Oil Tax Hike Threatens FTA Between US and Ecuador

COUNTRY BRIEFING - FROM THE ECONOMIST INTELLIGENCE UNIT

Proposed new legislation is designed to increase the Ecuadorean government’s income from oil revenues by some US$600m a year at current prices. However, it could ruin the chances of a bilateral trade agreement with the US, which must be initialled by a May 15th deadline. Negotiations between the two countries have been in abeyance since March as a result of the proposals.

As have other oil-producing countries, Ecuador has moved to capture a greater share of the windfall earnings arising from a tripling of oil prices since 2002. Talks on a free-trade agreement (FTA) deal with the US began two years ago, at the same time as Andean neighbours Peru and Colombia. The latter two have both now signed agreements, which must now be ratified by their respective legislatures (as well as by the US Congress).

In all three countries there has been substantial domestic opposition to freer trade with the US, largely from producers such as farmers who see it as prejudicial to their interests but also from a vociferous nationalist lobby that considers it a capitulation to US pressure. In Ecuador, however, indigenous groups form the backbone of opposition to the trade accord. They have proven to be a potent force of protest in the recent past, contributing to direct action that has given rise to successive bouts of extreme political instability.

Indigenous groups may not even need to mobilise in order to derail the trade agreement; a backlash reaction to proposed changes in oil-operating contracts could do the job for them. A government bill currently before Ecuador’s Congress would increase the government's share of profits to 50%, from the current average of 30%. An alternative bill being promoted by some lawmakers would raise the State’s share still higher, to 60%.

Foreign oil companies have threatened to take legal action if new rules are imposed, which they say violate the terms of production-sharing agreements signed as far back as 1992. Fifteen foreign oil companies currently operate in Ecuador, including Repsol-YPF (Spain); Agip (Italy); the Andes Petroleum consortium, headed by CNPC (China); and Occidental Petroleum (US).

Investment protection is at stake

Although the US government is not bound to interfere in the foreign dealings of its domestic companies, the issue is closely tied to FTA negotiations because rules guaranteeing the enforceability of contracts are a central part of bilateral trade deals. FTA talks were suspended when the oil plans were first announced, and are yet to resume. Unless a comprise solution can be worked out by mid-May, a trade deal is unlikely to be brought before the US Congress for ratification before the mid-term elections later this year. Manuel Chiriboga, Ecuador's chief trade negotiator, denies Ecuador is reneging on its commitment to investment protection clauses in established contracts, but has acknowledged that completing the trade deal on time is now a remote possibility.

Ecuador's negotiating position is far weaker than that of countries it is trying to emulate. In Venezuela, the government of Hugo Chávez declared the production-sharing agreements under which oil companies were operating to be unconstitutional, and thereby null and void, forcing companies to “migrate” to new joint-venture agreements. These include a substantially higher share of revenues for the state, and a substantially lower share of ownership and control for the foreign companies.

However, unlike Ecuador Venezuela is home to some of the world's largest hydrocarbons reserves. As a major oil exporter, it is also awash with foreign-currency earnings and fiscal resources, and therefore less vulnerable to international pressure than Ecuador. Despite an initial flurry of threats to litigate, most foreign oil producers adopted the new contracts in Venezuela.

The same arguments and policy stance have also been adopted in Bolivia—where the new government of President Evo Morales enjoys close ties with Caracas—and is implementing a more onerous tax regime for oil companies. But the difference here too is that, publicly at least, Bolivia has rejected the idea of greater free trade with the US, preferring to grab easy oil revenues instead.

Ecuador is at risk of losing on both fronts. Its relatively modest oil reserves and weak finances do not give it the same room for manoeuvre as Venezuela in negotiating with oil firms, and it could alienate much-needed foreign investors. And if it fails to sign and then ratify a trade accord with the US, prospects for further development of non-oil export sectors will grow dim.