I started earlier this week a series about what it means to "control" oil. I have put up three diaries already (see links below) about what it means in general to "control" oil, how prices are set, and the issue of security of supply for an importing country. This new diary looks at the question of who gets the "rent" from oil, i.e. the profit from its exploitation:
The global fight for the control of oil
The global fight for the control of oil (II) - oil prices
The control of oil (III) - Security of supply, imports, boycotts
The players
Oil is usually sold at prices which are significantly above the cost of its actual production. Part of that is linked to the fact that in theory the price is set by the marginal cost of production of the last barrel required to clear the market (i.e. the most expensive) and in practice, factors such as taxes and geopolitics increase the real price from its "pure" market price. In any case, for most producers, there is a significant profit to be made from producing a barrel of oil and selling it on the international market. That difference between production costs and market price, is called by economists the "rent" and represents pure profit from the activity of oil production. Who controls that rent? Who gets it?
Let's see who the claimants are:
- (i) anyone that has control (in the sense of having the ability to block the flow of oil in any way);
- (ii) anyone that can influence what the cost of producing the oil is;
- (iii) anyone that can influence what the market price for oil is;
To some extent, some of these categories recoup one another, but it does introduce a few more actors. The whole crew is thus the following:
- the authorities in the country of production (including the central government, whatever local authority may be involved, and any other entity which may have regulatory authority). The existence of a national oil company can bring into the game a more or less autonomous additional player (i), (ii) and potentially (iii);
- the authorities in any country of transit (again, national and local);(i) and (ii)
- the oil companies involved in oil production or transportation (i), (ii) and possibly (iii);
- the authorities of the country(ies) of origin of the oil companies, which can put regulatory or tax hurdles or support for investment in the country of production (ii);
- the main contractors for the field and pipelines and tanker shipments (that's a new player!) (ii);
- the military authorities of any country and/or the leaders of any group potentially able to sink tankers, to destroy oil production infrastructure or pipelines or to kill oil workers (i) and (iii);
- the authorities of oil consuming countries, which can put in place policies to encourage or restrain oil use (iii);
Claiming your share of the pie
As a simple rule, anybody that has the ability to block the flow of oil will be able to extract a piece of the rent. The stronger you grip on that flow, the bigger the piece of the pie.
If it is impossible to do without your participation, your claim will be very high - that's typically the case of the country of production.
If it is merely inconvenient or more expensive to do without you, i.e., if a substitute is conceivable, then your "rights" to the rent will be limited. This is the case of oil companies (because of competition between them) of suppliers throughout the chain and even of transit countries (you can find an alternative except in very exceptional cases).
The share of the oil revenue that goes to each participant in the chain is usually linked very directly to the actual cost of that item, with an additional profit remuneration in a fairly narrow band (typically 10 to 20% return per annum). That profit component can vary with oil prices (i.e. with the size of the rent) or not. Most of the intermediate players will get a fixed price for their services and in effect capture very little of the rent ; they also take very little risk and usually get paid whatever happens on the market (price risk) or to the oil production levels (volume risk):
- A pipeline operator will usually take neither price nor volume risk on oil as it is paid through a "capacity charge" (which remunerates the right to use the pipe, not its actual use); this is as close as you can get to a utility position, and thus it capture little of the rent (but it makes decent money without much risk - it only requires the basic operational competence to run the asset.
- tanker operators will take oil volume risk as their remuneration is proportional to the volume transported. (They take a different price risk linked to the tanker market itself, i.e. the supply of tankers for the demand of oil transport). But they don't usually depend on one specific project and can switch to other routes as necessary. Their share of the rent is usually low, unless there is a specific shortage in the tanker market which makes their service suddenly more valuable.
In general, oil majors try to slice big oil projects in as many self-standing tranches as they can. Such "tranches" provide a specific service (like transportation, or electricity production, or very specific industrial processes in the oil chain) and benefit from a dedicated revenue stream linked only to the ability to perform the service as required, whether the oil production requires it or not. This makes such tranches easily financeable by banks (that's what I do) and they thus require little rent.
In general, contractors and sub-contractors are usually paid a fixed price for their goods and services; their remuneration will depend on their operational performance, but not on the actual oil flow. Most oil service companies (drilling, transport, equipment supply, legal, tax and financial advisers, etc...) fall in that category.
Nabbing the rent
Some rent element can nevertheless enter here through "requirements" by one of the main parties (the oil company or the host country) to use local or favored suppliers. If such suppliers provide the same service at an inflated cost, it reduces the rent by effectively distributing it in advance to that service provider and its "supporters". If the oil company managing the project is entitled to deduct these expenses from the project, as is typical in a PSA through the cost oil mechanism, it might be tempted to inflate such expenses and get some of that rent back from the contractor via transactions outside the scope of the project itself. As this bites into profit oil, the beneficiaries of such profit oil - and first and foremost the host country - will usually fight against such attempts to exaggerate costs. The reverse may alos be true: if the host country imposes its service providers at inflated prices, the oil company will see its ultimate revenu shrink as what it gets in profit oil is reduced (see diary I for the definition of cost oil and profit oil).
This is the grayest area of the oil business, and this is where you have all the corruption stories and where the Halliburton of this world thrive: capturing "rent" by disguising it as legitimate operational costs is one of the oldest trick in the books. Fighting that requires transparency, and perpetual vigilance by the main parties (the oil company, the host country and any regulatory authority involved) viz. fishy behavior of their partners - and viz. its own executives, which ca neasily abuse their power to allocate big contracts or big revenue flows.
With the oil industry involved in such huge projects with a relatively small number of people involved, it's fairly easy to "lose" millions here or there - after all it's barely a few tenth of a percent of overall project costs... which makes these millions very tempting for individuals and yet relatively unimportant for the organisations involved.
In my next installment, I'll focus more specifically on the negotiations between the oil majors and the host countries.