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Matthew Smith

Matthew Smith

Matthew Smith is Oilprice.com's Latin-America correspondent. Matthew is a veteran investor and investment management professional. He obtained a Master of Law degree and is currently located…

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The Small Latin American Nation That Could Benefit From Russia’s Oil Ban

 

  • Washington’s decision to ban Russian oil after it invaded Ukraine has left refiners in the U.S. scrambling to secure new sources of heavy crude.
  • Ecuador, a country that has been struggling for more than a decade to revive its flagging oil industry, has the potential to provide that oil.
  • Ecuador’s current president has already begun to reform the oil industry, but significant investment will be needed if Ecuador wants to take advantage of this opportunity. 

 

For over a decade the deeply impoverished and mountainous South American nation of Ecuador has battled to revive its flagging oil industry. Washington’s decision to ban Russian energy imports in the wake of the invasion of Ukraine has sparked speculation that Ecuador, which has oil reserves of over 8 billion barrels, can fill the supply gap. Since 2021, U.S. refiners have been looking at whether Ecuador can supply the heavy crude oil that many of their facilities are configured to process. According to Bloomberg, U.S. refiners Valero and Marathon as well as multinational Shell have held meetings with Ecuador’s national oil company Petroecuador, responsible for over 75% (Spanish) of the Andean country’s petroleum output, to secure supplies of crude oil for their operations. These events have sparked considerable optimism for Ecuador’s national government in Quito that the Andean country will be able to finally attract the foreign capital required to revive its ailing petroleum industry. This is a crucial step for rebuilding Ecuador’s debt-laden economy, which was hit hard by the COVID-19 pandemic, shrinking 7.8% during 2020, with Quito forced to default on its sovereign debt.

Heavy-handed government intervention and unchecked corruption, notably during former President Rafael Correa’s decade in office, coupled with an unfavorable regulatory environment acted as significant deterrents to foreign investment. That caused chronic under-investment in exploration and development activities as well as maintenance and refurbishment of crucial energy infrastructure thereby sharply impacting upstream operations and petroleum production. The steady decline of Ecuador’s hydrocarbon sector weighed heavily on the impoverished South American country’s petroleum-dependent economy. The recent surge in crude oil prices coupled with ongoing industry reforms and growing demand for Ecuador’s petroleum will sustain Quito’s planned production growth as the government seeks to stabilize the country’s ailing economy. It was Correa’s former vice-president and successor President Lenin Moreno who, after entering office in May 2018, embarked on a series of ambitious industry reforms aimed at rebuilding Ecuador’s oil industry after a decade of neglect. This included crucial changes to hydrocarbon sector regulation to make the oil industry investable for private investors, at the time when Quito urgently needed to bolster foreign investment to kickstart the economy. 

A key reform was the introduction of production sharing agreements, known as PSAs, in place of the flat fee service contracts ushered in by Correa a decade earlier. Those service agreements are a significant deterrent to private energy investment because they force oil companies to take on all the exploration and production risk in exchange for a flat fee paid by Quito for each barrel of crude oil produced. Worse yet, those contracts prevent drillers from accessing reserves-based lending limiting their opportunities to obtain the considerable capital required for exploration and development activities. The already grave situation was aggravated by crude oil’s precipitous price plunge which began toward the end of 2014 and eventually saw the international Brent benchmark price plummet to under $30 per barrel by early 2016. 

As a result, the payments from the fee service agreements became a significant financial burden for a cash-strapped Quito with payments being made late or not even at all. Those past due payments left Quito with an estimated debt of $300 million to $1 billion annually, further weighing on an already heavily indebted country where government debt was already over 45% of GDP by the end of 2018 and still climbing.

The restoration of PSAs was a crucial step to making Ecuador’s oil industry investable once again. This is because the rights bestowed by the agreement to the land and oil reserves contained within allow loans to be secured against the asset, meaning that drillers can access credit to finance exploration, development, and production activities. PSAs also reduce the financial burden for Ecuador’s government at a critical time when Quito is drowning in debt because of the government being forced to secure additional loans due to the economic damage wrought by the pandemic. Another important measure was Moreno’s decision to withdraw Ecuador from OPEC at the start of 2020, thereby removing the need for the oil-rich South American nation to comply with the cartel’s OPEC Plus production quotas limiting production growth. Related: Biden Is Using A Cold-War Era Act To Ramp Up Battery Metal Production

Despite Moreno’s reforms, Ecuador’s oil industry failed to attract the desired level of private investment, in part because of the considerable uncertainty created by the 2021 presidential election. Correa’s protégé, Andres Arauz, was pegged as the leading candidate. If he had won it would have meant a return to heavy-handed regulation and significant government intervention in the hydrocarbon sector, although during a second-round runoff pro-business former banker Guillermo Lasso emerged victorious. There is also the tremendous overhang left by a decade of harsh government intervention and regulation as well as corruption associated with the Correa administration.

Upon entering office, Lasso, who is Ecuador’s 47th president, issued a decree (Spanish) containing a 100-day action plan, aimed at significantly boosting the Andean country’s oil production. An essential element of that decree was opening-up national oil company Petroecuador’s operations to private investors, renegotiating existing contracts to encourage greater investment, and privatizing government-owned assets. Lasso is also in the process of renegotiating existing service agreements with a view to transitioning them to PSAs thereby reducing the government’s financial burden and incentivizing greater petroleum industry investment. These steps are crucial to boosting crude oil production which will deliver an economic windfall for Ecuador’s ailing debt-laden economy where petroleum extraction is a key growth driver.

Oil rents, which are essentially the gross profit generated by petroleum production, according to the World Bank, were responsible for 6.7% of Ecuador’s 2019 gross domestic product. Crude oil is also Ecuador’s largest export accounting for nearly a quarter of all exports by value during 2019. Those numbers underscore the petroleum industry’s importance, which is rising because of substantially higher prices, as a source of income for a cash-strapped national government. The pandemic forced Quito to secure over $7 billion in World Bank and IMF loans while causing the economy to contract by 7.8% during 2020, further adding to Ecuador’s financial burden.

While Lasso is targeting oil production of 1 million barrels per day by 2025, there are signs that Ecuador is struggling to grow production despite all the recent industry reforms. For January 2022, Ecuador only pumped an average of 442,789 barrels per day, a worrying 13% decrease compared to a year earlier, although it was 59% greater than a month prior when the country only produced 278,574 daily because of pipeline outages which forced the government to declare force majeure (Spanish) on all oil contracts. 

Source: Ministry of Energy and Non-Renewable Natural Resources, U.S. EIA.

The sharp December 2021 decline in production along with Quito’s declaration of force majeure can be blamed on the shuttering of the privately-owned OCP and Petroecuador’s SOTE pipelines for most of that month. Those pipelines are the only means of transporting crude oil extracted in Ecuador’s eastern Amazon basin to the Pacific port city of Esmeraldas. Severe riverbed erosion (Spanish) in the Napo Province has been a serious operational hazard for the pipelines since the completion of Ecuador’s Coca Codo hydroelectric dam. Landslides were responsible for rupturing both pipelines in April 2020 causing 15,000 barrels of oil to spill into the Coca and Napo rivers which threatened the water supply of the nearby city of Coca. The OCP pipeline was again ruptured (Spanish) by falling rocks in late-January 2022, seeing it spill 6,300 barrels of oil into the Napo and Coca rivers. The risks posed by erosion and landslides are constant and further outages, as well as oil spills, are likely because of rockfalls causing ruptured pipelines.

These events highlight that considerable investment is required, notably for crude oil pipeline upgrades, to overhaul and replace Ecuador’s aging petroleum infrastructure. This is not the only major risk impacting Ecuador’s ability to boost output and U.S. oil shipments. Repayments for oil-backed loans from Asia, mainly China, Thailand, and India, taken out by Correa during his time as president to fund infrastructure projects and social programs were absorbing anywhere up to 90% of Ecuador’s crude oil exports. That coupled with infrastructure outages and a lack of investment in industry operations is weighing heavily on Ecuador’s ability to ramp up oil production and exports to meet increased U.S. demand.

By Matthew Smith for Oilprice.com

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