ConocoPhillips Wins A Significant Victory In Ongoing Arbitration Battles With Venezuela

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Last Friday, ConocoPhillips (NYSE:COP) was awarded $66.8 million as compensation in a dispute against Venezuela’s state-controlled oil company, Petroleos de Venezuela SA (PdVSA). The dispute was over oil production cuts implemented under Organization of Petroleum Exporting Countries (OPEC) production quota policy in 2006-2007. The ruling was given by the International Chambers of Commerce (ICC), a Paris-based international arbitration panel that found that these production cuts implemented by PdVSA breached agreements that it had signed with ConocoPhillips. [1]

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What Are Production Quotas?

The OPEC is a collection of major oil exporters of the world, which come together periodically to discuss production quotas in order to maintain a fair and favorable (to OPEC nations) demand-supply situation and prices. If oil prices shoot higher on the back of higher demand, countries have an incentive to produce more and flood the market with supply, which leads to a crash in oil prices. This volatility in the market makes it difficult for them to plan their national budgets with any degree of certainty since it becomes impossible to predict revenues. Hence, these countries decide to maintain a particular level of supply in the market in order to stabilize prices. This necessitates production to be kept limited, and each country is awarded a specific maximum quota for production. Producing more than the quota provides an incentive for other countries to do the same, hence it is in every country’s interest to adhere to agreed production levels.

In order to keep its production level within the mandated quotas, PdVSA forced Conoco to reduce its output during 2006-07 in breach of contract agreements.

Going Forward

There are two issues to be examined. Firstly, will the PdVSA cough up the amount asked for by the ICC? Secondly, does victory before the ICC have any bearing on Conoco’s ongoing dispute against the Venezuelan government in the ICSID?

Given the maverick and unpredictable behavior of Venezuela’s President, Hugo Chavez, it is legitimate to ask if PdVSA would agree to pay this amount. It would be instructive to look for similar examples from the past. A case in the ICC against PdVSA was filed by Exxon Mobil (NYSE:XOM) and the latter was awarded $908 million as compensation earlier this month. PdVSA eventually paid $255 million, deducting $191 million that it claimed Exxon owed it for the repurchase of bonds linked to Cerro Negro, $300 million in offshore PDVSA accounts that Exxon had frozen during the dispute, and $160 million that the ICC panel awarded the Venezuelan company in counterclaims. However, it is to be noted that this was a case of asset expropriation due to nationalization of oil assets, similar to the one Conoco is currently pursuing in the ICSID. In 2007, as a part of the Venezuelan government’s nationalization drive, PdVSA had assumed control over ConocoPhillips’ interests in the Petrozuata and Hamaca heavy oil ventures, and the offshore Corocoro development project.

In light of the ICC ruling, we believe that Conoco has at least won a moral victory for the next battle against the Venezuelan government in the ICSID. Strictly speaking, there is no connection between the ICC and the ICSID. However, we believe that the ICSID will uphold the basic principles applied in the ICC ruling. Also, Exxon is pursuing the same case in the ICSID which it won in the ICC. It will be difficult for the ICSID to ignore the ruling given by the ICC while coming up with its own verdict. Therefore, we believe that ICSID will rule in Exxon’s favor. And if it does that, there is no reason why Conoco’s claims should be rejected since the complaints are similar in nature. Hence, our prediction is a victory for Conoco before the ICSID. ((Venezuela state oil firm to pay Exxon fraction of arbitration award, The Globe And Mail))

Let’s now examine the question of the amount of monetary compensation. The ruling in the Exxon case by the ICC appears to back Venezuela’s position that companies whose assets are nationalized should be compensated for the amount invested, i.e. book value, rather than the market value the assets might fetch if sold. It remains to be seen if the ICSID also adopts the same position. We think that the question of the amount of compensation, however, could very well become a moot point. This is because in January this year, Venezuelan President Hugo Chavez declared that the country would no longer abide by decisions given by the ICSID. Any victory for Conoco or Exxon in such a case is more likely to be moral than anything else.

In summary, we believe that Cococo will win a victory in the ICSID but in unlikely to be compensated by the PdVSA. As for the $66.8 million it is supposed to be paid by the PdVSA, we believe that the latter will pay up. This is because it is a much smaller amount than what was paid to Exxon, and also because Venezuela does need western oil companies for future projects. PdVSA lacks the technological sophistication to extract oil from the Orinoco basin, which has rich reserves. Hence, we think that it wouldn’t want to jeopardize future collaboration opportunities for a relatively meager sum.

The amount of $66.8 million dollars will have hardly any significant impact on the company’s net income which stood at $5.2 billion as of June 30, 2012. The victory is only significant in the sense that it sets a precedent for any future disputes that might arise in other countries. [2]

We recently revised the Trefis price estimate for ConocoPhillips to $60 which is about 5% ahead of its market price.

Understand on Trefis how a company’s products impact its stock price

Notes:
  1. CORRECT: ConocoPhillips Awarded $66.8 Million Against Venezuela, MorningStar []
  2. ConocoPhillips Q2 2012 Report, SEC []
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