Petroleum Industry Regulation within Stable States

Solveig Glomsrød, Petter Osmundsen

• Publisher: Routledge
• Year: 2017
• ISBN:
  9781351911566
• Edition: 1
• Topic: Economía
• Subtopic: Teoría económica

This book addresses the challenges facing stable democratic states in dealing with oil companies in order to secure general welfare gains. Political stability means that such states should be able to take a longer term perspective. The principal topic considered is petroleum industry regulation but the insights extend to other non-renewable natural resources. A particular issue addressed is the question of tax competition between producing countries. Within the context of company/government relations the book considers such current topics as the challenges of dealing with merged companies and the strategic choices facing tax authorities.

Chapter 1

Introduction

Solveig Glomsrød and Petter Osmundsen

Petroleum production partly takes place in politically young or unstable regimes where good governance can hardly be said to penetrate the societies. Under such circumstances the overall political uncertainty might dominate the minds and decisions of resource owners as well as petroleum companies while making efforts to create a niche for petroleum extraction. The evident curse of petroleum wealth under such political conditions is outlined by Gelb et al (1988), Karl (1997) and Auty and Mikesell (1998) among others. Social science petroleum research in a broader context has tended to respond by focusing on geopolitical affairs and petroleum company corporate behaviour (Yergin, 1991; Mitchell et al., 2001). However, there are petroleum producing countries where administrative capacity and political basis allow for a longertime perspective and more fine-tuning of petroleum taxes and regulations than is practised in many young and unstable regimes. The particular focus of this book is the challenge facing this kind of mature petroleum states in dealing with oil companies and oil revenues for the sake of general welfare in an experienced democracy. Our principal focus is petroleum, but the insights in resource administration generalize to other non-renewable natural resources.

Which are the stable states that we refer to? It is not the ambition here to come up with a definition of stability. Risk is a multiple faceted phenomenon, and even genuine ignorance about future outcomes should be kept in mind when considering the prevailing degree of stability in a petroleum province. A recent attempt to deal systematically with risk in petroleum producing countries has been presented by the HIS Energy Group. The HIS Energy Group developed a database for studies of risk elements and established indicators for total risk involved in operations. Risk was divided into three main categories: general political risk, fiscal risk and exploration and production risk. When the aggregate risk indicator was estimated by country, it turned out to assign the same total risk to operations in two countries as different as Norway and Nigeria. Norway ranks high on fiscal risk, and Nigeria ranks high on political risk.

Still, Norway is not Nigeria. Although perception of risk may vary considerably, it may be a baseline to assume that the OECD countries are major candidates to be listed as stable states in the petroleum regulation context. Countries like the UK, the Netherlands, Norway, Canada and the USA have considerable deposits of non-renewable and scarce natural resources. However, the OECD countries will see their share of petroleum reserves reduced in the coming decades. According to IEA (2003) the OECD countries’ share of oil production will fall from 30 per cent in 2002 to only 11 per cent in 2030. The stable petroleum states are in the declining phase, whereas in recent years the new provinces outside the OECD area have come up with the most significant prospects of oil and gas reserves worldwide.

A first reaction to this development might be to expect less stability in the future global petroleum environment. However, regimes in several oil producing developing countries are now on the move towards more socially sustainable governance. This development is important to OECD countries, as 70 per cent of oil investments from now until 2030 will take place outside the OECD area, and about 40 per cent of these investment are made to serve demand from OECD countries. With support from the IMF, governments currently work to improve transparency in financial affairs in developing countries. Among the financial flows, oil revenues and taxes are of particular concern. Eventually, regimes that are rich in petroleum or other natural resources are likely to develop more sophisticated regulatory tools. Hence, in a dynamic context the petroleum management issues discussed in this book might become useful to petroleum resource owners beyond the petroleum states that may be characterized as stable today.

The degree of sophistication in petroleum management and taxation is not as much a question of the competence of the government officials as it is a question of the quality and reliability of the decentralized tax administration. Take royalties as an example. Royalties are used extensively in many countries, even if it is common knowledge that royalties are non-neutral and may convey detrimental incentives for reservoir management as well as cause petroleum fields to be closed down prematurely. A likely explanation for still relying on royalties is that this tax instrument – linked to extraction volumes – is easy to administer. Neutral tax devices, like a resource rent tax, call for detailed monitoring and control of income and costs, which are more challenging and less transparent tasks. The countries with less reliable administrations in many cases must see part of the petroleum rent lost in exchange for a tax system that works.

Tax Competition Between Producer Countries

The regulatory systems of stable states are also under pressure. Interaction among oil companies and governments can be perceived as a multi-dimensional game over licences, production efforts, taxes and information. There is a rent bargaining constellation between extraction firms and the government. There is also a tax competition between governments in different extraction countries, attempting to attract the most qualified firms. By their inherent global mobility, transnational oil companies may have a strong bargaining position towards resource extraction countries. The mobility and the presence of outside options give credibility to implicit threats of relocation. However, the effective bargaining power is reduced if the number of qualified firms is high, as collusion may be hard to sustain. Thus, the recent mergers and acquisitions in the petroleum industry pose a challenge to governments in petroleum host countries, which are confronting dominant giants like ExxonMobil, TotalFinaElf, BPAmoco and ConocoPhillips. A possible response to the reduction in bargaining power would be for the governments to cooperate in tax and regulatory design. An emerging example may be seen in recent talks between British and Norwegian governments over efficient use of infrastructure across the border, and indications of a reduction in the Norwegian/British tax rate gap.

Traditional tax theory argues that tax on natural resource rent is neutral and can be taxed 100 per cent without distorting economic decisions. However, we do not observe that governments tax 100 per cent of the resource rent, as pointed out by Stiglitz and Dasgupta (1971). Often, only half the rent is captured by taxes.

What factors may explain this tendency by governments to refrain from more thorough rent capture? A punitive tax regime may be detrimental to the oil companies’ incentives. Multinational oil companies may focus more on tax management than on petroleum resource management. Transfer pricing activities – i.e. the allocation of costs to high tax regimes and revenue to low tax regimes – is one example. Also, the most productive resources and competence may be allocated to countries where the companies keep a larger fraction of the rent. The limitations of exorbitant taxation are often not accounted for in the simplest theoretical tax models.

Another reason for more lenient resource taxation is tax competition among various host countries. In an industry with economies of scale and barriers to entry there may be a host country concern that companies move to other provinces. The petroleum resources are immobile, but multinational oil companies can adjust their involvement from full presence to narrow physical field operations. Oil companies may consequently be considered as highly mobile. The petroleum companies decide on their degree of participation by means of global real investment portfolio decisions. By being mobile, the transnational oil companies can obtain lower taxes by threatening to move their scarce and valuable competence to another country, thus obtaining a mobility rent in an industry with substantial entry barriers (Osmundsen, Hagen and Schjelderup, 1998).

A third limiting factor on resource taxation is that the government typically lacks the necessary information to differentiate taxes so as to capture the entire rent, i.e. the extraction companies gain an information rent. The companies benefit from private information on economic and strategic conditions.

In this book, traditional resource taxation theory (e.g. Campbell and Linder, 1985) is combined with recent theory of international taxation (e.g. Zodrow and Mieszkowski, 1986; Kind, Knarvik and Schjelderup, 2000; Olsen and Osmundsen, 2003, 2001; and Gresik, 2001). In chapter 2, Petter Osmundsen pictures some of the new challenges facing the tax authorities. First of all, the high number of mergers and acquisitions has reduced the number of potential firms to attract, raising the stakes in tax bargaining. Second, the discovery of large petroleum reservoirs in West Africa and the Caspian region poses a serious challenge to other extraction countries. Third, the opening up for multinational enterprises in the Middle East and Russia represents additional options for the major oil companies. New options for private international companies may also emerge if state owned companies lose administrative privileges over rights to national reserves and more of these reserves become exposed to competition for contracts. All these changes imply enhanced international tax competition. On the other hand, the fear of acts of terror and the lack of confidence with respect to contractual and tax conditions in newly opened extraction countries may work in the favour of OECD extraction countries.

What strategies are feasible for OECD host countries facing enhanced tax competition? One obvious strategy is to implement measures that reduce entry barriers for new oil companies. A high number of companies will enhance the relative bargaining power of the government. This may to some extent alleviate the recent loss in bargaining power due to the considerable number of mergers and acquisitions in the petroleum industry. The challenge is to attract mid-size companies that have sufficient financial capacity. Also, the government may try to forestall collusion on the part of the companies. A relevant measure in this respect is to stimulate a heterogeneous corporate base, e.g. a diversity of companies in dimensions like size, geological focus and level of vertical integration. Heterogeneous company tax base may give the government some leeway for a conquer-and-rule strategy. Yet another strategy would be to initiate collusive behaviour over tax matters on behalf of various extraction countries. The latter may prove to be a difficult task due to political, cultural and economic differences. One example of important differences with respect to preferences over tax design is that whereas some countries are wealthy and patient tax collectors, other countries are in desperate need of current revenue. Some extraction countries like Australia and the UK may also have a more diverse objective function than simply revenue maximization. In addition to revenue they have objectives of self-sufficiency of petroleum.

Taxes and Agglomeration Economics

In design of taxes and regulations for petroleum extraction, the government needs to be alert to changes in corporate strategy. The petroleum companies are now pursuing focusing strategies through considerable portfolio adjustments in order to concentrate scarce resources on fewer activities and geographical areas where they have comparative advantages.

The financial volume of projects – or materiality in corporate lingo – is considered important. In return for a significant presence, they demand larger contributions after tax, measured in absolute value, from each of the selected activities. A stronger focus on the financial volume of projects is partly also a result of the mergers and acquisitions in the industry, with larger companies going for high materiality projects that can justify the relatively high level of indirect costs in large corporations. Implications of cluster externalities for optimal tax and regulatory design are discussed by Osmundsen, Emhjellen and Halleraker (2004).

Another regulation policy issue is the concept of industrial clusters. The literature on industrial clusters (e.g. Matsuyama, 1991 and Venables, 1996) discusses the possibility of positive externalities, or agglomeration economies, which give rise to geographical clustering of related production activities. The externalities offer competitive advantage, e.g. cost reductions, which are not obtained outside the geographical cluster. The size of the externalities is typically a function of the size of the industry.

Consider the starting point for offshore activities in two different provinces – the North Sea and the Caspian Sea. In the North Sea, initiating petroleum activity could benefit from a rich marine tradition and offshore suppliers, research institutions and consultancies. The Caspian Sea on the other hand was landlocked without the beneficial presence of an extensive marine/supply sector (although there was experience with on-shore oil production) or related suppliers with access to highly educated human capital. The unfavourable lack of an industrial cluster basis for the Caspian Sea was clearly negligible in comparison with the reserve prospects of the region. It was definitely found to be worthwhile to plunge into the Caspian Sea when the opportunity came up and step by step a growing sector built up the industrial environment to play within. However, the cluster externalities might be relatively more decisive for localization in other provinces than the Caspian region. Cluster advantages can be historically exogenous as in the examples above, or a result of the growth of the petroleum industry itself.

Presence of positive company and industry externalities may represent a source of dynamics in localization strategies. When considering leaving a producing region and moving to a newly opened province, it is less economical to be the first to do so. The activity level and the infrastructure in the current location work as mobility-preventers. However, as companies start to move, the economies of scale and agglomeration economics may rapidly change the relative attraction of migrating versus staying in the province. Threats of relocation should be considered in light of such dynamics embedded in scale and cluster externalities.

Chapter 3 focuses clustering incentives and the optimal government response to observed changes in localization strategy. As outlined by Hans Jarle Kind, Petter Osmundsen and Ragnar Tveterås, there are several reasons why the extent of interaction between agents – and therefore the potential for knowledge externalities – may be expected to be larger within the petroleum sector than within most other sectors. First, a number of remedial actions have been undertaken with respect to organization and communication in order to reduce transaction costs between different agents in petroleum production, e.g. standards have been set on issues ranging from technical specifications to design of procurement contracts. Second, geographical co-localization is widespread in the petroleum sector. Third, there is a tight integration between petroleum companies and their suppliers. For instance, even though the suppliers have changed to turnkey deliveries, the petroleum companies still have sizeable staffs of engineers working closely with the suppliers, sometimes even formalized as common project organizations. It should further be noted that parallel working processes, time-critical supply chains and mutually dependent R&D call for tight coordination between the different agents (petroleum companies, turnkey suppliers, and sub-contractors). Accordingly, there are substantial management and coordination challenges.

Transfer Issues

Given the relatively high rate of rent capture within the Norwegian petroleum tax system, the companies might benefit considerably from transferring revenue to other tax regimes. The Special Tax on petroleum revenue amounts to 50 per cent on top of the general corporate tax of 28 per cent that also applies to non-shelf activities. Consequently, both the non-shelf economy and foreign countries are attractive tax havens. The Petroleum Tax Commission of Norway identified transfer of shelf revenue to non-shelf activities as a major deficiency in the tax system. In chapter 8, Nina Bjerkedal and Torgeir Johnsen provide a summary of the proposals made by the Commission to deal with this and other deficiencies that were identified in its report, in particular barriers to entry due to lack of interest compensation for losses carried forward.

A tax regulator has to consider transfer pricing and profit shifting to tax havens – but avoid double taxation of ethically well-behaved companies. Since the oil companies are transnational and face a global variety of resource tax systems, transfer-pricing issues are pervasive. In chapter 4, Thomas Gresik argues that transnational corporations thrive for many reasons. Oft-stated reasons include proximity to customers and resources through vertical integration and operational economies of scale (e.g. in administration, R&D, and/or production activities). The economic advantage often conferred by these attributes is also attractive to many national and state governments. Transnational or foreign direct investment (FDI) not only creates direct economic benefits such as jobs and taxable income but significant indirect benefits such as knowledge spill-overs. However, the ability of individual governments to reap the benefits of transnational investment is compromised by a third characteristic of transnationals: the flexibility to shift production and resources across national boundaries. This flexibility not only helps transnationals minim...