The Oil and Gas Law Review: Ecuador

Introduction

With approximately 8.27 billion barrels of reserves, and a daily production of approximately 520,000 barrels per day, Ecuador's crude oil production continues to be the most important export in the country, as it has been over the last four decades.

In 2020, the Ecuadorian government has continued its efforts to recover and strengthen its hydrocarbon industry. However, in the first semester of 2020, Ecuador's oil production collapsed by an average of 58 per cent, because of the rupture of the Heavy Crude Oil Pipeline and the Trans-Ecuadorian Pipeline System, as a consequence of a landslide of great proportions near to the Coca River, because of an aggressive erosion phenomenon. Nonetheless, by the end of 2020, the government expects to reach a production of 530,000 barrels per day and increase it up to 580,000 barrels per day by 2021.2 This effort will mandatorily include offering oilfields to private companies through public tender rounds, as well as continuing the improvement of operations of the state-owned company in charge of the exploration and exploitation of hydrocarbons in Ecuador, Petroamazonas EP (PAM).

Legal and regulatory framework

i Domestic oil and gas legislation

Ecuador has a civil law system with its most recent Constitution approved on October 2008 and partially amended in 2015. Pursuant to Articles 1 and 408 of the Constitution, natural resources are the unalienable property of the Ecuadorian state. Articles 313 to 315 of the Constitution establish that the state is responsible for the management of 'strategic sectors' through state-owned or state-controlled companies, and the regulation of such sectors through the corresponding public entities. Strategic sectors include, among others, energy in all its forms, non-renewable natural resources (including oil and gas, and mining), and hydrocarbons refining. By exception only, the government may delegate such activities to local or foreign private, public or mixed-economy companies. Private companies with the required experience, and technical and economic capacity may enter into contracts with the Ecuadorian state.

The Hydrocarbons Law regulates the Ecuadorian oil and gas industry. It contains the basic regulations for all the different types of contracts to be entered into with the state, including contract termination, state income and fiscal terms, transportation, commercialisation, exports, distribution, pricing and other provisions.

Furthermore, there are several specific regulations that regulate specific matters of the industry; for example, Regulations to the Hydrocarbons Law, Hydrocarbons Operations Regulations, Hydrocarbons Operations Environmental Regulations, as well as other laws and regulations regarding environmental issues, taxation, and accounting, among others.

ii Treaties

Ecuador is a party to the New York Convention (NYC), which has been in force since 1962.3 Additionally, Ecuador has subscribed to the Inter-American Convention on International Commercial Arbitration of Panama of 1975, in force since 1991. In 2017, Ecuador denounced all of the bilateral investment treaties to which it was subscribed. Finally, Ecuador has subscribed to 18 double taxation treaties.

iii Regulation

The Ecuadorian state currently acts through:

  1. the Ministry of Energy and Non-Renewable Natural Resources (the Ministry). On 18 May 2018, the President of Ecuador ordered the merger of the Ministry of Hydrocarbons, Hydrocarbons Secretariat, Ministry of Electricity and Ministry of Mines, creating the Ministry, which assumed all their attributions. The Ministry is in charge of carrying out hydrocarbons policies, and is responsible for executing, amending and administering areas and oil contracts, as well as the country's hydrocarbons resources.4 Because of this, the Ministry is now the entity that represents the Ecuadorian state in the execution of exploration and production contracts under the Hydrocarbons Law;
  2. the Energy and Non-Renewable Natural Resources Regulatory Agency, which is in charge of regulating, controlling and supervising the technical, administrative and operative activities in the different stages of the hydrocarbons industry, including upstream, midstream and downstream activities. On 6 May 2020, the President of Ecuador ordered the merger of the Hydrocarbons Regulation and Control Agency (ARCH) with the Mining Regulation and Control Agency and the Electricity Regulation and Control Agency, into a single entity called Energy and Non-Renewable Natural Resources Regulatory Agency, which will attached to the Ministry.5 According with the executive decree, this merger should have been implemented within 60 days from the issuance of the executive decree; however, it has not finished yet. This new agency will assume all the rights and obligations of the ARCH;
  3. the Ministry of the Environment (MAE), which is the national environmental authority in charge of applying environmental policies, and regulating, controlling and supervising all the environmental issues in all industries, including oil and gas; and
  4. the Internal Revenue Service (SRI), which is involved in taxation matters for all industries, including oil and gas.

Licensing

Pursuant to the Constitution and the Hydrocarbons Law, the state may award the following contracts to private, public or mixed-economy companies: (1) association contracts; (2) participation contracts; (3) risk service contracts for the exploration and production of hydrocarbons; or (4) other forms of delegation pursuant to Ecuadorian law.

Regarding the aforementioned types of contracts, Ecuador has traditionally implemented two types of contracts – participation contracts and service contracts – for the exploration and production of hydrocarbons. Petroamazonas, the national oil company, has also entered into specific integrated service contracts with PAM, which are risk service contracts.

i Participation contract

The participation contract model was used by Ecuador from the early 1990s through to 2010, when Ecuador, pursuant to new reforms in the national oil industry, switched to the service contract model. Ever since 2010, it was the policy of the government of Ecuador to award services contracts for the exploration and production of hydrocarbons, and not to award participation contracts. However, in 2018, the participation contract was reinstated through Executive Decree 449 dated 12 July 2018. Thereafter, in the latest oil and gas round called 'Intracampos 1', seven oilfields were awarded to private companies under participation contracts and using exclusively participation contracts for the awarding of oil fields is expected to continue.

The participation contract is a production sharing agreement entered into by the state, pursuant to which it delegates to the contractor the right to explore and produce hydrocarbons in the area designated in the contract. The contractor bears the risk for all investments and assumes all costs and expenses required for exploration, production and development. The contractor has the right to participate in the production, which is calculated taking into consideration the production volume and the sales price of crude oil. The sales of the contractor's participation in production constitutes the contractor's gross income, from which the contractor must pay all investments, costs and expenses, applicable taxes and profit sharing contributions. The participation in production may be received in kind or in cash, subject to prior agreement between the parties.

In line with the Constitution, a participation contract includes a formula to adjust the contractor's take, to ensure that Ecuador's take in the contract (oil sales and taxes) is higher than contractor's.

ii Service contract

Under the service contract, the contractor is required to provide exploration and exploitation services, invest in equipment, materials and technology with its own economic resources and at its sole risk, in exchange for a fee per net crude oil barrel produced and delivered to the state at the measurement point. The contractor's fee considers an estimate of the amortisation of the investments, costs and expenses and a reasonable profit taking into consideration the risks borne by the contractor. The contractor is the sole and exclusive operator and will be entitled to the payment of a tariff per barrel of net oil produced in the contract area. The state takes 25 per cent of the gross income from the sales of the crude produced in the contract ('sovereign margin'). Variations on the international price of oil affect the payment of the contractor's per barrel fee. Payment to the contractor is made in accordance with the monthly 'available income' derived from the production of the contract area. The available income is the value of the gross income of the crude produced in a certain month (barrels produced multiplied by the market price of oil) minus the 'sovereignty margin' (25 per cent of gross income) mentioned above, transportation and commercialisation costs of Ecuador and certain applicable taxes and contributions. If the available income in a given month is less than the per barrel fee payment, the contractor only receives the amount of the available income and the difference is accumulated in an accumulation account ('carry forward' account).

iii Integrated service contracts

In 2012, PAM assumed the operations of all the fields and areas that were operated by the state at the time. Pursuant to a specific integrated services contract, the contractor agrees to carry out specific works, activities or services for PAM, which continues to be the designated operator of the field, providing the technology, capital, and equipment or machinery necessary to perform its obligations, in exchange for a fee in cash. In this type of contract, the state generally retains the operational risks, and the contractor only assumes the risk of its own investments made to provide the services in exchange for a fee.

iv Tender process for awarding participation and service contracts

When Ecuador decides to carry out exploration and exploitation activities, it may choose, following specific bidding regulations, private companies, associations or consortia that have the required financial solvency and technical capabilities in the hydrocarbons industry.

The Hydrocarbons Bidding Committee is in charge of conducting the bidding procedure and enacting the bidding terms. Once the winning bidder is awarded, the corresponding contract is entered into between the Ministry and the awarded company.

v Special procedures for awarding specific integrated services contract with PAM

The state has conducted procedures to award specific integrated services contracts to companies for the purpose of increasing the production of existing fields under the operation of PAM. Once the potential partners have been determined, the board of directors of PAM resolves to begin a process for the direct negotiation of the contract with the selected bidder.

vi Revocation and expiry of licences

With respect to the contracts subscribed with the Ministry, the Hydrocarbons Law establishes several causes for which the Ministry may declare the unilateral termination of a contract, which is called 'caducity'. The effects of caducity are the immediate return of all assets and production to the government and calling up contractual bonds. Caducity may be declared for breach of contract, unfulfilled committed activities, suspension of activities, failure to deliver the government's take, transfer of contractual rights without prior approval of the Ministry, among others. To declare caducity, the Ministry must comply with the procedure established in the law. In contrast, regarding contracts subscribed with PAM, termination causes will be indicated in the contract, including termination by mutual agreement.

Production restrictions

There are no restrictions on production or exports of entitlements. Under participation contracts, the contractor is entitled to receive the agreed participation, and is responsible for the costs of transportation and export of its share of production. Under service contracts with the Ministry and specific integrated services contracts with PAM, all production is delivered to the state at the delivery center, and the state is responsible for the transportation and export of the production. There are no requirements for sales of production into the local market.

Although the commercialisation of hydrocarbon derivatives has been an activity heavily regulated by the state that includes subsidies for many products (gasolines, diesel, liquid petroleum gas, among others) and regulated prices, in May 2020 the President of Ecuador amended the price regulation for hydrocarbon derivatives. The amendment included the liberalisation of prices for some types of gasoline and diesel, which will now be calculated on a monthly basis considering the Oriente crude and the WTI marker. The President of Ecuador changed the regulated prices model to a new model using a band system with monthly variations limited to ± 5 per cent US$ per gallon from the initial prices established in the execute decree. If the variation is higher than 5 per cent, the state would have to subsidies the difference. This new system has been in force since 1 July 2020.

Assignments of interests

Transference of interests in participation contracts and services contracts with the Ministry require prior approval from the Ministry. Failure to obtain such approval is cause for termination under caducity. The 'transference of interests' approval procedure is regulated and requires the Ministry to determine that the assignor is technically and financially capable to conduct the operations under the contract. The transference requires the assignee to pay a fee equal to: (1) US$5,000 per each percentage of participation interest assigned; or (2) 0.001 of the net profits obtained in the year preceding the transfer or assignment. The assignor has to pay a fee equal to US$5,000 per each percentage of participation interest assigned. Ministry authorisation is mandatory, notwithstanding whether the transference involves or not a change in control. The Ministry usually takes from 4 to 8 months to issue the authorisation.

Specific services contracts with PAM also include provisions regarding mandatory prior approval for transference of interest that involve change of control. Transferences that does not involve change of control only have to be notified.

Tax

Ecuador's take (in addition to crude sales income) also comes from the following taxes and contributions:

  1. 25 per cent income tax rate;
  2. 12 per cent profit-sharing (12 per cent of net profits before income tax);
  3. 12 per cent value-added tax;
  4. 5 per cent currency remittance tax;
  5. municipal taxes; and
  6. other fees and contributions levied by hydrocarbons and other authorities.

In the Ecuadorian tax system, foreign and local sourced income is subject to income tax, which applies to all industries, including oil and gas. Companies operating through locally incorporated companies or a subsidiary are subject to pay annual income tax on the net profit of each year at a rate of 25 per cent.

Dividends paid after the payment of annual income tax are exempt, provided that: (1) the final beneficiary is not an individual with permanent tax residency in Ecuador; and (2) the Ecuadorian company complies with the shareholders' annual annex report to reveal the final effective beneficiary of the company. Dividends paid to individuals who are tax residents are subject to a 25 per cent income tax withholding over the 40 per cent of the received dividends.

Additionally, interest paid on loans between related parties is deductible for income tax purposes as long as it is not higher than 20 per cent of the profits of the local receiving party before labour participation (15 per cent), plus interests, depreciation and repayment, otherwise it will not be deductible.

i Withholding taxes

According to Ecuadorian legislation, all payments or crediting on account, whether directly or indirectly, considered as taxable income for the recipient, are subject to withholding taxes. Therefore, remittances of income from an Ecuadorian source to non-residents are subject to withholding taxes. The tax is withheld on the gross amounts remitted, with no deductions allowed. The taxpayer of these withholding taxes is the non-resident beneficiary. However, the local taxpayer is considered as a withholding agent, and as such, is jointly and severally liable.

Almost all types of payments made abroad are subject to income tax withholdings, at a 25 per cent rate; however, this percentage can be reduced through the application of double taxation treaty benefits. A 2 per cent withholding tax applies to payments made to local beneficiaries for the provision of services, and a 1 per cent withholding tax is applied to the acquisition of goods. Income tax withholding at a rate of 35 per cent applies to payments made abroad to recipients in tax havens, low taxation jurisdictions or preferential tax regimes.

Interest payments and financial fees are generally subject to 25 per cent income tax withholding; however, if the loan has been granted by a foreign financial institution, specialised non-financial institution or an international organisation, no income tax withholding shall apply on these interest payments, provided that additional requirements are met.

ii Remittance tax

All Ecuadorian taxpayers that remit currency abroad are subject to a 5 per cent tax on the amount transferred, regardless of whether the transaction is made through a financial institution or if the financial resources are not located in Ecuador. Dividends distributed to foreign residents shall be exempt from remittance tax to the extent that the recipients of the dividends are not domiciled in a tax haven or a lower tax jurisdiction. Remittance tax payments may be considered income tax credit for five fiscal years in some cases.

iii Transfer prices

Ecuador follows Organisation for Economic Co-operation and Development rules, complying with the arm's-length standard.

Environmental impact and decommissioning

The Ecuadorian Constitution provides a regime of strict liability for environmental damage. Article 396 of the Constitution sets forth that 'liability for environmental damage is strict'. Strict liability, within the context of the Constitution, means that for the oil operator to be liable, the state shall only establish that environmental harm exists, and that the harm was found in the areas where the oil operator undertook petroleum activities referred to in the Constitution. Under the Constitution, strict liability is a liability 'without fault'. Thus, the state does not need to prove the existence of a causal link between this action or omission and the environmental damage found in the areas where the oil operator conducted operations. To be exempt from liability, however, oil operators must establish that the damage arises from: (1) force majeure; (2) actions or omissions of the party affected by the damage; or (3) actions or omissions of a third party. This strict liability requires full restoration of the ecosystem to its original state, in addition to the obligation to compensate affected third parties, as well as the respective fines that may be applicable.

The Organic Environmental Code establishes the general environmental guidelines and environmental policy of the state. This law sets out each of the environmental authorities and their duties and establishes the Environmental Management System. Private investments in projects that might impact the environment are required to obtain an environmental licence through this system, for which an environmental impact assessment must be carried out. Without the environmental licence, no activities can be performed. For oil and gas activities, the environmental licence must be obtained by the operator. Additionally, throughout the life of the contract, the operator must carry out environmental audits according to the corresponding environmental impact assessment.

The Environmental Regulation to Hydrocarbon Operations contains specific provisions pertaining to the exploration, production, storage, transportation and industrialisation of hydrocarbons. All activities that could have an impact on the environment are contemplated in this regulation. Under this regulation, operators must deliver an annual programme of environmental activities to the Ministry by the first of December of every year. Operators must also deliver an environmental budget for the following year for evaluation and approval on the basis of the pronouncement of the Undersecretary for Environmental Protection. Additionally, the operator must provide an annual environmental report due by January of each year.

i Decommissioning

The contractor must perform the final environmental impact assessment audit. Additionally, all tax and labour matters arising during the term of the contract, as well as all pending obligations with subcontractors, must be liquidated.

Foreign investment considerations

i Establishment

A branch of the foreign company or a local subsidiary must be created to enter into a contract. It is not necessary that the branch or the subsidiary be set up in Ecuador during the tender process, but it is mandatory once the contract has been awarded.

The following documentation or information is required to establish a foreign branch in Ecuador:

  1. the company's bylaws should allow for establishment of branches in foreign countries;
  2. a legal existence certificate granted by the corresponding government authority;
  3. a resolution from the shareholders, board of directors or any other duly authorised body or official, authorising the establishment of a branch, assigning a minimum initial capital of at least US$2,000 and appointing a legal representative in Ecuador;
  4. issuance of a power of attorney granted to whoever is appointed as the company's legal representative of the branch in Ecuador;
  5. Ecuadorian consulate certification that the company exists; and
  6. a corporate bank account in Ecuador with at least US$2,000.

The procedure to establish a branch is the following:

  1. submit a petition to the Superintendence of Companies that includes the documents listed above;
  2. the Superintendence of Companies will issue a resolution approving the registration and the power of attorney;
  3. the resolution must be registered in the Mercantile Registry; and
  4. after the resolution is duly registered, a local tax ID number (RUC) and the commercial licence ('Patente') must be obtained in the corresponding municipality.

Upon completion of this procedure, the branch is ready to operate.

The procedure to incorporate a company is the following:

  1. the issuance of a public deed of incorporation from a public notary;
  2. register the public deed of incorporation in the Mercantile Registry;
  3. once the incorporation is duly registered, it must be notified to the Superintendence of Companies to take note of the incorporation; and
  4. after the registration in the Mercantile Registry and the Superintendence of Companies, the RUC and the commercial licence ('Patente') must be obtained in the corresponding municipality.

Upon completion of this procedure, the company is ready to operate.

The Organic Law of Entrepreneurship and Innovation enacted on 28 February 2020 introduced the Simplified Stock Company (SAS). The SAS is a very flexible company, available equally for a startup or for a large corporation. The main characteristics of the SAS, among others simplified rules that make it very attractive, are the following:

  1. it can be sole proprietorship;
  2. the minimum capital is one dollar;
  3. it is created by means of a private document with no need of notaries and registries procedures (except if real estate is contributed to the SAS);
  4. they can issue different types of shares (ordinary or preferred), thus facilitating capital raising.

Additionally, any company may be transformed into a SAS when its shareholders so decides. SAS are subject to the same corporate income tax rate.

Additionally, to subscribe a hydrocarbons exploration and production contract, the company must be registered in the Hydrocarbons Registry of the Ministry.

It may take up to six weeks to complete the entire procedure (for an SAS, the time reduces considerably). The costs for setting up a branch or incorporating a company will not exceed US$5,000, plus legal fees.

ii Capital, labour and content restrictions

Capital

Ever since the establishment of the US dollar as the legal currency in Ecuador, there are no restrictions on capital movements abroad, other than the remittance tax, or access to foreign exchange of currencies.

Labour

Below are some general considerations regarding the Ecuadorian labour regime:

  1. Minimum wage for 2020 is US$400 dollars/month.
  2. Two additional mandatory pay checks, commonly referred to as the thirteenth and fourteenth salaries. Thirteenth salary must be made in December, while the fourteenth must be made by March (Cost region) or August (Highlands or Amazon region).
  3. From the thirteenth month onwards, a payment, corresponding to 8.33 per cent of the employee's salary, must be made to the reserve fund.
  4. The employer must pay 12.15 per cent of the employee's salary to social security, on a monthly basis.
  5. Normally, contracts are signed with an employee for an undefined duration. If the employer wants to terminate the contract, the employee must be indemnified.
  6. Employees have the right to 15 days of vacation each year, plus one additional day per year worked over five years for the same employer.
  7. Employees are required to work eight hours per day, 40 hours per week. By mutual agreement, the employee may work extra hours for overtime pay. However, in the oil and gas industry, special working schedules can be used with prior approval of the labour authority.
  8. The company must have internal regulations regarding safety and healthcare for the employees.
  9. Profit sharing: employees are entitled to participate in the employer's annual profits (net profits before income tax). In general, the percentage of profit sharing is 15 per cent. However, for companies that have signed an exploration and production contract with the state, the percentage is 3 per cent (12 per cent goes to the state).

Outsourcing employees is prohibited. However, oil and gas companies are allowed to contract complementary services or technical and specialised services under civil regulations instead of labour regulations, if such activities are not directed related to the company's primary business activities.

As of May 2018, the Amazon Region Law has been in force, establishing the preferential employment right, which means that companies carrying out their activities in the Amazon region shall hire no less than 70 per cent of local residents, to perform non-skilled activities, save the cases where qualified skilled labour does not exist.

Additionally, the Hydrocarbons Law establishes certain limitations for hiring local and foreign workers, which must be observed, and in accordance with immigration legislation, all foreign workers must obtain a visa.

Finally, as a result of the state of emergency declared in Ecuador caused by the covid-19 pandemic, the Humanitarian Law came into force, which allows for temporary flexibility in some labour regulations. Among other things, this law contemplates: (1) the extension of coverage and payment facilities of social security; (2) the celebration of agreements between employees and employers to preserve work and guarantee stability; (3) the creation of the emergent contract for a defined term of one year, renewable for one additional year; and (4) the reduction of working hours, among others.

iii Anti-corruption

The Constitution and the Organic Criminal Code are the primary laws that criminalise corruption-related crimes. Thus, the Constitution sets out prohibitions and liability warnings for public officials when performing their duties, as well as when handling public goods and resources. The aim is to prevent them from being involved in bribery, extortion, influence peddling, embezzlement and unlawful enrichment. Other laws, such as the Organic Law on Public Service, the Public Procurement Law, the Organic Law on the Transparency and Social Control Branch, and the Organic Law on the Council for Citizen Participation and Social Control also set forth anti-bribery rules. Additionally, Ecuador is a signatory to the Inter-American Convention against Corruption of 29 March 1996. Under Ecuador's Constitution, a new branch of government, the Citizens' Participation and Social Control Council, is in charge of national anti-corruption efforts. Finally, in 2005, Ecuador ratified the UN Convention against Corruption.

Despite the general legislation described above, Ecuador does not have specific anti-corruption rules for the oil and gas industry. Nevertheless, the Ministry is working on new anti-corruption rules that will be applicable to state-owned oil companies.

Current developments

Continuing along the same lines as done by the Ministry in Intracampos 1, it is expected that a new round, 'Intracampos 2', will be launched in the last quarter of 2020, using the same model of the participation contract from the previous round, where six oil fields are expected to be awarded.

In July 2020, the President of Ecuador issued an executive decree authorising the delegation of the joint management of the Esmeraldas Refinery between EP Petroecuador and a private investor. According to the executive decree, the private investor must carry out the necessary studies and investments at its own risk and expense to improve the quality of the fuels and efficiency of the Esmeraldas Refinery and to reduce emissions. The joint management delegation does not imply sale of the assets, so the refinery will continue to be owned by the state. Additionally, the private investor will be required to build, at its own risk, a new refinery exclusively owned by it consisting of a high-conversion facility to refine Esmeraldas Refinery's waste for a fee. The refined wasted will be returned to EP Petroecuador for subsequent sale, so it will be considered as a maquila method. The Ministry will be in charge of carrying out the international public tender, for which it must prepare the bidding specifications and the contractual model, which it is expected to launch in the final quarter of 2020.

As a result of the amendment of the hydrocarbons derivatives regulations and liberalising prices under the band system explained above, opportunities for companies engaged in the import of derivatives and construction of storage systems for hydrocarbon derivatives have emerged and it is hoped that private investment will be attracted to the construction of storage systems and derivative imports to compete on equal terms with EP Petroecuador, which is allowed under the Hydrocarbons Law. In addition, since this remarkable amendment, EP Petroecuador will be allowed to lease and make its storage infrastructure available to third parties at competitive rates to be set by the Ministry, eliminating the lack of storage capacity for private importers.

Finally, in September 2019, Ecuador committed to join the Extractive Industries Transparency Initiative (EITI) as an implementing country, with the aim of guaranteeing transparency and efficiency in the management of Ecuador's natural resources. After completing the candidature application in August 2020, it is expected that Ecuador will become an implementing country in October during the next EITI International Meeting.

Footnotes

Footnotes

1 Sebastián Cortez Merlo is a partner, Francisco Larrea Naranjo is a director and María Elena Sanmartín is an associate at Noboa Peña & Torres.

2 National Oil Production, Ministry of Energy and Non-Renewable Natural Resources,
www.recursosyenergia.gob.ec.

3 Ecuador subscribed to the NYC with the following reservations: (1) apply only to recognition and execution of award rendered in states parties; and, (2) apply only to awards derived from legal relations, contractual or not, considered as commercial, according to the internal legislation.

4 Executive Decree 399 dated 18 May 2018.

5 Executive Decree 1036 dated 6 May 2020.

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