[NGW Magazine] Ecuador changes upstream terms

This article is featured in NGW Magazine Volume 2, Issue 21

Ecuador’s contract shift marks a major step for the stagnating upstream sector and a break from the past, as it returns to production-sharing agreements in order to regain the foreign investment its economy needs.

Ecuador’s recent decision to return to production-sharing contracts (PSCs), which were abandoned seven years ago under a previous government, could be a major step for the country’s E&P sector but the change is long over-due and challenges remain, experts say.

The government said in October that from that month it plans to bring back so-called ‘participation’ contracts – as they are known in the country – that are known elsewhere in the industry as PSCs. PSCs work by giving the operator ownership of the share of oil or gas they have extracted.

The previous government of Rafael Correa got rid of the PSC model in 2010, in a move that some say was damaging to the development of the Andean nation’s energy industry – particularly since it deterred private companies from wanting to undertake upstream work there.

Instead, Correa brought in service contracts – a model that works by giving private companies a fixed tariff per barrel of oil extracted. PSCs have been written into Ecuadorean law as an option, but only recently has the government decided to revive them, the country’s oil and gas minister Carlos Perez said in a document posted on the oil and gas ministry’s website.

Service contracts have not proved to be an effective means of boosting exploration and, as a result, oil reserves at privately-operated fields have not increased significantly in recent years, Perez added.

The government hopes to “encourage investments in the hydrocarbons sector by shifting the perspective from state-driven investments with financing aid, to direct private investments with support of the state,” he said. PSCs are more flexible and are more adaptable to varying market conditions.

Experts say that the change spells positive change for the sector. “The previous service model never worked in Ecuador and has never properly incentivized production in any country,” a Houston-based partner at US law firm Mayer Brown, Jose Valera, told NGW.

“As a consequence of this model, exploration suffers, there is no proper replenishment of reserves, and the reserve base of a country sinks. It is not the kind of contract that attracts E&P companies,” he added.

The government said the PSC model would be reinstated during two upcoming licensing rounds, called Intracampos and Sur Oriente. The first round is due to take place in November. Eight areas, all in the centre and south of the Latin American country, will be up for grabs during the Intracampos round. 

The fields, which are largely unexplored but close to existing production facilities, have estimated reserves of up to 610mn barrels and investment is expected to reach $1.25bn. Meanwhile a total of 16 blocks will be on offer at the Sur Oriente round, which is due to be held in the second quarter of next year.

The Sur Oriente areas – which extend over an area of around 27,000 km², are close to Block 192, the largest oil block in neighbouring Peru. However reserves at Sur Oriente are still unknown. The area “potentially has huge reserves” but they still need to be determined, the oil and gas ministry indicated.

The new model could represent a major boost for Ecuador’s struggling E&P sector, in a country so dependent on crude revenue, said Valera. “Ecuador’s production has been fairly stagnant within a narrow band for some years,” he said.

The smallest Opec member, Ecuador has struggled with low global oil prices over the last three years, and investment has taken a hit.

Before the crash in prices in mid-2014, most of the investment in Ecuador’s energy market was limited to Chinese banks and energy markets which signed a series of oil-for-loan deals with Quito, leaving the country with a large amount of debt. However falling oil prices since 2014 forced Correa to try to attract more private investment into the sector, resulting in a shift away from resource nationalism and towards private investment as it tried to find alternative sources of financing to support its faltering economy.

Formerly isolated from the international capital markets, Quito became increasingly-investor friendly. In 2014 it signed a trade agreement with the European Union. In 2009, it had refused to sign a similar agreement. That pro-business attitude was heightened with the appointment of Lenin Moreno as president in March of this year.

One of his principal aims is to encourage foreign companies to invest in Ecuador’s energy industry, especially through reducing regulatory barriers to foreign investment. “Moreno’s government is taking a more pragmatic approach,” said Valera, noting that the previous government was ideologically committed to the service model.

“The service model was put in place in a context of rising prices and the state wanted to maximise its profit,” he commented. However in doing so, the government wasn’t thinking about the longer-term development of the country’s energy sector, he said.

When the service fee model is used, there is little progress with exploration and reserves are not replenished, he said. This is because companies are attracted to fields that are low risk and have been explored before, preferably by a private company, he added.

Now it has become clear that a change is needed because of the fiscal needs of the country but also because low oil prices are persisting, he said. However, the return to PSCs will not immediately solve Ecuador’s damaged relationship with private companies, Valera warned. The country “does not have a good track record in the manner in which it has dealt with companies in the E&P sector,” he cautioned.

The service fee model was imposed on companies and – under threat of expulsion from the country – some changed to the new model, while others left the country completely, he said. “It’s a tall order for Moreno to bring industry back. It is going to be a challenge for Ecuador to go back to industry and say ‘this model is more conducive to doing E&P work here,” he added.   

Another rising pressure on Moreno’s government is its relationship with OPEC, which has come under strain recently due to commitments to reduce oil output that Quito agreed last year with its fellow members.

Now Ecuador is keen to cut back on those commitments, as it believes it is not in the country’s interest to lower oil production. Negotiations with Opec are another burden on the president, and the issue needs resolving before Quito can seriously consider increasing production.

The revival of PSCs is nonetheless a strong sign that Moreno’s government wants to make lasting changes to the industry, and is prepared to take practical steps to make that happen.

Sophie Davies