Ecuador: Correa's Play for Greater Influence in the Oil Sector
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Today I'm sending you a piece on Ecuador's recent move to change the terms of its contracts with oil investors to keep more of the returns in the state. As we watch the world's energy market, political details like this are essential to know. The article explores the geopolitical implications of the move and the how key investors are likely to react.

This is nothing short of the real world with real consequences on the amount the meter reads to fill up your gasoline tank, your investments abroad and the overall worth of those dollar bills in your wallet right now. You don't get this kind of information on your typical media news networks. The truth is, this event is one you may not have heard about - not only do you have to keep your ears to the ground, you've got to know where to look.

For all things under the radar and overly important, my source is STRATFOR. They provide in-depth intelligence for those that need to know. Read their article, and join their email list to get weekly reports and special discounts on memberships.

John Mauldin
Editor, Outside the Box


Ecuador: Correa's Play for Greater Influence in the Oil Sector

April 21, 2010

jmotb042210image001

RODRIGO BUENDIA/AFP/Getty Images
Ecuadorean President Rafael Correa (R) and Venezuelan counterpart Hugo Chavez
at a press conference in Quito, Equador, on March 26

Summary

Ecuadorean President Rafael Correa is pressuring foreign oil investors to change from production-sharing agreements to service contracts, or else face expropriation. Correa is looking to enhance the state's authority over oil revenues and thus enhance his own political security, but is making the move at the expense of Ecuador's long-term economic development.

Analysis

Foreign oil executives are making their way to Quito, Ecuador, to try to work out a compromise over oil production contracts with Ecuador's left-leaning president, Rafael Correa. The small Organization of the Petroleum Exporting Countries (OPEC) member is pressuring foreign oil investors to change the terms of their contracts with the goal of bolstering the state's authority over the oil sector. The foreign firms currently operating in Ecuador will likely acquiesce to the new terms to keep production running at a minimal rate, but these contractual changes are liable to come at the expense of Ecuador's long-term investment growth.

Correa is an economist by training who has frequently expressed his disillusion with market reforms in Latin America and believes economic power should reside within the state. He has been trying since 2007 to change foreign oil contracts from production-sharing agreements, under which the foreign producers can have partial ownership of the fields they operate, to servicing contracts, under which the producers would have to pay a production fee and then get reimbursed for the cost of their investment. In the latter scenario, the state ends up getting more revenue for itself and the producer ends up making less money overall since it can only make profits from remuneration fees - the amount per barrel that the government is willing to pay companies for producing its oil. In other words, the foreign companies incur the risk of investing resources into a project with none of the potential rewards associated with high oil prices. If the foreign oil companies do not agree to the government's terms, Correa has threatened to push for new legislation that would allow the state to expropriate the oil fields.

Naturally, the expropriation threats have spread concern among investors who have watched Ecuador expand state authority over the country's resources to beef up its coffers, and thus politically insulate the regime with populist-driven handouts to the poor. Correa will certainly benefit from having more of Ecuador's oil revenues at his disposal than in the bank accounts of foreign oil firms, but he also risks hampering the country's overall economic growth. Balancing between the benefits of short-term political capital and long-term economic risks will not be easy, particularly when the president is already struggling to revive the economy as investment flows are declining and domestic consumption remains weak. Moreover, the indigenous community that Correa claims to represent is showing stronger signs of coordinated opposition to the already politically embattled president and are now latching onto a controversial water law to corner Correa on his environmental defense policies.

Ecuador's economy depends heavily on its oil sector, which accounts for roughly a quarter of gross domestic product, 68 percent of total export earnings and 35 percent of fiscal revenues. The country is exporting about 470,000 barrels per day (bpd) of oil this year - down from an average of 503,000 bpd in 2009 - and has proven crude reserves of about 6 billion barrels. Ecuador exports a heavy sour crude called Napo and a medium-heavy, medium-sour crude called Oriente that is produced in the northeast of the country. Though Ecuadorean crude is of a better grade than Venezuela's, Ecuador has to incur a higher transport cost to ship the crude across the Andes to the Pacific coast for export. As part of its proven crude reserves, Ecuador has an estimated 900 million barrels (and 1.3 billion barrels of potential recoverable reserves) in the Ishpingo-Tapococha-Tiputini (ITT) block in the Amazon rainforest. The crude in this region, however, is a lot heavier than the country's other grades and would thus require more technical skill to extract. The Ecuadorean government would also face heavy resistance from its well-organized indigenous community regarding the environmental cost of exploiting those reserves.

The foreign companies currently operating Ecuador's oil fields in the northeast include Brazil's Petroleo Brasileiro (Petrobras), Spain's Repsol YPF, Italy's Eni and Chinese consortium Andes Petroleum (led by CNPC and Sinopec Corp). These firms produce 42 percent of Ecuador's oil, while state firms Petroecuador, Petroamazonas and Rio Napo handle the rest of production, albeit with far less technical skill. Ecuador has yet to publicize the remuneration fee it would be willing to pay the foreign firms in new service contracts, but one draft agreement calls for the state to retain at least 25 percent of gross income from extracted oil sales. The details of these negotiations are now being worked out between foreign oil executives and state officials in Quito as the threat of expropriation lingers.

Many of these companies have reason to take Correa's expropriation threats seriously. After the state took over U.S. oil company Occidental Petroleum's assets in 2006, claiming the firm's contract had expired, Correa further raised investor fears in late 2007 when he imposed a 99 percent windfall revenue tax on foreign energy firms to help make up for the state's commercial bond debt obligations. That move led to a number of arbitration suits at the World Bank's International Center for Settlement of Investment Disputes. Ecuador has also expropriated two blocks belonging to Anglo-French oil firm Perenco over tax disputes.

Now operating under the state's growing shadow, foreign oil companies that have stuck it out in Ecuador thus far are measuring the costs and benefits of their future investments. The companies that do stay will likely do so for either geopolitical purposes or basic economic need, but will not be inclined to further Ecuador's long-term oil growth.

China's Andes Petroleum consortium has a relatively simple and direct objective: It needs crude to support Chinese industrial growth, and is willing to go to the ends of the earth and into unappealing investment climates to get it. The Chinese do not bring substantial technical expertise to the table, but will be the most willing to negotiate terms with Quito so that they can continue extracting oil. Spain's Repsol, on the other hand, is a heavily state-influenced company that will often make energy decisions that give more weight to Madrid's foreign political interests than to its own economic rationale. Acting as a foreign policy arm, Repsol is likely to agree to Correa's contractual demands to allow Spain to maintain a high level of engagement in Latin America. Brazil's state-owned Petrobras sees itself as the continental energy power of the future and carries a geopolitical ambition to saturate the Latin American energy sector as a way of extending Sao Paulo's influence. Profits are thus not likely to factor as heavily into Petrobras' negotiations with Quito. Ecuador is likely to face the most resistance from Italy's Eni, a firm that is far more politically independent and will be more concerned about its bottom line in Ecuador.

The Ecuadorean government will use expropriation and extended operating contracts as the stick and carrot to try to coerce foreign firms into signing service contracts. Unless the government offers an attractive per barrel remuneration fee - and indications thus far suggest this is not the case - most firms are likely to settle reluctantly on the new contractual terms to remain in country and maintain minimal production. However, they will no longer have the incentive to invest further in exploration and deep drilling, particularly in the technically more complex fields in the Amazon. New investment will also be difficult to come by, as investors grow more skittish because of these regulatory shifts. These moves against foreign oil firms will affect the country's future economic growth, particularly as oil production declines and harder-to-tap fields need to be extracted. But as Correa says, for every minute that passes without signing the new contracts, "there are millions of dollars going to these companies." Those millions of dollars are political capital lying in wait for the Ecuadorean state.


Disclaimer

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Posted 04-22-2010 2:06 PM by John Mauldin