Petroleum Development in Oil-Importing Developing Countries

While it is unlikely that many of the oil-importing developing countries will become major petroleum exporters, a higher degree of self-sufficiency would reduce their dependence on OPEC producers and improve their balance of payments.

The non-OPEC, less-developed countries differ widely with respect to their current petroleum export-import balances and their likely production potential (table 1). A few countries, including Egypt and Malaysia, are substantial petroleum exporters and are, therefore, highly dependent upon the development of their petroleum resources for their foreign exchange income. Another group of countries is in near balance in petroleum production and consumption, but must expand its output substantially over the next few years if the countries are to avoid becoming large net importers. This latter group includes Argentina (net importer), and Peru and Zaire (net exporters). Still another group, including Brazil, Colombia, and India, has substantial production and good prospects, but is a considerable distance from self-sufficiency. The largest group of less-developed countries has no production, and for most the outlook for significant petroleum discoveries is not promising.

Whatever the level of potential output, an important factor in oil exploration and development is the commitment of the government to petroleum investment, either through a government oil enterprise or incentives that encourage foreign companies to invest in such activities.

Before the sharp rise in world petroleum prices in 1973-74, many oil-importing developing countries had little interest in promoting oil exploration by negotiating contracts with petroleum companies or by providing adequate financial and technical resources for their government oil enterprises. Following the rise in oil prices, some, such as Brazil and India, expanded government exploration and development activities, but did not encourage foreign petroleum investment until recently.

Modern petroleum agreements

The modern minerals agreement negotiated with host governments (whether concerned with petroleum or other minerals) is an anomaly. It is nominally a contract to conduct certain activities under host government supervision, but since the risk and financing are borne by the contractor, it is a foreign equity investment. The foreign investment is basically the contract itself, since in most agreements title to the resources in the ground and even to the equipment and installations is held by the host government or reverts to it at the termination of the contract. Moreover, most host governments do not regard the contracts as covenants to be honored throughout their term, but look on them as a framework for more or less continuous negotiation as the relative bargaining power and opportunities created by new conditions change in favor of the government.

Whether it takes the form of a production-sharing contract, a joint venture, a risk-service contract, or a concession contract, the modern petroleum contract prescribes the activities of the contractor in considerable detail, including the number of exploration wells to be drilled or exploration outlays to be made, the development and production of any discoveries, and, frequently, the price and other conditions for the sale of the oil.

Since, in recent years, world oil prices have been quite high relative to the operating and capital costs actually incurred for development and production of successful oil discoveries, the governments of host countries have claimed the bulk of the gross revenues produced. Indeed, the share of net revenues claimed ranges from 85 to 95 percent. A profit share of 10 to 15 percent on the output of a large field may yield a very attractive internal rate of return to the petroleum company if no account is taken of risk. But the economics of investment decision making in a high-risk environment requires an expected or probability-adjusted internal rate of return that takes into account several categories of risk. These include low probabilities of finding large fields and higher probabilities for smaller fields; risks at the development stage (since not every production well drilled in a known field will yield oil that can be produced economically); and a variety of other risks relating to costs and world oil prices, plus the political risk of contract violations. The perception of risk (as well as the degree of risk aversion) differs among petroleum companies, and the companies and host governments have differing evaluations of risk and compensation for risk. Differing contract terms designed to achieve the same ratio of net returns to the contractor and the host government will yield substantially different expected internal rates of return for the same petroleum field, after adjustment for the probability that the returns will be realized. Also, actual rates will differ greatly with the size of the field discovered and other conditions for the same set of contract terms.

Effect of contract terms on Petroleum exploration

The initial efforts of oil-importing developing countries to attract foreign petroleum relatively have frequently brought little exploration, in considerable part because they have not offered sufficiently attractive terms to private investors. Countries with small proved reserves often pattern their agreements along the lines of those negotiated by countries with substantial reserves and favorable geologic conditions for large discoveries.

High-risk exploration requires generous terms in order to provide substantial rewards for successful ventures. Moreover, since newly discovered fields in regions not producing oil are likely to be relatively small, while exploration and development costs are quite high, the expected present value of petroleum projects before taxes may not be exceptionally high even if contract terms are quite generous. Once important discoveries are made, new contracts more favorable to the government can be negotiated on tracts in the same general area.

The governments of oil-importing developing countries have generally done a poor job in structuring their tax and revenue production-sharing arrangements for relieving maximum exploration activity and maximum efficiency in the development of discoveries. They have patterned their petroleum laws and model contracts on those of countries with different petroleum characteristics or have been more concerned with maximizing potential government revenues than with attracting petroleum companies to undertake exploration. For example, some governments have sought to extract large signature bonuses for exploration contracts in high-risk areas or have imposed rigid, unrealistic expenditure requirements. Model contracts employed by governments have frequently been formulated with a view to satisfying domestic ideological objections to foreign investment in petroleum production, or to protecting the monopoly status of politically powerful state petroleum enterprises. Both these motivations apply to Argentina, Brazil, and Peru, among others. Although there has been some improvement in contract terms, for example, in Brazil, with a consequent rise in exploration activity, many years of potential production have been lost, at enormous cost to the country.

An analysis of contract terms has shown that most fiscal systems are regressive, or at best proportional rather than progressive, as measured by the relationship between the government's share of net revenues and the quality of the field. A progressive fiscal system is more likely to provide an acceptable internal rate of return on high-cost-low-volume fields than a regressive system. It therefore not only encourages the development of such fields when they are discovered but also raises the risk-corrected internal rate of return of a prospective exploration investment. A fiscal system is made regressive through large signature bonuses, high royalties, and production-sharing arrangements, while progressivity is produced by a heavy reliance on net profits taxes. Not only will a better structuring of fiscal terms in petroleum contracts increase the attractiveness of projects to prospective investors, it will also tend to increase the expected net present value of government revenues as well.

Most contracts provide for lower output or revenue shares for the contractor from higher incremental production in areas under contract. Such arrangements not only reduce the expected net present value from an exploration investment, but also discourage additional production from higher cost fields when they are discovered. Graduated royalties have a similar effect on the efficiency of production.

This question must be answered first of all in terms of the objectives of the host government and the stage of exploration and development of a country's petroleum resources.

Although several factors affect the attractiveness of a country for exploration by foreign companies, including contract provisions not directly related to the sharing of net revenues, there are a number of times when international petroleum companies have shown increased interest following a liberalization of contract terms. It is true that the announcement of significant oil discoveries is powerful bait for attracting petroleum companies, but a combination of few or no discoveries and harsh contract terms elicits little interest in exploration.

Not only is it possible for a government to increase its share of rents from new contracts negotiated after discoveries have been made and interest in exploration has increased, but it is possible, based on geologic knowledge of the area, to structure contracts to establish different terms for individual areas with differing degrees of risk. If no reserves have been proved in certain areas, contracts might be shaped with a view to stimulating maximum interest in exploration, say, in high-risk—high-cost offshore areas, or in jungle areas such as the Amazon and eastern Peru.

The role of government oil enterprises

Government oil enterprises are almost universal in developing countries with petroleum production, and their activities include exploration, production and refining, and negotiating contracts with domestic and foreign companies. In many producing countries—including Argentina, Brazil, and India—these produce most of the country's oil and are responsible for most exploration. Although the exploration and production activities of the government enterprises should be continued, governments also should encourage foreign investment to maximize the exploration and development of the country's petroleum reserves, just as they should utilize foreign investment for economic development in all productive sectors of the economy.

Of particular importance in a national hydrocarbons program is the creation of a market and transportation for natural gas, which substitutes for petroleum in many uses and can be exported in the form of liquefied natural gas. Since, in many cases, exploratory wells yield gas rather than oil, the possibility of marketing gas at a profitable price is an important factor in attracting petroleum companies and will affect the expected internal rate of return from an investment. This should be an important function of the government oil enterprises.

Government oil enterprises should supplement their own activities by utilizing the technical and financial resources of foreign petroleum companies, and foreign companies are the most important conduit for the transfer of such resources. The external debt crisis experienced by many less-developed countries in 1982-83 has limited the capacity of some government oil enterprises to maintain or expand their exploration and development activities. The efficiency of a government oil enterprise should be judged on the basis of its success in mobilizing external resources for the country's national petroleum and gas programs rather than its own performance in exploration and development.

U.S. government policies and foreign petroleum investment

The single most important U.S. government policy affecting the investment of U.S. petroleum firms in developing countries is tax policy, particularly that relating to crediting taxes paid to foreign governments against U.S. tax liabilities. U.S. tax policy has been substantially tightened since 1977 in terms of the method of calculating taxable income from foreign sources and eligibility for crediting foreign taxes against U.S. tax obligations. The alleged position of the Internal Revenue Service (IRS) is "neutrality" in the sense of neither encouraging or discouraging U.S. foreign investment by means of the tax system.

A more relevant issue is whether U.S. tax policy should favor U.S. petroleum investment in all or selected non-OPEC, less-developed countries, or even in certain OPEC developing countries outside the Middle East, for example, Indonesia and Ecuador. Tax discrimination in favor of foreign investment not only involves a measure of discrimination against domestic investment, but is in effect a form of tax subsidy that can be justified only in terms of the expected social benefits.

There are changes in IRS regulations within the framework of existing tax law that could remove obstacles to foreign tax credibility arising from the nature of foreign tax laws without compromising the principle of tax neutrality or of providing a tax subsidy. For example, U.S. petroleum companies might be permitted to elect the per country tax limitation for deducting losses against U.S. tax liabilities. This avenue should certainly be sympathetically explored as a means of promoting U.S. petroleum investment countries where the issue has arisen, such as Guatemala.

The other way in which the U.S government promotes foreign petroleum investment has to do with Overseas Private Investment Corporation (OPIC) investment guarantees. The practice of insuring high-risk investments by providing compensation limited to the actual unrecovered value of the investment has great limitations as an inducement to such investment. However, there are types petroleum investment for which OPIC insurance has been attractive and presumably this has a positive influence on investor decisions. OPIC should be given flexibility for shaping insurance programs that will induce petroleum investment in non-OPEC, less-developed countries.

The role of international assistance institutions

The UN has recognized the need for increased exploration in the oil-importing developing countries, but the approach of the UN General Assembly has been to pass resolutions proposing the transfer of large amounts of financial and technical assistance to developing countries supporting state petroleum enterprises. These resolutions have encouraged an ideological bias against foreign investment in mineral resources by referring to several UN resolutions relating to the sovereignty of developing countries over their natural resources. This is nonsense. In virtually all developing countries, the minerals in the subsoil belong to the state, and the governments exercise full control over the exploitation of these resources.

Somehow sovereignty over natural sources has been equated with socialism that is, the exploitation of resources by state enterprises. It is not surprising most industrial countries have not been willing to contribute large sums to international agencies for financing investments that could be undertaken by international petroleum companies with large financial resources, including the partially or wholly government-owned petroleum enterprises of Britain, France, and Italy! Moreover, most investments by international petroleum companies in the developing world are made in the form of contracts with state petroleum enterprises that provide the latter with ownership of the petroleum and facilities for production and a substantial measure of control over operations.

The World Bank group has made a number of loans for petroleum exploration and development. The World Bank group can play a useful role in promoting petroleum development in two ways: (1) by providing financial and technical assistance to poor countries for geological mapping, limited seismic exploration, evaluating petroleum prospects, and formulating, exploration strategies; and (2) by serving as a catalyst for attracting foreign and domestic equity and loan capital for high-risk exploration and development.

In view of the limited resources of the World Bank and of regional international financial institutions such as the Inter-American Development Bank, it is questionable whether these institutions should be making large loans to state enterprises for their direct operations unless it can be shown that financing for petroleum exploration and development is not available from private international sources. There may be a few cases where this is true, but international petroleum companies deny that they are unwilling to make risk investments in developing countries, even where there is little prospect of producing more than enough oil to satisfy the domestic market for the foreseeable future.

The catalytic function can be exercised by loan and equity investments which constitute only a small portion of the total investment but which serve to provide a "presence" of the World Bank group in a contract. Since the International Finance Corporation (IFC) is empowered to make equity investments and has considerable experience in structuring joint private-state ventures, the IFC should be encouraged to play a major role in promoting the negotiation of contracts for petroleum exploration and development. The presence of the IFC could be an important factor in safeguarding petroleum companies against serious contract violations or expropriations.

Implications of recent events

Recent events have indicated that non-OPEC, less-developed countries should make greater efforts to attract foreign investment in their petroleum sectors:

• The world price of oil declined in 1982-83 by 15 to 20 percent below the 1981 level, and world oil supplies became more abundant.
• Expectations of a continuous rise in oil prices over the next decade or so have changed substantially so that investors are less confident that, if they make a petroleum investment today, real oil prices will be significantly higher five or ten years hence when the projects come on-stream.
• Exploration budgets of major international petroleum companies have declined as a result of reduced cash flow, and there has been a decrease in their exploration and development expenditures and commitments to the oil-importing developing countries. This means that only the more promising prospects are being considered for investment and companies are unwilling to make large commitments in the form of bonus payments and minimum exploration expenditures for high-risk ventures.
• The 1982-83 debt crisis in many oil-importing countries—including Argentina, Brazil, Chile, Colombia, the Philippines, and Turkey—has affected the need for foreign investment in the petroleum sector.

The bulk of the financing for exploration and development by the government oil enterprises has come directly or indirectly from external sources, and the debt crisis has meant a sharp cutback in net foreign borrowing for many. The lending capacity of the World Bank has been strained by the extraordinary demands of its members for assistance in dealing with structural balance-of-payments problems, and a high level of loans for petroleum exploration and development cannot be expected from this source. This suggests that in the case of those oil-importing developing countries whose government oil enterprises have been responsible for the bulk of the exploration and development activity in the past, there must be a greater reliance on foreign investment if these activities are to be maintained or expanded.

The recent decline in the world dollar price of oil has benefited these countries, but this does not reduce their need to find and develop their petroleum resources. Between 1980 and 1983 the dollar appreciated in terms of other major currencies by about the same percentage as the decline in the dollar oil price, and dollar prices of exports of the oil-importing developing countries declined sharply between 1980 and mid-1982. Moreover, despite the decline in dollar oil prices, the oil deficits of these countries are projected to rise over the next decade.