Will a rise in oil prices rescue Ecuador’s struggling economy?
By Matthew Smith
For decades, oil rich Ecuador proved to be a risky and unprofitable jurisdiction for foreign companies seeking to tap its vast mineral wealth. This peaked with the $9.5 billion court ruling against integrated international energy major Chevron in 2011. The tribunal alleged that Texaco, which was acquired by Chevron in 2000, had for three-decades pumped petroleum waste into waterways around Ecuador’s northern Amazonian city of Lago Agrio. The judgement, which a U.S. court found to be a product of fraud, did considerable harm to Ecuador’s reputation as a destination for foreign investment.
That combined with significant controls on capital, excessive taxation of profits and an opaque regulatory environment significantly deterred foreign investment in Ecuador’s commodity sector. This has prevented Quito from fully exploiting and benefiting from the Andean country’s considerable natural resources. A perfect storm of sharply weaker oil prices, aging infrastructure and excessive debt is crushing Ecuador’s oil dependent economy.
By the end of 2019, Ecuador’s financial crisis was so severe that Quito decided to withdraw from OPEC allowing it to avoid the cartel’s mandatory production cuts. Early last month the Andean country’s central bank forecast that Ecuador’s economy will shrink by a worrying 7.3 percent to 9.6 percent during 2020. That along with sharply weaker oil and onerous levels of government debt forced President Lenin Moreno’s administration to negotiate with bondholders to avoid a sovereign debt default.
Oil’s latest price crash is a major contributor to Ecuador’s dire economic state. By 2019 petroleum and mining generated just over 6 percent of the oil dependent economy’s GDP compared to 12.5% in 2013 when the last oil boom peaked. Crude is the Andean country’s primary export responsible for 35 percent of its total exports in 2019. The financial impact of substantially weaker oil prices is magnified by Ecuador’s inability to boost production despite vast oil reserves of over 8 billion barrels.
While Ecuador, unlike its neighbor Colombia, has considerable proven oil reserves estimated at 8.3 billion barrels, it is struggling to grow production. That could be blamed on regulation which disincentivized foreign investment in Ecuador’s hydrocarbon sector and the constraints imposed by OPEC’s production cuts. Quito has taken significant measures to boost oil output. The key one of those was leaving OPEC to avoid compliance with the cartel’s mandatory production cuts which would have limited plans to boost Ecuador’s oil output.
Aside from quitting OPEC, Moreno’s administration is focused on reforming the Andean country’s hydrocarbon sector and reversing the policies of resource nationalism enacted by his predecessor Rafael Correa. It was during the latter’s tenure that Ecuador’s reputation as a difficult and unprofitable jurisdiction for foreign energy companies arose. That can be squarely blamed on Correa’s interventionist approach to managing Ecuador’s copious natural resources. During his presidency onerous taxes as well as unfavorable contracts were imposed on private oil companies and there were even instances of asset seizures.
Crucial improvements made by the Moreno government are the reintroduction of participation contracts, improved profit-sharing arrangements and reduced taxes for energy companies. The restoration of participation contracts is especially important because it allows private petroleum explorers and producers to book oil reserves. That allows them to be more easily valued in accordance with industry methodology and access reserves-based lending, making all-important capital more accessible. Those measures send a signal that Ecuador is open for business and is ready for more oil exploration and production activity. This has already sparked an uptick in interest from foreign oil companies. In early 2019, foreign oil companies including Geopark, Frontera and Gran Tierra acquired interests in the Intracampos blocks located in in the Oriente Basin in northeastern Ecuador near the Colombian border.
Quito’s reforms point to a brighter long-term outlook for Ecuador’s economically vital petroleum industry, although foreign investment may not occur as rapidly as needed.
While Moreno’s administration has overturned his predecessor’s policy of resource nationalism, there is still a long way to go to convince foreign oil companies that Ecuador is open for business. This is reflected by the World Bank’s Doing Business 2020 report where Ecuador received an extremely low rating, ranked 129 out of 190 countries, indicating that it remains a risky jurisdiction for foreign energy companies. It is Ecuador’s high levels of state interventionism that were identified as a key hazard.
The latest oil price slump is amplifying Ecuador’s unattractiveness for foreign oil companies. In response to the March 2020 oil price crash and considerable uncertainty triggered by the COVID-19 pandemic, oil companies around the world slashed spending and shuttered non-essential and uneconomic operations. It is investment in exploration and development activities in higher risk jurisdictions which is the most adversely affected.
Aside from elevated political risk, Ecuador’s relatively high estimated breakeven price of $39 per barrel, a mere $2 lower than the current market price, is further deterring investment. This is further exacerbated by Ecuador’s main Napo and Oriente oil blends being benchmarked to West Texas Intermediate rather than Brent. That prevents companies pumping crude in Ecuador benefiting from Brent’s premium price, which is roughly $2 per barrel higher than WTI.
Recent severe civil unrest, pipeline ruptures and the heavy impact of the COVID-19 pandemic on Ecuador are also ratcheting up risk for foreign oil companies. These events are all preventing Quito from growing Ecuador’s oil output and achieving its 2020 target of 590,000 barrels daily.
Aging infrastructure is also weighing on Quito’s oil ambitions. Multiple April 2020 pipeline ruptures caused oil production to plunge to a low of 68,000 barrels daily, reducing the monthly total to 225,242 barrels daily or less than half of March’s 539,629 barrels. It took until May 2020 for repairs to be completed and pipelines to reach full operational capacity, which saw that month’s output rise to an average of 333,339 barrels daily. It wasn’t until June when production reached full capacity averaging 514,863 barrels daily which was 3 percent lower than the equivalent period in 2019.
For these reasons, Quito will not achieve its all-important goal of boosting oil production to an average of 590,000 barrels daily. That will impact Ecuador’s oil dependent economy worsening the fiscal crisis gripping the Andean country. It will take some time for Quito’s reforms to the petroleum industry to be recognized and attract the much-needed investment to head-off the growing crisis.
Credit: Oil Price