While real oil prices rose dramatically during the 1970s, there does not appear to have been a corresponding increase in petroleum exploration in the oil importing developing countries. Total exploration activity in these countries, measured by the number of exploratory wells drilled, was no higher in 1979 than in 1971, while in the United States over the same period it increased by about 50 per cent. The same picture emerges if seismic crew-months rather than wells are used as an index of activity. This apparent lack of response in developing countries cannot be explained in terms of an absence of geologic potential. A Bank-sponsored survey of oil and gas potential in oil importing developing countries concluded that of 70 countries evaluated, 38 had very high, high, or fair petroleum potential, and of that group only 8 countries were considered adequately explored.
Before accepting that private sector exploration has not been responsive to oil price increases, a number of caveats should be considered. First, as the chart indicates, over half the exploratory drilling in oil importing developing countries was undertaken by the government-owned national oil companies of a small number of large countries (notably Argentina, Brazil, and India), so trends in exploration in the public sector are as important as those in the private sector. Although reliable data are not available, fragmentary evidence suggests that, in fact, both public and private sector exploration have been relatively stagnant over the decade, although for different reasons.
Second, available data refer to total exploratory wells rather than the more relevant “new field wildcats” (exploratory drilling in areas with no proven petroleum, for which data are not available). Since by far the largest volume of exploratory activity takes place within producing basins, these data mask the trends in exploration in frontier areas which are more relevant for the majority of the oil importing developing countries. Finally, private sector exploration responds to higher prices only with a considerable lag, because of the time required to acquire exploration rights, evaluate existing data, and mobilize equipment. Since the second oil price “shock” of 1979–80, a modest increase in exploratory activity has occurred. Although over half this increase is attributable to higher national oil company exploration (in Argentina and Brazil), it is at least possible that a lagged increase in private sector exploration is underway.
Despite these caveats, it appears that private sector exploration in the oil importing developing countries has not increased at the rate previously anticipated nor to the extent observed in developed countries, particularly the United States. It is also clear that foreign oil company participation in oil importing developing countries has been dominated by a few very large multinationals. This is relevant to the analysis of constraints on private sector exploration in these countries. Two types of constraints appear to exist: those originating in developed countries and those originating in the oil importing developing countries themselves.
Bias in developed countries
The existence of special tax benefits for income arising from domestic petroleum production for both U.S. companies and individual shareholders is a major subsidy for domestic U.S. petroleum investment but it discourages exploration overseas, including in the developing countries. The United States is the major potential source of oil exploration capital in the developing countries. In recent years, progressive tightening of tax rules for the overseas petroleum income of United States corporations has increased this tax bias in favor of domestic petroleum investment. Tax benefits include the widespread use of “drilling funds,” which permit individuals to deduct from personal income a high share of exploration costs in the year incurred (and until very recently at marginal tax rates up to 70 per cent). The drilling fund is probably the single most important explanation for the unique presence of many small exploration firms in the United States.
|(In per cent of ultimate recoverable reserves)||0||14|
At the corporate level, discriminatory tax benefits include the retention for most companies of a substantial depletion allowance, which effectively shields 22 per cent of gross domestic petroleum income from taxation, and favorable income consolidation rules, which permit the deduction of losses incurred in domestic petroleum operations from domestic nonpetroleum income. A recent study showed that the effective corporate tax rate on petroleum income from United States operations is less than 15 per cent. A neutral tax system would impose the same effective tax rate on income from all sources, whether derived from domestic or foreign operations.
Constraints in LDCs
Four main types of constraints within oil importing developing countries can be distinguished: small fields; government policies; gas-prone areas; and political risk.
The global distribution of petroleum field sizes is highly skewed. While there are good prospects for economic discoveries in the developing world, there is a high probability that many of the fields encountered will be small by the standards of the major multinationals. It is widely acknowledged by oil industry representatives that the major oil companies are primarily interested in areas with potential for large fields—in excess of 500 million barrels of oil—and have no serious interest in exploring for oil fields with reserves of less than 50 million barrels (although they may, nevertheless, develop small fields discovered while searching for larger ones). Nor are they interested in exploring for gas fields with reserves of less than 3-5 trillion cubic feet—the minimum reserves required for a liquified gas export project to be economic. Yet, given the historical distribution of field sizes, it can be expected that over 70 per cent of fields discovered in developing countries will be in the smaller range. From the country’s point of view, at present costs and prices, these small fields can make an important contribution to net foreign exchange earnings. For a “typical” range of exploration and development costs, fields considerably smaller than 50 million barrels can generate an attractive economic rate of return (after allowing for the risk of sinking a “dry hole”).
If this is the case, why do private companies not search for these fields? The concentration of private sector exploration in developing countries in a few large firms (see the chart) has a bearing on this question. The few large firms engaged in international exploration have limited managerial resources; they seek to limit their exposure in developing countries and frontier areas, and ration exploration expenditures in line with current and expected internal cash generation. Thus they undertake only a limited set of the potentially profitable investments. While from a corporate viewpoint it is rational to invest limited resources in the search for large fields, profitable opportunities of vital importance to the developing countries get deferred.
Who does the exploration in developing countries?
Source: Petro Consultants.
1Shell, British Petroleum, Mobil, Texaco, Chevron, Exxon, and Gulf.
2Fortune 500 assets over US$1 billion.
3Fortune 500 assets US$100 million—$1 billion.
4Fortune 500 assets less than US$100 million.
A related point is that small fields, especially those in large countries, are less likely to produce an exportable surplus. The major oil companies and the developed country state oil companies are anxious not only to make a profit but also to secure physical access to crude to maintain security of supply for their downstream operations and home countries, respectively. For the majority of smaller North American independent oil companies, used to discovering and developing fields in the range of 1 to 10 million barrels, the “small fields” in developing countries are potentially profitable. However, their participation remains very minor, despite some increase in recent years. Smaller companies appear to be deterred by the large scale of international exploration expenditures relative to their cash flow, the tax benefits available for domestic exploration, and concerns about political risk in developing countries.
Government policy in developing countries can be a constraint to private sector exploration—either because acreage is not available to the private sector or because the terms and conditions on which it is available are unacceptable when compared with alternative investment opportunities. In most oil importing developing countries, public sector petroleum investment broadly coincides with national investment because, given the huge capital requirements of the industry, the only feasible alternative to foreign investment is often public sector investment. The presence of state oil companies transcends ideological boundaries and is often more a manifestation of nationalism than socialism. (This is true for most European developed countries too.) While it is understandable that governments of developing countries wish to avoid total dependence on foreign companies, in the 1970s state oil companies often held exploration rights over areas well in excess of what they could hope to explore in the near future. Often they were not subject to the same requirements applied to private investors to explore an area or relinquish it, and undoubtedly part of the supposed failure of private companies to respond to new opportunities was, in fact, a reflection of the lack of access to the more promising areas.
The fiscal terms in petroleum contracts may also have deterred private sector exploration in some cases. In response to the large oil price increases, countries raised substantially the government share of project revenues from royalties, taxes, production shares, and so on to obtain for the state a larger share of the resource rent and to limit the “windfall gains” made by investors. However, the structure of the fiscal terms in many cases not only limited windfall gains but also made it unprofitable for investors to explore for small fields.
Many basins in oil importing developing countries have characteristics that suggest that gas rather than oil may be found. Reserves have to be very large if liquified natural gas schemes are to be economic, and even then the capital requirements of such schemes are so vast that only a minority of very large oil companies could contemplate them. Smaller gas reserves may well be economic if a domestic market can be found, but private oil companies have shown little interest in exploring for gas fields where the output would be sold within the developing country.
This reluctance to become involved in gas development for the domestic market in developing countries results from several factors: the large financial commitment in distribution and marketing infrastructure, which has low returns on investment and a long payback period; the high political risk involved in having an investment tied to a single (usually government) buyer; the high market risk associated with sales linked exclusively to the growth of national demand; the absence of clear ex ante gas pricing rules; and the problem of access to foreign exchange to ensure remittance of earnings. Some of these problems—those relating to pricing and access to foreign exchange—can be alleviated through revised petroleum contracts; others—such as infrastructure costs—can be reduced by the financial involvement of multilateral lending agencies. But an important number of small economic gas prospects are unlikely to be sufficiently interesting to be explored or exploited by the major oil companies, even with contract revisions.
It is widely contended that corporate perceptions of high political risk are a serious impediment to exploration in the oil importing developing countries. The evidence suggests, however, that the major oil companies, while welcoming measures to stabilize relations with governments, do not see political risk as a fundamental impediment to involvement in developing countries. In part, this is because they can diversify such risk among countries just as they diversify their geologic risk by exploring in different areas simultaneously. The greatest concerns about political risk are, in fact, expressed by the smaller, primarily North American, independent companies who have less scope to diversify across countries and less experience in dealing with governments in the developing world.
It is sometimes suggested that developing countries should respond to company perceptions of political risk by offering more attractive fiscal terms. If this is interpreted to mean a low government share of profits whatever the size of the future discovery, however, that is likely to increase rather than decrease political risk. Incentive terms following an unexpectedly profitable discovery are inevitably widely perceived as unfair and accelerate demands for renegotiation of terms. A preferable response to political risk is to reduce the variance of the expected return and to accelerate payments to the investor in the early years of production, thus reducing the period during which the company is at risk. The implication is that the government should adopt a progressive fiscal system that accelerates company cash flow and limits the government profit share in the early years, but then increases that share progressively thereafter as actual field profitability increases.
Removing the constraints
In the developed countries, special tax benefits that deter investment in the developing world could be revised to improve both tax efficiency and equity. In the developing countries, improved government policies could accelerate exploration by ensuring that all oil companies—including the national oil companies—are subject to specific requirements to explore areas under license within a specified period or relinquish them, thereby increasing access to and competition for inactive acreage.
Increased exploration for small fields can also be encouraged through improved tax design. Typically, fiscal terms have tended to emphasize capturing revenues at the expense of exploration for small fields. Better-designed fiscal structures are needed, that minimize the fiscal burden on marginal fields but are strongly progressive with actual field profitability. This type of system is not only efficient but also contributes to contractual stability by automatically adjusting the government revenue in line with the actual outcome of exploration and development. The Bank has been working with developing country governments to assist in the design of such efficient fiscal systems.
The World Bank’s oil and gas lending program (through which US$1.5 billion has been lent for 39 projects) has been designed around the reduction of constraints on exploration and development in the oil importing developing countries to stimulate greater private sector exploration on terms that will encourage investment but ensure a fair share of benefits for the host country.
Loans for exploration and appraisal drilling, such as those in Tanzania and Pakistan, have helped the national oil company evaluate, respectively, a small gas-prone structure and a small oil field. Over half the development lending program is for gas development, particularly the financing of transmission and distribution infrastructure. The availability of this type of financing can stimulate increased exploration and development by private investors (for example, in Thailand and Bolivia) by limiting their financial and political exposure. Various forms of Bank “presence” have been formulated in the hope that they will provide an additional element of stability to government-company relations and thereby encourage new entrants (particularly the smaller, independent oil companies) into exploration as well as a higher level of cofinancing of development projects with private capital sources.
At the moment, national oil companies play a major role in exploration in many oil importing developing countries. Even with a shift toward greater private sector participation, the role of the national oil companies will continue to be important, partly because countries will not be prepared to have so strategic an industry exclusively in the hands of foreign companies and also because they will have a key role in those economic investments of little interest to the multinationals. They will, for example, have a key role in the exploration, production, and transmission of natural gas for the domestic market; the exploration of small fields; and investments in enhanced recovery from currently producing fields operated by the national oil company. Thus, there will continue to be a need for increased investment funds and technical assistance from multilateral agencies, such as the Bank, to support these national oil companies.
In conclusion, there do appear to be significant constraints to private sector involvement in exploration in the oil importing developing countries. In part, these constraints are inherent in the nature of the geological potential, technology, and political environment, and in part result from government petroleum policy. The Bank of and gas program provides a source of technical assistance to assist governments in devising improved petroleum policies to increase the flow of exploration investme while ensuring that the country’s interests are fully protected. The lending program is intended to be a catalyst that, by reducing the constraints, can stimulate an in increase petroleum investment in the oil importing developing countries far in excess of the amount of Bank lending.