Government preferences should take into account wider factors than those considered by private investors. This is because governments are concerned with the linkages between petroleum production and the rest of the economy. Also, governments are or should be responsible for the interests of future generations.
The key depletion choice is usually considered to be whether to produce now or to leave the oil and gas in the ground until later. However, the government is not simply a resource manager. It has to consider linkages between the petroleum sector and the rest of the economy (Hirschman 1981).
- Fiscal linkages are the revenue which can be captured by government from production and sale of oil or gas. There is a parallel set of linkages to the balance of payments from export revenues. The strength of the link will be a function of the net value of the output and the fiscal terms which govern the sector. The link arises through revenue available to the government for expenditure on consumption or investment outside the petroleum sector and the foreign exchange earned from exports to pay for imports to the non-petroleum sector of the economy.
- Forward linkages refer to the provision of oil products or gas to the rest of the economy either as energy or as feedstock.
- Backward linkages cover the factor inputs in the supply chain from the domestic economy into the oil and gas sector in the form of labour or local content which would not otherwise be employed or would be employed at lower productivity.
Taken together, these linkages provide a ‘multiplier effect’ from the petroleum sector to the rest of the economy. The multiplier effect depends partly on how the government allocates its revenues between consumption and investment, and partly on the capacity of the economy to benefit from the output and input linkages. These may be large in a well-functioning economy with underemployed inputs, small in a badly functioning economy where underemployed potential is not brought into action, and small in a large diversified economy with few underemployed resources. Culture may also be a factor, as in Guyana’s situation. Government policy itself affects the strength of these linkages by creating an environment for economic development under the rule of law, property rights, competition and the operation of markets for investment, goods and services, and by investing in infrastructure, health and education.
Within these country and time-specific constraints, the government has three possible, but not mutually exclusive, choices. It may also be constrained by constitutional provisions or by an overriding law or policy which diverts revenue to development funds and heritage funds and constrains the share which the political executive controls through the budget process.
- The first option is to spend on consumption. This provides the population with utility (and may also have some multiplier effects as local inputs are used to supply the population’s spending).
- The second is to put the money into real domestic investments. This can mean physical capital such as infrastructure, factories and modern farms, but also human capital such as education and health. These investments create a return of future income which can then be consumed, saved or invested in building the wealth of the economy.
- The third option is financial: paying off public debt and investing, through special funds, in financial assets. Often these are foreign assets, to avoid the Dutch disease effects on inflation and the exchange rate of high levels of local expenditure.
There are many different views on the optimal deployment of resources. In theory at least, ‘the portfolio composition problem (to produce or not) can be separated from the expenditure (deployment) decision’ (Stiglitz 2007). Also, in the meantime, the government has the option to go and borrow (at a cost) using its potential reserves as the basis to secure the loan. However, in practice the two are linked, because part of the indigenous population of many petroleum-dependent economies suffer high unemployment and low per capita incomes, creating popular pressure for local spending and investment. In many oil-exporting countries this linkage is in fact extremely large and highly politicised.
The question is therefore how to align depletion policy with development policy, including the institutional framework and the realities of local development potential outside the petroleum sector. Linkages critically affects depletion preferences because they affect the ‘profitability’ – or contribution to the welfare function – of investing revenues from depletion into national economic development.
The ideas of forward and backward linkages must be viewed in the context of something called ‘technological strangeness’. Thus, for example, in the most extreme case, the development and production of oil on Guyana’s native indigenous tribal lands in (say) the depths of the rainforest jungle are unlikely to lead in the near term to the local tribes building drilling rigs from scratch. A less extreme example is in Georgetown where the local economy around Demerara River has a few shipping and construction yards used to service a less advanced shipping sector. The problem here is that their technology are not suited for a modern offshore industry and therefore new supply bases must be developed for Guyana’s emerging offshore oil fields.
Hence, the extent to which the depletion of oil might encourage the development of the local supply chain and local content depends upon the existing nature of the local economy. This will change over time. The slower the depletion rate, the more opportunity there is likely to be to develop local capacity. This is crucially important in the context of sustainable development since strong backward linkages will promote the non-oil economy for when the oil runs out or is no longer wanted. Even if there is less oil production domestically, the developed local capacity still has the option to use its skills abroad.
Therefore, the good practical path for Guyana is to decide when it wants to produce the oil and at what rate of depletion. The decision could be of two options; first the local industry could be developed quickly by the transfer of the relevant skills and technology from more advanced oil-producing countries. However, this will have the negative effect of allowing for too of a long time for to develop local capabilities. By contrast, secondly, the industry could take a conscious decision to develop a solid base to provide local content where Guyanese service companies will have a significant share of the local market.
Therefore, the key idea is that reserves in the ground constitute an item of wealth and countries should not spend annually more than that wealth could earn as income after the (discounted) value of the resource has been replaced by other income-generating assets. An early version of this was Hartwick’s Rule (Hartwick 1977). This argued that all the revenues net of production costs should be invested. This is often referred to in the literature as ‘invest resource rents’. This, at least in theory, maintains the stock of wealth of the country which then provides a permanent income which can be spent. Put another way, ‘consumption in each period should be limited to permanent income or, in this case, the implicit return on government wealth’ (Barnett and Ossowski 2003). The best measure of the direction and sustainability of the fiscal system is the primary non-oil balance. If it is balanced, then the fiscal position is sustainable. If it is in deficit, being funded by the oil revenues, then clearly it is not sustainable assuming at some point oil revenues dry up as a result of depletion or being no longer required. In reality, all resource exporters appear to be depleting natural capital faster than they are building up other forms of capital, and so are becoming poorer, whatever their income levels (Heal 2007).
As such, for any government, slower or staged project development for oil and gas production, i.e. relatively slow depletion, can help to stagger the revenue inflow. This brings a number of benefits. It helps prevent the economy from overheating; causing inflation, and a possible exchange rate appreciation, leading to an attack of Dutch disease. It may constrain the project from crowding out other sectors of the economy from access to factor inputs. By constraining popular expectations, slower revenue inflows can also help mute pressures on government to spend on projects which may be unnecessary, unwise or simply too large for the economy to digest.
Smaller revenue inflows spread over a longer time can also make the ‘pot’ seem less worth fighting for; this can help reduce the domestic conflict often exacerbated by such projects (Collier and Hoeffler 2004). Slowing the revenue inflow also gives more time for the government to develop the policy-making capacity which is a necessary condition for creating a ‘developmental state’. This is a key element in reducing the potential for an attack of the resource curse (Mkandawire 2001). Finally, from the government’s perspective, slowing development gives local service industry capability a chance to emerge. This would help to maximize the backward linkages from the project to the local economy, thereby assisting the process of diversification and increasing growth.