3.2 Common Features of the Industries

strategic investments aimed at securing future supplies of energy and minerals.

There are many aspects of this investor-state dynamism that present challenges to policy advisers and decision makers in resource-rich states. For example:

What kind of company or pattern of companies is best suited to achieve a country’s policy on extractives and development generally?

The choice is wide. Alongside long-established companies from the Organisation of Economic Co-operation and Development (OECD) countries, there are state-owned enterprises from Malaysia, the Middle East, and the Republic of Korea and new players from Brazil, China, India, and the Russian Federation, all making significant impacts. Significant diversity in industry ownership and financing structures has emerged from the resulting South-South pattern of investment; the use of resource-for-infrastructure deals is one example of the latter. Moreover, the growing number of so-called junior or mid-cap companies as investors means that a focus by policy makers and their advisers on the “supermajor” companies that long dominated the EI sector is now inappropriate. This diversity is also evident in the destinations of investment, the points along the exploration-to-extraction continuum and across energy and other mineral commodities (Barma, Kaiser, Le, and Vinuela 2012). A further element of complexity in investor-state relations is the international character of investment in the EI sectors. More than ever, there are opportunities for investors to structure their operations, on- and offshore, to take advantage of this context. As a result, national tax and regulatory authorities face challenges in regime design, monitoring, and enforcement.

3.2 COMMON FEATURES OF THE INDUSTRIES

Long, risky, and costly exploration and development

Each of the EI sectors is characterized by long, risky, costly, and very capital-intensive development.2 For oil and gas, there is additionally a high cost at the exploration stage, with dry wells and resulting losses being common. A state that wishes to go it alone in the EI sector needs significant financial resources and an economy with sufficient diversity to allay concerns about EI sector investment risk (Boadway and Keen 2010). States that, more typically, choose to attract and rely on international investment, need to have in place a legal, contractual, and fiscal regime that investors can understand and trust. These states must also have a political track record that provides investors with reasonable assurances against adverse changes when a major discovery is made and/or exploitation is under way (see chapter 4).

Conditions and assumptions that exist at the beginning of a project—at the time when laws are drafted and contracts awarded—are almost certain to change over the course of the project investment. Initial decisions are usually made when there is great uncertainty about the sector’s potential, based on what is known about the geology at the time of exploration. There is also uncertainty about the future economics, markets, risks, and politics that will affect the project. The incentive for a state to revisit the terms of the initial bargain struck is increased by the shift in bargaining power that occurs in the event of a commercial discovery and a substantial investment by the foreign investor.

Sophisticated management and specialized technology

A second common feature is the dependence of the EI sectors on sophisticated management and specialized technology.3 This dependence affects the development of host-state institutional capacity. States developing their EI sector must have sufficient institutional capacity to adequately oversee sector operations and for adopting the competitive licensing, contractual, and fiscal regimes required to attract needed skills and technology (see chapter 5).

The challenge here lies in finding ways of enabling a transfer of expertise and sourcing of business to local firms in order to ensure a long-term benefit to the domestic economy.

Asymmetric access to information

Partly due to the complex management skills and technology that characterize the EI sectors, governments are at an informational disadvantage vis-à-vis international investors and operators (Stiglitz 1989; Nutavoot 2004). The government is likely to be informed about its future fiscal intentions, but the private investor undertaking exploration and development will probably be better informed about technical and commercial aspects of a project. This has important implications for the design of license or contract award procedures, fiscal design, and fiscal administration as well as the engagement of outside technical assistance. It can also be the root of subsequent dissatisfaction by a government about the terms negotiated with investors by its predecessor(s) and trigger demands for a review of those terms.

With increasing sources of competition in the EI sector, and the role of national resource companies, this is less of a

40 OIL, GAS, AND MINING

problem than it once was. Access to information remains a challenge, however, for many governments in resource-rich economies and is compounded by a tendency of some of them to be overly secretive about such information once it has been obtained.

Price volatility

A fourth feature common to both the petroleum and mining sectors is the volatility of prices, costs, and rents. The extreme volatility of prices not only poses macroeconomic management challenges but also raises issues about the design of fiscal terms. A fundamental policy issue with which governments must constantly grapple is the question of how the burden of the risk of price and revenue volatility should be divided between the investor and the government.

Volatile commodity prices can also have dramatic impacts on a country’s exchange rate, with the effect of driving up the value of the currency if commodity prices are rising and pushing it lower when they fall. This will be worsened by capital inflows and outflows.

The volatility or variability of costs receives much less attention, but deserves more. EI costs vary widely across time and across projects, creating significant issues for both the design of fiscal regimes and their administration. When costs soar for investors, as can happen in both the mining and hydrocarbon sectors, tensions with governments are likely to result from the necessary remedial actions. Rents (discussed in the following subsection) are also volatile as a result of dramatic fluctuations in price. (See figure 2.1 on oil prices in chapter 2.)

The challenge lies less in the wide variability of prices than in the difficulty in predicting them. Most forecasts about pricing turn out to be wrong (IMF 2012, 10). The consequences can be severe. Besides the impacts of variation on the size of resource rents (which creates difficulties for planning), longterm price trends can make it economically unfeasible for investors to extract reserves, even if technology has improved. This can leave assets stranded.

Substantial rents

Both the petroleum and mining sectors are capable of generating very substantial economic rents. By rent is meant the revenues in excess of all costs of production, including those of discovery and development, as well as the normal return to capital. The cost of extraction can be significantly less than the price that the resource can obtain on the market, not least when there is an important oligopolistic element in world markets, as is the case with oil.

These rents can be a very attractive tax base for governments on both efficiency and equity grounds (IMF 2012, 10). Securing rent for the state requires care in the design of the fiscal regime, to avoid disincentivizing investors and because rent revenues can be highly volatile. To illustrate, the average profit measured in percentage of revenues among EI companies was between 25 and 30 percent in 2006. This compares with less than 20 percent for the pharmaceutical industry and with a mere 5 percent for the EI sector in 2002 (Ericsson 2012, 1). However, while rents in mining can occasionally be high, this is only at the peak of cycles (as in 2006). For large parts of the oil industry these rents are structural. There is nothing in mining that equates to the US$8 per barrel production costs of Saudi Arabia and the Islamic Republic of Iran.

The challenge for some states is in the volumes of resource wealth, which will strain the capacity of the existing state system, aggravate capacity problems, and create tensions in its relations with investors.

Adverse environmental and social impacts

The EI sectors can have major adverse environmental and social impacts. In the past, these issues have not always been well recognized or addressed by governments, but good practice has improved greatly since the end of the 20th century. Avoiding or mitigating these impacts depends on appropriate legislation or regulation, enforcement capacity, and fiscal regimes that incentivize good behavior by the investor, while recognizing the costs involved and the need to internalize those costs.

As more and more EI companies sign on to international environmental and social standards or implement their own, the challenge for many governments is to ensure that local communities, indigenous peoples, and other affected citizens are able to participate in decisions relating to the exploitation of the resource and benefit from the development of the resource.

Resource exhaustion

By their nature, oil, gas, and mining resources are nonrenewable.4 They will eventually be exhausted. This distinguishes these industries from most, perhaps all others and presents policy makers with a number of important issues, ranging from decisions on optimal rates of exploration, development, and exploitation (through fiscal regime design) to appropriate frameworks for macroeconomic

CHAPTER 3: THE EXTRACTIVE INDUSTRIES 41