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More investment needed

Faced with a mountain of foreign debt, Ecuador needs new private-sector investment if it is to keep raising oil production—a cornerstone of government revenues. But foreign firms are still wary of the unstable Andean nation, writes Robert Olson

GOVERNMENT officials are talking of a crisis in the oil sector, despite production surpassing 0.5m barrels a day (b/d) for the first time in the country's history, in January. State-owned PetroEcuador's production is falling, although the companySouth America's third-largest oil firm—posted record profits of $1.3bn in 2003.

With the completion of the new 450,000 b/d OCP heavy-oil pipeline, rising production from heavy-oil fields operated by privately owned companies has more than compensated for the declines at PetroEcuador. But, as the result of under-investment in the upstream sector by private oil producers, OCP throughputs are only around 200,000 b/dfar below the 390,000 b/d predicted when operations began on the $1.1bn project.

Huge foreign debt

Grappling with a huge $11bn of foreign debt, the government is trying to raise revenues while paring its fiscal deficit, as part of a financing deal with the International Monetary Fund. Oil exports already account for a third of government revenues and lifting oil production is the easiest and least painful way for the government to improve its finances. The administration of President Lucio Gutiérrez is committed to raising oil output to 0.613m b/d by 2007, which would place Ecuador in the same league of Latin American oil producers as Colombia. Such an increase would increase the value of oil exports to $3.3bn if oil prices stood at $18 a barrel—far above the $2.37bn earned in 2003, based on significantly higher prices. Total production in Ecuador averaged 0.52m b/d in the first half of this year, with 191,000 b/d coming from PetroEcuador and private firms (including those that produce for PetroEcuador) pumping the rest.

Accomplishing this goal means the government must reverse the slide in production at PetroEcuador, while encouraging new private investment. It is unlikely to be an easy task. Privately owned companies are interested, but remain cautious. Stifling bureaucracy, rapidly shifting oil policy and a nagging $200m tax dispute weigh heavily on plans for new investments.

And although the government is open to more private-sector participation in the oil sector, nationalists are unhappy with plans to lower taxes and royalties, while environmentalists are opposed to expanding oil production in the sensitive Amazonian basin. Indigenous peoples also actively oppose oil operations, both for environmental reasons and because they receive few benefits, such as jobs and income, from upstream activities.

There is little doubt that Ecuador is an under-exploited oil province with sufficient reserves to support such an increase in output. The country already boasts 4.6bn barrels of reserves—far more than neighbouring Colombia—and untapped unconventional heavy-oil fields could add at least 0.7bn barrels. However, developing these reserves to raise production will need billions of dollars.

A study commissioned by Andean Development Corporation and InterAmerican Development Bank concluded that Ecuador could raise output to 0.73m b/d by the end of the decade, but that this would require $5.8bn. The private investors that backed the OCP pipeline claim that at least $8bn is needed to raise output to the combined 0.85m b/d capacity of the OCP pipeline and PetroEcuador's Sote pipeline. These figures are far out of the reach of the government, meaning that privately owned firms would have to fund almost the entire capital-investment programme.

At present, the main focus is on helping PetroEcuador to reverse its falling production. The company has suffered from steep budget cuts as the government has tried to close its budget deficit, but the resulting lack of exploration and maintenance on its upstream assets has left the firm exposed to natural decline rates at its five main fields. Several attempts in the last two years to bring in privately owned firms to help redevelop these fields have foundered amid opposition from PetroEcuador's unions, or unattractive investment terms.

The government is trying to push a reform to the Hydrocarbons Law through Congress that would allow PetroEcuador to sign association contracts with privately owned companies. The private-sector firm would take over operation of one of PetroEcuador's fields and would share any increase in output above an agreed baseline with the state-owned company. PetroEcuador would receive a minimum 35% interest in the field, with its share of output rising when oil prices rise above a certain agreed level.

'This looks to be a workable model, but, as always, the devil is in the details. Baseline production is an extremely flexible idea and arriving at a number that is acceptable to both parties will not be easy,' remarks an executive at one of the privately owned firms operating in the country.

In late July, the government withdrew from Congress a bill proposing these changes, because of opposition to it from lawmakers. But cabinet officials say similar legislation, which they argue is vital to reversing PetroEcuador's declining production, will be proposed before the end of the year. If the government's desired measures are pushed through, it hopes to move quickly in tendering at least three of PetroEcuador's main fields—Shushufindi, Lago Agrio and Culebra-Yulebra, which together hold some 0.85bn barrels of proved reserves.

Under-investment

But complicating matters is the under-investment in these properties that means their output may already be below their proposed baseline level. Although the operating contracts set out a procedure through which the privately owned firm can recover the investment needed to return to the proposed baseline level, investors are unconvinced.

'If PetroEcuador doesn't have enough money to invest in its fields, how do we know they will have the money to pay us back if we do?' says the oil executive.

Despite the unresolved problems, bringing in private-sector companies could see 50,000-70,000 b/d added to PetroEcuador's production within two years as the operators drill badly needed new wells and replace ageing infrastructure, say PetroEcuador and the government. Should the first three fields be tendered successfully, the other two main fields, Libertador and Sacha, with a combined 0.51bn barrels of reserves, would quickly be opened up to the private sector.

Whether privately owned companies are interested in investing in Ecuador is another question. The country's notoriously unstable governments make predicting future policy difficult. Making matters worse, big firms active in the country are embroiled in a $200m tax dispute with the government, which decided in 2001 that oil companies were no longer entitled to VAT refunds, which other exporters receive. In response, the firms are reviewing their investment plans and some have opened arbitration proceedings against the government.

The companies in the OCP consortium, however, face a significant dilemma. The firms signed ship-or-pay commitments for most of the capacity of the pipeline. These commitments in turn underpin the financial structure of OCP. As a result, OCP is financially healthy, despite heavy-crude output falling far below what had been expected when the project was first conceived. Upstream firms are absorbing significant losses on these contracts, which stretch out for 15 years, and some must either abandon their investments or sink more capital into their properties to reduce their exposure to the OCP contracts.

Facing losses

The local unit of Brazil's Petrobras is facing multi-million dollar losses because of delays in starting production from block 31, where development costs have been estimated at $0.8bn. The company had hoped to begin early production of 40,000 b/d this year, but this target has been pushed back until 2006 because of a lack of infrastructure in the area.

In the meantime, Petrobras must pay over $60m a year to OCP under an 80,000 b/d ship-or-pay agreement. The company wrote off some $100m of its investment in the block in 2003 and expects to record further losses in 2004. Petrobras is looking for a partner or buyer for the property.

Repsol YPF, which holds a 100,000 b/d ship-or-pay commitment with OCP, produced only 10,000 b/d in 2003, but the company constructed production facilities at block 16 that should permit the firm to quickly lift output to 75,000 b/d, although output levels depend on the government agreeing to extend some of Repsol YPF's concessions. The Spanish firm booked a Euro162m ($199m) loss in 2003 related to its Ecuadorian holdings.

Eni is also facing losses, as it is struggling to lift output at its wholly owned block 10 to the 60,000 b/d specified by its ship-or-pay contract with OCP. The Italian company is also said to be looking for a buyer for its Ecuadorian assets.

However, not all the firms involved in OCP are doing badly. Two of the biggest private investors, Occidental Petroleum, of the US, and Canada's EnCana, are set to post significant increases in output this year. Occidental is targeting a 30,000 b/d production increase in block 15 this year, which will take the block's output up to 75,000 b/d. And EnCana hopes to top 75,000 b/d this year, up sharply from 51,000 b/d in 2003, although much of this rise will come from block 15, where Occidental is the operator.

Meanwhile, EnCana is evaluating the results of a 3-D seismic programme it carried out in 2003, as well as preparing exploration work on its newly acquired blocks 14 and 17. Perenco, which holds rights to 20,000 b/d of OCP capacity, is on track to meet that target from its fields in blocks 7 and 21.

Asian interest

Interest in Ecuador is also mounting among Asian firms, as Asian refiners have become important customers for Ecuador's Oriente and Napo crude blends. China's CNPC and Sinopec have been building their presence in the country. In the last months of 2003, CNPC acquired block 11 from Lumbaqui Oil, while Sinopec paid $100m for a 14% stake in ConocoPhillips' Block 16, which produces 57,000 b/d.

The government hopes to capitalise on this new interest by relaunching its stalled ninth bidding round for exploration acreage, as well as its long-delayed Ishipingo-Tambococha-Tiputini (ITT) project. The ITT area is said to hold 0.7bn-1.4bn barrels of 14-16°API heavy crude.

PetroEcuador has long hoped to bring in private partners that could build a heavy oil upgrader to support up to 100,000 b/d of synthetic crude production. The estimated cost of the ITT projectaround $3.5bnmeans only the largest foreign oil companies would contemplate such a venture. ChevronTexaco, Total, CNPC and Sinopec have all expressed interest in the project. But the fields' location, within the Cuyabeno national park, a pristine area of Amazonian jungle designated a Biosphere Reserve by the United Nations, complicates matters.

Big companies are increasingly trying to polish their environmental credentials and oil operations in the Amazon are plagued with controversy. Some investors in Ecuador, such as EnCana, Perenco and Burlington Resources, have been targeted by environmental and indigenous people's activists who hope to pressure the companies into ending their involvement in oil activities in the Amazonian rainforest. The OCP pipeline struggled to secure funding after activists pressured West LB, a German bank, into withdrawing funding, as they fought the routing of the line through an environmentally sensitive mountain forest.

Some potential investors in PetroEcuador's fields worry that their image could be tarnished by the regular oil spills from the Sote pipeline, which has ruptured dozens of times in mudslides, spilling tens of thousands of barrels of crude. Sote's maximum capacity is 390,000 b/d. At present, PetroEcuador says throughput is 290,000 b/d.

The experience of ChevronTexaco is something investors are keen to avoid. The US major is mired in a messy multi-billion dollar lawsuit, launched by Ecuadorian indigenous groups that accuse the company of dumping toxic waste around the Amazonian oilfields it was a partner in between 1964 and 1992.

Environmental cause celebre

The company scored a partial victory in 2003 when a US court refused to hear the case, saying it did not have jurisdiction over the matter, but it ruled that any judgement handed down by an Ecuadorian court would be enforceable in the US. The case has become a cause celebre for environmental groups and threatens to tarnish the firm's image, just as Brent Spar did to Shell.

The US firm is fighting the suit, claiming it is being unfairly blamed for pollution caused by other parties. ChevronTexaco is also pushing for its former majority partner in the fields, PetroEcuador, to assume its legal costs and it argues that a government-approved $40m remediation programme it carried out in the area in the late 1990s absolves it of further responsibility.

Regardless of the outcome of the ChevronTexaco case, investments are likely to continue in Ecuador. The firms tied to ship-or-pay commitments with OCP have little option but to invest in more production capacity to reduce their losses while the government appears to understand the need to bring in private-sector capital to rejuvenate PetroEcuador's ageing fields. Whether Ecuador's full potential as an oil exporter is achieved, however, will largely depend on whether companies can earn acceptable returns.

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