This article looks at the main causes which led to the historic plunge in the price per barrel of West Texas Intermediate (WTI) crude oil and explores potential opportunities which may arise after the crisis for the oil industry in Ecuador.
We have witnessed the worse oil market crisis in history. The consequences of the fall in price will be felt across the world and the industry: upstream, midstream and downstream[1]. At first glance these consequences are of course concerning for the global economy, but in the medium term they could become opportunities.
On April 20, the marker price of WTI oil – a futures market for sales of barrels of this type of US crude oil delivered in May – fell to historically low levels and turned negative. In practice, this means that oil producers are paying buyers to take the oil off their hands. It made more economic sense to pay to offload the oil than to keep and store it.
The COVID-19 pandemic and its effects have caused this unusual fluctuation in oil prices. Over the past few years, prices have been stable between US$40 and US$60 per barrel. No one, including the oil industry, was prepared to face a pandemic.
Below are the reasons which triggered the plunge in the price of WTI on Monday, April 20.
- Excess Production
The lockdowns in various countries and shuttering of industries worldwide due to the pandemic have cut global demand for energy by a third compared with normal levels. This is a drop in consumption of approximately 29 million barrels a day according to the International Energy Agency.
On April 12, the Organization of the Petroleum Exporting Countries (OPEC) together with Russia (OPEC-Plus) decided to cut production by 9.7 million barrels a day (equivalent to 10% of total production) for the May and June markets. Another cut in production is being considered by the Texas Railroad Commission, the state agency that can regulate oil production. It looks like the OPEC cut was not enough and the Texas cut was not in time.
Neither a cartel taking decisions coordinated with Russia, nor the USA as the world’s largest oil producer has been powerful enough to put the brakes on the market in the face of the COVID-19 pandemic.
Ecuador, which produces less than half a million barrels a day, does not have influence on the global oil supply. Ecuador has not been part of OPEC since the beginning of 2020, so it is not affected by the cuts in production agreed by the organization. The rupture of Ecuador’s two main oil pipelines – Trans-Ecuadorian Oil Pipeline System (SOTE) and Heavy Crude Pipeline (OCP), forced it to reduce oil production which does not affect the global market but would be unintentionally minimally reducing production levels while repairs take place.
- Lack of Storage
The main storage hub for WTI crude oil produced in the USA is in Cushing, Oklahoma, which has seen its capacity filling rapidly. Alternative storage options are tankers and ships which, due to the demand for storage, have increased costs. Tankers and ships are only temporary solutions with an expiry date and which do not reassure the market.
- Production Costs
With the lack of storage and low prices of WTI, it is more profitable to pay to have the crude oil taken away than to shut down wells in production and then restart them. It is less costly to lose crude, give it away or pay to have it removed than to shut wells and lose more money and time restarting production. Even if a decision was made to completely shut down production, this is an operation which could take weeks or even months depending on the wells. So, this has created a circle of problems where halting production is not a feasible possibility and storage is scarce.
The oil industry is being affected by the greatest crisis in its history and without clear possibilities of recovery. Unless the global economy reopens soon and energy consumption increases, the oil industry will continue to face issues of low demand and lack of storage.
Oil will not vanish as the main source of global energy and will still be relevant when this pandemic passes. The industry, investors and countries will reflect, make necessary changes and even rethink oil as energy, but it will not disappear.
After the pandemic, countries which depend on oil will need to participate in the industry’s resurgence. It is this need that means we can start to think about the opportunities the pandemic can bring to Ecuador’s oil industry, starting now.
ELIMINATION OF FUEL SUBSIDIES IN ECUADOR
After the failed attempt to eliminate fuel subsidies in October 2019, excessively low oil prices present an attractive chance for the Ecuadorian government to revisit this option. While prices are low, it would be expected that by liberalizing the price of fuel, the value will remain at current levels or even lower and therefore, albeit temporarily, alleviate the adverse political effects.
The Regulation of Prices of Oil Derivatives establishes fixed sale prices for derivatives and, depending on the price the State buys them at on the international market or refines them internally, varies the amount paid for the subsidy.
OIL EXPLORATION AND PRODUCTION CONTRACTS
Throughout the history of oil in Ecuador, exploration and production contracts have been amended and changed depending on the price of oil. For example, in 2010 when the price of oil was very high, it was decided to change the production sharing agreements (where production is shared between the state and the contractors) for service contracts (where the contractor is paid a fixed fee per barrel produced. This way, the state benefitted from high prices and marketed all crude produced by the contractors at international prices. At the latest oil round – Intracampos – new production sharing agreements were signed, a conservative approach for the state since oil prices were moderate. This way it shares the oil price risk because both the state and the contractor can market the percentage of crude which corresponds to them. Depending on the oil price, the state bears the risk of the international sale price of crude and allows the contractor to bear the risks of exploration and production.
From an investment perspective and in the eyes of the international markets, changing contracts with every fluctuation in price is not the most advisable approach. It sends a message of legal uncertainty due to a failure to stick with the agreed terms; however, if history repeats itself, any amendment should be considered to review the following:
Change to a production sharing agreement. In 2010, companies that had production sharing agreements with the state were obliged to renegotiate and switch to service contracts. In light of the need for investment in the country and to increase production, the interest of operators in returning to production sharing agreements could be analyzed. In this type of agreement, the operating risks and crude price risks are shared with the state, and it motivates companies to increase production to receive a higher quantity of oil.
Force Majeure clauses. Take advantage of the chance to review force majeure clauses, above all regarding definitions of a pandemic and clearly set out the consequences if this continues or a new one emerges.
Carry forward. Service contracts signed with the Ministry of Energy and Non-Renewable Natural Resources (MERNNR), and specific service contracts signed with Petroamazonas contain similar rules on events of accumulation or carry forward. Although each contract has its own characteristics, in general, the carry forward is triggered when there is not enough income to cover the payment of services rendered and an amount receivable is generated for the contractor. The income is created by the value of crude multiplied by the price, and given the current oil prices it is likely that neither the state nor Petroamazonas have enough income to cover their payment obligation. Due to the price of crude, and depending on the time the recovery takes, this lack of payment may cause problems for the contractors which will end up translating into a lower investment in oil production. It will all depend on how long the crisis goes on for and how much each company can endure.
No one could foresee the consequences and scope of this pandemic, and these contracts could not estimate the impacts. If there is a chance to amend the contracts, it is important to review the events of accumulation in view of the pandemic and negotiate other options that avoid having to take other measures.
REACTIVATION OF OIL AND GAS PROJECTS
Before the state of emergency due to the pandemic, the MERNNR and Petroecuador were preparing processes to delegate to private enterprise and contract out various projects in the oil industry such as: (i) the construction of a new refinery; (ii) repowering and delegating management of the Esmeraldas refinery; (iii) Intracampos II and Southeast oil rounds; (iv) liquefied natural gas (LNG) storage and purchase projects; and (v) off-shore oil exploration.
These projects will undoubtedly be affected by the current crisis. However, an upturn in the price of oil is expected which will enable investors to have enough capital to invest in new projects, and Ecuador must be prepared for when this happens.
An analysis of WTI prices over the past 50 years shows a clear tendency to fall and rise. Historically, once prices fall, they eventually recover whether due to external events like wars or market rules. Once industries reopen it is estimated that consumption will not only return to normal but could increase, with which oil prices should also rise considerably.
OIL AND GAS STORAGE MARKET
The low demand for energy during the crisis has revealed a lack of storage for oil production and a lack of foresight. Ecuador has not felt this yet due to the rupture of its oil pipelines, but a lack of space is a possible alternative especially when it is not in the country’s interests to sell oil, at least in spot markets, at current prices. Petroecuador, in its last spot sale in March 2019, called off the public tender as the bids for the purchase of Oriente crude did not satisfy the national interests.
Whether this pandemic continues for years, or simply to anticipate future falls in demand in the global market, it is important to encourage the construction of oil storage facilities by preparing regulations to facilitate authorizations and other requirements needed for private investors to participate.
It would be wise to take advantage of the situation to consider the regulation of the liquefied natural gas (LNG) market. This technology allows for more efficient transport and storage of liquefied gas. In Ecuador there is no specific regulation for this industry which could attract investment to construct and import LNG ships and machinery both on-shore and off-shore.
NEW ENERGY
For several years, Ecuador has been evaluating a “change in the productive matrix” from an economy dependent on oil and subject to volatile prices, to more renewable energy. There are several projects which delegate construction and electric power generation to private enterprise, in particular the Villonaco II and III wind power project, Aromo solar power project and another wind power project in the Galapagos Islands. Others are in the pipeline for power generation and concessions for management of existing plants, particularly hydroelectric plants. There is also interest in geothermal, hydroelectric and wave power projects.
It is hoped that, in view of the fragility shown by oil markets, investors and countries will focus their capital and efforts on sources of renewable energy to move away from oil dependency. This oil crisis gives Ecuador an opportunity to focus its efforts on new types of energy.
* This analysis is informative and does not constitute and cannot be taken as an opinion of PBP or legal advice for any purpose.
[1] Upstream: exploration and production. Midstream: transport. Downstream: refining, processing, industrialization, storage and marketing.
Editorial Board
