A Little Bit of Opening Up: The Middle East Invites Bids by Foreign Oil Companies

In mid-November Kuwait held a conference on ‘The Role of International Oil Companies in the Development of Oilfields in Kuwait’. More than 200 executives from foreign oil companies (FOCs) shared what was, according to observers, a lively and open debate with the Kuwait Petroleum Corporation (KPC), Kuwaiti parliamentarians and government representatives. One of the aims of the conference was to elucidate the terms for foreign participation in the opening up of Kuwait’s upstream oil sector with a view to increase production of the northern oilfields from currently 400,000-450,000 b/d to 900,000 b/d by 2005. However, beyond this issue, which centres on the type of contract to be offered, KPC and the government side had to justify to their parliamentarians why it is necessary to invite FOCs at all.

The Kuwait conference was not an isolated event. Many countries in the Middle East either have already signed contracts with FOCs or are contemplating moves to allow foreign participation in their upstream sectors. And the FOCs are queuing up with their chequebooks at the ready. Although the countries concerned consider different degrees of foreign involvement and different fiscal regimes, there are some common themes running through the various debates.

Why opening up and why opening up now?

When a country decides to open up its upstream sector to foreign companies this means first of all that the hegemony of its national oil company (NOC) will be abandoned. Several explanations for such a course of action spring to mind immediately. The country might be in urgent need of foreign capital. This is certainly the case in Iran, Iraq, Algeria and to some extent in Qatar. Indeed many countries are not only interested in the development of their oil and/or gas reserves but emphasise the importance of infrastructure programmes to which FOCs have to commit themselves. Those Middle East countries which have comparatively low credit ratings find it difficult or too expensive to raise funds in the international capital markets. Hence, admitting foreign firms which will bring that elusive capital with them into the country appears, at first glance, an attractive and almost inevitable solution.

Not all countries are restricted in this way. Kuwait is a case in point. Thus, we have to consider other motives for the opening-up strategy. Traditionally, and not only in the oil sector, foreign companies are invited as a means of procuring the relevant technology. However, when capital is abundant, a country should be able to buy off the shelves all the technology it needs. This leads to the next issue which is the scarcity of management resources needed to apply efficiently frontier technologies.

Kuwaiti parliamentarians have voiced concerns about a different type of expertise needed by KPC to negotiate with highly skilled and experienced FOCs, and that, as a consequence, Kuwait might get an unfavourable deal when signing contracts with foreign firms. While matters such as this should not be taken lightly, it should not be overlooked that the opening-up to foreign companies and their business cultures offers a chance for any NOC to restructure and modernise itself.

A further rational that is frequently put forward for getting FOCs involved are security concerns. If a country feels threatened by its neighbours, the presence of international firms is regarded as a shield against foreign aggression. It is assumed, or at least hoped, that the FOC would want to protect its investment and pressurise its home government into intervening on behalf of the host country in such conflicts. At the above mentioned conference in Kuwait, the Kuwaiti oil minister was amongst those arguing in this way. However, it is hard to see, how the presence of FOCs in a country would deter, say, an aggressor. Evidence from other regions, for example Nigeria and Iran under the Shah, raises different security arguments: a significant involvement of foreign companies could cause domestic political tensions.

A final objective to be considered here, is the desire to increase production. Some countries might not be able to this on their own and thus want to cooperate with FOCs. For OPEC members this strategy raises some uncomfortable questions about their quotas. What happens when total production needs to be cut to a lower quota? In this event, a member country either has to reduce the NOC’s share of output in favour of the FOC’s share, or it has to decrease the FOC’s production which may discourage foreign investors.

Fiscal Regime

Neither Iran nor Kuwait who are currently opening-up their upstream sectors offer Production-Sharing Agreements (PSAs). Instead they have opted for service agreements or quasi-service agreements (as in the case of Iran’s buy-backs). These types of contract entail little risk, if any, for the FOC. However, the rewards, usually in the form of a pre-specified fee, do not rise sufficiently should discovery be substantial or oil prices increase. In addition, service contracts tend to be awarded for short periods of time. On the other hand, under a PSA the FOC bears most or all of the risk but its reward is a function of both production and price (subject to some ceiling). PSAs are signed for a time-span of up to 30 years.

In a nutshell, fiscal regimes are designed to maximise government revenue while at the same time providing sufficient incentives to foreign investors. Service agreements are regarded as less incentive-friendly than PSAs. Nonetheless, Iran’s experience with buy-back agreements shows that although FOCs might not like these contracts, they willingly sign them. Some simple game theory (alternatively, common sense will suffice) can easily explain why foreign firms agree to contracts that they claim not to like. First, there is the evergreen hope that the contract structure might change in favour of foreign firms as time goes by. Second, company A fears that if they refuse to sign the agreement, company B will do so. If then, at some time in the future, the contract on offer becomes more attractive for foreign investors, company B might be better placed for the award of the new agreement. It should not be forgotten that in the mid-1960s the large FOCs were not at all keen to sign the then newly introduced PSAs. These, over time, have nevertheless become one of the most common contract types.

From the point of view of the host countries it seems sensible to offer short-term contracts if foreign investment is needed chiefly for infrastructure purposes and the NOC is considered to be well capable to explore and develop reserves.

Globalisation

As globalisation marches through industries and economies it is not surprising that previously closed oil producing countries should invite FOCs. However, this appears to be a one way street: FOCs come into a country but the role of the NOC is curtailed. Why can the NOC not bid for the contracts on offer? Does this mean that after all these years the NOC cannot deliver? If this is the case, then it is certainly a good move to admit foreign firms, at least for a short period, in order to put pressure on the NOC to modernise itself and to adopt management strategies that will then enable it to run the country’s oil sector efficiently.

On the basis of the above discussion, the most important question that needs to be addressed is: who benefits from opening up? Is it the NOC, the host government, or the FOC? When opening-up the oil sector, many discretionary decisions have to be made. The scope for mistakes is great. It is therefore imperative to put in place an efficient institutional framework before entering into negotiations with FOCs.

By: K. Bindemann

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Country and Regional Studies , Oil

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