Why are “smooth” revenue streams important from the local government’s point of view? “Smooth contracts are useful for governments before future oil prices are known, since the government is less exposed to the enormous swings in revenues tied to volatile oil prices,” Van Benthem notes. “Such revenue swings make government planning very difficult.” For example, it is not uncommon for an African oil producing country’s government budget to be 75% or more dependent on hydrocarbon revenues. When oil prices fell in 2009, Gabon had to slash its budget by 13%, the researchers note in their paper.
Smooth contracts work well for foreign investors, too, provided “the government keeps its part of the deal” and does not go on to expropriate the assets of the foreign company, Van Benthem says. “It is important to realise that expropriations are to be expected in times when returns on investment turn out to be very high,” as in the case when oil prices soar to record heights. In such situations, local governments may feel that foreign companies are taking too high a percentage of the profits without investing enough back into the country. “It is important [for firms] to recognize this risk beforehand, when they structure their contract.”
The best balance, Van Benthem says, is to write a contract that allows the government to benefit just enough from high profits to deter it from expropriation. That way, foreign firms can still expect to earn good profits at high oil prices, and they can agree to provide the country with substantial tax revenues even if the oil price drops. Local governments will “recognize that [in the long term] it is costly for them to expropriate,” even if that seems tempting in the short term. For a contract to successfully prevent a country from seizing assets, “the short-term gains from expropriation cannot be too high relative to the various costs of expropriation,” according to Van Benthem.
Taking a hit
One particularly salient cost of expropriation, the authors note, is the hit a country’s reputation can take when it seizes an oil firm’s assets. In their research, Van Benthem and Stroebel found that it is often harder for countries that have a reputation for being “less reluctant” to expropriate to negotiate an “ideal” contract that reduces their exposure to oil price volatility. That’s because foreign investors already know (or have good reason to fear) that such countries are willing to seize their assets. From the point of view of the government, notes Van Benthem, “the more likely you are to expropriate, the harder it is for you to convince oil companies [or other foreign investors] to give you a contract that provides you with smooth revenues. That is to say, the harder it is to get the sort of contract that provides strong tax revenues even when [oil] prices are low.” Likewise, governments of countries where there are only “limited domestic legal challenges” to expropriation (because of a weaker legal framework for protecting foreign investors) — as well as a lower level of foreign direct investment — are less likely “to get much oil-price smoothing from their contracts” with foreign investors.
