legal regime for hydrocarbons operations in ecuador

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Copyright OGEL 2004OGEL Cover v1.1

Oil, Gas & Energy Law Intelligence

Legal Regime for Hydrocarbons Operations in Ecuador by D.G. Lamanna

www.gasandoil.com/ogel/ Issue : Vol. 2 - issue 1 Published : February 2004

PETROBRAS ENERGA ECUADOR Legales Dr. Daro G. Lamanna

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LEGAL REGIME FOR HYDROCARBONS

OPERATIONS IN ECUADOR

By DARIO GERARDO LAMANNA

(Manager, Legal Affairs, PETROBRAS Ecuador) I.- LEGAL AND REGULATORY FRAMEWORK Oil activities in Ecuador are governed by the provisions of the Law of Hydrocarbons, by the regulations issued by the President of the Republic for the enforcement of such Law, by the regulations issued by the Minister of Energy and Mining, and by the Contracting Guidelines for each bidding modality. II.- REGULATORY AUTHORITIES The Executive Branch, headed by the President of the Republic, is in charge of the regulation and formulation of hydrocarbon policies, as provided in section 5, Art. 171 of the Political Constitution of Ecuador. The Minister of Energy and Mining, in view of the powers granted by Art. 9 of the Law of Hydrocarbons, is in charge of submitting to the consideration of the President of the Republic the national hydrocarbons policy in all its aspects. The Ministry of the Environment, the Ministry of Foreign Trade, the State Oil Company of Ecuador - PETROECUADOR, the National Institute of Cultural Heritage and the municipal councils of the cantons where oil companies operate also have competence to regulate aspects related to oil activities. The Internal Revenue Service (SRI) has competence to regulate tax issues related to oil activities and to monitor compliance with these obligations. III.- CONTROL AUTHORITIES Pursuant to the provisions of Art. 11 of the Hydrocarbons Law, the National Hydrocarbons Office (DNH), an internal unit of the Ministry of Energy and Mining, is the technical and administrative department in charge of controlling and monitoring oil operations either directly or through specialized national or foreign professionals, firms or companies hired for this purpose. The DNH must oversee compliance with the regulations concerning the quality, quantity, reliability, continuity, timeliness and safety of the various oil activities, on the basis of the regulations issued by the Minister of Energy and Mining. The National Environmental Protection Office (DINAPA), another internal unit of the Ministry of Energy and Mining, is the body in charge of approving Environmental Impact Studies (EIA) and Environmental Management Plans.


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With respect to environmental issues, the Ministry of the Environment also has competence to control oil activities, within its scope of action. IV.- HYDROCARBON EXPLORATION AND EXPLOITATION According to the Political Constitution of Ecuador and the Hydrocarbons Law, the State is in charge of exploring and exploiting deposits of hydrocarbons and other related substances, in any physical state they may be in, which are located within the national territory, including the areas covered by the waters of the territorial sea, which are the inalienable and imprescriptible property of the State. This activity is carried out directly by the State Oil Company of Ecuador PETROECUADOR which can so itself of through third parties via contracts of association, participation, services contracts for hydrocarbon exploration and exploitation, or other contractual forms in effect in the Ecuadorian legislation, such as marginal field contracts or shared management contracts. These contracts are subject both to the terms and conditions common to all of them, as well as to specific regulations. In addition, semi-private companies may also be established with national and foreign companies of renowned competence, legally established in the country. A.- TERMS AND CONDITIONS COMMON TO ALL HYDROCARBON EXPLORATION AND EXPLOITATION CONTRACTS: 1.- Selection and hiring The selection of contractors and the awarding of hydrocarbon exploration and exploitation contracts, except those for specific works or services, must be made via a special bidding system, whose structure, requirements and procedures are established in the relevant regulations issued by the President of the Republic, with the goal of diversifying the adjudication of contracts between state and private companies. For this purpose, the Special Bidding Committee (CEL) is composed by the following officials: a. The Minister of Energy and Mining, who acts as Committee chairman; b. The Minister of National Defense; c. The Minister of Economy and Finance; d. The General State Comptroller; and, e. The Executive President of PETROECUADOR. These principal members may delegate their representation only to the official following in seniority. However, delegates may not delegate their representation. All contracts must be preceded by reports from the State Attorney General and the Joint Command of the Armed Forces. Contracts signed must be registered with the Hydrocarbons Register, which is kept by the National Hydrocarbons Office (DNH). If deemed convenient to the interests of the State, the Special Bidding Committee (CEL) may adjudge more than one contract to the same contractor. However, in case the same contractor signs more than one contract, for income tax payment purposes such


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contractor may not consolidate the losses suffered in one contract with the earnings made in another. Likewise, if deemed favorable to the State, contracts may be modified by mutual agreement between the contracting parties and after approval by the Special Bidding Committee (CEL). For this they shall need the prior favorable reports of the State Attorney General, the Joint Command of the Armed Forces, the Governing Council of PETROECUADOR, and the Minister of Energy and Mining. 2.- Contractual Area Each contract shall include one block with a land area not to exceed 200,000 ha, divided in lots measuring 20,000 ha or less each, pursuant to the charts drawn by the Military Geographical Institute; or a block with a maritime surface not to exceed 400,000 ha, divided in lots measuring 40,000 ha or less, pursuant to the charts drawn by the Navys Oceanographic Institute. These lots must have a rectangular shape, with two sides on an North-South bearing, except when the natural boundaries or those of other reserved or contractual areas prevent it. Before the execution of these programs and if the lots are found on land allocated by the State to indigenous communities or to Afro-Ecuadorian peoples, and in view that such programs may cause damage to the environment, PETROECUADOR, its affiliates or the contractors or their associates must hold consultations with these ethnic groups or communities. To this end, they shall hold public assemblies or meetings to explain and expose the plans and purposes of their activities, the conditions under which they will be carried out, their duration and the possible direct or indirect environmental impacts that they may have on the community or its inhabitants. A minute or other public document shall be drawn to bear witness of the acts or agreements reached. After the consultation is made, the Ministry of Energy and Mining shall make the decision most favorable for the interests of the State. 3.- Return of contract areas After the exploration phase is completed, the Contractor may only retain the areas where exploitable commercial hydrocarbons have been discovered, in complete lots, selected as established in the development plan, unless the Contractor agrees with PETROECUADOR to carry out new exploratory activities during the first three years of the exploitation period. If the contractor fails to carry out the agreed exploratory activities or fails to discover exploitable commercial fields, the contractor must return to the State the areas retained. Fields discovered during the exploitation period whose hydrocarbon productivity has been verified but which have not been developed and put in production within the next five (5) years after the approval of the development plan for the area, shall also be returned to the State. This restriction, as well as the return of areas, does not apply to services contracts for the exploration and exploitation of hydrocarbons, given the nature of their contractual relationship, where contractors act as operators for PETROECUADOR, although at the risk of such contractors.


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All contractors or associates who return areas to the State are bound to deliver to the Ministry of Energy and Mining all the background information, records and all geological, geophysical, drilling or other studies related to the areas returned. 4.- .Duration a) Crude oil exploration and exploitation contracts contemplate two periods: (i) the exploration period, which may last up to four (4) years, extendable for up to two (2) more years, prior justification by contractor and authorization from PETROECUADOR. Operations must begin and continue on the ground within the first six (6) months from the registration of the contract in the Hydrocarbons Register, which shall be made within thirty (30) days from the signing of the contract. As stated before, the contractor may retain areas to carry out additional exploratory work during the first three years of the exploitation period. (ii) The exploitation period, which may last up to twenty (20) years. PETROECUADOR may extend such period in accordance with the provisions of the development plan for the area and provided it is convenient to the interests of the State. At the end of the exploration period, the contractor may only retain the areas where commercial hydrocarbons have been found, in complete lots, selected as established in the development plan, unless the contractor agrees with PETROECUADOR to carry out new exploratory activities within the first three years of the exploitation period. b) Concerning contracts for the exploration and exploitation of natural gas, the relevant contract must include the technical and economic terms and conditions provided in the Hydrocarbons Law, where applicable. In these cases, the exploration period may also last up to four years, extendable for up to two more years, prior justification of contractor and authorization by PETROECUADOR. At the end of the exploration period and before the beginning of the exploitation period, the contractors are entitled to a period for the development of their market and the construction of the necessary infrastructure. This period shall last five years, extendable according to the interests of the State, in order for contractors, by themselves or in association with third parties, to commercialize the natural gas discovered. The exploitation period for these contracts may last up to twenty-five (25) years, extendable by PETROECUADOR if favorable to State interests. Contractors will begin the exploitation period upon authorization of PETROECUADOR. 5.- Exploratory Program All contracts shall require an exploratory program, which shall be executed as agreed by the parties. If stratigraphic or structural traps are detected, the contractor or his associate must drill at least one exploratory well per each 100,000 ha or fraction above 50,000. The wells drilled must reach depths that penetrate potentially oil bearing geological formations. Likewise. For contract areas of 50,000 ha or less, the contractor or his associate must drill at least one exploratory well. 6.- Development and Production


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The Law provides for an average investment of no less than a value equal to 120 dollars and 180 dollars per year per hectare, for land and marine surfaces, respectively, during the first three years of the exploitation period. For this purpose, only the area reserved for exploitation shall be taken into account. Investments in successive years shall be agreed between the parties. Drilling wells at distances of less than 200 m from the boundary of the respective area of exploration or exploitation requires the prior authorization of the Ministry of Energy and Mining. The Ministry of Energy and Mining is in charge of fixing the production rate of maximum effectiveness at well, deposit or field level, so as to allow its rational exploitation from a technical and economic point of view, in accordance with the regulations in effect. . The exploitation of fields common to two or more areas of the contract makes it compulsory to sign operational unified exploitation agreements with the purpose of achieving greater effectiveness and economy in the operation. 7.- Guarantees a) Guaranty of seriousness of offer.- Bidders must include in their proposal a bank guaranty of seriousness of their offer, issued by a financial institution legally organized or established in Ecuador, for the amount specified by the Special Bidding Committee (CEL). Such guaranty must be unconditional, irrevocable and immediately payable, and be valid for the same time of validity of the proposal plus thirty (30) days. b) Exploration Guaranty: an exploration guaranty in cash, State bonds or other form satisfactory to the State is required. It must be the equivalent of 20% of the investment the contractors agree to make during the exploration period. This guaranty shall be returned to contractor or his associate at the end of the exploitation period and once contractor has shown that he has complied with all his obligations or when the contract is terminated, prior justification of failure to obtain favorable results during the exploration period. This guaranty shall be cashed in case of noncompliance with any of the obligations stipulated for the period in question. c) Exploitation Guaranty: the Law requires a guaranty equivalent to 20% of the investments which contractor agrees to make during the first three years of this period, which shall be reduced in direct proportion with the fulfillment of the annual program agreed, or which shall be returned on termination of contract due to lack of commercial production, duly justified by contractor and accepted by PETROECUADOR. The contractor or his associate shall lose this guaranty if they fail to comply with the contractual obligations during the first three years of the exploitation period, without prejudice of PETROECUADOR's right to collect by coercive measures the amounts owed by contractor. 8.- Royalties The State shall receive monthly royalties according to the following scale:


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a) Royalties of no less than 12.5% over the gross production of crude oil, measured at the storage tanks in collection centers, after separating water and other foreign matter, when average production of the respective month is less than 30,000 barrels per day; b) Royalties of no less than 14% when the average production of the month reaches 30,000 but less than 60,000 barrels per day; and c) Royalties of no less than 18.5% when the average production of the month is 60,000 barrels per day or more. The aforementioned percentages of royalties shall apply to the aggregate production of each company and its affiliates, subsidiaries and associates, as well as to consortia of companies and de facto societies. For free gas deposits and the products obtained therefrom, a minimum monthly royalty rate of 16% shall be paid. In service contracts for the exploration and exploitation of hydrocarbons, contractors, acting as operators of PETROECUADOR, shall not be subject to the payment of royalties. As the total production of the contract is owned by PETROECUADOR, this company shall take from the net production the percentage equivalent to royalties payable to the General State Budget. In contracts for the provision of specific services, for the additional exploitation and exploration of marginal deposits or in participation contracts for the exploration and exploitation of hydrocarbons, contractor does not pay royalties either. However, in the case of participation contracts, royalties are paid to the participants therein, taken from the State participation in the production of the area of the respective contract. Royalties, income taxes, State participation and in general all taxes dependent on the sales prices of hydrocarbons in the foreign market shall be regulated by the actual sales or reference prices according to prevailing conditions. The reference price of hydrocarbons shall be the weighted average price of the last month of foreign sales of hydrocarbons made by PETROECUADOR. In the case of natural gas, the reference price of substitute energy sources shall be taken into consideration. Reference prices may be discussed with production companies from time to time as justified by prevailing conditions. The royalties and the royalty equivalent that companies and PETROECUADOR must pay, respectively, for their own consumption and for hydrocarbon losses in their normal operations shall be regulated by the sales prices in the countrys domestic market. 9.- Other payments to the State In addition, the State shall receive at least: admission premiums, surface rights, compensation payments and contributions in compensatory works:


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a) As admission premium for the exploration of hydrocarbons, the State shall receive, within thirty days after the date of registration of the respective contract in the Hydrocarbons Register, a minimum amount of fifty sucres per hectare. Within thirty days after the beginning of the exploitation period, the State shall receive, as admission premium, no less than one hundred-fifty sucres per hectare of surface retained for that period; b) During the exploration period, the State shall receive a surface right of no less than ten sucres per hectare per year. Such payment shall be made for the entire year in the month of January. In case the first payment does not correspond to a full year, it will be paid in proportion to the respective months; c) During the exploitation period, the State shall receive, per hectare per year, a surface right of no less than fifty sucres during the first five years and one hundred sucres after the sixth year; d) For the use of water and natural building materials found in the area of the contract and owned by the State, contractors or their associates shall pay in advance, within the first thirty days of each year, starting on the registration of the contract, the minimum amounts of twenty-four thousand dollars during the exploration period, and sixty thousand dollars during the exploitation period. Both amounts shall not be reimbursable in the case of service contracts for the exploration and exploitation of hydrocarbons. In case the first payment does not correspond to a full year, it shall be made in proportion to the respective months. Off-shore operations shall not give rise to this payment; e) In addition, all contracts must stipulate compensation works according to government plans, for a specific amount, in accordance with the size of the contract area and its closeness to discovered deposits. In no case shall this contribution be less than two hundred sucres per hectare of reserved area, and shall be invested within the next five years. All the monetary amounts specified in sucres in the Law shall be converted into US dollars, at a rate of twenty-five thousand sucres per dollar. Contractors having contracts for specific services, additional exploitation and exploration of marginal fields or of participation for the exploration and exploitation of hydrocarbons are exempted from these payments. Contractors with services contracts for the exploration and exploitation of hydrocarbons are also exempted, but they must pay each year to the State, from the beginning of the exploitation period, a non-refundable contribution equivalent to 1% of the amount paid for the services prior to the deduction of employees' participation and income tax. This amount shall be destined to promote research and development of scientific and technological services in the field of hydrocarbons and, in general of Mining, by the Ministry of Energy and Mining. 10.- Other Obligations: a) To hire, within six months from the beginning of operations, to be carried out directly or through contracts, a minimum number of Ecuadorian personnel equivalent to ninety-five percent of workers, ninety percent of administrative staff and seventy-five percent


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of technical staff, unless there are no national technicians available. Within two years ninety-five percent of the administrative staff must be Ecuadorian; b) To carry out a technical and administrative training program, at all levels, according to the regulations of the Law, so that within the first five years of the period of exploitation, the execution of operations is wholly carried out by Ecuadorian workers and administrative staff and by a minimum of ninety percent of national technical personnel. The ten percent of foreign technical staff shall foster the transfer of technology to national personnel. c) To submit deposit exploration and development plans to the approval of the Ministry of Energy and Mining, before the beginning of their execution; d) To provide the Ministry of Energy and Mining, every quarter or when requested, reports on all topographic, geologic, geophysical, drilling, production, reserve assessment and estimates works and other activities; e) To provide the Ministry of Energy and Mining, when required, economic data related to all relevant issues as well as exploration or exploitation costs; f) To use modern and efficient machinery and to apply the most adequate methods to obtain the highest productivity, observing the reserve conservation policy established by the State; g) To allow public use, as required by the corresponding Ministry, of communication roads, airports, maritime and inland ports they may build; h) To submit, within the first three years of the exploration period, the aerophotogrammetric mosaic of the land area of the contract, using the scale and the specifications as determined by the Military Geographical Institute. The aerophotogrammetric survey, if not already done, shall be made by or under the control of the Military Geographical Institute and the negatives shall be the property of the State; i) To make a final delimitation of the area of the contract and to deliver the corresponding charts within the first five years of the exploitation period, following geodesic methods or other scientific methods, according to the Regulations of the Ministry of Energy and Mining. This work shall be carried out, on behalf of the State, by the Military Geographical Institute or the Navys Oceanographic Institute, as the case may be. If the aforementioned charts already exist, the company must update them; j) To contribute, during the exploration period, to the development of national technical education and to the granting of scholarships, in the country or abroad, for specialized studies in the hydrocarbons industry; k) to submit for the approval of the Ministry of Energy and Mining, until December 1 of each year, a detailed program of the activities to be carried out during the following calendar year, including the investment budget. In addition, during the exploitation period, the contractor must submit each year for the approval of the corresponding


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Ministry, the updated five-year program for the activities to be developed, including their budget, together with the operating program referred to in the previous paragraph. l) To submit, also during the first month of each year, a detailed report of the operations carried out during the preceding year, including data on exploration, production, reserves, domestic sales, exports, personnel and other information about the works; m) To keep books in the Spanish language and updated records of financial accounts and costs, with the respective ledgers and vouchers, and to preserve them for the entire period of the contract and up to ten years after that. n) To submit to the Ministry of Energy and Mining, within the first quarter of each year, the general balance, the statement of results and the inventories corresponding to the economic exercise of the preceding calendar year; o) to invest a minimum of ten percent of their net profits, according to the results of the financial statements, in the development of the same or of other hydrocarbon industries in the country; p) To build hygienic and comfortable living quarters for employees and workers in stable work camps, as per the plans and specifications approved by PETROECUADOR. q) To supply housing, food and transportation facilities in work camps to inspectors and other State officials; r) To welcome students or graduate students from higher technical institutes related to the hydrocarbons industry, in the number and for the periods agreed with PETROECUADOR, so that they can make practices and studies on field work and the industry. Transportation, housing, food and medical expenses shall be on the account of the companies; s) To submit to the approval of the Ministry of Energy and Mining, programs and projects and their respective financing to prevent exploration and exploitation activities from adversely affecting the economic and social organization of populations living in the areas where the aforementioned activities take place or any local renewable and non-renewable natural resources. Likewise, New population settlements as necessary must be planned. For the above-mentioned approval the Ministry of Energy and Mining shall rely on the reports issued by the respective regional development organisms and the Ministry of Social Welfare. t) To conduct oil operations according to the environmental protection laws and regulations and the security of the country and with respect to international practice in areas of preservation of fish farming and the agricultural and cattle industry. To this end, the Law provides that contracts must contain the respective guarantees. According to the Law of Environmental Management, in order to begin any activity which may entail an environmental risk, the relevant permit must be obtained from the Ministry of the Environment. u) To prepare environmental impact studies and environmental management plans to prevent, mitigate, control, rehabilitate and compensate environmental and social


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impacts arising from their activities. These studies shall be evaluated and approved by the Ministry of Energy and Mining in coordination with the environmental control agencies and their environmental follow-up shall be entrusted directly or by delegation to auditing firms qualified for that purpose. v) According to the Law of Environmental Management, all contractors who, in the course of their work determine that their activities may cause or are causing environmental damages to the ecosystem, are bound to report such damages to the Ministry of the Environment or to the relevant institutions of the autonomous sectoral regime. Competent authorities shall adopt the required measures in order to redress the problems detected. In case of failure to comply with this provision, the offenders may be fined with twenty to two hundred general minimum vital wages. 11.- Property a) Final importation: During the period of exploration and during the first ten years of the period of exploitation, companies that have signed hydrocarbon exploration and exploitation contracts may import free from any customs duties any equipment, machinery, implements and other materials necessary to execute such contracts. b) Temporary importation: it means the temporary introduction in the country of oil machinery or equipment, under the Organic Customs Law. c) Availability: Contractors or their associates may not sell, encumber or withdraw during the term of the contract any part of the property referred to in the previous paragraph, without the authorization of the Ministry of Energy and Mining. With a favorable report of PETROECUADOR, property imported duty free may be transferred or sold, when such property is no longer of use in the work of the interested company. First, an appraisal must be made by delegates of PETROECUADOR and the Ministry of Economy and Finance, so as to charge the proportionate part of the customs duties previously exempted on the value of the property appraised. If the transfer is made to another company exempted from paying customs duties, only the favorable report of PETROECUADOR will be required. The State or PETROECUADOR shall have priority in the purchase of such items; such purchase shall be made without paying the assessed taxes. d) Reversion to the State: At the end of an exploration and exploitation contract due to expiry of the term or for any other reason arising during the term of exploitation, contractor shall give to PETROECUADOR, at no cost and in good state of production, the wells in activity at that time, and in good state of repair, all the equipment, tools, machinery, facilities and other real and personal property that may have been purchased for the purposes of the contract, as well as to transfer those goods indicated by PETROECUADOR to the places indicated by the company. If the contract is terminated during the exploration period, the obligation of contractor is limited to deliver to PETROECUADOR, at no cost and in good state, the wells, camps and infrastructure works. e) Payments in special cases: during the last ten years of the term of a hydrocarbons exploration and exploitation contract, PETROECUADOR may agree with contractor or his associate to make investments under special amortization conditions and to pay the non-amortized part at the end of the contract.


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f) Conservation: Negligence, carelessness or malfeasance in the conservation of property subject to reversion and which is virtually the property of the State can result in civil and criminal liability under the law. g) Benefit in favor of third parties: Indigenous communities and Afro-Ecuadorian populations settled in the areas of direct influence where hydrocarbon exploration or exploitation works are conducted, may benefit from the infrastructure built by contractors or their associates, after the oil exploration or exploitation stage is completed, provided there are no more stages following. 12.- Transfer The transfer of a contract or the assignment to third parties of the rights arising from a hydrocarbons exploration and exploitation contract is null and void if not preceded by an authorization by the Ministry of Energy and Mining, without prejudice of a declaration of forfeiture, as described below. The State is entitled to receive a premium for the transfer, and the beneficiary company must sign a new contract in economic conditions more favorable to the State and PETROECUADOR than those contained in the original contract. This legal provision stipulates the following payments to the State: a) If the assignment is made during the period of exploration or research, construction of infrastructure or market development, in the case of natural gas contracts, the assignor must pay the State a premium of five thousand US dollars (US$ 5,000) for each one percent of participation in the contract assigned to third parties, and the assignee must increase the amount of the training investments calculated for the year the assignment takes place in proportion with the percentage of participation purchased. b) If the assignment is made during the exploitation period, the assignor shall pay the Ecuadorian State, as transfer premium, an amount equal to 1 per mil of the net profits obtained during the year preceding the year when the transfer or assignment takes place, for each one percent of participation assigned or transferred to third parties, calculated on the basis of the Income Tax Return. This premium in no case shall be less than five thousand US dollars (US$ 5,000) for each one percent (1%) of participation, for one time only. The funds shall be deposited in the Single Current Account. The assignor shall give the Ministry of Energy and Mining, as improvement of the economic terms of the original contract, five thousand US dollars (US$ 5,000) for each one percent (1%) of participation, for one time only. c) On contracts for the additional exploitation and exploration of marginal fields, the amounts corresponding to transfer premiums and improvement of economic terms of the original contract shall be equal to ten percent (10%) of the amounts above indicated. In association contracts, if the assignment is proposed during the exploitation period, CEPE shall have a preferential right thereon, pursuant to Art. 15 of the Hydrocarbons Law, under the same terms and conditions specified in the assignment application. In this case, CEPE shall be exempt from paying any premium and from improving the economic terms of the original contract.


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When contractor is a consortium or an association of companies, the partial or total association of the rights arising from the contract among those companies, or the assignment to mother companies, affiliates, or subsidiaries of the companies that are part of the consortium or association, shall only require the authorization of the Minister of Energy and Mining and shall not be subject to the payment of the premium or the improvement of the economic terms of the contract to the State, as far as this does not imply transfer to third parties of rights arising from the original contract. Likewise, if the assignor is one company and the partial or total assignment of the rights arising from the contract is made in favor of a mother company, affiliate or subsidiary of the assignor, only the authorization of the Minister of Energy and Mining is required, and the assignor shall not be subject to paying the premium or improving the economic terms of the contract in favor of the State, as far as this does not imply transfer to third parties of the rights arising from the original contract. 13.- Forfeiture The Ministry of Energy and Mining may declare the forfeiture of the contract, if contractor: 1. Fails to pay royalties, admission premiums, surface rights, participation and other commitments established under the Law or the contract; or fails to comply with any of the obligations specified in paragraph IV(a)(10) hereof; 2. Fails to deposit the corresponding bonds or guarantees in the form and the term stipulated in the contract; 3. Fails to begin exploration activities as provided in the contract or if once such activities have begun, suspends them for more than sixty days without justification. 4. Suspends exploitation operations for more than thirty days, without just cause, previously accepted by the Ministry, except force majeure or Act of God, which shall be notified to PETROECUADOR within a maximum term of ten days; 5. Fails to resume exploitation operations within a maximum term of thirty days, once the causes that prompted the suspension thereof have ceased; 6. Fails to invest the minimum annual amounts, fails to drill wells or fails to execute the tasks relevant to the exploration and exploitation period as established in the contract; 7. Prevents or hinders surveillance and auditing by authorized State officials, or fails to supply data and other information about any other business related to the oil activity; 8. Incurs in falsehoods due to bad faith or fraud, in statements or reports on technical data on exploration, exploitation, industrial activities, transportation or commercialization, or on economic data related to investments, costs or profits; 9. Fails to invest the profits, as stipulated in the contract; 10. Has recurred to fraud or other illegal means to sign the contract;


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11. Transfers rights or signs private contracts or agreements for the assignment of one or more of its rights without the authorization of the Ministry; 12. Becomes part of consortia or associations to carry out exploration or exploitation operations, or withdraws from them, without the authorization of the Ministry of Energy and Mining; and, 13. Repeatedly violates the Law and its regulations. Prior to the declaration of forfeiture of a contract, the Ministry of Energy and Mining shall notify contractor, fixing a term of no less than thirty nor more than sixty days, from the date of the notice, for contractor to comply with his neglected obligations or to clear all charges against him. The declaration of forfeiture of a contract implies the immediate return to the State of the areas of the contract, and the delivery of all equipment, machinery and other exploration or exploitation devices, industrial or transportation facilities, at no cost for PETROECUADOR, and also, the automatic loss of the bonds and guarantees delivered under the Law and the contract, which shall be kept by the State. 14.- Other cases of Noncompliance Noncompliance of the contract which does not result in forfeiture or which does not violate the Law or the Regulations shall be penalized with a fine imposed by the National Director of Hydrocarbons of between two hundred and three thousand US dollars, according to the seriousness of the infraction, in addition to indemnities for damages and the repair of the damages caused. Indemnities payable for damages caused on lands, crops, buildings or other property due to the exploration or development of oil production activities shall be established by experts designated by the parties. In case of disagreement, the Ministry of Energy and Mining shall appoint an arbitrator. The penalties imposed by the National Director of Hydrocarbons can be appealed before the Minister of Energy and Mining, whose resolution may in turn be appealed before the District Tribunals of Administrative Disputes. 15.- Settlement of Disputes: Legal acts of sector institutions may be challenged either in administrative or legal grounds. When an act is challenged on administrative grounds, it shall be done so in accordance with the regulations of the Legal Administrative Regimen of the Executive Power. When based on legal grounds, it shall be filed with the District Tribunal for Administrative Disputes. Conflicts arising from contracts governed by this Law may be settled via the application of mediation and arbitration systems. Also, an international arbitration procedure can be stipulated, subject to the international agreements signed and ratified by Ecuador, as is the case of the ICSID. B.- SPECIAL FEATURES OF THE VARIOUS CONTRACTUAL MODES As indicated above, the law contemplates the following modalities for hydrocarbon exploration and exploitation works: association contracts, participation contracts,


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services contracts for the exploration and exploitation of hydrocarbons, for the additional exploration and exploitation of marginal fields, shared management contracts, or the incorporation of semi-private companies. 1.- Participation Contract: Under this contract, contractor assumes at his sole risk all the investments, costs and expenses required to execute exploration, development and production activities. Once production begins, the contractor shall have the right to a participation in the production of the contract area, which shall be calculated on the basis of the percentages offered and agreed in the contract, on the basis of the volume of hydrocarbons produced. This participation, valued at the sales price of hydrocarbons in the area of the contract, which in no case may be below the reference price, shall constitute the gross income of contractor, from which deductions will be made and the income tax will be paid, pursuant to the regulations provided in the Law of Internal Tax Regime. The participation of contractor may also be paid in cash, upon agreement with PETROECUADOR. The other portion of the production in the area of the contract belongs to PETROECUADOR. However, this does not imply that PETROECUADOR has to assume any part of the investment or of the costs or expenses required for the exploration and exploitation of hydrocarbons. The participation of PETROECUADOR in the production of the contractual area shall never be less than the percentage corresponding to royalties which must be paid to the State, as stated before. In case of return or total abandonment of the area of the contract by contractor, the State shall owe nothing and the contractual relationship shall be terminated.. 2.- Association Contract: In these contracts, PETROECUADOR contributes with rights over areas, deposits, hydrocarbons or other rights of its own, and the associated company assumes the commitment of making the investments agreed between the contracting parties. In exchange for these contributions, the parties shall participate in the production according to the scale of participation agreed by the parties. If the associated company wishes to make expenses or investment exceeding the minimum amounts stipulated, the scale of participation in the results of the production established in the associations contract shall not be modified. In case of abandonment or total return of areas due to lack of productivity, PETROECUADOR shall owe nothing to the associated company and the association contract shall be terminated. 3.- Services Contract: Under this contractual mode, contractor agrees to provide, with his own economic resources and at his sole risk, oil exploration and exploitation services in the area of the contract. If contractor finds commercially exploitable fields, he will be entitled to the reimbursement of his investments, costs and expenses and to payment for his services. This reimbursement shall be made solely with respect to the gross revenues produced by the deposits found in the area of the contract, from which the corresponding amounts shall be deducted before making any distribution of funds. If it is convenient to the interests of the State, the reimbursement and payment for services to contractor may be


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made in kind or in a combination form. Contractor shall have a preferential option to buy the production of the area of the contract, at a price which in no case may be less than the reference price, to be established in accordance with the last average monthly price of foreign sales of hydrocarbons of similar quality made by PETROECUADOR. V.- TRANSPORTATION OF HYDROCARBONS THROUGH PIPELINES According to the Hydrocarbons Law, the transportation service for hydrocarbons through main pipelines may be provided under any of the following options: - By PETROECUADOR, which may do it directly or delegate it through association contracts, consortia, operation contracts or other contractual forms contemplated in the Ecuadorian legislation; or also by organizing for that purpose semi-private companies. These contracts are awarded subject to the special bidding procedures mentioned before. Or, - By national of foreign private companies of renowned competence in these activities, upon direct authorization issued by the President of the Republic, via Executive Decree, on the basis of a report issued by the Minister of Energy and Mining. Such companies assume the responsibility and sole risk for the investment, without compromising public funds. When a pipeline is built by a private company on the basis of the authorization granted by the President of the Republic, the company must provide the transportation service to all users requiring such service, in the terms and conditions that may be freely stipulated between the parties. Such terms and conditions may not be discriminatory, although they might be different according to several factors characterizing several categories of users. If the company that operates the pipeline cannot agree with new users on the transportation rate, the new users may ask the Minister of Energy and Mining to fix such rates. The Minister shall fix the rates, taking into consideration the costs and expenses and a reasonable profit over the investment, in accordance with international oil practice; the Minister may in no case cause damage to the interests of the operator or the user, nor create discriminatory situations with the current users of the transportation system. The State is entitled to ask users who have signed hydrocarbon exploration and exploitation contracts with the State to hire the transportation of the State participation in the respective contractual areas with the company that operates the pipeline in at least the same conditions agreed for the transportation of their own production. In case capacity exceeds the capacity agreed in such arrangements, operator shall offer such capacity in the market, in similar terms and conditions, to all possible interested parties. The State shall have a preferential right to hire this excess capacity in the terms and conditions offered. Transportation by secondary pipelines of other contractors.- Contractor is entitled to use existing transportation means, according to the contract.


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Under Art. 57 of the Hydrocarbons Law, transportation by oil pipelines and gas pipelines (regardless if they are main or secondary lines), is a public service and must be provided on an continuous and uninterrupted form. The last paragraph of Art. 249 of the Constitution of the Republic provides that the State shall guarantee that public services provided under its control and regulation must respond to principles of accessibility and continuity and shall oversee that the prices or rates charged by such services are equitable. The public service of transportation of hydrocarbons is subject to the regulations established by the Ministry of Energy and Mining, as per Art. 9 of the Hydrocarbons Law. Paragraph 21 of Art. 1 of the Regulations for Hydrocarbon Operations provides that transport operating agreements must be signed when a secondary pipeline of a contractor has excess transportation capacity and is required to transport hydrocarbons from other contract. According to the text and the sense of the above-mentioned precepts, and without ignoring that the property and administration of a private secondary pipeline is exclusively of private nature, and that the use of its transportation capacity must respond to terms and conditions freely negotiated and agreed, we must also admit that, under circumstances of real technical and economic necessity and in view of the nature of the transportation of hydrocarbons as a public service, destined to satisfy a general need, the owner of a private pipeline may not refuse the right to transport hydrocarbons from other areas, when transportation capacity is available. To refuse would mean not only to go against the particular interest of the contractor requesting such transportation, but ultimately to oppose the primordial general interest of the nation. We believe that, given the fact that the transportation of hydrocarbons is a public service, controlled and regulated by the State through the Ministry of Energy and Mining, in compliance with the aforementioned constitutional mandate which provides that this activity must respond to principles of accessibility, the Ministry of Energy can ask a contractor to allow the transportation in his pipeline of the oil of another contractor, which cannot be otherwise evacuated. Establishment of rights of way for transport.- The hydrocarbons industry, including the transportation of oil, is declared a public service under Art. 4 of the Hydrocarbons Law. Therefore, the expropriation of real property and the constitution of general and special servitudes, as required, are authorized. In the contracting guidelines and in the contracts, the State guarantees the right of way, on land owned by third parties, in view of fulfilling the respective contracts, both for the installations of the secondary pipeline as for service roads and storage areas. Contractor has the right and the obligation to build secondary pipelines for the transportation of oil to collection centers, or to connect with the main pipelines, according to the provisions of Art. 60 of the Hydrocarbons Law and the Participation Contract Guidelines.


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The right to constitute servitudes, such as the right of way, is not limited to the surface of the area of the contract, but it extends to the entire path which the pipeline must follow, both within and outside the area of the contract, even if it has to cross an area corresponding to another contractor. Indeed, a company may not refuse passage of a secondary pipeline through his contracted block, because the contract does not grant him rights on the land, or on the expropriated areas, or on the servitudes established on that block, as these are constituted in favor of PETROECUADOR, which assigns the use thereof to the company. The delimitation of the area of the contract only serves to determine the surface where the company is entitled to carry out the activities specified in the contract. Accordingly, there are no impediments for a secondary pipeline of a contractor to cross the contract area of another contractor, provided the general procedures for the establishment of servitudes or the expropriation, if needed, are complied with, or via agreements with owners, settlers or holders. Rates.- The transportation rate for a private secondary pipeline must be agreed between the owner of the pipeline and the user. The legal provisions which determine the intervention of the State to fix the rate in case of disagreement between the parties is clearly defined in the case of the main pipelines. In any case, the State, following the constitutional mandate of Art. 249, can and may persuade the parties to reach an equitable and acceptable agreement. VI. THE ECUADORIAN STATE OIL COMPANY PETROECUADOR The Ecuadorian State Oil Company PETROECUADOR - and its affiliates were created via a special law in view of the execution of exploration, production, industrialization, commercialization and transportation activities. Its goal is to develop hydrocarbon activities aimed at making the best use of resources belonging to the inalienable and imprescriptible patrimony of the State, for the economic and social development of the country. The following are PETROECUADOR organs: the Board of Directors, the Administrative Council, the Executive Presidency and other technical and administrative units as necessary for the administration of its business. The Board of Directors is composed by the Minister of Energy and Mining, who will chair it, by one delegate of the President of the Republic, by the Minister of Economy and Finance, by the Minister of Foreign Trade, Industrialization, Fisheries and Competitiveness, by the Head of the Joint Command of the Armed Forces, by the Secretary General of Planning of CONADE and by one representative for the workers. Its functions are to establish the business policies of PETROECUADOR, and to approve its policies, plans and budgets.


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The Administrative Council is the organ in charge of planning and coordinating the activities of PETROECUADOR, and is composed by the Executive President and four members appointed by the Board of Directors of PETROECUADOR, proposed by its Chairman. The Executive President shall be appointed by the Board of Directors of the company from a threesome proposed by its Chairman. He is the legal representative of the company and directly responsible for the technical, financial and administrative management thereof.


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VI. ENVIRONMENTAL AND COMMUNITY ISSUES 1. Environmental Impact Assessments (EIA) Before beginning any hydrocarbons operations, an Environmental Impact Assessment (EIA) and an Environmental Management Plan must be prepared, following the provisions of the Environmental Regulations for Hydrocarbons Operations. In addition, governmental and business policies provide for the specific compliance of the following laws and regulations: on hydrocarbons; water; forestry and preservation of natural areas and wildlife; environmental pollution prevention and control; agrarian reform and colonization; noise pollution prevention and control; air quality standards; solid residue pollution; and the Environmental Management Law. 2. Consultation and participation In addition to the requirements listed above, a process of consultation and participation, provided in the National Constitution and in the Regulations for Consultation and Participation, must be complied with. The main goal of this process is to establish a procedure to negotiate an agreement with the indigenous populations of the area for the prevention, mitigation, control and rehabilitation of adverse socio-environmental impacts, and at the same time to promote the positive aspects generated by hydrocarbon activities. The competent governmental agent is the Ministry of Energy and Mining. The Regulations provide for two series of negotiations:

a. A negotiation prior to issuing the invitation for the bidding process (called pre-bid consultation). The government agent in charge of the bidding process must also handle the pre-bid consultation.

b. A negotiation prior to the approval of the Environmental Impact Assessment (called pre-operational consultation). The company executing hydrocarbon activities is responsible for the execution of the pre-operational consultation.

The agreements resulting from the negotiation process may include compensation mechanisms mainly in the areas of health and education. This compensation must be coordinated with local development plans and executed by the indigenous communities or jointly with government plans. Resolutions and agreements reached in the pre-operational consultation must be formalized, notarized and registered with the Undersecretariat of Environmental Protection; they shall be binding for the parties and may be enforced by judiciary or administrative means. VII. ASSIGNMENT OF RIGHTS OR SALE OF OIL ASSETS 1.- Sales of rights and obligations under contract Art. 79 of the Hydrocarbons Law provides that the transfer, sale or assignment to third parties of the rights arising from a contract may be made with the authorization of the


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corresponding Ministry, otherwise it is invalid, giving rise to the declaration of forfeiture. The aforementioned Article also provides that the State shall receive a premium for the transfer and that the beneficiary company must sign a new contract in economic terms more favorable to the State and to PETROECUADOR, than those contained in the original contract. Art. 1 of the Regulations for the Transfer or Assignment of Rights and Obligations of Hydrocarbons Contracts, issued via Decree 1363, published in Official Registry 293 dated March 27, 2001, reiterates the aforementioned legal provision. Also, Art. 13 states that transfer or assignment contracts signed without following the procedure stipulated in the Regulations are not legally valid. Art. 2 of the Regulations states that any total or partial transfer or assignment may only be made in favor of duly qualified national or foreign companies, according to the terms and requirements stipulated under the law and the regulations and under economic conditions more favorable to the State. The process begins with a request from the seller or from seller and buyer together to the Minister of Energy and Mining requesting him to authorize the sale or assignment. The Minister then requests a report form the National Hydrocarbons Office, which sends the documentation to the Contracts Administration Unit of PETROECUADOR, which prepares a technical, economic and legal evaluation of the proposed buyer. Once the qualification of PETROECUADOR and the favorable reports of the National Hydrocarbons Office and the Legal Advisors of the Ministry of Energy and Mining have been obtained, the Minister of Energy, via Ministerial Agreement, authorizes the viability of this legal act. When the ministerial agreement is obtained, the required payments are made and the transfer contract is converted into a public deed with the intervention of the Executive President of PETROECUADOR, authorized by the Administrative Council of the entity. The deed containing the transfer or assignment of the rights of the contract is registered in the Register kept by the National Hydrocarbons Office. The transfer, sale or assignment becomes effective on the date this is accomplished. 2.- Sale, assignment or transfer of stock This can be made via a common contract for the sales of stock of a company which has an oil contract with PETROECUADOR. The transfer of stock must be notified to the Superintendency of Companies; however, this notice by itself does not constitute an act of legalization or is a requirement for the legal validity of the transfer, it is rather a formality to keep the relevant control agency, in this case the Superintendency of Companies, informed.


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According to Art. 187 of the Law of Companies of Ecuador, the person considered as owner of the stock is the person whose name appears in the Stock and Stockholders Book of the Company .

Art. 188 of the same Law provides that ownership of a stock is transferred via an assignment note signed by the transferor, and that such assignment must be written on the relevant stock certificate or in a page attached to it, and recorded in the Stock and Stockholders Book. This is because the transfer of ownership of a stock only becomes effective on the date it is recorded, as specified in Art. 189 of the same Law. Art. 189 also states that such registration is valid only once it has been signed by the legal representative of the company, at the presentation and delivery of a notice where assignor and assignee notify of the transfer of the stock subject of the assignment. In addition, the Law of Companies (Art. 189 above), prohibits the establishment of requirements or formalities for the transfer of stock that are not expressly stipulated in that Law, and any statutory or contractual stipulation which establishes those formalities or requirements is invalid. Any total or partial sale of stock must be notified to the Ministry of Energy and Mining and to PETROECUADOR. When the sale affects all or most of the stock, the provisions of paragraph 2, Art. 7 of the Regulations for the Transfer or Assignment of Rights and Obligations of Hydrocarbons Contracts, Decree 1363, apply: companies or consortia involved in transfers or assignments of any stock or participation, provided such transfer or assignment implies a current or future change in the operation of the contract, or changes its corporate name or purpose, must submit to the provisions of this Executive Decree with respect to the payment of premiums and improvement of the economic terms of the contract. Therefore, there shall be no exception that prevents payment of the amounts provided in this Decree, in the percentages and quantities stipulated herein. The transfer or sale of stock does not in itself imply any change in the corporate name or the legal status of the assignor company, as it remains independent from its stockholders. The legal fiction of change in the legal status has only one purpose, that is, to generate the payment of the fees established in the law in the case of the transfer of rights and obligations of a contract.

It is not necessary to sign a new contract, as this is not a transfer of the rights and obligations of the contract, but a sale of stock. The formalities begin with a notice sent by the contractor to the Ministry of Energy and Mining, informing of the sale of the stock. If required, a ministerial agreement is issued ordering payment of the transfer premium and the improvement of the economic terms of the contract. In order to issue the ministerial agreement, the Minister relies on the reports issued by the National Hydrocarbons Office and the Legal Department of the Ministry. Once the ministerial agreement is issued, the agreed fees are paid.


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3.- Sales of assets of contractor incorporated to contract.- 3.1.- Legal status of property with respect to oil contracts.- At the termination of a contract, the goods purchased are subject to a double regimen with respect to the State: a).- During the exploration period. If the contract is terminated while contractor is still in the exploration period, contractor is not obligated to hand over to the State the goods it purchased to fulfil the purposes of the contract, except camps and infrastructure works. b).- During exploitation period. If contract is terminated during the exploitation period or due to the conclusion of the duration of the contract, (which includes the periods of exploration and exploitation), contractor must hand over to the State all the equipment, tools, machinery, installations and other movable and immovable property purchased for the development of the contract. 3.2.- Sale.- During the term of validity of an oil contract, the property of the contractor can be sold, encumbered or donated, but only with the prior authorization of the Ministry of Energy and Mining, as mandated by Art. 30 of the Hydrocarbons Law. In this case, the Ministry acts via the National Hydrocarbons Office as the agency in charge of controlling all the activities of the oil companies in the country. Contracts also stipulate that a list of these goods must be submitted to PETROECUADOR. For the purposes of the sale, any goods purchased by the contractor under the definitive importation regime (for consumption) must be distinguished from those imported under the temporary regime. In the first case, the prior authorization of the Ministry of Energy and Mining is required before the signing of a common sales contract. In the case of goods imported in the country under the temporary regime, they can be sold in two ways: a).- Outside the temporary importation regimen.- Seller nationalizes the goods (that is, pays the relevant taxes), and reaches an agreement about the price with the buyer. Obviously, these goods cannot be reexported as they have already been nationalized. b).-Under the temporary internment regimen.- In the case of a sale between two contracting companies, both seller and buyer have the right to apply this regime. In general, the Organic Customs Law allows the constitution of a new beneficiary of the regimen., who after the 5 years stipulated by the Hydrocarbons Law, would have either to reexport or nationalize the goods, by paying the relevant taxes.

In all cases the authorization of the Ministry of Energy and Mining is needed.


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Goods under temporary internment, by their own nature, are not subject to Art. 29 of the Hydrocarbons Law concerning reversion to the State, unless they are nationalized. From the moment the contract moves to the exploitation period, the goods purchased outside the temporary internment regimen are affected by the provisions of the Hydrocarbons Law concerning reversion at the end of the contract.

legal regime for hydrocarbons operations in ecuador

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