Infernal Ramblings
A Malaysian Perspective on Politics, Society and Economics

Managing the Petroleum Industry

Written by johnleemk on 7:43:18 am Apr 5, 2007.

There are not many private oil companies in the world today. Most oil campanies, like Malaysia's Petronas, are state-owned and state-controlled. The few exceptions are mainly American firms, such as ExxonMobil, or a few European companies like Shell.

Yet, oddly enough, these exceptions are the dominant companies in the oil industry today. Few, if any, nationalised corporations have managed to match their prowess.

The normal explanation puts the blame on these Western firms for "colonising" third world countries and exploiting their resources. But I find this simplistic view very difficult to justify, especially since most state-owned companies from Malaysia to China also "exploit" the resources of other countries.

If the nationalised oil firms had a superior process than the private Western companies, the market system would naturally let them rise to the top. Yet instead, the Western companies have maintained their dominance of the industry. I believe this is mainly because state-owned firms don't have an incentive to innovate.

After all, with all the oil money flowing in, few governments are going to complain about a few missing cents here or there. A profit-maximising firm, however, would probably blow a gasket about wastage, and certainly would always be looking for ways to improve its production processes. This is a more logical explanation for why private firms (which incidentally happen to be from the Western first world) dominate the petroleum markets.

Yet there are some not completely unfounded arguments for state control of the local petroleum industry. After all, the natural resources of a country belong to its people. The profits gained from them should not be flowing to a single firm, let alone a firm that isn't even from that country itself. Some left wingers would also bring in the "exploitative" nature of first world firms, but I'd be more concerned with granting these companies unwarranted monopolies, which can make any firm, big or small, first world or third world, exploitative.

The history of countries which have opted to grant monopolies to foreign oil companies is worse than that of countries which opted to nationalise their petroleum industry instead. Many of these countries, such as Nigeria, have seen the foreign firms and the government become obscenely well-off, with little (if any) wealth trickling down to those on the ground.

Ultimately, however, it is almost as bad to grant a monopoly to a nationalised company. In the first place, many of these firms only exist because of government support, without which they would vanish. They are incapable of competing with the private firms, because the private sector often has an incentive to innovate and avoid wastage, as opposed to even the most efficient governments, which basically have to fight the resistance of a bureaucracy to change.

Curious, I looked at how Western countries have attempted to deal with this problem. In Europe, the North Sea has significant reserves of petroleum in territory belonging to several countries, including the United Kingdom, Norway, Denmark, Germany, and the Netherlands. These countries grant licences to different companies to operate different blocks of their fields; the licence is granted to the highest bidder, if I'm not mistaken. Many countries, like the UK, grant licences on an annual basis.

The result is a steady inflow of revenue to the government, while still allowing for extraction of the resources by a more efficient and innovative private sector. Since the licences are granted on an annual basis in countries like the UK, these companies cannot afford to get complacent, or else they will be replaced by a new bidder.

This is of course not necessarily a completely satisfactory arrangement. For example, unless a local firm bids for licences, the profits will flow mainly out of the country. One might argue that this the market being efficient — if local operators were competent, they would be able to successfully bid for a licence.

This argument ignores the fact that there are huge barriers to entry in the petroleum business. These barriers are mainly capital-related — it costs obscene amounts of money to start a new oil company. As a result, it's difficult for new companies to get off the ground.

The government might be able to solve this by providing capital for new private companies. It could offer to match every dollar of capital that a new firm can raise, in the form of a loan. This would cut the costs of entering the market, and certainly introduce more competition, which is rarely a bad thing.

The new problem that arises is that if too many firms enter an industry, the price of oil may actually go up. The reason for this is that firms may not be able to take advantage of economies of scale — if there are a thousand, rather than ten firms in the market, there will be a lot of duplication of effort. There's a careful balancing game involved whenever the government gets involved in the economy.

Still, I think it's best to avoid the trap of leaning too far in favour of the private or government sectors. Each of these has its own role to play in the economy; a total monopoly granted to the private sector results in a stifling lack of competition and no returns at all flowing to the original owners of the resource, while a total monopoly by state-owned firms results in inefficiency. The best middle course seems to be a licensing process for the rights to drilling, while also augmenting the availability of capital for new competitors in the industry.

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Infernal Ramblings is a Malaysian website focusing on current events and sociopolitical issues. Its articles run the gamut from economics to society to education.

Infernal Ramblings is run by John Lee. For more, see the About section. If you have any questions or comments, do drop him a line.

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