Ecuador Oil Sector’s New Year Resolutions: Leave Opec and Produce More

December 10, 2019

More than a century ago, legendary Ecuadorian president, Eloy Alfaro, signed the country’s first ever oil exploitation contract. A flurry of further deals eventually saw Anglo Ecuadorian Oilfields, that would later become part of BP, emerge as the dominant player Ecuador’s oil industry, producing steady amounts in the coastal province of Santa Elena.

Ecuador’s coast may have been the starting point for the country’s oil industry but it wasn’t to remain its epicentre. Rumours of immense oil wealth in Ecuador’s jungle continued to draw international investors east, with both Shell and Standard Oil conducting extensive exploration. By the 1960s the Oriente, as the area east of the Ecuadorian Andes is known locally, began producing commercial amounts of oil. That sparked an oil rush, with companies from around the world vying for blocks in Ecuador’s jungle over the following three decades. Yet their status and business conditions would constantly change as different Ecuadorian governments altered national oil policy. New state oil companies emerged as major players in the industry, while various foreign firms left in protest at their treatment. That Ecuador, which joined international oil cartel Opec in 1973, should assume greater control over its natural resources was both fair and in keeping with prevailing global trends at the time. Yet the country’s political instability meant its oil policies would swing, pendulum-like, from ‘investor friendly’ to ‘resource nationalism’.

The government of Rafael Correa, 2007 to 2017, oversaw a swing to resource nationalism. In a time of record commodity prices, a windfall tax was created to increase the state’s share of profits. Meanwhile existing oil companies that had production sharing contracts with the Ecuadorian state saw them forcibly changed to service contracts. Now Moreno’s administration is trying to attract international oil firms by creating more welcoming conditions for investors.

Investor friendly

Carlos Pérez, the former Minister for Energy and Non-Renewable Resources oversaw crucial changes to the oil contract. “The service contract model that the last government favoured was not very attractive for international companies. We’ve changed that to a participation contract, which allows companies to book reserves. Another crucial element is that they are fair. We use a formula that means when the oil price is high, both Ecuador and the companies benefit. And when it is low, we both suffer. That fairness has helped it attract oil and gas firms. For example, in our Intracampos Round we had successful bidders for seven of the eight contracts offered, with a total investment of $1.2billion.”

You would expect a minister to talk up his government’s new oil contracts but many in the industry view them as a positive development. Fernando Emanuele is the CEO of Orion Energy, a privately-owned, Ecuadorian-focused oil company backed by British and Singaporean investors. In 2014 it acquired two blocks in the jungle in Ecuador’s northeast and operates under the service contract model. Emanuele is keen to stress that the service contracts are not all bad, noting that, despite the name, the Ecuadorian version is different to service contracts in other countries, like Mexico. “If we don’t produce, we don’t get paid. We earn per barrel, so really, it’s a revenue sharing contract with a fixed fee.” However, he agrees that there are some serious drawbacks. “We can’t get reserved-based lending, which cuts off an important source of funding. That’s because we rely on the state, in particularly the Ministry of Energy and Non-Renewable Resources’ trading branch, PetroEcuador, to commercialise our oil. Once it sells the oil it repays us out of the national budget. That means that if the oil price falls or Ecuador has budgetary problems our payments can be delayed. In 2017, we didn’t get paid for six months, which put us under enormous strain.”

if the oil price falls or Ecuador has budgetary problems our payments can be delayed. In 2017, we didn’t get paid for six months, which put us under enormous strain…

The new participation contracts avoid that problem and therefore should succeed in attracting more investment. “We are planning to expand in Ecuador”, says Emanuele, “and will be bidding for some of the blocks coming available under the new contracts. We will stick to the northeast of Ecuador, where you have nearfield exploration opportunities. That’s great for a mid-sized company like us because it’s the type of exploration risk we can carry on our balance sheet. And if you find oil, then the infrastructure is already in place to take it to the market. There are some larger scale opportunities that will become available in the southeast of the country over the next decade but they are too big for us to take on.”

New projects

Ecuador’s oil industry officially began more than 100 years ago with Alfaro’s first contract to the Englishman, Carlton Granville Dunne, in 1909 but there are still at least 4.7 billion barrels of oil that have been untouched. That’s an incredible strategic asset for the country but one that may lose its value in the future as new energy technologies replace oil. Pérez believes global oil demand will be in decline by 2040 and that “it’s imperative that we make the most out of our resources now”. But with the right investment conditions he estimates that oil production could hit 700,000 within a few years, up from its current level of 550,000 barrels per day (bpd).

That 2040 deadline has given Ecuador’s oil market a sense of urgency because there are several challenges that need to be overcome if the country is to make the most of its black gold. Ecuador’s northeast oil basins are served by excellent infrastructure, with current pipeline capacity of 850,000 bpd. Yet decades of constant production mean these maturing basins are also becoming more geologically complex. Some of the most exciting, barely-touched oil basins are in the country’s southern jungle but they come with social challenges, as some tribes are against the industry, coupled with a lack of infrastructure. Pipelines, matter, says Emanuele. Orion’s access to the northern pipeline “means we pay transport costs of less than $3 per barrel – if we had to truck it the cost would be around $20.”

Under the previous administration you would have expected state firms, such as national E&P firm Petroamazonas, to be called on to boost production and build infrastructure. But as Pérez frankly admits in his exclusive interview with LatAm INVESTOR, the national oil firm, “lacks capital”. As a result, opportunities will be created for international firms.

“There is definitely a shift in the market environment and the government is embracing local and international investment to the oil and gas sector”, observes Juan Cevallos, founder and President of the eponymous oil production equipment supplier Importadora Juan Cevallos, known as IJC. His firm sources the best oil equipment from around the world and maintains a well-stocked inventory to supply Ecuador’s hydrocarbon industry. Cevallos is confident that it could help with a new southern pipeline, given that it is already a trusted partner of the $1.4billion northern oil duct, OCP. “Ecuador’s largest international private-sector oil and gas investment so far was the OCP pipeline, that takes crude from Ecuador’s northwest jungle region to the refinery on the coast. We worked on the construction of that project, providing the tubes, valves and joints it needed in 2003 and 2004. Then we have stayed as a partner, providing the spare parts for essential maintenance during the pipeline’s operation. I’m proud to say that in 2007 OCP selected us as the best provider out of more than 700 other companies.”

Some large energy infrastructure projects were hit by political problems so it remains to be seen if this government can have more success…

Fortunately for companies like IJC the new government has an ambitious portfolio of energy projects. The most urgent is the refinery, with the existing plant at Esmeraldas only able to process 110,000 bpd. Moreover, fuel produced by the 42-year-old refinery will soon fall foul of the International Maritime Organisation’s new 0.5% sulphur regulations. The government is also inviting private-sector bidders for a new 300,000 bpd refinery, having decided to scrap the protracted, expensive and corruption-ridden attempt of the previous administration to build one.

The challenge for this government, says Cevallos, is not only attracting the investment but making sure the projects actually get built.  “Some large energy infrastructure projects were hit by political problems so it remains to be seen if this government can have more success. For example, in 2014 we won an important contract to supply all of the fitting for the multiuse pipeline being built from Cuenca in the highlands to Pascuales on the coast. Unfortunately, the project became enveloped in the Odebrecht scandal, that we are far removed from, but we are proud to have met the technical requirements. Likewise, we supplied the parts for a 90km, 48-inch diameter pipeline that was laid for the Refineria del Pacifico coastal refinery project. Again, we are proud to have fulfilled our duties but sadly that project has also been halted for political reasons.”

Environmental care

Ecuador is faced with a dilemma. The bulk of its proven oil reserves are to be found in the midst of its other great natural resource – the Amazon rainforest. Much of the oil is in or around Yasuní, a national park whose rainforest is one of the most biodiverse places on the planet. Previous president Correa floated an ambitious scheme for developed countries to pay to leave the oil untouched but it proved economically unviable. That means Ecuador, a country still struggling to provide its poorest with acceptable healthcare, education and housing, must find a way to use one endowment without damaging the other.

For many years that seemed impossible. The state, often inefficient or corrupt, proved unable to develop and enforce the stringent environmental standards needed to develop oil and gas in the Ecuadorian jungle, while some international companies were criminally negligent towards their ecological obligations. Fortunately, that changed in Correa’s administration and Ecuador’s oil and gas industry is now governed by strict local and international regulations.

Perez is clear that responsible production in the rainforest is vital if Ecuador is to realise its oil and gas potential. “In the ITT hydrocarbon deposit, which is one of our main targets, we have raised production to 80,000 barrels per day (bpd). But the potential is even greater, with scope for 200,000 bpd.” The emphasis on environmental protection has led to a new type of oil service company that is capable of delivering safe energy projects in the rainforest. FYI Business Group, an Ecuadorian engineering and construction firm that specialises in energy, mining and water projects, is a good example. “We’ve built three production platforms in the ITT oil field”, explains FYI Business Group CEO, Fabián Yar. “We did everything from definitive design to production. These platforms were subject to four audits. First PetroAmazonas inspect your work, then the Ministry of Environment, then the international guarantor countries that have a commitment to protecting Yasuní and finally the community. One of our environment audits had 450 different items that had to be independently checked every month, so these were very stringent tests. It is probably one of the most controlled oil and gas areas in the world. I’m proud to say that not only did we pass the audits but we have won ecological awards for our care of the environment.”

Ecuador will have to develop its own set of best practises and technology, because nowhere else in the world has identical conditions to Yasuní. FYI Business Group is leading the charge. “We created some innovative ecological solutions. For example, in one project our idea, which the client accepted, was to place a temporary road that can be removed when oil production stops. It means that eventually the jungle returns to its original state. We invest heavily in buying the most ecologically-friendly equipment and supplies from around the world to ensure that we minimise the environmental impact. Another innovation is that we don’t use local wood for constructing the campsite and the facilities. We bring our own prefabricated equipment.”

Extracting oil responsibly from the jungle is never going to be easy, explains Yar, but it’s not impossible. “Ecuador can and is exploiting its oil and gas potential in an environmentally responsible manner. The environmental regulations are among the strictest in the world, but if companies comply with them then they can make successful projects.”

With all this talk of the challenges, one may wonder why investors would come to Ecuador in the first place. Perhaps the best reminder comes from Orion Energy, which recently scaled back its pan-Latin American aims to concentrate on Ecuador. Emanuele notes that “as Mexico’s energy reform stalled, Venezuela sunk further into deep problems and even Colombia, which was the oil and gas darling of the region, struggled with poor infrastructure and too much competition for reserves that are not that big”, it became apparent that Ecuador is one of the most attractive countries in Latin America.

Alfaro was a force of nature – a revolutionary-turned-president who achievements, such as opening up the oil sector and building the Quito-Guayaquil railway, dragged Ecuador into the 20th century. Yet Ecuador has always been a tough country to govern and Alfaro was killed on the streets of Quito by a conservative mob. Fast-forward 100 years and another Ecuadorian reforming president, Lenin Moreno, is trying to modernise Ecuador’s oil industry. And while Moreno will hope to avoid Alfaro’s grisly fate, he too is looking to British investors to kickstart his hydrocarbon revolution.