Chapter 7. Institutional Oversight of the Oil Sector
- Harinder Malothra, Milan Cuc, Ulrich Bartsch, and Menachem Katz
- Published Date:
- January 2004
In this chapter, we present the structure of institutions that oversee the oil sector. After reviewing the legal framework, we discuss the role of national oil companies.
Countries that have had success in managing their oil sectors usually have a sound legal structure, with a set of laws tailor-made for the oil sector. On the most basic level, the ownership of natural resources—onshore or offshore—is defined. In most countries, a law specifies that the state is the owner of subterranean and sub-marine resources found beyond a certain depth, with private ownership, as in the United States, a rare occurrence. More detailed laws usually govern how and under what type of contract foreign direct investment can be invited to develop oil, and which institution will regulate industry operations. A model contract is often attached to the law, setting out contract terms in general while leaving commercial details open for negotiation. Laws organizing budget operations specify the revenue-collecting institution.
The successful institutional setup normally distinguishes between two tasks in oil sector management: (1) strategic issues regarding the oil industry—for example, the drafting and implementation of legislation, licensing, general contract design, negotiations with foreign investors, and government equity participation; and (2) tactical issues, such as the daily monitoring of oil operations in order to safeguard the appropriate extraction of oil, as well as the social and natural environment. The commercial interests of operators may not always coincide with the interests of the resource owner, and it is therefore important to have an independent regulatory institution.
The technological and financial requirements, as well as the risks involved, mean that most countries have to attract foreign direct investment in order to develop hydrocarbon deposits. Experience has shown that fiscal regimes—that is, the systems that specify the payments due to governments out of oil sales proceeds—differ in their attractiveness to investors and in the level of revenue and risk allocated to the government.24 Fiscal regimes are sustainable over the long term only if the terms of the agreement, which inevitably have to be drawn up before the potential for hydrocarbon production is known in a given area, are still agreeable once a discovery has been made and production has started. For a fiscal regime to be successful, “fiscal neutrality” is required; that is, the fiscal regime should not have an unwanted influence on the commercial viability of a given hydrocarbon deposit—the main factor in the decision to develop a field—and on the decision to abandon a deposit before the reserves are depleted.
Most countries now use combinations of royalties and profit-based instruments to fulfill the governments’ objectives for collecting revenue from project operators (see Box 4).25 Royalties ensure that the governments receive a minimum payment of revenue from the start of production, irrespective of the project’s profitability. Profit-based instruments ensure that the governments reap the benefits of profitable projects. In addition, granting signature bonuses to governments when exploration licenses are being awarded can produce sizable revenue for governments independent of exploration success; also, as very early sunk costs, these bonuses entice companies to move speedily. Finally, oil companies that are incorporated locally—which may be a legal requirement—usually pay corporate income tax.
Box 4.Production-Sharing Contracts
In many countries, fiscal regimes are codified in production-sharing contracts or agreements (PSCs or PSAs). Under these arrangements, the state retains ownership of the resource and appoints the investor as “contractor” to assist the government in developing the resource. Payment for the contractor is a share of production, and the government will not reimburse the contractor for exploration spending if hydrocarbon deposits do not justify development.
The PSC will usually specify a portion of total production that can be retained by the contractor to recover costs (“cost oil”), while the remainder (“profit oil”) is split between the state and the contractor according to a formula set out in the PSC. Royalties or limits on cost oil for any given year ensure some government revenue from the beginning of the project life. In principle, the government receives physical products from the project, but very often agrees on joint marketing with the contractor.
In addition to profit oil, partners in the agreement can be levied petroleum income tax, as well as various forms of bonuses. Recent years have seen large increases of, in particular, signature bonuses payable at the signing of the agreement, and thus not specified in the same. Depending on the setup of the different components, a PSC can be designed to be indistinguishable from a royalty/profit tax combination in financial terms.
National oil companies (NOCs)
Governments should evaluate carefully the costs and benefits of NOCs. In very general terms, NOCs are justified in relatively large countries that have the human and financial resources that make a local oil industry a realistic and promising prospect. Adequate conditions have to be created to ensure an effective control over NOCs and international investors by the administration. NOCs should be given the commercial freedom to concentrate on efficiency in producing oil rent, with a clear dividend policy.
Beginning in the 1960s, governments increasingly sought to control oil-extracting activities more directly than through mere legislation and regulation. NOCs were created to accomplish this and to force a faster technology transfer than had been achieved previously. Three arguments can be listed in favor of NOCs. First, the nationalizations of the oil industry in the late 1960s and early 1970s were spectacularly successful in increasing the producers’ share of the resource rent. Second, direct national control over production volumes facilitates the management of the worldwide supply and demand balance, whether countries are members of the Organization of Petroleum Exporting Countries (OPEC) or not. With an entirely private oil industry, a government decision to cut production would be more difficult to implement; similarly, private investors would not, like Saudi Arabia, hold the roughly 2 million barrels per day excess capacity that has enabled the country to close sudden supply shortfalls—for example, during the Iranian revolution, the war over Kuwait, or, more recently, the oil sector strike in Venezuela. Third, given the proprietary nature of much of the exploration and development technology, the development of local oil industries probably would not have taken place without forced joint ventures with international technology leaders. Several developing-country NOCs are now technologically on par with the biggest international oil companies (e.g., Petrobras of Brazil and Pemex of Mexico).
However, NOCs pose numerous challenges to the organization and control of the oil sector.26 Most important, these are related to their unclear position in the principal-agent relationship between the state and the oil industry. The NOC should be the agent that takes part in joint-venture oil projects. Often, it is also the revenue-collection and regulation agent for the state, which makes it the principal vis-à-vis the foreign investors.
In many countries, NOCs have become the vehicle to achieve a broad range of national economic, social, and political objectives, to the detriment of commercial objectives. NOCs have had to create jobs, increase local content of oil sector demand, provide social infrastructure, support regional development, supply transfers through the underpricing of petroleum products, and provide financing for government budgets by borrowing against future oil revenue. The commercial efficiency of NOCs is frequently rated as poor.27
Equity participation in oil projects increases government exposure to risk. NOCs have to participate in the financing of exploration activities that may not result in commercial discoveries. The investment needed to develop an oil field may be very large compared with the government budget. Governments, therefore, carry much more of the exploration and reserve risks of oil activities when they participate directly in projects than when they confine themselves to revenue collection.28
B. Current Practice
Oil operations in the group are dominated by international oil companies (see Table 8 for a summary of this section). Nevertheless, five out of the seven African oil-producing countries have NOCs. Ministries of finance in these countries are generally in charge of following up on oil revenue payments by the oil companies. All the countries use either production-sharing arrangements (PSAs) or royalty and tax combinations (like the Memoranda of Understanding of Nigeria) to define relations between the government and the oil companies, except for Gabon, where some older fields are still operated under concession agreements. Under the PSAs and the royalty/tax contracts, the main sources of government oil revenue are the payment of royalties out of the gross production of oil29 and the sharing of profits between the state and the oil companies after deductions are made for operating and capital costs.
Contract terms differ widely across countries. The government’s share in percent of the total value of production, or the government take, is largest in Nigeria and Cameroon.30 These countries capture more of the resource rent through the working interest that their NOCs hold in oil fields, which, of course, also means that their governments are exposed to some of the inherent risks of resource exploration. The government’s share in Equatorial Guinea is the smallest, partly because the country’s three oil fields are in an early phase of development. The fields will produce more government revenue as they mature.
Only Angola and Nigeria have organized competitive bidding rounds to allocate exploration rights; however, some exploration blocks have been allocated to companies on a more ad hoc basis, even in these countries. Angola and Nigeria also receive large initial bonus payments upon approval of new exploration license agreements, and only in these countries are contract terms deemed “international best practice” by industry experts.
Contractual arrangements are often not transparent in the oil-producing countries, as contracts are available only to a small circle of officials and amendments are frequently negotiated—a practice that increases the difficulties of following up on oil revenue. Parliaments are generally not involved in licensing for exploration or development. In some cases, license allocation—and, in all cases, negotiations of contracts—are confidential. In some countries, model production-sharing contracts are readily available (Angola, Cameroon, Equatorial Guinea, and Nigeria). However, model contracts are frequently changed during block allocation negotiations, and the outcome of the negotiations may not be announced publicly. In particular, signature bonus payments are often not included in the PSAs, and transparency is often lacking.
C. Discussion and Recommendations
Participants in the Douala workshop acknowledged that governments often lacked the capacity to oversee effectively the oil sector operations of foreign and national oil companies. One of the problems most often cited was the complex details in oil production contracts. They noted the constructive role NOCs have played in other regions in creating domestic expertise and increasing the government’s share of oil revenue. However, they acknowledged that the financial performance of NOCs had been hindered by a lack of a clearly defined purpose, “mission creep,” and conflicting demands placed on them by society.
Many participants agreed that NOCs should be allowed to concentrate on maximizing revenue and that administrative units within the government needed to be strengthened in order to meaningfully monitor NOC activities. Technical assistance will be required to achieve better oversight by governments. In some countries, it will also be a challenge to make government positions sufficiently attractive to retain staff once they have been trained, rather than lose them to oil companies.
Governments may lobby the international oil companies operating in their countries to provide technical assistance and training to governments. Often, existing oil production contracts already contain obligations on oil companies to do this; however, these provisions may not have been effectively utilized so far. Discussion should also aim at reducing the complexity of oil production contracts.
Reforms of NOCs’ statutes and structures should refocus activities on oil and gas production. Companies should concentrate on their commercial roles, and managers should be evaluated on their commercial achievements. Companies could be subjected to the discipline of financial markets by floating at least a minority share of assets in stock markets, where they exist. Valuation would make it easy to evaluate the performance of managers and policies.