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OO RUEHWEB

DE RUEHQT #1722/01 1951828
ZNR UUUUU ZZH
O 141828Z JUL 06
FM AMEMBASSY QUITO
TO RUEHC/SECSTATE WASHDC IMMEDIATE 4831
INFO RUEHBO/AMEMBASSY BOGOTA PRIORITY 5792
RUEHBR/AMEMBASSY BRASILIA PRIORITY 3627
RUEHCV/AMEMBASSY CARACAS PRIORITY 1868
RUEHLP/AMEMBASSY LA PAZ JUL 9951
RUEHPE/AMEMBASSY LIMA PRIORITY 0771
RUEHSG/AMEMBASSY SANTIAGO PRIORITY 2990
RUEHGL/AMCONSUL GUAYAQUIL PRIORITY 0827
RUEHSO/AMCONSUL SAO PAULO PRIORITY 0172
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