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June 16, 2020

Argentina: Econviews Monthly Report

BY Miguel A. Kiguel, Andrés Borenstein, Lorena Giorgio, Mariela Díaz Romero, Rafael Aguilar, Isaías Marini

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( 37 mins)

Recent Developments

  • COVID-19: 85% of the country has normalized activities with social distancing recommendations (with the exception of tourism, massive events and inter-jurisdictional transport, which are not allowed). In the case of the Metropolitan Area, the pace of contagion is accelerating, and strict controls subsist, but some new activities have been allowed.
  • In the case of the Metropolitan Area, the pace of contagion is accelerating, and strict controls subsist, but some new activities have been allowed.
  • Negotiations with creditors continued after the country entered in sovereign default on May 22nd. On May 26th, the government made a 2 d offer for the restructuring of dollar debt (foreign legislation). The implicit prices of new bonds were more attractive in comparison to the 1st offer, in the range of USD 48-50 (10% EY). Country risk remained near 2,600 bps.
  • FX controls were tightened for imports in June: importers will have to use their own dollars before accessing to the official FX market. The CB could purchase reserves after having sold USD 1,800 bn since mid-April.
  • The official FX was being depreciated at a constant rate of 0.13% daily, but today accelerated to 0.3%, reaching ARS 69.62 per US Dollar, while the spread with the BCS reduced from 70% to 60%.
  • The CB has lifted the minimum rate for time-deposits to 30% (26.6% before).

Figure of the Month

CB’s Assistance to the Treasury (Temporary advances and CB’s profits) could be up to

7.9%

of GDP this year; 3.6% of GDP were already transferred until May.

 

To Be Alert

On June 22 nd , the Government will face the maturity of TJ20 (mostly held by external creditors) for

130 bn

The maturity is equivalent to 6% of monetary base.

What’s Coming Next

  • Economic activity is likely to have reached a floor in April and is expected to rebound somewhat in the following months. However, we expect the economy to contract 10.0% this year, the worst recession since the end of the Convertibility in 2001. It could take 3 years to recover the pre-crisis level (4Q-2019).
  •  Debt restructuring: the new deadline for negotiations, which was on June 12th , was re-extended for one more week.
  • As we already expected, fiscal measures to support the private sector will be extended for some more time. For example, the Emergency Family Income (EFI) will be paid for a 2nd time, and a 3 rd payment is being analyzed. This way, we still expect primary deficit to reach 5% of GDP this year.
  • Given the tightening of FX controls for imports, there could be an inflationary effect on the price of imported goods. Additionally, the CB could accelerate the pace of depreciation in the following months, and there will be pressure on prices once the quarantine is over. This way, inflation is likely to increase in the following months despite price controls. We still expect annual inflation to reach 50% this year.
  • Given the tightening of FX controls for imports, there could be an inflationary effect on the price of imported goods. Additionally, the CB could accelerate the pace of depreciation in the following months, and there will be pressure on prices once the quarantine is over. This way, inflation is likely to increase in the following months despite price controls. We still expect annual inflation to reach 50% this year.

 

Summary of Main Indicators

Argentina: Econviews Monthly Report 35

Graph of the Month

Argentina: Econviews Monthly Report 36

Recent Economic Developments

External financial conditions have improved in May. Now the market expects a V-shaped recovery, as most indicators suggest that the economy has reached a floor in April and will rebound in the following months. Stock markets have reached their same pre-crisis level, emerging-markets risk has receded (although is still high), and currencies have appreciated, such as the Brazilian Real. However, the impact of COVID-19 will still be hard on global growth and uncertainty prevails, as there is no known treatment yet.

In this context, Argentina has entered in the 9th sovereign default of its history since May 22nd . However, it seems that both creditors and the Government expect to seek an agreement in the short term, as country risk has been around 2,600 bps since then. There have been offers from both sides. On May 26th , the Government made a 2nd offer and the implicit prices of new bonds were more attractive in comparison to the 1st offer (USD 38-42), in the range of USD 48-50 (assuming an exit yield of 10%). Creditors presented their own proposals, with implicit prices of USD 60. The deadline for negotiations was June 12th, but was extended for a week. Argentina could offer a sweetener linked to exports. The amount being negotiated (bonds for USD 66 billion) implied payments for USD 125 billion, and the 1 st offer reduced that amount to USD 83 billion. In the 2nd offer, the Government increased the offer in only USD 5 billion but advanced some payments, which led to an improvement in the present value.

FX controls were hardened in June, especially for imports. Through Communication “A” 7030, the CB established importers will have to use their own dollars before resorting to the FX market, and access to it will be subject to the CB’s approval. In addition, it limited the access for individuals who have made MEP/BCS operations within the last 90 days, with the commitment of also refraining from these operations during the following 90 days. The entity relaxed FX controls for SME’s and some key imports (medicines and fertilizers for the agricultural sector). The CB lost USD 1,800 billion in reserves since mid-April, until it was able to resume purchasing at the beginning of this month (USD 88 million per day on average). This way, reserves stand near USD 43 billion. Regarding the exchange rate, the official FX was being depreciated at a constant rate of 0.13% daily, but today accelerated to 0.3%, reaching ARS 69.62 per US Dollar, while the spread with the BCS reduced from 70% to 60%.

The CB raised the floor for time-deposit rates to 30.02%, seeking to sustain the peso demand and thus lower the FX spread. Badlar and private TM20 rates closed May at 26.6%, the previous floor established by the CB. There is a difference between CB’s 1-day reverse repo rate (19%) and other free rates, such as the call rate -private banks or the 1-day reverse repos rate, which are in levels of 16% and 14%, respectively. This indicates a high level of liquidity in the banking system.

Monetary aggregates grew strongly in May. In fact, the monetary base grew ARS 264 billion, mainly in concept of assistance to the Treasury via profits (ARS 430 billion), which has already totaled ARS 1.052 trillion this year (3.6% of GDP). The monetary base closed the month at ARS 2.131 trillion (7.4% of GDP), accumulating a ARS 236 billion growth as of May. Considering that assistance to the Treasury totaled over a trillion pesos, the CB’s sterilization effort via Leliqs and reverse repos is remarkable. In addition, as the CB concentrated its efforts on boosting the granting of credits to sustain economic activity, credit to the private sector went up 4.4% monthly. In turn, private sector’s deposits increased 6.8% monthly on average. With a higher preference for liquidity in the context of uncertainty generated by the crisis, and an increase in transfers from the Government to the private sector, the M2 reached a yearly growth of 100.5%.

Fiscal accounts kept deteriorating. In April, primary expenditure recorded a 96.8% yearly increase, boosted by measures the Government took to sustain production and employment, and aid provinces amid the crisis. Social expenditure took a 98.6% y/y leap and included the payment of the first installment of the Emergency Family Income (EFI). On the other hand, total revenues of the non-financial public sector grew scarcely 14%. This way, the primary deficit soared to ARS 228.8 billion during the month (0.8% of GDP). Tax revenues grew only 14.4% y/y in May and will display a poor performance in June too. As assistance to the private sector continued in May and will do so in June (including the EFI), we expect a further deterioration of the fiscal accounts, leading to a primary deficit of 5% of GDP in 2020.

Monthly inflation scored below 2% again in May. Food and beverages rose only 0.7%, their lowest mark since 2017. However, the economy’s reopening and the monetization of the deficit may lead to higher rates past midyear.

With the first phase of lockdown being the strictest, April appears to have set a floor for activity (and may stand out as one of the worst months in economic history). Industry and construction collapsed 33.5% and 75.6% y/y, respectively. Preliminary data shows a rebound in May, consistent with the easing and geographic segmentation of the lockdown: retail sales cut their y/y fall from 57.6 to 50.1%, while automobile sales jumped from around 7,500 to 20,000 units, a number close to pre-quarantine records. Good marks on other indicators such as cement and electricity consumption are also fanning hopes of a recovery. However, due to accelerated contagion in the Buenos Aires Metropolitan Area (AMBA) in previous weeks, authorities have warned stricter measures could return.

Finally, on June 8th the President shook up the news cycle by announcing the intervention of Vicentin, a soybean trader based in the Santa Fe Province which defaulted in December.

A political confrontation that will impact economic performance

There seems to be some tension within the administration between the moderate sectors, and the more radical ones, led by Cristina Kirchner. This confrontation has surfaced recently, and it is critical to understand which will be the direction of government policies, especially once the lockdown is lifted and the country moves to a new normality.

Argentina: Econviews Monthly Report 37

Initially, Alberto Fernández seemed to be in command, and the government’s handling of the Coronavirus crisis did strengthen the President’s popularity and power. However, Cristina appears to be gradually making a comeback, a situation that has come to the surface with the government’s controversial proposal to expropriate Vicentin, one of the largest soybean trading companies. Vicentin had defaulted last December, it is in Chapter 11 and was in negotiations with various groups to capitalize the company and restructure its debts.

In the midst of the negotiation, the President accompanied by Senator Fernandez Sagasti (a close ally of Cristina), announced the intervention of the company and the intention to expropriate. It certainly looked like a victory for the most radical wing of the coalition, which raises questions regarding government policies in the future.

Argentina: Econviews Monthly Report 38

This conflict is taking place at a time when the President’s positive image, while still high, is slowly dropping as people are starting to lose patience with the prolonged lockdown and start to feel the fatigue of remaining at home, while the economic consequences on people’s income and on the viability of firms are starting the erode the support for the more prudent health policies.

The way this conflict between the hawkish and dovish wings of the government settles will affect the business and investment climate for coming months (and years) and it is likely to impact on the pace of the recovery from the depths of the Coronavirus crisis. Needless to say, it will also affect the potential economic benefits of reaching an agreement with the bondholders and getting out of default.

Debt restructuring: the parties are close, but not yet there

The debt restructuring has been haunting the government since inauguration. Contrary to its initial intentions of a friendly agreement that only involved an extension of maturities, the country came up with an offer that included deep haircuts of interest and principal, and finally went into default on May 22nd . It is now struggling to reach a deal with the creditors. The administration clearly underestimated the complexity of the problem and overestimated the significance of the support of Nobel laureates, political leaders and the IMF (on a biased debt sustainability analysis) to reach a deal with the bondholders. In the end, this was a negotiation about the capacity and willingness to pay for a country that by and large is solvent and needs time to restructure the amount and composition of its debt.

Argentina: Econviews Monthly Report 39

The debt restructuring has been haunting the government since inauguration. Contrary to its initial intentions of a friendly agreement that only involved an extension of maturities, the country came up with an offer that included deep haircuts of interest and principal, and finally went into default on May 22nd . It is now struggling to reach a deal with the creditors. The administration clearly underestimated the complexity of the problem and overestimated the significance of the support of Nobel laureates, political leaders and the IMF (on a biased debt sustainability analysis) to reach a deal with the bondholders. In the end, this was a negotiation about the capacity and willingness to pay for a country that by and large is solvent and needs time to restructure the amount and composition of its debt.

Argentina: Econviews Monthly Report 40

The distance regarding the financial terms of the new bonds is small (two or three dollars). Argentina has already achieved a substantial reduction in the NPV of its debt, and it seems that the negotiations center on the value of the new bonds, on the treatment of the exchange bonds relative to those issued after 2016, on legal issues regarding the interpretation of the CACs, and on the possibility of adding some type of sweetener if the economy does better than in the somber projections presented by Guzman.

Argentina: Econviews Monthly Report 41

The distance regarding the financial terms of the new bonds is small (two or three dollars). Argentina has already achieved a substantial reduction in the NPV of its debt, and it seems that the negotiations center on the value of the new bonds, on the treatment of the exchange bonds relative to those issued after 2016, on legal issues regarding the interpretation of the CACs, and on the possibility of adding some type of sweetener if the economy does better than in the somber projections presented by Guzman.

Despite all these problems, we do expect that the government will reach a deal with the bondholders. A successful deal means that Argentina will restructure all the bonds issued under foreign legislation and will not leave any loose ends, otherwise it will remain in selective default and would not be able to reap the benefits that debt restructuring would entail. In the past, governments that achieved successful deals achieved an acceptance of over 90% of the bondholders. Argentina does not seem to be yet there.

COVID-19: has the economy already hit bottom?

The government decided early on a very stringent lockdown that for more than two months has kept the number of cases under control. We are now entering a new phase, following a slight relaxation of the lockdown, and seem to be nearing the peak of the contagious phase in Buenos Aires. Although this peak appears that it is going to be much milder than in Brazil or Mexico, we still need to see how it plays out.

Argentina: Econviews Monthly Report 42

The lockdown has had a large impact on the economy. We expect a drop of around 11.8% in economic activity in the first semester, while the poverty level will most likely exceed 40% of population; figures not seen since the depths of the 2001 economic depression.

Argentina: Econviews Monthly Report 43

The economy appears to have bottomed down in April, though the pace of recovery is still very slow. According to Google indicators, there seems to have been a modest increase in mobility in the country, though the recovery is mainly taking place in the industrial sector and outside the large urban areas. The bet is that Argentina will enjoy a V-shaped recovery with a significant expansion in the third and fourth quarter, with rates of growth above 7.5% in the last quarter of the year.

The strength of the recovery will largely depend on three factors. First, on whether there is an agreement on the debt that at least would help to maintain the flow of credit to the private sector which would otherwise will become (even more) scarce. Second, it will depend on the business climate that prevails in coming months, especially regarding regulations, price controls and access to the foreign exchange market. Third, it will depend on the overall macroeconomic framework, especially on the policies adopted to reduce the fiscal deficit, to bring down inflation and to provide a clear outlook about tax and trade policies.

Perhaps these policies could be adopted within an IMF program that would at least ensure some consistency between fiscal, monetary and exchange rate policies.

COVID-19: has the economy already hit bottom?

The government seems to be postponing the announcement of most economic policies (such as the way in which it plans to remove or soften the foreign exchange controls, or the presentation of the budget to Congress) till the time when it succeeds in restructuring the debt and the lockdown is lifted. This has meant that even six months after inauguration there is still no economic plan nor an indication about how the government plans to deal with many challenges it still faces.

Argentina: Econviews Monthly Report 44

The authorities do not seem to have realized that a successful debt restructuring is only a first step and that, in itself, does not restore growth, replenish international reserves, or bring down inflation. It is only a necessary, though not sufficient condition, to start addressing the numerous problems and imbalances that the economy is confronting.

Argentina: Econviews Monthly Report 45

It is useful simply to enumerate many of them to understand the challenges that it confronts and some of the trade-offs that might be involved.

  1. A decade of stagnation which has been compounded by the Coronavirus crisis. As a result, there are large demands to improve the living standards and to rapidly bring down poverty. The challenge is how to get the economy growing again while it needs to reduce the fiscal deficit and inflation, and with very limited access to credit. The answer of course lies in promoting private investment, though this requires a market-friendly promoting.
  1. A large fiscal deficit in an environment in which the level of taxation is already extremely high and complex. The reduction in the deficit requires dealing primarily with public expenditures, addressing social security and the public sector wage bill, which is politically difficult, especially in the absence of growth.
Argentina: Econviews Monthly Report 46
  1. An overvalued exchange rate is at the heart of the problem, but the Central Bank is afraid to devalue due to the potential impact on inflation and the social consequences, especially while a large part of the population is in quarantine. How and when will the Central Bank restore a “competitive” exchange rate, and can it do it without destabilizing inflation?
  2. A convoluted foreign exchange rate regime with innumerable controls to protect international reserves. To avoid a devaluation the government implemented tight foreign exchange controls (the so called “cepo”), a regime that discourages foreign investment as there is uncertainty about the ability to the access to the FX market to repay loans, repatriate capital or to pay dividends. Besides, it creates uncertainty about the ability to pay for imports that are essential to sustain economic activity.
Argentina: Econviews Monthly Report 47
  1. There are large distortions in relative prices, especially in utility rates, that discourage investment in the energy sector, precisely at a time when the economy desperately needs dollars, and the gas and oil sectors are potential sources of exports. In the past, governments found it difficult to remove the freeze due to fears about inflation and loss of political support among consumers. The way to deal with the problem was to subsidize consumption, but today the fiscal situation makes this approach impossible.
  2. Last, but no least, there are contradictory signals about the degree of government intervention, the degree of protectionism that the government is seeking, its approach towards Mercosur, and the willing to reach an IMF program even if it requires some austerity measures and tight monetary policy.
Argentina: Econviews Monthly Report 48
  1. Last, but no least, there are contradictory signals about the degree of government intervention, the degree of protectionism that the government is seeking, its approach towards Mercosur, and the willing to reach an IMF program even if it requires some austerity measures and tight monetary policy.

The bottom line is that the government still lacks an economic plan.

Challenges for the energy sector: the jigsaw puzzle

The energy market in Argentina is at a juncture. On the one hand, it has the second largest global reserve of unconventional gas, the fourth largest of shale oil and vast capacity for renewables from wind to solar and biofuels. Yet, the situation is worrisome. The combination of an uncertain world market and the recent volatility in domestic policies has brought investment almost to a halt and this is threatening the development of the sector. There are new concerns about Argentina becoming again a net importer of gas, with the negative implications it will have on the already strained fiscal accounts and on the amount of dollars that imports may take in a fragile external equilibrium.

Argentina: Econviews Monthly Report 49

The oil and gas sector plays a critical role. The governments have been betting on Vaca Muerta to provide the much-needed dollars that would result from higher oil and gas exports. Some reports have even argued that Vaca Muerta, in terms of exports, could be equivalent to the soybean revolution of recent decades.

Argentina: Econviews Monthly Report 50

Output of oil and gas is no longer growing and worse, investment has been mostly paralyzed in Vaca Muerta, the capital of unconventional hydrocarbon in the Province of Neuquén, well before the effects of the Covid-19. The main reason was the lack of a clear policy towards the sectors in recent years in terms of prices, subsidies, the commitment to honor contracts and inability to secure financing as Argentina lost access to the international financial markets.

The policies towards natural gas will be critical, as Argentina’s policy matrix is highly dependent on gas (roughly 55%). Thanks to Vaca Muerta, Argentina has the potential to produce all the gas it needs, and in addition, at the right price and with the appropriate infrastructure, it can even become a significant exporter. Policies are critical, because there are also scenarios in which Argentina would become again a net importer of gas at very high prices, which in the last decade meant large government subsidies and a buoyant trade deficit in the energy sector.Argentina swung from a net exporter to a net importer of energy to a balanced situation now. The pendulum could move either way, depending on how the government shapes the system.

Argentina: Econviews Monthly Report 51

The big risk now is that the new government freezes once again prices of gas and electricity for long periods, which will in all cases lead to large subsidies. The government cannot afford them, as it is running an already large primary deficit. So a critical question seems to be: does it pay a higher price for imported LNG or does it provide incentives to domestic production? There is always the alternative of passing through to consumers the actual cost of energy, a decision that the previous Peronist administration refused to do and that Macri’s government only partially did at a very high political cost. However, one needs to keep in mind that the cost of these subsides was substantial, and that one point they reached around 4% of GDP, an amount that today would be impossible to finance.

The pandemic has made the situation worse, as international oil and gas prices collapsed, posing new challenges especially for oil production.

The government has come to an ad-hoc solution for upstream oil producers setting the “Argentine barrel” at USD 45, keeping producers afloat as well as oil-producing provinces that partly rely on the royalties for financing the budget.

Argentina: Econviews Monthly Report 52

The structure of contracts is complex with little institutional certainty. Every segment of the marker faces different set of hurdles. For gas, the government is allegedly working in a 4-year contract structure, which may not be as generous as the old “Plan Gas”, but would keep some investments flowing.

There are challenges and uncertainties ahead that need to be removed for Argentina to exploit all its energy potential. To jump from pilot projects to fully-fledged development Argentina needs more supportive macro and political frameworks and a modern labor environment, part of which has been upgraded in the previous administration. Companies have gone a long way in their learning curves, but more is needed to reduce production costs.

Oil production, stop & go?

Oil has been the ugly duckling of the Argentine energy market for a while. Everyone was thrilled about gas for several reasons: the energy matrix is based on gas, Argentina urgently needed to replace gas imports with local production, the price incentive was huge at a given point, especially when the Kirchner administration launched the Plan Gas that paid for new production as much as USD7.5 per million of BTU (USD 6.5 now). These signals led most firms to channel their resources or unconventional hydrocarbons towards gas rather than oil.

Argentina: Econviews Monthly Report 53

However, gas has its problems. First, it is more difficult to export, due to lack of infrastructure and hence, in the absence of government policies, its price is determined by the market forces of supply and demand. There is a surplus of gas in summer that often cannot find buyers abroad, especially in Brazil that is an important potential market.

That story is mostly over, as gas prices dropped and then oil, whose prices were linked to international markets, recovered part of the shine, at least until the Covid-19 outbreak. The main advantage of oil was that it could be easily exported, while there are difficulties to sell gas, subsidies that have not been fully honored and payment timings often depend on the fiscal situation. So the environment for oil started to look less risky.

After falling in 2016 and 2017 oil production had risen again by 2.5% in 2018 and a further 4% in 2019. While not exempt from regulations, oil is less subject to transport constraints and seasonal factors such as the gas. And more importantly, there is a well-functioning international market to sell any local surplus. So, with the problems of excess gas in the summer, the cuts to “plan gas” implemented by the previous administration and the infrastructure bottlenecks, many firms shifted investments from gas to oil in the last couple of years.

Argentina: Econviews Monthly Report 54

Argentina has produced an average of 508k barrels of oil per day in 2019. The highest point in history was in 1998 when after privatizing YPF and opening the market to new investments Argentina produced 848,000 barrels of oil per day. Then, a constant reduction in investment made it fall to 489k barrels a day in 2017. In the first 4 months of 2020 the industry produced an average of 506k barrels a day. Considering the low activity in May and June, we should assume that in 2020 output growth will cease, to say the least.

In April domestic sales of fuel contracted by two-thirds compared to pre-pandemic levels and 64% down y/y. So, that lower demand translated into crude output being cut in April by 13.5% compared to February on a seasonally adjusted basis. Investment had stopped before the pandemic. The freezing of prices at the pump enacted in August 2019 coupled with financial and regulatory uncertainty fueled by the change of government had almost paralyzed new developments in Vaca Muerta.

The recent growth of oil has also been driven by the surge of unconventional oil. In 2017, the proportion of shale and tight oil was a mere 9.3% of total output. That ratio jumped to 13.3% in 2018, 19.4% in 2019 and in the first 4 months of 2020 unconventional production was 23.4% of the total oil output.

Beauty and the risk of the so called “Argentine barrel”

The reduction of international prices also sent shivers down the industry’s spine in such way that exporting the crude was no longer an alternative, at least not a profitable one. This administration had capped prices at the pump, even when YPF (partly owned by the government) was a net loser. Under current circumstances the government came to the rescue and once again resuscitated the so called “Argentine barrel” or “barril criollo”. This means that the domestic transactions are based on a barrel of USD 45 for the “Medanito”, the oil produced in the province of Neuquén. Other types of oil are sold at a discount. Escalante (the key product in the Atlantic basin) is based at USD 35.37 for the month of June. According to the decree the Argentine barrel will be valid until the end of the year unless Brent trades above USD 45 for 10 consecutive days. In addition, the government eliminated the export tax while oil price remains below 45 and will reach 8% only if it surpasses USD 60. In addition, the government suspended the inflation adjustment of the fuels tax until October. Firms will have to keep headcount level stable in return.

Argentina: Econviews Monthly Report 55

The Argentine barrel essentially does two things: it gives some assurances to the economics of oil producing firms and sets a floor for oil royalties, a critical source of revenues for 7 provinces. In 2019 crude oil generated over USD 1.2 billion for Argentine provinces, but the price effect (and to a lesser extent the lower output) reduced the monthly average from USD 100 million to just USD 36 million last April. Chubut received just USD 12 million (part of which is pledged already) and Neuquén less than USD 11 million.

According to a study from Instituto General Mosconi, an energy think tank, if Brent remains at USD 40 and the Argentine barrel at USD 45, consumers will have transferred USD 840 million to companies, oilproducing provinces, and the Federal government (0.2% of GDP). It does not look too expensive to sustain an activity that has long term impact on macro sustainability and could be a source of investment and jobs. Naturally, the distribution of the burden could shift, but knowing that consumers had received a windfall from the non-adjustment of prices at the pump from last winter, it does not look too unfair either. Unions are another important stakeholder behind the “Barril Criollo”, as firms have kept the headcount, albeit with a 25% wage reduction.

For firms, the “Argentine barrel” should be a solution when and if the downstream sector is back again in the market. However, some firms think that this help from the government might become the perfect excuse to freeze prices when and if international prices surpass the USD 45 threshold. There is no free insurance, the government might claim. The depreciation of the FX is another risk for firms, as when the government freezes prices, it does do in local currency.

Reshaping the gas sector

Increasing the production of gas is crucial for Argentina, as the energy matrix has a high dependence on natural gas, representing 50% of total. It is also the holy grail of the energy trade balance, which showed strong deficits when there was a lack of gas. After jumping from the lows of 2014 to the peak of early 2019, natural gas production has been decreasing strongly since mid-2019. Investment fell as well. In the first four months of this year finished exploitation Wells fell almost 50% compared with the same period of 2019. Moreover, around 45% of gas production comes from unconventional fields, in which production is falling around 25% y/y on average. This means that if new wells are not drilled in the second half of the year, during the winter of 2021 it may be necessary to increase LNG imports.

Argentina: Econviews Monthly Report 56
Argentina: Econviews Monthly Report 57

The production of natural gas displayed a “V-shape” during the last decade, growing from 2014 to 2019.The Austral and the Neuquén basins have been the only ones with absolute growth in the last 10 years and account for the 86% of total production. Unconventional natural gas production showed a very strong performance during the last decade and especially during the last five years, while conventional natural gas production in 2019 turned out to be 41.1% lower than 10 years ago and 6.8% lower than in 2018. In contrast, non-conventional production has been growing without pause, and already represents more than 40% of total natural gas production.

Argentina: Econviews Monthly Report 58

The strong rise in gas production, especially in the Neuquén basin, has allowed the country to improve its energy trade balance in 2019. On the other hand, after the restart of gas exports to Chile, Brazil and Uruguay, the first LNG export was carried out last year.

Argentina: Econviews Monthly Report 59

The bad news is that investment in the sector measured by finished exploitation wells showed an absolute decrease of 23.1% between 2009 and 2019, while in 2019 there was a retraction of 9.3% compared to the previous year. This fall increases to around 40% regarding the peak of 2015.

The local price of natural gas is likely to continue to be regulated for some years. This is not a “pure” commodity that can be internationally benchmarked, as it is not easily transportable and requires expensive infrastructure to be shipped. The problem of freezing the local price for natural gas is that investments will be reduced and more LNG will have to be imported -at higher prices than the domestic one-, spending international reserves, which are currently in short supply, to the purchase of a resource that could be produced locally.

Argentina: Econviews Monthly Report 60

The reference “incentive price” to encourage investment in the gas sector might be considered high by a government that refuses to pass to consumers a larger share of total costs. Thus, the search for the best instrument to promote investment and reactivate production in the sector depends largely on the decoupling of gas prices at the wellhead from the rates paid by residential users, which have been frozen during the year and are likely to continue unchanged for the next months despite the expected depreciation of the exchange rate.

Argentina: Econviews Monthly Report 61

Setting a local gas price: between a rock and a hard place

The local price of natural gas has traveled along a winding path. It went from those days when it was kept “artificially” low at around USD 2.0 per million BTU and did not reflect real costs, to the ascending path designed during the Macri Administration in order to encourage shale and tight gas production. In the local market, the price of domestic natural gas at the wellhead showed an average annual increase of around 8% between 2010 and 2019, while this rise reaches 72.2% if we compare the average price in 2010 with the average price in 2019. As natural gas imports are concerned, Argentina paid in 2019 twice the local price.

Argentina: Econviews Monthly Report 62

On the other hand, the income received by gas producers differed from the price paid by consumers due to the incentives granted by the government that guaranteed a minimum price for local production. Only between 2016 and 2018 the price received by producers exceeded USD 5 per million BTU, at the same time that subsidies began to drop and consumers started to pay a higher percentage of total costs.

Argentina: Econviews Monthly Report 63

During the first four months of the year, local natural gas price has fallen 16.2%, from USD 2.41 per million BTU in December 2019 to USD 2.02 in April. Prices will likely continue to move south in the coming months, as the tariffs paid by consumers remain frozen and the exchange rate continues to depreciate without haste but without pause. So, gas distributors are likely to buy cheaper, at least measured in USD terms.

In this scenario, if the Government wants to set a minimum price for producers similar to last year’s (USD 4.5 per million BTU), incentives will need to increase to around 55% of that price compared to 12% in 2019.A price for producers near USD 4.5 per million BTU is in line with the one guaranteed by the “Gas Plus Program” in 2008 (between USD 4 and USD 5 per million BTU), but far below the price at which incremental production was remunerated by the Gas Plans of 2013 and 2016 (around USD 7.5 per million BTU). Although the Argentine experience shows that it is complex to determine an equilibrium price that encourages investment and a shift in production, a mechanism that seems to have worked is to set different prices for new and old gas.

Argentina: Econviews Monthly Report 64

One alternative to find price incentives for production of conventional gas is to hold auctions between producers, distributors and CAMMESA (the electricity dispatch Agency). From an efficiency point of view, this auction system would facilitate future convergence towards a system without subsidies, as the distance between demand and supply prices is known. However, it would likely define a price higher than USD 3.5 per million BTU, which is the highest amount the Government would be willing to guarantee. A price of USD 3.5 per million BTU for producers with local prices at around USD 2 per million BTU, implies that the government should cover through subsidies around 40% of the price received by producers.

Argentina: Econviews Monthly Report 65

If incentives are not found, the situation will lead to underinvestment, which would in turn drive imports up again. But it may not be enough just to guarantee a minimum price for producers. The local market does not justify by itself the development of ambitious projects, such as Vaca Muerta. There is not enough market today for the large investments that this type of development needs. Finding an export way out is the key.

So far, beyond some exports to Chile, not much has been achieved. More action will need more infrastructure investment. The first step would be to build the pipe from Neuquén to San Nicolás (it was supposed to be tendered last October), as the first step towards delivering gas to Brazil. The second ambitious step was the liquification facility at Bahia Blanca, a project that is estimated to cost several billion dollars to be managed by YPF. The flagship oil company is today quite indebted and thirsty for cash and would unlikely engage in such venture now.

Argentina: Econviews Monthly Report 66

In a nutshell, here comes a new crossroads for the sector. No investment will derive in more imports than Argentina can afford. More investment in gas development could solve the winter’s shortfall but would create over supply in summer. And money is too short (and prices too low) to double the bet and eliminate infrastructure bottlenecks. In the meantime, it is critical that Argentina respects the contract structure. The PPA contracts signed in the electricity generation market would be the benchmark that oil and gas producers will use to assess business in Argentina. It is also important that the government understands the different nature of the unconventional market. There, investment in fracking needs to be carried out on a permanent basis, hence there is no place for old men in Patagonia.

Argentina: Econviews Monthly Report 67

It is complex to define the best instrument to reactivate the investment of the main producers, but it is increasingly clear that apart from ensuring clear rules that allow to create a broader market in the future, the Government should guarantee a competitive price in dollars that covers the real replacement cost of new gas developments during a period of at least four years. Without such an umbrella to withstand eventual future devaluations, it is difficult for energy companies to decide to resume drilling.

Argentina: Econviews Monthly Report 68

Challenges for the medium and long term

The strong dependence of the energy matrix on fossil fuels, and in particular on natural gas, puts both, the production of this resource and self-sufficiency at the center of the scene. A shock of productive investments to reverse the stagnation of the sector is the consensus among industry players and, therefore, the measures that could be taken by the government, especially those aimed at reaching a price agreement that allows improving the profitability of the sector, which will impact on its investments, will be decisive in recovering lost confidence and predictability in a business whose results are always seen in the medium and long term.

Therefore, increasing oil and gas production is the key, promoting and increasing both local and international investment within a framework of a better business climate and certainty regarding the rules of the game. It is also necessary to reformulate fiscal incentives in a climate of national, provincial and municipal legal security.

The exploitation of unconventional resources appears as a complimentary solution to the energy supply problems of a country that went from self-sufficiency achieved in the 1990s to dependence on energy imports. As the investments and costs that must be faced for its extraction are significantly greater than those necessary for conventional production, it is a priority to articulate policies that seek to improve the business climate, encourage investment and offset the negative effects of the recent drop in current and expected levels of international prices.

A sustained improvement in macroeconomic fundamentals and the business climate, along with the help of the international context regarding the downward trend in energy prices, are very likely to accelerate investment decisions in the sector.

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