"Don't steal—the government hates the competition."

That's one of my favorite quotes. It works for just about every country (the United States is a good example), but Argentina is what's on the table here.

The story of Argentina's handling of its oil sector is stunning in its ineptitude and contains more flip-flops than a California beach.

Argentina's oil history begins with small-scale exploration in the late 19th century. The first discovery occurred in 1907, near a village on the coast in arid Patagonia, far to the south in a country that's nearly twice the size of Alaska. Explorers were looking for water.

By the early 1900s, the country's economic growth was taking off, and by the time World War I started, it had catapulted itself to tenth in the world in terms of wealth per capita.

The Argentine government at that point produced alongside private companies. It soon found this arrangement disagreeable, however, as the aims of the state and the for-profit companies differed considerably.

The government's solution was to reorganize its enterprises in 1922 into the national oil company Yacimientos Petroliferos Fiscales (YPF).

YPF played nice for a while, but in the 1930s began to slowly expand its reach in zones with higher potential, leaving the scraps for the international oil companies (IOCs). Not surprisingly, the IOCs began to shun Argentina's upstream sector.

Oil investments continued to dwindle through the 1940s and '50s. The nationalist government won few friends during World War II with its position as officially neutral and unofficially sympathetic to the Nazi regime.

The populist government of Perón that followed didn't do any better; constitutional reform in 1949 declared Argentina's resources to be an inalienable property of the nation—a slap at private oil companies, especially the Seven Sisters (the seven biggest oil companies in the mid-20th century, including Royal Dutch Shell, Standard Oil of New York and California, and Texaco).

To make matters worse, much of the profits made by the government in the oil sector found their way into the national treasury rather than back to YPF. The national company had less money available to reinvest into its projects, and—again, not surprisingly—production capacity deteriorated significantly.

Broken Record

The next 40 years didn't help Argentina's position on the world oil scene, as political instability led also to an unstable legal framework for the hydrocarbon industry. Military and civilian governments constantly repealed each other’s policies regarding private investment in the oil and gas sector.

Reasonably successful economic discoveries came in the 1960s and '70s, but continued intervention from the Argentine government meant that sustained development was difficult. IOCs saw through the sham of several attempts to court foreign capital—most of the new laws and regulations disproportionally favored YPF. Oil production and reserves stagnated as a result.

YPF finally began to realize around 1990 that it would need to let the operators own some of the oil in order to attract any sort of investment.

Buenos Aires went a step further in 1993 when it privatized YPF. The move brought in a flurry of foreign investors, including IOCs. Investments in the upstream sector quickly doubled in less than a decade.

Then came yet another wrinkle in the welcome mat. Just because YPF was private didn't mean that the government was any more accommodating to the oil and gas sector. This, combined with low oil prices worldwide, meant that exploration expenditures quickly dropped off.

Things got worse with Argentina's economic depression between 1998 and 2002, when the government defaulted on its national debt and unemployment reached as high as 25%.

When Spanish firm Repsol SA put out an offer in 1999 to purchase 98% of YPF for US$15 billion, analysts cheered. The move was a win-win, they said: Repsol was a company that could guide Argentina's oil sector onto the right path.

And along came… another flip-flop. A series of decrees from the economic ministry raised the export duties levied on oil higher and higher, as high as 45% in 2004. These huge taxes significantly hampered any sort of development.

Between 1999 and 2004, through these taxes, royalties, and regulations, the government slowly increased its take from 30% to more than 70%. You can see what happened to production:

Hard as it might be to believe, worse was yet to come. In November 2007, the ministry decided to set the domestic price of oil at US$42 per barrel—at a time when the spot price was more than double that at US$95 per barrel.

Argentina's oil woes seemed to have finally come to a halt in 2011, when Repsol-YPF announced the massive Vaca Muerta shale discovery in the province of Neuquén, near Argentina's border with Chile. The size of the field is truly spectacular: the EIA estimated the formation to contain more than 15 billion barrels of oil and more than 300 trillion cubic feet of natural gas.

Argentina looked poised to reverse its downward trend in production. Instead, in April 2012 President Cristina Fernández de Kirchner made perhaps the worst decision in the country's long history of bad decisions.

In a massive cash grab, she announced that Argentina would nationalize 51% of YPF, claiming that Repsol had not done enough to invest in Argentina. No ifs, ands, or buts. The measure passed among lawmakers with overwhelming enthusiasm.

Repsol and Spain were understandably incensed, and many other firms exploring in the country began to fear for their own futures as well. Investments began to plummet again.

The Situation Now

Thankfully for Argentina, the Vaca Muerta discovery is so significant and so economically alluring that even the country's transgressions from the legislative side haven't dissuaded all its suitors.

In July 2013, Chevron (CVX) signed a US$1.24 billion deal with Argentina's YPF to drill 100 wells in the basin in the first stage of development and up to 1,500 in total. The company plans to be producing 80,000 boepd from Vaca Muerta by 2017.

To Argentina's credit, the government has now made it slightly easier for companies to earn more from their export activities. It's cut export and withholding taxes, and has even allowed oil developers an exemption from the tough foreign earning repatriation laws in Argentina.

Thanks to these new regulations, interest is once again beginning to pick up in not just Neuquén Province, but across the country.

It's time to dig deep under the skin of Argentina's hydrocarbon industry.

The Dead Cow Means Business

The immense Vaca Muerta discovery (yes, that would be the "Dead Cow" discovery) has lured companies back into Argentina to look for oil and gas. The number of exploration meters drilled in the country in December 2013 was more than four times higher than in the same period in 2010.

Nearly 60% of this exploration is being done in the province where the Vaca Muerta shale is located, Neuquén, which happens to also be the third-largest hydrocarbon-producing province in Argentina. Indeed, Argentina estimates it will need roughly US$300 billion over the next six years to develop the basin. That said, this truly is a world-class shale basin from a geological standpoint.

The Chevron deal in July 2013 brought plenty of other suitors to the table, with many major companies signing important joint venture (JV) agreements—investments that Argentina needs. Though these deals are smaller than the US$1.24 billion and more than 1,500 wells planned by Chevron, each comprises an important step forward.

Other important steps are coming from changes to Argentine tax law. Under the new regulations, companies that invest more than US$1 billion over five years in Argentina will be allowed to export 20% of oil and gas tax-free. They can also keep their export earnings offshore and won't have to repatriate them back into Argentina.

These changes create a disproportional advantage for larger companies that can invest large sums of money over a long period of time. Smaller companies will not only have to contend with lower oil prices (meaning lower netbacks), but also with the strict currency control systems that Argentina has in place. Given that Argentina is facing an inflation problem at the moment, this could be a significant disadvantage.

There are a few juniors in the game, such as Americas Petrogas (BOE.V) and Madalena Energy (MVN.V). Argentina is really a major's playground, though, so growth for smaller companies will depend on their ability to package themselves for sale to larger ones.

Offshore exploration exists, and a few permits have been issued, but right now all eyes are on the Vaca Muerta shale and the Argentine government's determination to develop those resources. Offshore drilling is further complicated by the fact that much of the potential reserves lies near the Falkland Islands, an area claimed by both Argentina and Britain.

Argentina's Production—Heading into Windfall Territory

Argentina's oil production is currently concentrated in two southern provinces: Chubut (28%) and Santa Cruz (22%). Neuquén sits in third place at 19%. All of the production has been conventional, though that will change as Vaca Muerta begins to ramp up production.

Only a few companies control most of the oil supply. In fact, the top 10 producers in Argentina produce more than 94% of the oil.

The new tax laws, which favor larger companies, will help exacerbate this trend, as smaller companies will most likely not be able to pony up $1 billion over five years.

The gas situation is similarly top-heavy—dominated by a few large firms. However, from a revenue perspective, the gas producers have been given an absolute windfall from the Argentine government. In February 2013, the government raised the natural-gas price paid to producers from $2.50/MMBTU to $7.50/MMBTU, triple the price from just two years ago.

Obviously, the government has realized that it's cheaper to encourage foreign capital to produce domestically rather than continuing to rely on expensive gas imports.

Argentina has the highest per-capita usage of natural gas in South America (stemming from its natural-gas power plants), almost eight times higher than neighboring Brazil. A cheaper source of natural gas would greatly decrease energy costs in the country and boost industry.

The Fiscal System Is Improving

On the surface, Argentina appears to have a very good fiscal structure. It has a 12% tax-deductible royalty and a corporate income tax of 35%. Typically, this would put the country near the top when it comes to government take. However, Argentina has one of the most stringent export taxes in the world.

If the WTI price is between US$45/bbl and US$80/bbl, the export tax is 45%. When the oil price rises above US$80/bbl, the maximum price an oil company can receive for its oil is US$70/bbl, regardless of how high the global oil price is.

This is already a significant improvement over what it was just early last year, when the maximum oil price for producers was set at US$42/bbl. This price was set in 2007 in order to curb exports, but instead had the opposite effect of reducing production altogether.

More Than 36,000 Kilometers of Pipelines

Oil and gas infrastructure has been steadily increasing in the country over the past few years. Thanks to decades of past production, service companies stand at the ready. More oil drill rigs are operating in the country right now than at any time within the past 10 years:

Argentina has more than 6,000 km of oil pipelines, with most of the system carrying oil from Neuquén province to Bueno Aires, Chile, and two other ports on the east coast of Argentina. YPF, Sinopec, and Total own various parts of the pipeline system.

As for gas pipelines, the network is extensive, with over 30,000 km of pipelines laid. The two main companies that control it are Transportadora de Gas del Sur (TGS) and Transportadora de Gas del Norte (TGN).

The Argentine government did promise to YPF a railroad to connect the Vaca Muerta to the rest of the country. No plans to ship oil, however—its planned 81 carriages and two locomotives will primarily ferry goods and equipment from Buenos Aires.

Argentina has a refining capacity of roughly 800,000 barrels per day, about the same amount of oil production that it had in 2012. Its refining capacity, nevertheless, is still insufficient to satisfy domestic demand, and the country plans to import 6.3 million barrels of gasoline and 44 million barrels of diesel next year. Refineries total 11, but only four have a capacity of greater than 100,000 barrels per day.

What you just read was an excerpt from the current issue of the Casey Energy Report. As dysfunctional as the government may be, the Vaca Muerta discovery is big enough to make it worthwhile for international oil companies to deal with the obstacles… and for investors to take a second look.

The Casey Energy team found a low-risk way to play the massive potential this vast Argentine oil field presents—it’s a company with a market capitalization of US$140 billion and global production of 2.3 million barrels of oil equivalent per day.