Iraqi Oil: the controversial black stuff

So now the UN Security Council has given approval to the coalition's occupation of Iraq. Let's not kid ourselves, it is an occupation. Though, I mean that with as little negative connotation as possible. It is in any case, an occupation that is sorely needed, and the coalition's responsibility under international law. As the occupying power, the coalition has an obligation to care for the Iraqis. To some, the occupation looks like an attempt by America to control Iraq's oil supply. I won't deny that oil played a part in America's decision to go to war. It is true that America wouldn't mind busting up OPEC if that were possible. I don't believe that America is in Iraq to plunder oil though. What is important for the future of Iraq with regards to oil is to make sure that whatever fills the vacuum (whether it be a monopoly, or a panoply of firms) in the management of Iraq's hydrocarbons, not be directly controlled by the state. Oil should not be used to fund the wishes of the ruling party, as it did for at least three decades.

The best suggestions that I've heard for the management of Iraq's oil is for a trust with an independent board of directors be set up to collect royalties from the firms that actually manage the oil recovery. The money could then be distributed to the public on an equitable basis. When communism collapsed in Russia, a number of public oil firms emerged. The shares for these firms were widely distributed, but what ended up happening was that most of the shares went the market almost immediately as the poor went and cashed in below the true value of the shares, which were then bought up by the wealthy and influential. This in turn has probably only exacerabted inequality in Russia. This scenario should be avoided in Iraq. Also, private firms should probably not be allowed to own oilfields directly. The problem with oil is that it is quite comparable to the fishing industry (and it's pretty well publicised what has happened to fish stocks). Ownership of oil is established throgh the rule of capture. He who pumps the oil can claim ownership of it. This creates an incentive for all participants to pump as much oil as possible with the hopes ot pumping it all out before their competitors do so.

Oil could probably be administered in a similar way to which forests are managed (at least in Canada). Forests suffer from the same rule of capture incentive. Thus, the governments lease large sections of forest to logging companies for incredibly long-term leases. This creates an incentive for the company to reseed the clearcut areas of perform more selective cutting. Logging companies, in addition to paying for the lease, have to pay a royalty to the government in the form of a stumpage fee for each tree cut. This creates an incentive to use the tree resources efficiently, with as little waste as possible, after all, cutting trees and only getting a few boards out of it is just a plain waste. Unfortunately, it does create an incentive to cut the biggest trees possible, because they offer the most wood for ths stumpage fee. Perhaps, logging companies should be charged by the amount of volume cut... Anyways, back to oil...

Iraq's oil resources could be managed in a similar way. Oil companies should bid for long-term leases to Iraq's oilfields, which would give them an incentive to manage the rate of extraction carefully, rather than pump as much as possible, as fast as possible. The companies would then pay a royalty on the basis of volume of oil pumped, into a trust fund for the Iraqi people, administered by an independent board. Nevertheless, this plan is very controversial. Many would balk at the idea of giving oil companies 25 or 50-year leases to a country's oil-fields. Let us examine the alternatives though. A government-owned oil company would have the advantage of being able to strategically manage the country's oil resources as a whole. However, such a firm would be vulnerable to government meddling, political influence, and would have the potential to be used as a slush fund (ahem, Jacques Chirac and Elf-Aquitaine). The main function of such a company would be to raise money for the tax-shy public, which would create an incentive to pump as much as possible as fast as possible. Another alternative would be for individual firms to own oil-fields directly. As it has already been shown this creates an incentive to suck up as much oil as possible, then dump the land. A similar situation would result from short-term spot transactions with regards to oil-field leases. If firms had to bid each year for the privilege of pumping Iraq's oil, the incentive would be to pump as fast as possible during each firm's tenure. There would also be little reason for a firm to set up shop in the first place because their lease would be up in a year or two, which is insufficient to get an adequate return on investment. If there is imperfect competition though, the Iraqi people/government could be placed in a weak bargaining position because oil fields have little other use except as oil fields. Because of the specialised nature of the assets, the oil firms could bargain down the terms of their rent/lease and extract quasi-rents (the difference between the present value of the contract and the value of the contract under its next best alternative) from the government. In my opinion, the optimal solution is to have long-term leases that lock in the oil companies in the long term. Of course, it is important that the Iraqi government not reneg on its end of the deal by attempting to nationalise the oil company and its assets.

So where does that put America and the "coalition of the willing"? So far no one really knows what will happen. The UN is phasing out the Oil-for-Food Program,and placing Iraq and its oil under coalition cum America's jurisdiction. Will America make the optimal choice? Only time will tell. So far, the picture is mixed. President Bush has talked about holding repudiating Saddam's oil contracts (mostly with Russia and France) and holding fair auctions for the new oil contracts. For some reason, this reminds me of ancient Rome's publicani: tax farmers. The system worked like this: there were a number of tax-farming firms, which would promise to pay the republican government a certain bundle of denarii to tax a province. The publicani would then try to collect at least that much money in taxes from the chosen province, and any excess would be profit for the firm. The auctions for these firms were held every five years with the election of a two new Censors. This got out of control really fast, as the republican government kept raising the ante for its wealthiest provinces. Eventually, the bar was raised so high, that not even the publicani could raise enough denarii through their rapacious taxation methods to pay for the contracts. As a result every side lost (especially the taxpayers of the province).

Fortunately, in the present situation, America's tenure of control of Iraq should be relatively short. The oil firms that will bid will probably only get short-term contracts (unfortunately), as undoubtably the new Iraqi administration will be eager to run its own oil contract auction. While the auctions are inevitble (and they are the optimal way of determining the price paid and received), what is sad is that the oil companies will get only short term contracts, will be prone to government meddling, and the situation will be totally contrary to the interests of the Iraqi people. The best solution for them would be to ensure a steady stream of income from their oil as it is extracted gradually over a long period of time. Some renegociation should be possible to take changes in economic conditions into account, but on the whole, there should be no move towards a short-term spot transaction system. Once again, the best solution I've seen would charge the oil firms involved a royalty on a per unit of volume pumped basis. The money from the lease and royalties could then dumped into a trust fund for the Iraqi people and provide an equitable payout in the form of allowances/stipends, or better yet, a combination of health and education allowances and pensions.