The control of oil (V) - oil majors vs. host countries

I started last week a series about what it means to "control" oil. I have put up four diaries already (see links below) about what it means in general to "control" oil, how prices are set, and the issue of security of supply for an importing country. This new diary continue the third one about who gets the "rent" from oil, i.e. the profit from its exploitation, by looking at the relationship between oil majors and host countries.

The global fight for the control of oil


The global fight for the control of oil (II) - oil prices


The control of oil (III) - Security of supply, imports, boycotts


The control of oil (IV) - sharing the oil 'rent'

In this post, I look at the dynamic of negotiations between a host country and a foreign international oil company (i.e. an oil major, or "big oil"). This obviously supposes that the country is open to foreign investment, which, as we know, is not the case of many of the biggest producers. It does apply to a number of countries around the world, which may or may not have a strong domestic oil industry of their own.

Let's see the factors than can favor the host country:

• it can kill off the project at any time, thus wiping out the oil company's investment;

• it can impose unexpected costs for doing business to the oil company and thus kill its profitability (micro-management and over-policing of the project, bureaucratic-administrative hurdles/hassles or incompetence, delays, etc...);

• it can play off various oil companies (and their home countries) against each other to get the most favorable terms;

• its ability to evaluate the oil assets on its own, and to independently assess production costs - and, even more significantly, to fully develop them on its own;

• the larger the size of the asset under consideration, the more interested the large oil majors will be as they tend to focus more and more on larger fields which bring economies of scale.

• of course, the larger the overall reserves of the country, the stronger its power, as oil companies know that they will need to come back for more transactions and need to be seen as "fair";

• in such a context of repeat business, a country that has a reputation for stability and reliability (in sticking to agreed contractual terms, even when unfavorable) can probably attach a price to these qualities which are not seen in all oil-producing countries and which have real value for the oil companies, and thus get better terms for itself. Stability is thus a plus ; oil companies have often accepted to value - and deal with - dictatorial regimes because they provide this much needed stability;

• conversely, a weaker country leadership may not be able to afford deals which are seen domestically as "unfair" to the country, thus bringing oil companies to improve their terms.  This will depend on the degree of democracy within the country, transparency of the oil transactions, and existence or not of a domestic consensus on the use of the oil reserves. The existence of such a consensus, despite the messy comings and goings of domestic politics, is also strongly appreciated by oil companies.

• if they manage their oil wealth well enough, they may be able to have a sufficient credit rating to get access to international financial markets without the help of the oil majors.

And those favoring the oil companies:

• they have deep pockets and can afford to take their time to reach an agreement, no project having a massive impact on their balance sheet, whereas the expected revenues of the investment may represent significant income for the host country and have a real macro-economic and thus political impact;

• they benefit from the high visibility of the project in the country (and in some cases internationally), which limits the likelihood that the local authorities will have the stomach for a failure to find terms of agreement; they can also be expected to have more experience in handling local authorities, public relations and expectations than many of the countries have in dealing with major corporations;

• they have the technical know-how and expertise and are thus indispensable. The fact that they often form consortia to run projects also limits the competition;

• depending on the local competences, they may also have a better knowledge of the actual production costs and may be able to capture some of the rent by inflating the apparent production cost and pocketing the difference;

• they will benefit from the support of their home government. This can take the form of the carrot (direct financial help or indirect help to finance export of equipment by contractors from that country, diplomatic or political support for other issues of importance for the host country, trade agreements, authorisation to export weapons, etc...) or of the stick (diplomatic or military pressure, trade restrictions, withholding of assistance, support for hostile countries, etc...)

• they can provide financing for the investment, including for any funding required to be done by the local party (if required by local law) on a bilateral basis likely to be less intrusive or conditional than international finance, whether public or private;

• their ability to handle the whole oil chain for the project, and to manage the complex web of contractual relationships required, especially when several countries are involved.

It is impossible to get a general conclusion on who gets the upper hand in such negotiations. A lot can depend on the technical parameters of the project. A very difficult project, engineering-wise, will favor the oil companies. A risky project (because of geological uncertainty, high costs, complexity, etc...) will also tilt the remuneration towards the oil companies as they will provide most of the investments and they will require that the return / potential loss balance be acceptable. More generally, the less the country is able to bear risk (by co-investing, by requiring early and/or minimum payments irrespective of the project's progress), the less it will be able to claim the "rent", i.e. the pure profit once the initial costs have been borne, because the investors will require a higher return for the higher risk they bear.

And yet, in the end, oil companies mostly require a decent return on their capital, and this is what they get. They will get a slightly higher return than their internal requirement for a project that performs as planned and with "average" oil prices. This will compensate for the cases when the project is delayed, is less successful than expected or when the oil prices drop below the "average" scenario. If things go better than expected, the oil companies will get some extra remuneration, but most of it will go to the host country. They will usually get a higher share of improved performance if they can justifiably argue that they are responsible for it, but they will only get a smallish portion of oil price increases.
The notion of "average" oil prices is of course a hot topic of discussion. Until recently, most oil companies would use an "average" long term price for oil in the USD 15-18/bbl range, with a requirement for projects to still make a return with USD 10/bbl oil and be cash flow positive above a level around USD 6-8/bbl. Such levels were seen as reasonable long term average or stress levels. With the price increases in the past few years, oil companies are beginning to reevaluate their minimum required levels.