Turkey - Oil, Gas and Petroleum Projects

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 9748 13/:; / ~X:; 17('n;,'' uL/ L1: PROJECT PERFORMANCE AUDIT REPORT TURKEY PETROLEUM EXPLORATION PROJECT (L-1916) OIL RECOVERY ENGINEERING PROJECT (L-S-013) BATI RAMAN ENHANCED OIL RECOVERY FIELD DEMONSTRATION PROJECT (L-1917) THRACE GAS EXPLORATION PROJECT (L-2327) JUNE 25, 1991 Operations Evaluation Department This document has a restrictei distribution and may be used by recipients only in the performance of their official duties. Its contens may not otherwise be disclosed without World Bank authorization. ABBREVIATIONS AND ACRONYMS CFD - Cubic feet per day Bbl - Barrel (42 US gallons of liquid) GOT - Government of Turkey EOR - Enhanced Oil Recovery EMENA - Europe, Middle East and North Africa TPAO - Turkish Petroleum Corporation GDPA - General Directorate of Petroleum Affairs EIE - Energy Conservation Agency IMF - International Monetary Fund IOC - International Oil Company CURRENCY EQUIVALENTS Turkish Lira per US dollar (Mid-year average) 1978 - 24.3 1985 - 522.0 1979 - 31.1 1986 - 674.5 1980 - 76.0 1987 - 857.2 1981 - 111.2 1988 - 1422.3 1982 - 162.6 1989 - 2121.7 1983 - 225.5 1990 - 2608.6 1984 - 366.7 THE ORLDBANKFOR OFFICIAL USE ONLY THE WORLD 8ANK Washington, D.C. 20433 U.S.A. 01ice of Diector-Ceneal Oprationh Ivalukmatn June 28, 1991 MEMORANDUM TO THE EXECUTIVE DIRECTORS AND THE PRESIDENT SUBJECT: Project Performance Audit Report on Turkey Petroleum Exploration Project (1916-TU); Oil Recovery Engineering Project (Loan S-013-TU); Bati Raman Enhanced Oil Recovery Field Demonstration Project (Loan 1917-TU)l and Thrace Gas Exploration Project (Loan 2327-M) . Attached, for information, is a copy of a report entitled "Project Performance Audit Report on Turkey - Petroleum Exploration Project (1916-TU); Oil Recovery Engineering Project (Loan S-013-TU); Bati Raman Enhanced Oil Recovery Field Demonstration Project (Loan 1917-TU)l and Thrace Gas Exploration Project (Loan 2327-TU)" prepared by the Operations Evaluation Department. This document has a restrict-d distribution and may be used by recipients only in the performance of their official duties. Its cc, , nts may not otherwise be disclosed without World Bank authoriation. FOR OFFICIAL USE ONLY PROJECT PEMRM CE AUDIT UP PETROLEUM EXPLORATION PROJECT. OIL RECOVERY ENGINEERING PROJECT. BATI RAMAN ENHANCED OIL RECOVERY FIELD DEMONSTRATION PROJECT. AND THRACE GAS (LOANS-1916-TU. S-013-TU. 1917-TU. 2327-TU) Table of Contents Page No. Preface ............................................................. 1 Basic Data Sheets ................................................... iii Evaluation Summary .................................................. ix PROJECT PERFORMANCE AUDIT I. INTRODUCTION................................................... 1 II. BACKGROUND..................................................... 3 Turkey's Petroleum/Macroeconomic Setting in the 1970's and 1980's.................................. 3 Petroleum Sector Policies in the 1970's and Early 1980's........................................... 4 The Setting During the Preparation, Appraisal and Board Approval of the Loans........................ 5 Objectivies and Scope of the Projects..................... 6 III. SPECIFIC PROJECT ISSUES - IMPACTS OF LOANS..................... 7 Outcomes of Projects..................................... 8 Technology Transfer and Oil Industry Practices........... 8 Forced Account Drilling by TPAO in the Thrace Project................................................ 10 Generic Problems Associated with Bank Financed Petroleum Exploration Projects......................... 10 IV. SECTOR POLICY AND INSTITUTIONAL ISSUES - IMPACTS OF LOANS...... 14 Exploration Promotion.................................... 14 GDPA Strenghtening.. ...................... 16 TPAO Re-organization... .... 16 Natural Gas Pricing...................................... 20 V. PERFORMANCE OF THE GUARANTOR, BORROWER, AND BANK............... 20 Performance of the Guarantor............................. 20 Performance of the Bank.................................. 21 Performance of TPAO...................................... 22 This document has a restricted distribution and may be uspAd by recipients only in the performance of their offcial duties. Its contents may not otherwise be disclosed without World Bank authorization. Table of Contents (Cont'd) VI. CONCLUSIONS AND LESSONS LEARNED................................ 23 Conclusions.............................................. 23 Lessons Learned.......................................... 24 REFERENCES ................................................... 27 ATTACHMENTS 1. Comments from the Turkish Petroleum Corporation (TPAO) .......... 28 2. Comments from the General Directorate of Petroleum Affairs ...... 29 i PROJECT PERFORMANCE AUDIT REPORT TURKEY PETROLEUM EXPLORATION PROJECT, 'OIL RECOVERY ENGINEERING PROJECT, LATT RAMAN ENHANCED OIL RECOVERY FIELD DEMONSTRATION PROJECT, AND THRACE GAS EXPLORATION PROJECT (LOANS-1916-TU. S-013-TU. 1917-TU. 2327-TU2 PREFACE i. This report presents the results of a performance audit of the first four petroleum loans the Bank made to Turkey. The Lorrower was the Government of Turkey (GOT) in the case of two of the loans, the Petroleum Exploration Project (L-1916) and the Bati Ramau Oil Recovery Field Demonstration Project (L-1917). For the other two loans, the Oil Recovery Engineering Project (L-S-013) and the Thrace Gas Exploration Project (L-2327), the borrower was the Turkish Petroleum Corporation, Turkiye Petrolleri A.O. (TPAO). Loans (L-S-013 and 1917) financed the enhanced oil recovery (EOR) project at the Bati Raman field, the largest oil field in Turkey. The engineering loan (L-S-013), amounting to US$2.5 million, was approved on November 30, 1978, and this first stage of the project was completed in early 1980. The second phase of this project, the Bati Raman EOR field demonstration project, was financed by a US$62.0 million loan (L-1917) which was approved on November 18, 1980, became effective on June 16, 1981, and was closed on June 30, 1987, three years later than foreseen at the time of appraisal. The total amount disbursed was US$54.6 million with the unutilized portion of the loan (US$7.4 million) being cancelled. ii. The petroleum exploration project was the third petroleum operation, in Turkey, financed by the Bank. Financing was provided through loan, L-1916, for an amount of US$25 million, the major portion of which was used to finance seismic data acquistion and processing, as well as wild-cat exploration drilling in the search for new petroleum reserves. This project was appraised simultaneously with the Bati Raman EOR field demonstration project (L-1917), being approved and becoming effective on the same dates as loan, L-1917. The undisbursed portion of the exploration loan (L-1916) amounted to only US$0.13 million, which was cancelled; while this loan was closed on December 31, 1985, one year late. iii. The fourth Bank financed Turkish petroleum operation was the Thrace Gas Exploration Project, for which US$55.2 million was provided through loan, L- 2327. This loan was approved May 28, 1983, becoming effective on November 3, 1983, and was closed on December 31, 1987, in accord with the appraisal estimate. The amount disbursed was US$41.64 million, with the remaining undisbursed US$13.56 million being cancelled. This exploration loan financed, like Ihe earlier one (L-1916), wild-cat exploration drilling and seismic data collection, processing and interpretation, though on this occasion the exploration objective was targeted on the search for natural gas. Li iv. The Project Performance Audit Report (PPAR) is a report prepared by the Operations Evaluation Department (OED). In preparing this PPAR, OED has reviewed the Project Completion Reports (PCR) for the four petroleum projects (Re;ort Nos: 7916, 7941 and 7845) earlier issued by Country Department I of the Europe, Middle East and North Africa (EMENA) Regional Office in mid-1989. OED reviewed also relevant Bank reports and operational files. In addition, OED staff interviewed Bank staff and management associated with the projects' concoption and implementation, and extensive discussions were held with the staff ani management of TPAO on issues related to the projects audited here, during a visit by OED staff to Turkey. v. Following standard procedures, OED sent copies of the draft PPAR for comments to the TPAO (the borrowers of loans S-013 and 2327), the Government of Turkey (the borrower of loans 1916 and 1917) and guarantor of all the loans and the General Directorate of Petroleum Affairs (GDPA). Comments were received from TPAO and GDPA. These are reproduced in Attachments I and II respectively of this report. iii PROJECT MOEROM=NC AMT REPORT (LOAN-1916-Ty.I BASIC DATA 88E MET PROJECT DATA Appraisal Item Estimate Actual Total Project Cost (US$ millions) 45.0 64.5 Cost Over/Under Run () - +30.0 Loan Amount (US$ million) Disbursed 25.0 24.9 Cancelled - 0.1 Date Physical Component Completed 06/84 12/85 Proportion of Time Over-run (1) - +30.0 Economd.,, Rate of Return (Z) Not Applicable Not Applicable Financial Rate of Return (Z) Not Applicable Not Applicable Institutional Preformance Satisfactory Satisfactory CUMULATIVE ESTIMATED AND ACTUAL DISBURSEMENTS (US$ millions) FY81 FY82 FY83 FY85 FY86 FY87 Appraisal Estimate 4.0 17.0 24.0 25.0 - - - Actual 0.0 0.7 2.3 10.1 13.3 24.8 24.9 Actual as Z of Appraisal 0.0 4.1 9.6 40.5 53.4 99.2 99.5 Actual as 2 of Net Loan Amount 0.0 2.8 9.3 40.7 53.6 99.7 100.0 iv UMs Date Planned Actual Date Identification Early 1979 Preparation 10/79 Preappraisal 11/79 Appraisal 02/80 Negotiations 09/80 09/80 Board Approval 11/18/80 11/18/80 Loan Signature 11/24/80 11/24/80 Effectiveness 03/24/81 06/16/81 Project Completion 06/30/84 12/31/85 Loan Closing 12/31/84 12/31/85 Sta&e of the Proeat Cycle Total Han-weeks Though Appraisal 25 P':.appraisal through Effectiveness 17 Supervizion _AU TOTAL 95 V PROJECT PEROIMANCE AUDIT POT BATI RAMWR ENHANCED OIL RECOVERY FIELD DEMONSTRATION PROJECT (LgAN-1917-TU) AusC DAT SHMET --------------------------------------------------------------------- MEE PROJECT DATA Appraisal Item Estimate Actual Total Project Cost 102.0 78.1 (US$ millions) Cost Over/Under Run () - -23.4 Loan Amount (US$ million) 62.0 62.0 Disbursed 62.0 54.6 Cancelled - 7.4 Date Physical Component Completed 06/84 06/87 Proportion of Time Over-run (%) - +42.9 Economic Rate of Return (%) 1/ 61.0 62.6 Financial Rate of Return (M) Not Available Not Available Institutional Performance Satisfactory Satisfactory 1/ On the Raman field component. CUMULATIVE ESTIMATED AND ACTUAL DISBURSEMENTS 1/ (US$ millions) 1981 1982 1983 1984 1985 1986 1987 1988 1989 Appraisal Estimate 14.5 54.5 59.5 62.0 - - - - - Actual 2.1 9.1 20.9 34.6 44.7 49.7 52.5 54.5 54.6 Actual as % of Appraisal 14.3 16.6 35.1 55.8 72.1 80.1 84.7 87.9 88.1 Actual as % of Net Loan Amount 3.9 16.7 38.3 63.4 81.9 91.0 96.1 99.8 100.0 1/ Estimate & actual include adjustments for Engineering Loan-S-013 for US$2.5 million. ------------ w----------------------------------------------------------- vi UtM Date Planned Actual Date Identification Early 1978 Preparation 10/* '9 Preappralsal 11/79 Appraisal 02/80 Post-Appraisal 06/80 Negotations 09/80 Board Approval 11/18/80 Loan Signature 11/24/80 Effectiveness March 1981 06/16/81 Project Completion 06/30/84 06/30/87 Loan Closing 12/31/84 12/31/87 STAFF INPUTS Stage of Proiect Cycle Total Man-weeks Through Appraisal 160 Post-Appraisal through Effectiveness 13 Supervision 168 TOTAL 341 ----------------------------------------------------------------------- vii PECT FzBzgmmNC AMDT DAMOR IMM ThRACZ UAS EMPORATION PltOJECT (LOA.2327-TU1 BASI D&ET SHET Appraisal ItU Estimate Actual Total Project Cost 98.9 64.1 (US$ millions) Cost Over/Under Run (1) - -35.2 Loan Amount (US$ millions) 55.2 55.2 Disbursed 55.2 41.6 Cancelled - 13.6 Date Physical Component Completed 06/87 12/87 Proportion of Time Over-run (2) - 10.7 Economic Rate of Return (Z) Not Applicable Not Applioable Financial Rate of Return (%) Not Applicable Not Applicable In.'titutional Performance' Satisfactory Satisfactory -------------------------- ----- w ----------- --- ------------------------ CUMULATIVE ESTIMATED AND ACTUAL DISBURSEMENTS (US$ millions) 1983 1984 1 1986 JI1 19 1989 Appraisal Estimate 4.3 24.2 46.3 55.2 - - - Actual 0.0 0.7 6.2 13.6 29.3 40.4 41.6 Actual as % of Appraisal 0.0 2.9 13.4 24.6 53.1 73.2 75.4 Actual as % of Net Loan Amount 0.0 1.7 14.9 32.7 70.4 97.1 100.0 ------------------------------------------------------------------------- viii im Date Planned Actual Date Identification 11/82 Preparation 12/82 Appraisal 01/83-02/83 Negotiations 05/83 05/83 Board Approval 06/83 05/28/83 Loan Signature 06/30/83 Effectiveness 10/31/83 11/03/83 Project Completion 06/30/87 06/30/87 Loan Closing 12/31/87 12/31/87 STAFF INPUTS Staze of the Proinct Cycle Total Man-weeks Through Appraisal 50 Post-Appraisal through Effectiveness 15 Supervision 102 TOTAL 167 ix PROJECT PERFORMANCE AUDIT REPORT TURKEY PETROLEUM EXPLORATION PROJECT, OIL RECOVERY ENGINEERING PROJECT, BATI RAMAN ENHANCED OIL RECOVERY FIELD DEMONSTRATION PROJECT, AND THRACE GAS EXPLORATION PROJECT (LOANS-1916-TU, S-013-TU, 1917-TU, 2327-TU) EVALUATION SUMMARY Introduction 1. This report is a Project and US$66.5 million respectively. Performance Audit Report (PPAR) of the first four petroleum loans the Objectives Bank extended to Turkey over a period of obout ten 3. The objectives of the EOR years (1978 - 1987), from approval of loans were: the first loan to closure of the last two loans. Since all four operations - to expand Turkey's are reviewed in the same document, recoverable petroleum the report is refered to also as a reserve base through "cluster audit" report. During this application of EOR period world petroleum markets technology to the Bati underwent extreme turmoil: first, Raman field; there was the doubling of oil prices in 1979/80 to levels of - to increase the about US$45/bbl.(1988$); second, this country's crude oil was followed by the world recession production through of the early 1980's which, in turn, development of the precipitated a 307 decline in real recently discovered oil prices by 1985; and third, oil extension of the Raman prices crashed in 1986 to levels field; and about one-third of those prevailing in 1981, in real terms. - to assess gas reserves and production potential 2. Two of the loans at the newly discovered financed, in two phases, the enhanced Hamitabat gas field. oil recovery (EOR) project at the Bati Raman field - the largest oil The objectives of the field in Turkey - and, the other two exploration loans were: loans financed petroleum exploration efforts. The amounts approved and - to support the effort by disbursed for the EOR loans were the Turkish Petroleum US$64.5 and US$57.1 million Corporation (TPAO) to respectively. In the case of the find new petroleum exploration loans (Petroleum reserves through the Exploration and Thrace Gas introduction of modern Exploration Projects) the approved g e o 1 o g i c a 1 a n d and disbursed amounts -: re US$80.2 geophysical surveys, and x financing of an a major decline in the costs of exploration drilling petroleum services in the mid-1980's programmes; because of the recession in the oil industry. The other exploration - to promote exploration project (which was effective in mid- act iv ities by 1981) was completed about one year international oil late, in part due to TPAO's severe companies (100) in management and staff problems at Turkey through policy coim'encement of the project. This changes and the project was the only one to strenghtening of local experience a cost overrun of some 3OZ institutions; and, above the appraisal estimate, essentially because of a major - to provide technical expansion in seismic coverage and an assistance to TPAO and increase in exploration drilling training for its staff. activities. Implementation Experience Results 4. This PPAR does not focus 6. The results of the in detail on the implementation of operations audited in this report the projects in question, since this fall into two catogories - those of is well recorded in the three Project an overall policy character and, Completion Reports (PCR) for these those specific to the individual projects (Report Nos. 7845, 7916 and projects. In regard to petroleum 7941). The Bati Raman EOR project policy, the Bank's dialogue with the experienced a delay of three years in Turkish authorities both during completion due to severe staff preparation and Implementation of the shortages; procurement delays (in four loans, and especially in the part arising from TPAO' a context of the structural adjustment unfamiliarity with Bank procedures); programme, played an important role and, inadequate performance of some in effecting desirable changes in of the contractors and consultants. Turkish petroleum policy. In However, the final project cost was particular, in 1979/80 the Goverment about 23Z below the appraisal of Turkey (GOT) began moving away estimate (some 12% lower in foreign from its failed "self-sufficiency" costs and 42Z below in local costs). policies of the 19700s which laid the The large local cost underrun arose basis for significant turn-arounds primarily because of the devaluation both in petroleum sector performance of the Turkish lira vis-a-vis the US and in that of TPAO. These policies dollar. included reform of the Decree No.20; further measures to open-up Turkish 5. In the case of the acreage to IOCal and, raising oil and exploration loans, the Thrace project gas prices to reflect their (which became effective in late 1983) opportunity costs. was completed on time, with final costs being 351 below original estimates. This came about, despite 7. From the project some expansion in seismic coverage, perspective, the Bati Roman EOR because of two factors. The first project was highly successful being the changes in the lira/dollar achieving all of its objectives. It rate noted above, and second, due to demonstrated the successful xi application of "frontline" EOR into petroleum lending in Turkey. technology - total oil production First, lending to the petroleum from the Bati Raman area increasing sector in Turkey has resulted in a ten-fold to in excess of 9,000 broad degree of success whether barrele/day; and, through the measured from the perspective of drilling of production wells at the institutional development, sector Raman field incremental oil performance, or policy dialogue. This production would rise by 1.5 million is unique in the Bank's experience barrels over the 1989-1996 period with energy lending to Turkey, since yielding an ex-post economic rate of lending for power development has had return in excess of 60%. none of these characteristics. This begs the question of the degree to 8. In the case of the which this better experience with exploration projects results were petroleum is not in large part due to mixed. The Thrace project was the substantial autonomy and stature unsatisfactory having not achieved of TPAO, qualities which are absent its primary objective - finding new in TEK, the power sector's main gas reserves; however, it contributed institution. Second, there is the to considerable expansion of well known, though not well geological knowledge and the further practised, lesson of the importance strenghtening of TPAO. The first of having the correct petroleum exploration project, however, covld policy environment in place as a be considered a success in that it prelude to successful investment resulted in a 14 million barrel lending in the sector. Without the addition to recoverable reserves, GOT undertaking a basic shift in the though at current oil prices their petroleum policies of the 19701s, the exploitation is uneconomic. foundation would not have been laid for the turn-around in performance of 9. During the implementation either the sector or TPAO. of the four projects the financial position of TPAO improved 11. THe third and fourth .significantly - the company's lessons learned involve exploration debt/equity ratio had improved from projects. To the degree that the an unsatisfactory 2.4:1 in 1979 to Bank finances wild-cat drilling in 1:7 by 1989, and its return on any future exploration projects (the capital employed in 1989 was still justification of which would have to about 20Z having declined from its be very strong in the audit's 1985 level of some 39Z, prior to the judgement), the lesson is two-fold. oil price collapse in 1986. Finally, First, the Bank should review the in regard to compliance with broad eLploration strategy of the covenants this was generally borrower. However, Bank involvement satisfactory, though in the case of becomes inappropriate when it is TPAO's re-organization this was required to act as if it is the achieved with some justifiable delay, exploration department of a petroieum but was unduly company exploration venture traumatic. participant. Second, in any future Bank financed exploration projects Findings and Lessons Learned the Bank should not have to endorse and/or approve details of exploration 10. There are five main ventures such as, well locations and lessons learned from the experience depths. The fourth lesson is the well gained from the Bank's first venture known one of the very high risk xii involved in exploration projects, 12. The final lesson learned highlighting the need for such concerns the TPAO re-organization. projects to be financed with equity This was unncessarily traumatic, in rather than debt. part, because of a lack of clarity and understanding between the GOT, Bank and TPAO in terms of what they did not want to achieve - the "de- integration" of TPAO. The Bank needs to approach such corporate restructuring with greater caution and less arrogance, especially when it has little substantive experience to bring to bear on the issue, as was the case in 1979/80 regarding integrated corporate structures in the petroleum sector. 1. The Country Department I of the EMENA Regional Office did not agree that the Bank demonstrated "arrogance" on the issue of TPAO re-organization during preparation and implementation of loans (L-1916 and 1917-TU). PROJECT PERFORMANCE AUDIT REPORT TURKEY PETROLEUM EXPLORATION PROJECT, OIL RECOVERY ENGINEERING PROJECT, BATI RAMAN ENHANCED OIL RECOVERY FIELD DEMONSTRATION PROJECT, AND THRACE GAS EXPLORATION PROJECT (LOANS-1916-TU. S-013-TU. 1917-TU, 2327-TU) I. INTRMODUCTION 1.01 This report presents a Performance Audit Report for the first four loans that the Bank extended to Turkey in the petroleum sector; as such, it represents a "cluster" audit in that all four lending operations are reviewed in the same document. The loans were prepared, disbursed and administered over a 10-year period, 1978-1987, as set out below: &_A_ Amount Disbursed amer US$ m1n. Sianed Effective Glopd US$ m1n, L-S-013 2.5 11/08/78 02/28/79 N.A. 2.5 L-1916 25.0 11/24/80 06/16/81 12/31/85 24.9 L-1917 62.0 11/24/80 06/16/81 12/31/87 54.6 L-2327 55.2 06/30/83 11/03/83 12/31/87 41.6 1.02 Two of the loans financed the enhanced oil recovery (EOR) project at the Bati Raman field. This was achieved in a two-step operation, the first phase of which was an engineering loan (L-S-013) for US$2.5 million, which financed a comparative analysis of alternative EOR technologies. Based on the findings of the first phase, that carbon dioxide (C02) injection into the reservoir be the preferred technology, the second phase of this project was undertaken. This was financed through loan, L-1917, the Bati Raman EOR Field Demonstration Project, for nn amount of US$62 million. These two operations had as their overall objective the expansion of Turkey's recoverable petroleum reserve base, through the application of advanced secondary oil recovery technology. This was especially important for the Bati Raman field since this was the largest oil field in Turkey, and because of the very viscous and heavy chatacter of oil produced there (API gravity 12-13), primary oil recovery methods had resulted in only some 1.5% of oil-in-place being recovered, while water flooding would result in increasing yields only to some 4% recovery. These two Bank financed projects were highly successful in achieving this prime objective - indeed, oil production in the entire Bati Raman field increased from 900 bbls/day before application of the EOR technology to some 9,000 bbls/day by 1990, with about 90% of this increase attributable to the EOR techniques applied. 2 1.03 The two other operations financed petroleum exploration through the Petroleum Exploration Project (L-1916) and the Thrace Gas Exploration Project (L-2327). There were two key objectives of these loans. The first was to support the effort, by the Turkish Petroleum Corporation (TPAO), to find new petroleum reserves and, in this context, about 502 of the proceeds of both loans were used to finance wild-cat drilling in prospective areas, with another 402 for financing the acquisition, processing and interpretation of seismic information. The sec-nd main objective was to promote exploration activities by international oil companies (IOC) in Turkey through policy changes and institutional strengthening. The Thrace Gas Exploration operation was unsuccessful in achieving the first objective. In the case of the Petroleum Exploration Project, this can be considered a qualified success in that small amounts of oil were discovered (some 14 million barrels of recoverable oil), however, these were considered non- commercial to exploit given the level of oil prices since 1986. In regard to the second objective, this was a success by any standards considering the large number of 1OCs that showed renewed interest in Turkey. 1.04 In the course of preparation of the audited projects, issues arose that became the subject of conditions of some of the loans. These conditions, inter alia, were:- (i) of a technical character - the establishment of an exploration committee and Bank approval of exploration well location (L-1916 and 2327); also, the establishment of an advisory panel of experts on EOR (L-1917); (ii) of an organizational nature - complete separation of all TPAO activities dealing with imported oil from those concerned with domestic oil (L-1916 and 1917); (iii) of a financial character - establishment of separate accounts and financial statements for all TPAO's domestic and imported oil activities (L-1916 and 1917); that TPAO refrain from using internally generated funds for its subsidiaries, and that a debt to equity ratio of not greater than 1:1 be maintained by TPAO (L-1916, 1917 and 2327); and (iv) of a policy nature - that the price of natural gas to consumers be not less than the opportunity cost of fuel oil (L-2327). Compliance with these conditions was generally satisfactory, though in the case of TPAO's re-organization this was achieved with some delay - a delay which in the audit's judgement was fully understandable, given the nature of what was originally contemplated and what was finally achieved. 1.05 The PPAR does not review the implementation of any of the four projects in detail, since this is well recorded in the three PCRs for these projects (Report Nos.7845,7916 and 7941), which also provide useful analyses of project outcomes and relevant lessons learned. The approach followed in the PPAR in terms of issues addressed is selective. In the first place, the PPAR puts in proper perspective Turkey's petroleum sector policies and performance in the 1970s, and the major charvas in such policies introduced by the GOT in the late 1970's and early 1980's at the initiation of Bank petroleum lending to the country, and the commencement of the structural adjustment program. Specific issues which are subsequently focussed on include:- (i) the impact of the improved foreign exchange availability from the audited Bank loans in facilitating state-of-the art oil technology transfer and improved oil industry practices by TPAO; (ii) special problems associated with Bank financed petroleum exploration projects - namely, radical changes in project scope; use of debt rather than equity financing to fund exploration projects; the inadequacy of the risk analysis to justify such activities; and, the inappropriateness of the Bank financing wild-cat drilling; (iii) the role of the audited exploration projects 3 in promoting successfully increased exploration activity by international oil companies (IOC); and, (iv) the re-organization of TPAO. II. BACKGROUND Turkey's Petroleum]Macroeconomic Setting in the 1970's and 1980's 2.01 In many respects, Turkish economic development from the mid-1950's to the mid-1970's was satisfactory, with real output increasing by more than 62 annually. Unlike many other countries, GDP growth remained strong during the world recession of the mid-1970's with real output rising by about 7.2% annually between 1970-1977. However, this growth was fueled by a rising public sector deficit and in 1977 real GDP growth declined to 4.4%. Concurrently, a balance-of-payments (BOP) crisis erupted, the most prominent feature of which was a large resource gap, amounting to some US$4 billion, or 9% of GDP. This was foreseeable, since the resource gap had continuously increased from US$0.6 billion in 1973 or 3% of GDP, to the 1977 level. One major factor that contributed to this deterioration was the rapid increase in the cost of imports, which trebled between 1973-1977, when they reached US$5.8 billion. The four-fold increase in world oil prices in 1973/74 combined with a doubling of oil import volumes between 1973-1978, in large part due to inappropriate domestic petroleum policies, played a significant role in triggering the BOP crisis. In 1978, the oil import bill was about US$1.4 billion which absorbed some 60% of merchandize export earnings, however, by 1979 in the wake of the Iranian revolution and the accompanying further rise in oil prices, oil import costs had risen further to US$2.4 billion, consuming all merchandize export earnings. 2.02 In this context, petroleum issues became a focal point of the economic problems facing Turkey in the late 1970's and early 1980's, thereby providing the basis for the Bank's first loans to the petroleum sector which are the subject of this audit report. Turkey's rapid economic growth during the period from the mid-1950's to the early 1970's had been fueled increasingly by low cost petroleum. However, indigenous oil production having peaked in 1969 at about 66,000 bbls/day when it satisfied as much as 452 of oil demand, reversed itself and began a steady decline throughout the 1970's. Indeed, from the resource standpoint, by 1979 proven recoverable petroleum reserves only amounted to some 115 million barrels, or about one year's oil consumption. The Table below shows how the levels of domestic oil production have varied between 1970-1989, as well as the behavior of oil consumption in this period. There are three points illustrated in this Table: 4 TABLE TURKEY OIL PRODUCTION and DEMAND Oil Production Bble/day Oil Demand YEAR TPA0 (%) TOTAL '000 Bbleday 1970 19,500 (30) 65,000 145 1980 17,300 (40) 42,800 290 1985 18,900 (49) 38,700 310 1988 27,400 (58) 47,000 370 1989 34,300 (65) 52,900 380 (i) domestic oil production declined by about one-third between 1970-1980, but this trend was broken in the mid-1980's with production rising by about one-third between 1985 and 1989. One of the subject projects of this audit - the Bati Raman EOR operation - played a key role in effecting this turn around, which prevented the share of domestic production in meeting oil demand from dropping below 15% throughout the 1980's; (ii) TPAO's share of local production has increased steadily from 30% in 1970 to 65% by 1989, while in absolute terms its production has doubled between 1985 and 1989 in large part due to the Bati Raman EOR project; and (iii) oil consumption reached the level of some 300,000 bbls/day in 1980, about double its 1970 mark - poor pricing policies being an important contributor to this development. However, during the 1980's more appropriate pricing policies were instrumental in reducing the rate of growth of oil demand relative to growth of GDP, so that oil consumption only rose at about 3% annually. Petroleum Sector Policies in the 1970's and Early 1980's 2.03 Turkey's petroleum sector policies in the 1970's, in response both to the 1973/1974 vorld oil price increases and the diminished control of world oil supplies and reserves by the major international oil companies (IOC), contributed significantly to the worsening of its oil problem. There were three issues which affected, very negatively, the petroleum sector during the 1970's:- (i) the promulgation of Decree No.20 in March 1974; (ii) the policy of maintaining very low retail oil prices; and, (iii) the acute shortage of foreign exchange from about 1976 onwards. 2.04 Decree No.20 represented Turkey's initial response to the jump in world oil prices in 1973/74. However, it changed fundamentally the Petroleum Law of 1954 which governed private sector petroleum activities. Similar to the policies pursued in many oil importing countries, this Decree fixed well-head oil prices at the December 31, 1973 level of US$ 5.21/bbl plus verifiable cost increases. The difference between this domestic price and the world market price was deposited into the Decree No.20 Fund. The main objective of this measure was to extract for the State a significant share of the windfall profits generated by domestic oil producers due to the surge in world oil prices. However, as its financial crisis worsened, in 1977 the GOT indicated 5 that the well-head price was the Turkish lira equivalent of the US$5.21/bbl December 31, 1973 price using the exchange rate of that date; hence it was the lira price and not the US dollar price that was fixed. This meant that with the March 1978 devaluation, the dollar value of the well-head price was reduced to US$2.92/bbl. Of course, these price levels became a major deterrent to continued petroleum exploration and development activities by IOC's, and indeed, such activities virtually ceased after 1978 (see para. 4.02). 2.05 The second problem with Turkish oil policy in the 1970's was that of petroleum products being priced well below their opportunity costs at the retail level. Indeed, with domestic oil production declining throughout the 1970's, these low oil pices resulted in oil import volumes having to increase at the incrodible rate of about 12% annually between 1973-1977 (while GDP increased at around 6.9% per annum in this period), in order to fuel petroleum demand rising at some 8Z annually. 2.06 The acute shortage of foreign exchange, from around 1976, was the third area which affected severely Turkish petroleum sector developments. This foreign exchange unavailability was a major impediment to IOC's either starting or sustaining exploration activities in Turkey; of course, this was additional to the measures related to Decree No.20 noted above. This problem created difficulties for companies having to remit resources to cover debt service costs and profits; moreover, since the GOT required that all Turkish domestic oil needs be met befnre any oil could be exported, this meant that there was no foreign exchange earnings stream that the IOC's could count on as a means of covering their foreign exchange needs. This unavailability of hard currency affected also the exploration program of TPAO which severely limited the company's ability to procure essential foreign equipment, services and supplies, resulting in increased drilling problems (see para. 3.08). The Setting During the Preparation, Appraisal and Board Approval of the Loans 2.07 Judgements regarding the design and preparation of the audited projects require that the setting be understood in which these elements of the project cycle were undertaken. This covers the period from 1977 to 1983, during the early years of which Turkey experienced severe financial and political crises which had profound effects in fundamentally re-orienting, ultimately, the economic and energy policies of the GOT. In the first place, the BOP crisis that erupted in 1977 marked the end of the period of Government's attempt to maintain economic growth in the face of the very adverse international and domestic economic climate. An indication ti;at the GOT was serious about policy change became evident in September 1977 when retail petroleum prices were increased by about 50% - however, they were still below their opportunity costs. This was followed, in September 1978, by another increase (about 80%) in retail petroleum prices which then brought them roughly in-line with opportunity costs. 2.08 Second, the process of searching out new policy directions in the energy sector initially did not represent a consensus within the GOT, and was resisted by the Energy Minister in 1978 and early 1979. These reservations took two forms. On the one hand, there was a reluctance expressed to Bank financing for any energy sector projects, other than power, because of the Bank's likely 6 conditionality applied to the sector. On the other hand, the GOT repeatedly aired its lack of enthusiasm for the Bank undertaking an overall energy sector review. This the Bank saw correctly as an essential requirement for any major new lending initiatives in the energy sector, especially since it lacked in-depth knowledge of the sector's institutions having not made previous loans to the Turkish petroleum sector. 2.09 The third perspective from which the setting during the late 1970's should be seen involves the modification, in April 1979, of the 1974 Decree No.20 which had stopped virtually all exploration and developident activity in Turkey by the IOC's. This reform of Decree No.20 represented a fundamental shift in Turkish petroleum policy by making petroleum exploration and production more attractive to foreign companies. Indeed, this new focus on exploration promotion signalled that the GOT had recognized at last that the level of oil/gas exploration and development activity desired in Turkey could not be undertaken solely by TPAO because of severe resource limitations, from the financial, human and physical resource standpoints. The two key changes made in Decree No.20 involved well-head oil priceis. These modifications were: (i) the price of "old" oil was defined in terms of US dollars and not Turkish lira; and, (ii) the price of "new" oil was set essentially on par with world market prices. 2.10 The fourth perspective evidenced the increasing pragmatism in the GOT's new petroleum policy further promoting exploration by IOC's. This was adopted in January 1980 as an important component of the Bank's first Structural Adjustment Loan (SAL I) to Turkey (L-1818), which supported major reforms in the economy. Under this promotional initiative successful IOU's would be permitted to export up to 35% of their newly discovered oil to cover their foreign currency costs. This measure went some way towards meeting the concerns of the oil companies regarding foreign exchange availability to meet their obligations (see para. 2.06). 2.11 Further factors that defined the setting in the late 1970's/early 1980's were: (i) the second oil price shock of 1979/1980; (ii) the hemorrhage of TPAO's top technical and manageriil staff through migration to many of the state oil companies in the Middle East as salaries in TPAO declined substantially in real terms; and, (iii) the bold decision by the GOT in 1979 to launch a drastic and painful series of measures to stabilize the macroeconomy, which was announced on January 25, 1980 at the time of SAL I (L-1818). These measures included increased incentives for foreign investments in the oil sector (see para.2.10); greater reliance on market forces; and, efforts, inter alia, to enhance domestic resource mobilization through more realistic pricing. Obiectives and Scope of the Projects 2.12 The Bank's entry into petroleum lending in Turkey in the late 1970's was characterized initially by a very cautious approach, which was appropriate in the audit's judgement. This was evident at the outset during the preparation of the US$2.5 million Bati Raman EOR Engineering Loan (L-S-013) - the first Bank petroleum operation in Turkey. Here, because of the inherent technical risk of the project, prudence dictated that the scope of the EOR project be undertaken in three distinct phases:- (a) Phase I - in which a comparative evaluation study of the various EOR methods applicable to the Bati Raman reservoir be performed; 7 (b) Phase II - requiring a field pilot test of the selected EOR method in the reservoir itself to be operated; and (c) Phase III - if the pilot test phase proved successful, the pilot would become part of the full-scale EOR project and the tested EOR method would be applied to the entire field. 2.13 Phase I of the project was covered by the scope of the Ingineering Loan (L-S-013) which included also the preparation of the design and detailed engineering of the pilot plant for Phase II. Phase II was supported through the US$62 million Bati Raman EOR Field Demonstration Loan (L-1917), which was described, appropriately, in the Second Project Brief (1) as a "giant engineering loan". The objectives and scope of this operation are described in detail in the PCR (Report No.7916, para.3.02) and are summarized here:- (a) to expand Turkey's recoverable oil reserves through the demonstration of new OR techniques at the Bati Raman field, applying the test to 10% of the reservoir, and to e:snance Turkey's medium-term petroleum production capacity; (b) to increase the country's oil production in the short-term by developing newly discovered oil reserves in the Raman oil field, through drilling and completion of 18 new production wells; (c) to evaluate the gas reserves and production potential of the newly discovered Hamitabat gas field by fracturing and testing 6-10 wells to provide estimates of reserves and field productivity; and, (d) to provide technical assistance to strengthen TPAO's management and organization. 2.14 The objectives and scope of the first exploration project (L-1916) are outlined below with details given in the PCR (Report No.7941, paras. 2.04- 2.05):- (a) to increase Turkey's petroleum production potential through introduction of modern geological and geophysical studies, surveys and relevant techniques; (b) to implement a limited exploration drilling program to help determine if the prospects developed by the studies and surveys yielded new finds; (c) to promote exploration activities by helping the General Directorate of Petroleum Affairs (GDPA) attract IOC's to Turkey; and (d) to support energy conservation programs in industry through the provision of technical assistance for an energy audit program, designed to identify potential energy savings among major energy users. 2.15 Finally, in the case of the second exploration project (L-2327) the main objectives were (Report No.7845, para.3.01):- (a) to assess the gas potential of TPAO's licenses in the Thrace basin; and (b) to strengthen TPAO's ability to design and implement an integrated basin-oriented exploration program. The project scope included:- (a) seismic surveys and interpretation; (b) rehabilitation of three heavy duty exploration rigs; (c) exploration drilling of eleven wells in four of TPAO's 14 license blocks in Thrace; (d) studies, technical assistance and training for TPAO staff. III. SPECIFIC PROJECT ISSUES - IMPACTS OF LOANS 3.01 The PCRs for the audited projects present a generally satisfactory account of the projects' successes and failures. In this Section the audit focusses on specific project issues that arose either in the preparation or implementation of the projects in question. After briefly highlighting the principal eutcomes of the four operations, discussion turns to three specific issues:- the impact of enhanced foreign exchange availability, through the Bank's lending, in facilitating technology transfer to, and improved oil industry 8 practices by, TPAO; forced account drilling by TPAO; and, the generic problems associated with the Bank's debt financing of petroleum exploration projects. Outcomes of Prosesto 3.02 The audit's assessments of the outcomes of the four projects generally concurs with those presented in the respective PCRs - though there Is one area in which a different judgement has been made. This concerns the Thrace Gas Exploration Project, which the audit considers to have been unsatisfactory, when viewed from the totality of its objectives. 3.03 As set out in the PCR (Report No.7916, paras. 5.01-5.04) for the Bati Raman EOR projects (L-S-013 and 1917), despite the Field Demonstration project being completed about three years late, these projects fully achieved their objectives. Indeed, the Engineering project (L-S-013), which addressed Phase I of the Bati Raman EOR development, was fully successful providing the basis on which the follow-on demonstration project was designed and structured. The Field Demonstration project (L-1917) was highly successful when viewed from any perspective:- (i) it demonstrated the successful application of the carbon dioxide EOR technology in the pilot area; (ii) total oil production in the entire Bati Raman field increased from some 900 bbls./day prior to initiation of the EOR technology in the pilot area to about 9,000 bbls./day in 1990. About 90% of this increase can be attributed to the EOR project; (iii) through the drilling of 17 production wells, incremental oil production at the Raman field was expected to increase by about 1.5 million barrels over the period 1989- 1996. The ex-post and ex-ante economic rates of return, for the incremental production for this component of the project, were estimated both at about 60%, though the oil price estimates used f*.- the ex-post evaluation were only about 40% of those used for the ex-ante evaluation; and, (iv) hydraulic fracturing in the Hamitabat field increased natural gas yields from some 15 million cubic feet/day (cfd) to some 60 million cfd. Finally, the EOR project is economically profitable and sustainable even at current low oil prices. 3.04 However, despite this delay the EOR project was completed at a cost some 23X below the appraisal estimate. There was a similar cost saving in the Thrace exploration project which was completed at a cost around 35% below original estimates. This arose, despite a significant expansion in seismic coverage, primarily because of a major decline in the international costs of petroleum services in the mid-1980's as the oil sector went into sharp decline. On the other hand, in the ease of the first exploration project, its completion costs were about 301 above appraisal estimates. This over-run in costs was due in large part to a significant expansion in project scope. In particular, the level of seismic coverage under the project doubled compared to the original estimate. Technolozy Transfer and Oil Industry Practices (A) EOR Technology. 3.05 The successful introduction and transfer of the carbon dioxide EOR technology as applied to the heavy oil characteristic of TPAO's Bati Raman field represented, in the judgement of the audit, a major achievement of the two loans 9 (L-S-013 and L-1917) that supported this project. In 1980 at the time ot appraisal of loan L-1917, in the USA there were only seventeen carbon dioxide EOR projects under-way, while outside of the USA the only such operation was an E12 Acquitaine project in France. As such, the Bank financed Bati Raman EOR project could be considered as being at a "cutting edge" of ROR technology at the time the operation was decided upon. Given the new and advanced nature of the technology involved, an important feature of the project's design which was included at the Bank's suggestion, was the creation of a panel of international experts to review the results of tests and to advise TPAO on optimizing implementation procedures. 3) Exploration Technology 3.06 From the standpoint of the transfer to TPAO of technology relevant to petroleum exploration, both of the exploration loans (L-1916 and 2327) made important contributions. Indeed, geological and geochemical studies were coordinated with other exploration work so that full basin studies resulted, enabling prospectiveness to be assessed on a regional, and a basin-by-basin level. (C) Oil Industry Practices 3.07 Another important impact of three (L-1916,1917 and 2327) of the four Bank loans audited in this report, was to enable TPAO to effect a shift in its approach to doing business which became more in-line with normal oil industry practices. In particular, TPAO changed from undertaking all of its exploration drilling and test-related activities by itself, to the more efficient one of contracting for highly specialized well services from international oil service companies that sp-cialized in these areas. These included cementing services in the Thrace project (L-2327), and fracturing and testing of gas wells at the Hamitabat field in the Bati Raman EOR Demonstration project (L-1917), and electric logging. 3.08 Of course, the worsening foreign exchange shortage in Turkey during the mid-to-late 1970's increasingly forced TPAO to rely on "domestic self- sufficiency" for the provision uf al' of its drilling, well services and other activities. In this setting, the company was forced to resort to the use of local materials, such as drilling muds and cement, some of which later proved to be of inferior quality to those available internationally, resulting in the drilling process being hampered, especially in deep wells. This led to unsuccessful well completions and an inability to test properly exploration objectives in the Thrace area(2). 3.09 However, the provision of foreign exchange under the Bank's loans enabled these materials constraints to better drilling performance to be overcome; the rehabilitation of three of TPAO's rigs was undertaken; and, more use of specialized services from international companies, laid the basis for improved TPAO efficiency. 10 Force Accoupt DrilUg by TPAO in the Thrace Project 3.10 During preparation of the Thrace project the issue of Bank financing of force account drilling by TPAO arose which, though touched on in the PCR of the Thrace exploration project (Report No.7845, Part III, Section 1), deserves to be commented on further. Discussion in the Bank, prior to negotiations, revolved around the question of the most cost effective manner of undertaking the drilling component of the project. In particular, whether it should be done by TPAO under force account procedures, or through international competitive bidding (ICB). 3.11 The Energy Department prevailed in its view that the drilling should be executed under force account, provided that it did not result in expanding TPAO's drilling capacity beyond that required after the project was completed, a position with which the audit concurs. It is worth reiterating the main reasons put forward for supporting force account drilling (3):- (i) TPAO's drilling rigs were already in place and needed no mobilization - added to which there would be a period of at least one year before any foreign company could familiarize itself with drilling conditions in Turkey ; (ii) foreign companies could not avail themselves of the pool of local expertise (drilling engineers and technicians) which TPAO possessed, since they were not available on the open market in Turkey. Additionally, TPAO's pool of skilled personnel were inexpensive by international standards; (iii) TPAO possessed Romanian rigs, which though very heavy, were still of low cost even after rehabilitation under the Thrace project (see para. 3.09); and, (iv) vcrengthening well drilling capabilities in an institution like TPAO was an appropriate institution building objective. Clearly, the situation for this petroleum project was very different from that of a road project, where low skilled workers would be required and readily available locally, and all that was needed may be foreign management and some foreign technical personnel. Generic Problems Associated With Bank Financed Petroleum Exploration Projects 3.12 In November 1984 the Bank's Board agreed to new guidelines for petroleum lending (OMS 3.82). Indeed, in the judgement of the audit the issues illuminated in the two audited exploration projects .-1916 and 2327) highlight the wisdom of the revised Bank guidelines in circumL4ribing Bank financing of high risk wild-cat drilling characteristic of these petroleum exploration projects. In particular, the following three issues, wh .ch emerged in these two projects, are of special relevance regarding Bank finan;IIg of such operations:- (a) the very siSnificant changes in scope of the targetad exploration areas in both projects (see paras. 3.13-3.16). Indeed, throughout the implementation of both projects, the Bank appeared to be involved in what was tantamount to virtually "continuous appraisals" being made of the petroleum prospectivity of the original areas in which exploration activities had been planned, as well as the prospectivity of the new areas of interest; (b) the inappropriateness of loan financing being used as an important source of funding for a high-risk exploration program rather than equity financing. This became increasingly relevant as exploratory drilling failed to yield significant commercial finds; (c) there is the issue of the adequacy of the risk analysis undertaken to justify proceeding with high risk exploration projects 11 (a) Radical Changes in Project Scope in Exploration Projects 3.13 The concept of "continuous appraisal" in the case of petroleum exploration projects perhaps merits some explanation. Because of the uncertainty of exploration results, one of the unique featuree of such projects is that in the course of project implementation the next actions to be taken critically depend on the preceding ones just completed, in a manner not capable of being foreseen at appraisal. As a result of this, if early results are disappointing, for example based on geophysical and geological studies, then major decisions need to be taken regarding shifting the focus of the exploration thrust to entirely new areas. This occurred in both of the two audited exploration projects (see paras. 3.17-3.20). In such circumstances, the Bank's concurrence with such changes was required in accordance with agreed procedures (see para. 3.16). 3.14 In reviewing the Bank's records and through interviews with staff, the distinct impression is created that the Bank found itself, in the course of implementation of these two projects, operating virtually like the exploration department of an oil company, with one very important distinction - namely, that not being an equity participant, it had nothing at stake or at risk. This arose in terms of the nature of the decisions having to be made by Bank staff and consultants regarding, for example, the location of drilling sites. In this context, the Bank appeared to have extended itself somewhat from being essentially a financing and advisory institution. 3.15 The changes in project scope outlined above, were discussed in the PCRs for both projects (see PCR Report No. 7941, para.2.06 and No. 7845, para.3.02). However, in the view of the audit, the issue deserves further ventilation, since radical and inherently risky changes in the scope of petroleum exploration projects during implementation represent one of the key factors that raise questions about the appropriate role of the Bank in this aspect of its petroleum lending program. 3.16 Both exploration projects contained covenants (see for example, Project Agreement L-1916, Section 3.05) setting out procedures to be followed in regard to Bank approval prior to the drilling of Bank financed wells. These covenants were fully complied with by TPAO for both projects (see PCR Report No.7941, Annex 1 and No.7845, Part III, Section 7). These conditions were essentially two-fold:- (i) the establishment of a committee of exploration experts, including two independent experts acceptable to the Bank, to evaluate the exploratory drilling program under the project and make recommendation-: *,nd, (ii) at least one month prior to moving a drilling rig to an anticipated drilling location under the project, this committee shall furnish to the Bank for its approval of such individual well location, its assessment of such location based on the geological data and the drilling program for such location. 3.17 In the case of the first exploration project (L-1916), the first major change in project scope was to defer drilling in the Bati Raman/Hasro region, while more seismic work was carried out, and shift to the Thrace area. In the Bati Raman/Hasro area, which was included in the original project scope, geological studies and seismic work carried out at an early stage of the project, demonstrated that there were no subtle trapping structures. Since the seismic 12 - acquisition was less than planned (US$5-6 million less) and no case for drilling in that area then could be made with the US$7-8 million allocated for it, this implied that there would be a significant unspent balance in the loan amount unless reallocated to TPAO exploration activities el4ewhere in the country. This is the context in which the notion of including the Thrace region in an expanded project scope arose. Of course, the question worth raising was why was cancellation of the outstanding unspent balance not pursued more vigorously? 3.18 What the audit has been able to ascertain was that TPAO had found several gas fields in Thrace after some extensive exploration (not financed by the Bank), and the prospects for finding more gas fields in that region looked good. Additionally, the Bank's experts concluded that there was good technical justification for such a shift in project scope and reallocation, and, above all, indications were that TPAO intended to submit a new loan request to the Fank for financing exploration in Thrace (this subsequently gave rise to the second exploration loan (L-2327) - also the subject of this audit). In pursuit of this, four shallow appraisal wells were drilled in Thrace (with funds from L-1916) which helped delineate the extent of the Umurca gas field and indeed, may have expedited the preparation of the second exploration project (L-2327). 3.19 In another area of the original project scope, the Hakkari region, in 1982 TPAO requested the Bank to finance drilling of one very deep well. After review of the data the Bank's experts concluded that the data available were insufficient to support such a well, and finance was refused. The well, which was drilled by TPAO with its own finance, was unsuccessful - this area ultimately was the subject of a farm-in by Amoco in 1984. However, by 1984 new seismic data now had identified possible oil-bearing structures which were located in the original project area in southeastern Turkey. The Bank therefore supported a ten well drilling program in this nrea with a foreign cost of US$9 million equivalent, compared to the appraisal estimate of 4-6 wells. This resulted in the discovery of the four small non-commercial oil fields referred to above (see para. 1.03). 3.20 In the second exploration project (see PCR Report No. 7845, para.3.02), lack of success of the first round of drilling in the Thrace basin raised again the chance of cancellation of a large part of the loan, as had occurred with the first exploration project (see para. 3.17). However, in order to avoid such a cancellation and to salvage the project, in December 1985, a major modification of the project scope area was proposed by the Turkish authorities. This involved exploration activities, beginning with seismic work, in the basins of the West Taurus and the Black Sea coastal regions. The Bank eventually agreed to a scaled down program (from the US$15 million foreign exchange cost proposed to US$5 million) which included about 2,000 kilometers of seismic surveys. Subsequently, TPAO had requested that the funds from this project (L-2327) be used also to support drilling outside of Thrace and in the expanded project area. After review, the Bank decided that the remaining funds should be used for drilling in the original Thrace area (which proved unsuccessful, see para. 1.03) and not for any new drilling activities in the expanded project scope areas of West Taurus and the Black Sea coastal regions, which were considered as virgin areas. 13 3.21 These examples illustrate how the areas of exploration interest, and the nature and type of exploration activities in a given region, underwent radical shifts to-and-fro in the course of project implementation, as better data and information became available. The audit does not wish to suggest that any of the experts made "incorrect" judgements. Clearly, major efforts were made genuinely by TPAO and the Bank's experts to use the resources in the most prospective areas. However, since the issue of cancellation of significant unspent loan balances is usually only reluctantly faced by either the borrower or the Bank, a natural tendency emerges to try to "salvage" projects, as distinct from trying to limit one's losses, an approach that would reflect a more "commercial" approach to a high risk venture, such as exploratory drilling. 3.22 Finally, as judgements about issues of high risk and allied cost were involved, and the Bank was not an equity participant having anything at risk or at stake, this raises another question about the weight that should be attached to the views, of where and whether to drill, of such a financially disinterested party. In other words, how could the Bank really play a role in decision making like that of the exploration department of an oil company when it is not one? It would appear that even within the framework of the revised petroleum lending guidelines of 1984 (OMS.3.82), such questions still need to be raised about the appropriate role of the Bank in the financing of such endeavors, given the very nature of exploration activities. (b) Inappropriateness of Debt Financing of Exploration Projects 3.23 The second area of concern regarding the Bank role in exploration financing arose during preparation of the first petroleum exploration project (L-1916). Here, the appropriateness of the proposed level of debt financing for TPAO's exploration program was questioned by the Bank (4). Bank concern was expressed that TPAO not finance a large part of its exploration program through loans from the Decree 20 Fund. The Bank considered that if sufficient commercial oil were not discovered to recover these exploration costs then this added debt burden could impair TPAO's financial stability. The Bank view, which was endorsed subsequently by the GOT, was that funds above an agreed limit would be supplied to TPAO from the Decree 20 Fund in the form of equity or quasi-equity, repayable only when TPAO made adequate profits. (c) Risk Analysis of Exploration Projects 3.24 The third issue relates to that of risk analysis of exploration projects. This question generated debate in the Bank in the early 1980's and was focused on at the Decision Meeting for the Thrace project. At that time it was agreed that:- "the Bank should develop the analytical tools so that for exploration projects of this nature (i.e. the Thrace project) a risk analysis should be undertaken to demonstrate that there is a convincing case for proceeding with the scheme.....the Appraisal Mission undertook to present such an analysis in the SAR"(5). This SAR presented an extensive analysis of the different categories of risk the project was exposed to (6):- (i) the geological risk - that insufficient hydrocarbon reserves would be found to recover the exploration expense. This was viewed as "manageable" since the basin had already yielded proven gas reserves; (ii) the technical risk - that the project may not be completed efficiently due to drilling and testing 14 difficulties. This was considered small because the drilling conditions were understood and the services of specialized service companies were to be financed by the loan; and, (iii) the economic risk - that even if gas was found its quantity may be inadequate to provide an acceptable return on the investment required to deliver it to markets. This was considered small since the basin was near to the large Istanbul market. 3.25 In summary, the Thrace SAR concluded that "the overall project risk is small because the minimum size discovery required to provide an acceptable economic rate of return is less than one tenth the expected size of the anticipated discoveries"(7). Though this reflected a grossly over-optimistic view, the analysis performed by the Bank did attempt to spell-out the risks involved in a manner not before done in Bank petroleum exploration projects. However, further work in this area of risk assessment is called for as long as the Bank continues to provide financial support to petroleum exploration wild-cat drilling activities. IV. SECTOR POLICY AND INSTITUTIONAL ISSUES - IMPACTS OF LOANS 4.01 Here the audit discusses a few sector policy and institutional issues that were important results of the audited projects. The issues in question are:- (i) exploration promotion; (ii) GDPA strengthening; (iii) TPAO re- organization; and, (iv) natural gas pricing. Exploration Promotion 4.02 The success in promoting increased exploration activity by IOC's in the 1980's emerged as an important achievement of Turkish petroleum policy. Some credit can be attributed, in this regard, both to the Bank's dialogue on petroleum policy with the Turkish authorities in the late 1970's, and to the first exploration project (L-1916) which included as one of its objectives, the promotion of new exploration activities by the IOC's (see para. 2.14). As discussed above (see paras. 2.03-2.04), the promulgation of Decree No.20 in early 1974 and the acute shortage of foreign exchange in the late 1970's led to a severe decline in the exploration activities by IOC's in Turkey. This is clearly illustrated in Fig.I below. This shows the behavior of three variables of relevance in Turkey (8) during the period 1975-1989:- (i) the total footage of exploration wells drilled by IOC's; (ii) the number of 1OC's holding exploration permits; and, (iii) the number of exploration permits held by bOC's. Exploration Activity & Permits Held By IOCs Fmm 1975-1989 320 30 0- ------------------ 2800 260- 240- 220- 200- 180I 140- -- 120- 100- 60- 40 -- - ------ 20 1975 1977 1979 1981 1983 1985 1987 1989 1976 1978 1980 1982 1984 1986 1988 YEAR /7 Number of Exploration Permits Held by 10C's Divided by 10. + Total Footige Drilled by 10C's, 000's feet. 16 4.03 Particularly evident from the above Figure is the decline, by almost two-thirds, in exploration footage drilled by IOC's between 1975 and 1979. Also shown is the collapse, by about four-fifths, in the number of IOC's holding exploration permits over the same period. It would be recalled (see para. 2.09) that Decree No.20 was reformed fundamentally in April 1979 as part of the major shift in Turkish oil exploration strategy to attract increased IOC exploration and development activity. In addition, in early 1980 Decree Nos.8/178 and 8/910 were issued which addressed the remittance problems IOC's had been experiencing, by allowing the companies to export up to 35% of newly discovered oil to cover their foreign exchange costs (see para. 2.10). These measures contributed in no small manner (along with the higher oil prices associated with the second "oil shock"), to the turn-around in exploratory drilling activity evident after 1979 in Fig.I. GDPA Strengthening 4.04 An important institutional gain under the first exploration project (L-1916) was the intensified training of personnel, and re-organization, of the General Directorate of Petroleum Affairs (GDPA). This was an achievement that was not characterized by the difficulties that the TPAO re-organization experienced, due largely to the fact that the GDPA was a smaller and less strategic agency in the petroleum sector. Since the re-organization the GDPA has played a important role in promoting Turkish petroleum acreage to IOCs by initiating proposals, that eventually became law, for changes in the petroleum law making operations in Turkey of IOCs less onerous. TPAO Re-organization 4.05 The issue of the re-organization of TPAO figured prominently during the preparation, negotiations and implementation of three of the audited projects (L-1916, 1917 and 2327). The audit takes a different view to that set out by the Bank in its SARs for these projects, regarding the justification of this re- organization. This issue became quite a cause of friction between TPAO, the GOT and the Bank during the 1979-1982 period. In the judgement of the audit, there appeared to have been a lack of clarity on the part of the Bank as to why TPAO needed to be re-organized; and, if so, what suc-h a re-organization could and could not achieve; and especially, what aspects of TPAO's performance were determined more by GOT policies than its corporate structure. 4.06 The problems TPAO faced in the late 1970's and early 1980's dominantly stemed from inappropriate GOT policies (see pares. 2.03-2.06), and in the view of the audit, not with inherently structural problems in the company which a re-organization could remedy. This view cannot really be considered as one primarily benefiting from hindsight, since as outlined below this should have been apparent to the Bank ex-ante. Indeed, TPAO's poor financial performance in the late 1970's was a direct product of GOT policies. 4.07 First, increased international oil prices after the first oil shock were not passed on fully to consumers by the GOT. Therefore, these financial costs were left to TPAO to bear. This was unsustainable and its resolution lay with GOT action to allow retail oil prices to reflect their full opportunity costs. Steps towards this end eventually were initiated in 1979/80 by the GOT in 17 connection with its new structural adjustment policies supported by the Bank in the first SAL (L-1818). 4.08 Second, TPAO experienced serious foreign exchange losses in its oil import transactions in the late 1970's which were being purchased on credit. This came about as the Turkish lira's devaluation accelerated without this being reflected immediately in consumer prices dominated in lira, due to GOT policy then in force. Third, in keeping with GOT policy prevailing at the time, local crude oil production was used to cross-subsidize imported crude oil and product supplies since the financial cost of local petroleum was much lower than that of imported petroleum. Naturally, this diminished further TPAO's financial performance. 4.09 Fourth, given Turkey's major financial problems at that time, the GOT severely restricted the ability of TPAO to limit the significant decline in salaries of its top professional staff in the late 1970's due to accelerating inflation. Since suchi staff possessed highly marketable skills and were very much in demand in oil producing countries in the region, there was tn exodus of key staff and management from TPAO which weakened the company at the very critical period when it was about to embark on a major exploration and development program vital to the country's economy. Of course, this issue of salaries had nothing to do, once more, with the company's structure but with GOT policy applied to a company operating, in principle, under private commercial law, since TPAO was not a State Economic Enterprise (SEE). 4.10 The above strongly suggests that TPAO's main problems essentially were the results of inappropriate GOT policies and not one of inadequate corporate structure. However, the Bank did not appear to view the company's difficulties primarily from that perspective. Indeed, the SAR explicitly highlights the reasons for TPAO's restructuring, as viewed by the Bank:- "TPAO is currently responsible for arranging for the import of and the payment for all the country's petroleum products and crude oil requirements, for refining a third of the imported crude, and for implementing a US$1,300 million refinery expansion program which will increase its annual capacity from about 5 million tons to about 15 million tons. In addition, it is responsible for a rapidly expanding exploration and development program aimed at decreasing the country's dependence on petroleum imports. The rapid growth of these two distinct activities within the same management control system has tended to reduce the efficient utilization of the management resources available to the company"(9). 4.11 The SAR goes on to state:- "Recognizing the management and administrative advantages of separation of the domestic oil and imported oil- related activities, the Government has made plans to have TPAO sell their Izmir and Mid-Anatolian refinery complexes to Istanbul Petrol Ref inerisi Anonim Sirketi (IPRAS), a wholly owned subsidiary that runs a refinery of 5 million-ton capacity located near Istanbul"......while "TPAO would remain solely responsible for exploration, exploitation and processing of domestic petroleum resources. This reorganization is an important step for increasing management efficiency and rationalizing Government policy towards the sector. It will: (1) permit greater clarity in formulation of objectives of each activity; (ii) facilitate the adoption of a more rational set of financial and pricing policies for each 18 activity; and (iii) help avoid potentially harmful cross subsidization of one activity of the other"(10). 4.12 The audit has been unable to identify any significant analysis or study undertaken by the Bank as a basis for proposing such a major reorganization of TPAO. This was especially the case since "a more rational set of financial and pricing policies" for up and down-stream petroleum activities were to be achieved basically through changes in GOT policy, as distinct from a reorganization of TPAO. For example, the cross subsidy issue between local oil production and oil import activities was another case of chanSes in GOT policies being required and not corporate restructuring to address this problem. Of course, the key distinction needs to be drawn between undesirable economic, as distinct from possibly necessary financial cross-subsidies between these two activities. 4.13 The economic cross-subsidy arose because inputs and outputs were not priced according to opportunity costs - changes in GOT policy were needed to address this. The financial cross-subsidy issue came about when even with opportunity cost pricing, domestic oil production was very profitable pre-1986, but for example, refining operations suffered financial losses because of the then international price structures between crude oil and products. In this case, through an integrated corporate structure profitable local production activities were used to off-set financial losses in other areas of activity. 4.14 The fact that TPAO's activities included both domestic and imported oil activities was perfectly natural - it was, after all, a petroleum company. Moreover, there was no evidence presented to support the SAR's claim which went to the core of the Bank's reasons for seeking TPAO reform, that "the rapid growth of these two distinct activities within the same management control system has tended to reduce the efficient utilization of the management resources available to the company" (9). Indeed, recognizing that in the late 1970's TPAO was experiencing a severe hemorrhage of its top professional staff due to salary constraints imposed by the GOT (see para. 4.09), should have suggested a more prudent approach by the Bank in addressing what it perceived to be the company's problems. 4.15 The restructuring of TPAO also has to be seen in the context that up to that point in time - 1979/80 - the Bank had had little substantive experience in the petroleum sector, especially concerning the integrated operational corporate structure of oil companies. In fact, the caution that the Bank's engineers exhibited justifiably in regard to the design and preparation of the EOR Bati Raman project (L-S-013 and 1917), appeared strikingly to be absent when the Bank's non-engineering staff and management began dealing with the issue of TPAO's structure. 4.16 The importance of an integrated operational structure, though with discrete and defined profit centers, has always been recognized in the oil industry, and became well illustrated in 1986 after the collapse of oil prices when the profit structure of the oil industry underwent major change for the second time in just over a decade. This is commented on in the PCR for the first exploration project (PCR Report No.7941,paras.4.03-4.06). As discussed above (see para. 4.13), prior to 1986, the up-stream production operations were those 19 of high profitability, while downstream refining and marketing activities were either of very low profitability or sustained losses. This reflected the industry's profit picture throughout much of the period 1974-1984. After 1986, however, this profit picture changed, with increased profitability down-stream and less so up-stream. In this context, the possibility could arise of profits from down-stream operations being used to financially cross-subsidize exploration . and production activities, as the industry goes through another price cycle. 4.17 The implementation of the covenant (Section 3.03 of the Project Agreement for L-1916) dealing with TPAO's reorganization required a considerable time, for the reasons set out in the PCR of the first exploration project (Report No.7941, para. 4.03); primarily, a lack of consensus among the Turkish authorities. This was not surprising given the ambiguous language of the covenant and the lack of clarity in what the Bank really sought to achieve through the reorganization. At the outset such clarification was requested from the Bank, by the Energy Minister, soon after the signing of loans 1916 and 1917 in November 1980 (7), since a possible interpretation both of this covenant and the rationale presented in the SAR (see para. 4.11), was that the reorganization was to achieve the "de-integration" of TPAO. Hjwever, the Bank then clarified that it wished primarily to have separate financial accounts maintained for TPAO's domestic and oil importing operations, as well as a corporate structure that did not "de- integrate" TPAO. 4.18 Despite this clarification, misunderstanding persisted until well into 1982 as evidenced by the GOT proposal that was approved by the National Security Council, that all refineries be under the control of IPRAS which would no longer be a subsidiary of TPAO, thereby "de-integrating" TPAO. This led to strong opposition from TPAO, which fortunately in the audit's view, eventually prevailed in overturning this proposal. After further delay a new law No.2929 was passed in October 1983 setting-up PETRUR as the sector's holding company, with five subsidiaries. Under this arrangement TPAS became the petroleum exploration and development subsidiary; TUPRAS - the refining subsidiary, with other subsidiary companies for other areas of activity. 4.19 This new structure, with PETKUR as holding company, introduced a new bureaucratic layer in sector decision making, however, it did not remain in place for long, since in June 1984 the GOT reversed the formation of PETKUR and TPAO reverted back to its original status with a few modifications in its structure of subsidiaries (see PCR Report No.7941,paras.4.04-4.06). What was important was that TPAO became both the holding company of the sector and the company with responsibility for exploration and production. However, it's integration was preserved as it could receive dividends from its subsidiaries other petroleum activities and deploy these as the company's management saw fit in light of the company's investment strategy. 4.20 In the end, the reorganization of TPAO concluded with a structure that appeared satisfy Turkish requirements. It was achieved however through a rather traumatic process in which the Bank seems to bear a share of the responsibility due to a lack of clarity on its part regarding its objectives at the outset. If the Bank had wished essentially to have separate financial accounts maintained for TPAO's exploration and development activities, on the one hand, and for all other oil activities on the other hand, then this should have 20 been stated unequivocally, without any recourse to the notion of "reorganization" etc. If it also wished to have TPAO restructured into separate operational companies, broken down by domestic and imported oil activities, then it needed to state categorically that it was not seeking the "de-integration" of TPAO, which is what was implied by the notion that cross subsidies from one activity to the other would be avoided (see para.4.12), without sp3cifying which type of cross-subsidies were being addressed. Natural Gas Pricing 4.21 Another important energy policy advance achieved in 1983 under the second exploration project (L-2327) - the Thrace Gas project - involved natural gas pricing. Prior to this project the GOT's gas pricing policy was embodied within the Petroleum Law's definition of petroleum, which included natural gas. As such, there was no pricing policy explicitly focusing on natural gas. However, in the course of negotiations agreement was achieved on setting natural gas prices close to the opportunity price of the tradeable residual fuel oil, with some discount allowed for quality differentials. This was covenanted and complied with (PCR Report No.7845, Part III, Section 7.). V. PERFORMANCE OF THE GUARANTOR, BORROWER. AND THE BANK 5.01 In this Section the focus turns to the audit's judgements on the performance of the borrower, the guarantor and the Bank, each of which is discussed separately. In the case of two of the audited projects (Bati Raman EOR Field Demonstration, L-1917, and the Petroleum Exploration Project, L-1916) the borrower was the GOT which on-lent about 97% of the resources to TPAO, the remainder being channeled to EIE for the performance of technical energy audits to identify conservation potential, and to GDPA for strengthening this institution. In the case of the other two audited projects (Oil Recovery Engineering Project, L-S-013, and the Thrace Gas Exploration Project, L-2327) the loans were made directly to TPAO. Performance of the Guarantor, the Government of Turkey, and the Borrower of L-1916 and L-1917 5.02 There is little question that the profound changes in petroleum policy that were undertaken by the GOT beginning in the 1979/1980 period laid the basis for the country to begin tackling its difficult petroleum sector problems (see paras.2.3-2.10). The actions by the GOT, in particular, to modify the terms of Decree No.20 in 1979, set the basis for successfully attracting the IOC's back into exploration and production activities at their own risk, and reflected an important shift in petroleum strategy away from the "self-sufficiency" policies advocated in the 1970's. 5.3 By tackling the problem of petroleum pricing at the well-head and retail pricing levels in 1979/80 as part of its adjustment program, the GOT demonstrated a determination to proceed with sound petroleum policies despite the short-term political difficulties that such policies entail. Such measures were followed through with natural gas in 1984, when the GOT established a gas pricing policy, in conformity with the covenant attached to the Thrace project (L-2327), which set such prices relative to their opportunity costs. The GOT is 21 to be commended for its foresight in permitting more rational economic factors to play a significant role in its petroleum policy. In contrast, the power sector . is yet to to be the target of such enlightened policy shifts. Performance of the Bank 5.04 The PCRe (Reports Nos. 7845,7941 and 7916) provide good accounts of the Bank's role and institutional performance during preparation and implementation of the projects. In particular, the Bank is considered to have performed well in both phases I and II of the Bati Raman EOR project (Report No.7916,para.7.01), a view shared by the audit. For example, the Bank correctly exhibited a cautious approach towards the introduction of the new EOR technology - technology which at the time was at the "front-line" of EOR technologies; and, it provided good advice to TPAO which the company accepted and acted on during the course of implementation of this project. This PCR also noted that the Bank should have devoted somewhat greater effort in educating TPAO staff in the Bank's procurement procedures, since this was the first petroleum operation the Bank supported in Turkey. Once more, these are sentiments shared by the audit. 5.05 In the case of the exploration projects (L-1916 and 2327), the PCRs (Report No.7845 and 7941) are more guarded in their judgements of performance, which they consider to have been mixed. This is a view that the audit also shares. On the positive side, the PCR for the first exploration project (Report No.7941, para.5.05) highlighted the contribution to the professional training of TPAO staff from both the training component of the project, and from the frequent contact between staff of the Bank and TPAO. Indeed, the Bank's support for TPAO's exploration and development program in the 1980's also led to an important exchange of views between the Bank and TPAO on technical matters, as well as on petroleum policy issues, especially on the need for accelerated exploration promotion of Turkish acreage to IOC's. Additionally, the Bank's dialogue with TPAO and the GOT on petroleum policy matters appears to have influenced positively the outcome of such policy. In fact, this represents the main achievement of the Bank's energy sector dialogue in Turkey from the late 1970's up to the late 1980's, when compared with the virtual failure of such dialogue in the case of critical electric power sector policy issues in this period. 5.06 There are a two additional areas in which Bank performance in the exploration projects need to be commented on. These issues involve the Bank's assessment of risk, especially in the Thrace project; and, the TPAO re- organization. 5.07 The SAR for the Thrace exploration project presented an extensive qualitative analysis of the three types of uncorrelated risks - geological, technical and economic - that the project was exposed to. This represented a useful attempt by the Bank to clarify the nature of the risks involved, and was one of the first occasions that the risk and justification of an exploration project had been so fully reviewed in an SAR. Though the SAR's assessment turned out to be grossly over-optimistic, it was a worthwhile elaboration of the risks Pt stake. 22 5.08 The audit concurs with the view in the PCR (Report No.7941,para.5.04) that the covenants attached to Loans, L-1917 and 1916, regarding the reorganization of TPAO, attracted an unduly large share of the Bank's attention. Furthermore, the audit considers that the Bank was incorrect on insisting that the oil importing and domestic oil activities of TPAO be "completely separated". Some merit could be seen in advocating the maintenance of separate financial accounts for these activities, as a means of at least defining separate profit centers. However, there was considerable ambiguity in the language of both the covenant and the SAR which led to great misunderstanding and lack of clarity regarding what the Bank really had intended, especially since an interpretation of that language was that it implied "de-integration" of TPAO. Finally, the Bank's strong stance on this issue was particularly misplaced and could even be deemed arrogant at that time,2 since the institution then (1979/80) had had little substantive experience in the petroleum sector, especially its integrated corporate structure. Performance of TUO 5.09 The discussion on TPAO performance in the PCR for the Bati Raman EOR project (Report No.7916, para.9.01), tended to highlight the considerable delay in project completion and the factors contributing to these delays. Valid though some of these observations may be, they tend to lose sight of the framework within which TPAO was expected to perform, especially during of the first 3-4 years of project implementation. Though the Bati Raman project was completed three years later than foreseen at appraisal (see para.3.4), its actual costs were about 23% below original estimates and the project achieved, indeed even exceeded, its objectives. Moreover, given the staffing and morale problems TPAO faced in 1979/80, at the time of appraisal of Loans, L-1916 and 1917, and the traumatic re-organization that the company was put through in the early 1980's, TPAO's overall performance must be considered as satisfactory, in the view of the audit. 5.10 Of special importance in judging the company's performance was the complete financial turn-around it achieved during the period of implementation of the audited projects. Indeed, by 1985 (before the drop in oil prices) TPAO had achieved a 39% return on total capital employed, and by 1989 this was about 20%. Furthermore, the company's debt/equity ratio had undergone dramatic improvement - increasing from the unsatisfactory level in 1979 of 2.4:1 to that achieved in 1989 of 1:7. In summary, the company faces the 1990's in an incomparably stronger position than when it entered the 1980's. 2 The Country Department I of the EMENA Regional Office did not concur with the view that the Bank demonstrated "arrogance" on the issue of TPAO re-organization during preparation and implementation of loans (L-1916 and 1917). 23 VI. CONCLUSIONS AND LESSONS LEARNED 6.01 Turkey's failed petroleum policies of the 1970's which were structured around the notion of "self-sufficiency" had led to: (i) the collapse of oil production by about 1/3 between 1970 and 1980; (ii) subsidized oil prices which stimulated oil demand and, in turn, increased oil import volumes by some 12% annually over the decade, thereby exacerbating the scarcity of foreign exchange; and, (iii) severe decline in the level of IOC effort in exploration and production activities in the country. 6.02 There is little doubt, however, that a successful turn-around in the country's petroleum sector policies and performance was achieved after 1979/80. These policy changes were facilitated by the Bank's dialogue and focus on key issues in the petroleum sector. This was undertaken in the context of the preparation and implementation of the audited projects, which occurred in tandem with the preparation of the Bank's structural adjustment support program. Among the key policy issues addressed successfully were: (i) action on setting oil and natural gas prices at the well-head and retail levels consistent with their opportunity costs; (ii) changes in the Decree No. 20 law to remove disincentives to IOCs exploration and production activities in the petroleum sector; and, (iii) further measures to promote the opening-up of prospective Turkish petroleum acreage to IOCs. 6.03 Among the audited projects success attended Phases I and II of the Bati Raman EOR project financed through Loans, L-S-013 and 1917. These operations illustrate the Bank in its classical role of facilitating the successful transfer of advanced oil recovery technology to a state oil company, TPAO. As a result of these operations, by the end of the 1980's oil production in Turkey rose by about 1/3 above the low int of 39,000 bbls./day to which it had collapsed by the mid-1980s. Addit.nally, both components of the project were resounding successes. In particular, there was the increased oil production at the Raman field yielding an ex-post economic rate of return in excess 60%, and the four-fold rise in gas production from the Hamitabat field. 6.04 The delay of three years in completion of the Bati Raman EOR project is discussed at length in the PCR (Report No. 7916). The main factors contributing to this delay were severe staff shortages; procurement delays; and, inadequate performance of some contractors and consultants. However, what must not be forgotten is that despite the long implementation period, the final project cost was about 23% below the appraisal estimate. This combined with good oil recovery yields resulted in the project remaining profitable and sustainable despite the 50% decline in oil prices since 1985. 24 6.05 In contrast to the success of the EOR project, the exploration projects experienced mixed results. The Thrace project was unsatisfactory, in the view of the audit, given its failure to achieve its prime objective - that of finding new gas reserves in Turkey. In forming this judgement account was taken of the tremendous gains made by TPAO, during the project implementation period, in terms of staff training, institutional and financial strengl;hening, and consderable expansion in knowledge about the geology and prospectivity of the Thrace region, and the west Taurus and Black Sea areas. The first exploration project, L-1916, however was judged as satisfactory by the audit, in view of its success in achieving its prime objective - discovering new oil reserves, though only 14 million barrels of recoverable oil was found but which are not commercial to develop at current low oil prices. 6.06 The four petroleum loans provided further benefits to TPAO, some of which were highlighted in the PCR of the first exploration project (Report No. 7941, paras.6.01-6.04). These include:- (i) the increased tendency by TPAO's management towards an outward looking strategy, in which, for example, joint ventures with IOCs become less the exception; and, (ii) a re-organized company that has retained its integrated character, but at the same time has identified better the company's profit centers. The retention of TPAO's integrated structure reflected sound policy. However, it reinforces the importance of the company regularly reviewing its exploration strategy in light of the prospects for further discoveries in Turkey, as well as prevailing and expected oil prices. Given the difficult geology and costly exploration effort involved, a period of sustained low oil prices will necessitate that TPAO reassess the level of exploration effort it should undertake in Turkey. This would ensure that profits being earned from the company's other oil operations are not used, over a sustained period, to maintain unprofitable exploration activities. 6.07 Finally, through components of the first petroleum operation, the GDPA was strengthened and the EIE became instrumental in promoting interest in the performance of energy conservation technical audits in industrial enterprises. The GDPA, as the government agency responsible for granting licenses to foreign and local oil companies, developed good and accessible archives as a result of support granted under the project. Lessons Laraed 6.08 Only one tf the three PCRs for the four audited projects touches on the lessons learned - the PCR for the first exploration project, L-1916. In the view of the audit, there are five areas in which important lessons can be learned, given the extensive experience that was acquired from the Bank's first venture into petroleum lending in Turkey. These areas refer to the success of petroleum lending contrasted with the unsatisfactory results of power lending in Turkey; the importance of the policy environment; the inadvisability of the Bank being involved in all decisions of the borrower in exploration projects; the very high risks of exploration projects; and, the Bank's posture regarding the TPAO re-organization. 6.09 Lending to the petroleum sector in Turkey has resulted in success from the standpoint of institutional development, policy reform and sector performance. This has been unique in the Bank's experience of energy lending to 25 Turkey, since lending for power development has had none of these characteristics. This suggests that the first lesson learned is that the better experience with petroleum lending is due, in large part, to the autonomy and stature of TPAO, characteristics absent in TEK, the power sector's main . institution. 6.10 The second lesson learned is the well known, though not as well , practiced one, of the vital importance of having the correct petroleum policy environment in place as a prelude to successful investment lending in the sector. Without the GOT undertaking the fundamental shift in its petroleum policies in 1979/80, away from its failed "self-sufficiency" doctrines of the 1970's, the basis would not have been laid for significant turn-arounds in both sector performance and that of TPAO. For example, the changes enacted in the Decree No.20 law, and the measures to open-up prospective Turkish acreage to IOCs exploration and development efforts, were essential to the success of the promotion components of the exploration projects. Secondly, the new oil pricing policy of pursuing opportunity cost pricing at the well-head and retail levels, and then similar measures taken for natural gas prices, provided the necessary condition for the major turn-around in TPAO's financial performance. 6.11 Of course, a relevant point that needs to be raised in the context of setting the correct policy framework, relates to the fact that the GOT had begun in 1979/80, a major program of structural adjustment with significant Bank support. An essential part of that adjustment package concerned changes in petroleum pricing policy and enhancing incentives for increased private sector activity in the petroleum sector. In the judgement of the audit, it was this framework that laid the basis for the fundamental shifts in petroleum policy - the GOT had accepted that such shifts occur in other sectors of economic activity and, therefore, those in petroleum were to be seen as part of a larger whole. Regrettably, in the energy sector only the petroleum sector attracted such focus - the power sector was left untouched by the "new" thinking. The consequences of this piece-meal, but familiar pragmatic, approach remain painfully in evidence a decade later given the situation in the power sector. 6.12 The third lesson concerns the Bank's role in exploration projects, especially in financing wild-cat drilling. When financing the exploration programs of state oil companies, the Bank usually insisted on being a full participant in all aspects of the exploration strategy, including decisions about where, and to what depth wild-cat wells should be drilled. In the absence of technically skilled joint-venture partners, this may appear to have been sound policy at first sight. However, the experience during implementation of both of the audited exploration projects was that radical changes in scope of the targeted exploration areas was the norm. When to this was added the Bank's policy of being involved in all major decisions of the exploration program, this resulted in the institution becoming caught-up in "continuous appraisals" of petroleum prospectivity in the continuously shifting targeted areas. In this situation, the Bank ended-up operating like the exploration department of an oil company, with the important distinction that it was neither an oil company, nor an equity participant, and had nothing at risk. 6.13 In the view of the audit, the lesson here is that to the degree that the Bank finances wild-cat drilling in any future exploration projects (the 26 justification of which would have to be very strong in the audit's judgement), the lesson is two-fold. First, the Bank should review the broad exploration srater of the borrower. However, Bank involvement becomes inappropriate when it is required to act as if it is the exploration department of a petroleum company exploration venture participant. Second, in any future Bank financed exploration projects the Bank should not have to endorse and/or approve details of exploration ventures such as, well locations and depths. 6.14 A further lesson learned from the two audited exploration operations, was the very high risk associated with exploration projects. This has been the experience with other petroleum exploration projects, and highlights the need for such projects to be financed with equity and not debt resources. The Revised Guidelines for Petroleum Lending of November, 1984 (0MS.3.82) appropriately restrict the Bank's future financing of exploration drilling. 6.15 The final lesson learned involves the TPAO re-organization. This was unnecessarily traumatic. This arose in part because of a lack of clarity (as reflected in the language of both the SAR and loan agreements) and understanding between the Bank, the GOT and TPAO, in terms of what they did not wish (the "de- integration" of TPAO) to achieve through this re-organization. The Bank needs to approach corporate restructuring issues with greater caution and less arrogance, especially when it has had little substantive experience to bring to bear on the issue, as was the case in 1979/80 regarding integrated corporate structures in the petroleum sector. The Country Department I of the EMENA Regional Office did not concur with the view that the Bank demonstrated "arrogance" on the issue of TPAO re-organization during preparation and implementation of loans (L-1916 and 1917). 27 U&RENCEI (1) Second Project Briefs, Bati Reman BOR Filed Demonstration Project, Jan. 17, 1980. (2) Thrace Exploration Project Brief, Jan. 12, 1983. (3) Memo from R.Berney (Project Officer) to E.McCarthy (Division Chief), April 14, 1983. (4) Letter from Baig (acting Division Chief) to Director General Finance Ministry, April 9,1980. (5) Decision Memo, Thrace Gas Exploration Project, March 21, 1983. (6) SAR Thrace Gas Exploration Project (Report Mo.4433-TU), para.4.01-4.16, June 2, 1983. (7) SAR Thrace Gas Exploration Project (Report No. 4433-TU), para.4.15, June 2, 1983. (8) Private Communication, November 1990, from Mr. Abmet Akcael, Director General, GDPA. (9) SAR Petroleum Exploration Project (Report No. 3092-TU) , para.3.23, Oct. 17, 1980. (10) SAR Petroleum Exploration Project (Report No. 3092-TU), para.3.24, Oct. 17, 1980. 28 ATTACHMENT I Coments from TPAO, the Borrower URGZill PAX NO : (202) 676-0560 FROM: Ozer Altan Chairman and General Manager TPAO TO: Mr. Yves Albony Chief, Infrastructure and Energy Div. Operations Evaluation Dept. cC3 Mr. Jossef Buky Acting Chief, OEDD3 We reviewed the draft PPAR of the four World Bank loans to our country and the TPAO namely (L-S-013), (L-1916), (L-1917) and (L-2327). In general we think that the World Bnak and TPAO have had a good cooperation during all phases of the above projects. Even though in certain areas, effectiveness of World Bank support were inadequate, but we believed that lending those loans to TPAO has resulted in success from the standpoint of company performance which was acknowledged by the Bank also. In overall evaluation we share the content of the PPAR. Best Regards. 21.6.91 29 Comments from the GDPA, General Directorate of Petroleum Affaire TOs World Bank Washington, D.C. 20433 USA Name: Jozeef Buck, Acting, OEDD3 Fax Tels 202-676-0560 Dept/Div OEDD3 Dept/Div No. 175/30 Room No. T9-077 Tel No: 202-473-1684 FROM: Ahmet C. ARCAEL, General Director Fax Not 1351364 City: Ankara ORGANIZATION: General Directorate of Country: Turkey Petroleum Affaire Reft Your Fax dated June 14, 1991 Dear Sir, I have reviewed the draft report which has been prepared satisfactorily to my belief and there is nothing to add. Best Regards Ahmet C Akcael General Director