by Cyrus Sanati
FORTUNE -- Chevron is taking quite a gamble snuggling up with Argentina. The U.S. oil giant confirmed this week it is officially partnering up with Argentina's (now) state-controlled energy company, YPF, in a bid to help the firm develop the South American nation's potentially vast deposits of oil shale, which, according to some estimates, could have the third-largest such reserves in the world.
But while the potential payout from the field could mean huge profits for Chevron (CVX) down the road, it may not be worth all the accompanying drama. That's because the fields in question are currently subject to a nasty ownership dispute between Argentina and Repsol, the Spanish energy firm. By essentially siding with Argentina, Chevron is not only alienating itself from the other energy companies, it is also potentially putting billions of dollars in future revenue up in jeopardy.
There is an unwritten code among the big energy companies -- "It's always us vs. them." In this case, "us" refers to the large privately controlled energy companies, such as BP (BP), Chevron, ExxonMobil (XOM), and Repsol, while "them" refers to the energy-rich nation-states and their state-controlled energy companies. In practice, the saying means that if a privately controlled energy company is screwed over by a nation in some way, be it by expropriation, the ripping up of contractual agreements, or through a surprise hike in royalty rates, the other energy firms promise not to try and capitalize on the others' misfortunes. This has helped the privately controlled energy companies retain their dominance amid a tricky political economic backdrop.
So it came as a bit of a shock to the industry when Chevron announced last fall that it had signed a memorandum of understanding with YPF to hunt for oil shale in Argentina's energy-rich province of Neuquen. That's because only a few months prior, the Argentine government, under the direction of President Cristina Fernandez, "renationalized" YPF, which at the time was controlled by the Spanish energy giant, Repsol, and known as Repsol YPF. The grounds for the expropriation were dubious, but Argentina isn't really known for its adherence to international law -- or to contractual agreements of pretty much any kind. This is the nation that, after all, has defaulted on its debt seven times, three of which occurred in the last 30 years.
Repsol had thought suing Chevron would have been enough to make the U.S. energy firm back off. The firm even used peer pressure as a tactic, quoting Christophe de Margerie, chief executive of French energy giant Total in its suit saying that he was "not going to take advantage of Repsol and leap at assets that may well be cheaper given the situation," noting further, "that's not our style."
But after months of negotiation with the Argentine government, Chevron announced this week that it was making its relationship official with the new YPF and investing $1.24 billion to drill some 100 wells with the company in Argentina's "Muerta Vaca" field. Chevron could potentially spend up to $15 billion over the lifetime of the project, making it one of the largest investments in the country by a foreign company.
Now, the fact that the field's name translates to "dead cow" is just the first odd thing about this deal. Indeed, the terms of the agreement hark back to the time when the privately controlled oil firms ruled the world, as in, before OPEC came on the scene in the 1970s. A spokesman for Chevron confirms that the company would be splitting both the expenses and the profits with YPF right down the middle. That could be considered a very generous agreement. Indeed, an oil company in negotiations with a state-controlled entity would be ecstatic in reaping a fraction of that amount and would be expected to front most, if not all, of the expenses.
Argentina would have probably promised the moon to any energy firm willing to enter into a new contract with YPF at this point. Argentina's reputation is already in the dumps and has proved time and again that it is willing to forgo international law to get what it wants. For example, if the ruling Peronist party falls out of power, the next government may use that as a justification to "renegotiate" all oil contracts signed with the previous government.
What is so troubling is that Chevron knows firsthand the political risks here. Last November, an Argentine judge froze the assets and future income of Chevron's Argentine business unit after Chevron "lost" a $19 billion drumhead trial in Ecuador over an oil spill, which allegedly occurred in the country over 20 years ago by Texaco (absorbed by Chevron in 2001). Miraculously, though, last month, an Argentine appeals court overturned the ruling, saying that Chevron's Argentine affiliate was a legally distinct operating unit from Chevron corporate, and therefore the lower court erred in freezing its cash.
Chevron is using pretty much the same argument to have Repsol's case against it thrown out in the U.S. and EU. It argues that Chevron Argentina is a legally distinct operating unit, which means any lawsuit dealing with its operations needs to not only list Chevron Argentina as a defendant but also needs to be filed in an Argentine court as it only has operations in Argentina. Chevron is playing with fire here as it is setting a precedent by which any "dispute" that may come up between Argentina and Chevron in the future must be handled by the Argentine court system.
The political and legal risks seem clear here but there are business risks, too. It is doubtful that courts in the EU will stand back and allow Chevron to take advantage of Repsol's misfortune. As such, Repsol could seek retribution by targeting Chevron's operations in the EU. Chevron has recently moved into Eastern Europe, with shale oil and gas operations launched in Romania, Bulgaria, and Poland. While currently small, Chevron's Eastern European operations are expected to ramp up production in the very near future. Chevron is also in the U.K., producing some 46,000 barrels a day of oil and 122 million cubic feet of gas from its operations in the North Sea. The company also operates several marketing agreements with refiners and retail stations across the European Union.
Additionally, Chevron may have a harder time finding a partner for some new ventures now that they have broken the "us vs. them" code. Energy companies almost always these days partner up with other major oil companies to share in the risks associated with large projects, so Chevron needs to maintain good relations with its fellow energy companies to grow. While the industry probably won't shun Chevron altogether, as the company is much too big to ignore, some companies may be less accommodating when negotiating future agreements.
Some may even decide to pull their money out of joint ventures already in progress. For example, Repsol is a junior partner on several Chevron-led projects, including at least one in Canada and another in the Gulf of Mexico. A Chevron spokesman says that Repsol is a junior partner in another Chevron-led venture in offshore West Africa. Junior partners provide cash and support, so if Repsol chooses to withdraw due to its lawsuit, then those projects that are ramping up could be derailed, permanently.
But despite all the legal, political, and business risks, Chevron has unapologetically doubled down on Argentina. It is doing so not because of a lack of other opportunities, as there are shale basins all over the globe waiting to be tapped. Rather, it is doing so because the terms offered up by Argentina were just too good to pass up. For Chevron's sake, hopefully the deal doesn't turn out to be too good to be true.
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