Understanding and Mitigating COVID-19 Oil Price Impacts
By Tom Mitro
May 20, 2020
As the Executive Session explores the ways in which the power and influence of actors impact the governance of extractive industries, Tom Mitro, Executive Session participant, CCSI senior fellow, former oil executive and professor, helps us understand how this dynamic is at play during current low oil prices provoked by the pandemic. In turn, Tom gives guidance to oil rich governments seeking to strategize their response facing oil companies’ pressure. The findings of this blog are extended in a forthcoming broader framework on “the power and influence shifts over the lifetime of extractive industry projects.”
Oil and gas, like most commodities, are subject to great swings in price resulting in “boom or bust” cycles in economies that are dependent on earnings from oil and gas. Those cycles, even in “boom” times, negatively impact government debt, inflation, currency exchange, interest rates, employment, foreign investment, local content, and even corruption. Reduction in demand, due to the current COVID-19 situation, has created a dramatic drop in prices. Of course, oil company investors are also affected, but often have more options to deal with these impacts. It is important for governments and citizens of oil producing countries to understand how this dynamic affects the leverage of each party, and what governments, even with few options, can do to anticipate and respond.
Price swings impact economic and political stability
Being dependent on oil for a large segment of revenues often results in less diversification and flexibility in the economy as investors move out of other sectors into the oil sector and as foreign oil-related exchange rate movements make exports of other products less competitive. This results in fewer alternative sources of tax revenue available. During times of high prices, governments in developing economies see pressure from below to spend on new public projects and are swamped by banks willing to lend to them. Few governments during boom times have the political support or established built-in mechanisms to save and to diversify their economies using funds derived from the fiscal and taxation system applied to the oil sector. Employment may rise during boom periods, but so does public debt and corruption as numerous construction contracts are awarded. When oil prices drop, public projects are halted, debt service becomes untenable, employment declines, and a devalued currency makes imports prohibitively expensive. Investment by the foreign oil companies is cut. Intense pressure is applied by oil companies to improve their “deal” or to provide fiscal incentives. Political instability is exacerbated. The government and the economy become vulnerable and exposed.
Greater oil company options create leverage during times of low prices
In almost all cases, relative power will shift towards the government in times of higher oil prices, and to the international oil companies in times of lower oil prices. In general, the higher the commodity prices, the greater the power of the resource owner – that is, the government. The lower the prices, the more that power shifts to the entities with the greater access to capital, technology and markets – the international oil company investors.
Governments, as the owners and/or granters of petroleum mineral rights, in many cases receive 50% or more of petroleum sector profits through the fiscal system comprised of royalties, taxes and production sharing. The oil companies share the remainder. Consequently, the government tends to benefit more, proportionately, than the oil company investor from price increases, but suffers more profoundly from decreases. This fiscal structure effect can accentuate shifts in government vulnerability and influence due to price movements.
Oil companies also suffer during ”bust” times, but they have more options to anticipate and mitigate the impacts. Companies have learned to follow common practices and pursue strategies to:
- diversify by investing in downstream and chemicals which often remain profitable during times of low oil prices (e.g. “vertical integration” structure of the large IOC majors and some state-owned companies like Aramco),
- adopt conservative corporate treasury and “capital discipline” practices that avoid investments in less attractive projects and overborrowing,
- carry out price hedging,
- sell off operations to generate cash,
- apply pressure to their supply chain and sub-contractors to reduce prices,
- hire or fire employees, and
- quickly ramp up or cut back new investments.
This ability to “withhold” investment is often used as a lever during periods of low prices to pressure host governments to relax regulations, roll-back taxes and royalties, or create new fiscal incentives. During times of low prices, the combination of all these factors shifts power away from government and to the oil companies.
The boom cycle shifts in power can be seen most clearly in the large run up of oil prices in the 1970’s when many governments (UK, US, and most OPEC members, to name but a few) increased taxes and their equity shares of projects. In 2006, when oil prices exceeded $90 per barrel, the government of Angola was able to obtain bids of $1 billion from interested companies just for the rights to explore offshore. More recently, economic stabilization clauses in company agreements with governments have restricted options for governments to change laws or agreements, partly out of concern that governments would attempt to improve their deals during times of higher oil prices. Yet, during periods of low oil prices, the ability of oil companies to minimize their losses and to unilaterally reduce new investments is often used to pressure governments to grant fiscal incentives as a condition of resuming investments. See for instance, Chevron’s statement in 2017, “Existing tax terms are not very attractive. We have been working … with various departments of the government of Angola so that we can make it feasible and we can invest. Our investment will depend on what will result from these negotiations.”
Governments can adopt strategies to mitigate impacts of low prices
In light of all this, what can a government realistically do to offset negative impacts of the shift in leverage during this current time of reduced demand and low oil prices?
- Resist the urge to grant large, long-lasting incentives to investors during a time of low oil prices. In most cases, investors will eventually return anyway as markets stabilize. The recoverable oil and gas reserves in the country will not diminish just because of delays in investments. Further, it is debatable whether these incentives ever really result in greater investment or better results for the government. Oil companies face their own pressures from shareholders and lenders to minimize investments during low price periods which may not be changeable by granting fiscal incentives. Additionally, companies typically have contractual cancellation penalties in other operations that create disincentives for stopping work there; this further limits their ability to respond with new investments in countries providing fiscal incentives. Even if investment in a country does end up being stimulated by fiscal incentives, it often has negative short term impacts on government revenues at a time when it can least afford it, in the form of increased funding required for the national oil company, higher costs increasing tax deductions and lowering taxes paid, and more oil going to investor cost recovery. And typically, it takes years before renewed investments will result in more production and additional government revenues. All this takes place at a time when low prices place oil dependent countries in a precarious financial position– made even worse by demands for spending to ameliorate local social and economic impacts of a pandemic.
- Support legitimate oil company initiatives to reduce costs by other means. Some prime areas for savings are to eliminate expensive expatriate positions, restructure sub-contracts or supply agreements to obtain pricing concessions or link charges to oil prices, reduce or eliminate executive bonuses and pay rises, or, depending on contractual obligations, move away from more expensive foreign contractors to less expensive local suppliers. Resist cost recovery and tax deductions for expatriate severance packages that are not country-specific. Reductions in company operating costs immediately benefit government revenues via reduction in tax deductions and cost recovery or through reducing the cash calls on national oil companies. Arbitrary reductions in safety and environmental programs, deferral of essential maintenance, or unjustified or indiscriminate “sacking” of local staff should be avoided.
- Exercise caution in approving sales of IOC equity interests which introduce low-cost under-capitalized companies into the mix during times of low prices. They may be more aggressive in reducing operating costs but less capable of ramping up investment later. Many of these companies are speculators with sufficient funding to buy up interests cheaply when prices are low, but with no funds to invest in the country, and whose strategy is to immediately sell off their interest at a premium or farm out as soon as prices rise. There is little benefit to the government or the country from this type of activity.
- Use the lessons from the current price environment to build mechanisms in the broader government fiscal and monetary policies to minimize impacts of future “bust” cycles. These may include initiatives to:
- create or strengthen sovereign wealth funds and budget stabilization funds,
- impose rules prohibiting the use of commodities as collateral for debts,
- impose price-related limits on government expenditure budgets during times of high prices,
- establish formal limits on government debt levels,
- refine broader monetary policy,
- pursue opportunities to diversify the economy and minimize import reliance made more urgent when low oil prices have driven the currency to a low value, and
- plan for restrictions on new fossil fuel investments that will eventually accompany climate change treaties obligations. The impacts may end up closely mirroring the current low-price environment.
None of these measures are administratively or politically easy for any country to implement, but governments will continue to be vulnerable to low prices and the boom or bust cycle if they don’t recognize and anticipate these impacts and respond more proactively.