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Petroleum Contracts: What does Contract Theory Tell Us? Philippe Aghion 1 Luca Quesada 2 1 Harvard University 2 Universidad Torcuato Di Tella International Workshop on Microeconomics Applied to the Energy Industry December 15th, 2011 Aghion,

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Petroleum Contracts: What does Contract Theory Tell Us?

Philippe Aghion 1 Lucía Quesada2

1Harvard University 2Universidad Torcuato Di Tella

International Workshop on Microeconomics Applied to the Energy Industry December 15th, 2011

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 1 / 23

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Introduction

Increases in oil prices led to expropriations of oil and gas companies by countries.

Sizable expropriations like Bolivia and Venezuela. More subtle: Increase in corporate (sectoral) tax rates like England.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 2 / 23

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Introduction

Increases in oil prices led to expropriations of oil and gas companies by countries.

Sizable expropriations like Bolivia and Venezuela. More subtle: Increase in corporate (sectoral) tax rates like England.

What we do:

Describe the main characteristics of petroleum contracts. Use contract theory to rationalize those contractual forms. Try to understand why governments may be justified to renege on past agreements.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 2 / 23

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Outline of the talk

Type of petroleum contracts that prevail. Emphasis on the most common

  • nes:

Production Sharing Agreements and Concession Contracts.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 3 / 23

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Outline of the talk

Type of petroleum contracts that prevail. Emphasis on the most common

  • nes:

Production Sharing Agreements and Concession Contracts.

Model of contracting customized to the oil industry.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 3 / 23

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Outline of the talk

Type of petroleum contracts that prevail. Emphasis on the most common

  • nes:

Production Sharing Agreements and Concession Contracts.

Model of contracting customized to the oil industry. Contracting issues in the industry.

Moral hazard. Hold-up. Enforcement problems. Uncertainty and grievance.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 3 / 23

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Outline of the talk

Type of petroleum contracts that prevail. Emphasis on the most common

  • nes:

Production Sharing Agreements and Concession Contracts.

Model of contracting customized to the oil industry. Contracting issues in the industry.

Moral hazard. Hold-up. Enforcement problems. Uncertainty and grievance.

Conclusions

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 3 / 23

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Prevailing contracts between countries and oil companies

Production Sharing Agreements (PSA).

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 4 / 23

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Prevailing contracts between countries and oil companies

Production Sharing Agreements (PSA). Concession Contracts.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 4 / 23

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Prevailing contracts between countries and oil companies

Production Sharing Agreements (PSA). Concession Contracts. Risk Service Agreements: Company supplies services and know-how to the State in exchange for a fee. It bears all the exploration costs. The State remains the owner of the produced oil.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 4 / 23

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Prevailing contracts between countries and oil companies

Production Sharing Agreements (PSA). Concession Contracts. Risk Service Agreements: Company supplies services and know-how to the State in exchange for a fee. It bears all the exploration costs. The State remains the owner of the produced oil. Joint Ventures: Ownership of the production is specified by the participation of the company and the government on the venture. Government is entitled to a share of profits, but it also bears a share of development and operation costs.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 4 / 23

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Production Sharing Agreements

State owns the resource and all the installations and plants.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 5 / 23

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Production Sharing Agreements

State owns the resource and all the installations and plants. Company is hired to explore, exploit and develop the resource in exchange of a share of production.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 5 / 23

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Production Sharing Agreements

State owns the resource and all the installations and plants. Company is hired to explore, exploit and develop the resource in exchange of a share of production. Risk of exploration entirely born by the company.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 5 / 23

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Production Sharing Agreements

State owns the resource and all the installations and plants. Company is hired to explore, exploit and develop the resource in exchange of a share of production. Risk of exploration entirely born by the company. After discovery and extraction, company pays a royalty.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 5 / 23

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Production Sharing Agreements

State owns the resource and all the installations and plants. Company is hired to explore, exploit and develop the resource in exchange of a share of production. Risk of exploration entirely born by the company. After discovery and extraction, company pays a royalty. Company retains a percentage of production to recover costs (cost-oil).

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 5 / 23

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Production Sharing Agreements

State owns the resource and all the installations and plants. Company is hired to explore, exploit and develop the resource in exchange of a share of production. Risk of exploration entirely born by the company. After discovery and extraction, company pays a royalty. Company retains a percentage of production to recover costs (cost-oil). Remaining production is shared between country and company (profit-oil) according to some specified rule.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 5 / 23

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Concession Contracts

Grant exclusive rights to explore, develop and export petroleum on a specific territory and for a specific period of time.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 6 / 23

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Concession Contracts

Grant exclusive rights to explore, develop and export petroleum on a specific territory and for a specific period of time. State transfers ownership of the mineral resource to the company for the duration of the contract.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 6 / 23

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Concession Contracts

Grant exclusive rights to explore, develop and export petroleum on a specific territory and for a specific period of time. State transfers ownership of the mineral resource to the company for the duration of the contract. Company has to secure the entire financing and technological capabilities and bears all exploration and production risks.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 6 / 23

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Concession Contracts

Grant exclusive rights to explore, develop and export petroleum on a specific territory and for a specific period of time. State transfers ownership of the mineral resource to the company for the duration of the contract. Company has to secure the entire financing and technological capabilities and bears all exploration and production risks. Company pays royalties as a portion of petroleum production. Computed based on

Surface area granted (surface royalty). Petroleum production (proportional royalty).

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 6 / 23

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Contracting Model

Two parties to the contract: Company (C) and State (G).

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 7 / 23

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Contracting Model

Two parties to the contract: Company (C) and State (G). 3 periods: t = 0, contracting and exploration; t = 1, 2, production.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 7 / 23

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Contracting Model

Two parties to the contract: Company (C) and State (G). 3 periods: t = 0, contracting and exploration; t = 1, 2, production. Contract assigns control rights and a profit sharing rule.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 7 / 23

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Contracting Model

Two parties to the contract: Company (C) and State (G). 3 periods: t = 0, contracting and exploration; t = 1, 2, production. Contract assigns control rights and a profit sharing rule. To start exploration: sunk, non-contractible investment I.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 7 / 23

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Contracting Model

Two parties to the contract: Company (C) and State (G). 3 periods: t = 0, contracting and exploration; t = 1, 2, production. Contract assigns control rights and a profit sharing rule. To start exploration: sunk, non-contractible investment I. An oil reserve is discovered with probability q(I).

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 7 / 23

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Contracting Model

Two parties to the contract: Company (C) and State (G). 3 periods: t = 0, contracting and exploration; t = 1, 2, production. Contract assigns control rights and a profit sharing rule. To start exploration: sunk, non-contractible investment I. An oil reserve is discovered with probability q(I). Size of the reserve R is observed by both parties but not verifiable.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 7 / 23

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Contracting Model

Two parties to the contract: Company (C) and State (G). 3 periods: t = 0, contracting and exploration; t = 1, 2, production. Contract assigns control rights and a profit sharing rule. To start exploration: sunk, non-contractible investment I. An oil reserve is discovered with probability q(I). Size of the reserve R is observed by both parties but not verifiable. Production in period t requires a non-contractible effort et, which costs ψ(et, I). Production costs = 0.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 7 / 23

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Contracting Model

Two parties to the contract: Company (C) and State (G). 3 periods: t = 0, contracting and exploration; t = 1, 2, production. Contract assigns control rights and a profit sharing rule. To start exploration: sunk, non-contractible investment I. An oil reserve is discovered with probability q(I). Size of the reserve R is observed by both parties but not verifiable. Production in period t requires a non-contractible effort et, which costs ψ(et, I). Production costs = 0. Production is yt is random. Depends on effort: Higher effort increases the probability of higher production.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 7 / 23

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Contracting Model

Two parties to the contract: Company (C) and State (G). 3 periods: t = 0, contracting and exploration; t = 1, 2, production. Contract assigns control rights and a profit sharing rule. To start exploration: sunk, non-contractible investment I. An oil reserve is discovered with probability q(I). Size of the reserve R is observed by both parties but not verifiable. Production in period t requires a non-contractible effort et, which costs ψ(et, I). Production costs = 0. Production is yt is random. Depends on effort: Higher effort increases the probability of higher production. Prices are unknown at t = 0 but known before production.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 7 / 23

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Contracting Model

Two parties to the contract: Company (C) and State (G). 3 periods: t = 0, contracting and exploration; t = 1, 2, production. Contract assigns control rights and a profit sharing rule. To start exploration: sunk, non-contractible investment I. An oil reserve is discovered with probability q(I). Size of the reserve R is observed by both parties but not verifiable. Production in period t requires a non-contractible effort et, which costs ψ(et, I). Production costs = 0. Production is yt is random. Depends on effort: Higher effort increases the probability of higher production. Prices are unknown at t = 0 but known before production. Company pays income taxes at a rate equal to it.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 7 / 23

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Concession Contract

Initial investment I and the effort levels (e1, e2) are chosen by C.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 8 / 23

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Concession Contract

Initial investment I and the effort levels (e1, e2) are chosen by C. At the end of periods 1 and 2, C pays royalties, Tt, to G. Royalties can be

Surface royalties: Tt = pt ¯ y Proportional royalties: Tt = ptγyt, γ ∈ (0, 1).

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 8 / 23

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Concession Contract

Initial investment I and the effort levels (e1, e2) are chosen by C. At the end of periods 1 and 2, C pays royalties, Tt, to G. Royalties can be

Surface royalties: Tt = pt ¯ y Proportional royalties: Tt = ptγyt, γ ∈ (0, 1).

Government take is ut = Tt + it(ptyt − Tt).

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 8 / 23

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Concession Contract

Initial investment I and the effort levels (e1, e2) are chosen by C. At the end of periods 1 and 2, C pays royalties, Tt, to G. Royalties can be

Surface royalties: Tt = pt ¯ y Proportional royalties: Tt = ptγyt, γ ∈ (0, 1).

Government take is ut = Tt + it(ptyt − Tt). Company take is πt = (1 − it)(ptyt − Tt) − ψ(et, I).

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 8 / 23

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PSA

Initial investment I and the effort levels (e1, e2) are chosen by C.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 9 / 23

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PSA

Initial investment I and the effort levels (e1, e2) are chosen by C. β (cost-recovery factor) is specified by the contract, usually between 30% and 50%.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 9 / 23

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PSA

Initial investment I and the effort levels (e1, e2) are chosen by C. β (cost-recovery factor) is specified by the contract, usually between 30% and 50%. Cost-oil in period t = 1 is c1 =

  • I/p1

if p1βy1 ≥ I βy1 if p1βy1 < I.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 9 / 23

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PSA

Initial investment I and the effort levels (e1, e2) are chosen by C. β (cost-recovery factor) is specified by the contract, usually between 30% and 50%. Cost-oil in period t = 1 is c1 =

  • I/p1

if p1βy1 ≥ I βy1 if p1βy1 < I. Cost-oil in period t = 2 is c2 =        if p1βy1 ≥ I (I − p1βy1)/p2 if p1βy1 < I ∧ p2βy2 ≥ I − p1βy1 βy2 if p1βy1 < I ∧ p2βy2 < I − p1βy1.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 9 / 23

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PSA (cont.)

Reminder production in each period is profit-oil, ˜ πt = yt − ct.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 10 / 23

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PSA (cont.)

Reminder production in each period is profit-oil, ˜ πt = yt − ct. ˜ πt is shared in a proportion αt for G and 1 − αt for C.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 10 / 23

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PSA (cont.)

Reminder production in each period is profit-oil, ˜ πt = yt − ct. ˜ πt is shared in a proportion αt for G and 1 − αt for C. αt can be fixed (fixed shares) or a function of production (sliding scales).

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 10 / 23

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PSA (cont.)

Reminder production in each period is profit-oil, ˜ πt = yt − ct. ˜ πt is shared in a proportion αt for G and 1 − αt for C. αt can be fixed (fixed shares) or a function of production (sliding scales). Government take is ut = ptαt(yt − ct) + itpt(yt − αt(yt − ct)).

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 10 / 23

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PSA (cont.)

Reminder production in each period is profit-oil, ˜ πt = yt − ct. ˜ πt is shared in a proportion αt for G and 1 − αt for C. αt can be fixed (fixed shares) or a function of production (sliding scales). Government take is ut = ptαt(yt − ct) + itpt(yt − αt(yt − ct)). Company take is πt = (1 − it)pt(yt − αt(yt − ct)) − ψ(et, I).

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 10 / 23

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Moral Hazard and Risk Sharing

When effort is not observable, if company does not fully appropriate the benefits of effort ⇒ it exerts inefficiently low levels of effort.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 11 / 23

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Moral Hazard and Risk Sharing

When effort is not observable, if company does not fully appropriate the benefits of effort ⇒ it exerts inefficiently low levels of effort. Sources of uncertainty:

Existence, size and quality of the reserve unknown before exploration. Drilling costs depend on the unknown characteristics of the field. Government owns the resources under the surface: risk of expropriations or contract renegotiations.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 11 / 23

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Moral Hazard and Risk Sharing

When effort is not observable, if company does not fully appropriate the benefits of effort ⇒ it exerts inefficiently low levels of effort. Sources of uncertainty:

Existence, size and quality of the reserve unknown before exploration. Drilling costs depend on the unknown characteristics of the field. Government owns the resources under the surface: risk of expropriations or contract renegotiations.

Large companies drill wells in different locations ⇒ Diversify risk. Can be thought of as (almost) risk neutral.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 11 / 23

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Moral Hazard and Risk Sharing

When effort is not observable, if company does not fully appropriate the benefits of effort ⇒ it exerts inefficiently low levels of effort. Sources of uncertainty:

Existence, size and quality of the reserve unknown before exploration. Drilling costs depend on the unknown characteristics of the field. Government owns the resources under the surface: risk of expropriations or contract renegotiations.

Large companies drill wells in different locations ⇒ Diversify risk. Can be thought of as (almost) risk neutral. Hence, avoid MH by making the firm residual claimant.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 11 / 23

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Moral Hazard and Risk Sharing: Contractual Provisions

A concession contract with surface royalties makes the firm residual claimant ⇒ guarantees efficient effort at production stage.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 12 / 23

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Moral Hazard and Risk Sharing: Contractual Provisions

A concession contract with surface royalties makes the firm residual claimant ⇒ guarantees efficient effort at production stage. Not true under PSA ⇒

Contracts include work programs with commitments in terms of drilling and production. This calls for monitoring effort from the State.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 12 / 23

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Assets Specificity and Hold-up: Framework

Hart and Moore (1988): Suppose that Parties have to make sunk relationship-specific investments. Outcome is difficult to describe at the contractual stage (non-contractible). Contract can be renegotiated once the outcome becomes observable.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 13 / 23

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Assets Specificity and Hold-up: Framework

Hart and Moore (1988): Suppose that Parties have to make sunk relationship-specific investments. Outcome is difficult to describe at the contractual stage (non-contractible). Contract can be renegotiated once the outcome becomes observable. Then, Parties are exposed to opportunistic behavior (hold-up): share the benefits of the investment with the other party. Parties lower their initial investment.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 13 / 23

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Assets Specificity and Hold-up

Investments in oil exploration I are large and highly specific in nature.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 14 / 23

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Assets Specificity and Hold-up

Investments in oil exploration I are large and highly specific in nature. Company is in charge of this investment in all existing contractual arrangements.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 14 / 23

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Assets Specificity and Hold-up

Investments in oil exploration I are large and highly specific in nature. Company is in charge of this investment in all existing contractual arrangements. Exposed to opportunistic behavior and hold-up once a discovery is made. Usually through adjustments in the tax system.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 14 / 23

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Assets Specificity and Hold-up

Investments in oil exploration I are large and highly specific in nature. Company is in charge of this investment in all existing contractual arrangements. Exposed to opportunistic behavior and hold-up once a discovery is made. Usually through adjustments in the tax system. Idea: It is ex-post optimal for the government to increase the tax rate when I is large.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 14 / 23

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Assets Specificity and Hold-up

Investments in oil exploration I are large and highly specific in nature. Company is in charge of this investment in all existing contractual arrangements. Exposed to opportunistic behavior and hold-up once a discovery is made. Usually through adjustments in the tax system. Idea: It is ex-post optimal for the government to increase the tax rate when I is large. Hence, company invests less than the efficient level.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 14 / 23

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Assets Specificity and Hold-up: Contractual Provisions

Make the state a partner in the exploration phase (share the costs):

Make exploration costs deductible from income-taxes. State reimburses part of the exploration costs.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 15 / 23

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Assets Specificity and Hold-up: Contractual Provisions

Make the state a partner in the exploration phase (share the costs):

Make exploration costs deductible from income-taxes. State reimburses part of the exploration costs.

Assign residual control rights to C (Grossman and Hart, 1986):

Stabilization clause: State commits not to change its laws. Allow the company to sell all its share of oil in the international market (avoid hold-up through exchange-rate policy).

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 15 / 23

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Assets Specificity and Hold-up: Contractual Provisions

Make the state a partner in the exploration phase (share the costs):

Make exploration costs deductible from income-taxes. State reimburses part of the exploration costs.

Assign residual control rights to C (Grossman and Hart, 1986):

Stabilization clause: State commits not to change its laws. Allow the company to sell all its share of oil in the international market (avoid hold-up through exchange-rate policy).

Appropriate renegotiation design (Aghion, Dewatripont and Rey, 1994):

Renegotiation clause that makes explicit the conditions for renegotiations. Duration of the contract structured in short-term phases. Company can

  • pt-out at the end of each phase.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 15 / 23

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Poor Enforcement: Framework

Suppose that There is a probability that the contract will not be fully enforced in the future.

This probability is likely to be increasing in the company’s profits (higher when prices are higher). Expropriations or unilateral change of terms of the contract (increased royalties or reduced share of profit-oil).

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 16 / 23

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Poor Enforcement: Framework

Suppose that There is a probability that the contract will not be fully enforced in the future.

This probability is likely to be increasing in the company’s profits (higher when prices are higher). Expropriations or unilateral change of terms of the contract (increased royalties or reduced share of profit-oil).

Then, Company loses part (or all) of its assets ⇒ reduces the expected returns

  • f the investment.

Implicitly increases the company’s discount factor (values the present relatively more, while the contract is still enforced).

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 16 / 23

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Poor Enforcement

Main problem: Find an impartial third party within the country’s judiciary system.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 17 / 23

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Poor Enforcement

Main problem: Find an impartial third party within the country’s judiciary system. Important issue: Reserves under the soil are property of the State.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 17 / 23

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Poor Enforcement

Main problem: Find an impartial third party within the country’s judiciary system. Important issue: Reserves under the soil are property of the State. This creates sovereign risk: unilaterally changing the terms of the contract or expropriating.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 17 / 23

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Poor Enforcement

Main problem: Find an impartial third party within the country’s judiciary system. Important issue: Reserves under the soil are property of the State. This creates sovereign risk: unilaterally changing the terms of the contract or expropriating. Enforcement problems (say, possibility of expropriation) are associated with:

Inefficiently low levels of initial investment (I). Too quick extraction rates: Early extraction.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 17 / 23

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Poor Enforcement: Contractual provisions

Safeguard clauses to create mechanisms to resolve disputes (improve enforcement).

Disputes to be solved outside the State’s judiciary system. Credible and fair third party to mediate: International Commercial Arbitration. Which law governs the oil contract? In general, the host State law. Sometimes, a combination of international law and the host State law. Highly progressive income taxes (reduce temptation).

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 18 / 23

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SLIDE 68

Poor Enforcement: Contractual provisions

Safeguard clauses to create mechanisms to resolve disputes (improve enforcement).

Disputes to be solved outside the State’s judiciary system. Credible and fair third party to mediate: International Commercial Arbitration. Which law governs the oil contract? In general, the host State law. Sometimes, a combination of international law and the host State law. Highly progressive income taxes (reduce temptation).

Extra contractual tools:

Reputation concerns on the State’s side: Compliance improves future contract terms. Loses power if government worry only about short-term. Threat of not reinvesting in the country by the company. May lose power

  • nce oil has been found (easy to find a replacement).

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 18 / 23

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Ex-post Uncertainty and Grievance: Framework

Hart and Moore (2008): Contractual performance depends upon the contracting parties’ willingness to cooperate ex-post on some aspects of the agreement that are not ex-ante contractible.

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SLIDE 70

Ex-post Uncertainty and Grievance: Framework

Hart and Moore (2008): Contractual performance depends upon the contracting parties’ willingness to cooperate ex-post on some aspects of the agreement that are not ex-ante contractible. Performance “within the letter of the contract” (enforceable) vs. performance “within the spirit of the contract” (non-enforceable). Contract works as a reference point for the parties’ perceptions of entitlement. Party who gets less than what he/she feels entitled to, reduces ex-post cooperation (provides only enforceable performance).

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 19 / 23

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SLIDE 71

Ex-post Uncertainty and Grievance: Framework

Hart and Moore (2008): Contractual performance depends upon the contracting parties’ willingness to cooperate ex-post on some aspects of the agreement that are not ex-ante contractible. Performance “within the letter of the contract” (enforceable) vs. performance “within the spirit of the contract” (non-enforceable). Contract works as a reference point for the parties’ perceptions of entitlement. Party who gets less than what he/she feels entitled to, reduces ex-post cooperation (provides only enforceable performance). Then Under certainty, rigid contracts are efficient (no room for grievance). With uncertainty: trade-off between rigidity and flexibility.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 19 / 23

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SLIDE 72

Ex-post Uncertainty and Grievance

How can parties who feel aggrieved reduce ex-post cooperation?

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 20 / 23

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SLIDE 73

Ex-post Uncertainty and Grievance

How can parties who feel aggrieved reduce ex-post cooperation? Company:

Cutting quality of the oil delivered. Delaying payment of royalties.

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SLIDE 74

Ex-post Uncertainty and Grievance

How can parties who feel aggrieved reduce ex-post cooperation? Company:

Cutting quality of the oil delivered. Delaying payment of royalties.

State:

Performing excessive controls. Changing regulations. Generating hostile feeling among the population about foreign firms.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 20 / 23

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SLIDE 75

Ex-post Uncertainty and Grievance

How can parties who feel aggrieved reduce ex-post cooperation? Company:

Cutting quality of the oil delivered. Delaying payment of royalties.

State:

Performing excessive controls. Changing regulations. Generating hostile feeling among the population about foreign firms.

Generate inefficiencies in multiple aspects of the contract execution.

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SLIDE 76

Ex-post Uncertainty and Grievance: Contractual Provisions

Under uncertainty, rigid contracts often call for renegotiations:

Size of the reserve is low and company wants to renegotiate. Oil quality is very high and the State wants to renegotiate.

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SLIDE 77

Ex-post Uncertainty and Grievance: Contractual Provisions

Under uncertainty, rigid contracts often call for renegotiations:

Size of the reserve is low and company wants to renegotiate. Oil quality is very high and the State wants to renegotiate.

Make the contract more flexible to reduce this renegotiation-type grievance.

Flexibility in concession contracts: Progressive royalty scheme based on some profitability indicators. Flexibility in PSAs through non-linear schemes for sharing profit-oil.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 21 / 23

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SLIDE 78

Ex-post Uncertainty, Grievance and Political Economy

Governments often care only about the short-term.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 22 / 23

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SLIDE 79

Ex-post Uncertainty, Grievance and Political Economy

Governments often care only about the short-term. Company faces many successive short-termist governments.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 22 / 23

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SLIDE 80

Ex-post Uncertainty, Grievance and Political Economy

Governments often care only about the short-term. Company faces many successive short-termist governments. Governments want to maximize private benefits from holding power.

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SLIDE 81

Ex-post Uncertainty, Grievance and Political Economy

Governments often care only about the short-term. Company faces many successive short-termist governments. Governments want to maximize private benefits from holding power. First government may accept to sign a contract that ensures high levels

  • f bribes to government officials, but is detrimental to the country in the

long run.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 22 / 23

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SLIDE 82

Ex-post Uncertainty, Grievance and Political Economy

Governments often care only about the short-term. Company faces many successive short-termist governments. Governments want to maximize private benefits from holding power. First government may accept to sign a contract that ensures high levels

  • f bribes to government officials, but is detrimental to the country in the

long run. Even under certainty the country may feel aggrieved ex-post.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 22 / 23

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SLIDE 83

Ex-post Uncertainty, Grievance and Political Economy

Governments often care only about the short-term. Company faces many successive short-termist governments. Governments want to maximize private benefits from holding power. First government may accept to sign a contract that ensures high levels

  • f bribes to government officials, but is detrimental to the country in the

long run. Even under certainty the country may feel aggrieved ex-post. May justify expropriations.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 22 / 23

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SLIDE 84

Conclusions

Contract theory is useful to explain the evolution of petroleum contracts.

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SLIDE 85

Conclusions

Contract theory is useful to explain the evolution of petroleum contracts. Moral hazard: Inefficiently low effort levels ⇒ Work programs and monitoring effort.

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SLIDE 86

Conclusions

Contract theory is useful to explain the evolution of petroleum contracts. Moral hazard: Inefficiently low effort levels ⇒ Work programs and monitoring effort. Hold-up: Inefficiently low initial investments ⇒ Commitment clauses and renegotiation rules.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 23 / 23

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SLIDE 87

Conclusions

Contract theory is useful to explain the evolution of petroleum contracts. Moral hazard: Inefficiently low effort levels ⇒ Work programs and monitoring effort. Hold-up: Inefficiently low initial investments ⇒ Commitment clauses and renegotiation rules. Enforcement problems: Inefficiently low investment and too quick extraction rates ⇒ International commercial arbitration and contract law; reputation and threat of not reinvesting.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 23 / 23

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SLIDE 88

Conclusions

Contract theory is useful to explain the evolution of petroleum contracts. Moral hazard: Inefficiently low effort levels ⇒ Work programs and monitoring effort. Hold-up: Inefficiently low initial investments ⇒ Commitment clauses and renegotiation rules. Enforcement problems: Inefficiently low investment and too quick extraction rates ⇒ International commercial arbitration and contract law; reputation and threat of not reinvesting. Uncertainty and grievance: Inefficient compliance ⇒ Increased flexibility.

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 23 / 23

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SLIDE 89

Conclusions

Contract theory is useful to explain the evolution of petroleum contracts. Moral hazard: Inefficiently low effort levels ⇒ Work programs and monitoring effort. Hold-up: Inefficiently low initial investments ⇒ Commitment clauses and renegotiation rules. Enforcement problems: Inefficiently low investment and too quick extraction rates ⇒ International commercial arbitration and contract law; reputation and threat of not reinvesting. Uncertainty and grievance: Inefficient compliance ⇒ Increased flexibility. Add short-termist governments: Renege on previous agreements (expropriations).

Aghion, Quesada (Harvard, UTDT) Petroleum Contracts Rio de Janeiro Dec 15, 2011 23 / 23