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Copyright © 2010 Thunderbird School of Global Management. All rights reserved. This case was prepared by Professor Michael H. Moffett and Rebecca Mitchell, MBA ‘08, for the purpose of classroom discussion only, and not to indicate either effective or ineffective management. The authors would like to thank Edward E. Miller and Dale F. Reid for helpful comments. All remaining errors are the sole responsibility of the authors.

Michael H. Moffett

The Pacific LNG ProjectHating the Chileans for a territorial dispute that happened in 1879 is not a good reason for not providing a clear and bright future for your children.

Edward E. Miller, President, Gas TransBoliviano S.A.

Each year, Bolivia’s presidents mark the “Day of the Sea,” often with a vow to recover a Pacific port. The landlocked navy has not been disbanded; it chugs forlornly around Lake Titicaca. Maps in bar-racks, and in the offices of some politicians, still show Bolivia’s pre-1879 boundaries. Schoolchildren learn that they have an inalienable right to a coast.

“Chile and Bolivia: The Inalienable Right to a Beach,” The Economist, December 4, 2003.

In December 2003, the Pacific LNG Consortium feared it was nearing an end to its long-term effort to develop Bolivian natural gas for export. Three companies—Repsol YPF (Spain, 37.5%), BG Group (United Kingdom, 37.5%), and PanAmerican Energy, a unit of BP (United Kingdom, 25.0%)—comprised the Pacific LNG Con-sortium. The Consortium’s objective, in brief, was to develop Bolivian gas, build a pipeline to the Pacific coast, construct a liquefied natural gas (LNG) liquefaction facility, and export the LNG to California via pipeline from a port in Mexico.

Bolivian politics was, by far, the single biggest challenge for Pacific LNG. First, the Bolivian people were still not comfortable with the development of their natural resources by foreign investors. Second, Bolivia was not sure it wanted its natural gas exported anywhere, whether it be Mexico, the United States, or, most seriously, their historic enemy and hated neighbor, Chile. And, finally, Pacific LNG planned to run the pipeline across the Atacama Desert of northern Chile to the Pacific Coast, clearly a highly controversial route.

Ed Miller had been the originator (conceptualized on a cocktail napkin) and primary face, voice, and mo-tivator for the Pacific export of Bolivian gas for nearly a decade. Miller’s challenge was to align all of the moving pieces of a complex and expensive project (estimated at nearly $5 billion) quickly, before the window of op-portunity closed. Soon, Bolivian gas, its economic promise, and prospects for aiding the development of South America’s poorest country might find itself locked in the ground. Pacific LNG’s memorandum of understanding (MOU) for the gas sale was about to run out.

The LNG Project ChainThe alignment of an LNG chain, from upstream gas reserves to final customer consumption, is expensive and complicated anywhere in the world. For the Pacific LNG Consortium, to move Bolivian gas to the California market required a complex series of business relationships and agreements extending from the upstream (Bolivian gas) to the bottom of the downstream (the final U.S. buyer).

Upstream. The gas would come from the recently discovered Margarita Field in the far south of Bolivia, in the Tarija Department (province). The Margarita Field was estimated to hold more than 13 trillion cubic feet (tcf )

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of gas, more than enough to support a 20-year gas sale of economic size. Pacific LNG would pay the Bolivian government 18% royalty on all gas produced at the wellhead.

Pipeline. The natural gas would be gathered from the Margarita Field and transported by pipeline to a gas liquefac-tion facility on the Pacific coast. Pacific LNG wished to pursue the shortest distance to the coast by constructing a pipeline across the Chilean province of Antofagasta. This was the very same province which Bolivia had lost to Chile in a war more than a century ago. The Bolivian people, not necessarily the Bolivian government, wanted the pipeline to take a more circuitous route north across Bolivia and then west across southern Peru to the Pacific.

• ChileanRoute.ThepreferredroutingbytheConsortiumwastobuilda400-milepipelinefromBoliviaacrossthe Atacama Desert of northern Chile, as illustrated in Exhibit 1. This was the shortest and cheapest route, terminating at either Mejillones or neighboring Patillos.

• PeruvianRoute.ThepreferredroutingbythemajorityofthepoliticalforcesinBoliviawouldsendthepipelinenorth through Bolivia, then west across southern Peru to the coast. It would add 150 miles to the pipeline length, an additional $600 million in project cost, and end at the Peruvian port city of Ilo.

Liquefaction. This was the critical step in the creation of liquefied natural gas (LNG). Natural gas had always been restricted in its use by transportation; it had to be moved from wellhead to customer via pipeline. With the commercialization of gas liquefaction, the gas could be reduced to a liquid (the volume of the gas was 600 times smaller as a liquid), and then transported anywhere in the world. For Bolivian gas, this meant moving the natural gas via pipeline to the LNG plant somewhere on the Pacific coast for liquefaction.

Once the natural gas feedstock reached the terminal on the Pacific coast, it would enter into a series of processing, liquefaction, and storage steps, called the LNG train. LNG developments often consist of at least two trains, allowing economies of scale for the sum of the two, but retaining the operational efficiencies, flexibility, and reliability of individual trains. Pacific LNG planned a two-train liquefaction plant capable of producing 6.6

Exhibit 1. Bolivian Gas to the Pacific

BrazilPeruBolivia

Chile Argentina

Paraguay

La Paz

SouthPacific

BolivianGas

Fields

After liquefaction (LNG), it can be moved north to a receiving terminal on the Mexican coast for transport by pipeline to the California market

Camisea

Pisco

Santa Cruz

Tarija

Ilo

PeruvianRoute

Mejillones

ChileanRoute

Lima

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million metric tonnes of LNG annually. At this annual rate, the LNG facility would need 314 billion cubic feet of gas per year (bcf/yr), and over a 20-year gas development project, approximately 6.28 trillion cubic feet of gas. This was roughly half the gas in the Margarita Field. The two-train plant was important to the buyer because it would provide additional reliability over the long term.

The first step in liquefaction would be the removal of any remaining condensates and impurities from the natural gas. The gas would then be passed through a heat exchanger, where the gas would be cooled to -161º centigrade and liquefied. The newly created LNG would then be stored in insulated tanks until loaded onto LNG ships for transportation to market. However, this differed depending on the pipeline path.

The Chilean ports of Mejillones and Patillos were deepwater ports with natural protection from the open sea. Typical weather conditions were mild, with annual fog and storm conditions minimal. That was not the case for the Peruvian port of Ilo. Ilo was openly exposed to ocean swells, and would require the construction of either an extended sea wall or LNG loading facilities farther offshore. Construction of a sea wall would be costly and difficult. The offshore facility would be costly as well, as the liquid gas lines from the plant to the loading facilities would have to be heavily insulated to maintain the gas liquidity. Ilo also suffered more difficult weather, including a much higher fog-day count per year than the northern Chilean ports.

Shipping. The LNG would then be moved by ship from the liquefaction plant to a receiving terminal on the northern Mexican coast. Since LNG remains a liquid throughout the transportation process, by insulation and not by cooling or compression, LNG ships are uniquely designed and devoted solely to the LNG market. Most LNG ships today can be loaded in 12 hours or less for maximum utilization of the costly LNG fleet.

Regasification. Once reaching the Costa Azul receiving terminal at Ensenada on the northern coast of Mexico, the LNG would be offloaded into a regasification plant. A receiving terminal consists of a jetty and berth for the LNG tanker, vaporizers for regasification (regas), and storage tanks. The gas would then enter a natural gas pipeline network for transportation and sale to the southern California market. The receiving terminal was already under construction.

Sale. In December 2001, Ed Miller and the Pacific LNG Consortium signed an MOU with Sempra Energy, a San Diego-based energy development company, for the future purchase and sale of natural gas from Bolivia. Sempra would purchase the LNG from Pacific LNG for shipment and sale to California.

Pacific LNG also worried about securing financing for the project. The purchase and sale agreement was the first critical element for financing. With a sale agreement in-hand, the Pacific LNG Consortium would be more likely to secure the financing for construction of both the pipeline and the liquefaction facility. The second element was the routing. Chile enjoyed a much higher credit rating in the global capital market than Peru, and a Chilean routing and LNG plant would be very beneficial for financing.

The MOU would expire in July 2002. After that, Sempra would search out alternative sources of LNG, including gas produced from Camisea (Peru), West Papua (Indonesia), and Sakhalin Island (Russia). The total project cost was estimated at between $4.0 and $4.8 billion, depending on routing, infrastructure needs, and access to financing.

Bolivian Gas

Bolivia possessed some of the largest reserves of natural gas in South America, second only to Venezuela. The primary gas fields ran in a north-south direction through central Bolivia, largely to the south bordering on Ar-gentina. And, although Bolivia had been blessed with sizeable reserves of natural gas, as an agricultural society, it could use little of it. It did need electrical power, and gas was increasingly the fuel source for electrical power globally, but Bolivia had little capital for the development of its own electrical power.

So, Bolivia exported its oil and gas, mostly to Brazil and Argentina. Petrobras, Brazil’s national oil company, had brought much of its expertise in exploration, development, and production to Bolivia beginning in 1995. In

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the spring of 1999, the 3,000 km Bolivia-Brazil pipeline was completed, connecting the Tarija and Chuquisaca gas fields in Bolivia with Porto Alegre in southern Brazil. The Bolivian section of the Bolivia-Brazil pipeline was owned by Gas TransBoliviano SA, a consortium of companies including Enron, Shell, Petrobras, and British Gas. Bolivia began exporting natural gas to Brazil via the pipeline in 1999 under a 20-year take-or-pay contract between YPFB (Yacimientos Petroliferos Fiscales Bolivianos), the national oil company of Bolivia, and Petrobras. The gas agreement had assumed that Brazilian sales would grow steadily, but Brazil had been unable to absorb contracted volumes due to lower-than-expected demand. Petrobras was now attempting to revise the contract.

Bolivia had begun exporting gas by pipeline to Argentina in 1972 under a 20-year export contract. The pipe-line itself was financed by a loan from the World Bank and facilitated by Gulf Oil. After the contract’s expiration in 1992, several extensions were signed until 1999, when Bolivia began exporting gas to Brazil. Argentine sales were temporarily suspended, but restarted in 2002. Clearly, Bolivia needed more customers than just Brazil and Argentina, and Chile could be one such customer. As the world leader in copper mining and refining, the Chilean copper industry had an enormous energy appetite. Bolivian gas could go far in quenching Chilean thirst.

The Atacama

Towards Atacama, near the deserted coast, you see a land without men, where there is not a bird, not a beast, nor a tree, nor any vegetation.

Alonso de Ercilla, in La Araucana, 1569.

The focal point of the project’s pipeline path was the history of animosity between Bolivia and Chile over the ownership of Antofagasta Province. Antofagasta was home to the Atacama Desert, the driest place on earth.1 Annual rainfall was estimated at 1 mm per year, but large parts of the desert had never recorded rainfall.

Sparsely inhabited, the Atacama was home to fewer than one million people, nearly all located in coastal towns or isolated mining camps scattered across the desert. The land was home to mounds of guano (dried bird dung). This was the Salitre, the “Chilean Saltpeter fields,” rich in sodium nitrate used in fertilizer and saltpeter. Un-fortunately, the market for saltpeter collapsed with the invention of synthetic nitrate in 1900. Recent years had seen the development of large copper and lithium deposits, representing a new future for the desert.

Critically, the Atacama occupied a 600-mile-long sliver of land separating Bolivia from the Pacific Ocean. In the eyes of many Bolivians, this separated Bolivia from its economic future. From Bolivia’s inception in 1825 up to 1879, the Litoral Department, the Bolivian coastal province, was the country’s access to the sea. This stretch of Pacific coastline contained the port cities of Arica, Iquique, Tocopilla, Patillos/Mejillones, and Antofagasta.

Although actual title to the northern part of the Atacama had never been clearly established, all three countries—Bolivia, Chile, and Peru—used it with few problems until the growing international trade in nitrate in the 1860s and 1870s forced the issue. In 1879, Bolivia imposed an export tax on the Chilean and British companies mining the nitrates of the Atacama. The ten-cent tax was intended to finance the development of the Antofagasta port facilities, facilities used mostly by Chilean fishermen. The Chilean government objected, arguing that, as a result of a complex set of trade treaties over the years between the three countries, Bolivia had no such right to tax. The ensuing war, The War of the Pacific, finally ended in 1884 with the Chilean navy

1 The Atacama has often been compared to the surface of Mars, and has been used extensively by the National Aeronautical and Space Administration (NASA) of the United States to test and simulate its series of Mars landers.

Exhibit 2. The Atacama Desert

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gaining the upper hand. Chile claimed unilateral title to the Atacama. Bolivia was cut off from the Pacific and became a landlocked country.

The following 120 years were filled with contentious trade negotiations and treaties between Bolivia, Chile, and Peru. Bolivia believed that its rightful territory had been unjustly taken. Chile argued that, historically, land changed hands in all parts of the world as a result of war. Peru, also a loser in the 1884 settlement, supported Bolivia’s claims, but only when they were beneficial to Peruvian interests.

The Bolivian People and Privatization“Chile just wants the good business with Bolivia, forgetting about this problem that is still hanging,” said Jorge Torres, a leader in the Revolutionary Left Movement, a nationalistic party that opposes the Chile option. “Ninety percent of Bolivians will say, `Go with Peru.’ The people’s sentiments are clear. This is about dignity.”

“Lingering Feud with Chile Threatens Bolivia’s Pipeline Plan,”The New York Times, July 8, 2002.

Bolivia is a complex combination of ethnic groups and political power. Its origins lie with the Incas, followed by Spanish occupation and an assortment of other European interlopers over time. The Aymara, Quechua, and Guarani, the predominant native peoples, the originarios, occupy most of the mountainous west of the country, including the capital city of La Paz. The country’s politics and power were historically dominated by the lighter-skinned people of European descent residing in the eastern lowlands. The originarios were now gaining power, and it was their voice being heard about the development of Bolivian gas.

History of Disappropriation

Bolivia declared its independence in 1809 and, after years of war, gained its independence from Spain in 1825. Named after the South American hero Simón Bolívar, Bolivia’s future was to be filled with political instability and war.2 The quarter century which followed Bolivian independence saw alternating regimes of mismanaged republics and discriminatory dictatorships. A continuing debate during this time was the role foreign companies would or could play in the Bolivian economy.

Bolivia nationalized or disappropriated the assets and activities of foreign oil companies twice in the past century. Disappropriating, the term often used in Bolivia for nationalization, is based on the concept that the people of Bolivia are “taking-back” a right or ownership which had previously been allocated. The first was during the Chaco War between Bolivia and Paraguay (1932-1935), a war over oil, and yet another instance in which Bolivia lost territory. Since its independence in 1809, Bolivia had lost nearly half of its total land area through war. Chaco itself was a barren, dry, inhospitable land, about which neither Paraguay nor Bolivia had ever expressed interest. That changed quickly when Standard Oil of New Jersey (U.S.) discovered oil there in 1932. The war that followed took more than 100,000 lives before Bolivia succumbed.

The Bolivian government believed that Standard Oil had not paid its proper taxes in Chaco and had ac-tively worked to undermine the Bolivian war effort. As a result, Standard Oil was nationalized in 1937, followed by a payment of indemnification years later. (According to The New York Times of April 23, 1942, Bolivia paid Standard Oil $1,729,375 for lands seized in 1937. This was the first time Standard Oil of New Jersey had ever suffered an expropriation of its assets anywhere in the world.) YPFB, Bolivia’s national oil company, was then founded to take possession of Standard Oil’s assets. YPFB struggled for years afterwards to raise capital in the international marketplace, as the world’s markets questioned Bolivian political stability.

New Bolivian leadership eventually decided, with the influence of the United States, that it did indeed need foreign oil company interests. The Oil Code of 1956, also called the Davenport Code after the U.S. law firm which drew up the new law (Schuster and Davenport), reopened the door to foreign investment—specifically, 2 Simón José Antonio de la Santísima Trinidad Bolívar y Palacios Ponte Blanco, more commonly known as Simón Bolívar, or The Liberator (1783–1830). Bolivar is credited with either leading or inspiring the independence movements of Colombia, Peru, Ecuador, Venezuela, and Bolivia from under Spanish colonial rule.

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Gulf Oil. The program was described as “denationalization,” the reversal of the nationalization of an industry. After the reentry of foreign oil companies and their subsequent financial success, political winds once again moved against foreign interests. General René Barrientos suspended the Oil Code in 1968, followed by outright disappropriation by General Alfredo Ovando on October 17, 1969. This time, Gulf Oil (United States) was the target. The international markets once again shunned Bolivia.

Economic Reform and a Decade of Turmoil

The election of President Gonzalo Sánchez de Lozada (“Goni”) in 1993 brought Bolivia change. A life-long member of the Movimiento Nacionalista Revolucionario (MNR), a powerful political party in Bolivia, Goni introduced economic reform which dismantled the state-capitalist model used since the 1950s.3 This new Capitalization Program, as it was called, allowed foreign investors to hold ownership and control of public en-terprises, including airlines, railroads, and electric utilities in return for capital injections. This was followed by a new hydrocarbon law in 1996 which opened Bolivia’s oil and gas sector. IOCs were now welcome, and rapid investment in exploration and development followed. As seen in Exhibit 3, this resulted in a major expansion of Bolivia’s reserves of natural gas. Bolivia saw new hope for economic and infrastructure development funded by the export of Bolivia’s gas.

Goni’s government also undertook a number of initiatives to counter the growing cocaine industry. In 1995, it was estimated that Bolivia produced one-third of the world’s coca that was processed into cocaine. Although the government offered compensation for voluntary eradication of coca production, the effort was largely unsuc-cessful and grossly unpopular. Violent protests followed, and Goni’s popularity plummeted.

General Hugo Banzer was elected President in 1997. Although Banzer had campaigned against the privati-zation of many Bolivian companies, including YPFB, his regime continued the free-market policies of the previ-ous government. In 1998, the financial crises in Argentina and Brazil, along with lower world prices for many export commodities, drove the Bolivian economy into recession. Banzer’s efforts to eradicate coca production were proving successful, eliminating Bolivia as a world supplier of coca, but undermining the Bolivian economy. The near-depression economic conditions in the country drove streams of people into the cities. Political unrest and violence followed.

3 Gonzalo Sánchez de Lozada Sánchez Bustamante is credited with the reduction of Bolivia’s inflation from 25,000% to less than 10% in 1985, when he was the Minister of Planning. His economic policy, known as shock therapy, was primarily that prescribed by Harvard economist Jeffrey Sachs.

Exhibit 3. Bolivia’s Growing Natural Gas Reserves

0

10

20

30

40

50

60

1997 1998 1999 2000 2001 2002 2003

Trillion cubic feet (tcf) of gas

Proved Reserves(90% probability of recovery)

Probable Reserves(50% probability of recovery)

Source: Yacimientos Petrolíferos Fiscales Bolivianos (YPFB).

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In 1999 was the start of another failed high-profile privatization initiative in Bolivia, the Cochabamba Water Wars. As part of its continued development lending to Bolivia, the World Bank required Bolivia to move towards privatizing a number of its major public water utility systems. Cochabamba, Bolivia’s third-largest city, had a woefully inadequate system, with more than half the population of the city without running water. The Bolivian government awarded a 40-year contract to the sole bidder, a consortium of multinational companies called Aguas del Tunari. The consortium was to provide water, sewage, and electrical services to the city of Cochabamba.4 Soon after the consortium took operational control over the Cochabamba water system, it increased water rates. Public outrage in the early months of 2000 led to a four-day strike that shut down the city, culminating in two days of public riots. As a result of this conflict, the Bolivian government agreed to lower water rates and reclaim control of the Cochabamba water system.

Sánchez de Lozado, Evo Morales, and Natural Gas

El gas no se vende. (Our gas is not for sale.) Bolivian Populist Slogan

In August 2001, President Banzer resigned from office as he battled personal illness. His vice president, Jorge Fernando “Tuto” Quiroga Ramírez, was then sworn in and remained president until the August 2002 elections. In the August 2002 national elections, none of the candidates for president received a super majority (50% plus one of the popular vote). It was then up to the Bolivian congress to choose between the top two candidates: Gonzalo Sánchez de Lozada, or Evo Morales. Sánchez de Lozada won by a narrow margin over coca advocate and originarios leader Evo Morales.

Over the following year, the consortium worked aggressively with the Bolivian government to obtain the permits and rights needed to move forward. In May 2002, Pacific LNG took its case to the general public, noting that the Chilean pipeline route was clearly preferred, and the Chilean route would allow operational start-up at least six months earlier than the Peruvian alternative. One month later, interim President Quiroga announced that he would postpone the decision on the pipeline route. Pacific LNG quickly secured a six-month extension on the Sempra MOU.

As a result of the congressional selection of Sánchez de Lozada over Evo Morales in August 2002, the newly formed government was a coalition. The coalition had three widely publicized objectives: (1) economic reactivation (fiscal stimulus); (2) elimination of governmental corruption; and (3) social inclusion, specifically the voice of the indigenous peoples. By February 2003, the situation had worsened. Bolivian President Sánchez de Lozada had proposed an income tax of 12.5% on the Bolivian middle class to fill the growing government deficit. Evo Morales and his followers objected. Riots ensued in La Paz, resulting in a number of deaths. Sánchez de Lozada’s government, which had acknowledged publicly that it supported the Chilean pipeline route, held on to its power by the smallest of margins.

The Camisea Threat

The lack of decision of the port by which the Bolivian gas should be exported is causing a strain in the agreement between the Consortium and Sempra Energy, the main issues being the price at the delivery point that would vary depending on which port is chosen. The exclusivity agreement is also in play, if Bolivia misses this window of opportunity it would have to wait fifteen years before it would be able to attempt to enter the California market again, making Bolivia dependent on Brazil as its main purchaser of natural gas. The most pressing matter is that there are four other countries com-peting for the California market, such is the case of Peru (Camisea), Russia (the Sakhalin Islands), Australia (Western Shelf), and finally Indonesia (Botang). Camisea of Peru is the more developed in regards to the project than Bolivia, and the Sakhalin Islands is the one that has the most advantages, as it is closer to the California coast, and it already counts with a liquefaction plant.

“Pacific LNG Project,” Indacochea & Asociados, Abogados, October 2002, p. 2.

4 The multinational consortium included International Water (U.K.), Edison (Italy), Bechtel (U.S.), Abengoa (Spain), and two companies from Bolivia, ICE Ingenieros, and the cement maker SOBOCE. The consortium was guaranteed a 15% annual rate of return on a 40-year contract worth $2.5 billion.

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In March 2003, in an attempt to provide a third-party opinion, the Bolivian government published the results of an independent consulting company’s assessment of the pipeline path alternatives. The report, produced by Global Energy Development, a U.S.-based consultancy, supported the Chilean path. Without committing, the Bolivian authorities publicly acknowledged that the Chilean pipeline route made more economic sense. The report also noted the competitive threat posed by Peru’s Camisea field.

Camisea was a large gas deposit in the Ucayali Basin, on “the wrong side of the Andes,” as it was often described. Located deep in the cloud forest in eastern Peru, natural gas had been discovered by Shell in 1981 in two fields, San Martin and Cashiriari, situated on opposite banks of the Camisea River. The development rights were originally held by a joint venture between Shell (U.K./Netherlands)and Mobil (U.S.). After spending more than $250 million in exploration and preliminary development, the companies had chosen to walk away in 1998. Two years later, a consortium of companies led by PlusPetrol (Argentina) and Hunt Oil (U.S.) began development of the Camisea field on a much smaller scale. Camisea was expected to start producing and moving gas by pipeline over the Andes to the Pacific coast to Pisco, roughly 600 km south of Lima, in 2004. There, the gas was to be sold to a variety of domestic utilities and industrial users.

The Peruvian government believed Camisea’s real value lay in exports, where the LNG could gain a global price, not a domestic one. Although a second pipeline was already under construction to move the gas north to Lima, there was as yet no real commitment to construct an LNG liquefaction facility. Several proposals were under consideration, including a third pipeline to run south to Ilo, which would both provide gas for the rapidly expanding Peruvian copper industry and possibly a site for an LNG facility.

Public opposition to the Chilean pipeline route and the Bolivian government’s appearance of favoring that route once again led to public uproar. In April 2003, Peru presented a new proposal, prompting the Bolivian government to order a new study. The new proposal was for the pipeline to use the Peruvian port city of Ilo as its destination, where it would be combined with a gas pipeline running down the Peruvian coast from Cami-sea. Peru’s argument was that the greater scale and volume of gas delivered would improve the economics of the proposed LNG liquefaction facility significantly.

The Pacific LNG Consortium, now into a third six-month extension of its MOU with Sempra Energy, grew increasingly worried. The Bolivian political environment seemed to be unraveling. Within weeks, a number of major foreign investors in the oil and gas sector began exiting the country. Petrobras applied for a reduction in the price and volume associated with its take-or-pay contract under the Bolivian-Brazil pipeline agreement, and El Paso Energy (U.S.) announced it was selling its stake in that same pipeline.

Competitive Economics

Sempra Energy was now looking at alternative suppliers of LNG for its Costa Azul receiving and regasification terminal at Ensenada, Mexico. Sempra, like others in the LNG chain, was feeling squeezed between suppliers and customers. On the customer side, Sempra was operating in a highly competitive California market, includ-ing potential new sources of domestic gas. Although the 2002-2003 period had seen a tight market with natural gas prices rising, Sempra believed that new capacity and new supplies would inevitably come into the market and drive prices back down. Ultimately, whether natural gas was produced in Bolivia or in Kansas in the United States, final price competitiveness was critical to sales.

At the same time, Sempra and its associates building the Costa Azul receiving and regasification terminal needed to secure a reliable long-term supply of LNG. Exhibit 4 illustrates how Pacific LNG saw the relative competitiveness of potential suppliers for Costa Azul. Although Pacific obviously knew more of the design and cost detail for the Bolivian gas, much of the competitive cost data for Indonesia and Russia could be roughly approximated from available information.

• Gas supply (upstream). This was the cost of acquiring the gas at the wellhead from the country owner. It is largely determined by the type of fiscal regime (royalty/tax agreement or production sharing agreement) which the developer has with the government. Specific elements driving cost are the royalty rate, the corporate income

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tax rate, and the ability to deduct cost and recover investment. The existing development agreements in all four options listed in Exhibit 4 were believed to be relatively competitive, plus Pacific had continued to argue that it was this price which could benefit if Bolivia chose the lowest cost route—the Chilean route.

• Pipeline costs. For Bolivia, this was the core of the debate. The Peruvian route was longer, requiring a larger diameter pipe to accommodate the greater pressure needed to move the gas the longer distance. The Indonesian gas, although slightly offshore in West Java, had to be piped only a short distance to the onshore LNG facility. The Russian gas was also to be produced offshore, then piped down the Sakhalin peninsula to the LNG plant, all within a very harsh and difficult environment.

• Liquefaction. Among the competitive suppliers, all were using state-of-the-art technology, the same two-train scales, with roughly equal cost. The Peruvian port facilities would require additional costs over those of the Chilean route. The Sakhalin facility, because of its complexity, was expected to have very high LNG costs.

• Shipping. The transportation cost of LNG had fallen over the past decade with the introduction of ever-larger LNG tankers. Shipping costs were therefore driven by tanker availability and distance. Costa Azul would be the first major LNG import facility on the western coast of North America, and many LNG market participants wanted to open up the Pacific Basin; shipping costs would be competitive. Bolivian gas, either via Chile or Peru, clearly had a proximity cost advantage over both Russia and Indonesia.5

• Regasification. Since Costa Azul was the single buyer and was building a state-of-the-art 1 bcf/d receiving facility, regas costs would be both low and the same for all potential suppliers.

5 There are three types of shipping contracts commonly in use in the LNG markets today: free on board (FOB); cargo, insurance, and freight (CIF); and delivered ex-ship (DES). If the buyer is responsible for shipping, pricing is FOB. If the LNG seller is responsible for shipping, then the pricing at the receiving terminal is DES. The third form, CIF, is when the seller is responsible for shipping, but transfer of ownership is in mid-voyage, typically international waters.

Exhibit 4. Competitive Delivered Costs to Costa Azul, Ensenada, Mexico

Russia Indonesia Peru ChileSakhalin Bitung Ilo Mejillones

($/mmbtu) ($/mmbtu) ($/mmbtu) ($/mmbtu)LNG contract price $4.00 $4.00 $4.00 $4.00

Gas royalty (18% of price) $0.72 $0.72 $0.72 $0.72Pipeline costsLength (miles) 550 400Length (kilometers) 885 644Diameter (inches) 34 30Total pipeline costs ($/mmbtu) $0.35 $0.18 $0.85 $0.46Liquefaction $1.60 $0.70 $0.67 $0.64Total FOB cost ($/mmbtu) $2.67 $1.60 $2.24 $1.82

Shipping costsFixed cost charge $0.05 $0.05 $0.05 $0.05Distance charge ($/mile) 0.00015 0.00015 0.00015 0.00015Distance (miles)* 4,551 7,062 4,012 4,272Total shipping ($/mmbtu) $0.73 $1.11 $0.65 $0.69

Regasification $0.30 $0.30 $0.30 $0.30Total Delivered Cost ($/mmbtu) $3.70 $3.01 $3.19 $2.81

Gross margin ($/mmbtu) $0.30 $0.99 $0.81 $1.19

*Assuming average speed of: 14 knots 14 knots 14 knots 14 knots*Estimated time for delivery: 13 days 13 h 21 days 0 h 11 days 23 h 12 days 17 h

Source: Author calculations.

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Pacific LNG had repeatedly made the same argument to the Bolivian government. Given highly competitive market prices for gas (for example, $4/mmbtu in Exhibit 4), the returns to the upstream owner—the Bolivian government—would be maximized by capturing all cost efficiencies. (Appendix 1 provides a graphic price history of natural gas prices in the United States, this project’s target market, for the most recent decade.) If Pacific LNG could use the Chilean path, it would be the lowest cost supplier to Costa Azul and could then pay the highest potential returns to the upstream gas owner, Bolivia.

Peru’s Counteroffer

Under a treaty already signed between Bolivia and Peru, Ilo would be a rented port, and would be subject to Bo-livian law, not Peruvian. The site offered was under a 99-year renewable lease. The agreement covered all stages of the LNG development: the gas pipeline, a potential oil pipeline, and the LNG liquefying plant.

The prospective Camisea development was now taking shape. The plant would be located 170 kilometers south of Lima, with a single liquefaction train of 4.45 mmtpa (million tonnes per annum) capacity. The Peruvian marine facilities would consist of a 1.4 kilometer trestle with LNG loading berth, a dredged ship channel, and an 800-meter-long breakwater. The total cost of the single train, marine facilities, LNG pipeline spur from the Camisea mainline, trestle, breakwater, and associated facilities, was estimated at $4 billion. If the Bolivian gas could be brought into this facility, it would obviously support a second train.

The Peru option, although more costly because of length, could simplify the legal dimensions of the busi-ness, as Bolivian sovereignty would eliminate double-taxation concerns and other tariff restrictions. Southern Peru was also more geologically stable, not being subject to the same occasional earthquake as those experienced in northern Chile. Although not offered in writing, the Peruvian ambassador to Bolivia had speculated publicly that Peru might consider covering the incremental pipeline construction costs. This did not, however, make up for the lower margins resulting from higher pipeline operating costs.

The Pacific LNG Consortium, however, had doubts about the ability of Peru to fulfill its promises. The Camisea reserves were capable of only supporting a single LNG train at Ilo, making the Bolivian gas critical to Ilo’s ability to attract a global customer. A second concern was in the pecking order of gas treatment at the pro-posed Ilo plant. Would Bolivian gas receive equal treatment? Although the Peruvian government assured Bolivia that Bolivian gas would be of the highest priority, questions remained.

Chile’s Counteroffer

The Chilean pipeline route was physically shorter, but politically more complex. The original plan had been to route the pipeline to the port city of Mejillones (already the end-point of the Argentine gas pipeline) or neighbor-ing port of Patillos. The Mejillones designation had resulted in competing offers from other Chilean port cities, led by Iquique, an existing free trade zone site. Both cities had campaigned in Chile and Bolivia for selection, offering a variety of tax incentives.

The Chilean government now presented a counteroffer, also offering tax sovereignty to Bolivia over the pipeline and LNG facility. The Pacific LNG Consortium believed that with this added provision, the Chilean LNG facility could be operated at close to economic cost, allowing more of the value in the LNG chain to be captured by the upstream segment, Bolivia. This was important under evolving Bolivian law, as all hydrocarbons were a national resource and their development had to occur under a single set of Bolivian laws and principles on behalf of the Bolivian people. Chilean authorities assured the Consortium that their interests were largely local employment and port services, not the business or tax base of the LNG plant.

There was another side to Chile’s potential role in the project, Chile’s own energy needs. Chile’s economy was by far the strongest and most rapidly growing among the Pacific coastal countries of South America. To sustain that growth, Chile needed energy. By 2003, Chile was generating 25% of its power from natural gas, while the demand for gas was growing at more than 20% per year. Chile had been importing gas from Argentina since the late 1990s, but there was increasing concern that Argentina’s own energy needs would limit its future as

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a source of pipeline gas for Chile. Although under extensive study, there was still no real commitment to build an LNG receiving facility on the Chilean Pacific coast. If Chile did build an LNG receiving and regasification facility, it could theoretically import LNG from anywhere.

Feelings about Bolivia and Chile’s dispute over the Atacama remained so strong that the two countries still did not have formal diplomatic relations. Many in Bolivia feared that if they accepted the Chilean route, Bolivia would be implicitly recognizing Chile’s control over the Atacama. (Ironically, most of the Bolivian population was unaware that Bolivia had exported crude oil via the Arica, Chile, port for many years. Transredes of Bolivia operated a small 18,000 bbl/d crude oil pipeline between Cochabamba, Bolivia, and Arica, Chile. The pipeline, however, operated only periodically depending on Bolivian crude oil demands.) The Bolivian government had made it clear that it saw this possible pipeline route as recognizing Bolivia’s right of free access to the Pacific. The Chilean government had made it equally clear that it did not see that as part of any potential agreement.

The public debate over the development of Bolivian gas finally erupted in September 2003, the beginning of the Bolivian Gas War. A rising tide of antigovernment sentiment was now arguing for Bolivia to develop the raw natural gas within the country and capture more of the value-added benefits domestically, rather than at some port in Chile or Peru.

Even if this obstacle is surmounted, left-leaning Indian leaders do not want the gas sold at all. Many believe that, if it is, the United States and multinational oil companies will benefit from cheap gas at Bolivia’s expense. And few trust the government to spend gas revenues wisely. Of late, the oil and gas sector has been responsible for almost half of Bolivia’s foreign invest-ment. But the head of the state oil company [YPFB], Raúl Lema, has given warning that if investors are put off, and the gas fails to get to market, Bolivia’s oil self-sufficiency will end within four or five years.

“Bolivia: Highly Flammable,” The Economist, September 11, 2003.

The Chilean pipeline path was now widely assailed as a “Gas to Chile” project. On October 12, the Boliv-ian government imposed martial law in El Alto, the mountainous city which largely surrounded La Paz, after 16 demonstrators were shot by police. President Sánchez de Lozada, fearing a military takeover if he backed the Chilean option, suggested the military conduct its own analysis of the project. Five days later, Evo Morales’ sup-porters from Cochabamba tried to march into Santa Cruz, the largest city in the east, where support was strongest for President Sánchez de Lozada. Sánchez de Lozada, fearing either a military coup or a populist revolt, offered his resignation in a letter to the Bolivian Congress. After Goni’s resignation was accepted and Vice President Carlos Mesa sworn in, Goni left Bolivia for the United States. He continued to speak out in favor of gas exports, as illustrated by his editorial in The Washington Post later that same month, presented in Exhibit 5.

The Bolivian government was still unable to make a decision about the project, despite the prospect of earning an additional $1 billion a year from exports. For a country whose total gross domestic product was only $8 billion, that was a lot of money. For Pacific LNG, time was nearly up. The Consortium convened for one last effort to gain the Bolivian government’s approval for the project.

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Exhibit 5. The Best Choice for Bolivia by Gonzalo Sánchez de Lozada

During my first term (1993-97), I instituted policies that enabled Bolivia to find and develop reserves that could last us hundreds of years at current usage rates. These resources have the power to transform Bolivia's future. The plan to export liquid natural gas from a Pacific port to California would have doubled Bolivia's export revenue, closing our fiscal deficit in as little as five years. We would have switched hundreds of thousands of homes and vehicles to natural gas, lowering people's energy costs. Crucially, we would have fueled progress where Bolivians want it most, by investing 100% of gas tax revenue in health and education—the best way to lift people out of poverty. For all their attacks on the gas export project, they have failed to explain their alternative. Proposals to nationalize Bolivian industries and clamp down on free trade do not answer the question of how resources will be found to solve Bolivia's problems. Bolivia already has experience with economic programs like these. In the early 1980s, they brought us to the brink of collapse, with an inflation rate of 25,000%. Anti-globalists boast that rejecting gas exports has reclaimed Bolivia's future. That's like saying the best way to feed one's family is to lock the refrigerator door. Our country's long-term energy needs are dwarfed by its vast supplies. Bolivia can afford to sell its gas. The hard truth is, it can't afford not to. This dark scenario could get even worse. The eastern states of Bolivia sitting on natural gas wealth may resist being shackled in poverty. We might even see a push for secession and a devastating civil war. Such chaos in the continent's heart would spread beyond Bolivia's borders, destabilizing its neighbors, and disrupting the region's economy. Taken to the extreme, Bolivia could become the Afghanistan of the Andes, a failed state that exports drugs and disorder.

Source: “Abstract: Bolivia’s Best Choice,” by Gonzalo Sánchez de Lozada, The Washington Post, November 13, 2003, p. A31.

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Appendix 1. U.S. Wellhead Gas Prices (US$/mmbtu)

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

$7.00

Jan-

95Ap

r-95

Jul-9

5O

ct-9

5Ja

n-96

Apr-

96Ju

l-96

Oct

-96

Jan-

97Ap

r-97

Jul-9

7O

ct-9

7Ja

n-98

Apr-

98Ju

l-98

Oct

-98

Jan-

99Ap

r-99

Jul-9

9O

ct-9

9Ja

n-00

Apr-

00Ju

l-00

Oct

-00

Jan-

01Ap

r-01

Jul-0

1O

ct-0

1Ja

n-02

Apr-

02Ju

l-02

Oct

-02

Jan-

03Ap

r-03

Jul-0

3O

ct-0

3

January 1995 – December 2003, monthly

Source: U.S. Energy Information Administration.

Appendix 2. Corpwatch.org’s Assessment