Sun | Sep 24, 2017

Walter Molano | Ecuador: Off to the races

Published:Friday | February 24, 2017 | 2:00 AM
Ecuador’s President Rafael Correa met with the foreign press in Quito, Ecuador, on Wednesday, February 22, after general elections over the weekend. The race is now headed to a run-off. Correa, who was elected in 2007, won praise for ushering in stability in Ecuador after a severe economic crisis that saw three presidents toppled by street protests.

As the votes for the presidential race are tallied, many people are wondering what lies ahead.

The small Andean nation faces several important challenges. The first is its ageing oil industry. Although a member of OPEC, Ecuador's oil industry is relatively young. It took flight in the mid-1960s when Texaco was given a concession to explore and develop oil in the Amazon Basin.

In 1967, the company struck black gold in Lago Agrio and moved into full-scale production in 1972. Soon afterwards, the Ecuadorean government formed a state-owned oil company, PetroEcuador, to help develop the field, and by the mid-1970s the consortium was majority owned by the government.

The oil sector proved to a boon for the economy, representing more than half of its exports and a third of government revenues. However, much of its production has been redirected internally, leaving a declining amount for the export markets. Ecuador produces about 550,000 barrels per day, less than one of the larger fields in Iran or Saudi Arabia.

Unfortunately, exports dropped five per cent y/y in 2016, to 395,000 barrels per day. The country needs to ramp up investment to ensure that production keeps up with the country's demands.

The problem is that the government has limited resources. Moreover, its antagonistic attitude towards international oil companies has kept a lid on exploration activity. In 2016, there was only one rig in operation. This was down from 27 in August 2014.

One of the problems is the government's environmental lawsuit against Chevron. In 2001, Chevron acquired Texaco, along with all of its legal liabilities. A big one was a lawsuit that the Ecuadorean government had brought against Texaco for oil spills in the Amazon. The suit alleged that the company had spilled waste from its oil exploration efforts into local streams and rivers, killing wildlife and endangering the indigenous population.

The court initially levied a judgment of US$18 billion, which was later reduced by half. The case is ongoing, with the Ecuadorean government attempting to seize Chevron assets in Canada. Although the case has its merits, it does not endear the country with the international investor community. As a result, it will be difficult for Ecuador to get the investment it needs to develop its vast hydrocarbon deposits.

This is one of the reasons this presidential election was so important. A different leader will be a marked change from the confrontational demeanour of former President Correa. Hence, international investors will be more willing to make longer-term commitments.

The second major challenge facing the country is its exchange rate. In 2000, Ecuador adopted the dollar as its national currency, eschewing the sucre. The decision was timely. After a decade of a strong dollar, the greenback began losing ground when the United States Federal Reserve adopted a more accommodating monetary stance. The Fed slashed interest rates after the terrorist attacks of 9/11, and later moved to a policy of quantitative easing after the onset of the financial crisis. At the same time, soaring commodity prices and strong capital inflows allowed emerging market currencies to soar.

Dollarisation boost

Dollarisation may have been an albatross around Argentina's neck in the 1990s, but it proved to be a lifesaver for the small Andean country. Inflation stabilised, confidence returned and the economy roared. Ecuador gained competitiveness against its main trading partners, particularly Colombia and Peru. Ecuadorean flower producers gained on their Colombian counterparts, and began to dominate important markets, such as Russia.

However, the trend is now moving in the opposite direction. Treasury yields are on the move, as the Fed begins to tighten monetary policy. The dumping of treasuries by countries opposed to US President Donald Trump's rhetoric is also helping the dollar move even higher.

None of the Ecuadorean presidential candidates mentioned the need to abandon the dollar, but it will need to be addressed by the incoming administration. Changing the currency peg may prove to be a tricky proposition, with serious implications for the financial sector.

In the meantime, the new government will need to deal with the current situation. Deflation is helping to realign relative prices, but further fiscal adjustment will need to be implemented. The government shortfall was 5.7 per cent of GDP, forcing it to access the international capital markets for more financing.

Ecuador needs to get the deficit under control as soon as possible, particularly by cutting spending. This means that the level of economic activity will remain depressed.

The economy shrank about 2.3 per cent y/y in 2016, and it will be lucky to grow more than one per cent y/y in 2017. That is why the new government has to do all it can to restore investor confidence and attract capital inflows to fuel an economic recovery.

- Dr Walter T. Molano is a managing partner and the head of research at BCP Securities LLC.

wmolano@bcpsecurities.com