislation and resultant regulatory uncertainty for operators in such places as Uganda. In countries where local content bills have been enacted, such as Ghana in late 2013, the ambitious targets for local participation and the shortfall in domestic capacity not only have raised costs and risks of project delays for IOCs, but also have left operators open to increased scrutiny and consequent penalties, which in extreme cases have included license revocation.
Experience from countries with local content quotas has already raised concerns around the inefficient allocation of economic resources, which are magnified in nascent energy sectors in Africa. Mandatory targets can lead to the creation of numerous short-lived and inefficient companies that typically would not prosper in a competitive market. They also force the use of suppliers who often lack the requisite technical and financial competencies, resulting in the IOC and eventually the state paying a higher price for services. Stipulations for local equity participation, especially where host governments control the formation of consortiums, also expose IOCs to risks of breaching anti-corruption legislation in their home jurisdictions, but failure to oblige can also result in adverse discrimination, as demonstrated with Cobalt International Energy in Angola. When provisions for local content participation prove to be beyond the capacity of the local industry and labor force, bureaucratic bottlenecks are likely to emerge as applications for exemptions are processed, setting the stage for increased corruption to avoid project delays. Operators in Ghana have already warned that the local content bill endangers the expansion of the energy sector and the government's objectives, namely its production target of 250,000 barrels a day by 2021.
Despite these difficulties, expectations among local constituencies for immediate benefits and a multiplier effect remain high, especially in countries such as Sierra Leone, Tanzania, and Mozambique, where skepticism around efficient resource management is acute based on past experiences with the mining sectors. However, a lack of community engagement by key stakeholders, including host governments and operators, can fuel grievances over unequal distribution of wealth and displacement of livelihoods and give rise to disruptive unrest around operational sites.
In Tanzania's Mtwara-while bouts of unrest in early 2013 were eventually quelled after costly damage and delays to a US$1.2 billion gas pipeline project-the underlying drivers persist as communities in the underdeveloped region complain about the opaque manner in which offshore gas is being developed. Although the affected communities currently support the IOC's activities and instead hold the government accountable, operators face increased risk of targeted disturbances if the local population continues to feel sidelined in the resource's development. If expectations for local content provision are left unchecked or dividends are seen to be mismanaged, operators in the hydrocarbon sector and host governments will be at risk of backlash from the surrounding population. Recent militancy in the Niger Delta and industrial action for "Gabonisation"-a government policy signed in 2010 but never ratified that would require 90% of all workers in Gabon's petroleum sector to be citizens-provide palpable examples of the potential risks that IOCs face. Moreover, the reputational risk for these companies is also high, especially given growing shareholder activism over the past decade.
IOCs face challenges managing their relationships with host governments and local communities as they seek to develop East Africa's rich resources. Aligning their plans early with the expectations of stakeholders in producing areas is critical to IOCs' success; failure to do so leaves the companies at risk of creating-or at least allowing-unrealistic expectations to develop. This process requires of IOCs not only an understanding of the immediate needs and desires of stakeholders, but also the ability to judge how they will evolve over the lifespan of their investments. Change is inevitable, but IOCs can secure their long-term interests-and the commercial value of their projects-if they understand how the investment environment will evolve and why.
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