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Sunday, October 18, 2020

Be patient: Oil does not disappear – Strengthen institutions for Guyana’s growth

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Bobby Gossai, Jr.
Bobby Gossai, Jr. is currently pursuing the Degree of Doctor of Philosophy in Economics at the University of Aberdeen with a research focus on Fiscal Policies and Regulations for an Emerging Petroleum Producing Country. He completed his MSc (Econ) in Petroleum, Energy Economics and Finance from the same institution, and also holds an MSC in Economics from the University of the West Indies. Mr. Gossai, Jr.’s professional experiences include being the head of the Guyana Oil and Gas Association and senior policy analyst and advisor at the Ministry of Natural Resources and Environment.

The privatisation in an economy can set in motion a vicious circle. Even without corruption, rapid privatisation means that governments receive less than fair market value for the companies they sell-off. While privatisation has highlighted the problem, conflicts over the fairness of natural resource privatisations and contracts are endemic around the world.

Responding to these Risks

Local agency problems are widespread. They cannot simply be wished away and there are no magic solutions. The hope that privatisation would solve agency problems (including problems of corruption) was a dream only of those who do not understand the underlying economics. However, while agency problems cannot be eliminated, there are some contractual and institutional arrangements that make them worse than others. The reason that net profit contracts are not used – even though they might seem efficient – is that they exacerbate agency problems. Hence, these are some of the steps that governments can take to mitigate these risks.

Strengthen Institutions before Engaging in Privatisation

It is no accident that privatisation has been beset with so many problems. Privatisation has often occurred before good institutions which can conduct, for instance, fair, competitive, and efficient auctions, are in place. And privatisations have also occurred before institutions that can collect taxes and enforce contracts are in place. This suggests that these governmental institutions need to be strengthened prior to engaging in privatisation. Yes, there may be some losses of public revenues in the interim, but these losses (essentially of a short-run cash flow) pale in comparison to the losses that have occurred in the privatisation process (which are related to the value of the stock, not just the cash flow.)

Nevertheless, this raises a problem: If the government has developed these strong institutions, perhaps it is better for it to go one step further, and develop the institutions for oil extraction itself, i.e. develop efficient and honest state-owned enterprises for oil extraction, as Norway and Malaysia did (and as Chile did in the case of copper.) There is one marked advantage of this strategy: It avoids the agency problem of privatisation itself, in the process of which the government may lose a substantial fraction of the value of the asset.

Oil Doesn’t Disappear

In the case of fields that have not been developed, there is a strong argument for waiting: the assets will not disappear. Indeed, if the price of oil rises over time, the value of the assets beneath the ground grows over time. Especially in cases where costs of extraction are currently high and might be lowered over time with the progress of technology, the return to waiting may be higher than on any other investment the government might make.

Hotelling’s analysis (1931) offers a framework for determining the optimum time to take resources out the ground. In principle, the portfolio composition problem (whether to hold one’s wealth as oil beneath the ground or as some asset above the ground) can be fully separated from the expenditure decision. Although in practice, the two get linked. As the country sees its income rise (as a result of extraction) there will be pressure to spend the money. International advisers will emphasize that the country is not wealthier; it has just changed the composition of its asset base – but this argument may have only limited resonance with the electorate. This suggests delaying extraction of resources below the ground until the country can reinvest the resources well above the ground.

A further problem arises when it is known that the government – when it gets hold of the money from the extraction of the resources – will use it for its own purposes and not more broadly for the people. For instance, the government might buy arms to perpetuate its power. The people might benefit to some extent, but clearly not as much as they could or should. The prospects of the money being used better later may be greater than the prospects today, even once some time discount factor is taken into account. Again, patience is what is required. Institutional arrangements can be designed to help ensure the proceeds do to help the people, but they are hard to enforce ex-post and difficult to know what to do in the presence of a variety of forms of reneging on the terms (Stiglitz 2006).

Identify Provisions for Renegotiation ex-ante

It must be recognized that when large deposits of oil or minerals are found, or when the price of the oil or mineral rises markedly in an unexpected way, there are likely to be incentives to renegotiate contracts, especially if the original contract is not subtle enough in identifying the different circumstances in which such renegotiation might be desirable. Inevitably, with fixed costs already invested, these renegotiations can put governments in a bind. If the private company does not accede to the demands, it loses the contract. By the same token, oil companies may claim that the quality of the oil is worse than they anticipated, or costs are greater than they anticipated, and demand better terms, threatening to leave. Again, the country government is in a bind. If the company leaves, there will be a costly delay in bringing the oil on line, and any new company brought in may demand terms not much different from those being demanded by the oil company. Often governments simply accede to the demands.

Every contract is subject to dispute, and this is no less true of oil contracts. In some cases, the company may have made investment commitments as part of terms of the lease (or sale). However, when the commitments are made in terms of dollars invested, there might be non-arm’s length accounting, with the company overvaluing the investments. On the other hand, there is a myriad of ways short of losing the contract in which the government can harass the contractor, many of which might not have been precluded by the contract. Since the discovery of a large find is likely to change the economic circumstances of the parties, producing both political and economic interest in a renegotiation, the parameters under which a renegotiation can occur should be identified ex-ante so that agreements can be reached with less hostility than otherwise.

In the end, too often the country loses twice – first from the unfair contract or privatisation, and second from political turmoil and adverse international attention from the investment community when an attempt is made to set things right.

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