UNITED STATES DISTRICT COURT SOUTHERN DISTRICT OF NEW YORK

CHEVRON CORPORATION,

Plaintiff,

11 Civ. 0691

v.

STEVEN DONZIGER ET AL.,

Defendants.

Expert Report of Brent C. Kaczmarek, CF A

NA VIGANT CONSULTING, INC.

1801 K STREET NW, SUITE 500

WASHINGTON, DC 20006

1 JULY 2011

Table of Contents

I. Scope of Work and Qualifications .................................................................................................... 1

II. §umlnary of Conclusions ................................................................................................................... 2

HI. The Development of Ecuador's Oil Industry and the Government's Historical and Current Participation in the Industry ............................................................................................................. 4

A. B. C. D. E. F.

Late 1800s to 1960: Failure of Early Oil Exploration Initiatives ............................................ 5 1961 - 1969: Discovery of Oil and Development of Oil Infrastructure .................................. 6 1969 - 1984: Increased Government Intervention and Participation in the Oil Sector ........... 8 1985 - 1993: Ecuador Develops Additional Blocks Using Risk-Service Contracts ............. 16 1993 - 2006: Ecuador Converts Risk-Service Contracts to Production Sharing Agreements20 2006 - 2009: Ecuador Institutes Law 42 ............................................................................... 21

G. 2010 to 2011: Ecuador Renegotiates PSAs Back to Risk-Service Contracts ........................ 21 H. Conclusion ............................................................................................................................. 22

a. Oil Production ..................................................................................................................... 23

b. Oil Refining ......................................................................................................................... 24

c. Oil Transportation ............................................................................................................... 25

IV. Impact of the Oil Sector on Ecuador's Economy .......................................................................... 26

A. Exports ................................................................................................................................... 26 B. Gross Domestic Product (GDP) ............................................................................................. 28 C. Fiscal Revenues and the National Budget ............................................................................. 29

11

Listing of Figures

Figure 1: Map of Concession Area and SOTE Pipeline ................................................................ 8

Figure 2: Economic Benefit Derived by Ecuador from the Consortium (1972 to 1992) ........... 15

Figure 3: Distribution of Economic Benefit Derived from ConsOliium Crude (million US$) ..... 16

Figure 4: Original Concession Area and Blocks Currently Licensed in Ecuador ........................ 18

Figure 5: Ecuadorian Oil Production, 1972 - 2009 ...................................................................... 20

Figure 6: Ecuadorian Crude Oil Export Price, 1972 to 2009 ........................................................ 22

Figure 7: Oil Production in Ecuador (1972 - 2009) ..................................................................... 24

Figure 8: Ecuador Exports (1970 - 2008) ..................................................................................... 27

Figure 9: Ecuador GDP v Oil Exports (1965 - 2009) .................................................................. 28

Figure 10: Tax Contribution of the Oil SectoL. ........................................................................... 30

III

I. Scope of Work and Qualifications

1. Navigant Consulting, Inc. ("Navigant") has been asked by Gibson, Dunn & Crutcher LLP

("Counsel") to prepare this expelt report in connection with the litigation proceedings

commenced by Chevron Corporation ("Chevron") in the United States District Court of the

Southern District of New York against Steven Donziger et al. We have been asked by Counsel

to outline the history and development of the oil industry in Ecuador, the government of

Ecuador's historical participation in the oil industry, and the influence of the oil industry on the

Ecuadorian economy. Our experience and expertise on these matters is derived from our prior

work as experts in international arbitral proceedings between foreign investors in the Ecuadorian

oil industly and the Republic of Ecuador. In two of these international arbitrations, we were

appointed as experts by Chevron Corporation.

2. I, Brent C. Kaczmarek, am a Managing Director in the Washington, DC office of

Navigant Consulting. I have been retained as a financial, valuation, and damages expert in more

than 60 international arbitrations, in which I have presented opinions on behalf of both Claimants

and Respondents (including sovereign states) in roughly equal proportion. More than 50 percent

of these arbitrations have involved matters in the energy sector. I hold the designation of

Chartered Financial Analyst, a globally recognized designation held by professionals

demonstrating competence in the valuation of various asset classes (common stock, bonds,

derivatives, real estate, etc.) and the decision-making process concerning investments in these

asset classes. I received this designation in 1998 from the Association for Investment

Management and Research (now CFA Institute), the governing body of charter-holders. There

are charter-holders and charter-holder candidates residing in more than 160 countries worldwide.

My cUlTiculum vitae are provided as Appendix A to this repOlt.

3. Navigant is being compensated for my services with respect to this engagement based on

my hourly rate and the hourly rates of other staff that have assisted me with this engagement, and

the number of hours that we have worked. My CUlTent hourly rate is $625 per hour. The hourly

rates of other Navigant staff vary from US$ 325 - US$ 525 depending on their experience levels.

Navigant's fees with respect to this engagement are not contingent on either our opinion or the

outcome of the related litigation.

H. Summary of Conclusions

4. Prior to the discovelY of oil in the Oriente, Ecuador's economy was largely agrarian. The

discovelY of oil in the Oriente under a single, 1964 Concession granted to a consortium of

foreign investors that included Gulf Oil and Texaco Petroleum Company ("Consortium") and the

subsequent construction of the SOTE pipeline (which transp0l1ed oil to the Pacific coast where it

could be sold in the international marketplace) transformed Ecuador's economy. Ecuador was

eager to participate directly in the exploitation of hydrocarbons to boost its revenues, so a new

hydrocarbons law was passed that called for the formation of a state-owned entity (CEPE,

subsequently renamed Petro ecuador) to represent the government's interests; and CEPE was able

to acquire a 62.5 percent interest in the Consortium at cost, rather than at market value. Ecuador

also passed a series of measures to maximize the benefits it could derive from the exploitation of

hydrocarbons. As a consequence of these measures, the concession area was reduced by more

than 75 percent, the exploitation period of the Concession was reduced from 40 years to 20

years, the production royalty rate payable to the government was increased from 6 percent to

18.5 percent, the income tax rate was increased from 35 percent to 87.31 percent, and the

Consortium was required to contribute a share of its production to the domestic market at

subsidized prices. These measures enabled Ecuador to capture more than 97 percent of the total

economic benefits from the 1973 Concession over the next 20-years, or approximately US$ 23

billion.

5. Ecuador sought to expand its role in the international oil export market in the mid-1980s

by inviting foreign investors to bid on newly established "blocks" for exploration and

development. The initial contracts to explore and exploit these new blocks were risk-service

contracts. Under a risk-service contract, the foreign finn would bear the exploration risk and

would not recover any of its exploration costs if there was no commercial discovery. However,

if there was a commercial discovery, Ecuador would reimburse the company for its exploration

costs plus the costs of developing the fields (including interest). In addition, the foreign firm

would be paid a fee to cover the costs of production plus a profit element. However, the

payment of these amounts to the foreign firm would be limited to the receipts Ecuador would

generate from the sale of oil produced from the fields. Thus, the foreign film would assume all

of the exploration risk but was guaranteed a profit if oil were discovered.

2

6. Shortly after signing several risk-service contracts and achieving many commercial

discoveries, a period of sustained low oil prices reduced the receipts that were needed to

reimburse the investors and pay the profit element. Indeed, in some situations, Ecuador had to

dedicate 100 percent of the oil receipts to pay the investors, thus deriving no benefit from the

risk-service contracts. Consequently, beginning in 1993, Ecuador began to renegotiate these

contracts (and issue new contracts) as production sharing agreements (PSA) to shift the burden

and risk of low oil prices onto the investors. Under the PSAs, Ecuador was allocated a share of

daily production free of any exploration, development, or operating costs. Thus, Ecuador

ensured that it would derive economic benefits from the contracts and placed all of the risk on

the investors.

7. The PSA regime appeared to work well for Ecuador until the mid-2000s when oil prices

began a steep climb. Although Ecuador had shifted oil-price risk to the investors under the PSA

framework, it did not believe the investors should keep the rewards associated with higher oil

revenues from their production share. Accordingly, Ecuador sought to convert the PSAs back to

risk-service contracts in 2006. After that effort failed, Ecuador passed Law 42 which effectively

provided Ecuador an "additional participation" in the investor's sale of oil when oil prices

exceeded the price prevailing at the time the PSA was negotiated (adjusted for inflation). The

additional participation was initially set at 50 percent, but was subsequently increased to 99

percent in 2007. Thus, Ecuador essentially eliminated any gains investors could reap from

higher, international oil prices, but left the investors with all the downside risk associated with a

fall in oil prices. Then in late 2010 and early 2011, when faced with rapidly declining

investment and production after Law 42, Ecuador once again pushed investors to either convert

their PSAs back to risk-service contracts or leave the country.

8. As a result of the series of measures enacted by Ecuador since the late 1960s, Ecuador

(through state-owned Petro ecuador) has been and continues to be the dominant player in the

production, refining, transportation, and export of oil. It is by far the single largest producer of

oil accounting for over 50 percent of current production. Following the expiration of the 1973

Concession in 1992, Petroecuador became the sole producer/operator of the fields previously

covered by the 1973 Concession and continues to manage most of those fields today. From 1972

to 1992 the Consortium produced a total of 1.469 billion barrels of oil from the Concession, of

3

which TexPet's share was 565 million banels. From 1992 through 2009, Petro ecuador produced

a total of 1.174 billion barrels of oil from the same Concession fields. Total oil production in

Ecuador during the period from 1992 to 2009 was 2.8 billion barrels, or nearly double the total

amount produced by the Consortium from 1972 to 1992.

9. Petroecuador owns and operates all of the country's domestic refineries. These refineries

purchase clUde oil from the oil producers at subsidized prices and refine this oil to produce

petroleum products to meet the countlY's domestic needs. Petro ecuador also operates the SOTE

pipeline which is one of two major pipelines transporting oil from the Oriente to the Pacific coast

(for export to the world market). The second major oil pipeline (the OCP) is privately operated,

but will revert to government ownership after 20 years of operation.

10. In summary, since oil was first discovered in the Oriente, Ecuador has continuously

altered its hydrocarbon regime to ensure that the state derives the maximum possible benefit

from the exploration and exploitation of oil while taking on minimal or no risk. Given the

benefits Ecuador has derived, it is not surprising that oil has been (and continues to be) a

significant source of expOli receipts, GDP, and government revenues. Ecuador's dependence on

oil as an engine to its economy has contributed to a continuous cycle of government intervention

aimed at maximizing the benefits to Ecuador.

In. The Development of Ecuador's Oil Industry and the Government's Historical and Current Participation in the Industry

11. Ecuador today has the third largest oil reserves and is the fifth largest producer of oil in

Latin America. I However, until the discovelY of oil in the Oriente region in 1967, Ecuador had

nascent domestic oil production and relied extensively on imports of refined oil products to

sustain its domestic consumption needs. In the sections that follow, we set forth a chronology of

events leading to the development and maturation of the oil sector and the government of

Ecuador's participation in the sector.

I Oil Sector RefOlID in Ecuador: Changes for Better or Worse? Business News Americas, Energy Intelligence Series, March 201I.P.2NAV-l

4

A. Late 1800s to 1960: Failure of Early Oil Exploration Initiatives

12. The genesis of oil-related exploration activity can be traced back to 1878 when Ecuador

granted the first petroleum concession in the Santa Elena peninsula region (adjoining Ecuador's

Pacific coast).2 However, the concession did not result in a commercial discovery. Subsequent,

but very small, discoveries were ultimately made in the peninsula region. In 1918, Anglo

Ecuadorian Oilfields Ltd. (a subsidiary of what is today British Petroleum) began exporting

small amounts of crude from the Santa Elena Peninsula. The peninsula remained the primary

focus of exploration and exploitation activity in Ecuador for the early part of the 20th centmy.3

13. Oil exploration in the Oriente region4 of Ecuador was initiated in 1921 when a subsidiary

of Standard Oil received a concession for 2.5 million hectares in the region.s The concession

allowed for 25 years of surveys and studies, 6 years for exploration, and 40 years for

exploitation. However, Standard Oil did not discover any oil and the concession was cancelled

in 1937.6

14. That same year, the government passed the new oil law (Oil Law of 1937) and issued

Royal Dutch Shell a concession to explore and exploit a 10 million hectare concession zone in

the same region.7 This concession allowed for a 5-year exploration period and 40-year

exploitation period. However, by 1948, Shell had returned most of the concession area to

Ecuador declaring that the Oriente lacked commercially viable petroleum.8

15. Later in 1948, Standard Oil and Shell joined hands to form a consortium which received a

new concession of 4 million hectares.9 However, this consortium also did not find petroleum in

2 The concession was granted to M.G. Meir and Company for the exploration and exploitation in the Santa Elena Peninsula. "Politics and Petroleum in Ecuador." MaJiz, John D. 1987. p. 45. NAV - 2

3 ld.

4 The Oriente region is one of three main geographic regions in Ecuador. These three regions include: 1) the "lowlands" which is an area along the Pacific coast, 2) the "highlands" which is a high altitude belt of the Andes running nOlih-south through the center of the countly, and 3) the "Oriente" or eastern lowlands which are the eastern slopes of the Andes and part of the Amazon River basin. The Oriente region accounts for almost half the country's total surface area but is home to less than 5 percent of the country's population. The Oriente region is also the least developed region in the countly.

5 "Politics and Petroleum in Ecuador." Martz, John D. 1987. p. 46. NAV - 2 6 rd. at p. 47

7 ld. at p.48

8 ld. at p. 52

9 ld. at p. 52

5

the concession area and abandoned its efforts. Thirty years of exploration without a single

commercial discovery lead then President Galo Plaza Lasso to declare that oil in the Oriente was

a myth. 10

B. 1961 - 1969: Discovery of Oil and Development of Oil Infrastructure

16. Despite the failures of prior oil exploration efforts in the Oriente, Ecuador renewed its

effort to obtain foreign investment in the early 1960's to further explore the undeveloped Oriente

region for oil. II This effort was primarily borne out of Ecuador's desire to stimulate economic

development and job creation in the region. 12 In June 1963, Texaco Petroleum Company

("TexPet") submitted, on behalf of TexPet and Gulf Oil, an application for a concession in the

Napo and Pastaza provinces of the Oriente region ("1964 Concession".)13 In February 1964,

Ecuador issued Decree 205-A whereby Ecuador granted the 1964 Concession to the

Consortium. 14 The concession covered an area of 1.65 million hectares. The concession had a

maximum duration of 58 years, which was broken into two phases: i) a 5-year exploration period

(with a possible 3-year extension), and ii) a 40-year exploitation period (with a possible 10-year

extension). TexPet and Gulf Oil (through their local affiliates in Ecuador) were each entitled to a

50 percent interest in the concession. 15 TexPet and Gulf Oil agreed that TexPet would operate

the Concession on behalf of the Consortium for the first ten year-period with a possible renewal

of this term for subsequent periods. 16

17. During the period from 1964 to 1969 the Consortium conducted exploration activity in

the concession area. Part of this investment included the acquisition of additional rights to a

second concession. In July 1965, the Consortium obtained the rights to a large area adjacent to

the 1964 Concession area (commonly referred to as the "Coca Concession") from Minas y

10 Id. at p. 52

II Concession Contract between the Government of Ecuador and Texas Petroleum Company; Supreme Decree No. 205-A, 21 Febrnmy 1964, p. 2. NA V - 3

I2Id. 13 As per Supreme Decree No. 205-A, the Concession was assigned to TexPet which in turn transferred the Concession to

Compania Texaco de Petr6leos, C.A. ("Texaco del Ecuador") and Gulf Ecuatoriana de Petr6leo, S.A. ("Gulf Ecuatoriana"), which were branches of TexPet and Gulf in Ecuador. Concession Contract between the Government of Ecuador and Texas Petroleum Company; Supreme Decree No. 205-A, 21 February 1964, Clause 1. NA V - 3

I4 Id.

15 Id. at Clause 43 (b) 16 Napo Joint Operating Agreement Between Texaco Petroleum Company and Ecuadorian Gulf Oil Company, 1 January 1965,

Article 6. NA V - 4

6

Petr6leos del Ecuador ("Minas,,).17 Thus, during 1965 to 1969, the Consortium conducted

exploration activity within the Coca Concession area as well. The area encompassed by the

Coca Concession was approximately 650,000 hectares. 18 Thus, the total area covered by the two

concessions totaled 2.08 million hectares.

18. In April 1967 the exploration efforts of the Consortium yielded its first successful

discovery when oil was located within the 1964 Concession at Lago Agrio at a depth of 10,175

feet. 19 A second discovelY occurred in 1968 when oil was also discovered at Shushufundi. 20 In

December 1968, drilling started on the Shushufundi field and two reservoirs ("T" and "U")

within this field were identified as commercially viable shortly thereafter. In JanualY 1969, a

third discovery was made at the Sacha oilfield at a depth of 10,160 feet? I The finding of crude

in these three fields definitively established the potential of Ecuador's oil reserves.22

19. Subsequent to the discovery of oil at Lago Agrio, the Consortium invested between US$

260 million and US$ 300 in developing the oil fields (approximately US$ 1.56 billion to US$

1.80 billion in today's US dollars).23 The Consortium also constructed the Trans-Ecuadorian Oil

Pipeline System (Sistema de Oleoducto Transecuatoriano or "SOTE") at an estimated cost of

between US$ 108 million and US$ 120 million (the equivalent of approximately US$ 700

million in today's US dollars),z4 as well as a highway paralleling the SOTE. The SOTE pipeline

is approximately 310 miles (503 kilometers) long, extending from Lago Agrio to the marine

terminal of Balao in the Esmeraldas Province. The construction of the SOTE and the parallel

roadway was a significant undertaking because the pipeline had to cut across the Andes

mountain range that separates the eastern provinces from the pacific coast (see Figure 1 below).

17 See "Authorization to Transfer Land from Minas y Petr61eos del Ecuador S.A. to Petrolera Pastaza CA. and Petrol era Aguarico S.A.," Agreement No. 844, 27 December 1965. NAV -5. The ConsOliium obtained the rights to the Coca Concession in exchange for a payment (to the owners of Minas) ofUS$ 100,000 and a royalty payment of2 percent of the net value of all clUde oil and natural gas to be produced within the Coca Concession.

18 I d.

19 "Informe Estadfstico 1972-2006," Petroecuador, 2006, p. 65. NAV - 6 20 I d. at p. 61 21Id. at p. 60 22 Id. at p.52. Over the period 1967 to 1969, additional oil discoveries were also made at other oil fields within the Concession

area. 23 US District Court Judgment in "Phoenix Canada Oil Company Limited, Plaintiff, v. Texaco, Inc., Texaco Petroleum Company

and Ecuadorian Gulf Oil Company, and Gulf Oil Corporation," Civil Action No. 76-421-JRR, US District Court for the District of Delaware, 13 March 1987, p. 5. NA V - 7

24Id. at p. 4. A similar pipeline that parallels the SOTE for the most pali (the "OCP") was completed in 2003 at a cost of US$ 1.3 billion.

7

The SOTE provided a critically important conduit for transporting oil from the Oriente to the

coast, thereby enabling Ecuador to access the world market.

Figure 1: Map of Concession Area and SOTE Pipeline25

COLOMBIA

Ba]ao

PERU

Elevation - N - A 1000 -1000 Distance 500 lOOkm 2<JO so'n

, 0

C. 1969 -1984: Increased Government Intervention and Participation in the Oil Sector

20. The discovery of oil at Lago Agrio and the construction of the SOTE were watershed

events that spawned the development of the oil sector in Ecuador and transformed Ecuador's

economy. They also brought increased focus and attention on the prospect of oil production on a

large scale which heightened the government's interest in the oil industry. Accordingly, Ecuador

undertook a number of measures to consolidate its control over the economic benefits the oil

industry was about to produce. Indeed, the discovery and ultimate development of oil in the

25 "Informe Estadistico 1972-2006," Petroecuador, 2006, p. 68 (as modified by Navigant Consulting). NA V - 6

8

Oriente enabled Ecuador to join the Organization of Petroleum Exp01iing Counties ("OPEC")

cmiel in 1973 thus giving the country immediate global visibility and relevance. In the following

paragraphs, we briefly outline how Ecuador consolidated its control.

21. In June 1969, Ecuador issued Decrees l323 and 1324 that reduced the total area of the

1964 Concession and the Coca Concession to 500,000 hectares each.26 As a result the

Consortium was forced to release 930,000 hectares of land. Some of the returned land contained

proved oil reserves. Ultimately, Petro ecuador (the state owned oil company) was able to extract

oil from these returned hectares. These decrees also increased the royalty rate from 6 percent of

production to 11.5 percent of production27 and imposed new financial obligations on the

Consortium.28 FUlihermore, they also altered the economics of the SOTE pipeline whereby the

Consortium was forced to relinquish ownership of the SOTE once it was fully amortized. 29

22. In September 1971, Ecuador passed a new Hydrocarbons Law (the "1971 Hydrocarbons

Law") which repealed and replaced the 1961 Oil Law.30 Aliicle 1 of the 1971 Hydrocarbons

Law called for the formation of a State-owned oil corporation (Corporacion Estatal Petrolera

Ecuatoriana, or "CEPE", later renamed "Petro ecuador") which would be responsible for the

exploration and exploitation of the nation's hydrocarbon resources. The 1971 Hydrocarbons

Law provided for direct government participation in oil production. Ecuador also issued

Supreme Decree 430 that applied the 1971 Hydrocarbon Law retroactively to the 1964

Concession. 31 Supreme Decree 430 required the Consortium to sign a new concession contract

(the "1973 Concession") within one year of its enactment at which time the 1964 Concession

would be terminated.32 This new concession contract required the Consortium to release an

additional 327,625 hectares within the 1964 Concession and 173,392 hectares within the Coca

26 Supreme Decree No.1323, 26 June 1969, Clause 3. NAV - 8 27Id. at Clause 9.

28 The Consortium was to provide approximately US$ 20 million to finance the construction of certain community infrastructure projects such as highways, access roads, and airports. Supreme Decree No. 1323, 26 June 1969, Clause 14 (b). NA V - 8

29 The amortization period was subsequently set for approximately 15 years such that the pipeline would be fully amortized in 1986. As a consequence, the Consortium would have to pay Ecuador transit fees to get their oil to international markets after 1986. The official handover of the SOTE to Ecuador OCCUlTed in March 1986. See "El SOTE Y su Historia." http://www.sote.col11.ec/sote/portal/main.do?code=404O. NAV - 9.

30 1971 Hydrocarbon Law (English Translation), 27 September 1971, Final Section. NAV -10 31

Supreme Decree No. 430, 6 June 1972, p.1. NA V-II 32 Id. at p. 2

9

Concession.33 In essence, Decrees 1323 and 430 together reduced the total Concession area

available for exploitation from 2.08 million hectares to 491,355 hectares, a 76 percent reduction.

As noted above, some of the areas returned contained proven reserves or wells that had tested

positive for oil.

23. The 1971 Hydrocarbon laws also gave CEPE the option to acqUIre a 25 percent

ownership interest in the Concession at cost (i.e., book value) rather than market value.34 CEPE

exercised this option by acquiring a 25 percent interest in the Concession effective June 1974.35

The option to allow CEPE to participate in 25 percent of the Consortium's activities retroactively

at book value was advantageous for Ecuador because CEPE never bore any exploration risk.36

Effective 6 June 1974, the 50 percent interest held by Texaco Petroleum and Gulf Oil in the

ConsOliium were equally reduced by 12.5 percent to 37.5 percent to allow for CEPE's 25 percent

participation. The total amount paid by CEPE for the 25 percent interest in the Concession was

US$ 45 million (US$ 22.5 million to both Texaco Petroleum and Gulf Oil).3? Subsequently,

CEPE acquired Gulfs 37.5 percent interest in the Consortium (as well as Gulf Oil's interest in

the SOTE) at book value effective 31 December 1976, thereby raising CEPE's ownership

interest in the Consortium to 62.5 percent.

24. The 1973 Concession also reduced the exploitation period of the conceSSIOn from 40

years to 20 years,38 with the termination date set for 6 June 1992.39 Upon termination, all

331973 Contract, 6 August 1973, p.3 NAV-12 34 1973 Contract, 6 August 1973, Clause 52.1. NA V - 12 35 Purchase agreement for CEPE's 25 percent participation in Consortium, January 1974. NAV - 38. CEPE did not acquire an

ownership interest in the SOTE in 1974.

36 The market value of the Consortium would have been significantly higher than book value at the time. Spot and future prices of oil in 1974 were very high due to the Arab Oil Embargo that was triggered in October 1973. Thus the market value (determined using a discounted cash flow approach) would have clearly been much greater than the histOlical costs of drilling and developing the fields (i.e., book value).

37 US District Court Judgment in "Phoenix Canada Oil Company Limited, Plaintiff, v. Texaco, Inc., Texaco Petroleum Company and Ecuadorian Gulf Oil Company, and Gulf Oil Corporation," Civil Action No. 76-421-JRR, US District Court for the District of Delaware, 13 March 1987, p.12. NAV -7. By contrast, the profits realized by CEPE from Consortium operations over the period 1972 - 1992 were over US$ 5.7 billion (see Section VI below), which is more than 100 times what CEPE paid for its ownership interest. Furthermore, Petoecuador (the successor of CEPE) has been the sole operator of the Concession since 1992 and it continues to operate and generate profits from the Concession today.

38 1971 Hydrocarbon Law (English Translation,) 27 September 1971, Section 21. NA V-I 0 39 1973 Contract, 6 August 1973, Clause 4.1. NA V -- 12

10

commercially exploitable hydrocarbon reserves and production assets would transfer over to

CEPE at no cost.40

25. Under both the prior regime and the new regIme, the Consortium (as well as other

producers in Ecuador) was required to contribute a propOliion of its total production (at a

subsidized Internal Market Price or "IMP") towards fulfilling the domestic consumption needs of

Ecuador.41 The 1973 Concession regime raised the cap for domestic market contributions

(including royalties) from 20 percent to 51 percent of production,42 thereby limiting the total

quantity of oil that could be exported by the Consortium at higher international market prices.43

26. The 1971 Hydrocarbon Law also increased the royalty rate from 11.5 percent to between

12.5 and 16 percent depending upon the average monthly production of oi1.44 The Consortium

was also required to pay higher initiation premiums and annual surface taxes and was required to

invest monies in a variety of public works over a 5-year period.45 Finally, the Consortium was

also required to reinvest 10 percent of its net profits in the country to support Ecuador's

economic development.

27. Ecuador also initiated a series of tax and royalty decrees between 1971 and 1977 that

significantly increased the economic benefits Ecuador derived from the conceSSIOn. These

decrees increased the royalty rate from 16 percent to 18.5 percent of production, and the income

tax rate from 35 percent to 87.31 percent.46

28. In summary, the measures implemented by Ecuador between 1969 and 1977 reduced the

Concession area by 76 percent, halved the exploitation period from 40 years to 20 years,

effectively tripled the initial royalty rate from 6 percent to 18.5 percent, increased the income tax

rate from 35 percent to 87.31 percent, and also substantially increased the Consortium's

40 [d. at Clause 51 41 [d. at Clause 19 42 [d. at Clause 19.3. This Clause stipulates that TexPet and Gulf can export at least 49 percent of their production. 43 US District Court Judgment in "Phoenix Canada Oil Company Limited, Plaintiff, v. Texaco, Inc., Texaco Petroleum Company

and Ecuadorian Gulf Oil Company, and Gulf Oil Corporation," Civil Action No. 76-421-JRR, US District Court for the District of Delaware, Note 17, 13 March 1987, p.8. NAV -- 7

44 1971 Hydrocarbon Law (English Translation,) 27 September 1971, Section 46. NA V-I 0 45 [d. at Section 23

1973 Contract, 6 August 1973, Clause 28, 27.1, & 47. NA V - 12 46 Supreme Decree No. 664, 28 July 1974, Art. 2. NA V - 13

Supreme Decree No. 1056, 15 October 1974, Art. I, and 2. NAV -14 Supreme Decree No. 982,4 December 1975, Art. 1. NAV -15

11

contributions to the domestic market. They also resulted in CEPE (now Petroecuador) acquiring

a 62.5 percent stake in the ConsOliium at book value.

29. As a result of these measures, Ecuador was able to retain the vast majority of the

economic benefit that derived from the Concession. We have calculated the economic benefits

that each participant in the Consortium actually received between 1972, the year oil production

began, and 1992, the year Petro ecuador took over as the sole participant in the Consortium.

30. To detelmine the proportion of economic benefits Ecuador derived from these measures,

as well as the nominal value of these benefits, we gathered and reviewed five primalY sources of

financial data: i) data on royalty contributions, domestic market contributions, and export

volumes for Texaco Petroleum over the period 1972 - 1992 were obtained from the Direcci6n

Nacional de Hidrocarburos ("DNH"); ii) information on oil export prices (FOB Balao) for the

period 1972 to 1992 was obtained from Petroecuador's statistical reports ("Informe Estadistio

1972-2006"); iii) data on the prevailing internal market price (IMP) was obtained from

Ministerial Resolutions issued by Ecuador; iv) information on Texaco Petroleum revenues,

expenses and net income were obtained from Texaco Petroleum's financial statements for its

Ecuador operations for the period 1972 - 1992; and v) historic daily exchange rate data

(US$/Sucre) for the period 1972 - 1992 was obtained from a third party publisher.47

31. Since the production volumes and Consortium costs were shared between the participants

in propOliion to their ownership interest, we were also able to use the Texaco Petroleum financial

statements to estimate the revenues, expenses, and profits for Gulf Oil and CEPE. Annual

average exchange rates were used to convert the Sucre-denominated revenues, expenses, and

earnings recorded on the Texaco Petroleum financial statements to US dollars.

32. The economic benefit for Texaco Petroleum and Gulf Oil is calculated as the sum of the

after-tax net income generated by each company during the 20-year period. Since our analysis

does not entail a point estimate of value that requires adjustments for the time value of money,

the use of accounting profits rather than cash flow as the measure of economic benefit should not

matter so long as all capital investments were fully depreciated (or sold off in the case of Gulf

47 Global Financial Data, US$ - Sucre Annual Average Exchange Rates, 2010. NAV - 16

12

Oil) at the time Texaco Petroleum and Gulf Oil exited the Consortium. In other words, the use

of accounting profits or cash flow as a measure of economic benefit should lead to identical

results.

33. The financial statements we obtained indicate that Texaco Petroleum generated a

cumulative total economic benefit ofUS$ 480 million from 1972 to 1992.48 Gulf Oil's economic

benefit for the period 1972 - 1976 is estimated to be US$ 149 million.49

34. The economic benefit calculation for Ecuador is more complex than the sum of the

accounting profits earned by CEPE because Ecuador also received economic benefits from the

Consortium in other forms. In total, Ecuador received 5 forms of economic benefits: 1)

accounting profits earned by CEPE, 2) in-kind royalties, 3) cash royalties, 4) income tax

payments from Texaco Petroleum and Gulf Oil, and 5) sales of clUde oil to the domestic market

at subsidized prices (i.e., below intemational market prices).

35. CEPE's accounting profits from 1972 to 1992 were estimated using Texaco Petroleum's

financial statements with appropriate adjustments to reflect CEPE's actual participation in the

Consortium. Also, it is our understanding that CEPE did not pay income taxes as a state-owned

company. 50 Even if CEPE did pay income taxes, such payments would simply be a transfer of

economic benefits from one arm of the govemment to another. Accordingly, we determined

CEPE's accounting profits for the period 1972 - 1992 to be US$ 5.758 billion.51

36. Ecuador's economic benefits associated with royalties are calculated as the sum of the

cash royalties paid by Texaco Petroleum / Gulf Oil, and the market value of in-kind royalties

(i.e., barrels of oil) that were paid. Based on the information in Texaco Petroleum's financial

statements, we calculated that Texaco Petroleum paid US$ 671 million in cash royalties while

Gulf Oil paid US$ 127 million in cash royalties.52 It is our understanding that CEPE did not pay

any cash royalties. Our analysis also indicates that the Consortium delivered 139 million barrels

48 Appendix E: TexPet Income Statements, 1972-1992

49 Appendix G: Economic Benefit Analysis

50 It is also our understanding that CEPE did not make cash royalty payments to Ecuador. 50 Accordingly, when calculating CEPE's net income, we did not include royalty expenses associated with cash royalties.

51 Appendix G: Economic Benetlt Analysis

52 Appendix G: Economic Benetlt Analysis

13

of oil to Ecuador as in-kind royalty payments between 1972 and 1992.53 To independently value

the 139 million barrels of clUde oil paid to Ecuador as in-kind royalties, we multiplied the

amounts delivered by the international market pnce Ecuador obtained from the

commercialization of the in-kind royalty contribution (as indicated by the free on board ("FOB")

prices obtained at the marine expOli tenninal in Balao). Accordingly, we valued the in-kind

royalty contributions of the ConsOliium at US$ 2.81 billion. 54

37. To estimate the economic benefit Ecuador derived from taxes, we determined that

Texaco Petroleum paid total taxes of U$$ 2.24 billion over the period 1972 - 1992 while Gulf Oil

paid an estimated US$ 0.35 billion in taxes over the period 1972 to 1976.55 Thus, Ecuador

collected total taxes ofUS$ 2.59 billion from Texaco Petroleum and Gulf Oil.

38. The economic benefit to Ecuador from the domestic market subsidy was calculated as:

[Volume of Gil Supplied to Domestic Market] * [International Market Price -IMP1

39. Ecuador set the IMP well below the price of elUde oil in the international marketplace

which enabled domestic refineries (owned by CEPE) to purchase elUde oil at highly subsidized

prices. In tum, the domestic refineries could then process the elUde into refined products such as

gasoline and diesel and offer those products to the domestic market at subsidized prices. 56 Thus,

the Consortium's domestic market sales served to subsidize the domestic consumption of energy

in the Ecuadorian economy. Employing the above fonnula, we calculated that the domestic

contribution of elUde oil by the Consortium generated an economic benefit to Ecuador of US$

10.72 billion. 57

5] This assumes that CEPE and Gulf made proportionate royalty and internal market contributions as per their ownership interest in the Concession. We note that the royalty contributions of CEPE were made to the Government, but the Government assigned all royalty contributions (from CEPE and other producers) back to CEPE for export.

54 Appendix C: Production and Appendix D: Prices. Based on spot checks conducted of the total in-kind royalty contributions by producers and the total volume of crude exported by Ecuador, it appears that Ecuador was exporting all of its in-kind royalty collections (see for instance, DNH "Balance Nacional de Movimiento del Petroleo Crudo Nacional," 1977-1986. NAV -26. Our review of the DNH statistical publication indicates that Ecuador exported all of its in-kind royalties through CEPE.

55 Since Gulf and Texaco had the same ownership interest in the Concession for the period when Gulfwas a participant in the Concession (1972 - 1976), we assume that taxes paid by Gulf over this period are equal to the taxes paid by TexPet. See Appendix G: Economic Benefit Analysis: Actual Model. In reality, taxes paid by Gulf could differ slightly from taxes paid by TexPet primarily due to slight differences in their revenues (which are in turn due to slight differences in the volume of oil annually expOlied by TexPet and Gulf.)

56 "Politics and Petroleum in Ecuador." Martz, John D. 1987. p. 102. NAV - 2 57 Appendix G: Economic Benefit Analysis

14

40. Accordingly, the total economic benefit derived by Ecuador from the production of oil

between 1972 and 1992 under the 1973 Concession was US$ 22.7 billion as shown in Figure 2

below.

Figure 2: Economic Benefit Derived by Ecuador from the Consortium (1972 to 1992) 58

$25,000

$20,000

<£7 $15,000 :g .: o ~ :§ $10,000

$5,000

$0

Total Value Captured by

Ecuador

Value of Internal Value of Royalties Estimated CEPE Texaco/GuifTaxes Market Subsidy Profit Paid

41. As Figure 2 demonstrates, the largest economic benefit to Ecuador was the domestic

market subsidy of US$ 10.7 billion. The other four economic benefits, however, generated total

cash benefits to Ecuador ofUS$ 12.0 billion.

42. Overwhelmingly, Ecuador received the vast majority of the economic benefits generated

by the Consortium's activities. Ecuador received US$ 22.67 billion (or 97.3 percent) of the US$

23.30 billion of economic benefits generated by the Consortium. Together, Texaco Petroleum

and Gulf Oil received just US$ 629 million (or 2.7 percent) of the economic benefit generated by

the Consortium. Figure 3 below shows how the total economic benefit of the Consortium

production was distributed between Texaco Petroleum, Gulf Oil, and Ecuador ("ROE").

58 Appendix G: Economic Benefit Analysis

15

Figure 3: Distribution of Economic Benefit Derived from Consortium Crude (million

US$)59

TexPet Profits, $480,2.1%

Gulf Profits, $149,0.6%

43. The above distribution of economic benefits directly resulted from the series of measures

that were implemented by Ecuador between 1969 and 1977 that resulted in a significant transfer

of economic benefit from Texaco Petroleum and Gulf Oil to Ecuador.

D. 1985 -1993: Ecuador Develops Additional Blocks Using Risk-Service Contracts

44. Subsequent to the 1964 concession and up until the mid-1980s there was virtually no

foreign investment in Ecuador's oil industry. Indeed, the reforms implemented in the early

1970s (including the September 1971 hydrocarbon law and subsequent creation of the state­

owned oil company CEPE) discouraged foreign involvement in the industry.60 However, by the

early 1980s there was a growing need for new exploration and development in order to increase

reserves and maintain production.61 This was coupled with a general belief that CEPE would not

59 Appendix G: Economic Benefit Analysis

60 "Politics and Petroleum in Ecuador." Martz, John D. 1987, p. 346. NAV - 2 ; Petro Ecuador Company History, p. 2. NAV-39; CEPE was subsequently renamed Petro Ecuador in 1989.

61 "Politics and Petroleum in Ecuador." Martz, John D. 1987, p.346. NAV - 2.

16

be able to accomplish such a task on its own.62 Consequently, Ecuador began to implement new

refOlms to encourage investments by international oil films that possessed the expertise and

capital needed to further explore the Amazon region for oil. Notably, a significant portion of the

areas (or "blocks") awarded in the 1980s and 1990s were areas that the Consortium was

compelled to release back to Ecuador in compliance with the measures enacted in the early

1970s.63 Figure 4 below shows all blocks that are currently active in Ecuador, as well as the

names of private parties that hold licenses to these blocks. The blocks that are not color coded

(in grey) represent blocks operated by Petro ecuador.

62 ld. at p. 347-348.

63 The Consortium originally had rights to explore and exploit over 2 million hectares ofland, but ultimately retumed over 1.5 million hectares back to Ecuador. Some ofretumed areas containing proven reserves were directly exploited by Petro ecuador and became "Petroecuador" fields. The unexplored retumed areas were awarded under risk service contracts or PSAs to private investors.

17

Figure 4: Original Concession Area and Blocks Currently Licensed in Ecuador

Final Concession Area

--~ - SOTE -- OCp

!;I - Pollducloa

Outline of Original Concession Area

~ ~~~~c'ANO$ ... TECPECUAOOR

~ ... PETROBElL

... PETRORJENTAL U Y 17

Q 0 ... PSOL.YI'f t& Bogul.c~plrOll. Tly~ouno

!;I _ AHDESPETROLEIJIot Tara_ o ::=~DOII CITY 27

!;I A01P01LECUAOORl O ~ U2J CNPCl1

o ECUADORTLC 18 I'i31I ESPOL

~ mB CANADA GRANOE1

SUELOPETROL

45. In line with the 1971 Hydrocarbons Law, Ecuador opted to retain full ownership over the

discovery of any commercial discoveries of hydrocarbons in its new contracts. Thus, rather than

grant a share of production to foreign firms, Ecuador chose to use risk-service contracts.64 Under

a risk-service contract, the foreign firm would bear 100 percent of the exploration risk. Thus, if a

commercial discovery were not located, the foreign firm would not recover any of its exploration

costS.65 However, if a commercial discovery were located, Ecuador would reimburse the

company for its exploration costs plus the costs of developing the fields (including interest) . In

64 "Politics and Petroleum in Ecuador." Martz, John D. 1987, pp. 349-350. NAV - 2 65 Id.

18

addition, the foreign firm would be paid a fee to cover the costs of production plus a profit

element. 66 However, the payment of these amounts to the foreign firm would be limited to the

receipts Ecuador would generate from the sale of oil produced from the fields. 67 Thus, the

foreign firm would assume all of the exploration risk but was guaranteed a profit if oil were

discovered. Ecuador would retain ownership of the oil but bear all of the risk of uncertain future

oil prices since low oil prices might mean all oil sale receipts would need to turned over to the

foreign firm to cover the required payments.

46. The first of these service contracts was signed in 1985 with the u.s. firm Occidental

Petroleum Company.6S Several additional contracts were signed over the course of the late 1980s

with firms including British Petroleum, the Brazilian state-owned oil firm Petrobras, the u.S.

super major Conoco, and French firm Elf Aquitaine, among others.69 Many of these contracts

resulted in successful oil discoveries, and by the mid to late 1990s production from the new

fields began to increase Ecuador's total production to record levels (see Figure 5 below).

66 Id.

67 I d.

68 EI Petroleo en Ecuador, p. 27. NAV-17 69 Id.

19

Figure 5: Ecuadorian Oil Production, 1972 - 200970

250,000 .......................................................................................................... --.................................. .

,2l 200,000 ............ -..................... -..................... -....................... -.................................................... -........ . ,.Q ,.Q

"C r:: tU rn g 150,000 - _._._--.-----

oJ:: E-< r::" o .... 1:: 100,000 ............................................... .-. . ........... -... -................................ -................................... .

= "C e ~ :-;:::l o 50,000

1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008

E. 1993 - 2006: Ecuador Converts Risk-Service Contracts to Production Sharing Agreements

47. In 1993 Ecuador began to implement production sharing agreements (PSAs) in lieu of

risk-service contracts.71 Under a PSA, the foreign firms would be a part owner of reserves and

therefore entitled to a share of the oil production. In exchange for giving up partial ownership of

the oil reserves, Ecuador received a share of production free from all exploration, development,

and operating costs. The switch in contract structures was driven by the low price of oil (see

Figure 6 below) and the relatively high exploration and production costs at the new fields . In

essence, Ecuador was earning little (if any) profit from the risk-service contracts since it was

obligated to reimburse the foreign firms' costs with low oil price receipts. Consequently,

Ecuador sought a new, more profitable contract structure.

70 See Appendix F.3: Production by Sector

71 Political Economy in Ecuador's Oil Sector, p. 7. NAV-IS

20

48. Ecuador not only switched to the PSA contract in the midllate 1990s for new blocks to be

explored and exploited by firms such as Santa Fe, Amoco, and Triton,n it also forced most of the

foreign firms operating under risk-service contracts to convert to PSAS.73 By converting risk­

service contracts to PSAs, Ecuador shifted the oil price risk to the foreign firms and guaranteed

itself a profit regardless of international oil prices.

F. 2006 - 2009: Ecuador Institutes Law 42

49. Beginning in 2002, the market price for clUde oil began to rise (see Figure 6 below), with

the magnitude of the rise amplifying in subsequent years. Given this rise in oil prices, Ecuador

sought to renegotiate PSAs back to risk-service contracts that would allow Ecuador to be the sole

beneficiary of the rising oil price environment. However, international oil companies operating

in Ecuador refused to accept this renegotiation. As a result, Ecuador passed Law 42 on 25 April

2006 which gave Ecuador an "additional participation" of 50 percent (calculated as 50 percent of

the difference between the market price of oil and the contract reference price, which is the sale

price of oil at the time the PSA contract was executed, adjusted for inflation). 74 Ecuador

subsequently increased the additional participation to 99 percent in October 2007 via Decree

662.75 However, in the face of rapidly declining investment and production (see Figure 4 above),

Ecuador subsequently reduced the additional participation to 70 percent.76

G. 2010 to 2011: Ecuador Renegotiates PSAs Back to Risk-Service Contracts

50. In late 2010 and early 2011 Ecuador began renegotiating the conversion of PSAs back

into risk-service contracts. As of early 2011 all but 4 foreign firms had accepted the

renegotiations. 77 Those companies that did not agree to the renegotiation had their assets

nationalized. Under the new agreements Ecuador once again retains complete ownership over its

hydrocarbons and has accepted the risks (and benefits) of fluctuating international oil prices.

72 EI Petrolco en Ecuador, p. 28. NAV-17

73 "Ecuador's tactics alarm oil companies", Houston Chronicle at p. 2; Ecuador begins renegotiating service contracts after Maxus fight", Latin America Energy Partners. NA V -19

74 Law 2006-42. NA V -20

75 Decree 662. NAV-21

76 Political Economy in Ecuadors Oil Sector at p. 7. NAV-IS

77 Oil Sector Reform in Ecuador: Changes for Better or Worse? p. 5. NAV-l

21

51. Ecuador's renegotiation of oil contracts with other private investors IS depicted

chronologically in Figure 6 below against the backdrop of changes in the international price of

crude oil from 1972 to 2009. As can be seen in Figure 6, large run-ups in the price of oil precede

Ecuador's use of the risk service contract model while a sustained period of low crude prices

preceded Ecuador's renegotiation of the contracts to PSAs.

Figure 6: Ecuadorian Crude Oil Export Price, 1972 to 200978

90.00

80.00

-~ ~ 70.00

'"' QJ

r:l.. f;Ft 60.00 r.n ::> oJ 50.00 v ·c

Q..

:= 0

40.00

= rU 30.00 ·c

0 '"d tU ::s 20.00 v

loLl

10.00

-------------------------------_._---------- Ecuador tries to renegotiate . 'ba<Ho servicecontracts,

implements windf II tax ___ Ecu.ydor b~gi!!~!<? look £:!:__ Ecuador b~gi.!'!, to ___ ---- _ l--.. -

foreign investors under renegotiate the risk service 1

ri sk service contract model contracts converting to PSAs I I I 1

-- -- - -. 1"-- •. - -- --.--.. ----.------ r--1 • 1 1 1 1 1 1 1 1 • 1 ---.. ------•. --------------.. ---.------.-.- ,.---.. -.. -._·_····_··_--_·_·_-_···_-----_·_---·---- 1-· .-----. 1 1 1 1 1 1 1 1 ·_------1·_··_·_- -·------------·-----·----· ·--·-·--·····---1-----·-·--·-.-.. --------... ------.-----.---. 1 1 1 1 I· 1 1 1 .-------.-._._-------.---1- 0

_.---------------- -

• 1 1 1

• 1 1 __________________ 0'- _.____ ._. _______________________ ._. ___________ 1 ___ • __________ ••• ________ ._. ___ • ___ •• ___ ---____ + _________ _

• • 1 1 • 1

• 1 1 1 1 1 -_ .. _----_-----0 ______ --- ___ .1 ________________ .__ _ ____________ .__ _ ________ . 1 _______ ._. ___ ._. ________ ._ _ ________________ 1 __________ . 1 • 1 1 1 1

• 1 1 1 1 _____ -------------------______ 1 ______ ----------------•• _--- __________ . ____________ 1 _______ • __ ._______ _ ___ •• ______ . _______________ .• __ 1 1 1

I I I • 1 1

1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008

H. Conclusion

52. Since oil was first discovered in the Oriente region, Ecuador has been and continues to be

the dominate participant in the sector. Ecuador (through state-owned Petroecuador) receives a

majority of the oil produced in the country, retains a monopoly on oil refining, and controls the

oil transportation infrastructure. We summarize Ecuador's participation in oil production,

refining, and transportation below in the following subsections.

78 See Appendix D: Crude FOB Export Price

22

a. Oil Production

53. Figure 7 below summarizes oil production in Ecuador for the period from 1972 to 2009.

It is worth noting that Ecuador had a 62.5 percent participation in the 1973 Concession between

1977 and 1992 after which its participation increased to 100 percent. When Ecuador's interest in

the 1973 Concession is combined with the oil production from Petroecuador owned fields, the

production shares from privately operated fields and royalties, it is evident that Ecuador has been

and continues to be the single largest oil producer and recipient of produced oil in Ecuador.

54. From 1972 to 1992 the Consortium produced a total of 1.469 billion barrels of oil from

the Concession, of which TexPet had a share of just 565 million barrels.79 From 1992 (when

TexPet left Ecuador) through 2009 Petroecuador wholly owned and operated the Concession

fields, producing a total of 1.174 billion barrels of oil. 80 During the period from 1992 to 2009

total oil production in Ecuador was 2.8 billion barrels, or nearly double the total amount

produced by the Consortium from 1972 to 1992.81

79 Appendix C.l

80 Appendix F.3; Therefore, TexPet's share of pro duet ion represents just 21 percent of the total oil produced at the Concession fields through 2009. From 1992 to 2006 Petroecuador drilled a total of 317 new wells (both in the Concession fields and in other Petroecuador-owned fields). See Informe Estadistico 1972-2006: Exploraci6n NAV - 41

81 Appendix F.3

23

Figure 7: Oil Production in Ecuador (1972 - 2009t2

225

200

175

<Il 150 Qj ~ ctJ 125 ~ ..... 0 <Il r:: 100 0 ~ ~ 75

50

25

a 1972 1975 1980 1985 1990 1995 2000 2005 2009

• Other Fields (Private) • Petroecuador Fields • Consortium Fields

b. Oil Refining

55. Ecuador (via Petroecuador) also owns all of the country's refineries. Ecuador currently

has three primary oil refineries that are owned and operated by Petroecuador: Esmeraldas, La

Libertad, and Amazonas. 83

56. Esmeraldas is the largest refinery and was the first refinery to be built in the mid-1970s

shortly after oil production in the Oriente commenced. Its original capacity was 55,000 barrels

per day (bpd) which was subsequently expanded in stages to 110,000 bpd. 84 It is currently being

upgraded to increase its capacity utilization. La Libertad refinery is located on the peninsula and

82 See Appendix F.3: Oil Production by Sector (1972-2009)

83 Oil Sector Reform in Ecuador: Changes for Better or Worse? Page 14. Business News Americas, Energy Intelligence Series, March 2011. NAV - 1

84 1d.

24

is comprised of three pnmary distillation units with a combined capacity of 45,000 bpd.85

Petro ecuador acquired control of the refinery from private parties (Anglo American and Gulf) in

1989/90. Amazonas is the smallest refinery with a capacity of 20,000 bpd resulting in a total

combined refining capacity of 175,000 bpd.86

57. The refineries purchase crude oil from the oil producers at the subsidized IMP and refine

the crude to produce varying types of petroleum products to fulfill the country's domestic market

needs. However, the capacity of these refineries has not been sufficient to fulfill the domestic

needs and Ecuador has historically imported lighter refined products (such as gasoline and

diesel) to cover the shortfall. The government is presently focusing on increasing domestic

refining capacity by improving the efficiency of existing plants and is also building a large new

refinery (Refine ria del Pacifico) with a planned capacity of 300,000 bpd at a planned

construction cost ofUS$ 12.5 billion. 87

c. Oil Transportation

58. Ecuador has two major oil pipeline systems. The first is the SOTE that was built by the

Consortium in 1971. It runs from Lago Agrio to the Balao oil terminal on the Pacific coast and

has a capacity of 400,000 bpd.88 The SOTE was owned by the Consortium until 1986, at which

time ownership reverted to CEPE/Ecuador.89 The SOTE remained the sole conduit for exporting

oil from the Oriente through the 1990s, which made the country vulnerable to disruptions to the

SOTE. Ecuador experienced this first hand after the 1987 earthquake caused severe damage to a

large section of the SOTE resulting in significant disruption to production and exports. The

capacity of the SOTE also limited the amount of oil that could be produced and exported from

the Oriente.

85 Id. at p. 15 86 Id.

87 Id. at p. 16

88 Oil Sector Reform in Ecuador: Changes for Better or Worse? Page 13. Business News Americas, Energy Intelligence Seties, March 2011. NAV-l

89 "El SOTE Y su Historia." http://www.sote.com.ec/sote/portal/main.do?code=4040. NAV - 9

25

59. Construction of a second oil pipeline called the Oleducto de Crudos Pesados ("OCP")

was commenced in the late 1990s, with the OCP becoming operational in November 2003.90 The

OCP has a capacity of 450,000 bpd and it mostly parallels the route of the SOTE.91 The OCP

immediately doubled Ecuador's oil pipeline capacity leading to a sharp increase in Ecuador's

crude oil production, as private companies are no longer constrained by the capacity limits of the

SOTE. The OCP system is primarily used by private oil producers, with Petroecuador relying

upon SOTE. The OCP was built and operated by a private consortium (OCP Ecuador S.A.), with

ownership reverting to the government after 20 years of operation. 92

60. In summary, the government is the dominant player in the production, transportation, and

sales of oil to the international market, and also retains a monopoly on the refining of crude oil

within Ecuador.

IV. Impact of the on Sector on Ecu.ador's Economy

61. Prior to the discovery of oil in the Oriente, Ecuador's economy was largely agrarian.93

The countly's export revenues were driven almost entirely by cacao, coffee, bananas, and

sugar.94 The discovery of oil completely transformed the structure of the economy. It generated

significant export revenues, accelerated GDP growth, and served as a significant source of

revenues for the government budget. In the sections below, we summarize the government's

participation in the oil sector, and then examine the impact of the oil sector on the domestic

economy.

A. Exports

62. Since full scale oil production began in the Oriente in mid-1972, oil has dominated

Ecuador's exports. Figure 8 below charts Ecuador's exports over the period from 1970 to 2009.

Export revenues were practically non-existent prior to 1972. But in 1975, less than three years

after full scale oil production commenced, export revenues rose substantially with oil accounting

90 Oil Sector Reform in Ecuador: Changes for Better or Worse? Page 13. Business News Americas, Energy Intelligence Series, March 2011. NAY-l

91 Id.

92 Id.

93 "Ecuador: a countly study, Chapter 3." Federal Research Division, LibralY of Congress. NAY - 22 94 Id.

26

for 67 percent of export revenues.95 By 1980, export revenues had risen well above US$ 2.5

billion - more than ten times the export revenues generated in 1970. In 2009, oil accounted for

roughly half of Ecuador's exports.

Figure 8: Ecuador Exports (1970 - 2008)96

16,000

14,000 -------------------------- ---------------------------------------.---------------------------------------------.. -.. ..---------.. -.. -.. -.---.--------------.. ---.-

12,000 --.---------------.-.-.--.--------- ... ----.--------------.... --.... --------.---.-.--.-------- .. -.--.. -.-.. -.---.... ---.-...... -.-... -----.... - -..... -------.

~

~ 10,000 o o ~ 8,000 --..... - .-.-.--.---------.-.--.---.----.-.---.... ---.. -.. --------.-...... -.-------... --.------... --.-.. -.. --.-.. . ~ .9 ~ 6,000

4,000 . - ... -.------.---.-.-.... ----.-...... - .--.. -----.------.-..... -----

2,000 - .. -------..... ---..... --. ----

1970 1975 1980 1985 1990 1995 2000

• Oil Exports • Non-Oil Exports

2005 2009

63. Ecuador's economy has grown increasingly reliant on proceeds from oil exports.

Reduction in oil export revenues, such as those caused by sudden oil price declines, has resulted

in significant fluctuations in the overall trade balance. For example, the recent drop in oil prices

in late 2008 and 2009 amidst the global economic slowdown significantly impacted Ecuador's

export revenues. Receipts from oil exports for January 2009 were 65 percent lower than those in

95 See Appendix F.2: Exports by Sector (\965-2008)

96 Appendix F.2: Exports by Sector (\960-2008)

27

January 2008. This caused total exports receipts in January 2009 to fall almost 48 percent from

January 2008.97

B. Gross Domestic Product (GDP)

64. GDP is a measure of the value of all goods and services produced by a country. It is a

key measure of the performance of any economy. The discovery and production of oil in the

Oriente strongly influenced the growth in Ecuador's economy beginning in the 1970s (see Figure

9 below).

Figure 9: Ecuador GDP v Oil Exports (1965 - 2009)98

60,000

50,000

TexPet Commences Oil

Production in the Oriente 40,000

---fF7 Cfl ::>

30,000 ~ .9 --..... ~ --P-. 20,000 0 l?

10,000

1965 1970 1975 1980 1985 1990 1995 2000 2005

- GOP - Oil Exports

14,000

12,000

10,000 m ::> ~ o .....

8,000 ~ rJJ

1::: 6,000

0 0.. x

>.I.l -..... 0 4,000

2,000

65. Figure 9 above also reveals a strong correlation between oil exports and Ecuador's GDP.

This correlation is not just dependent upon the volume of crude oil exported, but also the price at

97 Oxford Analytica, "Ecuador: Oil price drop reveals economic weakness," 31 March 2009. NAV - 23

98 Appendix F.l : Oil Exports as percent ofGDP (1965-2009)

28

which it is exported, which in turn depends on the international market price of oil. Ecuador's

nominal GDP was relatively flat between 1965 and 1971 - growing at a rate of just 5 percent per

year over this period. The economy started growing much more rapidly in the 1970s once oil

production was initiated in 1972. In fact, GDP doubled between 1972 and 1974 alone due to the

export of crude by the Consortium. GDP continued to grow sharply through the late 1970's

aided by a sharp increase in global oil prices during this period. World oil prices slumped in the

early 1980s and again in 1986 causing Ecuador's GDP to slump as well. GDP recovered in the

early 1990' s in line with the recovelY in oil prices, but dropped again in the late 1990s due to the

weakness in oil prices and the rapidly declining value of the sucre.99 The replacement of the

sucre with the US dollar and the rapidly increasing prices of oil in the 2000s caused GDP to

more than triple between 2000 and 2008. In 2009 GDP fell amid falling world oil prices (and

thus lower oil exports) during the global financial crisis.

C. Fiscal Revenues and the National Budget

66. Given the significant contribution of the oil sector to Ecuador's exports and its GDP, it is

not surprising that the oil industry has contributed more to Ecuador's national budget than any

other sector over the past three decades. The oil sector directly contributes to the State budget in

four ways: 1) income taxes paid on oil exports, 2) cash and in-kind royalty contributions (which

are exported and monetized by the government), 3) income generated from government-operated

oil fields and refineries, and 4) production sharing on oil fields operated by foreign companies.

67. A comparison of tax (and royalty) revenues from the oil sector and the rest of the

economy reveals how Ecuador has utilized the oil industry to expand the state's spending

programs to grow the economy. As shown in Figure 10 below, the oil sector contributed

between 20 and 50 percent of the tax revenue collected by the State from 1972 to 2009.100

99 EIU Ecuador 2009 Counhy Profile, 2009, p. 19. NAV - 24

100 Appendix F.5: Tax Contribution of the Ecuador Oil Sector. Note that taxes from the oil industIy fell to only 20 percent of total taxes in 2009 amid very low oil prices during the economic crisis in 2009. While official data are not yet available, we expect taxes from the oil sector to have increased significantly in 2010 as oil prices rebounded.

29

Figure 10: Tax Contribution of the Oil Sector101

14,000

12,000 -1 ....................•... -......... -.. --........... -..... - ...... -... -.. -..... --....• -............. -.......... -... --...•... -.-.-...........•. --......... -... -..•..... ---.... --.. --.•...... -.

to,OOO .................... __ ._._.--_ •... _._ ............. --_ ....... _ ... _.----_ ..... --........ -._ ............... __ .. _ ........... _--....... --.. --....... _ ................. -

fA- 8,000 :g

I=: o ...... -~

6,000

4,000 ..... _ .... -_ ... -.......... _ .......... _ ..... _ ... _ ........ _._ .... _ ......... _ ...... __ ..... _ ........ _---== .... _ ....... --........... --...... -

2,000

1972 1975 1980 1985 1990 1995 2000 2005 2009

• Taxes from Other Industries • Taxes From Oil Industry

68. It is evident from these data that Ecuador would not have been able to achieve the level

of economic growth that it did but for the contributions of the upstream oil sector.

Brent C. Kaczmarek, CF A

101 [d.

30