Managing Commodity Lifecycles, Petroleum

6. Role of the state in managing petroleum price cycles

Petroleum producing countries struggle to manage the effects of petroleum price cycles.  Wild swings in oil and gas prices can produce wild swings in a country’s GDP and make long-term planning difficult.  Prolonged periods of weak petroleum prices can result in low tax revenues from the sector, corporate disinvestment and unemployment.  Rising petroleum prices bring a different range of challenges.  Although they generally have the positive effect of boosting tax revenues they can also result in hard-to-manage inflows of capital which distort local markets and drive up the value of the local currency. The principal impacts of petroleum price volatility are felt in the following areas: government revenues, spending, investment, inflation, exchange rates and risks of resource curse. The remainder of this section is addressed to a discussion of these challenges - many of which are interlinked - and to strategies for dealing with them.

Petroleum revenue volatility and fiscal vulnerability

Governments obtain revenues from the petroleum companies through taxation (which include direct taxes such as corporate income tax, specific additional profits taxes as well as indirect taxes), from royalties and from possible State participation.  Some countries have production sharing agreements where a proportion of the production goes to the government in return for the grant of operating rights. Since corporate income taxes are effectively a tax on profits so they shrink markedly when petroleum prices fall, reducing the flow of government revenues.

Government revenues from petroleum activities are becoming more and more related to profits instruments than to royalties or taxes assessed on gross incomes. Therefore, they are more sensitive to petroleum price or cost movements. This drawback of new fiscal regimes is fully compensated in the long term by their higher progressivity in relation to the government take in the petroleum rent resulting in greater government revenues over a full cycle.

Petroleum revenues may represent a high share of the government revenues in resource-rich countries which are generally defined as the countries where the annual petroleum revenues exceed 25% of the total government revenues. This share may be over 75% in the largest exporting countries. The higher that share, the larger the impact of price volatility on revenues and the country fiscal vulnerability.  

Spending, investing or saving petroleum revenues

A critical question for the management of annual petroleum revenues in developing countries is how to allocate them between three main categories of uses and in what proportion:  (1) consumption spending, (2) investing in domestic projects of quality to be carefully selected and (3) saving— to transfer wealth across time or across generations— in financial assets which are often maintained abroad for achieving expected safer and better returns. Another option is to use an increase in revenues to pay off existing national debt. Such allocation have to be decided taking into account the benefit of current and future generations and ensuring development sustainability in spite of the finite nature of any non-renewable and exhaustible petroleum resources. Some frontloading of consumption spending to benefit presently poor generations may be welfare improving but only if designed in a proper way.  

The allocation may depend on many factors, among others the stage of macroeconomic development, the level of reserves and resources, the horizons for their depletion, the potential for exploration, and the related uncertainties for each such factor. Countries may benefit from long lasting resources or by contrast short reserves horizons, resulting in large differences in terms of wealth and sustainability. The latter may be assess by considering ranges of alternative scenarios, with updates when more information becomes available, checking whether these finite resources are being utilized in a sustainable manner.

First, when deciding on the allocation of revenue, there are inevitably strong pressures when petroleum prices are high to increase government spending on consumption, which is to say on such things as officials’ wages, healthcare programmes, welfare provision and pensions. Some such spending is clearly expedient as a means of ensuring that the benefits of a commodity boom are widely spread, and seen to be widely spread.  However, such a policy has the disadvantage that it is difficult and politically unpopular to reduce such spending when petroleum prices fall and government revenues decline.

Second, strong practical and economic reasons exist for ensuring instead that the larger part of revenues arising from the taxation of the petroleum companies is directed towards investment in the country in non-petroleum sectors, in priority socioeconomic projects. Revenue spending on investment is important for diversification and sustainable development. Those investments might include health, education and infrastructure, such as the construction of hospitals, transportation facilities and power plants as well as agriculture. This makes sense from the point of view of a country’s broader economic development but it is also easier to ramp up and ramp down investment projects than it is welfare programmes when a fall in petroleum prices forces an adjustment, as inevitably it will. 

Third, strong reasons also exist to save petroleum revenue to transform revenues generated from subsoil wealth into financial assets. A tool to do it is by establishing a petroleum fund. Two main objectives are assigned to such a fund (or funds but a single fund may have the two objectives): to establish buffers to attenuate revenue fluctuations (often called the “stabilization” component which allows to deal with short-term volatility) and to save for the future (often called the “future generation” component, which may be misleading). Such fund is generally provided for by a “petroleum revenue management act”, as in Timor Leste (2005), Ghana (2011, amended in 2015; see Box 1), Uganda (2015) or Tanzania (2015), which also set forth precise fiscal rules for the allocation of annual petroleum revenue to the petroleum fund, and then how to transfer amounts from the fund to the annual budget or an investment fund. Today more than 40 petroleum funds exist in the world. The fund is in most cases invested outside the petroleum country, in the authorized classes of financial assets only. It should not be used as collateral for government debts or guarantees.

The structure of the Ghana Petroleum Funds

“The Petroleum Holding Fund, the Ghana Heritage Fund and the Ghana Stabilization Fund were established under the Petroleum Revenue Management Act of 2011.

The Act anticipates that when Ghana’s natural resources are eventually depleted, the two sovereign wealth funds will cease to exist and all remaining assets will transfer to a new fund, the Ghana Petroleum Wealth Fund.

The Ghana Stabilization Fund’s aim is to mitigate the negative effects of oil revenue volatility on the national budget, and sustain public expenditure capacity in the unanticipated event of a revenue shortfall.

The Ghana Heritage Fund’s aim is to save oil revenues for future generations of Ghanaians.

The Petroleum Revenue Management Act ensures that together the funds provide, “for the collection, allocation and management of petroleum revenue in a responsible, transparent, accountable and sustainable manner for the benefit of the citizens of Ghana in accordance with Article 36 of the Constitution.”

Source: CCSI

Government revenues from natural resources are unlike those from other industries, since natural resources are non-renewable and finite. They are, in effect, part of a country’s capital stock.  Accordingly, it is logical that a substantial part of the rent from the drawing down of this capital stock should be deployed in investments which replace, and ideally augment, the nation’s capital stock.  This principle, encapsulated in what is known as “Hartwick’s rule” (1977) after the economist who originated it, “states that natural resources countries, to behave sustainably, must ensure that the aggregate value of all the assets they are passing on to future generations does not decline.” This objective is indeed uneasy to meet except partially.

Another objective which was initially promoted for regulating petroleum funds is the “permanent investment hypothesis” (PIH) intended to control the pace of use of available funds. When the PIH is applied to petroleum wealth, a country would sustain a constant consumption flow equal to the implicit return on the present value of the estimated future government revenues. This would also assume that the marginal utility of spending wealth is the same across generations. This theoretical and very simple approach does not consider that current generations may be relatively poorer than future ones. Moreover, it does not take into account the impact of petroleum wealth uncertainties and price volatility. Petroleum funds should only be seen as complementary policy tools available to a producing country, not the main fiscal policy instrument. The critical decision remain the fiscal policy and the fiscal rules adopted by the country (see Box 2). Petroleum revenue management has indeed to be integrated into the budget approval process by the parliament in conformity with the law.  

Petroleum funds should only be seen as complementary policy tools available to a producing country, not the main fiscal policy instrument. The critical decision remain the fiscal policy and the fiscal rules adopted by the country (see Box 2). Petroleum revenue management has indeed to be integrated into the budget approval process by the parliament in conformity with the law.  

Economic performance of petroleum-rich countries

“Economic performance in resource-rich developing countries RRDCs) has typically been weak, plagued by two recurrent mistakes—low savings rates and boom-bust cycles.

…Until recently RRDCs had lower public investment rates than comparators. Boom-bust cycles—the ramping up of sometimes inefficient spending after positive revenue shocks, and abrupt expenditure reductions after adverse shocks— have been the norm. This is consistent with the evidence that fiscal policies have been more procyclical in RRDCs.

Better management of resource revenue volatility is clearly central: higher macroeconomic volatility is a main channel for the growth-damaging “resource curse,” and volatile government spending is less effective and productive. Until recently growth in RRDCs has been lower than in non-resource economies, despite the abundant resource wealth.

Two key features of optimal resource revenue management, developed in the recent analytic literature and in this paper’s approach, can help to avoid these problems. First, a high proportion of resource revenue should go to savings and domestic investment. Second, RRDCs need to avoid boom-bust cycles by aiming to more or less smooth consumption, or current spending, and in particular to delink it from the dynamics of resource revenue. The goal is to increase current spending in a sustainable way while scaling up investment appropriately given capacity constraints, and to sustain the resulting higher public capital stock.

…Inadequacies of the permanent income hypothesis (PIH) for RRDCs. Fund papers and policy advice have often been guided by the broad principles of the PIH.  While the desirability of smoothing and of avoiding unsustainably high levels of consumption should continue to anchor sustainability frameworks, some tilting of consumption paths toward relatively poorer current generations in RRDCs may be welfare-improving.

Further, conceptually, the PIH is silent on the question of desirable investment dynamics, and so does not help with the dialog on where to invest the resource wealth—at home or abroad. Because investment abroad and at home have very different implications for the current account, the PIH similarly falls short in shaping discussions on the optimal dynamics of the current account in RRDCs.

Source Macroeconomic frameworks for resource-rich developing countries, IMF, 24 August 2012

Key to the success of managing petroleum revenue effectively is public transparency.  It is important that the revenues derived from the petroleum sector, and fluctuations in these revenues, are visible to the interested public.  In some countries this issue is already being addressed through schemes such as the Extractive Industries Transparency Initiative (EITI).  Some large companies now also openly publish their payments to government.  However, it is equally important that there is transparency in the distribution of the revenues derived from the petroleum sector. This is not only an important factor in social cohesion, but it is easier for governments to justify the hard decisions they will inevitably have to make when revenues from petroleum production decline if the distribution of these revenues is seen to be fair and in the best interests of the economy overall.

Macroeconomic effects, resource curse risks and need for diversification

Volatile commodity prices can have dramatic impacts on a country’s inflation and exchange rate, driving the value of its currency higher when commodity prices are rising and driving it lower when they weaken. The effects can be magnified further by capital inflows.  Foreign direct investment in resource projects will place additional upwards pressure on a country’s currency. 

These currency shifts are a reflection of an underlying economic reality.  This is that the economic wealth of the country hosting the subsoil resource has increased by its production, something which should in time be reflected in higher wages and higher standards of living.  However, the speed with which these effects arise can be distorting to the local economy and have undesirable side-effects. As such, they sometimes require careful management and communication for attenuating the too often originally exaggerated expectations of the population in case of petroleum production. 

The immediate effect of a strengthening currency is to make imported goods suddenly cheaper and thus to encourage importing. This is not so much of a problem when the imported goods are investment goods but is more problematic (less sustainable) if the surge in buying is focused on consumer goods such as luxury items.

There are also structural challenges posed by currency strength resulting from windfall petroleum revenue.  An increase in a country’s currency increases the foreign currency costs (commonly US dollar costs) of all those producing internationally non-petroleum tradable goods, some of which will not have the benefit of product price increases and which will accordingly see their international competiveness reduced and their margins squeezed.  This is commonly called the “resource curse syndrome” or the “Dutch Disease”, after the rapid escalation in the currency of the Netherlands which took place in the wake of the discovery and production of the giant Groningen gas field in the 1960s.

Subject to the scale of the exchange rate increases and the likely consequential damage to the overall economy, it can make sense for governments to seek to neutralise the effects of rapid currency appreciation by saving part of the petroleum revenue into a petroleum fund for overseas investments. These capital outflows will put immediate downwards pressure on the local currency. Then, from that accumulated wealth abroad, the government can draw on to support its economy and its public spending when petroleum prices are weaker. In particular, a key focus is also to reasonably invest locally in priority projects to support the diversification of the economy. The matter of what is an appropriate balance in these investments between domestic and overseas investments will vary from country to country. It depends among others on absorptive capacity constraints in order to prevent weaknesses in project selection and implementation.

In this Raw Talks video, Paul Steven explains the Resource Curse concept.

One way to reduce the susceptibility of a resource-based economy to the effects of petroleum price volatility is to reduce its net dependence on the oil and gas production and export by promoting a policy of diversification toward non-petroleum activities (see Box 3). To achieve this, governments need to use the revenue from petroleum exploitation to promote development in activities not linked to the sector and which, ideally, will be able to continue to operate sustainably after the petroleum reserves have been depleted.  Exactly what other activities might be suitable to fulfil this role will vary from place to place but might include agriculture, aquaculture, horticulture, forestry, tourism, manufacturing or service sector activities.

Progress remaining to be achieved in resource-rich countries

“Fiscal policy in resource-rich countries tends to be highly procyclical and more so than for other economies. Contrary to other studies, we do not find evidence that procyclicality has declined over time. We also find that adoption of fiscal rules or resource funds do not have a significant impact on fiscal cyclicality, but general political institutions do help. The lack of progress on these likely partly explains why fiscal procyclicality, on average, has not declined in recent years.

Our results have important policy implications. First, more efforts are needed to establish a comprehensive fiscal policy framework in resource-rich countries that can help cope with heightened uncertainty and volatility. These frameworks should be based on a solid long-term anchor to guide fiscal policy and should explicitly incorporate commodity price uncertainty.

This means putting more emphasis on building precautionary savings during good times to help weather shocks in a countercyclical fashion.

Next, further efforts to improve the institutional framework are needed, including enhancing transparency and accountability.

Tax policies aimed at diversifying the revenue base would reduce government’s overdependence on commodity revenues and improve its ability to run countercyclical policies.

Finally, efforts to diversify the economy beyond the commodity sector are also critical.”

Source: Macroeconomic Stability in Resource-Rich countries The Role of Fiscal Policy, IMF Working Paper, Elva Bova, Paulo Medas, and Tigran Poghosyan, February 2016

Some strategies for investing petroleum revenues are focused on oil and gas upstream and downstream integration; which is to say, promoting the development of activities aimed at supplying the petroleum companies (with anything from equipment to catering services) and in processing and using the products (e.g. refinery, petrochemical production, gas plant).  Where these activities can be profitably undertaken locally, then it makes economic sense to do so.  In doing so, it may be possible to build-up a cluster of mutually-supporting resource-related activities.  Such matters need to be carefully treated on a case by case basis.  What such investments do not do, however, is reduce the economy’s vulnerability to commodity price fluctuations. Moreover, those categories of investments, for example refineries today require large capacity to be justified, are often not profitable in small exporting countries.