1 Contracts in Natural Resources: What Does Contract Theory Tell Us? Philippe Aghion November 1, 2007
Introduction Some governments (e.g in Latin America) are forcing renegotiation on previous contracts with oil and gas companies What does contract theory tell us about: 1. why this may happen? 2. is this legitimate? 3. to which extent contract better contract design can avoid such events? 4. potential role for complementary institutions?
Asimpleframework Two parties, the country and the oil company Two or three periods: contracting period and one or two revenue periods The project entails some initial investment I 0 and yields uncertain profit flow π 1,π 2 Contract specifies distribution of control rights and sharing rule over profits
Contracts between countries and oil companies There are two prevailing forms of contracts between countries and oil companies (e.g Total) 1. Concession contracts : the oil company owns the assets and plants, and receives the whole production the company bears all the risks and incurs all investment and exploitation costs the company pays a preset dividend R to the country each period, plus local taxes
2. Production sharing contracts production is shared between the company and the country according to a preset (linear) rule the country is usually represented by a national company the national company participates to operational decision making the oil company commits to finance investments and production in exchange, the company has priority claim on the production this claim is the cost oil production minus the cost oil is shared between the oil company and the country (or thenationalcompany)
thus country gets r 1 =min(0,α(π 1 C 1 ) + ), and r 2 =min(0,α(π 2 [C 1 π 1 ] + ) C 2 ) + )
Potential sources of contractual inefficiencies 1. bad distribution of risks between contracting parties 2. inadequate balance between risks and incentives...basic moral hazard model 3. hold up (by the country) and underinvestment (by the oil company)...basic hold up model 4. ex post inefficiencies and grievance (country may not cooperate ex post, as in Hart and Moore (2007) s Contract as a Reference Point paper) 5. poor enforcement (no powerful court like for foreign debt)
At first sight: 1. 2 is not really a problem if effort is incurred by oil company which is essentially risk-neutral 2. 1 can be potentially solved by proper contract design main issues are 3, 4 and 5
Hold-up problem (Williamson, 1975) The problem: once investment is sunk, country can hold up the company anticipating this, company may underinvest Ways around the problem: 1. renegotiation design (Aghion-Dewatripont-Rey, 1994) 2. vertical integration (Grossman-Hart, 1986)
Problem is that contracts between country and foreign company are not fully enforceable Three potential mitigators: 1. reputation, however governments are shortlived 2. company s threat of not reinvesting in the country (as non-refinancing threat for dynamic debt contracts in Bolton-Scharfstein,1990) Additional mitigator: establishment of a credible and fair third party
Ex post uncertainty and grievance (Hart-Moore, 2007; Hart, 2007) idea 1: for contractual relationship to work, the parties need to cooperate ex post, and this is not contractible idea 2: one party may decide not to cooperate if it feels aggrieved ex post
Flexible versus rigid contracts in Hart-Moore (2007) Rigid contract: specifies a fixed price p, like concession contract problem is that ex post cost/valuation may fall so much out of range that one party finds it optimal to force renegotiation for example in buyer/seller relationship: if p<p L where p L c = r s + 1 2 G, then seller forces renegotiation similarly, if p>p H where v p H = r b + 1 2 G, then buyer forces renegotiation if p / [p L,p H ], then renegotiation is forced with resulting grievance.
Flexible contracts: specify a range of prices [p, p]fromwhichone party can pick ex post the advantage is that ex post uncertainty has more chance to not result in forced renegotiation no renegotiation as long as H =[p L,p H ] [p, p] isnon-empty However flexibility may itself be a source of grievance the party that did not pick the price might feel aggrieved by the other party
Back to the concession contracts Plus: the exploitation risk is borne entirely by oil company...country gets fixed R...which seems right since oil company can diversify risks and incurs the investment Minus: this contract is rigid country more likely to tear up the initial contract to force renegotiation e.g if at interim period new information flows in that π i >> R Forced renegotiation 1. forced renegotiation amounts to breach of contract 2. hard to prevent such breach in absence of credible third party 3. in fact breach of concession contract is similar to debt repudiation... 4....there are no international courts to deal with such breach
Another justification for forced renegotiation contract was initially negotiated by a bad government previous government signed a disadvantageous deal for the country but which yielded personal advantages why should new government feel committed by such agreements? parallel with political economy literature on public debt and defaults (Persson and Svensson (1988)) an international court might conclude that the responsibility is shared between the country and the oil company
Back to the production sharing contracts Plus: more flexible than concession contract therefore less prone to forced renegotiation ex post also, country shares control rights and therefore has the potential to benefit morefromtech- nology transfers. Minus: country faces more risk than under concession contract namely, country bears most of the risk on costs e.g when oil cost rises, it takes longer before the country perceives its share of oil revenues if C 2 too high, then country ends up with π 2 =0 country may end up feeling even more grieved than under concession contract
Questions: 1. can one reduce scope for ex post grievance in production sharing contracts by introducing more profit-contingent nonlinear sharing schemes through more short-term contracts whereby governments share upfront investments 2. since countries decide about local taxes, does incentive scheme in the contract really matter and in fact does contractual form matter at all? parallel with debate on sovereign debt and exchange rate policy (Tirole (2003)) 3. are costs and/or profits truly verifiable (Russia, Angola contested costs)?
First question: complicated contracts may be hard to enforce, and short term contracts may deter investments; investments may not be verifiable; countries may not be able to finance a sizeable share of investment Second question: taxes only apply to profit oil,notto cost oil country may want to commit not to change tax rule all the time in order not to discourage investment Third question: tough international audits are generally used to assess costs and therefore profits
Remaining question: how can a country minimize the risks of collusion between oil companies and bad governments? role of international courts...who controls them?
Natural resources, quality of government, and growth Interesting fact: 1. natural resources seem to be growth enhancing in autocracies... 2....but not in democracies