Briefing Notes 7 and 8 [1,2] gave an overview of different types of contractual arrangements in the upstream petroleum sector and defined key payment streams under production sharing agreements (PSAs). This note, the last in a three-part series, provides quantitative examples of how varying fiscal parameters affect the size and timing of government revenue streams. To this end, the note takes two sets of fiscal parameters—one progressive and the other regressive—and follows revenue streams over the life of a contract.

Two Fiscal Systems

The simulations take a hypothetical field that, over 19 years, produces 100 million barrels of oil. The production profile (Figure 1), associated costs, and financial flow calculation methodologies are taken from [3]. The simulation considers both steady oil price levels and the historical annual price of Brent crude oil—an important marker crude whose price movement is taken as a barometer of the overall oil market—expressed in 2006 U.S. dollars[1] between 1988 and 2006 (Figure 2). The average price in Figure 2 is $30 a barrel. The first year of operation is the year in which the contract becomes effective. It is worth noting that the start of production in Figure 1 is much sooner than what occurs in practice; the exploration period was shortened for brevity in this note.

The two fiscal cases are summarized in Table 1. In both cases, for income tax purposes, straight-line depreciation of capital expenditures over five years is assumed and there is no limit on the recognition of expenses incurred for petroleum operations, which may be carried forward from one year to the next until they are fully recovered. For computing the government’s share of profit oil in production sharing, a ceiling on cost recovery is imposed in one case. Smaller payments, such as surface rental and other fees, are omitted for simplicity.

The first case considered is regressive: royalty, tax, and production sharing rates do not increase with increasing net-of-cost income. There is a signature bonus of US$20 million, the royalty rate is fixed at 10 percent, and cost recovery for production sharing is restricted to 60 percent in any given accounting period. All these provisions are designed to ensure early revenue. The government receives 70 percent of profit oil. After these payments, the contractor pays an income tax of 30 percent on profits derived from the remaining income.

The second case does not have a signature bonus and has sliding scale royalty and production sharing schedules, the details of which are shown in Table 2. The royalty rate does not reach 10 percent, the rate set in case 1, until the extracted oil fetches at least US$25 a barrel. As the oil price increases, however, the royalty rate rises with it and reaches a maximum of 40 percent above US$60 a barrel, considerably above that in case 1. The government’s share of profit oil increases as the contractor’s internal rate of return (IRR) increases. As Briefing Note 8 described, this sliding scale production share makes this PSA a rate-of-return contract. The government share is zero if IRR is 20 percent (in practice, and especially in new PSAs, the government shares production from the outset), and is only 40 percent when IRR is between 20 and 30 percent. The government’s share rises rapidly above this threshold, and is as high as 90 percent when IRR exceeds 50 percent. In case 2, an income tax of 30 percent is paid before profit oil is shared.

Impact of Different Price Levels

Constant oil price scenarios

Calculations were carried out assuming different constant oil price levels. In each scenario, a constant oil price was assumed during the entire life of the contract, and the same calculation was repeated at seven price levels, ranging from US$20 to $80 a barrel.

Figure 3 shows the percentage of net-of-cost income that flows to the government. Each price level represents a scenario run. Annual revenues were computed using discounted cash flow analysis to take the time value of money into account (see Briefing Note No. 7). The discount rate used in this note was 12.5 percent. The percent received by the government was computed by dividing the aggregate discounted government revenues by total discounted receipts from the sale of oil minus total discounted expenditures (that is, net income).

It is immediately clear from Figure 3 that the two fiscal systems are very different. In case 1, the percent received by the government declines with rising oil price, whereas the reverse is observed in case 2, clearly illustrating that case 1 is regressive, case 2 progressive.

Figure 4 shows the contractor’s rate of return, which is a measure of profitability. In case 1, the rate of return is markedly lower than that in case 2 at low oil prices, but the two curves cross near US$45 a barrel above which case 1 gives higher rates of return. That is, case 1 is unattractive to investors in a low oil-price environment but very attractive if oil prices soar.

What these two figures illustrate is that a progressive regime is more likely to assure a reasonable return to investors even when world oil prices are low (or alternatively in high-cost fields, such as marginal fields), but limits the amount of profits that the contractor can earn in “good times.” Conversely for the government, a progressive regime may provide less revenue when times are tough—low oil prices, high production costs, or both—but provide more income if the project becomes profitable.

Impact on Revenue Flow

Figure 5 shows annual government revenues using the oil price history shown in Figure 2. This assumes that the price of oil extracted in this hypothetical field fetches the same price as Brent. There are marked differences between the two cases during the first five years. In the first year, the government receives a signature bonus of US$20 million in case 1 but nothing in case 2. The government receives no revenue in year 2, and in practice years of little revenue will last longer than a year. As production starts, government revenue rises more rapidly in case 1, but falls below that in case 2 beginning in year 7. Government revenues in case 1 are more front-loaded.

Table 3 compares the overall government revenue over the life of this oil field at different (constant) oil price levels, calculated using discounted cash flow analysis. In case 2, despite being back-loaded, the aggregate revenue is lower than in case 1 below US$40 a barrel, but is 14 percent higher at US$80 a barrel, a highly profitable scenario, The ratio of government revenues is higher for a doubling and quadrupling of oil prices in case 2.

Observations

The two cases discussed in this note illustrate the type of trade-offs that governments have to consider in setting fiscal parameters. So-called regressive parameters are more likely to ensure early revenue as well as minimal revenues in adverse circumstances, but also to discourage investments, especially in marginal fields. Progressive regimes may encourage investments in adverse situations and also increase government revenues in favorable circumstances, but could delay the arrival of government revenues and reduce them if oil prices fall, production costs increase, or both.

Table 3 also illustrates that, as one would expect, the impact of oil price variation on government revenue volatility is amplified if fiscal parameters are linked to profitability indices. But it is difficult to try to control revenue volatility by means of fiscal parameters. A recommended approach is to design the fiscal system to maximize government revenue in the long run, and to use other instruments¾such as oil funds or risk management strategies including hedging¾to deal with revenue volatility.

In all cases, the government’s (and the government’s perception of investors’) assessment of future oil price movements, production cost escalation, and the field’s prospectively (its attractiveness as an exploration target) will influence how to set fiscal parameters for long term government revenue maximization.

This three-part series has had to simplify complex issues for the sake of readability and brevity. The long term nature, large upfront investments, and significant uncertainties surrounding petroleum projects present a considerable challenge to the formulation of the fiscal framework and contractual terms in any country. It is important to note that, because each project is situation- specific, fiscal systems cannot merely be transplanted from one country, area, or project to another; what works well in Algeria may not work well in Cambodia. In this regard, it is important to retain flexibility in fiscal systems¾capable of adapting to changes in market conditions, government policy, and geological and country risks.

References

[1] World Bank. 2007. “Contracts for Petroleum Development – Part 1.” Petroleum Sector Briefing Note No. 7, October.

[2] World Bank. 2007. “Contracts for Petroleum Development – Part 2.” Petroleum Sector Briefing Note No. 7, November.

[3] Daniel Johnston. 2003. International Exploration Economics, Risk, and Contract Analysis. Tulsa, Oklahoma: PennWell Corporation.

(Source: World Bank Newsletter, Petroleum Sector Briefing Note, February 2008)

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Arjun Thapan, director general of the Southeast Asia department of the Asian Development Bank (ADB), which is organising the 15th Greater Mekong Sub-region (GMS) Ministerial Conference in Cha-Am, Thailand, said the economic crisis had highlighted the importance of  intraregional trade in the wake of falling demand  from major trade partners.

“The current economic downturn has probably put growth back at least a couple of years,” he told the Post Thursday from Thailand. “The whole question of creating domestic demand – not in complete substitution of external demand but at least in partial substitution – [is now critical].”

In Cambodia garment exports, which make up around 98 percent of Cambodia’s total merchandise exports, fell 26 percent in the first quarter of the year, based on Commerce Ministry figures.

The US takes 64.9 percent of the country’s total garment exports and the European Union 20.3 percent.

According to the World Bank, intra-GMS trade involving Cambodia is almost nonexistent, with even the garment sector sourcing the bulk of its fabric from outside the region due to trade barriers.

GMS member countries inked a Cross-border Transport Agreement (CBTA) in 1999 in an effort to ease the customs burden by fast-tracking procedures at border-crossings by allowing some goods shipments to be certified as “low risk”. The agreement was part of a much-wider program to invest in the region’s transport infrastructure, but Thapan said it was “very much” delayed.

“We want the ministers to understand that it is behind schedule, and we want them to take note of the fact that their prime ministers have been demanding that at every summit they make progress on implementing the CBTA,” he said.

Sjaak de Klein, country manager for transport company TNT, which added Cambodia into an Asia-wide express services road network in May, said experience showed that removing barriers to trade had a positive impact on trade volumes.

“We have seen it in Laos where better connectivity for the country has led to an increase in trade,” he said, referring to a new highway linking the country to Vietnam.

That has been accompanied by a CBTA inked last week after 10 years of negotiations allowing trucks from Vietnam and Thailand to transit through Laos without having to be unloaded and re-loaded.

Thapan said work was progressing at half-a-dozen pilot border crossing sites under the transport agreement, but none were fully operational and it was still taking around four hours, and up to 10 in some cases, to clear shipments.

“This is not helping trade and it is not helping investment because of the high costs involved,” he said. “We think it’s time for the countries to take an integrated view of both transport and trade facilitation.”

Source: VOA news

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According to the hand-written statement by the council, Dinh La Thang, president of Vietnam Oil company, led a delegation that met Sok An to express the company’s interest in searching for oil in Cambodia, reported The Cambodia Daily.

“Excellency Sok An welcomed the intentions of Vietnam Oil and urge the company to continue to cooperate and hold further discussion with the Cambodian National Petroleum Authority.

Discussion at the hour-long meeting had not been very detailed and did not include the designation of areas for oil exploration, adding that the company had just asked for initial support from Sok An, On Chandar, Information Officer for Council of Ministers, quoted by the Cambodia Daily as saying.

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“This ‘curious coalition’ that we hear about has been remarkably effective in demonstrating what you can achieve through a voluntary and consensus-building process in which governments, civil society, the companies and many others have all felt inspired to play a leading part,” so began the remarks by Richard Paniguin of BP at the EITI plenary conference in London in March 2005 [1–3]. He went on to cite the experience of Azerbaijan, which had pledged to become a pilot country in implementing EITI in 2003.

The government of Azerbaijan’s “strong commitment was based on the understanding that EITI objectives substantially correspond to the government’s development agenda,” stated Samir Sharifov, Executive Director of the State Oil Fund of Azerbaijan, at the same conference. Pointing to support at the highest political level as being essential to effective implementation of EITI, Samir Sharifov highlighted the important role that the November 2004 memorandum of understanding signed by various stakeholders played in developing a workable implementation mechanism in his country.

Of the 27 countries that are at various stages of EITI implementation, 17 are in Africa, 4 are in the Americas, 3 in Central Asia, 2 in East Asia, and 1 in the Middle East. This briefing note begins with Azerbaijan—which has published more EITI reports than any other country— in some detail, followed by the EITI experience of five other countries.

Azerbaijan

Azerbaijan has large and mostly untapped hydrocarbon resources. The government has signed two dozen production sharing agreements to date. The State Oil Company of Azerbaijan (SOCAR) was established in 1992 with the merger of two state oil companies, and is party to every production sharing agreement. Production has been ramping up rapidly since 2004.

The government announced its decision to pilot EITI implementation in June 2003. An Ordinance of the Cabinet of Ministers established an EITI Committee in November 2003 as a section of the State Oil Fund of Azerbaijan (SOFAZ). SOFAZ was established by presidential decree in 1999 and receives a portion of revenue flows from oil, with the balance going directly to the state budget. SOFAZ conforms to modern standards of governance in many respects. Amongst others, it is subject to an annual external audit to international standards, and audit reports are published on its multi-language website. SOFAZ is a winner of the 2007 United Nations Public Service Award, the most prestigious recognition of excellence in public service, in the category of “improving transparency, accountability, and responsiveness in the public service.” The EITI Committee is chaired by the Executive Director of SOFAZ and leads the implementation of EITI.

In most countries, civil society organizations (CSOs) have formed EITI coalitions. CSOs have a crucial role in helping the public understand the importance of oil revenues to a country and how those revenues should be managed. CSOs are also generally involved in the process of appointing an administrator (audit-company) to reconcile payments and revenues. In Azerbaijan, CSOs formed the Coalition of Non-Governmental Organizations for Improving Transparency in Extractive Industry (“NGO Coalition”) in May 2004. At the time, the NGO Coalition issued regulations governing its membership, operations, rights and responsibilities, and procedures. The NGO Coalition maintains a dedicated website in English and Azeri to keep the public and the international community closely informed of all the EITI related activities occurring in Azerbaijan [4].

In November 2004, the government, local and foreign companies, and the NGO Coalition signed a memorandum of understanding (MoU) on EITI in Azerbaijan. Today, 24 extractive industries companies and 75 NGOs are signatories to the MoU. The latter include research institutions, environmental groups, lawyers’ associations, women’s and human rights groups, and societies promoting democracy and transparency.

The Executive Director of SOFAZ publicly credited this MoU, which was signed after almost 10 months of intensive consultations, as one of the crucial elements for the success of EITI in Azerbaijan at the London EITI conference in 2005.

The MoU on EITI defined the rules for the EITI process and disclosure of payments made and revenues received. The MoU stated that the EITI Committee would issue two reports annually: a semi-annual one covering January to June, and an annual one covering the entire year. The MoU established a group to select an internationally recognized audit company through a competitive tender to review and aggregate the reports submitted by the government and participating companies.

The NGO Coalition has been participating in the meetings and activities of the parties to the MoU on EITI. It has also held a number of round-table discussions, workshops, seminars, talk shows, radio dialogues, and training sessions. Training of trainers has been conducted on subjects such as production sharing agreement analysis.

The Coalition has also issued written opinions on EITI reports. In 2006, the Coalition carried out two campaigns: “Oil Revenues are Ours” and “Oil Revenues Are For All of Us.” In the first campaign, the

Coalition hosted a competition for journalists to submit articles on analysis of the estimated expenditures of SOFAZ for 2006, the impact of oil revenues on socioeconomic development, or symptoms of Dutch disease (by which an overvalued currency leads to the shrinking of the traditional export sector, such as garments in Cambodia). The second campaign had an extensive outreach component by means of conferences, roundtable discussions, radio programs, newspaper articles, meetings with representatives of local communities, TV talk shows, press conferences, and distribution of books and posters.

Azerbaijan has published five EITI reports to date, covering the period from 2003 to 2006. The reports summarize payments by payment type but not by company. Aggregated payments are reported separately for foreign companies and local companies. The NGO Coalition has issued written opinions on the last three reports. Commenting on the third report, the Coalition noted that it was the first time all of the oil and gas producing companies in Azerbaijan were included, and urged that payments be further disaggregated by company to facilitate identification of sources of discrepancies.

BP, a dominant private oil company operating in Azerbaijan, independently published the payment data it had reported to the EITI audit company for 2004 in its “BP in Azerbaijan Sustainability Report 2005,” while Statoil, another important player in Azerbaijan, annually publishes payments to government in every country in which they have a significant presence, including Azerbaijan, in its “Statoil and Sustainable Development” reports.

Commenting on the fourth report, the NGO Coalition said that non-reporting by one company that had not joined EITI was one of the sources of discrepancies, and urged full participation by all petroleum companies. In October 2006, the non-reporting company joined EITI.

Other Countries

Cameroon

The Republic of Cameroon made a public commitment to EITI in March 2005 at the EITI plenary conference. In announcing the government’s commitment, Finance Minister Abah Abah said that this “decision was the culmination of a carefully considered process,” pointing to the consultation carried out not only with the stakeholders in the country but also at the sub-regional level.

As a demonstration of the government’s commitment to promoting transparency, Minister Abah Abah also pledged that the government would soon start publishing on its website quarterly information on total oil production, prices, and revenues to the government, and that the national oil company, the Société Nationale des Hydrocarbures (SNH), would start posting on its website the main elements of the company’s audit report prepared by a reputable international auditing firm.

In June 2005, the government issued a decree creating a multi-stakeholder committee in charge of implementing EITI. In September 2005, another decree established a Technical Secretariat in the Ministry of Economy and Finance to coordinate the activities of the multi-stakeholder committee. The government published a fully cost work plan and made it widely available.

The government began publishing past audits of SNH as well as production, sales, revenues, expenditures, and transfers to the treasury. Both of these reports are available on SNH’s website [5]. In November 2006, the first EITI report covering July 2000–December 2004 was published. In March 2007, Cameroon became one of a handful of countries to have published a second EITI report, covering 2005.

Ghana

Ghana, an important mining country, committed to EITI in June 2003. The Deputy Ministers of Mines and Finance are two important champions of the process. The Minerals Commission released revenue figures for the first time in September 2003. The governing body of Ghana EITI (GEITI)—the National Committee—is a multi-stakeholder group chaired by the Ministry of Finance and Economic Planning, and consists of government representatives, two civil society representatives, and one representative from the Ghana Chamber of Mines representing the mining industry (See GEITI website [6] for more information). An EITI Secretariat, which coordinates all EITI activities, resides in the Ministry of Finance and Economic Planning.

The first EITI report covering January to June 2004 was issued in February 2007, nearly four years after the government made a public commitment to EITI. Ghana, like Nigeria [3], has chosen to publish payments and revenues by company and payment type. Although company participation was voluntary, the companies that contributed about 99 percent of the royalty payments (which in turn accounted for 89 percent of the total mining revenue stream) participated. In April 2007, The Ministry of Finance and Economic Planning organized a round table to discuss the findings and recommendations of the EITI report and follow-up actions.

Mauritania

Mauritania, an oil producer, established an oil fund in 2006, enabling clear tracking of oil production and revenues. Mauritania also has significant mineral deposits. In September 2005, Prime Minister Boubacar announced the government’s commitment to EITI. The Prime Minister designated a former finance minister as the EITI coordinator. In January 2006, the government issued a decree establishing an EITI National Committee. The Committee has 30 members and draws a number of its members from the mining industry and civil society, including the international NGO Transparency International. In May

2006, the National Committee held a workshop on EITI aimed at engaging the stakeholders involved in the EITI process and discussing the Committee’s future work program. The National Committee maintains its own website [7]. In March 2007, Mauritania released its first EITI report for 2005, covering both petroleum and mining companies.

Guinea

Guinea, rich in mineral resources, committed to EITI in April 2005. In June 2005, a ministerial decree established a Steering Committee responsible for the technical operation of EITI under the Ministry of Mines and Geology. Half of its members are from the government and the other half from mining companies and civil society. The Steering Committee’s mandate as stipulated in the decree is to organize the data in the mining sector; implement financial, sales, technical, economic, and environmental audits; and publish mining revenues in an accessible and comprehensive manner. In July 2005, the Steering Committee drafted an organizational chart for EITI.

In addition to the Steering Committee, the overall structure of EITI includes a Management Committee (five members including the Prime Minister), a Technical Secretariat, and, falling under the Steering Committee, an Executive Committee (five members) and three sub-committees (statistics, audit, and communication and capacity building).

The EITI process in Guinea has been participatory and consensus-based, facilitating active involvement of all three stakeholder segments: government, mining companies, and civil society. Capacity building activities were undertaken in 2005 to help key people in the public institutions and private companies involved in revenue data management understand requirements of the EITI process.

An EITI report covering 2005 has been published. The process of data collection and reconciliation prompted one mining company to pay income tax in 2006 for the first time. EITI has also fostered a culture of discussion among all the key stakeholders, particularly on how revenue allocation and administration for community development are decided, and significant differences in the fiscal terms in mining agreements from company to company.

Peru

Minerals exports account for more than half of Peru’s total exports. The government committed to EITI in May 2005. An EITI Action Plan drafted by a multi-stakeholder committee was adopted and published on Peru’s EITI website in June 2005. In May 2006, the government published an Executive Decree that approved the EITI Action Plan, created an EITI Working Group which represented the entire stakeholders’ constituency, and provided a legal basis to the implementation of EITI. At the request of industry and CSOs, the Ministry of Energy and Mines has drawn up a Ministerial Resolution establishing criteria to ensure the legitimacy and qualifications of civil society representatives on the Working Group. In December 2006, the EITI Working Group was established. A unique feature of Peru’s EITI process is its plan to carry out audits at the sub-national as well as the national level.

Observations

The experience in Azerbaijan and elsewhere suggests that the more disaggregated the reporting, the more the stakeholders benefit from the process; disaggregation makes it easier to identify where discrepancies are occurring. Azerbaijan’s EITI report for 2005 reinforces the point made in [3] that, if even one company does not submit data, revenues and payments cannot match and it will be more difficult to identify sources of discrepancies. Legislating participation in EITI is one way of ensuring full participation.

Guinea’s experience, as with Nigeria’s [3], demonstrates that, by raising awareness and publicizing independent monitoring of company payments, more effective revenue collection may ensue. This not only increases government revenue, but also contributes to creating a level playing field for companies operating in the country. In the long run, such an outcome helps to strengthen the sector and make it more efficient.

References

[1] EITI website www.eitransparency.org. Email eitiinfo@eitransparency.org.

[2] World Bank. 2007. “Extractive Industries Transparency Initiative.” Petroleum Sector Briefing Note No. 4.

[3] World Bank. 2007. “Country Experience with EITI – Part 1.” Petroleum Sector Briefing Note No.5.

[4] The Coalition of Azerbaijan Non-Governmental Organizations. www.eiti-az.org/ts_gen/eng/index.htm.

[5] www.snh.cm.

[6] GEITI. www.geiti.gov.gh.

[7] www.mauritania.mr/itie.

(Source: The World Bank Newsletter, August 2007)

• Country Experince with EITI-Part I

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We are looking at close to a billion dollars saved,” the Executive Director of Nigeria EITI (NEITI) told news reporters in January 2007, attributing the additional revenues to the close monitoring of the oil companies in 2004 and 2005 under NEITI [1]. EITI, through multi-stakeholder partnerships, supports improved governance in resource-rich countries through the verification and full publication of company payments and government revenues from oil, gas, and mining [2, 3].

If the criterion for being resource-rich is that at least 25 percent of the government’s total revenue or of total export proceeds is from oil, gas, or mining, then 50 countries were resource-rich based on the data from 2000–2005. The region with the largest number of resource- rich countries was Africa (18), followed by the Middle East (11), the Americas (8), Central Asia (6), East Asia (5), and Europe (2). The resource-rich East Asian countries were Brunei, Indonesia, Vietnam, Mongolia, and Papua New Guinea, of which the last two are mineral-rich. Other Asian countries, such as Timor-Leste and Cambodia, are already resource-rich or have the potential to become so in the future. To date, 27 countries have publicly committed to EITI, including Mongolia and Timor Leste in East Asia. Eight countries have issued one EITI report or more. No two EITI programs are alike; each country has adapted and added to the EITI criteria to suit its particular circumstances and objectives.

In terms of scope, the country with the widest coverage is arguably Nigeria, perhaps reflecting the desire and determination to redress decades of oil revenue mismanagement (see [4]). NEITI takes EITI as a starting point and tackles a host of other issues that EITI criteria do not cover (see “EITI in Context” in [3] for what the criteria do not cover). São Tomé and Príncipe and Timor-Leste have legislated revenue disclosure. This briefing note covers Nigeria in some detail on account of its comprehensive coverage, extensive outreach to civil society, and the lessons it offers for the management and accountability of the petroleum sector. It is the first of a two-part series describing the experience of these and other countries.

Nigeria

Nigeria has a long history of oil production and is Africa’s largest oil producer. Oil revenue accounts for more than 40 percent of the country’s gross domestic product (GDP), 80 percent of government revenue, and 90 percent of total exports. President Obasanjo committed the government of Nigeria to EITI in November 2003 and launched NEITI in February 2004.

The NEITI process consists of financial, physical, and process audits. Physical and process audits are not required by the EITI criteria [3], but NEITI has included them to strengthen governance in the sector. The first complete set of reports, covering the six-year period from 1999 to 2004, was published in April 2006; about 2½ years after Nigeria first endorsed EITI. The report represented the most comprehensive audit of the petroleum sector in Nigeria’s history. The administrator (for reconciling payments and revenues; see [3]) for the audit covering 2005 is being contracted. The tender for the 2006 audit, which will include the so-called value-for-money audit of petroleum sector processes— examining whether expenditures are reasonable and prudent—will be issued in the second half of 2007.

The financial audit is at the heart of EITI. The principal benefit streams examined in the 1999–2004 audits were:

• Oil related flows: petroleum profit tax, royalty, gas flaring penalty, reserves additional bonus, and signature bonus
• Non-oil related flows from the petroleum sector: value-added tax, education tax, and withholding and PAYE (pay as you earn) tax to federal and state governments
• Proceeds of sale of crude oil and gas allocated to the government (typically the largest of all inflows to the government), and cash-call payments made by the government (representing financial outflows), in accordance with the government’s equity share in joint venture operations.

The audit covered material payments from 22 companies as well as government financial flows through seven joint venture operations. The findings were reported by company and payment type. This audit also published a report entitled “Issues in Government Financial Systems,” which outlined the difficulties encountered during the financial audit and made recommendations to improve government accounting for better management and control of key revenue sources in the petroleum sector. Subsequent work by the administrator identified weak recording practices in the government agencies as the primary cause of the discrepancies, and reduced the unexplained discrepancies to 0.01 percent [5]. The final audit report was released to the public in December 2006. Inter-agency reconciliation processes have been simplified and improved as a result of using the reporting templates.

The physical audit carried out a material balance on hydrocarbons (oil and gas) in the country—that is, tracing the volume of hydrocarbons from production to the final point of sale. The audit covered hydrocarbons produced, lifted, flared (for gas), lost, refined, and exported; refined products imported; and all refined products supplied on the domestic market. Significant inconsistencies in volumes were found as well as shortcomings in metering and book-keeping. The audit found a systematic loss of crude oil between the wellhead and terminals. Fluctuations in the pipeline flow rates suggested thefts at night [5]. The audit report made several recommendations to strengthen physical accounting.

The process audit reviewed the transparency and efficiency of refinery operations and refined product importation; capital and operating expenditures; oil and gas licensing processes; the process for marketing natural gas; and the process for marketing the federal government’s equity crude oil. A large number of recommendations were made in a series of reports issued under process audits. Thanks to public-awareness raising and publicity in the media, issues such as transparency of the oil licensing rounds have been widely discussed.

In response to these findings and recommendations, President Obasanjo in May 2006 directed NEITI to set up and chair an Inter-Ministerial Task Team to address the problems identified in the audit, including institutional weaknesses, poor record-keeping practices, inadequate accounting systems, and poor interface among government entities. The Task Team was constituted and began meeting in August 2006. The relevant government agencies proposed their own remediation measures, set up study teams, and established an inter-agency committee to ensure consistency of information across the government. Steps are being taken to provide assistance to government agencies to strengthen capacity for interfacing with each other. NETI is now being extended to cover the mining sector [5]. Additional information on NEITI activities is available on the NEITI website [6].

The champion of EITI is the Director General of the Nigeria Geological Survey Agency. A 28-member National Stakeholders Working Group (NSWG), established in February 2004 by President Obasanjo, steers implementation. NSWG draws members from civil society (2 representatives), media (1), government (14), local and multinational companies (3), the private sector (4), the National Assembly (2), and the Houses of Assembly at the regional government level (2). The NEITI Secretariat coordinates the work of NSWG, which has technical, legislative, focal (for capacity building), civil society, and media teams. The civil society team engages the wider public and helps build capacity within civil society organizations (CSOs). Capacity building is aimed at helping CSOs understand how EITI works so that they can ask the right questions; educate their constituency and the general public about the oil industry and its revenues; and gain a better understanding of the data and information contained in EITI reports so that they can disseminate information more effectively. NSWG recognizes the limitations of traditional media (newspapers, television, radio) for rural populations and communication difficulties in a country with more than 500 languages, and places emphasis on dissemination of information through a grassroots-based communication strategy and the engagement of rural communities and regional CSOs. NEITI has conducted several “road shows” around the country to interact with civil society representatives and disseminate information, including audit findings. Training of government leaders, legislature, and civil society on petroleum economics, the flow of funds, and the role of NEITI is underway.

In February 2006, a memorandum of understanding (MoU) was signed between NSWG and CSOs with a view to advancing civil society’s participation in NEITI, ensuring independence of CSOs in the NEITI process, helping to build CSO capacity, and ensuring proper internal communication among CSOs. Civil society involvement in EITI in Nigeria has helped government ensure that the EITI process leads to enhanced revenue collection, encourages all companies to provide revenue data, helps identify possible sources of oil theft, and contributes greatly to strengthening the quality of public debate about oil issues nationally. In June 2007, the government passed an NEITI Bill into law. This legislation guarantees mandatory annual audits of the extractive industries sector; oil companies will be legally required to disclose payments; and the recently established Oil Revenue Monitoring unit will be made formally independent of the Finance Ministry and merge with the NEITI Secretariat.

Legislative Approach to Disclosure

São Tomé and Príncipe endorsed EITI principles in June 2004. The country is not yet an oil producer, but has already taken significant steps to write transparency provisions into legislation. An Oil Revenue Law was unanimously approved by the National Assembly and signed by the president in December 2004. This law requires all oil payments to be deposited directly into a national oil fund held by an international custodial bank. Deposits, withdrawals, and holdings of the fund are made public through a newly established public information office and by posting on the internet. The law requires competitive tenders for oil contracts, makes all oil contracts public, mandates the inclusion of anticorruption and transparency provisions in contracts, and declares null and void those confidentiality clauses in oil contracts that are at variance with the transparency requirements of the law. There is therefore a firm legal basis for São Tomé and Príncipe to implement EITI once commercial production starts.

Timor-Leste is a new natural gas producer. Like São Tomé, Timor-Leste has also taken significant steps to ensure transparency in its petroleum sector, and involved civil society in the process. In October 2004, the government released a “Public Consultation Discussion Paper on Establishing a Petroleum Fund for Timor-Leste.” A series of public consultation sessions were held in every district of the country and written comments were submitted. The government released a draft Petroleum Fund Law in January 2005 and further public consultation followed, including testimonies given by CSOs before the Parliament. The Law was passed unanimously in June 2005.

The law requires all revenues associated with petroleum operations to be deposited into the newly created Petroleum Fund. The law cites transparency as a fundamental principle. It stipulates that quarterly reports on the performance and activities of the Petroleum Fund must be published, and that an internationally recognized accounting firm be appointed as an independent auditor of the Petroleum Fund. The auditor’s annual report, which states the aggregate amount of payments made by each payer, must also be published. A consultative council that includes members of civil society and the business community is tasked with advising the Parliament on matters related to the Fund’s performance and operation, and effective use of appropriations from the Fund. According to the law, monies from the Fund spent by the government (in accordance with the “estimated sustainable income”) must flow through the state budget.

The government of Timor-Leste has set up a Petroleum Transparency website in English, Portuguese, and Tetum (a local language) [7]. Posted on the website are the quarterly reports on the Petroleum Fund, various laws related to the petroleum sector (Petroleum Act, Petroleum Taxation Act, Petroleum Fund Act), model production sharing contracts, and sample contracts and their amendments, as well as an earlier version of the Petroleum Fund Act and various comments submitted on the Petroleum Fund discussion paper. Such commitment to disclosure by the government helps build a general climate of accountability and transparency in the sector. The first meeting of the national EITI working group was recently convened in Dili.

Other Countries

Mongolia

Mongolia is the second of the two East Asian countries implementing EITI. A significant producer of copper and gold, Mongolia committed to EITI in December 2005. It has made rapid progress in the last 18 months and has established a multi-stakeholder working group as well as a work plan. Mongolia is currently in the process of setting up a secretariat, whose first task is to appoint an administrator.

Kazakhstan

Kazakhstan, the largest oil producer in Central Asia, committed to EITI in June 2005. Kazakhstan is where Mongolia is in the EITI process, having created a multi-stakeholder working group and a work plan, and being in the process of establishing a secretariat.

Gabon

Oil accounts for about one half of GDP, two thirds of government revenue, and 80 percent of total exports in Gabon. Gabon committed to EITI in March 2005 after issuing a ministerial decree to establish an EITI Working Group a month earlier. The Working Group includes representatives of all administrations involved in oil revenue collection and management. A stakeholders’ group responsible for EITI implementation is chaired by a representative of the President’s office and includes representatives from the prime minister’s office, ministerial departments, civil society, the oil sector, and the mining sector. A website was launched in October 2005 and the government published, in December 2005, an EITI report covering 2004. The stakeholders observed that the first EIEI report omitted a major revenue stream, which was subsequently included in the second report. However, not all oil companies have reported, and the administrator has not made attempts to reconcile the discrepancies between payments and revenues.

Observations

Nigeria’s first EITI report was ambitious and covered six years and a range of issues beyond payments and revenues. By publicly highlighting the weaknesses that needed attention, NEITI has already achieved the objective of quantifying where the gaps are, identifying the likely causes, and recommending remedial actions. Nigeria’s experience also suggests that, by providing greater scrutiny over revenue collection, EITI can lead to increased (or more efficient) revenue collection.

Gabon’s experience shows that one barrier to providing an adequate level of detail in reporting is poor availability of data on financial flows. It also shows that, absent a legal obligation to report, participation of all companies, without which meaningful comparison of payments and revenues cannot be made, may be difficult.

References

[1] Vanguard. 2007. “Extractive Industries Transparency Initiative saves $1 billion.” January 2.

[2] EITI website www.eitransparency.org. Email eitiinfo@eitransparency.org.

[3] World Bank. 2007. “Extractive Industries Transparency Initiative.” Petroleum Sector Briefing Note No. 4.

[4] World Bank. 2007. “Avoiding the Resource Curse.” Petroleum Sector Briefing Note No. 3.

[5] Bright Okogu. 2007. “Implementing EITI: The Nigerian Experience.” www.geiti.gov.gh/downloads/nigerian_experiences_with_EITI_presentation_bright_okogu.pdf.

[6] NEITI. www.neiti.org.

[7] www.transparency.gov.tl.

(Source: The World Bank Newsletter, Special Supplement: Gas & Oil, July 2007)

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How have some resource-rich countries managed to avoid the resource curse? Nigeria and Indonesia make an interesting comparison. They exported comparable amounts of oil in the first half of the 1980s. Both have large populations and regional and ethnic tensions. Yet Nigeria, despite being the world’s sixth largest oil exporter in 2005, has one of the poorest populations in sub-Sahara Africa and come to epitomize what can go wrong with oil wealth, while economic growth in Indonesia until 1996 has won praise. And this enormous difference in outcome is not because Indonesia had inherent advantages over Nigeria before the first oil boom of 1973–74. In fact, the initial conditions in Indonesia were anything but favorable: a military regime that came into power in 1966, a low adult literacy rate, high levels of ethnic and linguistic diversity which can lead to conflicts (see [1] for the impact of oil wealth on civil strife), and pervasive corruption.

This note describes and contrasts some of the policies implemented by Nigeria, Indonesia, Malaysia, and Botswana in response to large inflows of resource revenues, and their consequences.

Nigeria

In 1970, Nigeria had an active private sector and a large labor force, holding great promise to become the region’s economic power house. Successive governments have embraced three common objectives: economic growth, greater domestic participation in both the oil and nonoil sectors, and more equitable distribution of income across ethnic groups and regions. As the first oil boom of 1973–74 began to generate substantially larger state revenues, the government initially tried to save excess income. But this attempt at saving was short-lived. As the size of the new oil wealth became widely known, political pressures to spend all of it at home mounted and the government soon accelerated spending as if the high oil prices were permanent.

Budget deficits grew, and, encouraged by projections of continually rising oil prices, the government began to borrow abroad. These foreign debts soon became unsustainable.

During 1975–1980, the government gave priorities to infrastructure (transport and communications); mining and manufacturing; agriculture and water supply; and health, education, and housing, in that order. Spending on primary education was greatly increased, and one major achievement was the use of oil income to fund almost universal primary education. Although self-sufficiency in agriculture was the desired goal, investment in agriculture declined. In other areas, many projects were quickly started without due attention to their economic viability, coordination, or sequencing, and with few safeguards against waste and corruption.

The second oil boom of 1979–80 prompted another spending spree, giving rise to higher salaries and new investment projects, including construction of the new inland capital, Abuja. The lion’s share of investment in agriculture and industry went to a few large, high-cost projects such as steel, irrigation, and fertilizer production. The policy of maintaining a relatively low interest rate, combined with rising wages and the appreciating exchange rate (see [1] for a discussion on Dutch disease), encouraged capital-intensive industries based on imported inputs. These distortions and inefficiencies in the economy slowed down competitive industrialization and the share of industry in gross domestic product (GDP) actually fell from 19 percent in 1974 to 10 percent in 1994.

After 1980, oil revenues collapsed and real income per person fell sharply. The income from oil exports in Nigeria was among the most volatile on account of fluctuating oil production—exports more than halved between 1979 and 1983—in addition to oil price volatility, plummeting from a high of US$25 billion in 1980 to a low of $6 billion in 1986. During the oil booms, the Nigerian currency appreciated and agricultural exports halved. Poor policy choices amplified the adverse effects of oil revenue volatility, making the investment climate extremely unattractive.

In the face of mounting economic difficulties, the new military government that came into power in 1983 imposed a program of fiscal austerity, including across the board budget cuts, reduced imports, and foreign exchange rationing. The wage bill could not be reduced for political reasons, and budget cuts resulted in many unfinished projects. Continuing deficits and emerging debt-servicing problems led the government to adopt a structural adjustment program in 1986. But downsizing the public sector and improving fiscal administration again proved politically difficult. The third oil boom of 1990 led to more public spending [2].

Like many large oil exporters, Nigeria has historically subsidized fuel prices. This has not only carried an enormous cost, but led to a widespread black market, smuggling of subsidized fuels to neighboring countries, inadequate financing to maintain and modernize domestic refineries, and frequent fuel shortages coupled with price spikes that hurt consumers and especially the rural poor. Cheap fuels have also encouraged non-essential and inefficient fuel consumption. Increasing fuel use, together with smuggling, raise “apparent” domestic demand—fuels smuggled out of the country are not actually consumed on the domestic market but appear in the statistics as domestic consumption—and cut oil exports, reducing revenue to the government.

Agricultural performance in the 1970s and 1980s fell far short of the goal of self-sufficiency. Despite efforts under the “Operation Feed the Nation” in the 1970s, Nigeria—once a modest exporter of farm products—became a large net importer of food by the early 1980s. A lack of clarity in land ownership rights; public spending targeting urban rather than rural infrastructure; cheap food imports thanks to the stronger exchange rate; loss of skilled workforce to migration to urban areas; and inefficiency in the distribution of domestic inputs and technical support contributed to this disappointing outcome. The quality of economic policy in Nigeria progressively deteriorated after 1990. Business activity was affected by personal ties and endemic corruption. Some suspect General Abacha alone of having stolen an estimated US$2.2 billion of government revenue during his presidency between 1993 and 1998 [3].

Nigeria returned to civilian rule following the elections of 1999 and has been making concerted efforts to tackle corruption and accelerate development. In 2004 an Economic and Financial Crimes Commission was established, which began trying people for corruption in a civil court for the first time. The government has adopted an oil-price-based fiscal rule that mandates saving excess oil income when world oil prices rise above a reference price. Allowing corruption to fester for decades, Nigeria has not found it easy to root it out. Oil still provides some 85 percent of the government’s revenue and continues to be a source of strife and mismanagement. Nigeria has publicly demonstrated its commitment to revenue transparency by launching the Nigeria Extractive Industries Transparency Initiative, which will be discussed in future briefing notes.

Indonesia

In the mid-1960s, Indonesia was one of the poorest countries in the world, with large government deficits and hyper-inflation nearing 1,500 percent a year at one point. President Suharto came into power in 1966. Despite being a military one with high concentration of power in the president, the Suharto government gave priority to economic growth, emphasizing infrastructure, education, capital-intensive industry, and, above all, agriculture to which an unusually high proportion of government spending was allocated.

President Suharto appointed a team of five economic advisers, all academics drawn from the Faculty of Economics at the University of Indonesia. They were technocrats, well educated and competent, and exerted considerable influence. Focusing on macroeconomic stability and tight control over inflation and budget deficits, the government brought down inflation drastically by 1969. President Suharto’s 31-year grip on power, which could have led to economic failure, enabled a long-term view and continuity in policy-making.

Agriculture, which accounted for three-quarters of total employment in the early 1960s, played a key role in the country’s growth and poverty reduction. During the first oil boom, the government allocated about 20 percent of its investment expenditure to agriculture, compared to only 2 percent in Nigeria. The government gave large subsidies to inputs (fertilizers, pesticides); invested in irrigation, roads, and schools in rural areas; and helped stabilize rice prices. Fortunately for Indonesia, the timing of these policies coincided with the Green Revolution, which introduced high-yielding crop varieties. Oil revenues funded fertilizer subsidies and spread of high-yielding varieties. These helped raise rice yields in the late 1970s and early 1980s and Indonesia turned from having to import almost a third of the world’s traded rice in some years to self-sufficiency by 1985, a goal earlier considered unattainable by many.

The country was also “helped” by Pertamina’s financial scandal of 1975. Pertamina, Indonesia’s national oil company, failed to repay its loans in 1975 after making extensive and diverse business investments and accumulating some US$10.5 billion in debt, equivalent to almost 30 percent of Indonesia’s GDP. This scandal greatly diminished Pertamina’s reputation and political influence, delayed overly ambitious and risky investments in the oil sector (and when oil prices fell in the 1980s, there was still time to cancel the planned projects), and strengthened the hand of reformers.

When oil prices fell in the early 1980s, the government reacted swiftly with a series of measures that combined expenditure reduction, exchange rate devaluation in 1983 and 1986, and economic reform. The response was dramatic. Between 1983 and 1992, the share of manufactures in total merchandise exports rose from 7 percent to nearly 50 percent. Some officials have even come to regard the collapse of world oil prices as a blessing in disguise.

This is not to say that all economic policies were sound. The government has maintained large fuel price subsidies (prices were more than doubled in 2005, but the total subsidy bill in 2006 is still an estimated US$7 billion) and this has had similar negative effects to those in Nigeria. The financial crisis of 1997–98 affected Indonesia more than other Asian economies, and some analysts argue that the way the country’s rapid growth interacted with weak institutions contributed to the severity of the crisis [4]. Nevertheless, Indonesia illustrates how a major oil producer has overcome unfavorable initial conditions and temptations to squander oil windfalls to achieve impressive economic gains.

Malaysia is endowed with diversified natural resources that include oil, rubber, tin, and palm. Like Indonesia and Nigeria, Malaysia faced ethnic tensions, but the government deliberately pursued a policy of improving the welfare of the majority group, Buminputeras, who were rural and poorer than other groups.

A critical element of success was the high savings rate that made capital available for investment. Households were frugal by nature, and in addition workers were required to contribute to a compulsory savings scheme. Government expenditures favored education, housing, and health, and achieved a geographically balanced distribution.

Malaysia promoted export-oriented manufacturing from the early 1970s. One unsuccessful policy was use of oil income in the early 1980s to launch heavy and chemical industries (vehicles, steel, and cement) by public sector companies enjoying government protection. This policy led to economic difficulties. The size of the public sector doubled between 1966 and 1981. The recession of the mid-1980s returned the country to private sector- led economic development.

Instead of import substitution, Malaysia pursued economic diversification and export-oriented industrialization. Sensible economic policies were formulated and implemented by professional civil servants, academics, and technocrats. In the early stage of development, the government focused on labor-intensive industrialization utilizing workers from rural areas. Fortunately, around that time, multinational companies were relocating manufacturing to developing countries where wages were lower. To supply skilled workers to the rapidly expanding manufacturing sector, the government allocated a substantial portion of the budget to education.

As a first step, the government provided free primary education. Secondary education was expanded in line with progress made in primary education, and the enrollment tripled from 1960 to 1990 [5].

At the time of independence in 1966, Botswana was extremely poor. Botswana is not an oil producer but is the world’s largest producer of gem-quality diamonds. A small country, Botswana ranks among the most successful resource-rich countries, thanks to prudent fiscal policies toward managing revenue generated from diamond mining. Much of the diamond income has been spent on infrastructural development, education, health, and agriculture, and little on “prestige” projects.

To assess its fiscal performance, the government has constructed an index called the budget sustainability ratio. It is the ratio of non-investment spending (that is, consumption) to non-mineral revenue. A ratio greater than unity indicates that the government is using mineral revenues to finance consumption, which is unsustainable in the long run.

In 1972, in the same year the commercial production of diamonds began, the government established a fund to save excess revenues abroad to finance budget deficits in times of need, and introduced an incomes policy specifically designed to prevent mining wages from pulling up general wages. Consensus politics has evolved and taken hold in Botswana, leading to a high level of transparency in public revenue collection and expenditure. The ruling elite has left technocrats and professional civil servants (who were among the best educated) alone to implement sensible policies.

The government has historically had a reputation for being relatively clean, but a number of scandals broke out in the early 1990s. In response, the government established a Directorate of Corruption and Economic Crime in 1994 to good effect. Corruption has remained well below levels seen in most other developing countries. Table 1 ranks countries in order of increasing corruption according to a perception index compiled by Transparency International. In addition to the countries surveyed in this note, Saudi Arabia—the world’s largest oil exporter—and Iceland—perceived to be the least corrupt—are included for comparison.

Conclusions

Until recently, the economic trajectory of Nigeria reflected many policy errors and deteriorating governance generally considered responsible for the natural resource curse: large expenditures on dubious prestige projects, a growing public sector that is not able to contract in times of low oil prices, and outright thefts of oil revenue, to mention a few. In contrast, Indonesia has managed to achieve a four-fold increase in GDP per person through political stability, good economic policy, rapid productivity improvement in agriculture, poverty-focused policies, and an effective response to large oil revenue volatility. Indonesia, Malaysia, and Botswana have all relied on highly trained technocrats and given them relative autonomy to run the economy. These examples illustrate that the resource curse is not inevitable, but also that a strong political will and commitment to sound economic policies, sustained over many years, are needed to avoid it.

References

[1] World Bank. 2007. “Oil and Gas: A Blessing or A Curse?” Petroleum Sector Briefing Note No. 2.

[2] Amuzegar, Jahangir. 1999. Managing the Oil Wealth: OPEC’s Windfalls and Pitfalls. New York: I.B. Tauris Publishers.

[3] Pan, Esther. 2005. “The Pernicious Effects of Oil.” Council on Foreign Relations. www.cfr.org/

publications/8996/pernicious_effects_of_oil.html.

[4] Temple, Jonathan. 2001. “Growing into trouble: Indonesia after 1966.” http://ksghome.

harvard.edu/~drodrik/Growth%20volume/ Temple-Indo.pdf.

[5] Auty, R.M. Resource Abundance and Economic Development. 2001. Oxford: Oxford University

Press.

(Source: The World Bank Newsletter, Oil and Gas, May 2007)

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Q: Oil and gas is very much in the news in Cambodia today. We understand that this is your first mission to Cambodia. What is the purpose of this mission?

This is primarily a fact-finding mission for me. The Oil, Gas, and Mining Policy Division, to which I belong, has done a lot of work in oil-producing countries, but this is a complex area and there is no “one policy-fits-all” solution to managing oil revenue well. First I have to understand the country-specific situation.

Q: We have heard quite a bit about the so-called resource curse. What is it? What can we do to avoid it?

A: When people hear that great mineral wealth has been discovered in their country, most people assume that this can only mean good news, but sadly the opposite is often the case. The “resource curse” refers to the general observation that, since the 1970s, countries rich in natural resources (particularly oil, gas, and minerals) have achieved a slower rate of economic growth than resource-poor countries.

Oil in particular generates a huge revenue stream for the government, but the number of taxpayers contributing to the oil revenue is small. This makes the government feel less accountable to its citizens, and often leads to worsening governance. Large oil exports, bringing in lots of foreign currency, can lead to a rise of the local currency in a way that makes other exports less competitive.

This may adversely affect Cambodia’s garment exports, for example. Also, oil revenue is extremely volatile and unpredictable, making it difficult for even the most responsible of governments to handle it well. But such problems are not inevitable. Among developing countries, Botswana, Chile, Indonesia, and Malaysia have largely avoided them. These governments have followed a prudent fiscal policy much of the time.

Q: Every year, around 30,000 people enter the labor force in Cambodia. Can the new petroleum industry in Cambodia create jobs for them?

A: The petroleum industry is capital intensive but employs very few people. This makes it all the more important for the government to manage oil revenue well. The benefit of the petroleum industry for job creation will be indirect: sound fiscal policy leading to higher economic growth, resulting in more jobs.

Q: We hear the government revenue will increase by a huge amount once production starts, and especially after the initial investment costs are recovered. But, at the same time, people here are worried about how the revenue will be managed. What lessons are there from other countries?

A: It is important to have adequate checks and balances safeguarding the revenue and its management. Experience elsewhere shows that it is often difficult to avoid large-scale corruption. Increasingly, oil producing countries are recognizing the importance of transparency through disclosure and dissemination of information to the public. For example, a growing number, including Nigeria, are now implementing the Extractive Industries Transparency

Initiative, whereby all payments made to the government and all revenues received are separately and independently audited, the figures verified, the two sets of figures reconciled (the two numbers should match), and finally the audit results are published on a regular basis.

In this way, citizens can see exactly how much money was received by the government, and hold the government accountable for how it spends the money. If the amount of the extra revenue flowing to the government is very large, the government may find it difficult to spend all of it well. For this and other reasons, some countries have decided to save a portion of the money: for a rainy day (for example, the price of oil could collapse, resulting in a large reduction in government revenue one day), for an unforeseen disaster (such as tsunami), or for future generations.

Q: What is the World Bank doing in the oil and gas sector in Cambodia?

A: We are working closely with a number of donors to ensure that our assistance to the government is well coordinated. The donor group can share lessons from other petroleum-producing countries, help the government tailor the lessons to the Cambodian situation, help strengthen institutional capacity across a number of ministries and institutions to manage oil revenue well, and help ensure there is widespread public scrutiny and debate to help guard against bad practices and promote good uses of revenues.

(Source: The World Bank Newsletter, Number 4, Volume 6, June 2006)

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Surging world oil prices since the end of 2003 have prompted many governments of net oil importing countries to consider various ways of reducing dependence on imported oil through conservation and energy diversification. For net oil exporters, much higher revenues are welcome news overall but pose a considerable challenge in how best to spend the extra income sustainably in the long-term interest of society. Recent rises in petroleum[1] prices have spurred many new exploration activities. Spending on worldwide exploration and production is estimated to have risen 30 percent in 2006 to US$268 billion [Upstream, 2007]. Natural gas prices have risen with oil prices.

Natural gas can be produced during oil production—in which case it is called associated gas because it is associated with oil as it is extracted—or on its own (called non associated gas). Consumption of natural gas, which offers many environmental benefits, has been growing faster than that of oil.

World consumption of oil in 2005 amounted to 82.5 million barrels[2] a day and 2.7 trillion cubic meters (equivalent to about 47 million barrels a day of oil) of natural gas. At the end of 2005, it was estimated that world oil production could be sustained for another 41 years if no more oil was discovered and the rate of production remained the same. The corresponding number of years for natural gas was 65 years [BP, 2006]. Oil and gas consumption has been growing faster than the rate of their discoveries, raising concerns about long-term petroleum supplies.

Crude oil is almost never used as produced. It is refined to make “white” products—liquefied petroleum gas (cooking gas), gasoline, kerosene, and diesel—and residual fuel oil. Worldwide, demand for white products is growing much more rapidly than that for residual fuel oil (used to generate electricity or heat).

The petroleum industry is commonly considered to comprise upstream and downstream sectors. Upstream involves exploration, development, and production of oil and gas. During exploration, wells are drilled in search of an undiscovered pool of oil or gas. If a commercial discovery—demonstrated to contain reserves that justify the investment of capital and effort to bring the discovery into production—is made, some development work is carried out until commercial production can begin.

Ownership of petroleum resources is typically specified in legislation or in the constitution. With the exception of the United States, oil that is underground is considered to belong to the state in all countries. After oil is extracted out of the ground, title to the oil is typically transferred, at a point agreed upon with the state, to the producer who can sell it freely and retain a portion of the earnings. Downstream covers transport, refining, petrochemicals, distribution, and retail. This note first discusses the upstream sector, followed by a section on downstream.

Oil Price Volatility

Crude oil and petroleum products are widely traded and effectively have a single price after allowing for transportation costs and quality differences. One characteristic of oil that is much talked about is its price volatility. Figure 1 shows annual world oil prices from 1960 through 2006 in nominal and real terms.

Nominal prices represent prices paid by consumers at the time of purchase. Real prices take nominal prices and adjust them for inflation (rising cost of living) over time. For example, $1 in 1960 would have been worth 6.6 times more in 2005. This means that the average oil price of $1.9 a barrel in 1960 is equivalent to $12.59 a barrel when expressed in 2005 U.S. dollars. In real terms, oil prices averaged US$32 per barrel between 1960 and 2006. There were large price swings during this period, ranging from a low of $9 in 1970 to a high of $88 a barrel in 1980.

For several decades now, oil prices have stayed far above production costs. Saudi Arabia, the lowest cost producer, can produce oil and deliver to the nearest port for about US$3.50 a barrel. The difference between the market price of oil and the price needed to induce oil production—that is, the price above which oil production occurs because it is profitable—is called “rent,” which is a measure of excess profit. Even at $30 a barrel, oil production was already handsomely profitable; world oil prices were more than double that in 2006.

Oil has a large rent, meaning it is extremely profitable to engage in oil production and sale. How this large rent should be split between the oil company and the government is an important policy and strategic question. All governments want to maximize their revenues, but if they try to keep too large a proportion of the rent, few investors will sign contracts for exploration and production. An even more difficult challenge is how to spend the oil rent, once received, for sustainable economic development.

Factors Affecting Supply and Demand—And Oil Prices

The price of any commodity goes up if supply falls short of demand, and conversely falls if demand exceeds supply. Crude oil prices behave no differently. Political events, weather, and other factors affect the supply-demand balance. The two largest spikes in oil prices in Figure 1—1974 and 1980—were both caused by political events disrupting oil supplies: the Arab oil embargo following the Yom Kippur war fought between Israel and a coalition of Arab forces in October 1973, and the Iranian revolution which began in 1978 and which resulted in a reduction of 3.9 million barrels a day of crude production by 1981.

A very important determinant of world prices unique to the oil industry is the policy of the Organization of Petroleum Exporting Countries (OPEC). Formed in 1960, OPEC today consists of 12 large oil producers: Algeria, Angola, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates, and Venezuela.

They account for about 40 percent of world oil production and hold two-thirds of proven reserves. Since 1982, OPEC has been setting oil production quotas for its members in an attempt to ensure that oil prices do not fall too low from overproduction, or rise too high from under-production. If oil prices rise too high, high energy costs could cause a worldwide recession, which in turn would reduce demand and potentially lead to an oil price collapse.

Although OPEC members produce less than half of global oil, it holds the majority of the world’s spare capacity. This means that only OPEC can increase or decrease production at will. OPEC’s united production policy through quotas (even if compliance is an issue), ability to adjust supply, and relatively high share of global oil production give it an enormous ability to affect world oil prices.

Sweet and Sour

Although a single price is often quoted in news reports, there is a variety of crude types and associated prices. Two most commonly quoted benchmark crude prices are for Brent, produced in the North Sea, and West Texas Intermediate (WTI), produced in the United States. They are both light and “sweet.” “Sweet” and “sour” are two words used to indicate the amount of sulfur in a given crude oil. If the level is relatively low (say less than 0.5 percent), the crude is sweet; conversely, if there is a lot of sulfur, the crude is sour. Heavy crude yields proportionally more residual fuel oil than light crude.

The lightness of crude is indicated by a measure of density called API gravity. API gravity is specific to the oil industry; the higher the API, the lighter the crude. Brent contains 0.35 percent sulfur and has an API of 39.5; WTI contains 0.32 percent sulfur and has an API of 39.0. An analysis of the samples from the wells drilled by Chevron in Cambodia in 2004–05 reportedly had an API gravity of 44, which would make the analyzed crude very light.

The lighter and sweeter the crude, the easier and less costly it is to refine it into usable products. Demand for white products as well as for products with low levels of sulfur has grown rapidly in recent years. Against this backdrop, the supply of light, sweet crude has been declining. The price difference between sweet and sour crude oils has, as a result, been widening in recent years.

In August 2006, WTI spot prices averaged US$73.68 a barrel, but Mexican Maya, which is heavy and sour, averaged $58.83, giving a price difference of $17.85 a barrel in that month.

Special Case of Natural Gas

Oil and gas are often discussed together but in many respects they are very different commodities.

• Ease of transport Oil, being a liquid, is easily transported by ship, rail, and truck. Gas takes up too much space if it is to be transported by truck or ship as a gas. Natural gas is transported in pipelines, but for very large distances crossing water, natural gas is cooled to –163ºC and carried in specially designed sea vessels as liquefied natural gas (LNG). The infrastructure for LNG costs billions of dollars and requires liquefaction plants at export terminals and re-gasification plants at import terminals. Once gas arrives at a market, it requires a distribution pipeline network. All this makes natural gas much more expensive to transport, distribute, and store than crude oil and refined liquid products. This means that potential markets for gas are significantly more restricted than for oil. As a result, half of the world’s discovered gas has not been commercialized. Today, more than 150 billion cubic meters of associated gas are estimated to be flared (burned) or vented annually because there is no financially viable market for the gas.
• Size of rent Natural gas typically has a much smaller rent than oil.

As with oil, gas exploration and production is capital-intensive with high upfront costs, but market prospects are much less certain for gas. For this and other reasons, gas development and commercialization take longer than oil development.

Where a market for natural gas does exist, natural gas is the fuel of choice for many applications. It is much cleaner than liquid fuels, emitting far fewer fine particles than diesel or residual fuel oil when combusted. Fine particulate matter causes serious respiratory (lung-related) illnesses and premature deaths, and is the most serious pollutant in many developing country cities.

On the global environmental front, switching from coal to natural gas in power generation halves emissions of greenhouse gases (gases that are considered responsible for global warming). Another advantage of natural gas in the power sector is the higher efficiency that can be achieved. Power plants fueled by residual fuel oil may achieve thermal efficiencies of 38–40 percent and coal-fired plants have historically achieved efficiencies of 33–38 percent. Against these numbers, combined cycle plants using gas turbines typically achieve 50–55 percent efficiency. Higher efficiencies mean that more fuel is used to make electricity and less fuel is wasted in the production process.

Downstream Oil and Gas

Crude oil is taken to a refinery and processed into various fuels, solvents, lubricating oils, asphalt, and coke. Complex refineries are designed to maximize production of white products by “cracking” residual fuel oil, but they are more expensive to build and operate, and have larger economies of scale (that is, smaller refineries are proportionally more costly than larger ones, so that the refinery has to be very large to be profitable) than simple refineries. Simple refineries do not convert residual fuel oil into white products nor can they make ultra-clean fuels. These limitations have made small, simple refineries more and more uneconomic. Increasing economies of scale mean that there are fewer and larger refineries today than in the past.

The first call on natural gas is large-scale applications, such as power generation and industrial use. Large scale applications are attractive because laying down a large pipeline to one destination (such as a giant power plant) is much cheaper than laying down a complex network of small-diameter pipelines to serve numerous small users (such as households, restaurants, and shops). In industrial applications, natural gas is a feedstock for fertilizers and chemicals such as ammonia and methanol. Residential and commercial use of natural gas includes space heating, cooking, water heating and commercial cooling. Natural gas is also compressed and used as an automotive fuel in the form of compressed natural gas (CNG).

Competition is usually possible in theory at most stages across the supply chain in oil and gas. One notable exception is gas transmission (that is, transporting gas over long distances) and distribution, which exhibit characteristics of a natural monopoly. A natural monopoly occurs when one firm can meet most or all of market demand and still achieve a lower average unit cost than if there are two or more firms in the industry. That is, there is great scope for economies of scale over a very large range of output. In transporting natural gas, it would be much more economic and efficient to lay down one large-diameter pipeline, even if that means no competition, than four parallel pipelines of small diameter, together amounting to the same total capacity.

Where the most efficient production and operation is through a monopoly, economic regulation by the government becomes very important, so that the monopoly operator does not extract a “monopoly rent”—that is, gaining a profit far in excess of what might have been realized if there was effective competition—from consumers.

Oil and Gas in Cambodia

In January 2005, Chevron announced Cambodia’s first significant petroleum discovery, stating that it had found oil in four exploration wells and gas in one well during a six-well program in an offshore area called block A. Appraisal work is ongoing to obtain a better estimate of how much oil and gas block A is likely to contain and their quality. The results are expected some times this year.

International experience suggests that the most important role for the government is regulation of the sector to ensure—where competition is possible—fair and vigorous competition in a level playing field to safeguard the interests of both producers and consumers as well as the environment, and economic regulation to mitigate potentially adverse effects of natural monopolies.

This is the first in a series of briefing notes to familiarize readers with issues and concepts in the petroleum industry that may have special relevance for Cambodia. There is increasing recognition around the world that citizen participation can contribute to better financial management in a way that brings benefits to the entire country. Chances of having meaningful citizen participation are enhanced when the public is well informed.

References

[1] Upstream. 2007. “E&P players plan New Year fireworks.” January 5.

[2] BP. 2006. “Statistical Review of World Energy 2006.” www.bp.com/productlanding

(Source: The World Bank Newsletter, Petroleum Sector Briefing Note No. 1, March 2007)

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