The following are excerpts from lecture by Professor Paul Stevens, in Januuary 2000. Professor Stevens was educated as an economist and Middle East specialist has taught at the American University of Beirut (1973-79) and the University of Surrey (1979-93). He is now Professor of Petroleum Policy and Economics at the Centre for Energy, Petroleum and Mineral Law and Policy in the University of Dundee, Scotland. He publishes widely and consults for many companies and governments.
State domination in the oil sectors of the Middle East was not how the story began. The industry developed this century under the auspices of a series of concession agreements granted to various combinations of the major private oil companies—the so-called “Seven Sisters” (eight if the French CFP is included). To use their modern names these were BP, Chevron, Exxon, Gulf, Mobil, Shell and Texaco
These concessions, although to some extent individual contracts, had a number of common features. They had very long lives. Despite the fact they were signed in the 1920s and 1930s, had they not been swept away in the 1970s, many would still be in force today. They also covered very large areas of territory –-n some cases the whole country with no obligation to relinquish. Finally, they gave enormous managerial freedom to the companies virtually creating a state within a state. The companies could decide what exploration should be done, which fields should be developed and what production should be. They also determined unilaterally the posted price, which was used to compute taxes.
Increasingly such agreements sat uneasily in the world of the 1950s and 1960s as Europe's post-colonial chapter eventually closed. Newly independent countries—either de jure or de facto—began to consider their position as sovereign entities who wished to exert independence for all to see.
New smaller oil companies—the so-called independents—led by ENI of Italy began to offer newer terms to governments in the form of joint venture arrangements, production sharing agreements and service contract agreements. All these offered a role for host government to a greater or lesser degree. This required either the existence of a national oil company (NOC) or at the very least an oil ministry which could monitor and regulate the activities of the foreign companies. Hence, in the 1960s especially, most of the countries of the region created NOCs whose purpose was to learn the business of international oil and act as the vehicle for greater control by the host governments.
As the 1960s progressed and Arab nationalism began to gain ground, there were growing calls in the Middle East (as elsewhere in the Third World) to nationalize the old style concessions. Governments however were reluctant. There was the memory of Dr Mossadegh of Iran who had pursued such a path in 1951 and been removed from power in 1954 by covert US and British intelligence action fomenting a coup. He was arrested and spent the rest of his life in prison or under house arrest.
Such memories provided a powerful disincentive to imitate. Providing a further disincentive, the oil price was beginning to weaken. The extremely effective control mechanism exercised by the majors began to fray around the edges as new entrants competed. Among these were the newly formed NOCs. It was feared by those in host governments who knew the business that nationalization would sweep away the control mechanism leading to price wars and intense competition thereby completely undermining oil prices.
Participation, a Stage before state control :
However, popular pressure grew, reaching a peak with the Six Day War of 1967. To try and assuage these demands, beginning in 1967, the then oil minister of Saudi Arabia— Shaikh Yamani— proposed the concept of "participation". This would involve host governments taking an eventual majority equity share in the operating companies working in their own countries together with some equity in the downstream activities of the majors.
This "catholic marriage" as Yamani described it was intended to restore market control by forcing out the newly arrived independents. Negotiations began although along the way the downstream dimension was shelved. In October 1972, the "General Agreement on Participation" was signed between a number of host governments and the majors. In the event, the agreement had been overtaken by events. Crude markets began to show signs of strength as ever growing demand coupled with supply limitations as the majors ceased investment after Yamani's announcement. Also several countries starting with Algeria rapidly followed by Iraq simply nationalized.
Conclusions : Oil Nationalization and After
By 1976, the host governments of the region through their NOCs had taken control of the oil operations within their own boundaries. The state now dominated the sector although in some cases foreign companies continued to play a role either under the agreements other than the old style concessions or in some form of service role to the NOCs. At the time it was seen as a triumph for the sovereignty of Third World governments and with some justification. The countries showed they could manage their own affairs and operate their own oil fields. It was undoubtedly, at the time, a necessary rite of passage in the maturity of the countries. Self respect and dignity demanded it.
However, in this domination of the state, seeds were planted for problems to come. They derived from economic thinking in the 1970s and 1980s associated with the economic theory of politics, theories of public choice and the economics of principle-agent. These concepts argued that politicians and bureaucrats allocating economic resources would behave in such a way as to cause a serious mis-allocation of these resources.
Most relevant in this context of the NOCs was the idea that the management structure of state enterprise would seek to capture economic rent for their own benefit to the exclusion of the rest of society. Furthermore, they were able to do this because of the information asymmetries between them (the agents) and their political masters (the principles). The politicians simply did not have enough information to know whether their NOC was doing a good or a bad job. The NOCs were extremely opaque. The result was that in many cases the NOC became a state within a state. The ultimate example being outside the region—Pemex in Mexico. This it must be stressed was not corruption to top up Swiss banks accounts although undoubtedly that did go on. Rather, it is rent seeking to make employment conditions better in a variety of ways other than very large salaries which public sector employment tended to preclude.
The subsequent performance of the NOCs was mixed. In the upstream, in many cases, there was little to do. The reserves were there and the fields were large. It was simply a case of keeping the oil flowing. Most of the companies were competent technically and some, such as Saudi Aramco, were regarded as world class in this respect. However, in terms of commercial ability the performance was less encouraging. This became increasingly apparent after the oil price collapse of 1986. The private oil companies employing the latest technology began to make spectacular cuts in the cost of finding, developing and producing the barrel. By contrast, most NOCs experienced ever growing costs although the lack of transparency makes this assertion difficult to verify other than through casual empiricism.
However, the serious problems came from the NOCs investments abroad—a classic method of deepening the information asymmetries described above. In terms of the upstream, such investment made little sense. It amounted to using state funds to create a cash cow for another government to milk. This could only be justified if there was no prospect of finding more oil at home or if such investment helped technology transfer. This latter argument however is thin when it is remembered that much of the technology is embodied in the service companies which can be employed at home.
The main area of foreign investment was in the downstream. In the period immediately after the First Oil Shock of 1973, most of the NOCs in the region drew up grandiose plans to build refineries within their own borders. It was argued that the economics of refinery location had changed and it was seen by many in the NOCs and as a natural progression and as a vehicle for economic development. In the event, except for Saudi Arabia, these plans were scrapped. It was realized eventually how much capacity everyone was planning to build in a world already awash with excess refining capacity following the reversal of oil demand growth after 1973. However, as private oil companies began to sell refineries and marketing networks in the 1980s, a number of the NOCs, following the lead of the Venezuelans, began to buy this capacity. The official version of motives revolved around the need to lock-in volume outlets faced with growing competition from non-OPEC and that such a move was a natural progression in developing an oil company.
However, it is possible to also explain these purchases as part of a general herd instinct (common also among the private oil companies) and above all in terms of principle-agent arguments. Investing abroad placed even greater shrouds of mystery over the activities of the NOCs. If the politicians were unsure about what was happening at home, this was doubly so when the operations were abroad. Two problems were common to these downstream investments. Often far too much was paid for old inefficient equipment or low quality marketing sites. Often the commercial realities undermined the desire to lock-in volume. For example, Gulf crude in the US found it increasingly difficult to compete with Western Hemisphere crude, especially when that crude was trying to capture market share.
After the 1986 oil price collapse, all of the NOCs began to face budgetary constraints. The collapse in oil price meant governments were desperate to secure every possible dollar of oil revenue. The NOCs were therefore regarded as little better than tax collectors for the state although their ability to divert rent to their own interests remained strong protected by a lack of transparency.
As the 1990s progressed, governments began to grow increasingly suspicious of the behaviour of their NOCs. For example, successive oil ministers in Kuwait after liberation began to institute strategic reviews relying heavily on outside advice. Today, in the low price world triggered by the Jakarta OPEC meeting in November 1997, such suspicions have become even more powerful as tax revenue becomes ever more vital. This has begun to lead to changes which may well transform the state domination of the oil sector in the Middle East.
The first change is a restructuring of NOCs, a process already begun in many of the countries.
This has two objectives. The first is to improve the transparency of operations and the second is to create a structure which may be more amenable to control. The problem with this approach of course is that restoring control to the politicians may not solve the underlying problems. In their turn they are liable to pursue their own agenda and their own form of rent seeking. The result is that growing voices are heard for privatization of the national oil companies.
The second change is to encourage the entry of foreign oil companies. It is seen that this will achieve a number of objectives. At a practical level it may relieve the budgetary constraints on investment in the sector. It will also give access to improved technology. Not so much at an engineering level since this is available from the service companies but rather new project management technologies. One of the most obvious and immediate benefits is that foreign companies will provide a transparent benchmark. This will go along way to overcome the underlying information asymmetries. Politicians will be able to make a simple comparison between what it costs the NOC to generate a dollar of revenue and how quickly it can be produced and the performance of the foreign company. Grave disparities will generate questions and demands for greater transparency. Eventually, foreign company involvement may actually provide a competitive environment within the country. This, above all else, is what is required to improve NOC performance.
Implementation of these changes faces serious constraints. Privatization is sensitive given the central and strategic importance of the oil sector in the Middle East. Also, privatization as such is not a necessary condition to improve NOC performance. Of far greater importance is the creation of competition in which the NOC must operate. While not excluding the possibility of domestic capital involvement for some countries, realistically on any scale, competition requires foreign company involvement. This too is sensitive as can be seen from the current bitter dispute over upstream access in Kuwait between elements of the National Assembly and the Oil Ministry. Many would regard foreign company entry as a reversal for the victories of the 1970s and an abrogation of sovereignty.
However, if the present low oil prices continue for any length of time, as seems likely, business as usual with state domination of Middle East oil is no longer an option. Oil revenue dollars will be at a premium for governments and the NOCs will increasingly be forced to deliver. This will force greater private sector involvement in the oil sectors of the Middle East although the process will be far from smooth or straightforward.
© 2000 Mena Report (www.menareport.com)
