A Tale of Two Petro-States (Part I of III)

Norway manages its oil wealth much better than Canada does
November 1, 2012

Petroleum is a resource unlike any other. It is the world’s most strategically important and valuable resource. The world is dependent on fossil fuels for 80% of its energy, even though it is also threatening life on the planet.

Countries that have oil in abundance may be considered fortunate, but for most of the countries so endowed, historical experience shows that oil has been more a curse than a blessing.

As a young graduate student doing research on the impact of oil wealth in Venezuela, I encountered Juan Pablo Perez Alfonso, who, as Venezuela’s petroleum minister at the time, was the driving force behind the creation of OPEC. Although initially very surprised when he described oil as “the devil’s excrement,” I eventually came to understand the wisdom of his words.

A large body of research has found that the vast majority of the 30 petro-states -- those which are highly dependent on petroleum for 50% or more of export revenues, 25% or more of GDP, and 25% or more of government revenues — have had worse economic, distributional, and political outcomes than have the non-resource rich countries.

Norway is an outstanding exception to this experience of other petro-states. With a population of 5 million, it is a major petroleum producer and exporter. It is currently the 13th largest oil producer (2.4 million barrels per day) and the 8th largest oil exporter (2.2 million barrels per day). Norway is also currently the world's fifth-largest gas producer (104 billion cubic metres) and the third-largest exporter (99 billion cubic metres).

Petroleum figures prominently in the Norwegian economy, accounting for half of its exports, 25% of government revenues, and 21 % of its GDP.

Canada is also a major producer and exporter of oil and gas. We are the world's 6th largest oil producer (3.2 million barrels per day) and the world's 9th largest oil exporter (2 million barrels per day). Canada is the fourth-largest gas producer (161 billion cubic metres) and the world's third-largest exporter (95 billion cubic metres).

Oil and gas account for almost 8% of Canada’s GDP, and for 18.5% of Canada’s merchandise exports, double its share in 2002. Canada, uniquely, is also a major importer of oil, with Quebec and the Atlantic provinces dependent on foreign oil for more than 80% of their fuel needs.

Norway’s economy is one-quarter the size of Canada’s, and roughly two-thirds larger than Alberta’s economy.

Both Norway and Canada are part of economic blocs to which most of their oil and gas exports go. Over 90% of Norway’s exports go to European Union countries. Virtually all of Canada’s petroleum exports go to the United States.

Norway is not a full member of the EU, but has associate status as a member of the European Economic Association. Norway’s entry into the EU was defeated in two national referendums, in 1972 and 1994. A major reason for Norway staying out of the EU was that its national regime for managing its offshore resources, notably petroleum and fish, is inconsistent with EU rules on competition.

Canada, as a member of NAFTA, has accepted major limitations on its ability to manage its oil resources in a deregulated continental market. It also gave up policy tools to encourage upstream and downstream development of oil-related activities.

Norway is a rare exception, having largely escaped the resource curse that has afflicted so many petro-states. Norway stands on top of the latest United Nations Human Development Index, which brings together economic indicators, level of education, and life expectancy. Canada was ranked sixth. When adjusted for inequality, Norway remains number one, but Canada slips to 12th position.

The UK’s Economist intelligence unit ranked Norway number one in 2011 on its Democracy Index, based on a number of criteria: election freedom and fairness, security of voters, influence of foreign powers on government, and capability of civil servants to implement policies. Canada was ranked number 8.

Norway ranked 3rd on Yale University’s Environmental Performance Index, which ranks countries based on a range of policy areas, from water and air pollution to biodiversity and climate change. Canada was ranked 37th.

Due to a unique combination of factors, Norway has managed its oil wealth extraordinarily well. The voluminous research on petro-states confirms the overriding importance of government policy and institutions in determining a country’s success (or failure) in managing its oil wealth. Good policies and good institutions are the hallmarks of the Norwegian experience.

Alberta resembles Norway in several ways. With a population of 3.7 million, it is by far Canada’s largest petroleum province. It accounts for 70% of Canada's oil and gas production. Alberta’s prominence as a petroleum producer — with its vast tar sands reserves (the second largest in the world) and rapidly expanding production — will only grow in the future.

Alberta currently produces 3.2 million barrels per day. Tar sands production, most of which is exported to the U.S., accounts for more than half of the total. Production has doubled over the last eight years to 1.7 million barrels per day (bpd) in 2011. It is projected to double again to 3.7 million bpd by 2021, and to reach 6.2 million bpd by 2030.

While Canada falls well below the standard petro-state threshold, oil and gas accounts for 29% of Alberta’s GDP, 70% of its exports, and 28% of government own-source revenues. Thus Alberta most definitely qualifies as a petro-state. Unlike the others, however, it is not a sovereign state, but rather a province within the Canadian federation. The impact of oil does not end at the Alberta border, but affects the whole of Canada. Thus, how oil wealth is managed is a major national issue with potentially huge political, economic, social, and environmental consequences.

There is nothing inherently good or bad in having access to petroleum or any other resource. It is what nations do with it that matters. The challenge for petro-states is to overcome, mitigate, or convert their wealth’s potentially distorting social, political, economic, and environmental effects. Their success in this regard will determine whether and to what extent this resource becomes more a blessing than a curse. The following features (not an exhaustive list) are present to a greater or lesser degree in all petro-states.

  • Petro states are vulnerable to severe boom-and-bust cycles. During a period of rising prices and/or expanding production, oil revenues swell. This, along with the influx of investment, drives up the currency exchange rate, crowding out other export- and import-competing sectors of the economy, a phenomenon known as “Dutch disease.” It reduces their competitiveness and impairs the diversification of the economy. Imports and inflation rise. During the bust, the reverse happens. Prices, production, and investment decline, causing oil revenue and GDP to drop, budget deficits to grow, and debt to accumulate.
  • Oil generates extraordinary rents, or excess profits, that are far beyond the normal return on investment. In Adam Smith’s classic definition, rents are profits “reaped by those who did not sow.”
  • In petro-states, powerful domestic and foreign interests tend to capture a disproportionate share of the oil rent, thereby exacerbating inequality.
  • The high technology and capital nature of the petroleum industry, as well as transportation and market requirements, mean that it is generally dominated and/or controlled by foreign oil companies.
  • The petroleum sector’s high technology intensity, combined with access to plentiful foreign exchange, means that there is limited incentive to develop domestic oil-related upstream and downstream economic linkages. Inputs such as machinery and equipment and specialized services are mostly imported.
  • Its enclave nature also means that a small number of workers are paid very high wages compared to those in the rest of the economy. This increases inequality and exerts upward pressure on wages elsewhere, with consequent inflationary and competitiveness pressures.
  • Oil booms induce an in-migration of foreign labour to fill the expanded job demand. Foreign migrants are generally paid less than nationals, creating a labour underclass and further worsening inequality.
  • Access to oil wealth also shapes political institutions and the relationship between the state and the market.
  • With the inflow of petroleum revenues, other taxes are eliminated or reduced. Non-oil taxes as a percent of GDP tend to be low compared with other countries. As oil revenue dependence increases and non-oil tax revenue declines, so also does fiscal accountability and citizen participation. As the link between taxation and representation weakens, the state becomes more accountable to oil interests than to the (lightly-taxed) population.
  • Petro-states are often plagued with governance problems: corruption, lack of transparency, weak regulatory regimes, etc.

How successful has Canada/Alberta been in managing its oil wealth? How does it compare to Norway in avoiding what has been a curse for many oil-rich countries.

Acknowledging that major differences between the two countries often make comparisons difficult, I will examine the Canada-Alberta experience using Norway as the benchmark.

Key to Norway’s success in managing its oil wealth were a number of pre-existing conditions: a stable and deeply-rooted democracy with well-developed political institutions; a technically competent and honest bureaucracy; a deeply egalitarian culture; and a highly engaged citizenry. Prior to oil, Norway had an advanced and diversified economy based mainly on agriculture, forestry, fishing, shipping, and manufacturing. Unemployment was low. One of the most equitable societies in the world, Norway had a generous welfare system supported by a high and diversified tax base.

Norwegians have traditionally had high levels of trust in government, combined with an underlying distrust of foreign corporations. Norway has had a long political tradition of dealing with large foreign companies and a legal framework in place dating back to its experience in earlier times with hydropower. Ownership of Norway’s petroleum resources resides with the Norwegian state to manage on behalf of its citizens.

Following the discovery of the giant Ekofisk field in 1969, there was extensive public debate to determine how best to manage the country’s new-found oil wealth, out of which emerged a strong consensus that laid down the guiding “go” principles for managing its petroleum resources. They became known as the Ten Oil Commandments. With the overriding goal to ensure that oil was to be developed for the benefit of the entire society, they are:

  1. There should be national governance and control of all petroleum operations.
  2. Norway should become self-sufficient in oil.
  3. New industrial sectors should be developed based on petroleum.
  4. Petroleum development must take existing industries and environmental protection into consideration.
  5. Usable gas should not be burnt off.
  6. Petroleum from the offshore should as a general rule be landed in Norway.
  7. The state should be involved at all levels in the co-ordination of Norwegian interests, including an integrated oil industry.
  8. A state oil company should be established.
  9. Production activities in the North should take account of its special conditions.
  10. Close attention should be paid to the foreign policy implications of oil discoveries.

A 1974 Ministry of Finance white paper concluded that control over the pace of oil development was essential to ensure that impacts didn't outstrip Norway's adjustment capacity. And secondly, getting control required the development of Norwegian technological expertise to ensure that elected politicians had an independent information source on which to manage the industry.

The paper specified that the state would seek to secure the greatest possible share of the economic rent for the state, which would then be distributed in an egalitarian way across Norwegian society. It also stated that control of the oil industry was as important as, and inseparable from, maximizing its share of the oil rent.

Statoil, the state-owned oil company created in 1972, would become not only an operator, but involved in all stages of the oil production, from upstream exploration, to refining, to petrochemicals and retail.

A highly skilled state bureaucracy was able to bargain effectively with the oil industry. Officials understood that the only way that Statoil could stand up to the power of the multinational oil companies was by building an independent technological capacity. They knew that it would not be possible to secure a high share of the economic rent if it did not have a technologically skilled Statoil in reserve, which could take over if the multinationals were to leave.

Statoil was given privileged access to the oil fields in a way that concentrated initial investment and risk with the multinational oil companies, while giving a large share of the benefit to Statoil. It was partnered with the oil companies in almost all licence groups, which provided the opportunity to accelerate its technical competence.

Active industrial policy was decisive in achieving the goals of creating a Norwegian supply industry. A 1972 Norwegian content decree required that, where they were economically competitive, Norwegian goods and services were to be preferred. Companies would use Norwegian workers where possible.

Government also supported enhanced education and training and the creation of research institutions to aid the Norwegian companies. The Norwegian educational system quickly adapted to meeting the needs of the new industry.

Statoil secured agreements to ensure that Norwegian engineering firms would participate in joint ventures with American companies.

The Norwegian shipping industry was also uniquely placed to participate in the offshore oil industry. It had the shipyards, the skilled workers, and engineers. Its capital and technological base was easily convertible. Companies adapted their production to the construction of oil-rigs -- a peculiar type of ship. Moreover, the Norwegian fjords were well suited for producing the concrete underwater structures.

Norway’s sovereign wealth fund

By standard economic measures, Norway is managing very well through the petro-boom, which began in 2002 and, with a brief break in 2009, continues to this day. It has maintained low inflation, moderate growth, and close to full employment. It has also maintained a stable exchange rate with its most important trading partner, the EU. Throughout, it has registered huge trade and current account surpluses.

A major reason for Norway’s success is its sovereign wealth fund, which currently stands at $US 656 billion, and rising. The Norwegian government has no net debt, but rather a massive net surplus which has grown from 81% of GDP in 2002 to 157% of GDP in 2011.

In the wake of Norway’s experience of instability in the 1980s, the idea of creating a financial buffer separating revenues and expenditures led to the establishment of the Petroleum Fund in 1990. In 2006, it was integrated with the government’s pension scheme and re-named The Government Pension Fund-Global. The Fund is managed on behalf of the Norwegian people for the benefit of current and future generations. Given the aging population, it serves to pre-fund public pension spending.

The fiscal rule established for the Fund, adopted in 2001, is that the government can spend (on average) over the business cycle what amounts to the real expected return on the capital in the Fund, which is estimated at 4%. The idea behind the fiscal rule is that spending only the returns from the Fund will insulate fiscal policy and the domestic economy from petroleum revenue fluctuations.

All government petroleum revenues are transferred to the Fund, which then must be invested abroad. The Fund is integrated into the central government budget, making the state’s use of petroleum revenues fully transparent.

The fiscal rule ensures the petroleum wealth is not consumed, but converted to financial wealth which can be used to help finance a generous welfare state into the future.

The Fund acts as a buffer between fluctuating oil revenues and public expenditures. It also serves as a stabilizing mechanism for the exchange rate, since capital outflows increase when petroleum revenues increase. It also produces a more stable industrial structure, mitigating Dutch disease impacts from a booming oil sector.

An elaborate system of checks and balances created for the Fund’s operation ensures a high degree of transparency and accountability.

The Ministry of Finance is responsible for the ownership of the Fund. It establishes the investment strategy. It defines the asset allocation and risk limits. It ensures risk diversification and adequate financial returns over the long term. It also monitors and evaluates the management of the Fund and defines responsible investment practices.

The Fund’s investments are divided into three asset classes. Global equities (over 8,000 publicly-traded companies in 50 countries) comprise 60% of its investments. It is exclusively a minority shareholder or portfolio investor. Global fixed income investments comprise 35%, and global real estate investments make up the remaining 5% of the Fund’s investments. The geographic distribution of the Fund’s investments is: 40% EU, 35% U.S., 2% Canada, and the remaining 23% mostly in Asia.

The Norwegian Parliament, which is the ultimate owner of the Fund, makes the broad policy decisions. The Ministry of Finance reports annually on the Fund’s activities to the Parliament. The operational responsibility of the Fund is delegated to the central bank, the Norges Bank. A unit within the Bank — separate from monetary policy deliberations and other activities of the Bank — is devoted to the Fund’s management. The Bank reports regularly to the Ministry of Finance. A complete list of Fund investments is published once a year. The auditor-general, in turn, monitors the Ministry of Finance.

(Bruce Campbell is executive director of the CCPA. This three-part series comparing how Norway and Alberta/Canada manage development of their oil resources is excerpted from a longer study that he completed after visiting Norway. Full text of the study will be available later in early 2013. The second part of this series will appear in our December-January issue.)