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In many countries, the NOC devises and implements sector policy, and even in countries where a ministry is formally

in charge, the NOC often contributes substantially to decision making due ministries in such countries are often blurred. The NOC has frequently been the writer and to its superior resources and industrial expertise. The boundaries between the NOCs and the

TRANSFORMING NOCS FOR VALUE CREATION

decisions are not in the best interest of the public. NNPC, Pertamina, and Algerias Sonatrach

enforcer of the rules and game participant all at the same time, raising the likelihood that once were examples of this all-in-one institutional set-up, but now all of them have been aim for an institutional setup that separates policy making (which is the responsibility of the body). This institutional arrangement is commonly known as the trinity or Norwegian

functions from the NOC to newly formed executive (or independent) bodies, and to eventually government) from corporate strategy (NOC) and sector regulation (independent regulatory model.

subject to reform. The most common reform trend has been to transfer licensing and regulatory

The promise of overcoming conflicts of interest through independent regulatory bodies is conceptually appealing. Implementing such an arrangement properly requires frameworks that may not exist in some countries, such as strong governance principles, regulatory freedom from political intervention, and strong training and human resources policies to competently staff two sets of institutions. Consequently there are still several prominent NOCs with consensus as to whether this should be achieved through separate departmental consensus today that the regulatory role should be separate from operations, but there is no comprehensive powers over the petroleum sector, including Petronas and Sonangol. There is a

responsibilities at the NOC or the ministry or through a truly independent body.

LOCAL CONTENT POLICIES AND VALUE CREATION


Local content policies affect both IOCs and NOCs, although not necessarily to the same extent. backward linkages (that is, supplying input to the local economy through transfer of technology, They were first introduced in the North Sea in the early 1970s and ranged from restrictions on

imports to the creation of NOCs. The aim of local content policies has evolved from creating

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creating forward linkages (that is, processing the sectors output prior to export through, for example, the establishment of refineries, petrochemical industry, and the production of thus going beyond the oil and gas sector value chain. (i) Governments use various instruments to implement their local content policies, including: (ii) (iii) (iv) (v) (vi) (ix) impose training obligations; fertilizers). More recently, local content has come to include wider economic diversification,

the creation of local employment opportunities, and increasing local ownership and control) to

simple contractual requirements that favor the use of local goods and services or

regulation and taxation that discriminate in favor of local industries, and other protectionist measures; regulation or contractual obligations that foster the transfer of technology from international to domestic companies;

bidding parameters that include local content among the criteria for winning oil and gas exploration and production licenses and contracts; investment in infrastructure and education; local ownership requirements; and the mandatory incorporation of foreign companies; direct government intervention through state owned enterprises (SOEs). incentives to foreign investors to reinvest their profits domestically;

(vii)

(viii)

It has been argued that local content policies create distortions, inefficiency, and, in some cases, policies is strongly influenced by the degree of technological strangeness. even corruption. However, this cannot be generalized. Inefficiency introduced by local content An economy that is very limited or primitive can hardly be expected to quickly be able to supply services (let alone to build forward linkages). Furthermore, the ability of the rest of the resources are developed, which is determined by the governments depletion policy. For example, Norway decided to develop its hydrocarbons more slowly than the United Kingdom, companies and expertise. with the explicit objective of allowing a Norwegian service sector to develop. By contrast, the United Kingdoms speedy development of its North Sea resources attracted American service Economic histories of a number of developed and developing countries show that linkages between the primary resource sector and other sectors influenced economic growth. These linkages are defined by the technologies of resource extraction. In some cases, the development of the resource sector stimulates the rise of industries that supply its inputs and that process 2|Page economy to develop a service sector often depends upon the speed at which the oil or gas

the staple products prior to export. Thus, an economy gradually becomes diversified. However, with the rest of the economy, and the country falls into a staple trap. In transition economies,

the diversification does not take place if the linkages are weak, such as when inputs are supplied from abroad. In this case, production concentrates in the resource sector that has little contact where a number of economic sectors from the former Soviet period have been destroyed, crowding out by the oil sector may hinder economic recovery. If this is the case, the use of local content policies to encourage economic diversification and the development of strong backward linkages may be appropriate. Local content policies are in essence a tradeoff between short-

framework may be required to execute the governments local content policies, it is essential that this framework be transparent, reliable, and predictable.

term efficiency and long-term economic development. While a comprehensive legal and fiscal

results depend on policy design. Especially in developing countries (and in developed countries in the early stages of development of the sector), NOCs tend to be given a primary role in advancing local content. This may range from the creation of backward linkages to processes and activities aimed at creating forward linkages and in some countries may go beyond the oil and gas sector value chain. More often than not, however, NOCs have little control over their

The NOC can be instrumental to the promotion of forward and backward linkages. But the

governments local content policies, either in terms of policy objectives or implementation

choices. The economic efficiency and the effectiveness of a local content policy depend more on (i) aim to achieve clear and measurable targets;

them). The elements of good local content policy design should include: (ii) (iii) (iv)

its design than they do on who implements it (the government, the NOC, the IOCs, or all of

strangeness; gradually maximize local value added; sectors;

set realistic objectives that take into account the degree of technological focus on the development of local capabilities that can be transferred to other

(v)

(vi)

be flexible and dynamic.

be coherent with other government policies and tools; and

provide for the assessment and disclosure of progress towards targets;

in some cases even corruption. In terms of implementation, the NOC may well be given a 3|Page

Policies that disregard these principles risk creating long-term inefficiency and distortions, and

prominent role among other stakeholders. But the government needs to avoid overburdening functions of the NOC. This is particularly relevant in countries where the NOC is the only

the NOC with non-core non-commercial objectives that may be at odds with the business company authorized to carry out petroleum activities and thus has limited possibilities for sharing the exploration and development risk with other parties, since this strategy requires, business investments. Furthermore, oversight and enforcement of local content policya role policya role that can be played by both the NOC and IOCs. among other things, a superior level of operational efficiency and the ability to prioritize core that belongs to the stateshould be separated from the facilitation and implementation of the Brazil and Malaysia have some similarities when it comes to the design of local content requirements and the role played by their NOCs, Petrobras and Petronas, in policy implementation. For both countries, increasing the contribution of the sector to local economic local content requirements are encouraged through the licensing process. Malaysia mandates developmentis among the objectives of their petroleum sector policy. To this end, minimum local incorporation of foreign companies and a minimum share of domestic equity holding and requires petroleum companies to acquire all materials and supplies locally or to purchase them directly from the manufacturer when not locally available. Brazil awards petroleum rights in acceptable share of local content, which differs depending on the location of the block and the competitive licensing rounds on the basis of three parameters: cash bonus, work program, and phase of development. Given that the Petroleum Act of 1974 gives Petronas exclusive rights and

local content. Brazils regulator, Agencia Nacional do Petroleo, determines the minimum powers over Malaysias hydrocarbon resources, the NOC has been the main vehicle for its

sharing contracts that Petronas negotiates and enters into with participating IOCs. In addition, Petronas has invested in creating a skilled workforce, developing technology, and supporting local content policies, since this is the task of the regulator. However, Petrobras has adopted local content as its own operating strategy. Contrary to Petronas experience, when Petrobras the local supply industry. By comparison, Petrobras does not have to enforce its governments was established, there was no oil industry in Brazil. The country was not perceived as

countrys local content policies, which translate into contractual obligations under petroleum

prospective, and costs were higher than those in more established oil provinces. This situation allowed the NOC to build a strong competitive advantage and to reduce its own operating costs

left Petrobras no choice but to develop the industry from scratch. Investing in technology, and remains at the core of Petrobras business strategy. Petrobras is well known for its superior

human capital, and the development of the domestic supply industry was inevitable. This choice technology and operating experience in deepwater and ultra-deepwater exploration and

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Petrobras strategic and operating decisions, even when they generated less revenue for the important, but energy security was paramount. government. For both countries the hierarchy of objectives was clear: backward linkages were As a result, the two NOCs were able to define local content policies that suited both their governments objective to use the petroleum sector as a springboard for growth and economic development and their own business and value creation strategies. Heading for a change? One thing that Malaysia and Brazil do not have in common is geology.

toward Petronas, the Brazilian government did not impose specific targets or interfere with

capability and shipbuilding expertise. Similar to the behavior of the Malaysian government

production. This capability was developed domestically, building on existing industrial

Most Malaysian fields have been producing for over 30 years, and production levels are infrastructure. This not only affects Petronas business strategy and its governments energy economic development and the type of local content requirements that should be chosen going forward. By comparison, although Brazil is a large oil producer, only 60 percent of its proved reserves are developed. The country still has a large number of sub-mature and frontier acreage, including the sub-salt province. Brazil has strongly enforced local content policies in the past. But it may have good reason to relax some of its local content requirements in the oilfield services industry, which is already under pressure because of the governments insistence that more of the equipment used offshore be owned by Brazilian firms or built in this would result in increased costs and delays for Petrobras and other operators and ultimately exploitation. South Africas local content policy is different from other petroleum producing countries, in that the country aims to address both technological disadvantages and broader societal liberal issues. The country has opted for a local content requirement mandated by law to fast-track equitable access to and sustainable development of South Africas mineral and petroleum minimum equity holdings by previously disadvantaged parts of the population. It also includes operations, Petro SA employs primarily South Africans and relies on local companies and resources. The recently introduced Black Economic Empowerment (BEE) policy requires Brazil. The Brazilian government would need to be watchful to avoid choking local capacity, as slow the pace of development of the pre-salt deposits and the value created from their future. Petrobras domestic success with the drill bit is likely to further strain the regional policy, it also affects the extent to which local content policy can be used to further Malaysias declining. The remaining fields are of lower quality, relatively small in size, and far from existing

employment and procurement requirements. Owing to the strong domestic focus of its 5|Page

to be geared towards sustainable national growth. The criteria for investing include job creation decision to locate the Coega refinery in one of the poorest provinces in South Africa was largely

suppliers for the majority of its procurement needs. Petro SAs asset ownership strategy tends and poverty alleviation. This includes opportunities for local participation. For example, the guided by social development considerations. But South Africa and Petro SA are not blessed with good geology, and the NOC has to import petroleum to satisfy its countrys consumption

needs. Petro SA has a track record of over performance in local content development and BEE implementation. However, production is declining and no major discoveries have been made. Petro SAs operational performance has been deteriorating since 2006. To support future of vertical integration to mitigate project risk. The NOCs strategy and investment choices reflect an attempt to balance the need to invest efficiently and secure supplies with domestic economic development and wealth redistribution objectives. The financial crisis and related credit crunch growth, the NOC has been stepping up its exploration expenditure and aims to pursue a strategy

have increased demands on Petro SA to extend financial assistance to its domestic suppliers to had sufficient funds to carry out its planned investment program. But if new discoveries are not producing assets. made soon, the government may have to consider a more flexible mix of commercial and social Petrobras, Petronas, and Statoil are often offered as examples to demonstrate the relationship

fulfill the requirements of the governments local content policy. At the end of 2008, Petro SA objectives that leaves the NOC with sufficient resources to build a more solid portfolio of

between value creation and technological advantages and managerial prowess, much of which was internally generated as the companies evolved. Each company benefits from the freedom to enter into partnerships and joint ventures with IOCs and other NOCs and operates in a petroleum sector that is relatively open to competition. These features have always privileges. In fact, special privileges were granted to these NOCs with the objective of fast tracking characterized their strategy, even when their governments have afforded them special economies of scale by allowing the NOC to build a portfolio of assets and technical and NOCs administrative and financial independence and given them a commercial focus.

managerial skills through mandatory participation in contracts or concessions operated by

IOCs. Consequently, since their establishment, the respective governments have granted their The three countries wanted to use the petroleum sector as a springboard for economic development and diversification. Although local content policies were mandated by law, and the 6|Page NOCs were given a special role in promoting them (this no longer formally applies to Statoil),

objectives for the creation of new capacity and therefore were not a burden to their NOCs. Since a strong local supply industry would decrease outflows of foreign currency as well as the cost of operations, the interests of the government and those of its NOC were aligned. The three NOCs adopted a similar strategy with respect to investment in technology and human capital. not have occurred had the NOCs passively relied on their special privileges. Competent management meant that, notwithstanding the prevalence of government officials on their BOD, the government generally did not interfere with the NOCs strategy and operational management. What triggered changes in corporate governance for these NOC? Brazil and Petrobras were pursuing energy self-sufficiency when the NOC was partially privatized, and its corporate same time, the government revoked Petrobras special privileges. governance was reformed to reflect the requirements of a joint stock quoted company. At the markets, allowing them to improve efficiency and develop competitive advantages, which would

country as a whole. The policies were designed to enhance existing capacity, and had feasible

they were tailored to the development of backward linkages that would benefit the NOC and the

Managerial and technical competence provided them with a dominant position in their domestic

The NOC had to compete with IOCs for access to petroleum resources. However, Petrobras had gave it a natural advantage over other market participants. Indeed by that time special

already developed a knowledge of domestic geological basins and deepwater technology that

privileges were useless and counterproductive to the rapid development of Brazils resource discoveries in the pre-salt area, the situation has changed. Brazil is no longer chasing energy self-sufficiency. Control over the pace of exploration of the large pre-salt resources and increased rent capture motivated a further change in Petrobras corporate governance. Special

base. More private investment was needed to leverage the NOCs capacity. After the recent large

privileges have been chosen to protect and exploit the newly-found resources. Hopefully the government will look to the experience of other large resource owners and avoid the pitfalls that come from excessive self-reliance, interference with the NOC strategy and management, and poor macro-fiscal management.

When the Storting decided to partially privatize Statoil, it was against the backdrop of decreased

profitability due to the oil price crash in 1998, and significant cost overruns by the NOC. Its of Statoil on politics and the domestic economy. By that time, Statoil had developed a large

privileges had been revoked almost 14 years earlier over concerns about the growing influence 7|Page portfolio of domestic assets and operational knowledge that mitigated the loss of privileges.

Regardless, its privileges would have been revoked in 1994 when Norway decided to join the

European economic zone, which required adherence to non-discriminatory market policies.

With partial privatization in mind, the government initiated a series of sector and governance reforms aimed to improve checks and balances and to pave the way for increased competition. State Direct Financial Interest (SDFI), which was also restructured. The NOC already had a

Prior to privatization, Statoil was hoping to receive part of the petroleum assets managed by the dominant position at home, but wanted to expand internationally, and it hoped to limit the cost of acquiring participation in new assets through a license swap. It did eventually receive the

and falling production levels, Statoil was looking to fast-track its international expansion. A the Storting to approve it. State ownership in the combined entity dropped to 67 percent (from consolidation with Norsk Hydro seemed ideal. The government favored the merger and asked 80 percent), but the new entity was bigger and stronger. The trigger for the merger was not rent

majority share of SDFIs divested assets. A few years after privatization, with rising oil prices

for international acreage, and the need to strengthen Statoils position in the Norwegian Sea and Arctic that may hold large hydrocarbon deposits.

capture or control over the industry. Rather it was Norways declining fields, stiffer competition

the Norwegian sector of the Barents Sea, an environmentally harsh deepwater region of the Petronas is wholly owned by the government of Malaysia. Three of its subsidiaries are listed on the Malaysia Bursa. Petronas corporate governance arrangements do not rank particularly high on the governance scorecard primarily because of the level of government presence in the corporate structure and the absence of external checks and balances that are associated with performance. On the contrary, a symbiotic relationship has developed over time between the quoted companies. But these deficiencies do not appear to have significantly affected the NOCs NOC and its government. Petronas strategy of helping to create forward and backward linkages, promoting energy self sufficiency, and seeking diverse sources of energy has played an important role in the Malaysian economy. Its role wasand remainsso indispensable to the economy that through several governments and various price cycles the NOC managed to keep its tax contribution below 30 percent until the early 1980s, and it now fluctuates around 35 percent, which is one of the lowest tax takes among NOCs. Petronas experience suggests that the corporate governance structure may be less relevant to value creation than the procedures and processes that govern the functioning of such structure.

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