Norway: Economic diversification and the petroleum industry

Nov 08, 2004 01:00 AM

This is an abridged version of a paper delivered by Professor Noreng, Norwegian School of Management, at the 10th Annual Energy Conference of The Emirates Centre for Strategic Studies and Research (ECSSR), 26-27 September, Abu Dhabi, UAE.
The full paper will be published in the forthcoming conference book "The Gulf Oil and Gas Sector: Potential and Constraints" due to be published in 2005 by ECSSR, PO Box 4567, Abu Dhabi, UAE.

The rationale
For well over 30 years, a consistent Norwegian policy has been to diversify in order to reduce dependence on petroleum revenues and the ensuing risk exposure to oil and natural gas price instability. Before oil, in the 1960s, Norway enjoyed comparatively strong economic growth, full employment and a current account surplus, and therefore had no urgent need to rush ahead with petroleum development.
This comfortable economic situation formed the basis for a strong bargaining position in relation to the international industry. The concern was to hedge the bargaining position by means of insight and competence to control the industry. This objective led the government to impose obligations other than just taxation on the oil companies.

The rationale, in brief, was that the petroleum industry operated on public land, and was extracting resources-in-the-ground that were in public ownership. Consequently, lifting oil and gas means depleting a public capital base, for which compensation should be found in the building up of other assets to secure a continuity of income. Norway, like the UK, practices discretionary licensing, awarding licenses through bargaining with oil companies over multiple objectives.
The government-landowner can demand more than money, depending on the situation and bargaining power. The rational solution is to develop a local supply of some competitive goods and services required by the petroleum industry, not to demand an indiscriminate use of local suppliers.

One risk is that the requirements of the petroleum industrybecome a balancing factor in regional, industrial and employment policies. Another is that the petroleum industry becomes a substitute for the capital market, creating jobs that are not competitive and not sustainable. A third risk is that the petroleum industry will cause local cost pressure, driving out other economic activities.
The transfer of knowledge can be in both parties’ interest. The government-landowner has a legitimate interest in enhancing its bargaining position through the development of competence and the knowledge base. The local community has a legitimate interest in competence growth to compensate for resource depletion. The oil industry will need local personnel and skills, as well as a local constituency. The scope and methods of the knowledge transfer are negotiable.

Norway’s success in achieving high local content is largely due to government policies, which encouraged partnerships between foreign and domestic companies, and made research programs mandatory. These ensured that technology developed in Norway would be among the best of its kind. Since 1970, successive governments have regarded it as essential to promote competition in the oil industry, while at the same time actively promoting the business opportunities for Norwegian industry.
Norwegian oil and gas production has increased significantly over the past three decades, and Norway ranks today as the world’s third largest exporter of crude after Saudi Arabia and Russia. The oil industry now accounts for a considerable share of the Norwegian economy. Petroleum production and pipeline transport create substantial revenues for licensees and the government. Through its demand for goods and services, this sector also generates substantial activity. The petroleum business has thereby been a prime mover in developing such sectors as mechanical engineering and associated services.

Procurement policy
In the early 1960s, Norway had no indigenous oil industry; but around 1970 there was consensus on the need to create one, with the help of the government. At the outset, a favourable economic situation created a strong bargaining position with the oil industry. The use of local goods and services was explicitly ensured by law between 1972 and 1994; at times, the Norwegian share was above 90 % of input.
Norway has a large oil service industry that today appears oversized. It has also established itself as a leader in offshore petroleum technology, and developed petroleum business clusters; but for some, survival is at issue.

In 1972, the government, in relation to petroleum, was reorganized, with the establishment of the Norwegian Petroleum Directorate NPD, as the administrative branch and Statoil, the national oil company, as the caretaker of commercial interests. At the same time, a preference policy for Norwegian goods and services was introduced, accompanied by a policy of knowledge transfer and research cooperation.
To enforce procurement policy, in 1972 the Ministry of Industry established a Goods andServices Office as a watch-dog to control the oil companies’ contracting and procurement activities: prior to tender invitations, the operator had to announce the tender schedule and companies to be invited. The ministry’s role was to ensure that qualified Norwegian companies were included on the bidders list.

At contract award stage, the operator was required to inform the ministry of its evaluation, along with the recommended supplier, price, country of origin and Norwegian content. The Norwegian content was calculated as value added in Norway both in manpower and monetary terms. Ownership of the company was of less interest; what mattered was where the work was to be carried out, that is, in Norway or abroad.
The role of the ministry was to ensure that a Norwegian bidder was awarded the contract, when competitive in terms of price, quality, delivery time and service. If the ministry was not convinced, consent could be withheld.

The emphasis placed on the Norwegian content made it an essential factor for all oil companies, and indeed, the ministry used this as one of the criteria when evaluating companies competing for new acreage. The ministry’s policy was to be transparent and predictable in respect to enforcement of the procurement policy. Moreover, as an observer in all license groups, the ministry secured insight into all the operators’ contracting activities. Good cooperation between the authorities and the operators, and the contracting and supplier industry was essential in developing the high local content in Norway that at times exceeded 70 %.
After the conclusion of the agreement on the European Economic Area (EEA) in 1994 between Norway and the EU, the procurement policy was discontinued. At present, the Norwegian share of goods and services to the oil industry is about 50 %.

The establishment of the Norwegian state oil company, Statoil, in 1972 and the involvement of two Norwegian private companies, Norsk Hydro and Saga Petroleum, in upstream oil and gas activities was intended to secure a central role for Norwegian industry. International oil majors were placed in the role of technical assistants and joint teams were used to fast-track the Norwegian companies into fully-fledged operators.
Consensus in Norway was that operatorship was needed to learn the tools of the trade and to be able to meet foreign oil companies as equals.

Following its establishment in 1972, Statoil was allocated a minimum of 50 %, along with Norwegian engineering contractors. The joint ventures had certain work principles on which the Norwegian engineering contractors established a basis for the transfer of technical know-how and experience.
An important consequence of executing projects in Norway was that the tendering activities for contracting and procurement of goods and services also took place locally. It often happened that the staff could provide information about capable local contractors and suppliers.

Transfer of knowledge
The license terms for the international oil companies made it mandatory to transfer skills and competence to the Norwegian companies. Personnel from Statoil, Norsk Hydro and Saga participated initially in the oil majors’ training courses and received on-the-job training schemes in their overseas operations. The oil majors recruited young Norwegian engineers and trained them overseas for a significant period, before they were taken home to "Norwegianise" their organizations.
The transfer of technology and the cooperation in research and development have been among the most successful aspects of Norway’s petroleum policy. By compelling oil companies to transfer competence and to cooperate in the development of new technology, Norway could assume the role of a leader in international petroleum development.

Within a relatively short period of time, Norwegian competence and technology for Norwegian conditions were developed. Competence strengthened Norway’s bargaining position with the international oil industry. Technology development led to a significant cost reduction and an ensuing expansion of the resource base.
During the 1990s, investment costs per boe in new oil and gas fields on the Norwegian continental shelf were reduced by around 4-5 %/year. The background was the strong research and development effort during the 1990s and the cooperation between oil companies, the supply industry and research institutions.

In Norway, the requirement to transfer competence and to cooperate in the development of new technology was introduced in the third licensing round in 1973. A practical result was that the international oil company Mobil, as the initial operator at the giant Statfjord field, systematically had to train Statoil to take over the task.
The fourth licensing round in 1979 introduced provisions for technology development cooperation between foreign oil companies and Norwegian research institutions. Cooperation agreements made the oil companies contribute funding, insight and expertise to develop technology in Norway.

They wereof three types.
One type called "50 % agreements" required operators to conduct at least 50 % of the research and development needed to develop a prospect in Norway at Norwegian institutions.
Another type used in the fourth and fifth licensing rounds required operators to conduct a specified research effort in advance of new licensing.
A third type involved "goodwill agreements", where the oil companies made an attempt to conduct as much petroleum related research and development as possible in Norway, without any advance commitment as to the sum or volume of the effort. Initially, the research and development "goodwill" programs were based on dialogue with the industry and were developed to support its needs and priorities.

Technology cooperation soon grew to large volumes, especially the "goodwill" agreements. More than half went to engineering firms, the rest to Norwegian oil companies, maritime services, mechanical industry and research institutions. The value of the technology cooperation should be seen in the light of the lead times for technology breakthroughs, which usually are 10-15 years.
From around 1980 to the mid-90s, the Norwegian oil industry has made major advances in drilling and sub-sea technologies and the application of information technology, and hence, cost reduction. The formal technology cooperation was also discontinued in 1994, but it continues on a more informal basis.

One success story has been the development of sub-sea technology. Significant resources were allocated to sub-sea research and development in the early 1980s. Side effects from the research and development through industrial cooperation have encouraged a larger degree of openness from oil companies towards the domestic industry, availability of oil company expertise, and coordination of research and development efforts of oil companies and suppliers.
Important synergies were obtained by the joint development of technology.

In 2001, a wide cooperation venture was launched to establish a national strategy for research and development. An important goal of this initiative is to ensure more integrated and effective cooperation in the oil and gas cluster for research as well as for the demonstration and commercialisation of technology.
Attention is focused on achieving synergies throughout the whole research chain and on relationships between oil companies, suppliers and research institutes. The pilot projects involve close collaboration between suppliers, research institutes and oil companies. Such cooperation will in itself contribute to creating a forward-looking, market-focused expertise network.

Petroleum revenue management
In Norway, the 1973-74 quadrupling of the oil price caused alarm. The Finance Ministry was concerned about the overheating of the economy and advocated caution, meaning a more moderate rate of development of the oil industry as well as moderation in the use of oil revenues.
At the same time, however, Norway’s open economy was hit by the international recession in the wake of oil price rises. Anticipating the financial surpluses, the government embarked on a costly counter cyclical economic policy that raised real incomes by 25 % during three years, 1974 to 1977, seriously compromising the competitiveness of non-petroleum activities.

Because of cost overruns and delays, oil revenues did not come as expected, and by the end of 1977, Norway had the highest debt ratio ever attained by any developed country, 50 % of GNP. The currency was devalued and in 1979-80 the government called an economic emergency, freezing incomes and prices.
Already by 1979 oil output was on-stream as planned and oil prices were rising as a result of the Iranian revolution. Prospects were good, and spending was able to resume, until oil prices fell in 1986. The oil price decline provoked a change of government and a policy of economic austerity until the early 1990s.

Established by parliament in 1990, the Petroleum Fund received its first true transfers in 1996. It receives the central government’s net cash flow from petroleum activities, as well as the return on fund investments. Expenditures comprise an annual transfer to the Ministry of Finance corresponding to the amount of petroleum revenues applied in the fiscal budget to cover the non-oil deficit, plus the fund’s administrative costs.
The fund acts as a buffer which provides greater flexibility in economic policy should oil prices or activity in the mainland economy decline, and serves as an instrument for dealing with the financial challenges presented by an ageing population and the prospect of declining oil and gas volumes. In principle, the normal rate of return of the fund, considered to be 4 %, goes to the budget. In practice, there is some violation of the rule as parliament tends to vote somewhat larger transfers in the annual budget transactions.

The significance of Norway’s experience
The historical background, especially the strong maritime tradition, makes any imitation of Norway’s experience difficult. The first major difference lies in contrasting technical challenges.
Whereas in the Middle East, and especially in the Gulf countries, oil extraction takes place in comparatively easy conditions, either onshore or in shallow waters offshore, generally from giant or super-giant fields, in the North Sea, conditions are hostile, often in deep waters, but always with harsh weather conditions, and in many cases from smaller or medium-sized prospects.

The degree of adversity and the less favourable geology mean that the geological, technical, environmental and financial risk is far higher in the North Sea than in the Middle East. The quadrupling of oil prices in 1973-74 and the nationalization of the oil industry in many OPEC countries squarely put the North Sea in a central position on the international oil map.
The enhanced interest in prospects strengthened the bargaining position of the Norwegian government. This did not reduce the technical challenges, but permitted a sustained and coordinated effort in petroleum related research and development, drawing on domestic intellectual resources and the cooperation of the international oil industry. The results are to be found in sub-sea, processing, transportation and reservoir management technologies that on some points are world leaders.

In the Gulf States, the technical and geological challenges are less overwhelming, although there is a case for technology improvement, not the least in areas such as reservoir management to enhance the rate of recovery. Consequently, there is a good case for strengthening the effort in petroleum related research and development in the Gulf states; but it should be focused on selective targets.
There is less of a need to develop an entirely new petroleum technology than to improve aspects of the technology currently in use and eventually to become world leaders in some areas. The requirement is a heavier focus on technical training and education in science.

The second major difference lies in contrasting economic backgrounds. Whereas the Gulf states, and much of the Middle East, until the early 1970s suffered from poverty and underdevelopment, Norway at that time was a developed and diversified economy, with a highly educated population enjoying full employment and a high standard of living. Consequently, in the 1970s, for the Gulf states, huge oil revenues appeared as an unmitigated blessing, while for Norway they also represented a risk and a menace to the established industries.
For the Gulf states, oil revenues represented an enormous supplement to the economy and the opportunity in the space of a few years to leap phases of development that, under other conditions can take generation, not the least in matters of education and health. For Norway, by contrast, oil revenues not only represented a supplement to the economic base, but also a substitute for established activities, so that the net gain was less dramatic.

Moreover, the oil industry, by raising the domestic cost level, has appeared as a threat to employment, as it could easily destroy more jobs than it creates. Against this backdrop, there has been a constant pressure to diversify for the sake of employment, also through the oil services and supply industries, and in this way enhance the value added in relation to oil and natural gas.
In the Gulf states, there is a good case for engaging more systematically in the petroleum procurement industries. But this requires skilled labour at competitive costs and competent management. Even with a large oil industry, the Gulf states have historically imported most equipment, components and parts.

The overhaul and subsequent expansion of the Gulf oil industry mean heavy investment for many years and corresponding procurement needs. The risk is that short-term convenience will direct Gulf oil industry procurement contracts to friendly foreign firms.
Instead, the procurement program should be handled by locals, benefiting from the chance to develop a Gulf oil supply and services industry, which eventually could serve markets in neighbouring oil-producing countries. This could be done in cooperation with foreign investors -- oil companies as well as manufacturers -- to the benefit of the trade balance, employment and competence.

The employment situation varies. Some Gulf states rely overwhelmingly on foreign labour for manual tasks and domestic labour is extremely costly. Others, not least Saudi Arabia, have an employment problem, especially among youth, and a pressing need to create more jobs. In so far as the domestic oil industry needs maintenance, renewal and eventually capacity expansion, there is a domestic market for goods and services that is not met by local suppliers.
Again, the need is to be focused and selective, at least in an initial phase, and to target some points in the upstream petroleum value chain. A relevant ambition would be exports of some goods and services for the international oil industry. Again, the requirement is the appropriate training of labour and managers, as well as willing investors.

Political differences
The third major difference lies in the political economy. Although Norway, like the Gulf states, is a monarchy, its character is different. In Norway, the role of the state is traditionally that of the redistributor of money, levying taxes on incomes, turnover and property, with sums reallocated by a democratically elected parliament. Although oil revenues are high (Norway extracts about 1 bpd per person) they have not altered this basic function of the state. Indeed, maintaining taxation on the citizens has enabled the build up the Petroleum Fund and use the petroleum revenues indirectly.
In the Gulf, the role of the state is essentially to distribute petroleum revenues, without taxing the citizens, and hence, the need for democratic control. The risk is a vicious circle, where reluctance to hand over power to democratically elected bodies defers taxation of the citizens, prolonging and intensifying the dependence on petroleum revenues and the ensuing risk.

Among the Gulf states, medium-term economic prospects differ profoundly, and in some cases a prolonged dependence on petroleum revenues does not seem to entail high economic and social risks. In other cases, the outlook is quite different, not the least because of high population growth. Here, the pressure for diversifying the income base and finding employment opportunities is likely to intensify.
The crunch could be the willingness to tax the citizens in return for a more formal political participation. Without the state securing a broader income base, there would be scant hope for using oil revenues more indirectly, and hence an increasing risk of discontinuities in economic and social development.

In Norway, both the state and the market have had a role in the policy of economic diversification in relation to petroleum. One key lesson is that market forces alone never would have accomplished the transfer of competence, the successful establishment of supply and service industries, or the Petroleum Fund.
If left to market forces, in the economy as in politics, oil companies would have had a preference for foreigners with a proven competence, established foreign suppliers of goods and services, often with a long-term symbiotic relationship with the oil industry, and politicians would have competed shamelessly for the maximum use of petroleum revenues, combining promises for tax breaks with generous pledges for public expenditure.

Against these risks, a long-term state strategy has worked out surprisingly well, based on a broad political consensus. The consensus, in turn, is based on a long history of representative, transparent and accountable government. For example, Norway’s Petroleum Fund has to publish annual reports on its operations and its operations under the scrutiny of the Comptroller General, appointed by parliament, as is the case involving other public revenues and expenditure.
The other key lesson is that the state alone could never have accomplished its objectives. It needed the cooperation of a competent and willing private sector. The tradition of shipping, shipbuilding and mechanical industry evidently was of great help.

Even if the primary petroleum industry in Norway still has a high degree of state ownership, there has never been any question of nationalizing the oil supply and service industries. Indeed, the role of the state was essentially to facilitate petroleum business opportunities for the private sector.
The state in its licensing policy honoured foreign oil companies that gave a priority to Norwegian goods and services, measuring the value and the domestic content percentage, but not specifying what Norwegian goods and services were preferred. This policy set the framework for a preferential Norwegian petroleum supply and services market, but with competition and flexibility and no central planning.

Loose coordination between ministries ensured a high degree of flexibility. The Ministry of Petroleum and Energy would grant licenses, the Ministry of Industry would evaluate industrial projects and applied research, and the Ministry of Education would supervise basic research and training. The government departments provided incentives and it was up to the partners to find and develop the projects.
This ad hoc approach meant that many projects in hindsight were of dubious value, but the cumulative effect was a significant build-up of competence and insight that was essential for technological progress and ensuing cost reduction in the offshore Norwegian petroleum industry, which was beneficial to the oil companies, the Norwegian supply industry, the government, the tax collector, alike.

In hindsight, however, the preferential policy went too far, as around 1990 at least four fifths of the new prospect content was domestic. The advantages were jobs and profits in Norway, but the disadvantages were too few and too weak impulses from abroad, too much dependence on the petroleum industry for Norwegian manufacturing and too little exports to markets in other oil producing countries.
Norway’s experience shows clearly that access to petroleum resources can be used as a bargaining tool, especially to obtain benefits that are of a common interest. Today, in a situation of a tight oil market, this evidently also applies to the Gulf states. Their major advantage is the availability of huge proven oil reserves at low cost, which enhances attraction for the oil industry. Their major disadvantage is the absence of a manufacturing base and a correspondingly skilled labour force, as well as the paucity of technological and scientific research. Consequently, it would be futile to emulate the Norwegian experience in all aspects.

The strong commercial tradition in the Gulf could help, however, especially in cooperation with foreign partners. Access to petroleum can only be used as a bargaining chip insofar as foreign oil companies are admitted upstream in some way. Incentives do not work with exclusion. With a modicum of participation, it would be possible not only to require foreign oil companies to train locals and transfer knowledge, but also to help develop some local supply and service industries and even bring them along to markers in other oil provinces.
In this respect, the Norwegian experience could provide a useful example, positive as well as negative. The merchant class of the Gulf sates could provide the local partners for the international oil industry, and subsequently help diversifying the economy by establishing a more independent income base. With the prospect of a long-term presence, foreign oil companies would have an evident self-interest in training locals to develop a pool of skilled local labour.

Regional cooperation is another element. The diversity of the Gulf states contributes to the complementarity of their economies and labour markets. Regional cooperation aimed at common economic diversification would be able to draw on larger markets, more human resources and more capital than individual efforts.
Policies to build up a common base of petroleum supply and service industries would encounter intra-Gulf rivalries and jealousies, but the benefit would be a stronger bargaining position with the international oil industry. The alternative could be parallel efforts and a fragmented bargaining position.

The first priority could be to diversify within petroleum by developing a local supply industry. Prospects for the oil market indicate a need to maintain and eventually expand capacity.
Today, there is little local content in the deliveries. Developing a local or regional oil service industry could mean diversifying income sources and at the same time create jobs. The need and the potential in this direction are evidently greater in Saudi Arabia than, say, in Kuwait, Qatar or the UAE.

The second priority could be to develop competence in relation to petroleum. This would be most successful in cooperation with the international oil industry, which would mean openingup to foreign operators.
This would be politically controversial in some countries; but relying on a single, nationalized operator unfortunately means isolation from competence developing elsewhere.

The third priority would be to develop a fund, with the aim of using petroleum revenues indirectly. One such already exists in Kuwait and Abu Dhabi, but should be considered in Saudi Arabia in the light of the current high oil prices that might not last forever.
Consequently, a wise strategy would be not to adapt expenditure to temporarily and unexpectedly high oil revenues, but rather to put unexpected income aside in a stabilization fund to cushion the domestic economy and promote diversification.

Source: Middle East Economic Survey
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