The Fuse

Ecuador Begins Rainforest Drilling in Effort to Avoid Venezuela’s Fate

by Paul Ruiz | @pmruiz | September 08, 2016

Following years of near stagnant levels of crude output, Ecuador’s government announced on Wednesday the start of oil production from a segment of the Yasuní-Ishpingo Tambococha Tiputini (ITT) block, a controversial decision that could significantly increase Ecuador’s oil output over the next decade but will anger environmentalists and indigenous rights groups. The ITT, a 3,800-square mile stretch of Amazonian rainforest pocketed in the easternmost corner of Ecuador, boasts more than 4,000 plant species and wildlife, one of the most biodiverse habitats in the world. With the beginning of production, Ecuador has added 20,000 b/d to its output, with plans to raise this to 40,000 b/d by year-end, all at production costs rumored to be as low as $12 per barrel, per government sources.

In 2007, Ecuador’s socialist government, led by Rafael Correa, placed the area off-limits when it sought international payments in exchange for the government’s commitment to forgo the potential income it would receive from drilling there. But Ecuador’s international fundraising campaign did not raise enough cash, and in 2013, the government decided to move ahead with plans to drill in the oil-rich reserve. The oilfields constituting the ITT—each located within the area of the Yasuní National Park—are thought to contain up to 1.2 billion barrels of proved oil reserves, certainly not among the largest untapped oilfields in the world, but enough for the Andean country to significantly increase its current total production.

The oilfields constituting the ITT—each located within the area of the Yasuní National Park—are thought to contain up to 1.2 billion barrels of proved oil reserves, certainly not among the largest untapped oilfields in the world, but enough for the Andean country to significantly increase its current total production.

An essential revenue source for the government, oil supports its many social service programs. Now under the strain of low resource revenues, sluggish global oil demand growth, a strong U.S. dollar, and the ongoing rebuilding efforts following a 7.8-magnitude earthquake that struck Quito earlier this year, Ecuador’s government needs money to fund big-ticket energy projects. This has led the government to introduce new taxes and steep cuts to capital expenditures, amounting to $6 billion, or 6 percent of gross domestic product. Although opening the Yasuní-ITT area will undoubtedly increase the country’s total oil production, it may do little to improve overall economic conditions in the short-term, and may even make it more dependent on its bilateral relationship with China in the long term as the country deepens ties with its transpacific trade partner.

New Opportunities

Opening the ITT could represent the next best opportunity for Ecuador to significantly increase current total production. In 2015, the country’s output reached 540,000 barrels per day (b/d), a level that has grown by only 9,000 b/d since 2005 despite growing proved oil reserve estimates. Ecuador now has 8 billion barrels in proved reserves, a 64 percent increase over 2005. The country’s Ministry of Hydrocarbons recently said developing the ITT could produce 300,000 b/d by 2022, potentially increasing current production by over 50 percent within the next several years.

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Ecuador’s historically acrimonious relationship with international oil companies (IOCs) complicates efforts to boost production from mature oil fields. Between 2007 and 2010, Correa—a bombastic populist leader elected in 2006—along with the country’s center-left Alianza PAIS-dominated National Assembly passed measures requiring oil companies to pay the government up to 80 percent of revenues generated from resource extraction, often under the threat of expropriation. Production fell, and as many as seven of the twelve IOCs operating in Ecuador pulled out, effectively leaving only state-run Petroecuador and a few other international partners, such as Italy’s Eni and Spain’s Repsol that each had major investments in the country’s most productive provinces.

Ecuador’s historically acrimonious relationship with international oil companies (IOCs) complicates efforts to boost production from mature oil fields.

The tide seemed to turn in 2013 when the government, emboldened by higher oil prices and the prospect of even greater resource revenues, opened new oil fields for private investment. Petroecuador granted Halliburton, Schlumberger, Sinopec and others access to the Sacha oil field, one of the largest in the country, at a discounted service fee in a series of joint ventures with the national oil company. Outside influences also strained investment. In July, Sacha’s main operator, Operaciones Rio Napo, a joint venture between Petroamazonas and Petróleos de Venezuela (PdVSA), entered bankruptcy when the cash-strapped Venezuelan state oil company encountered financial difficulties.

In 2013, Ecuador opened an eleventh licensing round to spearhead oil exploration in the country’s southeastern provinces to further attract investment, but only four companies responded. The most prolific prizes were awarded to Repsol and Andes Petroleum, a consortium of Chinese state-run oil companies that were set to begin production when oil prices fell.

Yasuní-ITT oil production presents an opportunity for Ecuador to attract investment, and it may do so by strenghtening international partnerships with state firms from China, whose trade ties have become increasingly important in recent years. As a condition of its complex oil-for-loans agreements, the Ecuadorian government has given Chinese national oil companies the ability to resell up to 90 percent of its oil exports on the global market. In addition, Yasuní-ITT oil production can provide added urgency for China, Ecuador, and its regional investment partner Venezuela to complete a mammoth 300,000 b/d refinery on Ecuador’s Pacific Coast. Doing so would help alleviate Ecuador’s reliance on expensive refined imports, which last year accounted for 154,000 b/d of products from the United States, and far exceeded the country’s 175,000 b/d refining capacity.

Limited Potential

Among the smallest members of OPEC, Ecuador does not hold a lot of geopolitical sway in setting global oil prices. The country, along with its regional ally, Venezuela, requires high prices to support sprawling social programs but has been incapable of materially affecting policy within the bloc. Prior to the OPEC meeting in Vienna this summer, Quito hosted representatives from other Latin American oil producers, including Colombia, Venezuela, and Brazil, to advocate for country-specific production quotas that would drive up global prices; representatives from these governments have so far been unsuccessful in their efforts, but Ecuador has renewed its advocacy for an output freeze ahead of OPEC talks in Algiers later this month.

Prior to the OPEC meeting in Vienna this summer, Quito hosted representatives from other Latin American oil producers, including Colombia, Venezuela, and Brazil, to advocate for country-specific production quotas that would drive up global prices.

Instead of being able to affect prices, Ecuador is instead making both upstream and downstream investments that are more oriented toward the longer-term. Opening its southeastern oil fields and the Yasuní-ITT to exploration and development are one part of this strategy. Another is to include a steady stream of new international partnerships with its state-run oil companies to improve technical know-how and efficiency. For now, Ecuador’s downstream investment in the Pacific Coast refinery has arguably become less economically sensible given low global oil prices. Under current market conditions, refined products can be purchased comparatively cheaply, dampening at least some of Petroecuador and PdVSA’s early enthusiasm that the project would be constructed along its initially expeditious timeline.

In the short term, increasing Ecuador’s total output and refinery capacity will do little to help finance government programs. The government expects very minimal year-end production from the Yasuní-ITT area, and the refinery is not scheduled to come online for at least two years. In the interim, the International Monetary Fund says Ecuador’s economy will contract 4.5 percent in 2016, requiring it to impose strict budgetary controls to help balance social spending. Ecuador has so far instituted import controls on oil, cut spending on energy subsidies in the commercial trucking and aviation industries, and introduced excise taxes on cigarettes and alcohol.

Last year, Ecuador’s oil production costs averaged $24 per barrel and were $39 per barrel to break-even. With WTI averaging $45 per barrel this month, profit margins derived from currently extracted resources are very narrow.

With WTI prices currently hovering between $40 and $50 per barrel, Ecuador’s heavier, and lower quality Oriente and Napo blends sell at a discount, generating fewer revenues for government coffers than higher quality grades. Although there is uncertainty around the true production costs in the Yasuní-ITT, the project will likely only make sense if prices stabilize in the coming years and the country is able to make the necessary investments in its refining infrastructure to cut back meaningfully on its expensive refined product imports. Last year, Ecuador’s oil production costs averaged $24 per barrel and were $39 per barrel to break-even. With WTI averaging $45 per barrel this month, profit margins derived from currently extracted resources are very narrow.

Meanwhile, Ecuador would be well-served to invest further in its hydroelectric power potential. Fifty percent of the country’s electricity sector is powered by oil, an inefficient allocation of resources given the country’s ample access to rivers. At least some of the money raised by the Yasuní-ITT development fund was intended to be directed toward this purpose, but Ecuador’s opaque politics and checkered history with international lenders cast doubts over Rafael Correa’s intentions. Indeed, it is this troubled relationship with the international community that may draw Ecuador deeper into its trade relationship with China as its capital financing needs grow.

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