PETROECUADOR - A CRUMBLING GIANT

C O N F I D E N T I A L QUITO 001920

SIPDIS

SENSITIVE
SIPDIS

TREASURY FOR SGOOCH

E.O. 12958: DECL: 08/03/2016
TAGS: ECON
SUBJECT: PETROECUADOR - A CRUMBLING GIANT

REF: A. QUITO 4525-91


B. QUITO 1735

C. QUITO 1905-03

D. QUITO 0579

E. QUITO 1973-91

Classified By: EconOff Sara Ainsworth for reasons 1.4 (b&d)










1. (C) Summary. Petroecuador, Ecuador's state-owned oil
company, has sole responsibility over the country's most
lucrative resource, yet is suffering from a severe financial
crisis, a steady decline in production, and a terribly
inefficient and inadequate refining capacity. Graft
permeates all levels of its cumbersome bureaucracy, and the
company's union tends to reward its most unproductive
personnel.

Its equipment and production technologies are
woefully outdated, yet under-investment and forced oil
subsidies to consumers cripple the company's budget.
President Palacio submitted a proposal to Congress on May 17
that addresses some of these problems but falls short of a
much-needed overhaul, and which anyway will likely languish
in Congress in the run-up to the election.

Reforming Petroecuador in any meaningful way will be an uphill battle;
pumping more money into the company will not cure its ills.
Even as the company becomes more inefficient and production
continues to decline, Petroecuador continues to be a magnet
for political elites that are motivated by manifold
opportunities for graft and patronage. Consequently there is
an absence of political will to get the job done. End
summary.

Productivity A Rolling Stone
--------------


2. (U) Oil is Ecuador's most important export, constituting
60% of total exports in the first quarter, and projected to
bring in close to $3 billion for the state in crude revenues,
and another $500 million in corporate taxes from the
industry. Petroecuador, the state energy company, has annual
sales of more than $5.5 billion, and on its own accounts for
16 percent of Ecuador's GDP. Last year, the company
generated $2.3 billion for the treasury, representing 40% of
the total national budget.

Despite record petroleum prices, Petroecuador is suffering from a severe financial crisis, a steady decline in production, and a terribly inefficient and inadequate refining capacity. In recent years, Petroecuador has struggled to contract out its undeveloped oilfields.
Finally, industry service providers are wary of working with
the company due to its abominable payment record and
questionable business practices.


3. (U) Petroecuador has changed little since its inception
in 1989. Industry contacts told EconOff that Petroecuador's
performance has spiraled downward in the last ten years due
to corruption, nepotism, lack of transparency, financial
hardship, and slow bureaucracy (reftel A). In 1992, the
company produced about 120 million barrels per year; today it
produces about 71.5 million barrels per year, implying an
annual loss of almost $2.5 billion.

Natural well deterioration accounts for some of this loss, but increased politicization, manipulation of the company's revenues, lack
of capital investment and exploration, and poor management
practices have amplified inefficiencies and financial
hardship. Private oil companies have meanwhile taken the
lead in Ecuador's oil industry, producing about 20 million
barrels per year starting in 1994 and 120 million barrels per
year today.

Fossilized Structure
--------------


4. (U) Petroecuador's architects modeled it after
Venezuela's state energy company, PDVSA, which began as an
agglomeration of several companies each with its own
corporate culture and independent operations. Petroecuador
was started from the ground up, and the Government of Ecuador
(GOE) partitioned its production chain into three functional
arms: Petroproduccion, in charge of exploration, extraction
and crude production; Petroindustrial, responsible for
refining; and Petrocomercial, which manages transportation of
crude oil and local sales of oil derivatives.

It is at once a partner, contractor, regulator and
producer, and in each of its guises subject to political
influence from the central government. Petroecuador's
schizophrenic mandate discourages cooperation and triples
bureaucratic procedures.

Each subsidiary maintains its own human resource, legal and administrative functions, duplicating efforts and increasing inefficiencies and bottlenecks.


5. (U) Petroecuador's strict legal structure stifles good
business practices necessary for smooth functioning in the
global energy sector. Its endless procedures and approvals
processes are a major departure from the decentralized nature
of most oil companies. Industry contacts told EconOff that
Petroecuador personnel are known for their indecisiveness and
untimely decisions; "final" decisions are almost always
referred to another colleague for approval.

Stone-Age Technology
--------------


6. (U) Petroecuador has grossly underinvested in its fields
and facilities since its inception. According to
Petroecuador's published budget for 2005, it spent $178
million on investment, while foreign operating companies in
Ecuador invested a total of $1.7 billion. Most of
Petroecuador's current infrastructure is now obsolete.
Petroproduccion geologists would regularly complain during
industry roundtables about the company's lack of technology
and resources for maintenance and new wells; 240 of its 800
wells were closed due to a lack of funds. Its warehouses are
empty; the company often re-uses valves and reportedly pulls
up old tubing to use in new wells. Petroproduccion's pumps
are more than twenty-years-old and its valves are used for
more than a decade. The industry standard use for both is
four years.


7. (U) Ten years ago Petroecuador lost its authority to
develop and administer an independent budget. Red tape and
government bureaucracy also inhibit Petroecuador's budget
execution and contribute to its declining operating budget,
which must be approved by Ecuador's equally inefficient
Congress. As a result, Petroproduccion now owes its
suppliers more than $80 million in back payments.


8. (U) Government subsidies for refined crude products,
which are covered using Petroecuador's proceeds from crude
exports, will reduce its resources by more than $1.1 billion
this year. Petroecuador sells a $10 tank of butane for
$1.60, and a gallon of diesel for less than half its import
price. Outstanding debts to Petrocomercial of $450 million
from electricity generators, the largest beneficiaries of
subsidized fuel, also reduces Petroecuador's budget (reftel
B).

Ramshackle Refineries
--------------


9. (C) Petroindustrial runs Ecuador's three oil refineries,
which have a combined capacity of 176,000 bpd. The largest,
Esmeraldas, was built in 1975 and refines just over 100,000
bpd. Japanese technology was used for the original design
and subsequent upgrade in 1980, and it was renovated again in
1993 using Spanish technology. Former Minister of Energy
Fernando Santos told EconOff that the refinery is inefficient
and poorly maintained; he compared it to a Japanese car
upgraded with German parts. He said that of its 2,500
employees, 2,000 lack the required skills, and that
Esmeraldas could run with as few as 600 employees. The IMF
has long advocated a full-fledged audit of the Esmeraldas
refinery, and in 2003 estimated that Petroecuador could save
$300-500 million by shutting it down and importing oil
derivatives.


10. (C) Domestic consumption of diesel, gasoline and other
refined products outstrips refining capacity, and imports
will reach $1.8 billion this year. Previous upgrades to the
three facilities to enable heavy crude processing have had a
limited effect on capacity and have not improved refinement
processes. Private investors have no incentive to invest
under the GOE's current subsidization policies. The GOE has
proposed reinvesting revenues from Block 15, until recently
managed by Occidental Petroleum (Oxy),into Petroecuador's
refineries. However, as required under Ecuadorian law, the
GOE would first need to conduct feasibility studies for
building or upgrading refinement capacity, and a
legally-mandated tender would take years to secure under
government contracting regulations. In the most optimistic
case, a new refinery would not be completed until 2013.
Industry contacts tell us that investment is unlikely to
improve current operations; Santos likened investment into
Esmeraldas to dumping money into a hole in the ground.

Transparent As Mud
--------------


11. (C) Petroecuador's structure and lack of financial
accountability make corruption endemic. On the financial
side, each of the various subsidiaries is not responsible for
its spending practices. Petroproduccion, for example, has no
consolidated debt and keeps no accounts receivables figures.
Santos told EconOff that each of Petroecuador's subsidiaries
has its own "mafia", and kickbacks for contracts are a
regular practice.

Three years ago Petroecuador reportedly tried to contract a company to supply tubing for a well but were unable to locate a company willing to pay Petroecuador 25% of the contract bid. Another company told EconOff about the phantom "three-percent man", whereby a company must pay a 3% commission to secure prompt payment. Two GOE henchmen
allegedly control the assignment of contracts issued by
Petroecuador in return for "commissions" paid before
contracts are announced. Industry contacts allege the
typical practice for Petroecuador's president is "to pilfer
the company and get out".

Over the years, Petroecuador personnel have been implicated in smuggling rings that extorted more than $100 million annually in government oil, and in selling precursor chemicals used to make cocaine (reftel C).

Sindicato Stonewalling
--------------


12. (SBU) Industry sources have told us that Petroecuador's
labor unions control major decisionmaking within the company.
Workers engage in strikes or slowdowns on a regular basis in
order to demand greater benefits or block changes. Many
suggest Petroecuador's unions were key in recent government
decisions to expel Oxy and to squash the PDVSA-Petroecuador
deal to refine crude. Union members went on strike in March,
for example, shutting down production at five key
Petroecuador production facilities to demand the expulsion of
Oxy and to extract federal funds from the GOE (reftel D).


13. (SBU) Efforts to reduce the unions' strength have
failed. Of the 33 Petroecuador workers dismissed in 2003 for
sabotage and terrorism, 27 were reinstated and returned to
their posts after the Ecuadorian Supreme Court ruled in their
favor. Each worker received almost $20,000 in compensation.
New Petroecuador President and former Minister of Labor Galo
Chiriboga has long ties with organized labor, and most
insiders expect that he will continue to cede to union
demands.

Petrified Personnel
--------------


14. (U) Petroecuador has long had a reputation for hiring
incompetent employees out of nepotism and for political
reasons (reftel E). In the last sixteen years, Ecuadorian
presidents have appointed twenty heads of Petroecuador. Many
have had little or no experience in the oil industry; former
president Fernando Gonzalez, appointed last April, was a
lawyer and a vocal proponent for the cancellation of Oxy's
contract. Petroproduccion Vice-President Jaime Crow has
experience in the downstream business but little background
in his subsidiary's primary exploration and production
functions.


15. (U) Lower-level technical staff within Petroecuador are
paid significantly less than employees of private companies.
Petroecuador's most talented employees often leave to pursue
higher-paying jobs with private energy companies. A
Petroecuador employee cannot expect a clear career
progression within the company. Each change of senior
management in all three subsidiaries results in significant
turnover and politicization. Promotions and preferences are
based on employees' ties to the current power brokers.

All of this cripples employee efficiency. While Oxy produced
100,000 bpd with 318 employees, Petroproduccion produces
190,000 bpd with 1,500 workers, suggesting that each of Oxy's
employees is three-times more efficient.

Comment
--------------


16. (U) On May 17 President Palacio submitted a proposal to
Congress that would resolve some of Petroecuador's problems
but which falls short of a total overhaul, and which will
likely languish in Congress during the run-up to the coming
elections. Under Palacio's proposal, one of five members of
Petroecuador's Board of Directors would be elected by
technical experts, Petroecuador's president would be required
to have at least fifteen years of industry experience, and
nepotism and conflicts-of-interest in board appointments and
the presidency would be forbidden. The proposal would create
planning, audit and administrative functions at the
parent-company level, develop a human resource management
system, enact contracting laws that include at least three
offers, and mandate a yearly external audit by an independent
international accounting firm. The proposal would allow
Petroecuador to issue bonds to increase its financial
resources, deduct its costs and investment budget.


17. (C) Although the proposal attempts to address some of
the company's inefficiencies, privatization would still be
the best solution to instill a culture of accountability and
efficiency within Petroecuador, but this is politically
unpalatable. Attempts during the Sixto Duran administration
to adopt privatization were met with staunch opposition by
the oil labor unions, which successfully convinced the
populace that privatization was a scheme to line the pockets
of an already wealthy handful of Ecuadorian businessmen.


18. (C) Reforming the state company in any meaningful way
will be an uphill battle, and will require more than pouring
money into Petroecuador or assigning it a robust budget.
Increasing transparency, instituting independent audits and
oversight, separating Petroecuador's budget from central
government resources, injecting private capital and
accountability, and increasing and enforcing regulations are
some useful prescriptions. Cultivating an awareness of
Petroecuador's corruption in the Ecuadorian public and
encouraging the public to demand accountability from the
steward of its country's most valuable natural resource might
be helpful in pushing politicians to reform the system.
Presidential buy-in for reforms is important but not enough.
Two years ago, former President Gutierrez purged Petroecuador
and demanded reforms to combat corruption, but his tenure in
office was short-lived. Ecuador's revolving door presidency,
and congress's ability to block change, makes pushing reforms
more difficult.


19. (C) Even as Petroecuador becomes more inefficient and
production continues to decline, political elites continue to
find opportunities for graft and patronage. They strongly
support a powerful state role in Petroecuador and are
unlikely to support a move toward privatization. Despite a
growing public recognition of the company's ineptitude, as
evinced by the recent public outcry when Ecuador's Social
Security system began investing in Petroecuador, there is an
absence of political will to cure what afflicts Ecuador's
wealthiest corporate citizen. End comment.
BROWN