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UBC Theses and Dissertations

Uncertainties and petroleum resource production in developing countries Woods, John Togbakollie 1970

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UNCERTAINTIES AND PETROLEUM RESOURCE PRODUCTION IN DEVELOPING COUNTRIES by J. TOGBAKOLLIE WOODS B.Sc. , University of Kentucky, 1966 A THESIS SUBMITTED IN PARTIAL FULFILMENT OF THE REQUIREMENTS FOR THE DEGREE OF MASTER OF ARTS In the Department of ECONOMICS We accept this thesis as conforming to the required standard: THE UNIVERSITY OF BRITISH COLUMBIA September 1970 I n p r e s e n t i n g t h i s t h e s i s i n p a r t i a l f u l f i l m e n t o f t h e r e q u i r e m e n t s f o r a n a d v a n c e d d e g r e e a t t h e U n i v e r s i t y o f B r i t i s h C o l u m b i a , I a g r e e t h a t t h e L i b r a r y s h a l l m a k e i t f r e e l y a v a i l a b l e f o r r e f e r e n c e a n d s t u d y . I f u r t h e r a g r e e t h a t p e r m i s s i o n f o r e x t e n s i v e c o p y i n g o f t h i s t h e s i s f o r s c h o l a r l y p u r p o s e s may be g r a n t e d by t h e H e a d o f my D e p a r t m e n t o r by h i s r e p r e s e n t a t i v e s . I t i s u n d e r s t o o d t h a t c o p y i n g o r p u b l i c a t i o n o f t h i s t h e s i s f o r f i n a n c i a l g a i n s h a l l n o t be a l l o w e d w i t h o u t my w r i t t e n p e r m i s s i o n . D e p a r t m e n t o f Economics T h e U n i v e r s i t y o f B r i t i s h C o l u m b i a V a n c o u v e r 8, C a n a d a D a t e ACKNOWLEDGEMENTS Without the cooperation of certain individuals, this work would not have materialized. A l l of these individuals deserve my heartfelt thanks and deep appreciation. F i r s t , to Dr. Dale Orr for his daily counselling and words of encouragement; second, to Prof. A. D. Scott also for his advice, and to my friends, Faculty and Staff of the Department of Economics, U.B.C., for any contribution, however small. Lastly to my wife for her typing services and patience, and to Dr. Cy r i l Bright, Secretary of Planning and Economic Affairs in Liberia for his ardent support. i -ABSTRACT When making economic analyses about a c e r t a i n industry, i t i s e s s e n t i a l to make some basic assumptions. One of these assumptions i s e i t h e r c e r t a i n t y or uncertainty. With c e r t a i n t y , p redictions about economic behaviour can be made l e s s cautiously. The petroleum industry i s alleged to be influenced by elements of uncertainty, hence we expect that most of the decisions made i n the industry are governed by expected uncertain outcomes. The task of th i s study, therefore, was to f i n d out what the unce r t a i n t i e s might be i n the petroleum industry of the developing countries. F i r s t , we discovered that governments of the developing countries may expect f a r too much from t h e i r o i l resources. This expecta-t i o n may be derived from various sources. One of them i s the fore i g n exchange necessary to buy arms to defend t h e i r t e r r i t o r i e s ( l i k e i n the Middle East). Another source may be the pressing needs to accelerate economic growth. F i n a l l y , some of the countries may simply wish to be n a t i o n a l i s t i c . Regardless of the source, these expectations lead to some unc e r t a i n t i e s i n the industry. Secondly, some uncertainties are created by the o i l producing companies themselves. By accumulating very large c a p i t a l r e l a t i v e to companies i n other i n d u s t r i e s , companies make themselves vulnerable to i i p o l i t i c a l p o l i c i e s . And one reason why th i s accumulation of large c a p i t a l i s pos s i b l e i s that t h e i r home governments have provided the economic incentives f o r them to expand. T h i r d l y , there i s some degree of uncertainty s p e c i f i c to the petroleum industry. In the exploration stage, any ad d i t i o n to ca p a c i t i e s i s random. This randomness imposes unc e r t a i n t i e s about the supply conditions i n the industry. Also, there are a se r i e s of unce r t a i n t i e s about whether o i l can be found i n c e r t a i n place or not, q u a l i t i e s and quant i t i e s that are of commercial values, the changes i n the r e s e r v o i r conditions during productions and the usual u n c e r t a i n t i e s which face any i n d u s t r i e s , i . e . p r i c e or demand conditions, and cost or supply conditions. L a s t l y , the governments and o i l companies j o i n t l y agree to maximize the t o t a l p r o f i t s of o i l by seeking a common p r i c e p o l i c y but there i s a reasonable degree of uncertainty about how to share t h i s p r o f i t . We f a l l short of f i n d i n g an optimum device for sharing the rent. However, we can conclude that the optimum rent sharing p o l i c y depends l a r g e l y on the time horizon of the government of the developing country, and the type of economic growth i t p r e f e r s . i i i TABLE OF CONTENTS Page ABSTRACT t i TABLE OF CONTENTS i i i . LIST OF TABLES - ' i v LIST OF FIGURES v CHAPTER INTRODUCTION 1 I UNCERTAINTY AND THE GENERAL CHARACTERISTICS OF PETROLEUM DEVELOPMENT IN DEVELOPING COUNTRIES... 5 II AN ASSESSMENT OF THE PROBLEMS OF UNCERTAINTY 2 3 III PROBLEMS OF UNCERTAINTY IN EXPLORATION... 4 6 IV THE STRUCTURE OF THE CRUDE PETROLEUM MARKET 6 4 V THE RENT OF PETROLEUM RESOURCES AND SOME OPTIMUM SHARING STRATEGIES IN DEVELOPING COUNTRIES 79 SUMMARY 1 0 2 REFERENCES 1 0 4 i v -LIST.OF TABLES Page TABLE 1.1 AVERAGE DEGREE OF INTERDEPENDENCY OF PETROLEUM AND SOME PRODUCTIVE SECTORS IN JAPAN, ITALY, USA, AND NORWAY . 10 1.2 ANGLO-IRANIAN OIL COMPANY LTD. PAYMENTS TO GOVERNMENT AND PROFITS 1930-1039 12 1.3 LIQUIDITY AND LEVERAGE OF SELECTED INTERNATIONAL COMPANIES, 1969 13 1.4 RELATIONSHIP BETWEEN TOTAL INVESTED CAPITAL AND VALUE ADDED IN SELECTED INDUSTRIES 18 2.1 WORLD "PUBLISHED PROVED OIL RESERVES" AT END OF YEARS AND PERCENT BY AREAS 1962-1967 27 2.2 WORLD CRUDE OIL PRODUCTION 31 2.3 LESS DEVELOPED COUNTRIES-DAILY AND YEARLY PRODUCTION OF CRUDE BY REGIONS, 1968 & 1969 32 2.4 WORLD PETROLEUM PRODUCTION 1959-1969 33 2.5 WORLD PETROLEUM CONSUMPTION PATTERN BY REGIONS/ COUNTRY AND SELECTED PERIODS 34 2.6 A COMPARISON OF EXPORT MULTIPLIERS, CANADA, UNITED STATES AND VENEZUELA- 41 2.7 TOTAL U.S. EXPORTS AND PERCENTAGE OF CRUDE PETROLEUM 42 3.1 THE UTILITY OF A DRILLING VENTURE 62 4.1 CONCENTRATION RATIOS IN THE UNITED STATES OIL INDUSTRY PERCENTAGE OF NATIONAL OPERATIONS BY THE TOP SEVEN AND TOP TWENTY COMPANIES 73 V LIST OF FIGURES Page FIGURE 4.1 THE SUPPLY OF FUNDS OF AN INTEGRATED PETROLEUM FIRM 69 5.1 A HYPOTHETICAL SUPPLY AND DEMAND CURVES OF THE PETROLEUM INDUSTRY 96 5.2 A SECOND-BEST OPTIMUM PROFIT SHARING BETWEEN COMPANIES AND GOVERNMENT 99 - 1 -INTRODUCTION "A l l over the world, o i l - r i c h countries want more of what foreigners are pumping out of their territory". ^ Business Week "The people who lived for 5,000 years without petroleum can li v e without i t for many more decades in order to achieve their legitimate rights". ^ Moammer Khedaffi "The governments' contracts with international companies are based on profit sharing through realized prices and not posted prices". Jerry Haynes~* These three quotations represent the range of view points which crowd the interplay of negotiations and bids by foreign firms to ^ " A new way to squeeze the o i l companies", Business Week, May 16, 1970, p. 44. 2 Col. Khedaffi made this statement to 21 foreign o i l companies in T r i p o l i , Libya. See "Libya Price Fuss Heats Up". Oi l and Gas  Journal, February 9, 1970, p. 29. 3 Jerry Haynes, "Indonesia Offshore D r i l l i n g Increases: International Company Operations Encouraged by Stable P o l i t i c s , Economics and Contract Terms". World O i l , November, 1969, p. 121. - 2 -produce petroleum resources i n most "developing" countries^* of the free world. These a t t i t u d e s r e f l e c t the u n p r e d i c t a b i l i t y , speculation and v u l n e r a b i l i t y of the free world petroleum industry, e s p e c i a l l y given the i n e v i t a b l y impatient and dynamic environments of economic and s o c i a l development. Speculation and u n p r e d i c t a b i l i t y are i n d i c a t i v e of the absence of perfect information. Where.there i s imperfect information, unce r t a i n t i e s characterize decision-making processes and i n e v i t a b l y influence business behaviour. For an example, an employee who may lose h i s job f o r tardiness may have to secure an alarm clock even i f he i s accustomed to waking up at early hours of the morning. As yet another example, a lack of c e r t a i n t y about the future demand or supply conditions may be a b a r r i e r to the f u l l r e a l i z a t i o n of the goal of maximizing the expected net returns on a business venture. With t h i s i n mind, the purpose of t h i s thesis i s to draw atte n t i o n to some unc e r t a i n t i e s i n the petroleum industry i n most develop-ing countries. 4 The term "developing" has taken on several d e f i n i t i o n s i n the past two decades. Most of these d e f i n i t i o n s are r e l a t i v e to the requirements which a country has to meet i n order to increase i t s standard of l i v i n g comparable to the countries of Western Europe and North •America. A summary of theories of economic development can be found i n Stephen Enke, "Economists and Development: Rediscovering Old Truths", Journal of Economic L i t e r a t u r e , v o l . VII, No. 4, December, 1969. - 3 -In most of these developing countries, the r i g h t to the sub-surface resources such as petroleum i s reserved only to the state, a sovereign e n t i t y . In most cases, fo r e i g n companies provide the entre-preneurship required for adding economic values to these resources. These companies may be only l e g a l e n t i t i e s , but may also be very astute and i n t e r n a t i o n a l i n business p r a c t i c e s . 'Establishing a formal business r e l a t i o n s h i p between two pa r t i e s of these descriptions (sovereignty vs l e g a l e n t i t y ) i s the lawyer's business but the s e t t i n g i s very important to economists f o r three reasons. F i r s t l y , an economic analysis of the given s i t u a t i o n requires some basic assumptions drawn from an established r e l a t i o n s h i p . Secondly, a p r e d i c t i o n about the economics of the s i t u a t i o n may require a l t e r i n g t h i s r e l a t i o n s h i p i n the long-run. T h i r d l y , i f the business atmosphere or s e t t i n g of th i s established r e l a t i o n s h i p appears uncertain, a r e l a t i v e l y high discounting f a c t o r may dominate the economic analysis of the p r o j e c t . Such may be the case concerning the r e l a t i o n s h i p between o i l firms and developing countries. Among the unce r t a i n t i e s governing the r e l a t i o n s h i p between fo r e i g n o i l companies and developing o i l - r i c h countries, we i d e n t i f y , 1) uncertainty of a general nature introduced i n chapter I; 2) uncertainty about s p e c i f i c problems of excess reserves, f l u c t u a t i o n s i n the na t i o n a l income and government revenues, chapter I I ; 3) uncertainty about explora-t i o n , chapter I I I ; 4) uncertainty about the structure of the producing - 4 -f i r m and the a l i e n a t i o n of the r i g h t to the resource, chapter IV; and 5) uncertainty about the p r i c e structure and p r o f i t sharing, chapter V. Our obje c t i v e i n w r i t i n g t h i s thesis i s not to i n d i c t a company or a government. We simply wish to make economists aware of the kind of unc e r t a i n t i e s involved i n t h i s industry. 5 -" CHAPTER I UNCERTAINTY AND THE GENERAL CHARACTERISTICS OF PETROLEUM DEVELOPMENT IN DEVELOPING COUNTRIES In recent years, o i l - r i c h developing nations have made several moves to nationalize petroleum industries within their boarders. This vulnerability of the petroleum industry to the p o l i t i c a l policy of nationalization by the developing countries deserves some attention by economists. F i r s t l y , i t appears that the developing countries are not being well advised about the economics and the nature of the industry with which they are dealing. Consequently, these countries may be expecting far too much from the development of this resource. Section I of this Chapter introduces some of the reasons why we believe that this expectation may be too high. Secondly, perhaps some of the uncertainties in the petroleum industry have been overemphasized. Are the uncertainties of this industry greater than those, for example, in agriculture or aviation? Probably not. The second section introduces the general concept of uncertainty. Specifically, we think that uncertainties have provided the incentive for some petroleum companies to accumulate too much capital and to become large (measured in terms of capital size) relative to other industries. - 6 -Accordingly, we shall proceed to b r i e f l y examine these characteristics. Characteristics of Petroleum Resource Development Some changing policies of the government of some o i l - r i c h developing countries towards private o i l companies seem to indicate that these countries i n i t i a l l y overestimated the expected contribution (in terms of local employment and purchases) which their o i l resources can make to their gross national p r o d u c t . T h u s , the changing policies of governments stemming from the unrealized over a l l expected contribution of petroleum resources to the level of local purchases and employment may lend support to uncertainties in the industry in the long run. There are, indeed, several other factors in the developing o i l - r i c h countries which contribute to the changing mood of their govern-ments. Among them, "economic backwardness" is paramount. A nation which As a case in point, the government of Venezuela has given a f u l l support to o i l workers unions' efforts to secure higher wages and improved fringe benefits. Also, this same government has deliberately adapted a policy of maximizing i t s revenues from existing level of petroleum production with the intention of decreasing the dominance of the o i l industry accounting for 90 percent of i t s exports and 20 percent of G.N.P. but at the same time employs 2 percent of the labour force of a population growing at the rate of 3.5. See Peter Odell, "The O i l Industry in Latin America:, in Edith T. Penrose, The Large International Firm in  Developing Countries; The International Petroleum Industry. (London: George Allen and Unwin Ltd. 1968), pp. 295-6. W^e define "economic backwardness" as a situation where the income per head is below $300 but is capable of being increased given certain conditions. See Enke, Stephen, Economics for Development, (Englewood C l i f f s , N.J.: Printice Hall Inc., 1964), p. 17. - 7 -finds i t s e l f in this condition often finds i t imperative to quickly convert i t s natural resources into foreign exchange earnings required for purchasing the goods and services necessary for "economic forwardness". But "economic backwardness" i t s e l f may pose an obstacle for the development of petroleum resources. Basic infra-structure in transportation and communication, for example, may be a necessary prerequisite for attracting a firm into the industry. The general response to such a state of backwardness, or a pressing need for economic progress, is for the develop-ing nation to provide f i s c a l incentives such as duty-free privileges, and exemption from income taxes for a certain phase of the operation, in order to attract firms into the industry. The experience of this author and of others'' suggest that these incentives are not li k e l y to contribute to the objective of maximiz-ing the net rent of the stock of resources in the long run. This is true because these incentives are considered temporary by the providers but construed to be permanent by the recipients who may disregard the changing mood of the environment in which they are dealing. However, to say this does not exclude the possibility of providing different incentives for attracting firms in the industry. An example of g such an incentive, suggested by Prof. Tussing , is an investment made by ^Arlon Tussing & Gregg Erickson, Mineral Policy, The Public  Lands and Economic Development: The Case of Alaska, by permission. (Fairbanks, Institute of Social, Economic and Government Research, Univer-sity of Alaska, 1968), pp. 67-79. g Arlon Tussing & Erickson, op. c i t . p. 107. - 8 -the nation i n the state of knowledge about the g e o l o g i c a l endowment of the resource. This investment may create large enough demand for the stock of information required to induce the actual decision to invest i n , for example, mineral resources. Among the objectives of t h i s study i s to review some theories about the gathering of t h i s stock of information. However, our att e n t i o n i s f i r s t focused on the s i z e of the payoffs or the con t r i b u t i o n of petroleum development to the economy of a developing country. As a f i r s t approximation, consider petroleum resource develop-er ment to be a " D i r e c t l y Productive A c t i v i t y " i n Hirschman's terms . We can measure the degree of i t s interdependence with other sectors i n the economy of the producing country by simply computing: 1) the proportion of i t s t o t a l output that does not go to f i n a l demand but rather to other i n d u s t r i e s , and 2) the proportion of i t s output that represents purchases from other i n d u s t r i e s . These two measures have been suggested to represent"forward" and "back-ward" linkages r e s p e c t i v e l y . Table 1.1 shows average values for these measures for the economies of four advanced c o u n t r i e s . ^ 9 A. 0. Hirschman, The Strategy of Economic Development, (New Haven, Yale U n i v e r s i t y Press, 1958), pp. 77-119. 1 0H. B. Chennery and T. Wantanbe, "International Comparison of the Structure of Production," Econometrica, v o l . 26, No. 4, October, 1958, p. 493. - 9 -i i Column I of Table 1.1 contains s i x i n d u s t r i e s , i n c l u d i n g petroleum and natural gas. Column II indicates the r a t i o s of purchased inputs to value of t o t a l products o r i g i n a t i n g from these s i x i n d u s t r i e s . Compared to the r a t i o s (Column III) of the intermediate inputs to the t o t a l demand for a given product i n each of these selected i n d u s t r i e s , the r a t i o s i n Column II are much lower. This means that on the average, primary petroleum production, for example, requires only 15 cents purchased inputs to every d o l l a r worth of i t s product. On the other hand, 97 cents of every d o l l a r value of petroleum products i s sold to other i n d u s t r i e s i n these four economies. The former r e l a t i o n s h i p of input purchases to d o l l a r value of products measures the backward linkage, while the l a t t e r r e l a t i o n s h i p of sales to other i n d u s t r i e s and t o t a l product values, represents the forward linkage of petroleum production. When these linkages are measured for developing economies, d i f f e r e n t conclusions must be made regarding the r a t i o s i n Column I I I . In the developing countries, one may even expect Column I I I r a t i o s to be as low as those i n Column II of the advanced countries. This means, that both the forward linkages and the backward linkages i n the developing economies are low compared to those same linkages i n the advanced economies. This conclusion must be true because the developing economies do not have i n d u s t r i a l c a p a c i t i e s which require as much purchases from the petroleum 11 i n d u s t r i e s as the i n d u s t r i a l c a p a c i t i e s of the advanced countries require. 11. We are counting exports as a " f i n a l " (non-intermediate) demand. - 10 -TABLE 1.1 — AVERAGE DEGREE OF INTERDEPENDENCY OF PETROLEUM AND SOME PRODUCTIVE SECTORS IN JAPAN, ITALY, USA, AND NORWAY I II III "Backward Linkage" "Forward Linkage" 'Intermediate Primary-H-Production (Low U and High W) Sectors Ratio of Purchased Inputs to Value of Total Products In % Ratio of Intermediate to Total Demand for a Given Product In % 1. Petroleum & Natural Gas 15 97 2, Agriculture & Forestry 31 72 3, Coal Mining 23 87 4..- Metal Mining 21 93 5. Non-Metalic Minerals 17 52 6. Electric Power 27 59 Primary is here defined as a sector which has low purchasing power from other industries. Source: Econometrica, vol. 26, No. 4, October, 1958, p. 493. - 11 -Consequently, most of the o i l produced i n the developing economies c o n s t i t u t e a primary export commodity and the p r i n c i p l e expected contribu-t i o n may be i n terms of the d i r e c t payments to the governments of the developing countries. Compared to the c o n t r i b u t i o n to the gross n a t i o n a l product of the economy through forward or backward linkages, d i r e c t payments to governments i n taxes, bonuses, and/or r o y a l t i e s have a l a r g e r order of magnitude. However, the s i z e of these payments va r i e s with respect to time and between producing countries. Before 1950, f o r example, some major producing countries were c o l l e c t i n g around 25-30% of the net revenues of petroleum production (Table 1.2). Today, on the other hand, the 12 same countries are r e c e i v i n g between 60-90% of the net p r o f i t . One reason for t h i s development i s that the number of producers have increased considerably within the past decade. Another reason i s that o i l producing countries now have r e l a t i v e l y greater chances to enter the actual production process i f they are not s a t i s f i e d with the o f f e r s of e x i s t i n g producing companies. Knowledge about the resources as well as i t s market conditions strengthens the bargaining power of the developing countries to increase t h e i r share of the rent. The importance of such knowledge i s ou t l i n e d i n the next section and d e t a i l e d i n chapter I I I . Indonesia and Venezuela are among these countries. See footnotes 1 and 3. Table 1.2 Anglo-Iranian O i l Company Ltd."*" Payments to Government and P r o f i t s 1930 - 1939 (U.S. $0002) J930 1931 1932 1933 1934 1935 1936 1937 1938 1939 T o t a l 1930-9 1. Taxable Income i n c l u d -ing Depreciation 20,784 10,570 15,937 16,055 19,192 19,936 30,419 35,204 35,903 25,795 229,795 2. Royalty and Tax Paid to Iranian Government 5,670 378 7,406 4,998 6,045 6,137 7,224 9,926 9,260 7,758 64,802 % On Income (Item 1) 28 35 47 31 32 30 23 29 25 30 28 , i 3. Depreciation, Amortiza-t i o n & U.K. Income Tax 5,141 5,385 2,766 4,500 5,520 5,091 7,493 6,488 11,227 11,275 64,886 % On Income (Item 1) 25 29 27 39 39 37 33 18 33 43 29 4. Net After Tax P r o f i t s 9,973 4,807 5,765 6,557 7,627 8,708 15,702 18,790 15,416 " 6,762 100,107 % On Income (Item 1) 47 46 36 40 39 43 54 53 42 27 43 "*" Subsidiaries are excluded 2 Conversion i s based on $2.80 per h Source: The Large International Firms, i n Developing Countries, p. 68. - 13 -Uncertainty i n the Petroleum Industry In addition to the problem connected with the development expectation (outlined above as ch a r a c t e r i s t i c of petroleum resource develop-ment i n developing countries), other uncertainties play a v i t a l role i n the decision-making process. This r o l e i s greater i n the e a r l i e r stages 13 of petroleum development, s p e c i f i c a l l y i n the exploration stage. In that stage, decisions are made based on thei r expected influence on future events. For example, the amount of money to be spent on an exploration a c t i v i t y i s usally determined by the economic value of the expected reserves to be found. But uncertainty i s also present to an unusual extent i n the l a t e r stages of petroleum production, p a r t i c u l a r l y for foreign firms producing o i l i n the developing countries. These firms are uncertain about whether the governments of those countries w i l l increase their tax rates, r o y a l t i e s or bonuses. There i s also the usual uncertainty about the market prices of the products as wel l as the prices of the factors of production, and i n f a c t , the p o l i t i c a l climate i n which the resource i s located i s subject to unexpected change. Granting that a l l these uncertainties exist i n the industry, one of the tasks of this study i s to assess their effects and to suggest ways of minizing t h e i r costs i n the industry. 13 For an excellent discussion, see J. C. Grayson, Decisions  Under Uncertainty, (Boston, Harvard University Press, 1960). - 14 -j The direct effect of uncertainty i n the industry i s viewed i n terms of i t s substantial influence on costs and the l e v e l of invest-ments. In p a r t i c u l a r , the output capacity and costs of operating a petroleum f i e l d are seldom known with confidence u n t i l a large fixed investment has been committed or sunk into exploration and development. In professional terms, the production function of a contemplated "plant" w i l l not be known with any degree of confidence u n t i l after production commences. Furthermore, world conditions, such as the Suez C r i s i s i n 1956 or a new discovery, are uncertainties which may generate s h i f t s i n 14 the world demand for and supply of crude o i l . In addition to these, the influence of technical s h i f t s and c y c l i c a l fluctuations i n the business cycle cannot be ignored as a further source of uncertainties. The effects of uncertainties outlined above play a p a r t i c u l a r role i n the evaluation of expected revenues i n the present r e s t r i c t i n g the sources of c a p i t a l used i n the industry. This r o l e w i l l be described l a t e r . Uncertainty also affects i n s t i t u t i o n a l factors which lend themselves to an examination. But for the moment, i t i s appropriate to examine the direct cost of uncertainty. We w i l l define the cost of uncertainty as the net benefit gained by obtaining certainty. Frank Knight"'""' has contributed the c l a s s i c a l d i s t i n c t i o n between r i s k s and uncertainties. According to Knight, i f uncertain events 14 M. A. Adelman, "World O i l Outlook", i n Marion Clawson, edited for Resources for the Future, Natural Resources and International Develop-ment, (Baltimore, John Hopkins University Press, 1964), p. 28. ^Frank Knight, Risk, Uncertainty and P r o f i t . (Boston, Houghton M i f f l i n , 1921), pp. 43-6. - 15 -obey certain p r o b a b i l i s t i c rules, they are called " r i s k s " . For instance, i t i s risky to buy a ti c k e t i n a r a f f l e because i t i s highly probable your tic k e t w i l l not be drawn to win. The r i s k s are capable of being pooled. Unfortunately, i t i s not so easy to transform a l l uncertainties into r i s k by pooling th e i r costs. D i f f i c u l t i e s a rise when the occurence of the uncertain events are infrequent and unique and when there i s a lack of an i n s t i t u t i o n to manage the transformation. Events of this nature are r e a l uncertainties. Recognizing this d i s t i n c t i o n , we s h a l l note that costs of some uncertainties can be minimized, through an i n s t i t u t i o n a l arrangement such as insurance. The p r i n c i p l e involved i s to break down a large quantity of uncertainty into smaller b i t s and spread them among individuals with s i m i l a r c h a r a c t e r i s t i c s . For example, an in d i v i d u a l who wishes to avoid paying higher medical costs from an auto accident w i l l purchase an auto insurance premium. By so doing, he spreads the cost, i n case of an accident, over many individuals who are i n the same group with him. By the same token, several geographically contiguous countries with s i m i l a r geological c h a r a c t e r i s t i c s , may e f f e c t i v e l y obtain a degree of certainty i n thei r petroleum resource development embarking upon j o i n t or regional geological information gathering. Under this condition, the expectations of each country's petroleum exploration w i l l remain the same but the costs of deriving those expectations w i l l be spread among the participants. We s h a l l survey the l i t e r a t u r e on the implication of this - 16 -problem i n Chapter I I I of this study. Meanwhile, the cha r a c t e r i s t i c s of the management or firms i n the petroleum industry beg my attention next. Characteristics of a Petroleum Producing Firm In assessing the effects and the costs of uncertainty i n the petroleum industry, i t was alleged that uncertainty plays a central role i n influencing investors' attitude towards the futute and the nature of the source of c a p i t a l . In this section, we w i l l examine the characteris-t i c s of the firm i n the l i g h t of how i t s c a p i t a l structure may provide a source of uncertainty v i a v u l n e r a b i l i t y to p o l i t i c a l p o l i c i e s . A s t a r t i n g point i s to review the c a p i t a l structure of a firm i n the industry. Table 1.3 provides a factual summary of the c a p i t a l structure of several firms. As a case i n point, a l l the petroleum firms under review have debt equity ratios less than 30%. This simply means that no more than 30 cents of a d o l l a r c a p i t a l i z a t i o n i s obtained from external sources. One company holds more than f i v e times as much int e r n a l funds as external funds for c a p i t a l i z a t i o n . Outside the petroleum industry, however, only one company appears to be conservative i n our sense. Most of the other companies maintain at least a one-to-one correspondence relationship between debt and in t e r n a l c a p i t a l . The r a t i o of c a p i t a l to value added i n the industry i s very high. From the examples of Table 1.4, no o i l company maintained less than 60 cents sales on a d o l l a r of invested c a p i t a l . This relationship TABLE 1.3 Liq u i d i t y and Leverage of Selected International Companies 1969 I I I I I I IV V VI COMPANY Total Equity Total Retained Earnings Total Long Term Debt Cash Dividends Retained Earnings as % of Equity Debt as % of Capital $m $m U.S. $m U.S. $m U.S. 1. Standard O i l (N.J.) 1,0093 7863 2174 806 79 22 2. Gulf O i l 5039 3556 1447 312 70 28 3. Getty O i l 1230 1114 117 11 91 10 j. 4. I.B.M. 5276 3000 554 407 56 11 i 5. Gen Tel & Electronics , 2314 925 2867 160 40 123 6. International Paper Company 1122 556 373 66 50 33 Source: Company's Annual Reports provided the absolute figures i n Volumns I-IV. V-VI were computed. - 18 -TABLE 1.4 Relationship Between Total Invested Capital and Value Added i n Selected Industries 1969 I II I I I Invested Capital COMPANY Sales3 Invested Capital as % Net Sales $m U.S. $m U.S. 1. Mobil O i l 6000 4000 66.7 2. Texaco 5800 5900 102.0 3. General E l e c t r i c 8000 3000 37.5 4. Crysler 7000 2000 28.6 5. Gulf O i l 4900 5300 103.3 6. Du Pont (E.I.) 3600 2600 67.3 7. Shell O i l 3500 2700 62.8 8. Good Year 3000 1000 33.3 9. Sun O i l 1800 1600 88.8 Sales include revenues derived from at least 50% i n manufacturing and mining operations as of December 31, 1969, A l l sales exclude excise taxes except for some petroleum companies. Invested Capital includes c a p i t a l stock, retained earnings and surpluses. Source: Company's Annual Report (1969) except Column I I I , computed from Columns I and I I . - 19 -between c a p i t a l and value added or sales, gives r i s e to diminishing returns to fixed c a p i t a l i n the short-run. Perhaps, the significance of t h i s diminishing returns may be reflected by the s e n s i t i v i t y of the i '16 management to p o l i t i c a l p o l i c i e s . The nature of the management of a petroleum firm i n a develop-ing country today has been recognized by most writers to be very complex. Prof. Penrose concluded: "These firms or groups ...possess extensive power for the exercise of which they are accountable to no one ... Their a c t i v i t i e s guide the search for p r o f i t but their motive i s not a simple motive for making money".1? Although these ch a r a c t e r i s t i c s appear to provide a cushion to the leverage of management to p o l i t i c a l or national p o l i c i e s , we w i l l argue that high r a t i o of fixed c a p i t a l to value added makes the firm even 18 more vulnerable to these government p o l i c i e s . Subsequently, we w i l l show that this structure imposes diminishing returns on the input of the management i n this industry more so than on those i n other industries. This assumption of diminishing returns to management i s the basis of our discussion i n Chapter V where the role of conservation i n production i s also defined. The next section describes this role of conservation. This s e n s i t i v i t y has been demonstrated i n a number of ways i n d i f f e r e n t countries. In the U.S., see for example, "Emotions guiding Vote on Percentage Depletion" World O i l , November 1969, pp. 11-14. (New York: Frederick A. Praeger, 1966), p. 10-12. ^ E d i t h T. Penrose, Large International Companies i n the  Developing Countries; The International Petroleum Industry, (London: George Al l e n and Unwin Ltd., 1968), p. 27. - 20 -Conservation The management of any natural resources today requires conservation for e f f i c i e n c y . The term "Conservation" has embraced several d e f i n i t i o n s i n the l i t e r a t u r e , some of which c o n f l i c t with one another. Without considering the differences i n meaning for the sake of brevity, s u f f i c e i t to sum up the fundamentals of the wave of growxng concern for conserving natural resources. 1. The prevention or reduction of physical waste of natural resource products; 2. Optimum rate of extraction or pattern of extraction of an exhaustible resource over time; 3. Preservation of the c a p i t a l stock, as i n fi s h e r i e s or to an environmental complex such as Watershed; 4. Preservation of open space or unspoiled wilder-ness for aesthetic, s c i e n t i f i c , and recreational purposes; 5. Attention to the quality of environment, such as minimizing water degradation or p o l l u t i o n of the atmosphere, s o i l s and scenery. 18 For an example, o i l sector i s too dominant i n Venezuela, accounting for 90 percent t o t a l exports and 20 percent of G.N.P., but employs "only 2 percent of the labour force. This background to v u l n e r a b i l i t y of o i l companies to government policy i s discussed by Peter R. Odell, "The O i l Industry i n Latin America" i n Penrose, op. c i t . p. 274. 19 H. J. Barnett and C. Morse, Scarcity and Growth, Resources for the Future, Inc. (Baltimore, The John Hopkins University Press, 1962), pp. 72-82. - 21 -The apparent c o n f l i c t between some of these d e f i n i t i o n s can be resolved by an economist as soon as he conceives of a cost-benefit analysis or alternative uses of the resource i n question. For the purpose of this study, the most important concept of conservation i s that which relates to the commercial uses and the necessity for administration or l e g i s l a t i o n of resources which are treated as common-property. In petroleum production, this concept relates to the r e s t r i c t i o n of production especially where a firm or in d i v i d u a l on i t s own r e s t r a i n t cannot assure the preservation of an o i l f i e l d . The basic hypothesis underlying this concept i s that a rent maximizing petroleum resource owner w i l l remove crude o i l from his reservoir at a commercially optimum rate, and would do so e f f i c i e n t l y only i f s e l f interest i n a l l 20 inputs i s opportune. The basis for understanding this hypothesis w i l l be elaborated i n Chapter IV. In summary, I have generalized the cha r a c t e r i s t i c s of petroleum resource development i n developing countries. S p e c i f i c a l l y , the problems of economic backwardness, uncertainty and the nature of the management have been b r i e f l y explored. Add i t i o n a l l y , the problem of conservation i n this p a r t i c u l a r industry has been exposed. My next task i s to attempt to reduce these generalizations into s p e c i f i c facts and problems whose solutions w i l l be subsequently sought. Wallace F. Lovejoy and Paul T. Homan, Economic Aspects of O i l Conservation Regulation, (Baltimore: The John Hopkins University Press, Resources for the Future, 1967), pp. 21-22. - 22 -Accordingly, Chapter I I proceeds to state the facts and to formulate problems therefrom. Chapter I I I reviews some thoughts on solution to the problem of reducing uncertainty, while Chapter IV throws l i g h t on the structure of the industry and how property rights are obtained. Chapter V provides a summary which puts the welfare (as far as the producing firm and the resource country are concerned) aspect i n perspective by providing a feasible p r o f i t sharing arrangement or device. - 23 -CHAPTER I I AN ASSESSMENT OF THE PROBLEMS OF UNCERTAINTY From the generalizations made i n Chapter I regarding c h a r a c t e r i s t i c s of the development of petroleum resources i n developing countries, four implications may be drawn: 1. Developing "countries t y p i c a l l y over-estimate the backward linkages of petroleum resource development; 2. I f petroleum production i s not carried out under the economic conservation rules governing common-property resources, the present value of the anticipated rent to the developing countries may not be maximized; 3. There i s probably more o i l available now than the would can consume. Yet, because of uncertainty, there i s a tendency to provide more incentives to carry on even further discovery a c t i v i t i e s . 4. The proportion of the rent gained by the national governments of the developing countries depends on the kind of i n i t i a l contractual arrangements, the era i n which the nation became a producer, and the nature of the extracting firm with which the i n i t i a l contractual arrangements are made. But the passage of time seems to r e f l e c t favourable changes for these countries. The purpose of this Chapter i s to translate these four implications into facts and figures from which meaningful problems can be formulated. Subsequent chapters w i l l provide solutions for some of these problems. Meanwhile, I proceed to l i s t d i f f i c u l t i e s encountered i n translating these implications into concrete facts. - 24 -As an example of the d i f f i c u l t i e s involved, the s t a t i s t i c a l reporting agencies often withhold certain information on grounds that t h e i r disclosure i s not i n the best interest of the companies and the industry as a whole. Furthermore, f i n a n c i a l s t a t i s t i c s by companies operating i n the developing countries, for reasons stated e a r l i e r i n Chapter I about the t r a d i t i o n and v u l n e r a b i l i t y to public p o l i c i e s , are ©classified and made unavailable for research purposes. Despite these d i f f i c u l t i e s , the facts about the petroleum industry are t r a d i t i o n a l l y reported i n one of several aggregate forms: 1. World reports on production consumption, ^ reserves, refinery and-marketing a c t i v i t i e s ; 2. Regional, national and state a c t i v i t i e s i n the industry; 3. World-wide company a c t i v i t i e s i n research, development and exploration;^2 4. General a c t i v i t i e s i n the national economy as reported by the United Nations Regional Offices such as the Economic Commission for A f r i c a (E.C.A.), the Economic Commission for L a t i n America, (ECLA), and the Economic Commission for Asia and the Far East (ECAFE). See Petroleum Facts and Figures, 1966. The tot a l s on some of the s t a t i s t i c a l tables do not add up because certain information was withheld for publication. Richard Sparling et a l . , Capital Investment of the World  Petroleum Industry, The Chase Manhattan Bank Energy D i v i s i o n , 1966. Since economic decisions, especially i n resource a l l o c a t i o n , are made on incremental benefits against incremental costs, the aggregate facts referred to above do not render much aid i n f a c i l i t a t i n g such decision-making. C i t i n g an example, i t i s d i f f i c u l t on the basis of these figures to calculate the marginal cost incurred i n l i f t i n g a 23 barrel of crude to the surface of an o i l reservoir. However, the facts about the petroleum industry i n developing countries, at best i n their aggregate forms, can be used to make general, second-best conclusions about where the industry has come from, where i t i s heading, who i s gaining or losing, and i n par t i c u l a r what minimum relationship can be established to restore p r e d i c t a b i l i t y i n the economic milieu of the industry. From these points of view, we f i n d the following fac t s . The Facts and Problems About Crude Reserves World t o t a l petroleum crude reserves have been r i s i n g steadily because the rate of discovery has increased and the sources discovered have higher average deposits per discovery since 1950. Table 2.1 shows world "published proved reserves", and the percentage composition per region from 1962 to 1967. I t can be observed that developing countries maintain over 75% of t o t a l world reserves and over 80% of the free world supplies. Paul G. Bradley, The Economics of Crude Production, (Amsterdam: North Holland University Press, 1966). _ 26 -Reserves are, by analogy, inventories for petroleum producers. The optimum quantity of reserves i s determined by imputing costs against the benefits for holding. Although this problem w i l l be taken up i n the next chapter, s u f f i c e i t to observe that there i s a basic difference between inventory held for manufacturing and inventory held as crude reserves. The difference l i e s i n the fact that a l l holding costs of the former are rather more e x p l i c i t than those of the l a t t e r . To understand the difference between costs of holding reserves and costs of inventories held for manufacturing, the two concepts need to be c l a r i f i e d . Petroleum crude reserves are a result of the difference between the rate of production and the rate of discovery, while manufactur-ing inventory i s the difference between the levels of production and sales. The l a t t e r difference i s determined by unexpected changes i n demand and price levels while the former i s determined by sheer luck i n discovery plus a v a i l a b i l i t y of f i s c a l incentives (depletion allowance of 25 percent and 33 percent i n U.S. and Canada respectively). We might expect a manufacturing inventory to be d i r e c t l y related to short-run market conditions or business cycle fluctuations over which a firm has no direct control, but rather adjusts the l e v e l of inventory to them. On the other hand, the volume of petroleum reserves held may not bear a direct relationship to the business cycle i n the short-run. I t may be i n the best interest of the firm to correlate production to demand, but since o i l i s discovered and enters reserves i n unpredictable and lumpy amounts, this w i l l not leave a strong relationship between reserves and demand conditions. Table 2.1 World "Published Proved O i l Reserves" at End of Years and Percent by Areas 1962 - 1967 ( B i l l i o n BBLS.) AREAS/COUNTRY 1962 Res. % 1963 Res. % 1964 Res. % 1965 Res. % 1966 Res. % 1967 Res. % USA 38. ,7 12. .2 38. ,6 11. ,5 38. ,7 11. ,2 39. ,4 11. ,0 39. ,8 10. ,2 40. ,0 9. ,6 Canada 4. ,8 1. .6 5. .6 1. ,7 7. ,0 2. .0 7. ,7 2. ,2 9. ,1 2. ,3 9. ,5 2. ,3 Caribbean 18. .4 5, .9 18. ,4 5. .5 18. .8 5. .4 19. .3 5. ,4 19. ,6 5. ,0 19. .4 4. .6 Other W. Hemisphere 5. .8 1. .9 5. ,9 1. .7 6. .8 1. .9 5. .9 1. .6 7. ,5 1. .9 7. .5 1. .8 Total W. Hemisphere 68. .2 21. .6 68. .5 20, .4 71. .3 20. .5 72. .3 20. .2 76. .0 19. .4 76. .4 18, .3 Western Europe 1. .8 .7 2. .2 .8 2. .7 .8 2. .6 .7 2. .9 .8 2. .8 .7 A f r i c a 12. ,3 3. .7 16. ,3 4. ,9 19, .4 5. .6 •23. .0 6. .5 32. ,4 8. ,3 42. .3 10. .1 Middle East 193. .9 61. .1 207. .0 61. .7 211, .5 60. .9 214. .9 60. .1 234. ,6 59. .9 248. .5 59. .5 USSR, E.Europe & Red China 39. . l b 12, .7 40. ,6 12. .0 30, .8 8, .9 33. .5 9. .4 33. .8 8. .6 35. .8 8. .6 Other Eastern Hemisphere .6 .2 1. .0 .2 11, .6 3, .3 11, .0 3. .1 11. .8 3. .0 11. .8 2, .8 Total Eastern Hemisphere 249. .8 78, .4 266. .8 79. .6 276. ,0 79, .5 285. .0 79. .8 315. .5 80. .6 341. .2 81. .7 Free World ^ 287. .5 90, .6 305. .8 96, .1 316, .5 91, .1 323, .8 90, .6 357, .7 91, .4 381, .8 91, .4 Developing World }of Free World }of World 243. .2 84, 76. .5 .5 259. ,4 84, 77. ,8 .3 268. .1 84, 77, ,7 .1 274. .1 84. 76, .6 .7 305. .9 85. 78. .5 .1 329. .5 86. 78, .3 .9 World 317.5 100 335.4 100 347.3 100 357.3 100 391.5 100 417.6 100 South America and Mexico Includes the East Indies and South East Asia World Reserves less USSR, China and East Europe World Reserves minus : USA, Canada and Western Europe Source: S t a t i s t i c a l Review of the World O i l Industry, B r i t i s h Petroleum. - 28 -In the case of either reserve accumulation or manufacturing inventory accumulation, the optimum l e v e l held depends on the motives for holding. For s i m p l i c i t y and convenience, l e t us assume that 24 "buffer stock ' motive i s the p r i n c i p l e reason for firms to hold inventory, i . e . when sales exceed their anticipated l e v e l , the buffer fin i s h e d -goods inventory carried i n order to prevent "runouts i s depleted, or accumulated i f sales forecasts are unduly o p t i m i s t i c . " By the same token, excessive production over an anticiapted l e v e l depletes the buffer stock of reserves while a production rate short of the anticipated l e v e l leads to the accumulation of reserves. In each case, there are costs for either holding or not holding inventory and each firm, whether i n manufacturing or i n petroleum production, decides these costs and determines the optimum inventory/sales r a t i o (in the case of the manufacturing firm) or the reserves/output r a t i o ( in the case of the petroleum producing firm). In general the cost of holding any asset i s the rate of discount. For our purposes, this rate depends on how the owner of the reserves discounts future revenues as against present intakes. P a r t i a l l y , this i n turn depends upon the alternative uses of the owner's money while waiting. The higher this rate, the more i t w i l l cost the owner to wait. 24 Michael Evans, Macroeconomic A c t i v i t i e s : Theory, Forecasting  and Control; (New York: Harper & Row, 1969), pp. 201-204. Mentions at least three motives for holding inventories: transaction, buffer stock and speculative. - 29 -To bring this argument on l i n e with the theme of this study i s to conclude that one of the factors which influence the rate at which an operator heavily discounts the future i s p o l i t i c a l i n s t a b i l i t y or fear of uncertain and unfavourable government p o l i c i e s . On the government side, pressing needs for development or national emergencies such as war may also be a factor which may influence heavy discounting of the future as against the present. However, the rate of discount i s necessarily related to the expected prices of crude. When the rate of discount i s r i s i n g , price of crude i s constant i t w i l l pay to run down reserves now and l a t e r Conversely when the price expectation i s low, i t has the same effect as a high discount rate: i t pays to throw excess reserves into the market now. Despite these costs, there seems to be advantages of holding reserves. Accumulation of reserves can provide s e l f - s u f f i c i e n c y i n production, r e f i n i n g and marketing. This w i l l increase the prob a b i l i t y of the firm receiving a predictable flow of crude at stable and competitive costs. Also, holding reserves serves as s t a b i l i z a t i o n function by allowing gradual adjustment of existing producing f i e l d s against competition from newly discovered ones. This adjustment i s gradual because actual production cost i s small and i t takes a considerable 25 amount of money and time to develop new f i e l d s for production. M. A. Adelman, World O i l Outlook, i n M. Clawson, ed., Natural Resources and International Development. (Baltimore: John Hopkins University Press, 1964), p. 67. - 30 -We w i l l now focus our attention on the facts and problems of petroleum extraction or production. Facts and Problems of Petroleum Production Table 2.2 provides information about the growth i n regional productivity before 1963. In 1948, for an example, North and South America commanded 78 percent of the world t o t a l petroleum output; the Middle Eastern countries produced only 12.2 percent; while Europe and the rest of the world contributed 7.5 percent and 2.2 percent respectively. This balance had shifted by 1963. The share of the Western Hemisphere had f a l l e n to 33 percent while those of the Middle East and A f r i c a had increased by twofold and fourfold respectively. The present production picture appears even more dramatic for the developing countries. In 1968 and 1969, these countries produced a steady and strong 54 percent of daily world production. This phenomena i s outlined on Table 2.3 In addition to d i v e r s i f i c a t i o n of the sources of petroleum production within the past decade, there has been a rapid expansion i n the volume of world output. Table 2.4 below v e r i f i e s this statement. I t can be seen that 1969 output was double that of 1959. Annual increases i n output averaged more than 7 percent over the same period. TABLE 2.2 World Crude O i l Production 1948 1963 AREA North America (USA) South America & West Indies Europe A f r i c a Middle East Far East & Oceania Total, World M i l l i o n Barrels 2087 575 257 13 417 61 Percent of World 61.2 16.9 7.5 0.4 12.2 1.8 M i l l i o n Barrels 3125 1468 1713 434 2486 250 3410 100.0 9476 Percent World 33.0 15.5 18.1 4.5 26.2 2.6 99.9 includes USSR Source: Paul G. Bradley, The Economics of Crude Production. - 32 -TABLE 2.3 Less Developed Countries-Daily and Yearly Production of Crude by Regions, 1968 & 1969 000 Barrels Daily M i l l i o n Barrels Annually AREA " 1969 1968 1969 1968 SOUTH AMERICA 4716 4625 1721 1692 W. Indies 3 1176 64 1183 Lati n America 4540 4442 1657 1625 AFRICA 4987 3947 1820 1444 N. Africa, 4396 3723 1604 1362 W. A f r i c a 591 224 216 82 MIDDLE EAST° 12356 11241 4510 4114 ASIA AND FAR EAST 488 1053 465 385 Far East 401 364 146 133 Oceania^ 87 319 689 Total LDC 22547 20866 8516 7635 World 41404 38317 15112 l|020 includes estimated Caribbean production. average of l a s t s i x months, influenced by the Nigerian C i v i l War. does not include Kuwait-Saudi neutral zone, only Indonesian and Burnei-Malaysia. LDC = Less Developed Countries Source: World O i l , February 15, 1970, p. 96. - 33 -TABLE 2.4 WORLD PETROLEUM PRODUCTION - 1959 - 1969 YEAR In M i l l . BBL Annual Increases 1969 15112 8.1 1968 15020 9.3 1967 12888 7.7 1966 11962 8.6 1965 11010 7.3 1964 10263 8.3 1963 9476 7.1 1962 8852 8.7 1961 8144 6.2 1960 7666 6.2 1959 7110 7.8 Source: World O i l , February 15, 1970, p. 96. There are several factors which contributed to the rapid expansion i n the volume of world output. One of these factors was the rapid expansion i n the consumption demand of Western Europe and Japan. Within the period mentioned above, the proportion of world consumption coming from these two areas doubled. North American consumption rate als grew, while that of the developing countries grew rather slowly r e l a t i v e to th e i r producing capacities. Table 2.5 indicates the world o i l consump tion pattern from 1948-1968. TABLE 2.5 World Petroleum Consumption Pattern by Regions/Country and Selected Periods (1^ 1000 Barrels Daily) REGIONS/COUNTRIES PERIODS. * 1948 1958 1963 1968 Consumption 5 { World Consumption % World Consumption % World Consumption ° ( World North America 6215 66.8 9850 52.1 11,550 43.7 14,410 37.7 USA (5760) (61.9) (9080) (48.4) (10,550) (39.2) (10,380) (32.1) South America 604 6.5 1420 7.1 1,830 6.9 2,370 6.1 Western Europe 1681 a 18.1 3120 16.6 6,080 22.5 9,980 25.2 Japan 340 2.8 1,250 4.7 2,810 7.3 Others 805 8.7 4010 b 21.4 6,150b 22.8 9,220b 23.7 b World Total 9305 100.0 18749 100.0 26,860 100.0 38,790 100.0 c Less Developed Areas 799 8.5 2780 14.8 3,770 14.0 5,770 14.3 includes USSR and China, includes USSR and Eastern Europe. includes South American, Asian and African regions, consumption rates reduces to 7% i f South A f r i c a i s excluded Sources: 1. B r i t i s h Petroleum^Statistical Review of the World O i l Industry, 1968. 2. Bradley, The Economics of Crude Petroleum Production, p. 5. - 35 -Perhaps the most important factor i s the increase i n the number of companies engaged i n petroleum production. As an i n d i c a t i o n , Fanning reported that 28 U.S. companies were active i n foreign explora-t i o n and/or production of o i l before 1945. By 1958, that number increased to 190. The combined number of U.S. with other foreign companies 26 operation increased by 380\ from 218 to 598 within the same period. Furthermore, an expanding range of petroleum products are playing a s i g n i f i c a n t part i n -increasing the industry's t o t a l demand. A forecast for 1970 shows a smart jump of 11 percent over 1969 of 1,7555 thousand barrels of crude per day used for producing products ranging 27 from coke and asphalt to lubes and waxes. In view of these fac t s , ( s e l f - s u f f i c i e n c y and rapid expansion of petroleum production), problems are l i k e l y to evolve i n developing countries, even though these may not be as serious as i n advanced countries. In the f i r s t instance, the conservation problem associated with common-property resources evidenced i n the North American production region i s not relevant to the concession areas comprising the developing countries. Invariably, concessions are granted to one producing company per given o i l f i e l d and covering a large area. Under such a circumstance, 26 Leonard M. Fanning, The Sh i f t of World Petroleum Power  Away from the United States, A study and Report for Gulf O i l Corporation. (Pittsburgh, 1958), Table 7. 27 "Modest Gains Forecast for 1970", O i l and Gas Journal. January 26, 1970, pp. 113-116. - 36 -the "rule of capture" does not apply. When the rule of capture applies to a production area, the main problem i s a physical waste due may be to reduced pressure required for l i f t i n g the crude to the surface of the ground. No single producer can i n t e r n a l i z e the cost associated with such a waste and the whole area cost becomes a s o c i a l - 2 8 cost. The other problem associated with production on the firm's side has already been touched upon. This applies to the discounting factor which plays a very important role i n the day-to-day decision-29 making by a firm. How much o i l i s l i f t e d out of a well today generally affects how much can be taken out tomorrow. Given constant prices, and under conditions of certainty regarding the quantity of reserves, a high rate of interest or discount w i l l cause production timing to s h i f t towards present periods. A low rate, on the other hand w i l l allow production to s h i f t towards future periods. An adequate treatment w i l l be given to the implications of interest rates and the s h i f t i n g of production i n chapter IV. Meanwhile, another problem must yet be raised about producing petroleum resources i n developing countries; the problem of i n -s t a b i l i t y of output. I n s t a b i l i t y i n output and employment caused by variations i n the demand for exports generally i s an important problem for a l l countries 28 Lovejoy and Homan, Economic Aspects of O i l Conservation  Regulation, (Baltimore: The John Hopkins University Press, Resources for the Future, 1967), pp. 21-22. 29 Anthony Scott, "The Theory of the Mine Under Conditions of Certainty" i n Mason Gaffney, Extractive Resources and Taxation: (Madison: University of Wisconsin Press, 1967), pp. 25-60, - 37 -producing petroleum resources, especially so when thei r incomes heavily depend upon these exports. However, the type of fluctuations i n incomes and employment resulting from this v a r i a t i o n i n export demand may d i f f e r i n the developing countries from that i n the advanced countries. 30 Four of these differences seem especially s i g n i f i c a n t . F i r s t l y , a large proportion of unemployment resulting from contraction of exports may be "disguised" i n the developing countries. Secondly, a large reduction i n physical exports cannot be offset by a corresponding reduction i n physical imports without undue hardship. Thirdly, the " m u l t i p l i e r " effect of a contraction i n foreign trade i s l i k e l y to be less pronounced i n less developed countries than i n advanced countries. Fourthly, export industries i n developing countries are i n some cases concentrated i n foreign hands and p r o f i t s derived from these industries are l i k e l y to be transferred. Because the main impact of variations i n exports are f e l t on the p r o f i t transfers, a s i g n i f i c a n t change i n exports may re s u l t i n a r e l a t i v e l y i n s i g n i f i c a n t change i n domestic income. Benjamin Haggins, Economic Development, (New York: W. W. Norton & Co. Inc., 1959), pp. 545-568. - 38 -Also consider the s i t u a t i o n where the output of the developing country changes due to supply conditions, and the developing country has a revenue sharing agreement with a foreign producer. I f the exporting country i s a monopolist or o l i g o p o l i s t ( i . e . faces a demand curve with less than perfect e l a s t i c i t y ) , the revenue received from exporting w i l l vary less than i f the market i s perfectly competitive. As the export volume of the imperfect competitor varies, the price w i l l vary i n the opposite d i r e c t i o n , somewhat cushioning the effect on t o t a l revenue. How-ever, t o t a l revenue generated should s t i l l be expected to vary d i r e c t l y with quantity exported, since we expect demand,for most countries, o i l to be e l a s t i c . Hence, any change i n revenue by the developing country from exports, may be viewed as having s i g n i f i c a n t repercussions on the government budget. Accordingly, we proceed to analyze the difference between fluctuations i n national outputs r e s u l t i n g from variations i n exports i n developing countries and advanced countries i n terms of 1) secondary "super-multiplier" effects of a contraction i n foreign trade and 2) f i s c a l p o l i c i e s . We begin t h i s analysis by showing how variations i n exports cause fluctuations i n national outputs of a given country. The following model i n par t i c u l a r explains the relationship of exports to national income. - 39 -Model 1 Given the marginal propensities to save of a country, we derive the e l a s t i c i t y of domestic income to exports as a function of exports and t o t a l savings. Given: 1. dY •• 1 dX s + m 2. dY E = A = X dY X ^ Y~ dX A e.g. 1 and 2 y i e l d , 3. _ . X tx = Y s + m 4. E x sY: + ..mY Assume balanced trade: i . e . X = M then 4 becomes 5. E X or E X = - r—;—n : X S + X S/X + 1 E = • 1 as X -> °° x Y = GNP X = Total Exports M = Total Imports m = Marginal prop to imp s = Marginal prop to save E = Income e l a s t i c i t y of exports SX= Total Savings 'A - 43 -From t h i s analysis, the e l a s t i c i t y , Ex of domestic income to exports i s a c r u c i a l interpretation of the extent to which national output can be affected by variations i n export demand. The magnitude of Ex i s , i n turn, determined by the r a t i o of national savings to the l e v e l of exports. I f t h i s r a t i o i s very small, i . e . exports increase i n f i n i t e l y while the l e v e l of national savings remains correspondingly constant, Ex w i l l approach or equal unity. This means, cete r i s paribus, that variations i n exports w i l l have profound effects on the l e v e l of national outputs of a given country. I f , on the other hand, the r a t i o of national savings to exports i s high, say greater than unity, income w i l l be less e l a s t i c to variations i n exports, assuming that everything else i s equal;-there w i l l be less fluctuations i n national income r e s u l t i n g from variations i n exports. (See Column V,.Table 2.6 below). To appreciate the significance of t h i s analysis, we need to examine the orientation towards and concentration on export commodities from a t y p i c a l developing country, r e l a t i v e to an advanced country. Let us examine the case of Venezuela and the United States. Table 2.7 shows U.S. petroleum exports as a percentage of t o t a l exports from 1930-1938. Petroleum exportsN averaged 12% of t o t a l exports i n t h i s period. On the other hand, Table 2.8 indicates that 97% of t o t a l Venezuela exports consists of only two primary commodities. Petroleum, one of the two primary commodities i s 92% of t o t a l exports. Certainly, any rate of contraction i n petroleum exports w i l l have a greater impact on t o t a l exports of Venezuela than on the t o t a l exports of the United States, TABLE 2.6 A Comparison of Export M u l t i p l i e r s , Canada, United States and Venezuela 1961-1965 Year/Country I I Savings^ S I I I Exports X IV Savings-Export Ration S/X Income E l a s t i c i t y of Exports (Ex) i n % 1961 Canada ($ m i l l i o n ) 8128 U.S.A. ($ thousand m i l l i o n ) 78.3 Venezuela ( M i l l i o n Boliveres) 4626 7398 25.0 8663 1.09 3.10 .53 .47 .24 .65 1962 Canada do. USA " Venezuela 9173 89.6 5202 8031 26.3 9161 1.14 3.40 .56 .46 .22 .64 1963 Canada " USA Venezuela 9880 94.3 5549 8855 28.1 9212 1.11 3.30 .60 .47 .23 .62 1964 Canada " USA Venezuela 11237 100.3 7553 10166 32.0 11364 1.10 3.10 .66 .47 .24 .60 1965 Canada " USA " Venezuela 13700 113.0 8184 10809 33.6 1121 1.26 3.30 .58 .44 .23 .58 Table 2.6 continued Legend 1) Savings are defined as the t o t a l domestic c a p i t a l formation at current prices i n a given year = fixed c a p i t a l formation allowances, Government and private savings, net addition to stocks and current foreign transactions account d e f i c i t or surplus. 2. Include exports of goods and services at current prices. 3. Computed according to Model 1, i . e . Ex _ 1 S/X + 1 Source of Columns 1 and 2: Year Book of National Accounts S t a t i s t i c s , 1966 UN Publication No. E. 67. XVII. 14 N. York. Note: To compare an e l a s t i c i t y of income to exports for a t y p i c a l developing country to an advanced country, columns V of Table 2.8 provides some figures for two advanced countries and one developing country. These figures are computed on the basis of Model 1. For an example, a 1% change i n 1961 exports, w i l l lead to 4 tenths of a percent change i n the l e v e l of Canadian income, 2 tenths of that of the United States and more than half of a percent change i n the national income of Venezuela. - 42 -TABLE 2.7 Total U.S. Exports and Percentage of Crude Petroleum (In M i l l i o n of Dollars) Year Total Exports Petroleum Exports Percent Petroleum 1930 3,781.2 495.2 13.1 1931 2,377.9 271.2 11.4 1932 1,576.2 . 208.9 13.3 1933 1,647.2 200.6 12.2 1934 2,100.1 228.3 10.9 1935 2,243.1 251.1 11.2 1936 ' 2,418.9 264.5 10.9 1937 3,298.9 378.1 11.5 1938 3,057.2 390.2 12.8 Source: Survey of Current Business Reported by L. Fanning, American O i l Operation Abroad McGraw H i l l , ( N. York, 1947) p. 132. TABLE 2.8 Share of Primary Commodities i n Total Exports from Selected Developing Countries i n 1938 I I I I I I P r i n c i p l e Commodities A l l specified Commodities Country and Percent of Total Exports as percent of t o t a l exports Egypt Cotton, 77; Seeds and O i l , 6; 83 Zambia ( N. Rhodesia) Copper 90 90 Malaysia Tin, 17; Petroleum, 10; Rubber, 48 75 Iran Petroleum 73 73 E l Salvador Coffee, 87 87 Trinidad & Tobago Cocao 8; Sugar, 17 Petroleum 66 91 B o l i v i a Tin 71 71 Peru Cotton 18; Lead 5; Copper 5; Petroleum 34 81 Venezuela Coffee 5; Petroleum 92 97 a. 1938 i s selected to avoid the trend of post war and post p o l i t i c a l independence desire for i n d u s t r i a l d i v e r s i f i c a t i o n . Source: Higgins, Economic Development, Table 24-1, pp. 552-554. 4 3 c e t e r i s paribus. For example, a 5% contraction i n petroleum export demand w i l l reduce t o t a l exports of Venezuela by 4.6% while that of the United States w i l l shrink only by s i x tenths of one percent. We conclude therefore, that because domestic output may be very responsible to changes i n the exports of petroleum i n some developing countries, a v a r i a t i o n i n the demand for these exports w i l l have serious repercussions on the whole economy. In the case where income i s not e l a s t i c to the l e v e l of exports, the repercussions may be i n the government's budget. Accordingly, the following model defines the r e l a t i o n -ship between the national budget and the l e v e l of exports. Model 2 Given the marginal propensities to consume and/or save, we show that government's a b i l i t y to spend at the margin depends on the domestic marginal tax rate and the variations i n exports. A l l symbols are defined as before i n Model 1 except those added here. Given 1. dy = 1 dX s + m Assume that the size of government expenditure G needed to bring about a desired change i n outputs Y, i s a function of marginal propensities to save out of disposable income, and denoting t as the marginal tax rate; 2' || = (s + m) (1 - t ) ; o < t < 1 from 1 and 2. - 44. -1 • , . v = 1 dG 3. dY = s + m (s + m) (1 - t) Solving for dG i n terms of dX and rearranging, 4. dG = (1 - t) dX We conclude from equation 4 that a government's budget can expand on the margin only i f exports expand (provided t i s constant). Putting i t another way, given a constant marginal tax rate, a v a r i a t i o n i n exports w i l l produce variations i n the government's budget by the extent of the marginal tax rate. As an example, government budget w i l l vary by half of the magnitude by which exports change i f the domestic marginal tax rate on export revenues i s 50%. For s t a b i l i z a t i o n purposes, t and G can be used as f i s c a l p olicy instruments to adjust the l e v e l of national outputs v i a equation 2 when there i s a flu c t u a t i o n i n exports, i . e . a r i s e i n exports can be matched by a corresponding decrease i n t i n order to maintain G at a constant l e v e l . Again, we argue that the relationship just defined between government budgets and the v a r i a t i o n i n exports, i s stronger for a developing country than an advanced country. The most obvious reason i s that the developing countries almost invariably excel i n the export of a single dominant commodity such as petroleum. In summary, two important problems have emerged from the facts about the production of petroleum i n developing countries. F i r s t l y , the high r a t i o of fixed c a p i t a l costs to the t o t a l costs of operation gives the rate of interest or discount a prominent place i n the day-today decision-making by the producing firm or region. Secondly, crude petroleum has been - 45 -declared the "nerve centre" of the economies of some developing countries so that any disruption i n i t s production rate or export demand immediately constrains the whole economy. These two main problems ( c a p i t a l i z a t i o n and i n s t a b i l i t y ) explain why the petroleum industry i s highly unpredict-able and p o t e n t i a l l y vulnerable to public p o l i c i e s . These two char a c t e r i s t i c s gain further importance due to uncertainty i n the explora-tory stage of production. This leads to Chapter I I I where we w i l l attempt to provide some solutions to the problems a r i s i n g i n the exploratory stage of petroleum production. - 46 -CHAPTER I I I PROBLEMS OF UNCERTAINTY IN EXPLORATION In general, certain information must be available before any economic development can r a t i o n a l l y be decided upon. This s i t u a -t i o n i s nq less true for the development of petroleum resources i n developing countries. In fa c t , s a t i s f y i n g the demand for information preceeding the actual l i f t i n g of crude o i l to the surface, requires a very heavy investment. For such an investment, there i s a high degree of uncertainty surrounding the a. p r i o r i evaluations or estimates of i t s returns. The purpose of this chapter i s to examine s p e c i f i c problems confronting the o i l - r i c h developing countries regarding the uncertainties of i n s u f f i c i e n t knowledge about thei r o i l resources. In the process, we s h a l l define exploration and review some recent thoughts on the economic analyses of exploration expenditure. Subsequently, we w i l l consider the role of the developing countries and then review the more general economic consideration given to further d r i l l i n g and exploration expenditure. - 47 -The D e f i n i t i o n of Exploration Exploration i s defined as 1) any geological or geophysical a c t i v i t i e s which involve finding information about the existence of crude reserves i n a s p e c i f i c area, or 2) any a c t i v i t i e s based on e x i s t i n g information designed to produce additional information about the pro b a b i l i t y of finding crude reserves within a given physical structure. The f i r s t d e f i n i t i o n i s what we refer to as "prospecting" while the second f a l l s i n the Vexploratory d r i l l i n g " category. I t i s our b e l i e f that the decisions made i n each category are by no means i d e n t i c a l . Therefore we examine each type of a c t i v i t y separately, beginning with prospecting exploration. Economic Decision-Making i n Prospecting Exploration Production cost analyses i n the petroleum industry habitually regard outlays on prospecting a c t i v i t i e s as given. For example, Bradley's studies concerning the economics of the production of crude petroleum simply considered that these outlays are not d i r e c t l y related to payments needed to secure the necessary factors of crude production. Thus, he states: "Exploration costs are not d i r e c t l y assignable to crude production; for the most part they are ^ allowed to remain outside the scope of the study..."' Bradley, The Economics of Crude Petroleum Production (Amsterdam: North Holland University Press, 1966), p. 10. - 48 -Yet, the study recognized that exploration costs are conditional upon available development alternatives. To give another example, Grayson takes prospecting outlays and results as given i n his extensive studies of d r i l l i n g decisions under uncertainty. Yet he, too, recognizes that nearly 70 percent of this industry's c a p i t a l expenditure i n the U.S. originates from t h i s 32 state of petroleum development. As another example, Herfindahl points out, i n his work on the meaning and measurement of neral costs, that i t i s indispensable to study mining costs intensively without decomposing such costs into finding, mining and other stages of production. Here, he also f a i l s to relate the exploration cost a c t i v i t i e s to the t o t a l costs 33 of mining i n a more e x p l i c i t way. Not exhausting out l i s t of examples, we mention Fisher, who empirically concludes that there i s a substantive d i s t i n c t i o n between the supply curve of exploratory e f f o r t s and new petroleum discoveries which he believes are due to the influence of economic incentives. Ultimately, Fisher confined his analysis largely 34 to wildcat d r i l l i n g . Lee Preston's economic analysis of exploration for non-ferrous metals observes that the present state of knowledge has not indicated 32 Grayson, Decisions Under Certainty, (Boston: Harvard University Press, 1960), pp. 5-6. 33 Oris Herfindahl, "The Long-run Cost of Minerals" i n Three  Studies i n Mineral Economics. Resources for the Future, Inc. (Washington, D.C, 1961), p. 14. 34 Frank Fisher, Supply and Costs i n the U.S. Petroleum Industry. Resources for the Future Inc., (Baltimore: The John Hopkins University Press, 1964), p. 3. - 49 -the ultimate l i m i t to natural resources available i n the earth's 35 crust. Consequently, the study deals with the problem of the extent to which the supply l i m i t a t i o n of these natural resources, p a r t i c u l a r l y non-ferrous resources, whether actual or anticipated, may take the form of successful exploration. Thus, i t defines exploration as 1) a l i s t of physical a c t i v i t i e s which include geophysical testing, d r i l l i n g , and trenching; 2) a l l costs incurred p r i o r to some s p e c i f i c events, i . e . , a l l expenses other than purchases or long-term leasing of mining s i t e s , which are made i n advance of the management decision which establishes the size of the management plant. C l a r i f y i n g the second d e f i n i t i o n along 36 s i m i l a r l i n e s as the United States Bureau of Mines, this study further makes an absolute d i s t i n c t i o n between "exploration for new ore bodies and routine d r i l l i n g which are made before extentions of operations i n existing f i e l d s . " In routine d r i l l i n g , according to Preston, "the probing of new areas becomes an in t e g r a l part of the mining operation." Aware of this d i s t i n c t i o n , he too takes prospecting expenditure as a given while he gives considerable treatment to the-problems associated with routine d r i l l i n g . As a resu l t of the tendency by experts to take the decisions which lead to heavy investment i n prospecting for crude o i l reserves as a given state of a f f a i r s , this study i s not complacent about the issue. Lee Preston, Exploration for Non-ferrous Metals, Resources for the Future, Inc. (Washington, D.C., 1960), pp. 26-7. 36 According to Preston, The Bureau of Mines defines prospecting as the search for ore, and exploration i s the work involved i n gaining knowledge of the. size,shape and position of the ore body. Preston, op. c i t . , p. 26. - 50 -While we offer no new major solution to the current trend, we w i l l give further consideration to an existing suggestion. This suggestion i s based on the ideas of those who propose that information or knowledge be the chief product of exploration of the prospecting type. Of the many proponents of the idea that information i s the chief product of exploration, Bradley suggests that exploration i s analagous to research and development a c t i v i t y of a manufacturing plant; hence, the chief product of exploration e f f o r t i s knowledge. Following this same argument, Herfindahl asserts that, for the purposes of economic analysis, natural resources be viewed as part of the c a p i t a l stock of 37 a country. At the same time, since substantial investments are required to bring these c a p i t a l stocks to a certain form before they can y i e l d productive services, these investments may be considered as part of these resources. Therefore, exploration outlays are a part of petroleum resources viewed also as part of the t o t a l c a p i t a l stock of the countries which possess them. This argument appeals to us. From the point of views of developing countries which are engaged i n planning and coordinating their general c a p i t a l requirements, exploration a c t i v i t i e s are j u s t as important as any other investment a c t i v i t i e s . Furthermore, i f a group of explora-tion expenditures i n these countries were solely responsible for the discovery of a certain deposit, the costs of exploration would be 37 Oris Herfindahl, Natural Resource Information for Economic  Development. Resources for the Future, Inc., (Baltimore: The John Hopkins Press, 1969), p. 187. - 51 -appropriately depreciated or expensed over the l i f e of this deposit. But, the r e a l d i f f i c u l t y i s the uncertainty of exploration; some ventures simply produce no discoveries, hence, no asset against which they can be expensed. This seems to be the basis of the argument for depletion allowance prevalent i n some advanced countries l i k e the United States and Canada. With this caveat, how much exploration a c t i v i t i e s are then optimum for the developing countries, considering f i r s t the r i s k and the c a p i t a l constraint? We give thought to some more views of others on t h i s issue. We begin by asking ourselves the same questions that G r i f f i t h and A l l a i s addressed themselves to: "What i s the expected value of a unit 38 of the earth's crust?" G r i f f i t h ' s reply to this question suggests a vast program of general a p p l i c a b i l i t y to the problem of gaining geological information and locating mineral deposits i n the developing countries. In his words, "The precise estimate of this parameter forms the basis for national and international planning for i n d u s t r i a l develop-ment and i t may be used as a base for evaluating the natural wealth of 39 areas of the earth's crust." But this approach seems very ambitious 38 M. A l l a i s , "Methods of Appraising Economic Prospects of Mineral Mining Exploration Over Large T e r r i t o r i e s " . Management Sciences, v o l . 3, No. 4, (July, 1957), p. 285. 39 John C. G r i f f i t h , "Exploration for Natural Resources" Operations Research, v o l . 14, (March - A p r i l , 1966), pp. 187-209. - 52 -considering the "ways" and "means" of some developing countries. Pursuing the same problem of how much exploration, Tussing has observed that geologists themselves have not provided any yard-s t i c k of the quantity and the u t i l i t y of information per unit area 40 of land. However, accuracy i n predicting the characteristics of natural resources depends to a reasonable extent on the quality and quantity of available geological information. For this reason, any amount of information i s more advantageous than none. Accordingly, there appears to be some net s o c i a l benefits accruing to a developing country which possess some minimal geological information about their petroleum or any natural resources. I t i s the a c t i v i t i e s involved i n obtaining this minimum information which we have conveniently referred to as prospecting. F i r s t l y , the quality and quantity of information from prospect-ing such as geological surveys or mapping, may reduce the degree of uncertainty surrounding the evaluation of the p r o f i t a b i l i t y of further exploration and development investment. Hence, the potential returns to the domestic economy may be substantial when this reduced uncertainty attracts private i n i t i a t i v e which leads to pr o f i t a b l e discoveries of o i l . When no discovery i s made, there may be a minimum loss to the domestic 40 Tussing and Erickson, Mineral P o l i c y , The Public Lands  and Economic Development: The Case of Alaska, by permission. (Fairbanks, I n s t i t u t e of Social Economic and Government Research, Univer-s i t y of Alaska, 1968), pp. 67-68. - 53 -economy since such private c a p i t a l largely consists of foreign c a p i t a l which may have no alternative uses i n the domestic economies of - H -the developing countries. Secondly, i n the short-run, private large o i l companies have greater advantages over any developing country with respect to the s i z e and e f f i c i e n c y of exploration e f f o r t i . e . seismic crew and r i g s . These companies have greater success r a t i o s than even smaller companies i n the same business. However, the i n i t i a l a t t r a c t i o n of a company or number of companies to any potential o i l producing state i s a direct function of the quantity and quality of the existing i n i t i a l information i n that country. The greater the number of large companies finding o i l , the greater w i l l be the p r o b a b i l i t y of at least one of them to be r i g h t i n their estimation of the r e s u l t of exploration. Hence, existing prospect-ing information may confer a net benefit derived from some degree of certainty from intensive private i n i t i a t i v e i n finding o i l deposits. Thirdly, there are many projects whose s o c i a l benefits far exceed private benefits. Prospecting exploration as defined i s a l i k e l y candidate for such projects. These projects provide d i v e r s i f i e d products of d i f f e r e n t i a t e d benefits for d i f f e r e n t consumers. For example, a geological map provides information about the texture of the s o i l , characteris-t i c s of o i l , and other mineral deposits. The c o l l e c t i o n of the benefits [ | We are assuming that c a p i t a l made available for exploration a c t i v i t i e s may not be u t i l i z e d i n any other industry. - 54 -from this information far exceeds any portion thereof. Thus, the s o c i a l benefits of any geological or topographical survey may be greater for the whole society than for any member of that society. In addition, the employment provided by the information agency i s a s o c i a l benefit which cannot be taken into account by a private investor. To the extent that the net marginal product of each employee i s p o s i t i v e and would perhaps be zero i f not so employed, these members are making net contribu-tion to the society as a whole. For these reasons the gathering of any i n i t i a l information may perhaps be done appropriately by the govern-ments of the developing countries. L a s t l y , most of the countries with which this study concerns 41 have been under the regime of the concession system at one time or another. In such a case, the l e v e l of sophistication and technical c a p a b i l i t i e s of the governments on such aspects as geological information, marketing, engineering and finance may be c r u c i a l i n s t r i k i n g .a bargain for an optimum package of concessions and benefits. These aspects enable the government to negotiate equally with private concessionaire. For our purposes, these are good enough reasons which may j u s t i f y a p a r t i c i p a t i o n i n the gathering of natural resource information. But there are also costs for obtaining such information. Such costs are the a l t e r n a t i v e uses to which resources employed i n this a c t i v i t y may be put. The problem i s to demonstrate that such alternative benefits exceed the ones enumerated above. In any case, there are r i s k s involved. 41 The concession system i s defined i n Chapter IV of this study. - 55 -How much of the r i s k which a developing country i s w i l l i n g to assume i n exploration depends on the circumstances i n each country. 42 H i s t o r i c a l perspective does not reveal general rules of a p p l i c a b i l i t y . Some developing countries such as Egypt and India are equally p a r t i c i p a t i n g i n exploration a c t i v i t i e s with private companies. In India, i t was government exploration i n i t i a t i v e which spurred the rate of discovery even!j;hough private companies held many years of concession to do so. Further, the trend i n the industry i s i n favour of developing countries p a r t i c i p a t i n g i n the actual decision-making process of the development of the i r resources. Any form of such p a r t i c i p a t i o n at th i s point i n time f i t s i n with r e a l i t i e s . In addition, the slow production rate of petroleum resource, indicated by the excess capacities of existing private firms, may not conform to the p o l i c i e s of some developing countries who, for various reasons, highly discount the future. More incentives to these companies to explore without commensurate rate of production may simply mean a loss of valuable present to future revenues. For a n a l y t i c a l purposes, any expenditure on natural resource information may conveniently be c l a s s i f i e d as a s o c i a l overhead c a p i t a l . 43 According to Hirschman, s o c i a l overhead c a p i t a l i s defined as an 42 A recent thinking on this l i n e i s re f l e c t e d i n one of these documents of the ECA of the United Nations: 1) National Resource Inventory, E/CN.14/CART/169, 25 July 1966; 2) An Ideological Geodetic Goal for Developing Nations, E/CN.14/CART/155, 30 June 1965. 43 A. 0. Hirschman, The Strategy of Economic Development, (New Haven: Yale University Press, 1958), pp. 84-7, for a f u l l discussion of the ch a r a c t e r i s t i c s of s o c i a l overhead c a p i t a l . - 56 -expenditure on basic services without which "Primary Productive A c t i v i t i e s " of a country may be impossible. The various reasons given above are s u f f i c i e n t to support this suggestion. At the same time, we now look at other decisions i n more exploration a c t i v i t i e s . Wildcat D r i l l i n g Exploration Decisions There i s yet another stage of exploration which has been extensively analyzed by economists and s t a t i s t i c i a n s who either e x p l i c i t l y or i m p l i c i t l y assume that the information j u s t described above, usually o r i g i n a t i n g from the findings of geologists and geophysicists, i s given. 44 I t i s further assumed, by Herfindahl that this information, unlike that of a manufacturing firm, does not a l t e r the "state of the a r t " i n the production function. Rather, i t i s considered as an input on the same footing as other inputs. I t i s also assumed that, because of uncertainty, the investment decisions of this category of exploration are based on p r o b a b i l i t y analysis. F i n a l l y , i t i s | assumed that each d r i l l i n g firm knows i t s opportunity costs are positive but y i e l d diminishing returns. Given a l l these assumptions, most writers have drawn s i m i l a r conclusions which we summarize. At the same time, each writer's approach has been s l i g h t l y d i f f e r e n t from those of the others. 44 This work has also been f u l l y discussed by Herfindahl, op. c i t . p. 51. - 57 -For example, G r i f f i t h recommends through "grid d r i l l i n g that a negative binomial f i t s better than the Poisson d i s t r i b u t i o n , the lo c a t i o n a l pattern of known o i l wells i n Kansas. While we are unequipped to render value judgments on the efficacy of the two methods, we believe that the Poisson d i s t r i b u t i o n has constant probability i n a l l parts of i t s continuum, whereas the negative binomial represents a contagious eff e c t . When occurrences of events are contagious, the i r d i s t r i b u t i o n s tend to cluster . I t i s believed' that o i l deposits are b a s i c a l l y of the 45 contagious type due to their genetic control. A second example i s the study by A l l a i s which does not recommend grid d r i l l i n g , but chooses the Poisson d i s t r i b u t i o n to describe the occurrences of deposits within a wide region, such as the Sahara. Based on available information, A l l a i s found that the t o t a l value of deposits has a lognormal d i s t r i b u t i o n , with median of 70 b i l l i o n s francs and a standard deviation of 1.35. These deposits would be worth between 1 and 46 1,000 m i l l i o n dollars per 100 km2. In the same dir e c t i o n as A l l a i s , but working with the grid system, Bradley and Uhler found that s p a t i a l occurrence of petroleum 47 reservoirs can be depicted as following a stochastic process. Using 45 The meaning of this expression should not be taken l i t e r a l l y . As used, i t refers to the way i n which sediments are buried and combined under pressure and heat through a long time, i n order to form hydrocarbon materials. For a b r i e f explanation, see Clute Jensen, Economics of O i l Production, Economic-Action Series, University of Wisconsin, (Madison, Wisconsin, 1959), pp. 3-4. 46 A l l a i s , op. c i t . , p. 313. 47 Paul Bradley and Russel Uhler, Stochastic Model for Determining the Economic Prospects of Exploration for Large Regions. University of B r i t i s h Columbia, 1969, p. 2. - 58 -i i barrels of reserves discovered as random variables and conditional upon the number of wildcat wells as a single composite input, they found that the binomial d i s t r i b u t i o n f i t s the occurrences of reservoirs i n the case of Alberta o i l f i e l d s . On the other hand, the lognormal d i s t r i b u t i o n better f i t s the size d i s t r i b u t i o n of a l l reservoirs. The above examples are stochastic processes intended to estimate the probable petroleum, reserves and their expected values, given some i n i t i a l information. But there are alternative methods currently i n use by most o i l operators. One such method i s suggested by Adelman as the "step- out explora-tion methods. This i s his description of i t : "A pattern of wells i s d r i l l e d accordingly (existing prices warrant p r o f i t a b i l i t y ) ^ progressively outward and estimates are made of the ultimate recoverable reserves which are 'proved' thereby. These newly proved gross reserves increase at a decreasing rate though, as e a r l i e r noted, i t may for a time be at an increasing rate i f the o r i g i n a l well chanced >•-•"» to be at the edge of the f i e l d - as the l i m i t s of the pool are approached and f i n a l l y delineated." 48 The parenthesis i s mine. 49 M. A.Adelman, The Supply and Price of Natural Gas: Supplement to the Journal of I n d u s t r i a l Economics, B a s i l Blackwell, (Oxford, 1962), - 59 -Consequently, there i s some form of r e v i s i o n implied upward or downward of reserve estimates long ( f i v e to s i x years) after the beginning of exploration. So that the output (proved reserves) i n a period must be related to the inputs of some preceeding periods. Hence, the increments to proved ultimate reserves, say i n 1968, must be strongly related to exploration expenditures i n 1967; less related to 1966 and so on. However, Adelman warns that increments to proved reserves are related to so many previous years i n an unformed and an accidental way, so that time series cannot help to explain exploration expenditure patterns Adelman also warns that the relationship between exploration outlays and returns are unpredictable, because 1) the amount of any successful e f f o r t i s ascribed to a combination of e f f o r t s and not j u s t to that one e f f o r t ; 2) the amount of such expenditures does not determine the capacity of reserves to be discovered, the addition to reserves or capacity i s a random component. This random component i s the basis on which most decisions are made regarding petroleum development. The influence of this random component on these decisions depends on whether the decision maker i s a big o i l producer, i . e . a "major" or a small producer, i . e . , an "independent". For the industry as a whole, the larger the industry, the less i s the importance of this random component because the greater and more widespread the exploratory e f f o r t , the better the chances of o f f s e t t i n g good and bad luck. Adelman, i b i d . , pp. 6-7. - 60 -Grayson presents a detailed picture of the decisions made i n the l i g h t of this random disturbance. We summarize his whole argument as follows: 1. These decisions can be described i n the form of payoff Table that l i s t s the consequences of every possible act given each possible event. 2. The consequences of act-events are usually measured i n monetary terms, taking into account the "present value" of any future income streams. 3. "Personal p r o b a b i l i t y " estimate c r y s t a l l i z i n g the decision makers past and current information and experience i s much more preferred than any other probability estimate used i n preparing a payoff table. 4. P r o b a b i l i t i e s are mu l t i p l i e d by the doll a r consequences of each act-event to obtain the weighted average present value of each act. The act which has the highest expected money value or weighted average present value i s chosen over i t s counterparts. As mentioned before, we are not i n the position to accept or reject these seemingly p r a c t i c a l approaches advanced by Adelman and Grayson to the problem of evaluating expenditures made i n exploratory d r i l l i n g or "development". There i s one economic aspect of such expenditure that can be relevantly assessed: the u t i l i t y of income. That i s , whatever the magnitude of such expenditure or the d i f f i c u l t y i n assessing the i r expected returns, the relevant maximand i s the expected u t i l i t y derived from these outlays. U t i l i t y measurement i s i n i t s e l f a d i f f i c u l t concept i n economics. T r a d i t i o n a l l y , this measurement has been made i n ordinal terms so that i n t e r -personal comparison, i . e . , the u t i l i t y of exploration a c t i v i t i e s A i s so many units more for indi v i d u a l Y than for i n d i v i d u a l X, has been impossible. This prediction d i f f i c u l t y has been partly resolved by two famous studies: Grayson, op. c i t . pp. 234-78. - 61 -1) Daniel Bernoulli proposed that dollars could be converted to their u t i l i t y values by the use of logarithmic curves depicting diminishing marginal u t i l i t y . By multiplying the u t i l i t y of the doll a r consequences by their p r o b a b i l i t i e s , we derive the i r expected u t i l i t y value. I f , for example, an in d i v i d u a l wishes to gamble SX i n several exploration ventures, he w i l l maximize the expected u t i l i t y of this amount by choosing the venture with positive u t i l i t y i n excess of negative u t i l i t y . This approach was only an aggregate solution to the problem of making predictions. But economic analysis i s always choosing those decisions made on a marginal basis. In this case, Neumann and Morgenstern provide a more appropriate approach.52 2) The N-M u t i l i t y index, as this approach i s commonly ca l l e d , i s intended to be used for making predictions and i t i s based on the p r i n c i p l e assumption that individuals exhibit a high degree of consistency i n their preferences. With this index, i t i s possible to calculate the preferences of any alternative involving r i s k , i . e . , the u t i l i t y numbers of any two alternatives leave no choice for such number to be assigned. Consider the following example: an operator wishes to spend $5,000 to explore for reserves i n a given region. According to his experience, the probability i s .3 that he w i l l h i t a successful w e l l with a reserve value of $15,000 and the other 7 out of 10 wells w i l l be dry holes. The problem i s the decision to d r i l l or not to d r i l l . To make this decision, i t i s necessary to interview the operator and discover his indifference map for every l e v e l of subtraction from his current wealth (exploration expenditure re s u l t i n g i n losses) and every increment to wealth r e s u l t i n g from those expenditures. Assigning an a r b i t r a r y ranking to each of these points enables us to derive a u t i l i t y "Neumann-Morgens tern, Cardinal U t i l i t y " i n William Baumol. Economic Theory and Operations Analysis, 2nd ed., (N.J.: Englewood C l i f f s , 1965), pp. 512-524. function for this operator. Multiplying these u t i l i t y levels by thei r corresponding p r o b a b i l i t i e s provides the expected u t i l i t i e s of the prizes. Assume that the u t i l i t y of a dry hole expenditure to this operator i s -10 while that of the successful well i s 90. The expected u t i l i t y of the t o t a l venture according to N-M index i s , (when p= prob a b i l i t y = .3) U(P) = P(90) + (1-P)(-10) 37 = 27 + (-7) 20 = 27 - 7 Since expected u t i l i t y of d r i l l i n g i s 20 unit, a positive number, the t o t a l u t i l i t y of this producer must exceed that of losses incurred i f a dry hole occures. We tabularize t h i s argument: Table 3.1 The U t i l i t y of a D r i l l i n g Venture Expected Money Money Expected U t i l i t y Probl. Values Values U t i l i t y Dry hole -10 .7 -$5,000 -$3,500 -7 Successful 90 .3 10,000 3,000 27 Total Outcome 1.0 - 500 20 According to the information portrayed on the table above, the t o t a l expected monetary values of this exploration venture i s negative. In this sense, the venture proves to be a loss and the decision should be made not to d r i l l the w e l l . But the N-M u t i l i t y index indicates that the t o t a l u t i l i t y gained from d r i l l i n g the well i s 20 uni t s , a positive number greater than the negative u t i l i t y of dry hole money. Consequently, - 63 -the decision to d r i l l the wel l maximizes the u t i l i t y of the operator, irresp e c t i v e of the money losses. It follows from this analysis that i t i s the u t i l i t y , not the monetary values of any exploration venture, that should be taken into account. This u t i l i t y can be derived assuming the operator's behaviour r e f l e c t s acts of consistency, aspirations for high probability of success, independence and t r a n s i t i v i t y . In summary, we have pointed out i n this Chapter that exploration a c t i v i t i e s i n the petroleum industry must necessarily be analyzed from two d i s t i n c t perspectives: prospecting, and d r i l l i n g or development. I t i s impossible to say how much prospecting or exploration i s optimum for any developing country. In any case some i n i t i a l information may l i k e l y be advantageous than not. Regarding d r i l l i n g exploration, the output i s a random increment to crude reserves. But expenditure on this random increment i s not ascribed to the direct output alone. Whatever process i s involved i n the decision making, i t i s the u t i l i t y of the money spent or the expected u t i l i t y of the reward that i s of any importance. We are i n d i f f e r e n t about whether a private or a public firm does this exploratory d r i l l i n g . Some developing countries find i t p r o f i t a b l e to do so. Others f i n d i t very costly and would be better off with private i n i t i a t i v e . The structure of these private companies may also be a problem for the developing countries with o i l resources. Chapter IV outlines this problem. - 64 -CHAPTER IV THE STRUCTURE OF THE CRUDE PETROLEUM MARKET The previous chapter emphasized the random nature of expenditures to the results of exploration a c t i v i t i e s which set the i n i t i a l condition for the development of petroleum properties. There are yet other conditions which equally affect the i n s t i t u t i o n a l arrange-ments and give r i s e to the setting of major economic p o l i c i e s affecting the a l l o c a t i o n of o i l resources. In this chapter, our task i s to examine a few of these additional conditions. In the f i r s t section, the problems of market structure w i l l be elucidated. S p e c i f i c a l l y , we propose that alienation of the rights to o i l properties may also contribute to the problems of market structure. Further, we conjecture that the nature of the resource may be a necessary, though not a s u f f i c i e n t condition for the kind of structure existing i n the petroleum industry today. With this caveat i n mind, l e t us proceed with the i n t r i g u i n g problems of the market structure and derive their sources. Firm's Own Source of Capital as a Lever for Market Expansion The amount of reserves which the industry holds i n r e l a t i o n to the output of petroleum crude i t produces i s the reserve-output r a t i o , - 65 -Theoretically, the source of supplies necessary to i n v i t e new entrants may be physically l i m i t e d by the quantity of reserves held by existing firms and the t o t a l there i s to be found. In addition, when existing demand expands, the existing firms can speedily cater to that demand from their reserves at a lower marginal cost than a new entrant which may j u s t be s t a r t i n g to acquire new sources. From these cogent points of view, one can reasonably predict that a high reserve output r a t i o concentrated i n the hands of a few firms may be i n d i c a t i v e of market imperfection because, i t f o r e s t a l l s certain desirable aspects of free competition; the b a r r i e r to entry. H i s t o r i c a l l y , this s i t u a t i o n does not resemble the r e a l i t i e s of the industry. The industry i s able to expand because of: 1) sheer luck i n discovery; 2) imperfect market for the funds which make such expansion possible; and 3) the system of the a l i e n a t i o n or ownership of o i l proper-t i e s . The reason for holding higher reserves prompted by sheer luck has been considered i n d e t a i l i n the l a s t chapter. But the question of imperfect c a p i t a l market draws our attention at this point. The analysis compares the opportunity costs of the firm's undistributed p r o f i t to costs of loanable funds obtained i n the free c a p i t a l market and i t shows that existing firms have extra advantages over new entrants for a t t r a c t i n g c a p i t a l . . But these advantages are not necessarily related to successes i n discovery of new o i l properties hence no r e s t r a i n t on the number of firms entering the industry. - 66 -We assume that these are the only two sources of c a p i t a l available to an existing firm for the expansion of crude o i l producing a c t i v i t i e s . On thei r books, petroleum firms have four sources of funds: 1) customers; 2) investment incomes with other firms; 3) lenders and 4) purchasers of new shares. Claims on these funds are made by suppliers 53 of goods and services, governments, shareholders and debtholders. Referring to Table 1.3 i n chapter I, we fi n d that petroleum companies hold very large percentages of their equity c a p i t a l i n retained earnings, r e l a t i v e to other manufacturing companies. When firms are largely self-financed, as i t appears to be the case with petroleum companies, over a period, we expect shareholders and lenders to play a less important role as a source of funds. The main source of funds becomes the firm's customers. On the other hand, the firm must 53 The annual reports of most o i l companies contain an analysis of sources of funds and uses of funds. See for example, Texaco Canada, 1969 Annual Report. 54 An excellent analysis involving the major companies was made by Penrose, op. c i t . , p. 100. On the other hand, based on aggregate data, evidence found did not support any s i g n i f i c a n t difference between debt equity, r a t i o of mining and of manufacturing industries i n Canada. See for example, M. W. Bucavetsky, "The Taxation of Mineral Extraction: "Canada Studies of the Royal Commission on Taxation, No. 8, p. 61. - 67 -dispose of current cash flows by honouring current commitments f i r s t and then governments and shareholders' claims. The residuals are l e f t for the expansion of the business. This residual i s the retained earnings. The p r i n c i p l e behind holding retained earnings i s that firms cannot pay out a l l of thei r p r o f i t s i n dividends and then go back to shareholders for funds to finance further expansion. Were that to happen some shareholders would have alternative choices for reinvesting their dividends and they may not be w i l l i n g to plow back thei r entire dividends into the same firm. Consequently, the firm makes a decision about undistributed p r o f i t s as a function of the. l e v e l of expansion requirement and the question i s how much. Because of the c a p i t a l i n t e n s i t y of the petroleum industry, not only i s investment expenditure large r e l a t i v e to value of output (see Table 1.4), but there i s a necessity to mobilize investment funds very quickly when new sources of reserves are found i n order to obey the "rule of capture." Hence, the amount of retained earnings which thes firms hold must be substantial and made accessible instantaneously. For these reasons, the supply of retained earnings of petroleum firms must exhibit varying price e l a s t i c i t i e s . "'"'For a somewhat si m i l a r discussion of a supply of funds origi n a t i n g from entrepreneurs' own source of funds and external funds involving an imperfection i n the c a p i t a l market, see, for example, M. Bronfenbrenner, "Reformation of the Naive P r o f i t Theory," Southern  Economic Journal, A p r i l , 1960. - 68 -Figure 4.1(a) below i l l u s t r a t e s the supply curve of the firm's i n t e r n a l funds or retained earnings. There i s an opportunity cost to holding any wealth i n very l i q u i d form. This opportunity cost arises from not lending and might be equal to the rate of interest on government bonds. As i n t e r n a l funds are depleted, an additional cost i s incurred. At some point i n time, the opportunity cost of not holding in t e r n a l funds begins to r i s e . For an example, the firm may incur an opportunity cost of not being able to grasp i n time a mining claim or property with a potential rate of return higher than the existing rate of return on the firm's investments. On these footings, the supply curve of a firm's i n t e r n a l funds may be e l a s t i c at lower levels and slope upwards for higher quantities of funds. See Figure. 4.1(a). Figure 4.1(b) shows the supply curve of the firm's external funds. We assume that a certain'sum i s made available to the firm i n discrete amount at an i n i t i a l rate of in t e r e s t . As more external funds are required by the firm, they may be borrowed only at higher rates of int e r e s t . Consequently, the supply curve of external funds portrays a step - l i k e shape as we consider higher quantities of funds. Given these two alternative sources available to the firm, the t o t a l supply of funds available to the firm i s depicted.by Figure 4.1(c). Given the demand for funds, the amount of in t e r n a l and external funds used for expansion of the firm can be eas i l y determined. For example, at the firm may enter the c a p i t a l market while also using some, but not a l l , of i t s i n t e r n a l funds. - 69 - 70 -Thus, the r i s i n g opportunity cost of not holding in t e r n a l funds or of borrowing funds from the c a p i t a l market makes i t feasible for petroleum firms to hold and maintain a high l e v e l of retained earnings as buffer c a p i t a l . I t has also been argued that firms i n this industry have greater access to market funds than other firms because thei r crude reserves may be used as c o l l a t e r a l for l o a n s . 5 6 This may be true, but the main point i s that these reserves were largely acquired through retained earnings i n the f i r s t place. Therefore, we conclude that the a v a i l a b i l i t y of retained earn-ings reinforced by market opportunities for borrowing c a p i t a l may f a c i l i t a t e possible expansion i n t h i s industry. Equally important i s the assumption that the p r o f i t s of o i l companies appear to be higher than manufacturing companies i n developing countries. We w i l l examine this assumption l a t e r . For now we argue very s u p e r f i c i a l l y that depletion allowances and other f i s c a l incentives are probably the reason behind this assumption. Furthermore, i t has been shown that most of the o i l companies i n developing countries are subsidiaries of large o i l companies of the free world. These subsidiaries do not have to make as much direct divident payments to the public as the i r parent companies. As a r e s u l t , a substantial portion of th e i r after tax p r o f i t s are undistributed and may also form a lever for expansion. ^^Penrose, op. c i t . , p. - 71 -Since the a b i l i t y for the firm to expand i s here defined to be contingent upon i t s retained earnings, the growth of those retained earnings may be a contributing factor to the structure of the petroleum industry i n any country today. Thus i t can be hypothesized that: L i q u i d i t y i s essential for the expansion of a petroleum firm. Symbolically, o 1 - 0 1t - 1 E = — — = a + a.L^; a. > 0, where 0^  represents the current integrated output and L^ the retained earnings to equity r a t i o . Because of the d i f f i c u l t y involved i n obtaining data on a firm's operation, even i n a developed country l i k e Canada, we fin d i t impossible to test this hypothesis. However, Table 1.3 provides an impression of the retained earnings to c a p i t a l r a t i os for selected companies. We leave the interpretation of the ratios up to the reader. Expansion i n the petroleum industry t y p i c a l l y i s i n terms of extensive integration. By integration, i t i s meant that a firm i s active l y engaged i n exploration, development and production, transporta-t i o n , r e f i n i n g , and marketing. Among others, integration has been acclaimed by the l i t e r a t u r e to be the chief policy whereby large petroleum firms effect their control over p r o f i t s and make entry into the industry very costly for newcomers. The c a p i t a l b a r r i e r to entry has recently appeared to decline i n importance, inasmuch as many new producing firms (private, state and mixed) have been organized. - 72 -There are three closely related thoughts on integration as a d i s t i n c t c h a r a c t e r i s t i c of the structure of the petroleum industry. The f i r s t opinion derives from the case of the P a c i f i c Coast petroleum industry reviewed by Joe Bain. According to Bain, the fact that f u l l y integrated firms account for f a i r l y high proportion of crude production and a very high production of r e f i n i n g and refined products d i s t r i b u t i o n , i s strategic to the determination of both intermediate and f i n a l prices throughout the industry."^ The theory i s that integrated firms, as large crude producers r e l a t i v e to non-integrated firms, set intermediate prices, and as very large refiners and d i s t r i b u t o r s of refined products, exercise a substantial influence over f i n a l prices as w e l l . I t i s also noted by Bain that the seven majors were buyers of about 65 - 70 percent of the t o t a l crude produced i n C a l i f o r n i a . Thus we are not error i n assuming at the onset that integrated petroleum firms play a strategic 58 role i n price determination i n the industry. Another opinion about the role of integration i n the petroleum industry i s that of de Chazeau and Khan, emerging ten years after Bain's. This opinion concerns the whole petroleum industry i n the United States 59 rather than a segment of i t . "^Joseph Bain, The Economics of the P a c i f i c Coast Petroleum Industry, Part I (Berkeley: Stanford University Press, 1945), p. 210. Loc. ext. 59 Melvin de Chazeau and Alfred E. Khan, Integration and Compe- t i t i o n i n the Petroleum Industry (New Haven, Conn.: Yale University Press, 1959), pp. 36-40. - 73 -According to de Chazeau and Khan, the petroleum industry i s highly concentrated. Table 4.1 shows concentration r a t i o s i n the industry, for selected years. Table 4.1 Concentration Ratios i n the United States O i l Industry PERCENTAGE OF NATIONAL OPERATIONS BY THE TOP SEVEN AND TOP TWENTY COMPANIES 7 Companies 20 Companies Net Domestic Crude Production (1955) 29.1 47.5 Production Abroad By U.S. Companies (1955) 94.0 98.0 Refinery Throughout (1955) 53.7 86.2 Sales of Gasoline (1954) 49.6 80.4 Pipeline Services (1948) 56.7 88.2 Source: de Chazeau and Khan, op. c i t . , p. 18. Table I I I . Concentration i n the various segments as shown on the table above r e f l e c t s i n large measure the high degree of geographic integration i n the industry. For our purposes, this type of integration i s the main contribution of de Chazeau and Khan to our understanding of the structure of the industry. However, the information about the number of companies producing 94 percent of t o t a l production abroad i s , indeed, not helpfu l i n understanding the curve structure of o i l i n the developing countries. For the number of operating firms i n the developing countries has increased several f o l d over the past decade. Hence, concentration ratios must be declining. Also, de Chazeau and Khan contend that firms i n the industry have strong mutual interests i n avoiding competition because they are large i n size and small i n number - an indication of the presence of o l i g o p o l y . 6 ^ Furthermore, smallness i n number enables these firms to achieve a degree of monopolistic ends by a concerted e f f o r t or market collaboration. An examination of current situations also indicates that the a b i l i t y of these firms to collude i s declining over time due to the increase i n thei r number and decrease i n r e l a t i v e share of market output. Penrose, rendering an opinion more or less on the international 61 scene, e x p l i c i t l y points out the significance of v e r t i c a l integration. According to this opinion, a high degree of v e r t i c a l integration makes i t possible for firms to allocate overhead costs to dif f e r e n t operations and i n setting prices at which goods and services are transferred between subsidiary e n t i t i e s of firms. If we assume that firms minimize taxes to maximize retained earnings, then the scope of a l l o c a t i n g overhead costs may be an e f f e c t i v e way of doing i t . In th i s connection, Penrose also asserts that prices charged by parents to a f f i l i a t e s for management services, 6^de Chazeau and Khan, op. c i t . , p. 36. 61 Penrose, op. c i t . , p. 100. - 75 -patents and others, may be adjusted over a wide range. The implications of these practices w i l l become apparent i n Chapter V, when we discuss rent. Here too, we note that such implications have declining influence i n the long-run due to the downward pressure of low cost discoveries exert on prices. The three opinions viewed above should not lead to an evaluation of v e r t i c a l or horizontal integration of the petroleum industry as entire-l y undesirable. I t may be that integration i s a necessary condition for e f f i c i e n t operation of the industry. From this point of view, o i l firms o f f e r "several reasons for extensive integration: 1. I t assures outlets for crude, hence a steadier flow of crude o i l for r e f i n e r i e s . 2. More e f f i c i e n t operation of r e f i n e r i e s as a res u l t of an assured and managed flow of crude o i l . 3. More f l e x i b l e and e f f i c i e n t adjustments to short-run changes i n the demand for different products i n d i f f e r e n t areas reflected i n quick inflows of crude o i l . 4. Avoids the consequence of fluc t u a t i o n i n prices which raise costs to producers and consumers. Many of these reasons offered do not hold up under close exami-nation. Where crude i s supplied by many producers, i t i s i n the i r p r o f i t maximization interest to provide r e f i n e r i e s with a r e l i a b l e flow of inputs. There are several other reasons which may j u s t i f y v e r t i c a l i n t e -gration i n the petroleum industry, however, F i r s t l y , v e r t i c a l integration may be an attempt to capture enough of the reserves of crude to create a - 76 -bar r i e r to entry. There may also be economies of management or information, advantages i n financing, or physical advantages of plant structure. In the past some firms have enjoyed these advantages and further increased th e i r scale of operations over many years of existance. The significance of such expansion, for the purpose of this study, i s the growing suspicion which developing countries may create for the bigness of these firms. This i s a source of uncertainty, hence a problem for developing petroleum resources i n the developing countries. We focus our attention on the problem of alienating o i l properties. The Alienation of Petroleum Properties i n the Less Developed Countries Professor Tussing has c l a s s i f i e d systems of natural resource development i n three broad categories: 1) the discovery system, where development rights are obtained by discovery and appropriation; 2) the leasing system, where the development rights are obtained by competitive bids; and 3) the concession system, where development rights are obtained . . 62 by negotiation. The alienation of petroleum properties i n the developing countries i s characterized by a l l three of these systems, but the concession system predominates. Egypt, Indonesia and other developing Tussing & Erickson, "Mineral P o l i c y , The public Lands and Economic Development: The Case of Alaska" i n Mining and Public  Policy i n Alaska, (Fairbanks, I n s t i t u t e of So c i a l , Economic and Government Research, University of Alaska, 1968). pp. 39-50. - 77 -countries operate under the concession system, but i t may be gradually 63 phasing out. The discovery system where the state appropriates a l l discoveries exists i n Cuba and Mexico. A l l other L a t i n American countries have a mixture of two or more systems. For our purpose, the most a t t r a c t i v e feature of the concession system i s that the right to extract the resource i s given to one or few developers per o i l f i e l d . This may automatically eliminate the necessity for conservation regulation. That i s , the common property problem appears to be irrelevant under this system. But the problem of sole-ownership or monopoly exploitation i s inherent. Therefore, the alien a t i o n of o i l properties may be a necessary barrier to entry under the concession system. When there i s a common property problem, i t has been argued by the conservationists that a monopoly i s a necessary economic i n s t i t u t i o n for more e f f i c i e n c y . T h i s e f f i c i e n c y c r i t e r i o n i s based on i n t e r n a l i z a t i o n of the s o c i a l cost by the producer. In f i s h e r i e s , for example, crowding 63 The management contract system i s rapidly replacing the concession system. See foot note 1, 64 Ewell Murphy, J r . " O i l Operation i n La t i n America: Scope for Private Enterprise," International Lawyer, Vol. 2, No. 3, p. 455. 65 Howman and Lovejoy, Economic Aspects of O i l Conservation  Regulation, (Baltimore: The John Hopkins University Press, Resources for the Future, Inc. 1967), pp. 3-39. - 78 -i s an externality which creates s o c i a l cost, i . e . , too many fishermen on a p a r t i c u l a r f i s h i n g ground may lead to a whole day's labour and use 66 of a f i s h i n g e f f o r t at a zero or negative returns. Consequently, uncertainty of tenure may be a problem for o i l pools, f i s h e r i e s and the l i k e . But security of tenure i s not a s u f f i c i e n t condition for an optimum a l l o c a t i o n of these resources; i t i s only a 67 necessary condition for e f f i c i e n c y . For this reason, the concession system, earmarking the alienation of rights to petroleum reserves i n some developing countries, i s a necessary but not a s u f f i c i e n t condition 68 for the a l l o c a t i o n of resources i n the petroleum industry. Other conditions may be p o l i t i c a l , s o c i a l or psychological. These remain outside the scope of this study. However, we b r i e f l y admit that the o i l p o l i c i e s of the large o i l consuming nations have a substantial influence on the structure of the o i l industry. Most of these p o l i c i e s favour administered prices v i a production control which protect their domestic industries against price erosion of o i l and related industries (Coal). 6 6See an excellent discussion by Clive Southey, Studies i n  Fisheries Economics (unpublished Doctor's d i s s e r t a t i o n , University of B r i t i s h Columbia, 1969. ' .' ^^Gaffney Mason, Taxation and the Extractive Resources (Madison, Wise: University of Wisconsin Press, 1967), p. 338. 68 This argument i s equivalent to that made for u n i t i z a t i o n i n North American o i l f i e l d s . See for example, J. W. McKie and S. L. McDonald, "Petroleum Conservation i n Theory and Practice" Quarterly  Journal of Economics. Vol. LXXVII, No. 1, February, 1962, p. 110. Note that i t may also be possible to have a compulsory u n i t i z a t i o n under the concession system. For example, two concessions may have a common boundary over an o i l pool. < CHAPTER V THE RENT OF PETROLEUM RESOURCES AND SOME OPTIMUM SHARING STRATEGIES IN DEVELOPING COUNTRIES Perhaps the most important consequences of uncertainty and i n petroleum resource development i n developing countries are related to the sharing of the rent between the private producing firms and their host governments. In the Middle East, Sheick Abdullah T a r i k i indicted 69 o i l companies for a three b i l l i o n dollars default i n royalty payments. In Venezuela and other developing countries of the Western Hemisphere, the suspicion appears to focus on the "tapping of th e i r wealth and carrying i t away", so that squeezing o i l companies has become the convenient course for popularity. Dr. Juan Perez Alfonso estimated i n 1943 that after 25 years of operations, o i l companies share of o i l p r o f i t s was i n the order of magnitude of 77 percent as against the Venezue-lan government's 23 percent.^ When Alfonso became Venezuelan o i l Minister i n 1958, he was instrumental i n establishing the 50-50 p r o f i t sharing arrangements existing between o i l companies and the government at that time. 69 Sheick Abdullah T a r i k i , "The Price of Crude O i l and Refined Products", Proceedings, Second Arab Petroleum Congress (Beruit, 1960), p. 13, 15 and 20 cited by J. E. Hartshorn, O i l Companies and Governments, (London: Faber and Faber, 1962), p. 20. Hartshorn, i b i d , , pp. 269-73. - 80 -Consequently, after 1960, the p r o f i t s of o i l companies were under pressure i n most producing developing countries. The consequences of uncertainty and v u l n e r a b i l i t y began to show up. Generally, companies were d i s i n c l i n e d to increase output i n areas with increasing propensities to tax. This reduction i n output did not hurt the revenue position of, especially, the more i n f l u e n t i a l producers l i k e Venezuela (increased revenue from $866 m i l l i o n i n previous years' peak to $1 b i l l i o n i n 1959) since they could afford to increase their intake by increasing the tax rate. However, the pressure on the companies' p r o f i t s began to take the d i r e c t i o n of the price structure, thus providing the setting of the i n t e r -national o i l price policy. With this b r i e f introduction to what we consider to be c r u c i a l to the uncertainty governing the o i l industry i n the developing countries, we offer i n this chapter the summary of a l l the arguments i n previous chapters. The purpose of this summary i s to focus a l l the issues on one topic: the p r o f i t of petroleum resources i n the developing countries. The procedure of c e n t r a l i z i n g the arguments i s as follows: 1) the supply curve of o i l i n the industry w i l l be established; 2) the current price structure reviewed; 3) rent defined and some p r o f i t sharing devices w i l l be discussed. - 81 -Supply Price of Crude Petroleum Resources-Petroleum i s a stock or an extractive resource. Because low output demand i n any extractive resource means production from low-cost nearby areas and higher demand means production from high-cost distant areas, the industries of these resources are increasing costs. Petroleum 71 i s thus an increasing-cost industry. Our aim i n this section i s to examine the costs or price necessary to induce factors into this industry. Effi c i e n c y i n the petroleum industry requires, among other things, that investment both i n discovery (described i n chapter III) of unknown o i l and the time-rate of extraction of existing known o i l be optimized. By understanding both the short and long-run costs, public authorities i n the developing countries may apply the economic concept of e f f i c i e n c y i n the use of their petroleum supplies. The most e f f i c i e n t rates of use or production are those which require no waste-that i s , the value of losses which are greater than the cost of preventing those losses. This i s the concept of conservation implied i n the assertion i n chapter IV that assurance of ownership i s a necessary condition for a l l o c a t i o n of resources i n the industry. The volume of o i l which can be ultimately recovered from most o i l reservoirs i s a function of the most e f f i c i e n t rate of production. This An example of the discussion of why petroleum i s an increasing cost industry i s given by Adelman i n , for example. Supply and Price of  Natural Gas, (London: B a s i l Blackwell, 1962), pp. 10-20 - 82 -rate i n turn depends upon the optimum number of wells and pressure 72 factors or natural drives beneath the reservoir. For ourpurposes, there are two categories of costs necessary for extracting a unit of o i l per time period from a given reservoir. F i r s t , the operating or extraction costs include some wages, f u e l s , maintenance and other related expenditures. These costs may vary with output and they t y p i c a l l y constitute a very small proportion compared with the r a t i o of development and exploration costs to t o t a l costs of 73 production i n any given period. Development and exploration costs of production include w e l l construction and development costs, such as fracturing., equipments, s i t e f a c i l i t i e s and other a r t i f i c i a l processes which help to maintain the pressure factor i n the reservoir. These costs can be allowed to vary only with respect to the long-run. The summation of these extraction and development costs are the t o t a l investments per unit of "capacity" output and the producer w i l l produce that unit only i f price covers these investments and allows for a margin of returns on investments. The relationship between this price and the capacity output i s ca l l e d the supply curve. 72 These drives are created by 1) gas disolved i n o i l , 2) water entering the reservoir and sweeping o i l before i t and 3) the amount of gas already associated with the o i l . 73 Bradley estimates of the Middle Eastern and North African countries' o i l fieds indicate that development costs average from 14 to 28 cents and extraction costs average between 3 to 5 cents on a barrel of o i l , allowing for a 20 percent return on investment. See P.G.Bradley, Statement to the U. S. Senate Committee on Anti-Trust and Monopoly, A p r i l 1, 1969, p. 2-3. - 8 3 -In the short-run, that i s , treating development investment as f i x e d , the unit costs f a l l over a wide range of output. In the long-run, more investment i s required, and without new discoveries, unit cost associated with new capacity w i l l r i s e . This means diminishing returns to output as production continues over time and given a price, i t may pay to discontinue production or "cap o f f " wells. Hence, the supply or the marginal cost curves of an operator of a given unit of "proved reserves" r i s e over time. For the industry as a whole i t i s con-ceivable that these cost curves also slope upward. Therefore, the petroleum industry i s an increasing cost industry. There are certain conditions which influence the industry marginal costs. Increase i n the number of wells increases the rate of production. This has an effect on the ultimate recovery. For example, four wells each producing 25 barrels a day from a given unit of "proved reserves." But since wells are not costless, an addition to wells may only be induced by the market opportunity available to the operator. These opportunities consist of the expected price and the market rate of interest or the cost of c a p i t a l , assuming perfect competition. - 84 -When the price of o i l i s high and the discount rate i s high, operators may increase the number of wells i n order to increase present output. Low prices and discount rate w i l l reverse this investment , . . 74 decision. Expected r i s e i n prices may have the same effects as the low present prices and expected increases i n the rate of discount make future output unattractive because of their low present values. This may have the effect of influencing increases i n the present rate of production. The significance of this expected increases i n the rate of discount i s the same as expected unstable p o l i t i c a l situations i n the developing countries. Another factor affecting the supply curves of the industry i s technological change. For example, foam i s a new innovation which now lowers costs of secondary recovery.^ The discovery of low-cost supplies also affect the supply curve of the industry. Low-cost sources generally influence the evalua-tion of the expected returns or prospects of existing higher-cost sources Hence, i n the long run, "shut down" decisions may be made'sooner when low cost sources are discovered. Bradley, i b i d . , p. 8. Note that we are dealing with the concession system where there i s no effect of proration on this decision. 7 5See World O i l , A p r i l , 1970. - 85 -The l a s t factor which may have an influence or the decision by a producer to shut down i s the royalty paid to the government of the host country. Given a market price, when the royalty payment plus long-run marginal cost exceed that p r i c e , i t may not pay to produce o i l i n the long run. I t i s , therefore, i n the interest of the government to l e t royalty be a residual of the price and marginal costs including producer's p r o f i t . According to McKie and McDonald, royalty payment which allows reasonable rate of returns on existing investment may induce extensive 76 marginal development of new f i e l d s . This argument provides the basis of analysis of the p r o f i t sharing device to be examined l a t e r . For now, we must examine the present o i l price structure. The Price of Crude O i l i n Developing Countries As usual, a discussion of an economic problem especially i n the Western World must st a r t with the world of perfect competition, though u n r e a l i s t i c t h i s world may be. We follow s u i t and imagine such a world once more. Given the supply conditions described above, a perfectly competitive price of o i l may be represented by what Leeman^ has ca l l e d a "basin or craters" of prices determined for a l l regions by the minimum transportation cost over the distance connecting buyers- to s e l l e r s ' regions. 7 6 J. W. McKie and S. L. McDonald, "Petroleum Conservation i n Theory and Practice". Quarterly Journal of Economics. Vol. LXXVII, No. 1, February, 1962. p. 110. ^Wayne Leeman, The Price of Middle East O i l , (Ithaca, N.Y.: Cornell University Press, 1962), p. 86. - 86 -Putting the same argument i n another way, Prof. Adelman has written that the world crude price structure can be stable only i f 1) the f.o.b. prices i n any exporting region are the same to a l l destina-tions; 2) price i s the same for a l l buyers i n any importing region, and 3) i f the marginal cost equals the price i n exporting regions as well as i n importing regions, the difference between the prices i n any two 78 regions w i l l be approximately the amount of transport cost. When these three conditions hold, the whole system i s i n competitive e q u i l i -brium. Translating this to the price of o i l i n the developing countries means for example, that there would be no difference between the f.o.b. price of o i l i n Venezuela and the Middle East i f the marginal cost of producing the same quality of o i l was the same i n both countries. Also, the New York or the London price for the same quality of o i l coming from the two regions would d i f f e r approximately by the cost of shipping i t to New York or to London. 79 However, the marginal costs vary between producing regions. 78 Adelman,"World- Outlook','in M. Clawson, Natural Resources and  International Development, (Baltimore: The John Hopkins University Press, 1964), p. 50. 79 Due perhaps to differences i n development costs among regions. See Bradley, op. c i t . , p. 2. - 87 -Therefore, the f.o.b. price of Middle East o i l depends on the marginal cost and the marginal cost i n turn depends on the l e v e l of output. The same i s true for Venezuela, or Nigeria. Given everything else equal, the marginal costs should be equated over regions j u s t as the marginal costs of production are equated over a f i e l d by ind i v i d u a l producers under perfect competition. This i s conceivable. Since, for instance, the r a t i o n a l London r e f i n e r i e s are maximizing p r o f i t s , they w i l l import from low marginal cost (including transportation) sources u n t i l the r i s i n g output l e v e l raises the marginal cost of that region equal to the higher marginal cost region. Eventually, we should have the marginal cost equal for a l l regions. This means that the price of low cost regions w i l l always move towards high cost regions u n t i l they come to compete 80 with each other. In effe c t , there would be no geographic price discrimination. In practice, we observe posted and published prices i n the industry. Are these r e a l prices i n the sense that they represent demand-supply interaction? We present the chronological price pattern as we survey the various views about the price of crude o i l . 80 Levy described the confrontation of Persian Gulf Price and the Carribean Prices i n the U.S. East Coast as the "high and low" range theory. See Walter Levy, "The Past, Present and Like l y Future Price Structure for International O i l Trade" Proceedings, Third World Petroleum Congress. (Lieden, 1951), Sec. X, reprint 16, 1951. 88 -The price of crude o i l i n the free world before the Second World War was based on the r u l i n g prices of the Gulf of Mexico, usually 81 known as the "U.S. Gulf Plus". Probably, the only other world price 82 was the f.o.b. Constanta found around the Rumanian production region. However, the Gulf plus remained very constant despite the fact that the Middle East and other low cost regions were expanding production at a very rapid rate. There are probably two reasons why this constancy was maintained. F i r s t l y , there were only a few international producers (about seven) and 83 about t h i r t y independent producers i n the whole industry. Because markets were independent or separated, i t was therefore possible for these companies to protect their investments i n U.S. production by seeking to maintain the U.S. price. Secondly, i t was also possible for companies acting as o l i g o p o l i s t s , i . e . , one firm seriously recognizing the effect of r e t a l i a t i o n by others i f his action affects the price structure i n any way. Consequently, the "Gulf plus" price automatically became r i g i d , given a constant demand and no desire on the part of any producer to increase output. Another price pattern developed i n the Middle East, d i s t i n c t i v e of the "Gulf plus" during the war. This pattern was based on the transactions between France and the U.S. Navy i n 1945 under the Land-Lease Act. This price pattern came to be known as the Persian Gulf Price which 81 Leeman, op. c i t . , p. 89. 82 Levy, op. c i t . , p. 5. 83 Leeman, op. c i t . , pp. 91-3. • u - 89 -after the war, diverged and maintained a market d i s t i n c t i v e of the "Gulf plus". The Persian Gulf price then became the "basing poing" with a structure f a l l i n g from $2.95 to $1.05. After the war, the Persian Gulf prices began to decline while the "Gulf plus" remained r e l a t i v e l y constant. At the same time post-war tanker rates took a downward trend and the marketing t e r r i t o r y or "Watershed" of the Persian Gulf was expanded. The spread of the "Watershed" i n East and West di r e c t i o n of the Suez Canal was confronted at the A t l a n t i c by the Caribbean prices and on the P a c i f i c by the Indonesian and the Californian prices, a l l based on the "Gulf plus" price. According 84 to Levy , the lower l i m i t of the Persian Gulf prices was competitive with the Caribbean while the upper l i m i t confronted the "Gulf plus" i n the P a c i f i c , thus suggesting a possible range of the Persian Gulf prices. These two prices were thus kept apart by the P a c i f i c and the A t l a n t i c oceans. B a s i c a l l y , these two prices have dominated the free world crude o i l market and the l i n k between them has been rather loose. But petroleum product prices for both regions have been d i r e c t l y linked together by 85 transportation costs. We observe here that a loose l i n k w i l l exist between a product price of two d i f f e r e n t regions i f the markets are kept somewhat separated and that i n the short-run low prices can move i n the d i r e c t i o n of higher prices only under a perfectly competitive condition. " ! 84T _ . Levy, or*, c i t . , p. 1. 85 Leeman, op. c i t . , p. 113. - 90 -j Given t h i s observation, assume that differences i n the p r i c e s of crude o i l i n various markets i s a function of the marginal cost and transportation cost. On the basis of t h i s function, the p r i c e structure should determine the market share of each producing country. The e x i s t i n g crude o i l p r i c e s do not r e f l e c t arm's length p r i c e s . There are several j u s t i f i c a t i o n s f o r t h i s claim. F i r s t l y , low cost sources are not allowed to compete with e i t h e r high-cost sources or with each other. The reason for t h i s i s that the same companies which manage low-cost sources are i n v a r i a b l y the same companies managing high-cost sources. For an example, S h e l l Co. of Canada has managing i n t e r e s t s both i n Alberjia and i n the Caribbean and there i s no reason to expect that Shell's output from the two regions w i l l compete with i t s e l f . Another j u s t i f i c a t i o n f o r the absence of arm's length p r i c i n g of crude o i l i s that companies i n the industry are a c t i v e l y engaged i n i n t e r l o c k i n g production, marketing and transportation a c t i v i t i e s . For an example, most concessions i n the Middle East consist of several companies under a j o i n t management which makes the output d e c i s i o n independent of the desire of any one member company to increase i t s r e l a t i v e share of output. This output decision under j o i n t management i s made i n the l i g h t of u n p r o f i t a b i l i t y r e s u l t i n g from lower p r i c e s . Under a competitive s i t u a t i o n , where there are independent producers, the output d e c i s i o n i s - 91 -made considering p r o f i t a b i l i t y due to r i s i n g marginal cost. For this reason, i t i s i n the interest of a l l producing companies to keep output at a l e v e l that w i l l not d i s t o r t t h e i r established price. Therefore, we conclude that j o i n t operation provides the atmosphere for c o l l u s i o n and possibly a zero conjectural price v a r i a t i o n . A t h i r d j u s t i f i c a t i o n was given i n Chapter IV about the integration of firms i n the industry. I t was pointed out that such integration makes i t possible for firms to set prices for intermediate and f i n a l products. Since the a f f i l i a t e s of these large international petroleum firms produce o i l and s e l l to their parent companies for r e f i n i n g , the prices of these transactions are simply transfer prices, which r e f l e c t accounting for tax, balance of payments, and depreciation charges. Apart from these, crude o i l prices between a parent company and an a f f i l i a t e do not r e f l e c t marginal costs and they may be adjusted over a wide range. This range, i s determined by a company's owned crude requirement for r e f i n e r i e s . In this case, only product prices matter to 86 the firm. However, this integrated effect on prices i s not expected to l a s t . A fourth j u s t i f i c a t i o n for the claim that arm's length prices are not relevant to crude o i l prices i n most developing countries i s that these prices may be contract prices which are i n s e n s i t i v e to current supply and demand conditions. Contract prices may be set at the beginning 86 Penrose, Large International Firm i n the Developing Countries:  The International Petroleum Industry, pp. 185-197. George Al l e n & Unwin Ltd. London, 1968. - 92 -of the period and remain fixed throughout the l i f e of the contract. Or, such prices may be escalated at various phases of the contract. Some contract prices may be contingent upon certain conditions. For an example, a contract may set off a provision requiring a buyer to pay a price that i s paid by another party i n the same region ( t h i r d party clause). Or, the buyer may be required to pay a price that i s comparable to what the same buyer i s offering another s e l l e r i n the same region (single party clause). Again, we think that such prices have no relevance to marginal costs. The most important j u s t i f i c a t i o n i s that there has been a deliberate policy by the governments of both the larger o i l exporting 8 7 and importing countries to maintain prices against market forces. For example, Venezuela joined the Middle East producing countries to form the Organization of Petroleum Tixporting Countries (O.P.E.C.) which resolved i n 1960 to permit prices not to change. The p r i n c i p l e reason for such a policy may be a maintenance of government's revenues. On the side of the large consuming nations, the United States desires to maintain prices i n order to avoid d i f f i c u l t i e s a r i s i n g from import r e s t r i c t i o n and with the Texas Railroad Commission. In Canada, the proration system of the Alberta o i l f i e l d s i s no exception to the price maintenance policy. In the countries of Western Europe, coal prices are on parity with o i l prices. A drop i n o i l prices means substitution of o i l energy for coal 87 Adelman, op. c i t . , p. 82. - 9 3 -energy, depending on the price e l a s t i c i t y of demand. Hence, price maintenance i s geared towards protecting both the domestic crude o i l and coal industries. In general then, we may conclude that the buyers as we l l as s e l l e r s of crude o i l i n developing countries have vested interest i n maintaining prices d i f f e r e n t from arm's length prices. For our purposes, these are good enough reasons why we think there i s no competitive price for crude o i l produced by the developing 88 countries.. However, the existing price structure i s probably more stable than i t would be under a competitive s i t u a t i o n . This may be desirable from both the company's and the country's points of view. From the company's point of view, a more stable p r i c e , whether competitive or not, assures more meaningful planning of investment i n capacities and a r e l a t i v e l y smooth flow of output pattern. In other words, a stable price insures a company against greater r i s k and uncertainty than would be the case of a less stable price. However, should this company be given the choice to choose a higher fluct u a t i n g price structure than a lower stable one, the former would no doubt be a favourable choice. From the point of view of the producing developing countries, a high and stable price of o i l assures not only a stable national income, (see chapter II) but also a stable government revenue on which a meaningful 88 Other reasons have been given by various writers i n the f i e l d . See for example, Leeman, op. c i t . , 3, has stated as one reason, posted prices are unacceptable to n o n - a f f i l i a t e s . However, we note that price i n competitive crude market i s l i k e l y to be more stable than not. - 94 -development planning may be based. We need only to consider the United Nations Trade Development conference proceedings i n order to appreciate * .89 thxs fact . Assuming that there i s an agreement on a price structure (and there usually i s ) , the most d i f f i c u l t and the most unpredictable aspect of petroleum production i n developing countries i s a formula for sharing the p r o f i t . In the following section, we b r i e f l y examine this problem. P r o f i t from Petroleum Production and Uncertainty i n Sharing Arrangement Petroleum i n the ground, not yet discovered has no value. Several a c t i v i t i e s (some of which we have already mentioned) must be carried out before value can be imputed to the resource. In the f i r s t place, the entrepreneurship or the incentive to organize the venture has to be present. Then, the entrepreneur must obtain the right from the landowner at some costs (royalty or bonuses) which vary between developing countries. In addition, the producing firm or entrepreneur may be required to spend a huge sum of money to develop infra-structure such as housing, e l e c t r i c power, schools for the children of the employees, f i r e and police protections and sometimes recreational f a c i l i t i e s . In isolated regions these i n d i v i d u a l a c t i v i t i e s may not be p r o f i t a b l e but when aggregated with 89 The general conclusions from these conference are i n favour of price s t a b i l i z a t i o n of export commodities of developing countries. - 9 5 -90 t h ^ o i i ^ o p e r a t i o n the -fc«».tal project could be pr o f i t a b l e . Also, the actual expenditures for "thio prospecting, wildcat d r i l l i n g and extrac-t i o n of crude o i l which we have discussed i n previous Chapters. F i n a l l y , the tax l i a b i l i t y i s assessed by the host government. The rea l source of uncertainty since 1959 has been this amount of the rent paid i n taxes. In spite of these payments which have j u s t been enumerated, we believe the t y p i c a l producing region earns above a normal rate of return (excess p r o f i t s ) on investment. Figure 5.1 demonstrates this phenomenon. Based on the discussion i n the preceding section about the r e l a t i v e marginal cost of production i n each producing region, i t can be argued that the industry extracts excess p r o f i t s from o i l produced i n the developing countries. For example, given the price ( P Q ) which •applies when a high cost b a r r e l i s produced i n the U.S., a lower cost (equal to P ^ ) per barrel i n the Middle East or P ^ i n Venezuela must y i e l d large p r o f i t s i n those regions. Given this s i t u a t i o n , i t can be concluded that excess p r o f i t (which w i l l be referred to as rent) may be inherent i n the industry regard less of where the development of the resource takes place. How should this rent be shared between producing firms and the developing countries? I owe much gratitude to Dr. Dale Orr for this valuable comment - 96 -INDUSTRY U S A j » V E N E Z U E L A MIDDLE EAST Figure 5 • I A H Y P O T H E T I C A L S U P P L Y A N D D E M A N D C U R V E S O F T H E W O R L D P E T R O L E U M I N D U S T R Y . - 97 -P a r a l l e l to the "share cropping system" and the "share system" i n farming and fi s h e r y , the t r a d i t i o n a l method of sharing the rent from petroleum ( i n most developing countries,) has been the fixed f r a c t i o n a l p r o f i t sharing system. For example, the Creole Petroleum Company shared i n the r a t i o of 50-50 percent of p r o f i t with Venezuela up to 1957. Generally, the governments of the developing countries have shown a very strong desire to r e t a i n a greater proportion of the rent than they currently share. But there i s a l i m i t to which that share can be expanded. The producing company's required share of the rent may be estimated by comparing the i m p l i c i t rate of returns to i t s best alternative investment. Given this rate, one may argue that the firm may be w i l l i n g to y i e l d to an increase i n government's share. In the short run, since investments i n physical f a c i l i t i e s are foregone or sunk, the opportunity cost of giving up just a l i t t l e more of the rent may, to a large extent, be determined by how much i s l e f t to cover the company's short-run costs. If the company's share cannot cover these costs, i t may not y i e l d to such a bargain. I f i t does y i e l d , and i t s revenue f a l l s short of long-run costs, then while i t may not shut down existing operations, i t surely w i l l not invest i n new capacity. A factor which may decrease the government's bargaining power i s that many of the projects i n developing countries are j o i n t ventures. The operating companies are interlocked i n various a c t i v i t i e s and this may, i n f a c t , make i t d i f f i c u l t for the country to find a "new" firm to enter the industry. For an example, a dispute between Iran Petroleum Company and the government of Iraq, c e r t a i n l y w i l l involve B r i t i s h Petroleum^ - 98 -• . • . I Royal Dutch-Shell, Compangnie Francaise, Jersey Standard and Socony Mobil, who are a l l parent companies. Given these si t u a t i o n s , there i s a "budget constraint" l i n e representing t o t a l p r o f i t s which must be shared by developing countries and petroleum producing firms. Figure 5.2 demonstrates this sharing relationship. Assume now that there i s a lump sum defined p r o f i t n be shared between the two parti e s . Let II and II denote company's and government's c S share respectively. I t i s possible for the government to appropriate a l l of the p r o f i t s , which case i s shown by the ^g0> o r f° r the company not to pay taxes at a l l , shown by II J co We can draw an indifference curve for a government, derived from i t s long-run u t i l i t y function. I t i s i n the long-run interest of a government to allow companies to earn excess p r o f i t s since t h i s w i l l o f f er an incentive for new firms to come i n which the i r advanced technology and develop resources. Even though we might be able to j u s t i f y a convex long run indifference curve for the government, therefore a tangency, we cannot indicate where i n the p r o f i t l i n e this w i l l be. \ F i g u r e - 5- 2 S E C O N D - B E S T O P T I M U M P R O F I T S H A R I N G B E T W E E N C O M P A N I E S AND G O V E R N M E N T . - 100 -The slope of the indifference curve w i l l be MU /MIL . This . . Ilg . lie e s s e n t i a l l y a trade off between today and tomorrow. P r o f i t s given to companies could be considered an "investment" for economic growth i n the future. From thi s point of view, the indifference curve of far sighted countries w i l l reach a slope of -1 (therefore tangency) at a higher point on the p r o f i t curve. This yields r e l a t i v e l y more p r o f i t to the company than would be the case of near sighted developing countries. There are several factors that might affect bargaining power for p r o f i t shares. The increase i n the number of firms may cause the company to expect a more competitive s i t u a t i o n , thus urging that the company pays more p r o f i t s or else other firms may soon be contracted to come i n . In addition, a r a d i c a l change i n a country's leadership may make p r o f i t sharing a scape-goat, thus s h i f t i n g the opportunity l i n e downward. A l i b e r a l government may work i n the opposite d i r e c t i o n . The conditions of current p r o f i t sharing may change. For example, a change i n the knowledge about the resource may given the government a greater bargaining power than before. In a l l these cases the parties concerned must be aware of the changing mood to which we referred i n chapter I and to be able to adjust to them. This w i l l bring about a better understanding and cooperation the absence of which may result into a non-optimal a l l o c a t i o n of resources i n this industry. The f l e x i b i l i t y described here i s the same as that to which Prof. Adelman refers. A fixed percentage on a barre l of o i l regardless of cost may defeat the purpose of capturing the rent. A f l e x i b l e rate which - 101 -allows for changes i n economic conditions may actually be an optimum 91 rent sharing strategy. According to our proposals, changes i n the economic conditions, i . e . prices and costs have effect only on the t o t a l s ize of the rent but not on sharing of i t . In conclusion, we find a r i s i n g supply curve i n the petroleum industry. There are additional reserves that could be p r o f i t a b l y developed i n probably every producing region. But the price i s a r t i f i c a l l y set for the reasons suggested e a r l i e r . P r o f i t s are being extracted by both the producing companies and the developing countries. However, there i s uncertainty about how this can be shared i n an optimal way. The optimum p r o f i t sharing choice depends on the type of economic growth desired by the developing country. P r o f i t s l e f t to the private company w i l l encourage economic growth through development of natural resources, s p e c i f i c a l l y , petroleum. However, p r o f i t s extracted by the government would l i k e l y be used to foster economic growth through s o c i a l overhead c a p i t a l , or investment i n human c a p i t a l . I t must be recognized that the multinational nature of this industry makes na t i o n a l i z a t i o n a useless exercise. Unless a nation i s an i s l a n d , n a t i o n a l i z a t i o n of petroleum companies simply means the use of l o c a l resources but not the maximization of the p r o f i t . 91 Adelman,"World O i l Outlook" i n Marion A. Clawson, edited. Natural Resource and International Development. (Baltimore: The John Hopkins University Press, 1964). Prof. Adelman suggests that governments share of the p r o f i t i s not cost. However, a fixed per b a r r e l rate of sharing may be a cost rather than a rent, op. c i t . , p. 107. - 1 0 2 -S U M M A R Y Petroleum may be considered as a c a p i t a l stock of a developing country. Its a v a i l a b i l i t y may l i m i t the size of the productive services required for some development a c t i v i t i e s of that state. Meanwhile, the optimum rate of petroleum production and the d i s t r i b u t i o n of income derived from i t s output has eliminated perfect competition i n the pro-duction process i n most of the developing countries. This elimination of perfect competition from the production theory of a nation's petro-leum resources leaves us with an alternative analysis of an imperfectly competitive economic order for a firm producing petroleum resources i n a developing country. Throughout this thesis we have examined this imperfect economic order and prescribed a second-best optimum reward to the country which owns the natural resource c a p i t a l and to the firm which provides man-made c a p i t a l , technology and s k i l l s . The thesis more or less overlooked N the present arrangements of sharing rents from petroleum production i n most developing countries. However, some of the inadequacies of the present system and the potential threat to the s t a b i l i t y of the economic order of that system need to be further explored. The second-best arrangement of the economic order proposed i n this thesis may simply serve as a convincing rationale for optimum pro-f i t sharing from petroleum production i n developing countries. This rationale i s based on the economic p r i n c i p l e of maximizing the present - 103 -v a l u e s o f t h e r e s o u r c e . However, t h e p r o p o r t i o n o f t h e p r o f i t w h i c h t h e h o s t governments o f t h e d e v e l o p i n g c o u n t r i e s may e x p e c t as a r e w a r d f o r t h e u t i l i z a t i o n o f t h e i r p e t r o l e u m r e s o u r c e s , may depend on t h e i r t i m e m o t i v a t i o n towards economic and s o c i a l development. C o u n t r i e s w h i c h have s t r o n g p r e f e r e n c e s f o r r a p i d economic development now, may do so a t t h e expense o f h a v i n g t a x a t i o n on t h e p r o f i t s o f c u r r e n t p r o d u c e r s . T h i s may, i n f a c t , pose g r e a t e r p roblems o f u n c e r t a i n t y t h a n w i l l be t h e c a s e i f t h e s e p r o d u c e r s a r e a l l o w e d a m a r g i n o f p r o f i t as an i n c e n t i v e f o r r e i n v e s t m e n t i n t h e f u t u r e . - 104 -REFERENCES ADELMAN, M. A., "World O i l Outlook" i n Marion A. 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BRADLEY, Paul & UHLER, Russell, Stochastic Model for Determining  the Economic Prospects of Exploration for Large Regions. Vancouver: Department of Economics, University of B r i t i s h Columbia, 1969. BRONFENBRENNER, Martin, "Reformation of the Naive P r o f i t Theory," Southern Economic Jo u r n a l , ( A p r i l , 1960). BUCAVETSKY, Martin W., "The Taxation of Mineral Extraction," Studies  of the Royal Commission on Taxation, No. 8, Canada. CHENNERY, H. B., & WANTANBE, T., "International Comparison of the Structure of Production," Economica, Vol. 26, No. 4, (October, 1958). CUMMINGS, Ronald, "Some Extention of the Economic Theory of Exhaustible Resources," Western Economic Journal, Vol. VII, No. 3. DE CHAZEAU, M. & KHAN, A. E., Integration and Competition i n the Petroleum Industry,New Haven Conn.: Yale University Press, 1959. 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Ithaca, N.Y.: Cornell University Press, 1962. LEVY, Walter. "The Past, Present and Li k e l y Future Price Structure for International O i l Trade". Proceedings, Third World Petroleum  Congress, Leiden: Sec. x reprint 16, 1951. L0VEJ0Y, W. F. & ROMAN, P. T. Economic Aspects of O i l Conservation  Regulation. Baltimore: The John Hopkins University Press, Resources for the Future, Inc. 1967. MCKIE, J. M. & MACDONALD, S. L. "Petroleum Conservation i n Theory and Practice". Quarterly Journal of Economics. Vol. LXXVII, No. 1. ' February, 1962, p. 110. MURPHY, Ewell, J r . " O i l Operation i n L a t i n America: Scope for Private Enterprise," International Lawyer. Vol. 2, No. 3 PETER, R. Odell "The O i l Industry i n L a t i n America" i n Penrose, Large  International Companies i n Developing Countries. London: George Al l e n & Unwin Ltd. 1968. PENROSE, Edith T. Large International Firm i n the Developing Countries: The International Petroleum Industry .London: George Al l e n & Unwin.1968. PRESTON, Lee. Exploration for Non-Ferrous Metals. Washington, D.C.: Resources for the Future, Inc. 1960. SCOTT, Anthony D. "The Theory of the Mine Under Conditions of Certainty." i n Mason Gaffney edited, Extractive Resources and Taxation. Madison: University of Wisconsin Press, 1967. SPARLING, Richard et a l . Capital Investment of the World Petroleum  Industry. The Chase Manhattan Bank Energy D i v i s i o n , 1966. SOUTHEY, Clive. Studies i n Fisheries Economics (Unpublished Doctor's Dissertation, University of B r i t i s h Columbia, 1969. TUSSING, A. & ERICKSON, Gregg. "Mineral P o l i c y , The public Lands and Economic Development: The Case of Alaska," i n Mining and • Public Policy i n Alaska. Fairbanks, I n s t i t u t e of Soc i a l , Economic and Government Research, University of Alaska. 1968. UNITED NATIONS. The Price of O i l i n Western Europe. Geneva: prepared by the Secretariat, Economic Commission for Europe, 1955. E/ECE/205. 

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