An oil account can serve a number of purposes. It could be a mechanism for monitoring oil financial flows, a stabilisation fund to take account of fluctuating oil prices, or a savings device to establish a permanent fund to service the state or its citizens. The policy arguments for a permanent fund are canvassed everywhere for an emerging economy, but if a permanent fund is to be created, a number of issues must be addressed in the law: namely, what is the desired size of the permanent fund and what should be the path to achieve the desired size, that is, how is the division of income between current expenditures and savings are to be determined during the period of production.
Building a permanent fund requires the restriction of current expenditures to a level below oil revenues, at least during the initial period of oil production. A key policy and drafting issue is the determination of whether to cap expenditures by law and if so, what the cap should be and how “hard” it should be. In Norway, for example, there is no cap as such. Withdrawals from the oil fund are set equal to the deficit in the budget, and the build-up of a permanent fund depends solely on annual discretionary decisions regarding the budget. In Sao Tome and Principe, on the other hand, the law itself specifies hard limits on the amount of annual expenditures. The Timor-Leste Petroleum Fund Law takes a somewhat similar approach in requiring an annual calculation of the maximum estimated sustainable income taking account of the country’s oil wealth.
However, the law allows the parliament, on an annual basis, to exceed the ceiling under certain specified conditions. [Timor-Leste Petroleum Fund Law: “No transfer shall be made from the Petroleum Fund in a fiscal year in excess of the Estimated Sustainable Income for the Fiscal Year unless the Government has first provided the Parliament with” certain reports and explanations. However, “[i]f required under the law of Timor-Leste, transfers from the Petroleum Fund are exceptionally permitted for the purposes of refund of tax, in the event of an overpayment of tax… This amount represents a reduction of the Petroleum Fund receipts and shall not be considered as part of the appropriation (the amount approved by the Parliament for the relevant fiscal year)]. Setting the size of the permanent fund involves intangible choices of intergenerational equity, assumptions about the efficiency of current expenditures and public investment and estimates about the size and value of a country’s petroleum resources. One rough rule of equity, adopted by the Saotomean oil revenue management law, is to try to maintain an even revenue flow to the government or its citizens, throughout both the period of production and afterwards. The Timorese petroleum fund law uses a similar approach through its calculation of the “maximum sustainable annual expenditures.” This can be done in principle by finding the present value of the oil resource and making available for current consumption the expected return on the estimated value plus the return on the balance in the oil account. To do this, however, requires estimates of a number of variables and any process will provide only a rough levelling of revenues. The estimated value of the resource in particular changes over time when and if new commercial discoveries are made, and as prices change.
As part of setting a ceiling, whether mandatory or indicative, it is usually necessary to place a well-defined value on the petroleum resources of the country. If all revenues are put into a fund and then only earnings from the fund are used to support current expenditures, such estimates would not be necessary, but this would result in a very low level of initial spending. While in some cases this may be consistent with absorptive capacity, it is very unlikely to be consistent with political pressures for rapid development and spending shall arise, once commercial petroleum is found. This estimation requires a number of assumptions-the size of the petroleum reserves and extraction rates, future prices, and the discount rate to determine the present value of the reserves. Price assumptions particularly can result in widely differing values of reserves and hence widely different levels of permissible spending (Bell and Faria 2007). The wide range of prices over the last ten years could allow for a great deal of discretion and thus could create the temptation to predict an increase in future prices to justify higher current expenditures.
To avoid this, we recommend that the law tie the numbers to some objective determination. In the case of Sao Tome and Principe, the projected price is based on the historical price over the prior 10 years. For new oil streams such as Guyana, it is necessary to look at comparables to obtain the historical figures, but this can be done by using some core of basis adjustment which, while nor entirely free of subjective elements, will cause only modest variations in the calculated average price. This has three advantages. First, it is based on known numbers. Second, it will change only slowly year to year, as a new year is added to the calculation to replace the oldest figure in the prior calculation. Third, the production figures used are those in the plans that producers have to file with the government. These will usually be conservative providing a bias to the estimate of oil wealth. Over time, new discoveries may increase the estimated oil wealth, and the use of a formula such as that in Sao Tome and Principe will again adjust (although if very substantial new commercial discoveries occur, the level of reserves can result in a significant increase in the amount of permitted annual spending). However, since it is unlikely that such estimates must be adjusted downward, these changes, unlike projections of future prices, should not lead to the situation in which governments must decrease the level of spending year to year.
The Saotomean oil revenue management law provides for a second set of spending limits unrelated to the build-up of a permanent fund. Before actual oil production, a country may receive limited oil revenues in the form of signature bonuses and possibly other payments. These amounts are relatively small but should nevertheless move through the oil fund. In the case of Sao Tome and Principe, formulas try to spread these funds over five years, the estimated period prior to commercial oil production. Of course, there may ultimately be no production as exploration may not turn up commercially producible reserves.
Even if no permanent reserve is envisioned, there is still often a need for a stabilisation reserve. One of the most serious problems incurred by resource-rich countries is the fluctuation in spending. When prices are high, spending increases. When prices then fall, however, the spending cannot be sustained. This may result in a stop-go pattern of development with increased pressures to borrow – the net effect being that resource-rich governments are also among the most heavily indebted. A permanent fund with annual spending limits, as in Sao Tome and Principe, helps avoid this problem since the formulas act to smooth expenditures even during periods of significant price fluctuations. If in the first year or two of commercial oil production prices are very low compared to historical prices, initial revenues may not be able to support expenditures at the level calculated at historical prices. The local oil revenue management law must address this problem in part by incorporating an initial one-year lag after the commencement of commercial oil production into the determination of the limit on revenue expenditures, and by limiting the amount to be spent to actual prior-year revenues plus expected earnings on the permanent fund balance. If there is to be no permanent fund, one can create a stabilisation reserve within the oil account (or as a separate account) to address price fluctuations. In determining whether monies should be transferred in or out of the stabilisation fund, one could use formulas for projecting prices and future production that would be similar to those used in determining how much to transfer to a permanent reserve. To avoid political estimates, valuations should be tied to market data, to the extent possible. It would also be possible to incorporate forward markets into a hedging strategy to provide more stability of income flows (Dodd 2004). Because of the unpredictable nature of future oil prices, prudence would suggest building a significant reserve in connection with the stabilisation fund – that is, the initial spending levels should be less than the amounts expected to be available even after stabilisation until a reasonable reserve is accumulated. If only a stabilisation fund is used, the estimate of future prices becomes more critical. A permanent fund, except in its earliest years, provides a much larger fund balance or “reservoir” from which current expenditures can be financed. Hence, the inevitable difference between forecasted or current prices and the prices used to calculate the limits is much less likely to result in a liquidity or funding problem.
Uses of Revenues
An oil revenue management law could reasonably be restricted to the receipt, management, and control of oil revenues without addressing expenditures apart from whatever overall spending limits are imposed. Nevertheless, a number of laws establishing funds have specified some restrictions as to areas of use. For instance, the use of funds may be restricted to certain priority sectors or there may be sec allocations to regional or local governments. In the case of Guyana, regional allocations – often a highly contentious issue – must be specified, but sectoral allocations must only be broadly predetermined. Regional allocations are highly political and have been the central focus of many conflicts regarding the use of oil revenues. This is true for example in areas where greater disclosure is needed for the special oil revenue allocations made to oil-producing state and local governments (Brosio 2000). The statute should contain only a general requirement that the revenues be used in connection with a national development plan and poverty reduction strategy or, in the absence of such plan or strategy for priority, in “education, health, infrastructure, and rural development.” The drafters must consider more detailed limitations on the activities of future governments which may be inconsistent with democratic notions, holding that parties and candidates in the future should be free to determine the details of their own expenditure choices within the ceilings.
Another important idea has been the direct distribution of a portion of the annually available funds to citizens of the country. Apart from the Alaskan fund, however, no fund has provided for direct distribution. Although frequently pointed to as a model, the constitutionally required allocation of revenues to the fund and direct distribution have been criticised for diverting revenues from the general fund and depressing expenditures for education, infrastructure and other social needs (Davis et al. 2001).