New update below 1-23-08 dhfjr.

I’ve avoided writing about the current conflict over oil contracts in Ecuador because my family owns an interest in an oil company operating in Ecuador (City Oriente) and my opinions will probably find less than a warm welcome from participants on either side of the issue. But as tensions escalate and potential for disastrous outcomes grow, I feel the need to have a say, with hopes for an acceptable outcome for all.

I’m not directly, not even indirectly involved in the decision making process at City Oriente, but I do have two brothers that work for the company and have gleaned bits and pieces of what’s happening through them and by following events on the Internet. Some of the details I offer will be wrong, but hopefully close enough to reality to offer a general understanding of the situation. The issues are complex. Right and wrong get clouded in the debate. First a little history:

My dad worked in Ecuador during the late 60’s and early 70’s during the infancy of the oil business in the eastern provinces of that small South American country. He was a salaried employee of an American corporation based out of California. He also held a small minority interest in the company. The principal companies with concessions during the era were mostly large American oil giants like Texaco and Shell oil. My dad’s company, Cayman International, was tiny in comparison. Nonetheless, Cayman did acquire a concession, then financing to explore for oil and to develop the field if oil was found. His efforts proved fruitful.

In the end, Cayman was acquired by another company. Dad got a job with the new owners for a time but eventually they parted ways and his involvement in the business ended. Subsequently, a series of different companies acquired the now highly productive concession that had belonged to Cayman.

The original contracts Ecuador signed with foreign investors required oil companies to perform seismographic studies, drill test wells and then install production facilities should oil be discovered. Once production began, a percentage of the oil produced (around 20%) would go to Ecuador; the remaining oil would be property of the producing company for sale in international markets. In addition, companies would be required to pay an income tax on any profits derived from their activities.

As time went by, these contracts went by the wayside. Some expired due to age, others after acquisitions of the companies holding them.

The original contracts should have generated a lot of money for the Ecuadorian government. 20% of gross production is, at minimum, half of profits, if not more, when the high cost of development and production in remote areas is factored into the equation. In fact, Ecuadorian oil has generated a lot of revenue for the state, unfortunately, most of this has ended up in the hands of a wealthy few, and a lot of the wealth has exited the country.

Here’s how it happened.

Once Ecuador had proven reserves, investors (some would call them economic hit-men), offered proposals that seemed to be of benefit to the nation. Proposals like electrification projects. But these projects were negotiated by politicians that were more interested in their own enrichment than that of their country. Some of the projects were intentionally overvalued, allowing large amounts of money to be siphoned off by those that arranged the deal on both ends. Ecuadorian politicians took kickbacks in exchange for overpriced contracts to build the facilities, contractors made excessive profits for their work, politicians got rich and banks were satisfied because Ecuadorian oil reserves were collateralized as guarantee of payment. As oil was produced, a portion of the government’s share paid the notes.

Years later, the price of oil fell. Suddenly Ecuador was left with a crushing debt accumulated over time formed by a series of these bad agreements. Companies holding the notes figured they’d never be repaid and sold the notes to individuals for as low as 10 cents on the dollar. Some of the buyers of the notes may very well prove to be the original corrupt politicians (perhaps now living in and owning a nice piece of Miami, Florida) that earned their money by stealing it in the first place, and other foreign interests. These transactions did nothing to reduce or eliminate Ecuador’s financial obligation, they just changed who held the notes.

When oil prices rebounded, Ecuador resumed making payments against the money the country had borrowed plus accrued interest. Even though oil revenues were high, a significant amount of the country’s income was tagged as payment against these loans, leaving little money for successive governmental administrations to spend at home. Then, of course, the new crooks in office took their piece of the pie and left even less for the next man in line. I don’t know the exact figures, but I do know the percentage of revenue that actually made it into any meaningful project for the benefit of the people is extraordinarily low.

Dad returned to Ecuador in the late 90’s and in a series of transactions acquired a small but marginal and unproductive block from Cayman’s original concession for City Oriente, a privately held company in which he owns a substantial interest. Prevailing thought among oil professionals was that the area was inconsequential (he obviously disagreed). The block had minimal production—something less than five hundred barrels a day. Oil was selling for 20 some-odd-dollars a barrel. City Oriente purchased the property for a price in the neighborhood of $20 million dollars. Under terms of the new contract, City was required to do additional exploration and development. As with Cayman’s original contract, a percentage of the oil would go to Ecuador, but now the percentage was higher. I don’t know the exact terms, but I think Ecuador got 25% of gross production up to a given number of barrels per day and more above that number. In addition City Oriente was required to pay a 38% income tax on profits derived from the sale of oil.

City borrowed money for new drilling projects. Their first efforts were directed at a couple of wells he had drilled years ago and plugged because they were so remote that it was impossible to extract the oil at the time, and also because most thought they’d be marginally profitable at best. The oil they contained is low-gravity or thick oil, harder to extract and ship and also worth less per barrel than high-gravity crude. The wells outperformed expectations.

Then City drilled new discovery wells and got them on-line, once again in an area thought to be worthless. Production levels for City’s block rose to over 4,000 barrels a day. City delivered their portion of oil to the government as the contract required and also paid taxes on their income.

However, the people living in the region where the oil wells lie were unhappy. They saw large amounts of a valuable resource being pumped from the ground beneath their feet and saw very little in benefits from the sale of said oil. They had little or no idea where the money went; they just knew it failed to find its way home. Understandably, they began to clamor for better treatment.

Environmental activists also had their say. Early oil exploration and development was done without much if any respect for the environment (as was also the case in the United States. The oil museum in Luling, Texas has pictures of oil rigs stacked along the ground like cars in a parking lot and rivers of crude running through creek beds).

City made provisions for both. After negotiating with locals they paid doctors to service the needs of locals free of charge, bought cattle for some, and financed other projects (without being required to by the government). Wells were drilled with the latest techniques; one platform served as a central location for various horizontal holes to reduce the footprint of both drilling and production facilities.

Most other companies operating in Ecuador made no provisions for the native occupants of the land, aside from employing factions of the Ecuadorian army for protection of their facilities.

Meanwhile, the cocaine industry continued to grow in the region, fueling both ultra-left and ultra-right factions, mostly in Colombia, but also in neighboring Peru and Ecuador as well. Anyone telling you that cocaine is exclusively owned by leftists is lying or ignorant of the facts.

When Rafael Correa was elected president he was given a mandate: to see that a larger part of proceeds from the sale of Ecuador’s resources should stay home and benefit Ecuadorians. He inherited a condition that made this impossible. Unable to eliminate the country’s external debt, he turned to foreign oil companies and demanded a larger cut of proceeds.

A benchmark price for oil was set (I believe in the case of City it’s $28/barrel). Correa demanded 50% of any profits derived from the sale of oil above the benchmark price. While this may appear to be good for the government, it is an unworkable agreement and in the end would bankrupt oil companies. It will also mean less revenue for Ecuador in spite of the higher percentage of the government’s take as production grinds to a halt.

What many fail to realize is that oil prices go up, production costs also go up. As you produce oil, you diminish reserves. Oil companies make money selling oil and must do additional exploration and build additional production facilities to ensure a supply in the future. The cost of doing exploration in a world of diminishing returns has gone up exponentially. So much so that if City had paid what Correa demanded, they would have lost $500,000 last year, and that in spite of suspending further drilling operations.

City’s contract with Ecuador provided a provision for arbitration of disputes. A tribunal under the auspices of the World Bank, comprised of members appointed by both sides in the dispute and one neutral party was created. Unlike most companies in Ecuador, City filed for arbitration and refused to pay the additional money Correa demanded. The case is under consideration at the moment. Most companies did enter into new contracts, although many of them have failed to make payment under the new terms. They can’t afford to.

Correa’s response was harsh. Instead of 50% of income above the benchmark price Ecuador was to receive under the previous decree, he upped the percentage to 99% above benchmark for all foreign oil companies operating in Ecuador. This is absolutely an unworkable equation. Correa has also said that he will cancel all contracts of companies in arrears since the 50% above benchmark decree was announced, Wednesday of this week.

He has also indicate that he will not accept the decision of the arbitration.

Negotiations are in progres to come up with a workable solution to this conflict.

It appears that Correa’s goal is nationalization of Ecuador’s oil. With the track record of the national company in mind, that won’t be a good thing for the country. But there’s a possibility that Correa will try to reach an agreement where Ecuador owns the oil and oil companies are paid as contractors for their services. This is unlikely to attract investors from foreign countries (outside of China, with their huge pile of depreciating dollar denominated notes), but if he can pull it off, he may be able to keep production from undergoing a precipitous collapse.

If he nationalizes these companies without some sort of acceptable compensation for loss of investment, he will find both himself and Ecuador in major trouble. Even his mentor, Hugo Chavez has indicated he will repay Conoco-Philips for a least a portion of Conoco's investment into Venezuela.

This is an on-going event and will be worth watching in the near future.

From my perspective, the era of privately owned oil is soon likely to be a thing of the past and big oil as dead as the dinosaurs.

As far as City Oriente and Ecuador are concerned, unfortunately both will be probably suffer from the backlash as large and powerful moneied interests from within and from outside the country fight over the spoils of their land. City Oriente may fall victim to Ecuador, but if so, Ecuador may find themselves in the cross-hairs of the World Bank.

If anyone involved in this proceeding thinks my depiction of events is inaccurate, I welcome your contribution and perspective to the discussion. I will be the first to admit that my vantage point is limited and that my opinion is somewhat biased.

New update 1-23-08

City's production in Ecuador has fallen from over 4000 barrels per day to something slightly below 3,000/bpd since the government demanded higher revenue taxes. With no chance of realizing profits, City was forced to suspend ongoing drilling and development programs. In this climate attracting financing is impossible.

My dad estimates that had City been allowed to proceed with plans, production could have been raised to somewhere around 10,000/bpd.

On another note, when you consider that during years when oil prices fell into the <$10/barrel range notes on the national debt were sold to private interests at something along the lines of 10 cents on the dollar and the holders of these notes are collecting on 100% of their value plus interest, it is time for these debts to be cancelled.

I'm sure some rich guy somewhere disagrees.

Usury is a sin and a goddamned crime.

Under biblical law, all debts should be cancelled after 49 years and properties returned to the original owners. Perhaps in light of the way Ecuador's debt was created and has been (mis) managed, it is appropriate for Ecuador to reassume ownership of their oil.

On the other hand, Ecuador should compensate City for its investments and be cognizant that finding and producing oil is a complicated and complex activity, the intracies of which cannot be learned in a class-room or be performed entirely with the use of computers and fancy software. City Oriente holds the key to effective development of the block it manages in Ecuador's field while employing environmentally friendly methods. City's owners and managers have proven themselves relatively honest practioners, interested not only in personal profit, but also in the welfare of Ecuador and its citizens.

Room remains for a mutally advantageous relationship in this venture.

My two cents, for whatever it's worth. dhfjr.