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Ecuador Oil: What’s Next?

Will foreign oil companies agree to radical changes in their Ecuador contracts before the March 8 deadline?

Inter-American Dialogue

Ecuadorean President Rafael Correa [has] set a March 8 deadline for oil companies to agree to changes in their concession contracts. What are the chances the companies will agree to the changes in that timespan? Will they swallow hard and make concessions, pack up their bags and leave the country, or find some middle ground with the government?

Hernando Otero, senior associate at Appleton & Associates and Liliana Diaz, Principal at 1492 LLC: Sometimes it is necessary to make the best of a bad situation. International oil company contracts in Ecuador were on uncertain ground before President Correa's term. Back in April 2006, an amendment to the existing Hydrocarbons Law declared the state was entitled to a share of the extra revenue of oil sales in excess of contractually negotiated prices under existing production contracts. A second piece of legislation—a July 2006 decree issued by former President Palacio—provided the state's share of that revenue to be 50 percent. Consequently, since coming to office President Correa has increased the stakes by augmenting that share to 99 percent in October of 2007. What is certainly favorable, if anything, from President Correa's approach is that his government is open to renegotiating existing agreements to convert them into purely service contracts where international oil companies operate as mere contractors in exchange for a fee. This of course is an equally unpalatable option that denies affected companies the right to book reserves. However, refusing to consider any alternatives other than demanding that original production contracts be respected may leave international oil companies pursuing this option, without a viable piece of the oil business in Ecuador. City Oriente's decision to file an international arbitral claim in October 2006 has allegedly brought about criminal complaints against its officers for embezzlement.

Roger Tissot, Director of the Markets & Countries Group at PFC Energy: According to a recent report by insurance company AON, Ecuador presents one of the highest risks to investors. This should not be a surprise due to Ecuador's recent history of constant political and regulatory uncertainty, added to the risks to operations caused by local communities' opposition to oil activities in the Oriente region. However, despite all these problems, oil companies have expressed their desire to continue operating in Ecuador,
and are willing to work toward a negotiated solution, according to Rene Ortiz, president of Ecuador's private oil companies' association. Although Ecuador's oil potential is dwarfed when compared to Venezuela, the country still offers attractive options: an existing infrastructure able to transport oil from the Amazon to the Pacific coast, large known reserves that can be developed, such as the ITT project, and, until recently, relatively attractive fiscal terms. Since the oil business is often about location, international oil companies (IOCs) would rather find a negotiated solution than pack up their bags and leave the country, leaving behind large investments and wondering where else they could replace those known reserves. Moreover, IOCs must be aware of the management and operational limitations of Ecuador's national oil company (NOC), Petroecuador. In fact, according to local media reports, Petroecuador never had any quality control process. The government has even denounced the culture of corruption that has been prevailing in the company for years. Without a viable NOC, and due to the significant economic impact oil has on government revenues, President Correa's options are limited. Compensating for Petroecuador's technical and management limitations through NOC-NOC deals poses its own problems. PDVSA, the likely partner, has many problems of its own in Venezuela, where President Chavez faces inflation pressure, declining oil production, and increasing political discontent from a very important segment of his own constituency: the urban poor. As such, PDVSA will be under increasing pressure to address Venezuelan problems, perhaps at the cost of international ventures. The other NOCs, from China or other importing countries, will be willing to expand investments in Ecuador as long as new fiscal terms allow them to meet their rate of return expectations. Perhaps these companies may be more flexible than IOCs regarding government expectations vis-à-vis the sharing of the petroleum rent, but they will demand stability in fiscal terms. Thus, I expect IOCs and the government to find a middle ground in their negotiations.

Patrick Esteruelas, Latin America Analyst at the Eurasia Group: Ecuador has pushed for very aggressive terms, but enjoys little leverage due to its low reserves and lack of attractive opportunities and could be forced to roll back its demands. Correa gave companies two alternatives. They can either stick with production-sharing agreements and continue to turn over to the state 99 percent of any windfall earnings above an average baseline price of $24 per barrel, or they can agree to switch to new service contracts and relinquish all equity. Companies will consider neither option. Continuing to pay 99 percent of
their windfall earnings to the state will make their operations unviable, and they have no faith that they will be properly compensated and reimbursed for investment costs which run upwards of $1 billion if they switch to service contracts. While Correa has set a very high bar publicly, the government has behind closed doors laid out the possibility of a compromise that would preserve a minimally acceptable profit margin for private companies. At the end of last year, Ecuador's Constituent Assembly approved a broad new tax bill that includes a 70 percent windfall revenue tax on new oil and mining contracts above a price benchmark to be negotiated individually. Under the auspices of the new law, the government could conceivably lower the existing windfall tax on foreign oil companies from 99 percent to 70 percent, and negotiate a new higher base price that could limit how much the companies will end up contributing to the state.

Jose Valera, Partner at King & Spalding LLP: In general, I anticipate that the companies are more likely to stay than to go, and that agreements will be reached by the deadline. At present, the government has set up negotiating teams with City Oriente (US), Petrobras (Brazil), Perenco (France), Repsol-YPF (Spain), and Andes Petroleum (China). These are the largest private-sector companies currently
operating in the country. President Correa has stated that the companies have three options: they continue under the present contract regime but are subject to the 99 percent extraordinary oil profits tax; they convert their contracts to service agreements; or leave the country. If the companies choose to leave the country, all they will be left with is a claim for damages. If they stay, they maximize opportunities to recover investments made. It's a matter of making the best choice out of a bad situation. The government clearly prefers the conversion of existing contracts to service agreements, under which the companies would not acquire ownership of production at the wellhead and would be paid a fee and cost reimbursement in cash. The companies too may be inclined more toward this option, given that the 99 percent extraordinary oil profits tax makes further operations uneconomical in large part. In any event, however, the government is asking for a waiver of all rights to dispute resolution under the auspices of the ICSID. The government wants all investment or contract disputes be heard by Ecuadorean courts now on.

Republished with permission from the Inter-American Dialogue's weekly Latin America Energy Advisor newsletter. 

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