Oil boom coming? Don’t tell anyone!

In 2009, a colleague of mine had an idea about how Ghana could innovate using its coming oil wealth. Being pretty well connected, he worked up some research and then flew to Accra for a meeting with the vice-president. He was heard out politely but at the end of his presentation his hosts politely informed him that he was too late. Although the first oil was not due out of Jubilee field until December 2010, over a year later, the government had already planned its first two years of oil income. Cabinet debates had been had, promises had been made, spending commitments laid down. My friend flew home with a new definition of what it meant to be early in the curve.

It’s a particularly graphic example of the expectations that accumulate so fast around natural resource wealth. Politicians and journalists herald the arrival of a new era, even when, as Lutz Neumann recently pointed out, the numbers are often quite modest in terms of overall economic growth and don’t stack up to what you might call natural resource “wealth”. The trouble is, these expectations can actually weaken a government’s negotiating position.

It turns out that in contract negotiations, like so much else in life, wanting it bad is a bad idea. You’re likely to get more the easier you find it to walk away from the table.

One problem with extractives negotiations is that they are a far more serious commitment than other kinds of foreign direct investment. The levels of capital and risk lead to arrangements that last a generation – 20, 30, even 40 years. Compare an offshore gas play in East Africa to, say, building a factory in a Chinese free trade zone. Manufacturing companies build for redundancy, to be able to scale production down and up around the world as demand, local costs and exchange rates fluctuate quarter by quarter. Whereas the sunk capital in most oil projects past the exploration stage are so great that both sides are tied in for the long term. You don’t get to date in extractives, or even go steady. You meet the family, have a couple of chaperoned outings and then bam. It’s more of an arranged marriage.

And it’s an issue that’s sharpening. Investment in exploration and development in the global oil industry has increased six times so far this century – over 25% a year every year. This is the play out of the end of Easy Oil we keep reading about as companies push further and deeper. One deep offshore well can cost $200 million. This naturally impels companies to seek longer term agreements and more guarantees on sunk investment – and an intensification of the irreducible conflict of interest not only over take – who gets how much – but also frontloading – who gets how much when.

The exponential rise in investment costs also creates a very different interest and dynamic around expectations for companies as opposed to governments. The editor of a national newspaper in Kenya recently expressed great scepticism to me because the government had just downplayed recent announcements by Tullow over the size of discovered in exploration in Turkanaland in the north east of the country. Tullow issued various statements about oil and gas shows and how the pay zones were bigger than anticipated, and then the government stepped in to play it down. Surely these people don’t make mistakes like this, was his point. There must be a cover up. They must be planning to disguise how much they’ve found so they can steal some of it, was the implication.

But the devil is nearly always in the detail. “Shows” mean next to nothing commercially because there are many times more hydrocarbons in the ground than will ever be exploited. But Tullow, like any listed oil company that lives or dies by its share price, have an interest in talking it up. Independent companies want to show big finds to jack shareholder confidence and up their coming buy-out price. Oil majors are obsessed about booking more reserves. There are all kinds of glass-half-full things you can say about exploration which are entirely true and don’t constitute business malpractice, but which might, when received across the Chinese whisper effect of the Internet, lead bystanders back in the country itself to over-anticipate the scale of the coming natural resource boom.

If a country talks up its coming mineral wealth, it is weakening its BATNA – Best Alternative to a Negotiated Agreement. Now that a considerable part of parliament, media and dinner table conversation is around economic growth, international profile and so on, you’d better deliver. There are perhaps a dozen countries across Africa alone right now with public debates about how to spend wealth that isn’t yet there.

And the thing is, the more a country can wait for its oil wealth the more it can get out of the same amount of resources in negotiations with the same oil companies. Companies are calculating their internal rates of return (IRR) on investment which depends directly on how fast they can recover all the capital investments they make at the start of an oil project. Because of the nature of rent, by the way, this can be very different to market value of oil produced. For instance, Deutsche Bank analysts have predicted that ExxonMobil could earn an IRR of 19 percent on the service agreement it holds for the field of West Qurna in Iraq even though it is only being paid a remuneration fee of about 2 percent of the value of the oil being produced.

If governments can afford to allow companies to recover costs, they can obtain revenue splits over the long term which are more favourable. The difference in results can be startling. Pedro van Meur recently wrote that different tax regimes applied to the same resources could result in a 17 percent government take in the Bahamas and a 68 percent take in the Netherlands, because the Dutch fiscal regime emphasises profit sharing rather than royalties – back-ended rather than front-ended compensation.

But you have to be able to wait in the first place.

In the long run, these soft phenomena of expectations and habits determine far more in terms of a country’s economic security and health than the actual numbers around its oil wealth. Take Saudi Arabia, Russia and Iran, who between them will account for over a quarter of all oil traded across international borders this year and have oil industries dating back to before the Second World War. Russia and Iran both have a “fiscal break even” of over $100 a barrel this year. If oil doesn’t average $100 a barrel throughout the year their budgets for normal government spending will go into deficit. Even for fabulously oil rich Saudi Arabia the figure is $78 per barrel.

Expectation turned into chronic dependence and, if one were to look at the political economies of those three countries, a lot else besides.

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