Colombian Oil Update: Escalating Security Issues Interrupt Production

| About: Gran Tierra (GTE)
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Colombia is in the midst of an oil-boom that has seen it become the fourth-largest oil producer in Latin America, after Venezuela, Mexico and Brazil. It has become a particularly attractive choice for small to mid-sized oil companies seeking to take advantage of Colombia's increasing political stability and lack of hydrocarbon exploration. This has created a fast moving and dynamic oil industry that requires investors to be fully aware of the latest political, economic and industry developments along with the many and constantly changing risks. One of the key risks is the fluid and unpredictable security environment, which will be reviewed in this the first installment in a series exploring the Colombian oil industry, its investment potential, recent developments and investment ideas.

Overview of oil production in Colombia

Colombia has proven oil reserves of 2.3 billion barrels located in six major basins across the country. These are the Eastern Llanos, Putumayo-Caguan, Middle Magdalena, Upper Magdalena, Catatumbo and Eastern Cordillera basins as shown by the map below.

Source: Agencia Nacional de Hidrocarburos (Colombia)

It is in these basins where the majority of Colombia's oil exploration and production occurs with 2011 production reaching 917,000 barrels of oil equivalent per day (BOEPD). The largest company is the Colombian government controlled Ecopetrol (NYSE:EC), which earlier this year briefly became the largest company in South America by market-cap. There is also the largest independent oil company in Colombia, Canadian based Pacific Rubiales (PEGFF.PK) which operates the Rubiales field in the Llanos Basin. As well as a number of small-to-medium sized explorers and producers including Canadian mid-cap Petrominerales (OTCPK:PMGLF) with its main production also in the Llanos Basin and small-cap Gran Tierra Energy (NYSEMKT:GTE) which produces most of its oil in the Putumayo Basin.

One of the primary risks faced by these companies when operating in Colombia is the significant lack of transport infrastructure. This means that the majority of all oil produced is transported by long distance oil pipelines that run from the major basins to coastal ports. The long distances and rugged terrain that these pipelines cover make them particularly vulnerable to sabotage or even disruption from equipment failure. Colombia's major oil pipelines are set out on the map below.

(Click to enlarge)

Source: Ecopetrol

In order to maximize the benefits Colombia is obtaining from this boom and the recent high oil prices over the last year the Colombian set a 1 million BOEPD output target which it expected to achieve in 2011. But because of protests, sabotage and internal conflict resulting from the country's ongoing civil war that target has yet to be achieved.

A fluid and changing security environment

Earlier this year I wrote that the security situation was showing increasing signs of stability because Colombia's primary internal belligerent the Fuerzas Armadas Revolucionarias de Colombia (FARC) had softened their stance. This included reopening dialogue with the Colombian government and publicly declaring that they had renounced the use of kidnapping for ransom, which they had long used as a method of extorting money to fund their operations.

However, recently the security environment has worsened with increased instability arising from an escalation in attacks by the FARC. There has been a significant increase in the scale, frequency and intensity of attacks in south western department of Cauca and the north eastern department of Norte de Santander, which have been shaded grey in the map below.

(Click to enlarge)

This has seen an escalation in attacks on oil companies, their employees, well-heads and oil pipelines. For the first four months of 2012 incidents of sabotage nearly tripled from 13 to 37 incidents. There was also the recent murder of five Ecopetrol oil workers at an Ecopetrol well in southern Colombia earlier this year. But the conflict has now escalated and further intensified in the south western department of Cauca.

Conflict in Southwestern Colombia

In the past week there has been an outbreak of heavy fighting between government forces and the FARC in the south western province of Cauca. To date this fighting has seen almost 3,000 people displaced from their homes and serious interruptions to the Ecopetrol owned and operated Trans-Andean pipeline. This pipeline connects the oil fields of the Putumayo-Caguan basin to the Pacific port of Tumaco.

The department of Cauca bordering the south departments of Narino and Putumayo and Huila to the west has for decades been a guerrilla strong-hold. It holds particular significance for the FARC because of its strategic location straddling important road routes connecting the southern Colombian jungles with Colombia's only Pacific ports of Tumaco and Buenaventura. It also the region through which the majority of traffic between Colombia and Ecuador passes. All of which makes it an important trafficking route for the smuggling of narcotics and arms.

These disruptions have forced those companies operating in the Putumayo basin to reduce production because they are unable to ship the oil they extract to the port facilities in Tumaco or store large quantities of oil onsite. In addition, the region lacks sufficient road infrastructure to be able to efficiently transport large volumes of oil by road.

Declining security in Northeastern Colombia

The security situation in northern Colombia around the department of Norte de Santander and the Venezuelan border has also worsened. Since the start of this year the FARC have increased the intensity of their attacks in the region including attacking the two main oil pipelines in the area.

This has seen disruptions to the 480 mile long Cano Limon-Covenas pipeline that runs from the Llanos basin near the eastern Venezuelan border to the Colombian Caribbean port of Covenas. It has also attacks on the 110 mile long Rio Zulia - Ayacucho Pipeline that runs from the Catatumbo Basin in east central Colombia to Ayacucho, a main oil pipeline hub. This has had some impact on the production of oil companies operating in the Llanos and Catatumbo basins though not as severely as the conflict in Cauca.

Future outlook for the domestic security situation

However, at this time the risk of further disruption to oil pipelines and production from sabotage and an escalation in the internal conflict is high and I only see it increasing over the short to medium-term. I have formed this view for two reasons; firstly the FARC have reinvigorated their offensive strategy with a focus on escalating attacks on urban areas and disrupting Colombian state infrastructure, while seeking to control key narcotics and arms trafficking routes. Secondly, after a series of significant set backs at the hands of the Colombian military in 2010 and 2011, they are seeking to prove they are still a credible force.

Finally, the changes made to the distribution of oil royalties by the Santos government has incentivized armed groups like the FARC to attack oil pipelines, well-heads and oil company personnel. Previously oil royalties were paid to the local governments of the areas where the oil fields are located, motivating armed groups to kidnap and assassinate local government officials in those areas as a means of extorting money.

But with President Santos changing the royalty distribution system, they are now collected and disbursed by the central government. This has removed the incentive for armed groups and in particular the FARC to target local mayors and government officials for extortion. Although it has now seen them move to attacking oil infrastructure such as pipelines and well-heads as a means of extorting money from oil companies.

Escalating civil conflict is disrupting oil production

The escalation in the attacks on oil infrastructure and the civil conflict has in all likelihood prevented the Colombian government of achieving its national goal of one million BOEPD output per day. It has also led to reduced production for many of the oil companies operating in Colombia, because they are dependent on the pipelines as a result of the countries poor internal infrastructure. However, government controlled Ecopetrol has announced that its ability to achieve its 2012 production targets is back on track after reaching agreements with the police and military to tighten security.

The oil producer most affected by the escalation in the conflict because of the intense battles now raging in Cauca is Gran Tierra. The company is dependent for the majority of its production from its wells in the Costayaco field in the Putumayo basin. The only means of transporting oil produced in this field is by the Trans-Andean pipeline that travels through the heart of the conflict zone. The map below shows the geographic location of Gran Tierra's operations in Colombia.

Source: Gran Tierra Investor Presentation April 2012

For these reasons the company recently announced that it is unable to meet its 2012 production target. The company had set a 2012 oil production target of 20,000 to 21,000 BOEPD but because of these disruptions has only been averaging second quarter production of 16,300 BOEPD. This is lower than its first quarter average daily production of 16,742 BOEPD.

This will obviously have an effect on the company's bottom-line and prevent it from fully exploiting its production potential. For the first quarter 2012 the company reported a 4% fall in revenue and a $300,000 loss net loss, which can be attributed to production disruptions. The company has also cut is capital expenditure by 14% to $380 million because of the impact the reduced production in conjunction with a depreciating oil price is having on revenues. Accordingly shareholders in Gran Tierra should be bracing themselves for a poor full year 2012 financial result.

The company's dependency on its Colombian production and the risks that this creates for investors were discussed in my earlier article "Gran Tierra Energy: Is It Time To Invest In This Latin American Oil Small Cap?." It is clear the security situation in Colombia is quite fluid and any changes for the worse clearly have the capacity to adversely affect oil production. It is also clear that Gran Tierra needs to diversify its production further in order to mitigate this risk.

Despite this setback there are still many things about Gran Tierra to like including; that management have recognized this risk and that the company has an extensive exploration program in place. Accordingly, it is only a matter of time before alternate sources of production inside and outside of Colombia increase to the point where this risk is sufficiently mitigated to reduce the disproportional impact it currently has on revenue.

I also like the fact that the company is debt free with solid provable reserves of 34 million BOE and despite the disruptions is averaging over 16,000 BOEPD. For all of these reasons, I believe that the company has a strong future in Colombia, particularly when it is considered that only 30% of the country has been explored for hydrocarbons.

Bottom line

Normally in such circumstance I would suggest that investors exercise considerable caution and take a wait and see approach with a view to waiting for signs that the security situation is stabilizing. However, because of Gran Tierra's strengths combined with the 33% drop in share price since my last article and 12% for the year, I believe that it currently presents as a buying opportunity for risk tolerant long-term investors.

Disclosure: I am long EC. I also may initiate a long position in GTE over the next 72 hours.