Energy: Oil and Gas 2019

Last Updated August 09, 2019

Ecuador

Law and Practice

Authors



Ferrere is the only multi-jurisdictional, purely South American law firm. It has 250 attorneys across Bolivia, Ecuador, Paraguay and Uruguay, offering international service across all four jurisdictions. The Energy & Natural resources department comprises two highly experienced partners, one counsel, one experienced senior associate, and three associates. The team recently advised Gran Tierra Energy and Frontera Energy through all stages of the bidding round that started in September 2018, including the registration process, offer presentations and execution of the contract. The firm is involved in work related to a higher percentage of the country´s oil production than any other Ecuadorian law firm.

According to Ecuador’s Constitution, non-renewable natural resources (including petroleum) are part of the unalienable assets of the State. Therefore, oil exploration and exploitation activities must be carried out by the State through its Public Companies or by Mixed Economy Companies. These activities could be granted to private entities (through contracts accepted by Ecuadoran law) as well, but only by exception.

When E&P activities are carried out by private entities, these companies operate as contractors of the State and are entitled to receive petroleum as their share in Production Sharing Agreements or as payment in Service Agreements.

The ministries and agencies that regulate petroleum activity in Ecuador are as follows:

  • the Ministry of Energy and Non-Renewable Natural Resources (the “Ministry”) is in charge of establishing public policies regarding oil and gas, mining and electricity, as well as granting licences and oilfields to public and private companies. It also grants and manages contracts;
  • the Agency for Hydrocarbon Regulation and Control (ARCH) regulates all upstream, midstream and downstream hydrocarbon operations; and
  • the Ministry of Environment grants authorisations for all hydrocarbon activities, according to the environmental laws and regulations.

The Republic of Ecuador has two State-owned companies (National Oil Companies – NOCs) in the hydrocarbons industry:

  • Empresa Pública de Exploración y Explotación de Hidrocarburos (PETROAMAZONAS EP), which is in charge of the exploration and production of oil and gas (Upstream Operations), is currently the main oil producer, and is in charge of exploring and producing hydrocarbons in more than 21 fields; and
  • Empresa Pública de Hidrocarburos del Ecuador (EP PETROECUADOR), which is in charge of transporting, refining, storing and commercialising the country’s oil (midstream and downstream operations), both nationally and internationally.

As per Executive Decree 723 of 21 April 2019, President Moreno has decided to merge both companies. This process is being led by the Minister of Energy and Non-Renewable Resources, and must be completed by 31 December 2020.

The Ecuadorian Constitution establishes that the State has exclusive ownership of energy resources, minerals, hydrocarbons, biodiversity and forest resources. All hydrocarbons belong to the State, so PETROECUADOR and PETROAMAZONAS have preferential rights for upstream, midstream and downstream operations.

Additionally, the Constitution and other regulations such as the Hydrocarbons Law, the Regulation of the Hydrocarbons Law, the Hydrocarbons Operations Regulations and the Hydrocarbons Operations Environmental Regulation set the petroleum legal framework for the carrying out of oil and gas activities in the country.

Private companies must have an executed contract in order to explore and develop hydrocarbons, according to the Ecuadorian law.

A general contract has a four-year term for exploration, which can be extended up to six years, and a 20-year term for production, which can also be extended if reserves have been added or if there are new investments with a five-year plan.

The Hydrocarbons Law provides the following form of contracts for traditional upstream and E&P activities:

  • Association, between the Ministry (concession and areas) and a private entity (investments) with a participation in production;
  • Production Sharing, whereby the Ministry delegates exploration and exploitation activities to a private entity. The private entity is paid a percentage of participation of the effective production. As per recently enacted reforms to the Hydrocarbons Law Regulations, the contractor's percentage of participation will be valued according to the reference price, adjusted by the quality of the crude oil, the volume of hydrocarbons produced, and sales price limits;
  • Service Contracts for Exploration and Exploitation, which are service provision contracts where a company (domestic or foreign entity) will use its own economic resources to provide the Ministry with services of hydrocarbon exploration and/or exploitation in areas designated for that purpose, investing capital and using the necessary equipment, machinery and technology for the fulfillment of the contracted services, in exchange for a tariff per barrel of oil produced and delivered; and
  • Contract for the Provision of Specific Integrated Services to NOCs, which are considerably different to Association, Participation and any E&P Service Contracts, in that the companies are compelled to execute specific works or services for the NOC, providing the technology, capital and necessary equipment or machinery for the fulfillment of the acquired obligations. For its services, the contractor will receive a cash payment agreed by the parties (usually in the form of a per barrel tariff).

Licences must be issued through formal bidding procedures. Public tender processes are carried out under the terms and conditions set by the Ministry. Usually, once a bidder is qualified, they must submit a technical and economic bid to back up their investment proposal. This proposal will be qualified by the Hydrocarbons Tenders Committee, which may recommend that the Ministry awards a contract. Once the bidder has been awarded the contract, they must open a local branch or subsidiary to execute the contract in Ecuador.

By exception, licences could be awarded directly (without a bidding process) to national oil companies from foreign countries. 

Under the Constitution, the Hydrocarbon Law and the contract terms, the government’s take cannot be lower than the private party's. In a service contract, the government’s take consists of the oil export price minus the per barrel tariff paid to the company, plus all applicable taxes. The government take is always at least 25% of the gross income of the oil exports of the contract, plus all oil transportation and commercialisation fees. The company’s take consists of the per barrel tariff received from the government, minus the expenses (investments, operating costs, taxes, etc) that need to be paid according to the law and the contract. The company's take may be reduced when oil prices are lower than required to cover the per barrel tariff.

Under a production sharing contract, the government take consists of income from the oil exports of its share, to which taxes and contributions paid by the company are added. In this case, the participation of the contracting company consists of income from the oil exports of its share, minus expenses (investments, operating costs, taxes, etc) that must be paid in accordance with the law and the contract.

Principally, the main taxes are 25% income tax, 12% value-added tax, and 15% profit-sharing.

The law contains a ring-fence provision under which each contract must keep its accounting independent from other contracts entered into by the same party. Therefore, each contract is considered as an independent unit for tax purposes. Consequently, the profits under one contract may not be offset against the losses under another contract, or against other activities of the company.

The company pays 15% profit-sharing, of which 3% corresponds to direct and indirect employees of the company and the remaining 12% to the government activities with the communities within the area of influence of the exploration and production established in the contract. The company must also pay 25% income tax. Moreover, if the company is incorporated in a tax haven, the 25% income tax tariff increases to 28%.

Other applicable taxes include the 12% value-added tax that the company pays on all goods and services required for its operations. Such tax is not refundable under production sharing contracts. Under service contracts, the amount established (12% value-added tax plus the stated tariff in the contract) is invoiced once a month.

The income of a service contract comes from fees paid to the company by the government. In a production sharing contract, the income is based on the sales price and the reference price of oil.

Tax returns are filed annually, and the fiscal year runs from January 1 to December 31 of each year. The statute of limitations for the tax authority to review timely filed tax returns runs out after three years.

Moreover, the company can deduct its investments in accordance with the rules for amortising investments for each contract, as well as all operating and transportation costs of each fiscal year and all taxes and contributions paid each year in accordance with the law and the contract.

In accordance with the Ecuadorian Constitution, PETROAMAZONAS has preferential rights to explore and produce oil and gas in the entire Ecuadorian territory. PETROAMAZONAS currently produces more than 75% of the oil in Ecuador.

Pursuant to the law, national oil companies from other countries do not need to participate in a bidding process to be awarded directly with an E&P contract.

The Hydrocarbons Law establishes that the contractors and associates in the exploration of hydrocarbons must contract a minimum of Ecuadorian personnel: 95% of the working personnel, 90% of the administrative personnel, and 95% of the technical personnel must be Ecuadorian.

Likewise, if the activities are carried out in the Ecuadorian Amazon circumscription, the norms of preferential employment have been established, by virtue of which no less than 70% of the assigned personnel to such area shall be residents of the circumscription.

Pursuant to the Hydrocarbons Law, in order to proceed with the development and production stages, exploration commitments and/or activities must have been performed within the first four years, extendable for an additional two years. Therefore, production is carried out in the subsequent 20 years in the case of oil exploration and production contracts.

Nonetheless, the Hydrocarbons Operations Regulations allow early exploitation, under which the contractor may execute development and production activities within the exploration period, subject to prior authorisation from the Ministry.

Once a commercial discovery has been made, it must be reported to the Ministry. A request must be submitted to the Ministry,  containing the investing company’s field development plan. Once the field development plan has been approved, the production stage will start. The Ministry has the capacity to regulate fields and well production rates.

The licensee or contractor acts as an operator and, therefore, has to take on all investments, exploration and production risks, as well as environmental liability pursuant to its environmental obligations. Additionally, the contractor must comply with all laws, especially employment laws, regarding the maximum number of foreign employees. Other key terms include termination provisions in the event of the contractor breaching the law or contract.

For E&P contracts, the transfer of interests is regulated in the Hydrocarbons Contract Transfer Regulations, published in the Official Registry 293 of 27 March 2001.

The law requires prior approval from the Minister of Hydrocarbons for the assignment after an evaluation of the assignee has been completed. Such approval needs to be issued within a ministerial decree. The assignor shall pay a premium for the transfer, which is calculated based on the transferor’s net income filed in the preceding year, and which may be divided between the transferee and the transferor. Furthermore, the assignee shall pay the Ministry a premium for the improvement of the economic conditions of the contract, in the amount of USD5,000 for each 1% of shares transferred.

Contracting rights may be transferred upon payment of the respective premiums, if such operation was approved by the Ministry. If the company does not proceed accordingly, such action may provoke a unilateral termination of the contract (caducidad). Likewise, failure to comply with this procedure could trigger the government’s power to unilaterally terminate the contract.

Through its competent authorities, the State has the capacity to regulate E&P operations as well as production rates. Additionally, as a member of OPEC, Ecuador is subject to its production rates, so restrictions may apply.

Most oil production is transported to the “Balao” Terminal on the Pacific Coast. The SOTE pipeline is owned by PETROECUADOR and transports ORIENTE crude oil of an average of 24 degrees API. On the other hand, the OCP pipeline is owned by a private consortium of companies and transports NAPO crude oil of an average 18 degrees API.

Pursuant to the law, a private company may build and operate a pipeline until the maturity date set in each contract when, subsequently, the pipeline will be relinquished to the State. OCP is currently the only primary pipeline owned by a private entity.

A system of secondary pipelines (RODA) is owned by PETROAMAZONAS but each operating company is in charge of constructing its own facilities when a production sharing contract is celebrated. The point of delivery is typically at the connection to a secondary pipeline, for service contracts. On the other hand, the operator must pay transport fees to the different secondary or main pipelines it wishes to use to get its oil to the Pacific Coast, for production sharing contracts. Under each contract, companies may also construct and use a secondary pipeline with a prior authorisation from ARCH.

Private companies may construct and operate refineries, upon the State's authorisation. Nevertheless, all existing refineries are currently owned by PETROECUADOR.

Pursuant to the law, private companies are authorised to distribute and sell petrol, diesel and LPG to final consumers, upon approval of the Ministry. Private companies receive subsidised products from PETROECUADOR or its subsidiaries, and are allowed to have a margin that is set by the government each year. As per recently enacted regulations, subsidies set on prices of certain fuels have been reduced or lifted. Accordingly, profit margins for distributors are no longer in force for certain fuels.

Finally, it should be noted that, pursuant to the law, most gas stations are privately held by distribution companies, and some are held by private individual owners required to be affiliated with a distribution company.

The law states that, in an event of shortage in transportation capacity, the oil produced by the NOC has preference over the oil produced by private entities. Accordingly, lasting transportation capacity shall be distributed among private producers, subject to the production capacity of each company. However, it should be noted that there is currently enough transportation capacity to transport oil to terminals, through SOTE and OCP.

Transportation tariffs for OCP are set by the contracting parties, while those for SOTE are set by PETROECUADOR following a regulation that considers quality and distance.

As regards commercialisation and distribution, PETROECUADOR currently has the majority of such markets, and all the commercialisation and distribution is done through products sold by PETROECUADOR. However, private companies may access such phases upon obtaining authorisation from ARCH and the Ministry, which will evaluate the financial and technical capacities of the solicitor. 

A licence from the Ministry or ARCH, depending on the case, is required in order to execute distribution or commercialisation activities. Licences do not result from bidding processes and may be renewed every five years. For the State to issue a licence, the factors of technical capacity, economic means, locations and plans may be observed, among others.

All oil products excluding lubricants are produced, refined or imported by PETROECUADOR. Therefore, in order for private companies to perform related activities, a licence from the Ministry of Hydrocarbons is required, or a contract must be signed with PETROECUADOR that establishes the terms of the activities.

The following taxes apply to downstream operations:

  • 12% value-added tax;
  • 15% profit-sharing; and
  • 25% income tax.

PETROECUADOR is in charge of refining and importing hydrocarbon products. Furthermore, pursuant to the law, the distribution of such products shall be made exclusively by PETROECUADOR, acting by itself or through the contractual forms established in the law. Therefore, PETROECUADOR has preferential rights for distribution. However, private companies do most of the distribution, given that PETROECUADOR owns few gas stations.

There are no specific local content requirements for downstream operations established in the Hydrocarbons Law. However, if downstream operations are carried out in the Ecuadorian Amazon circumscription, the norms of preferential employment have been established, by virtue of which no less than 70% of the assigned personnel to such area shall be residents of the circumscription.

As a general rule, all activities are controlled by ARCH, which may impose fines and is competent to suspend any establishment and even terminate a licence or contract. Furthermore, an environmental licence is required for downstream operations, and companies must abide with environmental regulations.

Pursuant to the Constitution and the law, the hydrocarbons industry is deemed to be a strategic sector and all its phases are of public purpose. Accordingly, the Ministry may declare eminent domain on lands, buildings, facilities and other assets, in accordance with the law. For this purpose, all expenses and payments must be borne by the private investor. This faculty does not apply for gas stations.

The law deems that some pipelines are constructed under the provisions established in each contract and used by private companies. However, such pipelines may serve a public purpose, so third parties may request to access that infrastructure in similar terms applicable to the owners.

Although subsidies to certain fuels have been reduced or even eliminated by the Ecuadorian government, other fuels remain highly subsidised. At the time of writing, PETROECUADOR continues to be the sole importer and producer of hydrocarbons derivates that are sold to private distributors and commercialising companies for a pre-established price (for certain fuels) and with pre-determined price profit margins for sales to the public (for certain fuels). Consequently, there are no pre-established profit margins for distributors for certain fuels.

The Hydrocarbons Law and its Regulations set the legal framework for the export of crude oil, natural gas and petroleum products.

The Hydrocarbons Operations Regulations establish that the Ministry shall determinate the quotas for the export of hydrocarbons to public and private companies, based on the estimates of releases (levantes), the current legal framework and corresponding contractual provisions. Furthermore, the Ministry shall be responsible for the distribution of the exported volumes.

The Ministry is in charge of approving any transfer of interest in downstream licences or an indirect transfer of ownership. Subsequently, the payment of premiums is required by law. Regarding taxes for transfers of interest in downstream licences, capital gains tax on the sale of shares is applicable.

Foreign investment is permitted without constraints. Furthermore, the law does not provide an obligation to have local partners.

Foreign investment may be protected through Investment Agreements, which seek to obtain stability. As per an Investment Agreement, investments generated in the country have tax incentives such as a reduction of three points on income tax percentage, deductions for the calculation of income tax, exoneration of the remittance tax, and exoneration of advance payment made for income tax for five years for all new investments. Such benefits are available if the investor executes an Investment Agreement with the State.

Foreign investors will have tax stability in the income tax and other national direct taxes, exclusively with respect to the rates and exemptions of each tax in force on the date of subscription of the Investment Agreement.

Non-discriminatory treatment is offered in the administration, operation, expansion and transfer of investments, which shall not be subject to arbitrary or discriminatory measures. Investments and foreign investors will be granted full protection and assurance, in such a way that they will have the same protection as Ecuadorians receive within the national territory. As per the law, the property of investors will be protected and all forms of confiscation are prohibited, for either national or foreign investments.       

Regarding dispute resolution methods for oil contracts, international arbitration may be agreed by the contracting parties, subject to approval from the State General Attorney Office. International arbitration for an Investment Agreement will only be applied if the value of the matter at hand exceeds USD10 million, and will be held under the rules of UNCITRAL, PCA, ICC or CIAC.

It is important to note that international arbitration under Bilateral Investments Treaties (BITs) with other countries may not be accessible, given that Ecuador has denounced most of them. Despite such denunciation, the survival clause or “Sunset Provision” applies to investments made before the termination date, extending protection for an additional period. All other future investments may be outside the scope of treaty protection.

Finally, it must be noted that, according to the Hydrocarbons Law, following due process, the State has the power to terminate an oil and gas contract unilaterally (caducidad) upon breach of law or contract as a result of the administrative procedure set in the law. The termination decision can be challenged judicially and may be followed by actions for damages after termination.

The principal environmental laws are the Organic Environmental Code and its Regulation, the Unified Text of Secondary Legislation on the Environment (TULAS) and the Environmental Regulation for Hydrocarbon Activities.

The environmental regulators are the Ministry of the Environment, the Water Secretary, and the Decentralised Autonomous Governments (provinces and cities).

After the contract is awarded, the company will have to satisfy all legal and contractual requirements, including obtaining an Environmental Licence, after completing the procedure set in the law. Pursuant to the law, authorised environmental consultants shall prepare an Environmental Impact Study (EIS), which is a requisite for the issuance of the Environmental Licence. The EIS presents the characterisation of the environmental conditions prior to the execution of the project, risk analysis and a description of the specific measures to prevent, mitigate and control the environmental alterations resulting from the implementation of the project.

Although the law dictates that a community consultation process is required in order to acquire an Environmental Licence, the State has competence to issue the final decision even if the majority of the community opposes the project. Accordingly, Environmental Licences are issued by the Ministry of the Environment for each phase of the industry (exploration and production) upon approval of the EIS by the same ministry.

It must be noted that the Constitution prohibits extractive activities in protected areas and in areas declared as intangible, including logging. Exceptionally, hydrocarbons may be exploited at the grounded request of the President of the Republic, and after declaration of national interest by the National Assembly, which, if deemed convenient, may call a referendum.

Furthermore, the Ministry of the Environment has competence to conduct audits and oversee compliance with the EIS and all applicable laws. As a result, in case of breach, aside from penalties, it may determine that the company has to remediate environmental damages. If the company does not proceed accordingly, the Ministry of the Environment may request the termination (caducidad) of the contract from the Ministry of Energy and Non-Renewable Resources.

Additionally, Ecuador has a strict liability regime for environmental damages, so the burden of proof for demonstrating that no damage has occurred falls on the operating company. Liability for environmental damages may not be assigned to subcontractors, although a knock for knock clause may be included. There are no caps on liability under local legislation. There may be a cap on liability on certain contracts among private entities or subcontractors, but there are none in contracts signed directly with the State.

As for the main contractual requirements, it is important to mention that a common provision is for conducting an environmental baseline to determine the status of the assigned area. As per each contract, the company may have to operate in compliance with the applicable environmental standards during the term of the project. To terminate a project, the Ministry of the Environment shall approve a final audit.

Environmental regulation is the most notable area that contains differences between onshore and offshore operations.

The Environmental Regulation for Hydrocarbon Activities states that, for offshore management of liquid waste, any offshore platform shall have adequate tanking capacity to receive fluids from drilling and production, in order to remove polluting components prior to their discharge. In offshore operations, the discharge of oil-based drilling muds, which must be treated and disposed of on land, is prohibited. On closed platforms, closed circuits must be installed for the treatment of all liquid waste.

Regarding offshore exploratory and advanced operations, exploratory drilling shall include gravel processing systems, with closed effluent treatment systems, and a system of grey water treatment. Additionally, for offshore production tests, the agent must use systems to recover and treat polluting fluids.

In the temporary or definitive abandonment of an operations area, in offshore drilling a well must be permanently abandoned and the agent must take other measures to avoid damage or impediments to fishing, navigation or other activities.

On offshore industrialisation facilities, extracted gas has to be dehydrated and the formation water shall be discharged into the environment or injected in accordance with the provisions of environmental regulations.

In order to proceed with decommissioning, either PETROAMAZONAS or the Ministry of the Environment shall require an environmental audit. However, third-party claims may be effective despite the fact that the Ministry of the Environment has either approved such audit or has conditioned acceptance upon remediation.

There are three specific laws that regulate climate change: the Constitution, the Environmental Organic Code and its Regulations.

The Ecuadorian Constitution establishes that the State will adopt appropriate and transversal measures for the mitigation of climate change by limiting greenhouse gas emissions, deforestation and atmospheric pollution. In accordance with this, the Environmental Organic Code establishes that the State must create and strengthen the conditions for the implementation of mitigation and adaptation measures to fight climate change. 

On the other hand, the Environmental Organic Code establishes that the Decentralised Autonomous Governments (provinces and cities) may incorporate criteria of climate change in their respective territorial planning.

The Ministry of the Environment has exclusive competence for granting licences for all oil and gas activities, to ensure they are conducted in compliance with environmental laws and regulations.

However, Decentralised Autonomous Governments have competence to grant permissions for any infrastructure construction required for the development of oil activities (facilities) and other operating permits.

Another issue that raises awareness is communities' attempts to block oil and gas activities, with several constitutional actions alleging lack of a proper community referendum having been filed.

The Ministry may regulate further features that relate to interests in heavy crude below 15 degrees API, pursuant to article 32 of the Hydrocarbons Law, although this right has not yet been executed in a particular case.

There are specific regulations that refer to liquefied natural gas, as in the Regulations for LNG Marketing Activities.

Furthermore, LNG projects may be expected to provide a contractor with a higher participation/tariff from the State, given the higher risks involved.

The main current issue is the return of production sharing contracts after more than ten years of exclusively service contracts, with the Ministry recently awarding seven production sharing contracts to domestic and international companies during the Intracampos Bid Round. Furthermore, the State has announced that other following Bid Rounds shall occur: Intracampos Round II, Suroriente Round, and Offshore Round. The State in conducting analysis to determine the convenience of releasing a bid round of Sacha block for private companies, through either PETROAMAZONAS or the Minister.

The Organic Law on Production Development, Investment Attraction, Employment Generation and Fiscal Stability replaced the previous oil Windfall Tax with a State participation where the State’s production share will increase if the reference price increases. In no case will the participation of the State be lower than the original participation established in the contract.

Furthermore, the President of Ecuador issued the Regulations for Application of the Law Amending the Hydrocarbons Law, which modified the previous Production Sharing Contract Regulations. Therefore, regulations now indicate that Bidding Guidelines must include adjustment parameters for the State’s production participation according to price and production volume whereas, in the preceding regulations, the minimum production share limits depended entirely on production volumes.

Ferrere

Avenida 12 de Octubre N26-48 y Lincoln,
Edificio MIRAGE,
Piso 16.
Quito,
Ecuador

+593 2 381 0950

adonoso@ferrere.com www.ferrere.com
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Law and Practice

Authors



Ferrere is the only multi-jurisdictional, purely South American law firm. It has 250 attorneys across Bolivia, Ecuador, Paraguay and Uruguay, offering international service across all four jurisdictions. The Energy & Natural resources department comprises two highly experienced partners, one counsel, one experienced senior associate, and three associates. The team recently advised Gran Tierra Energy and Frontera Energy through all stages of the bidding round that started in September 2018, including the registration process, offer presentations and execution of the contract. The firm is involved in work related to a higher percentage of the country´s oil production than any other Ecuadorian law firm.

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