Editorial: Oil crash hits Ecuador’s public finances

Ecuador’s Minister of Strategic Sectors, Rafael Poveda, seemed tired when he sat down with The Northern Miner in Quito last week. The minister, who has a degree in law and an MBA, had returned the night before from China, where, off and on since 2011, he has led a team negotiating financing for Ecuador’s largest oil refinery project — President Rafael Correa’s most ambitious enterprise since he took office in 2007.

Oil is Ecuador’s main export, and it makes up 50% to 60% of its revenues. But the collapse in crude prices has hit the small Andean nation hard. Javier Cordova, the country’s mining minister, noted in a separate interview that Ecuador has lost US$7 billion in oil revenues so far this year, and that the government is fully cognizant (and has been for quite some time) of the need to diversify the economy.

Reggie Thompson, Latin America analyst for Stratfor, a geopolitical intelligence and advisory firm, notes that under Correa, Ecuador has relied on oil revenues for a lot of social programs, “but as revenues keep eroding, some programs like social security have been slashed, which has led to resistance within some constituencies.”

He adds that “Ecuador has one of the highest rates of public spending per capita in all of Latin America, and so this situation really is unsustainable for the Correa administration. There are definitely going to be salary freezes and firings that have to occur at some level.” (Correa is also trying to pass changes in the Constitution that will allow him to run for a fourth term in 2017.)

For his part, Minister Poveda hopes that by 2025, mining will make up 5% of gross domestic product, up from less than 1% today. “We have many advantages that make Ecuador attractive,” he says. “The mineral reserves we have are very big and are of very good quality, operating costs are among the lowest in the region and the infrastructure we have helps the development of mines, plus we are offering tax incentives.”

Ecuador has come a long way since Correa imposed a moratorium on exploration and mining in 2008. Consultants Wood Mackenzie started working with the government in 2013 and intensified its efforts in 2014, when it helped create a strategic plan for developing the mining sector.

In May 2014, Wood Mackenzie and the Ministry of Strategic Sectors and the Ministry of Non-Renewable Natural Resources presented recommendations to Correa, most of which were approved and implemented over the rest of the year. Then, in February 2015, Correa carved out the mining sector from the other non-renewable resources and promoted Cordova to head the new Ministry of Mining to elevate the sector’s status, and dedicate administrative resources to its development.

Patrick Barnes, principal of metals and mining in Wood Mackenzie’s Houston office, says Ecuador has taken steps to reduce the tax burden and provide tax stability, with five key changes, now enshrined in law:

• The introduction of fiscal stability contracts for 15 years, renewable once, that protect companies against changes in income tax, value-added tax (VAT) and currency exportation tax.

• Accelerated depreciation, which helps mining companies increase their tax shield in the early years for certain mining-related equipment.

• The use of net present value to calculate the “sovereign adjustment” owed to the government. Under the Constitution, the state must receive at least 50% of the benefits from a mining project. The previous formula used to calculate this balance of financial benefits was based on a company’s undiscounted net income. The new formula ensures that the sovereign adjustment can’t kick in until well after full recovery of a company’s investment in present value terms, to appropriately value investors’ cost of capital.

•  A change to exempt the purchase of mining equipment overseas from a 5% currency exportation tax — a tax on U.S. dollars that flow out of the country.

•  The way the government calculates the tax on extraordinary gains. The government now uses a fixed base price (the average metal price of the last 10 years, plus one standard deviation), rather than negotiating a base price at the time a contract is signed to guarantee predictability. Barnes estimates that under the new rules, the tax won’t be applied unless prices are truly extraordinary. He also emphasizes that the tax can’t kick in unless the project investment is recovered from a financial perspective.

The effect of these reforms will vary on the cost structure of each project, but Wood Mackenzie estimates that, as an example, they reduce the tax burden of the Mirador copper project in the country from 35% of revenue to closer to 27% — the regional average for this project. Comparing as a percent of revenue facilitates comparison of the overall impact of multiple taxes that apply to different lines of the income statement.

Barnes notes that a few other pro-mining reforms have been sent to the National Assembly for approval regarding VAT reimbursement for mineral exports, which lifts restrictions on foreign investment in “small mining,” and places limits on capital gain taxes to facilitate project financing.