Cablegate: Regulation for Hydrocarbons Reform Revised

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DE RUEHQT #1722/01 1951828
ZNR UUUUU ZZH
O 141828Z JUL 06
FM AMEMBASSY QUITO
TO RUEHC/SECSTATE WASHDC IMMEDIATE 4831
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RHEHNSC/NSC WASHDC 2199
RUEATRS/DEPT OF TREASURY WASHDC
RHMFIUU/DEPT OF ENERGY WASHINGTON DC

UNCLAS QUITO 001722

SIPDIS

SENSITIVE
SIPDIS

DEPT FOR WHA/AND
TREASURY FOR SGOOCH

E.O. 12958: N/A
TAGS: ECON EPET EINV
SUBJECT: REGULATION FOR HYDROCARBONS REFORM REVISED

REF: A. QUITO 1669
B. QUITO 1680
C. QUITO 889

1. (SBU) Summary: President Palacio issued a decree July 11
correcting the implementing Regulation of the April
Hydrocarbons Law that had been published in the Official
Register on June 29. The previous regulation offered
potentially important opportunities for companies to mitigate
the law's most draconian provisions, but the revised
regulation swept those openings away. The law's
constitutionality remains at issue, but no decision is
expected by the court before the October elections. Former
Minister of Economy Borja, Minister of Energy Rodriguez and
Presidential Secretary Apolo reportedly disagreed on the
law's regulation; the embarrassingly public dispute and
disarray culminated in Borja's and Apolo's resignations
(reftels A and B). Meanwhile, the GOE continues to lack any
clear plan for the additional revenue generated from the
Hydrocarbons Law and the Oxy seizure, raising fears of a
spree of irresponsible spending and/or pilfering in the
Palacio Administration's final months. End summary.

Previous Regulation at Odds With Hydrocarbons Law
--------------------------------------------- ----

2. (U) President Palacio issued a decree July 11 to correct
the Regulation of the Hydrocarbons Law that was published in
the Official Register on June 29. The previous regulation
differed in important ways from the Hydrocarbons Law,
including Article 8 which allowed energy companies to
mitigate certain elements of the reform, which former
Minister of Economy Diego Borja concluded would reduce the
GOE's fiscal receipts by more than $400 million this year.
While the Hydrocarbons Law reform in April (reftel C)
disregarded investment and calculated extraordinary payments
to the GOE based on gross revenues, the June 29 regulation
allowed companies to amortize investments if they had not
already produced up to 40 percent of their proven oil
reserves. Palacio's decree also eliminated three other
articles and two supplementary clauses that changed the
calculation of the reference price and required oil companies
to turn over 60 percent of extraordinary revenues to the
state if they did not sign new contracts within 60 days.

3. (SBU) It is unclear why the Palacio Administration
allowed the Official Register to publish the previous
regulation. The Attorney General has initiated an
investigation into who changed the regulation. Rumors within
the government speculate that energy companies may have
provided kickbacks to alter the regulation in their favor.
Government sources tell us Borja and Minister of Energy Ivan
Rodriguez, despite working together to rewrite the Regulation
of the Hydrocarbons Law Reform, privately disagreed on how to
address the discrepancies between the regulation and the law.
Borja had congressional and industry backing for changing
the regulation and eventually won out over Rodriguez, but not
before sacrificing his job last week (reftel A).

Regulation Codifies Calculation of Revenue
------------------------------------------

4. (U) The revised regulation, published in the Official
Register July 13, contains an equation to calculate the
revenue-sharing mechanism which forces companies to share
with the government all income generated by average monthly
prices higher than those at the time the original contracts
were signed. It specifies the government is entitled to at
least 50 percent of the extraordinary revenue determined by
the formula and requires the companies to submit monthly
production and sales information. After Petroecuador
calculates the additional payments, companies will have 30
days to deposit these funds into one of two accounts;
proceeds from up to 23 API grade heavy crude will be funneled
into the Special Account for Social and Productive
Reactivation (CEREPS), while sales from superior crude will
be deposited into a separate account at the Central Bank for
use in the general budget.

5. (U) The regulation requires companies to make monthly
payments to the GOE based on production, not sales, creating
a timing problem for companies that normally produce over
several months until they have enough oil to contract a
tanker. Monthly payments based on production rather than
sales will create a cash flow problem. In addition,
companies are concerned that the regulation requires
Petroecuador to define a reference oil price instead of using
the actual price from individual transactions. Nor does the
regulation clarify how these additional payments to the GOE
will be treated under Ecuador's tax regime.

Constitutional Challenge Continues
----------------------------------

6. (U) At the same time, the Constitutional Court has two
cases pending questioning the constitutionality of the April
Hydrocarbons Law. The Quito Chamber of Commerce and the
Pichincha Chamber of Industry filed cases last month that
allege the law violates contract sanctity by retroactively
and unilaterally applying the law to current contracts. A
decision on its constitutionality probably won't be addressed
until after the presidential and congressional elections in
October, so many companies will find themselves complying,
giving the GOE 50 percent of additional revenue which could
eventually be declared unconstitutional. If the court
decides in the GOE's favor, U.S. companies can pursue
international arbitration for violations to our Bilateral
Investment Treaty after the six-month waiting period ends in
October.

Companies' Perspectives
-----------------------

7. (U) The potential for legal challenges places foreign
energy firms in limbo, obligated by the MOE to pay the
additional revenues or be subject to fines, but acutely aware
that under Ecuadorian law, firms which sign illegal contracts
can face prosecution. Most companies expect the GOE will
require them to abide by the terms of the law despite their
unwillingness to sign contracts that have no legal basis.

8. (SBU) City Oriente, a small family owned U.S. company
operating only one block along the Colombian border, remains
stymied until the Hydrocarbons Law is either declared
unconstitutional or the GOE retracts the law entirely. City
refused to sign a contract with Petroecuador based on the now
superseded regulation because it is unwilling to sign
anything that could be found inconsistent with the
Hydrocarbons Law. In the meantime, City released its two
drilling rigs after declaring force majeure in April (reftel
C) and will release the one remaining workover rig at the end
of July. City continues to service its loans and is setting
50% of its revenues aside if required to pay the GOE.
Barring exemption from the law, City informed the GOE of its
two remaining options: terminate its concession with
Petroecuador and be compensated under Ecuador's Constitution
or convert their participation contract to a service or
association contract. City plans to maintain their current
holding pattern, if necessary, until February or March of
next year. If the new regulation requires them to begin
paying 50% of their revenues to the GOE, they will do so.

9. (SBU) Burlington Resources, recently purchased by Conoco
Philips (the only other remaining U.S. company active in
Ecuador's oil patch), is a 45% participant in two blocks
operated by Perenco, a private French-owned company.
Burlington's local manager expects that Conoco will
eventually sell their small stake in Ecuador following the
Hydrocarbons Law. Burlington and Perenco continue to drill
in Block 7 but Burlington has ceased operations in Block 21.

10. (U) Andes Petroleum is reportedly waiting for the change
of government in January, but will comply with any legal
orders to pay 50% of their production to the GOE. Industry
sources report that Repsol is eager to extend the term of its
concession, and is the most likely to negotiate a new
contract. Petrobras, on the other hand, is in a stronger
position under Ecuadorian law as a state entity, and
reportedly is disinclined to negotiate. Petrobras reportedly
has its eyes on the ITT, a large, unexplored field that
Ecuador has long considered offering in concession to a
foreign oil company.

Lacking a Plan
--------------

11. (U) The GOE has no concrete plans of how it will use the
additional hydrocarbons revenue. Estimates are as high as
$800 million in additional revenue from Occidental's former
fields and another $300-500 million from the new Hydrocarbons
Law, implying additional oil-related revenue this year
collected by the GOE of as much as $1.3 billion. Only the
funds that enter CEREPS are restricted by the law that
created it which requires 20% of deposits to go into an oil
stabilization fund, and the remaining 80% is automatically
allocated across sectors.

Comment
-------

12. (SBU) Ecuadorian officials are violating several of
their own laws in an effort to increase oil rents. Despite
the provisions of the CEREPS, the government will probably
have difficulty resisting pressure by powerful interest
groups to increase current spending in the run-up to the
October presidential election. The expected rise in current
spending financed by these extraordinary oil revenues is
likely to have a significant adverse impact on public
finances over the medium term. There is an equally likely
chance the Palacio Administration may attempt to line their
pockets before departing, leaving behind empty coffers and a
legacy of spending.
JEWELL

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