Argentina - Oil and Gas Credit Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 3321-AR STAFF APPRAISAL REPORT ARGENTINA OIL AND GAS CREDIT PROJECT May 26, 1981 Energy Department This document hias a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENT (May 1, 1981) Currency Unit = Peso (A$) US$1.00 = A$3,190 A$1.00 = US$0.0003134 PRINCIPAL ABBREVIATIONS AND ACRONYMS USED B Barrels (42 US gallons, 159 liters) BANADE Banco Nacional de Desarrollo B/d Barrels per day CFD Cubic feet per day ERR Economic rate of return FRR Financial rate of return GdE Gas del Estado GDP Gross domestic product GWH Gigawatt hours (one million kilowatt hours) KWH Kilowatt hours LPG Liquified petroleum gas (propane/butane) MW Megawatt (thousand kilowatts) Toe Tons of oil equivalent WPI Wholesale Price Index YPF Yacimientos Petroliferos Fiscales FISCAL YEAR January 1 - December 31  FOR OFFICIAL USE ONLY ARGENTINA OIL AND GAS CREDIT PROJECT STAFF APPRAISAL REPORT Table of Contents Page No. I. THE OIL AiND GAS SECTOR .............. ............. 1 A. Energy Resources ...................................... 1 B. The Oil and Gas Sector ....1............................ Exploration ...... ................ 1 Production ................ . ....................... 2 Refining and Transport ........................... 3 Domestic Demand .................................. 4 Imports ....... .......................... 5 Investment Program ............................... 5 Public Sector Institutions .................. 5 C. Sector Issues and Bank Strategy ............... 6 Issues ........ ................. 6 Bank Strategy ............ ........ . ................. 8 II. ROLE OF THE PRIVATE ARGENTINE FIRMS ....................... 8 A. Background ............................................ 8 B. Review of the Main Argentine Oil Firms .... ............ 9 C. Main Types of Contracts Between YPF and Private Firms .11 D. Operating Consortia and Joint Ventures .12 E. Prospective Investments of the Private Sector and YPF's Bidd:i'ng Program .14 F. Sources of Financing for Petroleum Exploration and Development Projects of Private Argentine Firms. . 15 This report is based on the findings of missions which visited Argentina in July and November 1980 comprising Messrs. J. F. Zuniga-Rivero, N. V. Santiago, and F. A. Batzella., This document has a restricted distribution and may be used by recipients only in the p=rformance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  Table of Contents (Cont'd) - ii - Page No. III. THE INTERMEDIARY--BANCO NACIONAL DE DESARROLLO .... ......... 16 A. Organization and Operations ........................... 17 Board of Directors, Management and Staff .... ..... 17 Operations ....................................... 18 B. Oil and Gas Lending ................................... 18 Past Operations ............. 18 Appraisal and Supervision of Oil and Gas Projects. 18 Future Operations in the Oil and Gas Sector .... .. 19 Organizational Arrangements for Oil and Gas Lending ........................................ 20 Project Pipeline, Size of Proposed Loan and Cofinaning . .................................... 21 Coordination with YPF ............... * ............ 21 C. BANADE's Financial Structure, Results and Projections . 22 Financial Structure .............................. 22 Revenues and Costs ............... ................ 23 Sources of Funds ................ ................. 23 Quality of Portfolio .............. ............... 23 Auditing Arrangements ............. ............... 24 Financial Projections ............. ............... 24 IV. THE PROJECT ................................................ 25 A. Background and Objectives .............................. 25 B. The Proposed Loan ...................................... 26 Terms and Conditions .............................. 26 Subloan Terms and Conditions ...................... 26 Subproject Review ................................. 27 Technical Assistance Component .................... 27 Procurement and Disbursement ...................... 27 Advance Contracting and Retroactive Financing ..... 28 C. Benefits and Risks .................. ................... 28 Benefits .......................................... 28 Risks ............................................. 29 V. AGREEMENTS REACHED AND RECOMMENDATION ...................... 30 A. Agreements Reached .......... i ....... ................... 30 B. Recommendation .................... ..................... 30  Table of Contents (Cont'd) - iii - ANNEXES 1-1 Crude Oil and Natural Gas Production (1975-1979) 1-2 Retail Prices of Principal Hydrocarbon Products 2-1 Sample of Argentine Private Companies Active in the Hydrocarbon Sector 2-2 Partial Listing of Hydrocarbon Exploration and Field Development Contracts 3-1 BANADE: Organization Chart 3-2 BANADE: Finanicial Statements 3-3 BANADE: Policy Statement for Financing Exploration, Exploitation and '['ransport of Oil and Gas 4-1 Loan Disbursement Schedule 5-1 Selected Documents and Data Available in the Project File MAP  ItIt  I. THE OIL AND GAS SECTOR A. Energy Resources 1.01 Argentina has a substantial and diversified energy base. The exploitable hydropower potential is estimated at about 200,000 gigawatt hours annually (GWH, one million kilowatt hours (KWH)) representing a thermal equivalent over 50 years of about 2.5 billion tons of oil equivalent (Toe); a large part of these resources is far from load centers and requires relatively high costs to develop. Proven reserves of crude oil at year end 1978 totalled 330 million tons (2.4 billion barrels (B)) and those of natural gas, 21.2 trillion cubic feet (520 million Toe), equivalent to 15 years and 50 years of current output, respectively. There are also deposits of low quality thermal coal, and potential for vegetable fuels (firewood, bagasse), geothermal, wind and solar energy. 1.02 During 1970-75, primary energy output grew less than domestic demand primarily because oil production declined. This resulted in a weakening of Argentina's overall domestic energy position and increased petroleum imports. A marked improvement took place from 1976 onwards. Primary energy output rose from 1976 to 1979 by about 4.5 percent per annum. Crude oil output increased and hydro capacity doubled, reaching 3,200 MW (megawatts, one thousand KW) in the latter year. In 1978, energy demand totalled 42.3 million Toe, which is comparable to other countries with a similar level of develop- ment. 1.03 While energy resources are diversified, energy consumption depends largely on hydrocairbons. Petroleum and natural gas, together accounting for only 14 percent of' reserves, currently meet 56 percent and 26 percent, res- pectively, of domestic energy demand. The hydropower potential, on the other hand, represents some 60 percent of energy resources but meets only about six percent of domestic consumption. Plans are underway to develop 25,000 MW of new capacity to balance resources and consumption. At the same time, the Government has given top priority to attaining petroleum self-sufficiency by the mid-1980's. Additional efforts in coal exploration and a gradual expansion of nuclear power based on domestic uranium resources complement the petroleum and hydropower programs. B. The Oil and Gas Sector Exploration 1.04 Argentina's oil and gas sector ranks third in output and fourth in refining capacity in Latin America. In Argentina's 18 sedimentary basins, the potential hydrocarbon bearing areas cover about 1.2 million sq. km on- shore and 0.6 million sq. km offshore. Another 0.9 million sq. km of poten- tial areas are loc:ated in water depths beyond the 200 meter line. Of these basins, only six (see Map) are currently producing and their remoteness from the main refining and consumption centers poses difficult logistical  - 2 - problems. These are: (i) the Northwestern basin in the provinces of Salta and Jujuy; (ii) the Cuyo basin in northern Mendoza and San Juan provinces; (iii) the Neuquen basin situated in southern Mendoza, Neuquen, La Pampa and Rio Negro provinces; (iv) the San Jorge basin in Chubut and Santa Cruz provinces; (v) the Southern or Austral basin located in Santa Cruz and Tierra del Fuego provinces; and, (vi) the Malvinas basin located mainly offshore Tierra del Fuego. The Cuyo basin is probably the best known and most thoroughly explored, while the least explored are the Southern and Malvinas basins. Cumulative oil discoveries since 1907 have amounted to about 5.6 billion B, of which 3.1 billion B have already been produced. After a decline in exploration in the period 1970 to 1975 when private companies were virtually barred from it, both geophysical exploration and exploratory drilling have increased since 1976, and the decline in known reserves was reversed in 1978 when 272 million B were added to this category, largely because of resumption of exploration by private firms following the Government's policy of encouraging such activities, under a system of risk contracts (para. 2.10). 1.05 Yacimientos Petroliferos Fiscales (YPF, the State Oil Company) is concentrating its onshore seismic surveys in the Neuquen and North- western basins. Private companies that have been awarded risk contracts by YPF have stepped up both onshore and offshore seismic work. 1.06 Exploratory drilling activity (including extension and delineation wells) has declined somewhat since 1974 mainly because of scaling down by YPF; in contrast, exploratory drilling by private companies has increased significantly. Drilling has been concentrated in the Neuquen, San Jorge and Northwestern basins where several discoveries were made in 1978 and early 1979. At the end of 1978, one semi-submersible marine platform and 74 drilling rigs were active, of which 40 belonged to YPF. Of the remainder, 14 were providing services to YPF and the rest were operating in areas contracted to private companies. By mid-1979, the number of active rigs had declined to 57, but an upturn in exploratory drilling took place in the latter part of 1979 and during 1980 when the number of rigs reached 69. Production 1.07 After production declines during the period from 1973 to 1975 when YPF's performance deteriorated and private companies found prices unremunerative, output of crude oil increased from the second half of 1976 onwards at an average of five to six percent per year (Annex 1-1). In 1979, output of crude oil and condensate reached about 173 million B, the highest production ever. This was brought about largely by private companies who now provide about a third of crude output (see para. 2.03). 1.08 Output of natural gas, which is mainly associated with crude, reached 1.2 billion cubic feet/day (CFD) in 1979 (para. 1.13). Private companies accounted for only about 15 percent of gross output in 1979, largely because of the low prices set by the Government for natural gas until recently. Reflecting the geographic distribution of crude output, natural gas produc- tion is concentrated in Santa Cruz and Neuquen (about 54 percent of total  -3- production in 1979i>), although the fastest growth is taking place in Tierra del Fuego whose ouLtput is now about ten times its 1973 level and provides about 15 percent of national output. Refining and Transport 1.09 Argentina's refining capacity of some 705,600 barrels/day (B/d) for primary distillation and 120,000 B/d in catalytic cracking, reforming and related processes has been sufficient until now to meet domestic demand for most products except for lighter and middle distillates. Most of the twelve existing refineries are small and only four of them have a capacity of more than 100,000 B/d -- the YPF refineries at La Plata (Buenos Aires province) and Lujan De Cuyo (Mendoza), the Shell Dock Sud Refinery and the Exxon refinery at Campana. The two large YPF refineries (out of six owned by YPF) are both based on advanced refinery processes (e.g., catalytic and hydro- cracking) but their relative capacity to produce lighter and middle distillates is below that of the private sector. To correct this imbalance, which has resultecd in an excess of residual fuel oil, the Bank has appraised a proposed Refinery Conversion Project whose aim is to increase the output of higher value middle and lighter distillates by the two major YPF refineries. 1.10 In 1979, the average capacity utilization in all Argentine re- fineries was about: 76 percent -- 85 percent for YPF refineries and 60 per- cent for private refineries. This was due principally to insufficient allocation of domestic crude by the Government to private refineries com- bined with restrictions on crude oil imports. As a result of policy changes aimed at minimizing processing and marketing costs of petroleum products, domestically produced crude is now allocated according to in- dividual refineries' share of the market for petroleum products. 1.11 In the t:ransport subsector, a system of pipelines is owned and operated exclusively by YPF (crude and petroleum product pipelines) and Gas del Estado (GdE, the state gas company) which has natural gas pipe- lines. Only 45 percent of crude and about one-third of products are moved by pipeline, the remainder being transported by coastal tankers, rail and road. Crude oil pipelines total some 1,700 km in length and 0.43 million B/d iin capacity, and are concentrated in Neuquen and the northern area. Crude from the southern production centers is transported by tankers entirely owned and operated by YPF. Product pipelines amount to 2,950 km and nearly 0.4 million B/d of capacity. Trunk pipelines for natural gas extend along the length of the country, connecting the producing areas in the extreme north and south with the consumption centers around Buenos Aires. Gas pipeline capacity of 1 billion CFD is sufficient to meet summer demand, but falls short of potential winter peak demand by about 20 percent, thus restricting gas use. Expansion of the northern and southern trunklines and conistruction of a new pipeline from the gas-rich Neuquen fields to the Buenos Aires industrial belt, to be completed in 1982, will ease supply bottlenecks and aLlow better utilization of gas resources. Storage capacity for crude oil and petroleum products is about 18 million B each or about 35-40 days' supply which is adequate in light of Argentina's relatively high degree  -4- of self-sufficiency. For natural gas, very little storage is available. The Bank-financed natural gas optimization study (para. 1.13) includes a review of investment requirements for the transport and storage of natural gas. Domestic Demand 1.12 In 1979, domestic demand for petroleum products including field and refinery consumption amounted to about 193 million B. In 1978, trans- port accounted for about 54 percent, power generation 20 percent, industry 15 percent, and the residential and commercial sectors combined, 11 percent. 1/ Estimates of consumption in 1979 indicate a similar demand pattern. Increase in sales to final consumers from 1971 to 1979 averaged nearly 3.9 percent p.a. Consumption of gasoline, which accounts for about 25 percent of total product consumption, declined in 1974-75 when its relative price increased substantially, but resumed afterwards its historic growth of 5.5 to 6.0 percent p.a. Consumption of industrial diesel and fuel oil fell due to replacement by natural gas in industry and by hydropower in electricity generation. Consumption of liquified petroleum gas (LPG) has been growing fairly rapidly, replacing kerosene for household use. 1.13 Natural gas has become increasingly important for meeting Argentina-s energy requirements. Industry accounts for nearly half of total natural gas use, followed by power generation (20 percent) and residential, commercial and Government sectors (about 30 percent combined). Natural gas consumption has grown rapidly throughout the 1970s, at an average rate of close to nine percent per year from 1971 to 1978. In the latter year, however, consumption declined by nearly three percent, when demand by industry and by the power sector fell. As previously mentioned, gas production is averaging about 1.2 billion CFD, but about 30 percent of this is being flared. Inadequate utilization of natural gas has been caused by: (i) insufficient incentive to producers due to low delivery prices paid by GdE; (ii) high gas-oil ratios found in most new fields; (iii) transport and storage bottlenecks particularly for the peak winter period; (iv) reluctance on the part of large volume fuel oil consumers to shift to natural gas due to supply inter- ruptions and higher gas prices (which were ten percent above fuel oil prices until recently); and, (v) limited reinjection facilities for natural gas in existing oil fields. However, as part of the Bank-financed Oil and Gas Engineering Project (Loan 1880-AR), the Government is carrying out a study which will analyze the optimum development and utilization of natural gas on a regional and national basis, together with an assessment of alternative uses for fuels to be replaced by gas and of related investment requirements. Intermediate corrective steps are already being taken, including the raising of prices paid to producers and the adjustment of relative prices to consumers to make fuel oil more expensive to utilize. The country is also expanding its gas gathering and trunk pipelines as well as distribution systems to be able to reduce and eventually eliminate flaring of gas. 1/ Transport and industrial consumption include agricultural sector use.  5- Imports 1.14 Argentina has traditionally enjoyed a relatively high degree of petroleum self-sufficiency. Net import requirements of crude oil and petroleum products in 1979 amounted to just about 12 percent of domestic demand, down from 15 percent in 1975. Imports are higher for natural gas, and amount to nearly 20 percent of domestic demand, due to previously- mentioned reasons and a long-term import contract with Bolivia. The pro- portion of hydrocarbon requirements met by domestic production has increased from 82 percent in 1973 to 87 percent in 1979. However, with the substantial increases in international prices, the net oil and gas import bill for 1979 rose to about US$?1.0 billion compared to about US$400 million for the previous year. Investment Program 1.15 The investment program in the oil and gas sector during 1980- 85 aims at: (i) achieving self-sufficiency in crude oil by the mid-1980s; and, (ii) improving the transport infrastructure for moving oil and gas from production sites to the processing and consumption centers. The plan is based on the assumption that total energy demand will increase by five percent a year, while demand for oil will grow at a lower rate (four percent a year) due to substitution of natural gas for fuel oil, expan- sion of hydropowe.r production and energy conservation (para. 1.20). 1.16 The Government is in the process of updating the investment program for the oil and gas sector. A preliminary figure, based on projects prepared by YPF and GdE, indicates investments in the public sector up to 1989 of about US$';16 billion equivalent (in 1979 prices); private sector investments may ireach about US$10 billion over the same period (paras. 2.13 and 2.14). Exploration and field development are expected to absorb nearly 80 percent of the total investment. The Government has set the above mentioned investment targelts in order to discover and develop at least 2.3 billion B of additional crude reserves, which appears reasonable. This would help maintain the reserves/prodluction ratio at 15 years throughout the 1980s. Transport and distribution of gas would require about US$2 billion equivalent and refining about US$1 billion. Public Sector Institutions 1.17 The Energy Secretariat within the Ministry of Public Works is the Government's mainL energy policymaking and administrative body. It consists of two subsecretariats -- for fuels, including nontraditional energy sources, and for electricity. Responsibilities of the Secretariat include: (i) pricing and investment policies; (ii) the approval of exploration and development contracts negotiated between YPF and private companies; and, (iii) development of new energy sources and overall energy planning.  - 6 - 1.18 YPF, which the Bank deals with in connection with the Oil and Gas Engineering Project, was established in 1922 and is the Government s main entity for implementing oil and gas policy. YPF is a vertically integrated company which operates in virtually every branch of the oil and gas sector except marketing of natural gas and LPG. In 1979, it accounted for about half of total exploration (in terms of meters drilled), over two-thirds and 85 percent of crude oil and natural gas output, respectively, and 73 percent of petroleum refining. With assets of about US$6 billion equivalent and net annual sales of about US$3 billion equivalent in 1979, YPF is a big company even by international standards and is the largest in Argentina. Negotiating and supervising exploration and development contracts on behalf of the Government with foreign and local private companies (the latter would be the subborrowers under the proposed project) has become an increasingly important function for YPF with the growth of private sector involvement in oil and gas activities. 1.19 GdE, a state enterprise established in 1957, is responsible for importing, processing and marketing natural gas and LPG. The priority given by the Government to increased utilization of natural gas in the country will have an important bearing on its future development. However, expansion of the company, which had some US$720 million equivalent in sales in 1978, would be restricted somewhat by the Government's policy of encouraging in- creased involvement of private firms in natural gas processing and trans- mission. Thus, the new Center-West trunk pipeline is to be constructed, owned and operated by a consortium of foreign and local private firms which will transport gas for a set fee. C. Sector Issues and Bank Strategy Issues 1.20 Two principal issues affect the Energy Sector in Argentina:+ (i) the inadequacy of energy planning, and (ii) the inappropriate pricing of energy resources. These problems, which are partly interrelated, are being gradually overcome. The Government is in the process of preparing a com- prehensive energy plan, to which the Bank is providing significant contribu- tions in a variety of ways. A study on a least-cost power expansion program was funded under the FY76 Power Project. An audit of hydrocarbon reserves, seismic surveys and the previously-mentioned natural gas utilization study is being financed by the Oil and Gas Engineering Project. The country s coal potential will be assessed in connection with the recently approved Coal Exploration Project. The Government is starting to develop an energy conservation program. As an initial step, the Government plans to carry out an energy audit of major energy-consuming industries, with a view to identifying priority areas and measures for energy conservation. The proposed Refinery Conversion Project would finance part of the cost of the energy audit which would focus on retrofitting possibilities among the major energy- intensWve industries ior conservation purposes. A proposed. sero43 -i-faX credit project to the Banco Nacional de Desarrollo (BANADE, the government- owned development bank) would also include a component to finance retrofitting  - 7 - by medium size industries. The Energy Plan now under preparation is intended to integrate into one comprehensive document the preliminary results of the various studies, including those being undertaken together with other agencies, such as the U.S. Department of Energy, and previously-existing information. 1.21 Fuel pricing in Argentina is complex, and relates both to the absolute level of fuel prices and to the relative pricing of various energy sources at different stages from production to consumption. Fuel prices are Government controlled. From early 1976 until mid-1978, the Government enacted substantial price increases at all levels, which measured in current US dollars terms signified increases of about 40 percent for crude oil prices, 114 percent for retail prices of petroleum products, and 85-90 percent for natural gas tariffs (see Annex 1-2). However, in an attempt to slow down inflation, the G:)vernment kept these price increases significantly below increases in the overall price level and in fuel import costs during late 1978 and 1979. Consecluently, by the end of 1979, prices of petroleum products were below international levels, with the retail price of petroleum products averaging US$0.75/gal. 1.22 Considerable progress to modify this situation has been made during 1980 and 1.981 partly as a result of the dialogue with the Bank, espe- cially in the context of the Oil and Gas Engineering Project. The Government is implementing l new policy of increasing gradually prices of crude oil, petroleum product:s and natural gas to a level which would generate sufficient funds for YPF ancl GdE to service their debts and fund their investments, with a view to reaching international price levels over the long run. Real price increases for petroleum products for the year ending May 1981 have been about 16 percent. There have been some favorable changes as well in the structure of relative prices, with natural gas now slightly cheaper for large consumers than fuel oil. 1.23 In spite of recent peso devaluation, retail prices for petroleum products in Argentina are now reasonable and above the CIF prices of imported petroleum products, ranging from about US$2.09/gallon for premium gasoline to about US$1.26/ga]Llon for diesel in May 1981. A large percentage of final product prices, however, is accounted for by taxes and does not accrue to crude producers or refiners. So far, however, crude delivery prices set by the Government have been sufficiently attractive for private companies to bid for YPF's exploration and development contracts (para. 2.10). 1.24 To ensuire reasonable consumer price levels of petroleum products in the future, an understanding has been reached with the Government, in connec- tion with the proposed project that consumer prices of petroleum products should not declinie in constant terms (as measured by nonagricultural wholesale price index) with prices at May 1, 1981 as the reference prices. The Govern- ment has also stated its intention to continue adjusting petroleum product prices periodically to reflect adequately changes in internal price levels and international petroleum prices, taking into account the results of the natural gas optimization study financed under Loan 1880-AR.  -8- Bank Strategy 1.25 The Bank's strategy in the petroleum sector includes four main elements. The first, which was initiated under the Oil and Gas Engineering Project, consists of assisting in the planning of hydrocarbon development. The Oil and Gas Engineering Project is expected to give rise to a number of other projects, including exploration/development, gas recycling, secondary recovery, and oil and gas transport infrastructure. Some of these projects could be considered for future Bank financing. The second element consists of institutional improvement in the public sector; both the Oil and Gas Engineering Project and the proposed Refinery Conversion Project would contribute significantly to institution-building of YPF. The third element of the Bank's strategy consists of supporting the Government's policy of increasing the role of the private sector in petroleum exploration and development to achieve improved sector efficiency, which is the objective of the proposed project. The last element involves engaging in a pricing/sector policy dialogue with the Government. II. ROLE OF THE PRIVATE ARGENTINE FIRMS A. Background 2.01 Unlike other developing countries, Argentina counts on a well- established group of about 45 locally-owned private firms operating in the hydrocarbon sector. Local private firms began producing oil in 1916, in parallel with the State owned oil concern and, later, with foreign investors. Until the outbreak of World War II, private firms both foreign and local accounted for roughly half of total domestic oil output; their share declined to about 20 percent by the late 1950's, when total domestic oil production had fallen to less than half of consumption. Subsequently, until 1976, the development of the hydrocarbon sector was hampered by erratic shifts in resource development policies which resulted in low efficiency of the state enterprises, and an unfavorable investment climate for private companies. After a short period of liberal investment policies in the late 1950's, most contracts with foreign firms were annulled by the mid-1960's. This was followed by new negotiations with the multinationals in the late 1960's, and a spurt of investment and output until 1972, when renewed nationalistic policies curbed private initiatives in the sector. This, combined with the prices of oil, gas and products being held at unrealistically low levels, led to sub- stantial declines in reserves, crude output and refining. 2.02 In 1976 the government introduced far-reaching policy changes aimed at encouraging the private sector's participation in oil and gas exploration and field development, as the key toward attaining petroleum self-sufficiency by the mid 1980's. The government-owned enterprises, YPF and GdE, were radically streamlined to improve the efficiency of their operations. YPF's Iet,a status was cbhange-d from a government agency to a state-owned corporation, structured along private company lines. The Government instructed YPF to farm out to private contractors, to the extent possible, the exploration of  -9- new oil and gas reservoirs, and the development and exploitation of known reserves requiring> new investments, especially as regards the marginal, more risky and capital-absorbing projects. Contracts were to be awarded on the basis of competitive bidding, with foreign firms being encouraged to partici- pate in the bidditng on condition that they associated themselves, even on a token basis, with private Argentine firms. 1/ In 1978, new legislation was passed specifically to regulate and encourage risk contracts for the exploration of new reservoirs and their subsequent development by private companies (or consortia of companies) winning area awards from YPF. 2.03 The private sector responded with growing eagerness to the new policy orientationi of the government. With only one or two exceptions, several bids were submitted for each contract offered by YPF for bidding, so far. In the period 1976-79, private companies concluded 12 exploration contracts and 18 production and secondary recovery contracts with YPF covering 85,000 km and 5,100 km , respectively, and entailing minimum investment commitments of about $1.06 billion. As a result, oil production by private firms increased from 6.0 mil ion m3 in 1977 (24 percent of total domestic production) to 9.6 million m in 1979 (35 percent of total domestic produc- tion), and is expected to increase further substantially, both in absolute and in relative terms. The most significant participations of multinational oil companies in YPF's contracts has been concentrated in the largest and riskiest (but also potentially most profitable) exploration projects requiring capital investments of a nmagnitude beyond the reach of Argentine firms. Typical of this type of venture are the exploration projects in the south, mostly off- shore, which are being undertaken by Exxon, Shell and Total with only minor participation by Argentine firms. Other large foreign petroleum firms, such as Occidental, Amoco, Cities Services, Union Oil of California and Union of Texas, as well as other companies like Fluor, Ascot, Butes and Blocker, have preferred to participate with Argentine firms in smaller scale onshore exploration and field development projects. Consortia made up exclusively of Argentine firms hacve been awarded the bulk of the less risky onshore field development and secondary recovery contracts, as well as the less capital- intensive exploration contracts. B. Review of the Main Argentine Oil Firms 2.04 About thirty out of the forty or so Argentine companies operating in hydrocarbon exploration and production participate in one or more of the consortia which have won the award of a YPF contract; the remainder have limited themselves to providing specialized services (drilling, well work-overs, well and equipment servicing and repairs) for a fixed fee to YPF and to the major private operators. Of the companies which are active in the mainstream of oil and gas exploration and field development only about 15 possess the financial strength, the technical experience and competence to act as "operators" in a consortium, i.e., to effectively implement, with thbe financial support of the other members of the 1/ The purpose of this limitation is to foster the transfer of technology.  - 10 - consortium, the work required under a typical YPF contract. The appraisal mission acquainted itself with seven of the most active and experienced oil firms in Argentina which are among the likely prospective borrowers of the proceeds of the proposed line of credit. 2.05 Only three of these companies have assets in excess of $100 million -- a respectable size in absolute terms, but quite modest by international oil industry standards. These are Bridas, with total assets of about US$330 million equivalent as of September 1979; Perez Companc, with about US$270 million equivalent as of May 1980; and Techint, with about US$130 million equivalent as of June 1979. 1/ All three have been in operation for over 30 years. Though petroleum activities constitute their principal source of income, they are among the most diversified of the Argentine firms operating in the hydrocarbon sector: Bridas and Perez Companc have assets also in agriculture, forestry, mining, insurance and banking, while Techint is an engineering firm involved also in the design and construction of civil works. The next two companies in this group, Astra and Pluspetrol, are, respectively, the oldest and the most recent of the seven, the former having been active in petroleum production since 1916, while the latter was created in 1977 from the merger of two engineering and construction companies. Both concentrate on petroleum exploration and production, though Astra also operates a refinery and a distribution network. Astra-s assets amounted to US$63 million equivalent as of December 1979 while Pluspetrol's amounted to US$58 million equivalent in March, 1980. The two other companies surveyed by the mission were Quitral-Co and Inalruco, both active since the 1950 s, with assets of US$23 million equivalent (June, 1979) and US$51 million equivalent (June, 1980), respectively. Both are also quite active as members of award-winning consortia. 2.06 All of the above companies have several contracts with YPF: Bridas and Perez Companc are each involved presently in eight contracts with YPF; Astra and Inalruco, in seven; Techint and Pluspetrol, in four; and Quitral-Co, in three. Each company is the operator in at least one of the consortia holding the contracts and, in at least one other contract, participates with a major foreign oil company, taking full advantage of the attendant transfer of 1/ Financial data for these companies should be considered indicative only, and cannot be easily compared with each other, for three reasons: (a) the difference among the closing dates of the companies- fiscal years affects the significance of the financial information because of very high inflation prevailing in Argentina (local currency has been converted into US dollars at the official rate of each fiscal year's closing date); (b) the accounting techniques adopted by each company to adjust financial data for inflation are not strictly comparable; and, (c) there are differences among the techniques adopted by each company to report their participations in consortia and in the equity of other companies. In particular it should be noted that, unlike fixed assets, holdings of securities cannot be adjusted for inflation according to Argentine law, so that the assets of companies holding a sizeable portfolio of shares of other companies are considerably undervalued.  - 11 - technology. At least one of the contracts in which each company participates is an exploration contract (three in the case of Bridas and two in the case of Inalruco) involving state-of-the-art technology and high risks. They are well managed and have a competent technical staff. Their field operations, visited by the mission, appear to be fully adequate. All seven of these companies operate efficiently, with their lifting costs on average lower than YPF's. The average contractual price for the oil they produce is about US$16.50/B equivalent. 2.07 The financial situation of the seven companies varies from case to case, but is generally satisfactory. The balance sheets of five of them show a significantly positive net working capital, although two have a current ratio of 0.6:1. TIeir total debt to equity ratio varies between 1:1 and 4:1. The total indebtedness of these companies towards banks and financial institutions ranges from 0.3 times equity to 2.3 times equity, the average being around one times equity. A synoptic presentation of the principal areas in which the seven companies are involved is given in Annex 2-1. C. Main Types of Contracts Between YPF and Private Firms 2.08 According to Argentine law, all hydrocarbons belong to the State. YPF acts as the Government's agent for oil and gas exploration and field development. In this capacity, it can sign contracts with private contrac- tors to carry out this function for specific areas and periods. Contracts are regulated by the 1967 Hydrocarbons Law (No. 17,319) and by the 1978 Risk Contracts Law (No. 21,778). Besides plain service contracts, under which the contractor provides to YPF specific services for a given fee (which would not give rise. to projects eligible for financing under the proposed line of credit), the contracts requiring the contractor to invest and assume on itself the related business risk fall into two broad categories: (i) development, exploitation, and secondary recovery contracts; and, (ii) exploration, or risk contracts. Certain common principles underly both types. All contracts set the period during which a given area is assigned to a contractor, the minimum amount of investment and/or technical work, which the contractor undertakes to carry out, and the contractor's remunera- tion, which is always linked to the amount of oil produced. Under all contracts the title to the area's subsurface rights remains with YPF, which holds it in the name of the State; hydrocarbons produced by contractors must be delivered to YPF against the agreed fee, at least until such time as the Government declares the country self-sufficient. At that point, contractors may be remunerated partly in kind, and allowed to export their excess produc- tion. All contracts are to be awarded to qualified private firms (meeting tests of financial solvency and technical competence) on the basis of inter- national competitive bidding. Bids can be submitted either by individual firms or by a consortia of firms. As previously mentioned, foreign firms may participate in the bidding provided that they are members of a consortium in which an Argentine firm 1/ also participates (irrespective of the percentage of the latter's participation). 1/ Defined by law as companies which are registered in Argentina, and which are, directly or indirectly, majority-owned (51 percent or more) by Argentine nationals.  - 12 - 2.09 The characteristics of the different contracts vary considerably within this general framework. The duration of contracts (after which the contractors must return the awarded area to YPF, including the equipment needed to operate the field) range between 12 and 20 years for development, exploitation and secondary recovery contracts (depending on the complexity of the work to be performed), with the possibility of extensions of up to five years in case new reserves are discovered. Exploration (risk) contracts are divided into two periods. The first period, for exploration proper, can be up to five years for onshore, and seven years for offshore areas, followed by a development and exploitation period, which can be as long as 25 years if oil or gas are discovered in commercial quantities. The contract's term can be suspended for up to 10 years at the contractor's request, if large natural gas reserves are found, to permit the construction of infra- structure needed to collect and deliver the gas to GdE. 2.10 Until recently, many primary and secondary recovery contracts were awarded on the basis of the remuneration expected by the bidders for production in accordance with the minimum production curve defined by YPF, with a system of penalties and premiums, but this did not provide sufficient incentive to improve a field's yield. The system of contract awards is now based on: (i) the bid price of the contractor per unit of output delivered to YPF; (ii) the amount of minimum investment commitment (financial or physical) which the contractor undertakes to carry out; or, (iii) a combination of both according to given formulae. In the case of exploration contracts, the minimum amount of investment to be carried out in specified phases of the exploration period is always set by YPF, and the contracts are awarded on the basis of the remuneration demanded by contractors for the oil and gas in case of discovery. At the end of each exploration phase (normally the exploration period is subdivided into three phases) the contractor must return to YPF 50 percent of the remaining area, unless a discovery has occurred. If the contracted investments are not carried out, the contractor must pay to YPF an amount equivalent to the short-fall. Performance bonds are generally required to ensure compliance with this obligation. Both investment commitments and the contractor's remuneration are adjustable to reflect domestic and inter- national inflation. Most contracts, however, fix a ceiling of 60 percent of international crude prices to the maximum fee payable by YPF for oil delivered to it by private contractors, regardless of the adjustment formulae. So far, this has not been a constraint to bids. During negotiations, an understanding was reached with the authorities that this ceiling and other bidding conditions would be adjusted from time to time, as needed, so as to assure the continued interest of private firms in YPF's bidding program. An understanding was also reached that contracts will continue to be awarded with due regard to economy and efficiency in the execution of projects. The average payment by YPF to private contractors for oil production under existing contracts is slightly higher than one-half of the current international price of crude oil. D. Operating Consortia and Joint Ventures 2.11 Out of the 30 or so development and production contracts currently in existence, only six have been signed by individual firms; all the others, as well as all exploration (risk) contracts, have been concluaea by Y?7 with  - 13 - consortia of two or more firms. Since joint ventures have no legal validity under Argentine law, such consortia amount to unlimited liability partnerships, in which the partners are jointly and severally responsible for the execution of the contract. The consortia are regulated by operating agreements among the partners. One of the partners is designated as operator, and is in charge of the physical execution of the contract, while the other partners supply their share of investment funds. The partners share the consortium's assets and liabilities in proportion to their percentage participation. Decisions are made by a weighted majority of votes, and in most cases are binding on all partners. In case of noncompliance of one of the partners, the others have the option, after a specified number of days, of either substituting themselves for the noncomplying partner (who thus forfeits all his rights in the consortium) or of requesting YPF to designate another suitable firm to take the noncomplying partner's place. The latter procedure applies also to operators. YPF regulations and consortia operating agreements generally permit any of the partners to pledge his rights deriving from the contract as security against bank loans. They often grant to the lender prior rights to production payments and, in case of the borrower's default, the right to assume the borrower's rights in the consortium and to request YPF to replace the borrower with another suitable oil firm. 2.12 An alternative to consortia is the creation of ad hoc corporations for the specific purpose of bidding for a given contract. This would make it easier to attract to hydrocarbon projects venture capital from non-oil sources. Nevertheless, this system has been seldom used for a variety of reasons. First,, tax considerations render consortia more appealing to Argentine companies because they'can offset against the company's other income the losses incurred during the long gestation period of exploration, field development or secondary recovery projects undertaken through a con- sortium, which is not possible when the project is undertaken by a separate company. Second, according to Argentine law, a firm-s participation in the fixed assets of a consortium can be revalued in the firm-s financial state- ments to account for inflation, while investments in other companies' shares must be carried at their historic cost. Thus, investments in ad hoc corpora- tions are not fairly reflected in the parent company-s balance sheet and lead to an undervaluation of assets and equity and, therefore, of the company's borrowing capacity. Third, foreign investors show a distinct preference for consortia since minority participations in limited liability companies cannot be reported on a consolidated basis according to most tax codes, so that direct investments in fixed assets (as is the case with consortia) entail considerable fiscal advantages. The above constraints to the creation of specialized companies are only partially compensated, especially as concerns investments in exploration projects, by a special provision of the risk contract law which permits the full depreciation in the same year of invest- ments in equity in an oil company, if such equity is used by the company exclusively for financing hydrocarbon exploration. Another provision of the same law allows companies engaged in hydrocarbon projects to carry forward losses, for tax purposes, for up to 10 years, and to revalue them from year to year to account for inflation, until they are written off.  - 14 - E. Prospective Investments of the Private Sector and YPF's Bidding Program 2.13 In order to achieve the authorities' goal of attaining energy self-sufficiency by the mid-1980's, the private sector would have to invest a minimum of US$5 billion over the next five years to barely maintain its current share of Argentina's total oil production (currently 35 percent). A precisely quantified projection of private investment is not possible; nevertheless, on the basis of the industry's recent performance, of the Government's stated intention to pursue its current policy of encouraging private investments, of the indicative investment programs of the sample of private Argentine oil firms visited by the mission, and assuming that suitable sources of financing are present, private investments, foreign and local, in oil and gas exploration and development through 1985 could significantly exceed the above-mentioned amount. 2.14 In 1980 alone YPF offered for bidding seven exploration and six development and secondary recovery contracts requiring, respectively, minimum investment commitments of $140 million and $320 million (see Annex 2-2). The actual investments which these contracts will require are likely to exceed these minima by very sizeable margins: exploration projects, if successful, will require large amounts of funds for field development, and production and secondary recovery projects are likely to justify financially a flow of investments well beyond the strict minima mandated by the contracts. Taking into account these considerations, as well as the consistent trend of yearly increases in YPF's yearly contract awards, these data are consistent with the above estimates of total private investments. 2.15 The bulk of the funds is expected to come from multinational oil companies, especially the more costly exploration projects, and their sub- sequent development in case of success. Argentine private firms would have to contribute between 25 and 30 percent of total private investments for the desirable global investment program to be completed, given (i) the legal requirement that foreign investors associate themselves with Argentine firms; (ii) the added security against future nationalizations represented by the participation of Argentine private capital in the consortia; and, (iii) the lack of interest of foreign companies in the smaller field development and secondary recovery projects. This would require about US$1.5 billion or more during the disbursement period of the proposed line of credit (mid-1981 to mid-1985). This order of magnitude is consistent with the current investment programs of the seven firms surveyed by the mission. These firms plan to invest, between now and 1983, based on the contracts they have already signed and on the requirements of their projects underway, about $700 million. 1/ Whether the private sector investment plans will in fact be carried out within the planned timeframe will depend to a very large extent on the availability of appropriate financing. 1/ Three of the seven firms, Bridas, Perez Companc, and Astra, are committed to investments in excess of %15f0 -mi3Allom each &xiixgixthe thkree7-eat period; the investment commitments of another three, Techint, Pluspetrol and Inalruco, range between $50 and $100 million; Quitral-co, which is involved in only three projects, plans to invest less than $30 million.  - 15 - F. Sources of Financing for Petroleum Exploration and Development Projects of Private Argentine Firms 2.16 Inadequate access to fresh capital and to bank credit has become one of the key bottlenecks to a greater participation of Argentine private firms in petroleum exp:Loration and development projects. Argentina's capital market has very moderate depth; the oil industry is considered fairly risky, and firms find it difficult to mobilize fresh equity from the market. As a result, most oil companies in Argentina rely almost exclusively on the incorporation of retained earnings into capital as a source of capital in- creases. A greater recourse to the creation of specialized companies for the purpose of carrying out specific projects is being increasingly considered by some oil firms (para. 2.12) as a means of attracting risk capital from non-oil related sources. From discussions arising during the preparation of this project, BANADE and IFC are also studying the possibility of parti- cipating in such ventures, perhaps through the creation of a special equity participation funid for risk capital investments in petroleum projects. BANADE-s equity :investments would also be eligible for financing under the proposed loan (para. 4.05). 2.17 Although, as mentioned in para. 2.07, several Argentine oil com- panies still have solid financial structures, many of them are considered to be at the limit of their borrowing capacity, according to the stringent standards of the Argentine banking community which also perceives the oil industry as risky. This is because Argentine banks, with the possible excep- tion of BANADE, possess little, if any, expertise in petroleum projects, and are in no position to evaluate the intrinsic merits of a project. Thus, they base their lending decisions principally on the strength of the borrower's balance sheet position. An exception to this pattern has been, in the past, the acceptance by Argentine banks, as security for their loans, of the pledge of YFF-s production payments to a firm according to old model contracts based on the minimum production curve (para. 2.10). Such financing, however, was just short-term cliscounting of future invoices in fields already in production. Furthermore, Argentine banks make local currency loans almost exclusively on commercial terms, with a maximum maturity of six months. Though such loans are frequently rolled over, their nature is hardly adapted to the requirements of petroleum project financing. 2.18 The only source of long-term financing in local currency for petroleum projects is BANADE (Chapter III.) Besides these loans from BANADE, the only other source of medium- and long-term financing for petroleum projects has been, so far, foreign exchange loans from the Euro-currency market. Such loans are available both from local banks (with the limitations discussed in para. 2.17) and directly from foreign banks, many of which operate branches in Argentina. Access to the latter's credit is generally still restricted in amount and in availability to the strongest and best established local oil firms. These loans are only available for the financing of field development and secondary recovery projects, and not for exploration projects. Their maturity is generally limited to five years, with no more than one year grace. They carry variable interest rates of about one per- centage point or more above LIBOR. Their maturities are hardly suitable to the needs of petroleum project financing, especially as concerns initial field development which requires long (up to five years) gestation periods before generating sizeabLe returns.  - 16 - 2.19 The above considerations explain the modest indebtedness to banks of Argentine oil firms (para. 2.07) in spite of their relative financial strength, and their considerable requirements of credit financing. Total debt to banks and financial institutions of the seven major oil firms surveyed by the mission amounted, according to their latest financial statements, to the equivalent of US$330 million of which almost half was at short term, compared with total assets of US$880 million. The expected materialization of the investment program discussed in paras. 2.13-2.15 will require a much greater recourse to bank credit, especially at long term, by Argentine oil firms. Assuming that at least 30 percent of the projected investments will be financed with fresh equity or self-generated cash, bank credit for more than US$1.0 billion will be required by the domestic private oil firms through 1985. The proposed line of credit is intended to help bridge this financing gap directly and indirectly. III. THE INTERMEDIARY--BANCO NACIONAL DE DESARROLLO 3.01 Banco Nacional de Desarrollo (BANADE) was created as an autonomous government-owned development bank in 1970 from the former Banco Industrial, which, in turn, had been established in 1944 to provide term financing for industry. By early 1976, however, lending at highly negative interest rates had almost completely eroded BANADE's equity base, and its lending operations came to a virtual standstill. Recognizing the importance of this institu- tion as virtually the only domestic source of term financing for industry, the Government recapitalized BANADE, brought in an experienced board of directors and adopted a new charter. In order to support efficient indus- trial projects and assist in overall institution building, the Bank made a US$100 million loan to BANADE in 1977 (Loan 1463-AR), which is almost fully committed. 3.02 Approximately 55 percent of the funds under Loan 1463-AR have been utilized to finance reequipment of local industry to increase production efficiency, enabling firms to compete in a new environment of reduced protec- tion. Most of the borrowers for this purpose have been medium and small industries. The remaining funds have been used for capacity expansion of larger enterprises. In part, as a result of Bank efforts, BANADE's institu- tional capacity to appraise projects has been enhanced, and a new unit has been created to perform industrial sector studies to focus BANADE's promo- tional efforts. Although some institutional improvement is still necessary (paras. 3.06 and 3.07), BANADE has been strengthened significantly; it is now the fourth largest bank in Argentina, in terms of both loans and deposits, and has been able to continue its support of industrial and mining activities in the country. BANADE's charter underlines its role as a term-lending industrial development institution within the Government's overall policy framework, and provides safeguards for the maintenance of operational autonomy, satis- factory evaluation standards and financial viability. It is an institution of sufficient size and importance to finance the fast-growing oil and gas sector, and an appropriate channel for a Bank loan to the sector.  - 17 - 3.03 The fo:llowing is a brief description of BANADE-s management, overall activities in the oil and gas sector, and other aspects relevant to the proposed project. Additional information on past operations, including BANADE's charter and statement of policy, is contained in the appraisal report of the Industrial Credit Project (Report No. 1521B-AR). The forth- coming second indlustrial credit project appraisal report will contain more detailed informat.ion on BANADE's overall operations. A. Organization and Operations Board of Directors, Management and Staff 3.04 BANADE"s board consists of a chairman, two vice chairmen, and nine directors, all appointed by the Government for terms of four years. The present chairman, vice chairmen and directors had several years of experience with banking, industry and the Government prior to joining BANADE. 3.05 BANADE is administered through its general manager and six assistant general managers (see organization chart, Annex 3-1). Lending operations are conducted through four departments: (i) investment and development credit (industrial project financing); (ii) mining credit; (iii) ordinary credit (commercial banking operations and development credit for small and medium industries); and, (iv) external financing (import/ export financing). Resource mobilization activities are carried out by the finance department (local) and the external finance department. BANADE has 33 branches through- out the country and some 3,600 full-time employees. 3.06 Although BANADE has several experienced professionals, institution building has taken somewhat longer than expected for several reasons. Management, which has devoted more time to day-to-day operations, has not been able to mount effective staff development programs and implement im- provements in the control system. BANADE also has less than fully com- petitive salary scales, a problem faced by other Government agencies as well. Since salary scales are fixed on a Government-wide basis, and are outside of management-s control, management has responded by allowing tech- nical staff in particular to work part-time to enable them to supplement their salaries with other activities. The existing situation is stable, and, although nct ideal, involves a long-established practice in BANADE and other state enterprises and thus is difficult to modify. The overall institutional issue is being addressed in the context of the Bank's super- vision of Loan 1463-AR and the proposed second industrial credit project. The proposed project concentrates on strengthening BANADE's oil and gas lending unit (paras. 3.21 to 3.23). 3.07 Although monthly financial statements are prepared for management, BANADE's management information system also requires improvement to permit efficient monitoring, programming and planning of operations. Appropriate measures including the possibility of hiring specialized consultants are being discussed together with the institutional issues mentioned above.  - 18 - Operations 3.08 BANADE lends to a broad cross section of industries in several sectors. In 1980, about 67 percent of total portfolio were local currency loans, and the remainder were foreign currency loans. About two-thirds of the loans made by BANADE in 1980 were for fixed asset financing. For local currency loans in particular, about 80 percent of commitments were made to manufacturing industries, close to ten percent to mining and other extraction industries and about ten percent to services and other activities. BANADE also acts as a financial agent for Government-owned enterprises to secure foreign long-term funds at reasonable terms. 3.09 The total loan portfolio of BANADE amounted to about A$3,700 billion at year-end 1979 (about US$2.3 billion equivalent) and reached about A$7,100 billion (about US$3.6 billion) by year-end 1980. B. Oil and Gas Lending Past Operations 3.10 To date, BANADE has made eight loans for oil and gas development projects using its own resources. Most of these loans were made in 1977 to finance projects involving contracts awarded by YPF in 1976, with no loans made during the last two years. BANADE has not lent for exploration projects to date. Total amount outstanding for oil and gas projects at year-end 1979 was about US$77 million equivalent. 3.11 An analysis of five of the subprojects financed by BANADE showed ex ante financial rates of return (FRR) in real terms in excess of 30 percent. In view of the products involved, the lower than world prices stipulated in contracts as delivery prices to YPF, and the cost of inputs (likely to be higher than border prices on average), the economic rates of return (ERR) should exceed the FRRs significantly. The overall implementation experience of BANADE to date has been satisfactory, with no significant arrears and with only one project experiencing moderate problems due principally to excessively low contracted output prices. Appraisal and Supervision of Oil and Gas Projects 3.12 Although the information contained in BANADE s appraisal reports in the past is acceptable, its evaluation of technical aspects and risks relied almost exclusively on YPF's guaranteed minimum production curve specified in contracts in the past (para. 2.10). Based on this, BANADE was willing to finance up to 15 percent of the gross value of the minimum produc- tion. When YPF changed the basis for its production contracts, eliminating the minimum curve, BANADE felt itself incapable of evaluating oil and gas projects and decided to suspend lending to the sector. 3.13 Supervision was also minimal and consisted mostly of disbursement checks to ensure that funds were being utilized for the stated purposes, with little if any follow-up thereafter.  - 19 - Future Operations in the Oil and Gas Sector 3.14 BANADE,, with Bank assistance, has prepared and adopted a statement of policy on oil and gas activities which emphasizes project appraisal as the principal basis for lending and investing. BANADE would finance mostly primary and secondary recovery projects of private firms including pipelines and gas treatment plants, as well as some exploration projects presented by financially strong firms. The policy statement, which was discussed and agreed to during negotiations, incorporates the key points on appraisal/ supervision criteria mentioned below (See Annex 3-3). 3.15 BANADE's appraisal of projects would be based on a detailed fea- sibility study p-resented by sponsoring firms which would enable BANADE to evaluate the technical, financial and economic viability of subprojects, including enviro:c;mental aspects. Information requested would include the geophysical, geological and reservoir aspects, plan of investments, and projected operating costs, production and revenues. The experience and technical capability of the operator and of the sponsoring company would be considered in t5e evaluation, together with the conditions of contract with YPF and the operating agreement among the partners involved in the project joint venture. B1ANADE may finance any or all of the partners involved in such joint ventures. 3.16 BANADE's oil and gas development loans would be secured by inter alia an assignment of contract rights and would finance up to 80 percent of project costs. At least 20 percent of the project cost (or the proportionate amount if BANADE finances only some of the partners in a joint venture) would be provided by the sponsors from their own resources. 1/ Loans would remain general liabilities of sponsoring companies. Where ad hoc corporations are set up to undLertake a project, completion agreements would be required from the parent firms. To ensure that sponsoring companies are adequately structured financially to undertake the project, they would have limits on debt/equity ratios (at most 3:1) and have adequate annual term debt service coverages over the life of the loans. Loans would have a fixed amortization period, with provisions for accelerated repayment based on a percentage of relevant production payments. 3.17 For exploration projects, sponsoring companies should provide at least 30 percent of project costs (proportional amount in the case of joint ventures) b:>y funds unsecured by the contract. Sponsoring companies should be capable of servicing their debts in the event the exploration project is unsuccessful. To ensure this, the companies would be required over the life of the loans to maintain: (a) at most a debt/equity ratio of 3:1 after deducting the investments for the exploration project from both assets and equity; (b) adequate annual term debt-service ratios and, (c) a minimum current ratio. Loans would have maximum amortization periods of up to fifteen years and could be prepaid by the borrower or folded into development loans by BANADE if the project is successful. 1/ Or sources which would not be secured by assignment of YPF contract rights.  - 20 - 3.18 BANADE would supervise the projects, which would include frequent field visits during implementation, and submission to BANADE of annual reports on investment plans and production projections, and quarterly reports on investments made, operating expenses, production and revenues. BANADE would also require borrowers to present audited annual financial statements. 3.19 In order to help offset the cost of appraisal and supervision, BANADE may request for warrants or loan convertibility options in connection with its lending operations. Since some of the technically qualified project sponsors may be undercapitalized, BANADE may also invest (minority participa- tion) in the equity of oil and gas firms. 3.20. As previously mentioned (para. 2.17), most commercial banks are not equipped to appraise oil and gas projects. BANADE would utilize its appraisal capability as a catalyst to mobilize funds from local and foreign banks for properly screened sub-projects (para. 3.24). Several private banks already have indicated their intention to jointly finance subprojects with BANADE. Organizational Arrangements for Oil and Gas Lending 3.21 BANADE carried out its oil and gas lending operations in the past with a small staff consisting of a coordinator, an engineer and a financial analyst. Recognizing the large demand for and complicated nature of petroleum projects, BANADE has established a separate division in its mining department to deal with energy projects, particularly oil and gas projects. A division head, who has several years of experience with BANADE dealing with large state projects, has already been selected and has started promotional activities. The division presently has several financial analysts and an economist, but no technical staff. To strengthen the division, BANADE would hire three geologists and three petroleum engineers within the next few months. Due to BANADE's salary level constraints, however, it cannot expect to hire senior technical staff (para. 3.06). BANADE would therefore contract from a consult- ing firm the full-time services of an experienced geologist and petroleum engineer for a minimum period of two years to help appraise projects and to train BANADE's staff on the technical aspects of oil and gas lending. Ini- tially, the review of BANADE's appraisals under the proposed loan would be supplemented with field visits by Bank staff to assist in building up BANADE's appraisal and supervision capacity (para. 4.07). The objective would be to develop sustainable general oil and gas project appraisal and supervision skills within BANADE, such that in the future, it would only require special- ized consultancy assistance on a case by case rather than on a full time basis. Some overcapacity would be built into BANADE's technical staff to allow for staff turnover. 3.22 To assist BANADE in this regard, US$1.0 million of the proposed loan would be set aside to finance consulting assistance and training of BANADE's staff. In order to accelerate the hiring of consultants,  - 21 - advance contracting would be permitted up to the full amount of this com- ponent, including retroactive financing of up to US$200,000. The qualifi- cations, experience and terms and conditions of employment of the consul- tants shall be satisfactory to the Bank. The hiring of petroleum engineers and geologists for the energy division, and the selection of an appropriate consulting firm, would be conditions of effectiveness of the proposed loan. Agreement was reached during negotiations that BANADE would maintain adequate staff, including consultants, for oil and gas lending. Project Pipeline, Size of Proposed Loan and Cofinancing 3.23 Surveys carried out by BANADE and the Bank indicate that substantial investments are planned by private Argentine companies (para. 2.15), and that inadequate access to appropriate credit and to fresh capital has become a key bottleneck to implementation of petroleum development projects by local firms. Assuming a continuation of present Government policies, a line of credit of US$200 million could be committed in less than two years. Given the need for appropriate funds in this sector, BANADE would arrange for joint financing at the subproject level from other sources and is actively exploring cofinancing of about US$100 million under standard conditions. Since actual negotiations may take time, provision would therefore be made to associate cofinancing with the proposed loan after Board presentation. Such an arrangement would be similar to the cofinancing operation of US$100 million (now completely dis- bursed) associated with Loan 1463-AR. 3.24 To the extent necessary to attract joint financing at the subproject level, BANADE would: (a) share subproject information with other lenders; (b) include a cross-default clause in its subloan agreements; and, (c) skew its subloan amortization schedules towards later maturities. 3.25 BANADE would like to resume lending to the oil and gas sector as soon as possible with Bank financial and technical support. BANADE began its promotional efforts in November 1980 and is expected to have one or two subprojects soon. In order to maintain the momentum of BANADE's efforts, it is proposed to approve retroactive financing in the amount of US$5 million for subproject expenditures made after April 1, 1981. Coordination with YPF 3.26 Close coordination would be required between BANADE and YPF at the policy and operating levels to enable BANADE to program its oil and gas lending on the basis of YPF's plans to award contracts, and to give BANADE access to b.idding and technical information necessary in the appraisal of specific subprojects. Agreement was reached with the Government during negotiations that YPF will facilitate provision of relevant information to BANADE.  - 22 - C. BANADE's Financial Structure, Results and Projections 1/ Financial Structure 3.27 Banade's policy statement limits total debt to ten times capital and reserves. As of year-end 1980, BANADE's debt/equity ratio was 5.5:1, which, although much higher than the 2.6:1 ratio of year-end 1979, still allows for considerable additional leverage (Annex 3-2). BANADE would not require additional capitalization to draw down the proposed loan. The debt/equity ratio rose due to continued growth in liabilities (both locally mobilized time and demand deposits and foreign borrowings) and some equity erosion in real terms (para. 3.28). Total assets reached A$9,068 billion at year-end 1980 (about US$4.6 billion equivalent), a 29 percent p.a. increase in real terms (using the WPI, wholesale price index, as deflator) over the year-end 1979 level. The growth of assets, loan portfolio and equity compared with the inflation rate are shown below: 1976 1977 1978 1979 1980 in A$ billion Total assets 216 622 1,901 4,464 9,068 Index 100 288 880 2,067 4,198 Total loan portfolio 119 381 1,392 3,676 7,136 Index 100 320 1,170 3,089 5,997 Equity 84 211 517 1,166 1,398 Index 100 251 615 1,388 1,664 Wholesale price index 100 249 612 1,525 2,410 3.28 As shown above, from 1976 to 1980, total assets increased forty-two fold, 2/ the loan portfolio sixty fold from a smaller base, and equity-about seventeen fold. The wholesale price index increased about twenty-four fold over the same period. Thus, while assets, including the loan portfolio, increased substantially in real terms, the equity base of BANADE declined by about 30 percent over the same period. Although not satisfactory, this result is still a distinct improvement over the results in 1975 prior to the Bank's involvement with BANADE, when equity declined to only about US$7.0 million equivalent after years of lending at highly negative interest rates in real terms. Management has implemented several steps to help ensure maintenance of equity value in real terms in the future (para. 3.29). 1/ This section was prepared in cooperation with the LCPID2 Division. 2/ Almost all of BANADE's assets are financial.  - 23 - Revenues and Costs 3.29 BANADE now charges a floating interest rate on its term loans in pesos which is based on the Central Bank-computed weighted average of interest rates paid on term deposits (tasa testigo); short-term loans are made on a high nominal fixed rate basis. BANADE used to charge peso interest rates in term loans linked to the wholesale price index, which proved satisfactory at a time when most peso lending was made using Central Bank and equity funds. However, with the growth of time and demand deposits, which now fund some 30 percent of assets (up from eight percent in 1977), BANADE became exposed to substantial risks arising from divergence between the deposit rates and relending rates. T'his eventually caused a negative spread leading to the erosion of BANADE's equity in real terms mentioned above. Since May 1980, all new term loans in pesos have interest rates based on the tasa testigo. In March 1981, interest rates on all outstanding term peso loans were converted from a WPI base to a tasa testigo base invoking a clause incorporated into loan agreements allowing BANADE to change the index for peso interest rates. Loans using foreigna currency funds are passed on in the same currency as borrowed, with a spread for BANADE. 3.30 The high rate of inflation experienced in Argentina precludes a meaningful detailecl analysis of past income and expenses. However, rough estimates indicate administrative expenses of about 3.0 percent of average total assets, which is lower than the estimated 4.0 percent in 1975 but still somewhat high, due principally to the number of small loans made, the system of branches, and the still large number of certain categories of staff relative to volume of operations. As efficiency further improves due to measures such as staff training and restructuring of the management control system, this should decline somewhat over the next few years (para. 3.34). Sources of Funds 3.31 At year-end 1980, about 39 percent of BANADE's liabilities were accounted for by deposits, another 42 percent by foreign obligations, with the remaining amount accounted for by miscellaneous liabilities. A term loan of US$250 million (eight years term) made by a consortium of foreign banks to BANADE, acting as financial agent for several state-owned enterprises, is included as part oE BANADE's foreign obligations. BANADE's local resource mobilization capability, using the system of branches, gives it considerable flexibility in providing peso funds for projects, in addition to funding its more traditional, short-term commercial banking operations. Quality of Portfolio 3.32 The board of BANADE reviews the status of past due loans monthly to determine the reserve to be set aside from income for possible losses. In common with othLer financial institutions in Argentina, and due to the difficult situation facing the industrial sector as a whole, BANADE's arrears situation deteriorated over the past year. Total loans in arrears amounted to about 6.4 percent of total portfolio at year-end 1980, compared to about four percent at year-end 1979. Portfolio provisions, at about 10.2 percent  - 24 of total portfolio at year-end 1980, and reserves which are part of BANADE's equity. BANADE's term loans are secured by pledges on assets, mortgages and other guarantees. Most short-term commercial credits representing about 13 percent of BANADE's portfolio are unsecured. Auditing Arrangements 3.33 Due to legal obstacles in the past to the use of private external auditors, under Loan 1463-AR the Bank made special arrangements with the Central Bank of Argentina to fulfill the Bank's external auditing requirement. Audited reports were received up to 1978. After discussions regarding the audit report for 1979 and subsequently, for 1980, the Bank was informed that the Central Bank would be unable to undertake the auditing task in the future due to pressing matters in the financial sector requiring its attention. Also, due to changes in regulations, BANADE may now, and in fact is required to, hire an external auditor. BANADE is now in the process of selecting an auditor to begin with the 1981 audit. In view of the reluctance of external auditing firms to undertake ex post audits and the delays such an arrangement could cause, BANADE has proposed an interim arrangement involving its Sindico, a representative of the National Executive Authority who oversees compliance with the provisions of BANADE's charter and Central Bank regulations, and of operations and accounting procedures. The Sindico would hire independent accountants and would present the audited statements for 1980 with comparative figures for 1979 in accordance with the Bank's requirements. The scope and timing of the audit, the personnel involved and the schedule for presentation of audited reports were discussed and agreed during negotiations. Agreement was also reached during negotiations for the establishment of separate accounts for the proposed loan. Presentatior of audited accounts satisfactory to the Bank for 1980 with comparative figures for 1979 and the hiring of an external auditor acceptable to the Bank for the 1981 audit would be conditions of effectiveness of the proposed loan. Financial Projections 3.34 Indicative financial projections of BANADE (Annex 3-2) show the debt/equity ratio remaining below 10:1 over the forecast period up to 1985, with some growth in real terms of the loan portfolio (7.0 percent p.a.) and total assets (4.5 percent p.a.). Although the growth rates are moderate, structural shifts are expected within the portfolio, with more emphasis on medium- to long-term lending and less on working capital peso denominated loans. Correspondingly, on the liabilities side, time and demand deposits are expected to remain practically constant in real terms over the forecast period. Deposits with BANADE increased sharply over the past few years partly due to its strong efforts but also due to the turmoil in the financial sector which led to deposit shifts from private to public banks. As a more secure financial intermediary with a large share of deposits, BANADE then also had to provide a larger share of working capital credit to industry. With the expected improvement of conditions in the financial system, BANADE can then emphasize medium- and long-term lending based on both foreign borrowing, its deposit base which is projected to remain constant in real terms, and its equity. Due to the change in BANADE's peso lending index (para. 3.29) and  - 25 - satisfactory financial policies in general, BANADE's equity is projected to increase by about 4.8 percent p.a. in real terms over the forecast period, taking into account some initial deterioration in 1981 up to March before the change of the index and continued increases in loss reserves. The projected loan assets, loan portfolio and equity are shown below in 1980 pesos. (A$ billion in 1980 prices) 1980 1981 1982 1983 1984 1985 Total Assets 9,068 10,192 10,758 11,043 11,230 11,347 Loan Portfolio 7,136 8,696 9,231 9,541 9,800 9,991 Total Equity 1,398 1,281 1,470 1,550 1,630 1,769 Administrative expenses have been projected to decline only moderately to about 2.4 percent of average total assets by 1985, to take into account the costs of new areas of lending such as for petroleum and energy conservation. IV. THE PROJECT A. Background and Objectives 4.01 The proposed project is in response to a Government request to the Bank for financial and institutional assistance in oil and gas sector development. In pursuit of its objective to improve sector efficiency and increase output, the Government has given top priority to enhancing parti- cipation by private firms in petroleum exploration and development. However, for reasons mentioned previously, given the magnitude of required investments, local firms have found it increasingly difficult to secure appropriate finan- cing for required investments and would have problems with participating actively in sectorc development unless additional funds are made available. 4.02 The proposed project would support the Government's efforts to strengthen the role of the Argentine private sector in an accelerated pro- gram of oil and gazs sector development by: (a) providinlg long-term financing for sound exploration, primary and secondary recovery projects, including pipelines and gas treatment plants; and, (b) providinag technical assistance to develop BANADE-s institutional capacity to identify, appraise and supervise oil and gas projects. The project would also act as a catalyst, through BANADE, to mobilize re- sources from foreign and local banks for properly screened subprojects and would be a vehicle for sectoral policy discussions with the Government. 4.03 The proposed project was identified during the visit of a Bank petroleum sector m:ission in August 1979; preparation was assisted by a mission in July 1980. Appraisal took place in November 1980.  - 26 - B. The Proposed Loan Terms and Conditions 4.04 The proposed loan of US$100 million would be made to BANADE with the guarantee of the Argentine Government. It would be utilized to finance the foreign exchange component of petroleum projects implemented by the private sector and would include a technical assistance component of US$1.0 million. The loan would be made at the current Bank interest rate (presently 9.6 percent p.a.) and standard commitment fee on the undisbursed balance (0.75 percent p.a.). BANADE would relend the proceeds in US dollars at 13.5 percent p.a. which includes both a spread and a cross currency risk for BANADE. BANADE's equity investments in connection with specific subprojects would also be eligible for financing under the loan. The proposed loan is expected to be committed by December 31, 1983 and disbursed by December 31, 1985. The loan would have a term of 15 years including three years of grace with the amortization schedule in approximate conformity with: (a) the composite subloan and agreed investment amortization scheduled at the time of commitment for US$99.0 million; and (b) the standard Bank amortization schedule for the US$1.0 million technical assistance component. Funds from subloans which are prepared or investments sold ahead of schedule would be retained by BANADE and be used for similar projects. The amortization schedule applicable to each subloan and the schedule of repayment to the Bank in respect of each investment shall provide for a grace period not exceeding three years in the case of subloans and five years in the case of investments, and shall not extend beyond 15 years from the date of loan signing. The above-mentioned terms and conditions and those mentioned below (paras. 4.05 to 4.11) were discussed and agreed upon with BANADE during negotiations. Subloan Terms and Conditions 4.05 Eligible subborrowers or recipients of BANADE investments would be private Argentine companies 1/ which have been awarded (or are part of a consortium which has been awarded) an exploration (risk) or primary or. second- ary recovery contract by YPF. Subloans and investments would finance the foreign exchange component of oil and gas exploration and primary and secondary recovery projects, including related investments such as pipelines and gas treatment plants. Financing from the proposed loan would be limited to US$20 million per subproject, even though average subproject size is expected to be about US$80-100 million, to encourage BANADE to seek joint financing of the larger subprojects from other intermediaries and to ensure that Bank loan funds are distributed over a reasonable number of subprojects. Agreement would be obtained from BANADE at negotiations that it will obtain, for each subproject, the necessary funds to complete the subproject financing plan prior to presentation of the subproject to the Bank. The amortization schedule of the proposed loan would allow BANADE the flexibility to blend medium term funds from other sources with long-term Bank funds. 1/ At least 51 percent owned, directly and indirectly, by Argentine nationals, as defined by law. Foreign firms may have a majority position in the joint ventures implementing subprojects, but only the share of the Argentine partners would be financed under the loan.  - 27 - 4.06 Subloans would be secured to the satisfaction of BANADE, including through an assignment of production payments and contract rights. When ad hoc corporations are. established to implement a project, completion agreements would be obtained from the parent companies. Subproject Review 4.07 BANADE