CEPMLP Internet Journal Volume 11 : Article 8

Not to be quoted without permission of the author

"RESOURCE CURSE" AND INVESTMENT IN OIL AND GAS PROJECTS: THE NEW CHALLENGE

by Professor Paul Stevens
email : p.j.stevens@dundee.ac.uk

Natural resource projects should generate wealth for an economy and promote both economic development and a reduction in poverty. The logic behind this view can be seen either in terms of common sense or based upon economic development theory. In the case of the latter, capital constraints and dual gap analysis (whereby an economy is constrained not just by its level of savings but also by its access to foreign exchange) imply the revenues accruing from natural resource projects should break these constraints. However, the reality observed over many decades seems to be the reverse. With a few exceptions, most countries having an abundance of minerals or hydrocarbons seem to perform worse in terms of growth and poverty reduction than resource poor countries. Large windfall gains from such projects appear to create severe distortions in the working of the economy and the political system with strongly negative socio-political consequences. This phenomenon has been given the name of "resource curse".

Interest in "resource curse" has a long history. In the 1950s and 1960s, development economists such as Raul Prebisch pointed to the negative effects of being a primary product exporter. This centred on the declining terms of trade between the underdeveloped periphery and the industrial countries of the centre. In the 1970's attention was drawn to the phenomenon of "Dutch Disease" following Holland's experience after the development of the giant Groningen gas field. Thus windfall revenues generated domestic inflation, which together with being a "petro-currency", led to an appreciation of the real exchange rate. This made imports cheaper and non-hydrocarbon exports dearer leading to a significant contraction of the non-hydrocarbon traded sector. In the 1980's, as part of the rise of ideas such as the economic theory of politics and theories of public choice, attention switched to the negative effects of large natural resource revenues on governance issues. Thus they were seen to promote bad government, corruption, conflict and to entrench existing regimes.

More recently, "resource curse" has become firmly associated with the impact of such projects on the macro-economy of the country (including development issues linked to poverty). This interest in "resource curse" has revived for a number of reasons: -

Following growing pressure from various NGO's, the World Bank is holding an "extractive industries review". This independent review is intended to consider whether, given the potential for "resource curse", the Bank should continue to invest in such projects. The Review is now scheduled to conclude in June 2003 (see www.eireview.org). This review has prompted input from various interested parties which has attracted much comment. For example, Oxfam America commissioned a study examining the phenomenon. The report (Extractive Sectors and the Poor. October 2001 www.oxfamamerica.org/eireport/index.html) has attracted considerable attention if only because it concludes that .. "the best course of action for poor states would be to avoid export-orientated extractive industries altogether." (Page 17).
A number of countries are beginning the process of starting major natural resource projects that could open them to the threat of "resource curse". These range from many of the transition countries such as Kazakhstan and Azerbaijan to more traditional developing countries such as Angola and Chad. Many of the countries, under pressure from the Bank and the IMF, are seriously examining ways to avoid the problem. Indeed such measures at attempted mitigation (see below) have now become part of the standard package imposed by the Bank and the IMF.
The major multinational corporations which carry out such projects are increasingly concerned with corporate reputation issues. As the NGO's put ever greater pressure on the companies, they are responding by considering the impact of their projects on the countries and how potentially negative impacts might be offset. In the 1990s, it was environmental and human rights concerns which exercised the companies. Now for the more responsible it is how they may play a role in mitigating the "curse".
In recent years a new set of financing techniques have been developed whereby external sources of funds for such projects are concerned that the potential negative impact might threaten the viability of the projects and hence their investment. For example, the International Finance Corporation of the World Bank is insisting that all natural resource projects for which it is considering funding must be accompanied by an environmental, social and economic impact assessment.

The attention being given to the issue carries a number of serious implications for future investments in such projects: -

It could well influence the size of such investments in the future. If shareholders are uneasy about the consequences of their companies investing and doing damage, this could well lead to a trend of such companies simply returning the funds to their shareholders thereby reducing investment in such projects. Such concerns are likely to become part of the growing "ethical package" which attracts many share holders.
Equally, it will have significant implications for the geographic direction of such investments. Countries that already have a record of poor governance are likely to be shunned by the more responsible corporations. Since many of these countries are resource rich, especially in hydrocarbons, this could raise the prospect of future shortage although it is more than likely that this will be mitigated by the willingness of less scrupulous companies to invest.
Finally, there is a great danger that the industry splits into companies who are responsible and ethical, and companies who operate with much lower standards and are simply in business to earn a "quick buck" with no thought to the consequences. It is not inconceivable that some national oil companies could be amongst this latter group. This disreputable tail could well bring discredit on the whole industry further inhibiting investment and perhaps reinforcing dangers of shortage.

There exists a large literature that tries to explain the transmission mechanisms from the flows of revenues to negative impacts. The explanations are far from being mutually exclusive. In all probability, to get "resource curse" requires a number of the transmission mechanisms to be present at the same time. Also, some of the transmission mechanisms are extremely difficult to pin down:-

The negative impacts on the fiscal stance can be driven by the potential for a long term decline in the terms of trade against hydrocarbons and minerals and the consequences of revenue volatility as prices fluctuate.
The negative effects on the non-oil traded sector have several transmission mechanisms. Obviously Dutch Disease is a major source of problems. There is also the danger that during the development of the projects, the rest of the economy is "crowded out" from access to key factor inputs. Large scale revenues can encourage gigantomania whereby large projects are attempted which subsequently fail because they are over-ambitious. Such revenues can also lead to the development of a rentier society where there is a disconnect between effort and reward. In all cases, these mechanisms will aggravate dualism where a vibrant oil, gas or mineral sector exists along side a weak poorly performing rest of the economy. Finally, there is the temptation by the host government to try and squeeze more revenue out of the existing agreement (Ray Vernon's "obsolescing bargain"). This can inhibit much needed investment.
The sources of worsening poverty are extremely difficult to pin down. In general, rates of economic growth are poor which inhibits any tendency for benefits to "trickle down". Furthermore, the type of economic growth disadvantages agriculture and hence job creation. Empirically, spending on health care, longevity and education declines although precisely why this should be the case is far from clear. The economy becomes more vulnerable to external shocks from which the poor cannot protect themselves. Finally, both aggravated corruption and inflation harms the poor disproportionately as does any domestic conflict.
Problems with governance are numerous. The revenues increase the role of the state in the economy. This is especially damaging for transition economies where the key objective is to reduce the role of government. Revenues raise expectations which can force governments into quick, ill-thought out decisions. They also increase the size of the pot encouraging corruption. Finally, fluctuations in revenue make rent seeking easier by bureaucrats if only because it deepens the information asymmetries between themselves and their controlling ministries. The fluctuations speed changes which in turn deepen the information asymmetries at the heart of rent-seeking.
Finally there are negative influences on the political set up in a country. The revenues support existing regimes and governments simply because they allow low tax rates and large patronage. They also allow large spending on internal security further entrenching regimes. The revenues increase the potential for internal conflict and even civil war. Such countries also tend to be more heavily militarised. Furthermore, the project operations often inflame local sensibilities. The discovery of resources in a discontented region fuels separatist tendencies.

Cures for "resource curse" are far from convincing, not least because there is still great uncertainty over what causes it in the first place: -

Oxfam America, apart from concluding such projects should not be done, also offer a series of other means to reduce the impact of "resource curse". These cover diversification, the promotion of transparency, only aiding governments which are democratic and pro-poor and finally allowing outsiders to monitor and control revenues. Such solutions are at best impractical and at worst simply unrealistic.
The IMF/World Bank cures involve macro-economic stabilization programmes including the creation of Natural Resource Funds to sterilize revenue inflows. However, currently the position of such funds within the IMF is extremely controversial and a series of workshop/seminars are planned for June to try and resolve the differences. Both institutions are also linked into the development of "poverty reduction strategy processes" which, through processes of consultation, should produce spending agendas for the revenues. Finally their emphasis is on tackling governance problems, especially corruption.

Much remains to be understood about the phenomenon before more definitive solutions can be offered. Meanwhile concern will remain to haunt a great many projects currently under consideration.

CONCLUSION: There can be little doubt that "resource curse" issues will become a key driver of natural resource project investment decisions in the first decade of the twenty-first century in the same way that environmental factors affected project investments in the last decade of the twentieth century.

Dundee 16^th June 2002

Paul Stevens
CEPMLP
email : p.j.stevens@dundee.ac.uk
(added 18 June 2002)

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