Peru - Petroleum Production Rehabilitation Project

Document of ; f4r The World Bank FILE COpY FOR OFFICIAL USE ONLY / R4.t No. 2705-PE STAFF APPRAISAL REPORT PERU PETROLEUM PRODUCTION REHABILITATION PROJECT February.11, 1980 Energy Department Latin American & Caribbean Regional Office 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 US$1.00 = S/.196.52 as December 31, 1978 US$1.00 = S/.250.00 estimated December 31, 1979 US$1.00 = S/.225.00, estimated average calendar year 1979 FISCAL YEAR January 1st to December 31st WEIGHTS AND MEASURES MW = Megawatt (thousand kilowatt) GW = Gigawatt (million kilowatt) 6 TOE = Tonnes of oil equivalent (14.415 x 10 Kcal) bbl = Barrels of 42 gallons b/d = Barrels per day MBPD = Thousand barrels per day gl. = Gallon Bcf = Billion cubic feet SV. = Peruvian Sol Km. = Kilometer (0.62 miles) PRINCIPAL ABBREVIATIONS AND ACRONYMS USED GOP = Government of Peru MEM = Ministry of Energy and Mines ELECTROPERU = National Power Generation and Distribution Company PETROPERU = Petroleos del Peru (National Petroleum Company) IPC = International Petrolum Company EPF = Empresa Petrolera Fiscal COFIDE = Corporacion Financiera de Desarrollo  FOR OF]FICIAL USE ONLY PERU PETROLEUM PRODUCTION REHABILITATION PROJECT STAFF APPRAISAL REPORT Table of Contents Page No. I. THE ENERGY SECTOR .................................... 1 A. Intro,luction . ................................... 1 B. Resource Base .................................... 1 Hydropower ......**........... .......... 2 Natuaral Gas ..................................... 2 Coal ........................................... 2 Geothermal .................................... I 3 Non-commercial Fuels . . .......................... 3 C. Patterns of Future Energy Consumption ............ 3 D. Energy Sector Planning and Policy ................ 4 II. THE PETROLEUM SECTOR .... I 6 A. Introduction ........... 6 B. Historical Perspective .......................... I 7 C. Petroleum Resources ......, 8 Geology ......................................, 8 Reserves... 9 Recent Production Trends. 10 D. Development Prospects ............................ 11 New Exploration Activity . . .11 Production ...... . 11 Exports ...12 Investment ...12 E. Government Policy .... . .13 Background ...13 Exploration and Development Policy . .13 Pricing Policies ...15 Taxation and Incentive Policy .. .17 Role of the Bank . . 18 III. THE BORROWER ..19 Backg,round .... . ................... 19 Operations ...20 Organ,ization ...20 Staffing, Management and Salaries 21 Accounting and Auditing . .22 Insurance ...23 This document has a restricted distribution and may be used by recipients only in the 1performance of their official duties. Its contenst may not otherwise be disclosed without World Bank authorization.  Table of Contents (Continued) Page No. lv. THE PROJECT. 23 Background ....................... .................... 23 Project Description ...... ............................ 24 1. Rehabilitation of Existing Production ....... 24 2. Development of New Production Potential ..... 27 3. Consultancy Services and Training .... ....... 29 Project Implementation ............................... 30 Project Costs ........................................ 31 Project Financing Plan ............................... 33 Disbursement and Allocation of Bank Loan .... ......... 33 Procurement ......... ................................. 34 Project Risks ........ ................................ 35 Training .......... ................................... 35 Environmental Consideration and Safety .... ......... 36 Schedule and Reporting ............................. 36 V. FINANCIAL ASPECTS OF PETROPERU .36 A. PETROPERU's Past Financial Performance and Present Position .36 B. PETROPERU's Future Finances .38 VI. ECONOMIC AND FINANCIAL ANALYSIS OF THE PROJECT 44 VII. SUMMARY OF AGREEMENTS REACHED .46 This report has been prepared by Messrs, E. D. McCarthy (Mission Leader), P. Lizaur (Financial Analyst), R. Berney (Economist) and W.J. McKenney (Petroleum Engineer).  LIST OF ANNEXES 1.01 National Energy Usage by Source of Energy 1.02 Residential and Commercial Energy Usage by Source of Energy 1.03 National Energy Usage by Final Consuming Sector and Subsector 1.04 Projected Energy Consumption by Source and Sector 2.01 The Peruvian Model Contract 4.01 Reserve Potential of PETROPERU's Northern Jungle FieLds 4.02 Status of' Wells in Northern Jungle Operations 4.03 Estimated Production Using Artificial Pumping Equipm ent 5.01 PETROPERIJ Oil Production Rehabilitation Project Estiimated Operating Costs 5.02 PETROPERIJ Oil Production Rehabilitation Project Projected Statements of Income 5.03 PETROPERIJ Oil Production Rehabilitation Project Projected Statements of Sources and Applications of Funds 5.04 PETROPERIJ Oil Production Rehabilitation Project Projected Balance Sheet in Billion of Soles 5.05 PETROPER1J Oil Production Rehabilitation Project Schedule of Sources and Uses of Cash 5.06 Notes and Assumptions on Financial Statements 6.01 Economic Calculations: Brea y Parinas Production Rehabilitation 6.02 PETROPER'U Oil Production Rehabilitation Project Incremental Financial Cost and Benefit Streams 6.03 Economic Calculations Jungle Artificial Lift Project MAP IBRD 14470 PERU. Petroleum Sector. Pacific Coast Operations. MAP IBRD 14471 PERU. Petroleum Sector. Northern Jungle Operations.   I. THE ENERGY SECTOR A. INTRODUCTION 1.01 Crude oil is the dominant source of energy in Peru, supplying approximately 80% of Peru's commercial energy requirements. Although Peru's energy resource base is relatively diverse and there is scope for expanding the role of hydropower and coal in future electricity generation, petroleum will still provide the major part of Peru's energy requirements throughout the rest of this century. After being dependent on imported crude oil for many years to meet its petroleum needs, domestic oil production increased almost threefold between 1976 and 1979, enabling Peru to export oil in sub- stantial quantities for the first time since 1958. Despite this encouraging production trend, domestic consumption is likely to rebound after several years of stagnation so that Perti's continued ability to meet its domestic oil requirements beyond the early 1980s is far from assured unless new oil reserves are discovered and existing production is maintained to the extent feasible. 1.02 As a consequence, the Government's strategy in addressing Peru's future energy needs must focus on ways to increase petroleum production through exploration and development while at the same time restraining the growth in demand for petroleum. Exploration, particularly in the Amazon basin will require considerably more resources and technical expertise than the Government can be expected to provide during the next decade; it will therefore require a policy that will attract substantial amounts of risk capital over an extended period from foreign oil companies. At the same time, the Government should complement its efforts in attracting exploration investment by adopting pricing policies which take into account the need to replace petroleum by other energy sources, and which set the prices of petroleum products at levels which encourage their efficient use in the industrial and transport sectors. 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 through the end of the century. Section II will treat the petroleum sector in a more detailed manner. B. RESOURCE BASE 1.04 Peru's resource base is diverse. In addition to known (proved and probable) oil reserves of about one billion barrels (140 million tons - TOE) and estimated undiscovered reserves of from two to twenty billion barrels, Peru has potentially economically viable hydroelectric sites which have a capability of generating an estimated 30 to 60 GW of which only 1.4 GW are currently being used. It also has coal reserves estimated at about one billion tons (660 million TOE) which are almost completely unutilized, and some potential geothermal sites. However, gas reserves are small; estimates range from one to two trillion cubic feet (28-56 million TOE).  -2- Hydropower 1.05 With an average growth rate since 1965 of 7.3%, hydropower is, over the long term, the most rapidly growing energy sector in Peru (see Annex 1.01 for details). TJhile accounting for only 6% of total energy usage (9% of commercial energy production) its potential for continued growth is enormous, as current capacity, about 1400 MW, is less than 3% of the country's estimated economically viable hydropotential. In fact, on the basis of projects under construction and on the drawing boards, it would be possible to increase capacity to 3400 NW by 1990, corresponding to an average annual growth rate of 7.5%. 1.06 While additional hydropower sites are available, only 15% of poten- tial sites are on the Pacific side of the Andes. New large scale hydropower projects will, therefore, be quite expensive, since they will require addi- tional expenditures on by pass tunnels or long distance high voltage trans- mission lines. Furthermore, development of the best sites for large dams would result in flooding of intensively cultivated valleys which could make them socially and economically unacceptable. Mini-hydroplants serving a local market might however be a viable alternative to diesel electricity generating plants in many regions, and the government is actively promoting this alterna- tive for more isolated mountain villages. Natural Gas 1.07 Natural gas is not an important contributor to Peru's energy needs. It is produced primarily in the northwestern coastal oil-producing areas around Talara, where it is used primarily as a fertilizer feedstock rather than as a direct energy source. Output over the past decade has ranged from 77 billion cubic feet (bcf) in 1969 to 65 bef in 1975, and is expected to remain at 70 to 72 bcf per year for the next five years (about 14 million bbl oil equivalent) even though some declines in existing fields can be expected as a result of water flooding for secondary oil recovery operations in the Talara area. 1.08 Although some sizeable gas fields have been discovered in the Amazon region, they are not large enough to justify the cost of a pipeline from their isolated locations to potential consumption centers. Most of the oil fields produce only small quantities of gas which is used for local fuel requirements, with the remainder reinjected to provide additional lift. Besides the Amazon, the only other area with considerable potential is in the offshore Progreso Basin; however, most of the potential producing areas of this basin lie on the Ecuadorian side of this basin. Coal 1.09 Coal is Peru's least exploited energy resource; current production accounting for less than one percent of total energy consumption. However, at least four known fields hold considerable potential as supply sources for thermal power plants and metallurgical grade coke. The Government is currently  - 3 - studying investing in a 480 megawatt power station at one of these sites, which, based on the limited geological work undertaken at this time, has a total reserve (proven, probable and possible) of 270 million tons (170 million TOE). The cost of such an investment program would be oln the order of $300 million (in 1978 prices), and the lead time five to ten years. 1.10 Information on coal formations in other parts of the country is somewhat sketchy to permit an adequate judgement about whether or not economic deposits exist. However, in a number of regions general geological conditions appear favorable and may have given rise to coal beds that were :Ln an earlier geologic age continuous over many hundreds of square kilometers. Additional exploration and proving up of known deposits should be a high priority of the GOP. Nuclear Fuel 1.11 OnLly a limited amount of exploration has yet been undertaken for Uranium, mostly in the 1960's, and no exploitable concentrates of this mineral has been found. Geothermal 1.12 Peru has no proven geothermal energy reserves. It has, however, numerous warm and boiling springs in many parts of the country. The Govern- ment is only now beginning to study its geothermal resources. Data on thermal gradients and heat flow is, as a result, still insufficient to estimate the inferred reserves. Based on the properties of the many known hot springs, the broad geological characteristics of the country, and the analogy with the proven geothermal energy reserves in Northern Chile, total inferred reserves are on the order of 400 MW hours, while speculative reserves are put at some 20 times more than inferred. Non-Commerc:ial Fuels 1.13 Non-commercial fuels - wood and other residual vegetable matter - accounted for one third of Peru's total energy usage in 1976. They were the major fuel source for household cooking needs, accounting for 70% of all residential and commercial energy consumption in 1976, down from 75% in 1965 (see Annex 1.02). Consumption in this period grew by less than 1% per year. In 1972, 75% of the rural population used wood as their primary energy source, whiLe another 16% used other secondary vegetable sources. In urban centers, kerosene is the most important cooking fuel, being used by 58% of the population with wood being used by about 19%. C. PATTERNS OF FUTIJRE ENERGY CONSUMPTION 1.14 Available figures for 1976 indicate a total energy consumption equivalent to 75 milLion barrels of oil (10.6 million TOE), of which oil accounts for 54%, firewood 27%, hydropower 6%, natural gas 5%, coal 0.5% and other noncommerical sources 6.5%. While Peru will continue to be heavily dependent on petroleum for its energy needs throughout most of this century,  - 4 - there is some prospect that the rapid growth of both hydroelectric and thermal electric coal based power stations could reduce petroleum's share to about half of the country's total energy requirements by the year 2000. In the medium term, however, conservation measures will have the most important influence on the country's overall energy situation. 1.15 On the basis of current trends and current known reserves, Peru is expected to continue to have a small overall petroleum surplus available for export through 1983. Whether Peru will remain a net petroleum exporter throughout the 1980s, however, will depend primarily on the level of explor- atory work and resultant discoveries in the Amazon region, where most of the as yet undiscovered reserves are expected to be found. Since Peru does not have adequate resources to undertake a major exploratory program at this time, the GOP's strategy is to rely primarily on foreign oil companies for the exploration and development of indigenous oil resources, particularly in the Amazon basin, and to develop hydropower, coal and thermal resources in order to avoid increasing the country's dependence on oil. 1.16 Major shifts in the sectoral usage of energy are likely to take place during the next two decades. Preliminary projections indicate that if there is no radical change in energy sector policy, as might be expected, the transport sector will continue to increase its share in petroleum usage, from about 44% presently to about 48% by the end of the century, while indus- try and agriculture will decrease their direct usage from 34% to about 27%. Petroleum usage for electricity generation will also have to increase to make up for short term shortfalls in the growth of hydro and coal fired power stations, particularly in regions not connected to the major national grids. As a result, by 1985 oil consumption for electricity production will increase from about 9 to 14% before falling off to 11% by the turn of the century. It is also projected that, although most of the increase in coal production will take place after 1985, by the year 2000 coal will account for 30% of the electricity produced in the thermal plants. Annex 1.04 provides some estimates for the pattern of energy consumption by source and sector that may emerge assuming that no new policy directives are initiated to expand the use of hydro and coal fired thermal power plants above currently planned levels. D. ENERGY SECTOR PLANNING AND POLICIES 1.17 The Ministry of Energy and Mines (MEM) is assigned the responsi- bility for coordinating all energy planning activities. Operational respon- sibility is divided between the various semi-independent bodies responsible for the subsectors. ELECTROPERU, the national power company, is responsible for electric power generation and distribution. PETROPERU, the parastatal oil company, is responsible for all phases of production and distribution of petroleum and petroleum products. Two other companies are currently active in Peru; Occidental Petroleum, an independent US based company, is the most important, with a successful exploration and development program in the Amazon, and a smaller secondary recovery program in Talara. Belco, a smaller US based company, has been active in offshore primary and secondary recovery programs for about 20 years; its production is about one fourth that of Occidental's. Both companies have production sharing contracts with PETROPERU.  - 5 - 1.18 The M4EM has had the advatL,age ci a natiunal energy bala.nce atudy (prepared in cooperation with tba i4..ri tsy a UMited Natict s p:roject team working in the Office of Sectoxial ajr: ri,} sn a major hydroelectric pover planning exercise, prepared by Lahmt,!y, ntei LiAticnal as part oi a Republic of Germany grant and funds from Batk s most recett power loan (1;215-PE). This survey's conclusions, which should become available in 1980, wilL be used in the preparation of a power sector master plan to determine an optimal sequence for investment in new generating and transmission facilities. In addition, in 1978, a US team under the management of the US Department of Energy undertook an assessment of Peru's energy resources and planning in collaboration with Peruvian energy managers. This binational group assessed Peru's energy resources, and supply and demand options to the year 2000, and suggested some alternative energy strategies for the country. 1.19 The U.S. Report recommended that the Government strategy focus on ways to maximize the production of oil and on ways to minimize its consumption. The latter objective could be accomplished by: (i) developing hydroelectric and coal energy sources; (ii) shifting towards renewable energy resources where possible, particularly small scale hydroelectric, geothermal, and biomass plants for the smaller isolated communities; (iii) improving energy efficiency in industry; and (iv) electrification where possible of urban and regional transport systems, which by 2000 are projected to account for almost 50% of national oil consumption, to minimize energy costs. Nuclear power was not considered as a viable option, at least before the year 2000. This new emphasis on coal and renewable resources in addition to the continued emphasis on the development oi- the petroleum sector, will play an important role in Peru's multi dimensional energy program. There may be scope for a program of small scale hydropower facilities tied to rural development projects, as well as for a program for rapidly evaluating the country's coal poten,tial. 1.20 With the completion of this latest energy study and arn increasing awareness on the parit of the government of the importance of energy planning in helping formulate a coherent energy strategy for Peru to the year 2000, consideration is being given to strengthening the capabilities of the existing government lbodies currently responsible for planning in the sector. One proposal to achieve this objective which is under discussion is establish- ing an "energy institute" which would help coordinate the various facets of government policy, particularly in regard to energy demand management and conservation measures which do not receive adequate attention at: present; such an "institute" could play a critical advisory role to senior government policy makers. At this juncture, the setting up of such an inst:itute is still at an embrionic stage. While such an "institute" or a similar entity, may warrant Bank assistance in the future, its short-term financing needs are likely to bie met through grants from entities such as UNDP and firom private foundations, as well as possibly from government budgetary sources.  - 6 - 1.21 The core of a successful energy program for Peru, however, is the implementation of its petroleum development strategy. The Bank's involvement in the petroleum sector as a result of the proposed loan will allow it to establish a dialogue with the Government on the implementation of this strategy; this in turn, will help create the continuous and stable policy frame work that is an essential prerequisite to obtaining the necessary level of exploration investment from both national and foreign enterprises working in the sector. II. THE PETROLEUM SECTOR A. INTRODUCTION 2.01 Peru, Latin America's first commercial oil producer, has recently become again a net exporter of crude oil after a long period starting in the early 1960s, when the country was dependent on imported crude oil to meet its domestic requirements. Following the completion of the Trans Andean Pipeline in late 1977, oil production rose rapidly from 80,000 b/d to over 190,000 b/d in 1979 and is expected to reach 210,000 b/d by 1980. Current estimates of proven and probable reserves are approximately 1 billion barrels, sufficient to maintain production for another 12 years at current output levels. 2.02 Exploration activity, which was at a high level during the first half of the 1970s, has fallen off sharply since 1976; only one of the original 16 prospecting consortia continues to be active in the Amazon region, and no new exploration contracts have been signed since April 1978. Both technical and political considerations have been important factors in this decline in exploration activity. Technically, the Amazon basin was found to have a far more complex geological structure than first envisaged, with reserves being found in smaller traps rather than in the hoped for large scale anticline structures. Politically, the GOP's vacillating attitudes towards foreign petroleum companies - ranging from the expropriation of the International Petroleum Company in 1968, to the vanguard 50-50 production sharing contracts of the early 1970s - accompanied by the recent proposed return to Democratic Government, with elections scheduled for May 1980, has caused most companies to adopt a go-slow stance to new exploration ventures. 2.03 A number of companies are, nevertheless, reviewing the existing technical data and have shown some signs of wishing to begin new exploration ventures once some of the political problems are resolved. The Government issued on December 7, 1979, a new Decree Law clarifying its position on the type of production sharing contract that it is willing to offer foreign com- panies. The Government projects that exploration investment on the order of about $400 million per year throughout the 1980s will be required to maintain sufficient production to meet the growing domestic demand and still continue to export; and PETROPERU is, at best, likely to be able to provide one-half of this.  -7- B. Historical Perspective 2.04 Peru is one of the oldest oil producing countries in the Western Hemisphere. The first oil wells were drilled in 1863 on the Ncorthwest Coast near Talara, four years after the first commercial fields in the USA were developed. By 1920 Peru was producing about 12 million barrels of oil per year, 40% of the total South American output. 2.05 During the 1920's and 1930's, Peruvian production grew relatively slowly reaching a peak of 17.6 million barrels per year in 1936, while other Latin Amer:ican countries, notably Venezuela and Argentina, expanded theirs rapidly, so that by 1940 Peruvian output accounted for no more than 5% of the total for South America. 2.06 During the late 1940's and 1950's, with gasoline and fuel oil prices amongst the lowest iLn the world and reduced producers' profit margins, growth in consumption outstripped that of production. By 1958, partly due to this situation the princiLpal foreign oil company, International Petroleum Company (IPC), the producer of 90% of Peru's crude output, terminated all development and exploration actJivity for almost two years. 2.07 While prodLuction from the traditional coastal and offshore producing fields in Northern Pleru grew slowly throughout the 1960's, consumption con- tinued to grow rapidLly, and Peru became increasingly dependent on crude oil imports to meet its own domestic requirements. To reverse this trend of increasing oil dependence, the new military government undertook a major effort at the end of- the 1960's to stimulate exploration activity in Peru's Amazon basin east of' the Andes. A few important discoveries, and no sig- nificant failures, gave rise to high expectations regarding the hydrocarbon potential of the Amazon basin. 2.08 The transandean pipeline system, the largest single investment project in Peru's history, was initiated in 1972 on the basis of these optimistic projections. When completed in late 1977 and extendled with a branch line to the Occidental Petroleum fields in 1978, total cost was over $800 million. Most of this was financed by PETROPERU on stringent medium term commercial banlc and supplier credit terms, with the expectation that the pipeline would reach full capacity (and be expanded) shortly af'ter completion. 2.09 The initial exploration successes, however, were followed by a number of unsuccessi-ul exploratory wells in what had been regarded as very large structures wit:h promising hydrocarbon potential. These disappointments, the high explorationi costs of the Peruvian Amazon basin, the inflexible work obligations stipulated by the exploration contracts, and a part icularly critical modification in US tax legislation, 1/ all contributed to the exodus 1/ In 1976, US companies, in order to qualify their exploration losses for an offsetting domestic (US) tax liability, abandoned their operations; these losses, because of changes in the US tax code, would not have been allowable the following year.  - 8 - of 15 of the original 16 exploration companies by the end of 1976. However, Occidental Petroleum, the one successful foreign company, has continued to invest in new exploration in the jungle with notable further success (IBRD Map 14471). 2.10 Following the increase in international crude oil prices in 1973, Peru's net oil import bill rose sharply, averaging approximately US$200 million per annum between 1975-77 and represented a severe burden on Peru's deteriorating balance of payments. However, due primarily to the continued efforts of Occidental, the earlier discoveries of PETROPERU, and the completion of the TransAndean pipeline network, Peru's production in- creased sharply and by mid-1978 Peru again became self-sufficient in oil. Since then, production has continued to increase and PETROPERU has been able to export significant volumes of petroleum and petroleum products. Revenues from these exports in 1979 are expected to reach over US$600 million. 2.11 This recent encouraging production trend, however, conceals a number of structural weaknesses and policy concerns elsewhere in the sector which give rise to uncertainty regarding Peru's ability to continue as a net exporter of oil. In the first place, the recent increase in production is attributable almost solely to the efforts of a single company, Occidental. PETROPERU's production, after increasing sharply in 1977 and 1978, has been erratic in recent months; as a consequence, the role that PETROPERU will play in contributing to future production remains uncertain. Second, the financial difficulties of PETROPERU brought to a virtual standstill new investment in exploration and production. Finally, the lack of a coherent strategy for attracting foreign exploration capital had created uncertainty as to whether, during the next three or four years, the level of investment required to bring about a growth in reserves sufficient to meet domestic demand throughout the remainder of the 1980 will be forthcoming. C. PETROLEUM RESOURCES Geology 2.12 Peru is comprised of four major geologic provinces each of which contains sedimentary basins with hydrocarbon bearing potential: (1) the coastal belt, the narrow region lying between the coastline on the west and the Andean Cordillera on the east; (2) the Amazon region, the low jungled plain along the eastern and northeastern areas of Peru; (3) the Andes Cordillera, the high and geologically complex north-south trending ranges that form the backbone of Peru and separates the coastal belt from the Amazon region; and (4) the offshore basins lying between the Peru-Chile trench and the coastline where up to 4 basins have been detected. 2.13 Almost all of Peru's petroleum production has historically been obtained from the Northwestern coastal belt (IBRD Map 14470). The latest discoveries were based on gravity surveys in the mid-fifties, which led to two major onshore fields, and seismic surveys in the late 1950's and early 1960's, which led to seven offshore fields.  - 9 - 2.14 The three important sedimentary basins of the Amazon region, the Maranon, Ucayali, and Madre de Dios basins are part of large asymmetric depressions between the Andes on the west and shield areas on the east. Current production comes primarily from the Maranon basin which contains 13 fields, all discovered by PETROPERU and Occidental Petroleum. The traps are predominantly 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 PETROPE'RU. No oil production has been established as yet from the Madre de Dios basin, although large oil seeps are known. 2.15 The hydrocarbon potential of the third geologic province, the Andes Cordilleras, appears low and the complexity of its geology probably precludes serious exploration efforts in the foreseable future. However, the now abandoned Pirin Field is located in the Altiplano basin and additional small fields may be discovered in this region. Reserves 2.16 Estimates of Peru's recoverable crude oil reserves vary widely. In 1977, PETROPERU estimated reserves at approximately 750 million barrels. How- ever, some experts, including those from the US Geological Survey, believe that the 40% recovery factor used to obtain the 550 million barrel Amazon reserves figure is over optimistic, and consider a lower recovery factor of 28% more representative. On the basis of this lower recovery factor and the depletion of reserves in 1978, the current estimate of the US Geological Survey for proved reserves is 565 million barrels as follows: Primary Recovery Reserve Estimates In millions of Barrels Region PETROPERU Estimates US Estimates Amazon 550 385 Talara COnshore 132 120 Talara Offshore 74 60 Total 756 565 The US Geological Survey estimates that additional reserves - amounting to 500 million barrels -- can be recovered from known reservoirs through the application of secondary recovery methods. When inferred reserves of 30 million barrels of heavy crude oil in the Occidental lB block area are added, total reserves amount to 1095 million barrels, or approximately 10-12 years of production at present rates. Peru's reserves in the context of South America's total oil reserves are small, amounting to only 4%.  - 10 - 2.17 The question of undiscovered reserves is much more difficult to assess reliably. While estimates of ultimately recoverable reserves vary from 2 billion to 40 billion barrels, most of the higher estimates are based on expectations for the Amazon Basin in large stratigraphic traps 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 ten to fifteen years. Recent Production Trends 2.18 After stagnating throughout the first part of the 1970's, output started to increase in 1977 as production from the jungle came on stream, averaging 91,000 b/d as compared with 76,000 b/d in 1976. The past 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 the early 1960's. From an average daily production of 112,000 barrels/day (b/d) in the first quarter of 1978, output increased by over 50% to an average of 181,000 b/d by the fourth quarter, due exclusively to a fourfold increase in output from Occidental's operations in the north- eastern jungles of Peru; average production throughout 1978 averaged 150,500 b/d. Total production in the period 1976-78 is summarized in the table below. Daily Average ('000 b/d) 1976 1977 1978 Total Output 76.4 91.1 150.5 PETROPERU 37.2 52.0 50.8 (Coast) (32.7) (32.7) (31-5) (jungle) (4.5) (19.3) (19.3) Occidental 7.3 10.5 70.8 Belco 31.9 28.6 28.9 Source: PETROPERU. 2.19 In 1979 Peru will export approximately 25 million barrels of crude oil and refined products, equivalent to one-third of its total production. Aggregate crude oil output in January and February averaged 165,000 b/d and in March increased to 184,000 b/d; since early April, production has been averaging 210,000 b/d. These production levels compared with an average production of 92,000 b/d fifteen months ago in January 1978 provides some measure of the surge in Peru's crude oil output during this period. With the volume of crude oil refined domestically in Peru currently averaging 135,000 b/d, there is a sizeable margin in crude oil alone available for export. Furthermore the prospects for continuing as a net exporter, at least in the mid-1980's, are encouraging. Longer term prospects will depend to a large extent on Peru's ability to attract new exploration investment over the next few years.  - 11 - D. DEVELOPMENT PROSPECTS New Exploration Activity 2.20 The GOP is still uncertain about the aggregate level of exploration that can be anticipated over the next few years, particularly exploration in the Amazon jungle region. Although as its financial position improves PETROPERU is expected to renew its exploration activities, a large part of future exploration will necessarily have to be undertaken by private petroleum companies given their expertise and the magnitude of the effort required; it is still too early to tell how private foreign companies will react to the GOP's new initiatives. However, it is clear that a number of foreign petro- leum companies believe that Peru has considerable undiscovered reserves, par- ticularly in the Amazons. Furthermore, refinements in seismic techniques over the past five years have improved the probability of finding this oil. More detailed work is expected both in the northern jungle areas where previous exploratory activity has yielded a firm preliminary data base on which to build, and in the Central and Southern Amazon areas which have as yet been only sparsely explored. While a number of new companies, including Sun Oil, Shell, and Aininoil have shown preliminary interest, and both Occidental and Belco are interested in exploration activities on new blocks, no new explo- ration contracts have been signed since April 1978. Production 2.21 The overall petroleum picture through 1985 looks promising, with even conservative forecasts showing a continued exportable surplus for the entire period. Production is forecast to increase from 151,000 b/d in 1977 to 197,000 b/d in 19793, and then to continue to grow slowly until it reaches a peak average output of about 231,000 b/d in 1983. 2.22 Occidental's Amazon operations are expected to provide more than half of this total through at least 1983. With its high exploration success rate continuing through 1978, Occidental should be capable of maintaining production from its Amazon fields above 100,000 b/d through 1984. Since the decline in primary production from existing Belco and PETROPERU coastal operations should be more than offset by the planned secondary recovery projects coming on stream in the early 1980's, the major uncertainties affecting the 1985 production estimates are limited to two factors. (1) PETROPERU's production from new finds, particularly near its current Amazon operations. (2) New exploration success in newly opened jungle areas by private petroleum companies. 2.23 Even on a conservative basis, which discounts any possible explo- ration discoveries by companies not currently operating in Peru, aggregate crude oil otltput in 1985 should not fall below 200,000 b/d. Estimated crude oil production between 1978-85 is summarized below:  - 12 - ESTIMATES OF FUTURE DAILY CRUDE OIL OUTPUT IN PERU, 1978-1985 Actual (thousands barrels per day) 1978 1979 1980 1981 1982 1983 1984 1985 OCCIDENTAL 64 114 133 141 135 127 109 89 1. Jungle (64) (109) (115) (111) (98) (84) (66) (54) 2. Coast (secondary) (-) (5) (18) (30) (37) (43) (43) (35) BELCO 28 28 31 31 29 28 26 24 PETROPERU 58 55 55 59 61 76 93 109 1. Jungle (27) (26) (26) (31) (27) (32) (34) (36) 2. Coast (31) (29) (29) (28) (34) (44) (59) (73) Total 151 197 219 231 225 231 228 222 Domestic Demand 118 125 128 133 138 144 151 158 Aggregate Exports 33 72 91 98 87 87 77 64 PETROPERU's share of Exports 49 59 61 59 63 58 52 Source: Petroperu and Mission Estimates. Exports 2.24 Domestic demand for petroleum products is expected to remain fair- ly stable until 1980, and to increase at about 5% per year thereafter. As a result, exports, which will total about 25 million barrels in 1979, are projected to fall slowly to about 23 million barrels by 1985. After supplying the domestic market, PETROPERU's share of the 1979 export market will amount to about 17.8 million barrels; PETROPERU projects crude exports of 14.8 mil- lion barrels for $480 million, and about 3 million barrels of products for about $120 million for a total of $600 million. Investment 2.25 Investment prospects in the next 3 or 4 years look encouraging. The major thrust will be the continuation of Occidental's efforts in exploring for and developing new and existing fields in its contract areas, complemented by substantial investments in secondary recovery projects. On the basis of dis- cussions with all parties concerned, the mission believes that under favorable circumstances, the major elements are likely to be as follows: i. Occidental would invest some $200 million in developing its Amazon jungle contract areas Lots IA and 1B (see map IBRD 14471), and another $190 in secondary recovery investments in the Talara area.  - 13 - ii. Belco would invest $35 million in new exploration, development, and secondary recovery operations off-shore Talara aimed primarily at main- taining its current production levels. iii. PETROPERU would spend about $75 million in 1979 and about $200 million thereafter primarily for development and secondary recovery projects in known producing areas, and to step-up its exploration effort in the Maranon basin. iv. Other foreign companies appear to be interested in undertaking new exploratory activity, principally in the Amazon basins. If an adequate climate for foreign investment is maintained (including adequate incentives for high risk - high cost exploration undertakings) investment in exploration involving three or four additional companies might average $50 million per year in the mid-1980's with further investment depending on the level of actual discoveries. 2.26 If half of the above projects were to materialize Peru could expect that a total of about $2 billion would be invested in petroleum exploration and development activities during the first half of the 1980s, 40% of which would come from PETROPERU. This level of investment should be adequate to ensure at least continued exports through the end of the 1980s and self- sufficiency through at least the first half of the 1990s. E. GOVERNMENT POLICY Background 2.27 Peru's petroleum policy has historically been focussed on the activities of the International Petroleum Company (IPC) which first started production in Peru in the early 1900's. Throughout several decades, rela- tions had often been strained on matters related to concession agreements, tax liabilities and oil prices. In the 1960's disagreements between the Government and IPC were transformed into a full-scale political crisis which culminated in the expropriation of all of IPC's assets in 1968 against alleg- edly owed back taxes, when a new military government came to power. This was followed by the passage of a new Petroleum Law in 1969 that prohibited the granting of new exploration and development concessions to private firms. The law also gave a monopoly on all downstream petroleum related activity to PETROPERU, the company created to take over the administration of IPC's assets. Only Belco, a small independent oil company exploring in the off- shore coastal areas south of Talara, was allowed to continue its exploration and production activities. Exploration and Development Policy 2.28 In 1970 the Government modified its exclusionary policy and devel- oped a new framework for foreign private participation in the petroleum sector. The basis for the new cooperation was the "Peru Model" contract. (Annex 2.01) Under this formula private companies could explore for oil  - 14 - and eventually operate production facilities but to do so they had to enter into exploration and development contractual arrangements with PETROPERU, generally on the basis of a 50-50 split of production. The contractor had to pay all its exploration, development and operating costs out of its share of gross revenues, and PETROPERU was required to pay all of the company's tax obligations from its share. Because of its basic conceptual simplicity and ease of implementation, the Peru Model provided a firm basis for initiating a new phase of foreign involvement in the exploration of the Amazon region. Led by the discovery of a dozen oil fields in the Oriente basin by Occidental and by PETROPERU in the early 1970's, 16 other consortiums signed contracts for exploring sections of the Amazon. IJnfortunately, these early promises of considerable hydrocarbon potential in the Amazon basin were not fulfilled (paragraph 2.09). Faced with the realization that production from the Amazon basins would be substantially less than expected, with the prospects of mounting costs for oil imports as world petroleum prices rose, and with the knowledge that neither PETROPERU nor the GOP had sufficient resources to carry out the required intensive exploration program without foreign assistance, the GOP initiated in 1977 an active campaign to re-attract private companies to renew exploration activity. 1/ In addition to providing more favorable terms, the GOP recently reopened for exploration contracts 25 blocks (each 400 thousand hectares) of onshore and offshore coastal areas which had been previously reserved for PETROPERU, in addition to the 47 blocks (each 1 million hectares) reopened in the Amazon in early 1977. 2.29 While a number of oil companies have shown renewed interest in new contracts for some of these areas, Occidental's contract on a second block (Block 1B) contiguous to its existing contract area has been the only new contract concluded. The response to PETROPERU's call for bids for secondary recovery projects, however, in the Talara oil fields has been much more promising. Occidental signed a contract and started secondary recovery operations in 1978 based on the standard "Peru Model" - that is production sharing - and MAPCO had negotiations well underway for secondary recovery operations onshore Talara, when GOP issued the new basis for exploration and production contracts, in which it is stated that future secondary recovery projects will be carried out by PETROPERU (itself or in joint ventures). 2.30 As part of the 1977 campaign to re-attract private risk capital into exploring the Amazon basins, the GOP hired an internationally recognized investment bank consortium to evaluate the alternative types of contracts for consideration in future exploration and production agreements. Their find- ings were made available recently to a high level government sub-committee under the direction of MEM, which presented to the highest authorities of Peru the basis for future exploration and production contracts. On December 6, 1979, the Peruvian Cabinet approved Decree Law 22774 which updated the "Peruvian Model?? to better comply with current trends in the international oil industry. In this regard, the following main aspects and modifications have been introduced into the new Law: 1/ The Government had suspended the awarding of new contracts since September 1973.  - 15 - (i) flexibility is given to PETROPERU in drawing up new contracts, in such a way that payments in kind made by PETROPERU to its contractors in exchange for their services, would be a func- tion of the geological characteristics, exploration risks and presumed devealopment costs. Moreover, PETROPERU might take part, with not less than 25% equity participation, in joint ventures with private oil firms; (ii) PETROPERU shall carry out any new secondary or tertiary recovery project, although acquired rights will be honored; and (iii) PETROPERU's contrators would directly pay to the Peruvian Treasury its own income taxes; 1/ therefore, US-based companies would be eligible for full tax credit in the U.S. It is clearly stated in the new Law, and it has been reconfirmed during dis- cussions with senior Government officials, that it is Peru's objective to rely on private risk capital for a substantial portion of the required investment in oil exploration and production. The new Law, although quite general and in need of some refinement, provides framework for negotiating new agreements. In this regard GOP has already been approached by some oil compan:ies indicating their intentions to participate in the exploration of the Peruvian jungle, although it is likely that progress will depend on the outcome of renego- tiations of existing contracts now underway (paragraph 2.38). Pricing Policy 2.31 Following the 1973 international oil price increases, GOP's con- sumer pricing policy for petroleum was to endeavour to protect the economy from the disruptive effects of immediate price increases towards import parity. Petroleum product prices, which had not been increased since June 1969, continued unchantged until June 1975. At the same time, consumption of petroleum products, which had maintained a modest growth rate of approxi- mately 3% per annum between 1970-73, more than doubled this rate of growth between 1973-75, imposing an increasing burden on Peru's balance of payments. Although small price increases took place in 1975 and again at the beginning of 1976, the first determined action to stem the rapid rise in consumption came in July 1976 when regular gasoline prices were more than doubled from US$0.31/gallon equivalent to US$0.77/gallon equivalent. Further increases to keep up with inflation took place in 1977 and 1978, not only affecting domestic prices of gasoline but also of diesel, fuel oil and kerosene prod- ucts. As of September 1979 the domestic prices of the more important petro- leum products were as follows: 1/ Tax bracket would be 68.5% of net income before taxes.  - 16 - Soles/gallon US$/gallon 1/ Premium gasoline (octane 95) 230 0.96 Regular gasoline (octane 84) 200 0.83 Diesel 98 0.41 Fuel Oil 75 0.31 2.32 The impact of these price increases is evident in the overall con- sumption trend for petroleum products. From an average daily consumption of 116,000 b/d in 1975, 2/ consumption fell to 113,400 b/d in 1978, and is not expected to exceed 116,000 b/d in 1979. The impact is even more striking for for gasoline consumption: from an average daily consumption of 36,300 b/d in 1975, consumption fell by 25% to 27,400 b/d by 1978, and 1979 consumption is forecast to decrease further to 26,900 b/d, the same consumption level as in 1969. However, some of this decrease was due to the depressed state of the economy. 2.33 Equally important has been the improvement in the fiscal contri- bution brought about by these price increases, despite the overall reduction in consumption. At the beginning of 1976 excise taxes on gasoline were 14%. In 1979 they had increased to 32%. While prices are still well below those found in Europe, they are significantly higher than the average for North and South America; the following table is indicative of this trend. Overall, the Government has increased prices to keep up with inflation on six separate occasions from January 1978, the most recent increase 11% in January 1980. RETAIL PRICES OF SELECTED PETROLEUM PRODUCTS AS OF MARCH 1978 Ecuador Bolivia Colombia Peru Chile US France (US $/gallon) Premium Gasoline 0.19 0.66 0.50 0.89 1.17 0.72 1.83 Ordinary " 0.16 0.30 0.40 0.76 0.91 0.65 1.70 Diesel 0.14 0.24 0.38 0.37 0.76 0.63 1.05 Kerosene 0.10 0.08 0.38 0.38 0.53 0.60 0.63 Fuel Oil 0.08 0.21 0.40 0.28 0.61 0.31 0.32 Source: Mission Estimates and International Petroleum Annual, March 1978. 1/ Exchange rate, US$1.0 = 240 Soles. 2/ Does not include PETROPERU's own consumption of petroleum products which averaged about 5-6000 b/d.  - 17 - Retail prices of kerosene and diesel oil have been maintained at low levels. Peru's price policies for kerosene are based on socio-economic grounds, since it is the prime source of fuel for cooking and heating for the poor, but con- tinued subsidization of diesel oil and fuel oil, which are used in the trans- port and industrial sectors, distort consumption patterns and lead to imbal- ances in domestic refinery output requirements. For the proposed project (paragraph 5.05 (iii)) the government will increase ex-refinery prices of petroleum products in 1980; this measure will, of course, also lead to increases in retail prices. In addition, starting in 1981 a best effort clause regarding future price increases to reach international price levels gradually has been agreed. In monitoring these periodic adjustments we would review individual product prices and product growth patterns, arnd encourage the government to move towards interfuel price relationship based on the opportunity cost of competing fuels. Taxation and Incentive Policy 2.34 Foreign contractors previously were isolated from the impact of domestic tax legislation by their "Peruvian Model" contracts. These con- tracts called for a distribution of benefits based exclusively on the gross petroleum output. In the standard contract the foreign company got to sell at international prices 50% of the oil it produced net of all tax obligations, be they import duties, export taxes, production taxes or income taxes. One of the goals of these contracts when they were first introduced was to improve the climate for new foreign investment by eliminating the possibility of conflicts on tax related issues; issues that in the past had formed the basis for disputes between the GOP and foreign oil companies. However, isolating the contractors through the device of requiring PETROPERU to pay all their taxes out of its share of the revenues meant that PETROPERU has had to bear the full brunt of all oil related taxes imposed by the GOP on the Petroleum Sector. The most iTmportant taxes paid by PETROPERU are: (1) income tax on foreign contractor's net income; (2) profits remittance taxes for foreign contractors; (3) export and import taxes on petroleum and petroleum products; (4) import taxes on capital goods and operating materials and equipment for itself and for foreign contractors; (5) employment taxes and special regional production taxes, again for itself and for foreign contracts, and (6) Income tax on its own operations. 2.35 PETROPERU's tax obligations accrued from its foreign contractors operations grew rapidly along with the rapid growth of their output; from $10.6 million in 1975 (2% of PETROPERU's gross revenues) to an estimated US$89.1 million in 1978 (12.5% of PETROPERU's gross revenues). This occurred in part because an unexpected ruling by the Peruvian IRS led to the calcula- tion of foreign contractors' tax obligations in a way that made them greater than the value of the 50% of the gross production that PETROPERU received from these companies to cover the tax obligations. 2.36 Further, PETROPERU's payment of import and export taxes stopped it from trading (or swapping) different types of petroleum and petroleum prod- ucts, everL though such swaps could have been financially advantageous for Peru. Fur-thermore, export taxes that depend on the source of the crude oil  - 18 - also distort the efficient allocation of resources. Because the export taxes on petroleum from the coastal regions are $0.90 per barrel higher than that for petroleum from the Amazon, PETROPERU has been encouraged to export its lower grade Amazon petroleum and use its higher grade coastal petroleum domestically even though the latter would bring a better export price. 2.37 On December 6, 1979, GOP issued a Law Decree clarifying the taxation regime that will apply to the petroleum sector, and instructing PETROPERU and foreign oil companies on how taxes are to be reported for 1978 and 1979. 1/ 2.38 Under the new taxation regime, foreign oil companies operating in Peru will be liable for paying to the Peruvian Treasury its own income taxes (tax bracket 55%) and profit remittances taxes (30% of net income after taxes). 2/ On the other hand, PETROPERU will continue to be liable for paying on behalf of its contractors taxes on export of crude oil, import duties on materials and equipment, and production royalties and cannons. However, overall import and export tax payments, as well as royalties, now will be deductible from PETROPERU's income tax calculations. Taxes accruing from 1978 and 1979 operations will be reported under the new tax regime outlined above, although the new Law Decree fell short of specifying who, PETROPERU or foreign oil contractors, will be liable to the Peruvian Treasury for paying foreign oil contractors' income and remittances taxes for 1978 and 1979, a matter which is under negotiation. The new tax regime assimilates the petroleum sector to the general tax code of Peru and, although burdensome, it would correct past damaging effects on PETROPERU's finances. US-based companies operating in Peru would be eligible for U.S. tax credits, under the recently issued guidelines of the United States IRS. Assuming a satisfactory conclu- sion of renegotiations of existing contracts now underway, there would be a basis for renewed investment by the private sector. Role of the Bank 2.39 Bank involvement in Peru's petroleum sector has several important objectives. First, with internal demand likely to rebound after several years of stagnation, it is essential that PETROPERU be able to maintain the production capacity of existing facilities and also have the capacity to develop new production potential, if Peru is to avoid becoming a net oil importer again in the early 1980s. The provision of urgently needed pumping equipment will help achieve this objective by stabilizing and increasing PETROPERU's production from the jungle and coastal producing fields; in addition, providing financial assistance for updating a feasibility study for an important secondary recovery project, will prepare the ground for a large 1/ The deadline for filing these returns has been extended for the fourth time to March 1980. 2/ Contractors' taxes on income to the Peruvian Treasury will be provided to PETROPERU in the form of yearly equity injections for the purpose of helping finance PETROPERU's investment program.  - 19 - investment in new production capacity. The second important objective of Bank involvement in the sector would be to facilitate a solution to PETROPERU's two most pressing institutional difficulties: the weakened operalting and managerial capabilities brought about by the recent loss of numerous technical personnel; and the need to return PETROPERU to a sound financial footing by strengthening the company's capital structure, rationalizing the current tax regime, and by encourasging PETROPERU to exercise a greater degree of financial independence than currently exists. Thirdly, by providing financial assis- tance for updating a feasibility study for an important secondary recovery Project, the Bank will. better be able not only to ensure a sound technical and economic basis for proceeding with the project, but more importantly, to play an active ro:Le in mobilizing finance for this project from a number of inter- ested financial and investment institutions. Finally, by responding quickly to PETROPERU's current: financing needs at a critical time, the Bank would be in a position to establish an effective dialogue with the pertinent government ministries on a number of sectoral policy matters affecting the future devel- opment of the sector -- among them, exploration incentives for new contract areas in the jungle, a need to define more precisely the activities of pri- vate companies, and domestic pricing for petroleum products. 2.40 An effective dialogue has already been initiated between the Bank and Peru's policy makers on these matters which will be further studied under the proposed loan. With the possibility of another round of petroleum explo- ration activity in the near future, the Bank has the prospect of providing not only urgently needed long-term financing to PETROPERU, but the analytical basis to the government for it to determine the best means of attracting additional investment in the sector. III. THE BORROWER Background 3.01 The national oil company, Petroleos del Peru (PETROPERIJ), was established by Decree-Law 17753 on July 24, 1969 following the nationali- zation of the production and refining operations held at the time by the foreign-owne!d International Petroleum Company (IPC). 1/ On this date, PETROPERU absorbed the production operations of the Empresa Petrolera Fiscal, (EPF) a government-owned oil company with production operations in the Northern Peruvian. coastal region, in an area nearby to those of IPC, and 1/ Esso Corporation.  - 20 - assumed responsibility for the management and administration of IPC's produc- tion and refining operations. In 1973 PETROPERU acquired the Conchan, Lobitos and Ganso Azul companies which were privately owned. 1/ As a result of these acquisitions, PETROPERU now controls 100% of the refining capacity and 98% of the petroleum products marketed in Peru. Operations 3.02 PETROPERU is the official entity for conducting all the state's activities in the hydrocarbon sector, including not only exploration, produc- tion, refining and marketing of all petroleum products, but also activities related to pipeline transportation of crude oil, fertilizer production and petrochemicals. PETROPERU also has a small fleet of petroleum tankers which are used for the transport of crude oil and petroleum products between the Peruvian coastal ports as well as for river transport in the Peruvian Amazon region. 3.03 PETROPERU's production, which averaged 50,800 b/d in 1978, comes from two main producing areas: (a) the coastal area where average daily output in 1978 was 31,500 barrels; and (b) the jungle area where average daily output in 1978 was 19,300 barrels. PETROPERU's refining operations comprise four main refineries which have an overall capacity of approximately 170,000 b/d. The two largest refineries are at La Pampilla (92,000 b/d) and Talara (65,000 b/d) and together account for almost all of Peru's refining capacity; two small refineries are located in the jungle to meet the small market needs of that area. PETROPERU has a network of storage depots and retail outlets located throughout the country. Except for lubricants, PETROPERU is the sole marketer of petroleum products in the country. The other major petroleum operation owned by PETROPERU is the Trans-Andean pipe- line which extends from San Jose de Saramuro in the northern jungle to the northern coastal port of Bayovar, a total length of 853 km. In addition, a northern branch line from Occidental's producing fields linking up with the main Trans-Andean pipeline is also owned by PETROPERU. The design capacity of the Trans-Andean pipiline is approximately 240,000 b/d and of the northern branch line, 100,000 b/d. Organization 3.04 PETROPERU is governed by a Board of Directors consisting of nine members. The Chairman of the Board is the highest ranking official within PETROPERU. Four members of the Board are representatives of the Ministry of 1/ Conchan - A small refinery operation; Lobitos - a foreign-owned company (Burmah Oil) with production and marketing operations in the coastal area; Ganso Azul - a Peruvian-owned company with a small production operation in the Central jungle. El Oriente, a Peruvian-owned private oil company with a small production operation in the Central Jungle. Gulf Oil Company marketing and distribution operations in the metro- politan Lima area were also acquired.  - 21 - Energy and Mines and two others are representatives of the Ministry of Industry, and the Ministry of Economy and Finance; the remaining two members are representatives of PETROPERU's professional and working-level employees, in accordance with Peru's industrial legislation requirements. Nlone of the managers of the key operating departments, including the general manager, are represented on the Board. 3.05 The Board has responsibility for approving all interna]L policy matters related to personnel administration, general salary increases, invest- ment decisions, and budget matters. During the period of severe economic recession in 1978, salaries of public sector entities such as PETROPERU were strictly controlled by Central Government guidelines and any genesral salary increase required prior approval of the Cabinet. In recent months this control has been somewhat relaxed and the Board now has alithority to approve general salary increases within the framework of the approved budget. Never- theless, because of the complex financial dependence of PETROPERIJ on the Central Government PETROPERU has been unable to exercise any substantive degree of financial operating independence since 1973. 3.06 The General Manager, in collaboration with the key operational managers in the exploration-production, refining and engineering departments, have responsibility for day-to-day operational matters. The aut'hority of the General Manager is relatively limited, however, and many matters such as minor operational investment decisions are referred directly to the Board. 3.07 The field offices also have limited authority and routine opera- tional matters are frequently submitted to Lima for approval, particularly in past months with t:he shortage of experienced field personnel. The general lack of managerial authority within the company and over-centralized control by the Central Government in recent years, have frustrated PETROPERU's oper- ating efficiency and has contributed to the current weak institutional situa- tion of the company. PETROPERU's management organization will be reviewed in conjunction with the second study (ref. paragraph 3.14) aimed at improving PETROPERU's financia'L management practices. Staffing, Management and Salaries 3.08 The total rnumber of employees of PETROPERU is approximately 8,500, somewhat larger than private oil companies. This is, in part, attributable to the widespread use of contractors by private companies in their field opera- tions, particularly drilling, while PETROPERU has endeavored to build up an in-house technical expertise. Approximately 1,000 of PETEROPEREU's employees are located in the central headquarters in Lima; a sizeable number are located in PETROPERU's field offices, the most important of which are in Talara and Iquitos. The Talara office employs approximately 4,000 personnel and the Iquitos office approximately 700. 3.09 PETROPERU's senior management is competent and has extensive expe- rience in the petroleum industry in Peru. PETROPERU's middle management how- ever, is much less experienced and has been weakened by the loss of numerous technical and administrative staff in the past 12-18 months. This has been  - 22 - primarily due to salary difficulties within the company since 1976 at a time when there was a resurgence of petroleum activity in Peru which provided an alternative and nearby market for PETROPERU's experienced operating personnel. The Exploration and Production Department in Lima lost almost 50% of its technical staff in 1978. Most of these engineers had an average experience of 12 years or more; the average experience has been reduced in consequence to less than 5 years. 3.10 Earlier this year measures were taken by the Government aimed at improving the salary structure of all the major public sector enterprises, including PETROPERU. First, a policy decision was taken to free such enter- prises from salary ceiling strictures which had severely limited the ability of public sector enterprises to improve the salary conditions of their staff. Second, a salary increase came into effect in March which increased most salaries of professional staff by some 25-30%; additional benefits were also included in the salary package. As a consequence, PETROPERU's salaries are now comparable with those of Peruvians employed in private petroleum companies in Peru, and the loss of staff from PETROPERU to con- tractors operating in Peru has declined. Further salary increases are expected later this year. During negotiations, agreement was reached with the government and PETROPERU that the competitiveness of PETROPERU's salaries will be maintained throughout the implementation of the project. For this purpose, PETROPERU will inform the Bank at regular intervals not exceeding 6 months, of any salary increases for its professional staff, and make a comparison of such salary levels with equivalent levels in private oil com- panies operating in Peru. 3.11 Despite this loss of experienced staff, PETROPERU has shown itself capable in past months of attending to its most urgent operational needs with its current staff. Nevertheless, considerable strengthening of PETROPERU's technical capabilities will be required if PETROPERU is to be able to exercise a more dynamic role in exploration and production throughout the next decade. For this reason the proposed loan contemplates the training of PETROPERU's less experienced staff, consultancy services to help train PETROPERU's field staff in maintenance of new pumping equipment, and an upgrading of PETROPERU's reservoir engineering capabilities so as to optimize the design of field production installations, and produce oil at a rate that would lead to the most efficient overall recovery. Accounting and Auditing 3.12 Because PETROPERU was created as a result of a merger of IPC and EPF, and subsequently absorbed five other smaller private petroleum operations with substantially different accounting procedures, the standardizing of all these different accounting and budgeting procedures, as well as updating and modernizing them, is still being resolved. Substantial progress has been made in recent years, and standardization will be finalized shortly. 3.13 PETROPERU's internal audit department, under the direction of a Chief Internal Auditor, reports directly to PETROPERU's Board of Directors and is subject to audit review by the Office of the Comptroller and Auditor General of Peru. PETROPERU's Chief Internal Auditor has prepared a plan of  - 23 - action to gradually tackle the company's auditing procedures, but implementa- tion difficulties are likely to occur due to the limited experience and capabilities of its current staff. Due largely to the nationalization of privately-owned industries in 1968, and the vast work load imposed on the Auditor-General's office, no external auditing of PETROPERU's accounts was undertaken until 1976 when the government retained Evans, Tapia and Associates (representatives of Arthur Young and Co.) for a period of two years. Since discrepancies existed in PETROPERU's fixed assets valuation anid depreciation schedules, as well as in several other accounts, the independent auditors were unable to certify PETROPERU's accounts for fiscal years 1976 and 1977; they did acknowledge, however, that substantial improvements had been made in 1977 by PETROPERU and the government in clarifying PETROPERU's financial position. Despite progress over the last two years in upgrading its accounting systems, there is still scopi for improvement in such areas as, asset valuation, contracts for leased equipment, cost accounting, and certain equipment purchases. 3.14 In order to help PETROPERU in these matters, two studies will be financed as components of the proposed loan; these studies would be carried out in close collaboration with PETROPERU and COFIDE 1/ by qualified consulting firms. The first study is aimed at helping PETROPERU carry-out an in-depth study of its fixed assets, including the urgently needed physical counting and book reconciliation. The second study is aimed at modernizing PETROPERU's overall accounting, budgeting, and internal auditing procedures as well as improving information requirements throughout the company. Consultants to help PETROPERU to carry out the second study will be appointed not later than August 31, 1980. The first study and the inventory of its fixed assets and book reconciliatiorn will be completed not later than August 31, 1981. The second study will be completed not later than October 31, 1981. Insurance 3.15 PETROPERIJ carries adequate comprehensive insurance cn all its facilities and equ.ipment against fire, blow-outs, damage, earthquakes and theft. Insurance agreements are entered into directly by PETROPERU either with foreign insurance companies or with local insurance companies reinsured by foreign insurance companies. IV. THE PROJECT Background 4.01 Historically, most of Peru's crude oil has been produced from the onshore and offshore Northeastern coastal area close to Talara (Map IBRD 14470). This area has been in production for more than 100 years and until the early 1960's met all of Peru's domestic oil requirements. More than 10,000 wells have been drilled in the area and approximately 1 billion barrels of crude oil produced. 1/ COFIDE - Corporacion Financiera de Desarrollo: Peru's main development financing institution entrusted - inter alia - with responsibility of helping to strengthen institutional aspects of public sector agencies.  - 24 - 4.02 Current production from the Talara area is approximately 60,000 b/d, about half of which comes from PETROPERU's production operations. PETRO- PERU's production, however, has been declining steadily for many years from this area, down from 63,000 b/d in 1965 to 31,000 b/d in 1978. Despite the large number of wells drilled and the extensive production history, a con- siderable volume of oil can still be recovered through reactivation of old wells, further drilling in known producing areas, and application of secondary recovery methods. 4.03 Crude oil production in the northern Peruvian Amazon basin first started in the early 1970s but a significant increase in production came about only with the completion of the Trans-Andean pipeline. By the end of 1978 production had reached 120,000 b/d, or 2/3 of Peru's total output. The bulk of this production originated from Occidental's producing fields; PETROPERU's production from the Amazon region averaged only 25,000 b/d and has been erratic in past months due to the lack of pumping facilities as reservoir pressures declined. Moreover, the recent loss of many experienced technical staff, investment constraints, and the cessation of exploration activity, gave rise to doubts as to whether PETROPERU could even maintain current production levels from either its coastal or jungle areas. 4.04 Against this background, the Minister of Energy and Mines requested that a Bank mission visit Peru in early 1979 to review the financial require- ments of the petroleum sector and to assist in its future development. Fol- lowing a reconnaissance mission in February 1979 and a subsequent preparation mission in April, an initial package for possible Bank financial assistance was identified. A Bank Appraisal Mission subsequently visited Peru between May 22 and June 9, 1979, and a short updating mission returned in July 1979. PROJECT DESCRIPTION General Objectives 4.05 The project comprises several components designed, first, to increase Peru's oil production in the short term by rehabilitating production operations under the control of PETROPERU; second, to enhance Peru's medium term petroleum production capacity by undertaking detailed seismic surveys in known producing areas of the northeastern and central jungle, and by preparing a secondary recovery investment project to be implemented in the early 1980s; and, finally, to strengthen the financial and technical capability of PETROPERU. Each of the components is described in detail in the ensuing paragraphs. 1. Rehabilitation of Existing Production 4.06 This component comprises: (a) the provision of pumping equipment to restore declining production from fields in the Peruvian Amazon jungle; and (b) bringing into production 300 temporarily abandoned wells in the North Western coastal area.  - 25 - (a) The Installation of "Artificial Lift" in PETROPERU's Northern Jungle Operations ($11.9 million) 4.07 PETROPERU's crude oil production in the Northeastern jungle presently originates from four producing structures. The most prolific of these is Corrientes, whose present production is approximately 16,000 barrels per day; three smaller fields, Yanayacu, Pavayacu and Capirona, make up the remainder of a, total average output from this area of 20,000 b/d (see Map IBRD 14471). The reserve potential of these fields and the total volume of oil produced so far is given in Annex 4.01. 4.08 Originally, sufficient potential energy was available in these reservoirs to allow the wells to produce without recourse to any artificial help. However, the somewhat heavy nature of the oil and the limited amount of gas in solution has restricted the natural flow of oil from these wells to a short life span of a few months. In order to be able to maintain sufficient pressure which will allow the reservoir to produce at its maximum capacity, artificial lift methods, i.e., "gas lift" or pumping equipment, are normally installed in the prodiucing fields. 4.09 PETROPERU recently acquired 12 electrical centrifugal down-hole pumps: 5 have already been installed and 7 will be installed shortly. Approximately 35 additional electro centrifugal pumps will be required for the four producing structures. In addition, a workover rig 1/ and a pulling unit 2/ would be acquired to enhance the efficiency of PETROPERIJ's operations as well as help increase the level of production from these fie:Lds. The availability of these units would reduce the high helicopter transportation costs between different fields and speed up the servicing of weLls during their productive life. The combined estimated cost of these units is US$3 millions. All these additional units would be financed under tlhe proposed project. In addition, reservoir simulation studies for the four producing fields would be undetrtaken. These studies would simulate mathematically the 1/ Workover Rig: A workover rig is light drilling equipment used to service oil (and gas) wells during their productive life span. Among the services it can perform are: recementing a producing zone to shut out intruding water which allows the oil to be produced free of any contamination; sand control to stop abrasion in the production tubing and in the surface installations; putting a well back in production by shutting off an exhausted producing horizon and starting production from a new horizon; cleaning obstructing materials from inside the production tubing or casing. A workover rig consists of a mast, transmission engines, pumps, mud tanks, etc. The dimensions of these components are related to the depth capacity for which the rig is used. 2/ Pulling Unit: A rig used to keep a well in production, but limited to the operation of pulling out the production tubing and pumps and running it back down with other equipment or the same equiLpment after it has been repaired. It does not have the capability of drilling a well.  - 26 - actual producing conditions of each of the fields. The purpose would be to compare the simulation studies with the actual production and reservoir engineering data from these fields which will enable PETROPERU to improve the present operational control and determine future development of each of these producing fields. The total cost of these studies is estimated at US$300,000 and would take four months to complete. Annex 4.02 lists the actual producing wells in PETROPERU's Northern jungle operations and indicates the present and future requirements for artificial lift systems. As a result of the proposed investment, an initial increase in production of approximately 18,500 b/d, or almost 70% greater than present levels, would be obtained; production will decline thereafter at approximately 20% per year. The expected production profile is outlined in Annex 4.03. (b) Reactivation of 300 Temporarily Abandoned Wells in PETROPERU's Coastal Operations ($12.1 million) 4.10 Significant volumes of primary production can still be recovered from wells in the Talara area (Map IBRD 14470) that had been shut down as marginal in the period prior to the increase in international oil prices in 1973. During the 1950's and 1960's when production from a well fell below what was then considered the economic limit (typically five barrels per day), the surface and subsurface production facilities were dismantled and relocated in wells which had greater production potential. While workover and remedial treatment of some of these wells continues as part of an ongoing investment program, new pumping equipment is required to enhance production from a large number of wells that have ceased to produce. It is estimated that some 1,250 idle wells (out of a total of 10,000 wells drilled) could be reactivated. Of this total, approximately 300 oil wells are located in the western sector of the Brea Parinas field. 4.11 Several pumping systems have been used in these wells during their productive life. It is proposed that a combination of these systems be acquired for the entire operation as follows: Pumping Unit No. of Wells permanent 48 Mechanical moveable 36 Mechanical with central electric system 120 Swabbing 1/ 96 300 1/ Swabbing: An intermittent pumping operation using a mobile pumping unit which periodically cleans up the producing formation of a well in order to restore its production capacity. This pumping unit allows one to obtain, in a very short time, the volume of oil the well would be capable of yielding. The swabbing unit is installed in a truck so that it can attend to a number of wells in the same day.  - 27 - The proposed investment will provide financing for the installation of pumping equipment and other accessory equipment and facilities required to reactivate primary production from 300 wells. PETROPERU's technical staff is currently studying specific locations of wells to be activated and will determine which pumping units should be installed on which wells. Bank staff would review the adequacy of these preparative steps before any disbursement under this compo- nent of the loan takes place. It is estimated that the additional primary production from the 300 wells would initially be 400,000 barrels per year, declining at approximately 5% per year in the 10-year period considered. 1/ Total incremental production is estimated to be 3.5 million barrels. 2. Development of New Production Potential 4.12 This component comprises: (a) reactivation of PETROPERU's explora- tion activity by undertaking seismic surveys to delineate more fully a number of promising structures in the northeastern and central jungle areas; (b) the updating and completion of a feasibility and basic engineering study for a secondary recovery project. (a) Reactivation of Exploration Activity - Semi Detailed and Detailed Seismic Surveys ($11.3 million) 4.13 Due to worsening financial difficulties which have severely limited the availability of internal funds, PETROPERU's exploration activity has declined markedly; no exploratory drilling has taken place since early 1978 and seismic work has also had to be curtailed. While the government's overall strategy in exploration relies on attracting an increased leveL of investment in explora,tion from foreign oil companies (paragraph 2.30), an important complementary role will be played by PETROPERU, particularly in the immediate future, in intensifying its exploration effort in a limited number of areas where its earlier exploration activity has met with success and where the prospect for discovering new oil reserves is promising. These areas have already been quite extensively prospected by PETROPERU. 4.14 The initial phase of PETROPERU's exploration program will con- centrate on carrying out more extensive seismic coverage in two known produc- ing areas of the Peruvian Amazon region: the north-eastern section of Block 8 in the north-eastern jungle, and two different regions within Block 31 in the central jungle area. In Block 8, the currently producing fields of Pavayacu, Yanayacu, Valencia and Corrientes have clear geological alignment with the currently producing and recently discovered fields in Occidental's Block 1B (See map tEBRD 14471). In between these two producing areas, seismic prospecting has been carried out but only with a wide spacing, making it essential for detailed seismic surveying to be undertaken to evaluate more comprehensively the potential of this area and delineate more precisely geological structures that are likely to be present. In addit:ion, the full 1/ Production is expected to continue well beyond their ten year period.  - 28 - extent of the Pavayacu and Valencia producing structures in PETROPERU's Block 8 has not been fully delineated by the seismic work undertaken so far; seismic work needs to be completed on two other promising structures, Chambira and San Juan, which have also been detected in Block 8. Overall, this regional area is regarded as the most attractive area in all of Peru for detecting new oil bearing prospects capable of being brought into production in a short period. 4.15 Block 31 is located in the central jungle area where small oil fields have been producing since as early as 1939; the oil is of excellent quality in regard to sulfur content and viscosity. Although this area is located far away from the Trans-Andean pipeline system, pipeline connection to the nearby river 30 km away and subsequent transportation of crude oil by barge to one of several small refineries located in the jungle is feasible. The main objectives of the proposed seismic program to be undertaken in Block 31 is to detect new, shallow, oil bearing formations at depths of approximately 3,000 feet. Most of the oil discoveries made so far have been detected by surface geology surveys. Subsequently, a group of companies in the early 70s (Signal, Hispanoil and Total) undertook seismic work in this area. However, the coverage was limited and advances in seismic technology in the past few years fully justify a more extensive seismic program. 4.16 The seismic component would comprise, in the first phase, the carry- ing out of 1,600 line-kms of semi-detailed surveying in two blocks of the jungle (800 km in Block 8 and 800 km in Block 31) with multiple coverage to be done by contractors, followed by conventional processing of the seismic information obtained. Following completion of the seismic work, it is planned to undertake a further 500 line-kms of detailed seismic survey in these two blocks. A mutual agreement between PETROPERU and Bank staff on the interpreta- tion of the seismic results of the first phase, and on the justification for undertaking additional seismic work, would be reached before the second phase begins. This will be a condition of disbursement for the second phase. (b) Feasibility Study for Secondary Recovery Project (US$2.2 million) 4.17 PETROPERU has been planning for some time a secondary recovery project in the Brea-Parinas area aimed at recovering some 40 million addi- tional barrels of oil. A feasibility study was undertaken in 1974 by Keplinger Associates; subsequently, PETROPERU invited proposals for imple- mentation of the project from two Latin American companies, both of which submitted detailed proposals. Considerable information, therefore, exists regarding the proposed secondary recovery project. What is required at present is to update the current information, define the number of reservoirs to be included, program an efficient primary production, complete the basic information and conceptual design work, and then start mobilizing the required financing. This sub-project would comprise the updating of existing informa- tion involving approximately 200 man/months of consultancy services; the study would take 4-6 months to complete. Bank financing of the secondary recovery project itself could be envisaged in a future lending operation.  - 29 - 3. Consultancy Services and Training ($3.0 million) 4.18 This would assist PETROPERU, first, by undertaking two studies aimed at strengthening the company's financial and administrative management systems; second, by providing foreign technical experts for specific operational bottlenecks and consolidating the overseas training program for PETROPERU's operating and technical staff, and finally by undertaking studies to help define more precisely PETROPERU's future role in the sector, and to recommend policy alternatives concerning pricing of hydrocarbons to maximize the hydro- carbon sector's contribution to the economic development of Peru. 4.19 The first set of studies aims at establishing the steps needed to improve PETEIOPERU's current financial administration and management informa- tion practices. In order to achieve this, studies (paragraph 3.14) would be undertaken by an experienced financial management consulting firm(s) in collaboration with PETROPERU's middle and upper management. In particular, emphasis will be given to cost control budgeting system, inventory control, fixed assets revaluation, cash management, general accounting procedures, and upgrading PETROPERU's electronic data processing and procedure manuals. Upon completion of these studies, the recommendations of the consultants would be discussed with PETROI'ERU's top management and a phased action program agreed with the Bank for its, implementation. 4.20 Financing of technical advisory services would allow E'ETROPERU to hire individual or teams of consultants. These consultants would advise PETROPERU's production and field staff on specific day-to-day operational difficulties which have become more acute as a result of the recent loss of experienced operational staff. In addition, funds would be available for the provision of teclhnical advisory services for the maintenance and repair work of the large number of pumping units which will be procuredl under the proposed project. Also, funds would be available to help train PETROPERU's less experienced operating personnel in reservoir engineering practices. The recruitment of young petroleum engineers, sending them through a field training program, selecting the most promising for additional specialized training abroad, will help strengthen PETROPERU's operations. 4.21 Finally, in the context of the overall development of the petroleum sector, a study would be undertaken which would examine the futuare explora- tion and development investment requirements needed to maintain production at a level which would assure the country's self-sufficiency in crude oil throughout the next decade. In so doing, the study would help define more precisely the borrower's role in the future development of the sector, the level of investment to be undertaken by PETROPERU in complementing the explora- tion activity of foreign oil companies, as well as outlining the legislative framework, policy initiatives and specific incentives required to step up exploration activity in the sector. This study would also examine, inter alia, the economic benefits to be derived from increasing the capacity to the northern branch pipeline system, and would come up with specific recommenda- tions for optimizing the timing of this investment. Agreement was reached during negotiations that the government will exchange views with the Bank  - 30 - on the findings of the study and on the action intended to be taken for the carrying out of the final recommendations of such study. A second study could also be undertaken concerning pricing of hydrocarbons which will, recommend policy alternatives to maximize the hydrocarbon sector's contribution to the economic development of Peru. The study will analyze pricing policies and price levels on a product-by-product basis to recommend pricing policies that would ensure rational allocation of resources and the financial viability of PETROPERU. The impact of such policies will be assessed in financial and economic terms, taking into account, inter alia, opportunity costs, social implications, demand elasticity, supply constraints, alternative energy sources and the measurement and costs of explicit and implicit subsidies. Project Implementation 4.22 Project implementation schedules of each of the individual sub- projects are summarized below: Completion Current Status Date (February 1980) 1. 'Production Rehabilitation (a) Installation of Artificial Lift Quotations July 1981 Requested for Initial Pumping Units (b) Reactivation of 300 Abandoned Wells Equipment list July 1982 being drawn up 2. Development New Production Potential (a) Seismic Surveying Bidding documents July 1981 being prepared (b) Preparation Secondary Recovery Consultants being July 1980 Project selected 3. PETROPERU - Consultancy Services and TOR being Dec. 1981 Training finalized by PETROPERU Most of the individual components to be financed by the Bank will be carried out within 18-24 months with the exception of the reactivation of 300 wells for PETROPERU's coastal operations which is expected to take somewhat longer. These timetables are considered realistic, particularly given the urgency attached to the projects and the steps already taken to get them underway.  - 31 - 4.23 PETROPERU'S Exploration-Production department will have overall responsibility for implementation of the important production rehabilitation component of the project; direct responsibility for installing the pumping units and undertaking well workovers will fall under the field operating departments located in Iquitos (for the Northern jungle operations) and Talara (for the coasital operations). The seismic surveys will be undertaken by experienced seismic contracting firms working under the direc:tion of the exploration-production department. Despite the loss of experienced technical staff throughout 1978 from both the Lima and field department offices, PETROPERU's senior technical management is experienced and competent. There is a core of experienced staff in the field to ensure that these components of the project will be undertaken efficiently. Until PETROPERU's staff becomes familiar with the maintenance and repair of the pumping units, however, the services of specialized experts will be needed on a continuing basis over and above those normally provided in the initial contract. For this purpose, and for other specialized needs related to this phase of the project, funds will be made available which will allow PETROPERU to acquire such services as the need arises. 4.24 For the coastal operations, the existing operating staff is con- sidered competent to undertake the reactivation of 300 temporarily abandoned wells. Although the proposed investment will mean stepping up appreciably an ongoing program, it will not require additional operating staff but rather a more concentrated focus of available staff on the Brea-Parinas area where the project: will be carried out, as well as a rationalization of existing infrastructure (stores, warehouses, maintenance shops) that was designed more for the needs cf a refinery operation than for a secondary recovery operation. 4.25 The preparatory work for a secondary recovery project in the Brea Parinas area will be undertaken by a qualified consulting engineering firm with extensive experience in secondary recovery; PETROPERU's Exploration and Production department will supervise the work of the consultants. A short- list of qualified consulting firms was drawn up by PETROPERU in November 1979 and an invitation to submit proposals will be sent to each firm in December. It is expected that PETROPERU will sign a contract by January 1980, with work on the feasibility study and the basic engineering starting shortly afterwards. 4.26 Finally, the proposed review of PETROPERU's financial and adminis- trative management systems will be undertaken by a qualified consulting firm with prior experience in evaluating financial management systems of both national and private oil companies. The terms of reference for this study will be mutually agreed upon between PETROPERU and the Bank, and the review will be completed by June 30, 1980. Project Costs 4.27 The total cost of the project is estimated at US$50.7 million of which US$32.5 million, or 64%, represents the foreign exchange component; this estimate is based on 1979 prices. Customs duties and taxes are estimated at  - 32 - about US$5.3 million. Physical contingencies have been estimated on the basis of an overall composite 12% rate for equipment, materials and consultancy services. This contingency factor has been derived on the basis of 8% rate for pumping equipment and seismic contracting services and a higher 20% rate for drilling materials, other surface and subsurface equipment, and consultancy services where the volume, scope and costs are less well defined. Engineering services have been calculated on the basis of unit costs of US$9,000 per man- month, which approximates actual costs for similar services recently financed under Bank loans. Price escalation has been calculated on the basis of a 9% inflation rate during 1980 and 1981. Local cost estimates have been calculated in US$ equivalent on the assumption that internal inflation rates in Peru will be matched by continuous adjustments to the exchange rate which reflects Peru's exchange rate policy. 4.28 Estimated costs of the projects are summarized below: Summary Capital Costs (in US$ million) % of Sub-Project Local Foreign Total Base Cost 1. Production Rehabilitation 11.8 12.2 24.0 59 (a) Artificial Lift (4.2) (7.7) (11.9) (29) (b) Reactivation 300 wells (7.6) (4.5) (12.1) (30) 2. Development New Production Potential 2.2 11.8 14.0 34 (a) Seismic Survey (2.0) (9.8) (11.8) (29) (b) Preparation Secondary Recovery Project (0.2) (2.0) (2.2) (5) 3. Consultancy Services and Training 0.5 2.5 3.0 7 Sub Total 14.5 1/ 26.5 41.0 100 Physical Contingencies 1.7 2.8 4.5 Price Escalation 2.0 3.2 5.2 TOTAL 18.2 32.5 50.7 1/ Includes about US$5.3 million customs duties and taxes.  - 33 - Project Financing Plan 4.29 The total estimated cost of the project, US$50.2 million equivalent, including physical and price contingencies, is expected to be funded as follows: Local Foreign Currency Currency Total (%) PETROPERU 18.2 - 18.2 (36) IBRD - 32.5 32.5 (64) TOTAL 18.2 32.5 50.7 (100) Bank funds will cover 64% of total estimated financing requirements and 100% of the foreign exchange component. PETROPERU will finance all local currency expenditures. 4.30 It is proposed that the Bank loan be made to PETROPERU with the guarantee of the government at the current lending rate plus a guarantee fee for a period of 17 years, including 3 years of grace. The principal equipment items for the two rehabilitation components i.e. 1 (a) and 1 (b), are pumping units, subsurface equipment, and electro-centrifugal pumping units 1/ which have, on average, a uiseful productive life of at least 20 years; oil reserves in the Talara area and in the jungle are sufficient to sustain production for at least the same period. For the seismic component it is not feasible to relate this investmenat to the useful productive life of any discovery that may result. Though the recent past exploration success in this area indicates that the prospect for new discoveries are promising with further drilling, uncertainty exists as to the timing of any benefits derived from the seismic work; this would argue for longer term financing. On the basis of the above considerations, and in view of PETROPERU's need for longer term financing given its high debt servicing payments through 1982, and the critical impor- tance of being able to sustain a modest exploration program, a loan term of 17 years, including 3 years of grace is recommended. In addition, because Peru faces medium term balance of payments problems which are expected to become serious at the time repayment of the proposed loan will begin, it should receive as much financing as possible on longer terms. Disbursement and Allocation of Bank Loan 4.31 The proposed Bank loan of US$32.5 million would finance the following items: (i) 100% of foreign expenditures and 80% of local expenditures for pumping equipment, surface and subsurface equipment, drilling equipment, and other imported materials related to the following project subcomponents: 1/ Repair/replacement of the motor (5% cost) will be required every 2 years.  - 34 - 1) installation "artificial lift" in the jungle (1(a)) 2) reactivation 300 wells Talara (1(b)) 90% of total expenditures (representing the estimated foreign exchange component) for Seismic party services related to subcomponent 2(a) would also be financed under the proposed loan. (ii) 90% of total expenditures for consultant's services carried out in connection with project sub-components 1(a), 2(b) and 3, and 100% of foreign expenditures for training; (iii) No disbursements would be made under project sub-component l(b) pending Bank review of a satisfactory preparative plan (paragraph 4.11); no disbursements would be made for expen- ditures for the second phase of seismic party services under 2(a) without comprehensive discussion of seismic results (paragraph 4.16); (iv) Retroactive financing up to the amount of US$2.0 million would be made for equipment orders placed after February 1, 1980 in respect of 1(a) and 1(b), as well as for seismic party services (2(a)) and consulting services (2(b)) con- tracted after the same date. These equipment orders (i.e. pumping units) are urgent since production has been declining sharply from a number of wells. PETROPERU has already financed the purchase of some pumps from its own funds and is depending on the Bank loan to help finance the continuation of the pump installation program. Disbursement of the Bank loan is expected as follows: (US$ Million) 1980 1981 1982 Incremental 5.0 16.6 11.0 Cumulative 5.0 21.5 32.5 The loan would be fully disbursed by December 31, 1982. Procurement 4.32 Equipment and materials, as well as the seismic party services, to be financed by the Bank loan will be procured by international competitive bidding procedures following Bank guidelines. Contracts for: (a) drilling materials and surface and sub-surface equipment other than pumps; (b) the first 17 pumps to be acquired for the jungle operations (1(a)); and (c) processing and reprocessing of seismic data, may be awarded after soliciting price quotations from suppliers or contractors satisfactory to the Bank from  - 35 - not less than three member countries and Switzerland; provided, however, that the aggregate amount of contracts so awarded shall not exceed US$3 million. Qualified local suppliers and members of the Latin American Free Trade Associa- tion participating in international competitive bidding would be accorded a preference of 15%, or the prevailing duty, which ever is lower. Project Risks 4.33 The risks associated with the project are those inherent in petro- leum production. The extensive production history of the Northern coastal and jungle fields establishes a high degree of confidence in the recoverable reserve estimates and in the reservoir behaviour of each of the producing fields. PETROPERU has considerable operating experience in the I'alara coastal area and in supervising seismic surveying in the jungle, so that little difficulty is anticipated in carrying out the reactivation of 300 temporarily abandoned wells or the seismic work program. 4.34 There is some risk in the installation of artificial lift systems for PETROPERU's jungle operations where PETROPERU has just recently been acquiring experience with electric submersible pumping equipment. Teething problems in the efficient use of this equipment, and more particularly in the specialized maintenance and repair work which will be required, will inevit- ably arise. In order to reduce such risks, the Bank has provided funds for financing the ongoing technical services of the suppliers of this equipment to train PETROE'ERU's field personnel in a comprehensive maintenance program; in addition, the funds could be used to finance experts from Occidental's nearby operations who also have experience in the use of artificial lift. With this technical expertise provided for, PETROPERU's existing staff would be capable of implementing efficiently each of the project components. It is possible that the seismic program may not detect structures that warrant subsequent exploratory drilling,, or that the drilling of such structures does not result in commercial oil discoveries. However, given the recent prospecting success in the Peruvian jung'Le, the potential benefits in detecting new oil bearing structures through a more comprehensive seismic coverage of these areas, far outweigh the risks inlvolved. Training 4.35 PETROPERU 'has lost many of its experienced engineering and operating personnel in the past two years. Recently recruited operating personnel, as well as less experienced supervisors, will receive training in standard reservoir engineering practices and production control procedures. In addi- tion, the acquisition of new equipment facilities will necessitate training programs for PETROPERU's field staff. Overseas visits to specific equipment suppliers and to facilities using equipment of the kind included in the project will also be! required. Approximately 60 man months of staff time has been allocated for this purpose.  - 36 - Environmental Considerations and Safety 4.36 No major environmental risks are likely to result from implementa- tion of the project. PETROPERU's crude oil from the jungle is highly saline in content and has to be treated, both physically and chemically, before transportation by pipeline. The residual formation water, which has a salt content on average of 100,000 PPM, is discharged into the Rio Corrientes, whose flow fluctuates between 300 cu.m. per second and 1,000 cu. m. per second. Fish, however, are not affected adversely because of the rapid dilution of the salt water. During the frequent heavy rainstorms in the jungle local oil spills in the vicinity of the production facilities occa- sionally give rise to a thin film of oil in the Rio Corrientes. While these films are rapidly dispersed in the fast flowing rivers of the area, PETROPERU's is endeavouring to reduce the frequency of such occurrences. PETROPERU's overall safety record has been good and safety practices routinely used are in accordance with acceptable industry practices. Schedule and Reporting 4.37 The proposed project is scheduled to be completed by December 31, 1982. During negotiations agreement was reached with PETROPERU to submit quarterly progress reports on progress of each of the project subcomponents. V. FINANCIAL ASPECTS OF PETROPERU A. PETROPERU's Past Financial Performance and Present Position 5.01 Following an initial period of financial stability, PETROPERU's financial situation started to deteriorate sharply after 1973. This dete- rioration was due primarily to three factors: first, a government policy of subsidized domestic prices following the increase in international crude oil prices in 1973; second, the growing tax obligations which PETROPERU paid on behalf of the contractors which reached a high point in 1978 when production from the jungle increased sharply and Peru started to export again crude oil and products; and third, the large debt servicing payments 1/ which began to fall due in 1978, almost all of which were denominated in strong foreign currencies, at a time when the Peruvian sol was undergoing frequent devaluations. By the end of 1978, the company's financial position had become so precarious that it found itself not only unable to meet its burgeoning tax obligations but faced the prospect of defaulting on the large debt servicing payments that were due in 1979. The financial indicators summarized below show the deterioration that has taken place since 1974. 1/ Due to the large investment program, primarily in pipelines, carried out between 1974-77 (Reference para. 2.08).  - 37 - Relevant Financial IndLicators 1973 1974 1975 1976 1977 1978 1979 /c Net income (US$ millions) /a 8.25 10.30 5.30 12.76 3.80 4.50 0.00 Current ratio 1.06 0.92 0.84 0.80 0.87 0.4L7 0.62 Total debt/equity 65/35 86/14 90/10 89/11 91/9 92/8 81/19 Total taxes/revenue (',) 7.55 8.39 20.10 17.65 11.40 17.98 42.03 /b Return on equity (x) 8.20 9.99 4.31 7.10 1.58 2.40 0.00 Return on assets (%) 3.30 2.13 3.19 6.42 14.67 9.69 3.47 /a Average exchange rate for the year. /b Includes equipment import taxes that would be reimbursed to PETROPERU as equity contribution. /c Estimated. Net profits afer tax declined from US$10.3 million in 1974 to US$3.8 million in 1977, while PETROPERU's revenues climbed from US$400 million in 1974 to US$1,079 million in 1977; in 1978 and 1979, PETROPERU would have incurred a net loss if the contractors' tax obligations had been calculated as in previous years. 5.02 A summary of PETROPERU's financial position in FY74 through FY78 and of its estimated position as of December 31, 1979, is given below: Billions of Soles Tentative Fiscal Year Ending December 31 1973 1974 1975 1976 1977 1978 1979 Assets Net fixed assets 8.10 15.52 35.39 75.04 154.05 333.30 421.20 Other assets 0.10 3.46 4.43 1.18 1.1O - - Net current assets 3.20 11.60 15.92 30.12 75.61 44.60 77.30 Total assets 11.40 30.58 55.74 106.34 230.76 377.90 498.50 Equity and Liabilities Equity 4.00 4.21 5.24 11.67 19.72 29.20 95.30 Long-term debt 2.50 11.97 29.00 54.31 121.95 245.60 274.70 Other liabilities 1.90 1.80 2.18 2.82 2.43 4.30 4.00 Current liabilities 3.00 12.60 19.02 37.54 86.66 98.80 124.50 Total equity and iiabilities 11.40 30.58 55.74 106.34 230.76 377.90 498.50 Total debt/equity ratio 65/35 86/14 90/10 89/11 91/9 92/8 81/19 As is apparent from the above, PETROPERU has had a seriously undercapitalized and deteriorating f:Lnancial structure for several years, attributable to the large investment program undertaken in the first part of the decade which was financed almost exc:Lusively by debt; by end 1978, the total debt/equity ratio was 92/8.  - 38 - 5.03 In early 1979, with PETROPERU's financial difficulties mounting, GOP set about remedying the causes of the company's financial weakness by preparing a phased recovery program. Subsequently, important steps were taken to strengthen PETROPERU's position and to ensure its ability to meet debt-servicing payments throughout the remainder of calendar year 1979. These steps included (i) the government's agreement to assume the servicing of that component of PETROPERU's external debt i.e. US$388 million, that had accrued from the financing of subsidies to the domestic market for imported crude oil and petroleum products during the 1973-78 period; (ii) the government's agreement to provide substantial equity infusions; (iii) frequent domestic price increases 1/; and (iv) a reassessment of the overall taxation system affecting PETROPERU and the sector, a review which was completed and made official on December 6, 1979. B. PETROPERU's Future Finances 5.04 In late July 1979, during discussions with GOP it was agreed that PETROPERU's future financial position, after 1979, would be projected with a view to: (a) Assuring a minimum debt-servicing capability, especiaLly in the critical period 1980-83 when large debt payments fall due; (b) further strengthening PETROPERU's capital structure through debt relief and equity infusions; and (c) ensuring PETROPERU's future cash generation through improve- ments in profitability to enable it to resume its exploration activities. 5.05 Financial Covenants. The specific measures required to achieve these objectives have been discussed and agreed with GOP during negotiations and incorporated in the following financial covenants: (i) GOP shall make the following contributions to PETROPERU's equity for the purpose of servicing debt: (a) US$45 million during fiscal year 1980; (b) US$45 million in 1981; and (c) US$30 million during fiscal year 1982. These contribu- tions may be made pursuant to the provisions of Decree-Law 22775, 2/ or from other sources as shall be determined by GOP. 1/ From January 1978 to October 1979, GOP has increased domestic prices on five different occasions. On September 1979, a 10% increase was approved by the Government, and on January 1980 an additional 11% increase was also approved. 2/ Which provides that the income tax collected from petroleum companies operating in Peru will be provided to PETROPERU as an equity contribu- tion to finance capital investments.  - 39 - (ii) In addition to (i), GOP shall (a) issue a Supreme Decree which would make official an equity infusion to PETROPERU of about S/15,500 miLlion effective January 2, 1980, amount equivalent to the March 1979 principal payments to JAPECO and Wells Fargo Bank (already complied with); and (b) issue a Supreme Decree that would make official the taking over by the Peruvian Treasury of about S/25,000 million of PETROPERU's short-term obligations to the Banco de la Nacion related to losses effectively borne by PETROPERU because of earlier price subsidies which have not yet been refunded by GOP. Issuance of the latter Decree would be a condition of effectiveness. (iii) GOP shall increase ex-refinery domestic product prices on a quarterly basis by 10% (in soles) in 1980 1/. Thereafter, the GOP shall use its best efforts to carry out a pricing policy whose objectives will be to eliminate all subsidies andi enable PETROPERU to self-finance a reasonable portion of its invest- ment program. To this end, GOP, to the extent possible, will maintain consumer and domestic ex-refinery prices in real terms taking into account the rate of domestic inflation or increases in the purchase price of crude oil by PETROPERU for the domestic market, whichever is greater, and make additional increases to domestic prices in order to reach international price levels. In addition, GOP shall, not later than 30 days before the end of each fiscal year, review with the Bank the pricing policy for the year in question and the actions GOP intends to take to carry out such policy during the next fiscal year, taking into account the pricing studies to be carried under the proposed loan. (iv) PETROPERU Shall maintain, at all times, a minimum quick ratio (current assets excluding inventories divided by current liabil- ities) of 0.6 in 1980, 0.7 in 1981, 0.9 in 1982, and 1.0 in 1983 and thereafter. (v) Except as shall be otherwise agreed between the Bank and PETROPERU, PETROPERU shall not incur any medium and/or long term debt if, after the incurring of such a debt, PETROPERU's debt/equity ratio would be greater than: 75/25 in fiscal year 1981, 70/30 in 1982, and 60/40 in 1983 and thereafter. No debt/equity limitation has been provided for 1980 ,given uncertainties on timing of planned equity contributions. I]n respect of fiscal year 1980, GOP may withdraw profits from PETROPERU in an amount that shall not be greater than the posi- tive difference, if any, obtained by deducting from the aggregate amount of GOP's contribution to PETROPERU's equity made during L980, the amount of the proceeds of such contributions used for purposes c,f servicing PETROPERU's debt. 1/ Slightly higher than the current projected annual inflation level for 1980 of 40%.  - 40 - (vi) PETROPERU shall maintain a minimum debt service coverage ratio of 1.1 in 1980, 1.4 in 1981, 1.9 in 1982, and 2.0 thereafter. If at the time of the Bank's periodical review of PETROPERU's financial performance, its debt service coverage ratio did not meet the agreed targets, GOP would agree to take appropriate measures, satisfactory to the Bank, so as to bring debt service coverage to the agreed level. In addition, PETROPERU shall furnish to the Bank, not later than 90 days after the beginning of the year, a program of action for purposes of maintaining the applicable debt service coverage ratio throughout such Fiscal Year. (vii) PETROPERU shall undertake and implement, with the help of consulting firm(s) acceptable to the Bank, first, an indepth study of its fixed assets including physical counting and book reconciliation; second, a study aimed at modernizing PETROPERU's overall accounting, budgeting, as well as improving information requirements throughout the company. Consultants for the second study will be appointed not later than August 31, 1980. The first study will be completed not later than August 31, 1981, and the second not later than October 31, 1981 (paragraphs 3.14 and 4.19). (viii) PETROPERU would have its accounts audited by independent auditors and would submit to the Bank each year, beginning in 1980, and no later than five months after the end of the fiscal period an external audited report of its financial statements. (ix) PETROPERU would closely collaborate with its external auditors in resolving qualifications raised on previous accounts no later than the end of fiscal year 1981. (x) PETROPERU would annually review with the Bank its capital investment program and related financing sources by a date no later than September 30 each year, starting in 1980. (xi) GOP would provide PETROPERU with a short-term credit line until December 31, 1981, to cover any deficit in working capital. Based on PETROPERU's audited accounts for the year 1981, GOP and the Bank will exchange views on the convenience of a GOP's contribution to PETROPERU in an amount adequate to cover its working capital needs. If such exchange of views shows such a convenience, GOP shall take all such action as be necessary to make such equity contribution.  - 41 - 5.06 Projected Financial Results - General. When reviewing PETROPERU's financial projections it should be noted that GOP has recently issued (December 7, 1979) the new basis for future exploration/production agreements in the petroleum sector (para 2.30), and announced its intention to renego- tiate existing contracts to adapt them to the new basis. Formal negotiations with Belco started in. late January 1980 and are proceeding and negotiations with Occidental are supposed to begin shortly; but the outcome of negotiations on some of the key parameters (particularly, the crude oil production split between PETROPERU and. each of its contractors) is unknown. The financial projections are predicated on the Government taking the specific measures mentioned in para 5.05, and on the assumption that PETROPERU would maintain at least the actual crude oil production split. Based on discussions with PETROPERU and the Government, this latter assumption is reasonable, and even if the assumed produc:tion split is less than expected, there is a cushion for PETROPERU to be able to meet the financial covenants and even to attain the financial projections through faster price increases 1/. The assumptions in regard to production, revenues, operating costs and international crude oil prices are summarized below and discussed in detail in the annexes. 5.07 Production Schedule. Peru's future crude oil production has been based on the projected output from PETROPERU and the contractors' currently producing oil fields over a 10 year period. In addition, output resulting from three secondary recovery projects planned in the Talara area have also been considered. Overall output is 5% lower than official government esti- mates for the period 1980-82, 10% for 1983-85, and 15% for 1986--89. Peru's production schedule is summarized below: PERU: CRUDE OIL PRODUCTION SCHEDULE (Average Production for the Period in MBPD) 1980-82 1983-85 1986-89 PETROPERU's production 63.6 78.3 55.9 Contractors' production 152.7 151.6 120.7 Peru's total production 216.3 229.9 176.6 5.08 Revenue and Operating Cost Estimates. For the next ten years, unless new oil discoveries are made, PETROPERU will derive a gradually increasing proportion of its projected revenue from domestic sales, with 1/ Domestic prices have been increased yearly only by the forecast domestic inflation rate..  - 42 - exports comprising a correspondingly smaller proportion of gross revenues. Revenue estimates for the year 1979 indicate gross sales of about S/.227.7 billion (US$1,012 million) of which 48% would be local sales and 49% exports. The export contribution to PETROPERU's gross revenues would steadily decline over time reflecting (a) an internal demand for petroleum products growing at an estimated rate of 4% p.a. until 1983 and at 5% p.s. thereafter, and (b) declining crude oil production. By the year 1985, PETROPERU would generate 55% of its revenue in the local market and only 43% through the export of crude oil and products. 5.09 Spot market prices for crude oil in 1979 are projected to average US$26.82, based on prices realized by PETROPERU through July 1979. Crude oil prices for subsequent years, in current terms, have been assumed to reach US$38.07 per barrel in 1985, and US$46.27 by 1989. Detailed prices and assumptions are given in Annex 5-6. Operating costs estimates are based on actual data made available by PETROPERU. PETROPERU's operating cost structure has three main components: costs related to PETROPERU's own operations, local purchases of crude oil from contractors and, tax payments to GOP made by PETROPERU on behalf of its contractors. 1/ Annex 5-1 shows in detail PETROPERU's projected operating costs. 5.10 Financial Projections: PETROPERU's finances were projected taking into account the financial covenants outlined in paragraph 5.05 and on the assumptions mentioned in paragraphs 5.06-5.09. (a) Period 1980-1985: The following table provides a summary of PETROPERU's future finances (in current soles) for the period 1980-1985, and is taken from the detailed income statements, statements of sources and uses of funds and balance sheets as given in Annexes 5-2 to 5-5. 1/ These tax payments (import and export duties and royalties and cannons) to GOP are considered as the cost to PETROPERU for its share of the contractors' crude oil production.  - 43 - PETROPERU: SUMMARY FINANCIAL PROJECTIONS (Soles in Billions-Current Terms) Year Ending December 31 1980 1981 1982 1983 1984 1985 PETROPERU's crude oil production (10 bbl) 20.2 20.4 22.2 27.8 33.9 39.9 Total crude oi available to PETROPERU (10 bbl) 73.2 81.1 74.9 78.1 77.2 76.4 Net sales revenue 420.1 642.3 709.5 864.1 948.9 1,047.1 Cost of goods sold 327.5 499.5 524.8 619.4 694.1 807.8 Net profit after tax 14.9 32.9 46.6 68.3 68.9 58.0 Internal cash generation 49.9 77.3 100.8 134.1 145.9 146.0 Return on assets (%) 5.2 5.7 5.9 6.5 5.5 4.2 Long-term debt/'equity ratio 61/39 42/58 33/67 24/76 19/81 14/86 Total debt/equity ratio 68/32 52/48 44/56 37/63 32/68 29/71 Quick ratio 0.8 1.3 1.6 2.0 2.2 2.3 Debt service coverage ratio /a 1.1 2.4 2.5 2.3 2.3 2.2 /a Taking into account equity injections from GOP for the sole purpose of ser- vicing debt. The projections indicate that PETROPERU's overall financial position would improve over the four years FY80-83. Due to larger prof-its and to Government equity contributions, to be provided under the new Law from contractors' income taxes, PETROPERU's capital structure would be strengthened from a debt/equity ratio of 92/8 in 1978 to 37/63 by 1983. PETROPERU's current liquidity position would also improve by 1983 when the quick ratio is projected to reach 2.0. Finally, the rate of return on assets would steadily increase from an estimated level of 3.5% in 1979 to 6.5% by 1983; thereafter, the rate of return wou:Ld gradually decrease as a result of the decreased volume of crude oil available for export, the revaluation of of PETROPERU's fixed assets which would have taken place, and substantiaL additions to fixed assets that would not yield over the period 1980-85 but, subsequently, cost savings and/or increase in crude oil production. (b) Period 1985-1990: After 1985, PETROPERU's financial position will depend primarily on its ability to increase crude oil clutput. Assuming that no discoveries are made either by PETROPERU, the existing contractors or new contractors, E'ETROPERU's own production plus its share from the contractors wrill not be sufficient to cover domestic demand from 1985 onwards. As a consequence, the financial projections beyond 1985 would show a gradual deterioration in PETROPERU's main financial indicators. If on the other hand, modest discoveries were to be found as appears likely (given the expected increase in exploration activity by existing and new contractors and by E'ETROPERU, which will now have more resources for this purpose), IPETROPERU's financial position would be consolidated beyond 1985.  - 44 - 5.11 Sensitivity analyses show that variations in Peru's oil production schedule is the critical factor affecting PETROPERU's key financial indica- tors, and that PETROPERU's ability to slightly increase overall oil output 1/ would be the most influential factor in consolidating its finances from 1985 onwards. In addition, international oil prices increases would benefit PETROPERU's finances during the first half of the 1980s when the country will be a net exporter of crude oil. If no discoveries are made, PETROPERU's own production, plus its share from the contractors, would not be sufficient to cover domestic demand after 1985; as a consequence, PETROPERU would have to supply an increasing proportion of the domestic market with crude oil purchased at international prices. To cover the eventuality that no new discoveries are made, and the possibility that higher increases in inter- national prices occur, GOP would have to adjust at a faster pace domestic and ex-refinery prices in accordance with PETROPERU's weighted average pro- duction costs in order to reach international price levels (para. 5.05, iii). VI. ECONOMIC AND FINANCIAL ANALYSIS OF THE PROJECT 6.01 The two production rehabilitation project components will provide an increase in petroleum production of 30 million barrels of crude oil over the first ten years of the project's life. The seismic component will result in a more extensive seismic coverage of two known producing areas of the Peruvian jungle which is expected to lead to the detection of new structures with oil bearing potential. The subsequent drilling of these structures, which would take place shortly afterwards, could lead to further discoveries, with new oil reserves being brought into production in a relatively short period. 6.02 The benefits of the two production components can be measured by the increased foreign exchange earnings and savings that they will make possible. The economic rates of return are extremely high, primarily because of the incremental nature of the investments. In both cases the projects can take advantage of existing infrastructure; the wells have already been drilled, the reserves are well established, and the transport pipeline systems are in place with unutilized capacity. In addition, oil price increases over the past several years have dramatically increased the profitability of all production enhancement petroleum projects. In fact, had PETROPERU been in better financial condition, these investments would have already been implemented, as they were viable projects at petroleum prices considerably lower than those that prevail today. It is not possible to quantify precisely the benefits derived from the seismic survey component. However, a comparison 1/ In the order of 10% over actual estimates.  - 45 - with Occidental's high success rate in exploration drilling following detailed seismic work in Block lB (which borders on the north-western reaches of PETROPERU's Block 8), makes it likely that new structures will be detected as a result of the proposed seismic work program in Block 8 too, and that these in turn would lead to new oil discoveries, so increasing the level of Peru's proven oil reserves. An analogous argument can be made for the seismic work in Block 31 which has; been in production for 40 years and which warrants a more extensive seismic coverage. Production Rehabilitation Components (i) Northwestern Coast 6.03 This investment will increase production by about three million barrels over the project life, assuming that three hundred wells are put back into production, thal: the average well output is 3.5 barrels per day per well during the first year (total 383,250 barrels), and that output declines by 5% per year (i.e. 1916 barrels per year) over the ten year life of the project. When crude oil is vaLued at US$25.85 per barrel in real terms throughout the project life and the annual incremental operating costs are 20% of the invest- ment cost, the economic rate of return of the project will be over 100% and the payback period 0.8 years (see Annex 6-1). 6.04 A sensitivity analysis shows that an increase in capital costs of 50% would decrease the rate of return to 95%, and that combined with an increase in the rate of decline in output from 5% to 10% per year (38,325 b/y) would decrease the rate of return to 88%. 6.05 I'he incremental financial rate of return of this component is 20.85%, considerably lower than the economic return to Peru, because of the taxes levied on PETROPERU's operations. It has been assumed that the incremental production will be exported at a conservative price of US$25.85 per barrel in real terms. Details; on the incremental financial costs and benefit streams are given in Annex 6-2. Incremental Financial Rate of Return - Sensitivity Analysis Base Case 20.85% l0% Increase in Investment Cost 17.65% 10% Increase in Revenues 28.35% 10% Decrease in Revenues 12.75% 20% Decrease in Revenues 3.15% 10% Increase in Operating Costs 20.25% 10% Decrease in Operating Costs 21.55%  - 46 - (ii) Jungle Operations 6.06 For a capital cost of US$11.7 million, this project component will increase output from the jungle fields by 27 million barrels over the project's life. Production will be increased by 60% from about 27,000 b/d 1/ to about 44,000 b/d at the beginning of 1981, and is expected to fall by about 20% per year thereafter (see Annex 6-3 for details for production and operating costs). Since the total investment takes less than one year to come on stream (and in fact output will increase incrementally with each pump placement), the economic rate of return will be well over 100%. The financial return to PETROPERU is also well over 100% and the pay-off period less than two months. A sensitivity analysis shows that because the rate of return is so high that no reasonable set of alternative assumptions brings the return down below 100%. VII. SUMMARY OF AGREEMENTS REACHED 7.01 Assurances were obtained from the Government during negotiations that: (a) the competitiveness of PETROPERU's salaries will be maintained throughout the implementation of the project (paragraph 3.10); (b) GOP would increase domestic ex-refinery prices by 10% per quarter during 1980. Thereafter, the GOP shall use its best efforts to carry out a pricing policy whose objec- tives will be to eliminate all subsidies in order to eventually reach international prices, and enable PETROPERU to self-finance a reasonable portion of its investment pro- gram; (c) GOP shall make the following contributions to PETROPERU's equity for the purpose of servicing debt: (a) US$45 mil- lion during fiscal year 1980; (b) US$45 million in 1981; and (c) US$30 million during fiscal year 1982; (d) GOP would provide PETROPERU with a short-term credit line until December 31, 1981, to cover any deficit in working capital. Based on PETROPERU's audited accounts for FY81, the Government and the Bank will exchange views on the convenience of a GOP's contribution to PETROPERU in an amount adequate to cover its working capital needs. If such exchange of views shows such a convenience, GOP shall take all such action as be necessary to make such equity contribution; 1/ Assumes that current production will increase from its present level of 20,000 b/d to 27,000 b/d once temporary difficulties with initial pumping units are overcome.  - 47 - (e) in respect of fiscal year 1980 the GOP may withdraw profits from PETROP'ERU in an amount that shall not be greater than the positive difference, if any, obtained by deducting from GOP's contribution to PETROPERU's equity in 1980, the amount of the proceeds of such contributions used during such year for purposes of servicing debt (paragraph 5.05, v); and (f) GOP undertakes to establish a committee composed by high representatives of the Ministries of Energy and Mines and Economy and Finance, PETROPERU and COFIDE, responsible for coordinating the carrying out of the sector investment and pricing studies, and would exchange views with the Bank on the findings (paragraph 4.21). 7.02 Assurances were obtained from PETROPERU during negotiations that: (a) PETROPERU shall undertake and implement, with the help ofE a consulting firm acceptable to the Bank, an in depth study of its accounting and information procedures (para- graph 3.14 and 5.05 (vii)); (b) PETROPERU would have its accounts audited by independent auditors and would submit to the Bank each year, beginning in 1980, and no later than five months after the end of the fiscal period, an external audited report of its financial statements and project accounts (paragraph 5.05 (viii)); (c) PETROPERU would closely collaborate with its external auditors in resolving qualifications raised on previous accounts no later than the end of the fiscal year 1981; (d) F'ETROPERU would annually review with the Bank its capital investment program and related financing sources by a date not later than September 30 each year, starting in 19130 (paragraph 5.05 (ix)); (e) PETROPERU would retain a minimum debt service coverage ratio of 1.1 in 1980, 1.4 in 1981, 1.9 in 1982, and 2.0 thereafter. If at the time of the Bank's periodical review of PETROPERU's financial performance, its debt service coverage ratio did not meet the agreed targets, the GOP would take appropriate measures, satisfactory to the Bank, so as to bring debt- service coverage to the agreed level (paragraph 5.05 (vi)'); (f) PETROPERU will submit monthly progress reports on each of the project components (paragraph 4.37); (g) PETROPERU shall maintain, at all times, a minimum quick ratio of 0.6 in 1980, 0.7 in 1981, 0.9 in 1982, and 1.0 in 1983 and thereafter;  - 48 - (h) the fixed assets inventory and book reconciliation will be completed not later than August 31, 1981; and the study aimed at modernizing its accounting, auditing and information requirements will be completed not later than October 31, 1981 (paragraph 3.14); and (i) PETROPERU shall not incur any medium and/or long term debt if, after the incurring of such a debt, PETROPERU's debt/ equity ratio would be greater than: 75/25 in fiscal year 1981, 70/30 in 1982, and 60/40 in 1983 and thereafter. 7.03 A condition of loan effectiveness would be that the Government shall issue a Supreme Decree which would make official the taking over of about SI. 25,000 million of PETROPERU's short-term obligations (paragraph 5.05 (ii). 7.04 A condition of disbursement would be (a) that following completion of the first phase of seismic work, a comprehensive discussion of the seismic results and interpretation with Bank staff would take place before any detailed seismic survey is undertaken (paragraph 4.16); and (b) that the preparation of component l(b) is reviewed by Bank staff (paragraph 4.11). 7.05 With satisfactory resolution of the items outlined above, the proj- ects constitutes a suitable basis for a Bank loan of US$32.5 million. The term of the loan would be 17 years, including a grace period of 3 years.  PERU; National Energy Usa&e by Source of Energy (in Tealaries - Calaries X 10 ) 196s 1966 96 5 1968 1969 970 Hydroelectric 2868 4.0 3040 3404 3749 3979 4104 Natural Ga6 5056 7.1 5078 4355 4485 461 4598 Petroleu. 3004g 42.0 30590 31873 40168 40422 40782 Coal '273 0.3 503 1417 501 510 432 Wood 27324 38.2 27462 27596 27734 27869 28005 Bagasse 3700 5.2 4000 3590 3415 3095 3785 Other residual Vegetable 2305 3.2 2320 2330 2340 2350 2365 7btIl - 7 732-6394 8283' 8hoP 1971 1972 1973 19745 1976 % Hydroelectric 4604 4877 5127 5612 5880 6233 5.9 Natural Gas 4;433 4264 4172 4293 5307 5750 5.5 Petroleum 45159 46829 50950 55092 56883 57285 54.3 Coal 633 447 575 481 445 488 0.5 Wood 28139 28276 28412 28547 28684 28819 27.3 Bagnsse 4150 4310 11395 4610 4485 44oo 4.2 Other residual vegetable 2375 2385 2395 2410 2420 2430 2.3 0 Total AohoQ 91391 96028 iopi1t 10410i 105505 100 SOURCE: Ministry of Energy and Mines and UNDD National Energy Balaflce Study  12 PERU: Residential and Commercial Energy Usage by Source or Energy (in Tcalaries - Calaries x 10 Average Annual 1969 1970 1971 1972 1973 74 1975 1976 Growth Total 31346 31906 32456 33286 33928 34376 35049 35585 2.1 Electricity 1123 1238 1219 1423 1527 1697 '1897 1969 9.8 1Natural Gas 231 275 471 659 649 586 554 613 8.8 LPG 432 521 595 659 783 920 1011 1037 5.8 Kerosene 4759 4904 5036 5243 5500 5537 5784 5996 4.o Coal 1399 1359 1319 1279 1240 1199 1160 . 1120 2.5 Woo&i 21050 21246 21442 21637 21832 22028 22223 22418 1.1 I Residual Vegetable 2352 2363 2,"(4 2386 2397 2449 2420 2432 0.5 o SOURCE: Ministry of Energy and Mines and UNDP National Energy Balance Study Residential and Commercial Energy Usage by Source of Energy (in %) 1969 1970 197lW 1972 1973 1974 1975 1976 Electricity 3.6 3.9 3.8 4.3 4.5 4.9 5.4 5.5 llatural Gas 0.7 0.9 1.5 2.0 1.9 1.7 1.6 1.7 LEG 1.4 1.6 1.8 2.0 2.3 2.7 3.0 2.9 rerosene 15.2 15.4 15.5 15.8 16.2 16.1 16.5 16.8 Coal 4.5 4.3 4.1 3.8 3.7 3.5 3.3 3.1 Wood 67.2 66.6 66.1 65.0 64.4 64.1 63.4 63.0 Residual Vegetables 77.5 -2 7.32 .1 7,0 6.9 6.8 Total 100 100 100 100 100 100 100 100 SOURCE: Ministry of Energy and Hines and UNDP National Energy Balance Study I/ Hay not total due to roundinR  12 PERU: National Energy Usage by Final Consuming Sector and Subsector (in Tcalaries - Calaries X 10 ) 1969.1 1970 1971 1972 1973 19744 1975 1976 Residence and Commercial 31346 31906 32456 33286 33928 34376 35049 35585 Transport 16434 16796 17907 19254 21473 21220 22674 22185 Industry 29481 31282 31679 30179 30118 33665 36298 36885 Pablic Sector 1500 1491 1542 1655 1907 2792 2311 2623 Non Energy use 1333 11457 1319 1172 1286 1355 1368 1559 Total 88og 82932 84903 85546 88712 93208 97700 98837 Industry Sector g/ Manufacturing 12053 13066 12983 13008 14790 15770 18260 18747 % Mining 5026 4969 6029 7985 8111 8655 9257 8575 Agriculture and agroindustry 6861 6640 7625 6854 6673 6408 6505 6359 Fishing and related industries 5624 6771 1615 2923 4103 2752 3411 Total 2,9564 31982 30770 31187 3493 37092 SOURCE: Ministry of Energy and Mines and UNDP National Eneray Balanee St.ndy !/ Includes a small amount of double counting due to sector producing energy for other U' sectors H,  PERU: PROJECTED ENEiGY CON1SUNPTION BY SOURCE AND SECTOR (in million barrels oil equivalent) Petroleum Products Natural Gas Coal Electricity 1976 % 1985 % 2000 % 1976 1985 2000 1976 1985 2000 1976 1985 2000 Industry 13.5 30.5 16.2 26.0 33.2 25.0 2.8 2.6 5.0 0 0 4.1 2.6 4.0 8.5 Agriculture 1.5 3.4 1.6 2.6 2.4 1.8 - - - - - - 0.2 0.2 0.3 Transport 19.4 43.8 27.0 43.3 63.9 48.1 - - - - Residential & Commercial 5.8 13.1 8.9 14.2 18.7 14.1 - - - - - - 1.6 2.9 9.1 Electricity 4.1 9.2 3.7 13.9 14.7 11.0 0.7 0.6 - - - 6.4 - - - TOTAL DEMAND 44.3 100.0 62.4 100.0 132.9 100:0 3.5 3.2 5.0 0 0 10.5 4.4 7.1 17.9 Source: Peru: United States Cooperative Energy Assessment  - 53 - ANNEX 2.01 THE PERUVIAN MODEL CONTRACT The Peruvian Model Contract is basically a production-sharing contract in which oil production at the well-head is divided between PETROPERU and the contractor. All the investment has to be provided by the contractor, including the concomitant risk, without any counterpart contribution by PETROPERU. The precise oil split between the PETROPERU and the contractor is determined by the contract, which is normally on a 50/50 sharing basis. PETROPERU undertakes to pay the contractors' principal Peruvian tax obliga- tions (i.e., income, remittance, export, and import taxes) out of its share of the oil, with the exception of some minor taxes on company assets. The duration of the contract can vary: exploration and development contracts have an average duration of 30 years, compared to 15 years for secondary recovery projects. Contractors' work obligations are clearly specified on a yearly basis in the agreement, and in the event the contractor relinquishes its block before completing the agreed work program a pre-determined penalty payment would have to be paid. Despite some difficulties related to the magnitude and flexibility of the work obligations and the more recent cormplications between the U.S. contractors and the U.S. Internal Revenue Service (IRS) regarding the eligibility of certain taxes paid by PETROPERU for a foreign tax credit, the Peruvian Model Contract is an extremely easy agreement to monitor. It does not require GOP to examine the books of foreign subsidiaries operating in Peru and oil companies currently active in Peru-Occidental and Belco are satisfied with the Model. However, reservations have been expressed by U.S. companies on the implications of a possible change in the Perurian tax regime vis-a-vis the U.S. I.R.S.  - 54 - ANNEX 4.01 Page 1 RESERVE POTENTIAL OF PETROPERU'S NORTHERN JUNGLE FIELDS Corrientes The Corrientes field (also known as Trompeteros) is located close to the Corrientes River in alternately dry and swampy terrain. To date, 26 wells have been drilled of which 21 are producing; well productivity varies between 300 to 4,000 b/d. Corrientes has an estimated 140 million barrels of recoverable oil; approximately 16.5 million barrels had been recovered by the end of 1978. Pavayacu The Pavayacu field is located between the Corrientes and Tigre rivers to the northeast of Corrientes (see map). The nearby terrain is drier but also more hilly. Fourteen wells have been drilled of which 12 were producing in February 1979, giving rise to a total production of 2,500 b/d. At the beginning of April 1979, three electrical centrifugal pumps were installed which increased production almost immediately to 9,700 b/d. Because the production from the reservoir was greater than the capacity of the pumps, it was necessary to "choke" the wells until pumps with greater capacity were obtained. Total estimated recoverable reserves from Pavayacu are 25 million barrels, of which 1.2 million had been produced by the end of 1978. Capirona This field is also located on the Corrientes River to the south of Pavayacu. The terrain is dry but less hilly than Pavayacu. Five wells have been drilled so far, one of which has been abandoned; total production from the three wells, currently in production, is on the average, 600 b/d. Total recoverable reserves are estimated to be 6.1 million barrels of which 0.3 million had been recovered by the end of 1979. Yanayacu The field is located on the right bank of the Rio Maranon. The terrain is swampy which makes operations extremely difficult in the area. Twelve wells have been drilled so far of which 10 have been producers. Currently all the wells are shut down due to the very low production from the field (32 b/d) caused by the low energy available in the reservoir and the physical characteristics of the crude, 170 API and 3,000 SSU viscosity. This field has an estimated volume of recoverable reserves of 13 million barrels of which 0.44 million barrels have been recovered so far.  F T'MA"'n PF-SRVES IN MAIIN PRODUCING STRUCTURES OF PETROPERU'S NORTHERN JUNGLE OPER~ATIONS FINIAL RECOVERY (BLS.) REMAfLXfNG RESERVES AS STRUCTURE PETROLEUM ENOT ACCU(ULATED OF 31--l)-7R (RLS._ STRU(.TU!RE FORMATION INSIIU (BLS) DEVELOPED DEVELOPED TOTAL POCTION DEVELOPED TOTAL Corvtejatc C, C t.-C o 285'000,000 43.9 122'000,000 3'000,000 125,000,000 14'896,900 107'103,100 3'000,000 11103,100 7' 390,550G 32.8 455,000 - 455,000 - 455,000 -455,Q ' 13'175,519 2S.S 21'069,G00 - 21'06q,000 1'632,S2: 19'436,179 - 19'436,174 359'506,019 143'524,000 3'000,000 146'524,000 16'529,721 126'994,279 3'000,000 129'994,2i9 Vivia.t 4'415,250 26.0 1'749,000 - 1'149,000 60,291 1'08,709 - 1'089,70) Pozo-Cz,sa Stacca 2'262,220 26.6 601,000 - 601,000 - 601,000 - 601,3C0 TOTAL CORVIE.TES 366'7S3,489 145'274,000 3'0C0,000 148'274,000 16'590,012 728'683,998 3'000,000 131'683,988 c<rte-tO,'2 c:LJfr-cctAco 19'976,000 34.13 3'476,000 2'650,000 6'126,000 329,62& .3'146,312 2'650,000 5'7%,372 Pc.vaycza Ckhn-t7-Cetio 39'010,190 36.5 13'026,700 1'189,000 14'215,700 796,237 W2'230,463 1'189,000 13'419,463 Chc;ztz-Po na 11'813,015 22.7 1'303,200 1'373,000. 2'616,200 - 1'303,200 1'373,000 2'675,200 Sub-Th'atfl SG'325,205 14'329,900 2'562,000 16'891,900 796,237 13'533.663 2'562,000 16'095,663 .24'260,757 29.8 2'237,000 5'000,000 7'237,000 314,700 1'862,300 S'000,000 6'862,300 TOTAL PA VAYVACUI 75'083,962 16'566,900 7'562,000 24'128,900 1'170,937 15'395,963 7'562,000 22'957,q63 vazaycac Cf';.ta-Pora 2'695,221 17.3 466,000 - 466,000 25S,734 210,366 - 210,3566 ui'Ja"'L 54'374,321 23.3 12'679,000 12679,ooo 175,965 12'493,035 - 12'4.-,05 TaTAr Y5AAVACO 57'069,542 13'145,000 - 13'145,000 441,699 12'703,401 - !O,103,401 J.ca Cont--Ctiw 1'426,346 30.0 259,400 162,900 42S,300 - 257,4o 16,900 422,300 1'199,22o 24.2 764,600 1,0ezvo J50,300 - 164,600 186,200 350,800 TOTAL VALENCIA 2'625,572 424,000 355,100 799,100 424,000 355,100 779,100 TOTAL GEKERAL 500'962,565 172'885,900 13'5b7,100 192'453,000 18'532,276 160'353,724 13'5W7jlOO V13'920,824 0sD. a-  I. STATUS OF WELLS IN NORTHERN JUNGLE OPERATIONS Number of Wells Structure Producing Intermittent Nonproducing Being worked over Total Corrientes 15 -- 5 1 21 Pavayacu 4 1 6 1 12 Capirona 1 3 - - 4 Yanayacu -- -- 10 - 10 TOTAL 20 4 21 2 47 II. FUTURE REQUIREMENTS FOR ARTIFICIAL LIFTS Wells with Artificial Lift Wells Requiring Artificial Lift Installed Being installed Total To be installed Stand-by Total Corrientes 1 6 7 14 /a 3 17 Pavayacu 4 1 5 7 3 10 Capirona - _ _ 4 _ 4 Yanayacu - - - 4 /b - 4 TOTAL 5 7 12 29 6 35 /a For Corrientes,wells numbers 10, 15 and 16 do not currently need artificial lift . However, it is believed that they will soon be required and will be installed as soon as needed. /b For Yanayacu, although a total of 10 wells need artificial lift , orders will be placed only for 4 units initially until a comparison of the relative merits of hydraulic and electro-centrifugal pumps for this field has been fully evaluated.  57 - ANNEX 4.03 Page 1 of 2 ESTIMATED PRODUCTION USING ARTIFICIAL PUMPING EQUIPMENT (BPD) Production Corrientes Pavayacu Capirona Yanayacu Total Actual 19,000 7,000 580 0 26,580 With artificial pump 26,675 12,663 2,662 3,000 45,000 Increase in production (Year 1) 7,675 5,663 2,082 3,000 18,420 Year 2 6,140 4,530 1,666 2,400 14,736 Year 3 4,912 3,624 1,333 1,920 11,789 Year 4 3,930 2,899 1,066 1,536 9,431 Year 5 3,144 2,319 853 1,229 7,545 Year 6 2,515 1,855 683 983 6,036 Year 7 2,012 1,484 547 786 4,829 Year 8 1,610 1,187 437 629 3,863 Year 9 1,288 950 350 503 3,091 Year 10 1,031 760 280 402 2,473 Notes: An annual decline of 20% has been estimated. On annual production, 9.6% has been considered the rate of downtime due to equipment stoppage for maintenance and/or repairs.  FUTURE PRODUCTION FORECASTS FOR PETROPERU'S NORTHERN JUNGLE OPERATIONS 60,000 __ __. 50,000 - ----1---- 1 o~~~~~~~~~~~~~~~~~~~~~~ 1I I~~~~~~~~~~~~~~~~~ Ic 40,000 - Forecast production afteir acquisition of 35 new pumping I ~~~rTh ~~~~~Forecast production with existing 12 pump ngunits. 0 20,000 ~~- - --__ 10,000 _ _ _ _ II- - I - A 'I J~~~~~~~~~~~~~~~~~~~~~~~~~~ IU Lii LU LI)~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ 4 li Fi-41975 j1976 1j977 978(1[979 1980 181 198 1931984 1985 1986 1987F 1988 189i 190 91 99 9931 rN) 0 I-1h C  PERU: PETROPERU OIL PRODUCTION REHABILITATION PROJECT ESTIMATED OPERATING COSTS (IN BILLIONS OF SOLES) 1980 1981 1982 1983 1984 1985 Labor and social benefits 19.3 26.9 32.3 37.1 L 7 49.1 Materials and consumables 21.1 28.5 35.7 42.5 51.2 60.4 Purchased services 41.1 50.1 62.9 75.7 92.4 112.1 Petroperu's taxes- 82.5 111.7 129.3 155.1 166.6 176.5 Local purchases of crude oil 59.9 132.7 106.2 116.9 112.2 113.6 Imports of crude oil and products 6.5 9.6 15.4 26.4 64.9 142.2 1 Un Total 230.4 359.5 381.8 453.7 530.0 653.9 @ 1/ Excluding income taxes. Energy Department Report Prepared January 1980 Co 0  PERU: PETROPERU OIL PRODUCTION REHABILITATION PROJECT PROJECTED STATEMENTS OF INCOME IN BILLIONS OF SOLES 1980 1981 1982 1983 1984 1985 Domestic inflation () 40 - 20 15 15 15 Crude oil spot market prices (US$ per barrel) 28.18 30.15 31.96 33.88 35.41 38.07 Local purchases of crude oil (US$ per barrel) 21.80 24.26 25.72 27.26 28.90 30.63 Crude oil available to PETROPERU (mill. bbl.) 73.20 81.07 74.93 78.09 77.20 76.44 Own production (mill. bbl.) (20.20) (20.40) (22.20) (27.80) (33.90) (39.90) Contractors' share (mill. bbl.) (28.90) (29.90) (30.00) (28.60) (24.90) (20.80) Local purchases (mill. bbl.) (9.60) (15.37) (9.93) (9.33) (7.78) (6.84) Equity injection (14.50) (15.40) (12.80) (12.36) (10.62) (8.90) Operating revenues Domestic sales 168.9 242.1 323.1 396.0 477.0 573.3 Export Sales 233.7 377.5 362.0 440.9 444.4 445.7 Miscellaneous 17.5 22.7 24.4 27.2 27.5 28.1 Total revenues 420.1 642.3 709.5 864.1 948.9 1O047.1 Cost of goods sold Local purchases of crude oil 59.9 132.7 106.2 116.9 112.2 113.6 Imports of crude oil and products 6.5 9.6 15.4 26.4 64.9 142.2 Crude oil contribution from GOP 116.9 165.3 170.2 192.6 190.3 183.6 Labor, materials, taxes and services 124.3 165.8 199.2 238.4 272.1 307.3 Depreciation 35.0 44.4 54.2 65.8 77.0 88.0 Less own consumption and inventory build-up (15.1) (18.3) (20.4) (20.7) (22.4) (26.9) Cost of goods sold 327.5 499.5 524.8 619.4 694.1 807.8 Selling expenses 35.1 45.3 53.8 63.4 71.6 80.3 Administrative expenses 4.6 5.9 7.0 8.2 9.3 10.4 Income from operations 52.9 91.6 123.9 173.1 173.9 148.6 Financial charges 19.4 18.0 19.9 20.8 20.3 19.3 Extraordinary gains 0.4 0.5 0.5 0.5 0.5 0.5 Net income before income taxes 33.1 73.1 103.5 151.8 153.1 128.8' Income taxes 18.2 40.2 56.9 83.5 84.2 70.8 o Net profit 14.9 22.9 46.6 68.3 68.9 58.0 Energy Department Report Prepared January 1980  PERU: PETROPERU OIL PRODUCTION REHABILITATION PROJECT PROJECTED STATEMENTS OF SOURCES AND APPLICATIONS OF FUNDS IN BILLIONS OF SOLES 1980 1981 1982 1983 1984 1985 Sources of Funds Net profit from operations 14.9 32.9 46.6 68.3 68.9 58,0 Non-cash charges 40.2 51.1 61-9 74.4 86.7 98.9 Total internal cash generation 355. 84.0 108.5 I4DW: 155.6 156,9 GOP equity infusions 141.8 190.8 170.2 192.6 190.3 183.6 Obligations assumed by GOP 34.4 17.0 17.0 17.0 - - Long-term borrowingsll 56.3 53.0 47.0 32.4 21.7 14.4 Total sources 287.6 344.8 342,7 384,7 367,6 354,9 Application of Funds Additions to fixed assets- 169.5 209.2 212.5 227.6 211.1 195.9 Reduction of long-term debt 29.3 35.3 41.8 47.8 53.1 58.2 Obligations assumed by GOP 8.5 42.5 17.0 17.0 - - Indemnity and pension plan payments 0.7 1.0 1.5 1.9 2.5 3.0 Cancellation of contracts 0.8 - - - - - Total increase/decrease in working capital 78.8 56.8 69.9 90.4 100.9 9_7.8 Total applications 287.6 344.8 342.7 384.7 367.6 354,9 Debt Service Coverage 1/ including fixed assets revaluation Energy Department Report Prepared January 1980  PERU: PETROPERU OIL PRODUCTION REHABILITATION PROJECT PROJECTED BALANCE SHEET IN BILLION OF SOLES 1980 1981 1982 1983 1984 1985 ASSETS Current assets Cash and bank deposits 25.6 85.1 156.2 249.0 358.6 .474,3 Accounts receivables 36.4 51.2 64.3 78.4 90.1 103.1 Inventories 48.2 66.0 83.7 100.4 118.5 141.2 Pre-paid expenses 6.2 7.6 9.5 11.4 13.8 16.6 Net current assets 116.4 209.9 313.7 439.2 581.0 735,2 Fixed assets Long-term receivables from Peruvian treasury 50.9 34.0 17.0 - - - Land, plant and equipment (net of depreciation) 480.7 645.5 788.5 927.7 1,038.9 1,118.6 Other fixed assets 12.3 10.8 9.4 7.9 6.5 5.0 Net fixed assets 543.9 690.3 814.9 935.6 1,045.4 1.123.6 Total assets 660.3 900.2 1128.6 =1i374.8 1.626-4 =858^8 LIABILITIES AND OWNERS' EQUITY Current liabilities Accounts payable 84.1 115.1 143.4 173.1 208.5 259.5 Current portion of long-term debt 32.9 38.7 44.3 49.7 55.2 60.6 Current liabilities 117.0 153.8 187.7 222.8 263.7 320.1 Long-term liabilities Long-term debt 273.5 265.7 271.0 255.6 224.3 180.4 Debt related to past crude oil imports 50.9 33.9 17.0 - - - Indemnities and pension fund provisions 7.4 11.6 16.2 21.4 27.1 33.6 Differ credits 2.3 2.3 2.3 2.3 2.3 2.3 Long-term liabilities 334.1 313.5 306.5 279.3 253.7 216.3 Total liabilities 451.1 467.3 494.2 502.1 517.4 536.4 Net owners' equity 209.2 432.9 634.4 872.7 1,109.0 1,322.4X Total liabilities and owners equity 660.3 =900.=2 .128_. 1A374.8 1a626.4 14858.8 ts 0 Energy Department Report Prepared January 1980  PERU: PETROPERU OIL PRODUCTION REHABILITATION PROJECT SCHEDULE OF SOURCES AND USES OF CASH IN RTLLInNS OF SOLFS 1980 1981 1982 1983 1984 1985 SOURCES Net increase in working capital 78.8 56.8 69.9 90.4 100.9 97.8 Increases in accounts payable 27.3 31.1 28.3 29.7 35.4 51.1 Increases in current portion of long-term debt - 5.8 5.6 5.4 5.5 5.4 Total 106.1 93.7 103.8 125.5 141.8 154.3 USES Increases in accounts receivable 7.6 14.8 13.1 14.1 11.7 13.0 w Increases in inventories 19.7 17.8 17.7 16.7 18.1 22.7 Increases in prepaid expenses 3.9 1.4 1.9 1.9 2.4 2.8 Decreases in current portion of long-term debt 50.0 - - - - - Total 81.2 34.0 32.7 32.7 32.2 38.5 CHANGES IN CASH 24.9 59.7 71.1 92.8 109.6 115.8 C) Energy Department Report Prepared January 1980  - 64 - ANNEX 5.06 Page 1 of 2 Notes and Assumptions on Financial Statements The financial projections have been made on the basis of the crude oil production schedule and projected operating costs detailed in Annexes 5-1 and 5-2 and the assumptions indicated below: 1. Prices. Average spot market prices for crude oil in 1979 are projected to average US$28.20, and are based on spot market prices realized by PETROPERU through July 1979. Spot market prices for subsequent years have been assumed to retain a 10% premium over and above the highest OPEC posted price for crude sold under long-term contracts (i.e., US$23.50 per barrel as July 1979). In this regard, it has also been predicated that OPEC prices under long-term contracts would remain linked to the US dollar inflation rate. Ex-refinery prices for petroleum products sold in the domestic market in 1979 (GOP controlled prices) are projected to average US$0.24 per gallon. Domestic prices for subsequent years were assumed to increase at a rate of 10% p.a. in real dollars during the period 1980-82, and to remain linked to the dollar inflation rate thereafter. Assumed spot market price for crude oil and ex-refinery domestic prices for the period 1980-1985 are shown in the table below: PETROPERU: PRICE ASSUMPTIONS (Current Terms) 1980 1981 1982 1983 1984 1985 Spot market prices $/bbl 1/ 28.18 30.15 31.96 33.88 35.91 38.07 Ex-refinery domestic prices $/gl 0.26 0.29 0.33 0.35 0.37 0.39 1/ Constant in real terms at US$25.85 per barrel. 2. Administrative and Selling Expenses related to PETROPERU's activi- ties have been projected to be S/.33.3 billion (US$148 million) in 1979 and are based on actual costs provided by PETROPERU. Administrative and selling expenses for subsequent years have been assumed constant in real terms. 3. Depreciation has been calculated according to the schedules approved and authorized by the Peruvian Internal Revenue Service summarized below: Annual Depreciation % (Straight Line) Machinery and equipment 10 Transportation equipment 20 Talara's refinery and fertilizers' plant 5 Pampilla's refinery 4 Pipelines 6.7 Buildings and civil constructions 3  - 65 - ANNEX 5.06 Page 2 of 2 4. Asset Revaluation. PETROPERU's revaluation practices apply to all its non-fully depreciated assets with associated outstanding debt: denominated in foreign currencies. The yearly revaluation amount of each specific item is, therefore, related to the increase of its outstanding debt obligations due to variations in the exchange rate of the sol and each specific currency over the preceding fiscal year. 5. Taxes. It has been assumed that PETROPERU's overall tax obligations would be computed in accordance with the recently issued Supreme Decree 22775, that assimilates the petroleun sector into the General Tax Code of Peru. 6. GOP Equity Contributions to PETROPERU will amount to US$45 million in 1980, US$45 million in 1981, and US$30 million in 1982. An equity contribu- tion of about US$62 million effective January 2, 1980 has also been assumed. In addition, GOP would appropriate, to comply with the new legislation, yearly equity contributions to PETROPERU on the amount of its contractors' income taxes, estimated at a yearly average of about US$200 million for purposes of capital investment pIrojects. 7. Debt Related to Crude Oil Imports During the Period 1973-78. Short term debt incurred by PETROPERU to finance petroleum imports in the period 1973-78 amounted to ',/.85.4 billion (US$380 million), of which S/.25.9 billion (US$115 million) has already been repaid to the external creditors. The GOP has agreed to (a) assume the servicing of the outstanding portion of this debt i.e., principal repayments of S/.8.5 billion in 1980, and S/.17.0 billion in each of the years 1981, 1982 and 1983, and; (b) to transfer to E'ETROPERU the portion already repaid to the external creditors by equivalent reduction in PETROPERU's 1979 tax payments.  PERU: ECONOMIC CALCULATIONS: BREA & PARINAS PRODUCTION REHABILITATION (in US$'000) ___ __ Sensitivity- Value Investment Operating Net Bene- 10% Decline Revenue with Net Benefits Year Output of Costs Costs fit to Output 10% Declining to (Barrels) Output Country (Barrels) Output2/ Country 0 5,350 0 -5,350 -5,350 1 383,250 9,907 0 1,690 8,217 383,250 9,907 8,217 2 364,090 9,412 0 1,690 7,722 344,925 8,916 7,226 3 344,920 8,916 0 1,690 7,226 306,600 7,926 6,236 4 325,760 8,162 0 1,690 6,472 268,275 6,935 5,245 5 306,660 7,927 0 1,690 6,237 229,950 5,944 4,254 6 287,440 7,431 0 1,690 5,741 191,625 4,953 3,263 7 268,270 6,934 0 1,690 5,244 153,300 3,928 2,238 8 249,110 6,439 0 1,690 4,749 114,975 2,972 1,282 9 230,000 5,946 0 1,690 4,256 76,650 1,981 291 10 210,790 5,449 0 1,690 3,759 - 0 0 INTERNATIONAL RATE OF RETURN (IRR) = over 100% = over 100% IRR with 50% higher investment cost = 95.7% = 88.5% 1/ At $25.85/barrel. 2/ 10% per year of first year's output.  - 67 - ANNEX 602 PERU: PETROPERU OIL PRODUCTION REHABILITATION PROJECT INCREMENTAL FINANCIAL COST AND BENEFIT STREAMS (US$ millions, Real Terms) InvestmP7t Operating Total Cost - Revenues Costs T'axes 1980 1.1- - 1981 - 9.90 1.77 4.46 1982 - 9.41 1.84 4.- 1983 - 8.91 1.91 3.70 1984 - 8.42 1.98 3.41 1985 7.93 2.05 3.12 1986 - 7.43 2.15 2.81 1987 - 6.93 2.25 2.50 1988 - 6.44 2.36 2.19 1989 - 5.94 2.47 1.87 1990 - 5.45 2.59 1.56 1/ Inc:lude Import Taxes. Financial Rate of Return 20.85%  - 68 - ANNEX 6.03 Page 1 of 2 pages PERU: ECONOMIC CALCULATIONS JUNGLE ARTIFICIAL LIFT PROJECT (in $1000) Increase in Net in Production Value of, Investment Operating Benefits Year BarrelsxlOOO Output- Costs Costs Of Project 0 0 0 8,680 0 -7,560 1 6,079 157,140 0 9,820 148,320 2 4,863 125,710 0 9,820 125,890 3 3,890. 100,560 0 9,820 90,740 4 3,112 80,450 0 9,820 70,630 5 2,490 64,370 0 9,820 54,550 6 1,992 51,490 0 9,820 41,670 7 1,594 41,200 0 9,820 31,380 8 1,275 32,960 0 9,820 23,140 9 1,020 26,370 0 9,820 16,550 10 816 21,090 0 9,820 11,270 1/ Valued at $25.85 per barrel  -69- ANNEX 6.03 Page 2 of 2 pages PERU: PETROPERU OIL PRODUCTION REhABILITATION PROJECT JUNGLE ARTIFICIAL LIFT: INCREMENTAL FINANCIAL COST AND BENEFIT STREAMS (US $ millions, Real Terms) Capital Operating Total Costs 1/ Costs Taxes Revenues 1980 8.68 - 3.02 1/ - 1981 - 9.35 54.36 173.8 1982 - e 9.70 39.28 139.0 1983 - 10.07 30.84 111.2 1984 - 10.45 24.09 89.0 1985 - 10.84 18.65 71.2 1986 - 11.36 14.26 57.0 1987 - 11.90 10.71 45.6 1988 - 12.47 7.81 36.4 1989 - 13.06 5.49 29.2 1990 - 13.68 3.57 23.3 1/ Equipment import duties Financial Rate cf R^turn 1022'  - 70 - APPENDIX RELATED DOCUMENTS AND DATA AVAILABLE IN THE PROJECT FILES A. General Reports and Studies Relating to the Sector and PETROPERU 1. Inventario, evaluacion e integracion de los recursos naturales de la zona Iquitos, Nauta, Requena y Colonia Angamos. Diciembre 1975 2. Plan Nacional de Desarrollo para 1979-1980, INP 3. Plan de Mediano Plazo 1978-82. Programa de Inversion Publica. INP, Enero 1979 4. Financial Reports of PETROPERU 1969-1977 5. PETROPERU's Detailed Financial Statements 1976 and 1977 6. Talara Secondary Recovery Project. Occidental Peruana Inc., 1978 7. Contrato de Operaciones Petroliferas en la Selva. Occidental Peruana Inc. 8. Evaluation of Objectives and Problems in Geophysical Exploration for Petroleum in the Oriente Basin of Peru, David M. Holroyd B. Selected Working Papers Relating to PETROPERU and the Project 1. Cost Estimates 2. Working papers on PETROPERU's financial position 3. Working papers on the economic and financial analysis of the project 4. Organization and statutes of PETROPERU 5. Detailed project description  IBRD- 14470 S1-20 - f'r)t , , . s1Joa SEPTEMrBER 979 vrlO7 , ' ,' t g X .1-10~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~-0 P A C I x w stB7.0'~~~~~~~~~~~~~~~~~~~~~~~~~7 | , t 20_ / \ O C A tVN r~~ ~~~~ ~ ~ ~ ~~~~~~~~~~~~~~~~~~~~~~~~~~ I " |