Petroleum Crude oil Natural gas LNG Fractionation Oil fields Dissolved gas drive Gas-cap drive Water drive OIL EXTRACTION & PRODUCTION How was oil used after its discovery in western PA? What products did it replace? How geologists find oil now?

OIL EXTRACTION & PRODUCTION Regulation of drilling (“drilling mud” and other wastes) and refining (air pollution and other wastes)

OIL EXTRACTION Common law Rule of capture Monogahela case (PA, 1907): “every landowner or his lessee may locate his wells wherever he pleases … He may crowd the adjoining [landowner] …”

OIL EXTRACTION Does the common law tend to ensure production at the maximum efficient rate of recovery? If not, how might we achieve this goal? “unitization” and “pooling” by regulation in U.S., solving the collective action problem. By single (government) owner most everywhere else. “secondary recovery”

How did the world oil business change in the 1970s?

Economics of Oil Industry Shift from control by private oil companies toward state-owned companies Declining profitability View of western oil companies in developing world

Nationalization 1917: Russia 1931: Mexico  PEMEX 1970s: Libya, Iran Do nations have a legal right to nationalize private assets? “act of state” doctrine in international law

OPEC and Oil Prices: 10/73-3/74: OPEC embargo more than doubles world prices Israeli-Egypt war : price more than doubles again Iranian revolution OPEC price controls Post 1983: declining OPEC power What is OPEC’s goal in supply/price-setting? What is impeding OPEC’s ability to control prices now?

Production by National Oil Companies

Source: US EIA“Hubbert’s peak”

Source: BP

Oil Resources in Developing Countries: Political Risk What is “political risk”? What sort of political risks can undermine the value of a firm’s investment? Nationalization/expropriation Policy change (regulatory; monetary) Terrorism/war/civil strife “concessions” Lease term & lessee duty to produce Absolute ownership of subsurface

How can firms contemplating investment in developing countries predict political risk? Timeline Early 20 th c: rapid growth of international oil industry 1930s-70s: Latin American nationalizations 1960: OPEC formed 1960s-70s: Middle east nationalizations 1973: first oil crisis in US; price controls instituted 1977: second oil crisis in US

Oil Resources in Developing Countries: Political Risk Assessing/Predicting Risk: “Grand Tours” approach “Old Hands” approach Quantitative analysis Qualitative analysis: “Delphi” technique Do you think political risk is predictable?

Oil Resources in Developing Countries: Political Risk “corporate managers came to view risk analysis as an ‘ivory tower exercise,’ rooted in academic theory rather than managerial practice.” HBS Note on Political Risk Then how do companies (or their investors or insurers) decide when political risk is too great? What characteristics do you think are correlated with political-legal stability, or negatively correlated with political risk?

Oil Resources in Developing Countries: Political Risk What should investors look for? 1. Veto points in the policy process (e.g., divided government, separated powers, federalism)? 2. System stability, but political change? 3. Strong independent bureaucracy & judiciary? In other words, “credible commitments against arbitrary policy changes”: e.g., “takings clause”?

How can corporate managers manage political risk? Oil Resources in Developing Countries: Political Risk Insurance Sharing risk with host nation Do you think something like the World Bank’s risk guarantee for investment in electric infrastructure could work for oil exploration? Is it needed? Should the World Bank be in the business of reducing investor risk?

Modern Petroleum Agreements: 3 approaches 1.Legislatively-prescribed terms 2.Delegation to national oil company 3.Hybrid system Standardization  equal treatment Rigidity (how?) Government bargaining power? Flexibility  best deal (how?) Comparison problems  potential corruption or discrimination

Modern Petroleum Agreements Selecting contractor/developer: What are the differences between these approaches? What are the advantages/disadvantages of each? Discretionary licensing Auction Open Competition

Modern Petroleum Agreements What are the important differences between these different methods of foreign participation in developing domestic oil resources? Licensing/concession Joint venture Production sharing agreement Service contract