Peru - Petroleum Production Enhancement Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 3856-PE STAFF APPRAISAL REPORT PERU PETROLEUM PRODUCTION ENHANCEMENT PROJECT July 19, 1982 This document has 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 EQUIVALENTS Currency Unit - Sol (S/.) Average of End of Year Year 1981 1980 1981 June 1, 1982 US$1000 = S/. 426.60 S/. 341.17 S/. 506.17 S/. 644.04 S/. 1 = US$0.0023 US$0.0029 US$0.0020 US$0.0016 S/. 1000 -. US$2.34 US$2.93 US$1.98 US$1.55 FISCAL YEAR January 1 to December 31 WEIGHTS AND MEASURES GW = Gigawatt (million kW) kW = Kilowatt TOE = Tons of oil equivalent bbl = Barrels (of 42 gallons) BD = Barrels per day gal = US gallon (3.78 liters) bcf = Billion cubic feet km = kilometer (0.62 miles) tpd = tons per day tpy = tons per year ABBREVIATIONS AND ACRONYMS CENTROMIN = Empresa Minera del Centro del Peru (Mining Company of Central Peru) COFIDE = Corporacion Financiera de Desarrollo (National Development Bank) D. L. = Decree-Law ELECTROPERU = National Power Generation and Distribution Company IDB = Inter-American Development Bank IPC = International Petroleum Company MEM - Ministry of Energy and Mines MINEROPERU = Empresa Minera del Peru (State-owned mining company) PETROPERU = Petroleos del Peru (National Petroleum Company) PMSC = Project Management Service Company PPU = PETROPERU Project Unit  - i - FOR OFFICIAL USE ONLY PERU PETROLEUM PRODUCTION ENHANCEMENT PROJECT STAFF APPRAISAL REPORT Table of Contents I. THE ENERGY SECTOR . ........................... ................ 1 A. Introduction ......... 0.................................................. 1 B. Energy Balance and Resource Base ........... ............. I Hydropower ................................................... .. * 2 Natural Gas ............................................ .............. 2 Coal ............................................................. 3 Geothermal Resources ............................................ . 4 Nuclear Fuels and Developments ....................... 4 Other Energy Resources ...................... .. . 4 C. Energy Consumption and Outlook ....... .......... ........... 5 D. Energy Sector Organization, Planning and Policies ....................... .0 ..................................... 6 E. Framework for Proposed Project o...... 8 II. THE PETROLEUM SECTOR ............. . ........... . .................. . 8 A. Past Developments and Overview .................... o...... 8 Bo Government Policy ... ............. .. ...... . 10 Petroleum Exploration and Development Strategy.o ... so............o ..................... ................... 10 Historical Perspective .............. ... ............. 10 Current Policy ..... *......................... ........................ 11 Pricing Policy ........ 0.... 6-0 ........................................ 12 Taxation Policy ........................ 0...*.......... ................. 15 C. Petroleum Resources ..... ............ . . . .............. . 17 Geology ...... s.o....... o.......................o.... o........ 17 Reserveso ........ o......o .................................. 17 Recent Production Trends ........... ......... ......... . 18 This report was prepared by Messrs. C. Khelil, P. Vabre, and B. Zinman (consultant) of the Energy Projects Department. This document has 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.  - ii - D. Consumption of Petroleum Products ................ o..... 19 E. Refineries, Industrial Plants, Marketing and Transportation..0 ..........................o.,o*. oe ...... 20 F. Development Prospectse ...... . ...... ..... 21 New Exploration Activity .. . ... 21 Exports ......... ..... ............. 22 Investment. .. . ...,.. ...... ............... . - . . 23 Role of the Bank ........... o. .....a..... a........*. 24 III. THE BORROWER........oo..............o . . ............ .. *-S 25 Back-round. ........ .o...O.... ........ ...... .......** 25 Operations... ........... Ge.................... - ...... 25 Organization ....................... . -o^ e...... 26 Staffing, Management and Salaries .................... 27 Accounting and Auditing ............................. . 28 Insurance ............. ........ 29 IV. THE PROJECT .......o....... ooo........................Icoo.... 29 Project Background and Objectives ............00....... 29 Project Description .......................... -.... 30 1. Enhancement of Existing Oil Production .. .30 2. Consultancy Services and Training ................ 32 Status of Project Preparation . . 33 Project Implementation .. .............. ....... -..... 34 Project Costs .. . .................... 36 Project Financing Plan ....................... ...... 37 Co-financing ........................... ...... .....* 38 Proposed Loan Terms ............................ 39 Disbursement and Allocation of Bank Loan ............. 00 39 Procurement ................ . e .. .... 40 Project Risks ..............0 , , 0.00 .... ....... ..... 40 Training ................................... -...... 41 Environmental Considerations and Safety . ............. 41 Schedule and Reporting ........................ ...... 41 V. FINANCIAL ASPECTS .... ........ o_ . ................... 42 IntroductionO ..;............ .@...........s. -..... 42 Past Financial Performance .................... ... .000 42 Present Financial Situation . ......... ....... 44 PETROPERU's Investments ...... I9o@ ....... .....a@0@D e 46 Financial Prosoects .... .................... -,Z so.... 49 Summary Assessment and Financial Covenants......... 52 VI. ECONOMIC AND FINANCIAL ANALYSIS OF' THE PROJECT............. 53 VII. AGREEMENTS REACHED AND RECO;NMENDATIONSO.............. -O..... 54  - iii - LIST OF ANNEXES 1. Glossary of Technical Terms ............................. 56 2. Related Documents Available in Project File . . 58 3. Energy Sector Table 1 - National Energy Usage by Source of Energy .. . .......... . 60 Table 2 - National Energy Usage by Final Consuming Sector . ............... 61 Table 3 - Energy Consumption by Source (%) .. 62 Table 4 - Exports and Imports of Petroleum Derivatives by Volume and Value ....... 63 Table 5 - PETROPERU'S Refinery Output ............ 64 Table 6 - Price of Petroleum Products ............ 65 Chart I - Weighted Average Retail Price of Petroleum Products in Peru.... 66 4. Terms for New Oil Contracts ......................... .... 67 5. PETROPERU - Organization Chart .......................... 68 6. Reserves and Production Potential of the Laguna-Zapotal Fields .............. 69 Chart 1 - Production Forecast of Laguna-Zapotal Fields.... .............. 70 7. Review of Status of Petroleum Production Rehabilitation Project-Loan 1806-PE ................... 71 8. Notes and Assumptions on Financial Projections .......... 74 PETROPERU Financial Projections Table 1 - PETROPERU - Income Statements ....... ..... 78 Table 2 - PETROPERU - Balance Sheet ........... .... 79 Table 3 - PETROPERU - Sources and Uses of Funds ............................... 80 9. Economic and Financial Analysis of the Project Table 1 - Project Economic Cost and Benefit Streams . . 81 Table 2 - Project Financial Cost and Benefit Streams ....................... . 82 MAPS IBRD 16174 - PERU - Contract Areas of Petroleum Operations IBRD 16175 - PERU - Pacific Coast Operations  I  I. THE ENERGY SECTOR A. INTRODUCTION 1.01 Petroleum is the dominant source of energy in Peru, supplying about 80% of the country's commercial energy requirements. There is scope for ex- panding the role of hydropower and, to a limited extent, coal for future electricity generation. Nonetheless, petroleum will still provide the major part of Peru's energy requirements for the rest of this century. After having been dependent on imported crude oil for many years to meet its petroleum needs, Peru increased its oil production almost threefold between 1976 and 1979, enabling it to export crude oil in 1978 for the first time since 1958. With this encouraging production trend, domestic consumption rose sharply after several years of stagnation. Peru's continued ability to meet domestic oil requirements beyond the mid-1980s, will be assured only if new oil reserves are discovered and developed. 1.02 As a consequence, since 1980, the Government's strategy in addressing Peru's future energy needs has been aimed at increasing petroleum production through accelerated exploration and development while attempting to restrain domestic demand and encourage efficient use of petroleum products, mainly through pricing policy. In this connection, the Government has recognized that petroleum exploration and development, particularly in the Amazon basin, require more resources and technical expertise and management skills than it can provide. Partly for this reason the Government has adopted legislative and policy measures designed to attract foreign oil companies, several of which have already committed substantial amounts of risk capital for petroleum exploration in Peru. 1.03 The following paragraphs present a brief description of the hydro, gas, coal, and other energy sources, along with a discussion of the anticipated energy use patterns over the next several years. Section II will treat the oil sector in a more detailed manner. B. ENERGY BALANCE AND RESOURCE BASE 1.04 Peru has potentially large and diverse energy resources. Proved and probable oil reserves total about 800 million barrels, of which proved reserves amount to about 715 million barrels. Gas reserves are relatively small; according to PETROPERU, proved gas reserves amount to about 2,100 bcf (49 million TOE) and an additional 775 bcf (18.6 million TOE) of probable reserves are estimated. Peru has numerous hydroelectric sites with an econo- mically potential capacity totaling 60 GW, of which only 1.7 GW have been developed. Some coal deposits suitable for thermal power generation or for metallurgical coke have been identified but most of the country has not been adequately explored for coal. Warm and boiling springs exist in many parts of the country but the size of geothermal resources is unknown. In Peru's rural areas, wood is the single most important energy source, accounting for about 75% of energy requirements.  1.05 A summary of the Ministry of Energy and Mining's (MEM) estimate of Peru's gross energy balance is shown below: Primary Energy Source % Share End Use 1/ % Share Oil 60.0 Industry and Agriculture 36.3 Firewood and Dung 26.0 Residential and Commerce 36.2 Hydropower 6.2 Transportation 21.4 Natural Gas 4.7 Public Sector 3.0 Bagasse 2.5 Other (incl. non- Coal 0.6 energy use) 3.1 100.0 100.0 Source: MEM - National Energy Balance, 1981 Hydropower 1.06 With an average annual growth rate of 6.7% in installed capacity since 1965, hydropower has been growing rapidly. While accounting for only 6.2% of Peru's primary energy source (8.4 % of commercial energy production), its potential for continued growth is enormous, as current capacity of about 1,700 MW represents only about 3% of the country's estimated technically viable hydro potential of some 60,000 MW. Development of a good part of this potential, however, will involve tapping hydroelectric resources of the Atlantic watershed since only 15% of potential sites are on the Pacific side of the Andes. Thus, most new sites would be far from demand centers, with consequent increases in the cost of delivering energy to consumers. In any case, MEM plans to develop as much of the country's hydro potential as is feasible, and as part of its master plan for the central-north system, the Ministry has specified some 30 hydroelectric power projects which are at various stages of study. In this connection, a Bank-financed power engineer- ing project (Loan 2018-PE) is helping to finance preparation of prefeasibility and feasibility studies for 12 hydroelectric projects, totalling over 1,000 MW of generating capacity, the construction of which must begin within the next two to four years to meet accelerating power demand in Peru with a minimum of dependence on thermal generation. To help meet the cost of hydropower expan- sion, the Government, toward the end of 1980, initiated a program of monthly electricity tariff increases averaging close to three percent per month in real terms. The Government is maintaining a program of regular increases during 1982, with the objective of enabling the sector to finance one-third of its investment program from internally generated sources. Natural Gas 1.07 Natural gas is not an important contributor to Peru's energy needs. It is produced mostly as associated gas primarily in the coastal oil-producing areas in the northwest around Talara, where it is used mainly as a fertilizer I' Peru's total energy consumption amounted to about 12 million TOE in 1980.  feedstock rather than as a direct energy source. Most of the fields in the Amazon region produce only small quantities of gas which is used for local fuel requirements with the remainder either flared or injected to provide additional lift in oil-producing wells. Peru's total gas output has fluctuated between 64 and 86 bcf p.a. from 1970 through 1980. Production is projected to total 70-75 bcf per year for the next five years (about 14 million bbls of oil equivalent). 1.08 Estimates of Peru's undiscovered gas resources range widely -- from one to 11 trillion cf. As mentioned earlier, PETROPERU estimates proven and probable reserves at 2,875 bcf. Proven reserves of PETROPERU's Aguaytia fields in the Selva Central (Central Jungle) account for over one-half of the nearly 970 bcf of non-associated gas reserves (proven and probable) in the Selva. The proven reserves of this field, however, do not, at this time, justify the cost of a pipeline from its isolated location to potential con- sumption centers. The only other area with considerable potential is in the offshore Progreso Basin; most of the potential producing areas in that basin, however, lie in Ecuador's territory. Coal 1.09 Peru has been producing coal since the latter part of the nineteenth century. From about 1960 onward, much of the production and all exports of coal ceased. Over the past 10 years, coal output has averaged only about 30,600 tpy, and in recent years accounted for less than one percent of Peru's total energy sources. Thus, only a small part of industry's demand for coke and coal has been met from domestic production. To fully meet its needs, which are relatively modest, Peru imports about 40,000 tpy of coking coal and about 144,000 tpy of coke. 1.10 Coal deposits -- ranging from lignite to anthracite -- have been reported in 18 of Peru's 24 Departments. But even in central and northern Peru, where the deposits seem to have the best economic potential, the coal strata are subvertical, highly fractured, and the thickness as well as the quality of the seams vary widely within short distances. While no reliable record of cqal reserves exists for Peru, MEM estimates total "inferred reserves" 1 at about 1.1 billion tons, of which anthracite constitutes about 880 million tons. Only 2.4% of this latter total represents "measured reserves," for which tonnage has been computed from measurements in outcrops, trenches, mine workings or drill holes. 1.11 Modest exploration efforts for coking coal are being made by SIDERPERU for its Chimbote steel plant, and by MINEROPERU for coal to fire a proposed ELECTROPERU power plant. Also, CENTROMIN has recently begun explor- ing for coking coal to meet its own needs. Despite these efforts, Peru lacks a systematic evaluation of its coal resources. All in all,.new financially feasible coal mines could only be developed if exploration delineates suffi- cient reserves, if the scale of production is large enough, and sizeable 1/ Estimates based on a broad knowledge of the geological bed or region; few thickness measurements are available.  -4- markets, involving domestic and export market studies, are assured. In this connection, the IDB is reviewing the possibility of making a loan to help the Government define the country's coal resources, training in coal mining opera- tions, and to assist in development of a specific coal mining facility. Geothermal Resources 1.12 The absence of geothermal drilling programs in Peru precludes an accurate estimate of proven reserves of this resource. From the properties of hot springs in the country's areas of active volcanism, the geology of the country, and analogy with proven reserves in northern Chile, U. S. Geological Survey (USGS) geologists concluded, in a joint Peru-U.S. energy assessment in 1978-79, that the country probably has a large geothermal resource base com- pared to the world average. A further study, financed by the Latin American Energy Organization (OLADE) and performed by Italian consultants -- based on geological studies only -- identified six areas in southern Peru which appear promising; also, a consultant's study, financed by the New Zealand Government, noted the possibility of geothermal development in Cajamarca in northern Peru. Further geophysical and geochemical investigations would be desirable, aimed at selecting the most promising areas and identifying drilling sites. The Federal Republic of Germany is considering assistance to Peru for this purpose. Nuclear Fuels and Developments 1.13 Uranium has been detected in a number of places in Peru but none of the occurrences has been of sufficient grade or size to warrant physical exploration. While only limited exploration has been undertaken in the past in the more accessible areas in the Western Andes, the most favorable areas are now believed to be along the foothills of the Eastern Cordillera and in the adjoining jungle area. In this connection, the Peruvian Institute of Nuclear Energy (IPEN), working with UNDP/IAEA geologists, has divided the country into exploration districts and is exploring 20,000-30,000 sq km of the most promising terrain. The group will train Peruvians and acquire data for the purpose of attracting foreign capital for exploration. IPEN is also conducting research on nuclear energy using a zero power (10 watts) research reactor provided by Argentina under an agreement for nuclear cooperation. In addition, Argentina is providing a research center at Huangaral. There are currently no firm plans for construction of a nuclear power plant in Peru. Other Energy Resources 1.14 About 60% of Peru's land surface is covered by natural and cultivated forests. MEM estimates the annual gross primary energy potential available from this resource as greater than the gross primary energy currently consumed in Peru. Virtually all of the forest lands, however, are located in the thin- ly populated Selva (Amazon) region. Still, fuelwood and other forms of bio- mass accounted for about 67% of all residential and commercial energy usage in Peru in 1980, down from about 75% in 1970.  -5- 1.15 Despite Peru's enormous forest resources, depletion of wood supply -- and even serious deforestation -- is a problem in some areas. The Government is making some effort to deal with this problem through its recently estab- lished reforestation institute (PRONARE), but information is scarce on the availability of wood in different regions or on present deforestation problems. 1.16 Bagasse, animal residues, and other sources of renewable energy re- present less than 5% of Peru's energy supply. 1.17 With the exception of small hydropower facilities, (typically 50-500 kW plants), other forms of renewable energy resources such as solar and wind are quantitatively unimportant in Peru. Given the hydro potential in the Andes, the dispersion of small rural centers, and lack of rural electrifica- tion, small hydro-power is well suited to the Sierra. Prior to MEM's initia- tion of the small hydro program in 1979, about 146 of such plants were operat- ing throughout the Andes. Since 1979, ELECTROPERU, which is executing agency for the program, has built a number of additional plants, bringing total in- stalled capacity of small hydro to about 300,000 kW. ELECTROPERU has also initiated studies on 50 more projects. The program is being financed from an electricity tax levied on users by ELECTROPERU. In addition, the small hydro program is receiving funds from USAID, the Federal Republic of Germany, and Switzerland. C. ENERGY CONSUMPTION AND OUTLOOK 1.18 In 1980, Peru's energy consumption totalled the equivalent of 87 million barrels of oil (12 million TOE), of which oil accounted for 60%, fire- wood 24%, hydropower 6.2%, natural gas 4.7%, bagasse 2.5%, coal 0.6%, and other non-commercial sources 2.0%, (Annex 3, Table 1). While Peru will con- tinue to be heavily dependent on petroleum for its energy needs throughout most of this century, there is some prospect that the rapid growth of both hydroelectric and coal-fired power stations could reduce petroleum's shar7 to about half of the country's total energy requirements by the year 2000. Over the medium term, however, exploration for, and development of, oil resources, petroleum pricing policy (paragraphs 2.13-2.15), and additional conservation measures will have the most important influence on the country's overall energy situation. 1.19 Consumption of hydroelectricity increased the fastest of all energy sources from 1965 to 1980, with an average annual rate of 6.9%. The use of petroleum also grew rapidly (6.3% p.a.) over the same period. On the other hand, consumption of coal and natural gas increased very slowly, at 1.5% and 1.0% per annum respectively. As to noncommercial fuels, the consumption of wood, dung, and yareta (a vegetable-based fuel) rose very little, at less than 1% per year, while less bagasse was burned for energy in 1980 than in 1965. 1/ Peru-U.S. Joint Energy Assessment, 1979.  - 6 - Petroleum accounted for about 80% of Peru's commercial energy consumption in 1980. (For past consumption trends and the demand structure for petroleum products see paragraphs 2.31-2.33 below). 1.20 For the 1970-1980 period, the respective shares of total demand of the residential and commercial, industrial, and transport sectors have re- mained fairly constant. The residential/commercial and industrial/agriculture sectors have each accounted for about 36% of energy consumption in the latter year, with transport's share averaging about 22% (Annex 3, Table 2). Energy consumption trends over the 1970-1980 period were marked by the substitution of oil and gas products for non-commercial fuels. 1.21 Noncommercial energy in Peru is used principally in the country's rural areas. Along with animal dung and the yareta plant, wood serves as the main cooking fuel for rural households, especially in the Sierra. Little charcoal is consumed. In spite of the rural areas' dependence on wood and dung, however, the absolute level of consumption of these fuels has remained fairly static over the last 10 years, so that their share of total energy usage has decreased. This reflects the replacement of wood and dung as cooking fuels by kerosene and LPG due, in large part, to the low, subsidized prices of certain hydrocarbons. (Since 1976, the cost of fuelwood for cooking has been higher than that of kerosene in many parts of the jungle and the Sierra.) Rural migration to urban centers has accentuated this substitution. 1.22 The burning of bagasse by the sugar industry to produce heat for sugar processing and electricity constitutes the main industrial energy use of biomass. But this consumption has decreased since 1976, because of output problems in the sugar industry and increased sales of bagasse as a feedstock for Peru's paper industry. As to other agricultural residues, some cotton-gin wastes are being burned for drying cotton. Alternate energy sources such as geothermal, solar, and wind energy do not contribute to current energy consumption (except for some water pumping by windmills in isolated areas). 1.23 MEM projections indicate that, with no radical change in sector policy, the use of energy among final consuming sectors would not change markedly between now and the year 2000. As shown in Annex 3, Table 3, how- ever, MEM estimates that, if the Government succeeds in its efforts to develop hydropower and coal, the use of these resources would increase substantially as a percentage of total energy use in the country, while the share accounted for by petroleum would fall fairly sharply and that of noncommercial energy would rise somewhat by the year 2000. D. ENERGY SECTOR ORGANIZATION, PLANNING AND POLICIES 1.24 The Ministry of Energy and Mines (MEM) is responsible for coordinat- ing all energy activities and for energy pricing. Under MEM's policy guid- ance, various semi-independent bodies share operational responsibility in the energy sector. ELECTROPERU, the national power company, is responsible for electric power generation and distribution for the country as a whole; ELECTROLIMA operates power facilities serving the Greater Lima area and  - 7 - several utilities and mining companies produce and distribute electricity in other urban areas. PETROPERU, the national oil company, is involved in all phases of exploration, production, transportation, refining, and distribution of petroleum products. Also, two private oil companies -- Occidental and Belco -- have become increasingly active in Peru in petroleum exploration and production. More recently, Superior and Shell have signed production-sharing contracts and have begun exploration programs. Hamilton Bros-Petroinca has also signed such a contract, and several additional foreign oil companies are negotiating contracts or have shown interest in doing so. Coal exploration and development are undertaken mainly by the state mining company, MINEROPERU. Development and conservation of forestry resources are under the aegis of the Ministry of Agriculture. 1.25 In recent years, MEM has become involved in energy planning and has received a substantial amount of technical assistance for this purpose. The UNDP, for example, has provided assistance for an energy balance study com- pleted in 1976. MEM continues to update the energy balance, and based on this work it has developed projections up to 1990 and 2000. The major assessment of energy resources and planning mentioned earlier was carried out jointly by the US Government and Peru and completed in 1979. Also, the Federal Republic of Germany financed a survey of Peru's hydroelectric potential in 1979, and has, together with the Bank, financed a power sector master plan completed in 1980. 1.26 While the Government has sufficient knowledge of the country's energy situation to elaborate a comprehensive resource development program -- except for coal resources and geothermal potential -- little progress has been made in comprehensive energy planning thus far. For some time, the Government has been considering establishment of a national energy council to develop and coordinate sector policies, and to promote energy development. The issue of creating such a council for these purposes, however, is not an active one in Peru, largely because the Government's policy is to concentrate efforts on developing the two main subsectors which have the greatest potential -- hydro- power and petroleum. 1.27 As part of its demand management policy for energy, the Government has taken some significant steps on the petroleum and electric power pricing front. In addition, it has supported specific energy conservation efforts, although a nationwide program to conserve energy does not exist. In this con- nection, the recently approved Bank Loan (2117-PE) for a petroleum refineries engineering project is designed, in part, to assist PETROPERU in reducing energy consumption while improving efficiency in Peru's largest energy-inten- sive industry -- petroleum refining. Also, energy audits have been carried out for six of Peru's largest industrial consumers, and a study has been arranged with a French organization to define priority areas for energy savings, principally in the industry and transport sectors. In addition, MEM is seeking ways to substitute coal and hydropower for oil in various industries.  -8- 1.28 Since the Government is giving priority to acceleration of petroleum exploration and development and to further expansion of hydropower, it has not placed great emphasis on various other renewable energy technologies. None- theless, a number of research studies sponsored by several Government agencies are under way on wind turbines for water pumping, solar distillation and dry- ing, solar water heaters and cookers, and biogas digestors. The mining sec- tor, which is important in Peru, provides the greatest opportunity for the use of renewable energy, specifically solar application for heating for water. E. FRAMEWORK FOR PROPOSED PROJECT 1.29 The proposed project for enhancing petroleum production in the Laguna-Zapotal oilfield is important to the Government's strategy for the energy sector and, in particular, for the petroleum subsector. The basis for this strategy is that, together with expansion of the country's hydropower capacity, exploration for, and development of, petroleum resources are the most promising means by which Peru can meet its energy requirements over the next two decades. The importance of the proposed project, in quantitative terms, is illustrated by the fact that the resulting increase in production -- ranging from 5,000 BD to 13,000 BD over the life of the project -- would, by 1985, meet about 8% of Peru's domestic demand for petroleum products and also contribute substantially to the country's balance of payments improvement, an important objective of the Government's overall economic development policy. 1.30 Within the petroleum sector, the proposed project would fit into the Government's strategy of leaving to private oil companies the bulk of high risk exploration as well as petroleum development in more difficult producing areas; PETROPERU would develop its existing coastal fields where it has been active traditionally and where the risk is low (as in Laguna-Zapotal). Else- where, PETROPERU would operate only three areas in the jungle. Since the results cf major exploration efforts of the private oil companies will not be forthcoming until the latter part of the 1980s at the earliest, it will be ex- tremely important, during the interim period, for Peru to increase its crude output substantially in order to ensure continuation of its self-sufficiency in oil. By making possible a rapid and substantial increase in petroleum pro- duction, the proposed project would contribute significantly to the success of the Government's strategy for the sector and to achievement of the country's broader economic development objectives. II. THE PETROLEUM SECTOR A. PAST DEVELOPMENTS AND OVERVIEW 2.01 Peru's first oil wells were drilled in 1863, making it one of the oldest oil-producing countries in the Western Hemisphere and, rapidly, a net exporter of petroleum. However, during the late 1940s and 1950s, with gaso- line and fuel oil prices among the lowest in the world and reduced producers' profit margins, growth in domestic consumption outstripped that of production so that the country became a net importer in 1958. In 1968, following a  - 9 - military coup, the Government nationalized the International Petroleum Company (IPC), the producer of 90% of Peru's crude output. 2.02 While production from the traditional coastal and offshore producing fields in northern Peru rose slowly throughout the 1960s, consumption conti- nued to grow rapidly, and Peru became increasingly dependent on crude oil im- ports to meet its own domestic requirements. To reverse this trend of in- creasing oil dependence, the Government took measures at the end of the 1960s, to stimulate exploration activity in Peru's Amazon basin east of the Andes. Sixteen consortia, involvin, some 58 private oil companies, signed contracts to explore for oil in the jungle. 2.03 The initial exploration success of PETROPERU and Occidental, however, was followed by a number of unsuccessful exploratory wells by other contrac- tors. These disappointments, the high cost of exploration in the Amazon Basin, and a critical modification in U.S. tax legislation (paragraph 2.07) contributed to the departure from Peru of 15 of the original 16 exploration consortia by the end of 1976. In late 1979, the Peruvian Government updated its petroleum law (paragraph 2.09) and arranged for U. S. oil companies to pay income taxes directly to the Peruvian Treasury rather than through PETROPERU, thus making the U.S. firms eligible for U. S. tax credits. These actions permitted renegotiation of some of the existing contracts with foreign oil companies, but were apparently not conducive to attracting new investment from additional companies. 2.04 After the Presidential election in Peru, held in May 1980, the new Government adopted a liberalized petroleum law (December 1980)1/ which again encouraged a considerable amount of interest in oil exploration. As a result, several foreign oil companies signed production-sharing contracts (paragraph 2.12) with PETROPERU, both offshore and in the Amazon region, and a number of additional firms are investigating exploration opportunities in Peru. 2.05 In any event, following completion of the Trans-Andean Pipeline in late 1977, oil production rose rapidly from 91,000 BD in that year to an average of 150,000 BD in 1978, and 195,000 BD in 1980. Thus, production con- tinued to increase and Peru has been able to export significant volumes of crude and petroleum products. Revenues from these exports rose from US$52 million in 1977 to US$810 million in 1980, when they accounted for more than 20% of the country's total merchandise export earnings, as shown in Annex 3, Table 4. 2.06 Current estimates of proven and probable petroleum reserves total 600-800 million barrels, sufficient to maintain production for another 9-12 years at current output levels. In the long term, however, significant addi- tional petroleum production in Peru will depend on the extent of discoveries by the private oil companies and PETROPERU, since current oil exploration, even if successful, will not result in substantial output until the late 1980s 1/ See Annex 4 for a description of the terms for new oil contracts.  - 10 - at the earliest. Continued substantial export of oil in the medium term, and possibly even Peru's self-sufficiency beyond the mid-1980s, will depend, in large part, on the pace of investment in the development of existing fields both by private oil companies and PETROPERU, and on domestic demand growth for petroleum products. The pace of this latter growth, in turn, will, to a considerable extent, be a function of the Government's pricing policy (paragraphs 2.13-2.19). B. GOVERNMENT POLICY Petroleum Exploration and Development Strategy 2.07 Historical Perspective. In 1969, following nationalization of the International Petroleum Company (IPC), the Government introduced a petroleum law which prohibited the granting of new exploration and development concessions to private firms. In 1970, the Government modified its exclusionary policy and developed the "Peru Model" contract under which private companies could explore for oil and eventually operate production facilities. Production-sharing contracts with PETROPERU provided that the contractor firm pay all of its own exploration, development and operating expenditures, while receiving 50% of production, and PETROPERU was to pay all contracitor tax obligations from its share. Because of its conceptual simplicity and ease of implementation, the Peru Model provided the basis for extensive interest by private foreign companies in exploration of the Amazon region. Several fields were discovered by Occidental and PETROPERU in that region, but all of the other consortia which signed contracts in the early 1970s fa'led to discover fields sufficiently attractive to maintain a presence there; - the last of these contracts was signed with Belco in August 1973, after which the Government suspended the awarding of new contracts. 2.08 Following continued escalation in the cost of imported oil and reali- zing that neither PETROPERU nor the Government had adequate technical or financial resources to carry out the required level of exploration in the Amazon area, the Government, in 1977, initiated an active campaign to attract private foreign companies again so as to renew exploration activities. The Government opened areas for contracts, both offshore and onshore, which were previously reserved for PETROPERU. This resulted in signature, in April 1978, of an exploration-production contract with Occidental for a second block in the jungle (Block 1-B, see IBRD Map 16174) and a production-sharing contract 1/ A U.S. Internal Revenue Service ruling, which stated that income taxes paid on behalf of U.S. companies would no longer be eligible for tax credits in the United States, also contributed to the departure of these companies. Moreover, in 1976, U. S. companies, in order to qualify their exploration losses for an offsetting domestic (U.S.) tax liability, abandoned their operations in Peru; these losses, under the new U. S. tax code, would not have been allowable beginning in 1977.  - 11 - with a consortium of private companies led by Occidental ("Oxy-Bridas") for secondary oil recovery in the Talara area. 2.09 In the meantime, the Goverment carried out a review of the contrac- tual framework for petroleum exploration and production in light of the developments in the oil industry at that time. On December 6, 1979, it issued Decree-Law 22774 which redefined the basis for contracts with private oil companies. In particular, the new law provided for: (i) flexibility for PETROPERU in negotiating the production-sharing contracts to take into account the geological characteristics, exploration costs and presumed development costs, and the option for PETROPERU to participate in joint ventures with private oil firms; (ii) the carrying out by PETROPERU of all secondary or tertiary recovery projects; and (iii) direct payments by the contractors of income taxes to the Peruvian Treasury, thus making American firms eligible for full tax credit in the United States. 2.10 While oil companies awaited with interest the results of the lengthy renegotiations of contracts with Belco and Occidental to be completed in July 1980, they did not consider the terms required by the revised law sufficiently competitive with those offered by other oil-producing countries. At about the same time, the Oxy-Bridas production-sharing contract was also transformed into a service contract. 2.11 Current Policy. The new Administration elected to office in Peru in mid-1980 reassessed the overall investment strategy in the sector. Additional incentives were devised to attract new investments by oil companies needed to maintain a satisfactory degree of petroleum self-sufficiency. As part of this strategy, PETROPERU's role was confined to the relatively less risky explora- tion and development activities which did not require special technology or large financial requirements. This new policy was embodied in Decree Law 23231, issued on December 26, 1980, which includes two major features: (i) execution of secondary recovery projects by PETROPERU in collaboration with national or foreign companies on a contract basis (as in the case of Oxy- Bridas instead of by PETROPERU exclusively); and (ii) introduction of a re- investment tax credit scheme to attract both national and foreign companies involved in successful oil exploration and production. Accordingly, foreign companies can deduct up to 40 percent 1 (90 percent for national companies) of their pre-tax Peruvian income for qualified investments in petroleum explo- ration and development. 2.12 As a result of the new tax investment credit and expression by the Government of active interest in encouraging private foreign investment in petroleum exploration and development, the investment climate has brightened considerably. In February 1981, Superior Oil signed a contract with PETROPERU for an area in Block 2 in the Northern Jungle. Shell signed a contract in July 1981 for exploration in Blocks 38 and 42 in the Lower Central Jungle area. Belco signed a third contract in January 1982 for exploration in Block 1/ 50% south of the 7th parallel.  - 12 - Z-28 offshore. Hamilton Brothers-Petroinca signed a contract in May 1982 for Block 7 in the jungle. Union of Texas is negotiating for Block 6, also in the jungle, and Elf is negotiating for blocks Z-8 and Z-9 offshore. (See IBRD Map 16174). Discussions have also been held with several other interested com- panies, among them Cities Service, Sun and Deminex. In addition, companies such as Mobil and Conoco, as well as a number of private Peruvian companies, have purchased geological data on a number of jungle blocks. Based on the Bank appraisal mission's review and discussions in Lima, exploration and development investment of private oil companies and PETROPERU is projected to average about US$500/600 million per year in the 1982-1985 period (paragraph 2.44). Pricinig Policy 2.13 Following the sharp increases in international oil prices which began in 1973, Government policy was based on protecting the Peruvian economy from potentially disruptive effects of immediate price hikes required to reflect international increases. Thus, domestic petroleum product prices, which had not been increased since June 1969, were kept unchanged until June 1975. At the same time, continued growth in petroleum product consumption at home, particularly of gasoline, put a growing strain on Peru's balance of pay- ments. Beginning in 1976, the Government therefore made a determined effort to increase domestic product prices and to slow the especially rapid growth in gasolines consumption. Regular gasoline prices were more than doubled in July 1976, followed by further increases in subsequent years, affecting not only gasoline but all major refined products. 2.14 In 1980 - an election year during which the political visibility of price acti-Tns was very high -- the Government authorized two -rice increnses which resulted in a weighted average price, in soles, of petroleum products about 24% above the level prevailing on January 1, 1980. This actually represented a substantial decrease in real terms since domestic inflation was about 60% in that year. These price increases, ere, however, in line with the pricing covenant included in Loan 1806-PE, 17 if the 30% increase, in soles, which was delayed until January 5, 1981, is included. In 1981, how- ever, the Government approved a series of further sharp price increases (in March, July, September, and December), resulting in a 138% increase in product prices (in soles) from the January 1, 1981 level, or a 36% annual increase in real ter-ms (see Annex 3, Table 6 and accompanying Chart). 2.15 The level of prices in Peru which took effect on January 31, 1982, the date of the first increase authorized in that year, is summarized below for the major products and compared with corresponding prices then prevailing in selected countries: 1/ Under the pricing covenant, the Government was to authorize four quarterly increases of 10% each for ex-refinery prices in 1980.  - 13 - Retail Prices of Selected Petroleum Productsl/ Border Product Prices/ Peru3/ USA Colombia Argentina4' Ecuador Bolivia (US4/gal equivalent) Regular gasoline 94 97 124 112 163 60 69 Domestic kerosene 96 24 107 96 124 24 43 Diesel 94 74 121 96 67 44 69 Fuel Oil 58 49 79 - - 28 65 Comparison between border prices (or "international prices"), which reflect the opportunity cost of exporting these products, and prices then prevailing in other Latin American countries and the United States, shown in the table above, indicates that petroleum prices of certain products in Peru are signi- ficantly below the international level. Although gasoline prices are equiva- lent to international prices, the retail prices of kerosene, diesel and fuel oil are still maintained at low levels. Peru's pricing policy for domestic kerosene is based on socio-economic grounds, since that product is the prime source of fuel for cooking and heating for the poor. This policy and the subsidization of diesel oil and fuel oil, used in the transport and industrial sectors, tend to distort consumption patterns and lead to imbalances in output requirements of Peru's refineries. 2.16 Taxes on sales of petroleum products are an important source of reve- nue for the Government. The two main taxes levied are: a consumption tax, ("impuesto selectivo al consumo") based on a percentage of the ex-refinery sales price, which varies by both region and product, with gasoline taxed at the highest rate (60%) and domestic kerosene taxed at the lowest rate 13%; and the "impuesto general a las ventas," a sales tax which equals 16% of the ex- refinery sales price plus the consumption tax for the product; in addition, the Government levies an 8% road tax and a 6% transportation tax on ex-refin- ery prices applied to gasoline sales. The current price structure for the products for which prices are Government-controlled indicates that PETROPERU receives on the average 53% of domestic retail prices. The table below shows the price structure for major products as of June 1, 1982: 1/ January 1982 price levels as converted using exchange rates in effect at that time. 2/ Price FOB Curacao, as of November 7, 1981. 3/ Prices as indicated in Ministerial Resolution No. 09-82EFC/15 of January 29, 1982 and converted at an exchange rate of S/525 per US dollar, as of that date. 4/ December 1981 prices, converted using a weighted average of financial (60%) and commercial exchange rate.  - 14 - PETROLEUM PRODUCT PRICE STRUCTURE IN PERU (In Soles per Gallon) Regular Domestic Gasoline Kerosene Diesel Fuel Oil PETROPERU's revenue (Ex-ref:inery price) 296.6 118.2 286.4 215.5 Selective Consumption Tax 178.0 15.4 131.7 120.7 Transport and road fund taxes 41.5 - - - Sales taxes 78.8 21.4 66.9 53.8 Distributor's margin 55.1 23.2 39.4 _ Retail price 650.0 178.2 524.4 390.0 PETROPERU's revenue as a percent of retail prices % 46 66 55 55 2.17 The current price structure of petroleum prices is still inadequate on three grounds: (i) the average retail price is still below the interna- tional level, which reflects the opportunity cost of exporting the products. Prices would need to be raised by about 12% (in US$ terms) on the average to reach international levels, (ii) the inter-product price structure results in uneconomic fuel choice in the sense that domestic kerosene is heavily subsi- dized (resulting in a domestic price which is about one-fourth of the inter- national price), and fuel oil and diesel oil are also subsidized as compared to gasoline prices, which are at international levels, and (iii) the system of ex-refinery prices, within the overall taxation framework for PETROPERU, results in insufficient revenues from the company's domestic sales which, in turn, has a detrimental effect on its finances and limits its capacity to generate funds internally for its investments (paragraph 5.04). 2.18 The Government is fully aware of the deficiencies in its pricing structure and PETROPERU is carrying out a hydrocarbon pricing policy study being financed under Loan 1806-PE. The study is being undertaken with the assistance of Arthur D. Little International (ADL) and is scheduled for completion by April 1983. The aim of the study is to improve the analytical base for making changes in the overall domestic price structure and taxation framework. 2.19 Moreover, the series of substantial price increases which took place in 1981 (paragraph 2.14) and thus far in 1982 have shown the determination of the Government to progressively eliminate subsidies for petroleum products and to remedy PETROPERU's poor financial performance. In the current year, the Government has approved five price increases (January 29, March 1, April 3, May 30, and July 4) which have raised the average price of petroleum products by 60% in sol terms, or 19% in U.S. dollar terms, from the January 1, 1982 level. The average price of petroleum products is now the equivalent of US$.73 per gallon (US$30.70 per barrel). In July 1982, the Government confirmed its intention to continue its program of increases in dollar terms for the balance of 1982 so as to reach international levels by the end of the year (about US$34 per barrel), and to implement any further increases in 1983  - 15 - required to enable PETROPERU to achieve the financial targets set forth in the proposed loan agreement (paragraph 5.24). Taxation Policy 2.20 The petroleum sector is an important source of revenues for the Government, via sales and consumption taxes at the retail level and through taxes on PETROPERU and its contractors as operating companies. The most im- portant taxes paid by PETROPERU are: (a) income taxes on its own operations, at a maximum rate of 55%; (b) taxes paid on its own behalf and on behalf of foreign contractors, as follows: (i) export taxes on crude and petroleum products, at 18.5% of the FOB value; (ii) import duties on capital goods, operating materials and equip- ment ranging from 6-45%, depending on the good; (iii) royalty taxes, at 8% of the value of the country's production based on a weighted average of domestic and export prices; (iv) a special regionaJ tax (called "canon" tax) paid on jungle pro- duction, at 10%!' of the value of production based on a valua- tion price equal to the domestic price minus transportation, distribution and refining costs; and (c) miscellaneous taxes paid on its own operations, such as employment taxes, tax on equity, and sales and consumption taxes on materials and equipment. The overall impact of these taxes on PETROPERU's finances can be summarized as follows: 1/ In 1982, a canon surtax of 2.5% was added, and the valuation price is now computed on the basis of the weighted average of domestic and export prices.  - 16 - Taxes Paid by PETROPERU in 1981 (in Billions of Soles) Tax Levied on Tax paid on Petroperu's behalf of Tax Operations Contractors Total Income Tax 0 b/ - 0 Export Tax 34 17 51 Import Duties - 23 23 Royalties 12 25 37 Canon Tax 2 12 14 other Taxes 6 - 6 Total 54 77 131 Source: PETROPERU It should be noted that all these taxes, with the exception of the income tax, are levied on PETROPERU regardless of its financial performance. In 1981 these taxes represented about 24% of its revenues and, although a deductible expense, resulted in a strongly negative impact on PETROPERU's finances (para- graph 5.05). In April 1981, however, the Government promulgated a Decree-Law which will progressively reduce the export tax to about 3.5% of the FOB value by 1984. 2.21 In the past, PETROPERU had also been responsible for payment of in- come tax obligations of its foreign contractors. This obligation was elimi- nated by Decree-Laws 22774 and 22775 issued on December 6, 1979, which provide that foreign oil companies operating in Peru are liable for paying their own income taxes (55%) and profit remittance taxes (30% of net income after taxes) directly to the Government Treasury. Contractors now remit taxes in kind to the Treasury, which transfers them to PETROPERU as capital contributions to be used for financing PETROPERU's investment program. The Government's invest- ment tax credit scheme embodied in D. L. 23231 has reduced the contractor's income tax obligations and therefore the level of automatic equity contribu- tions to PETROPERU (see paragraph 5.07). D.L. 23231 does not provide, however, that PETROPERU can benefit from the investment tax credit arrangement which is reserved for foreign and Peruvian private oil companies under con- tract with PETROPERU. a/ Excluding sales and consumer taxes and import duties on equipment, materials and services, which are already included in PETROPERU operating and investment costs. b/ PETROPERU paid no income tax in 1981 since it had practically no operating prcfit in that year.  - 17 - C. PETROLEUM RESOURCES Geology 2.22 Peru is comprised by four major geologic provinces, each of which contains sedimentary regions with hydrocarbon-bearing potential: (i) the coastal belt -- the narrow region lying between the Pacific coastline on the west and the Andes Cordillera on the east; (ii) the Amazon region -- the low jungle plain along the eastern and northeastern areas of Peru; (iii) the Andes Cordillera -- the high and geologically complex north-south trending ranges that form the backbone of Peru and separate the coastal belt from the Amazon region; and (iv) the offshore regions lying between the Peru-Chile trench and the coastline where up to four basins have been detected. 2.23 Almost all of Peru's petroleum production has been obtained, histori- cally, from the northwestern coastal belt (IBRD Map 16174). The latest dis- coveries have been based on gravity surveys in the mid-1950s, which led to two major onshore fields, and on seismic surveys in the late 1950s and early 1960s, which led to seven offshore fields. 2.24 The three important sedimentary basins of the Amazon region, the Maranon, Ucayali, and Madre de Dios basins are part of large asymmetric de- pressions between the Andes on the west and shield areas to the east. Current production comes primarily from the Maranon basin, which contains 22 fields, all discovered by PETROPERU and Occidental Petroleum. The traps are predomi- nantly faulted anticlines, located primarily by seismic surveys. The Ucayali basin, which has characteristics similar to those found in the Maranon basin, has two producing fields both under the control of PETROPERU. No oil produc- tion has been established as yet from the Madre de Dios basin, although large oil seeps are known. 2.25 The hydrocarbon potential of the third geologic province, the Andes Cordillera, appears low and the complexity of its geology probably precludes serious exploration efforts in the foreseable future. However, the now-aban- doned Pirin Field is located in the Altiplano Basin and additional small fields may be discovered in this region. Reserves 2.26 Estimates of Peru's recoverable crude oil reserves vary widely for several reasons, the most important of which are: (i) lack of sufficient petrophysical well data in the northwestern coastal belt despite the great number of wells drilled during the last 100 years, (ii) lack of sufficient production history from the water injection project now being carried out by Oxy-Bridas northwest of Talara, and (iii) insufficient production history of the recent discoveries by both Occidental and PETROPERU in the Maranon.  - 18 - 2.27 On the basis of existing studies _Y the current estimate for proved reserves ranges between 550 and 715 million barrels, as shown below: Proved Reserves Estimates (as of 12/31/81) In million barrels Region Lower Estimate Upper Estimate Amazon 360 470 Talara Onshore 2/ 136 177 Talara Offshore 53 69 Total 549 716 Source: PETROPERU and Bank mission estimates. 2.28 Additional probable reserves are estimated at between 70 and 100 million barrels, including rese,rves from secondary recovery operations and ex- tensions of existing fields. - Also, reserves in the order of 30 million barrels from heavy crude fields are classified under the "possible" cate- gory. When proved and probable reserves are added, total reserves amount to about 600-800 million barrels, or approximately 9-12 years of production at present rates. Peru's reserves in the context of South America's total oil reserves are small, amounting to only about 4% of the total for the continent. 2.29 The quantity of undiscovered reserves is much more difficult to assess reliably. While estimates of ultimately recoverable reserves vary from 2-40 billion barrels, most of the higher estimates are based on expectations for large stratigraphic traps ir the Amazon Basin and in deep water at the edge of the continental shelf. Both require expensive technologies; for the latter, the technology is still in the development phase and may not be viable for the next 10-15 years. Recent Production Trends 2.30 After stagnating through the first part of the 1970s, output started to increase in 1977, as production from the jungle came on stream, and for that year averaged 91,000 BD as compared with 76,000 BD in 1976. The year 1978 was an important turning point for Peru's production. Peru was not only able to attain self-sufficiency but became a net petroleum exporter for the first time since 1958. From an average daily production rate of 112,000 BD in 1/ Carried out by PETROPERU, Scientific Software Company, and DeGoyler and McNaughton. 2/ Includes additional proved reserves from the ongoing Oxy-Bridas water injection program in northwest Talara. 3/ Several consulting firms, such as Inlab and Intercomp, are developing, for PETROPERU, better estimates of secondary recovery reserves in the Talara area fields.  - 19 - the first quarter of 1978, output increased over 50% to an average of 181,000 BD by the fourth quarter and averaged 150,500 BD for the full year, due ex- clusively to a fourfold increase in output from Occidental's operations in the northeastern jungles of Peru; production since then has levelled off in the 190,000-195,000 BD range. Total production in the period 1977-81 is summar- ized below: Daily Average ('000 BD) 1977 1978 1979 1980 1981 Total Ouput 91.1 150.5 191.6 195.0 193.0 PETROPERU 52.0 50.5 46.0 43.8 42.0 (Coast) (32.7) (31.2) (23.4) (22.0) (22.6) (Jungle) (19.3) (19.3) (22.6) (21.8) (19.4) OCCIDENTAL 10.5 70.8 106.3 105.6 104.7 BELCO 28.6 28.6 28.3 27.9 26.7 OXY-BRIDAS - - 0.3 11.1 17.7 19.6 Source: PETROPERU D. CONSUMPTION OF PETROLEUM PRODUCTS 2.31 Consumption of petroleum products -- which is supplied by about two- thirds of Peru's domestic production -- increased at an average rate of 6.2% during the period 1960-75. The domestic demand for petroleum products de- creased slightly, however, in the 1976-78 period. This abrupt change in con- sumption trend can be attributed mostly to the economic crisis then prevailing in Peru (no real increase in GDP) and to implementation of sharp price in- creases for petroleum products, starting in mid-1975, following a long period during which prices remained constant. With the resumption of increased eco- nomic activity in 1979 and 1980, and the decline of domestic petroleum prices in dollar terms, d mand increased by about 4.8% in 1979 and 8.5% in 1980, to reach 126,300 BD 2 in the latter year. In 1981, however, domestic demand in- creased by only 2.6%, to about 129,600 BD, due mainly to the impact of the 36% price increase, in real terms, in that year. 2.32 An historical comparison of GDP and consumption growth of petroleum products shows that they are highly correlated. While GDP had increased by an average of 4.5% p.a. in the period 1960-1980, consumption of petroleum pro- ducts rose by an average of 5.2% over the same period, resulting in an esti- mated long-run energy/output coefficient of about 1.15 in Peru. For 1982, domestic demand for petroleum products is projected to grow by only 4.2%, 1/ Oxy-Bridas' operating contract in fields northeast of Talara resulted in the shift of production from PETROPERU to Oxy-Bridas in 1978. 2/ Excluding PETROPERU's own consumption averaging 4,000-6,000 BD.  - 20 - which would reflect, in part, the price increases in real terms targeted for that year. Medium-term projections of demand, however, are based on a GDP growth forecast of 5% p.a. in the period 1983-1990 and an energy/output coef- ficient of 1.0, to take into account further price increases, the impact of energy conservation measures, and the substitution of non-petroleum energy sources such as hydroelectricity. 2.33 The trend in the structure of demand for petroleum products summa- rized below indicates a growth of kerosene and LPG consumption as a result of low absolute and relative prices of these products, and a decrease in gasoline consumption, with a corresponding increase in diesel consumption resulting from the conversion of trucks and buses from gasoline to diesel engines in the mid-1970s and the relatively higher prices of gasoline (paragraph 2.13). The rapid increase in middle distillates consumption indicates that Peru's exist- ing refinery capacity will be insufficient to satisfy the demand for these products in the mid-1980s. PERU - STRUCTURE OF DEMAND FOR PETROLEUM PRODUCTS (Percent) 1965 1970 1975 1980 LPG 1.0 1.8 2.9 2.8 Gasoline 31.7 29.9 31.5 22.3 Middle Distillates 36.1 36.6 36.8 44.8 (diesel oil) (20.1) (20.2) (19-5) (24.3) (kerosene) (13.1) (12.1) (11.8) (14.1) (jet fuel) ( 2.9) ( 4.3) ( 5.5) ( 6.4) Residual fuel 31.2 31.7 28.8 30.1 Total 100.0 100.0 100.0 100.0 Source: PETROPERU E. REFINERIES, INDUSTRIAL PLANTS, MARKETING AND TRANSPORTATION 2.34 PETROPERU owns and operates two main refineries -- La Pampilla, near Lima, with a capacity of 100,000 BD, and Talara, 1,000 km northwest of Lima, with a capacity of 65,000 BD - which account for approximately 92% of total refining capacity in Peru. In addition, PETROPERU owns four small refineries in the jungle. 2.35 The refining industry in Peru faces two problems. First, the two major refineries are operated almost continuously without allowing for reason- able maintenance. Moreover, energy consumption in the refineries is high, as they were built at a time when energy was cheap and the main emphasis was on keeping capital costs low. To help remedy this problem, the Bank's petroleum refineries engineering loan (Loan 2117-PE), is helping PETROPERU's industrial department carry out studies and develop programs for overhauling the mainte- nance system, achieving energy saving, and improving the operational effi- ciency of the main refineries.  - 21 - 2.36 The second problem relates to inadequate domestic refining capacity to meet growing consumption of middle distillates. As indicated in paragraph 2.32, above, Peru will have to import these products some time between 1985 and 1990 if no additional refinery capacity for them is completed in the 1980s and demand continues to grow at about 5% per annum. The size and configura- tion of additional facilities required will, however, depend on overall energy demand growth and the success of conservation and inter-fuel substitution efforts. It is therefore important that future refinery investments be based on careful planning and on an analysis of alternatives. Investments for the refineries would also take account of priorities in the petroleum sector as a whole. 2.37 In addition to running refineries, PETROPERU also operates a 300-tpd ammonia plant, a 510-tpd urea plant, a 10,000-tpy isopropyl alcohol plant, a 5,000-tpy acetone plant, and a 7,700-tpy carbon black plant. 2.38 PETROPERU controls about 98% of the marketing facilities in the country. Its transportation system includes principally the North-Peruvian (Transandean) Pipeline built to take the crude oil from the jungle to the coast. This pipeline, which starts at San Jose de Saramuro in the Selva, ends in the port of Bayovar after crossing the Andes at 2,400 m above sea level (See IBRD Map No.16174). The pipeline includes an 856-km trunk line which came on stream in mid-1977, a 253-km Northern Branch linking the Occidental Petroleum fields and a 204-km feeder line (Corrientes branch) which links all PETROPERU fields. The main pipeline, working at 70% capacity, currently carries an average of 135,000 BD. F. DEVELOPMENT PROSPECTS New Exploration Activity 2.39 The actions taken by the Government in December 1980, to modify the petroleum law have shown very rapid results in attracting foreign investment in exploration activities. Government plans for PETROPERU call for concentra- tion by the company on development and production of its own oil fields while maintaining petroleum exploration activity in Blocks 8, 31 and 35 in the jungle and onshore in the Northwest Coastal area of Peru. The aggregate level of exploration that can be anticipated over the next few years, although un- certain, can be expected to be significant given the trend set by the recent signing of exploration/production contracts. 2.40 Occidental's Amazon operations are expected to provide a little less than half of Peru's total production over the next five years. With its high exploration success rate having been maintained through 1981, Occidental should be capable of maintaining production from these oil fields at 100,000 BD through 1986. The 1980-81 decline in primary production from existing Belco and PETROPERU operations should be more than offset by the secondary recovery and development projects projected to go on stream in the next few years. Three major uncertainties will affect 1986-90 production: (i) the level of PETROPERU's production from new finds, particularly near its current  - 22 - Amazon operations, (ii) exploration success in newly-opened jungle areas by private petroleum companies, and (iii) delay by PETROPERU in carrying out planned development and secondary recovery projects. 2.41 Even on a conservative basis, which discounts any possible explora- tion discoveries by companies such as Superior and Shell and others not yet operating in Peru, aggregate crude oil output in 1986 should not fall below 200,000 BD. Actual and estimated domestic crude oil production, domestic demand, and exports for 1980-86 are summarized below: ESTIMATES OF FUTURE DAILY CRUDE OIL OUTPUT IN PERU (1980-1986) (Thousands of Barrels per day) ACTUAL 1980 1981 1982 1983 1984 1985 1986 OCCIDENTAL 105.6 104.7 104.6 100.0 100.0 100.0 100.0 BELCO 27.9 26.7 25.5 25.5 25.5 25.5 25.5 OXY-BRIDAS 17.7 19.6 20.0 20.0 18.0 16.0 14.0 PETROPERU 43.8 42.0 56.9 63.0 64.0 70.0 72.0 1. JUNGLE (21.8) (19.4) (33.4) (37.0) (34.0) (32.0) (30.0) 2. COAST (22.0) (22.6) (23.5) (26.0) (30.0) (38.0) (42.0) Others ! - - - - - 5.0 15.0 Total 195.0 193.0 207.0 208.5 207.5 216.5 226.5 Domestic Demand 130.9 133.4 139.2 146.1 153.4 161.0 16S.0 Aggregate Exports 64.1 59.6 67.8 62.4 54.1 55.5 57.5 PETROPERU's Exports 44.4 43.2 45.6 45.2 38.9 40.6 43.0 Source: PETROPERU and Mission Estimates Exports 2.42 After supplying the domestic market, PETROPERU's share of the 1981 export market amounted to about 16 million barrels, which at an average export price of US$35 per barrel, represented about US$550 million in revenue. Domestic demand for petroleum products is expected to increase at about 4.2% in 1982 and to increase at about 5% per annum thereafter. As a result, 1/ Includes estimates of output in these years by Superior Oil Co. and Shell Oil, assuming discoveries resulting from their current exploration pro- grams in Peru.  - 23 - exports which totalled about 22 million bbl in 1981, are projected to reach 25 million bbl in 1982, and decrease thereafter to about 21 million bbl in 1986. 2.43 Occidental and Belco export crude oil, which is refined outside Peru. In 1981, PETROPERU exported about 6.5 million bbl of crude oil to Japan under a long-term contract with prices adjusted quarterly. The balance of PETROPERU's crude and petroleum products exports are sold on the spot market mainly to other countries in the area. Investment 2.44 Investment prospects for oil exploration and development in the next three to four years look encouraging, mostly as a result of the recent Govern- ment policy to attract new capital from foreign oil companies. On the basis of discussions with all parties concerned, the mission believes that under normal circumstances, the major elements are likely to be as follows: i. Occidental would invest about US$200 to $300 million per annum in developing its Amazon jungle contract areas to maintain its current production level and for additional secondary recovery investments in the Talara area (Oxy-Bridas contract). ii. Belco would invest about US$40 million per annum in new exploration and development activities in its offshore blocks aimed primarily at maintaining its current production levels. iii. Superior would invest about US$20 million during the period from mid- 1981 to mid-1983 in drilling two exploratory wells. Investments beyond that date would depend on the results of these exploration activities. iv. Shell would spend a minimum of US$100 million over the next four years in a two-stage exploration program (two exploratory wells in the first phase and four wells in the second phase). v. PETROPERU would spend about US$115 million in 1982, US$135 million in 1983, US$150 million in 1984, and US$180 million in 1985 for develop- ment and production enhancement projects in known producing areas, and to continue its exploration drilling effort in the Maranon basin in the jungle. vi. Other foreign companies have expressed interest in undertaking explo- ration activities, principally in the Amazon Basin and offshore. The amount of investment in the next years will depend on the pace of signature of new contracts, some of which are already at an advanced stage of negotiations. 2.45 These investment plans would result in a total investment in explora- tion and development activities of about US$1,800 to US$2,000 million in the period 1982-1985. This amount implies that PETROPERU would still undertake about 30% of the total investment, a share which appears reasonable compared  - 24 - with past performance, although on the high side given PETROPERU's limited technical and financial capabilities. The total amount of investment from all sources will be heavily dependent on the degree of exploration success by foreign contractors and the number of contracts signed with private companies for exploration and development of the blocks allocated to them. Role of the Bank 2.46 There are several cogent reasons for Bank involvement in the hydro- carbon sector in Peru. Clearly, the sector deserves priority support because the country's economic situation would deteriorate seriously if Peru fails to remain a net exporter of petroleum beyond the mid-1980s -- which would happen if no additional production occurs. The Government's policy -- which the Bank has encouraged and which has been successful thus far -- is to promote invest- ment by private companies for exploration and production in the jungle and offshore, and in some areas on the coast. This policy also places a well- defined limit to the scope of PETROPERU's operations. 2.47 The first Bank loan to PETROPERU (Loan 1806-PE, US$32.5 million) was primarily designed to increase production in the short term through a produc- tion rehabilitation program, and to prepare further investments through seis- mic surveys and secondary recovery studies. Another objective was to streng- then the technical and financial capability of PETROPERU, so that the company could efficiently assume its role in the sector. The project got under way more slowly than expected because of the complexity and diversity of the com- ponents; a substantial delay in making the loan effective mainly as a result of the change in government in mid-1980, shortly after the loan was signed; inexperience of the Borrower with Bank procedures, this being the first Bank loan for the petroleum sector in Peru; and PETROPERU's weak implementation capacity. Substantial progress leading to a rapid increase in PETROPERU's production has been achieved, however, over the past several months, which is also reflected in the rapid increases in commitments and disbursements of the Bank loan which totalled US$18 million and US$8 million, respectively, by mid- June 1982 (Annex 7). As expected, by July of this year, financial commitments had been made for most of the remaining equipment and materials to be pur- chased under the project and a substantial additional increase in production has been achieved by PETROPERU. 2.48 Bank lending to PETROPERU is also well justified. PETROPERU, which is Peru's largest public entity, remains important in terms of its acreage, size, petroleum exploration and development activities, refineries, and related industries. Its proposed production enhancement program, moreover, is the key to ensuring Peru's self-sufficiency in petroleum until possible dis- coveries by private company oil exploration are made later in the 1980s. In addition, Bank involvement would help provide assistance to achieve further improvements in the company's operating efficiency and financial performance, thus improving the company's creditworthiness. And it has permitted the Bank to serve as a catalyst for substantial amounts of co-financing for the pro- posed project and to encourage private bank lending for future projects of the same type in Peru.  - 25 - 2.49 As was the case in our policy dialogue during implementation of the first petroleum loan, continued Bank lending in this sector would support a further increase in the role for private companies, not only as suppliers of equipment and institution-building services, but also as direct participants in PETROPERU's operations. As a case in point, Bank encouragement played an important part in the use of a project management firm in connection with the proposed project. Bank involvement would also provide continued support for improved energy policies on the part of the Government, particularly in the crucial area of petroleum product pricing. III. THE BORROWER Background 3.01 The national oil company, Petroleos del Peru (PETROPERU), was estab- lished by Decree-Law 17753 on July 24, 1969, following nationalization, in October 1968, of the production and refining operations of IPC. At the same time, PETROPERU absorbed the production operations of the Empresa Petrolera Fiscal (EPF), a state-owned oil company with production operations in the northern Peruvian coastal region near the acreage of IPC, and assumed respon- sibility for management and administration of IPC's production and refining operations. In 1973, PETROPERU acquired five other small companies which had been privately owned. As a result of these acquisitions, PETROPERU now accounts for 22% of Peru's crude oil production, 100% of refinery capacity, and 98% of the marketing of petroleum products. PETROPERU was given status equivalent to a private corporation by Legislative Decree 43 of March 4, 1981. This latter action gave PETROPERU somewhat greater independence from the Government than in the past in some specific activities -- e.g., in the matter of salary levels and procurement procedures -- thus permitting PETROPERU to avoid personnel problems and procedural delays encountered in im- plementation of Loan 1806-PE and other projects. Nevertheless, PETROPERU is still very dependent on Government policies in the petroleum sector which affect the company significantly. Operations 3.02 PETROPERU is the official entity for conducting all Government acti- vities in the hydrocarbon sector, including exploration, production, refining, and marketing of all petroleum products, as well as activities related to pipeline transportation of crude oil, fertilizer production, and petrochemi- cals. PETROPERU, through a subsidiary, also has a small fleet of petroleum tankers used to transport crude oil and petroleum products between the Peruvian coastal ports as well as for river transport in the Peruvian Amazon region. 3.03 PETROPERU produced on the average 42,000 BD in 1981. Its refining operations comprise six refineries which have an overall capacity of approxi- mately 178,400 BD. PETROPERU has a network of storage depots and retail out- lets throughout the country. Except in the case of lubricants, PETROPERU is the sole marketer of petroleum products in the country. The other major  - 26 - petroleum facility owned by PETROPERU is the 856-km Trans-Andean pipeline (paragraph 2.38). Organization 3.04 PETRG2ERU is governed by a Board of Directors consisting of nine mem- bers. The Chairman of the Board is the company's highest ranking official. Three members of the Board are appointed by the Ministry of Energy and Mines, three by the Ministry of Economy, Finance and Commerce, one member represents the Armed Forces, and the remaining two members represent PETROPERU's profes- sional and working-level employees, in accordance with Peru's industrial legislation requirements. The present Board includes a high proportion of individuals with experience in private business and industry. None of the managers of the key operating departments, including the General Manager, is represented on the Board. 3.05 The Board has responsibility for approving all policy matters related to personnel administrat