Streetwise Professor

July 25, 2007

NOC, NOC! Who’s There?

Filed under: Commodities,Energy — The Professor @ 2:20 am

I write this on the plane (Business First is the way to go!) returning from a 2 week stay in Beijing, where I taught a course in energy risk management to executives from the two largest Chinese oil companies, Sinopec and PetroChina. My involvement with these two national oil companies (NOCs) sparked some thinking about NOCs in general, and the future role of the private integrated oil majors (IOMs).

It is well known that NOCs are playing an increasingly important role in the world oil and gas markets. Indeed, they increasingly control the reserves, and the access thereto. It is also well known that the NOCs lack the technical expertise of the IOMs, especially when it comes to exploring, developing and operating more challenging fields (e.g., deep water offshore) which will be the source of an increasing fraction of the world’s growing energy needs. Absent access to the technical expertise of IOMs, NOCs will be unable to produce as much oil, with predictable—and unpleasant—implications for oil prices.

Can NOCs obtain the requisite technical expertise under contracts that do not provide an equity share to output? (This is what Russia is trying to do, as with its recent announcement of the deal with Total to develop the Shtokman field.) They can obtain some technical expertise in this way, no doubt, but there are compelling reasons to believe that vertical integration is efficient in oil exploration, development and production. As a result, there will be a substantial efficiency loss when NOCs produce and own output, and acquire technical support via contracts with IOMs that do not extend equity rights to the latter.

Integration is efficient due to the nature of the process of exploring for and developing oil reserves. Especially with regards to technically challenging projects, such as deepwater fields, oil exploration and development are informationally intensive. Moreover, a good deal of this process involves identifying and exploiting real options. As information is produced during the process of exploration and development, it is used to make decisions about how to proceed going forward. The IOM has a substantial advantage not only in generating the information, but in knowing how to utilize that information to make better decisions about the exercise of real options.

There is no way in hell to write a contract that provides the owner of the technical expertise (e.g., an IOM) with the incentive to utilize this information optimally. This is true for a variety of reasons. First, the contingencies are too numerous and too difficult to specify ex ante, hence any contract will be incomplete. Moreover, even if the parties were to attempt to specify such contingencies, due to the technical complexities, they would be nigh impossible for third parties to verify. It is well known that the inability to verify also contributes to incompleteness.

Integration greatly mitigates this problem. The owner of the knowledge captures the value of using it efficiently because it also owns the output—the oil and gas. It internalizes the benefits of better decisions.

It should also be noted that there are arguably far more imposing barriers to transferring information across firm boundaries than within firms (although transfer within firms is not free either.) Again, issues of verifiability and completeness confound addressing information transfer by contract.

Thus, we are confronted with a dispiriting state of affairs. Those who own the reserves are loath to provide equity rights therein to those with the information and expertise. Maximizing the value of those reserves requires allowing those with the information and expertise to utilize that information to exercise the myriad real options in an oil or gas project efficiently. Equity ownership of production—integration—is an efficient way of providing incentives to those with the information and expertise to use it effectively. The incentives are inherently much weaker when the reserve owning NOCs merely contract for services from the IOMs with the information and knowledge. This translates into lower output and higher prices.

Not that equity ownership is a panacea when opportunism is unchecked. Equity rights have never been secure, and they are less so now (witness the expropriations in Russia and Venezuela.)

Is integration gone forever? Probably not. The deadweight losses that will arise as NOCs attempt to acquire IOM expertise without giving equity rights will provide an incentive for a major rethink. For instance, Mexico’s autarkic energy policy is leading the country’s oil industry to a precipice with dire financial consequences for the government. Resource nationalism may feel good, but it don’t pay the bills. Even when this realization dawns on even the most reflexive nationalist demagogue, and reserve owners permit some form of equity participation by those with the know-how, we won’t be in Nirvana due to the tenuous nature of these equity rights when expropriation is a threat.

This all has interesting implications for another subject of interest—energy policy as a response to purported anthropogenic climate change. Proposals for taxation of hydrocarbons (or direct controls on consumption through cap-and-trade or CAFÉ-type policies) are premised on the assumption that it is necessary to raise the costs of oil consumption to offset the effects of environmental/climate externalities. But hydrocarbons are already heavily taxed. Moreover, the foregoing argument implies that the insecurity of property rights in energy production and the inefficiencies of acquiring exploration and development expertise through contract are reducing oil output, and will reduce it even more in the future. These inefficiencies in property rights and organization are effectively implicit taxes on hydrocarbon production. It may well be the case that even when one takes environmental impacts into account, oil and gas output is too low today because the explicit and implicit taxes are bigger than the efficient tax. Certainly, arguing for higher hydrocarbon taxes based on a tacit assumption that environmental externalities are the only distortion in energy production and consumption (which seems to be the case, as existing explicit and implicit taxes are almost never mentioned in this debate) is bad economics.

The distortions arising from insecure and inefficient property rights in oil exploration, development, and production are real, and likely to become larger in the future. These costs should be accounted for in any policy decisions on carbon taxes. So far, I have seen no evidence that this subject has even been mooted, let alone considered seriously. This bodes ill for effective energy policy in an age of climate change hysteria.

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  1. [...] a post titled “NOC! NOC! Who’s There?” I wrote in the summer of 2007 about the difficulties of joint ventures between national oil [...]

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