Thursday, 22 October 2009

The pitfalls of protectionism shown by Brazil and Mexico (China Post, August 2009)

Brazil and Mexico are planning to increase the number of oil and gas jobs allocated to domestic companies. Like most protectionist schemes, the unintended consequences on employment, production and revenue outweigh the intended ones. In Brazil, with a massive new offshore oil discovery, President Luiz Inacio “Lula” da Silva is proposing to award some exploration and production rights to Petrobras, the state-owned but publicly-trading oil group, without options for foreign firms. A new state company Petrosal would also award over half of shallow-water contracts to local companies. In deeper waters beyond the capacity of local companies, foreign bids would be invited but those pledging to incorporate Brazilian staff or technical resources would be favored.

Mexico is on a similar protectionist trend. President Felipe Calderon signed off in December 2008 on plans to increase “local content” in the Mexican energy industry to 25%, partly by creating a support fund for Mexican companies.

Ironically, this protectionism in energy is the opposite of the open trade that Mexico and Brazil have adopted in regional trade agreements and international competition in other fast-developing sectors such as agriculture and aerospace. So why oil?

In fact, governments both rich and poor intervene considerably in oil and gas — including in the labor market — because the revenues can change the fate of the country. Oil allowed Angola to repay IMF debt and helped revitalize the UK economy under Margaret Thatcher. Indeed, blocking bids from foreign companies was a strategy of Norway, which actually postponed drilling to allow the country to build up other domestic oil service activities to run alongside the burgeoning industry.

The logic driving such decisions runs thus: Countries without domestic oil and gas companies find the exploration and production process becomes an enclave economy, with foreign experts shipped in and out and the fiscal proceeds going straight to government by way of royalties instead of to local companies and employees. But there are pitfalls to protectionism.

Firstly, state-owned oil and gas companies have proven less efficient than private corporations. “On average, NOCs (national, state-owned, oil companies) extract resources at a far lower rate than IOCs (independent oil companies),” says Mark C. Thurber, Director of the Program on Energy and Sustainable Development at Stanford University.

This is because monopolies are not subject to competition and are prone to corruption: Gazprom, Russia's state-owned gas company, has debts totalling US$40 billion and has brought only one new Russian gas field on stream since the early 1990s.

State companies also pursue political strategies not relevant to — and sometimes at odds with — the business of drilling. Iran, for instance, has just pledged to fund a refinery in Uganda. This makes no commercial sense, since Iran is struggling to develop its own small refining capacity (it rationed gasoline in 2006) and landlocked Uganda has no comparative advantage in refining. However, Iran may be increasing such overseas oil deals to complicate potential sanctions against its nuclear program. The problem is that inefficiency doesn't simply mean getting consistently less oil, or getting it slower. It can mean sharper slumps in oil production than with more experienced and efficient firms. In countries where oil revenues generate a significant fraction of the economy, such slumps wreak havoc on government budgets, leading to extravagant overspending or intolerable austerity.

Greater state involvement in exploitation can therefore harm fiscal planning. Venezuela shows the dangers.

“Hugo Chavez has remade PdVSA (Venezuela's state-owned oil company) into a government puppet that spends liberally on social programs, but it consistently undershoots its production targets,” says Dr. Thurber. This means the terms of foreign contracts are frequently changed to balance the government books, deterring foreign investment, which further undermines oil production and thus government spending upon which the population increasingly depends. Similar policies mean Venezuela is now short of once-abundant coffee and sugar too.

Protecting labor markets is, on balance, problematic if not incoherent. Mexico's oil group Pemex is employing foreign firms to help improve its low oil recovery rates at the same time as the Mexican government tries to increase the domestic labor share: it is precisely because its domestic industry has been unproductive that Mexico needs to invite foreign companies in.

In Brazil, the offshore reserves in question are enormous and could deliver up to 1.3 million barrels per day. Maximizing the benefits of such a find would be best served by the competitive pressure of open bidding, yielding steadier tax revenue, from foreign firms as well as Petrobras.

In the current crisis governments everywhere are tempted to intervene in markets but what makes sense during the good times makes sense during the bad times too: the patriotic solution is to let the market do the work.