Peru - Petroleum Production Rehabilitation Project

Document of On l The World Bank FILL kAi: FOR OFFICIAL USE ONLY Report No. P-2706-PE REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO PETROLEOS DEL PERU WITH THE GUARANTEE OF THE REPUBLIC OF PERU FOR A PETROLEUM PRODUCTION REHABILITATION PROJECT February 13, 1980 This document has a restricted distribution and may be used by recipients only in the performace of their oflfeial duies. Its contents may not otherwise be disclosed without World Bank authrization.  CURRENCY EQUIVALENTS The exchange rate is being adjusted daily roughly in line with the difference between domestic and international inflation. The exchange rate and currency equivalents in effect on January 31, 1980, were as follows: Currency Unit = Sol (SI.) Calendar 1979 January 31, 1980 US$1 = S/. 225 S/. 255 S/. 1 US$0.0044 US$0.0039 S/. 1,000 = US$4.44 US$3.92 Fiscal Year January 1 to December 31 Abbreviations COFIDE = Corporacion Financiera de Desarrollo (National Development Finance Corporation) ELECTROPERU = Electricidad del Peru (National Power Generation Company) ERP = Economic Recovery Program IPC = International Petroleum Company MEM = Ministerio de Energia y Minas (Ministry of Energy and Mines) PETROPERU = Petroleos del Peru (National Petroleum Company)  FOR OFFICIAL USE ONLY PERU PETROLEUM PRODUCTION REHABILITATION PROJECT LOAN AND PROJECT SUMMARY Borrower; Petroleos del Peru (PETROPERU) Guarantor: Republic of Peru Amount: US$32.5 million Terms: Seventeen years, including three years of grace, at 8.25 percent interest per annum plus a guarantee fee of 0.25 percent per annum payable by the Borrower to the Guarantor and a service fee of 1.5 percent per annum payable by the Borrower to the National Development Finance Corporation (COFIDE), which will be a party to the Loan Agreement. Project Description: The project's objectives-are to increase Peru's oil production in the short term by an initial 19,600 barrels per day, to sustain the level of petroleum production in the medium term and to improve the financial situation and technical capability of PETROPERU. These objectives would be accomplished through (i) the rehabilitation of existing PETROPERU wells on the coast and the jungle; (ii) the undertaking of seismic surveys in the jungle and the updating of a feasibility study for a secondary recovery project on the north coast; and (iii) the provision of consultants' services and training to strengthen PETROPERU financially and technically and to study overall petroleum sector investment requirements and domestic pricing policies. The project faces no special risks. Technical assistance would be provided to PETROPERU under the project to train its personnel in the use and maintenance of equipment (also to be provided under the project) with which PETROPERU has not had previous experience. This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contenst may not otherwise be disclosed without World Bank authorization.  - ii - Estimated Cost: Local Foreign Total -----(US$ million)----- (a) Production rehabilitation 11.8 12.2 24.0 (b) Seismic surveys and studies for new production 2.2 11.3 13.5 (c) Technical assistance and training 0.5 2.5 3.0 Baseline costs 14.5 26.0 40.5 Physical contingencies 1.7 3.1 4.8 Price contingencies 2.0 3.4 5.4 Total Project Cost 18.2 32.5 50.7 Financing Plan: Local Foreign Total ---------US$ millions---------- Bank - 32.5 32.5 PETROPERU 18.2 - 18.2 Total 18.2 32.5 50.7 Estimated Disbursements: CY1980 CY1981 CY1982 ----------US$ millions--------- Annual 5.0 16.5 11.0 Cumulative 5.0 21.5 32.5 Rate of Return: Over 100 percent Staff Appraisal Report: Report No. 2705-PE, dated February 11, 1980  INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATION OF THE PIRESIDENT OF THE IBRD TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO PETROLEOS DEL PERU FOR A PETROLEUM PRODUCTION REHABILITATION PROJECT 1. I submit the following report and recommendation on a proposed loan to Petroleos del Peru (PETROPERU) with the guarantee of the Republic of Peru for the equivalent of US$32.5 million to help finance a Petroleum Production Rehabilitation Project. The loan would have a term of 17 years, including three years of grace, with interest at 8.25 percent per annum. The Govern- ment of Peru would charge PETROPERU a guarantee fee of 0.25 percent per annum and the National Development Finance Corporation (COFIDE) would charge the company a service fee of 1.5 percent per annum, thus bringing the cost of the loan to PETROPERU to 10 percent per annum. PART I - THE ECONOMY 1/ 2. A basic economic report entitled "Long-Term Development Issues: Peru" (Report No. 2204-PE) was distributed to the Executive Directors on April 13, 1979. This part is based on the report's findings as well as those of more recent economic missions to Peru. Country data sheets are attached as Annex I. Background 3. Peru, the fourth largest country in Latin America, is divided by the Andes mountains into three distinct regions. The coastal region (the Costa), constituting about 10 percent of the country's territory, is home for about 46 percent of the population. It consists of a narrow belt of dry plains, intermittently irrigated valleys and Andean foothills. Modern economic activity is concentrated in the Costa, particularly in Lima. The Sierra, with 44 percent of the country's population, encompasses the highlands above 2,000 meters which occupy one-fourth of the country. The remaining two-thirds of the area is occupied by the sparsely populated Selva, vast tropical lowlands east of the Andes. The rugged topography limits trade between the three regions. 4. Peru's natural resources include large deposits of varied minerals located mainly in the Sierra and the southern coast. Another major natural resource asset is the large fishing potential in coastal waters, although the magnitude of this potential is subject to sharp fluctuations. Agricultural land is limited, and most of the soils suitable for intensive agriculture are already being farmed. (Energy resources are discussed in detail in paras. 34-36.) 5. After three decades (1930-1960) of rapidly falling mortality rates, the rate of population growth had risen to 2.9 percent p.a. In the early 1960's, birth rates started a gradual fall, mainly caused by the urbanization 1/ The section is substantially unchanged from the Lower Puira Irrigation Rehabilitation President's Report of November 6, 1979 (Report No. P-2642PE).  - 2 - process and by improved education. But as death rates continued to fall, population has continued to grow at about 2.8 percent p.a. Since death rates are expected to fall further, population growth is likely to remain at around 2.8 percent p.a. over the next 25 years, unless an effective demographic policy is adopted. Given the normal lag between the drop in birth rates and its impact on the growth of working-age population, the labor force is expected to grow well in excess of 3 percent per year during the next 15 years. Past Development Policies 6. Since the military came to power in 1968, the Government has followed a development strategy directed at achieving economic growth and at narrowing the sharp differences in wealth and opportunities between population in various income classes and geographical regions. The Government has tried to correct class and regional imbalances by expanding the role of the State in the economy, changing the pattern of asset ownership, reducing foreign ownership of national resources, orienting industry and agriculture toward producing essential goods for the domestic market, stimulating the deconcentration of economic activity out of Lima, and reforming the educational system to make it more responsive to local economic and social needs. Through nationalization and creation of new enterprises, the State has taken direct control of over 150 enterprises in key economic sectors, and its share in total capital formation has risen from less than one-fourth in 1968-70 to about one half in 1974-1978. By imposing complex legislation, the Government has also strictly controlled the operations of the private sector. 7. As a result of these actions, the pattern of asset ownership in the economy has changed drastically. Through nationalization, the share of assets owned by foreigners fell sharply. A sweeping land reform redistri- buted 45 percent of the country's best farmlands to workers' cooperatives benefitting some 25 percent of all rural families. Through other laws, industrial workers were given shares in the firms which employed them and, in the mining sector, a share in profits. The Government has also given a strong autarkic orientation to its agricultural and industrial sector policies and strengthened the incentives for industries outside of Lima. 8. The Government's programs have benefitted large numbers of Peruvians, but they have hardly reached the poorest half of the population which continues to live in abject poverty. It is estimated, for example, that about three quarters of rural families, mostly "minifundistas" (those farming less than 2 ha) and the landless seasonal workers, have not been reached by social programs. The Government imposed controls on prices of a number of domestic- ally produced goods and heavily subsidized imported petroleum and foodstuffs. Most of the subsidized products, however, were more important in the consump- tion basket of high and middle-income Peruvians than in that of the poorest groups. Moreover, the maintenance of artificially low prices for some products--such as meat and cereals--actually hurt the poor who produced these items, and affected production negatively. 9. In the final account, one of the most significant achievements of the Government was the promotion of the cultural and political integration of the country. Owing in great part to the land reform, an important segment  - 3 - of the rural population has become better organized and is able to communicate its priorities in a more forceful and articulate way. Unfortunately, although many of the policies and structural changes carried out since 1968 were meant to achieve rapid growth and more equality, the cost of these measures proved to be excessive and their implementation inefficient. The Economic Crisis 10. Until 1977, the military Government followed expansionary fiscal and credit policies. A rapid increase in spending by the public sector (including large defense outlays) was not matched by a parallel increase in revenues. Pricing, interest rate and foreign exchange policies until 1976 encouraged consumption and discouraged savings, exports and, sometimes, overall production. As a result of these policies, aggregate demand considerably exceeded aggregate supply. This excess demand, in turn, led to widening external gaps and to strong inflationary pressures, with a resulting loss of international reserves and a massive build-up of external debt. 11. This imbalance was aggravated by circumstances beyond the control of the authorities. Anchovies, the fishing industry's principal product, virtually disappeared as the annual catch dropped from around 10,000 metric tons in 1968-71 to an average of 2,300 metric tons in 1975-78. Between 1974 and 1978, furthermore, Peru's terms of trade worsened sharply. Export prices, particularly for copper and sugar (which together accounted for almost one- fourth of merchandise exports), fell from their very high 1974 levels at a time when import prices soared. Petroleum reserves, which in the early 1970's were predicted to lead to a quick, major expansion in export earnings, have taken much longer than expected to come on line. 12. Public sector savings dropped steadily in relation to GDP from 4.4 percent in 1970 to dissavings of 2.6 percent in 1977. A major cause for this was a massive erosion of the tax base owing to excessive tax incentives, loopholes in the tax system and weak enforcement. At the same time, there were rises in the budgetary cost of subsidies for foodstuffs and petroleum products, and sharp increases in military imports and local expenditures. Much of public investment, furthermore, was increasingly concentrated on capital-intensive projects with long gestation periods and little immediate contribution to the growth of output or employment. 13. Inflation accelerated from 5 percent per year in 1970 to 38 percent in 1977. Interest rates on domestic banking system loans, however, remained substantially negative in real terms, discouraging financial savings and stim- ulating capital flight. Moreover, the exchange rate remained practically constant between 1968 and 1975, thus contributing to the overall disequilibrium. National savings fell dramatically from 16 percent of GNP in 1970 to 8 percent in 1977, when they financed only about one-half of investment. Following a period of rapid expansion in 1968-74 during which GDP grew by more than 6 percent per year, the growth rate dropped progressively and became negative in 1977. 14. The growing disequilibrium described above was reflected in the balance of payments. The current account deficit averaged US$1.1 billion per year in 1974-77, equivalent to nearly 9 percent of GNP. To finance this  - 4 - deficit, Peru accumulated a massive external debt. Peru's total pri-vate and public external debt--including short-term indebtedness--stood at almost US$8.3 billion by year end 1977, equivalent to two-thirds of GDP and four times exports. Much of this debt was contracted on fairly short maturities with three-fourths of the public sector's long-term debt--which is estimated to have totaled US$6.3 billion--scheduled to be repaid over the 1978-82 period. 15. Beginning in 1975, successive economic teams made several efforts to cope with the mounting economic crisis. A major stabilization program was initiated in June 1976, when the sol was devalued from SI. 45 to SI. 65 per U.S. dollar, fiscal and credit policies were tightened and interest rates were raised . This program was initially successful in reducing the fiscal deficit and the loss of foreign exchange. Nevertheless, it was abandoned later in the year as a consequence of strong popular opposition and a lack of consensus within the Government regarding the gravity of the financial situation. Further attempts to stabilize the economy were initiated in March, July and September 1977 but they were not successful. A stand-by arrangement was negotiated with the IMF and approved in November 1977, but its targets were not met. While these efforts proved to be false starts, they succeeded in somewhat reducing the gap between national savings and investment from a peak of 11.5 percent of GNP in 1975 to 8.5 percent in 1976 and 7.4 percent in 1977. 16. By mid-1978 the economic crisis had reached grave proportions. The drop in GDP had intensified and inflation had further accelerated to an annual rate approaching 100 percent. Moreover, the private sector was finding it increasingly difficult to open letters of credit for new imports and the banking system's net international reserves had dropped to a negative level of US$800 million. It had become clear that the public sector was fast approach- ing the point where it would no longer be able to fully service its external debt. Peru was no longer creditworthy. Financial instability had reached the point where practically all economic activities were adversely affected. Stabilization Efforts 17. A new economic team was named in May 1978. Since then, the Govern- ment has adopted a number of important measures aimed at strengthening public finances, stimulating exports and stemming the loss of international reserves. By means of a crawling peg, the sol was devalued from S/. 130 to the U.S. dollar in May to almost S/. 200 to the U.S. dollar by year-end 1978; since then the sol was devalued a further 20 percent. Most subsidies were elimi- nated, thus closing an important drain on public savings. Other price controls were relaxed. In addition, a number of tax measures were adopted and Government expenditures were restrained. Interest rates on bank loans were raised from 16 to 31.5 percent per year. Peru reached agreement with foreign commercial banks to reschedule US$185 million of principal payments due in the second half of 1978 until January 1979. The Government also negotiated a stand-by arrangement for SDR 184 million, which was approved by the IMF on September 15. In July 1979, this stand-by was replaced by a new stand-by arrangement for SDR 285 million, (of which, SDR 232 million will be financed from the Fund's supplementary financing facility) in support of the same financial program. Peru's debt outstanding to the IMF as of June 30, 1979 was equivalent to SDR 439.8 million. Finally, the Government refinanced the bulk of the public external debt due in 1979 and 1980.  - 5 - 18. The Government's financial stabilization program, supported by the stand-by, aims at a dramatic improvement in public sector finances in 1979. Public sector current account savings are to rise from - 0.7 percent of GDP in 1978 to 4.0 percent of GDP in 1979. To this end, the Government adopted a 1979 budget that aims at a 10 percent real increase in tax revenues, while severely holding down current outlays. Payments for wages and salaries are budgeted to fall by some 12 percent in real terms, partly as a result of a planned reduction in excessive civil service employment. The elimination of subsidies on food and petroleum products, initiated in mid-1978, will further contribute to the control of current expenditures. The largest cut is for defense outlays. On the revenue side, measures already adopted--including a 10 percent import surcharge, a higher tax on traditional exports and an increased tax on interest charged on bank loans--are expected to permit attainment of the revenue target. On the other hand, real capital expenditures are budgeted to rise by over 20 percent. In short, execution of the program has been very good, and as of June 30, 1979 central government current savings exceeded the budgeted savings by 13.3 percent. In spite of this progress, however, inflationary pressures remain strong, with the consumer price index rising at an annual rate of 65 percent. Debt Restructuring 19. Major debt-relief operations carried out in late 1978 enabled Peru to reduce substantially the debt-service burden for 1979 and 1980, postponing repayment to the 1982-1986 period. In May 1978, the Soviet Union rescheduled the equivalent of about US$140 million of maturities originally due in 1978-80. These amounts are to be repaid over a 10-year period including three years of grace. In November, at a Paris Club meeting, the OECD countries agreed to reschedule 90 percent of principal payments due by the public sector to governments and guaranteed suppliers in 1979 (US$250 million) and 1980 (US$263 million). These amounts are to be repaid over a period of eight years, including three years of grace. The Paris Club agreement states that 1980 maturities will be rescheduled provided that Peru agrees with the IMF, by December 31, 1979, on a financial program for 1980. The Paris Club creditors also agreed to reschedule 90 percent of the principal payments due in 1979 and 1980 (about US$30 million in each year) on private sector debt guaranteed or insured in the creditor countries. In addition, Peru has negotiated smaller amounts of debt relief with non-OECD countries. 20. As regards the large medium-term public debt to commercial banks, in keeping with an agreement concluded in December 1978, Peru has been repaying in 1979, the bulk of the US$185 million rolled over from 1978 (para. 17 above). The agreement reached between the Government of Peru and the commercial banks gives the Government the option of refinancing up to 90 percent of the maturi- ties due in 1979 and 1980. The government, however, has recently indicated that it intends to forego a large part of this debt relief, in view of the much improved balance-of-payments situation (see para. 24).  -6- Social Situation 21. The economic crisis of recent years has been reflected in two conse- cutive years of negative growth. Total Gross Domestic Income fell by 0.6 percent in 1977 and a further 0.6 percent in 1978. In this two-year period GDP per capita dropped by over 8 percent. This situation, in turn, has been reflected in incomes and employment. Nearly one-half of Peru's labor force is believed to be unemployed or underemployed, i.e., earning less than the minimum wage or working less than 35 hours a week and wishing to work more. According to government estimates, the purchasing power of salaries had fallen 40 percent by 1978 compared to 1970 and that of wages by over 16 percent. In these circumstances, the social situation has been unavoidably tense, and several general strikes have taken place during the past year. 22. In July, 1979 the military government promulgated a new constitution, written by a popularly elected assembly. The government has called for elections in May, 1980 and the transfer of authority to a civilian government is scheduled to take place in July, 1980. At present the authorities are maintaining an informal dialogue with the leaders of the major political parties in an effort to ensure the continuity of economic policies following the political transition. The Economic Recovery Program 23. With the financial stabilization program and the debt restructuring described above, the Government has brought the fiscal and external gaps under control. These efforts, however, have not yet helped much in overcoming the deep economic recession. To this end the Government conceived an Economic Recovery Program (ERP) which would reverse the decline in GDP and lay a basis for a financially sound economic recovery. The ERP includes, in addition to the above-mentioned stabilization actions, measures to open up the economy, stimulate industrial sector efficiency, promote non-traditional exports, strengthen the tax system by broadening its base, and generally improve the efficiency of resource allocation in the private and public sectors. In this connection, the Government formulated a Public Sector Investment Program that aims at redirecting public investment towards projects of clear economic priority and positive effect on production and employment. In support of the ERP, the Bank approved a US$115 million program loan in May, 1979. Progress in carrying out the ERP is generally satisfactory with performance in some critical areas--e.g., export promotion--actually exceeding expectations. 24. The Government's program has also led to a strong balance of payments performance in 1979, which is essential for economic recovery and to restore net international reserves. This was achieved by maintaining an export-oriented foreign exchange policy, realistic interest rates, and the promotion of non- traditional exports. In addition, Peru benefitted from substantial price increases for petroleum, silver, copper and other commodities. The Peruvian Government also intends to improve foreign debt management by, inter alia, making greater use of aid from official bilateral and international donors to the extent possible. Much of Peru's large foreign short-term debt (estimated at over US$2 billion as of year-end 1978) is expected to be rolled over or refinanced as the gradually improving economic situation permits new trade- related credit lines to be opened. The trade balance is expected to be  - 7 - strengthened by a further drop in military imports, by favorable world prices for minerals, and by the availability of a large petroleum surplus for export. The recent completion of the Trans-Andean pipeline should allow Peru to export an average of nearly 80,000 barrels per day in 1979-82, adding some US$850 million per year to gross export earnings. Even though about one third of the projected gross petroleum exports would leave the country as profit remittances, this still implies a major improvement over recent years, when Peru was spending in excess of US$200 million per year on fuel imports. On balance, Peru can be expected to enter the 1980s with a strong trade surplus. 25. As economic activity recovers to an annual growth of about 6.5 per cent in real terms during 1979-85 and the volume of petroleum exports stagnates and eventually declines, the value of imports is expected to outpace exports. Nevertheless, the country is expected to show a strong balance-of-payments performance through the mid-eighties, with current account surpluses hovering around the US$1,100 million mark and with a substantial build up of foreign exchange reserves in spite of heavy debt repayment obligations. The situation may, however, drastically change after 1986, eventually resulting in increasing current account deficits. Considering the expected medium-term balance-of- payments performance and assuming that the authorities continue to carry out the ERP and to maintain prudent financial policies, Peru is creditworthy for Bank lending. PART II - BANK GROUP OPERATIONS IN PERU 26. The Bank has made 36 loans in Peru for a total amount of US$732.1 million, net of cancellations. About 33 percent of the Bank's lending to Peru has been for transportation (mainly highways and ports), 22 percent for agriculture, 16 percent for the May 1979 Program Loan, 12 percent for electric power, 11 percent for mining and industry and about 6 percent for education and urban development. 27. Of the US$297.1 million undisbursed as of December 31, 1979, almost 95 percent is attributable to the seven project loans and the program loan made since 1976. The slow start-up of the project loans--only two of which were "repeater" operations--as well as the slow progress of previous opera- tions was due, in large part, to weak project execution capacity and to a shortage of counterpart funds that worsened as the economic situation deteri- orated during this period. As a result, disbursements have averaged about US$25 million per year over the past few years (Annex II contains a summary statement of Bank loans as of December 31, 1979, and notes on the execution of on-going projects). In an effort to improve this situation: (i) the Bank has recently opened a Resident Mission in Peru; (ii) the Executive Directors have approved modifications in the Education and the Lima/Amazon Corridor Projects (see Annex II for further details); (iii) adequate counterpart funds have been provided by the Government for 1979 and 1980; and (iv) the Government has set up a special commission to monitor loan execution and resolve administrative problems. With these actions and since start-up problems facing some of the newer projects have now been largely overcome, the pace of disbursement is now increasing. Almost US$20 million was disbursed on project loans in the first semester of FY 1980.  - 8 - 28. Program Loan disbursement started slowly because of the unfore- seen increase in foreign exchange available to Peru as the result cf booming exports and continued depressed import levels as well as substantial debt rescheduling. In order to accelerate disbursements, the list of eligible imports has been expanded to include additional high priority industrial inputs. In recent months, Program Loan disbursements have increased markedly. As of February 4, 1980, US$41.2 million had been disbursed and applications for the withdrawal of an additional US$17 million were pending. 29. The main objectives of Bank lending to Peru have been to assist in (a) the creation of the physical and social infrastructure needed to sustain and foster development; (b) the expansion of productive capacity in crucial sectors; (c) the consolidation of structural and institutional changes, particularly land and education reforms; (d) the strengthening of agencies to implement and operate projects effectively; and (e) improving living conditions for the urban and rural poor. In the past, Bank lending concentrated on infrastructure in the transportation and power sectors. More recently, the Bank's emphasis has shifted to more directly productive fields -- mining, agriculture and industry -- to aid Peru in surmounting its balance of payments problems. Lending for social projects has also grown. 30. The next operations that would be ready for the Executive Directors' consideration are a small rural development project to increase agricultural and livestock production in the Sierra, a provincial airports project and a sixth agricultural credit project. Preparation is underway on a mining operation and a highway maintenance project is also planned. 31. Bank loans constituted about 7.0 percent of Peru's total outstanding debt, including undisbursed, at the end of 1978, and absorbed about 3.7 percent of the country's external debt service in 1978. Assuming increased recourse to long-term bilateral and multilateral aid by Peru, the Bank's share of the country's outstanding public foreign debt by 1985 could reach 12 percent and its share of debt-service would be around 5.5 percent. 32. IFC commitments to date have been US$26.5 million (US$15 million to the Southern Peru Copper Corporation for the Cuajone Copper Mining Project) of which US$14.0 million is held by the Corporation. A summary statement of IFC investments as of December 31, 1979 is presented in Annex II. 33. The other principal aid agencies lending to Peru -- IDB and USAID -- are expected to continue giving special attention to agriculture with IDB emphasizing agricultural credit and AID stressing rural development. Total loan commitments as of October 31, 1979 by IDB and USAID were US$500.9 million and US$198.3 million, respectively, and their shares of debt service as of end-1978 were 1.0 percent and 0.5 percent, respectively.  -9- PART III - THE ENERGY AND PETROLEUM SECTORS The Energy Sector 34. Peru's energy resources are large and diversified but relatively unexploited. Economically viable hydroelectric potential is estimated at 30,000-60,000 MW of which only about 1400 MW are currently being used. Proven and probable oil reserves are about one billion barrels, while current annual production is approximately 70 million barrels. Some coal deposits suitable for thermal generation or metallurgical coke have been identified but most of the country has not been adequately explored. Finally, there are some gas reserves -- mostly non-commercial -- and possible substan- tial geothermal potential which the Government is only now beginning to study. 35. Data for 1976--the latest available--indicate a total energy consumption for the year of 75 million barrels of oil equivalent, of which petroleum accounted for 54 percent, firewood and other non-commercial sources 34 percent, hydropower 6 percent, natural gas 5 percent and coal 1 percent. Petroleum was even more important in terms of commercial energy requirements, supplying about 80 percent of demand. 36. After twenty years of dependence on imported petroleum, an almost threefold increase in domestic production between 1976 and 1979 has enabled Peru to meet internal demand, which has grown little in recent years, and to produce a surplus for export. As the country's economic situation improves, however, demand will rebound and current proven reserves are only likely to be sufficient to satisfy domestic requirements through the mid-1980s. Although conservation measures and accelerated development of hydro-electric and coal resources will help meet future energy requirements and should be encouraged, Peru will continue to be dependent on petroleum for at least 50 percent of its energy needs through the end of this century. If the country is to avoid again becoming an oil importer over the medium run, the Government must rapidly increase exploration and secondary recovery efforts. 37. The Government is just beginning to devote attention to energy sector planning, which is now coordinated by the Ministry of Energy and Mines (MEM). Operational responsibility for the various subsectors is divided among autonomous Government enterprises. The National Petroleum Company, PETROPERU, is responsible for all phases of the production and distribution of petroleum products. In addition, two U.S. companies (Occidental and Belco Petroleum) explore for, and produce, petroleum under contract with PETROPERU. Power generation is the responsibility of the national power company, ELETROPERU and various local state-owned companies handle distribution in the larger cities. Coal exploration and development is usually undertaken by the state mining company, MINEROPERU. 38. An August 1979 energy assessment, jointly prepared by the Peruvian Government and the U.S. Department of Energy, recommends the creation of an energy institute that would do energy sector planning and study and promote energy resources for which no agency currently has clear-cut responsibility (e.g., geothermal power, biomass and, to some extent, coal). The Government  - 10 - is now considering establishing such an entity. Other recommendations of the report are to: (i) develop hydroelectric and coal resources; (ii) shift towards the use of renewable energy resources, particularly for small communities; (iii) improve energy efficiency in industry; and (iv) electrify, where possible, urban and regional transport systems, the principal petroleum users. Nuclear power is not considered a viable option before the year 2000. 1 39. The energy assessment, plus a master plan for development of the nation's hydroelectric resources financed by the Bank under Loan 1215-PE, and a UNDP financed energy balance study, provide the analytical basis for developing an energy sector strategy to guide future policy making and invest- ment. The Bank intends to continue to explore ways in which it might further assist the Government in this effort. The Petroleum Sector 40. Reserves. Peru is comprised of three major geologic zones, each of which contains sedimentary basins with hydrocarbon bearing potential: (i) the Costa, particularly around Talara in the north (Brea-Parinas) where, until the 1970s, almost all of Peru's oil production was concentrated; (ii) the Selva region -- the low jungle plain along the eastern and northeastern areas of Peru -- currently the source of most production and the area with the largest potential reserves; and (iii) the Sierra, where commercial potential appears low. 41. In 1977, PETROPERU estimated national proven and probable reserves for primary recovery at approximately 750 million barrels. Some experts, however--including those from the U.S. Geological Survey--believe that this figure is overly optimistic and that a more prudent estimate for primary recovery is 565 million barrels. In addition, the Geological Survey estimates that about 500 million barrels can be recovered from known reservoirs through the application of secondary recovery methods. Total reserves, therefore, amount to over one billion barrels. This represents approximately 14 years of production at present rates. 42. Estimates of the scope of undiscovered reserves vary from 2 billion to 40 billion barrels. The higher estimates are based on expectations of sizeable recovery from potentially large reservoirs in the Amazon basin and in deep water at the edge of the continental shelf, the exploitation of which will require expensive technologies which are still in the development phase. 43. Production and Exploration. Peru is one of the oldest oil producing countries in the world. The first oil wells were drilled in 1863 on the northwest coast near Talara, four years after the first commercial fields in the U.S. were developed. The country was self-sufficient for many years. 44. During the late 1940s and 1950s, with prices for gasoline and fuel oil as well as producers' profit margins at very low levels, growth in domestic con- sumption outstripped that of production. By 1958 the situation had deteriorated  - 11 - to the point where the principal foreign oil company operating in Peru, the International Petroleum Company (IPC -- a subsidiary of Exxon) terminated all development and exploration activity for about two years. As a result, while consumption continued to grow rapidly through the 1960s, production from the traditional coastal and offshore fields in northern Peru grew slowly and Peru became increasingly dependent on crude oil imports to meet domestic requirements. 45. To reverse this trend, the Government undertook a major effort in the early 1970's to stimulate exploration activity in the Amazon basin. A few important initial discoveries gave rise to high expectations regarding the hydrocarbon potential of this area. The Transandean Pipeline system to connect the jungle fields to the coast -- the largest single investment project in Peru's history -- was initiated on the basis of these expectations. When completed in late 1977 and extended with a branch line to the Occidental Petroleum fields in 1978, the total cost of the pipeline was over US$800 million. 46. The initial successes were, however, followed by a large number of unsuccessful exploratory wells. These failures, high exploration costs in the Selva, the inflexible investment obligations stipulated by the exploration contracts and an unfavorable change in U.S. tax legislation, all contributed to the exodus of 15 of the original 16 foreign exploration companies by the end of 1976. Aside from Belco, which had been operating on the coast for many years, Occidental Petroleum was the only foreign company to remain and to invest in new exploration in the Selva with notable success. 47. Output stagnated through the mid-1970s as Selva production remained at low levels and coastal production dropped. With the 1973 increase in oil prices, Peru's oil-import bill rose sharply. It averaged over US$200 million annually between 1975-1977, contributing to a serious deterioration in the balance of payments. In 1977, however, production from PETROPERU and Occidental discoveries in the Selva began to come on stream. Output increased from 46,400 b/d in 1976 to 91,000 in 1977 and to 181,000 b/d by the fourth quarter of 1978, with the 1978 increases coming almost entirely from Occidental operations. By mid-1978 Peru was self-sufficient in oil and net exports for the year totaled US$145 million. For 1979, production is estimated to have averaged over 190,000 b/d and net exports to have reached about US$670 million. 48. Prospects. Based on expected development of proven reserves and the initiation of secondary recovery projects now being planned, Peru should continue to be self-sufficient through the mid-1980s. This will require investment on the order of US$1,000 million in the early 1980s, which is expected to come from Occidental, PETROPERU and Belco. Domestic consumption, however, is expected to resume growth in 1980 and to increase at about 5 percent per year thereafter. If Peru is to meet internal demand after 1985 and to continue exporting, significant additional investment in petroleum exploration and development will be needed. Although the Government expects that foreign oil firms would play an important part in this effort, it wishes to preserve a significant role for PETROPERU, particularly in areas of the Selva and Costa  - 12 - where the company has already invested considerable effort. Over the next few years, PETROPERU can develop the promising areas it has begun to explore much more rapidly than new oil companies. However, because of its limited financial and technical resources and the enormous costs involved, Peru is expected to be dependent on foreign firms through the mid-1980s for 70-75 percent of the investment necessary to find and develop new reservoirs in the Selva. The country's ability to attract approximately US$1,000 million in additional investment to attempt to make it self-sufficient through the mid-1990s will, therefore, depend on the adoption and maintenance of appropriate sector policies and incentives. 49. The history of Peru's relations with foreign oil companies has been mixed. There were continual difficulties with IPC which culminated in its expropriation in 1968. In 1969 foreign concessions were prohibited, but in 1970 Peru changed its policy and established a new framework for foreign participation in the petroleum sector with the "Peru Model" contract. Under this formula, which initially proved attractive to investors, private firms explored for oil and operated production facilities, usually on the basis of a 50-50 split of production with PETROPERU. The foreign oil company paid all its exploration, development and operating costs out of its share of gross revenues; PETROPERU paid all of the firm's Peruvian taxes. 50. In 1977 and 1978, the Government made a new effort to attract private companies to reinitiate exploration and development activity. It opened, for exploration and secondary recovery, large onshore and offshore blocks in coastal areas which had been previously reserved for PETROPERU, as well as 47 million hectares in the Amazon. A number of oil companies indicated interest in new contracts in the jungle areas; however, only Occidental signed an agreement. The principal factors dampening foreign firms' interest were the high risk of new exploration combined with political uncertainty engendered by upcoming elections and a re-evaluation by the Government of the "Peru Model" contract in light of greatly increased world oil prices. Also, U.S. firms found that they were unable to credit their Peruvian income taxes against U.S. taxes under the "Peru Model" contract. 51. After carefully considering alternative exploration contracts with the assistance of a consortium of investment banks, led by Lehman Bros. - Kuhn Loeb, the Government adopted new guidelines for such contracts on December 6, 1979. At the same time, it modified the tax system applicable to foreign oil firms. Under the new laws, foreign firms would continue to contract with PETROPERU to explore for, and extract, hydrocarbons. However, the share of production they retain would be linked to the world price of petroleum and their volume of production. Also, foreign firms would pay their own Peruvian income taxes, thus enabling them, in principle, to credit such payments against U.S. taxes. PETROPERU would receive foreign oil company income tax payments as a capital contribution. The terms of the new tax law have required that the existing Occidental and Belco contracts be modified. Both companies have indicated that they are prepared to renegotiate their contracts; renegotiations have already begun with Belco and technical dis- cussions have been initiated with Occidental. Renegotiation of the Occidental  - 13 - contract is expected to begin shortly. The new laws provide a framework for attracting new investors and a number of foreign firms have indicated their interest in initiating discussions with the Government. Assuming that the renegotiations are successfully completed, prospects are good for substan- tial foreign investor interest in a new round of exploration in the jungle. 52. Pricing Policy. The Government maintained domestic oil prices at the same level from 1969 to 1975 in spite of the 1973 international oil price increase. As a result, consumption more than doubled in the 1973-75 period imposing a heavy burden on Peru's balance of payments. The first determined action by Peru to stem the rapid rise in domestic consumption came in 1976 when gasoline prices were more than doubled. Further increases have been imposed, particularly since 1978. Gasoline prices are now over US$1.00 per gallon, higher than the average for North and South America, although lower than those in Europe. Consumption, particularly of gasoline, has declined since 1975. The Government is following a policy of increasing prices to keep up with inflation; they have been raised five times since January 1978 -- most recently by 10 percent in January 1980. 53. PETROPERU. This state-owned company was established in 1969 following the nationalization of IPC. It incorporated IPC assets, a small government-owned production company, and, in 1973, several other privately- owned oil firms. As a result, PETROPERU now controls 100 percent of Peru's refining capacity and markets 98 percent of the petroleum products sold in the country. In addition to conducting all state exploration and production activity, it owns and operates the Transandean Pipeline and produces petro- chemicals and fertilizer. 54. PETROPERU has a Board of Directors of nine members, five of whom are appointed by MEM, two by other ministries and two by PETROPERU's staff. The Chairman of the Board has broad authority in the management of the Company. PETROPERU's senior management is generally competent and has extensive experi- ence in the petroleum industry in Peru. PETROPERU's middle management, however, is much less experienced and has been weakened by the loss of numerous technical and administrative personnel in 1977/78. This has been primarily because of a limitation placed on salary levels since 1976. In early 1979, the Government improved the salary structure of all the major public sector enterprises, including PETROPERU. As a consequence, PETROPERU's salaries are now comparable with those of private petroleum companies in Peru and the departure of staff has declined. 55. Aside from the loss of professional staff, PETROPERU's most serious problem in recent years has been financial. A number of factors have resulted in a financial crisis requiring Government action to help PETROPERU avoid bank- ruptcy. These factors included: (i) US$400 million in short term debt incurred by the company to finance petroleum imports which were sold domestically at a subsidized price; (ii) almost US$800 million in loans on relatively stringent supplier and commercial terms to finance the Transandean Pipeline which, until recently, yielded no revenue; and (iii) the requirement under the "Peru Model"  - 14 - contract that PETROPERU pay all foreig oi:z companies' taxes. The Government has taken a series of measures to help resolve PETROPERU's financial problems and restore its creditworthiness and further measures will be taken in connec- tion with this proposed loan (see paras. 3-81). PART IV - THE PROJECT Objectives 56. This, the Bank's first petroleum operation in Peru, comes at a critical juncture for the future development of the sector. Without a sub- stantial new exploration and development program in the immediate future, Peru runs the risk of again becoming a petroleum importer in the mid-1980s. The proposed loan would help finance an immediate expansion of production so that Peru can meet its domestic needs and maintain an exportable surplus in the short run. It would also finance the preparation of secondary recovery project and seismic surveys to provide the basis for the expansion of produc- tion in the medium term. Most importantly, however, the Bank's participation in this project has led to the development of a financial recovery program for PETROPERU which is expected, within a few years, to generate sufficient internal resources to enable it to reinitiate exploration and to undertake new develop- ment projects. Also, the Bank's involvement has permitted it to begin a dialogue with the Government on policy issues regarding the future development of the subsector. 57. The project was prepared by PETROPERU. A Bank mission visited Peru to appraise the project in May 1979. The appraisal report (2705-PE dated February 11, 1980) entitled "Staff Appraisal Report -- Petroleum Production Rehabilitation Project", is being distributed separately. Supplementary data are contained in Annex III. Negotiations took place in Washington from January 7 to 15, 1980 and the Peruvian Delegation was headed by Mr. Augusto Morales, General Manager of PETROPERU. Project Description 58. The Project would consist of: (a) the installation of 35 pumps to provide artificial lift for existing wells in four reservoirs in PETROPERU's northern jungle fields; the acquisition of two maintenance rigs to service wells in the jungle areas; and the carrying out of studies to improve the efficiency of exploitation of these reservoirs; (b) the installation of various types of pumping systems to reactivate primary production from 300 wells in PETROPERU's coastal fields; (c) updating and expanding a feasibility study for a secondary recovery project in the Brea-Parinas area on the Costa;  - 15 - (d) 2,100 km of seismic surveying in two phases and processing of the information obtained; and (e) consultants services and training to strengthen PETROPERU both financially and technically, and to study future sector investment requirements and petroleum pricing policy. 59. Artificial Lift for North Jungle Operations. These fields currently produce about 20,000 b/d/. Originally, sufficient pressure was available to allow production without recourse to any artificial help; however, the heavy nature of the oil and the limited gas in the solution has restricted its natural flow. Pumping equipment would be installed in order to maintain sufficient pressure necessary to permit production at maximum capacity. 60. PETROPERU has acquired 12 pumps with its own resources. Approxi- mately 35 additional pumps would be financed under the proposed project. With this equipment, production would be increased in the first year of operation by approximately 18,500 b/d--93 percent greater than the present production level of these fields--and would decline thereafter by approximately 20 percent per year. PETROPERU would also acquire two rigs to maintain and service wells in the jungle and improve their production. Finally, reservoir simulation studies would be carried out to enable PETROPERU to exploit these fields efficiently in the future. 61. Reactivation of 300 Wells in PETROPERU's Coastal Operations. Signi- ficant primary production can still be recovered from wells in the Talara area that had been shut down as marginal in the period prior to the increase in international oil prices. Three hundred wells would be reactivated under this project with the installation of new pumping equipment. Total production of these wells would be increased by about 1,100 b/d initially, which would decline by approximately 5 percent annually. PETROPERU is currently identi- fying the wells to be reactivated and determining the specific type of pumping equipment to be used. Bank approval of PETROPERU's well reactivation program would be a condition of disbursement for the component (Section 3.05 and Schedule 1, para 4(b) to the draft Loan Agreement). 62. Feasibility Study for a Secondary Recovery Project. PETROPERU is planning a secondary recovery project in the Brea-Parinas area aimed at recovering some 40 million additional barrels of oil. A feasibility study was undertaken in 1974 by Keplinger Associates, a U.S. firm. Subsequently, PETROPERU invited proposals for implementation of the project from two Latin American companies, both of which made detailed presentations. Considerable information exists, therefore, regarding the proposed secondary recovery project. However, costs must be updated, the scope of the proposed project must be defined and design work done. This would require approximately 200 man/months of consultancy services by a qualified firm and take 4-6 months to complete. The cost of consultants is estimated at about US$9,000 per man/month. The qualifications of the consultants selected for this,and other technical assistance components of the project, as well as the terms and conditions of their employment, would be acceptable to the Bank (Section 3.02 of the draft Loan Agreement). Bank financing would be considered for the secondary recovery project which would result from this study.  - 16 - 63. Seismic Survey. Because of its financial difficulties, PETROPERU's exploration activity has declined significantly. No exploratory drilling has been done since early 1978 and seismic work has been curtailed. Since the discovery of new reserves is urgent, PETROPERU is planning to reinitiate its exploration program primarily in two producing areas of the jungle. The initial 1,600 km phase of this program, to be financed by the proposed loan, would focus on potential oil bearing structures which have not yet been fully delineated. A second, more detailed phase covering 500 km, would be carried out provided that the Bank and PETROPERU agree that a second phase is justified based on a review of the results of the first phase. Such agreement would be a condition of disbursement for the second phase (Section 3.06 and Schedule 1, para 4(c) of the draft Loan Agreement). 64. Technical Assistance and Training. About 110 man-months of technical assistance at an estimated US$9,000/man-month would be provided: (i) to improve PETROPERU's financial and technical capabilities; and (ii) to study the overall development of the petroleum sector. Under item (i), consultants would assist PETROPERU in strengthening its financial administration, account- ing and management information practices and procedures. The company's fixed assets would also be inventoried. Under item (ii) of this component, a study of the Peruvian petroleum sector's future exploration and investment require- ments--and of the optimal institutional framework for the sector--would be made. The domestic pricing of hydrocarbons would also been examined. 65. The National Development Finance Corporation (COFIDE) would assist PETROPERU in the selection of consultants for the technical assistance referred to above. It would also help supervise and review their work (Section 3.02(c) of the draft Loan Agreement). PETROPERU would retain consultants to carry out the financial, accounting and management information studies by August 31, 1980 and these studies would be completed by October 31, 1981 (Sections 3.02(b) and 3.07 of the draft Loan Agreement). Upon completion of these studies, PETROPERU would exchange views with the Bank on their findings and on a program to put their recommendations into effect (Section 3.07 of the draft Loan Agreement). The Government would establish a com- mittee--to include representatives of the Ministry of Economy and Finance, MEM, COFIDE and PETROPERU--to coordinate the petroleum sector development studies (Sections 3.01 of the draft Guarantee Agreement and 3.09 of the draft Loan Agreement). The Government, COFIDE and PETROPERU would, upon completion of the sector development studies and 90 days before the end of each year for three years thereafter, exchange views with the Bank on the actions to be taken to implement the studies' recommendations (Sections 3.08(b) and 4.07 of the draft Loan and Guarantee Agreements, respectively). 66. In addition to the studies, about 220 man/months of experts' services, at an estimated US$9,000/man-month, would be provided: (i) to advise PETROPERU's production and field staff on resolving day-to-day oper- ational difficulties that have become more acute as a result of the loss of experienced operational staff; (ii) for the maintenance of the pumping units which would be procured under the proposed project; and (iii) to train PETROPERU's operating personnel in reservoir engineering practices and in production control procedures.  - 17 - Project Cost and Financing Plan 67. The total cost of the project is estimated at US$50.7 million including taxes of US$5.3 million. The proposed Bank loan of US$32.5 million would cover the foreign exchange component, which represents about 64 percent of total costs. PETROPERU would finance the remaining US$18.2 million in project costs and is exploring the possibility of obtaining co-financing for a part of this amount with commercial Banks. If co-financing on appropriate terms is arranged, the Executive Directors' approval would be sought for the addition of a cross-default clause to the legal documents. 68. Retroactive financing in an amount of up to US$2 million is proposed for consultants' services contracted after February 1, 1980 for the updating of the Brea Parinas feasibility study and to cover down payments on orders for pumps placed after that date (paragraph 4(a) of Schedule 1 to the draft Loan Agreement). PETROPERU has already financed the purchase of some pumps with its own funds but, because of its limited resources, the company is depending on the Bank loan to help finance the continuation of this program. Any delay in ordering the pumps would be costly for both Peru and the company since production has declined or stopped completely in some fields. Project Execution 69. The project would be executed over a three-year period (1980-82). PETROPERU would carry out all project components and would be assisted by COFIDE--a party to the proposed Loan Agreement--in the execution of the financial, sector investment and petroleum pricing studies. COFIDE is the government's development finance bank and, in addition to arranging financing for projects, it assists state enterprises in improving their financial performance and project analysis capability. 70. Despite the loss of some experienced technical staff, PETROPERU has the capability to carry out the rehabilitation components of the project effi- ciently. In order to ensure retention of qualified staff, PETROPERU would maintain the competitiveness of its salaries with those of private oil companies operating in Peru and would report to the Bank at least every six months on any vacancies in professional positions in its departments responsible for explora- tion and production and on the action it would take to fill such vacancies (Section 4.01(b) of the draft Loan Agreement). Disbursement and Procurement 71. The Bank loan would finance: (i) 100 percent of foreign expendi- tures and 80 percent of local expenditures for equipment and materials; (ii) 90 percent of services for seismic surveying; (iii) 90 percent of expendi- tures for engineering and consulting services; and (iv) 100 percent of foreign expenditures for training. 72. Goods and services to be financed by the Bank loan would be procured under international competitive bidding procedures in accordance with Bank guidelines, except that certain contracts may be awarded through limited international tender from not less than three member countries of the Bank and  - 18 - Switzerland. These are (i) contracts for highly specialized drilling materials and surface and subsurface equipment other than pumps; (ii) the first 17 pumps, which are being financed retroactively; and (iii) processing services for seismic data, which are highly specialized and available from only a limited number of firms. In the aggregate, such contracts will not exceed US$3 million. Qualified local suppliers and those from Latin American Free Trade Association and Cartagena Agreement member countries participating in international competitive bidding would be accorded a preference representing the difference between the prevailing duty actually applicable and the duty applicable to goods imported from non-member countries, or 15 percent, on the c.i.f. price, whichever is lower (Schedule 4(B) to the draft Loan Agreement). Financial Analysis 73. PETROPERU's financial situation has deteriorated seriously in recent years. By the end of 1978, the company's position had become so precarious that it found itself unable to meet burgeoning payments on foreign oil companies taxes it owed to the Government and in danger of defaulting on the large debt service payments due in 1979. By 1978, its current ratio had fallen to 0.47, its debt/equity ratio was 92/8 and its debt service coverage ratio was below 1.0. PETROPERU's seriously undercapitalized financial structure was a result of price subsidies to consumers, rapidly increasing tax payments and the large investment program (principally the oil pipeline) undertaken in the first part of the decade and financed mainly by debt. 74. In early 1979 with PETROPERU's financial difficulties mounting, the Government set about remedying the causes of the company's financial weakness, which were in large part the result of the Government-imposed situation outlined in paragraph 55. Important steps were taken to strengthen PETROPERU's position and to ensure that it would be able to meet future debt-servicing payments. These steps included: (i) a program of frequent domestic price increases for petroleum products; (ii) Government agreement to assume the servicing of a portion of PETROPERU's external debt, including short term obligations of 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; and (iii) modification of the provisions governing payment of foreign oil firm taxes mentioned in para. 51. These measures, plus equity infusions during the course of 1979, have helped PETROPERU overcome a financial crisis. 75. In order for PETROPERU to achieve long-run financial stability, this project would support the Government's comprehensive financial recovery program for PETROPERU, whose objectives would be to: (i) further strengthen PETROPERU's capital structure through equity infusions; (ii) assure PETROPERU a minimum debt-servicing capability, especially in the critical 1980-82 period when large debt payments fall due; and (iii) maintain the company's liquidity. 76. To strengthen PETROPERU's capital structure, the Government recently made an equity contribution of S/. 15,500 million (US$60.8 million) to the company and would, as a condition of loan effectiveness, assume PETROPERU's remaining short term obligations arising from price subsidies previously borne by the company (Section 7.01 of the draft Loan Agreement).  - 19 - These obligations are estimated to amount to about S/. 25,000 million (US$98 million). Provision has already been made for this action in the Government's 1980 financial program. In addition, the Government would make capital contributions of at least US$45 million each in 1980 and 1981 and US$30 million in 1982, which would be used by PETROPERU to service its debt (Sections 2.03(a) and 4.06(a) of the draft Guarantee and Loan Agreements respectively). 77. In order to help avoid imposing the burden of price subsidies on PETROPERU in the future, it has been agreed that the Government would increase ex-refinery domestic prices by 10 percent per quarter in 1980 (Section 4.03(a) of the draft Guarantee Agreement). Thereafter, the Government would use its best efforts to carry out a pricing policy whose objectives would be to eliminate subsidies and enable PETROPERU to self-finance a reasonable portion of its investment program. To this end the Government would attempt to increase prices in accordance with the domestic rate of inflation or the increase in prices paid by PETROPERU for the acquisition of oil for the domestic market, whichever is greater. To the extent possible, it would also make additional increases in order to reach international price levels (Section 4.03(b) of the draft Guarantee Agreement). Thirty days before the end of each year, the Bank and the Government would exchange views on progress in carrying out these policies and on proposed actions for the coming year (Section 4.03(c) of the draft Guarantee Agreement). In this exchange of views, the Government and the Bank would take into account the recommendations and conclusions of the hydrocarbons pricing study mentioned in para. 64 (4.03(c) of the draft Guarantee Agreement). 78. This program of capital contributions, debt relief and price actions, as well as the modification in petroleum legislation (including tax provisions) mentioned in para. 51, should substantially strengthen PETROPERU's financial situation over the next few years. This will be reflected in a progressive improvement in the company's financial indicators. PETROPERU would maintain a minimum debt service coverage ratio of 1.1 in 1980, 1.4 in 1981, 1.9 in 1982 and 2.0 thereafter (Section 5.05(a) and (b) of the draft Loan Agreement). Within 90 days after the beginning of each year, PETROPERU and COFIDE would submit to the Bank a program of action designed to enable PETROPERU to meet these targets (Section 5.05(f) of the draft Loan Agreement). The Government would take all actions necessary to enable PETROPERU to achieve the agreed upon debt service levels (Section 4.05(a) of the draft Guarantee Loan Agreement). Also, PETROPERU would not incur any debt without the Bank's agreement if such debt would cause its debt/equity ratio to exceed 75/25 in 1981, 70/30 in 1982 and 60/40 thereafter (Section 5.07 of the draft Loan Agreement). For 1980, it has been agreed that withdrawal by the Government of PETROPERU's profits would be limited to not more than the total of any capital contributions made during 1980 less the amount of such contribution used during that year to service debt (Section 4.04(a) of the draft Guarantee Agreement). 79. To insure that PETROPERU would be sufficiently liquid to meet its working capital requirements, PETROPERU would maintain a quick ratio of more than 0.6 in 1980, 0.7 in 1981, 0.9 in 1982 and 1.0 thereafter (Section 5.06 of the draft Loan Agreement). During 1980-81, when the company would still bear a heavy debt burden, the Government would make arrangements to extend a short-term line of credit to PETROPERU until December 31, 1981 to cover any working capital deficits (Section 4.08 of the draft Guarantee Agreement).  - 20 - 80. While PETROPERU's accounts have been audited regularly, a number of qualifications were made on its 1977 financial statements, primarily because of difficulties with the valuation of the company's assets. To correct this situation, PETROPERU and COFIDE would submit to the Bank a plan for the resolution of outstanding audit qualifications on its 1977 financial statements by May 31, 1980; the company would resolve these qualifi- cations by December 31, 1981. To this end, PETROPERU would, by August 31, 1981, complete an inventory of fixed assets and a reconciliation of its books regarding such assets. PETROPERU would also present to the Bank plans to resolve any audit observations on its 1978 and 1979 statements within sixty days of completion of these audits and would carry out such plans by December 31, 1981 (Section 4.05 of the draft Loan Agreement). 81. If the above measures are taken and oil revenues -- which have been projected conservatively -- reach expected levels, PETROPERU would be put on a sound financial footing within the next four years. Its rate of return on assets would increase from an estimated 3.5 percent in 1979 to about seven percent by 1983 and the company would generate sufficient internal resources to enable it to re-initiate its exploration program. Economic and Financial Benefits 82. The economic rates of return of the two production rehabilitation components are extremely high (estimated at well over 100 percent), primarily because of the nature of the investment. 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. Since all the project's incremental production would be exported, or would substitute for imports, total foreign exchange earnings (or savings) over the next ten years would be almost US$780 million at current prices. Because the project's economic rate of return is so high, sensitivity analysis indicates that it would not become marginal under any reasonable set of assumptions. The project's financial rate of return to PETROPERU is lower because of taxes, but it still averages over 100 percent for the project as a whole. 83. In addition to the economic and financial benefits of the project, there are important unquantifable benefits in resolving PETROPERU's financial difficulties and strengthening its financial administration and technical capability. These actions and the secondary recovery and seismic studies to be financed would lay the foundation for initiation of urgently needed ex- ploration and secondary recovery programs that would enable Peru to remain self-sufficient in petroleum production in the future. The sector invest- ment study would provide guidance to PETROPERU and the Government in planning for the future development of the petroleum sector and the pricing study would provide the Government with the analyses necessary to adopt a rational domestic pricing policy.  - 21 - Project Risks 84. The risks associated with the project are those inherent in petro- leum production. The production history of the northern coastal and jungle fields provides a high degree of confidence in the recoverable reserve esti- mates and in the reservoir behavior of each of the producing fields. PETROPERU has considerable operating experience in the Talara coastal area and in super- vising seismic work, so that little difficulty is anticipated in carrying out the coastal reactivation or the seismic components. 85. There is some risk in the installation of artificial lift systems for PETROPERU's jungle operations since the company has just recently begun acquiring experience with electric submersible pumping equipment. Problems in the efficient use and the maintenance and repair of this equipment will inevitably arise. In order to reduce these difficulties, the Bank has provided funds to finance technical services to train PETROPERU's field personnel in a comprehensive maintenance program. Environmental and Safety Considerations 86. 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 before transportation. The residual water produced, which has a high salt content, is discharged into the Rio Corrientes. 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 occasionally 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 the company's practices are in accordance with acceptable industry standards. PART V - LEGAL INSTRUMENTS AND AUTHORITY 87. The draft Loan Agreement between PETROPERU, COFIDE and the Bank, the draft Guarantee Agreement between the Republic of Peru and the Bank and the Report of the Committee provided for in Article III, Section 4(iii) of the Arti- cles of Agreement are being distributed to the Executive Directors separately. 88. The main features of the Loan Agreement are referred to in the text and listed in Section III of Annex III. A special condition of loan effective- ness would be that the Government assume PETROPERU's remaining short term liabilities (para 76). A condition of disbursement for the coastal well re- activation program would be Bank approval of the proposed program (para. 61). A condition of disbursement for the second phase seismic survey would be prior agreement by PETROPERU and the Bank that the second phase was justified (para. 63).  - 22 - 89. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Bank. PART VI - RECOMMENDATION 90. I recommend that the Executive Directors approve the proposed loan. Robert S. McNamara President Attachment February 13, 1980 Washington, D.C.  - 23 - AI4EX I !A-ALI 3A Page 1 of 5 PERM - SOCIAL INDICATORS DATA SHEET PERU IREPESNCE GROUPS (ADJUSTED AnYRAES UANO AIEA (THOUSAND SQ. I.) -MAOST RECENT ESTIMATE) - TOTAL 11ir5.2 SAME SAMS NEXT HICHER AGRICILTURAL 260.0 MOSTt RECENT GEOGRAPRIC INCOME INCOME 1960 lb 1970 lb ESTIMATE /b REGION /c GROUP /d GROUP /a GNP PER CAPITA (USU) 250.0 420.0 740.0 1124.4 1097.7 1942.6 ENERCY CONSUMlPTION PER CAPITA (EILOGRAJS OF COAL EQUIVALENT) 445.0 619.0 642.0 943.1 730.7 1646.7 POPULATION AND VITAL STATISTICS TOPULATION, D-YEAR (MILLIONS) 10.2 13.5 16.4 01R1l1 POPUtATION (PERCENT OF TOTAL) 46.3 57.4 62.8 59.3 49.0 51.2 POPULATION PROJZCTIONS POPULATION IN YtEA 2000 (MILLIONS) 29.0 STATIONARY POPULATION (KILLIONS) 55.0 YEAR STATIONARY POPULATION IS REACMED 2085 POPUATION DENSITY PER SQ. RM. 8.0 11.0 13.0 23.5 44.6 28.2 PER SQ. 1XM. AGUICULTURAL LAND 33.0 44.0 54.0 80.5 140.7 100.5 POPULATION AGE STCTUtE (PERCENT) 0-14 YRS. 44.2 45.0 43.9 40.9 41.3 35.4 15-64 TRS. 52.0 51.9 53.0 54.4 55.3 56.3 65 YtS. AND ABOVE 3.8 3.1 3.1 3.9 3.5 5.1 POPULATION GROWTH RATE (PERCENT) TOTAL 2.6 2.9 2.8 2.4 2.4 1.7 URlAN 4.7Lg 5.0 4.5 3.7 4.5 3.0 CRUDE BIRTH RATE (PER THOUSAND) 47.0 42.9 39.0 32.8 31.1 27.5 CRUDE DEATH RATE (PER THOUSAND) 19.0 14.7 12.0 8.5 9.2 9.1 CROSS REPRODUCTION RATE 3.1/h 2.9 2.8 2.4 2.2 1.8 FAMILY PLANNING ACCEPTORS, ANNUAL (TOUSANDS) .. .. .. USERS (PERCENT OF MARRIED WOMEN) .. .. .. 17.7 34.7 FOOD AND NUTRITION It.OEX OF FOOD PRODUCTION PER CAPITA (1969-71.100) 110.0 102.0 90.0 99.4 104.4 102.0 PER CAPITA SUPPLY OF CALORIES (PERCENT OF REQUIREMENTS) 97.0 99.0 100.0 107.0 105.0 120.8 PROTEINS (GP.AMtS PER DLY) 50.0 61.5 61.7 60.4 64.4 80.9 OF WHICH ANIMAL AND PULSE 25.0 24.0 25.3 28.3 23.5 31.3 CHILD (AGES 1-4) MORTALITY RATE 28.0 20.0 16.0 6.7 8.6 5.1 HEALTH LIFE EXPECTANCY AT BIRTH (YEARS) 48.0 53.0 55.7 63.6 60.2 65.6 INFANT MORTALITY RATE (PER THOUSAND) *- 122.0/f *- 76.1 46.7 45.5 ACCESS TO SAFE WATER (PERCENT OF POPULATION) TOTAL *- 35.0 47.0 63.4 60.8 69.4 URBAN .. 58.0 72.0 79.5 75.7 85.1 RURAL .. 8.0 15.0 38.6 40.0 43.0 ACCESS TO EXCRETA DISPOSAL (PERCENT OF POPULATION) TOTAL .. 36.0 .. 58.8 46.0 70.1 URBAN .. 52.0 .. 77.8 46.0 88.3 RURAL .. 16.0 .. 24.5 22.5 33.2 POPULATION PER PRYSICIAN 2200.0/t 1920.0 1580.0 1841.9 2262.4 t343.2 POPULATION PER NURSING PERSON 3620.07T 3200.0 .. 933.7 1195.4 765.0 POPULATION PER 'dOSPITAL BED TOTAL 490.0hL 470.0 500.0 563.4 453.4 197.6 URBAN .. 410.0 340.0 279.4 253.1 260.2 RURAL *- 3450.0 1300.0 1140.9 2732.4 1055.0 ADMISSIONS PER HOSP'TAL RED .. 19.0 .. 25.7 22.1 17.3 HOUSING AVERAGE SIZE OF HOUSEHOLD TOTAL 4.9 5.5 4.9/1 5.0 5.3 4.7 URBAN 4.8 .- 5.1/1 4.8 5.2 4.4 RUlEAL 4.9 .. 4.7/1 5.3 5.4 5.! AVERAGE NUMBER OF PERSONS ?ER ROOM TOTAL 2.3 2.3 1.9/1 1.3 1.9 1.1 URBAN 2.0 *- 1.77? 1.3 1.6 1.2 RU'RAL 2.7 . 2.4/1 1.5 2.5 1.2 ACCESS TO ELECTRICIT (PERCEPT OF DWELLINGS) TOTAL 26.0 32.1 32.1/1 54.3 30.0 66.0 tltlAN 50.7 .. 54.371 80.1 71.7 95.i RURAL 4.0 2.771 4 4.2 17.3  - 24 - ANNEX I TABLE 3A Page 2 of 5 PERU - SOCTAL INDICATORS DATA SIEET u2EFEPECE GROUPS (A ISTED A4YERAGES PERU - ISST RwECEN ESIMT a SAME SAME NEXT HIGHER MOST RECENT GEOGRAPHIC INCOME INCOME 1960 /b 1970 /b ESTIMATE /b REGION /c GROUP /d GROUP /e EDUCATION ADJUSTED ENROLLMENT RATIOS PRIeARY: TOTAL 83.0 107.0 110.0 107.3 102.5 101.7 MALE 95.0 114.0 116.0 109.1 108.6 110.0 9'EMALE 71.0 99.0 107.0 107.4 97.1 92.8 SECONDARY: TOTAL 15.0 30.0 49.0 40.5 33.5 51.2 MALE 18.0 34.0 54.0 40.4 38.4 56.4 FEM4ALE 13.0 26.0 44.0. 39.0 30.7 43.7 VOCATIONAL ENROL. (Z OF SECONDARY) 20.0 17.0 23.0 18.3 11.5 18.3 PUPIL-TElACMR RATIO PRIMARY 34.0 40.0 40.0 37.1 35.8 27.1 SECONDARY 12.0 23.0 23.0 17.9 22.9 25.3 A"MLT LITERACY RATE (P31CENT) 61.0 .. 72.0 77.4 64.0 86.1 CONSUMNPTION PASSENGER CARS PER THOUSAlD POPULATION 8.0 17.0 17.6 29.1 13.5 53.4 RADIO RECEIVERS PER THOUSAND POPULATION 101.0 134.0 131.0 172.1 122.7 225.9 TV RECEIVERS PER THOUSAND POPULATION 3.0 29.0 32.0 67.9 38.3 102.6 NEWSPAPER ("DAILY GENERAL INTEREST") CIRCULATION PE!R ThOUSAND POPULATION .. 124.0 96.0 76.1 40.0 78.5 CINEMA ANNUAL ATTENDANCE PER CAPITA .. .. .. 4.2 3.7 3.6 LABOR FORCE TOTAL LABOR FOPCE (THOUSANDS) 3100.0 4300.0 4600.0 FEMALE (PERCENT) 21.0 20.7 21.9 21.5 25.0 24.5 AGRICULTURE (PERCENT) 52.5 44.8 40.0 30.2 43.5 28.9 INDUSTRY (PERCENT) 19.6 20.1 20.0 23.8 21.5 30.6 PARTICIPATION RATE (PERCENT) TOTAL 31.3 29.1 29.1 30.9 33.5 33.8 MALE 49.2 45.8 45.3 47.3 48.0 51.3 FEMALE 13.2 12.1 12.8 13.3 16.8 16.3 ECONOMIC DEPENDENCY RATIO 1.6 1.5 1.6 1.5 1.4 1.3 INCOME DISTRIBUTION PERCENT OF PRIVATE INCOME RECEIVED BY HIGHEST 5 PERCENT OF HOUSEHOLDS 39.0/k .. .. 23.7 20.8 HIGHEST 20 PERCENT OF HOUSEHOLDS 64.4/k 61.0/1 .. 58.7 52.1 57.6 LOWEST 20 PERCENT OF HOUSEHOLDS 2.5/k 1.97 .. 2.9 3.9 3.4 LOWEST 40 PERCENT OF HOUSEHOLDS 8.07k 7.o71 .. 9.9 12.6 11.0 POVERTY TARGET GROUPS ESTIMATED ABSOLUTE POVERTY INCOME LEVEL (USS PER CAPITA) URBAN .. .. 235.0 265.6 270.0 RURAL .. .. 180.0 185.1 183.3 ESTIMATED RELATIVE POVERTY INCOME LEVEL (USS PER CAPITA) URBAN .. .. 293.0 396.3 282.5 550.0 RURAL .. .. 200.0 308.1 248.9 403.4 ESTIMATED POPULATION BELOW POVERTY 'NCOME LEVEL (PERCENT) URBAN .. .. 49.0 35.2 20.3 RURAL .. .. .. 46.6 35.3 Not available Not applicable. NOTES /a The adjusted group averages for each indicator are population-weighted geometric means, excluding the extreme values of the indicator and the most populated country in each group. Coverage of countries among che Indicators depends on availability of data and is not uniform. /b Unless ocherwise noted, data for 1960 refer to any year between 1959 and 1961; foc 1970 between 1969 and L971; and for Most Recent Zstimare, between 1974 and 1977. ,c *acin Amertca & Caribbean; /d Incermediate Middle Income (5S51-1135 per capita, 1976); /e Upper t1iddle Income (S1136-2500 per capita, 1976); /f 1970-75i; / 1956-61; /h 1960-65; /i 1964; [962; /k Personal income within labor force; /1 1972. Most Recent Estimate of GNP per capica is for 1978. Au.gusC, 979  -25- lae3 of S mozm= Ot 3SIL pxcAsM Noe ihaithe dot. are dress frce ooc.. g-soell judgd the wet wrtboritsth. and reliahle, It -4l also ho noted that tbsp Mr Mt t. iVtea-- 110't 0o.r blotes. of the laok of standardiood defiolties .0* ac0.9t 00d b differenat noostrio. in collecting the data. fte dAte w0, s.0.0h01.0, "Ojful to describe or60r of 0111toda, -codte trds., .0d fehract-iee cer-tain major diffeenes- be%.*= coartlift. Th. a4umt.d so.0 for each Indicator wre popxlotlcus..o hsl.d eintio me, omldiag the .*0rwms emboss of the Idicaetor oW th. etwopps* to look of dAt..