Philippine  Petroleum  Exploration  and  Development  –  Charting  Stormy  Waters    The  Philippine  petroleum  upstream  industry  has  been  facing  a  lot  of  challenges  lately   hugely   affected   by   a   combination   of   external   and   internal   factors,  which  may   result   to   a   slow   down   in   exploration   and   development   activities.   The  volatility   in  oil  prices,  external   security   threats   in   the  West  Philippine  Sea,  and  political  risk  perennially  attached  to  the  Philippine  resource  industry,  may  cause  some  explorationists  to  stay  in  the  sidelines  while  waiting  for  the  dust  to  settle.    The   International   Energy   Agency   recently   announced   that   the   oil   market   is  “massively  oversupplied.”  With  sanctions  likely  to  be  lifted  on  Iran  following  the  finalization  of  a  nuclear  deal,  it  is  expected  that  as  much  as  20  million  barrels  of  stored  oil  will  be  added  to  the  global  market.  Currently,  Iran  is  the  fourth-­‐largest  holder  of  crude  oil  reserves  in  the  world  and  the  major  oil  companies  are  already  lining  up  to  tap  these  resources.      The   rising   oil   supply   coupled   with   the   recent   effects   of   the   slowing   China’s  economy   will   dampen   demand   leading   to   further   price   drops.   The   Chinese  economy  is  expected  to  grow  less  than  7  percent  this  year,  its  slowest  rate  since  1990,   and   could  decelerate   even  more  next   year.   China   rattled   global   financial  markets   on   11   August   2015   by   devaluing   its   currency   to   revive   economic  growth.  The  move  is  aimed  to  help  Chinese  companies  by  making  their  products  less   expensive   in   export  markets.   The   stock  market   have   been   hit   by  massive  sell-­‐offs  stemmed  only  by  active  government  intervention  including  suspension  in  trading  of  more  than  half  of  listed  firms  and  a  halt  to  initial  public  offerings  to  check   the   slide   in   equities.   Construction   is  weaker   than   ever   as   the   real   estate  industry   struggles  amidst   a   threat  of   a  bubble.  Consumer   spending,  which  was  supposed  to  pick  up  the  slack,   is  not  that  strong  and  financial  services,  a  major  driver  of  economic  growth  when  the  stock  market  was  booming,  are  slipping.    Saudi   Arabia,   OPEC’s   de   facto   leader   and   most   powerful   member,   reportedly  continues   to   pump   oil   at   record   high   rates   as   OPEC   maintained   its   daily  production  target  during  the  downturn.  Credit  Suisse  surmised  that  Saudi  Arabia  is  working  to  get  oil  prices  low  enough  to  undermine  US  shale  investment.  Credit  Suisse   further   noted   that  while   Saudi   Arabia   is   expected   to   be   running   a   20%  deficit  in  2015,  the  major  oil  producer  is  likely  to  be  able  to  afford  a  "price  war"  for  the  foreseeable  future.  Oil  prices  are  down  to  their  lowest  level  in  six  years.  Despite  oil  prices  taking  a  sharp  nosedive  significantly  below  the  $60  per  barrel  break-­‐even  point  of  several  shale  producers,  a  few  producers  are  still  continuing  with  plans   for  deploying  more  rigs   in   the  near   future.  Credit  Suisse  stated   that  the   cost   of   production   for   US   shale   will   fall   30%,   and   that   80%   of   shale   oil  produced  will  make  financial  sense  to  produce  with  prices  below  $60  a  barrel  at  the  end  of  this  year.  The  oil-­‐futures  market  projects  oil  prices  will  bounce  back  to  near  $70  a  barrel.  Adding   to   the  glut   are   large  oil   companies  or   countries   that  depend   on   oil   revenue,   which   continues   to   produce   to   bring   in   cash   flows  regardless  of  price.        

Waiting  at  the  Sidelines    Upstream   investments   in   frontier   and   marginal   areas   are   usually   the   first  casualties  during  low  oil  prices.  Petroleum  companies  are  responding  by  cutting  capital   expenditure   programs   and   in   the   absence   of   a   price   rebound,   deeper  budget  cuts  will  follow.      At  the  home  front,   if   the  results  of  the  5th  Philippine  Energy  Contracting  Round  (“PECR”)  are  any  indication,  petroleum  exploration  in  the  country  is  expected  to  slow   down   in   the   short   term.   Formally   launched   on   09  May   2014,   PECR5   is   a  mechanism   whereby   the   Philippine   government   through   the   Department   of  Energy   (“DOE”)  bids   out   areas  with  potential   energy   resources   for   exploration  and   possible   development   and   production   providing   a   more   transparent   and  competitive  system  of  awarding  petroleum  service  contracts.  There  are  currently  twenty   (29)  Petroleum  Service  Contracts   -­‐   seven   (7)   under  Production  Period,  twenty-­‐two   (22)   under   Exploration,   seventeen   (17)   awarded   thru   direct  negotiations,  and  twelve  (12)  awarded  thru  PECRs.    

 Department  of  Energy  

 For   the   eleven   (11)   areas   placed   for   bidding   under   PECR5,   only   three   (3)  companies   submitted   bid   proposals.   Out   of   the   three   that   submitted,   only   two  qualified  -­‐  Ratio  Oil  for  Area  4  (NE  Palawan),  and  Colossal  Petroleum  for  Areas  5  (NE  Palawan)  and  7  (Recto  Bank  Block).  The  other  bidder,  Yulaga  Oil  Exploration  Enterprises,   which   bid   for   Area   1   (Ragay   Gulf),   was   disqualified   for   failure   to  submit   complete   documents.   Despite   the   numerous   international   roadshow  

presentations  conducted  by  the  DOE  to  promote  PECR  5,   it  was  noticeable  that  the  big  players  stayed  in  the  sidelines.    Industry  sources  are  now  suggesting  that  the  DOE  do  away  with  the  bidding  process  of  awarding  service  contracts  because  of  the  long  lead  time  in  acquiring  new  acreage  and  the  high  costs  of  promotion,  which  lately  do  not  translate  to  any  tangible  investments  by  the  big  players.    Meanwhile   resources   companies   are   keenly   anticipating   the   passage   of   the  Bangsamoro  Basic  Law  (“BBL”)  particularly  focusing  on  the  contentious  issue  of  ownership  of  natural  resources.    Although  the  Constitution  provides  that  natural  resources   belong   to   the  state   by   virtue   of   the   Regalian   doctrine,   under   the  Malacanang-­‐backed  House  of  Representatives  version  of  the  draft  BBL  bill,  only  the   Bangsamoro   government   will   have   exclusive   jurisdiction   over  natural  resources   located   in   the   Bangsamoro   territory.   Under   Section   8,   “The  Bangsamoro  Government  shall  have   the  authority,  power,  and  right   to  explore,  develop   and   utilize   the   natural   resources,   including   surface   and   subsurface  rights,   inland   waters,   coastal   waters,   and   renewable   and   non   renewable  resources  in  the  Bangsamoro.”  The  Bangsamoro  Government  shall  also  have  the  power   to   declare   nature   reserves   and   aquatic   parks,   forests,   watershed  reservations   and   other   protected   areas   in   the   Bangsamoro,   amending   the  following   laws,   among   others:   the   National   Integrated   Protected   Areas   System  Act;   the  Forestry  Code  of   the  Philippines;   PD   87,   the  Petroleum  Exploration  and  Development  Law  of  1972;  and  the  Philippine  Mining  Act  of  1995.      Because   of   the   apparent   unconstitutionality   of   certain   provisions   of   the   draft  BBL  bill,  Senator  Ferdinand  R.  Marcos  Jr.,  chair  of  the  Senate  Committee  on  Local  Government,  filed  on  10  August  2015  a  substitute  bill,  Senate  Bill  2894,  entitled  "Basic  Law  for  the  Bangsamoro  Autonomous  Region".     Sec.  165  of   the  bill   states  that:   “The   Bangsamoro   Regional   Government   shall   have   the   authority,   power,  and   right   to   control   and   supervision   over   the   exploration,   utilization,  development,   and   protection   of   the   mines   and   minerals   and   other   natural  resources   within   the   Bangsamoro   Autonomous   Region   in   accordance   with  responsible   mining   policies,   the   Philippine   Constitution,   and   the   pertinent  provisions   of   this   Basic   Law.   Provided,   that   the   strategic   minerals   such   as  uranium,   petroleum,   and   other   fossil   fuels,   mineral   oils,   and   all   sources   of  potential  energy  shall  remain  under  the  control  and  supervision  of  the  National  Government;  provided  further  that  in  the  utilization  and  exploration  of  strategic  minerals,  the  Bangsamoro  Regional  Government  shall  be  consulted.”    Also,  under  Sec.  166:  “Qualified  inhabitants  who  are  bona  fide  inhabitants  of  the  Bangsamoro  Autonomous   Region   shall   have   preferential   rights   over   the   exploration,  development,   and   utilization   of   natural   resources,   including   fossil   fuels  (petroleum,   natural   gas,   and   coal)   and   uranium,   within   the   Bangsamoro  Autonomous   Region.    Existing   rights   over   the   exploration,   development   and  utilization   of   natural   resources   shall   be   respected   until   the   expiration   of   the  corresponding   leases,   permits,   franchises   or   concessions,   unless   legally  terminated.”    Majority   of   the   17   senators   who   signed   the   report   submitted   by   Marcos'  committee  expressed  intention  to  interpellate  or  amend  the  substitute  bill,  which  Marcos   vowed   to   address.   The   substitute   bill   consists   of   17   articles   and   215  

sections  while   the   original   draft   contained   18   articles   and   244   sections.   In   his  sponsorship  speech  on  the  draft  law,  Marcos  assured  the  public  that  his  version  of   the  Bangsamoro  bill   is   "constitutional,   all-­‐embracing   and   inclusive"   and  will  protect  the  country's  national  interest  and  reserves  to  the  national  government  its  powers  enshrined  under  the  Constitution.    Looming  Uncertainties  in  the  Horizon    Three   recent   developments   have   also   dampen   the   industry’s   enthusiasm   and  again   cast   serious   doubts   as   to   the   integrity   of   the   petroleum   service   contract  system’s  legal,  regulatory  and  fiscal  regime.    Tañon  Strait  Service  Contract  Constitutional  Challenge    In  a  recent  case  “Resident  Marine  Mammals  vs.  Sec.  Reyes”,  the  petitioners  sought  to  enjoin  the  DOE  from  implementing  SC46  and  to  have  it  nullified  because  SC46  violates  the  Constitution  and  covers  the  Tañon  Strait  NIPAS  area.  The  Supreme  Court  held  that  following  the  safeguards  established  in  the  La  Bugal  B’laan  case,  PD  87   although   enacted   in   1972  before   the   adoption   of   the   1987  Constitution,  remains   to   be   a   valid   law   and  may   serve   as   the   general   law,   which   a   service  contract  for  petroleum  exploration  and  extraction  may  be  authorized.    However,  the  Supreme  Court  noted  that   the  President  was  not  the  signatory  to  SC46  and  the  same  was  not  submitted  to  Congress  making  it  null  and  void.    The  Court  also  held  that  SC46  was  not  executed  for  the  mere  purpose  of  gathering  information  on  the  possible  energy  resources   in   the  Tañon  Strait  as   it  also  provides   for   the  parties'   rights   and  obligations   relating   to   extraction   and  petroleum  production  should   oil   in   commercial   quantities   be   found   to   exist   in   the   area.  While  PD  87  may   serve   as   the   general   law   upon   which   a   service   contract   for   petroleum  exploration  and  extraction  may  be  authorized,  the  exploitation  and  utilization  of  this   energy   resource   in   the   present   case   may   be   allowed   only   through   a   law  passed  by  Congress,  since  the  Tañon  Strait  is  a  NIPAS  area.  Since  there  is  no  such  law  specifically  allowing  oil  exploration  and/or  extraction  in  the  Tañon  Strait,  no  energy   resource   exploitation   and   utilization   may   be   done   in   said   protected  seascape.”   Any   seismic   survey   or   drilling   in   a   protected   area   may   only   be  implemented  pursuant  to  an  Environmental  Compliance  Certificate  secured  after  undergoing  an  Environmental  Impact  Assessment.      The  DOE  requested  the  Office  of  the  Solicitor  General  (“OSG”)  to  file  a  Motion  for  Reconsideration   on   the   grounds   that   then   President   Gloria   Macapagal-­‐Arroyo  granted   a   Special   Authority   to   then   DOE   Secretary   Vicente   Perez   and   that  Congress   had   been   notified   of   the   execution   of   SC   46.  The   Motion   for  Reconsideration  was  filed  by  the  OSG  on  July  16,  2015.      West  Philippine  Sea  Dispute    Petroleum  exploration  in  the  highly  prospective  Western  Palawan  shelf  and  the  Reed   (Recto)  Bank,   undisputed  part   of   the  Philippine   exclusive   economic   zone  where   the  Philippine  government  has   exercised   “sovereign   rights”   through   the  award  of  service  contracts,  have  also  been  threatened  by  the  ongoing  territorial  

dispute   with   China.   Prof.   Jay   L   Batongbacal   in   his   lecture   on   “U.S.   Maritime  Security  Policies  and  Philippine  Maritime  Territorial  Claims”  cited  documents  that  the   Philippine   occupation   of   the   Kalayaan   Islands   was   made   as   a   security  perimeter   around   the   Reed   Bank,   where   then   President   Ferdinand   Marcos  granted   oil   exploration   contracts   to   American   companies   but   which   was  discouraged  by  US  Embassy  officials.    The  Philippine  government  has  pursued  an  arbitration  case  against  China  and  a  high-­‐level  Philippine  delegation  went  to  The  Hague  for  the  oral  arguments  on  the  case  on  7-­‐13  July  2015.  In  January  2016,  the  Philippine  government  expects  the  International   Arbitral   Tribunal   to   issue   its   award.     In   the   meantime,   the  Philippines  confirmed  that  it  would  meet  the  United  States’  appeal  to  resolve  the  dispute.   Following   a   regional   security   conference   held   in   Kuala   Lumpur,   the  Department  Foreign  Affairs  came  out  with  a  statement  that,  "As  a  means  of  de-­‐escalating   tensions   in   the   region,   the   Philippines   fully   supports   and   will   pro-­‐actively  promote  the  call  of  the  US  on  the  'three  halts'-­‐  a  halt  in  reclamation,  halt  in   construction   and   a   halt   in   aggressive   actions   that   could   further   heighten  tensions.”    The   West   Philippine   Sea   tension   has   seriously   affected   business   decision   to  pursue   further   exploration   work   in   the   disputed   area   amidst   armed   threat   to  seismic   vessels   and   drill   ships.   Exploration   activities   in   SC72   covering   Recto  Bank   operated   by   Forum   Energy   Plc.   has   been   a   recent   casualty   with   Forum  declaring  force  majeure  on  15  December  2014.    Unpaid  Royalties  to  the  Government    What   will   ultimate   cause   apprehension   and   uncertainty   to   the   petroleum  upstream   industry   is   the   pronouncements   by   the   state   auditing   agency,   the  Commission  on  Audit  (“COA”),  which  has  ruled  that  the  Malampaya  natural  gas  SC47   consortium   owes   the   government   P53.1   billion   (or   $   1.2   billion)   in   back  royalties.   COA   instructed   the  DOE   to   collect   the   alleged  under-­‐collection  of   the  government’s  share  for  the  period  2002  to  2009.    The   DOE,   including   its   predecessors   from   the   Bureau   of   Energy   Development,  Ministry   of   Energy   and   the   Office   of   Energy   Affairs,   has   represented   to   the  industry   that   the   service   contract   provides   for   a   sharing   of   60   percent   for   the  government   and   40   percent   for   the   consortium   after   deducting   allowable  expenses.  The   Philippine   government   assured   petroleum   service   contractors  that   though   they   are   not   exempted   from   payment   of   income   taxes,   the   taxes  would   be   part   of   the   60   per   cent   government   share.   COA   disputed   this  interpretation   arguing   that   if   it   were   to   follow   this   interpretation   then   the  government  would  be  receiving  less  than  the  mandated  60  percent.  Though  the  DOE  is  with  the  private  industry  on  this  issue,  the  retroactive  application  of  this  COA  ruling  is  another  manifestation  of  the  Philippine  government’s  propensity  to  change  the  rules,  particularly  on  taxation,  in  the  middle  of  the  game.      In  addition  to  these  game  changers,  the  Philippine  Petroleum  Association  of  the  Upstream  Industry  (Oil  and  Gas),  has  raised   issues  that  are  currently  hounding  

the   industry   which   includes:   Processing   time   and   bureaucracy   in   relation   to  approval  of  Tax  Exemption  Certificates;  Customs,   Immigration,   and  Quarantine  issues;   Effluent   standards   and   water   classification   regulations   by   the   DENR;  exploration   on   ancestral   domain   claims   and   free   prior   and   informed   consent  under   the   Indigenous  People’s  Rights  Act;   and  Amendment   of   Executive  Order  No.  556   to  provide   flexibility   to  Philippine  National  Oil  Company  –  Exploration  Corporation  in  farming  in  and  out  of  service  contracts.      Malampaya  Natural  Gas  –  Stimulus  for  the  LNG  Industry?    All  eyes  of  the  industry  are  now  focused  on  the  expiration  of  Malampaya’s  SC38.    The  outcome  of  the  negotiations  with  the  operator,  Shell  Philippines  Exploration  BV  (“SPEX”),   for   the  extension  of  SC38   that  expires   in  2024  will  determine   the  viability  of   a   liquid  natural   gas   (“LNG”)   industry   in   the   country.   It   is   estimated  that  the  Malampaya  gas  field’s  recoverable  reserve  end  of  field  life  is  3.08  to  3.29  trillion   cubic   feet   (“TCF”),   whereas   the   total   committed   quantity   under   the  current  Gas  Sales  and  Purchase  Agreement  is  2.7  TCF.  Total  production  as  of  June  2013   was   1.3   TCF.   The   Malampaya   gas   field   fuels   three   (3)   base-­‐load   power  plants   in   Batangas   with   a   capacity   of   2,700   megawatts   (MW)   representing  around  40%  to  50%  of  Luzon's  power  requirements.    In  October  2013  SPEX  publicly  disclosed  details  of  the  Malampaya  Phases  2  and  3  (MP  2  and  3)  of  the  Malampaya  Deepwater  Gas-­‐to-­‐Power  Project  involving  the  drilling   of   two   additional   production   wells   (MP2)   and   installing   a   second  platform  to  house  additional  compressors  for  depletion  compression  (MP3).    The  two   phases   have   been   estimated   to   cost   US$250m   and   US$750m   respectively,  and  were  targeted  for  completion  by  February  2014  and  December  2015.      SPEX  has  indicated  that  the  members  of  the  consortium  would  like  to  contract  up  the   remaining  gas   in   the   field  but   for   this   to  happen,   they  will  have   to   request  approval   of   the   extension   of   SC38   in   order   to   commit   the   investments   in  adjoining  areas  needed  to   firm  up  the  reserves.   Investments  needed  to   firm  up  additional  resources  would  take  time  to  plan  and  implement  and  the  consortium  would  need  the  certainty  that  the  contract  would  extend  beyond  2024  to  make  those   investments.   DOE   officer-­‐in-­‐charge   Zenaida  Monsada   said   SPEX   affirmed  the   request   for   extension   but  while  waiting   for   Shell’s   definitive   stance   on   the  matter,   the   DOE   has   advised   the   major   oil   firm   to   submit   a   formal   proposal.  Absent  such  formal  request,  Monsada  said  that  nothing  would  prevent  the  DOE  from   talking   to   other   interested   parties.   The  DOE   plans   to   bid   out   the   unused  banked   gas   from   the   Malampaya   gas   field   and   the   awarding   is   set   to   be  announced  in  November  2015.  The  banked  gas  is  set  to  be  extracted  by  the  end  of  2015  and  delivered  to  the  winning  bidder  beginning  Jan.  1,  2016  up  to  Feb.  23,  2024.  The  total  volume  of  banked  gas  may  be  able  to  run  a  400-­‐megawatt  (MW)  power  plant  until  2024.    Contracting  up  the  remaining  Malampaya  reserves  to  one  party  would  assist  the  entry  of  liquid  LNG  by  resolving  a  key  uncertainty  in  the  market.    The  party  who  contracts  for  the  gas  is  able  to  use  it  while  everyone  else  wanting  to  use  gas  now  knows  they  only  have  imported  LNG  as  an  option.  According  to  the  2013  report  

“Philippines  Natural  Gas  Master  Plan,  Phase  One  Report:  Assessment  of  the  Role  of  LNG  within  the  Philippines  Energy  Market”  prepared   for   the  DOE  by   the  Lantau  Group  (HK)  Ltd.,  there  is  a  reasonably  robust  economic  case  for  a  modest  (600-­‐800MW)  of  LNG-­‐fired  combined  cycle  gas  turbine  that  can  economically  dispatch  at  mid-­‐merit   capacity   factors   requiring  an   investment  of   about  US$300m   in  an  LNG   import   terminal   somewhere   in   Luzon.     Mid-­‐merit   plants   supply   the   gap  between  base  load  and  peaking  plants,  which  operate  during  peak  hours.      Establishing   an   LNG   industry   in   the   country   faces   an   uphill   battle   due   to   its  capital-­‐intensive  nature   involving   the  development  of  a  strategic   infrastructure  for  receiving,  storage,  transmission  and  distribution.  There  remain  challenges  in  bringing   LNG   into   the   Philippines   and   incentivizing   the   market.   Today   LNG  prices  simply  do  not  cover   the  capital   costs  of  new  plants.   If  non-­‐power  use  of  the  LNG,  like  an  alternative  fuel  for  transport,  can  ultimately  defray  some  of  the  initial   investment   costs   then   that   would   permit   more   power   capacity   to   be  economically  built.  In  the  short  term,  gas  demand  will  benefit  from  plunging  oil  and  gas  prices  and  its  increased  affordability.  But  the  long-­‐term  outlook  for  gas  is  not  so  clear  according  to  the  International  Energy  Agency.  The  competitiveness  of   LNG   versus   other   fuels   remains   a   key   demand  uncertainty.   It   is   difficult   for  LNG   to   compete   with   cheap   coal   and   falling   costs   for   renewables.   In   the  Philippines,  which  currently  resorts  to  cheap  and  quick  to  install  power  sources  without  internalizing  the  environmental  costs,  coal  remains  the  fuel  of  choice.  If  the   Philippine   government   adopts   stronger   climate   policies,   renewables   may  take  over  the  slack.    Conclusion    Behind  the  seemingly  relentless  supply  of  oil  coming  into  the  market,  companies  and   host   countries   need   to   revaluate   their   upstream   energy   strategies.  Companies   are   refocusing   on   core   assets   while   putting   large   investments  through   a  much   tougher   vetting   process.   Amid   tight   cash   flows,   marginal   and  low-­‐return  projects  will  be  have  to  be  placed  in  the  back  burner   if  not  outright  cancelled.  The  Philippines  still  have  to  hit  the  elusive  black  gold  bonanza  outside  of   the   Northwest   Palawan   basin.     Deepwater   petroleum   resources,   which   the  Philippines   hope   to   strike   big,   are   fraught   with   technical   operational  complexities,   cost   enormous   sums   of   money,   and   threatened   by   externalities  arising   from   the   conflict   with   China.   Instead   of   clouding   the   service   contract  system  with  its  resource  nationalism  tendencies  and  bureaucratic  inefficiencies,  the  government  must  ensure   that   companies  have  contractual   stability   in   their  high-­‐risk  investments.      

Fernando  “Ronnie”  Penarroyo  is  the  Managing  Partner  of  Puno  and  Penarroyo  Law  (fspenarroyo@punopenalaw.com).  He  used  to  work  with  the  Oil  and  Gas  Division  of  the   Department   of   Energy   as   a   geologist.     He   is   currently   involved   in   numerous  petroleum   exploration   and   development   projects   advising   both   local   and   foreign  energy  companies.