Overview

Colombia's Investment Environment

The Republic of Colombia ("Country"), commonly known and referred to as Colombia, is located in the northwest corner of South America. The Country shares its border with Venezuela to the east, Brazil to the southeast, Peru and Ecuador to the south, and Panama to the northwest. Colombia’s northern borders are located on the Caribbean Sea, while its western border is the Pacific Ocean.

Colombia is the fourth largest country in South America, covering approximately 1.1 million square kilometres; the Country is approximately the size of California and Texas combined. Colombia is the third-most populous country in Latin America, after Brazil and Mexico; there are approximately 45 million people living in Colombia.

The Oil and Gas Industry in Colombia

Oil is currently Colombia’s leading export and source of foreign income, constituting an estimated one-third of the country’s foreign revenue. Historically, all oil production was undertaken by Ecopetrol in contracts of association with foreign companies. Ecopetrol is the majority state-owned company responsible for the exploration, extraction, production, transportation and marketing of oil for export. Colombia was considered to be at risk of becoming a net oil importer and, as a result, the regulatory regime in Colombia underwent a significant change effective January 1, 2004, with the formation of the Agencia Nacional de Hidrocarbos (the “ANH”). The ANH has the responsibility of regulating the Colombian oil industry, requiring Ecopetrol to compete directly with foreign and domestic companies. Ecopetrol was formerly a wholly-owned state oil company and became a publicly-held company in 2004. Ecopetrol maintains its exploration and production activities throughout Colombia and enters as a competitor in exploration bid rounds. The introduction of the ANH and changes to the fiscal regime has resulted in a significant increase in Colombian exploration activity and competition. These changes together with increased commodity prices, makes Colombia an attractive environment for the Corporation to do business.

ANH Exploration & Production Contracts

An E&P Contract is the principal contract used by the ANH to grant exploration and production rights. Under the terms of an E&P Contract, an exploration and production company retains the exclusive: (i) rights from the ANH to explore and produce conventional hydrocarbons; (ii) rights to the income from any new exploration block, subject to royalties to be paid to the ANH; and (iii) contractual rights for the use of subsoil. E&P Contracts also include a provision for a high price share if a cumulative production of 5 million bbls is reached on a particular field or block. Under a specific contract area, an E&P Contract is a long term contract divided into the following stages: Exploration Period, Evaluation Period and Production Period as described below.

Exploration Period

This stage has a six-year term divided into several (typically one year) exploration phases. Each phase may be extended for two additional months if the contracting party complies with the conditions contained in the E&P Contract to obtain such extensions.

At the start of each exploration phase, a bank guarantee for a percentage of the value of the work program will be established. This amount may vary in the special bid rounds according to its terms of reference. During this period, the exploration and production company has to carry out a minimum exploration program to determine if a commercial prospect exists. During the first phase, this commitment typically involves completing a new seismic program and/or the drilling of an exploratory well.

At any time during the exploration period, the contracting party may relinquish part of the contracted area by demonstrating that, despite the relinquishment, it will be able to comply with its obligations under the E&P Contract for the remaining part of the contracted area.

If there is a discovery, a written declaration to such effect must be submitted to the ANH by the contracting party.

Evaluation Period

This stage is designed to allow the contracting party to determine the commercial viability of a discovery by conducting an evaluation program for a maximum of two years, depending on the activities to be performed. This period may be extended for an additional year subject to the conditions established in the E&P Contract and for two additional years if the evaluation plan relates to heavy oil or gas. Once the evaluation program is completed, the contracting party must submit written notice to the ANH of its unconditional decision to commercially exploit the discovery or not.

According to an E&P Contract, if an exploration and production company considers that the evaluated area has no commercial potential it must relinquish such area to the ANH.

Production Period

The production period has a duration of twenty-four years per productive field and can be extended until the end of the economic life of the field subject to certain requirements established in the E&P Contract, including: (i) continuous production in the field during the preceding four years; (ii) demonstration by the contracting party that during the previous four years it has drilled one exploratory well each calendar year; and (iii) payment of 5% to 10% of the value of the remaining reserves to the ANH, depending on whether such payments relate to oil (10%), gas (5%) or heavy oil (5%).

Fiscal Regime

Government Royalties

Royalties payable during the production period are calculated on a field-by-field basis using a sliding scale that ranges from 8% (for incremental production up to 5,000 bbls/d) up to a maximum of 25% (for incremental production above 600,000 bbls/d) as illustrated below:

Hydrocarbons with less gravity than 15° API pay 75% of the royalties applicable to light gravity crude. The Corporation pays an 8% royalty on oil at or above 15° API and a 6% royalty on oil below 15° API to the government of Colombia on oil production. The conversion factor for natural gas is 1 bbl = 5.700 cubic feet of gas.

High Price Share

Prior to 2008, E&P Contracts included a high price sharing formula (the “Original HPS Formula”) which fixed the government’s participation percentage at 30%. In 2008, the formula was amended so that the government’s participation percentage increases as oil prices increase (the “Amended HPS Formula”). The Amended HPS Formula only applies to E&P Contracts signed in 2008 or later. The Original HPS Formula applies to the Coati, Cravoviejo, Cachicamo and Pájaro Pinto blocks. The Amended HPS Formula applies to the Llanos 19 block and the Andaquíes block. The Morpho block is currently not subject to either the Original HPS Formula or the Amended HPS Formula because the original agreement between Ecopetrol and the ANH for the Rio Horta block (from which the Morpho block was carved out of) is not subject to either formula.

Amended HPS Formula (Liquids)

High price sharing for liquids is triggered when gross cumulative production exceeds 5 million bbls and oil price (WTI) is in excess of benchmarks, according to the following formula:

ANH Payment = Price of Hydrocarbons at Delivery Point x Contractor Net Volume x Q,

Where:

Q = [(P - Po) /P] x S

P = WTI price

Po = Reference price

S = Participation percentage

Reference base price (Po)

S Factor:

Economic rights for the use of subsoil

Exploration Areas

For each phase of the exploration period, the exploration and production company is required to pay to the ANH the following fee:

Amount per hectare in each phase, in US$ (2010)

Evaluation and Production Areas

For liquid hydrocarbons, the semi-annual payment in 2010 equals the contractor’s share of production of liquids multiplied by $0.1236/bbl. This amount is indexed using the U.S. inflation index.

Taxes

The Corporation’s pre-tax income from Colombian sources, as defined under Colombian tax law, is subject to Colombian income taxes at a statutory rate of 33%. Costs related to the acquisition or construction of real property, plant and equipment are subject to a special tax deduction in the year of acquisition equal to 30%.

A “presumptive” minimum income tax exists which may apply in years with little or no taxable income. When applicable, presumptive income tax is calculated as 33% of 3% of prior year’s adjusted net tax equity. The excess may be carried forward for five years and recovered against taxable income. Tax losses may be carried forward without limitations to offset taxable income.

The Corporation’s entity is also subject to an equity tax. Currently the equity tax is based on 1.2% of the Corporation’s net equity value, payable yearly. However, the Government of Colombia recently introduced changes, by which equity tax will be calculated as 4.8% of the Corporation’s net equity value as at December 31, 2010 and payable over four years.

Overriding Royalties

Cravoviejo Block

The Corporation is a party to a participation agreement dated December 9, 2005 a royalty agreement dated March 16, 2007 related to the Cravoviejo block. These gross overriding royalty rates total 8.2%, however, the impact of deducting certain costs reduces the effective royalty rate to between 7.0% and 7.5%.

Pájaro Pinto Block

The Corporation acquired a 100% working interest in the Pájaro Pinto block in 2007. The Corporation entered into a royalty agreement dated May 22, 2007, which grants the assignor of the 100% working interest in the Pájaro Pinto block with a 3% royalty (before expenses, costs and government royalties and certain other costs).

Llanos 19 Block

The Corporation entered into royalty agreements dated October 28, 2009, one with the party to the Llanos 19 E&P Contract and the other with another partner, each of which grant a 2% royalty payable by the Corporation to each of these counterparties (government royalties, transportation costs, marketing and certain other costs).