A Sea of Troubles, Part I

Damman No. 7, the first commercially viable well in Saudi Arabia, 1940s.

[Caveat lector- I’m not a petroleum scholar; my entire claim to knowledge is to have read a book or two on oil and having done a few months’ work at an agency dealing with commodities. ¡Cuidado!]

Oil is fascinating. A black, gooey, and inedible substance cursed with a terrible smell, it has somehow become the primary energy source behind our industrial society and the single most important commodity in the world. Wars have been won and lost over it, fortunes made and unmade, and the destinies of nations altered forever. Oil is power, and control of it is essential to both the companies and countries that deal in it. As Churchill wrote in 1911, despite the “sea of troubles” oil brings, “mastery itself [is] the prize of the venture”.

It’s this interaction between oil and politics that interests me most- how politics affects the way it’s produced, sold, and marketed. And so I’ve put down a pair of meditations on this topic, focusing on the relationship between companies and exporting nations. They’re best read together, but since they’re to be published in successive months, they can be read independently as well. And while they deal with oil specifically, many of these observations can be applied to commodities more generally, including “next-generation” commodities such as lithium and cobalt.

Part I: The Avalanche

For the first fifty years of its existence, the petroleum industry mostly operated domestically, in the oil regions of the US and Russia. Being great powers, these two nations could more or less do as they wished within their own borders, and nobody batted an eyelid. However, in the next fifty years of the oil age, to satisfy the ever-growing demands of a nascent hydrocarbon society, most world production shifted to the concession structure, where international oil companies, typically hailing from the developed world, produced oil from developing or post-colonial nations.

Running a concession as an international integrated oil company is not simply another form of plantation ownership. You first have to negotiate with some local potentate on terms for a concession, an agreement that gives you the rights to the oil in a given territory, typically over the staunch resistance of conservatives who find foreign involvement anathema to traditional values. Next comes drilling dry hole after dry hole in barren deserts or steaming jungles, often without communication or basic supplies, sometimes even without water, owing to the remoteness of the area. On the off chance you do strike oil, you’ll have to figure out how to transport it, either by pipeline or by tanker, either of which require huge capital commitments, and in the case of a pipeline, further haggling with local governments, especially if it crosses international borders- each ruler wants his take in exchange for granting transit rights.

Once you’ve got the oil moving, it’s got to end up in a refinery somewhere in the region, which, if you want to maintain margins, you’ll have to build and operate yourself, another huge capital commitment. In addition, since oil fields degrade over time, you’ll have to start maintaining the field pretty much from the get-go, while constantly investing in the latest cost-reducing wellhead technologies to stay ahead of the competition. These tasks will require foreign expertise, since little to no locals have enough training to do any of this. This in turn requires setting up expatriate “outposts”, with commensurate facilities and expenditure.

Once it’s refined to a usable product, like gasoline or naphtha or jet A-1, you’ve got to bring that to market. In order to sell it, you’ve got to have a distribution system (what oil men call a marketing system), which not only means a logistics system (another huge capital commitment), but also a local customer base and market awareness that requires time, effort, and significant investment in human capital to acquire. And since this is oil we’re talking about here, gas stations themselves are pretty massive investments, requiring appropriately-scaled chains, with the requisite expenditure in a network of physical stores, branding, and marketing, in order to establish a competitive brand for the average motorist.

Point being- it’s hard to explore, develop, refine, transport, and market oil. Really, really, hard. Perhaps, then, it’s not necessarily a bad thing to have international oil companies involved in the extraction of national resources. They bring the specialized knowledge and the boatloads of capital, absent in many developing countries, to drag oil out of the ground, make it into a usable, revenue-generating product, and sell it for the (partial) benefit of the exporting government. Despite the price tag of de facto foreign corporate control over the economy, any developing nation that goes without their involvement is likely to find itself worse off.

For example, compare Mexico and Venezuela, who both started oil production within a decade of each other. In 1938 Presidente Lázaro Cárdenas nationalized all foreign oil holdings in Mexico, while in 1943 the Venezuelan government took an entirely different approach, retaining total foreign ownership but negotiating a 50–50 split of oil profits from its concessionaires, Standard Jersey (now Exxon) and Royal Dutch/Shell. By 1947, Venezuela was earning 7% higher margins than Mexico on each barrel, even though their percentage of total profits was half Mexico’s; their export volumes were six times Mexican exports.

Despite the overwhelming majority of oil being produced by concession in the past, few, if any, exist today. That’s because paradoxically, every single drop you drag out of the ground worsens your position vis-à-vis the exporting government. When you sell a barrel, you have to pay a royalty to the exporting nation, a royalty that is (usually) spent on national development, minus a substantial “tribute” to the royal family or the territory’s rulers. This increases the ability of the exporter to do three things: to actually run the concession, capital, know-how, and all; to defend the country (and by extension, the concession) against foreign incursion; and to create a relatively stable governmental structure. All of this increases the chance that the exporting nation can actually get away with nationalization without being toppled by invasion or coup or suffering massive inefficiencies owing to a lack of foreign know-how and capital.

Yet what determines precisely when and on what terms such a change takes place? Though a country may be, say, 56% capable of running the concession itself, this is often hard to determine, and besides, why should a multinational oil major be interested in giving up 56% of a concession? As long as both sides need each other, why shouldn’t the major get the best deal it can, be it 44% or 74%, regardless of the state of the exporting government?

Yet despite the vastly different stages of development between the world’s exporting nations, for almost all of them, the balance of power between companies and countries tipped decisively in the producers’ favor during the pivotal period 1970-1.

It’s a tale that illustrates a key concept in negotiation- the paramount importance of precedents. From 1950 onwards, most concession oil, whether in Saudi Arabia or Algeria, was produced under essentially the same terms as Venezuela’s arrangement with Jersey and Shell. The companies retained 100% ownership, but profits were to be split on a 50–50 basis with the exporting government.

After finalizing these new arrangements, Jersey conducted an internal study in 1950 on how to manage relations with exporting governments. It observed that “the safety of our position in any country depends [in large part on] whether our whole relationship is accepted at any given moment by the government and public opinion of the country as fair. If it is not so accepted, it will be changed.” It further concluded that “there is something inherently satisfying in the 50–50 concept. If we ever admit in any country that an equal division is less than ‘fair’, the ground will be cut out from under our feet in every country. 50-50 is a good position which needs no defense… [any worse position] would have no such appeal and could only be rear-guard defense positions in an unlimited retreat.”

What Jersey noted was in essence the game theory concept of focal points. In the unlimited possibilities for the division of spoils, it is impossible, in theory, to reach an agreement; there is always something better or worse for both parties, and therefore no reason to reach agreement. However, given that we aren’t profit-maximizing robots but humans, there are certain points which bear significance to us as “fair”, “natural”, or “to be expected”. for whatever reason. 50–50 seems a very “natural” way for us to split things (at least, to me), though clearly this is neither necessarily a moral split nor one found within the parameters of the problem of dividing spoils.

Given this arbitrary concept of “fairness”, 50–50 is only “fair” until it is not. Any deal with terms better than 50–50 will set a new focal point, a new precedent for a “fair” deal, weakening the 50–50 focal point. And given the “natural” inclination towards 50–50, anything different, say 55–45, might well be far weaker than 50–50 while diminishing the strength of 50–50. If not 50–50, why 55–45 and not 56–44? Or, for that matter, why not 60–40 or even 80–20?

Jersey and the rest of the sette (actually otto) sorelle (Shell, BP, Socal/Chevron, Gulf, Jersey, Texaco, and Socony/Mobil, plus CFP/Total) who then dominated international oil production understood this reality. They tacitly (and explicitly, when given an antitrust waiver from the US Justice Department) moved in concert, knowing that if any one of them were to give better terms to any given exporting country, they would all face a rapid downhill spiral.

What they did not, however, count on was the entrance of new players. Try as they might, the otto sorelle could not stop Enrico Mattei’s ENI or Japan’s Arabian Oil Company from cutting in. Desperate to get a piece of the action, they made 75–25 deals in 1957/8 with Iran and Saudi Arabia, respectively. But these deals were new deals, not a revision of past arrangements, making this particular precedent a weak fit for the sort of revision the otto sorelle desperately wanted to avoid. In any case, new deals with new, smaller players based on the 50–50 principle continued to emerge, such as Occidental’s 1965 deal with Libya.

While the 50–50 principle stayed intact for now, deals like Occidental’s created another major problem. Occidental had become one of the “big boys” overnight with a huge strike in Libya’s Idris field in 1967, but being a relatively small player before then, it had virtually nothing in the way of alternative sources of oil. If Libya’s government were to put the squeeze on Occidental’s production, it was done for. For a poor but oil-rich country, oil is but a means to obtain revenue, and it can borrow money using its reserves as collateral to stay afloat in the short term. But an oil company cannot exist without oil, and the only alternative to renegotiation, to buy oil at market price in order to meet contractual obligations, would be financial ruin.

And with the ascension of a radical young officer named Muammar Gaddafi to Libya’s helm in 1969, this is exactly what happened. In 1970, he imposed production cuts on Occidental, forcing it to come to new terms: 55–45.

As former Shell chairman David Barran put it, “the avalanche had begun”. With a new focal point established at 55–45, all companies operating in Libya were forced to accept it. And when the news flashed from cables all over the world, all hell broke loose.

The Shah of Iran too demanded 55–45, and got it. The companies were obliged to offer the same, on the basis of the new concept of “fairness”, to all the other Gulf countries. Meanwhile, Venezuela passed a law mandating a 60–40 split. In a desperate attempt to stave off the flood of “leapfrogging”, the companies established a united front, demanding to negotiate one definitive deal with all the OPEC countries. The megalomaniacal Shah somehow thought this one-shot deal would undermine the 55–45 arrangement that he had helped make into the new norm, dealing a blow to his prestige, and demanded two negotiations instead of one, one with OPEC’s Mediterranean Committee and the other with its Persian Gulf Committee. The first deal, negotiated in early 1971 with the Persian Gulf Committee in Tehran, confirmed the 55–45 arrangement. Yet in a display of how fragile the 55–45 focal point was, the Mediterranean Committee in Tripoli came out to a far higher split instead. (The Shah was furious.)

The formerly stable focal points of 50–50 and 100% foreign ownership were dead. But as 55–45 is a much weaker replacement, everything was open for renegotiation, and just as Jersey’s 1950 study predicted, there were only rear-guard positions in an unlimited retreat. The Tehran and Tripoli agreements were supposed to last five years, but there was no reason why the wave of upward renegotiation should halt there. The deals were further revised starting in 1972–3, led foremost by the “radicals” in Algeria and Libya. The result was that by 1975, Gulf and BP were ponying up 98% of their Kuwaiti profits to the Kuwaiti government.

The same unlimited retreat applied for ownership as well. In 1971, a 25% ownership share was set as the minimum exporting government stake in OPEC concessions, to be expanded to 50% by 1982. Yet in 1972, Iraq fully nationalized its concession, the Venezuelans followed suit in 1976 with the establishment of PDVSA, and by 1979, the sun had set on the greatest concession of all, Saudi Arabia’s Aramco.

Yet while power had shifted to the producers, the degree of nationalization reflected the level of development in each nation. Take the nationalizations of 1974/5 in two major producers, Libya and Kuwait. Oil was first produced in Libya in 1961, while in Kuwait the famous Burgan field started producing in 1946. That’s a difference of fifteen years’ worth of oil revenues- a lot of money to be put towards development, especially in the area of domestic oil capabilities. The deals made by the two countries reflects this readiness (or lack thereof)- Kuwait negotiated a 100% takeover, while Libya made deals amounting to an 85–15 ownership split (and 83–17 for offshore production). But wait, that’s not all- with their resources and know-how, the Kuwaitis managed to build their own production, refining, and marketing system, even acquiring Gulf Oil’s refining system in Europe (and 21% of BP) during the 1980s, while the Libyans were eventually forced to sell back some of its shares in the partially-nationalized companies to their original concessionaires.

In the final analysis, while the degree of nationalization is ultimately determined by the individual nation’s level of development and its readiness to effectively operate the concession, so long as both companies and countries require each other, one cannot ignore the international environment, especially with regard to precedent. While presently the concession system is rather dead, with few developing countries willing to forgo ownership rights of their non-renewable resources, some degree of foreign involvement in production is still the status quo around the world, both in oil and other commodities. And as long as this is the case, it behooves both companies and countries to understand the factors that influence the relationship between the two, regardless of whether you take the position of the companies (“We wuz robbed!”) or the countries (to quote former Russian energy minister Yuri Shafranik, “Eta nasha neft!” — “It’s our oil!”).

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Guitarist, cinephile, and sometime intellectual. Join me on a journey through ideas, music, and film as I read PPE at the University of Oxford.

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Perry Aw

Perry Aw

Guitarist, cinephile, and sometime intellectual. Join me on a journey through ideas, music, and film as I read PPE at the University of Oxford.

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