A new contractual model is used in the Ecuadorian oil & gas industry for the development of crude fields through private investment

With the ongoing oil crisis, the Ecuadorian State has develop new ways to get financing from exploration and exploitation of crude blocks in the Amazon; resulting in a new type of contract which has raised criticism for its legality. However, with the General State Budget depending mainly of that resource, it is important to describe and analyze carefully this new deal; being the role of the Office of the General Comptroller the supervision of the State resources.

By the end of 2015, the Ecuadorian State, through one of its public companies, subscribed a “Contract for the Provision of Specific Integrated Services”, with enterprise related to a private company. This new type of contract meant that the Contractor finance the execution, optimization, production activities and operation support in a block of the Ecuadorian Amazon Region, for an approximate investment of 4,100 million dollars to be disbursed over 20 years.

The normative for procurement of the Public Company allows it to make direct contracts that tend to obtain economic benefits from intangibles arising from legal or contractual rights.

Under this model the state pays the private company a fee per barrel regarding all block fields production, unlike previous “Contracts of Specific Integrated Services” with funding from the contractor, signed in 2014, for the execution of optimization activities, improved recovery activities and exploration activities, under which the payment of the fee was limited only to the incremental production generated by private investment.

One of the main reasons that motivated the subscription of this “Contract of Specific Integrated Services” with funding from the Contractor is the lack of resources to perform CAPEX and OPEX investments expected in the Development Plans and therefore maintain or increase the production. Currently, the block production is approximately 70.000 BOPD1; however, 1 Barrels of oil per day according to the Public Company’s estimated production, in case that it does not have the resources to execute the planned investments from 2016 and onwards, the production would decline 25% per year, decreasing by the year 2021 to 10.000 BOPD1.

In order to increase and sustain the block’s crude production for the last 3 years, the Public Company required an annual average of USD 320 million for capital expenditures and $ 180 million for expenses and operating costs. Due to the low WTI2 crude price and the export price of Ecuadorian crude, the state reduced the budget allocation to the Public Company in recent years.

The interpretation of the Ecuadorian State with the signing of this contract is that the Ecuadorian Public Company continues as owner and operator of the block, even though the private company is responsible for the investment (CAPEX) and operating expenditures (OPEX) in the subsoil as a percentage, so that another percentage corresponding to surface OPEX is assumed by the State through its public company. This new business proposed model states that the Contractor assumes investment costs, freeing up that item from the General State Budget and from the Government.

Previous specific integrated services contracts with funding by the Contractor for optimization activities, improved crude recovery and exploration – commonly called “Contracts for Mature Fields” – were signed as a result of the crude rounds carried out in 2011 and 2013, in which the area of activities was limited only to one field, the contract term was agreed in 15 years and the payment of the fee per barrel only corresponded to the incremental production calculated over a contractually agreed Referential Production Line and generated as a result of the investments made by the Contractor.

Meanwhile, in the recently subscribed contract, the activities area corresponds to a whole block, within which there are several fields in production; the term has been agreed in 20 years; and the payment is done through a fee per barrel of total production of the Block, ergo, there is no Referential Production Line.

The legality of the signing of this contract is still on debate. Since, the Public Company hired a specialized international legal consultancy, which indicates that this contractual mode is provided in Article No. 2 of the Hydrocarbons Law. This article states that the works or specific services that Public Enterprise has to execute can be performed by itself or entering into contracts for works or services; but this refers specifically to the mature fields.

Another important stipulation is contained in the article 16 of the Reformed Regulation to the Hydrocarbons Law issued in 2010, indicating that the fields in production by public companies will not be delegated through contractual arrangements (association, participation, providing services for hydrocarbons exploration and exploitation contracts) provided in article No. 2 of the hydrocarbons Law to private initiative, without prejudice to enable them to perform specific service contracts in accordance with Article No. 17 of the hydrocarbons Law, which refers to works or specific services contracts in marginal fields.

As all the fields that are part of the area of Contract activities are mature and non-marginal fields, it would not apply the exception provided in Article No. 16 of Reforms Regulation to the Hydrocarbons Law, mentioned above.

The analysis of this new contractual model must be thorough, especially all the matters related to the resources that the Public Enterprise received by concept of an intangible asset that was listed as “Contract Right”; the “Carry Forward Clause” without interests for cases where available income is not sufficient to cover the amount of the fee; the scope of services to be rendered by the Contractor in favor of the public company, ergo, if the services are limited to activities of production optimization, or whether on the contrary investments in improved crude recovery are contemplated; which part reserves itself the right to take decisions regarding the management of the reservoir; among others.

Regarding to the new legal figure “Intangible Right”, that comes from the specific integrated services contract with funding by the Contractor, the Budget Classifier of Public Sector Incomes and Expenditures allows annotating revenues from the value of the prestige that the company of state-or sectional property has in monetary terms; and other intangibles. The Contractor amortizes the intangible during the contract term and the Public Company records it as a deferred tax liability.

The established fees in the contract for the three phases of the Activities Plan include the amount of productive investments (CAPEX), operating costs (OPEX), taxes, and a fee for contract law and the Contractor utility, which is paid in money for each barrel produced. Furthermore, according to the payment mechanism established in the contract, if the funds from crude exports become insufficient, the fee may be funded with market resources for the payment of the domestic price of derivatives or the budget of the Public Company.

One of the main problems of the Ecuadorian Public Enterprise is that resources received for this contract were transferred to the General State Budget, because of the agreement for their liquidity management signed with the Ministry of Finance; therefore this does not work as a company that manages its own resources, but depends on the state budget allocations.

Consequently with the statements above, the challenge for the Office of the Comptroller General of Ecuador, which is currently auditing this new type of contract, is to understand and analyze the environment that led to its subscription in order to determine its legality, to verify compliance with the Activities Plan foreseen in the contract, and the destination of the provided resources to ensure that these are not used for other purposes other than investments in the hydrocarbon sector to increase national crude production.

1 Barrels of oil per day

2 West Texas Intermediate

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