Ecuador – Game Changer

They say commodity producers are price-taker and that has been the belief since then. Today, I am sharing you with a piece on Equador’s recent move to redefine this rule.

Ecuadorean President Rafael Correa is pressuring foreign oil investors to change from production-sharing agreements (PSA) to service contracts, else to face expropriation. Correa is looking to make the state’s authority over oil revenues, hence his political security and also perhaps at the expense of Ecuador’s long term economic development.

The left-leaning President Rafael, an economist by training has frequently expressed his disillusion with market reforms in Latin America and believes economic power should reside within the state. Shifting from PSA to servicing contracts, under which producers would have to pay a production fee and then get reimbursed for the cost of their investment. The state will end up getting more revenue for itself and the producers end up making less money overall since it can only make profits from remuneration fees – the amount per barrel that government is willing to pay companies for producing its oil. In another words, the foreign companies will incur risk of investing resources into a project with none of the potential rewards associated with high oil prices.

With his populist-driven handouts to the poor, Rafael will certainly strengthen his political base, which also showing stronger signs of coordinated opposition.
Equador’s economy depends heavily on oil, which accounts for roughly a quarter of GDP, 68% of total export earnings and 35% of fiscal revenues. The country is exporting about 470,000 barrels per day of oil this year – a heavy sour crude called Napo and a medium-heavy, medium sour crude called Oriente that is produced in the northeast of the country.

Many of these companies have reasons to take Rafael’s expropriation threats seriously. After the state took over US oil company Occidental Petroleum’s asset in 2006, claiming the firm’s contract had expired, Rafael further raised investor fears in late 2007 when he imposed a 99% windfall revenue tax on foreign energy firms to help make up for the state’s commercial bond debt obligations. And that led to a number of arbitration suits at the World Bank’s International Centre for Settlement of Investment Dispute. Equador has also expropriate two blocks belonging to Anglo-French oil firm Perenco over tax disputes.

It looks like most firms will have to settle reluctantly on the new contractual terms to remain in the country and maintain minimal production. But they will not have good incentive to invest further in exploration and deep drilling, particularly in the technically more complex fields in the Amazon.