ENCYCLOPAEDIA

OF
HYDROCARBONS

ISTITUTO DELLA
ENCICLOPEDIA ITALIANA
FONDATA DA GIOVANNI TRECCANI
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 ENCYCLOPAEDIA OF HYDROCARBONS

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 ENCYCLOPAEDIA OF HYDROCARBONS

volume iv

HYDROCARBONS:
ECONOMICS, POLICIES
AND LEGISLATION
SCIENTIFIC CO-ORDINATION
Alberto Clô
(Hydrocarbons: economics and policies)
Piero Bernardini
(Hydrocarbons legislation)
 INDEX OF VOLUME IV

HYDROCARBONS:
ECONOMICS AND POLICIES

1 – MINERAL RESOURCES BETWEEN SCARCITY AND GROWTH

Alberto Quadrio Curzio, Fausta Pellizzari, Roberto Zoboli

1.1 – THE ECONOMIC THEORY OF EXHAUSTIBLE NATURAL RESOURCES 3
1.1.1 – Introduction 3
1.1.2 – Producibility and scarcity: the classical dynamics 3
1.1.3 – From natural to general scarcities: marginalists and neoclassicals 4
1.1.4 – Dynamics with and without natural scarcities: macroeconomists, structuralists, stylizers 7

Alberto Quadrio Curzio, Fausta Pellizzari, Roberto Zoboli

1.2 – TECHNOLOGICAL INNOVATION, RELATIVE SCARCITY, INVESTMENTS 11
1.2.1 – Innovation and resource use efficiency: stylized facts 11
1.2.2 – The mechanisms of technological innovation for energy and the environment 15

Peter R. Odell
1.3 – RESERVES AND RESOURCES 23
1.3.1 – Oil 23
1.3.2 – Natural gas 32

Donald W. Jones
1.4 – THE MACROECONOMIC IMPACTS OF OIL PRICE SHOCKS 43
1.4.1 – A short history of a controversial topic 43

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 1.4.2 – Microeconomic mechanisms that transmit oil price shocks to the macroeconomy 44
1.4.3 – Monetary policy in response to oil price shocks 45
1.4.4 – What constitutes an oil price shock? 45
1.4.5 – The econometrics of oil price shocks 46
1.4.6 – Non-US evidence 46
1.4.7 – The impact of oil prices on the macroeconomy 47

2 – BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY

Carol Dahl
2.1 – OUTLINE. OIL AND OIL PRODUCT DEMAND 49
2.1.1 – Overview of global oil use 49
2.1.2 – Theoretical issues in modelling energy demand 54
2.1.3 – The effect of demand and supply on market price 57
2.1.4 – Demand elasticities and their uses 61
2.1.5 – Econometric estimates of energy demand models 63
2.1.6 – International data sources 67
2.1.7 – Survey of demand elasticities by product, region and sector 69

Morris A. Adelman
2.2 – BASIC CONDITIONS FOR CRUDE OIL PRODUCTION AND COST FUNCTIONS
IN THE SHORT AND LONG RUN 75
2.2.1 – Introduction 75
2.2.2 – Oil and gas supply: an industry of rising costs 77
2.2.3 – Exploration as permanent source of company/government discord 79
2.2.4 – Conclusions 82

Olivier Appert, Jean-Pierre Favennec

2.3 – ANALYSIS OF COST STRUCTURE AND FUNCTIONS IN OIL TRANSPORT AND REFINING 85
2.3.1 – Oil transport 85
2.3.2 – Oil refining 96

Oliviero Bernardini
2.4 – THE ECONOMICS OF NATURAL GAS 107
2.4.1 – Introduction 107
2.4.2 – The demand for natural gas 108
2.4.3 – Natural gas supply 123
2.4.4 – The production function and the costs 145
2.4.5 – From regional to global markets 149

James T. Jensen
2.5 – INTERNATIONAL TRADE AND THE LNG INDUSTRY 155
2.5.1 – Gas trade 155
2.5.2 – Economies of scale and transport costs 161
2.5.3 – International contracts 167
2.5.4 – The LNG industry 171

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 3 – PUBLIC POLICIES AND THE OIL INDUSTRY

Alberto Clô
3.1 – STATE AND MARKET REQUIREMENTS DETERMINING OIL POLICIES 187
3.1.1 – Oil and the economy: an inextricable link 187
3.1.2 – Oil and politics: the lessons of history 190
3.1.3 – The philosophy of public intervention 192
3.1.4 – Oil policy in the United States 198
3.1.5 – European public policies 201
3.1.6 – Peak and decline of public policy 205
3.1.7 – Oil, social conflict, policy crises 212
3.1.8 – Policies and the market: striking a balance 213

Donald W. Jones
3.2 – URBANIZATION AND ENERGY USE 219
3.2.1 – Urbanization and agricultural change 219
3.2.2 – From agriculture to industry 220
3.2.3 – Building cities 220
3.2.4 – Concentrating populations 220
3.2.5 – Increasing incomes 221
3.2.6 – Substituting modern energy for traditional energy 221
3.2.7 – The bottom line: aggregate energy implications of urbanization 222

Enzo Di Giulio
3.3 – ENVIRONMENTAL EXTERNALITIES 225
3.3.1 – The concept of externality 225
3.3.2 – Regulation or the market? 227
3.3.3 – Oil and gas externalities 228
3.3.4 – Assessment of externalities 232
3.3.5 – Climate change 236

4 – MARKET STRUCTURES AND PRICE POLICIES IN THE OIL AND GAS INDUSTRY

Philip K. Verleger Jr.

4.1 – MARKET STRUCTURES AND PRICE POLICIES IN THE OIL AND GAS INDUSTRY:
THE CASE OF OIL 239
4.1.1 – Introduction 239
4.1.2 – Economic theories of price setting in the oil industry 239
4.1.3 – The oil industry transformation: from coordination to commodity markets 245
4.1.4 – Oil as an economic commodity: OPEC policies and price dynamics 248
4.1.5 – Conclusion 251

Massimiliano Marzo
4.2 – UNCERTAINTY AND RISK MANAGEMENT 255
4.2.1 – Introduction 255
4.2.2 – Forward and futures contracts 256
4.2.3 – Options 261

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 4.2.4 – OTC instruments 266
4.2.5 – Exchanges for physicals 271
4.2.6 – Conclusions 272

5 – KEY ACTORS IN THE HYDROCARBONS INDUSTRY

AND COMPANY STRATEGIES

Alberto Clô
5.1 – THE OIL INDUSTRY: ITS PLAYERS AND STRUCTURE FROM ITS ORIGINS
TO THE OIL SHOCKS OF THE NINETEEN SEVENTIES 275
5.1.1 – The players 275
5.1.2 – From the pioneers to the American oil industry 279
5.1.3 – From American to international industry 282
5.1.4 – An exceptional period 292
5.1.5 – Towards a new equilibrium 297

Robert Grant
5.2 – OIL COMPANY STRATEGIES FROM 1970 TO THE PRESENT 301
5.2.1 – Driving forces of industry change 301
5.2.2 – The oil and gas majors: the traditional model 304
5.2.3 – Diversification and the quest for reserves (1974-1984) 305
5.2.4 – Internal restructuring for efficiency and flexibility (1985-1994) 307
5.2.5 – Changes in organizational structure 310
5.2.6 – Consolidation: the wave of mergers (1995-2002) 312
5.2.7 – Current directions in strategy 315
5.2.8 – Adapting to an uncertain future 320

6 – THE NATURAL GAS INDUSTRY FROM MONOPOLY TO COMPETITION

Carlo Scarpa
6.1 – ECONOMIC ASPECTS 323
6.1.1 – The segments of the gas sector 323
6.1.2 – Redrawing the boundaries of the monopoly 327
6.1.3 – Structural choices and drivers of change 328
6.1.4 – Potential structure and regulation of the gas industry 332
6.1.5 – Regulatory reform in the European Union 334
6.1.6 – Regulation in Italy before the reform 339
6.1.7 – Regulatory reform in Italy 340
6.1.8 – Conclusions: the public interest, monopolies and competition 348

David Bardey, Amedeo Piolatto

6.2 – THE REGULATION THEORY AND ITS PROSPECTS 351
6.2.1 – Introduction 351
6.2.2 – Why regulate? 351
6.2.3 – Regulation under complete information 353
6.2.4 – Regulation under asymmetric information 356

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 6.2.5 – Capturing 361
6.2.6 – Privatization 363
6.2.7 – Conclusions 364

7 – GEOPOLITICS AND SECURITY

Gawdat Bahgat
7.1 – THE AMERICAN POINT OF VIEW 367
7.1.1 – Introduction 367
7.1.2 – The Strategic Petroleum Reserve 369
7.1.3 – The Arctic National Wildlife Refuge 369
7.1.4 – The Gulf of Mexico 370
7.1.5 – Natural gas 371
7.1.6 – Coal 373
7.1.7 – Nuclear energy 373
7.1.8 – Russia’s oil potential: myth or reality? 375
7.1.9 – The Caspian Sea: a new frontier 377
7.1.10 – Africa: security and political challenges 379
7.1.11 – The Middle East: opportunities and risks 380
7.1.12 – Conclusion 382

Jean-Marie Martin-Amouroux
7.2 – THE EUROPEAN POINT OF VIEW 385
7.2.1 – The difficulties of geopolitics and lessons learned from insecurity 386
7.2.2 – Instruments for managing oil crises 387
7.2.3 – Construction of more resilient energy systems for the long term 390
7.2.4 – Diversification of imports and cooperation with exporting countries 393
7.2.5 – Market liberalization and supply security 396
7.2.6 – Results, limitations and uncertainties of the European approach 397

8 – PRODUCER-EXPORTER COUNTRIES

Jean-Marie Chevalier, Marie-Claire Aoun

8.1 – GEOPOLITICS OF OIL AND GAS EXPORTING COUNTRIES 401
8.1.1 – Oil and gas revenues 401
8.1.2 – The Middle East and Far East 406
8.1.3 – Africa: oil curse with a ray of light 413
8.1.4 – Latin America: between strong government control and a competitive market 416

Bülent Gökay
8.2 – OIL AND GEOPOLITICS IN THE CASPIAN SEA BASIN 423
8.2.1 – Geopolitics of Caspian oil 424
8.2.2 – Oil pipelines 425
8.2.3 – NATO’s bombing of Yugoslavia and Caspian oil 426

Øystein Noreng
8.3 – ISLAM AND OIL 431
8.3.1 – Religion and petroleum 431

XIX
 8.3.2 – The present predicament 431
8.3.3 – The historical background 433
8.3.4 – Islam’s economic principles 435
8.3.5 – Oil and Islamic economic principles 438
8.3.6 – Clash of civilizations or clash of interests? 443

9 – FUTURE SCENARIOS

Fatih Birol
9.1 – THE FUTURE OF HYDROCARBONS 447
9.1.1 – The global outlook for oil and gas 447
9.1.2 – Demand 448
9.1.3 – Production and trade 449
9.1.4 – Environmental implications 451
9.1.5 – Investment needs and financing 451
9.1.6 – Major uncertainties 452
9.1.7 – Towards a sustainable energy future 455

Peter R. Odell
9.2 – FUTURE OUTLOOK: THE QUALITATIVE ASPECTS 457
9.2.1 – Oil 457
9.2.2 – Natural gas 463
9.2.3 – Oil and gas as renewable resources 470

The Scientific Co-ordinator expresses his warmest appreciation for the precious collaboration provided by Dr. Lisa Orlandi

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HYDROCARBONS LEGISLATION

10 – INTERNATIONAL LAW

Paolo Mengozzi
10.1 – THE SOVEREIGNTY OF STATES OVER THEIR NATURAL RESOURCES 477
10.1.1 – The end of the Second World War and the tendency of states to extend their sovereignty 477
10.1.2 – The powers of coastal states 477
10.1.3 – Oil concession contracts and stabilization clauses 478
10.1.4 – The principle of permanent sovereignty of states over their natural resources
and developing countries 480
10.1.5 – The pacta sunt servanda principle in western literature and in arbitral case law 481
10.1.6 – The need for a link between the pacta sunt servanda principle
and the rebus sic stantibus rule 484
10.1.7 – Bilateral joint exploitation agreements concluded between coastal states with reference
to common oilfields or awaiting definitive delimitation of the continental shelves 485
10.1.8 – Cooperation among states: the Reformulated and Conventional Gasoline case 486

Tullio Treves
10.2 – INTERNATIONAL LAW OF THE SEA AND EXPLOITATION OF THE SEA’S RESOURCES 491
10.2.1 – The various maritime zones and their evolution 491
10.2.2 – Marine resources in light of the 1982 Convention on the Law of the Sea
and of other international rules 493
10.2.3 – Outer limits and delimitation of the zones under national jurisdiction 494
10.2.4 – Mineral resources in zones under national jurisdiction: the exploration and exploitation
regime 497
10.2.5 – Artificial islands, installations and structures 498
10.2.6 – Cables and pipelines 500
10.2.7 – The regime of mineral resources of the international seabed 500
10.2.8 – Non-mineral resources in the economic zone and on the high seas 503
10.2.9 – Dispute settlement 503

Sergei Vinogradov
10.3 – ENVIRONMENTAL PROTECTION IN THE PETROLEUM INDUSTRY 507
10.3.1 – Introduction 507
10.3.2 – Environmental impact of the petroleum industry 507
10.3.3 – International environmental legal frameworks relevant to the petroleum industry 509
10.3.4 – Soft law relevant to the petroleum industry 519
10.3.5 – National legal frameworks 520
10.3.6 – Environmental management tools 521
10.3.7 – Conclusions 522

Sergio Maria Carbone

10.4 – CIVIL LIABILITY FOR OIL POLLUTION DAMAGE TO THE MARINE ENVIRONMENT 525
10.4.1 – The evolution of international rules. The 1969-71 Convention system 525

XXI
 10.4.2 – The updating of the Convention system 526
10.4.3 – Criticism of the Convention system and the relevance of insurance coverage 528
10.4.4 – The progressive confirmation of the criterion of the shipowner’s strict liability
and its limits 530
10.4.5 – The concepts of compensable damage and ship for the purposes of the application
of the international rules 532
10.4.6 – The Bunker Convention 533
10.4.7 – The relationship between the Bunker Convention and the rules on limitation
of liability for maritime claims 535
10.4.8 – Conclusions and prospects for the evolution of the system 536

Andrea Giardina
10.5 – BILATERAL INVESTMENT TREATIES AND THE NORTH AMERICAN FREE TRADE
AGREEMENT 539
10.5.1 – Introduction 539
10.5.2 – Bilateral investment promotion and protection treaties 539
10.5.3 – The North American Free Trade Agreement (NAFTA) 545

Andrea Giardina
10.6 – THE ENERGY CHARTER TREATY OF 1994 551
10.6.1 – Introduction 551
10.6.2 – Trade, transit, the environment and energy efficiency, and competition 551
10.6.3 – Investment promotion and protection 553
10.6.4 – Dispute settlements between investors and states and between states 555

Thomas W. Wälde
10.7 – ORGANIZATION OF THE PETROLEUM EXPORTING COUNTRIES (OPEC) 559
10.7.1 – Introduction and background 559
10.7.2 – History and structure of OPEC 560
10.7.3 – OPEC and the international oil market 563
10.7.4 – OPEC and international energy law 564
10.7.5 – Conclusions 571

Thomas W. Wälde
10.8 – THE INTERNATIONAL ENERGY AGENCY (IEA) 575
10.8.1 – Overall profile 575
10.8.2 – Origin 577
10.8.3 – Autonomy or integration: IEA relations with the OECD 577
10.8.4 – Budget 578
10.8.5 – Governance 578
10.8.6 – Membership 579
10.8.7 – Accession 581
10.8.8 – Emergency response mechanisms in the IEA 581
10.8.9 – External relations (relation with “non-member countries”) 584
10.8.10 – Policy and technical research and consultation 585
10.8.11 – Energy research and technology 586
10.8.12 – Conclusion 586

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 11 – SUPRANATIONAL LAW

Peter D. Cameron
11.1 – EUROPEAN UNION AND THE LIBERALIZATION OF THE ENERGY MARKET 591
11.1.1 – Introduction 591
11.1.2 – Hydrocarbons licensing 591
11.1.3 – Gas 595
11.1.4 – The complementary role of competition law 609
11.1.5 – Conclusions 611

12 – NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY

Ernest E. Smith
12.1 – UNITED STATES OF AMERICA AND CANADA 613
12.1.1 – Preliminary remarks 613
12.1.2 – Ownership of hydrocarbon resources 613
12.1.3 – State participation and state companies 618
12.1.4 – Form and nature of exploration and development agreements 618
12.1.5 – Investment protection 625
12.1.6 – Fiscal and currency regulation 627
12.1.7 – Operating conditions 628
12.1.8 – Environmental issues 632
12.1.9 – Dispute settlement 638
12.1.10 – Conclusions 638

Elizabeth Bastida, Carlos Valiente Noailles

12.2 – ARGENTINA, BRAZIL, MEXICO AND VENEZUELA 641
12.2.1 – Introduction 641
12.2.2 – Argentina 642
12.2.3 – Brazil 648
12.2.4 – Mexico 654
12.2.5 – Venezuela 659

Elena V. Novikova
12.3 – RUSSIAN FEDERATION 671
12.3.1 – Sovereignty 671
12.3.2 – Ownership and title to the underground petroleum resources 671
12.3.3 – Structure of the petroleum legislation 672
12.3.4 – Operating conditions 675
12.3.5 – State control and participation 676
12.3.6 – The price of oil and gas 676
12.3.7 – Contracting for goods and services 677
12.3.8 – Investment protection 678
12.3.9 – Environmental protection 678
12.3.10 – Currency regulation 679
12.3.11 – Applicable law 680
12.3.12 – Dispute settlement 680

XXIII
 Gulmira Utegenova
12.4 – KAZAKHSTAN 683
12.4.1 – Introduction 683
12.4.2 – Petroleum legislation 683
12.4.3 – The subsoil use contract 684
12.4.4 – State participation and key regulatory agencies 686
12.4.5 – Contract duration 687
12.4.6 – General structure of a subsoil use contract 687
12.4.7 – Tax regime of hydrocarbon contracts 688
12.4.8 – Environmental protection 692
12.4.9 – Insurance, governing law, stabilization 693
12.4.10 – Suspension and termination of subsoil use contracts 694
12.4.11 – Dispute settlement 695
12.4.12 – Protection of investments under international treaties 695
12.4.13 – Currency regulations 695

Mette Gravdahl Agerup

12.5 – NORWAY 697
12.5.1 – Sovereignty over the petroleum resources 697
12.5.2 – Ownership and title to the underground petroleum resources 697
12.5.3 – Structure of the petroleum regulation 698
12.5.4 – Operating conditions 701
12.5.5 – State participation through a state oil company or otherwise 702
12.5.6 – Fixing the price of oil or gas for tax and other purposes 703
12.5.7 – Fiscal structure 703
12.5.8 – The petroleum contract and the parties thereto 704
12.5.9 – Applicable law 705
12.5.10 – Dispute settlement 705

Michael Taylor
12.6 – UNITED KINGDOM 707
12.6.1 – Introduction 707
12.6.2 – The structure of petroleum regulation 708
12.6.3 – Operating conditions 710
12.6.4 – Pipelines 712
12.6.5 – UK oil and gas taxation regime 713
12.6.6 – Joint venture management 714
12.6.7 – Safety at work 715
12.6.8 – Environmental regulation 715
12.6.9 – Transfer of interest: licence assignments 716
12.6.10 – Abandonment and decommissioning 717

Mohammed Chemloul
12.7 – ALGERIA, LIBYA AND TUNISIA 721
12.7.1 – Algeria 721
12.7.2 – Libya 727
12.7.3 – Tunisia 735

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Sherif El Atfy, Mohamed M. Badran
12.8 – EGYPT 745
12.8.1 – Introduction 745
12.8.2 – Sovereignty over petroleum resources 745
12.8.3 – Ownership and title to underground petroleum resources 745
12.8.4 – The right to explore, develop, produce and dispose of petroleum resources 746
12.8.5 – Exploration and production terms, and expenditure commitments and bonuses 747
12.8.6 – State participation in the Egyptian Concession Agreement 748
12.8.7 – Pricing oil and gas under the Egyptian Concession Agreement 749
12.8.8 – The fiscal structure under the Egyptian Concession Agreement 750
12.8.9 – The parties of the Egyptian Concession Agreement 752
12.8.10 – Investment protection for exploration, development, and production operations in Egypt 752
12.8.11 – Environmental protection 754
12.8.12 – Applicable law to the Egyptian Concession Agreement 754
12.8.13 – Dispute settlement under the Egyptian Concessions Agreement 755

Adedolapo Akinrele
12.9 – NIGERIA 757
12.9.1 – Introduction 757
12.9.2 – Development of Nigerian oil and gas law 758
12.9.3 – Current structure of the Nigerian oil and gas sector 761
12.9.4 – State participation 762
12.9.5 – The impact of the law of the sea on Nigerian oil and gas law 764
12.9.6 – The licensing of oil and gas exploration and production 765
12.9.7 – Impact of environmental protection laws 767
12.9.8 – Development of natural gas 769
12.9.9 – Taxation of oil and gas 770

Atef Suleiman
12.10 – THE UNITED ARAB EMIRATES 773
12.10.1 – Introduction 773
12.10.2 – Sovereignty over petroleum resources 773
12.10.3 – Ownership and title to underground petroleum resources 774
12.10.4 – The structure of petroleum regulations and the operating conditions 774
12.10.5 – State participation through a state oil company or otherwise 777
12.10.6 – The price of oil and gas 778
12.10.7 – Fiscal structure 781
12.10.8 – The petroleum contract and the parties thereto 781
12.10.9 – Investment protection 782
12.10.10 – Environmental protection 782
12.10.11 – Currency regulation 782
12.10.12 – Applicable law 782
12.10.13 – Settlement of disputes 783

Msoud Vafakish Sistani

12.11 – IRAN 785
12.11.1 – Introduction 785
12.11.2 – Sovereignty over petroleum resources 786
12.11.3 – Ownership and title to underground petroleum resources 786

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 12.11.4 – The structure of petroleum regulations: the right to prospect, explore, develop, produce
and dispose of petroleum resources 787
12.11.5 – State participation through a state oil company or otherwise 787
12.11.6 – Buy-back agreements 788
12.11.7 – Investment protection 790
12.11.8 – Environmental protection 791
12.11.9 – Currency regulation 792
12.11.10 – Applicable law and settlement of disputes 792

Michael A.G. Bunter

12.12 – IRAQ 795
12.12.1 – Introduction 795
12.12.2 – The Islamic law and the early petroleum concessions in the Middle East 795
12.12.3 – Sovereignty over, and the ownership of petroleum resources and reserves 796
12.12.4 – Iraqi petroleum rights 797
12.12.5 – The Iraq Petroleum Company (IPC) concessions 799
12.12.6 – Modern geopolitics and the legal situation of Iraqi oil 801
12.12.7 – State participation and the nationalizations of the 1970s 802
12.12.8 – The Iraqi legal system 803
12.12.9 – The Iraqi legal framework of the petroleum sector 805
12.12.10 – Modern Iraqi draft petroleum agreements and contracts 806
12.12.11 – Arbitration in Iraqi law 808
12.12.12 – The legal status of the petroleum transactions negotiated by the Saddam regime 809
12.12.13 – Future developments 810
12.12.14 – The elections of 30 January 2005 811

Sultan M. Al-Abdulla
12.13 – QATAR 815
12.13.1 – Introduction 815
12.13.2 – Petroleum legislation 815
12.13.3 – Structure of operating conditions 816
12.13.4 – Petroleum operations with government participation 818

William L. MacBride Jr., Dana L. Hupp, Zhang Chunhe

12.14 – CHINA 821
12.14.1 – Sovereignty over petroleum resources 821
12.14.2 – Ownership and title to the underground petroleum resources 822
12.14.3 – Structure of the petroleum regulation 822
12.14.4 – Operating conditions 824
12.14.5 – State participation through a state oil company or otherwise 825
12.14.6 – Fiscal structure 827
12.14.7 – The Petroleum Contract and the parties thereto 828
12.14.8 – Investment protection 828
12.14.9 – Environmental protection 829
12.14.10 – Currency regulations 830
12.14.11 – Applicable law and the settlement of disputes 830

Mark Newbery
12.15 – INDONESIA 833
12.15.1 – Introduction 833

XXVI
 12.15.2 – Indonesian legal system: an overview 833
12.15.3 – Supervision of the oil and gas sector 834
12.15.4 – Upstream business activities 834
12.15.5 – Enviromental law and regional autonomy 839
12.15.6 – Downstream business activities 841
12.15.7 – Settlement of legal disputes 843
12.15.8 – Currency controls 844

13 – CONTRACTUAL REGULATION AND SETTLEMENT OF DISPUTES

Piero Bernardini
13.1 – CONTRACTUAL REGULATION WITH RESPECT TO EXPLORATION FOR
AND PRODUCTION OF HYDROCARBONS 847
13.1.1 – The oil contract 847
13.1.2 – Legal regulation 847
13.1.3 – Contractual regulation 848
13.1.4 – The evolution of the oil contract 850
13.1.5 – Conclusions 857

Paul Griffin, Silke Muter Goldberg

13.2 – IMPORT CONTRACTS AND TRANSPORT OF GAS 859
13.2.1 – Introduction 859
13.2.2 – Review of pipeline and LNG projects 860
13.2.3 – Structure of pipeline projects 860
13.2.4 – Some legal issues in relation to pipeline projects 861
13.2.5 – Allocation and attribution 863
13.2.6 – Structure of LNG projects 865
13.2.7 – Matters of general application 867
13.2.8 – Conclusion 877

Ahmed El Kosheri
13.3 – INTERNATIONAL ARBITRATION AND PETROLEUM CONTRACTS 879
13.3.1 – Introduction 879
13.3.2 – The arbitration precedents pertaining to the interpretation of the classical colonial type
of concession agreements 880
13.3.3 – The different solutions provided for under the arbitral awards rendered in absentia against
an expropriating host state 882
13.3.4 – Case law concerning disputes emerging under the second generation of petroleum
agreements 886
13.3.5 – The new rules conceived by the arbitral Tribunals 890

XXVII
 NOTES

UNITS OF MEASUREMENT

The units of measurement generally adopted are those of the Système International (SI), with corresponding mul-
tiples and submultiples. Only in particular contexts, typically connected with the petroleum industry, certain non-
SI units of current use have been maintained.

Main units of measurement adopted

ampere A henry H pascal Pa
angstrom Å hertz Hz poise P
atomic mass unit u horse-power hp pound lb
bar bar hour h pounds per square inch psi
barrel bbl inch '' (in) radian rad
becquerel Bq joule J second (angle) ⬙
British thermal unit Btu kelvin K second (time) s
calorie cal kilogram kg siemens S
candela cd kilowatt-hour kWh sievert Sv
coulomb C litre l
standard cubic foot scf or SCF or sft3
darcy D lumen lm
steradian sr
day d lux lx
stock tank barrel stb
decibel dB metre m
degree Celsius °C square metre m2 stokes St
degree Fahrenheit °F cubic metre m3 tesla T
degree (sexagesimal) ° minute (angle) ⬘ tonne t
electron volt eV minute (time) min tonnes of oil equivalent toe
farad F mole mol volt V
foot ' (ft) newton N watt W
gram g nit nt weber Wb
gray Gy ohm Ω yard yd
hectare ha parts per million ppm year yr

TERMINOLOGY AND SPELLING

In the sectors of petroleum engineering and chemistry, of the petrochemical industry and of the earth sciences,
specific terms, acronyms and expressions are frequently used. The criterion adopted in this work is based on their
frequency of use, i.e. given two possible terms, the more common one has been used. This criterion has also been
used for economics and law.
British spelling, according to the most authoritative reference works, has been adopted.

XXIX
 CHEMICAL NOMENCLATURE

In the nomenclature of simple compounds, the rules of IUPAC (International Union of Pure and Applied Chemistry)
have been adopted as far as possible, traditional names being limited to the cases admitted by IUPAC. When there
are two or more names admitted, the commonest one is adopted.
Two principal exceptions to the above rule have been applied in this work:
• For organic compounds used in the petrochemical industry, the name adopted is that listed in: Wells G.M.
(1999) Handbook of petrochemicals and processes, Aldershot, Ashgate; Brookfield (VT), Gower.
• The British English spelling of sulphur and sulphur containing compounds is adopted.

FOOTNOTE AND CITATION OF LEGISLATIVE TEXTS

Given the specialized terms used in economics and law regarding hydrocarbons, footnotes have been included that
provide information, observations, and comments that may also include references to the bibliography. References
to legal aspects and internet sites have also been included in the footnotes.
For the United States and Canada, there are some special cases regarding the citation of legislative texts. For Uni-
ted States and Canadian Acts, the Act has been named followed by the year. Where appropriate, such references have
been integrated, in the footnotes, using the standard citation models adopted by both countries.
Reference to the cases can be seen by the italics separated by v. (abbreviation of versus) in roman type, followed by
the year, the court and other references. If, however, a general reference is being dealt with, only the court, number
and date are supplied.

TRANSLITERATIONS

In writing names belonging to other languages with an alphabet other than the Latin alphabet, the Romanization
Tables compiled by the Library of Congress of Washington have been applied, introducing however certain modifications
intended to reduce to a minimum the number of diacritical marks, and – in particular in the case of Arabic and Persian –
adopting a number of transliterations by now accepted in local and international usage.

Opposite page:
Offshore platforms for the production of hydrocarbons in the Gulf of Suez (Egypt). The Belaym field is operated by the company
Petrobel, a joint venture in which Eni has a 50% share, through the company Ieoc, and Egpc, an Egyptian state company, has
the other 50%.
Eni’s presence in this country dates back to the 50s.

XXX
 HYDROCARBONS:
ECONOMICS AND POLICIES

1
MINERAL RESOURCES BETWEEN SCARCITY AND GROWTH

2
BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY

3
PUBLIC POLICIES AND THE OIL INDUSTRY

4
MARKET STRUCTURES AND PRICE POLICIES IN THE OIL
AND GAS INDUSTRY

5
KEY ACTORS IN THE HYDROCARBONS INDUSTRY
AND COMPANY STRATEGIES

6
THE NATURAL GAS INDUSTRY FROM MONOPOLY
TO COMPETITION

7
GEOPOLITICS AND SECURITY

8
PRODUCER-EXPORTER COUNTRIES

9
FUTURE SCENARIOS
 1.1
The economic theory
of exhaustible natural resources
1.1.1 Introduction
The contribution of economic theory (partly through a
reevaluation of history) is important both to interpret and
predict events, and to identify economic policies; this
happens especially when the world economy feels the
significant constraints imposed by some natural
resources and raw materials, partly due to the rapid
growth of a number of developing countries, and when
there is an urgent need to increase resources rapidly to
ensure continuing availability.
However, natural resource economics is
contradictory, although the problem of scarce resources
(of which natural resources are the most obvious
category) has been central to analysis for centuries. The
main reason for this is that economic theory is out of
step with prevailing economic conditions, as a
consequence of the varying concern for a crucial
phenomenon in the dynamics of economic systems: the
opposition-coexistence of the scarcity of natural
resources and the producibility of commodities. This
relationship is mediated by scientific and technological
progress which, in the long run, has gradually reduced
opposition and overcome scarcity until now.
Over the long term, the distinction between
exhaustible and renewable natural resources has been
weak, since all resources have been renewed and
augmented through substitution processes. Scarcities
have therefore always been relative rather than absolute.
Natural resource economics can be summarized by
dividing it into three main lines of thought: the theory of
producibility and scarcity developed by classical
economists; the theory of general and natural scarcities
developed by marginalists and neoclassicals; the theory of
dynamics with and without natural scarcities developed by
macroeconomists, structuralists and empirical stylizers.
Using this three-way subdivision, which is not
clearly codified in economic theory, the basic features of
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
each approach will be examined with special attention to
its early exponents. The literature on these themes is
extensive, but in our opinion, the central issue remains
unchanged: determining the influence of natural
resource scarcity on growth processes. The subject thus
has a specific focus and does not aim to provide a full
overview.
The historical starting point is the second half of the
Eighteenth century, although we will ignore
contributions such as those made by the Physiocrats
who, during the same period, developed a theory of
production based on the surplus generated by
agriculture.
This reevaluation will also closely follow some
earlier studies (Quadrio Curzio and Pellizzari, 1981;
Quadrio Curzio, 1997 and 1998).
1.1.2 Producibility and scarcity:
the classical dynamics
The years 1776 to 1871 saw the intellectual hegemony of
the classical economists: Adam Smith, Thomas R.
Malthus, David Ricardo and John Stuart Mill. Their
theory contained a grand design in which lie some
fundamental principles for future reflections on the
dynamics with natural resources. To summarize:
• The principle that the existence of a net product and
its accumulation are necessary conditions for the
growth of economic systems. The intensity and
continuity of growth increases in line with progress
which, in turn, depends on the ability, skill and good
judgement of labour. So Smith (1776) insisted on
man’s creative capacity, on the almost unlimited
producibility of goods and means of production.
• The principle that there is a structural gap between
population growth and the increase of food supply:
as the former grows according to a geometrical
3
MINERAL RESOURCES BETWEEN SCARCITY AND GROWTH
progression, it increasingly diverges from the latter,
which follows an arithmetical progression. Thus,
Malthus (1798) introduced the absolute scarcity of
natural agricultural resources, predicting a tragic
end for the dynamics of economic systems and for
humanity.
• The principle that in the dynamics of economic
systems, the ongoing constraints imposed by limited
natural resources could slow down or even halt
growth, leading to a stationary state, if technical
progress was insufficiently intense. Thus, Ricardo
(1817) introduced the relative scarcity of natural
resources, exploited in order of decreasing quality
and on which technical progress could operate by
limiting the constraints imposed by scarcity itself.
This key principle in Ricardian theory has four other
corollary principles: a) the rent is that part of the net
product which can be attributed to the natural
resource by virtue of the “original and indestructible
powers” which it brings to the production process. It
emerges as soon as the scarcity of the resource
begins to condition production, and increases in the
dynamic process which accentuates the scarcity
itself; b) the price of the product generated by the
natural resource (or, with reference to the Ricardian
context, the price of corn produced by the land) also
varies depending on the degree of scarcity, causing
resort to increasingly less productive resources or
expensive means of producing the same resource. As
a result, price levels also change with economic
dynamics, increasing in line with scarcity; c) the
rational use of scarce resources implies that they are
used in order of decreasing quality and productivity.
This leads to the principle of diminishing returns;
d) there is a relationship of interdependence between
raw materials and commodities.
• The principle of the inevitability and desirability of
the stationary state, since technical progress can only
delay the moment at which the economy reaches this
point. So, according to Mill (1848), a stationary state
is not negative, but may represent an ideal balance,
encouraging moral and social progress. No growth in
the population or wealth should not be interpreted as
no improvement. Considering the potential impact of
quantitative growth on the Earth’s beauty, Mill hopes
that man will choose a stationary state before being
forced to do so by the exhaustion of resources
resulting from population growth.
In conclusion, Ricardo came closest to the
opposition-coexistence paradigm. By reassessing
Malthus’ extremism and limiting Smith’s optimism, he
could have ascribed the essence of the dynamic workings
of economic systems to the scarcity-producibility
paradigm by admitting a process of continuous growth,
albeit with phases of stagnation. Unfortunately, he was
4 ENCYCLOPAEDIA OF HYDROCARBONS
unable to fully exploit the concept of relative scarcity
contained in his theory; by underestimating technical
progress, he ended up predicting the advent of the
stationary state without growth.
This is classical theory (which is sketchy regarding
many aspects but, nonetheless, magnificent) on the
principles of creation of the social product; its distribution
among wages, profits and rents; and its subdivision
between consumption and investments, on which the
growth over time of ‘the wealth of nations’ depends.
The contributions of later economists develop some
aspects of this theory and abandon others which
subsequent insights will see as being of extreme
importance.
This discussion will be highly selective, making
reference exclusively to those economists believed to be
most innovative.
1.1.3 From natural to general
scarcities: marginalists and
neoclassicals
Marginalist theory, which dominated from 1871 to 1936,
and neoclassical theory, which followed marginalist
theory, are based on the pairing exchange-scarcity: given
the scarcity of resources and individual preferences, all
economic problems are resolved through the efficient
use of these resources and exchange between the
individuals who own them.
Despite differences between the individual
economists belonging to these two schools of thought
and the tendency to oversimplify, we believe that they
shared a general theory of stationary scarcity covering
all production factors: land, labour and capital.
This explains why problems relating to natural
resources lose their specific identity, becoming
particular instances of a general theory of scarcity and
marginal productivity. It also explains the pivotal
importance of studying the conditions which allow for
the optimal use of resources (and not only natural
resources) which constrain production and consumption
in a stationary context. In a situation where all
production factors are scarce, the role of land in the
process of accumulation and of natural resources in
processes of growth, does not require specific analysis.
Nevertheless, even within this line of thought, there are
some specific studies of natural resources, although
these are not considered sufficiently important to form
the basis for a general theory.
Energy resources, intensive-extensive use, limitations
on development
The first contribution of note is by William Stanley
Jevons (1865), also considered a forerunner of

marginalism. He predicted the end of British industrial
supremacy due to the rapid exploitation and progressive
depletion of mines, leading to a loss of competitiveness
and development compared to other countries, richer in
natural resources. Jevons believed that an increase in the
energy efficiency of coal use could not prevent
stagnation, since this would not lead to more
preservation but to an increase in the scale of production
and, thus, more consumption. Essentially, technical
progress would lead to a less intensive use of coal which
would be more than offset by its more extensive use.
Jevons thus underestimated the potential of technical
progress to identify and develop alternative energy
sources, but his pioneering work highlighted a problem
which is still important, concerning the constraints
placed on a country’s development by the availability of
energy resources.
Use of natural resources and social well-being
The second contribution, considered the foundation
for all subsequent theories, is that of Harold Hotelling
(1931). In his famous article, Hotelling attempts to
define the rate of depletion allowing the owner of an
exhaustible resource to maximize obtainable profits.
Since the resource stock is limited, an increase in current
depletion entails a reduction in future depletion; to
maximize profits, under conditions of perfect
competition, the present value of price of the resource in
any given period, net of extraction costs, must be the
same; otherwise it would be possible to increase profits
by changing depletion in different periods. If extraction
costs are negligible, the resource must be depleted so as
to allow the price to grow in line with interest rates. With
this result, known as Hotelling’s rule, the ownership of
an exhaustible resource is equivalent to the ownership of
any other financial activity.
Hotelling shows that competitive depletion is also
socially optimal: the depletion rate of a mine which
maximizes obtainable profits also allows for the
maximization of the resource’s social value, whereas a
monopoly leads to a lower rate of depletion than that
which would be socially desirable. However, it is
important to observe that Hotelling demonstrated the
efficiency of the depletion rate under competitive
conditions, defining social well-being in terms of
resource consumption and discounting the benefits
deriving from future consumption; this procedure could
be heavily criticized for the differing importance
attributed to different generations.
Non-renewable resources: restrictions
on growth and technical progress
Hotelling’s work influenced an enormous quantity of
literature, especially during the 1970s, when the energy
crisis became manifest in all its severity. Within this
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
THE ECONOMIC THEORY OF EXHAUSTIBLE NATURAL RESOURCES
literature, which can be traced back to neoclassical
aggregate growth models, two different lines
of thought can be identified: one concerning
renewable resources and the other concerning
non-renewable resources. Both renewable and
non-renewable resources can be depleted; the former
can be regenerated and thus decrease, increase or remain
constant depending on the interactions between
depletion and natural regeneration capacity; the latter
are finite and the artificial regeneration process,
or recycling, where possible, is conditioned by costs
and technology.
Below, this discussion will be limited to
contributions concerning non-renewable resources.
Since it is impossible to describe each individual
study, their most important features will be
summarized. Often fairly complex in formal terms,
these contributions are similar in terms of the
techniques used, mainly the theory of optimal control,
and the issues tackled. These concern both the
problem of how best to deplete resources in
accordance with the constraints imposed by the
resource stock, the size of the work force and available
technology, and the problem of ascertaining if limited
availability may constrain potential growth.
Since the continuous depletion of non-renewable
resources inevitably leads to exhaustion, it becomes
important to predict if economic activity is sustainable
and whether a given level of per capita consumption can
be maintained (Stiglitz, 1974). Non-renewable resources
are a constraint when they are essential to production;
however, this constraint may be mitigated by technical
progress, which can lead to both lower consumption of
the exhaustible resource and the potential for recycling,
by lengthening the depletion period of the exhaustible
resource. Above all, however, technical progress can
allow for the substitution of these resources with others
available now or in the future.
Technical progress is thus crucial in order to counter
the constraints imposed by non-renewable resources and
studying the factors that encourage technological
advances becomes fundamental. Although some works
suggest that technical progress is exogenous, does not
entail costs and proceeds steadily, in more realistic
studies, technical progress depends on a series of
decisions (research, investment, etc) which cannot be
considered exogenous.
However, despite the inevitable uncertainties
regarding technology’s role in freeing us from the
constraints imposed by non-renewable resources, many
studies are characterized by an optimistic view of man’s
inventive capacity. They thus aim to develop rules for
non-renewable resource management, so as to ensure
that the decrease in stock is offset by an increase in
investments in human capital, and to ensure the
5
MINERAL RESOURCES BETWEEN SCARCITY AND GROWTH
maintenance of a given level of production and
consumption.
Non-renewable resources and optimal depletion
The optimal depletion of non-renewable resources
can be defined in terms of both social and private
objectives.
Socially optimal depletion must create the most
socially desirable situation, and therefore requires the
definition of those factors which influence social well-
being. In such analyses, the most important problem
derives from the fact that the term ‘social well-being’ is
heavily debated. Social well-being depends on the
availability of goods and services, but also on their
distribution. Thus, evaluating social well-being involves
a value judgement on the optimal distribution, both
within a given generation and among different
generations, posing the additional problem of what time
interval to consider.
Two specific concepts of well-being have frequently
been adopted in the literature on socially optimal
exploitation. The utilitarian approach (Dasgupta and Heal,
1974) states that social well-being is maximum when the
sum of the utilities due to consumption by different
generations is maximum. The utility of future generations
is thus discounted, a practice justified by some on the
basis of uncertainty but heavily criticized by others for the
differing importance attached to different generations. The
egalitarian approach (Solow, 1974b) is inspired by the
rules of distributive justice upheld by John Rawls (1971),
according to which the optimal path must equalize the
well-being of different generations at the highest possible
level. If social well-being is determined on the basis of per
capita consumption, well-being can be maximum only if
per capita consumption is maximum and constant over
time. These different concepts of social well-being have
had a crucial influence on the definition of the optimal
depletion policy.
Studies aimed at determining the optimal depletion
path for resource owners generally have as their
objective the maximization of the profits obtainable
from depletion. Since the depletion rate thus determined
may differ from that which is socially desirable, analyses
have been undertaken on the policies to be adopted in
order to eliminate divergences and allow for resource
depletion which is compatible with the maximization of
social well-being.
The determination of the optimal depletion rate from
a private point of view also poses the problem of the best
time-span to consider for the resource owner, despite the
absence of the problems of distributive justice
mentioned above. Since obtainable profits depend on the
relationship between the price of the resource and
depletion costs, this literature investigates the factors
which influence these variables. In particular, attempts
6 ENCYCLOPAEDIA OF HYDROCARBONS
are made to: a) determine the depletion path and the
price dynamics, with reference to different market
regimes; b) analyse the changes in the optimal path,
considering the potential substitution of the exhaustible
resource with other resources, both exhaustible and
renewable; c) analyse the potential for recycling and its
costs; d) analyse the potential variations in extraction
techniques, the costs of depletion, the prices of potential
substitutes, in the estimates of reserves, the rate of interest
and demographic dynamics. The variety of approaches
makes it impossible to present a detailed analysis here,
although it is worth considering some results referring to
specific hypotheses, showing the conditions which are
necessary along an optimal depletion path.
Exploitation of non-renewable resources and price
and royalty dynamics: a simplified model
A non-renewable resource differs from a normal
commodity in that it is non-producible and is available in
limited quantities. Current depletion thus has an
opportunity cost, given by the benefit of using the
resource in the future rather than at the present. This
opportunity cost, also known as the royalty, must be
taken into consideration in depletion decisions. It
accounts for the difference between the normal
requirement of efficiency in the use of producible
resources (which implies that the price and the marginal
extraction cost are identical) and in the use of
exhaustible resources (whose price must be higher than
the marginal extraction cost and equal to the depletion
cost, plus the opportunity cost).
A further condition for efficiency in the depletion of
exhaustible resources concerns variations in royalty and
price over time. If the depletion costs are negligible, the
price of a unit of extracted, or surface, resource is equal
to the price of a unit of resource in the ground, in other
words to the royalty; as already shown by Hotelling, both
must grow in line with interest rates. Even if the resource
owner decides not to deplete it, he thus has an income
because the value of the non-extracted resource grows at
the rate of interest.
Even when the marginal extraction cost is constant,
the royalty grows at the rate of interest; since the price is
equal to the sum of the royalty and the marginal
extraction cost, its trends will depend on the weight of
these two components. If the value of the royalty is
initially low when the amount of available resource is
high, the price of the resource (which is dependent on
the marginal extraction cost, assumed to be constant)
grows more slowly than the interest rate; the fact that the
resource is exhaustible thus has a minimal impact. As
time passes, however, since the royalty grows at the rate
of interest, its impact on the surface price of the resource
increases and the price thus tends to increase until it
reaches the interest rate.

However, there is a limit on price increases which
depends on the maximum marginal willingness to pay
for the exhaustible resource: in many studies, this limit is
represented by the price of a substitute. In the simplest
models, optimal depletion must involve price increases
so as to cancel out demand at the exact moment when
the resource is exhausted, simply decreeing the end of
the era of that resource (Solow, 1974a). If there are
substitutes which are not currently competitive, optimal
depletion must entail price increases to allow for the use
of other previously unused resources, and the resource
must be exhausted at the point when it becomes
economically viable to use the substitute. If there are no
current substitutes, optimal depletion must entail price
increases to encourage both a greater efficiency in the
use of the resource and greater investments in the search
for alternative resources.
Non-renewable resources: scarcity and efficiency
The analytical scheme described above has been
used to investigate how depletion paths should be
modified. It considers that the depletion of exhaustible
resources begins with the best and most easily accessible
reserves, with effects on the dynamics of extraction
costs; knowledge of the resource stock is limited, but can
be improved by exploration and research activities.
Further alterations in important parameters and
functions have been introduced in later models in order
to render the analysis of non-renewable resource
depletion more realistic. However, despite these
innovations, contributions to this line of research seem
directed more at analysing the problems posed by the
scarcity of natural resources in terms of efficiency than
in terms of constraints on growth.
1.1.4 Dynamics with and without
natural scarcities:
macroeconomists,
structuralists, stylizers
Since economic theory never develops in a linear
fashion, a single problem often attracts opposing,
compatible or complementary theories. Thus, during the
1940s, while the neoclassicals continued their analysis,
theories based on classical economics emerged
successfully to tackle the dynamic phenomena of
economic systems. The interest in this field had never
completely disappeared, as demonstrated by Joseph
Alfred Schumpeter who developed a dynamic theory in
1911, which was elaborated upon during subsequent
decades. However, it was probably the study by John
Maynard Keynes (1936) which brought to the fore a
macroeconomic approach based on the classicals
(Pasinetti, 1977). It also became apparent during these
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
THE ECONOMIC THEORY OF EXHAUSTIBLE NATURAL RESOURCES
years that technical progress had been constant in the
economies of industrialized countries for over a century,
with increases in production capacity through
accumulation.
Below, we will examine some exponents of this
approach, subdividing them into macroeconomists,
optimistic structuralists and realistic structuralists, and
empirical stylizers.
Macroeconomists
Roy Forbes Harrod (1939 and 1948) examines the
accumulation of capital, the dynamics of the work force
and technical progress. As far as natural resources and
land are concerned, after essentially restating classical
theory, Harrod accepts the theory of a driving force due
to accumulation, but criticizes it for various aspects and
abandons two: population dynamics, which for Harrod
become exogenous; the dynamics of diminishing returns
from land, which he considers quantitatively negligible
so that he does not attribute a role to natural resources in
his dynamic theory.
In the neoclassical macrodynamic mould, Robert
Solow (1956) assumes that there are no scarce resources
which cannot be augmented, stating that the introduction
of a scarce earth factor would obviously lead to
Ricardian diminishing returns. Essentially, these
reformulations of dynamic theory underestimate scarce
resources, as is apparent also in important reviews of
growth theories (Hahn and Matthews, 1965).
Optimistic structuralists
Optimistic structuralists develop multisectoral
models. The first in chronological order, in 1937, is John
von Neumann (1945-1946), who tackles the problem of
maximum growth; albeit with numerous significant
differences, he also lays the foundations for the approach
based on industrial interdependencies adopted by
Wassily Leontief (1941 and 1953). Other economists
proceed along the same lines, including Luigi Lodovico
Pasinetti (1965 and 1981).
For von Neumann, goods are products not only of
natural production factors but, above all, of themselves.
This means that natural production factors, including
labour, do not pose problems for growth. The limitations
on scale imposed by natural production factors is thus
denied, although their role in production is recognized.
Leontief is more cautious, although whilst
considering all sectors which treat raw materials in his
theoretical and empirical work, he does not examine the
limitations of scale imposed by natural resources on the
production system. In this context, he writes: “Invisible
in all these tables, but ever present as […] a whole
additional set of factors determining this country’s [the
USA’s] productive capacity and, in particular, its
comparative advantage vis-à-vis the rest of the world, are
7
MINERAL RESOURCES BETWEEN SCARCITY AND GROWTH
the natural resources […] Absence of systematic
quantitative information, similar to that which has been
collected […] with respect to capital and labour,
prevents us as yet from introducing this important
element explicitly into this preliminary analysis”
(Leontief, 1953).
Pasinetti is another economist who has developed
multisectoral models, but without considering natural
resources and the constraints which these place on
dynamics. However, he does consider accumulation,
technical progress, the distribution of income and human
capital.
These structural theories represent extremely
important contributions to an understanding of
dynamics, technologies, technical progress and
accumulation. However, they lie at the opposite extreme
to the marginalist approach, moving from generalized
static scarcity to absolute dynamic producibility and
ignoring relative dynamic scarcity, in which natural
resources matter. The return to the classicals is thus more
Smithian than Ricardian. Of the pairing scarcity-
producibility, more importance is attributed to the latter
in the often implicit belief that technical progress and the
rapid growth of industrialized economies eliminates the
constraints imposed by resources. These authors are
therefore fundamentally optimistic.
Realistic structuralists
A structural theory which espouses the role of land
and raw materials is that of Piero Sraffa (1960),
developed as early as the 1930s. This theory deals
mainly with the relationships between the distribution of
income (salaries, profits, rents), the prices of
commodities and raw materials, and the choice of
production techniques in a one-period context.
This theory, described as neo-Ricardian by some,
devotes little space to natural resources, but borrows
some important categories from the classicals. This leads
to subsequent theories including natural resources
which, for dynamic analysis, have also made use of
variations on multisectoral models like those developed
by von Neumann and Leonfief. We refer in particular to
the approach adopted by Alberto Quadrio Curzio (1967)
and taken up in studies by other authors (for a review:
Quadrio Curzio et al., 1996; Quadrio Curzio, 1997),
including those by Quadrio Curzio and Fausta Pellizzari
(1981 and 1996) which includes all the previous
contributions, also dealing with many other problems.
These works are about natural resources and raw
materials in multisectoral production theories, both one-
period and dynamic. Two sets of production sectors are
considered, with analytical simplifications: in the first
set, each specific sector produces a single commodity
with the use of commodities and produced means of
production; the second set comprises sectors which also
8 ENCYCLOPAEDIA OF HYDROCARBONS
make use of non-produced means of production, i.e.
natural resources (such as land) and which generate raw
materials (such as corn), also used as means of
production in the first set of sectors.
These studies do not consider the isolated instance of
a single natural resource, but rather the productive
interdependence of the whole economy, prices and the
distribution of income. As such, the theory has four
central categories.
Natural resources and raw materials. The most
obvious distinction is between reproducible and non-
reproducible resources, not always crucial considering
the long-term substitutability linked to technical
progress. In other words, not everything comes down to
the distinction between land and agricultural raw
materials (renewable) on the one hand, and mineral
deposits (exhaustible) on the other.
In a one-period context, the difference between
reproducibility and non-reproducibility loses
significance. A mineral deposit, measured in terms of
volume or surface units per unit of raw material
produced, has the same impact on production as land
does on corn. Furthermore, several deposits are usually
in production given the limited extraction capacity of
each, per given time unit, compared to the level of
production required. This is the case for lands of
differing quality.
In a dynamic long-term context, all natural resources
are historically reproducible, since scientific and
technical progress has always moved the constraints
imposed by scarcity forwards, albeit with slow growth
and complex substitution mechanisms. For this reason,
the distinction between reproducible and non-
reproducible resources in the long term is not,
historically, crucial.
Intensive rents and extensive rents. Rents are
coessential with natural resources and are part of the net
national product which can be attributed to scarce
resources. There are two types of well-known rents from
scarce natural resources: intensive and extensive.
Restricting this discussion to extensive rents, which may
include intensive rents, these emerge when two or more
natural resources of differing quality are in activity, each
producing a homogeneous raw material.
The analysis of rents establishes two orders for
scarce natural resources: the order of efficiency and the
order of rentability. The first depends on costs per unit of
product and on production per hectare, and is the one
adopted in producing lands. The second explains how
rents behave in already active processes, when the
economic system’s level of activity grows by increasing
the number of land processes in operation.
Techniques and compound technologies. Techniques
are characterized by a multiplicity of interdependent
sectors, each using a natural resource and producing a

raw material involved directly or indirectly in the
production of all other commodities. Technologies, on
the other hand, are n active techniques, since each has a
maximum production scale restricted by the scarcity of
the natural resource used.
This concept also leads to an analysis of how the
technology is modified within the dynamics as a result
of the existence of non-produced natural resources and
means of production. On the basis of a compound
technologies scheme, with a multiplicity of techniques
each characterized by a non-produced natural resource
or means of production, the composition of these
techniques in processes of accumulation and growth is
analysed. This involves a complex analysis of orders of
efficiency (dynamic-physical, dynamic-values and
dynamic prices-distribution) among techniques and thus
their order of activation in accumulation and in the
dynamics itself. This results in various dynamics which
are non-proportional due to the different structure of
technologies, depending on the differing importance of
production surpluses which cannot be accumulated.
Technical-technological progress. Technological
scarcity is inversely related to technical progress. A
complex series of technical progresses is identified
(structural, natural, linear, absolute, relative) since in the
compound technologies model, progress can only be
classified through reference to numerous variables. The
distinction between progress in a technique and in a
technology makes it possible to evaluate the
interrelationships between technical and technological
progress. This distinction also makes it possible to
determine the consequences of these progresses
regarding the extent to which the economic system can
accumulate and grow, and weaken the constraints
imposed by non-produced means of production.
This structural analysis, whilst certainly schematic
and incomplete, clearly shows elements of realism. It
takes into account the constraints imposed by natural
resource scarcity, as well as history – albeit briefly in the
classification of different types of technical progress. It
should not be forgotten that historically, the constraints
imposed by natural resources have always been
overcome in the long term.
Empirical stylizers
This name covers a variety of different types of
analysis which share stylized historical or quantitative
methods, extremely important in reducing the gap
between the abstractions of pure theory and the full
description of phenomena. This has led to the
construction of an extremely important semitheory
which has produced some significant results and
complements to pure theory.
The first line of research of interest here is the
historical-quantitative study of growth and development,
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
THE ECONOMIC THEORY OF EXHAUSTIBLE NATURAL RESOURCES
which gathered momentum in the 1930s with the
fundamental contributions by Simon Kuznets (for a brief
overview: Kuznets, 1990).
Kuznets believes that attention should again be
focused on long-term dynamics, in the mould of the
classical economists, and on century-long dynamics
which contain shorter cycles. The historical-quantitative
approach is extended by Kuznets, in his numerous later
works, to other central issues in development such as: a)
the relations between demographic trends and economic
development; b) the influence of technological
innovations; c) structural transformations; d) historical
tendencies to inequalities in income; e) the accumulation
of capital; and f ) the limited international spread of
development.
This historical-quantitative theory thus shows the
complexity of development, dealing with natural
resources and the environment when: examining the
structural transformations of the economy and
agriculture; examining the accumulation of capital;
analysing technological innovations and their importance
for energy and industrial activities; analysing the impact
of innovations on the environment.
In short, it can be said that Kuznets is optimistic
regarding the ability of technologies to respond, through
adaptation mechanisms, even to the negative effects on
the environment which they may initially cause.
The other line of analytical-quantitative thought
worth mentioning here is Leontief’s (1977), applied to
natural resources. It should be remembered that his
contribution has been included by some in the category
of large global predictive models which originated in the
1970s. This pairing seems unconvincing, partly because
whilst Leontief bases his work on economic theory,
global models are non-theoretical predictions, and partly
because Leontief, to some extent, reacts against those
global models which make extremely pessimistic
predictions about the exhaustion of natural resources and
the fear that the world economy will collapse. These
models support the concept of an absolute scarcity of
natural resources, leading to proposals that a generic
condition of ecological and economic stability should be
attained, a sort of stationary state (Meadows et al.,
1972).
Leontief develops a model of the world economy
based on the economic theory of input-output, reaching
the conclusion that natural resources-raw materials are in
a condition of relative scarcity. The model consists of
various interconnected input-output submodels relating
to different parts of the world, analysing the
interrelationships between the production and
consumption of goods and services, and that of natural
resources. Leontief’s conclusion is very similar to that of
Kuznets, and can be summarized as follows: “the
principal limits to sustained economic growth and rapid
9
MINERAL RESOURCES BETWEEN SCARCITY AND GROWTH
development are political, social and institutional in
character rather than physical. No insurmountable
physical barriers exist within the Twentieth century to
the accelerated development of the developing regions ”
(Leontief et al., 1977).
A new interest in global modelling has emerged in
parallel with environmental concerns when these have
been perceived as dangers of a systemic global nature in
recent years. Alongside the increasing production of
global ecological models – especially those for climate,
and large multidisciplinary models of the large-scale
interactions between ecological and social systems –
there has been a resumption of global modelling in the
1970s mould, or similar to it, mentioned but not dealt
with in detail here.
In conclusion, we believe that there is a continuing
opposition between approaches dealing with global
constraints and absolute scarcity, and those dealing with
relative scarcity. This divergence results from the
different evaluations of the potential impact of
innovation and its generation mechanisms, which still
appears to be the most divisive element between the two
approaches, even in their most recent environmentally-
oriented form.
References
Dasgupta P.S., Heal G. (1974) The optimal depletion of
exhaustible resources, «The Review of Economic Studies»,
41: Special volume for the Symposium on the economics
of exhaustible resources, 3-28.
Hahn F.H., Matthews R.C.O. (1965) The theory of economic
growth: a survey, in: American Economic Association-Royal
Economic Society, Surveys of economic theory, London,
Macmillan, 1965-1966, 3v.; v.II.
Harrod R.F. (1939) An essay in dynamic theory, «The Economic
Journal», 49.
Harrod R.F. (1948) Towards a dynamic economics, London,
Macmillan.
Hotelling H. (1931) The economics of exhaustible resources,
«The Journal of Political Economy», 39, 137-175.
Jevons W.S. (1865) The coal question: an inquiry concerning
the progress of the nation, and the probable exhaustion of
our coal-mines, London, Macmillan.
Keynes J.M. (1936) General theory of employment interest and
money, London, Macmillan.
Kuznets S. (1990) Popolazione, tecnologia, sviluppo, Bologna,
Il Mulino.
Leontief W. (1941) The structure of the American economy,
1919-1929, Cambridge (MA), Harvard University Press.
Leontief W. (1951) The structure of the American economy,
1919-1939, New York, Oxford University Press.
Leontief W. (1953) Domestic production and foreign trade.
The American capital position re-examined, «Proceedings
of the American Philosophical Society», 97, 332-339.
Leontief W. et al. (1977) The future of the world economy,
New York, Oxford University Press.
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Malthus R. (1798) An essay on the principle of population,
London, Johnson.
Meadows D.H. et al. (1972) The limits to growth. The first
report to the Club of Rome, New York, Universe Book.
Mill J.S. (1848) The principles of political economy with some
of their applications to social philosophy, London, Parker.
Neumann J. von (1945-1946) A model of general economic
equilibrium, «The Review of Economic Studies», 13.
Pasinetti L. (1965) A new theoretical approach to the problems
of economic growth, Città del Vaticano, Pontificiae
Academiae Scientiarum Scripta Varia.
Pasinetti L. (1977) Dalla dinamica classica alla dinamica
keynesiana, in: Sviluppo Economico e distribuzione del
reddito: saggi di teoria economica, Bologna, Il Mulino.
Pasinetti L. (1981) Structural change and economic growth,
Cambridge, Cambridge University Press.
Quadrio Curzio A. (1967) Rendita e distribuzione in un
modello economico plurisettoriale, Milano, Giuffré.
Quadrio Curzio A. (1997) Rendita, in: Enciclopedia delle
Scienze Sociali Treccani, Roma, Istituto della Enciclopedia
Italiana Treccani, 1991-2001, 9v.; v.VII, 395-407.
Quadrio Curzio A. (1998) Risorse e rendita: un contributo
teorico con premesse storiche, «Il Risparmio», 3, 417-441.
Quadrio Curzio A., Pellizzari F. (1981) La teoria economica
delle risorse naturali: una storia sofferta e imbarazzante
ma aristocratica e creativa, «Energia», 2, 14-29.
Quadrio Curzio A., Pellizzari F. (1996) Risorse, tecnologie,
rendita, Bologna, Il Mulino.
Quadrio Curzio A. et al. (1996) Materie prime, in:
Enciclopedia delle Scienze Sociali Treccani, Roma, Istituto
della Enciclopedia Italiana Treccani, 1991-2001, 9v.; v.V,
559-575.
Rawls J. (1971) A theory of justice, Cambridge (MA), Harvard
University Press.
Ricardo D. (1817) On the principles of political economy and
taxation, London, John Murray.
Schumpeter J.A. (1949) The theory of economic development,
Cambridge (MA), Harvard University Press.
Smith A. (1904) An inquiry into the nature and causes of the
wealth of nations, London, Methuen, 2v.
Solow R.M. (1956) A contribution to the theory of economic
growth, «Quarterly Journal of Economics», 70, 65-94.
Solow R.M. (1974a) The economic of resources or the resources
of economics, «The American Economic Review», 64,
1-14.
Solow R.M. (1974b) Intergenerational equity and exhaustible
resources, «The Review of Economic Studies», 41: Special
volume for the Symposium on the economics of exhaustible
resources, 29-45.
Sraffa P. (1960) Produzione di merci a mezzo di merci, Torino,
Einaudi.
Stiglitz J.E. (1974) Growth with exhaustible natural resources:
efficient and optimal growth paths, «The Review of
Economic Studies», 41: Special volume for the Symposium
on the economics of exhaustible resources, 123-137.
Alberto Quadrio Curzio
Fausta Pellizzari
Roberto Zoboli
Università Cattolica del Sacro Cuore di Milano
Milano, Italy
ENCYCLOPAEDIA OF HYDROCARBONS
 1.2
Technological innovation,
relative scarcity, investments
1.2.1 Innovation and resource use
efficiency: stylized facts
The role of technological innovation for resources
use and conservation is often measured by empirical
indicators of intensity or efficiency which express
the evolution of resource use in relation to variables
such as population and GDP. The historical
evolution of these indicators tends to indicate a
process of decoupling – in other words, a decrease
in the energy/emissions intensity of economic
activity or an increase in the efficiency/productivity
of resource use.
These empirical regularities have led to the
proposition of stylized facts representing the
relationships between resource-use efficiency and
economic growth known as environmental Kuznets
curves (Stern, 2004), given their similarities with the
regularities identified by Simon Kuznets (1955) in the
long-term relationships between economic growth and
the distribution of income.
The importance of these indicators lies also in the
fact that some international and national institutions
use them to evaluate the effectiveness of energy-
environmental policies and sustainability strategies
(IEA, 1997, 2001a,b; OECD, 2002; DEFRA/DTI,
2003; EEA, 2003).
Furthermore, some countries tend to set
intensity/efficiency targets for important policies; an
example is the target on emissions intensity in relation
to GDP adopted by the United States in its own
climate policy as an alternative to the Kyoto Protocol
target based on emission levels.
However, the economic interpretations of the
innovation mechanisms underlying the progress
suggested by efficiency indicators, nonetheless,
remain open and complex at the very time when there
is increasing demand for further substantial advances
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
in resource-use efficiency. This chapter will survey the
empirical evidence on the medium- and long-term
dynamics of these indicators and will discuss their
significance. This will be followed by an analysis of
the possible role played by economic factors
(especially resource prices and markets) and
institutional factors (especially climate policy) in
triggering and supporting progress in the use
efficiency of energy resources.
Decoupling indicators and environmental Kuznets
curves: meaning and limitations
With reference to a scheme of type I⫽P⭈A⭈T,1 the
total impact (I, e.g. the consumption of energy) can be
expressed as the product of the impacts of population
P, affluence A, i.e. the level of development measured
by per capita GDP, and of the impact per unit of
economic activity, i.e. I/GDP, as an indicator of the
system’s technology, T. Thus formulated, this is an
accounting identity, useful for the decomposition
analysis of the relative role of P, A and T in the
evolution of I over time or its differing levels in
different countries.
The role of P and A as pressure factors (generally
increasing) pushing I to increase is obvious, whereas T
is an intensity indicator which measures how many
‘impact units’ are required by an economic system (or
by a sector) to produce one unit (one euro) of GDP. It
is therefore a technical coefficient which, if referred to
the system, represents its overall efficiency in the use
of a given resource and expresses the average state of
technology in a highly stylized way. A decrease in T
over time indicates an increase in efficiency, and may
1 Starting from Ehrlich’s formulation (1971), numerous
variants of this scheme have been used to study the
dynamics of global resources, especially in relation to
population.
11
MINERAL RESOURCES BETWEEN SCARCITY AND GROWTH
be considered a direct indicator of decoupling between
economic activity and resource use.
IPAT-like schemes highlight three features of
decoupling analysis and Kuznets curves. First, if the
dynamics of T alone are examined, this may provide
misleading indications of the crucial or even exclusive
role of technological innovation for resource-related
problems. The decrease in T may be strong, but I may
be stable or increasing if increasing efficiency is
insufficient to offset the scale effect caused by the
growth of P and A. The reverse may also occur in
phases when poor economic growth (decrease in A)
causes I to decrease, but not T, as was the case in
Eastern Europe and Russia at the beginning of the
‘transition to the market’ in the 1990s. Therefore, a
decrease in I is always a positive sign for resources,
but it may not result from a structural improvement in
the specific efficiency of resource use (i.e. in T); by
contrast, a decrease in T always indicates a structural
increase in efficiency, but does not necessarily mean
that total resource use (i.e. I) is declining. The
ambiguous implications of decreases in T are
important, for example, in the case of global
greenhouse gas emissions, where T is deceasing
(efficiency is increasing) but I is increasing. This is
important, for example, in appraising the United States
climate policy, which sets a target for the emissions
intensity of GDP, i.e. for T, in contrast to the emissions
level target, i.e. for I, adopted by the Kyoto Protocol.
In this case, even significant achievements on the
T-based targets do not necessarily mean a successful
policy in terms of I, which is the environmentally
relevant variable.
Second, although a decrease in T indicates that
something positive is occurring in the system, this
must be explained in technological and economic
terms. In the IPAT scheme outlined above, it is
assumed that the variables P, A and T are independent
of one another. In fact, the dynamics of economic
systems show that these three variables are
interdependent, due to a series of direct and indirect
causal links and, over the medium to long term, to
dynamic feedback mechanisms. For example, the
evidence suggests that population dynamics (P)
depend partly on the dynamics of per capita income
(A) and, to some degree, vice versa.2 Similar
relationships and feedback mechanisms also emerge
for T, whose dynamics may depend on GDP (per
capita), and vice versa if T refers to a key resource
such as energy. Furthermore, the dynamics of I may
also influence that of T if the scarcity signalled by the
impact stimulates, through the markets (relative
prices) or policies, processes of invention, innovation
and diffusion of new technologies, resulting in specific
efficiency in the use of that resource. In practice, a
12
decrease in T reflects a complex combination of
economic and technological micro- and
macro-processes, including dynamic feedback
mechanisms, which are of a heterogeneous,
non-deterministic and partially endogenous nature.
These will be discussed in detail in the remainder of
this analysis.
Third, Environmental Kuznets Curves (EKC)
concern precisely some of the relationships mentioned
above, for example, between I and GDP or between T
and GDP ( per capita); however, though they may
supply empirical regularities of great heuristic interest,
they do not provide a satisfactory economic
explanation for them. The hypothesis suggested by the
EKC is, in short, that an inverted U relationship
between resource consumption and per capita GDP
can be documented for a certain number of resources,
pollutants and energy sources. Consumption (of
energy) or emissions (of pollutants) initially increase
when levels of economic development are relatively
low, since a scale effect, driven by A and P, prevails;
they later tend to decrease more or less proportionally
when levels of economic development are higher,
becoming decoupled from per capita GDP due to the
predominance of an efficiency effect driven by T .3
Like its original Kuznetsian formulation for income
distribution, this hypothesis is based not on a
theoretical model but on an insight originating from,
and supported by, empirical evidence. Only recently
have some studies attempted to formulate the EKC
hypothesis in formalized models (Andreoni and
Levinson, 2001; Chimeli and Braden, 2005).
This discussion will not cover the theoretical
formalization and different formulations of EKCs. It is
worth noting, however, that if the formulation
concerns a relationship between I and GDP ( per
capita), the analysis of EKCs supplies the same
information as the analysis of T. Furthermore, if an
EKC relationship between I and GDP ( per capita) is
hypothesized, there must also be one between T and
GDP because P and GDP always increase (with some
exceptions) in the medium-long term, and decoupling
must therefore have occurred at some level of GDP. By
contrast, if there is an EKC relationship between T and
GDP (per capita), this does not necessarily mean that
there is a similar relationship between I and GDP,
since P and GDP may have driven I more than could
2 For a survey of the different viewpoints of economists
on the positive or negative effect of population on economic
growth: Zoboli, 1996.
3 For a presentation of EKCs with a discussion of the
main hypotheses and empirical evidence: De Bruyn et al.,
1998. Detailed surveys of the literature are presented in:
Dasgupta et al., 2002; Dinda, 2004; Stern, 2004.
ENCYCLOPAEDIA OF HYDROCARBONS

be offset by the decrease in T. This is true, for
example, for global CO2 emissions (see below).
The main limitation is that by identifying GDP
(per capita) alone as the principal explanatory
variable, the analysis of EKCs suffers from the same
limitations as the analysis of decoupling, or of T, but
with an additional danger. The empirical evidence
provided by EKC relationships might actually give the
misleading impression that rapid growth towards high
levels of per capita GDP automatically leads to
efficient resource use, and that the best policy for
reducing their environmental impact is economic
growth. However, the IPAT scheme indicates that a
growth in GDP ( per capita) necessarily leads also to a
scale effect on resource consumption and emissions
for each level of T and P.
Generally speaking, only if the negative effects of
the increase in GDP (per capita) on T are constantly
higher than its positive effect on I, can the process of
economic growth lead to an absolute decrease in I,
assuming the effect of population growth as given.4
This is important for global energy consumption and
greenhouse gas emissions, given the rapid growth of
population and income in developing countries. The
negative elasticity of T on the growth of per capita
GDP will need to be extremely high in the near future,
due to a stationary or even increasing T in many of
these countries, in order to avoid a possible
‘catastrophe of scale’ resulting from the dynamics of
income and population. Therefore, although the
relationship between economic growth and
environmental efficiency is an important stylized fact,
economic growth remains only an implicit explanation
of environmental efficiency and does not obviate the
need for explicit strategies to improve T through
specific innovations.
Indicator trends and empirical analyses
Indicators of energy intensity/efficiency and of
emissions from energy sources (i.e. T in the above
scheme) have been monitored for years by various
international bodies (such as the IEA, International
Energy Agency), national agencies (such as the US
Department of Energy, DOE) and other institutions.
Despite a constantly increasing energy consumption,
the emerging trends are towards an increasing energy
intensity of GDP (primary sources) only in those
developing countries with low development but rapid
growth, and a constantly decreasing energy intensity
of GDP in all other countries.
The consumption of primary energy per unit of
GDP was already decreasing by the late Nineteenth
century in the United Kingdom, and by the 1920s and
1930s in the United States, Germany and France. In
Italy, delayed industrialization led the energy intensity
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
TECHNOLOGICAL INNOVATION, RELATIVE SCARCITY, INVESTMENTS
of GDP to increase until the 1950s, although it
remained structurally low in comparison to other
countries, followed by decreasing intensity from then
until the present. From the 1970s, coinciding with the
oil shocks, these trends were further consolidated,
spreading to all developed countries. In Germany, for
example, real GDP increased by 50% between 1970
and the early 1990s, whereas the consumption of
primary energy remained almost constant.
The decline in the energy intensities (primary
sources) has recently involved numerous developing
countries still in the initial phases of industrialization.
In China, for example, despite an enormous increase
in the demand for energy, the reforms in the late
1970s, aimed at raising energy prices, led the energy
intensity of national income to decrease by 50%
between 1980 and the late 1990s (Zhang, 2000).
Numerous studies have investigated the general
and specific factors involved in the decrease of energy
intensities over time. Generally speaking, decreases in
individual developed countries can be ascribed to:
changes in the sectoral mix of the production
structure, especially the relatively decreasing weight of
energy intensive sectors, partially reflecting changes in
the division of labour between countries on a global
scale; substitution between sources and changes in the
energy mix, resulting in higher economic output at any
given level of total energy consumption; specific
technological innovations for energy conservation and
efficiency.
The decline in the energy intensity of output has
led to a parallel decrease in the intensity of CO2
emissions in relation to GDP, magnified by the
‘decarbonization’ of energy consumption through a
continuous transition towards sources with lower
specific emissions. In the United States, the carbon
intensity of primary energy consumption has fallen by
0.25% per year since 1800, whereas the corresponding
decrease worldwide has been 0.3% from 1850
(Gruebler et al., 1999).
These efficiency processes intensified significantly
after the 1970s, when energy price increases and the
resulting perception of energy scarcity led to the
adoption of technological strategies and policies to
encourage energy conservation (Martin, 1990; Casler
and Afrasiabi, 1993; Rosenberg, 1994, 1996). In some
cases, decreasing intensity and greater energy
efficiency derived from non-specific innovations.
4 If I⫽f (P,A,T), where A is an indicator of economic
development, with ⭸IⲐ⭸A, ⭸IⲐ⭸P, ⭸IⲐ⭸T ⬎0 and T⫽g(A),
with dTⲐdA⬍0, the total derivative of I on A will be negative
if ⭸IⲐ⭸A⬍⭸IⲐ⭸T⭈dTⲐdA, i.e. if the direct positive effect of A
on I is less than the negative effect of A on T, given the
effect of T on I.
13
MINERAL RESOURCES BETWEEN SCARCITY AND GROWTH

Fig. 1. Dynamics
800
of real global GDP 700
and CO2 emissions 600

index 1950=100
from fossil fuels. 500
400
300
200
100
0

1950
1952
1954
1956
1958
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
year

global GDP global CO2 emissions

These include changes in material use in some sectors
which, as a result of lightness and dematerialization,
have led to lower energy requirements for the same
function. Similar developments towards greater use
efficiency in relation to GDP have emerged for most
industrial materials. In the case of minerals and metals
– which have historically seen the coexistence of
materials whose use intensity increased and decreased
in relation to GDP – the 1970s represented a turning
point, and the worldwide decline in use intensity has
extended to almost all metals (Tilton, 1989; Considine,
1991; Labson and Cropton, 1993; Fortis, 1994).
Towards the end of the 1990s, the decline in energy
intensity slowed in many countries, which can broadly
be attributed to decreases in the real prices of fossil
fuels; however, this did not reverse the basic trend
towards greater efficiency (see below).
Although this evidence supports the idea that there
is a Kuznets curve for energy, the studies of EKCs
have mainly concerned emissions of pollutants and the
greenhouse effect, in connection with policies to
combat climate change. The first studies on the
relationships between atmospheric emissions and
Fig. 1, clear indications emerge, at least on the global
level. This shows that CO2 emissions from fossil fuels
have decoupled from global GDP since the 1970s,
reflecting the structural changes which had occurred
for energy. However, emissions continue to increase
and the decoupling is therefore ‘relative’, i.e. a
decrease in emission intensity, rather than ‘absolute’.
This is due to the impact of other macrofactors such as
population and real per capita income, which have not
been offset enough by increased efficiency. Albeit with
some differences, this is the situation in most
individual countries.
Figs. 2 and 3 show the same processes in a very
long term perspective, from 1870 to 2000, in terms of
Kuznets curves.6 Emissions continue to increase as
real global GDP grows, although to a lesser extent,
and there is thus no Kuznets curve for emission levels.
However, an EKC relationship does appear to exist for
5 For some environmental problems, such as waste
production, there is no evidence for progress in line with a
Kuznets curve (Mazzanti and Zoboli, 2005a).
6 In Figs. 2 and 3, the data on emissions from fossil

income in the quest for a Kuznets curve date back to
the early 1990s (Holtz-Eakin and Selden, 1992; Ten
Kate, 1993; Grossman and Krueger, 1994; Selden and
Song, 1994). These were followed by numerous
studies debating the statistical-econometric aspects
and the economic interpretation of environmental
Kuznets curves (Yandle et al., 2002), gradually calling
into question the reliability of the empirical evidence.5
In the case of CO2 emissions from fossil fuels, the
tendency to decouple from economic development has
been studied with divergent results, both for individual
countries and globally. This results partly from the
small time span considered and from the fact that
these studies deal with cross-country data for a limited
number of years. On the other hand, if a long or very
long time span is considered, such as that shown in
sources are those produced by CDIAC (Carbon Dioxide
Information Analysis Center). The data on GDP are drawn
from the OECD (Organisation for Economic Co-operation
and Development) database. The data published by the
OECD for real global GDP are estimates by Angus
Maddison for the years 1870, 1900, 1913 and time series
from 1950 to 2000. The data for the years 1871-1899 and
1901-1912 are our extrapolations based on the assumption
of a constant average annual growth rate between the two
available years. The data for the period 1914-1949, given the
instability of the world economy during this period, which
makes a constant growth rate an unrealistic assumption, are
our estimates. It has been assumed that global GDP is
proportional, in every year of the range, to the total GDP of
a set of 44 countries in Maddison’s database, representing
68% of global GDP in 1913 and 71% in 1950. It should be
noted that the same countries, including the major
industrialized nations, account for between 68% and 71% of
global GDP for the whole period 1950-2000.

14 ENCYCLOPAEDIA OF HYDROCARBONS
 TECHNOLOGICAL INNOVATION, RELATIVE SCARCITY, INVESTMENTS

emissions intensity, which presents a roughly inverted 2000), on the other, it also concerns the use of scarce
U compared to real GDP, as predicted by the theory. If resources and therefore conforms to the model of
efficiency represents the state of technology, “innovation scarcity” outlined in Chapter 1.2.
innovations and structural changes in economic Specifically, the innovation is influenced by:
systems have had continuous and significant effects a) specific signs of relative scarcity emerging from the
over the past fifty years, but these remain insufficient markets and prices that possibly lead to specific
compared to the demand for innovation needed to resource-use innovations; b) the numerous public
stabilize or decrease the level of emissions. policies adopted by all countries in these sectors;
c) macroeconomic dynamics and structural changes
in economic systems; d ) general innovations in other
1.2.2 The mechanisms fields. In turn, innovative processes for resources
of technological innovation influence all these sectors to some extent.
for energy The hypothesis of ‘induced innovation’, originally
and the environment formulated by John Hicks in the 1930s in the context
of economic macrodynamics, is currently being
The trend of the indicators examined above suggest rediscovered and applied to the impact of markets and
the working of innovation for natural resources, but prices on innovation.7 This hypothesis suggests that a
only offer an implicit explanation of the mechanisms
by which innovation itself emerges and operates. If, on
the one hand, innovation for energy and emissions 7 More precisely, the Hicksian hypothesis refers to

conforms to normal innovation mechanisms (Malerba, ‘induced invention’ (Hicks, 1985).

Fig 2. Global CO2 emissions 7,000

from fossil fuels
vs. global GDP levels 6,000
global emissions of CO2

between 1870 and 2000.

5,000
(Mt of C)

4,000

3,000

2,000

1,000

0
1,000,000 10,000,000 100,000,000
global GDP
(millions of international Geary-Khamis dollars at 1990 prices)

Fig 3. Intensity
intensity of CO2 emissions (t of C/M$ of GDP)

400
of CO2 emissions
from fossil fuels 1917
vs. global GDP levels 350
between 1870 and 2000. 1970
300

250 1932

200 1945

2000
150
1870
100
1,000,000 10,000,000 100,000,000
global GDP
(millions of international Geary-Khamis dollars at 1990 prices)

VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION 15

MINERAL RESOURCES BETWEEN SCARCITY AND GROWTH

change in the relative prices of factor inputs tends to induced innovations aimed at conserving the resources
generate technological innovation which reduces the which the markets indicated to be scarce (Quadrio
use of the factor whose price has increased relative to Curzio, 1983; Sylos Labini, 1984; Quadrio Curzio et al.,
that of other factors. 1994; Mokyr, 1995; Quadrio Curzio and Zoboli,
This hypothesis provides results not dissimilar to 1995a,b; Rosenberg, 1996; Quadrio Curzio and
those of the multisectoral models of rents, growth and Zoboli, 1997; Popp, 2002).
the distribution of income described in Chapter 1.2, The interpretation of relative energy prices as the
although quantity variables play a central role in the main driving force towards energy-related innovations,
dynamics theorized in the latter (Quadrio Curzio and however, has been undermined by events over the past
Pellizzari, 1996, 1999). The Hicksian induced two decades. The fall in the real prices of energy after
innovation hypothesis has had numerous theoretical the mid-1980s has not led to an inverse innovation
and applied developments in the recent past (Ruttan process in which energy, now less scarce, replaces
and Hayami, 1985; Kemp, 1997; Ruttan, 2002; other production factors. Again, using general
Mazzanti and Zoboli, 2005b, 2006), and has been indicators, Fig. 4 shows that the strong price increase in
reproposed by numerous recent models of the 1970s led to a decline in the intensity of CO2
‘endogenous innovation’ applied to energy and climate emissions from fossil fuels, closely linked to the
policies (Carraro et al., 2003). consumption of primary energy; however, the fall in
The discussion below will cover two specific real prices which followed did not change the
contexts where the hypothesis of induced innovation declining trend of energy-emissions intensity, which
may apply: the role of prices on energy efficiency and still continues.
the role of public policies, especially climate change Although this pattern may be influenced by
policies, on emissions efficiency. expectations regarding climate policies, which might
have prevented abandoning the paths of
Relative prices and technological innovation energy-emission saving, efficiency’s inertia is too
The exceptional increases in energy and raw strong for it not to have more structural explanations.
materials prices in the 1970s resulted not only in Whereas in a narrow neoclassical economics view, this
structural changes in economies and innovative lack of symmetry would argue against relative prices
processes of a systemic nature with an impact on the playing a crucial role, in a structural and evolutionist
overall efficiency of resource use, but also in specific view, this may be an important indication of the nature

0.33 80

0.31 70

0.29
60
intensity of emissions of CO2
(103 t of C/M$ of GDP)

0.27 real price of oil ($/bbl)

50
0.25
40
0.23
30
0.21
20
0.19

0.17 10

0.15 0
1950
1952
1954
1956
1958
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000

year

intensity of emissions of CO2 oil prices in 1999 dollars

Fig 4. Real energy prices and intensity of CO2 emissions between 1950 and 2000.

16 ENCYCLOPAEDIA OF HYDROCARBONS

of induced innovation processes in the presence of
fixed capital.
Most innovations which conserve energy and raw
materials are incorporated in medium and long-term
capital goods (such as industrial plants, vehicles and
houses); this may explain both a degree of slowness in
the adoption and diffusion of currently available
energy efficiency solutions, and the poor reversibility,
for a considerable time, of the efficiency gains
acquired.
Analysing energy efficiency mechanisms over the
long term, Rosenberg (1994) suggests that even if
different energy sources can be easily substituted with
each other, and it is possible to conserve energy
without significantly altering processes and products,
the attainment of a greater energy efficiency always
requires some capital investment. As a consequence,
increases in efficiency tend to be slow despite the
availability of energy conservation technologies and
the strong pressure to conserve exerted by markets and
prices. The reason is that although these technologies
meet the criterion of lowering the specific costs of
energy inputs, they do not lower total costs since they
entail investment costs. Only in proximity to capital
renewal cycles and/or when energy prices are
extremely high and expected to remain so for a long
time, is the adoption of these technologies beneficial
in terms of total costs.
Mechanisms of this type emerge with great
complexity in the construction sector, whose energy
consumption accounts for about 40% of the European
Union (EU) total. The adoption of available energy-
saving technologies in constructions could lead to a
reduction of a fifth compared to current levels.8
However, in this sector, numerous variables affect
decisions to invest in efficiency, the agents making
these decisions are heterogeneous, and there are
difficulties in measuring efficiency compared to other
sectors. For new buildings, the decision to incorporate
energy efficiency is taken by the builder or by the
owner. In both cases, the fundamental economic
problem is to get the market to recognize the
property’s increased value due to the investment in
efficiency, which leads to lower consumption and cost
savings throughout the property’s useful life.
Investment in retrofitting constitutes a
fundamentally different problem from an economic
standpoint, since this entails choosing when to make
the investment, if it is worth making at all. Generally
speaking, current energy prices have more impact on
this type of investment than future prices. This is
because they influence total costs during the possible
period of non-adoption, which is closest to the present
and thus more weighted, since costs are discounted to
present value. The interesting aspect of retrofitting
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
TECHNOLOGICAL INNOVATION, RELATIVE SCARCITY, INVESTMENTS
costs is that if they are expected to fall sufficiently fast
in the future, retrofitting is postponed. Therefore, even
if the present value of expected energy savings is
higher than the present cost of retrofitting (i.e. if the
net benefit is positive), the technology may not be
adopted if technological innovation is continuous and
fairly rapid, or if future public incentives (which
reduce adoption costs) are expected to be higher than
current ones (Jaffe and Stavins, 1994).
This example shows that not only current prices
but also expectations regarding prices may play a
significant role in the substitution of capital with other
capital that incorporates greater efficiency. Even if
these price expectations later turn out to be wrong,
with lower cost savings than those expected due to
falling prices, once greater efficiency is attained, it is
still more expensive to return to lower efficiency than
to maintain that acquired; this is since the energy
saved has a positive value, regardless of its price. If
strong price increases have induced investment in
capital which incorporates efficiency, a change which
produces lower signs of scarcity (i.e. a price decrease)
may slow down the adoption and diffusion of efficient
technologies, but is unlikely to lead to a reverse
towards lower efficiency. This is all the more true for
changes like those which took place after the 1970s,
which radically reconfigured advanced technological
and economic systems. Specifically, the greatest
inertia of efficiency is shown by long-lived capital and
that which is most interconnected through
infrastructure systems; this is true both for processes
of adoption and of substitution with other technologies
(Gruebler et al., 1999). To this should be added the
cumulative learning processes associated with the
market expansion of new technologies, which reduce
costs and consolidate positive economic returns, even
when there are changes in relative prices that are
unfavourable to the newly-adopted technology.
Explicit investments in research and development,
and in new innovations follow similar paths. Only
stable favourable conditions, such as increases in
energy prices believed to be lasting, trigger the process
of investment in the research and development of new
technologies up to the commercial stage. After this
stage, there is a gradual diffusion of new technologies
that follows logistic models (take-off, maturity,
saturation and decline). As such, relative energy prices
may act – to use Rosenberg’s terminology – as
‘focusing devices’, mechanisms which identify the
most valuable areas of research and development and
8 This would be equivalent to a 10% saving in net
imports of petroleum products, and a reduction in
greenhouse gas emissions equal to 20% of the EU’s
commitments in the Kyoto Protocol.
17
MINERAL RESOURCES BETWEEN SCARCITY AND GROWTH
innovation. Except under extreme conditions of
change, each cluster of innovations tends to start with
earlier efficiency standards and raise them, partly
driven by long-term research and development
programmes, such as those of the European Union,
which do not respond immediately to changes in
economic variables. The current state of the energy
market mainly has an impact on new research and
innovation programmes, leading to different priorities
in the allocation of financial resources. This is obvious
from the history of scant attention to programmes for
renewable energy sources when oil prices are low
(regardless of environmental pressure).
This interpretation of the irreversible effects and
innovation inertia associated with strong or lasting
changes in relative prices is also supported by
evidence from historical price trends in real terms.
Although the debate remains open, there is increasing
evidence for the existence of long-term declining, or
not increasing, trends in the prices of most raw
materials and energy sources. In contrast to the
hypothesis of increasing resource scarcity, the drop in
real prices over the long term suggests relative
abundance. The latter, combined with continuous
gains in use efficiency, may support the hypothesis of
a one-directional technological dynamics of the type
described above. In fact, strong signs of scarcity,
through phases of high real prices, induce increases in
efficiency. However, the subsequent decline in real
prices does not cause increased intensity in the use of
energy and materials, given the inertia of fixed capital
and programmes of investment in innovation.
Efficiency thus tends to move in one direction towards
the lower, more advanced, part of the Kuznets curve in
accordance with mechanisms similar to those
suggested by theories of growth stages, long waves
and alternation between dominant technologies
(Vasco, 1987; Rostow, 1990; Marchetti, 1991;
Gruebler et al., 1999).
Similar efficient innovation mechanisms are also at
work for the supply of resources. Even when real
prices are falling, the supply of energy and raw
materials continues to increase, supported by the need
to compensate for falling prices with higher quantities
and by innovations which reduce extraction costs, and
thus allow producers to maintain their rents. The role
of cost saving innovations in maintaining high supply
levels in the petroleum sector is well known (IEA,
2001b).
In other words, the relative prices of energy and
materials may act as initial driving forces in long-term
dynamic processes which lead to changes in
technological and production systems. These are
capable of definitively changing the starting conditions
to such an extent that subsequent inverse changes in
18
relative prices do not have a symmetrical effect
compared to increases. The unusual intensity of energy
price changes during the 1970s may help to explain
both the accelerated declining trend of energy
intensities, and their non-reversal in response to the fall
in real energy prices during the 1980s-1990s. However,
it is true that the latter did decelerate innovation
processes for efficiency, and this is an important issue
for energy and climate change policies.
Climate policies and technological innovation
Despite their important role, changes in relative
prices cannot be the only explanation for the observed
innovation processes, since resources and the
environment are subject to numerous public policies
which influence the prices themselves, the quantities
supplied and demanded, investments in research and
development, and other variables.
Specifically, taxation and regulation policies have
traditionally played an important role in filtering
changes in energy prices, altering them both in an
amplificatory and compensatory way. Furthermore,
the average levels and structure of energy prices are
heavily differentiated in different countries, since
energy products are subject to a variety of forms of
taxation unparalleled in other sectors. Given that
demand is relatively inelastic in the short term, the
main aim of energy taxation is to increase revenues.
However, the structure and level of prices determined
by the tax burden may objectively have the effect of
encouraging conservation and efficient technologies in
the medium-to-long run or, conversely, may act as an
implicit subsidy encouraging high consumption. In
recent years, the emergence of concerns about the
climate has become manifest in the introduction of
energy-environmental taxes (in particular, Carbon-
Energy Tax or CET) in various European countries.
Such policies may introduce scarcity signals which, in
the case of environmental resources such as the
climate, cannot be provided by the market, thus
stimulating also technological innovation.
The current debate sees different positions on the
economic and technological impact of
energy-environmental policies (Jaffe et al., 2003). On
the one hand, the hypothesis of a “loss of
productivity/competitiveness” states that: energy
conservation and emissions reduction policies create
opportunity costs for the production system; these
policies depress growth and the competitiveness of the
most environmentally advanced countries; innovations
to meet policy requirements crowd out innovation in
other more productive areas of technology. On the
other hand, the “Porter hypothesis” (Porter and van der
Linde, 1995) claims that: the investments induced by
energy-environmental policies do not crowd out other
ENCYCLOPAEDIA OF HYDROCARBONS

investments; the policy-induced innovations can
reduce compliance costs; investments in
environmental innovation may generate competitive
advantages for the technologies and products of the
businesses which undertake them.
Essentially, the whole debate revolves around
whether or not energy-environmental policies
stimulate innovation, if the latter is economically
advantageous in terms of net social costs and if it can
generate new market areas for investors.
Although areas of agreement and dissent remain
on this issue, the policy debate of the 1980s and 1990s
led to a concentration on the costs and innovation
effects (or the ‘dynamic efficiency’) of the objectives
and tools adopted by the policies. Theory and
empirical evidence suggest that the economic
instruments have lower social costs than traditional
policy instruments (restrictions on quantity, standards,
controls, etc.) and may be more effective in
stimulating innovation. In the case of energy and the
climate, this first led to proposals to introduce
carbon-energy taxes (CETs) and, subsequently, to
proposals to create markets for tradable emissions
permits (ET, Emissions Trading).
CET proposals in Europe date back to the 1980s
and have met with strong resistance from some
countries and economic stakeholders, based on the
hypothesis of a loss of productivity/competitiveness.
They were sidelined after the Rio Conference in 1992,
when the European proposal of a global carbon tax
failed due to American resistance. Some European
countries, however, have implemented domestic CETs.
In contrast to the enormous number of ex ante
simulations of the impact of CETs on the economic
and technological system, there are few ex post
analyses of their impact, which tell us little about
effects on innovation in practice (Baranzini et al.,
2000; Mazzanti and Zoboli, 2000). Generally speaking,
it appears that this policy instrument has mainly had
the effect of correcting the complex energy taxation
system, with a dubious and probably negligible impact
on both induced innovation and competitiveness.
With the Kyoto Protocol, the emphasis has shifted
towards the other main economic instrument for
environmental policy, i.e. the creation of markets for
tradable permits (in their two main forms, ‘cap and
trade’, and ‘baseline and credit’). Initially proposed by
the United States following numerous national
applications to atmospheric pollutants, these
instruments have become characteristic of the Kyoto
Protocol and have generated a wide-ranging debate
which is still open. After the refusal of the United States
to ratify the Protocol in 2001, the EU has taken the lead
in implementing these instruments, up to the creation of
the European Union Emissions Trading Scheme
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
TECHNOLOGICAL INNOVATION, RELATIVE SCARCITY, INVESTMENTS
(EU ETS) for CO2 (Directive 2003/87/EC). The related
Linking directive allows ETS operators to use carbon
dioxide credits deriving from Joint Implementation
(investments in Annex I countries, i.e. industrialized and
transition countries) and Clean Development
Mechanism (investments in non-Annex I countries,
mainly developing ones) to comply with their
obligations under the EU ETS.
The European scheme started in 2005 and involves
about 12,000 businesses in the most emission-intensive
sectors (from the production of thermoelectric power
generation to the paper industry), accounting for about
40% of total emissions in the EU. With the EU ETS,
which is the largest emission market in the world, the
hitherto small global CO2 market has taken off,
generating a reference price for CO2 and thus an
opportunity cost for emissions. The latter makes it
advantageous to adopt abatement technologies or
technological innovations able to conserve energy and
reduce emissions.
Also in the implementation of Kyoto instruments,
induced innovation takes on a central role both in
reducing the costs of attaining the objectives (Table 1)
and in the possibility that Europe may play an
important role in supplying efficient technologies to
the global energy-environment system.
Generally speaking, it can be expected that the EU
ETS is cost-effective since it should lead to reductions
in compliance costs (i.e. lower GDP losses) compared
to other policy instruments with the same objectives.
However, it is not clear if and how it can actually
produce high incentives for innovation. The task of
allocating emissions quotas has been assigned to
individual EU countries, albeit conditional on the
approval by the Commission. In general, countries
have set CO2 emission quotas in a way which is not
particularly restrictive, thus pursuing low costs
implementation for national industries (in line with the
loss of productivity/competitiveness hypothesis) and
with discretional allocations among the national
industries involved.
The result is a certain global abundance of quotas
compared to the Kyoto path; combined with an
expected flow of low cost carbon credits from
developing countries (from the implementation of the
Linking directive) and Eastern Europe/Russia (so-
called ‘hot air’). This suggests a market development
marked by low CO2 prices (from 6 to 15 €/tCO2eq
according to the simulations9). These low carbon
prices will be unable to induce significant investments
in emission reduction, since they encourage operators
to enter the market as purchasers of the reductions
9 tCO2eq: tonnes of carbon dioxide equivalent.
19
MINERAL RESOURCES BETWEEN SCARCITY AND GROWTH

Table 1. Costs of the Kyoto Protocol: values (%) of GDP compared to the reference scenario
with and without induced innovation (Criqui and Kitous, 2003)

Kyoto (ET and flexible instruments) Kyoto (ET and flexible instruments)
Countries
without induced innovation with induced innovation

2010 2015 2010 2015

Australia ⫺0.18 ⫺0.55 ⫺0.15 ⫺0.37
Japan ⫺0.15 ⫺0.25 ⫺0.11 ⫺0.19
European Union ⫺0.25 ⫺0.44 ⫺0.21 ⫺0.36
Eastern Europe
0.34 1.73 0.09 1.11
and Russian Federation

Attached I countries ⫺0.52 ⫺0.87 ⫺0.42 ⫺0.69

United States ⫺0.03 ⫺0.05 ⫺0.01 ⫺0.03
Non-attached I countries 0.00 0.01 0.00 0.00
World total ⫺0.14 ⫺0.18 ⫺0.12 ⫺0.16

attained by others at a lower cost than their own
reductions. The main effects on innovation will
probably be limited to the adoption of existing
technologies and their diffusion, partly on an
international level through investments in joint
implementation and clean development mechanisms.
Only once low-cost reduction opportunities have been
exhausted will CO2 prices rise and signal scarcity,
inducing greater pressure to innovate.
It is therefore uncertain if and when the
development of the emission permits market will lead
to innovations for energy and the environment in
Europe, even compared to the United States. The
latter’s climate policy is explicitly targeted at
technological programmes and emissions intensity
objectives, although these are not particularly
restrictive and thus, per se, do not represent a
significant incentive.
The importance of energy-climate policy’s function
as a dynamic incentive for innovation is stressed by the
various analytical models of the impact of Kyoto which
adopt ‘endogenous innovation’ hypotheses. However,
these models emphasize the numerous difficulties in
understanding actual innovation mechanisms (Carraro
et al., 2003). For this reason, if policy tools are
insufficient to generate the necessary innovations, new
and explicit research and development policies for
energy and the climate should be activated; at the same
time, the large research programmes already underway
in Europe and individual countries should be
strengthened (Popp, 2004).
From this point of view, it should be noted that
energy and the environment are already of significant
importance in European Union research programmes,
with a specific budget of 4.8 billion of euro (10% of
the total) in the VII Framework Programme currently
underway, and may receive important input from other
areas of innovation, such as materials and
nanotechnologies. They also represent an important
component of the National 2005-2007 Research
Programme launched in Italy.
The possibility that innovation for the
energy-climate may play a role in the Lisbon Strategy
to make the Union’s economy more innovative is
highlighted by the launch of the Environmental
Technologies Action Plan (ETAP). The ETAP was
adopted by the European Council in March 2004
(European Commission, 2005) and clearly espouses
the viewpoint here described as the Porter hypothesis,
when it stresses that: a) environmental technologies
employ more than 2 million people in the EU; b) the
impact of environmental policies on employment is
neutral or positive; c) the negative effects of pollution
control policies on competitiveness are limited; d )
environmental innovations may generate international
market opportunities, given the increasing involvement
of large, rapidly developing countries such as China in
global energy-environment policies, especially in the
post-Kyoto scenario.
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Milano, Italy
ENCYCLOPAEDIA OF HYDROCARBONS
 1.3

Reserves and resources

1.3.1 Oil judged the turning point for peak global oil
consumption to be around the late 1990s or the early
Reserves’ discovery and appreciation processes Twenty-first century (Grenon, 1979). A total of no
to date fewer than twelve pessimistic studies of oil’s
The potential future availability of oil has long prospects at that time were analysed in detail in a
been an issue for both the industry and government research project at the Centre for International
policymakers (Williamson, 1963). As long as it Energy Studies at Erasmus University, Rotterdam
remained a relatively unimportant energy source, with
its use on a significant scale restricted to a relatively
small number of countries (most notably the US), as 72 3,600
was the case until after the Second World War, a fear 66 3,300
of global scarcity was not a real issue. For the few
mainly oil using countries before 1939, their concern 60 3,000
Sau
was related to a perceived scarcity of indigenous 54
OPEC 2 di A
rabi 2,700
supplies. a3
Post-1945, however, in the context of oil rapidly 48 2,400
OP
non-OPEC EC
becoming the most important source of global energy 42 2,100
needs (with oil eventually supplying over half of the
Mbbl/d

Mt
world’s total energy use by 1958), a widely held 36 1,800
perception emerged that the world would be unable to 30 non-OPEC 1,500
continue to run on oil for the rest of the Twentieth
century (Odell, 1963). 24 1,200
This view grew in strength in the 1960s as oil use 18 900
expanded at over 7% per annum, and was powerfully
set out in an article by no less than the chief geologist 12 600
OPEC 1
of British Petroleum in the very early 1970s 6 300
(Warman, 1972). Though the fundamental validity of
the analysis which produced this result was 0 0
1980 1985 1990 1995 2000
challenged (Odell, 1973), pessimism on oil’s future
year
prospects persisted. It was eventually expressed most
emphatically and succinctly in a study, subsequently
1. Saudi Arabia 8.5 Mbbl/d, discretionary
published with a high profile launch by British production
Iran 4 Mbbl/d, others at
Petroleum, under the title Oil crisis . . . again? (BP, current conservation limits possible future
1979). That study purported to show that world oil 2. Saudi Arabia 12 Mbbl/d,
discoveries
and developments
production (outside the Soviet bloc) would others + 2.8 Mbbl/d
necessarily have to peak in 1985, only six years after 3. Saudi Arabia 14-16 Mbbl/d proven and probable
publication, as shown in Fig. 1. Other companies and
institutions concerned with energy forecasting Fig. 1. A forecast of oil depletion (BP, 1979).

VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION 23

MINERAL RESOURCES BETWEEN SCARCITY AND GROWTH
(Odell and Rosing, 1980). This showed that the fears
for an impending near-future scarcity of oil were
based on totally inappropriate parameters; first of a
world fully explored for oil and, second, of a world in
which ‘the end of history’ was thought to have been
reached on the processes of increasing knowledge
and advancing technology in the oil industry. These
supply-side absolutes were then, moreover, combined
with another absolute belief, viz. the absurd notion
that oil had a perfectly inelastic supply price curve.
Needless to say, developments in the real world
soon undermined all the component parts of these
scaremongering hypotheses. By 1979, oil demand
growth came to a standstill as the impact of the first
oil price shock of 1973-74 was fully felt.
Thereafter, in the context of the second oil price
shock of 1979-80, the use of oil fell year by year to a
low in 1983 (when it was more than 10% under its
1979 historic peak). It then took nine years to 1992 for
global oil use to recover to its 1979 level. Thereafter,
even over the final eight years of Twentieth century,
growth in oil use remained relatively weak with an
increase of only 11% (an annual average of 1.2%), and
over the twenty-one years from 1979 by a mere 11.2%
(that is, 0.5% per annum). Cumulatively, the use of oil
over the last thirty years of the Twentieth century
totalled about 90 Gtoe, rather than the 250 Gtoe which
was so confidently forecast by the industry in the early
1970s (Warman, 1972).
On the supply side, the growth in conventional
oil reserves from new discoveries (and, even more
importantly, from the appreciation of reserves in
fields long since discovered) has run quickly
ahead of oil used. The data are shown in Table 1.
Almost 1,350 Gbbl of oil (184 Gtoe) were added
to proven reserves between 1971 and 2004.
Over the same period, only 785 Gbbl (107 Gtoe)
were consumed.
From these data, one can argue for a world which
over the last thirty-four years has been ‘running into’
oil rather than ‘out’ of it, as so widely forecast in the
1970s and as currently widely perceived (Laherrère,
2003).
Starting with the situation at the end of 2000,
as the baseline from which to study the prospects
for oil in the Twenty-first century, 1,028 Gbbl (140
Gtoe) of proven reserves were then available for
production. This was not only sufficient to satisfy
the year 2001 demand of 26.3 Gbbl (3.6 Gtoe),
but also another thirty-six years of oil use at the
same level of annual production. Even if oil use
were to grow at 2% a year from the 2000 base, then
already known reserves could theoretically supply
all the oil required for the first quarter of the
Twenty-first century.
24
We can, however, confidently predict that the
volume of proven reserves as declared in 2000 will
continue to appreciate. Such appreciation has, indeed,
been a long continuing process, based first, on
frequent reappraisals of reservoirs’ potential; second,
on the perfectly normal enhancement of geological
knowledge as a consequence of production experience
leading to extensions to fields; and third, from
improving rates of recovery from the oil-in-place in a
reservoir, as a result of significant advances in
production technologies (Meyer and Olson, 1981;
Odell, 1994; Smith and Robinson, 1997; McCabe,
1998).
A conservative view of the likely appreciation of
the volume of oil declared proven in 2000 is shown in
Fig. 2. This indicates a reserves gain by 2020 (without
any new discoveries) of about 350 Gbbl (47.7 Gtoe).
This is sufficient to extend the availability of oil from
the world’s currently exploited and known (but still
undeveloped) fields by the equivalent of about thirteen
years’ supply at the 2000 level of production (Shell
International Petroleum Company, 2001).
Indeed, one can strongly argue, first, that the
advanced technologies now in use for defining or
redefining the size and characteristics of oil fields
(particularly through the so-called 4D seismic
methodology, whereby the dynamic qualities and
behaviour of a reservoir under production can be
simulated), and second, the new production techniques
now being developed (most notably, horizontal drilling
and enhanced oil recovery methods), together serve to
add a significant new dimension to the prospects for
enhancing the capabilities of the world’s existing oil
fields to produce additional oil.
To date, however, large investments in these new
technologies have mainly been restricted to oil
producing areas in North America and the North Sea.
They have shown significant success, measured in
terms of additional oil production already achieved,
and of a potential for future production that would not
otherwise have been possible (Smith and Robinson,
1997).
The application of these technologies in other parts
of the world is only a matter of the time required to
create, first, the demand for the additional oil and,
second, the politico-economic conditions in which the
necessary investments by companies possessing the
relevant expertise can be made. This applies generally,
but it is specifically important in respect of the two
richest oil regions in the world, viz. the Middle East
and the former Soviet Union.
In the Middle East in the 1970s and 1980s, the
impact of the nationalization of the oil companies
working in most of the countries in the region,
combined with the subsequent financial, managerial
ENCYCLOPAEDIA OF HYDROCARBONS
 RESERVES AND RESOURCES

Table 1. Development of conventional oil reserves (1971-2004)

Proven reserves Production of oil Gross additions Net growth Reserves-to-

at start of year in year to reserves or decline in reserves production ratio
(Gbbl) (Gbbl) (Gbbl) (Gbbl) (yr)
1971 521 18.4 38 20 28.3
1972 542 19.4 54 35 27.9
1973 577 21.2 35 14 27.2
1974 591 21.2 32 11 27.9
1975 602 20.2 31 11 28.4
1976 613 21.9 4 ⫺18 30.3
1977 595 22.6 16 ⫺7 27.2
1978 588 22.9 45 22 26.0
1979 610 23.7 22 ⫺2 26.6
1980 608 22.8 34 11 25.7
1981 619 21.3 67 46 27.1
1982 665 20.1 30 10 31.2
1983 675 20.0 21 1 33.6
1984 676 21.1 44 23 33.8
1985 699 20.5 30 9 33.1
1986 708 21.4 67 45 34.5
1987 753 21.9 129 107 35.2
1988 860 22.8 83 60 39.3
1989 920 23.5 87 63 40.3
1990 983 23.8 26 2 41.8
1991 985 23.7 65 41 41.4
1992 1,026 23.9 46 22 43.3
1993 1,048 23.7 31 7 43.9
1994 1,055 23.8 29 5 44.3
1995 1,060 24.1 48 24 43.0
1996 1,084 24.7 40 14 44.9
1997 1,098 24.4 ⫺67 ⫺93 45.0
1998 1,005 26.0 31 6 38.7
1999 1,011 25.5 31 4 39.6
2000 1,015 26.5 40 13 38.3
2001 1,028 26.3 39 13 39.1
2002 1,030 26.2 28 2 39.3
2003 1,036 27.3 33 6 37.9
2004 1,062 28.3 54 26 37.5
Total 27,948 785 1,343 558

Source: Development of reserves of conventional oil based on contemporary data from the annual surveys of world oil reserves
in the «Oil & Gas Journal» (1970-2004); «World Oil» (1971-2005); De Golyer [...] (1975-1983); production data from the BP (1971-2005).

VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION 25

MINERAL RESOURCES BETWEEN SCARCITY AND GROWTH
Fig. 2. The appreciation
of proven reserves 2,500 a forecast of a 2020 backcast of 1945-2000 declarations of reserves
of conventional oil (Shell/USGS)
compared 2,250 a 1996 backcast of 1945-1995 declarations of reserves (Campbell)
with cumulative demand a 1970 backcast of 1945-1969 declarations of reserves (Odell)
(1945-2000). 2,000 contemporaneous declarations of reserves (OGJ/World Oil)
cumulative demand curve
1,750
1,500
oil (Gbbl)
1,250
1,000
750
500
250
0
1945 1950 1955
and/or technical limitations of most of the State
entities to undertake the necessary exploration and
exploitation work, has resulted in much of the
upstream oil industry in the world’s most significant
oil producing region now being out of date. An
appreciation of the need for radical change has,
however, gradually taken place so that agreements to
secure the expansion of the industry are now
underway. When the proposed and potential joint
ventures between many international oil companies
and the various state corporations in Iran, Kuwait,
Saudi Arabia, Iraq and elsewhere in the region become
operational during the first decade of the Twenty-first
century, they will lead to a very significant
enhancement of the region’s reserves and of its
production potential (Odell, 1997; Centre for Global
Energy Studies, 2001; Baqui and Saleri, 2004).
Similarly, the oil industries of Russia and of other
former Soviet Republics await the application of new
technologies and methodologies through joint venture
structures with international oil companies which are
financially capable of undertaking the work.
As they are gradually put in place, the productivity
of the oil industries of countries in Russia, Ukraine,
Azerbaijan, Kazakhstan and Turkmenistan seem likely
to be revolutionized (Khartukov, 1997; Krylov et al.,
1998; Considine and Kerr, 2002). Indeed, by 2004, the
proven reserves of these countries have already
increased by over 50% from their levels of a decade
earlier.
It is, in part, these politico-economic components
in the evolution of the prospectivity of world oil that
are significant in undermining the validity of the
renewed efforts by some to claim that an oil supply
26
1960 1965 1970 1975 1980 1985 1990 1995 2000
year
crisis is pending (Campbell, 1997 and 2003; Laherrère,
1997 and 2003; Campbell and Laherrère, 1998).
Once again, as with their predecessors such as
Warman (1972) and Hols (1972) in the 1970s, their
forecasts of a near-future peak in global oil production
fail to recognize the dynamics of the processes
whereby oil reserves and production evolve; and they
equally avoid the central role played by both
economics and politics in equilibrating the markets
(Lynch, 1999).
Such irrational warnings of an early Twenty-first
century oil scarcity should thus be ignored, particularly
as one recalls the huge costs that were imposed on the
world economy by the earlier acceptance by many
energy and economic policymakers of the 1970s’
prognostications of oil scarcity (Adelman, 1993;
Odell, 2001-2002a). That episode was responsible in
large part not only for the much higher oil prices and
the economic and social problems that these caused,
but also for the very large non-viable investments that
were made in alternative energy production systems
and in the exploitation of higher cost energy reserves
(McCabe, 1998; Odell, 1998). The world at the present
time can ill afford an unnecessary repetition of that
near disastrous set of events. The world’s already
proven reserves of oil (and the processes whereby they
evolve) do, indeed, in themselves eliminate any
significant up-side restraint on the development of
production for the first quarter of the Twenty-first
century, given the maintenance of a minimum
inter-quartile price range for oil of about 18-22 dollars
per barrel (in $ of 2000) level, as through most of the
twenty year period since the oil price collapse in 1986.
On the contrary, any up-side constraint on supply
ENCYCLOPAEDIA OF HYDROCARBONS

seems more likely over the first twenty years of the
Twenty-first century to be imposed by the continuation
of the relatively slow demand growth which, as shown
above, has persisted for the past twenty years.
Oil demand will, in particular, be constrained by
the increasing competition which it will have to face
from natural gas in many markets across much of the
world in the period to 2020.
Beyond that date (and thus also beyond the
importance of currently proven reserves and their
evolution through appreciation, based on increasing
knowledge and technological progress), one has to
turn to the more uncertain issue of the size of the
ultimate world’s oil resource base and to its
prospective exploitation. This has been described as
“the unknown, the unknowable and the unimportant”
(Adelman, 1993), a description which in purely
economic terms is entirely appropriate. In a
competitive market with many active players, what is
demanded is supplied (produced), providing the price
is high enough to sustain profitable business.
Moreover, demand also has to be anticipated by
investments which are made in finding and developing
reserves so that, given the long lead-time for this
process, the market can be served. As shown above,
the industry has responded in exactly this way, in spite
of the pessimism for the long-term future of oil in the
early 1970s, over the past thirty years. This response
led to the creation by the late 1980s of a
reserves-to-production ratio of almost forty years,
as shown in Table 1.
In this context, it is thus not surprising that there
has been only one year since 1979 in which the
industry’s exploration and development activities did
not lead to the full replenishment of the stock of
reserves, viz. in 1997. This was the year when a
number of countries’ reserves declarations were
downgraded by «World Oil» because of doubts as to
the recoverability of oil in the context of a sharp
downturn in prices. This clearly indicates that the
normal economic process of stock renewal is working
effectively. Any serious concern over the rate of
conversion of the world’s oil resources to reserves
would be justified only in the event of a run of
consecutive years (a minimum of, say, five or six) in
which annual production exceeds the annual gross
additions to reserves.
There is an argument, most recently used by
Campbell (1997), that annual additions to reserves
(comprising both new discoveries and the appreciation
of reserves in previously discovered fields) should not
be taken to indicate replacement or replenishment of
the reserves stock. Such replenishment should, he
claims, be judged only against discoveries of entirely
new reserves, while additions to reserves arising from
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
RESERVES AND RESOURCES
the re-valuations of earlier discoveries should be dated
back to the year of the initial discovery of the field
concerned. But this is not a robust argument.
As far as the oil economy is concerned, the ‘why
and the wherefore’ of the development of reserves are
immaterial. It is the fact of their occurrence and of
their declared availability at a particular time to supply
the market that is of the essence in terms of balancing
future supply against future demand. This makes the
nature of the time-series which Campbell (1997) have
produced, in which data on the increases in reserves
from discovered fields are backdated to the year of
discovery, invalid for purposes of forecasting supply.
Under this procedure, the more recently discovered
fields have had less time to go through the normal
process of appreciation than fields discovered many
years (or even decades) ago, so that comparisons
between the recoverable reserves in long-since
discovered fields and those in recently discovered
fields are rendered invalid. The backdating of reserves
with hindsight, in the context of newly developed
technologies of reserves’ assessments and
recoverability, coupled with significantly changed
production cost and market prices, is simply
inappropriate to the contemporaneous economic
evaluation of oil exploitation. It makes the past look
more attractive than it really was to the economic
decision makers of the time, while the present is made
to appear less attractive.
For example, as shown in Fig. 2, the prospects for
the industry in 1950 depended on the then indicated
existence of only about 125 billion barrels of
remaining proven reserves at a time when some 65
billion barrels had already been used, so that the
volume of reserves then declared appeared to be
relatively modest compared with the then annual rate
of use of 8 billion barrels. But twenty years later in
1970, it was shown that almost 375 billion barrels of
remaining recoverable oil had existed in the fields
discovered by 1950.
Thereafter, with the passing of another twenty
years to 1990, the graph shows that the still-to-be
recovered reserves from the population of fields in
1950 had increased still further by about another 50
billion barrels. Thus, the feared pending oil scarcity
suggested by some pessimists in the 1950s, predicated
on the basis of the argument that “almost half of the
world’s known oil reserves had already been used”,
was entirely groundless (Odell, 1963).
More recently, in 1995 when the contemporary
scaremongering of oil scarcity re-emerged (Campbell
and Laherrère, 1998), it was argued by the new
‘Jeremiahs’ that the approximately 1,000 billion
barrels (13.5 Gtoe) of remaining proven reserves were
able only to sustain growth in production for another
27
MINERAL RESOURCES BETWEEN SCARCITY AND GROWTH
four or five years because by then “half of the world’s
oil would have been used up”, so that the tenuous
Hubbert hypothesis, viz. that production is bound to
start falling once 50% of known oil has been used,
would become applicable (Deffeyes, 2001; Holtberg
and Hirsch, 2003). But that has not happened, simply
because the declared proven reserves in 1995 are
already known to have been significantly understated.
The 1,060 billion barrels of reserves declared in 1995
are now known to have been closer to 1,250, even
though the process of the appreciation of the reserves
declared by 1995 is by no means over. As shown in
Fig. 2, the ultimate appreciation of the reserves
declared in 1995 is likely to be over 330 billion barrels
by 2020.
Now that the importance of the appreciation over a
lengthy period of time of previously discovered
reserves has been so clearly demonstrated, one can
clearly see why the pessimism in earlier decades over
the future of oil was totally unjustified. The 1970
declared remaining economically producible reserves
of about 520 billion barrels are, as shown in Fig. 2,
now reported to have exceeded this volume
by more than 300 billion barrels. Recognition in 1970
of the significance of the phenomenon of proven
reserves’ appreciation would have eliminated the
pessimism that was then so generally expressed
(Odell, 1973). It may, indeed, even have inhibited the
oil price shock of 1973-74 and, thereafter, the whole
gamut of adverse consequences for the international
oil industry, in particular, and for the world economy,
in general.
The high probability that the year 2000 declaration
of over 1,050 billion barrels of proven reserves will be
shown by 2020 to have been more than 1,450 billion
(as a result of the factors set out above) is a highly
significant input to the evaluation of the prospects for
the conventional oil industry over the twenty year
period. Of greater significance is the fact that even
without any further discoveries of oil, the peak of
conventional annual oil production will not occur
during the present decade (as threatened by Campbell,
1997) for supply-side reasons; unless the price of oil
collapses, so undermining otherwise profitable
production operations. It is, indeed, falling demand
that is more likely to produce a premature peak in
global production.
Nevertheless, no matter how plentiful the presently
declared remaining conventional reserves of oil are
(after due account has been taken of their future
appreciation), they still provide only for a finite future
of increasing oil production: to the year by which
steadily increasing demand will have depleted some
50-60% of the calculated, up-dated reserves in the
already-discovered fields. When this stage in the
28
evolution of the world's conventional oil industry is
eventually reached, the remaining reserves must
clearly be ‘saved’ to serve the market in the
subsequent period of declining output. With
approximately 1,000 billion barrels of oil consumed by
2004, some 41% of the world’s presently proven and
appreciating reserves of conventional oil have already
been depleted.
Without any more discoveries, approximately 48%
will have been depleted by 2010 and about 68% by
2020, on the assumption of an average 1.5% per
annum increase in consumption in the meantime.
Thus, without a continuing oilfields’ discovery
process, conventional oil production would peak in the
middle of the second decade of the Twenty-first
century.
In other words, in other than strictly economic
terms, under which an approaching recognition of
relative scarcity would lead to a rising long-run supply
price and a consequential restraint on demand,
continuing discoveries of new oil fields are of the
essence in ensuring the ability of the industry to
sustain an increasing level of global production post-
2015. These prospects are analysed below.
Ultimate conventional oil resources’ depletion,
1940-2140
As Fig. 3 shows, since the 1940s there have been a
large number of estimates of ultimately recoverable
oil. In 1940, the world was thought to have less than
100 Gtoe (733 billion barrels). Estimates of resources
rose rapidly in the late 1940s and throughout the 1950s
and 1960s as the global oil industry not only expanded
geographically, but also increased the intensity of
development.
Most notable, of course, in this latter respect was in
the Middle East which was exploited on a large scale
for the first time during that period. By 1970,
estimates of ultimate global oil resources had settled
down at around 300 Gtoe (2,200 billion barrels), so
leading to a major fear of scarcity in the context of the
widely held belief that this figure represented the
ultimate truth on the future availability of oil
(Warman, 1972); albeit a view of limited prospects
which was challenged by other observers (Odell, 1973;
Styrikovich, 1977; Odell and Rosing, 1980).
Since then, however, the hitherto rapid increase in
the demand for oil from 1950 to 1973 (averaging 7.5%
per annum) fell sharply, so significantly undermining
the previously perceived need for large volumes of
future supplies. Meanwhile, interest in the ultimate
reserves of the Middle East evaporated with the
nationalization of the international oil companies in
most of the countries in the region. Instead, a more
intensive appraisal of the oil wealth elsewhere in the
ENCYCLOPAEDIA OF HYDROCARBONS
 RESERVES AND RESOURCES

Fig. 3. Assessments 600

of total world initial oil 4,000
reserves over time. 500

400 3,000

oil (Gbbl)
oil (Gtoe)
300
2,000

200

1,000
100

0 0
1940 1950 1960 1970 1980 1990 2000
year

values of 31 individual assessments by year of assessment (Krylov et al., 1998)

trend fitted to Krylov's data with extrapolation to 2000

value range for Shell's assessments in 1995 and 1998

Flat earthers' assessments (McKenzie, 1996; Campbell, 1997)

United States Geological Service (USGS, 2000)

world became of greater interest, in both the
industrialized and the developing countries (Odell,
1981).
As also shown in Fig. 3, estimates of ultimately
recoverable reserves now reach to much higher levels
(to over 500 Gtoe), although four recent estimates
remain at under 300 Gtoe. These latter estimates
provide quite an extraordinary view of the prospects,
given that a total of 280 Gtoe of oil has either already
been produced or declared as proven.
The observers (defined as the Flat earthers in the
key on Fig. 3) responsible for these forecasts are, in
essence, simply repeating the discredited 1970s belief
in the proverbial ‘end of history’ when almost all of
the world’s oil was considered to have already been
discovered. There are not, they argue, any additional
regions of great potential which remain unexplored;
nor do they visualize any likelihood of the continuing
ability by the oil industry to further enhance the
percentage rate of recovery of oil from known
reservoirs through continuing technological advances.
The views add up to nothing less than a
proverbial ‘flat-earth theory’ in which the sciences
and technologies of oil discovery, development and
exploitation are at the edge of that world and are
about to fall off into oblivion (Hiller, 1997;
Campbell and Laherrère, 1998; Deffeyes, 2001). It
is inconceivable that the hypothesis could be correct,
given not only the absence of any indicators for the
cessation of the industry’s exploratory and
production research activities (Downey et al., 2001),
but also the absence of the critically important
economic indicator which would emerge in the
context of an impending near future scarcity, viz. a
long-term rising real price for the commodity
(Adelman, 1993; Lynch, 1999).
Referring back again to Fig. 3, however, it can be
seen that all of the assessments made since 1980
(except, that is, for the four forecasts of the
‘flat-earthers’), lie well above 300 Gtoe (2,200 billion
barrels), while four assessments are above 400 Gtoe
(3,000 billion barrels). This latter figure was already
the mid-point of the range presented by Shell in 1995
in its assessment of the world’s ultimate reserves of
conventional oil (Shell International Petroleum
Company, 1995).
This assessment, of course, included the oil that
had then already been used (105 Gtoe) and the oil that
had already been proven (146 Gtoe). Shell further
reported “an estimated 500-1,000 billion barrels
(70-140 Gtoe) of oil yet to be discovered, plus a
further 400-500 billion barrels (55-70 Gtoe) of oil
which are expected to be recoverable from known
fields through the wider application of current and
new technologies” (Shell International Petroleum
Company, 1995). This adds up to a range of ultimately
recoverable reserves of 2,700-3,300 billion barrels
(365-450 Gtoe). Shell’s more recent 1998 and 2001

VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION 29

MINERAL RESOURCES BETWEEN SCARCITY AND GROWTH
analyses basically confirmed its previous estimates of
ultimate reserves, whilst the United States Geological
Service in its massive World petroleum assessment
exercise, involving several years of work by scores of
oil geologists, established a mean value for the world’s
oil resource base of 3,003 billion barrels (420 Gtoe)
(USGS, 2000; Groenveld et al., 2002).
Overall, the mid-point of Shell’s estimates as well
as the mean value defined by the USGS assessment
and the mid-point of the highest and lowest of all the
other assessments shown in Fig. 3 is just over 410
Gtoe (approximately 3,000 billion barrels). This was
also the mean value for the world’s ultimately
recoverable volumes of conventional oil which
emerged from analyses of the future of oil made by the
author of this paper together with colleagues at
Erasmus University Rotterdam in the early 1980s
(Odell and Rosing, 1980).
This figure thus provides a generally and widely
accepted one from which a full depletion curve for the
exhaustion of the world’s conventional oil can be
constructed. This curve is shown in Fig. 4 for the
period from 1940 (when only 0.34 Gtoe of
conventional oil had been produced) to 2140 when the
proverbial ‘last’ economic-to-produce barrel is close to
being extracted. The graph shows a peak production
year of 2030 at 4.6 Gtoe, compared with around 3.8
Gtoe in 2004.
The further expansion of conventional oil
production is thus demonstrated to have some
twenty-five years to run. At that time it will peak at a
level about 20% above present production levels. This
allows for an average annual growth rate in output of
about 1.2% a year until 2020 and, thereafter, at a
gradually slowing annual rate of increase over the
following decade until peak production is eventually
reached in 2030.
Fig. 4. Production curves 9
for conventional
8
and non-conventional oil
(1940-2140).
7
6
oil (Gtoe)
0
1940 1960
30
Non-conventional oil resources finally
enter the market
Thirty years is by no means a long time-horizon
for the future of oil; nor is the indicated annual rate
of increase in output very different than that of the
last thirty years. The future of oil over the period to
2030 and beyond is not, however, dependent only on
the expansion of output from the conventional oil
resource base as described and discussed above. It
will also involve the production of significant
volumes of so-called non-conventional oil, which can
be simplistically defined as oil which has to be
recovered from habitats other than deep reservoirs in
which oil occurs as a liquid with a viscosity which
makes it capable of flowing or being pumped to the
surface (Martinez and McMichael, 1997; Meyer,
1997). In terms of both geology and chemistry, the
distinction between conventional and non-
conventional oil is by no means absolute. Indeed,
much of the latter has been converted from the
former by degradation, involving significant changes
in the chemistry of the oil and, therefore,
modification of its physical properties.
Moreover, as far as the interest in non-conventional
oil from an economic standpoint reflects the ability to
derive useful petroleum products (or close substitutes
for such products) from it, then no division between
conventional and non-conventional oil is strictly
necessary. The availability of products from the latter
to serve oil markets can be viewed as part of the
continuum of a very long-term oil supply process.
It is, indeed, no different from the ways in which
supply developed in the past; as, for example, in the
following developments: the extraction of heavier oils
from conventional reservoirs as improvements in
technology made its production and refining
economically viable; the winning of oil from offshore
conventional oil
non-conventional oil
1980 2000 2020 2040 2060 2080 2100 2120 2140
year
ENCYCLOPAEDIA OF HYDROCARBONS

fields as in the Gulf of Mexico to supplement
indigenous supplies to the US market previously
derived from onshore fields in Texas, Louisiana and
other States; and in the evolution of North Sea
offshore oil production to substitute supplies from
elsewhere in the world for European markets.
These relatively recent changes in supply patterns
were ‘seamless operations’ in the context of the
industry’s continuing technological process and its
ability to organize and finance the development of the
new supplies (Odell, 1998). Most oil consumers
remained blissfully unaware of these changes in the
origin of their supplies. The same will be true in
respect of the future switch to non-conventional oil
production.
It is interesting to note that the only UN
organization concerned with oil per se, viz. the UN
Institute for Training and Research Centre for
Heavy Crude and Tar Sands (UNITAR), straddles
the technical divide between conventional and
non-conventional oil. The significance of this is
further enhanced by (or perhaps is even a function
of) the location of UNITAR in Alberta, Canada,
where the more than 50-year-old conventional oil
industry has now been complemented by the
world’s largest existing commercial operations for
the recovery of non-conventional oil (from the
Athabasca tar sands). These are already producing
500,000 barrels a day of oil products and 500,000
of bitumen (Meyer and Olsen, 1998; Verbicky,
1998; NEB, 2000; Williams, 2003). These
operations are, moreover, largely owned by
companies whose principal activities elsewhere in
Canada and in other countries are concerned with
conventional oil (and gas) production.
A similar process of diversification by such
companies is also underway in Venezuela where, in
recent years, the experience of the state owned
industry has been extended from the production of
heavy oil to the initial production of the reserves of the
vast Orinoco oil belt in the form of orimulsion,
involving a different and innovative technology
(Aalund, 1998). In other words, an equally ‘seamless’
process in the Venezuelan oil industry has, in effect,
already led to the initial stage of diversification of the
country’s traditional oil industry to non-conventional
oil production (Williams, 2003).
The Athabasca tar sands and the oil belt of the
Orinoco region are self-evidently new sources of
non-conventional oil, from which conventional oil
supplies can initially be complemented.
Estimates of the oil in place in the two areas are
conservatively put at 4,000 billion barrels, of which up
to 15% could be extracted with present technology.
This volume of recoverable non-conventional oil is
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
RESERVES AND RESOURCES
already equal to 40-67% of Shell’s estimates of the
expected additions to global reserves of conventional
oil. Even more significant, no less than 178 billion
barrels of non-conventional oil in western Canada
were formally declared as proven reserves in 2002,
thus making Canada now second only to Saudi Arabia
in its oil wealth.
Increasing knowledge and improving technology
have already led to more than 50% real cost reductions
in non-conventional oil production. Thus (in the
context of real oil prices which remain at or above the
late Twentieth-century level through the first decade of
the Twenty-first century) very large-scale
developments in Canada and Venezuela will be
underway by 2010. There are, moreover, known
extensive occurrences of non-conventional oil in many
countries, including Brazil, China, the former Soviet
Union, India, Madagascar, the US and The Democratic
Republic of Congo. Their exploitation not only
requires conditions which attract large investment
funds and technological expertise, but it also implies
that there are requirements for such non-conventional
oil developments in order to meet global or
regional/national demands.
Nevertheless, the continuing absence of a strong
enough motivation for a comprehensive and
systematic evaluation of ultimately recoverable
reserves of non-conventional oil, in the context of
adequate supplies of conventional oil to meet the
slowly rising demand until 2020, necessarily
undermines the utility of attempting to define the
world’s non-conventional resource base of proven,
probable and other reserves.
Yet this is the most effective basis on which a
potential production curve for such oils in the
Twenty-first century could be established. In its
absence, we can do no better than take a deliberately
modest figure for future non-conventional oil
availability and, on that basis, define a full-life
depletion curve starting from 2000. This exercise is
shown in Fig. 4, for which there is an assumption of a
total ultimately recoverable resource base of
non-conventional oil of 3,000 billion barrels (400 Gtoe).
The curve derived from this volume of resources shows
a slow build-up to peak production of 4.4 Gtoe in 2080:
an output at that date which is of roughly the same
magnitude (4.6 Gtoe) as that of the peak of
conventional oil production some fifty years earlier.
Finally, as shown in Fig. 5, when the depletion
curve of non-conventional oil is added to the depletion
curve for conventional oil, then non-conventional
supply is seen, first, to take over as the more important
growth element in the total oil supply curve after 2020
and, second, to push the combined peak production of
oil another thirty years into the future, viz. to 2060
31
MINERAL RESOURCES BETWEEN SCARCITY AND GROWTH
when the global oil production level reaches 6.6 Gtoe;
almost twice that of current global oil output.
Thereafter, this combined output of conventional and
non-conventional oil enters a long period of decline.
Even so, in 2100 the combination of the outputs of
conventional and non-conventional oil still supports an
oil industry which is approximately 28% larger than
the industry in 2000.
In other words, we argue with confidence that large
volumes of oil will continue to be offered to the global
energy market throughout the Twenty-first century, but
that the expansion of the industry will likely cease by
about 2060. Thereafter, given the assumptions made
above of reserves’ availability, a slow decline will
necessarily ensue. It seems more likely than not,
however, that this supply-side limitation will be
subsumed within a somewhat sharper decline
engendered by a falling demand for oil as natural gas
and renewables substitute it in an increasing number of
end-uses.
The supply of oil has, as analysed above, been
divided formally into conventional and
non-conventional components. We have, however,
previously argued the case that oil will, of course, be
supplied to consumers in future without specific
reference to its origin. Indeed, the origin of available
oil will be variable from time to time and from place
to place, and dependent on all the factors that each of
the many suppliers of oil has to take into account when
determining their supply schedules in the light of
changing circumstances.
As shown in Fig. 5, supplies of conventional and
non-conventional oil can be viewed as complementary
for the whole of the Twenty-first century, but more
especially so after 2030 when non-conventional oil
Fig. 5. The complementary
relationship of conventional 9 conventional oil
and non-conventional total conventional and non-conventional oil production from 2000
oil production (1940-2140). 8 date and volume of peak conventional and non-conventional oil production
6
oil (Gtoe)
0
1940 1960
32
production grows to exceed 1 Gtoe per year (equal to
approximately 20 Mbbl/d). It will, however, be the
2050s before non-conventional oil becomes the more
important source of supply.
Nevertheless, over the whole of the century,
oil’s contribution to the total hydrocarbon supply
will fall progressively from a 63.8% share in 2000
to only 29% in 2100 (Table 2). This will, in part,
reflect a resource-base restraint, but, in greater
part, it is more likely to indicate a demand-
constraint as the global hydrocarbon industry
increasingly turns its attention to (and makes more
of its investments in) the supply of natural gas,
partly for purely economic reasons and partly for
environmental reasons. Under those circumstances,
the world will not be running out of oil, or even out
of the ability to expand supply beyond the limits
shown above.
It could, instead, be running out of markets in the
face of increasing competition from gas so that as
shown in Fig. 6, the contribution of gas to the total
hydrocarbon supply will already exceed that of oil by
the late 2030s. Soon after 2060, as shown in Table 3
and Fig. 7, oil’s cumulative contribution in the
Twenty-first century to the global hydrocarbon supply
will have fallen to less than 50%.
1.3.2 Natural gas
Resource abundance
After a number of false dawns from the mid-1970s
to the early 1990s, for the anticipated near-future
major expansion of natural gas, for both geo-political
and environmental reasons (viz. diversification away
1980 2000 2020 2040 2060 2080 2100 2120 2140
year
ENCYCLOPAEDIA OF HYDROCARBONS
 RESERVES AND RESOURCES

Thus by 2000, gas contributed almost 24% of

Table 2. Contributions of oil to the total supply global energy use: less than 2.5% behind the
of hydrocarbons (2000-2050 and 2100) contribution of coal. Expectations for its continuing
expansion in both absolute and relative terms are now
Total oil Total oil Oil’s share generally accepted (Odell, 1998; Shell International
and gas supply supply of the total Petroleum Company, 2001; Natural gas [...], 2002;
(Gtoe) (Gtoe) (%)
New hydrocarbon [...], 2002; Adelman and Lynch,
2000 5.8 3.7 63.8 2003).
2010 7.1 4.3 60.1 Along with the rise in demand, there was an even
more rapid growth in the proven reserves, from 57
2020 8.6 5.1 59.3 Gtoe in 1975 to almost 160 Gtoe by 2004. After taking
2030 10.5 5.6 53.3 into account the production of about 49 Gtoe over the
same period, this implies a more than tripling of
2040 12.5 6.2 49.6
discovered reserves over the thirty years. The
2050 14.1 6.5 46.1 reserves-to-production ratio (based on current annual
production of about 2.4 Gtoe) has, over the same
2100 15.5 4.5 29.0
period, increased from 34 to 67 years. Gas production
has expanded in all major regions except the former
from energy dependence on Middle East oil and much Soviet Union, as have the remaining proven reserves
reduced CO2 emissions compared with other carbon of all the regions except North America. In brief, all
fuels, respectively) global natural gas production has the major indicators point to gas expansion as the
finally entered a period of continuing and significant norm, with a firm expectation that the process will
expansion. continue (Thackeray, 2002; IGU, 2003a).
Indeed, in the last decade of the Twentieth century, Concern about the future availability of gas at the
world gas production (and consumption) grew almost global level has never yet become an issue of any
50% more quickly than that of energy overall, albeit at significance (Delahaye and Grenon, 1983) in marked
an average annual rate of growth of only 2.1%. In the contrast to the many previously perceived concerns for
first five years of the Twenty-first century, the growth the adequacy of the world’s oil resources (see above).
rate has increased to 2.5% per annum. This There have, however, been recent fears for the
development seems at last to negate the earlier continuity of supply availabilities in three regions, viz.
well-established and widely-held views that the natural the US, Western Europe and the former Soviet Union.
gas resource-base and/or the energy markets which gas In the US, these fears have some justification,
could serve were too limited to make possible its given the maturity of the industry (which dates back to
emergence as a third significant energy source the early years of the Twentieth century) and the low
alongside coal and oil (Marchetti, 1978; IGU, 1997; reserves-to-production ratio (a little under ten years)
Odell, 1998). with which the industry has worked for almost twenty

Fig. 6. Oil and gas supplies 18

total hydrocarbons supply 125
in the Twenty-first century.
16
oil
14 gas
100
hydrocarbons (Gtoe)

12
oil (Gboe)

10 75

8
50
6

4
25
2

0
2000 2010 2020 2030 2040 2050 2060 2070 2080 2090 2100
year

VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION 33

MINERAL RESOURCES BETWEEN SCARCITY AND GROWTH

Table 3. Cumulative contributions of oil and natural gas to the energy supply in the Twenty-first century

Cumulative oil Oil’s share Oil’s share

Cumulative oil
Period and gas of cumulative total per decade indicated
(Gtoe)
(Gtoe) (%) (%)
1860-2000 176 120 68.2 –
2001–2010 65 40 61.5 61.5 (01-10)
2001–2020 150 91 60.9 60.5 (11-20)
2001–2030 245 145 59.0 56.2 (21-30)
2001–2040 365 206 56.5 51.6 (31-40)
2001–2050 495 266 53.7 46.3 (41-50)
2001–2060 645 330 51.1 42.7 (51-60)
2001- 2070 810 393 48.5 38.3 (61-70)
2001–2080 950 443 46.6 34.9 (71-80)
2001–2090 1,085 485 44.7 32.0 (81-90)
2001–2100 1,215 522 42.9 28.0 (91-00)

years. Recent reappraisals of old gas-producing areas
together with new, mainly offshore reserves
discoveries have, however, converted the earlier
pessimism into moderate optimism for continued
growth in both reserves and annual production
(Natural gas [...], 2002).
The level of production is, indeed, now getting
back closer to the earlier all-time high, over thirty
years ago in 1972. Nevertheless, the country is now
also having to import over 100 billion cubic metres
(90 Mtoe) in order to meet burgeoning demand – in
spite of a more than tripling of the gas price since
1990. The implications of this for the future of the US
natural gas industry in the Twenty-first century are
discussed in the Chapter 9.2).
In Western Europe, recurring fears of gas scarcity
were taken so seriously in the mid-to-late 1970s (at a
time when indigenous production was in its infancy)
that restraints on gas use for power generation were
directed by the European Commission. At the same
time, the Netherlands, then the principal European gas
producing country, prohibited any additional exports.
Later, the UK and Norway also deliberately
constrained production. The fears were, however,
entirely irrational, given that they were based on
incorrect assumptions, viz. first, that the gas supply
was price inelastic and, second, that indigenous proven
reserves, based on a very limited exploitation of the
potentially gas-rich provinces of north-west Europe,
told the full story of the future supply possibilities. In

Fig. 7. Cumulative oil 1,800

and gas production
in the Twenty-first century. 1,600 cumulative oil and gas production
1,400 cumulative oil production
hydrocarbons (Gtoe)

1,200
1,000 cumulative gas production
exceeds that of oil in 2064
800
600
400
200
0
2000 2010 2020 2030 2040 2050 2060 2070 2080 2090 2100
year

34 ENCYCLOPAEDIA OF HYDROCARBONS
 RESERVES AND RESOURCES

reality, it was the limitations on demand and
inappropriate government policies that jointly
inhibited gas exploration and exploitation as they
made investments in upstream developments
uninteresting and unrewarding (Odell, 1988). The
situation and outlook have, however, been reversed
since 1990 with a resulting more than 50% increase in
West European production. There does, nevertheless,
still remain a tendency for the countries concerned
(except Norway) to report reserves and prospects
conservatively, so persuading energy policy makers
that high gas dependency is unwise (Odell, 1995,
2001-2002b).
One notable element in the fundamentally-changed
politico-economic situation, following the break up of
USSR, has been the maintenance of the level of
declarations of proven natural gas reserves in the
Former Soviet Union (FSU), and especially in Russia,
whose reserves constitute over 80% of the FSU’s total.
This reserves position has been achieved in spite of the
political and economical traumas that affected the
newly independent countries of the former Soviet
Union, and in the context of a declining demand there
for natural gas (from 666 billion cubic metres in 1991
to a low of 464 billion cubic metres in 1999) as a
result of those problems. The reserves-to-production
ratio for the FSU as a whole is now over seventy-seven
years, well ahead of the world average of sixty-seven
years.
Given these outlooks in 2000 for natural gas in the
three most important world markets for its production
and consumption then, in an evaluation of its
long-term future, natural gas can be seen to be starting
its Twenty-first century role from a much more
favourable base than that for oil. Proven global
reserves simply as declared (but without taking
account of the inevitable appreciation which will
emerge from the continuing development of the
industry) could keep global gas production growing at
about 3% a year for over twenty-five years. Even then,
about one-third of current proven reserves would still
remain unused in 2030.
Some years prior to that, of course, the continuing
ability of conventional gas production to grow would
depend on additional reserves having been found in
the meantime, but this is already a certain prospect
(Cornot-Gandolphe, 1995; USGS, 2000).
Indeed, large volumes of additional reserves are
widely and generally expected because most of the
existing gas producing provinces have been
developed relatively recently, and thus remain areas
in which continuing additional investments in
exploration and production would remain relatively
low cost. There are, moreover, other large areas of
potential, both onshore and offshore, which remain
entirely or almost entirely unexplored. The current
range of estimates of recoverable conventional gas, in
Table 4, shows that 238 Gtoe of natural gas had been
used or was recognized as proven reserves by the
beginning of 2005, and that another 198-303 Gtoe of
additional reserves are forecast. These are described
as being “extremely conservative” assessments for
some regions, so that “additional reserves could
exceed the total shown in the table” (IGU, 2003b).
Indeed, the United States Geological Survey in its
recent comprehensive world-wide evaluation of

Table 4. World conventional gas reserves and resources, by region and percentage depletion by 2005 (in Gtoe)

Estimates Ultimately Percentage

Proven
Region Production of additional recoverable depletion of
reserves
reserves reserves reserves
North America 28.8 6.9 30-52 66-88 32.6 to 43.6
Central
3.6 6.4 7-22 17-32 11.3 to 21.1
and South America
Europe (excluding FSU) 8.8 4.7 5-14 18-28 31.4 to 48.9
Former Soviet Union 20.1 52.5 96-110 168-183 10.9 to 12.0
Middle East 5.2 65.5 29-50 100-121 4.3 to 5.2
Africa 2.8 12.7 5-14 21-30 9.3 to 13.3
Asia Pacific
5.2 12.8 26-41 44-59 8.8 to 11.8
(excluding FSU)

Total 76.5 161.5 198-303 436-540 14.2 to 17.7

Source: WEC/IIASA, 1995; Rogner, 1996; BP, 2001; IGU, 2003b.

VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION 35

MINERAL RESOURCES BETWEEN SCARCITY AND GROWTH
remaining undiscovered conventional gas resources
arrived at a mean value of almost 400 Gtoe (USGS,
2000).
In plotting a global production curve for depleting
the volume of the natural gas indicated (Fig. 8), two
assumptions have thus been made:
• First, that the supply of gas will increase at a rate
which ensures that the combined growth rate in the
use of hydrocarbons (oil and gas) can be met. This
will require a growth rate in gas supply in excess
of 2% per annum for the first half of the century,
and thereafter at a progressively lower rate of
growth until 2140.
• Second, that the growth curve for conventional
natural gas will persist until the time at which the
use of about 40% of the mid-point of the range of
the ultimately recoverable resources is
approaching, viz. by the late 2030s. Thereafter, the
slope of the curve will gradually fall away under
the pressure of an increasing reserves restraint,
until the peak production of conventional gas is
reached in the 2050s.
By then, about 240 Gtoe of the world’s ultimately
recoverable conventional gas of 480 Gtoe (the
mid-point of the range shown in Table 4) will have
been used. As shown in Fig. 8, the decline curve then
sets in, and by 2100 conventional gas supply is down
to less than half of its peak rate in the mid-Twenty-first
century. By the end of the century, the ultimate
resource base as presently defined will be almost 90%
depleted.
Given the results of these assessments of the future
supply prospects for conventional natural gas, it is
self-evident that the maintenance of a rising
availability of hydrocarbons each year through the
second half of the Twenty-first century will depend on
the exploitation of non-conventional gas resources
(Delahaye and Grenon, 1983).
Fig. 8. Production curves 9
for conventional
8
and non-conventional gas
(1940-2140). 7 non-conventional gas
6
gas (Gtoe)
5
4
3
2
1
0
1940 1960
36
The potential availability of these, even in the
recent past, has been only modestly evaluated – so
modestly, indeed, that they did not figure at all in IGU’s
(International Gas Union) 1997 presentation of world
gas prospects (IGU, 1997), except as an unspecified
component in the gas reserves data for North America
(and thus included as an unknown element in the
additional gas reserves’ figure for that region in the
Table 4). For most of the rest of the world, the potential
for gas recovery from the range of unconventional
habitats (viz. coal-bed methane, tight formation gas,
gas from shales and gas remaining in situ after
conventional production) has not yet become a relevant
question as a result of the large remaining conventional
gas resources in relation to demand expectations over
the first half of the Twenty-first century.
Thus, only speculative figures exist for the global
non-conventional gas resource-base. One such set of
figures has been derived from the in-depth study made
by the Vienna-based IIASA (International Institute for
Applied Systems Analysis) in the mid-1990s, Global
energy perspectives to 2050 and beyond (WEC/IIASA,
1995). This indicated potentially recoverable resources
in the range of 779-948 Gtoe, of which 138 are already
known and considered to be technically and
economically recoverable. As shown in Table 5,
non-conventional gas resources are geographically
distributed across all the world’s continents (except
Antarctica which was not included in the analysis).
The study also made estimates of possible
resources of gas in hydrates, with the global and
regional results as also shown in Table 5. These figures
are gigantic (compared with other non-conventional
gas resources, let alone set against conventional gas’
prospects), but have since been challenged (USGS,
2001; Cherkashov and Soloviev, 2002). Further
attention is given below to these prospective
resources’ exploitation.
conventional gas
1980 2000 2020 2040 2060 2080 2100 2120 2140
year
ENCYCLOPAEDIA OF HYDROCARBONS
 RESERVES AND RESOURCES

Production potential Fig. 8 and Fig. 9. It is, nevertheless, reasonable to

For the purpose of modelling the Twenty-first assume that once the technology of producing gas
century supply curve, production of non-conventional from coal measures and other non-conventional
gas is predicated to begin at the time (around 2020) habitats in the US has been perfected, it will rapidly
when conventional gas production may require some spread to other areas of significant potential (USGS,
supplementation so that an availability of gas 2001; Coal bed [...], 2003). This development will lead
sufficient to sustain an annual growth of ⫾2% in the thereafter to a rapid build-up of production, providing
overall hydrocarbon supply can be achieved. Note that that demand for natural gas continues to grow (as we
this is a pessimistic view of the timing of the initial forecast), and that energy prices remain high enough
use of non-conventional gas, given that not to justify the investment required (as we predicate).
insignificant volumes of such gas are already being This process of increasingly intensive and extensive
recovered in the US, mainly from coal measures non-conventional gas exploitation will, we suggest,
(Gas [...], 2003) reflecting the more than 24% of begin in earnest in the 2020s (although it will have
current global gas use that is concentrated in that begun earlier in the US and China).
country. As shown in Fig. 9, non-conventional gas will,
Globally, however, the amounts of from the 2020s to 2050, complement output from the
non-conventional gas that will be produced in the short decelerating rate of increase in conventional gas
medium term seem likely to be modest, because of supplies. After 2050, when conventional gas supplies
competition from lower cost conventional gas start to decline, defined non-conventional reserves and
production. It is thus likely to be the second quarter of their production potential will have become substantial
the Twenty-first century before the output of enough to enable the global production of gas to
non-conventional gas is large enough to impact continue to increase. Thus, non-conventional gas is
significantly on the shape of the production curves in forecast to take over as the more important component
in the total supply in the mid-2060s.
On the assumption that the ultimately recoverable
Table 5. World non-conventional gas resources reserves of non-conventional gas total 650 Gtoe, equal
by region (Gtoe) to 80% of the low end of the range of the IIASA
defined resource base of 780 Gtoe (as shown in Table
Coal-bed methane, 5), and so excluding any gas recovery from
tight formation geo-pressured gas and gas hydrates, then output will
gas, gas from Gas hydrates*
reach an ‘inevitable’ peak towards the end of the
Region shales and gas and
remaining after geopressured gas Twenty-first century (see again Fig. 8) when its
conventional cumulative production reaches about 340 Gtoe; that is,
production 50% of the defined level of ultimately recoverable
North America 210-230 6,089 reserves.
Meanwhile, as shown in Fig. 9, the peak of total
Central and conventional plus non-conventional gas output will
87-95 4,567
South America also occur in 2090 with a cumulative production from
2001-90 of about 650 Gtoe. More than fifty years
Europe
32-40 761 prior to that, however, in the 2030s, the annual
(excluding FSU)
contribution of gas to the global energy economy will,
Former Soviet as shown in Fig. 6, exceed that of oil; while by 2064,
139-181 4,186
Union cumulative gas use in the Twenty-first century will
exceed that of oil (see again Fig. 7).
Middle East 86-112 190
Of greater importance, however, is natural gas’
Africa 27-32 381 continuing ability until 2080 to sustain the annual
increase in the hydrocarbon supply required by the
Asia Pacific
198-258 2,474 then diminishing rate of growth in the demand for
(excluding FSU)
energy. There is thus no real significant shortfall in
Total 779-948 18,647 hydrocarbons’ availability to satisfy overall demand,
except possibly in the last decade of the century with
* A more recent evaluation (Cherkashov and Soloviev, 2002) the post-2090 decline in the peak production of natural
assesses the world resources of potentially recoverable hydrates at
only 8-10% of the estimated total in this column, but it does not gas (see again Fig. 9). Even this could be avoided,
give a regional breakdown. See text. however, given the likelihood that additional gas
Source: Rogner, 1996. supplies could well emerge in the second half of the

VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION 37

MINERAL RESOURCES BETWEEN SCARCITY AND GROWTH
Fig. 9. The complementary 12
relationship of conventional
11
and non-conventional gas
production (1940-2140). 10
9 non-conventional gas
8
gas (Gtoe)
7 peak conventional
6 non-conventional
5 gas production
4
3
2
1
0
1940
century from the initial period of exploitation of gas
hydrates (Lowrie and Max, 1999; Gas [...], 2000).
Such a new source of supply would make but a tiny
dent in the 18,647 Gtoe of such resources indicated in
Table 5. Even the recent 90% lower estimates of 1,600
to 2,000 Gtoe of exploitable gas hydrates reserves
(Cherkashov and Soloviev, 2002) would be only
modestly depleted by a late Twenty-first century
demand for up to 350 Gtoe of such gas, as a
supplement to the gas produced from conventional and
other non-conventional habitats.
Another 50 years or more of continuing scientific
advances and developments in engineering capabilities
for gas hydrates production (Carroll, 2003) would
seem to give more than enough time to enable a small
number of the 70 regions worldwide with gas hydrates
on the sea bottom (Cherkashov and Soloviev, 2002) to
be brought to commercial exploitation. Thereby the
late Twenty-first century hydrocarbons supply-side
gap, revealed by the foregoing analysis, could be
filled.
Natural gas’ environmentally friendly
characteristics
Unlike oil, the production and transportation of gas
has not led to environmental problems in terms of
adverse effects on landscapes or marine conditions.
Explosions and accompanying fires do, of course,
constitute a danger of life, but they have not occurred
frequently. While increasing the production and use of
conventional gas to roughly three times its present
level will exacerbate the problems noted above, they
hardly seem likely to constrain pipeline supplies,
38
conventional gas
total conventional and
production from 2020
date and volume of
and
1960 1980 2000 2020 2040 2060 2080 2100 2120 2140
year
except on a temporary basis and in particular
locations.
More concern does, however, arise from the now
rapidly growing bulk international movements of gas
in its liquefied state (LNG, Liquefied Natural Gas) by
ocean going tankers. Such movements and the
accompanying liquefaction/loading and
unloading/regasification facilities are inevitably more
hazardous, and will need to be closely monitored and
regulated as volumes expand. Current annual
movements are under 0.15 Gtoe (compared with 0.4
Gtoe of pipelined gas), but this is expected to increase
threefold by 2025, and by the last decade of the
Twenty-first century, it could account for up to 10% of
the forecast annual supplies of some 10 Gtoe of natural
gas to global markets (Quinn, 2000; Jensen, 2003).
In spite of the world’s increasing use of carbon
energy in the Twenty-first century, the massive
substitution of coal and oil by natural gas will
restrain the rate of growth in anthropogenic-created
emissions of CO2 by roughly an estimated 15%,
compared with the emissions which would have
occurred, had the year 2000 percentage contributions
of the three carbon fuels to the total supply of energy
remained unchanged. This percentage reduction in
CO2 emissions from the changing carbon fuel mix
will, moreover, be further enhanced by the expected
increasingly successful processes of sequestering
CO2, rather than allowing it to go to the atmosphere
(Freund, 2002; Torp, 2002; Moritis, 2003). As a
result, CO2 emissions overall from carbon energy use
in 2100 seem unlikely to be much more than twice
their 2000 level.
ENCYCLOPAEDIA OF HYDROCARBONS
 RESERVES AND RESOURCES

The lower CO2 emissions from gas per unit of
energy used compared with coal and oil, make gas the
preferred carbon fuel (EIA, 1994; Gregory and
Rogner, 1998; Freund, 2002; Natural gas [...], 2002;
New hydrocarbon [...], 2002; Jean-Baptiste and
Ducroux, 2003). Thus, many industrialized countries
have already specified a much increased gas use as the
main means by which they can meet their lower
emissions targets under the terms of their Kyoto
Protocol. Many developing countries also see
increased gas use as a principal means not only of
cleaning up their cities, but also achieving more
generous developmental assistance in return for lower
CO2 emissions (Bartsch and Müller, 2000; IEA, 2002;
Paik, 2002; Chow, 2003).
The Twenty-first century implications for this
steadily rising preference for natural gas (even over
oil) are shown in Fig. 10. Gas supply overtakes that of
oil in the 2040s, and in the last decade of the century
it accounts for about 73% of the world’s hydrocarbons
supply. Methane itself is, however, also a greenhouse
gas which, when released to the atmosphere, is some
four times more significant than CO2 on a unit basis,
so causing concern over its contribution to climate
change and rising sea levels.
More than insignificant volumes of gas can be lost
to the atmosphere in production operations, while
pipeline leakages are a major problem in some
200
gas
oil
150 gas production
exceeds that of oil
hydrocarbons (Gtoe)
countries, notably those of the Former Soviet Union
(Van de Vate, 1997). More effective engineering and
improved operational systems will become increasingly
required as volumes of gas supply increase more than
five times over the century, particularly as much of this
increase will be derived from the production and
transport of gas in countries without much previous
experience of the industry, for example, in Latin
America and the Asia Pacific region. A failure to
achieve high enough standards in preventing methane
emissions could, in due course, produce an institutional
constraint on gas production, the impact of which
might well become great enough to moderate the
upward slope of the supply curve shown in Fig. 9.
Only in extreme circumstances, however, is it
possible to envisage as serious an environmental
constraint on gas production and use as that faced by
coal and oil.
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41

The macroeconomic impacts
of oil price shocks
1.4.1 A short history
of a controversial topic
Since the 1973 OPEC (Organization of Petroleum
Exporting Countries) oil embargo, the role of rapid,
unanticipated increases in oil prices has been a topic
of intense interest, among both economists and the lay
public. Considering the magnitude of widespread
national recessions during the 1970s, the controversy
surrounding research on the macroeconomics of oil
price shocks may seem surprising: why would anyone
doubt the capacity of oil price shocks to cause the
major movements in GDP (Gross Domestic Product)
which have been observed in so many countries?
Possibly most important in fueling the controversy
is the small share of GDP that oil and its close
substitutes have comprised in most economies: 1.5%
to 3% prior to the 1973 episode. Experienced
macroeconomists doubted that even a sizeable shock
to such a small part of the economy could have the
observed effects. Second, the 1973 episode itself was
not a clean experiment because a number of other
major factors were emerging at the same time. The
world economy was just getting off the post-Bretton
Woods fixed exchange rate regime. A number of
countries, including the United States, was teetering
on the brink of recession at the time of the 1973
shock; in the United States in particular, monetary
policy tightened right around the time of the 1973
shock. Separating these effects and deciding the role
of oil price shocks in post 1973 movements of GDP,
unemployment rates, and other recessionary indicators
has been technically difficult; the potential answers to
oil’s role have been seen as important components of
diverse doctrinal programs, ranging from fundamental
paradigm shifts in macroeconomics to more purely
political agendas. Many technical results were clouded
by the limited ability to control enough variables to
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
1.4
test precise hypotheses, while econometric results
were filtered through strong preconceptions about how
the world worked and equally strong desires about how
it should work. Third, some major industrial countries
were not nearly as hard-hit by the 1973 shock as
others, and econometric analysis was unable to offer
widely satisfactory explanations. Putting all these
factors together has fueled a quarter-century of
vigorous research and equally vigorous controversy
about the ability of oil price shocks to cause
macroeconomic recessions.
In 1983, James Hamilton published a paper
identifying a Granger-causal relationship between oil
prices and GDP in the United States during the entire
post-Second World War period through the 1979-80
episode associated with the Iranian Revolution and the
opening of the Iran-Iraq War (Hamilton, 1983). The
author found that oil prices had increased sharply prior
to every recession the United States experienced in the
post-war period. Several years later, McMillin and
Parker (1994) found that decreases in oil prices during
the decades between the First World War and the
Second World War, accompanying the discovery of
new fields and the development of new extraction and
refining technologies, had contributed to economic
growth, even during the difficult decade of the 1930s.
While Hamilton’s paper was ultimately more
influential, the combined findings pushed the evidence
of oil prices’ ability to affect the macroeconomy back
nearly sixty years before the OPEC embargo.
The year 1989 saw two particularly influential
publications on the economics of oil price shocks, with
results pointing in opposite directions. Douglas Bohi
published a monograph that was unable to find a
relationship between oil price movements and
three-digit-SIC (Standard Industrial Classification)
employment in Japan and the United States during the
1973-74 and 1979-80 oil price shocks, from which he
43
MINERAL RESOURCES BETWEEN SCARCITY AND GROWTH
concluded that the ensuing recessions were attributable
to inappropriately tightened monetary policy rather
than oil price shocks (Bohi, 1989). Knut Anton Mork
pursued some unresolved results from Hamilton’s
1983 paper, which showed a weakening of the oil
price-GDP relationship during the 1970s (Mork,
1989). With the additional observation of the
non-response to the 1986 oil price collapse, Mork
noticed that oil price increases appeared to impede
economic growth but oil price decreases, at least
during the post-Second World War period, did not
appear to boost growth. Mork introduced the concept
of asymmetric effects of oil prices with separate
variables for increases and decreases. This asymmetric
oil price variable was able to yield a stable relationship
between oil prices and GDP during the full post-war
period. The asymmetric macroeconomic effect of oil
prices has been widely accepted since Mork’s 1989
publication, but the matter of whether the oil
price-GDP relationship has been stable has not been
resolved to the satisfaction of all researchers,
particularly during the 1990s.
One of the results of the asymmetric oil price
specification is that both unanticipated oil price
increases and unanticipated decreases can have
disruptive effects on an economy. Lilien’s dispersion
(Lilien, 1982) or sectoral shocks hypothesis offers a
mechanism to account for this behaviour, and Gilbert
and Mork (1986) offered an early explanation for the
phenomenon along similar lines. This effect can
account for the lack of positive response around the
world to the 1986 oil price crash.
1.4.2 Microeconomic mechanisms
that transmit oil price shocks
to the macroeconomy
During the 1990s, following the challenge from Bohi
and the asymmetric relationship identified by Mork,
research focused on transmission mechanisms by
which oil price shocks might cause, or contribute to,
macroeconomic recessions. Several major possible
transmission mechanisms have been identified and, to
varying extents at present, researched; a) labour
markets; b) capital equipment utilization; c) interest
rate channels; d ) uncertainty and investment pauses;
e) the sectoral shocks hypothesis. These mechanisms
need not be mutually exclusive.
Labour market channels. Analysis of labour
market mechanisms has used the concept of aggregate
and allocative channels, the former being the
traditional macroeconomic mechanisms of potential
output effects, income transfers, and wage stickiness,
and the latter involving the closeness of match
44
between desired and actual factor input levels across
firms. Research on labour markets has observed that a
given level of unemployment is comprised of far more
extensive destruction and creation of jobs, with the
observed unemployment rate being a net result. Davis
and Haltiwanger (2001) found that oil price shocks
cause more job destruction than job creation in nearly
every industrial sector, with a magnitude about twice
that of monetary shocks. The reallocative impact of the
OPEC shock of 1973Q3 to 1974Q4 amounted to about
11% of the total US manufacturing employment over
the fifteen quarters following that episode. They found
much of this reallocation within four-digit industries,
which suggests that Bohi’s research may have
examined employment changes at too aggregated a
level to find the effects of oil price shocks.
Keane and Prasad (1996) found that oil price
increases depressed real wages for all workers in the
United States but raised the relative wage of skilled
workers. They found that oil price changes did not
appear to cause labour to move into sectors with
relative wage increases. It is possible that oil price
shocks change optimal technologies in industries in
ways that destroy part of workers’ less tangible
skills, inducing them to find employment in
industries requiring skills below their apparent
human capital levels. Part of workers’ human capital
may be firm-specific; thus separation becomes a
more potent force for downward mobility, at least in
the short term. The same study suggests that skilled
labour may be a substitute for energy in many
industries.
Capital equipment utilization. This channel has
not received empirical examination to date, but Finn
(2000) has developed a relatively aggregative model in
which oil price increases depress capital’s future
marginal product, which reduces investment and future
capital stock. Oil price increases thus can have long-
lived effects on output.
Interest rates. Several studies have found that
interest rates respond to oil price increases (Ferderer,
1996; Hooker, 1996, 1999; Balke et al., 2002). Balke
and co-authors found asymmetric responses of
short- and long-term interest rates to separate positive
and negative oil price shocks, and found evidence
of a choosing of quality in the spread between
four- to six-month period of commercial paper and
six-month Treasury bills. This relationship suggests
a search for security when an oil price increase
heightens uncertainty in the economy.
Uncertainty and investment pauses. Bernanke
(1983) developed a model of irreversible investment in
which an oil price increase heightens uncertainty and
causes firms to defer investment until some of the
uncertainties are clarified. This model has not been
ENCYCLOPAEDIA OF HYDROCARBONS

applied to macroeconomic impacts of oil price shocks
although a number of authors have alluded to the
possibility of such an effect producing the phenomena
they observe.
Sectoral shocks. The sectoral shocks hypothesis
(Lilien, 1982; Hamilton, 1988), known alternatively as
the employment dispersion hypothesis, proposes that a
shock that has differential effects across sectors will
have a larger impact on aggregate unemployment.
Greater dispersion of sectoral shocks increases the
labour reallocation required, which leads to a larger
overall unemployment rate. The reallocative impacts of
any price shock, positive or negative, can cause an
increase in job creation and destruction, leading to an
increase in aggregate employment as time is required
for resources to be reabsorbed elsewhere in the
economy.
Loungani (1986) found evidence supporting the
possibility that oil price shocks were such a sectorally
dispersed event. Other researchers (Keane and Prasad,
1996; Carruth et al., 1998; Davis and Haltiwanger,
2001) have found partial support for this view of the
potency of oil price shocks.
1.4.3 Monetary policy in response
to oil price shocks
Early scepticism that oil comprised a large enough
sector of the economy to be responsible for the
recessions following the price shocks has led to a
number of studies that try to distinguish between the
effects of oil price shocks and monetary policy
shocks around the episodes of 1973-74, 1979-80 and
1990-91. The small number of observations, as well
as the intricacy of the economic interactions
involved in modelling, have rendered it difficult to
obtain clear results. Bernanke and co-authors (1997)
claimed to have established that monetary policy
shocks were the dominant contributor to the
recessions of 1974-75, 1982, and 1991, and that the
preceding oil price shocks were of little
consequence. Their modelling approach, a VAR
(Vector AutoRegression) simulation exercise,
required specification of how private capital markets
operated; a re-examination of their model and data
by Hamilton and Herrera (2004) found that the
Bernanke and co-authors model implied that the
Federal Reserve would have had to depress the
federal funds rate by 900 basis points and that
private investors would have had to overestimate the
funds rate for thirty-six months in a row. Allowing
for a more plausible monetary policy, Hamilton and
Herrera found that monetary policy could do little to
mitigate the effects of oil price shocks.
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
THE MACROECONOMIC IMPACTS OF OIL PRICE SHOCKS
The alternative hypothesis, that monetary policy
has systematically responded to oil price shocks and
has been responsible for the post-shock recessions
instead of the oil price shocks, is sometimes called the
systematic monetary policy hypothesis. Hooker (2000)
found that the federal funds rate became less sensitive
to oil price changes at the very time the systematic
monetary hypothesis would have required it to become
more sensitive.
Altogether, current evidence suggests that the
recessions following the past quarter century’s oil
price shocks were due to these shocks, rather than
monetary policy.
1.4.4 What constitutes
an oil price shock?
The analysis of oil price shocks began with a single oil
price variable used in regressions, which was capable
of estimating symmetric effects of oil price changes.
Mork’s (1989) asymmetric approach used separate
variables for oil price increases and decreases. This
construct was able to yield a stable relationship
between oil price shocks and GDP over the entire
post-war period through the late 1980s, but, by the
mid-1990s, it began to perform less effectively in later
sample periods. It became recognized that the term
‘shock’ implied an unexpected change, rather than just
a change, in the oil price, and that the measure of a
genuine shock might well be more intricate than the
asymmetric oil price variable.
Lee and co-authors (1995) were the first authors to
develop a measure of the oil price that accounts for the
surprise component of a particular price change. Their
measure divides the change in each period by an index
of recent volatility of oil prices. Hamilton (2001)
showed that the oil price shock measure in this article
was capable of yielding a stable relationship between
oil prices and GDP over the entire postwar period
through the 1990s.
Hamilton (1996) introduced the NOPI (Net Oil
Price Increase) concept, with a variable that used only
positive changes which reached a level greater than
had been reached within the previous year. The
one-year NOPI measure yielded a stable oil price-GDP
relationship through the date of publication, but
subsequent analysis of the NOPI concept found that
extending the one-year time period to three years
improves the stability of the oil price-GDP
relationship. The three-year NOPI measure identifies
an oil price increase as a shock only if the price
surpasses the highest observed price during the
previous three years, and the size of the shock is only
the percentage by which the three-year peak is
45
MINERAL RESOURCES BETWEEN SCARCITY AND GROWTH
exceeded. Hamilton (2003), recognizing the
simultaneity between oil supply and price,
experimented with a physical measure of oil supply
disruption, with results quite similar to those obtained
with the three-year NOPI variable.
1.4.5 The econometrics
of oil price shocks
Early econometric analysis of oil price shocks
relied on ordinary least squares regression
estimation, generally augmented with
autocorrelation corrections. These analyses were
generally structural estimations, from which
elasticities could be derived readily. Hamilton
(1983) introduced the newer time-series technique
of VAR to the subject, to accommodate the time-
series character of macroeconomic data, and most
analyses since then have used VARs (error
correction models, another time series technique,
have been used in oil price-macro analyses as well.)
Because of the lag structure of VARs, the regression
coefficients are not interpretable as elasticities. The
coefficients of the impulse response function
calculated from a VAR are technically the partial
elasticities to the dependent variable with respect to
the independent variable, and accordingly the sum
of the lagged IFR (Impulse Response Functions)
coefficients could be interpreted as roughly
comparable to an elasticity (of GDP to oil prices),
but the results of the IFR calculation are dependent
on the method of triangularization of the VAR in a
way that introduces an element of arbitrariness into
the estimation that has been difficult to measure
(Hamilton, 1994).
While the analysis of oil price shocks has turned to
mechanisms that convert these price movements into
large and sustained output and employment
movements, the time series econometrics has not kept
up with its ability to test structural hypotheses.
Structural approximations with VARs are constructed
with triangularization methods that imply causation,
but the results are sensitive to the ordering of
variables. Coefficient values are not readily
interpretable as magnitudes of coefficients in
structural economic models, and the interpretation of
impulse response functions may not be entirely clean
measures of the effect of a variable of interest. This is
an area where improvement in application should be
expected in the coming decades. In the meantime,
hypothesis testing of structural relationships such as
can be conducted with cross sectional data is not a
straightforward matter in oil shock-macroeconomy
research.
46
1.4.6 Non-US evidence
Much of the empirical estimation of oil price shocks'
impacts on aggregate economic performance has been
conducted with US data. Nonetheless, some work was
done early on non-US data, and research has been
published recently on examination of European
countries. Burbidge and Harrison (1984) used a VAR
approach with a symmetric oil price change
specification to compare the response of the United
States, the United Kingdom, Canada, Japan, and
Germany following the 1973 and 1979-80 oil price
shocks. They found that oil price shocks affected all
these countries, but that Japan was more strongly
affected by the 1979-80 shock than the 1973 one.
Mork and co-authors (1994) estimated VARs with
Mork’s (1989) asymmetric oil price specification for
seven OECD (Organization for Economic Cooperation
and Development) countries from 1967 to 1992.
France, the United Kingdom, West Germany, Canada,
and Japan exhibited much of the temporal pattern of
response as found in the United States, but Norway,
being a major oil producer, had a positive response to
oil price shocks.
Several European studies have appeared recently.
Using a symmetric oil price specification over the
period 1989-99, Papapetrou (2001) reported impulse
response functions for effects of oil price changes on
Greek industrial production and employment of
⫺0.027 and ⫺0.008. These relatively small impacts
excluded the periods of the large oil shocks of the
1970s, but oil prices still accounted for about 20% of
the forecast error of industrial production and around
10 to 20% for employment, considerably larger than
the impact of interest rates. Cuñado et al. (2003) used
a VAR approach to study fourteen European countries,
comparing the performance of alternative oil price
specifications. Hamilton’s NOPI specifications and
Mork specifications yield significant impacts of oil
price shocks in eleven cases, and the Lee and
co-authors (1995) variance-conditioned specification
in thirteen instances. The negative effect of an oil price
shock on industrial production typically reached its
peak about six quarters after a shock, and recovery
was reached by ten to twelve quarters. Miguel and
co-authors (2003) simulated a real business cycle
model, much like Finn’s (2000), to study impacts of oil
price shocks on Spain’s economy. They emphasized
the exogeneity of the interest rate to the Spanish
economy, an important difference from the US case.
They found oil price shocks could account for 60% of
the business cycle fluctuations from 1970 through
1998.
Bachman and Jacquet (1998), in unpublished work
conducted for the US Department of Energy’s Office of
ENCYCLOPAEDIA OF HYDROCARBONS

the Strategic Petroleum Reserve, conducted VAR
analyses of oil price shocks on fifteen developed and
developing countries of the Pacific Rim: the United
States, Canada, Mexico, Chile, Australia, Japan, the
Philippines, Indonesia, Singapore, Hong Kong,
Malaysia, Thailand, Taiwan, South Korea and China.
Few other studies have targeted many of these countries.
They used the Mork asymmetric oil price specification
and found negative responses of GDP in the first and
second years after both oil price increases of 100% and
decreases of 50% across many of these countries.
1.4.7 The impact of oil prices
on the macroeconomy
The most recent OLS (Ordinary Least Square)
non-VAR estimate of the oil price-GDP elasticity for
the United States is Mory’s (1993) estimate of ⫺0.055.
This amount is very close to the sum of lagged oil
price coefficients Mork and co-authors (1994)
estimated for the United States with a VAR, ⫺0.054,
but the lag coefficients component in the denominator
of the reported coefficients is unknown. This number
need not be a reliable estimate of the impact of oil
price shocks on US GDP. The Mork and co-authors
article reports VAR estimates of the oil price-GDP
relationship for about a dozen OECD countries, and
the sum of the lagged oil price coefficients varies
considerably across countries. However, because of the
construction of those coefficients, inferences from
direct comparison of their magnitudes are hazardous.
The sum of Hamilton and Herrera’s (2004) impulse
response coefficients over forty-two months for the
United States is ⫺0.055, using the one-year NOPI
measure of oil price shocks. The sum of impulse
response coefficients over eight quarters in Hamilton
(2003), estimated for the United States over 1997-98,
is -0.116 using the three-year NOPI and ⫺0.535 using
the method developed by Lee and co-authors (1995) to
measure oil price surprises. Thus, the three-year NOPI
indicates a sizeable GDP response when the hurdle of
the three-year previous high oil price is exceeded.
European studies show a similar range of responses,
but with the variability to be expected among
countries with different industrial structures and
monetary policies.
Government agencies and agencies such as the
IMF (International Monetary Fund) and OECD not
infrequently report oil price-GDP elasticity
estimates that are actually simulation results. The
results have varied between ⫺0.002 and ⫺0.01.
These numbers are not to be taken seriously. The
large simulation models do not attempt to use
asymmetric oil price change specifications nor
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
THE MACROECONOMIC IMPACTS OF OIL PRICE SHOCKS
develop measures of the surprise content of some oil
price changes. These models also specify oil only as
a commodity input into production functions in
ways that would not distinguish it from coffee or
sugar. None of the mechanisms that research has
found to be plausible transmission mechanisms
capable of converting oil price shocks into
disproportionately large GDP movements are
present in these models (Jones et al., 2004)
Raymond and Rich (1997), using a
regime-switching model, found evidence that oil price
shocks appear not to cause an economy to change
from a growth regime to a recession regime. However,
they did find statistically significant evidence that the
NOPI measure of oil price shocks has a strong
depressing effect on the growth rate in low-growth
periods. These findings are consistent with the more
casual observations that the great oil price shocks of
the last quarter of the twentieth century occurred when
economies were either teetering on the brink of
recession or entering into what could otherwise have
been a milder recession.
Altogether, it appears that oil price shocks have not
precipitated these recent recessions – they may have
tipped earlier ones – but they have helped incipient
downturns become full-scale recessions.
References
Bachman D., Jacquet P. (1998) Macroeconomic response to
oil price shocks in Pacific rim economies, Eddystone (PA),
Wharton Economic Forecasting Associates, July.
Balke N.S. et al. (2002) Oil price shocks and the U.S. economy.
Where does the asymmetry originate?, «The Energy
Journal», 23, 27-52.
Bernanke B.S. (1983) Irreversibility, uncertainty, and cyclical
investment, «Quarterly Journal of Economics», 98, 85-106.
Bernanke B.S. et al. (1997) Systematic monetary policy and
the effects of oil price shocks, «Brookings Papers on
Economic Activity», 1, 91-142.
Bohi D.R. (1989) Energy price shocks and macroeconomic
performance, Washington (D.C.), Resources for the Future.
Burbidge J., Harrison A. (1984) Testing for the effects of oil-
price rises using vector autoregression, «International
Economic Review», 25, 459-484.
Carruth A.A. et al. (1998) Unemployment equilibria and
input prices. Theory and evidence from the United States,
«Review of Economics and Statistics», 80, 621-628.
Cuñado J. et al. (2003) Do oil price shocks matter? Evidence
for some European countries, «Energy Economics», 25,
137-154.
Davis S. J., Haltiwanger J. (2001) Sectoral job creation and
destruction response to oil price changes, «Journal of
Monetary Economics», 48, 465-512.
Ferderer J.P. (1996) Oil price volatility and the macroeconomy.
A solution to the asymmetry puzzle, «Journal of
Macroeconomics», 18, 1-26.
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Finn M.G. (2000) Perfect competition and the effects of energy
price increases on economic activity, «Journal of Money,
Credit and Banking», 32, 400-416.
Gilbert R.J., Mork K.A. (1986) Efficient pricing during oil
supply disruptions, «The Energy Journal», 7, 51-68.
Hamilton J.D. (1983) Oil and the macroeconomy since World
War II, «Journal of Political Economy», 91, 228-248.
Hamilton J.D. (1988) A neoclassical model of unemployment
and the business cycle, «Journal of Political Economy»,
96, 593-617.
Hamilton J.D. (1994) Time series analysis, Princeton (NJ),
Princeton University Press.
Hamilton J.D. (1996) This is what happened to the oil price-
macroeconomy relationship, «Journal of Monetary
Economics», 38, 215-220.
Hamilton J.D. (2001) A parametric approach to flexible
nonlinear inference, «Econometrica», 69, 537-573.
Hamilton J.D. (2003) What is an oil shock?, «Journal of
Econometrics», 113, 363-398.
Hamilton J.D., Herrera A.M. (2004) Oil shocks and
aggregate macroeconomic behaviour. The role of monetary
policy, «Journal of Money, Credit and Banking», 36, 265-
286.
Hooker M.A. (1996) What happened to the oil price-
macroeconomy relationship?, «Journal of Monetary
Economics», 38, 195-213.
Hooker M.A. (1999) Oil and the macroeconomy revisited,
Washington (D.C.), Mimeo, Federal Reserve Board, August.
Hooker M.A. (2000) Are oil shocks inflationary? Asymmetric
and nonlinear specifications versus changes in regime,
Washington (D.C.), Mimeo, Federal Reserve Board, August.
Jones D.W. et al. (2004) Oil price shocks and the
macroeconomy. What has been learned since 1996, «The
Energy Journal», 25, 1-32.
48
Keane M.P., Prasad E.S. (1996) The employment and wage
effects of oil price changes: a sectoral analysis, «Review
of Economics and Statistics», 78, 389-400.
Lee K. et al. (1995) Oil shocks and the macroeconomy: the
role of price variability, «The Energy Journal», 16, 39-56.
Lilien D. (1982) Sectoral shifts and cyclical unemployment,
«Journal of Political Economy», 90, 777-793.
Loungani P. (1986) Oil price shocks and the dispersion
hypothesis, «Review of Economics and Statistics», 68, 536-
539.
McMillin W.D., Parker R.E. (1994) An empirical analysis
of oil price shocks in the interwar period, «Economic
Inquiry», 32, 486-497.
Miguel C. de et al. (2003) Oil price shocks and aggregate
fluctuations, «The Energy Journal», 24, 47-61.
Mork K.A. (1989) Oil and the macroeconomy when prices go
up and down: an extension of Hamilton’s results, «Journal
of Political Economy», 97, 740-744.
Mork K.A. et al. (1994) Macroeconomic responses to oil price
increases and decreases in seven OECD countries, «The
Energy Journal», 15, 19-35.
Mory J.F. (1993) Oil prices and economic activity. Is the
relationship symmetric?, «The Energy Journal», 14, 151-161.
Papapetrou E. (2001) Oil price shocks, stock market, economic
activity and employment in Greece, «Energy Economics»,
23, 511-532.
Raymond J.E., Rich R.W. (1997) Oil and the macroeconomy:
a Markov state-switching approach, «Journal of Money,
Credit and Banking», 29, 193-213; Erratum, 22, 555.
Donald W. Jones
RCF Economic and Financial Consulting
Chicago, Illinois, USA
ENCYCLOPAEDIA OF HYDROCARBONS
 2.1
Outline.
Oil and oil product demand
2.1.1 Overview of global oil use
History of oil demand
Crude oil has a long history of uses. The first
users gathered oil from accumulations that had
seeped up from beneath ground or collected it with
sponges from the surface of water. Over 5,000 years
ago, the Sumerians, Assyrians and Babylonians
collected bitumen – a sticky black substance from
which lighter oil products had evaporated – and
mined rock asphalt to use as building materials.
Before they fell down, Jericho’s walls are thought to
have been caulked and its roads paved with either
this bitumen or asphalt mixed with strands of fibre
and sand. The first known petrochemical industry
also used petroleum to make paints and repellents
for insects and rodents. Noah’s ark and Moses’
basket may well have been waterproofed with
petroleum products. Torches burned brighter if
dipped in bitumen. Unverified rumour suggests that
the Egyptians used some oil concoction to mummify
their Pharaohs.
Oil was not only used in the industrial sector but
also in the service sector. Doctors kept petroleum
products in their bags of pharmaceuticals. They used
such products as salves to stop bleeding and as
liniments to give relief to gouty limbs, rheumatic
joints and sore muscles. Bitumen mixed with sulphur
was used to make an ointment for body sores and
mixed with beer to make a health tonic to cure coughs,
diarrhoea and other ailments. It was even employed in
magic rites to scare away evil spirits. Oil proved useful
in the household as well. The early Chinese used oil in
lamps and cooking stoves. They even drilled down to
bring up oil through bamboo pipes and improved its
quality by filtering the oil through cloth or sand.
Oil also had military uses. Although the ancients
did not “float[ed] to victory on a sea of oil” (Lord
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
Curzon, in Yeomans, 2005), as did the allied troops in
the Second World War, the Chinese used oil to polish
swords and armour. The Assyrians used it to lubricate
the wheels on their fearful chariots. Later, the Greeks
and Trojans would pour oil on the sea and set it ablaze
to stop each other’s ships.
The Greeks and Romans, however, had a more
plentiful supply of wood, stone and marble, and
eventually lost much of the bitumen building
technology developed in the Middle East. Thus an
early substitution of more plentiful for less plentiful
resources can be seen.
Distilling or heating crude oil to capture separate
products with different boiling temperatures is
thought to have been invented in Alexandria around
100 b.C. Distillation enabled the development of
Greek fire. This useful weapon, made from
petroleum products mixed with now unknown
ingredients, would ignite when it became moist. In
the Seventh century and beyond, Byzantines would
pump the mixture through tubes, shoot it on the tips
of arrows or throw it in hand grenades onto enemy
ships.
The Mongolians were also reported to have used
arrows dipped in oil and set ablaze as their horses
thundered across Central Asia, into the Middle East
and through the gates of Europe. As early as 900 b.C.,
the Burmese mined oil products and used them for
preserving buildings, caulking boats and illumination.
Later, Marco Polo brought back reports from Baku of
seeping inedible oil that was good to burn and to cure
the mange of camels. By 1300, along with other
travellers – including the Crusaders – he had brought
back Arab and Persian knowledge of distillation to
Western Europe.
In the New World, the English found asphalt in
Trinidad and the Spanish conquistadors found
asphalt in Cuba, which they both used for caulking
49
BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY
their ships. The Europeans found that the Mayans
used oil for both religious and secular purposes –
anointing priests’ bodies and fuelling religious as
well as secular fires. The Aztecs figured out how to
make these gummy substances into chewing gum
and toothpaste, while the Inca’s distilled bitumen
into medicinal products. In North America, trappers
learned of the medicinal qualities of oil from the
native population who used it internally as an elixir
and topically to protect the skin from the sun, wind
and rain.
The beginnings of the modern oil industry can be
traced to Austro-Hungarian Galicia and Romania in
Eastern Europe. Oil came from hand-dug pits and
was refined into kerosene, which had been
discovered independently in the 1850s by Abraham
Gesner in the US and James Young in Scotland.
Kerosene was burned in a lamp invented around the
same time by the Polish pharmacist Ignacy
Lukasiewicz.
With the application of drilling technology
borrowed from the search for salt brine, oil was
discovered in Pennsylvania in 1859 at about twenty
metres. Later discoveries followed in the US and in
Baku beginning in 1873 and in the Dutch East
Indies in 1885. With the knowledge of distillation of
oil into kerosene, the kerosene lamp, and drilling
technology that enabled more underground oil
discoveries, oil products – particularly kerosene –
were on their way to becoming global commodities.
During the great age of illumination from 1859 to
the turn of the century, kerosene from oil rapidly
began to replace and overtake kerosene from coal
and more expensive whale oil. John D. Rockefeller
and others gave away free lamps to sell their
products, demonstrating the importance of
complementary goods in the use of oil products.
Even today, oil products used as energy are used in
conjunction with complementary capital goods. We
burn oil products in vehicles in the transport sector,
in furnaces to heat our homes, in boilers to produce
hot water or steam – for process heat or to generate
electricity, and in turbines to push our jets and
electric generators.
In this way, oil consumption has evolved as its uses
have grown and as it has replaced and been replaced
by other products. Fig. 1 shows how petroleum and
other energy product consumption has evolved since
1850. At first oil was not even on the ‘radar screen’ as
were coal and wood. Kerosene was by far the most
important oil product. By the mid-1880s, oil was still a
small share of total energy consumption. For Standard
Oil, the largest refiner in the world at the time, over
80% of a barrel of crude oil went to the production of
kerosene. With the invention of the electric light bulb
50
4,000
oil
energy consumption (Mtoe)
3,500
coal
natural gas
3,000
wood
2,500 hydro
nuclear
2,000
1,500
1,000
500
0
1850 1875 1900 1925 1950 1975 2000
year
Fig. 1. Global energy consumption
by fuel type 1850-2002 (Grübler, 1998; EIA, 2005).
One tonne of oil corresponds to 7-8 barrels depending
on the density of the crude.
by Thomas Edison in 1879 and the spread of
electricity generation, electricity for lighting soon
started to make inroads on the kerosene market.
However, to date, complete substitution has not yet
occurred as two billion people worldwide still do not
have electricity and rely on kerosene or biofuel for
light. By the turn of the century, only 60% of
Standard’s barrel was for kerosene. At the same time
lube and fuel oils had climbed from 5% to over 25%
of the barrel to lubricate and fuel the industrialization
process in the western world.
Other technological changes were also to have
irreversible effects on the refinery slate. Nikolaus von
Otto invented the first practical four-cycle internal
combustion engine in 1876, Daimler and Benz had
invented the first automobile that used the internal
combustion engine by 1885, and Rudolf Diesel
invented the diesel engine that became very popular
for marine transport and later for truck transport in
1895. Ford equipped automobiles with gasoline
engines and introduced the assembly line in 1913
making automobiles affordable to the mass market.
The private vehicle caught on quickly. American
vehicle registrations increased from 8,000 in 1900 to
over 4 million by the roaring Twenties. Over this same
period, European registrations climbed to almost three
quarters of a million, while South America and Asia –
with a somewhat later start – had around 50,000, and
75,000 cars respectively.
By the First World War, oil had become a strategic
material used to power and lubricate internal
combustion engines in the air, on land, on and even
under the sea. Regular gasoline-powered vehicles
moved troops and supplies. High-octane aviation
gasoline fuelled planes – at first for reconnaissance
and later for dogfights and bombing raids.
ENCYCLOPAEDIA OF HYDROCARBONS

Diesel-fuelled tanks were developed. Diesel-fuelled
allied submarines had a longer range than German
coal-powered U-boats. Marine military and merchant
fleets were being switched from steam to diesel.
Estimated oil demand for allied military use in
Europe ran between 700,000 and 1,000,000 barrels
a month by 1918 (80% of this oil was met
by US production). After the First World War
personal mobility continued to increase, especially
in the US.
The Twentieth century became increasingly
characterized by travel, with an ever-shrinking globe
fuelled by oil products. By 1929, there was one car for
every five people in the US, one for every thirty
people in France and England, one for every 700
people in Japan and one for every 6,130 people in the
Soviet Union. At this time in the US, 85% of a barrel
of oil went to gasoline and fuel oils.
Commercial aviation began in the US in 1913
and in the United Kingdom in 1916. With the end of
the war, surplus military planes were available to
give the private commercial sector a boost. The first
regularly scheduled international commercial flight
went from London to Paris in 1919. France, the
Netherlands, Japan, Germany and Italy soon
followed suit with domestic services established in
1918, 1919, 1922, 1925 and 1926, respectively.
After the Russian revolution, Soviet leaders believed
that air travel was the best way to link together its
twelve time zones and the Soviets began their first
civilian routes in 1921. Imperial Airways, the
predecessor to British Airways, was established in
1924 to link the British Empire together. It
established the first commercial flights to India in
1929 cutting trip time from three weeks to one. By
1939, the first regularly scheduled transatlantic
passenger flight service began.
Although oil consumption fell in the early 1930s in
response to the Great Depression – demonstrating the
effect of income or economic activity on oil demand –
oil product consumption soon resumed its climb and
surpassed wood consumption during this difficult
decade.
Oil was the lifeblood of the modern military during
the Second World War even more so than in the First
World War. The average allied army division of the
Second World War needed fuel for equipment
comprising 187,000 horsepower, whereas an average
First World War division required fuel for equipment
totalling about 4,000 horsepower. Even more
astounding is the fact that the daily gasoline
consumption of the US Air Force in Western European
countries, during the most intense activity, exceeded
all US gasoline shipped to Europe for all purposes
between 1914 and 1918.
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
OUTLINE. OIL AND OIL PRODUCT DEMAND
Despite the cessation of hostilities in 1945 and
the post-war breakup of global empires, the growth
in petroleum consumption continued unabated.
Fig. 1 also shows how global oil consumption took
off between 1947 and the Arab oil embargo of
1973 with average annual growth exceeding 7%.
Once the prize, kerosene had sunk to less than
7% of a barrel. Bunkers, consisting of fuel oils and
some kerosene, had increased to almost 8% as the
shipping fleets increasingly turned to oil products
as the fuel of choice. Motor and aviation gasoline
and the fuel oils constituted about 85% of the
product barrel by 1950.
The Second World War caused a brief hiatus in
the growth of both the civilian vehicle stock and
commercial flights. After the war, some military
planes – now jets – again crossed over to civilian
use. Jets could fly higher and faster and were more
comfortable than their propeller-driven
predecessors. Pan Am airlines began its fabled
round-the-world commercial flights in 1959 when
jets were criss-crossing the globe and linking
together the continents. By the mid-1970s, some 60
airlines worldwide were flying the Boeing 727 and
scheduled passenger-kilometres had increased to
576 billion from 21 billion in 1948. The automotive
world saw a less spectacular, but still significant
increase over the same period as the world’s stock of
passenger cars had climbed to 260 million from
about 43 million in 1948.
As a consequence, oil products used for energy
increased over five-fold between 1948 and 1974. Jet
fuel showed the largest growth rate (from a very
low base) and the fuel oils gained relative share at
the expense of gasoline and kerosene as fuel oil
became more important for electricity generation,
industry, diesel road and diesel rail use. By 1974,
about a quarter of the world’s electricity was
generated from oil.
These changes in both total consumption and in
relative product shares resulted from a variety of
factors. Worldwide income growth averaged 5% per
year over this time period. A declining real oil price
was also a contributing factor. Fig. 2 shows real US
oil prices since 1861 along with the historical
average of $31.50 from 1860 to 2004. Prices
generally fell in real terms from 1948 to 1973 even
while oil consumption was growing spectacularly.
However, with the price run-ups resulting from the
Arab oil embargo in 1973 and the Iranian revolution
in 1978, the tides shifted. Overall oil product
consumption dipped before resuming a general
upward trend but at a much slower average growth
rate of about 1% a year. The price peaked in real
terms in 1981 and then generally showed a
51
BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY
100
90
80
70
2004 $/bbl
60
50
40 historical average $ 31.50
30
20
10
0 petroleum as well. Naphtha and distillates have
1860 1880 1900 1920 1940 1960
year
Fig. 2. US oil price 1861-2004
(API, 1971; US Department of Commerce, 1975;
EIA, 2004a; CEA, 1929-2004).
downward trend, with a precipitous drop in 1986,
until starting to rebound in 1998, and only
recovering its historical average in 2004.
By 2002, the product mix had shifted again.
Residual fuel, non-jet kerosene, and international
marine bunker fuel fell from 1974 levels, both in
absolute and relative terms while the rest of the
products claimed a larger share of the barrel.
Because a variety of other fuels could be used to
produce steam (coal, natural gas, nuclear, hydro and
wind power), oil consumption in the electricity
generation sector was particularly hard hit. Oil
product consumption in electricity generation fell in
absolute terms, with electricity’s share of the total
barrel falling from around 12% in 1973 to only 6%
of the barrel by 2002. Industrial users, which also
had substitutes for oil in under-the-boiler use,
increased oil consumption only slightly and their
share of the barrel also fell. The big beneficiary in
the decades since the Arab oil embargo has been the
transport sector with an average growth rate of about
2.3% per year over this same period.
Global oil demand balances by major region
Crude oil has come a long way since its earliest
days in Babylonia, China and Egypt. Some of its
historical uses, such as warding off evil spirits and
mummification of Pharaohs have been abandoned
altogether. Other uses such as for illumination,
lubrication and medicine still exist but now consume
only a small share of the global barrel. Kerosene
lamps still light the homes of many of the world’s
poor and petroleum-based asphalt still paves our
roads and airfields as well as providing materials to
cover roofs and floors. Petroleum-based cutting oils
and lubricants still lubricate, but now the use is for
home appliances, engines and motors along with
cutting and grinding activities. New uses now
52
dominate the barrel. Well over half of the oil in the
world goes to the transport sector. Oil runs our
trains, flies our planes and sails our boats. It drives
our automobiles, motorcycles, Sport Utility Vehicles
(SUVs), trucks, semi-tractors, buses and tractors. It
also heats our homes and buildings and creates
process heat to can our food and make our paper,
cement and other products.
There are a variety of non-energy uses for
1980 2000 provided feedstocks for the petrochemical industry
since the 1920s. For example, about half of the
world’s ethylene – the largest basic organic chemical
by weight – is produced from petroleum-based fuel,
mostly naphtha. Products made from ethylene
include plastics, packing materials, antifreeze,
detergents and synthetic fibres. Butadiene is another
important basic chemical and is used to make
synthetic rubber and carpets. Paraffin from
petroleum is used in candy, candles, polishes,
packaging, cosmetics, medicines and toiletries.
Petroleum coke is used in carbon and graphite
products and in electrodes and anodes.
Both the level of consumption and its rate of
growth vary among countries. The twenty largest
consumers of oil, shown in Fig. 3, consume about
75% of the global oil production. The US is by far
the largest consumer followed by Japan and China.
South Korea, India and China have displayed the
fastest growth rates over the period. If growth
continues for all these countries at these same
rates, China will overtake the US in oil
consumption in just over three decades, Korea will
overtake in about four decades, and India would
overtake in about four and a half decades. At the
other end of the spectrum, oil consumption has
fallen in a number of countries, most notably in
Russia and unified Germany.
Changes in oil consumption are driven by two
major factors. First, oil consumption is tied to the
level of economic activity. China and India’s rapid
increase in oil consumption mirrored their high
economic growth rates in the same period. Russian
income fell precipitously with the fall of
communism, and with it, oil consumption also fell.
The unification of East and West Germany was a
painful process with falling income, along with the
decrease in total energy and oil consumption. Again
we see the link between economic activity and oil
consumption. The level of economic development
can also impact consumption; a country’s growth
rate in oil consumption tends to level off and fall as
the economy matures, often reflecting saturation
effects and structural shifts within the economy
towards less oil-intensive industries.
ENCYCLOPAEDIA OF HYDROCARBONS
 OUTLINE. OIL AND OIL PRODUCT DEMAND

Fig. 3. Oil product all other

consumption Australia (1.8%)
by 20 largest consuming Netherlands (1.8%)
countries and average
Taiwan (4.1%)
annual growth rates
Indonesia (4.5%)
in oil consumption
in percentage Iran (3.7%)
for the period 1980-2002, Spain (1.9%)
with the exception Saudi Arabia (4.1%)
of Russia whose United Kingdom (⫺0.1%)
average refers Italy (⫺0.2%)
to the period 1992-2002 Mexico (2.0%)
(EIA, 2004a). France (⫺0.6%)
Canada (0.5%)
Brazil (2.9%)
South Korea (6.4%)
India (5.6%)
Russia (⫺5.4%)
Germany (⫺0.6%)
China (4.9%)
Japan (0.3%)
United States (0.7%)
0 2,000 4,000 6,000 8,000 10,000 12,000 14,000 16,000 18,000 20,000
kbbl/d

The second major factor that drives changes in oil
consumption is consumer choice. Consumers normally
choose to substitute a product, if they find another that
is cheaper, better, or perceived as more secure. France,
Italy and the United Kingdom have demonstrated this
substitution effect. All three experienced a small
growth in total energy consumption over the last two
decades but a decline in oil consumption as a result of
switching to other technologies and fuels for
electricity generation. France went heavily into nuclear
power, Italy substituted oil for gas from Russia and
Algeria, while the United Kingdom substituted oil for
domestic gas and nuclear power.
From 1980 to 2003 oil consumption fell in Eastern
Europe and the Former Soviet Union (FSU) by more
than five million barrels a day. However, global oil
consumption went up almost 17 million barrels a day
in the same period. China, the US, South Korea, India
and Brazil accounted for about two thirds of this net
increase and the Middle East accounted for about
20%.
The heterogeneity of growth patterns can be seen
in the overall use of energy as well. Table 1 shows the
total energy consumption converted into million
barrels per day of oil equivalent (Mbde) and the share
coming from each primary energy fuel source.
Overall, oil constitutes just slightly less than 40% of
world commercial energy consumption with coal and
natural gas almost another quarter each. Nuclear and
hydro power together account for another eighth with
each roughly having an even share.
North American shares are close to the global
averages but otherwise shares vary considerably
across regions. The Middle East – with its massive
oil and gas supplies – gets over half of its
commercial energy from oil and much of the
remainder from natural gas. South and Central
America with little coal and large hydro-resources
consume little coal and nuclear but more oil and
hydropower. Western European countries consume
the highest share of nuclear power but a much lower
share of coal than average. Eastern Europe and FSU
consume the highest share of natural gas and the
lowest share of oil as a result of having an
abundance of former Soviet gas on their doorstep.
Africa consumes a very small share of nuclear, a bit
less natural gas than average with a larger share of
oil and coal. As regards Asia and Oceania,
non-OECD (Organization for Economic
Cooperation and Development) countries, which are
dominated by China and India, use the highest share
of coal, whereas OECD countries (Japan, New
Zealand, Taiwan, South Korea, Australia) have a
higher oil and nuclear share but a smaller gas share.
Oil use is dependent upon the availability of other
fuels for sectors within the economy and varies among
regions and countries. Worldwide, transport is
estimated at around 58% of the barrel. It is the largest
share for all regions but varies from a high of about
76% in North America to a low of about 42% in the
Middle East. Industry comes second with about 16%
and electricity comes third with about half of

VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION 53

BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY

Table 1. Total commercial energy consumption and shares by fuel and major region in 2002 (EIA, 2004b)

Other Total
Region Oil Coal Natural gas Nuclear Hydro
renewable* Mbde
World total 39.0% 24.0% 23.1% 6.6% 6.5% 0.8% 193
North America 40.9% 21.0% 24.1% 7.8% 5.2% 1.1% 54
Central and South
50.5% 3.7% 18.1% 1.0% 25.5% 1.1% 10
America
Western Europe 42.2% 14.0% 22.5% 12.8% 7.1% 1.4% 34
Eastern Europe
20.9% 21.1% 46.3% 6.3% 5.4% 0.1% 25
and FSU
Middle East 55.1% 1.4% 42.4% 0.0% 1.0% 0.0% 9
Africa 42.9% 29.1% 20.6% 0.9% 6.4% 0.1% 6
Asian and Oceanian
35.5% 46.9% 9.3% 2.2% 5.7% 0.4% 42
non-OECD countries
Asian and Oceanian
45.9% 24.1% 13.9% 10.6% 4.3% 1.2% 13
OECD countries

* Electricity generation from other renewables including geothermal, solar, wind, and biomass

industries’ share. However, industries’ share is over
20% for the Middle East, non-OECD Asia and OECD
Asia/Oceania but is less than 15% in OECD North
America and Africa. The electricity share is lowest in
OECD Europe (around 5%) and highest in the Middle
East (about 25%).
For the OECD, data are almost completely
categorized with only a small share in the
non-specified category. OECD North America
allocates only 9% of its oil consumption to the
commercial, public and agricultural sectors while
OECD Asia/Oceania allocates almost 19% to these
same sectors.
Clearly, since the uses of oil vary, the specific oil
products used per region vary. Gasoline is the largest
share of the barrel worldwide as well as in the majority
of regions – except Western Europe, the Middle East,
China, India and Asia/Oceania. In three of these areas
(Western Europe, India, and Asia/Oceania) diesel fuel
is the largest share.
Non-coincidentally these three regions have
gasoline prices that average over $30 higher per
barrel than diesel prices. These large price
differences as shown in Table 2 are largely an
artifice of the tax structure. From the wholesale
prices for delivery in New York Harbour, ARA
(Amsterdam, Rotterdam or Antwerpen), and
Singapore, you can see that the wholesale prices of
gasoline and gas oil are quite similar across regions.
However, the end use prices, once taxes are
included, vary significantly. Taxes and occasionally
subsidies account for most of the price differences.
Gasoline, in particular, is heavily taxed – especially
in Western Europe and Asia.
Comparing the US to Canada, note the higher retail
gasoline prices in Canada and the lower consumption
share. However, gas-oil price and share are both higher
in Canada. Thus, Canada’s colder climate and lower
population density favours using more gas oil for
heating despite its higher price. Such climate variation
may have regional as well as seasonal effects. The
Middle East, with lots of cheap oil, consumes a lot of
residual oil to generate electricity. China with about a
98% household electrification rate has a far lower
need for kerosene light than India with its 43%
electrification rate demonstrating the significant effect
that infrastructure and policy may have on the energy
sector.
2.1.2 Theoretical issues
in modelling energy demand
The previous section of this article shows how oil
product demand has changed over time and how it
varies across the world. This section of the paper
continues to build economic models that will help
explain these oil product consumption patterns,
forecast future changes, and evaluate the effects of
policy. For each of the above products and uses,
underlying decisions have been made on how much
energy to consume and in what form.

54 ENCYCLOPAEDIA OF HYDROCARBONS
 OUTLINE. OIL AND OIL PRODUCT DEMAND

Table 2. World survey of selected petroleum product prices (including taxes) relative to 2002-2003
(prices in dollars per barrel; EIA, 2004b)

Residential fuels Industrial fuels

Gasoline Diesel fuel Heavy fuel
Region/country Gas oil Kerosene LPG Gas oil
oil
Wholesale product prices*
New York Harbour 35.48 -- 36.16 -- -- 36.16 29.13
ARA 33.19 -- 34.12 -- -- 34.12 26.36
Singapore 32.10 -- 31.70 -- -- 31.70 26.33
North America Retail prices**
Canada 94.11 60.25 71.95 -- -- 47.21 36.73
Mexico 96.96 71.71 -- -- -- 42.93 13.77
United States 69.30 62.50 55.99 50.82 24.11 40.45 31.67
Central and South America Retail prices**
Argentina 95.13 67.77 32.38 62.54 56.81 -- --
Brazil 102.35 63.85 16.91 24.36 115.43 -- --
Colombia 69.26 35.66 25.65 41.37 46.12 -- --
Costa Rica 96.43 67.41 25.86 67.12 130.86 -- --
Cuba 79.51 43.47 27.97 13.44 43.53 -- --
Ecuador 81.65 42.72 29.75 -- 19.14 -- --
Peru 125.41 84.60 36.46 83.16 164.57 -- --
Uruguay 131.63 61.16 21.41 66.65 109.74 -- --
Venezuela 6.85 4.12 4.12 9.74 21.72 -- --
Western Europe Retail prices**
France 198.87 151.47 76.90 -- -- 63.04 44.26
Germany 184.41 145.38 76.21 -- -- 58.16 37.90
Italy 185.30 155.84 153.90 -- -- 128.27 41.64
Netherlands 211.59 143.79 110.76 -- -- -- 40.91
Norway 223.99 198.12 128.56 -- -- 103.70 78.06
Spain 144.19 125.65 73.81 -- -- 63.64 43.69
Sweden 186.95 155.60 136.30 -- -- 56.12 --
Switzerland 162.12 175.15 56.67 -- -- 46.70 34.94
Turkey 175.61 137.64 127.51 -- -- -- 43.52
United Kingdom 207.89 199.98 52.65 -- -- 50.46 39.71
Eastern Europe and FSU Retail prices**
Czech Republic 154.04 121.92 68.48 48.22 25.71
Hungary 171.75 153.55 -- -- 153.58 36.26
Poland 148.26 118.67 71.60 -- -- 56.94 25.71
Romania 97.29 76.46 -- -- -- --
Middle East Retail prices**
Iran 14.26 2.90 1.55 2.90 -- -- --
Kuwait 32.58 28.63 9.54 28.63 -- -- --
Saudi Arabia 38.21 15.70 6.38 18.48 -- -- --
United Arab Emirates 42.86 40.00 24.40 44.28 -- -- 7.00
Africa Retail prices**
Algeria 27.92 26.93 19.70 10.07 -- -- --
Nigeria 34.28 34.28 15.82 31.64 -- -- --
South Africa 59.14 52.62 -- -- -- -- --
Far East and Oceania Retail prices**
Australia 69.15 91.36 -- -- -- -- --
China 55.64 50.87 -- -- -- -- --
Hong Kong 228.50 128.82 -- 97.64 110.20 98.67 --
India 104.92 72.33 -- -- -- 53.75 37.63
Indonesia 28.46 30.36 21.00 28.00 -- 6.40 --
Japan 141.24 112.01 63.02 -- -- 45.12 46.56
South Korea 175.55 72.65 86.54 -- -- 86.66 49.70
Taiwan 97.00 66.79 -- -- -- 36.37 30.77
Thailand 57.23 52.46 60.12 -- -- -- 37.19

* Wholesale price is for regular conventional gasoline

** Retail price is for premium gasoline

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BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY
Consumers use energy for the end-use products
they consume, while all other sectors use energy as an
intermediate good or as a factor of production. The
former is called end-use demand, while the latter is
called a factor demand. This section contains some
simple optimization models to organize thoughts on
how optimal decisions should be made for both
end-use consumer demands and for intermediate
factor demands for the industrial, commercial, public
and electricity generation sectors.
Household or consumer demand
Households should choose the bundle of goods
within their constraint set that maximizes their
satisfaction. In a static world where consumers have n
goods to choose from, economists represent
satisfaction by a utility function
U (X1,X2,…,Xi,…,Xn,Env)
where Xi represents consumption of the i th good and
Env represents other environmental factors such as our
preferences, infrastructure and weather. Now it may
seem strange to represent people’s happiness by a
function. However, this formulation is not as strange
as it first seems. Each of us has preferences and
prefers some goods to others and some bundles of
goods to other bundles of goods. For example, you
may prefer a Lamborghini to a Ford. Under some
fairly reasonable assumptions about preferences, we
can represent such preferences by a function.
The actual numerical values the function takes on
is not important, provided that the function correctly
ranks our preferences across the range of goods. So,
you know you prefer a Lamborghini, but you may not
rush out and buy one, since you may be constrained by
your income. In our optimization we need to take this
constraint into account. To make the problem as
simple as possible we assume consumers spend all
their income. The amount a consumer spends on the i th
good is the price of the i th good (Pi) times the amount
consumed of the i th good (Xi) equal to Pi Xi . The
amount spent on all goods is the sum of the amounts
spent on each good equal to:
n [2]
Y ⫽P1 X1⫹P2 X2⫹… ⫹Pn Xn ⫽冱 Pi Xi
i⫽1
The consumers want to choose the amount of the n
goods to maximize their utility subject to their budget
constraint. To keep our initial problem as simple as
possible, put all energy goods into one product called
E with price PE and put all other goods together in one
non-energy good called N with price PN. PE and PN are
not influenced by the consumer but come from the
market. In studies that consider aggregate energy
demand, the price used is a weighted average of the
prices PEi of all j energy goods:
56
j
PE ⫽冱 ai PEi
i⫽1
The weights for each of the prices are typically
either expenditure shares or energy content. For
example, the total expenditure on energy consumed is
兺 i⫽1
j
PEi Ei where PEi is the price of the i th energy
product and Ei is the consumption of the i th energy
product. If ai was the share of expenditure for the i th
energy product it would equal the cost for the i th
energy product divided by the cost of all energy
products equal to:
j
PEi Ei Ⲑ冱 PEi Ei
i⫽1
If the weights were the share in energy content
then
j
ai ⫽Ei Ⲑ冱 Ei
i⫽1
where Ei is the energy content of the i th energy product
measured in such units as kilocalories, kilojoules or
Btu (British thermal units). Turvey and Nobay (1965)
show that expenditure shares are the theoretically
preferred weighting option. A similar index would be
created for non-energy goods. Typically, studies use the
consumer price index, the GDP deflator or some other
index that is already reported for non-energy goods.
The consumer’s goal is then to maximize utility:
U ⫽U(E,N )
subject to his or her budget constraints:
PE E ⫹PN N ⫽Y
To maximize subject to a constraint, turn to
calculus. Using the Lagrangean multiplier technique,
we optimize the function with the constraint attached
as follows:
[1] ᑣ⫽U(E, N )⫹l(Y⫺PE E⫺PN N )
Taking the partial derivative ⭸ of Eq. [1] with
respect to E, N and l yields our first order conditions
in Eqs. [2], [3] and [4], respectively:
ᑣE ⫽ ⭸UⲐ⭸E ⫺lPE ⫽0
[3] ᑣN ⫽ ⭸UⲐ⭸N ⫺lPN ⫽0
[4] ᑣl ⫽Y⫺PE E ⫹PN N ⫽0
We can solve these general functions for E and N.
Under some fairly reasonable assumptions, the
solution to the above functions represents a maximum
which we designate by adding an asterisk (*). The
general solutions for our choice variables would be:
[5] E* ⫽DE (PE, PN,Y )
[6] N* ⫽DN (PE, PN,Y )
ENCYCLOPAEDIA OF HYDROCARBONS

These functions are interpreted to be consumer
demand functions because they represent optimal
consumption – given own price, other prices and
income. The shape of these functions would result from
the preferences and the technologies surrounding
product use. In reality, we don’t consume two goods but
we consume many goods. The problem could easily be
modified to include j separate energy products (Ei for
i⫽1,…, j), k separate other goods (Ni for i⫽1,…, k) and
m separate environmental variables (Envi for i⫽1,…,m)
giving us j⫹k demand equations as follows:
[7] E*i ⫽DE i(PE1, …, PE j ,PN1, …, PNk,Env1, …, Envm,Y )
[8] N*i ⫽DNi(PE1, …, PE j ,PN1, …, PNk,Env1, …, Envm,Y )
If one of the goods is a fixed amount in the short-
run, the amount rather than the price may be included.
For example, suppose one of the above equations is the
demand for gasoline. Since the world has a huge fleet
of vehicles with 7% or less of this stock being scraped
each year, more consumers may make decisions based
on the auto they own rather than the price of autos.
Factor demand for the industrial, commercial
and electricity sectors
When businesses demand energy, they want it to
produce goods and services to sell. Let’s suppose a
business sells good Z. To produce Z, it needs energy
(E) and non-energy (N ) inputs. Again, let’s restrict
ourselves to two inputs to keep the problem as simple
as possible while still allowing some choice. The
technology for producing Z from E and N is
represented by a production function Z⫽Z(E,N ).
The producers know the unit price of their output
(PZ), and they know the unit price of their inputs
(PE and PN). Further, assume competitive input and
output markets, implying that producers face prices
rather than a demand function, for output, and supply
functions for inputs. The producer’s objective is to
maximize profits or:
[9] p ⫽PZ Z(N,E) ⫺PN N ⫺PE E
Note that in this case, producers can hire more
factors to produce more output and we do not need to
add an income constraint as in the consumer case
above. The producer chooses how much of inputs E
and N to produce and these choices determine how
much output the producer sells. Taking the partial
derivative of [9] with respect to E and N, our
first-order conditions for optimizing Eq. [9] are in
Eqs. [10] and [11] respectively:
[10] pE ⫽PZ ⭸ZⲐ⭸E ⫺PE ⫽0
[11] pN ⫽PZ ⭸ZⲐ⭸N ⫺PN ⫽0
Again under some fairly reasonable assumptions,
solutions to the above general equations represent a
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
OUTLINE. OIL AND OIL PRODUCT DEMAND
maximum. Indicating the solutions with an asterisk
(*), we can write them in general notation as:
[12] E* ⫽DE (PE , PN , PZ)
[13] N* ⫽DN (PE , PN , PZ)
Substituting optimal energy and non-energy
consumption into the production function yields the
production or supply of output:
[14] Z* ⫽SZ (PE , PN , PZ)
Eqs. [12] and [13] represent the factor demand for
energy and non-energy, while Eq. [14] represents the
supply of the good produced. Thus, if this optimization
represented a cement producer, Eq. [12] would
represent the producers demand for energy to produce
cement, Eq. [13] would represent the demand for
non-energy factors to produce cement, and Eq. [14]
would represent the supply of cement.
To generalize the above industry model to j energy
inputs and k non-energy inputs, m environmental
variable, and n outputs, you would add their variables
to the equations j⫹k factor demands and n output
supplies:
[15] E*i ⫽DE i(PE1, …, PE j , PN1, …, PNk , Env1, …
…, Envm,PZ1, …, PZn) i⫽1, … , j
[16] N*i ⫽DNi(PE1, …, PE j , PN1, …, PNk , Env1, …
…, Envm,PZ1,…, PZn) i ⫽1, … , k
[17] Z*i ⫽SZi(PE1, …, PE j , PN1, …, PNk , Env1, …
…, Envm,PZ1, …, PZn) i ⫽1, … , n
If one of the factors is fixed in the short run,
(usually some sort of capital good) the amount of
the existing capital good rather than its price is
included. Sometimes the amount of the output (Zi )
rather than the price of an output (PZi) is included.
This is especially true for estimates of energy or
energy product demand for an economic sector or
the whole economy. If the demand were for the
industrial sector, value added in the industrial sector
might be included instead of output price. If the
demand were for the whole economy, an economic
activity variable such as Gross Domestic Product
(GDP) might be included.
2.1.3 The effect of demand and
supply on market price
Demand
Energy consumers and producers come together
in energy product markets to determine price. The
section above indicated variables that we would
expect to be in our demand equations. We would expect
57
BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY
the quantity purchased of an energy product
(Ed ) such as gasoline to be influenced by a number
of prices: a) its own price (PE); b) the price of
substitutes such as diesel fuel (Psb); c) the price of
complementary goods such as automobiles (Pcm);
d ) the price of output (PZ) for producers or income
(Y) for consumers; e) environmental variables such
as technical efficiency of vehicles as measured by
kilometres per litre (T), energy policy such as
gasoline taxes or regulations on auto efficiency
(Pcyd), and weather (W). Total market demand (Ed)
will also be influenced by the number of buyers
(#buy). Thus, we can write market demand as:
[18] Ed ⫽Dd (PE ⫺, Psb ⫹, Pcm ⫺, Py
or Y ⫹Ⲑ⫺, T ⫹Ⲑ⫺, Pcyd ⫹Ⲑ⫺,W ⫹, #buy⫹)
The signs to the right hand side of the variables
indicate whether the variable will have a positive (⫹),
negative (⫺) or uncertain (⫹/⫺) effect on gasoline
purchases. For example own price has a negative
effect.
Thus, if gasoline own price (PE) goes up, the
quantity of gasoline demanded will go down.
Alternatively, if the price of the substitute diesel fuel
(Psb) goes down, drivers may switch to a diesel
vehicle with their next purchase and gasoline
consumption would go down. Lowering the price of
a complement (Pcm) such as vehicles, may cause
people to buy more and larger vehicles and increase
their purchase of gasoline. Raising income is likely
to increase gasoline purchases as people may drive
more and buy larger cars. However, for a few energy
product uses, such as kerosene for illumination, a
higher income might cause consumers to switch to
electricity and reduce their consumption of
kerosene. Thus, the sign on income depends on
whether the good is a normal or an inferior good.
The sign on technology and policy is uncertain and
depends on the policy or technology. Raising vehicle
fuel efficiency might decrease gasoline
consumption, whereas the introduction of low fuel
efficiency SUVs might raise consumption. Good
weather and the number of drivers should have a
positive effect on consumption.
If we hold all variables constant and change only
price, we will trace out what economists call a demand
curve with the amount consumed (E) for different
prices (PE; Fig. 4).
If other variables but price change, the whole
demand curve shifts. For example, an increase in
demand, which could be caused by increasing the price
of a substitute, decreasing the price of a complement,
increasing income for a normal good, or decreasing
income for an inferior good, is shown in Fig. 5 by DE1.
A decrease in demand, which could be caused by
58
decreasing the price of a substitute, increasing the
price of a complement, decreasing income for a
normal good, or increasing income for an inferior
good, is shown in Fig. 5 by DE2.
Supply
In the Section 2.1.2 we derived a supply equation
(Z*) as a function of factor and output prices. From
such a function for any set of prices and environmental
variables, we can determine how much output is
produced. Let Es equal Z* from that equation. Then for
any level of output (Es), we can go back and determine
total output cost (TC ) and develop a total cost function
TCE⫽TC(Es). Profits are price times output minus
total costs or:
[19] PE sEs ⫺TC(Es)
Maximizing profits in this framework gives some
interesting insights into how producers should behave.
Assuming the producer can’t influence price, we can
optimize with respect to Es by taking the partial
derivative of Eq. [19] with respect to Es to get:
[20] PE s ⫺ ⭸TCⲐ⭸E s ⫽0
or:
[21] PE s ⫽ ⭸TCⲐ⭸E s
The second term in the above equations ⭸TCⲐ⭸E s
represents how costs change with changing output.
This is called marginal cost (MC). We expect that
marginal cost, which is a function of energy
output, slopes up or, as we produce more energy,
that the MC or cost of the last unit is higher as
shown in Fig. 6.
Suppose that price is PEs1. In this way profits
are being made on all units up to Es1, since the
price is greater than the marginal cost of all units.
After Es1, note that the marginal cost is greater
than the price, so production beyond Es1 would
reduce profits. Thus, whatever the market price,
the energy producer should set price equal to
PE
DE
E
Fig. 4. Demand (DE) for energy product E.
ENCYCLOPAEDIA OF HYDROCARBONS

PE
DE1
DE
DE2
E E
Fig. 5. Shifts in demand (DE)
for energy product E.
marginal cost. The supply curve is represented by
the marginal cost curve.
Going back to the output supply curve from Eq.
[17], we also note that marginal cost or output
supply is a function of output and input prices as
well as environmental variables. Thus, we represent
the supply of an energy product (Es) as a function of
the price of output (PE), let’s say gasoline, and prices
of inputs or factors of production (Pf ) such as crude
oil, refinery workers or labour, distillation towers
and other capital as well as catalysts. Other prices
include the price of similar or substitute goods (Psb)
that could be produced instead of gasoline such as
diesel or residual fuel oil, and the price of
by-products or complementary goods to gasoline
(Pcm) such as propylene, which is a by-product
of gasoline in a catalytic cracker and is used as a
petrochemical feedstock.
Environmental variables include refinery
technology and other technical changes related to
supply, government policies such as environmental
restrictions that make gasoline more expensive (Pcys),
and the number of sellers (#sell).
[22] Es ⫽ f (PE ⫹, Pf ⫺, Psb ⫺, Pcm ⫹,T ⫹Ⲑ⫺,
Pcys ⫹Ⲑ⫺, #sell⫹)
Again the signs (⫹/⫺) next to the right-hand
side variables indicate whether the variable will
have a positive or negative effect on gasoline
production. If marginal cost slopes up, raising
price (PE) will raise production, raising the cost of
factors of production (Pf ) will increase the cost of
gasoline and decrease the amount produced.
Raising the price of substitute or similar goods
that could be produced (Psb) will cause a shift
away from gasoline, whereas raising the price of a
by-product (Pcm) will cause a shift towards
gasoline. Technical change in gasoline production
that reduces costs should increase production
whereas technical change that reduces cost for
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
OUTLINE. OIL AND OIL PRODUCT DEMAND
PE
SEs⫽MC
PEs1
Es1
Fig. 6. Marginal cost
is the supply curve.
other similar goods should decrease production.
The effect of government policies depends on the
policy. Laws that have been passed to improve
refinery safety or limit the use of methyl tert-butyl
ether (MTBE – a chemical that increases gasoline
octane) raises production costs and reduces
production. Policies that have encouraged research
and development in refinery operation increase
production. More suppliers will increase total
production at every price.
If other variables besides own price change in
Fig. 6, we shift the whole energy supply curve as
shown in Fig. 7. For example, an increase in supply
that could be caused by decreasing the price
of a factor of production, decreasing the price of
a similar good, or increasing the price of a
by-product is shown in Fig. 7 by SE1. A decrease in
supply, which could be caused by increasing the
price of a factor of production, increasing the price
of a similar good, or decreasing the price of a
by-product, is shown in Fig. 7 by SE2.
Equilibrium price and quantity
We can hold all variables but price and quantity
constant and put together supply and demand from
Figs. 4 and 6 in Fig. 8. Together supply and demand
will determine market price in this model.
If price were PE1 in this market, we can see that
sellers would want to sell more than consumers would
want to buy. The excess quantity would push prices
down until the market was in equilibrium at PE*.
Alternatively, if price were PE2, buyers would
want to buy more than sellers would want to sell.
Sellers would bid up the price until the market was
in equilibrium at PE*. At equilibrium, buyers
would want to buy E* and sellers would want to
sell E*.
Changes in other variables would shift supply or
demand causing equilibrium prices and quantities to
change as shown in Figs. 9 and 10. For example, let
59
BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY

PE SE2 his total revenues. We can see how market power adds
to profits in Fig. 11.
SE In a competitive market, the marginal cost curve is
the supply curve. The price is determined where the
SE1 supply or marginal cost curve crosses the demand curve
at a price of PE* and a quantity of E*. Economic profits
are any extra profits above the cost of producing. Since
the producer gets PE* for each unit and the cost of that
unit is measured along MC, the economic or extra profit
is the area between PE* and the marginal cost curve up
E to E* or the area PE* ac in Fig. 11. Now notice what
happens if the monopolist raises price to PEmp.
Fig. 7. Shifts in the energy supply curve. Economic profits (abdPEmp) become larger than before.
Thus, we would expect increasing monopoly power in a
market that would raise prices.
PE Alternatively, market power on the part of the
buyer would have the opposite effect on price as
SE buyers want to pay a lower price. For example, when
PE1
large multinational companies first came to the Middle
PE* East to negotiate oil concessions, they often had
market power. We can think of the demand curve for
PE2
these multinationals as the marginal benefit to them as
a buyer. If they were willing to pay a price for a certain
DE unit of oil, they must value that unit by at least that
price. The difference between what they pay for the
E* E good and the value they place on it is called consumer
Fig. 8. Equilibrium price and quantity. surplus. A buyer with market power will want to pick a

Fig. 9 represent the gas oil market. Increasing the PE

SE
price of natural gas (a substitute) increases demand for
gas oil to DE1 causing an increase in price to PE1 and PE1
quantity to E1. Increasing the price of gas oil furnaces
(a complement) decreases demand for gas oil to DE2 PE*
causing a decrease in price to PE2 and quantity to E2. PE2
Alternatively, changing supply variables could shift DE1
the entire supply equation. Decreasing the price of
crude oil (a factor of production) increases the supply DE
DE2
of gas oil to SE1 in Fig. 10, decreasing the price of gas
E2 E* E1 E
oil to PE1 and increasing gas oil sales to E1. Increasing
the price of gasoline (an alternate good that can be Fig. 9. Increases and decreases in demand.
produced) decreases the supply of gas oil raising
gas oil price to PE2 and decreasing quantity to E2.
PE SE2
In all the above analyses, consumers and producers
have not had any market power and the market has set SE
prices. However, in the oil industry some ‘big players’ PE2
have had market power and have been able to SE1
influence market price. For example, the Organization PE*
of Petroleum Exporting Countries (OPEC), which is PE1
estimated to own about three quarters of remaining
world oil reserves, sets quotas to raise oil prices. The DE
market with most concentrated power on the sellers’
side would be with one seller, called a monopoly. The
E2 E* E1 E
seller is called a monopolist. A monopolist should
choose the point on the demand curve that maximizes Fig. 10. Increases and decreases in supply.

60 ENCYCLOPAEDIA OF HYDROCARBONS
 OUTLINE. OIL AND OIL PRODUCT DEMAND

point on the supply curve to maximize the value or PE

MC⫽SE
consumer surplus of his or her purchases. The market
with the most concentrated power on the buyer’s side
would be with one buyer, called a monopsony PEmp d
(or unilateral monopoly of demand), and the buyer is
called a monopsonist. PE* c
Fig. 12 illustrates how a monopsonist should use his b
or her monopsony power to maximize consumer a
surplus when buying from a competitive market. If
sellers are competitive, the marginal cost curve is the
DE
supply curve. If buyers are competitive as well, market
price and quantity would be PE* and E* and buyer or Emp E* E
consumer surplus would be PE* ca. However, the
monopsonist can pick any point along the supply Fig. 11. Monopoly power raises
curve. If the monopsonist buys Ems paying PEms, the market prices.
consumer surplus would be the larger PEmsbda. Thus,
we would expect that increasing monopsony power in
a market would lower prices. rewrite the above elasticity in terms of partial
derivatives as:
⭸E⭈P
2.1.4 Demand elasticities [25] ed ⫽ 144 1
⭸P⭈E
and their uses
Another common way of writing an elasticity that
Often we need to measure demand and supply can be easily verified with calculus is:
quantity responses to prices and/or other variables
⭸lnE
for energy plans and policy design. For example, if [26] ed ⫽ 1441
⭸lnP
oil demand and supply are very responsive to price,
only a small change in price (DP⫽Pt⫺Pt⫺1) will Using Eq. [23], it is easy to see that if the price
be needed to bring about equilibrium after demand elasticity is ⫺0.5 and price goes up by 100%, quantity
or supply shocks hit the oil market. If gasoline demanded falls by 50%, since:
demand in Asia is very responsive to income
[27] DEⲐE ⫽ed (DPⲐP)⫽⫺0,5 ⭈100% ⫽⫺50%
growth and income falls sharply – as it did in the
late 1990s with the Asian economic crisis – or If the demand elasticity is less than ⫺1, quantity
income rises sharply – as it has done before and demanded responds by a larger percent than the
after the crisis – there will be a large effect on percentage price change, and we call the demand
gasoline consumption and, consequently, a large price-elastic. If the demand elasticity is between
effect on oil consumption. OPEC leaders will then ⫺1 and 0, the quantity demanded responds by a
want to track Asian income changes closely, to smaller percentage than the percentage price
determine how much oil production capacity is change, and we call the demand price-inelastic.
needed. Economists use elasticities to provide such
a measure of responsiveness. For example, the
price elasticity of demand (ed) is the percentage PE
MC⫽SE
change in quantity of energy consumed divided by a
the percentage change in price. We write this as:
d
DE PE*
12 c
% change in quantity E PEms
[23] ed ⫽ 111111311244 ⫽ 12 b
% change in price DP
12
P
We can rewrite the elasticity as:
DE⭈P DE
[24] ed ⫽ 144 41
DP⭈E Ems E* E
Applying calculus and taking very small changes
in price or taking the limit as DP goes to zero, we can Fig. 12. Monopsony power lowers the market price.

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BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY
Demand price elasticities show how responsive
energy consumers are to price and also give
important information on the relationship between
price changes and total revenues for the goods
sold. We know that total revenue equals price
multiplied by quantity sold and the demand
elasticity is given by Eq. [23].
Suppose that this elasticity equals ⫺2 for
residual fuel oil in electricity generation. If price
decreases by 10%, quantity demanded increases by
DE/E⫽ed (DP/P)⫽⫺2(⫺10%)⫽20%. The 10%
price decrease causes revenue to decrease, but the
20% quantity increase causes revenue to increase.
Since the numerator or quantity effect is larger,
total revenues increase.
We can see this same effect for different
elasticities in Table 3. When price falls from 50 to
45 (a 10% decrease at an elasticity of ⫺2), the
quantity demanded increases by 20% to 9.6.
Revenue increases from 400 to 432. Alternatively,
if demand is inelastic with elasticity ⫺0.5, then a
10% decrease in price raises quantity by only 5%
and revenues fall to 378.
Demand elasticities can also be used to show
how much price will change from a supply
disruption. For example, oil supply was disrupted in
1956 with the Egyptian seizure of the Suez Canal; in
1973 when the Arabs cut production to embargo the
US and the Netherlands for supporting Israel; and
again in 1978 with the Iranian Revolution. We can
use elasticities to measure price change from such
disruptions. We know that:
[28] ed ⫽(DEⲐE)Ⲑ(DPⲐP)
then:
[29] (DPⲐP)⫽(DEⲐE)Ⲑed
With the Iranian Revolution, Iran’s production fell
from around 6 million barrels per day to less than 1
million barrels per day between September 1978 and
January 1979. Since other producers were only able to
make up a portion of this decrease, world oil
production fell from about 62.5 million barrels per day
in September 1978 to about 60 million barrels per day
in January 1979 – a decrease of about 4%. If the
short-run price elasticity of demand is ⫺0.05, Eq. [29]
shows that the price change needed to reduce demand
by this amount would be:
[30] (DPⲐP)⫽(⫺4%)Ⲑ(⫺0.05)⫽80%
Nominal oil prices in September 1978 were around
$14.50 per barrel. An 80% increase would raise them to
1.8⭈14.5⫽$26.10. Although prices did not immediately
jump to $26.10 because of contracts, nominal oil prices
had surpassed $26 by November 1979.
62
Income elasticity of demand (ey), which tells us
how sensitive sales are to income change, is:
DE
12
% change in quantity E
[31] ey ⫽ 111211111244 ⫽ 12
% change in income DY
12
Y
If ey⬎1, demand is income elastic, and we have a
luxury good. For example, demands for air travel and
jet fuel tend to be luxury goods. For a luxury good,
sales increase at a faster percentage rate than income.
If 0⬍ey⬍1, demand is income-inelastic, and the
sales increase at a slower percentage rate than income.
Studies suggest that the demand for gas oil for heating
in industrial countries may be income-inelastic with an
income elasticity around 0.5. If ey⬎0, we have a
normal good, but if ey⬍0, we have an inferior good.
For example, kerosene for lighting is an inferior good.
As consumers in developing countries with access to
the electricity grid get richer, they will switch from
kerosene to electricity for lighting.
A cross price elasticity of demand ecross tells us
how the quantity demanded of one good changes when
the price of another good (Po) changes or:
DE
12
% change in quantity E
[32] ecross⫽ 11121111111111244 ⫽ 12
% change in price of another good DP
12o
Po
For example, if the cross price elasticity of demand
for gasoline with respect to the price of diesel fuel is
0.5, then DEⲐE⫽0.5(DPo ⲐPo). If diesel price goes up by
10%, the percentage increase in gasoline demand is
DEⲐE⫽0.5(DPo ⲐPo)⫽0.5(10%)⫽5%. Such a positive
cross price elasticity of demand indicates that the two
goods are substitutes in demand. When the price of
one product goes up, we substitute it by increasing the
consumption of the other good. However, if the cross
price elasticity of residual fuel demand with respect to
the price of fuel oil boilers is ⫺1.2, then if the price of
fuel oil boilers falls 20%, the percentage demand
change for fuel oil is DEⲐE⫽⫺1.2(⫺20%)⫽24%.
Such a negative cross-price elasticity of demand
indicates that the two goods are complements. If the
Table 3. Revenues related to elasticities
Income
Elasticity Price Quantity
(price⭈quantity)
⫺2 50 8 400
45 9.6 432
⫺0.5 50 8 400
45 8.4 378
ENCYCLOPAEDIA OF HYDROCARBONS

price of one of the goods goes down, people consume
more of that good and also more of the
complementary good.
The time period over which we measure demand
elasticities influences the size of the elasticity. In the
short run, for example one year, if the price of gasoline
goes up, people may drive less. However, in the long
run when they have time to fully adjust to the price
increase, they are likely to acquire a more
fuel-efficient car and may even move their residence
to reduce their travel. Thus, consumers are more
price and income responsive in the long run than
in the short run.
2.1.5 Econometric estimates
of energy demand models
Because demand elasticities are very helpful for
forecasting and for policy analysis, energy and
energy products may have been subjected to more
demand studies than any other goods and factors. To
estimate demand elasticities, actual data is collected
on quantity demanded and variables that should
affect the quantity demanded. Functions are then
selected and fit through the actual data using
statistical techniques and demand elasticities can be
derived from these estimates.
Since 1973, and even before, a large number of
energy-demand studies have been carried out at
various levels of aggregation, covering various time
periods, and using various models for all sorts of
energy products. These models have a variety of uses
including forecasting, policy analysis, evaluating
structural change and understanding adjustment
processes. Different models may be appropriate given
the resources at hand, the available data and the
purpose of the model.
This section contains a variety of popular models
that have been applied in demand estimation.
Single equation models
The simplest models are one-equation models,
which have the advantage of being simple and
undemanding in terms of data requirements. To get
some intuition about econometric estimation of energy
demand, take the simplest of the equation models,
which is a static model that fits the quantity of the
energy product (E) on the price of the fuel (P).
Assume that no other right-hand side variables change,
so quantity demanded can be represented solely as a
function of price, and we have T observations. Then:
[33] Et ⫽b0 ⫹b1Pt
where Et is quantity demanded in time period t, Pt is
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
OUTLINE. OIL AND OIL PRODUCT DEMAND
the price in time period t, and b0 and b1 are constant
for all t⫽1,...,T.
In this equation, Et is called the dependent variable
and Pt is called the independent variable. The
observations on Et and Pt are used to estimate b0 and
b1. If we had the two data points, a and b on our
demand curve, which is the straight line in Fig. 13, we
could connect them and have estimates for b0 and b1
in Eq. [33].
In Fig. 13, the observations for a and b fall on
the demand curve, so the errors are zero. However,
usually our data points do not lie exactly on the
actual demand curve but random errors in each
period (et ) may push the oil consumer off his
demand function, making actual consumption (Et )
demand plus an error term as shown by all the
other observations off of the demand curve in Fig.
13. Those observations to the right of the demand
curve have positive errors and to the left of the
demand curve have negative errors. Kennedy
(2003) gives three reasons for such errors: the
omission of chance events such as a war, unusual
weather or temporary shifts in taste that are not
included in the function; errors in measurement of
the variables that have crept in as a result of data
usually being collected by governments and
businesses using surveys of only a portion of the
population; and randomness in human behaviour
that can’t be captured by any variable (e.g.
sometimes you want to drive to the shopping centre
and sometimes you don’t).
Although all variables that systematically affect
demand should be included, we are often unable to
include the myriad of random events that affect oil
consumption. However, all is not lost if the effects of
these errors average out to zero (i.e. that on average
positive errors are offset by negative errors) or these
errors are not related to explanatory variables on the
right-hand side of the equation.
Then we may still get estimates of b0 and b1 that
are good on average and that allow us to do statistical
analysis. The science of econometrics helps us to
correctly apply statistical analysis to estimate
economic models and use them for inference and
forecasting.
One popular criteria in econometrics for
choosing estimators is to minimize the sum of the
squared errors from the estimated line to the data
points. This methodology is called Ordinary Least
Squares (OLS) or regression analysis. For a correct
interpretation of the results refer to econometric
theory in Pindyck and Rubinfeld (1998) or other
econometric texts.
In practice, the simplest demand model is usually a
static model that fits the quantity of the energy product
63
BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY
(E) on the price of the fuel (P) and some measure of
income (Y ):
[34] E ⫽b0 ⫹b1P⫹b2Y
Other prices are represented in this framework by a
price index which is used to deflate both the energy
price and income into real prices. These models can be
made more complicated by adding other variables (as
shown in Eq. [18]) to represent demographics,
weather, prices of competing fuels, and prices of
complementary goods. To get good estimates using
such models, we need to include all the important
variables that influence our oil product consumption
that have changed over the sample. If we omit
variables that have changed, our elasticity estimates
are likely to be wrong. For example, suppose Eq. [34]
is the demand for gasoline and we omit income and fit
the model using only price and quantity on data from
1975 to 2005. We find that our price elasticity is
positive. That is, when price and consumption of
gasoline go up. Such a result is likely to derive from
the missing income variable. That is, as income has
gone up over time, it has stimulated gasoline
consumption which was then erroneously attributed to
the rising price. Thus, if you are using an econometric
demand estimate, be sure the equation includes all the
important variables that affect demand, unless the
missing variables have not changed over the sample or
are not related to right-hand side variables included in
the model.
To the simple static model, we could add some
measure of the stock of energy using appliances or
equipment (Sk):
[35] E ⫽b0 ⫹b1P⫹b2Y⫹b3 Sk
These models, which include a stock of energy
using equipment, will tend to capture short-run
adjustments in energy demand given the capital stock.
P
a
b elasticities, particularly for price.
Et⫽β0⫹β1Pt
Q time-series may provide more changes in the variables
Fig. 13. Estimating demand
from real world data.
64
Distinguishing between short run and long run
is typically done in three ways using a single
equation. The first relates to the data type. If we
have data that represent a number of economic
entities or regions at a single point in time, we have
cross-section data (gasoline consumption for 32
countries in 2005 would be cross-section data). If
we have data for a single economic entity across a
number of time periods, we have time-series data.
(Italian gasoline consumption for years 1980 to
2005 would be time-series data.) If we have data
that represent a number of economic entities or
regions across a number of time periods, we would
have cross-section time-series also called panel data
(gasoline consumption for 32 countries for the
years 1980 to 2005 would be panel data).
Cross-section data is more likely to let us measure
long-run adjustments, particularly if prices and
incomes are very different across the cross-sections.
For example, suppose you are using a cross-section
of countries for 2005 to estimate gasoline demand.
Included in your cross-section are low-price Gulf
countries and high-price European countries. The
Gulf state residents have made long-run
adjustments in their vehicle stock and driving
patterns to their income levels and low prices,
whereas the Europeans have made long-run
adjustments to their income levels and high prices.
The regression should then pick up these long-run
differences.
The advantage of greater price and income
variation in cross sections has two negative aspects.
First, we may be capturing locational bias with
energy-intensive industries locating in cheap energy
areas. Hence, for industrial demand or other
moveable demand, price elasticities could predict
too large a reduction in energy consumption, if
prices in all areas were to increase simultaneously.
A second bias may result from other non-included
variables in the model that influence energy
demand. If these variables are related to price or
income, their effects will be attributed to price and
income with the direction of the bias uncertain and
dependent on the relationships between the
included and excluded variables. Hartman (1979)
feels that because of these locational and structural
differences, cross-section data overstates
Time-series, particularly short ones, are more
likely to capture short-run effects. The disadvantage of
short time-series is frequent inadequate changes in the
variables or not enough observations. Longer
and more observations, but may also suffer from
structural change.
ENCYCLOPAEDIA OF HYDROCARBONS

According to these interpretations, under the best
circumstances, Cross-section Time-series (CT)
would give us the advantage of more variation
across a much larger data set, which would measure
some mix of long and short-run effects. However,
our CT also has the potential disadvantages of both
types of data.
The data can be further divided in its periodicity.
Annual data is by far the most commonly used.
Quarterly and monthly data can dramatically increase
the sample size. However, many series are not
available this often, and there are problems of
seasonality that need to be taken into consideration.
People drive more on nice days but use more heat on
cold days.
A second way of distinguishing long-run from
short-run using CT data is described in Baltagi and
Griffin (1983). Using this methodology, the basic
estimation equation is:
[36] Eit ⫽b0 ⫹b1Pit ⫹b2Yit
Cross-country variation will be associated with the
long-run and will be obtained by regressing the mean
of each country’s quantity (Ei⫽兺Tt⫽1 Eit ⲐT ) on the mean
of each country’s prices (Pi⫽兺Tt⫽1 Pit ⲐT ) and incomes
(Yi⫽兺Tt⫽1 Yit ⲐT ) and the mean of any other variable in
the model, or:
[37] Ei ⫽b0 ⫹b1Pi ⫹b2Yi
Variation within a country will be associated with
the short-run and will be captured by a pooled
regression where each country’s consumption and
explanatory variables are deviated from their
respective means or:
[38] (Eit ⫺Ei ) ⫽b1(Pit ⫺Pi) ⫹b2(Yit ⫺Yi )
The third, and most ubiquitous technique for
separating out short and long-run effects on single
equation models, is to make the model dynamic by
adding lagged values to the model. The simplest and
most common way of doing this is to add a lagged
endogenous variable (Et⫺1). The lagged endogenous
model, also called a stock adjustment, partial
adjustment, adaptive expectations, Koyck, or
geometric lag model is:
[39] Et ⫽b0 ⫹b1Pt ⫹b2Yt ⫹b3Et⫺1
b3 in this model is between 0 and 1. Then, the effect of
a price change in the current period is b2, its effect one
period out is b2 b3, two periods out is b2 b 23, etc. The
total long-run effect is quite easily calculated because
it is b2 Ⲑ(1⫺b3). The advantage of this model is that it
is simple and flexible to use with an intuitively
appealing lag shape. When price or income changes,
the immediate effect is the largest, with the changes
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growing geometrically smaller the farther out they are
taken. The disadvantages include a fairly restrictive
shape for the lag that is constrained to be the same for
both income and price. Further, the lagged endogenous
and other variables often move together. This effect
called multicollinearity may make it difficult to get
very precise estimates for the coefficients of the
model.
There are more flexible forms that nest the lagged
endogenous model within a form that allows an
inverted V lag as well. With an inverted V lag, changes
in income or price have a small effect immediately, but
with time consumers gradually increase adjustment
and then gradually decrease adjustment farther out.
The two standard procedures for doing this are:
[40] Et ⫽b0 ⫹b1Pt ⫹b2Pt⫺1⫹d1Yt ⫹d2Yt⫺1⫹sEt⫺1
and:
[41] Et ⫽b0 ⫹b1Pt ⫹d1Yt ⫹s1Et⫺1⫹s2Et⫺2
Although these lags are less restrictive than the
lagged endogenous model, they seem to suffer an even
greater tendency towards multicollinearity.
A more general way to make a simple model
dynamic is to put in lags on some or all of the
independent variables. These models will be called
distributed lag models and can be represented as:
m n
[42] Et ⫽b0 ⫹冱 ⫽bi Pt⫺i ⫹冱 di Yt⫺i
i⫽1 i⫽1
Here m equals the number of lags on price, and n
equals the number of lags on income. This model has
the advantage of being flexible and allowing different
lags on different variables. In practice however, there
is often so much multicollinearity across time for the
variables that the model does not give very precise
estimates for individual parameters.
When we estimate econometric models, a
larger sample size gives us more information and
is likely to improve our estimates or put them
closer to the true parameters. However, estimating
more parameters requires more information,
which is likely to worsen estimates. The sample
size minus the number of parameters estimated is
called the degree of freedom. Since increasing the
sample size or decreasing the number of
parameters when all necessary variables are
included should improve our estimates, models
with more degrees of freedom should provide
better estimates. If we think that adjustment would
occur over ten periods, we could include lagged
values for ten periods with no constraints.
However, this would rapidly use up our sample.
Sometimes lags are constrained to be on a
polynomial to help deal with problems of
65
BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY
multicollinearity and loss of degrees of freedom.
Such a model is called a polynomial distributed
lag model.
The above models assume that the b’s are the
same, whether price and income increase or
decrease. However, sometimes we believe that
consumers will respond more to increases than
decreases in these variables. In such a case,
asymmetric models such as those discussed in
Gately (1993) can be employed.
Multiple equation models
From single equation static and dynamic models,
researchers have moved to more sophisticated
behavioural specifications requiring multi-equation
models (as discussed more completely in Dahl, 2005).
Four types of multi-equation models are included
below.
A popular set of models is one that investigates
interfuel substitution using some kind of energy-
share equations such as the translog and logit model
or other systems of equations such as the
generalized Leontief. Flexible functional forms have
been most popular in this context because they put
less restriction on the shape of the function and are
less likely to force the function to be the wrong
shape giving bad elasticity estimates. Such models
have been used to investigate questions of
substitution between total energy demand and other
factors such as labour as well as the choice between
energy products. This approach has the advantage of
putting in cross-equation restrictions implied by
producer or consumer theory.
Another type of simultaneous system includes
structural models with equations describing the use of
the stock of energy using equipment as well as the
purchase decisions for the stock of energy using
equipment. These types of models have become
increasingly popular as household surveys have
provided data on appliances and fuel choices.
Expenditure system models consider consumer
expenditures on goods simultaneously and also allow
restrictions to be placed on the estimated equations
implied by consumer theory.
Finally, there are true simultaneous systems models
representing a particular market. In these models,
supply and demand are estimated simultaneously or at
least demand is estimated using variables from the
supply equation. Although most demand models are
estimated with a fleeting wave at supply in passing, a
few models do consider the supply side more explicit.
Econometric issues
Although many econometric models of demand
ignore supply, we know that prices in markets are
66
typically determined by the interaction of both supply
and demand, with a variety of variables affecting the
demand and supply equations. To see what problems
ignoring supply might cause us, consider Fig. 14,
which represents the market for gasoline at different
times. Over time both demand and supply shift. In
each panel, the intersection of demand and supply at
various market equilibria creates a data point. In Fig.
14 A, if only the supply shifts and we fit a line through
the three data points, we will estimate the demand
equation. In Fig. 14 B, if only the demand curve shifts,
and we fit a line through the three data points, we will
estimate the supply equation. In Fig. 14 C if both the
demand and supply curves shift, and we fit a line
through the nine data points, we will get neither the
demand nor the supply curve.
Thus, when evaluating demand models we need to
determine whether a demand curve was estimated as
in Fig. 14A. The statistical term for whether we really
have a demand curve is called identification;
mathematical properties for whether a demand curve
is identified can be found in Pindyck and Rubinfeld
(1998).
Even if the identification problem has been dealt
with adequately, simultaneous system bias is a second
problem that can be encountered with simultaneous
systems. This problem is a bit more subtle and
difficult to understand. In Fig. 15, let D and S be the
relevant demand and supply curves. Let D⫹et be the
demand function when the error is positive and D⫺et
be the demand curve when the error is negative.
Notice that a positive error raises the price, and a
negative error lowers the price. Therefore, a right-hand
side explanatory variable is not independent of the
error.
Let’s see how this relationship between the
errors and the price affects the demand estimates.
In Fig. 16, the solid line is the true demand curve
(Dtrue) and the small circles are observations when
the errors and price are not related. However, if the
error and price are positively related, then positive
errors would have higher price and negative errors
would have lower price, as shown in the figure by
the observations represented by the boxes. From the
figure you can see that the estimated line (Dbiased)
would be steeper than the true line. Kmenta (1997)
shows mathematically that regression estimates that
fit a line through the boxes will result in demand
equations that are on average less elastic or steeper
(as shown by the dotted line) than the true equation.
Thus, another issue to be considered in estimating
demand curves is simultaneous systems bias.
Fortunately, there are ways to fix this problem. The
simplest such method used in just one equation is
called Instrumental Variables (IV) or two Stage
ENCYCLOPAEDIA OF HYDROCARBONS

Least Square (2SLS). The instruments, which must
be exogenous or independent of the error, are used
to create a new estimated price variable in a first
regression. This new price variable is then used
in a second regression. This methodology as well as
more complicated systems methods for dealing
with systems bias can be found in Pindyck and
Rubinfeld (1998) among many other econometric
texts.
OLS is used extensively in demand analysis.
However, this is not the most appropriate methodology
if price is influenced by the error. The question must
then be asked if it is ever appropriate to use OLS to
estimate demand.
Note that in Fig. 17, when supply is perfectly
elastic, errors in the demand equation do not influence
supply. Then, if demand is identified, OLS is
appropriate. There are a number of cases when supply
is perfectly elastic or demand shifts do not influence
price. If consumers are a small part of the market, then
shifts in their demand are unlikely to affect price.
Thus, if granny comes to visit or a small firm
temporarily runs a second shift that increases gas oil
demand for heating, it is unlikely to affect the gas oil
price. Even an individual state, province or country
– if they are not large – may not affect the price of gas
oil which is heavily influenced by global markets.
If governments regulate price as they have often
done in the electricity sector, random shifts in demand
are then prevented from changing the price and OLS is
appropriate.
Last, since the supply curve is the marginal cost
curve in a competitive market, if marginal costs are
flat, supply will be perfectly elastic and OLS is
appropriate.
2.1.6 International data sources
In order to estimate demand functions statistically, real
world data on energy product consumption and
variables that influence energy consumption – such as
price and economic activity – are needed. Most
national governments have statistical offices that
P S1 P P S1
S S2
S2
S3
D3
D2
D D1 D1 D2
E E
A B C E
Fig. 14. Changes in demand
and supply over time.
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routinely collect a variety of data for their economies
relating to: social issues – including health,
demographics, education and the environment; general
economic and financial issues – including aggregate
production, consumption, investment, trade, prices,
interest rates, government budgets, money supply,
banking statistics and infrastructure; and energy
markets – including consumption, production, trade,
transformation, prices, and environmental effects for a
variety of energy products along with infrastructure
such as roads, vehicles and sometimes even appliance
stocks.
The data is usually reported at an aggregate level;
sometimes for sub-regions such as states or provinces;
sometimes by a major consuming sector (residential,
industry, commercial, electricity generation and
transport); and sometimes at an even more
disaggregate level – by industry or even individual
households and companies.
International organizations may collate this
information in CT data by time and country. For
example, the United Nations (UN), which has 191
member countries, collects a variety of data from
national statistics offices. If you need aggregate
P
ε1
D⫹εt
S
D⫺εt
D
ε2
E
Fig. 15. When price and error are related in demand.
P
S3
D3 Dtrue
Dbiased
E
Fig. 16. What happens to observations when the price
and errors are not independent?
67
BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY
cross-section or CT data to estimate demand, they
might be a good source. Their most comprehensive
data set is the United Nations Common Data Base
(UNCDB) that is only available online by
subscription. It currently contains around 430 series
from forty international data sources for all
available countries and areas. All but three of the
sources are from UN departments, or specialized
and affiliated UN agencies. You can see the series
and sources for a selected number of years in their
online free demonstration. There are a number of
series that might be of interest to researchers doing
demand estimation at the aggregate level, including
energy production and consumption by type:
a) bunker fuel use; b) energy exports, imports and
stock changes; c) CO2 emissions; d ) motor vehicles
in use; e) rail passenger and freight travel; f ) air
passenger and freight travel; g) aggregate price
indexes; h) value added by major industry; i) gross
domestic product; j) consumption. Since this
database gives original sources, it might be the
starting point to find other UN documents. Brief
descriptions of all UN data publications as well as
their online databases are available on the UN
website. The UN also might be a good place to
begin a search for national statistics, since it gives
links to central statistics offices in almost
three-quarters of its member countries.
A couple of UN publications are specifically
devoted to energy consumption, production and
some trade flows by country, continent and energy
source including biomass – Energy statistic
yearbook since 1984, preceded by the Yearbook of
world energy statistics published from 1981 to 1983
and World energy supplies first published in 1952
with annual publications from 1959 to 1979. The
UN’s approximately biennial publication Energy
balances and electricity profiles, published since
1982, shows energy production, conversion and
P International petroleum annual (IPA), published
D⫹ε
S2
D
D⫺ε
E monthly which has been published since 1989,
Fig. 17. When to use OLS
to estimate demand.
68
consumption for the various fuels utilized in
selected developing countries as well as thermal
electricity by fuel use.
Two specialized agencies of the UN – the World
Bank and the International Monetary Fund (IMF) –
publish the World Bank development indicators and
International financial statistics respectively. These
both contain a variety of economic, financial and
social statistics including a few energy series. The
CD rom and online versions contain information
dating back to 1960 and 1948, respectively, for
some series.
The OECD, which has 30 mostly rich member
countries, also collects a variety of information. Its
website provides links to an even wider variety of
statistical sources worldwide, including central
banks and statistics offices. Links to statistical
sources by topic can currently be found by clicking
on statistics on the OECD website.
By following these links you will find brief
descriptions of the sources with freely accessible
data. The International Energy Agency (IEA) is the
OECD repository for a rich variety of energy data.
The most recent volume of two of its publications
Key energy statistics and Energy balances are
currently available online. Price data is much
sparser than quantity data, but the IEA’s Energy
prices and taxes, which has been published
quarterly since 1984 with data for OECD countries
going back to 1978, is a valuable resource.
The US Energy Information Administration
(EIA) of the US Department of Energy is a rich
source of free energy data online for the US but
also has three annual publications that deal with
international data. The International energy annual
published since 1979, has provided information by
country on energy consumption; production of oil,
coal, natural gas and primary electricity; petroleum
and product supply, imports, exports, prices and
consumption; and population, GDP and CO2
emissions by fossil fuel. It was preceded by the
from 1967 to 1978. The data in IPA focused more
exclusively on petroleum and had been published in
other forms by the US government since 1949.
US EIA’s International energy outlook contains
reference historical data and forecasts out to 2025
for production and consumption of coal, oil, natural
gas, electricity and CO2 emissions for major world
regions, key countries, key industries and key
sectors, various scenarios on oil price and world
income growth. EIA’s International petroleum
contains monthly statistics to help track the world’s
oil market with oil production, including lease
ENCYCLOPAEDIA OF HYDROCARBONS

condensate statistics and natural gas liquids for key
oil producing countries; global information on oil
demand and supply; along with oil stocks and
imports for OECD countries.
The transport sector takes over 60% of world
oil products and over 20% of world energy demand.
Therefore its use and infrastructure are important
components in oil and energy demand. The most
extensive source of international country level
highway transit statistics is the International Road
Federation. Since 1958, it has published World road
statistics, which has extensive information on
kilometres of roads by type, expenditures on roads
and user taxes. Moreover, it offers information on
vehicle production, exports, imports and
registrations, as well as road traffic, fuel use,
accidents and fuel taxation. The publication, which
is the source of road statistics for many of the other
international publications featured here, can be
ordered online. Gasoline and diesel prices for
numerous countries since the early 1990s have been
featured in the German Technical Cooperation’s
Fuel prices and taxation.
Governments are not the only source of
international statistics. British Petroleum has collated
energy data in its Statistical review of world energy
since 1952. The review is free online and contains
production, consumption and reserve data for
sixty-five economies for coal, oil and natural gas
along with major trade movements. It also contains
information on nuclear and hydropower consumption
and some limited price information on oil and natural
gas. Databases are also available for purchase from
private energy intelligence companies such at Platts.
Their price service for oil and product prices has been
collecting data and publishing it in Platt’s oil price
handbook and oilmanac since 1952. Information on
their various price services is currently available from
their website.
The Journal of energy literature frequently has
articles featuring data sources for various energy
products. More on data sources and link updates are
maintained online.
2.1.7 Survey of demand elasticities
by product, region and sector
Transport fuel demand elasticities
The transport sector consumes the largest share
of oil worldwide (estimated at around 60%) and its
petroleum product demand probably has been the
most studied of all the oil products. Highway transit
uses the largest share of transport fuels with
gasoline being the dominant fuel, followed by
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
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diesel with small amounts of LPG used as well. A
recent survey of the demand for road fuel
consumption (Goodwin et al., 2004), considered
69 highway transport demand studies. As in earlier
surveys, they find a fair amount of variation in
highway fuel demand but come to some general
conclusions regarding demand elasticities. Their
survey results for models with both short-run and
long-run estimates are based mostly on OECD
countries. They find the short-run or one-year
demand elasticity for transport fuel is ⫺0.25 and
the long-run price elasticity is ⫺0.64 while their
short and long-run income elasticities are 0.39 and
1.08, respectively. Over half of the price elasticity
adjustment comes from changes in vehicle
efficiency, while over half of the income elasticity
adjustment comes from changes in miles travelled.
Studies that include highway diesel fuel have less
price-elastic demand.
Since they aggregate studies on gasoline, diesel
fuel, and total highway transit fuel and contain little
work for non-OECD countries, summary statistics are
also provided from 76 oil demand or product studies
published since 1990 and summarized in Table 4. Both
mean and median values were computed for all
categories of fuel reported here. The median values
tended to be a bit less elastic and better behaved and
are included in Table 4. The categories with estimates
for both OECD and non-OECD countries are listed
first, allowing a comparison of elasticities across
richer and poorer countries.
Gasoline
Gasoline is estimated to be somewhat under
half of global transport fuel consumption.
Evidence suggests that demand is price-inelastic,
with a median elasticity of ⫺0.22 in the richer
OECD countries in the short run and ⫺0.80 in the
long run. Median short-run income elasticity is
0.25 with the long-run slightly elastic at 1.07
suggesting that gasoline demand grows slightly
faster than income, all else equal. In the
non-OECD countries, gasoline demand is probably
a bit less price-elastic. Somewhat surprisingly, the
median income elasticity suggests that demand is
slightly below one or that gasoline grows slightly
slower than income in non-OECD countries.
Gasoline consumption can change because
people drive longer or shorter distances measured
in miles or kilometres or because they buy more or
less-efficient vehicles. Six studies on OECD
countries consider how distance in gasoline using
vehicles changes in response to changes in price
and income. The median elasticities suggest that
about half of the short-run adjustment to price
69
BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY
comes from changing distance driven, but that one
fourth of the long-run adjustment comes from
changing distance driven. The studies also suggest
that about 80 percent of the short-run adjustment to
income comes from changing distance driven but
only about 40 percent of the long-run adjustment
comes from changing distance driven.
Diesel
Diesel demand is estimated to be about a third of
global transport fuel. Although some diesel is used in
personal automobiles, particularly where gasoline
taxes are much larger than those for diesel fuel, much
more diesel is used in large trucks for freight hauling
and also in mass transit buses. The median values
suggest slightly lower price elasticities and slightly
higher income elasticities for diesel than for gasoline.
Some studies combine gasoline and diesel fuel
together into highway fuel. In general, they support the
separate studies but suggest an unexpectedly high
income elasticity of total highway transport fuel
demand for the OECD of 1.37. Two studies consider
the total demand for oil for transport. They include
gasoline and diesel as well as LPG, jet fuel and
international bunkers. These latter three constitute
around a fifth of the global use of transport fuels. The
median values for total transport fuels are similar to
those for diesel fuel but are perhaps a bit less income
elastic.
Heavy fuel oil demand elasticities
Heavy fuel oil, also called residual oil, has demand
studies on both OECD and non-OECD countries. Its
share of the worldwide barrel is now only around 10%
– about a quarter of which is used for bunker fuel for
international shipping, slightly less for industry, with
the bulk of the rest used for electricity generation. The
results from these studies are much more erratic than
for transport fuel – probably reflecting the much more
diverse uses for heavy fuel oil. OECD long-run price
elasticity may be greater than 1 in absolute value, but
income elasticities are positive in some countries and
negative in others, ranging from ⫺2.25 to ⫹2.35. The
evidence is stronger that income elasticity is greater
than 1 for non-OECD countries.
However, the range of elasticities is so wide that
we are left with little confidence in either median or
average category values for these estimates. Dahl
(1993) found this same dichotomy with more stable
elasticity estimates for transport fuels and more erratic
elasticities for fuel oils.
Aggregate oil demand elasticities
Some studies estimate aggregate oil demand
elasticities. The majority use the world price of
70
crude oil denominated in dollars as its price
variable. These studies suggest long-run price
elasticities less than ⫺0.25 in both OECD and
non-OECD countries and an income elasticity
considerably greater than 1 for OECD countries and
less than 1 for non-OECD countries. Since oil
demand is derived from the demand for oil
products, consumers are responding to the price for
oil products. Thus, some studies use the price of oil
products in their demand equations.
Demand is four times as elastic when product
prices are used instead of crude oil prices. The more
elastic response to product than crude prices is not
unexpected, since a change in crude price results in
a much smaller percentage change in product price.
If product price and crude oil price are closely
related, either oil or product prices could be used to
accurately measure consumer response. However,
given the high taxes paid on oil products that may
change for environmental and revenue needs, the
changes in the exchange rates between the dollar
and other currencies, and other restrictions on price
– such as oil price stabilization funds – local oil
product prices and the world price of crude oil may
not move together in a systematic way. In this case,
the estimates from oil prices will not accurately
reflect the true consumer response. Further, the
estimated OECD income elasticities are
unbelievably high, especially when product prices
are used, leaving us with little confidence in these
aggregate estimates.
LPG and kerosene demand elasticities
LPG is a clean burning mixture of short
hydrocarbons, mostly propane and butane. A
couple of studies look at LPG demand in the
OECD, where industry uses about half, transport
another 10% or so, and the agricultural,
commercial and residential sector use the rest. A
couple of other studies look at LPG demand in
non-OECD countries, where around 40% is
thought to be used by industry, somewhat less than
10% is used in transport, and the rest is non-
specified, but probably a considerable portion is
used for heating and cooking. The median values
suggest that price elasticities might be similar in
the OECD and non-OECD countries, but that non-
OECD demand might be over twice as income
elastic in the long run.
Three quarters of the kerosene in OECD
countries is designated as jet fuel. The majority of
the rest is used in the residential and commercial
sector, most likely as heating oil. In the non-OECD
countries less than 60% is used for jet fuel, with
the IEA being unable to designate where the
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 OUTLINE. OIL AND OIL PRODUCT DEMAND

Table 4. Median elasticities of fuel demand from survey of major oil products
for OECD and non-OECD countries

OECD non-OECD

Price Income Price Income

no. of elasticity elasticity no. of elasticity elasticity
Product Product
studies studies
short long short long short long short long
term term term term term term term term

Gasoline 10 ⫺0.22 ⫺0.80 0.25 1.07 Gasoline 12 ⫺0.13 ⫺0.51 0.12 0.84
no. of estimates 175 233 174 220 no. of estimates 69 70 71 105

Diesel fuel 3 ⫺0.10 ⫺0.29 0.48 1.16 Diesel fuel 9 0.10 ⫺0.38 0.23 1.36
no. of estimates 7 7 6 14 no. of estimates 25 25 25 44

Petroleum used for 7 ⫺0.14 ⫺0.44 0.48 1.37 Petroleum for

highway transport highway transport 1 ⫺0.25 ⫺0.69 0.33 0.98
no. of estimates 25 24 23 23 no. of estimates 2 2 2 2

Heavy fuel oil 7 ⫺0.15 ⫺1.13 ⫺0.05 0.00 Heavy fuel oil 5 ⫺0.23 ⫺0.60 0.25 1.13
no. of estimates 13 15 7 13 no. of estimates 13 13 13 39

Oil products* 6 ⫺0.06 ⫺0.24 0.21 1.68 Oil products* 4 ⫺0.03 ⫺0.08 0.38 0.96
no. of estimates 41 38 17 14 no. of estimates 21 21 27 26

Oil products** 2 ⫺0.57 ⫺0.91 0.67 3.99 Oil products** 2 ⫺0.12 ⫺0.52 0.92 0.66
no. of estimates 18 6 12 6 no. of estimates 1 21 1 21

LPG 2 ⫺0.28 ⫺0.63 0.12 0.52 LPG 4 ⫺0.23 ⫺0.55 0.12 1.13
no. of estimates 3 2 3 3 no. of estimates 14 13 14 46

Non-jet 1 ⫺0.02 ⫺0.06 0.25 0.66 Non-jet

fuel kerosene fuel kerosene 7 ⫺0.08 ⫺0.10 0.21 0.40
no. of estimates 1 1 1 1 no. of estimates 35 23 24 60

Jet fuel 3 ⫺0.20 ⫺0.43 0.19 1.15

no. of estimates 8 8 8 40

Miles 9 ⫺0.10 ⫺0.23 0.21 0.43

or kilometres
travelled
no. of estimates 14 19 15 15

Light fuel oil*** 4 ⫺0.04 ⫺0.27 0.04 0.42

no. of estimates 14 15 12 14

Oil products for 8 ⫺0.24 ⫺0.62 0.23 0.54

industrial use
no. of estimates 17 18 8 8

Oil products for 5 ⫺0.10 ⫺0.17 0.10 0.15

residential use
no. of estimates 26 26 24 24

Oil products for 3 ⫺0.46 ⫺0.72 0.56 0.78

commercial use
no. of estimates 4 4 4 4

Oil products 3 ⫺0.02 ⫺0.29 0.47 1.05

for transport
no. of estimates 21 27 10 16

Oil products 3 ⫺0.11 ⫺0.76 0.22 1.09

for non-transport
sector
no. of estimates 15 18 7 12

* Price related to crude oil

** Price including taxes
*** Residential and industrial consumption

VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION 71

BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY
remainder is used. However, it is believed that
much of this kerosene in poorer countries is burned
for heat and light. The median values show non-jet
fuel kerosene demand to be very price-inelastic for
both the richer and poorer countries with income
elasticities considerably less than one. In many of
the poorer countries, the income elasticity is
negative, which suggests that kerosene is an
inferior good. Thus, as poor households get richer,
they move away from kerosene for lighting to
electricity which is more desirable. A couple of
studies also look at the demand for jet fuel in non-
OECD countries. The median long-run values are
price-inelastic and income elastic and are not too
dissimilar to the demands for highway transit fuels.
Light fuel oil demand in the OECD
About a third of light fuel oil not used as diesel
fuel goes to the residential sector in the OECD with
the remainder divided roughly equally between the
industrial, commercial, and agricultural sector. Five
studies were found that estimate various demands for
light fuel oil. One looks at aggregate consumption,
three look at residential consumption and one looks at
industrial consumption. Since median values were
similar for these three categories, they have been
combined into one light fuel oil category. It is
suspected that a substantial portion of this fuel might
be used for heating in all sectors but agriculture, and
demand appears to be comparatively unresponsive to
price and income.
Oil product consumption by major sector
in the OECD
Around 15% of OECD oil consumption goes to
non-transport industry use. About 40% of this is
naphtha, which is mostly used as a petrochemical
feedstock. LPG and residual fuel oil, used mostly for
space and process heat, are roughly 20% of this and
gas oil has a slightly smaller share. Seven studies look
at oil product consumption in the industrial sector in
OECD countries. Price and income are inelastic in the
short and long run with median values very near those
for LPG in OECD countries. Income elasticities are
considerably smaller than for transportation fuels and
a bit smaller than for light fuel oil in the industrial
sector.
Just over 5% of OECD oil goes to the residential
sector. Almost 60% of this consumption is gas oil,
another quarter is LPG and somewhat less is kerosene
with a small amount of residual fuel oil. Five studies
look at total oil consumption in the residential sector.
Medians suggest that the residential sector is the most
non-responsive to price and income changes with all
median elasticities below 0.2 in absolute value. A
72
slightly larger share of OECD oil is used in the
commercial-government sector. Of this about two
thirds is gas oil, then in order of usage kerosene
followed by LPG with a small amount of residual oil.
Three studies have looked at total oil consumption in
the commercial sector. Median elasticities suggest
that the commercial sector is more price and income
responsive than either the industrial or residential
sectors. Demand is income inelastic but the price
elasticities rival those of gasoline. Three studies look
at oil demands for non-transportation fuels. The
medians suggest that non-transportation demand is
more price-elastic in the long-run than transportation
fuels with a similar long-run income elasticity.
However, these more aggregate results on oil not for
transport are not consistent with all the more
disaggregate OECD demands for non transport fuels
which all suggest long-run income elasticities of less
than 1 and long-run price elasticities of less than
⫺0.76.
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ENCYCLOPAEDIA OF HYDROCARBONS

Williamson H.F., Daum A.R. (1959) The American petroleum
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International energy annual 2002, Washington (D.C.),
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OUTLINE. OIL AND OIL PRODUCT DEMAND
Gately D. (1993) Oil demands in the US and Japan. Why the
demand reductions caused by the price increases of the
1970’s won't be reversed by the price declines of the 1980’s,
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73

Basic conditions for crude oil
production and cost functions
in the short and long run
Oil and natural gas are fluid minerals occurring in
underground reservoirs. Investment is needed to locate
the reservoir, to drill to contact it, and then to appraise
the data indicating success (profitability) or failure. In
case of success, investment is also needed to install the
apparatus for liquid to flow to the surface in order to
connect it with a pipeline or tanker terminal. It is
conventional and correct practice to draw the line there.1
Profit on any producing investment will differ
enormously among projects. In nearly all countries
(and partly in the United States in recent decades), the
subsoil wealth is owned by the national government.
At both the initial and later phases, a proposed
division of profit between the landlord-State and the
investing company must be acceptable to the involved
parties. Since company-State relations vary from
important to decisive in determining the initial
investment and its continuing flow, we must pay much
attention to these investments.
If acceptable to both sides, the investment will
engender a flow of oil or gas that always decreases over
time as the reservoir pressure falls and water content
increases. At any given point in time and in every
producing unit, if there is no additional investment,
output will decline toward zero by some roughly
constant proportion until the well is shut down.
More specifically, the annual decline rate is
approximately 10% of production in the United States.
At this rate, output drops by half every seven years;
crude oil production in the United States peaked at
around 9 million bbl/d in 1972. With zero investment,
it would now represent less than 300,000 bbl/d and has
actually decreased to approximately 5.8 million bbl/d.
Thus, approximately 95% of current United States
crude oil output is from investment since 1972. In the
Middle East, decline is only around 4%. Moreover,
Saudi Arabia peaked near 10 million bbl/d in 1980,
which is about the same as current output. Hence,
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
2.2
about 64% of that current output is from investment
since 1980. The rule of thumb in Venezuela has long
been a little over 20%. In Iran, during mid-2005, there
is a secondary report of 8% decline onshore and 13%
offshore. Whatever the rate, the industry constantly
keeps investing and installing new capacity, even to
produce the same amount. It exists because it invests.
With no investment, it would soon cease to exist.
2.2.1 Introduction
The meaning of ‘capacity’
Recalling the constant decline and replacement,
obviously capacity is not some sort of stone-wall
boundary which no producer can go past. In the
short-run, capacity can be slightly increased, but only at
a higher price in order to cover the higher marginal cost,
with less down time at existing facilities, and with
increasingly costly facilities that are brought on-line.
Some relatively high-cost wells (which one can call the
‘nor or never’ wells) may be brought into production,
particularly with operators’ fear that prices will soon fall.
However, even with such exceptions, a given increase
becomes increasingly costly. That is, the supply curve
becomes more and more steep until it becomes vertical.
As always, allowing for the passage of time
complicates the picture. Capacity is everywhere a
‘moving target’ driven by profit. Static or even
declining capacity never signals the ‘running out of
oil’. In a competitive industry, it means fewer places to
drill in order to add capacity profitably at the current
price. If such places become persistently fewer, then
the annual capacity additions decline, and, ultimately,
1 This paper is based on Adelman (1995) and other
works cited.
75
BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY
total capacity. Before 1900, output had declined in
several states within the USA; before 2000, it
happened in most of the country.
Oil production is ‘stable at capacity’, meaning
continuous stirring at all frontiers. Rigs must be hired
(or built) in advance, labour hired and trained, and so
on. Chance plays a role, and so do mistakes. Hence,
transitory excess capacity is to be expected from time
to time in any given place. However, excess capacity
persisting year after year is a burden, requiring some
explanation as to why capacity is being deliberately
held off the market. Like any restraint, it is a symptom
of monopoly (i.e. competition dominated by a single
individual or group).
A cooperating group prevents capacity growth
even when the value of the new production far exceeds
the cost of investing in expansion. If greater group
output will lower the market price, then there is no
profit but rather a loss in expanding capacity, no
matter how cheaply it can be done. In the United
States, the system of ‘market demand pro-rationing’
that prevailed during the years 1934 to 1970
represented a monopoly of a few states, especially
Texas. Therefore, estimates of excess capacity, and of
changes therein, were calculated and published. They
have long since ceased to appear because excess
capacity has vanished.
The importance of this lack of excess capacity is
emphasized by recent history. Capacity to produce
Arabian Heavy and other similar crude oils was not
counted as capacity in the years 2004 and 2005
because these crude oils were supplied but not
demanded. Capacity to produce heavy crude oil was
not in excess. Officially, it did not exist. However, this
omission ignores the price dimension. The heavy oils
were offered, but only at a relatively small discount
which was too small to attract buyers. This condition
changed in November 2004 when heavy crude oils
were priced at a much larger discount, which indeed
moved them to refineries.
The world’s output limited by monopoly
The monopoly constraint, and its symptom of
tremendous excess capacity, has operated in the world
market for many years. During the year 2004¸ OPEC
(Organization of Petroleum Exporting Countries)
member nations sold less on the world market than in
1974. Although they produced approximately the same
amount of 29 million bbl/d , the quantity consumed at
home increased from 1.7 million bbl/d to 7.4 million
bbl/d in 2004. The fraction for domestic use had no
connection with the world market or with price. Over
the same thirty years, non-OPEC sales nearly doubled.
Lower OPEC sales out of the lowest-cost area
during a period of industry growth only make sense if
76
the OPEC nations acted as a monopoly. If each
individually preferred to keep its greatest resource
underground, each could act alone with no need of
group action. Their actions would depend on their
individual discount rates on future gains.
Incidentally, it is important to note that these
internal discount rates must be higher than the rates for
private holders; their national wealth, most of it in oil,
is undiversified. Each OPEC nation faces uninsurable
dangers of internal and foreign violence, much greater
than private holders. Hence, if they acted individually,
they would speed-up output, not slow it down.
The relatively large price increase since 1973 has
not been smooth, nor could it be. At each price
increase, the group has had to estimate how consumers
will react, and how soon. Since 1999, they have
repeatedly been forced to assess the market. Their
announced price objectives rose from $18-$21,
$23-$25, over $30, and so on. However, it is their
actions that are most important. Specifically, OPEC
members have repeatedly cut output or quotas (except
for the latter part of 2004), only to resume them at the
end of the year; outside that time interval, their
judgment was that oil was too plentiful. They had to
reduce their output, either by reducing quotas or by
less formal means. For example, as in the case of
China, explaining the current price level by strong
demand is unsound, notwithstanding the accuracy of
the Chinese statistics; the group decision already had
taken China into account.
At any given point in time, nations like Saudi Arabia
or Kuwait could have announced investment for higher
capacity and sold the higher output forward (i.e. for
delivery as the new capacity was installed). This higher
output would have lowered the price level immediately,
but unequally. Since price is a backward continuum, this
action would have lowered even the current price.
However, such individual output-raising action taken by
any large OPEC producer would mean individual, as
opposed to group, decision-making, and thereby
represent the end of the cartel. One cannot reproach
collective monopolists for acting like a monopoly.
Inventory, the century old pattern
and the recent policy
The industry’s seasonal inventory movement is
century old. Stocks of products (and to a lesser extent
crude) decline every spring, between the winter fuel oil
consumption peak and the summer driving
consumption peak. To hold stocks, especially product
stocks, provides for the consumption peaks more
cheaply than building a stock of refining capacity, first
of heavy-products then light-products. However, OPEC
managers had to keep the price in clear view, and knew
that “a little more than a little is much too much”.
ENCYCLOPAEDIA OF HYDROCARBONS
 BASIC CONDITIONS FOR CRUDE OIL PRODUCTION AND COST FUNCTIONS IN THE SHORT AND LONG RUN
The collapse of 1985 told OPEC members that
small excess inventories in the second quarter led to a
small price reduction, which got out of control.
Ultimately, the small excess inventories pulled the
price far down because only group understanding
could keep it up. The fear has become almost an
obsession during the great price surge beginning in
March of 1999. In December 2004, having appeared to
tolerate zero excess capacity for one whole year, their
nerve apparently failed them, and they decided on
another cut in quotas for the spring quarter. However,
the anticipation promptly sent prices up again, and this
time the rise was an unwelcome one. It is even
possible that it threatened economic recovery,
particularly in Europe. The story breaks away during
mid-2005, with no attempt to predict the outcome.
However, the concept is crystal clear: the market
constraint is not set by demand or supply, but by group
policy.
‘They should invest more’
Some have urged (or even pleaded) that both the
private companies and the OPEC nations should invest
more. Such pleas are routinely ignored. After all,
investors seek to preserve and increase profit;
however, the rules are different for competitors versus
cooperators. In any given project, fresh investment
stops when the competitive operator reckons that
additional investment will cost more than the market
value of the additional oil to be obtained. However, the
value of the oil is different under competition versus
monopoly. The competitive operator is beckoned
forward by the price because what an operator will add
to supply is not sufficient to affect the price. In other
words, the competitive operator is held back from
more investment by rising cost, in both the short and
long run.
2.2.2 Oil and gas supply:
an industry of rising costs
This concept does not mean that costs have been or
will be rising over time, that is a separate matter on
which nothing will be said. At any given point in time
within the competitive sector, and subject to
knowledge at that moment, more output can be
attained only at higher cost.
A competitor invests until the cost rises to equal
the price. However, members of a monopoly group
will refrain from additional investment even when its
cost represents only a small fraction of the current
price of oil because more production by the entire
group would degrade that value in a potentially
significant way. In short, the group must keep in view,
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
not the price of the new oil, but its marginal revenue.
More oil sold at a lower price likely implies negative
marginal revenue. Alternatively, in terms of very
simple visuals, the competitive industry supply is
forward-rising such that the higher the price, the more
supply it brings forth; in contrast, the monopolized
industry supply becomes backward-bending such that
a rising price reduces demand, thereby lowering
output.
Confusion about marginal cost
Raising output to the point where price equals
marginal cost does not represent a deficit in the
competitive sector. In an industry of rising cost,
marginal cost always exceeds average cost, except for
chance-fluctuations. The typical mistake is to take
marginal cost as a part of total cost; instead, marginal
cost is the change in total cost, produced by greater or
lesser output.
Sunk costs, where they actually exist, indicate a
mistake, namely an investment expected to be
profitable that turns out not to be. Even then, the loss
is not total, and need not be crippling, because the
operator has the alternative to postpone any production
until a more suitable time.
Summary calculation of cost per barrel
Let K represent the needed investment expenditure,
and Q the additional capacity that it brings. The
fraction K/Q, investment per unit of increased output,
varies from country to country. It is an average, and
describes ‘high cost’ and ‘low cost’ countries,
neglecting the variation within countries. If possible,
we can also divide up the investment by its purposes,
and write the fraction more precisely as:
[1] Cost = (K/Q) (i ⫹a ⫹c)
The new investment outlay K is divided by the
new output Q and the fraction is partitioned into the
purposes of the outlay over the lifetime of the new
development project. All the letters within
parentheses are in percent per annum. The factor i
denotes the rate of return on development
investment (net of discovery, to be treated soon). The
factor a denotes the reservoir decline rate of the new
oil. The operating or current cost is c. This is current
variable cost, but it is a function of investment. The
initial value of c follows a conventional assumption
as 5% of the investment. However, this value is
subject over time to a strong upward force and a
weaker downward force. As production declines, the
per unit cost increases (e.g. United States variable
costs roughly double every seven years). The rising
cost is also discounted, albeit at a much lower rate
than the development rate i.
77
BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY
Since there is relatively little risk around the rate
that must be paid to insure current expenses, the
effect of discounting is less.
We will write down three conventional values and
let the reader substitute his/her own. The development
rate of return i is 12%, the decline rate a is assumed
10% (too high outside the United States), and an
adjusted operating cost c of 8%. This last rate is much
higher, of course, than the initial rate of 5%. It reflects
both the decline rate and the secondary discount rate.
For every thousand dollars per daily barrel of
capacity, the incremental cost per barrel is
approximately 82 cents. If, for example, the
investment is $25,000 bbl/d, and (a⫹i⫹c)⫽0.30, then
the annual revenue needed to pay a minimal acceptable
return of 30% is $7,500. Dividing this amount by 365
gives us the cost per barrel of $20.55.
Discovery as an economic activity
In theory, an individual company might invest in
development and not attempt to discover any new oil.
In fact, nearly all oil companies conduct both
exploration (i.e. research) and development. The
boundaries between them are not clear for three
reasons. First, some of the information used for
discovery of new oil is drawn from developing old oil.
Second, an oil company must continuously look at
prospects in both discovery and development, and rank
them to decide which is worth investment. Third, the
process of appraisal is on the borderline because it
attempts to know the result of an exploration
investment just made, or whether a discovery is worth
following up for the sake of the profits on its
development.
As operators drill around or into an existing
deposit, they will learn by trial-and-error more about
local geology. The fact that twice as much is left in the
ground as is produced tells us immediately that there
is an elastic-changing boundary between produced and
unproduced oil. It pays to know more about the
boundary. However, knowledge costs money.
Therefore, even development specialists to some
extent must be in the exploration business in order to
get the most out of their specialty. The industry is a
vast network of search for discovery and development
investment, with the profit of each one the opportunity
cost of the others. Exploration and development are a
collection of construction projects rarely completed on
time and within budget.
Some governments allow for relatively free
exploration and then sell, or otherwise allocate, the
development rights. An oil seeker may have many
ideas about where the good fields are. The oil seeker
may feel that the few good ideas not only offset the
bad, but actually provide, on balance, a higher rate on
78
any discovery investment. Development is not a sure
thing. If it were, the lack of risk would provide only a
risk-free rate of return. Many development wells are
dry holes. However, the threshold rate of return on
exploration is higher than on development, even under
the most restricted definition of development, given
there is greater variability in exploration results.
In our assumed scheme above, we will allow not
12%, but a possibly excessive 18% net return, on the
mixed investment of discovery-development.
Operating expenses are unchanged, as is the allowance
for the natural decline of any developed production.
The total return on the mixed discovery ⫹
development ⫹ production is now 36%: $24.66 per
barrel incremental cost, or 98 cents for each thousand
dollars of capital expenditures per daily barrel. Thus,
we assume exploration-cum-development should
require approximately 10% more than development
taken alone. This amount is an average number;
discovery alone would take a much higher rate of
return to be viable.
Of course, this scheme assumes that exploration
rights include development rights, so that the operator
can imagine exploration and development taken
together. However, the risk differential creates an
incentive for the landlord to breach or re-interpret a
contract. In the 1970s, Iraq granted exploration rights
to a French, a Brazilian, and a Russian oil company.
Subsequently, each of the three companies discovered
a new field. The government of Saddam Hussein took
each away from the finder and gave it to its national
company for development. This action was
remembered when Iraq sought international capital in
1990 and it obtained none. Thwarted, Saddam Hussein
changed from the role of acclaimed ‘enforcer’ of
OPEC quotas to the role of robber. Ultimately, he
invaded Kuwait.
An example of an honest disagreement was the
2002-03 negotiations between Saudi Arabia and
various international companies. The companies
sought rates of return that made some allowance for
exploration-development risk. The Saudi government
was disinclined to grant such returns where it would
not allow any discovery-development. The parties
were being consistent, and they agreed to disagree on
the scope of the new investment and, therefore, on its
terms.
Fictions about ‘finding costs’
Exploration has spawned two fictions about oil
operations: sunk costs, and ultra-long times between
discovery and profitability. Sunk costs per barrel in
exploration do not exist because there are no
oil-finding costs per barrel. A cost per barrel has a
numerator and a denominator. It exists when there is a
ENCYCLOPAEDIA OF HYDROCARBONS
 BASIC CONDITIONS FOR CRUDE OIL PRODUCTION AND COST FUNCTIONS IN THE SHORT AND LONG RUN
causal relationship between the numerator (i.e. money
spent) and the denominator (i.e. new oil producing
capacity or ‘reserves’ to be discussed later). There is
no way to match an increment of new capacity with a
corresponding expenditure for a given time period in
any area, let alone in a narrowly defined time or place.
In any terrain, good or bad, there is no cost of finding
a barrel of oil there. There is only a probability on
which the operator may or may not risk any
investment.
Exploration investment per unit is not a sunk cost
because it is not a kind of unit cost. Exploration
investment is the purchase of options to develop, most
of which are bound to be worthless. Success or failure
in buying a particular bundle of options depends on
how profitable the resulting development investments
are.2 There is no exploration cost per barrel, and
certainly life in oil would be much simpler if the
opposite were true.
2.2.3 Exploration
as permanent source of
company/government discord
The probabilistic nature of exploration will always be
the most intractable issue between a nation-host and an
oil company, especially a foreign one. In prospect¸
before drilling, the exploring company only offers the
average value of what they expect to realize on a
whole group of prospects. If they find nothing, the
money is lost and that is the end of it. If what they find
is considered of about average value, it will be
developed. However, contention arises if the explorer
finds something worth more than the originally agreed
upon average value. A rich discovery means a
discontented landlord. The host government feels
cheated or aggrieved¸ and thinks of how much more
the operator can now afford to give. Moreover, the
government and the company will probably disagree
on the estimations of prospective profits.
The importance of taxes is not a one-time issue.
On the contrary, the government can, in practice if not
in theory, change the tax rules even when previously
agreed upon. Higher prices will bring pressure to
increase taxes. A change in tax rates is the most
straightforward. A government determined to get more
money can do so because it has the local physical
force.
Therefore, a higher market price will not
immediately increase oil production investment, and
may even decrease it. The price increases after 1973
are sometimes said not to have affected investment for
some time, until the discoveries in Alaska, the North
Sea and Mexico. In fact, investment in these areas had
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
already been committed to development before 1973.
Delay in oil investment caused by unfavourable tax
expectations may also be the reason why the price
increases after 1999 have not stimulated any great
wave of investment which could be detectable from the
statistical record, such as it is.
Although this author does not agree with the
following, some hypothesize that oil companies are
timid and stupid. However, there is no foundation for
the belief that the oil market is somehow imperfect,
because it is untrue that there is a lack of forward
pricing. The sales of crude oil reserves are a forward
sale of crude oil, and the trade press demonstrates that
in-ground reserves have been routinely sold for at least
half a century.
Finding-developing investment:
the great unknown since 1985
Until about 1985, the fraction K/Q could be
calculated for nearly all of producing countries. The
numerator included both exploration and
development outlays, and therefore overstated total
development investment per unit. The sub-divisions
(the factors inside parentheses of equation [1]) were
sometimes available, though usually not. However,
known K/Q permitted comparison of one country’s
average cost compared with another. Adjusted for
inflation, the numbers may still be correct for all we
know.3 In reality, we do not know, because the basic
data, new oil investment per country (K) and
capacity per country (Q), are no longer in the public
domain. Indeed, information on most of the world’s
production has either deteriorated or disappeared
entirely; for example, Middle East field-by-field
2 I once believed that the more independence among
options the better because of its reducing the variability of
the portfolio and raising the average. This is not so. Smith
and Thompson (2005) recently showed that the present value
may be increased by the interdependence; the operator can
more quickly drop a bad prospect.
3 Cost in Iraq is about $3 per barrel. The Interim
Planning Minister of the government of Iraq “has prepared a
medium-term plan to increase oil production to 3.5 million
bbl/d by the end of 2007. Estimated expenditures to
maintain and increase production are in the range of $4
billion” («The Wall Street Journal», 2004). Over a three year
period, we assume a decline rate of 4%, doubtless too low
due to the destruction in the three wars and 13 years of
sanctions. We set to zero this continuing loss of capacity.
Then the normal loss over three years is 0.3 million bbl/d ,
and the starting point is 2.2 million bbl/d. The net increment
is from 2.2 to 3.5 million bbl/d, or 1.3 million bbl/d. If this
costs $4 billion, the investment is $3,077 per additional daily
barrel of productive capacity. If we treat the investment as
part of a big discovery-development effort, and assign it a
15% net return, the gross return is 33%, and the combined
total is ($3,100⫻0.33)/365⫽$2.80 per barrel.
79
BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY
production data have ceased to exist, as have those
of other areas.
Natural gas as ‘oil equivalent’
Making matters worse is the growing importance
of natural gas. Gas is often stated as ‘barrels of oil
equivalent’, usually converted at 5,500 to 6,000
cubic feet per barrel. However, there is no such thing
as ‘oil equivalent’. It may make sense to reckon
‘barrels of oil equivalent’ at a given burner tip at a
given time, but our objective is the relation between
wellhead values. From wellhead to combustion lies a
pipeline or tanker trip several times as expensive per
heat unit of gas as it is for oil. The cost penalty is
different for every distance, and therefore at every
wellhead. It changes over time and there is no
escape from the need to measure oil and gas output
separately. Gas was once a minor contaminant of
price and capacity data; today, it is a major
destroyer, unless it is separately known.
In order to measure oil and gas reserves before one
decides whether to invest, one must consider what will
be forthcoming to make the investment worthwhile or
not. Therefore, reserves must be calculated before any
investment decision can be made. Petroleum
engineering texts explain what kinds of data are
needed, and how they are used to predict a declining
stream of oil and/or gas. The reserves are simply the
cumulative of total estimated future production. Of
course, the estimated future production depends on the
time, which must be calculated in advance, when
production is no longer worthwhile and must cease. In
the simplest case, output declines at some constant
percentage a, so that Qt⫽aQt⫺1. Then R is the
cumulated Q, that is: R=∫ T0 Qt dt. The limiting values
are R⫽Q/a so a⫽Q/R. In applied work, we reduce R
to allow for a finite end to the stream of annual output.
In words, reserves are the sum total of all oil that is to
be produced and paid for by the new investment. The
decision to invest is the decision to create new ‘proved
reserves’.
The concept that proved reserves are the sum total
of all oil to be produced by past investment is
mandatory in the United States. We often read that this
requirement is a quaint relic ordered by the Securities
and Exchange Commission since 1978. In fact, proved
reserves in oil go back to the year 1918 and to 1946 in
gas. Between those dates and 1980, reserves were
calculated in the United States by local industry
committees, and summed up by the American
Petroleum Institute or American Gas Association in
order to obtain State and national totals. This practice
guaranteed continuing peer review of the local
amounts. The committee members swore not to reveal
the details of their reckoning to anyone, not even to
80
their own companies. There is no record of any
violation of oaths.
This ratio, Q/R, and the observed decline rate are
fairly stable in North America. They vary between 1
and 2% either way in any given year, according to
anecdotal data in other regions (excluding the Middle
East). This stability is not an accident and the decline
rate is an integral part of the maximizing process.
Output from any reservoir could be stretched out to
doomsday from a very small development investment,
and the decline rate brought nearly to zero; but a larger
investment and higher decline would greatly improve
the rate of return. However, the improvement
dissipates rapidly as one speeds-up. Somewhere in the
interval is a maximum rate of return. There is a
complex interaction between investment and cost. Few
North American fields produce more than 20% of
their reserves in a given year (see below).
This introduces not an error, but a range of
uncertainty. In any given oil company, or for a group
of them, proved reserves (R) sum up what will be
produced from apparatus currently in place and paid
for by cash or debt. There is also some production to
come out of the apparatus planned, but it is not yet in
place and not yet paid for. The value of this
production-to-be approaches a maximum (i.e. the
value of an option on it). That is, in the short run, the
value (i.e. price) of additional output is known with
relatively fair accuracy, and the investment needed is a
little better known. The value of this un-produced oil
in the ground is the value of expected output minus the
investment needed to produce it. Imagine now
additional future output with less known about it, both
as to its price and as to the investment needed to
produce it. Thus, proved reserves have been enlarged
into the concept of ‘probable reserves’ (i.e. reserves
yet to be proved).
An early important example was in 1944 when
DeGolyer & MacNaughton (D&M), a geographically
based petroleum consulting firm, estimated Middle
East reserves at 16 billion barrels, proving 5 billion
probable. Thirty years later, in 1975, those same fields
(i.e. Middle East fields discovered before 1944) had
already produced 45 billion barrels, and were credited
with proved reserves of 75 billion (these numbers were
once publicly available, though no longer). No one has
derided those estimates, nor should they. The D&M
engineers estimated proved reserves and probable
reserves from what was known at the time. As
knowledge increased, the estimates of reserves
inflated.
Whatever the uses of probable reserves, the only
published estimate for the world is by the United
States Geological Survey. However, all such estimates
require a process in time. Therefore, they are
ENCYCLOPAEDIA OF HYDROCARBONS
 BASIC CONDITIONS FOR CRUDE OIL PRODUCTION AND COST FUNCTIONS IN THE SHORT AND LONG RUN
comparable not with production and capacity as it is
known or estimated now, but as it will be when current
knowledge is better applied and there is also future
growth of knowledge to supplement it.
The flow of oil and gas development investment
builds up a known stock of proved reserves plus a set
of options. Some of these options are already marked
for early development into reserves. Their market
value is the discounted present value of this expected
output less the investment needed to develop it. From
this point, the options range from those reservoirs
already designated and soon to be developed into
proved reserves, down a range of doubtful ones,
ending with those many bad bets not followed up.
These are all processes in time.
Oil/gas production is a process of growing
knowledge. Some of this growing knowledge is a slow
co-product with development-production experience,
and some is the infiltration of new ideas into oil and
gas production. The history of offshore
exploration-development offers many examples of
both. In 1950, development offshore was zero. By
1975, wells had reached an asymptotic water depth of
approximately 1,000 feet. The barrier was fixed by the
steel requirements of offshore platforms, which
increased as the square of the water depth. By 2000,
wells were being drilled to 10,000 feet. The steel
barrier had not been wished away, but avoided, by
direct placement of wells on the sea floor.
Concluding the discussion of proved reserves and
probable reserves, we can turn our attention to
‘ultimate reserves’. The concept of ultimate reserves is
the amount of oil in the ground that cannot be
increased because it is fixed by nature. Ultimate
reserves constantly shrink by production. The estimate
of ultimate reserves is a forecast of all oil ever to be
produced and consumed. To know ultimate reserves,
one needs to know all future science, all future
technology, and that common store of know-how
which does not rise to the dignity of either. One needs
not only to know everything about oil and gas
production, but also everything about their
consumption, this knowledge governs the amount to
be demanded and produced. Since these will never be
known, ultimate reserves will forever remain
unknown.
The idea is simple but somehow hard to grasp. It is
not a matter of saying that “there’s more [or less] oil
around than you think, whatever you think”. The
arguments for a stingy or a bountiful nature are
equally useless because they are not based on any
existing evidence and, by definition, cannot be. There
are not, and cannot be, any figure of ultimate reserves.
Estimates may fool the estimator, or at least comfort
the estimator in his/her ignorance. Estimates of peak
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
output are feasible only if the estimator knows
everything. If a person knew the total in the ground
now, the structure of costs, and prices to generate what
will some day be produced, then that individual might
partition it between the known past and the supposed
future. An illusory knowledge of the future is a
comfort to those that do not know the past. So too is
the refinement of computer graphics to calculate the
year of disappearance of ultimate reserves.
The ‘old paradigm’
Since minerals were first extracted, policy has been
ruled by fear, or what we call the old paradigm. Since
the earth’s crust is fixed, the total amount of mineral in
it is also set. Since “they’re no longer making any
more of this stuff, it is bound to get more scarce and
valuable over time”.
This fact has long been taken for granted.
Somehow, though, it has not worked. For example, the
1972 Limits to Growth predicted that copper would be
completely depleted by the year 2000. Looking at the
market one would never suspect it, but this paradigm
should have boosted the prices of minerals of all kinds.
However, the most recent roundup fails to show any
pervasive pattern in mineral prices.4 They should have
been heading up over the long-run, but most have
headed down. To be sure, there is one deficiency about
these price data. Price movements of minerals are
determined not only by the depletion of minerals but
also by extraction cost (i.e. cost of current inputs of all
other factors). Some of these extraction costs have
been governed by the general improvements in
productivity, and would tend to pull down the total
mineral’s cost and price. Yet, should this hold of all of
them? Considering the independence of various
minerals’ prices, this record must be explained, but it
has not been.
One general solution exists. The notion of a finite
amount of a given mineral held by the total of
producers was adopted into economics by Harold
Hotelling. He proved that with an ‘exhaustible
resource’, the unit value of the in-ground mineral
stock had to rise at the rate of discount on all other
assets devoted to production of the mineral. Therefore,
the later higher values would be discounted down to
the present at the same rate as the rate by which prices
were rising.5 Arbitrage would assure that the present
4 Tilton (2003). See especially the appendix by Peter
Howie.
5 Dasgupta and Heal (1979), p. 156. In this work,
equation 6.5 states that the wellhead price rises at the rate of
interest: “It would not be an exaggeration to regard [it] as
the fundamental principle of exhaustible resources”. They
call it the Hotelling Principle.
81
BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY
discounted value of all units of the stock, above and
below ground, should be equal. A unit still held in the
ground should have a value equal to the value of a unit
available for immediate sale. This concept is known as
the Hotelling Valuation Principle and represents the
essence of the theory.
This was a novel and important result, for it led
to a testable hypothesis. In the United States, many
reserve packages are sold in any given year.
Interested petroleum engineers and investors created
an active, well-informed market. A long-established
and repeatedly verified rule had been (and still is)
that the value of a barrel in-ground is 1/3 of the spot
price (Bradley and Gipson, 1987). This value should
be increased to half the spot price by including in
the price the portion of sales value paid to royalty
owners and others. However, even with this
adjustment, the observed average reserve value for
any year was only about half the spot price (i.e. half
of predicted). Furthermore, the value of a barrel in-
ground should have no relation to the rate at which it
was extracted, for the same basic reason: the lower
value of a flow of receipts by discounting would be
exactly offset by the gains of automatic appreciation
in the value of the in-ground assets. This was an
additional independent disproof because if it was
correct, then earlier extraction had a greater value
than later extraction. This contradicted the principle
that the time of extraction was invariant to the value
of a barrel.
Campbell G. Watkins demonstrated this one-half
rule held for Canadian sales of reserves. Later he and
Morris A. Adelman demonstrated that it held also for
United States reserves. Continuously from 1946 to
1986, the spot price did not fall below the average
reserve value plus one standard deviation of reserve
values. In nearly every year, the spot price exceeded
the average reserve value by two standard deviations.6
From 1982 to 2003, a period during which the data
on reserve values were estimated by linear regression
(and were much more reliable), the spot price in every
year did not fail to exceed the reserve price plus at
least one standard error. In fact, in nearly every year, it
exceeded the reserve price plus two standard errors. Of
course, this relation adjusts every year for the
fluctuations of the spot price.
Therefore, the Hotelling theory was not refuted or
discredited. On the contrary, the theory is internally
consistent, which is all that can be expected of any
theory. The Hotelling theory created the test for the
assumption that the industry treats reserves as a stock
decreasing in amount and increasing in unit value.
Because the theory is sound, it can be, and has been,
used to test this assumption, which has always failed to
hold.
82
2.2.4 Conclusions
The inherent characteristics of oil production
The peculiar characteristics of oil and gas
production do not generate any cycle of over- and
under-production. Of course, erroneous expectations
of the amount demanded could create excess capacity.
This event can happen sometimes in a commodity sold
in open markets where output adapts to any price
changes and where the price equates short-run supply
and demand. In such a market, the higher-cost
capacity is idle at first, especially when its output need
not be lost for good. From what we have seen and tried
to explain, the exact opposite is true; high cost
capacity continuously expands over decades, while
low-cost capacity sporadically contracts and is more or
less, even over a relatively long period of time.
Excess capacity was important in the monopolized
United States industry. However, it disappeared after
1970 when large scale US imports were finally freed
of regulation. Since then, excess capacity has been
unknown in the world industry, except among OPEC
producers. It, therefore, constitutes an additional
independent proof of OPEC monopoly behaviour.
The non-OPEC portion, which today is nearly
2/3 of total world oil sales, has never reported any
excess capacity, nor is any expected. As always, only
the monopolized portion is characterized by excess.
The industry is like a prisoner of past investment,
unable to adjust to excess capacity without a long
period of working it off. That could, of course,
happen by chance. However, a reservoir decline rate
of around 7% (over and above any depreciation in
the apparatus) makes that highly unlikely; the
decline rate is not that high by chance. Rather, it is a
rational response to basic physical laws. All else
being equal, to invest more for a higher decline rate
and a quicker return is best in order to make the
producing more worthwhile. Moreover, this response
also makes production more expensive. One cannot
continue very far up the production-reserves curve
before reaching the point of maximum net return,
which sets the observed decline rate.
The role of the State
As a fighting faith, Socialism had long been dying
before it was officially buried in 1990. Yet most of the
world’s oil is still produced by national companies,
largely but not entirely, in OPEC countries. There are
some basic reasons, none of which will soon
disappear:
6 (Adelman and Watkins, 2003). See also the addendum
including results for 2003.
ENCYCLOPAEDIA OF HYDROCARBONS
 BASIC CONDITIONS FOR CRUDE OIL PRODUCTION AND COST FUNCTIONS IN THE SHORT AND LONG RUN
• Private enterprise in oil within a producing country
would be difficult to reconcile with its one voice
within OPEC. More specifically, private oil
companies will likely favour cutting national
output to raise prices, but they would present many
strong reasons to have the burden borne by other
such companies.
• There is powerful sentiment that the sub-soil
wealth must be developed by its owner, namely the
ruling government. The notion that the owner is
mediocre at development and poor at discovery is
relatively unimportant, especially when costs are
so low. After all, average well output is high,
decline rates are low, and old fields persist for
decades, as in the Middle East.
• One cannot forget that there are payoffs, kickbacks
and jobs. There is also strategy, which is the belief
that access or equity ownership of oil acreage or
reserves conveys some advantage on the owners or
their nation. In the 1970s, the governments of
France and Japan made large investments for
reasons of strategy. Fifty years later, the leading
strategists are China and India. They will achieve
as much.
• Over time, oil income has become more important
to these societies, not less. Oil production
represents less than half of GDP, but this use of
national income statistics assumes that the
industries which serve the oil industry¸ as well as
the recipients of net oil income, are in fact
independent of oil income. They are counted
separately from oil, but cannot exist without it. The
First Gulf War performed a crude experiment using
Iraq as the guinea pig. The year 1990 was a
relatively normal oil-export year; in contrast, there
were no exports in 1991. Iraq GDP fell by 86%, a
rough, but valid, measure of oil’s importance to the
OPEC nations.
• There is the remarkable rise in population in
Middle East countries. This rise is sometimes
interpreted as increasing the ‘need’ for oil funds,
but this interpretation also confuses an application
of income with the ability of the income receiver to
obtain that income. The more valuable the oil, the
more it is worth fighting for among regions of a
country.
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
Basic conditions for oil and gas production
We have explored the relation between the basic
physical conditions of oil and gas production and their
behaviour in the market. The industry is bound by
these conditions because they are necessary, but not
sufficient, to determine its economic workings. There
is nothing about these physical conditions that is
inconsistent with an industry relying on the ordinary
rules of competitive behaviour, either in the short- or
the long-run.
As for the 21° century, ignorance about basic costs is
constantly increasing, along with increasing confidence
in what is not known, or sometimes cannot be known,
such as ‘ultimate reserves’. The volatility of oil prices,
especially the two great upward surges, starting 1973
and 1999, cannot be explained by basic conditions, nor
can we say whether or not the current level of oil prices
will continue into the long-run. This level can only be
explained by the OPEC nations forming an effective
monopoly. However, there is nothing about the basic
conditions which proves that this state of affairs will or
will not continue throughout time.
References
Adelman M.A. (1995) The genie out of the bottle. World oil
since 1970, Cambridge (MA)-London, MIT Press.
Adelman M.A., Watkins C.G. (2003) Oil and natural gas
reserve prices 1982-2002: implications for depletion and
investment cost, MIT-CEEPR Paper 03-016 WP.
Bradley H.B. (editor in chief) (1987) Petroleum engineering
handbook, Richardson (TX), Society of Petroleum Engineers.
Dasgupta P.S., Heal G.M. (1979) Economic theory and
exhaustible resources, Cambridge, Cambridge University
Press.
Smith J.L., Thompson R. (2005) Diversification and the value
of exploration portfolios, MIT-CEEPR Paper 05-007 WP.
«The Wall Street Journal» (2004), 11 December.
Tilton J.E. (2003) On borrowed time? Assessing the threat of
mineral depletion, Washington (D.C.), Resources for the
Future.
Morris A. Adelman
Department of Economics
Massachusetts Institute of Technology
Cambridge, Massachusetts, USA
83
 2.3

Analysis of cost structure

and functions in oil transport
and refining

2.3.1. Oil transport Oil-producing regions are in most cases a

long way from the industrialized countries,
The various methods of transport which are the biggest consumers of oil.
It is enough just to glance at a map In 2003, nearly 2.3 billion tonnes of crude oil
showing the locations of the world’s and refined products were transported over great
oil-producing and oil-consuming regions to distances. Crude oil accounted for 78%
appreciate that massive quantities of of this tonnage. And this enormous
oil have to be transported over enormous volume is constantly increasing (⫹19% since
distances (Fig. 1). 1996, ⫹7% since 2000) as world oil
consumption rises. In short, some half of all the

465
840 425
755
320 170
215 810
485 935 985 EUROPE 210
40 80 FORMER USSR
UNITED STATES - CANADA
730
60
10
OTHER ASIA
30 MIDDLE 170 280
25 90 260 OCEANIA
200
50 110 EAST
20 150 120
75 20 CHINA 200
375 165 1015 330
10 75 15 30 10
10 100 210 30
35 120
130
AFRICA 560
120 220
60 155
400 295 10 35
515

LATIN AMERICA 50

15
15
30
185
data in million tons

production refining crude and

consumption
2002 crude and capacity (as of petroleum
2002
LNG 1 January, 2003) product flow

Fig. 1. Petroleum worldwide in 2002.

VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION 85

BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY

Table 1. Oil imports and exports

(Oil trade 2002 in million tonnes)

To Rest
Latin Other
USA Canada Europe Africa China Japan of the Total
America Asia
From World

USA – 4,9 15,9 10,7 0,5 1,1 4,0 5,2 1,0 43,3

Canada 95,5 – 0,2 0,5 – – 0,2 0,1 0,2 96,7

Latin America 195,4 6,4 8,4 23,2 0,6 0,9 0,9 7,6 4,7 248,1

Western Europe 57,0 24,6 3,5 – 10,0 3,6 0,7 5,4 2,3 107,1

CIS 9,8 – 7,4 214,6 0,5 8,1 1,2 10,4 2,5 254,5

Middle East 114,7 6,9 14,5 161,1 36,9 38,9 195,4 324,1 3,2 895,7

North Africa 13,6 5,1 6,2 87,3 4,0 0,3 3,6 5,7 – 125,8

West. Africa 55,5 1,0 9,9 35,2 2,7 9,5 3,8 38,3 – 155,9

Other Africa – – – – – 6,4 1,5 0,8 – 8,7

Australasia 2,9 – – – – 1,6 4,4 11,6 0,3 20,8

China 1,3 – 0,5 0,3 – – 4,1 10,3 – 16,5

Japan 0,3 – – 0,1 – 1,6 – 2,2 0,6 4,8

Other Asia Pacific 8,3 0,1 – 4,5 0,3 28,4 28,3 32,0 – 101,9

Unidentified 6,7 2,5 – 49,9 – – 2,4 1,3 – 61,8

Total 561,0 50,5 66,5 587,4 55,5 100,4 250,5 455,0 14,8 2151,6*
* 10 million tonnes non unidentified.

crude oil produced in the world is transported a Oil is a liquid pollutant and its vapours are
very long way (Table 1). combustible, so it presents certain transport
An examination of maritime transport of problems. Sea transport of oil requires special
hydrocarbons as a proportion of total world ships. Oil pipelines can eliminate the need for sea
maritime trade reveals that oil represents a transport, but the amount of investment they
significant, though decreasing, share of all trade. require and the permanence of their installation
Oil currently accounts for 30% of total mean that they are only justifiable for large,
tonne/miles covered (Fig. 2). long-term volumes.

Fig. 2. World marine 24,000

trade. 22,000
20,000 all goods
18,000
16,000
Gt/miles

14,000
12,000
10,000 crude oil
8,000
6,000
4,000 petroleum products
2,000
0
1968

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

year

86 ENCYCLOPAEDIA OF HYDROCARBONS
 ANALYSIS OF COST STRUCTURE AND FUNCTIONS IN OIL TRANSPORT AND REFINING
Each form of transport (tanker and pipeline)
has its own advantages and drawbacks. Safety and
the environment are of increasing importance
nowadays and are among the principal criteria by
which such pros and cons are measured. Pipeline
transport is clearly safer, even though pipelines
can rupture or be sabotaged. Much progress has
been made in sea-transport safety in recent years;
despite such progress, however, the fact remains
that it takes only one tanker accident and the
resulting pollution to give an extremely negative
image of the sea transport of hydrocarbons.
Fortunately, such accidents are extremely rare in
proportion to the volume of traffic (Table 2).
In any event, most buyers of crude oil have no
choice with regard to the mode of transport,
which is determined at the outset by the existing
supply infrastructure. Sea transport is the least
costly, most flexible and most common method
(and in many cases it is the only option). Oil
produced in the North Sea, in most African
countries and in the majority of Middle Eastern
states is transported by sea.
In certain cases, however, the buyer does have
a choice between sea-only transport and a
combination of sea and pipeline. For example,
Saudi crude can be transported to Europe either
via tankers circumnavigating Africa by way of the
Cape Point or via Egypt’s Sumed pipeline, which
links the Red Sea with the Mediterranean.
Another major exporter of crude, Russia, uses
various pipeline/sea combinations, including
pipeline plus sea transport from the Baltic and
North seas, and pipeline only through Eastern and
Central Europe to the former East German
Republic (Deutsch Demokratische Republik,
DDR) via the Druzhba pipeline.
As a further example, a refinery in the
Stuttgart region in southern Germany has three
Table 2. Tankers versus pipelines
Investments
Operating Costs
Flexibility
Volumes handled
Implementation time
Upgrading in progress
Security/Environment
(impacts on image)
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
pipelines at its disposal to pump crude from
Mediterranean ports: the South European Pipeline
(Fos-Strasbourg-Germany), the TAL (Transalpine
Line, Trieste-Austria-Bavaria) and the CEL
(Central European Line, Genoa-Southern
Germany).
Most countries where oil consumption has
reached a certain level have developed their own
refining industries, which are capable of meeting
most of their needs. Therefore, and despite the
existence of huge export refineries in countries
such as Saudi Arabia and Venezuela, the transport
of refined products over considerable distances is
relatively insignificant in comparison with the
transport of crude. However, because of regional
imbalances between supply and demand for
refined products (disparities which are becoming
more acute with rising imports by the United
States and China), the transport of refined
products is still significant: in 2003, transport of
refined products (requiring transport ships
smaller than the tankers used for carrying crude)
represented 22%, or nearly 500 million tonnes, of
total oil transport.
Refined products are generally transported
over shorter distances, but the dispersal of end
consumers and the diversity of the products
transported pose specific problems: for example,
the holds of transport ships must be cleaned
between each product batch, and ships or
pipelines specially built for carrying refined
products cannot always be used. Furthermore,
pipelines carrying refined products are relatively
rare: they are largely confined to the US and, to a
lesser extent, Europe. Even markets whose
significance in terms of unit consumption is tiny
require refined products in all their different
forms: solid (bitumen), liquid (fuel oils, gasoline
fuels) and gas (Liquified Petroleum Gas, LPG).
Tankers Pipelines
Major
Limited
(geopolitical implications)
Planned, negotiable Low
Very flexible Not adaptable
100-400 kt/cargo 10 to 100 Mt/year
2-3 years Long to very long
Very good
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BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY
Each of these products has to conform to certain
standards and specifications, and the risk of
contamination across product lines means that
transporting or storing them in the same
receptacle is out of the question.
Aside from ship and pipeline, the most
commonly used methods for transporting refined
products are barges, rail tankers and tanker
trucks, the latter two being the only methods
capable of bringing products directly to the end
consumer
Sea transport
The various types of ship used
Three principal types of ship are used for
carrying oil, classified according to their dwt
(deadweight tonnage), i.e. the amount of cargo
that the ship can carry in addition to its own fuel
and supplies. To these three principal categories
can be added the largest of all supertankers, the
Ultra-Large Crude Carriers (ULCCs), as well as
Panamax-class carriers:
• Ultra-Large Crude Carriers (ULCCs) have a
dwt of between 325,000 and 600,000. Very
few of these giant ships are currently active.
• Very Large Crude Carriers (VLCCs), with a
dwt of over 160,000, are used on routes from
the Persian Gulf westwards to the Caribbean,
US and Europe, and eastwards to Southeast
Asia (Japan, Korea and Singapore). The
largest VLCC tankers are used for supplying
Europe and the US. When empty, these ships
can negotiate the Suez Canal.
• Suezmax, with a dwt of between 100,000 and
160,000, is specially designed to be able to
use the Suez Canal when loaded. Suezmax
vessels are also used for transporting crude
from West Africa to the Caribbean, the US and
Europe.
• Aframax ships, which have a dwt of between
80,000 and 100,000, are used in regional traffic
(North Sea, Mediterranean, Caribbean/US).
This is the largest carrier-class allowed to enter
American ports when fully loaded.
• Panamax carriers are used on certain routes
only. Their size (60,000 dwt or less) means
that they can use the Panama Canal (serving
such routes as California/the Gulf of Mexico
or the Pacific coast of South America/the US
eastern seaboard).
The world oil-tanker fleet-capacity peaked at
about 330 million dwt in the late 1970s before
falling to under 250 million dwt with the oil
crisis of 1986. Since then, it has been rising
88
steadily, reaching some 300 million dwt in 2004.
Requirements in terms of transport capacity
fluctuate in line with world oil demand, while
the emergence of non-OPEC (the Organization
of the Petroleum Exporting Countries)
production in regions nearer to consumption
markets has also helped to dampen capacity
requirements. Slowdown in demand can force
shipowners to mothball many of their larger
tankers, something that happened in the early
1980s when charter rates were so low that
shipowners were unable to operate their fleets
profitably. Economic growth since 2000, in Asia
especially, has sparked renewed chartering
demand.
Most (two-thirds) of the world tanker fleet is
independently owned, while the other third
belongs to the oil companies themselves; of these,
ownership by national companies is growing at
the expense of the majors. The fleet mainly
comprises large tankers and is currently
undergoing refurbishment in the wake of new
safety regulations.
The different types of shipping charter
Three types of tanker charter exist:
• Bareboat charters: the tanker is placed at the
disposal of the charterer for a specific period
of time. The tanker is equipped by the
charterer, which also pays its operating costs.
The charter hire rate (paid monthly) reflects
the capital costs of the tanker. Bareboat
charters are therefore similar to leasing
agreements, and generally incorporate a
purchase option.
• Time charters: the tanker is placed at the
disposal of the charterer for a specific period
of time (anything from six months to several
years) and operating costs are borne by the
ship-owner.
• Spot or voyage charters: the shipowner agrees to
transport cargo from one designated port to
another and applies a cargo tariff per tonne of
cargo transported, with all costs included. Spot
charters can cover consecutive stages on the
same itinerary. Although they were practically
unheard-of in the early 1970s, these are now the
most frequent form of charter agreement.
The cost of sea transport
For shipowners, costs per tonne transported
are a key factor, as owners are unable to operate
for long under a certain threshold without having
to lay up part of their fleet. These costs comprise
two components: depreciation of the tankers
ENCYCLOPAEDIA OF HYDROCARBONS
 ANALYSIS OF COST STRUCTURE AND FUNCTIONS IN OIL TRANSPORT AND REFINING
(which is connected to investment costs), and
operating costs, including port duties and fuel.
Depreciation of tankers. The price of tankers
depends partly on construction costs and partly on
market equilibrium. While the life expectancy of
a tanker is theoretically quite long, in many
countries the legal depreciation period is eight
years. Furthermore, tanker life expectancy is
reduced as a result of rapid obsolescence due to
advances in technology and tighter safety
regulations.
Construction costs fell in the 1960s, mainly
due to the trend set by Japanese shipyards:
reduced steel consumption, productivity drives
leading to faster construction times, new
technology and more. But while progress in this
area has continued, costs have since risen
markedly as a result of ever-stricter construction
regulations.
For a 280,000 dwt double-hulled VLCC, the
2005 order price is in the region of $300 per dwt.
Construction costs per dwt decrease with size up
to 200,000 dwt; a tanker of just 80,000 dwt, for
example, costs about $500 per dwt. Hull costs rise
at a rate that is less than proportional to tonnage.
The cost of propulsion gear is proportional to
power, which is a function of the square root of
tonnage. Beyond 200,000 dwt, costs per
deadweight tonne vary little as there are few dry
docks big enough to accommodate tankers of this
size, which also need a double propulsion system.
Since the oil fleet occasionally finds itself in
periods of overcapacity, the market for
second-hand tankers is very active. Prices and
write-downs relative to new tankers are expressed
in dollars per dwt; of course, they also depend on
the age and condition of the tanker, as well as on
market conditions.
The lowest price limit on the second-hand
market is the scrapping price, at which ships are
sold for scrap to special breaking yards.
Operating costs. Most operating costs remain
the same regardless of the voyage; of these,
tanker-depreciation and capital costs, repair,
maintenance and inspection duties can all be
directly charged to the tanker, while general
company costs are harder to break down.
Other operating-cost components vary,
depending on the voyage: salaries and associated
social security expenses as well as supply and
provision costs all rise as the length of the voyage
increases; port dues, canal charges, and piloting and
tug duties depend on the route; and consumption of
bunkers (fuel oil, diesel fuel) and lubricants
depends on distance, tonnage and speed.
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
Thus the consumption of fuel oil, which can
be expressed as a function of speed3, rises steeply
as speed increases, while for most other costs the
greater the speed, the lower the cost per tonne
(and the quicker the voyage). Bunker prices per
tonne depend on the refuelling port and on
provisioning agreements.
Port and canal duties are fixed costs charged
in proportion to tonnage. Port duties vary greatly
from one port to another. The principal canals
used by oil tankers are the Suez, the Panama and
the Kiel (which serves the Baltic Sea market).
Canal authorities publish tariffs of their
applicable transit duties at regular intervals
(usually once per year).
Personnel costs have significantly decreased
in recent years due to reductions in crew size,
but crews cannot be cut much further for
reasons of safety (and the bigger the tanker, the
higher the level of safety required). Tankers
also have to undergo port maintenance, the
costs of which can rise steeply if the tanker’s
crew is too small to carry out part of the
maintenance work while the tanker is at sea.
Tankers of over 100,000 dwt have crews of
about 30. Total personnel costs also depend on
the nationality of the crew and the country in
which the tanker is registered: social security
charges, for instance, are much higher for
European- and North American-registered
tankers than for open-registry tankers.
Then there are demurrage charges, or
penalties for exceeding time allowances; in
certain cases, these can be applied on top of port
duties in oil terminals that are particularly
congested and which consequently assign time
limits for tankers to load and unload. These costs,
stated in dollars per day in excess of the
contractual limit, can be significant.
It is difficult to give precise indications of
transport costs per deadweight tonne as these
clearly depend on a large number of factors. We
can, however, assign approximate shares to the
principal operating cost items for tankers (Fig. 3).
We can also compare daily operating costs for
different types of tanker and trace recent cost
trends; costs in the early years of the present
decade ranged from $6,000 per day for a ‘large’
(80,000 dwt) tanker carrying refined products, to
over $11,000 per day for a VLCC.
The price of sea transport
This is the price of transport as paid by the
buyer, a rate generally negotiated between the
shipowner and the charterer. As in every
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BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY

insurance The published Worldscale rate (flat, or level

administration
supply and stocks
repairs and maintenance
manpower
37% 13% 14%
Fig. 3. Breakdown of VLCC
operating costs.
market, oil transport prices vary in accordance
with demand and supply and can fluctuate
greatly, occasionally diverging significantly
from actual costs. The setting of tariffs for
voyage charters operates according to a
free-market model whereby the law of supply
and demand enjoys carte blanche. Deals are
struck by brokers, who are based in London and
New York for the most part.
Of all the different indices used for setting
spot and time-charter prices, the most widely
used is the Worldscale index; this is reviewed
regularly (usually every 1 January) by the
London-based Worldscale Association, in
accordance with changes in certain costs, such
as bunkers and port dues. This index gives
nominal transport prices for every possible
combination (or route) between port of loading
and port of unloading.
100) represents typical transport costs for a given
voyage (or route). It is expressed in dollars per
tonne for a ship with a capacity of 75,000 tonnes
sailing fully loaded at a speed of 14 knots,
making a return trip between the designated port
25% 11% of loading and the port of unloading, in standard
conditions of size, speed, consumption and time
spent in ports of call.
If the shipowner and charterer negotiate a
price at Worldscale 85, this means that
transport costs for the charterer are 85% of the
flat rate. For example, the flat rate for a voyage
between Quoin Island and Augusta via the
Cape was set at $18.24 dollars per metric tonne
for 2003; so, in the instance cited, the cost
would be $15.50 per metric tonne. The flat rate
for the same voyage via Suez was only $7.60
dollars, but Suez Canal charges would have
had to be factored in. Transport prices
expressed as a Worldscale percentage
obviously vary greatly depending on the size of
the ship used, and therefore on the amount of
cargo transported. For VLCC-class tankers,
rates usually remained well below Worldscale
100 until the early years of the present decade;
by the end of 2004, however, they had reached
200%. Rates for small tankers carrying refined
products can be as high as 300 or 400% of
Worldscale flat.
Spot-chartering rates are particularly
volatile since they are extremely sensitive to
fluctuations in supply and demand (Fig. 4).

Fig. 4. Spot rates. 450

400
Mediterranean-North-West Europe
350 25,000-30,000 dwt (products)

300
Arabian Gulf-East
70,000-100,000 dwt
Worldscale

250

200

150

100

50

Arabian Gulf-Europe 200,000-300,000 dwt

0
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004

year

90 ENCYCLOPAEDIA OF HYDROCARBONS
 ANALYSIS OF COST STRUCTURE AND FUNCTIONS IN OIL TRANSPORT AND REFINING
They are susceptible to seasonal variations and
are also influenced by the occurrence (or
anticipation) of other phenomena: war,
political tensions, changes in crude prices, and
new regulations. Time chartering rates are less
volatile.
Chartering transactions are performed by
brokers, whose duties include an obligation to
ensure transparency in dealings. Average
chartering prices, expressed as percentages of the
Worldscale index, are regularly published by
various bodies.
When entering into a chartering agreement,
shipowners have to weigh the freight rate against
their operating and capital costs, which are
directly proportional to the time elapsed and can
therefore be expressed in dollars per day; they are
measured against the Daily Net Return (DNR),
which expresses the daily margin against variable
costs (Fig. 5).
In case of spot chartering, variable costs refer
to bunker charges, port dues and so on, which are,
keep in mind, paid by the ship-owner.
DNR can vary considerably for the same
chartering rate, depending not only on bunker
costs but also on the age of the ship, as a new ship
consumes much less fuel than an old one. If a
chartering agreement gives a DNR higher than
the sum of daily costs (operating costs plus
capital costs), the difference represents the
shipowner’s profit.
Transport prices and costs
Margins as defined above have frequently
been negative since the 1990s, which means
transport costs were usually higher than transport
selling prices. While costs are relatively stable,
selling prices depend on market conditions and
fluctuate considerably.
The market itself is equally volatile and
has changed considerably since the beginning
of the present decade; it is now
predominantly a seller’s market, with many
tankers laid up as a result of the introduction
of drastic safety regulations, fewer new
tankers and increased traffic; furthermore,
average charter rates are often higher than
those employed in the 1990s. With a strong
increase in demand for oil and a consequent
increase in sea traffic, rates in 2004 were
higher than they had been for many years: the
average rate for VLCCs was Worldscale 150.
The introduction of new tankers in 2005 has
eased demand on the tanker fleet and thus
reduced rates.
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
crew, maintenance and repairs, oil and supplies,
insurance and management costs
⫹
economic depreciation
⫹
margin
⫽
DNR ($/d)
(freight charge given by the spot market-minus variable costs )
Fig. 5. DNR: the shipowner’s
margin.
Transport by pipeline
Overview
The use of pipelines for carrying hydrocarbons
in liquid and gas form was first adopted on a
significant scale in the US and is now common
worldwide. The total length of the global trunkline
network (i.e. pipelines not including gathering
lines, storage systems and final distribution) is
well in excess of 1.2 million km. Gas pipelines
account for over half of this figure.
Among the many active pipelines worldwide,
the foremost include:
• In the US, the Trans-Alaska crude-oil pipeline
linking the Prudhoe Bay oil fields to the
Pacific seaboard, and the Capline, which runs
roughly parallel with the eastern bank of the
Mississippi.
• Also in the US, three major US pipelines
carrying refined products: the Plantation, the
Colonial and the Explorer.
• In Canada, three major Canadian crude-oil
pipelines: the Interprovincial, linking
Edmonton to Toronto, the Mackenzie Valley
and the Kitimat-Edmonton.
• In Eastern Europe, the Russian pipeline network,
operated by Transneft, a state-owned company
with a monopoly on the pipeline transport of
crude oil. Via its subsidiary Transnefteproduct, it
also has a monopoly on the piping of refined
products. Crude-oil pipelines link the Urals to
Central and Eastern Europe (the Druzhba
system), to Novorossijsk on the Black Sea and to
Primorsk on the Baltic. The Ventspils terminal in
Latvia, formerly the mouth of a major pipeline, is
no longer used by Transneft. In the same region
we should also mention the Eastern
Europe-Russia network, linking the Siberian
refineries with Angarsk, and the Caspian
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BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY
Petroleum Consortium (CPC) pipeline, which
links Kazakhstan to Novorossijsk via Russia.
There are very few refined-product pipelines in
this region. Among the most significant of this
type are the Samara-Briansk-Leninvaros
(Hungary) pipeline and another serving the Baltic
(the Transnefteproduct system).
• In Western Europe, major crude pipelines
include the north-south system linking the
North Sea ports with Germany and Belgium,
and the south-north system, which links the
Mediterranean ports to Central Europe (South
European Pipeline, TAL and CEL). Western
Europe also has some major refined-product
pipelines, such as the Trapil system in France,
the Mediterranean-Rhone pipeline, the
Rotterdam-Venlo-Ludwigshafen pipeline and
the Spanish network.
• In the Middle East, major crude oil pipelines
include the Tapline, which links Abqaiq and
Sidon (partially closed), the Kirkuk-Tripoli
pipeline (also closed), the Sumed pipeline
(which enables the transport of oil from the
Gulf states to the Mediterranean without using
the Suez Canal) and the Abqaiq-Yanbu
pipeline in Saudi Arabia. Most of the oil
pipelines from Iraq and Saudi Arabia have
been closed for political reasons, as they
represent obvious targets for sabotage.
The principal constraints on pipeline transport
Oil pipelines work in conjunction with sea
transport as one more link in the crude-oil supply
chain. Relatively few pipelines directly link the
place of production to the refinery; and, as we
saw above, pipelines carrying refined products
are relatively rare except in the US, where they
were first used in about 1930. We also examined
the comparative advantages and disadvantages of
pipeline and tanker transport above.
One important consideration here is that the
notion of ‘capacity’ in the transport of
hydrocarbons via pipelines is not a totally reliable
parameter: it depends on many factors, such as
the viscosity of the product being pumped. Initial
capacity can be considerably augmented by the
installation of secondary pumping facilities.
The key advantages of pipelines relative to
other modes of oil transport (coastal shipping via
small tankers, river navigation, railway and road)
include low operating costs, direct routes and
immunity to climatic conditions. However,
pipelines require heavy investment, with
enormous infrastructure responsibilities for the
oil companies and absolutely no flexibility of use.
92
So what are the principal technical and
operational constraints in pipeline transport?
In the case of crude oil, the principal
constraints are those imposed upon the
transporter by the refiner:
Preservation of the quality of the crude during
transport. The risk of contamination, although
lower for crude than for refined products, is
nevertheless real. Crude oils of different qualities
can become mixed during storage at the terminal
prior to pumping, while the risk of contamination
is also present in the pipeline itself between
successive batches of crude. This problem does
not arise when the entire storage and pipeline
system handles only one class of crude, which in
fact is often already a blend of specific quality;
this is the case, for example, with the Urals Blend
that is pumped from Russia via the Druzhba
pipeline.
Preservation of quantities. This requires
accurate and reliable metering methods at the
upstream terminal, the destination refinery and
the downstream terminals. Maximum admissible
loss rates are contractually established. Barring
major incidents on the pipeline, most losses occur
during storage.
Logistical and batch-sequencing constraints.
As an example of this, it takes an average of 15
days for the Société du Pipeline Sud Européen
(SPLSE) to pump a batch of oil from the
Mediterranean (Lavéra) to Karlsruhe.
Refined products are usually pumped via
multi-product pipelines of smaller diameter than
those used for carrying crude. These pipelines are
capable of carrying practically every kind of
refined product (including LPG under certain
conditions) with the notable exception of heavy
fuel oils. In the rare event that they are
transported by pipeline, heavy fuel oils are only
pumped over very short distances, usually via
special pipelines that are heated to a temperature
of about 90°C.
In Europe, refined-product pipelines have a
diameter of 32" and pump 15 million tonnes per
year. The capacity of a pipe depends not only on
its diameter but also on the viscosity of the
product being transported and the power of the
pumping stations; for example, using the same
plant, a given pipeline can pump twice as much
petrol as liquid fuel oil.
In the more common instances where two or
even three light-refined products are transported
(i.e. gasoline, kerosene/jet fuel and diesel), the
different products are sent by batches following
certain procedures that regulate, for instance, the
ENCYCLOPAEDIA OF HYDROCARBONS
 ANALYSIS OF COST STRUCTURE AND FUNCTIONS IN OIL TRANSPORT AND REFINING
sequence in which the products are pumped.
Since refined products must meet precise
specifications (density, sulphur content and
water content), precautions have to be taken to
prevent contamination at interfaces.
Contaminated products can either be returned to
the refinery for recycling to the required
specifications or mixed with a lower-grade
finished product.
Pipeline transport costs
Contrary to the situation with sea transport,
pipeline transport makes it difficult to draw a
distinction between the pipeline transport selling
price, or transport tariff, and cost price. In the
case of crude oil, the companies that produce or
refine the oil are in most instances the owners of
the infrastructure by which the oil is transported.
There are exceptions however: the Sumed
pipeline linking the Red Sea and the
Mediterranean, for example, and the
state-owned pipelines of oil producing/exporting
countries.
Despite these exceptions, the companies in
charge of managing pipeline infrastructure can
generally be regarded as overseeing an asset
whose purpose is not to generate its own
profitability but rather to ensure the profitability
of related upstream and downstream activities.
Oil pipeline transport costs break down into
two main components: the depreciation of
investment and the operating costs.
Capital expenditure and depreciation. Laying
a pipeline involves a whole series of operations
that are straightforward in essence; however, they
must be carefully planned and sequenced if
operations are to proceed quickly enough to
prevent the accumulation of crippling capital
expenditure costs.
Investment comprises materials, pipe-laying,
right-of-way and damage compensation to
landowners, sundry expenses and pumping
stations. In some cases, it also includes the
terminal (storage) costs associated with the
construction of the line.
Equipment depreciation periods vary. The pipe
itself generally has a depreciation term of 20-25
years. The real deterioration of the pipe generally
takes much longer, thanks to such highly effective
anti-corrosion methods as cathodic protection.
Pumps and metering gear depreciate fairly
quickly due to technological progress and the
modernization that results.
Operating costs. In addition to fixed costs
such as depreciation and financial expenses, we
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
must also consider the costs incurred in keeping
the pipeline working. However, operating costs
such as those for personnel are not really
variable because, unless the pipeline is closed
for extended periods, staff members remain
employed.
These costs tend to vary in line with the
installed capacity of the pipeline rather than its
real throughput. Although pipelines require little
in the way of labour, the latter is highly
specialized and therefore costly. Automation and
remote management are deployed to the full in an
attempt to reduced labour costs.
Energy bills can account for up to one-third of
operating costs. This percentage depends on the
number of pumping stations, i.e. on the
throughput and geology of the pipeline. Energy
consumption per tonne pumped varies with the
square of the pipe’s throughput. Consumption
rises in areas where head loss is significant
(mountainous regions, an arrival point at a higher
altitude than the departure point and so on) and
when, for a given throughput, the product being
pumped is more viscous.
Modern pipelines require practically zero
maintenance. However, the greater the automation
of the line, the higher the maintenance costs for
pumping stations and metering apparatus. Among
other cost items, we can also cite insurance costs,
administrative expenses and rent charges.
Tariffs
While the tariffs proposed (or imposed) by
the companies operating oil pipelines take into
account costs classified as fixed (capital
depreciation, personnel and maintenance costs)
and variable (mainly energy), they also
comprise elements that are wholly commercial.
These depend on the location-related
advantages enjoyed by the oil pipeline, i.e. the
extent to which it can offer significant savings
on sea transport. The Sumed pipeline, for
example, obviates the need for a long and
costly voyage around the African continent by
tankers that are too big to use the Suez Canal
(Table 3).
Other forms of transport
All other means of transporting liquid
hydrocarbons – cabotage (home trade, coastal
shipping), inland navigation, and rail and road
transport – almost exclusively involve refined
products, though there are exceptions like Russia,
where substantial volumes of crude oil are
transported by rail.
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BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY
Table 3. Pipeline transportation costs
Construction costs (Cap Ex)
Pipes, valves, piping equipment
Installation cost
Acquisition of right-of-way, compensation, reimbursement of damage
Surveys and control
Pumping stations
Terminals
Operating costs (Op Ex)
Salaries and wages, energy costs, maintenance
Other charges: rents - telecommunications, insurance, overheads
Table 4 provides a comparison of four methods
of transporting refined products, indicating
relative cost elements for each method and the
constraints affecting each.
Cabotage (home trade, coastal shipping)
It is difficult to make a clear distinction
between cabotage and general maritime traffic.
The definition of cabotage (trade or transport in
coastal waters) and its etymology (navigation
from cape to cape) point to short-haul coastal
traffic. As this suggests, cabotage generally takes
place within view of the coast or within one
country’s territorial waters, as opposed to long-
haul (i.e. open-sea) voyages. The role played by
cabotage varies in line with regional geography.
Cape-to-cape navigation is especially suitable
as a method of transporting refined products in
countries with exceptionally rugged coastlines.
Cabotage is thus widely practised as a means of
distribution in Japan and the Philippines, while in
the US it is hardly practised at all outside the Gulf
of Mexico and the eastern seaboard.
The situation in Europe falls somewhere
between these two extremes. Many areas are
particularly suited to this kind of transport: the
Pyrenees, several regions of Italy, the Dalmatian
coast and the refineries of the
Amsterdam-Rotterdam-Anvers (ARA) zone, the
last of which serve the major ports of Germany,
Britain and France.
Coastal tankers are capable of carrying all
types of refined product, from LPG to bitumens,
in vessels specially designed for specific cargoes.
Some of these ships are multi-product tankers,
with separate holds for different refined products.
94
Base: 5 €/in/m
15 €/m
1 to 5 M €
2 to 4 M €
Oil companies often own their own coastal fleets
and charter additional freight requirements from
specialist companies. Coastal ships range in size
from a few thousand to tens of thousands of
tonnes.
Transport tariffs for international cabotage are
among the highest on the Worldscale index. As
for national cabotage, many countries require
ships to be locally registered and rates vary
greatly according to the regularity of traffic.
Transport by inland navigation
In river transport, the slower the barge travels,
the lower the cost of transport: fuel consumption
is extremely sensitive to speed. Inland navigation
is therefore perfectly suited to the transport of
heavy products that do not require special
handling and whose economic feasibility is
scarcely affected by considerations of time.
Cost-effectiveness is therefore increased with the
transport of less-expensive products. Inland
navigation is ideal, for example, for the transport
of fuel oil as long as a considerable distance is
involved. As it is less cost-effective for the
transport of white products, however, inland
navigation is becoming less and less significant,
even though two-thirds of global storage capacity
are connected to a waterway.
The vessels used on canals and rivers range in
size from self-propelled barges with capacities of
between 300 and 1,500 tonnes to the large pusher
convoys of the Mississippi, which can be as big as
40,000 tonnes, and the 5,000-tonne barges that
ply the Rhine between Rotterdam and Basle.
In Europe, inland navigation is most intense
on the Rhine, via which barges carry supplies to
ENCYCLOPAEDIA OF HYDROCARBONS
 ANALYSIS OF COST STRUCTURE AND FUNCTIONS IN OIL TRANSPORT AND REFINING

Germany, North-eastern France and Switzerland.
However, traffic on the Rhine, and therefore the
provisioning of all the regions it serves, is
vulnerable to fluctuations in water levels.
Rail transport
Rail transport remains the main way of
supplying depots that are not connected to the
source of production either by a network of
pipelines or by sea or waterway. Although the rail
companies offer reduced tariffs, rail remains, in
general, a costly mode of transportation.
Compared with other bulk-transport methods, it is
especially costly in Europe, but somewhat more
competitive in Canada and Russia, where tariffs
are significantly lower; in fact, a significant
proportion of refined product is transported by
rail in Russia.
In Europe, the longest trains can carry up to
2,500 tonnes, while certain products such as LPG
and lubricants can be delivered in single-wagon
consignments of between 30 and 80 m3. Price
greatly depends on the volume to be transported,
and, once tonnage reaches significant levels,
construction of a pipeline becomes feasible.
Road transport
Nearly all terminal transport of refined
products takes place by road, as does some bulk
transport between refineries and depots. Most
heavy products (such as bitumen and fuel oil) that
cannot, except in special circumstances, be
transported by pipeline, are also transported by
road. Tanker trucks are ideal for bringing small
volumes to almost any destination, making them
an extremely flexible means of transport.
Road transport also includes the supply of
retailers like service stations and fuel pumps, and
the delivery of domestic fuel to end consumers
via smaller trucks equipped with pump meters.
In the case of bulk transport, the vehicle most
often used is a semi-articulated tanker truck with
a capacity of 40 tonnes. These trucks cover an
average of 100,000 km per year, cost over
$120,000 to buy, and are usually owned by
specialist transport firms. As for terminal

Table 4. Comparison of methods of transport

Road Rail River Pipeline

High by unit
if sound
Low by unit, high Moderate by unit, Very high and made
Investment cost-effectiveness
overall high overall over a short period
is required
(push boat)

Mainly borne High, and borne

Infrastructure costs – Toll duties
by State entirely by company

High for Low (personnel ⫽

Personnel costs Very high Fairly high self-propelled barges, high in skills but low
low for push boats in numbers)

High except when volumes justify collective

Maintenance costs Very high Very low
installations and automation

Return costs Empty return Empty return Return in ballast Nil

Outward, practically
Fairly dense and
everywhere; natural The most circuitous
Length of route limited by natural The most direct
obstacles impose route, where it exists
obstacles
significant detours

Climactic conditions during

Very sensitive Not very sensitive Sensitive Not affected
transit

Flexibility of use Very high Very limited Very limited Nil

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BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY
transport, this is generally carried out by tanker
trucks with a capacity of 20 tonnes or even less in
certain regions.
2.3.2 Oil refining
Technical background
Introduction
Refining is a vital link in the oil industry. In
fact, absolutely no one consumes crude oil; we
consume refined products only, as used in
transport, domestic and industrial applications,
and the petrochemical sector. The refined
products most often consumed are gasoline,
diesel and fuel oil. The fastest-growing refined
products in terms of consumption are jet fuel and
diesel; consumption of fuel oil is declining.
Worldwide consumption of refined products,
refinery fuel included, is currently in excess of
3.6 billion tonnes per year, or 80 million barrels
per day. According to International Energy
Agency figures, annual consumption in 1973 was
a mere 2.75 billion tonnes.
The purpose of refining is to transform the
various kinds of crude oils into finished products
that meet certain precise specifications (Fig. 6).
For the present purposes, we shall not examine
upgrader plants, whose job is not to create finished
products, but rather to transform ultra-heavy crude
into so-called synthetic crudes using conversion
units. The resulting synthetic crude is of much
higher quality and is therefore easier to market.
Venezuela has a few plants of this type.
Oil refining, i.e. the transformation of crude
into end products, used to be a perfectly
straightforward affair: a simple distillation
process was enough to separate out useful
fractions such as lubricants. The modern
refining industry did not really come into being
crude oil
Middle East
Saudi Arabia, Iraq,
Iran, Kuwait, UAE
Africa
Nigeria, Gabon, Congo,
Angola, Algeria, Lybia
North Sea
other countries
CIS (ex USSR)
Venezuela, Mexico
Fig. 6. Refining target.
96
until the construction of the world’s first
distillation unit in Boston in 1863. Its purpose
was to produce lamp oil, the only petroleum
product consumed at the time. Then the car was
invented, sparking a rapid expansion in
consumption of petrol and diesel. At the same
time, new techniques such as continuous
distillation and thermal cracking emerged; these
were followed by thermal reforming and then,
just before the Second World War, by the
introduction of catalysis in transformation
processes.
At present, the principal refining operations
fall into four categories: a) separation of crude oil
into various cuts; b) enhancement of the qualities
of certain cuts; c) transformation of heavy cuts
into lighter cuts (conversion); d ) final preparation
of finished products through blending (Fig. 7).
Refineries comprise a number of distinct
parts: a) the processing plant proper, where the
crude is separated into cuts, certain cuts are
enhanced and heavy cuts are converted into
lighter ones; b) utility works, i.e. facilities
producing the energy (fuel, electricity, steam,
etc.) needed for refining processes; c) tank farms;
d ) reception and dispatching facilities, and
blending units.
Processing facilities
Every crude oil on the market is unique,
depending on the deposit it comes from. The most
common crudes have a density of between
0.8 g/cm3, i.e. around 45°API, and 1.0 g/cm3, i.e.
10°API (the API, or American Petroleum Institute
degree, is the standard unit of measurement of
crude density). Light crudes yield higher
quantities of light products (motor fuels) while
heavy crudes yield heavier fractions like heavy
fuel oil.
Atmospheric distillation or topping separates
the crude into different cuts ranging from lighter
main petroleum products
liquefied petroleum gases propane, butane,
LPG automotive fuel
gasoline regular, premium, unleaded
jet fuels
diesel fuel, home-heating fuel
heavy fuel oils normal, low sulphur content,
very low sulphur content
bitumen naphthas, special gasoline
(white spirit, aviation gasoline),
other products kerosene, light marine diesel,
special fuel oils, lube base stocks,
paraffins-waxes
ENCYCLOPAEDIA OF HYDROCARBONS
 ANALYSIS OF COST STRUCTURE AND FUNCTIONS IN OIL TRANSPORT AND REFINING
fractions through to petrol, kerosene cuts, diesel
cuts and finally atmospheric residue. In the
condition yielded by distillation, these cuts cannot
generally be used without further processing.
Atmospheric residue, for example, is generally
reprocessed in a vacuum-fractioning tower to
separate a light fraction (vacuum distillate) and a
heavy fraction (vacuum residue). The vacuum
distillate can then be used as feedstock for the
production of lighter cuts by processes such as
catalytic cracking, while the vacuum residue can
be used as the base for making bitumen or fuel
oil. Similarly, since the octane rating of the heavy
gasoline produced by this phase of refining is too
low for it to be used as the base for motor
gasoline, it is further processed in a
catalytic-reforming unit. Another process also
designed to increase the octane rating (of
high-gravity gasoline) is isomerization.
Additional processing is increasingly
required nowadays to eliminate the sulphur
content from refined products. Fuels now have
to comply with extremely strict regulations on
sulphur content (in Europe, 50 ppm of sulphur
for petrol and diesel as from 2005; in the US,
30 ppm for the same products as from 2006).
Most cuts are therefore processed in
hydrodesulphuration units.
Most modern refineries also include
conversion units, in which heavy hydrocarbon
molecules are cracked to yield lighter
molecules. We can distinguish between various
types of cracking: thermal cracking (viscosity
breaking or vacuum residue coking); catalytic
cracking (of which the most common process
quality
improvement
conversion
separation
light
blending
heavy
Fig. 7. Refining principles.
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
is Fluid Catalytic Cracking, FCC);
hydrocracking, where a vacuum-distilled
charge is treated by high-pressure hydrogen in
one or more catalysts.
The refining sequence to be used largely
depends on the kind of crude being processed and
on market requirements in terms of finished
products (volume and quality). As an example,
FCC cracking is better suited for yielding
gasoline bases, while hydrocracking is ideal for
producing high-quality diesel and, in some cases,
jet fuel.
Utilities, storage, blending and dispatch
Utilities such as fuel, electricity, steam,
compressed air and cooling water are largely
produced within the refinery. In many cases,
however, refineries have to import part of their
electricity needs from the grid.
End products are obtained by blending the
intermediate and semi-finished products (which
are also called bases) proceeding directly from
the refining units. Blends are calibrated to meet
the specifications and requirements of
commercial products.
Storage areas occupy significant amounts of
space: some tanks can hold over 100,000 m3 of
oil. The tanks used for storing end products are
smaller. Refineries must also be equipped with
facilities for discharging crude oil and
dispatching products.
Types of refinery
Refineries can be classed into three
categories, depending on their sophistication:
• Topping or hydroskimming refineries, which
essentially comprise atmospheric fractioning
towers as well as, in most cases, a catalytic
reforming unit and hydrodesulphuration units
for middle distillates.
• So-called complex refineries, which are also
equipped with conversion units ranging in
nature from catalytic cracking (FCC) to
hydrocracking and visbreaking (Fig. 8).
• So-called ultra-complex refineries, which also
feature standard and deep conversion
installations capable of directly processing
residues to yield value-realizable products
(light refined products, gas, electricity and so
on). Ultra-complex refineries are still fairly
rare, unless we include simple coking
processes in this category. A number of
ultra-complex refineries are to be found in the
US, where they are specially designed for
processing heavy crudes.
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BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY

Economic factors This expansion of refining capacity has been

accompanied by an even faster proliferation of
The global refining situation secondary processing capacity (reforming,
Global refining capacity, expressed in terms cracking etc.) in attempts to augment yields and
of atmospheric distillation capacity, was on the improve the quality of light and medium
order of 4.1 billion tonnes per year, or distillates (fuels) while simultaneously reducing
approximately 82 million barrels per day, in 2004. the production of heavy fuels, for which demand
In 1950, capacity was a little over 1 billion has collapsed.
tonnes, but from that point rose quickly to reach The real challenge facing the refining industry
the 4 billion tonne mark by 1980. The apparent is how to keep up with changes in the market.
stagnation in capacity between 1980 and 2004 While the decline in demand for heavy fuel oil
conceals the fact that capacity had in fact fallen to and the solid growth in consumption of fuels are
under 3.6 billion tonnes in 1985 in the wake of hardly new phenomena, some recent
the second energy crisis, only to rise again after developments in requirements on product quality
the oil-price slump of 1986 (Fig. 9). have had a major impact on refining:
This apparent stability since 1980 in terms of • The elimination of lead from petrol: the
global capacity also conceals some considerable octane index is a key indicator of petrol
geographic disparities. Roughly speaking, we can quality as it indicates the fuel’s resistance to
say that North America (which remains the self-ignition, the phenomenon that causes
world’s leading refining region) has seen its knocking in spark-ignition engines. The higher
capacity remain practically unchanged since the octane index, the higher the resistance to
1980, while Western Europe has lost 30% of its knocking. To improve the octane index, lead
capacity in the same period. Most new refineries compounds were traditionally added to petrol.
have been built in the Middle East and Asia; The prohibition of lead has brought about the
furthermore, plans to build new refineries are emergence of new processing techniques
essentially focused on Asia. designed to produce high-octane petrols that
In total, there are just over 700 refineries are lead-free.
worldwide. Average refinery capacity is thus on • Reduction in the sulphur content of fuels
the order of 6 million tonnes per year or 120,000 (gasolines and middle distillates), achieved
barrels per day. However, the largest refineries through the construction of desulphuration
can handle over 25 million tonnes per year units and the conversion of existing plants.
(500,000 barrels per day) while many small • The introduction of new restrictions on fuel
refineries with capacity of 1 million tonnes per quality, such as limitations on olefin and
year are to be found in oil-producing countries aromatics content in fuels, which has led
such as the US and in countries where refiners to rethink conventional production
consumption is low. processes.

Fig. 8. Refining
gas
scheme-conversion. C3 LPG
HCO⫽Heavy Cycle Oil; C4 LPG
atmospheric distillation

LCO⫽Light Cycle Oil. light naphtha

reformer gasoline
heavy
naphtha 1 Mt/y naphtha
gasoline

jet fuel
gas oil
iC4
8 Mt/y

diesel oil/
HDS

vacuum distillate catalytic heating oil

cracker
1,8 Mt/y
distillation
vacuum

atmospheric residue 1,8 Mt/y

LCO
HCO

3,5 Mt/y

fuel oil
visbreaking (20%)
vacuum residue
1,5 Mt/y

98 ENCYCLOPAEDIA OF HYDROCARBONS
 ANALYSIS OF COST STRUCTURE AND FUNCTIONS IN OIL TRANSPORT AND REFINING
Fig. 9. Refining
capacities in 1980 and 2004 1,089
1,019
and projects.
11
North America
357
335
14
South and
Central America
1980 4,068 Mt/y
Refining costs
Investment
The construction of a new refinery is a long,
costly and complex operation. Some three years
elapse between the decision to build the refinery
and its opening; this period is preceded by
months, if not years, of preliminary research. The
scale of investment involved in the construction
of a refinery depends mainly on its size, its
complexity and its location.
Size and complexity. In general, it is
estimated that a refinery built in Europe with a
capacity of 160,000 barrels per day (8 million
tonnes per year), equipped with catalytic
cracking, visbreaking and gasoline units, would
currently cost some $1.5 billion. This cost could
rise considerably with the addition of
exceptionally restrictive anti-pollution
regulations that address not only the immediate
environs of the refinery (waste) but also the
quality of products.
In the case of a slightly smaller (5 million
tonnes per year) simple refinery (atmospheric
distillation with catalytic reforming and
hydrodesulfuration plants), the cost would be less
than half of the figure for the larger refinery
above. Conversely, a refinery equipped with a
deep conversion unit, such as fluid coking with
coke gasification or residue hydrocracking, would
cost at least a billion dollars more than a refinery
equipped with a conventional (e.g. FCC)
conversion plant (Table 5).
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
1,031
689
734
528
11
Eastern Europe
Western and other former
Europe Soviet countries 1,002
484 627
275
75
18
Africa and Asia
Middle East
capacity in Mt/y (at 01/2004)
2004 4,102 Mt/y projects 135 Mt/y
Complexities notwithstanding, size generates
some significant economies of scale: if we double
the charge processed by a reactor, the quantity of
steel necessary for the construction of this reactor
(and its cost) increases roughly by only two-thirds
(in fact, the quantity of steel needed is
proportional to the surface area of the reactor,
which increases with the square of the
dimensions; volume increases with the cube of
the dimensions). These economies are confined,
however, by the limitations on the size of certain
units. The maximum capacity of an atmospheric
distillation unit will, for example, be some 12
million tonnes per year, so refineries with larger
capacities will therefore have two atmospheric
distillation columns.
Location. Equipment transport and assembly
costs are significant factors in total construction
costs. A refinery that is built at a great distance
from the factories that produce its principal
components (columns, reactors etc.) will
therefore be more expensive than an identical
refinery built near its equipment suppliers (which
is the case in the leading industrialized countries).
Shortages of qualified local labour mean that
external technicians have to be sent in, and this
too has a significant impact on costs. Finally,
severe climactic conditions (as in Siberia and the
far north of North America) can also add to
equipment costs.
Other factors. Since off-sites (utilities,
storage, loading and discharging areas) can
account for over half the investment costs of a
99
BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY
simple refinery, the configuration of the refinery
has an important impact on investment. For
example, autonomy of electrical energy (bought
from the grid or produced locally) and the size of
the tank farm, as well as the size of the loading
and discharging areas and the methods employed,
all affect costs. In certain cases, the refinery can
be designed to handle special crudes such as sour
crude, and this significantly increases reactor
costs.
Breakdown of costs
Costs are traditionally broken down into:
variable costs, which are directly proportional to
the amount of crude processed; fixed outlay costs,
which are process-independent; capital costs.
Variable costs. These include the price of
chemicals and catalysts, and the financial
expenses associated with the immobilization of
crude and products during production and
storage.
Chemical products have accounted for limited
variable costs since the virtual disappearance of
tetraethyl lead, formerly used as a fuel additive.
However, other additives are increasingly
incorporated into refined products to improve
their properties (but this does not always take
place at refinery level).
Catalysts are used in many refinery processes
such as reforming, cracking, isomerization,
alkylation and hydrodesulphuration. The
catalysts used in reforming contain precious
metals, and their price can reach several hundred
dollars per kilogramme or even higher. The
catalyst is then regenerated (continuously, in
modern units), and at the end of the process
cycle the precious metals are recovered and
re-used. In catalytic cracking, however, the spent
Table 5. Refinery investment cost (M$)
Basic refinery
5 Mt/y
Process units
230
(excl. cracking)
Cracking complex
– 375
(FCC, Alkyl., visbreak.)
Deep conversion complex – –
Offsites (Utilities production
550
units, storage, shipping facilities)
Total 780
100
catalyst is continuously removed from the unit
and new catalyst introduced. Total catalyst costs
can come to several dollars per tonne of crude
processed.
To highlight immobilization costs, we can
look at a typical European refinery that processes
crude from the Middle East. It takes some 40 days
to transport the crude to the refinery; before it is
processed, the crude is stored for several weeks to
allow impurities to settle out and to ensure
sufficient reserves for avoiding stock outages and
meeting legal requirements on emergency stocks.
Processing is rapid, but the end products then
spend a further few weeks in storage. In all,
weeks or even months elapse between the
purchase of the crude and the sale of the products
it yields. In the meantime, the cost of the crude,
already paid for but with no value realized on it,
has to be covered: by a loan, for example.
Immobilization costs can therefore be over two
dollars per tonne of crude processed.
Fixed outlay costs. These costs include
personnel and maintenance costs, insurance,
charges and general expenses, all of which are
largely unaffected by the quantities refined.
Personnel costs are the same whether or not the
refinery is working to full capacity. The number of
employees in a refinery varies enormously. A
simple refinery will employ a minimum of 200 to
250 people. However, personnel numbers depend
much more on the complexity of the refinery than
on its size. A large, fairly complex refinery in
Europe can employ up to 1,000 people. Other
factors can also lead to increased personnel needs,
such as the presence of several small units in the
same refinery or an extensive social services
infrastructure (as in the refineries of the former
USSR).
Upgraded refinery Deeply upgraded refinery
8 Mt/y 8 Mt/y
360 360
375
700
740 1,020
1,475 2,455
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 ANALYSIS OF COST STRUCTURE AND FUNCTIONS IN OIL TRANSPORT AND REFINING
Maintenance costs are more or less
proportional to initial investment and can
represent between 3 and 4% of investment
annually.
General expenses include charges, insurance
and miscellaneous operating expenses.
Capital costs (recovery and returns). Capital,
whether the initial investment cost of a new
refinery, the costs of revamping an existing one or
of constructing a new plant in an existing
refinery, has to be recouped. It also has to
produce revenue. If an investment is financed
entirely by loan, the corresponding capital costs
include yearly repayments and interest. If the
investment is fully self-financed, the refiner has
to recover its capital and generate revenue.
To return to the example of the refinery with
an annual capacity of 8 million tonnes and
costing 1,5 billion dollars, imagine that the
capital investment is financed entirely by loan
with a repayment period of 10 years and an
interest rate of 8%: the average annual cost will
be about 200 million dollars for the first 10 years
of the refinery’s life, then nil in subsequent years.
This figure breaks down as follows: capital ⫹
interest ⫹ (with the refinery working to full
capacity) a charge of $25 per tonne of crude
processed.
Total cost and attendant factors. Refining
costs depend, as we have seen, on a great many
factors, and this makes it difficult to give accurate
cost estimates. Fixed costs can represent up to
80% of the total cost of processing every tonne of
crude. Of these fixed costs, capital charges are
particularly significant. This means global costs
can vary greatly depending on whether or not the
installation has reached payback point.
If we take the case of the new refinery
equipped with a conventional conversion plant as
described earlier, total costs per tonne of crude
processed are on the order of $35 or more – on
condition, that is, that it is working to its full
annual capacity of 8 million tonnes. Costs per
tonne, of course, increase significantly if the
refinery is working well under capacity.
If, on the other hand, we take the example of a
refinery whose investment has been largely
recouped (which is the case with most refineries
in operation in the principal refining regions),
costs are much lower, even as low as $15 per
tonne. But these refiners too are subject to
expenses resulting from investment in necessary
modernizations, even if only to improve the
quality of their products or reduce the
environmental impact of the refinery.
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
Expressed in terms of tonnes or barrels of
crude processed, these costs are comparable to the
refining margins obtained by the operators
(margins that fluctuate with market conditions).
Other factors, aside from capital costs, play a
more or less-significant role; the foremost of
these is capacity utilization rate. In a refinery
working at 66% of its capacity, unit-fixed costs of
processing are 50% higher than for a refinery
working at 100%. In theory, therefore, it is in the
refiner’s interest to work at the highest possible
capacity. Practices may differ in cases where
excess output in a given refining region can flood
the market and therefore reduce the margins
achieved; in this situation, it may be more in the
refiner’s interest to reduce its capacity utilization
rate, at least temporarily.
As we saw, according to the law of economies
of scale, the larger the refinery the smaller the
unit investment and, consequently, the lower the
capital costs. Furthermore, for a given operating
capacity rate, the larger the refinery is, the lower
the unit processing costs, minus capital. The size
of the refinery has very little bearing on
personnel costs and general expenses, and
maintenance costs rise at a rate far slower than
increases in size; hence the notion of a minimum
cost-effective threshold, which is on the order of
5 million tonnes per year (100,000 barrels per day)
for atmospheric distillation. At present, except in
some very special cases, no smaller refineries
exist.
The complexity and the location of the
refinery influence not only its capital costs but
also costs relating to labour, maintenance and
other issues. As we shall see in the next section,
complex refineries are capable of obtaining
higher margins than simple refineries, which
enables them to cover higher refining costs.
Refining margins
Definitions
The (gross) refining margin for each tonne of
crude processed is the difference between the
ex-works value of the products obtained and the
cost of the crude entering the refinery; the value
realization of the products is calculated by
multiplying their price by their respective yields,
which vary from one refinery to another.
The net margin is equal to the gross margin
minus variable costs, which include chemical
products, catalysts and carrying charges related to
the immobilization, especially the storage, of
crude and products.
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BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY
To reach break-even point, gross margin must
cover total processing costs; to put it another way,
net margin must cover fixed costs, i.e. all outlay
costs and capital costs. The result is thus equal to
net margin minus fixed costs.
We should note that the value realized on
products takes into account the net (i.e. sold)
output of the refinery, that is, after deduction of
internal consumption of refinery gas and fuel oil
for the utilities. This consumption is not
insignificant: in a refinery equipped with a
conventional conversion plant, it represents some
5-6% of the crude processed. For the present
purposes, although it is classified as a variable
cost, we shall not include this consumption in
processing costs as compared against margins.
Typical margins for typical refineries, known
as margin indicators, are published by oil
companies and trade journals. In Europe, margin
indicators typically refer to an imaginary refinery
located in Rotterdam and operating in a highly
competitive environment.
It is also possible to calculate a per-unit
margin, equal to the difference between the value
of the products yielded by the unit and the value
of the feedstock. Unlike finished products,
feedstock and intermediate products do not yet
have any market value. We can however evaluate
the prices of these feedstocks and intermediary
products on the basis of their potential uses; to do
so, we use an opportunity cost, i.e. the price that
the feedstock or product would command if put to
an alternative use.
Per-unit margins are of great interest to
refiners as they indicate which units are
profitable, which have to work at maximum
capacity and which should work at a slower rate.
These economic imperatives are frequently
unworkable owing to technical constraints,
however.
Factors that influence margins
The gross margin obtained by a refinery
essentially depends on its degree of complexity. A
refinery equipped with cracking units for
high-octane gasoline bases produces lighter
products (fuels) that meet extremely strict
specifications and have a higher market value.
Furthermore, a sophisticated refinery can
more readily process heavy or sulphur-rich
crudes, putting its conversion plant to maximum
use. These crudes offer price differentials that are
often substantial in relation to lighter, low-sulphur
crudes, and with higher oil prices, price
differentials widen further.
102
A better margin does not necessarily mean
greater profitability, as the costs for a complex
refinery are higher than those for a simple
refinery. In reality, the margins obtained are
sometimes considerably higher than the published
margins. There are a number of reasons for this.
The published margins refer to the principal
products only (such as motor fuels and fuel oil)
but not to specialist products (oils, bitumens,
LPG, petrochemicals and so on), which are often
a more lucrative activity. For example, stock oils,
which are obtained via increasingly complex
refining processes, and even in some cases
finished oils, generally offer attractive returns.
Some refineries play this situation to their
advantage by producing for niche markets.
Similarly, a refinery that is part of a
petrochemical complex is better positioned to
realize value on certain cuts (naphtha, etc.) and
benefit from lower raw-material rates.
More generally, prices (even prices of the
major products) are often higher than those
applied in margin-indicator calculations where the
refinery has a favourable geographic location: a
refinery located inland, and moreover in an
oil-importing region, will sell its products at
prices higher than those given by the international
indices (Rotterdam, US Gulf, Singapore, etc.).
Changes in margins
Until the mid-1970s, margins had remained at
levels that were broadly satisfactory for the
industry. Increasing consumption of refined
products ensured margins that were capable of
covering long-run marginal costs, including the
recovery of invested capital and the returns
generated. The principal concern of the oil
companies (and of many governments) was how
to satisfy demand. In the larger European
countries, this meant building one new refinery,
or installing the equivalent new capacity, every
year.
Over the decade as a whole, prices for a
typical refinery remained at an average of $2 per
barrel. Taking into account monetary erosion, this
figure would be about $7 per barrel in today’s
money.
At the turn of the decade, though, the situation
changed drastically and margins fell right across
the board. Increases in crude prices in 1973 (as a
result of the Yom Kippur war) and in 1979-80
(with the Iranian revolution) caused consumption
to level out and then to decrease. The enormous
surpluses of fuel oil caused by a decline in
demand and the lack of conversion capacity had
ENCYCLOPAEDIA OF HYDROCARBONS
 ANALYSIS OF COST STRUCTURE AND FUNCTIONS IN OIL TRANSPORT AND REFINING
the effect of widening the gap between fuel-oil
prices, which were already very low, and those of
light products.
At the same time, refining capacity began to
far outstrip supply, especially in Europe and the
US. This overcapacity had two consequences:
since marginal processing costs per barrel were
very low, more and more refiners began to
process more crude, and therefore to add to the
surplus of products (a short-term gain with long-
term consequences). The ultimate result was a fall
in margins.
As total refinery costs had to be spread across
quantities of products far in excess of the optimal
volumes owing to overcapacity, unit costs grew
significantly.
This ‘scissor effect’, in conjunction with
stagnation in consumption in the 1980-85 period,
made itself felt in the form of low profitability,
which forced refiners to reduce their capacity. In
the US, this reduction occurred rapidly and to a
relatively limited extent; however, with the
restructuring of the refining industry, many
smaller, independent refineries closed down. In
Europe it came later but with far more drastic
effect: of 150 refineries, some 50 had to close
down. Also, many of the refineries that survived
saw their distillation capacity slashed as a result
of the closure of older plants; there was even, in
some cases, the conversion of distillation plants
into visbreaking units. In Japan, restructuring was
more limited in scope as the country was a major
importer of products (primarily from Singapore
and the Persian Gulf) and had no excess capacity
problems.
This drive to reduce capacity came to an end
around 1985, at the time of the oil crisis (OPEC
production quota policy and crude oil prices
based on netback agreements). The sharp drop
in crude oil prices that resulted from this policy
relaunched product consumption, which was
also stimulated by new demand from emerging
economies. The fall in the value of the dollar in
the same period was another contributing
factor.
The situation by this time was the reverse of
the 1970s crisis. Margins increased until the end
of the 1980s, reaching levels that, for the first
time in a decade, were entirely satisfactory to
operators.
Margins remained moderate throughout the
1990s at no more than a few dollars per barrel –
far lower than total costs for a new refinery.
There were a number of reasons for this: on the
one hand, world consumption of refined
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
products taken as a whole was growing very
slowly (1-2% per year) during this period; on the
other hand, refinery capacity-utilization rates,
always a key factor for margin trends, were low,
although they were improving towards the end
of the decade.
While capacity was significantly reduced in
most regions (with the notable exception of the
former USSR, which on the very eve of its
demise and the ensuing collapse in demand
found itself with a gigantic overcapacity
problem that, even today, has not yet been fully
absorbed), the mismatch between the supply
structure of the refineries and the demand
structure of the economy persisted for years. In
their efforts to reduce fuel oil surpluses
associated with the lack of conversion capacity,
some refiners found themselves forced to cut
back on their output.
Here, it is worth noting an aggravating factor
in times of overcapacity: real refining capacity is
often higher than the published or stated capacity.
There are several reasons for this:
• Some indicators underestimate real capacity,
and some countries only take into account
distillation capacity necessary for supplying
cracking units. In the former USSR, the real
capacity of most of these units was well above
the design capacity.
• Mothballed capacity can be quickly
reactivated.
• Major progress has been made in addressing
stoppage times for maintenance work.
Intervals between stoppages have stretched
from every two or three years to every five
years; this means a refinery can now operate
more than 95% of the time.
• The phenomenon known as ‘capacity creep’:
the tendency to step up capacity from initial
design capacity caused by limited investments
by refiners in certain units
(‘de-bottlenecking’) that have not yet been
factored into estimates.
So far this decade, the situation has changed
from one year to another: the significant rise in
margins in 2000 was followed by a decrease in
2001, which became more accentuated in 2002, to
be followed by a net improvement with high
margins since 2003.
The reason for this rise in margins is the
significant increase in world demand, driven
mainly by the US and by such emerging
economies as China. This rise in demand is also
the cause of the extremely high
capacity-utilization rate of refineries in many
103
BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY

Fig. 10. Gross refining 12

margin (refinery with Arabian Light
10
cracking – North West Brent Blend
Europe).
8

$/bbl
4

⫺2 crude cost: CIF Europe

products cost: FOB Rotterdam
⫺4
82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
year

regions. It is no longer any exaggeration to
speak of saturation in the refining sector,
especially in conversion units, with the United
States worst affected. Worldwide refining
capacity, not including the persistent
overcapacity in the former USSR (which is
currently on the order of 3 million barrels per
day), can be estimated at a little less than 81
million barrels per day. According to the
International Energy Agency, global production
of crude oil and liquid natural gas reached a
similar level in 2004, at slightly over 81 million
barrels per day (a uneasy equilibrium that is the
perfect illustration of the tension that grips
today’s oil market).
Moreover, major oil consumers such as the US
and Europe (Figs. 10 and 11) are becoming
increasingly dependent on imports for supplying
their oil-product demands (Japan has always been
a major importer).
Margins according to region
Margins vary greatly from one region to
another in the United States, but in general they
are still much higher than in Europe. The lowest
margins are those obtained by complex FCC-type
refineries in the Gulf of Mexico region. This is a
highly competitive, import-intensive region where
margins are affected by refined products arriving
principally from Europe and South America.

$/bbl Rotterdam-Brent-cracking
7 Rotterdam-Brent-hydroskimming
5
3
1
⫺1
$/bbl
⫺3
8 US Gulf-LLS-cracking 95 96 97 98 99 00 01 02 03 04
6
4
2 $/bbl
Singapore-Dubai-hydrocracking
0 7
Singapore-Tapis-hydroskimming
⫺2 5
⫺4 3
95 96 97 98 99 00 01 02 03 04 1
⫺1
⫺3
95 96 97 98 99 00 01 02 03 04

Fig. 11. Development of net refining margins. In the legends: refining centre, crude type, refinery type.
LLS⫽Light Louisiana Sweet.

104 ENCYCLOPAEDIA OF HYDROCARBONS

 ANALYSIS OF COST STRUCTURE AND FUNCTIONS IN OIL TRANSPORT AND REFINING
Margins are much higher in the Midwest and even
more so in California, due partly to the better
balance between supply and demand and partly to
higher prices for products. Californian motor fuel
specifications (the California Air Resources
Board, CARB, regulations) are more stringent
than federal requirements, and this situation is
reflected in prices. In refining regions like the
Gulf of Mexico and California, where many
refineries are equipped to handle heavier crude
oils, refiners can enjoy particularly high margins
when the price differential between heavy and
light crudes widens significantly. This has been
the case since 2003.
In Asia, the situation was favourable until
mid-1997. Margins often reached 3 or $4 per
barrel due to heavy demand and protectionist
measures in certain markets. Serious shortages in
refining capacity made Asia a major importer,
mainly from the Middle East. Margins collapsed
in 1997 as a result of the economic crisis that
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
swept the region at this time and the simultaneous
introduction of new and significant refining
capacity.
In Europe, the margins of a typical complex
refinery located in Rotterdam remained extremely
low throughout the 1990s (on the order of 1 or $2
per barrel) but recovered early this decade.
Bibliography
Favennec J.-P. (sous la coordination de) (1998) Exploitation
et gestion de la raffinerie, in: Le raffinage du pétrole,
Paris, Technip, 1994-1999, 5v.; v.V.
Masseron J. (1991) L’économie des hydrocarbures, Paris,
Technip.
Olivier Appert
Jean-Pierre Favennec
Centre for Economics and Management
IFP School
Rueil-Malmaison, France
105
 2.4

The economics of natural gas

2.4.1 Introduction throughout the thirty-year period, is particularly

Over recent decades, natural gas consumption has
increased in almost all parts of the world at a
significantly higher rate than the consumption of
primary energy as a whole (Table 1). In the period
between 1974 and 2004, consumption grew
worldwide by an annual average of 2.7%,
compared to 1.9% for primary energy, with its
share of total primary consumption increasing
from 19% to 24%.
In some countries and world regions, however,
the disparity between growth rates was far greater.
The rapid growth which occurred in Africa and
Asia, with average annual increases of nearly 10%
striking. However, this growth was paralleled by
large increases in primary energy consumption as a
whole in these regions. Natural gas consumption
grew as rapidly in Japan and Oceania; but the more
limited increase in total primary consumption led
to a five-fold increase in the share of natural gas
during the period under consideration. Europe, too,
was characterized by a rise in gas consumption far
greater than that of primary energy (2.9%
compared to 0.7%), with gas almost doubling its
share during this period. Russia and the other
former Soviet countries represent a case apart;
here, the 35% drop in total energy consumption
following the collapse of the USSR was reflected

Table 1. Contribution of natural gas to meeting primary energy needs in the world regions
between 1974 and 2004 (BP, 2005)

Average annual growth (%) Share of total primary consumption (%)

World regions Natural Primary
Ratio 1974 1984 1994 2004
gas energy*
United States and Canada 0.4 1.1 0.4 30.4 25.8 26.5 25.1
Japan and Oceania 7.1 1.5 4.6 2.8 10.5 12.8 13.8
Europe 2.9 0.7 4.0 12.5 16.0 18.6 23.8
Russia and other former Soviet countries 2.9 0.2 16.0 23.4 35.3 48.5 52.9
Asia 9.3 5.4 1.7 3.1 5.1 7.1 9.5
Middle East 8.3 5.4 1.5 18.8 22.9 32.9 41.9
Africa 9.9 4.1 2.4 3.9 13.1 16.0 19.8
Latin America 5.2 3.4 1.5 14.2 18.5 17.6 23.8
World 2.7 1.9 1.4 18.8 20.8 22.6 23.7

* Excluding non-commercial primary energy.

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BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY

in a drop of only 15% in natural gas consumption.

Moreover, after 1997 natural gas consumption in Table 2. Worldwide consumption of natural gas
this region recovered significantly faster than that in the major use sectors in 2002 (based on IEA data,
of other fuels, and gas now meets over 50% of Natural gas information, 2004)
primary energy needs.
Significant increases in the share of natural gas Use sectors Consumption (Gm3)
over the past three decades were recorded in all
Electricity generation 854.8
regions and practically all the countries in the in power stations 542.2
world with the exception of the United States and in cogeneration plants 312.6
Canada; here levels of penetration were already
high (30%) at the beginning of the period under Other energy sector uses 458.0
consideration. This extraordinary growth can be production of hydrocarbons 234.0
district heating 108.0
attributed mainly to the ease and versatility of use pipeline transportation 67.5
of natural gas and to its greater environmental final distribution 26.0
compatibility which have significantly favoured others 22.5
this source over solid and liquid fossil fuels.
End-uses 1,321.7
Moreover, it was made possible by the rapid Industry and agriculture 628.5
growth in proven natural gas reserves and the chemical and petrochemical 261.7
construction of adequate transport, storage and other heavy industry* 208.7
distribution systems. light industry** 133.1
This chapter starts by examining the main uses other industrial activities*** 25.0
of natural gas and the substitution processes which Civil uses 689.2
have led this fuel to dominate in many sectors and commercial and services 184.8
countries over recent decades. In this context, some residential 504.4
issues will be analysed in depth, such as the
Transportation 4.0
markedly seasonal nature of consumption and the
limited sensitivity to prices which to some extent Total 2,634.5
differentiate natural gas from its major
competitors. The chapter goes on to examine the * Includes ferrous and non-ferrous metals, non-metallic minerals,
size of the resource base, to describe the natural paper and cardboard. ** Includes food, textiles, the mechanical and
vehicle industries, wood and furniture, etc. *** Includes agriculture,
gas cycle and discuss major supply-side issues, construction and mining.
which mainly concern the uneven geographical
distribution and exploitation of the resources and 1 The reference framework for statistics on the demand,
the relatively higher costs of transportation, storage supply and prices of natural gas (and other energy sources)
and distribution. The chapter concludes with an is that of the IEA (International Energy Agency). These
examination of international gas trade and a statistics have been partially integrated with the data
detailed analysis of the liquefied natural gas published annually by CEDIGAZ (Centre International
d’Information sur le Gaz naturel et tous Hydrocarbures
industry, the most dynamic sector for future Gazeux, 1997-2004) and BP (British Petroleum, 2005) and
supplies. with the data available from the databases of the EIA
(Energy Information Administration). The IEA data are from
official government sources; CEDIGAZ and BP data are
prevalently of industrial origin. In practice, all these sources
2.4.2 The demand for natural gas refer to one another, and differences mainly result from the
use of different conventions. The same sources are also cited
Worldwide, the consumption of natural gas is by the World Energy Council (2001).
concentrated in the end-use sectors, which accounted 2 The unit of measurement used for natural gas in this

for 50% of total consumption in 2002, the most recent
year for which homogeneous data on consumption by
sector is available for all world regions.1 This was
followed by the power generation sector with just over
32%, while the remaining 18% went to the other
energy sector uses. Final consumption was shared
almost equally between the residential, commercial
and public sector and the industrial sector, with 52%
and 48% respectively, while a mere 0.3% was used for
passenger and freight transport.
chapter is the cubic metre measured at 15°C and 760 mm of
Hg with a higher calorific value of 9,150 kcal/m3. This value
represents the world average in recent years. Notoriously, the
energy content of natural gas varies significantly from field
to field, with differences as great as 1-2% compared to the
world average. The energy content has also changed over
time; averaged out on a world level, the higher calorific
value at consumption has increased from 9,008 kcal/m3 in
1978 to 9,161 in 2001. It also varies significantly between
production and consumption; for example, worldwide, the
higher calorific value at the wellhead in 2001 was 9,252
kcal/m3.

108 ENCYCLOPAEDIA OF HYDROCARBONS

 THE ECONOMICS OF NATURAL GAS

Table 3. Share of natural gas in energy consumption in the major sectors and world regions in 2002
(based on IEA data, Natural gas information, 2004)

Electricity End-uses (%)

Other energy
generation and Transportation Total
World regions sector uses Industry Civil and
cogeneration of people Total (%)
(%) and agriculture other uses
(%) and goods
United States and Canada 14.0 54.4 39.2 0.1 74.8 28.3 23.1
Japan and Oceania 19.9 3.5 15.2 0.1 21.9 11.2 14.7
Europe 12.3 31.3 36.7 0.1 51.1 28.0 21.4
Russia and other former
40.1 62.8 52.2 0.2 70.6 49.3 48.1
Soviet countries
Asia 9.0 12.8 10.0 0.1 3.5 5.2 7.2
Middle East 46.0 68.4 37.6 0.0 42.2 28.0 37.6
Africa 23.7 17.5 17.8 0.0 2.9 5.3 10.6
Latin America 14.7 48.9 25.2 1.4 12.7 13.1 17.5
World 17.3 37.5 27.4 0.2 28.8 19.5 20.3

End-use functions and substitution
processes
Overview of end-uses and penetration of final
consumption
A more detailed examination of worldwide
consumption by sector (Table 2)2 highlights the
importance of cogeneration (combined generation of
electricity and heat), which accounted for 37% of the
gas consumed in the generation of electricity in 2002.
Other energy sector uses were dominated by oil and
gas production; this, together with consumption by
compressor stations for pipeline transport and final
distribution of gas, accounted for over 70% of
consumption in this sector.
Final consumption was dominated by the residential
sector with 38% of the total, reflecting the convenience
of natural gas for cooking and space heating, despite
the high costs of local distribution. In this context, it is
worth noting the greater importance of gas
consumption in the chemical industry and other heavy
manufacturing sectors compared to light industry,
which is penalised by higher distribution costs
associated with the greater geographical distribution of
the food, textile and mechanical products industries and
their lower unit energy requirements.
An examination of the contribution made by
natural gas to meeting the energy needs of each sector
is provided in Table 3 with reference to the eight large
world regions introduced in Table 1. The choice of
world regions is based mainly on the availability of
organized statistical data, but nonetheless seems
appropriate for the purposes of the present analysis
since it identifies areas where the main substitution
factors in energy supply and demand are relatively
homogeneous.3 A more detailed breakdown for each
individual country would certainly provide a more
accurate and tangible view of the development of
natural gas in different local contexts. However, given
the multiplicity of different situations, the resulting
picture would be fragmentary and partial and would
greatly complicate this overview. The chosen
subdivision is also well suited to the examination of
supply and of the other components of the natural gas
system dealt with later in this chapter.
Table 3 shows a degree of penetration worldwide
increasing from a minimum of barely 0.2% for
3 For reasons of economic, energetic, historical and
cultural homogeneity, the definition of world regions used
here does not correspond fully to that of the IEA, which, in
addition to geographical contiguity or proximity, privileges
institutional, political and commercial affinities. These
differences essentially concern South Korea, Mexico and
Turkey, which in this chapter are incorporated into Asia,
Latin America and the Middle East respectively. In the IEA’s
subdivision, by contrast, South Korea is included in the
Asia-Pacific region alongside Japan, Australia and New
Zealand; Mexico in North America, alongside the United
States and Canada; Turkey in Europe. This analysis also
required the reclassification (where possible) of the Baltic
countries, which in the original historical series of the IEA
were included in the former Soviet region, whereas in this
chapter they are part of Europe. The other republics are
included in the region of Russia and the other former Soviet
countries. Only the definition of Africa is identical to that of
the IEA. In any case, the differences between the two
classification systems are relatively small, and do not modify
the description of the characteristics of the natural gas sector.

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BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY
passenger and freight transport to 17% for electricity
generation,4 27% in industry and 29% in residential,
commercial and public sector, reaching a maximum
of 38% in the other energy sector uses. The data
reported show that the degree of penetration in
different sectors varies significantly from region to
region, at times by more than an order of magnitude
compared to the world average. This significant
variability can be traced to differences in
fundamental factors related to: a) the level of
economic, demographic and urban development;
b) the availability and exploitation of oil and gas
resources; c) the relative convenience of alternative
energy sources; d ) the existence of gas transport and
distribution networks; e) climatic conditions;
f ) energy and environmental policies.
It is not surprising, for example, that penetration is
high in all sectors in relatively developed regions, with
ample reserves and net exporters of natural gas
(Russia and the other former Soviet countries, Middle
East). A high degree of penetration of natural gas is
also found in net importing regions with relatively
scarce or decreasing resources but enjoying high levels
of economic and urban development and with decades
old transport and distribution systems (United States
and Canada, Europe). In these regions, however,
penetration in the power generation sector is lower due
to competition from other sources, notably coal and
nuclear power.
By contrast, the share of gas is fairly low, even in
the residential, commercial and public sector and in
industry, in regions characterized by strong
economic and urban development but high supply
costs (Japan and Oceania, represented on the
demand side mainly by Japan). Penetration is
particularly low in regions with lower or
intermediate levels of economic development
lacking logistic transport and distribution systems,
especially when they do not possess ample natural
gas resources (Asia). Even in regions with
substantial resources, the share of natural gas may
be relatively low due to insufficiently developed
transport and distribution infrastructures, as well as
to competition from other primary sources such as
coal and hydropower (Africa and Latin America).
Historical trends
The distribution of natural gas among end-use
sectors has changed considerably over the course of
recent decades, as shown in Table 4. Worldwide, the
significant increase in the share of electricity
generation is reflected in a decrease in the share of
industrial end-uses, while the residential, commercial
and public sector and other energy sector uses have
maintained an almost constant share. At the beginning
110
of the period, industrial uses accounted for 35% of
total gas consumption, compared to 22% for electricity
generation, 27% for the residential, commercial and
public sector and 16% for other energy sector uses. By
2002, these shares had essentially been reversed, with
electricity generation accounting for 36%, buildings
for 26% and industry for 23%.
However, the global pattern compensates and
masks fairly divergent patterns in individual
geographical regions, largely reflecting developments
in the major consuming areas: the United States and
Canada, Europe, Russia and other former Soviet
countries, which together accounted for 94% of world
gas consumption in 1971 and for 74% in 2002.
Nevertheless, the historical decline in the share of
industrial uses and the strong increase in electricity
generation is common, to a greater or lesser extent, to
all eight regions except Africa. The obvious
explanation is the high cost of power generation from
natural gas compared to oil until the early 1970s; to
which should be added the political decision in many
countries, particularly in Europe, to save the less
polluting gas (compared to oil and coal), for more
‘noble’ purposes in industry, such as chemical
feedstock and the residential and commercial sectors.
The use of gas took priority in the industrial sector,
given the greater geographical concentration of
consumption and the consequent lower cost of supply.
Large industrial plants could usually be reached with
relatively short connections to regional and national
transport networks,5 whereas supply to the residential
and commercial sector required the construction of
extensive distribution networks under towns and
suburbs.
By contrast, the pattern of consumption in the
residential, commercial and public sector varies
markedly with the region. This sector’s share of total
natural gas consumption has remained essentially
unchanged, albeit with minor oscillations, in the United
States and Canada, and Latin America, and has fallen
only slightly in Japan and Oceania. In other regions it
has risen more or less sharply, especially in the less
4 As far as generation from thermonuclear,
hydroelectric, geothermal and other non-combustible
renewable sources (unless otherwise specified) is concerned,
the convention which attributes to these a performance
identical to the mean of the thermoelectric generation
replaced is adopted. As such, the data reported on electricity
generation from non-fossil fuels differ significantly from
those supplied by IEA statistics, which assume a
performance of 100% for hydroelectric power, 33% for
nuclear energy, 10% for geothermal energy; in calorie terms
860, 2,600 and 8,600 kcal/kWh respectively.
5 In many countries, the early transport networks were
usually planned to supply large concentrations of demand in
the industrial sector.
ENCYCLOPAEDIA OF HYDROCARBONS
 THE ECONOMICS OF NATURAL GAS

Table 4. Distribution of worldwide natural gas consumption by use sector during the period 1971-2002
(based on IEA data, 1960-2004; 1971-1987; 1989-2001; 1996-2004; 2001-2004)

Distribution among uses (%)

Total
World regions and years consumption Electricity Industry Civil
Other energy
(Gm3) generation and
sector uses
and and other Total
cogeneration agriculture uses

United States and Canada

1971 666 17.4 16.7 32.1 33.8 100.0
1981 615 17.0 13.7 33.5 35.7 100.0
1991 625 20.1 16.4 26.6 37.0 100.0
2002 741 25.4 12.8 27.1 34.7 100.0

Japan and Oceania

1971 6 31.3 0.6 47.4 20.7 100.0
1981 39 59.7 2.9 20.4 17.1 100.0
1991 78 61.3 3.6 18.0 17.1 100.0
2002 115 58.9 3.9 20.0 17.2 100.0

Europe
1971 147 19.2 10.1 43.0 27.7 100.0
1981 314 15.0 11.3 39.5 34.1 100.0
1991 399 16.6 16.8 30.5 36.0 100.0
2002 526 25.1 11.0 27.0 37.0 100.0

Russia and other former Soviet countries

1971 233 36.5 16.5 36.2 10.8 100.0
1981 402 36.7 13.3 36.4 13.7 100.0
1991 709 52.4 7.9 26.2 13.5 100.0
2002 586 52.8 12.0 13.8 21.4 100.0

Asia
1971 10 18.9 32.1 44.7 4.3 100.0
1981 31 13.9 29.9 49.0 7.2 100.0
1991 98 28.3 29.9 33.5 8.4 100.0
2002 239 41.2 19.4 27.1 12.3 100.0

Middle East
1971 21 6.3 25.5 61.1 7.1 100.0
1981 41 38.9 23.4 29.8 7.9 100.0
1991 114 28.2 32.9 24.7 14.2 100.0
2002 233 36.4 19.1 22.6 22.0 100.0

Africa
1971 3 15.5 66.1 15.0 3.4 100.0
1981 18 33.2 43.8 20.2 2.8 100.0
1991 43 31.1 43.2 21.4 4.3 100.0
2002 73 45.8 22.9 19.6 11.7 100.0

Latin America
1971 28 25.5 24.9 41.0 8.6 100.0
1981 64 20.5 23.3 49.6 6.6 100.0
1991 91 24.2 25.6 41.4 8.8 100.0
2002 151 29.9 32.2 29.1 8.8 100.0

World
1971 1,114 21.7 16.3 35.3 26.6 100.0
1981 1,524 23.7 14.2 35.9 26.1 100.0
1991 2,157 32.7 15.6 27.6 24.0 100.0
2002 2,664 36.0 14.4 23.4 26.2 100.0

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BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY
developed Africa, Asia and the Middle East where,
starting from extremely low values, it has practically
tripled in the last thirty years. However, only in the
United States and Canada, and in Europe, is the degree
of penetration greater than 35%, while in the other
regions it has remained in the 10 and 20% bracket.
Other energy uses show stability or decline in
almost all regions, due to the decreasing importance of
oil and gas production and transport compared to other
uses. The high share of gas consumed in this sector in
Africa in 1971 (66%) reflects the production of
Algerian and Libyan gas almost exclusively for export
during this early period. On the other hand, a
decidedly upward trend is seen for Japan and Oceania,
and for Latin America, linked to the development of
natural gas resources in Australia, Argentina, Bolivia,
Mexico and more recently in Trinidad and Tobago.
Factors of substitution
Over recent decades, natural gas has found ample
room for new applications, especially in regions with
less developed economies, driven in part by the
increase in energy requirements and constraints on the
potential of traditional sources (oil and coal).
The faster growth of gas compared to most
alternative sources of energy has led to a significant
and often vigorous penetration which can be
interpreted as form of substitution for other sources.
The following overview of the historical dynamics of
natural gas penetration in the different world regions
in the major end-use sectors (electricity generation,
industry and buildings)6 is useful for a better
understanding of the factors of substitution favouring
the growth of this source over most others.
Penetration in industrial uses
Historically, industry was the sector in which
natural gas first gained importance in practically all
countries of the world. It is in large plants consuming
great amounts of energy located in areas close to
production fields that natural gas is most convenient; a
pipeline extension is quite suitable without any need
for an extensive distribution network. As shown in
Table 5, by the early 1980s natural gas already met
over 20% of industrial final consumption in all the
most industrialized regions, except Japan and Oceania,
and in two of the four less developed regions (Middle
East and Latin America).
Before the development of large international
transport systems, conditions favouring the
development of natural gas, differed considerably
within the large regions into which the world has been
divided for the purposes of this analysis. In Europe in
the early 1980s, natural gas accounted for 40% of final
industrial consumption in the Netherlands and 25% in
112
Italy, but less than 10% in Switzerland and Sweden.
Similarly, the relatively high penetration of natural gas
in the industrial sector in Latin America mainly
reflects the availability of this resource in Argentina,
Mexico and Venezuela.
Asia, with the exception of Indonesia and a few
other South-East Asian countries, does not possess
large natural gas resources, and the substitution of coal
and oil is a much more recent phenomenon. A similar
situation exists in Japan and Oceania, a region with
significant gas resources only in Australia but
dominated by the energy requirements of Japan, a
country which was accessible by sea using
technologies which had only recently been developed
in the early 1980s.7 The African continent comprises
countries (Algeria and Nigeria) with large natural gas
resources, others (South Africa and Zimbabwe) with
huge coal deposits, and yet others which, lacking
significant resources, utilise local biomass fuels in
small and medium-sized factories, and oil products in
larger plants.
The enormous convenience of natural gas in the
industrial sector, even in countries without significant
resources or distant from the world’s largest fields, is
evident from the significant degree of penetration
witnessed in Japan and Oceania and in Asia from 1980
onwards. By contrast, the strong increase in Africa
mainly reflects the process of industrialization,
especially in some North African countries and in
Nigeria. Following the oil crises of the 1970s and the
increasing sensitivity to the environment, almost all
European countries have adopted energy policies
encouraging the development of natural gas for most
uses.
However, in a number of regions and in some
countries natural gas consumption in industry has
undergone some back substitution in the 1980s in
favour of competing energy sources. In the Middle
East, in the absence of suitable transport and
distribution infrastructure, natural gas has not
managed to keep pace with the high growth in energy
requirements over the past decade and has lost ground
6 Consumption of natural gas in the other energy uses
sector is correlated mainly with the production of oil and
gas, and is not significantly affected by substitution with
other sources; as such, it is not considered in this context.
Similarly, there is no detailed examination of the uses of
natural gas in passenger and freight transport, since this is
negligible almost everywhere, and depends entirely on the
support policies adopted by individual countries while
awaiting technological advances, e.g. in the field of fuel
cells.
7 The transportation of liquefied natural gas began in
1964 and accounted for 15% of international gas trade in
1980.
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 THE ECONOMICS OF NATURAL GAS

Table 5. Penetration of natural gas in industrial end-uses between 1980 and 2002
(based on IEA data, 1960-2004; 1971-1987; 1989-2001; 1996-2004; 2001-2004)

Total Distribution among sources (%)

World regions and years consumption Coal and Oil Natural
(Mtoe) Renewables Electricity Total
derivatives products gas
United States and Canada
1980 500 10.5 29.9 34.1 10.3 15.2 100.0
1990 437 10.9 23.5 32.9 12.3 20.4 100.0
2002 432 6.4 25.1 36.3 9.7 22.4 100.0

Japan and Oceania

1980 132 17.9 48.8 5.2 4.2 24.0 100.0
1990 148 16.2 45.2 8.0 4.4 26.1 100.0
2002 164 15.1 41.5 12.2 3.6 27.6 100.0

Europe
1980 476 17.7 34.2 23.2 8.2 16.8 100.0
1990 422 17.6 26.1 26.4 8.0 21.9 100.0
2002 392 9.2 28.4 29.8 7.0 25.6 100.0

Russia and other former Soviet countries

1980 446 13.5 19.4 28.8 25.9 12.5 100.0
1990 455 8.6 15.9 39.4 21.2 15.0 100.0
2002 212 11.9 10.8 31.4 28.2 17.7 100.0

Asia
1980 292 58.3 21.3 4.6 5.7 10.0 100.0
1990 453 54.6 19.9 6.3 6.9 12.2 100.0
2002 647 36.2 26.9 8.4 9.5 19.0 100.0

Middle East
1980 42 7.9 61.5 23.7 0.3 6.6 100.0
1990 63 7.7 44.7 38.6 0.4 8.6 100.0
2002 117 6.8 46.2 37.1 0.3 9.7 100.0

Africa
1980 62 27.0 20.3 4.8 34.2 13.6 100.0
1990 76 21.3 18.8 10.8 33.5 15.6 100.0
2002 82 17.7 18.2 15.4 28.7 20.1 100.0

Latin America
1980 116 5.1 34.3 20.7 28.1 11.8 100.0
1990 149 5.6 28.4 20.8 30.6 14.7 100.0
2002 167 6.1 29.8 21.8 22.0 20.2 100.0

World
1980 2,066 20.2 29.2 22.6 13.6 14.4 100.0
1990 2,203 21.0 23.9 24.4 13.3 17.4 100.0
2002 2,213 17.2 27.3 22.9 11.6 21.0 100.0

to oil products. The reduction in the United States and
Canada which occured in the 1970s and 1980s reflects
the decline of the natural gas industry in the United
States until reforms in this sector took effect in the
early 1990s.8
The decline seen in Russia and other former Soviet
countries is more difficult to interpret, given the
disruptions accompanying the collapse of the Soviet
economy. The decrease in the share of natural gas in
the share of coal (almost unique in the world) and a
significant growth in renewable sources, which in this
region almost exclusively consist of the heat produced
in cogeneration and district heating plants. The overall
effect of this decline is that, worldwide, natural gas use
in industry has appeared to lose ground to oil products
over the past decade and especially to electricity,
8 Deregulation of production during the 1980s and of

the industrial sector was accompanied by a recovery in transport and distribution between 1985 and 1992.

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BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY

Table 6. Penetration of natural gas in residential, commercial and public end-uses between 1980 and 2002
(based on IEA data, 1960-2004; 1971-1987; 1989-2001; 1996-2004; 2001-2004)

Total Distribution among sources (%)

World regions and years consumption Coal and Oil Natural
(Mtoe) Renewables Electricity Total
derivatives products gas
United States and Canada
1980 433 1.9 23.5 43.3 2.6 28.8 100.0
1990 450 2.1 16.4 40.9 2.0 38.6 100.0
2002 515 0.5 12.0 40.9 1.5 45.1 100.0

Japan and Oceania

1980 71 0.7 55.8 12.1 1.9 29.7 100.0
1990 100 1.1 44.5 12.9 1.6 40.0 100.0
2002 139 0.2 43.3 12.8 2.7 41.0 100.0

Europe
1980 453 15.5 38.3 19.9 9.4 17.0 100.0
1990 461 11.0 25.3 26.0 14.4 23.3 100.0
2002 480 2.7 22.4 33.4 13.4 28.0 100.0

Russia and other former Soviet countries

1980 266 25.3 27.1 19.7 20.2 7.8 100.0
1990 339 15.5 22.3 27.2 25.7 9.3 100.0
2002 276 3.7 9.9 37.5 36.8 12.1 100.0

Asia
1980 579 16.1 6.7 0.3 74.5 2.4 100.0
1990 742 18.6 8.5 0.9 67.1 4.9 100.0
2002 866 8.8 14.2 3.1 62.4 11.5 100.0

Middle East
1980 31 5.9 55.9 9.2 12.0 17.0 100.0
1990 79 3.8 52.3 17.0 8.2 18.7 100.0
2002 133 1.0 36.2 31.7 6.3 24.8 100.0

Africa
1980 146 1.9 7.8 0.3 86.6 3.4 100.0
1990 196 1.5 8.1 0.7 84.6 5.1 100.0
2002 260 1.1 9.8 2.7 80.4 6.0 100.0

Latin America
1980 91 0.2 33.9 4.2 48.4 13.3 100.0
1990 101 0.2 34.6 7.1 37.1 21.0 100.0
2002 122 0.1 32.8 9.1 29.8 28.3 100.0

World
1980 2,070 11.8 23.4 16.8 34.5 13.5 100.0
1990 2,468 10.5 18.8 17.7 35.3 17.6 100.0
2002 2,791 3.8 17.7 20.8 34.8 22.9 100.0

whose penetration in industrial sector uses is in any
case considerably more vigorous than that of natural
gas, albeit at lower levels.
Penetration in the residential, commercial and
public sector uses
Natural gas use in the residential, commercial
and public sector developed with a significant delay
compared to the industrial sector, mainly due to the
high costs and protracted development of
distribution networks required to send gas from the
production fields and long distance transport
networks to end-users (houses, shops, public
buildings, etc.). In fact, only in the United States and
Canada did the share of natural gas in the
residential, commercial and public sector exceed
20% in 1980 (Table 6). Europe, Russia and the other
former Soviet countries exceeded this share in the
early 1980s, while the high penetration of gas (above
40%) attained in the United States and Canada was

114 ENCYCLOPAEDIA OF HYDROCARBONS


destined to fall in later years, under pressure from
the faster growing electricity.
With the exception of this region, where natural
gas uses in the residential, commercial and public
sector seem close to saturation, consumption of this
fuel has grown at an impressive rate at the expense of
all other sources, with the exception of electricity. The
Middle East, where the share of gas has risen from
10% to 30% in only two decades, is a striking case.
However, even the other less developed regions in the
world (Africa, Latin America and Asia) promise an
extremely high rate of penetration as urban
distribution networks are developed.
In the more developed regions, ongoing
penetration trends are reflected in the decline in the
use of oil products, the main competing sources in the
residential, commercial and public sector, and are
matched only by the faster growth of electricity. In the
less developed regions of Asia, Africa and Latin
America, the main declining fuel in the residential,
commercial and public sector is biomass, since oil
products retain an important edge over natural gas
outside urban areas not yet reached by distribution
networks. In these areas of the world, gas consumption
in the buildings sector is more strongly correlated with
the typically high population growth and urban
migration, since gas distribution networks are built
mainly in capital cities and larger towns, whereas links
to smaller towns are developed much more gradually
unless they happen to be close to transport lines.
The Japan and Oceania region is an unusual case;
here the degree of penetration of natural gas in the
residential, commercial and public sector has remained
stable at around 12% over the past two decades. In this
region, the high costs of natural gas supply in Japan,
which dominates consumption in this region, has
reduced its convenience compared to alternative oil
products, and utilisation in the residential, commercial
and public sector are concentrated almost exclusively
in the vicinity of gas-fired power stations, in turn
located close to regasification terminals.
In the United States and Canada, Japan and
Oceania and in Europe, consumption in buildings are
concentrated in the residential sector (70%, 69% and
83% respectively). The data available for other world
regions show a higher concentration (on average about
40-50%) in the commercial and public sectors, due to
the warmer climate and reduced space heating needs
(in most of Asia, the Middle East, Africa and in many
countries of Latin America) or to the widespread use
of district heating (Russia and the other former Soviet
countries). In these countries, residential sector
consumption is concentrated in cooking uses, usually
too low to justify the construction of extensive
distribution networks.
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THE ECONOMICS OF NATURAL GAS
Penetration in electricity generation
Electricity generation is the sector with the highest
rate of natural gas penetration over the past two
decades (Table 7). Worldwide, its share in terms of
primary energy input to power generation has risen
from less than 12% to over 17%. Although this
phenomenon is universal, the degree and dynamics of
penetration vary considerably between countries,
depending on the relative convenience of alternative
resources and the energy policies adopted.
Historically, strong recourse to natural gas for
electricity generation is found only in the Middle East
and in Russia and the other former Soviet countries,
the regions which have the largest resources of this
fuel. In Russia and most other former Soviet countries,
natural gas has rapidly replaced oil and even coal, and
now dominates the electricity generation sector with
40% of total inputs. In the Middle East, natural gas
overtook oil in the mid-1990s, and would probably
have reached 60% of total input today were it not for
the contribution of coal towards electricity generation
in Turkey and Israel.9
At the beginning of the 1980s, aside from these
two regions, only the United States and Canada and
Japan and Oceania had a the share of natural gas
greater than 10%. In the United States, gas-fired
generation was important only in those states with
significant reserves compared to coal (Texas,
Louisiana, etc.); the decline in share during the 1980s
reflected the drop in gas production, which lasted until
reforms in the sector. Since the second half of the
1970s, Japan has adopted a diversification policy
aimed at excluding oil to the benefit of all other
sources, including coal. Electricity generation in Japan
and Oceania, as a whole, nevertheless continues to be
dominated by this source due to the contribution of
Australia, where coal accounts for almost 80% of total
input to electricity generation; the share of natural gas
is similar to that of nuclear energy (produced only in
Japan).
In Africa gas utilisation in power generation is
influenced by the markedly different endowment of
gas and coal resources in the northern and southern
parts of the continent. The relative robustness of
coal reflects the importance of the South African
economy in the African region as a whole, while the
vigorous penetration of natural gas reflects the
strong growth of the North African, Nigerian and a
few other economies. In this region, oil-fired
generation continues to be important (at least in the
short term) due to its greater convenience compared
to power transmission to small and widely scattered
9 In the case of Israel, due to political circumstances
rather than to economic convenience.
115
BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY

Table 7. Penetration of natural gas in electricity generation between 1980 and 2002
(based on IEA data, 1960-2004; 1971-1987; 1989-2001; 1996-2004; 2001-2004)

Total Distribution among sources (%)

World regions and years consumption Natural
(Gm3) Coal Oil Nuclear Renewables Total
gas
United States and Canada
1980 656 46.8 9.7 13.3 11.0 19.2 100.0
1990 879 46.4 3.5 10.4 18.9 20.8 100.0
2002 1,177 44.5 3.0 14.0 19.7 18.8 100.0

Japan and Oceania

1980 158 19.5 38.9 11.0 11.9 18.7 100.0
1990 213 25.4 23.1 17.2 19.7 14.6 100.0
2002 281 36.7 9.6 19.9 21.9 11.9 100.0

Europe
1980 585 44.2 15.6 6.2 10.4 23.5 100.0
1990 760 35.7 7.6 7.0 26.9 22.8 100.0
2002 828 29.4 4.9 12.3 29.0 24.5 100.0

Russia and other former Soviet countries

1980 428 32.4 25.1 22.7 5.6 14.3 100.0
1990 592 24.1 11.5 38.7 12.2 13.5 100.0
2002 444 21.1 3.7 40.1 17.9 17.2 100.0

Asia
1980 205 46.1 25.4 1.5 2.3 24.8 100.0
1990 410 55.3 11.7 4.5 6.6 21.9 100.0
2002 878 61.9 6.0 9.0 6.6 16.5 100.0

Middle East
1980 26 0.0 61.6 28.2 0.0 10.2 100.0
1990 53 4.5 47.8 41.4 0.0 6.3 100.0
2002 152 11.2 36.9 46.0 0.0 6.0 100.0

Africa
1980 52 51.8 14.5 7.8 0.0 25.8 100.0
1990 77 51.1 14.6 14.5 2.7 17.2 100.0
2002 117 44.8 10.4 23.7 2.5 18.6 100.0

Latin America
1980 114 2.1 25.0 9.2 0.7 63.1 100.0
1990 170 3.4 17.2 9.9 2.1 67.4 100.0
2002 255 4.5 16.1 14.7 3.0 61.7 100.0

World
1980 2,224 38.6 19.2 11.8 8.2 22.2 100.0
1990 3,154 36.5 10.1 15.2 16.4 21.8 100.0
2002 4,132 38.5 6.8 17.3 16.5 21.0 100.0

towns in rural areas. Similar conditions prevail in
Asia, with some countries richly endowed with coal
resources (China and India) and others with oil and
gas (Indonesia, Malaysia, Thailand). Aside from
Japan and Oceania, this is the only region
characterized by an increasing share of coal-based
generation, which now accounts for over 60% of
total input. By contrast, despite its rapid penetration,
natural gas currently accounts for less than 10% of
the total.
Trends in Europe reflect the impact of energy
policy choices in individual countries more than
economic convenience. In this context, the role played
by nuclear power is all important; during the two
decades under consideration, this resource tripled its
share of primary input into generation. Substitution by
this fuel has taken place not only at the expense of oil,
which was in any case of minor importance by 1980,
but also of coal and has certainly slowed the growth of
natural gas, which had the next to lowest share with

116 ENCYCLOPAEDIA OF HYDROCARBONS


barely 12% of the total in 2002. In this context, it is
worth remembering the position of the European
Commission, which in the late 1980s was still
discouraging the use of natural gas for electricity
generation, in favour of the buildings sector and
industrial uses.
Latin America is the only region where electricity
generation is dominated by renewable energy
(essentially hydropower). The lack of gas
transportation infrastructure has restricted the use of
this source for electricity generation in those countries
which possess the largest resources (Argentina,
Bolivia and Venezuela), while hydropower is
well-distributed throughout the region. It is also
significant that Colombia, a coal-exporting country,
generates most of its electricity from natural gas and
not from coal. Like other less developed regions, the
use of oil for electricity generation continues to be
important since it allows for the reaching of rural areas
with small-scale plants without building large
electricity transmission networks.
The seasonality of consumption
Energy demand is by its very nature seasonal. It
varies with the season and month of the year as a
function of climatic, economic and social factors
prevailing in each country. Different forms of energy
are often characterised by an even greater degree of
seasonality, depending on the availability of resources
and the technical constraints affecting their production
and transport.10 Natural gas stands out from other
fossil fuels due to the more marked seasonal variation
of demand, related to the particular combination of
end-uses, and the higher cost of managing seasonality
compared to alternative sources such as oil derivatives.
As these two aspects are inseparable, they will be dealt
with together.
Seasonality and sectoral requirements
The seasonal pattern of natural gas consumption
varies markedly from country to country as a function
of sectoral uses, especially the production of heat for
space heating, power generation and oil and gas
production. It also varies over time depending on the
different sectoral growth in consumption. In the
following analysis seasonality is examined with
reference to the excursion in consumption, defined as
the ratio of maximum to minimum monthly
consumption observed over the course of a period of
time. Consumption patterns in the intervening months
may be important for the technical management of
supply; however, this is not the subject of this
chapter.11 Table 8 compares the average excursion
during the period 2001-04 for all the countries
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
THE ECONOMICS OF NATURAL GAS
belonging to the IEA,12 in decreasing order, together
with the sectoral distribution of gas consumption
during the period 2001-02, the last years for which
data are uniformly available.
The excursion tends to increase in proportion to
the share of consumption in the residential,
commercial and public sector and district heating,
which is in any case linked mainly to the space heating
needs of buildings. Indeed, the only difference is that
space heating in buildings entails combustion in
individual boilers installed on end-user premises,
while district heating employs large centralized plants
with distribution of the heat produced, sometimes with
the cogeneration of electricity. Consumption for
industrial uses also contributes to the excursion,
especially when this is concentrated in light industry
(mechanical, textile, food industries) where space
heating in working areas often accounts for a very
significant portion of final consumption.
By contrast, consumption for power generation and
energy sector uses (mainly the production and
transport of oil and gas) are generally more evenly
distributed over the course of the year and tend to
flatten the seasonal consumption cycle. The variation
is also reduced by the consumption of gas in heavy
industry, where requirements largely reflect process
uses, which tend to be relatively stable over the course
of the year. The table shows the breakdown of OECD
(Organization for Economic Cooperation and
Development) countries into three classes of
seasonality in relation to the distribution of gas
consumption among major sectors,13 distinguishing
10 Hydropower and other renewable sources are
emblematic in that their availability depends on climatic
conditions. In some sectors, particularly electricity
generation, the changing availability of renewable sources
during the year can determine a significant seasonal pattern
in the use of fossil fuels and other non-renewable resources.
11 For example, the management of storage facilities
may be critical if cold winter weather lasts longer than
expected.
12 With the exception of the Republic of Slovakia, for
which IEA data are available only from the second half of
2004. Organized monthly consumption data are not available
for countries outside the IEA. However, the patterns are
consistently replicated except in countries with weak
climatic changes, where gas consumption is relatively stable
over the course of the year.
13 The only exception is Norway (not reported in Table
8), which has an average variation of 8.5 but a share of
seasonal consumption of only 0.4%. This country’s natural
gas consumption is concentrated in the production of oil and
gas (86%) and almost all its natural gas production (99%,
excluding consumption for production) is exported. The
high average variation is linked to the production regime,
which tends to closely track the requirements of importing
countries, characterised by generally high seasonality.
117
BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY

Table 8. Seasonality as a function of sectoral consumption in OECD countries during the years 2001-04
(based on IEA data, 1960-2004; 1971-1987; 1989-2001; 1996-2004; 2001-2004)

Share (%) Share of gas consumption by sector (%)

Average
Countries Stable Seasonal Energy Electricity District Heavy Light Civil
variation* Total
consumption** consumption*** sector generation**** heating**** industry industry uses
Countries with marked seasonality
France 4.9 28.6 71.4 1.0 2.0 5.9 25.6 13.8 51.6 100.0
Czech Republic 4.8 27.0 73.0 1.4 2.1 16.3 23.5 9.5 47.2 100.0
Switzerland 4.3 23.7 76.3 0.0 1.8 5.9 22.0 8.8 61.6 100.0
Sweden 4.2 29.1 70.9 0.2 0.4 37.3 28.6 15.1 18.4 100.0
Hungary 4.1 25.5 74.5 1.8 13.4 15.0 10.3 7.3 52.2 100.0
Countries with intermediate seasonality
Germany 3.2 38.3 61.7 1.5 15.2 5.0 21.7 7.4 49.3 100.0
Austria 3.2 48.6 51.4 7.7 17.0 16.8 23.8 5.4 29.3 100.0
Denmark 2.9 36.1 63.9 13.1 16.6 33.4 6.5 10.6 19.9 100.0
South Korea 2.8 35.9 64.1 0.0 25.5 10.8 10.4 6.6 46.7 100.0
Italy 2.7 41.9 58.1 0.5 21.7 10.1 19.7 10.9 37.1 100.0
Netherlands 2.4 31.7 68.3 4.1 20.6 10.9 6.9 14.3 43.1 100.0
Luxembourg 2.4 37.4 62.6 0.0 19.4 4.7 18.0 30.5 27.5 100.0
United Kingdom 2.3 46.3 53.7 8.3 26.7 4.2 11.4 5.6 43.9 100.0
Poland 2.3 41.6 58.4 8.5 0.8 7.5 32.3 6.0 45.0 100.0
Finland 2.3 44.8 55.2 6.9 14.6 50.6 23.3 2.7 1.9 100.0
Belgium 2.2 49.3 50.7 0.4 13.2 9.4 35.7 2.7 38.6 100.0
Countries with weak seasonality
Canada 1.9 50.4 49.6 20.2 10.0 1.4 20.2 11.5 36.8 100.0
Greece 1.8 92.3 7.7 1.8 74.4 1.2 16.1 5.2 1.3 100.0
United States 1.8 51.3 48.7 8.5 21.8 6.2 21.0 6.5 35.9 100.0
Turkey 1.7 62.2 37.8 0.5 51.4 13.9 10.3 2.1 21.8 100.0
Australia 1.6 73.4 26.6 15.1 24.9 3.4 33.4 4.6 18.5 100.0
Portugal 1.6 73.1 26.9 0.0 46.8 8.0 26.4 9.5 9.4 100.0
Spain 1.6 55.5 44.5 0.1 10.5 10.2 45.0 16.0 18.3 100.0
Ireland 1.5 71.1 28.9 0.0 53.0 1.8 18.2 5.3 21.8 100.0
New Zealand 1.4 81.5 18.5 2.5 40.1 1.7 38.9 9.0 7.8 100.0
Japan 1.3 75.9 24.1 0.5 66.8 0.3 8.7 5.0 18.7 100.0
Mexico 1.2 95.6 4.4 35.5 39.1 0.0 21.0 2.2 2.2 100.0

* Mean value of the ratio of maximum to minimum monthly consumption observed during the years 2001-04. ** Referring to consumption
in the energy, electricity generation and heavy industry sectors. *** Referring to consumption in the district heating, light industry and civil
sectors. **** In the case of cogeneration plants, gas consumption has been shared between electricity generation and district heating
proportionally to the production of electricity and heat.

118 ENCYCLOPAEDIA OF HYDROCARBONS

 THE ECONOMICS OF NATURAL GAS

countries with weak countries with intermediate countries with

excursion excursion marked excursion
120 50 14

45
12
100
40
natural gas consumption (Gm3)

natural gas consumption (Gm3)

natural gas consumption (Gm3)

35 10
80
30
8
60 25
6
20
40
15 4

10
20
2
5

0 0 0
January-01
July-01
January-02
July-02
January-03
July-03
January-04
July-04

January-01
July-01
January-02
July-02
January-03
July-03
January-04
July-04

January-01
July-01
January-02
July-02
January-03
July-03
January-04
July-04
Fig. 1. Monthly consumption trends of natural gas in OECD countries grouped
according to seasonal variation (2001-04).

between countries where the share of consumption production cycle (intermediate processes and storage)
linked to space heating (buildings, district heating and which effectively regulate flows from production to
light industry) is indicatively: over 70% with final consumption. In the case of oil, these are:
excursion greater than 4; between 50 and 70% with pipeline or oil tanker transport, crude oil storage
excursion between 2 and 4; less than 50% with facilities at ports, railway stations and refineries, the
excursion lower than 2. refining process itself and product storage facilities
Fig. 1 aggregates the data for all the countries both at the refinery and at land and sea transport hubs
falling into the three categories. Overall, countries and finally storage located at end-user premises.
with marked seasonal excursion show a 6-fold increase For both oil and natural gas, geology and the
from minimum to maximum monthly consumption, porosity of geological strata limit the potential for
countries with intermediate excursion a 3-fold increase adapting production profiles to demand to cases where
and countries with weak excursion an increase of just production can be distributed over numerous
over 30%. The figure also shows the significantly reservoirs; moreover, the production of associated gas
greater importance at world level of countries with is often determined by that of oil, unless reinjection is
weak and intermediate excursion compared to those adopted, which entails increased costs, or the excess
with marked excursion: the average annual gas is flared into the atmosphere, leading to pollution
consumption of the country groupings during the and a waste of resources. After extraction from the
period 2001-04 was 74, 339 and 898 billion m3 reservoir, natural gas does not require refining, but
respectively. only purification and drying, continuous processes
which do not interrupt the flow of gas.
Managing seasonality Transport and local distribution phases also do not
Only in the case of electricity are storage costs (in allow significant flexibility, since there are no genuine
batteries, pumping plants, etc.) so high that production buffers. It is not usually economic to size
at any given moment in time is almost identical to transportation infrastructure downstream of production
demand. For other energy sources, these costs tend to on the basis of the peak capacities required for only a
be far lower, and production may precede consumption
by several weeks or even months. The discrepancies
between production and consumption are managed by 14 Buffers are devices allowing decoupling of

appropriately exploiting the various buffers14 in the consecutive processes with differing dynamic properties.

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BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY

Table 9. Modulation of supply and storage capacity in OECD countries during the years 2001-04
(based on IEA data, 1960-2004; 1971-1987; 1989-2001; 1996-2004; 2001-2004)

Capacity to modulate supply* Working gas/ annual

Countries Average variation
(%) consumption (%)
Mexico 1.2 100.0 0.0
Japan 1.3 100.0 0.0
New Zealand 1.4 100.0 0.0
Ireland 1.5 100.0 0.0
Portugal 1.6 100.0 0.0
Australia 1.6 100.0 5.8
Turkey 1.7 100.0 9.2
Greece 1.8 100.0 0.0
Finland 2.3 100.0 0.0
Luxembourg 2.4 100.0 0.0
Netherlands 2.4 100.0 4.9
Sweden 4.2 100.0 0.0
Switzerland 4.3 100.0 0.0
Norway 8.5 100.0 0.0
United Kingdom 2.3 100.0 3.6
Spain 1.6 91.7 9.1
South Korea 2.8 66.7 0.0
Belgium 2.2 58.3 4.2
Denmark 2.9 58.3 13.7
Canada 1.9 58.3 19.4
Poland 2.3 33.3 11.5
United States 1.8 33.3 19.5
Italy 2.7 25.0 16.6
Austria 3.2 16.7 35.2
Germany 3.2 16.7 19.7
Hungary 4.1 16.7 23.3
France 4.9 16.7 22.4
Czech Republic 4.8 8.3 21.9

*The capacity to modulate supply is calculated as the fraction of the months in which the difference between consumption and supply is less
than 10%.

few months of the year. In the case of pipeline
transport and local distribution, the potential for real
time adaptation of supply to demand is limited by the
power of compressor stations and the size, length and
critical pressures of the pipelines.15 Using liquefaction
and regasification terminals for storage depends on the
interval between two loads (typically a few weeks) and
generally only allows for the management of daily
peaks in the importing country. The natural gas in
transit in methane tankers represents less than 1 billion
m3 worldwide at any given moment. Finally, because
of the low energy density of gas, storage in municipal
15 The gas contained at any given moment in a typical
international gas pipeline (length 1,000 km, diameter 40
inches, pressure 100 bar) is in the order of 60-100 million
m3, measured under standard temperature and pressure
conditions. Variations in the gas pressure of a few
atmospheres allow for a degree of flexibility (line-pack);
however, this is only available for short periods, generally
less than a day, and is limited to about ten million m3.

120 ENCYCLOPAEDIA OF HYDROCARBONS


storage facilities has an extremely high cost per unit of
energy; the costs of storage on end-user premises are
prohibitive.16
The potential for managing the seasonality of
requirements by adapting supply on a monthly basis
decreases drastically with increasing annual excursion
in demand, as shown in Table 9. In fact, the only
countries where the ratio of supply (production+net
imports) to consumption is close or equal to 1 in all
months of the year are those with: small variations in
requirements (countries where consumption is
concentrated in electricity generation or in the energy
sector); withdrawals that have a minimal impact on the
throughput of large international transport networks
even during periods of maximum demand (Finland,
Luxembourg, Sweden, Switzerland);17 numerous
natural gas production fields whose exploitation as a
whole is flexible to variations in demand (Norway,
United Kingdom, Netherlands).
Other countries must resort to gathering gas in
storage reservoirs (working gas) during months when
requirements are low, in sufficient quantities to meet
demand during months of high consumption which
cannot be covered by withdrawals from transport
networks or production fields. Fig. 2 shows a clear
inverse relation between the availability of storage and
the degree to which requirements are met exclusively
by supplies.
Short and long-term elasticity
Natural gas systems are characterized by
infrastructures which are fixed or almost impossible to
modify in the short term, leading to heavy restrictions
on the adaptability of consumption to variations in
exogenous conditions. The high investment costs and
30
annual consumption (%)
25
working gas/
20
15
10
5
0 calorific value of around 8.7 Gcal/m3 compared to 8.25
15 25 33 60 92
months with
consumption equal to supply (%)
Fig. 2. Modulation of natural gas supply
and storage capacity in OECD countries (2001-04).
Countries are grouped by month shares
with monthly consumption
equal or close to monthly supply
(production+supply).
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
THE ECONOMICS OF NATURAL GAS
long time required to build transport and distribution
networks limit the potential for significant increases in
consumption following reductions in natural gas
prices; significant price increases lead to a concurrent
drop in consumption only when plants fuelled by
alternative lower priced energy sources are already
installed or readily installable, or by foregoing a part
of the energy service. However, the sensitivity of
demand to price variations differs substantially
between electricity generation, industrial uses and the
residential, commercial and public sector.
In the electricity generation sector, gas
consumption tends to be relatively elastic to price.
Generally speaking, power companies generate
electricity from an assortment of plants using different
energy sources with the objective of minimizing costs
(or maximizing profits) depending on the demand for
energy, its hourly profile, generating cost and selling
prices. At the national level (and at the company level,
if it owns sufficiently diversified plants) a significant
increase in relative gas prices generally results in a
significant drop in consumption in favour of
alternative fuels.18 Similarly, if sufficient gas-based
generating capacity is available, falling prices lead to
increased consumption. Variations in gas prices are
also reflected in power generating costs and in the
price of electricity, with further impacts on
consumption in the short term; this is more evident in
countries with electricity exchanges.
In the industrial sector, short-term switching
between energy sources is generally less pronounced.
Unlike the power sector, there are generally no valid
economic reasons for maintaining parallel plants based
on alternative sources within a single industrial unit.
Given the high costs, companies install multiple plants
only when continuity of supply is absolutely critical
for the integrity of machinery and industrial processes.
Most companies do not respond in the short term to
price increases, when these can be passed on to their
products, or adjust to them by improving the plant
efficiency or limiting consumption when this does not
16 Oil products in the liquid state have a calorific content
per unit volume about 1,000 times greater than that of
natural gas in the gaseous state under standard temperature
and pressure conditions. Gas oil, for example, has a lower
100 Mcal/m3 for methane.
17 The maximum monthly variation in Swiss gas
requirements during the period 2001-04 (about 340 million
m3) corresponds, for example, to a variation of only 0.2% in
the average overall flow rate of the gas trans-national
pipelines carrying gas to the country.
18 There are obviously repercussions on other sources of
generation as well (hydroelectric, nuclear, etc.), but the
market segments are largely distinct, and the main effect is
concentrated in the thermoelectric fossil fuel-based sector.
121
BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY

Table 10. Elasticity by use sector during the period 1978-2002

(based on IEA data, 1960-2004; 1971-1987; 1989-2001; 1996-2004; 2001-2004)

Variable and sector Elasticity Multiple R R squared F statistic T statistic

Absolute price
Civil uses ⫺0.542 0.813 0.687 37.961 ⫺4.155
Industry ⫺0.689 0.742 0.610 45.899 ⫺5.046
Power generation ⫺0.610 0.684 0.535 20.024 ⫺4.302

Relative price
Civil uses ⫺0.231 0.850 0.734 45.641 ⫺1.672
Industry ⫺0.295 0.871 0.776 188.107 ⫺3.651
Power generation ⫺0.363 0.652 0.445 11.351 ⫺2.380

Per capita GDP

Civil uses 1.241 0.847 0.738 75.701 7.368
Industry 1.095 0.812 0.699 67.529 7.420
Power generation 1.278 0.822 0.693 43.496 6.035

significantly affect the industrial process; for example,
by saving on space heating or reducing the process
temperature within the tolerance limits. Conversely, a
drop in prices may lead to greater carelessness in the
use of gas, wastage and increased consumption.
In the residential, commercial and public sector,
sensitivity to variations in the price of natural gas is
even lower, especially in the case of residential uses,
partly due to the low or inexistent diffusion of
appliances fuelled by alternative sources and in part to
the consumers’ limited perception of prices changes.
Unlike industrial companies, which closely track the
price of energy day by day, especially in the case of
energy-intensive manufacturing processes, in the
residential and small business sectors, variations in
price usually become apparent with the billings after
several months’ delay. Moreover, in many areas
regulatory mechanisms tend to attenuate price
variations, distributing them over relatively long
periods, and thus altering the consumer’s
responsiveness. Over periods longer than a year, the
residential, commercial and public sector does
however tend to react to persistent higher prices by
decreasing less essential energy uses, for example by
reducing heat losses and the indoor temperatures.
Econometric analysis confirms the reduced
importance of short term price variations in determining
gas demand compared to variations in infrastructure
linked variables which reflect the longer term
development of energy systems. Tables 10 and 11 report
the statistical results obtained with simple logarithmic
specifications, relating consumption to prices and per
capita GDP (used as an indicator of the infrastructure
development) in the United States, Japan and the
European Union and OECD member countries
(EU-15). For these countries, the IEA publishes uniform
and comparable annual data, covering a quarter of a
century (1978-2002), a sufficiently long period of time
to allow for a statistically meaningful comparison.19
The following concentrates on an examination of
the elasticity of consumption in the three sectors under
consideration (residential, commercial and public;
industry; power generation) and in the three areas
(United States, EU-15, Japan) with respect to three
variables: the absolute price of gas referred to the base
year 1978; the relative price compared to alternative
fossil fuels; the rate of growth of per capita GDP. The
first two variables can be considered short-term, since
prices change year by year over a time-frame too short
for infrastructures to adjust significantly. The third
variable changes slowly over time and is clearly
long-term. The alternative energy sources used for
comparison obviously vary depending on the sector. In
the residential, commercial and public sector,
electricity and gas oil were considered; in the
industrial sector gas oil, fuel oil and coal; in the power
generation sector fuel oil and coal. To avoid
unnecessarily cumbersome analysis, the tables report
only the arithmetical averages of the values relating to
the sectors (or countries) included in the sample.
The results reported in Table 10 referring to the
averages by sector obtained by aggregating across all
the countries, indicate significant price elasticities and
confirm lower values in residential, commercial and
public uses compared to industry and power
19 For an evaluation of the significance of the results
reported in the tables, reference should be made to a normal
distribution, 22 degrees of freedom (24 yearly observations
minus two regression variables) and a degree of significance
of 5%, for which the critical values of the F and T statistics
are 8.65 and 2.07, respectively.

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 THE ECONOMICS OF NATURAL GAS

Table 11. Elasticity by geographical area during the period 1978-2002

(based on IEA data, 1960-2004; 1971-1987; 1989-2001; 1996-2004; 2001-2004)

Variable and area Elasticity Multiple R R squared F statistic T statistic

Absolute price
United States ⫺0.289 0.687 0.501 12.179 ⫺2.947
OECD Europe ⫺0.600 0.864 0.754 46.734 ⫺6.369
Japan ⫺0.928 0.824 0.707 50.174 ⫺5.242

Relative price
United States ⫺0.073 0.686 0.493 14.852 ⫺0.829
OECD Europe ⫺0.469 0.863 0.754 88.805 ⫺3.526
Japan ⫺0.463 0.849 0.743 48.835 ⫺5.448

Per capita GDP

United States 0.147 0.699 0.519 13.377 2.443
OECD Europe 1.416 0.897 0.811 72.714 8.510
Japan 1.806 0.874 0.789 94.834 8.978

generation. Industry shows the highest elasticity with
respect to absolute prices, and, predictably, power
generation the highest elasticity with respect to
relative prices. All three sectors show a greater
sensitivity to changes in absolute gas prices compared
to relative prices; this would substantiate the relatively
scarce propensity to maintain multiple plants using
different fossil fuels. However, the ratio of the two
elasticities is appreciably greater for the power
generation sector (0.59 as opposed to 0.42). The
elasticity of consumption to per capita GDP is
considerably above 1 in all three sectors. The lower
elasticity in the case of industry probably reflects the
generally more widespread use in this sector, and a
lower degree of dependence on the development of
distribution networks.
Table 11, presenting the results obtained by
aggregating over all sectors in each of the three areas,
reveals considerable differences between the United
States, EU-15 and Japan which can be explained in
terms of the different degree of maturity in natural gas
uses. The lower price elasticity of the United States,
particularly in relative terms,20 reflects advanced
diffusion in most uses and decade-long habits. In
Japan, the high elasticity, especially to absolute prices,
reflects the historically very high cost of natural gas
imported as LNG (Liquefied Natural Gas) and used
mainly for electricity generation. As might be
expected, the European Union has an intermediate
position with respect to variations in absolute price,
while the higher elasticity with respect to relative
infrastructure; at the other extreme, the very high
elasticity shown for Japan reflects the very low
diffusion of gas in industrial and especially residential,
commercial and public uses (see above). The
long-term elasticity is also relatively high for the
European Union, though lower than in Japan, due to
the relatively scarce or intermediate diffusion of gas
use in many EU member states.
2.4.3 Natural gas supply
The gas chain
Since the 1980s, the regulation of the natural gas
sector has led to profound changes in the structure,
organization and regulation of the industry, with the
unbundling of monopoly activities from competitive
concerns and the emergence of a completely new
wholesale business.21
Although these changes have modified the
operating practice of companies, they have not
significantly altered the organization and technical
characteristics of the gas chain, which can still be
conveniently discussed with reference to four main
phases: production; international transport; storage;
20 However, it should be noted that in the case of relative
prices, the degree of significance of the T statistic is below
the critical value.
21 This revolution first made a sporadic appearance in a

prices is a consequence of greater substitutability in
the power generation sector compared to Japan. In the
United States, the extremely low long-term elasticity
(with respect to per capita GDP) reflects the
practically ubiquitous diffusion of distribution
few countries (the United States, the United Kingdom,
Australia, New Zealand, Argentina and Chile) but then
spread rapidly to a multitude of other areas (the European
Union, Turkey, Japan and various Asian countries) and is
also starting to take root in Russia and some African
countries (Algeria, the Republic of South Africa, etc.).

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BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY

Table 12. Weekly average number of drilling rigs operating in 2004

(based on statistics by Baker Hughes, 2005)

Use by type Use by source

World regions Total rigs
Onshore Offshore Oil wells Gas wells Mixed wells

United States and Canada 1,456 101 256 1,300 2 1,557

Japan and Oceania 14 7 9 7 6 22

Europe 29 41 49 18 3 70

Russia and other former Soviet countries 328 5 228 106 0 334

Asia 96 79 126 47 2 176

Middle East 196 34 183 47 0 230

Africa 34 14 46 2 1 48

Latin America 225 66 216 68 6 290

World 2,378 347 1,113 1,595 20 2,727

inland transport and final distribution. This section
focuses on the technicalities of the industry, on the
infrastructures, the operating companies and the
linkages between the various components of the
system.
Production
Natural gas production employed about 700,000
people worldwide in 2004. This is a rough estimate
obtained by subdividing employment in the oil and gas
sector on the basis of the energy content of the oil and
gas produced since, as is well-known, exploration and
production activities are largely shared up to extraction
of the raw fuels from the underground reservoir and
before entry into the transport network feeding into end
markets. The estimate refers to upstream activities.22
The estimated number of producers worldwide
runs into several thousands, but only a few hundred
are involved in the whole cycle from exploration and
development all the way to the exploitation of wells. In
fact, most companies produce less than 100 million
m3, and the largest group in numerical terms consists
of tiny enterprises often run on a family basis.23
Nevertheless, the sector is fairly concentrated, in line
with the high capital investments which characterize it.
The 15 largest companies, with an annual production
of over 30 billion m3, accounted for 47% of world
production in 2004; together with the following 50
medium-large companies, with a production of over 3
billion m3, they account for 64% of world production.
The same 65 companies accounted for almost 70% of
the world’s proven natural gas reserves.
Alongside these operators are several hundred
service companies involved in activities ranging from
geophysical and seismic surveys and assessments to
drilling onshore wells and operating offshore
platforms. Over the past two decades, to improve
efficiency and lower costs, most multinationals and
many state companies have adopted management
models based on outsourcing the more specialized
activities limiting in-house responsibilities as much as
possible to general administration and strategic
planning.
A typical example are companies which supply
drilling services and hire platforms for offshore
operations, around 50 companies worldwide. This is
an activity which varies significantly over time, being
22 The main upstream activities are: contract negotiation,
geological and geophysical studies and research, field
analysis based on seismic surveys, data processing and
reservoir evaluation, drilling of exploration wells with
assessment of the subsurface geology, drilling of
development wells, management of subcontracts,
preparation of production wells, reservoir exploitation,
related commercial and administrative activities.
23 Most of these very small producers are found in the
United States, where they exploit the residual resources
remaining in stripper wells. These are wells transferred from
companies to private individuals when they reach very low
production levels (generally below 1,700 m3/d). According
to the IOGCC (Interstate Oil & Gas Compact Commission,
2005) there are 272,000 wells of this type in the United
States. With an average production of about 440 m3/d of
natural gas, they supplied a total of about 44 billion m3/yr or
7% of the United States’ total production in 2004.

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Table 13. Extraction of the liquid fractions of natural gas in 2004 (Worldwide […], 2005)

Average Quantity Fraction Production Energy

Number Capacity
World regions 3 capacity treated treated of liquids content
of plants (Gm /d)
(Gm3/d) (Gm3/d) (%) (Ml/d) (% of raw gas)

United States and Canada 1,501 3,477 2.3 2,119 85.8 397 14.5

Japan and Oceania 8 151 18.9 106 87.8 45 33.7

Europe 51 690 13.5 278 26.7 37 3.2

Russia and other former Soviet countries 32 79 2.5 40 1.8 38 1.6

Asia 50 508 10.2 429 48.1 57 5.7

Middle East 72 824 11.4 582 51.2 283 22.4

Africa 22 489 22.2 273 32.7 64 6.9

Latin America 81 528 6.5 386 51.9 106 12.9

World 1,817 6,746 3.7 4,213 44.5 1,027 9.8

highly sensitive to oil prices, which it tracks with a
roughly one year time lag. Investment costs are in the
order of 10 million dollars for an onshore drilling rig
and between 50 and 500 million dollars for an offshore
platform.24 The cost of the service is about 10,000 and
60,000 dollars per day, respectively, during peak
periods. Outsourcing of these activities is obviously
benefitted by the fact that service companies can count
on better exploitation of assets, and there are
practically no companies on the market which carry
out drilling with their own equipment.
During 2004, there were on average 2,730
operating rigs worldwide, almost 60% of which in the
United States and Canada alone (Table 12). Again on a
global level, 87% of the rigs operated onshore and
58% on gas wells. Utilisation of rigs varies
considerably according to region, reflecting the extent
and location of resources. In the United States and
Canada 6% of rigs were used offshore, as opposed to
21% in the rest of the world. Similarly, the distribution
between oil and gas is very different; in the United
States and Canada, 83% of wells were drilled in gas
reservoirs, compared to only 25% in the rest of the
world. Using the data for 2004, it is possible to
estimate an average productivity of 1.5 wells per
month per drilling rig, equivalent to about 20 days
between successive drillings (including the time
needed for transportation and set-up). However,
productivity varies significantly with prevailing
conditions. In 2004, high oil prices led to a strong
increase in development wells (92% of the total) which
take longer to drill than exploration wells.
After extraction, the gas is generally dehydrated
and treated to remove impurities and separate out
liquid and solid hydrocarbons. Of particular
importance is the recovery of non-methane
hydrocarbons, which in 2004 contributed about 10%
of the energy content of the raw gas produced
worldwide, and significantly more in some parts of the
world, especially in the Middle East and in the Japan
and Oceania region (Table 13). The chemically pure
products which accompany methane are mainly
ethane, propane and butane, but over half of the
non-methane extract consists of naphtha used in
chemical synthesis, natural gasoline and other blends.
Over 50% of worldwide natural gas liquid
extraction capacity is found in the United States and
Canada, but over the past decade installed capacity
in the Middle East has increased rapidly.
Additionally, with stagnating production, the
extraction of liquids in the United States has fallen
to 38% of the world total. The percentage of gas
treated to recover higher molecular weight
hydrocarbons varies considerably depending on
quantity and the market value of the products
extracted, as well as on environmental regulations
and the standards of downstream markets.
A final aspect of the production phase regards the
conversion of gas into liquids by chemical synthesis,
undertaken close to the well head to reduce transport
costs. Both producing and consuming countries have a
vested interest in developing Gas-To-Liquids (GTLs)
technologies: producing countries without market
outlets for their gas, in order to reduce environmental
24 The figure of 500 million dollars refers to the
Petronius platform, the world’s largest, measuring 640 m in
height and weighing 43,000 t.

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Table 14. International gas trade between 1965 and 2004 (CEDIGAZ, 1997-2004)

Gas exported (Gm3) Total Share

Year By methane Share of marketed gas of exports
By pipeline Total (Gm3) (%)
tanker tankers (%)
1965 22.5 0.7 23.2 3.0 750 3.1

1970 42.9 2.7 45.6 5.9 1,040 4.4

1975 112.3 13.1 125.4 10.4 1,264 9.9

1980 169.6 31.3 201.0 15.6 1,519 13.2

1985 178.0 50.9 228.9 22.2 1,742 13.1

1990 235.3 72.1 307.4 23.5 2,068 14.9

1995 304.5 93.4 397.9 23.5 2,204 18.1

2000 400.9 139.3 540.2 25.8 2,490 21.7

2004 502.1 178.0 680.0 26.2 2,763 24.6

Exports refer to the producing country. However, the data reported do not include trade within the former Soviet Union area. The gas produced
is net of reinjection and other losses during the extraction phase.

pollution resulting from flaring or venting of characterized by strong elements of monopoly

associated gas into the atmosphere (the case of
Nigeria), or as a solution for depleting oil resources
(the case of Qatar); importing countries, in order to
diversify energy supplies away from traditional Middle
Eastern suppliers.
Technologies for converting natural gas into
liquids are still in the development stage. The
process is classic steam reforming with the
production of hydrogen and carbon monoxide
(Syngas), followed by catalytic (Fischer-Tropsch)
synthesis. The main products are: mostly gas oil
(50-80% of the total, practically free of sulphur and
polynuclear aromatics); liquefied gases, naphtha,
lubricants and waxes of various types (0-30%).
Currently there is one operating pilot plant (in
Malaysia) and two plants are under construction (in
Qatar and Nigeria). About 50 projects are in the
research phase, with a total conversion capacity of
about 130 billion m3/yr.25
control, though only marginally affected by any
form of regulation.27 International transport is
generally undertaken by state owned companies
and/or private multinationals with upstream
activities, or by national transport companies with a
long standing supply role in their own country.28
Pipeline transport
After the Second World War, enormous advances
in pipeline transport technologies in terms of
resistance of materials to high pressures and extreme
temperatures and the capacity of compressors, led to
increased efficiency and lower costs. At least until the
mid-1960s, the growth in exports was linked to the
construction of international gas pipelines; at the same
time, as transport distances within large countries were
also increasing. Worldwide, the average transport
distance tripled from about 300 km in 1950 to almost
1,000 km in 1970.

International transport
Most of the gas produced worldwide is
consumed in the country of origin. In 2004, just
over a quarter of net natural gas production was
sent to areas of consumption outside national
borders.26 However, this share has increased very
25 The main companies involved in the development of
GTL are Sasol, Shell, ExxonMobil, BP and ChevronTexaco.
26 The corresponding shares in the oil sector were about
50% for crude and intermediates and 35% for refined
products.
27 In relation to new investments, for example, European

rapidly from almost negligible levels in the 1960s,
as can be seen from Table 14, which also
distinguishes between the role of pipeline and
tanker transport. Both these forms of transport can
be described as essential infrastructures and are
directives impose third party access for a fraction of the
import capacity and for a limited number of years.
28 In terms of ownership of import infrastructure in
European countries, the most important companies are
Gasunie, Gazprom, Eni, E.On Ruhrgas, ExxonMobil,
NNPC, OMV, Shell International, Sonatrach.

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Table 15. Characteristics of international pipeline transportation systems operating in 2004

(CEDIGAZ, 2004)

Number Length** Capacity Average capacity Exports

Producing area Average age* (yr)
of pipelines (km) (Gm3/yr) (Gm3/yr) (Gm3)

United States and Canada 9 28.3 11,854 129.3 14.4 121.8

Japan and Oceania 0 – 0 0.0 0.0 0.0
Europe 17 12.1 8,381 223.4 13.1 154.2

Russia and other former

10 22.2 9,188 183.3 18.3 153.6
Soviet countries

Asia 3 13.0 1,515 15.3 5.1 15.3

Middle East 1 5.2 1,300 17.0 17.0 4.8
Africa 4 10.9 6,436 43.0 10.8 36.7
Latin America 8 11.5 6,157 71.9 9.0 15.7
World 52 17.6 44,831 683.2 13.1 502.1

* Average age weighted with capacity. ** Pipeline lengths are related to world regions depending on the exporting country. Distances are
measured from the reservoir in the producing country to the border of the importing country.

The growth in pipeline transport during this period
was linked essentially to Canadian gas exports to the
United States and the transmission of Russian gas
within the Soviet Union. Dutch29 gas and Russian gas
were first exported to Europe in the 1970s, while Latin
America saw its first Bolivian gas export initiatives.30
However, it was in the 1980s that the largest
international transportation networks were built, linked
initially to the exploitation of North Sea resources and
the export of Algerian and Mexican gas. From the
1990s, there have also been numerous projects for
pipeline export from countries of Asia and Latin
America and, in recent years, from the Middle East as
well.
In 2004, there were 52 operating pipelines for
international gas transport with a total capacity of
almost 700 billion m3/yr, 72% of which was utilised in
that year (Table 15). The characteristics of
international pipelines vary considerably. The average
length is 860 km, but this ranges from a minimum of
120 km (the HAG gas pipeline between Hungary and
Austria) to a maximum of 3,750 km for Russian
pipelines, corresponding altogether to a sum total of
about 45,000 km. The average capacity is 13.1 billion
m3/yr, but this ranges from less than 1 billion m3/yr to
Employment in the operating phase depends mainly
on the number of compressors, which require constant
maintenance and are generally installed 150-200 km
apart. For all the international gas pipelines, direct
employment is estimated at a total of 3,000 technicians,
working essentially on operation and maintenance.
Tanker transport
A significant boost to the development of
international trade came from cryogenic transport
technology, which allowed the overcoming of technical
and economic obstacles posed by long sea voyages
while reducing the risk inherent in fixed connections
and helping to promote competition. Liquefied
natural gas transport is generally competitive
compared to pipeline transport over distances greater
than 3-4,000 km; however, these figures are highly
sensitive to the type of route.31 Introduced in the
1960s, LNG rapidly conquered an important market
share, especially during the 1980s, increasing its share
of international gas transport from 4% in 1970 to 15%
in 1990 (Table 14).
29 Dutch gas exports fell sharply after 1980, when the

almost 80 billion. The average diameter also varies
significantly depending on pipeline capacity, length
and compressor power; from a minimum of 20 inches
to a maximum of 56 inches, in the case of the new
pipeline to transport Russian gas from the Yamal
peninsula.
Dutch government adopted a policy of saving its resources
for future use.
30 Through the Yabog gas pipeline (Yacuiba, Rio
Grande), of rather limited capacity, originally built to export
Bolivian gas to Argentina. The flow of gas has now been
reversed.
31 Especially in the case of subsea gas pipelines.

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BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY
LNG technology opened up a Japanese market and
other markets of the Far East with rapidly growing
consumption; at the same time it allowed for the
exploitation of vast resources in countries which had
no other outlet for their gas, and where the potential
for local consumption was limited in the short term
(Algeria, Indonesia, Qatar) or held back by
competition from other sources (Australia). In 1980,
almost 60% of LNG exports were of Asian origin
(Brunei and Indonesia) and destined for the Japanese
market. Exports from Africa (Algeria and Libya) were
aimed essentially at the European and American
markets. This period also witnessed the rapid growth
of LNG exports from the Middle East and Australia,
destined almost entirely for the Far Eastern markets,
while the addition of Nigerian gas gave a new boost to
African exports, directed mainly (90%) at Europe.
LNG exports from Latin America began only at the
end of the 1990s, and were targeted mainly at meeting
the increasing production deficit of the United States.
Both in terms of technology and logistics, the LNG
cycle is considerably more complex than pipeline
transport. It involves pipelines from producing fields
within the exporting country, liquefaction terminals,
loading and unloading ports, methane tankers,
regasification terminals and pipelines linking these to
transport networks within the importing country. The
complexity of the system is also reflected in the staff
employed. Worldwide, the sequence of activities from
the liquefaction to the regasification numbered a total
of about 20,000 employees in 2004, compared to
3,000 for pipeline transport. In terms of gas volumes,
the international transport of 1 billion m3/yr of gas by
pipeline required an average of 6 employees compared
to 110 employees for gas tanker transport.
Table 16 shows the main characteristics of the LNG
transport system, broken down by world regions. The
major feature that comes to light is the far greater
degree of capacity utilization of liquefaction terminals
compared to regasification terminals (88% compared
to 41% worldwide in 2004). Excluding Latin America,
which currently has only one operating regasification
terminal (Dominican Republic), which came on stream
in 2004, the world average is influenced by the very
low utilization of capacity in Japan and Asia
(specifically South Korea); capacity is maintained
high for security reasons and in order to modulate
peak loads in the absence of underground storage
facilities. The table also highlights the large
differences between the frequency of tanker voyages
as a function of distance and tanker capacity. In 2004,
LNG tankers from Africa and mainly directed towards
Europe, made an average of 25 voyages with an
average cargo of 89,000 m3. Tankers originating in the
Middle East and directed mainly towards the Far East,
128
made only 9 voyages, with an average cargo of
135,000 m3.
The data reported in the table also reflect the drive
towards economies of scale to reduce the high costs of
the transport chain. The capacity of liquefaction trains
has actually tripled since the 1970s to today’s 3 Mt of
LNG per year, equivalent to almost 4 Gm3 of gas.32
This increase is correlated with the significant
increase in storage capacity in those regions which
have most recently developed liquefaction plants:
120,000 m3 of liquefied gas per liquefaction train in
Latin America (Trinidad and Tobago) compared to an
average of 49,000 in Africa. A similar trend, although
less marked, can be seen in the case of regasification
terminals, with an evident increase in the average
capacity of vaporizers and storage tanks in the most
recently developed gas offloading areas.33 Similarly,
the inverse correlation between the age and average
capacity of LNG tankers in different regions reflects
the large increase in capacity over time: from
30-50,000 m3 of LNG in the 1970s, to 150,000 m3 and
over in more recent years.34
Underground storage
The seasonal gas storage is mainly undertaken in
underground geological formations. There are two
main types of underground storage: in porous
substrata (depleted reservoirs and aquifers) and in
cavities or caverns (in impermeable salt formations).
Most storage capacity is found in depleted reservoirs,
followed by aquifers, salt caverns and rarely in rock
formations or abandoned mines.
Table 17 reports the distribution of underground
storage facilities in the main world regions, together
with their operating characteristics. Storage facilities
are concentrated in regions with marked seasonal
variations in consumption (see above), and are
completely absent in three of the eight regions under
consideration. Most underground storage facilities are
owned by transport or distribution companies, and
they are managed jointly and integrated with transport
activities. Storage activities can be spread out over
several plants and carried out under competitive
32 One m3 of natural gas in the liquid phase is equivalent
to 615 m3 in gaseous form. One t of LNG corresponds to
1,317.8 m3 of natural gas in the gaseous phase.
33 An exception is Japan, which uses regasification
terminals to store gas. The most recent storage tanks
installed in this country have a capacity of 200,000 m3 of
LNG.
34 The initial development of LNG exports from Algeria
and Alaska is reflected in the far lower average capacities in
the United States and Africa. Many old LNG tankers are no
longer earmarked for specific routes but still find
opportunities in the spot trade.
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 THE ECONOMICS OF NATURAL GAS

Table 16. Characteristics of the LNG cycle in 2004 (CEDIGAZ, 2004; IEA, Natural gas information, 2004)

Storage Liquefaction Volume Utilization Capacity per train

World regions Liquefaction
Ports Terminals capacity* capacity liquefied** of capacity Liquefaction Storage
(Liquefaction terminals) trains
(Mm3) (Gm3/yr) (Gm3) (%) (Mm3/yr) (103 m3/yr)

United States and Canada 1 1 2 0.1 1.9 1.7 88.4 1.0 54.0
Japan and Oceania 1 1 3 0.3 15.4 12.2 79.0 5.1 86.7
Europe – – – – – – – – –
Russia and other former
– – – – – – – – –
Soviet countries
Asia 4 11 25 1.9 79.2 70.7 89.2 3.2 75.7
Middle East 3 5 10 1.1 42.3 40.5 95.6 4.2 110.0
Africa 5 6 27 1.3 48.9 39.0 79.7 1.8 49.2
Latin America 1 1 3 0.4 15.0 14.0 93.3 5.0 120.0
World 15 25 70 5.1 202.7 178.0 87.8 2.9 72.1

Storage Regasification Volume Utilization Capacity per line

World regions Vaporization
Ports Terminals capacity* capacity regasified** of capacity Vaporization Storage
(regasification terminals) lines
(Mm3) (Gm3/yr) (Gm3) (%) (Mm3/yr) (103 m3/yr)

United States and Canada 5 5 28 1.2 30.5 19.2 62.8 1,089 41.1
Japan and Oceania 14 25 219 13.9 242.7 77.0 31.7 1,108 63.6
Europe 10 10 57 2.1 61.2 35.8 58.4 1,074 36.9
Russia and other former
– – – – – – – – –
Soviet countries
Asia 6 5 74 4.1 96.5 41.7 43.2 1,304 55.0
Middle East 1 1 7 0.3 6.3 4.3 67.8 900 36.4
Africa – – – – – – – – –
Latin America 1 1 2 0.2 2.5 0.2 7.2 1,250 80.0
World 37 47 387 21.7 439.7 178.0 40.5 1,136 56.0

World regions Weighted average age Capacity Average capacity Yearly frequency
Tankers
(LNG tanker fleet)*** (Yr) (103 m3 of LNG) (103 m3 of LNG) of voyages

United States and Canada 4 21.4 291 76 8.4

Japan and Oceania 9 13.4 1,189 127 14.8
Europe – – – – –
Russia and other former
– – – – –
Soviet countries
Asia 53 20.0 6,063 114 16.9
Middle East 46 10.7 6,265 135 9.4
Africa 25 27.6 2,235 89 25.3
Latin America 10 3.0 1,383 135 14.7
Others**** 22 28.4 2,131 96 14.8
World 170 17.2 19,556 115 14.8

* Refers to gas in the liquid phase. ** Refers to gas under standard conditions. *** The region refers to the producing country.
**** Refers to the number of tankers not used on specific routes which carry out short-term and spot sales.

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BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY

Table 17. Characteristics of underground storage infrastructure at the beginning of 2004

(CEDIGAZ, 2004; IEA, Natural gas information, 2004)

Capacity (Gm3) Working gas Maximum

Depleted Salt
World regions Aquifers Other Total Cushion Working per plant delivery
reservoirs formations Total
gas gas (Mm3) (Mm3/d)
United States and Canada 359 40 31 3 433 146 130 276 300 2,640
Japan and Oceania 4 0 0 1 5 1 1 2 262 20
Europe 56 22 27 4 109 78 69 147 635 1,435
Russia and other former
34 12 1 0 47 72 121 193 2,574 769
Soviet countries
Asia 0 0 0 0 0 0 0 0 0 0
Middle East 2 0 0 0 2 2 2 4 950 15
Africa 0 0 0 0 0 0 0 0 0 0
Latin America 0 0 0 0 0 0 0 0 0 0
World 455 74 59 8 596 299 324 623 543 4,880

market conditions; legal or ownership separation from
other activities of the gas chain is not generally
required. Only in circumstances where there is a high
concentration of facilities under a single operator does
storage become an essential infrastructure and de facto
a monopoly, thus requiring regulation.35 Based on the
data available for the few companies exclusively
undertaking storage activities, employees can be
estimated as about 15,000 worldwide.
Table 17 shows the working gas (active reserve)
which can normally be delivered to balance demand
and for field production. In some countries (including
France and Italy) a significant portion of this gas is
maintained by law as a strategic reserve to meet the
temporary unavailability of one or more sources of
supply (imports, domestic production) or exceptionally
high demand (very cold winters). The remaining gas
(almost 50% worldwide) cannot generally be delivered
without compromising operation of the storage
facility; known as cushion gas, it is essential to
provide the basic thrust in the delivery phase.
Typically, underground storage facilities are filled
during the months when demand is low and emptied in
the months when it is high (summer and winter
respectively in the northern hemisphere). However, in
recent years, with the liberalization of gas markets, the
frequency of the storage filling and emptying cycle
has increased in some countries (the United Kingdom
and the United States) in order to exploit price
opportunities between purchase and sales, using
storage facilities to all effects as a gas parking facility.
The possibility of increasing cycle frequencies
capacity of the storage facility. While the former
depends mainly on the natural characteristics of the
storage system (permeability and rigidity of the
geological formation), on the amount of cushion gas
and the pressure (generally lower than 150 bar), the
latter depends on compressor capacities. Natural
deliverability decreases as the facility progressively
empties, tending to zero as only cushion gas remains.
Towards the end of the natural cycle, any increase in
withdrawals to meet peaks requires the use of pumps.
Short-term storage to meet daily peaks (peak
shaving) can also partly make use of the storage tanks
of LNG regasification terminals; these can be quite
large, in the order of 100 million m3 of gas under
standard conditions. However, although they are
locally significant (for example in the UK and Japan),
the role played by these terminals overall is marginal.
Short-term storage functions for daily or hourly
modulation may also be performed by transport and
local distribution networks, when input exceeds
delivery. However, even in the largest transport
networks, the so-called line-pack does not normally
exceed about 10 million cubic metres over the course
of a day (roughly 5% of the gas contained in the
pipelines). Finally, in many parts of the world
traditional gasometers are still widely used to manage
local peaks.
Table 18 illustrates the distinctive properties of the
three main types of underground storage facility: total
capacity; volume of working gas; maximum pressure
35 Currently, these are regulated only in Italy, the United

depends on the maximum deliverability and injection Kingdom and the United States.

130 ENCYCLOPAEDIA OF HYDROCARBONS

 THE ECONOMICS OF NATURAL GAS

properties generally requires a preparatory

Table 18. Technical properties of underground exploration phase, seismic analyses and drilling,
storage facilities: representative worldwide values significantly increasing costs. An assessment of the
(UNECE, 1999) capacity requires determining the rock’s porosity
and its ability to withstand high pressures. After
Properties
Depleted
Aquifers
Salt ascertaining the suitability for conversion into a
reservoirs caverns storage facility, an average of 4 years are required
Depth (m) 1,270 900 1,260 and sometimes much longer to prepare the
formation for storage, injection and delivery.
Pressure (bar) 134 90 150
Compared to a depleted reservoir, development
Total capacity costs are also raised by connections to the gas
1,760 930 550
(Mm3) transport network for injection of cushion gas,
Working gas (%) 49 42 70 absent in aquifers, and dehydration plants, since the
stored gas is usually saturated with water vapour.
Maximum delivery
14 6 18
(Mm3/d)
Salt caverns
Number of wells 32 19 11 Salt caverns have characteristics which make them
ideal for storing natural gas. However, they are not
Duration (d) 64 66 22
well-distributed in nature and are extremely expensive
to develop, with investment costs two or three times
and deliverability; number of wells; duration, obtained higher for the same storage capacity. Salt caverns are
by dividing the volume of working gas by the practically impermeable to gas, which therefore does
maximum delivery. The properties of individual not leak into the atmosphere, but their preparation
facilities differ significantly from one another, to some requires salt removal by leaching, a process which
extent due to their partial interdependence; for takes several years and which generally incurs high
example, maximum delivery depends on the pressure costs to avoid polluting the surrounding land. Given
and number of wells, and the proportion of cushion the rigidity and low permeability of the walls, salt
gas. The data reported are therefore merely caverns require relatively little cushion gas (as little as
representative, mainly illustrating the principal 30% of the total volume); in the event of an
differences between the three types of storage facility. emergency, this can be fully extracted without
compromising the functioning of the facility.
Depleted reservoirs The same properties make it possible to attain high
Depleted reservoirs are the most common form of delivery rates. Salt formations often reach depths of up
underground storage facility due to their broad to 10 km, but storage facilities are usually no deeper
availability and lower development costs. Their location than 1-2 km, since at greater depths temperature and
and geological properties can be easily identified using pressure conditions make the salt fluid and difficult to
the data collected during the earlier resource extract. The best storage facilities in caverns are
exploitation phase, and field preparation phase does not spherical or oval in shape and up to a couple of km in
usually take longer than a couple of years. diameter; depending on the type of geological
The potential for converting a reservoir into a formation, they may be wide and shallow rather than
storage facility depends on three main factors: the deep and narrow. Moreover, their size is determined by
maximum pressure allowed by the geological duration requirements and delivery levels, and it may
formation, which determines its capacity in terms of be preferable to develop several medium-sized storage
volume; the amount of cushion gas needed to supply facilities at a given site rather than a single large one.
the basic thrust during utilization; and the porosity of
the rocky sediment which influences maximum Domestic transport and local distribution
delivery. The main item of expenditure concerns the Domestic transport and local distribution ensure
wells which must be drilled to reach the project the transfer of gas to end-users. In most of the large
specifications; this can be 10-20 times greater than the gas consuming countries, these two activities are
flow during gas production from the field. carried out by separate companies: transport
companies convey large volumes of gas, generally
Aquifers over long distances; local distribution companies
Unlike depleted reservoirs, the location and dispatch smaller gas shipments over relatively short
properties of aquifers are not usually known. As a distances. The boundary between the two is somewhat
consequence, the determining of geological blurred, however; large consumers (electric power

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BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY
stations and many industrial plants), due to the large
volumes and high pressures involved, are generally
supplied directly from transport networks.
Additionally, in some industrialized countries (such as
the United Kingdom and France) and almost all
developing countries, transport and distribution are
carried out by the same company.
A meaningful distinction between transport and
local distribution can be made only on the basis of the
physical characteristics of the two activities and
specifically the transport pressure and the diameter of
the pipes. The term transport is usually applied to the
transfer of large volumes of gas from point of origin
(wellhead or import terminal) to point of final delivery
(power station, industrial plant, local distribution
network), generally at pressures of over 15 bar and in
pipelines with a diameter ranging from 20 to 40
inches. In the larger countries, a distinction is also
made between national transport at pressures of above
40-50 bar up to over 80 bar, essentially for the transfer
of large bulk volumes, and regional transportation at
lower pressures for final delivery. The pressure and
size of the pipelines are commensurate with the
volumes of gas to be transported and the transfer
times, determined in turn by the incoming flow and
the transportation distances.36
Transport capacity increases with the working
pressure in a non-linear way37 and is determined by
technological characteristics (steel quality and
production techniques) and by physical phenomena.
Along its journey, the flow of gas slows down due to
the energy dissipated by the viscous friction between
the gas molecules and the inner wall of the pipeline.
Maintaining required flow rates in transport tubing
requires compression at regular intervals, when the
pressure drops below a critical value characterising the
network, generally around 55-60 bar. In networks with
a prevalently linear configuration, compressors are
spaced at intervals of 100-200 km; meshed networks
require a compressor every 10-20,000 km2.
Centrifugal compressors are generally used, driven
by gas turbines which work in a similar way to aircraft
turbines. The turbines have varying capacities in the
range 10-30 MW, depending on the type of service.
Before compression, the gas is filtered to remove
impurities (dust, water, liquid hydrocarbons, etc.)
which would otherwise compromise operation of the
compressor and the integrity of the pipelines (in which
the gas can move at velocities close to the speed of
sound). The gas can heat up considerably during
compression and, if necessary, is cooled in heat
exchangers on exit to avoid damaging the pipelines
and their lining.
Delivery from the transport system to local
distribution networks generally takes place at
132
pressures of around 15 bar, more rarely at higher or
lower pressures (24, 12 or 5 bar depending on the
circumstances). Final distribution within town
networks is carried out at a broad range of pressures,
depending on user characteristics. The primary
pressure reduction stations feed into medium-pressure
networks with further reductions (initially to 0.5 bar
and 100 mbar) ending at deliveries to residential
customers, generally at pressures of between 20 mbar
and 40 mbar.38 Simulteanously, the diameter of the
pipes decreases to 10-12 inches for the larger users
and 2-3 inches for residential end-users.
The inter-linkage between bulk transport and
local distribution systems typically makes use of
automatic pressure regulation devices guaranteeing
close coordination between the different elements
(injections, compressor stations, withdrawals,
maintenance, network extensions, etc.). Remote
measuring and control from a central despatch
station allows timely intervention over the entire
transport system, from cross border
interconnections to linkages with large end-users
and local networks, which in turn operate despatch
systems on a local scale.
The development of transport and distribution
infrastructure by major world regions over the period
from 1970 to 2003 is shown in Table 19 in terms of km
of pipeline. The length of transport lines reported in
the table also include international gas pipelines but
their contribution is minor (less than 5%), with the
exception of Africa (35%), where export pipelines play
a dominant role in the energy economy, and Latin
America (14%). However, it is impossible to draw a
clear boundary between pipelines for national and
international transport, since the latter are also
employed for domestic transport.
By 2003, transport networks had reached a total
length of about 1.2 million km worldwide, compared
to the 5.1 million km for distribution networks. Table
19 shows the faster growth of distribution networks
compared to transport networks in almost all world
regions. Worldwide, the ratio has increased steadily
from 2.5 in 1970 to 4.4 in 2003. The differences
36 In the United States, transport from the largest
reservoirs located in the South to the main areas of
consumption in the North-East takes several days. In most
European countries transfer from entry points at national
borders does not generally require longer than a day.
37 For an equivalent pressure drop, the capacity of a
pipeline is proportional to the diameter of the tube to a
power of about 2.5.
38 Conventionally, for the sake of brevity and clarity,
pressures are always given with reference to the atmospheric
pressure base. For example, a pressure of 20 mbar
is 1.020 bar.
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 THE ECONOMICS OF NATURAL GAS

Table 19. Development of transportation and distribution networks (103 km) worldwide during the period 1970-2003
(CEDIGAZ 1997-2004; IEA, 1960-2004; 1971-1987; 1989-2001; 1996-2004; 2001-2004)

World regions and networks 1970 1975 1980 1985 1990 1995 2000 2003

Transportation
United States and Canada 448 464 475 493 500 500 507 510
Japan and Oceania 2 4 7 10 13 15 17 20
Europe 91 122 155 190 214 230 249 262
Russia and other former Soviet countries 68 95 132 175 203 205 215 227
Asia 3 5 6 9 15 23 32 44
Middle East 2 3 7 9 12 17 22 28
Africa 2 3 5 7 9 13 18 23
Latin America 13 17 21 32 35 37 44 47
World 628 715 808 925 1,000 1,039 1,104 1,161

Distribution
United States and Canada 1,013 1,110 1,215 1,338 1,516 1,697 1,777 1,908
Japan and Oceania 48 65 86 95 118 125 125 133
Europe 373 476 602 677 921 1,203 1,407 1,571
Russia and other former Soviet countries 63 105 136 183 290 550 647 886
Asia 53 84 104 124 174 210 254 304
Middle East 2 2 5 13 29 49 71 108
Africa 2 4 6 9 18 28 36 51
Latin America 12 17 26 39 59 106 124 166
World 1,565 1,863 2,179 2,479 3,125 3,966 4,441 5,128

Distribution/transportation ratio
United States and Canada 2.3 2.4 2.6 2.7 3.0 3.4 3.5 3.7
Japan and Oceania 28.8 17.0 13.0 9.7 9.3 8.4 7.3 6.8
Europe 4.1 3.9 3.9 3.6 4.3 5.2 5.7 6.0
Russia and other former Soviet countries 0.9 1.1 1.0 1.1 1.4 2.7 3.0 3.9
Asia 20.7 16.2 16.5 14.0 11.7 9.1 7.9 6.9
Middle East 0.7 0.7 0.7 1.5 2.4 3.0 3.2 3.9
Africa 1.3 1.3 1.2 1.2 1.9 2.1 1.9 2.2
Latin America 0.9 1.0 1.2 1.2 1.7 2.9 2.8 3.5
World 2.5 2.6 2.7 2.7 3.1 3.8 4.0 4.4

between regions mainly reflect variations in sectoral
contribution, in extension of distribution networks and
in transport distances. The greater transport distances
in North America lead to a far higher ratio in Europe,
although distribution networks are more or less
equally widespread. At the other extreme, Africa, with
limited diffusion of residential uses and long
transportation distances (linked in part to international
trade) has a ratio of just over 2.
Viewed from this angle, the Japan and Oceania and
the Asia region seem somewhat anomalous; these are
also the only regions where the ratio of distribution to
transport network lengths has fallen over time. Both these
areas import most of their gas in the form of LNG and
have privileged the use of gas for electricity generation
near terminals (with short transport distances),
developing uses in residential, commercial and public
and industry mostly in proximity to power stations.
The system described above comprises about
350 transport companies worldwide, about 225 of
which in the United States alone.39 International
statistics on distribution are fragmentary and
related assessments are necessarily approximate
given the enormous variety of local situations. For
example, the State of California, with a population
of 35 million, has 8 gas distributors, whereas
Georgia, with a population of just over 8 million,
has more than 70. Similarly, in Europe, Italy and
Germany have hundreds of local distributors,
whereas the Netherlands have only 12 and the
United Kingdom none. Crude estimates based on
39 Specifically, 25 companies for interstate transport
(covered by Federal regulations) and 200 companies for
transportation within individual states (regulated by state
authorities).

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Table 20. Employment in gas transportation and distribution in 2003

(figures estimated on the basis of data from CEDIGAZ, 2004; Eurogas, 2005; various enterprises)

Employment (103) Users per km of pipeline per employee

World regions Users (106)
Transportation Distribution Total employee Transportation Distribution

United States and Canada 22 505 527 170.5 323 22.8 3.8

Japan and Oceania 3 21 24 22.5 919 6.2 6.3

Europe 15 313 328 123.3 376 17.3 5.0

Russia and other former

14 222 236 109.8 465 16.4 4.0
Soviet countries

Asia 5 52 57 45.3 792 8.5 5.9

Middle East 4 25 29 46.2 1,603 6.8 4.4

Africa 3 14 17 12.7 746 7.0 3.7

Latin America 5 39 44 27.2 616 9.1 4.3

World 72 1,191 1,263 557.6 441 16.1 4.3

the available international sample and sectoral The development of reserves

consumption in the different world regions give
result in about 3,000 local distribution companies
worldwide, about a third of which are in the United
States. Very often, these companies are
horizontally integrated with other public utilities
such as electricity, water and urban waste. They are
both publicly and privately owned, with a strong
trend towards (at least partial) privatization in
almost all countries.
Network management activities typically have
a high employment rate, especially for distribution
networks. However, employment in this sector is
set to fall significantly with the gradual separation
of network and marketing activities, the greater
efficiency introduced with network regulation,
subcontracting of meter reading and the
development of remote measuring. Currently, it
can be estimated that just over 70,000 people are
employed worldwide in transportation, and almost
1.2 million in the distribution sector; these figures
partly include employment in gas marketing in
countries where network and sales activities have
not yet been separated. Employment is closely
related to the number of customers, estimated to
be over 550 million worldwide, a great majority of
which in the residential and small business
sectors. The data provided in Table 20 indicate a
worldwide average of about 440 users per
employee, but this number varies considerably
depending on the sectoral distribution of
customers.40
and resources
In the United States, the exploitation of natural gas
for energy purposes began over a century ago, but for
many decades this source was considered the poor
cousin of oil on account of its physical characteristics,
exemplified by its extremely low energy content per
unit volume and its dependence on a fixed
infrastructure for transport and distribution. A
substantial proportion of resources was discovered
accidentally during exploration and development
activities in the oil sector. Considered more of a
impediment than a resource, these discoveries were
often not even recorded and were rediscovered in later
periods.
Associated and non-associated gas
It is estimated that about 35% of known gas
resources in the 1970s were of associated gas
(CEDIGAZ, 1997-2004, year 2000), that is gas
dissolved in crude oil or filling the cavities above
oil reservoirs and which inevitably escaped when
the oil was extracted. The high cost of downstream
use did not justify its recovery, except for specific
local activities, mostly in industry. Before the
great depression of the 1930s, significant
gas production occurred only in the United
40 Not surprisingly, the number of customers per
employee is lower in areas dominated by residential uses,
reflecting winter heating.

134 ENCYCLOPAEDIA OF HYDROCARBONS

 THE ECONOMICS OF NATURAL GAS

Table 21. Balance of gross natural gas production* between 1960 and 2004
(CEDIGAZ, 1997-2004; IEA, 1960-2004; 1971-1987; 1989-2001; 1996-2004; 2001-2004)

Reinjected into Flared or vented Self-consumption Marketed

Year Gross production
reservoir into atmosphere and other uses** production***

Quantity (Gm3)
1960 614 72 76 20 446
1970 1,330 85 161 45 1,040
1975 1,567 78 173 52 1,264
1980 1,854 113 164 59 1,519
1985 2,105 171 103 88 1,742
1990 2,524 235 110 110 2,068
1995 2,730 306 103 117 2,204
2000 3,073 346 95 142 2,490
2004 3,428 408 94 164 2,763

Share (%)
1960 100.0 11.8 12.4 3.3 72.6
1970 100.0 6.4 12.1 3.3 78.2
1975 100.0 5.0 11.1 3.3 80.6
1980 100.0 6.1 8.8 3.2 81.9
1985 100.0 8.1 4.9 4.2 82.8
1990 100.0 9.3 4.4 4.4 82.0
1995 100.0 11.2 3.8 4.3 80.7
2000 100.0 11.3 3.1 4.6 81.0
2004 100.3 11.9 2.7 4.8 80.8

* Corresponds to total production in the raw form before combustion or venting into the atmosphere, reinjection, treatment and
self-consumption. Losses during the treatment phase include purification and the extraction of liquid fractions (LPG - Liquefied Petroleum
Gas, gasolines and other condensates). ** Consumption for the operation of treatment plants and other plants. *** The gas is sent into gas
pipelines towards markets and subject to further losses (not included in the table) in gas pipelines and compressor stations before consumption
in intermediate or end-use sectors.

States41 as a replacement for town gas, produced
from coal, to meet urban demand.
At least until the middle of the Twentieth century,
associated gas from oil reservoirs, of no economic
value, was flared at the wellhead, contributing to
pollution and (unknowingly at the time) to the
production of greenhouse gases. In the United States,
oil production without recovery and treatment of the
associated gas was prohibited beginning in 1947, but
in the rest of the world over 30% of the natural gas
produced continued to be flared into the atmosphere,
and far more in some countries like Saudi Arabia.42
During the 1950s (mainly in the United States),
reinjection to improve oil recovery began to spread
and gas was used to some extent for field operations,
including power generation. In recent years, new
opportunities have emerged such as the use of
technologies for conversion of gas to liquids; though
costly to produce, these entail far lower transport
costs.
During the 1970s, the strong increase in oil prices
led to a re-evaluation of natural gas resources as a
replacement for oil in many uses and interest in the
recovery of associated gas from oil fields as well as in
non-associated gas development grew in many
producing countries. A number of Middle Eastern
producers developed local industries based on natural
gas, particularly in the petrochemical sector, and used
gas for electricity generation and in the residential
sector. Numerous large projects for pipeline export
were conceived, and international transport based on
liquefied natural gas took off.
However, gas losses remain significant in many
producing countries, due mainly to the lack of
economic alternatives for their use but also because
reinjection, in any case, represents a cost. On a world
scale, marketing as a fraction of wellhead production
41 Most of the resources known in the United States at
that time were of associated gas.
42 It is estimated that since the beginning of resource
exploitation over 15,000 billion m3 of natural gas (almost
5% of currently known original resources) have been wasted
in this way.

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Table 22. Balance of natural gas production (Gm3) in the world regions in 2004
(CEDIGAZ, 1997-2004; IEA, 1960-2004; 1971-1987; 1989-2001; 1996-2004; 2001-2004)

Gross Reinjected Flared or vented Self-consumption Marketed

World regions
production into reservoir into atmosphere and other uses production
United States and Canada 861 108 4 34 715

Japan and Oceania 45 1 0 5 39

Europe 384 36 5 14 329

Russia and other former Soviet countries 817 0 11 13 793

Asia 339 7 7 37 288

Middle East 417 93 12 32 280

Africa 319 110 45 16 148

Latin America 246 52 10 13 171

World 3,428 408 94 164 2,763

increased from an average of 73% during the 1960s, showing that in 2004 the countries of Africa, Latin
stabilizing at values close to 82% in the 1980s before America and the Middle East contributed 64% of
falling slightly since the 1990s. The increase in the gas flared, vented into the atmosphere or
marketed gas up to the late 1980s is largely explained reinjected worldwide, as compared to a total gross
by the significant drop in the share of associated gas production of only 29%.
flared or vented into the atmosphere and the increase
in reinjected gas (Table 21), but also reflects an 180
appreciable decline in the share of associated gas in 160 oil
total production, from values above 40% in the 1960s 140 natural gas
to values close to 20% at the end of the 1980s; this 120
100
Gtoe

was due above all to the growing contribution of

Russian gas to world production.43
The stabilization and slight drop in marketed gas
since the 1990s is due essentially to the increasing
contribution of producing areas with reserves of
largely associated gas, especially in Africa, Latin
America and the Middle East. In the former two
regions, associated gas accounts for over 50% of
proven reserves, and in the latter for just under 50%.
Also contributing to the drop is the increasing quantity
used for gas treatment, consisting of drying,
purification and extraction of liquid fractions
(liquefied petroleum gas, gasoline and other
condensates) included in Table 21 under the heading
Self-consumption and other uses.
Overall, associated gas reserves represent today
about 25% of total proven reserves.44 This figure has
fallen significantly from values of nearly 35% in the
1970s, thanks to investments in areas favouring a
greater preponderance of non-associated gas
resources. But, as already noted, production over the
past decade and more has been growing faster in
areas with associated gas resources.45 This is
reflected in the balance by world regions in Table 22,
80
60
40
20
0
1960 1965 1970 1975 1980 1985 1990 1995 2000
year
Fig. 3. World proven reserves of natural gas and oil
during the period 1960-2004.
43 Over 99% of the gas extracted from Russian fields is
non-associated gas. In contrast, almost 50% of the total gas
production of the United States from the beginning of
exploitation up to the end of the Twentieth century was of
the associated type.
44 A rough estimate of the share of associated gas in
proven reserves in world regions is: United States and
Canada 11%; Japan and Oceania 4%; Europe 16%; Russia
and other former Soviet countries 1%; Asia 9%; Middle East
42%; Africa 55%; Latin America 52% (CEDIGAZ,
1997-2004).
45 The case of Nigeria is well-known; here between 50
and 70% of associated gas is still flared in the atmosphere.
In fact, the local market is extremely limited, and only
through the export of liquefied gas and conversion into GTL
can this gas be monetized.

136 ENCYCLOPAEDIA OF HYDROCARBONS


Proven reserves
Rapid growth in proven reserves began in the
1970s, with the economic re-evaluation of natural gas
(Fig. 3). In 1960, these amounted to 40% of those of
oil. Between 1960 and 1985 they increased 5.5 times,
compared to 2.5 times for oil, corresponding to about
86% of the latter in energy terms. Relative growth
slowed in the following decade due to the sizeable
re-evaluation of oil reserves during the second half of
the 1980s, but then picked up again with renewed
vigour; since 2000, proven reserves of natural gas have
been larger than those of oil.46
The most eloquent indicator of the resource base is
the reserves to production ratio (R/P), which
corresponds to the number of years of remaining
production, assuming that both reserves and
production remain constant over time. Worldwide, the
R/P ratios for oil and gas show significantly divergent
trends, with increasing longevity of remaining gas
reserves (Fig. 4). Over the course of the two decades
ending in the 1970s, the R/P ratio for oil fell from 36
to 27 years, compared to an increase for natural gas
from 38 to 45 years. During the 1980s, in the new
conditions emerging from the energy crises of the
preceding decade, energy savings and oil substitution
together with the re-evaluation of oil reserves caused
the R/P ratio for oil to rise again to about 40 years. At
the end of the 1980s, the ratio for natural gas was
almost 60 years and continued to grow, though at a
slower rate despite the increase in proven reserves, due
to the strong increase in consumption; it seems to have
stabilized at around 65 years at the beginning of the
new century. On the other hand, the R/P ratio for oil
had already stabilized around a value of 40 years
during the 1990s.
This worldwide trend conceals significant diversity
between the main regions which reflect differences
both in natural gas resources and production dynamics
(Table 23). Two regions, the Middle East and Japan
and Oceania, had an R/P ratio of over 100 years in
2004; the former rising, the latter falling. Two regions,
70
oil
reserves/production
60
(remaining years)
natural gas
50
40
30
20
10
1960 1965 1970 1975 1980 1985 1990 1995 2000
year
Fig. 4. World reserves/production ratio during
the period 1960-2004.
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
THE ECONOMICS OF NATURAL GAS
Africa and Russia and the other former Soviet
countries, had an R/P ratio in 2004 of between 50 and
100 years, declining in both cases. Latin America and
Asia had a falling ratio, although still over 40 years,
while in Europe the ratio has remained practically
constant for some time at just over 20 years. Of greater
concern is the situation in the United States and
Canada where the R/P ratio has now fallen to an
average of 10 years, below which the exploitation of
resources generally becomes inefficient and damaging
to reservoirs.
A very significant fraction of reserve growth has
taken place in offshore reservoirs, largely as a result of
the availability of new exploration and development
technologies. Given the higher development costs,
their contribution to total proven reserves is generally
decisive in world regions where resource exploitation
is most advanced (in the United States and Canada,
and in Europe). However, as shown in Table 24, their
share of total reserves has grown dramatically in all
regions with the exception of Latin America, where
offshore reserves were already prevalent in the 1970s,
and of Russia and the other former Soviet countries,
characterized by enormous onshore resources and a
very low ratio of coastline to land area.47 Offshore gas
production in the different world regions closely
mirrors the extent of resources, as shown in Table 25.
With the exception of the United States and Canada,
Europe and Latin America, the R/P ratio of offshore
reserves is higher, in some areas considerably higher,
than that of onshore reserves (77 compared to 65 years
worldwide).
Of greater significance for the evaluation of trends
in reserve growth is the concept of addition to reserves
in a given year which, since this eliminates the effects
of different trends in consumption. Additions to
reserves, calculated by adding a given year’s
production to the difference between the proven
reserves at the end and beginning of the year,48 is
reported in Table 26 for each world region in the two
periods 1970-89 and 1990-2004. The data show that
the addition to oil and gas reserves worldwide was
basically identical during the years under
46 Data on proven reserves vary significantly from
source to source, and above all over time. The present
assessment attempts to reconcile the three main historical
sources: CEDIGAZ, «Oil & Gas Journal», BP statistical
review of world energy.
47 Data on offshore reserves are to be considered
approximate given the rapid technological advances which
have led to a constant revision of assessments.
48 Proven reserves generally refer to December 31 or
(alternatively) January 1 of a given year. In any case,
reserves at the beginning of a year are equivalent to the
reserves existing at the end of the previous year.
137
BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY

Table 23. Reserves, production and their R/P ratio in the world between 1970 and 2004
(CEDIGAZ, 1997-2004; IEA, 1960-2004; 1971-1987; 1989-2001; 1996-2004; 2001-2004)

World regions and reserves 1970 1975 1980 1985 1990 1995 2000 2004

Proven reserves (Tm3)

United States and Canada 9.4 8.5 8.0 8.4 7.5 6.5 6.2 7.0
Japan and Oceania 0.1 0.2 0.2 0.7 1.0 1.6 2.7 4.0
Europe 4.1 4.5 4.5 6.2 6.0 6.9 7.6 6.9
Russia and other former Soviet countries 12.1 23.7 31.0 37.5 52.0 58.2 56.9 56.3
Asia 1.5 3.1 4.6 6.3 9.6 11.5 12.1 12.3
Middle East 6.6 15.3 18.5 25.8 37.8 44.6 53.9 71.6
Africa 3.8 5.2 5.7 5.9 8.5 9.9 11.0 13.8
Latin America 1.9 2.4 4.4 5.4 6.9 7.8 7.7 7.8
World 39.4 63.1 76.9 96.3 129.3 147.1 158.2 179.8

Production (Gm3)
United States and Canada 651.8 619.7 624.4 548.0 611.7 685.3 722.6 715.0
Japan and Oceania 1.8 6.6 13.0 17.6 25.2 33.6 36.6 39.3
Europe 115.9 223.4 248.7 252.7 237.2 271.3 302.9 328.5
Russia and other former Soviet countries 198.0 289.3 434.8 643.0 814.6 705.2 723.1 792.9
Asia 15.2 30.7 61.1 92.1 123.8 176.9 235.5 287.7
Middle East 19.5 37.6 44.1 64.0 99.9 146.9 207.0 280.1
Africa 3.4 12.5 27.2 51.3 70.9 85.1 127.8 148.3
Latin America 34.5 43.7 65.5 73.5 85.0 99.6 134.9 171.2
World 1,040.1 1,263.5 1,518.8 1,742.2 2,068.3 2,203.9 2,490.3 2,763.0

R/P ratio
United States and Canada 14.5 13.8 12.8 15.3 12.2 9.5 8.6 9.8
Japan and Oceania 42.1 33.2 15.0 40.6 40.0 47.4 72.6 102.7
Europe 35.0 20.3 18.1 24.7 25.5 25.6 25.1 21.2
Russia and other former Soviet countries 61.0 81.9 71.3 58.3 63.8 82.5 78.7 71.0
Asia 97.1 102.4 75.3 68.5 77.2 65.2 51.5 42.8
Middle East 339.4 407.5 420.1 403.8 378.7 303.9 260.3 255.5
Africa 1,127.6 419.4 208.9 114.8 119.7 116.1 86.3 93.4
Latin America 54.3 53.8 66.5 74.0 81.4 78.3 57.4 45.4
World 37.9 49.9 50.6 55.3 62.5 66.7 63.5 65.1

consideration. However, while annual additions to Resources

natural gas reserves increased slightly from one period
to the next (0.8%), the additions to oil reserves fell
significantly (⫺12%).
Appreciable differences between world areas are
apparent for natural gas, highlighting the extreme
sensitivity of additions to reserves to specific underlying
factors. Foremost among these are technological
advances which have opened up new horizons for
offshore resources, particularly at great depths beneath
the sea surface. The quadrupling of additions over the
two periods in Japan and Oceania (essentially in
Australia) and the significant increase in Africa and the
Middle East are particularly striking. The increase is still
positive in the United States and Canada and in Asia, but
falls below the world average in Europe and, especially,
in Latin America and in Russia and the other former
Soviet countries where it is practically halved.
Proven reserves refer to those located in known
reservoirs,49 for which there is a good degree of
certainty that gas can be produced under the
technological and economic conditions prevailing at
the time of the evaluation. An assessment of the future
potential of natural gas cannot exclude a brief analysis
of probable reserves and potential resources. Probable
reserves are those additional reserves which are likely
to become available for production in known
reservoirs as a result of technological advances and the
improved knowledge of fields, assuming there are
suitable economic conditions for their development.
Potential resources are resources whose existence can
49 A known reservoir is a reservoir that is adequately
characterized through seismic analyses and drilling,
including information acquired during the production phase.

138 ENCYCLOPAEDIA OF HYDROCARBONS

 THE ECONOMICS OF NATURAL GAS

Table 24. Offshore reserves during the period 1970-2004

(CEDIGAZ, 1997-2004; IEA, 1960-2004; 1971-1987; 1989-2001; 1996-2004; 2001-2004)

World regions and reserves 1970 1975 1980 1985 1990 1995 2000 2004

Offshore reserves (Tm3)

United States and Canada 1.1 1.3 1.5 1.5 1.6 1.3 1.2 1.3
Japan and Oceania 0.0 0.0 0.1 0.6 0.7 0.9 1.6 2.7
Europe 0.9 1.4 2.1 3.0 3.5 4.2 5.2 5.0
Russia and other former Soviet countries 0.2 0.3 0.5 0.7 1.7 3.1 3.6 4.2
Asia 0.3 0.8 1.8 2.6 4.7 7.7 8.4 8.7
Middle East 1.2 2.9 6.6 9.8 13.4 16.3 24.0 29.3
Africa 0.2 0.3 0.6 0.8 1.2 1.8 2.2 3.0
Latin America 0.7 1.0 1.6 1.8 1.7 1.8 2.1 1.8
World 4.4 8.1 14.9 20.8 28.4 37.1 48.2 56.1

Total reserves (Tm3)

United States and Canada 9.4 8.5 8.0 8.4 7.5 6.5 6.2 7.0
Japan and Oceania 0.1 0.2 0.2 0.7 1.0 1.6 2.7 4.0
Europe 4.1 4.5 4.5 6.2 6.0 6.9 7.6 6.9
Russia and other former Soviet countries 12.1 23.7 31.0 37.5 52.0 58.2 56.9 56.3
Asia 1.5 3.1 4.6 6.3 9.6 11.5 12.1 12.3
Middle East 6.6 15.3 18.5 25.8 37.8 44.6 53.9 71.6
Africa 3.8 5.2 5.7 5.9 8.5 9.9 11.0 13.8
Latin America 1.9 2.4 4.4 5.4 6.9 7.8 7.7 7.8
World 39.4 63.1 76.9 96.3 129.3 147.1 158.2 179.8

Share (%)
United States and Canada 11.1 15.4 19.1 18.2 20.8 19.1 18.9 18.5
Japan and Oceania 11.6 18.1 70.5 79.4 69.7 59.1 61.2 67.0
Europe 22.2 31.6 47.3 48.6 58.2 60.5 67.8 72.0
Russia and other former Soviet countries 1.2 1.2 1.6 1.8 3.2 5.3 6.3 7.5
Asia 19.8 23.9 39.4 40.5 49.5 66.4 69.0 71.0
Middle East 18.1 19.0 35.7 38.0 35.3 36.5 44.5 41.0
Africa 3.9 6.0 10.9 13.0 13.5 18.2 20.0 22.0
Latin America 34.7 44.3 35.8 33.8 25.0 23.1 27.3 23.0
World 11.2 12.8 19.4 21.6 22.0 25.2 30.5 31.2

be deduced only from geological knowledge, and for
which no other data exist beyond those which can be
extrapolated from known reservoirs in neighbouring
areas or in other areas with similar characteristics.
The financial norms in force in most countries
oblige companies to declare the proven reserves in the
reservoirs assigned to them. The evaluation of
probable reserves is based both on oil industry data
and on comparative analyses with similar geological
provinces. Estimates of the extent of potential
resources are based essentially on geological analyses.
While proven reserves are defined with reference to a
given historical moment in time, probable reserves and
potential resources make reference to a period of
several decades, during which there is a good
probability that they will be added to proven reserves.
The data on probable reserves and potential
resources introduced below are based on the
evaluations of the US Geological Survey (USGS),
one of the most authoritative institutions in this
sector.50 The USGS has undertaken periodic
calculations of worldwide hydrocarbon resources
since 1984 for oil and since 1987 for natural gas.51 In
the most recent update, resources were estimated on
the basis of information gathered for 270 geological
provinces in 96 countries, referring to subsurface
formations with a hydrocarbon content above a
50 Unlike the World Energy Council (2001) and other
international bodies, which only publish data on proven
reserves, the USGS specializes in the evaluation of probable
reserves and potential resources.
51 Specifically, five evaluations for oil and four for
natural gas. The latest USGS update (2003) also gives
separate estimates for natural gas liquids. The analytical
effort is very extensive, involving around forty experts for a
period of 3-5 years.

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Table 25. Offshore production in the world between 1970 and 2004
(CEDIGAZ, 1997-2004; IEA, 1960-2004; 1971-1987; 1989-2001; 1996-2004; 2001-2004)

World regions and production 1970 1975 1980 1985 1990 1995 2000 2004

Offshore production (Gm3)

United States and Canada 91.1 120.2 159.7 131.4 157.2 161.9 172.9 173.7
Japan and Oceania 0.0 1.6 3.2 5.7 8.9 14.0 15.9 17.8
Europe 15.9 45.2 84.1 98.7 113.8 156.9 204.8 241.1
Russia and other former Soviet countries 3.5 8.0 12.7 15.9 10.9 6.5 5.2 4.8
Asia 0.0 8.1 16.5 36.5 50.2 76.5 116.6 141.9
Middle East 1.0 2.0 8.5 12.3 19.0 35.8 51.2 66.9
Africa 0.1 0.2 1.3 3.6 3.9 4.4 11.6 12.6
Latin America 10.0 11.0 16.5 20.4 28.2 39.3 50.6 71.4
World 121.6 196.3 302.5 324.5 392.1 495.3 628.7 730.2

Share of total production (%)

United States and Canada 14.0 19.4 25.6 24.0 25.7 23.6 23.9 24.3
Japan and Oceania 0.0 24.9 24.8 32.2 35.5 41.6 43.4 45.3
Europe 13.7 20.2 33.8 39.1 48.0 57.8 67.6 73.4
Russia and other former Soviet countries 1.8 2.8 2.9 2.5 1.3 0.9 0.7 0.6
Asia 0.0 26.2 27.0 39.7 40.5 43.3 49.5 49.3
Middle East 5.1 5.3 19.3 19.2 19.0 24.4 24.7 23.9
Africa 2.9 1.6 4.8 7.0 5.5 5.2 9.0 8.5
Latin America 29.0 25.2 25.2 27.8 33.2 39.5 37.5 41.7
World 11.7 15.5 19.9 18.6 19.0 22.5 25.3 26.4

R/P ratio
United States and Canada 11.5 10.9 9.6 11.6 9.9 7.7 6.9 7.5
Japan and Oceania – 24.1 42.6 100.0 78.4 67.4 106.3 152.0
Europe 56.6 31.7 25.3 30.7 30.9 26.8 25.6 20.7
Russia and other former Soviet countries 42.9 35.1 38.5 42.4 151.8 476.9 705.9 887.7
Asia – 93.4 110.1 69.9 94.3 100.1 77.2 61.6
Middle East 1,200.0 1,457.8 777.2 798.5 703.0 455.3 502.9 438.2
Africa 1,500.0 1,580.9 478.1 211.9 294.9 409.1 210.5 241.7
Latin America 65.0 94.8 94.5 90.1 61.5 45.8 43.7 25.0
World 36.2 41.2 49.2 64.0 72.4 74.8 79.7 76.9

threshold which, depending on the area under
examination, ranged from 1 to 20 million bbl of oil
equivalent (0.1 and 2 billion m3 of gas). The USGS
assessments are restricted to the gas in conventional
hydrocarbon reservoirs, and exclude the vast
quantities of methane trapped in coal-bearing
formations (coalbed methane), in permafrost layers
in sub-arctic areas (Siberia and Alaska) and on the
sea floor, since these are not well known and are
unlikely to be exploited during the coming 30 years.
The data reported in Table 27 indicate that,
worldwide, by the end of 2004 just over 14% of total
natural gas reserves originally in place had been
produced (including gas liquids), 33% were still
available for production in the form of proven reserves
and 19% as probable reserves in known fields.
Potential resources deducible from geological
information accounted for the remaining 33% of
original resources. The global distribution of probable
reserves and potential resources does not differ very
significantly from that of proven reserves. However, as
might be expected, there is clearly a greater
concentration of potential resources compared to
proven and probable reserves in areas where
exploitation is most advanced.
The degree of exploitation of original resources
varies considerably from region to region, passing
from values below 5% in the Middle East, Africa
and Japan and Oceania to above 20% in Europe and
50% in the United States and Canada. In 2004,
proven reserves accounted for 33% of total original
resources and 39% of remaining resources
worldwide. Table 27 shows a significant disparity
between regions in terms of the degree of
development of original resources; proven reserves
represent about 20% of remaining original resources

140 ENCYCLOPAEDIA OF HYDROCARBONS

 THE ECONOMICS OF NATURAL GAS

Worldwide, potential resources are shared almost

Table 26. Annual addition to proven gas and oil equally between offshore and onshore reservoirs, but
reserves during the period 1970-2004 (BP, 2005) their distribution varies significantly from region to
region (Table 28). Offshore fields account for more
1970- 1970- 1990-
Ratio
than 90% of resources in Japan and Oceania and in
2004 1989 2004 Europe, and for less than 20% in the Middle East.
Gas (Gm3) About 75% of potential resources are believed to be
United States and Canada 522 466 593 1.27 in the form of non-associated gas. The prevalence of
Japan and Oceania 125 55 214 3.89 non-associated gas is confirmed in all regions and
Europe 305 334 268 0.80 represents a significant reversal with respect to
Russia and other former proven reserves and historical production, often
Soviet countries 1,711 2,180 1,117 0.51 characterized by the far higher share of associated
Asia 397 392 404 1.03 gas. It is also interesting to note the great disparity
Middle East 1,838 1,483 2,288 1.54
between potential and proven offshore reserves
Africa 324 239 432 1.80
Latin America 233 287 165 0.58
(Table 24): in Russia and the other former Soviet
World 5,456 5,436 5,481 1.01 countries, for example, offshore reserves represent
7.5% of total proven reserves but 60% of potential
Oil (Gm3)
resources. Finally, Table 28 highlights the importance
World 5,433 5,778 5,111 0.88
of natural gas liquids, which represent 18% of
potential resources worldwide; only in the United
in Latin America and Europe, compared to 40% and States and Canada is the contribution of gas liquids
over in other regions. Probable reserves are quite thought to be lower than 10%.
sizeable; worldwide, additions to reserves during the The USGS estimates carried out in different years
next two or three decades in known reservoirs show a constant re-evaluation of potential resources
(probable reserves) correspond to just under 60% of which partly mirrors that of proven reserves
proven reserves existing at the end of 2004. It is examined above. A comparison of successive
interesting to observe that this growth is far greater estimates must necessarily exclude probable reserves,
in areas where exploitation is most advanced and since these were not considered in evaluations prior
where the subsurface is better characterised: about to 2000. Table 29 shows a 40% increase in potential
180% in the United States and Canada, 150% in resources between the 1987 and 2000 evaluations, as
Europe and 95% in Latin America, as opposed to compared to 85% for proven reserves. This
60% in Russia and the other former Soviet countries significant difference can be attributed to the high
and less than 40% in the remaining regions. increase in proven reserves between 1987 and 1994,

Table 27. Extent of natural gas resources (Tm3) in the world at the end of 2004 (USGS, 2003)

Cumulative Proven Probable Potential Original

World regions
production reserves reserves resources resources

United States and Canada 37.4 7.0 12.7 16.9 74.0

Japan and Oceania 0.5 4.0 1.6 4.1 10.3

Europe 8.5 6.9 10.5 13.7 39.5

Russia and other former Soviet countries 18.0 56.3 35.3 52.0 161.5

Asia 4.5 12.3 7.4 13.1 37.4

Middle East 3.7 71.6 23.3 48.0 146.6

Africa 1.8 13.8 5.5 12.4 33.6

Latin America 3.4 7.8 7.3 18.9 37.3

World 77.7 179.8 103.6 179.1 540.3

Probable reserves and potential resources correspond to USGS evaluations. Cumulative production and proven reserves are updated to 2004
with data from the IEA, 1960-2004; 1971-1987; 1989-2001; 1996-2004; 2001-2004.

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BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY

Table 28. Distribution of potential resources (Tm3) by resource type (USGS, 2003)

Location Type of reservoir Type of gas

World regions Associated Non-associated Natural Gas Total
Onshore Offshore
gas gas gas liquids
United States and Canada 12.0 4.9 5.5 11.4 15.5 1.4 16.9
Japan and Oceania 0.1 4.0 0.5 3.6 3.2 0.9 4.1
Europe 1.2 12.4 1.8 11.9 11.0 2.6 13.7
Russia and other former Soviet countries 21.1 30.9 9.8 42.2 44.1 7.8 52.0
Asia 6.8 6.4 2.4 10.7 11.3 1.8 13.1
Middle East 39.3 8.7 10.6 37.4 36.5 11.6 48.0
Africa 4.7 7.7 6.1 6.3 10.0 2.4 12.4
Latin America 5.4 13.4 7.1 11.8 15.4 3.5 18.9
World 90.6 88.5 43.7 135.4 147.1 32.1 179.1

while the increase between the last two evaluations is
almost identical (25%). In addition to total resources
on a world scale, Table 29 reports the increase
between 1994 and 2004, broken down by
geographical area. The comparison shows a
significant disparity in the re-evaluations of potential
resources, with very high increases in some regions
(the Middle East52 and the United States and Canada)
and virtually non-existent or even negative in others
(Russia and other former Soviet countries).
Geographical distribution
Attention has already been drawn to the strong
increase in the average transport distance of gas from
producing fields to final consumption in the 1950s and
1960s. Although pipelines of 2,000 km and longer
52 The reassessment of the proven reserves of the Middle
East is particularly evident, accounting for over 70% of the
increase and due almost entirely to the reserves of Qatar.

Table 29. Historical re-evaluation of natural gas resources (Tm3) during the period 1987-2004 (USGS, 2003)

Year Cumulative production Proven reserves Potential resources Total resources

Year of USGS evaluation

1987 29.1 96.3 128.8 254.2
1991 39.6 110.6 135.4 285.6
1994 43.4 142.9 143.5 329.8
2000 77.7 179.8 179.1 436.7

Variation 1994-2004
United States and Canada 10.3 0.6 18.5 29.4
Japan and Oceania 0.5 2.5 0.6 3.7
Europe 4.3 0.2 2.2 6.7
Russia and other former Soviet countries 11.1 ⫺0.8 ⫺9.7 0.6
Asia 3.0 2.2 1.3 6.5
Middle East 2.6 26.5 12.5 41.6
Africa 1.6 4.8 2.0 8.3
Latin America 1.8 0.2 8.0 10.0
World 35.2 36.1 35.6 106.9

Probable reserves are excluded as these were not evaluated by the USGS before 2000. 2004 cumulative production and proven reserves
are updated with data from the IEA (1960-2004; 1971-1987; 1989-2001; 1996-2004; 2001-2004). For potential resources the variation refers
to the period 1994-2000.

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Table 30. Reserves, production and consumption by region and country in 2004 (BP, 2005)

Proven Degree
Production Consumption Reserves/ Reserves/
World regions reserves of self-sufficiency*
(Gm3) (Gm3) production consumption
(Gm3) (%)
United States and Canada 6.896 725.7 736.2 98.6 9.5 9.4
United States 5,293 542.9 646.7 83.9 9.7 8.2
Canada 1,603 182.8 89.5 204.2 8.8 17.9

Japan and Oceania 2,539 41.6 100.3 41.5 61.0 25.3

Australia 2,462 35.2 24.5 143.7 70.0 100.5
Japan 40 2.8 72.2 3.9 14.2 0.6
New Zealand 37 3.6 3.6 100.0 10.3 10.3

Europe 5,565 307.5 493.1 62.4 18.1 11.3

Norway 2,461 78.5 4.6 1,706.5 31.4 535.0
Netherlands 1,492 68.8 43.5 158.2 21.7 34.3
United Kingdom 590 95.9 98.0 97.9 6.2 6.0
Romania 305 13.2 18.8 70.2 23.1 16.2
Germany 207 16.4 85.9 19.1 12.6 2.4
Italy 188 13.0 73.3 17.7 14.5 2.6
Poland 116 4.4 13.2 33.3 26.4 8.8
Denmark 94 9.4 5.4 174.1 10.0 17.4
Hungary 34 2.9 13.0 22.6 11.6 2.6
Ireland 20 0.7 4.1 16.4 29.7 4.9
Austria 15 2.1 9.5 22.0 7.2 1.6
Slovakia 15 0.2 6.8 2.9 76.5 2.2
France 14 1.6 44.7 3.5 8.9 0.3
Other countries 14 0.4 72.3 0.6 34.5 0.2

Russia and other former Soviet countries 58,235 740.9 561.3 132.0 78.6 103.8
Russia 48,000 589.1 402.1 146.5 81.5 119.4
Kazakhstan 3,000 18.5 15.2 121.7 162.2 197.4
Turkmenistan 2,900 54.6 15.5 352.3 53.1 187.1
Uzbekistan 1,860 55.8 49.3 113.2 33.3 37.7
Azerbaijan 1,370 4.6 8.5 54.1 297.8 161.2
Ukraine 1,105 18.3 70.7 25.9 60.4 15.6
Other countries 454 11 32 34.6 40.7 14.1

Asia 11,781 287.6 274.4 104.8 41.0 42.9

Indonesia 2,557 73.3 33.7 217.5 34.9 75.9
Malaysia 2,464 53.9 33.2 162.3 45.7 74.2
China 2,229 40.8 39.0 104.6 54.6 57.2
India 854 29.4 32.1 91.6 29.0 26.6
Pakistan 790 23.2 25.7 90.3 34.1 30.7
Burma-Myanmar 445 7.4 1.3 586.8 60.1 352.9
Bangladesh 436 13.2 13.2 100.0 33.0 33.0
Thailand 430 20.3 28.7 70.7 21.2 15.0
Brunei 345 12.1 2.3 536.3 28.5 152.9
Vietnam 235 4.2 3.3 126.1 56.0 70.5
Philippines 107 2.1 2.5 83.8 51.0 42.8
Other countries 889 7,7 59,5 68,3 192,7 82,5

Middle East 72,723 283.1 288.3 98.2 256.9 252.2

Iran 27,570 85.5 87.1 98.2 322.5 316.5
Qatar 25,783 39.2 15.1 259.6 657.7 1,707.5
Saudi Arabia 6,754 64.0 64.0 100.0 105.5 105.5
United Arab Emirates 6,060 45.8 39.6 115.7 132.3 153.0
Iraq 3,113 2.5 2.5 100.0 1,225.6 1,225.1
Kuwait 1,572 9.7 9.7 100.0 162.1 162.1
Oman 990 17.6 8.8 199.0 56.3 111.9
Yemen 478 0.0 0.0 – – –
Syria 250 5.2 5.9 88.9 48.1 42.7
Other countries 153 13.6 55.6 24.4 11.3 2.8

Africa 13,942 145.1 82.6 175.7 96.1 168.8

Nigeria 4,997 20.6 7.7 268.0 242.6 650.1
Algeria 4,545 82.0 21.2 386.8 55.4 214.4
Egypt 1,725 26.8 25.7 104.3 64.4 67.1
Libya 1,491 7.0 6.3 111.4 213.0 237.3
Other countries 1,184 8.7 21.7 40.1 136.1 54.6

Latin America 7,509 169.3 180.6 93.7 44.4 41.6

Venezuela 4,219 28.1 28.1 100.0 150.1 150.1
Bolivia 782 8.5 2.4 356.7 92.0 328.2
Argentina 613 44.9 37.9 118.5 13.7 16.2
Trinidad and Tobago 588 27.7 12.0 230.2 21.2 48.9
Mexico 421 37.1 48.2 77.0 11.3 8.7
Peru 247 0.9 0.9 95.3 287.9 274.4
Brazil 245 11.1 18.9 58.7 22.1 13.0
Colombia 114 6.4 6.3 101.6 17.8 18.1
Chile 108 2.1 8.3 25.6 50.8 13.0
Other countries 172 2.5 17.6 14.2 68.8 9.8

World 179,190 2,700.8 2,716.8 99.4 66.3 66.0

* Degree of self-sufficiency calculated as production/consumption.

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Table 31. Average distance travelled by natural gas from origin to destination by importing area
(IEA, Natural gas information, 2004)

Transportation Quantities imported (Gm3) Average distance (km)

and world importing regions 1983 2004 2030 1983 2004 2030
Gas pipeline
United States and Canada 22 111 104 1,441 1,525 1,427
Japan and Oceania – – 8 – – 1,794
Europe 120 323 486 1,653 1,754 1,883
Russia and other former Soviet countries 84 115 145 1,763 1,794 1,850
Asia – 15 67 – 540 2,237
Middle East – 25 50 – 947 700
Africa – 1 15 – 90 2,500
Latin America 2 27 70 2,970 1,065 1,300
World 227 617 944 1,685 1,623 1,756
LNG tanker
United States and Canada 3 18 365 6,130 5,105 9,660
Japan and Oceania 26 77 132 5,335 6,195 7,142
Europe 13 36 257 1,875 3,979 5,783
Russia and other former Soviet countries – – – – – –
Asia – 42 120 – 5,553 4,366
Middle East – 4 9 – 4,484 2,750
Africa – – – – – –
Latin America – 1 7 – 760 2,300
World 43 178 890 4,343 5,419 7,323
Total
United States and Canada 25 129 468 2,065 2,037 7,839
Japan and Oceania 26 77 140 5,335 6,195 6,837
Europe 133 358 743 1,675 1,976 3,233
Russia and other former Soviet countries 84 115 145 1,763 1,794 1,850
Asia – 57 187 – 4,210 3,606
Middle East – 30 59 – 1,456 1,013
Africa – 1 15 – 90 2,500
Latin America 2 28 77 2,970 1,056 1,391
World 270 795 1,834 2,106 2,473 4,457
Distances refer to individual importing countries. The reported data include imports and transportation between countries within each region,
including the former Soviet Republics.

were already in use before 196053, gas was produced
and used almost entirely within national borders; only
after 1970, with increasing international trade, did the
average length exceed 1,000 km worldwide. Over the
last thirty years, growing requirements in an
increasing number of countries, compared to the
strong concentration of proven reserves in limited
areas of the world, have led to a growing geographical
imbalance between demand and supply and a rapid
increase in transport distances.
The gap between consumption, production and
reserves, observed for the world macro-regions, is
even more marked in individual countries within
the various regions (Table 30) and is certain to
increase over the coming decades. The following
evaluation of the future logistics of natural gas, is
drawn from the IEA’s demand and supply scenario,
used for the most recent investment forecasts to
2030 (IEA, 2003a). These forecasts indicate the
appearance of numerous new transport routes
between producing and consuming countries, both
via pipeline and LNG tanker. In many cases, natural
barriers in the form of mountain ranges and the
presence of oceans favour transport in liquefied
form, and this is predicted to double its contribution
to almost 50% of total transport during the period
under consideration.
A quantification of foreseen developments in
international transport are compared with historical
53 However, only the Transcanadian gas pipelines
transporting gas from fields in Alberta and British Columbia
to Oregon and California, built in 1957 and 1958, envisaged
international transport.

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 THE ECONOMICS OF NATURAL GAS

Table 32. Average distance travelled by natural gas from origin to destination by exporting area (IEA, 2003b)

Transportation Quantities exported (Gm3) Average distance (km)

and world exporting regions 1983 2004 2030 1983 2004 2030
Gas pipeline
United States and Canada 20 122 95 1,525 1,416 1,525
Japan and Oceania – – – – – –
Europe 60 154 120 323 461 461
Russia and other former Soviet countries 139 269 422 2,308 2,430 2,199
Asia – 15 22 – 540 1,685
Middle East 2 5 91 490 675 1,769
Africa 2 37 116 2,028 1,882 2,059
Latin America 4 16 79 1,837 1,583 1,195
World 227 617 944 1,685 1,623 1,756
LNG tanker
United States and Canada 1 2 – 5,686 5,686 –
Japan and Oceania – 12 100 – 7,177 5,573
Europe – – 6 – – 6,877
Russia and other former Soviet countries – – 22 – – 9,867
Asia 23 71 131 4,959 4,569 10,206
Middle East 3 40 332 8,522 8,544 9,150
Africa 16 39 198 2,736 3,975 4,784
Latin America 0 14 101 – 3,134 3,732
World 43 178 890 4,343 5,419 7,323
Total
United States and Canada 21 123 95 1,797 1,474 1,525
Japan and Oceania – 12 100 – 7,177 5,573
Europe 60 154 126 323 461 766
Russia and other former Soviet countries 139 269 444 2,308 2,430 2,579
Asia 23 86 153 4,959 3,854 8,980
Middle East 5 45 423 4,952 7,716 7,570
Africa 19 76 314 2,652 2,960 3,777
Latin America 4 30 179 1,837 2,313 2,619
World 270 795 1,834 2,106 2,473 4,457
Distances refer to individual exporting countries. The data include exports and transportation between countries within each area, including
the former Soviet Republics.

trends in Tables 31 and 32, referring respectively to
importing and exporting regions.54 The figures indicate
that the average transport distance will almost double
from about 2,500 to 4,500 km during the period
considered, reflecting both the growing role of LNG
and the increased importance of long-distance haulage
(especially towards the United States and Canada
region) and the longer transport distances on new sea
routes (from Latin America and the Middle East).
On the import side, the incremental demand for
international transport as a whole is dominated by the
United States and Canada and by Europe, each
accounting for over a third of the total increase,
followed at a distance by Asia. Growth in LNG
imports is also largely dependent on the contribution
of the United States and Canada, with over 50% of the
total increase, due to growing limitations on traditional
overland imports from Canada. On the export side, the
data clearly highlight the increasing role played by the
Middle East, followed by Africa: taken together, they
account for almost two thirds of the increase in
international export trade; but the contribution of Latin
America and of Japan and Oceania (Australia) are also
significant in relative terms, the latter relying entirely
on LNG technology.
2.4.4 The production function
and the costs
The main elements of the natural gas system have
been described in the above. This section focuses on
the economic aspects with the overall objective of
54 The data on quantities reported in these tables do not
always correspond to IEA forecasts since, in order to
provide a more complete overview of pipeline transport,
they include contributions to transport between countries
within macro-regions. The main difference concerns
transport between the former Soviet countries.

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BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY
estimating the costs of natural gas supply in the world
macro-regions. The starting point is the above
mentioned analysis of investments published by the
IEA in 2003, the most recent and authoritative study in
this sector covering the whole world. The study refers
to the period up to 2030 and addresses the issue of
investments as a function of energy demand growth,
the economic characteristics of reserves in the
different world areas and technological advances in
production and transport techniques (IEA, 2003b).
The following section briefly discusses the main
assumptions underlying the IEA investment forecasts
and examines the main results. The section concludes
with a consideration of the contribution of the other
production factors (other than capital), to arrive at an
overall evaluation of the cost of natural gas to the
end-user over the coming quarter of a century.
The investment scenario
As already mentioned, the IEA scenario refers to
the projections of demand formulated in the 2002
World Energy Outlook. In the light of events
subsequent to the IEA analysis, some of the
assumptions may seem outdated or at least
debatable;55 though not to the point of substantially
altering the overall results. The IEA’s assumptions
refer to five main components: exploration and
production; LNG transport; pipeline transport; local
distribution and underground storage.
Exploration and production
New production capacity required worldwide to
replace the fields depleted over the course of the
thirty-year period (2000-30) is over double the
increase in demand between the beginning and end of
the period. New developments in seismic techniques
using underground sensors, the widespread application
of horizontal drilling and the use of multiphase pumps
in offshore environments, especially in water depths of
over 1,500 m, are expected to allow further
improvements in the identification of reservoir
properties and an increase in success rates.56
Although a strong increase in drilling is predicted
in lower cost areas (Middle East and Africa), unit costs
will tend to rise worldwide due to the development of
smaller and more marginal reservoirs in many world
regions (United States and Canada, Europe) and the
growing contribution of offshore reservoirs.
Furthermore, in many regions enhanced recovery of
resources using thermal, chemical and biological
processes will tend to increase unit costs. Finally, in
many regions, the lower quality of reserves will be
reflected in the increasing investment costs in gas
treatment plants.
146
LNG tanker transport
The increasing importance of the Middle East and
Africa as exporting areas towards Europe and North
America will stimulate the development of LNG
transport, whose contribution to international trade is
expected to increase six-fold, to approach that of
pipeline transport by 2030, with a significant increase
in the utilization of liquefaction capacity. In parallel,
increasing security of LNG supply sources and the
growing role of international trade will result in better
utilization of regasification capacity.57
Advances in liquefaction and refrigeration
technologies will contribute to lowering the unit costs
of LNG transport, though less than in the past.58
Economies of scale will continue to reduce costs in the
various parts of the LNG cycle: in liquefaction
terminals through increasing capacity of the trains and
number of trains per terminal;59 in regasification
terminals through increasing vaporizer capacities and
storage tank size; in LNG tankers through an
increasing number of refrigeration chambers.60
Increasing recourse to offshore liquefaction and
regasification terminals is reflected in construction
costs which are comparable to or lower than those for
onshore terminals, since they are independent of port
activities and attract less public opposition.
Pipeline transport
Pipeline transport capacity will grow mainly as a
result of increased requirements in relatively new
regions (Asia and Latin America). Growth is forecast
to be stronger for export flows from producing to
consuming countries (Russia and other former Soviet
countries towards Europe and Asia; between the
countries of Latin America), but will be considerable
also for high pressure transport inside countries which
55 For example, export flows from Russia to the United
States appear to be underestimated. Similarly, the increase in
transport and distribution capacity and in storage capacity in
Japan seems too low.
56 Over the past two decades, worldwide drilling success
rates have increased from around 83% to about 93%; further
increases will therefore be limited.
57 As already noted, the currently low worldwide
utilization of capacity (40%) can be attributed essentially to
Japan, where it is barely over 30%.
58 The earliest projects consumed 15-20% of the
liquefied gas; in plants of recent design, the
self-consumption included in contracts has been halved to
8-10%.
59 Over the 1990s, the capacity of new terminals more
than tripled from 2 to 7 million t/yr of LNG.
60 LNG tankers in the range 200 and 250,000 m3 are in
the design phase. These can be compared with the average
size of the current world fleet (115,000 m3), of the largest
tankers currently in use (137,000 m3) and of those under
construction (145,000 m3).
ENCYCLOPAEDIA OF HYDROCARBONS

have recently begun to use gas. Utilization of more
resistant materials will allow for further increases in
the diameter, pressure and transport capacity of gas
pipelines, significantly cutting transport costs over
long distances. However, the large contribution and
increasing unit costs of labour (the main component of
onshore pipeline investments) will tend to limit the
decrease in unit costs.61
A very substantial increase in sub-sea gas pipelines
is foreseen, both for export (between the countries of
Asia and from the Middle East to Europe) and for the
exploitation of offshore resources. However,
technological advances in materials and techniques for
laying pipelines on the sea floor will continue to
reduce the investment costs of sub-sea pipelines
significantly.62
Local distribution
The increase in worldwide demand will be
concentrated in the electricity generation sector,
which, given the high pressures involved, normally
requires direct connection to transport lines. In
countries which have recently begun to use natural gas
(especially in Africa, Asia and many parts of Latin
America), relatively favourable climates often
preclude the widespread use of winter heating and,
therefore, reduce the convenience of building
extensive networks to supply the residential (and
commercial) sectors. In these countries, investments in
local distribution networks will be aimed mainly at the
industrial sector, with lower unit costs.
Technological advances are unlikely to affect the
unit cost of distribution networks significantly;
however, investment costs will vary considerably
between the various world regions and individual
countries, as a function of the cost of labour and the
prevailing supply sector (residential and commercial
as opposed to power generation and industry).63
Underground storage
The increase in underground storage capacity will
be concentrated in countries with cold winters,
requiring seasonal demand balancing. Significant
development is also forecast for some exporting
countries (especially in the case of associated gas) and
transit countries. The construction of new storage
capacity will also be driven by the liberalization of gas
markets, which encourages short-term sales, temporary
parking of gas in storage facilities to take advantage of
arbitrage opportunities. The impact of technological
advances in upstream oil and gas development on
investment costs in storage facilities will tend to be
counterbalanced by more restrictive environmental and
safety regulations in most of the world, and no
significant variations in unit costs are predicted.
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
THE ECONOMICS OF NATURAL GAS
Supply costs in 2030
The results of the IEA study are summarized in
Table 33, with reference to all the main cost
components in terms of three fundamental parameters:
the increase in capacity of the various components of
the global supply system between 2000 and 2030; the
related total investments; the specific unit investments.
The overall results show that 55% of investments
worldwide are required to develop production
capacity. Pipeline transport accounts for 18% of
overall investments compared to only 8% for LNG
transport (inclusive of LNG tankers and liquefaction
and regasification terminals), despite the far more
rapid growth of the latter.64 Local distribution
accounts for 16% and storage for 3% of the total.
These figures vary significantly from region to region,
depending above all on investment costs in exploration
and production and in transport infrastructure; though
these often have contrasting effects.
The most interesting data concern unit investments,
which appear highly diversified in different regions.
The overall unit investment along the whole natural gas
chain ranges from a minimum of dollars 235,000/Mm3
per year in the Middle East to a maximum of dollars
1,369,000/Mm3 per year in the United States and
Canada. Here, too, the main difference can be
attributed to exploration and production costs, which
range from a minimum of dollars 220,000/Mm3 per
year in the Middle East and dollars 335,000/Mm3 per
year in Africa, to a maximum of dollars
4,600,000/Mm3 per year in Europe. The significant
61 The contribution of labour costs varies considerably
between countries and world regions. For example, in the
United States, the average investment cost for onshore gas
pipelines increased from 470,000 to 760,000 dollar/km
between 1990 and 2000, essentially due to the increase in
the cost of labour, which currently accounts for about 50%
of the total unit cost. In China and other developing
countries, the cost of labour currently contributes about 10%
to the total cost, but this is likely to increase significantly in
the future.
62 The data available for the United States suggest that
unit costs halved (from 1,800,000 to 900,000 dollar/km)
between 1990 and 2000; the contribution of labour fell from
about 850,000 to 400,000 dollar/km, while the contribution
of materials fell from about 600,000 to 200,000 dollar/km.
63 The contribution of labour costs is inversely
proportional to the diameter of the pipes, and is therefore
significantly higher for networks aimed at the residential
and commercial sectors.
64 The incremental capacity is similar for both forms of
transportation (about 900 Gm3/yr between 2000 and 2030),
but the larger investments in replacing old gas pipelines
should be taken into consideration, especially in the regions
which developed earliest (United States and Canada, Russia
and other former Soviet countries, Europe).
147
BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY

Table 33. Investments in natural gas supply capacity (2000-2030) (IEA 2003b)

Exploration Tanker
Variables and world regions Liquefaction Regasification Transmission Distribution Storage Total
and development transportation**

Incremental capacity (Gm3)

United States and Canada 124 0 420 216 827 80 0 624
Japan and Oceania 84 90 56 13 14 6 75 312
Europe 55 6 268 139 693 84 5 418
Russia and other former
Soviet countries 500 22 0 167 535 129 18 669
Asia 478 82 139 119 827 30 69 797
Middle East 638 335 5 95 202 19 280 1,276
Africa 459 192 0 66 57 2 160 813
Latin America 429 107 0 88 356 6 89 632
World 2,767 834 888 903 3,510 356 697 5,542

Total investments (109 $)

United States and Canada 509 0 32 118 182 13 0 854
Japan and Oceania 47 12 7 15 13 2 7 103
Europe 252 1 19 83 113 23 1 491
Russia and other former
Soviet countries 271 3 0 117 50 39 2 481
Asia 200 11 8 76 74 10 7 386
Middle East 139 47 0 65 15 5 28 299
Africa 153 27 0 33 3 0 16 232
Latin America 159 14 0 51 40 2 8 275
World 1,730 115 66 558 489 94 68 3,120

Average unit investment

(103 $/Mm3·yr or 103 $/km)
United States and Canada 4,105 – 76 546 220 163 – 1,369
Japan and Oceania 560 133 123 1,112 953 299 94 330
Europe 4,595 167 70 597 163 274 118 1,173
Russia and other former
Soviet countries 542 136 – 703 93 298 96 719
Asia 418 134 59 642 89 340 95 484
Middle East 218 140 74 688 74 273 99 235
Africa 333 141 – 500 53 – 99 285
Latin America 371 131 – 575 113 319 93 434
World 625 138 75 618 139 263 98 563

* Transmission and distribution are expressed in 103 km. ** Sea transportation is shared among regions proportionally to the capacity
of (or investments in) liquefaction terminals.

differences between regions in the unit costs of local
distribution reflect the greater concentration of
investments in the industrial (rather than residential)
sector in areas with relatively warm winters.
The supply costs reported in Table 34 have been
estimated from the IEA investment forecasts,
considering depreciation expenses, operating costs
(materials and labour) and natural gas consumption
and losses, present in almost all phases of the cycle.65
The data reported are mean values centred around the
year 2030, and reflect the costs incurred along the
whole natural gas chain.66 The cost to the end-user
distinguishes between gas produced and consumed
within a country, gas imported by pipeline and gas
imported as LNG. The cost takes account of the matrix
of international flows identified by the IEA. However,
while the IEA only considers trade between different
world regions, the estimates reported in Table 34 also
include trade between countries within individual
regions.67
65 Based on parameters widely employed in
prefeasibility studies in the gas industry.
66 The assessment is inevitably sensitive to the
parameters used to estimate operating costs, but not
excessively so. For example, an overall increase in the
depreciation period of 10% increases supply costs by 5%,
whereas a reduction of 10% in gas consumption and losses
decreases costs by only 2%.
67 The largest differences concern flows within Europe,
the countries of the former Soviet Union and Asia.

148 ENCYCLOPAEDIA OF HYDROCARBONS

 THE ECONOMICS OF NATURAL GAS

Table 34. Average unit cost to the end-user in 2030 by form of supply (IEA, 2003b)

Supply (Gm3) Average cost ($/103)

Total
World regions Imports Imports average cost
Domestic Total Domestic Total ($/MBtu)
By pipeline As LNG By pipeline As LNG
United States and Canada 768 98 248 1,114 97 71 55 85 2.6
Japan and Oceania 93 5 108 206 40 31 51 46 1.4
Europe 314 410 181 905 101 45 54 66 2.0
Russia and other former
739 127 0 867 33 32 0 33 1.0
Soviet countries
Asia 547 49 91 686 43 31 62 45 1.4
Middle East 377 40 7 424 32 21 49 31 1.0
Africa 186 10 0 197 41 40 0 41 1.2
Latin America 368 54 5 427 47 36 60 46 1.4
World 3,391 794 640 4,825 58 43 55 55 1.7

Imports include flows between countries within individual regions.

The average worldwide cost resulting from this
exercise in 2030 is 1.7 dollar/MBtu. This cost refers to
the end-user and varies significantly from one world
region to another, both due to domestic production and
supply costs and the different contribution of domestic
production and imports. The costs range from a
minimum of 1.0 dollar/MBtu in the Middle East and in
Russia and the other former Soviet countries, to a
maximum of 2.0 and 2.6 dollar/MBtu in Europe and
the United States and Canada respectively. Given the
method of estimation, these results only reflect
production costs and do not include any economic
margin in the various components of the gas chain.
Actual market prices reflect the market conditions of
crude oil, oil products and other fuels with which
natural gas is in competition, as well as the indexing
mechanisms established in supply contracts. For a
comparison, reference can be made to the mean price
of the gas imported in the United States and Canada,
in Europe and in Japan and Oceania, which averaged
5.0, 3.9 and 4.8 dollar/MBtu, respectively, in 2003.
Table 35 shows the significant contribution of
investment costs to the total cost of supplying natural
gas to the end-user. Over the whole chain this amounts
to 50% worldwide, ranging from a minimum of 43%
in the United States and Canada to a maximum of 55%
in Africa. The far stronger variations for individual
components of the chain reflect the varying
contribution and cost of labour and materials in
different parts of the world, as well as differences in
gas consumption and losses along the chain.
Specifically, these range from a minimum contribution
of 23% for local distribution in the United States and
Canada to a maximum of 61% for exploration and
production in Asia. Worldwide, the highest share of
investment costs is in exploration and production at
56% and transmission at 55%. These are followed by
regasification at 48%, liquefaction at 47% and storage
at 44%. LNG transport and local distribution have a
lower share, around 30%, due both to the higher
contribution of the labour factor and the consumption
of materials, including natural gas itself.
2.4.5 From regional
to global markets
Definition of a global market
Markets are global when it is possible to purchase
commodities anywhere in the world and at any time, in
any quantity and for any period of time, based on the
price resulting from the unrestricted balance of supply
and demand on a global level. Markets are not global
when they are segmented on account of product
quality differentiation by constraints in transport
systems or obstacles of a commercial, regulatory or
fiscal nature.
In the case of oil, the convenience of sea transport
between different parts of the world has, from the
outset, allowed for a high degree of flexibility in flows
between origin and destination. Longer-term contracts
for oil and its derivatives exist, but from the mid-1980s
oil tanker cargoes have increasingly been purchased at
spot prices determined on international markets (New

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BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY

Table 35. Percentage values of depreciation in supply costs (IEA, 2003b)

Exploration
Sea
World regions and Liquefaction Regasification Transmission Distribution Storage Total
transportation
development
United States
49 – 46 53 23 38 – 43
and Canada
Japan and Oceania 55 45 50 54 35 51 36 50
Europe 52 46 47 53 26 41 32 45
Russia
and other former 57 47 – 52 29 45 30 53
Soviet countries
Asia 61 48 50 55 32 48 33 53
Middle East 58 47 48 56 30 46 28 51
Africa 58 47 – 58 30 – 31 55
Latin America 51 43 – 50 25 39 30 46
World 56 47 48 55 29 44 32 50

York Mercantile EXchange or NYMEX and the of gas between origin and destination. Gas prices in
International Oil Exchange or IPE). In the case of oil, the world’s main regions are far less correlated than
CIF (Cost, Insurance and Freight) prices in different those of oil, especially as far as monthly variations are
parts of the world are correlated and price differences concerned (Table 36).
essentially reflect differences in quality (Table 36).
Natural gas is quoted on the commodities markets Current market regions
(Henry Hub in the United States, National Balancing It is possible to identify three distinct regional gas
Point in the United Kingdom, Zeebrugge in Belgium), markets characterized by different mechanisms for
but at prices which have an exclusively regional or price determination. The US market is dominated by
local consequence, since the infrastructures suited to gas to gas competition, with prices indexed at the
managing interregional transport in real time are not Henry Hub; these reflect the balance between supply
normally in place. They would need to be planned and and demand and are therefore extremely volatile. The
implemented years in advance. The lack of suitable Japanese market continues to be dominated by take or
transport infrastructures precludes price discovery pay contracts, aimed at guaranteeing security and
reflecting the balance between supply and demand on continuity of supply, with rigid price formulas indexed
a global scale, because of restrictions on the free flow to a basket of oil products. In the European market,
long-term indexed contracts prevail, but the greater
potential for renegotiation and ongoing deregulation
table 36. Correlation of the average CIF are gradually encouraging competition and affecting
price and its variations in the major importing areas price formation, albeit in a still limited way.
(data based on IEA statistics referring to the period
January 1993-June 2005) The role of LNG
The globalization of the natural gas market is
Natural gas Oil generally associated with the development of LNG,
since this does not depend on rigid infrastructures
Monthly value (%)
United States and EU-15 76.1 99.5
which constrain the origin and destination of gas, as is
United States and Japan 76.3 98.5 the case for pipelines. Globalization would also be
EU-15 and Japan 86.2 98.4 possible in the case of pipeline transport, were the
technical and commercial conditions such as to allow
Monthly variation (%) rerouting the gas between different parts of the
United States and EU-15 25.9 92.4
network. Highly meshed networks, such as those in
United States and Japan 7.6 58.5
EU-15 and Japan 36.4 42.0 place in Europe and the US, only allow for the creation
of regional markets since the transport capacity to

150 ENCYCLOPAEDIA OF HYDROCARBONS


other world regions is insufficient. However, the
European market cannot be considered a genuine
regional market as long as it continues to be
segmented on a country by country basis by take or
pay contracts, destination clauses, price indexing
formulas and other restrictions which prevent the
emergence of a true market.
In the case of LNG, transport costs have a
significant impact on final prices, and proximity
between producing and consuming countries provides
a strategic advantage in contract negotiations.
Currently, the main transport flows identify two
regional LNG markets: the Asia-Pacific basin,
revolving around Indonesian, Malaysian and
Australian suppliers; and the Atlantic basin,
comprising the producers of North Africa and Latin
America. Trade flows from the Middle East towards
Asia, Europe and the United States are still not
sufficiently important to form a separate market and
tend to follow the pricing logic of these two basins.
The development of LNG projects
LNG projects originally had, and in part still have,
an integrated structure from production to liquefaction,
sea transport and regasification, with marketing based
on CIF contracts. The need to share risks has generally
led to different forms of joint participation in the
upstream segment of the chain (production, liquefaction
and storage, transport and marketing), corresponding to
the sale of LNG, and in the downstream segment
(storage and regasification, distribution and retail sales)
corresponding to its purchase.
In this context, the structure of participation in the
upstream segment is particularly relevant.
Liquefaction and storage are typically managed in a
joint venture between the production companies (the
state companies of producing countries, international
oil companies), the purchasing concerns and financial
institutions. Transport is entrusted to a commercial
maritime company which is usually partly owned by
the same parties operating in the liquefaction phase.
The 1990s saw the emergence of various partially
non-integrated projects characterized by the separation
of sea transport from production and liquefaction, with
the purchase of LNG on the basis of FOB (Free On
Board) contracts. Decoupling sea transport from the
other components allowed for greater flexibility and
opportunities for consuming countries, whose
companies entered into the ownership and
management of LNG shipping. Sometimes these
companies obtained a minority share in upstream
development projects in order to increase the security
of supply and gain greater control over prices. At the
same time, oil companies also began to own shares in
the sea transport and regasification phases.
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
THE ECONOMICS OF NATURAL GAS
More recently, independent concerns are taking the
opportunity for greater involvement in the ownership
of maritime companies, decoupled from specific
supply chains, with the objective of supplying spot or
short-term markets. Based on forecasts of strong LNG
growth, some independent companies have even
underwritten purchase contracts without a specific
market outlet (Wood, 2005). The most recent
developments suggest the possible extension of the
tolling model to liquefaction plants, with the
separation of production from liquefaction. However,
it is also true that these liberalising developments are
in part counterbalanced by the need to ensure a return
on investments.68
Despite the increasing flexibility of the LNG
market, it is unlikely that merchant facilities will
become established in the near future. Indeed, the
participation of purchasers bound by take or pay
contracts, at least for a part of the total production,
still remains a critical element in the development of a
liquefaction project.
Surplus capacity and spot markets
Over the past decade, the Atlantic basin has seen
increased flexibility in the gas market induced by the
high prices of the gas sold on the US market (after
2000) and the liberalization process under way in
Europe (since 1998). After almost twenty years of
inactivity, regasification terminals on the Atlantic
coast of the United States, have again begun to
operate at full capacity; with the major difference
that they no longer work exclusively with reference
to long-term contracts, but on the basis of short-term
contracts and spot sales based on the price
determined at Henry Hub. This logic has also
affected the European market, which has seen an
increase in re-routing of LNG cargoes originally
destined for Europe (especially Spain) towards the
United States since 2001.
While the focus in the Atlantic basin has
increasingly turned to prices, in the Pacific basin the
almost exclusive link with LNG has continued to
favour long-term take or pay contracts, for reasons
linked to security and reliability of supply. Even in this
market, however, spot sales and short-term sales have
begun to emerge, as a result of contingencies (such as
the temporary closure of the Arun plant in Indonesia),
which have had the merit of showing the sustainability
of more flexible forms of supply. The Japanese
68 See, for example, the exemption from third-party
access granted by the Federal Energy Regulatory
Commission, FERC, to the United States Hackberry plant
in order to encourage investments in regasification
(FERC, 2002).
151
BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY
utilities, which own most of the regasification
terminals, have for some years been pushing for
greater contractual flexibility, based on a mix of short,
medium and long-term contracts, aimed on the one
hand at safeguarding the profitability of investments
and the security of supply, and on the other at
balancing fluctuations in demand. Also, some Asian
and Australian suppliers have shown a greater
willingness to move towards shorter term take or pay
contracts (5 years as opposed to the two decades of
traditional contracts).69
The increase in short-term contracts and spot sales
is due to both short-term factors (the Asian crisis of
1999, the shut-down of liquefaction terminals, the
interruption of nuclear plants in Japan, high price
increases in the United States) and structural factors
(surplus liquefaction and regasification capacity, greater
commercial flexibility in Europe with the gradual
elimination of destination clauses). The growing gap
between the capacity of plants and their actual
utilization has already been mentioned (Table 16). In
the case of liquefaction, surplus capacity was in the
order of about 25 Gm3 in 2004. In the case of
regasification, the surplus of 250 Gm3 was concentrated
in Japan but was also significant in other areas.
Overall, it can be seen that the share of spot and
short-term sales on worldwide LNG markets has risen
from 1% in 1992 to about 9% in 2004. The strong
growth in recent years has essentially been determined
by the American market, where spot supplies
accounted for about 50% of world spot purchases in
2001 and 90% in 2004.70
Towards a global market
Between 1950 and 1980 gas markets developed
from basically national to regional and it is almost
certain that by 2030 they will have evolved from
regional to global. This depends essentially on the
development of international trade in liquefied gas.
However, for a genuinely global LNG market to
develop a gradual convergence of market practices in
the three large regional markets is required. In the
Japan and Oceania region, in Asia and in Europe, there
is a need for greater flexibility in pricing mechanisms;
in the United States, a greater reliance on long-term
contracts might facilitate the construction of import
terminals.
The forecast surplus capacity in the LNG chain
should facilitate a higher degree of liberalization in
LNG trade with the creation of a global market over
the next two decades. Current expansion plans indicate
an ongoing gap between the supply and demand for
liquefaction and regasification capacity, although this
seems certain to be smaller than in the past.
Furthermore, in the future, increasing sea transport
152
capacity decoupled from specific long-term supply
contracts appears to be a likely outcome.71
Overall, it is clear that over the coming decade
contractual flexibility will increasingly become the
strategic element in capturing new market share,
driven by the growing importance of the US market. In
this context, the forecast development of new
regasification terminals on the Pacific coast is
significant; this should transmit liberalization trends to
Asia and to the Japan and Oceania basin.72
Supply arbitrage will be determined by the need to
exploit the capacity of producing country terminals
and the price differential between different markets,
especially with respect to the US market, as has been
seen in recent years with LNG cargoes re-routed from
European ports towards the United States, and the
increase in prices at the Zeebrugge terminal, the main
LNG hub in Europe. This trend also affects Australia,
which is expanding its liquefaction terminals,
especially with a view to serving the US market.
Although globalization depends on the
development of LNG, it is not limited to LNG. In fact,
growing competition from LNG will tend to bring
globalization also to pipeline trade.
References
Baker Hughes (2005) BHI International rig count, Baker
Hughes.
BP (British Petroleum) (2005) BP statistical review of world
energy, London, BP.
CEDIGAZ (Centre International d’Information sur le Gaz
naturel et tous Hydrocarbures Gazeux) (1997-2004) Natural
gas in the world, Rueil-Malmaison, CEDIGAZ.
CEDIGAZ (Centre International d’Information sur le Gaz
naturel et tous Hydrocarbures Gazeux) (2004) LNG trade
and infrastructures, Rueil-Malmaison, Institut Français du
Pétrole.
69 The contract between the Malaysian MLNG Tiga and
some Japanese utilities, which involves a fixed long-term
supply for 60% of the volume, and annual contracts for the
remaining 40% is significant in this context.
70 Short-term supply accounted for 64% of LNG imports
to the United States in 2001 and 71% in 2004 (CEDIGAZ,
2004).
71 Malpensa (2002) notes that already in 2000 BP had
ordered three large LNG tankers (and an option on the
construction of another two) without specifying either the
origin or destination of the LNG. In 2004, 15 LNG tankers
not covered by specific supply agreements were in various
phases of construction.
72 At the end of 2004, 6 regasification terminals were
planned for the Pacific coast, with an annual capacity of
about 50 Gm3. These terminals represent 15% of the entire
regasification capacity currently in use or in the construction
or planning phase in the United States.
ENCYCLOPAEDIA OF HYDROCARBONS

Eurogas (2005) Annual report 2004-05, Eurogas.
FERC (US Federal Energy Regulatory Commission) (2002)
Hackberry LNG Terminal, L.L.C.: preliminary determination
on non-environmental issues, FERC Order 3049, 18
December.
IEA (International Energy Agency) (1960-2004) Energy
balances of OECD countries, Paris, Organization for
Economic Cooperation and Development/IEA.
IEA (International Energy Agency) (1971-1987) World energy
statistics and balances, Paris, Organization for Economic
Cooperation and Development/IEA.
IEA (International Energy Agency) (1989-2001) Energy
balances of non-OECD countries, Paris, Organization for
Economic Cooperation and Development/IEA.
IEA (International Energy Agency) (1996-2004) Natural gas
information, Paris, Organization for Economic Cooperation
and Development/IEA.
IEA (International Energy Agency) (2001-2004) Monthly natural
gas survey, Paris, Organization for Economic Cooperation
and Development/IEA.
IEA (International Energy Agency) (2003a) World energy
outlook 2002, Paris, Organization for Economic Cooperation
and Development/IEA.
IEA (International Energy Agency) (2003b) World energy
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
THE ECONOMICS OF NATURAL GAS
investment outlook 2003, Paris, Organization for Economic
Cooperation and Development/IEA.
IOGCC (Interstate Oil & Gas Compact Commission) (2005)
Marginal oil and natural gas. American energy for the
american dream, 2005 Report.
Malpensa M. (2002) Il mercato LNG: la nuova frontiera,
«Energia», 23, 60-73.
UNECE (United Nations Economic Commission for Europe)
(1999) Study on underground gas storage in Europe and
central Asia, New York, United Nations.
USGS (United States Geological Survey) (2003) World
petroleum assessment 2000. Description and results, Reston
(VA), USGS.
WEC (World Energy Council) (2001) Survey of energy
resources, London, WEC.
Worldwide gas processing survey (2005), «Oil & Gas Journal».
Wood D. (2005) Where we are: relationships, contracts
evolve along the supply chain, «Oil & Gas Journal», 103,
54-59.
Oliviero Bernardini
Autorità per l’Energia Elettrica e il Gas
Milan, Italy
153

International trade
and the LNG industry
Natural gas has been, until recently, essentially a
regional fuel. Until the early 1990s, cross-border
gas pipeline trade was largely limited to the major
North American, European and Russian pipeline
grids. A small but growing Liquefied Natural Gas
(LNG) market supplied OECD (Organization for
Economic Co-operation and Development)
markets in East Asia, Europe and North America.
However, there was very little interaction among
the various regional markets; the concept of a
‘world gas market’, analogous to the thriving
‘world oil market’, was all but inconceivable.
Now that is changing. The development of
gas-fired combined cycle technology (CCGT,
Combined Cycle Gas Turbine) has made gas the fuel
of choice for power-generation, stimulating global
interest in acquiring gas supply. This has not only
made importers out of previously gas-poor regions,
it has also taxed the traditional supplies of North
America and Europe, forcing them to look further
afield to satisfy their growing requirements.
Technological improvements, both in long-distance
pipelining and in LNG, have reduced the costs of
moving gas over long distances. There are also more
limited options for oil discoveries. Therefore,
international oil companies have turned their
investment attention to ‘monetizing stranded gas
assets’.
2.5.1 Gas trade
The most significant importers to date have been
the major industrialized countries in the OECD.
Table 1 lists the top nine gas importers in 2003,
showing the portion that comes in by pipeline and
as LNG, as well as the percent that imports
represent of the total gas supplied to markets in
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
2.5
the country. As markets change, new import
patterns follow. The United Kingdom, which has
been in surplus for many years, now faces
significant import requirements as its North Sea
production begins to decline and its demand for
gas continues to grow. While neither India nor
China imported any gas before 2004, both are
expected to become substantial importers in the
years ahead.
The major exporters have been countries with
large gas reserves relative to their own
requirements. Table 2 lists the top 11 exporting
countries in 2003, including their pipeline and
LNG imports together with the percentage share
that the imports represent of total production.
Many of the countries on the list still have
significant surplus reserves for export and are
prime candidates for expanded trade. Canada,
which has been the major cross-border supplier to
the United States, is an exception. It has found
difficulty in keeping up with North American
demand, and its ability to increase its exports
significantly is suspect.
In 2003, nearly 60% of world oil production
entered international trade, largely by tanker. In
contrast, only 21% of world gas production
crossed an international border. Yet that
represented a significant increase from 1978,
when only 11% of gas production traded
internationally, at a time when world oil trade was
54% of production. Fig. 1 illustrates the recent
share of world oil and gas production in
international trade, including that portion moving
in pipelines and as LNG.
Gas transportation costs
The low density of natural gas makes it more
costly to contain and to transport than either oil or
155
BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY

Table 1. Major gas importing countries, 2003

Imports
Pipeline LNG Total Total
as a percent
net imports net imports net imports gas supplied
of supply

United States 81.8 12.7 94.5 644.0 14.7%

Germany 76.4 0.0 76.4 94.1 81.2%

Japan 0.0 79.8 79.8 82.5 96.7%

Italy 55.9 5.5 61.4 69.6 88.3%

France 31.8 9.9 41.7 43.5 95.9%

South Korea 0.0 26.2 26.2 26.2 100.0%

Spain 8.7 15.0 23.7 24.2 97.9%

Turkey 16.2 5.0 21.2 21.6 98.1%

Belgium/Luxembourg 14.3 3.2 17.4 17.4 100.0%

coal. The result has been that gas – to paraphrase
a description of regional French wines – ‘does not
travel well’. Fig. 2 illustrates the costs of
transporting gas, oil and coal as a function of
distance. In addition, gas-transport economics are
particularly sensitive to economies of scale.
Large-diameter pipelines and large LNG projects
minimize long-haul transport costs, but they may
provide larger deliveries than the target market
can readily absorb. It is almost always cheaper to
transport oil by tanker than by pipeline.
Gas-transport costs are more complex however.
For shorter distances, pipelining is usually more
economical than LNG processing. Moving LNG
by tanker requires costly liquefaction and
regasification processing, regardless of the
distance over which the gas is to be moved.
Therefore, although the costs of moving the LNG

Table 2. Major gas exporting countries, 2003

Exports
Pipeline LNG Totale Total
as a percent
net exports net exports net exports gas supplied
of supply

Russia 131.8 0.0 131.8 578.6 22.8%

Canada 90.8 0.0 90.8 180.5 50.3%

Norway 68.4 0.0 68.4 73.4 93.1%

Algeria 33.1 28.0 61.1 82.8 73.8%

Indonesia 3.7 35.7 39.4 72.6 54.3%

Netherlands 29.2 0.0 29.2 58.3 50.2%

Malaysia 1.6 23.4 25.0 53.4 46.8%

Qatar 0.0 19.2 19.2 30.8 62.3%

Trinidad and Tobago 0.0 11.9 11.9 24.8 48.0%

Nigeria 0.0 11.8 11.8 19.2 61.4%

Australia 0.0 10.5 10.5 33.2 31.7%

156 ENCYCLOPAEDIA OF HYDROCARBONS

 INTERNATIONAL TRADE AND THE LNG INDUSTRY

70 from neighbouring countries, such as Canada to

60 oil trade
the United States or the Netherlands to
world production (%)

Germany. But as markets grow and taxes on

50
40
30
20
10
0 movements that often characterize
1978
1980
1982
1984
Fig. 1. International oil and gas trade as a percentage
of production.
over distance – once liquefied – are less than
those of pipeline gas, short-haul LNG is usually
not competitive with pipelining.
Because of limitations on offshore pipeline
technology, early marine gas movements were
often conceded to LNG. The first gas shipments
from North Africa to France, Italy and Spain, for
example, were in the form of LNG because of the
inability to lay pipelines across the deep water in
the Mediterranean. However, the successful
demonstration of deepwater pipelining, with the
laying of the Trans-Mediterranean Pipeline from
Algeria through Tunisia to Italy in 1981, has
enabled pipelines to compete with LNG for many
marine movements. The expansions from Algeria
to Italy, Spain and Portugal have all been by
pipeline since the first inauguration of the
trans-Mediterranean system.
Regional trade patterns
The early cross-border trade in North
America and Europe was commonly by pipeline
supplies increase, longer-haul trades, such as
LNG or pipelines from North Africa to Western
Europe, are becoming increasingly important.
total gas trade The International Energy Agency (IEA)
pipeline trade describes these movements as ‘inter-regional
LNG trade trade’, to distinguish them from the shorter
‘intra-regional trade’. While not all
1986
1988
1990
1992
1994
1996
1998
2000
2002
interregional trade represents long-haul
year transport, the regional distinction is a useful
way to look at the trend towards longer-distance
cross-border trade in natural gas. The IEA
defines its ‘regions’ in some of its publications,
such as the World energy outlook 2004. With
minor modifications, this analysis has adopted
the IEA’s regions as a basis for tracking trends
in international trade. The regions utilized in
this report are: OECD Europe, OECD North
America, Northeast Asia, the Transition
Economies, Africa, Southeast Asia (including
Australasia and South Asia), the Middle East
and Latin America. Two other important regions
– China and India – were not involved in
cross-border trade until India’s first LNG
import in 2004, but are expected to be key
importers in the future.
Fig. 3 traces the development of international
gas supplied to markets between 1978 and 2003.
Consumption of gas within the country in which it
was produced amounted to 84.4% of supply in
1978, but had declined to 79.1% by 2003.
Intra-regional trade grew from 6.6% in 1978 to
8.3% by 2003, a growth rate of 4% per year over
the period. However, inter-regional movements,
both by pipeline and as LNG, grew more rapidly
at over 10% per year.

Fig. 2. Illustrative costs 4

36'' low pressure 42'' high pressure
of gas, oil and coal offshore gas line offshore gas line 20
transport, showing gas’s (10.3) (30.5)
20'' onshore 36'' low pressure two train LNG,
higher costs and the effects 3 gas line 56'' low pressure
onshore gas line including
of scale (in brackets gas (2.6) (10.3) onshore gas line
regasification (8.9) 15
(32)
dollars/MBtu

deliverability capability
dollars/boe

in Gm3).
2
10

1 crude oil coal by

onshore 5
crude line tanker collier

0 0
0 2,000 4,000 6,000 8,000 10,000 12,000
distance (km)

VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION 157

BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY
Fig. 3. Sources 3,500
of world gas supply 1978 (%) 2003 (%)
(1978-2003).
3,000 domestic
intra-regional
inter-regional
2,500 LNG
2,000
Gm3
1,500
1,000
500
0
1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002
North America
The gas industries in the three major OECD
gas importing regions – North America, Europe
and East Asia – developed quite differently. North
America, with the large gas resources of the
United States and Canada, grew as an almost
completely self-contained regional system. In
recent years, the demand growth in the US could
not be fully supported by domestic gas, so it has
come to rely increasingly on Canadian surpluses.
But by 2003, intra-regional trade, largely from
Canada to the US, still accounted for only 11.4%
of North American supply.
The liberalization and restructuring of the
North American gas industry in the late 1970s and
early 1980s was a response to a failed period of
wellhead price controls in both the US and
Canada. The abandonment of price controls and
the opening of access to the pipeline system
occurred after the substantial increase in world
energy prices, following the oil-price shocks of
the early 1970s. One result was much higher
prices in North America, which served to depress
demand, creating a ‘gas bubble’ of surplus supply
for an extended period. This led to price
competition and the resulting inability to market
formula-priced LNG in North American markets.
The conservation-induced ‘gas bubble’ is the
major reason for the dip in North American gas
supplied in the early 1980s.
LNG has represented the only inter-regional
trade for North America. Exports have been based
on a small 1.3 million-tonne liquefaction facility
in the Cook Inlet of Alaska, which began exports
158
LNG imports
84.4 79.1 inter-regional imports
6.6 8.3 intra-regional imports
5.0 6.1
4.0 6.4 domestic supply
year
to Japan in 1969. The LNG import trade was
initially begun with Algeria in 1972, with the
construction of the first of four LNG receipt
terminals. Hovever, a pricing dispute with
Algeria, coupled with a restructuring of the North
American gas industry that made higher-priced
gas unmarketable, led to a sharp reduction in the
level of LNG imports. For a time, all US
terminals were shut down – two of them for more
than 20 years. But with the resumption of interest
in North American LNG imports, all four are once
again operating and have expanded or will
expand. In addition, a large number of potential
new import terminals have been proposed, with
several of these having passed the approval stage.
Northeast Asia
The pattern of natural gas development in
Northeast Asia was totally different. While both
Japan and Taiwan had small amounts of domestic
production (South Korea had no domestic gas),
the Northeast Asian industry had developed
almost entirely based on LNG imports. By 2003,
97.4% of the gas consumption in the three
Northeast Asian countries was based on imported
LNG. Thus, where North America was largely
self-contained, Northeast Asia was almost entirely
dependent on inter-regional LNG trade.
The first import into this market was the
Alaskan contract with Tokyo Electric and Tokyo
Gas in Japan in 1969. It was followed in 1973 by
a delivery from Brunei to Japan and in 1977 by
deliveries from Indonesia and from Abu Dhabi.
Japan was joined as an importer by South Korea
ENCYCLOPAEDIA OF HYDROCARBONS

in 1986 and by Taiwan in 1990. As recently as
1996, these three Northeast Asian importers
accounted for 78% of world LNG trade.
Between 1977 and 1994, the Alaskan and Abu
Dhabi imports were the only supplies originating
outside the Asia/Pacific region. Then an Abu
Dhabi expansion in 1994 and projects from Qatar
in 1997 and Oman in 2000 expanded the role of
Middle East gas in the Northeast Asian market.
Europe
If North America was largely self-contained
and Northeast Asia was almost entirely dependent
on inter-regional trade, European gas demand
developed in a much more complex way. The IEA
defines OECD Europe to include the newer
Eastern European members – the Czech Republic,
Hungary, Poland and the Slovak Republic. This
larger definition of Western Europe encompasses
what for a time were three separate, and largely
isolated, regional gas-distribution patterns – the
Continent, the United Kingdom and the imports
from the Russian grid.
Except for small North Sea boundary trades
with Norway and the Netherlands, the United
Kingdom was self-contained until the start-up of
the Interconnector pipeline in 1998, linking the
UK with Belgium. Initially, the Interconnector
was utilized largely as a means of exporting UK
North Sea surpluses to the Continent. More
recently, it has become a seasonal balancing
pipeline, exporting to the Continent in the
summer but importing in the winter to
accommodate the United Kingdom’s winter
peaking demand. As the UK increasingly must
depend on imports, the Interconnector may be
used to supplement the country's declining
North Sea supply. Likewise, if the commitment
to LNG imports is so large as to exceed UK
requirements, it can be used to bleed off the
surpluses to the Continent. The UK market is
therefore now integrated with the Continental
grid.
The former Eastern European countries that
are now part of OECD Europe were originally
exclusively supplied by the Russian grid. In
addition, Finland, most of Austria and Turkey
were also supplied by the Russian grid. These
patterns are also shifting, as the two grid systems
become more fully integrated. All the OECD
countries that were formerly exclusively supplied
by the Russian grid have now diversified, with the
exception of the Slovak Republic.
The market share of domestic supply to OECD
Europe has declined from 58% of the total in
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
INTERNATIONAL TRADE AND THE LNG INDUSTRY
1978 to 37% in 2003. The share of intra-regional
supply has also declined from 24% to 22%.
Inter-regional pipeline supply and LNG have
experienced the fastest growth. Thus the reliance
on supplies from outside OECD Europe has
grown from 17% of the total gas supply to 41%.
While Italy was a significant gas producer in
the early post-Second World War years, and
several other Continental countries, such as
Germany and France, have also had limited gas
production, it was not until the discovery and
development of the giant Groningen field in the
Netherlands in the early 1960s that a significant
Continental grid began to take shape. Groningen
gas is high in nitrogen; the initial deliveries to
Belgium, France and Germany were made through
a low calorific value system. The Netherlands has
for many years imported higher calorific value
gas and provides a richer blended gas system as
well.
The first Norwegian gas discoveries were
associated gas from the Ekofisk field in the early
1970s. The initial gas deliveries to the Continent
were to Germany, starting in 1977. Subsequent
Norwegian gas discoveries further up the
Norwegian North Sea, including the giant Troll
field, were also connected to the Continent. There
are now five separate marine pipelines serving
Germany, Belgium and France. The Netherlands
and Norway, together with limited exports from
the UK and Denmark, have been the source of all
the intra-regional gas in OECD Europe.
The major expansion of the Russian gas grid
(including supplies from the Ukraine and
Turkmenistan) into Western Europe took place in
1973/74, when pipelines to Germany and to Italy
ultimately made it possible to deliver gas from
Russia’s super-giant gas fields of West Siberia
into OECD Europe. From this base, the Russian
share of the OECD Europe market has grown
substantially. From a market share of 13% in
1978, it rose to a peak of nearly 27% in 1999
before an increase in LNG imports slightly
reduced its share. But the Russian share still stood
at 25% in 2003.
Algeria began its shipments to Europe as LNG
in 1964, with deliveries to France and the UK. It
followed with expansions to Belgium and Spain
and much later to Greece, Portugal and Turkey.
With the construction of the Trans-Mediterranean
Pipeline in 1981, Algeria added Italy to its list of
customers. Then, when the Maghreb pipeline to
Spain and Portugal was completed in 1996,
Algeria added a second pipeline route transiting
the Mediterranean into Europe.
159
BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY
While the Netherlands, Norway, the former
Soviet Union and Algeria constitute the lion’s
share of cross-border (intra and inter) trade into
Europe, LNG from other suppliers is becoming
increasingly important. Libya joined the ranks of
LNG exporters with projects to Italy and Spain in
1971. With the rapid increase in LNG trade,
Nigeria, Trinidad and Tobago, Egypt and Qatar
have also been added as suppliers through
long-term European contracts, while other LNG
shippers have supplied short-term volumes.
Despite the growth in Norwegian exports, the
inter-regional volumes have grown more rapidly
and now constitute 67% of total cross-border
trade.
Other Markets
To date, international gas trade has been
dominated by countries attached to the North
American, European and Russian pipeline grids as
well as the Northeast Asian LNG importers. Other
international trade has been scattered. For many
years, Bolivia exported gas to Argentina until
shipments stopped in 2000. Bolivia began major
exports to Brazil via the Bolivia-to-Brazil
Pipeline in 2000, but early deliveries were
disappointingly below expectations. Argentina has
exported gas to Chile, Brazil and Uruguay.
There have also been scattered trades in the
Middle East. Afghanistan exported gas to Russia
until the late 1980s and Iraq exported to Kuwait
until the Gulf War in 1990. Before the Iranian
Revolution, Iran was exporting to Russia and
commenced shipments to Turkey in 2001. Iran
also imports small quantities from Turkmenistan
and is also actively trying to initiate a pipeline
project to India via Pakistan, but progress has
been slowed by tensions between the two South
Asian countries.
In Southeast Asia, pipeline exports from
Myanmar to Thailand commenced in 2000.
Singapore began importing from Malaysia in 1992
and from Indonesia in 2001.
Forecasts
The IEA, in its World energy outlook 2004,
makes projections of inter-regional gas trade up to
2030. The IEA estimates of inter-regional imports
for 2030 compared to recent history show that
OECD Europe, which accounted for 63% of world
inter-regional trade in 2003 – 21% of it in the
form of LNG – will show the largest share of
growth in trade to 2030. However, its share of
world inter-regional trade will shrink to 52%, as
North America, India and China emerge as major
160
importers. The IEA does not attempt to estimate
the share of trade that LNG will capture relative
to pipelining. For Europe, Libya is joining the
pipeline exporters with its new Greenstream line
to Italy, and Russia and Algeria will continue to
compete for pipeline markets. However, LNG is
expected to grow more rapidly.
North America’s share of the growth of
inter-regional trade will be second only to that of
Europe. This is likely to be entirely in the form of
LNG.
The slowing growth of Northeast Asian (IEA
estimates have been adjusted to include Taiwan)
markets means that the region will lose its share
of inter-regional trade from 37% of the total to
20%. While pipeline options are under study for
both Korea and Japan, most of the growth is
expected to remain as LNG.
Both India and China are joining the list of
importers: India with its Daheej terminal receipts
from Qatar beginning in 2004 and China with
receipts from Australia into its Guandong terminal
in 2006. Political difficulties have stalled
potential pipeline projects into India, from
Afghanistan and Iran – transiting Pakistan – and
from Bangladesh. Until these political issues are
resolved, LNG is expected to capture the
inter-regional market into that country.
China is contemplating both LNG imports and
possible pipeline projects from the Kovytka field
in East Siberia or from Sakhalin. The way in
which the delivery balance finally develops
depends in part on the way in which gas markets
respond to the introduction of higher-priced
domestic gas, via the ambitious West-to-East
Pipeline from western China into Shanghai.
According to the IEA estimates for
inter-regional exports up to 2030, the Middle East
and Africa are expected to be the dominant
sources of supply growth. Together they
accounted for 33% of trade in 2003, but that share
will rise to 55% by 2030. The Middle East exports
will be predominantly in the form of LNG. While
North Africa is likely to emphasize pipeline
deliveries most heavily, exports from Nigeria and
other West African countries will probably be in
the form of LNG.
The transition economies will slip in share of
the export trade, from 39% in 2003 to 23% in
2030. Russia’s major supply area in Western
Siberia is maturing as its super giant anchor fields
– Urengoi, Yamburg and Medvezhye – begin to go
into decline. Expansion depends heavily on the
development of its challenging discoveries such as
Shtokman in the Barent’s Sea and the Yamal
ENCYCLOPAEDIA OF HYDROCARBONS
 INTERNATIONAL TRADE AND THE LNG INDUSTRY

Peninsula fields. In the East, Sakhalin is

1,250 optimum pressure drop
developing as major source of LNG – and about 30% between stations

pipeline pressure (lb/in2)

possibly pipeline – exports, while Kovytka in East
1,000
Siberia is a major candidate to supply China by
pipeline. 750
There will be further growth in Southeast flow
Asia, particularly from Australia, and from Latin 500
America. These exports are expected to be in the
station 1 station 2 station 3
form of LNG. 250

2.5.2 Economies of scale line pressure

and transport costs
Pipeline design and economics
The energy utilized for the transport of gas in
a pipeline is required, not only to overcome
frictional losses as is the case with oil, but also to
maintain the density of the fluid in the line. If
compressor stations are spaced too far apart, the
frictional pressure losses will result in gas
expansion in the line, to the detriment of its
carrying capacity. Thus gas pipelines are very
sensitive to compressor station spacing. An
optimum pressure drop in conventional lines is
about 30%, before pressures should be boosted
back to maximum design levels. This idealized
configuration for a traditional low-pressure line is
illustrated in Fig. 4. In the illustration, the
compressor stations are spaced about 120 km
apart.
Pipelines benefit from significant economies
of scale. As a result, pipeline designers prefer to
size the pipeline as large as market conditions will
permit, in order to minimize transport costs. But
markets are not static, they tend to grow. A line
that is designed for a particular flow rate will
often be under-utilized during the early period of
market build-up, with flows less than optimum.
Such a line is said to be ‘underpowered’. This
raises the unit cost of transportation, since the
Fig. 4. Pipeline operating conditions
at optimum: the effect of boosting compression
to optimize flows.
effectiveness of each line is apparent as it
approaches optimum utilization rates, as is the
deterioration in economics once the line must be
overpowered to increase flow rates still further. In
designing a system for a new market, the
developers need to decide how to select the best
size, given the expectations of market growth.
Selecting a pipe size that is too small risks an
early decision for costly physical expansion;
choosing one that is too large may subject the line
to prolonged periods of under-utilization.
Most new lines are designed to meet a market
target that is significantly larger than that
available initially. The most common method of
controlling costs is to delay the investment in
some compressor stations until growth in the
market requires them to meet the design target. At
reduced early flows, pipeline frictional losses are
low enough that the system can operate effectively
even with a reduced number of stations (Fig. 6).
1.25
cost per 1,000 km (dollars)

30" pipeline
design-capacity of the line is not fully utilized. 36" pipeline
At some point in market growth, the pipeline
operators are often faced with a flow 1.00 overpowered
requirement that is higher than optimum. They
may elect to utilize more compression to try to
pack more gas into the line, before they make
0.75 underpowered
the decision to invest in added capacity. This
‘overpowering’ option also incurs an economic optimum
penalty, since flow rates do not increase 5 6 7 8 9 10 11 12
sufficiently to offset the higher costs associated throughput (BCM)
with the higher pressures.
Fig. 5 illustrates the costs for two 1,000 km Fig. 5. Pipeline throughput
pipelines – with diameters of 30⬙ and 36⬙ – at versus transport
various flow rates. The improving cost cost for a 1,000 km, 1,000 psi line.

VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION 161

BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY
In a growing market, once the limited
increases in capacity from overpowering are
obtained, it is necessary to consider physical
expansion of the line. Such expansions are usually
achieved by an alternating process of ‘looping’
and adding more compression to existing stations.
In looping a pipeline, sections between
compressor stations are duplicated, providing two
sections of pipe where only one existed before. In
the looping process, the reduced line losses in the
doubled lines enable the gas to enter the
compressors at the next station at a high enough
pressure to boost discharge pressures to design
levels, despite the fact that the station cannot
achieve as high a compression ratio as it can at
original design flows. This pattern of pressure
operation is illustrated in Fig. 7.
After initial looping, the next expansion step is
usually to add compression at selected stations to
further increase the flow capacity. At some point
in the leapfrogging process of line looping and
compressor expansion, the line effectively
becomes fully duplicated. There are examples of
many multiple lines in some of the older systems
in the United States – in one case as many as nine
parallel pipelines at one location. In some cases,
this existence of parallel pipes enables the system
to segregate gases of a different quality, where
there is some advantage to doing so.
High-pressure pipelining
One of the major technical developments of
the 1990s was the introduction of improved steels
that made high-pressure pipelines feasible. The
traditional pipelines that were laid onshore in
North America and Europe were limited to about
1,100 psi. But a number of pipelines laid during
the 1990s were designed for pressures of between
1,250 pressure drops between stations 1 and 3
corresponding to the reduced flow
pipeline pressure (lb/in2)
1,000
750
reduced flow
500
station 1 no station 3
250 station 2
0
line pressure
Fig. 6. Pipeline operating conditions,
omitting a compressor station during market
build-up period.
162
1,250 pressure drop reduced
in looped sections
pipeline pressure (lb/in2)
1,000
750
increased flow
500
station 1 station 2 station 3
250
0
line pressure
Fig. 7. Pipeline operating conditions,
looping pipe between stations to increase
pipeline capacity.
2,200 psi and 2,800 psi. These pressure ranges are
useful for long-distance pipelining and have
proved especially useful for marine lines. For
example, the newer North Sea lines connecting
Norway’s Troll field with the Continent are all
high-pressure lines.
High-pressure lines are also valuable where
the target market is gas-fired power generation.
The traditional low-pressure lines may have
problems handling transient flows where the
power generators are dispatched as intermediate
or peaking loads. In contrast, the high-pressure
lines have more ‘line pack’ and can absorb the
variations in transient loads more easily. This was
one of the rationales for the high-pressure
Yacheng pipeline from offshore Hainan Island,
China, to Hong Kong, which commenced
operation in 1996.
The increasing trend towards offshore
exploration and production requires greater use of
marine pipelining. This has been particularly true
in the North Sea, the offshore Gulf of Mexico,
West Africa and in Southeast Asia. In addition,
there are situations, such as pipelines from North
Africa across the Mediterranean to Southern
Europe, where marine pipelines offer a
competitive alternative to liquefaction and
shipping the gas as LNG.
The need to position compressor stations for
optimum flows poses a special challenge to
marine pipelines. In shorter hauls, such as from
most production platforms in the Gulf of Mexico,
compression on the producing platform is
sufficient to deliver the gas to an onshore
compressor station. But for the longer distances,
such as have been increasingly encountered in the
North Sea, it may be necessary to add a ‘riser’
ENCYCLOPAEDIA OF HYDROCARBONS

platform to house an intermediate booster
compressor station. These platforms add
significantly to the cost of the system.
The first gas delivery from the Norwegian
North Sea to the Continent was associated gas
from the Ekofisk field, delivered to Emden,
Germany. This required a 440 km, 36" line,
which has two riser platforms, effectively
averaging 145 km between stations. Satellite
fields in the Ekofisk area utilized the Ekofisk
platform for onward compression; as exploration
proceeded further north, some of the fields also
utilized the Ekofisk complex as a booster
station.
One of the advantages of high-pressure
pipelining when applied to marine lines is that it
reduces the need for intermediate booster
compressor stations. The group of pipelines
designed to serve the Continent from Troll in the
Norwegian North Sea are high-pressure lines. As
an example, the 42" Franpipe system delivers
from a central North Sea riser platform to
Dunquerque in France over 840 km, without the
need for another riser.
Fig. 8 illustrates the advantages of
high-pressure pipelines. It uses for illustration a
movement equivalent in distance to the Franpipe
system in the North Sea (850 km) and designed
for 15 Gm3. If the line were to be built with the
earlier low-pressure technology, it would require
riser platforms and looping to handle the volume.
With a high-pressure system, the total CAPital
EXpenditure (CAPEX) is significantly lower and
the resulting tariff is 36% lower than it would be
with the low-pressure system.
Trends in pipeline construction costs
The introduction of high-pressure pipelining
led to a substantial cost reduction for those
situations where it was applicable (it may not be
indicated for small or short lines or lines that are
interconnected with a low-pressure grid).
However, the cost reduction was associated with a
significant change in design. In those cases where
standard designs are utilized, there may be an
increasing cost burden on pipelining, since there
have been increases in the costs of labour and
materials.
Individual pipeline project costs vary
significantly from project to project, even for
identical designs, because of local differences in
terrain, degree of urbanization, regulatory
constraints and local labour costs. Therefore,
given the fact that the number of new pipeline
projects undertaken annually is limited, it is
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
INTERNATIONAL TRADE AND THE LNG INDUSTRY
capital expenditure (106 dollars)
3,000 1.40
pipeline tariff (dollars/MBtu)
2,500 1.20 must be
looped
1.00
2,000
0.80
1,500
0.60
1,000
0.40
500 0.20
0
high low
0.00
high low
pressure pressure pressure pressure
compressor compression pipe
stations
Fig. 8. Illustrative marine pipelining
costs – newer high-pressure line compared
to older low-pressure line with compressor
riser platforms.
difficult to get a large enough sample of projects
to establish trends in pipeline costs.
One pipeline cost series that does provide a
time series of pipeline construction cost trends is
the annual Pipeline economics issue of the «Oil &
Gas Journal». It publishes a summary of US
pipeline construction costs, broken down by
pipeline diameter, project length and four cost
elements: right of way, materials, labour and
miscellaneous costs. While it is limited to US
projects, the sample is large enough to give some
sense of cost trends and how much cost variation
there is among similar pipeline projects.
There are wide cost variations for similar
projects even in the same year. For example, the
2005 survey lists 12 different projects involving
36" pipe. The average cost for the 12 was 1.15
million dollars per km, but the range was from a
high of 2.19 million dollars to a low of 0.72
million dollars. In general, costs were at their
peak for pipeline projects that were very short in
length or were located in very urbanized areas
such as the United States Northeast. For the six
projects that were longer than 50 km and outside
the urbanized Northeast, the range was smaller. It
varied from a high of 1.11 million dollars per km
to a low of 0.72 million dollars, with an average
of 0.88 million dollars.
A time series for pipeline costs from the
«Oil & Gas Journal» survey suggests that there
has been some tendency for rising costs for
similar projects. Fig. 9 shows an index of both 36"
pipeline costs and compressor horsepower. While
the compressor horsepower trend rises only 17%
163
BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY
over the 14-year period, the 36" pipe trend
increases 155%. Several features of US pipeline
construction costs may make this time series
overstate the cost increases somewhat for other
markets. The demand growth in the high-cost
Northeast has led to a significant number of
shorter, more costly looping expansions.
Furthermore, the resistance to energy project
siting – NIMBY (for Not In My Back Yard) – has
complicated and lengthened the approval process
for new pipelines. In markets where regulations
are less stringent, some of these cost increases
may not apply.
However, the sharp escalation in steel costs in
the mid 2000s, accompanying the burst of
Chinese demand, has seriously affected pipeline
costs. Since steel typically has represented 20% to
30% of the costs of large-diameter pipelines, any
significant escalation in steel costs has a
substantial impact on pipeline construction costs.
The effect is somewhat greater for the smaller
lines, since the capacity of larger pipe increases
somewhat more rapidly than does the steel content
of the pipe.
Deep-water pipeline technology
One of the most significant developments in
pipeline technology is the ability to lay pipelines
in deep water. When the first Algerian gas exports
to Mediterranean Europe began, the technology to
lay pipe across the deep trench that separates
Tunisia from Sicily, or Morocco from Spain, did
not exist. Hence, the first exports were in the
form of LNG, despite the fact that short-haul
LNG pays a significant economic penalty because
of costly liquefaction and regasification,
regardless of the distance required.
The deep-water pipelining problem was first
solved with the construction of the
%
36" pipeline
250
compressor horsepower
200
150
100
index 1990⫽100
50
1990 1992 1994 1996 1998 2000 2002
year
Fig. 9. Trends in pipeline construction costs
(36" pipelines and compressor horsepower).
164
Trans-Mediterranean pipeline system from
Algeria through Tunisia to Italy in 1983. This line
crossed a 600 m trench between Tunisia and
Sicily. Since that technical breakthrough, all gas
export expansions from Algeria to Italy or to
Spain have been by pipeline, rather than as LNG.
One of the key elements of this technology
is the development of new techniques for
laying pipe in deep water. On the conventional
‘S lay’ barge, sections of the pipe are welded in
the horizontal position on the deck of the
vessel. The pipe sections describe an ‘S’ as
they are fed off the barge horizontally, slope
down to the seabed and settle in horizontally
again. In order to prevent buckling of the pipe,
sharp angles must be avoided and the sloping
length of pipe between the barge and the
seabed must be long.
The new technology, pioneered by Eni’s
affiliate, Saipem, is called ‘J laying’. The ‘J lay’
barge holds the pipe in a vertical position for
welding and then it feeds it vertically down to the
seabed, minimizing the length of pipe that must
be supported by suspension from the barge. While
there are some problems with welding in this
position, the technique permits greater depths
without the risks of destructive stresses on the
pipe itself.
It was clear at the time the trans-Mediterranean
system was laid that the cost advantage favoured
the pipeline option over LNG for the shorter
distance to Italy. However, both LNG and
pipelines have experienced cost changes over time
as technology has improved. For LNG, the cost
reductions in liquefaction and in tankers have
been substantial. For liquefaction, the largest
improvements have come in the scale of the
liquefaction trains. From a period when turbine
design limited trains to about 2 million tonnes,
sizes have rapidly increased, providing improved
economies of scale. The pivotal event in
liquefaction design occurred with the construction
of the first train in Trinidad and Tobago in 1999.
That train was the first to break the previous 2
million-tonne-train barrier, and it set off a wave of
expanded train designs. Four million-tonne trains
are now normal and Qatar has 7.8 million-tonne
trains on the drawing boards.
Tanker-cost reductions appear to be much
more the result of shipyard competition than of
either scale or design improvements. For a time,
2004 Japanese shipyards dominated the LNG tanker
business, but the entry of Korean yards into
competition in the 1990s set off a wave of price
reductions.
ENCYCLOPAEDIA OF HYDROCARBONS

The cost improvements in pipelining have
come primarily from changes in design, such as
high pressures and marine pipelaying. However,
the underlying tendency for material and labour
costs to rise seems to be a partial offset to the
design improvements.
The perception that trans-Mediterranean
pipelining costed less than LNG probably held
true until the late 1990s. In the mid 2000s,
pipelining’s superiority is not as clear-cut. Fig. 10
provides an illustration of the comparative
economics of pipelines and LNG from Algeria to
Italy, from both a pre-Trinidad and Tobago
perspective of 1997 and another in 2005. It shows
the pipeline as the cheaper alternative in 1997 but
indicates that LNG may have won out by 2005. In
the illustration, LNG costs have benefited from
the cost-reduction trends of the last few years, but
the use of the same pipeline design in the two
periods would have resulted in a cost increase
(assumed to be about 25%) due to higher material
and labour costs.
It is difficult to make direct comparisons of
the economics of the two gas-delivery systems.
The pipeline in the illustration is designed to
deliver to Rome (although the actual
trans-Mediterranean system goes further north)
and would be delivering gas along the way in
Sicily and southern Italy. The LNG project
comparison is limited to delivery of regasified
LNG at the La Spezia terminal near Genoa,
without any ongoing further distribution. Thus
their destinations are not strictly comparable.
Also, the trans-Mediterranean system was
substantially expanded in 1996, providing some
potential for economies of scale over the original
design.
The comparative economics of a
Mediterranean crossing to Spain more clearly
favour pipelining. The construction of the
Mahgreb Pipeline to Spain was also completed in
Fig. 10. Illustrative costs 2.50
of delivering gas from
Algeria (Hassi R’Mel) 2.00
dollars/MBtu
to Italy. Estimates assume
original pipeline design 1.50
sizing, two-train LNG
plants, present construction 1.00
costs and 90% pipeline
load-factor operation. 0.50
0
LNG trans-Med
pipeline
La Spezia Rome
1997 perspective
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
INTERNATIONAL TRADE AND THE LNG INDUSTRY
1996. Despite the assumed increase in pipeline
costs and the reduction in LNG costs, the pipeline
alternative is favoured in both cases.
Deep-water pipeline technology has opened up
a number of options for gas pipelining that were
previously unavailable. Norway had been unable
to land North Sea gas on its own territory because
of the Norwegian trench that separates the
mainland from the North Sea shelf. In 1985,
Statoil was able to cross the trench for the first
time with the Statpipe system, landing the
Statfjord gas at Karsto on the mainland, before
retransmitting it across the trench to the North
Sea onward compression risers.
However, the most challenging deep-water
transmission system to date has proved to be
the Blue Stream project, which crosses the
Black Sea from Russia to Turkey. This 374 km
marine pipeline, jointly owned by Eni and
Gazprom, achieves depths of 2,150 m. It
commenced operation in 2003. At such great
depths, care must be taken to avoid external
stresses on the pipe which might cause it to
implode. At 2,150 m, pressures exceed 3,100
psi. As a result, the Blue Stream line is
designed to withstand 5,150 psi and operates at
a pressure of nearly 3,700 psi.
There has been a great deal of attention paid to
the technical – and cost – improvements in LNG.
But the demonstration of deep-water pipe
technology opens up competition between
pipelines and LNG for marine movements that
were previously unfeasible.
Economies of scale in pipelining
Pipelines exhibit significant economies of
scale. While the costs of onshore pipeline
construction tend to be a function of the diameter
of the pipeline, the carrying capacity is more
closely related to the cross-sectional area of the
pipe, a function of the square of the diameter.
pipeline pipeline to Rome
costs
have water crossing
risen; pipeline to coast
LNG costs
have regasification
come
down tanker transport
liquefaction
pipeline to plant
LNG trans-Med
pipeline
La Spezia Rome
2005 perspective
165
BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY
onshore pipelines
high pressure
1.50 low pressure
dollars/MBtu
1.00
0.50
0
42" 36" 30" 42" 36" 30"
Gm3
42" high pressure, 30.2
36" high pressure, 20.5
30" high pressure, 13.6
42" low pressure, 12.9
36" low pressure, 8.8
30" low pressure, 5.9
Fig. 11. Illustrative costs of delivering gas
by pipeline over a 1,000 km distance
(gas deliverability in Gm3).
Thus an onshore pipeline with twice the diameter
tends to have four times the capacity of the
smaller line. Marine pipeline comparisons are
somewhat less straightforward, but scale
economies are still very important.
Fig. 11 compares the costs of delivering gas
over 1,000 km via several sizes of onshore and
offshore pipelines. For onshore pipelines in the
illustration, an increase in size from a 30"
pipeline to one of 42" reduces the cost by 32%.
If the 42" line is converted to high-pressure
operation, the total cost reduction is 51%. For
offshore lines, the savings with scale are even
greater. The 42" line saves 37% over the 30"
line and 63% when the 42" line is designed for
high pressure.
The ‘tug-of-war’ between pipeline scale
economies and market size
To minimize costs, pipeline designers like to
utilize the largest possible pipeline size. However,
many markets are not large enough to support the
larger volumes, creating what might be described
as a ‘tug-of-war’ between market size and
optimum pipeline sizing.
LNG has the advantage that the larger
volumes from worldscale liquefaction trains
can be distributed to smaller terminals in a
number of markets, thereby avoiding the
overloading of any one terminal. On the other
hand, LNG terminals are sited at coastal
locations and the regasified LNG must be
166
offshore pipelines further transported inland by pipeline if it is
high pressure to serve interior markets. Thus countries with
1.50 low pressure urban concentrations at the coast, as was the
case with Japan, Korea and Taiwan, are well
suited to LNG supply. The large and
1.00 populous interior regions of countries, such
as China or India, must be supplied by
0.50
pipeline, even if the gas originates at a
coastal LNG terminal.
It is difficult to generalize how economical
0
42" 36" 30" 42" 36" 30"
pipeline supply will be to various countries, but
some idea of the scale challenges to markets
Gm3 can be gained by comparing the sizes of various
42" high pressure, 28.0
36" high pressure, 19.0 national markets. Fig. 12 provides one such
30" high pressure, 12.7 comparative illustration. It utilizes historic data
42" low pressure, 12.9
36" low pressure, 8.8 from a number of the larger countries that
30" low pressure, 5.9 already have or have contemplated pipeline
supply, to create a ‘gas market size index’. The
Index takes the incremental gas for final
consumption (excluding power generation) for
the five-year period 1998 to 2002. It adds to it
the amount of additional gas that would have
been required had 25% of all incremental power
generation in CCGT units been fuelled by gas in
combined cycle gas turbine units. This is
designed to represent the size of the market that
a project developer might have hoped to supply
in the various countries.
Fig. 12 also shows the delivery capacity of a
42" high-pressure pipeline, as well as that of both
36" and 30" low-pressure lines. The graph does
not attempt to adjust for indigenous consumption
nor for imports of LNG. But it shows how small
35
30
42" high pressure pipeline
size index (Gm3)
25
20
15
36" low pressure pipeline
10
30" low pressure pipeline
5
0
China
Korea
Japan
Brazil
India
Pakistan
Turkey
Thailand
25% power CCGT load
gas consumption
Fig. 12. Gas market size index
for selected isolated gas-importing countries
compared to pipeline delivery capacities.
ENCYCLOPAEDIA OF HYDROCARBONS

some of these markets are compared to the
delivery capacity of pipelines, as well as how
dependent the justification of large diameter
pipelines is on the development of a
power-generation market.
China, which shows the largest Gas Market
Size Index, is heavily dependent on the rate at
which gas can capture the power-generation load.
The ambitious 4,200 km West-to-East Pipeline
from the Tarim Basin to Shanghai is designed as a
12 bcm system, a considerably lower capacity
than a 42" high-pressure line would provide. Yet
the delivered cost from the pipeline is
considerably higher than the cost of coal in the
market region.
Although Korea has been a much smaller gas
market than Japan – 26.9 Gm3 in 2003 compared
with Japan’s 76.5 Gm3 – its faster growth rate
gives it a higher Gas Market Size Index. Both
Japan and Korea have been entirely dependent on
LNG supply through the mid 2000s, although
both have given serious consideration to pipeline
supply alternatives. However, a division of the
growing gas market between LNG and pipeline
supply makes it even more difficult for the
available market to justify large diameter
pipelines. In Japan’s case, the pipeline option is
further complicated by the fact that it does not
have a national gas distribution grid, having
developed its industry in isolated regions
surrounding its LNG import terminals. Since the
costs of pipeline construction in Japan are very
high, this represents a substantial barrier to the
pipeline option.
Brazil’s expected demand for thermal power
was a major motivation for the construction of
the 3,415 km Bolivia-to-Brazil gas pipeline
which went on-stream in 1999. The design
capacity of the line is 11 Gm3, but by 2003
actual deliveries had only reached 4.9 Gm3. The
difficulties of building new gas-fired power
generation (with must-run status) in the face of
heavy Brazilian reliance on hydro power,
together with currency devaluation problems,
have been a barrier to achieving planned levels
of operation.
From Fig. 12, it is evident that much of India’s
expected growth in gas demand will come from
power generation. Because of the political
problems of supplying Iranian or Turkmen gas via
Pakistan or importing from Bangladesh, the first
gas imports are as LNG. While pipeline projects
remain under discussion, a division of the market
between LNG and pipeline supply will complicate
the pipeline scale problem.
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
INTERNATIONAL TRADE AND THE LNG INDUSTRY
2.5.3 International contracts
Issues addressed in international gas contracts
Both pipelines and LNG projects are highly
capital-intensive, with the potential for significant
financial risks to investors. Thus it is not
surprising that both pipelines and LNG
investments have traditionally relied on long-term
contracts between buyer and seller as a means of
sharing risks. The centrepiece of these agreements
is the Sale and Purchase Agreement or SPA.
While there are some differences in contract
terms, many of the terms and conditions that
govern pipeline and LNG trade are similar.
Contracts themselves can be many pages in length
but will generally cover the following topics: a)
term; b) quantities; c) rates of offtake; d ) volume
obligation; e) source of supply; f ) point of
delivery and transportation; g) gas quality and
other technical provisions; h) price; i) force
majeure; j) and dispute resolution.
Term
This portion of the contract defines the term
over which it will be effective and specifies the
timing of initial deliveries. Early contracts were
commonly of at least 20 years’ duration and
contracts of 25 to 30 years were not uncommon.
With the restructuring of the natural gas industry
in North America, the United Kingdom and
increasingly the European continent, there has
been pressure to shorten contracts. This has been
most pronounced in pipeline contracts, while
somewhat less so in LNG contracts. The contract
will commonly specify a ‘plateau’ level of offtake,
but since most customers need some time to grow
into their planned market demands, it will also
provide a ‘build-up’ period, during which a lesser
offtake liability applies.
The liberalization of gas markets has led to the
development of short-term and spot-market
trading. In the liberalized North American and
UK pipeline markets – and increasingly in the rest
of Europe – ‘open’ or ‘Third Party’ Access (TPA)
to the systems is required by regulation. Thus the
traditional pattern whereby customers purchased
both transportation and gas as a bundled product
has been eliminated, and customers buy the gas as
a commodity and arrange transportation
separately. Since gas has become a tradeable
commodity in these markets, the spot market has
become the predominant form of pipeline trade.
When these markets first liberalized, there was
an overhang of spare pipeline capacity and it was
easy to arrange short-term pipeline capacity in
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BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY
order to move the gas. In the United States,
pipeline capacity is arranged on a monthly basis
during what is called ‘bid week’. In a period of
surplus capacity, long-term commitments were
unnecessary. However, as expanded pipeline
facilities were needed, investors required some
assurance of debt service coverage. Thus a
pipeline capacity commitment – a ‘ship-or-pay’
agreement – came into being. Various potential
customers would bid for expanded capacity during
an ‘open season’, and the winning shippers would
undertake a long-term obligation for payment
very similar to the earlier long-term contract.
Lengths might have been shorter, but they would
still need to be long enough to cover debt service.
While short-term trading has also developed in
LNG, it is a much smaller factor than it is in
pipeline trading. As of 2004, the volume of
short-term LNG trades was still less than 12% of
total trade and no new LNG facility had been
launched without at least some portion of the
production ‘anchored’ by long-term contracts.
Thus the long-term contract is likely to remain the
mainstay of the LNG business, even if it is much
less important in pipelining.
Quantities, rates of offtake
Both pipeline and LNG contracts commonly
specify a target or ‘plateau’ volume. This is
usually called the Annual Contract Quantity
(ACQ). In order to enable customers to grow into
their contract commitments, most contracts
establish a build-up volume schedule at some
level less than the full ACQ. There may also be
provisions for some flexibility to increase or
decrease annual contract volumes as well as, in
some cases, some provision for seasonal
flexibility.
Because of the importance of scheduling
tanker deliveries for optimum facility utilization,
LNG contracts will provide for an annual delivery
programme. This will provide a schedule for the
delivery and receipt of cargoes over the year.
Pipelines commonly measure capacities on a
daily basis and thus many contracts will specify a
Maximum Daily Quantity (MDQ) in addition to
the ACQ. Customer requirements will typically
vary over a 24-hour period, but for traditional
pipeline loads these transient variations can be
handled by ‘line pack’, the storage provided by
gas in the pipeline under pressure. However,
where the intra-day loads vary too significantly
they can undermine pipeline deliverability, so that
most contracts will specify some limitation on
hourly flows as well. For example, some pipelines
168
in the Northeast of the US, where seasonal
space-heating loads predominate, utilize a ‘6%
rule’. That is, the customer cannot take more than
6% of his MDQ in any hour. That amounts to a
70% daily capacity factor on the basis of the peak
hourly send-out.
This provision has proved to be especially
important in the growing utilization of pipeline
gas to CCGT or Combustion Turbine (CT)
power-generation loads. These units, when on
intermediate or peaking service, can cause severe
drains on pipeline line pack. Some of the newer
pipelines designed for these types of customer
loads now utilize high-pressure operation to
maximize line pack.
Since pipelines are the ultimate vehicle for
delivery of gas to customers, they are the link
between storage services and final utilization.
Thus many pipelines offer some form of seasonal,
storage or peaking service to meet these uneven
demands.
Volume obligation
In the traditional contract, the risk-sharing
principle is often stated as: the buyer takes the
volume risk and the seller takes the price risk.
This buyer’s obligation commonly takes the form
of a ‘take-or-pay’ clause. If the buyer is unable to
accept deliveries of the gas at the price level
specified in the contract, he will still be obligated
to pay for gas as if he had taken it. For LNG
contracts, this is commonly at the level of 90% of
the ACQ, although customer pressures for greater
offtake flexibility have led to reductions in this
level in some cases. Contracts may include
‘make-up provisions’, specifying how the
customer may recover gas volumes paid for but
not taken. In some cases, these may include some
form of penalty payment.
Pipeline contracts, often designed to serve
more seasonal or varying loads – and often
backed by storage – may be more flexible. They
may also use a ‘minimum bill’ provision instead
of the take-or-pay clause. This simply multiplies
the minimum required volume-take by the price,
to specify a sum of money that is to be paid for
the period.
Source of supply
Pipelines and LNG facilities require enough
supporting gas reserves to make sure that the
delivery levels specified in the contract can be
met throughout contract life. For LNG facilities, it
is common to dedicate a specific proved reserve
of natural gas to the contract to guarantee such a
ENCYCLOPAEDIA OF HYDROCARBONS

delivery schedule. Since gas fields late in life face
declining deliverability, it usually requires the
dedication of more gas reserves than the total sum
of gas to be delivered under the contract. For
example, it might require as much as 28 years of
reserve commitment at plateau volumes to
guarantee deliverability over a 20-year contract.
In pipelining, where new fields in a producing
basin are being added through exploration, the
rigid dedication of specific reserves may well be
waived. In such a case, the supplying company
‘warrants’ (promises) that it will deliver gas over
the life of the contract, even if it cannot tell the
customer specifically where the gas will come
from. This ‘warranty gas’ is very common in
North American pipeline operation, even though
there have been some well-publicized failures at
times in the past.
Point of delivery and transport
Contracts specify the point at which title
passes from seller to buyer. For pipelines, this is
apt to be a meter station. However, for LNG
contracts the common options are either Free On
Board (FOB) or ex-ship. FOB deliveries take
place at the loading flange connecting the vessel
to the liquefaction plant, while ex-ship deliveries
take place at the vessel’s discharge flange
connecting it to the receipt terminal.
Tankers may be owned by seller, buyer or by
third-party tanker operators. When deliveries are
made FOB, the tanker may be owned by the buyer
or a third party, while in the ex-ship delivery case,
it may be owned by the seller or a third party. The
contract will usually specify who bears cost
responsibility for unanticipated extra transport
costs, such as for delays or for excess ‘boiloff ’ on
the tanker.
Most contracts have traditionally had
‘destination clauses’ that restrict the flexibility of
the buyer to resell gas that was contracted
specifically to him. These destination clauses
have come under fire from the regulatory
authorities as restrictive of the operation of a free
market, and they are gradually being eliminated in
many contracts.
Another issue in dispute, for those contracts
that do not restrict destinations, is the sharing of
any additional profitability between governments
and companies when LNG cargoes are redirected
to a more profitable market. This was a
particularly difficult issue between the
Government of Trinidad and Tobago and the LNG
producers who were active in the Atlantic Basin
arbitrage market.
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
INTERNATIONAL TRADE AND THE LNG INDUSTRY
Quality and other technical provisions
Contracts specify the procedures to be used for
measurement and testing of the gas to be
delivered as LNG or transported in a pipeline.
They also provide gas-quality specifications that
are acceptable for LNG deliveries or for pipeline
transportation. The quality specifications may be
in the form of a simple range of acceptable
heating values of the gas or they may be more
specific about chemical composition.
Quality has become a major issue in LNG
trade. Early contracts were commonly destined for
a single customer or group of customers whose
systems were designed around the specification of
the particular gas they were receiving. However,
with the emergence of much greater trading
flexibility, cargoes are now frequently diverted to
customers whose original supplies were of a
different quality.
The problem is especially severe in LNG,
since markets in North America and much of
Europe are accustomed to pipeline supply of
comparatively lean quality (high methane content,
with comparatively low concentrations of higher
hydrocarbons). However, many LNG exporters
have no market for the gas liquids and leave a
substantial portion of the heavier hydrocarbons,
such as ethane and propane, in the gas stream.
This yields a gas with a higher heat content and
may cause interchangeability problems in certain
markets. It is possible to modify these ‘hot’ gases
by nitrogen or air blending, or even by liquids
extraction, but it remains a problem for many
receiving terminals. Gas quality has become an
area of major concern and is under study by
industry committees.
Europe has traditionally had a gas-quality
problem for its pipelines, since the Gronigen gas
that is exported by the Netherlands is high in
nitrogen, with a resulting lower heat content. As a
result, Gasunie in the Netherlands has two export
systems – the low-calorific Gronigen system and
a more common higher-calorific value system.
Price
If the buyer is expected to assume the volume
risk in a long-term contract, the seller is expected
to assume the competitive risk of energy price
changes. The contracting parties commonly agree
on a ‘base price’ as a part of the contract. This
base price takes into account the ability of gas
from the project to compete in the target market at
the time when the contract is signed. But the
fluctuation in energy market prices is usually
captured by a price-adjustment or price-escalation
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BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY
clause. This clause will commonly be linked to
some transparent and reliable published energy
price series. While it may be adjusted continually,
it is more common to average it over some period,
such as quarterly, and make the price adjustment
at that time.
When gas has first been introduced to most
markets, it has had to compete with other fuels
such as oil or coal. Since much gas initially was
distributed by government companies or regulated
public utilities, competitive market pricing for it
was uncommon. Thus the practice in most
markets – until recently – has been to key the
price escalation clause to other fuels. The target of
these price-escalation clauses varies significantly
by region.
In Europe, where pipeline contracts cover
the largest portion of the import volume, the
practice has been to refer to some mix of
distillate and residual fuel oil. These published
fuel-oil quotations may be for North European
or Mediterranean ports or for Rhine barges, as
the market dictates, but they must have two
characteristics. They must be unquestionably
reliable, and they must have an established
history so that they will be likely to continue to
moderate the base price well into the future, in
the way the contracting parties originally
intended.
The price-escalation practice in Asia is
somewhat different. With little history of gas
utilization and interfuel competition before the
introduction of LNG, the Japanese markets
initially chose to link energy prices to Japanese
crude-oil prices, and that pattern has been
followed until recently by other Northeast Asian
markets. The crude-oil price series for most
contracts is the Japanese Customs Clearing price
for crude oil, usually known as the Japanese
Crude Cocktail (JCC). It is the monthly composite
price – stated in dollar/barrel – of all crude oil
imported into Japan.
Oil prices in the 1990s and 2000s have at
times been quite volatile and this has made some
oil-linked gas prices quite volatile as well. A
collapse in oil prices, for example, could place a
major LNG project at substantial risk. Therefore,
some contracts have sought to limit the volatility
risk by introducing ‘floor prices’. At specific oil
prices, the floor price is activated and serves to
limit the drop in the oil-linked contract price.
Because the introduction of a floor price provides
protection for the seller, but not the buyer, some
contracts utilize ‘S’ curves in the interests of
symmetry. These limit both upward and
170
downward movements of the contract price within
prearranged limits.
North American gas pricing has taken an
entirely different course from that in Europe or in
Asia. Both the United States and Canada
maintained wellhead price controls on natural gas
until the late 1970s, so the pricing clause in
long-term contracts was essentially unable to
operate. By the 1970s, it became apparent that
wellhead price controls created regulation-induced
shortages of gas; both governments abandoned
wellhead price controls as a failed experiment.
They opted instead for commodity competition to
set market prices for gas. Thus the concept that
competing gas prices – gas-to-gas competition –
should set prices for gas, made the idea of
oil-linked price escalation clauses obsolete.
In North America, a system of transportation
‘hubs’ has developed, where buyers and sellers
can trade the commodity and arrange onward
transportation by acquiring rights to pipeline
capacity to move it. The major reference point is
in South Louisiana – Henry Hub – where a
number of major pipelines interconnect. The
North American pricing system is keyed to price
quotations at Henry Hub and prices at other hubs
are related to it by price differentials called ‘basis
differentials’. These basis differentials roughly
approximate the costs of moving gas from Henry
Hub to the market in question, although they can
vary with the state of the market. The price
quotations at Henry Hub are for physical
transactions and are quoted in the trade press, but
Henry Hub is also the reference point for gas
futures contracts that are traded on the New York
Mercantile EXchange (NYMEX).
For North American LNG imports, there is
pressure to adopt gas-linked – rather than
oil-linked – price escalators, using Henry Hub
pricing as the reference. Gas-linked pricing,
however, has subtly shifted the risk-sharing terms
of the traditional long-term contract. While the gas
linkage is designed to capture gas competition,
rather than oil competition, it has weakened the
risk assumption of buyers. A buyer with a contract
linkage to the Henry Hub spot market can readily
resell an LNG cargo at market, absorbing very
little volume risk in the process. Thus for
gas-linked pricing, risk has migrated upstream to
the producers and this has stimulated a trend by
sellers to contract with their own marketing
affiliates, thus effectively integrating downstream.
Both China and India, as comparative
newcomers to the LNG trade, have attempted to
break free of the rigid JCC oil-linkage that exists
ENCYCLOPAEDIA OF HYDROCARBONS

elsewhere in Asia. A Chinese contract for
Australian supply sharply reduced the percentage
change in the gas price for a given oil-price
change. Two Indian contracts signed in 2004 for
gas from Qatar did the same. One of the Indian
contracts included a five-year moratorium on
oil-linkage. Furthermore, while Europe still has a
substantial proportion of oil-linked contracts,
there has been a trend towards the use of ‘price
reopening’ clauses. These clauses provide for
revisiting the price clause under certain
circumstances, if another pricing approach at
some future time better meets the original
intentions of buyer and seller. Such reopeners
would enable these contracts to switch to
gas-linked prices at hubs, such as the United
Kingdom’s National Balancing Point (NBP) or
Germany’s Dutch border hub, and to become at
some point reliable price reference points.
While pipeline pricing for gas purchased from
the producers has typically been bought on
contract, the resale of gas by the pipeline systems
has typically been by means of published tariffs.
Where the restructuring of the industry has
unbundled the commodity transactions from the
capacity transactions, tariffs still apply to
transport in most cases.
One final set of contract terms in the pricing
sector is that involving invoicing and payment
procedures. While these are comparatively
straightforward, there have been several cases
where confusion over the operation of the pricing
clause in LNG contracts has led to the seller
invoicing at one price and the buyer paying at
another, until these disputes were finally settled.
Force majeure
This is an important clause in any long-term
contract and covers unanticipated disasters in the
supply or demand for gas under the contract. It is
especially important that this clause be carefully
written to minimize any ambiguity as to what is
covered.
Dispute resolution
It is important for contracts to spell out the
governing law that will apply to contract disputes.
Care is usually taken to make sure that this is a
system of law that is neutral to the interests of
both parties. All contracts also provide for some
mechanism for resolving disputes in the
interpretation of contract terms. This is usually a
procedure for arbitration. The contract may spell
out a method by which a panel of arbitrators is
selected or it may refer disputes to an
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
INTERNATIONAL TRADE AND THE LNG INDUSTRY
international arbitration organization such as the
International Chamber of Commerce or the
United Nations Commission of International
Trade Law.
2.5.4 The LNG industry
Because of its low density, natural gas is more
costly to contain and to transport than either oil or
coal. Prior to the development of LNG
technology, gas was unable to utilize that
mainstay of international oil trade – marine
transportation – and remained essentially a
regional fuel. The development of LNG offered a
tanker-transportation option, and with the
improvements in technology and costs, gas is
rapidly becoming an internationally traded
commodity.
The basic elements, their technology
and cost structures
The liquefaction process refrigerates natural
gas to cryogenic temperatures (approximately
minus 162°C), where it becomes a liquid at
atmospheric pressure and occupies a volume that
is 1/600th that of the fuel in its gaseous form. It
can thus be stored in heavily insulated tanks or
moved overseas in special cryogenic tankers.
While LNG is often used to store natural gas for
peak send-out in temperature-sensitive markets
(peak shaving), the major interest in LNG is
focused primarily on its role as a method of
moving natural gas in international trade.
An LNG project represents a ‘chain’ of
interrelated capital investments. The chain
consists of four (occasionally five) links: a) field
development; b) in some cases a pipeline to the
coast; c) the liquefaction facility; d ) tanker
transportation; e) the receipt/regasification
terminal. Each element is capital-intensive. For
new projects, the investment is commonly front-
end loaded. Since revenue does not begin to flow
until the project is complete, breakdowns and
delays in any part of the chain adversely affect
capital recovery and a project’s Internal Rate of
Return (IRR).
Fig. 13 illustrates the balance of CAPEX and
margins for a hypothetical LNG project. It uses a
West African greenfield source supplying an
Italian regasification terminal and designed for
two 4 million-tonne trains. This illustration has a
total CAPEX of 5.0 billion dollars and would
require a margin of 2.70 dollars to cover costs and
return on investment to deliver gas from West
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BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY
Africa to Italy. In the illustration, 66% of the
CAPEX is located in the host country, 10% is
located in Italy and the remaining 24% is required
for the tankers.
Field development involves the exploration
and production expenditures – the drilling of
production wells (including production platforms
in offshore fields), field-gas treatment and the
laying of a gathering system to deliver the gas to
the plant or to a pipeline for further
transportation. LNG projects tend to be large, to
benefit from economies of scale; thus the
supporting gas reserves must be large enough and
sufficiently economical to support a liquefaction
facility over its working life. Suppliers usually try
to maintain a field deliverability that will support
full plant operation over a 20-year period. To
maintain full contract deliverability in the face of
field decline requires a reserve significantly in
excess of the volume covered by the contract. This
might mean, for example, that it will require as
much as 28 years of reserves to honour the
deliverability commitment on a 20-year contract.
The requirement for a large block of quality
reserves tends to restrict LNG plants to those
locations where there is either a giant field or a
cluster of smaller fields that can ‘anchor’ the
plant. Thus small and scattered gas fields may be
utilized as satellites to the anchor field(s) but
normally will not be used themselves to justify a
new facility. The selection of the best supporting
gas supply can be described as ‘cherry picking’.
CAPEX
(dollars.109)
field
development
(varies) 1.6
liquefaction 1.7
tankers
(10 at 180 million
dollars apiece) 1.2
regasification
(varies) 0.5
total 5.0
Fig. 13. Elements of an LNG delivery system basis:
two 4.0 Mt greenfield trains – 3,400 nautical miles
(approximately the distance from Nigeria to Italy)
requires about 12 Tft3 of reserves to support
a 20-year contract.
172
This implies a possible deterioration in the
economic viability of the reserves, as exports
increasingly tap into a country’s reserve base,
possibly offsetting some of the savings that come
from the expansion of the facilities.
While it is common to assume that flared
associated gas is of zero value and thus desirable
as feed to a liquefaction plant, highly productive
non-associated gas fields are often better sources
of supply than flared gas. The flared gas
frequently occurs in small, scattered locations at
low pressure, necessitating high gathering and
compression costs to deliver it to the plant gate.
On the other hand, gas condesate fields –
containing gas liquids in the form of a high-
quality light crude oil – are often highly prized,
since the co-product credits from the sale of the
liquids contribute significantly to the economics
of the project.
Although it is often possible to deliver the gas
from the gathering system directly to the
liquefaction plant, production from the interior of
the country may have to be pipelined to a coastal
location for liquefaction. This was the case in
both Algeria and Libya, for example, and the
proposals for gas from Sakhalin and from Bolivia
also require pipeline-delivery systems. This
burdens the feed gas with pipeline charges, a
problem for a process in which the final delivery
volumes to the customer are reduced by process
fuel, tanker boiloff and possibly regasification
fuel.
There are several different liquefaction
processes, but they all rely on compression of the
margin
(dollars) gas followed by expansion cooling through a
valve (the Joule-Thompson effect used in
refrigeration). The size of an individual
liquefaction module – the liquefaction ‘train’ –
0.80 has been a function of compressor technology.
Until the 1990s, train sizes were limited to about
0.97 2 million tonnes and a greenfield facility would
often require three trains, to be economical.
However, improvements in compressors have now
made it possible to design much larger trains. As
0.60
of the end of 2004, the largest operating train was
5 million tonnes, but Qatar’s expansion plans
0.33 include trains up to 7.8 million tonnes. Larger
trains benefit from economies of scale, and it is
2.70 now possible to justify a new greenfield facility
with a single, larger train.
Of the several tanker designs, all feature an
exterior hull and an insulated interior containment
system for the liquid. The cryogenic tankers are
much more costly than oil tankers, both because
of the low density of the product and the need for
ENCYCLOPAEDIA OF HYDROCARBONS

insulation and low temperature metallurgical
designs. The number and size of tankers tend to
be dictated by the trade. While smaller tankers
were common for the original Mediterranean
trades from Algeria and Libya to southern Europe,
longer hauls favour larger tankers, so sizes have
been increasing.
Tanker capacities are stated in cubic metres of
liquid and the largest tanker in service at the end
of 2004 was 145,000 m3. Such a tanker can
deliver about 85 million m3 of gas per trip. Qatar’s
expansion plans have explored the possibility of
tankers up to 250,000 m3 in size.
The final link in the LNG ‘chain’ is the
regasification terminal, which receives the LNG,
stores it in cryogenic tankage until needed and
then regasifies it for delivery into the takeaway
pipeline system. Regasification terminals may use
either gas-fired or seawater regasification
systems. The seawater gasifiers are more
expensive to build but cheaper to operate. They
are thus well suited for base load send-out.
Gas-fired units are more costly to operate but are
well suited to locations, which are designed to
meet highly peaking send-out requirements.
History of world LNG trade
The first LNG tanker shipment in 1958 was
from Lake Charles, Louisiana, to Canvey Island in
the United Kingdom, aboard the experimental
vessel, the Methane Pioneer. It was followed in
1964 by the first commercial trade – the Camel
project – which delivered Algerian gas to the UK
and France. Three more trades had started by
1969 – an additional delivery from Algeria to
France, one from Libya to Italy and Spain, and
one from the Cook Inlet to Japan. The latter was
the first Pacific Basin project.
While the first deliveries from Algeria were
comparatively short hauls to Europe, the United
States first entered the market in 1972, when
deliveries began for a small Distrigas (Cabot)
project at Everett, Massachusetts. Deliveries
began in 1978 for the much larger contracts by El
Paso Natural Gas to Columbia Gas for Cove
Point, Maryland, and Southern Natural Gas at
Elba Island, Georgia. They were followed by the
start-up of the Trunkline project for Lake Charles,
in 1982.
The development of the early US projects took
place during a period of unprecedented change in
international energy markets. This included the
two oil-price shocks, the widespread
nationalization of the international oil companies
concession areas within the Organization of
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
INTERNATIONAL TRADE AND THE LNG INDUSTRY
Petroleum Exporting Countries, OPEC, and the
restructuring of the North American gas industry.
While LNG imports into Europe continued to
increase, the North American trade all but
collapsed, thereby blunting what was expected to
be a substantial growth in Atlantic Basin trade.
The Pacific Basin LNG trade started up slightly
later than the Atlantic trade, with the Cook
Inlet/Japan deliveries in 1969 followed by
Brunei/Japan in 1973. However, with the
substantial slowdown in interest in LNG in the
Atlantic, the balance of interest shifted to the
Pacific, as Korea and Taiwan joined Japan as
importers. Between 1975 and 1996, the
Asia/Pacific region demand increased by an
average of 3.3 Gm3 per year (about 2.4 million
tonnes, slightly more than the capacity of the
typical LNG train at the time). In contrast, Europe
and the United States increased only 0.76 Gm3.
Since 1996, Atlantic Basin markets have begun to
take off, so that average Atlantic growth has been
4.0 Gm3 per year compared to Asia’s 4.2 Gm3.
These are roughly equivalent to the capacity of a
more modern 3 million-tonne train.
The principal initial suppliers of the growing
Northeast Asian markets were from the
Asia/Pacific region – Indonesia, Malaysia,
Australia and Brunei. The first Middle East
project in Abu Dhabi went ahead in 1977, but
there was no significant expansion until an Abu
Dhabi expansion and the major new projects from
Qatar and Oman in the late 1990s. In contrast, the
slow early growth of European and US markets
limited the Atlantic Basin suppliers to Algeria and
Libya. But with the start-up of liquefaction plants
in Trinidad and Tobago and Nigeria in 1999,
Atlantic Basin supply is now growing rapidly.
A number of factors have combined to
stimulate the renewed interest in LNG:
a) combined cycle power generation for electric
power markets; b) technology-based cost
reduction, making previously uneconomic trades
attractive; c) environmental concerns; d ) the
choice of gas by previously ‘gas poor’economies;
e) the growing concern for traditional supplies in
the face of growth; f ) the ‘stranded gas’
phenomenon.
Combined cycle power generation. The
thermal efficiency of traditional steam boilers for
power generation is limited thermodynamically to
about 38%. But by placing a high-temperature gas
turbine on the front end, and then recovering the
high temperature turbine exhaust for steam
generation in a heat exchanger, the combination
– a ‘combined-cycle’ (CCGT) unit – can achieve
173
BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY
thermal efficiencies approaching 60%. In
addition, these units have relatively low capital
costs, come in smaller, market-friendly sizes and
have short-planning lead times. The turbines are
similar to those on jet aircraft and thus the fuel
must be either natural gas or a very high-quality
distillate product. CCGT units have become the
power-generation systems of choice for electric
markets around the world.
Technology. Technology has made it possible
to design new LNG liquefaction facilities and
tankers for substantial cost reduction. As a result,
trades that once seemed uneconomical have
become attractive. The liquefaction cost reduction
has been due to a number of factors. With more
activity and more design constructors, plants have
benefited from greater competition and higher
productivity. The maturing of the industry, with
diversified supply sources, has led to less
emphasis on ‘gold plate’ plants to ensure
reliability. Substantial improvements have come
from increasing plant sizes and the resulting
economies of scale; expansion by means of one
modern 4 million-tonne liquefaction train can cut
the costs of liquefaction by about 38%, compared
with the average 1.8 million-tonne trains that
represented the average size during the 1980s.
This is illustrated in Fig. 14.
Tanker costs have come down as well.
Perhaps most of this improvement has been the
result of greater activity and the resulting
competition among shipyards for business.
Increased tanker sizes have also improved
economics, although the scale improvements are
not as marked, since the size increases have been
less dramatic. A 138,000 m3 tanker could
probably cut the capital costs per cubic metre by
about 3%, relative to the 125,000 m3 tanker of
the early 1990s. The effect on transport costs is
illustrated by an Algeria/United States Gulf
Coast example in Fig. 15.
Environment. Environmental concerns are
clearly a positive influence in the interest in
natural gas. Not only is processed gas free of
sulphur and particulate matter, it is also favoured
over coal and oil in the increasing concern
for global warming. Gas has a higher
hydrogen-to-carbon ratio, minimizing CO2
emissions, but CCGT’s higher thermal efficiency
requires less fossil fuel per MWh generated. By
comparison with a coal-fired boiler, gas-fired
CCGT units can cut CO2 emissions by about 40%.
Even after factoring in the CO2 evolved in
liquefaction, transport and regasification of LNG,
the emissions savings still amount to about 26%.
174
600
most of the decline
is attributable to scale
500
plant cost (dollars)
400
300
200
100
0
average current proposed
1.8 Mt train 4.0 Mt train 7.5 Mt train
attributable to scale attributable to cheaper
construction
current CAPEX average CAPEX 1980-1990
Fig. 14. LNG liquefaction plant cost
reduction illustrated basis:
average cost per tonne of capacity
for plants built from 1980 to 1990, versus costs
of current larger trains.
Interest from ‘gas poor’ countries. Japan,
Korea and Taiwan, which have very limited gas
resources of their own, have been the backbone of
LNG trade since the early 1970s. However, now
some of the ‘gas poor’ emerging market countries
have turned to gas-fired CCGT units to fuel their
power-generation growth, making them
significant new targets for LNG imports. India,
China and Turkey are prime examples of this
group.
Supply concerns. Some economies that have
substantial gas industries are becoming interested
in LNG, to offset problems with traditional supply
or to provide supplier diversification. This is the
case in both the United States and the United
Kingdom. The perception of North American
self-sufficiency evaporated with the U.S. ‘gas
price shock’ of 2000. As recently as 1998, the UK
was a net exporter to the Continent through the
Interconnector pipeline, linking Bacton in the
United Kingdom with Zeebrugge in Belgium.
Now, with growing markets in the face of
declining prospects for North Sea production, the
UK is turning to LNG imports to supplement its
domestic supply. With a somewhat different
motivation, Spain has attempted to diversify its
heavy reliance on one country – Algeria – by
entering LNG import markets in a major way.
‘Stranded gas’. Another factor that has led to
the higher interest in LNG is the emergence of
concern for ‘stranded gas’. At one time,
ENCYCLOPAEDIA OF HYDROCARBONS
 INTERNATIONAL TRADE AND THE LNG INDUSTRY

most of the decline is market. In the examples shown, only a small

attributable to tanker portion of the CAPEX budget – 9 to 13% – is
1.50 price drop
invested in the receiving country. In contrast, the
majority of the capital expenditures – 51% to 70%
– is invested in the producing country, thus
dollars/MBtu

1.00 indicating the critical importance of the host-

country negotiations in the development of a
project. Tanker expenditures vary with distance.
0.50 The long-haul Qatar/United States East Coast run
has the highest percentage – 41% – of the CAPEX
budget in the illustrations shown.
0.00
The traditional LNG project was carefully
125,000 m3 138,000 m3 200,000 m3 structured to share risks among the participants.
tanker in tanker in tanker
1991 2004 (proposed) The centrepiece of the project was the long-term
contract between buyer and seller for LNG –
attributable to scale attributable to tanker known as the Sale and Purchase Agreement
prices
(SPA). The length of the early contracts was
2001 cost 1991 cost
typically 20 years, although longer contracts were
common. The point of delivery might have been
Fig. 15. LNG tanker cost reduction
illustrated basis:
either FOB or ex ship, depending on which party
Algeria to US Gulf Coast – 1991 versus 2004, assumed the tanker-transport responsibility, but in
125,000 m3 versus current larger tankers. either case the operation of the receipt and
regasification terminal was downstream of the
point of delivery and thus outside the scope of the
companies searching for oil in international contract. Tankers might have been owned by
concession areas treated a gas discovery as a ‘dry either buyer, seller or independent shipowners.
hole’ and abandoned further effort in the area. They were traditionally dedicated to the specific
Now, with the possibility of major oil discoveries trade, usually for the life of the contract.
narrowing in many areas and with a mounting The risk-sharing logic of the contract was
inventory of gas discoveries, companies are much embodied in the phrase: “the buyer takes the
more willing to concentrate on gas-development
possibilities. 7,000
capital expenditure (106 dollars)

The role of the long-term contract 6,000

9%
in traditional LNG sales 5,000
9%
10% 21%
The major links of the traditional LNG project 11%
‘chain’ – field development, liquefaction, tanker 4,000 29% 40%
13% 20%
transportation and receipt, and regasification – 3,000 17% 30%
have traditionally been viewed as interdependent,
2,000 37% 40% 35% 27%
since a failure of any link affects the operation 18%
and profitability of the others in the chain. Since 1,000
LNG projects are commonly international 33% 29% 26% 24% 22%
ventures, parts of the chain are subject to different 0
Trinidad/
US East Coast-
expansion

Indonesia/
Japan-
greenfield

Nigeria/
US East Coast-
greenfield

Qatar/
US East Coast-
expansion

Bolivia/Chile/
US West Coast-
greenfield

laws and regulations. Production and liquefaction

are subject to the fiscal and legal system of the
producing country, and regasification is subject to
consuming country regulations. Tankers operate in
a kind of international no man’s land. The fact
that operations are affected by differing regasification tanker LNG liquefaction
regulatory systems complicates the structure of transport
the venture and introduces an element of political pipeline field investment
risk into the process. Fig. 16. Illustrative capital expenditure profiles
Fig. 16 illustrates a representative balance of for selected LNG projects, assuming
the capital expenditures for several selected LNG two 3.3 Mt trains and an annual field investment
trades potentially serving the North American of 3.85 dollars/MBtu.

VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION 175

BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY
volume risk and the seller takes the price risk”.
The volume risk was usually in the form of a
take-or-pay provision to assure buyer offtake at
some minimum level. The price risk was
commonly a price-escalation clause to transfer
responsibility for energy-price fluctuations to the
seller. The early contracts viewed oil, not gas, as
the competitive target, and thus ‘price risk’ in the
indexation clauses was principally defined in oil
terms, a pattern that persists in some markets to
this day.
The contractual terms binding creditworthy
buyers and sellers enabled LNG projects to obtain
favourable financing, giving them a debt-equity
ratio and cost of capital more nearly resembling
utility financing than that of corporate equity
investments. In the original pattern of LNG
project development, nearly all buyers were either
large government or franchised utility companies
from OECD countries.
The fact that the purchasers were either
regulated utilities or government monopoly
companies enabled them to lay off some of the
market risk to their end-use customers. Once a
contract was approved by the regulators or
government overseers, the price and volume terms
became part of the regulated resale rate structure
and end-users picked up the tab. Since
credit-worthiness of the buyer was not usually an
issue, LNG projects were able to obtain
favourable financing, giving them a debt-equity
ratio and cost of capital more nearly resembling
utility financing than that of corporate equity.
This pattern has been changing. Interest in
LNG has spread to smaller buyers, such as
independent power projects, whose
credit-worthiness may be in question. Furthermore,
the restructuring of the gas industry often limits the
ability of buyers to lay off contractual risk. As a
result, the financial risks of the newer projects are
often inferior to those that marked the early days of
the industry, and buyers may be less able to obtain
favourable financial terms.
Liquefaction investments in the producing
country have been commonly based on significant
gas discoveries. Companies holding the relevant
exploration licences have initiated most of the
projects and the discoveries have been dedicated
to the contract, to ensure a reliable supply over the
life of the project.
Projects have usually been joint ventures of
several companies, bound together in a
‘shareholders agreement’ or a ‘joint venture
agreement’, depending on the nature of the
licence, with one of the group appointed as the
176
operator. The effect of this structure is that
companies have operated as if they were
shareholders in a corporation, rather than as
independent and competitive corporate entities.
Therefore, marketing has usually been done by
the venture rather than by the individual partners,
a system which has reduced the number of
competing marketers. Competition exists but it
has been between projects rather than among the
individual participants in the venture.
The SPA envisioned a system in which
particular trades were essentially self-contained,
involving a specified liquefaction facility as the
source of the LNG, along with dedicated tankers
to shuttle between the specific plant and its
destination. The bilateral nature of the trades
made it unnecessary to build in design flexibility
for the tankers to serve other ports, and questions
of interchangeable gas quality were largely
ignored. Gas interchangeability has become a
major issue, particularly in the United States and
United Kingdom, as the restructured LNG
industry develops greater destination flexibility.
The volume obligation in the long-term
contract was embodied in the take-or-pay clause,
and commonly obligated the buyer to take a
minimum of 90% of his annual contract quantity.
The contract was designed to ensure that the debt
service on the financing could be met and thus,
ideally, would provide for level cash flow over the
contract period. However, real markets seldom
behave ideally. Most markets grow so that a
volume that is keyed to current demand will be
inadequate to meet future requirements several
years down the road. Consequently, most
contracts feature a ‘plateau’ volume and a ‘ramp
up’ period for the customer to grow into his
volume commitment. Markets may also have
distinct seasonal swings if they have a large
proportion of temperature-sensitive load. In
addition, market uncertainties about economic
cycles also cause demand variability.
Buyers and sellers have historically found
ways to adapt the rigid contract structures to the
realities of a somewhat uncertain market. Well
before the restructuring of the gas industry in
North America and the UK created active gas spot
markets, LNG buyers and sellers – by mutual
agreement – utilized short-term markets to adjust
over and under commitments among themselves.
These transactions, never a large part of total
LNG trade, were usually arranged bilaterally and
were better described as ‘short-term sales’ rather
than ‘spot sales’. One of the most active
participants in this short-term market has been
ENCYCLOPAEDIA OF HYDROCARBONS

Kogas in South Korea. Its seasonal market has
been difficult to accommodate within the
constraints of the typical 90% take-or-pay
limitation, and it has frequently gone heavily into
the short-term market for peaking requirements.
In the traditional contract, tankers were
dedicated to a specific trade. Even though some
surplus tanker capacity could occur at times when
buyers were taking their contractual minimums, it
was difficult to reschedule the surplus vessels
since they were technically committed to the
buyer’s trade at his discretion. The fact that
newbuild tankers were commonly ordered to
service a new LNG contract meant some tankers
– which had become surplus to requirement –
remained in lay-up. A number of tankers
originally ordered for the Algeria/United States
trades and the PacIndonesia project from
Indonesia to the US West Coast, in the 1970s,
remained in lay-up for 15 years or more when
those trades were abandoned.
One of the features of most contracts was the
‘Destination restriction’ clause. This limited the
ability of the buyer to resell any surpluses that he
might experience on his own account, thereby
preserving any margin on the resale for the
account of the seller.
Gas industry restructuring: a challenge
to the traditional system
The theoretical model for the restructuring of
the gas – and electric power – industries
represents a substantial challenge to this highly
structured, risk-averse form of business
relationships. The restructuring process – first
begun in the United States, Canada and the United
Kingdom – assumes that the traditional form of
government monopoly or regulated public-utility
operation of electricity and gas is inefficient. A
system based on market competition inherently
provides lower prices and more desirable service
options for consumers. It envisions free-market
competition among buyers and sellers to set
commodity prices for gas – ‘gas-to-gas
competition’.
However, since the supply of gas is usually
geographically removed from its ultimate
consumption, the model also envisions a
competitive market for transport capacity in a
system that is subject to open or third-party
access. For LNG, the model thus sees the ‘LNG
chain’ reconstructed efficiently through
independent competitive offerings of each of the
relevant links, which are free to operate
independently of one another. Since many market
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
INTERNATIONAL TRADE AND THE LNG INDUSTRY
decisions involve time lags between buyers’ and
sellers’ revenue objectives, with volatile price
behaviour in the meantime, it also envisions a
system of ‘risk management’ through the use of
various types of financial derivatives, futures
contracts, options and swaps.
The restructured industry in North America
and the UK features a high proportion of spot
trading, with prices that are often very volatile.
The few long-term contracts that remain are of
comparatively short duration. Contract prices are
keyed to a gas market indicator, since oil-linked
pricing is a poor indicator of the value of gas in a
gas-to-gas competitive market. The fact that
pricing is tied to the market makes the traditional
take-or-pay contract of limited value.
The trade press reports prices for reference
points such as Henry Hub in the US or the
National Balancing Point in the UK, providing
market information for traders. Less liquid
quotations for other ‘hubs’ provide a means of
developing ‘basis differentials’ for relating prices
at other locations to the reference price. While
some abuses have developed over trade press
price reporting, the futures market (such as the
Henry Hub quotation on the NYMEX) provides
transparent market information for risk
management. Transportation capacity, like the
commodity itself, can be readily traded among
parties.
If there is one single feature that differentiates
the restructured North American and European
gas industries from the traditional LNG trade, it is
the disappearance of the long-term contract as the
central business relationship between buyer and
seller. Therefore, the central question in
determining how a global gas market is likely to
develop is whether or not the traditional SPA will
survive in a restructured LNG industry and, if so,
in what form.
The emergence of a new market structure
While a very small short-term LNG market
has been in existence for nearly a decade, it has
grown rapidly in the past several years. As
recently as 1997, short-term LNG transactions
accounted for only 1.5% of international LNG
trade. In the ensuing five years, the volume of
short-term transactions increased sevenfold, and
in 2003 accounted for 8.9% of international trade.
Substantial surpluses of LNG capacity relative
to demand existed throughout the 1980s, largely
as a result of pricing disputes between Algeria and
its customers. However, the early inflexibility of
trade linkages made it difficult to consider any
177
BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY
significant short-term trading. But by the early
1990s, surplus capacity again began to appear and
serious short-term market began to develop.
Short-term surpluses began to appear east of
Suez in the early 1990s. They were the result of
over eight million tonnes of debottlenecking
capacity additions in South East Asia, during a
period when both Indonesia and Malaysia were
adding expansion trains. They were sustained later
in the decade by the slowdown in Asian markets
and by the emergence of new export capacity
from Qatar and Oman in the Gulf. However, by
1999, further Middle East expansions (as well as
the start-up of Trinidad and Tobago and Nigeria in
the Atlantic Basin) now seem to have
institutionalized the surpluses.
As the rigidities associated with the old-
style contract have softened, more volumes have
become available for short-term and spot sales.
The flexible volumes originate in several ways.
Much of them come from the mismatch between
dedicated plant expansion and customer market
growth. Most long-term contracts have a
‘ramp-up’ period to allow the customer to grow
into his ‘plateau’ contract commitments, and
these volumes are increasingly being utilized to
feed the short-term market. As the industry
ages, more and more gas is coming to the end of
the original contract period, enabling the sellers
to renew the original agreement or to take back
the volumes for more flexible sales.
Debottlenecking of existing facilities creates
capacity that has already been financed by the
original contract.
With increased competition among projects for
the market, companies seem more willing to
commit to a project with some portion of the
output ‘uncovered’. Since the seller’s greatest
concern is debt service while the loan obligation
is still outstanding, it may increasingly be
possible to tailor the contract length to the shorter
period of loan payout, giving the seller greater
flexibility to put volumes on the short-term
market.
While ramp-up volumes have always existed,
their availability for short-term trade is more
recent. Because they become available when
project capacity goes online, they can be
marketed quickly without waiting for complex
negotiations between buyer and seller. Actual
ramp-up capacity potentially available for
short-term markets is larger than its actual
utilization for short-term market sales.
For a business with a 40-plus year history and
a pattern of 20-year contracts, it is not surprising
178
that many early contracts have reached the end of
their initial period. In most cases, the contracts
have been renewed, in many cases with the
original customer under renegotiated terms.
In the newer, more flexible LNG market, it is
less likely that those contracts coming up for
renewal will simply be rolled over to their original
buyer, largely unchanged. Some volumes may
well be taken back by the sellers to place on the
short-term market, but it is likely that many of the
contract relationships will be retained, albeit with
altered terms.
The volumes available for renegotiation from
contract expiration appear only slowly, given the
long-term nature of most of the contracts. Recent
contracts frequently have shorter terms, but it will
take time for these newer contracts to expire. New
contracts may last 15 years, although some
extensions or debottlenecking expansions may
have even shorter terms.
Contract expiration is most pronounced in the
Pacific Basin, where much of the early LNG
growth took place. Indonesia and Australia are
particularly vulnerable. In Indonesia’s case, the
declining fortunes of the Arun plant in Western
Sumatra complicate the wind-down process.
Arun’s gas supply is in an advanced state of
depletion; the separatist rebellion in the Aceh
province is a disincentive to salvage its operation
through bringing in gas from elsewhere.
Nonetheless, Indonesia is still attempting to offset
the loss by expansion at other locations,
particularly from the newer-proposed Tangguh
project.
The slow pace at which contracts are up for
renewal does not necessarily preclude early
renegotiation. The combination of sellers seeking
expanded markets and buyers wanting more
flexible contracting terms gives significant mutual
incentives to reopen some of these contracts
before they reach maturity. However, it is
probably more likely that these early
renegotiations will lead to higher – if more
flexible – contract volumes, rather than releasing
contract volumes to the spot market.
Another source of flexible volumes is the
increase in capacity through debottlenecking.
Debottlenecking effectively added 18% of the
incremental capacity. Since the original contracts
effectively financed the plant, the debottlenecked
capacity is largely costless to the sellers. While
this capacity could readily be diverted to the
seller’s portfolio of short-term volumes for
trading, much of the debottlenecking –
particularly in the Pacific Basin – has also been
ENCYCLOPAEDIA OF HYDROCARBONS

contracted out on a long-term basis, often as a
part of a renegotiation of the original contract.
The slowdown in the Pacific market has
intensified the competition among a number of
potential projects. This has in turn been
exacerbated by the trend to larger train sizes. A
combination of earlier growth with smaller trains
meant that project developers could justify
expansions more easily. However, now it takes
longer to assemble enough demand to justify one
of the new, larger trains. The consequence of these
trends is that competing projects often find it
difficult to justify expansion using the old
contract coverage of an earlier period. Faced with
competition from other projects in the same
situation, project developers have shown more of
a tendency to launch a new project with contract
coverage than might have been deemed prudent in
the past. Hence, more volumes in new projects
show up as ‘uncommitted’ – that is, uncovered by
long-term contracts.
Tankers were traditionally dedicated to
specific trades. The contractual obligation to
deliver the maximum contract quantity at the
buyer’s discretion usually meant that the tanker
was unavailable for other cargoes even when the
buyer had reduced his receipts. Tanker
maintenance was commonly scheduled for those
periods when the buyer’s demand was likely to be
low; however, some degree of tanker idling was
inevitable.
The dedication of newbuild tankers to new
contracts made the tanker fleet rather inflexible.
Tankers idled for any reason found it very
difficult to find alternative charters and were
likely to be laid up. In the late 1970s and early
1980s, several trades for which tankers had been
ordered either failed to materialize or collapsed
after a brief period of operation. These included
the failed PacIndonesia trade from Indonesia to
California and the Algeria/United States trades to
Cove Point, Elba Island and Lake Charles, which
shut down after less than two years. In addition,
two tankers that had been built on speculation
never got contracts. In all, 15 tankers were laid up
by these events. Although six of these were
subsequently scrapped, the remaining nine
remained idle – several for more than 20 years –
before being refitted for a newer, more flexible
tanker market. Fig. 17 provides a history of tanker
capacity and utilization.
The contract dedication of tankers threatens
inefficient scheduling of the tanker fleet. For
example, it is possible to envision cross shipping,
which can occur when the tankers dedicated to
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
INTERNATIONAL TRADE AND THE LNG INDUSTRY
one trade effectively cross in opposite directions.
In such a case, an exchange agreement might
minimize transportation costs. To illustrate,
ConocoPhillips was considering at one point the
possibility of bringing its Bayu Undan gas in the
Timor Sea gas (via a Darwin, Australia
liquefaction plant) into a possible Baja California
terminal. It is also an owner of the Cook Inlet
LNG plant that is dedicated to the Japanese
market. Had this venture gone ahead under the old
dedicated tanker ground rules, the combined cross
trade of Alaska/Japan and Bayu Undan/Mexico
would have had a combined shipping distance of
10,547 nautical miles. However, had it been
possible to make a flexible exchange deal of
Alaska to Baja California and Darwin to Japan,
the combined shipping distance would have been
more than halved (5,055 nautical miles).
Cross-shipping has not been a major issue to date,
but with the growing geographic dispersion of
supply sources and markets, it is likely to be more
important in the future.
The industry initially took the view that LNG
tankers had a limited effective life. Therefore, it
was often assumed that a tanker would not outlast
the terms of the original contract; new vessels
would need to be ordered if the contract was
renewed. This early view has now given way to
the recognition that these tankers may have a
useful life of as much as 40 years, and need not be
replaced when a contract extension has been
negotiated.
In many cases, these still-useful tankers are
idled when a contract renewal calls for new
vessels. However, an inventory of ‘used tankers’ is
now being actively utilized for short-term trading.
800
Jensen estimates
700
contracted capacity
103 Gm3 nautical miles
600 factor - 83% in 2001
contracted capacity
500 factor - 72% in 1993
contracted capacity
400 factor - 39% in 1983
300
200
100
0
1980 1990 2000
year
net surplus capacity idled1 capacity
short-term utilization contract utilization
1 Fifteen vessels built for collapsed trades or on speculation
Fig. 17. LNG tanker capacity compared with tanker demand.
179
BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY
Creating spare tanker capacity in newbuild
tankers is not a costless exercise, but many of
these second-hand tankers can trade for
comparatively low charter rates.
Fig. 17 suggests that there remains an
overhang of surplus capacity available to support
extensive short-term market trading. However, it
is not clear at what level of capacity-utilization
the market becomes ‘tight’. Press reports during
late 2002 spoke of ‘tight’ tanker markets as a
result of upsets in the Asia/Pacific market. Yet the
average capacity factor for contracted volumes for
the year was only 81%.
Clearly some unutilized capacity is difficult to
avoid. A tanker temporarily idled in one trade may
not be able to take the time off its base contract to
haul a cargo for different trade. Where the
utilization of the tanker is at the buyer’s
discretion, he may see little to gain by releasing
the vessel temporarily.
One new trend in flexible contracting is to
eliminate or curtail the destination-restriction
terms, thereby giving the buyer the possibility of
economic gain if he diverts his own surplus into
the short-term market. It remains to be seen how
this trend in LNG contracting will affect the
practical limit on tanker-capacity factors. There is
some evidence that tanker investors are willing to
speculate in new tanker capacity to trade on the
short-term market. The trade press commonly
reports on new vessel orders that are uncommitted
to a particular trade and appear to be bought on
speculation. While, presumably, second-hand
tankers – where the economic exposure of such an
investment is limited – are obvious candidates for
speculative spot trading, the conclusion is more
ambiguous when it is applied to newbuilds. Some
of the North American gas merchants placed
orders for speculative vessels before the financial
troubles in that sector developed. Some of those
orders were cancelled. But the larger LNG majors,
such as British Gas, British Petroleum and Shell,
have all been mentioned as ordering uncommitted
tankers. However, the growing trend by some of
the majors towards downstream integration,
through self-contracting with their own marketing
affiliates, clouds the distinction between tanker
contracting and tanker trading. A tanker that has
been ordered to shuttle between various major
company-controlled liquefaction and receipt
facilities may not appear to fit the traditional
definition of a ‘dedicated’ trade, but it would be
hard to class it as truly ‘speculative’.
In the restructured markets of North America,
and increasingly in Europe, companies utilize
180
financial derivatives for managing price risk. In
the United States, the futures market on the
NYMEX has proved to be highly successful and
serves as a potential model for gas risk
management in other countries. It has provided a
very liquid vehicle for hedging short-term US
gas-market transactions. It has also enabled
companies to stabilize revenues and profitability
when market volatility would otherwise cause
them to fluctuate unacceptably. Furthermore, it
has enabled buyers and sellers to lock in current
market-pricing conditions for future physical
transactions.
Applied to LNG, it would enable the parties to
offset the sometimes irregular delivery of LNG
cargoes. A transaction for Middle East LNG for
the US Gulf Coast can be locked in to the current
market price despite the fact that it might take
three weeks for the vessel to deliver the cargo.The
greatest amount of activity on the NYMEX is
concentrated in the near future, and the liquidity
of the market drops off substantially within the
first two years. As a result, it is increasingly
difficult to hedge price transactions for large
volumes very far into the future.
At one point, some vocal advocates of the
use of financial derivatives argued that they
could be ultimately used to hedge multi-billion
dollar LNG investments, thereby replacing the
long-term contract in managing project risk. The
concept, highly controversial at the time, has
now lost most of its credibility. The futures
markets rely heavily on speculators, who tend to
act as the counter parties to the hedging
activities of companies. However, their interest
declines for transactions very far into the future.
For longer-term positions, the market has relied
on over-the-counter ‘swaps’, for which the
specialist market-trading companies and the
investment banks act as the counter parties.
Enron, for example, was a major specialist in
long-term gas swaps. One of the principal
consequences of its bankruptcy proceeding has
been to default on some of its long-term
commitments, adversely affecting the
profitability of those who relied on it for hedges.
The near collapse of the trading companies has
markedly changed the outlook for long-term risk
management in LNG. Since some of the affected
companies were leaders in the effort to develop
the long-term derivatives market, their problems –
and in some cases their complete withdrawal from
trading activities – have sharply reduced the
number of players who are prepared to accept that
risk.
ENCYCLOPAEDIA OF HYDROCARBONS

One of the features of this new LNG market is
the emergence of self-contracting. The clash
between the two structural models of the
international LNG industry – the traditional,
risk-averse, contract-dependent model and the
free market, trading model – has substantially
shifted the balance of risks and rewards among
the parties in ways that are not yet fully
understood. The long-term contract gave sellers
the assurance that they had secure outlets without
the need to integrate downstream as the industry
has traditionally done in oil.
However, it appears that it is increasingly
difficult to find buyers in restructured markets,
such as those in the United States and United
Kingdom, who can deliver on the traditional
volume commitment. Buyers in these markets
often try to minimize market risk by tying the
price escalator to a gas-market indicator, since it
may be very difficult to sell gas priced at
oil-linkage in a gas-to-gas competitive market,
and the captive ratepayers are largely gone. In
contrast, a volume obligation tied to a
gas-competitive market indicator easily enables
the buyer to resell surplus volumes in the market
with very little loss from what he is obligated to
pay by the escalation clause. Hence, a significant
part of the market risk appears to have migrated
upstream. In the face of the market and political
risks in LNG investments, integrating downstream
and creating a diversified supply portfolio would
seem to make good sense as an investment
strategy for producers.
One problem is that the price tag for the
highest degree of diversity – participating in a
number of markets from a diverse portfolio of
supply sources – is so large that few companies
can afford it. This tends to favour the
‘super-majors’ with their large capital budgets;
but there also seems to be a place for specialist
‘niche’ players, who can concentrate on a specific
situation that they may be able to control.
Integration in LNG has another face, as well.
For those buyers who still exert some control over
their own markets, the possibility of acquiring an
upstream position in production – usually
expected to be the most profitable link in the
chain – offers a method of upstream integration.
Kogas in Korea was one of the first buyers to
acquire an upstream stake by obtaining an interest
in Qatar’s Rasgas 1 project. It has also been the
path of the Chinese National Offshore Oil
Company (CNOOC) in acquiring an equity
interest in the Australian North West Shelf
project, as a part of the Guangdong purchase
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
INTERNATIONAL TRADE AND THE LNG INDUSTRY
contract, and negotiating a similar position in
BP’s Indonesian Tangguh project in return for the
Fujian contract.
It has also been the route that Tokyo Electric
and Tokyo Gas have followed in acquiring an
equity interest in the Bayu Undan project in the
Timor Sea. Interestingly enough, ConocoPhillips
– the seller in Bayu Undan – has reversed its role
by acquiring a position in Qatar’s North Field in
return for a contract to buy from Qatargas for the
US market. In that case, ConocoPhillips is
offering access to the US market through its
established marketing affiliate in the United
States.
LNG pricing, transport costs and netbacks
It is common to see discussions of LNG that
build up the price at which it could be sold
profitably from the underlying costs of field
development, liquefaction, tanker transport and
regasification. This approach to price formation is
commonly termed ‘cost-of-service’ pricing, since
it assumes that prices are driven by costs.
That is not the way that LNG and gas pricing
works in a competitive marketplace. Gas is an
interchangeable commodity whose value from two
different sources is the same, regardless of the
possibly different cost structures of the suppliers.
After failed experiments in wellhead price
controls on a cost-of-service basis, both the
United States and Canada abandoned this
approach to pricing in the 1970s in favour of one
that would allow prices to be set competitively in
the marketplace.
The pricing mechanism that allows the seller
to value his production at its value on the market
(after deducting the costs to deliver it there), is
termed ‘netback’ pricing. Fig. 18 illustrates the
differences between cost-of-service and netback
pricing, using a hypothetical LNG project
delivering to the US Gulf Coast from a greenfield
liquefaction plant 6,200 nautical miles distant
(roughly the distance from Nigeria). If the
supplier’s wellhead cost is 0.80 dollars, he could
justify his project on a cost-of-service basis if
regasified LNG were priced at 3.26 dollars. If he
were subject to utility regulation, that is the price
he would be allowed. However, in a 4 dollars
competitive market, his netback is 1.42 dollars,
rather than the 0.80 dollars price he would have
received under cost-of-service pricing, enabling
him to retain some economic rent.
For many years, world gas markets consisted
of a series of isolated pipeline or LNG trade
pairings with little communication among them.
181
BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY
The rigidities of the long-term contract, with its
dedicated links of supply sources, tankers and
receipt terminals, made it difficult to initiate
short-term or spot transactions. Pipelines, with
their inflexible physical links between sources and
markets, were, if anything, even more regionally
constrained. The result was that international gas
trade operated within a series of isolated regional
markets with little or no communication between
them.These rigid patterns began to break up in the
1990s as LNG surpluses in the Asia/Pacific
market and uncommitted receipt terminal capacity
– especially in the United States – made
short-term transactions possible. While still small
as a percentage of total international trade, these
short-term transactions began to create
price-driven linkages outside the traditional,
restricted regional markets. Thus a real ‘world gas
market’ began to emerge.
However, a ‘world gas market’ should not be
confused with the much more flexible world oil
market. The high costs of LNG transportation still
protect some regional supply/demand linkages
from interregional competition. When there is
surplus capacity in liquefaction plants and
tankers, suppliers may be prepared to compete in
distant markets. However, to do so, they must be
willing to operate on a marginal cost basis,
recovering less than their planned return on
investment.
Considering the possible trades to the North
5 relevant market.
market price for
regasified LNG
4 marginal supplier of LNG for world markets, it is
dollars/MBtu
3 cost-of-service
price built up
from costs
2
1 netback built down
from market price
0 LNG liquefaction trains and larger tankers to
cost-of-service
regasification tanker
cost transportation
netback production cost
Fig. 18. Cost-of-service pricing contrasted
with netback pricing for LNG – a hypothetical LNG
trade into the United States.
Assumptions: 0.80 dollars wellhead cost,
two 3.3 Mt trains, greenfield facility,
6,200 nautical miles from US Gulf Coast,
4 dollars market price.
182
American West Coast, including those from
western South America, only Trinidad and Tobago
in the Atlantic Basin has lower transport costs to
the US than to Europe. The Middle East has
somewhat lower transport costs to southern
Europe (Spain) than to Japan, but the transport
costs are almost identical to northern Europe
(Belgium). Not surprisingly, eastern Pacific Basin
supplies have lower transport costs to the West
Coast than to Northeast Asia, but Asian supplies
are closer to Japan.
It is evident that distant spot cargoes can
compete on an out-of-pocket basis virtually
anywhere in the world in times of surplus
capacities, but they suffer a substantial cost
penalty when suppliers are trying to recover their
full costs in a tight market.
The high costs of transport to more distant
markets, such as the US Gulf Coast or Northeast
Asia, are partially offset by a tendency for these
markets to have higher landed prices for LNG,
particularly if the Middle East is to become the
marginal source of LNG to world markets. In the
United States, Henry Hub has become the price
reference point for US gas markets. Prices in
other regional markets are related to Henry Hub
prices by means of ‘basis differentials’. These
tend to reflect the costs of transport between
Henry Hub and the market in question. Actual
basis differentials can be higher or lower than
those that transport costs would imply, depending
on the relative strength or weakness of the
If indeed the Middle East is becoming the
possible to conceive of a system of LNG basis
differentials reflecting the costs of transporting
LNG from the Middle East to the various market
terminals. Fig. 19 illustrates what these LNG basis
differentials might look like, assuming transport
costs in typical 138,000 m3 tankers.
Qatar has been considering the use of larger
netback minimize costs of delivering gas to distant
liquefaction markets. If Qatar were to supply the Gulf Coast
cost on long-term contracts with dedicated larger
tankers, it would tend to reduce the basis
differential to that market. Fig. 19 shows that this
development, using 200,000 m3 tankers, would
reduce basis differentials by about 0.14 dollars.
As yet there are no receipt terminals on the US
or Mexican West Coasts, but several proposals are
under active study. The West Coast basis
differential is unlikely to be set by direct
shipments from the Middle East to the West
ENCYCLOPAEDIA OF HYDROCARBONS
 INTERNATIONAL TRADE AND THE LNG INDUSTRY

Coast, since several Pacific Basin suppliers to the short-term volumes is usually considerably longer
Northeast Asian market would be able to deliver than the average length of voyage for contract
gas to that market more cheaply than Qatar. Fig. sales; this indicates the importance of surplus
19 shows a comparison between the differential tanker capacity to reach markets that might be
that would be set by delivering gas directly from difficult to serve economically on long-term
Qatar versus a differential that would be set by contracts. However, companies can elect to create
displacement of Sakhalin gas from Japan to Baja excess tanker and terminal capacity in order to
California. If Sakhalin accepted the same netback take advantage of arbitrage trading, though the
from Baja California than it would otherwise get deliberate creation of excess capacity is not a
in parity with Middle East shipments to Japan, it costless exercise. To create an annual surplus
could reduce the West Coast direct basis capacity of 25% in receipt terminals involves
differential by 0.31 dollars. about a 10% increase in the costs of
regasification.
The emergence of arbitrage to link prices The creation of excess capacity in liquefaction
among regions or in tankers through purchases of newbuilds is
An important part of this new trading pattern somewhat more costly. A 25% spare capacity may
is the emergence of arbitrage between markets. cause about a 22% increase in liquefaction costs
Arbitrage enables the trading company to divert and a 21% increase in tanker costs. For tankers,
cargoes to those markets that provide the highest however, the short-term trading has tended to
netbacks. However, the capability to arbitrage concentrate on used tankers that are no longer in
requires sufficient excess capacity in tankers and their original service. For such vessels, the costs
receipt terminals to take advantage of market can be considerably reduced below newbuild
opportunities when they occur. Some of the excess capacity levels.
excess capacity is the result of the normal Much of the interregional arbitrage that has
imbalances between supply and demand, which occurred to date has been in the Atlantic Basin,
can be utilized when available, to seek out the primarily involving Trinidad and Tobago and
best netbacks. Nigeria as suppliers and the United States and
The average length of tanker voyage for Europe (primarily Spain) as market destinations.
Gas moves to whichever market will offer the
highest netback, with flows shifting accordingly.
Atlantic Basin Pacific Basin
Another pattern of arbitrage has developed
basis established between Northeast Asian markets and Atlantic
larger tankers via Sakhalin
2.00 would reduce 2.00 displacement rather Basin markets via shipments from the Middle
the US Gulf than Middle East. Middle East suppliers, principally Qatar, are
Coast basis East direct
in a position to ship either to Asia or to the
1.50 1.50 Atlantic Basin as markets dictate.
dollars/MBtu

dollars/MBtu

Fig. 20 provides an example of how this

arbitrage operates, using one of the most common
1.00 1.00
Atlantic Basin arbitrage patterns. It assumes a
case in which a Trinidad and Tobago shipper is
0.50 0.50
indifferent as to whether he ships to Huelva in
Spain or Everett on the US East Coast, since he
receives the same netback from either market. The
0 0 case assumes his ex-ship price in Huelva is
Italy
Spain
Belgium
US East Coast

US Gulf Coast

India
China
Korea
Japan

Baja California

3 dollars, although he would receive only 2.82

dollars in Everett – a lower price that is offset by
his lower transportation costs.
basis direct Lake Charles, on the US Gulf Coast, suffers
138,000 m3 basis from two disadvantages relative to Everett: it
basis Sakhalin forfeits Everett’s pipeline basis differential over
200,000 m3 displacement
Henry Hub and it is further from LNG supply
sources. Therefore, in this case, the Trinidad and
Fig. 19. Illustrative basis differentials assuming Tobago shipper may be indifferent to Huelva or
the LNG hub is set in the Middle East, Everett but both provide superior netbacks to
assuming 138,000 m3 tankers. Lake Charles.

VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION 183

BASIC ECONOMICS OF THE HYDROCARBONS INDUSTRY

4 surpluses, tanker rates will be discounted, shifting

Lake Charles suffers from the arbitrage balancing point to more distant
an inferior basis differential supplier locations.
and higher transport costs
The current lack of any LNG terminals on the
Eastern side of the Pacific has eliminated the
3 possibility of an Atlantic Basin style of arbitrage
to develop in the Pacific Basin. However, the
Atlantic Basin and the Pacific Basin are linked
dollars/MBtu

through the Middle East, which can act as a swing

2 supplier to both Asia and the Atlantic Basin. This
is illustrated in Fig. 22, which shows the netbacks
to Qatar from the US Gulf Coast, Spain and
Japan.
The Japanese price data, like the Spanish price
1
data, is for all LNG imports and thus includes the
stabilizing effect of contractual volumes. When
US prices have been strong, they have provided
the best netbacks to the Middle East. Japan
0 usually provides better netbacks than Spain, but
Trinidad/Spain

Trinidad/Everett

Trinidad/Lake Charles

Nigeria/Spain

Nigeria/Everett

Nigeria/Lake Charles

Qatar/Spain

Qatar/Everett

Qatar/Lake Charles

the fact that Japan has a much more limited

short-term market tends to focus the Middle East
trading volumes on Europe.
The active pursuit of LNG terminal options
both on the US West Coast and in Mexico, for
both Mexican markets and for trans-shipment to
FOB loading port transport California, raises the possibility of a Pacific
Basin arbitrage similar to that in the Atlantic.
For a number of reasons, this market will
Fig. 20. Netbacks to Trinidad and Tobago,
behave quite differently from the Atlantic Basin
Nigeria and Qatar loading ports from Spanish
and US terminals. Assuming that a 3 dollars
ex-ship delivery from Trinidad and Tobago to Huelva, 10
Spain, is arbitraged against a Trinidad and Tobago Trinidad and Nigeria have
delivery to Everett, Massachusetts. 9 similar netbacks from Spain
but Trinidad does better
8 against the US Gulf Coast
7
dollars/MBtu

When the arbitrage is set between Everett and 6

Huelva, both Nigeria and Qatar achieve higher
5
netbacks in Spain than they do in either Everett or
Lake Charles. As prices shift on both sides of the 4
Atlantic, the arbitrage balancing points shift with 3
them and the LNG shipments tend to seek out the 2
better netbacks.
1
Prices have fluctuated substantially on both
sides of the Atlantic, providing ample opportunity 0
Jul 00 Jul 01 Jul 02 Jul 03 Jul 04
for arbitrage. Fig. 21 illustrates the netback
Trinidad and Tobago/Lake Charles
performance from actual prices in selected
Nigeria/Lake Charles
markets from 2000 through 2004. Since the Trinidad and Tobago or Nigeria/Spain
transport costs from both Trinidad and Tobago
and Nigeria to Spain are virtually identical, the
two suppliers netback similar prices from that Fig. 21. Illustrative netbacks
market. Trinidad and Tobago enjoys a transport for selected Atlantic basin arbitrage
patterns – Trinidad and Tobago and Nigeria
advantage to Lake Charles and so would be to Spain and US Gulf Coast. US prices
expected to enjoy a higher netback than Nigeria. are market prices; Spanish prices
The netbacks of Fig. 21 assume tanker transport at are import prices and include imports
fully allocated transport rates. In times of tanker with relatively stable contract terms.

184 ENCYCLOPAEDIA OF HYDROCARBONS

 INTERNATIONAL TRADE AND THE LNG INDUSTRY

9 one. The LNG basis differentials will be based

US Gulf Coast can be
8 Japan usually gives an attractive market on displacement of Asia/Pacific region supplies
better netbacks when US prices to Northeast Asia, rather than by direct
7 are strong
than Spain, but is shipment from the Middle East. For example, a
6 much less active in
short-term markets Sakhalin displacement (0.31 dollars cheaper
dollars/MBtu

5 than direct delivery from the Middle East) has

4 been used in Fig. 19 to establish the basis
3 differential for Baja California, relative to the
Middle East. In addition, distances are longer
2
for the Pacific Rim source/market pairings, with
1
the result that it requires much more tanker
0 capacity to take advantage of an arbitrage
situation. For example, it takes twice as many
Jul 00 Jul 01 Jul 02 Jul 03 Jul 04 tankers to move the same quantity of LNG from
Lake Charles Spain Japan Bontang in Indonesia as it would to move it to
the North American West Coast.
Fig. 22. Illustrative netbacks from the US Gulf Coast,
Spain and Japan to the Middle East, showing arbitrage
patterns. US prices are market prices; Spanish James T. Jensen
and Japanese prices are import prices and include Jensen Associates
imports with relatively stable contract terms. Weston, Massachusetts, USA

VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION 185


State and market requirements
determining oil policies
3.1.1 Oil and the economy:
an inextricable link
Modern states have always considered oil, and energy
in general, as a wholly specific good within the whole
spectrum of economic activities. It has become
increasingly important for: a) economic development;
b) the distribution of wealth within and among
consuming countries, and between the latter and
producing countries; c) the international balance of
power and national security; d ) processes of social
change. This has led states to believe that choices in
this area could not be fully delegated to market
mechanisms, the large corporations which controlled
the markets, the producing states on which they
depended or to international bodies.
The motivations behind and objectives of public
policy in the energy sector (conventionally described
as energy policy) were, in formal terms, to safeguard
the higher interests which the ruling classes (and
sometimes private citizens themselves) believed could
be identified and protected only by the state. A
conviction which arose and became consolidated in
the late Nineteenth century (first in military circles
and subsequently in the government elites) was based
on the premise that the new international order taking
shape and the rise or fall of powers depended, to a
greater extent than in the past, on the strength of their
industrial base. A country with hundreds of millions of
peasants would not count militarily compared to one
which had an ample supply of coal, steel and iron. This
was the basis for the supremacy, economic and
otherwise (Wright, 1990), which the United States of
America was acquiring over European countries.
In 1901, the British historian Leo Amery warned
that the successful powers will be those who have the
greatest industrial base; those people who have the
industrial power and the power of invention and of
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
3.1
science will be able to defeat all others. “The events
of the subsequent half century confirmed these
predictions. […] Thanks to science and technology,
industrial productivity became an even more essential
component of a nation’s power. Alterations in
international contributions to industrial production
were reflected in international changes in terms of
military power and diplomatic influence” (Kennedy,
1987).
In the correlation between science, technology
and industry, energy was a crucial variable – oil
more so than other sources. Its use value (measured
by the opportunity-cost) was considerably higher
than the price paid and the specific weight it
occupied in the generation of income. The
extraordinary cycle of technical and scientific
innovations which occurred at the turn of the
Twentieth century1 reinforced the reciprocal
correlation between economic progress and the
demand for commercial energy2 which had begun
with the Industrial Revolution. Oil was an essential
element in this cycle, to such an extent that it became
an unavoidable factor in production functions and
common to all other activities. Economic history and
energy history show that the diffusion of great
innovations has always needed, and been made
possible by, new ways of using energy sources, even
those which had been known for a considerable time.
1 Including: the incandescent lightbulb (Swan and
Edison, in 1880), the internal combustion engine (Benz, in
1885), the electrolytic process for making aluminium (Hall
and Héroult, in 1886), the first flight (Wright brothers, in
1903), synthetic rubber (Hofmann, in 1909), the synthesis of
ammonia (Haber and Bosch, in 1913).
2 The term commercial energy is used to describe those
energy sources which figure in market transactions.
Non-commercial energy forms include biomasses other than
those which are produced industrially and sold.
187
PUBLIC POLICIES AND THE OIL INDUSTRY

Table 1. Oil and world economic growth (1900-2004)

Energy
Income* Energy Oil Per capita Per capita Per capita consumption
consumption Population income energy oil per unit
Year (1012 dollars consumption**
(109) (1012 dollars consumption consumption of income
in 2001) (Mtoe)
in 2001) (toe) (toe) (toe/dollars
(Mtoe) (%) in 2001)

1900 1.09 0.55 0.02 3 1.60 0.68 0.34 0.01 0.50

1950 6.70 1.85 0.52 28 2.52 2.66 0.73 0.21 0.28

1960 10.70 3.01 1.07 36 3.02 3.54 1.00 0.35 0.28

1970 17.50 5.02 2.25 45 3.70 4.73 1.36 0.61 0.29

1980 25.30 6.64 2.97 45 4.44 5.70 1.50 0.67 0.26

1990 34.20 8.12 3.14 39 5.29 6.47 1.53 0.59 0.24

2000 46.00 9.08 3.54 39 6.08 7.57 1.49 0.58 0.20

2004 50.09 10.22 3.77 37 6.38 7.85 1.60 0.59 0.20

* Global GDP.
** Commercial energy.
Sources: Income 1900 and 2004: our estimates from various sources; 1950-2000: Worldwatch Institute (2003). Energy and oil 1900-1960:
Cipolla (1977); 1970-2004: BP (2005). Population 1900-1990: Livi Bacci (1998); 2000: Worldwatch Institute (2003); 2004: our estimates.

The result, on each occasion, was an upwards
turning point in development paths (Clô, 1993).
The qualitative specifics of the various sources
have always governed substitution processes and
determined, in every historical period, the
supremacy of one over the others, independently
of their abundance and relative prices.3 It is thanks
to oil that the world economy has experienced its
most extraordinary phase of expansion over the
past century (Table 1), with a roughly 47-fold
increase in real income, as measured by global
GDP, a 12-fold increase in per capita GDP and a
4-fold increase in population. This growth
accounts for about 80-90% of the roughly 19-fold
increase in energy consumption – about half is
driven by oil consumption. Although its first
applications dated to the second half of the
Nineteenth century, it was only with the advent of
the new century that the penetration of oil into the
energy balances of the most advanced countries
competitiveness, oil became the primary energy
source, definitively overthrowing the centuries-old
supremacy of coal.
3 Were this not the case, coal would always have
maintained a dominant position, given its greater physical
abundance and lower prices. This type of revolution
occurred at the beginning of the Middle Ages when the
watermill spread with great rapidity throughout Europe;
once again, five centuries later, when the use of hydraulic
energy to drive machinery spread to a large number of
production processes; and again from the second half of the
Eighteenth century with the beginning of the coal era, “a
strategic element in the rise of industrial civilization”
(Cipolla, 1977), which made it fully apparent that energy
was essential for economic growth.
4 The average posted prices of Arabian Light crude
(used as a reference base for pricing the crudes quoted in the
Eastern hemisphere) between 1950 and 1970 were around
1.75-1.80 $/bbl, with peaks of 2.10 after the 1956 Suez
crisis.
5 The majors are the seven large oil companies which

became significant, with a growth curve for
consumption – according to the law of doubling
every ten years proposed by the Frenchman
Ailleret (1963) – which saw the consumption of
oil increase between 1910 and 1950 to around 500
million tons. The stability of nominal oil prices at
around 1.80 $/bbl, and the fall in real prices
guaranteed4 by the large oil companies (majors),5
encouraged a further 5-fold leap in consumption
to 2.3 billion tons in 1970. Thanks to its growing
dominated the international oil market (outside the United
States and the Soviet countries) until the end of the 1970s:
Standard Oil of New Jersey, founded by David Rockefeller
in 1870 (subsequently Exxon, from 1998 ExxonMobil);
Royal Dutch Shell, established in 1907 with the merger
between Royal Dutch of Holland and the British Shell
Transport; British Petroleum (BP), founded in 1901 with the
name Anglo-Persian Oil Company; Gulf Oil, established in
1907 and absorbed by Chevron in 1994; Chevron, formerly
Standard Oil of California, established in 1911 with the
break-up of Standard, like Mobil Oil; Texaco, established at
the beginning of the last century.

188 ENCYCLOPAEDIA OF HYDROCARBONS

 STATE AND MARKET REQUIREMENTS DETERMINING OIL POLICIES

55
the second oil crisis (1979-1980)
price (dollars per barrel, in nominal values)

50

45 the first Gulf crisis (17 January 1991)

40 the second Gulf crisis (19 March 2003)

35

30

25

20

15 attack on the Twin Towers

(11 September 2001)
10

5 Asian economic crisis (1998)

oil counter-shock (1986)
0
1980 1985 1990 1995 2000 2005
year

Fig. 1. Trend of international oil prices.

The serious economic recessions and profound of economic stagnation, whilst the recent strong
adjustment processes which followed the unforeseen, increases have jeopardized recovery.
but not unpredictable, rise of over 9 times of the real It is also unlikely to be the case in the future,
prices of oil (Fig. 1)6 to peaks of 40 $/bbl in 1980 considering the recent and widely accepted energy
(after, but not due exclusively to, the two oil shocks of scenarios (IEA, 2004b) which forecast an exponential
1973-74 and 1979-80) led to a temporary turning point increase in the demand for energy. Given the state of
in the growth curve of consumption. This was due to technology and the low social acceptability of nuclear
the combined effect of significant improvements in power and coal, this will lead to comparable increases
energy efficiency, changes in production mixes, in the demand for oil, predicted to remain the primary
substitution of oil with coal, nuclear power and natural energy source. In an international political scenario
gas. The decrease was mainly concentrated in the which has become significantly more unstable and
member countries of OPEC (Organization of uncertain after September 11, how to ensure a
Petroleum Exporting Countries), which almost halved harmonious development of the enormous
production. However, the market pendulum later investments10 thought necessary to guarantee a correct
swung back towards oil: the combination of the price balance between potential demand and incremental
countershock in 19867 with increasingly rapid supply is the huge and complex challenge facing the
economic growth, especially in developing countries,
and the start of a new phase of expanding consumption
led to new peaks in 2004 of 4.2 Gt (about 1 Gt higher 6 The average prices of Arabian Light increased from

than the preceding record of 1979). 1.80 $/bbl in 1970 to 35.9 in 1980, equivalent to about 100
This increase in demand, given the near dollars in 2004 currency.
7 To minimum levels in 1986 lower than 10 $/bbl and
saturation of spare oil capacity8 and the serious average values during the 1990s of 15-16 current $, except
political tensions following the tragic attack on New the peaks of over 35 during the First Gulf War in 1991 and
York’s Twin Towers on 11 September 2001, had the minimum levels of 10 $ following the Asian economic
repercussions on oil prices, with an increase of over crisis of 1998.
8 Spare capacity is the production capacity which can be
100% between 1999 and 2004 to mean values close
activated in the very short term and sustained over time
to 40 $/bbl, with some analysts predicting future without causing any damage to the extraction potential of
levels of above 100 dollars.9 This increase (Clô, reservoirs.
2004b,c), sudden but again predictable, dispelled the 9 This forecast is endorsed by numerous analysts; most

illusion that the impact of oil on the fate of world recently the investment bank Goldman Sachs in the report
economies was destined to decrease. This was not US Energy: Oil, of March 2005.
10 The IEA predicts a need for investments in the world
the case, considering that for the fourth time in the oil industry of 3,000 billion dollars during the period
past three decades (Fig. 2), an increase in crude oil 2002-2030, equivalent to about 105 billion dollars per year
prices preceded or coincided with a prolonged phase (IEA, 2004b).

VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION 189

PUBLIC POLICIES AND THE OIL INDUSTRY

8 40
Arabian Light

price (dollars per barrel, in nominal values)

7 35

6 30
economic growth (%)

5 25

4 20

3 15

2 10

1 world GDP 5
growth rate
0 0
1970 1975 1980 1985 1990 1995 2000 2005
year

Fig. 2. Oil price and world economic growth.

world’s governments. This is the case as much at the
beginning of the Twenty-first century as it was at the
beginning of the Twentieth: upon this challenge
depends the fate of the economy and, more
importantly, the survival of much of the world’s
population.11
3.1.2 Oil and politics:
the lessons of history
Were we to examine only the close correlation
between oil and economic progress, ignoring the
political motives which have always played a vital role,
we would not have a clear view of developments over
the past century on the oil markets, both international
and within individual countries, or of the motives
underlying the intrusion of states. With oil, economic
development, previously based almost entirely on the
use of domestic coal, became detached from the
ownership of the energy source on which it mainly
relied and on which its future depended. The
geographical distribution of the demand for oil has
tended to progressively diverge from the geographical
distribution of supply, with the former being
concentrated in North America, Europe, Japan and,
subsequently, other Asian countries, and the latter in
the Middle East, North Africa, South America and the
Soviet Union (later Russia).
Industrially dominant countries have become
increasingly dependent on energy from abroad,
resulting in risks and situations of economic and
political vulnerability. With oil, energy has ceased to
be a prevalently economic factor to become a motive
and arena for political conflict between importing
states, between these and exporting states, between
companies and states. The stakes are high: to acquire
direct control of oil resources, increase the security of
supply, consolidate one’s own power in relation to
other countries, secure oil rent. A full understanding of
market dynamics, processes of substitution between
energy sources, the evolution of their relative prices,
and the geographical distribution of investments
cannot avoid the political implications which these
have always had, though it would be equally wrong to
attribute all developments to them. At the same time,
these implications have always conditioned the
international and military policies of the great powers,
and especially the United States.
These implications were already obvious to
Germany, the world’s second industrial power in 1912
when it purchased 25% of the Turkish Petroleum
Company12 (the holder of oil exploration and
exploitation licences in the territories of Mosul and
Baghdad) through the Deutsche Bank, already
involved in the construction of a railway link to
Baghdad. They were obvious to Russia, which from
the late Nineteenth century had made efforts to attract
foreign capital to develop the oil resources discovered
in the Caucasus (Baku), accounting by the year 1900
11 The world population lacking electrical energy
amounted to about 1.5 billion people in 2002, with 2.6
billion lacking any commercial energy source.
12 Other shareholders were Royal Dutch Shell with 25%
and the Anglo-Persian Oil Company with 50%.

190 ENCYCLOPAEDIA OF HYDROCARBONS


for about half of world production. They were yet
more obvious to Winston Churchill when on 17 July
1913, in a House of Commons debate on the
Admiralty, of which he was First Lord, he strongly
upheld the critical importance which the oil issue
would increasingly hold for the Royal Navy13 and for
the very survival of the nation. “If we cannot get oil,
we cannot get corn, we cannot get cotton and we
cannot get a thousand and one commodities necessary
for the preservation of the economic energies of Great
Britain” (Ferrier, 1982). Noting that, even then, “the
open market is becoming an open mockery”, he also
declared that “our long-term policy is that the
Admiralty should become the direct proprietor and
independent producer of its own oil supplies” (Murat,
1969). This would happen through three lines of
action: by building up strategic reserves of oil, able to
meet requirements in times of war and price variations
in times of peace; by purchasing oil directly on the
international markets, when it was particularly cheap;
by acquiring the direct and full control of oil
companies.
Churchill’s speech had an enormous impact on the
British newspapers of the time and on public opinion
in general, but above all, it speeded up the plans to
enter the oil industry already drawn up by the
government. This was to occur a year later with the
purchase by the British Treasury (through an injection
of capital of 2 million current pounds sterling) of the
majority shareholding of the Anglo-Persian Oil
Company (from 1935, Anglo-Iranian Oil Company;
from 1954, British Petroleum). Anglo-Persian was an
oil company founded in 1909 by the wealthy British
diplomat William Knox D’Arcy which held in a single
60-year concession, granted by the Shah of Persia, all
oil exploration, extraction and exportation rights in 4/5
of Iran (1.2 million km2).14 It is not without
significance that the act with which the British
Parliament ratified the contract, giving the government
a sort of golden share, obtained royal approval only six
days before the outbreak of the First World War in
August 1914 (Longrigg, 1968). This event shows that
non-involvement in the oil world, entrusting supply
exclusively to foreign private enterprise, and the
absence of a national industry or instruments with
which to regulate the domestic markets would have
meant (for any State under the conditions then
prevailing in the oil markets) being subject to the will
of others, e.g. foreign companies or their home
governments. Ultimately, this would have led to
relinquishing independence as an industrial power.
France suffered the most severe consequences of this,
but the condition was common to all. The world’s fifth
industrial power, without oil, the French State
entrusted its limited needs exclusively to the American
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
STATE AND MARKET REQUIREMENTS DETERMINING OIL POLICIES
company Standard Oil of New Jersey, in accordance
with an almost free trade policy, with only a few
limited interventions in the fields of taxation and
tariffs.15 After entering the war, France was forced to
ask the United States for help in late 1917. This was
because it lacked oil stocks, was unable to find ships
to meet its military requirements (since Great Britain
had requisitioned the ships flying the English flag
previously used), and crude oil prices had been pushed
to stratospheric levels by speculation. This forced the
French government to take upon itself all oil-related
decisions by creating a large number of public
bodies16 and introducing a system of restrictions
which effectively created a monopole d’État, with the
state acting as single purchaser; when faced with the
country’s interests: “Any consideration of private
interest must disappear”17 (Murat, 1969). Following in
the Colbertist tradition,18 the birth in France of the
most state-controlled model for the regulation of the
oil industry in the entire Western world was a
consequence of the war regime. But more than
anything, it was a consequence of the United States
using oil as a weapon of political pressure; it imposed
strict conditions on its French ally for meeting its
request for help, also during subsequent international
13 In 1913, the Royal Navy had already converted 45%
of its fleet from domestically produced coal to naphtha
manufactured from imported oil, thus acquiring a crucial
advantage over the German fleet in terms of speed.
14 The agreement with the British Treasury guaranteed
the company a significant injection of capital and a
long-term outlet for fuel oil with the Royal Navy. For its
part, the government, as well as ensuring supply for the
fleet, took on a fundamental role in the Middle East,
guaranteeing full political protection for the expansion of
Anglo-Persian. The government only reserved the right to
nominate two members of the company’s Board of
Directors, undertaking to avoid any interference in company
decisions. This principle was restated and always respected
by subsequent governments. Until 1964, the Treasury
retained the absolute majority of shares in British Petroleum,
until 1983 a controlling share; only in 1987 was the
company definitively privatized with the government
retaining, during the initial phase, some golden shares which
have now been removed.
15 An initial tariff law was adopted in France as early as
1864 to protect the few small domestic refineries; this
protection was abandoned in 1903.
16 One of the most important was the Office National
des Combustibles Liquides (ONCL), established on 10
January 1925 and replaced by the Direction des Carburants
from 1939.
17 Declaration by the French minister for supply,
M. Clémentel.
18 Jean-Baptiste Colbert (1619-1683), Louis XIV’s
Prime Minister, pursued trade policies to support the
manufacturing industry and the construction of
infrastructure (especially roads, canals and the fleet) to
consolidate French power in Europe.
191
PUBLIC POLICIES AND THE OIL INDUSTRY
crises.19 This was seen as an intrusion into its domestic
affairs which France did not intend to tolerate again,
either from its traditional Western allies or even less
from other countries; as was to occur in October 1973,
when the international market was thrown into turmoil
by the oil embargo of Arab countries.
During the 1970s, Jacques Chirac’s government,
with the support of the whole country, took the drastic
decision to launch the largest ever programme for the
construction of nuclear power stations20 – over 50 in
little more than two decades. The aim was to
completely abolish the use of oil in electricity
generation, with the aid of copious public funds, as yet
not exhausted. This decision was not motivated by the
presumed economic convenience of nuclear power
compared to oil, but by the desire to render the
country totally independent in electricity, which would
most heavily condition future economic progress. This
was a political rather than an economic decision.
In Europe, oil policies developed out of the
experiences of the First World War and the subsequent
international conflicts for the control of Middle
Eastern resources. They were born out of a need and
desire for national defence: a public good which only
the state could provide.21 This conviction became
strongly rooted in the governmental, diplomatic and
military establishment. Ever since, European
governments have generally been inclined to intervene
in the oil business, taking control out of the hands of
private enterprise, wholly or in part; limiting market
mechanisms and potential external interference. This
led to the basic decision that energy should be
considered the absolute prerogative and an integral
part of national sovereignty, which could not be left to
the will of others or ceded to supra-national
regulations. This was to occur during the long and still
incomplete road towards a single European market and
single policy – objectives attained in most countries
for currency,22 but not yet for energy. The arguments
in favour of cooperation were possible for coal, and
led to a common policy in the form of the European
Coal and Steel Community (ECSC).23 However, since
conflicts of interest prevailed to such an extent in the
case of oil, no common policy was possible.
3.1.3 The philosophy
of public intervention
Oil’s fundamental importance on the economic level
and its strategic importance on the political level led to
a philosophy of public intervention in the oil industry
which has few parallels in other sectors.24 Intervention
began in the 1920s and increased to reach its apex
after the oil shocks of the 1970s, at which point there
192
was a change of direction. Here, as elsewhere, reform
processes began towards a free market approach which
led states to renounce the exertion of coercive power
where it was believed (rightly or wrongly) that the
market and competition could operate effectively.
Public intervention characterized most consuming
countries, even those with strong free market
traditions, with recourse to different measures
depending on the specific energy, institutional and
social context. Market regulation, tariffs duty,
exclusive rights, public ownership, protection,
subsidies, administered prices and taxation policies are
some of the numerous ways with which energy
policies have expressed themselves over time. They
have resulted in alterations in the structure of the
markets, both domestic and international; restrictions
on the degree of freedom enjoyed by companies;
conditioning of their strategies, behaviour,
performances.
The objectives pursued by these policies were
equally complex: a) to alter the market attractiveness
of the various energy sources to guide the decisions of
economic agents towards mixes thought to be more
reliable; b) to encourage the penetration of
entrepreneurial interests into the foreign countries with
the greatest production potential; c) to strengthen
national industry, when foreign private industry was
19 In 1941, the United States and Great Britain cut off
Japan’s oil supply to undermine its acts of aggression against
China. In 1956, during the first Suez Crisis, the United
States made the help requested by France and Great Britain
conditional on their promise to evacuate the Canal Zone by
the end of the year (Murat, 1969).
20 Five contracts between 1974 and 1980 ordered 32
900-MW reactors and 16 1,300-MW reactors. A further six,
4 1,300-MW and 2 1,450-MW reactors, were ordered
between 1983 and 1986. The objective set out in 1974 of a
nuclear capacity of 45,000 MW was achieved 13 years later,
in 1987. In 2004, 56 reactors were operational, with a total
capacity of 63,000 MW, accounting for almost 80% of total
electricity production and exporting about 60 billion kWh.
21 Public goods are those goods consumed by the whole
of society and not only by single individuals. They are
characterized by being: non-excludable (once produced, it is
impossible to prevent anyone from using them, e.g. street
lighting) and indivisible (the minimum quantity produced
cannot be acquired by a single consumer, e.g. national
defence). According to Mittra et al. (1995): “There is no
doubt that energy supply is a public good. At the individual
level, access to and the guarantee of a minimal level of
energy supply is a basic need […]. The market can achieve
this, but at a price which cannot be paid by all”.
22 On 1 January 2002, the euro was introduced as the
single currency in 12 of the 15 countries then belonging to
the European Union (Great Britain, Sweden and Denmark
did not adhere).
23 Established in Paris on 18 April 1951 with effect from
23 July 1952.
24 The only comparable sector is agriculture.
ENCYCLOPAEDIA OF HYDROCARBONS

considered insufficient and unsuited to guaranteeing
full protection of national interests; d ) to prevent the
major companies from exploiting a dominant position
in the domestic markets;25 e) to reinforce the
continuity and security of supply through strategic
stocks and investments; f ) to adopt environmental
legislation aimed at containing the social costs linked
to the production and use of energy sources.
National policies have played a crucial role in the
internal dynamics of individual markets and, to an
increasing extent, in those of the international
markets, given their increasingly close
interdependence. However, national policies have
taken little account of this; as a result, individual
action has prevailed over cooperation, with lower
benefits and higher costs than those which are
theoretically possible, and an outcome often far
from what was expected. The most obvious example
is the positive correlation which has always existed
(and still exists) between American oil imports and
international oil prices; in other words, between the
domestic policies conditioning the former and their
impact on external markets. All the phases of
international price rises which have succeeded one
another over the past half century have been caused
or accompanied by increases in American imports
(and vice versa). The strict price controls on the oil
produced in the United States were, for example, the
main cause of the triplication of crude imports
during the 1970s26 and, not least, the causes of the
price leap which occurred during the shocks of those
years. Similarly, the subsequent increase in domestic
production and the Energy Policy and Conservation
Act 1975 – which introduced measures to reduce
demand, starting with the new standards for motor
vehicles with the Corporate Average Fuel Economy
(CAFE) – encouraged a decrease in imports and the
resulting price countershock.
Alongside the policies of consuming countries, the
dynamics of the international markets were
increasingly conditioned by the policies of producing
countries. These policies were aimed mainly at
exercising the right to sovereignty over the exploitation
of natural resources which the United Nations had
solemnly recognized in 1966.27 This objective entailed,
as a necessary but not sufficient condition, a profound
revision of the concessions system which had allowed
the large Western companies, thanks to the political
protection of their home governments, to take full and
uncontested control over their internal resources
(Verdross, 1964; Cattan, 1967a,b; Rouhani, 1970). As
the desire for independence grew in producing
countries, these concessions were increasingly
perceived as odious instruments to “transfer their
national sovereignty to third parties” (Sutowo, 1962),
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
STATE AND MARKET REQUIREMENTS DETERMINING OIL POLICIES
and as the most blatant evidence of exploitation by the
companies and their countries of origin. Overcoming
these “more imposed than negotiated” contractual
relations (El-Sayed, 1967), moving towards a levelling
of the balance of power between North and South, and
overcoming the dominant international petroleum
order to develop a national industry which could take
account of their needs for domestic growth was the
objective of the activities of OPEC, founded in
Baghdad on 14 September 1960 by the major
producing countries.28
Below, this analysis will be limited to the public
policies, excluding environmental policies, of
consuming countries belonging to the Organization for
Economic Cooperation and Development (OECD).29
These countries have contributed most to the growth in
worldwide demand for oil, accounting for 70% up to
the early 1970s (Table 2); their importance, though
undermined in numerical terms by the increasing
weight of Asian countries, will be no lesser in the
future than it was in the past. The ability to guarantee
the complete adequacy of oil supply flows compared
to expected levels of demand, the investment strategies
of companies, and the dynamics of oil prices will
depend on the evolution of the comparative public
policies of old and new consuming countries. These
policies will show a marked asymmetry between the
market philosophy increasingly adopted by Western
governments and the philosophy of public intervention
adopted by new consumers, as was once the case for
the former.
25 The dominant position (a central concept in European
anti-trust legislation and policy) is an expression of the
market power detained by a company in the relevant market
within which it operates; this power allows the company to
set prices higher than those which would exist under
conditions of perfect competition, thus guaranteeing greater
profits than those believed to be normal, with a loss of
well-being for society as a whole.
26 From 3.2 Mbbl/d in 1970 to 6.0 in 1973 and 8-9 in
1977-79.
27 In Resolution no. 2158/1966 (Permanent Sovereignty
over Natural Resources) the UN reaffirmed (point 1)
“the inalienable right of all countries to exercise permanent
sovereignty over their natural resources in the interest of
their national development” and (point 5) “to secure and
increase their share in the administration of enterprises
which are fully or partly operated by foreign capital and to
have a greater share in the advantages and profits derived
therefrom on an equitable basis”.
28 OPEC was founded by 5 countries: Saudi Arabia,
Iraq, Iran, Venezuela and Kuwait. In time, these were joined
by a further 8: Qatar (1961), Libya (1962), Indonesia
(1962), United Arab Emirates (1967), Algeria (1969),
Nigeria (1971), Gabon (1973), Ecuador (1973); the latter
two, however, subsequently left the organization.
29 Established in Paris in 1961 by the countries of
Western Europe, the United States, Canada and Japan.
193
PUBLIC POLICIES AND THE OIL INDUSTRY

Table 2. World oil demand (Mbbl/d)

2030/2002
Area 1950 1960 1970 2002 2010 2020 2030
(%)
North America 6.9 10.6 16.2 22.6 25.5 28.7 31.0 ⫹37
Western Europe 1.0 3.8 8.8 14.5 15.3 16.3 16.6 ⫹14
Pacific region 0.4 1.1 8.2 8.4 8.9 9.4 9.5 ⫹13
OECD 8.3 15.5 33.2 45.5 49.7 54.4 57.1 ⫹26
Russia – 2.4 5.3 4.7 5.5 6.5 7.6 ⫹62
China – 0.2 0.6 5.2 7.9 10.6 13.3 ⫹155
India – – – 2.5 3.4 4.5 5.6 ⫹124
Non OECD 2.4 5.8 13.2 28.6 37.5 48.8 60.4 ⫹111
World* 10.7 21.3 46.4 77.0 90.4 106.7 121.3 ⫹58

Demand for energy 37.0 60.0 100.0 217.2 256.1 302.5 346.2 ⫹59
Oil’s share (%) 29.0 35.5 46.4 35.5 35.3 35.3 35.0 ⫺0.5

* From 2002, the data includes bunkers and variations in reserves not attributed to specific areas.
Sources: 1950-70: Clô (2000); 2002-30: IEA (2004b).

The similarity of objectives externalities31 and resulting social costs linked to

By analysing the evolution of the policies adopted
by consuming countries, four conclusions can be
drawn: a) the similarity between and convergence of
their underlying motivations, and the objectives which
they aimed to attain; b) the diversity of the mix of
instruments adopted by individual countries; c) the
divergence, or even conflict of interests, in their
application; d ) their discontinuity over time, though
along essentially similar lines.
Let us begin with the objectives. It is true that the
rational basis and motivations traditionally adopted in
support of oil policies have been to correct market
failures, where it was believed that the market was not
spontaneously able to achieve the efficient allocation
of resources. However, it is equally true that an
analysis of the individual measures taken shows that
they often responded to a specific request for
protection by individual and well-organized private
interest groups (Stigler, 1971). Both the theory of
public interest, especially in Europe, and that of
private interest, especially in the United States, thus
find an empirical confirmation in oil policy, though it
is difficult to determine which of the two played the
greater role on any given occasion.
The main failures,30 be they genuine or
the use of oil. This leads to: excess demand;
overexploitation of oil resources by those who
possess them; excess imports by those forced to
rely on them; a lower degree of development of
other sources of energy. Equally: to counter the
risks of international political crises due to
exporting countries (bar none) using oil as a
weapon of political pressure, with shock effects on
prices and quantities. Additionally: to avoid the
international political costs incurred by
dependence on imports and the resulting
limitations on sovereignty. According to James
Schlesinger, former Secretary of Defence and
Energy, had the United States been dependent on
Libya in 1986, it would have been unable to
impose economic sanctions or bomb Tripoli and
Benghazi for the support given to international
terrorism. The same can be said of the later
embargo against Iran (Kohl, 1991).
• To avoid physical oil shortages resulting from the
intrinsic incapacity of competition mechanisms
and the related price systems, to ‘discount’ future
30 This discussion does not take into account external

manipulated for the purpose, which have been cited in
support of oil policies over time can be subdivided
into four general categories:
• To reinforce national security in the belief that the
market does not take account of the negative
environmental failures, dealt with in Chapter 3.3.
31 The term externality is used to indicate the costs and
benefits of the production, and use of a good which are not
fully represented in market prices. The result is a loss of
efficiency, in the sense that a reallocation of resources would
allow for a higher level of well-being.

194 ENCYCLOPAEDIA OF HYDROCARBONS


Table 3. Oil shocks compared
Duration
Dates Name
(d)
26/7/1956-7/3/1957 Suez Crisis 240
5/6/1967-10/6/1967 Six-Day War 6 2.0
5/10/1973-22/10/1973 Yom Kippur War 15
1/9/1978-31/3/1979 Iran Crisis 212
2/8/1990-28/2/1991 First Gulf War 210
19/3/2003-1/5/2003 Second Gulf War 14
* Excluding countries with a planned economy. ** Posted Price Arabian Light for 1956 and 1967; pricing on Rotterdam product prices for
1973 and 1979; Brent Dated for 1990 and 2003. *** Variation December 1978-December 1980.
requirements or events and the reluctance of
private investors to take on huge high risk
investments whose returns are delayed in time. In a
context dominated by private enterprise and
competition, investment choices are preferably
directed towards technological solutions with lower
capital costs, faster development and shorter
pay-back time. The behaviour of companies is
conditioned by short-termism. The mix of
investments is unlikely to coincide with what
would be socially desirable. Price fluctuations lead
to substitutions between sources which are
sometimes independent of the time required for
investments to mature, the relative availability of
sources, and their long-term development costs.
The ideal price is not the lowest price, but that
which ensures the investments needed to produce a
sufficient amount of energy to satisfy demand over
the long term, with a socially desirable mix of
sources. Yet the world and the oil market are
anything but ideal.
• To undermine the instability and unpredictability
of oil prices which have always accompanied the
most competitive phases of the markets: given the
opposing negative effects which would ensue for
economies, when faced with sudden rises, or for
investments and future supply, when faced with
sudden drops. In the absence of some form of
coordinated decision-making, the industry is not
self-adjusting; in other words, it is unable to
spontaneously reach a position of stable market
equilibrium through the servomechanism of prices;
this inevitably results in oversupply or deficit and,
consequently, in price instability. Paul Frankel has
written: “The problem of oil is that there is always
too much or too little” (Frankel, 1946).
• To counterbalance the considerable market power
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
STATE AND MARKET REQUIREMENTS DETERMINING OIL POLICIES
Decrease in supply* Price variation** (%)
(Mbbl/d) (%) 60 d 90 d
2.0 11.4 0 0
5.0 0 0
1.6 2.8 ⫹153 ⫹235
3.7 6.9 ⫹20 ⫹169***
4.9 9.2 ⫹136 ⫹98
2.0 2.6 ⫺18 ⫺9
of the large companies which once dominated the
international scene and the structure of the
domestic European and Japanese markets; or to
counterbalance the market power of the exporting
countries which, through OPEC, almost completely
control the marginal supply of oil, and thus have
the power to condition its price trends on the
international markets without fixing them directly.
The relative importance of these failures and thus
the direction and intensity of the public policies
targeted at them have varied over time depending on
several factors: international crises; the evolving
structure of the international market, from a long
period of oligopolistic control by the majors to the
prevailing conditions of, relative and far from perfect,
competition; dominant ideologies and policies. Of all
these failures, the one which has dominated
government agendas has been national security or the
security of supply, i.e. the ability to rely upon a regular
flow of oil at equitable prices along the whole
petroleum chain, as a protection from the political
crises which have occurred almost once a decade since
the Second World War (Table 3). Scarcity of supply
entails two types of costs which can be reduced by
public intervention, as opposed to market mechanisms:
one associated with the transfer of wealth due to oil
imports,32 and the other with the reallocation of
32 “A reduction in aggregate demand will, in general,
reduce the market price to the benefit of all domestic
consumers, yet individual buyers do not figure into their
decision calculus the benefits of lower prices paid by others.
[…] A collective decision on the volume of imports, which
takes into consideration the additional benefits of smaller
demand, compared to individual decision-making will
reduce the volume of imports and place downward pressure
on the world price compared to the outcome without
intervention” (Bohi and Toman, 1986).
195
PUBLIC POLICIES AND THE OIL INDUSTRY

resources following a price shock. Public intervention
in the market may contain both by increasing
availability with strategic stocks to reduce imports and
contain the price effect, and/or by reducing demand
(by taxing consumption or imports) and thus imports
(Bohi and Toman, 1986).
The diversity of measures
Contrasting with the similar motivations and
objectives of oil policies were the different measures
with which these were pursued in each country, for
two different types of reasons.
First, it is worth stressing that the organizational
structures, laws and legal systems of energy regulation
became consolidated in each country as a function of
the prevailing institutional traditions (centralism,
federalism, regionalism); the specific characteristics of
individual markets (size, territorial distribution,
density of consumption); social, economic and
territorial imbalances; the economic and political
culture (state-control or free-market); the robustness
and vitality of private capitalism; and, finally, the
objectives of public interest, and consequent
obligations, which each state believed should be
connected to the issue of energy (public services,
universal service).
The second reason is the position of strength or
weakness in which each country came to find itself in
relation to the oil issue, in terms of three main
indicators (Table 4): oil’s share of energy consumption,
indicating the stage of economic development of each
country, the domestic availability of oil or other

Table 4. Foreign degree of dependence (%) for energy and oil (1952-2002)

1952 1960 1970 1980 1990 2000 2002

UNITED STATES Energy 0 6 7 14 14 27 27

Oil 12 16 21 38 44 59 60
Oil/Energy 37 46 45 44 40 39 39
JAPAN Energy 2 42 85 88 83 80 81
Oil 100 98 100 100 100 100 100
Oil/Energy 8 34 72 68 57 50 49
EUROPE* Energy 17 35 59 52 46 48 49
Oil 88 92 97 84 78 72 74
Oil/Energy 11 33 57 51 41 41 40
GREAT BRITAIN Energy 0 28 51 2 2 ⫺17 ⫺14
Oil 100 100 100 0 ⫺15 ⫺57 ⫺54
Oil/Energy 10 28 49 41 39 36 35
FRANCE Energy 29 43 68 73 51 49 49
Oil 97 93 97 98 96 98 98
Oil/Energy 16 36 61 56 38 34 34
GERMANY Energy 1 12 43 48 48 61 61
Oil 56 82 94 96 96 97 97
Oil/Energy 3 22 45 41 36 38 37
ITALY Energy 46 65 82 86 83 84 85
Oil 99 90 98 98 95 95 94
Oil/Energy 23 52 75 69 59 51 51
OECD** Energy 6 17 29 29 25 28 28
Oil 27 41 59 57 51 52 53
Oil/Energy 26 40 50 48 42 41 41
CHINA*** Energy 2 1 0 ⫺2 ⫺1 4 2
Oil 72 33 7 ⫺14 ⫺20 29 33
Oil/Energy 3 4 11 16 13 20 20
RUSSIA*** Energy 0 ⫺10 ⫺14 ⫺20 ⫺21 ⫺37 ⫺45
Oil 5 ⫺28 ⫺37 ⫺39 ⫺40 ⫺117 ⫺152
Oil/Energy 20 27 35 39 30 20 20

Oil/Energy: impact of oil consumption on energy consumption. * 15 countries except for 1952: EEC with 6 member-countries. ** For the
years 1952, 1960, 1970 our estimates from various sources. *** For 1960 data from 1962; for 1970 data from 1971.
Sources: IEA (2004a); except 1952 and China, Russia 1962: Ippolito (1969).

196 ENCYCLOPAEDIA OF HYDROCARBONS


sources of energy, and the prevailing capital stock;
dependence on foreign countries for energy
consumption, an indication of the country’s overall
vulnerability; dependence on foreign countries for oil
consumption, an overall indicator of the country’s
strength or weakness in relation to oil. Two
conclusions emerge from a comparison between
countries: the privileged position of the United States
over Europe and Japan, resulting from a dependence
on foreign oil supply up to 10 times lower; the
significant differences within Europe, with some
countries, such as Great Britain, the Netherlands and
Germany being in a privileged position and others,
such as France, Spain and especially Italy, being
significantly disadvantaged.
Conflict of interests
The structural diversity of individual countries
explains, on the one hand, the specific paths taken
by their policies and, on the other, the conflict of
interests characterizing their relations. This only
rarely leads to concerted actions of a bilateral or
multilateral nature, even when faced with serious
international crises. There is a conflict of interests
especially between countries forced to import oil
and countries with an ample supply of it. The
former aims to minimize prices and the latter,
albeit undeclaredly, aims to maximize them or
prevent them falling in order to support domestic
production, even at the expense of heavy
macroeconomic costs.
This conflict became clearly apparent between
the United States, on the one hand, and Europe and
Japan, on the other, during the shocks of the 1970s.
These were thought by some scholars (Blair, 1977)
to have been abetted, or at any rate not hindered, by
the oil companies and the United States
themselves. The increase in international prices
was important not only for the cash tills of the
former, but also for America’s need to increase its
otherwise declining domestic production and thus
reduce dependence on foreign oil, forecast to reach
levels “incompatible with national security”, as
argued forcefully by The oil import question: a
report on the relationship of oil import to the
national security, drawn up by George Shultz for
President Richard Nixon (1968-74)33 in February
1970 (Clô, 2000). Yet more explicit was the
National Petroleum Council which, at the end of
1972, claimed that an increase in American
production and decrease in imports required a rise
in domestic oil prices and those on the
international markets of between 60% and 125% to
make oil less attractive (NPC, 1972). Six months
later, on 18 April 1973, Nixon declared in a
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
STATE AND MARKET REQUIREMENTS DETERMINING OIL POLICIES
dramatic Energy message to the nation that in the
immediate future “we must face up to the
possibility of occasional energy shortages and
some increase in energy prices”. This prophetic
warning, like that pronounced by James Akins of
the State Department in an article in Foreign
Affairs, again published in April 1973 (with the
significant title The oil crisis. This time the wolf is
here; Akins, 1973), was heeded by few, since the
situation did indeed develop in this direction.34
Equally conflicting interests divided the European
countries. Great Britain, for instance, has always
considered its domestic oil and natural gas resources a
national good to be exploited with domestic policies
that, from the Continental Shelf Act 1964 and the
United Kingdom Offshore Oil and Gas Policy 1974
(Cmnd 5696), should be aimed at promoting “British
interests […] by directing sales especially at national
industry” and at “achieving oil self-sufficiency for
reasons of the balance of payments and national
security” (UK Department of Energy, 1976). These
policies were not devoid of anti-competitive
undertones and indifference to any common European
interest. In this context, it is interesting to note the
decision of the Prime Minister Margaret Thatcher to
avail herself of her special powers (golden share) in
the selling of shares in BP to block the entry of Arab
interests, in her view incompatible with defending
those of Britain.
No less significant, finally, is the case of the
Netherlands; immediately after the outbreak of the
first oil shock in 1973, it requested the help of its
European partners, since (alongside the United States)
it had been hit by the embargo decreed by the Arab
countries belonging to the Organization of Arab
Petroleum Exporting Countries (OAPEC) for the
support given to Israel. This help was not forthcoming
due to France and Great Britain’s fears of provoking
negative reactions from Arab countries, the
indifference of the other eight member countries of the
European Community,35 and to the minimal or
nonexistent power of its institutions that were helpless
and unable to play any role in the development of the
crisis. This solidarity was even less than that, albeit not
exempt from costs, guaranteed by the United States to
France in 1917.
33 The years of presidential mandates refer to election
dates, and not to those of office, generally held from 20th
January of the following year.
34 Between 1977 and 1983, imports declined from 8.6 to
4.3 Mbbl/d.
35 The six states which had established the European
Community in 1957 (France, Germany, Italy, Belgium,
Luxembourg, the Netherlands) were joined on 1 January
1973 by Denmark, Ireland and Great Britain.
197
PUBLIC POLICIES AND THE OIL INDUSTRY
3.1.4 Oil policy in the United States
From Harry S. Truman (1944-52) to George W. Bush
(2000-04; 2004-), no President of the United States
has failed to formally adopt his own national energy
policy, aimed at resolving the critical issues induced
by the country’s dependence on oil.36 National security
and independence have been the most frequent
watchwords, with a double objective: firstly, to acquire
control of the oil resources and ensure the political
stability of the producing countries where the largest
discoveries were being made, which were targeted by
the strategies of the American majors, and on which
the United States would inevitably come to depend;
secondly, to protect national resources and the national
oil industry from international and even domestic
competition. Both foreign and domestic policies were
directed towards these objectives in a reciprocal way
because as the latter became increasingly unable to
meet domestic imbalances, with the consequent
recourse to imports, the former would increasingly be
called upon to remedy this situation. However, these
policies operated in accordance with contrasting
philosophies. Foreign policy favoured a free-market
approach, with Washington demanding that other
powers allow American companies to enter new
extraction zones with the application of the open door
principle37, and that consuming countries not hinder
their freedom of manoeuvre in their end markets.
Domestic policy was based on state control, with
recourse to all forms of protectionism and the negation
of any semblance of a free market or competition, with
costs significantly higher than the expected or attained
benefits. These policies will be examined separately.
From diplomatic conflict
to the new international order
There were two mutually connected ways of
acquiring direct control over foreign oil resources,
especially in the Middle East. On the one hand,
reinforcing political influence over local governments
whilst simultaneously defining the distribution of
resources with other Western powers, especially Great
Britain. On the other, ensuring the entry of American
majors into the oil consortia which held (almost)
exclusive concessions in those countries. This had
already happened in Europe at the San Remo
Conference (24 April 1920) when France was
awarded, as compensation for the war, a share of
23.75% in the Turkish Petroleum Company (from
1928, Iraq Petroleum Consortium), requisitioned from
Germany. This share was later devolved by the French
government to the Compagnie Française des Pétroles
(CFP), a mixed company set up for the purpose in
1924.
198
The clash between Western diplomacies over the
repartition of areas of political influence reached its
apex at the end of the Second World War and directly
involved Franklin Delano Roosevelt (1932-44) and
Winston Churchill. The United States’ proposal to
divide up the Middle East, with Saudi Arabia under its
influence, led to the signature in August 1944 of the
Anglo-American Petroleum Agreement; this was an
intergovernmental cartel that should have defined the
respective areas of interest and simultaneously
establish how oil supply was governed on the
international markets and its allocation among the
various importing countries.38 In February 1945, on
the American ship Quincy, anchored in the Great
Bitter Lake, Roosevelt met the powerful Saudi ruler
Ibn Saud, and obtained consent to his proposal. The
death shortly afterwards of President Roosevelt and
the unwillingness of his successor Truman to follow
through with the agreement with the British led to its
demise, but did not prevent the United States from
acquiring absolute hegemony over the oil industry and
the Middle East.39 In 1948, the five major American
oil companies controlled 50% of all the world’s
reserves40, as compared to 10% in 1940. The
establishment and the extent of US supremacy would
thenceforth depend on two main axes. The first with
the American companies which were given the
36 For example, Truman and the National Security
Resources Board of 1947 and the Paley Commission of
1950-52; Eisenhower (1952-60) and the Cabinet Advisory
Committee on Energy Supplies and Resources Policy of
1955; Kennedy (1960-63) and the National Fuels and
Energy Study of 1961; Johnson (1963-68) and the
Resources Policy for a Great Society of 1964; Nixon and his
Project Independence of 1974; Ford (1974-76) and the text
of the Omnibus Energy Independence Act of 1975; Carter
(1976-80) and the National Energy Plan of 1977; Reagan
(1980-88) and the Energy Security Report of 1987; Bush
(1988-92) and the National Energy Strategy of 1991; Bush
(George W. jr.) and the US National Energy Policy and
Global Energy Security of 2001.
37 The open door principle referred to policies aimed at
guaranteeing equal trading rights on foreign soil. It was
initially proposed by the United States to Great Britain,
Germany, Russia, Japan, France and Italy at the end of the
Nineteenth century in the attempt to reconcile their various
interests and respective spheres of influence in China.
38 The allocation was to take into account different
factors, including “available reserves, sound engineering
practices, relevant economic factors, and the interests of
producing and consuming countries, […] with a view to the
full satisfaction of expanding demand” (Yergin, 1991).
39 In 1948, it produced 275 Mt of a total world supply of
435 (excluding the USSR). In Europe, the penetration of
American companies was facilitated by the Marshall Plan,
even in those countries which protected their national
industries (France, Italy, Spain and Belgium).
40 Outside the United States and the Soviet countries.
ENCYCLOPAEDIA OF HYDROCARBONS

primary task of managing the allocation of oil among
Western nations as cheaply as possible, with the
assumption that “the companies were the tools of
American foreign policy and that the interests of the
companies were essentially identical to the national
interests of the United States” as concluded by the
Church Commission (US Senate, 1975). The
international activities of the large majors essentially
depended on the ‘symbiotic’ relationship which they
continued to retain with their home governments, to
whom they guaranteed the security of foreign supply,
obtaining in exchange support for their expansion and
protection of their foreign interests,41 as reputedly
occurred in the subsequent half century. The second
axis was with Saudi Arabia, to which Washington
guaranteed the defence of its territorial integrity from
any external or internal threat, in exchange for a
commitment to ensuring a secure flow of low-cost oil,
and not only to the American market of which it has
always been the first or second supplier. This
commitment coincided with Saudis’ interests in
maximizing the long-term value of their huge oil
resources (1/5 of the world’s)42, which were their only
source of income. This special relationship has always
governed the equilibrium, economic and otherwise, of
the international oil market.
The strongest evidence of the United States’
strategic interest in Riyadh emerged in early August
1990, with the mobilization of 400,000 men and a
deployment of forces unprecedented since 1945, in the
immediate aftermath of the Iraqi invasion of Kuwait.
This intervention was aimed at restoring the rule of
law, whilst preventing Saddam Hussein from setting
his sights on Saudi Arabia, with the risk that he would
assume uncontested dominance of Middle Eastern
resources. Since then, the United States have
undertaken to safeguard the waters of the Persian Gulf,
which were patrolled by thirty ships in 2004, “almost
twice those used in the 1980s, when military
operations to protect oil cost the American tax-payer
4-5 $/bbl” (Barnes et al., 2005). A cost repaid in part
by Saudi Arabia, which “earns about $1 a barrel less
on sales to the United States than on sales to the
countries of Europe and East Asia. That discount
translates into a subsidy to US consumers of $620
million per year” (Morse and Richard, 2002).
The international oil order, which was to govern
the industry and the world market from the early
1950s until the late 1970s, was built on the political
relations between the Western powers; the symbiotic
relationship between these powers and the major
international oil companies; their contractual relations
(concessions) with producing countries, and the
oligopolistic coordination among oil consortia thanks
to the close network of interlocking directorates
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
STATE AND MARKET REQUIREMENTS DETERMINING OIL POLICIES
linking the majors. In the United States and Europe,
though never acknowledged by the latter, this order
ensured market and price stability, company
confidence and the development of investments.
Nevertheless, this order rested on an unequal political
balance which was unable to withstand the radical
transformations underway in producing countries and
within Western countries themselves.
Domestic regulation
After half a century of benign neglect towards the
uncontrolled capitalism of the early pioneers, United
States policies on the oil industry first manifested
themselves strongly in 1911 in the government lawsuit
against the Standard Oil Company.43 As the first
application of the Sherman Act 1890, the Supreme
Court ordered the break-up of the New Jersey holding
into 33 separate companies because “it had with acts
of intimidation acquired the control of shares in over
70 oil companies in order to monopolize trade”
(Singer, 2002). This decision, however, destined to
change the history of the oil industry in America and
elsewhere, did not signal the beginning of a
free-market phase but over half a century of absolute
state control, with a plethora of legislative and
administrative, federal and state regulations which
would devoid the market of any vestige of
competition. Among the policies which contributed
most heavily to this situation were the control of oil
production, the imposition of import quotas and tax
incentives for companies.
Control of production (prorationing)
The rights to oil extraction, belonging to
landowners, and ownership, which the law of capture
assigned to landowners when brought to the surface,
meant that producers had a strong influence in the
United States and made it impossible to coordinate
their decisions in any way. From the birth of the
industry, protests and alarms had been raised about the
increasingly predatory nature of crude oil extraction
and the significant price fluctuations which prevented
the industry from attaining any prospect of stability
41 This was to occur, for example, in 1951, when
Mossadeq’s Iranian government nationalized the
Anglo-Iranian Oil Company, but was forced to succumb two
years later to the coup which established Reza Pahlevi on the
throne, given the impossibility of selling a single barrel of
oil on the international markets due to the boycott imposed
by Western powers (Odell, 1986).
42 In early 2005, the proved reserves of Saudi Arabia
amounted to 259 Mbbl of a Middle East total of 729 (35%)
and a world total of 1,277 (20%) (Worlwide […], 2005).
43 Standard Oil Company v. United States (1911),
Supreme Court of the United States, 221 US 1.
199
PUBLIC POLICIES AND THE OIL INDUSTRY
and development. As early as 1869, an association of
oil producers had been established in Pennsylvania,
which proposed the coordinated management of
production flows within the limits of actual demand; it
was a failure. These worries were compounded by
others, advanced by conservation movements, which
denounced the waste deriving from the excessive
exploitation of domestic oil reservoirs, and the damage
which might ensue for an essential and irreplaceable
national good like oil. A philosophy which, in the end,
coincided precisely with the aim of stabilizing the
markets and prices, pursued in vain by producers. The
confederate states set about applying this principle.
The prorationing policy was first applied in 1915 in
Oklahoma, then to a greater extent in Texas in 1931,
when the Governor Ross Sterling decided to close the
wells after “the state of insurrection and open
rebellion” which exploded following the collapse of
prices to 13 cents a barrel (Yergin, 1991). Led by the
Texas Railroad Commission, the producing states
began to introduce mechanisms to restrict oil
production, effectively extended to the whole country
by Roosevelt with the Connally Hot Oil Act 1935,
which forbade intra-state sales in violation of their
internal restrictions. The central administration thus
came to play a role as coordinator and controller of
supply identical to what the major oil companies were
attempting to achieve on the international markets.
What the United States producers had been unable
to achieve with private means they obtained through
the mandatory powers of the law, in exact accordance
with the theory of private interest, inaugurating a long
and still vital tradition of good relations between the
oil lobby and the administration44 (Bradley, 1996). The
prorationing policy took the form of a dense and
highly complex series of state and federal regulations
aimed at avoiding even tiny excesses in supply, so as to
prevent downward pressures on prices.45 As the
Federal Trade Commission stated in 1952, “in and by
itself, none of these elements could be described as a
definitive tool to control the industry; but together
they form a perfect model of monopolistic control over
the production of oil and its distribution, and over the
price paid by consumers” (FTC, 1952). The
consequences were an increase in prices, due to the
restriction of supply to levels aligned with demand,
and an increase in extraction costs, since the reservoirs
most affected were those with highest productivity and
lowest costs (Kahn, 1964). No less significant were the
consequences for the strategies of the majors; unable
to exploit their domestic reserves and enticed by the
greater profitability of those abroad, they moved their
hub of activity to the most promising areas of the
Middle East. This created the conditions for a
reduction of American reserves, and the impossibility
200
of keeping up with the strong increases in domestic
consumption. The exact opposite of what the
administration wanted to achieve.
Import quotas
From 1932, the Federal Oil Conservation Board
had claimed that import quotas should be the basic
means of controlling domestic supply. The idea was
then set aside following the discovery of new
reservoirs in Texas, which made it possible to maintain
a positive balance in the foreign oil trade. The vast
availability of low-cost foreign resources, combined
with domestic restrictions was, however, a strong
incentive to search for oil abroad and then import it to
the United States, where prices were kept artificially
high by these same restrictions. In 1948, the United
States thus became a net oil importer. The rapid
growth in imports led Congress to confer upon
President Dwight D. Eisenhower, with the Trade
Agreements Extension Act 1955, the power to impose
quotas if thresholds (peril points) were exceeded that
would expose the country to “unacceptable security
risks” (API, 1992); this occurred at the end of the
same year with the introduction of voluntary controls
on imports by companies.
The disappointing results,46 the first Suez Crisis in
1956, and the strong pressure exerted by Defence
circles convinced President Eisenhower to enact the
Mandatory quotas on oil imports ordinance on 10
March 1959, imposing import quotas to “protect
national security”, to the cry of “drain American
first!”. The outcome was to raise the final prices of oil,
at an estimated cost to American consumers of 5-6
billion current dollars per year (API, 1992), without
44 President George Bush first worked as an oil man in
Texas. His son George Bush jr. was elected in 2000 with the
support of the oil companies from which his vice president
was drawn: Dick Cheney, President of Halliburton, one of
the world’s largest oil industry service companies.
45 This form of control involved rationing the number of
days on which production was allowed, altered year by year
depending on requirements. In the State of Texas, among the
richest oil zones, production was allowed, for example, for
261 days in 1952, falling to 194 during the slight economic
recession of 1954, to 122 in 1958 after the reopening of the
Suez Canal, to a minimum of 97 days in 1962. The control
of production was also differentiated between different
reservoirs, mainly affecting those with higher productivity
and lower cost, with marginal reservoirs being completely
exempt.
46 The companies agreed ‘voluntarily’ to accept the
quotas established by the Oil Import Administration. Since
there was no restriction on the import of petroleum
intermediates and derivatives, however, they simply limited
themselves to replacing crude oil with the latter, with the
result that net imports doubled from 0.88 Mbbl/d in 1955 to
1.6 in 1959.
ENCYCLOPAEDIA OF HYDROCARBONS

succeeding in increasing reserves or domestic
production, since companies preferred to invest in
more profitable foreign activities.47 The United States
were forced to fall back on foreign markets to satisfy
increasing demand; the quotas were made obsolete by
this turn of events and President Richard Nixon was
forced to officially abolish them in August 1973, a few
months before Egyptian troops invaded Israel,
sparking off the first oil shock.
Tax incentives for oil companies
These were measures aimed at reinforcing national
security, reducing exploitation risks, guaranteeing
conditions of neutrality to high capital intensive
industries and avoiding double taxation for companies
operating abroad. Two instruments were adopted: the
depletion allowance, the exemption from taxation of a
fixed percentage48 of the income deriving from oil
production to compensate companies for risk and
encourage self-financing to replace reserves;49 a
foreign tax credit, in existence since the 1918 Revenue
Act, which allowed companies to consider the tax paid
abroad as a tax credit for that due in their country of
origin. This measure allowed American companies to
meet the demands of producing countries for increased
income tax without being in any way affected, since
the excess amount paid was deducted from that owed
to the United States Treasury. The companies could
thus satisfy the producing country without altering
their own position. The policy of tax incentives was
one of the mainstays of United States regulations –
aimed, from the outset, at supporting production rather
than containing demand. It took an anticyclic form
over time, being relaxed during periods of high prices
and high profits, as with the 1975 Tax Reduction Act50
and the 1980 Windfall Profits Tax51, and tightened in
contrasting situations, as Ronald Reagan did in 1987
and George Bush senior in 1990, approving expensive
incentives to production (1991-95: 2.5 billion dollars)
and simultaneously rejecting higher taxation for
consumers, as was widely the case in Europe.
Compared to their intended outcome, US
regulation polices obtained little at enormous cost:
“for six decades, until 1980, the US oil market was
controlled by one form of government regulation after
another. We have had, in other words, one energy
security policy after another, usually aimed at
protecting the domestic industry from competition by
imports. None of these policies contributed in any real
way to national security, but all of them left a legacy of
waste and inefficiency” (Bohi, 1993). Moreover, none
of these policies had any effect on the natural decline
of oil reservoirs or on the inability of all Presidents,
regardless of their political affiliations, to overcome
social resistance to the exploitation of the Arctic
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National Wildlife Refuge in Alaska or the
liberalization of the Federal Outer Continental Shelf.52
Therefore, after a century of continuous growth, oil
production in the United States reached its all-time
high of 11.3 bbl/d in 1970,53 before irreversibly
declining to levels of 7.7 bbl/d in 2004, identical to
1955. During the same period, imports roughly tripled,
exceeding 10 Mbbl/d in 2004, 60% of total domestic
consumption.
3.1.5 European public policies
As already noted, oil policies in European countries
got underway immediately following the First World
War, when coal was still dominant; the oil market was
still extremely limited in extent and already firmly in
the hands of the international majors; the domestic oil
industry was lagging behind; the existing capital stock
was unsuited to supporting the penetration of oil. The
47 The mandatory programme placed a ceiling on
imports of crude oil and its derivatives equal to 9% of
predicted demand. The loophole of importing intermediates
was removed, since no company could import more than
10% of its quota in the form of intermediates. Thus
contrived, however, the ‘9% of demand’ formula allowed
imports to increase more rapidly than domestic production.
From 1963, the programme was modified: the ceiling was
calculated on the basis of domestic production rather than
demand.
48 27.5% until 1965, later reduced to 22% with the Tax
Reform Act 1969.
49 Given the way it was structured, this was a genuine
tax relief. The depletion allowance is a subsidy proportional
to the value of the oil produced. This gives companies an
incentive to produce, at all price levels, more than would
otherwise be feasible. This outcome, in contrast to that
obtained by prorationing, was accentuated by the faculty
granted companies to deduct from their revenues all the
intangible costs of drilling and exploitation, written off
elsewhere in the same way as tangible costs.
50 With the Tax Reduction Act, the US Congress seemed
to embark upon a downscaling of the tax privileges which
the oil companies had enjoyed for 57 years. The depletion
allowance was abolished for the largest companies and
limits were imposed even for small companies, with the
depletion rate being lowered to 15%. At the same time,
measures were adopted to prevent intangible drilling
expenses incurred abroad being used to offset domestic
income for taxation purposes. Finally, the foreign tax credit
was reduced to some extent.
51 A tax rate of 30% for wells producing from 1979 or
before, and up to 70% for other productions depending on
their typology and that of the producer.
52 The Federal Government controls about 1/3 of US
territory and about 98% of all offshore areas which could
potentially be exploited for oil-related activities. Altogether,
these areas are thought to contain 85% of undiscovered oil
reserves and 40% of undiscovered natural gas.
53 Including natural gas liquids.
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PUBLIC POLICIES AND THE OIL INDUSTRY
objectives of public policy were numerous: a) to
encourage the search for and exploitation of domestic
resources; b) to counterbalance the dominant power of
the large oil companies; c) to encourage the growth of
a national industry, without impeding the necessary
entry of the foreign companies which controlled the
sources of supply; d ) to accelerate the penetration of
oil without excessively damaging a coal industry
which, even in 1950, numbered about 1.8 million
employees; e) to tax energy sources to condition their
economic incentives for companies and bolster needy
state coffers without affecting inflation or the
competitiveness of companies. Despite their diversity,
European policies were based on two lines of action.
An indirect line, with the domestic regulation of
markets and a direct line, with national oil companies,
private or public. These two lines were inversely
correlated with one another: the stronger the presence
of the companies, the less intense domestic regulation,
and vice versa.
Domestic regulation
Generally speaking, domestic regulation policies
fell between two extremes. On the one hand, stringent
public control in weak countries lacking domestic
resources of oil or other energy sources; without a
robust national industry; minimal and sometimes
non-existent political influence in oil regions; forced
to depend heavily on the international majors. On the
other hand, the policies of, relative and apparent,
free-market abstention in strong countries which
benefited from one or more of these conditions. The
first group comprised France, Italy, Spain and Austria,
which were heavily dependent on oil, almost totally
dependent on foreign supply and had limited domestic
coal reserves. The second group included in primis
Great Britain, with enormous reserves of coal to begin
with and then hydrocarbons, strong political influence
in the Middle East, the dominant position of BP and
Royal Dutch Shell, and the Netherlands, which also
benefited from the activity of the latter. Germany and
Belgium were in an intermediate position, relatively
free-market in terms of oil because they were
protectionist on coal, adopting subsidies, tax
incentives and tariffs to cancel out any cost differential
between imported oil and coal.54
The heartland of strict and systematic public
intervention in the oil industry was, without doubt,
France. It had a system hinging, on the one hand, on
the careful centralized planning of the country’s short
and long-term requirements and, on the other, on the
régime d’importation du pétrole introduced with the
law of 30 March 1928. This established a state
monopole délégué with the power to delegate to
companies, through complex and discretionary
202
permits, the rights to import, refine and distribute oil.
A system which replaced “the import quotas imposed
by the power of the trusts with quotas imposed by the
state” (Murat, 1969). Until the 1980s, under the more
virtual than real threat of a failure to renew the permits
(Martin, 1992), the government imposed all sorts of
obligations on companies, depending on the
circumstances. Specifically: a) the use of ships flying
the French flag; b) obligatory oil stocks;
c) geopolitical diversification of imports; d ) contrats
d’intérêt national for the import and refining of
preferential crudes, especially from Iraq and Algeria
(which accounted for over 1/3 of imports in the
1960s); e) accords francs-pétrole to mitigate the outlay
of US currency, with oil paid for 60% in dollars and
40% in francs, to be deposited in a specific account
and destined for purchases from France; f ) control of
French companies over a production capacity, at least
equal to national consumption.
Not dissimilar to the 1928 French law was the
Italian r.d.l. no. 1741/1933 (Disciplina
dell’importazione, della lavorazione, del deposito e
della distribuzione degli olii minerali e dei carburanti);
this introduced a system of licences for oil imports,
subsequently abolished after the Second World War,
and concessions for the construction of refineries
which, in post-war practice, did not actually place any
limitations on their excessive building. However,
domestic Italian regulation did not play the same role
as that in France given the weakness of the central
administration and the political decision to effectively
delegate to the national company both the role of
‘planning’ the system and of acting as its primary
supplier. These roles, however, did not in any way
prevent foreign companies from entering Italy in large
numbers (Bruni and Colitti, 1967; Torrani, 1982).
National companies
In European policy, the direct intervention of the
state and public ownership played as important a role
as indirect intervention. Considering the results
achieved, this was actually the most successful form of
regulation. It would have been difficult for France,
Italy and Spain to own large oil companies (in 2005,
the fourth, seventh and eighth largest in the world,
respectively), had these not originated from public
initiatives. By contrast, in countries like Germany
where this did not occur, or did so in a milder form, no
substantial national oil industry developed. In Great
54 In Germany, coal production peaked in the mid-1950s
with a workforce of 600,000, dropping to about 100,000 in
the mid-1990s. In 1990, subsidies still amounted to about 11
billion Deutsche marks, funded until 1995 through a tax
burden of 7-8% on electricity prices (Jochem et al., 1996).
ENCYCLOPAEDIA OF HYDROCARBONS

Britain, public ownership was marginal, due not to an
ideological choice but to the reassuring presence on its
territory of two of the seven major oil companies.
Proof of this is that in other energy sectors, where
private enterprise had not achieved comparable results,
public ownership became dominant after the
nationalizations in the 1940s of coal (National Coal
Board), electricity (British Electricity Authority)55,
and natural gas (Gas Council, from 1972 the British
Gas Corporation). Proof of this is, above all, the fact
that Great Britain turned to public ownership in the
case of oil, too, when it needed to safeguard its
national interests in the North Sea. This led to the
establishment of the British National Oil Corporation
(1975), involved in oil exploration, development and
production activities and a commercial operator with
rights to 51% of all the crude oil extracted. This was a
more radical position than that which the producing
countries were negotiating with the oil majors, and
which met with fierce resistance from British
companies, among others.
Despite the specificity of individual situations, the
origins of national companies in Europe are similar,
and can be attributed to three motivations: to correct
the failures of the oil market, especially in terms of
national security; as an anti-trust measure and to
counterbalance the private power of the major oil
companies; to compensate for the reluctance of private
capital to invest in an industry characterized by huge
investments, high risk, long-term horizons, deferred
profitability. The establishment of Agip in 1926 by the
Italian State was, for example, a direct consequence of
the indifference which domestic private capital had
shown towards the oil industry, despite the extremely
generous public subsidies guaranteed by the 1912 law,
which went so far as to offer the free supply of
machinery. These subsidies were described by Luigi
Einaudi as “drilling into the state’s coffers”.
Out of the post-war ashes of Agip rose Eni,
established with Law No. 136/1953, and presided over
by Enrico Mattei until his sudden death on 26 October
1962. Eni was founded after a lengthy parliamentary
battle and a political clash ongoing since 1945, when
Mattei had been nominated Extraordinary
Commissioner of Agip with the task of liquidating and
privatizing it (Clô, 2004a). Eni was established mainly
to give the country a strong national industry, which
would allow it to weaken the endemic scarcity and the
high cost of energy supply, and overcome Italy’s
chronic technological backwardness. In this case, too,
the aim was to reduce the gap between Italy and other
industrially advanced countries, which based their
future development on the availability of cheap oil.56
The law with which it was founded specifically gave
Eni an exclusive right to exploit the oil resources of
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the Valle Padana (which at the time, amidst heated
arguments, were thought to be large) and the following
specific tasks: “to promote and undertake initiatives of
national interest in the field of hydrocarbons and
natural gases […], of chemistry and the research,
production, regeneration and sale of nuclear fuels and
in the sector relating to this activity” (art. 1) and “to
carry out activities to treat, transform, use and market
hydrocarbons and natural gases” (art. 2).
The other important European experience of public
ownership was in France, with a double formula. The
first was state’s minority (though influential)
shareholding in the capital of mixed companies,
starting with the Compagnie Française des Pétroles
(CFP),57 included for its strategies and role in the
exclusive club of international majors. Operating since
1955 with the trademark Total, it was named Total
CFP in 1985 and then given the definitive name of
Total in 1991. The second formula was the creation of
state owned companies (operating in a regime of
private law), with specific aims in one or more
segments of the petroleum chain;58 most of these
merged in 1965 to form ELF-ERAP which, after
merging with ANTAR in 1970 and the Société
Nationale des Pétroles d’Aquitaine in 1975, came to
represent 25% of the French market. In 2003 it merged
with Total (which in turn had purchased the Belgian
Fina in 1999) to form the Total Group, the world’s
fourth-largest oil company. Other state companies of
lesser importance were also established: in Spain,
CAMPSA (1927) and Hispanoil (1965, from 1986
Repsol); in Austria, OMV (1956); in Germany,
VEBA (1929), until 1956 fully controlled by the state,
which now owns 36%; in Japan, the Japan National
Oil Company (1967).
The national oil companies, under the historical
conditions in which their work began, played a
fundamental role in the development of the European
oil industry. Not only because they built most of the
infrastructure needed to accelerate the penetration of
oil, but also for their competition strategies towards
55 It became the Central Electricity Authority in 1955
and was subdivided into the Electricity Council and the
Central Electricity Generating Board in 1957.
56 For an examination of Eni’s origins and a statistical
analysis of its first 50 years of activity, see Clô (2004a).
57 Initially, the public share was 25%, increased to 35%
from 1928 with voting rights of 40%. The numerous others
include: the Société des Transports Pétroliers par Pipeline
(TRAPIL) and the Société Française des Transports
Pétroliers (SFTP).
58 Development of the reservoirs discovered in
Aquitaine by the Société Nationale des Pétroles d’Aquitaine
established in 1944; exploration in French territories by the
Bureau de Recherche Pétrolière (BRP) established in 1945.
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the dominant majors, in the absence of any vestige of
anti-trust policies or bodies, and for the state control
governing their policies. This characteristic allowed
for industrial projects which would have been difficult
to undertake in private contexts, and which subsequent
market appeal showed to be extremely foresighted.
Just think of Italy’s conversion to gas begun by the
Società NAzionale Metanodotti (SNAM) from its
foundation in 1941 (by Agip), with the construction in
a single decade of a network of gas pipelines covering
over 3,000 km, tripling to about 9,000 in 1970, or the
large and technologically advanced projects to import
natural gas over long distances (from Algeria, Russia,
the Netherlands) launched in the 1960s. These were
entrepreneurial insights which the large private
international companies would begin to act on only
several decades later.
The role of European state owned companies was
no less significant on the international level, due to
their strategies of attacking the otherwise
insurmountable entry barriers to the acquisition of
exploitation rights abroad. These strategies aimed to
overcome the traditional contractual agreements which
had hitherto regulated the relations between
companies and producing countries. The most
important new development was the copartnership
agreement signed in 1957 between the National
Iranian Oil Company and the Italian Agip to establish
a company (the Société Irano-Italienne des Pétroles)
on the basis of political, legal and economic equality.
This agreement, and those which followed, undertaken
by other European state owned companies like
ELF-ERAP and Hispanoil, did not give shareholders
much satisfaction, but changed the course of the
history of oil.
Domestic regulation and foreign competition
Despite intense regulation and the vast extent of
public ownership, public intervention did not exclude
market mechanisms and competition from the
European oil world – quite the opposite, for the simple
yet crucial fact that these mechanisms were
determined by the interfuel competition between oil
and coal. This external competition, rather than
internal structural characteristics, conditioned the
dynamics of prices. Public policies not only failed to
prevent this, but supported it by accelerating the
reconversion of their economies to oil, strengthening
oil infrastructure and refusing to protect the huge
domestic coal resources. It is a more free-market
policy than it might appear, especially in comparison
with the United States. Below, the reasons for this will
be examined briefly.
Until 1950, 2/3 of oil consumption remained
circumscribed to the United States. In Europe, the use
204
of coal, generally of domestic origin, remained
dominant. In this context, the price of oil had little
importance. Even a heavy drop would not have had the
effect of increasing consumption. The picture changed
when the link between oil and economic growth
became clearly apparent, worries about its scarcity
were dispelled and the difficulties of significantly
developing coal became evident. At that point, the
majors began a strategy of attack on European coal
aimed at maximizing the penetration of oil in the
shortest possible time. The European and Japanese
markets were the only ones able to absorb increasing
Middle East production, given the effective closure of
the American market, and to allow for a full
exploitation of the growing economies of scale in
transportation and refining. An increase in supply and
decrease in costs supported an attack strategy hinging
on the price factor.
The substitution of oil for coal was not, however,
the outcome of a mechanical and transparent
competition process. A crucial role was played by the
different rules governing the oil and coal industries.
Even though the conviction persisted in some
government circles that Europe should maintain, for
political reasons, a high domestic coal production like
the United States, this did not culminate in actions to
relaunch its production (Ippolito, 1969). Rather, the
spread of the new philosophy of abundant oil at low
prices signalled its irreversible decline. Between 1950
and 1970, coal production was halved and
employment fell three-fold, with mine closures
everywhere. In the coal economy, every mine closure
is irreversible. What for two centuries had been the
glory of the European economy became merely a
motive for social concern.
Fearing a return of the coal industry to pre-war
monopolies (the Ruhr cartel) and under pressure from
the United States, the ECSC (European Coal and Steel
Community) imposed rigid regulations along three
main lines: a downward levelling of coal prices in all
countries, regardless of differences in cost and the
specific competitive circumstances with regard to
competing oil products; obligation of
non-discrimination in prices and the publication of
posted prices; a ban on any form of agreement or
combination between companies, in contrast to what
occurred, and was permitted, for the major oil
companies. This created a series of obligations which
denied coal mines the benefits of a market economy,
granted to their oil competitors, imposing on them
only its costs.
By contrast, there was no form of regulation or
prevention of the entry of oil companies, simply
because they were indispensable. Their penetration
strategy hinged upon two fundamental lines: refining
ENCYCLOPAEDIA OF HYDROCARBONS

policy and pricing policy. The typology of investments
and the planning of refining cycles were tailored to
maximize yields of heavy products, in direct
competition with coal, and limit yields of light
products destined for types of consumption where they
could not be replaced by other sources, e.g.
transportation and the petrochemical industry. The
pricing policy adopted by companies was both
instrumental and complementary to the quantity
policy, with the common objective of maximizing the
impact of oil through competition with coal.
Despite the similar costs of oil in European
countries, the prices of its derivatives were
differentiated in each market depending on the costs of
competing products, the actual potential for
substitution, the flexibility of demand with regard to
prices. The prices of fuel oil, where the potential for
penetration was highest, were thus set at lower levels
than those of coal for each type of use, whilst those for
gasoline not subject to competition were fixed in a
quasi-monopolistic regime. Where fuel oil prices were
lowest, gasoline prices were highest, and vice versa, to
avoid affecting overall profitability.
From the mid-1950s, under pressure from
increasing international competition, fuel oil prices
began to fall, further decreasing coal’s competitiveness
and causing serious financial crises in coal companies.
Coal’s price advantage over fuel oil, which had been as
high as 40%, was overturned, with differentials in
1960 between 20% and 100%. The only way of
rebalancing the price ratio would have been a taxation
policy or protectionism similar to that adopted in the
United States, which did not happen. Taxation policies
everywhere were tailored to the pricing strategy of the
oil companies, heavily penalizing light fractions
(gasoline) and only marginally affecting heavy
fractions (fuel oil).
By 1970, the majors’ conquest of the European
market was complete. At the same time, foreign
energy dependence leapt from 11% in 1950 to about
60%. All this was perhaps inevitable, since shifting to
oil had indisputable economic benefits. However, the
political implications were no less important, although
these did not overly concern national governments and
community institutions. The energy question took on
very different connotations from before. Whilst
Europe’s coal economy was essentially a situation
internal to the Old Continent, the oil economy was
intercontinental in scope and importance. Once a
source of cooperation, energy became a source of
debate between European states; unable to reach any
sort of common policy, energy remained the domain of
national sovereignty.
No less interesting is the comparative analysis of
European and United States’ policies. The
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protectionism of the United States contrasted with
European free-market attitudes towards oil imports, to
the detriment of domestic coal resources. The
additional costs faced by the American economy had
corresponding benefits for the European economy.
Unknowingly, the United States were subsidizing
Europe through its refusal to import crude oil at low
cost, consequent excess supply and decreasing prices.
To this should be added the ‘protective umbrella’
which American spare capacity guaranteed the rest of
the Western world, allowing it to deal with
international crises, as in 1956 and 1967.
3.1.6 Peak and decline
of public policy
The modern history of the energy industry saw a
revolutionary turning point in the 1970s. Not that
there were no earlier events which corrected trends –
as at the turn of the century with the establishment
of the great technological innovations linked to the
use of oil and of electricity – but their combined
effect had, nonetheless, been to encourage the
harmonious growth of energy systems which came
to a halt only with the Second World War. After this,
real aggregates again began to expand at a faster rate
than before. This virtuous cycle was interrupted by
the oil shocks of the 1970s. These shocks combined
to produce devastating effects on the world
economy, with the first serious recession since the
war and the abandonment of hitherto dominant
models for the organization of production; on the
structure of the international oil market, with the
banishment of oil companies from traditional
production areas and the collapse of the oligopolistic
coordination which had guaranteed market growth
and stability with the establishment of genuine
competition as a mechanism for determining oil
prices; and last, but not least, on world oil power
which evolved towards a “new international order, a
zero-sum game that would see a wholesale
redistribution of wealth from the North to the South
and a diminution of the international stature of the
United States and the other major industrial powers”
(Stanislaw and Yergin, 1993).
Oil shocks and economic crises
The oil shocks simultaneously highlighted oil’s
central role in the economic development of modern
societies and their resulting vulnerability. Statistical
evidence confirms the hypothesis of a close causal
relationship with the recessions that hit the world
economy. Industrialized countries experienced a drastic
reduction in growth rates to values that were close to
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PUBLIC POLICIES AND THE OIL INDUSTRY
zero or even negative, which had not occurred since the
aftermath of the Second World War.59 The drop was
instant in the United States, Japan and Great Britain,
with negative values as early as 1974, and delayed but
more severe in other countries. Recovery occurred at
far lower rates than those preceding the shocks. The
unexpected and violent outbreak of the second shock
returned the economies to a stagnation which was less
widespread and less intense but far more prolonged,
although Japan remained relatively unaffected.
The recessions differed from preceding ones for
their intensity and their conjunction with inflation
rates not seen since the war. With the first shock, these
increased up to five-fold, with levels in 1972 ranging
from 3% in the United States and 7% in Great Britain,
to levels in 1974-75 between 10% in the United States
and 18-20% in Japan, Italy and Great Britain.
Germany was the only country which remained
unaffected, with rates close to 6%. The severe response
of Western economic policies made it possible to halt
price rises and the endogenous activation mechanisms
feeding them, bringing inflation back under control,
albeit at higher levels than those preceding the shocks.
These results were soon cancelled out by the second
shock, with inflation rates in most countries (United
States, France, Great Britain, Italy) close to or
exceeding the two figure rates touched during
1974-75. Japan and Germany were unaffected, due
respectively to the rigid salary block imposed in 1979
and the strict monetary policy of the Bundesbank.
Another critical variable was unemployment.
Negligible in Japan, France, Germany, Great Britain,
and not far from natural rates in the United States and
Italy, unemployment rose steadily (except in Japan)
over a single decade (1973-83) to levels of between 8%
and 11%, the highest since the Great Depression. In
only three years (1973-76), the number of unemployed
rose by 65% in OECD countries (18.5 million). At the
same time, the labour productivity was halved, leading
to a profound reorganization of production processes,
with a further contraction of the work force and a
lowering of the capacity to absorb new labour entering
the job market. In 1982, there were 30 million
unemployed in OECD countries, three times more than
ten years earlier. A final, but perhaps most keenly felt,
imbalance in the OECD area affected the balance of
payments, which went from positive to negative to the
tune of about 70 billion current dollars in 1980. This
was a fairly modest deterioration considering that the
oil bill had increased 8-fold to 290 billion, but one
which raised the spectre of pathological crises in the
foreign balance of payments and their sustainability.
Regardless of the similar directions taken by
macroeconomic indicators in different countries, some
important distinctions between individual situations
206
and indicators support the idea that the energy variable
was not alone in generating these severe recessions.
Thus, after both shocks, Germany managed to avoid
high inflation rates, and Japan, high unemployment
– whereas Great Britain failed on both accounts. These
differences can be attributed not only to the degree of
dependence of individual countries on the oil market –
had this been the case, Japan and Great Britain should
have registered performances opposite to those
actually seen – but also to other factors, such as: a) the
economic policies pursued by different countries
before and in response to the crises; b) their
institutional characteristics, especially in terms of
industrial relations and price-salary indexing
mechanisms; c) the extent of the increase in energy
prices experienced by each country; d ) each country’s
reaction capacity as a consequence of their energy
systems, the availability of domestic resources, the
efficacy of public policies. In the general belief of
governments, the crises nevertheless constituted the
main reason for what Eckstein described as the great
recession. “The energy crisis was the single main
cause. Without it, the world economy would have
suffered only a slight slowdown in 1974 and would
have seen 1975 as the first year of recovery. But when
the energy crisis was added to an already extremely
vulnerable economic situation, it was sufficient to turn
the beginnings of a recovery into the most severe
post-war recession” (Eckstein, 1978).
The difficult path to international cooperation
In the general perception, the crises took on
connotations which were not exclusively economic,
being likened to huge national calamities and the
definitive end of an era. This was partly due to the
widespread belief that the dramatic price rises were
destined to persist over time (and the illusions fostered
after 1973 soon vanished), at levels projected towards
100 $/bbl and above. This perception was encouraged
by political factors. The crises were experienced and
interpreted as a threat to the West’s political security
and economic solidity: “the moral equivalent of a war”
as emphatically stated by the President of the United
States, Jimmy Carter. There were four main reasons
for this: a) the belief that the price increases had
fundamentally political motivations and that adequate
responses should be sought in politics; b) that they
were determined not by market forces but by OPEC,
seen as both an anti-Western political coalition and an
economic cartel; c) that the enforced expulsion of the
59 The drop was particularly violent after the first shock,
passing from growth rates for GDP of 5-6% in OECD
countries in 1972-73 to a modest 0.5% in 1974 and a
contraction of 0.3% in 1975.
ENCYCLOPAEDIA OF HYDROCARBONS

majors from OPEC countries had removed the main
instrument of mediation between the opposing
interests of producing and consuming countries;
d ) that the changes in the international balance of
power strengthened the Soviet Union, given its more
than self-sufficiency in energy and its political and
military support for the most radical Middle Eastern
countries (Levy, 1974), as with Egypt and Syria during
the Yom Kippur war.
These convictions, particularly deep-seated in the
United States administration, motivated the response
policies of Western nations, aimed on the domestic
level at reducing dependence on oil imported from
OPEC and on the international level at activating
international cooperation. The latter aimed to prevent
the path of bilateral relations, pursued with
determination by France on the basis of the special
arrangements developed with the Arab world (Odell,
1986), from reinforcing OPEC’s negotiating position.
The standard-bearer of a multilateral strategy of
opposition between the two blocs was the American
Secretary of State, Henry Kissinger. He started from
the assumption that “our economies and our
well-being are today held hostage by decisions taken
by other countries, that the energy crisis has
jeopardized our economy and subjected our foreign
policy to incredible pressure […], weakened industrial
democracies and undermined the political unity
underlying the security of free nations” (Kissinger,
1982), and advocated the establishment of a body to
coordinate the domestic policies and international
action of industrialized countries.
This body, the International Energy Agency (IEA),
was founded in Paris on 15 November 1974, on the
initiative of the OECD (and as its autonomous agency)
and, in time, came to number 26 member states.60
Until 1992, France refused to join. The initial intention
was to carry out “an International Energy Programme
for cooperation in the field of energy […];
development and implementation of a long-term
cooperation programme to reduce dependence on
imported oil, including conservation of energy,
development of alternative sources of energy, energy
research and development […]; promotion of
cooperative relations with oil producing countries and
with other oil consuming countries, particularly those
of the developing countries”.61 In fact, the Agency’s
field of action remained circumscribed to the mere and
hardly ever applied management of oil emergencies
due to supply disruptions, with the adoption of
measures to reduce demand and an oil-sharing plan to
distribute shortfalls in an egalitarian way, drawing on
the compulsory stocks imposed on individual member
countries and equivalent to 60 days’ worth of net
imports.
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
STATE AND MARKET REQUIREMENTS DETERMINING OIL POLICIES
Although there was a growing conviction among
IEA member countries that a stronger cooperative, or
even pre-emptive, response to crises would have
greater benefits, and lower costs, than independent and
uncoordinated actions, this was actually never
achieved (Bohi and Toman, 1986), as highlighted by
the crises which followed one another from the 1970s
onwards. Despite its intentions, the IEA never
managed to become a tool for substantial and effective
international cooperation, never going beyond the,
albeit laudable, activity of monitoring the markets,
auditing national energy policies, encouraging
governments, and developing predictive scenarios.
Even during the First Gulf War in 1990, the Second
Gulf War in 2003 and the severe price tensions in
2004-05, its actions had no significant effect. It was
limited to a formal application of the agreed rules
(release of stocks only in the case of a demonstrable
crude shortage, which never occurred), and failed to
influence the most critical aspect of these crises: the
price shock, which could have been halted even by a
limited, or merely hinted at, recourse to reserves.
The successive oil shocks led to and highlighted
the increasingly international nature of energy issues
due to: the growing number of countries involved, both
consuming and producing; the globalization of the
markets emphasized by the increase in financial
transactions; the far greater size, 3-4 times larger, of
the physical amounts involved. All these elements
reduced the effectiveness and increased the cost of
individual responses, but were not taken into
consideration in national policies, despite their
obvious inability to tackle and condition the crisis
situations which the dominant market forces imposed
and continue to impose on both consuming and
producing countries.
Public policies and adjustment processes
On the domestic level, public policies, albeit with
differing intensity in individual countries, fell back on
all available means to reduce dependence on imported
oil, especially from OPEC. The main lines of action
were: reduction of consumption (given identical
income), incentives and subsidies for domestic
production, diversification of sources. Even the young
Churchill had stated that “safety and certainty in oil lie
in variety, and variety alone” (The real […], 2005).
This diversification strategy followed two different
lines: the diversification of geopolitical origin,
60 23 OECD member countries belonged to the IEA.
Initially, France and Finland were not members, joining in
1992.
61 Art. 6 of the Decision of the Governing Board of
OECD which led to the establishment of the IEA.
207
PUBLIC POLICIES AND THE OIL INDUSTRY
especially regarding oil, and structural diversification,
in the conviction, in both cases, that there were “good
reasons, both theoretical and practical, to believe that a
private market could not achieve this adequately”
(Helm, 1993). In 1980, the French Commissariat
Général du Plan stated that: “There are fields in which
market forces and competition alone do not seem
sufficiently strong to mobilize individual actions
rapidly, as one might hope, making these converge in
the collective interest”.62
Specifically, this line of action explains the 35-fold
growth in nuclear production between 1970 and 1990
to 600 Mtoe, which almost completely substituted the
use of fuel oil for electricity generation in Europe
(excluding Italy), the United States and Japan. This
substitution can mainly be attributed to the favourable
conditions ensured by public regulation through state
aid, cost plus tariffs, which guaranteed that electrical
companies would recoup their costs; monopolistic set-
ups which guaranteed demand and full use of the
power stations. The need for public regulation, and
therefore the potential for market failure, is
demonstrated by the fact that when these conditions no
longer prevailed in a market context which had
become competitive and private, no nuclear powers
stations were built. The nuclear industry was pushed
out of the market by economic rather than
environmental factors (Clô, 2005).
It is beyond the scope of this article to provide an
account of all the public provisions adopted in
response to the crises, given their vast numbers and the
impossibility of determining which adjustment
processes were due to these or, more probably, to the
virtues of the market. These difficulties are
compounded by their frequently contradictory nature,
given the contrasting objectives pursued: to diminish
the social impact of crises, encourage investments to
reconvert energy systems, contain consumption and
bolster depleted public coffers. In the United States,
for example, President Nixon decided to block oil
prices in August 1971, with Executive Order 11615.
This measure was confirmed with the approval of
price ceilings on domestic production in the 1973
Emergency Petroleum Allocation Act, accompanied by
a highly complex system for the allocation of oil
among the various refineries and rigid controls on
final prices, at levels lower than international prices.
This set of provisions had paradoxical effects:
supporting demand, penalizing domestic production,
encouraging imports, regardless of the rhetoric about
national security.63 Equally disastrous was British
fiscal policy during the first years of exploitation of
the North Sea reservoirs, with a marginal corporation
tax that in 1982 absorbed 90% of the profit/cost
differential, leading companies to threaten to abandon
208
all exploration of new areas. This threat was overcome
by the tax reform of 1983, although for the oil
companies, Great Britain remained one of the
countries at highest risk (Surrey, 1987).
Market mechanisms and public policies, however
virtuous, nevertheless had their effects: generating a
drastic adjustment of energy systems and production
methods to the new relative prices of energy (towards
other goods) and oil (towards other sources), both in
terms of demand and supply. The demand for energy,
after the uninterrupted growth since the war,
experienced first a slight contraction followed by
stabilization, despite economic recovery. The energy
efficiency (unit of energy per unit of real output)
underwent a structural improvement of up to 35% in
industry, due to the price effect and the public policies
implemented: the establishment of efficiency
standards, tax incentives for energy saving and
taxation policies to discourage consumption.64
Still more drastic was the adjustment of the
demand for oil alone, which was hardest hit by the
combined effects (price, income, substitution)65 of its
new relative prices. After sluggish growth during the
1970s, demand fell sharply during the first half of the
1980s by an amount equivalent to the entire
consumption of Japan. The illusions that consumers
lacked market power which had governed OPEC’s
actions were – unfortunately for them – rapidly
dispelled. This collapse was exacerbated in Europe
and Japan, but not in the United States, by a voracious
taxation policy. Between 1970 and 1990 (Table 5), the
tax burden on each barrel of oil consumed increased
7-fold in Europe to 56 dollars, compared to the 25
deducted by producing countries. This was equivalent
to 58% and 26% respectively of the final price.
According to Jean-Marie Chevalier, the tax burden of
62 Statement contained in the energy planning document
to 1990 drawn up in 1980 for the French government and
entitled La relève du pétrole (Commissariat Général du Plan,
1980).
63 According to Joseph P. Kalt of Harvard University, the
oil price and allocation controls led to a new increase in US
imports of 2.5 Mbbl/d (Kalt, 1981).
64 Especially important were the actions taken by
France: with the establishment in 1974 of the Agence pour
les Economies d’Energie, incorporated in 1982 into the
Agence Française de la Maîtrise de l’Energie (AFME;
Finon, 1996). In Germany, between 1973 and 1988,
13 billion marks were spent on subsidies to increase energy
efficiency, with calculated savings of 31 Mtoe (43 if the
price effect is also taken into consideration).
65 The price effect refers to the reduction in demand in
response exclusively to the increase in the real prices of oil;
the income effect is that which can be attributed to the
resulting decrease in income; the substitution effect is the
decrease in demand resulting from substitution with other
sources of energy.
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 STATE AND MARKET REQUIREMENTS DETERMINING OIL POLICIES

Table 5. Oil barrel prices structure in European countries (1961-2005)

Income of producing Tax burden Company costs

Final price
Year countries in European countries and margins

($/bbl) (%) ($/bbl) (%) ($/bbl) (%) ($/bbl) (%)

1961 1 6 7 52 6 42 14 100

1970 1 6 8 57 5 37 14 100

1975 10 30 15 45 8 25 33 100

1980 33 51 22 34 10 15 65 100

1985 33 46 28 39 11 15 72 100

1990 25 26 56 58 15 16 96 100

1995 20 18 78 69 15 13 113 100

2000 29 23 80 63 17 13 126 100

2005 45 30 82 55 23 15 150 100

Sources: 1961-75: «Petroleum Intelligence Weekly», 16 May 1977; 1980-2005: our calculations.

consuming countries amounted to 1,000 billion euro
during the early years of the third millennium, equal to
2/3 of the total oil surplus, the difference between
income and the final sales costs of oil in the world
(Chevalier, 2004).
No less significant was the adjustment in the
geopolitical distribution of oil supply. After a decade of
stagnation, investments aimed at expanding crude oil
production underwent an exponential growth in the 16
years between 1970 and 1986 of about 1,700 billion
constant dollars, over twice the amount spent during
the previous 20 years (Clô, 2000). Their geographical
distribution was the opposite of that suggested by the
Ricardian theory (successive exploitation of lands in
inverse proportion to their productivity), and were not
aimed at those areas with the highest probability of
success, lowest costs and greatest profitability, but at
those where companies could operate with lowest
political risk. This decision was almost unavoidable,
given their expulsion from OPEC countries, but
nevertheless entailed an enormous waste of economic
resources.66 These investments allowed for incremental
production in new oil areas such as the North Sea and
Alaska, in old areas like Mexico, and in a large number
of marginal discoveries which had become viable at the
new price levels. This undermined OPEC production,
which halved over a few years to a minimum of 16
Mbbl/d in 1986, giving rise to a price countershock.
From market failures to the market
The adjustment processes had extremely
significant structural effects on the energy balances of
Europe and Japan, and far lesser effects in the United
States, with opposing effects on the respective energy
vulnerability indexes (Table 4). Between 1970 and
1990, oil’s share of energy consumption was reduced
by 5 points in the United States, as opposed to 15-16
in Europe and Japan; foreign oil dependence fell by 19
points in Europe, remained constant in Japan, and
increased by 23 points in the United States; the foreign
dependence of overall energy use fell by 13 points in
Europe, 2 points in Japan, and doubled in the United
States to levels which were, nevertheless, far lower
than those of other areas. These trends were
consolidated during the following decade and the early
years of the third millennium, with slight
improvements in the balances of Europe and Japan,
and further deteriorations in that of the United States.
The drastic drop in the worldwide demand for oil
and the even more significant contraction in OPEC
production led, as already noted, to a price
countershock halfway through 1986, to below 10
$/bbl. This was followed by a recovery to nominal
values which fluctuated between 15 and 17 dollars
until the end of the 1990s: half the level of earlier
peaks and equivalent, in real terms, to pre-crisis levels.
This new situation of market stability was encouraged,
66 3/4 of exploitation investments were targeted at the
economically marginal areas of North America and northern
Europe, containing only 8% of proved reserves, compared to
less than 1/6 in OPEC countries, which controlled 77% of
reserves, with finding costs 10-15 times lower (Desprairies
et al., 1984).

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PUBLIC POLICIES AND THE OIL INDUSTRY
on the one hand, by technological innovations,
especially in the exploitation phase, with significant
reductions in production costs and the resulting
breakevens; on the other, the reestablishment of a
reassuring margin of spare capacity67 and, thus, an
operative flexibility in international exchanges which
made it possible to withstand new tensions in the
Middle East, starting with the bloody 8-year war
between Iraq and Iran (1980-88), which had no impact
on the market prices of oil.
The return to a structural phase of low prices, the
improvement of energy balances, the dispelling of
dark prophecies regarding the scarcity of oil resources
had the effect of excluding the oil issue from public
consciousness and government priorities, in the
illusory belief that the underlying reasons for the
crises no longer subsisted. The defence of national
security also lost much of its political importance, due
in part to the collapse of the Soviet Union (1989),
although it continued to be evoked, through inertia, in
government documents and the innumerable, though
insignificant, European Union Green papers (CEC,
1984, 1995, 2000a, 2000b). The case of the United
States was typical. The reports drafted for President
Ronald Reagan by the Department of Energy (1987)
and the Department of Commerce (1988), though
stressing the national security risks of increasing oil
imports, reached the conclusion that: “no action to
adjust oil imports needs to be taken” (Kohl, 1991).
This was due in part to the ineffectiveness of previous
actions: “One lesson from the energy crises of the
1970s that should not be lost is the damage to the
economy that comes from the misguided actions of
government policy makers. So far, in scoring market
failures against planning failures, the market wins”
(Bohi, 1993).
It was in this context that the conviction began to
spread (first in the United States, and then in Europe
and Japan) that also in the energy sector, the market
and competition could operate more effectively than
the state, energy (commodities or services) did not
need any specific regulations, and the task of public
intervention was to ensure the optimal working of the
markets and, at most, to regulate environmental
protection. In government agendas, the energy
question was in effect supplanted by the related
environmental issues. The victory of free-market over
Keynesian ideas, consolidated from the late 1970s
with the simultaneous election victories of Margaret
Thatcher in Great Britain (1979) and Ronald Reagan
in the United States (1980), heavily affected the
energy industry as it did other industries. The basic
idea, not lacking empirical confirmation, was that
failures of the state were worse than the market
failures which they were intended to prevent.
210
Unlimited faith in the foresight of states was thus
replaced by the idea that the markets, though
imperfect, represented a good system for organizing
economic activity, whilst governments could, at most,
occasionally improve their results.
In the case of energy, criticisms and attacks were
levelled at the inefficiencies of public ownership; the
monopolistic structure of activities where the market
and competition could have operated, such as
electricity generation or the sale of gas (directives
1996/92/EC, 1998/30/EC, 2003/54/EC, 2003/55/EC);
the damage caused by public regulations which had
discouraged any private enterprise. The new structure
of the international oil market, which had become
global, with prices fixed transparently through free
and efficient negotiations, also contributed to render
earlier national policies anachronistic and difficult to
implement; however, this did not create the political
conditions for a different and common form of
international action. In the end, this outcome was
encouraged by processes of international economic
liberalization and the renewed drive towards European
integration with the Single European Act (The Hague,
17 February 1986), the Treaty on European Union
(Maastricht, 7 February 1992), the establishment of
the Single European Market (1 January 1993), the
Amsterdam Treaty (2 October 1997). Three
fundamental decisions were taken: a gradual move
towards supra-national policies in contexts hitherto
subject to national regulation; the creation of a single
market, understood as a space without internal
borders; the establishment of the principle of
competition as its founding principle.
This new market philosophy led consuming
countries to dismantle the whole range of instruments
which they had adopted; to remove any form of
intervention and any planned approach; to strengthen
the workings of the markets, in the belief that oil had
no specific requirements compared to other
commodities – that the market itself was able to satisfy
the public interest. This decision was the stronger and,
in some senses, the more courageous because the
recovery of oil consumption and the strong growth of
natural gas consumption predicted, in both cases, an
increasing dependence on imports.
This new market philosophy found concrete
expression along converging lines:
• Market deregulation, with the removal of obstacles
to free enterprise, including: price controls,
permits, obstacles to exchange, tariffs. The most
significant decision was, without doubt, that of the
67 The rate of use of OPEC capacity fell by more than 20
points to 60% between 1975 and 1985.
ENCYCLOPAEDIA OF HYDROCARBONS

French Parliament to liberalize the oil sector with
Law No. 1443/1992. The most important was the
liberalization of prices in the United States
initiated by President Carter in late 1979, and
finalized by President Reagan in 1981.
• Eliminating or reducing interventions which
distorted competition, such as subsidies and state
aid, unless authorized by Brussels (in 2000, coal
subsidies still amounted to around 7 billion euro;
EC, 2002).
• The safeguard of competition, entrusted to specific
independent regulatory authorities.
• In Europe, the privatization of public companies:
BP in Great Britain (begun in 1977 and finalized in
1987); CFP-Total (1986-96) and ELF-Aquitaine
(1986-96) in France; Repsol in Spain (1989-97);
VEBA in Germany (1987); OMV in Austria (in
1987, with the state retaining 31.5% of capital
stock); Eni in Italy (begun in 1995, with the state
retaining a controlling position in 2004 with 30%).
• The general weakening, except in the United
States, of the bilateral relations which consuming
countries had developed over time with
producing/exporting countries, at a time when the
need for more intense cooperation, if anything,
required them to be strengthened.
The gradual demise in Europe of national energy
policies was not accompanied by the simultaneous
development of a European energy policy, with the
exception of the related environmental issues,
especially following the Kyoto Protocol.68 The
attempts by the Brussels Commission to strengthen its
powers and the Community’s role in the energy sector
with the signature of the Single European Act 1986 or
the Treaties of 1992 and 1997 had no effect, with
governments preferring to maintain a full, though now
marginal, decisional autonomy.69 Though lacking
formal powers, the Commission tried to strengthen its
role by coordinating and monitoring national policies
in a way not dissimilar to the IEA in Paris, setting out
aims to rationalize consumption, diversify sources and
reduce energy dependence. However, these objectives
remained confined to the level of mere statements and
hopes, without identifying ways to attain them. Only
in the field of renewable resources, directly correlated
with environmental issues, did the European Union
acquire deliberative powers by fixing quantitative
objectives for their development (directive
2001/77/EC).
The market philosophy was adopted by most
traditional consuming countries, but not by the
developing countries (starting with those in Asia, like
China, India, South Korea, Taiwan, Thailand)70 which
were taking on an ever greater role in the international
hydrocarbon markets, given the inability of their
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STATE AND MARKET REQUIREMENTS DETERMINING OIL POLICIES
domestic production to satisfy exponentially
increasing demand.71 It is interesting, in fact, to
observe that these countries have adopted energy
policies similar to those once adopted in Western
countries for essentially similar reasons: a) the
safeguard of national security and economic
development, minimizing the political and economic
risks deriving from increasing dependence on foreign
supply. These policies, which on the domestic level
involve the careful planning of long-term development
needs, take the form of severe regulation of the
domestic markets; b) the almost exclusive presence of
national public companies; c) limited openness to
foreign capital; d ) strong public support for
investments in plants and infrastructure. Their political
actions on an international level are fully
complementary: political agreements with producing
countries for the joint exploitation of oil resources,
natural gas and other sources; support for the
construction of large infrastructure, especially for the
transportation of oil and gas; partnerships with foreign
companies and governments; close coordination of the
strategies of national companies targeted towards the
planning priorities set out by central governments.
The strong asymmetry between the
market-oriented policies of Western countries and the
state-control policies of Asian countries would not in
itself be a cause for concern if the conditions of the
international markets, for both oil and natural gas, had
not begun to show worrying signs regarding the
adequacy of oil supply to meet the predicted strong
increase in demand in the early years of the third
millennium. This makes it impossible to rule out the
risk of a conflict of interests between the East and
68 The European Union ratified the Kyoto Protocol on
31 May 2002 and, independently of its effective application,
adopted directive 2003/87/EC on 13 October 2003 which
introduced the System for the exchange of greenhouse gas
emissions quotas, applied from 1 January 2005. On 16
February 2005, the Protocol came into effect after reaching
the required adherence of countries accounting for 55% of
total greenhouse gas emissions.
69 On the occasion of the signature of the Single
European Act, the governments approved a declaration
establishing that the new environmental regulations would
not reduce their autonomy in deciding on the development
of the energy sectors. In the Union Treaty, the member states
established the principle of unanimity on decisions
concerning environmental regulations affecting the energy
sector (McGowan, 1996).
70 In 2003, these five countries together consumed
12.5 Mbbl/d of a worldwide demand of about 78 Mbbl/d,
equal to 16%.
71 The IEA’s forecasts to 2030 suggest an increase in oil
consumption in India and China of 11.2 Mbbl/d, of a total
increase in worldwide demand of 44 Mbbl/d, accounting for
about 25%.
211
PUBLIC POLICIES AND THE OIL INDUSTRY
West for control over resources which are predicted to
become relatively scarce. A conflict not unlike that
seen a century ago between Western diplomacies,
though presenting higher risks.
At the end of the Nineteenth century, the entire
Western world could count on the United States’
abundant oil reserves and on its political influence
over the major exporting areas. These conditions have
both gradually vanished. Of the 36 billion t of reserves
which the United States boasted in 1860, just under 3
remained in 2004, with an annual production of 0.5.
This gives a life-span, under current conditions, of
only 6 years. Once the largest producer, the United
States are now the largest importer. This reversal, and
the simultaneous appearance on the international oil
scene of the major Asian countries, leads to the risk of
tensions over the control of oil resources. “Energy is a
capital game, whose possession is a question of
survival […]. The control of oil resources naturally
becomes the object of power struggles in the
international arena” (Paris, 2005).
At the dawn of the Twenty-first century, this is true
for the United States no less than for China. A net
importer of oil from the mid-1990s, China has become
in a decade the world’s second consuming country.
Every extra barrel consumed internally translates into
an extra barrel imported from abroad. For China,
energy, especially oil, has become a purely political
issue which directly affects national security.
Interestingly, risks of this type have been identified by
the Chinese authorities, as in France or Great Britain a
century ago, especially for supplies of oil by sea, 80%
of which pass through the Malacca Straits, particularly
vulnerable to terrorist acts or piracy. The result is the
urgent need for China to develop alternative supply
routes, with systems of oil pipelines from all possible
areas of supply (Head […], 2004; China […], 2005).
3.1.7. Oil, social conflict,
policy crises
The abandonment and withdrawal of energy policies
was also determined in part by their growing inefficacy.
Until the 1970s, the issue of oil, and energy in general,
was a priority on state agendas, but the general public
remained essentially uninterested, except during the
most acute international crises. All decisions remained
confined to governmental institutions, chanceries and
the business community, without significant external
ties in public opinion, local communities and political
groups. Public policies, regardless of the results
actually achieved, were easy to implement because they
could be carried out without interference. Discovering
oil or gas, attracting investors, building oil pipelines or
212
refineries, and disposing of oil refined products were
perceived positively by the whole community since this
was a prerequisite for the greater well-being affecting
increasingly large sectors of the population – a social
conquest worth fighting for. The first environmental
movements, such as Gifford Pinchot and Theodore
Roosevelt’s early Twentieth century conservation
movement in the United States, or William Kapp’s
pioneering studies (1950) on the environmental crisis
remained politically and intellectually circumscribed
phenomena.
The situation altered drastically and irreversibly
with the crises of the 1970s. The shock experienced by
public opinion, the political classes and lobbies at
seeing their own future at the mercy of hostile foreign
countries; discovering they were vulnerable to
uncontrollable external factors; seeing their well-being
endangered, had devastating effects. Specifically, the
crises led to a turning point in energy policies, with
paradoxical consequences: highlighting the need for
them and simultaneously reducing their efficacy. There
were various reasons for this. In the first place, they
actually affected different income brackets unequally,
to the detriment of the less well-off.72 Every remedy
stressed these inequalities and met with harsh
opposition. Second, their effects in different
geographical areas varied, with violent conflicts
between those who should have attempted to resolve
the problem by increasing their domestic production
and those which benefited at no social cost. Between
areas, like Texas, which hoped for rises in crude oil
prices to encourage investments, and areas which
opposed them because they were forced to buy. Hence
the Texans’ motto: «let’s leave the bastards in the cold
and dark» (Landsberg, 1981).
These motivations were compounded by the third
and most important: the emergence in the energy
question of environmental, social and political issues
which went well beyond problems linked strictly to
energy. Any possible choice would have led to endless
and irresolvable controversies, in an inextricable web
of ideologies, facts, interpretations, with the result that
the status quo remained unaltered. These were
triggered, above all, by the new cycle of apocalyptic
predictions started by the first global modelling
studies promoted by the Rome Club.73 Both World
72 The quantitative differences in the energy
consumption of high and low income groups appear to be
far less significant than the monetary differences in income.
This is compounded by the fact that at low income levels,
the demand for energy presents extremely low flexibility to
prices.
73 A private international cultural organization
established in Rome in 1968.
ENCYCLOPAEDIA OF HYDROCARBONS

dynamics (Forrester, 1971) and famous The limits to
growth (Meadows et al., 1972) predicted a
catastrophic decline for humanity due to the
insurmountable limitations which would ensue from
the imminent “exhaustion of resources”, “outbreak of
wars, epidemics, social conflicts”, “the uncontrollable
decline of population levels and the industrial system”.
The sharp rise in oil prices was interpreted as the first
symptom of these prophecies of doom and not as a
temporary insufficiency of production capacity. The
fact that the situation developed in a different
direction, as shown by the data in Table 1, is of
secondary importance here, because it was precisely
this type of collective perception of the crises which
conditioned the arguments about what to do. There
was a widespread conviction that a drastic rethink of
the traditional view of the relationship between
well-being and energy was necessary (Shurr, 1978),
through a profound modification of lifestyles, as
predicted by Ivan Illich with his exhortation to give up
“motor vehicles and only use bicycles” (1978).
The energy question, intertwined with all these
problems, came to represent an opportunity, pretext or
arena for never-ending and irresolvable conflicts
between opposing coalitions, opposing
Weltanschauung and opposing underlying value
systems (Landsberg, 1981). The objective view of
events fragmented into each protagonist’s different
perception: “where one stands depends on where one
sits” (Darmstadter et al., 1983). An expansionist view
of economies – the assumption that greater growth
would improve well-being, and that one should
guarantee the broadest and cheapest supply of energy
possible – clashed with a conservationist Malthusian
view which refuted the logic of growth in order to
preserve scarce natural resources, halt the
deterioration of the quality of life and save humanity
from impending tragedy.74 Hence the conflict between
those who espoused the logic of energy supply and
those who supported the logic of demand; between
those who believed that resort to fossil fuels was
essential and those who idolized renewable sources;
those who supported large industrial plants and those
who favoured small distributed production centres;
and, finally, between those who argued for energy
planning and those in favour of decentralizing
decision-making to the myriad peripheries of each
country.
These anti-growth and anti-energy sentiments,
which were not reflected in a corresponding
willingness to give them up, fed hostility towards the
large companies, turning the clocks back to the attacks
on the robber barons of the late Nineteenth century.
Although everyone demanded to have the energy they
needed, no-one was prepared to pay the inevitable
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
STATE AND MARKET REQUIREMENTS DETERMINING OIL POLICIES
social price (according to the reigning slogan “Not in
my backyard”). A case in point: between 1976 and
2005, not one single refinery was built in the United
States, although gasoline consumption grew by 45%.
The quest for consensus became a priority over all
other requirements, faced with social conflicts which
became increasingly severe as the crises produced
increasingly damaging effects. The ability of policies
to achieve their watchwords gradually decreased in
this paralysing conflict between centre and periphery,
one area and another, consumers and producers,
producers and producers. As the American National
Academy of Sciences wrote: “Energy policy involves
very large social and political components with an
irreducible element of conflicting values and political
interests that cannot be resolved except in the political
arena” (Landsberg, 1981); but policies proved
incapable and unable to resolve them, effectively
leaving all decisions to the markets.
3.1.8 Policies and the market:
striking a balance
The return to conditions of abundant supply and low
oil prices led, as already noted, to the illusion that
energy policies had lost their raison d’être, apart from
withdrawing and making the markets even more free
and efficient. This illusion was dispelled at the
beginning of the new millennium for reasons that were
both political and economic. The illusion was
dispelled for political reasons on the morning of 11
September 2001 with the terrorist attack on New
York’s Twin Towers, although there was no apparent
direct connection between this tragic event and oil,75
and the American response which followed: the war on
terror, military intervention first in Afghanistan and
then Iraq, the querying of the traditional alliance with
Saudi Arabia (Barnes et al., 2005). The illusion was
dispelled for economic reasons with the renewed
tensions from the second half of 2003 in the
international oil markets, with prices doubling in a
year to values above 50 dollars a barrel. This price
crisis put oil back in the centre of the economic arena
and the interest of public opinion, governments,
central banks, as had not been the case since the early
1980s.
74 “Any social structure disintegrates beyond a certain
threshold of energy consumption” wrote Ivan Illich (1973) a
few months before the outbreak of the October 1973 crisis.
75 Except for the fact that 15 of the 19 terrorists were of
Saudi nationality and that Saudi Arabia had given financial
support to anti-Israeli terrorist groups and Islamic
movements in central Asia (Barnes et al., 2005).
213
PUBLIC POLICIES AND THE OIL INDUSTRY
This crisis was both circumstantial and structural.
It was circumstantial due to the combination of acute
and prolonged political tensions in the Middle East
with an extraordinary growth in international
demand,76 driven by China and, again, by the United
States. As Peter Odell wrote: “The world is still
running into oil rather than out of it” (Anarchy […],
2004) as people immediately began to repeat. It was
structural due to the saturation of available spare oil
capacity,77 able to respond immediately to increases in
demand or interruptions of supply, with two
consequences: the near cancellation of margins of
flexibility in international oil flows and the
concentration of available capacity in the OPEC
countries of the Persian Gulf and, specifically, Saudi
Arabia. This allowed OPEC to resume a position of
leadership in the incremental supply78 of oil and to
condition the dynamics of prices through regulation.
Political and economic developments focused the
public eye on the vulnerability of economies to the
risk of interruptions in oil supply and price shocks,
under conditions which were different, and worse,
from the past. First, due to the altered structure of the
international oil market, which had become global,
competitive, unstable, conditioned by the dominance
of financial transactions79 and their underlying
speculative intentions. Second, due to the withdrawal
of energy policies, as during the recent crisis with the
complete absence of any response by increasing
supply (drawing on the enormous stocks) or measures
to contain demand. Third, because the hub of the
market had gradually moved eastwards,80 so that the
dynamics and political decisions of those countries
conditioned it more than those of Western countries.
Fourth, due to the weakening or abandonment of the
solutions which had helped to resolve the preceding
crises: increase in domestic oil production,
development of nuclear power, greater resort to coal.
Fifth, due to the inadequacy of national policies in
tackling issues which are increasingly supra-national
in character, while there are severe difficulties in
agreeing on effective supra-national policies, as in the
case of the failed European energy chart (1991),
intended to establish a sort of code of behaviour for
collaboration between Western countries and ex-Soviet
countries (Romoli, 1991). The efforts made by
Community bodies to initiate policies of cooperation
with oil or gas exporting countries have not yet
achieved any significant concrete results.81
The main challenge faced by the world is how to
satisfy future oil ‘hunger’, with demand predicted to
increase by 60% between 2002 and 2030 to 121
Mbbl/d. An increase equivalent to 1.3 times the entire
production of OPEC countries in 2004.82 Meeting this
challenge will require considerable time and two main
214
conditions. The first is the urgent need to develop new
oil production capacity, given the time required for
investments to mature. Development potential is not
lacking, although it must be said that, of the initial
quantity of proved reserves of a century and a half ago
(276 Gt), slightly over half has already been
consumed, mainly during the second half of the
Twentieth century. The problem is how to render
residual reserves of conventional oil, or
non-conventional oil, accessible through coherent
investment decisions (Adelman, 2004). These
decisions, however, are slow to emerge because
companies are less inclined to invest, despite the
extraordinary profits made possible by high market
prices.83
This investment gap is caused by the growing
uncertainties inherent in the oil business, political
76 After 2 years (2001-02) of basic stability, demand
leapt by about 1.9 Mbbl/d in 2003 (⫹2.4%) and by 2.7 in
2004 (⫹3.4%) to a total of 82.5.
77 In only two years, spare capacity almost vanished,
passing from just under 6% in 2002 to values in late 2004 of
about 2% (after dropping to 0.6% in September), the lowest
levels for 30 years.
78 Between 1985 and 2003, out of every 10 added
barrels of demand (in absolute terms 20 Mbbl, equal to 2.5
the whole annual production of Saudi Arabia), 7 were met
by OPEC production, prevalently of Middle Eastern origin.
79 The volumes of daily Nimex transactions of West
Texas Intermediate crude, on which the crudes of the
western hemisphere are priced, reached an average threshold
of 200 Mbbl/d in 2004, 250 times higher than physical
production, barely 0.8 million.
80 With a 7 point increase over a few years of the share
occupied by the Asian area to 29% of worldwide demand for
oil: essentially identical to that of North America and far
higher than that of Europe.
81 In October 2000, an energy dialogue began between
the European Union and Russia, aimed mainly at
identifying infrastructure of mutual interest; in January
2004, negotiations began on the trade in nuclear materials,
again with Russia; in May 2003, the European
Commission published a communication on energy policy
towards neighbouring countries (EC, 2003); energy
cooperation between Europe and Mediterranean countries,
launched at Barcelona in 1995, saw increased interest in
2003 with two ministerial conferences: one held in Athens
in May, and the other in Rome in December. Finally, a
discussion between oil producing and consuming countries
was started in 1991, and renamed International Energy
Forum in 1999; since 2000, it has had a permanent
secretariat based in Riyadh.
82 In 2004, OPEC production amounted to a total of
33.6 Mbbl/d.
83 Measured by the investments/sales ratio, the
inclination to invest has fallen by 20% in the years
1995-2000 to 15-16%, the lowest level since the late 1980s.
According to the IEA, current investments are lower than
those needed to meet demand expected for 2030
(Energy […], 2005).
ENCYCLOPAEDIA OF HYDROCARBONS

tensions and the difficulty of gaining access to
producing countries;84 increasing costs and risks in
new frontier areas, and the long time required for
investments to mature; to this is added a new and more
critical problem: the prevalence in the philosophy and
strategies of Western companies of decision-making
policies which are more financial than industrial,
oriented more towards the short than the long term.
The combination of low investments with the gradual
decline of oil production in an increasing number of
mature reservoirs (18 countries, including the United
States and Great Britain,85 have passed their
production peak), with the ever increasing difficulty of
discovering new fields, makes most large companies
unable to replace current production. In conclusion,
the logic of the market seems inadequate and far from
able to ensure a satisfactory balance in the future
between oil supply and demand. In short, the markets
seem to be showing manifest signs of failure.
The second condition for overcoming the challenge
posed by oil hunger is the creation of the political
conditions for a return of Western companies to
producing countries, especially in the Middle East,
since the whole world needs this oil to the tune of 75%
of all incremental demand.86 This return is motivated
also by the increasing difficulties experienced by these
countries in developing their production capacity and
the growing need to finance their public budgets.87
The conclusion is that, as never before, there is now an
absolute need for cooperation, stability and peace. But
as never before, these have been put to the test during
this phase of history. A need for cooperation between
producing and consuming countries but, no less
importantly, among old consuming countries, and
between these and new consuming countries. It would
be an important step forward if all parties showed full
awareness of this to avoid the quest for secure energy
supply becoming, as is currently the case, a motive for
international tension and conflict. The developments in
events on the world oil stage have basically shown the
need for politics to play a part again – in the awareness
that in the energy sector, the market is not the be all
and end all.
The structural conditions which encouraged and
made the transition to the market convenient – above
all, the surplus supply of hydrocarbons and excess
electricity generating capacity – are disappearing, to
such an extent as to lead to the emergence, in an
energy scenario marked by new tensions, of
concerns even in those countries which had relied on
them most. The potential for market failure requires
state intervention to resume its role, alongside
allocation mechanisms, albeit in a different form and
with renewed instruments, with resort to more
rigorous domestic policies to govern demand, an
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
STATE AND MARKET REQUIREMENTS DETERMINING OIL POLICIES
intensification of research and development
activities in non-conventional oil and renewable
resources, close international coordination of
national policies and a policy of cooperation with
producing/exporting countries. International
policies, environmental policies and energy policies
must be aimed at pursuing the objectives of security,
stability, low cost – today, no less than in the past,
albeit in a different form.
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Alberto Clô
Dipartimento di Scienze Economiche
Università degli Studi di Bologna
Bologna, Italy
The Author thanks Patrizia Bassani, Massimo Ponzellini,
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assistance in acquiring data and bibliographical references.
217

Urbanization and energy use
Urbanization involves more than just transferring
population from the countryside to cities. Cities
do not exist in a predominantly rural country, so
they have to be built, and the lifestyles of rural
residents are drastically transformed. When the
transition is complete, urban residents may use
several times more energy, and energy from
different sources from what they, or their parents,
used in the countryside. The currently
industrialized countries of the OECD
(Organization for Economic Cooperation and
Development) generally made this transition over
a period of about a century or a century and a
half, but the post-Second World War developing
countries are making the urban transition much
more rapidly.
The urbanization and industrialization of the
currently industrialized world were not smooth
or painless, but the concurrent development of
energy-using technologies with the relocation of
the populations allowed a more interactive
adaptation to both sets of changes. The
developing countries making these transitions
after the Second World War frequently have had
to employ some advanced, energy-using
technologies such as inter-regional transportation
systems alongside pre-industrial technologies in
agriculture and manufacturing, with resulting
strains on their economies and societies that
differ from the experience of the currently
industrialized countries. A combination of
comparison between the experience of the
industrialized countries, and the observations of
recent experience in post-war developing
countries is used here to understand how
urbanization changes energy use, and how
continued urbanization in the world is likely to
alter aggregate energy use.
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
3.2
3.2.1 Urbanization
and agricultural change
During the urbanization of the West in the Nineteenth
century, the removal of workers from agriculture
required that those remaining in agriculture be able to
produce more than they did before. Actually, it was
typically the increases in agricultural productivity that
forced people off of farms and into cities rather than
departures for the city requiring agricultural
productivity improvements. Either way, urbanization
requires higher agricultural productivity, which has,
since the early Twentieth century, involved
mechanization of and greater use of energy in
agriculture. The release of land from supplying draft
animals with fodder adds to the productive capacity of
the agricultural sector, in addition to any increases in
productivity per acre or per worker. Turning from draft
animals for power has required the use of chemical
fertilizers, which require petroleum feedstocks, to
substitute for dung, and the fertilizers often have
required pumped irrigation, which requires either
liquid fuel or electricity.
In the quarter century following the Second World
War, Taiwan shifted from 67% human-supplied energy
and 33% animal-supplied in its agriculture to 35%
human-supplied, 5% animal-supplied, and 60%
mechanical. In the early 1970s, during its Green
Revolution, nearly 17% of India’s oil imports went to
fuel its agricultural tractors.
During the Nineteenth century, international trade
in food products allowed an increase in agricultural
productivity to occur in countries that were not
necessarily undergoing as rapid an industrialization. In
the Twentieth century, especially in the years following
the Second World War, major agricultural exporters
included some highly urbanized and industrialized
countries such as the United States and Australia. As
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PUBLIC POLICIES AND THE OIL INDUSTRY
the Twenty-first century begins, some poorer
countries, particularly in sub-Saharan Africa, may
experience rapid urbanization with little improvement
in their agricultural productivity; nevertheless, the
foreign exchange resources for international food
purchases will remain problematic.
3.2.2 From agriculture to industry
Although services are playing a larger role relative to
industry than they did in the Nineteenth and early
Twentieth centuries in the countries of the currently
developing world, the shift out of agriculture will
involve a transfer of much of the labour force to
industry. In India, moving workers from traditional
agriculture to the least energy-intensive
manufacturing, i.e. textiles, quadrupled the energy
requirements per transferred worker.
Even traditional industry, which has had an urban
focus, where workforces can be assembled from a
smaller area, uses more energy per worker and per unit
of output than agriculture does. Within industry, with
modernization, the share of metals increases, partly
because of the changes in the products produced and
partly because of the replacement of wooden and
leather parts with metal ones. More recently, plastics
have entered the picture, in terms of both final
products and industrial equipment. Both metals and
plastics are highly energy-intensive.
Industrial production, with its more diverse array
of inputs and procedures, and its larger, more spatially
concentrated labour forces, requires increased
reliability in the delivery of all of these inputs. While
traditional fuels such as firewood and charcoal can
supply industrial heat, fossil fuels and electricity, in
particular, provide more reliable power sources.
Additionally, higher quality products may require
production with more evenly delivered power such as
that provided by electricity.
3.2.3 Building cities
Construction materials in traditional societies tend to
reflect local resources. Locally available materials
continue to be reflected in urban construction, but
more industrialized materials, from bricks to precut
wood, tend to be used in cities rather than in rural
structures. In addition, private industrial buildings and
public structures, which tend to be absent or at least
scarce in rural areas by virtue of their scale, tend to
require stronger materials which are themselves
industrial products that require energy inputs to
produce. Bridges and paved streets comprise typical
220
urban infrastructure which are absent in rural towns
and villages. Production of the construction materials
is considerably more energy-intensive than their
assembly in the construction process.
Evidence from India in the late 1970s indicates
that construction required only 2,087 kcal per rupee of
output, while cement production took 15,344 and iron
and steel required 8,757. Other industrial production is
less energy-intensive: 4,552 for non-ferrous metals
and 2,708 for chemicals. Philippine data from the
early 1980s show a similar pattern of relative energy
intensities: four times as much energy per peso of
concrete production as required for basic metals, and
sixty times the requirements of agricultural
production.
3.2.4 Concentrating populations
The concentration of people in cities creates a number
of changes from rural life. First, assembling larger
proportions of a country’s population in its cities
allows the scale of production to increase, but requires
a number of activities which play minor roles in the
economic lives of rural populations. Second, since
urban populations produce little or none of their own
food, those products must be transported to them,
frequently over long distances. Third, the public and
private infrastructure needed to keep large
concentrations of people healthy and safe requires
energy to build and operate. Fourth, the array of daily
activities of people living close together changes from
those they would have engaged in as country folk.
Fifth, density changes the practicality of particular fuel
choices.
Scale of production. An important characteristic of
industrialization is the emergence of a wider array of
more specialized products. Concentrating labour
forces in cities allows more specialized producers to
find workers with the requisite skills, and makes it
profitable to build specialized facilities in which to
employ them. Nonetheless, assembling a labour force
in a city frequently requires energy for transport that
was not used in rural production, and the more
specialized goods must be sold over a larger territory.
Turkish data on cement production indicate that
expanding the market area from 6 to 190 km reduced
labour and capital costs per unit of output by 60%, but
increased transport costs 16 times, leaving delivered
output costs about 50% higher.
The fuel demands of large-scale industry are
considerable, and storing this fuel takes space. Urban
land is of much higher value than rural land, and its
conservation is required. Shifting from charcoal to
coal or fuel oil saves on land costs of urban industry as
ENCYCLOPAEDIA OF HYDROCARBONS

well as delivering more reliable power. More compact,
higher-BTU (British Thermal Unit) fuels are also
transportable over longer distances than are traditional,
biomass fuels, and their transport is more likely to use
fossil fuels.
Food delivery. Farmers in traditional societies
consume a large share of the food they produce and
produce much of what they consume. Urbanization,
and the increased agricultural productivity required to
support it, changes this. More food is transported for
longer distances, and much of it requires more
processing to survive the trip. In the mid-1960s, the
United States used 7% of its national energy
consumption to process food and another 2% to
transport its food. India and Pakistan, during the
mid-1970s, devoted one-third to one-half of this share
of energy consumption to their food processing and
about two-thirds of the United States share to
transporting food. Urbanization was much lower in
India and Pakistan than in the United States at the
time, and their overall energy use per dollar of GDP
(Gross Domestic Product) was considerably lower.
These figures give some indication as to how far the
two South Asian countries had to go in their growth of
energy use.
Infrastructure. Construction of infrastructure has
already been addressed. Once built, infrastructure
must be operated and maintained. Concentrations of
people are subject to devastating outbreaks of disease,
which the emerging cities of the Nineteenth century
rediscovered. Water treatment and litter collection are
two important components of the sanitation required to
make modern cities livable. Despite limitations on the
extent of these services that many cities in developing
countries deliver, these activities, together with
municipal lighting, can consume as much as 5 to 6%
of total private fuel use in Third-World cities, judging
from evidence collected in Mexico City, Nairobi, and
Calcutta in the mid-1970s.
Domestic routines. What households do with their
energy use is important in developing countries, since
they account for 40 to 90% of national energy use.
Rural households produce at home many of the
goods and services that similarly placed urban
households purchase. Baking, food preparation away
from home, and clothes washing, frequently use less
fuel when they are conducted outside the household,
whereas others such as weaving and sewing tend to
use fuel out of the home that would not be involved in
home production.
The most prominent difference between rural and
urban household energy use occurs in personal
transport. Farmers may spend one-quarter to one-third
of their time commuting to and from fields, but they
typically walk or use animal power. In cities,
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URBANIZATION AND ENERGY USE
commuters, even those in lower income ranges, tend to
use fuel-consuming transport modes. Even allowing
for walking and bicycle use, transport can take from
25 to 60% of total household energy in developing
countries.
Density and fuel choice. Third-World cities are
frequently served by industrial-scale fuelwood
providers who make their deliveries in gasoline or
diesel-powered trucks. However, residential densities
of cities encourage more compact fuels than the
biomass fuels used by rural households. Survey
evidence from Hong Kong in the 1970s indicated that
a 1% increase in population density in a district,
holding income constant, reduced the share of
firewood and charcoal in household energy
consumption by 0.25%, with a concomitant increase in
the share of kerosene.
Urban densities also reduce the cost of electricity
transmission and distribution relative to those costs in
rural areas. This effect tends to increase electricity
consumption.
3.2.5 Increasing incomes
While urbanization may take its toll temporarily on
various health indicators, as it did during the
Nineteenth century, eventually real incomes increase
with development. Income elasticities of household
energy demand have been estimated to range from 0.5
to over 1.0 in a number of developing countries in
Latin America, Asia and Africa. Increasing income also
encourages the purchase of energy-using appliances,
ranging from refrigerators and washing machines to
microwaves and toaster-ovens. To the extent that some
of these products are manufactured domestically, the
increase in household energy demand will feed back
into increased demand for industrial energy.
Rising incomes also shift households from
awkward, dirty energy sources, such as biomass, into
cleaner, easier-to-use modern fuels. The Hong Kong
data indicate an income elasticity for the share of
modern fuels in household fuel budgets of 1.17. These
modern fuels can be utilized more efficiently than their
traditional counterparts, which would tend to dampen
growth in aggregate energy use. Nonetheless, some
cooking traditions, such as grilling, find kerosene and
electricity poor substitutes for wood or charcoal.
3.2.6 Substituting modern energy
for traditional energy
Depending on their resource bases, some early
industrializing countries have used enormous
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PUBLIC POLICIES AND THE OIL INDUSTRY
quantities of biomass fuels, particularly fuelwood.
Industry used wood to provide heat for manufacturing
processes, and households used it for cooking,
washing, and space heating. Deforestation caused by
fuelwood exploitation was a large-scale and
widespread phenomenon in parts of the United States
during the middle and later decades of the Nineteenth
century. Aggregate data on the growth of modern
energy consumption, primarily fossil fuels, in the
United States from the middle of the Nineteenth
century to the middle of the Twentieth give the
impression that energy use per dollar of GDP
increased by a factor of about 3 and per capita by a
factor of nearly 25. Adding energy from wood to these
energy consumption data changes those impressions
drastically. Energy use per dollar of GDP rose by
about 20% between 1880 and 1920 and then declined
to about 75% of the 1880 level by mid-century. Energy
use per capita increased by a factor closer to 3, not 25
times.
Data suggest that the United Kingdom, despite its
popular image of being an almost exclusively
coal-fired country both industrially and domestically
since the Eighteenth century, relied on a considerable
proportion of biomass fuels, from wood to turf, in its
household sector well into the Nineteenth century. The
growth of modern energy consumption in the United
Kingdom overstates the true growth in its energy use,
although to a lesser extent than in the wood-rich
United States.
As developing countries urbanize and industrialize
– and not all industrialization will take place in urban
areas – they will substitute modern energy for
traditional energy. An exclusive focus on the growth of
modern energy alone will overstate the true increase in
their energy use.
3.2.7 The bottom line:
aggregate energy
implications
of urbanization
The individual effects noted, and occasionally
quantified, in the preceding sections are difficult to
add up into a simple measure of how much
urbanization affects a nation’s energy use. To assess
the aggregate effect of urbanization on energy use,
Donald Jones has analyzed 1980 data from a group of
fifty-nine developing countries, and Jyoti Parikh and
Vibhooti Shukla have studied data on seventy-eight
developing and industrialized countries at intervals
between 1967 and 1985. Despite some differences in
data and statistical methods, both Jones and Parikh and
Shukla obtained broadly similar results. Both studies
222
held constant the effects of other influences expected
to affect energy use: income or GDP per capita, the
extent of industrialization, population density, and
energy prices facing consumers in different countries.
Jones studied modern energy (fossil fuels and
electricity), traditional energy (biomass and animate
energy) and total energy separately, while Parikh and
Shukla studied total energy (the sum of modern and
traditional energy).
Jones used PPP (Purchasing Power Parity)
adjustments for GDP to correct for price differences in
non-tradeable goods, which are lower in low-income
countries. Parikh and Shukla used GDP converted to a
common price through direct ER (Exchange Rate)
conversions. The PPP correction raises the income
imputed to low-income countries relative to that of
higher-income countries. Energy use will be more
responsive to PPP-adjusted GDP than to ER-measured
GDP, because a given cross-country variation in
energy use will be associated with a larger range of
income measured with the ER conversion than with
the PPP correction. Both methods are valid, but the
differences in their measurement should be recalled
when comparing results based on the different
measures.
Parikh and Shukla’s total energy measure, when
compared across countries at different levels of
development, will mix substitutions between
traditional and modern energy, making total energy
appear less responsive than modern energy to
variations in income, urbanization or other measures
of development. Again, there is no correct measure of
energy use, but different measurements show
somewhat different results.
The elasticity of total energy use per unit of GDP
with respect to urbanization (i.e. the percent change in
energy associated with a 1% increase in the percent of
a country’s population living in cities) was estimated
by Jones to be 0.35 in 1980. The urbanization
elasticity of modern energy per unit of GDP in the
same year was 0.47. Per capita urbanization elasticities
were 0.35 and 0.30 for modern and total energy.
Urbanization elasticities of traditional energy, either
per capita or per dollar of GDP, were not significantly
different from zero. Parikh and Shukla estimated the
urbanization elasticity of total energy per capita to be
0.47, essentially identical with Jones’s estimate of the
modern energy elasticity per dollar of GDP; the
difference in measurement of GDP is probably largely
responsible for the difference in magnitudes of these
estimates.
The urbanization elasticities were estimated
controlling for the effects of GDP per capita, the
extent of industrialization, and in some cases
population density. Jones’s estimates of the GDP
ENCYCLOPAEDIA OF HYDROCARBONS

elasticities of total and modern energy use were 1.10
per dollar of GDP and 0.95 for per capita, while
Parikh and Shukla’s estimate for total energy per dollar
of ER-converted GDP was 0.47. GDP elasticities of
traditional energy are statistically zero. The
industrialization elasticity per dollar of GDP is 1.08
for modern energy but zero for traditional energy. On a
per capita basis, that elasticity is 0.83 for modern
energy, but negative, ⫺0.67, for traditional energy.
Parikh and Shukla’s elasticity with respect to the
agricultural share of GDP is ⫺0.69. These estimates of
the sensitivity of energy use to urbanization were
generated with data collected no later than 1985.
Estimates prepared for this article, using 2000 data
from eighty-four developing and newly industrialized
countries, indicate a broad stability of the earlier
results. Using PPP-adjustments to GDP, the
urbanization elasticity of modern energy per dollar of
GDP is estimated at 0.36. The GDP elasticity is 0.50,
and the industrialization elasticity is 0.47.
Looking forward, the United Nations projects that
world urbanization will increase by about 40% in the
single generation between 2000 and 2030. If GDP per
capita and industrialization remained unchanged,
which they will not, Parikh and Shukla’s urbanization
elasticity suggests that total energy use per capita
would increase by 19%. Jones’s per capita urbanization
elasticity would yield a 12% increase in modern
energy alone. China and India had 32 and 28% of their
populations urbanized in 2000, and both conceivably
could increase those shares by 50 to 100% over the
coming 30 years, which could increase those two
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
URBANIZATION AND ENERGY USE
countries’ energy consumption per capita or per dollar
of GDP by 50%. Even cutting these parameter
estimates back to allow for changes over a longer
period suggests that continued urbanization can be
expected to be a major contributor to growth in energy
consumption over the coming century.
Bibliography
Jones D.W. (1989) Urbanization and energy use in economic
development, Oak Ridge (TN), Oak Ridge National
Laboratory, ORNL-6432.
Jones D.W. (1989) Urbanization and energy use in economic
development, «The Energy Journal», 10, 29-44.
Jones D.W. (1989) Energy implications of urbanization in the
Third World, in: Lundqvist L. et al. (editors) Spatial energy
analysis. Models for strategic decisions in an urban and
regional context, Aldershot, Avebury, 49-69.
Jones D.W. (1991) How urbanization affects energy use in
developing countries, «Energy Policy», 19, 621-630.
Jones D.W. (1994) Energy use and fuel substitution: lessons
learned and applications to developing countries, in: Bentley
W.R., Gowen M.M. (editors) Forest resources and wood-
based biomass energy as rural development assets, New
Delhi, Oxford & IBH, 69-104.
Parikh J., Shukla V. (1995) Urbanization, energy use and
greenhouse effects in economic development: results from
a cross-national study of developing countries, «Global
Environmental Change», 5, 87-103.
Donald W. Jones
RCF Economic and Financial Consulting
Chicago, Illinois, USA
223

Environmental externalities
3.3.1 The concept of externality
Over the last few decades, the significant increase in
energy consumption associated with the growth of
economies has resulted in the intensification of local
environmental impacts and in the appearance of
environmental changes at a global scale. An extensive
body of technical literature has developed around this
theme, based in part on earlier economic considerations
of external effects. This literature concerns both positive
aspects (what has been done) and normative ones (what
should be done). In this article, emphasis will be placed
on the former. In particular, the objective of these pages
is to illustrate the following aspects: a) the concept of
externality; b) the role played by oil and gas in
generating externalities in the various phases of the
production cycle and in the uses thereof; c) the
problems associated with the monetary evaluation of
externalities; and d) the characteristics of a global
externality of great importance, namely climate change.
Externality is an effect exercised by the action of
an agent, for example through the production or
consumption of a good, on another agent. A classic
case is that of cigarette smoke. Agent A smokes a
cigarette (from which action he obtains pleasure), but
his action generates a negative impact on agent B, who
cannot tolerate smoke. In other words, a variable (the
cigarette) appears in B’s utility function, which is
under the control of agent A, and whose value is
decided by agent A, without taking into account the
effect on B, and whose growth destroys agent B’s
utility. In this case, we speak of a negative
externalities.1 Other conditions of negative externality
highlighted in literature are: that externality is an
unintentional effect of an activity that is, however,
legitimate (Mishan, 1971); and that the agent causing
the damage does not compensate the damaged party
(Baumol and Oates, 1988).
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
3.3
To complete the picture, it must be pointed out that
there are also cases of positive externalities. For
example, if we interpret A and B as two neighbours,
and we assume that A possesses a garden adjacent to
B’s house and which can be seen from it, then we have
a positive externality: B’s utility increases as a result
of the increase in quality of A’s garden, a variable that
is not, however, under B’s control.
Cases of utility functions that, without any
possibility of control by the agent, incorporate variables
present in other agents’ production functions are also
possible: a person who lives in the vicinity of a power
station with a strong polluting impact is damaged by the
poor air quality resulting from the plant’s emissions.
Although this definition might seem simple and
univocal, and although the concept of externality has
been studied since the days of Alfred Marshall, one of
the fathers of economic theory, it is in fact characterized
by considerable ambiguities. Tibor Scitovsky, in a well-
known article on the subject (Scitovsky, 1954), defines
it as one of the most elusive concepts in economic
theory. In particular, this ambiguity emerges in the
distinction drawn between technological externalities
and pecuniary externalities (Viner, 1931). The two
examples of the cigarette and of the garden are cases of
technological externalities, i.e. of external effects that
come about independently of market mechanisms. By
1 In more rigorous terms, it can be stated that agent B’s
utility function incorporates a variable (the cigarette) which
is not under his control, but rather under that of agent A:
UA
f (Xa, Sa); UB
f (Xb, Sa). Agent A’s utility (UA) depends
on Xa, a certain basket of goods consumer by A, and on Sa,
the number of cigarettes consumed by A; the utility of agent
B (UB) is a function of the basket of goods consumed by B
(Xb) and of Sa, the consumption of cigarettes by A.
The function UA increases with respect to Xa and Sa,
while the function UB increases with respect to Xb and
decreases with respect to Sa.
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PUBLIC POLICIES AND THE OIL INDUSTRY
contrast, pecuniary externalities are a consequence of
how the market operates and occur by virtue of
variations in prices; generally, they refer to variations in
the prices of the productive inputs used by an enterprise
as a consequence of variations in the output of another
enterprise. For example, a producer of textiles who sets
up another plant in an area where there is full
employment causes an increase in the cost of labour in
that area, and thus a damage to the other enterprises in
the same territory. Similarly, the establishment of a huge
business centre in an area can cause a rise in property
prices in that area, bringing economic advantages to
house owners (positive pecuniary externalities) and
economic disadvantages to those intending to buy or
rent a house (negative pecuniary externalities).
Pecuniary externalities have been at the centre of a
wide-ranging debate in economic theory, which has
essentially concentrated on whether state intervention
targeted at controlling them is appropriate, and also on
their function in a static or a dynamic context.
With the spread of industrialization and the
consequent appearance of environmental problems,
technological externalities (in particular negative ones)
have become increasingly important. It is to these that
reference will henceforth be made. The literature
identifies at least two types: private (exhaustible) and
public (non-exhaustible). In the second case, the
consumption of externalities by certain agents does
not influence the consumption of other agents. Air
pollution is a clear example of this: the fact that one
agent breathes in dirty air does not reduce its
availability for other agents. This represents, at one
and the same time, a case of externality and one of
public good2 (air). By contrast, an oil spill in the sea is
an example of an exhaustible externality: country B
will be unaffected by the oil spill due to the fact that
the oil, moved by the sea currents, heads for country
A. Nevertheless the difference is elusive because, with
respect to the inhabitants of country A, the externality
once more takes on the nature of a public good. As
shown by Bator (1958), a lot of externalities are
characterized by the nature of a public good.
A third type of externality is that due to congestion
(for example, road traffic), in which the agents are at
the same time damaging and damaged. Where the
damage done is discharged directly into the
environment and only indirectly involves man, we can
talk of environmental externality (e.g. acidification of
the forests). In relation to the geographical scale
selected, its character may be local (e.g. high
concentrations of particulates in a city), regional (e.g.
acid rain) or global (e.g. global warming). The size of
the scale is important, as its extent often means an
increase in scientific uncertainty regarding the
problem and an increase in the complexity of
226
negotiation associated with the international
agreements necessary to address the problem. It is the
appearance of environmental externalities of a global
character that gave a strong boost to the concept of
sustainable development.
According to the definition of the Brundtland
Report (WCED, 1987), sustainable development
means development that meets the needs of the present
generations without compromising the ability of future
generations to satisfy theirs. Concise as it may be, this
definition expresses a rather complex concept in
which the two ideas of intergenerational equity and
intragenerational equity are crucial: for sustainability
to exist, it is necessary not only for the future
generations to be able to achieve their aims, but also
for the present ones – in particular those belonging to
the poor countries – to be able to satisfy their needs.
Hence, protection of the environment and the
harmonious development of poor countries are the two
key points of the idea of sustainability: reflecting on the
real possibility of coexistence between these two
objectives is a theme of great interest. Many authors
have explored the theme of sustainability from different
standpoints. An important distinction is that between
strong sustainability and weak sustainability: the former
requires constancy in time of the stock of natural
capital, while the latter (Solow, 1986), which is less
stringent, refers to the constancy of natural capital and
capital generated by man as a whole, thus admitting the
possibility that the latter (e.g. roads or factories) can in
time replace natural capital. Constancy in time of
natural capital is, according to some authors (Pearce et
al., 1990), the key condition for sustainability, without
which its elementary contents would be lacking (e.g.
growth of per capita income, improvement in levels of
nutrition, health and education).
From the economic point of view, externalities
represent a form of failure of the market, or rather they
exist because there is no market which, assigning a
price to them, achieves an optimal allocation of
resources. With reference to the example of the power
station mentioned above, an externality exists because
the social cost of pollution is not computed in any way.
In other words, where there is no intervention by the
regulator, the producer of electric energy does not pay
for the pollution associated with what he produces.
More generally, there is no market that takes on the
social cost of pollution (Fig. 1). The MPB curve
2 Public good is a good characterized by non-rivalry and
non-excludability. In other words, the amount consumed by
one agent does not reduce the amount consumed by other
agents (non-rivalry) and it is not possible to exclude any
agent from consuming the good (non-excludability). City
lighting may be taken as an example of a pure public good.
ENCYCLOPAEDIA OF HYDROCARBONS

private benefit external cost
A
C It can be demonstrated that at B*, the point at
MPB MEC
A*
B private cost and external damage. In other words,
D correct (price
private marginal cost  external
O B* kWh
Fig. 1. Optimal level of externality and Pigouvian tax.
represents the Marginal Private Benefits, i.e. the
marginal profits of the producer associated with the
production of electricity (kWh). The MEC curve
expresses the Marginal External Cost associated with
the kWh produced. If it is assumed that the
environment has a certain capacity to assimilate
pollution, the MEC curve could start from a point to
the right of the origin. The MPB summarizes the
difference between the market price of the kWh and
the marginal costs necessary to produce it. Assuming
that we are in perfect competition (that the price per
kWh is constant and is an element for the producer)
and that marginal costs are increasing, marginal
profits will decrease with an increase in kWh.
Conversely, marginal externality, which affects all
those who suffer from the impact of the power station,
increases with increasing production of electricity.
Here, implicitly, it is assumed that externality is
monetized, i.e. that the environmental impact is
translated into a monetary value. This is a complex
operation that plays a crucial role within the context of
controlling externalities (see below).
It can be seen in Fig. 1 that, in the absence of any
control by the regulator, the producer increases his
production up to point D, at which his marginal profits
are nil and his total profits are equal to the area AOD.
Corresponding to this production level there is a
marginal externality equal to CD and a total externality
equal to the area OCD. In other words, the free market
leads to a non-Pareto optimal point, at which point the
well-being of the collectivity is not maximized.
To the right of B*, in fact, marginal externality
costs are higher than marginal private benefits, that is,
the private well-being generated by electricity
production is more than offset by environmental
damage. The opposite situation occurs to the left of
B*, where marginal externality is lower than marginal
profits. B*, therefore, represents the point at which the
well-being of the collectivity is maximized: to reach it,
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ENVIRONMENTAL EXTERNALITIES
it is necessary to eliminate the externality BB*DC; the
residual externality OBB* represents the optimum
pollution level.
which marginal private benefits are equal to marginal
externality, the price of electricity incorporates both
moving from D to B*, one passes from a traditional
competitive market situation (price
marginal private
cost) to one in which the failure of the market is
marginal cost).
At market level, and referring to a generic situation
of partial equilibrium, this situation is illustrated
in Fig. 2: the internationalization of externality implies
passing from point C to point A, with a consequent
reduction in the quantity produced (OB*) and an
increase in the price (OA'). While this passage involves
a loss of surplus equal to ABC on the one hand, on the
other, it implies a reduction in environmental damage
equal to ABCD, and therefore a net gain (ADC). In B*
we have the maximum social well-being (OAE) and the
optimum pollution level (OBA).
3.3.2 Regulation or the market?
The aim of environmental policy is to incorporate
external costs into the price of goods. Essentially, it
can be carried out in two ways: through a command
and control strategy, that is, having recourse to
environmental standards that forbid going beyond
point B* (see again Fig. 1), the penalty for doing so
being the payment of a fine; or alternatively, through
economic instruments of pollution control (Pigouvian
taxes, negotiable pollution permits) which, being
non-punitive, exploit the rationality of agents to take
them to the point of optimum externality. Arthur Cecil
Pigou (1920), for example, envisaged making the
E supply  MEC
price
D
A
A' supply
C'
C
B'
B
demand
O B* C'' quantity
Fig. 2. Externality and price.
227
PUBLIC POLICIES AND THE OIL INDUSTRY
producer pay a tax that lowers his marginal benefits to
an extent that reaches nil at point B*, thereby inducing
the producer to stop production at the point of
optimum externality. This idea forms the basis of
energy and environmental taxation (taxes on
emissions, carbon tax, tax on the energy content of
fuels, etc.).
Both the command and control approach and
economic instruments aim to internalize externality,
i.e. make the cost of it fall on the polluter (PPP,
Polluter Pays Principle). Naturally, the application of
this principle does not prevent the polluter from
transferring the costs of pollution onto other agents,
for instance the consumer.
Hence, more generally, internalizing externality
means that it is considered within the economic
system, through forms of regulation or private
negotiation between damagers and damaged. Ronald
Coase (1960) proposes the latter solution. Coase
claimed that control of externalities by the regulator is
superfluous, as market failures occur because
ownership rights, i.e. the rights to use the environment,
have not been assigned to the various agents. As he
saw it, were ownership rights to be assigned to the
damager, or to the damaged party, bargaining would be
possible between the two agents, with resultant
compensation, generally monetary, which would lead
towards the optimum externality level. This is true
whoever possesses the ownership rights (the damager
or the damaged party). In this case, market forces,
without the intervention of public authority, would
resolve the pollution problem.
In other words, the bargaining proposed by Coase
represents a form of market in which the good
externality can be exchanged. It is obvious that the
widespread existence of externalities in our societies
confutes Coase’s theorem to a certain extent: often
bargaining does not take place, not only because of the
failure to assign ownership rights, but due to certain
obstacles that thwart it. Among these are the
transaction costs associated with bargaining (e.g.
acquiring information, negotiating, ensuring the
agreement is respected) which are often extremely
high, and bargaining is therefore not worthwhile.
But at other times, bargaining does not take place
because the agents are both damagers and damaged at
one and the same time. This occurs, as has been seen,
in the case of traffic pollution, both generated and
suffered by the motorist. Another example is
overexploitation of a natural resource to which there is
free access, such as the sea: beyond a certain limit,
fishermen are, at the same time, both winners (higher
profits) and losers (overexploitation and exhaustion of
stocks) through their own fishing activity. In this case,
a form of self-regulation by fishermen could solve the
228
problem, were it not for the possibility of strategic
behaviour and free riding by some agents. The free
rider pursues his own interest to the detriment of other
agents and, therefore, represents a classic obstacle to
the proper management of public assets.
3.3.3 Oil and gas externalities
A thorough examination of the externalities associated
with oil and gas should take into account the entire life
of these two fuels, including the phases of exploration
and of plant closure. The phases which have the greatest
impact on the environment are considered below:
drilling, production and treatment, transport, and use of
fuels in their end-uses and in energy industries.
Drilling
The externalities of this phase mainly concern the
immission into the environment of a volume of
drilling-related waste products. The amount of such
material is around 4,000-8,000 m3 per 1,000 m drilled,
containing: a) cuttings removed from the bottom of the
well; b) exhausted drilling muds which, composed of
water, oil or polymer and stabilizers (lubricants,
surfactants), are used for cooling and lubricating drills,
and for capturing cuttings; c) impure waters, having a
low pollution load (rainwater and plant washdown
water); d ) waters associated with the dewatering of
muds prior to their disposal; e) fluids having a high
polluting load (spent oils and spent acids); f ) gaseous
emissions derived from diesel whose combustion
enables the plant to operate.
Given the considerable mass of substances sent
into the environment, drilling plants are fitted with
waste treatment and disposal systems. For example,
drilling muds, produced at the rate of about 1,300 m3
per 1,000 m drilled, are deposited first in a temporary
collecting basin and then dewatered and purified.
Similarly, fluids having a high polluting load are
stored in a special fluids tank before being disposed of
in compliance with specific legislation.
Waste products from the drilling phase which are
particularly harmful for the environment, include
barite (barium sulphate), used as a weighting material
and which contains heavy metal impurities, and
chromium, present in thinning agents.
Impermeabilization of the soil, by means of
geomembranes or natural bentonite, is the traditional
defence against the penetration of polluting fluids into
aquifers.
Greater problems are caused by offshore drilling,
because of the limits placed on the discharge into the
sea of oily fluids and drilling cuttings, which vary
from one geographical area to another.
ENCYCLOPAEDIA OF HYDROCARBONS

Production and treatment
The extraction of oil and natural gas also involves
the automatic extraction of considerable volumes of
water. Water is present in geological formations where
hydrocarbons are trapped (layer water), it can be
separated during the formation of hydrocarbons
(formation water), or can be reinjected into the deposit
in order to maintain high pressure (process water).
These waters may contain various types of impurities:
heavy metals (e.g. lead and mercury), inorganic salts
(e.g. nitrates and sulphates), aromatic hydrocarbons
(e.g. benzene), phenols, and chemical additives used in
the hydrocarbons treatment phase (e.g. foam
preventers). The current trend is to reinject production
waters into the subsoil, because of the high costs of
treatment if they were discharged into surface water
bodies.
Furthermore, in the production and treatment
phases, emissions produced by gas flaring and gas
venting are released into the air. Emissions due to gas
flaring mostly involve H2O and CO2, while those due
to venting are CO2, CH4, and VOC (Volatile Organic
Compounds).
Options to limit such emissions include prevention
and the optimizing of operations or, ex post, reinjecting
the gases into the deposit or using them as a source of
energy. H2S (hydrogen sulphide), in particular, is a
typical problem of the oil industry, because of its
impact on man and the environment, and due to the
volumes involved, which can be considerable.
Transport
Apart from stray emissions, mainly of methane,
linked to the losses that occur in pipelines, oil spills
also play a particular role among the externalities in
the transport phase, especially because of the possible
scale of such events and their emotive impact on
public opinion. Oil spills are the accidental release of
oil or petroleum products into the sea or into fresh
water. Spills may come from tankers or from oil
deposits, refineries or pipelines. Once spilt, the oil
generally floats on the surface of the water forming a
slick which, as time goes by, becomes thinner and
thinner. The spill spreads fairly quickly and it
increases with the diminishing density of the oil and
any increase in temperature. When the spill takes place
in a river, the oil can sink, due to the lower density of
fresh water compared with sea water. In relation to the
size of the spill and to the sea and wind conditions, the
impact on the ecosystem may be insignificant or
disastrous, above all for marine animals and birds.
The typology of oil also influences the impact on
the environment: lighter oils, which are very volatile,
evaporate in a couple of days but they have a high
capacity to penetrate sands, whereas the heavier ones
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
ENVIRONMENTAL EXTERNALITIES
have a low or zero evaporation capacity and a reduced
capacity to penetrate sands.
Small-scale spills represent a far greater volume of
total oil spilt into the environment than large-scale
spills (90% and 10% of the total, respectively); even
so, the latter are characterized by a stronger emotive
impact.3 Small-scale spills are of varied origin: for
example, they can derive from ordinary shipping
operations, from offshore oil drilling, or from the
dispersion into the environment of the oil used in car
engines. At a worldwide level, compared to total spills,
the transport of crude oil accounts for about 13% and
oil production activity for 2%, while spills connected
with oil consumption and those caused by natural
infiltration from the ocean bed account for 38% and
47% respectively (NRCouncil, 2003).
The size of the spill must not be confused with the
gravity of the damage: sometimes, even if the spill is
very large, the damage to the environment may be
limited by the fact that the accident occurs in the open
sea, far from the coastline.
One of the most serious environmental disasters
resulting from an oil spill, perhaps the worst, was that
involving the US oil tanker the Exxon Valdez, which
had a catastrophic impact on the Alaskan shores, a
fragile ecosystem rich in wildlife.
End-uses and energy industries
Over and above the polluting effects generated in
the drilling, production and treatment, and transport
phases, the most conspicuous element of the
environmental impact of oil and gas is linked to their
end-use and the energy industries (the electricity
sector and refineries). This is due to the widespread
use of these two fuels in every economic sector. In
particular, at a local and regional level, the pollution
associated with the combustion of oil and gas, which
exercises a strong impact on human health,
agricultural crops, materials and forests, is of
considerable importance.
With regard to the impact on human health, a
distinction must be drawn between acute and chronic
effects: the former are associated with a short-term
increase in pollution (e.g. a few days); the latter,
however, are connected with exposure over a long
3 Among the major oil spills are those that involved the
following vessels: the Exxon Valdez (USA), 1989: 39,000 t
of oil spilt off the coasts of Alaska; the Khark 5 (Iranian),
1989: 80,000 t of oil spilt off the Moroccan coast; the Haven
(Cypriot), 1991: 144,000 t of heavy oil spilt in the Gulf of
Genoa; the Aegean Sea (Greek), 1992: 73,500 t in the Bay of
La Coruña (Spain); the Braer (Liberian), 1993: 84,000 t
south of the Shetland Isles; the Erika (Maltese), 1999:
20,000 t along the coasts of Brittany; and the Prestige
(Bahamas), 2002: 63,000 t along the Galician coast.
229
PUBLIC POLICIES AND THE OIL INDUSTRY
period and can appear even years later. In both cases,
an important role is played by powders, sulphur
dioxide and nitrogen oxides, tropospheric ozone,
carbon monoxide and VOC.
Particulates
Total Suspended Particulates (TSP) are solid or
liquid particles whose diameter can vary between
100 mm and 0.005 mm. Those associated with the oil and
gas cycle are produced by traffic and by combustion in
industrial plants or by electricity generation, through the
emission of primary particulates and/or the successive
formation of sulphates (from sulphur dioxide) or
nitrates (from nitrogen oxides) which perform the role
of particulate precursors.
Particulates mainly attack the respiratory system,
as they are concentrated in the nose, throat and
bronchioles, or else reach the lung alveoli. In the latter
case, they may be absorbed by the blood, and thus
become more hazardous.4
Sulphur dioxide and nitrogen oxides
Sulphur dioxide (SO2) derives from the
combustion processes of fossil fuels containing
sulphur. Although oil, and more particularly gas, play
a less significant role than coal, they contribute
towards increasing the level of these emissions.
Sulphur dioxide is produced above all by the
generation of electricity, refineries, steel industry, oil-
fired central heating, and diesel engines. An irritant
with a pungent smell, sulphur dioxide has a negative
impact on human health, in particular on the
respiratory system.
In the short term, high sulphur dioxide
concentrations can cause irritation to the eyes and to
the upper breathing ducts; in the long run, especially if
combined with high PM10 levels, it can cause shortage
of breath and a weakening of the lungs and the immune
system. Moreover, it contributes towards the formation
of particulate matter, being a precursor thereof.
Nitrogen oxides (NOx), and in particular nitrogen
monoxide (NO) and dioxide (NO2), are air pollutants
originating from combustion processes, especially
those at a high temperature (power stations,
combustion plants, petrol and diesel engines).
Nitrogen dioxide also contributes towards the
formation of photochemical smog.
The effects of nitrogen oxides on human health are
similar to those of sulphur dioxide, mainly affecting
the respiratory system (asthma, bronchitis, pulmonary
emphysema). NOx are also harmful for plants, causing
the leaves to fall.
Sulphur dioxide and, more generally, sulphur
oxides (SOx), ammonia (NH3) and nitrogen oxides
(NOx) play an important role in the phenomenon of
230
acid rain. Released into the atmosphere, the oxides
come into contact with water, generating a series of
acids (sulphurous, sulphuric, nitrous, nitric, carbonic)
which reduce the pH values, making atmospheric
precipitations acid. Acid depositions can occur in wet
form (rainfall, snow) or dry. In this latter case,
acidification takes place on the ground, after the
polluting particles have been deposited on the ground.
In the first place, acid rain causes damage to
forests, reducing their photosynthesis capacity and
eroding the leaves of the trees. Various countries are
affected by acid rain, including Germany, the United
Kingdom, the Scandinavian countries, the eastern
United States and Canada. In Italy it is estimated that
it has damaged about 10% of all wooded areas. Acid
rain also damages buildings (corrosion of
monuments), human health (damage to the respiratory
system and to the circulatory system) and fauna. With
regard to the latter, fish living in acidified rivers and
lakes are particularly affected, dying when the pH of
the water drops to around the value of 4.5.
Lastly, acid rain renders elements such as
aluminium, nickel, lead and cadmium more soluble,
and these penetrate the soil and enter the food chain,
causing damage to animal and human health. Since
they form in the atmosphere, acid particles can be
transported by wind for distances of more than a
thousand kilometres, and thus the place where oxides
are emitted and the place where precipitation takes
place may not coincide.
Acid rain is thus a typical phenomenon of
transboundary externality, which makes it difficult to
control, both due to the involvement of a number of
countries and to the intrinsic uncertainty of the
transport of polluting substances in the atmosphere.
4 Conventionally, reference is made to inhalable
powders, that is Particulate Matter (PM) smaller in size than
10 mm (PM10), for which the European Union (European
Council, 1999) has defined, as from 2005, the following
standards: mean annual standard, 40 mg/m3; mean daily
standard in 24 hours, 50 mg/m3; number exceeding the daily
standard in one year, 35. Indicative objectives, as from
2010, are 20 mg/m3, 50 mg/m3 and 7, respectively.
According to the EEA (EEA, 2002), in the European Union
(with 15 Member States), about 50% of PM10s (primary
particulates and secondary particulates) are produced by
road transport and by the energy industries, and are
characterized by an appreciable downward trend. Less, but
increasing, attention is given to inhalable particulates
(PM2.5s) which, smaller in size than PM10s, are able to
penetrate as far as the lung alveoli. The numerous dose-
response studies conducted to assess the PM10/mortality
ratio, while not univocal, suggest that an increase of 10
mg/m3 causes an increase in daily mortality of between
0.5% and 1.5%. In the eight largest Italian cities the
concentration of PM10s of more than 30 mg/m3 would cause
about 3,500 deaths a year (WHOE, 2002).
ENCYCLOPAEDIA OF HYDROCARBONS
 ENVIRONMENTAL EXTERNALITIES

Table 1. Comparison between air quality standards in the European Union and the United States
(Hayward, 2004)

Exceedence target
Standard mg/m3
(day/year)
EU USA EU USA
Ozone (8 h) 120 157 26 1
PM10 (24 h) 50 150 35 1
PM2,5 (annual average) none 15 n.a. 1
SO2 (24 h) 125 365 4 1
NO2 (annual average) 40 100 none 1
NO2 (1 h) 200 none 20 not available
CO (8 h) 10 10 none 1

The limits to concentrations of sulphur dioxide and ozone concentration, therefore, tends to follow both a
nitrogen dioxide tend to be more rigid in the European seasonal and hourly course, i.e. it increases in the
Union than in the United States, although the USA summer months and, during the course of the day,
shows greater severity with regard to exceeding the reaches its highest values in the hottest hours, between
limit (Table 1). In both areas, in particular in Europe, the end of the morning and the early afternoon,
significant reductions have been recorded in emissions especially when the airspeed is low. In high
of both nitrogen oxides and sulphur dioxide (Table 2). concentrations, ozone damages the respiratory system,
With regard to sulphur dioxide, these reductions are irritating the nose and the throat and causing breathing
due to the increasing use of natural gas in the energy difficulties, especially for those already suffering from
industries and in the residential sector, as opposed to respiratory disorders, e.g. pneumonia, chronic
coal and oil; for NOx, on the other hand, the reductions bronchitis, asthma. It also has a damaging effect on
are the effect of abatements achieved in the transport monuments and buildings, and a harmful impact on
sector and in electric power stations.
In part, the decreases in emissions have been
prompted by control policies set up in various areas. In Table 2. Emissions reductions in European areas
Europe, some countries (including Sweden, Norway from 1980 to 2000 (EMEP, 2004)
and Denmark) have set up forms of control of SO2
and NOx levels based on taxation, while in the United Countries SO2 (%) NOx (%)
States the regulator has adopted specific programmes Czech Republic, Hungary, Poland,
(e.g. the Acid Rain Programme; the Ozone Transport 73 42
Slovakia
Commission, OTC; and the REgional CLean Air
Austria, Switzerland, Germany 89 49
Incentives Market, RECLAIM), based on negotiable
pollution permits, to control the emissions of both Estonia, Latvia, Lithuania, Russia
73 21
sulphur dioxide and nitrogen oxides. (European part)
Denmark, Finland, Iceland, Norway,
87 21
Tropospheric ozone Sweden
The ozone (O3) present in the stratosphere (the Belgium, Luxembourg, Netherlands,
upper layer of the atmosphere) performs an essential 76 36
Ireland, United Kingdom
function for man, as it screens the Sun’s ultraviolet
rays. At lower levels, however, in the troposphere, France, Greece, Italy, Portugal, Spain 62 4
ozone has a harmful effect. It constitutes a secondary Albania, Armenia, Belarus, Bosnia
pollutant, formed by chemical reactions between the and Herzegovina, Bulgaria, Croatia,
Cyprus, Georgia, Kazakhstan,
following precursors: nitrogen dioxide (NO2), carbon 40 26
Moldova, Romania, Slovenia,
monoxide (CO), methane (CH4) and Non Methanic Macedonia, Turkey, Ukraine,
Volatile Organic Compounds (NMVOC). Yugoslavia
The photochemical reactions that give rise to ozone
Total Europe 67 24
are influenced by sunlight and air temperature. The

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PUBLIC POLICIES AND THE OIL INDUSTRY

plants, stunting their growth and, at high
concentrations, causing necrosis of the leaves.
Carbon monoxide and VOCs
Transport and, to a lesser extent, the steelmaking
industry, refining and papermaking are among the main
causes of carbon monoxide (CO) emissions. Carbon
monoxide is a highly noxious pollutant which binds with
the haemoglobin naturally present in blood and forms
carboxyhaemoglobin, thereby reducing the capacity of
the blood to convey oxygen to the body cells.
The main effects on human health depend on the
level of concentration of the CO absorbed. They range
from headaches, dizziness, nausea and fatigue to
urinary and faecal incontinence, loss of memory and
neurological damage, which may be fatal
(concentrations greater than 500 mg/m3). A standard of
10 mg/m3 over 8 hours is set in both the European
Union and the United States.
NMVOCs are other pollutants produced by
transport and industrial processes. These include
ethane, propane and butane. In general, VOCs can be
aliphatic or aromatic hydrocarbons. Among the latter
is benzene, a colourless liquid that can be absorbed by
man both orally and by inhalation, and is carcinogenic.
VOCs also contribute towards the phenomenon of
photochemical smog which generates ozone.
A summarized list (concerning Italy) of the
pollutants associated with each phase of the gas and
oil cycle for the generation of electricity is set out in
Tables 3 and 4.
3.3.4 Assessment of externalities
The definition of an optimal pollution level, which
could be an objective for the regulator, is linked to the
possibility of comparing the benefits of the polluting
activity with pollution costs (see again Fig. 1).
However, monetizing environmental damage is an
extremely complex operation.
Willingness to pay and willingness
to accept compensation
The two concepts that measure environmental
damage in monetary terms are Willingness To Pay
(WTP) in order to avoid environmental damage, and
Willingness To Accept (WTA) compensation for
environmental damage suffered. In more rigorous terms,
these are the Hicksian measures of consumer surplus (or
the difference between the price that a consumer would
be prepared to pay for a given quantity of a good, and
that actually paid), which make reference to the concepts
of compensative variation and equivalent variation. The
former represents the sum of money which, taken from
the agent, prevents the occurrence of environmental
damage in the future (WTP), while the latter represents
the amount of money that should be given to the agent to
compensate him for the loss of well-being following
environmental damage (WTA).
Numerous studies, both empirical and theoretical
(Bishop and Heberlein, 1979; Hanemann, 1991;
Shogren et al., 1994), show that these two measures
are not equivalent, the former being higher than the
latter. David Brookshire and Don Coursey (1987) have
evidenced that the difference between WTA and WTP
may be considerable (between 2.4 and 61 times), while
John Horowitz and Kenneth McConnell (2002) have
observed that the WTA/WTP ratio is higher for public
goods than for private ones.
The divergence between WTA and WTP originates
in both the economic sphere and that of psychology.
The income effect and the substitution effect are
examples of the former, as well as the possibility of

Table 3. Gas cycle in Italy, emissions into the air (g/kWh) (Feem, 1997)

Production Power
Pollutant Drilling Transport Total
and treatment generation
SO2 neg neg neg Neg neg
NOx 0.0031 0.010 0.011 0.44 0.46
CO neg 0.0049 0.0043 0.22 0.23
CO2 0.20 8.42 1.73 432.9 443.3
PTS neg neg neg neg neg
COV nq nq neg 0.038 0.038
CH4 neg neg 0.15 0.029 0.18
N2O nq nq nq 0.003 0.003

neg, negligible; nq, not quantified

232 ENCYCLOPAEDIA OF HYDROCARBONS

 ENVIRONMENTAL EXTERNALITIES

Table 4. Oil cycle in Italy, emissions into the air (g/kWh) (FEEM, 1997)

Drilling Transport Transport Electricity

Pollutant Refining Total
and production of crude oil of fuel oil generation
SO2 0.0045 0.04 0.17 0.83 1.12 2.16
NOx 0.0034 0.04 0.067 0.32 0.56 0.99
CO nq nq 0.006 neg 0.084 0.090
CO2 5.93 3.0 35.7 35.1 693.2 772.9
PTS neg neg 0.0088 0.025 0.14 0.17
COV 0.013 nq 0.046 1.39 0.028 1.48
CH4 0.021 neg 0.0022 neg 0.018 0.041
N2O nq nq nq nq 0.002 0.002

neg, negligible; nq, not quantified

protest against payment of a sum of money for damage
suffered (Mitchell and Carson, 1989) and the fact that
WTP, unlike WTA, is limited by balance sheet
constraints. The latter includes the theory of cognitive
dissonance and the prospect theory of Daniel
Kahneman and Amos Tversky (1979), who show that
in the sphere of gains agents behave differently
compared with the sphere of losses: a greater value is
attached to the loss of a good than to the gain deriving
from acquiring the same good.
At an operational level, the possibility of very high
WTA values, and, consequently, overly burdensome
financial compensations for environmental damage
imposed on enterprises, has prompted certain
prestigious economists, such as the two winners of the
Nobel Prize in Economics, Kenneth Arrow and Robert
Solow, to suggest the use of WTP in monetizing
externalities (NOAA, 1993).
Total economic value
The willingness to pay to protect an environmental
good (e.g. a nature reserve) against possible damage
reflects the Total Economic Value (TEV) of the good.
The TEV is the sum of three values: use value, option
value, and existence value.
The first of these refers to the current use of the
good (e.g. collecting firewood), the second to a
potential use in the future (e.g. visiting the park in ten
years’ time), and the third to the willingness to pay
simply for the existence of the good, quite apart from
any use, present and future.
Consideration of the option value, and even more
of the existence value, poses numerous conceptual and
operative problems. Ample literature exists on the
concept of option value, and on the more subtle one of
quasi-option (the value of the information made
available by the preservation of a natural resource),
focused both on the conditions of its existence and on
the role of uncertainty, and on the question of its sign,
positive or negative (Freeman, 1993).
As far as existence value is concerned (Krutilla,
1967), while some authors (Pearce and Turner, 1990)
maintain this stems from an altruistic attitude of the
agents and is a highly significant concept, others
(Cummings and Harrison, 1995; Weikard, 2002)
believe it to be a useless concept, and weak at an
operational level. This clash of opinions is of great
importance because of its practical implications: taking
into account the existence value can significantly alter
the monetary valuation of environmental damage.
A prime example of this is the environmental
incident involving the Exxon Valdez oil tanker which, in
1989, spilt about 257,000 barrels of crude oil along the
Alaskan coastline. In computing the environmental
damage, account was also taken of the existence value.
This choice sparked a debate – of a scientific as well as
legal nature – between the Exxon company, the State of
Alaska and the United States Government. In particular,
the concept of existence value and the possibility of
measuring it were attacked in a study sponsored by
Exxon (Desvouges et al., 1993), which constitutes a
point of reference for literature on the subject.
Another key problem in monetizing environmental
damage is that concerning the operation of discounting,
which tends to assign less weight to damage that takes
place in the future than to that which occurs at present.
In other terms, the extension of the traditional
discounting operation to the environmental field
constitutes an implicit discrimination vis-à-vis future
generations and, therefore, a negation of the concept of
sustainable development.
These limits have been pointed out at different
times by many experts who have questioned the two
sources of the discounting operation: time preference

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PUBLIC POLICIES AND THE OIL INDUSTRY
and social opportunity cost. With regard to time
preference, which summarizes the preference assigned
by agents to the consumption of a good today rather
than in the future, some authors (Pigou, 1920; Strotz,
1956) have pointed out that the impatience from which
this time preference stems is irrational. With regard to
social opportunity cost, which reflects the productivity
of capital over time, some authors have criticized the
implicit assumption that returns stemming from the
investment of capital are wholly reinvested from one
period to another and not consumed (Parfit, 1983).
The broad range of critical literature on the social
discount rate, which is at times highly critical (Cowen
and Parfit, 1992) and at times more moderate
(Markandya and Pearce, 1991), reflects the complex
nature of the question and the central role that
discount operation plays within the context of the
environmental debate.
Valuation techniques
Apart from the theoretical problems illustrated
(option value, existence value, discount rate), the
monetizing of environmental damage is characterized
by considerable difficulties of measurement. Basically,
three valuation techniques are available: hedonic
prices, travel costs and contingent valuation.
The first two monetize the value of the
environment. There is no reference market for these, so
recourse is made to a surrogate market. In the case of
hedonic prices, the market concerned is that of
property. This technique is based on the idea that, other
conditions being equal, property prices tend to increase
with improved environmental quality, and hence reflect
this. The clause ‘other conditions being equal’ is
extremely important, as the market value of property is
affected not only by the quality of the environment, but
also by other classes of variables: the property
(characteristics and size of the houses); neighbourhood
(characteristics of the district, availability of services);
access (availability of means of transport, quality of
transport links with the town centre). Therefore in some
cases, such as urban areas, it may be that property
prices are high in spite of poor environmental quality;
whereas in rural areas characterized by high
environmental quality, they might be low. This occurs
because of the influence that other non-environmental
variables exercise on house prices.
The technique of hedonic prices consists in making
statistical estimates in order to assess to what extent
each variable, including environmental, influences the
price of property. As an example, we may consider the
historic series of property prices in an area, or we may
refer to prices in a number of areas in the same year
(cross section). In this way, given a certain amount of
properties, and explaining to what extent the variation
234
in their overall monetary value depends on the quality
of the environment, it is possible to monetize the use
value of the environment. Naturally, such exercises are
quite complex, as they inherit all the technical
problems of the statistical survey, including the
possibility of correlation between explicative variables
and/or of omission of important variables.
Furthermore, the possible imperfection of the property
market, the low mobility of agents and the imperfect
information on environmental damage can
significantly undermine the monetizing of
environmental quality. The reliability of the hedonic
prices technique would, however, increase if the
variation in house prices were linked to the occurrence
of a precise event of an environmental character (e.g.
damage to a seashore following an oil spill).
The technique of travel costs is similar to that of
hedonic prices. It is used mainly for the valuation of
places of recreation (e.g. parks), and uses as its
surrogate market the expenses incurred by agents to
reach such places. Among the difficulties inherent in
this technique are the following: statistical obstacles
(linked both to the heterogeneity of the data surveyed,
and to estimating it); identifying the classes of travel
expenses to be considered (e.g. fuel, road tolls, car
wear and tear, car insurance); monetizing the
opportunity cost of the free time used to visit the place
to be assessed; and identifying the imaginary travellers
for whom the visit is not the main objective.
The third technique, that of contingent valuation,
differs from the other two in that it does not consider a
surrogate market, but derives the value of the
environmental good through an interview. This
technique is characterized by great flexibility which
permits the assessment of numerous classes of goods
and environmental damage, succeeding in capturing
not only current use values, but also option and
existence values. It has also been used, particularly in
industrializing countries, to assess public goods and
infrastructures (e.g. sewerage systems, waste collection
service, drinking water), whereas in industrialized
countries it has been used mainly to evaluate
environmental assets and environmental policies.
The questionnaire is presented in a direct interview
or, less frequently, by mail or telephone. Traditionally,
it is made up of three sections: an introduction,
containing information and questions on the
respondent’s environmental attitudes; a central section,
in which the question on the WTP for a certain good is
asked; and a conclusion with questions on the
respondent’s socio-demographic characteristics. The
question on the WTP may be put by means of: a) an
open question; b) a bidding game, starting with a WTP
value proposed by the interviewer which the
interviewee may accept, in which case an increase will
ENCYCLOPAEDIA OF HYDROCARBONS

follow, or refuse, in which case a reduction will
follow; c) cards, when the respondent chooses among
various monetary values of reference indicated on a
card, some of them showing how much the interviewee
already pays for certain public services; d ) take it or
leave it, in which the respondent has to choose
whether to accept (take) or refuse (leave) a price drawn
at random from a variety of pre-defined prices.
The main intrinsic limit to contingent valuation is
its hypothetical nature, i.e. the fact that the interview
does not give rise to any real payments (Seip and
Strand, 1992). In addition, there could be an
information problem as in many cases the interviewee
does not have direct knowledge of the good (e.g.
assessing a public policy or a species threatened with
extinction). More generally, the technique of contingent
valuation is hampered by possible biases, the most
important of which are (Mitchell and Carson, 1989):
• Strategic bias, linked with phenomena known as
free riding (the declaration of a lower WTP than
the real one, expecting other interviewees to pay
for the proposed good) and overpledging (the
declaration of a higher WTP than the real one so as
to positively influence the offer for the good
valued, in the belief that there is no relation
between what is declared and the possible real
future payment).
• Starting point bias, namely the possibility that the
declared WTP values may be conditioned by
values proposed in the bidding game.
• Payment vehicle bias, i.e. the probability of a
protest answer (lower WTP than the real one)
associated with an instrument of payment (e.g. tax)
which instead ought to be neutral.
• Budget constraint bias, i.e. the possibility that the
respondents may express their WTP making
reference not to their own economic situation, but
to a hypothetical balance sheet constraint.
• Part-whole bias (known as embedding), namely the
possibility of ample variations in the declared WTP
according to whether the good is valued in
isolation or as part of a larger set of goods.
• Symbolic bias, i.e. the possibility that the specific
good being valued is regarded by the respondent as
a symbol of the environment in general, giving rise
to an excessively high valuation.
With respect to WTP, each of these biases can lead
to systematic errors (non validity) and/or random
errors (non reliability). The possibility of errors which
would invalidate the results, together with the Exxon
Valdez episode, brought contingent valuation into the
centre of a wide-ranging debate (Hausman, 1993;
Bjornstad and Kahn, 1996) which had major
operational repercussions, to the extent that the
National Oceanic and Atmospheric Administration
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
ENVIRONMENTAL EXTERNALITIES
(NOAA, 1993) of the United States set up a study
group (NOAA Panel) with the task of defining
guidelines for contingent valuation.
Among the NOAA Panel’s suggestions, the
following should be pointed out: a) the direct
interview, carried out by an interviewer; b) a pre-test,
prior to the survey proper, aimed at identifying
possible effects induced by the interviewer or by the
use of photographs; c) carrying out the interviews long
after the event that caused the damage, so as to
mitigate the influence of emotional reactions on the
part of the interviewees; d ) the advisability of
reminding the respondent of the existence of
substituted goods; e) the production by the Federal
Government of standard reference surveys and values,
in particular for oil spills, that can be adopted as a
reference for subsequent contingent valuation studies.
In the literature on environmental damage
assessment, attention is drawn to the dose/response
approach which, while not arriving at an effective
monetization of the damage, does aim to define in what
measure a certain quantity of pollutant (dose) has an
effect on human health (response), in terms of mortality
and morbidity. Having defined this effect, the
monetization of damage to human health and of death is
a further, complex exercise, involving such concepts as
VSL (Value of Statistical Life) and YOLL (Years Of Life
Lost), which necessarily takes place at a level in which
moral values and, more generally, ethics are involved.
In such a context, ExternE (Externality from
Energy) certainly represents a point of reference in the
literature on assessing environmental damage caused
by energy. ExternE is a research project of the
European Commission (European Commission
1995a,b, 1999a,b, 2003) targeted at monetizing
externalities stemming from the use of energy. The
study is characterized by its length and complexity
and, starting from a common methodology, it arrives at
monetizing the externalities of the various fuels at an
individual European country level. A possible impact
pathway of pollutants adopted by ExternE is illustrated
in Fig. 3, which offers a summarized picture for
assessing environmental externalities, showing the
various and numerous critical steps of the process,
from the polluting emission to the monetized
environmental damage.
Each step is the object of quantitative analysis,
often using models, and this confirms how complex
and uncertain the operation of monetizing externalities
is. The values that emerge, therefore, must necessarily
be interpreted as a rough guide. Table 5 sets out, for the
production of electricity in various countries, the
monetized externalities associated with the various
energy sources: the environmental damage associated
with the gas cycle and with the oil cycle is between 1-4
235
PUBLIC POLICIES AND THE OIL INDUSTRY

emission
transport and atmospheric chemistry
inputs to land and water
the city and to the fuel used (European Commission,
2003): for cars using gasoline, it is between about
0.8 €/100 pkm5 (Helsinki) and 1.7 €/100 pkm
(Brussels); for cars using diesel, between about
1.3 €/100 pkm (Helsinki) and 5 €/100 pkm (Athens).

impact on land and water (e.g. pH of water) 3.3.5 Climate change

impact on flora and fauna
welfare losses
(commercial losses, mitigation costs,
recreational values, existence value)
Fig. 3. From emission to environmental costs
(adapted from European Commission, 1999a).
and 3-11 cents of one euro per kWh, respectively.
These are lower values than those of coal damage but,
with the exception of peat, higher than those of other
energy sources. As far as passenger transport is
concerned, including the cost of vehicle production and
fuel in the externality of atmospheric emissions, the
value of damage in the urban cycle varies in relation to
Within the context of externalities in the gas and oil
sector, climate change, i.e. the variation in the
climate attributable to human influence on the
composition of the atmosphere, is of particular
importance. This influence is said to increase the
natural greenhouse effect which, induced by certain
greenhouse gases present in the atmosphere (carbon
dioxide, water vapour, methane, nitrogen oxide and
ozon), makes life possible on Earth, keeping the
temperature of the planet about 30°C higher than it
would be without the gases. In particular, human
activity, especially that entailing the combustion of
5 Passengers per kilometre (pkm) is the unit of
measurement of transport demand; it indicates the trip of one
passenger per km, calculated as the sum of the products of the
number of passengers transported by the relative distances.

Table 5. Externalities (includes climate change, public health, employment, damage to materials)
of production of electricity using various fuels (cent €/kWh) (European Commission, 2003)

Coal
Country Peat Oil Gas Nuclear Biomass Hydroelectric Solar Wind
and lignite
Austria 1-3 2-3 0.1
Belgium 4-15 1-2 0.5
Denmark 4-7 2-3 1 0.1
Finland 2-4 2-5 1
France 7-10 8-11 2-4 0.3 1 1
Germany 3-6 5-8 1-2 0.2 3 0.6 0.05
Greece 5-8 3-5 1 0-0.08 1 0.25
Ireland 6-8 3-4
Italy 3-6 2-3 0.3
Norway 1-2 0.2 0.2 0-0.25
Netherlands 3-4 1-2 0.7 0.5
Portugal 4-7 1-2 1-2 0.03
United Kingdom 4-7 3-5 1-2 0.25 1 0.15
Spain 5-8 1-2 3-5* 0.2
Sweden 2-4 0.3 0-0.07

* biomass burnt together with lignite

236 ENCYCLOPAEDIA OF HYDROCARBONS


fossil fuels, is said to intensify the natural
greenhouse effect, causing global warming.
Oil, gas and coal, when burned, emit carbon
dioxide (CO2), the main cause of global warming.
Greenhouse gases have a different potential for climate
change (Global Warming Potential, GWP): CO2, for
example, has a GWP equal to 1, methane (CH4) equal
to 21 and dinitrogen oxide (N2O) equal to 310. Hence,
CO2 plays a major role because of the considerable
– and increasing – volumes emitted globally (in 2002,
53.8% compared to 1973) as an effect of increasing
energy consumption (in 2002, 69.5% compared to
1973). Coal, oil and gas have decreasing coefficients
of carbon dioxide emissions: 4.11 (anthracite), 3.07
(crude oil), and 2.35 (dry natural gas) respectively.
Although consensus as to the existence of man-
made global warming has increased in the last 15 years,
there is still a lively on-going debate about climate
change. At least three of the points under discussion
deserve mention: the temperature measurement; the role
of cosmic radiation and of the Sun; and the relation
between anthropogenous emissions of greenhouse gas
produced and temperature.
With regard to the first point, it should be noted
that terrestrial temperature can be measured in
alternative ways: on the Earth’s soil, with radiosonde
balloons, and by means of satellites. Temperatures
measured at the Earth’s surface (which began to be
recorded in 1856) indicate an increase in the average
terrestrial temperature of between 0.4° and 0.8°C.
More recent measurements, using balloons (since
1957) and satellites (since 1979), contradict to a
certain extent those on the surface. With regard to the
second point, some experts (Fastrup et al., 2000) have
stressed that the temperature increase could be the
effect of fewer clouds, which in turn is determined by
a flow of cosmic radiation weakened by natural
variations in solar activity. On the third point, there is
uncertainty both as to the role of the oceans in
absorbing carbon dioxide, and that of aerosols in the
water vapour condensation process and, therefore, in
the formation of clouds, an element which influences
the climate by reflecting sunlight in space.
Lastly, mention must be made of the innate
difficulty of forecasting the effects of a possible
increase in temperature on sea level increases, rainfall,
regional climate variations, agricultural production, the
ecosystem and, in general, on society and the economy.
The existence of a scientific consensus on the
hypothesis of global warming has been contested by
two Declarations (Leipzig, November 1995; Bonn,
November 1997), signed by about a hundred scientists,
emphasizing that satellite measurements did not show
any increase in temperature. The considerable intrinsic
uncertainty concerning climate change is also
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
ENVIRONMENTAL EXTERNALITIES
recognized by the IPCC (Intergovernmental Panel on
Climate Change), a body set up in 1988 by UNEP
(United Nations Environment Programme) and by
WMO (World Meteorological Organization), which
does, however, consider that there is robust scientific
evidence of the predominant role of anthropogenous
activities in temperature increases over the last fifty
years. In its third report on climate (Watson, 2001), the
IPCC forecasts for 2100 a temperature increase of
between 1.4° and 5.8°C and an increase in sea level of
between 0.09 and 0.9 metres. This is said to depend on
the increased concentration of carbon dioxide in the
atmosphere, predicted to rise to 540-970 ppm in 2100,
against 280 ppm in the preindustrial age and 368 ppm
in the year 2000. It is this uncertainty connected with
climate change which indicates that there is room for
implementing the precautionary principle, according
to which, when threatened by irreversible damage to
the environment, the lack of complete scientific
certainty should not be used as a reason for postponing
preventive measures.
Absorbed into Principle 15 of the Rio de Janeiro
Declaration, one of the products of the United Nations
Conference on Environment and Development
(UNCED) in 1992, the precautional approach played an
important role in the United Nations Framework
Convention on Climate Change (UNFCCC). This
international treaty came into force in March 1994, and
three years later, in December 1997, gave rise to the
Kyoto Protocol. In fact, the Protocol defines legally
binding limits to greenhouse gas emissions in the
countries listed in Annex I, that is, the industrialized
countries of Europe, North America and the Pacific
area. The importance of the Protocol lies in the fact that
by limiting carbon dioxide in the first place, it involves
the combustion processes of fossil fuels and, therefore,
it has a direct impact on all sectors of the economy.
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San Donato Milanese, Milan, Italy
ENCYCLOPAEDIA OF HYDROCARBONS
 4.1
Market structures
and price policies in the oil and gas
industry: the case of oil
4.1.1 Introduction
The price of crude oil and the process used to
determine it have been the subject of continued
interest from at least the end of the Second World War.
Following the defeat of the Axis powers in 1945,
control of world oil shifted to seven major integrated
companies. The prices these companies charged for
products to consumers in nations recovering from the
war’s destruction raised the hackles of many
governments (Adelman 1972; Levy 1982; Skeet 1989).
Their interest increased dramatically when crude
prices quadrupled, shortages occurred, and
oil-exporting countries began to exert a more
dominant market role after the Yom Kippur War and
Arab Embargo of 1973.
That interest has been sustained for forty years
even as the market changed. Over four decades, the
oil market has evolved from one administered by a
“clumsy cartel” (Adelman 1993) to a true
commodity market where prices are ‘discovered’
through trading on organized futures markets and
less formal over-the-counter markets. Throughout
this period, a group of oil producers has attempted to
influence prices, succeeding sometimes and failing
at others.
This paper traces the theories regarding how oil
prices are determined, comparing them with actual
market developments. The picture that emerges is one
of theories almost always being developed to explain
past events, while offering very poor predictions for
the future.
The paper begins by examining economic theories
regarding how oil prices are set. Over fifty years, these
hypotheses have evolved from simple to
extraordinarily complex ones. They share a general
characteristic, though, regardless of complexity; they
produce terrible forecasts.
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
The paper’s second section turns to theories of
oligopolistic coordination and administered prices.
Behavioural economists have offered explanations that
rely less on strict theory and more on an understanding
of market structure. At times, this school of thought
has done better; however, behavioural predictions have
also failed. The difficulty in forecasting oil prices
stems from oil’s transformation into a commodity.
Economic theorists postulating complex oligopoly
theories for oil price determination invariably neglect
one point: crude prices are derived from an arbitrage
relationship between crude and products. The
heterogeneous nature of crude oil, the skewed
geographical disruption of reserves, the changing
relative demand for petroleum products, and the
absence of complete vertical integration make it
almost impossible to manage crude prices at all times.
Indeed, attempts to manage markets are certain to fail
when surplus capacity is exhausted at any point in the
distribution chain.
The conclusion examines how OPEC has
responded to changing conditions and the
organization’s effect on prices.
4.1.2 Economic theories of price
setting in the oil industry
There is a rich literature on how oil prices are
determined, though much of it became irrelevant as
soon as it was published. Economists have presented
numerous different models of oil price determination
over the last forty years showing how a stylized oil
cartel should allocate production. These theoretical
models will be summarized below. However, the
analysis begins not with work published following the
1973 embargo, but with a volume published
twenty-seven years earlier.
239
MARKET STRUCTURES AND PRICE POLICIES IN THE OIL AND GAS INDUSTRY
Early theories on oil price determination
Frankel sketched out the fundamental problem
confronting oil producers: abundance. He reported that
the oil industry has generally confronted a situation
where the oil available to the market exceeds demand.
Frankel also recognized that the industry needed to
control the volume of crude oil production and
refinery construction, a fact that most economists
writing thirty years later missed: “The Majors are, as
we have seen over and over again, always eager for a
certain stability of the market. In this particular
instance, they want it even more than usual because
they know that sudden outbursts of flush production
create circumstances which favour the mushroom
growth of smaller refineries near the fields which get
their chance whenever and wherever a local one brings
prices down to a level below the national average”
(Frankel, 1946).
Frankel hints at a basic arbitrage relationship
underlying petroleum economics: the link between the
value of petroleum products to buyers and the prices
refiners are willing to pay for crude oil. In a
competitive market, refiners should be unwilling to
pay more for a barrel of crude than they can derive
from the value of products produced from the crude
and sold on the wholesale market (Adelman 1972).1
Frankel emphasized that it was in the
multinational’s interest to keep refinery construction
from becoming excessive. He suggested that product
prices would decline if too many refineries were built
and put into operation. The product price decrease
would reduce what refiners were willing to pay for
crude. Frankel also noted that some form of control
over crude oil production was required to limit the
potential drop in petroleum prices when product
supply from world refiners might exceed present
demand at current prices. He notes that before the
Second World War, the major multinational oil
companies (by which he meant Standard Oil of New
Jersey, Shell, and British Petroleum) had been the
market’s great eveners: “Their almost complete hold
on such critical producing fields as those of
Venezuela, Persia and Iraq made it possible for them to
open up and shut down production according to
market requirements” (Frankel, 1946).
Looking forward from 1944, Frankel foresaw the
need for a global agreement on oil, and noted that
some of the victorious allies proposed creating an oil
cartel. He suggested, essentially, an agreement through
which producers and consumers would cooperate to
maintain a relatively stable oil price. Such an
agreement, which some might characterize as a cartel,
was negotiated between the United Kingdom and the
United States in 1944. It contained the following
paragraph: “The governments of the USA and the UK
240
recognize that supplies of petroleum should be derived
from the various producing areas of the world, with
due consideration of such factors as available reserves,
sound engineering practices, relevant economic
factors, and the interests of producing and consuming
countries, and with a view to the full satisfaction of
expanding demand” (Frankel, 1946).
The concept put forward was not that different
from the proposal advanced by John Maynard Keynes
for stabilizing various commodities following the end
of the Second World War. Keynes was concerned with
meaningless short-period price swings and the
business cycles. He suggested creating buffer stocks
managed by an international organization that would
release supplies onto the market when prices rose
above a specified level, while buying from producers
when prices fell below a second stipulated threshold.
Keynes proposed financing the stocks through an
international credit union, a concept structured along
the lines of the International Monetary Fund (founded
two years after the idea; McNicol, 1978). President
Roosevelt vetoed the idea of a stabilization
programme (Frankel, 1946).
The period between the end of the war and 1960
was one of decreasing real oil prices as new
discoveries were made in countries such as Libya and
Algeria. The price decline led a group of major
producing nations to form the Organization of
Petroleum Exporting Countries (OPEC) in 1960. Levy
explained that the aim of the countries joining OPEC
was “to gain a voice and, possibly, even control over
posted prices for crude oil” (Levy, 1982).2 Levy
explained that the nations joining the organization
sought to create a system of prorationing3 production
to raise prices and income for themselves. Levy
argued that such controls were inadvisable and
1 Thomas (1982) provides a detailed explanation of
the calculation’s mechanics. The amount a refiner should
be willing to pay for a barrel is referred to as the netback.
Netbacks are calculated by taking the value of products
derived from a barrel of crude computed by multiplying
the share of each product times the product’s spot price,
and then subtracting refining and transport costs. For
example, if a barrel of crude produced two products
(A and B), in a physical mix of 66 % A and 33 % B, one
would multiply the price of A by 66 and add to that
33 times the price of B.
2 The original article was published in «The Economist»
on 19 August, 1961, under the title World oil in transition.
3 The term prorationing was introduced in the 1930s
when some states in the United States introduced a system
of oil conservation regulations. Producers were required to
reduce the output of oil below capacity to cut supplies
available to the market, thereby stabilizing prices.
Production was rationed by a government authority, meaning
that producers were allowed to pump only a fraction of their
capacity (Lovejoy and Homan, 1967).
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unnecessary. In a truly prophetic paragraph, he wrote:
“Oil stands in sharp contrast to many other primary
commodities moving in international trade, for which
production, prices, and employment have fluctuated
drastically within short periods of time. Oil, on the
other hand, has enjoyed a rapid and steady growth in
demand, relatively stable prices, and made an
unparalleled contribution to the revenues of producing
governments. For all these reasons, and also because
of the difficulties in resolving a range of political
issues, it is unlikely that any effective prorationing
scheme will be established in the near future” (Levy,
1982).
Levy and most other authors writing around
1960 seemed certain that the effort of oil producers
to control the market and force prices higher would
fail; they were right. Adelman (1972) estimates
that arm’s-length prices declined until 1969, but
there was no clear cause. Markets seemed to
become more competitive with the entry of new
producers such as Libya, and costs also seemed to
decline. With the exception of Adelman, though,
no one attempted to explain the fall in prices. In his
view, prices were driven down by the entry of low-
cost producers. Prices dropped until these
producers chose to restrain output and send prices
higher. “From the Second World War to 1973,
growth in new low-cost oil-producing areas greatly
outstripped growth in the high-cost areas. That is
how a competitive system operates to save
resources; then came the reversal. The lowest-cost
producers (members of OPEC) cut back
investment and output, producing only what they
could sell at current prices” (Adelman, 1995).
Adelman goes on to note that the behaviour of the
producing nations contradicted many economic
theories. In particular, he suggests that producing
countries would have high discount rates and thus seek
immediate gratification in the form of higher income
by maximizing production. He then ruefully concludes:
“There is no way to explain the price upheavals by
higher demand, deficient supply, changes in
discounting, or political objectives. The only story that
makes sense is that the sellers achieved some degree of
market control: monopoly” (Adelman, 1995).
Optimization models of oil price determination
The price increase in 1973 drew more attention to
the oil market, and generated a large number of papers
purporting to explain OPEC’s approach or the
strategies the authors believed OPEC should apply.
The first attempts to use economic theory to
predict the direction of oil prices, following the
1973-74 price escalation, applied the classical theory
of monopoly to the problem. Pindyck (1978)
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developed an optimal pricing model in which OPEC
countries establish a price plan that optimizes the
discounted revenue over an inflated time horizon.
Pindyck describes the cartel as confronting a net
demand for oil that is the difference between a
dynamic demand function for global consumption and
a dynamic supply function for the ‘competitive fringe’
(countries that are not OPEC members, now known as
non-OPEC producers). The optimal price trajectory
over time is determined as the sum of discounted
profits. The Pindyck model highlights the problems
associated with the attempt to optimize prices. The
results are highly sensitive to the rate at which
revenues are discounted. The predicted prices clearly
depend on the level of reserves. In Pindyck’s model,
reserves are assumed to be known in advance. Of
course, in reality, this is not the case. The Pindyck
model provides a rough characterization of OPEC’s
behaviour.
Hnyilicza and Pindyck (1976), in a subsequent
article (actually published prior to Pindyck’s article),
examine the implication for market behaviour of a
two-part cartel. The authors analysed a model in which
a cartel is composed of two groups of members: a
group of saver countries and a group of spender
countries.4 They suggest the saver countries will have
lower discount rates and, probably, larger reserves than
the spender nations. Again, as in Pindyck (1978), they
compute optimal price trajectories. They find that the
price trajectories will be very similar to the trajectory
predicted by the monopoly model if output shares are
fixed. The results change, though, if output shares are
allowed to vary. In a sentence that is strikingly
prophetic (Hnyilicza and Pindyck, 1976), they
conclude: “Recognizing that the cartel consists of
producers with somewhat different interests will be
essential in predicting its response to the future
cutbacks” (required by cartel members to achieve a
target price trajectory).
Eckbo (1975) offered a variant on the Hnyilicza
and Pindyck model by constructing an optimal price
path for OPEC as if the organization were a traditional
monopolist. However, his approach differs from the
earlier one because he breaks OPEC into three groups:
the price pushers (such as Iran, Venezuela, Algeria), an
expansionist fringe (identified as nations needing
more income and, thus, wanting increased production,
e.g. Indonesia, Nigeria, Iraq and Ecuador), and the
hardcore members (such as Saudi Arabia, Kuwait,
Libya). He removes the supply offered by the first two
4 The hypothesis was that Saudi Arabia, Libya, Iraq, Abu
Dhabi, Bahrain, Kuwait and Qatar form the nucleus of
savers, while Iran, Venezuela, Indonesia, Algeria, Nigeria
and Ecuador are the spender countries.
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MARKET STRUCTURES AND PRICE POLICIES IN THE OIL AND GAS INDUSTRY
groups and then calculates a price trajectory for the
hardcore members. He suggests the optimal price path
for countries such as Saudi Arabia with large resource
bases and smaller discount rates would be lower than
for countries in the first or second group.
Taking into account the lessons of eight years,
including the second oil price increase, and
recognizing the failure of optimization models such as
Pindyck’s, Teece (1982) offered an alternative model.
He comments: “Wealth-maximizing classical cartel
models relying on coordinated behaviour and
comprehensive collusion provide an inappropriate
model for analyzing OPEC behaviour” (Teece, 1982).
As an alternative, he proposes a model where several
key OPEC members determine the volume of oil
production by their budgetary needs. In this model,
these nations are predicted to cut production as prices
rise in order to conserve reserves for the future. This
model leads him to forecast a backward-bending
supply curve for certain OPEC members. He supports
his theory by referring to the production policies of
various OPEC states from 1970 to 1980, noting that
the nations he identified as key members did not cheat
on the quotas when the opportunity arose.
Furthermore, he comments that these countries held
more production in reserve despite having lower
production costs.5
Moran, surveying the various attempts to identify
optimal pricing strategies for oil, concludes that
attempts to explain the rise in oil prices through
optimization or income-maximizing approaches are
unrealistic: “The approach’s applicability to the real
world depends on the ability of self-interested actors to
identify the price and production paths that will render
their activities counterproductive” (Moran, 1982). He
notes specifically that the low price path
recommended by optimizing models for Saudi Arabia
could create enormous pressures on the Kingdom from
countries seeking higher prices. Although he does not
specify, one of these countries was Iran which, until
1979, had the military capacity to threaten Saudi
Arabia. Moran suggests that prices are determined as
much by political bargaining as by optimization.
However, before totally abandoning the premise
that oil prices are established through some type of
optimization process, one should consider the
omissions of the optimization models. Two are
immediately obvious. First, the models do not account
for uncertainty; second, the models make no
allowances for inventory changes. Furthermore,
models do not allow for the importance of the
geographic dispersion of producers, nor the
heterogeneity of crude oil.
The failure to account for uncertainty is a critical
deficiency in almost all models that attempt to
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prescribe the optimal price strategy for oil-exporting
countries. In most models, analysis begins with fixed
assumptions regarding demand, production by
noncartel members, reserves, and the political stability
of cartel members and other countries. Yet, in fact,
each of these assumptions can be questioned.
Perhaps the greatest degree of uncertainty occurs
in the assumed level of demand. Hnyilicza and
Pindyck (1976), and Pindyck (1978) establish a
framework in which global demand is sensitive to
prices. Thus, a price increase in their optimization
models reduces consumption, causing producers to cut
output. This allowance for the price sensitivity of
demand is a good beginning. However, global
petroleum demand is subject to at least two other
influences: the level of economic activity and the
possibility of other energy sources (including
conservation) displacing petroleum. No models allow
for these uncertainties.
Yet thirty years later, economists must admit that
economic activity and fuel substitution can and have
played important roles in determining oil prices. For
example, global oil consumption outside the former
Soviet Union declined in absolute terms from 1979 to
1984, and only returned to 1979 levels in 1989. The
drop in consumption was caused in large part by the
adoption of very harsh monetary policies by the US
Federal Reserve Board (Fed). The Fed’s policies led to
recession and reduced oil consumption. Demand for
oil was also depressed by the implementation of an
array of energy conservation programmes in
industrialized nations. At the least, any cartel
attempting to optimize prices must frequently
re-optimize its models.
A second degree of uncertainty concerns the
reserves thought to be available to the market from
cartel members and fringe producers. In their 1976
article, Hnyilicza and Pindyck note that changes in the
level of assumed reserves affect their results. However,
neither they nor other analysts such as Eckbo
contemplated the dramatic change in reserves or
technology that occurred between the mid-1970s and
the start of the Twenty-first century. As Adelman
(1995) repeatedly noted, there is no fixed supply of
reserves. Instead, reserves continue to grow as
technology improves. Forecasts of resource exhaustion
have often appeared in the past, and each time have
proved to be wrong.
Optimization models also fail to account for
changes in the political environment in consuming or
producing countries. A third uncertainty that is not
5 Under many circumstances, those countries with the
lowest costs would dominate in terms of market share in a
classical wealth-maximizing cartel.
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 MARKET STRUCTURES AND PRICE POLICIES IN THE OIL AND GAS INDUSTRY: THE CASE OF OIL
(and cannot) be treated in optimization models is
political uncertainty. None of the optimization models
introduced in the 1970s envisaged the political
changes that occurred in Iran or the Soviet Union’s
collapse. Yet both events had enormous impacts on
global oil markets.
At best then, purveyors of optimization models
need to warn that their recommendations for the
optimal strategy for cartel members must often be
adjusted to account for uncertainties regarding
demand, reserves and shifting political currents. A
second deficiency in price optimization models is
their failure to account for inventory levels.
Economists have long recognized that inventories
are a key determinant of price levels and trajectories.
As early as 1947, Working analytically described the
relationship between inventory levels and prices.
Williams (2001) reports that the type of relationship
first quantified by Working has been observed for
every commodity, and Verleger (1990) first
quantified the relationship for oil.
A major treatise by Williams and Wright suggests
the complications encountered by optimization models
when inventories are introduced. They examine the
problems confronted by authorities attempting to
stabilize, not optimize, a commodity price when
supply-and-demand levels are uncertain in an
environment where the commodity can be carried
forward. They show that inventories will be exhausted
with probability 1, and that prices will rise to
extraordinarily high levels (if not infinity) when stocks
are depleted (Williams and Wright, 1991).
Many of the results presented in Williams and
Wright can be extended to determining cartel strategy
and optimizing oil prices simply by altering the
objective function to optimize. They examine a market
where authorities optimize the joint welfare of
consumers and producers. Simple substitution of an
optimization function used by Pindyck, or Hnyilicza
and Pindyck would lead to a solution for a cartel. Such
an answer would not produce a smooth price function,
but would show periodic price deviations when storage
facilities were emptied or filled to overflowing by a
demand shortfall. The results might not be that
different from the actual pattern observed in oil
markets over a good part of the last three decades.
Finally, optimization models fail to account for the
geographic dispersion or the heterogeneous nature of
crude oil. Most oil market models ignore the fact that
oil is produced at a variety of locations. Most models
also ignore differences in the quality of crude oils. Yet
geographic and quality differences do impart
distortions onto the market that complicate the
optimization process, particularly because the crude
oils of the highest quality located closest to the market
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are generally produced by the cartel members most
likely to cheat on any agreement with the organization.
Nigeria, for example, falls into the category Eckbo
characterized as the expansionist fringe. Nigeria also
produces a highly desirable light crude oil that can be
delivered in a shorter time to US and European
refiners than can less desirable oil from the Middle
East. This provides Nigeria with the ability to extract
additional value for its crude, and creates an incentive
for the country to cheat on any production quota.
Venezuela is another case in point. Venezuela is
located even closer to the United States than Nigeria,
but its crude is generally inferior to almost all others
because it is heavy and has a high sulphur content.
Beginning in 1985, Venezuela sought to overcome the
quality problem by purchasing refineries in the United
States and modifying them with special equipment to
process its heavy crudes. The leaders of the country’s
petroleum industry indicated that these refineries
would enable them to boost production and ignore any
OPEC quota before the election of President Chavez.6
In theory, the cartel could overcome the quality and
geographic obstacles; in practice, they seem
insurmountable. Moran’s observation that the realities
of human relationships and politics make this
objective impossible explains the failure of the
optimization approach. Adelman described the
problem best in his 1980 article, The clumsy cartel
(Adelman 1993). He explained that the organization
was beset with pressures from other members during
periods of surplus capacity. He noted that Saudi
Arabia was fine-tuning a cartel with coarse
instruments. He then warned: “Where the long-run
optimum monopoly price lies, I do not know. If the
cartel should ever be perceived as anywhere near it,
there would be real danger to them. Without much
more room to raise prices to consumers, an ad valorem
tariff on oil would become a deduction from the
cartel’s revenues. The petrodollar flow could, at the
limit, be wholly diverted to consumer-country
governments” (Adelman, 1993).
Other theories for setting oil prices
Optimization models have an advantage – they
provide a simple, unified explanation for how prices
are determined. However, they suffer from a problem –
they do not work! The failure of optimization models
6 The Weekly Petroleum Argus interviewed Venezuelan
officials in December, 1997. An unnamed spokesperson told
reporters: “For years, we have been talking about quotas, but
each member is doing what they want to do. Rather than
playing the game, we have to establish a new agenda”. The
Argus reported that Venezuela was producing 3.3 million
barrels per day despite a quota of 2.5 million barrels.
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MARKET STRUCTURES AND PRICE POLICIES IN THE OIL AND GAS INDUSTRY
has led economists to seek less-elegant approaches to
predict how oil prices are determined. These analyses
generally focus on output decisions adopted by OPEC,
implicitly suggesting that the organization attempts to
set prices indirectly, while recognizing the market’s
uncertainties. The process takes a giant step from
theory to reality.
The approach taken by the realists can be seen by
comparing the monopoly problem postulated by the
theorists. The theoretical models stipulate that
producers will determine a sequence of prices (Pt ) and
quantities to be produced by individual members (Qt )
over time for all members to maximize the present
discounted value of producer revenues, given varying
discount rates of cartel members, total demand,
reserves, and expected production by nonmembers.
The realists, on the other hand, assume that members
will attempt to set production and observe prices,
making changes in production allocations among
members, as monitored prices deviate from the desired
target. This approach avoids the need to deal with the
geographic and quality differences noted above. It also
recognizes the need to adjust strategy frequently.
Griffin (1985) empirically examined four
alternative hypotheses to explain OPEC’s price-setting
behaviour. Using individual country production data,
he tested whether the nations followed: a) a market-
sharing approach; b) a competitive market; c) a
property rights model;7 or d ) a target revenue market.
Griffin found that all but the partial market-sharing
models were to be rejected for a majority of the
members. By contrast, the market-sharing explanation
was to be accepted for ten of the eleven members.
Teece et al. (1993) at once admire, but criticize the
approach, noting that Griffin’s results depend on the
model’s empirical specification. Gately (1984) reports
on unpublished research by Jones who extended the
data set. According to Gately, Jones concluded that the
market-sharing model still provided the best
explanation for market behaviour. Gately also reports
on research by Moran who describes the oil market as
being in transition. In Moran’s view, OPEC inherited a
market where the multinational oil companies had
developed supra-sovereign mechanisms for control,
and then “systematically unravelled it”. Under the
supra-sovereign system, the multinational companies
(particularly Aramco’s owners) operated under a super
majority voting system that prevented any one member
from raising production (Gately, 1984).
Gately likens OPEC’s situation to that of players
confronting a prisoner’s dilemma. Every member
benefits if all members abide by the production levels
set by agreement among the members, just as all
prisoners benefit if none cooperates with the
authorities. However, Gately suggests that if enough
244
OPEC countries overstep their quotas, then all are
better off by cheating. This likelihood is reduced,
though, because the game is played more than once,
and the players become aware of their counterparts’
behaviour.
Smith (2002) examines the history of oil price
setting and the behaviour of OPEC members. Smith
reviews statistical tests of alternative tests of market
structure and finds all wanting. He reports that the oil
market is not competitive, and finds that the market
has not been dominated by any of the standard market
models taught in economic theory, such as a
Stackleberg or Cournot oligopoly, or monopoly.
Instead, through some very clever and powerful
statistical tests, Smith suggests that OPEC’s oil
production has been dominated by a bureaucratic
cartel. Smith also reports that he can find no evidence
that Saudi Arabia was the dominant producer within
the cartel.
Smith’s introduction of the concept of OPEC as a
bureaucratic cartel is a new and exciting departure. He
explains: “In contrast to the frictionless cartel,
envisage a collusive syndicate of producers who
operate under the weight of transactions costs, i.e. a
bureaucratic cartel. In this model, any difficulty in
reaching consensus on proposed output revisions (and
the profit redistributions that would result) constitutes
an added cost. Such transaction costs could easily
outweigh whatever benefits would otherwise be
achieved via output reallocation, unless the scope of
the proposed reallocation is substantial and expected
to persist. Moreover, the cost of reaching consensus is
likely to be higher when the proposed adjustments are
in offsetting directions rather than in parallel” (Smith,
2002).
Smith tests this hypothesis by examining the
frequency with which OPEC members adjust
production to compensate for changes in output by
other members, as well as to offset production shifts
by nonmember nations. In his view, a bureaucratic
cartel would be unlikely to make many alterations
between members, but would respond to changes by
nonmembers. “Many temporary shocks that might
cause members of a frictionless cartel to adjust
production levels would rightfully be ignored until
they accumulate to a degree that justifies the cost of
taking a cooperative decision to reverse the status quo”
(Smith, 2002). His calculations confirm the result. He
concludes: “OPEC is much more than a
non-cooperative oligopoly, but much less than a
frictionless cartel. All traditional explanations of
7 The property rights model involved a test of whether a
producing nation’s share of production as a percentage of the
country’s output increased as production rose.
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OPEC behaviour (e.g. competitive, Cournot, dominant
firm, etc.) are strongly rejected, except the hypotheses
that OPEC acts as a bureaucratic cartel, i.e. a
cooperative enterprise weighed down by the costs of
forging consensus among members and, therefore,
partially impaired in the pursuit of the common good”
(Smith, 2002).
Those who have followed developments in world
oil markets closely for the last three decades will agree
with this view. They will, however, find the conclusion
regarding Saudi Arabia’s role implausible. Smith
states: “There is little evidence to indicate that Saudi
Arabia has acted as a leader or dominant firm within
the cartel, although that possibility cannot be formally
rejected, either. If the Saudis have performed such a
role, then at least we can say it has not been executed
with sufficient vigour or constancy to be clearly
discernable in the data” (Smith, 2002).
This conclusion is clearly wrong. Indeed, although
infrequent, the Saudi actions have clearly exerted
enormous influence on oil price development since
1973, particularly since 1980. In fact, changes in
Saudi practices correlate precisely with key changes in
regimes.
From 1973 to 1985, oil-exporting countries
followed a practice of setting posted or official prices
for crudes. Except for periods of market disruption
(such as what occurred in 1979 when Iranian output
collapsed), the organization’s members generally set
official prices as part of their periodic meetings.
In an effort to sustain this system of posted prices,
Saudi Arabia conceded market share to other
producers from 1981 to 1985. During this period,
Saudi output dropped from more than 10 million
barrels per day to 2.3 million barrels per day, while the
country’s share of total OPEC output declined from
42% to 16%.8
In 1985, Saudi Arabia unilaterally abandoned
posted prices, and offered buyers oil on a ‘to arrive
basis’.9 The Kingdom shifted to this pricing approach
to recover some of its lost market share when it could
not get other OPEC members to cooperate and cut
production. Its actions slashed prices from above $30
to less than $10 per barrel in six months.
When prices dropped to less than $10 in early
1999, Saudi Arabia again coerced other OPEC
members into cutting output: “There’s little question
that Riyadh designed the production-cutting deal,
reached an understanding with Iran, and then minced
few words persuading other to accept. But just in case,
Oil Minister Ali Naimi left the impression that the
alternative of Riyadh simply opening its taps was no
idle threat. Intense diplomacy kicked off when Prince
Abdullah addressed Gulf Cooperation Council
members in person at the inauguration of the Shaybah
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field, and helped bring most OPEC members in
on the deal, along with Mexico, Norway, and Oman”
(Saudi […], 1999).
The coerced (blackmailed) cooperation of the other
OPEC members and three additional producers, who
subsequently cut production by up to 10%, provides
conclusive evidence that Saudi Arabia has dominated
the global oil market at key moments.
The success of the Saudi intervention can be found
in price data. Verleger (2001) examined the daily
movement of oil price data from 1985 until 2003, and
found that spot prices of WTI and Brent crude oil
prices followed a mean reversion process without drift
from 1985 to March 1999. The results showed that
WTI reverted to a mean of $18.84 per barrel, while
Brent reverted to a mean of $17.10. Subsequent to
Saudi Arabia’s intervention, the process broke down
and prices have remained well above the two standard
deviation range established in the study. The
conclusion that oil prices revert to a mean confirmed
earlier results published by Dixit and Pindyck (1994).
The Smith view of OPEC behaviour, then, seems
to provide the best general characteristic of how oil
prices are set, with one exception. OPEC members are
seen to cooperate in a bureaucratic cartel where
production quotas are set periodically, and adjustment
of production shares is relatively costly to members.
The organization’s total output is set in a manner that,
over time, achieves a target price level.
This cooperative arrangement operates with the
acquiescence of Saudi Arabia. However, on at least
two occasions, the Saudis have intervened in the
market when the pact did not achieve goals determined
to be in their own interests.
4.1.3 The oil industry
transformation: from
coordination to commodity
markets
In the thirty-five years from 1970 to 2005, the world
oil market was transformed from the relative stability
created by the multinational oil companies,
characterized by Blair (1976), as a cartel to a
commodity market where large financial institutions,
hedge funds and commodity speculators had as much
say in determining prices as consumers, refiners or
8 The decline in Saudi output as a share of OPEC
production during this period seems to contradict Smith’s
view that the members of a bureaucratic cartel generally do
not adjust production to counter changes of other members.
9 To arrive pricing is a term of art in commodity markets
(Williams, 1986).
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MARKET STRUCTURES AND PRICE POLICIES IN THE OIL AND GAS INDUSTRY
OPEC members. By the beginning of the Twenty-first
century, the role of oil producers, including OPEC,
had diminished. By cutting production, OPEC might
be able to sustain prices well above the long-run
equilibrium. However, OPEC and other producers
refused to take steps to keep prices from surging well
above that level. As a result, an oil price rise with
many of the characteristics of a speculative bubble
developed.
The transformation began with the nationalization
of producing interests that had theoretically been
owned by the multinational oil companies that had
developed them.10 The eight largest multinationals had
worked much of the world’s reserves prior to the
mid-1960s. Often, these companies operated in
consortiums, jointly producing from a particular
country. For example, Adelman (1972) calculated that
the seven companies produced essentially 100% of
crude oil pumped outside North America and the
Soviet Union in 1950. The share controlled by these
companies dropped to 70% by the first half of 1969. In
most countries, production was managed by an
operating company jointly owned by the multinational
firms that had concessions in the country. For
example, Esso, Chevron, Texaco and Mobil owned
Aramco, the company that operated in Saudi Arabia,
while BP and Gulf jointly owned the company that
operated in Kuwait.
Blair (1976) asserts that the rules established by
the companies for operating in each country created an
effective, classic cartel through a system of restrictive
agreements. Under the system, he explains, the owners
of a given concession would decide on the total output
from a country jointly, with each firm allocated a
production share based on its ownership. Members
were proscribed from taking more than their allocated
share, or required to pay a prohibitive premium for the
extra oil lifted. Adelman (1972) provides more detail
on Saudi Arabia, indicating there were no punishments
for underlifting (taking less than the firm’s allocated
share), but overlifting was penalized.
According to Blair, control over total global oil
output was affected because each of the eight
companies operated in several different countries,
effectively providing a network through which the
members could communicate views on supply and
demand. In effect, this communication held prices
above costs, and well above the level Blair believed
would prevail in a free market. This is the mechanism
Levy credited for creating stable prices (see above).
Market data suggest this method did steady prices by
keeping supply and demand in balance. As Adelman
explained: “The governments are less able to operate a
successful cartel than the companies. Not only do they
lack the companies’ experience, but they also lack the
246
inter-company contacts at two levels: crude production
and sales (the joint ventures), and the refined product
markets” (Adelman, 1972).
The nationalization of equity interests owned by
the multinationals terminated this stabilizing factor.
From the mid-1970s forward, and especially after
1979, the brake on global production that had
balanced supply and demand in the past was lost.
OPEC members attempted to supplant the structure
created by multinational companies through
agreements to limit output; for a time, the effort
succeeded. Exporting countries would offer supplies
primarily to firms that had formerly owned
concessions at official prices or discounts from the
official prices and, in general, the companies would
take the oil.
Fadhil Al-Chalabi, OPEC Deputy Secretary from
1978 to 1989, explained that during the period after
1973, OPEC established a base or market price. Until
the end of 1985, the OPEC pricing mechanism was to
set a floor price for reference crude oil (until then,
Arab Light 34° API ex Ras tanura, called the OPEC
market crude) under which no member country was
supposed to sell its crude. This price was called the
official selling price on the basis of which prices of
other crudes were fixed, taking into account the
relative values of its various crudes based on the
difference in quality and geographic location.
(Al-Chalabi, 1991).
The system was kept in place until 1985. However,
it was far from successful during the twelve years the
members adhered to it. During the recession
immediately following 1973, and in the four and a half
years after, many members experienced problems
marketing their oil as the economic slowdown reduced
global demand. Al-Chalabi (1982) describes the chaos
from late 1978 to late 1981, when the system of
official prices became essentially irrelevant because of
the collapse of Iranian production and the outbreak of
war between Iran and Iraq. During this later period, a
number of countries seized on the tightness in world
oil markets to raise prices well in excess of the
theoretical OPEC market price. The organization held
a series of contentious meetings between 1980 and
10 Traditionally, writers such as Blair (1976) claimed the
market was controlled by concessions granted to the seven
largest multinational oil companies: Standard Oil of New
Jersey (Exxon or Esso), Standard Oil of California
(Chevron), Royal Dutch Shell (Shell Transport and Trading),
Mobil, Gulf, British Petroleum (BP), and Texaco. In his
work, Adelman (1972) adds an eighth: The French National
Company (Total). In addition, a number of smaller
companies such as Atlantic Richfield (Arco), Occidental,
Standard Oil of Indiana (Amoco), Elf, Sun and Petrofina
joined the ranks of majors after 1973, according to some.
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 MARKET STRUCTURES AND PRICE POLICIES IN THE OIL AND GAS INDUSTRY: THE CASE OF OIL
1982 as prices climbed from $15 to $40 per barrel.
During and following these meetings, Saudi Arabia
tried to follow a programme of price ‘moderation’,
while other members kept pushing for higher prices.
When prices peaked, Saudi Arabia posted a price of
$32 per barrel, while Iran posted a price of $37 per
barrel.
The high prices, combined with the US Federal
Reserve’s effort to arrest global inflation, triggered a
drop in economic activity and global oil demand. The
rate of growth of global GDP, which had averaged
3.5% from 1975 to 1980, fell to 1.6% in 1981 and 0%
in 1982. The trend in global oil consumption followed.
From 1975 to 1980, oil use in countries outside the
former Soviet Union increased at a rate of 2%. In the
next two years, consumption declined at a rate that
exceeded 3% per year.
The decline in global demand put pressure on
OPEC. In 1982, the countries again agreed to unify
their prices around a single market price. At the same
time, the members agreed to cut production in an
effort to reduce pressure to lower prices. Al-Chalabi
describes the adjustments made by the organization:
“As the deterioration in the market continued, the price
defense policy required OPEC to reduce its production
ceiling successfully from 18 Mb/d, fixed in March
1982, to 17.5 Mb/d in March 1983, and then to
16 Mb/d in October 1984” (Al-Chalabi, 1982).
The former OPEC Deputy Secretary General
explains that these cuts created pressure within the
organization and caused some members to reject them.
In an effort to maintain harmony, Saudi Arabia
accepted the role of swing producer. As Al-Chalabi
explains: “When OPEC agreed on an overall ceiling of
17.5 Mb/d in the aforementioned agreement (OPEC’s
March 1983 meeting), no specific quota was allocated
to Saudi Arabia, contrary to all other member
countries whose total national quotas amounted to
12.5 Mb/d. The 5 Mb/d difference between the overall
OPEC production ceiling of 17.5 Mb/d and the total of
those twelve countries’ production (12.5 Mb/d) was
considered to be a production swing to be allocated to
Saudi Arabia to fluctuate in light of market
developments, and within the overall ceiling of OPEC
production” (Al-Chalabi, 1982).
The agreement failed because the decline in
demand for OPEC oil forced Saudi Arabia to cut its
production from 6 million barrels per day in 1983 to
less than 2.5 million barrels per day in the summer of
1985. Saudi Arabia unilaterally elected to adopt a new
pricing system based on a price tied to products
derived from the crude oil11 when the other OPEC
members refused to negotiate production quotas to
share the demand decline. This change in strategy
allowed Saudi Arabia to recover sales, but collapsed
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
prices. OPEC permanently abandoned its system of
official prices in favour of a programme of production
ceilings intended to achieve a desired price level.
A principal contributor to the price collapse of
1985-86 can be found in the development of crude oil
in the North Sea, and the British government’s
adoption of policies that forced oil producers to
conduct crude oil transactions on a spot market. Oil
was discovered in the North Sea in 1969 and
production began in the early 1970s. The fields lay
primarily in lands belonging to the United Kingdom
and Norway (Mabro et al. 1986). The two countries
developed their fields differently. Both relied primarily
on large private multinational oil companies, but both
also created national companies to oversee and, in
some cases, control production; Norway created
Statoil, while the UK created BNOC (British National
Oil Company). The roles given to these companies
were very different. Statoil became just another oil
company and is not of interest here. BNOC, on the
other hand, played a key role in the oil market’s
development.
The British Parliament created BNOC in 1975
after the multinational companies refused to cooperate
with the United Kingdom by diverting supplies there
during the 1973 disruption. Mabro et al. explain that
BNOC was brought into being to establish government
control over disposal of its oil during an emergency.
BNOC was given equity interests or acquired equity
interests in most fields. As they came into production,
BNOC received part of the output. The firm had to sell
its oil immediately because it lacked storage facilities.
Initially, it sold oil on term contracts. Mabro et al.
report that BNOC set prices at official OPEC levels,
particularly during the period from the beginning of
11 The system was referred to as netback pricing. Under
the programme, the buyer of a barrel of crude oil from Saudi
Arabia literally paid a price tied to the value of the products
refined from the crude when the oil was sold. Thus, if a
refiner received $30 for the gasoline and distillate produced
from a barrel of Arab Light, the refiner paid Saudi Arabia
$30. If the refiner received $10 for the products, the refiner
paid Saudi Arabia $10. This programme transferred all the
risk associated with price changes to the producer (Saudi
Arabia), reversing a tradition that had been in place for
almost 100 years. Before the introduction of netback
pricing, refiners purchased crude oil at a fixed price and
then hoped to sell the products extracted from it for enough
to cover their costs. In point of fact, though, economic
research reveals that an arbitrage exists between products
and crude; Verleger (1982) quantifies this arbitrage. In 1985,
buyers refused to acquire Saudi Arabia’s crude because the
country insisted on charging a price well in excess of the
value of products derived from the crude because they did
not want or could not afford the financial losses. Purchases
resumed when Saudi Arabia shifted to netback pricing which
eliminated the risk of loss.
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MARKET STRUCTURES AND PRICE POLICIES IN THE OIL AND GAS INDUSTRY
production until October, 1984. At times, BNOC was
unable to dispose of its oil because these price levels
were above spot prices. In March 1982, early 1983,
and October 1984, the firm had to sell cargos at the
lower spot price, putting pressure on the term pricing
structure established by OPEC.12
BNOC exerted a second destabilizing force on the
global oil market that was probably much greater than
its occasional sales of spot cargos. Under the fiscal
regime adopted by the British government, producing
companies were taxed on the sales price of oil. As
prices rose, tax rates increased, effectively becoming
rent capture mechanisms. At one point, marginal rates
reached 75%. For a time, tax obligations were based
on the posted BNOC price if the companies elected to
process this oil in their own refineries, while the tax
on oil sold to third parties was based on the price
received (Horsnell and Mabro 1993). This had the
effect of subjecting a company such as Shell to a
marginal tax of more than 100% if oil from Shell
fields was processed at a Shell refinery when spot
crude prices were less than the BNOC price.13
The companies naturally worked to avoid taxation
by selling their production on the spot market when
spot prices were below the tax reference price. Their
actions created a large and very liquid spot market in
crude where none had existed before (Verleger 1987).
Changes made to the tax after 1984 provided an
increased incentive for companies to dispose of
production on the spot market, further breaking down
the integrated system that had been used to control
prices for decades. In particular, the administration of
the UK tax provided an enormous incentive to sell
crude on the spot market. The Oil Taxation Office
(OTO) would determine the arm’s-length value of any
crude retained by an integrated company for
processing in its refineries, while allowing the firms to
designate any sales made during a 30-day period as the
reference price for a cargo sold to a third party. This
system created an incentive for companies to engage
in forward purchase and sales transactions whenever
the overall price level fell.
Mabro et al. (1986) report that the number of such
transactions grew from 450 in the first quarter of 1984
to more than 1,200 in the fourth quarter of 1985. Many
of the transactions were daisy chain arrangements
where company A sold to B which then sold to
company C. Company C would then sell back to
Company A so that, in the end, company A processed
oil produced from its field, but avoided a high tax.14
Horsnell and Mabro (1993) find the number of
transactions peaked at 2,400 in the first quarter of
1987. At that time, the British government changed its
tax regime. The change in the British tax scheme came
too late, though, to salvage a system of official prices.
248
The creation of a visible spot market made it
impossible for oil-producing countries such as Saudi
Arabia to demand that buyers pay an oil price
significantly different from the price at which buyers
could obtain crude oil from arm’s-length sellers on the
spot market. As Verleger (1987) reported, oil had
become an economic commodity.
4.1.4 Oil as an economic
commodity: OPEC policies
and price dynamics
Crude petroleum and the products produced from
crude oil have always been commodities as defined in
any dictionary. However, neither crude oil nor the
products derived from crude could be classified as
economic commodities until 1986.
Verleger (1987) explains that a physical
commodity can be called an economic commodity
only if the following conditions are satisfied: a) there
must be a large number of producers; b) there must be
a large number of buyers; c) the physical commodity
must be homogeneous; d ) the commodity must move
freely to the market; e) it helps if the commodity is
storable; f ) finally, there must be an absence of
monopoly control over production or monopsony
control over demand.
Petroleum always satisfied all but the last
condition. However, as Adelman (1972) and Blair
(1976) noted, the major multinational oil companies
controlled the terms of sales and the oil flow to the
market until their assets in producing countries were
nationalized. Once these firms were removed, control
over the market was lost and oil became an economic
commodity.
The introduction of netback pricing and the
emergence of oil as an economic commodity
permanently transformed the oil market. Before this
shift in 1986, OPEC had insisted on establishing an
12 Petroleum Intelligence Weekly (1 March, 1982)
reported that buyers were pushing BNOC to cut its prices
below OPEC’s official levels. The article explained that
BNOC lacked buyers for its 1.1 million barrels of oil supply,
and faced competition from a growing spot market in North
Sea crude. The British government also refused to cut
production (which would reduce oil supply to BNOC)
because the revenues from oil sales were required to meet
the government’s budget goals.
13 For example, if spot prices were $30 per barrel and
BNOC’s price $34, Shell would have been subject to an
extra tax of $3 per barrel if it retained production from its
North Sea fields in its refineries.
14 Mabro et al. (1986) provide a fascinating description
of how a daisy chain is created. They also provide a
mathematical calculation of the gains from tax spinning.
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official oil price and production quotas for individual
members. After 1986, OPEC abandoned the effort to
set official prices. Instead, it focused its efforts on
managing production and inventories to achieve a
specific target price.
The strategy shift was made necessary by the
cartel’s inability to maintain a stable price
environment during the first half of the decade, and
the growing reliance on multinational oil companies
to hold unnecessary inventories when the
organization could not adjust production to keep
supply and demand balanced at official price levels.
For example, as spot prices plunged in 1985,
multinational companies refused to lift crude at
official prices from Nigeria. Other OPEC members
tried to force the multinationals to buy oil from
Nigeria; the effort failed, however.
Ultimately, exporters had to abandon fixed-price
contracts, shifting instead to price formulas tied to
principal commodity market prices. Prices for oil
delivered to the United States were generally tied to
West Texas Intermediate (WTI), the grade of crude
traded on the New York Mercantile Exchange
(NYMEX). Prices of crude oil delivered to Europe
from OPEC or other sources, such as Russia, were
generally tied to Brent crude, the widely traded variety
of oil produced in the North Sea. Prices of oil
delivered to Asian destinations were generally linked
to the price of Dubai or Oman crudes, the oils traded
in spot markets in the Middle East.
The key factors contributing to the permanent
change in OPEC’s approach to pricing were the loss in
confidence in the organization, the decline in demand
for OPEC production that required mothballing more
than half the organization’s productive capacity, the
availability of non-OPEC crudes quite similar to those
produced by the most vulnerable OPEC members, and
the development of a time premium for short haul
crudes. These factors forced OPEC to adopt more
transparent marketing approaches.
The loss in confidence in OPEC’s ability to sustain
its official price levels was, no doubt, the primary
factor forcing the cartel to abandon its effort to set
such prices. From 1973 to mid-1985, OPEC members
worked aggressively to maintain a posted or official
price system similar to that employed by the major oil
companies from the end of the Second World War to
the nationalization of their assets in OPEC countries.
Following the price collapse of 1986, oil-exporting
countries made a valiant effort to restore official
prices. The thirteen nations agreed at a meeting in
December 1986 to shift back to a system of fixed
prices (OPEC wins […], 1986).
The effort failed within a year because buyers
lacked the confidence that members would adjust
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
production to keep market prices in line with the
official prices producers were attempting to charge.
This lack of confidence prevented buyers from
accumulating inventories when consumer
requirements fell short of global supply. Historically,
oil companies had followed a practice of holding
significant stocks levels. IEA data published in 1990
showed that companies operating in OECD nations
had held stocks that would meet almost ninety days of
demand. The price collapse changed this attitude.
Lacking confidence in OPEC to sustain prices, these
firms aggressively cut stocks. As may be noted from
IEA data published in 1990, the days of supply
dropped from a high of eighty-three in 1981 to
sixty-six in 1988.
Reductions in inventory coverage were made by
crude oil buyers, primarily refiners, who had incurred
large losses on crude stocks. For example, refiners in
the United States buying Arab Light crude in January
and February, 1987 would have lost at least $1 per
barrel because the product produced from the crude
could not cover the official price (Updated […], 1987;
The key […], 1988). Buyers cut purchases and
whittled down stocks where they might once have
accepted such losses in the expectation that OPEC
would react to the problem and cut production.
Buyer willingness to reduce purchases and
inventory holdings in 1987 were, no doubt, boosted by
the knowledge that OPEC countries had ample surplus
capacity and were burdened by large financial
demands. The surplus capacity created an economic
environment where OPEC members could be
encouraged to produce above quota; many did. The
pressure to overproduce was strengthened by the oil
price decline from $40 per barrel in 1984 to the low
teens in 1986, which left all members in a weakened
financial state.
At one point, OPEC production may have dropped
as low as 50% of capacity. In December 1986,
OPEC output was 17.5 million barrels per day, while
capacity was 27.5 million barrels per day (OPEC
production […], 1986). Production bottomed in
March, 1987 at 15 million barrels per day, 54% of
capacity. Buyers had every incentive to acquire only
what they needed, and acted accordingly.
The third factor that undermined OPEC’s effort to
return to fixed-price crudes was the availability of
non-OPEC crudes similar to those produced by the
most vulnerable OPEC members. The weak link for
OPEC was Nigeria. In the late 1980s, the country’s
financial condition was precarious (it was not much
better in 2005), and the political situation so weak that
the country’s military seized power. The nation’s
position in the world oil market was made even more
vulnerable by the availability (on transparent,
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MARKET STRUCTURES AND PRICE POLICIES IN THE OIL AND GAS INDUSTRY
competitive markets) of North Sea crude oils, much
like those produced by Nigeria (light and low in
sulphur).
The Nigerian government could not market
production at an official price when buyers could view
quotes for equivalent crudes in real time from an
electronic market monitoring system. Invariably, the
Nigerian oil was too cheap or too expensive
(Nigeria […], 1987). The country’s solution was to
adopt a market-related pricing system. The
government agreed to lower the price charged to
buyers whenever the market price fell below the
official price to assure buyers a profit of at least $1
per barrel (Government […], 1987).
Through the course of 1988, other oil-exporting
countries followed the Nigerian example, although
initially, there were apparently a wide variety of
approaches. Gradually, the global market settled on a
set of formulas tied to principal crudes traded in the
global market: Brent, Dubai and WTI. As Horsnell and
Mabro note: “Market-related price formulas thus
emerged as the only possible alternative to the
disgraced system of price administration and the
disastrous netback pricing experiment” (Horsnell and
Mabro, 1993).
Horsnell and Mabro offer three explanations for
the formula system’s adoption: to relieve exporting
countries from the burden of discovering the economic
price of oil; to ensure, through the formula, that the
exporter realizes prices which reflect movements in
the general oil price level in the world petroleum
market; to ensure competitiveness between the crude
exported by a country and other substitutes a buyer
might chose.
The formula pricing was simple. The price of an
export crude oil, e.g. Arab Heavy shipped from Saudi
Arabia (PE) was determined by the price of a market
crude, e.g. WTI (PWTI) plus or minus a differential, D.
PE ⫽PWTI ⫾D
Exporting countries established different formulas
for the same crude oils exported to different markets.
For example, the price of Arab Light was indexed to
WTI, if shipped to the United States; Brent, if shipped
to Europe; and Dubai, if shipped to Asia. This led to a
situation where prices of the same crude differed
substantially between markets. For example, the price
of Arab Light, shipped FOB (free on board) in
January, 1989 from Saudi Arabia, carried a price of
$17.65 per barrel, if shipped to Asia; $18.44 per
barrel, if shipped to the United States; and $18.32, if
shipped to Europe (Updated […], 1990). Saudi Arabia
was able to maintain this price discrimination because
buyers were contractually committed to take oil to
specific destinations.
250
The adoption of formulas that linked OPEC crude
prices to market indicators enabled buyers to hedge
their purchases. A buyer acquiring oil from Saudi
Arabia at a price tied to WTI could sell WTI futures to
protect the purchase against a price decline while the
oil was in transit.
The introduction of formula pricing resolved the
problems created by the divergence between term
prices and market conditions. Buyers no longer
faced term prices that bore no relationship to the
crude’s market value. Furthermore, by linking prices
to liquid commodity markets, exporting countries
provided a means for buyers to hedge purchases.
The system has been so effective that it has
remained the primary means for marketing crude for
almost twenty years.
Lower stock levels altered the traditional
relationships between similar crude oils produced in
different locations. Economists have long recognized
that buyers will offer larger premiums for prompt
supplies of commodities when inventories are low,
compared to those times when stocks are high. Oil
markets reflected this condition as inventories
declined. For example, refiners viewed North Sea
crudes as being worth more than very similar Nigerian
crudes as stocks declined.15 OPEC producers in the
Atlantic, in particular (Nigeria, Algeria, Libya), found
buyers willing to pay higher prices for their crude than
for similar oil produced in the Middle East. At certain
times, the difference amounted to more than $2 per
barrel.
The fluctuation in these premiums made it
impossible to maintain a system of fixed term or
posted prices. Changing market conditions made it
impossible for OPEC members to establish a fair
permanent system of pricing differentials based just on
physical differences in crude oil.
OPEC addressed this problem by modifying many
of the formulas used to determine prices, so the crude
price was set when the crude arrives at its destination,
rather than when it was loaded on a ship. Such
deferred pricing means the price of a cargo of Saudi
crude arriving at a Houston refinery is determined on
the same day (called the pricing day) as a cargo of
crude from nearby Nigeria or Venezuela. For example,
the formula for Arab Light (PAL) shipped from Saudi
Arabia to the United States in the summer of 1989 was
written as
15 The difference in values would vary as the
‘backwardation’ (the difference between the price for
delivery in the future and the price for delivery today)
changes. The greater the backwardation, the greater the
value of close by or ‘short-haul’ crudes to crudes located at a
greater distance.
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 MARKET STRUCTURES AND PRICE POLICIES IN THE OIL AND GAS INDUSTRY: THE CASE OF OIL
45
PALt ⫽ 冱 (PANSt )Ⲑ10 ⫺$1.05
t⫽35
Deciphering the mathematics, the price of Arab
Light loaded on 1 September, 1989 was determined by
the average of the spot prices quoted for Alaskan
North Slope crude in the US Gulf 16 between 5
October, 1989 and 14 October, 1989. Implementing
this deferred pricing put exports from any OPEC
country on a competitive footing with any other
country.
Adopting price formulas addressed the problem of
locational differences and competition between
member countries, but it did not restore OPEC’s
market power. Oil-exporting countries lost much of
their control over the global oil market after the price
collapse in 1986. Between that year and March 1999,
nominal prices fluctuated in a relatively narrow range,
with a mean of roughly $15 per barrel. Prices surged
above the range only briefly in 1990 when Iraq
invaded Kuwait. The invasion was precipitated by low
oil prices brought on by Kuwait’s decision to disregard
its agreement with other OPEC members to cut output.
Throughout the 1990s, OPEC members
attempted, without great success, to institute
production cuts that would raise prices. Meetings
were held and pacts made, but the effect was
negligible. In part, the organization failed because
non-OPEC production rose; however, much of the
fault lay with OPEC. The organization’s production
and sales rose by more than 20% from 1991 to 1998
as prices fell by as much as 20%.
The behaviour of output and prices during this
period seems to confirm Smith’s broad conclusion that
OPEC acts like a “bureaucratic cartel, i.e. a
cooperative enterprise weighed down by the cost of
forging consensus among members and, therefore,
partially impaired in pursuit of the common good”
(Smith, 2002). The price and output behaviour also
seems to substantiate Smith’s conclusion: “There is
little evidence to indicate that Saudi Arabia has acted
as a leader or dominant firm within the cartel,
although that possibility cannot be formally rejected
either” (Smith, 2002).
OPEC became an organization dominated by a
single country in March 1999. At that time, Saudi
Arabia abandoned the passive role described by Smith,
and took control by convincing other oil-exporting
countries to cut production. Saudi Arabia backed its
call for coordinated output cuts by OPEC members
and other oil-exporting nations with an explicit threat
to increase production and drive prices to $5 per
barrel or lower, if its request was rejected.
The Saudi action came when the spot oil price had
declined to very low levels. WTI traded for
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
approximately $10 per barrel, while Brent was briefly
as low as $9.80 per barrel. Prices received by Saudi
Arabia averaged less than $9 per barrel for two months
(Saudi […], 1999). The depressed prices created
extreme difficulties for the country and caused it to
alter policy in several ways. First, Saudi Arabia
abandoned a long-standing position to keep its oil
output above 8 million barrels per day. Second, its
leaders postponed a plan to build market share.
Finally, the country switched from a passive to active
role within OPEC, telling other producers that Saudi
output would be boosted to 12 million barrels per day
if the others did not cut output substantially.
Petroleum Intelligence Weekly described the
Saudi’s explicit warning with the words cited earlier,
adding that “The surprisingly high total reductions of
2 million b/d and firm support from Iran should ensure
that, even with limited compliance elsewhere,
significant volumes will be taken out of the global oil
balance” (Saudi […], 1999).
Saudi Arabia’s threat succeeded. Much to the
surprise of OPEC’s many critics, compliance with the
March 1999 quotas was good. And much to the
astonishment of many analysts, spot oil prices rose by
150% over the year, reaching $25 per barrel by
December (for Brent).
Following this success, Ali Naimi convinced OPEC
members to keep inventories in consuming countries
tight. In meetings from the end of 1999 until March
2005, OPEC members reviewed the global
supply-and-demand balance and inventories in
consuming nations. Afterwards, the members would
almost always discuss global stock levels in the context
of their decision to increase or decrease production.
OPEC’s decision to follow the Saudi lead on
inventories created an environment that sent spot oil
prices rising in a mostly steady but, sometimes,
explosive manner. By lifting prices above production
costs, OPEC functioned for the first time as a
successful cartel dominated by a single country.
4.1.5 Conclusion
This paper has reviewed the development of oil pricing
from the 1960s to 2005, as well as the cycle of
successful and failed attempts to sustain prices at
16 Saudi Arabia initially set its crude price using the spot
price of Alaskan North Slope (ANS) crude delivered on the
Gulf Coast because ANS crude was a close substitute for
Saudi crude, and traded on the Gulf. However, ANS
production declined over time. After 1994, it was not traded
or delivered to the Gulf Coast. At this point, WTI was
substituted in the formulas for Arab Light.
251
MARKET STRUCTURES AND PRICE POLICIES IN THE OIL AND GAS INDUSTRY
artificially high levels. From the end of the Second
World War to 1973, oil prices were kept above output
costs artificially through joint production agreements
between a small group of multinational companies.
From 1973 to 1986, oil-exporting countries were even
more successful than the multinational companies in
maintaining prices above costs.
The price levels through this second period were
chosen by producers more or less ad hoc. They did not
follow optimization approaches recommended by
academics, but rather seemed to set prices somewhat
haphazardly.
Efforts to sustain high prices artificially failed in
1986, though, when new commodity-market-type
institutions, combined with declining demand,
eliminated producer control over the market. The new
institutions forced oil producers to abandon an official
price system in favour of market-related prices.
In this environment, producers struggled to regain
market control. They did not achieve this until 1999,
when Saudi Arabia began to dictate decisions
regarding oil volumes sold by exporting countries.
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Adelman M.A. (1993) The economics of petroleum supply.
Papers by M.A. Adelman, 1962-1993, Cambridge (MA),
MIT Press.
Adelman M.A. (1995) The genie out of the bottle: world oil
since 1970, Cambridge (MA), MIT Press.
Al-Chalabi F.J. (1982) A second oil crisis? A producer’s view
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After the second oil crisis. Energy policies in Europe,
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Dixit A.K., Pindyck R.S. (1994) Investment under uncertainty,
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Hnyilicza E., Pindyck R.S. (1976) Pricing policies for a two-
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Horsnell P., Mabro R. (1993) Oil markets and prices: the
brent market and the formation of world oil prices, Oxford,
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Levy W.J. (1961) World oil in transition, «The Economist»,
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Lovejoy W.F., Homan P.T. (1967) Economic aspects of oil
conservation regulation, Baltimore (MD), The Johns
Hopkins University Press.
Mabro R. et al. (1986) The market for North Sea crude oil,
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McNicol D. (1978) Commodity agreements and price
stabilization: a policy analysis, Lexington (MA), Lexington
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OPEC behaviour and world oil prices, London, Allen &
Unwin, 94-130.
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 MARKET STRUCTURES AND PRICE POLICIES IN THE OIL AND GAS INDUSTRY: THE CASE OF OIL
Nigeria: new terms leading to contract difficulties (1987), «The
Petroleum Economist», February, 71.
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Updated price scorecard for key world crudes (1990), «Petroleum
Intelligence Weekly», Special supplemental issue, 30
April, 2.
Verleger P.K. Jr. (1982) The determinants of official OPEC
crude prices, «Review of Economics & Statistics», 64, 177-
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«The Energy Journal», 11, 15-33.
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Gardner B.L., Rausser G.C. (editors), Handbook of
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«American Economic Review», 39, 1254-1262.
Philip K. Verleger Jr.
PK Verleger
Aspen, Colorado, USA
253

Uncertainty and risk
management
4.2.1 Introduction
The growing energy demand in the industrial world
and in emerging countries poses a series of highly
important challenges in managing the volatility of
price risk for the operators in all energy sectors. The
need to deliver various energy products to diverse
parts of the world, and the need to honour important
commitments with deadlines set far in the future
generate ever more pressing requirements to safeguard
against losses on capital accounts due to excessive
oscillations in the price of these energy products.
Hence, basically for coverage purposes, derivative
security1 instruments and markets have been
developed for energy commodities, primarily
petroleum products. In fact, after the first oil shock in
1973, which represented a turning point in the
management of oil supplies, operators started making
progressively greater use of futures as price
instruments to cover risks. However, it was not until
the 1980s that the first standardized futures contracts
for oil appeared on organized markets. Before that, in
fact, all hedging operations were essentially Over The
Counter (OTC), which is outside of any organized
exchange platform.
The progressive financing of energy transactions
developed throughout the 1980s and 1990s raised
numerous questions. By their very nature, derivative
securities create a new market which subjects the price
registered on the spot market 2 to further tensions. In
fact, in the absence of derived securities, the price of
oil is primarily influenced by impulses and news
mostly of a real nature, whereas with derivative
securities, the oscillations of this particular market
also affect the oil price. Hence, ensuring coverage
against greater fluctuations will entail an even greater
use of derivatives, which in turn, will continue to
influence the spot market.
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
4.2
It is clear from these remarks that a heavy use of
derivative securities is a self-reproducing element,
given the ever greater need to secure further coverage.
Thus, although derivatives play an essential role (i.e.
that of guaranteeing an adequate level of coverage),
their continued use can generate consequences that
cannot easily be controlled. The obvious growth of the
derivative market, as witnessed in recent years, has, in
fact, made spot prices even more volatile and has led
to the creation of increasingly more sophisticated
financial instruments in order to achieve price
coverage. This trend has led to an even more
widespread use of financial instruments in the energy
markets, providing unquestionable advantages for
operators exposed to price risks, but also giving rise to
added causes of uncertainty, since, as a consequence,
the spot market becomes highly volatile. In fact, the
ever increasing presence of derivatives on the market
tends to progressively separate the price dynamics
from the fluctuations caused by real-world factors,
which results in energy markets being dependent on
factors of a speculative nature, since derivative
securities are also often used for motives of pure
speculation.
It should be remembered that the basic external
conditions that oil companies have had to address
in the past are represented by a high degree of
uncertainty and instability. Governing these two
conditions has always been the primary aim of the
1 A derivative security is defined as a particular contract
or typology of financial investment which derives its value
over time from the value of another asset or assets, such as,
for example, shares, bonds or fixed-interest securities.
2 A spot market is a physical or virtual place of
exchange of goods or financial assets which takes place the
moment the price has been determined or fixed according to
market rules, valid for a limited time period.
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MARKET STRUCTURES AND PRICE POLICIES IN THE OIL AND GAS INDUSTRY
major oil companies. During the years between
1950 and 1970, this aim was achieved by means of
a high degree of vertical integration and industrial
concentration. The crisis in the 1970s, which
caused a marked degree of vertical disintegration,
the exclusion of companies from the main
production areas and the reduction of control of
supply to one-sixth, forced the companies to
identify other instruments to cover the risk and
instability connected with investments in the oil
sector, and in the energy sector in general. The
factors of high volatility, increased risk, and
greater operative and decisional flexibility led to
the search for new contracting methods, including
the creation of derivatives markets, such as the
New York Mercantile EXchange (NYMEX), the
regulated futures market started in New York in
1983, based on West Texas Intermediate (WTI)
crude oil; and the International Petroleum
Exchange (IPE), an unregulated market with
deferred delivery started in London in 1980 and
based on the North Sea Brent oil.
The success of these markets can be
documented. Consider the fact that, today, just the
transactions themselves have increased 200 times
compared to the initial amount, and their prices, as
determined by these transactions, are now the
consolidated point of reference for the physical
market. In 2004, NYMEX handled daily contracts
for 212 million barrels of crude oil per day, with
peaks of over 250 million bbl/d which corresponds
to 2.6 times the total world oil production, and to
265 times the reference physical production with a
daily value of 9 billion dollars (2,000 billion dollars
annually). If to these values are added the
transactions for petroleum products and methane
gas, volumes are at least doubled.
Clearly, the creation of derivative instruments has
aimed at safeguarding (albeit imperfectly) the oil
industry against excessive oscillations in oil prices,
and against those forms of market and oligopolistic
behaviour that led to the strong growth of
investments in the oil industry between the 1950s and
the 1970s. The birth and development of increasingly
more sophisticated markets for derivative securities
have enabled coverage to be provided not only for
price oscillations, but also for other types of risk (e.g.
political) which in the past were addressed by more
relational and bilateral measures. All this has
undoubtedly produced some positive effects. The
presence of a very active derivatives market, for
example, gives a strong impetus to converging spot
prices with those of futures, improving the efficiency
of market information as fluctuations in futures
provide important information on the spot price.
256
In the hydrocarbons market, futures and options
contracts are the dominant derivatives. There are
basically four reasons why derivative contracts
(forwards, futures, swaps and options) are used: a)
hedging; b) coverage against excessive price volatility
of the good forming the object of the contract; c)
trading activity linked to the prospect of obtaining
pure profit; and d ) exploiting the possibilities of
arbitrage due to possible price differentials between
different contracts. Note that the coverage referred to
relates both to the price levels of the good and to their
volatility. It is reasonable, in fact, to expect that each
operator desires protection against price oscillations
and excessively high or low price levels, according to
the objectives and the position to be assumed on the
market (whether selling or buying). Furthermore, the
role assumed vis-à-vis the physical market (whether a
net buyer or seller of goods) determines to a crucial
extent the type of derivative to be bought or sold, to
ensure coverage against adverse price oscillations of
the good.
The present article will examine first the role of
forward and futures contracts and subsequently that of
option contracts. A number of types of OTC
instruments will then be analysed (swaps, OTC
options, contracts for difference, spreads) and, lastly,
the Exchanges For Physicals (EFC).
4.2.2 Forward and futures
contracts
Forwards
A forward contract is an agreement to buy or sell
a good, a currency or a security (share or bond) at a
prefixed price, corresponding to a future date. The
spot market is, by definition, the market of immediate
consignment, in which the physical consignment of
the good or of the security forming the object of
exchange takes place immediately after the contract
has been signed.
In general, forward contracts are constructed in
such a way as to be of zero present value. This implies
that at the expiry date of the contract there are no
obligations pending for either party. A classic example
of such contracts regards the case of a refinery, which
buys oil and then sells the refined products (gasoline,
kerosene or other). If, for the sake of simplicity, we
suppose that the price of the final good (e.g. home
heating oil) has been prefixed exogenously, it is clear
that the company concerned will want to minimize the
price risk regarding its purchases of oil. In this case,
the combined use of various forward contracts for oil
will enable the purchase price to be blocked,
minimizing the risk exposure for this company.
ENCYCLOPAEDIA OF HYDROCARBONS

To clarify this, let T be the instant of time when the
forward contract expires, while PT is the spot price of
the oil as applied to time T. Moreover, we will indicate
Ft⫹TⲐt as the forward price fixed at time t with t⬍T: in
practice, Ft⫹TⲐt indicates the price of a forward contract
fixed at time t and expiring at T, utilizing all possible
information at the t th instant. Now, suppose that the
refined product is sold at a price equal to B. When a
company agrees to supply a quantity of a unitary
product at price B to the market at T, if the raw
material (oil) is bought at price PT , this means that the
expected cash flow will be B⫺PT : resulting in a
positive value if B⬎PT , but a loss for the company in
the opposite case. To avoid such a loss, the company
may find it advantageous to sign a contract of the
following type: buy a unit of oil today at the forward
price Ft⫹TⲐt fixed at time t, with delivery at T, and sell
at time T the same quantity on the spot market at price
PT . The cash flow of this operation is given by:
PT ⫺Ft⫹TⲐt. The operation just described guarantees
coverage as represented by the sale of the contracts on
the spot market, covered by the purchase on the
forward market.
The total cash flow will be:
B ⫺PT ⫹PT ⫺Ft⫹TⲐt ⫽B ⫺Ft⫹TⲐt
This means that the combined effect of the two
operations (the sale of B and the purchase of PT , plus
the sale of PT and the purchase of Ft⫹TⲐt is the
equivalent of buying at time t a given quantity of oil at
the forward price Ft⫹TⲐt to be used for the production of
the refined product (Fig. 1). The cash flow derived
from the sale of B after having paid PT is indicated by
the straight line AA, while the cash flow derived from
the operation is represented by the curve HH. The total
cash flow is indicated by the difference B⫺Ft⫹TⲐt. The
profitability of the operation can be immediately
verified already at time t (the initial instant). In fact, if
the forward price Ft⫹TⲐt is less than the proceeds of the
sale of the refined product at price B, the company
value
at T
H contract is often the subject of arbitration between the
B-PT A
0 minimal proportions.
F B PT
A
H object of the contract. More specifically, an investor
Fig. 1. Payment diagram for a forward contract.
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UNCERTAINTY AND RISK MANAGEMENT
will profit from the hedging operation as B⫺Ft⫹TⲐt . On
the contrary, if B⬍Ft⫹TⲐt, the company will suffer a
loss, and it will therefore prefer to agree to purchase
the oil directly on the spot market at instant T. It must
be emphasized that the amount of gains and losses just
described is determined exactly at the t th initial
moment, and there is no need to await the T th time to
verify this.
As may be deduced on the basis of the preceding
example, forward prices are an important vehicle of
information in many respects. In the first place, they
are an instrument which reveals the profitability of a
given business operation. Moreover, they are able to
convey information on the course of market demand.
In this sense, these contracts provide important
indications on the future course of demand, therefore
making it possible to implement a series of investment
planning policies.
The fundamental feature of forward contracts rests
on the fact that they are mainly bilateral contracts: the
parties agree on the quantity and date of delivery of
the good on the basis of their coverage requirements.
For this reason, such contracts are not standardized
(with regard to the characteristics of the good, place of
delivery and so forth) and are not listed on organized
markets. Furthermore, it is also possible to construct
ad hoc forward contracts, based on the specific
requirements of the parties, in order to construct the
exact hedging in relation to the specific case under
examination. This does not necessarily imply, however,
that it is not possible to determine a standardization
for forward contracts as well. In the oil market, for
example, there exists a standard of 500,000 barrels for
forward contracts with variations only in the place of
delivery, the deadline and the physical characteristics
of the good forming the object of the contract.
The price fixed for the forward contract (and also
for the futures contract, as explained more clearly
below) can vary a great deal from the price relating to
the reference asset. However, as the date of the expiry
of the contract approaches, the two prices must
necessarily converge. The price differential existing
between a forward contract and an analogous futures
two markets. Hence, between the acquisition of one
contract and the sale of another one, the difference
between the two prices progressively decreases and,
actually, in day-to-day practice this difference is of
Forward contracts can take on various features
according to whether they are more or less linked to
the actual physical delivery of the good forming the
starts with forwards which always provide for the
physical delivery of the good and, as such, represent a
257
MARKET STRUCTURES AND PRICE POLICIES IN THE OIL AND GAS INDUSTRY
mere extension of a spot contract. Then there are
contracts essentially based on speculation, the so-
called forward paper contracts. These are standardized
forward contracts which, by their nature, find no place
in the futures market, although they offer the same
benefits. Forward paper contracts foresee a definition
of the quality of the product as well as the terms for
delivery.
Futures
As pointed out above, the main difference with the
forward market regards the standardization of the
contract. Futures are listed on organized markets and
are fixed on the basis of standard characteristics. In
the first place, the size of a futures contract is smaller
than the corresponding forward contract. On the oil
market, for instance, the average size of the contract is
1,000 barrels or 100 t. Another essential distinction
between futures and forward contracts regards the
structure of the cash flow. Under a futures contract, the
gain or loss is paid on a day-by-day basis, whereas in
the case of a forward contract, the gain or loss is
recorded at the end of the contract period as a single
amount. Access to the futures market is allowed to
specialized operators who have deposited sufficient
funds in advance in accounts to be credited/debited
when there are gains/losses. Marking to market is the
process that enables the broker or the clearing house to
credit/debit the positions of the participants on the
market on a daily basis. If the futures price increases
compared with the previous day, the clearing house
withdraws funds from the accounts with selling
positions (short) and credits those with purchasing
positions (long). The opposite situation occurs if the
futures price decreases. The clearing house is a service
carried out by the market or by a company in which all
the components of the market participate.
Futures and forward contracts give the holder the
right and the obligation to make purchases or sales. As
opposed to other contracts for derivative securities
(e.g. options), the holder of a futures contract must
follow it through to the end; as failure incurs a penalty
to be paid.
The main reason for having recourse to futures
consists in the possibilities they provide in defining a
series of hedging mechanisms applicable to the
circumstance desired by the operator/investor. In
concrete terms, hedging consists in assuming a
position completely opposite to that considered on the
spot or physical market. In this way, every loss
registered in the physical market can be offset by a
gain in the futures market. It is very difficult to
achieve perfect hedging as, by definition of a futures
contract, numerous variables come into play.
Nevertheless, an adequate use of futures enables
258
hedging to be constructed to shield against unwelcome
price fluctuations.
There are two types of coverage: short hedging and
long hedging. A short hedge is adopted when an
investor (committed to purchasing a given quantity of
a given good) decides to sell (short position) a certain
number of futures contracts. A long hedge is adopted
when an investor (committed to the sale of a quantity
of a given good), decides to purchase (long position) a
certain number of futures contracts in an effort to
protect himself against price fluctuations.
An important component of the futures contracts is
the base, as it is termed. The base is defined as the
difference between the spot price St at time t of the
asset which is the object of hedging (e.g. oil) and Ft ,
the futures price to be used in the hedging operation:
Bt ⫽St ⫺Ft
If the futures market is efficient, as the contract
expiry approaches, the futures price nears the spot
price, so that (if the underlying asset in the futures is
the same asset that must be covered) the base is nil. If
the variation of the spot price is greater than the
futures price, that is, if St⬎Ft , then the base increases,
termed as the strengthening of the base. If, instead,
St⬍Ft , there will be a weakening of the base.
Let’s consider a few examples to help clarify this
explanation.
Short hedge
The Delta corporation buys a cargo of 500,000
barrels of oil at the price of $60/bbl on 2 October
2006. The futures price of oil stands at $60.55/bbl. To
cover itself against the price risk, Delta decides to sell
a number of futures. Five days later, on 7 October
2006, Delta sells the cargo at $59.40/bbl and buys
back the futures which are now exchanged at the price
of $59.80/bbl. The implications of this situation can be
seen below in terms of gains/losses (Table 1).
The net position becomes ⫺0.60⫹0.75⫽$0.15/bbl,
or in this case, following the hedging operation, Delta
has obtained a profit of 15 cents. However, if the
futures price on 2/10 had been $60.35/bbl, the net
result of the two operations (physical and futures)
would have been a net loss of 5 cents/bbl, i.e. still less
than the loss of 60 cents/bbl which would have
occurred without any hedging operation.
This simple example shows that the use of futures
does not necessarily improve the overall financial
position, as it is also possible that such operations will
result in losses, although less than those that could
occur in the absence of any hedging mechanism. Thus,
futures is credited with reducing the risk, and this, in
some cases, can mean appreciable advantages to the
investors.
ENCYCLOPAEDIA OF HYDROCARBONS

Table 1. Short hedge
Date Physical market ($/bbl)
2/10/2006 Purchase at 60.00
7/10/2006 Sale at 59.40
Loss⫽⫺60.00⫹59.40⫽⫺0.60
Long hedge
Let’s now imagine that on 1 September 2006, Delta
has undertaken to sell a quantity of oil on the physical
market, e.g. at a price of $50/bbl with delivery on 1
November 2006. Delta fears that the price will
increase during this period when it cannot buy the
necessary quantity as its storage capacity is exhausted.
To protect itself against price oscillations, Delta must
buy futures, which will then have to be sold on the
physical market at the moment the contract is
executed, so as to close the position. The total profits
and losses are shown in Table 2.
As one can see, the net cost of buying the oil is
equal to 500,000⫺40,000⫽$460,000/bbl. In this way,
the cost of the operation is minimum compared with
the gains it is possible to obtain. The example
presented here shows a profit from the hedging
operation, although it is not certain that such a profit
can be made in every case, as it depends on the prices
of the futures. But even in the case of a possible loss,
the main advantage of this type of operation concerns
the fixing of the net exchange price of the good when
the contract expires.
Tailing the hedge
An aspect particularly worth noting regards the
amount of futures contracts necessary to conclude or
cover the contract. In fact, as opposed to the forward
contract, the futures contract requires what is known
as tailing, that is, the quantity of futures contracts
necessary to effect hedging. Generally speaking, it is
possible to carry out what is called tailing the hedge
using a smaller number of futures contracts than
would be necessary using forward type contracts, as
the futures contract also considers the rate of interest
Table 2. Long hedge
Date Physical market ($/bbl)
1/9/2006 – Purchase of 10 futures expiring on 1/11/2006 at 45⫽450,000
1/11/2006 Purchase of 10,000 barrels at 50⫽500,000
Total spending
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UNCERTAINTY AND RISK MANAGEMENT
Futures market ($/bbl)
Sale at 60.55
Purchase at 59.80
Profit⫽60.55⫺59.80⫽⫹0.75
obtained in the marking to market operation.
Technically, therefore, tailing the hedge implies that
if a company wishes to guard against price
oscillations, for every 100 units of goods on the
physical market, it can use fewer than 100 futures
contracts.
To understand the implications of the above
description, we can consider the relation that exists
between spot and futures prices, as described in the
following equation:
[1] Ft⫹TⲐt ⫽St (1⫹r)T
with Ft⫹TⲐt , the futures price for a good to be delivered
after T periods, determined on date t; St , the spot price
of the good at time t; and r, the yield on an asset
without risk and expiring after T periods.
The same equation in continuous time may be
expressed as:
[2] F ⫽Se r(T⫺t)
Note that equations [1] and [2] must have an equal
sign, to avoid speculative arbitration manoeuvres.
For example, if the rate of interest is 2%
(on an annual basis) and the spot price of oil at time t
is $50/bbl, the futures price in one year is given as:
Ft⫹TⲐt ⫽50⫻1.02⫽$51/bbl.
This means that with one barrel of oil, the position
can be hedged by means of selling less than one gallon
of oil in futures terms. To understand the reason for
this, suppose it is desired to hedge 100 barrels on the
spot market, the cost of which is equal to
100⫻50⫽$5,000. How many oil futures barrels are
necessary to hedge against price oscillations? In other
words, our task is to identify the number of oil futures
barrels equal to n such that, on the basis of [1] or [2],
Futures market ($/bbl)
Sale of 10 futures on 1/11/2006 at 49⫽490,000
Profit⫽40,000
259
MARKET STRUCTURES AND PRICE POLICIES IN THE OIL AND GAS INDUSTRY
there will be: n⫻51⫽100⫻50. The result is:
x⫽100⫻(50/51)⫽98.03. Hence, to hedge 100 barrels
of spot oil, only 98.03 barrels of futures oil are
necessary, at the price indicated. This example
demonstrates what is called a perfect hedging
operation, in the sense that the present value of this
contract is zero.
However, tailing the hedge does not necessarily
have to guarantee a present value equal to zero in
hedging contracts. This happens if the oil spot price
changes following the drawing up of the contracts.
Clearly, the contract to buy or to sell the futures has
been signed and it must be honoured on the due date,
but its value changes with the change in the spot price
of oil which is why the investor may decide to use
precisely this hedging mechanism.
Convenience yield
The above remarks apply for all contracts (of a
financial nature or otherwise) based on a security or
an investment commodity, such as gold, for example.
Actually, many goods can be stored against certain
costs, logically called storage costs. Moreover, some
goods bring appreciable advantages merely by
possessing them, e.g. maintaining a given stock of oil
or natural gas produces value in itself, as the holder of
this asset does not need to turn to the market to be
supplied when need arises. This implicit yield is
known as the convenience yield.
Storage costs and the convenience yield are not
insignificant factors when it comes to determining the
futures price and hedging relations. To be more
precise, the convenience yield does not influence the
calculation of the hedging relations3 except in the rare
case in which the expiry of the futures bond coincides
exactly with the contract instrument (futures or
forward) used for the hedging operation.
The underlying logic of the convenience yield is
easy to understand if one reflects on the fact that
instead of buying a given quantity of oil to be stored,
it is always possible to use the same amount of
money in an alternative form of investment.
However, if sufficient quantities of goods were not
stored (in relation to future needs), it would be
necessary to obtain supplies from the market,
obviously involving higher transaction costs. The
convenience yield shows an actual net saving on
transaction costs, net of the non-profit in terms of
the rate of interest lost by investing in another
financial activity.
In practice, the convenience yield and the storage
costs cannot be easily seen. Publications often refer to
a net convenience yield, assessed by the difference
between the Current Value (CV) of the convenience
yield (gross) and the CV of the storage costs:
260
convenience yield (net) ⫽
⫽CV (convenience yield) ⫺CV (storage costs)
We can now integrate the evaluation formula for
the futures with the calculation of the storage costs of
the convenience yield:
futures price/(1⫹r) ⫽spot price ⫺
⫺net convenience yield
The relation between the convenience yield and the
futures price is then expressed as:
[3] (1⫹yt)Ft⫹TⲐt ⫽(St ⫹Kt) (1+ rt)
where Kt indicates the present value of the storage
costs, while yt indicates the convenience yield. If
instead the convenience yield is understood in net
form, the preceding formula then becomes:
[4] Ft⫹TⲐt ⫽St (1+ rt)Ⲑ(1⫹yt)
In a regime of continuous capitalization, the
preceding formula may be rewritten as follows:
[5] Ft ⫽St e (r⫺y)(T⫺t)
where, naturally, r is the instantaneous rate of interest
on a risk-free asset and y indicates the instantaneous
convenience yield.
Hence, with F0 as the futures price without any
convenience yield, the existing relation between F0 and
the price Ft⫹TⲐt in the presence of the convenience
yield is represented by:
[6] Ft⫹TⲐt ⫽F0 Ⲑ(1⫹yt)
Clearly, the presence of the convenience yield
radically modifies the hedging relations. In fact, in this
context, the quantity of futures to be sold so as to be
covered with respect to a given spot quantity of asset is
expressed by:
[7] SⲐF ⫽(1⫹y)Ⲑ(1⫹r)
A basic problem with hedging relations is having
to address the risks involved for expiry dates set far in
the future. If the convenience yield remains constant, it
is possible to determine a perfect hedging mechanism.
If, on the other hand, the convenience yield is not
constant, and the futures price is positively correlated
with the spot price, it is possible to determine a near
perfect hedging. Finally, if the correlation between the
spot price and the futures price is weak (or barely
existent), perfect hedging is difficult to achieve.
To provide an idea of this reasoning, let’s
consider a simple example. Suppose that the net
3 Note that a hedging relation indicates the number of
futures contracts needed in a spot market with respect to one
unit of goods.
ENCYCLOPAEDIA OF HYDROCARBONS

convenience yield is equal to y⫽1.5%. In this case,
the commitment to buy one barrel of oil one year
ahead is the equivalent (in terms of risk) of buying
1/1.015 barrels of oil today. Likewise, the
commitment to buy one barrel of oil in ten years’
time is the equivalent (in terms of risk) of buying
1/1.01510 barrels of oil today. Therefore, we can
hedge the obligation of buying one barrel of oil in
ten years’ time by selling a forward contract with a
duration of one year. The quantity of futures
contracts to be sold in one year’s time is represented
by the relation (1/1.01510)/(1/1.015)⫽1/1.0159.
As time passes, it is necessary to create contract
roll-overs in order to keep the long-term position
perfectly hedged. In fact, at the end of the successive
year, the number of futures contracts to be sold in
order to keep the position hedged, will be expressed by
(1/1.0159)/(1/1.015)⫽1/1.0158.
By selling a number of contracts equal to 1/1.0158,
the position remains hedged without any risk. It is
easy to imagine that as time passes, the number of
futures contracts that must be sold increases until the
end period of the obligation is reached (that is, when
the expiry of the spot coincides with that of the
futures), when the number of futures contracts to be
exchanged (so as to maintain the hedge) is exactly
equal to the number of spot contracts.
4.2.3 Options
Options are an extremely important and flexible
derivative instrument used both for activities of a
purely speculative nature, and as measures to hedge
positions.
We will attempt to briefly give an idea of the role
options play in the complex hedging mechanisms used
in the energy markets. To date, option contracts have
been issued in the oil market, but not in the gas
market. The first oil option was exchanged on the IPE
in 1983, while in 1986 the NYMEX launched an
option contract on the WTI. Since then, the use of
options has become progressively more intense.
General information
Options are divided into two categories: call and
put. The holder of a call option is granted the right to
purchase a given asset (a security or a good) at a
given price called the strike price. The holder of a put
option is granted the right to sell a given asset at a
prefixed price.
A further distinction regards the period in which
the option may be exercised. European options differ
from the American version. European options may be
exercised solely upon expiry, whereas American
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UNCERTAINTY AND RISK MANAGEMENT
options may be exercised at any time. Obviously, the
profit from a call option increases as the price of the
asset on which it is based increases. On the other hand,
if the price of the asset is lower than the strike price,
the value of the option is zero and the cost for the
holder is equal only to the purchase price of the
option. Hence, the profit for the holder of this option
can potentially be extremely high. The same thing
happens for the holder of a put option. If the price of
the asset is lower than the strike price, the advantage
of exercising the option is at its highest and the holder
can profit from the difference between the strike price
and the actual price.
In the forward market (futures market), both the
buyer and the seller of the contract are exposed to
analogous price risks. This is not the case for the
options market, in which the buyer and the seller have
an extremely different risk exposure. In general, a call
option is bought foreseeing a rise in prices, while a put
option is bought foreseeing either a drop in prices or a
stationary price level.
The intrinsic value of the option is defined as the
difference between the price of the underlying asset and
the strike price. The buyer of the option pays a premium
(or the price of the option) to the seller (or underwriter)
for the right to hold the option at that given strike. An
option’s value depends, among other variables, on the
time between the purchase and the expiry date of the
option. Therefore, the holder of the option is faced with
three alternatives: to exercise the option upon its expiry,
if it is a European option, and at any moment if it is an
American option; to sell the option, thus liquidating the
position; or to allow the option to expire.
The option provides the possibility to protect
oneself against adverse price fluctuations of the
underlying asset, which, it should be observed, may be
a futures contract or a spot contract.
The following is a summary of the obligations and
rights stemming from options.
Call option. A buyer has the right to purchase a
security (futures or spot) at the prefixed price stated in
the contract on an exact expiry date or earlier;
expectation: price increase of the given asset; a seller
has the obligation to sell the asset at a prefixed price at
the moment decided by the buyer (on the expiry date
or earlier); expectation: decreasing or constant price of
the given asset.
Put option. A buyer has the right to sell a security
(futures or spot) at the prefixed price stated in the
contract on an exact expiry date or earlier;
expectation: decreasing prices of the given asset; a
seller has the obligation to buy the asset at a prefixed
price at the moment decided by the buyer (on the
expiry date or earlier); expectation: increasing or
constant prices of the given asset.
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MARKET STRUCTURES AND PRICE POLICIES IN THE OIL AND GAS INDUSTRY
The price of an option depends on four basic
variables: a) the price of the underlying asset (spot
or futures); b) the time remaining until the expiry date;
c) the volatility of the asset; and d ) the interest rates of
a risk-free asset.
The relation between the price of the given asset
and the price of the option produces a series of
important criteria which characterize the option as
being: at-the-money, in-the-money, or out-of-the-
money. An option is defined as at-the-money when the
strike price (henceforth K) is exactly identical to the
price of the given asset (S ); an option is defined as
in-the-money when, in the case of a call (put) option,
the price of the given asset is higher (lower) than the
strike price. Clearly, an in-the-money option has a
positive intrinsic value. Finally, an option is of
out-of-the-money when the price of the given asset is
lower than the strike price in the case of a call option,
or higher than the strike price in the case of a put
option.
In general, the premium (or price) of an option is at
least equal to its intrinsic value.4 The value upon
expiry (or time value) is defined as the difference
between the premium (or price) and the intrinsic value
of the option. This term indicates the amount of money
that investors are prepared to pay above the intrinsic
value of the option. The time value of an option
diminishes as the date of the expiry of the option
approaches, given all the other elements. This is
because with the approach of the expiry date, there is
less room for variations in the market quotations of the
given asset.
An important element in assessing options is the
volatility of the object concerned. If, in fact, the
market of the said asset is highly volatile, the premium
for the options increases, as the likelihood increases
that the option will reach its in-the-money position.
Therefore, there exists a positive correlation between
volatility and price of the options. Calculation of the
volatility can be carried out by simply assessing the
available historical data of the asset. The historical
volatility in the price of the given asset can represent a
starting point to infer future volatility.
The role of implied volatility is certainly crucial in
the definition of exchanges of options. Implied
volatility indicates the expectation of future volatility
in the current price of the option. It indicates the
expectation formed by the market regarding future
volatility on the basis of the current price of the
option. Implied volatility is not easy to calculate, as it
requires a prior calculation of the option price by
means of a model price. Normally, in fact, the option
price is calculated using the Black and Scholes
formula (1973) to find the value of its intrinsic
implied volatility.
262
Lastly, the interest rate for a risk-free asset plays
a completely analogous role in calculating the price
of the options and in determining the price of other
derivative securities, as it represents a measure of
the opportunity cost of the investment in assets
alternative to the option. A variation in the market
rates of interest means a different assessment of the
future cash flows expected to be generated by the
option, and therefore implies a different option
price. The following are simple examples to help
clarify the subject.
Purchase of a call option
Let us consider an option for the purchase of a
given quantity of oil with a strike price of $50/bbl. The
price of this option on the market is fixed at $0.5/bbl.
This option gives the right to buy one barrel of oil at
the price of $50. If the price of oil rises to $55/bbl, at
the expiry of the contract the option assumes a positive
intrinsic value (and is thus defined as in-the-money)
and will definitely be exercised. In this case, the
intrinsic value of the option is $5/bbl, as determined
by the difference between the price of the asset and the
strike price. The net profit of this operation is equal to
the difference between the intrinsic value of the option
and its purchase price: 5⫺0.5⫽$4.5/bbl.
As shown in Fig. 2, as the price of oil increases, the
value of the call option will also increase. On the other
hand, if the spot price of the oil decreases, the intrinsic
value of the option becomes zero and so it would never
be advantageous to exercise it (out-of-the-money).
Purchase of a put option
Now consider the case of a put option, having the
same characteristics as the call option described in the
preceding example (i.e. strike price equal to $50/bbl). If
the price of oil goes down to $45/bbl, the holder of the
option will immediately exercise the option accruing a
profit of 50⫺45⫺0.5⫽$4.5/bbl. In this case, in fact, it
will be more advantageous to sell with a strike price
equal to $50 rather than be tied to a sale on the market
at the price of $45/bbl. On the other hand, if the spot
price rises to $52/bbl, the value of the option would
become zero and there would no longer be any profit in
exercising it. The payoff structure is illustrated in Fig. 3.
The analysis of the profits and losses described
above is valid from the standpoint of the buyer of the
option. If, instead, we adopt the seller’s point of view,
all the payoffs would be exactly reversed: so where the
buyer of the option makes a profit, the seller of the
same option suffers a loss (Hull, 2002).
4 Note that the intrinsic value of an option is defined as
the difference between the price of the given asset and the
strike price.
ENCYCLOPAEDIA OF HYDROCARBONS

profit/
losses
0 equal to $50/bbl; it is as though the fluctuations of the oil
50 PT
Fig. 2. Payment diagram for a call option.
profit/
losses
0
50 PT
Fig. 3. Payment diagram for a put option.
By their very nature, options represent a wager as to
the future course of the security or of the good represented
in the contract. As demonstrated by the above examples,
it is clear that the profits can be quite considerable. Due
to this characteristic, options lend themselves well to the
creation of synthetic hedging contracts.
Synthetic contracts
Options can be used to construct a security (or a
position) equivalent (in terms of cash flow) to a
forward or to a futures. For example, a long position
on a forward contract is obtained in an equivalent
manner through the simultaneous purchase of a call
option and sale of a put option, both with the same
strike price and the same contract expiry date. The
operation may be represented as follows:5
⫹forward ⫽⫹call ⫺put
This type of contract is defined as a synthetic long
forward.
Let’s now assume that the strike price is equal to
$50/bbl for the purchase of a given quantity of oil and
that both call and put prices are each equal to $0.5/bbl.
In this case, the profits and losses of this operation are
as follows: purchase of a call option (strike price
$50/bbl)⫽⫺0.5; sale of a put option (strike price
$50/bbl)⫽⫹0.5; total cost⫽0.
If the spot price of oil rises to $55/bbl, the call option
has an intrinsic value of 5, but the put option has no value
(and therefore it will never be exercised). The profit in
this case is equal to 5⫺0⫽$5/bbl. On the contrary, if the
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UNCERTAINTY AND RISK MANAGEMENT
price goes down to $45/bbl, the call option has no value,
while the value of the put option will be equal to
⫺$5/bbl. This combination presents the same profit and
loss structure as a long position on futures with a price
price were linked precisely to this value.
Such a case can be analysed in relation to a short
position in the forward contract: this position is
equivalent to the simultaneous purchase of a put
option and the sale of a call option, issued for the same
strike price and for the same expiry date. Observe:
⫹forward ⫽⫺call ⫹put
If we use the same data in this case as in the
preceding example, we see once again that the net cost
of the operation is equal to zero and the advantage
obtained from it (apart from the possible capital gain)
regards the possibility of fixing the transactions for the
asset concerned based on a given prefixed price.
Following the same scheme adopted above, the
situation will be: purchase of a put option (strike price
$50/bbl)⫽⫺0.5; sale of a call option (strike price
$50/bbl)⫽⫹0.5; total cost⫽0.
Therefore, if the price drops to $45/bbl, the put
option does not have an intrinsic value equal to 5,
while the call option has no value (and will not be
exercised). The profit obtained from this operation is
equal to: 5⫺0⫽$5/bbl.
Should prices rise to $55/bbl, then the put option
would never be exercised and the call option would
have an intrinsic value equal to ⫺$5/bbl.
Due to this flexibility guaranteed by the options, it
is possible to replicate the risk/yield characteristics of
a call option and of a put option through an
appropriate combination of forward and futures
contracts. For example, the purchase of a put option
and a long position on the forward contract is
equivalent to the purchase of a call option:
⫹call ⫽⫹forward ⫺put
This is also equivalent to the operation of selling
the forward offset by the purchase of a put option and
by the sale of a call option:
⫺forward ⫽⫺call ⫹put
All the variants just discussed are made possible
thanks to what is termed put-call parity. In fact, by
modifying the preceding equation, we obtain:
P ⫽F ⫺C
⫺C ⫽⫺P ⫺F
5 The⫹sign before the name of an asset indicates a
buying position for said asset. The – sign, on the other hand,
indicates the sale thereof.
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MARKET STRUCTURES AND PRICE POLICIES IN THE OIL AND GAS INDUSTRY
where P indicates the price of a put option, F the price
of a forward and C the price of a call option. The
validity of this equation is guaranteed by the arbitrage
activity that may be conducted in order to exploit what
is termed the mispricing between the various forms of
assets. In fact, if different combinations of option
contracts can be used to replicate the cash flow
guaranteed by forwards and futures, then the
arbitration activity will contribute towards maintaining
a correct price balance among the various assets.
Examples of hedging
We will now look at some examples of hedging
strategies which can be carried out through the use of
options. Let’s start with the strategy on the producer’s
part.
The producer
Suppose that the oil price is $58/bbl. The
producer expects prices to fluctuate between $55/bbl
and $63/bbl, so he will seek to utilize hedging to
avoid possible losses resulting from prices under
$55/bbl. A possible hedging strategy could be the
purchase of a put option with a strike price of
$55/bbl and the sale of a call option with a strike
price of $63/bbl. If the two options are exchanged on
the market at exactly the same price (e.g. $0.4/bbl),
the net cost of the transaction obtained from this
operation will be equal to zero. There could be a cost
if the price of the two options differs, but that would
not invalidate the hedging mechanism used.
Continuing with our example, if the oil price rises
above $63/bbl, the holder of the call option will
immediately exercise the option and the producer can
sell the oil at $63/bbl. In so doing, the selling oil
price remains blocked at $63/bbl.
The buyer
Now consider an airline that needs to purchase fuel
for its planes. Imagine that the company wishes to
hedge the price of the oil. If the spot price for fuel is
$60/bbl, the company wants to shield itself against the
eventuality of prices rising above $70/bbl. For this
purpose, it can buy a call option with a strike price of
$70/bbl, at the cost of $1.00. The purchase of this call
option can be financed through the sale of a put option
with a strike price of $50/bbl, at the price of $1.25.
The net cost of this transaction is
⫺1.00⫹1.25⫽⫹$0.25. If the spot price of the fuel
rises above $70/bbl, then the company will exercise its
call option, thereby managing to keep its purchase
price no higher than $70/bbl. If, however, the spot
price of the fuel drops below $50/bbl, then it would
behove the company to exercise the put option and
thus buy fuel at $50/bbl. On the basis of this example,
264
the company manages to keep the price fluctuations of
the raw material within a specific range.
Specific hedges
Options can be combined so as to determine the
optimal coverage to meet specific requirements. In
particular, the simultaneous purchase and sale of call
and put options can be a useful hedging strategy
against the price oscillations of an asset. Buying a put
option and a call option at the same strike price is
called straddling. If, on the other hand, the strike price
is higher for the call option than for the put option,
then the contract is called a strangle.
The profits and losses of a strangle are shown in
Fig. 4, where the strike price of the put option is valued
at $45/bbl, but that of the call option is $50/bbl. The
simultaneous sale of a call and a put option is called a
short strangle. In particular, if the call option has a
higher strike price ($50/bbl) than the put option
($45/bbl), the short strangle can be represented as
shown in Fig. 5.
Call spreads
Some hedging procedures foresee the purchase of a
call option and the sale of another call option with a
higher strike price than the former. In general, this type
of combination is sought when the operators are
expecting the market prices of the given asset to rise.
This instrument requires the payment of a premium as
the price of the option to be sold is usually closer to the
market price. The payoff structure in Fig. 6 illustrates a
call option for purchase at a strike price of $45/bbl, and
the call option for sale at a strike price of $50/bbl.
In this manner, the trader limits his profit to the
difference between the two strike prices. The waiving
of a larger profit is offset here by less exposure to
future volatility, as the two options have the same
expiry date and the same volatility. The maximum
profit obtainable is equal to the difference between the
two strike prices and the net premium paid.
Put spreads
Put spreads are defined as the combination of two
activities, such as the purchase of a put option and the
profit/
losses
0
PT
45 50
Fig. 4. Payment diagram for a strangle.
ENCYCLOPAEDIA OF HYDROCARBONS

profit/
losses
0 increase in the value of the given asset. In the same
45 50 PT
Fig. 5. Payment diagram for a short strangle.
profit/
losses
0 mention should be made of butterflies which involve the
45 50 PT
Fig. 6. Payment diagram for a call spread.
simultaneous sale of another put option with a lower
strike price than the former. This is the same type of
scenario examined above for call options. For the sake
of brevity, we will not analyse this case in detail, but
see the following reference for further information on
the subject (Hull, 2002).
Fences and collars
As previously seen, the buying and selling of put
and call options can help block the price of the
underlying asset within a given time period. Fences
and collars represent the combination of various
strategies used in the purchase and sale of call and/or
put options for the purpose of blocking the fluctuation
in the price of an asset within a specific time period.
Again, those interested are referred to more
specialized and operative sources from the standpoint
of trading positions (Hull, 2002).
Other strategies
A less common strategy, known as a calendar
spread, has been devised by the market where
options are used to guarantee the ample flexibility of
hedging mechanisms. Through this instrument, one
option may be purchased at a given moment (e.g. in a
predetermined month) and another option sold which
has been issued with the same strike price in a
different period (month). Investors employ this
strategy with the hope of gaining an advantage from
the difference existing between the volatility in the
two different moments and the period of time
between them.
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UNCERTAINTY AND RISK MANAGEMENT
When, however, one option is sold and another
with a higher strike price is purchased, a backspread
has been used. By this procedure, investors seek to
obtain a high profit in a market with an expected
way, a put ratio backspread involves the sale of a put
option with a higher strike price and the purchase of a
larger quantity of put options with a lower strike price,
so as to increase profitability when a drop in the prices
of the given asset is foreseen.
In general, these instruments are used when there
are reasonably well-founded expectations as to the
future course of the price of the asset concerned.
Option traders then adopt further combinations of
options for purchase and/or sale, in order to obtain the
maximum advantage from price differentials. A brief
purchase of a call option with a strike price equal to x,
for example, together with the sale of two call options,
the first with a strike price equal to y, and the second
call option with a strike price equal to z. The relation
between the strike prices is: x⬍y⬍z. In general, y is
very close to the market price of the asset concerned.
Naturally, other combinations are possible. In fact,
traders are constantly on the look-out for even more
sophisticated instruments, obtained through different
price combinations of various derivative securities
Although these strategies are commonplace in highly
specialized financial markets, they are not at all
frequent in markets with goods as their underlying
assets. It is reasonable to expect, however, that with
the ever increasing sophistication of the oil market and
the progressive expansion of financial transactions,
these practices will also spread to oil and other energy
markets.
Delta hedging
Delta hedging is a form of hedging by means of
options which is very important in trading activity. The
delta indicates the variation in the price of an option in
response to the variation in the price of the underlying
asset. In concrete terms, the delta is an index of
reactivity and indicates the degree to which the price
of the option reacts for each unitary price variation of
the underlying asset. It should be observed that the
delta can also be calculated in relation to the price
variation of a futures, when the option is based on a
futures. Theoretically, the delta is an at-the-money
option equal to 0.5: this means that if the price of the
given asset varies by a specified amount, e.g. x, the
price of the option varies up to 50% of that specified
amount. A mostly in-the-money option has a delta
approaching 1, while an out-of-the-money option has a
delta equal to zero; i.e. the price variation of the asset
has no influence on the price of the option.
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MARKET STRUCTURES AND PRICE POLICIES IN THE OIL AND GAS INDUSTRY
When options are used for hedging operations, the
delta provides indications regarding the quantity of
contracts for the asset concerned which must be
bought or sold in order to keep the position hedged.
The variation in the price of the security (or of the
goods) modifies the delta and consequently modifies
the number of securities to be bought or sold.
Suppose, for example, that the delta of a call
option for an oil futures is equal to 0.7. Suppose,
also, that the price of the option is equal to $8/bbl,
while the price of the relevant asset (in this case a
barrel of Brent oil) is equal to $40/bbl. Now consider
a company which has sold 1,000 call contracts to buy
200 barrels of oil. This position could be hedged by
buying 0.7⫻200⫽140 barrels of oil. By this
procedure, the profit and the loss of the two
operations tend to offset each other. In fact, if the oil
price rises by $5/bbl, then the profit obtained from
the 140 barrels purchased will be equal to
5⫻140⫽700, but the price of the option rises by
0.7⫻5⫽$3.5/bbl, entailing a loss on the options sold.
In this case, the investor loses 700DP, when the oil
price varies to the same extent as the delta. Generally
speaking, the delta of the given asset is, by
definition, always equal to 1, and so the long position
on the 140 barrels of oil has a delta equal to 700.
Hence, the overall delta on the whole operation is
zero, and the hedging position thus achieved is
defined as neutral with respect to the delta.
The delta may undergo variations following a
change in the price of shares. This entails an
adjustment of the position to avoid changing the degree
of coverage. In fact, following the $5/bbl increase, the
delta changes to 0.75 so that, in order to maintain the
same degree of coverage, it will be necessary to buy an
additional 0.05⫻200⫽10 barrels of oil.
The role of the delta in determining the price of
options was first introduced by Black and Scholes
(1973). It should be mentioned that delta hedging is
only one of several possible systems used, albeit the
one most widespread. It is indeed possible to construct
alternative hedging strategies based on indices that
determine variations in the volatility of the relevant
security (vega hedging) and other more sophisticated
indicators. These methods are mostly used in markets
for financial assets (shares or bonds), rather than
goods, although the progressive increase in the use of
options in the oil market gives a glimpse of its
potential success for the future.
4.2.4 OTC instruments
OTC instruments are derivatives which have been
specifically developed for use with hedging and/or
266
speculative activities to meet the unique demands of
investors, traders or companies. Given their specific
nature, they are not generally exchanged on organized
markets, but their price is determined as a result of
bilateral transactions.
Generally, all the financial instruments studied
above can have their OTC version. This is especially
important for contracts with quantities and
characteristics of the reference asset which are not
standardized or which cannot easily be standardized.
However, certain typologies of derivatives exist that
may be defined almost exclusively as OTC
instruments; swaps are included among these. Below
we will analyse the role of OTC options and other
specific contracts, such as Contracts For Difference
(CFD) and Exchanges For Physicals.
Swaps
Swaps play an extremely important role in the sector
of oil derivatives. In fact, this type of contract permits
perfect hedging, as swaps can be directly determined
and modified on the basis of the specific requirements
of the counterparties. Hence, swaps are an absolutely
flexible instrument well in keeping with the other types
of derivatives commonly used in the oil market.
The swap contract is an exclusively financial
transaction through which two counterparties agree to
exchange money on specific dates in the future, on the
basis of a given price formula. With this contract
specifically created to overcome risk, the swap user
guarantees a fixed price for a given asset for an agreed
time period. Thus stipulated, the contract enables the
signatory to exchange a series of payments determined
on the basis of the price oscillations of the goods
defined in the contract, against a payment based on a
fixed price, so as to eliminate risks due to excessive
fluctuation in prices.
Swap contracts have two basic advantages: in the
first place, they are purely financial transactions that
can be exchanged without any sort of risk connected
with the physical delivery of the good, due to a
different quality of the good, its terms of delivery, and
so on. In the second place, these contracts can be
exchanged at a future date, as they are not limited to
the time restrictions of futures and options. In spite of
these positive aspects, however, the swap market for
oil, or hydrocarbons in general, has not developed to
the same extent as options and futures have. This is
basically due to negotiation difficulties inherent in the
use of these instruments. Nevertheless, swaps are
unquestionably very important instruments for
carrying out hedging operations.
Technically, a swap can be applied to any asset, as
the physical exchange of the goods or assets is in no
way the subject of contractual negotiation.
ENCYCLOPAEDIA OF HYDROCARBONS

There are various types of swap contracts. The
most common swap is called fixed for floating, in
which the signatory of the contract (subject A)
undertakes to buy (or to sell) a quantity of the security
(or goods) defined in the contract, from (or to) the
user of the swap (subject B), at a fixed price, over a
given period of time. For his part, subject B
undertakes to sell (or to buy) the same quantity at a
flexible price over the same period of time. In the
latter case, the flexible reference price is fixed by the
two parties on the basis of a given price formula,
possibly linked to specific indicators.
From this information, it is inferred that the swap
involves two notional type transactions, which do not
necessarily have any correlation with the physical
exchange of goods. It is precisely the simultaneous
presence of these transactions that permits the absence
of any physical exchange of the given good. Consider
the following example of a person who purchases oil
(the owner of a refining plant) who, in fearing a price
increase, decides to use a swap contract to fix the price
of his purchase. The financial transaction underlying
the contract foresees the buyer purchasing a given
quantity of barrels of a particular quality, at a given
fixed price established by contract; and reselling the
same quantity and quality of product on the same
dates, but at a flexible market price, fixed on the basis
of a contractual formula.
If the flexible price exceeds the fixed price, the
financial broker who issued the swap pays the
difference to the buyer; and conversely, if the flexible
price is lower than the fixed price, it is the buyer who
pays the difference to the financial broker. The net
result of this operation means that the buyer must pay
a fixed price. In short, the gains that the user of this
contract could make will be offset by the losses that he
might possibly suffer at the moment he has to buy
quantities of oil on the market at a fluctuating price.
To illustrate this example more clearly, we will
consider a number of numerical values. Suppose that
Table 3. Payment diagram for a swap
Price of kerosene Fixed price
Period
($/t) ($/t)
2006Q1 451.35 450
2006Q2 448.22 450
2006Q3 453.75 450
2006Q4 452.63 450
Total 451.48 450
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
UNCERTAINTY AND RISK MANAGEMENT
an airline company intends to buy a given quantity of
kerosene throughout 2006. The company (company A)
intends to apply a hedging strategy to minimize the
risk of having to sustain sudden price increases of
kerosene. For this purpose, company A decides to fix
the price of kerosene at $450/t (Free On Board - FOB
Rotterdam), for the entire year of 2006. The desired
quantity of kerosene is 4,000 t.
The structure of the swap contract that could
benefit company A is as follows:
• Company A buys 4,000t of kerosene from subject
B (swap dealer) at the price of $450/t, for a fixed
contract period covering all of 2006.
• Company A undertakes to sell back the same
quantity to subject B at a fluctuating spot price
based on the quarterly average of the price of
kerosene, fixed on the Rotterdam market.
• Quarterly payments are made based on the
difference between the fixed price of $450/t and
the value of the price index considered above; if
the average price is higher than $450/t, then subject
B pays the difference to company A; the opposite
occurs if the average price is lower than $450/t.
Table 3 briefly sets out the payment structure, with
a summary of the in- and out-payments due to the
swap. As explained earlier, subject B sells company A
1,000 t of kerosene every month at a flexible price, but
buys the same quantity at a fixed price. The difference
between the two prices results in a profit (if positive)
or a loss (if negative).
In Table 4, we see that the purchases made at the
fixed price are (in the majority of cases) more than
offset by the gains derived from the sales at the
fluctuating price. It is observed that by the nature of
the contract, the only cash flow comes from the net
payments derived from the difference between the
fixed price and the flexible price. The transaction
represented in this example shows a profit for
company A. This outcome clearly depends on the
course of the flexible prices. The net result of this
Payments
Quantity Difference
(proceeds/losses
(t) ($/t)
on swap)
1,000 1.35 1,350
1,000 ⫺1.78 ⫺1,780
1,000 3.75 3,750
1,000 2.63 2,630
4,000 1.48 5,950
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MARKET STRUCTURES AND PRICE POLICIES IN THE OIL AND GAS INDUSTRY
Table 4. Costs and proceeds of a swap operation
Price of kerosene Fixed price
Period
($/t) ($/t)
2006Q1 451.35 450
2006Q2 448.22 450
2006Q3 453.75 450
2006Q4 452.63 450
Total 451.48 450
operation consists in making the outgoing cash flow
for the purchase of fuel a fixed cost for company A.
In summary, swap contracts are very flexible as
they do not include any constraints as to expiry dates
for payments, which may be prefixed by the parties.
These contracts are often used as a hedge against price
oscillations of goods for which standard derivative
contracts (futures) are not exchanged. For the oil
market, the quotes given on international providers
such as Platt’s or Argus are used as the basis for fixing
the fluctuating price.
The price of a swap contract depends on three
basic factors: the cost of hedging the position; the
rating of the swap user; and the margin required by
the broker who issues the contract. Among the
factors mentioned, by far the most important one is
the cost of hedging the position, which depends
entirely on the structure for the expiry dates of
futures or forwards, often used in hedging operations
for similar assets to those foreseen in the contract in
being. In fact, the swap contract can be synthetically
created (or replicated) through an appropriate
portfolio of futures contracts equivalent in volume,
quantity and quality (to the goods forming the
subject of the exchange), to be sold or bought at each
contract expiry date.
OTC options
In practice, various particularly complex types of
swap contracts exist which can be likened to option
contracts. This specific category of options (OTCs)
can be constructed on the basis of the counterparties’
requirements so as to create upper or lower limits on
the prices of given assets, for the purpose of limiting
exposure to price risk. There is no precise, universally
accepted definition of an OTC type option, as a large
variety exists on the market. However, in energy
markets, the most common form of such options is
called the Average Price Option (APO), or the Asiatic
option, to distinguish it from the American and
European options.
268
Quantity Proceeds from Cost
(t) sale to B of purchase
1,000 451,350 450,000
1,000 448,220 450,000
1,000 453,750 450,000
1,000 452,630 450,000
4,000 1,805,950 1,800,000
Exactly like the options exchanged on organized
markets, OTC type contracts give the buyer the right,
but not the obligation, to buy (in the case of a call
option) or to sell (in the case of a put option) the asset
concerned at a prefixed price in exchange for a
premium paid at the moment of buying the option.
Upon exercising it, instead of converting the option
into a futures type contract, an OTC type option is
converted into a monetary payment which goes from
the signatory to the holder of the option. Thus, these
types of contracts are purely financial and, like swaps,
cannot be used for making commitments for the
physical delivery of the good concerned.
OTC options have certain important differences
compared with traditional option contracts. Generally
speaking, an OTC option of a call type is often called a
price cap, while a put type is called a price floor.
Furthermore, such options may be exercised only on
the expiry date and only if the average price is higher
or lower than the agreed price. This distinguishes them
from the European options which may be exercised
only if the market price is higher than the strike price
and on the date of expiry, or from American options
which may be exercised at any time during the life of
the option. Lastly, OTC options are automatically
exercised on the expiry date if they are in-the-money.
OTC options generally cover a longer period of time
than a futures contract. Apart from these
characteristics, OTC options are just like those
commonly exchanged on the markets, as concerns the
inherent risk exposure of the option’s signatory and
buyer.
Price cap
To understand how a price cap is determined, we
can imagine that the investor buying the right to the
option seeks to protect himself against price
fluctuations and hopes to fix an upper limit (or cap) on
the price of oil or other fuel (e.g. kerosene for aircraft).
The agreement based on the OTC foresees that the
financial broker (the individual who issues or sells the
ENCYCLOPAEDIA OF HYDROCARBONS

option) pays the buyer of the option the difference
between the price cap and the average price of the
good concerned, calculated in each of three future
months when the monthly market price is higher than
that agreed upon in the price cap. In exchange, the
buyer of the option undertakes to pay the signatory of
the option a premium for the same quantity of fuel
calculated at a prefixed price.
The market price of an asset is often determined
on the basis of the average of the daily prices
published by a universally accepted information
provider (e.g. Platt’s). The option is automatically
exercised on the expiry date if the average market
price is higher than the agreed level of the price cap.
The contract is regulated at the end of each month
(just as with swaps) and the signatory pays the buyer
the difference between the prefixed price and the
average flexible price (calculated as above). If,
instead, the average of the prices of the given asset
remains lower than the agreed level of the price cap,
no interim payment is due.
In general, the price of this type of OTC option is
determined on the basis of the Black and Scholes
formula (1973). However, it is evident that an OTC
options contract can be replicated through the
construction of an appropriate portfolio of futures and
non-OTC options contracts. Thus, each participant in
the market is entitled to observe and verify that the
proposed prices are correct through appropriate
arbitration operations. Let us consider, for example, an
airline company that decides to use OTC type options
in order to limit its exposure to the fluctuations in
kerosene prices. To determine the prices of its trips, it
obtains quotations for three types of contracts: an
ordinary swap contract (called plain vanilla), a price
cap, and a price collar. Let’s look at what these are and
which of them is most beneficial for the company for
hedging the price of kerosene.
Plain vanilla. This type of contract is the classic
fixed for floating swap. If the spot price of kerosene is
higher than the fixed price established by contract, the
airline company will receive a cash payment equal to
the difference between the spot price and the monthly
average of the Platt’s quotations. If, on the other hand,
the price is lower, then the company must in turn make
a payment to the signatory of the futures.
Price cap. An alternative hedging method is the
purchase of a price cap. This method allows the
company to protect itself by fixing a maximum price
for the fuel throughout the period of the transaction.
This procedure is that of a real option. Its cost
depends, to a crucial extent, on how far the strike price
is fixed from the price cap. In practice, this is the
process used in determining how close the option is to
being out-of-the-money.
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
UNCERTAINTY AND RISK MANAGEMENT
If the average price of fuel is lower than the
prefixed cap in the agreement, the airline does not
have to pay anything to the supplier of the swap
contract and will buy his fuel on the market at the
lower spot price (in this case). However, should the
average price be higher than that established, the
company will receive a monthly payment from the
signatory of the swap agreement equal to the
difference between the price cap and the monthly
average of the CIF (Cost, Insurance and Freight) price
on aircraft fuel determined based on Platt’s quotations.
By means of this payment, the company manages to
offset the higher price being charged on the market.
Price collar. A simpler alternative is the price
collar. This procedure makes it possible to fix the
minimum price and the maximum price. Clearly this
minimizes the risk exposure in the sense that it avoids
both upward and downward fluctuations of the price,
so that the airline company is subject to risk only
within a given range.
Contracts for difference
All swap contracts are, technically speaking,
contracts for difference, as in the centre of the contract
there is a monetary payment fully defined by a
difference between two prices. Actually, in the energy
industry, and oil in particular, the expression Contract
For Difference (CFD) refers to a very specific
typology of contracts, as clarified below.
The price of the majority of contracts for the
purchase or sale of oil is determined based on the
Brent price. This makes it difficult, therefore, to use
Brent as a means of coverage, when its price moves
independently of the forward price. In this regard,
CFDs serve precisely to create a means to cover the
price differential that exists between the Brent spot
price and the first month of the futures on said Brent
(otherwise called futures on the first position).
CFDs are normally drawn up weekly, so they are
quoted on the basis of six weeks in advance, although
on the market there are market makers prepared to
quote contracts even with a longer expiry date.
Consider, for example, the case of company A which
is ready to buy a cargo of Arabian Light at a price
determined on the basis of the Brent weekly quotations
as reported by Platt’s, for the period of 12-16
September 2005. Today is 5 September. In the contract
it is established that Platt’s quotations are to be
increased by 50 cents ($ 0.5). Company A then decides
to sell the same cargo, using the quotations of the
Brent futures on the first position (with expiry date at
the end of October, given that it is the November
futures) incremented by 40 cents. Actually, company A
is not exposed to any price risk, as the charges are
prefixed for both purchases and sales, but it is exposed
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to the price differential between the Brent spot price
and the November futures. In fact, if the spot price
increases to a higher level than that of the forward, the
profit obtained on this transaction could be
transformed into a loss. To avoid this, company A uses
a CFD to block the price differential.
Now suppose (to finalize our example) that the
spot quotation for Brent shows a discount of 20 cents
with respect to the Brent quotation for November,
which is sold at $60/bbl. Hence, company A buys
Brent at the price fixed for the November futures with
a 20 cent discount, i.e. at the price $59.80/bbl, and
sells the November futures at $60/bbl. Note that the
spot price defined for the week of 12-16 September
2005 is, by definition, uncertain at the moment the
contract is fixed on 5 September.
Hence: actual purchase price⫽dated Brent⫹50
cents⫽(November Brent⫺20 cents)⫹50
cents⫽November Brent⫹30 cents; sale
price⫽November Brent⫹40 cents; gain⫽10 cents.
Let’s now consider that the week of 12-16
September has arrived. The cargo of Arabian Light is
priced as shown in Table 5, using Platt’s quotations.
To close the position, company A sells the dated
Brent at the average price and buys the November
Brent at the average price.
We therefore have:
• CFD: dated bought at $59.80/bbl; November sold at
$60.00/bbl; dated sold at $60.74/bbl; dated bought
at $60.75/bbl; gain: $0.94/bbl; loss:⫺$0.75/bbl.
• Physical exchange: bought at
60.74⫹0.50⫽$61.24/bbl; sold at
60.75⫹0.40⫽$61.15/bbl; loss: ⫺$0.09/bbl.
Therefore, net: 0.94⫺0.75⫺0.09⫽$0.1/bbl, which
equals a discount of ten cents as discussed above.
In this case, from the interaction between the
financial and physical transactions, a positive profit is
obtained. However, had there been a different trend in
the market, there could have been a loss on the CFD
and a gain on the physical transaction, but without
Table 5. Price of cargo of Arabian Light
(12-16 September 2005)
November Dated
12/9 60.40 60.35
13/9 60.75 60.65
14/9 60.70 60.85
15/9 60.90 61.00
16/9 61.00 60.85
Average 60.75 60.74
270
modifying the profit of 10 cents, which had been
blocked earlier.
Spread
Spread positions are an alternative way of using
futures. In spite of the considerable number of spread
typologies, they all share two important features. The
first regards the fact that to make a spread, at least two
futures positions are necessary, which must be
maintained concurrently. The second one concerns the
possibility of foreseeing a price variation in one or two
of the positions considered, so that the profitability of
a spread operation is a function of the price variation
in one of the two open futures positions.
There are at least three spread typologies
commonly used in energy markets: crack spread,
spark spread and frac spread. It should be observed
that spark spreads and frac spreads are contracts
mostly used in cross hedging between quotations of
electric energy and the natural gas used to generate it.
A frac spread is mainly used in partial hedging
between natural gas extraction and the generation of
propane gas. Substantially, the operation is very
similar to the spread used in the case of refining
fractioned oil in the various products derived from the
refining process (crack spread). In this case, however,
it is quoted in terms of the values of heat produced
(Btu). As there are no substantial differences between
frac spreads, spark spreads and crack spreads (apart
from the specific techniques due to product type), we
will concentrate on the contract most commonly used:
a crack spread.
Crack spread
An oil refinery is exposed to risk on two different
fronts. On one hand, the fluctuations of the raw
material (petroleum), and on the other hand, the
market for the finished product (gasoline and other
products). Given that refinery products generally have
stable prices, the risk of oil price increases is very high
for the company. Therefore, it might be better if it
arranges hedging directly in refining margins.
The theoretical refining margin is given by the
combined value of a number of products (diesel fuel,
gasoline, gas oil for heating) compared with the price
of crude oil. Since crude oil is quoted in dollars per
barrel, but products are quoted in cents per gallon,
their prices have to be converted into dollars per barrel
to be able to make a homogeneous comparison. To
accomplish this purpose, it is sufficient to multiply the
cents per gallon by 42 (as a barrel contains 42
gallons). To give an example of how the margin might
be calculated, we will use two barrels of oil as our
basis: one used in a contract for diesel fuel for heavy
vehicles and one used for gas oil for heating. Let’s
ENCYCLOPAEDIA OF HYDROCARBONS

assume that the gas oil for heating costs $1.5/gallon,
the diesel fuel for heavy vehicles costs $1.52/gallon,
while oil costs $60/bbl. Therefore: $1.5/gallon ⫻
42⫽$63/bbl of gas oil for heating; $1.52/gallon ⫻
42⫽$63.84/bbl of diesel fuel for heavy vehicles.
The sum of the sale of the two products is equal to
$126.84. The purchase of two barrels of oil costs the
company: 60 ⫻ 2⫽$120. The total margin is:
126.84⫺120⫽$6.84, while the unit margin per
product is: 6.84/2⫽$3.42/bbl.
If the refinery expects the oil prices to remain
stable or to increase, it will be advantageous to buy oil
futures and to sell gas oil futures, which translates into
selling crack. Conversely, buying crack means buying
gas oil futures and selling oil futures. Once the
company has decided whether to buy or sell crack, it
no longer has to be concerned about any absolute
variations in the prices of the assets.
Next, we will look at a simple example of the
fixing of refining margins through the use of crack
spreads. In September, a refinery decides to review its
crude oil purchasing strategy and its refining margins
for the winter period. With this in mind, the company
will seek to determine a hedging strategy using
spreads so as to fix its refining margins. On 20
September, the spread between the crude quotation for
December ($60/bbl) and the January quotation for gas
oil for heating ($1.5/gallon, equivalent to $63/bbl) is
positive and equal to $3/bbl. Thus the company sells
the December/January spread between crude and gas
oil for heating, fixing it at $3/bbl. In November, the
company buys the oil for refining purposes. The crude
oil futures is $62/bbl in November, $2/bbl higher than
the original position, while gas oil for heating costs
$1.52/gallon, the equivalent of $63.84/bbl. The margin
is now 63.84⫺62⫽$1.84/bbl. Without hedging, that
would be the effective margin, lower than that
originally foreseen ($3/bbl).
To see the effect of hedging, refer to Table 6 (losses
are shown in brackets). It can immediately be observed
that if the company had not used the combined
hedging of selling/buying futures, its margin would
have been $1.84/bbl, instead of $3/bbl, as originally
foreseen.
Other variations of the case just examined are
possible, for example, considering obligations to pay
at irregular or prefixed intervals. But the dynamics of
the hedging process does not change.
4.2.5. Exchanges for physicals
In general, the instruments discussed above (futures in
particular) are mainly linked with hedging or with
financial speculation. But some specific tools also
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
UNCERTAINTY AND RISK MANAGEMENT
exist for transactions related to exchanges of a
physical nature, referred to as Exchanges For
Physicals (EFP). With EFP, two counterparties
exchange the hedging obtained through futures with
the physical positions equivalent to them.
The most interesting feature of EFP consists in the
fact that they guarantee a separation between the
pricing of contracts and the conditions of physical
supply. The price is usually determined on the basis of
a prefixed futures contract. Generally, EFPs are
registered6 on the day the physical transfer of the good
is expected (or close to it). The price at which the
contract is registered is the futures price, used as the
basis for the contract. The contract price is not
revealed to the market until after the execution of the
contract has already taken place. For example, for
NYMEX, registration takes place the day after the
expiry of the contract.
The exchange volume is fixed by contract, even
though a certain margin of tolerance is permitted. It
should be borne in mind that the extent of any
divergences from the volumes specified in the contract
must be explicitly authorized therein. Since the
characteristics of the product (oil, for instance) do not
always exactly match those in the futures contract, the
parties often find it useful to agree on a series of
compensatory differentials. These differentials are
quoted publicly and are normally stipulated close to
the expiry of the contract (of the delivery of the
physical good), generally using an average of the
differentials published for a number of days.
Once the contract has been established, the parties
can use the futures market according to their own
needs. At the expiry of the contract, the parties inform
the brokers of the terms of the contract (number of lots
and price) to be registered and published. The
concurred price is used for closing both the futures
and the physical positions.
Only at the moment an EFP contract is registered is
it possible to exchange futures without a public
auction, as only the quantity and the trading month are
revealed to the market, but the clearing house must be
informed of the price. It must be remembered that
EFPs are essentially physical transactions, so only the
part relating to the futures negotiation is guaranteed by
the clearing house.
Observe the following example. Company X sells
500,000 barrels of Arabian Light to company Y, using
the October Brent as the price benchmark. The EFP
contract must be registered on 10 September at the
same price as that fixed the previous day, while the
6 In this context, registration is understood as the
physical execution of the contract.
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MARKET STRUCTURES AND PRICE POLICIES IN THE OIL AND GAS INDUSTRY

Table 6. Payment diagram for a crack spread

Financial exchanges Financial effects

Month Payments Futures
on futures for cash
September Crack spread sale

Purchase of crude ($ 60/bbl)

Sale of gas oil at $ 1.5/gallon ($ 63/bbl)

Net $ 3/bbl

November Purchase of crude at $ 62/bbl ($ 62/bbl)

Sale of gas oil at $ 1.52/gallon $ 63.84/bbl

Net $ 1.84/bbl

Crack spread purchase

Sale of crude $ 62/bbl

Purchase of gas oil at $ 1.52/gallon ($ 63.84/bbl)

Net ($ 1.84/bbl)

Refining margin
$ 1.82/bbl
without hedging

Net final refining margin

$3
with hedging

differential will be determined by the market
specifically on 10 September. Company X opens a
short position at the average price of $61.25/bbl,
whereas company Y opens a long position at the
average price of $60.00/bbl. The market price on 9
September is $60.15/bbl and the differential on 10
September is equal to a discount of 20 cents. The
profile of the cash flows is shown in Table 7.
Notice that both the buyer and the seller have a net
price of their positions with a discount of 15 cents. It
can likewise be noted that the actual registration of the
contract opens a futures position for the buyer and the
seller used for fixing their respective purchase and/or
sale price.
evidently essential and crucial. In fact, they are a very
versatile and effective instrument for all types of
coverage (short, medium and long-term).
However, precisely due to their versatility,
derivatives can also be a valuable instrument of
speculation and profit for traders. However, the
impressive growth of these instruments over the last
Table 7. Example of EFP
Company X Company Y
($/bbl) ($/bbl)
Short futures 61.25

Long futures 60.00

4.2.6 Conclusions EFP price 60.15 60.15

The analysis of the various typologies of derivative Profit from futures sale 1.10
instruments has highlighted several fundamental Profit from futures purchase 0.15
aspects. In the first place, derivatives are primarily an
instrument for safeguarding those who have Sale to Y 60.00
undertaken specific obligations, due to the Purchase from X 60.00
characteristics of their activity, in order to avoid losses
on their capital accounts due to excessive price Net sale price 61.10
oscillations. From this point of view, the use of Net purchase price 59.85
derivatives in managing risk and uncertainty is

272 ENCYCLOPAEDIA OF HYDROCARBONS


few years and the simultaneous increase in the
volatility of all products comprised in the energy
market, pose certain questions as to the negative
consequences of their excessive use. Indeed, the (real)
fundamental elements on which prices in the energy
market are based are made more or less irrelevant for
correctly determining the price of oil and natural gas.
This occurs because the requirements of hedging and
speculation have become so important that only a
small part of derivative contracts reach the stage of
actual physical regulation. In the sector of futures and
forwards, for instance, less than 1% of the contracts
stipulated in the NYMEX for Sweet Crude Oil are
actually regulated.
Nevertheless, the role of derivatives in the energy
industry is bound to increase, in view of the
importance of these instruments in hedging processes
for a vast and growing range of operators: industrial
groups, electric power generation plants, etc. What
makes a market for derivative products safe, in
reality, is the presence of control authorities who are
vigilant in examining possibly disturbing factors in
the market and any excessive growth of exposure to
particular instruments, on the part of specific
subjects. But up to the now, only the United States
has shown a propensity towards the use and
development of financial instruments (with all its
facets and consequences) unparalleled in the world.
However, in order to generate savings in energy
management, it can easily be envisaged that
opportunities will arise for having greater recourse to
these instruments in Europe, too (as a consequence
of gradual market deregulation). It is also important
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
UNCERTAINTY AND RISK MANAGEMENT
not to create a culture of using derivatives for
motives of pure speculation, but for the needs of the
physical market, from where, in the final analysis,
these instruments derive. Lastly, the importance of
supervising authorities for the supranational
coordination of controls over issuers of derivatives
and traders is re-emphasized, so as to prevent and
avert financial crises which (when they occur) risk
creating serious problems also for transactions of a
real nature, thereby making all investment activity
– which is the basis of the development of energy
markets – hardly profitable.
Bibliography
Grinblatt M., Titman S. (2002) Financial markets and
corporate strategy, Boston (MA), McGraw-Hill.
Walls D.W. (1995) An econometric analysis of the market for
natural gas futures, «Energy Journal», 16, 71-84.
References
Black F., M. Scholes (1973) The pricing of options and
corporate liabilities, «Journal of Political Economy», 81,
637-654.
Hull J.H. (2002) Options, futures, and other derivatives, Upper
Saddle River (NJ), Prentice-Hall.
Massimiliano Marzo
Dipartimento di Scienze Economiche
Università degli Studi di Bologna
Bologna, Italy
273

The oil industry:
its players and structure from its origins
to the oil shocks
of the Nineteen Seventies
5.1.1 The players
Companies, producing states, consuming states and
international organizations are the categories of
players which have written the history of the world
oil industry. The market structure, company
strategies, public policies and price dynamics are the
outcome of the complex interaction between these
players over time and the motives for conflict or
cooperation prevailing in any given historical phase,
the contractual relations through which they were
expressed, the chain of reactions and counter-
reactions to which they gave rise. This interactive
process has always been complex by its very nature,
due to the numbers and diversity of the interests
involved.
This chapter will first analyse the nature and role
of each category of players (Section 5.1.1), going on to
examine the development of the oil industry from its
origins in the second half of the Nineteenth century
(Section 5.1.2) up to the oil shocks of the 1970s,
which represented a turning point in oil industry
history (Sections 5.1.3-5.1.5).
The oil companies
In the oil company sector, there is a traditional
distinction between the large oil companies which, for
better or worse, have shaped the history of the industry
from the early Nineteenth century, and the smaller
companies which appeared on the scene half a century
later. This distinction, still valid in economic terms,
has lost much of its significance in terms of market
power since producing countries took full control over
the exploitation of their hydrocarbon resources during
the 1970s. It is, however, still helpful for an
understanding of past events.
The large international companies or majors – or
the ‘seven sisters’ according to the label reputedly
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
5.1
given them by Enrico Mattei, president of Eni
(1953-62) – are:
• Exxon, formerly the Standard Oil Company of
New Jersey (1899) which in turn developed out of
the Standard Oil Trust established in 1882 by John
Davidson Rockefeller (1839-1937) incorporating a
number of companies with Standard Oil of Ohio,
which he had founded in 1870.
• Royal Dutch-Shell, established in 1907 with the
merger, engineered by Henri Deterding, of
Holland’s Royal Dutch Petroleum Company with
the British Shell Transport and Trading Company,
which became financial holdings with 60% and
40% of the capital respectively.
• British Petroleum Company (BP), formerly
Anglo-Persian Oil Company, established in 1909
by the diplomat William Knox D’Arcy, who
obtained a concession for the whole country from
the Shah of Persia in 1901; it has been wholly
British-owned and controlled since 1914 by the
British government (Ferrier, 1982).
• Gulf Oil Corporation, established in 1907
following the first discoveries of oil in Texas by the
wealthy American family of aluminium magnates,
the Mellons, and purchased in 1984 by Chevron.
• Chevron, formerly Standard Oil Company of
CALifornia (SOCAL), which had emerged from
the dismemberment of the Standard Oil Trust in
1911.
• Mobil Oil, formerly Standard Oil Company of New
York-Vacuum Oil Company, which had emerged
from the dismemberment of Standard Oil in 1911
and was absorbed by Exxon in December 1999.
• The Texas Corporation (Texaco): American,
established in the early Twentieth century by Joe
Cullinan and absorbed by Chevron in 2001.
These seven majors are usually accompanied, given
the similarity of their roles and historical tradition, by
275
KEY ACTORS IN THE HYDROCARBONS INDUSTRY AND COMPANY STRATEGIES

the French state owned company Compagnie Française
des Pétroles (CFP), established in 1924 to take over
from German interests in the Ottoman Empire.
The characteristics shared by these companies
were as follows: a) long-standing tradition and
professional experience; b) their large size (both
absolute and relative); c) high degree of diversification
in terms of geography and production; d ) high and
balanced degree of vertical integration; e) high degree
of horizontal integration in the control of the lowest
cost hydrocarbon reserves; f ) purely private nature of
their management, to which BP and CFP were no
exception, although their capital was largely state
owned.
These characteristics translated into a
competitive advantage for the majors, to the extent
that they exerted almost complete control over the
international stage until the late 1970s (Penrose,
1968). Since then, the situation has changed
radically, with their degree of control over world oil
production collapsing from about 70% in 1970 to
just over 16% in 2005 (Table 1).
However, the strength of these large companies,
their capacity to generate wealth, and their
technological, industrial and commercial leadership in
the development of hydrocarbon resources have in no
way diminished; they demonstrate that competitive
regimes, such as those currently in place, can meet
objectives of growth and value generation even more
effectively than the quasi-monopolistic structures of
the past.
According to Paul Frankel, a leading petroleum
economist, “although it has diminished, the role of the
major oil companies is not dead. […]. To adopt
Lenin’s famous expression, they have lost the
‘commanding heights’ but still control trade in the
plains, given their dominant position in the transport,
refining and sale of petroleum products” (Frankel,
1982). A single figure suffices as proof: in 2004, the
combined income of Exxon and BP was 60% higher

Table 1. Rise and fall of the majors: petroleum production and reserves1 (Mbbl/d)

Company 1949 1960 19702 19803 1990 1995 2000 2005

Exxon 1.3 2.5 6.1 4.0 1.7 1.7 2.6 2.6
Gulf Oil4 0.5 1.6 3.2 1.2 – – – –
Chevron 0.4 1.0 2.6 3.0 0.9 1.0 1.2 1.7
Texas Oil5 0.5 1.4 3.2 3.3 0.8 0.8 0.8 –
Mobil Oil6 0.3 0.8 2.1 2.0 0.9 0.8 – –
Royal Dutch-Shell 0.9 2.0 5.1 3.7 1.9 2.2 2.3 2.1
British Petroleum 0.7 1.5 4.0 2.4 1.3 1.2 1.9 2.6
Total7 0.0 n.a. 1.2 1.3 0.5 0.8 1.4 1.7
Total major production8 4.6 10.8 27.5 20.9 8.0 8.5 10.2 10.7
World production9 8.5 18.7 40.3 48.7 51.1 57.8 63.7 65.6
Share of majors (%) 54.1 57.8 68.2 42.9 15.7 14.7 16.0 16.3
Reserves of majors 50.7 n.a. n.a. n.a. 35.9 33.8 45.0 42.2
World reserves10 (Gbbl) 78 260 471 555 918 940 1,003 1,062
Share of majors (%) 65.0 n.a. n.a. n.a. 3.9 3.6 4.5 4.0

1 Includes condensates and natural gas liquids and non-conventional crude.

2 Includes long-term purchases and overlifting on participation agreements.
3 Includes equity crude and buy-back crude.
4 Purchased by Chevron in 1984.
5 Merged with Chevron in 2001.
6 Merged with Exxon in 1999.
7 Initially a trade-name of CFP; from 1995, Total CFP; in 1999, merged with Fina and in 2000, with Elf.
8 The data include mergers and acquisitions from the year in which they took effect.
9 Excluding countries which formerly had a planned economy (former USSR, China).
10 Excluding countries which formerly had a planned economy (former USSR, China). End of year data.

Sources: 1949, FTC (1952); 1960-70, company balance sheets; 1980-95, «Energia»; 2000-05, «Petroleum Intelligence Weekly». World
production: 1960, API (1992); 1970-2004, BP. Reserves: 1960-95, API (1992); 2000-04, BP.

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 THE OIL INDUSTRY: ITS PLAYERS AND STRUCTURE FROM ITS ORIGINS TO THE OIL SHOCKS OF THE NINETEEN SEVENTIES
than that of all the countries belonging to OPEC
(Organization of the Petroleum Exporting Countries).1
The second category of companies comprises those
generally described as independents, since they do not
belong to the group of majors and: a) are much
smaller in relative terms; b) have entry and
competition strategies typical of newcomers; c) have a
partially integrated organization structure, generally
weighted towards downstream phases; d ) show a less
marked degree of diversification in terms of
geography and production, and an overall vocation
which is often typically national. This category
includes most of the American companies, not all of
which are still in operation, such as: Phillips
Petroleum, Occidental, Conoco, Atlantic Richfield,
Amerada Hess, Standard Oil of Indiana, Continental
Oil Cy (Conoco), Amoco, Sun Oil, Marathon, Murphy,
Union Oil, Getty Oil, some European companies such
as Petrofina, and Asian companies like the Japanese
Arabian Oil Company.
A final category comprises state owned
companies, the prime instrument adopted by
consuming states to pursue objectives in the national
interest which it was assumed could not be
spontaneously guaranteed by private interests, such as:
acquiring the control of petroleum resources;
countering the market power of the majors;
consolidating the role of national industry in the whole
petroleum cycle. This was the task entrusted to
companies such as the Eni, established in Italy in
1953; Elf-Erap, founded in France in 1964; Hispanoil,
in Spain in 1965; Petrobras, in Brazil in 1953. The
importance of these companies lay, above all, in the
types of strategy which they adopted to compete with
the majors and in the public role which informed their
behaviour. This characteristic had an impact on the
history and strategies of state owned companies in
their early decades of operation; today, with the
beginnings and consolidation of privatization
processes, their behaviour does not differ substantially
from those of other companies, even when their
control remains formally in the public domain.
By contrast, the companies controlled by
producing-exporting countries, generally known as
national oil companies, retain a public vocation; their
importance in their domestic economies and the world
oil industry has progressively increased as these
countries took full control over their mineral
resources. The establishment of these companies,
starting from the 1950s, originated from a variety of
needs, including: to acquire direct experience in
hydrocarbons, so as to gradually replace foreign
companies; to diversify the structure of their
economies by starting a process of industrialization in
the sectors downstream of extraction (refining,
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
petrochemical, chemical industries); to develop the
domestic distribution of hydrocarbons to support
economic development.
The first important state owned company, the
National Iranian Oil Company (NIOC), was
established in Iran in 1951. It was followed by others:
the Corporación Venezolana del Petróleo in Venezuela
in 1960 (now PDVSA); Permina, Pertamina and
Parmigan in Indonesia in 1962; the Kuwait Petroleum
Company in Kuwait in 1962 and Petromina in Saudi
Arabia in 1964 (later absorbed into today’s Aramco).
Since the 1980s, these companies, alongside others
established later, including the Russian and Chinese
companies, have become the new majors in oil
production, supplanting those of the past. The most
important national oil companies (Table 2) controlled
45% of production and 68.8% of proven reserves
worldwide in 2004.
Finally, there is one last category of economic
players, rarely mentioned in the past because they were
marginal and non-influential on market dynamics.
Specifically, these include: smaller companies,
operating in individual phases of the petroleum chain,
in individual countries or in niche markets, with
locally important competitive positions; traders and
brokers working in the marketing of crude oil and its
derivatives; investors and financial institutions. As a
group, these players, the true ‘invisible hand of the
market’, have taken on a fundamental role in
determining the dynamics of the international oil
market since the 1980s, with the vertical disintegration
of the large oil companies and the establishment and
consolidation of the large organized markets (futures
exchanges), especially those in New York (New York
Mercantile EXchange, NYMEX) and London (initially
the International Petroleum Exchange, absorbed in
2001 by the Intercontinental Exchange). This huge
multitude of commercial and financial operators
(hedge funds, investment banks, pension funds, etc)
determines the daily prices of crude oil and refined
products, negotiating mainly financial contracts for
West Texas Intermediate (WTI) crude for up to 300
million barrels on the New York exchange alone –
compared to a physical production of less than a
million and a worldwide production of close to 81
million barrels in 2005.
The states
There would be little point in mentioning this
category of players had their role been restricted to
that normally played in sectors considered strategic
1 Specifically, ExxonMobil made an income of 264
billion dollars and BP, 285 billion, compared to a total
revenue for OPEC countries of 346.5 billion.
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KEY ACTORS IN THE HYDROCARBONS INDUSTRY AND COMPANY STRATEGIES

Table 2. The national oil companies of producing countries (2004)

State Oil Oil

Revenues
State company Country share production reserves
(109 $)
(%) (Mbbl/d) (Mbb)l

Saudi Aramco Saudi Arabia 100 9.83 262,700 122

National Iranian Oil Iran 100 4.08 132,500 33

Pemex Mexico 100 3.75 14,803 70

PDVSA Venezuela 100 2.60 77,140 68

Kuwait Petroleum Kuwait 100 2.42 89,397 25

Petrochina1 China 90 2.12 11,019 47

Iraq National Oil Iraq 100 2.03 115,000 12

Lukoil1 Russia 1.74 15,972 34

Yukos Russia 73 1.71 12,581 15

Sonatrach Algeria 100 1.70 10,986 34

Petrobras1 Brazil 32 1.65 9,945 40

NNPC Nigeria 100 1.51 21,180 22

Adnoc United Arab Emirates 100 1.36 52,616 17

State company total 36.5 825,839 539

World total 81.1 1,200,700

State company share (%) 45.0 68.8

1 Listed company.

Source: «Petroleum Intelligence Weekly, Special Supplement Issue» (2005).

for the fate of the economy. Things change when, as
in the case of oil and gas, this is accompanied by
political motives leading states to adopt intervention
policies which heavily condition the structure of
industries, the behaviour of companies and their
performances. This has occurred, in all consuming
countries, with: a) interventions on market incentives
to orient the choice of consumers or producers
towards objectives believed to be unattainable through
the markets alone (market failures); b) easing the
entry of national companies to foreign countries by
providing political protection; c) conditioning import
flows from those countries believed to be most
reliable; d ) regulating the operations of companies to
prevent them from obtaining dominant positions;
e) pursuing conditions of security of supply. The
policies of producing countries, in turn: a) have
attempted to support the development of national
industries; b) condition the behaviour of foreign
companies; c) appropriate the lion’s share of
hydrocarbon’s rent; d ) intervene where necessary on
companies and trade flows to exert political pressure
on their home countries or on consuming countries.
This Chapter is not going to deal with the public
policies of both categories of countries, but it is worth
stressing three facts: over time, state intervention has
been extremely diverse in terms of intensity and
direction to such an extent that it cannot always be
considered the prime determinant of market dynamics;
beyond a generic similarity of intentions, there have
always been strong differences within the two groups
of countries; this fact, in turn, does not allow one to
describe their actions as concerted decision-making,
except on rare and circumscribed occasions. In fact,
debate, if not a conflict of interests, has usually
characterized relations within the group of consuming
and producing states – a situation even more prevalent
in relations between these two groups of countries.
The reasons for these conflicts originate with
structural differences between individual countries. In
the case of consuming countries: between states forced
to import oil or gas and those enjoying a substantial

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 THE OIL INDUSTRY: ITS PLAYERS AND STRUCTURE FROM ITS ORIGINS TO THE OIL SHOCKS OF THE NINETEEN SEVENTIES
domestic production (the United States from the outset
and, more recently, Northern Europe), with the former
having a vested interest in keeping prices low and the
latter in preventing excessively low price levels from
penalizing domestic supply. In the case of producing
countries: between states which destined most of their
production for export and those which consumed large
amounts domestically, and, equally, between those
with large hydrocarbon reserves (only partially
exploited) and those faced with the relatively
imminent prospect of their exhaustion. This distinction
was exacerbated by a differing degree of absorption of
oil and gas revenues: relatively low for countries with
large resources (the so-called low absorbers) and
exorbitant for countries with small resources (high
absorbers). These situations created different, or even
contrasting, ‘objective functions’; the former,
especially the dominant Saudi Arabia, aimed to project
exploitation and their energy leadership in oil into the
long term with price dynamics ensuring that they
remained competitive compared to competing energy
sources, and the latter had a vested interest in
maximizing their oil revenues in the short term, and
thus keeping prices as high as possible.
International organizations
Finally, there is a third category of players on the
oil scene, the international organizations, whose role
has doubtless been less important than that of the
companies and states, but which under some historical
circumstances have taken on an importance by no
means marginal. This importance lies not in the
decision-making capacity of these institutions as
distinct from that of their member countries, but rather
in the expression of the latter’s willingness to agree on
common or converging policies. The greater the
pressure exerted by cooperation between consuming or
producing countries on internal divisions, the greater
the role played by these institutions; the opposite was
true when conflicts prevailed.
The most influential institutions include, in the
case of consuming countries, the European Economic
Community (EEC) established with the Rome Treaty
on 25 March 1957. Energy has always been a key
sector in the process of European integration, as
highlighted by the establishment, at the same time as
the EEC, of the European Atomic Energy Community
(EAEC) or Euratom and, with the Paris Treaty of 18
April 1951, of the European Coal and Steel
Community (ECSC). However, energy’s strategic
nature actually kept this issue strictly within the
confines of the national sovereignty of individual
countries. Equally noteworthy is the Organization for
Economic Cooperation and Development (OECD),
established in 1961 by the industrialized nations,
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
which took on particular importance in the field of
energy from 1974, when the International Energy
Agency (IEA) was established under its aegis that
should have opposed the cartel of producing countries
following the oil shock of 1973-74 – an intention
which remained on paper, perhaps not for nothing.
The largest institution of producing countries is
OPEC (Table 3) established in Baghdad on 14
September 1960 by Iraq, Iran, Venezuela, Saudi Arabia
and Kuwait, and the possibility for any country to join
that had a substantial net export of crude petroleum.
Its main objectives, set out in its Statutes, were to: a)
coordinate and unify the petroleum policies of
member states; b) determine better means of
safeguarding the interests of countries both
individually and collectively; c) ensure the stability of
prices on the international markets by eliminating
damaging fluctuations; d ) ensure constant revenues for
producing countries and an efficient, cheap and
regular flow of petroleum to consuming countries, and
equitable profits for the oil industry.
The birth of OPEC, which occurred in the face of
absolute indifference from the Western world, by
uniting and uniforming the policies of the largest
producing countries, accelerated the process of
altering the balance of power with the oil companies
(and their home countries), gradually decreasing the
dominant positions which foreign capital had acquired.
With all its members, OPEC accounted for over half of
global oil production at the beginning of the 1970s – a
fact which the Western world came to realize suddenly
and bitterly.
Another international organization among the
producing countries is the Organization of Arab
Petroleum Exporting Countries (OAPEC), founded on
9th January, 1968 in Beirut by three, then moderate,
Arab countries: Kuwait, Libya and Saudi Arabia, with
headquarters in Kuwait and open to Arab countries
where petrol constitutes the principal and basic source
of national income. OAPEC is a regional
inter-governmental organization aimed at developing
an integrated oil industry through cooperation among
its member states that has consisted of 11 members
since 1982. The countries that joined the three founder
members are: Algeria, Quatar, Bahrain, United Arab
Emirates (1970), Egypt (1973), Iraq and Syria (1972),
Tunisia (1982) whose membership was suspended in
1986 (Tétreault, 1981).
5.1.2 From the pioneers to
the American oil industry
In the historical development of the oil industry, a
distinction can be made between an initial phase
279
KEY ACTORS IN THE HYDROCARBONS INDUSTRY AND COMPANY STRATEGIES

Table 3. Countries members of OPEC since the organization was founded to 2006 (data from 2004)

Production GDP
Year of Reserves Population GDP
Country (per capita
membership (Gbbl) (Mbbl/d) (%) (106) (109 $)
dollars)
Algeria 1969 11 1.3 4.4 32 84 2,623

Indonesia 1962 4 1.1 3.7 215 256 1,187

Iran1 1960 133 3.8 12.8 68 169 2,480

Iraq1 1960 115 2.1 7.1 26 23 891

Kuwait1 1960 102 2.3 7.8 3 52 19,587

Libya 1962 39 1.6 5.4 6 29 5,013

Nigeria 1971 36 2.4 8.1 130 71 549

Qatar 1961 15 0.8 2.7 1 28 45,953

Saudi Arabia1 1960 264 8.9 30.1 23 249 10,677

United Arab Emirates 1967 98 2.3 7.8 3 103 32,235

Venezuela1 1960 80 3.0 10.1 26 106 4,050

Ecuador2 1973 5 0.5 13 30 2,302

Gabon2 1975 2 0.2 1 6 4,711

OPEC total3 897 29.6 100 533 1,170 2,196

World total 1,144 70.6 6,381 53,424 8,373

OPEC share (%) 78.4 41.9 8.4 2.2

1 Founding member (14 September 1960).

2 Ecuador and Gabon left OPEC on 31 December 1992 and 1 January 1995, respectively.
3 Does not include Ecuador and Gabon.

Sources: OPEC (2004). Ecuador and Gabon: for reserves and production: BP (2005); for population, GDP and per capita GDP: United
Nations Statistical Division.

running roughly from 1859, the year to which its birth
is conventionally dated for the famous well drilled by
Colonel Edwin L. Drake at Titusville (Pennsylvania),
to the end of the Nineteenth century. During this
phase, the oil industry took off, but this development
remained wholly confined to the United States and
was marginal even in the energy context of that
country.2 This phase, however, became extremely
important for several reasons. First, because it
highlighted the central issue which would always
govern the oil industry: how to reconcile competition,
stability and growth. Second, because it was during
these years that J.D. Rockefeller’s Standard Oil of New
Jersey was founded and consolidated, a symbol of
American big business and a first mover not only in
the oil industry but also, according to Alfred Chandler
who first coined this expression, of modern industry
as a whole (Chandler, 1994): it was the first company
to base its efficiency and competitive edge on the
triple investment in production, distribution and
management. Third, because it was during this period
that the technological dynamics and management
strategies which were to characterize the sector’s
organizational structure began to emerge.
In 1870, oil consumption in the United States
accounted for less than 1% of the energy balance, and
for only 4% in 1900. Penetration was hindered less by
the infrastructure of the time than by the high costs of
rail transport and the strong fluctuations in current oil
prices: from 16,0 dollars a barrel in 1859 to 9.25 in
1860, 0.49 in 1861 and 1 dollar in 1862, up to 11,0
dollars in December 1864. Given these huge
variations, it is understandable that already by 1869,
2 Oil had already been discovered eleven years earlier in
the Caspian region near Baku by F.N. Semyenov. Statistics
on the production of crude oil in Romania date back to 1854
(Campbell, 2005).

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 THE OIL INDUSTRY: ITS PLAYERS AND STRUCTURE FROM ITS ORIGINS TO THE OIL SHOCKS OF THE NINETEEN SEVENTIES
an Association of Petroleum Producers had been
established in Pennsylvania with the aim of protecting
the interests of well owners and containing the
instability of prices by keeping production within the
limits of actual demand. Generally speaking, the
incentive to reach such an agreement was the entry
into production of large new reservoirs, which on
every occasion disrupted the earlier precarious market
balance. This led to pressing demands to limit drilling
and even to partially close producing wells by the
owners of older wells, unable to withstand excessively
low prices.
According to Paul Frankel (1946), the causes of
these perennial difficulties should be sought in three
factors: the exponential growth of the market (had
demand remained stable, supply would spontaneously
have reached a natural equilibrium); the absolutely
unpredictable nature of incremental supply given the
constant new discoveries; the vested interest of
companies in maximizing production to recoup their
enormous investments. This resulted in overinvestment
and excess production capacity which, accompanied
by low marginal production costs, both in absolute
terms and relative to the high fixed costs, inevitably
led to destructive price competition, as was repeatedly
the case. The alternative was some form of collusion
to limit supply and allow for the formation of an
acceptable price. The first attempts of this sort were
inspired by a desire to stabilize the market rather than
an attempt to drive up prices, although it is difficult to
draw a clear line between these two policies, whose
outcome was often identical.
However, the results of these attempts were
disappointing; the higher the price, the greater the
temptation to cheat by increasing one’s own supply. The
first to do so would benefit from high prices, higher
sales and larger profits. The weakness of these
agreements lay precisely in the fact that, whilst they
required the agreement of a vast majority of producers,
they could be destroyed by the defection of a small
minority. Frankel’s opinion is that “an association of
straight competitors with equal opportunities may have
its day, but it will not last, since the interests of the
participants are, however, paradoxical it may seem, to
such an extent identical that they cannot, in the long
run, be compatible” (Frankel, 1946).
The impossibility of reaching forms of
coordination of supply can essentially be attributed to
its high degree of dispersion among a large number of
companies, in turn, a consequence of the structure of
property rights governing the exploitation of oil
resources in the United States. Two of these rights
were of particular importance: the right to extract
crude oil had to be negotiated with individual
landowners, resulting in a large number of small and
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
medium-sized companies; the law of capture assigned
ownership of the oil extracted to the owner of the land
where it was brought to the surface, regardless of its
actual underground location (Penrose, 1968). Every oil
field could therefore be tapped by several owners, and
each producer had an incentive to extract the oil as
quickly as possible to prevent others from
appropriating it opportunistically.3
Attempting to attain a dominant position through
control over this dispersed extraction activity would
have been impossible. The young Rockefeller was well
aware of this, certain that this objective could be
achieved by taking control not of all the production
phases of the petroleum cycle, still less of the
upstream phase, but only of those which were
strategically most important. He therefore
concentrated all his resources first in refining, then in
transport, reaching an almost monopolistic control
over the industry by the end of the century. In refining,
he achieved a dominant position by first exploiting the
competitive edge conferred by economies of scale:
with refining costs half those of the largest rival
producers, Standard was able to rout the competition
and wield a potent negotiating weapon with the
railways to obtain lower costs for transport as well.
“The larger the volume transported, the larger the
discount. It was precisely the unprecedented
throughput of the Standard Oil Alliance which led to
the reduction of tariffs, and not vice versa. In April
1868, it was the railway companies which were
seeking out the 28-year-old refining entrepreneur”
(Chandler, 1994). Low transport and refining costs
and high volumes gave Standard, which had become a
federation of five oil companies, an increasing
competitive advantage.4
It was to be another great technological innovation
which gave the industry a yet more concentrated
nature, reducing costs and the pressure of competition:
the introduction in 1878 of pipelines for the
long-distance transport of crude oil.5 Investing in these
made it possible to lower transport costs to a third of
3 Even in the mid-1960s, there were 16,500 companies
operating in the oil and gas extraction sector, of which 9,500
in the oil sector alone.
4 Standard exchanged the shares of individual members,
who in legal terms remained independent, for those in over
30 refining companies: the result was an independent
financial structure able to supply a regulating tool for prices
allowing for a relative reduction of instability; nevertheless,
this remained within a range of annual fluctuation of over
30% throughout the 1870s.
5 Although the first pipeline dates back to the Tide Water
Oil Company (an association of crude oil producers), it was
Standard that fully realized their potential benefits, spending
30 million dollars (out of company assets of 3 million) on
the construction of its own network of pipelines.
281
KEY ACTORS IN THE HYDROCARBONS INDUSTRY AND COMPANY STRATEGIES
their previous levels (from 1.5 to 0.45 dollars a gallon)
and to make available vast storage capacity, ensuring
that refineries received a higher and more constant
flow of crude oil. This technological revolution was
followed by the introduction of an internal
management revolution by Standard (which had
become an Oil Trust6 in 1882), creating a vast national
and international distribution and marketing network,
such that the volume of sales could keep pace with the
unprecedented volume of production. This was done
by centralizing the supply of crude oil, mainly from
external producers, investing in human resources to
improve the management of this enlarged
organization, and targeting management at the
coordination and control of new functional activities.
Standard’s competitive edge did not therefore
depend solely on lower costs, but on its greater
functional and strategic efficiency. This organizational
model was to become a reference point for the entire
international oligopoly. Towards the end of the century,
when the associated companies of the Standard Oil
Trust came under the control of the new holding
company Standard Oil of New Jersey, the latter came
to dominate the United States market with prices that
were relatively stable within a range of values between
fifty cents and one dollar a barrel.
5.1.3 From American
to international industry
The gradual increase in demand outside the United
States, the entry to the market of the Middle East, the
establishment of all the majors, and the development
of an international market subdivided into large
regional markets (from the United States to Europe,
from Russia to Asia) gave rise to a second phase
running from the early Twentieth century to the end of
the 1930s (Yergin, 1991). This phase marked a dual
transition: from the initial rise to the development of
the oil industry, and from a phenomenon confined to
the United States to a worldwide phenomenon. The
first transition was encouraged mainly by the
extraordinary sequence of inventions and innovations
of the late Nineteenth century.7 The second transition
was due to the discovery of large oil resources outside
the United States, the spread of innovations in Europe,
and the entry onto the scene of most of the players
listed above.
This transformation was encouraged and
accelerated by an event of traumatic significance. In
1911, in the Government of the United States against
Standard Oil lawsuit, the Supreme Court ordered, as
the first application of the 1890 Sherman Act, the
break-up of the New Jersey holding because “it had
282
with acts of intimidation acquired the control of shares
in over 70 oil companies in order to monopolize
trade”.8 Following this injunction, Standard distributed
its stock among its shareholders, dividing itself into 33
companies, one of which remained Standard Oil of
New Jersey. This traumatic decision, ironically,
strengthened the United States oil industry, as the
extraordinary opportunities for growth emerging on a
global level could not have been fully exploited by a
single monolithic organization.
Due in part to this decision, the 1920s saw the
transformation of the American oil industry from a
quasi-monopoly to an oligopoly which, on the one
hand, made any strategy for domestic collusion
difficult after the harsh lesson imparted by antitrust
regulations and, on the other hand, forced old and new
companies to adopt innovative growth strategies. Two
strategies, in particular, turned out to be winning:
vertical integration and internationalization. Majors
and independents began to build refineries and
distribution networks in Europe, attempting to gain
control over those areas of the Middle East believed to
have the largest production potential. Competition
became international. The whole of this second phase
can be summed up by the long march of the majors
towards tight control over the world’s oil supply,
outside the United States and ex-countries with a
planned economy. The objective was no different from
that which had driven the first movers during the
American phase: to ensure conditions of market
stability, especially in terms of prices, to allow for an
ordered development of investments and of the
industry as a whole. However, the institutional context
from which this strategy emerged and the tools which
it adopted were different.
On an international scale, it was not sufficient nor
possible to acquire control over the transport and
refining phases, as Rockefeller had done in the United
States, in order to take control of the whole market.
The strategically most important phase was, in this
6 With the legal form of the trust, shareholders retained
ownership of their shares, but conferred on the trust their
voting rights. This enabled Rockefeller to control a large
number of transport, refining and distribution companies,
increasing his power at strongly contained costs. Standard
paid its investors an average of 19% annual interest on the
capital invested between 1882 and 1892 (Durand, 1962).
7 Specifically: the first cars with internal combustion
engines (Benz in 1885), the foundation of the Ford
Company (1902), the Wright brothers’ first flight (1903),
the first production of the Model T Ford (1907) in quantities
reaching 650,000 units in a few years (1911), the invention
of synthetic rubber (Hoffman in 1909).
8 The lawsuit in question marked the end of a long legal
battle started in Texas in 1889, even before the passing of
the Sherman Act (Singer, 2002).
ENCYCLOPAEDIA OF HYDROCARBONS
 THE OIL INDUSTRY: ITS PLAYERS AND STRUCTURE FROM ITS ORIGINS TO THE OIL SHOCKS OF THE NINETEEN SEVENTIES
case, the supply of crude oil, spread over a large and
increasing number of countries of enormous
geographical extent. The ability to achieve this
objective was determined by two conditions: the
establishment of property rights allowing them the
greatest possible control over reserves and the highest
degree of decision-making autonomy; the adoption, in
the relations between companies, of instruments for
oligopolistic coordination to prevent any form of
competition and to allow supply to be tailored to
demand, so that direct control of prices implicitly
became possible. The first condition found an
adequate response in the form of concessions; the
second, in that of consortia.
Concessions
Concessions were the legal instrument used to
regulate contractual relations between producing states
and foreign companies until the end of the 1970s.
Through these, companies came to enjoy rights over a
given area of the state granting the concessions; this
allowed them to explore for, extract and sell any
amount of oil discovered (at any price) in exchange for
payment.9 In legal terms, concessions took the form of
private contracts (El Sayed, 1967), alongside elements
of public law deriving from the specific nature of their
objective and the collective interest at which they were
aimed. This led to a heated debate between jurists
(Verdross, 1964; Cattan, 1967a, 1967b; Rouhani,
1970) on their legal nature which saw a contention
between those who stressed their public nature,
therefore subjecting them to the domestic laws of the
host states, and those who considered them to be quasi
international agreements, subject to international law
and the legal principle of pacta sunt servanda.
The latter interpretation was favoured by the
companies, given the advantages and freedom of
movement which concessions gave them, thanks to the
political subordination of the states to western powers
and their almost complete ignorance of the issues dealt
with in the concessions.10 This explains why, as the
desire for independence grew in producing countries,
concessions came to be considered the prime
instruments of the exploitation to which they felt they
had been subjected by the companies and by Western
nations. Indeed, it is undeniable that the early
concessions were “more imposed than negotiated” (El
Sayed, 1967). As an Indonesian politician later wrote,
they were increasingly seen as tools for “transferring
national sovereignty” to third parties (Sutowo, 1967);
at the same time, they formed a reference model for
concessions granted subsequently, so that “their
similarities were matched only by their simplicity”
(Cattan, 1967a). In the interests of companies,
concessions met three objectives: they maximized
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
their decision-making autonomy, relegating producing
states to mere recipients of rents; they ensured
conditions of future certainty, preventing the terms of
concessions being unilaterally reviewed by producing
states; they blocked or severely restricted the potential
entry of newcomers.
The consortia
Whilst relations with producing states were
regulated through concessions, those between
companies were regulated through consortia.11 The
first of these, which saw a union between American
and European majors, was the Iraq Petroleum
Company (IPC), which emerged in 1928 from the
Turkish Petroleum Company with the entry into the
group of shareholders of Standard Oil of New Jersey
(11.75%) and Mobil (11.75%) alongside BP (23.75%),
Royal Dutch Shell (23.75%), CFP (23.75%) and Mr
Gulbenkian, an influential Armenian businessman
(5%). The IPC was important for several reasons: it
helped consolidate the American presence in the
Middle East, despite the resistance hitherto offered by
the British; it was the reference model for the
consortia subsequently established in all petroleum
areas by the majors; it was the most striking case of
“joint control [of supply] through common ownership.
Through its mechanism, the majors were able
effectively to restrain competition” (FTC, 1952).
Analysing the IPC allows us to pinpoint the means by
which this tool for oligopolistic coordination worked,
applicable to all the other consortia set up in Saudi
Arabia, Iran and Kuwait, and covering almost all of
the Middle East.
The distribution of the shareholdings of the main
consortiums operating in the Middle East was as
follows:
9 Concessions defined: the surface area covered by the
company’s activities – generally, most or even all of the
State’s territory; its duration, generally between 60 and 75
years; the financial revenues to be received by the state as
owner of the resources (a royalty commensurate with the
quantity sold) and as a tax authority (an income tax
commensurate with the profits realized), all on the basis of
an annual report made by the companies, over which the
states were absolutely unable to exert any control (Mikdashi,
1966, 1972).
10 In civil law, it would be possible to state the existence
of an error of will, given one of the contracting parties’
complete lack of understanding of the actual situation;
however, in a historical perspective, it cannot be denied that
these agreements played a crucial role in ensuring the
development of a resource which would also become
essential for their economies.
11 This did not necessarily lead to similar collaborations
in refining or marketing, where partners were in fact given
greater freedom to compete.
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KEY ACTORS IN THE HYDROCARBONS INDUSTRY AND COMPANY STRATEGIES
• Arabian American Oil Cy (Aramco), holder in
Saudi Arabia of a 440 thousand square mile
concession, originally assigned (1933) for 66 years
to Standard Oil of California, and jointly
controlled by Standard Oil of California (30%),
Texaco (30%), Standard Oil of New Jersey (30%),
Socony-Vacuum Oil Co. (10%).
• An Iranian Consortium, established in 1953, owner
of the concession granted in 1901 to the Anglo
Persian Oil Co. Ltd, then the Anglo Iranian Oil Co.,
reviewed in 1933 for a period of 60 years, jointly
controlled by British Petroleum (40%), Shell
(14%), Mobil, Gulf, Esso, Texaco, Standard of
California (7% each), CFP (6%), Iricon (seven
minor American companies; 5%).
• Kuwait Oil Co. Ltd, owner of a 75-year concession
granted in 1934 covering the entire territory of
Kuwait, jointly controlled by Anglo Iranian Oil Co.
(50%), Gulf Exploration Co. (50%).
The scheme of activity drawn up for the IPC was,
as stated, taken as the reference basis for other
consortiums. The IPC did not operate as an
independent company. “Its policies and management
were determined by and made to serve the mutual
interests of the majors which jointly owned the
majority of its shares” (FTC, 1952). A sort of
‘brotherhood of oil merchants’ as its managing
director described it. Its purpose was essentially to
manage crude oil production jointly and distribute it
among its members according to their share in the
IPC. Its profits were kept to a negligible level by the
practice of charging its members prices below market
levels. Another function was to control the oil supply,
both actual and potential, which might derive from
new concessions granted to partners of the IPC or to
other companies. To prevent this potential competition,
the partners in the IPC signed the Red Line Agreement
which forbade them to compete for concessions in an
area covering most of the former Ottoman Empire. In
practice, the IPC was a protective measure to prevent
independent initiatives by partner companies, or
others, within the immense Red Line Area.
No less interesting is the self-control exerted by the
IPC over its own supply to avoid even tiny surpluses on
the market. Although thanks to the original concession,
obtained on 24th March 1931, for the east of the
country; the second concession obtained in 1932 that
extended to the territories west of the Tigris; and the
third one obtained in 1938 by the associated Bassorah
Petroleum Company for the south of the country, the
IPC controlled the whole territory of Iraq, it actually
limited exploration and production to reservoirs
covering less than 1% of its surface area.12 From the
beginning of its activity, the IPC effectively stifled
production in Iraq and the neighbouring regions, taking
284
care to conceal its conduct from the government in the
fear that the concession might be reduced or transferred
to independent companies, hungry for crude oil and
anxious to maximize production. In conclusion, the
creation of the IPC, like that of other consortia, made it
possible to: a) regulate the entry of new production onto
the markets in line with the expected growth in demand;
b) limit the competition which would otherwise have
taken place, with detrimental effects on prices; c) limit
potential competition from newcomers; d) resolve
otherwise insoluble conflicts of interest between the
majors in a structural way.
The cartels: the fruitless but instructive experience
of 1928
Although concessions and consortia date back to
the 1920s, it was only much later that their importance
became fully manifest. Both of these instruments
represented the majors’ ingenious structural long-term
response to an emerging market dynamics which saw
constant rivalry between producers, momentary
alliances and truces, intrigues of all sorts, constant
interference from governments and frequent price wars.
The most important of the latter exploded with
incredible violence in India in 1926-27 between Royal
Dutch Shell and Standard Oil of New Jersey. Having
had some of its properties seized by the Soviet
government in 1918, Shell had continued to purchase
crude oil from this country for the Indian market, as
did Standard. To force the government to grant it
compensation, Shell stopped purchases from the USSR
in 1926, asking Standard to do the same, although it
had no alternative sources of supply. Faced with the
choice between strengthening Shell’s contractual
position by upholding the principles of international
law which other countries might subsequently violate
and recognizing its leadership in the Indian market, and
thus weakening its own competitive position, Standard
did not hesitate to sacrifice the first option by
continuing to purchase Soviet crude.
Shell’s violent reaction followed on 10 September
1927, triggering a price war in all consuming markets
within the space of a few days. Standard’s harsh
response on the Indian market was met by Shell with
price reductions on the American market, to which
Standard responded with symmetrical cuts in Europe.
12 The reason for this behaviour can be understood in
light of the fact that during the Great Depression of 1929,
the supply of oil significantly exceeded demand, and
companies feared that higher production in Iraq would drive
price levels even lower. As a result, time-wasting tactics
were used not only in drilling and extraction activities, but
also during negotiations on the rights of passage of oil
pipelines.
ENCYCLOPAEDIA OF HYDROCARBONS
 THE OIL INDUSTRY: ITS PLAYERS AND STRUCTURE FROM ITS ORIGINS TO THE OIL SHOCKS OF THE NINETEEN SEVENTIES
The violence of this clash made it clear that growing
consumption, the entry of new companies and the
increases in supply were threatening to compromise the
ordered development of the markets. All this happened
in the presence of competition processes where the
equal strength of the forces in play would have
prevented the emergence of a clear winner. The time
had come to take measures against this occurring again.
The first, and most famous, cartel agreement was
signed on 27 September 1928 at Achnacarry Castle,
where Sir John Cadman, head of the Anglo-Persian
Company, and Mr Walter C. Teagle, head of Standard
Oil of New Jersey, were staying as guests of Lady and
Sir Deterding, head of Shell. Although the aim of the
visit, as Teagle openly admitted, was initially to go on
a hunt, they ended up discussing the more critical
aspects of the industrial oil industry. A 17-page
document, initially entitled Pool Association but then
known as the Achnacarry Agreement, set out the
principles and procedures for cooperation between
these companies which would put an end to “excessive
competition which has resulted in the tremendous
overproduction of today. […] The effect has been
destructive rather than constructive competition,
resulting in much higher operating costs. The
petroleum industry has not of late years earned a
return on its investment sufficient to enable it to carry
in the future the burden and responsibilities placed
upon it in the public’s interest, and it would seem
impossibile that it can do so unless present conditions
are changed. Recognizing this, economies must be
effected, waste must be eliminated, the expensive
duplication of facilities curtailed” (FTC, 1952).
Like monopolies, cartels are also surrounded by
false myths – above all, that according to which they
are aimed exclusively at imposing higher prices to
realize greater profits. Although these may be natural
aims, there may be other objectives, such as to
stabilize prices, production and profits; to protect the
capital invested; to protect against the risks of
destructive competition, whose negative effects would
not only have an impact on producers.13 Without
doubt, the term ‘cartel’ applies fully to the agreement
signed in 1928, although much uncertainty surrounds
its role and effects, despite the rivers of ink expended
on this subject, especially after the painstaking
investigation by the Federal Trade Commission in
1952. Although most of the majors belonged to the
cartel, some potential competitors were left out: minor
players in the industry as a whole, but important in
individual markets. Given these limitations, the
agreement’s significance lies above all in the
principles, objectives and procedures for market
stabilization that it set out, rather than in the results
which it achieved.
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
As far as the principles are concerned, the
agreement asserted the need to: a) accept and maintain
the market shares held by each member at the point
when the cartel was formed, whence the name ‘as is
agreement of 1928’; b) make existing infrastructure
available to competitors at favourable conditions, but
not at less than the actual costs incurred; c) add new
infrastructure only when needed to meet new
consumption; d ) maintain the economic advantages
deriving from its geographical location in each
producing area; e) prevent any surplus supply. Despite
the adherence of the majors, the agreement did not
attain its objectives, as shown by the protraction of
price instability throughout the 1930s.14 The
experience of the Achnacarry cartel was unsuccessful,
but not futile, since it clearly demonstrated that it was
inherently impossible to stabilize the markets through
agreements of this type, even with the adherence and
loyalty of most of the majors. Other more structural
and less uncertain paths would have to be taken.
Concentration and coordination
From the end of the 1930s, the adoption of cartel
agreements was definitively abandoned. Yet it was
from this point until the early 1970s that the petroleum
industry experienced, during what can be described as
its third phase, the period of greatest price stability
and most sustained growth. During the thirty years
between 1940 and 1970, about twenty saw essential
stability in nominal prices (with variations of ⫾5%),
whilst fluctuations occurred only in conjunction with
exceptional events (the Second World War, the Suez
13 This is true to the extent that the need for cartel
agreements arises mainly when an industry is in a phase of
recession or excess supply with falling prices. The contrary,
however, is not at all true: that rising prices can be attributed
to cartel manoeuvres, even where such forms of association
do exist. In fact, when the state of the market justifies price
leaps, intervention by cartels is entirely useless, whilst it
may slow or even halt the rise in prices.
14 It is a fundamental aspect of cartel economics that
even fringe groups of operators outside the cartel can thwart
the efforts of their participants, even though they may
benefit from their action. This threat was not even kept
under control by the majors’ purchase of these independents,
as recommended by the ‘as is’ clause. Their conduct towards
the independent companies was conditioned, on the one
hand, by the knowledge that if they were not included in the
agreement, they would be able to respond by cutting prices;
on the other hand, it was recognized that if they were
admitted to the cartel, they would have to be given a certain
share of the market, which would thus be taken out of the
control of the majors. Precise rules were established to
govern the supply of crude oil to independent refiners by the
majors, so as to prevent them forming a market outlet for
small crude producers and to prevent other potential
destabilizing situations.
285
KEY ACTORS IN THE HYDROCARBONS INDUSTRY AND COMPANY STRATEGIES

Fig. 1. International Standard Oil Company The Texas Socony-Vacuum Oil

companies: joint ownership of California Company Company
of subsidiaries and affiliates
in the Middle East 50% The Bahrein Petroleum 50%
(according to the best Company
information available
50%
as of January 1950) 50% California Texas
(FTC, 1952). Corporation
50% 50%
100% Far Eastern Petroleum Texas Exploration 100% Mediterranean
Company Company Refining Company
50%
50% California Standard
Exploration Company
50% 50%
South Mediterranean
Oilfields

30%
30% Arabian American 10%
Oil Company 30%

30%
30% Trans-Arabian Pipeline 10%
Company 30%

Anglo-Iranian Oil Royal Dutch-Shell Standard Oil Company

Company Group (New Jersey)
100% 100%
D’Arcy Exploration Anglosaxon Petroleum
Company Company

14. 4%
Middle East
60.9% Pipelines 24.7%

50%
Near East Development
Corporation 50%
23.75%
23.75% Iraq Petroleum
Company1 23.75%

23.75%
23.75% Basras Petroleum
Company1 23.75%

23.75%
23.75% Mosul Petroleum
Company1 23.75%

23.75%
23.75% Petroleum
Concessions1 23.75%

50% Consolidated Petroleum 50% 50% Company 50%

Company (Egypt)2

50% Consolidated 50%

Refineries
Gulf Oil
Corporation
unknown The Anglo-Egyptian unknown
Oilfields 100%
Gulf Exploration
Company

50%
50% Kuwait Oil
Company
1 Remaining partecipations are divided as follows: Compagnie Française
du Pétrole, 23.75%; Partecipations and Investiments, 5%.
2 The name of this exploration and producing company is unknown.

286 ENCYCLOPAEDIA OF HYDROCARBONS

 THE OIL INDUSTRY: ITS PLAYERS AND STRUCTURE FROM ITS ORIGINS TO THE OIL SHOCKS OF THE NINETEEN SEVENTIES
Table 4. The predominance of the oil majors (1949)1
Reserves
(Gbbl) (% tot.)
United States 9.4 33.6
Rest of world2 41.3 82.1
World2 50.7 65.0
1 Absolutedata refer to the seven majors; percentage data, to their share of the total for each area.
2Excluding countries with a planned economy.
Source: FTC (1952).
Crisis in 1956-57, the Six Day War in 1967). During
this phase, prices remained stationary at between 1.5
and 2.0 dollars a barrel; an extraordinary fact
considering that during the same period, demand
increased by a factor of eight, reaching about 3 billion
tonnes, and Middle Eastern supply, seventy-fold, rising
to over a billion tonnes.
How can this outcome, which followed fifty years
of instability, be explained?
The answer lies in the structural characteristics
which the industry began to take on under the control
of the majors, and the structure which they adopted
internally and in their relations with one another (Fig. 1).
By the end of the 1940s, the majors controlled 82% of
all proven petroleum reserves outside the United
States and the Soviet bloc, 86% of production, and
77% of refining capacity (Table 4). These high indices
of concentration are not in themselves sufficient to
explain the developments of this period, unless other
structural aspects are taken into account, such as:
a) the heavily integrated structure of the majors, both
in vertical and horizontal terms; b) the close
coordination of their operational and strategic choices,
especially in upstream activities; c) the restriction of
competition and the markets as a way of fixing prices;
d ) the predetermination of quotas in both the upstream
(crude) and downstream (products) phases of the
petroleum cycle. These were the foundations of an
organizational edifice which has no parallels
elsewhere and which, despite ideological prejudices,
actually allowed the western economy to avail itself of
an essential resource in a way and at a time which
would otherwise have been impossible.
Vertical integration
The oil industry is one of the main case studies for
the theory of vertical integration: because it was one of
the first industries to adopt an organizational structure of
this type, because of the large range of production
sectors involved, and, thirdly, of the size and
multinational nature of oil companies. The theoretical
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
Production Refining capacity
(Mbbl/d) (% tot.) (Mbbl/d) (% tot.)
1.6 31.5 3.0 44.4
3.0 85.7 3.1 77.3
4.6 54.6 6.1 56.7
debate over vertical integration has seen an argument
between those who stress the improved efficiency
resulting from this structure and those who lament the
limitations to competition which it inevitably entails.15
Specifically, improved efficiency could be attained in
two ways: by reducing transaction costs (Williamson,
1971) and by making more information available
(Adelman, 1955). These in turn resulted from the
uncertainty of the environment in which these
companies operated and the operational interdependence
of the various phases of the petroleum cycle.
The combination of high uncertainty and high
investment risk, inescapable base conditions of
petroleum economics, means that only companies able
to produce high flows of income which are stable over
time can generate investment flows able to ensure the
adequate replacement of depleted reserves and expand
capacity to meet demand. Only under conditions of
certainty can companies risk large amounts of capital,
generally out of their own pocket. The largest
companies therefore aimed to operate in all phases of
the value chain in order to avoid upstream risks
becoming a determining factor in their business as a
whole, and to avoid positive results in the risky and
expensive exploration for hydrocarbons being
compromised by difficulties in selling the product.
Consequently, crude producers built refineries to
transform their oil and networks to distribute it.
15 An examination of the development of the degree of
integration in the oil industry would seem to confirm the
model proposed by G.J. Stigler (1951) and K. Harrigan
(1983). According to this model, the high risk and high
transaction costs incurred during the take off and
development phase of an industry, when the limited size of
markets does not allow for the full use of investments, make
integration advantageous and encourages the formation of
quasi-monopolistic types of market. During the mature
phase, production specialization makes exit from segments
with increasing profits attractive, reducing sunk costs and
replacing a hierarchical relationship with a contractual one.
The result is a far more competitive structure.
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KEY ACTORS IN THE HYDROCARBONS INDUSTRY AND COMPANY STRATEGIES
During the take off and development phases, there was
in fact no alternative between a hierarchy (integration)
and the market, since the latter was yet to be created.
Frankel stresses that, from the outset, in the petroleum
industry those “prevail who have at their command
production and marketing on a sufficiently large scale
to take superior transport methods into their service,
and who can thus continue to improve their standing at
the expense of their competitors” (Frankel, 1946). In
the oil industry, the relations between each stage and
the subsequent one are quite close, given the size and
specialized nature of its facilities. “The refiner needs
to be assured of this market. The marketer needs to be
assured of his supply. Both need a steady flow of
products for efficient operation. […] There is a high
degree of mutual interdependence imposed by the
facts”.16 Integration therefore has two advantages: it
ensures market outlets for the refiner and supply for
the distributor; it also has the advantage of balancing
the profitability of production, refining and sales. As
such, a company involved in all phases of the industry
has better prospects of economic survival than those
operating on only one or two levels.17
The second incentive for integration is determined
by the high degree of operational interdependence in
the industry, combined with the high variability of the
external environment, entailing a need for constant and
unpredictable adjustments. Under these conditions,
integration allows for greater efficiency than an
organization consisting of separate stages.18 The costs
incurred when the whole business is considered as a
unit are lower than those resulting from the sum of the
partial optimization of individual phases. Vertical
integration makes it possible to improve the planning
of the size, location and type of investments regarding
long-term needs, but also to ensure a better short-term
joint exploitation than would be possible through
complex and incomplete contracts. The economics of
coordination, in short, allow for greater efficiency,
lower costs, greater competitiveness and a better
distribution of resources (Cross, 1953; McLean and
Haigh, 1954; Melvin et al., 1959).
The positive needs for efficiency are
counterbalanced by the less positive effects of the
restrictions on competition. According to Joe Bain,
“integration which goes beyond strictly technological
requirements is certainly of monopolistic origin”. This
is the case of the oil industry. Regardless of intentions,
the outcome of a high degree of vertical and horizontal
integration has been to: raise barriers against entry
which are difficult to surmount, especially in terms of
access to hydrocarbon resources, thus giving
considerable market power to a few large multinational
companies operating throughout the value chain;
restrict the extent of free commercial transactions on
288
the markets, by effectively replacing market exchanges
and prices with transfers inside companies; reduce the
space available for competition inside each production
phase and in their relations. The competitive edge
which integration gave companies structured in this
way meant that “once established, the concentrated
and integrated structure of the market became
self-perpetuating” (Adelman, 1983). The limited size
of intermediate markets was unable to offer
guaranteed outlets or supply to companies operating in
only a single production phase. Integration therefore
became an inevitable choice as a form of self-defence
against competitors which were already integrated (De
Chazeau and Kahn, 1959), thus raising barriers against
entry as should have happened simultaneously in
various production phases.19
16 Declaration by the President of Standard Oil of New
Jersey (TNEC, 1939).
17 Blair stresses that “the key to reducing uncertainty
and achieving a certain degree of profitability lay in an
uninterrupted flow of crude, from refining to the final
consumer. To the extent that control over any one of the
downstream stages was in the hands of others, this flow
could be interrupted and the production of crude oil would
thus find itself without an outlet, with obvious consequences
for profits” (Blair, 1977). These economic benefits were
stressed particularly strongly by the oil companies
themselves. Particularly significant is the evidence given in
1975 by W.T. Slick, Senior Vice President of Exxon, before
the Subcommittee on Antitrust and Monopoly of the United
States Senate: “Vertical integration is an efficient form of
industrial organization, commonly used by many companies
in many sectors. It makes it possible to tackle better the
uncertainties of the economic environment, since it ensures
the reliability of supply, the quality of the product, price and
service. It also allows for a better coordination of the future
prospects and activities of production stages with a high
degree of interdependence, and thus makes it possible to
contain inventories and circulating capital. Vertical
integration also improves a company’s access to the capital
market: the cost of capital is lower due to the lesser risk, but
also due to the potential to communicate to investors the
whole picture of interdependent investments”.
18 As such, interdependence alone does not constitute a
sufficient incentive for integration since this could be
avoided through suitable types of contract; however, in a
highly variable environment, these would become extremely
complex and onerous, entailing transaction and
renegotiation costs higher than those of integration
(Williamson, 1971).
19 “The vertically integrated company which is able to
achieve a monopoly in one phase of the industry can extend
its power to other phases or to subsidiary industries, where
competition would otherwise have been able to survive. An
integrated company may be better able to discriminate
between different purchasers, increasing its profits or
increasing its power of monopoly. Finally, in times of
shortage, it may use its control over the scarce resource to
eliminate or impede the growth of independent companies”
(Machlup and Taber, 1960).
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 THE OIL INDUSTRY: ITS PLAYERS AND STRUCTURE FROM ITS ORIGINS TO THE OIL SHOCKS OF THE NINETEEN SEVENTIES
The effects of vertical integration would have been
negligible had it not been combined with the strategy
of horizontal integration pursued by the majors
through their own internal growth, the acquisition of
smaller companies, and the establishment of consortia.
The most critical issue faced by the majors in the
aftermath of the Second World War was how to ensure
that the enormous reserves of crude oil recently
discovered in new oil regions, especially in the Middle
East, would end up in safe hands (i.e. companies
which already had market outlets) and not under the
control of other companies which could cut prices in
order to sell this oil. “The obvious solution was to join
in a somewhat polygamous wedlock – or at least in
respectable long term liaisons – through joint
ownership of the operative companies and long-term
supply contracts” (Penrose, 1971). In the final
analysis, integration reinforced the ability to control
production surpluses. “The integrated firm has chosen
to take on a heavier burden of fixed costs to gain lower
average costs of production or greater certainty. He
loses flexibility in the process […] and therefore has a
natural preference for stability in the market place”
(Caves, 1977).
Operational coordination
A central feature of the structural configuration
adopted by the majors was the control of crude oil
supply, along two main lines: the predetermination of
supply and the concentration of decision-making
among a limited number of people. The control of
supply aimed to govern global flows so as to fine tune
its growth precisely in line with that of estimated
demand. The results were surprising. Middle Eastern
production alone increased forty-fold between 1945
and 1970 without significant price variations. The
joint administration of supply first involved fixing
annual growth on the basis of estimated demand, fed
back through the integrated circuits of the majors and,
subsequently, by spreading this over the countries
under their control, depending on economic
calculations (costs) and political evaluations, with a
preference for those countries, such as Iran and Saudi
Arabia, which were closest to the western powers and
least subject to communist influence.
The ability of the majors to balance demand and
supply, in both time and space, would have been
expressed differently had they been unable to count
on another fundamental operational tool: the web of
interlocking directorates guiding and linking the
various consortia. Every major controlled a pyramid
of subsidiary and affiliated companies, jointly owned
by at least one other major. These joint shares
ownership were important mainly in the upstream
phases, although there were also many instances
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
involving the distribution of finished products.20 This
close network of company relationships was
accompanied by the concentration of
decision-making power in the hands of a few people,
facilitating the adoption of a common policy by the
major holdings of first level, full information on the
intended actions of competitors, and control over the
observance of shared rules by individual members of
the club. On a day-to-day basis, concentration
represented the most important tool for coordination
between companies. By 1950, the decision-making
power over all activities in the Middle East was
concentrated in 28 people (Fig. 2).
Pricing policies
One of our aims is to illustrate the functional
connections in the various historical phases between
industry structure and price fixing policies. Until the
Second World War, the United States, and Texas in
particular, was the largest producer and global
exporter of petroleum. It was obvious that the prices
applied in the Gulf of Mexico would eventually
become the marker price for all other crudes. It was
therefore adopted by all companies, first in the Cartel
Agreement of 1928 and then in common commercial
practice, the so-called basing point system, according
to which “one production point is accepted by
common consent, and all prices are quoted as the
announced mill price at that point plus freight to
destination” (Scherer, 1985).
All sellers essentially behaved as if the crude came
from a single location – in this case, the Gulf of
Mexico; this was therefore known as the Gulf Plus
system. If the oil was transported from another
production centre, the price at the offloading port was
nevertheless identical to that of crude oil of identical
quality from the Gulf of Mexico, regardless of
production and transport costs. For the consumer, it
made no difference if oil was purchased from one
supplier or another, whilst suppliers incurred a loss or
made a profit depending on whether the offloading
port was in fact at a greater or lesser distance than that
calculated for the Gulf of Mexico.
During the Second World War, oil became a factor
of strategic importance, forcing all the governments
involved to intervene directly on the oil market. The
protests of the British and American navies against the
high prices practiced by the Anglo-Iranian Oil
Company (formerly Anglo-Persian) and Aramco led to
a significant modification of the Gulf Plus system: the
establishment of a second basing point in the Persian
20 As in the case of Caltex, a joint venture between
Standard of California and Texaco in fuel distribution.
289
KEY ACTORS IN THE HYDROCARBONS INDUSTRY AND COMPANY STRATEGIES

international oil companies common directors Middle East operating

companies and holdings
A.C. Long

The Texas Company W.S.S. Rodgers Arabian American

Oil Company
H.T. Klein

H.D. Collier
Standard Oil Company R.G. Follis
of California Trans-Arabian Pipeline
Company
B.W. Letcher

S.P. Coleman

Orville Harden
Standard Oil Company Near East Development
(New Jersey) J.R. Suman Corporation

B.B. Howard Iraq Petroleum Company

C.L. Harding
Socony-Vacuum
Oil Company B.B. Jennings

Sir William Fraser

Middle East Pipelines
B.R. Jackson

E.H.O. Elkington
Anglo-Iranian N.A. Gass
Oil Company
Consolidated Refineries
F.G.C. Morris

J.A. Jameson

Sir Hubert Heath Eves

F.J. Hopwood Consolidated Petroleum

Company
J.W. Boyle

J.W. Platt

Royal Dutch-Shell Group J.H. Loudon The Anglo-Egyptian

Oilfields
G. Lengh-Jones

Sir P. Waley Cohen

Sir Fredrick Godber

C.W. Hamilton Kuwait Oil Company

Gulf Oil Corporation
W.B. Pyron

Fig. 2. Interlocking directorates in the oil companies of the Middle East (FTC, 1952).

Gulf. Effectively, the base price remained that of the
Gulf of Mexico, to which the actual cost of transport
to the offloading port was added. All countries east of
Italy thus obtained their supply at more advantageous
conditions from the Middle East, whilst those further
west found it more economical to purchase oil from
the United States. In 1944, Italy represented the
indifference line, where the Gulf of Mexico and
Persian Gulf CIF (Cost Insurance Freight) prices were
identical. As exports from the Middle East grew in
subsequent years, this line moved eastwards, reaching
New York by 1949. The simple equation determining
prices in all parts of the world was thus as follows:
P ⫹T ⫽X ⫹TR
where P is FOB (Free On Board) sale price in Texas,
T is freight cost from Texas to the east coast of the
United States (New York), TR is freight cost from the
east coast to the point of unloading, X is FOB sale
price of the crude oil concerned.
The export price of a Saudi crude, for example,
was therefore equal to the price of Texas crude in New
York, minus the freight cost from New York to the end
market (Table 5).

290 ENCYCLOPAEDIA OF HYDROCARBONS

 THE OIL INDUSTRY: ITS PLAYERS AND STRUCTURE FROM ITS ORIGINS TO THE OIL SHOCKS OF THE NINETEEN SEVENTIES
Table 5. Basing point system for oil prices in 1949
(eastern United States; current dollars per barrel)
United States Venezuela Saudi Arabia
West Texas Oficina Ras Tanura
(36° API) (36° API) (34° API)
FOB price 2.75 2.65 1.75
Freight 0.25 0.24 1.10
Quality
– – 0.04
differential
Customs duty – 0.11 0.11
Basing
3.00 3.00 3.00
point price
The prices of Middle Eastern crudes began to be
officially determined in 1950. From then on, the
informal practice adopted in the basing point system
was made explicit through the establishment of posted
prices until 1959,21 when the system was abolished
with the oil import quotas in the United States and the
de facto closure of the American market. Although
price stability can mainly be attributed to the structural
conditions of the industry which had generated the
basing point system, there is no doubt that this method
had its merits. Specifically: it made the regulation of
competition possible by reducing price determination
to the application of a very simple formula; it resolved
the enormous difficulties in tackling the qualitative
and spatial differences between crudes resulting from
the gradual increase in the number of geographical
areas producing and exporting oil.22
The greatest problem faced by companies was how
to achieve price stability given incremental supply flows
at costs up to 20 times lower than those in the United
States. Partly due to the prorationing of domestic
production, American prices remained at artificially high
levels. Without some form of control over international
prices to maintain these at the same level, American
production would have been displaced by imports. As an
alternative to the introduction of measures to protect the
American market, it was preferred to establish a modus
vivendi with competitors on foreign markets: sharing a
pricing policy according to which world postings were
based on those of Texas. The result was a sort of
‘invisible fence’ around the American market, built by
the deliberate policies of large foreign producers,
without which oil prices would almost certainly have
been lower (Blair, 1977).
The importance of posted prices
The crude oil posted prices have played a very
different role from normal definition of price, defined
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
as “the value of a commodity expressed in monetary
terms”. It is worth defining its meaning and nature.
Particularly interesting is the analysis by the British
economist Edith Penrose; she has reevaluated the
arguments of those who have interpreted the high
profitability of Middle Eastern oil as the rent earned
by producers at low cost or as abnormal monopoly
profit earned by the majors, thought to have kept
prices high to protect their investments in the western
hemisphere from an excessively rapid expansion of
Middle Eastern crude. Penrose also criticizes those
who have interpreted the relative drop in Middle
Eastern prices as proof of actual competition between
high and low-cost sources of supply.
Whilst, on the one hand, it must be recognized that
there is some truth in both arguments, it is also true
that they “attach too much importance to the price of
crude itself as a source of profit to the companies, and
as determinant of the competitive position of high and
low cost crude. […] The market price of crude oil was
of relatively little importance for the profitability of
most of the major companies simply because they sold
very little oil on a free market” (Penrose, 1971).
Although prices were defined as “the official
indication of the price at which an oil producer is
prepared to sell”, most crude oil was actually used
directly within the companies themselves. Sales
essentially represented internal transfers within each
major, or marginal sales to other integrated companies
on the basis of long-term contracts, at special prices. It
is true that the companies reported high profits from
their activities in the Middle East, but this is because
they had chosen to price the oil as if they had actually
sold it to their refineries.
At this point, it is important to clarify why the
companies attributed the largest share of their profits
to the production phase. Overall, in an integrated
company, the total cost is equal to the sum of the costs
21 Socony-Mobil was the first to officially set posted
prices for the sale of FOB Ras Tanura crude; shortly
afterwards, the other majors began to publish posted prices.
Mobil’s decision was closely linked to the revision of Saudi
Arabia’s participation agreements in the profits of Aramco,
which required the prices at which crude oil was sold to be
publicized.
22 It is worth noting Scherer’s considerations on the
effects of this price-fixing technique: “If every seller were to
apply his own pricing conditions autonomously and in a
non-systematic way for the thousands of current supplies, he
would almost certainly find himself applying lower prices
than his rivals for some of these supplies, with the danger of
triggering reprisals on the prices themselves. By contrast,
normal adherence to the basing point formula effectively
eliminates discretionality and uncertainty and, if all
companies play the game and apply the rules, price
competition itself is eliminated” (Scherer, 1985).
291
KEY ACTORS IN THE HYDROCARBONS INDUSTRY AND COMPANY STRATEGIES
incurred in every production stage. A profit is made
only when revenues exceed these costs. If at every
stage the product is transferred to the subsequent stage
at cost price, no profit is made until the final sale.
From an economic point of view, there are
circumstances which may induce an integrated
company to report a profit or loss in a specific stage of
its operations. If a company operates in a single
country under a single fiscal authority, it makes
relatively little difference where it decides to declare
its profits; however, it certainly makes a difference if
the company operates in several countries. This is the
case of the oil industry. Companies reported profits
upstream because they benefited from doing so both in
terms of fiscal regime and competition. Middle
Eastern subsidiaries sold practically all their crude oil
production to their shareholders, the majors, at the
posted price which was far higher than production
costs, making a high profit. Whether they used the oil
directly or sold it on to other majors, it was assumed
that all transfers were made at the posted price and that
all profits could be ascribed to the production phase.
The reasons for this were: to sell crude oil to
non-integrated outsiders at the highest possible price,
thus limiting their ability to compete on the products
market; to maximize income using the opportunity
given to American companies, through the depletion
allowance, to subtract from the domestic tax the 27.5%
of the gross income realized in the extraction phase; as
a consequence, to allow producing states to participate
in their profits at no additional cost, since the tax paid
to them was deducted from that due to the United
States Treasury.23 An increase in the posted price
meant higher tax revenues for the governments of
producing countries and lower revenues for the
companies’ home countries.
Consequently, for around fifteen years after the
end of the Second World War, nothing occurred
which could disturb the pricing system or alter the
organizational structure of the industry at source.
The companies had established a modus vivendi
which allowed them to coexist peacefully, whilst
their relations with the governments of producing
states were, by necessity, friendly because of their
political subjection to western governments. More
generally, the concentrated and vertically integrated
structure of the industry had made price
competition highly improbable, so that price levels
remained high compared to costs – however, not to
such an extent as to compromise the full
competitiveness of oil compared to the dominant
source, coal, that it was destined to replace. For all
these reasons, this period was described, albeit
exaggeratedly, as the ‘golden decade’ of the
petroleum industry (Frankel, 1962).
292
5.1.4 An exceptional period
The organizational structure cleverly constructed by
the majors ensured the stability of nominal oil prices
between 1950 and 1970 in a way that had never been
seen before and will never be seen again. It is true that
their economic significance was conditioned by their
prices being administered which did not derive from
the interaction between free market forces. But this
was precisely the outcome which the large companies
wanted: to govern prices by controlling real flows so
as to guarantee them that stability believed to be
necessary for the harmonious development of the
industry. The context of certainty within which the
companies operated allowed them to carry out the
primary function of the joint planning of investments
throughout the industry’s value chain, believed to be
impossible in a competitive setting. The stability of
prices was a yet more surprising outcome if we take
into consideration the large-scale phenomena observed
during this period, starting with the five-fold increase
in oil demand following the doubling of per capita
income, and moving on to the replacement of coal, the
penetration of durable consumer goods and the equally
rapid development of the petrochemical industry
(Table 6).
The increase in the size of the market, however,
represented a strong incentive for the entry of new
companies, given the high profits recorded.
Competitive pressures were heightened by the shift in
the focus of world production from the high-cost areas
of North America to the low-cost regions of the
Middle East and North Africa. In 1950, American and
Caribbean reservoirs still met 70% of world demand;
by 1970, their relative importance had been radically
altered by the eight-fold increase in Middle Eastern
production, compared to the mere doubling of North
American production. No year passed which did not
see the entry onto the markets of large quantities of
new oil crudes. Iran, Iraq, Saudi Arabia and Kuwait
23 The combination of the 50%-50% profit sharing rule,
the depletion allowance and high posted crude oil prices
eliminated the American companies’ tax liabilities to their
country of origin and placed the majors in a far better
position than they would have been in had their profits been
reported at a subsequent stage of their activity. In fact, some
companies managed in this way to avoid paying any tax to
the United States Treasury, whilst payments to producing
countries did not entail any additional cost. On the other
hand, the system used to give producing companies a share
of the profits was such that it gave the governments of these
countries a direct interest in variations in crude oil prices.
From their point of view, the system described was in fact
acceptable as long as the posted prices did not fall. For
precisely this reason, the system introduced a powerful
political incentive to maintain high price levels.
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 THE OIL INDUSTRY: ITS PLAYERS AND STRUCTURE FROM ITS ORIGINS TO THE OIL SHOCKS OF THE NINETEEN SEVENTIES

Table 6. Oil production and refining by main area (Mbbl/d)

1900 1920 1940 1950 1960 1970

Areas and countries P R P R P R P R P R P R

United States 0.2 n.a. 1.2 – 3.8 4.5 5.9 6.5 8.0 10.4 11.3 13.3
Middle East – – – – 0.3 0.4 1.8 0.9 5.2 1.5 13.9 2.8
North Africa – – – – – – – – 0.3 0.1 6.2 0.9
Latin America – – 0.4 – 0.9 0.8 2.0 1.3 3.8 2.7 5.3 4.8
Western Europe – – – – – 0.5 0.1 1.0 0.3 4.5 0.4 20.0
Eastern Europe 0.2 0.1 0.1 – 0.7 0.9 0.9 1.1 3.3 3.4 7.6 8.1
Other countries – – 0.2 – 0.2 0.6 0.2 0.9 1.1 2.8 3.8 3.2
World total 0.4 n.a. 1.9 – 5.9 7.7 10.9 11.7 22.0 25.4 48.5 53.1

P: production; R: refining; n.a.: not available.

Source: Clô (2000).

were joined by Algeria, Nigeria, Qatar and the United
Arab Emirates. The challenge faced by the majors was
how to control this vast influx of new oil without
repercussions on the markets.
Three forms of competitive pressures on prices had
to be contained: economic pressures, resulting from
the appearance on the market of cheaper crudes;
spatial pressures, due to the fragmentation of their
geographical areas of provenance; qualitative
pressures, resulting from the differing quality of crude
oils. In the light of these phenomena, the fact that
prices remained stable takes on even greater
significance. However, this was to be an exceptional
period. Beneath this apparent stability, evolutionary
processes were occurring which were to gradually
undermine the institutional foundations on which it
rested. Of these, two became particularly important:
the entry of independent newcomers onto the market,
with a low degree of vertical integration and of limited
size; the gradual strengthening, thanks mainly to
OPEC, of producing states’ efforts to increase control
over the exploitation of their resources.
the political support of their home governments, the
concession of new hydrocarbon areas in old and new
producing countries, and the withdrawal of old
concession-holders from some marginal regions.
Entry occurred through the enlargement of the
controlling groups of established consortia, but more
frequently through the formation of new consortia
not linked to the majors; the granting of individual
concessions; the establishment of joint ventures with
local companies. In 1946, there were fewer than ten
companies operating in the Middle East; by 1956,
this figure had increased to 19; in 1970, to 81. This
increase triggered a competitive process which was
to have a number of significant consequences.
Specifically, it was to modify the basic conditions of
the negotiating process between companies and host
states, shifting the balance of power towards the
latter (Table 7).
Table 7. Control of the market
by category of company

Newcomers on the oil market 1950 1973

To assess the effects of the entry of new
(Mt) (%) (Mt) (%)
companies, the oil production and refining phases
need to be considered separately. Although the Seven majors 280 95 1,550 84
companies described at the beginning of this chapter
Independents1 14 5 191 10
as independents had played a fairly important role
since the early Twentieth century, it was only from Public companies2 2 – 110 6
the 1950s onwards that they became established on
Total 296 100 1,851 100
the international markets. This development was
encouraged by the huge profits to be made and the 1 Amoco, Atlantic Richfield, Conoco, Marathon, Phillips, Sun, Unocal.

increase in demand and it was also encouraged by 2 CFP, Elf, Eni, Fina.

VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION 293

KEY ACTORS IN THE HYDROCARBONS INDUSTRY AND COMPANY STRATEGIES
Before dealing with these political aspects, it is
worth examining those of an economic nature, which
gave them impetus and vigour. The entry of new
companies had the immediate effect of accelerating
the development of new producing areas. Large
reservoirs were discovered and came into production
in Algeria (from 1955, almost exclusively by French
companies), Libya (Oasis Group in 1956), Nigeria and
the United Arab Emirates. During the years
1960-1970, reserves (in the non-Communist world)
increased by 41 billion tonnes, 32 of which in the
Middle East and North Africa as opposed to 4.5 in the
United States. The costs of these new reserves were
about 0.15 $/t in the Middle East and Africa,
compared to 1.4 in the United States and 3.0 in
Europe.
A significant proportion of this additional supply
was controlled by newcomers, outside the integrated
circuits of the majors. The difficulties in selling it on
the American market, given the prorationing of
imports, forced them to direct it towards the European
and Japanese markets, generating excess supply and a
downward pressure on prices in the as yet marginal
free transactions. The newcomers’ limited financial
resources did not allow them to delay the exploitation
of their reservoirs or to tailor supply flows to the
actual dynamics of demand; hence the need to send
their crude to market as quickly and in as large
quantities as possible in order to generate the revenues
needed to service their debts and recover the costs
incurred. As a free market slowly developed for crude
oil, the majors’ control over supply became less
effective. The downward pressure on prices was
compounded by that on the tax costs paid to producing
states. The newcomers’ need to ensure that they had
control over differentiated exploration areas to reduce
investment risks drove them to offer producing states
far more attractive contractual conditions than those
hitherto granted by the majors – a form of competition
which turned out to be far more important than that of
prices.
This process was significantly hastened by the
state owned companies being established in both
producing and consuming countries, and the
agreements which they signed starting from the
second half of the 1950s. The most historically
important was the joint venture agreement of 1957
between the National Iranian Oil Company and Enrico
Mattei’s Agip (Eni Group). For the first time, a joint
venture, the Société Irano-Italienne des Pétroles, was
established on a political, economic and legal basis,
radically unlike that which had regulated traditional
concessions. That an unimportant company like Agip
was able to guarantee conditions far more attractive
than those hitherto offered by the majors – in terms of
294
profit-sharing, participation in investments, control
over the destination of profits – was bound to have an
impact on the entirety of existing contractual relations.
This egalitarian agreement did not bring great
economic benefits to its shareholders, but it certainly
changed the course of the history of relations between
host states and foreign companies (Clô, 2004).
The entry of new companies radically altered the
terms of the bargaining process between foreign
companies and producing states, helped by the direct
entry of the latter into the oil industry. It was evident
that the concession to third parties of rights to the
exploitation of domestic resources could occur only
when this was found to be cheaper than direct
management by the states. These modifications did not
have an immediate impact on the entire existing
contract structure, but they did trigger an unstoppable
process of revisions. Even a small improvement
obtained by governments when releasing new
concessions, in the same country or elsewhere, led to
instant criticisms of old concessions and a growing
political push for their revision.
The pressure of competition in upstream phases
was compounded by that in downstream phases. As
demand grew, refining capacity increased four-fold
between 1950 and 1970 (Table 6). The location of
refineries tended to shift gradually towards consuming
areas, because it was cheaper to transport crude oil
than its refined products and limited the political role
of producing countries, and, finally, to save hard
currency and provide an incentive for the process of
post-war reconstruction. The geography of the refining
industry underwent a radical revolution. Whereas in
1940, 70% of capacity (outside the United States and
the Soviet Union) was dislocated near oil reservoirs,
this figure had fallen to 25% in 1960 and to just over
10% in 1970. At the same time, capacity in consuming
areas increased from 30 to 65 to 80%, with the
remaining share located in areas between production
and consumption centres.
Growth and the relocation of refineries were
accompanied by a reduction in the degree of control
exerted by the majors. New independent operators
entered the market, drawn by the prospects of large
profits and the increased availability of crude oil on
the free market. Forced by a low degree of
integration to obtain supply and sell their products
with short-term contracts, they contributed to
feeding the competitive dynamics which, given
surplus supply, could only lead to a lowering of
prices. This outcome was also aided by the
reappearance of Soviet oil on the international
markets. Before the Second World War, oil was a
fundamental part of Soviet exports, albeit with a
limited impact on the international market. Despite
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 THE OIL INDUSTRY: ITS PLAYERS AND STRUCTURE FROM ITS ORIGINS TO THE OIL SHOCKS OF THE NINETEEN SEVENTIES
its immense efforts to industrialize, the Soviet oil
industry had developed extremely slowly, so that the
growing domestic demand for energy was mainly
met by its abundant coal resources. It was the
special requirements of the war that gave the crucial
impetus to its development (Durand, 1962). Exports,
needed to increase revenues in hard currencies,
increased six-fold during the 1950s, although they
still accounted for a mere 2.7% of the international
trade in crude oil and products (0.24 of 8.8 Mbbl).
The central issue was the pricing policy adopted by
the USSR. The average cost of its oil, though little-
known or studied, was per se relatively low; since
almost all of its production was destined for the
domestic market, the marginal cost of export was still
lower. The Soviets were thus in a position of relative
strength from which to undertake a price war, even
though “there is no evidence that the Russians sell at
prices unrelated to costs, or are dumping in order to
disrupt world markets for political ends” (Adelman,
1972), as the great western powers accused them of
doing for their own political ends.
This was at the height of the cold war, so Soviet
trade policy was seen in a purely political light. In an
alarming article, «The Economist» stated on 19 August
1961 that the “Soviets consider and use oil as a
political tool”, aiming to make the west increasingly
dependent on their supply, to appear to be the
champion of underdeveloped nations by selling them
the oil at lower prices, and to worsen relations between
western companies. Essentially, the Soviets were
accused – regardless of factual data – of resorting to
the most abominable of capitalist practices: of selling
at dumping prices to conquer the western market and
eliminate its competitors, only to raise afterwards
prices again.
There is much propaganda in these arguments,
but these are the predominant sentiments which
explain the violent reactions against Enrico Mattei’s
decision to sign a substantial oil purchase contract
with the USSR in 1958.24 This contract is of
historic significance because it was the first
long-term contract between a producing state and a
consuming state, through their respective state
owned companies, because it represented a
significant portion of Italian imports (about 15%),
and because Italy’s payments were to consist of
Italian products, mostly manufactured by
companies belonging to the Eni Group itself.
Mattei’s decision was also dictated by the need to
acquire cheap oil supplies, given the majors’ refusal
to allow him any freedom of manoeuvre in the areas
under their control. A decision which certainly
increased the irritation and aversion of the oil
majors towards Mattei (Frankel, 1966).
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
Administered prices and market prices
The combination of evolutionary processes
examined above had the effect of reducing the degree
of oligopolistic coordination and control of trade
exerted by the oil majors. As always happens in the oil
market, the outcome of this change only became fully
apparent much later, but in order to understand it
completely, it is worth examining it from its origins.
Three consequences are of particular importance: the
emergence of a free market for crude oil outside the
integrated circuits of the majors; different criteria for
price formation and different dynamics in each subset
of exchanges; the increasing role played by producing
states. These will be examined separately below.
Even when the degree of control exerted by the
majors was at its height, crude oil exchanges took
place between the majors or with non-integrated
operators, albeit to an extent which was marginal
compared to global supply as a whole. The degree of
vertical integration and the balancing of
supply/demand was not always perfect, so there were
always excesses or shortages of crude in each
company. There were companies, such as RD Shell,
which were structurally ‘short’ on crude oil and others
like Gulf and BP which were ‘long’ on crude. This
situation was rebalanced through long-term contracts
for fixed amounts, anchored to posted prices. Even
these transactions, then, were not governed by the free
play of market forces, which only operated on
marginal parts of the oil industry and were
insignificant in the market as a whole in terms of the
prices they determined.
It was on this free market, known as the spot
market because it involved individual short-term
transactions, that most of the incremental supply of
crude oil outside the integrated circuits of the majors
was traded. A genuine free market emerged for a tiny
number of the total commercial transactions, but these
were important for the actual balancing of supply and
demand. The fact that it was a residual market was
inevitably reflected in the quotations, which
nevertheless represented the only information
available on market conditions. The operators on this
market were mainly independent or partially integrated
companies, commercial intermediaries, the majors (for
24 In most western countries, there was a de facto or
legal oil embargo against the USSR. In his significant
testimony, Lord Kearton stated that when, at the end of the
1950s, he attempted to sign an attractive oil import contract
between the British chemical company Courtaulds and the
USSR, he was brusquely stopped by the Foreign Ministry:
“I was told categorically that no circumstances could be
envisaged in which approval could be given. […] The then
permanent Secretary concerned told me that any such
imports would be over his dead body” (Kearton, 1985).
295
KEY ACTORS IN THE HYDROCARBONS INDUSTRY AND COMPANY STRATEGIES

Table 8. Posted prices, market prices, tax costs of Arabian Light ($/bbl)

Percentage % share
Posted price Market price Tax costs
Year difference of taxation
(A) (B) (C)
(B/A) (C/A)
1950 1.75 1.71 ⫺2.3 n.a. n.a.

1951 1.75 1.71 ⫺2.3 n.a. n.a.

1952 1.75 1.71 ⫺2.3 0.52 30.0

1953 1.93 1.93 – 0.75 38.9

1954 1.93 1.93 – 0.85 44.0

1955 1.93 1.93 – 0.82 42.5

1956 1.93 1.93 – 0.83 43.0

1957 2.01 1.90 ⫺5.5 0.88 43.8

1958 2.08 1.85 ⫺11.0 0.88 42.3

1959 1.93 1.70 ⫺12.0 0.76 39.4

1960 1.80 1.53 ⫺17.7 0.75 41.7

1961 1.80 1.45 ⫺19.5 0.75 41.7

1962 1.80 1.42 ⫺21.1 0.76 42.2

1963 1.80 1.40 ⫺22.2 0.79 43.9

1964 1.80 1.33 ⫺26.1 0.82 45.5

1965 1.80 1.33 ⫺26.1 0.83 46.1

1966 1.80 1.33 ⫺26.1 0.83 46.1

1967 1.80 1.33 ⫺26.1 0.85 47.2

1968 1.80 1.27-1.40 ⫺22-⫺29 0.88 48.9

1969 1.80 1.25-1.38 ⫺23-⫺30 0.87 48.3

1970 1.80 1.35 ⫺25 0.88 48.9

1971 2.13 1.78 ⫺22 1.27 59.6

1972 2.48 2.29 ⫺7.7 1.44 58.1

Yearly averages. n.a.: not available.

Sources: market price: 1950-67, Jenkins (1989); 1968-71, Clô and Peredo (1972). Tax costs: Rifaï (1974).

transactions for balancing purposes), non-integrated
refiners (especially those owning export-oriented
intermediate refineries), and non-integrated
distributors.
The competitive pressures accompanying the
creation of the free market, due in part to excess
supply, led to market prices which were increasingly
lower than the posted prices set by the majors. These
market prices were determined by taking as the
reference point the structure (quantities, quality,
location) of the latter, and applying to them a
percentage discount (Table 8). Until 1956-57, the two
sets of prices remained more or less in line with one
another. The downward pressure on prices was
contained during the early 1950s by the Korean War
(1950-53), the disappearance of Iranian exports
following Mossadeq’s nationalization (1951-54) and
the Suez Crisis (1956-57). When these exceptional
factors no longer subsisted, the gap between posted
prices and market prices began to increase from 1958,
with percentage discounts above 25 percentage points
from the mid-1960s onwards.

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 THE OIL INDUSTRY: ITS PLAYERS AND STRUCTURE FROM ITS ORIGINS TO THE OIL SHOCKS OF THE NINETEEN SEVENTIES
Faced with competition from the free market, the
majors initially responded by lowering their posted
prices. Later, due in part to the harsh reactions of
producing countries, the posted prices were kept
constant, applying discounts lower than those on the
spot market. From the second half of the 1950s, the
world oil market can be schematically subdivided into
three sub-markets: the US market, closed and with
prices above international levels; the Soviet market
(USSR and satellite countries), also isolated from the
rest of the world, with the exception of its net export
flows; the international market, which can in turn be
subdivided into the market administered by the majors,
accounting for 85-90% of total transactions, and the
free market or spot market, accounting for the
remaining 10-15%.
Phenomena similar to those described for the crude
oil market can be observed for the market of refined
products, where the increase in free transactions,
alongside the larger number of operators, led to the
formation of a free market fed on a daily basis by spot
transactions. From the end of the 1950s, these were
priced daily in the newsletter Platt’s Oilgram Price
Service published by McGraw Hill of New York.
Although it is true that the amounts traded on the free
market were marginal in terms of total end
consumption (no more than 5-10%), the prices were
the only indication of what consumers were willing to
pay, and for how much. This market was certainly
flawed, but the only one which could be described as
such.
The birth of OPEC
The reaction to competition from newcomers came
more from producing states more than from the
majors. The drop in posted prices, in fact, translated
into a drop in the oil tax revenues on which their
economies were almost entirely dependent. This
occurred without the host states being in any way
involved in the decision-making processes of the
companies, whilst divergences in their taxation
policies played an important role in encouraging
competitive pressures on the market. Whereas in much
of the Middle East, the tax revenues received by the
states were calculated on the basis of posted prices, in
the new producing states, such as Libya or Nigeria,
they were calculated on the actual market prices. This
disparity had helped the newcomers enter the market,
and was mainly engineered by them. By driving prices
downwards to compete with the majors, they had seen
their tax burden fall proportionally, whilst the same
could not immediately be said for the old companies.
Although the producing states’ reasons for
dissatisfaction with the majors were long-standing and
went well beyond the issue of prices, their drop
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
accelerated the states’ move to find common policies
and revise their contractual relations with the
companies. The creation of OPEC in September 1960
was a collective political act decided by its founders to
put an immediate end to the companies’ absolute
freedom to set prices. From its very first resolutions,
OPEC stated that the companies should not be allowed
to decide on any reduction in prices without first
consulting the states concerned. Although timid, this
was the first attempt in the history of international
economic relations to affirm the “inalienable
sovereignty of states over their own natural resources”
(Al Chalabi, 1980).
OPEC took two fundamental paths of action on the
price issue: on the one hand, it blocked their decrease
by revising taxation policy; on the other, it harmonized
fiscal policy, eliminating the damaging diversity of the
past. This dual action had the hoped-for results or, at
any rate, ensured that market dynamics did not have
negative repercussions on their oil income. The
freezing of posted prices effectively turned taxation on
revenues into indirect taxation (cents per barrel). Like
all other taxes of this type, these were treated as a cost
and became the minimum basis for prices. No
company would be able to go below the sum of
taxation plus production costs per barrel: the so-called
tax-paid cost. The unification of taxation policy and
the fact that the tax-paid cost became more or less
uniform and fixed in almost all countries helped to
delay the entry of potential newcomers, contain the
current supply of existing producers and stabilize
market prices. Taxation policy in the Middle East, in
short, encouraged the non-competitive structure of the
oil market.
5.1.5 Towards a new equilibrium
The years between 1950 and 1970 saw the highest
degree of domination by the majors, but at the same
time, the gradual emergence of evolutionary processes
that would eventually lead to it being overcome. The
whole world benefited during those years from the
extraordinary and unparalleled stability of the oil
markets, in terms of the full alignment of supply with
increasing demand; the flexibility of trade flows to
cope with any political tensions immediately and
without repercussions on prices; the reduction of real
oil prices to the benefit of global economic
development. The institutional conditions which
underpinned this stability gradually vanished, for
economic and political reasons. The combined effect
was to reduce the profitability of companies, lower
investments in the whole petroleum cycle, eliminate
the spare capacity which had ensured decreasing
297
KEY ACTORS IN THE HYDROCARBONS INDUSTRY AND COMPANY STRATEGIES
prices and security of supply, leading to the transition
in the early 1970s from a buyer’s to a seller’s market.
The higher taxes paid to producing countries and
lower prices did not help the profitability of
companies. Technological innovations and economies
of scale, driven by the increasing intensity of
competition, had allowed companies to maintain an
adequate, though decreasing, level of profitability up
to the mid-1960s. Subsequently, their ability to
generate resources sufficient to finance their future
declined drastically.25 Of extreme importance was the
majors’ strategy of gradually abandoning the Middle
East, aiming their investments at new and far more
costly areas. This was a strategy developed in the
knowledge that the course of history would inevitably
lead to the overthrow of the unequal balance of power
with producing countries on which they had based
their fortunes and built their dominant position in
those areas.
This led to a decision to build a production base
elsewhere which might represent a valid long-term,
though more limited, alternative to the reserves of
which they had hitherto availed themselves. The
mid-1960s thus saw the extraordinary adventures in
Alaska and the North Sea, hitherto unthinkable.26 The
potential to fully exploit these new discoveries,
however, inevitably required an improvement of profit
margins and thus of market prices, since current prices
were unable to support production costs up to five
times higher.
The pressure exerted by demand and costs, a fall in
investments, the exhaustion of spare capacity, together
with the producing countries process’ of detachment
from foreign companies, led to the great oil shocks of
the 1970s after the Yom Kippur War of October
1973,27 and in Iran after the destitution of the Shah
Reza Pahlevi and the ascent to power of the Ayatollah
Ruhollah Khomeini in November 1978. This resulted
in a leap in current prices from less than 2.5 dollars a
barrel in 1972 to peaks of 36 dollars in 1980 (90
dollars at 2006 prices). These crises marked a break in
the evolution of the global oil industry, with the
disintegration of the organizational structure built up
by the large majors, and the success of the market and
competition as a system for determining prices and
allocating resources.
Whilst it cannot be denied that the oil shocks were
triggered by the exhaustion of the operational margins
of flexibility previously guaranteed by excess
production capacity and the non-coincidental
worsening of political tensions in the Middle East, it is
also true that their overall outcome (especially in terms
of prices) can be attributed to the modifications which
had simultaneously become consolidated in the
structure of the oil industry, i.e. the forced removal of
298
western oil companies from the now dominant oil
regions of the Middle East, North Africa and Latin
America. The old order which the majors had managed
to ensure in the international markets was not replaced
by a new order, but “by confusion which led to general
chaos” (Frankel, 1980). The conditions of instability
and uncertainty experienced in the first historical
phases of the oil industry were destined to dominate.
“If the traditional compactness of the oil prices curve
was a sign of global order used (by the majors, editor’s
note) to dominate, the present irrational, capricious
behaviour of prices is the consequence of a chaotic
situation” (Frankel, 1980). This prophecy by Frankel
was to come true at least until the beginning of 2000.
A convergence of interests among the large
companies, and between these and producing countries
(not on the political level, but on that of economic
control of the market) was replaced, for all participants
in the “new oil game” as it was defined by Jean-Marie
Chevalier in 1973, by conflictual behaviour unable to
generate even a semblance of stability. Whilst the
substantial invariance of oil prices during the
1950s-70s was the most obvious sign of the
international order ensured by the majors, “the current
chaotic, irrational and capricious behaviour of prices is
the consequence of a disorderly situation in which
none of the forces in play (not even, it should be noted,
OPEC) is able to impose itself on the others in order to
create a new situation of balance and stability”
(Chevalier, 1973).
Changes outside the oil industry and endogenous
changes in the form of the companies’ response had
the combined effect of ensuring the absolute
dominance of competition and the market in setting
the prices of oil, its derivatives and other energy
sources linked to it, starting with natural gas. The
multiplication of the players confronting one another
each day on the market, the absence of long-term
contractual relations in trade flows, and the
organizational destructuring of the large groups meant
that the daily prices of the hundred or more crudes
traded were left wholly to the free play of supply and
25 The profitability rate of the majors fell from levels
close to 19% in 1956-57 to 13-14% during the years
1958-63, and to values of around 11% during the remainder
of the 1960s (PIRINC, 1971).
26 During the period 1958-70, exploration expenditure
amounted to 15 billion current dollars. Of these, only 3.5%
were spent in the Middle East, 55% in the United States, 7%
in Europe. The finding cost of a barrel was 20 dollar cents in
Europe, 17 in the United States and 0.25 in the Middle East
(Roushdi, 1972).
27 The crisis was triggered by the outbreak of war
between Arabs and Israelis following the invasion of Israel
by Egypt and Syria during Yom Kippur (the Jewish festival
of expiation) on 6 October 1973.
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 THE OIL INDUSTRY: ITS PLAYERS AND STRUCTURE FROM ITS ORIGINS TO THE OIL SHOCKS OF THE NINETEEN SEVENTIES
demand; this was exasperated, in the increasingly
frequent situations of geopolitical tension, by the
prevailing and unopposed and, perhaps, inevitable
financial speculation.
The supremacy of competition and the market,
whilst removing from sellers the power to set prices,
also recreated conditions of absolute unpredictability
and volatility, with repercussions on the risk and cost
of investments. As in the early decades of the last
century, the uncertainty and volatility of petroleum
prices dominate the international stage. The whole
world has now become fully aware of this with the
outbreak of the new crisis that has affected the entire
global energy scenario from the early Twenty-first
century, with oil prices and the related prices of
natural gas leaping from a minimum of 10 dollars a
barrel in 1998 to highs in 2006 close to 75 dollars: not
too far off, in constant money, from those reached in
the second oil shock.
This crisis is in many ways more complex than
those which were successfully overcome in the past.
The great challenge facing the world as a whole, today
as in the past, in an increasingly uncertain and
unstable international context, is the harmonious
development of the huge investments needed to
guarantee the equilibrium between potential demand
for energy and incremental supply. The ability to
provide adequate responses to this challenge will
determine the future fate of the world economy, the
international political balance, the environmental
sustainability of our planet and, not least, the
improvement of the living conditions of much of the
world population.
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ENCYCLOPAEDIA OF HYDROCARBONS
 5.2
Oil company strategies
from 1970 to the present
Since 1970, the world oil and gas industry has been
transformed by a series of massive shifts in the
economic, political and technological environment.
Adapting to these external forces has involved
major changes in the strategies of the oil and gas
companies. The impact of these changes is
indicated by a comparison of the leading
companies in the industry in 1970 and in 2004
(Table 1). In 1970, the industry was dominated by
the Seven Sisters,1 the leading US and
European-based petroleum companies that
pioneered the development of the industry for most
of the Twentieth century. Five of the sisters were
American: Exxon (then, Standard Oil New Jersey),
Mobil, Chevron (then, Standard Oil California),
Texaco, and Gulf Oil; the remaining two were
European: Royal Dutch/Shell Group, the
Anglo-Dutch joint venture, and British Petroleum
(BP). US dominance of the ranks of the leading oil
companies also extended beyond the Seven Sisters;
twelve of the twenty largest oil companies were US
domiciled. It is notable that all of the non-US
companies (except Royal Dutch/Shell Group,
PetroFina, and Nippon Oil) were either wholly or
partly publicly owned. All the leading companies
in 1970 were vertically integrated and had an
international spread of activities. The exception
was Nippon Oil whose main activities were
downstream and within Japan.
By 2004, the Seven Sisters had been reduced
to four: ExxonMobil, Royal Dutch/Shell Group,
BP and Chevron Texaco. These four had been
joined by Total (which had merged with Elf
Aquitaine and PetroFina) and ConocoPhillips to
create a leading group of six ‘supermajors’. But,
despite the continued dominance of a small group
of integrated, western-based majors, the top-20 list
of 2004 had changed greatly over the preceding
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
three-and-a-half decades. The most notable change
has been the widening international diversity of
the leading companies. The newcomers to the
ranks of the major oil and gas companies were
primarily state-owned companies that were based
either in major petroleum producing countries
(Pemex of Mexico, Statoil of Norway, PDVSA of
Venezuela, Gazprom of Russia) or in major
consumer countries (China Petroleum & Chemical
and PetroChina of China, SK Corporation of
South Korea, Indian Oil of India). Indeed, our list
grossly understates the importance of the national
oil companies from several oil producing
countries because they do not publish financial
accounts. On the basis of their estimated revenues,
Saudi Aramco and National Iranian Oil
Corporation would certainly be included in our
top-20 for 2004.
5.2.1 Driving forces
of industry change
Political factors
The most important factor causing change in
the structure of the industry and the strategies of
the oil and gas companies has been the changing
international political environment. The end of the
1960s and beginning of the 1970s saw growing
recognition by the oil producing countries of the
economic and political power that their ownership
of oil reserves conferred. Although the
Organization of Petroleum Exporting Countries
1 The term Seven Sisters was coined by Enrico Mattei
the founder of the Italian energy company, Eni, and was
popularized by Anthony Sampson in his book The Seven
Sisters (1975).
301
KEY ACTORS IN THE HYDROCARBONS INDUSTRY AND COMPANY STRATEGIES

Table 1. The world’s top-20 oil and gas companies ranked by sales (1970 and 2004)

Sales Sales
Company Company
in 2004 (109 $) in 1970 (109 $)
BP (UK) 285.1 Exxon (US) 16.6

Royal Dutch/Shell Group Royal Dutch/Shell Group

265.2 10.8
(Netherlands/UK) (Netherlands/UK)

ExxonMobil (US) 264.0 Mobil (US) 7.3

ChevronTexaco (US) 142.9 Texaco (US) 6.3

Total (France) 131.6 Gulf Oil (US) 5.4

ConocoPhillips (US) 118.7 Chevron (US) 4.2

Eni (Italy) 79.3 British Petroleum (UK) 4.1

Pemex (Mexico) 70.0 Amoco (US) 3.7

Valero Energy (US) 54.6 Atlantic Richfield (US) 2.7

Statoil (Norway) 50.1 Phillips Petroleum (US) 2.3

China Petroleum & Chemical (China) 49.8 Sun Oil (US) 1.9

Repsol-YPF (Spain) 48.0 Eni (Italy) 1.8

Marathon Oil (US) 45.1 Unocal (US) 1.8

PDVSA (Venezuela) 42.6* Elf Aquitaine (France) 1.5

PetroChina (China) 36.7 PetroFina (Belgium) 1.3

SK Corp (South Korea) 33.8 Continental Oil (US) 1.3

Petrobras (Brazil) 33.1 Getty Oil (US) 1.2

Nippon Oil (Japan) 30.4 Nippon Oil (Japan) 1.0

Gazprom (Russia) 28.9 Total** (France) 0.9

Indian Oil (India) 26.1 Petrobras (Brazil) 0.9

* Estimated.
**Total was then called Compagnie Française des Pétroles.
Sources: Company annual reports; «Fortune» and «Forbes», 1970 and 2004.

(OPEC) was founded in 1960, it was the
renegotiations of oil concessions by Libya in 1970
and Iran in 1971, followed by the Arab-Israeli war
of 1973, that put in place the conditions for
OPEC’s escalation of oil prices in 1973-1974.
The power and assertiveness of the oil
producing countries were also evident in a more
aggressive approach to the international oil majors.
From the 1960s onwards (earlier in the case of
Iran), many of the producer countries nationalized
the oil and gas subsidiaries and joint ventures
within their boundaries, thereby creating national
oil and gas companies responsible for exploiting
the countries’ hydrocarbon assets and making deals
with western oil companies (Table 2). The desire of
the producer countries to appropriate a larger share
of the value of their hydrocarbon resources was
simply a manifestation of political assertiveness
and economic development goals of the developing
world and the non-aligned countries. New oil
producing countries in the developed world
(notably, Norway and the UK) were just as keen to
maximize so that they could exploit their reserves
for the maximum benefit of their nations.
Auctioning of exploration and production licenses,
participation agreements, and new petroleum taxes
were not limited to the politically-aggressive
OPEC countries. Some of the most ambitious and
far-reaching attempts by producer countries to
appropriate the returns to petroleum resources were

302 ENCYCLOPAEDIA OF HYDROCARBONS

 OIL COMPANY STRATEGIES FROM 1970 TO THE PRESENT

Table 2. The establishment of national oil companies by OPEC countries (Tetreault, 1985)

Country Company Date established

Algeria SONATRACH 1963
Ecuador CEPE 1972
Gabon PetroGab 1979
Indonesia Pertamina 1971
Iran National Iranian Oil Corp. 1951
Iraq Iraqi National Oil Corp. 1964
Kuwait Kuwait Petroleum Corp. 1976
Libya NOC 1968-1970
Nigeria Nigerian National Petroleum Corp. 1977
Qatar QGPC 1974

Saudi Arabia* Petromin 1962

United Arab Emirates ADNOC 1971
Venezuela PDVSA 1975
* In 1974 the Saudi government acquired majority ownership of Aramco which, in 1988, became Saudi Aramco.

established by the Norwegian and British
governments in relation to North Sea oil.
However, the new-found power of OPEC did little
to ensure price stability. A central issue of the period
1970-2005 was the increased volatility of the price of
crude oil. If the first oil shock was the result of the
power of OPEC, the second oil shock, which followed
the Iranian revolution of 1979, demonstrated the
power of world markets to respond to shifts in world
supply. Since the early 1980s, crude hit lows of $8 a
barrel in 1986 and $10 in 1998, and highs of $31 in
1990 (following the invasion of Kuwait) and $60 in
2005 (Verleger, 1991).
The second political force for change was the
collapse of communism and the wave of liberalization
which opened many major oil and gas producing
countries to inward investment, which led to the
privatization of many previously state-owned oil and
gas companies, and encouraged globalization by
many domestically-focused energy companies.
Competition
The increasingly competitive structure of the
oil industry was apparent from the declining
position of the major oil companies over the
period. Until the early 1970s, the world oil industry
was dominated by a small group of major,
integrated oil companies, the above-mentioned
Seven Sisters. The smallness of this group and the
closeness of their relationships (four of them were
former members of the Standard Oil Trust)
encouraged ‘conscious parallelism’ in their
competitive behaviour. After 1970, the Seven
Sisters lost their dominant position within the
industry; during 1973-1987, their share of world
crude oil production fell from 29.3% to 7.1%, and
their share of world refinery capacity fell from
25.5% to 17.0% (Verleger, 1991). This decline was
a result of two key factors. First, the nationalization
of a large part of the majors’ oil assets after 1972.
Second, the expansion of smaller players including
state-owned oil producers (some formed from the
nationalized oil assets of the majors), and
domestically-based oil companies (e.g. Elf
Aquitaine, Nippon Oil, Neste, and Repsol) which
grew internationally. The result was a decrease in
both the economic and political power of the oil
majors.
Competitive pressures were exacerbated by the
emergence of excess capacity. The two oil shocks
depressed demand for oil products by encouraging
energy conservation and the substitution of
alternative energy sources for oil. The oil intensity
of the US economy2 halved over the period 1970 to
2 Measured in Btu (British thermal unit) per
constant-price dollar of GNP.

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KEY ACTORS IN THE HYDROCARBONS INDUSTRY AND COMPANY STRATEGIES
1990. On the supply side, the world crude oil
supply capacity increased due to expanded
exploration efforts and new exploration and
production techniques. Excess refining capacity
was exacerbated by refinery investment by many
oil producing countries. The result was excess
capacity throughout the industry’s value chain.
Technology
The physical challenges of offshore
exploration and production (E&P) and
transporting natural gas to consumer countries; the
economic incentives for utilizing heavy crudes
and converting heavier into lighter distillates; and
the technological opportunities made available by
advances in science and information technology
resulted in unprecedented innovation in petroleum
technology. The complexity and costs of the new
technologies have had many implications, such as
the outsourcing of many technical activities by
major oil and gas companies. By the beginning of
the Twenty-first century, some of the most
important players in the industry were the
engineering and oilfield service companies, such
as Schlumberger, Halliburton, Baker Hughes, and
Kerr McGee.
The investment costs of major projects
increased massively. Developing a major oil or gas
field, or building a pipeline, refinery, or a major
natural gas liquefaction complex each involved
multi-billion dollar investment expenditures.
Inevitably, joint ventures and other forms of
collaboration became more important.
5.2.2 The oil and gas majors:
the traditional model
By 1970, the world’s leading oil companies had
achieved a configuration of strategy, structure and
management systems that, for most of them, was
the culmination of more than half a century of
development. In terms of strategy, the crucial
features of the majors were their immense size,
vertical integration, and global spread. Despite the
different origins of the companies – Exxon (as
Standard Oil) had its origins in refining, Shell
began in transportation and trading, while Royal
Dutch, Texaco, and BP began in E&P – the
companies’ strategies had converged around a
common business model. All were integrated
vertically from initial exploration right through to
the retailing of refined products. The central logic
here was to limit risk by maximizing
self-sufficiency (thus, downstream activities
304
provided the secure outlets for the companies’
risky E&P investments). Most intermediate steps
were also managed internally: the companies
provided most of their own engineering and
oilfield services, and were some of the world’s
largest shipowners. All of the majors had
established important petrochemical businesses.
Economies of scale, together with vertical
integration and international expansion, meant that
the oil majors were some of the world’s largest
industrial corporations. In 1970, seven out of the
twenty biggest US companies (ranked by sales)
were oil companies, a higher representation than
any other industry. Indeed, during the 1970s, the
oil majors achieved their maximum size in terms of
numbers of employees. From the end of the 1970s,
the majors began to shrink in terms of numbers
employed (Table 3).
A key feature of the companies’ organization
was their high degree of centralization, unusual for
companies of their size and diversity of products
and activities. All the companies possessed
divisionalized structures, typically based upon a
combination of geographical, functional activity,
and product grouping. Yet, compared to other
industrial corporations, they had been slow to
adopt multidivisional structures (Chandler, 1962)
and continued to retain an unusual proportion of
decision making at headquarters level.
Centralization reflected the highly
interdependent activities of the oil companies. The
conventional multidivisional form with its
separation of strategic and operational decision
making was not feasible for the oil majors because
of the close interrelationships, both vertically
between their main businesses (exploration,
production, refining, and distribution/marketing),
and horizontally between their various final
products. Although most companies adopted a
regional divisionalization, geographically,
decentralization was limited by the need to
coordinate the flows of crude oil from the producer
countries to downstream activities in the consumer
countries. These coordination needs resulted in the
oil majors developing highly sophisticated,
administratively-planned economic systems.
Rather than operational management being
decentralized to the divisions, corporate
headquarters were responsible not just for strategic
decision making and resource allocation, but also
operational planning.
The administrative planning model, which
characterized the oil majors, emphasized
management’s role in optimizing coordination
within an essentially closed system. High levels of
ENCYCLOPAEDIA OF HYDROCARBONS
 OIL COMPANY STRATEGIES FROM 1970 TO THE PRESENT

Table 3. Employment among the oil companies in different years (numbers of employees)

1970 1980 1985 1990 2000 2004

Exxon 143,000 176,615 146,000 104,000 106,000* 85,800*

Mobil 75,600 81,500 71,100 67,300 – –

Royal Dutch/Shell Group 158,000 161,000 142,000 137,000 128,000 114,500

BP 105,000 118,200 129,450 116,750 112,150** 102,900**

Amoco 47,551 56,401 48,545 54,524 – –

Atlantic Richfield (Arco) 31,300 53,400 31,300 27,300 – –

Eni 76,000 128,000 129,000 82,700 80,178 70,948

Texaco 73,734 66,745 54,481 39,199 19,011 –

Chevron 44,610 40,218 60,845 54,208 36,490 67,569***

* ExxonMobil.
** Including Amoco and Arco.
***ChevronTexaco.
Source: Company annual reports; «Fortune Global 500», 1970-2004.

vertical integration insulated each oil company
from the volatility and uncertainty of intermediate
markets. This insulation from market uncertainty
echoed the central theme of J.K. Galbraith’s New
industrial state (1968). Where capital investments
are large and long-lived, big competitive integrated
corporations wielding substantial market power
provide insulation against the risks of competition
and fickle markets. The management of such
organizations is technocratic, requiring forecasting,
planning and coordination, supported by
sophisticated information systems and scientific
decision making.
The problem for the oil companies, and for
Galbraith’s theory, was that the companies were
unable to suppress and control the market forces
which their administrative systems were intended
to supplant. As a result of increased competition,
increased market volatility, and major economic
and political shocks, the structure and management
systems of the oil companies were subject to
increasing strain. Accelerating external change
rendered centralized decision making increasingly
inefficient; the hierarchical systems faced
information overload, and organizational reaction
times were too slow to meet the requirements for
dynamic efficiency in fast-moving external
environments.
The result was a quest for structures and
systems which would be capable of responding
quickly to external change, would foster
opportunism and an entrepreneurial drive for profit
but, at the same time, would permit planning and
investing for long-term development.
5.2.3 Diversification
and the quest for reserves
(1974-1984)
The first oil shock of 1973-1974 undermined the
administrative planning model of the oil majors in
two ways. First, they lost traditional control of the
markets for oil to a new player, OPEC. Second,
they lost a major part of their hydrocarbon reserves
as a result of nationalization by producer
governments. Their responses to the new
conditions were, first, to maintain their vertically-
integrated structures by seeking reserves in new
locations, and second, to seek new sources of
growth through diversification (Grant and Cibin,
1996).
The quest for oil
The new status of the oil majors as buyers of
oil increased their determination to restore vertical
balance. During the latter half of the 1970s,
upstream investment grew substantially, especially
in the politically-secure oil fields of the North Sea
and Alaska’s North Slope. Exploration was
expanded in both mature oil producing regions and
extended to frontier regions – primarily the Irish

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KEY ACTORS IN THE HYDROCARBONS INDUSTRY AND COMPANY STRATEGIES

Sea, South China Sea, Gulf of Mexico, the offshore
areas of West Africa and Australasia. Table 4 shows
the growth in upstream investment after the oil
shocks of 1973-1974 and 1979-1980. Greater
upstream investment was partly responsible for the
companies’ convergence towards a more similar
spread of international activities. Expanding North
American investment was a strategic priority for
the two European oil companies, while the most
strongly US-focused companies, notably Amoco
and Atlantic Richfield, increasingly sought oil
overseas.
Yet, despite increased exploration and large
discoveries in the North Sea, Alaska, and
elsewhere, the pre-1973 situation was irretrievable.
By 1975, the international oil and gas majors
supplied less than one half of their total oil
requirements from their own reserves, the
remainder had to be purchased from the
newly-powerful national production companies.
Diversification
Sharply higher oil prices and the sluggish
global economy of the late 1970s and early 1980s
meant near stagnant demand for oil and oil
products, and the emergence of excess capacity at
most stages in the companies’ value chains.
Nevertheless, the oil majors remained committed
to growth and, fuelled by strong cash flows from
higher oil prices, turned to diversification as the
major source of growth.
In 1970, the companies were almost wholly
specialized in oil, gas, and petrochemicals. By
1984, broadly similar patterns of diversification
had taken them into alternative energy sources
(primarily coal, but also solar power, nuclear
energy, and non-conventional hydrocarbons such
as tar sands and oil shales) and minerals such as
non-ferrous metals, phosphates, sulphur, and
cement. Other areas of diversification were
primarily a consequence of the desire to exploit
internally-developed technologies and
management capabilities, e.g. BP and Amoco
animal feed businesses, Shell’s detergents
business, Exxon and Texaco in electricity
generation. Amoco, Atlantic Richfield, BP, Exxon,
Shell, and Texaco formed venture capital
subsidiaries with the purpose of bringing to

Table 4. Average annual capital expenditures on oil and gas businesses

by selected companies, 1970-2004 (106 $)

1970-1973 1974-1978 1979-1982 1983-1986 1987-1990 1991-1994 1995-1999 2000-2004

Exxon* upstream 981 3,040 6,371 6,955 4,870 6,322 8,016 10,005
downstream 897 1,114 1,365 1,264 1,438 1,660 2,664 2,508
Mobil * upstream 426 863 2,106 1,548 1,208 1,214 – –
downstream 557 502 832 811 726 1,104 – –
Shell upstream 470 1,477 4,507 4,052 3,215 4,677 6,377 8,516
downstream 1,083 1,006 2,296 1,541 2,486 2,551 2,614 3,108

BP** upstream 306 780 3,387 2,974 2,401 3,620 4,998 10,118
downstream 430 422 696 961 886 937 1,421 4,830
Amoco** upstream 595 1,206 2,258 2,567 2,390 2,956 – –
downstream 242 289 563 542 451 548 – –
Arco** upstream 232 678 2,210 2,877 1,559 2,380 – –
downstream 267 591 433 286 556 545 – –
Chevron*** upstream 302 889 2,560 2,712 1,805 1,663 3,386 6,505
downstream 413 678 1,132 803 731 662 908 1,180
Texaco*** upstream 673 927 1,560 1,467 1,295 1,544 2,318 –
downstream 433 416 567 826 604 588 864 –
Eni upstream 332 981 2,104 2,150 2,531 2,431 2,992 4,808
downstream 145 246 368 260 628 501 544 596

* Combined data for ExxonMobil after 1995.

** Combined data for BP, Amoco and Arco after 1995.
***Combined data for Chevron and Texaco after 1999.
Source: Company financial accounts.

306 ENCYCLOPAEDIA OF HYDROCARBONS


market internally-developed technologies and
acquiring small, technology-based, new
companies. Several companies diversified more
widely: Exxon and BP into information
technology, Mobil into retailing (Montgomery
Ward) and packaging. Table 5 shows the
diversification of several leading oil and gas
majors.
5.2.4 Internal restructuring
for efficiency and
flexibility (1985-1994)
Changing corporate goals
During the 1980s, the major oil and gas
companies came under increasing pressure. After
reaching a peak in 1981, oil prices followed a
sharp downward trend and industry profits
declined in tandem (Al-Chalabi, 1991).
Between 1985 and 1994, almost all the
majors announced significant restructuring
initiatives which involved extensive asset
divestments, employment reductions, and
reformulation of their business strategies. A key
trigger was the precipitous decline in oil prices
in 1986 when increased production by Saudi
Arabia resulted in oil prices falling below $9 a
barrel. The result was a fundamental questioning
by the oil majors of their strategies and
organizational structures.
At the root of these restructuring initiatives was
the companies’ affirmation of profitability and
shareholder return as their primary goals. During
the 1970s, statements of corporate goals had
placed emphasis on growth and operational goals
such as replacing reserves, expanding
geographically, and improving efficiency and
technological progress. During the 1980s, these
goals became subsidiary to profit and return to
shareholders. The following statements were
typical:
• “Our primary goal is to improve both the
short-term and the long-term value of your
investment” (Mobil, 1987).
• “Our aim over recent years has been, and
remains, to achieve the maximum return from
our assets” (BP, 1988).
• “We are acutely aware that you expect to
receive a fully competitive return on your
investment […] and that’s what we intend to
deliver. Our standard […] is to become not only
one of the most admired companies in the
industry, but also one of the most valuable to
stockholders” (Texaco, 1989).
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
OIL COMPANY STRATEGIES FROM 1970 TO THE PRESENT
• “The Company gives the highest priority to
improving financial results and the return on its
stockholders’ investment” (Chevron, 1989).
The quest for improved returns to shareholders
provided the unifying theme behind the strategic
and organizational changes of 1985-1994. A clear
indication of the reorientation of corporate goals
from growth to shareholder value creation was the
introduction of share repurchases designed to
increase earnings per share by reducing the number
of outstanding shares. As in other aspects of
restructuring, Exxon was the leader. Between 1984
and 1986 alone, Exxon spent $6 billion on share
repurchases. All the other majors introduced
similar initiatives; instead of excess cash flowing
into diversification, the companies gave it back to
their shareholders.
From diversification to focus
The most prominent aspect of strategic change
during the mid and late 1980s was widespread
divestment of ‘non-core’ businesses. By 1990, the
leading oil companies had almost entirely divested
the diversifications of the earlier period. First to go
were the almost entirely unsuccessful, unrelated
diversifications such as Exxon’s Office Systems
venture, Mobil’s foray into general retailing, BP’s
dalliance with software and telecommunications,
even Eni (by far the most diversified of the leading
oil and gas majors) began to shed some of its
diversified businesses.
Then came divestment of most of the major
diversifications into related sectors. In particular,
all the majors sold off their metal mining
subsidiaries. By the beginning of the 1990s, only
Shell had a major metals’ mining business (it
divested Billiton in 1993). By 1994, the only one
of the majors with substantial interests outside of
energy and chemicals was Elf Aquitaine with its
‘health and beauty’ business (pharmaceuticals and
cosmetics). Some companies went even further
with their determination to ‘refocus on core
businesses’ (both Arco and Texaco divested major
parts of their chemical businesses, raising the
question of whether the technical linkages between
petroleum refining and petrochemicals were
sufficient to justify the majors’ continued
involvement in chemicals).
The companies also redefined their scope in
relation to their geographical spread of activities.
Downstream, all the companies narrowed their
geographical spread. By 1990, not one of the
companies was marketing in all 50 states of the
US, and most had refocused their European
operations, withdrawing from countries where their
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KEY ACTORS IN THE HYDROCARBONS INDUSTRY AND COMPANY STRATEGIES

Table 5. Diversification by Shell, Exxon, Mobil and BP (1974-1984)

ROYAL DUTCH/SHELL GROUP

1974 NV Billiton, metal and minerals exploration and production company, acquired
1975 Additional investments in gas-cooled nuclear reactors
1976 Seaway coal acquired for $ 123 million
Coal gasification plant built in Germany
Scallop Coal established in New York to trade coal
1977 Crows Nest Industries (coal producer) acquired
1979 Forestry investments in New Zealand and Chile

EXXON

1975 Exxon Nuclear International formed

1977 Exxon Minerals USA and Exxon Minerals International formed
1979 Reliance Electric Co. acquired for $ 1.2 billion
1980 Exxon Office Systems and Exxon Information Systems formed
1981 US$ 2.5 billion electricity generation project in Hong Kong started
16% of American Solar King (solar energy) acquired
1984 Coal production begins at Cerrejon, Columbia

MOBIL

1974 Acquires Marcor for $ 883 million – parent of Montgomery Ward (retailing) and Container Corp.
1975 Invests in coal mining and real estate
1977 Mt. Olive and Staunton Coal Company acquired for $ 47.5million
1978 W.F. Hall Printing acquired for $ 50.5 million
Electro-Phos Corporation (phosphorous refining) and Rexene Styrenics acquired.
Real estate investments in Hong Kong.
1980 Acquisition of companies producing plastics, phosphorous, and fertilizers.
Alternative energy investments include methanol (New Zealand), oil shale plant (Utah), uranium processing plant
(US), and coal-to-liquids plant (Kentucky)
1982 Mobil Diversified Businesses established to operate non-petroleum, non-chemical businesses
1983 Begins coal projects in Australia and Indonesia.
Acquires Baggies plastic bag company from Colgate-Palmolive
1984 Acquires can coating business from DuPont

BRITISH PETROLEUM

1976 Forms BP Nutrition Ltd (proteins & animal feed)

Forms Sonarmarine Ltd (underwater surveying)
1977 Acquires 50% of Clutha Development (Australian coal mining)
1978 Acquires R. McBride Ltd (engineering & construction)
Acquires Bakelite Xylonite Ltd (plastics) from Union Carbide
1979 Acquires 25% of Ruhrgas (gas refining & distribution in Germany)
1980 Acquires Selection Trust Ltd (global metals mining)
1981 Acquires Systems Control Inc. (computer systems)
Acquires Kennecott Corp. for US$ 1,77 million (by Sohio)
Acquires Verdugt NV (specialty chemicals)
Establishes BP Detergents International
Acquires 49% of Brascan Resoursos (tin)
Acquires 49% of Olympic Dam project (metals mining in Australia)
Takes 49% in Mercury Communications (telecom)
1983 Acquires NANTA (Spanish animal feed company)
1984 Acquires NORIA/UFAC (French animal feed company).
Establishes BP Energy Management (energy management systems)

Source: Company annual reports.

308 ENCYCLOPAEDIA OF HYDROCARBONS


market share was below 10%. A similar trend
occurred upstream. During the late 1980s and early
1990s, most of the companies reduced the number
of countries where they conducted exploration and
production in order to achieve better economies in
the use of infrastructure and knowledge.
Chevron’s description of its approach to
refocusing is typical: “[We] have taken a critical
look at our asset deployment to determine how
each of our businesses fits into the corporation’s
strategic plans. As a result, we have pulled out of
several geographic areas and businesses in order to
concentrate our resources where we have a
competitive advantage. And the process continues.
We are now disposing of our agricultural
chemicals, fertilizer and certain minerals
businesses. Almost $400 million of marginal US
producing properties have been sold, and we plan
to continue selling such properties in 1991”
(Chevron, 1990).
Among all the companies, strategy was
increasingly driven by rigorous financial analysis
of return on capital and impact on shareholder
wealth. BP described its flexible approach to
portfolio management active asset management.
Former Chief Executive Officer (CEO), Peter
Walters, described the approach as follows: “We
seek to ensure that our operations satisfy the
criteria of selective excellence: that is being among
the very best; and critical mass, which means
being of sufficient size to compete strongly in the
market [...] Within our strategic criteria, we
continually review all of BP’s activities –
hydrocarbon based or otherwise. If certain
operations are worth more for particular reasons to
others than to ourselves, or if they no longer fulfill
our requirements and show little prospect of doing
so, we are prepared to withdraw from or sell them.
Active asset management is convenient business
shorthand for this strategy”. (BP, 1988).
BP’s sale of its minerals business illustrated the
new line of thinking: “These major developments
will both enhance and protect the value of your
company by helping BP to re-focus increasingly on
its central or ‘core’ businesses [...] Why are we
making this divestment, when BP Minerals is
generating good profits? [...] Having acquired,
nurtured and developed the minerals business over
several years, we projected forward the increase in
commodity prices. Against these projections, we
are receiving from RTZ a net value which, we
consider, is a very positive reflection of future
earnings. Not only are we getting a good price, we
are raising money for better opportunities in other
businesses” (BP, 1988).
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OIL COMPANY STRATEGIES FROM 1970 TO THE PRESENT
The quest for efficiency
Reorientation of strategies around shareholder
value goals also meant increased emphasis on cost
efficiency. Exxon was the most explicit in
expressing its intention to become the “most
efficient competitor in each of our businesses, in
oil and gas, in chemicals, and in every other
activity” (Exxon, 1983).
Traditionally, efficiency was associated with
static efficiency, i.e. the exploitation of scale
economies in refineries, ships, distribution
networks, and other indivisible capital items,
together with operational planning of product
flows to optimize refinery scheduling and
minimize inventories and transport costs. Under
unstable market conditions, dynamic efficiency
became increasingly important, i.e. adjusting
capacity to demand, adjusting the mix of inputs
and outputs to changing price differentials, and
generally minimizing costs through maximizing
flexibility and responsiveness. Cost reduction
measures included:
• Capacity adjustment through closure of
refineries, storage capacity, and retail filling
stations, and the sale and scrapping of oil
tankers (Table 6).
• Reducing overhead costs, especially cuts in
middle management and headquarters
activities. At several companies, reductions in
corporate-level employees were achieved. At
BP, more than 2,500 head office employees
were cut from 3,000 to 380 (in addition, a
further 700 in corporate services were relocated
away from head office). In all, 1,150 corporate
level jobs were eliminated. At Exxon,
headquarters staff was reduced from 1,500 to
300. These economies were often accompanied
with relocation of companies’ head offices:
Exxon moved from New York to Dallas, Texas;
Mobil from New York to Fairfax, Virginia; BP
moved twice within London, while Shell sold
off more than half of its London Shell Centre.
• Developing and deploying cost-reducing
technology. Despite increased parsimony in
capital investment, there was a substantial
increase in expenditure on the development and
acquisition of new technologies that could
lower capital costs and increase operational
efficiency. Computer-aided seismic analysis
and reservoir modelling, light-weight drilling
platforms, new drilling techniques (including
horizontal and directional drilling), and
enhanced oil recovery techniques, substantially
reduced reserve replacement costs during the
1980s and early 1990s.
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KEY ACTORS IN THE HYDROCARBONS INDUSTRY AND COMPANY STRATEGIES
Table 6. Capacity reduction by the oil companies during the 1980s (Cibin and Grant, 1996)
Change in operable
refining capacity*
Exxon (1982-1987) ⫺28%
Royal Dutch/Shell Group (1981-1986) ⫺33%
BP (1982-1986) ⫺27%
Mobil (1986-1988) ⫹1%
Texaco (1986-1989) ⫺36%
Chevron (1986-1989) ⫺33%
Amoco (1986-1990) ⫺5%
Arco (1985-1987) ⫺63%
* The data show changes in capacity from the start of the first mentioned year to the end of the last mentioned year.
** Change in number of vessels.
*** North America only.
• Increasing flexibility and responsiveness was
also a source of cost advantage. Flexibility
involved technical improvement to refineries
and outsourcing many activities and functions.
Aligning business strategy with resources
and capabilities
Increased competitive pressure, together with a
stronger focus on profitability, encouraged a major
reorientation of the basis of company strategy.
Rather than imitating one another’s strategic
initiatives, the emphasis of strategy shifted towards
the pursuit of competitive advantage which,
inevitably, meant the exploitation of differences in
endowments of resources and capabilities.
Exploitation of distinctive resources and
capabilities included the following:
• Mobil combined its strong marketing
orientation and its traditional technical
strengths in lubricants to develop its worldwide
lubricants business. In its petrochemical
business, Mobil exploited its marketing and
product management capabilities to integrate
into fabricated plastic products.
• While most of the majors were selling off their
mature US fields, Texaco’s strengths in
enhanced recovery techniques encouraged it to
focus upon their exploitation.
• Arco utilized its two key strengths of low-cost
Alaskan oil and strong marketing orientation to
increase its market share on the West Coast of
the US by a retail strategy oriented around price
310
Change in deadweight Change in no.
tonnage of tanker fleet* of retail outlets*
⫺58% ⫺24%
⫺54%** ⫺16%
⫺63% ⫺18%
⫺18% ⫺30%
⫺12% ⫺65%***
⫺28% ⫺28%
⫺21% ⫺19%
⫹13% ⫺55%
leadership in gasoline, and differentiation
through offering a wide range of products and
fast-food catering at its service stations.
• Exxon relied upon its massive financial and
engineering strengths.
• Eni utilized its expertise at relationship
management in complex political situations to
negotiate deals with North African countries,
the Soviet Union and the post-Soviet states, and
to build on its natural gas expertise to create a
vertically-integrated natural gas major.
• BP, with its long history of discovering
‘elephants’ (very large oilfields), focused on
exploring for major new fields in frontier
regions and also being a ‘strategic innovator’,
i.e a first mover in identifying and initiating
major strategic shifts in the oil industry.
5.2.5 Changes in organizational
structure
Changes in strategy were accompanied by changes
in organizational structure. The principal changes
in organizational structure and management
systems over the period included the following:
Changes in divisional structure. Changes in
divisional structures were of two types: first, the
companies moved increasingly from a
geographically-based to a sector-based divisional
structure; second, they reduced the number of
divisions reporting directly to headquarters. By
ENCYCLOPAEDIA OF HYDROCARBONS

1991, the predominant organizational form was a
corporate headquarters with three principal
operating divisions: upstream, downstream, and
chemicals. However, there was significant
variation within our sample: Exxon maintained a
geographical structure with Exxon USA, distinct
from Exxon International and Imperial Oil of
Canada; Texaco’s structure was also partly
geographical; while the Royal Dutch/Shell Group
(which comprised over 200 national subsidiaries)
was uniquely decentralized.
The tendency for the companies to reorganize
into fewer divisions was a result of the divestment
of diversified activities between 1985 and 1990,
the transfer of many service and coordination
functions from the corporate headquarters to the
divisional level, and the desire to reduce
administrative overheads wherever possible. The
shift from a geographically-defined divisional
structure towards a divisional structure defined
around groups of products is consistent with the
trends observed for other diversified, multinational
companies (Stopford and Wells, 1972).
Vertical de-integration. The traditionally
centralized structures of the companies were a
consequence of vertical integration: so long as oil
production, transportation, refining, and
distribution needed to be coordinated, headquarters
retained an important role in operational planning.
With the development of efficient markets for oil
and oil products, and increased volatility within
these markets, the transactions costs of
intermediate markets fell, while the costs of
internal transfer rose. Shell was the first company
to free its refineries from the requirement to
purchase oil from within the group. Between 1984
and 1988, all the sample members granted
operational autonomy to their upstream and
downstream divisions, placing internal transactions
on to an arms-length basis. Upstream divisions
were encouraged to sell oil to whichever customers
offered the best prices, while downstream divisions
were encouraged to buy oil from the lowest cost
sources.
By the mid-1980s, the oil majors were
emerging as major players on the spot and futures
markets for crude and refined products. All the
sample members established oil trading divisions,
whose function was to serve the transactions needs
of the production and manufacturing divisions, and
even to trade for profit in the oil markets. Of the
total crude purchased by Shell International
Trading Group in 1994, 65% was from outside the
Shell group and 45% of sales were to third parties.
Texaco Trading and Transportation not only
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
OIL COMPANY STRATEGIES FROM 1970 TO THE PRESENT
serviced Texaco’s internal needs, but it also
engaged in substantial third party trading and by
1988, it was purchasing 9% of all US produced
crude oil.
The new logic was articulated by BP: “A
significant feature of the oil industry in recent
years has been the trend towards deintegration, or
separation of upstream crude production from
downstream refining and marketing. Each part of
the oil business then stands on its own, so allowing
its performance to be measured against the value of
its products in the international market. One
consequence of this has been the development
within the industry of a much clearer picture of the
true costs and profitability of the downstream oil
operations” (BP, 1983).
Changes in management systems. New strategy
and structures also involved changes in the systems
with which companies were managed. In
particular:
• The leading majors dismantled their
centralized, forecast-driven systems of
corporate planning in favour of less-formalized
and more performance-oriented approaches to
strategy making that was increasingly focused
upon the business divisions. These changes
involved the dismantling or downsizing of
corporate planning departments and the
transfer of strategy-making responsibilities to
line managers.
• Decentralization. Less vertical integration
permitted greater decentralization of decision
making. Decentralization involved devolution
of decision making from corporate to divisional
levels and from divisions to individual business
units. The objectives were to speed up decision
making, to encourage entrepreneurship and
initiative, and to reduce costs.
• Delayering. Decentralization of decision
making typically involves the stripping out of
layers of authority. At Texaco, the number of
layers of hierarchy between the CEO (Chief
Executive Officer) and first-line supervisors
was reduced from 14 in 1987 to 6 or 7 in 1990.
The CEO reported: “A dynamic new company
is emerging from Texaco’s restructuring. In the
office and in the field, Texaco people are being
challenged to perform, to be creative, to
become entrepreneurs in the true sense of the
word. And they are responding. Working in a
decentralized company, talented and motivated
people on the front lines of Texaco’s businesses
are taking the calculated and informed risks
that lead to better profitability” (Texaco, 1988).
At Amoco, decentralization was more radical:
311
KEY ACTORS IN THE HYDROCARBONS INDUSTRY AND COMPANY STRATEGIES
the company’s main divisions (upstream,
downstream, chemicals) were broken up into 17
separate businesses, each of which reported
directly to the corporate headquarters.
• Financial control and performance
management. All the companies placed greater
emphasis on budgetary control and short and
medium-term performance targets. The new
emphasis reflected the increased priority given
to profitability and financial accountability of
each division and business unit. The new
emphasis was reinforced through increased use
of profit bonuses and stock options to
incentivize senior managers. Thus, Texaco
identified itself as an “entrepreneurial
operation with bottom-line accountability”. Its
newly decentralized structure meant monitoring
each division on a monthly basis with “the
bottom line reviewed at the end of each year”.
One analyst commented: “Texaco employees
are being encouraged to change the
bureaucratic mindset, typical of large oil
companies, and take risks as an entrepreneur
would” (Texaco [...], 1989). Increased financial
accountability also meant increased pressure on
managers to meet demanding profit targets. As
Exxon Chemical’s President, Eugene
McBarayer, observed: “I feel my neck is in the
noose. If I don’t deliver, they’ll get someone
else in here who will”.3
5.2.6 Consolidation: the wave
of mergers (1995-2002)
Mergers and acquisitions pre-1998
Mergers and acquisitions had long been a
central feature of the corporate strategies of the
leading oil and gas majors. Several of the leading
majors had been created through mergers: Mobil
was created from the merger of Standard Oil of
New York (Socony) with the Vacuum Oil
Company; Atlantic Richfield was formed from the
merger of Richfield Oil Corporation and Atlantic
Refining Company; Eni was created from the
merger of Agip, Snam and several other Italian
energy companies; Royal Dutch/Shell Group was a
joint-venture between Royal Dutch Petroleum and
Shell.
During the late 1970s and 1980s, the majors
used acquisitions as a means of diversifying into a
number of new industry sectors. From the mid
1980s, acquisitions were mainly horizontal, i.e., the
acquisition targets were mainly other oil and gas
companies where the motives for acquisition were
312
primarily to build critical mass in existing markets,
to expand geographical scope, and to acquire
hydrocarbon reserves. Significant acquisitions
included: a) Chevron’s purchase of Gulf Oil
(1984); b) Texaco’s purchase of Getty Oil (1984);
c) BP and Royal Dutch/Shell Group’s purchase of
the outstanding shares of their US affiliates Sohio
(1987) and Shell Oil (1984), respectively; d ) BP’s
acquisition of Lear Petroleum and Britoil in 1988
and Burmah Oil in 1989; e) Amoco’s purchase of
Dome Petroleum (1987).
The creation of the ‘supermajors’
During the mid-1990s, excess capacity and
depressed profit margins were creating pressures
for mergers at the downstream level. In October
1996, Shell, Texaco, and Star Enterprise (a joint
venture between Texaco and Saudi Aramco)
announced the merger of their downstream
businesses within the US to create America’s
largest refining and marketing company. Similar
pressures were apparent in Europe where BP and
Mobil merged their downstream businesses into a
single joint venture.
However, the critical event that triggered
mergers and acquisitions on a much larger scale
was BP’s merger with Amoco (which was quickly
followed by its acquisition of Arco, one of the
smallest of the international majors). BP’s actions
sent a shock wave throughout the industry. The
outcome was a series of mergers and acquisitions
that represented the most rapid period of
consolidation that the oil and gas industry had
experienced since the growth of Standard Oil
during the 1980s.
The most significant of the new wave of
mergers was Exxon and Mobil’s announcement of
a merger agreement towards the end of 1998. This
was the biggest merger in history and created the
world’s biggest industrial corporation. It was a
clear indication to the other leading oil and gas
companies that the mergers were moving into two
divisions: the ‘supermajors’ represented by
ExxonMobil, BP-Amoco-Arco, and Royal
Dutch/Shell Group, and the others (Table 7).
The benefits of size
While stock markets rewarded these mergers
and acquisitions with higher valuation ratios, the
extent of real economic benefits was unclear. The
primary motivation appeared to be the desire for
3 For further discussion of restructuring by the majors,
see R. Cibin and R.M. Grant, 1996.
ENCYCLOPAEDIA OF HYDROCARBONS
 OIL COMPANY STRATEGIES FROM 1970 TO THE PRESENT

Table 7. Major mergers and acquisitions in the oil and gas industry, 1998-2002
(only includes acquisitions of companies with revenues exceeding $ 1 billion)

Leading oil Revenues in 1995 Leading oil Revenues in 2002

Date merged
and gas companies, 1995 (109 $) and gas companies, 2002 (109 $)

Exxon 123.92 ExxonMobil Corp. 182.47

Mobil 75.37 1999

Royal Dutch/Shell Group 109.87 Royal Dutch/Shell Group 179.43

Enterprise Oil 1.18 2002

British Petroleum 56.00 BP Amoco 178.72

Amoco 28.34 1998
Arco 15.82 2000

Chevron 31.32 ChevronTexaco 92.04

Texaco 35.55 2001

Total 27.70 Total 96.94

PetroFina n.a. 1999
Elf Aquitaine n.a. 2000
Conoco 14.70 ConocoPhillips 58.38
Philips Petroleum 13.37 2002
Tosco n.a. 2001

Eni 35.92 Eni 46.33

Repsol 20.96 Repsol-YPF 34.50

YPF 4.97 1999

Source: Company annual reports.

growth, particularly when low oil prices were
reducing revenues.4
Once the merger wave began, it was
sustained by companies’ fear of being relegated
to ‘second division’ status within the industry.
The positive stock market reaction to the
mergers was surprising, given that many studies
across other industries show that only a small
minority of mergers achieve measurable gains,
such as higher productivity, profits or share
prices, over the long term. The answer lies in the
enormous capital costs and risks inherent in the
exploration and production of oil. Moreover
only well-capitalized firms that are big enough
to afford the time, money and risk required to
play in this poker game can hope to thrive. As a
result of the stakes being so high, finding that
‘elephant’ of an oilfield has become the
industry’s obsession.
The arguments in favour of size were
articulated by Thierry Desmarest, chairman of
Total and architect of the mergers with PetroFina
and Elf Aquitaine. He argued that: “In the future,
the very large, major oil and gas companies will be
the best positioned to successfully meet the
necessary demands which will be made on our
industry. It will be their substantial size that will
give them:
• The necessary financial strength to carry out
large projects.
• The command of leading-edge technologies
and management skills.
• Adequate negotiating power with governments.
• The indispensable resilience and flexibility to
changing environments.
• The patience and long-term vision to develop
major projects that will require major advances
in technology or market development”
(Desmarest, 2002).
Desmarest offered the following as examples of
the increasing size of project being undertaken by
Total: a) the $2.5 billion Elgin-Franklin field in
the North Sea; b) the $4.3 billion Sincor project
in Venezuela for converting extra-heavy crude
into low-sulphur synthetic crude; c) the $2.6
billion Girassol oilfield project in 1,350 metres of
water off Angola; d ) the $2 billion development
of the South Pars gas field in Iran.
Desmarest also referred to the ability to spread
4 In December 1998, crude prices fell below 10 $/bbl.

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KEY ACTORS IN THE HYDROCARBONS INDUSTRY AND COMPANY STRATEGIES

Table 8. The world’s biggest listed oil and gas companies, 2004
(ranked by stock market value, $109)

Market
Company Country Sales Profits Assets
capitalization
Exxon Mobil US 263.99 25.33 195.26 405.25
BP UK 285.06 15.73 191.11 231.88
Royal Dutch/Shell Group Netherlands/UK 265.19 18.54 193.83 221.49
Total France 131.64 8.84 98.69 151.13
ChevronTexaco US 142.90 13.33 93.21 131.52
PetroChina China 36.70 8.41 64.23 111.03
Eni Italy 79.31 9.89 82.25 104.71
ConocoPhillips US 118.72 8.13 92.86 76.54
Gazprom Russia 28.88 5.84 90.29 69.90
Petrobras Brazil 33.11 6.15 46.43 48.38
China Petroleum & Chemical China 49.75 2.61 48.16 44.97
Schlumberger Netherlands 11.61 1.22 16.04 44.42
Statoil Group Norway 50.06 4.11 40.91 39.44
Repsol-YPF Spain 48.00 2.54 46.68 33.32
EnCana Canada 10.93 2.52 24.11 30.75
Surgutneftegas Oil Russia 7.67 0.66 18.32 29.76
Lukoil Holding Russia 23.14 3.87 26.46 28.52
Oil & Natural Gas India 9.78 2.16 19.18 27.86
BG Group UK 7.83 1.74 16.49 27.80
Occidental Petroleum US 11.51 2.57 21.39 27.74
CNOOC Hong Kong/China 4.96 1.40 8.88 23.83
Devon Energy US 9.19 2.19 29.74 22.65
Apache US 5.33 1.67 15.50 20.59
Halliburton US 20.47 0.98 15.80 19.41
Burlington Resources US 5.62 1.53 15.74 19.25

Source: «Fortune», 2004; Hoovers.com.

risks through undertaking multiple large projects in
different regions of the world. Thus, in Liquefied
Natural Gas (LNG), Total had invested in five
plants located in Indonesia, Nigeria, Qatar, and
Abu Dhabi. Another benefit of size is the greater
opportunities for learning that arise from pursuing
multiple projects. The more projects of a similar
type that a company undertakes (e.g. deep sea
drilling in North Sea, Gulf of Mexico, and offshore
West Africa), the greater the scope for learning,
innovation, and sharing of best practices. The
increased size and risk associated with major
upstream projects is indicated by Shell’s experience
with its massive Sakhalin-2 offshore gas project off
the coast of Siberia. By 2005, the estimated cost of
the project had risen to $20 billion, a cost over-run
of $10 billion (Shell [...], 2005).
In general, however, evidence of significant
economies of scale associated with being a
‘supermajor’ rather than a ‘major’ is hard to find.

314 ENCYCLOPAEDIA OF HYDROCARBONS

 OIL COMPANY STRATEGIES FROM 1970 TO THE PRESENT

Downstream, there are substantial cost and market
power advantages associated with market share in
individual national and regional markets, but few
scale economies at the global level. Upstream, size
increases bargaining power and allows for the
spreading of risk, but the main scale economies
relate mainly to the utilization of infrastructure
which is specific to particular regions and
hydrocarbon basins.
5.2.7 Current directions
in strategy
The oil and gas companies in 2005
Tables 8 and 9 show the leading players in the
world oil and gas sector in 2004 and 2003,
respectively. Table 8 ranks the biggest stock market
listed companies. However, it is important to
recognize that some of the world’s biggest and most
important oil and gas companies are state-owned
production companies. Many of these do not publish
comprehensive accounts; however, their importance
is evident from operational data. Table 9 shows the
world’s biggest oil and gas companies in terms of
reserves; the majority are state-owned National Oil
Companies (NOCs). Despite the fact that
ExxonMobil, Shell, and BP are among the world’s
biggest corporations, in terms of reserves (and also
crude oil production), they are overshadowed by the
leading NOCs: ExxonMobil’s reserves are about
one-tenth of those of the National Iranian Oil
Company and smaller than those of Pemex, the
Mexican national oil company.

Table 9. The world’s top-20 oil and gas companies ranked by reserves, 2003

Company Country State ownership (%) Reserves ($ 109/bbl)

Saudi Aramco Saudi Arabia 100 249

NIOC Iran 100 126

INOC Iraq 100 115

KPC Kuwait 100 99

PDVSA Venezuela 100 78

Adnoc United Arab Emirates 100 55

Libya NOC Libya 100 23

NNPC Nigeria 100 21

Pemex Mexico 100 16

Lukoil Russia 8 16

Gazprom Russia 73 14

ExxonMobil US 0 13

Yukos Russia * 12

PetroChina China 90 11

Qatar Petroleum Qatar 100 11

Sonatrach Algeria 100 11

BP UK 0 10

Petrobras Brazil 32 10

ChevronTexaco US 0 9

Total France 0 7

*Yukos was taken into government control during 2005.

Source: «Petroleum Intelligence Weekly», 2003.

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KEY ACTORS IN THE HYDROCARBONS INDUSTRY AND COMPANY STRATEGIES
The presence of two very different types of
enterprises in the oil and gas sector results in what
The Economist describes as a “fundamental
perversity” of the oil business: “Oil is the only
industry in which the best and largest assets (in this
case, oil and gas reserves) are not in the hands of
the most efficient and best-capitalized firms (the
western majors), but of national oil companies.
Two-thirds of the world’s oil reserves are found in
the Persian Gulf, where foreign firms are mostly
unwelcome. Exxon may hold the highest stock
valuation among listed firms, but it is dwarfed by
Saudi Arabia’s unlisted Aramco, whose oil reserves
are 20 times larger, and off-limits to foreigners”.
As we shall see, this asymmetry is central to the
strategic predicament facing the oil and gas majors.
As Table 8 shows, the international majors and
the NOCs are not the only significant players in the
world petroleum industry. A key feature of the
industry’s evolution since the days of domination
by the Seven Sisters has been an increasing
diversity in the types of companies in the industry.
Independent upstream companies such as Apache,
Devon Energy and Burlington Resources have
gained an increasingly important role. Many of
these independents have been pioneers in
discovering and developing oil and gas reserves in
frontier regions. Vertical specialization is also
evident in other stages of the value chain.
Schlumberger and Halliburton specialize in
integrated
national
petroleum companies
vertical scope
(e.g. Gazprom, refining and
Saudi Aramco, PDVSA, marketing
Pemex, companies
Kuwait Petroleum) (e.g. SK, Reliance,
Cepsa,
Nippon Oil)
downstream gas companies
(e.g. BG, Gaz de France,
E.ON AG)
specialized
national
Fig. 1. Strategic groups within the world petroleum industry.
316
providing technology and oilfield services,
especially drilling, to oil and gas companies.
Downstream specialists (refiners and distributors)
tend to be smaller and geographically focused.
Other new players on the international scene
are the downstream gas companies. Despite the
bankruptcy of the ill-fated Enron, a number of
other gas marketing and distribution companies
(notably, British Gas, Gaz de France and Eon) have
backward integrated into E&P and also expanded
internationally. Fig. 1 shows the principal strategic
groups of different types of company in the oil and
gas industry in terms of their positioning with
regard to vertical scope and geographical scope.
Thus, while the supermajors have activities that go
from exploration through to retailing and span the
globe, other companies operate in just a few
vertical activities and are concentrated primarily in
a single country.
Corporate performance
One of the most notable features of the oil and
gas industry has been its strong financial
performance. During the period 2002-2004, the
industry has been particularly profitable, with most
of the majors earning a return on equity that
has been more than double their cost of equity
(Table 10).
The recent profitability of the oil companies
has, of course, been the result of high prices for oil
supermajors
(e.g. Exxon, Shell, BP, Chevron,
majors Total, ConocoPhillips)
(e.g. Eni, Repsol,
Petrobras)
international
upstream companies
(e.g. Burlington, Apache,
EnCana)
service companies
(e.g. Schlumberger,
Halliburton)
geographical scope global
ENCYCLOPAEDIA OF HYDROCARBONS
 OIL COMPANY STRATEGIES FROM 1970 TO THE PRESENT

and gas. However, if we view the industry’s
financial performance over the past 20 years, we
find that profitability (whether measured as return
on equity, return on capital employed, or return on
sales) has been significantly above the average for
other industry sectors. It is a tribute to the
companies’ strategies that since the mid-1980s,
profits for most of the companies have remained
positive even during periods of depressed oil prices
(e.g. the late 1990s). This points to the
effectiveness of restructuring, downsizing, and new
technologies in cutting costs and refocusing the
companies around their most profitable business
activities.
The primary source of profitability has been
exploration and production (high oil prices during
2003-2005 have further boosted the high returns
traditionally associated with upstream activities).
By contrast, downstream has been unprofitable for
most of the past three decades (the result of excess
capacity and fierce price competition among
commodity products). During 2000-2005, the
economics of the downstream sector have been
transformed: a worldwide shortage of refining
capacity has boosted refining margins, whereas
retailing specialist service stations are increasingly
being transformed into convenience stores offering
a diversified range of goods and services.
Current strategies
The oil and gas sector is one of the few
industries where the major products supplied by
the industry have remained virtually unchanged
over many decades. The emphasis of competition,
therefore, is on accessing sources of oil and gas
and achieving efficiency in extraction, transport,
processing and distribution. The strategic priorities
of the oil and gas majors have remained much the
same over the past two decades and have been
common to all the leading companies. In
particular, the primary driving force behind
corporate strategy (the quest for hydrocarbon
reserves) remains the same.
However, while the primary strategic goal
remains the same, the way it is pursued has
changed. The growing importance of gas,
relationships with producer countries and their
NOCs, the changing basis for competitive
advantage, the growing role of technology and
other forms of knowledge have each influenced the
companies’ strategic thinking. Let us address some
of the main trends in the strategies of the
petroleum majors.
The quest for reserves
Rising oil prices since 2000 have revived the
age-old fear of exhaustion of the world’s petroleum
reserves. In 2004, the IEA (International Energy
Agency) estimated that the world will need to
spend $3 trillion over the next 25 years in order to
meet expected global oil demand. Almost one-half
of new production would come from existing
reserves, the remainder from enhanced recovery,
from new discoveries and from non-conventional
sources. For the majors, their crucial challenge is
that much of their production comes from large
fields in North America (notably, Alaska and the
Gulf of Mexico) and the North Sea. These
remnants of the first great wave of non-OPEC
exploration are now in decline.
As a result, the majors are pursuing other
non-OPEC sources of oil such as West Africa, the
Caspian, Russia, and the deep waters off Brazil.
Their biggest hopes, however, are pinned on

Table 10. Financial performance of the international oil and gas majors (2002-2004)

Sales ($ 109) Net income ($ 109) Return

Company on equity
2004 2003 2002 2004 2003 2002 (average, %)
BP 285.1
ExxonMobil 270.8 213.2 182.5 25.33 21.51 11.46 21.1
Royal Dutch/Shell 268.7 201.7 179.4 18.18 12.61 9.58 18.0
Total 152.6 131.6 107.7 11.96 9.07 6.25 23.4
ChevronTexaco 148.0 112.9 92.0 13.33 7.23 1.13 17.7
ConocoPhillips 121.7 99.5 58.4 8.13 4.74 ⫺0.30 10.9
Eni 74.2 64.7 50.3 9.05 7.74 5.49 21.7

Source: Company annual reports.

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KEY ACTORS IN THE HYDROCARBONS INDUSTRY AND COMPANY STRATEGIES
Russia, which opened up to private investment in
oil under Boris El’tsin and saw a surge in
investment and production. However, exploiting
these sources of oil is difficult, either because of
the technical challenges involved, or because the
countries concerned have become less welcoming
of Western investment. For example, the Russian
government has banned majority foreign
participation in many new natural-resource
concessions.
Other oil producing countries, both OPEC and
non-OPEC, have also become less accessible to the
Western majors. After international liberalization
during the 1980s and 1990s, countries in Latin
America and the Middle East have placed
increasing restrictions on foreign energy
companies. We seem to be observing a period of
renewed ‘resource nationalism’ by producer
countries.
Another dimension of resource nationalism is a
growing international role of NOCs. During the
1980s, Saudi Aramco, Kuwait Petroleum, and
PDVSA established downstream operations in the
United States and Europe. During recent years, the
oil and gas companies of Russia, India and China
have become prominent international players. With
the help of oil-service companies such as
Halliburton and Schlumberger, the NOCs have
access to modern technologies and are less
interested in partnerships with the Western majors.
Increasingly, NOCs are competing with the oil and
gas majors for concessions overseas. The takeover
battle between Chevron and CNOOC for control of
Unocal during 2005 illustrated this trend.
Strategies towards the development
of the natural gas sector
Another big growth area for the majors is
natural gas. For most of Twentieth century, gas had
been regarded as worthless and was flared rather
than exploited. “Find gas once and you’re forgiven;
find it twice and you’re fired”, industry wisdom
once dictated. From the 1980s onwards, gas
became increasingly important to the petroleum
majors. In 1982, gas consumption (in oil equivalent
terms) amounted to 15.8% of oil consumption, by
1992 the figure was 56.9%, while in 2002, gas
consumption had reached 74% that of oil. Gas’s
advantages lay both in cost (historically, at least
30% cheaper than oil), its environmental
friendliness, and its availability. If the Twentieth
century was the ‘age of oil’, the Twenty-first
century has been declared the ‘era of gas’ by some
observers. The most rapid source of consumption
growth has been the rapid expansion in the
318
construction of gas-fired power plants between
1990 and 2002.
The challenge for the oil majors has been
bringing their gas reserves to market. Gas is much
more difficult to transport than oil; it must either
be transported by pipeline or liquefied, and the
capital costs of exploiting gas fields that are distant
from major markets are immense. Between 2000
and 2005, a number of major gas pipeline projects
have been initiated: Eni’s Bluestream and
Greenstream pipelines bringing gas from Russia
and Libya; the 3,300 km Nabucco pipeline that
will bring gas from the Caspian to central Europe;
and the 5,000 km Alaskan pipeline project. Huge
investments in gas liquification plants have been
made in Qatar, Nigeria, Indonesia and several other
countries. Because gas is less transportable than
oil, international markets for gas have not
developed to the same extent that they have for
crude oil. The implication is that vertical
integration strategies have been very different for
oil and gas.
Vertical integration strategies
As already noted in the Section 5.2.5, a crucial
feature of the strategies of the petroleum majors
during the 1980s and 1990s was a dismantling of
the vertical integrated structures that had been
central features of the traditional model of the
international oil major. There were two aspects of
vertical de-integration. First, the companies
increasingly dissolved close operational linkages
between their vertically-related businesses. Second,
the companies became increasingly selective over
the vertical stages in which they participated. Thus,
most firms outsourced oilfield services, marine
transportation, information technology, and several
sold off their chemicals businesses. Nevertheless,
all the majors maintained their presence in
exploration, production, refining, and marketing
(even if the emphasis was increasingly on the
upstream businesses and little attempt was made to
ensure close upstream-downstream coordination).
The loose-linked vertical integration in oil was
inadequate to manage the majors’ gas businesses.
Effective exploitation of their upstream gas
reserves required investment in transport, storage,
liquification, distribution and marketing. Increased
involvement in downstream activities was
facilitated by the liberalization of wholesale and
retail gas markets during the 1990s. Shell, Exxon,
Mobil, and Total were especially prominent in
forging vertically-integrated gas strategies, though
none of them achieved the same degree of forward
integration in gas as Eni, which was unique among
ENCYCLOPAEDIA OF HYDROCARBONS

the majors to the extent that it had be founded upon
gas rather than oil.
The logic of vertical integration in natural gas
took the majors beyond gas. By 2005, all the
majors were significant players in electricity
generation. For example, at the end of 2004,
ExxonMobil owned a generating capacity of
3,700 MW and had almost $2 billion invested in its
power activities. For Shell too, power generation
and marketing had been a growth business, though
in April 2005, Shell announced the sale of its
Intergen power generation joint venture with
Bechtel to a private equity group.
Technology and knowledge management
The quest for reserves has taken the
petroleum majors to the Arctic and the depths of
the ocean. It has encouraged the companies to
develop enhanced recovery techniques in order
to extend the lives of mature fields. It has
resulted in the production of synthetic crudes
from sulphur-heavy petroleum, from coal, and
from tar sands and oil shale. Gas-to-liquids
technologies are being deployed to produce
gasoline from natural gas.
The result has been increased dependence by
the companies upon technology. However, the
remarkable improvements in efficiency and in the
capabilities of the oil and gas majors are not
simply due to the application of scientific
knowledge whose origins are in the research
laboratory. The enhanced technical and operational
capabilities of the companies are the result of
greater attention, not just to scientific knowledge,
but to knowledge more generally.
By 2005, all the leading Western oil and gas
companies had adopted some form of knowledge
management programme. The companies’
enthusiasm for knowledge management resulted
from a recognition that oil and gas was a
knowledge-based business and that competitive
advantage depended upon a company’s ability to
exploit knowledge more effectively than its
competitors. Some of the most striking advances in
knowledge management were in information
technology. Web-based technology, distributed
computing, and internet/intranet connections have
transformed collaboration and decision making in
the industry, especially in upstream. The oil service
companies (notably, Schlumberger and
Halliburton) have been in the vanguard of applying
advanced database management systems,
interactive software, and advanced modelling
systems to E&P activities (drilling, in particular).
However, the greatest challenges of technology-
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
OIL COMPANY STRATEGIES FROM 1970 TO THE PRESENT
based knowledge management are at the human
interface. The amounts of data generated and the
sophistication of software for analyzing it outstrip
the human capacity to process it. Attempts to
by-pass the human interface using artificial
intelligence (‘intelligent drills’, ‘smart oilfields’)
have proved disappointing. Hence, the key thrust of
current developments is improving the connections
between people and information through improved
portal design, better search engines, greater
standardization, taxonomy redesign and improved
information quality.
Attempts to improve the sharing and utilization
of experiential, ‘tacit’ knowledge have been even
more important than information management.
Communities of practice, informal groups of
employees doing similar jobs or engaged in similar
activities that share their know-how and assist in
problem solving have all been particularly useful.
More generally, the majors reported considerable
savings in costs and time from measures that
facilitated individuals’ knowledge sharing.
Encouraging sharing and utilization of
knowledge may require significant changes in the
way in which companies are organized and
managed. Under chairman John Browne, BP has
gone further than any other oil and gas company in
establishing organizational learning as a central
theme of its corporate strategy: “Learning is at the
heart of a company’s ability to adapt to a rapidly
changing environment. It is the key to being able
both to identify opportunities that others might not
see and to exploit those opportunities rapidly and
fully. This means that in order to generate
extraordinary value for shareholders, a company
has to learn better than its competitors and apply
that knowledge throughout its businesses faster and
more widely than they do. The way we see it,
anyone in the organization who is not directly
accountable for making a profit should be involved
in creating and distributing knowledge that the
company can use to make a profit” (Browne and
Prokesh, 1997).
Key elements of BP’s creation of a learning
organization were:
• Virtual teams: collaborative knowledge sharing
between employees with similar interests across
the company.
• Peer assist: meetings and workshops where
employees not directly involved in a project are
brought together to review progress, solve
problems, and recommend further areas of
investigation.
• After action reviews: a process adopted from
the US army involving discussion and review of
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KEY ACTORS IN THE HYDROCARBONS INDUSTRY AND COMPANY STRATEGIES
project successes and failures with a view to
drawing conclusions about future projects.
5.2.8 Adapting to an uncertain
future
The evidence of the past is that the oil and gas
majors make the most rapid and effective changes
when they are under pressure, in particular, when
their bottom lines are hit by falling energy prices.
One of the dangers of the present era of high prices
and wide margins is that it provides little incentive
for change.
Yet, the majors face tremendous uncertainties
about their future roles. Whatever the future course
of oil prices, the fundamental reality is that the
companies are dependent for their livelihood on
finding new petroleum reserves. Given the
difficulties of replacing non-OPEC reserves, it is
inevitable that the OPEC countries will account for
a growing share of world production. In these
countries, the presence of NOCs limits the access
of the Western majors to petroleum reserves. Even
in some of the major non-OPEC producers, Russia
in particular, the trend is towards protectionism and
the creation of ‘national champions’ such as
Gazprom. China and India, whose importance is
that they potentially represent the world’s two
biggest energy consumers, also appear to favour
the development of home-grown energy
companies.
One avenue for the Western majors to pursue is
to concentrate increasingly upon natural gas
because it is capital and technology-intensive,
giving them an advantage over the NOCs. The kind
of large, complex project where the Western
majors can offer the necessary financial,
technological and geopolitical resources and
capabilities is exemplified by the Shell-led
Sakhalin-2 project. This involves developing a
major sub-sea Russian gas field, liquefying the gas,
then shipping the LNG to both Japan and China.
LNG will also be shipped to California via a new
LNG regasification terminal in Mexico.
Following a similar rationale, another approach
would be for the majors to redefine their
relationship with the NOCs, i.e. increasingly acting
as partners where their primary role is providing
technical and commercial expertise and offering
access to Western markets. However, one problem
is that the oil and gas majors have increasingly
outsourced technology, especially upstream. As a
result, the technological leaders in exploration and
production, and the oil-service companies,
320
Schlumberger particularly, have taken the lead.
Over the past ten years, the majors have reduced
their research and development spending as a
percentage of sales. Shell’s research and
development fell from $701 million in 1998 to
$553 million in 2004. This represents a decline in
research and development spending as a proportion
of sales from 0.58% to 0.21%. Hence, one of the
key risks facing the majors is that they are
bypassed; the natural combination of
complementary resources and capabilities is the
NOCs with their vast hydrocarbon reserves and the
oil-service companies with their technical
expertise. It seems likely that, in order to gain
access to petroleum reserves in the producer
countries, the majors will increasingly have to
create partnerships with NOCs and commit to
comprehensive, integrated development schemes
combining transport, processing, petrochemicals
and power.
References
Al-Chalabi F.J. (1991) The world oil price collapse of 1986,
in: Kohl W.L. (edited by) After the world oil price collapse.
OPEC, the United States, and the world oil market,
Baltimore (MD), Johns Hopkins University Press.
BP (British Petroleum) (1983) Annual report and accounts,
London, BP.
BP (British Petroleum) (1988) Annual report and accounts,
London, BP.
Browne J., Prokesh S. (1997) Unleashing the power of
organizational learning. An interview with British
Petroleum’s John Browne, «Harvard Business Review»,
September.
Chandler D.A. Jr. (1962) Strategy and structures: chapters
in the history of the industrial enterprise, Cambridge (MA),
MIT Press.
Chevron (1989) Annual report, San Francisco (CA), Chevron.
Chevron (1990) Annual report, San Francisco (CA), Chevron.
Cibin R., Grant R.M. (1996) Restructuring among the world’s
leading oil companies, 1980-1992, «British Journal of
Management», 7, 283-307.
Desmarest T. (2002) Size is key to profitability, «Petroleum
Review», March, 12-14.
Exxon (1983) Annual report, New York, Exxon.
«Forbes» (1970; 2004).
«Fortune» (1970; 2004).
«Fortune Global 500» (1970-2004).
Galbraith J.K. (1968) The new industrial state, New York,
New American Library.
Grant M., Cibin R. (1996) Strategy, structure and market
turbulence: the international oil majors, 1970-1991,
«Scandinavian Journal of Management», 12, 165-188.
Mobil (1987) Annual report, New York, Mobil oil corporation.
«Petroleum Intelligence Weekly» (2003).
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Sampson A. (1975), The seven sisters: the great oil companies Texaco alters exploration and production (1989), «Wall Street
and the world they made, New York, Viking. Journal», 8 March, B3.
Shell admits impact of Sakhalin-2 overruns (2005), «Financial Verleger P.K. (1991) Structural change in the 1980s, in: Kohl
Times», 15 July, 1. W.L. (edited by) After the oil price collapse. OPEC, the
Stopford J.M., Wells L.T. (1972) Managing the multinational United States and the world oil market, Baltimore (MD),
enterprise: organization of the firm and ownership of the Johns Hopkins University Press.
subsidiaries, London, Longman.
Tetreault M.A. (1985) Revolution in the world petroleum
market, Westport (CT), Quorum. Robert Grant
Texaco (1988) Annual report, White Plains (NY), Texaco. Georgetown University
Texaco (1989) Annual report, White Plains (NY), Texaco. Washington, D.C., USA

VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION 321


Economic aspects
6.1.1 The segments
of the gas sector
It may seem slightly rash to speak of a gas sector,
since this expression, in fact, conceals a fairly
complex structure, in both economic and technical
terms. Indeed, the gas chain comprises numerous
segments, each of which lends itself to a different
economic analysis. Markets which are, at least
potentially, competitive coexist with natural
monopolies; local markets exist alongside others on an
international scale, in both the economic and political
sense, and so forth. Although in-depth analyses and
the requisite details are left to other chapters in this
work, it may be helpful to confer some conceptual
order on the issues current in the sector so as to clarify
the scope of regulation, or public intervention in
general, in the gas chain.
Moving from the upstream to the downstream
segments of the sector (in other words from the raw
material to the final consumer) this analysis can
appropriately begin with the supply segment.
Supply
As is known, gas is extracted from the earth and
cannot be manufactured, except to an extremely
limited extent; practically the only sources are the
natural gas reservoirs which exist in various parts of
the world (in Western Europe, mainly in the North Sea
and the Netherlands, with smaller quantities in Italy).
As a result, the upstream segment of this chain, that of
supply, is an intrinsically and inevitably international
market.
Whilst the notion of globalization is often
associated with that of fierce economic competition, in
the case of gas the limited geographical diffusion of
the raw material and the political decisions of the
countries which control it determine and limit the
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
6.1
potential for competition. Indeed, it could be thought
that the diffusion of reservoirs should help the easy
entry of companies into the sector, thus allowing for
strong competition in the wholesale gas markets.
In fact, at least two factors prevent this outcome.
First, although the location of reservoirs is generally
known, exploration for new sites is a relatively risky
activity, in part because their size and actual
accessibility become known (at least partially) only
after a series of preliminary activities which are
themselves expensive. As a consequence, only those
with enormous financial resources, able to rely upon a
portfolio of potential sites, can undertake such
activities; this situation generates economies of scale
which are mirrored in a degree of inherent
concentration of supply. Second, the exploitation of
subsurface resources is subject to restrictions and a
direct or indirect presence of the state throughout the
world; this in turn heavily conditions the structure of
the market. Only a few, often publicly owned,
companies are entitled to carry out these activities;
this was without doubt true in the past, leading to the
consolidation of dominant positions which not even
the recent liberalization processes in Europe have been
able to fully eradicate.
These factors have led to a high degree of
concentration and the widespread presence of public
bodies in the upstream segment of the gas chain. It
should also be remembered that the transportation of
natural gas in liquid form (which could encourage
some degree of competition in the supply phase) is
still little used due to the difficulties involved in
constructing liquefaction and regasification plants, and
the time and costs entailed by tanker transportation. As
a result, this technology is only competitive over
extremely long distances and/or where pipeline
transportation is not feasible. Essentially, genuine
competition between supply companies can occur only
323
THE NATURAL GAS INDUSTRY FROM MONOPOLY TO COMPETITION
where gas transportation infrastructures exist, and this
naturally limits the space for competition in any given
geographical area. Therefore, the scarcity of
competing companies is compounded by the scarcity
of the (expensive) infrastructure needed to force all
those involved to compete effectively; concentration
on a global scale is thus compounded by the difficulty
of ensuring that at least the (few) existing companies
can compete on the various markets.
In many cases, for reasons examined elsewhere in
this work, the number of companies may also be
limited on the demand side. In part, this may derive
from ‘reaction monopolies’, in part (and this is the flip
side of the same coin) from the fact that, faced with a
strong public presence on the supply side, there is an
equally strong presence on the demand side. For these
reasons, international trade relations rest on highly
politicized market structures, resembling bilateral
monopolies. Additionally, as noted above, in order to
allow demand and supply to coincide, there is a need
for the construction of an infrastructure (pipelines or
liquefaction and regasification plants) which, as well
as being extremely expensive, is also (at least in the
case of pipelines) idiosyncratic, in the sense that its
usefulness depends on the specific relationship linking
the contracting parties. All this clearly does not
represent a favourable premise towards the
development of competition in these markets.
The risks and large investments linking the
contracting parties in a highly specific way explain the
presence, in the supply segment, of contract types
which are fairly (though not wholly) peculiar to the gas
sector. The main type of contract on which it is worth
concentrating is known as the take or pay contract and
is characterized by the specification of a minimum
amount of gas1 for which the purchaser undertakes to
pay each year over a considerable number of years
(contracts of this type often have a duration of thirty
years), regardless of whether this amount is actually
withdrawn. The corresponding payment (generally
predetermined by indexing mechanisms) thus takes the
form of a fixed, and often huge, cost for the purchaser.
In addition to the amount specified, the purchaser may
buy additional quantities of gas at a price which is
either predetermined or calculated with a formula
known a priori, often linked to the spot price of gas
established at the moment of withdrawal.
Also typical of this contract are the so-called
make up clause, allowing the purchaser to withdraw
part of the minimum quantity, not withdrawn in a
given year, during the following year; and the carry
forward clause which, by contrast, makes it possible to
bring forward the withdrawal of amounts earmarked
for subsequent years on largely predetermined
conditions.
324
This contract structure thus allows the owner of
gas at the source to avoid the risk of the gas failing to
find a final purchaser. This risk falls entirely (for the
minimum contractual amount) on the purchaser, who
must in turn take suitable protective measures in his
relations with the end market. It should be noted that if
the payment linked to the minimum quantity were
predetermined without indexing mechanisms, the
purchaser, through this contract, could protect himself
from the risk associated with price variations. If the
payment is indexed, however, the purchaser is also
exposed to potential price increases, with a risk that
varies depending on the indexing mechanisms actually
adopted.
The justification, theoretical and otherwise,2 of this
contract structure can be traced back to the existence
of idiosyncratic investments incurred by the owner of
the gas at the source, who, in order to sell the gas, is
sometimes forced to build pipelines, in other words
infrastructure devoted exclusively to transactions with
specific purchasers. Against this justification, not
entirely unfounded, one might object that the cost of
the infrastructure could be borne by the purchaser, or
shared appropriately between the two contracting
parties, taking the form of a quasi-integration through
highly complex agreements binding the parties and
limiting their recourse to the market. The form of
risk-sharing envisaged by this type of contract can thus
be attributed mainly to the comparative contractual
power of the two parties, with the owner of the gas
generally being in a position to set conditions that the
purchaser may be forced to accept (the reverse may
also be true if there is a ‘buyer’s market’ rather than a
‘seller’s market’, as is generally the case).
In a market such as that for gas supply,
characterized by extremely inflexible infrastructure, it
is particularly important to achieve greater flexibility
through instruments allowing demand and supply to be
balanced more easily in order to encourage a situation
of genuine equilibrium. The presence of a neutral
operator in exchange processes is therefore highly
desirable whenever this offers the potential for
renegotiating a long-term contract (such as a take or
pay contract) and transforming it into a series of
short-term contracts; in this situation, the figure of an
independent operator able to offer transparent service
conditions to all parties is clearly required.
Various examples can be provided of the services
offered by such an operator: these range from the
1 This amount has typically been in the order of 70-80%
of the annual maximum.
2 For an overview of the theoretical literature on this
subject and of the policy debate, see Creti and Villeneuve,
2004.
ENCYCLOPAEDIA OF HYDROCARBONS

fundamental function of storage to the most advanced
on-line trading systems. The type of service which has
been most successful both in exchange practice and in
proposals to review the current market structure is the
so-called hub. The hub attempts to replicate the
conditions of a commodities market in the gas sector
by recreating its potential benefits such as the potential
for spot purchases and sales in order to compensate, to
some extent, for the limited availability of storage.
The wholesale gas trade thus takes place through
bilateral contracts, but may also rely on the hubs.
These are usually organized exchange centres which
combine financial spot transactions with a physical
delivery point for the commodity. The existence of
organized markets of this type, for transactions which
may be either physical or purely financial, has the
obvious advantage of allowing operators to hedge the
risk linked to price oscillations when the amounts
purchased through contracts specifying a
predetermined price do not fully meet the
requirements of the customers they wish to supply.
Furthermore, in the case of long-term indexed
contracts, the existence of organized exchange centres
provides operators with an (ideally) transparent and
non-manipulable point of reference to which indexing
mechanisms can be anchored.
Hubs may be either virtual or physical. A virtual
hub is a market (which may be electronic) where
operators with available gas (either through control of
reservoirs or purchase contracts) sell it to undertakings
which have (or count on having) the potential to resell
it (or the intention of consuming it directly). This type
of function leaves open the issue of the physical
delivery of the gas, which is certainly not a minor
aspect, considering the limited availability of
transportation infrastructure and the difficulty of
obtaining access to it. However, this problem does not
subsist (or can be managed far more directly) in
physical hubs, generally located near the main
interconnections between transportation networks and
equipped with fairly substantial storage facilities;
these hubs aim to ensure not only financial backing
but also the delivery of the commodity which is the
object of the transaction.
Within the gas market there is thus an important
distinction between the types of services offered: on
the one hand, the ancillary services of virtual markets,
on the other the services which traditionally
accompany the physical gas market, with the figure of
the hub linking the two.
There are various types of virtual services:
• Peaking: a short-term sales service, used to meet
sudden fluctuations in demand.
• A gas sales service offered even when transactions
at the hubs are carried out electronically.
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ECONOMIC ASPECTS
• Title transfer: the transfer of ownership of a
specific gas package, with transactions that may be
purely electronic.
• Electronic trading: a service through which
purchasers and sellers can connect directly to the
hub, facilitating direct negotiation.
• Financial services offered with the construction of
price indexes and the predisposition of
predetermined derivative products, used to
stimulate liquidity in exchanges and increase risk
coverage for operators.
• Support services offered to those participating in
hub activities, and including administrative
services, risk management services, consultancy
and clearing house activities.
The services associated with the physical gas
market offered by hubs generally consist of
transportation and, above all, storage activities; these
are similar to those normally connected to the
traditional use of infrastructure, but for shorter lengths
of time. The main services are listed below:
• Wheeling: transportation service between
interconnected pipelines through the hub itself.
• Parking: a short-term natural gas storage service.
• Loaning: a short-term storage service in which,
unlike parking, the hub advances small amounts of
gas which are subsequently replaced.
• Balancing: a short-term agreement to cover
temporary imbalances, frequently offered in
conjunction with parking and loaning.
• Storage: a traditional service offered in the
medium and long term.
• Compression: a service needed to carry out
transfers between pipelines operated under
different pressures, and which may in some cases
be offered separately from the transportation
service.
• Hub-to-hub transfer: an exchange service between
different market centres with delivery from one
hub after receipt at another.
Recent decades have been characterized by an
increase in the size and number of hubs (an example is
the agreement signed in 2005 between APEx, Endex
and Fluxys to develop an avant-garde hub at
Zeebrugge in Belgium). It is worth noting that this
development was due less to pressure from regulation
authorities than to the initiative of private natural gas
transportation companies. Although these initiatives
have not always had the desired results (due both to
the difficulty of obtaining the liquidity needed to feed
the market and the deep-seated tendency to keep
market information secret), it is clear that the potential
offered by the development of the market in general,
and of hubs in particular, is considered extremely
attractive by most of those operating in this sector.
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THE NATURAL GAS INDUSTRY FROM MONOPOLY TO COMPETITION
Infrastructure
As mentioned above, in order to link the supply
and demand for gas, large infrastructures are needed,
which can be subdivided into three main types: two
comprising large transportation networks, and one
concerning storage activities.
The first type of infrastructure is the network of
gas pipelines linking reservoirs to final consumers.
These are the large and appropriately reticulated
networks through which gas is transported by virtue of
pressure maintained by appropriate devices. This is
therefore a network (at high or low pressure) which
represents a typical element of a natural monopoly.
The boundary between national transportation
networks3 and local distribution networks is largely
arbitrary.4
The second typology concerns regasification plants
(which require corresponding liquefaction plants in
the countries of origin) which in numerous countries
represent an alternative to direct links to reservoirs.
Through these plants, gas is liquefied at origin, loaded
onto tankers and then unloaded in liquid form at
regasification plants, generally located near the coast.
Regasification plants thus represent an alternative to
the large international pipelines, although they in turn
require connection to the pipeline networks within
individual countries.
Regasification plants are usually large and
therefore generate significant economies of scale.
However, the need to build them near coasts
exacerbates the environmental problems which arise
with the construction of large industrial facilities: as a
result, the number of regasifiers is limited (but
increasing) and the construction of new plants is often
considered undesirable, at least from an environmental
point of view.5 For these reasons, these plants, whilst
not strictly classified as elements of natural monopoly,
are at least considered essential facilities, and may
thus be subject to a regulated access regime similar to
that adopted (as will be seen below) for the large
transportation networks.
Similar arguments can be made for the third type
of infrastructure present in this sector, in other words
storage facilities. As is known, gas can be stored under
specific conditions and on specific sites, and this is
essential if suppliers are to serve their customers; in
fact, demand varies continuously depending on the
withdrawals by consumers, leading to oscillations
which cannot be predicted with absolute accuracy. The
availability of sites where the supplier can store gas
and deliver it to the network when required is therefore
essential. The need to modulate supply concerns not
only short-term oscillations, but also longer term
requirements, such as, for example, the creation of
reserves ensuring security and continuity in a
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country’s supply; this is essential considering the
limited number of withdrawal points and the location
of most reservoirs outside national borders.
Sites devoted to storage must meet highly specific
geophysical criteria, and therefore exist in extremely
limited numbers. These structures are also essential for
access to the market, and therefore for the
development of competition, and consequently have
the status of essential facilities, with the
aforementioned characteristics concerning conditions
for access.
It should also be stressed that storage sites are
without doubt more necessary than regasification
plants. It would be inconceivable for the gas sector to
function without storage facilities available to those
needing to supply end-users; by contrast, the absence
(or non-availability) of regasification plants is entirely
possible. In Italy, for example, there was only one
regasification plant as of 2005. Regulations ensuring
access for all parties is therefore essential for storage
structures, but not for regasification plants. The
classification of the latter as essential facilities is
therefore a clearly pro-competitive denomination and
does not derive from requirements of a purely
technical nature.
Sales
In the gas sector, the relationship with the final
customer can be seen as an autonomous value creation
segment, conceptually separate from that of
infrastructure and wholesale supply. However, the
relationship between these various segments is
extremely close; on the one hand, to sell gas to
end-users, the latter need to be connected to a network
3 It is hardly worth noting that international
transportation networks are of extreme importance for the
development of competition in a country. In the specific
case of Italy, these form a bottleneck of enormous
importance. The main problem in this context is that it is not
clear which authority has jurisdiction over these networks,
with the result that they often lack effective regulation.
4 This is true in all networked sectors, where the
distinction between the local and national level is precisely
defined without the criteria being entirely clear. In the
Italian electricity sector, the definition of the national
carriage network is determined by regulation, whereas in the
gas sector the distinction is still lacking, increasing the
arbitrary nature of the situation.
5 Obviously, this highlights one of the many conflicts
between objectives of competition policy and energy policy
on the one hand, and of environmental policy on the other.
Whereas in the first instance the construction of regasifiers
may be highly desirable, in the latter, especially from the
point of view of local communities, the situation is very
different. Another way of interpreting the situation might be
to stress that specific interests may often hinder the pursuit
of the interests of the community as a whole.
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of distribution pipelines; on the other, it is self-evident
that to sell gas, it must be available, and this means
being able to buy gas wholesale in order to sell it
retail. This, in turn, entails the need for direct contact
with the owners of gas reservoirs (or the users of
regasification plants) or for those with wholesale gas
supply at their disposal to be interested in selling the
gas to third parties rather than intervening directly on
the end market.
Given the nature of gas, the relationship between
the seller and end-user is purely financial. The
commodity in question, though not homogeneous at
the beginning of the process, becomes so at the end,
after being fed into pipelines under fully standardized
conditions; in any case, by the end of the process the
gas possesses calorific properties which can be
measured and assessed in order to ensure completely
standard contracts. Additionally, once it has been fed
into the network, the gas is mixed with other gas
supplies of different origins, and this occurs in ways
which are not easy to predict and measure; as such,
those who withdraw gas from the network cannot
know with certainty which operator was responsible
for feeding it in. Consequently, when referring to gas
sales, we do not speak so much of the physical
delivery of a given amount, but of a contractual
relationship between those who withdraw a certain
amount of gas from the network and those who are
willing to feed the same amount of gas back to the
network. These contractual conditions mainly concern
prices, but may also include a series of post-sales
services or ways of managing energy efficiency.
It should also be considered that, at least for small
customers, there are potentially significant links
between the purchase of gas and that of other public
utilities. The sale of gas, which implies, as noted
above, a relationship of a mainly financial nature, may
be linked in various ways to the sale of electricity,
water or other services within the context of a
multiservice (or multiutility) strategy. This leads to the
topic of potential links between the gas sector and
other sectors. Technological links are fairly weak (the
networks are of a different nature, although their
maintenance may benefit from diversification of the
companies operating in this sector), whilst commercial
links are more significant, with a series of
implications for antitrust regulations (Polo and Scarpa,
2003a).
6.1.2 Redrawing the boundaries
of the monopoly
In the gas sector there are excellent justifications for
the vertical integration of the chains, but there are
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ECONOMIC ASPECTS
equally valid reasons to consider a separation of the
various segments opportune. The expression
‘separation’ (or, in the jargon employed by European
energy sector directives, ‘unbundling’) may in fact
refer to different approaches, with different
implications, that become important particularly when
one of these activities is run as a monopoly or forms a
bottleneck in the system, to such an extent as to be
described as an essential facility.
A first form of separation entails separate
accounting for the various activities. With accounting
separation, even if the strategic and organizational
management of the various activities is entrusted to
the same parties, it is possible to maintain a distinct
picture of the costs attributable to the various
segments. A second form of separation (described as
legal) by contrast, requires that different activities be
run by legally distinct entities (different companies) so
that accounting separation does not remain a mere
formality, and therefore becomes less easy to
circumvent. Additionally, the existence of different
companies and (one would hope) different managerial
responsibilities, may ensure the separate management
of the various lines of business and therefore prevent
the management of one activity being aimed at
maximizing joint profits.
In fact, this objective can only be convincingly
attained when the different activities are separately
owned so that they make reference to different groups
of shareholders with separate interests. This seems to
be the only company structure able to guarantee the
ultimate goal of the separation of activities, in other
words the completely independent management of the
segment operating as a monopoly. On the other hand,
separation entails a lack of coordination between the
actions undertaken by the managers of the various
activities. Although this lack of coordination implies
the absence of collusion, it is also true that it may lead
to some managerial inefficiency with potentially
significant consequences, especially in sensitive
sectors such as that of energy.
The issue of separation between activities is also
linked to the need to generate optimal levels of
investment (the so-called problem of hold up) in
situations where investors do not have direct access to
customers, except through reliance on a network, entry
to which depends on how the rules of the market are
designed. In this context, it should be noted that
vertical integration between the owners of a network
and those who use it to sell gas benefits investments in
the integrated company but has a detrimental impact
on other companies who use, or wish to use, the
network to sell their own gas in competition with the
network owner. As such, the problem of hold up is
overcome if there is horizontal as well as vertical
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integration and the network is therefore used
exclusively by its owner. Equally, the problem does not
appear pressing when there is total vertical separation
of the network since in this case the network manager
is neutral with respect to competition. Hybrid forms,
where the network owner/manager is vertically
integrated with one of the competitors for sales are
those least able to offer guarantees to investors.
6.1.3 Structural choices
and drivers of change
Given these potentially conflicting effects, it is
unsurprising that different countries have made
different choices, and that these choices have evolved
over time depending on the weight attached to the
various issues in different periods. Historically, the gas
sector has been characterized by important
vertically-integrated monopoly positions, and it is
therefore of particular interest to examine the main
experiences which first attempted to introduce
elements of competition into this sector, thus paving
the way for later reforms in the European Union.
The evolution of the gas sector in the United States
The conditions of the gas sector in the United
States of the Nineteenth century should be analysed
bearing in mind the prevailing climate in terms of
economic schools of thought. The American
Constitution was written when laissez-faire theories
inspired by Smith were becoming established with all
their innovative force; however, despite the cultural
predominance of these theories, the gas sector was
organized according to very different principles. The
first companies active on the gas market during this
period required huge capital investments to build
plants to treat the raw material and construct an
extensive network of pipelines. This made it necessary
to release exclusive sales licences to compensate for
the risk (believed to be high) of investing in this sector.
The first monopolies were therefore linked to covering
a heavy business risk.
The gas sector grew rapidly in the mid-Nineteenth
century; the companies operating in the sector began
to be considered good investment opportunities and
the exclusive sales licence was considered a crucial
factor in obtaining capital. However, government
bodies began to believe that the type of market which
had emerged required the development of municipal
ownership, or the imposition of regulations on private
companies, since the situation from the consumer’s
point of view had become unnecessarily onerous.
The first attempts at regulation were, in general,
fairly ineffective, despite the creation of numerous
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agencies (the first state agency was the Massachusetts
Board of Gas Commissioners, established in 1885)
with the power to regulate, by means of laws and
regulations, the activities of companies operating in
the gas sector and in the new electricity sector in order
to safeguard the public interest; despite this, from
1907 onwards all the States of the Union began to
establish their own control commissions (Busby,
1999).
After the end of the Second World War, the natural
gas market underwent further rapid development as
reservoirs in the north-eastern United States became
available and income increased in the same area;
demand thus became so high that it could be met only
by constructing and operating new gas pipelines. The
first attempts to regulate the gas market set two goals:
on the one hand, to guarantee end-users that given
quality standards, commensurate with the tariffs
demanded, were being met; on the other, to allow
investors to receive equitable profits for their services.
The drivers of change were the wide availability of the
product on the supply side, and growing pressure on
the demand side for more reasonable prices and for
greater availability of the commodity.
Beyond the state level, which saw various
regulation initiatives, the existence of federal controls
became particularly important; these were put into
effect by the Federal Power Commission (FPC),
established in 1920 with the specific task of regulating
the activity of gas pipelines which crossed several
states. The aim of these controls was to regulate the
flow of natural gas and to set prices and tariffs. To this
end, the FPC was given the power to veto
transportation and supply contracts, to release sales
licences to private companies, and to regulate the ways
in which the sale itself was to take place. The
Commission could also require the companies
operating in the sector to provide periodic reports on
their activities with the aim of monitoring market
development, and, last but not least, preserve natural
gas reserves by capping possible annual withdrawals.
In 1938, the Natural Gas Act turned the FPC
(whose formal powers were in fact fairly limited, and
whose interventions therefore met with numerous
objections) into a body with greater powers, known as
the Federal Energy Regulation Commission (FERC)
which was given some specific tasks, including:
• Regulating the flow of gas between different states.
• Setting rates and tariffs and approving natural gas
transportation contracts.
• Releasing certificates (for the companies requiring
them) stating the public utility of the service
offered, thus allowing the companies to use
interstate gas pipelines; the companies, however,
were required to offer the natural gas and
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associated services to local municipalities in the
areas crossed by these pipelines.
• Developing a standard accounting system for
companies operating on interstate pipelines, in
order to control their activities more easily.
• Requiring periodical reports (as a condition for
allowing the undertakings to continue their
activities) in order to monitor the administration of
the pipeline transportation service.
• Offering a consultative support service, aimed at
guaranteeing the maintenance of natural gas
reserves.
The FERC thus took over almost all the FPC’s
most important tasks; in addition, wielding the strong
powers which it had been given, it soon required the
owners of gas pipelines to allow gas from different
sources to be transported through their lines (thus
creating a sort of ‘third party access’), promoting
considerable changes in the seller-purchaser relations
that had been consolidated in the past. Companies
operating in the natural gas sector were later subjected
to further controls, including:
• Environmental controls established with the Clean
Air Act, aimed at protecting the air from excessive
pollution.
• Municipal or local controls, according to which
franchise privileges were subject to the regulations
in force in their jurisdiction, generally through the
levying of a tax.
• Controls by state regulatory commissions, with
powers similar to those of the federal agency, but
generally aimed at specific situations where the
supervision ensured by federal jurisdiction was
insufficient.
• Safety controls, aimed at ensuring full compliance
with the standards applying to activities in the
natural gas trade.
• Controls aimed at ensuring that antitrust
regulations were met and appealed to when
dominant positions and behaviour attempted to
limit the entry and activity of new operators.
The American natural gas market, taking into
consideration the peculiar federal political
configuration of the United States, is thus
characterized by a fairly dense and complex set of
regulations. The pyramidal structure of these controls
should however ensure some degree of
interpenetration between the various bodies entrusted
with guaranteeing the equity and efficiency of
operations and prevent the development of negative
situations such as the emergence of dominant positions
and agreements between companies which could
prejudice the functioning of the free market.
Federal regulations, while important, are not so
strict that they entail structural interventions state by
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ECONOMIC ASPECTS
state; as a result, the variety of structures chosen in
different parts of the United States is considerable.
This federal structure and the enormous autonomy of
individual states allows the existence of very different
situations; as will be seen, this is not unlike the
situation in the European Union.
The reform in the United Kingdom
The gas sector was privatized in the United
Kingdom in 1986, a move notable for the great speed
at which the requisite operations were carried out, to
the extent that their rapidity was criticized by bodies
such as the Energy Committee, by private consultancy
companies and independent observers. The British
government sold off the entire gas industry, without
the subdivisions carried out in the electricity sector,
and without applying effective regulations or
restrictions on the behaviour of companies already
present on the market (incumbents). This was the
second (and last) state industry to be sold as if it were
a single company (two years after the privatization of
British Telecom), and without putting in place
pro-competitive measures of any type.
The British gas industry had initially been
nationalized in 1949, merging a number of private
local companies into a single state company; from
1949 to 1972 bodies structured on a regional basis, on
which the new company was organized, were subject
to government regulation with the aim of establishing
prices, investments and financial policies. In 1972,
with the entry on the market of North Sea gas, it was
decided to merge all these bodies into a single
company, known as the British Gas corporation (BG),
with a more markedly commercial character,
well-suited to the dual function required of it: to act as
importer and distributor of gas for the nation. In the
early days of nationalization, the gas sector found
itself in competition with the coal market (an energy
source which at the time was considerably cheaper)
and with the novelty (for the time) represented by
electrical energy. Despite the competitive drive of
these energy sources, two crucial factors contributed
to the profitability of the gas sector: the potential, with
nationalization, to create a single efficient
transportation system able to lower costs, and the fact
that, by virtue of government policies, further systems
were introduced to control costs in the production and
transportation phases (Waddams Price, 1997).
The forms of price control applied in those years
by the British government can be interpreted as
interventions on the marginal cost, although they
attracted heated opposition, since it was commonly
believed that it was difficult to establish an equitable
price when profit margins were uncertain.
Nonetheless, the distribution monopoly guaranteed a
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lowering of costs which conflicted somewhat with the
increase in gas prices resulting from the adoption of
the marginal cost policy. One of the most important
aspects in establishing the price lay in the definition of
a so-called ‘market premium’: users, with the
exception of large industrial groups, had to pay a
higher sum than could be attributed to their actual use
or the cost of the energy.
Additionally, the gas industry suffered significantly
from the conflict between the government’s desire not
to impose an excessively complicated system of laws
and its policy of intervening in even more restricted
sectors. As with all the nationalized industries, in fact,
even in the gas sector the price applied was kept
artificially low by the two political parties which took
turns at government (Conservatives and Labour) with
the aim of containing the danger of rising inflation
rates. Despite this, in 1980, the same price control
policies led (in some ways paradoxically) to an
increase in prices following two actions which caused
the sector to suffer considerably. The first of these was
the imposition, from 1980 over three years, of a price
increase of 30% for residential use, whilst the second
was the lowering of the price applied to very small
consumers and those who had exceeded a given
consumption threshold: it is easy to see that the latter
manoeuvre in fact mainly benefited large consumers
and was, as a result, long considered unjustified and
politically inappropriate. Both examples are typical of
the types of manoeuvre adopted by the governments
which succeeded one another during this period, aimed
at an extremely detailed control of prices, leaving little
room for market mechanisms in the pursuit of
efficiency.
Drivers of change: the return to the private sector
In the early 1980s, some political powers began to
push for the gas industry to return to the private sector,
based on some strong arguments, the most pressing of
which was the sector’s financial state following
nationalization, judged to be embarrassing at the very
least. This demand also arose as a reaction to the
increases in gas prices, considered excessive by public
opinion (it should be remembered that shortly before,
an increase in the price of gas for residential use of
about 30% over three years had been decided); in fact,
successive governments and the management of BG
had difficulties in deciding upon a pricing policy
which had to tackle two problems.
On the one hand, there was a need to achieve
profits in a highly promising sector (especially given
the opening of new reservoirs, but conflicting with the
obligation to avoid monopoly prices) and in any case
to avoid the losses linked to the public administration
of the gas market. A reparatory manoeuvre was
330
attempted with the introduction of so-called scarcity
premiums, in other words a tax justified by the
exploitation and use of a non-renewable resource like
gas. Unsurprisingly, this attempt was judged by many
to be inopportune and badly-timed. On the other hand,
the fact arousing the greatest public indignation was
that a potentially profitable company like British Gas
was, in fact, incapable of developing effective policies
for the exploitation of the North Sea reservoirs.
Although BG’s annual reports stressed the need for
new and larger investments, in fact attempts were
made to render the company self-sufficient and
independent of government funding, even by skimping
on the requisite investments.
A significant portion of the responsibility for the
existence of these contradictions, which generated a
chaotic and unmanageable situation, was attributed to
the then manager of the sector, Dennis Rooke. The
first proposal for a return to management by a private
company was put forward in 1980, with the suggestion
(at the time almost informal) that British Gas should
be sold; the proposal, however, met with strong
opposition from both the management and the
workers.
The proposal became more credible when it was
inserted within the British Government’s privatization
programme, the largest and most radical ever
undertaken by a European government, and especially
after the privatization of British Telecom had begun in
1984; this was the first large public utility to be sold to
the private sector. However, the intrinsic differences
between the two companies concerned must be
considered: the telecommunications sector is subject
to rapid technological advances allowing for the entry
of various competitors, and competition in this sense
makes the (dominant) presence of a public company
relatively unnecessary; in fact, it could be seen as a
hindrance to technological progress. This is not the
case for the gas market, where a key role in
maintaining monopoly positions is played by exclusive
use of the network of gas pipelines; only in 1982, in
fact, did the Oil and Gas Act make it possible for
potential competitors to use the pipelines (owned by
British Gas), even though BG itself still retained
sufficient power to discourage any private company
from entering the market.
Privatization
The privatization of the sector was nevertheless
announced in May 1985, triggering a series of events
described as frenetic even by British public opinion.
The most significant event underlying the privatization
was the failure of the British Government to sell off
the airline company British Airways in its entirety at
the speed required; having included the revenue from
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this sale in the year’s budget and unable to proceed in
the desired direction, the Government unexpectedly
found itself in need of an alternative candidate to
generate the missing revenue. The need for funds and
the imperative to find them rapidly were thus the two
crucial factors behind the decision to privatize the gas
sector; to render its purchase more attractive (since the
sector was not as profitable as it might have been) the
Government took a fairly cynical view, failing to
safeguard the sales price of gas and thus sacrificing
the interests of consumers to its immediate need for
funds.
Before privatization, the gas system was
subdivided into twelve regional areas; a central body
(the Board) managed the whole national network,
leaving regional structures to local management.
End-users thus continued to pay the price set by area
managers, although the latter were in any case obliged
to follow the directives imposed by the Government,
within specified variability parameters. The initial aim
was therefore to maintain public ownership of the
central body (or at most to privatize it by creating a
company subject to regulation) and privatize the
regional bodies. This separation of the supply and
distribution systems would allow market development
in the gas sector, providing substantial profit
incentives (with shared pipelines made available to
private companies on a common financial basis)
thanks to exchanges between the new companies
operating on the North Sea gas market.6
However, this set-up conflicted with the operations
of British Gas, unwilling to provide the regulation
authority with any information on the purchase price
of gas. The management of BG seemed interested
mainly in maintaining its dominant position intact,
regardless of the national interest; Dennis Rooke (the
then chief executive officer) agreed to cooperate only
if the company was sold in its entirety and he was able
to maintain control of it. The outcome of this conflict
of interests was the sale of the entire state company,
with the only exception of some offshore reservoirs,
which were sold separately. The failure of the attempt
to divide the gas industry into separate segments
created substantial problems for the regulation
authorities, both because it was predicted that some
areas of the business would remain unregulated, and
because a structure so integrated both horizontally and
vertically would make the task of regulation extremely
complicated.
The Government’s decision implied that only 60%
of revenues would be subject to regulation, with a
distinction between tariffs applied to users consuming
less than 25,000 m3 of gas a year (regulated tariff) and
contracts established on a case by case basis for large
industrial users. As such, whilst residential users and
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ECONOMIC ASPECTS
small businesses were protected by regulation, large
industrial groups continued to benefit from specific
price policies, without the regulation authorities being
supplied with any information on how the sales price
was determined; it was thus easy to detect the presence
of a monopoly which was destined to last for some
time.
Generally speaking, it can be said that the
privatization of the gas sector was a hasty attempt by
the British government to plug a hole which had
emerged in the national budget and which led to the
extraction of the maximum surplus of consumers and
significant profits for new companies in the sector,
given the apparent (and partly structural) inability of
the regulation authority to establish an efficient system
of legal safeguards.
Regulation
The details of regulations were published in
December 1985, with the formula established for
controlling prices (the classic RPI-x, at least in its
basic form7) being widely debated due both to its
complexity and the delay with which it was proposed.
The tariff applied in the gas sector was uniform,
subdivided into separate (regional) markets and, unlike
the case of British Telecom, did not differentiate prices
according to use sectors or seasonal cycles. An
additional problem was that a large proportion of the
raw material was acquired from the North Sea
reservoirs, whose prices were subject to considerable
variations and, at least on the surface, completely
outside the control of British Gas. In any case, the
formula applied also included two additional factors.
A K factor (difficult to interpret in practice) referred to
projected future consumption during the year and
served to allow price increases above the basic price
cap; additionally, a Y factor reflected the trends of the
prices of gas extracted from the North Sea (and thus
represented a pass through factor).
However, the tasks of the regulation authority were
not restricted exclusively to determining the price cap,
distinguishing between purchase and other costs, but
also included actions aimed at encouraging
competition in this new market; this task was also
supported by the workings of the institution
responsible for controlling mergers and the formation
6 On the overall structure of the system and the delicate
balance between competition and regulation see e.g.
Waddams Price, 1994 and 1997.
7 The RPI (Retail Price Index) is the growth rate of
prices at consumption (inflation rate); x is the growth rate of
an exogenous variable (such as the growth rate of
productivity) fixed by the regulation authority for a given
number of years.
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of monopolies among companies, the Monopolies and
Mergers Commission (MMC). Both bodies, given the
existence of a monopoly and the relative lack of
regulation, played a far more prominent role in the gas
sector than in other market sectors although, ironically,
it was price discrimination in non-regulated sectors
which attracted the MMC’s attention. This institution
established the existence of a monopoly and of an
abuse of market power: the remedies adopted to
correct these distortions of the market included the
periodical publication of reports containing
non-negotiable prices for contracts and specific tariffs
to be applied to the gas transportation sector, reserving
10% of potential new customers for newcomers.
Subsequent events, with the separation of the
national transportation network from British Gas and
the later merger with the electricity carriage network,
are part of history. Two lessons can be learned from
the British experience. Concerning the transition (in
other words the transition from the public to the
private sector) it should be stressed that the decisions
taken should be considered within the
macrooeconomic and national budget policy context
which had emerged in Great Britain in the mid-1980s.
As far as the regulatory structure (after privatization)
is concerned, the British case showed an ability to
correct its aim with respect to its initial errors,
although clearly the separation of one branch from a
company already launched on the stock exchange is
far more problematic than any intervention carried out
before privatization.
6.1.4 Potential structure and
regulation of the gas industry
As seen above, even countries which are often
described as champions of competition and as
exemplary cases in the field of liberalization have
opted for different structures, and during different
historical phases have seen the successive
predominance of positions more or less oriented
towards monopolies, competition and more or less
direct forms of public intervention. There seem to be
numerous possible and practicable routes and it is
therefore important to assess their advantages and
disadvantages without prejudice. With reference to
structural set-ups, the main issues concern, on the one
hand, the vertical relations between companies
operating in different segments and on the other,
horizontal relations, in other words the degree of
concentration within each segment.
One possible route is that of the
vertically-integrated monopoly. This is probably an
excessively extreme option, which in most cases is
332
tempered by the presence of a range of companies, at
least in the downstream segment. Those elements
which, by contrast, remain integrated in most cases
and whose separation always encounters the greatest
resistance are the supply and the transportation
network.
Should separation be possible, it would be
opportune to identify the advantages and the
disadvantages. On the one hand, it must be stressed
that from a technical point of view, problems of
vertical coordination are fairly limited, at least when
the sector is in a mature phase. Unlike the electricity
sector, where the impossibility of storing the
commodity makes the instant balancing of demand
and supply problematic, in the gas sector the potential
for storage facilitates distribution and thus
coordination between the different phases of the
sector.
The most frequent arguments put forward in
defence of integration between supply, network
ownership and management, and final sales are the
following: the need to protect investments both
upstream and in the networks; and take or pay
contracts.
These arguments can be dealt with separately.
Research activities and the development of gas
reservoirs entail investments with high fixed costs that
cannot be recovered; it is therefore clearly in the
public interest to protect them. On the other hand, the
limited nature of the resources available worldwide
give those able to sell gas wholesale a market power
which compensates more than proportionally for the
investments made and their associated risks. In any
case, the uncertainties concerning the sale of gas on
the world markets do not seem sufficient to
compromise the profitability of investments in this
segment. The risks associated with exploration
therefore would not appear to justify the need for
vertical integration.
It is also evident that once a reservoir has been
discovered, further investments are required in the
infrastructure; this may include the construction of a
liquefaction plant for the sale of liquefied natural gas,
or that of a gas pipeline. The choice of one or other
type of infrastructure (which are not always both
plausible, since factors such as the location of the
reservoir are extremely important) is significant since,
whereas the sale of gas in liquid form ensures that its
destination remains extremely flexible, the
construction of a pipeline largely ties the reservoir to a
specific market (or group of markets).
When it is necessary to build a pipeline linking the
reservoir to a given place of sale, it is important to
specify, for the sale of clarity, which parties are
involved and what sort of integration is under
ENCYCLOPAEDIA OF HYDROCARBONS

discussion. On the one hand, there is the operator who
exploits the reservoir (usually the owner or
concession-holder, depending on the institutional
structure which may vary from country to country)
and on the other the importer, who buys the gas at
origin to sell it on the end market; a gas pipeline is
needed to connect these two parties, the construction
of which may be financed either by one of the two
parties, jointly by both parties or by a third party. The
importer must then address the end market, and the
important question is whether the importer can be
protected by vertical integration with those
transporting and distributing the gas.
The construction of a pipeline entails a huge and
fairly specific cost. In fact, the degree of specificity
(or idiosyncrasy) of the investment depends heavily on
the structure of the clientele; if the arrival point of the
pipeline is a single specific client, the degree of
idiosyncrasy is very high; if, on the other hand, it is a
hub where a multitude of customers obtain their
supply, the risk associated with the investment falls
significantly. As such, a first reason for encouraging
the establishment of hubs is precisely the potential for
reducing part of the risk associated with the
construction of pipelines. The traditional connection
between a reservoir and a final customer through a
pipeline links the two parties strongly; if the pipeline
leads to a hub, the gas can be sold to a large number of
potential buyers, so that the profitability of the
investment in building the pipeline would be exposed
only to a normal market risk and would not depend on
the decisions of a single customer.
It therefore seems opportune to guarantee special
protection on the destination market to those who
finance the construction of a pipeline if two combined
circumstances subsist: the need to depreciate
investments and the limited nature of the demand to
which those investments are addressed.
A different instance are investments made in the
past, which have already been recovered through
decades of use of the structures concerned and the
remunerations linked to this use; the case of
investments aimed at linking the point of origin of the
gas to an organized exchange centre is also different.
The legacy of the past should therefore be assessed
with care; specifically, investments connected to
infrastructures built decades ago, whose costs have
been amply recovered, do not seem to require
particular protection. Protection is more appropriate
for new investments, as recognized by European
Union and national regulations.
As far as the extent of the market is concerned,
Adam Smith’s recommendations on the relationship
between the specialization of labour and the size of the
market remain applicable. Whereas in the past, with
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ECONOMIC ASPECTS
typically one-to-one relationships, the construction of
new pipelines could legitimately be given special
protection, it now seems more reasonable to assume
connections which are not limited to a single market
but aimed at exchange centres to which the owner of
the gas can turn, finding a broad portfolio of potential
customers. The widening of the market therefore
allows the separation of functions between those who
import gas and those who sell it on the end market,
since remuneration does not depend on the potential
withdrawal of a single customer.
The possibility of this type of market organization
failing to guarantee the recovery of fixed costs can
only emerge if the competition within a hub was so
fierce as to compromise the sellers’ margins. However,
this currently seems a remote prospect.
A second argument in favour of integration
between those who import and those who sell gas on a
national market refers to take or pay contracts, which
oblige importers to purchase specific amounts of gas
each year, regardless of whether it is actually
withdrawn and sold (under profitable conditions). In
fact, the presence of a clause imposing a high fixed
cost on the importer represents a significant risk for
his balance sheet.
Nonetheless, this circumstance does not justify the
need for the same party to be present on both the
wholesale and the retail market. The importer’s
problem is to obtain a suitable profit and the most
obvious way of ensuring this is the contractualized
sale of the gas; it is irrelevant whether this occurs on a
wholesale or a retail market. The key to the problem,
then, may lie in the ability to organize a
non-penalizing wholesale market (sufficiently
protected to allow fixed costs to be recovered) and not
in completely preventing the entry of potential
competitors onto the retail market.
It is difficult to see on what grounds the argument
in favour of integration between importer and retailer
(already weak in itself) can be extended to support the
desirability of also incorporating the transportation
network within a single company (thus integrating
import, transportation and sales). The separation of
infrastructures (to be subjected to regulated and
therefore guaranteed tariffs) from commercial
activities taking place along the network does not have
any serious consequences, either for the development
of infrastructure, which depends on regulation, nor on
that of supply, whose remuneration depends on the
organization of the markets and not on the potential
for denying rivals access to the network.
It should also be considered that the separation of
the upstream segment (where take or pay contracts are
extremely common) from the downstream segment has
profound and detrimental effects on potential
333
THE NATURAL GAS INDUSTRY FROM MONOPOLY TO COMPETITION
competition in the latter segment. It should be noted,
in fact, that the holders of these contracts own a large
amount of gas at a marginal cost of zero, and therefore
represent potentially highly aggressive competitors on
the end market. However, this is very unlikely to have
a positive effect for consumers, since a potential
newcomer, to avoid the possibility of a price war, will
avoid challenging a dangerously aggressive rival like
the holder of take or pay contracts; the presence of
such an undertaking therefore discourages entry. If
entry occurs anyway, economic theory suggests that
companies, again to avoid an extremely dangerous
price war, attempt to divide up the market, failing to
make offers to customers already served by their rival
(when the market is decentralized, in other words if
most of the gas is exchanged though bilateral
contracts; Polo and Scarpa, 2003b). The danger is that,
even if there are several suppliers, the price will
remain high.
Additionally, referring back to the earlier argument
concerning potential competition in the gas sector,
hubs are also considered desirable by market
regulation authorities; these are seen as structures
capable of encouraging transparency in the sector,
freeing purchasers (or retailers) from long-term
contracts (typically encumbered by take or pay
clauses) with the few operators able to work in the
upstream segment. The idea in this case is to push
those who hold supply contracts to sell their gas on the
market (anonymously and in competition with other
national or international operators with available gas)
rather than through bilateral contracts. The aim of this
is to achieve a dual outcome: on the one hand, to force
companies with wholesale gas to compete for the same
customers (the entire market), thus preventing the
market from being divided up by bilateral contracts
with final customers, for which competition is often
very limited; on the other hand, to ensure that
operators buying from a hub are offered the same
price, and not take or pay contracts which typically
lead to fairly mild competition against rivals.
Obviously, there remains a need to ensure that the
greater competition possible in a hub (which may
attract supply from different operators, based in
different countries) is actually able to generate prices
lower than those which companies holding take or pay
contracts can apply outside an organized market.
Nevertheless, the greater transparency guaranteed by
this type of market, as far as the formation of
wholesale prices is concerned, is seen by regulation
authorities as being in itself a potentially significant
advantage.
Finally, it must be stressed that the existence of
vertical integration has a series of negative
consequences for competition in the final sales
334
segment. In fact, it is difficult to compete effectively
without the availability of gas under competitive
conditions, and having to pass through a network
which is not managed under conditions of absolute
neutrality. Unfortunately, the condition of Third Party
Access (TPA) to the network, according to which the
owner/manager of the network is obliged to allow
access to producers/sellers who need to deliver the gas
to final customers, though an important principle, is
only a hollow promise unless it is accompanied by the
necessary guarantees (including the price) for potential
newcomers.
In addition, the regulatory contract, generally
contained within the network code, is hardly ever a
perfectly complete contract, and therefore there is a
need to determine who has the right to intervene in
cases not covered (unambiguously) by the contract.
For this reason, the figure of the transportation
network manager is important: his neutrality in the
event of uncertainty is an important guarantee for
potential newcomers, whilst his absence represents an
obstacle to the liberalization of the market.
6.1.5 Regulatory reform
in the European Union
During the second half of the 1990s, the European
Commission began a policy of liberalizing the main
public utilities, such as electricity, gas and
telecommunications, setting out the main rules by
issuing a series of directives. Within this context, the
various member states were asked to define their own
national liberalization policies. The main gas sector
directive, 1998/30/EC,8 set August 2000 as the
deadline by which liberalization was to be completed.
The first of the problems tackled on a European
level9 concerned the creation of a level playing field
for incumbents, which dominated their respective
national markets, and potential newcomers. The
competitive structures identified concerned the
production and sales markets; however, the problem of
the infrastructure network linking these two markets,
represented by the existence of strong monopolies,
remained.
The general principle promoted by Directive
1998/30/EC is that relating to TPA, according to which
access to the network is granted on the basis of
non-discriminatory tariffs, commensurate with the
8 The Directive of the European Parliament and Council
of 22 June 1998 concerning common rules for the internal
natural gas market.
9 For a more detailed discussion of these issues, see Polo
and Scarpa, 2003c.
ENCYCLOPAEDIA OF HYDROCARBONS

costs of the service. The determination of these tariffs
could be entrusted, depending on the decisions by each
member state, to public regulation or to free
negotiation between parties. The subsequent 2003
Directive 2003/55/CE,10 however, eliminated the option
of negotiated access to the network, since experience
(especially in Germany) had shown that this was
excessively vulnerable to abuse by the network
operator (usually a vertically-integrated company).
TPA can be denied under two specific
circumstances. First, a technical congestion condition
was introduced, so that if the network has reached its
limit of capacity, an exception can be made to the TPA
principle. This exception is particularly important,
considering that international pipelines were generally
built as part of long-term gas supply programmes,
within which transportation capacity was established
on the basis of the amount contracted for by the
incumbent. As a consequence, even when the end
market is forecast to grow, import capacity is often
restricted by the technical properties of international
pipelines. Secondly, the manager can deny newcomers
access to the network if this causes financial problems
for incumbents due to obligations deriving from take
or pay contracts negotiated before the Directive came
into force. In this specific situation, the principle of
TPA to the network alone is clearly insufficient to
prevent an incumbent blocking the market. Therefore,
a second principle of transparency and the unbundling
of activities taking place under competitive conditions
from those offered under a monopoly was introduced.
To this end, it was considered essential to ensure
the transparency of the accounts (and costs) of the
companies operating in different segments of the chain
(accounting separation). More specifically, as far as
accounts were concerned, to ensure clarity and
adherence to the principle of transparency, the
Directive stated that: vertically-integrated natural gas
companies must maintain, in their internal accounting,
separate accounts for their transportation, storage and
distribution activities; companies carrying out other
activities in non-gas sectors must keep separate
accounts for these activities, as if they were carried out
by different companies.
It is important to note that the 1998 Directive
explicitly required internal accounting to be kept with
a separate balance sheet and profit and loss account
for each type of activity (of those seen above). Beyond
simple accountancy separation, individual countries
were free to decide independently whether or not to
opt for more radical solutions better able to safeguard
new competitors. In 2003, based on the first few years
of experience of liberalization of the sector, the new
Directive established legal unbundling as the
minimum standard for relations between companies
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operating in different segments of the gas chain. Mere
accounting separation, which had been chosen by
numerous countries to protect their major national
operators, was thus considered insufficient.
Another key point of the 1998 Directive was the
opening of demand and the notion of eligible
customer, in other words a customer able, given their
size or characteristics, to stipulate purchase contracts
with any supplier. These customers were identified as
those whose level of annual consumption exceeded a
certain threshold; however, a timetable was also
established for the gradual lowering of this threshold
in view of a gradual broadening of the free market
area.
The 1998 Directive defined all natural gas-fired
electricity producers and all other final customers
whose gas consumption exceeded 25 million m3/yr as
eligible customers, and therefore free to choose their
supplier, sign gas supply contracts and use the network
to transport gas. This threshold was lowered to 15
million m3/yr five years after its entry into force, and
to 5 after ten years. In principle, natural gas-fired
cogeneration plants were considered electricity
producers, and thus eligible customers by right,
regardless of their share of gas consumption; however,
member states, in order to safeguard the balance of
their electricity market, could introduce a specific
threshold for cogeneration plants which could not
exceed the level specified for other final customers
(initially 25 million m3). All distribution companies
were considered eligible customers for that portion of
the free market which they supplied. In any case,
member states were to ensure that the definition of
eligible customer resulted in an opening of the gas
market equal to at least 20% of the total market. Five
years after Directive 1998/30/EC came into force this
percentage rose to 28% of the total annual gas
consumption of the national market, and to 33% after
ten years.
The 2003 Directive led to a significant acceleration
of the process of opening the gas market, imposing
freedom of choice for non-residential users by July
2004 and also for residential users by July 2007 (thus
100% of the market). In fact, this final step is unlikely
to have a significant effect on the market, since the
size of residential customers is so small that it is
highly unlikely to justify particularly fierce
competition among suppliers.
The institutional structure of the sector is
generally left to the decisions of member states,
10 The Directive of the European Parliament and
Council of 26 June 2003, concerning common rules for the
internal natural gas market and rescinding Directive
1998/30/EC.
335
THE NATURAL GAS INDUSTRY FROM MONOPOLY TO COMPETITION

Table 1. National liberalization plans as of 2002 (European Commission, 2003)

Third party network access Opening of demand

State Unbundling Eligible Complete

Setting Resolution Type
customers opening
of access price of conflicts of regulation
in 2000 (%) (year)
Austria Negotiated Regulated Ex post Accounting 49 2001
Belgium Regulated Regulated Ex ante Corporate 59 2005
Denmark Regulated Regulated Ex post Corporate 30 Unspecified
Finland Regulated Regulated Ex post Ownership 90 2003
France Unspecified Unspecified Ex ante Accounting 20 Unspecified
Germany Negotiated Antitrust Ex post Accounting 100 2000
Greece Unspecified Unspecified Ex ante Unspecified Unspecified Unspecified
Ireland Ministry Ministry Ex-ante Corporate 75 2005
Italy Regulated Regulated Ex ante Corporate 65 2003
Luxembourg Ministry Ministry Ex ante Accounting 51 2007
the Netherlands Negotiated Regulated Ex ante Accounting 45 2004
Portugal Unspecified Unspecified Ex ante Unspecified Unspecified Unspecified
United Kingdom Regulated Regulated Ex ante Ownership 100 1998
Spain Ministry Ministry Ex ante Corporate 72 2003
Sweden Regulated Regulated Ex post Accounting 47 2006

although the 2003 Directive specified that each
country must create an independent regulation
authority, specific to this sector. It must be stressed
that independent means independent of the interests
of the gas industry, and not necessarily independent
of the government, which in many countries will
maintain direct control over the sector. The existence
of different situations, including that in Italy, where
the state maintains control of the largest company,
makes this standard less easy to interpret, although it
is implied that a public body is by definition
impartial. Unfortunately, this means that in various
countries the government will control both the
largest company and the body supervising activities
in the sector.
There are various controversial and unresolved
issues. Hitherto, directives have aimed mainly at
eliminating the main structural elements preventing
newcomers from entering the market. However, this is
clearly far from actually allowing the development of
competition on a remotely equitable basis, especially
considering the starting point, which sees the
dominant presence of one company in almost all
European countries.
National compliance plans
Within the boundaries established by European
Union Directives, countries have made different
choices regarding market liberalization, and the
resulting picture is fairly heterogeneous. Table 1
summarizes some characteristics of the national
liberalization plans adopted in various countries, with
reference to the main aspects of the reform process,
including third party access to the network, the
separation of activities carried out in a monopoly from
competitive activities, and the opening of demand. The
table refers to the early years of the entry into force of
the 1998 Directive, and not to more recent years, since
it was in the transition phase that the critical aspects of
market structures were determined.
Table 1 shows especially that only a minority of
countries has opted for genuine legal separation,
whereas two of the largest countries, France and
Germany, are characterized by accounting separation
alone; one of these, France, has not yet set a date for
the complete opening of demand. In fact, these
interventions do not seem to have encouraged an
effective process of market opening, due mainly to the
lack of measures aimed at better balancing the

336 ENCYCLOPAEDIA OF HYDROCARBONS

 ECONOMIC ASPECTS

competitive position of businesses, which presented
highly significant asymmetries in terms of size,
strategic power and relations with both sources of
supply and final customers.
Table 2, also based on European Commission data,
shows that, in fact, during the early years of the reform
process, the situation was in most cases fairly similar
to that preceding the reform, with very high levels of
concentration both in the wholesale and retail market.
This table also reports some data on market
performance, such as the percentage of large
customers who have switched to a new supplier, the
percentage of gas available through third party access
to networks of other undertakings, and the average
price for different categories of customers.
The first of these variables, transition to new
suppliers, is frequently used by policy makers as an
indicator of the effectiveness of competition, but its
interpretation remains fairly problematic since the
effectiveness of competition cannot actually be
measured by the frequency with which customers
change supplier, but by the changes in the conditions
at which they manage to obtain their supply (from a
new or old supplier). The fact that the figures reported
are fairly small is interpreted as an index of the
slowness with which competition has developed in the
sector, and in this sense the case of Italy seems
relatively reassuring; however, this interpretation
needs careful reconsideration, as will be seen below.
In contrast, price would appear to be a far more
important indicator, although it must be remembered
that competition and liberalization make these data
less significant. In a regulated market, in fact, prices
are public, whereas in a free market only estimates,
sometimes very rough, are available of the prices
applied by companies. However, some significant
elements of differentiation, though not particularly
marked, between countries do emerge; as a whole it is
not easy to identify significant and systematic
differences between countries which have opted for a
more competitive structure and those in which the
incumbent appears to have prevailed. This is especially
true of the British situation, which reflects a decade of
experience in the field of liberalization. Although
prices in the United Kingdom are on average lower
than those in other countries, those applied to large
customers are no different from the prices applied to
the same customers in countries where the
privatization process is less advanced, such as France,
Denmark, Belgium and Spain.
Table 3 shows the variation of prices in the largest
European Union countries compared to the European
average (always equal to 100), between 1995 and 2001
(European Commission, 2003). It can be seen that
Germany, in particular, is above the European average,
although its relative level has fallen regarding the
category of large consumers, especially. In Italy, the
prices of gas for large consumers have increased

Table 2. The development of a competitive market in Europe as of 2002 (European Commission, 2003)

Switching rate Average final price as of July 2001 Upstream

State
Gas transported
of large (€/MWh) concentration
with TPA (%)
customers (%) Large customers Small customers ratio (HHI)*

Austria ⬍5 ⬍5 22 n.a. 7,598

Belgium ⬍2 ⬍5 21 39 10,000

Denmark 0 0 19 40 2,841

France 3 10-20 19 41 5,932

Germany 2 ⬍5 27 43 2,405

Ireland 25 20-30 21 32 5,883

Italy 16 10-20 25 46 4,916

the Netherlands 17 ⬎30 24 29 2,634

United Kingdom 100 90 20 30 894

Spain 7 5-10 20 48 9,761

Sweden 0 ⬍5 24 43 10,000

* Herfindahl-Hirschman Index.

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THE NATURAL GAS INDUSTRY FROM MONOPOLY TO COMPETITION

Directive have been rather limited and, in fact, seem to

Table 3. Variability of gas prices in the main have stopped at the first stage, that of creating a level
European Union countries (European average=100) playing field for competition, without managing to
(European Commission, 2003) undertake more radical interventions aimed at
effectively altering the structure of the market, except
Large users Small users in a very few cases. Additionally, national situations
(420,000 GJ/yr) (84 GJ/yr) differ considerably and the reason for this is to be
Jan ’95 July ’01 Jan ’95 July ’01 found in the logic underlying the decisions taken in the
various countries.
Germany 130 110 108 107 An initial attempt to explain the still limited results
Italy 97 108 117 114 of liberalization policies lays these at the door of the
lesser opening of the market in those countries which
Spain 93 88 129 118
depend most heavily on imports. The supporters of this
France 83 87 108 101 line of interpretation stress the fact that the availability
of domestic gas is the natural factor which facilitates
United Kingdom 63 85 85 74
liberalization and that the countries which have
adopted policies least favourable to the development
significantly (compared to the European average) of competition in the market are in fact those which
whilst the same is not true for small consumers. depend most heavily on imports. Indeed, concerns
More generally, it appears that for large consumers regarding the security of natural gas supply are
of gas the reform process begun by the 1998 Directive thought to explain, and perhaps justify, a position of
has led to some degree of price convergence, whereas greater caution with respect to market liberalization.
a comparable phenomenon has not occurred for small Table 4 shows the situation of some of the main
consumers. In other words, despite numerous European countries at the start of the liberalization
contradictions, in those segments where competition process (which, as already noted, began in the United
functions effectively (large users), it is possible to see Kingdom long before the rest of the European Union).
some evidence for the development of a market where It can be seen that countries which are similar in terms
the law of the single price seems to have had at least a of their dependence on imports, such as Belgium,
tendential influence. In contrast, where regulation France and Spain have, in fact, made very different
prevails (small users, who, though they can choices, some of which (Belgium and Spain) are far
theoretically be competed for, are not in fact more courageous than this line of interpretation would
particularly attractive to gas sellers) the process of lead one to believe. Equally, almost independent
creating a coherent logic for price formation seems countries like the Netherlands and the United
inevitably to be far slower. Kingdom have followed significantly different routes,
It can therefore be concluded that liberalization with a more marked opening in the United Kingdom
policies in the European Union following the 1998 and a more cautious one in the Netherlands.

Table 4. Consumption and supply of natural gas in Europe before liberalization (IEA, 2002)

the United
Belgium Finland France Germany Italy Spain Sweden
Netherlands Kingdom
(1999) (1997) (1998) (1996) (1997) (1998) (1998)
(1998) (1990)
Consumption (109 m3) 15.6 3.59 37.18 89.56 57.98 49.61 58.31 12.71 0.86

Supplies (109 m3) 15.80 3.58 37.45 102.34 58.36 87.65 56.90 13.31 0.90

Domestic production 0 0 2.26 22.78 19.27 80.44 49.67 0.11 0

Imports 15.80 3.58 35.19 79.56 39.09 7.21 7.23 13.20 0.90

Share of domestic
0 0 6 22 33 92 87 1 0
production (%)

Share of imports (%) 100 100 94 78 67 8 13 99 100

Exports (109 m3) 0 0 0.81 3.6 0.04 38.89 0 0 0

338 ENCYCLOPAEDIA OF HYDROCARBONS


Table 5. Share of gas in total primary energy supplied in Europe before liberalization
Belgium Finland France Germany
(1999) (1997) (1998) (1996)
Gas (Mtoe) 13.33 2.91 33.40 75.24
TPES (Mtoe) 58.55 33.07 254.41 351.28
Share of gas (%) 22.8 8.8 13.1 21.4
A second line of interpretation attributes the
drive towards liberalization to the importance of gas
as an energy source. If a country depends largely on
this input, it is reasonable to expect a more
favourable attitude to liberalization, since this would
allow for lower prices. Table 5 shows some data on
the importance of gas as an energy source in various
European Union countries. The data is shown as the
share of gas in Total Primary Energy Supply
(TPES). This information is not wholly in
agreement, although it does provide (slight)
confirmation of the theory. A significant exception
is that of the Netherlands, the country which
depends most heavily on gas, but which appears to
have preferred a market structure where there is
more limited space for competition. Aside from this,
the country which has liberalized least is France,
where gas does not appear to play as central a role as
elsewhere, whilst the United Kingdom, Belgium and
Italy immediately showed, long before the 2003
Directive, a tendency towards greater openness (for
example the application of the regulated TPA
principle and the separation, at least in legal terms,
of the transportation manager), given their greater
reliance on gas for their energy consumption.
In interpreting this data, it should also be stressed
that competition and opening up the market are not the
only way to keep prices under control. Some countries,
in fact, have preferred to rely on their national
company, even where gas has shown a high rate of
penetration in energy consumption. In any case, it
seems that the pressure exerted by consumers
(especially large consumers) has played an important
role in the process of market opening.
6.1.6 Regulation in Italy
before the reform
The liberalization of the Italian market represents a
particularly interesting case study given the often
conflicting assessments which it has provoked
among observers. Whereas some have seen this as a
courageous reform, undertaken under difficult
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the United
Italy Spain Sweden
Netherlands Kingdom
(1997) (1998) (1998)
(1998) (1990)
47.47 34.94 47.19 11.61 0.71
163.32 74.26 212.41 112.78 50.78
29.1 47.1 22.2 10.3 1.4
circumstances, others interpret it as being essentially
a defence of the status quo. In order to understand
the issue, it should be remembered that natural gas is
a fundamental energy source for Italy; in 1997,
natural gas accounted for 55% of energy
consumption in the civil sector, 42% of consumption
in the industrial sector and 24% in the electricity
sector, with the latter growing constantly since
almost all new projects for power stations concern
gas-fired plants. Before the reform, the gas service
was characterized by strong concentration in the
supply and transportation phases and a significant
fragmentation of distribution where conditions of
local monopoly prevailed.
In 1997, according to the Italian Authority for
Electrical Energy and Gas (AEEG, 1998), almost 90%
of domestic production was ensured by Agip, which
was incorporated into the company Eni the following
year. Contracts held by Snam, owned 99.9% by Eni,
accounted for 94% of imports. The remaining 6% were
held by Enel, with contracts for about 7.5 Gm3/yr.
Snam, as well as managing almost all imports, was
also the owner of all import, carriage and domestic
transportation infrastructures, thanks to its 96% share
of primary high pressure distribution services. In
addition, through Agip, Eni controlled almost all
storage and modulation services on Italian soil. Snam
also owned 41% of shares in Italgas; it operated in the
distribution sector through local networks, partly
through its controlling or majority share in ten
distribution companies, accounting for about 30% of
low pressure sales. The Eni group thus controlled 73%
of primary distribution aimed at large industrial
customers, 67% of that aimed at electricity generation
and 33% of secondary distribution.11
The basis on which the final price was determined
was conventionally the cost of supply, but national
import contracts have never been made public; indeed,
for many years these were a state secret, given the
extreme sensitivity of the relations between an Italian
11 For an overview of regulation and competition in the
sector during the years preceding the reform, see Clô, 1992;
Amman, 1996.
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THE NATURAL GAS INDUSTRY FROM MONOPOLY TO COMPETITION
public state company and its foreign counterparts.12 It
should also be remembered that the clauses
concerning minimum oscillations were defined on the
basis of a take or pay formula which bound the
purchaser to a minimum threshold: if the
predetermined minimum was not purchased, the
agreed sum had to be paid anyway.
The wholesale price was set starting from a CIF
cost (Cost Insurance and Freight: in other words
including transportation costs to the border of the
supplying country) updated with an indexing
mechanism.13 From the upstream company, the gas
could flow to distribution companies aimed at civil
customers, or directly to large customers; the latter
case was described as primary distribution. The tariff
for sale to gas distribution companies was based on
agreements between Snam and the companies
involved, and was subject to monitoring by the
Interministerial Committee for Prices (Comitato
Interministeriale dei Prezzi, CIP); this was therefore a
semi-regulated price. For large customers, by contrast,
the price was determined on the basis of a collective
negotiation process involving suppliers and
consumers, and was reviewed on a multi-year basis.
Prices were indexed to the listings of petroleum
products and subject to monitoring, introduced by a
resolution by the Interministerial Committee for
Economic Planning (Comitato Interministeriale per la
Programmazione Economica, CIPE).
It is important to note that the prices thus
determined were nevertheless not commensurate with
the actual cost of transportation to the end-user. When
transportation was carried out by companies other than
Snam, the price remained unaltered and Snam credited
the final distributor for the transportation cost. The
collective negotiation tool limited Snam’s potential for
abuse, but did not ensure the efficiency of the prices
agreed; problems of transparency resulted especially
from uncertainty regarding the price agreed in natural
gas purchase contracts and the cost-sharing criteria
established by Snam in negotiating the sales prices.
Furthermore, distributors had no incentive to exert
pressure on Snam to obtain more favourable price
conditions, since they could pass the costs of
purchasing the raw material onto the final price and
take advantage of the development of the market they
served due to the tax incentives in favour of the civil
gas market. These premises formed the basis for
reforming the tariffs.
The gas tariffs practiced for small end-users,
subject to an administered pricing system, were
differentiated depending on the type of customer, with
a distinction between the tariffs for supply to the civil
sector and to other sectors. Supplies to the civil sector
were in turn subdivided into: a) residential uses such
340
as cooking, the production of hot water, individual or
central heating; b) commercial uses; c) craftworking
uses; d ) public bodies; e) companies with an annual
consumption below 200,000 m3.
An important characteristic of these tariffs was
their regressive structure and their subdivision based
on use. In some ways, the regressive pricing structure
aimed to reflect the cost of the service, which
decreased as the size of the customer increased.
Additionally, this structure aimed to encourage a
greater use of natural gas by rewarding the largest
users.
6.1.7 Regulatory reform in Italy
Profound regulatory changes took place in Italy during
the 1990s, first with the establishment of the Authority
for Electrical Energy and Gas (Autorità per l’Energia
Elettrica e il Gas, AEEG) with Law No. 481/1995, and
then with adherence to the European Directive on gas
in the Legislative Decree No. 164/2000, often known
as the ‘Letta Decree’, named after the Minister of
Industry at the time.
The first step, therefore, preceded pressure from
Europe (or at least the formal aspects of the process)
and to some extent anticipated some of the guidelines
which later emerged in the second European Directive
on gas, issued in 2003. The law establishing the
independent Authority also conferred upon it a degree
of power unusual in Europe, where many authorities
have a purely consultative role. Law No. 481/1995
established and defined the tasks of the AEEG which,
though operating within a market structure determined
by the decisions of Parliament, had the power to set
tariffs and control the development of competition in
the two markets under its jurisdiction. Although the
law itself specified that this power was to be exercised
12 As far as their general features are concerned, these
contracts did nevertheless contain some elements considered
non-negotiable, and others which could be partially
modified. The main fixed elements were the volume to be
purchased and the duration of the contract, whilst the main
renegotiable elements were the conditions for withdrawal
and the sales price. The contracts established predetermined
quantity oscillations around a specified value, reached after
a build up period of four years.
13 However, the price was affected by the cost of
international transportation and significant external factors,
such as predictions concerning the trends of crude oil prices,
the prices of alternative energy sources, the trends of energy
markets and the evolution of gas consumption in the
importing country. Other factors of importance in the final
price were the frequency of price adjustments and the delay
in indexing, and finally the indication of the interval
specified for the renegotiation of agreements.
ENCYCLOPAEDIA OF HYDROCARBONS

within the boundaries determined by government to
meet aims of a general nature, and later legislation
reinforced and broadened the role of the state, the
determination of tariffs remained the sole province of
the AEEG, which was nonetheless required to meet
various criteria. The first of these was transparency in
specifying the elements making up the final tariff; the
second, that tariffs should reflect the costs of the
service whilst meeting the prerequisite of economic
viability (in other words profitability) for companies
in the sector. Additionally, the pricing system was
required by law to be determined using an RPI-x price
cap system.
The early tariff reforms were carried out on this
basis, and thus predated and anticipated Directive
1998/30/EC, the spirit of which was obviously known,
at least in broad terms, in preceding years. Compliance
with Directive 1998/30/EC (despite all its limitations,
evident from the outset14 but later becoming more
apparent with experience) represents a second crucial
break with the past. In order to better understand the
import of the tariff review, it should be considered
alongside the structural reforms that followed the
reception of the 1998 Directive.
The new structure of the gas sector
The Italian plan for the liberalization of the gas
sector was approved in 2000 after a long debate,
rendered highly complex both by the dominant position
of the Eni group and by the fact that, from the mid-
1990s, Eni had been listed on the stock exchange, with
more than 60% of shares being owned by private
investors and the Ministry of Finance holding, and
being as yet unwilling to relinquish, a sufficient share to
ensure control of the company. The main points of the
decree with which the European Directive was approved
(Legislative Decree No. 164/2000) are as follows:
• «The import, export, transportation and carriage,
distribution and sales of natural gas, in whatever
form, however it is used, are free», although they
may require authorization.
• Transportation and distribution are free activities,
bound by the obligation to allow third party access
to networks. The TPA principle translates into
tariffs determined by the regulator (and not left to
free negotiation between parties). Access can be
denied only in the event of network congestion or
if the operator displaced by a new request for
access may incur serious economic and financial
difficulties resulting from take or pay obligations
contracted before the entry into force of Directive
1998/30/EC.
• The principle of separation was enacted with the
legal separation of activities carried out within the
Eni group; transportation and storage are managed
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ECONOMIC ASPECTS
by purposely created companies within the group
(Snam Rete Gas and Stogit respectively). Local
distribution and sales may not be conducted
through the same company; the same applies to the
production and import of gas. It should be noted
that this was not obligatory after the first Directive
of 1998, becoming so only after the second gas
Directive in 2003.
• The Letta Decree later introduced limitations on
both wholesale and retail, known as antitrust caps,
during the initial period of liberalization. Since
January 2002 no operator has been allowed to send
more than 75% of the total supply of gas into the
national pipeline network; this threshold decreases
by 2% a year until 2010, when the threshold value
will be 61%. Additionally, during the period
between January 2003 and December 2010, no
company can sell more than 50% of gas to final
customers. This means that, unless new measures
are taken, from 2010 these caps will be removed,
and all companies will be free to compete and
obtain any market share.
• From January 2003 all customers (including
residential users) are eligible to find their own
supplier.
• Tariffs for non-eligible customers (until 2003) and
for transportation, distribution and storage
activities are determined by the regulation
Authority (AEEG) according to criteria of non-
discrimination and cost-reflective tariff levels. The
Ministry for Economic Development maintains
jurisdiction over many specific issues, and each
year dictates the general guidelines within which
the Authority sets its tariffs. In fact, as will be seen,
since 2003 the AEEG has indicated some tariff
options which sellers must in any case make
available to residential customers.
It is worth making some brief observations on this
liberalization plan, before comparing it both with the
minimum requirements of Directive 1998/30/EC and
with the formulae adopted in comparable sectors.
As noted also by the AEEG, the high degree of
vertical integration within the same company group
(Eni), whose privatization came before market
liberalization, was a significant obstacle to the
development of competition in the gas sector. Under
these circumstances, the mere application of the
minimum contents of European provisions would have
been insufficient to meet the objectives of the Directive.
Specifically, in the absence of a legal reserve
applied to Snam, the restriction of eligible customers
14 Various criticisms can be found, for example, in Polo
and Scarpa, 2000; Clô, 2002.
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THE NATURAL GAS INDUSTRY FROM MONOPOLY TO COMPETITION
exclusively to the two categories specified in the
Directive (natural-gas fired power stations regardless
of annual consumption, and final customers with an
annual consumption of over 25 million cubic metres
per withdrawal site) would have reduced the size of the
market and opened it to Snam’s competitors. Unless it
was accompanied by other measures, Snam’s position
would have remained more or less identical in this
restricted market. In this context, it would have been
desirable above all to limit regulatory forms of
intervention able to guarantee the development of
effective competition in the downstream market for
secondary distribution and sales of natural gas to those
activities characterized by a natural monopoly, in other
words the transportation and distribution of natural gas
and the use of storage facilities.
It is therefore right to conclude (as the AEEG did)
that safeguarding the public interest needed to be
pursued on the one hand by defining a fairly high
threshold for eligible customers and, on the other, by
means of clear separation between the activities of a
natural monopoly (transportation network, storage,
distribution) from those which could be carried out
under competitive conditions (supply, sale to eligible
customers). These measures would have been effective
in preventing any abuses to the detriment of
competitors and consumers.
Unfortunately, separation stopped short at the
corporate level, and did not entail ownership
separation. Maintaining the ownership and
management of transportation and storage structures
within the same industrial group which dominated
production, imports and sales turned out to be
especially debatable considering the exceptions to
the TPA principle outlined above. Specifically, the
fact that one of these exceptions concerned an
evaluation by the network manager of potential
financial difficulties for an upstream company
bound by take or pay contracts, is fairly problematic.
The fears of potential competitors that this clause
might be cited to ensure privileged access to
companies belonging to the same group as the
network manager represented a credible threat to
competition. It should be noted that Eni holds most
of Italy’s take or pay contracts, and is therefore the
main potential beneficiary of this clause.
Antitrust caps have been seen as a way to reduce
the market power of the dominant company but, in
fact, these are fairly blunt weapons. First, these
limitations drive companies to compete less vigorously
since there is, in any case, a limit to the number of
consumers which they can obtain. Secondly, caps do
not force Eni to concede take or pay contracts, but
simply to yield (during the period in which caps are in
force) the gas which Eni (and only Eni) has managed
342
to transport to the Italian border. Finally, this rule fails
to specify any particular procedure for the surrender of
this gas, which is sold on the basis of annual contracts
to parties identified by the seller, who may find
themselves without gas the following year. In the
absence of transparent procedures, there is therefore
no long-term guarantee for the parties receiving gas
from Eni, other than by continuing to benefit from the
seller’s goodwill. These are certainly not conditions to
create an environment favourable to competition.
On the other hand, it must be recognized that the
timing of the opening of the end market in Italy was
unusually rapid, although unfortunately the limited
availability of the raw materials for potential sellers
substantially limited the hoped-for price decreases.
Although the end market is more fragmented than a
few years ago, thanks to the antitrust caps, in fact, the
expected price decreases have not occurred.
One final aspect worth recalling is the fact that
network activity is not entrusted to a central party in
charge of the development of the network and thus
acting as a general coordinator for the national gas
system. This choice, which is in some ways limited
to a simple ratification of the earlier situation, is in
other ways courageous since it makes it possible to
involve various parties in the funding of new entry
points through the tool of merchant (pipe)lines, thus
leaving considerable room for private enterprise.
The flip side of the coin is that the development of
the system occurs without a view to the collective
interest and that, without central management of the
system, investments remain linked exclusively to
long-term contracts without connections to
organized markets.
The revision of tariffs
The revision of tariffs introduced by the AEEG
starting with Resolution No. 41/1998 was based on
some key principles deriving from theories developed
both in the European Union and in Italy. The main
principles were those of transparency and
cost-reflectiveness. The explicit linking of price
dynamics to an RPI-x system would occur later, after
the first steps had been taken towards the requisite
transparency. This principle implies that the final price
must clearly indicate which portion of the price
remunerates each specific activity. Given the
subdivision of the gas supply service into different
logically and technically distinct phases, it is thought
necessary to inform the final user how his payment is
made up. This has both structural consequences for
unbundling and consequences in terms of tariffs, since
each phase is now allocated a specific remuneration,
determined by the regulator where there is a
monopoly, or by competition wherever possible.
ENCYCLOPAEDIA OF HYDROCARBONS

A second general principle of cost-reflectiveness
very simply identifies the cost of providing the service
or relinquishing the commodity as the basis on which
the remuneration of a given regulated activity is
determined. Applying this simple principle therefore
requires the far from simple identification of the cost
of services provided under a monopoly, and that the
price paid by the consumer be commensurate with the
cost incurred by the companies.
To understand the reasoning behind the new tariff
structure, the service offered must therefore be
subdivided into its phases and activities. More
specifically, with reference to the structure of the gas
sector, the following phases can be identified:
• The supply phase (import or national production).
• The transportation phase, involving the carriage of
gas over long distances through high pressure
pipelines or, in the case of liquefied gas, in
appropriate cryogenic tankers followed by
regasification in purpose-built plants.
• The carriage phase, involving transportation
undertaken by the network operator on behalf of
third party suppliers, in other words outside the Eni
group. This phase may comprise three types of
activity and undertakings: transportation through
the Snam network (the creation of Snam Rete Gas
took place only later since its listing on the stock
exchange dates to 2001) of gas imported on the
basis of contracts held by a third party (such as
Enel); transportation through the same network of
gas belonging to domestic producers other than
Agip; the carriage of gas through networks
belonging to local distribution companies, to large
industries and hospital complexes in an urban
context.
• The storage phase, which can be subdivided into:
storage for extraction, needed to optimize the
exploitation of natural gas reservoirs on Italian
territory; storage for modulation and operations,
involving the accumulation of gas reserves to meet
any sudden variations in demand over different
time scales; strategic storage, aimed at preventing
possible drops or interruptions in domestic and
foreign supply flows.
• The distribution phase, subdivided into primary
distribution (aimed at end and intermediate users)
and secondary distribution (aimed at the civil
sector, small businesses and the service sector).
• The sales phase, comprising connections, the
physical carriage of gas, measurement of
consumption, billing and the collection of
payments.
Roughly speaking, it should be noted that the
average final tariff for a small customer consists of the
following elements: about 20% for the wholesale cost
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ECONOMIC ASPECTS
of the gas, a third for fixed transportation, distribution
and storage costs, and the remainder (about 45% of the
final gross price) for national and local taxes.
In Italian tariffs, supply and international
transportation are included in the category of the
remuneration of raw materials, which therefore
includes both production costs (or the costs of
purchase from reservoir owners) and any costs
incurred for transporting the gas to the Italian border.
It should be noted that it is equivalent to the cost for
those who buy gas from Eni at the border (so-called
innovative sales).
It is worth analysing these individual components
before going on to examine in detail how these come
to form the price for the end-user.
Carriage tariffs
The transportation of gas through the high pressure
networks belonging to Snam, the dominant operator in
the high pressure transportation segment, can be
divided into the transportation of natural gas on its
own behalf (including uses for supply to third parties)
and transportation on behalf of third parties (or
carriage). The cost of the transportation service
undertaken by Snam on its own behalf has never been
explicitly recognized in the establishment of prices by
the institutional bodies charged with regulating the
sector.
Historically, the interventions by the CIP and later
by the Ministry for Industry, Commerce and Crafts,
have always considered transportation through high
pressure networks to be a component implicitly
included in the price of transferring natural gas; the
transparency principle was therefore not applied
before the AEEG’s intervention. In practice, the raw
material cost for gas delivered to local distributors was
determined based on the fact that until 1995 Snam was
a public monopoly vertically-integrated into import
and transportation activities. Even the contracts
linking Snam and distribution undertakings made
explicit reference only to the price of the raw material,
without any separate specification of the
transportation cost. However, compliance with
Directive 1998/30/EC called for an alteration of the
status quo in order to respect the transparency
principle, since all items of cost must be clearly
separated to form a non-distorted price.
Italian legislation made a different kind of
consideration concerning transportation through high
pressure networks on behalf of third parties (carriage),
already explicitly covered by Law No. 9/1991.
According to this law, Snam was obliged to carry
natural gas on behalf of third parties when the
following conditions were met: the natural gas was of
domestic origin; the natural gas transported was
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THE NATURAL GAS INDUSTRY FROM MONOPOLY TO COMPETITION
destined for companies controlled by, controlling or
belonging to the same group as the company
delivering gas to the network. This law also provided
some generic instructions on how the service cost was
to be determined, specifying that tariffs for carriage
should be determined with reference to the actual costs
of the service, the standards existing in other European
countries and finally to the cost of the raw material.
New tariffs for carriage were established by the
AEEG with Resolution No. 120/2001, later reviewed
but basically reconfirming the main principles. The
tariffs were set following a long debate, taking place
partly in the European headquarters, on the most
appropriate structure. At least three systems could
potentially be adopted: a distance-related tariff,
proportional to the distance travelled by the gas, which
reflects costs, but only insofar as these are proportional
to distance; an entry-exit tariff, calculated as the sum of
separate fees for delivery to and withdrawal from
specific points in the network, which recognizes the
costs linked to different points of withdrawal and
delivery depending on demand and the direction of
flow; a uniform (stamp) tariff, identical for each point
of delivery or withdrawal and every journey, and
therefore based on the average cost of the network.
The problem of applying the cost-reflective tariff
principle is to identify precisely how the costs of
carriage are formed, since these depend both on the
act of connection to the network and on the distance
travelled by the gas, which requires interventions to
maintain the pressure and involves some wear on the
infrastructure, and the withdrawal and delivery
profile, since costs also depend on the fact that at a
given point demand may be higher or lower than
supply and on the direction of flow (the delivery of
gas to a point of net withdrawal, in other words
where demand is higher than supply, may help to
save resources by reducing the average distance
travelled by the gas).
The choice made in Italy, in line with some
recommendations later made explicit on a European
level, was to adopt an entry-exit tariff, seen as a good
compromise for its sufficiently cost-reflective and
pro-competitive nature. In fact, the stamp tariff was
not thought sufficiently cost-reflective since each user
would pay an average system cost, with
cross-subsidization between those generating a limited
actual cost and those who, for reasons of size and
delivery/withdrawal characteristics, generate a high
cost but only pay a fraction of it. On the other hand,
the distance-related tariff, whilst failing to fully reflect
costs (which depend not only on distance but also on
the precise point of connection to the network), also
represents a potential obstacle to international
competition, which almost by definition comes from
344
companies which connect to a network at the border of
a country and therefore, to reach a given customer,
must travel the longest distances.
The Italian transportation tariff is thus made up of
the following components: a) a component for the
capacity booked at entry, known as TE, and another
for the capacity booked at exit (TU) from the national
network: entry-exit tariff; b) a component for the
capacity connected to the point of delivery to the
regional transportation network (TR); c) a commodity
component: volumes transported (TT); d) a fixed
component for each delivery point (TF).
The tariff thus distinguishes between operating
costs and capital costs, remunerated by a commodity
component and a capacity component. Whilst it is
thought that the variable component generates about
10% of the costs of carriage, the component relating to
the volume transported generates about 30% of total
income. This aspect is odd, but fairly widespread in
the tariffs for public utilities.
The principle according to which tariffs must be
cost-reflective (the problematic nature of which has
already been stressed) is tempered by the need to
provide incentives for both efficiency and
pro-competitive behaviour. In this case, remuneration
is designed to encourage the network operator, despite
its vertical integration with the dominant company in
the upstream segment, to carry more third-party gas by
providing remuneration considerably higher than the
marginal cost of each cubic metre of third party gas
transported.
Storage tariffs
As has already been stressed, storage facilities and
transportation networks play a fairly similar role from
an economic point of view, despite their obvious
technical differences. It is therefore unsurprising that
storage tariffs are constructed in a fairly similar way to
those for carriage, with an identical distribution of
fixed remuneration (70%) and remuneration
proportional to the volumes exchanged (30%).
As far as storage is concerned, there is a further
complication due to the fact that this comprises several
activities, such as input to the site (injection), the
amount of time gas is stored in the site (space and
peak availability) and finally withdrawal (delivery), in
addition to making the gas available for strategic
storage. Each of these activities has its own distinct
tariff, subject to different, but wholly coherent and
comparable, regulation systems.
Distribution tariffs
The mechanism for determining the variable
component used to specify that distributors serving
areas where civil consumption was lower should pay
ENCYCLOPAEDIA OF HYDROCARBONS

lower prices for their gas. This unusual diversification
of tariffs, introduced with CIP measure 17/1980 and
confirmed in the principles by the Ministry of Finance
until 1996, was aimed at encouraging the penetration
of natural gas by offering favourable pricing
conditions where levels of consumption were low, both
by attracting new users and encouraging old users to
increase individual consumption. This amounted to
subsidies to the distribution companies operating in
areas where, for climatic reasons, levels of
consumption were lower than average; it also
facilitated the process of substituting other heating
fuels with natural gas.
This was an attempt to use prices for the purposes
of industrial policy, encouraging a specific and risky
energy choice, given Italy’s heavy dependence on
imports for this energy source. On the other hand, the
country’s poverty in terms of primary energy sources
offered few alternatives which could ensure greater
security of supply. In any case, it must be noted that
this courageous and unpredictable choice of energy
policy was enacted by essentially ignoring any
criterion of allocation efficiency. Although this is not
the only important efficiency criterion, it should be
stressed that this decision was a significant burden on
the route towards an efficient tariff structure,
introduced following the Directives of 1998 and
2003.15
The structure of prices for the final customer
Since the liberalization of the sector on the demand
side, the purchase of natural gas by end-users,
including families, involves the payment of a free
price, and no longer a (regulated) tariff. Although all
customers are eligible, the AEEG has maintained
control over the tariff options offered to small
customers, identifying a supplier for each area, who
must offer a range of tariff options subject to the
control of the AEEG. This price, which defines the
economic conditions for supply, is freely determined
by the seller only as concerns sales costs, whilst the
other components are regulated by the energy
Authority. The final price is thus based on the sum of
regulated components and a margin determined with a
certain degree of freedom.
The structure of the regulated components is
identical for all operators, and is determined by the
energy Authority in such a way as to give each
operator incentives and penalties for the attainment of
common objectives of efficiency and quality. The
economic conditions for supply, defined as specified
by Resolution No. 138/2003, are comprised of a fixed
quota, linked to the fixed part of the distribution tariff
and approved by the AEEG for the thermal year in
question, and a variable quota, calculated as the sum
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ECONOMIC ASPECTS
of several variables, determined by the energy
Authority:16 a) a quota for the raw material; b) a quota
for wholesale marketing; c) a quota for transportation
through national and regional networks; d ) a quota for
storage; e) a variable quota for the distribution tariff.
To this should be added the sales margin; every
year, each distributor formulates tariff proposals which
must be approved by the energy Authority for that
thermal year, ensuring that the proposals meet the
criteria specified in tariff regulations. These tariff
proposals must remain within limits, compliance with
which is controlled by the AEEG, but which also take
the form of obligatory proposals, which must therefore
be offered to small customers, and not of genuine
regulated tariffs. The difference, of which the
Authority and operators seem to be particularly fond,
is in fact more apparent than real. Essentially, the
maximum prices (tariffs) are in any case approved by
the regulator within predetermined criteria, whilst
companies are free to offer their customers more
advantageous conditions.
Unlike the electricity sector, there is no single
national tariff in the gas sector; in fact, tariffs vary
considerably, as can be seen from Table 6. Although
the existence of a single national tariff cannot be
defended in terms of efficiency, the impression is that
the extent of variation is excessive, and especially that
it is unlikely to depend exclusively on the differing
costs sustained by the service in different towns.
The dynamics of prices
With the 1998 Resolution, applying Law No.
481/1995 which established the Authority itself, the
AEEG changed the periodic indexing mechanism used
15 The new distribution tariffs were established with
AEEG Resolution No. 138/2003 (and subsequent
modifications) which established a more efficient tariff;
however, concerns similar to those previously expressed
persisted as to the compensation of distribution areas with
high costs. In fact, the system adopted by the Authority is
extremely gradualist and has actually encouraged the
persistence of a situation where cross-subsidization is
widespread.
16 Specifically, as stated by the AEEG, the formula
adopted is (TDi⫹a1⫹b1)⫹QTi⫹QS⫹CCI⫹QVDi, where:
TDi is the variable quota of the distribution tariff, expressed
in €/GJ; a1 is equal to 0.027111 €/GJ; b1 is the unit
compensation quota of the distribution tariff, and may be
equal to 0 or negative depending on the unit distribution
cost; QTi is the quota relating to transportation through
national and regional networks for the thermal year in
question, expressed in €/GJ; QS is the component for
storage, in other words for the storage of gas used as a
reserve, set at 0.246052 €/GJ; CCI is the variable portion
for wholesale marketing (on 1 January 2004 this was
4.328264 €/GJ); QVDi is equal to the retail sales quota as
specified in Resolution No. 237/2000 expressed in €/GJ.
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THE NATURAL GAS INDUSTRY FROM MONOPOLY TO COMPETITION

Table 6. Price of gas in the Italian market for an annual consumption of 1,400 m3
(processed from 1998 AEEG data)

Fixed quota Variable quota Total

City Seller Distributor
(€/yr) (€/m3) (€/yr)

Modena Meta Meta Rete Gas 24.7 0.27 407.3

Reggio Emilia Blumet Agac 36.0 0.27 417.1

Naples Napoletanagas Clienti Napoletanagas 31.2 0.28 420.8

Verona AGSM Verona AGSM Rete Gas 42.0 0.28 436.0

Florence Fiorentinagas Clienti Fiorentinagas 31.2 0.30 455.1

Turin Italgas Più AES Torino 31.2 0.31 461.1

Brescia Asmea S.r.l. ASM Brescia 50.0 0.30 470.4

Bari AmGas S.r.l. AmGas 18.6 0.34 500.9

Trieste Estgas S.p.A. Acegas-Aps 18.0 0.35 505.1

Milan AEM Energia AEM Distribuzione 25.0 0.35 514.5

Rome Italgas Più Italgas Più 31.2 0.38 560.6

Palermo AMG Gas AMG Energia 42.0 0.50 743.3

to adjust the tariffs for methane gas distributed by
town networks, concerning the part relating to the
costs of the raw material. The mechanism used to
adjust gas tariffs, decided upon in April 1998, was
fixed experimentally for a transitional period to allow
the AEEG to define a system for bimonthly updates of
the tariff portion, which, as well as being more
effectively linked to the raw material, would also give
operators a stable and coherent point of reference to
changes in the market.
The indicators chosen to index the energy quota of
natural gas were those of the methane market (prices
of crude oils, gas oil and fuel oils), and mirror the
indexing criterion adopted in almost all international
contracts. Hence, this choice was aimed at attaining
objectives of security of supply for imported fuels, and
at offering guarantees for both importers, who saw
their costs recognized in line with the trends of
international listings, and for Italian producers, who
were thus given more secure sales conditions.
Whilst the component relating to the raw material
continues to follow this indexing mechanism, since
2001 the tariffs of regulated activities have been
adjusted according to a price cap (RPI-x) system, so
that the initial price is regulated to cover costs whilst
the dynamics within the regulation period of four
years is given. It should be remembered that, unlike a
pure price cap system, some aspects need clarification.
The first is the presence of uplift elements which
compensate companies for unforeseen events beyond
their control which have an impact on costs. There are
also premiums offered for participation aimed at
encouraging the careful management of demand and
for quality improvements.
The transition from the first to the second
regulation period led to a significant innovation in the
RPI-x system. During the first period, by applying
Law No. 481/1995 to the letter, the AEEG had
subjected prices to an annual decrease of x percent.
During the second regulation period, by contrast, the
Authority attempted to distinguish within the price
between a component remunerating costs controlled
by the company and one covering costs deriving from
long-term choices, which the company cannot
therefore reasonably control within the four year
regulation period. Whilst non-controllable costs are
associated with an x factor of zero, reflecting the belief
that the efficiency process cannot effectively affect
this part of the costs, that portion of the price covering
other costs is associated with an x factor higher than
that applied during the first regulation period.
A second important novelty was introduced by the
Decreto del Presidente del Consiglio dei Ministri,
D.P.C.M. of 31 October 2002, which slows down the
updating of tariffs and in particular the indexing of the
raw material, in an attempt to avoid sudden increases
in inflation by allowing only six-monthly updates of
tariffs. The same regulation explicitly states that in its

346 ENCYCLOPAEDIA OF HYDROCARBONS


updates of energy tariffs, the AEEG must take into
account the impact of these decisions on overall price
levels.17
Even leaving aside the debatable principle that the
Authority must set service tariffs with macroeconomic
aims in mind (a principle which in the past had serious
consequences for the balance sheets of Italian energy
companies), the basic idea is that greater control over
the variability of prices reduces repercussions on price
levels. In fact, the theoretical basis for this
intervention is far from clear, since less immediate
increases may have an impact on the variability of
prices, but it is unclear how this could influence the
average variation of price levels. The provision thus
seems aimed more at postponing the problem of price
increases than at tackling it effectively. The most
unfortunate consequence of this provision is that, by
dictating only a general criterion for spreading tariff
increases over a longer period, it actually reduces
transparency in the updating of energy tariff levels. In
fact, it is not at all clear how variations in the price
index affect the final price, so that when prices are
periodically updated, operators can only guess at the
AEEG’s interpretation of the situation, without any
certainty; they are thus exposed to what is seen by
many as a discretionary margin in the decision to
increase prices which is almost arbitrary.
Taxation
As already stated, almost 50% of the final price of
gas sold to the end-user consists of various taxes,
including domestic taxation (VAT and excise duty),
regional taxes and any local additions.
Regional taxes are excise duties which the Italian
ordinary statute Regions may set within a band
between 0.516 and 3.10 euro cents per cubic metre,
with the exception of Lombardy and the special statute
Regions, which have set this value at zero.
Additionally, in accordance with AEEG Resolution No.
237/2000, from the entry into force of the tariff reform
(1 July 2001), local councils can request distribution
companies to apply an additional tax on their tariffs to
fund subsidies for economically-disadvantaged
customers, the elderly and the disabled. This tax is
described as a social subsidy.18 In fact, by the end of
2004 only 180 out of 6,700 local councils had asked to
introduce this social subsidy.
National taxation comprises both a consumption
tax (excise duty) and value added tax (VAT, ad
valorem); it should be noted that the latter is applied to
the entire net amount due (including the excise duty
and regional addition) thus representing an example of
a tax on taxation.
An interesting aspect worth stressing is that
national and regional taxes have different rates
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
ECONOMIC ASPECTS
depending on the use for which the gas is destined: for
example, for domestic consumption (hot water and
cooking) VAT is 10% whereas for heating purposes it
is 20%, so that the tax burden ranges from 23% to
about 50%.
In the case of residential supply to a customer who
uses gas for cooking and heating, with an estimated
consumption of about 1,400 m3/yr (116 m3 per
month),19 the average cost of a cubic metre can be
subdivided as shown in Table 7.
It is clear that any proposed reform aimed at
reducing the cost of gas for end-users must start from
these data, which show that taxes, sales margins,
distribution and raw materials are by far the most
significant items of cost, whereas the use of national
transportation and storage infrastructure, though
important for the development of competition is
relatively insignificant (at least in direct terms) in the
formation of the final price.
The quality of service
As far as quality in the civil use sector is
concerned, all undertakings providing a gas service
and whose size is larger than a minimum level must
adopt a customer charter specifying its quality
standards, update these periodically and ensure that
they are met. The quality of services offered to
companies operating in the service sector or to
non-residential users is not covered by the regulations
in force on customer charters; however, it is subject to
investigation by the AEEG.
The gas service is characterized by a small number
of large operators (serving most users) and significant
fragmentation where operators with fewer than 10,000
users are concerned.
The percentage of operators which have introduced
a customer charter ranges from 100% of large
operators to 50% of small operators, but, for the latter,
this figure is destined to increase. The variability of
the required standards is significant since operators
17 The D.P.C.M. states that the AEEG must “define
methodologies for the updating of tariffs in relation to the
variable costs component which are to minimize their
impact on inflation; in particular, the frequency of updates
must be consistent with the aim of reducing the inflation of
energy prices, under the obligation to safeguard the full
profitability of energy companies and more generally the
competitiveness of the production system”.
18 The distribution company is required to include in the
bill issued by the seller, for all active customers, an amount
equal to less than 1% of the variable distribution quota net
of taxation, which is then devolved to the local council,
which administers it completely independently, on the basis
of the criteria chosen.
19 Those with this type of consumption profile are
considered a customer type in the Authority’s estimates.
347
THE NATURAL GAS INDUSTRY FROM MONOPOLY TO COMPETITION
Table 7. Components of the average price of a cubic metre of gas for an annual consumption of 1,400 m3
(processed from 1998 AEEG data, updated 30 September 2004)
Component Euro cents/m3
Cost of raw materials 13.9
National transportation 2.9
Storage 1.0
Wholesale 3.8
Distribution through local networks 7.5
Retail 2.3
Taxes 25.7
Total 57.1
are given the faculty to determine their own standards
depending on territorial and organizational factors,
which may affect quality standards. The general model
followed by customer charters states in at least four
specific standards that users should be reimbursed,
even if the failure to meet these standards does not
result from causes attributable to the operator.
Another factor taken into consideration by the
AEEG to ensure the quality of the service offered
concerns safety, with a percentage of the network
controlled that is obviously higher for large operators
than for small or medium operators. For large
operators, the need for further investigations has
emerged, with special reference to the way that
inspections are carried out, in order to make the
control policy of companies more transparent.
It is clear that the reimbursement procedure
developed by the Authority represents an incentive to
offer increasingly high quality standards. The
effectiveness of the AEEG’s intervention is probably
demonstrated by the fact that the number of
reimbursements actually paid to consumers has
increased considerably over time.
6.1.8 Conclusions:
the public interest,
monopolies and competition
The essential question at the end of this analysis of old
and new regulations in the gas sector, in general terms,
but above all in the interpretation of these principles in
the European and Italian contexts, is whether they have
had the desired effects. The basic problem in this
assessment derives from the fact that the goals set by
348
Percentage Percentage
of total price of net price
24.0 44.3
5.1 9.2
1.6 3.1
6.7 12.1
13.2 23.9
4.2 7.3
45.2 –
100.0 100.0
reforms of this type are so numerous and so diverse that
discussions of the topic become excessively complex.
The first issue is the protection of consumers, both
in terms of price and of quality. It can now be said that
European consumers are almost always (or at least in
many cases) free to choose their supplier, but this
alone tells us nothing about the effectiveness of the
reforms. The evidence for whether prices are falling is
not particularly reassuring; if the market power of
companies which have always been dominant is
maintained, prices also remain high.
Whether things could have been otherwise is
debatable. Perhaps with the benefit of hindsight it
could have been predicted that only the withdrawal of
the state from this sector could have led to legislation
effectively beneficial to competition, but member
states have always left the European Union outside the
choices concerning the public or private ownership of
companies. At any rate, only in a very few cases have
nation states agreed to relinquish the ownership of the
major companies which often, regardless of merely
ostensible privatizations, have remained (and are
destined to remain) largely within the public sphere.
The topic of security of supply lies at the heart of
the debate about the sector’s future, in part because
many nation states, as well as the European Union, are
debating their energy policy and noting with
increasing concern that the trend towards liberalization
is making it increasingly difficult to develop energy
policies. The fundamental problem is to determine the
appropriate context for the public sphere and what is
best left to the private sphere.
Whilst the main (legitimate) concern is that
regarding supply, it does not appear sensible to push
for an indiscriminate privatization of those who
ENCYCLOPAEDIA OF HYDROCARBONS

manage this essential segment in a country’s energy
policy. On the other hand, it is unclear why the control
of supply should be associated with a control over all
the segments in this sector, both those where
regulation could easily guarantee the efficient
management of infrastructure, and those of a
commercial nature where competition could be seen as
a natural way of organizing transactions.
The decision to open little more than formal spaces
for competition or private shareholders, as in the case
of Italy, does not seem to have been particularly
effective, and has hitherto mainly had the effect of
complicating the management of energy policy
without (as yet) bringing genuine benefits to
consumers. A greater separation between the topic of
safeguarding supply activities and those of the
development of the market (regulated or competitive)
seems to be the current challenge.
References
AEEG (Autorità per l’Energia Elettrica e il Gas) (1998)
Relazione annuale sullo stato dei servizi e sull’attività
svolta, Roma, Presidenza del Consiglio dei ministri,
Dipartimento per l’informazione e l’editoria.
Amman F. (1996) Il settore del gas naturale nazionale ed il
mercato interno europeo, «Economia delle Fonti di Energia
e dell’Ambiente», 2, 117-162.
Busby R.L. (editor) (1999) Natural gas in nontechnical
language, Tulsa (OK), PennWell.
Clô A. (1992) Regolamentazione e concorrenza nei servizi di
pubblica utilità: il caso del gas, «L’Industria», 2, 247-268.
Clô A. (2002) La liberalizzazione del mercato del gas metano:
le ragioni di criticità, «Energia», 4, 30-38.
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ECONOMIC ASPECTS
Creti A., Villeneuve B. (2004) Long-term contracts and
take-or-pay clauses in natural gas markets, «Energy Studies
Review», 13, 75-94.
European Commission - Directorate general for energy and
transport (2003) Second benchmarking report on the
implementation of the internal electricity and gas market:
updated report incorporating candidate countries,
Luxembourg, Office for official publications of the
European Communities.
IEA (International Energy Agency) (2002) Energy balances
of OECD countries, Paris, Organization for Economic
Cooperation and Development/IEA.
Polo M., Scarpa C. (2000) Gas: quanta concorrenza passerà
attraverso i tubi?, «Mercato Concorrenza, Regole», 2, 363-
376.
Polo M., Scarpa C. (2003a) Le imprese multiutility, in: Muraro
G., Valbonesi P. (a cura di) I servizi idrici tra mercato e
regole, Roma, Carocci.
Polo M., Scarpa C. (2003b) Entry without competition,
Innocenzo Gasparini Institute for Economic Research,
Working Paper 245.
Polo M., Scarpa C. (2003c) The liberalization of energy
markets in Europe, in: Padoa Schioppa F. (a cura di) Annual
report on monitoring Italy, Roma, Istituto di Studi e Analisi
Economica.
Waddams Price C. (1994) Gas regulation and competition:
substitutes or complements?, in: Bishop M. et al. (edited
by) (1994) Privatization and economic performance, Oxford,
Oxford University Press.
Waddams Price C. (1997) Competition and regulation in the
UK gas industry, «Oxford Review of Economic Policy»,
13, 47-63.
Carlo Scarpa
Dipartimento di Scienze Economiche
Università degli Studi di Brescia
Brescia, Italy
349

The regulation theory
and its prospects
6.2.1 Introduction
Competition plays a central role on markets. Under
perfect competition, the total welfare is maximized
and, as stated by the two welfare theorems, the
market allocation is Pareto optimal. Furthermore,
the government can achieve all Pareto optimal
allocations by accurately allocating resources by
means of lump sum transfers.
Conditions under which the two welfare
theorems hold are not extremely restrictive; still,
often some of them are not satisfied and, in
particular, it is frequently the case that market
structures are not competitive. The domain of
regulation includes the analysis of institutional
set-ups adopted to govern a market in which the
emergence of competition is hardly achievable
(or very costly).
Indeed, it is still difficult to delimit the scope of
regulation. While the term regulation is often used
to refer to a set of rules, targets, and mechanisms
imposed by the government (generally via an
independent agency) to regulate specific and
well-defined aspects of the economy, part of the
literature has adopted a broader definition,
including all forms of direct state intervention in
the economy. Henceforward, we stick to the first
definition (more a sectorial approach), considering
that the broader field mentioned in the second
definition would more appropriately belong to the
industrial policy or even public economics domain.
Even though public intervention in the
economy is not a recent issue, regulation emerged
as an independent discipline in economics during
the 1980s, when several fundamental articles were
written investigating which regulatory instruments
are most effective in protecting consumers and
promoting competition.
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
6.2
This work is articulated as follows: section
6.2.2 provides an explanation on why regulation
matters; section 6.2.3 introduces some of the most
common regulatory instruments in a framework of
complete information; section 6.2.4 deals with the
problems of regulating when information
asymmetries are taken into account; section 6.2.5
briefly summarizes the main problems of interest
groups that try to capture regulation agencies;
section 6.2.6 discusses whether it is more desirable
to have a public monopoly or a private regulated
market; the conclusion is found in section 6.2.7.
6.2.2 Why regulate?
The main purpose of economic research on
regulation lies in the justification for, and in the
appropriate forms of, public intervention in the
economy (normative approach). Part of the
literature on regulation has offered a more positive
analysis, trying to explain either why in some
circumstances one might observe a regulated
market – even if there is no reason for it from an
economist’s perspective – or, rather, why one
observes inefficient forms of regulation.1
Henceforward we focus only on the first kind of
approach.
It is well known that markets, under the
classical assumptions of free entry, including
1 This second approach is more frequent in the literature
on law and political science than in the economic one, still
one can find some contributions in the economic literature,
for instance by Joskow (1974), Williamson (1976), Mackay
et al. (1987), or Spiller (1990). Part of it, especially the more
recent works, concerns the problems of capture and the
relations between firms and politicians.
351
THE NATURAL GAS INDUSTRY FROM MONOPOLY TO COMPETITION
perfect information, low access costs, and perfect
financial markets, naturally converge towards
perfect competition. Some of these requirements in
many cases are not fulfilled: legal or natural
barriers and the cost structure, for example, might
result in a market failure, which means that
markets are not able to converge to an efficient
allocation.
Market imperfections can be of many different
types, e.g. natural monopolies, imperfect
information, externalities and public goods,
scarcity rents or destructive competition. This work
is focused on problems related to natural
monopolies, under perfect and asymmetric
information. Externalities are often considered to
justify environmental regulation or sometimes
regulation of telecommunications (e.g. regulation
for the allocation of spectrum).
Scarcity rents and destructive competition are
concepts used much more often by politicians and
political scientists than by economists. Scarcity
rents are the extra profits that are due to the fact
that a resource is particularly scarce, and this can
have an equity impact and also some negative
externalities.2 Destructive competition, meanwhile,
is due to unstable competition: myopic firms are
not making enough investments because of the
framework that is too risky, and this leads to long-
term inefficiencies.3
In Fig. 1 Marginal Revenue (MR), Marginal Cost
(MC), and demand functions of the firms are
represented. At the intersection between MC and the
demand function lies the perfect competition
equilibrium (q*; p(q*)), while the monopoly
equilibrium (q°; p(q°)) is derived from the intersection
of the MC and the MR functions. Consumers’ surplus
is the area underneath the demand function.
p (q)
MR
p (q°)
deadweight
loss MC
p (q*)
q° q*
Fig. 1. Marginal revenue, marginal cost
and demand functions of the firms.
352
The shaded area represents the so called deadweight
loss, which corresponds to the decrease in consumer
surplus net of the variation in the profits of the firms
(i.e. total surplus) that appears when moving from
perfect competition to monopoly, and due to the fact
that the total exchanged quantity falls and the
equilibrium price increases.
Every time a market failure occurs, we observe
a deadweight loss. Obviously, the benevolent social
planner’s aim is to maximize total welfare; which
implies the minimization of the deadweight loss.
From a normative perspective, to justify
regulation, it is not sufficient to show that a market
failure occurred. It also has to be proved that
public intervention can improve upon the
free-market equilibrium.4 In the range of all
feasible public interventions capable of increasing
welfare, one needs to pick the one for which social
welfare increases the most. Assuming that
regulating a market is the most efficient way to
deal with a certain market failure in the set of all
feasible public policies, it should be noted that
many alternative ways of dealing with market
failures have been proposed in the literature.
For instance, in the presence of externalities,
the Coase theorem states that private bargaining
would be sufficient to internalize all gains and
costs if there were no transaction costs.
Furthermore, the use of Pigouvian taxes and
subsidies, or a redefinition of property rights and
the creation of new markets could be other options
for dealing with market imperfections.
Generally what is crucial is not to understand
whether public intervention is efficient or not; to
justify regulation one does not need it to completely
remove the market failure, but rather, to increase
efficiency more than any alternative remedy. In a
classic framework, i.e. under the conditions of
perfect information and no transaction costs,
regulation is not always necessary since it is possible
to achieve the first-best solution without it.
Nevertheless, introducing a more complicated
setting, it might be that regulation is a desirable
solution because, for instance, it is less costly or
entails fewer distortions.
2 For an analysis of scarcity rents see, for example,
Olsen (1972) or Sanders (1981).
3 Destructive competition has been used, for example, to
give theoretical support to public intervention in airline and
truck transport in the US during the Thirties but was rejected
by most of the economic literature.
4 One considers that a market outcome improves upon
q
another one if it is feasible (possibly with transfers) and it
Pareto-dominates it, that is, all economic agents enjoy at
least the same utility and some of them are better off.
ENCYCLOPAEDIA OF HYDROCARBONS

As mentioned above, the presence of a
monopoly or, more generally, of any market
regime, other than perfect competition, might be a
source of inefficiency. Whenever possible, public
authorities first try to fix the problem through
competition policy instruments, fighting collusive
agreements, cartels, and any restriction intended to
increase the power of a firm.
For a firm, having some market power means
that market forces do not push down price and
profits; all units are sold at a price above MC and
the total quantity exchanged on the market is below
the optimal one, in the sense that part of the demand
is not satisfied even though consumers’ willingness
to pay is higher than the cost of producing the
additional units. This discrepancy, as already pointed
out before, generates a reduction in total welfare
(i.e. deadweight loss).
Even though monopolies are a priori not
desirable, it might sometimes be the case that a
monopoly is either the unique sustainable market
structure or the most efficient one. For instance, this
is the case of so-called natural monopolies, for
which regulation seems to be necessary.
To define natural monopolies, the notion of
Minimal Efficient Scale (MES) first has to be
introduced. This is the level of output that, given the
shape of the production function and current prices,
allows the firm to produce at the lowest possible unit
cost. In markets with high fixed costs and small
variable costs, a large MES is clearly observed
because, as long as the plant can allow for increases
in production, the low MC guarantees that the
average cost falls.
Two other notions needing introduction are
economies of scope and economies of scale. The
first one means that it is less costly to have several
goods produced by the same firm rather than
having several different firms producing them.
This implies that integration of firms is socially
desirable and thus, to some extent, a more
concentrated market might be enviable.
Economies of scale appear when it is more
profitable to have a given quantity of a good be
produced by a single firm compared to having
several firms each produce part of it.
When facing significant economies of scale or,
more precisely, when the MES is sufficiently large,
with respect to the demand function (which is
generally the case for electricity, gas, railroads,
etc.), a natural monopoly is present.
The intuition behind natural monopolies is simple:
as long as the average cost function is decreasing, it is
more convenient to increase the production of the
incumbent firm rather than create new plants which
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
THE REGULATION THEORY AND ITS PROSPECTS
duplicate the fixed costs. The alternative case (of
oligopolistic or competitive supply) does not imply
that some firms would incur losses, but simply that the
total cost of production would be higher than
necessary, and thus, total welfare would necessarily
decrease with respect to the first-best level of
production (which, in this case, would call for a single
firm satisfying the entire market demand resulting
from marginal-cost pricing).
From an analytical point of view, in a single-
product firm, we face a natural monopoly when, at the
equilibrium quantity q, the cost function C(q) is
sub-additive, i.e. if and only if C(
q i )⭐
C(q i ), for all
quantities such that
q i⫽q, where q i is the quantity
produced by firm i. In words, this means simply that
total costs for one firm to produce a given quantity q
are lower than the sum of the costs incurred by any
number of firms each producing part of the same
amount q.
Baumol et al. (1977, 1982) have contributed
crucially to regulation theory. These two articles
clarify that the presence of a monopoly in itself is
not always a sufficient condition to justify
regulation. When a monopoly is observed with an
absence of barriers to entry in a potentially
competitive framework – particularly, in the
presence of what Baumol et al. (1977, 1982)
define as contestable markets – it is possible that
no regulation is preferable to price regulation. It is
not simply the present market structure that matters
but rather the firm cost function and the entry
costs. Baumol et al.’s contestable market is a
proper market structure with specific
characteristics which are nowadays considered an
unrealistic framework, by most of the recent
literature, in particular, because it assumes that
there are absolutely no barriers to entry.
This assumption has a major consequence: even
if there were the presence of a monopoly, the
opportunity for any potential entrant to come into
the market, whenever it is possible to make profits,
imply that the incumbent, threatened by possible
entry, behaves as if it were in a competitive market.
Recently, there has been a revival of the literature
on contestable markets because it might be a good
description of ‘new technology’ markets, such as
those for Internet access or online communication.
6.2.3 Regulation under complete
information
The rationale for regulation derives from the fact that
the principal (i.e. the social planner or the regulator)
has objectives divergent from those of the agent (the
353
THE NATURAL GAS INDUSTRY FROM MONOPOLY TO COMPETITION
regulated firm). It is often assumed that the firm tries
to maximize its profits or its share value; more
generally it maximizes its surplus. The regulator’s
aim might be to meet some social and political
objectives (such as, for instance, the diffusion of a
certain service over the whole national territory),
technical requirement or to meet some economic
goals. This section basically concentrates on the third
type of goal.
Old regulation approaches
In practice, regulating means introducing some
rules and constraints aimed at curbing the agent’s
behaviour so as to increase economic performance.
The first attempts to regulate were of the ‘command
and control’ type, which consists of explicitly forcing
economic agents to maintain a specific conduct. For
instance, cost of service regulation (including rate of
return) belongs to this family of regulation.
Cost of service regulation basically tries to
impose pricing at average cost on the firm, including
the cost of capital in the computation. To estimate it,
the regulator looks at the cost of debt and the rent of
stocks of risk similar to the one of the firm.
Subsequently the regulator fixes the price to
ensure that the firm earns positive profits, but limits
them, for instance, to a given percentage of the
invested capital. Instead of fixing the price, the
regulator can choose the rate of return the firm is
allowed to enjoy. This kind of regulation leaves little
power to the regulator and has another important
drawback defined in the literature as the Averch-
Johnson effect: the firm has little incentive to
produce efficiently. More precisely, managers might
have the incentive to over-invest in physical capital
with respect to labour, therefore increasing capital
marginal cost. Moreover, there are few incentives to
invest in production-cost reduction. Finally, the
regulator often lacks a lot of important information
that is needed to implement such a policy, which
implies that, even if the regulator were able to
perfectly control firm behaviour, it might not know
which is the optimal policy.
A different kind of regulation, which reduces
even more of the regulator’s power over the firm, is
the so-called ‘price cap’. The price cap consists of
introducing a ceiling on the price of the firm. The
term pure price cap is used when the regulator is not
allowed to or cannot observe the costs of the firm at
all. A more efficient version of price cap consists in
fixing a price for a limited time-horizon, and then
reviewing it afterwards to extract as much surplus as
possible from the firm.
The main advantage of price cap regulation is that
to implement it the regulator does not necessarily
354
need to observe and measure the economic
performance of the firm. Moreover, by making the
firm the residual claimant for extra profits due to
costs reduction, the regulator gives the right
incentives to the firm. Price revision allows the
regulator to extract more surplus. Generally, this
price cap is increased in line with the inflation rate,
and reduced according to technological advances
(cost reduction), and possibly some firm-specific
factors.
Price revision entails a problem of commitment
and one of timing. The commitment problem is due
to the fact that, when renegotiation occurs, the
regulator unilaterally modifies the parameters and
can extract all of the extra profit deriving from the
reduction of costs. For the regulator it is then hard to
credibly commit not to renegotiate the cap for a given
period. The timing problem derives from the fact that
frequent revisions reduce the firm incentives to be
efficient, because exerting an effort to reduce costs is
less profitable. Proposing sporadic revisions might
not be credible and would involve the risk of leaving
too high of a surplus to the firm. One additional
drawback is that the firm might have the incentive to
reduce quality to increase the mark-up. To solve at
least the timing and credibility problems, the
regulator can propose an earnings-sharing clause.
The clause implies that at each revision the reduction
in costs is computed, and the new price is fixed, so as
to share the additional profit between the firm and
the regulator on the basis of some predetermined
sharing rule.
In the last decades another type of regulation
emerged, which differs from ‘command and control’.
Rather than constraining a firm’s behaviour,
‘incentive regulation’ consists in giving the right
incentives to the firm (so that its objectives become
closer to those of the regulator), giving the firm the
freedom to choose how to reach them. To some
extent, price cap regulation can be considered as a
precursor of incentive regulation. This change is
certainly a consequence of the difficulty in observing
the characteristics of a firm and controlling its
behaviour due to the information gap the principal
suffers from. Before moving to section 6.2.4, where
incentive regulation is analysed, the computation for
the social optimum that can be achieved under
perfect information in presence of a natural
monopoly is explained.
Regulating a natural monopoly
In the past, the typical approach to deal with
natural monopolies consisted of nationalizing
firms. At that time, firms were supposed to
maximize social welfare; in other words, managers
ENCYCLOPAEDIA OF HYDROCARBONS

were asked to price at MC even though this created
a financial loss (since in this framework the
average cost is higher than the MC). This loss,
according to classical economic theory, should
have been financed through lump-sum taxes.
This reasoning implies that managers are not
only rational and benevolent, but that they are also
perfectly informed about the shape of the cost
function (which may not always be the case).
Moreover, it is well known that lump-sum taxes are
not feasible.
The best remedy to this last problem could be
either a distortionary tax, or imposing budget
balance to public firms (i.e. to impose pricing at
average cost) but, of course, both of these solutions
are sub-optimal.
First, consider the case of imposing a tax to
finance the deficit of a public firm. Denote l the
cost of public funding, S(q) the consumer surplus,
and p(q) the price. The maximization problem of
the social planner is:
max(q,t)[S(q)⫺p(q)q]⫹[ p(q)q ⫺C(q)]⫺
⫺lt ⫽S(q)⫺C(q)⫺lt
so that qp(q)⫹t⭓C(q).
This maximization problem, in words, means
that the national firm maximizes the sum of
consumers’ surplus (net of the payment it receives)
and its profits, taking into account that the taxes
collected to have budget balance are distortionary.
Note that, since the social planner gives the
same importance to both consumers’ and
producer’s surplus, the price paid by consumers
and the determining revenue of the firm is seen
simply as a transfer of surplus from one agent to
another, but it does not have an impact on total
welfare. As a consequence, instead of considering
the sum of the surpluses of both the consumers
and the firm, it is possible to directly take into
account the consumers’ surplus net of production
costs.
The constraint implies that the government is
able to recover all of the production costs, via total
revenue from sales and the taxes collected. Since
taxes are distortionary, it is desirable to reduce
them to their minimum, which means that the tax
level will be fixed precisely to have perfect budget
balance (i.e. the constraint is binding).
The solution of the problem, generally defined
as Ramsey pricing solution, can be summarized by:
p(q)⫺b
1214 l 123
1 ⫽ 11 1
p(q) 1⫹l ep,q
where b is the firm MC and e denotes the demand
elasticity.
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THE REGULATION THEORY AND ITS PROSPECTS
This result can be interpreted in the following
way: the regulator tries to balance the social cost of
public funding and the cost of reducing the
quantity exchanged on the market. When l⫽0
(corresponding to the case of lump sum taxes) the
first-best solution can be applied and price can be
set at MC. On the other extreme, when the social
cost of public funding is infinitely large, the social
cost generated by taxes is such, that it is better to
recover sunk costs and to behave as a monopolist.
In fact, when l tends to infinity, l(1⫹l) goes to
one, and one is back to the standard result that the
Lerner index is proportional to the inverse of the
elasticity of demand.
The alternative approach, i.e imposing a
budget-balance constraint on the maximization
problem of the regulator, leads to very similar
results. In this case, the firm managers have to
ensure the firm does not make negative profits but
cannot rely on the tax revenue.
Solving the new maximization problem, one
obtains the same equilibrium condition as before:
p(q)⫺b
124 l 123
11 ⫽ 11 1
p(q) 1⫹l ep,q
but in this case l represents the Lagrange
multiplier of the budget-balance constraint (or the
positiveness of the profit function) and represents
the shadow cost of relaxing it. In other words, l is
the social cost of leaving more surplus to the firm.
In the case of a multi-product firm, results are
slightly different. When the monopolist produces
two independent goods, the solution of the same
program is:
p1⫺b1
1211
p1 ep2
1211 ⫽ 12
p2 ⫺b2
1211
ep1
p2
where b1 and b2 are the MCs of producing the two
goods.
This solution calls for price discrimination: to
have budget balance, the social planner distorts the
price of all goods, but, taking advantage of the fact
that demand elasticity is different for each of them,
he minimizes the social cost of having prices above
MC, by distorting prices more for those goods
whose demand is less elastic.5
The two-goods case is much more complex
when, instead of having independent goods, some
5 Given that at least some goods have to be priced above
MC to have budget balance, it is socially beneficial to
increase the price of the goods with more rigid demand, and
to leave the prices of others as close as possible to MC.
355
THE NATURAL GAS INDUSTRY FROM MONOPOLY TO COMPETITION
complementarities exist between the two. While
the maximization programme looks almost the
same, given the cross-effects we obtain:
p ⫺b l eq2,p2 ⫹eq1,p2 l 1
141111 ⫽ 122 1111132111 ⫽ 11 244
p1 1⫹l eq1,p1eq2,p2⫺eq1,p2eq2,p1 1⫹l ¥
e
where ¥e denotes the so-called super-elasticity. Note
that for normal goods the super-elasticity is always
positive except for complementary goods with
eq1,p2⬎eq2,p2
In this special case (which basically means that
an increase in the price of good 2 has a more
negative impact on the demand of good 1 than the
direct effect on q2), it is optimal to sell good 1
below its MC (incurring a loss), because this
implies an increase in sales of good 2 (which is
sold at a price higher than MC) which is
sufficiently large to compensate for the loss.6
In the presence of multi-product firms, it might
then be socially desirable that at least some of the
goods are priced above MC even in a first-best
framework if this implies that, via cross-subsidies,
other goods are sold below their MC. It is
interesting to notice, in such a framework, that a
regulated or nationalized firm can do better than
perfect competition.
An alternative approach, proposed by Demsetz
(1967) to deal with natural monopolies and, more
in general, with markets where competition is
difficult to achieve, consists in encouraging
competition for the market rather than within it.
Demsetz’s idea was to set up an auction to sell a
temporary right to serve a certain market with a set
of predetermined conditions. It is worth noticing
that an auction can be viewed basically as an ex
ante competition. The contract being temporary,
renegotiation occurs before each new auction –
allowing the regulator to take into account
technological or economic changes – and thus
ensures that the monopolist cannot abuse of its
power.
Meanwhile, the threat of possible competitors
gives incentives to the incumbent firm to reduce its
costs, ensuring the result of the subsequent auction
by proposing interesting market conditions.
This kind of design has many drawbacks, the
most important being that incumbent firms have
less incentive to choose long-term investments
because they might loose the auction in the future.
Two other downsides are that the incumbent firm
participating in an auction has an informational
advantage with respect to entrants and, finally, that
implementing this model might imply significant
transaction costs.
356
Up to now this chapter has considered that the
regulator is well informed about all of the relevant
variables, which is a strong and often not very
realistic assumption. In section 6.2.4 the perfect
information assumption is removed.
6.2.4 Regulation under
asymmetric information
Some generalities
The framework we considered in section 6.2.3
basically allowed the computation of the second-best
optimum. This has been possible because the
regulator has perfect information on the cost
function. This assumption being much more realistic
in the presence of a state-owned firm rather than a
private one, it is considered to be more appropriate
when facing a national firm, although it can be
applied to privately owned firms.7
Regulating a private firm is likely to raise
different problems from those analysed up to now.
As highlighted previously, a manager of a public
firm might even have some difficulties in
evaluating the real costs of their firm: clearly, for
the regulator of a private firm it is even more
difficult to obtain this information. On top of that,
one of the instruments of the social planner, when
the firm is nationalized, is to subsidize the
monopoly through taxes; but it might be politically
infeasible, for example, to have government
subsidization of a firm or to ask the firm to
deliberately make losses (i.e. to price at MC).
Transfers of money from government to the
firm are more likely to be allowed in the
6 The point is that a change in the price of good 2 has a
relatively big impact on the consumption of good 1, but a
small impact on good 2 itself. This implies that it is
profitable to increase the price of good 2 and reduce the
price of good 1: consumption of good 1 will dramatically
fall while good 2 demand will not decrease so sharply (it
might even increase, since we reduced the price of good 1).
The decrease in consumption of good 1 is beneficial
because this product is sold at a price lower than the MC,
and the increase in the price of good 2 raises the profit (and
allows to cover all the costs). An example of such a kind of
market could be the one for mobile telecommunication in
France or the UK: mobile phones can be bought for free or
at a price much lower than their MC, but then losses are
recovered by the extra-profits deriving from charging calls
above MC.
7 The privatization wave (due to public budget needs as
well as ideological reasons) that is observed in most of the
OECD (Organization for Economic Cooperation and
Development) countries and in the post-communist ones
explains why the most recent literature concentrates more on
regulation of private firms.
ENCYCLOPAEDIA OF HYDROCARBONS

procurement case. Loosely speaking, the
procurement case is when the government is the
only consumer of the good (it is the case, for
instance, for weapons firms). When the law allows
transfers, two very common regulating contracts
are the fixed-price and the cost-plus-fixed-fee
contracts.
The first one consists of fixing the price for a
good high enough to prevent the firm from making
losses. The second one is comprised of two
components: costs are entirely reimbursed, and
additionally, a fixed fee (independent of
performance) is transferred to the firm. It might
also be possible to construct a contract that is a
combination of the two, that is, total cost sharing
between the firm and the government, and a fixed
transfer as well.
The next two sub-sections are restricted to
regulation models that take into account
information asymmetries between the regulator
and the firm managers. Indeed, commitment
problems, as well as asymmetric and imperfect
information problems, induced economists to look
for new and more powerful schemes that take into
account developments in the literature on
incentives and principal-agent models.
With the Bayesian regulation,8 the regulator
does not observe some relevant variables or
functions (such as the demand function or the firm
marginal or fixed costs or both), and instead bases
its behaviour on some prior beliefs of those
variables. It then uses those beliefs to compute its
expected utility and then maximize it.
Adverse selection (i.e. the regulator does not
know the true cost of the firm) and moral hazard
(i.e. the regulator cannot observe the effort the
firm exerted to reduce its costs) are common
problems in this domain. The regulator then faces a
trade-off between giving the right incentives to the
firm to produce in an efficient way (thus choosing
the right effort and the right quantity and quality of
the final good) and extracting as much rent as
possible from the firm. Cost-plus and fixed-price
regulations represent the two extreme solutions to
this trade-off problem: fixed-price contracts ensure
the optimal effort but they are not efficient at all
from the rent-extraction point of view, conversely
all the contracts of the cost-plus type allow the
regulator to leave no rent to the firm, but do not
induce any effort.
Regulation under adverse selection:
the Baron and Myerson model
Hidden information problems can be of several
sorts: the regulator can, for example, lack some
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THE REGULATION THEORY AND ITS PROSPECTS
information on the cost function of the firm
(concerning fixed costs or marginal costs or both)
or it can be unaware of the demand function the
firm faces.
One of the first models considering the case of an
unobservable cost function is the Baron and Myerson
(1982) model. The cost function is linear: more
precisely, the firm faces costs C⫽bq, with fixed
costs normalized to zero. The MC, b, is the private
information of the firm and it determines the type of
the firm. This parameter can take two values:
{bL, bH} with probability (u) and (1⫺u) respectively.
Without loss of generality, consider bL⬍bH, then the
firm with MC bL is the most efficient one, while the
other one is the inefficient firm. The difference in
marginal cost is denoted Db. The regulator cannot
observe the true costs (i.e. the type of the firm) but
only the quantity produced.
The regulator can transfer an amount t of
money to the regulated firm. The profit of the firm
is calculated by the revenues from sales and the net
transfer of production costs:
P ⫽t ⫹p(q)q ⫺bq
where p(q) is the inverse demand function.
It is possible to include a moral hazard
component.9 Nevertheless, given the fact that the
MC is unobservable in this kind of model, it would
be impossible for the regulator to distinguish
between the moral hazard and the adverse selection
components. Thus, its behaviour would not be
affected by this change; the moral hazard
component would not give more economic insight
and would simply complicate notation.10 In fact,
when only the quantity is observable, a fixed-price
contract is the sole feasible option. In other words,
the regulator has no way to influence the level of
effort of the firm.
The original model of Baron and Myerson
(1982) considers a utilitarian social welfare
function, with different weights for consumers and
the firm, namely:
W⫽S(q)⫺p(q)q ⫺t ⫹aP
The parameter a, in this case, represents the
relative weight the regulator puts on the firm profit
8 This name comes from the fact that, in this kind of
model, agents attach to uncertain events a given probability,
which is computed using Bayes rule.
9 Introducing a moral hazard component means to have
a cost function of the type: C=(b⫺e)q, where e is the effort
and it costs Y(e) to the firm.
10 This kind of framework is known in the literature as
false moral hazard. An exhaustive analysis of it can be
found in chapter 7.1.4 of Laffont and Martimort (2002).
357
THE NATURAL GAS INDUSTRY FROM MONOPOLY TO COMPETITION
with respect to consumers’ surplus; there is no cost
of transaction or of collecting money for the
regulator.
The benchmark (first-best solution) is the
perfect information framework, which calls for MC
pricing, p(q)⫽S’(q)⫽b, leaving no rent to the firm
as long as the weight given to profits is smaller
than or equal to one.
The social welfare function can also attribute
the same weight to both consumers and the firm.
Consider that collecting money to finance the
transfers has a social cost l. With this alternative
formulation, the social welfare function becomes
W⫽S(q)⫺lt ⫺bq
and one is back to the framework considered in
section 6.2.3. It is known that, under perfect
information, the optimal pricing strategy is given
by the formula:
p(q)⫺b
124 l 123
11 ⫽ 11 1 (IRH) P(bH,bH)⫽0
p(q) 1⫹l ep,q
which coincides with the Ramsey Pricing solution
already discussed.
The regulator creates a direct mechanism, i.e.
a set of rules inducing the agent to declare its
type. Revelation occurs because the agent, by its
behaviour, ineluctably furnishes some
information (sends a message) to the principal.
The mechanism is said to be ‘truth-telling’ if it is
in the interest of the agent to reveal to the
principal its true type. In this case, a mechanism
consists in a menu of contracts. Each contract is a
‘transfer-price’ pair. The regulator proposes a
menu of two contracts, (tH, pH) and (tL, pL),
respectively designed for the inefficient and for
the efficient type.
Under asymmetric information, the firm
chooses one contract among those proposed by the
regulator. If the mechanism is well designed, the
firm chooses the contract that is intended for it. A
firm of type b can always pretend to be of type b,
thus it maximizes its profit:
P(b;b̃)⫽t(b̃)⫹p(q(b̃))q(b̃)⫺bq(b̃).
To ensure that each type chooses the contract
designed for it, one must check that the most
efficient firm has no incentives to mimic the less
efficient one and vice versa.
Following the classical literature on
information economics, we can construct the
Incentive Compatibility (IC) constraint and the
Individual Rationality (IR) constraint for the two
types of firms. Recall that the IR, also called
participation constraint, ensures that a rational
358
agent is willing to participate, that is: its
reservation utility (the payoff it can obtain by
staying out of the market) is lower than the one that
it can get if it decides to enter into the market. The
IC is a restriction that is imposed to make certain
that no type wants to mimic another one, that is:
for all types, truth-telling is the best strategy to
pursue.
Clearly it is not in the interest of an inefficient
firm to pretend to be of the efficient type. Since,
ceteris paribus, the surplus of the efficient firm is
always higher than the other’s, when the
participation constraint of the inefficient firm is
fulfilled so is the one of the efficient one. As a
consequence, the only two relevant constraints are
the IC for the efficient firm and the IR of the
inefficient one.
Normalizing the reservation utility of firms to
zero, one can construct the two constraints:
and
(ICL) P(bL,bL)⭓P(bL,bH)
The interpretation of IRH is simply that any rent is
left to the inefficient firm. Concerning ICL, it
means that the profit of the firm must be higher
when it chooses the contract designed for it than if
it mimics the inefficient one.
The optimal price the regulator chooses for the
efficient firm is pL⫽bL (in other words, the
efficient firm is asked to price at MC) and for the
inefficient one
u
pH ⫽bH ⫹ 1441 (1⫺l)Db
1⫺u
which means that the inefficient firm is allowed to
price above its MC. The distortion is given by the
second term
14u41 (1⫺l)Db
1⫺u
which represents the trade-off between rent
extraction from the efficient firm and cost
inefficiency when the inefficient firm produces.
The quantity produced is the optimal one for the
efficient type, while it is lower for the other.
The rents of the firms are respectively:
P(bL,bL)⫽Db q( pH) and P(bH,bH)⫽0, thus the
efficient firm enjoys a rent which is proportional to
the quantity produced by the inefficient one, and to
its informational rent, which is the difference in
costs between the two firms. The more a type is
efficient with respect to the other, the higher the
profit the regulator has to allow it, to ensure that
ENCYCLOPAEDIA OF HYDROCARBONS

the efficient type does not try to mimic the
inefficient one.
From Baron and Myerson (1982) model it can
be generally concluded that, under cost
unobservability, it is impossible to construct an
efficient scheme to induce both types to produce
the right quantity. Moreover, the informational rent
of the efficient firm allows it to obtain an
additional profit. This second result is basically the
same as Sappington (1982).
Baron and Besanko (1984) extended Baron and
Myerson (1982) adding two components: firstly,
the regulator can observe the firm type b at a cost
K; secondly, the cost function is composed by an
additional and random term, a noise e that the
regulator can never observe. Ex ante, the regulator
makes a transfer t(b) to the firm depending on the
declaration of the latter; in the second period,
possibly having observed the true type of the firm,
the regulator can impose a tax (also interpreted as a
fine) to the firm.
Baron and Besanko (1984) conclude that the
optimal tax has to be increasing in the difference
between the declared efficiency of the firm and the
true one, and thus is basically decreasing in b. This
result is true as long as there is not a moral hazard
problem (but only adverse selection ones) because,
otherwise, it would give an incentive to the firm to
increase its costs rather than make an effort to
reduce them. Introducing the possibility for the
regulator to buy information on the type of the
firm, the informational rent of the efficient firm is
lower.
The reasoning behind this idea is that, since
the regulator can obtain the information, it loses
value, and therefore, the informational rent is
inferior, which means that rent extraction is
greater and the difference in profits among the
two types is smaller. Finally, it can be shown
that in this framework the final price is lower
and that, provided the regulator chooses to audit
the firms, for firms with a higher declared b
(less efficient type) the likelihood of being
audited is higher.
While the two foregoing models assume that
the regulator has limited information on the cost
function, Lewis and Sappington (1988) explores
the case of a regulator that can observe neither the
cost function C(q) nor the quantity produced. The
demand function faced by the firm is defined as
Q( p,b), where b is the parameter known to the
firm but not to the regulator, who only knows the
probability of b being high (bH) or low (bL). Prices
have a negative impact on the demand function,
namely
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
THE REGULATION THEORY AND ITS PROSPECTS
⭸Q
11 ⬍0
⭸p
while demand increases in b: for any given price,
Q( p,bH)⭓Q(p,bL).
The firm is forced to serve all of the market at
the price p(b) chosen by the regulator, in exchange
it receives a transfer t. Its profit is:
P(b)⫽t(b)⫹pQ( p,b)⫺C[Q( p,b)]
The social welfare function is the same as Baron
and Myerson (1982):
W⫽S(q,b)⫺pQ( p,b)⫺t(b)⫹aP ⫽
⫽S(q,b)⫺(1a) PC(Q( p,b))
with no cost of public funds and a social planner
who considers consumers’ and firm utility
differently. While, for the case of perfect
information, the equilibrium implies full rent
extraction and price equal to MC. Under
asymmetric information one obtains results that are
different from Baron and Myerson (1982). In
particular, the finding is that, under decreasing
returns to scale, first-best can be achieved through
offering a contract
p*(b¥)⫽CM;
 t(b¥)⫽C(Q( p*(b¥);b¥))⫺p*(b¥)Q( p*(b¥);b¥) 
Notice that this interesting result holds only
with this particular model; if one introduces some
costs to public funds, it no longer holds true. In
that case, one would find that the optimal price is
the Ramsey price (which is above MC), and thus,
the firm has an interest in decreasing the quantity
sold. Under increasing returns to scale, results
depend on the shape of the demand function.
All of these models have been extended to
consider the case of a firm that produces several
goods that have to be regulated. Under these
circumstances, some other factors have to be taken
into account; among them, it is crucial to know
whether goods are substitutes or complements. An
extensive analysis of the regulation of multiproduct
firms can be found in Baumol et al. (1982) or in
Laffont and Tirole (1993). Some general results of
this literature are that the optimal pricing for each
good is the one for which the Lerner’s index is
equal to Ramsey pricing, adjusted to be incentive
compatible. Moreover, Ramsey pricing, in the
absence of a budget constraint, depends only on
the demand function, and in no way does it depend
on the cost function. Rent extraction is limited by
incentive compatibility (which might depend on
costs). When a firm is able to reallocate effort and
costs through brands, it might be better to simply
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THE NATURAL GAS INDUSTRY FROM MONOPOLY TO COMPETITION
consider the aggregate costs and efforts of the firm
(which moreover allows to decrease auditing costs)
than to monitor costs of the different sectors and
interfere with the investments of the firm and
effort choices, which might be sub-optimal.
Whatever the framework and the model, a
general conclusion that one would be tempted to
draw is that, in the presence of asymmetric
information, the regulator will not be able to apply
the first-best solution. Instead, he will make the
second-best choice and let a rent to the efficient
type, which will produce the right amount of a
good and will choose the optimal effort, while the
less efficient type will not get any rent and will
produce less than what it would had it been
optimal.
It has already been demonstrated that the first
part of the statement is false, that is: the regulator
can sometimes achieve the first-best solution even
under incomplete/asymmetric information, as
observed, for instance, in Lewis and Sappington
(1988) under decreasing returns to scale. Also, the
second statement might be false. For instance, take
the case of countervailing incentives: suppose there
is asymmetric information both on variable and on
fixed costs. It is quite common to have negative
correlation between fixed and variable costs. This
implies that there is no longer an a priori efficient
and an a priori inefficient type, but one firm
(FL;CH) with low fixed costs and high variable
costs, and another (FH;CL) with high fixed costs
and low variable costs. The first one is
recommended when a low level of production is
needed, while the second one is preferred for high
levels. To be more specific, three types of
equilibrium are possible:
• (FH⫺FL)⬍q(FL;CH)(CH⫺CL): this is the
standard case of no-distortion at the top (price
at MC for the low MC type and price above
MC for the other);
• (FH⫺FL)⬎q(FH;CL)(CH⫺CL): the optimal price
is equal to MC for the high MC firm, and
below MC for the other;
• q(FL;CH)(CH⫺CL)⬍(FH⫺FL⬍q(FH;CL)(CH⫺CL):
price is equal to MC for both firms.
Regulation under adverse selection and moral
hazard: the Laffont and Tirole model
In the following segment, except where
specified, the firm under consideration will have a
cost function of the type C⫽C(b,e,...)⫹e, with
costs that are increasing in the adverse selection
parameter b (technological factor), and decreasing
and convex in the moral hazard parameter e (which
represents the effort). Y(e) is the manager’s
360
disutility of effort and its first, second, and third
derivatives are all positive.11
Starting with the simplest possible model, one
considers the case of a regulator that wants to bring
a unique project of fixed size to fruition.
Subsequently one allows for a variable size of the
project, which implies a further concern for
pricing.
The cost function is assumed to be linear, i.e.
C⫽b⫺e, l is the social cost of public funding,
and the government reimburses the firm its costs,
plus a transfer t. The reservation utility of the
firm is normalized to zero. Since public funding
is costly, the regulator wants to extract as much
rent as possible from the firm, even when
considering a Benthamite (or utilitarian) social
welfare function that puts equal weight on the
firm profits and the consumers’ surplus. It is
straightforward to conclude that, under perfect
information (the first-best solution), the regulator
would pay the firm only its costs, including the
cost of effort Y(e); and the firm would choose
the optimal level of effort.
In this framework, a fixed-price contract could
accomplish the first-best solution and, moreover,
the regulator does not even need to monitor the
effort level, as long as it knows which level of
effort is the optimal one.
Unfortunately, perfect observability of both
costs and effort is not a frequent scenario. Consider
then that the regulator can only observe total costs
and knows that the parameter b can take two
values, namely b⫽{bL,bH}. In the two-type case,
the regulator offers two contracts to the firm,
specifying a transfer based on the observable total
cost adapted to the two possible values of b.
From the cost function, one can express the
effort as e⫽b⫺C and thus the cost of effort as
Y(b⫺C). The utility function of a firm is given by:
P(b)⫽t(b)⫺Y[b ⫺C(b)].
Not surprisingly, if the regulator problem is solved,
it is found that the IR of the less efficient type and
the IC of the most efficient type are both binding,
while the two other constraints are not.
Finally, given the prior probabilities n and
(1⫺n) that the firm is of a given type (the efficient
and the inefficient one respectively), one can
construct the regulator maximization program,
which will be:
11 The meaning of the restrictions on the first two
derivatives is clear: effort is costly and the cost is convex in
the effort. The restriction on the third derivative is for
technical convenience.
ENCYCLOPAEDIA OF HYDROCARBONS

maxn{S ⫺(1⫹l)[C(bL)⫹Y(bL ⫺C(bL))]⫺
⫺lP(bL)}⫹(1⫺n){S ⫺(1⫹l)[C(bH)⫹
⫹Y(bH ⫺C(bH))]⫺lP(bH)}
so that
nt(bL)⫹(1⫺n)t(bH)⫺Y(e)⫽0 (IR)
t(bL)⫺t(bH)⫽DY(e) (IC)
Solving the maximization problem, one obtains the
standard result of ‘no distortion at the top, no rent at
the bottom’. Specifically, the efficient type (bL) will
choose the efficient level of effort and will get a
rent12:
P ⫽Y(bH ⫺C(bH))⫺Y[bL ⫺C(bH)]
Conversely, the less efficient type chooses a
level of effort lower than the optimal one and does
not appropriate any rent. These results show that
asymmetric information reduces the power of
incentive schemes, and thus, of regulation, and
furthermore leaves a rent to the more efficient
firms. Generally, when the probability of being an
efficient type is higher it is possible to extract more
rent.
To conclude, the regulator proposes two
contracts (each of them designed for a particular
type) to the firm. Similar to the case of second
degree price discrimination, the firm chooses its
preferred contract and, in some sense, reveals its
true type. This fact has important consequences for
the enforceability of contracts: the regulator, once
it discovers that the firm is of the efficient type,
would be tempted to change the contract so as to
achieve the first-best solution (proposing a new
contract which is not IC). If this were the case, in a
repeated game, it would be impossible to induce a
first or second-best effort. This problem can be
overcome if contracts are enforceable by a court, or
if the regulator has a reputation for respecting
contracts.
Given the central role of information in
regulation, and, in particular, since a deeper
knowledge of the market can allow the regulator to
extract more rent or to induce higher effort, the
regulator will try to gather as much information as
possible.
Yardstick regulation is a basic way to learn
about the firm cost structure, its technology, and its
potential for reducing its costs. It consists in
comparing performances of different firms, either
in the same country or abroad, and rewarding those
that are performing better. This, of course, can be
done in the presence of several firms operating in
the same sector, or in similar ones that are not
competing in a common market, provided that the
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THE REGULATION THEORY AND ITS PROSPECTS
conditions under which they operate are
comparable, e.g. when the regulator controls
different geographical areas of the same,
fragmented market. In the presence of local
monopolies, if no idiosyncratic factors (such as
geographic, cultural or historical reasons) make it
impossible to compare markets, the regulator can
evaluate the relative performances of the local
monopolists and subsequently reward or punish
them. Of course, when the regulating agency has
all the necessary information, it can also carry out
yardstick competition, measuring a national firm
performance relative to its foreign counterpart. It
would even be possible to compare firms that
produce different goods, provided that the
technological environment is the same.
To implement yardstick competition, a model is
constructed that takes into account two
components of b, an idiosyncratic one and a
common one. If the latter part is null then one
returns to the former model. Conversely, when the
first component is absent, it is possible to obtain
more information on the two competitors and
attain the first-best solution by offering to the two
firms a contract with a fixed price that takes into
consideration the relative performance of the two
regulated firms. Of course, in all the intermediate
cases, the solution will be a weighted average of
the two previous cases. Yardstick competition is
then a very powerful instrument for the regulator to
obtain a final outcome much closer to the first-best
solution.
6.2.5 Capturing
Most of economic theory and, in particular, on the
economics of regulation, is based on a simple but
very strong assumption: public authorities (i.e.
politicians, the regulator, or more generally the
hypothetical social planner) are benevolent: all of
their decisions are made with the aim of
maximizing a given social welfare function, and
they always behave in the public interest.
What one observes in reality is not always
what economic theory would have predicted, and
12 This rent is called ‘informational rent’ and it is the
utility the regulator has to leave to the most efficient type so
as to convince it not to mimic the less efficient type. This
rent is a function of the effort exerted in equilibrium by the
bad type. This is the reason why the regulator wants the bad
type to choose a low level of effort, because the cost (i.e. the
additional rent he should leave to the efficient type to
prevent it from mimicking the ‘bad’ type) of implementing a
high level of effort would be too high.
361
THE NATURAL GAS INDUSTRY FROM MONOPOLY TO COMPETITION
often politicians behave in a manner different
from what is recommended by economists. To
explain this discrepancy, another theory has been
developed. Interest groups or lobbies can have a
major impact on policy formation. The idea that
economic agents can capture public institutions
is quite old in political science theory, and
slightly more recent in economic theory. The
first essays on this topic considered that big
trusts and lobbies were more eager to capture
politicians. Stigler (1971) shows that small
business industries are also able to capture policy
makers. Of course, big enterprises or powerful
consumer groups are more likely to have enough
power to capture politicians.
The Chicago school, with Stigler and Peltzman
among others, has been prolific on that subject
during the last three decades. Nevertheless, one
cannot neglect that most of these articles,
especially the less recent ones, do not take into
account the concerns raised by asymmetric
information. Given that under full information the
regulator is generally able to fully extract the rent
of the firm, it would be much harder to convince
the regulator to deviate from the best policy (also
because it might be difficult for the regulator to
motivate the choices of the firm). Under
asymmetric information it is significantly easier to
influence the regulator’s choice and convince it to
prefer one kind of intervention over another.
The ways in which lobbies try to influence
policy makers are numerous: bribes are not legal
and thus less common than one would expect;
bribery also has a low frequency because it could
eliminate the future opportunity for the lobby to
work with the regulated firm;13 firms might
promise not to publicly criticize the regulator and,
on the contrary, praise the regulating agency
employees; finally, firms can influence, bribe, or
negotiate with a third party (i.e. politicians,
economic advisors, medias, workers, citizens, or
shareholders) to convince the regulator to adopt
some particular behaviour.
To model a capture, one can construct a
hypothesis where the principal is the parliament,
the agent is the regulator, and there will be a
monopolist, and consumer associations. The
parliament has no information about the firm
costs or market demand, and thus, legislates
following the advice of the regulator and making
use of the information provided by it. Capturing
the regulator is costly and inefficient: the cost of
transferring a sum to the agent is increased by a
factor l (that is: the shadow price of a transfer is l
and it embodies both the risk of moral, pecuniary
362
or judiciary sanction and the organizational cost of
lobbying).
The parliament can punish the agency, and
maximizes the sum of the utility of all of the
agents in the economy. Benevolence of the
parliament is an over-simplification to make the
model more tractable; clearly it is itself exposed to
lobbying efforts.
Consider a simple model: firms can be of two
types {bL,bH}, their cost function is C⫽(b⫺e)q
and they receive a net transfer from the
parliament: T⫽t⫺Y(e). The agency is also
financed by the parliament. Its utility is the
difference between the transfer, s, that the
parliament accords to it and its reservation utility
s*. With some positive probability (smaller than
one), the agency obtains information on the true
type of the firm. The interest group knows
whether or not the agency received the signal
about its type. If the agency has information, it
can either report it to the congress or hide it. The
parliament maximizes total welfare. Since
collecting money is costly, the parliament will try
to minimize transfers to the firm and to the
agency.
As a benchmark, consider the case where the
cost of capturing is so high that it never occurs.
The agency has no incentive to misreport, and the
parliament chooses transfers so as to satisfy the
participation constraint, leaving no rent to either
the firm or the agency.
Suppose now that the transfer is feasible and
that the cost of a transfer from the firm to the
agency is null. Without entering into the details of
the model, its solution gives us the following
results: only the efficient type can have an interest
in capturing the agency, because the parliament
will always, at most, offer a contract that makes
the inefficient firm indifferent (that means that the
inefficient firm cannot increase its utility by
capturing the agency). Knowing that, the reaction
of the parliament is to try to decrease the incentive
for efficient firms to mimic the inefficient ones.
To do this, it reduces the rent of efficient firms.
Overall, the possibility that groups capture the
agency leads to a reduction both in the power of
regulation (i.e. the agency has less authority, and
13 To reduce the likelihood that their employees are
captured, most regulatory agencies prohibit them from
working for regulated firms more than a few years in a row
(often four or five years). Since, during these years, these
employees become experts in the domain of the regulated
firm, it is often the case that firms are prone to hire former
regulators.
ENCYCLOPAEDIA OF HYDROCARBONS

incentive schemes are less high-powered), and in
the overall welfare, even though some economic
agents might benefit. It is possible that, all factors
being, the presence of an interest group leads to a
reduction of its members’ profit.
6.2.6 Privatization
Up to now, the discussion in this chapter has been
focused on the regulation of private firms and the
management of nationalized firms, but the
question has not been asked as to whether it is
better to have a public or a private firm, which is a
major concern in this era of privatization.
The first privatization of the modern era is
probably the one of Volkswagen in Germany,
during the 1960s. However, the first important
wave of privatizations occurred in the UK under
Margaret Thatcher in the 1970s. This wave first
touched select industries and the banking sector
then, subsequently, telecommunications, transport,
gas, and electricity. In France and in Italy a first
attempt to privatize occurred in the 1980s,14 but it
is in the last few years that many important firms
have been at least partially privatized, such as
Renault, Thomson Multimedia, EDF and Eni (the
French energy firm and its Italian counterpart),
France Telecom and Telecom Italia.
The main drawback of public firms is that the
capital employed in the firm could have been
employed in a more efficient way, e.g. raising
profits that could be used to reduce distortionary
taxes or to redistribute wealth.
The main limit of private regulated firms is that
managers respond to two principals (the
shareholders and the regulator) who have divergent
objectives. The distortion deriving therefrom has
been described as being similar to the double
marginalization problem that occurs when two
monopolists are not coordinated.
The main conclusions of Laffont and Tirole’s
(1993) analysis of privatization are that this
conflict of interest between the two principals
reduces the effectiveness of the regulator and the
incentives for the firm managers who are more
eager to invest in noncontractible investments
(since they might profit more from them).
At the same time, nationalized firm managers
have to invest in order to serve aims different from
economic efficiency (e.g. unemployment
reduction). As a consequence, both public and
private firm managers are often not efficient in
cost reduction, and total welfare is lower than its
optimal level. A priori it is almost impossible to
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THE REGULATION THEORY AND ITS PROSPECTS
provide general statements on whether it is
preferable to have a nationalized or a private
regulated firm. Many more specific models have
been proposed to answer this question: among
them, Shapiro and Willig (1990), and Schmidt
(1990).
Siniscalco et al. (2001) is a much more
practical and empirical work, mainly focused on
the energy market. According to their conclusions,
two main reasons pushed finance ministries all
over the EU to privatize many state-owned firms:
budget concerns, and promotion of efficiency and
liberalization.
Since liberalization means an increase in
competition and a reduction in profits, one might
think that it should decrease the value of the
shares, and thus, it doesn’t seem optimal to
liberalize before selling the shares when the aim of
privatization is to reduce public deficit. In this
chapter it is shown that, at least in the energy
market, this is not the case and that it is better to
liberalize before starting the privatization process.
The main conclusions of Siniscalco et al.
(2001) are that there exists a negative relation
between the speed of privatization and the level of
vertical integration of a firm: vertical integration is
not good for competition because a vertically
integrated firm can subsidize less efficient sectors
via cross-subsidies; it becomes necessary to
restructure vertically integrated structures before
privatizing them.
Moreover, Siniscalco et al. (2001) observed a
positive correlation between the level of regulation
and the level of privatization. Good regulation
systems generate spill-overs to the capital market
and they are essential to have complete
privatization. The percentage of stocks sold is
proportional to the level of both vertical
disintegration and regulation.
The speed and quality of privatization varies
from country to country for several reasons:
institutional and legal factors can matter, but good
regulation and a competitive market are especially
crucial. This counter-intuitive result is because
agents anticipate that the market will be regulated:
an already regulated market has the advantage that
risk and uncertainty are reduced.
Siniscalco et al. (2001) conclude that vertical
disintegration and high regulation in electricity are
beneficial and make private regulated firms more
attractive (from the benevolent social planner
14 This privatization concerned, among others, Paribas
and many other French banks, Elf Aquitaine, SIRTI and
Alitalia.
363
THE NATURAL GAS INDUSTRY FROM MONOPOLY TO COMPETITION
perspective) than a state-owned firm. The fact that
privatizing a public monopoly allows for the
further transformation of the market into a more
competitive, private, regulated structure, further
reduces the rationale for public firms.
6.2.7 Conclusions
This chapter, which clearly could not be an exhaustive
review of all regulation literature, is focused on the
most recent aspects of regulation. Among the topics
not developed here, recent literature examines some
aspects that are particularly interesting: concerning the
framework in which the regulator operates, important
analyses have been carried on to determine the impact
of risk aversion. Several other studies focused on the
regulation in the presence of multidimensional
information asymmetries, of multiproduct firms, of
oligopolistic markets, of vertically integrated firms,
and the impact of regulation on the underlying
interactions among firms and goods. Finally, part of
the literature concentrated on the consequences of
regulation on quality and in particular on the
possibility to guarantee that regulation policies do not
negatively affect the quality of goods and services.15
The main conclusion drawn in this work is that
the regulator, missing crucial information on the
firm and/or on the market, has to induce the firm
to behave in a way compatible with social
objectives. To do that, the regulator has to give the
right incentives so as to change the utility function
of the firm in the desired direction. The regulator’s
actions dramatically depend on many factors,
among the most crucial being: its information set,
the power it receives from the government, and its
commitment ability.
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Journal of Economics», 84, 488-500.
Auriol E., Laffont J.-J. (1992) Regulation by duopoly,
«Journal of Economics and Management Strategy», 1, 507-
533.
Baldwin R. et al. (1998) A reader on regulation, Oxford,
Oxford University Press.
Berg S.V., Tschirhart J. (1988) Natural monopoly regulation,
Cambridge, Cambridge University Press.
Gence-Creux C. (2000) Regulation with a risk-averse
principal, in: Econometric Society world congress 2000
contributed papers from Econometric Society, Seattle (WA),
11-16 August, Paper 0588.
Loeb M., Magat W. (1979) A decentralized method of utility
regulation, «Journal of Law and Economics», 22, 399-404.
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Spulberg D.F. (1989) Regulation and markets, Cambridge
(MA), MIT Press.
References
Armstrong M., Sappington D. (2003) Recent developments
in the theory of regulation, Working Paper.
Baron D.P., Besanko D. (1984) Regulation, asymmetric
information and auditing, «Rand Journal of Economics»,
15, 447-470.
Baron D.P., Myerson R. (1982) Regulating a monopolist
with unknown costs, «Econometrica», 50, 911-930.
Baumol W. et al. (1977) Weak invisible hand theorems on the
sustainability of prices in a multiproduct natural monopoly,
«American Economic Review», 67, 350-365.
Baumol W. et al. (1982) Contestable markets and the theory
of industry structure, New York, Harcourt Brace Jovanovich.
Beard R. et al. (2001) Regulation, vertical integration, and
sabotage, «Journal of Industrial Economics», 49, 319-333.
Demsetz H. (1967) Toward a theory of property rights,
«American Economic Review», 57, 347-359.
Joskow P.L. (1974) Inflation and environmental concern:
structural change in the process of public utility price
regulation, «Journal of Law and Economics», 17, 291-327.
Laffont J.J., Martimort D. (2002) The theory of incentives.
The principal-agent model, Princeton (NJ), Princeton
University Press.
Laffont J.J., Rochet J.C. (1998) Regulation of a risk-averse
agent, «Games and Economic Behaviour», 25, 199-213.
Laffont J.J., Tirole J. (1993) A theory of incentives in
procurement and regulation, Cambridge (MA), MIT Press.
Lee S.H., Hamilton J. (1999) Using market structure to
regulate a vertically integrated monopolist, «Journal of
Regulatory Economics», 15, 223-248.
Lewis T., Sappington D. (1988) Regulating a monopolist with
unknown demand, «American Economic Review», 78, 986-
998.
Mackay R.J. et al. (1987) Public choice and regulation,
Stanford (CA), Hoover Institution Press.
Olsen E.O. (1972) An economic analysis of rent control in
new York City, «Journal of Political Economy», 80, 1081-
1100.
Sanders M.E. (1981) The regulation of natural gas. Policy
and politics 1938-1978, Philadelphia (PA), Temple
University Press.
Sappington D. (1982) Optimal regulation of research and
development under imperfect information, «Bell Journal
of Economics», 13, 354-368.
Scarpa C. (1998) Minimum quality standards with more than
two firms, «International Journal of Industrial Organization»,
16, 665-676.
Schmidt K. (1990) The costs and benefits of privatization,
Bonn, Bonn Universität, Discussion Paper A330.
15 Laffont and Tirole (1993) and Armstrong and
Sappington (2003) offer a detailed analysis of most of these
topics. Some particularly interesting papers on these
subjects are: Laffont and Rochet (1998,) Scarpa (1998), Lee
and Hamilton (1999), and Beard et al. (2001).
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 THE REGULATION THEORY AND ITS PROSPECTS

Shapiro C., Willig R.D. (1990) Economic rationales for the Williamson O.E. (1976) Franchise bidding for natural
scope of privatization, Princeton (NJ), Princeton University monopolies, «Bell Journal of Economics», Spring, 73-104.
Press.
Siniscalco D. et al. (2001) Regulation and privatization: David Bardey
the case of electricity, in: Amato G. (edited by) The
anticompetitive impact of regulation, Cheltenham, Elgar,
Amedeo Piolatto
220-244. Toulouse School of Economics
Spiller P.T. (1990) Politicians, interest groups and regulators: Université de Toulouse
a multiple principals agency theory of regulation, «Journal Toulouse, France
of Law and Economics», 33, 65-101.
Stigler G. (1971) The theory of economic regulation, «Bell We are grateful to Andrea Amelio, Sara Biancini, Federico
Journal of Economics», Spring, 3-21. Boffa and Florian Schutt for helpful comments.

VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION 365


The American point of view
7.1.1 Introduction
The United States of America is the world’s largest
energy producer, consumer, and net importer. In
recent years, it has depended on oil for about 40%
of its total primary energy requirements followed
by natural gas at approximately 24%. Despite this
overwhelming dependence on these hydrocarbon
resources, the nation has limited proven reserves of
both fuels. At the end of 2004, the US had 30.7
billion barrels of oil (2.7% of world’s total proven
reserves) and 5.23 trillion cubic metres of natural
gas (3.0% of world’s total proven reserves). These
limited reserves have not restrained production.
The US is the world’s third largest oil producer,
after Saudi Arabia and Russia, and the world’s
second largest natural gas producer, after Russia.
Most of US oil production comes from Texas,
Louisiana, Alaska, and California, while natural
gas production is concentrated in Texas, New
Mexico, Oklahoma, and Wyoming.
This huge amount of production means that oil
and natural gas reservoirs are rapidly depleting. To
complicate things further, consumption of the two
fuels is rising at an alarming rate. Thus, the
growing gap between production and consumption
is being increasingly filled by imports from other
oil and gas producing countries. By early 2005, the
United States imported approximately 58% and
17% to meet its oil and natural gas consumption
respectively. Most of the oil is imported from
Canada, Mexico, Saudi Arabia, and Venezuela,
while an overwhelming amount of the gas is
imported from Canada, and to a far lesser extent
from Trinidad, Algeria, and Qatar.
Faced with a steady growing dependence on
imported oil and natural gas supplies to meet its
expanding energy needs, the United States has
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
7.1
failed to articulate a coherent long-term national
energy policy. Both Democrat and Republican
administrations have not been able to reach a
consensus on an appropriate means to address
energy insecurity. Under President Franklin Delano
Roosevelt’s administration there was a strong belief
that the government could not solve the economic
problems facing the country without playing a role
in oil policy, which was considered a vital factor in
economic recovery. The intention was not to
nationalize the industry or make the industry
public, but to coordinate its activities. The President
Dwight David Eisenhower’s administration was
convinced that the growing share of imported oil in
US energy consumption represented a challenge to
the country’s national security and also to its
prominent role in world affairs. Accordingly,
Eisenhower’s energy policy aimed at reducing the
share of imported foreign oil and relying more on
oil supplies from Canada and Mexico, rather than
from faraway producers. Thus, after two years of
requesting voluntary import quotas, which oil
companies did not comply with, the President made
them mandatory in 1959. The impact of this
mandatory import quotas programme on U.S. oil
policy was varied. The United States became
relatively independent of foreign oil supplies during
most of the 1960s. Meanwhile, consumers had to
pay a higher price for Canadian oil. At the same
time, the programme stimulated production levels
that eroded domestic reserves rather than creating
stockpiles and spare capacity.
The Nixon and Carter administrations had to
deal with some of the most serious oil crises. In the
early 1970s, American domestic oil production
began its steady decline. Consequently, the
country’s dependence on imported oil increased.
Under these unfavourable circumstances the first
367
GEOPOLITICS AND SECURITY
price shock and an Arab oil embargo took place.
These two related events underscored America’s
sense of vulnerability to disruption of foreign
supplies. In response, Richard Nixon announced a
plan called Project Independence, the aim of which
was to develop domestic resources to meet the
nation’s energy needs without depending on
foreign suppliers. Nixon’s successor, Gerald Ford,
recommended a comprehensive energy programme
that featured higher taxes on imported oil and the
gradual phasing out of price controls that the
government had placed on domestic oil. He also
signed the Energy Policy and Conservation Act,
which authorized the establishment of the Strategic
Petroleum Reserve (SPR).
Coming to office in January 1977, Jimmy Carter
judged the energy crisis to be a national emergency
and offered a programme to deal with it. Breaking
with his predecessors, Carter focused more on the
demand side than the supply side of the energy
equation. His programme called for: reduced overall
energy consumption; significantly reduced imports;
increased reliance on coal and renewable sources of
energy like sunlight, wind, and wood; higher
gasoline taxes; and various tax credits and incentives
to encourage more efficient automobiles and home
insulation. Also, at the president’s request, Congress
created a new cabinet post in 1977, the Department
of Energy.
During most of the 1970s, the official objective
of US energy policy was to reduce dependence on
imported oil. The collapse of oil prices that
followed the global oil glut in the mid-1980s
undermined the sense of urgency to take drastic
action to control and restrain the American appetite
for more energy. Thus, few significant new federal
energy policy initiatives emerged during Ronald
Reagan’s administration or George H. W. Bush’s
administration. The two presidents, however,
managed to complete the process of deregulating
oil and natural gas prices. Throughout the 1980s
and early 1990s, the centrepiece of US energy
policy was to foster, at home and abroad,
deregulated markets that efficiently allocated
capital, provided a maximum of consumer choice,
and promoted low prices through competition. This
trend continued under President Bill Clinton’s
administration. Two characteristics shaped the
United States energy policy in the 1990s: real
energy prices were stable at low levels, and there
was no serious threat of disruption to oil supplies.
Therefore, there was no need for a sweeping new
energy policy or major energy policy initiative.
Since late in 1999, oil prices have been stable at
a much higher level than those in the 1990s. These
368
higher oil prices have reinstated and strengthened
the sense of energy vulnerability and the need to
formulate and implement a national energy policy.
Responding to this perceived energy crisis,
President George W. Bush established the National
Energy Policy Development Group (NEPDG) and
directed it to develop a national energy policy. Vice
President Dick Cheney headed the NEPDG, and in
May 2001 presented its assessment of the ‘energy
crisis’ in addition to a long list of recommendations
to avert the crisis and to enhance the nation’s
energy security. The thrust of these
recommendations was a long-term energy policy
that would include a broad combination of
measures to stimulate domestic production,
provide incentives for conservation, promote clean
technologies, and eliminate political barriers to
world markets. In other words, the NEPDG
recommended that the United States should address
both the demand and supply sides of the energy
equation and should diversify both the energy mix
and the energy sources. These issues will be
examined in detail in this chapter.
Specifically, the analysis will focus on national
measures to enhance the country’s energy security.
These measures include: the establishment of the
SPR, the potential development of the Arctic
National Wildlife Refuge (ANWR), deep-water
exploration in the US portion of the Gulf of
Mexico (GOM), and the growing role of natural
gas, coal, and nuclear power in the nation’s energy
mix. Internationally, the study will examine
Washington’s efforts to reduce its dependence on
Middle Eastern oil by consolidating strategic ties
with energy-rich regions such as Russia, the
Caspian Sea, and West Africa.
Energy security is simply defined as
sustainable and reliable supplies at reasonable
prices. The core for the sustainability and
reliability of supplies is the diversity of suppliers.
Rhetoric aside, this study argues that the calls to
achieve energy independence are unrealistic. The
United States does not have enough oil and natural
gas resources to meet its growing demand.
Furthermore, the nation’s production of both fuels
is falling, due to the maturity of the fields. Greater
energy efficiency, deep-water exploration and the
development of ANWR might temporarily slow
down Washington’s dependence on foreign
supplies but the direction is inevitable: deeper
dependence on foreign supplies.
The United States is a major player in the
global economic system. Within this system there
is one well-integrated oil market (the gas markets
are slowly but surely following suit). This means
ENCYCLOPAEDIA OF HYDROCARBONS

that oil and natural gas producers and consumers
share a common goal: stability of supplies and
prices. It does not matter who sells and who buys a
barrel of oil because, at the end of the day, the
market and prices adjust. The main characteristic
of today’s energy market is the interdependence
between all of the players (i.e. producers,
consumers, and oil companies). The United States
should overcome the illusion of energy
independence and instead work with other
consuming countries to ensure the availability of
oil and gas supplies from as many sources as
possible. Simultaneously, major consuming
countries should work with oil and gas producers
to promote economic development and political
stability. The outcome of these joint efforts would
strengthen and ensure global energy security.
7.1.2 The Strategic Petroleum
Reserve
A significant insurance against interruptions in
petroleum supplies is having a large stock of
replacement that the government can release swiftly.
This was the main justification for creating the
Strategic Petroleum Reserve (SPR), which is seen as
the nation’s first line of defence in the case of an oil
crisis. The need for a national oil storage reserve has
been recognized for at least five decades. Secretary
of the Interior, Harold Ickes, advocated for the
stockpiling of emergency crude oil in 1944.
President Harry Truman’s Minerals Policy
Commission proposed a strategic oil supply in 1952.
President Eisenhower suggested an oil reserve after
the 1956 Suez crisis. The Cabinet Task Force on Oil
Import Control recommended a similar reserve in
1970. These proposals were finally implemented in
the aftermath of the 1973-74 oil embargo. The price
shock and the embargo aggravated America’s sense
of vulnerability and created the right conditions to
move ahead with the plan to establish a national oil
storage. President Ford set the SPR into motion
when he signed the Energy Policy and Conservation
Act (EPCA) in 1975. The legislation declared it to
be US policy to establish a reserve of up to one
billion barrels of petroleum. The SPR was officially
established in December 1975 with a total storage
capacity of 700 million barrels. The GOM was
chosen as the location for the oil storage sites
because it contains many US refineries and
distribution points for tankers, barges, and pipelines.
The first crude oil was delivered to the SPR in 1977.
The SPR proved its value in 1991 when
President George Bush Sr. ordered the first
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emergency drawdown of the SPR. This step
contributed to the stability of the world oil markets
and prices. Two more public sales of crude oil from
the SPR were held in 1996 and 1997. In 2000,
President Clinton authorized another public sale in
order to bolster the US oil supplies and to alleviate
possible shortages of heating oil during the
upcoming winter. Finally, in the aftermath of the
11 September terrorist attacks against the US,
George W. Bush ordered the Department of Energy
to fill the SPR to its full capacity over the next few
years.
Although the SPR is considered the federal
government’s major tool for responding to oil
supply disruptions, two problems can be identified
with it. First, despite the increasing amount of
stored oil in the SPR, its value, measured by
days of net petroleum imports, is shrinking. The
volume of oil stored in the SPR in 1985 was
493.32 million barrels, which accounted for
115 days of import replacement. By early 2005
the volume peaked at 670.00 million barrels,
accounting for only 53 days of import replacement.
Second, under the EPCA there is no preset ‘trigger’
for withdrawing oil from the SPR. Instead, the
president determines that a drawdown is required
either by a severe energy supply interruption or by
obligations of the United States under the
International Energy Agency (IEA).
In 1991, the withdrawal was mainly in response
to a potential interruption of supplies due to the
Iraqi invasion of Kuwait, while the sale in 2000
was initiated to dampen price hikes. Since its
inception, the SPR has been used by policy makers
both as a tool of crisis management and as an
instrument to counter high oil prices. Policy
makers seeking price mitigation walk a fine line
between ‘calming’ the market, by showing that
there is sufficient crude available, and yielding the
unintended consequence of short-circuiting the
price mechanism and preventing the market from
equilibrating. This dilemma is magnified in
political debate, pitting the advocates of free
markets against the advocates of interventionist
government. A clear policy for the use of the SPR
needs to be established.
7.1.3 The Arctic National
Wildlife Refuge
ANWR is located on the northern coast of Alaska,
east of Prudhoe Bay, and is the largest oil field ever
discovered in the US. Studies conducted by the
United States Geological Survey (USGS) suggest
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that between 5.7 and 16.0 billion barrels of
technically recoverable oil1 are in the coastal plain
area of ANWR, with a mean estimate of 10.4
billion barrels (USGS, 2001). This estimate
includes oil resources in native lands and state
waters out to a 3 mile boundary within the coastal
plain area. To date, there has been no assessment of
the oil and natural gas resources for ANWR
outside of the coastal plain area. However, it is
unlikely that the non-coastal plain area of ANWR
has the same level of resources that are estimated
to be in the coastal plain area, due to differences in
geology.
This coastal plain area, known also as the 1002
Area, is thought by some geologists to be
America’s last great oil frontier and has initiated an
intense debate since the early 1950s. Beginning in
the 1950s, a group of bio-scientists launched a
grassroots campaign to gain protection for the area,
mainly from mining, the form of resource
development most common in Alaska at that time.
In 1960, Public Land Order 2214 was issued to
preserve the unique wildlife, wilderness and
recreational values of the area, which was
officially dubbed the Arctic National Wildlife
Range. During the following decade the context of
the discussion changed radically. Two
developments substantially influenced the debate:
the discovery of giant oil reserves at Prudhoe Bay
(1968), and the Arab oil embargo (1973). As a
result, Congress passed the Alaska National
Interest Lands Conservation Act (ANILCA, Public
Law 96-487), which President Carter signed
into law in early 1980.
The ANILCA provided some gains for both
sides of the debate: the environmentalists and those
who wanted to open the area for oil and gas
explorations. On the one hand, it more than
doubled the total set aside area to 19.6 million
acres, conferred upon it the new title ‘refuge’, and
officially designated 18.1 million acres of it as
‘wilderness’, thereby making it off limits to all
future development. On the other hand, section
1002 of ANILCA mandated that 1.5 million acres
of coastal plain be kept off the ‘wilderness’
menu and instead be evaluated in terms of both
wildlife and petroleum resources. Since then,
several factors have shaped the debate over oil and
gas exploration in the area. These include: the
change in oil prices from a rather low level in the
late 1980s and most of the 1990s to their relative
surge in the first half of the twenty-first century;
the Exxon Valdez oil spill of 1989, which was seen
as an example of what oil exploration can do to the
ecosystem and the environment in the region; and
370
the continuous improvement of drilling technology,
which suggests the hydrocarbon resources can be
developed with minimum impact on the region’s
wildlife.
Since the early 2000s, policy makers who
support oil and gas exploration in ANWR argue
that the development of the region’s hydrocarbon
resources would create new jobs, particularly for
the local population, would improve the balance of
trade for the US through reduction in the nation’s
import bill, and would provide a needed buffer
against future oil supply crises and price spikes. In
short, according to this line of argument, ANWR
would reduce dependence on overseas sources of
oil and strengthen national security by increasing
domestic supply and, thus, the reliability of energy
resources. Opponents to opening ANWR for oil
and gas exploration underscore the potential
damage to the region’s ecological system and
minimize these potential and uncertain economic
and political outcomes.
In conclusion, there has been little petroleum
drilling or exploration in ANWR. Thus, there is
little first-hand knowledge regarding the geology
of the region. The USGS oil resource estimates are
largely based on the geological conditions that
exist in the neighbouring state lands. Consequently,
there is considerable uncertainty regarding both the
size and quality of the oil resources that exist in
ANWR (EIA, 2004a). One thing is certain: debate
over this area will not cease, no matter what
decision is eventually made, or not made. Policy
makers, environmentalists and oil executives will
continue their intense debate over the issue of
ANWR and the 1002 Area for a long time
(Montgomery, 2003).
7.1.4 The Gulf of Mexico
Technological advancements that might facilitate
and accelerate oil and natural gas exploration in
ANWR have also been debated over a different
setting: the shallow and deep waters of the GOM.
The US offshore fields provide an important and
expanding source of domestic oil and gas. Indeed,
the GOM delivers more total energy to the US than
any other single domestic or foreign source (Snow,
2004). The first offshore well was drilled in the
GOM in 1947. Since then, the Gulf of Mexico
Outer Continental Shelf has established itself as
1 Technically recoverable resources are resources that
can be produced using current technology.
ENCYCLOPAEDIA OF HYDROCARBONS

one of the world’s great hydrocarbon basins; and
oil and gas production from its shallow and deep
waters play a significant role in the nation’s energy
outlook.
Since the 1980s, it has become obvious that the
Gulf shelf is mature, with the largest fields and
most economic prospects having already been
discovered. Despite this assessment, the Gulf shelf
has displayed significant resiliency, continuing to
make substantial contributions to the nation’s oil
and natural gas supplies. This resiliency can be
explained by technological advances, which have
enabled small fields to be highly productive, and
improved reserve replacement.
Disappointing and diminishing discoveries in
the shallow-water, combined with technological
advances, have prompted oil companies to invest in
deep-water explorations since the late 1970s. The
Minerals Management Service (MMS) defines a
deep-water project as one with a production
facility located in a water depth equal to or greater
than 1,000 feet (305 metres). After the initial flush
of large deep-water discoveries in the late 1970s
and early 1980s, the next ten years of exploration
in the Gulf’s deep-water were disappointing.
However, the pace of discoveries picked up
dramatically in the mid and late 1990s. This was
partly due to the passage of the Deep Water
Royalty Relief Act (DWRRA) in 1995, which
provides royalty relief for a portion of production
for deep-water leases (Godec et al., 2002).
This is also due to technological advances,
which have enabled the industry to access greater
proportions of oil and gas resources at
cost-effective rates. After its expiration in 2000, the
DWRRA was redefined and extended to promote
continued interest in deep-water exploration. In the
first few years of 2000, deep-water wells
accounted for about two-thirds of total US Gulf
output. Large fields include: Hoover-Diana,
Atlantis project, Thunder Horse,2 Crosby, Holstein,
King, King’s Peak, Mad Dog, Marlin, and Nakika
(EIA, 2004b). The majority of the hydrocarbon
discoveries in the deep-water of the GOM have
been oil fields. However, these fields contain
considerable quantities of associated gas.
Four factors are likely to substantially shape the
future of oil and gas exploration from the GOM.
First, the pace and extent of technological
advances: progress in technology has unlocked
new fields and extended the life of old ones at
cost-effective rates. Second, public policy that
regards providing access to shallow and deep water
areas: drilling bans were issued and extended in the
1980s and 1990s. These leasing moratoriums
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covered a large part of the GOM and substantially
reduced the area available for oil and gas
exploration. Third, financial incentives to stimulate
investment: the passage of the DWRRA in 1995
had a major impact on oil and gas exploration in
the GOM. The focus shifted from shallow-water to
deep-water. While the provisions of DWRRA
expired in 2000, new ones became effective in
2001. These new provisions are specified for each
lease sale based on prevailing economic
conditions. Fourth, environmental protection
requirements: for the last several decades offshore
oil and gas explorations have been subject to close
public scrutiny. The goal is to ensure that the
exploration and development (E&D) of
hydrocarbon resources do not pollute the ocean
and the coastal region. Accordingly, restrictions
have been imposed on air pollutants, ocean
discharge of drilling wastes, and produced water
from offshore facilities.
To sum up, technological advances, public
policy considerations, financial incentives, and
environmental restrictions will continue to shape
the pace and direction of the offshore hydrocarbon
industry in the foreseeable future.
Oil production in the GOM increased steadily
from 1990 through 2001 and then leveled off in
2002 and 2003. Shallow-water oil production has
declined steadily since 1997 but has been offset by
increasing deep-water production during this same
period. Gas production in the GOM has followed
similar trends. The GOM is likely to expand its
significant role in the United States’ energy
outlook. Indeed, the MMS projects that by 2013 oil
production from the GOM will reach about 2
million barrels of oil per day and 0.38 billion cubic
metres of natural gas per day (Melancon, 2004).
7.1.5 Natural gas
For the last few decades natural gas has been one
of the fastest growing sources of energy in the
United States and the rest of the world. From 1990
through 2003 natural gas consumption in the
United States increased by about 14% (EIA,
2004b). The increasing use of natural gas as an
industrial and electricity generating fuel can be
explained by two factors.
Natural gas is considered more environment-
friendly: generating less pollution in comparison
2 Known previously as Crazy Horse, it is the largest
single field ever discovered in the Gulf of Mexico.
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GEOPOLITICS AND SECURITY
with other fossil fuels. Second, the expanding
transmission and distribution network has
increased its availability and use.
Several characteristics of natural gas
consumption and production in the United States
can be identified.
• First, natural gas is consumed mainly in four
sectors: industrial, residential, commercial, and
electric power. Overall, in recent years, the
United States has depended on natural gas for
about 24% of its total primary energy
requirements. Most of the nation’s production
comes from Texas, Oklahoma, New Mexico,
Louisiana, Wyoming, Colorado, Alaska,
Kansas, California, and Alabama.
• The United States holds approximately 3% of
the world’s proven reserves, the sixth after
Russia, Iran, Qatar, Saudi Arabia, and United
Arab Emirates respectively, and is the world’s
second largest natural gas producer, after
Russia, and the largest consumer. This means
that the United States’ natural gas reserves are
rapidly depleting and the widening gap between
rising consumption and declining production is
being filled by imports. The Energy
Information Administration (EIA) projects that
total net imports of natural gas will rise from
15% of total gas consumption in 2002 to 21%
in 2010 and 23% in 2025 (EIA, 2004c).
• Natural gas flows into and out of the United
States reflect an integrated North American
marketplace. Canada is by far the largest
foreign supplier of natural gas to the United
States, providing enough net exports through
pipeline transport to meet over one-seventh of
annual US consumption (EIA, 2004d). Most of
these pipeline systems originate from supply
basins in British Columbia, Alberta, and Nova
Scotia (all in Canada). The extent to which the
US can count on Canada to help bridge the
supply-demand gap is a growing concern on
both sides of the border. Canada’s supply basins
are maturing, while its domestic consumption is
rising. As a result, the United States’ net
imports of natural gas from Canada are
projected to peak in 2010 then decline
gradually (EIA, 2004e).
• Mexico has considerable natural gas resources,
but the United States has historically been a net
exporter of gas to Mexico because industrial
consumers along the border are closer to US
supplies than they are to domestic supplies.
• The pricing of natural gas is not as
straightforward as the pricing of oil. Despite
increasing shipments of natural gas across
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oceans in the form of Liquefied Natural Gas
(LNG), the fuel is still largely considered a
continental commodity. Most of the natural gas
is traded between countries within the same
continent. Because of the integrated nature of
the North American natural gas marketplace,
prices for US imports from Canada generally
rise and fall in concert with price movements at
US trading locations. Thus, Canadian prices for
natural gas are often set at hubs where multiple
pipelines connect and storage facilities exist to
balance temporary or seasonal fluctuations in
the supply and demand.
• Since the beginning of the twenty-first century,
the United States has shown a great interest in
establishing an energy partnership with Russia.
American oil companies have been exploring
investment opportunities to develop Russia’s oil
and natural gas resources. Furthermore,
proposals to export oil from Russia to the
United States are under consideration. Since
late 2004, the two sides have been in
negotiations covering natural gas. American
officials have been urging Gazprom, Russia’s
and the world’s largest natural gas company, to
accelerate plans to build an LNG terminal in
northwest Russia that could supply fuel to the
United States. Meanwhile, Gazprom is looking
for new markets outside of Europe, its main
natural gas market.
• The Middle East is likely to play a growing and
significant role in the global and American
natural gas markets. The region enjoys several
advantages including substantial reserves, low
E&D costs, and largely un-utilized and
un-developed natural gas resources. In addition
to Algeria, which has been supplying LNG to
the United States for a long time, other
producers such as Qatar, Oman, and Egypt are
likely to start exporting large volumes of gas to
the United States in the near future.
• Domestically, growth in the supply of natural
gas is expected to come from Alaska. The
North Slope Alaskan natural gas pipeline is
projected to begin transporting Alaskan gas to
the lower 48 states in 2016 (EIA, 2005).
Additional supplies are projected to come from
the Rocky Mountain region, primarily from
unconventional gas deposits.3 Put differently,
the United States is not running out of natural
gas, only shallow and easy-to-find gas.
3 Unconventional gas includes tight (low permeability)
gas, sandstone gas, shale gas, and coalbed methane.
ENCYCLOPAEDIA OF HYDROCARBONS

More-advanced knowledge and improved
technology are increasing recovery rates from
unconventional gas reserves (Stott, 2005).
Another striking development, in addition to
these important characteristics of the United
States’ natural gas sector, is the increasing share of
LNG in the nation’s energy outlook. The United
States is both an importer and an exporter of LNG.
The first long-distance shipment of LNG was in
1959 and went from the United States’ Gulf of
Mexico to the United Kingdom (Kaplan and
Marshall, 2003). Since the early 1970s the United
States has exported LNG from Kenai (Alaska) to
Japan. On the other hand, most of the projected
import of natural gas will be in the form of LNG.
Indeed, the EIA projects that LNG will become the
largest source of net US imports by 2015, as
Canadian imports decline (EIA, 2003). Put
differently, the EIA expects LNG imports to rise at
an average rate of 16% per year between 2002 and
2025. Thus, US LNG imports are projected to rise
from 5% of net US natural gas imports in 2002 to
39% in 2010 and then to 66% in 2025 (EIA,
2004c).
In order to accommodate these increased
supplies of LNG, plans have been designed to
expand existing LNG facilities in the United States
and to build new ones. Currently, there are four
LNG import terminals in operation. These are:
Cove Point in Maryland, Elba Island in Georgia,
Everett in Massachusetts, and Lake Charles in
Louisiana. In addition, two terminals have received
final approval from the Federal Regulatory
Commission, which has jurisdiction over onshore
facilities. The Commission’s approval in September
2003 of Sempra’s Cameron LNG terminal was the
first such US regulatory approval for an LNG
import terminal in 25 years. In June 2004, the
second approval was granted to the Freeport LNG
project in Texas. Other proposals are under
consideration.
Historically, Algeria has been the United States’
largest supplier of LNG. However, since 2000,
Trinidad and Tobago has become the main supplier
of LNG to the United States. In addition to these two
countries, other suppliers include Brunei, Malaysia,
Nigeria, Oman, and Qatar.
7.1.6 Coal
Coal is America’s most abundant fuel source. The
US has the largest coal proven reserves in the
world. However, coal is one of the dirtiest sources
of energy and, consequently, the least favoured by
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policy makers and the general public. Coal is used
largely to generate electricity, and much less in the
industrial and residential sectors. The United States
Department of Energy projects that coal-fired
power plants will continue supplying most of the
nation’s electricity through 2025 (EIA, 2005). This
continued use of coal can be explained by the
increasing reliance on low sulphur coal (mainly
from the western US, primarily the Powder River
Basin and the Rocky Mountain regions) and the
reducing share of relatively higher sulphur
Appalachian coal (mainly from West Virginia and
Kentucky).
Western coal production has grown steadily
since 1970 and, particularly, since the early 1990s.
The implementation of the Clean Air Act
Amendments (CAAA) in 1990 was the main drive
for the growing consumption of western coal.
Building on congressional proposals advanced
during the 1980s: President Bush Sr. proposed
sweeping revisions to the CAAA that were
designed to curb three major threats to the nation’s
environment and to the health of millions of
Americans: acid rain, urban air pollution, and toxic
air emissions. The proposal also called for
establishing a national permit programme to make
the law more workable, and an improved
enforcement programme to help ensure better
compliance with the Act. After the House of
Representatives and the Senate approved the bill,
President Bush signed it into law in November
1990. There were several progressive and creative
new themes embodied in the Amendments.
Specifically, the CAAA promotes the use of clean
low sulphur coal and natural gas, as well as
innovative technologies to clean high sulphur coal
through the acid rain programme.
Finally, despite the United States’ huge coal
reserves, the nation’s coal industry is expected to
continue to face strong competition from other coal
exporting countries such as China, Colombia,
Indonesia, Russia, and Australia. With limited or
negative growth in import demand in Europe and
the Americas, the US share of total world coal
trade is projected to fall.
7.1.7 Nuclear energy
Nuclear power has been considered an important
source of energy since the early 1950s. Along with
coal, natural gas, hydropower, and oil, it is used to
generate electricity. The first commercial nuclear
energy powered facility went into operation at a
site on the Ohio River in Shippingport,
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Pennsylvania, in 1957. In the following years many
nuclear plants were constructed, licensed, and
connected to the electricity grid. Most of these
nuclear power plants received forty-year operating
licenses and are scheduled to expire around 2015.
However, this wave of enthusiasm for nuclear
power was broken by the accident at Three Mile
Island in 1979, which highlighted the safety
concerns of using nuclear energy power.4 Since
then, no new reactors have been built.
Furthermore, as operable nuclear power plants
have aged, some have become too expensive to
operate and have been closed. Thus, the joint effect
of shutdowns and the lack of new units has
drastically reduced the number of operable nuclear
plants.
Despite these developments, the United States
has the largest nuclear energy programme in the
world. In recent years, the US has had 104
commercial nuclear reactors which generate
approximately 20% of the nation’s electricity.
Improvements in the performance of the US
nuclear units, extensions of the life of plants, and
increases in output have kept nuclear power’s share
of electricity supply consistent since the early
1990s. Since the beginning of the century, both the
government and the private sector have sought to
further expand the share of nuclear power in the
nation’s energy mix. Accordingly, the US Nuclear
Regulatory Commission (NRC) approved several
applications for power up rates and licence
renewals.
Equally important, several initiatives have been
launched to ensure the cost-effectiveness and
safety of nuclear power. The Nuclear Power 2010
Programme, unveiled by the Department of Energy
in February 2002, is a joint government and
industry cost-shared effort to identify sites for new
nuclear power plants, develop and promote
advanced nuclear plant technologies, and evaluate
the business case for building new nuclear power
plants (DOE, 2005). The programme is focused on
reducing the technical, regulatory and institutional
barriers to deployment of new nuclear power plants
based on expert recommendations. Shortly after
this initiative was announced, a working group
issued a roadmap that recommended the
deployment of new advanced nuclear power plants
in the United States by 2010. While the current
generation of nuclear power plant designs provide
an economically, technically, and publicly
acceptable electricity supply in many markets,
further advances in nuclear energy system design
could broaden the opportunities for the use of
nuclear energy.
374
Since mid-2005, particular attention has been
given to the development of next-generation
nuclear energy systems known as Generation IV. A
group of ten countries that are interested in jointly
planning the future of nuclear energy have created
a Generation IV International Forum (GIF).5 The
GIF seeks to provide sustainable energy
generation that meets clean air objectives,
manages nuclear waste and thereby improves
protection for the public health and the
environment, excels in safety and reliability, has a
clear life-cycle cost advantage over other energy
sources, and has a level of financial risk
comparable to other energy projects (DOE, 2002).
In other words, the GIF seeks to develop an
ultra-safe, economic nuclear system that will be
designed to produce electricity and hydrogen with
substantially less waste and without emitting air
pollutants or greenhouse gases.
In summary, since the late 1940s US officials
have sought to articulate a national energy policy
that will reduce the nation’s energy vulnerability to
foreign supplies and diversify both the energy mix
and sources. The SPR was created as the nation’s
first line of defence against supply interruptions.
Explorations from ANWR and the GOM are meant
to increase domestic hydrocarbon supplies. The
rising share of natural gas in the nation’s energy
composition is meant to contain pollution and
reduce dependence on oil. Similarly, the renewed
interests and investments in clean coal technology
and nuclear power aim at diversifying the nation’s
energy mix. In addition to these important steps,
the US has sought to diversify its energy sources.
This strategy is based on the notion that
diversification is the first principle of energy
security. This, the argument goes, can be done by
exploring and developing energy sources outside
the Middle East. Thus, it has been suggested that
the US government should encourage oil imports
from friendly producers such as Russia, the
Caspian Sea, and West Africa. The following
sections will examine these efforts.
4 In March 1979, a reactor at the Three Mile Island
nuclear power plant in Harrisburg, Pennsylvania, suffered a
partial meltdown. Within weeks, attorneys filed a class
action suit against Metropolitan Edison Company (a
subsidiary of General Public Utilities) on behalf of all
businesses and residents within twenty-five miles of the
plant. Over the next fifteen years, the case went to the
Supreme Court and through various district and appeal
courts. In June 1996, the lawsuit was finally dismissed.
5 These ten countries are Argentina, Brazil, Canada,
France, Japan, Republic of Korea, Republic of South Africa,
Switzerland, United Kingdom, and the United States.
ENCYCLOPAEDIA OF HYDROCARBONS

7.1.8 Russia’s oil potential:
myth or reality?
Russia is a major player in the global oil market.
Since the late 1990s, Russia’s oil production has
experienced a steady resurgence. By the early
2000s, Moscow had regained its status as a major
oil producer and exporter and as a crucial player in
global energy markets. Prior to the breakup of the
Soviet Union, oil production peaked at 12.6 million
barrels per day (bbl/d) in 1987. Such high
production levels stemmed largely from the
exploitation of new petroleum reserves discovered
in western Siberia. The political turmoil that
accompanied the collapse of the Soviet Union was
a major factor in the decline of production in the
following decade. As the political situation
normalized, the oil industry stabilized and,
gradually, production started to grow substantially,
rising from 6.1 million bbl/d in 1996 to 8.5 million
bbl/d in 2003. In addition to the increasing stability
of the Russian political system, the introduction of
economic reform and the privatization of the oil
sector have contributed to this dramatic
turnaround. Many analysts project that Russia’s oil
production will continue its impressive rise for the
next few years. According to a recent assessment
by the EIA, Russian oil production is expected to
reach 10.9 million bbl/d in 2025, 43% above 2002
levels (EIA, 2004e).
Russia’s influence over the world oil market
has risen dramatically, in proportion to its
growing production. Since the early 2000s, the
European Union has negotiated energy
agreements with Russia. Moscow is a major oil
and gas supplier to several European countries.
The European-Russian energy dialogue is
focused on European investment in Russia’s oil
and gas sectors, in return for steady and secure
supplies. Similarly, the United States has shown
growing interest in establishing an energy
partnership with Russia. In April 2002,
Washington gave the Russian economy free
market status and, in October of the same year, a
US-Russian Energy Summit was held in Houston,
which brought together representatives of
government, business and academic circles from
both countries. This summit was followed by
another one in 2003, held in St. Petersburg, in
which the two sides pledged to further deepen
their cooperation. Accordingly, US officials
announced $130 million in loan guarantees from
its Overseas Private Investment Corporation to
help build a new storage and loading terminal on
the Baltic Sea.
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An earlier sign of this energy cooperation
between Washington and Moscow was LUKOIL’s
acquisition of Getty Petroleum Marketing Inc.
and its 1,300 gasoline stations in November 2000.
This step marked the first time that a Russian
oil company had purchased a publicly traded
company listed on the New York Stock Exchange.
Russia’s resumption of its role as a leading oil
producing power, after the relative stagnation
during most of the 1990s, has coincided with the
political and strategic changes that followed the
September 2001 terrorist attacks in the United
States. Developments since then have deepened
the United States’ sense of vulnerability to
imported oil supplies from the Middle East.
Within this context, an energy partnership
between Washington and Moscow has slowly
been taking shape. This emerging cooperation
between the world’s largest oil consumer and the
world’s second largest producer and exporter is
based on two foundations: American oil
companies will provide badly-needed financial
resources to Russia’s energy industry and, in
return, Moscow has presented itself in alternative
to the Middle East, as a stable oil supplier to the
United States.
Despite this growing enthusiasm to forge an
energy partnership between Moscow and
Washington, the prospect of massive amounts of
Russian oil flooding the American market is not
realistic. Traditionally, Russian oil exports have
been Europe-bound. The recent Russian oil
shipments to the United States are more symbolic
of good intentions than a breakthrough in US
energy security.
Several characteristics of Russia’s oil sector
need to be underscored:
• The country has a limited pool of proven crude
reserves. In 2004, Russia’s proven reserves
were estimated at 69.1 billion barrels, about
6.0% of the total world reserves. Major Middle
East producers hold much larger reserves:
Saudi Arabia (262.7 billion barrels or 22.9% of
total world reserves), Iran (130.7 billion
barrels or 11.4 %), Iraq (115.0 billion barrels
or 10.0%), the United Arab Emirates (97.8
billion barrels or 8.5%), and Kuwait
(96.5 billion barrels or 8.4%) (BP, 2004).
These relatively limited reserves are
particularly alarming considering that Russia’s
rate of oil production is exceeding the rate at
which new reserves are being discovered by a
significant margin. Put differently, the
depletion of existing oil fields in western
Siberia has raised fears that Russia’s current
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oil boom will be followed by a sharp decline in
the next few years (EIA, 2002). Finally, most
of Russia’s un-utilized oil reserves are located
in geographically remote and geopolitically
challenging fields.
• Production costs are much higher in Russia
than in the Middle East. The cost of production
in Saudi Arabia, for example, is less than
$1.50 per barrel, compared with the global
average of about $5 per barrel. In Russia, it
varies from one region to another, but overall,
it is much higher than in the Middle East. This
means that Russian firms cannot survive a
prolonged period of weak oil prices. For
example, if prices fall much below $15 per
barrel, the country’s exports will be severely
affected. Middle East producers, on the other
hand, can still make a profit at $10 per barrel.
• Given the structure of Russia’s oil industry, the
country does not have any spare capacity. In
other words, Russia’s oil industry is currently
dominated by private oil companies. Like any
private entities, these Russian companies seek
to maximize their profits by producing and
exporting as much as they can, with little
concern about strategic objectives. On the
other hand, in some Middle Eastern countries
the oil industry is dominated by the state. This
means that production and export policies are
driven by both commercial and strategic
interests. The Saudi government deliberately
maintains substantial idle capacity in order to
ensure stability in global oil markets. This can
be seen as an ‘insurance policy’ against an
interruption of oil supplies. For a long time,
whenever the world economy has been
threatened by political or social upheavals in
oil producing countries, the kingdom has not
hesitated to use its spare capacity to restore
stability and avert economic crises. Most of
the world’s spare capacity is concentrated in
Saudi Arabia.
• Foreign investment has been an important
component of the economic reform
programme, which started in the early 1990s.
Russian efforts to attract foreign investment,
however, have been hesitant and ambiguous.
As a result, the Russian economy as a whole,
and the oil sector in particular, has received a
minimal amount of direct foreign investment.
This modest success in attracting foreign
investment, which is largely out of proportion
with the country’s resources and economic
potential, reflects both a strong cash flow
resulting from high oil prices, and the rivalry
376
between three players with competing agendas:
the Russian government, the Russian oil firms,
and the international oil companies. As with
other governments, officials in Moscow do not
speak with one voice. Some members of the
political establishment understand the need to
integrate the country into the global economic
system and to forge close energy cooperation
with major oil and gas consumers, particularly
the European Union, the United States, Japan,
and China. These ambitious efforts are
restrained by the state led economy model,
which did not completely disappear with the
collapse of the Soviet Union. Currently, the
Russian oil industry is dominated by several
private oil companies. These companies are
credited with the impressive rebound in
Russian oil production since the late 1990s. In
other words, the Russians themselves have
been able to substantially increase their
production and exports. Consequently, they
feel little need for foreign investment,
particularly under the terms that the foreign
oil companies desire. Finally, international oil
companies need long term stability to
implement capital-intensive projects. Their
executives complain about problems with
federal and local legal regulations and taxation
policies.
• Russia has an extensive domestic oil pipeline
system with links to nearly all of the former
Soviet republics, but the country’s ability to
export its oil to markets beyond the borders of
the Former Soviet Union (FSU) is limited. This
reflects the close economic ties that Russia had
with fellow socialist republics during the
Soviet era. The break-up of the Soviet Union
meant that Russia needed to expand its oil
exports to Western markets in order to earn
badly-needed hard currency. Thus, since the
early 1990s, constructing pipeline routes
outside the FSU has become crucial for
Russia’s oil industry and exports. The
expansion of Russia’s pipeline capacity has not
kept pace with the country’s rising production.
Indeed, the biggest factor preventing the rapid
development of Russian energy exports is its
transport network, which is exclusively under
the state-owned monopoly, Transneft.
To sum up, the US should resist the
temptation to officially promote US imports of
Russian oil at the expense of oil from the Middle
East or anywhere else. The natural market for
Russian oil is predominantly Europe. In the
modern market, the US benefits by simple virtue
ENCYCLOPAEDIA OF HYDROCARBONS

of Russia’s rising exports, no matter where they
go. This also applies to production from the
Caspian Sea.
7.1.9 The Caspian Sea:
a new frontier
The 700-mile long Caspian Sea is located in
northwest Asia. Five countries (Azerbaijan, Iran,
Kazakhstan, Russia, and Turkmenistan) share the
Caspian Basin. Their policies on the E&D of the
region’s hydrocarbon resources, since the collapse
of the former Soviet Union in late 1991, have
been of great interest to energy officials from all
over the world. The region is important to the US
and other energy consuming countries because it
can contribute significantly to the world’s oil and
gas production. Equally important, it can
contribute to the diversification of global
hydrocarbon resources, and consequently, reduce
heavy dependence on the Middle East. In short, the
Caspian Sea has the potential to substantially
enhance global energy security.
The region is not new to the petroleum and
natural gas industry. It is worth remembering that
commercial energy output began in the Caspian
basin in the mid nineteenth century, making it one
of the world’s first energy provinces. By 1900, the
Baku region produced about half of the world’s
total crude oil. Since the early 1950s, however,
several developments have contributed to a
substantial reduction of Caspian oil production.
Concern over Baku’s vulnerability to attacks during
the Second World War, along with the discovery of
oil in the Volga-Urals region of Russia, and later in
western Siberia, led to a switch in the former
Soviet Union’s investment priorities. This new
policy resulted in decreased exploration and
production (E&P) in the Caspian for most of the
second half of the twentieth century. Since the late
1980s, however, Azerbaijan, Kazakhstan, and
Turkmenistan have gradually occupied centre stage
in the global energy markets. The three countries
have succeeded in attracting massive foreign
investment to their oil and gas sectors.
Since the collapse of the Soviet Union, several
international oil companies have negotiated and
signed agreements with Caspian states, particularly
Kazakhstan and Azerbaijan. These agreements
suggest that the geological potential of the Caspian
region as a major source of oil and gas is not in doubt.
The rate of investment, however, is (and will continue
to be) determined by the perceived risk in the region,
or what industry experts call above-the-ground risk.
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In other words, the risk is not in finding the oil and
gas, but in juggling the multitude of liabilities
associated with operating in difficult host country
environments. This section will examine the lack
of consensus on the legal status of the Caspian Sea,
and the disagreement over the most cost-effective
pipeline routes.
Regarding the legal status of the Caspian Sea,
in the twentieth century, the former Soviet Union
and Iran signed several agreements to govern their
relationship with respect to the Caspian Sea, most
notably the Friendship Treaty of 1921 and the
Treaty of Commerce and Navigation of 1940.
Moscow and Tehran agreed that the Caspian was
only open to their own vessels and was closed to
the rest of the world.
They also reserved a 12-mile zone along their
respective coasts for exclusive fishing rights.
However, no attempt was made to delimit an
official sea boundary between them: furthermore,
the treaties said nothing about the development of
mineral deposits under the seabed. Thus, many
analysts and policy makers have questioned the
applicability of these two documents to the new,
post-Soviet situation in the Caspian. Indeed,
Russia, Iran, and the three former Soviet Republics
have intensely disagreed on how to define the
Caspian as a body of water.
A fundamental question in this debate on the
legal status of the Caspian is whether or not it is
defined as a sea or a lake. According to the United
Nations Convention on the Law of the Sea, nations
bordering a sea may claim 12 miles from shore as
their territorial waters and beyond that a 200-mile
Exclusive Economic Zone (EEZ). If the Law of the
Sea Convention was applied to the Caspian, full
maritime boundaries of the five littoral states
bordering it would be established, based upon an
equidistant division of the sea and undersea
resources into national sectors. If the law were not
applied, the Caspian and its resources would be
developed jointly, a division referred to as the
condominium approach. After more than a decade
since the break-up of the Soviet Union, the five
littoral states have not agreed on whether to
characterize the Caspian as a sea or a lake. The
main point of contention centres around the uneven
distribution of potential oil and natural gas riches
in the basin.
The Russian position has varied over time.
Initially, Moscow argued that the Law of the Sea
did not apply to the Caspian because it was an
enclosed body of water, and that regional treaties
signed in 1921 and 1940 between Iran and the
former Soviet Union remain valid. However, the
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signing of several agreements between the other
three littoral states and international oil companies
to explore and develop hydrocarbon resources
beneath the Caspian’s water prompted Russia to
change its position. Thus, in 1996 Moscow
proposed that, within a 45-mile coastal zone, each
country could exercise exclusive and sovereign
rights over the seabed mineral resources. Since the
late 1990s, the Russian leaders have advocated the
principle of dividing the seabed and its resources
between neighbouring states. In line with this
approach, Russia signed agreements with
Kazakhstan (1998) and Azerbaijan (2001) dividing
the northern Caspian seabed.
Unlike Russia, Iran has been more consistent in
rejecting any bilateral agreement to divide the
Caspian. Tehran’s preference is for all five littoral
states to adopt a collective approach in developing
the mineral resources beneath the Caspian. Indeed,
for the last several years, Iran has increasingly
become the lone voice in the debate over the legal
status of the basin. The reason is simple: Iranian
shores on the Caspian seem to hold less oil and
natural gas reserves than the other four littoral
states.
Since the break-up of the Soviet Union in 1991,
the evolving positions of Azerbaijan, Kazakhstan,
and Turkmenistan regarding the legal status of the
Caspian have been driven by three interrelated
developments. First, the coastal areas of each of
the three countries are believed to hold more oil
and gas reserves than those of Russia and Iran.
Second, developing available hydrocarbon
resources is considered crucial to the economic
survival of these newly independent states, which
have very few other economic assets. Third, the
substantial international investments in the energy
sectors of these three countries have incited them
to be more assertive in their demands to divide the
Caspian Sea into national sectors.
In summary, the five littoral states have yet to
agree on the legal status of the Caspian Sea.
Despite this lack of consensus, a de facto regime is
emerging. Several international oil and gas
companies have decided not to wait for an
agreement and have started developing the Caspian
offshore fields. These ambitious and very
expensive deals between international companies
and littoral governments, however, face another
serious hurdle – the lack of an adequate system to
ship the region’s oil and gas to global markets.
With regard to pipeline diplomacy, given that
Azerbaijan, Kazakhstan, and Turkmenistan are
landlocked, they have to ship their oil and natural
gas by pipelines, which cross multiple international
378
boundaries. The issue of potential routes through
neighbouring countries has become a priority for
both regional and international powers as well as
for oil companies. The construction of a pipeline
would provide the transit states with several
financial and political benefits, including: access
to oil or natural gas for their domestic needs,
foreign investment and jobs, substantial transit
fees, and political leverage over the flow of oil and
gas. Thus, the process of choosing and
constructing pipeline routes is complicated and
requires delicate negotiations with many parties.
Until recently, the existing pipelines in the Caspian
region were designed to link the former Soviet
Union internally and were routed through Russia.
Most of the Caspian’s oil and gas shipments
terminated in the Russian Black Sea port of
Novorossijsk. Since their independence, there have
been political and security concerns as to whether
these Caspian states should remain so dependent
on Russia as their sole export outlet.
For several years a number of proposed routes
have been under consideration. These include: a
pipeline to the north to Novorossijsk (completed in
2000); a second one to the east from Kazakhstan to
China; a third one to the south-east through
Afghanistan to Pakistan; a fourth one to the south
across Iran; and finally, a pipeline to the west from
Baku to Azerbaijan to the Georgian port of Supsa
on the Black Sea (became operational in April
1999), or from Baku to the Turkish port of Ceyhan
on the Mediterranean (became operational in
2005). For several years, international companies
and the concerned governments have been engaged
in serious negotiations to determine the priority of
each pipeline. Both strategic considerations and
financial interests have shaped the outcome of
these negotiations.
Since the late 1990s, the United States has
promoted the BTC pipeline from Baku to Tbilisi to
Turkey’s eastern Mediterranean oil terminal at
Ceyhan as the Main Export Pipeline (MEP). Most
of the oil comes from the Azeri-Chirag-Gunashi
field complex in the Azeri sector of the Caspian
Sea, but Kazakhstan intends to export some of its
oil through this network. The BTC pipeline is
expected to be coupled later with a natural gas
pipeline linking Baku and Tbilisi to Erzurum in
Turkey’s eastern Anatolia region. In addition, in
February 2003, Greece and Turkey agreed to
construct a pipeline linking natural gas producers
from the Caspian Sea region with the European
market. Initially, the Russian government strongly
opposed the BTC. However, by mid-2001, Moscow
had dropped its opposition and focused on
ENCYCLOPAEDIA OF HYDROCARBONS

finishing the construction of the Caspian Pipeline
Consortium (CPC), which connects the Tengiz oil
field in Kazakhstan to the Russian Black Sea port
of Novorossijsk.
This project reflects cooperation between
Russian and American oil companies. Tengiz is one
of the world’s largest oil fields with substantial
high-quality proven reserves. The American oil
giant Chevron, now Chevron-Texaco, began
negotiating a deal to develop the field in 1990,
before the demise of the Soviet Union.
TengizChevrOil, a joint venture between Chevron,
Exxon-Mobil, and Kazakhstan, became operational
in 1993. The pipeline was officially opened in
November 2001.
Three conclusions can be drawn from this
discussion of pipeline diplomacy in the Caspian
Sea. First, given the domestic, regional, and
international rivalries surrounding oil and gas
fields in the Caspian, there is no doubt that
multiple export routes would increase the energy
security for consumers, producers, and the global
energy markets, by making deliveries less
vulnerable to technical or political disruptions on
any individual route. Still, energy security will
have to be balanced by economic feasibility, since
a larger number of pipelines would mean smaller
economies of scale. Second, the decision to choose
the most appropriate route reflects a competition
between strategic concerns and economic interests.
Most pipelines are built by companies, not by
governments. Ultimately, projects must stand on
their own commercial merit and the economics of a
project will dictate its success. In the long-term,
pipelines that make economic sense are more likely
to be built than those that do not. Third, pipeline
capacity and availability will, to a large extent,
influence the timing of oil and gas development in
the Caspian region.
In summary, the lack of consensus on how to
divide the Caspian Sea and the disagreement on
choosing the most cost-effective pipeline routes
have all negatively affected the investment climate
and the development of the region’s hydrocarbon
resources. There are other serious challenges as
well, such as the absence of both political
transparency and entrepreneurial culture, and
ethnic divisions.
7.1.10 Africa: security
and political challenges
West and Central Africa are other promising oil
producing regions. Since the late 1990s, the
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region’s oil production has been on the rise,
particularly from offshore oil fields. African
petroleum is particularly prized in the United
States because of its high quality: light and sweet
(low sulphur), which is tailor-made for US east
coast markets (Klare and Volman, 2004).
Furthermore, West African oil fields are closer to
the United States than those in Russia and the
Middle East. The majority of Africa’s crude
exports are destined for markets in the United
States and Western Europe. Given these
characteristics, the United States has worked with
several African governments to ensure political
transparency and economic development.
Meanwhile, American oil companies are
aggressively investing in the continent, particularly
in the two top producers: Nigeria and Angola.
Nigeria is the world’s seventh largest oil
producer and is a major supplier to Western Europe
and was the fifth largest supplier of crude oil to the
United States in 2003 (EIA, 2004f). A significant
challenge to the full utilization of the country’s
hydrocarbon resources is political instability. Since
its independence from the United Kingdom in
1960, Nigeria did not hold successful elections
under a civilian government until the late 1990s.6
The election of President Olusegun Obasanjo in
1999 (he was re-elected for another term in 2003)
provided a hope for stability. The federal
government, however, has been in conflict with
regional state governments over control of the
country’s offshore oil and gas resources. The
former wants to maintain its ownership and control
of all natural resources within the territorial waters,
while the states want more of the oil revenues to be
allocated to them and not to the federal
government.
Despite intense negotiations and signing
several agreements, a compromise has yet to be
reached. Thus, political and ethnic strife in the
Niger Delta region, where the majority of oil
reserves are located, often disrupts Nigerian oil
production. This includes kidnapping, seizure of
oil facilities, and illegal fuel siphoning. In addition
to disrupting domestic production, these political
upheavals contribute to the volatility of global oil
markets and prices. In September 2004, for
example, a local militia leader threatened to wage
‘all-out war’ against oil interests in the country,
unless revenues from oil sales are broadly shared
among Nigeria’s people. News of the threat sent oil
6 Attempts were made in 1966 and 1983 but ended in
violence and military coups.
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GEOPOLITICS AND SECURITY
prices in New York above $50 per barrel for the
first time.
Economic and political conditions in Angola
are not any better than those prevailing in Nigeria.
Angola is beginning its recovery from a
devastating twenty-eight-year civil war that began
shortly before the nation achieved independence
from Portugal in 1975. Angola’s civil war had a
devastating impact on the economic infrastructure
of the country and displaced an estimated 4 million
people. An agreement to end the civil war was
finally reached in April 2002, following the death
of Jonas Savimbi, the long-time leader of the
National Union for the Total Independence of
Angola.
Angola is sub-Saharan Africa’s second largest
oil producer behind Nigeria, with the majority of
its crude oil production located offshore in its
northern Cabinda province. This province faces a
situation similar to the Niger Delta states in
Nigeria. Cabinda produces more than half of
Angola’s oil and accounts for nearly all of its
foreign exchange earnings. Political tensions are
high in some areas of Cabinda as separatist groups
demand a greater share of oil revenues for the
province’s population. The separatist groups often
resort to violence, including sabotage and
kidnapping. Meanwhile, the government has
categorically ruled out the prospect of complete
independence for the oil-rich but poverty-stricken
province (EIA, 2004g).
The United States’ effort to address the ethnic
conflicts in Africa gained momentum following the
11 September 2001 terrorist attacks. Sub-Sahara
Africa became important not only to diversify
America’s oil supplies, but also as another frontier
in the war against international terrorism.
Thus, since the late 1990s and early 2000s, the
United States has taken initiatives to foster its
strategic cooperation with several African nations
and promote regional stability. For example, the
African Growth and Opportunity Act (AGOA) was
signed into law in May 2000. The Act offers
tangible incentives for African countries to
continue their efforts to open their economies and
build free markets. The Act has since helped spur
economic growth and bolster economic reforms in
the countries of sub-Saharan Africa and has
fostered stronger economic ties between the
countries of sub-Saharan Africa and the United
States. As a result, exports from the United States
to the region reached record levels after the
implementation of the Act, while exports from
sub-Saharan Africa to the United States have
increased considerably. Finally, the proponents of
380
the AGOA argue that the Act’s eligibility
requirements have reinforced democratic values
and the rule of law and have strengthened
adherence to internationally recognized human
rights in eligible sub-Saharan African countries.
Three interrelated conclusions can be drawn
from this brief discussion of oil from Africa. First,
the risk for the global economy and for the United
States is straightforward: if African producing
nations remain stable, they will grow as reliable
suppliers of oil and gas. If they continue to face
internal unrest and disruption they will create
shocks to the global economy. Hence, the US
economic and energy security rests increasingly on
fostering internal stability in Central and West
Africa. Second, transparency in public finance is
considered a key to promoting political, economic
and social reform in Africa (Goldwyn and
Morrison, 2004). Public accountability regarding
how oil revenues are spent is essential to fight
corruption. This accountability would strengthen
civil society and democracy in the region. Third,
the development of oil and natural gas in Africa
should add to the diversity of energy supplies in
the US and enhance energy security. But Africa has
its own socio-economic and political problems and,
therefore, cannot replace the Middle East as the
major source of energy to the global economy and
to the United States.
7.1.11 The Middle East:
opportunities and risks
The Middle East, particularly the Persian Gulf
region, is projected to maintain its status as the
world’s dominant supplier of oil and, to a lesser
extent, natural gas, in the foreseeable future. In
2003, the Persian Gulf accounted for about 22% of
US net oil imports, and 12% of US oil demand (the
figures for Western Europe are 30% and 17% and
for Japan 76% and 78% respectively). Middle East
oil production is expected to reach about
42.1 million bbl/d by 2025, compared to about 20.5
million bbl/d in 2001. The Persian Gulf production
as a percentage of world consumption during the
same time span will rise from 26.6% to 34.8%
(EIA, 2004c).
This impressive growth can be attributed to
several characteristics of the region’s energy
outlook. First, the Middle East holds the world’s
largest oil and natural gas proven reserves. The
infrastructure to explore and develop oil resources
is well established, including pipeline networks.
Meanwhile, a significant volume of the region’s
ENCYCLOPAEDIA OF HYDROCARBONS

natural gas is in the process of being developed and
utilized. Second, given the region’s geological
structure, the costs for oil and gas E&D in the
Middle East are the lowest in the world. Third, the
prevalence of spare capacity in the global crude oil
market, as well as the willingness and ability to
make effective use of the flexibility it provides,
have been key instruments of supply management
and a central feature of the oil price regime and
global energy security (Lajous, 2004). Historically,
spare capacity has always been highly concentrated
in a small group of Gulf oil producers led by Saudi
Arabia. The shrinking global excess oil production
capacity is a major reason for price volatility in
recent years. According to the EIA, in September
2004, this excess capacity was only 0.5-1.0 million
bbl/d, all of which was located in Saudi Arabia.
Given these characteristics, the global energy
market will always depend on oil and gas supplies
from the Middle East. True, energy security
comes from having a diversity of supplies, and oil
market is a global one, but the Middle East will
continue playing a crucial role in the stability of
global energy markets and prices. Within this
context, the notion that energy security can be
improved by reducing import dependence on oil
and gas from the Middle East is unrealistic and
misguided. The United States and other major oil
and gas consumers will always be dependent on
Middle East producers.
Several conclusions can be drawn from the
experience of the global energy market over the
last few decades. First, the Middle East has been a
reliable supplier of oil since the early 1980s. Even
when major producers experienced political and
security turmoil – i.e. the Iranian revolution
(1979), Iran-Iraq war (1980-88), the Gulf war
(1991), the Iraq war (2003) – other producers
increased their production to make-up for the
shortage of supplies and ensure stability of markets
and prices. On the other hand, since the beginning
of this century, all of the disruptions, other than in
occupied Iraq, have occurred in other oil producing
countries, such as Nigeria and Venezuela. In short,
the Middle East’s vast oil holdings overshadow its
history of turbulence. Second, global and American
dependence on oil and gas supplies from the
Middle East seems unavoidable. It is important to
point out that the United States has never been as
dependent on Middle East oil as Europe, Japan,
and the Asian Pacific regions have. This
dependence, however, need not be a problem. In
view of the recognized and growing importance of
the Middle East in global hydrocarbon markets,
consumer countries, led by the United States, can
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THE AMERICAN POINT OF VIEW
focus their efforts on enhancing the reliability of
Middle East suppliers, particularly in the areas of
attracting foreign investment and combating what
can be dubbed ‘oil terrorism’.
Third, American oil companies have invested
comparatively little in the Middle East since the
mid-1970s. In major oil producing countries in the
Middle East such as Iran, Iraq, Kuwait, and Saudi
Arabia, national oil companies were created and
took full control of their hydrocarbon resources.
The energy sector in the Middle East has been
largely closed to foreign investment since the
mid-1970s. Thus, American (and other
international) oil companies have had no choice
but to invest in other regions (i.e., the North Sea,
Russia, Caspian Sea, and West Africa). Since the
late 1990s, however, there has been a slow opening
of the Middle Eastern oil and gas sectors to foreign
investment. Thus, diversification means more, not
less, involvement and investment in the Middle
East.
Fourth, for several decades the United States
has subordinated its energy policy to strategic
considerations and interests. Accordingly, the
United States imposed unilateral sanctions against
major Middle Eastern oil producers (i.e., Libya,
Iraq, and Iran). The sanctions against the first two
have been lifted, while the ones against Iran have
been in effect since 1979. These sanctions have
blocked foreign investment in the energy sectors in
these countries and have prevented badly-needed
updates and modernization of their infrastructures.
As a result, oil supplies from these producers have
been substantially reduced. The United States
needs to pursue its energy security independently
from broader strategic interests. Promoting
economic development and political stability in the
Middle East will result in long-term oil supply
security for the entire world.
In order to meet worldwide rising demand for
oil and natural gas, and to replace existing and
future supplies that will be exhausted, substantial
investments need to be made. The IEA estimates
that the world will have to invest $16 trillion (1%
of global gross domestic product) on energy
supply infrastructure over the period 2001-30
(IEA, 2003). The oil and gas sectors will require
$3.1 trillion each (IEA, 2003). With
approximately 63.3% of world proven oil reserves
and 40.8% of proven natural gas reserves, the
Middle East is well-suited to meet the rising
global demand for energy. In order to sustain
growth in the Middle East energy sector some
$523 billion in capital spending will be required
in oil exploration and production operations and
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GEOPOLITICS AND SECURITY
$263 billion in natural gas infrastructure, in the
first three decades of the twenty-first century
(Leblond, 2003).
Most of these necessary investments will come
from private sources. This is in line with
significant change in the global economic policy.
Prior to the 1970s, the prevailing wisdom was that
the market economy had failed, particularly in non-
industrialized countries, and the Soviet model of a
state-led economy looked very promising. Since
the early 1980s, this perception was gradually
replaced by the so-called ‘Washington consensus’.
This model emphasizes free trade, opening to
foreign investment, selling public enterprises to the
private sector and an overall reduction of the state’s
role in the economic system. Despite this almost
global consensus, it seems that the global
hydrocarbon sector has been slow in
accommodating these changes. During the 1970s,
virtually all of the oil resources outside of North
America passed from international petroleum
companies to the governments of oil producers.
Each government created its own national oil
and gas companies. Currently, the bulk of the
world’s proven oil and gas reserves are still
controlled by national companies. This, however, is
slowly changing. Many oil and gas producing
countries have invited foreign investors back into
their energy sector, including both upstream and
downstream operations. Thus, some analysts have
argued that a new chapter in oil and gas industry is
about to be written.
Finally, it is important not to lose sight of the
crucial distinction between the ‘war on terrorism’
and the Middle East as a reliable source of energy.
Since the early 2000s there have been rising attacks
against Saudi oil installations. In early May 2004,
militants attacked an office of foreign petroleum
industry contractors in Yanbu, on the Red Sea, in
the western part of Saudi Arabia. Later in the
month, militants attacked a complex housing oil
employees in al-Khobar in the eastern part of Saudi
Arabia. Several people, including Saudis and
foreigners, were killed and injured. As the Saudi
ambassador to the US has acknowledged, the
terrorists’ goal is the disruption of the Saudi
economy and the destabilization the kingdom.
The attacks were orchestrated with the aim of
demonstrating that the royal family cannot
maintain security in the heart of its own oil
industry in the east and west of the kingdom. The
security of energy installations and foreign
workers will be crucial in shaping the future of
foreign investment in Saudi Arabia. For their part,
Saudi officials have sought to reassure global
382
markets about the security and stability of their
country. It is important to underscore that so far
the terrorist attacks in Saudi Arabia have not
resulted in a single barrel of oil being lost to the
market.
Similarly, in spite of the fact that the 2003 war
in Iraq caused negligible damage to the country’s
infrastructure, the prospects that Iraq will soon
become one of the world’s leading oil-producing
countries have yet to be realized. This shortfall
points up a crucial but neglected aspect of the
broader security failure in Iraq: the failure to
secure Iraq’s oil infrastructure against insurgent
attacks. For most of 2003 and 2004 a sabotage
campaign against Iraq’s 4,300-mile pipeline system
has crippled the country’s oil industry. Probably the
most disturbing aspect of oil terrorism in Iraq is
that it may become a new model for terrorists who
seek to destabilize the region. Understanding the
ramifications of instability in Iraq, the interior
ministers of several Persian Gulf states signed a
security agreement in May 2004 that called for the
exchange of information in the field of intelligence
and vowed to step-up the battle against growing
threats of terrorism in the region.
The possibility of further terrorist attacks
against oil installations in Saudi Arabia and Iraq
has contributed to the volatility of oil prices since
2003 by creating a ‘fear premium’, which has a
devastating impact on the US economy. Every
dollar per barrel increase in oil prices costs the US
economy about $4 billion a year. Consequently, a
‘fear premium’ of just $8 per barrel would create a
loss of $32 billion per year (Luft, 2004).
7.1.12 Conclusion
Since the late 1940s, the United States has sought
to secure sustainable and reliable supplies of oil
and natural gas at reasonable prices. In the decades
following, both the US energy outlook and the
global markets have substantially changed. The
United States has grown more dependent on
imported supplies of the two fuels. Similarly, the
dynamics of global markets have experienced an
immense change. The main characteristic of the
global oil market in the 1960s and 1970s was
confrontation. Most producing countries
nationalized their oil industry, reduced their
cooperation with international oil companies and
created the Organization of Petroleum Exporting
Countries (OPEC) to represent and protect their
interests. On the other side, consuming countries
established the IEA to promote their interests and
ENCYCLOPAEDIA OF HYDROCARBONS

coordinate their energy policies. Energy policy was
pursued in zero-sum terms: the gains of one side
were seen as the losses of the other side. Since the
late 1980s, this confrontational environment has
given way to growing efforts by producers and
consumers as well as oil companies to ensure the
stability of energy markets and prices.
Discussion of the US energy outlook suggests
three interrelated conclusions.
First, the United States’ effort to diversify its
energy mix and sources is crucial in ensuring
adequate oil and natural gas supplies at reasonable
prices. The main challenge the US faces at the
dawn of the twenty-first century is not that it
consumes energy at great rates: this skyrocketing
consumption reflects both geologic and economic
realities (i.e. the United States is a large country
and has the world’s most vibrant economy).
Instead, the major energy challenge that the United
States faces is that most of its energy infrastructure
is aging and rapidly reaching its physical limits.
Substantial investments need to be made to update
and expand this infrastructure.
The E&D of ANWR and reservoirs in the
shallow and deep water of the GOM are important
steps to increasing domestic production and
reducing dependence on foreign supplies. Similarly,
the SPR serves as the nation’s first line of defence
against an unexpected interruption of oil supplies.
The construction of natural gas pipelines and
terminals to import LNG will facilitate and
accelerate the switch to this clean fuel. Similarly,
investing in clean coal technology and next
generation nuclear plants would contribute to the
diversification of the nation’s energy mix.
Second, despite these serious efforts to increase
domestic production, the United States has very
limited oil and gas proven reserves. Stated simply,
the United States is a mature basin. As a result, the
gap between production and consumption is
widening and has been filled for several decades
by imports. Meaning, the United States will grow
more dependent on foreign countries to meet its
skyrocketing energy demand. This interdependence
between the United States and other consuming
countries, on the one hand, and producing nations,
on the other hand, should not be seen in negative
terms. The issue is not whether the United States
should import oil, but rather how to avoid being in
a position that makes it vulnerable to disruption.
Within this context, the availability of adequate
supplies is more important than the source of these
supplies. In other words, even if the United States
were able to import all of its oil from outside the
Middle East, it would still be vulnerable to Middle
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
THE AMERICAN POINT OF VIEW
Eastern upheavals that would impact global
production levels and prices. Washington is part of
a global energy and economic market where all
nations depend on each other.
Third, within this well-integrated market,
producers, consumers and oil companies have
established several forums to coordinate and
articulate their common interests and policies. The
International Energy Forum7 is a good illustration of
such cooperation. The goal of this dialogue is to
ensure a common energy future based on economic
prosperity and political transparency. Improved
political stability and sustained economic
development will, in turn, result in long-term energy
security for the United States and the entire world.
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Science and Technology (2005) Nuclear power technology,
safety and security.
EIA (Energy Information Administration) (2002) Country
analysis briefs: Russia.
EIA (Energy Information Administration) (2003) The global
liquefied natural gas market. Status and outlook, Report
DOE/EIA-0637.
EIA (Energy Information Administration) (2004a) Analysis of
oil and gas production in the Arctic National Wildlife Refuge,
Report SR/OIAF/2004-04.
EIA (Energy Information Administration) (2004b) Country
analysis briefs: United States of America, Washington (D.C.),
DOE/EIA.
EIA (Energy Information Administration) (2004c) International
energy outlook, Washington (D.C.), DOE/EIA.
EIA (Energy Information Administration) (2004d) US Natural
gas imports and exports: issues and trends, Washington
(D.C.), DOE/EIA.
EIA (Energy Information Administration) (2004e) Annual
energy outlook, Washington (D.C.), DOE/EIA.
EIA (Energy Information Administration) (2004f) Country
analysis briefs: Nigeria, Washington (D.C.), DOE/EIA.
EIA (Energy Information Administration) (2004g) Country
analysis briefs: Angola, Washington (D.C.), DOE/EIA.
EIA (Energy Information Administration) (2005) Annual energy
outlook, Washington (D.C.), DOE/EIA.
7 The International Energy Forum is an informal
gathering of energy ministers from energy producing and
consuming countries with the aim\ of building confidence,
exchanging information and developing a better
understanding of the underlying energy issues affecting the
world. The first gathering commenced in Paris in 1991 and
has since convened in different parts of the world.
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Godec M. et al. (2002) How U.S. Gulf of Mexico development,
finding, cost trends have evolved, «Oil & Gas Journal»,
100, 52-60.
Goldwyn D.L., Morrison S. (2004) Promoting transparency
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strategic and international studies, 7.
IEA (International Energy Agency) (2003) World energy
investment outlook 2003 insights, Paris, Organization for
Economic Cooperation and Development/IEA.
Kaplan A., Marshall G. (2003) World LNG trade responding
to increased natural gas demand, «Oil & Gas Journal»,
101, 74-76.
Klare M., Volman D. (2004) Africa’s oil and American
national security, «Current History», 103, 226-231.
Lajous A. (2004) Production management, security of demand
and market stability, «Middle East Economic Survey», 47,
18-25.
Leblond D. (2003) IEA: $16 trillion in energy investment
needed by 2030, «Oil & Gas Journal», 101, 35-38.
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Luft G. (2004) Iraq’s oil sector one year after liberation,
Washington (D.C.), The Brookings Institution.
Melancon J. (2004) Gulf of Mexico: oil and gas production
forecast 2004-2013, New Orleans, US Department of the
Interior-Minerals Management Service.
Montgomery S. (2003) ANWR development arguments and
their limitations, «Oil & Gas Journal», 101, 50-58.
Snow N. (2004) MMS forecasts higher Gulf of Mexico oil, gas
output, «Oil & Gas Journal», 102, 22-24.
Stott J.(2005) CERI: unconventional gas plentiful; technology
a must, «Oil & Gas Journal», 103, 32-34.
USGS (United States Geological Survey) (2001) USGS fact
sheet 0028-01, April.
Gawdat Bahgat
Center for Middle Eastern Studies
Department of Political Science
Indiana University
Bloomington, Pennsylvania, USA
ENCYCLOPAEDIA OF HYDROCARBONS
 7.2
The European point of view
The most likely energy scenario for the European
Union in 2030 is that at least 65% of primary demand
will still be satisfied by hydrocarbons. With the
enlarged European Union (EU) of twenty-five
countries and the North Sea energy resources well
into depletion by this date, dependency on external
sources will have reached 88% for crude oil and 81%
for natural gas, in other words, levels roughly the
same as those prior to the first oil crisis of 1973
(European Commission, 2004).
Such energy dependency will make European
economies and societies highly vulnerable for at least
three reasons. First, tensions on the world oil market
will be inevitable because of increasing demand from
the emerging economies in Asia and diminishing
available capacities resulting from insufficient
investment (Clô, 2004). Second, Europe’s entire
transport system relies on oil and, on top of this, 40%
of power generation will be gas-fired by 2030. Third,
by this date most oil and natural gas imports will
come from the Middle East, a region that in all
likelihood will remain politically unstable, and from
Russia and the Caspian countries which may not have
fully completed their transition to market economies.
Most of these hydrocarbon supplies will reach
their destination via long land or sea routes passing
through several foreign countries, or via straits (e.g.
Ormuz, Bab el-Mandeb, Suez, Bosphorus) exposed to
the risk of accidents or terrorist attacks (Hueper,
2004).
This prospect of increased vulnerability is cause
for concern for the EU and its members, who are well
aware of the high macroeconomic cost of energy
insecurity, even if the contribution of imported energy
sources to GDP has dropped considerably since 1973
(Costantini and Gracceva, 2004a). It is not surprising
then that security of supply, along with economic
competitiveness and environmental protection, has
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
become one of the three central objectives of all
European energy policies. Security of supply refers to
a situation in which all end-user demand can be met
by a supply in sufficient quantities at a reasonable and
relatively stable price. It thus comprises two aspects,
one physical and the other economic. The first is
fairly precise (availability of energy sources when and
where the consumer needs them), but the second is not
quite so clear-cut, unless it is limited to the absence of
any sudden price increases. In guaranteeing the
security of supply for the final consumer, the
reliability of internal networks (oil and gas pipelines)
has a role to play, but, since this aspect falls within
the province of national or community authorities it is
less worrying than the reliability of oil and gas
imports, which are influenced by international
relations and geopolitics (Laponche et al., 2001).
External energy security can be pursued along
different paths (Noël, 1999a, 1999b). The United
States (US), which has greater domestic
hydrocarbon sources than the EU as well as the
most powerful oil industry in the world and
unrivalled military strength, tends to accept its
dependency. However, it has attempted to guarantee
the security of the international markets from which
it obtains supplies by eliminating (either through
diplomatic or military channels) any obstacles to
freedom to conduct business and trade. Most
European countries do not have the same
capabilities on the international scene, and until
now, have had to safeguard the security of their
supplies by reducing external dependency and
establishing special relationships with certain
exporting countries. This European bilateralism,
contrasting with American multilateralism (Prodi
and Clô, 1975), has given rise to lively debate
within the International Energy Agency (IEA) but
has remained a permanent feature of the EU even
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GEOPOLITICS AND SECURITY
though it was qualified somewhat in a recent Green
Paper of the European Commission: “Security of
supply does not seek to maximise energy
self-sufficiency or to minimise dependence, but
aims to reduce the risks linked to such dependence.
Among the objectives to be pursued are those
balancing between and diversifying the various
sources of supply by product and by geographical
region” (European Commission, 2000).
However, since the Union is still without any
general authority in the field of energy policy, it is at
pains to translate its approach to energy security into
action. Consequently, certain EU members are
questioning the wisdom of the approach without
necessarily agreeing that the political conditions are
in place that would enable Europe to define a
community-wide policy (i.e. to speak with one voice
on the international scene and to act collectively) as
the US, Japan or China are able to do.
In order to really understand the special nature of
the European approach to energy security, it must be
placed in the context of the insecurity experienced by
most European countries since the beginning of the
Twentieth century (see Section 7.2.1). In 1968 the
ordeals suffered by these countries led them to create
special instruments for managing supply crises. These
instruments were accepted by the IEA in 1974 but the
EU is now seeking to redefine them (see Section
7.2.2). Rather than having to deal with energy crises,
Europe would prefer to prevent them. Therefore, in
the longer term, its aim is to create energy systems
that are more resilient by being less dependent on oil
imports (see Section 7.2.3). After a certain success in
this direction, Europe has recognized the persistency
of its dependency and has attempted to reduce the
associated vulnerability by diversifying its
hydrocarbon suppliers and concluding cooperation
agreements with some of them (see Section 7.2.4).
But the somewhat limited and uncertain results of this
international action have come out on the side of
those in favour of safeguarding energy security
through market liberalization (see Section 7.2.5). Is
this complex, open-ended approach to energy security
suited to the oil and gas geopolitics of the next fifty
years? The question remains open and merits further
discussion (see Section 7.2.6).
7.2.1 The difficulties
of geopolitics and lessons
learned from insecurity
Whether individual or collective, behaviour is
always shaped by experience and experience has not
been the same in all of the countries of Europe.
386
Even today, the United Kingdom or the Netherlands
do not share the same views as France, Germany or
Italy when it comes to energy security. However,
since the beginning of the Twentieth century, they
have all been confronted with the same difficult
geopolitical environment. One difficulty is that
until the discoveries in the North Sea, European
hydrocarbon resources were inaccessible. Also
because, even as a group, the European countries
have never been leaders in the world oil industry.
They discovered the consequences of this situation
both during the First World War and much later
with the succession of supply disruptions and price
shocks that occurred between 1956 and 1979. On
each of these occasions, either through debate or
conflict, they furthered what might be called the
‘European approach’ to energy security.
European dependency on the US oil industry
Compared with the US and Russia, which in
1900 produced 8.5 and 10.7 Mt (Million of tons)
of oil respectively, Central and Western Europe
had difficulty reaching 0.7 Mt, and this
production was concentrated in Austria and
Romania. There was some exploration but the
continent’s rare resources were not exploitable
with the technology of the time. The European
countries were thus compelled to satisfy virtually
all of their requirements by first importing
refined products and then, as they gradually
established their own refineries, by importing
crude oil. Imports rose rapidly at this time with
an annual average growth rate of 9.5% between
1865 and 1913 (Mitchell, 1978).
About one-third of imports in 1900 came from
Russia where the Nobels first, and then the
Rothschilds successfully exploited the crude oil
resources of the Baku region. But even at this time,
supplies were starting to decline. Even the robust
establishment of Royal Dutch in the Dutch East
Indies and the creation, in 1907, of the
Anglo-Dutch group Royal Dutch Shell, under the
leadership of Henri W. Deterding, failed to help
Europe in bringing new equilibrium to an oil
industry that was largely dominated by the US. On
the eve of the First World War, close to 80% of
Western Europe’s oil was supplied by Standard Oil
or companies resulting from its break-up. Their
dominant position worried the governments of
particular countries.
The UK government was the first to react,
through the Admiralty, which was concerned about
safeguarding its fuel-oil supplies following the
conversion of its vessels to this new fuel. In 1914,
Winston Churchill, First Lord of the Admiralty,
ENCYCLOPAEDIA OF HYDROCARBONS

signed an agreement with Anglo-Persian comprising
a long-term contract to supply the Navy, and which
also included an acquisition by the government of
51% of the capital of the company, which was later
to become British Petroleum (BP). Shortly
afterwards, judging its war effort to be threatened by
insufficient deliveries from Standard Oil, the French
government took similar steps. In 1923, having
become owner of the oil assets of Deutsche Bank in
Iraq, it created the Compagnie Française des
Pétroles (CFP) in which it retained 35% of the
capital and 40% of the rights to vote. Three years
later, the Italian government set up Azienda
Generale Italiana Petroli (AGIP) which laid the
foundations of a national industry from which Ente
Nazionale Idrocarburi (ENI) later emerged.
These direct interventions from states in the
organization of the oil industry were not motivated
solely by security concerns; although, security did
play a central role in a context of diplomatic and
military confrontations over the control of crude
sources in Latin America, the Middle East and later
in Africa. In addition to their mission to develop the
refining industry and distribution networks in their
home countries, the new state-owned companies had
the task of looking for hydrocarbons in territories
under their country’s national sovereignty (i.e.
colonies) and competing with multinationals
elsewhere; this included offering producing
countries more attractive exploration and production
agreements than the usual concessions. During this
period, which extended until the 1960s, security of
supply was measured in terms of the proportion of
oil imports that were controlled by national firms. In
France, state-owned companies were committed to
meeting at least 50% of national oil demand. Not all
of the European countries went so far, since they did
not all share the same confidence in the virtues of
interventionism, but they all considered that oil was
too serious a matter to be left in the hands of
industry alone. Oil supply must not depend solely on
the market because it is also a “reason and arena of
political contrast” (Clô, 2000).
Dependency on the oil producing countries
After the Second World War most of the
European countries maintained their desire for
national oil companies that could defend their
interests in the face of the multinationals. Yet, this
goal was now part of a broader issue, that of
security, since dependency was becoming
generalized, bringing with it greater vulnerability.
Inspired by the so-called ‘American way of life’,
economic growth became a huge consumer of oil
products. These products were needed to run the
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
THE EUROPEAN POINT OF VIEW
rapidly rising number of vehicles on the road and
the power stations that were doubling their
electricity output every ten years. Apart from the
natural gas that Italy, France, Germany, the UK and
the Netherlands were starting to produce, these
hydrocarbons were imported. Compared with the
oil consumption of Western Europe on the eve of
the first oil crisis, these imports corresponded to a
dependency rate of 97%, which was infinitely
greater than in North America (30%) and even
more than in Australasia (93%). Given the
pre-eminence of oil, total energy dependency had
now reached 60%, a spectacular leap from the 3.2%
in 1925 (Darmstadter et al., 1971). This average
dependency rate varied from one country to the
next, depending on the extent to which coal was
still used or on the part played by natural gas: 30%
in the Netherlands, 49% in the UK, 50% in
Germany, 77% in France, 84% in Belgium and 85%
in Italy (Prodi and Clô, 1975).
The oil which Europe had grown to depend on
for its energy supply no longer came from Russia
(which had become the Soviet Union) or North
America, but from the Middle East and Africa. In
this period of the 1950s marked by struggles for
political independence and economic development,
the countries in these regions were determined to
make their voices heard, notably through OPEC
(Organization of Petroleum Exporting Countries).
Western Europe, which bought roughly half its oil
consumption from these countries, thus discovered
its vulnerability:
• In 1951, with the nationalization of the oil
industry in Iran.
• In 1956, with the closure of the Suez Canal, one
of the main oil transit routes.
• In 1967, with the Six Day War and the second
closure of the Suez Canal.
• Between 1971 and 1973, with unilaterally
imposed price rises, nationalization of certain
oil assets and the embargo imposed on the
Netherlands and Portugal during the Arab-
Israeli war.
These events brought differing responses. While
the US recommended that the consumer countries,
embodied by the IEA, should take a united stand
against OPEC, Europe became divided over the
issue.
7.2.2 Instruments for managing
oil crises
What can be done in the case of a sudden and
unexpected disruption of oil supplies? This question
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GEOPOLITICS AND SECURITY
was not entirely absent from the preoccupations in
Europe after the Second World War, but it was not
central to the treaties affecting the organization of
energy supply in the region. Neither the European
Coal and Steel Community (ECSC), created in
1951, or the European Atomic Energy
Community-Euratom (EAEC) nor the European
Economic Community (EEC), set up in 1958, were
concerned with hydrocarbons, except to remove any
obstacles to their freedom of movement between
member states and to standardize the customs
tariffs applicable to imports. But the rate at which
coal was being replaced by oil products quickly
became a cause for concern.
In 1961, the president of the ECSC insisted that
the degree of security and regularity of supply must
always be a criterion in the coordination of energy
sources (Malvestiti, 1961). The task of coordinating
energy sources was soon taken over by the
Interexecutive Energy Group, which in 1964
adopted a protocol of agreements. For the first time,
an official text confirmed the need to diversify
energy supply sources in order to guarantee
long-term availability of supplies to consumers, and
suggested political intervention in the event of
disruption of supplies (Brondel, 2003). Another
step was taken towards defining a common energy
policy with the aggregation of the executives from
ECSC, Euratom, and EEC in 1967 and the adoption
the following year of the First Guidelines for a
Community Energy Policy. The only legal provision
available to the EEC to make progress on this front
was art. 103 of the Treaty of Rome, which provided
for the community to take temporary measures in
areas that did not fall within its competence.
First obligations to maintain stocks in 1968
The idea of acting together to combat the
increasing vulnerability of the European economies
was by no means accepted by all of the European
governments. Several countries (i.e. UK,
Scandinavian countries, Iberian Peninsula and
Greece) were not yet members of the EEC. Among
those that were, most were not prepared to give up
their energy policy prerogatives, or else they
preferred to consult each other in the context of the
Energy Committee of the OECD (Organization for
Economic Cooperation and Development). In 1967,
however, the second closure of the Suez Canal in a
little over ten years sounded the alarm. On 20
December 1968, following consultations with the
oil companies which gave their agreement, Council
Directive 68/414/EEC obliged EEC members to
maintain emergency stocks of crude oil and/or
petroleum products equivalent to at least 65 days
388
consumption, based on their average daily
consumption in the previous year. Added to the
stocks normally maintained by oil companies, total
available stocks would cover approximately four
months consumption. In the case of disruption of
imports from the Middle East alone, the EEC
countries could meet their needs for over two years,
provided consumption was reduced by 10%.
Against a background of rising oil uncertainty,
and following the entry of the UK, Ireland and
Denmark into the EEC, the question was taken up
again at the October 1972 summit and resulted two
months later in the publication of Council Directive
72/425/EEC. This Directive increased the
emergency stockpiling requirement to the equivalent
of 90 days consumption. It was followed in July
1973 by Council Directive 73/238/EEC, obliging
member states, in the event of disruption of supplies,
to use their stocks adequately, to regulate prices to
prevent abnormal rises, to give priority to supplies
of petroleum products to certain groups of users,
and to impose specific restrictions on consumption.
They were also urged to develop power generation
facilities that could use fuel other than oil in case of
an emergency (Willenborg et al., 2004). In
accordance with this directive, in 1973 and 1974
most Western European countries imposed speed
limits on their roads, heating and lighting
restrictions and petrol rationing, and in some cases
driving was even prohibited on certain days. Finally,
a few years later, Council Decision 77/706/EEC and
Commission Decision 79/639/EEC specified that
the reduction in oil consumption in the EEC was
normally fixed at 10% for no more than two months,
but in the event of a serious crisis, further reductions
could be imposed.
EEC takes a back seat behind IEA
After the start of the Arab-Israeli war in October
1973, the retaliatory measures decided upon by
OPEC were of considerable concern to the
European states. Meeting in Copenhagen in
December 1973, they discussed the possibility of a
more voluntarist policy to deal with the
vulnerability of their economies to oil supplies. Two
opposing points of view were expressed. France
favoured Euro-Arab dialogue and bilateral
agreements in order to avoid confrontation with the
exporting countries. Practically all the other
countries, however, supported the US position in
favour of the consumer countries taking a united
stand, with their interests being defended by the
IEA, as it was created for this purpose. All of the
European countries apart from France, Finland and
Iceland, agreed to this solution and, in November
ENCYCLOPAEDIA OF HYDROCARBONS

1974, signed the International Energy Program
(IEP) Agreement. Essentially, they were eager not
to dissociate themselves from the US, which was
wary of any European initiative in the Middle East.
Some also saw it as an opportunity to prevent the
Commission from encroaching too much on their
national sovereignty in the area of energy policy
(Willenborg et al., 2004).
In 1975, the system for managing oil crises that
the EEC had started to put in place was
complemented by the IEA system. It was more
ambitious but so complex that it has never actually
been used, except partially and unofficially in 1990.
The IEA system is based on two agreements: the
IEP and the CERM (Co-ordinated Emergency
Response Measures).
The aim of the first agreement, IEP, was to
promote “secure oil supplies on reasonable and
equitable terms”. It contains numerous measures,
ranging from establishing an information system on
the international oil market and consulting with oil
companies, to much longer term programmes to
reduce dependence on imported oil. Some of the
measures concern emergency situations
characterized by a 7% reduction in world oil supply.
Known as the Emergency Sharing System, these
measures concern the capacity to sustain
consumption for at least 90 days with no net oil
imports, a programme for restraining demand and
allocating available oil among participating
countries on an equitable basis. The 90 days
self-sufficiency are to be covered by industry stocks
(commercial and obligatory), government stocks
held exclusively to respond to emergency situations,
and stocks managed by agencies on the basis of
cooperative and cost-sharing arrangements. The
commitments of the participating countries can also
be met in two other ways:
• By fuel switching capacity, provided that this
capacity can be brought into operation within
one month, using secure supplies of fuel, and
subject to government control.
• By stand-by oil production defined as “a
participating country’s potential oil production
in addition to normal production within the
country’s jurisdiction”.
The programme of restraint measures for
reducing final consumption, which must be
respected by each country, can be implemented by
raising taxes on petroleum products, rationing
deliveries to bulk users or through public education
campaigns. Required reductions in consumption
can vary between 7% and 10%, in line with the
variation in loss of supply. Finally, in the event that
participating countries have available reserves in
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THE EUROPEAN POINT OF VIEW
excess of or below their requirements by
comparison with other countries, compensatory
mechanisms can be activated.
The CERM, adopted in 1984 by the governing
board of the IEA, was created for two reasons: first,
procedures for activating the measures provided for
in the IEP would be too long and complex in the
event of an oil crisis; second, the economies of the
participating countries could be seriously harmed
by disruptions that might escape the IEP trigger of a
7% loss in world supply, as happened at the time of
the second oil crisis. The CERM thus provides for
simpler and more rapid responses than the IEP.
Among them, the use of oil stocks is the most
effective, and it also acts as a threat to speculation,
but other measures can be used if drawing on stocks
proves inadequate: discouragement of abnormal
spot buying, demand restraint, short-term fuel
switching, etc. The CERM could have been
triggered in January 1990, at the time of the First
Gulf War, since it provided a framework for
preparations made by all of the IEA member
countries, plus France, Finland and Iceland, but it
was never officially activated.
New proposals from the EU
The EU mechanism for managing oil crises has
a number of flaws compared with that of the IEA: it
does not specify a level of oil supply loss to be used
as a trigger for drawing on stocks; no authority is in
place to implement stock-drawing measures; it can
only act with respect to stocks in excess of those
provided for in the IEP as all the EU members (15),
including Greece since 1977, Portugal since 1981
and France since 1992, have subscribed to the IEP.
Furthermore, the mechanism makes no provision
for situations resulting from price shocks.
However, the IEA system does not altogether
escape criticism. First, because only its non-
European members (US, Japan, Korea) have
completed it by adopting national mechanisms
aimed at using their strategic reserves to stop
speculative price increases. Second, several
European countries feel that the stockpiling
imposed by the IEA is too costly for oil companies
that are used to operating on a just-in-time basis,
especially during periods of extreme price volatility.
Last, because the IEA does not take into account
the risks of disruption that could come from the
natural gas market (Costantini and Gracceva,
2004b).
In the new context brought about by the creation
of the Internal Energy Market (IEM) and building
on the recommendations of the 2000 Green Paper,
the Commission of the European Union has
389
GEOPOLITICS AND SECURITY
therefore taken the initiative, since 2002, of
proposing two new directives, one on oil supply
security (COM/2002/488) and the other on natural
gas supply security (2004/67/CE).
Oil
The first directive is intended to deal with any
risks of disagreement with the US, Korea or Japan
that could make the IEP inoperative and also to
resolve some of the shortcomings in the EU oil
crisis management system.
To make this system more effective, the
stockholding requirement would be gradually
increased from 90 days to 120 days of internal
consumption by 1 January 2007, in other words, 30
days more than the level imposed by the IEP. But
these stocks would also have to be more clearly
defined (operational and strategic stocks) and
distributed (refineries and distributors) in order to
avoid distortions that might be harmful to
competition. The directive requires that each
member state therefore set up an agency to manage
at least one-third of the volume stocked, with this
central body being financed by a levy on oil
products charged to end-users or by compensation
from the state budget. In addition, crisis
management would become a community affair,
with the Commission, rather than national
governments, being responsible for setting the
emergency system in motion. Finally, given the
cross-border movements of goods, the directive
proposes a harmonized accounting system for the
stocks held, irrespective of the location of
refineries.
Natural gas
Natural gas supply security has never been
treated in the same way as oil security. But this does
not mean that it has been ignored. In 2000, Western
Europe had ninety-four underground storage
facilities with a total capacity of 60 Gm3 (billion of
cubic meters), equivalent to approximately 50 days
of average gas consumption (Arima, 2004).
Most states have generally complied with the
obligation to maintain their industrial gas stock at a
minimum level or with the requirement not to
exceed the ceiling applicable to imports from each
gas supplying country (Luciani, 2004). However, a
few states have been more cautious than others. In
Italy, imports from non-EU countries are authorized
only when storage capacity is at least equivalent to
10% of the volumes imported annually. In Spain,
gas transportation companies and traders must
diversify their supply as soon as they reach a level
where 60% of their supply of gas is coming from a
390
single country. The Netherlands controls the use of
reserves in order to guarantee the availability of the
Groningen reserves in the event of supply problems.
The proposed directive confirms the need for
storage, but specifies that the level should take into
account the geological and economic storage
possibilities in each member state. On the other
hand, it is much more precise concerning
differentiation between consumers: those
considered to be vital consumers, because they have
no replacement options, should be guaranteed
supply to cover 60 days consumption – in average
weather conditions – in the event that the single
most important source of gas supply is interrupted.
If the directive is adopted, it will help to clarify
the distinction between interruptible and
non-interruptible customers, who purchase their
gas at a different price (Luciani, 2004).
Is it really necessary to go as far as the
Commission proposes in managing the risk of
energy crises? Arguing on the grounds of the high
cost of the new measures, the Council of the
European Union and the European Parliament
rejected the proposal in 2003 and suggested
improving coordination between the EU and IEA
mechanisms. Nevertheless, the Commission can be
expected to return to the attack if the situation
worsens on the international markets. But the best
solution most probably lies elsewhere, in the
construction of long-term energy systems that will
be more resilient because they are not based solely
on oil.
7.2.3 Construction of more
resilient energy systems
for the long term
The best way of avoiding the costly management of
oil insecurity is to minimize the risk of crises by
constructing more resilient supply systems, in other
words, systems that can resist any shocks from their
external environment. But, given the inertia of
infrastructures and energy technologies, such
systems require long lead-times, often incompatible
with market demands and political conditions. It
was only with the oil crises of the 1970s that the
calls to reduce the energy vulnerability of the
European economies were heard. When oil prices
increased four-fold in just a few months, the
European governments reacted by adopting two
types of strategy: reducing the energy intensity of
economic activity; replacing imported oil with
other energy sources, either produced in Europe or
imported from more reliable sources.
ENCYCLOPAEDIA OF HYDROCARBONS
 THE EUROPEAN POINT OF VIEW

The results expected from these strategies varied
considerably from one country to the next, as did
the relative contributions of these results to market
mechanisms (prices) and regulations (standards).
Between 1975 and 1990, efforts remained largely
national and were influenced by each country’s
resources and industries as well as the nature of
their traditions, whether interventionist or liberal.
With the 1986 oil countershock, growing
environmental concerns, and the beginning of
energy market liberalization, the EU’s calls for
greater dialogue and coordination started to be
heeded. The Green Paper of November 2000 made
energy security part of the strategy for sustainable
development.
Less energy-intensive economies
In 1974, after tackling the most glaring cases of
energy waste, most of the European governments
changed their tax systems, regulations and subsidies
in order to improve energy efficiency in industry,
transport and the residential-tertiary sector. In some
states, special agencies were created to inform and
educate consumers and coordinate national
programmes in situ. While industry adapted
spontaneously to changes in relative prices of
energy, some national governments introduced
measures that went a long way towards reducing
energy intensity: insulation standards in residential
buildings and generalization of energy audits,
minimum performance requirements for boilers,
compulsory labelling of household appliances,
obligation to reduce fuel consumption of vehicles,
incentives to develop public transport, etc.
Because it was the only consensual response to
the challenge posed by energy dependency
(Commission Européenne, 1995), the EU’s action
gained influence in the early 1990s. This action was
expressed through three main tools:
• Directives obliging member states to amend
legislation in favour of greater energy efficiency
(dwellings and household appliances) and
encouraging them to use public procurement
and third party financing.
• R&D, demonstration programmes, diffusion and
promotion of best techniques, such as Thermie
and SAVE (Specific Actions for Vigorous
Energy Efficiency).
• Voluntary agreements with manufacturers of
energy-intensive goods, the best known being
the ACEA/JAMA/KAMA (Association des
Constructeurs Européens
d’Automobiles/Japanese Automobiles
Manufacturers/Korean Automobile
Manufacturers Agreement), which is between
the European, Japanese and Korean automobile
industry.
Finally, more recently, the EU has attempted to
reconcile market liberalization and energy
efficiency by conferring greater responsibility on
industrial and financial operators. Given the time
required to renew housing and household
appliances, the full impact of most of the directives
adopted between 1995 and 2003 will not be felt for
a few years time.
By facilitating reductions in the energy intensity
of economic activity through their energy efficiency
policies, national governments and the EU have
helped stem the rise in energy consumption and, in
doing so, have also helped to reduce energy
dependency (Table 1).
But the expansion of the EU to include
countries aspiring to rapid modernization,
particularly of their transport sectors, will lead to
new rises in energy consumption. The Green Paper
thus recommends stepping up efforts to reduce

Table 1. Evolution of final energy consumption (Mtoe) and final energy intensity (koe/US$95ppp1)
(Enerdata, 2003)

Consumption Consumption Annual Intensity Intensity Annual

1971 2000 growth (%) 1971 2001 variation (%)
West Europe 794 1,173 1.2 0.17 0.12 ⫺1.2
Denmark 16 15 0.0 0.19 0.10 ⫺2.2
France 125 172 1.1 0.18 0.12 ⫺1.4
Germany 183 250 1.1 0.18 0.12 ⫺1.4
Italy 89 133 1.4 0.14 0.10 ⫺1.1
United Kingdom 140 164 0.5 0.20 0.12 ⫺1.7
1 Kilo of oil equivalent by US$ 1995 value (purchasing parity power).

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GEOPOLITICS AND SECURITY
energy intensity since “only a policy geared to
controlling demand can lay the foundations for a
sound energy supply security policy” (European
Commission, 2000). Horizontal policies
(completion of the internal market, energy taxes,
energy saving schemes, dissemination of new
technologies) and sectoral policies (new balance
between modes of transport, major energy savings
in buildings) will all help to control demand.
Several directives, in particular COM(03) 739, are
being prepared to oblige member states to
demonstrate greater dynamism in all of these areas.
Substitutions for oil
Reducing the vulnerability of European
economies by restraining growth in energy demand
would not have sufficed without action to change
the structure of supply. The members were
incapable of acting in unity as they were urged to
do by the EEC (European Commission, 1974): each
member state acted as it saw fit, playing what it
thought was its best card to take advantage of the
competitive prices of other energy sources
following the steep rise in oil prices. The impressive
results that certain countries obtained in the two
decades after the first oil crisis now seem
particularly fragile in light of forecasts for 2030.
The UK, Germany and Belgium-Luxembourg,
where coal still represented 25-35% of primary
supply, all produced nationally in the first two
cases, boosted consumption and production of this
fuel. In Italy, a non-producing country, the
government supported the conversion of 8.3 GW of
fuel-oil to coal, notably through the expansion of
port infrastructures. These measures slowed down
(but have not stopped) the decline of coal in
European energy consumption. Poland’s future
accession to the EU should not change the decline
in mining activity. There is still the possibility of
importing coal and, according to the Green Paper,
given the present facilities and technologies,
imports should increase slightly to maintain a
certain diversification of electricity generation.
Natural gas rarely exceeded 10% of primary
supply in European countries in 1973, except in the
Netherlands, where it already represented more
than 40%. By 1985, the figure had reached 20%,
not only because it could be easily substituted for
oil products in thermal generation, but also because
abundant supplies quickly became available (Criqui
and Kousnetzoff, 1987). Production from the Po
Valley, Lacq and Groningen gas fields was
supplemented by North Sea gas. Furthermore,
governments took an active part in developing trade
with Algeria and the USSR, while safeguarding
392
supplies, by interconnecting the gas transportation
networks. Gas has without a doubt made the most
effective contribution to energy supply
diversification in Europe since 1973. The rapid
growth in gas consumption forecast for the next
decades (2.9% per year until 2010, and then 1.6%
in successive years) means that it will continue to
play an important role. But the exhaustion of North
Sea gas fields will also bring the risk of excessive
dependency and price tensions.
In the 1950s nuclear energy was presented as
the real successor to oil and it widely penetrated the
electricity generation market in many countries: UK
(22.1%), Spain (23.6%), Germany (28.1%), Sweden
(49.6%), Belgium (55.5%), France (77.7%). It thus
made an effective contribution to the diversification
of European energy supplies until 2003, but this
phase is now drawing to a close. With Italy, Austria,
Belgium and Germany now turning away from the
nuclear option, the wait-and-see attitude of the UK,
and the modest commitments of Finland in 2002
and France in 2004, the share of this energy source
in primary supply will be halved by 2030. The
Green Paper, while emphasizing the need for the
EU to retain its leading position in the field of civil
nuclear technology, acknowledges that nuclear
energy will no longer have an important role in
diversification of supplies.
The options that remain are new energy sources
and renewable energy sources (i.e. biomass, wind,
solar, small-scale hydropower), which, despite
seeing their production increase rapidly since the
mid-1980s, still make only a small contribution to
Europe’s energy supply as a whole; although, their
contribution is more significant at a national level
in a few countries such as Portugal (15.7%),
Finland (21.8%), Austria (23.3%) and Sweden
(28.8%). The broad consensus concerning these
substitute fuels, not least because of their limited
environmental impacts, explains why the EU has
made them a political priority. The Green Paper
advocates financial and fiscal incentives to reach
the goal of 20% by 2020. The objective set by the
renewable energy directive is to increase the share
of green energy sources in primary supply from 6%
to 12% (that is from 14% to 22% of power
generation) by 2010. Can these objectives be
reached? Nothing could be less certain, since, as the
Green Paper points out, “these forms of energy do
not have the same development facilities that other
sectors had” (European Commission, 2000).
The movement away from oil in the energy
supply market was very rapid until around the
mid-1980s, but then slowed down as oil again
became abundant and people became less
ENCYCLOPAEDIA OF HYDROCARBONS
 THE EUROPEAN POINT OF VIEW

Table 2. Evolution of primary energy supply in EU (25) (European Commission, 2004)

1990 (Mtoe) 2000 (Mtoe) 2030 (Mtoe) 1990 (%) 2000 (%) 2030 (%)

Solid fuels 431 303 300 28 18 15

Liquid fuels 596 636 674 38 39 34

Natural gas 259 376 628 17 23 33

Nuclear 197 238 185 13 14 9

Renewables 69 96 169 4 6 9

Total 1,552 1,649 1,956 100 100 100

concerned about security of supply. But even so, production capacities will shift to the Persian Gulf
the structure of Western Europe’s energy supply (⫹77%), the former Soviet Union (⫹79%) and
has changed appreciably, with less dependency on Africa (⫹115%), regions still subject to conflicts,
oil. The future is not likely to be quite so rosy, and in some cases terrorist attacks. Moreover, the
however, if the Green Paper has it right. Coal is reality of the ‘one great pool’ of oil means that
arousing distrust, nuclear power is falling from diversification has lost some of its interest.
favour, and renewables are taking off very slowly, This new vulnerability will not be alleviated by
which leaves only natural gas to diversify energy substituting oil with natural gas since, with the
supply (Table 2). exhaustion of the UK’s resources, gas will also
increasingly come from abroad. Supplies from
Norway could be increased from 52 Gm3 in 2000 to
7.2.4 Diversification of imports
and cooperation with
exporting countries Table 3. Evolution of crude supply
(%) of EU (15)
Given the limited possibilities when it comes to (Pauwels, 1994; IEA, 2004)
creating more resilient energy systems, Western
Europe has no choice but to seek more secure Origin 1973 1983 2003
external supplies. But since it is aware that it has
Middle East 66.6 30.9 22.6
little influence on international oil and gas market
organization, it has opted for diversification of Iran 13.9 8.4 6.4
suppliers and cooperation with some of them.
Iraq 7.0 3.2 1.6
Successful though precarious diversification Kuwait 11.0 1.0 1.0
To reduce their vulnerability, most European
member states have sought to diversify their oil Saudi Arabia 25.6 13.2 11.3
sources by reducing imports from the Middle East, Others 9.1 5.1 2.3
which were felt to represent an excessive share of
total imports. The success of this policy is clear: for Africa 24.4 23.4 18.7
the EU as a whole, this share fell from 66.6% in Ex-USSR countries 3.1 8.7 25.8
1973 to 30.9% in 1983 and to 22.6% in 2003. The
main beneficiaries of diversification have been the Latin America 1.8 7.2 1.5
former Soviet Union and the OECD countries, OECD 2.2 29.6 30.4
which saw their respective contributions leap from
3.1% and 2.2% in 1973 to 25.8% and 30.4% in United Kingdom 0.0 25.3 7.2
2003, thanks in particular to the rapid expansion of Norway 0.2 4.3 19.2
North Sea output (Table 3).
However, this trend is now coming to an end. Others 2.0 0.2 1.0
The location of oil reserves recoverable in the first 100.0 100.0 100.0
Total
decades of the twenty-first century will mean that

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GEOPOLITICS AND SECURITY
100 Gm3 with additional compression in the
existing pipeline, but other requirements will have
to be met by gas imports from Russia, the Caspian
area, Algeria, Libya, Nigeria, Egypt, and LNG
(Liquefied Natural Gas) from Qatar and maybe
even from Venezuela. This wider range of import
sources will only help safeguard Europe’s supply
security if potential suppliers can export the
required volumes at a reasonable cost. To do this
they will need to invest massively since they have to
mobilize more remote reserves, often at a high cost
(Yamal Peninsula and the Shtokmanovskoe field in
the Barents Sea), or set up liquefaction chains
(Arima, 2004). The World Energy Investment
Outlook (WEIO) has drawn up estimates of the
enormous investments required, which only large
national or multinational companies are in a
position to make. But will they do it? Will it suffice
for gas-producing countries to open up to the rest of
the world? The EU considers that more must be
done and that the way forward is through economic
and political cooperation.
EU cooperation with its suppliers
The idea of dialogue rather than confrontation
with producing countries is not new, but the
underlying reasons have changed. Initially, certain
European countries wished to safeguard security of
supply (which they believed the multinationals could
not guarantee them) by concluding direct agreements
with producing countries. The idea had been
sufficiently convincing for the EEC to take it up in
the form of Haferkamp’s proposals in April 1971,
followed by Simonet’s proposals in June 1973.
Immediately after the first oil crisis, it was decided at
the Copenhagen Summit in December 1973 to start
discussions with OPEC, while certain European
countries started talks with producing countries such
as Iran and Saudi Arabia. This two-fold approach
provoked violent opposition from the US. With the
backing of the UK, the US divided the European
nations and convinced them, with the exception of
France, to join the IEA (Chatelus, 1974).
Subsequently, regular but informal contacts were
maintained between EEC and OPEC representatives,
but the desire of the producing countries to export
refined products rather than crude oil became a
stumbling block. The second oil crisis revived the
idea of a price stabilization agreement but, as prices
began to fall, it was not pursued (Brondel, 2003).
Since 1990, cooperation with oil and natural gas
producing countries has again become one of the
key elements in Europe’s approach to energy
security, but the basis for such cooperation has
changed. With insufficient political and economic
394
weight to influence world markets, the EU has to
help its partners become attractive in the eyes of the
companies whose investments are essential. To do
this, the producing countries have to set up
institutions guaranteeing the transparency and
stability of regulations and tax regimes. In addition
to Norway, three major regions are concerned:
Russia and the former Soviet republics, the Gulf
States, and the Mediterranean countries. Norway
was encouraged by the EU to subscribe to the rules
of the 1994 directive on hydrocarbons licensing
which sought to establish equal access to
hydrocarbon exploration.
Eastern Europe
The cornerstone of European energy
cooperation with the Eastern-bloc countries should
have been the Energy Charter Treaty (ECT) signed
on 17 December 1994 in Lisbon. This treaty
followed on from the European Energy Charter,
which had been presented to a meeting of the
European Council in June 1990 by former Dutch
Prime Minister Rudd Lubbers. He had wanted to
make it “a catalyst for economic revival in Eastern
Europe and the USSR” (Axelrod, 1996). The initial
idea was to deal with the disorder expected to result
from the collapse of communism by encouraging
Western Europe, an energy importer, to transfer
capital and technology to the energy-rich former
Soviet Union. However, such investment was not
possible without a legal framework to ensure that
companies would be treated fairly and to remove
trade barriers in energy materials and products.
Rules would thus protect foreign investment against
political risks (discrimination, expropriation,
nationalization), breaches of contract, losses due to
war, and unjustified restrictions on transfer of
capital. Most of the rules adopted by the ECT were
modelled on those of the General Agreement on
Tariffs and Trade (GATT), superseded by the World
Trade Organization (WTO), and notably on the
principles of the Most Favoured Nation (MFN).
They applied to trade, trade related investment
measures, transit, transfer of technology, access to
capital, investment promotion and protection,
environment, and transparency. Given the difficult
relations between Russia and Ukraine, the
guarantee of safe transit was particularly important
(Commission Européenne, 1995).
Although signed by fifty-one countries, the ECT
did not meet the expectations of its promoters for a
number of reasons. First, the treaty was extended to
the US and Canada (neither of which signed it), and
to Japan, Australia and a few other countries, and
therefore deviated from its initial purpose of
ENCYCLOPAEDIA OF HYDROCARBONS

enhancing cooperation between Eastern and
Western Europe on the basis of their energy
complementarities. Second, Russia, the main
partner, after first having doubts about signing the
treaty, never ratified it because it felt that certain
aspects of its sovereignty were threatened by too
much free enterprise. In particular, Gazprom was
opposed to the transit protocol, which would have
imposed a disturbing level of competition
(Townsend, 2003).
But despite these disappointments, the ECT
brought rewards in the form of other EU
cooperation agreements either with Russia or with
the former Soviet republics.
With the latter, the INOGATE (Interstate Oil
and Gas Transport to Europe) programme, set up in
1995, and TRACECA (Transport Corridor
Europe-Caucasus-Asia) have proved to be useful
instruments for safeguarding the energy security of
Western Europe. The technical, economic and legal
information collected by INOGATE, as well as the
feasibility studies performed under the programme,
have helped reduce risks related to consolidation of
the gas pipelines between Kazakhstan and Central
Europe via Russia and Ukraine, between Ukraine
and Belarus, the Baltic States and Poland, Slovakia
and Hungary. Both programmes have provided
precious aid for the design of new pipelines and the
rehabilitation of old ones. Furthermore, twenty-one
countries in the region have signed an Umbrella
Agreement aimed at harmonizing the rules
applicable to hydrocarbon transport infrastructures.
With Russia, the Commission has attempted to
develop a strategic partnership from the difficult
dialogue started at the time of the ECT. To this end,
Commission President Romano Prodi (October
2000) tried to restore an atmosphere of confidence
between the EU and Russia with the aim of
encouraging European companies to invest in the
production and transport of Russian hydrocarbons.
The EU has drawn up a list of priority projects,
known as projects of common interest, under the
Trans-European Energy Network (TEN-E)
programme. High on the list is the project for a
northern trans-European pipeline carrying gas from
the Barents Sea to Germany and the UK. But the
Commission would like to go further by seeking
greater technical harmonization and interoperability
between Russian and Western European gas
networks, a subject under discussion by the
European Gas Regulatory Forum in Madrid.
Gulf Cooperation Council (GCC)
At the end of the 1980s, despite the fall in crude
oil prices and the reduction in imports from the
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THE EUROPEAN POINT OF VIEW
Middle East, Europe maintained its interest in the
region. Two important factors were the region’s
strong buying power and the role of the Gulf
Cooperation Council (GCC), a regional
organization comprising Saudi Arabia, United Arab
Emirates, Kuwait, Qatar, Bahrain and Oman. The
GCC originated as a security pact, and has
subsequently promoted economic cooperation. In
1989, the EU and the GCC concluded a
Cooperation Agreement whose objective was to
facilitate trade relations and market access, and
more generally to strengthen stability in the region.
However, the results did not match the expectations
of the signatories, since over the following years
trade relations did not significantly intensify, and
EU-GCC cooperation on oil and gas supply brought
no concrete results.
However, such cooperation appears even more
essential now that hydrocarbon imports from the
Middle East are set to increase. For the EU, a
politically stable and economically prosperous
region, open to investment from European
companies in hydrocarbon exploration, production
and transport, would make an effective contribution
to safeguarding supplies. In this respect, EU-GCC
cooperation should be possible since both parties
have mutual interests. They are interested in
preventing conflicts which could interrupt oil and
gas flows and threaten the energy security of
importing countries and the revenues of exporting
countries. They are also interested in reducing price
volatility and, if possible, keeping prices in a range
that will simultaneously encourage energy
conservation, rational use of traditional fossil fuels
and the development of nontraditional fuels and
other sources of energy (Luciani and Neugart,
2005).
To achieve progress in this area, several
proposals have been put forward. In addition to
continued dialogue on all questions related to
political stability and security in the region,
including proper governance and human rights, the
EU and the GCC should speed up Free Trade
Agreement (FTA) negotiations, in parallel with the
WTO accession of Saudi Arabia and the completion
of the GCC customs union. The EU could make an
effective contribution by abandoning duties on
imports of petrochemicals and aluminium
originating from the GCC against reciprocal
concessions from the GCC side. Furthermore, EU
and GCC dialogue could focus on “improving the
transparency of the oil market in order to build
capacity in advance of actual demand and to avoid
tensions on prices and production volumes;
establishing guidelines for the accumulation and
395
GEOPOLITICS AND SECURITY
liquidation of stockpiles and supporting
investments in transportation facilities in order to
avoid bottlenecks or emergencies; encouraging
vertical integration downstream and upstream, and
negotiating an appropriate instrument to regulate
and protect cross investment” (Luciani and Neugart,
2005).
Euro-Mediterranean energy partnership
In 1969-71 the EEC showed the first signs of
interest in the neighbouring southern Mediterranean
countries. In 1986 an important step was made
following the accession of Spain and Portugal as
efforts were made to promote an economic,
political, social and cultural partnership. The
resulting agreement, the Barcelona Declaration,
was finally made official on 28 November 1995 and
was adopted by the fifteen European Union
member states and the twelve Mediterranean
partners, from Morocco to Syria, but excluding
Libya. The declaration included three objectives:
the definition of a common area of peace and
stability through the reinforcement of political and
security dialogue; the construction of a zone of
shared prosperity through an economic and
financial partnership and the gradual establishment
of a free trade zone; the rapprochement between
peoples through a social, cultural and human
partnership (Sfligiotti, 2003).
At first sight, Europe’s energy security was not
concerned by the construction of such a
partnership. For the EU, the Euro-Mediterranean
area is first and foremost a hinterland, providing
Europe with additional growth capacity and extra
clout in dealings with North America or the Pacific
countries. In the eyes of the EU, the southern
Mediterranean countries would have everything to
gain in terms of political stability and economic
development. Not entirely convinced, however,
these countries insist that the energy sector, which
is their main asset in dealings with the northern
countries, should have a pivotal role in the
economic partnership, and that the appropriate
framework for investments and the activities of
energy companies should be created.
Almost ten years after the Barcelona
Declaration, the multitude of ministerial meetings,
the reports and the communications from the
European Commission have produced so few
results that some observers have even qualified it as
a complete failure (Bertelsmann Group for policy
research/Center for applied policy research, 2000).
So little progress has been made in terms of
economic reform and better governance that the
region is among those that attract the least capital.
396
In 2000, it accounted for less than 5% of all foreign
direct investment in emerging economies; whereas
it has considerable needs in terms of hydrocarbon
exploration and production and the development of
new energy infrastructures like the Hassi
R’Mel-Spain and Hassi R’Mel-Italy gas pipelines
or new liquefied gas carrier terminals to
accommodate more Algerian LNG.
Will the decisions made in 2002-2003 to better
target the use of the MEDA (Mesures
D’Accompagnement) budget, which accompanies
the measures of the partnership, and to set up
ad hoc groups to propose specific energy policy
actions or energy interconnections, be sufficient to
bring some success to the Euro-Mediterranean
energy partnership? Certain observers still have
doubts, believing that oil and gas supply cannot
form the main basis of regional partnership in the
present context of globalization of trade. Neither
the obvious complementarity between the northern
and southern Mediterranean nor the geographical
proximity of the two shores (factors put forward to
justify the partnership) can change the technical and
economic reasoning underpinning the formation of
costs and prices. Even the argument of confidence,
brought about by a certain social and cultural
proximity, appears shaky in view of the frequent
conflicts between neighbours (Chatelus, 1997).
7.2.5 Market liberalization
and supply security
Policies to encourage cooperation and help open up
oil and natural gas producing countries to European
companies capable of investing in exploration,
production and transport will only effectively
improve energy security if Europe remains an
attractive market for these same companies.
Nothing would do more for achieving this goal than
a large unified market, which has been the aim of
the EU since the Single European Act of 1986.
Hence, the conviction that an effective market is the
lowest cost way of addressing most long-term
energy security threats (Andrews-Speed, 2004). In
this perspective, market liberalization, unbundling
of the large vertically integrated state-owned
companies, the opening up of networks to
competition, and privatization all contribute to
energy security since they increase the number of
operators and diversify the networks. The resulting
flexibility in oil, gas and electricity supply provides
a guarantee of rapid adaptation to any disruption,
whether caused by external or internal factors. In
the case of natural gas, flexibility is further
ENCYCLOPAEDIA OF HYDROCARBONS

enhanced by the increasing number of LNG supply
sources and the installation of trading hubs (IEA,
2002).
Even if it proves to be correct, this view of the
situation does not yet correspond to reality. New
operators have indeed appeared on the energy
markets, but at the same time those that are able to
invest outside Europe have tended to fall in number,
since liberalization has promoted recomposition
and, through it, industrial concentration.
Furthermore, networks (in particular gas networks)
have continued to develop but there has been little
progress in terms of improving interconnections,
which are essential for interregional transfers. Half
of the natural gas consumed in the EU crosses at
least one border before reaching the end-user; but
numerous regions are not connected to any others.
The situation is even worse for electricity, with only
8% of total generated power being traded between
member countries. “The construction of new
transmission lines often raises local opposition at
strategic points, for example, around the Pyrenees
or the Alps” (European Commission, 2000).
Even if these obstacles were overcome, it is
unlikely that market operation alone would be able
to guarantee energy supply security. Dynamic
markets can be an incentive for companies to invest,
but there is no guarantee that this will lead to
greater flexibility. Why support the cost of a new
transport infrastructure that might benefit possible
competitors? Finally, the authorities must continue
to clearly define the responsibilities of the different
players and ensure that decisions dictated by the
market do indeed contribute to security of supply
(Esnault and Pirovska, 2004)
7.2.6 Results, limitations
and uncertainties
of the European approach
For the last hundred years, the risks surrounding
Western Europe’s hydrocarbon supply have not
disappeared, but they have changed profoundly.
These risks are no longer related to the weakness of
the European oil industry in the face of the
all-powerful US industry as: Shell, BP, Total, ENI,
Statoil and a few others are now openly competing
with ExxonMobil and ChevronTexaco. There is no
longer fear of possible embargoes decided upon by
a few producing countries, because today these
countries are numerous and, more importantly,
extremely dependent on the revenues from their
hydrocarbon exports. “No one country makes up a
significant portion of the oil market, certainly not
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
THE EUROPEAN POINT OF VIEW
like the US did for the industry’s first century. It is
unlikely that any group of nations could make
common cause to declare embargo that would be
effective any more” (Lynch, 2004).
Today, the remaining risks are elsewhere.
Disruptions of oil supply and also of natural gas
cannot be discounted given the vulnerability of
tanker itineraries and pipeline routes to terrorist
attacks or sabotage. Volatility of supply and price
tensions are also to be feared. On a tight world
market, because of the time lag between investment
commitments and a surge in demand driven by the
emerging economies, a few strikes or local disputes
would be enough to send prices spiralling and
deprive consumers of supplies at a stable and
reasonable price (De Lestrange et al., 2005).
Where does the European approach to security
stand in the face of such risks?
The measures that have been set up to manage
temporary disruptions (lasting a few months) are
satisfactory, although, it is unfortunate that the EU
lacks the autonomy to trigger the application of
these measures and to organize solidarity between
member countries. Cooperating directly with the
other IEA countries is certainly essential, but why
give up the possibility of doing this in a united
manner, especially if the EU’s interests do not
coincide with those of the US, Japan or Australia?
Why not fight abusive speculation by threatening to
place some of the stocks, held at the scale of the
EU, on the market?
In the longer term, and in the context of a
genuinely global oil market, it is understandable
why the EU (in contrast with its post-1973 strategy)
is no longer insisting on energy self-sufficiency.
The idea of self-sufficiency is nevertheless not
anachronistic when it takes the form of a resilient
energy system combining security of supply,
environmental protection and economic
competitiveness. This is precisely what can be
found in the Green Paper of 2000 but it is not stated
strongly enough to carry conviction. The margins
for manoeuvre that the Green Paper finds too
limited could be broadened:
• In terms of controlling energy demand with a
more ambitious transport policy than the one in
the White Paper of 2001 (the transport sector
will account for 60% of oil consumption by
2050 if energy use patterns remain unchanged).
• In terms of diversification of supply, by adding
nuclear energy and clean coal to natural gas and
renewable energy sources.
As far as the EU’s international actions to
improve its energy security are concerned,
Commission officials have clearly understood that,
397
GEOPOLITICS AND SECURITY
despite its efficiency, the market would never on its
own be able to guarantee supplies of oil and natural
gas, both of which are subject to changing
geopolitical forces. They have also understood that
the producing countries are not the only ones
entering into this geopolitical arena. They have been
joined by the transit countries, which will have
increasing influence in the coming decades.
Strategies concerning the movement of oil and gas
are therefore necessary, not only with respect to the
countries that suffer from being practically
landlocked (i.e. Iraq, Caspian area) but also those
through which these commodities have to transit (i.e.
Ukraine, Turkey). The EU thus made a wise decision
in devising cooperation programmes suited to each of
the regions that might contribute to its security of
supply (Chatelus, 1997). Unfortunately, its intentions
have not always been followed up by actions. The
ECT deviated from its path by opening up to North
America and Japan. In the Middle East, EU-GCC
cooperation has not given rise to a European strategy
to deal with the diplomatic and military omnipotence
of the US. Nor has Euro-Mediterranean dialogue
been any more effective. However, progress would be
possible if an increasing proportion of hydrocarbon
imports were transacted in euros, and if the EU made
a firmer commitment to financing major transport
infrastructures.
There is nothing mysterious about the EU’s lack of
power. Although the energy sector was at the origins of
the European integration project (ECSC and
EURATOM), it has never been the driving force. The
Green Paper deplores the fact that “the EU lacks the
means to negotiate and exert pressure. The Union
suffers from having no competence and no community
cohesion in energy matters […]. As long as the EU
fails to develop means to reduce the influence of the
international markets, this situation will remain the
Achille’s heel of the European economy and its ability
to influence dialogue at world level will remain
limited” (European Commission, 2000).
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399

Geopolitics
of oil and gas exporting countries
The geopolitics of oil and gas exporting countries
is fundamentally related to the money flows, which
originate from the production and trade of these
natural resources. This wealth is shared between all
the participants in the industry: national
governments, state agencies, political parties,
state-owned companies, and national or
international private companies. Therefore, part of
it is returned to citizens through different types of
public expenditure, such as educational or
healthcare services, infrastructure building, the
subsidization of social tariffs for transportation,
and water and energy goods.
In this setup, three different issues are relevant.
The first one concerns the amount of money which
is generated each year and its evolution over time.
The second issue is the appropriation for
redistribution of this money and its impact on local
economies, an impact which is frequently
associated with ‘the curse of oil’. Finally, the third
issue relates to governance systems and the actual
functioning of political institutions. The geopolitics
of oil and gas exporting countries is at the
confluence between the economics of oil and gas
and the political dynamics of each country. In
addition, each country has to define its own
position within the international geopolitics of oil
and gas (Table 1).
8.1.1 Oil and gas revenues
For energy exporting countries, oil and gas
revenues represent, in most cases, a significant
share of their Gross Domestic Product (GDP) and
also of their state fiscal resources. For 11 of the 20
surveyed countries, oil and gas export revenues
represent more than 17% of their GDP and more
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
8.1
than 58% of their budget resources (Table 2). With
such a degree of dependency, it is no wonder that
the evolution of these revenues over time plays a
key role in explaining the economic and political
development of these countries. In particular, two
elements have a direct connection with each
country’s development dynamic: the price of oil
(and gas) and the volume of its exports.
For most countries, the level of oil price and its
variations are an exogenous factor, although they
can sometimes play some role through the
Organization of Petroleum Exporting Countries
(OPEC). Most of the time, the level of world oil
price is far above the average cost of producing
crude oil, which is estimated to be around 7
dollars/bbl (worldwide average). The difference
between the world price of oil and the domestic
cost is the basis on which each country receives its
oil rent. In the case of natural gas, the volume of
the rent is less important than that for oil (on an
equivalent energy basis) because the cost of gas
transmission is much higher than the cost of oil
transportation (7 to 10 times higher). Moreover, at
the end user stage, gas faces the competition of
many energy substitutes, while many oil products
enjoy monopoly situations. For governments, the
difficulty in managing oil and gas rents comes
from the fact that oil and gas prices are volatile. In
addition, as these commodities are priced in
dollars, they may hurt the purchasing power of an
exporting country that buys abroad in different
currencies when the dollar is weak. This was the
case in 2004-05, with the low exchange rate of the
dollar versus the euro. Incoming revenues are not
predictable and high revenues may encourage
expenditures at risk.
The volume of exports is less of an exogenous
element. It actually depends on several factors,
401
PRODUCER-EXPORTER COUNTRIES

Table 1. Oil and gas reserves and production in 2003 (BP, 2004)

Oil Oil Gas Gas

reserves production reserves production
Countries % % % %
109 bbl of world 103 bbl/d of world 1012 m3 of world 109 m3 of world
total total total total

Middle East and Far East

Iran 130.7 11 3,852.0 5 26.7 15.2 79.0 3.0

Iraq 115.0 10 1,344.0 2 3.1 1.8 – 0.0
Kuwait 96.5 8 2,238.0 3 1.6 0.9 8.3 0.3
Saudi Arabia 262.7 23 9,817.0 13 6.7 3.8 61.0 2.3
United Arab Emirates 97.8 9 2,520.0 3 6.1 3.4 44.4 1.7
Brunei 1.1 0.1 214.0 0.3 0.4 0.2 12.4 0.5
Indonesia 4.4 0.4 1,179.0 2 2.6 1.5 72.6 2.8
Malaysia 4.0 0.3 875.0 1 2.4 1.4 53.4 2.0

Africa

Algeria 11.3 1 1,857.0 2 4.5 2.6 82.8 3.2

Egypt 3.6 0.3 750.0 1 1.8 1.0 25.0 1.0
Libya 36.0 3 1,488.0 2 1.3 0.7 6.4 0.2
Angola – – 885.0 1 – – – –
Chad – – 40.0 0.1 – – – –
Equatorial Guinea 8.3 1 249.0 0.3 – – – –
Nigeria 34.3 3 2,185.0 3 5.0 2.8 19.2 0.7

Latin America

Brazil 10.6 1 1,552.0 2 0.3 0.1 10.1 0.4

Bolivia – – – – 0.8 0.5 5.2 0.2
Colombia 1.5 0.1 564.0 1 0.1 0.1 6.1 0.2
Mexico 16.0 1 3,789.0 5 0.4 0.2 36.4 1.4
Venezuela 78.0 7 2,987.0 4 4.2 2.4 29.4 1.1

Total surveyed countries 911.8 79 38,385.0 50 67.8 38.5 551.7 21.1

World 1,147.7 100 76,777.0 100 175.8 100 2,618.5 100

both discretional and non-discretional. First, the
volume of exports depends on the existing
productive capacity and on the rhythm of
production that is decided by governments and/or
oil firms, sometimes under the constraints of
OPEC’s quotas. Only part of the actual production
is exported, the rest is used for domestic
consumption. Therefore, in some countries, the
rapid growth of domestic demand, sustained by
demographic growth, may lead to a problematic
decline in oil and gas exports volumes and
revenues (such as in Indonesia since the 1990s).
This question underlines the importance of
defining a national policy for natural resources,
which is a second factor for acting on volumes.
The issue of developing proven reserves and
encouraging oil and gas exploration is a question
of pure economic policy. Some countries want to
keep oil and gas development as a domestic
preference, with a nationalistic position aiming to
funnel oil and gas investments to their state-owned
companies. Others may concede more or less
liberal entry conditions to international investors.
In Latin America, for instance, there is a
permanent political debate about the place to be
given to international investors and also about the
amount of money to be invested in the oil sector by
state-owned companies. Gas reserves are generally
more open to international investors than oil
reserves because delivering gas to the markets is
more complex, and also because gas rent is lower
than oil rent.
These differences notwithstanding, solving the
question of a political opening to international
investors remains crucial for the equilibrium of
energy markets. The amount of resources at stake
in this issue is immense. A great deal of these
reserves is located in politically turbulent areas.

402 ENCYCLOPAEDIA OF HYDROCARBONS

 GEOPOLITICS OF OIL AND GAS EXPORTING COUNTRIES

Table 2. Oil and gas revenues (World bank, 2004; IMF, 2004)

Population, GDP Average annual Average annual

total per capita hydrocarbons hydrocarbons
2003 2003 revenues 2000-03 Exports 2000-03
Countries
% of total
constant % of total
million fiscal % of GDP % of GDP
2000 dollars exports
revenues
Middle East and Far East

Iran 66.4 1,715.2 59.3 16.8 82.0 19.9

Iraq 24.7 – 58.4 93.1 n.a. n.a.
Kuwait 2.4 16,737.7 68.4 47.6 91.9 45.9
Saudi Arabia 22.5 9,037.9 81.6 27.4 89.2 35.2
United Arab Emirates 4.0 19,717.5* 76.1 32.4 49.1 35.1
Brunei 0.4 – 85.8 52.7 88.2 80
Indonesia 214.7 781.3 31.3 6.1 22.6 8.1
Malaysia 24.8 4,011.3 n.a n.a n.a n.a

Africa

Algeria 31.8 1,915.5 69.9 25.8 97.1 35.5

Egypt 67.6 1,622.3 n.a n.a n.a n.a
Libya – – 72.5 36.1 97 36.6
Angola 13.5 814.3 80.9 33.9 90.3 67.9
Chad 8.6 217.8 n.a n.a n.a n.a
Equatorial Guinea 7.9 430.7 84 21.6 93.4 89
Nigeria 136.5 357.4 77.2 32.6 95.8 43.8

Latin America

Brazil 176.6 3,510.2 n.a n.a n.a n.a

Bolivia 8.8 1,017.3 n.a n.a n.a n.a
Colombia 44.6 2,017.0 9 2.7 27.8 44.6
Mexico 102.3 5,792.0 32.2 7 14.9 2.5
Venezuela 25.7 4,009.0 52.7 14.3 79.9 21.3

* Data 2002.

For instance, nearly 60% of world oil resources and
40% of world natural gas resources are located in
the Middle East. The problem is turning existing
resources into production, which means that huge
investments are needed. Many well-endowed
countries are persuaded that they can assume the
financial and technical burden of sustaining these
needed investments. Although this might be
acceptable, the closure of these countries to
international investors may also slow down the
speed of investments and increase the probability of
a supply shortage. On this matter, a comparison
of direct foreign investments’ flows between
different geographical areas is illuminating. The
most closed area is the Middle East.
The utilization of oil and gas revenues
Most of the large oil and gas exporting
countries are often harmed by what is called ‘the
curse of natural resources’. This expression reflects
the idea that the economic structure of countries
rich in natural resources is distorted by the
perverted effects of large exports revenues. Such
was the case the Netherlands in the Sixties, as it
was struck down by the ‘Dutch disease’; the Dutch
manufacturing sector suffered from the export
‘boom’ of natural gas. Recent empirical studies
show that during two decades, 1970-80 and
1980-90, economies abundant in natural resources
performed badly and none of them grew rapidly
(Sachs and Warner, 2001). Even when
geographical and climate variables are taken into
account, the evidence for the curse of natural
resources remains. So far among large exporting
country, Malaysia are the only economies that have
managed to escape the oil curse.
There is no universally accepted theory of this
phenomenon but the facts are there. A number of
indicators demonstrate the reality of the curse:
structure of the trade balance, structure of the

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PRODUCER-EXPORTER COUNTRIES
budget, and social indicators. The structure of trade
balances shows that oil and gas sales represent a
high percentage of export revenues. This situation
means that these countries are not able to export
anything else other than hydrocarbons. The rest of
the economy (agriculture, industry, and services) is
distorted by oil and gas wealth, which inflates
domestic prices and crowds out any other exports
(Fig. 1).
State budgets are constrained by unproductive
expenditures, which are driven by overdeveloped
state administrations. The investment in large
infrastructures, as well as in ensuring military
security, is then huge. And, significant investments
are made without taking into account the operating
and maintenance costs that follows initial
investments. Moreover, state budgets have to meet
social demands. In order to maintain social peace,
part of the oil and gas money is often redistributed,
especially through subsidized tariffs for natural
gas, automotive fuel, electricity and butane. Oil
money becomes in this way a substitute for
democratic legitimacy. By lessening the
dependence of a government from levied fiscal
revenues, it reinforces the power of the ruling
class. Unfortunately, oil money often widens the
gap between classes, a path which may end up
encouraging rebellions and coups d’état.
In many countries, there is a permanent fight
between the government and the state controlled
oil and gas companies for the sharing of oil and
Fig. 1. Export structure 100%
by main category
(UNCTAD, 2003). 80%
60%
40%
20%
0%
Iran
Kuwait
Saudi Arabia
UAE
food
items
ores and manufactured
metals goods
Year data: Algeria, Nigeria 2000; Egypt, Bolivia, Brazil, Colombia, Mexico, Venezuela,
Iran, Saudi Arabia, Indonesia and Malaysia 2001; Libya, United Arab Emirates, Brunei,
Angola 1990; Kuwait 1999.
404
gas money. State companies are generally required
to surrender oil revenues to the government, but
they also want to invest in their sector,
domestically and abroad. On the other hand,
governments are facing social and political
pressures, and they want to obtain more cash flow
in order to increase social spending.
Finally, social indicators of large oil and gas
exporting countries are generally rather poor
concerning education, nutrition, and health. They
do not reflect an actual process of economic and
social development (Table 3).
Governance
Governance is a major component of
geopolitics. In oil and gas exporting countries, the
question of governance has two main dimensions:
internal governance which concerns the
institutional functioning of the country, and
external governance which mainly concerns the
relationships with neighbouring and other foreign
countries. Internally, the quality of governance may
be measured by a number of indicators concerning
democracy, economic freedom, civil rights, and the
quality of the institutional and legal frameworks.
These indicators are generally low in oil and gas
exporting countries.
There is also the question of domestic conflicts
and the extent of corruption. Most oil and gas
exporting countries have some problems of ethnic
or regional conflicts, which are related in many
Indonesia
Malaysia
Brunei
Algeria
Egypt
Libya
Angola
Nigeria
Bolivia
Brazil
Colombia
Mexico
Venezuela
agricultural fuels
raw materials
unalocated
ENCYCLOPAEDIA OF HYDROCARBONS
 GEOPOLITICS OF OIL AND GAS EXPORTING COUNTRIES

Table 3. Development indicators (UNDP, 2004)

Combined
gross GDP
GDP
Human Life Life enrolment per capita
GDP per capita
Development HDI1 expectancy expectancy Adult literacy ratio for Education (Purchasing
Countries per capita (PPP dollar)
Index (HDI) 2002 at birth at birth rate primary, index2 Power Parity,
index2 rank minus
rank (years) 2002 index2 secondary PPP dollars,
HDI rank4
and tertiary 2002)
schools (%)3

High human development

Brunei 33 0.867 76.2 0.85 93.9 73 0.87 19,210 0.88 ⫺5

Kuwait 44 0.838 76.5 0.86 82.9 76 0.81 16,240 0.85 ⫺6
UAE 49 0.824 74.6 0.83 77.3 68 0.74 22,420 0.9 ⫺26
Mexico 53 0.802 73.3 0.81 90.5 74 0.85 8,970 0.75 5

Medium human development

Libya 58 0.794 72.6 0.79 81.7 97 0.87 7,570 0.72 6

Malaysia 59 0.793 73.0 0.8 88.7 70 0.83 9,120 0.75 ⫺2
Venezuela 68 0.778 73.6 0.81 93.1 71 0.86 5,380 0.67 21
Brazil 72 0.775 68.0 0.72 86.4 92 0.88 7,770 0.73 ⫺9
Colombia 73 0.773 72.1 0.78 92.1 68 0.84 6,370 0.69 4
Saudi Arabia 77 0.768 72.1 0.79 77.9 57 0.71 12,650 0.81 ⫺33
Iran 101 0.732 70.1 0.75 77.1 69 0.74 6,690 0.7 ⫺31
Algeria 108 0.704 69.5 0.74 68.9 70 0.69 5,760 0.68 ⫺25
Indonesia 111 0.692 66.6 0.69 87.9 65 0.8 3,230 0.58 2
Bolivia 114 0.681 63.7 0.64 86.7 86 0.86 2,460 0.53 6
Egypt 120 0.653 68.6 0.73 55.6 76 0.62 3,810 0.61 ⫺12

Low human development

Nigeria 151 0.466 51.6 0.44 66.8 45 0.59 860 0.36 15

Eq. Guinea 160 0.425 48.9 0.4 41.0 29 0.37 2,100 0.51 ⫺30
Angola 166 0.381 40.1 0.25 42.0 30 0.38 2,130 0.51 ⫺38
Chad 167 0.379 44.7 0.33 45.8 35 0.42 1,020 0.39 ⫺8

1 HDI is the average arithmetic of the life expectancy at birth index, of the education index and of the GDP per capita index.
2 The index for each country is between 0 and 1, where 0 corresponds to the lowest value found and 1 corresponds to the highest value. It is
calculated in the following way:
(value in country ⫺ minimum value)
1111111111311111
(maximum value ⫺ minimum value)
3 The number of students enrolled in a level of education, regardless of age, as a percentage of the population of official school age for that
level. The gross enrolment ratio can be grater than 100 as a result of grade repetition and entry at ages younger or older than the typical age
at that grade level.
4 A positive figure indicates that the HDI rank is higher than the GDP per capita (PPP dollars) rank, a negative figure the opposite.

cases to oil rents. In general, oil rents exacerbate
regional inequalities and the gap between those
who have access to oil money and those who do
not. A number of actual or potential conflicts in
Africa, the Middle East, East Asia or Latin
America are related to the location of oil and gas
wells. Beyond regional conflicts, the issue of
domestic and international terrorism recently
emerged. In certain areas, terrorism has become a
real threat for the functioning of exploitation and
production activities. Nowadays, it has a major
impact on plant security expenditures.
In developing countries, corruption is then a
constant of oil and gas activities. A significant part
of their rents is diverted from the official flows,
and often directly goes to individuals or groups in
powerful positions. In this context, increased
transparency, which results from countries
adopting the Extractive Industries Transparency
Initiative (EITI), could improve the situation and
also encourage foreign direct investments.
Externally, the relationships between
neighbouring countries are important for market
stability. Problems often concern sovereignty
contested over certain on-shore and off-shore
regions, the access to resources, and the production
of shared resources. They also concern energy
transit. With reference to this issue, the European

VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION 405

PRODUCER-EXPORTER COUNTRIES
energy charter is an important step for increasing
transit opportunities. The charter is an international
treaty which gives legal and institutional structure
to transit conditions. Energy transit creates
interdependency between countries. Their
appropriate management is thus an element of
stability.
Finally, each oil and gas exporting country has
to find its position within the big game of world oil
and gas geopolitics. Major importers of oil and gas
(the United States, Western Europe, China, Japan)
are keen to secure their energy supply and to build
special relationships with oil and gas exporting
countries. The United States have built a long-
standing relationship with Saudi Arabia, but they
need to diversify toward Africa, Latin America and
Russia. One of the major priorities of their foreign
policy is to secure access to Middle East oil. The
United States, the European Community, China
and Japan form a pool of strong competitors who
vie to gain access to resources. The current oil and
gas world situation is a combination of
globalization and renewed nationalism. Market
mechanisms are complemented by political
interferences. The oil and gas international picture
is complex and leaves room for negotiations, trade
off, and compromises.
8.1.2 The Middle East and Far East
Since oil was discovered at the beginning of the
Twentieth century, the Middle East1 has acquired
strategic importance for international superpowers.
Middle East proven oil reserves are estimated at
702.7 billion barrels, i.e. 61% of world oil
reserves, for 59 million people (1% of world
population). Its contribution to the world energy
production is 26% for oil and 7% for gas in 2003.
Access to these cheap resources remains vital for
the functioning of the world economy. Despite
geographical diversification efforts, world oil
dependence on the Middle East is still large and
should continue growing in the next decades. The
rich Arab oil and gas exporting countries, which
belong to the Gulf Cooperation Council (GCC),2
remain the main suppliers of crude oil to the world
market.
Middle East oil exporting countries can be
divided into two categories. On the one hand, there
are the oil-rich Gulf monarchies like Kuwait and
United Arab Emirates, which are characterized by
small populations and vast natural resources. On
the other hand, there are countries with large
populations and oil rents more strictly correlated to
406
the international context (Iran, Iraq and, to a lesser
extent, Syria).
Saudi Arabia, a key country, lies in the middle
with huge resource endowment but also a large and
fast growing population. With a population of
about 22 million inhabitants, Saudi Arabia has the
largest oil proven reserves in the world. The size of
the fields and their flexibility enabled the Kingdom
to play an important role as market regulator (a
swing producer) for many years by modulating its
production between 8 and 10 Mbbl/d. In 2003 for
example, Saudi Arabia, with Kuwait and the
Emirates, was able to compensate for the ‘missing
barrels’ that resulted from political crisis in
Venezuela, social unrest in Nigeria and war in Iraq.
The hydrocarbons endowment of the Far East
countries (Sultanate of Brunei, Malaysia and
Indonesia) is much more modest. Despite their
smaller oil and gas rents, the comparison of the Far
East exporting countries to the Middle East states
is nonetheless relevant and telling, since they have
experimented opposed policies in the management
of oil wealth, so as to escape the oil curse.
Income from oil and gas exports
Oil revenues of Middle East surveyed countries
between 1999 and 2003 are indicated in Table 2.
One may notice the high volatility and variation of
these revenues. Despite some diversification
efforts, the Middle East countries remain extremely
dependent on oil and gas revenues. Between 2000
and 2003, about 78% of their exports revenues
came from hydrocarbon exports and 69% of their
fiscal revenues from hydrocarbon revenues. Oil
and gas exports are also the main source of foreign
exchange inflows. For instance, 75% of the Saudi
budget is fed by oil revenues. In this setting, oil
price fluctuation remains the principal determinant
of growth, as its current balance depends mainly
on the oil price level: a 10% increase in oil prices
generates a rise of 14% of the Saudi GDP
(ESMAP, 2005). The level of prices needed by
Saudi Arabia to balance its budget is today
estimated at around 30 dollars/bbl.
During the oil boom in the 1970s, all producing
countries, especially the Middle East states,
received an exceptionally large rent stream. They
1 According to the World Bank, the Middle East includes
Iran, Iraq, Kuwait, Oman, Qatar, Saudi Arabia, Syria, United
Arab Emirates and Yemen. In this article, the Middle East
surveyed countries are Saudi Arabia, Iraq, Iran, United Arab
Emirates and Kuwait.
2 The GCC consist of Bahrain, Kuwait, Oman, Qatar,
Saudi Arabia and the United Arab Emirates.
ENCYCLOPAEDIA OF HYDROCARBONS

became ‘rentier’ economies, i.e. ‘‘countries that
receive on a regular basis substantial amounts of
external economic rents from foreign individuals,
concerns or governments’’ (Mahdavy, 1970).
Today, the renting system is reaching its limits.
Revenues depend on the oil price, which remains
an exogenous factor. So, Middle Eastern
economies are highly vulnerable to price shocks
and exchange rates.
As for the Far East countries, their oil
dependency dropped significantly since the 1970s.
Malaysia and Indonesia’s profiles are indeed highly
mixed. Their agricultural sectors account
respectively for 9.5% and 16.6% of the GDP.
Indonesia is the only OPEC member who has
succeeded its diversification strategy. Between
1983 and 2003, the ratio of oil exports to total
exports fell from 64% to 15.5%. This decline
contrasts with the export structure of Middle
Eastern countries, whose exports are dominated by
fuel products, with a very low share for the other
goods (Fig. 1).
With 1.1 billion barrels of proven oil reserves,
i.e. 0.1% of world oil reserves in 2003, Brunei
Darussalam is the only Far Eastern country largely
dependent on oil and gas exports: 88% of its
exports are hydrocarbons. The oil and gas sector
contribute about 40% of its GDP. Given the lack of
diversity of its economy and the heavy reliance on
volatile hydrocarbon revenues, Brunei is starting
now to promote development of non-oil exports
(and re-exports), such as tourism and financial
services. However, the main source of public
finances is corporate tax (around 30%) and is still
primarily collected from the oil and gas sector.
The evolution of the Middle East oil production
depends on the future investments in the oil and
gas sectors. Despite robust oil prices in the past
few years, few investments were made to increase
oil production. Thus, in 2004, the low spare
production capacity of the OPEC members did not
meet the rising oil demand, mainly because of the
Chinese (and American) economic growth.
Consequently, there are serious doubts about
the effectiveness of OPEC’s future role in the oil
market. Following to the International Energy
Agency (IEA), large investments are needed in
order to meet global oil demand prospects. The
main share of these investments must be done in
the Middle East region in order to expand capacity.
To a large extent, however, the decision remains
centralized in the hands of national oil companies
and governments, since most of their oil reserves
are still precluded to foreign investment (Kuwait
and Saudi Arabia). The core producer, Saudi
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
GEOPOLITICS OF OIL AND GAS EXPORTING COUNTRIES
Arabia, affirms that the investments will be made
and that the Kingdom can easily increase its
capacity. However, funding and technological
means continue to be major obstacles for the
investments and future production increase.
Furthermore, the evolution of the Iraqi situation
is an important determinant of the geopolitics of
oil. Iraq’s oil recoverable reserves are estimated at
115 billion of barrels, i.e. 10% share of world
reserves. Nevertheless, its position in the global oil
(and gas) market is not as significant as it should
be. In fact, these estimations do not take into
account that only 10% of the territory has been
explored. The reserves evaluation took place in the
1960’s, which at that time had low recovery rates.
In addition, Iraqi oil production comes from only
20% of the discovered fields. For this reason,3 the
Institut Français du Pétrole (IFP) estimates Iraqi
undiscovered reserves at around 100 and 150
billion barrels, that is at least the equivalent of the
current reserves. As it is well known, this country
underwent two decades of war and a decade of
sanctions. It needs now huge investments to
recover the existing production capacity, and to
develop and modernize the existing fields. The
current turmoil does not encourage investments.
Offshore production developments also
represent an important alternative for the future of
oil in the Middle and Far East. For instance,
although Malaysian reserves have declined since
1996, Malaysian production has been rising since
2002, thanks to new offshore developments. This
situation may be a positive outlook on production
in these areas.
The utilization of oil and gas revenues
and their impact on the economy
As previously stated, oil and gas revenues are
the main financial resource of government and
state budgets. These resources often transit through
National Oil Companies (NOC). In the Middle and
Far East, they are generally administered under
strong nationalistic rationale. In these areas,
countries have created their own companies
following national pressures in order to take state
control of resource exploitation. Examples are
everywhere in the first region: the National Iranian
Oil Company (NIOC, in the 1950s), the Iraqi
National Oil Company (INOC, in 1965), the
Kuwait National Petroleum Company (KNPC, in
3 According to the IFP, the density of the discovered
fields per unit area is very low in Iraq relatively to the other
Gulf countries: 1 field in Iraq against 2 for its neighbors per
4,000 km2 (3 for Kuwait and the United Arab Emirates).
407
PRODUCER-EXPORTER COUNTRIES

Fig. 2. OPEC oil revenues 600 70

evolution since 1971
500 60
(DOE, 1971-2003).

109 constant dollars 2004

50
400

dollars/bbl
40
300
30
200
20
100 10

0 0
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
net oil export revenues (109 costant dollars 2004)
crude oil price (OPEC basket) constant dollars 2004
(GDP deflator)

1960) and Saudi Aramco in 19884 in Saudi Arabia. governments also invest massively in public sector
As for the Far East countries, they have also employment. The wages and salaries represent
their own NOC, but they have more significantly about 16% on average of the government
opened their oil and gas sector to international expenditure. In Saudi Arabia, the administration is
investors. Many foreign companies are today considered as the “employer of first resort”. Private
involved in oil production in Malaysia and jobs are therefore often left to foreign workers
Indonesia. The former created its national oil and (Auty, 2001).
gas company, Petronas, in 1974, which is located in Admittedly, when oil revenues collapse, the
the world’s tallest buildings (Petronas Twin ability of these countries to maintain welfare
Towers). The latter formed its state company, payments and entitlements is drastically reduced
Pertamina, in 1957. Brunei’s oil industry is and the need for a policy reorientation becomes a
completely dominated by Brunei Shell Petroleum priority. When they increase again, facilities and
(BSP), a fifty-fifty joint venture between Royal characteristics of the rentier state return, and
Dutch/Shell and the government of Brunei. Since painful economic reforms get deferred.
2002, the sector is opened to other oil companies. During ‘hard times’, the Saudi Government was
Since the two oil shocks, the resources of oil forced to borrow heavily from domestic creditors
rich countries have fluctuated following global oil and thus, has accumulated over the years 170
prices. Total oil revenues of the OPEC countries billion dollars of domestic public debt, i.e. more
were 388 billion dollars in 1974, diminished from than 92% of its GDP according to the International
556 billion dollars in 1980 to 121 billion dollars in Monetary Fund (IMF) in 2002. This massive debt
1998 and climbed back to 338 billion dollars in is a burden that clearly limits the ability of the
20045 (Fig. 2). Kingdom to launch economic expansion reforms.
During the oil booms, the Saudi Government Moreover, military and security expenditures
accumulated some revenues as reserves overseas represent an additional heavy burden for these
(the petro-dollars) and made investments in the countries: 11.3% and 11.2% of the Saudi and the
domestic economy (physical infrastructure and Kuwaiti GDPs in 2002, respectively. The Iraqi
education and health expenditures). Middle East economy, for instance, was structurally modified
countries have also opened their economy to during the 1980s due to the Iran-Iraq War. The
imported goods, foreign workers and international military sector employed around 3% of the
companies, except in the oil and gas sector. population in 1975, but it absorbed 21% of it in
Some observers have identified a ‘Santa Claus
effect’ in rentier states like Saudi Arabia and 4 In 1980 the Saudi government acquired full control of
Kuwait. The government becomes very generous
Aramco. In 1988, the company changed its name from
and provides welfare goods (education, health, Arabian American Oil Company to Saudi Arabian Oil
water and electricity) to the population in order to Company (Saudi Aramco).
maintain social and political peace. These 5 According to EIA estimations.

408 ENCYCLOPAEDIA OF HYDROCARBONS


1988 at the end of the war. During 1981-1988,
military spending totalled 120 billion dollars, i.e.
256% of the same period’s oil revenue of 46.7
billion dollars (Alnasrawi, 2002).
These expenditures clearly have a negative
impact on economic growth. They reduce domestic
investment potential and block the development of
the productive economy. Furthermore, investment
needs by the infrastructure of energy in this region
are huge, especially if one considers that energy
consumption per capita there is one of the highest
in the world. For instance, the United Arab
Emirates and Kuwait hold the highest energy
use per capita: 9.6 and 9.5 toe (ton of oil equivalent)
per capita respectively in 2002, compared to 8 in
the United States, 4 in Western Europe and 1 in
China (World Bank, 2004).
The growth potential of these countries is
nonetheless tremendous considering the amount of
their oil and gas rents. Unfortunately, only 3
(Brunei, Kuwait and the United Arab Emirates) of
the 8 surveyed countries (Middle East and Far
East) figure among the high human development
group according to the classification of the United
Nations (Table 3). In fact, the GDP per capita of
the Middle East countries has been declining since
the 1980s, a fact largely attributable to the oil curse
(Fig. 3).
Several empirical studies confirm that the
growth model of Middle East states do not meet
necessary conditions for sustainable long term
growth.
The ratio of the gross foreign direct investment
relative to GDP has been very low since 1980 and
has never really taken off (Gylfason, 2001).
Furthermore, primary-exports dependence has a
negative impact on long term growth, due to the
high volatility of commodities prices. Few non-oil
tradable activities are competitive. For instance, we
Fig. 3. GDP per capita
since 1981
(World Bank, 2004).
constant 2000 dollars
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
GEOPOLITICS OF OIL AND GAS EXPORTING COUNTRIES
notice that agriculture was often neglected, except
in Iran where it represents 11% of GDP. Kuwait,
Qatar and Brunei do not hold resources other than
hydrocarbons: no agriculture, no water, and no
industry. They are also extremely dependent of
foreign qualified and non-qualified workforce.
Their only alternative is to invest oil rents in
external assets in order to generate new types of
revenue for future generations (Kuwait).
These states, Saudi Arabia in particular, also
did not adopt a performing taxation system. In
most cases, governments still rely on the
hydrocarbons sector for more than 80% of its
revenues.
In addition, even if Middle East countries hold
high investment rates for international standards,
they are characterized by low private-to-public
investment ratios. This ratio reflects an insufficient
transmission of savings to investment due to the
weakness of Middle East countries’ financial and
business environments, and to the inefficiency of
their investments, i.e. low productivity growth
(Sala-i-Martin and Artadi, 2003). In fact, the
preponderant role of the public sector introduces
distortions in product and factor markets, and
contributes to economic inefficiencies and
resource misallocation. Consequently, the
development of the private sector has been
squeezed, and often directly limited by the public
sector.
Concerning social indicators, poverty levels are
substantially lower than other countries with
similar levels of income due to the cohesive system
adopted by governments. Nevertheless, all Middle
East countries must now cope with high population
growth rates (one of the highest in the world). The
average population growth rates between 1960 and
2003 are 8.5% for the United Arab Emirates and
4.8% for Kuwait. The population growth of Saudi
50,000
45,000
40,000
35,000
30,000
25,000
20,000
15,000
10,000
5,000
0
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
Indonesia Iran Kuwait Malaysia Saudi Arabia United Arab
Emirates
409
PRODUCER-EXPORTER COUNTRIES

Fig. 4. Ratio population 45

over oil reserves 40
in 1983 and 2003
35 1983
(BP, 2004;
World Bank, 2004). 2003
30

103 bbl
25

20

15

10

0
Kuwait

UAE

Saudi Arabia

Brunei

Libya

Iraq

Venezuela

Iran

Mexico

Algeria

Angola

Nigeria

Malaysia

Egypt

Indonesia

Colombia

Arabia has far outpaced the growth of its economy,
and the ratio of oil reserves relative to population
dropped from 16,000 barrels in 1983 to 11,000 in
2003 (Fig. 4).
The Kingdom now needs high economic
growth in order to support a growing young
population (more than half of the population is less
than 25 years old). Both the consistently high
fertility rate (5.3 births per woman in Saudi
Arabia) and population increase will certainly have
dramatic implications on Saudi Arabia’s labour
market, educational system, as well as on the size
of future affordable subsidies.
As for Far East countries, we pointed out
before that Malaysia is one of those few countries
who have escaped the resource curse and
achieved true economic success. The Federation
diversified its economy from slow growth
commodities to high growth commodities. It is
important to note first that the Malaysian GDP
structure is partly due to the country’s natural
endowment, which is much more diversified than
that of the Middle East economies. Long before
discovering crude petroleum in the 1970’s and
Liquefied Natural Gas (LNG) in 1980’s, tin,
rubber, palm oil and timber generated a large
stream of resource rents into the Malaysian
economy. This diversified structure of primary
exports helped to smooth the impact of
commodity price fluctuations over time. Malaysia
achieved sustainable economic growth by means
of different channels. In order to reduce the
negative impact of fluctuating export revenues,
the government introduced labour intensive
industrialization that created employment in rural
areas and generated high growth. The Federation
Brazil
also invested heavily in human resource
development and developed a surprising capacity
to manage price export instability shocks. During
the 1985 oil shock, the government drastically
reduced public expenditure, adopted a
privatization policy and liberalized foreign direct
investments. High investments and savings rates
were also key elements for growth, which were
supplemented in the 1990s by capital inflows
from abroad (Mahani, 2001).
Features of governance
The Middle East has long been at the centre of
struggles for the control of resources and it
has been subjected to many intraregional and
internal conflicts, as well as religious and ethnic
divisions. It is one of the most militarized regions
in the world and many conflicts are often
motivated by oil access.
The internal governance indicators6 are very
poor. Saudi Arabia, the United Arab Emirates, Iran
6 The government indicators, reported by the World
Bank according to a point system from ⫺2.5 (worst
governance) to ⫹2.5 (better governance) are the following:
PS, Political Stability and absence of violence combines
several indicators which measure perceptions of the
likelihood that the government in power will be destabilized
or overthrown by possibly unconstitutional and/or violent
means, including domestic violence and terrorism; V&A,
Voice and Accountability includes in it a number of
indicators measuring various aspects of the political process,
civil liberties, political and human rights, measuring the
extent to which citizens of a country are able to participate
in the selection of governments; CC, Control of Corruption
is a measure of the extent of corruption, conventionally
defined as the exercise of public power for private gain. It is
based on scores of variables from polls of experts and

410 ENCYCLOPAEDIA OF HYDROCARBONS


and Iraq are classified by the Freedom House as
non-politically free states (Table 4).
They have repressive regimes with a high
degree of authoritarianism. Many Middle East
governments are considered as ‘paternalistic
autocracies’ because they initially based their
legitimacy on traditional and religious authority,
and maintained it through rent distribution. They
use their oil wealth for financing social programs
in order to appease pressures for democracy and
prevent the formation of social groups independent
from the state (Ross, 2001; IMF, 2004).
Pluralist elections are almost non-existent in the
region and, in many cases, the presence of a
commanding and powerful man has long
dominated their political landscape. Saddam
Hussein governed Iraq since 1979. Bashar
al-Assad, the current Syrian President, succeeded
his father in 2000 after 30 years of power; and the
Gulf monarchies have been hereditary since these
countries gained their independence (al-Saud
family in Saudi Arabia). Needless to say, women
still do not enjoy the right to vote in several Gulf
countries.
These states also suffer from underdeveloped
political institutions. As the government is relieved
from the fiscal pressure, it has no incentive to
promote the protection of property rights as a way
to create oil wealth. As the oil rents are
appropriated by the state and are not the result of
human effort, the need for developing effective
political institutions is reduced (Birdsall and
Subramanian, 2004). Instead, the economic life of
Middle East countries is dominated by lengthy
bureaucratic procedures and unclear regulations.
As the corruption perceptions index published on
line by Transparency International (TI) in 2004
shows, oil wealth is a breeding ground for
corruption. It classifies Saudi Arabia in the 71st
position, Iran 87th, Iraq 129th, and Indonesia 133rd
surveys; GE, Government Effectiveness combines responses
on the quality of public service provision, the quality of the
bureaucracy, the competence of civil servants, the
independence of the civil service from political pressures,
and the credibility of the government’s commitment to
policies; RQ, Regulatory Quality instead focuses more on
the policies themselves, including measures of the
incidences of market-unfriendly policies such as price
controls or inadequate bank supervision, as well as
perceptions of the burdens imposed by excessive regulation
in areas such as foreign trade and business development;
RL, Rule of Law includes several indicators which measure
the extent to which agents have confidence in and abide
by the rules of society. These include perceptions of the
incidence of crime, the effectiveness and predictability of
the judiciary, and the enforceability of contracts.
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on a survey that examined 146 countries (the 146th
being the most corrupt). However, the United Arab
Emirates, Kuwait and Malaysia still benefit from
performing indicators of institutional quality.
The Middle East region is an ethnical mosaic
with Sunnites who represent the majority; the
Shiites are present in Iran, Iraq, Bahrain and
Lebanon, the Wahabits in Saudi Arabia, the
Alaouits in Syria, Druzes in Lebanon and Syria,
and the Christians in Lebanon, Egypt, Syria,
Palestinians and Iraq. This diversity poses major
complication to the governance of the region.
Conflicts between groups and minorities are
diffused throughout the region. In addition to the
permanent fight for power between Sunnites and
Shiites, Kurds and Palestinians represent
populations that have either been oppressed by
several regimes (Kurds in Syria, Iraq, Turkey and
Iran), or confined in many refugee camps scattered
across the Middle East, with no political
representation for many years (Charillon, 2003).
It is interesting to discuss here Malaysian
ethnic diversity and the way authorities have
dealt with it. In fact, Malaysia has succeeded
in dealing with ethnic conflicts. After
independence in 1957, the presence of multiple
ethnic groups reflected variable economic
functions and revenues. The Bumiputeras (55% of
the population) had a lower income level,
lived in the rural areas and worked in agriculture
and in the public sector. The Chinese (33%) lived
in the urban areas and were in commerce and trade.
The Indians (10%) were mainly in rubber
plantations and were part of the lower income
group. Thus, these ethnic groups were separated by
race, culture, religion, social status, geographical
location, and education. The proportion of the poor
was notably higher among Malays compared to the
Chinese. After racial riots in 1969, the government
implemented affirmative action policies in favour
of the Malays and announced the New Economic
Policy (NEP). Its aims were to eradicate poverty
and to improve the social conditions of the Malays
by according them preferential treatment, within a
period of twenty years. During this period,
Malaysia achieved rapid economic growth,
significantly reduced poverty and was able to
insert Malays into a dynamic public sector.
Some Middle East states are still isolated from
the globalization trends. The Economic Freedom of
the World index (EFW) measured by the Fraser
Institute (Table 4) shows that Iran remains
extremely closed. Since the Revolution in 1979,
the Islamic Republic of Iran has been detached
from globalization trends, partly because of the
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PRODUCER-EXPORTER COUNTRIES

Table 4. Governance indicators

World
TI freedom index Governance indicators
EFW 20021
corruption per country3 2004
Countries perceptions 2003
index2
2004
Rank Ratings PR CL Status PS V&A CC GE RQ RL

Midde East and Far East

Iran 78 6 2.9 6 6 NF ⫺0.91 ⫺1.36 ⫺0.59 ⫺0.66 ⫺1.33 ⫺0.77

Iraq – – 2.1 7 5 NF ⫺2.87 ⫺1.71 ⫺1.45 ⫺1.51 ⫺1.79 ⫺1.57
Kuwait 18 7.4 4.6 4 5 PF ⫹0.29 ⫺0.48 ⫹0.71 ⫹0.55 ⫹0.10 ⫹0.65
Saudi Arabia – – 3.4 7 7 NF ⫺0.60 ⫺1.63 ⫹0.15 ⫺0.06 ⫺0.34 ⫹0.75
UAE 16 7.5 6.1 6 6 NF ⫹0.91 ⫺1.01 ⫹1.23 ⫹1.20 ⫹0.95 ⫹0.78
Brunei – – – 6 5 NF ⫹1.06 ⫺1.11 ⫹0.23 ⫹0.73 ⫹1.08 ⫹0.71
Indonesia 86 5.8 2.0 3 4 PF ⫺1.38 ⫺0.44 ⫺0.90 ⫺0.36 ⫺0.42 ⫺0.36
Malaysia 58 6.5 5.0 5 4 PF ⫹0.38 ⫺0.36 ⫹0.29 ⫹0.99 ⫹0.44 ⫹0.85
Africa

Algeria 118 4.6 2.7 6 5 NF ⫺1.42 ⫺0.91 ⫺0.49 ⫺0.46 ⫺0.93 ⫺0.62
Egypt 74 6.2 3.2 6 6 NF ⫺0.72 ⫺1.04 ⫺0.21 ⫺0.20 ⫺0.58 ⫹0.23
Libya – – 2.5 7 7 NF ⫺0.02 ⫺1.79 ⫺0.91 ⫺0.73 ⫺1.52 ⫺1.00
Angola – – 2.0 6 5 NF ⫺0.95 ⫺1.02 ⫺1.12 ⫺1.14 ⫺1.40 ⫺1.33
Chad 103 5.4 1.7 6 5 NF ⫺1.20 ⫺1.09 ⫺1.14 ⫺1.29 ⫺0.84 ⫺1.15
Eq. Guinea – – – 7 6 NF ⫺0.30 ⫺1.71 ⫺1.65 ⫺1.40 ⫺0.78 ⫺1.05
Nigeria – – 1.6 4 4 PF ⫺1.78 ⫺0.65 ⫺1.11 ⫺1.02 ⫺1.26 ⫺1.44

Latin America

Bolivia 58 6.5 2.2 3 3 PF ⫺0.65 ⫺0.01 ⫺0.78 ⫺0.63 ⫹0.05 ⫺0.66

Brazil 74 6.2 3.9 2 3 F ⫺0.13 ⫹0.34 ⫺0.15 ⫹0.02 ⫹0.19 ⫺0.26
Colombia – – 3.8 4 4 PF ⫺1.69 ⫺0.47 ⫺0.16 ⫺0.18 ⫺0.12 ⫺0.46
Mexico 58 6.5 3.6 2 2 F ⫺0.13 ⫹0.36 ⫺0.27 ⫺0.02 ⫹0.55 ⫺0.12
Venezuela 118 4.6 2.3 3 4 PF ⫺1.10 ⫺0.46 ⫺0.94 ⫺0.96 ⫺1.24 ⫺0.66

1 The index measures the degree of economic freedom present in five major areas: Size of government: expenditures, taxes, and enterprises;
Legal structure and security of property rights; Access to sound money; Freedom to trade internationally; Regulation of credit, labor, and
business, following a scale of 0 to 10 (not free to mostly free),
http://www.freetheworld.com/2004/efw2004ch1.pdf
2 Score relates to perceptions of the degree of corruption as seen by business people and country analysts and ranges between 10 (highly
clean) and 0 (highly corrupt),
http://www.transparency.org/cpi/2004/cpi2004.en.html#cpi2004
3 Political Rights (PR) and Civil Liberties (CL) are measured on a 1-to-7 scale, with 1representing the highest degree of freedom and 7 the
lowest. The resulting status is ‘F’, ‘PF’, and ‘NF’, respectively, stand for ‘Free’, ‘Partly Free’, and ‘Not Free’,
http://freedomhouse.org/ratings/allscore04.xls

American Sanctions which the D’Amato-Kennedy
Law imposed in 1996. The nation is divided
between moderates and conservatives, with the
latter still controlling defence and government
institutions. Several conflicts over borders oppose
Iran to the Gulf States, especially United Arab
Emirates over the Abu Musa Island, and of course
Iraq with the long lasting memories and economic
legacy of the Iran-Iraq War in the 1980s. These
specificities are even more important if one
considers the noteworthy strategic weight of Iran in
the region. It is the crossroad between Caspian,
Central Asian and Gulf countries. Its isolation is
still reinforced by the nuclear question and the
country’s refusal to find a compromise with the
superpowers.
Concerning the Middle East external
governance, the region underwent several wars
during the last decades: the Arab-Israeli Wars, the
Iraqi wars (Iran-Iraq during the 1980s, the Gulf
War) and the Lebanese war between 1975 and
1990 partly provoked by Syrian and Israeli

412 ENCYCLOPAEDIA OF HYDROCARBONS


interventions. These wars, even if initially not
taking place in oil producing territories, have had
major influence on oil geopolitics of the region
because of energy transit.
For more than half of a century now, the
Israeli-Palestinian conflict has been a major source
of destabilization in the area. Iran and Iraq (before
2003) embody major threats to Israel. In fact, this
conflict has opposed several Arab countries against
Israel. In 1973, the Organization of Arab Petroleum
Countries (OAPEC) used its oil for political ends,
by imposing an embargo on the United States and
the Netherlands for their explicit support to Israel.
The Middle East oil wealth and the energy
growing dependence of the United States
prompted the American administration to play a
major role in the region, with an initial partnership
established by President Roosevelt and King Ibn
Saud after the Second World War. From that time
onwards, Saudi Arabia has been able to rely on the
United States to assure its security and its defence
from external threats, like the ones posed by Iran,
Iraq and, to a lesser extent, Egypt (the three main
political challengers for regional influence). The
Gulf War with operation Desert storm in 1990-91,
the sanctions imposed later on Iraq, and the
American intervention in 2003, showed the
importance and priority accorded by the United
States to secure their oil supply in the region.
Their access to oil is a matter of national security
since the US economy and military forces depend
heavily on its flow.
The attacks of September 11th, 2001 have,
however, weakened Saudi-American relations, and
the United States military presence in Saudi Arabia
is contested by the population; 15 of the 19
hijackers were Saudis. The level of the
anti-American resentment in the entire region is
growing. However, Washington’s dream is to
reshape the Middle East and to stimulate
democratization in the region, starting with Iraq,
which was suspected of holding weapons of mass
destruction that were “ready for use within 45
minutes”. The American intervention in Iraq
reflects a new dimension of foreign policy during
the Bush administration, which was considered
after the 9/11 attacks. For America, democracy
enforcement is the best antidote to extremism and
Islamic terrorism.
However, despite some pacification elements
which appeared in 2005, namely the unprecedented
democratic elections in Iraq of a Kurdish president
and the Syrian withdrawal of Lebanon, the spread
of democracy to the whole region remains, for now,
highly improbable.
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8.1.3 Africa: oil curse
with a ray of light
With 13.4 % of the world population, 836 million
people, Africa accounts for only 3% in the world
primary energy consumption. Its contribution to
the world energy production is 11% for oil and 5%
for natural gas. Beyond these figures Africa’s share
is increasing and its contribution to the world oil
supply is becoming highly strategic.
Regarding oil and gas, African countries are
divided into two broad categories: those who are
oil and gas exporting countries and those who
import their oil. In the first category are a few key
countries such as Nigeria (2.9 Mbbl/d), Algeria
(2.1 Mbbl/d), Libya (1.9 Mbbl/d), which are three
important OPEC members. Angola is also in this
category (1.2 Mbbl/d), as well as Egypt, Equatorial
Guinea, and emerging oil countries such as Sudan,
Chad, São Tomé and Principe. In the second
category is South Africa, which has important
resources of coal but no significant production of
oil. A number of poor countries that are totally
dependent on oil imports are also in the second
category. For the latter type of country, when oil is
particularly expensive, oil imports become a
financial burden that dramatically hurts its
economic growth and activity.
As far as oil exporting countries are concerned,
all of them illustrate the oil curse; in most cases,
oil wealth is an obstacle to economic development.
With no exception, oil discoveries have
exacerbated poverty, instigated wars and boosted
corruption. A recent international initiative to
develop oil in Chad, one of the poorest African
countries, could have brought some hope for the
possibility of using oil money for economic
development.
The value of oil and gas exports
Just a few African countries have been
producing oil for decades. Many others have only
recently taken part in this type of production,
following an activity boom over African resources
that began in 1990. Several reasons explain the
rush to African oil. The United States are
becoming more and more dependent on oil
imports, which represent now more than 50% of
their domestic consumption. Therefore, they want
to diversify their supply in order to lessen their
dependence over the Middle East. African oil is
alight low sulphur crude that corresponds well to
the American demand for gasoline and middle
distillates. Another important reason for explaining
the boom is the remarkable progress made in deep
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PRODUCER-EXPORTER COUNTRIES
offshore technology for exploration and
production. Companies are now able to produce
under 2,000 meters of water. Offshore production
reduces country risk because there is no population
around the fields and the exporting facilities.
Since 1990, oil companies have been active in
obtaining licences for conducting oil exploration
and developing new fields. The oil majors are in
competition with small independent firms and also
with state-owned companies from emerging
countries. Indian and Chinese companies are
aggressively looking for oil resources all over the
world. All these signposts reflect the growing
interest for African oil.
For African oil and gas exporting countries,
the financial resources generated by exports
represent between 70% and 85% of total
fiscal revenues, between 20% and 35% of their
GDP. In Chad, the start of oil production doubled
the state budget. It is, however, interesting to
observe that the governments’ percentage of profits
varies from country to country. It goes from 28%
(in the case of the very specific project of oil
development in Chad) to 80% in Nigeria.
The expected evolution of production and
exports differs from one country to another. Some
countries are facing, for the moment, a decline in
production and reserves: Gabon, Congo, Cameron.
Gabon left OPEC in 1995. Most other countries are
very promising, especially for deep offshore
production in the Gulf of Guinea. Elsewhere there
are numerous areas that might be promising, but no
exploration has been conducted. The African oil
production could reach 15 Mbbl/d in 2010 as
compared to 10.5 in 2005. However, the evolution of
production primarily depends on the amount of
investments that will be decided and also on the new
discoveries that improved technologies may enable.
In Africa, oil investments are generally made by
international companies; their decisions depends
on the fiscal regime, and also on the general
attitude of governments regarding foreign direct
investments. Most of sub-Saharan countries
welcome foreign direct investments. North Africa,
Libya, Algeria and Egypt have opened to
international investors, although the investor’s role
remains under control. Algeria proposes joint
venture, which are partnerships between the state-
owned national company Sonatrach and one or
more international companies. Partners share the
exploration and production costs proportional to
their equity stakes. If exploration is successful, the
oil production is shared according to the same
proportions. These openings notwithstanding,
relationships between foreign companies and
414
national oil companies are often thwarted by
bureaucracy and delays.
Oil and gas income uses and their strategies
Nowhere in Africa has oil money been used for
promoting economic development. Trade balances
show that oil exporting countries are not capable of
exporting any good other than oil. Social indicators
and development indicators are low everywhere
(Table 3).
Nigeria provides one of the best examples of
the oil curse. Several plans for economic
development were launched in past decades but
they rapidly faded when the price of oil went down.
The share of population living in poverty increased
from 28% in 1980 to 66% in 1996. During the
same period, the average income per head
decreased from 800 to 300 dollars. More than 91%
of the population lives with less than 2 dollars/d.
One in 5 children dies before the age of 5, more
than 4 million people are infected with HIV, and 11
million children who should be at school are not.
The uneven distribution of oil money is the major
reason for the social unrest in the Niger delta and
the development of crude oil and oil product thefts.
By some estimates, the smugglers steal as much as
10% of country’s annual output, a criminal activity
valued at 30 billion dollars in 2004. Oil is sold
abroad and the profits have financed the creation
of a well-armed private militia in the region.
In Algeria, just after obtaining independence in
1962, oil production was still in the hands of
French companies. The Algerians created
Sonatrach in 1963 and the oil industry was
nationalized in 1971. At that time, oil and gas
industries were seen as strategic. They were
expected to trigger an actual process of economic
development. Access to cheap domestic oil and gas
was expected to boost ‘industrializing industries’:
steel, equipments, machinery, and petrochemicals
(Destanne de Bernis, 1971).
The model failed entirely and large state-owned
industrial companies performed badly. Oil money
turned to subsidies, social expenditures, and
infrastructure. Part of the oil rent was increasingly
siphoned by the military ruling elites.
The uneven distribution of oil money is one of
the core problems of oil rich countries. It is the
major political issue facing the ruling class. Social
expenditures are the price one must pay in order to
buy social peace. Maintaining low prices on
automotive fuels, kerosene, butane, and electricity
is an easy means for governments. In November
2004, a litre of diesel oil was priced 8 cents of
dollar in Libya, 10 cents in Egypt, and 15 cents in
ENCYCLOPAEDIA OF HYDROCARBONS

Algeria, while the international price was 37 cents.
Sometimes the state-owned oil company has a role
to play in the distribution, especially for the
sharing between government needs and state
company needs.
In Algeria, the state-owned company
Sonatrach, who controls most of the oil and gas
activities either as operator or in partnership with
international investors, uses part of the oil money
for its own investments. However, the recent
hydrocarbons law (adopted in 2005) reduces the
autonomy of Sonatrach vis à vis the government,
illustrating a permanent fight between public
entities for control of oil money.
In Angola, the national oil company Sonangol,
which is not an operator, has become a sort of
regulator of the oil sector albeit the political and
military turmoil. The company has set up
commercial entities to obtain a better valorization
of Angola’s oil. The company has also developed a
strategy of diversification toward
telecommunication, shipping, air transport, and
insurance. Sonangol is trying to export its know-
how in the organization of the oil sector to
neighbouring countries.
As a matter of fact, in all oil exporting
countries, it is almost impossible to track the
financial flows that are related to the oil business.
A number of key elements are considered as ‘State
secrets’. The whole picture is poisoned by poor
governance, the lack of countervailing power, local
wars, ethnic conflicts, and corruption.
The specific nature of governance
There is a huge deficit in public governance in
Africa. Indicators for democracy, economic
freedom, political rights, and civil liberties are
poor. In addition, most African oil rich countries
have created plethoric bureaucracies, and oil
money is increasing geographical disparities and
aggravating domestic conflicts. Political power is
in the hands of small minorities, which either are
factional oligarchies, military elites, or a
combination of both.
Domestic conflicts that are ethnic, geographic
or religious are present in most oil exporting
countries, with the exception of Libya and Gabon.
Sometimes, conflicts existed well before oil
discoveries (Angola, Chad, Sudan); but in most
cases, conflicts are exacerbated by oil money and
the struggle for its appropriation. Most of the
recent African wars were, more or less, related to
oil money (Copinschi, 2003).
Corruption is present in all African countries.
The World Bank and a number of international
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organizations such as Transparency International
try to fight against corruption and some progress
has been made.
In this context, oil companies are facing a
difficult situation. They are asked to give money to
‘political players’. They have to protect their
employees and their oil facilities. Sometimes, they
have to deal with two opposing factions. This
situation was the case of Gulf Oil (purchased in
1984 by Chevron) in Angola, and Elf Aquitaine
(now merged with Total) in Congo. An illustrative
fact is the political role the state-owned French
company Elf Aquitaine played in Africa for
decades. Elf was considered as the French
Government’s arm in Africa. In 2002, court action
was taken in France against a few former managers
of the company. A long spectacular proceeding
revealed huge amounts of money that had been
seized from oil money for the purposes of
financing political parties in Africa and in Europe,
and also for the personal enrichment of a few well-
placed people (Joly, 2003).
Most of African oil is produced by international
oil companies and state-owned companies, but oil
resources are now attracting new comers. In Libya,
when the international sanctions were lifted
(2004), the country opened its rich oil fields to
foreign investments. An international tender offer
attracted a great number of companies. One block
went to a major international company
(ChevronTexaco) and the others to smaller players
willing to invest in Africa. Among new comers are
small independent and state-owned companies.
Companies from China and India are particularly
aggressive. They desire access to oil resources in
order to secure their countries’ oil supply. New
comers are frequently accused of ‘contractual
dumping’ by international companies. They are
less pressured by financial markets and, therefore,
may be willing to accept lower financial targets. In
addition, these companies worry less about
pressure from environmental and human rights
activists. When activists forced Canada’s Talisman
Energy from doing business with Sudan, a Chinese
company was immediately happy to take its place.
Chad oil: miracle or mirage?
Chad, one of the poorest countries in Africa,
provides an example where the development of
domestic oil resources could be a catalyst for true
economic development. Oil was discovered in
Chad over 30 years ago, but years of civil war
worsen the political and technical task of
developing oil extraction and transporting it to an
ocean-based export facility. The ‘normal’
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PRODUCER-EXPORTER COUNTRIES
development of this oil would have reinforced local
conflicts, corruption, and further concentrated
power in the hands of a few. In 2000, the World
Bank, which usually does not deal with oil
investments, decided to enter the project as a
catalyst for the financing of a 4.2 billion dollars
Chad-Cameroon Petroleum Development and
Pipeline Project. This project was designed to carry
oil from over 250 wells drilled in the Doba basin of
southern Chad through a 1,050 km underground
pipeline to the Altantic coast of Cameroon. The
estimated 1 billion barrels of oil in the Doba fields
will be extracted over a period of 25 years with a
planned production of 225,000 bbl/d, earning Chad
some 3 billion dollars over project’s lifetime
(depending on the price of oil). Chad GDP was 1.4
million dollars. Chadian oil began to be exported
in July 2003. Production and exports are operated
by an ExxonMobil led consortium with
ChevronTexaco and Petronas, the Malaysian state
oil company, as part of the project.
The condition for World Bank participation in
the project was to set up an institutional system
aimed at reversing the oil curse and promoting
economic development. The key innovative feature
of the project was the establishment of a legal
framework that earmarks money for poverty
reduction expenditures, and the creation of a
committee (the Collège) to act as a ‘watchdog’ by
approving projects and monitoring the quality of
their implementation. Money must be directed
toward strategic sectors, the region of Doba and the
Funds for Future Generations. However, only a part
of the oil money was supposed to go to the
watchdog. All ‘indirect revenues,’ including
income tax on oil companies, are instead supposed
to go directly into government coffers. It is too
early to declare whether the Chad experiment is a
failure or a success. A success implies a strong
political will from the government, a strong
implication of the Chadian civil society for
watching the flow of oil money and its utilization,
and the actual ability of the judiciary to prosecute
cases of misuse, fraud or corruption. The role of
external actors is also important to guarantee the
success: the World Bank, the International
Monetary Fund, the United States and French
Governments can be important sources of pressure
for greater transparency and accountability. This
type of setup could have represented the first step
towards a better way of thinking about the
relationship between oil and economic
development. It emphasizes the importance of
transparency for all financial flow related to oil
business.
416
This set up is in line with the Extractive
Industry Transparency Initiative, which is trying to
obtain from public and private entities a
commitment to promote more transparency in
financial flow. A number of governments and
companies are now participating to this initiative.
In Africa, Ghana, Nigeria, Congo and Gabon all
participate in the initiative. It shows that progresses
can be achieved towards more transparency. In
Nigeria, after a long succession of military leaders
eager to tap the nation’s wealth for themselves, the
new president decided in 2003 to ‘clean house’. He
created a financial-crime investigation unit, which
is actively working.
8.1.4 Latin America:
between strong
government control
and a competitive
market
With 8.5% of the world population, 530 million
people, Latin America accounts for 6% of world
primary energy consumption. Its contribution to
the world energy production is 14% for oil and 6%
for natural gas.
Regarding oil production and exports, the two
major players are Mexico and Venezuela, the latter
being an important and influential OPEC member.
Other significant players are Colombia, Ecuador
(who left OPEC in 1995) and Argentina. The case
of Brazil, the largest country of the area with 174
million inhabitants is interesting; the country
produces significant volumes of oil and gas, but it
needs to import. One of Brazil’s specifications was
that biofuels made from sugar cane were to be
increasingly developed. These biofuels represent
roughly 50% of the automotive fuel used by
automobiles, trucks and buses in Brazil.
For natural gas, the major exporters
are Trinidad and Tobago, Argentina and Bolivia.
Trinidad and Tobago exports 4 billion m3 per year
of LNG, mainly to the United States market.
Bolivia, with its huge natural gas resources that
can be monetized, dramatically illustrates the
geopolitics of a gas rich country.
Latin America is a region of political tensions
from the North (Mexico) to the South (Argentina).
The recent economic crisis and the difficulties
encountered by liberalization have exacerbated
political struggles, weakened coalitions, and
strengthened populist movements and nationalist
claims. Presidents Lula da Silva in Brazil and
Chavez in Venezuela are the emblematic figures of
ENCYCLOPAEDIA OF HYDROCARBONS

Nationalism-populism. Nationalism is frequently
associated with local willingness to lessen the
political, commercial and cultural influence of the
United States. The region is facing real difficulties
for attracting investments. Foreign direct
investments have decreased in most countries
between 2000 and 2004. Investment is the key
economic issue in all these countries and
governments hesitate deciding the place to be
given to market mechanism versus government
control. The situation varies from almost complete
opening (Argentina) to total closure (Mexico).
Governments are also proposing solutions that
involve both public and private investment
participation in energy sector development. As
governments throughout Latin America
increasingly look toward public-private
partnerships, many questions remain. What do
these partnerships offer to private investors? What
is the benefit for the host government? Do these
partnerships offer a stable environment for long-
term investments? These are the central questions
for the geopolitics of oil and gas in Latin America
(CERA, 2004).
Wealth deriving from oil and gas
As compared to Africa and the Middle-East, oil
and gas exporting countries from Latin America
are less dependant on oil and gas revenues. These
revenues account between 9% and 53% of total
fiscal revenues (53% for Venezuela) and between
2% and 14% of GDP. However, many of these
countries do not escape the oil curse in terms of
economic development and social indicators.
Most Latin American oil and gas exporting
countries have significant potential for new
discoveries, onshore and offshore. Many countries
have been insufficiently explored. In term of oil
production, one of the most spectacular increases
will come from Brazil where substantial
discoveries, mostly offshore, have already been
made.
In other countries, the evolution of the
production will depend on the quality of field
maintenance and, much more importantly, on the
amount of money that will be invested in
Exploration and Production (E&P) activities.
Boosting the investments necessarily implies
opening the country to international investors, a
political attitude which directly hurts nationalism
and populism. In Venezuela, field maintenance has
been severely damaged by the oil strike of 2003
and the ‘reorganization’ of the oil sector. Venezuela
has a large potential for developing its extra-heavy
oil resources, and also natural gas resources could
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
GEOPOLITICS OF OIL AND GAS EXPORTING COUNTRIES
be exported in the form of LNG. However, the
associated investments are huge. The Mexican case
is similar in certain respects. Mexican potential for
oil and gas seems promising, but not enough
investments are made in E&P activities. Also, the
country remains closed to international investors
because, according to the Constitution, natural
resources belong to the Mexican people.
The case of Bolivia, one of the poorest
countries in the area is different. Bolivia has been
exporting gas (to Argentina) since 1972. Then in
1994, the country’s energy sector opened to private
investment and attracted a number of international
companies; exploration was successful. In 1997,
gas reserves (proven, probable and possible) were
estimated to be 278 billion m3 and a gas line was
built to export gas to Brazil (1999). In 2002, gas
reserves were revaluated at 2,185 billion m3 and
they could be much larger. Gas production and
exports became major national political issues.
Bolivian gas production could be substantially
increased, but the domestic market is small
(although gas is important for power generation
and automotive fuel), and there have been gas
production increases in Argentina and Brazil. The
solution would be to export gas to the world
market in the form of LNG, but Bolivia has no
direct access to the Pacific; it has to be negotiated
with Chile or Peru. Therefore, huge discoveries of
natural gas in a small country (9 million
inhabitants) become a domestic and international
political problem. The country is divided on this
question, which could lead to a national ‘gas war’.
How oil and gas revenues are used
Social expenditures are a priority for most
governments of Latin America. They also have to
finance the functioning of overstaffed
administrations. Governments’ financial needs
maintain a permanent fight to increase their take
on profits from oil and gas production. In Bolivia
and Venezuela, fiscal conditions on foreign
investors were changed unilaterally. The
development of Orinoco belt extra-heavy crude
was made possible by a provisional tax exemption;
but at the end of the period, royalties on extra-
heavy oil rose from 1% to 16.6%. The permanent
search for oil money is also a constant fight
between governments and national state-owned
companies: such as PDVSA in Venezuela, Pemex
in Mexico, Petrobras in Brazil, YPFB in Bolivia,
and Petroecuador in Ecuador.
National oil companies symbolize the oil
expertise and sovereignty that has been acquired in
these countries following long periods of
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PRODUCER-EXPORTER COUNTRIES
domination by international oil companies; yet,
these national oil companies are also governments’
cash cows. Some of these companies have
developed great ambitions to undertake E&P, not
only in their own countries but also internationally.
Petrobras and PDVSA are present in many
countries in Latin America and outside. In order to
meet their ambitions, the companies need money,
but part of their financial resources is under the
governments’ control. They can become very
powerful industrial and financial entities,
independent from the political power, albeit
state-owned. The stake is oil money: the proportions
shared between the government and the company,
and the amount of money that has to be left to the
company for domestic and international
investments. Along with the shared proportions of
oil money, and with urgent government need, a
piece of the ‘pie’ must also be reserved for the
future, which is directly dependent on the
investments that are made (or not made) now.
This fight for oil money is illustrated by the
Venezuelan strikes in 2002-03. President Hugo
Chavez, a former army lieutenant and populist
leader won the presidential elections in December
1998 with over 56% of the votes. In February
2002, Chavez’s opponents staged a coup d’état
that failed. In December 2002, the country was
crippled by a ten-day strike in opposition to
Chavez. On the opposition side were the
management and employees of PDVSA. A strike
in the company paralyzed Venezuelan oil
production for several months. Chavez broke the
strike, with popular support. He changed PDVSA’s
management and fired 16,000 oil workers. The
strike seriously damaged the human resources of
the company and a number of oil fields. Behind
the case the question of domestic oil investment
remains.
Oil money has been used to finance social
expenditures, but also to diversify the economy in
Mexico, Colombia, Bolivia and Brazil. In these
four countries, oil and gas exports represent a
reasonable share of total exports. The Mexican
economy as a whole has significantly reduced its
dependence on oil revenue over the two past
decades with oil exports falling from almost 70%
of Mexico’s total exports in the early 1980s to
roughly 15% in 2003. Mexico’s membership of the
North American Free Trade Agreement (NAFTA)
has been an important factor for the development
of export-oriented industries (Giugale et al., 2001).
On the contrary, Venezuela remains strongly
dependent on oil resources and dramatically
illustrates the oil curse.
418
Part of the oil money is also left to the
population under the form of subsidies.
Automotive fuels, kerosene, butane and sometimes
electricity public prices are well below
international prices. In Venezuela in December
2004, the prices of super gasoline and diesel were
respectively 4 and 2 cents of dollar/l, as compared
to an international price of 37 cents. In Mexico,
during 2004-05, high oil and natural gas prices
brought additional funds to the government, but
they also had negative effects. Mexico’s natural gas
price-setting mechanism, based on a US reference
market since 1995, has generated significant
discontent among Mexico’s consumers, following
the dramatic surge in US natural gas prices. In
2005, the Mexican government decided to increase
subsidies on gas and electricity tariffs a few
months before the presidential elections (CERA,
2005).
Among large oil and gas exporting countries
from Latin America, Mexico has achieved
increased economic development, which is highly
related to its exports to the United States. Other
countries, such as Venezuela, Bolivia, Colombia,
and Ecuador, are still at a low level of economic
development and suffer from the oil curse.
Bolivia’s external debt increased 17% in 2003,
reaching 5 billion dollars, the highest figure in the
past 10 years.
Typologies of governance
Internal and external governance are key
elements for understanding the geopolitics of oil
and gas exporting countries in Latin America.
There are national political tensions, tensions
between neighboring countries, and tensions on the
international scene because Latin America is
viewed as a stake for the United States, China,
Europe, and international oil companies (CERA,
2004).
From Mexico to Argentina, Latin American
countries have their own domestic conflicts.
Military elites are still principle figures, but
current conflicts concern more the disputes
between those who have been called “a factional
oligarchy” (Auty and Gelb, 2001) and the great
mass of the poor, who are sensitive to populist
slogans. Both opposing factions share a strong
nationalism, even if the factional oligarchy is much
more positive concerning the country’s opening up
to international investors. In Mexico, President
Fox, from the pro-business National Action Party
(PAN), did not obtain from Congress any
significant opening of his country to foreign
investments in the energy sector. The opposition
ENCYCLOPAEDIA OF HYDROCARBONS

between left and right is often exacerbated in the
western part of Latin America by regional claims
and the growing demands of the Andean Indians’
communities.
The political situation of Bolivia provides a
dramatic example of these oppositions. Increasing
poverty and unemployment were responsible for
growing social unrest, and brought down Sanchez
de Lozada’s government. In October 2003,
Sanchez de Lozada resigned and was replaced by
Vice President Carlo Mesa. In this context, the
monetization of gas reserves became a critical
national issue. The first change in the hydrocarbon
law increased the government’s hold on the sector.
This change was not enough for the
socialist-populist opposition led by Evo Morales,
and a referendum on the future of the country’s gas
reserves was organized in July 2004. Its positive
results, which approved a reinforcement of state
control over gas resources, opened the path toward
new tax and royalty increases. In April 2005,
Bolivia’s Senate authorized a new hydrocarbon law
that established steeper taxes for foreign oil and
gas operators. Gas money crystallizes all the
political factions: the populist movement, the
Indian communities, the provinces where gas is
located, the unions, and also the army. The
international companies that operate gas fields
have some difficulties regarding this new situation.
Companies operating in Bolivia are Brazilian
Petrobras (leading operator), French Total, British
BG and BP, Spanish Repsol. The political situation
is still aggravated by the fact that Brazil has not
paid its gas bill to Bolivia, with arrears of 250
million dollars (2005).
Another form of a political fight revolving
around oil and gas money is the question of
relationships between governments and the state-
oil companies. We have already mentioned the case
of Venezuela, in which President Chavez destroyed
the desire of autonomy of PDVSA. The situation is
different in Mexico, where Pemex’s expenditures
are controlled by the Congress. Pemex hands over
60% of its revenues to the government and
Congress decides how much it can spend. With
outside investments barred by the Constitution,
neither Pemex, nor Comision Federal de
Electricidad (CFE) are likely to have the ability
alone to meet Mexico’s long-term energy
investments requirements for oil, natural gas and
electricity. In the end, someone must pay the rising
energy cost. Ultimately, Mexico’s taxpayers will
bear this cost, as energy subsidies reduce the
amount of money available for other worthy
programs.
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GEOPOLITICS OF OIL AND GAS EXPORTING COUNTRIES
The international indexes of public governance
are unevenly distributed. Brazil and Columbia are
in a rather good position, but Venezuela appears to
be the most corrupted country with the lowest
index of economic freedom (Table 4).
As far as external governance is concerned, the
first question concerns the relationships between
neighboring countries. Relationships are not stable.
There are some dreams of economic integration
between countries of the Southern Cone; but when
the economic situation is poor, national egoisms
predominate. There is also a sort of rivalry for
Latin America leadership and zones of influence
between Mexico and Brazil.
Once again, Bolivia illustrates the South
American patchwork. The only way to monetize
rapidly its huge gas resources would be to build a
gas line to a Pacific port (in Chile or Peru) and a
LNG plant to have access to the large and
expanding Pacific market, mainly Mexico and the
United States. However, this project is politically
very sensitive. Bolivia’s relations with Chile have
been tense since the end of the Nineteenth century.
In 1884, Bolivia lost the Pacific War with Chile
and, with it, its entire costal area, leaving Bolivia a
landlocked nation. In 2001, the two governments
started informal discussions about the LNG
project. This discussion has reawaken Bolivia’s
aspiration to regain access to the sea. In July 2002,
protesters took the street in order to express
opposition to an LNG deal which could be
beneficial for Chile.
On the north-eastern side of the Southern Cone,
the relationships between Colombia and Venezuela
are fluctuating. President Chavez was envisaging
building an oil pipeline through Colombia in order
to gain access to the Pacific Ocean for exporting
oil to Asia. It would be deliberately detrimental for
Venezuelan exports to the United States and
deliberately beneficial to China. Also, the
relationships between the countries of the area are
sensitive to the question of drug production and
narcotics trading. Drugs production has partly
migrated from Bolivia to Columbia, and now to
Venezuela.
In 2005, populism and nationalism are the two
basic values shared by most Latin American
countries. Presidents Lula da Silva and Chavez,
although very different, are symbols of the
consensus. In 2005, President Chavez initiated an
agreement on energy cooperation between
Venezuela, Brazil and Argentina. He even
proposed an unrealistic merger between three
countries’ state-owned oil companies. One
component of this consensus is to reduce the
419
PRODUCER-EXPORTER COUNTRIES
political, economic and commercial influence of
the United States and to increase oil and gas
prices. Washington accuses Caracas destabilizing
the area, and the US State Department worries
about Venezuela militarization, following massive
purchases of weapons from Russia, Brazil and
Spain. The Chinese are present in the area not only
for oil, but also for steel, copper, and iron ore.
Latin America could symbolize the United
States/China conflicting interests for the access to
natural resources.
For Latin America’s economic future, the key
question is, once more, the issue of investments.
For the energy sector (oil, gas and electricity), it is
neither feasible, nor desirable, to finance the
sector’s necessary expansion of public funding.
Attracting international investors is the major
challenge, even though it deeply hurts nationalist
beliefs. For Latin American governments, the
difficulty is to find the right balance between
attracting investors and retaining control of major
strategic choices. Public-private partnerships are an
important step in this direction; for international
investors, however, the overall political, fiscal and
regulatory risks remain high in many cases. The
vicious cycle of reforms has to be broken in order
to avoid the politicians’ repetitive promise that
‘after this next change, the rule will be stable’.
Each Latin American country needs to set up an
appropriate and stable legal, fiscal, and regulatory
framework, which attract investors while
safeguarding public interest. It is not only an issue
for the appropriate energy supply of the future but
also for increasing the wealth of these countries.
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421

Oil and geopolitics
in the Caspian Sea basin
Over the past ten to fifteen years, the Caspian Sea
basin has attracted considerable attention because of
its potential as a significant source of oil and natural
gas for world markets, and international competition is
increasing over the control of these critical resources.
Geographically, the Caspian Sea is an enclosed body
of water, roughly 1,120 km from north to south and
320 km across, lying directly between the states of
Central Asia, Russia, the Transcaucasuian republics
and Iran. Its salt water connects to the Black Sea
through the Volga and Don rivers, the artificial
Volga-Don canal, and the Sea of Azov, a branch of the
Black Sea. In 1991, during the last days of the Soviet
Union, only two independent states – the Soviet Union
and Iran – bordered the Caspian Sea basin. But now
they have been joined by three new states –
Azerbaijan, Kazakhstan and Turkmenistan.
The Caspian Sea basin itself is located at the centre
of Eurasia, a region of rich diversity of peoples,
nations and cultures. The new countries of the region
appear as blots on the map, spots on the backs of
Russia, Turkey and Iran. In representations by the
Western press, they commonly appear in shabby
images of natural disasters, the genocide in Armenia,
wild horsemen and smiling centenarians in Georgia,
and as foreign and barbarous Muslims in Azerbaijan,
the North Caucasus, and Turkmenistan. But this is a
historically cramped understanding of the area, whose
culture and history predates much of that found in
Europe. The positive images that survive exist as
romantic memories of the Silk Road merchant routes
that connected Northern and Eastern Europe with Asia
Minor and the Greek colonies thousands of years ago.
The Argonauts were the first “foreign tourists”, so to
speak, that ever reached the Caspian region, and
Prometheus, who brought fire to mankind in defiance
of Zeus, was said to have been chained to a cliff in the
region (Owen, 1975; McLaurin, 1896).
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
8.2
Thousands of years have passed since then, but
people are still attracted to the Caspian Sea basin. In
modern times, the attraction has been related to the
region’s natural resources, especially its vast oil and
natural gas reserves. In a much earlier time, before the
mid-Nineteenth century, the region was one of the
best-known oil producers in the world. Before the
coming of the Russians, petroleum extraction was very
primitive, and for centuries, petroleum traders
extracted their product with rags and buckets. By the
time of the Tsarist government in 1871, the modern
petroleum industry began to take form with the
drilling that occurred in what is now the giant Bibi-
Eybat field in Azerbaijan. By the end of the
Nineteenth century, the area experienced its first
contact with Western capital as large foreign oil
companies entered the area and two competing
families began to dominate the Caspian oil industry.
The Nobel brothers arrived first, followed by the
French branch of the Rothschilds (Tolf, 1976) and, in
1898, Russia became the world’s largest oil-producing
country, holding on to this distinction until 1902, with
more than 50% of the world’s oil produced in the
Caspian region (Gokay, 2001).
With the collapse of the Tsarist Empire, civil war
spread throughout the region until the Bolshevik
revolutionaries finally seized control in 1921 (Gokay,
1997). Under Stalin’s First Five-Year Plan in 1927, the
Soviet state assumed full responsibility for the
production of Caspian oil, providing for central
planning, determining sites, organizing production,
and arranging for transport. Oil production quickly
recovered from the effects of war, revolution and civil
war, with 1928 output surpassing the former 1901
peak. The Soviet oil industry continued a period of
rapid growth during the following decade, with most
of this production coming from the Caspian Sea region
(Goldman, 1980).
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PRODUCER-EXPORTER COUNTRIES
Caspian oil played a major strategic role during the
First and Second World Wars, and protecting the
Caspian oil fields was always a Russian/Soviet and
Allied priority. The German leadership clearly
recognized its importance to its expansionist ambitions
and its form of mechanized warfare. Initially, they
sought access to the oil by negotiation and, following
the 1939 German-Soviet Pact, Soviet oil from the
region accounted for fully one-third of German oil
imports. When the German-Soviet rapprochement
failed with Hitler invading the Soviet Union, the Nazi
armies specifically targeted the oil of the Caspian
basin. Arguably, the fierce resistance of the Red Army
to the southern thrust of Nazi forces that denied
Germany its prized Caspian oil was one of the major
turning points in the Second World War.
When the Soviet Union dissolved in 1991, the vast
oil and gas resources of the Caspian basin were once
again open to exploitation by Western corporate
interests. A race has now begun among powerful
transnational oil giants to secure control, and with the
assistance of the most influential Western states,
policies have been designed to advance their
competition. In the decade since they have entered the
region, exploration has confirmed that the Caspian
basin contains at least between 70 to 200 billion
barrels of oil, or roughly 10% of the world’s reserves.
It is also thought that the world’s largest reservoir of
untapped oil and gas is to be found in Kazakhstan,
Azerbaijan and Turkmenistan, southern republics of
the former Soviet Union that make up the greater
Caspian basin region. Even though reports of possible
and confirmed reserves deposits differ widely, interest
in the region continues to accelerate. At stake are
billions of dollars in oil and natural gas revenues, as
well as the vast geopolitical and military advantages
that go to the power or powers that secure a dominant
position in the region (Fenyvesi, 1998).
Two basic questions arise around the oil resources
of the Caspian: who owns the rich oil and natural gas
resources, and who will have the control over the
transportation of the Caspian oil and gas to world
markets? The answers to these questions will strongly
influence how the world economy evolves in this
century, and who will sit at the head of the global
order that governs it.
8.2.1 Geopolitics of Caspian oil
Oil has become the pivot upon which the axis of war
or peace rests. This is consistent with a historical
pattern where control of precious minerals has always,
directly or indirectly, led to war. In the last century
alone, oil played a key role in at least ten of the twelve
424
major international conflicts.1 It seems that of all key
elements that are critical to modernization in the
Twentieth century, none is more likely to provoke a
major war between states than oil, and as oil reserves
decline, its importance will only grow in the decades
ahead (Homer-Dixon, 1999).
According to estimates, world oil production will
begin to reach the peak approximately by 2008
(Hirsch, 2005; Porter, 2005; Gokay, 2006a), which
means that the world is depleting oil reserves at a rate
of 6% a year. At the same time, demand growth is
rising at an annual rate of 2%, which means that the
world’s oil industry will have to find the equivalent of
8% a year in newly discovered oil reserves to maintain
an orderly oil market (Benner, 2004; Owens, 2007).
Unfortunately, discoveries are lagging behind,
primarily because new large oil deposits of oil are not
being found, and even if they were, there is a
considerable time lag between a discovery and turning
the oil into a useable energy source. While
conservation and renewable energy are much in the
news, the reality is that neither of these are likely to
make any significant dent in the steadily growing
demand for oil products. In this increasingly fragile
energy climate, competition for existing proven and
prospective reserves is increasing, and the Caspian
basin, with its vast fields of untapped oil, has now
become the focus in a new version of the “Great
Game”(Gokay, 2006b).
Unimpeded access to affordable energy has always
been a primary strategic interest of the United States,
which is now the only superpower remaining in the
post-Cold-War world. American dependency on
imported petroleum has been growing since 1972
when domestic output reached its maximum of 11.6
million barrels a day (Deffeyes, 2001). From that point
on, United States oil production went into decline, and
dependency on foreign sources of oil and gas
increased continuously.
For reasons both of world strategy and control over
natural resources, the United States administration is
determined to secure a dominant role in Eurasia. The
immediate task of American power in “volatile
Eurasia” has been described as “to ensure that no state
or combination of states gains the ability to expel the
United States or even diminish its decisive role”
(Brzezinski, 1997). These stated United States policy
1 Particularly the Middle East, home to many of the
world’s oil deposits, became a centre of geopolitical and
military tension throughout the latter half of the century (for
example, oil was a factor in Japan’s decision to go to war
against the United States in 1941, and the oil cartel, OPEC,
used an oil embargo of sorts in the wake of the Yom Kippur
War in the 1970s).
ENCYCLOPAEDIA OF HYDROCARBONS

goals include breaking Russia’s monopoly over oil and
gas transportation routes, promoting United States
energy security through diversified supplies,
encouraging the construction of multiple pipelines that
go through United States-controlled lands, and
denying other potential powers dangerous leverage
over the Central Asian oil and natural gas resources.2
This is a life-and-death struggle to monopolize energy
resources, which simply recognizes that oil remains
the lifeblood of a modern world economy. The United
States status as a superpower requires the control of oil
at every stage: from discovery to pumping, to refining,
to global transportation networks, and finally to the
marketing of oil. The Washington-based American
Petroleum Institute, voice of the United States oil
industry, has identified the Caspian basin as the area
of greatest resource potential outside of the Middle
East (Cohn, 2000; Dekmejian and Simonian, 2001;
Gokay, 2002a; Sukhanov, 2005). In 1998, when Dick
Cheney (United States current Vice-President) was
playing a central role in the United States oil industry,
he used these words to describe the Caspian basin:
“I cannot think of a time when we have had a region
emerge as suddenly to become as strategically
significant as the Caspian”.3
At stake in this competition is far more than the
fate of the resources of the Caspian basin. Caspian oil
is “non-OPEC oil”, meaning that supplies from this
region are less likely to be affected by the price and
supply policies applied by the oil-exporting cartel
(Gokay, 2007). Flows of large volumes of Caspian oil
through non-OPEC lands would erode the power of the
Organization of Oil Exporting Countries (OPEC), as
well as its ability to maintain high oil prices and to use
oil as a means of political blackmail (Shaffer, 2001).
The West’s concern about OPEC dates back to the
oil shock of 1973 that sent the global economy into
crisis. Before OPEC was founded, the great oil
companies of the West had ruled the oil market. Prior
to OPEC’s foundation, the Western oil giants had often
retained 65% or more of the revenue from a product
that was produced on someone else’s land. Then in
1960, many of the oil producing countries, from both
the Middle East and elsewhere, formed a cartel,
OPEC, to protect their interests. Currently, members
consist of Algeria, Indonesia, Iran, Iraq, Kuwait,
Libya, Nigeria, Qatar, Saudi Arabia, the United Arab
Emirates and Venezuela. Ecuador and Gabon
suspended their memberships in 1992 and 1994,
respectively. Saudi Arabia has traditionally dominated
the organization, owing to its enormous oil reserves.
The OPEC members produce about 40% of the world’s
crude oil. Large non-OPEC producers such as Mexico,
Norway and Russia also sometimes go along with the
cartel’s position of the day (Gokay, 2006b).
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
OIL AND GEOPOLITICS IN THE CASPIAN SEA BASIN
OPEC set itself a clear-cut and seemingly simple
goal: to present a common front in negotiations with the
giant oil companies, which themselves worked closely
together. In this way, OPEC set the stage for a new
process in which the producer states would eventually
take over some of the functions of the companies, at
least in production, and retain a significant amount of
the revenues. At first, OPEC had little impact, from its
founding in 1960 until 1973. Then, in October 1973, all
hell broke loose. In 1973, the United States and the
Western world were in the midst of an inflationary
spiral. The world had become highly vulnerable to
commodity cartels, as twenty years of prosperity and
accelerating population growth had created heavy
demand for energy resources. In the United States,
consumer prices were rising at an 8.5% clip, while
inflation rates in other nations were often much higher.
The demand for Middle Eastern oil had been increasing
throughout the industrialized world, and the needs of
these countries grew far faster than production. In this
period, OPEC was growing stronger, and was
determined to increase its share of the profits as well as
its influence in world politics (EIA, 2006).
On 17 October 1973, the OPEC countries
announced that they would no longer ship oil to states
that had supported Israel in its conflict with Egypt –
that is, to the United States of America and its allies in
Western Europe. At around the same time, OPEC
members agreed to use their leverage over the world
price-setting mechanism for oil so as to sharply
increase world oil prices. The complete dependence of
the industrialized world on oil, much of which resided
beneath the surface of Middle Eastern countries,
became painfully clear to the industrialized countries
of the West and Japan, marking a watershed in their
relations with the oil producing countries. OPEC’s
price hike caused sharply increased inflation in all
oil-importing nations.4
8.2.2 Oil pipelines
Getting oil from the Caspian-Caucasian to the world
markets is not easy because the Caspian basin is
landlocked. When the Soviet Union broke up in 1991,
multinational oil companies and governments of the
leading world powers wove a tangled web of
2 US Energy Secretary Bill Richardson telling Stephen
Kinzer, “On piping out Caspian oil, United States insists the
cheaper, shorter way isn’t better”(Kinzer, 1998).
3 S. Gowans (2001) Getting the pipeline map and
politics right. Swans, 12 November 2001,
http://www.swans.com/library/art7/gowans10.html
4 http://news.bbc.co.uk/1/hi/business/689609.stm
425
PRODUCER-EXPORTER COUNTRIES
competing pipelines, with leading roles played by
British Petroleum (BP) and Amoco, which merged in
1998, UNOCAL, Texaco, Exxon and Pennzoil, all of
which have already invested more than 30 billion
dollars in new production facilities (Kleveman, 2003).
This fabric of oil transportation represents a pipeline
map around the oil and natural gas resources of the
region that connects the area from the Balkans in the
West to Afghanistan in the East (Mendes, 2005). The
debate over which route to use for the Caspian’s
considerable oil reserves has inspired a high-stakes
tug-of-war among the countries of the region. At
present, the main operational oil export route follows
the line Baku-Groznyi-Tikhoretsk-Novorossiysk. Oil
exports from this route are dependent on tanker
transportation via the Turkish Straits.
The main alternative to this Russian pipeline is the
United States-backed Turkish route that runs from the
Caspian Sea to the Mediterranean. The
Baku-Tbilisi-Ceyhan pipeline (BTC) to transport
crude oil extracted from the Caspian Sea shelf to the
Mediterranean Sea basin was inaugurated on 25 May
2005 near Azerbaijan’s capital Baku.5 The construction
of this United States sponsored pipeline started in
2001, and its final cost totaled well over the 3 billion
dollars originally planned. The BTC stretches 1,760
km, including 440 km through Azerbaijan and 250 km
through Georgia. The pipeline is designed to carry oil
extracted from Azerbaijan’s sector of the Caspian Sea
by an international consortium comprising 11
companies. Banks provided 70% of the 3.3 billion
dollars it cost to build the pipeline via loans. A large
proportion of this debt came from public financial
institutions led by the International Finance
Corporation (IFC), the part of the World Bank which
lends to companies, rather than governments and the
European Bank of Reconstruction and Development.
This also allowed BP to secure further private
investment funding from banks like Citigroup. The
additional 30% came in the form of equity (capital
provided by the oil companies which hold shares in the
project). British oil giant, BP, holds a 30% stake in the
consortium running the pipeline. Other consortium
members include Azerbaijan’s state oil company
SOCAR, Amerada Hess, ConocoPhillips, Eni, Inpex,
Itochu, Statoil, Total, TPAO and UNOCAL.6
However, many in the oil industry are concerned
about a one-pipeline solution (depending on one major
pipeline only) because of various tensions in the region,
and would prefer a multiple pipeline strategy, including
a major route through Iran. Due to the current strained
relations between the United States and Iran, the
Iranian route seems uncertain. Yet, given commercial
realities, any political opening could shift the terms of
the pipeline debate very quickly (Gokay, 2001).
426
8.2.3 NATO’s bombing of
Yugoslavia and Caspian oil
The Balkans states are crucial to all these oil pipeline
routes because oil destined for Western Europe must
pass through one of them at one point or another
(Yannopoulos, 2001). During the 1999 Kosovo war,
some critics of NATO’s bombing of Yugoslavia alleged
that the United States and its allies in the West were
seeking to secure a passage for oil from the Caspian
Sea (Gokay, 2002b; Stone, 2005).7 This claim was
mocked by the British Foreign Secretary, Robin Cook,
who observed that “there is no oil in Kosovo” (Lloyd,
1999; Monbiot, 2001a). Of course, this was true but
irrelevant; the facts are actually very different. In
1997, BP and the Texas construction giant Halliburton
proposed a pipeline that would go from Burgas in
Bulgaria through Skopje in Macedonia to Vlore, a port
in Albania (Monbiot, 2001b). And on 2 June 1999, the
United States Trade and Development Agency, which
had financed initial feasibility studies, announced that
it had awarded a half-million dollar grant to Bulgaria
to carry out a feasibility study for the pipeline across
the Balkans (Wihbey, 1999). It seems, in practice, that
its location makes the Balkans a key regional stepping
stone to oil interests in Eurasia (Zemenides, 1997).
In 1996, the Bulgarian daily Continent reported
that the Albanian, Macedonian and Bulgarian Oil
(AMBO) decided to begin a construction of an oil
pipeline which would connect the Black Sea with the
Adriatic Sea. The pipeline would be 907 km long and
would transport oil from Russia, Azerbaijan and
Kazakhstan, with a capacity of 750,000 barrels daily.8
The construction, as estimated, would cost 825 million
dollars, and AMBO company has already obtained
exclusive rights from the governments of the three
countries to carry out this project. According to Gligor
Tashkovich, the head of AMBO, “the great advantage
of this route is that it crosses the entire Balkan
5 Baku-Tbilisi-Ceyhan (BTC) Caspian pipeline.
Hydrocarbons-technology.com, March 2007,
http://www.hydrocarbons-technology.com/projects/bp/
6 M. Katik (2003) Amid risk, Baku-Ceyhan pipeline
edges forward. Eurasianet.org, 1 December 2003,
http://eurasianet.org/departments/business/articles/eav12010
3.shtml;
Baku-Tbilisi-Ceyhan crude oil pipeline: milestones along
the way. Middle East Economic Survey, Vol. XLIX, n. 29,
17 July 2006,
http://www.mees.com/postedarticles/oped/v49n29-
5OD02.htm;
Baku-Tbilisi-Ceyhan pipe is being filled with oil. Russian
News and Information Agency NOVOSTI, 25 May 2005,
http://en.rian.ru/world/20050525/40411950.html
7 http://www.ncpa.org/bothside/krt/krt041901a.html
8 http://www.gasandoil.com/goc/news/nte30402.htm
ENCYCLOPAEDIA OF HYDROCARBONS

peninsula, thus completely eliminating the danger of
an oil spill in the Aegean”.
In the same period, it was also claimed by many
commentators that the main global objective of the
United States-led NATO operations in Kosovo was to
pacify Yugoslavia so that transnational oil
corporations could secure the oil transportation route
from the Caspian Sea into Central Europe (Schwarz
and Layne, 1999; Gowan, 2000; Fouskas and Gokay,
2005).9 Three weeks after the beginning of the war,
General Michael Jackson, commander of KFOR
(Kosovo FORce) in Macedonia and soon in Kosovo,
confided to the Italian daily, Sole 24 Ore: “Today, the
circumstances which we have created here have
changed. Today, it is absolutely necessary to
guarantee the stability of Macedonia and its entry
into NATO. But we will certainly remain here a long
time so that we can also guarantee the security of the
energy corridors which traverse this country”.10 After
NATO’s bombing campaign ended in March 1999,
the United States spent 36.6 million dollars to build
Camp Bondsteel in Southern Kosovo, the largest
American foreign military base constructed since the
Vietnam War. Camp Bondsteel was built by Brown
and Root, a division of Halliburton, which was the
world’s biggest oil services company and, at the time,
headed by the current United States Vice-President,
Dick Cheney. Rivalries being played out in the
Caspian basin will have a decisive impact in shaping
post-communist Eurasia and determining United
States influence in the development of the region
(Race [...], 1997). It also has worldwide, not just
regional consequences. For example, expansion of
United States influence in Eurasia poses a direct and
immediate threat to China because, among other
factors, the expansion of the Chinese economy is
directly dependent on access to petroleum. Its oil
needs are expected to nearly double by 2010, which
will force the country to import 40% of its
requirements, up from 20% in 1995 (Luft, 2007).
China’s increasing demand for oil on the world
markets has been a major factor in the rise in oil
prices, and will be the most important factor in
determining future oil pricing. Currently, China is the
world’s number two oil consumer after the United
States, and since 2000, has accounted for 40% of the
growth in the world’s demand for crude oil. Presently,
China’s proven oil reserves stand at 18.25 Gbl,11 and
oil imports account for one third of its crude oil
consumption. However, in response to a burgeoning
demand for energy, the Chinese government has:
• Stepped up exploration activities within its own
borders.
• Begun diversifying its energy sector to include
other energy resources.
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
OIL AND GEOPOLITICS IN THE CASPIAN SEA BASIN
• Actively explored developing new nuclear power
facilities.
• Reassessed it use of coal and natural gas.
• Sought the development of renewable energy.
• Promoted energy conservation and encouraged
investments into energy-friendly technologies, such
as hydrogen-powered fuel cells and coal
gasification.
This is all in a concerted effort to support an
8-10% rate of growth in its gross domestic production
(Berthelsen, 2003; China [...], 2005).
China has now become an active player in this new
“Great Game” by making a secure access to the oil and
gas reserves of the Caspian basin a cornerstone of its
economic policy. In 1997, the China National
Petroleum Corporation (CNPC), which employs more
than 1.5 million people, acquired the right to develop
two potentially lucrative oilfields in Kazakhstan,
outbidding United States and European oil companies.
China’s longest pipeline, running 4,200 km from the
Tarim Basin of Xinjiang province to a network of gas
and oil pipelines in the major east coast metropolis of
Shanghai, came into operation in August 2004. In
October 2004, construction began on a 988 km pipeline
from Atasu in Northwest Kazakhstan to Alataw Pass in
Xinjiang that will carry 10 million tonnes of oil a year
once it is completed. Feasibility studies are also
underway for the construction of over 3,000 km of gas
pipeline from Turkmenistan to Xinjiang, and the
Chinese government is also helping to develop oil
fields in Uzbekistan and hydroelectric power projects
in Kyrgyzstan and Tajikistan (Glenny, 2003).
A number of overlapping power blocs are emerging
in the Caspian basin that have a shared interest in the
development of its oil and gas resources. Theoretically,
oil and gas pipelines to China from Turkmenistan and
Kazakhstan could be extended to link into the pipeline
networks of both Russia and Iran. This model has been
9 S. Federici e G. Caffentzis (2006) War and
globalisation in Yugoslavia. Oliveworks, January 2006,
http://www.thing.net/~oliveworks/federicicaffentzis.html
10 It is clear that Jackson is referring to the 8th Corridor,
the East-West axis which ought to be combined to the
pipeline bringing energy resources from Central Asia to
terminals in the Black Sea and in the Adriatic, connecting
Europe to Central Asia. From East to West, the 8th Corridor
connects the Bulgarian Port of Burgas (also situated on the
Black Sea and in competition with Constanta) to Skopje
(Macedonia) and to the Albanian port of Dürres. And from
there, it connects with two Italian ports, Bari and Brindisi.
(Sole 24 Ore, 13 April 1999);
http://www.iacenter.org/warcrime/mcollon.htm
11 H. Hassan-Yari (2004) Analysis: Energy Geopolitics
in the Caspian. Eurasianet.org, 19 October 2004,
http://www.eurasianet.org/departments/business/articles/
pp101904.shtml
427
PRODUCER-EXPORTER COUNTRIES
dubbed the “Pan Asian Global Energy Bridge”, a
Eurasian network of pipelines linking energy resources
in the Middle East, Central Asia and Russia to the
Chinese Pacific coast. China’s pipeline network also
has the potential to bring about a significant strategic
realignment in the region. Currently, China derives
13.6% of its imports from Iran. In March 2004, China
signed a 100 million dollars deal with Iran to import
10 million tonnes of liquefied natural gas over a
25-year period in exchange for Chinese investment in
Iran’s oil and gas exploration. Growing Sino-Iranian
relations are undermining United States sanctions
against Iran, and the Bush administration has
sanctioned Chinese companies 62 times for violating
United States or international controls on the transfer
of weapons technology to Iran and other states
(Berthelsen, 2003; China [...], 2005). Russia is China’s
fifth-largest crude oil supplier, with Lukoil now
replacing Yukos as China’s main supplier of Russian
oil. China is expecting to import at least 10 million
tonnes of oil from Russia in 2005 and 15 million in
2006. Chinese-Russian energy relations appear to be
mirroring political and military relations as well. This
growing cooperation between China and Russia seems
to have resurrected former Russian Prime Minister
Evgenij Primakov’s idea for a strategic triangle
between Russia, India and China. These three states,
plus Iran, are bound together by shared interests in the
push for a multipolar world, respect for the principles
of state sovereignty and non-intervention with regard
to their respective “separatist” movements in
Chechnya, Kashmir and Xinjiang (Berthelsen, 2003;
China [...], 2005; Gokay, 2006a).
At the moment, Russia controls most of the export
routes for oil from the Caspian basin. According to the
view of Russian Defence Minister Igor’ Sergeev in
November 1999, the West’s policy “is a challenge to
Russia with the aim of weakening its international
position and ousting it from strategically important
regions” (Gokay, 2002a). Disputes over oil were at the
heart of Russia’s earlier decision to go to war against
Chechnya in December 1994 because its sole
operational pipeline for Caspian oil, the Novorossiysk
pipeline which goes directly through troubled
Dagestan and Chechnya, was threatened by Islamic
separatist forces (Towner, 2001). Redirecting the oil
around Chechnya would impose major costs if the
rebellion persisted, and foreign investors would have
been wary of any long-term investments. Russia’s
concerns about Chechnya also grew with the United
States-NATO war against Serbia in 1999 and the
subsequent NATO occupation of Kosovo, and tensions
within Russia escalated as the military campaign in
Chechnya began. In this context, the Russian 1999
intervention in Chechnya can be seen as a warning to
428
the United States, NATO and any rebellious
provincials that Russia is still a powerful military
force. With Vladimir Putin’s accession to power,
Russia continues to push an aggressive policy
designed to recover Russia’s control in central Eurasia.
And soon after Putin’s election, Russia’s National
Security Council declared the Caspian basin to be
Russia’s key foreign policy focus.12
The Caspian Sea basin, with its huge reserves of
oil, natural gas and strategic position, is a key arena of
rivalry between the United States, major European
powers, Russia, Japan and China. All of the major
powers, along with transnational oil giants, have been
seeking alliances, concessions and possible pipeline
routes in the region. In the midst of this increasing
competition, an open conflict between the United
States and China seems likely as China’s growing
reliance on Eurasian oil will ultimately bring it into
direct confrontation with the United States as the
world’s largest energy consumer (Norton-Taylor, 2001;
Wolfe, 2004; Leverett e Bader, 2005).
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Berthelsen J. (2003) Asia starts to gasp for energy, «Asia
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Brzezinski Z. (1997) A geostrategy for Eurasia, «Foreign
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Burke J. (2000) Russia seems to be planning civil unrest in
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Glenny M. (2003) To hell and Baku, «The Observer», 2
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Mendes A. (2005) A pipeline too far! Oil and oil pipelines:
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429

Islam and oil
8.3.1 Religion and petroleum
The purpose of this article is to contribute to the
understanding of the sudden changes imposed on the
Muslim oil-exporting societies of the Middle East
and North Africa by the uneven flows of oil revenues,
and how these changes are perceived in light of the
local culture and religious traditions, as well as the
tensions and conflicts that the petroleum industry and
ensuing revenues create, internally as well as
internationally. The article at first discusses the
present economic, social and political predicament of
the Middle East and the renewed relevance of Islam.
It then treats the historical background and the
economic tenets of Islam and, subsequently, the
relevance to the petroleum industry and the use of its
revenues. The final part examines the international
issues, the relevance of Islamic principles for the
world oil market, and relations between the major
Middle Eastern and North African oil exporters and
the buyers of their oil.
Religion and petroleum may seem unrelated
issues – one spiritual, the other material – but there
is an interactive relationship: religion influences the
normative basis of economic activity such as the
extraction of petroleum and the use of the ensuing
revenues; and the extraction of petroleum and the
use of revenues shape societies and international
relations, liable to cause tensions and conflicts that
are part of the social and political basis of religious
practice. Religion provides a normative basis which
also encompasses economic activity and, in return,
economic activity has effects that, at times, infringe
upon the principles of religion (Mills and Presley,
1999). For example, in renaissance Europe, the
Catholic Church prohibited charging interest for
credit, so there was a dispute between the banking
sector and the ecclesiastical authorities which, in the
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
8.3
end, were forced to yield, but not without strife that
included the Reformation.
This is briefly why religion matters to oil, and
vice versa. Islam is essential not only to
understanding the oil-exporting countries of the
Middle East and North Africa, but also to
understanding the economic, social and political
context in which the petroleum industries of these
countries operate, and the predominant principles
for economic behaviour in these societies. Islam is
also a practical religion with specific rules for daily
life, also conducting business and distinguishing
ethically clean behaviour, halal, from ethically
unclean behaviour, haram (Rodinson, 1966). Islam
explicitly respects private property, but prohibits
charging interest or wasting resources as long as
people are in need, commanding the redistribution of
wealth.
In practical terms, Islam matters to oil in the
Middle East and North Africa, as the prohibition of
interest calculation could influence the rate of
depletion of a finite resource, with a preference for
keeping more oil in the ground. Forbidding waste
can limit the spending of oil revenues, and
redistributing wealth may mean that the state
controls the oil money (Rutledge, 2005). The tenets
are pertinent to intergenerational equity, social
equity and economic organization. Such tenets are
not unique to Islam; they have counterparts in many
non-Muslim oil-exporting countries, from Mexico
and Venezuela to Norway and Russia, but in the
Islamic tradition, they have a spiritual foundation.
8.3.2 The present predicament
In the Middle East and North Africa, economic,
social and political development in the Twentieth
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century has been dominated by oil and oil money,
as direct revenues or as remittances and transfers.
The sudden and uneven flows of money have
caused successive social upheavals and, within a
couple of generations, a transformation that took
centuries in Europe (Fatany, 2004). Huge oil
reserves at low cost attracted the attention of the
great powers to the Middle East since before the
First World War, and provided the basis for a
specific form of development based on oil
revenues and the rentier state which still remains
predominant in the region. Since 1970, high oil
revenues have profoundly changed the societies of
the Middle East, but there has been little political
change that can cope with the ambitions of more
numerous, younger and better educated
generations. The outcome has been a society with
rising social and economic inequalities, and
generational conflicts. The combination of
economic distress, social tension and political
oppression pushes opposition into the mosque and
activates the Islamic references (Droz-Vincent,
2004). The reference to Islam can serve the double
purpose of defining an identity against Western
dominance and of criticizing rulers seen as inept
and illegitimate (Halliday, 2000). They appear
responsible for both an ill-attempted secularization
on a Western model and an economic and social
crisis, because of serving Western interests in
petroleum and economic policies.
Rising Western dependence on Middle Eastern
oil since the 1960s has not been matched by efforts
to stabilize the region politically, or even to
understand it. The United States is increasingly
dependent on oil imports and, indirectly, on the
Middle East supplying the world market with
volumes sufficient to stabilize prices (Noël, 2004).
There has, however, been little interest or insight
into Middle Eastern affairs, except through a narrow
pro-Israeli perspective aimed at belittling the
salience of the Arab world (Yetiv, 2004).
Historically, the wisdom of giving unquestioning
support to corrupt and authoritarian regimes because
they export oil is not evident. The error has been to
equate secure oil supplies with regimes more
dependent on Western backing than on a popular
mandate. Such a policy can backfire, as it did for the
United States in Iran. From this perspective, the
September 2001 terrorist attacks may appear as the
forerunner of more trouble insofar as they express a
widespread but, so far, hidden discontent; in that
case, oil supplies and prices would be at stake
(Klare, 2004). The Iraq War and the ensuing
occupation of Iraq appear as a United States move to
pre-empt any threat to oil supplies (Rutledge, 2005).
432
In the Middle East and North Africa, oil has led
to a special, capital-intensive mode of
development. With oil revenues, capital
accumulation could take place at a much higher
rate in the public sector than in private business.
Control of the accumulation process has moved
from private capitalists to public sector bureaucrats
and autocratic rulers (Chaudhry, 1997). Oil money
has strengthened the state and the bureaucracy in
relation to private business, creating a distinctive
political system based on the centralization of
petroleum revenues with the state (Gause, 1994).
Briefly put, the political process is that the rulers
do not tax citizens or businesses, but hand out
selective privileges, financed by oil revenues,
against loyalty and support from a largely parasitic
private sector. Access to large oil revenues
channelled through the treasuries is a distinctive
feature of the state in the oil-exporting countries of
the Middle East. These oil revenues make the state
a distributor of economic rent from oil and,
therefore, privileges and transfers, instead of being
a tax collector and redistributor (Pawelka, 1991).
Most economic activities outside the petroleum
sector depend on government permits, contracts,
support and protection. This is usually coupled
with an absence of taxes on property and income,
except for the religious tax, zakat.
The key economic problems of the Middle East
relate to population growth, inequity and economic
stagnation. The unequal distribution of power and
wealth means that the fruits of progress are
unevenly shared. Over time, this impedes the
creation of a home market for industrial products
and industrialization itself. The increasing
concentration of wealth and income among a small
number of people is unproductive. The very rich
tend to transfer part of their wealth abroad,
concentrate demand on imported luxury items –
impeding the growth of a wider home market for
less sophisticated products – and to keep part of
their wealth idle, as in numerous luxury dwellings
and cars, thereby diverting capital from more
productive uses.
The growth and power of the military are
common to most countries of the Middle East and
North Africa, whether oil exporting or not.
Military officers have repeatedly intervened to
keep countries and political systems together, so
that military government has been the rule rather
than the exception; Iraq is a good case in point.
The social origins of the military, especially the
junior officers, are largely in the urban middle and
lower middle classes. Historically, the military has
been an exponent of social and political change,
ENCYCLOPAEDIA OF HYDROCARBONS

but over time, the military establishment has
become a conservative force, defending its own
privileges and its budgetary priorities. At the
outset, military rule was socially radical, as in
Nasser’s Egypt, motivated by the aim of
redistributing wealth and income, of carrying out
profound reforms and asserting national interests
against the colonial legacy. It has, over decades,
acquired its own vested interests – meaning
budgetary appropriations, training and the most
modern equipment, apart from personal fringe
benefits and political influence. In the oilexporting
countries, the sudden influx of large oil revenues
proved an irresistible temptation for the military
establishment to demand more money. The military
establishment represents an important part of the
new class of technocrats – wielding power, but no
ability to earn revenues.
Indeed, the rise in military expenditure seems
easier to explain by the level of oil revenues than by
any sudden internal or external threats. Middle
Eastern oil exporters have a preference for military
spending not shared by oil exporters elsewhere. In
1998, Mexico spent less than 1% of gross domestic
product, GDP, on defence; Indonesia about 1%;
Malaysia, Norway and Venezuela about 2%; Iran
about 3%; but Oman and Saudi Arabia about 13%
(IISS, International Institute for Strategic Studies,
Database). Figures on military spending are difficult
to verify and data may be too conservative since
many governments are reluctant to reveal the scope
of their military effort, but throughout the Middle
East, probably a figure of between 12 and 15% of
GDP, or between 30 and 40% of oil revenues has
been spent on defence since 1973 (Humphreys,
1999). Military spending has diverted funds from
urgent civilian needs such as health, education,
infrastructure and food imports. High military
expenditure helps the armed services compete for
personnel and draw competence away from more
productive civilian tasks. High oil revenues in 1999
and 2000 have led to a further increase in military
spending (Middle East Economic Survey, 2000).
Since the end of the Cold War, the Middle East has
been the world’s leading market for arms and its most
militarized region, to the benefit of the weapons
industries elsewhere. In Islamic Iran, the military
evidently enjoys far less influence, privileges and
money than was the case under the Shah.
Against this backdrop of economic
mismanagement and social distress, the Islamist
opposition is strengthening, representing a social
revolt, as well as an assertion of cultural and
national identity in the wake of an unsuccessful or
incomplete modernization based on oil and the
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seizure of power by civilian and military
technocrats of the public sector (Khalaf, 2005).
The background is dynamic demographics in a
strained economic situation within a rigid political
context. Rapid population growth creates conflicts
of distribution, positions, priorities and values. The
immature and unstructured political systems keep
ageing leaders in power without being accountable
to the public.
The outcome is social and generational
conflicts over income and jobs, partly as a conflict
of views on how to organize society, and partly as
conflicts of power. The youngest generation makes
up the majority of the population. They have some
education, but few jobs, no wealth and no power.
Indeed, employment is the failed test for the
Muslim states a generation or two after
independence, and with declining oil revenues
(Kepel, 1994). This is a recipe for intergenerational
conflict with a social and cultural accent (Fargues,
1994). It prepares the ground for Islamist
movements.
The absence of democratic institutions means
that a peaceful transition of power seems unlikely
for the opposition. With rising economic problems,
the opposition is no longer the cause of only the
younger generations, but becomes an alliance of
diverse groups. In the Arab world, radical Islamism
took off as local movements in the mid-1980s,
coinciding with the fall in oil revenues. The
movements often acted as social welfare
organizations which supplemented the inadequate
public services; they enjoyed the active support of
young intellectuals. The governments found these
organizations more difficult to prosecute than the
preceding Islamist armed guerrilla movements, as
their welfare work was making them popular. The
next step was for the multiple Islamist
organizations to present political grievances which
can be a driving force for democracy (Hefner,
2000). The Bush jr. initiative for Middle East
reform apparently recognizes the need for change,
but Islamist movements seem set to take power
with a religious, social and nationalist agenda
(Khalaf, 2005). That would hardly be without
repercussions for oil policies and the world oil
market.
8.3.3 The historical background
Islam has always been a crucial force shaping
Middle Eastern and North African societies; it is
also a product of the region (Lindholm, 2002).
Many attitudes and practices, which today are
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considered Islamic, are often older, originating
in the region and justified by its habitat (Fatany,
2004). The merchant and Bedouin legacies are
important in this respect. A great religion can
also be seen as a political project aiming to
shape society, which is crucial to the historical
consciousness of Muslim societies (Rodinson,
1966). Islam’s overall political and economic
principles are sufficiently vague to survive as a
reference through the ages, and they lend
themselves to different and often opposing
interpretations, but there is a distinctive
common ground: Islam does not recognize any
separation of the worldly and the godly
(Mahfoud, 1994).
Through the ages, Islam’s judicial, political and
economic agenda has been developed and
supplemented by the learned, the ulama, a
combination of lawyers and theologians who have
served as judges, administrators, teachers and
religious advisors (Lapidus, 1975). Even if they
have had, at times, a considerable degree of
independence, the ulama have usually been
employed by the state, so that the development of
Islamic law and the Islamic political and economic
agenda has historically not taken place without
regard for the interests of the state. The exception
is the shia tradition, prevalent in Iran and parts of
Iraq, Lebanon and Syria, where the clergy has an
independent income base.
Integrating the worldly and the godly from the
outset distinguished Islam from Christianity,
embodying the political project to reconcile and
unite various clans and tribes and different social
classes through a monotheistic religion, combined
with a rudimentary welfare state. An important
objective was to establish an institutional order for
the emerging Arab merchant class, securing the
support of the Bedouins. The merchant class often
had large profits from long-distance trade but in
most cases, the trading routes went through
Bedouin territory; they had military superiority
and control of the trading routes (Andersen et al.,
1993). The traditional social base of the Muslim
state has been the merchant class, i.e. traders in the
bazaar. They represent the continuous and stable
element in Middle Eastern and North African
societies. The Prophet, Mohammed, was born into
an urban merchant family.
By its origins and subsequent development,
Islam appears as an urban religion (Planhol, 1993).
Islam, in many ways, appears as the ideological
superstructure of the merchant class, which is the
reason for the close link between the bazaar and
the mosque, and the fundamental respect of Islam
434
for private property and honest, personal
enrichment (Rodinson, 1966). It has sufficient
flexibility to take the Bedouin interests and points
of view into account, and make them submit to the
authority of the new state (Planhol, 1993). The
counterpart was a system of welfare and transfers
from the wealthy to the poor, including the
Bedouins who were both conservative and
egalitarian (Ruthven, 2000). The need to respect
salient Bedouin traditions can perhaps explain
Islam’s references to group loyalty and puritan
ways of life. As a consequence, Islam also had a
social promise from the beginning. From this
perspective, Mohammed was not only a prophet,
but also a statesman (Hartmann, 1992). The project
was not only to propagate a new faith, but also to
establish a new state with a specific social and
political order.
Historically, the most comprehensive
codification of Islamic law took place in the early
Abbasid Empire in the late Eighth and early Ninth
century A.D. The new Abbasid regime needed to
legitimize its rule. At this time, the religious
scholars also acquired social and administrative
positions, underlining the character of Islam as a
continuous process, where the interpretation of the
sacred texts serves a political purpose, most often
to legitimize the power in place. In times of turmoil
and the break-down of power structures, Islam can
also be invoked against the powers in place, with
the reinterpretation of the sacred texts legitimizing
disobedience to authority. An important historical
example is the crisis of Caliphal authority in the
Abbasid Empire in the early Ninth century
(Lapidus, 1975).
In modern times, the reinterpretation of the
sacred texts for the purpose of opposing authority
has been recurrent in Egypt since the 1920s, and
more recently in other countries, including Iran
(Pott, 2001). This development expresses the
instability and turmoil of Muslim societies caught
between secularizing governments and rising social
tensions. Since the mid 1980s, the Middle East and
North Africa have witnessed an increasing
ideological confrontation with religious references,
reflecting an economic and social crisis, and the
gradual erosion of the legitimacy of the rulers in
the aftermath of declining oil revenues. The battle
for the interpretation of the sacred texts is also a
battle for political power (Kepel, 2004). The
audience is now an increasingly urbanized and
educated population, distinguished by youth and
high unemployment in societies profoundly
marked by the uneven flows of oil revenues since
the early 1970s.
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The ruling class, with a basis in the public
sector, including the armed forces and the
nationalized oil industries, has the control of
economic and political life. Its position is being
challenged because of rising inequalities; this
conflict is particularly bitter in countries that
experienced a strong surge in oil revenues in the
late 1970s and early 1980s. Their subsequent
decline in the late 1980s and early 1990s produced
strong discontinuities in development. At first,
there were extensive disruptions of traditional
society. Subsequently, the attempt at technocratic
modernization failed. The adaptation of a western
economic and social model, financed by oil
revenues, was not successful; Algeria and Iran are
the typical examples (Shirley, 1995). Oil revenues
made an apparent modernization easy, but the
simple solutions proved elusive. Since 2000, high
oil prices have again contributed to political
stabilization, and the social and political stability
of the Middle Eastern and North African oil
exporting countries increasingly seem to hinge on
high oil prices because of the failure to develop
alternative sources of income and employment.
The result is the two-tiered economy. The public
sector represents the developed part. It consists of
the state apparatus, the national oil company, other
key state enterprises and the leading financial
institutions, all owned or controlled by the state. It
accounts for most of the value added. The private
sector, however, is less developed. It is dependent
upon selective favours and transfers. Private
businesses usually operate in imports, trade or
services, but seldom in large-scale manufacturing.
Agriculture is generally marked by low productivity
and is dependent upon public support. The merchant
class, the traders and craftsmen in the bazaar, needs
differentiation. Some merchants have succeeded,
through public favours and concessions, in gaining
considerable wealth. Others have been marginalized
by imports and large-scale trading. Nevertheless, the
respect for private property and the link between the
bazaar and the mosque are political essentials in
present Muslim societies.
8.3.4 Islam’s economic principles
Islamic economic thinking, inspired by the sacred
texts, the Koran, the hadith, the sunna and the
sharia, has developed in the Twentieth century as
an opposition to the neo-classical economics of the
Western colonialists and imperialists. It has been as
prevalent in non-Arab Muslim countries, such as
Iran and Pakistan, as in Arab countries.
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Ideologically, Islam appears as a capitalist
religion, with its emphasis on individual
responsibility, private property and the private
accumulation of wealth through trade and
productive work, provided it is honest, halal
(Rodinson, 1966). Islam positively prescribes
social justice, the sharing of wealth and welfare for
the poorer parts of society, and institutionalizing
compassion for the poor as a central element in the
faith. On the other hand, Islam explicitly prohibits
certain economic practices considered dishonest or
harmful to the common good, haram.
Consequently, Islamic economic thinking is
normative, aiming at a balance between private
initiative and social welfare. Honest work and
inventiveness are honoured; compassion is
mandatory; corruption, cheating and waste,
prohibited. The key tenets are sharing wealth,
prohibition, participation and sharing risk, and
prohibition of interest charges and waste. In
addition, the shia tradition observes a religious
income tax (see Table 1).
Sharing wealth is the primary economic
principle of Islam (Mills and Presley, 1999).
Alms, zakat, as a tax on capital, is one the five
pillars of the religion (Andersen et al., 1993).
Giving alms is part of the religious exercise and a
duty even when there is no state to collect
and redistribute it (Benmansour, 1994). The
obligation of giving alms complements the
prohibition of usury, riba. Both are redistributive
mechanisms and parts of Islam’s original social
and political project.
The wealth tax, zakat, takes the form of
annually ceding a part of the working capital. It
appears as the community’s share of wealth
produced (Mannan, 1987). It is also a levy on
property and savings. The purpose of zakat is both
to redistribute wealth, for the benefit of the poor,
and to counteract the hoarding of capital and
prevent a passive participation in economic life by
a rentier or leisure class (Hammad, 1989).
Consequently, the objective is to redress the social
balance, to finance charity and to provide
incentives for the productive use of capital. Zakat
is only applicable upon productive assets, here
meaning equity held for at least one year. It is not
levied upon personal consumption capital. The
major exception is agriculture, where zakat is
applicable to produce, not the land.
As a rule, the payment of zakat is in kind. On
cash assets and goods intended for sale, it is
usually 2.5% of the value. On produce from
naturally irrigated land, zakat is usually 10%; from
artificially irrigated land, it is 5%. On mining of
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PRODUCER-EXPORTER COUNTRIES
Table 1. The key Islamic economic principles
Notion Arabic term
Sharing wealth, capital tax Zakat
Interest
Riba
prohibition
Risk and profit sharing Mudarabah
Waste prohibition Israf
Religious income tax
Khums
(shia tradition only)
metals and exploitation of other buried treasures,
zakat is usually 20% of the value, which is relevant
for current petroleum exploitation. More recently,
Islamic economic thinking has dealt with taxing
industrial production. In this case, it has justified
the principle of a zakat of 10%. It should, however,
be exempt from craftsmen’s tools (Mannan, 1987).
Traditionally, zakat has not been levied on
buildings, but modern Islamic economic thinking
prescribes it to be levied on buildings for rent. For
individuals, there is an exemption of “zakatable”
income. This is the money needed to sustain
necessary consumption and to repay loans
currently due (Choudhury and Malik, 1992). Zakat
is to be imposed on productive assets left idle for a
year, as well as profits and windfalls from
economic activity and inheritance (Choudhury,
1986). For corporations, working capital is exempt
from zakat. The question of zakat in labour
intensive service businesses, where the human
capital is of key importance, so far seems to have
been largely overlooked.
Traditionally, as in many modern Muslim
states, zakat has a supplement in other taxes. The
most important are jizya, the poll tax on
non-Muslims, and the kharaj, land tax. The jizya is
often progressive, hitting the rich more than the
poor. The kharaj, land tax, is usually applicable on
lands conquered by military means. It is divided
into a proportional tax on the produce and a fixed
tax on the land. Another important tax is the ushr,
tithe, collected on farmed land.
The prohibition of usury, riba, has caused
different interpretations and is presently subject to
dispute (Naqvi, 1994). A lenient interpretation is
that the prohibition concerns unfairly high interest
rates, usury in the Western sense. This would
permit a fair rate of interest to make up for
436
General economic purpose Practical significance
Taxing capital for
Income redistribution
transfers to the poor
Time value
Prohibition of usury
of money indifferent
Capital participation
Joint ventures, partnership
by lender
Prohibition of waste No luxury consumption,
and idleness no hoarding
Payment of a fifth Independent religious
of net income income base
inflation and a modest return on capital invested. A
stricter interpretation is that any kind of interest
payment is prohibited. The majority of
commentators seem to agree on the latter
definition. The purpose is to prevent the rise of any
rentier class in the economic system. A yet stricter
interpretation is that Islam prohibits any unfair
gain from a transaction between unequal partners
(Hammad, 1989). A subtle differentiation is that
manifest interest, by a delay in delivery, is
prohibited. By contrast, hidden interest such as
profit sharing, trading and selling, or the sale and
repurchase of the same good, is tolerated. In
practice, a hidden interest is charged through
lending disguised as commercial operations. An
example is the borrower selling a good to the
lender, but with the obligation of repurchasing the
same good, at a given moment, at a price agreed
upon. Trade is tolerated in Islam, also as a
substitute for interest.
The intention of forbidding usury is to provide
for a minimum of social equity and justice, and to
prevent capital accumulation through lending
money at a high cost to borrowers. The ethical
objective is simultaneously to prevent the
exploitation of the needy and enrichment through
passive participation in the economic system.
Implicitly, this is also recognition of the fact that
capital is idle unless actively used by labour.
Against this backdrop, interest rates can be
tolerated as a tool of measurement, but not as an
objective of economic activity. A subtle modern
understanding is that a return on capital equivalent
to zakat, that is 2.5% on most assets, can be
tolerated. The intention of zakat is also to
encourage the usefulness of capita. Indeed, the rate
of zakat of 2.5% annually can implicitly be seen as
a natural value increase on capital assets.
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According to Islamic economic thinking, this
natural growth should be distributed to the
community. Any additional value growth of capital
assets should be kept by the owner and be subject
to normal taxation.
With the absence of interest, discount rates are
redundant as a tool in monetary and economic
policy (Choudhury, 1992). Monetary creation is
the prerogative of the central bank. Commercial
banks become investment managers for savings.
The cost of capital becomes the real rate of return
in business, and vice versa. Hence, the rate of
return in the financial sector is directly linked to
the rate of profit in the non-financial sector, where
the rate of profit measures the rate of growth of
productivity and output. To sum up, in principle,
lenders and borrowers are to have the same rate of
profit, giving incentives for investment in real
assets rather than financial assets.
In its practical orientation, the prohibition of
interest in Islamic economic thinking is a tool, not
an objective for policy (Naqvi, 1994). The purpose
is to replace interest payment with a more
equitable financial mechanism. The absence of
interest payment does not indicate a surplus
situation where capital has a zero shadow price,
nor does it indicate an indifferent or negative time
preference for income. For private individuals,
Islamic economic thinking recognizes the positive
time preference. Present income can be invested
profitably to enhance the future income base.
Future income can, at best, be mortgaged to
enlarge present purchasing power, but with the
undesirable social result of subjecting the borrower
to the lender. Hence, Islamic economic thinking
recognizes a positive private time preference for
income. This can be offset by a negative
government time preference for income. An
important purpose of a negative government time
preference for income is to take the depreciation of
the capital stock and the need for new investment
into account. Practically, this means that the
government will need higher revenues in the future
than today in order both to finance new investment
and improve social services. With a high
demographic growth rate, the case for a negative
government time preference for income
strengthens.
The counterpart to prohibiting usury or interest
is to encourage the sharing of risk and profit,
mudarabah. Participation with risk and profit
sharing is the Islamic substitute to the use of
interest; it associates unequal partners. It also
provides the weaker ones with access to capital,
when the joint ventures are successful. The
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objective is to bridge social differences through co-
operation and to avoid conflict. The sharing of risk
and profit is especially encouraged between labour
and capital. The problems are the agreement on the
ratio by which to share eventual profits, and that
some partners can bear losses more easily than
others. In any case, co-operation is an important
principle in Islamic economic thinking. An Islamic
economic joint venture recognizes equal rights of
workers and investors, applied to voting power as
to the distribution of profits. The equity
participation may be as subscribed capital or
imputed wages forgone. It can also represent the
value of labour time in production (Choudhury and
Malik, 1992).
Islamic economic thinking prescribes external
financing by an extension of the original joint
venture and borrowing money, but with the lenders
sharing the risk. The attractiveness to external
lenders is not in an interest rate agreed upon ex
ante, but profit is a function of the rate of return,
established ex post over a number of years. This
may deter investors from high-risk innovative
projects.
The prohibition of waste and idleness is another
principle of Islamic economic thinking, israf. It
concerns wasteful consumption, wasteful
production and the idleness of productive
resources, including capital. Wasteful consumption
above reasonable needs is associated with luxury
and injustice. It again engenders the use of
productive resources for wasteful needs to the
detriment of the daily needs of the population. The
social cost of luxury consumption and production
is fewer resources allocated to the production of
goods and services with a higher marginal utility.
The ethical imperative is that the productive
resources should be used for the common good, not
for the production of luxury articles for a minority.
Correspondingly, hoarding is prohibited because it
entails the use of productive resources for idle
purposes. Finally, the hoarding of capital is
prohibited as it entails the idleness of resources
which otherwise could be used for the common
good. In Islam, the payment of interest on loans
appears as waste, because it is compensation to the
lender without any active effort. The subjective
capitalization of risk by the lender is an
unnecessary burden on investment.
In political terms, Islamic economic principles
can also serve as a tool to fight or prevent the rise
of a rentier or leisure class, living off capital,
hoarding wealth and consuming conspicuously.
The Islamic interpretation of private ownership
finds it justification against this backdrop. In
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PRODUCER-EXPORTER COUNTRIES
Islamic economic thinking, private property to the
means of production and exchange is essentially a
functional right; its justification is individual
effort. Islam respects individual property when
acquired through the individual’s own labour, but
much less so when inherited (Naqvi, 1994). In
principle, all property belongs to God, but it is in
the custody of private individuals as caretakers or
trustees insofar as they respect Islam’s ethical
norms which includes productivity. Islamic
economic principles also tolerate managed
markets, i.e. the co-operation of different sellers to
set prices.
Insofar as these norms are not respected, the
Islamic state has a sovereign right to confiscate
private productive property. It can either keep it as
state property or hand it over to other individuals.
This principle also applies when the owner of
productive capital does not get a certain return on
the assets. The purpose is to enhance productivity
for the common good. In addition to zakat as a
capital tax, the threat of confiscation is a strong
incentive to productivity. Furthermore, Islamic
economic thinking insists on redistributive justice,
providing all members of society with a minimum
standard of living, regardless of their ability to earn
it. Islamic economic thinking also tolerates various
kinds of taxation to finance the social services and
income transfers.
The Islamic concept of ownership of land and
other natural resources is pertinent in this respect.
The principle of private land ownership is
respected insofar as the proprietor also works the
land; if not, land should be in public ownership.
Private property rights are limited, otherwise they
would deprive others of their rights (Benmansour,
1994). Absentee landowners living off land rent are
contrary to the letter and spirit of Islam. Likewise,
natural resources can be in private ownership, but
the economic rent must be shared by all members
of the community (Mannan, 1987). Individuals are
entitled to proper compensation for their efforts to
improve the use and value of natural resources.
This principle can justify the state ownership of
important natural resources, as for land. The
Islamic view is that natural resources are a gift
from God, and belong to both present and future
generations. Natural resources therefore belong to
the state which can delegate their commercial
exploitation according to Islamic principles.
Productivity is important in this respect –
exhaustible resources should not be misused by the
present generation, and the revenues from their
exploitation should be invested in other lasting
sources of income. The purpose is to enhance
438
economic development to make revenues from
exhaustible resources redundant once the resources
are exhausted (Al-Chalabi and Al-Janabi, 1979).
In its normative approach, Islamic economic
thinking, at times, seems to deal with ideals rather
than actual situations. In an economy organized
according to Islamic principles, the state is the
preferable owner of natural resources, including
land and minerals. Private initiative is encouraged
in trade and manufacturing where workers and
owners share risk and profit through co-operative
joint venture based on a high degree of industrial
democracy; lenders also directly share risk and
profit. Suppliers are permitted to cooperate so that
prices will be higher than under perfect
competition, but lower than under monopoly. The
absence of interest charges means that there is no
rentier class, and financial profits are never higher
than productive ones. There are strong incentives to
individual effort and capitalists owning means of
production and trade. This essentially concerns
capital accumulated through their active
participation and sharing of risk. The economic
surplus is created in both private and public
sectors. Social equity and welfare are essentially
ensured through the wealth tax.
This ideal economic model has its historical
basis in Islam’s social project. The crucial question
concerns the effect of the sudden influx of oil
revenues in Muslim countries – whether it has
contributed to the realization of this model or not.
The question is also how this objective has
eventually fared during the subsequent economic
adversity. The pivotal issues are the rate of
extraction of oil, the organization of the oil
industry and the use of the petroleum revenues.
8.3.5 Oil and Islamic economic
principles
An extractive activity such as the oil and gas
industry is, in principle, a finite process because
the resources are ultimately depleted. The present
extraction is dependent upon the historical record
and volumes already extracted. The present
depletion, again, sets the limits for future
extraction volumes. Even if exploration and
technical and managerial progress augment
volumes that can be commercially lifted, petroleum
extraction is a historical process, and so is the flow
of income, which raises the issue of equity over
generations.
Oil revenues as rentier income differ
qualitatively from productive income because they
ENCYCLOPAEDIA OF HYDROCARBONS

have their origin in the extraction of a finite
resource, not in human labour and productivity.
The value of oil provides payment above factor
costs which includes a normal profit. The
difference between the market value of the oil
lifted and the costs of exploration, development
and extraction with a normal rate of return for
capital, labour and materials, can be seen as a free
gift of nature, an economic resource rent caused by
the properties of crude oil (Dam, 1976). The
condition is that the price of a commodity is
substantially above production cost due to scarcity
or imperfect competition, or both. Oil in the
ground represents resource capital for the
landowner (Dasgupta and Heal, 1979). Lifting the
oil means depleting the owner’s resource capital. In
most countries, oil in the ground is government
property so that depletion rates, the organization of
the activity and the use of the revenues are public
concerns.
Any government-landowner, Muslim or non-
Muslim, first of all needs to decide on the rate of
depletion, i.e. how much petroleum to lift and how
much to leave in the ground. The choice of
depletion rates for oil and gas is the key policy
parameter in any petroleum producing country. The
choice has to consider the current and future need
for revenues. Simplistically, the depletion rate
appears as a problem of portfolio management
where the options are to leave oil in the ground or
to pump it out, eventually to reinvest the revenues.
The critical intertemporal condition is that
marginal utility, measured as the net present value
of sales, must be equal over time (Gordon, 1981).
Consequently, the timing of the extraction is
crucial, depending upon the discount rate used.
This argument is simpler for a private investor than
for a government-landowner. From the perspective
of Islamic economic principles, it makes little
sense. In theory, a producer aiming at maximizing
profit over time should be indifferent to pumping
out oil today or in the future, provided the future
revenues equal present ones adjusted for the
discount rate. Therefore, in practice, an anticipated
constant oil price represents an incentive to pump
out oil quickly, provided the discount rate is
positive. In this case, only the anticipation of oil
prices rising at a pace above the discount rate or a
negative discount rate could represent incentives to
keep oil in the ground. For a private investor, the
alternatives are essentially to invest in the firm’s
assets, in external assets, or to invest in oil in the
ground (Jabarti, 1977). A fourth alternative is to
pump out oil to finance current spending to
maintain other activities.
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From the perspective of a private landowner
operating with a positive discount rate, the oil left
in the ground can only yield a return when
appreciating in value. On the other hand, the
gradual depletion of a finite resource such as oil
is likely to lead to rising costs and prices, because
more marginal reserves have to be exploited. It
presupposes that the market price and marginal
cost are equal because of perfect competition
(Hotelling, 1931). In this perspective, the choice
of depletion rate is dependent upon the
relationship between the expected development in
real oil prices and the expected return from
investing oil revenues (Dasgupta and Heal, 1979).
As operations move to more marginal areas, the
marginal cost of extraction and the oil price can
be expected to increase. This can, in theory,
represent an incentive to leave oil in the ground,
if, as argued above, the expected price increase is
above the discount rate.
If over the period considered, the rise in oil
prices is expected to be higher than the rate of
return on investing oil revenues, the choice is to
leave relatively more oil in the ground. If investing
oil revenues is expected to yield a higher return
than oil prices are expected to rise, the choice is to
pump out relatively more oil. In brief, expected oil
price development should be weighed against the
perceived cost of capital. This is essentially a
problem of the time value of money, but also of
risk propensity and value preferences, as well as
market structures.
In practice, however, this easily makes an
argument for pumping out oil quickly. Most of the
time, the outlook is best for constant oil prices in
real terms. Experience is that oil prices seldom rise
substantially, but increase dramatically in
infrequent leaps. Therefore, the oil market has a
persistent risk of a price decline, at least a
temporary one. The market price of an exhaustible
resource is essentially unsteady over time, due to
exploration and discovery rates, depletion of old
fields, technological progress, demand fluctuations
and, not least, changing perceptions. Hence, the
usually reasonable risk consideration for a private
oil investor is to pump out quickly and invest the
revenues. Investor risk, generally, is lower in the
wider capital market than in the more narrow oil
market. For an oil exporting government, risk
considerations are more complex. Simplistically,
for a government-landowner the alternatives are,
essentially, to invest in domestic economic
development, foreign assets or oil in the ground. A
fourth alternative is to pump out oil to finance
current consumption.
439
PRODUCER-EXPORTER COUNTRIES
All governments, whether oil exporting or not,
have both current and future obligations to spend
money. A private investor may sell oil assets in the
market to realize most of the net present value, the
discounted cash flow from oil production, liquidate
debts and divest of loss-bearing activities. By
contrast, a government cannot divest of present or
future budgetary obligations. Contrary to a private
firm, a government faces a continuity of
expenditure obligations for administration, health,
education, pensions, etc. Therefore, for an oil
exporting government, realizing the discounted
cash flow in order to reinvest the money in other
assets involves serious risks. Future expenditure
obligations must be matched by future revenues.
For oil producing governments, the notion of net
present value for the oil assets may therefore be of
limited significance. The discount rate is arbitrary,
and some future budgetary obligations are difficult
or impossible to shred. A government may sell an
undeveloped oil field, realizing the net present
value at an early stage, but its budgetary
obligations are not equally transferable to private
investors, at least not without a high risk for the
citizens concerned. Oil property is transferable in
the marketplace, future budgetary obligations,
hardly.
A major risk is that spending gets the priority
over saving and investment. By experience, the
mere availability of oil revenues in any political
system tends to stimulate pressures for spending.
Access to oil appears as access to easy money. This
can generate claims that otherwise would not have
been voiced, and temptations to spend that would
not have been considered without oil revenues.
Another risk is that the oil revenues are invested
badly. Even if the general investor risk in the
capital market is less than in the oil market, any
major investor, such as an oil exporting
government, runs a high unsystematic or subjective
risk of not diversifying sufficiently. Different
political systems might be more open to pressures
to choose a higher risk portfolio. Anyway, most
portfolios of indirect, financial foreign investment
seem to yield a fairly moderate return which
should be considered when deciding the depletion
rate.
Against this backdrop, investment in domestic
economic development may seem a better
proposition for most oil exporting governments.
By experience, investment in health, education and
infrastructure give a long-term return at a fairly
modest annual rate. In a longer perspective,
investment in education is probably the single
factor that most clearly fosters economic growth
440
(Denison, 1967). Investment in agriculture
enhances domestic food supplies; in manufacturing
and services, it creates jobs and alternative sources
of revenues. There are, however, limits to the
amount of investment that the domestic economy
can absorb without returns falling and the economy
being overheated.
If pumping out oil and reinvesting the revenues
are not viable or appear too risky, keeping oil in the
ground to meet future budgetary needs is a sensible
option. Furthermore, oil projects compete for
capital with other sectors, and have to meet certain
basic criteria of return. This discussion shows
the complexity of the issue, but for a
government-owner, pumping out oil at a maximum
rate is not always compatible with long-term
economic needs. Consequently, for an oil exporting
government, portfolio considerations should also
consider intergenerational equity.
For a government exploiting finite natural
resources, the time preference of money is a
complex issue, and it is not fully reflected in the
discount rate. The government concerns are quite
different from the perspective of a private investor
concerned about short-term profit maximization.
Even for private oil companies, oil in the ground
represents an asset whose overall importance to the
bargaining position and the stock value may exceed
the discounted revenues. Oil in the ground does not
deteriorate in quality – it is subject to a price risk.
It may also increase in value because of
technological progress, even with constant real
prices. Oil represents a present and future
source of foreign exchange. Consequently, a
government-landowner has stronger reasons to
leave oil in the ground than a private investor does.
The fourth option, to pump out oil regardless of
price expectations and return on investment, is an
easy way for short-term income maximization. It is
useful for governments shorter of revenues than of
ambitions, but it leads to economic and political
discontinuities.
For Islamic governments, the prohibition of
interest makes calculations of net present value
indifferent to the timing of the extraction. This is
an argument for giving more consideration to
intergenerational equity, to give a higher priority to
the revenue needs of future generations. To the
extent the Islamic government prefers to use a
negative discount rate to offset the private sector’s
focus on immediate profits and to take population
growth into account, it would have even stronger
reasons for leaving oil in the ground. Even
assuming constant oil prices, for an Islamic
government, there may be economic sense in
ENCYCLOPAEDIA OF HYDROCARBONS

leaving part of the oil reserves for the future.
Assuming rising real oil prices, any government
not in dire financial distress would have strong
arguments for keeping more oil in the ground. For
Islamic governments, rising oil prices would weigh
even more strongly against a quick depletion of oil
reserves, as has indeed been the case when rising
prices in the oil market have provided incentives
for cutting output, causing a backward-bending
supply function as countries have extracted oil to
reach budget targets, not to maximize income.
The record of the Muslim oil exporting
countries considering Islamic economic principles
is mixed on most accounts. The depletion policy of
most Muslim oil exporters has apparently
vacillated, and the petroleum policies and uses of
oil revenues of Middle Eastern and North African
oil exporting countries are easy targets of Islamic
criticism, but the alternatives are not always
evident.
The key point of criticism is an excessive
extraction of oil and abuse of the revenues,
referring to huge military budgets and conspicuous
consumption by the ruling class. This amounts to
an accusation of double israf (waste), i.e.
squandering finite oil reserves for the illegitimate
purpose of wasteful, luxury consumption and
unnecessary military expenditure for the benefit of
foreign arms manufacturers and their corrupt
domestic importers. This coincides with a critique
of too rapid a depletion of the oil reserves, based
on considerations of riba, as the prohibition of
interest calculation would prescribe deferring
extraction and revenues as much as possible for the
benefit of future generations. Yet, more dimensions
of criticism are added; the priorities of military
spending and the rulers’ conspicuous consumption
infringe on the imperative of zakat, of distributing
wealth to the poor and, finally, reserving the oil
industry for the public sector technocrats,
excluding the participation of the private sector
merchant class, infringes on the imperative of
mudarabah, sharing risk and profit.
From this perspective, Islamic economic
imperatives are not esoteric or radical, but often
reflect common sense and experience of
economic agents. The major issue is the relevance
of the Islamic rejection of interest or usury for the
time preference for income and petroleum
revenues in particular. This concerns the
depletion rates for oil and gas. Another important
issue is the relevance of the Islamic respect for
private property on the choice of company
structure in the petroleum industry. A third
important issue is the relevance for the Islamic
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prerogative of sharing wealth and avoiding waste
in the use of petroleum revenues.
Concerns about resource depletion or the
domestic economic balance give a case for
producing oil according to income or budgetary
targets. A country with limited oil reserves could
prefer to stretch out their lifetime to secure a
minimum future income base by reducing output
as prices rise. Similarly, a country with a limited
ability to absorb oil revenues could apply such
considerations. The reason could be a rapidly
declining marginal utility of oil revenues by a
diminishing return on new investment, eventually
accompanied by bottlenecks and inflationary
pressures. Foreign investment could appear as an
irrelevant or undesirable option. This could present
a case for reducing oil production as prices
increase. The argument is that tomorrow’s income
requirements are likely to be higher than today’s,
and the marginal utility of oil revenues could be
higher in the future than at present. Consequently,
oil in the ground in the future would be of greater
value than today.
Depletion according to revenue targets takes
marginal utility explicitly into account. It implies
keeping oil in the ground once the ability to
reasonably absorb oil revenues has been reached.
Implicitly, depletion according to revenue targets
means reinvesting oil revenues in other durable
sources of income, preferably foreign exchange. A
minimum rate of return on investment puts a limit
on the need for revenues and, consequently, on oil
production. Furthermore, the rate of depletion
becomes inversely tied to the price of oil, because
the volume required to meet the revenue targets
declines with a rising oil price and rises with a
falling one. This amounts to a backward bending
supply curve which is a negative price elasticity of
oil supplies. This depletion principle is certainly
compatible with Islamic economic principles as it
takes intergenerational equity into account and
seeks to avoid wasteful consumption and
production. A minimum return on investment does
not necessarily conflict with Islam and its rejection
of interest, but can be seen as a measurement of
social utility. Keeping oil in the ground is not idle
use of reserves when the prohibition of interest
makes the net present value indifferent to timing of
the income.
Adjusting oil depletion to demographic
growth is likewise compatible with Islamic
economic principles as it, again, takes
intergenerational equity into account and seeks to
avoid waste. Most Muslim oil exporting countries
have a high rate of population growth, and the
441
PRODUCER-EXPORTER COUNTRIES

lack of alternative sources of income means that
future oil revenue needs are likely to be larger
than present ones; this makes intergenerational
equity a pressing problem. Another urgent
problem is to avoid wasteful depletion and
consumption today, as rapid demographic growth
may be an argument for depleting according to
target revenues. It may also be a case for using a
negative rate of interest in depletion calculations.
The outcome would be that oil revenues in the
future would be more valuable than at present.
Such a depletion principle would be compatible
with Islamic economic principles as this, too,
would take intergenerational equity into account,
while aiming to avoid wasteful production and
consumption (see Table 2).
Accelerating the depletion of finite oil reserves
increases the risk that future generations are left
with a poorer income base. Privatizing the oil
industry raises the risk of individual preferences
ruling a public asset. Using petroleum revenues
primarily for consumption purposes, including the
military, increases the risk of squandering wealth
and neglecting long-term structural issues. Using
petroleum revenues largely for individual benefits
increases the risk of a worsening income
distribution, undermining social and political
stability. Critics advocating a lower depletion rate,
organizing the oil industry with better
accountability, and using the revenues for
investment and public welfare programmes do not
have to be Islamic, but they can refer to Islamic
principles. The general criticism, based on secular
considerations of inter-generational equity,
efficiency and social justice, is relevant to most oil
exporting countries. It tends to coincide with an
Islamic critique of oil policies and oil financed
economic policies in key Muslim countries. The
policies often appear as short-sighted, inefficient
and socially unjust.
Historically, the advent of nationalist regimes,
with or without an Islamist reference, has generally
caused a slower rate of depletion of the oil reserves
and stronger co-operation in the Organization of
Petroleum Exporting Countries (OPEC), raising
the oil price. Salient cases are Libya after the 1969
revolution and Iran ten years later. For years, the
Islamist opposition to the Shah of Iran criticized
the oil policy for squandering resources by
pumping oil out too quickly and not taking the
revenue needs of future generations into account. A
further critique was that oil policy has benefitted
the new technocratic class based in the public
sector, and that it has benefitted the West (the
consuming countries), above all, the United States
by pumping out quickly and keeping prices low. A
similar criticism was voiced in Libya at the end of
the monarchy.
Concerns for revenue continuity and future
income requirements argue in favour of keeping
more oil in the ground than otherwise would have
been the case. This should be weighed against the
risk that oil prices will decline, so that oil in the
ground in the future will be of less value than
today. Correspondingly, an accelerated depletion of
the oil reserves should be weighed against the risk
that oil prices will rise. Managing the oil market
with the aim of gradually moving the price of an
exhaustible resource to the cost level of alternatives
takes intergenerational equity into account for both
producers and consumers, and is certainly
compatible with Islamic economic principles. The
problem is that the cost level of alternatives is
unknown and so is the time horizon required for
the price of oil to move to that level (Al-Chalabi
and Al-Janabi, 1979). The price path for oil chosen

Table 2. Islamic economic principles and oil policy

Meaning Practical
Notion
for the petroleum industry significance

Use petroleum revenues

Sharing wealth, capital tax Share petroleum revenues
to finance social welfare

Petroleum revenues as important Adapting rate of extraction

Interest prohibition
tomorrow as today to revenue targets

Participation of private agents when

Risk and profit sharing Joint ventures with private partners
they can make a positive contribution

Use petroleum revenues Not using petroleum revenues

Waste prohibition
for investment purposes for conspicuous consumption

442 ENCYCLOPAEDIA OF HYDROCARBONS


by the price leader and volume adjuster may not be
compatible with the interests of other oil exporters;
moreover, the price and volume path chosen by the
price leader may generate revenues exceeding the
reasonable marginal utility of return on domestic
investment projects. The alternative – to strictly
extract oil by revenue targets – would require
control of the market and price formation, unless
supply volumes were erratic which, again, would
engender instability. From this perspective, the
OPEC appears justified by Islamic economic
principles, as by the consumers’ need for oil
market stability.
Finally, from an Islamic economic perspective,
unemployment is israf, waste of labour and human
creativity. The drama in the Middle East is that the
oil industry has caused a flow of money, but few
jobs. At the same time, most Middle Eastern oil
exporters just sell the raw material and import
input factors for the oil industry as well as finished
petroleum and petrochemical products. Investing in
oil supply and service industries as well as in
secondary and tertiary petrochemicals would help
both job creation and the trade balance. Iran has
embarked on such a path, and Saudi Arabia
has stated intentions in this direction in the
8th Five-Year Plan 2005-09 (Khatib, 2004). This
is evidently a domain where the private sector has
a potential.
Islamic economic thinking, when applied to oil,
corresponds to what, on salient points, appears to
be common sense in large parts of the rest of the
world. There is, however, a profound conflict with
the attempted oil policy imposed by the United
States occupation authority in occupied Iraq,
aiming at large-scale privatization, raising volumes
of extraction, and using oil revenues to pay for the
occupying force (Looney, 2003). Iraq’s experience
under United States occupation raises the issue
whether the alleged clash of civilizations masks a
clash of interests (Klein, 2005).
8.3.6 Clash of civilizations
or clash of interests?
Petroleum policies and economic policies based
on petroleum revenues since the early 1970s in the
Middle Eastern and North African countries are
easy targets of Islamic criticism today. It is
questionable whether Islam originally has some
distinctive principles which are relevant nowadays
for organizing economic life. This does not
prevent contemporary Islamic scholars from
developing distinctive economic ideas. Some of
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ISLAM AND OIL
these principles are relevant to economic policy in
a modern society (Islam [...], 1994). They include
the sanctity of private property, the prohibition of
charging interest, the need to share risk, the
prerogative to redistribute income, as well as the
prohibition of waste and idleness. These economic
principles are also relevant to petroleum policy
decisions. Interest considerations influence the
rate of depletion of a finite resource. The
emphasis on private property and risk sharing
could influence the organization of the oil
industry. The definition of waste and the
prerogative to share wealth potentially affects the
use of petroleum revenues. Hence, Islam in a
modern interpretation potentially has a practical
impact on petroleum policy.
The Islamist charges are briefly that the
economic policies based on petroleum revenues
serve the narrow and short-term interests of a
technocratic class based in the public sector and
Western interests. They allegedly infringe upon the
principles attributed to Islam. The critique is
briefly that the ruling class is pumping out a finite
resource too quickly, and that the revenues serve a
limited number of people. The revenues, to a
considerable extent, finance the wasteful
consumption of a Westernized civilian and military
ruling class.
Prospects are that Islamist governments, or
governments under stronger Islamist influence,
will accede to political power in the major oil
exporting countries of the Middle East. This is
likely to coincide with rising demand for oil from
the Middle East, as demand increases and
extraction elsewhere stagnates or even declines
(IEA, 2004). The counterpart to a stronger call for
Middle Eastern crude is stronger competition
among the major oil importers to position
themselves. This is the background for Chinese
and Indian initiatives for comprehensive economic
deals with Middle Eastern oil exporters, essentially
Iran and Saudi Arabia, to have a first call for oil
and natural gas in return for investment capital,
industrial exports and arms. China’s and India’s use
of economic levers contrasts with the military
efforts of the United States which seems to have no
other means (Stelzer, 2001).
Rising demand for Middle Eastern oil is likely
to drive up prices, as the Middle Eastern oil
exporters will have little incentive to raise output if
revenue targets can be met by lower volumes when
prices go up. Moreover, they are likely to give
preferential treatment to trading partners with
comprehensive economic deals, which appears
detrimental to the United States. The risk is,
443
PRODUCER-EXPORTER COUNTRIES
therefore, that the political success of Islamist
movements in the Middle East will lead to rising
tensions with the United States over oil supplies
and prices, giving the United States stronger
reasons to stay in Iraq and even to threaten
neighbouring oil-exporting countries, but at the
same time, providing the Islamist movements with a
useful enemy, as is to some extent the case with the
Iranian government today (Ali, 2002). In return, the
strengthening of Islamist movements or even
governments in other Middle Eastern oil exporting
countries might provide right-wing United States
forces with a useful adversary, setting the stage for
a prolonged conflict (Tertrais, 2004). The United
States’s plans to reform the Middle East appear to
build on fantasy rather than insight (Salomon,
2004). The challenge is for Europe, together with
China, India and others, to come to terms with the
emerging Islamic political order in the Middle East,
on the basis of international law, mutual respect and
the right of self-determination (Leonard, 2005).
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Khalaf R. (2005) US democracy drive heartens the Islamists,
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445

The future of hydrocarbons
9.1.1 The global outlook
for oil and gas
For all the talk about the imminent end of the
petroleum age, oil and gas will continue to play the
leading role in meeting the world’s growing hunger for
energy for at least the next quarter of a century, and
probably well beyond. If governments maintain current
policies (the underlying premise of the World energy
outlook’s reference scenario: IEA, 2005), the world’s
energy needs would be more than 50% higher in 2030
than today, amounting to an average annual growth
rate of 1.6%. Oil and gas are expected to account for
more than 60% of that increase. In the medium term,
uncertainty regarding the prospects for hydrocarbons
concern the rate of investment in new capacity more
than the adequacy of reserves.
Methodology and key assumptions
of the World energy outlook
The IEA’s (International Energy Agency) World
energy outlook adopts a scenario approach to
analyse the possible evolution of energy markets to
2030. The central projections derive from a
reference scenario and are based on a set of
assumptions concerning government policies,
macroeconomic conditions, population growth,
energy prices and technology. The reference
scenario takes into account only those government
polices and measures that have already been
enacted, though not necessarily implemented.
These projections should not be interpreted as a
forecast of how energy markets are likely to
develop, but rather as a baseline vision of how the
global energy system will evolve if governments
take no further action to affect its evolution.
Other key assumptions in the reference scenario
include:
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
9.1
• Global GDP (Gross Domestic Product – the
primary driver of energy demand) growth is
assumed to average 3.2% per year over the
period 2003-2030, slightly less than in the
previous three decades. The rate will drop
from 3.8% in 2003-2010 to 2.7% in the last
decade of the projection period, as economies
mature and population growth slows in
developing countries. The economies of
China, India and other developing Asian
countries are expected to continue to grow
most rapidly.
• The world’s population is assumed to expand
from 6.2 billion in 2002 to over 8 billion in
2030 (an increase of 1% per year on
average). Population growth will slow
progressively over the projection period,
mainly due to falling fertility rates in
developing countries. Nonetheless, the share
of the world population living in developing
regions will increase from 76% today to 80%
in 2030.
• In the reference scenario, the average price for IEA
crude oil imports is assumed to fall back from
recent highs of over $60 a barrel to around $35 in
2010 (in year-2004 dollars), and then climb to $39
in 2030 ($65 in nominal terms). Gas and coal
prices are assumed to move broadly in line with oil
prices.
An alternative policy scenario takes into account a
range of new policies to address environmental
problems and enhance energy security that are
currently under consideration by countries around the
world. The 2005 edition of the World energy outlook
also presents a deferred investment scenario, which
analyses the impact of significantly lower upstream oil
investment in the Middle East and North Africa on
global energy markets.
447
FUTURE SCENARIOS
9.1.2 Demand
By 2030, the world will be consuming 16.3 billion toe,
up from 10.7 billion toe today. More than two-thirds of
the growth in world energy use will come from the
developing countries, where economic and population
growth is highest. Fossil fuels continue to dominate
energy supplies, meeting more than 80% of the
projected increase in primary energy demand in this
scenario.
Oil remains the single largest fuel (Fig. 1), with
two-thirds of the increase in oil use coming from
the transport sector. Demand will reach 92 Mbbl/d
(million barrels per day) in 2010 and 115 Mbbl/d
in 2030. Natural gas demand grows faster, driven
mainly by power generation. It will overtake coal
as the world’s second-largest primary energy
source before 2015. The share of coal in world
primary demand will fall slightly, with demand
growth concentrated in China and India. Nuclear
power’s market share will decline marginally, while
that of hydropower will remain largely constant.
The share of biomass will decline slightly, as it is
replaced with modern commercial fuels. The share
of other renewables, including geothermal, solar,
wind, tidal and wave energy, will grow more than
that of any other energy source, but still reach only
2% in 2030.
Oil will remain the single largest fuel in the global
primary energy mix in the reference scenario. Its share
will nonetheless fall marginally, from 35% in 2003 to
34% in 2030. Oil demand is projected to grow by
1.4% per year, from 81 Mbbl/d in 2003 to 92 Mbbl/d
in 2010, and to 115 Mbbl/d in 2030. Two-thirds of the
total increase in oil use will come from the transport
sector, where oil will remain the main fuel. Oil will
6,000
5,000
4,000
Mtoe
3,000
2,000
1,000
0 the World energy outlook period. In the five years to
1970 1980 1990 2000 2010 2020
oil other renewables
coal nuclear
gas hydro
Fig. 1. World primary energy
demand by fuel (IEA, 2005).
448
remain a marginal fuel in power generation, with its
share declining in every region.
Industrial, commercial and residential demand for
oil is projected to increase moderately, with all of the
growth coming from non-OECD (Organization for
Economic Cooperation and Development) countries.
Oil products will remain the main source of modern
commercial energy for cooking and heating in
developing countries, especially in rural areas. The use
of oil in non-transport sectors in OECD countries will
decline markedly.
After registering a strong growth of 2% in 2003,
world oil consumption in 2004 increased even more
quickly, by 3.6%. This marks the fastest rate of growth
since 1978 (Table 1). China, which saw a jump of 16%
or nearly 0.9 Mbbl/d in its oil use in 2004, accounted
for 30% of the global demand increase.
This surge came despite record oil prices. The
average IEA crude oil import price averaged over $36
a barrel in 2004, a jump of almost 30% from 2003.
The price of first-month WTI (West Texas
Intermediate) averaged $41.49 and that of Dated Brent
$38.27 in 2004. In 2005, prices continued to rise,
reaching over $70 for WTI in late summer (a record in
nominal terms). Adjusted for inflation, prices are still
below the levels of the 1970s. The surge in prices has
so far not cooled demand much, though there are signs
that high oil prices are starting to dampen economic
growth and energy demand, especially in Asia.
Assuming that prices fall back in the next few years,
oil demand is projected to continue to grow steadily
over the projection period, with developing countries
(particularly China and Africa as a whole) registering
the fastest rates of growth.
Some 95% of the increase in demand over the
projection period will be for middle distillates and
light fuels. The slight increase in heavy fuel demand in
developing countries, mainly in industry and for
bunkers, will be almost entirely offset by a fall in
demand for these fuels in OECD countries. Global
demand for middle distillates (diesel for road transport
and jet kerosene for aviation) will reach almost
49 Mbbl/d, an increase over 2003 of 18 Mbbl/d. The
increase in demand for light and middle distillates will
be about ten times greater than the increase in heavy
fuels in developing countries. Transport fuels will
account for the bulk of the increase in oil demand over
2030
2004, the entire increase in oil demand in the OECD
came from the transport sector.
Primary demand for natural gas will grow by 2.1%,
meaning that gas will overtake coal by around 2020 as
the world’s second-largest primary energy source. Gas
consumption will increase by three-quarters between
2003 and 2030, reaching 4,789 billion cubic metres
ENCYCLOPAEDIA OF HYDROCARBONS
 THE FUTURE OF HYDROCARBONS

Table 1. World oil demand, Mbbl/d (IEA, 2005)

2003 2004 2010 2020 2030 2004-2030*

OECD 47.0 47.6 50.5 53.2 55.1 0.6%

OECD North America 24.1 24.9 26.9 291.0 30.6 0.8%
OECD Europe 14.5 14.5 15.0 15.4 15.7 0.3%
OECD Pacific 8.4 8.3 8.6 8.7 8.8 0.3%

Transition economies 4.2 4.4 4.9 5.6 6.2 1.3%

Russia 2.5 2.6 2.9 3.3 3.5 1.2%
Developing countries 25.0 27.0 33.9 42.9 50.9 2.5%
China 5.4 6.2 8.7 11.2 13.1 2.9%
India 2.5 2.6 3.3 4.3 5.2 2.8%
Other Asia 5.1 5.4 6.6 8.3 9.9 2.3%
Latin America 4.5 4.7 5.4 6.5 7.5 1.9%
Africa 2.6 2.6 3.3 4.5 5.7 3.0%
Middle East 5.1 5.4 6.5 8.1 9.4 2.2%
Miscellaneous** 3.0 3.0 3.1 3.2 3.3 0.3%
World 79.2 82.1 92.5 104.9 115.4 1.3%

* Average annual growth rate.

** Includes bunkers and stock changes.

(Table 2). The share of gas in world energy demand
will rise from 21% in 2003 to 24% in 2030. Power
generation will account for most of the increase in gas
demand over the projection period because, in many
parts of the world, gas will be the preferred fuel in new
power stations for economic and environmental
reasons. A small but increasing share of gas demand
will come from gas-to-liquid plants, which convert
natural gas into distillate and other oil products, and
from hydrogen plants to supply fuel cells.
9.1.3 Production and trade
The world’s economically exploitable energy resources
are adequate to meet the projected growth in energy
demand in the reference scenario. Proven global oil
reserves today exceed the cumulative projected
production between 2003 and 2030. However,
additional reserves will need to be moved from the
possible and probable categories into the proven
category in order to avoid a peak in production before

Table 2. World natural gas demand by region, Gm3 (IEA, 2005)

2003 2010 2020 2030 2003-2030*

OECD 1,436 1,617 1,872 2,061 1.3%

OECD North America 775 848 964 1,039 1.1%
OECD Pacific 141 176 217 244 2.1%
OECD Europe 520 593 691 778 1.5%

Transition economies 637 705 815 925 1.4%

Russia 417 460 525 591 1.3%

Developing countries 636 893 1,374 1,803 3.9%

China 39 60 106 152 5.1%
India 28 42 71 98 4.7%
Other Asia 162 215 305 387 3.3%
Latin America 107 145 220 318 4.1%
Africa 74 107 165 232 4.3%
Middle East 226 324 507 615 3.8%

World 2,709 3,215 4,061 4,789 2.1%

* Average annual growth rate.

VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION 449

FUTURE SCENARIOS

the end of the projection period. Exploration will
undoubtedly be stepped up to ensure that this happens.
Global natural gas reserves are even larger relative to
projected rates of production. Nonetheless, there will
be a pronounced shift in the geographical breakdown
of sources of oil and gas production over the
projection period, in response to a combination of cost,
geopolitical and technical factors. Almost all the net
increase in production will occur in non-OECD
countries, mainly in the developing world.
World oil supply in the reference scenario is
projected to grow from 82.1 Mbbl/d in 2004 to 115.4
Mbbl/d in 2030 (Table 3). Non-OPEC countries
contribute most of the increase in global production
throughout the rest of the current decade. In recent
years, high oil prices have started to stimulate an
increased development of reserves in those countries.
Production is expected to continue to grow quite
strongly in transition economies, West Africa and
Latin America. The output of the transition economies,
which has soared in recent years thanks to rapid
growth in Russia, will continue to rise with a greater
contribution from Caspian countries. It will reach 14.5
Mbbl/d in 2010, compared to 11.4 Mbbl/d in 2004.
In the longer term, oil production in OPEC
countries, especially in the Middle East, is expected to
increase more rapidly than in other regions
(particularly in the second half of the projection
period) because their resources are much larger and
their production costs are generally lower. In the near
term, the OPEC cartel’s share, which currently stands
at 36%, will remain roughly stable due to rapid
production increases in several non-OPEC regions,
notably Russia and other transition economies. As
prices return to a level closer to the average of the last
two decades, incentives to raise output in non-OPEC
regions will diminish, increasing the call on oil from
OPEC producers. The second and third decades of the
projection period will see a more rapid growth in
OPEC’s market share. OPEC’s market share is
projected to reach 50% in 2030, slightly above its
historical peak in 1973. Global oil production is not
expected to peak before 2030, although output in most
regions will already be in decline by then. OPEC’s
market share would be lower if the effect of its
members’ policies limit production and increase
prices, thereby stimulating non-OPEC production of
conventional and non-conventional oil, and
encouraging alternative energy technologies.
Natural gas resources can easily meet the projected
increase in global demand through the projection
period, as proven reserves are now equal to about 67

Table 3. World oil production, Mbbl/d (IEA, 2005)

2004 2010 2020 2030 2004-2030*

Non-OPEC crude and NGLs 46.7 51.4 49.4 46.1 0.0

OECD total 20.2 19.2 16.1 13.5 – 1.5
North America 13.6 14.4 12.6 10.8 ⫺0.9
Europe 6.0 4.4 3.1 2.3 ⫺3.7
Pacific 0.6 0.5 0.4 0.4 ⫺1.4

Transition economies 11.4 14.5 15.6 16.4 1.4

Russia 9.2 10.7 10.9 11.1 0.7

Developing countries 15.2 17.7 17.6 16.3 0.3

China 3.5 3.5 3.0 2.4 ⫺1.5
India 0.8 0.9 0.8 0.6 ⫺1.2
Other Asia 1.9 2.1 1.7 1.3 ⫺1.7
Latin America 3.8 4.7 5.5 6.1 1.8
Non-OPEC Africa 3.3 4.9 5.2 4.7 1.4
Non-OPEC Middle East 1.9 1.7 1.5 1.4 ⫺1.3

OPEC crude and NGLs 32.3 36.9 47.4 57.2 2.2

OPEC Middle East 22.8 26.6 35.3 44.0 2.6
Other OPEC 9.6 10.3 12.1 13.2 1.3

Non-conventional oil 2.2 3.1 6.5 10.2 6.1

Miscellaneous 0.9 1.1 1.6 1.9 2.9

World 82.1 92.5 104.9 115.4 1.3

* Average annual growth rate.

** Includes oil sands, biofuels and gas-to-liquids production.

450 ENCYCLOPAEDIA OF HYDROCARBONS


years of production at current rates. The regional
outlook for production stems largely from the proximity
of reserves to markets and from the production costs.
Despite substantial unit cost reductions in recent
years, gas transportation remains very expensive and
usually represents most of the overall cost of gas
delivered to consumers. Production is projected to
grow strongest in terms of volume in the Middle East,
Russia and the other transition economies, which
together have most of the world’s proven reserves.
The growing regional mismatch between demand
and production will result in a major expansion of
international trade in oil and gas, both in absolute
terms and as a share of supply. Trade between
countries within each grouping will also expand. Oil
will remain the most traded fuel.
The volume of oil traded between World energy
outlook regions will reach 64 Mbbl/d in 2030 (well
over half of global oil production and over two-thirds
more than at present). As a result, 51% of all the oil
consumed worldwide will be traded between the main
World energy outlook regions in 2030, compared with
only 39% in 2003. This trend results from the steady
growth in demand in all regions and the increasing
concentration of production in a small number of
countries. The Middle East, already the biggest
exporting region, will see the biggest jump in oil
exports, from 19 Mbbl/d in 2004 to 39 Mbbl/d in
2030. Exports from Africa, Russia and other transition
economies will also continue to expand steadily in the
short to medium term, but all of them will have started
to decline by 2020. The OECD and developing Asian
countries will become increasingly dependent on
imports. Increased trade will strengthen the mutual
dependence among exporting and importing countries.
However, it will also intensify worries about the
world’s vulnerability to oil-supply disruptions, as
much of the additional trade will involve transport
along routes that are at risk of sudden closure. The
share of total gas supply that is traded between regions
will also grow strongly, from 13% at present to 19% in
2030. The largest volume increases in net gas imports
are expected to arise in Europe and North America,
where Canadian exports to the United States will not
be able to keep pace with rising US import needs.
9.1.4 Environmental implications
The projected trends in energy use in the reference
scenario imply that global energy-related
carbon-dioxide emissions will increase by 1.6% per
year over 2003-2030. Emissions will exceed 37 Gt in
2030, an increase of 13 Gt, or 52%, over the 2003
level. By 2010, energy-related CO2 emissions will be
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
THE FUTURE OF HYDROCARBONS
38% higher than in 1990. Power generation is expected
to contribute around half the increase in global
emissions from 2003-2030 and transport will
contribute one-quarter. Developing countries will be
responsible for almost three-quarters of the increase in
global CO2 emissions in the same period. They will
overtake the OECD as the leading contributor to
global emissions in the early 2020s. The increase in
emissions from China alone will exceed the increase
in all OECD countries and Russia combined. OECD
countries accounted for 52% of total emissions in
2003, developing countries for 36%, and transition
economies for 10%. By 2030, the developing countries
will account for 49%, the OECD countries for 42%,
and the transition economies for 9%.
Oil will account for 37% of the increase in energy-
related CO2 emissions over the projection period, coal
for 33% and natural gas for 30%. Emissions from
natural gas will increase most rapidly, doubling
between 2002 and 2030. However, they will still make
up only 24% of total emissions in 2030, up from 21%
now, because gas is the least carbon-intensive fuel. The
share of coal (the most carbon-intensive fuel) will fall
by three percentage points to 36%. Oil’s share will
drop by two points to 39%.
9.1.5 Investment needs
and financing
The global energy-supply projections described above
will call for a cumulative infrastructure investment of
$17,000 billion (in year-2004 dollars) over 2004-2030.
This investment will be needed to expand supply
capacity and to replace existing and future supply
facilities that will be retired during the projection
period. More than half of the investment will go
simply to maintain the present level of supply. Most of
the world’s current production capacity for oil, gas and
coal will need to be replaced by 2030. Indeed, much of
the new production capacity brought on stream in the
early years of the projection period will itself need to
be replaced before 2030. Some power plants and
transmission and distribution infrastructure will also
need to be replaced or refurbished, particularly in
OECD countries. It will be necessary for capital
spending to increase steadily through the period as
existing infrastructure becomes obsolete and demand
increases.
Total investment will amount to $3,200 billion
($118 billion per year) in the oil sector and around
$3,000 billion ($108 billion per year) in the gas sector.
Power generation, transmission and distribution will
require more than $10,000 billion ($380 billion per
year, equal to over 60% of total energy-supply
451
FUTURE SCENARIOS
investments). If investment in the fuel chain to meet
the fuel needs of power stations is included,
electricity’s share rises to more than 70%. Coal
investment will amount to almost $400 billion ($14
billion per year), or 2%. To produce and transport a
given amount of energy, coal is about a sixth as
capital-intensive as gas. Developing countries will
require about half of global energy investments
because their demand and supply will increase most
rapidly.
Exploration and development will dominate
global oil-sector investment, accounting for more
than three-quarters of the total over the period 2004-
2030. Only a quarter of upstream investment will go
to meet rising demand. The rest will be used to make
up for the natural decline in production from wells
already in production and those that will start
producing in the future. In fact, at a global level,
investment needs are far more sensitive to changes
in decline rates than to the rate of growth of oil
demand. Oil investment will be highest in North
America, the transition economies and the Middle
East. Although production in OECD countries is set
to decline in the coming 25 years, their oil-
investment needs will be high, since their unit costs
and decline rates are higher than in other regions.
Upstream unit costs are lowest in the Middle East.
Exploration and development of gas fields will
absorb 62% of global gas investment. Building
downstream infrastructure (high-pressure transmission
pipelines, local distribution networks, storage
facilities, LNG – Liquefied Natural Gas – liquefaction
and regasification plants, and LNG carriers) will
account for the rest. An increasing share of investment
will go to LNG supply. The OECD as a whole will
account for almost half of global gas investment. This
is close to the OECD’s share of the increase in global
demand over the projection period. North America
alone will claim more than a quarter of new
investment. Unit capital costs and production-decline
rates are much higher in the industrialized countries
than in other parts of the world.
The main exporting regions (Russia, the Caspian
region, the Middle East and Africa) will attract most
investment outside of the OECD. Although a bigger
share of drilling will occur in lower-cost regions, a
doubling of global production and a shift in drilling to
offshore fields will cause an overall increase in
upstream investment. Gas-processing costs, included
in exploration and development, may also rise as the
quality of reserves deteriorates. The Middle East will
have the largest requirement for LNG investment,
while the transition economies (including Russia) will
account for the largest share of investment in
transmission networks.
452
Globally, there is enough money to finance the
projected energy investment. Domestic savings alone
are much larger than the capital required for energy
projects. However, in some regions, those capital
needs represent a very large share of total savings. In
Africa, for example, the share is about half.
Although sufficient capital will be available overall
from domestic and international sources, it is far from
certain that all the infrastructure needed in the future
will be fully financed in all cases. Mobilizing the
investment required will depend on whether returns
are high enough to compensate for the risks involved.
More than in the past, capital needed for energy
projects will have to come from private sources, as
governments continue to withdraw from the provision
of energy services. Foreign direct investment is
expected to become an increasingly important source
of capital in non-OECD regions.
Oil and gas prices will play a key role in attracting
investment to the sector. In recent years, upstream
global oil and gas investment has tended to fluctuate
with changes in oil prices. The openness of countries
with large oil resources to foreign direct investment
will be another important factor in determining how
much upstream investment occurs and where. Today,
three major oil-producing countries (Kuwait, Mexico
and Saudi Arabia) remain totally closed to outside
investment. Access to many others, such as Russia and
Iran, is restricted.
Financing the required investments in
non-OECD countries will be a major challenge.
The financial needs in the transition economies
and developing regions are much bigger, relative to
the size of their economies, than in OECD
countries. In general, investment risks are also
greater in these regions, particularly for domestic
electricity and downstream gas projects. The
private sector will undoubtedly have to play a
bigger role in financing new energy projects in the
future. Few governments could fully fund the
necessary investment, even if they wanted to.
Raising private finance will depend critically on
the establishment by governments of an attractive
investment framework and climate.
9.1.6 Major uncertainties
In common with all attempts to describe future market
trends, the energy projections presented in the World
energy outlook are subject to a wide range of
uncertainties. Energy markets could evolve in ways
that are much different from either the reference
scenario or the alternative policy scenario. The
reliability of projections depends both on how well the
ENCYCLOPAEDIA OF HYDROCARBONS

model represents reality and on the validity of the
assumptions it works under.
Macroeconomic conditions have always been a
critical source of uncertainty. Slower GDP growth than
assumed in both of our scenarios would cause demand
to grow less rapidly. Growth rates at the regional and
national levels could be very different from those
assumed here, especially over short periods. Political
upheavals in some countries could have major
implications for economic growth. Sustained high oil
prices (which are not assumed in either of our
scenarios) would curb economic growth in
oil-importing countries and globally in the near term.
The impact of structural economic changes, including
the worldwide shift from manufacturing to service
activities, is also uncertain, especially late in the
projection period.
Uncertainty about the outlook for economic
growth in China is particularly acute. With China’s
emergence as a major energy importer, any faltering of
the country’s economic development would have
important implications for world energy markets.
China has been responsible for a large share of the
increase in world demand for raw materials (including
energy) in the last few years. It is also becoming an
important consumer of final goods, thereby
contributing to economic growth in the rest of the
world. There are increasing signs of overheating in the
Chinese economy and the risk of a ‘hard landing’ (an
abrupt slowdown in economic activity) is growing as
credit is tightened and investment drops. Such a
development could have a major impact on global
economic activity and, therefore, on energy
consumption and import needs worldwide.
The effects of resource availability and supply
costs on energy prices are very uncertain. Resources
of every type of energy are sufficient to meet the
projected demand through to 2030, but the future cost
of extracting and transporting those resources is
uncertain (partly due to a lack of information about
geophysical factors). Oil and gas producers, for
example, do not usually appraise reserves in detail
until they are close to actually exploiting them. The
amount of the world’s resources that can be produced
economically will depend partly on production
conditions and technological progress. Geopolitical
factors will also affect the development of energy
resources.
Changes in government energy and environmental
policies and the adoption of new measures to address
energy security and environmental concerns,
especially climate change, could have profound
consequences for energy markets. Leading
uncertainties in this area include: the production and
pricing policies of oil-producing countries, the future
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
THE FUTURE OF HYDROCARBONS
of energy-market reforms, taxation and subsidy
policies, the possible introduction of carbon dioxide
emission-trading and the role of nuclear power.
An alternative policy scenario, presented in the
World energy outlook analyses the global impact of
environmental and energy-security policies that
countries around the world are already considering, as
well as the effects of faster deployment of
energy-efficient technologies. In this scenario, global
energy demand and carbon-dioxide emissions are
significantly lower than in the reference scenario.
World global primary energy demand in 2030 reaches
14,658 Mtoe – 1,613 Mtoe, or almost 10%, less than
in the reference scenario (Table 4). Primary energy
demand grows by 1.2% per year, 0.4 percentage points
less than in the reference scenario.
Reduced oil and gas use account for most of the
overall fall in energy demand. Oil and gas demand
each falls by 10%. The reduction in demand for coal is
even greater, both in absolute and percentage terms,
thanks to the use of more efficient technology and
switching to less carbon-intensive fuels. The effect of
energy-saving and fuel diversification policies on
energy demand grows throughout the projection
period, as the stock of energy capital is gradually
replaced and new measures are introduced. Global
energy savings achieved by 2010 are very modest, at
only about 244 Mtoe, or 2%.
Improvements in the efficiency of current energy
technologies and the adoption of new technologies
along the energy-supply chain are a key source of
uncertainty for the global energy outlook. It is possible
that hydrogen-based energy systems and
carbon-sequestration technologies, which are now
under development, could dramatically reduce carbon
emissions associated with energy use. If they did so,
they would radically alter the energy-supply picture in
the long term. However, these technologies are still far
from ready to be commercialized on a large scale, and
it is always difficult to predict when a technological
breakthrough might occur.
It is uncertain whether all the investment in
energy-supply infrastructure needed over the
projection period will be forthcoming. Ample
financial resources exist at a global level to finance
projected energy investments, but those investments
have to compete with other sectors. More important
than the absolute amount of finance available
worldwide, or even locally, is the question of whether
conditions in the energy sector are right to attract the
necessary capital. This factor is particularly uncertain
in the transition economies and in developing nations,
whose financial needs for energy developments are
much greater relative to the size of their economies
than is the case in OECD countries. In general, the
453
FUTURE SCENARIOS

Table 4. World primary energy demand in the reference and alternative policy scenarios, Mtoe
(IEA, 2005)

Reference scenario Alternative policy scenario

Difference
with the
2003 2030 2003-2030* 2030 2003-2030* reference
scenario
in 2030

Coal 2,582 3,724 1.4% 2,866 0.4% ⫺23%

Oil 3,785 5,546 1.4% 4,967 1.0% ⫺10%
Gas 2,244 3,942 2.1% 3,528 1.7% ⫺10%
Nuclear 687 767 0.4% 878 0.9% 14%
Hydro 227 368 1.8% 370 1.8% 0.4%
Biomass and waste 1,143 1,653 1.4% 1,705 1.5% 3%
Other renewables 54 272 6.2% 344 7.1% 27%
Total 10,723 16,271 1.6% 14,658 1.2% ⫺10%

* Average annual rate of growth.

risks involved in investing in energy in non-OECD
countries are also greater, particularly for domestic
electricity and downstream gas projects. Creating an
attractive investment framework and climate will be
critical in order to mobilize the necessary capital.
The rate of investment in developing crude oil
production capacity in the Middle East and North
Africa region is a rather critical uncertainty for
world energy markets. A deferred investment
scenario, also presented in the World energy outlook,
analyses how energy markets might evolve if
upstream investment in each Middle East and North
Africa country were to remain constant as a share of
GDP at the average level of the past decade. This
would result in a $110 billion, or 23%, drop in
cumulative upstream Middle East and North Africa
oil investment over 2004-2030.
Lower investment on this scale causes Middle
East and North Africa oil production to drop by
almost a third by 2030 compared with the reference
scenario. Production falls further than investment by
the end of the projection period due to the
cumulative effect over this period. In 2030, total
Middle East and North Africa output reaches 35
Mbbl/d, compared with 50 Mbbl/d in the Reference
Scenario. Saudi Arabia’s production, at 14 Mbbl/d in
2030, is more than 4 Mbbl/d lower than in the
reference scenario. Middle East and North Africa’s
share of world oil production drops from 35% in
2004 to 33% in 2030 (against a rise to 44% in the
reference scenario). As a result, Middle East and
North Africa oil exports are almost 40% lower in
2030. By contrast, higher prices stimulate an 8%
increase in non-Middle East and North Africa oil
production compared to the reference scenario.
Natural gas production in Middle East and North
Africa countries also falls significantly, due to lower
global demand and lower output of associated gas.
Gas exports fall by 46% in 2030, with those of Qatar
falling furthest in absolute terms.
In the deferred investment scenario, the
international crude oil price is significantly higher
than in the reference scenario over the projection
period. In the reference scenario, the average IEA
import price is assumed to fall back from recent highs
to around $35 per barrel (in year-2004 dollars) in
2010, and then to rise slowly to $39 in 2030. In the
deferred investment scenario, the price increases
gradually over time, relative to the reference scenario.
By 2030, it is about $13 higher ($21 in nominal terms)
– an increase of almost one-third.
Natural gas prices rise broadly in line with oil
prices. The coal price also increases slightly. As a
result of higher prices and lower world GDP, global
energy demand is reduced by about 6% in 2030,
compared with the reference scenario. World GDP
growth, the main driver of energy demand, is on
average 0.23 percentage points lower per year.
Lower oil and gas revenues and higher prices cause
primary energy-demand growth in Middle East and
North Africa countries to slow, but less markedly
than in non-Middle East and North Africa regions.
Among the primary fuels, global demand for oil
falls most. Global oil demand, at 105 Mbbl/d in
2030, is 10 Mbbl/d lower than in the reference
scenario. Demand for both gas and coal also
decreases, mainly as a result of lower demand for
fuel inputs to power generation.

454 ENCYCLOPAEDIA OF HYDROCARBONS


9.1.7 Towards a sustainable
energy future
The projections presented here paint a sobering
picture of how the global energy system could
evolve from now to 2030. If governments stick with
the policies in force as of mid-2004, the world’s
energy needs will be more than 50% higher in 2030
than they are now. Fossil fuels (especially oil and
gas) will continue to dominate the global energy
mix, meeting most of the increase in overall
energy use. The shares of nuclear power and
renewable energy sources will remain limited.
Climate-destabilizing carbon-dioxide emissions
would continue to rise. Also, the sharply increased
dependence of consuming regions on imports from a
small number of countries, mainly in the Middle
East, would exacerbate worries about the security of
energy supply.
In no way can this vision of the energy future be
considered sustainable. G8 leaders, meeting with the
leaders of several major developing states at
Gleneagles in July 2005, acknowledged this when they
called for stronger action to combat rising
consumption of fossil fuels and related greenhouse-gas
emissions. Current energy trends are not set in stone.
Although the reference scenario projections above
presented the effects of policies already adopted (for
example, to combat climate change), governments
have declared their intention to do more. As the
alternative policy scenario shows, more vigorous
government action could steer the world onto a
markedly different energy path.
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
THE FUTURE OF HYDROCARBONS
Nonetheless, it is clear from this analysis that
achieving a truly sustainable energy system will
depend on technological breakthroughs that radically
alter energy production and use. The government
actions envisioned in the alternative policy scenario
could eventually stabilize carbon-dioxide emissions,
but they could not reduce them significantly using
existing technology. Carbon capture and storage
technologies, which are not taken into account in
either the reference or the alternative scenario, hold
out the tantalizing prospect of using fossil fuels in a
carbon-free way. Advanced nuclear-reactor designs or
breakthrough renewable technologies could one day
help free us from our dependence on fossil fuels.
These technologies, however, will have to become
much cheaper if they are to be widely applied. This is
unlikely to happen within the timeframe of the
analysis presented here. Developing and deploying
new clean technologies in these and other areas are the
key to making the global energy system more
economically, socially and environmentally sustainable
in the long term. Governments have a critical role to
play in accelerating this process as a matter of urgency.
References
IEA (International Energy Agency) (2005) World energy outlook,
Paris, Organization for Economic Cooperation and
Development/IEA.
Fatih Birol
International Energy Agency
Paris, France
455

Future outlook:
the qualitative aspects
9.2.1 Oil
Environmental constraints on oil’s production,
transport, and use
In spite of the dangers associated with the
production and transport of crude oil in or over fragile
environments (as for example, in the tundra regions of
northern Russia and North America and along
coastlines close to important maritime routes for
tankers), there have been few incidents which created
environmental problems leading to anything more
serious than temporary disruptions to scheduled
production and flows of oil around the world
(El-Hinnawi, 1981; NRC, 2003). This reflects both the
positive economic impact that oil activities produce
for oil-rich localities and, even more so, the ability of
the oil industry to secure the continuity of operations.
The industry has, moreover, in recent years become
increasingly aware of, and responsive to, the need for
environmentally friendly attitudes and has put both
effort and investment into minimizing the risk of
accidents (WBCSD, 1998) through major oil leaks,
spills, collisions, and fires. When and where these
have occurred, they have occasionally led to temporary
interruptions to local/regional supplies; a notable
example is the loss of millions of barrels of oil from
the damage done to Kuwait’s upstream facilities during
the Gulf War in 1991.
Except in the case of this problem, when there was
a marked impact on the oil price for a short period,
other past events have not really been significant at
much more than the local level (and certainly not at
the global level). Continuing guerrilla actions against
oil installations in American-occupied Iraq is
producing another exception.
There have, however, been instances of significant
restraints on oil exploration and exploitation arising
from purely environmental issues. These have usually
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
9.2
been resolved through ameliorative measures which,
while increasing the costs of undertaking particular
operations, have in the final analysis allowed the
developments to go ahead in an environmentally
acceptable manner. One example was the development
of the Wytch Farm oil field located in shallow coastal
waters in an environmentally sensitive area off
southern England. After a considerable delay arising
from these sensitivities, i.e. concerns about visually
intrusive drilling and production facilities and of
possible oil spillages into the shallow waters, it was
eventually agreed that the development could go
ahead, with the drilling of 10 km horizontal wells into
the oil reservoir from a remote, land-based, and
acceptable production location. There have been
similar requirements to protect a fragile environment
in the Dutch Frisian Islands.
Such restraints on development procedures have
generally been of local or, at most, regional, rather than
global, importance from an oil supply perspective. There
will undoubtedly be a proliferation of such requirements
in the Twenty-first century, as environmental concerns
become geographically more dispersed, encompassing
developing countries and the hitherto centrally-planned
economies, in addition to the member countries of the
International Energy Agency (IEA).
Early examples of this phenomenon can already be
seen. One example was in the recognition by
post-communist regimes in Russia of the need to
clean-up oil production and oil transport-related
pollution in its Arctic-located oilfields (Dmitrievsky,
2002). Another example is in the World Bank’s
insistence on serious environmental-protection
measures in connection with the exploitation of the
oilfields of Chad and the associated export pipeline
through neighbouring Cameroon.
Such measures were, indeed, required as a
condition for the Bank’s investment in the project.
457
FUTURE SCENARIOS
Similar requirements have also been imposed on the
oil export line from Azerbaijan to Turkey’s
Mediterranean coast. Nevertheless, the sum total of
the impact and costs of such environmental-protection
measures still seems likely to remain of relatively
minor significance at the global oil supply level.
However, one major onshore oil exploitation
constraint has already emerged, i.e. the continuing ban
in the US, including Alaska, on oil industry activities
in large areas of nationally protected environments.
The US oil industry, with support from interested
parties in favour of ensuring a nation that is self-
sufficient in oil, has strenuously objected to the
blanket ban over such extensive and prospective areas.
That pressure did, indeed, succeed in causing the
ban to be partially lifted as the US oil deficit worsened
in the mid 1990s, but most of the restraints remain in
place pending Congressional acceptance of President
Bush’s wish to facilitate enhanced oil production in the
US (Future [...], 2003).
Few other countries seem likely to follow suit in so
restricting large areas for oil exploration/exploitation.
Approving this type of ban on oil operations in regions
with high prospects would take the combination of a
willingness on the part of countries to forgo oil
revenues, and a relaxed attitude towards the issue of
oil self-sufficiency and exports.
Any such actions would be capable of making a
significant difference in the global rate of reserves’
discovery and, eventually, to the potential flow of oil.
The wealthiest of the Organization of the Petroleum
Exporting Countries (OPEC) countries (Kuwait, Saudi
Arabia, Libya, and the United Arab Emirates) do
satisfy the conditions indicated for such an
environmentally robust policy towards future oil
exploitation. This means that the emergence of such
restrictive policies on their part could be important in
restraining both reserves’ creation and production.
Such actions, however, remain unlikely. The other
more populous and less wealthy member countries of
OPEC (Iran, Iraq, Venezuela, Nigeria, Algeria, and
Indonesia) are eminently dependent on their oil
industries, and are seeking to expand them in order to
meet national development objectives. They would be
reluctant to have environmental considerations
inhibiting these aims. Canada, with its extensive areas
of Arctic and sub-Arctic environments, is particularly
exposed to possible damage from oil operations,
especially with respect to the heavy oils and tar sands
of Alberta – the proven reserves of which have
recently been declared at 178 billion barrels (Faithful,
2002), making it the country second only to Saudi
Arabia in its oil wealth.
Should Canada decide that only environment
friendly options can be valid for the exploitation of
458
their oil resources, then there would be serious
potential consequences for indigenous North
American oil supply capacity in both the long and
short term.
There is also the risk of a more general threat to
offshore oil prospects. This arises from the
environmental lobby’s pressure (activated through
the campaigning organization Greenpeace) to secure
a ban on deepwater exploration and production
because of the threat such activities are perceived to
pose to the marine environment (Rose, 1997). Both
physical and legal action has already been taken by
Greenpeace against those companies with
concessions for the exploration and exploitation of
oil in the UK and Norwegian sectors of the eastern
Atlantic margin.
Those attempts to impose an environmental
restraint on deepwater oil developments were,
however, successfully opposed by the UK and
Norwegian Governments (as well as by the oil
companies), so that these specific threats to the
exploitation of a potentially oil-rich region have been
eliminated for the time being. The issue is, however,
certain to emerge again in the near future: if not in
North West Europe, then elsewhere in the expanding
world of offshore oil activities (NRC, 2003).
A ban in the near future could conceivably be
extended to all the oil industry activities on the east
Atlantic margin through the proactive environmental
policies of the EU and the European Court (EEA,
2002). This currently seems unlikely, but it is by no
means impossible, particularly if there were to be an
incident which threatened serious damage to the
marine environment. If restraints were imposed, either
directly or through requirements that made the
protection of the environment much more costly, then
many billions of barrels of oil reserves would become
unproducible.
A European decision for such controls on the
exploitation of deepwater oil reserves could then
generate the possibility of similar constraints
elsewhere in the world. Under such circumstances, the
long-term prospects for global oil supplies from
deepwater offshore fields (representing the most
important of the world’s remaining undeveloped
conventional oil frontiers; Sasanov, 2002) would be
diminished and thus change the shape of the
conventional oil depletion curve shown in Fig. 4, in
Chapter 1.3.
To date, the limited geological knowledge of the
continent of Antarctica indicates that it has oil
potential but, given its adverse physical attributes,
any oil wealth that may be there is not included in
the estimates of the world’s ultimate oil resource
base (USGS, 2000). Pressures to restrict supplies
ENCYCLOPAEDIA OF HYDROCARBONS

from elsewhere (such as the deepwater offshore
margins) could, however, lead to a desperate ‘last
throw’ by the international oil industry to seek
permission to explore the ice-covered continent, in
spite of the agreement between interested nations
that it should remain an area free of potentially
polluting activities. In the context of any impending
oil supply crisis, the pressure for undermining that
agreement would become powerful and persuasive.
Likewise, any change that is proposed would be
equally strongly fought by the environmental lobby.
Impacting the international oil industry in a much
more emphatic and comprehensive way is the
environmental lobby’s attempt to constrain the use of
carbon fuels. This effort arises from its global concern
for the excessive emissions of CO2, whereby climate
change, in general, and global warming, in particular,
are hypothesized as the inevitable consequences (Jean-
Baptiste and Ducroux, 2003). Oil, in this respect,
holds an intermediate position between the more
polluting coal and the significantly less polluting
natural gas (Rosa, 2003). In addition, the impact of
emissions controls on limiting the use of carbon fuels
would seem to be about neutral with respect to the
demand for oil, unless and until motor vehicles en
masse are built and/or converted to run on fuels other
than oil products (Griffiths, 2001; Hoffmann, 2001;
Douaud, 2002; Rifkin, 2002). The significance of such
a development, given current costs, prices, and
policies, still appears to be at least a couple of decades
in the future, but an impact can, thereafter, be expected
from this fundamental change from oil to other fuels
in the energy intensive transport sector (European
Commission, 2003).
This slowly evolving change to the use of natural
gas/hydrogen for transport fuels is, indeed, the main
reason for predicating a post-2020 declining rate of
increase in oil use. This declining rate of increase,
compared with recent and near-future rates of
increase, will lead to a smaller share for oil in the total
supply of hydrocarbons (see Table 2 in Chapter 1.3).
A more intensive pursuit of the development of
clean vehicles could speed up and intensify the shift to
alternative vehicle fuels. This shift would create an
earlier downward pressure on the demand for oil,
particularly in the event of a broad international
agreement to impose differential taxation against oil
fuels in favour of natural gas or hydrogen (European
Commission, 2003).
The resulting squeeze on the use of oil in the
transport sector would, of course, eventually moderate
of even the slow forecast growth rate in cumulative oil
supply shown in Fig. 7 in Chapter 1.3. Under these
circumstances, the predicted 2060 date for oil’s peak
production would be delayed, as the restraints would
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
FUTURE OUTLOOK: THE QUALITATIVE ASPECTS
make the full development of the supply side potential
unnecessary (Groenveld et al., 2002; Salvador, 2005).
Regional issues in oil supply and demand prospects
Regional issues will be less important for oil
supply developments than for coal and natural gas.
Although world coal resources are widely dispersed,
both production and use are heavily concentrated in a
small number of countries, so that prospective supply/
demand relationships in the Twenty-first century will
vary geographically to a marked degree. The higher
costs of transporting natural gas likewise restrain its
marketability in countries remote from producing
regions.
This situation is quite different with respect to oil.
Proven reserves of conventional oil are presently
highly concentrated in the Middle East, with 62% of
the global total. In the absence of major surprises in
the location of the world’s remaining undiscovered
reserves of conventional oil, it is likely that the Middle
East’s share of the world’s ultimately recoverable
conventional oil will remain above 50%.
The other 50% (incorporating proven, probable,
and still to be discovered reserves) are likely to be
found around the rest of the world in a reasonably
equitable manner, except for East and South East Asia,
which is relatively poorer than elsewhere. Their future
exploitation, on anything like the scale of the upstream
oil industry in the Middle East, is unlikely to emerge
even in the very long term.
Meanwhile, as shown in Table 1, there is but a
modest correlation between the rank-ordering of
producing and consuming countries. Only the US,
Russia, China and Canada are rank-ordered in the
top-ten countries for both supply and demand. The
combined output of the other six ranked producing
countries is almost 75% larger than the total
consumption of the other six ranked consuming
countries: indicating a required large-scale and
complex pattern for international movements of oil.
The continuity of such massive international
movements of oil will persist throughout the remaining
25 years of expansion in conventional oil use.
Most of the movements involve intercontinental
transport but, even so, there are large tonnages moving
between countries in the same continent. As, for
example, from Mexico and Canada to the US, from
Norway to Germany and France, and from Russia to
many other countries of Europe. These high volumes
of trade in oil reflect the ease and cheapness of
transporting the commodity. In effect, the costs of
overcoming distance between supplying areas and
markets are modest compared with the value of oil in
the marketplace. By contrast, intercontinental and
intra-regional movements of coal are less than
459
FUTURE SCENARIOS

Table 1. Rank ordering of the top-10 oil producing and consuming countries in 2000

Production Consumption
% %
Mtoe Mtoe
net exports net imports

Saudi Arabia 506 84.2 US 938 64.8

Russia 459 71.9 China 309 43.4
US 330 0 Japan 242 100
Iran 203 65.5 Russia 129 0
Mexico 191 55.5 Germany 124 97.3
China 175 0 India 119 68.1
Venezuela 154 81.8 South Korea 105 100
Norway 154 94.8 Canada 100 0
Canada 148 32.5 France 94 96.8
United Arab Emirates 126 87.3 Italy 90 94.0
Total 2,446 Total 2,250
World total 3,868 World total 3,767
Percent of top ten 63.2% Percent of top ten 59.7%

Source: BP statistical review of world energy, 2005.

one-quarter the size. Geo-politics, rather than the geography of oil

The ease and low cost of oil transport, even
inter-continentally, has led to oil’s pre-eminence as an
international commodity, with its price determined in
the most active global marketplaces of London, New
York, and Singapore. These, between them, offer 24
hours per day of coverage for trading activities. This
basic framework of the organization of the
international oil market seems unlikely to change for
many decades, given the universal requirements for oil
and the need to move it around the world on a scale
which is large enough to enable regional and national
supply and demand imbalances to be equilibrated as
and when they occur; even in the very short term,
measured in terms of days, rather than weeks.
Nevertheless, in spite of the continuity of the
international oil system as described above, there has,
since the mid 1970s, been a much stronger relative rate
of growth of the upstream oil industry outside the
Middle East.
This is the result of two major occurences. The
first was the development of ‘away-from-Middle East
oil’ policies of oil importing countries in the aftermath
of the oil crises of the 1970s. The second came from
the inability of the state oil enterprises in the Middle
East, which were created post-1973 (following the
nationalization of the activities of the multinational oil
corporations there), to keep their industries abreast of
the new exploration and exploitation technologies
which were being developed elsewhere. As a result,
the Americas (North and South) and Europe
(excluding Russia) became less dependent on supplies
from the Middle East, the reserves of which have
become hugely under-utilized (Odell, 1997).
resources, seem likely to enable this new situation to
be sustained for at least the next two decades.
Meanwhile, the rapidly expanding economy of
South and East Asia (including China), with
inadequate oil reserves to meet growing oil needs, has
quickly achieved the status of the principal oil
importer from the Middle East. In 2005, almost 66%
of Middle East oil exports went to Asia. This trade will
continue for at least the next twenty years and
probably for much longer (Chow, 2003; IEA, 2003b).
Thereafter, on the reasonable assumption that there
will be no major changes in the existing spatial
distribution of reserves of conventional oil, and that
the supply of non-conventional oil will grow only
slowly until 2020, there seems likely to be a period in
which much of the world will once again become
more heavily dependent on oil from the Middle East.
This has, indeed, already produced an early
Twenty-first century upward pressure on prices and, of
course, a major stimulus for the more rapid
exploitation of non-conventional oil.
The reserves of the latter are, as already shown in
Chapter 1.3, more widely geographically dispersed.
Yet, there is an emphasis (in terms of evaluations made
to date of reserves potential) on locations in the
western hemisphere, mainly Canada and Venezuela,
where exploitation has already begun (Aalund, 1998;
Meyer, 1998) and is now entering a period of more
rapid growth (Future [...], 2003; Williams, 2003). This
should enable the demands of the Americas after 2020
(when the region will still be the world’s largest market
for oil), to be increasingly served by oil derived from
the continent’s large non-conventional reserves.

460 ENCYCLOPAEDIA OF HYDROCARBONS


The degree of Europe’s increasing exposure to
Middle East oil dependence after 2005, as
production from the North Sea and associated areas
ceases, at best, to grow and, at worst, to decline, will
depend essentially on the success which is achieved
in the more intensive and extensive exploitation of
the reserves of the Former Soviet Union (Considine
and Kerr, 2002). The speed at which this will
happen is more a question of geo-politics than of
either the undoubted resource potential of these
areas or the economics of their oil production and
delivery systems (New hydrocarbons [...], 2002;
Stinemetz, 2003).
The current high levels of international oil
companies’ interests in the Caspian Basin and in West
Siberia and the Barents Sea indicate their firm
expectations for reserves’ expansion, though there is
still scepticism over the degree to which these can be
realized (Kalyuzhnova et al., 2002). These doubts arise
as a result of continuing uncertainties over the stability
of the new regimes in the former Soviet republics, and
of their willingness to offer terms for oil exploitation
(including legal certainties concerning leases and joint
ventures) which justify the large investments required
from the oil companies. Nevertheless, all three of the
international oil industry’s ‘mega-majors’ (BP,
ExxonMobil and Shell) have already signed to
multi-billion dollar commitments with Russian oil
companies for the exploitation of the country’s oil (and
gas) resources.
The relative paucity of the Asia/Pacific region’s
conventional oil reserves (only a little over 4% of the
world total) has already been indicated, as has the
renewal in the short term of high growth rates in
energy demand, including that for oil. The two major
prospective areas within the region are onshore and
offshore China and the South China Sea. But, China to
date has generally disappointed the companies which
had previously interpreted it as having high potential.
More significantly, effective cooperation between
China and the international oil companies, on the basis
of which a much more extensive and intensive
exploration effort in China could be achieved, is still in
the process of being established.
The continuation of this situation will, at best, only
boost oil production to a level which helps to limit the
country’s future dependence on imports (Yang Jingmin
et al., 1998). In the meantime, net annual oil imports
grew to 146 million tonnes in 2005 compared with
only 25 million tonnes in 2000. Moreover, China also
became the world’s second largest oil consuming
country in 2002, when its use exceeded that of Japan,
which had hitherto been second only to the US for
more than three decades. China will almost certainly
retain that ranking on a permanent basis as its rapid
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
FUTURE OUTLOOK: THE QUALITATIVE ASPECTS
economic growth continues indefinitely to stimulate
energy/oil demand (van Vuuren et al., 2003).
In this context, the prospects for the South China
Sea become highly significant (Fig. 1). It also helps to
explain China’s claim to sovereignty over virtually the
whole of the maritime area, to the virtual exclusion of
the claims of the other countries (Brunei, Cambodia,
Indonesia, Malaysia, Vietnam, and the Philippines)
through their sectoral interests in the sea, based on the
established median line principle. The dispute has
necessarily eliminated serious interest to date in
exploration, let alone exploitation. Even worse, it
constitutes a continuing threat of conflict within the
region in which outside powers, notably the US and
Japan, could well become involved. No resolution to
the dispute is yet in sight, so the potentially large oil
resources of the area remain undiscovered and
undeveloped (Paik and Kim, 1995).
Meanwhile, China’s state-owned offshore oil
company China National Offshore Oil Company
(CNOOC) has intensified its own exploration
activities in the country’s coastal waters and has
accepted bids from foreign companies for additional
efforts to find more oil.
Nevertheless, the Asia-Pacific region’s 2005
dependence on more than 655 million tonnes of oil
from the Middle East (accounting for almost 70% of
the region’s total oil imports and over 60% of the total
demand for oil) will thus not only persist, but will also
almost certainly increase over the next two decades. In
the longer term, alternative large-scale imports from
Russia’s eastern Siberian and other Far East regions
could be developed (Paik, 1995; Kennedy, 2003). But,
as in the case of Russian oil exports to Europe, this
development will depend on the establishment of
satisfactory long-term conditions for foreign
investment in the relevant areas of Russia, the oil
resources of which have, to date, been exploited to
only a small degree.
Within the Asia Pacific region as a whole there are
extensive potential reserves of non-conventional oil,
but little progress has been made in defining, let alone
exploiting, them. Successes elsewhere in the world in
developing lower-cost technologies for exploiting
non-conventional oil will eventually encourage
investment in the region, but no significant
developments seem likely before 2020.
By then, political and economic relations between
the Asia Pacific region and the Middle East may have
become close enough to ensure the acceptance of
mutually advantageous interdependence between
them. This interdependence is based on the
exploitation of the Middle East’s reserves
pre-eminently for use in the Asia Pacific region
(Odell, 1997).
461
FUTURE SCENARIOS

Fig. 1. Boundary claims

for oil exploitation
in the South China Sea. C H I N A Hong Kong

AI T
N STR
LUZO
‘Hands off’
area proposed
Hainan aim
Island r y cl
by China 1974 nda
bou
tnam
Vie

LAOS
SOUTH PHILIPPINES

ary claim
THAILAND
CHINA

nd
SEA

Chinese bou
V I E T NA M
Mindoro
CAMBODIA

im
cla
ry
da
un
laim

bo
Spratly Islands

ine
ry c
aim

p
y cl

ilip
nda
Palawan

Ph
undar

bou

SULU
se
Cambodia bo

ine
Ch

SEA

laim
ry c
nda
ia bou
nes
o
Ind im
cla BRUNEI
Vietnam ry
bounda
S a b a h

Natuna Besar
NATUNA
M A L AY S I A S a r a w a k
SEA INDONESIA
SINGAPORE 0 186 miles

pipeline under construction

oil and/or gas fields oil and/or gas pipeline or planned

Possible new developments Beyond this critical development for expanding

The necessity of extending the world’s oil resource
base to include non-conventional reserves has already
been stressed. The initial hurdle in this respect has
recently been overcome with the Canadian decision to
declare as proven 178 billion barrels of such oil in
Alberta (Future [...], 2003).
Fig. 4 and Fig. 5 in Chapter 1.3 show how the share
of non-conventional oil will rise slowly in the first two
decades of the Twenty-first century but, thereafter, will
more emphatically contribute to the global supply of
oil. As shown in the Figures, a contribution of non-
conventional oil will have risen to over 50% when
global oil production is predicted to peak in 2060; and
thereafter to almost 90% of total supply by 2100. The
anticipated medium-term progress of this new
development has been described above. Its long-term
implications require deeper analysis.
oil supplies, there lies an even more fundamental
issue for oil’s future prospects, namely the validity of
the view still overwhelmingly accepted in the West
of an organic origin of oil and thus for its occurrence
within quite narrowly defined areas beneath the
earth’s surface. It is from this restrictive hypothesis
of the derivation of the world’s oil that most
estimates of the oil resources base have been made to
date (but see Styrikovich, 1977 and Krylov et al.,
1998 for alternative views on oil resources). There is,
however, a contrary view on the prospects for oil
arising from the Russian–Ukrainian theory of oil’s
abyssal, abiotic origin. This implies that oil is not a
‘fossil’ fuel and may well be a renewable resource.
An outline of this alternative theory and of its
significant implications are presented in the final
section of this paper.

462 ENCYCLOPAEDIA OF HYDROCARBONS


9.2.2 Natural gas
Regional gas markets
Viewed regionally, natural gas supply and demand
developments are subject to greater uncertainty than in
the case of oil. Oil is so easily and cheaply transported
that delivery restraints (even for countries remote from
areas of production) are of relatively minor
significance. Oil, in essence, is available virtually
everywhere on demand (except in the very short term).
Natural gas developments, on the other hand, have
been and remain exposed to regional considerations.
In fact, geography can be designated as the principal
influence at work in determining the speed and
character of emerging global gas supply and demand
patterns.
Such dominant regional variations make the global
presentation of the supply prospects for gas somewhat
less robust than those for coal and oil, in that decisions
on gas developments within individual regions are
capable of creating significant changes to the timing
of the evolution of global supply. This has happened
several times in recent decades. For example, in the
mid 1970s, the European Commission and individual
European Governments decided to restrict the growth
of gas demand and hence of gas supply; and, in the
US, in the 1990s, there was an inappropriate market
liberalization measure which constrained supply, so
leading to much higher prices which, in turn,
constrained demand.
Since such factors emerge as a result of a wide
range of contributory factors which are internal to the
region and of varying importance over time, it is
impossible to present specific conclusions on future
regional supply issues with a great deal of confidence
(even for the short to medium term, let alone for the
long term). The following comments thus represent
nothing more than indicators for likely developments
Table 2. Contribution of natural gas to total energy and carbon fuel use by region, 2005
Gas use
Region
(Mtoe)
North America 697.1
Central and South America 111.7
Europe (excluding Former Soviet Union) 488.1
Former Soviet Union 521.6
Middle East 225.9
Africa 64.1
Asia Pacific (excluding FSU) 366.2
World total 2,474.7
Average
Source: BP statistical review of world energy, 2006.
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
FUTURE OUTLOOK: THE QUALITATIVE ASPECTS
of significance in each of the seven world regions, as
designated by the 20th International Gas Union in 1997
and now used by that organization as the basis for its
regional reports (see also Lerche, 2000).
North America
Almost 30% of world gas use in 2005 was in North
America, with the US accounting for 80% of the
regional total (Table 2). As the US has long been
squeezed for indigenous gas reserves (initially because
of stringent regulatory controls on production and
transport over almost two decades to the mid 1990s
and, more recently, by an inappropriate form of market
liberalization), its upstream gas industry’s production
has stagnated at about 540 Gm3 (billion cubic metres)
per year.
Deregulation and liberalization has thus had to be
supplemented by federal Government support designed
to secure the re-expansion of proven reserves to a
degree sufficient to offset depletion, in the context of
an annual production of gas which became inadequate
to meet generally increasing demand (from 550 to 650
Gm3) in the 1990s, but with post-1999 stagnation to
2005. Though increased demand stimulated
technological advances in exploration and production
methods with positive results, particularly in the deep
waters of the Gulf of Mexico to 2001 (Gas [...], 2003),
the additional volumes of deep offshore and other gas
production since then have done little more than offset
declines in output from pre-existing producing
regions, including the Gulf ’s shallow water fields.
Meanwhile, growth in non-conventional gas
extraction from tight sandstones, gas shales and
coalbed methane in the Midwest and the Rocky
Mountains has come to contribute almost 10% of total
production (Gas [...], 2003).
Thus, the US market has attracted a large inflow of
supplies both from newly developed and from more
Share of total Share of carbon
energy use (%) fuel use (%)
24.9 28.5
22.3 33.1
24.5 29.2
52.7 58.8
44.3 44.6
20.3 21.8
10.7 10.7
23.5 26.8
463
FUTURE SCENARIOS
intensively exploited Canadian reserves (Canadian Gas
Potential Committee, 2001). These reserves, plus the
largely undeveloped and potentially equally important
reserves in Mexico, also offer hope for North
America’s short and medium-term future supplies of
conventional gas.
They will, nevertheless, have to be complemented
by large Liquefied Natural Gas (LNG) imports from
South America and other parts of the Atlantic basin
(such as Nigeria and other West African countries) in
the medium to long term. Indeed, foreign LNG’s
contribution to US gas supply is likely to increase
from its 2005 level of less than 2% to over 20% by the
early 2020s. This becomes possible in the context of
the continuation of the much higher gas prices to
which the US has succumbed since the turn of the
century (after decades of gas prices well below the oil
equivalent price).
Meanwhile, as demonstrated above, the US leads
the world in the commercialization of
non-conventional gas. Its reserves of these, on the
basis of present knowledge, appear to comprise
about 25% of those assessed for the world as a
whole (see Table 5 in Chapter 1.3). Their accelerated
development, already well under way compared to
coal measure methane production, could, if need be,
in the context of today’s higher prices, at least
sustain North America’s current natural gas
production. Larger scale exploitation in the longer
term (post-2020) could take annual production to
levels well above those of the first five years of the
Twenty-first century. This early significant North
America dependence on nonconventional gas
supplies seems likely to remain unique to the region
for at least the first twenty years of the Twenty-first
century. This reflects the generally greater
availability of conventional gas reserves (relative to
lower gas use) in much of the rest of the world (see
Table 4 in Chapter 1.3).
Central and South America
This region is bottom but one to Africa, in its
current use of gas, and is below the global average in
terms of the contribution of gas to the region’s energy
use. Over the past decade, however, the region’s
natural gas reserves have grown twice as fast as energy
use overall. Its proven reserves are in excess of 55
years of present production and is calculated as having
two to five times more ultimately recoverable reserves
of conventional gas (see Table 3 in Chapter 1.3).
Intensive exploration of its proven and
additional reserves was, until the last decade of the
twentieth century, constrained by institutional
factors and, equally important, by the typical long
distances between the location of potentially
464
available reserves and the centres of energy use
(Odell, 1981, 1984).
Institutional changes in most countries of the
region have now not only freed-up markets, but have
also encouraged the flow of capital to the gas industry
(in largest part at the expense of additional
long-distance power transmission lines from remote
and high-cost hydro-electricity projects). These
changes in energy strategy suggest a fast and radical
evolution of a geographically more intensive and
extensive gas industry (IEA, 2003a). Much
infrastructure is under construction for gas
transmission and distribution so that market growth
will be rapid in the short and medium term; with both
production and use expanding by upwards of 50% by
2010. By that date there will be at least a skeletal
network of gas facilities interconnecting Argentina,
Bolivia, Brazil, Chile and other neighbouring
countries in the southern part of South America. A
second integrating system is also emerging (albeit
more slowly in the face of adverse political conditions)
in the Andean region from Venezuela to Peru. A link
between the two systems could, however, be in place
by 2020 (Kurtz, 1997).
In the longer term, gas from non-conventional
habitats (especially from shales and tight formations)
offer larger potential resources, but they all await
exploitation pending the increase in demand. The
continent is also considered to be especially rich in
offshore gas hydrates (see Table 5 in Chapter 1.3). But,
as emphasised above, no progress can be expected in
the recovery of such resources until the technology for
gas hydrates’ exploitation has been proven elsewhere
in the world, where much larger gas demands justify
the research and development expenditures which will
be required to achieve a breakthrough. This is unlikely
until the mid-Twenty-first century at the earliest.
Europe (excluding Former Soviet Union)
Europe’s larger natural gas industry is a relatively
recent phenomenon, dating only from the discovery of
the giant Groningen field in the Netherlands in 1959
(Odell, 1969). This discovery not only initiated the
subsequent intensive search for hydrocarbons in the
North Sea and adjacent areas, but also enabled a gas
transmission system to be built in one of the most
heavily industrialized and most densely populated
regions of the world. In spite of serious
misinterpretations of both the supply and demand
potential in the late 1980s (leading to over a decade of
near-stagnation in indigenous gas supply; Odell, 1988,
1992) the industry expanded by over one-third in the
early 1990s.
This expansion included both more intensive and
geographically more extensive developments. Europe
ENCYCLOPAEDIA OF HYDROCARBONS

is now in third place to North America and the FSU in
the use of gas (see again Table 2) and, likewise, it is
the world’s third largest gas producing region. The
contribution of gas to the European energy economy
approached 25% in 2005 and is still rising, as gas
continues to substitute both coal and oil, for a
combination of economic and environmental reasons.
A near doubling of the European gas industry’s size by
2020 is highly likely, for which much of the gas
required will come from Europe’s own increasing gas
reserves: especially those of Norway (Odell, 1995). Of
the conservatively estimated ultimately recoverable
reserves of 18-28 Gtoe of conventional gas (see Table
4 in Chapter 1.3), only about 9 Gtoe have been used to
date (USGS, 2000). Most of the unexploited reserves
lie under the very extensive Norwegian continental
shelf (stretching from the North Sea to the North Cape
and into the Barents Sea, divided between Norway and
Russia). These reserves will, if fully exploited, be able
to supply much of Europe’s demand for gas for at least
the first quarter of the Twenty-first century
(Norwegian Ministry of Petroleum and Energy, 2002).
Nevertheless, given the anticipated large-scale
growth in demand, indigenous reserves will have to be
increasingly supplemented by some of the readily
available and relatively low-cost resources of Russia
and Algeria (and possibly from a range of other
countries as well, e.g. Turkmenistan, Iran, and Libya
by pipeline and from elsewhere as LNG). These
external sources are not only abundant, but are also
relatively low cost, compared with Europe’s more
expensive remaining offshore reserves (Mabro and
Wybrew-Bond, 1999). Their impact on keeping prices
under control will encourage further expansion of the
European gas market. As an average 2% per annum
demand growth can be expected over the next 20
years, Europe will become an increasingly attractive
region for supplies from additional external sources
over this period.
Europe’s gas future in the medium term (and even
more so in the longer term) will depend on the further
interconnection and integration of the external
supplying countries with the European market (IEA,
2002b). This will create a continental gas system
which will eventually extend from the Atlantic Ocean
and the North Sea/Barents Sea in the west, to the
Caspian Sea in the east, and from North Africa to the
Urals (Fig. 2).
A still major undetermined issue is whether the
gas-rich countries of the Middle East will either
choose or be able to compete in the market for
pipe-line gas to Europe with their own gas export
potential (Estrada et al., 1995; Mabro and
Wybrew-Bond, 1999). If so, then Europe will have
access to sufficient conventional gas resources to meet
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
FUTURE OUTLOOK: THE QUALITATIVE ASPECTS
increased demand for the whole of the Twenty-first
century. In this advantageous context, there is little
likelihood that Europe will become anything other
than modestly interested in LNG brought by tankers
from distant exporting countries, let alone in the
exploitation of nonconventional gas resources which
(except in locally favourable circumstances) appear to
be post 2050 options at best.
Former Soviet Union (FSU)
Apart from Russia, five other former Soviet
republics have large gas reserves and considerably
more potential for enhancing those reserves.
Collectively, they constitute the part of the world with
the largest conventional gas reserves. As shown in
Table 4 in Chapter 1.3, estimates of proven remaining
reserves exceed 52 Gtoe (almost 35% of the world’s
total), while assessments of likely economically
producible additional reserves range from 96 to 110
Gtoe (around 33% of the world total). As the collective
annual use of the countries concerned is currently just
over 0.5 Gtoe, even the remaining proven reserves give
a reserve-to-production ratio of over 85 years.
When the anticipated additional reserves are taken
into account (amounting to twice as much gas), there
will be a powerful motivation for long-term efforts by
Russia, Azerbaijan, Kazakhstan, Turkmenistan,
Ukraine and Uzbekistan to achieve more extensive and
intensive exploitation of their natural gas. The
motivation is related not only to ensuring the
continuity of their close to 50% level of gas
dependence in their own energy economies, but also to
enable them to exploit further developable market
opportunities in Europe (Stern, 1995) and
prospectively, in China, India and other countries of
East and South East Asia. (Wybrew-Bond and Stern,
2002; Stinemetz, 2003).
The existing pipeline links from Russia to Europe
and projects and proposals for additional links (see
again Fig. 2) already reflect this situation (Bakhtiari,
2003). The development of a gas system fully
integrated with the European demand area is a near
certain mid-Twenty-first century prospect, both
directly from Russia, and indirectly through Russia or
Turkey from Azerbaijan, Turkmenistan, and
Kazakhstan (Roberts, 1998; Focus [...], 2002). The
location of the latter countries, together with
Uzbekistan, is however, difficult compared with that
of Russia, as it involves higher transport costs. These
are partly because of the greater distances to European
markets, and partly because of the imposition of transit
fees by the intervening countries (Estrada et al., 1995;
Wybrew-Bond and Stern, 2002).
There are, indeed, already indications that the
former Soviet republics in Central Asia could more
465
FUTURE SCENARIOS

Fig. 2. Europe’s emerging

continental gas
1
supply system
(adapted and updated Oslo

N
Stockholm Helsinki

A
from a «Petroleum

E
Economist» map,

C
July, 1995). 2

O
Edinburgh

C
I
5 4
Dublin

T
N
3
8

A
6

L
T 7
London 9
A

Bonn 16

Paris
16
9
Vienna
10
Bern
15 16
11 16 16
14
15 12 Belgrade
Lisbon
Madrid 12
Rome

15
offshore 13
SPAIN
M E D I T E R R A N E A N S E A

S. ITALY 0 500 km
13 (Sicily)

1 Norwegian Sea 9 Germany onshore

2 N. North Sea 10 Austria
3 S. North Sea (British) 11 Po Valley
4 S. North Sea (other) 12 Adriatic
5 Irish Sea 13 S. Italy (Sicily)
6 Celtic Sea 14 S.W. France
7 Groningen/other Dutch onshore 15 N. Spain/offshore Spain
8 Baltic Sea 16 Eastern Europe
INDIGENOUS GAS IMPORTED GAS
annual production levels in the 1990’s Russian export lines to European frontiers
(109 . m3) existing
planned or under construction
75 Algerian export lines to LNG terminals
50 and to Italy and Spain
25 existing
10 or less LNG routes from North Africa to
main transmission lines in Europe Western European ports
existing LNG export terminal
planned or under construction LNG import terminal

appropriately seek links with South East Asia and even
East Asia. In South East Asia, however, their gas
export potential will have to compete with supplies
from the Middle East; while in East Asia their efforts
will run into competition from Russia’s large gas
potential in East Siberia and Sakhalin. The gas export
potential of these Soviet-created and now somewhat
artificial Central Asian republics, with a combination
of political and geographical disadvantages for foreign
trade, currently seems unlikely to be achieved on a
large scale before the second quarter of the
Twenty-first century (Focus [...], 2002; Kalyuzhnova
et al., 2002; Holmes, 2003).
Nevertheless, in the long term, the prospective
role of the hydrocarbon-rich countries of the FSU in
Eurasia’s gas markets will be achieved on the basis
of their large share of the world’s conventional and
non-conventional gas resources (see Tables 4 and 5

466 ENCYCLOPAEDIA OF HYDROCARBONS


in Chapter 1.3). It will also be accentuated by their
potential post-2025 exploitation of some small part
of the quarter of the world’s ultimate resources of
gas from hydrates which are estimated to lie within
their boundaries and offshore waters (see Table 5 in
Chapter 1.3).
Indeed, the gas wealth of Russia and of the other
gas-rich former Soviet republics provides what can
perhaps best be described as the single most
significant element in the world’s prospective
involvement with carbon fuels from 2050 onwards
(Vyakhirev, 1998).
The Middle East
This region’s dominance in proven conventional oil
reserves is not matched by the dominance of its proven
reserves of conventional gas. It is, nevertheless, still an
immensely gas-rich area with proven reserves of 65
Gtoe, now well ahead of the FSU’s 52 Gtoe of proven
conventional gas reserves (see Table 4 in Chapter 1.3).
Geographically, the Middle East’s reserves are much
more heavily concentrated, as they lie in an area which
is only about 8% of that of the FSU.
This contrast is not insignificant for development
potential, given the relatively high costs of gas
transport. However, in terms of the cumulative
production of gas, the FSU has produced more than
four times that of the Middle East, while in terms of
year 2005 gas production, the FSU’s was more than
two and a half times that of the Middle East.
Likewise, the FSU’s estimated additional reserves
(96-110 Gtoe) are significantly more substantial than
those of the Middle East (29-50 Gtoe), as also shown
in Table 4 in Chapter 1.3. The contrast continues in the
estimates (see Table 5 in Chapter 1.3) of
non-conventional reserves excluding gas hydrates (159
Gtoe in the FSU against 99 Gtoe in the Middle East).
For gas hydrates, the potential in the FSU could be up
to 20 times that of the Middle East. Compared with its
unique position in respect to oil reserves, the Middle
East’s natural gas future is significantly restrained not
only by this greater FSU potential, but also by their
contrasting political relationships with the gas
importing countries of Europe and Asia.
In spite of these contrasts in the political,
economic, and social characteristics between the
Middle East and the FSU, the two regions will
become more competitive in respect to their export
potential. While gas use in the Middle East in 2005
was only 42% of that in the FSU, this contrast will
become somewhat less pronounced in the coming
decades. It is, however, unlikely to fall below the
ratio of 2:1. Thus, the Middle East could become a
potential rival to the FSU, in general, and to Russia,
in particular, in terms of their gas exports to
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
FUTURE OUTLOOK: THE QUALITATIVE ASPECTS
accessible regions which have inadequate resources
to meet their future gas needs.
Europe has been designated above as one such
region, but it is already importing over 150 Gm3 (0.13
Gtoe) of Russian gas annually. Moreover, the political
changes in the FSU in the 1990s have eliminated
previous political restraints on Europe’s willingness to
expand its Russian gas imports, with the result that
major infrastructure developments for much enhanced
gas deliveries are under way (Bakhtiari, 2003). The
same is not yet true of the Middle East. Its gas exports
to Europe in 2005 remained close to zero (i.e. 6.6 Gm3
of LNG and 4.3 Gm3 by pipeline to Turkey) and no
further pipeline connectors are yet beyond the
techno-economic study stage (Economic [...], 2005).
Large-scale gas supplies from the Middle East to
Europe remain only a long-term prospect (Odell, 1995,
2002; Iran [...], 2002).
In the meantime, a more intensive exploitation of
the Middle East’s gas reserves seems more likely to be
orientated to South East Asian markets, notably the
Indian subcontinent, where proven and even additional
gas reserves are modest, relative to potential demand.
Nevertheless, economic and political considerations
seem likely to inhibit links between the Middle East
and Asia for the short and medium term. In the longer
term, however, the complementary relationship of the
two areas (with large gas reserves and resources, on
the one hand, and potentially large gas markets, on the
other) will exercise sufficient force to overcome the
constraints, although still in competition with possible
large-scale flows of gas from the former Soviet
republics of Central Asia (Roberts, 1998). Meanwhile,
Middle East exports of LNG will build-up quickly
from their 2004 level of 44 Gm3 per year as major
liquefaction projects in Qatar, Saudi Arabia, Oman and
Iran are completed (Flower and King, 2002). By 2020
these could supply upwards of 100 Gm3, principally
serving North America and East Asian markets to
which deliveries by pipelines will be constrained by
geography. The coastal or near coastal location of most
of the Middle East’s abundant gas reserves and
potential gives the region a ‘natural’ advantage of
significant proportions for LNG production facilities,
compared with the higher transport costs of gas from
the generally remote inland location of Russia and
Central Asian reserves. Mid-Twenty-first century LNG
exports from the Middle East of up to 250 Gm3 are not
beyond the limit of reasonable expectations (Jensen,
2003).
Africa
The Mediterranean littoral states, with almost 75%
of Africa’s proven gas reserves and an estimated 50%
of the continent’s unexploited and undiscovered
467
FUTURE SCENARIOS
conventional gas reserves (USGS, 2000), have long
been considered as part of the Eurasian gas region
(Estrada et al., 1995; Odell, 1995). Algeria already
competes with Russia for exports to Europe, and a
further expansion of the volume traded is certain as
new trans-Mediterranean pipelines are completed
(Mabro and Wybrew-Bond, 1999). The first line from
Libya to Italy is already operational and Egypt will be
connected to the system within the next 10 years.
Whilst long-term resource availabilities can certainly
sustain production expansion of significant
dimensions, there may well be constraints on
additional exports to Europe before 2020, as demand
growth falls away with the satiation of markets and in
the context of market competition from other
suppliers. Thus, there likely seem to be limits to the
ultimate scale of production developments in the
countries of North Africa.
Alternative LNG exports to the US will provide
required additional longer-term outlets, but in
competition with suppliers from Atlantic basin sources
such as Trinidad, Venezuela and Nigeria (Quinn, 2002;
Jensen, 2003).
One country, Nigeria, with about 5,000 Gm3 (4.5
Gtoe) of gas reserves, dominates the currently proven
gas reserves of the rest of Africa, with only 1,200
Gm3. Nigeria’s gas prospects have been known for 25
years, but economic and political conditions in the
country, as well as its location which allows gas to be
exported only as LNG, has kept the exploitation of its
large gas reserves on a low plateau for almost a
decade. A large, almost 20-year-old, LNG export
project was finally completed in 1999. Other such
LNG export projects are now under development and
will more than triple the volumes which can be
exported to European and North American markets
before 2015.
Meanwhile, the country’s considerable gas
reserves, plus smaller volumes of gas in other
countries of West Africa, are now seen as providing the
base for a regional gas transmission system in that part
of the continent, but such a capital-intensive and
politically difficult system in an area of low-energy
demand still remains a medium-term development
opportunity. In the longer term, such a regional
pipeline system could provide the starting point from
which a long mooted trans-Saharan line to the
Mediterranean could eventually be built; though
cooperation with Algeria in this development may well
prove difficult to achieve, given that Nigerian gas
would then become a competitor in Europe for
supplies from North Africa. An African gas grid thus
remains largely a long-term prospect.
In spite of limited exploration efforts elsewhere in
Africa, significant gas reserves (in relation to the
468
small energy markets) have been discovered, but are
not yet being much exploited for exactly the same
reasons as noted above for Nigeria. Though South
Africa’s high and growing demand for energy provides
a small market for gas from Mozambique, the low cost
of exploiting South Africa’s rich coal reserves does
constitute a limitation on gas markets developments,
especially for power generation. Similarly, offshore
gas from Namibia has to date failed to generate
interest enough in South Africa to make its
exploitation profitable.
Again, prospects for exploitation remain only for
the longer term, and, even then, will be on a modest
scale by world standards. Angola’s growing gas
reserves (mostly as gas associated with its large-scale
offshore oil developments) only seems to be
exploitable as LNG for export to the US, in
competition with supplies from other more favourably
located LNG projects (Gas [...], 2003).
Geologically, the Great Rift Valley of East Africa
remains an enigma in respect to its gas potential.
Limited exploration to date has proved the existence of
modest reserves, but more recently a possibility of
major discoveries from an intensified effort has
emerged. Given its location, however, in terms of both
regional markets and export potential, the region will
remain low in the international order of priorities of
most companies.
In brief, except for the Mediterranean-orientated
countries and Nigeria, the continent seems highly likely
to remain unimportant in global gas industry
development terms for at least the first quarter of the
Twenty-first century. Thereafter, Africa could become
the last of the world’s continents (except for Antarctica)
to secure extensive access to natural gas, and even
more so, to achieve its intensive use, as a basis for
economic growth and improved living standards.
Asia Pacific (excluding FSU)
This dominant world region, in terms of population
and prospective economic growth, is not only
relatively poor in currently declared proven gas
reserves (with only 8% of the global total) but is also
estimated to have relatively limited potential for
additional reserves of conventional gas (see Table 4 in
Chapter 1.3). The region’s clear-cut bottom ranking
with a mere 10.7% contribution of gas to total energy
use (see again Table 1) seems, moreover, to reflect a
more fundamental problem than the historical lack of
interest in exploiting the region’s gas resources. Even
in the 1990s, at a time of a rapid increase in the
region’s energy use, gas’ share in the energy market
rose only from 7% to 10%, and has not moved much
beyond this in the first five years of the Twenty-first
century.
ENCYCLOPAEDIA OF HYDROCARBONS

The very modest role of natural gas in the region
has not, however, excluded some important
developments in the recent past in the discovery and
exploitation of the region’s gas reserves (which
currently provide a reserves-to-production ratio of over
41 years). Gas production increased by almost 100%
in the 1990s, based largely and uniquely on the
innovative LNG production and transport technologies
that have been implemented as a result of the
archipelagic character of the region. Indeed, by 2005,
two-thirds of international trade in LNG was to Asian
Pacific markets – with no less than 68% of this
originating from supplying countries within the region
(Flower and King, 2002).
The high costs involved in the creation of a
comprehensive and integrated gas pipeline system (in
a region in which markets are fragmented by physical
geographical characteristics) remain a barrier to
pipelined gas being made available to users, and hence
to a more intensive exploration of the actual and
potential resources of the regions. Plans for an
international pipeline system within the region have
been proposed and discussed by regional development
organizations, but implementation has as yet been only
modest, namely from Indonesia to Malaysia.
Thus, as with oil, the continuing expansion of gas
use for the period to 2020 is more likely to depend on
imports from outside the region, i.e. from the Middle
East into the Indian subcontinent, from Russia’s far
eastern gas potential into China, Japan and Korea, and
from the Central Asian republics (Turkmenistan and
Kazakhstan) to both India and China (Paik, 1995,
2002; World [...], 2001; IEA, 2002a; Wybrew-Bond
and Stern, 2002).
For the smaller economies of South East Asia,
which are relatively better endowed with gas and
already more dependent upon it, the more intensive
developments of indigenous resources and the recent
or pending construction of international pipeline
connections to neighbouring countries (such a
Indonesia to Singapore, Myanmar to Thailand, Papua
New Guinea to Australia, and Bangladesh to India)
will gradually be achieved and keep those countries’
gas economies growing faster than their energy
economies overall. Meanwhile, both China and India
(the region’s largest countries and economies by far,
except Japan) have enhanced and accelerated their gas
exploration efforts, with potentially significant results
for the development of much increased indigenous gas
production and consumption by the second decade of
the Twenty-first century (Can India [...], 2003;
Chandra, 2003; Chow, 2003).
The region’s major LNG producers, i.e. Australia,
Brunei, Indonesia and Malaysia, will also continue to
build-up their LNG exports to Japan, South Korea,
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
FUTURE OUTLOOK: THE QUALITATIVE ASPECTS
Taiwan and, even more significantly in due course, to
China. This, in part, will reflect these energy
importing countries’ attempts to limit their dependence
on Middle East oil. Somewhat ironically, however,
Middle East oil will be substituted by LNG from the
Middle East – notably, Qatar, Oman and the United
Arab Emirates (Quinn, 2002; Wybrew-Bond and
Stern, 2002).
There remains one extraordinarily important
unresolved geo-political dispute in the Asian Pacific
region which relates to natural gas as well as to oil (see
above), i.e. the issue over the sovereignty of the South
China Sea, in general, and, in particular, to the
disputed ownership of the Spratly Islands, a small
group of tiny islands in a huge, relatively shallow
water area which is considered to have high
hydrocarbon potential (Fig. 1). The claim by China to
the exclusive mineral rights over most of the South
China Sea affects five South East Asian countries and
has thoroughly stymied the effective petroliferous
exploration of the area, from which expected
significant reserves of gas could be produced and
transmitted in conventional relatively short-distance
pipelines to the region’s centres of demand (Paik and
Kim, 1995). The medium to longer-term prospects for
the development of natural gas resources for the
countries concerned depend significantly on a solution
to this political problem.
Significant new developments for gas expansion
First, natural gas-fuelled combined cycle power
generation has recently come to provide the basis for a
much enhanced requirement for gas supplies in the US
and Europe, given that the technology’s high
conversion efficiency enables high-cost gas to
compete effectively with the use of lower-cost coal,
while the development also serves energy policies
which aim to reduce CO2 emissions (Haites and Rose,
1996; Freund, 2002).
This technical development, with attractive
economic and environmental advantages, will be
mainly responsible for the predicted more rapid
exploitation of known gas reserves and an enhanced
rate of exploration for new reserves in an increasing
number of countries in all parts of the world. This
phenomenon will proceed on a continuing basis over
the entire first half of the Twenty-first century.
Second, another potentially equally significant
technical development, which will enable gas to
compete with oil products in the latters’ most
important remaining markets, is also now getting
under way. This is the conversion of natural gas into
liquid transport fuels (Gas-To-Liquid, GTL) (Shook,
1997; Thackeray, 2001). There is a huge market
potential for gas from this technological development,
469
FUTURE SCENARIOS
as transport fuels now account for over 50% of oil use
(which is roughly the equivalent of two-thirds of the
present total world market for natural gas).
GTL technology could thus also fundamentally
alter the economics of geographically remote gas
exploitation, hitherto inhibited by the high cost of
getting such gas to markets.
Oil-to-gas conversion plants in resource-orientated
locations (including offshore locations using floating
conversion facilities) will overcome this problem.
Additionally, the liquid products of GTL conversion
are cleaner-burning fuels, with lower emissions of
both particulates and greenhouse gases. The medium
to longer-term impact of GTL on gas use (and hence
on the future geographical spread and intensity of the
exploitation of the world’s gas reserves, eventually
including non-conventional gas occurrences) will thus
be a major factor in ensuring the global rate of build-
up gas supplies (see Chapter 1.3), so confirming the
practicality of the long-term process of substituting
gas for oil.
Third, there is also a potentially equally significant
(albeit a longer-term) role for gas in the transport
sector. There are two sequential elements to this
development. In the shorter term there will be a major
expansion of Compressed Natural Gas (CNG) as an
alternative fuel for road transport vehicles (as a direct
substitute for oil products). This has already made a
modest contribution to fuelling specific types of
vehicles, notably buses and delivery vans operating
within a limited range of their depots or garages, so
avoiding the disadvantage for CNG arising from the
need for more frequent re-fuelling.
Technical developments to overcome this problem
(and the eventual mass production of gas-using
engines) will, in time, greatly enhance the percentage
of vehicles that can run on natural gas.
In the longer term, growing concern for the
atmospheric pollution and the high emissions of
greenhouse gases by motor vehicles will likely
stimulate requirements for motor transportation based
on the use of hydrogen. In the context of needing to
produce that hydrogen at as low a cost as possible, the
only economic means would be its production in
large-scale static plants using natural gas as the input
fuel and with provision for the CO2 by-product to be
collected for subsequent sequestration, rather than its
release into the atmosphere (Griffiths, 2001;
Hoffmann, 2001; Rifkin, 2002).
This will add significantly to the global demand
for natural gas at a time when non-conventional gas
production is (as shown in Fig. 4 and Fig. 5 in Chapter
1.3) emerging as the most important component in the
commodity’s long-run supply curve. The rise in gas
output to an annual rate of more than 11 Gtoe by 2090
470
(over 50% higher than the peak rate forecast for oil
production) is thus predicated in part on a gas
conversion-to-hydrogen requirement whereby a more
environmentally friendly global energy economy can
be created.
9.2.3 Oil and gas as renewable
resources
Biogenic carbon energies’ limitations
As already shown in Chapter 1.3, renewables will
do no more than modestly supplement the
increasingly important contributions of oil and
natural gas so that the 2% per annum rate of growth
in energy demand can be maintained until mid
century. Thereafter, there will be a slowly declining
rate of increase in the demand for energy. This will
be down to only 1.2% per annum in the 2090s. As a
consequence, the supply of renewables will then need
to increase only modestly for much of the rest of the
century. Indeed, any significant increases in the
requirements for renewable energy supplies will,
even in the later decades of the century, only occur if
they are competitive with carbon fuels.
For oil and gas, assessments of conventional and
non-conventional reserves and resources indicate that
their joint production will continue to expand, while
they remain competitive with alternative sources. They
can also become increasingly environment friendly in
the context of the already ongoing development of
cleaner production and consumption technologies
(Williams, 1998). This will remain the situation until
the 2060s, beyond which a possible constraint arising
from resources limitations, can be hypothesized.
Although such a possible supply shortfall emerges
from an overly pessimistic assessment of oil and gas’
ultimately recoverable reserves, it does, nevertheless,
suggest an element of fragility in the long-term future
during which satiating the demand for energy remains
dependent on the exploitation of finite volumes of
resources of oil and gas.
Note, however, that over the close-to-sixty years to
go before there could be a potential supply shortfall,
there is plenty of time and scope for an intervening
fundamental reappraisal of oil and gas supply-side
limitations, both globally and regionally.
The abiogenic theory of the origins
of hydrocarbons
Any element of doubt over the future availability of
oil and natural gas suggests that such appraisals should
not exclude reconsideration of the questionable
validity of the original Eighteenth century hypothesis
that oil and gas are exclusively generated from
ENCYCLOPAEDIA OF HYDROCARBONS

biological matter in the chemical and thermodynamic
environments of the Earth’s crust (Abbas, 1996). Such
a reconsideration is a reasonable proposition, given
that there is an alternative modern Russian-Ukrainian
theory of the origins of oil and gas, even though it is
one which has generally been treated with scepticism
(or even with scorn) in the West (Kenney, 1996). This
is reflected in the apparent absence of a willingness to
publish reasoned critiques of the alternative theory.
For example, in The coming oil crisis, the
petroleum geologist Colin J. Campbell writes: “few
people take the hypothesis of an inorganic origin of oil
seriously” (Campbell, 1997). He then, however,
demonstrates his apparent lack of familiarity with the
subject by citing only one reference. Moreover, he
designates that reference as the “original paper” on the
theory, even though it was not published until 1994, as
a paper on a specific application of the then already
50-year-old inorganic theory. This paper argues that
recent success in drilling and developing oil and gas
fields in pre-Cambrian rocks in the Ukraine
demonstrated the validity of the inorganic origin of oil
(Krayuskin et al., 1994). Even one decade earlier,
however, in a standard text on Petroleum geology,
some pages were devoted to the theory of the
inorganic origins of oil and gas, with the conclusion
that “our present stock of petroleum hydrocarbons
would represent biogenic additions to a fundamentally
primordial endowment” (North, 1985).
Recent applications of the inorganic theory of the
origin of petroleum have, however, led to claims for
the possibility of the Middle East fields being able to
produce oil ‘forever’ (Mahfoud and Beck, 1995). A
further application leads to the concept of repleting oil
and gas fields in the Gulf of Mexico, so that
hydrocarbons can be redefined as a “renewable
resource, rather than a finite one” (Gurney, 1997).
There has also been the discovery of 12 fields on the
flanks of the Dnieper-Donets basin in Ukraine, with
recoverable oil reserves of 1.6 billion barrels and over
100 Gm3 of gas reserves, the major part of which “is
produced from the pre-Cambrian crystalline
basement” (Krayuskin et al., 1994).
Other indicated locations in the copious literature
on abiogenic oil and gas occurrence include: Algeria,
China, India, Libya, the North Sea, the US (Kansas,
Texas, and Wyoming), Venezuela, Vietnam, Western
Canada and, of course, widely in Russia (e.g.: the
north Caucasus, Komi, Siberia, and Volga-Urals).
More generally, it was already argued 30 years ago
that “all giant oil fields are most logically explained
by inorganic theory given that the simple calculation
of potential hydrocarbon contents in sediments shows
that organic materials are too few to supply the
volumes of petroleum involved. The very fact of
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FUTURE OUTLOOK: THE QUALITATIVE ASPECTS
giant oil fields can refute the whole complex of
argumentation in favour of organic theory”
(Porfir’ev, 1974).
Given the scope and the complexities of the
scientific evidence for and against the abiotic theory, it
is difficult for a non-physical scientist to make a
judgement on its validity or otherwise. It does not,
however, seem to be any more inherently excludable
for consideration as an explanation for the occurrence
of hydrocarbons in the Earth’s crust than the organic
hypothesis of the derivation of oil and gas. Its
importance in evaluating the ultimately available
hydrocarbon resources in the Twenty-first century is
self-evident.
Instead of having to consider a stock reserve
already accumulated in an unknown, but finite,
number of so-called ‘oil plays’, there is the possibility
of evaluating oil and gas as renewable reserves in the
context of whatever demand development may emerge
over an unlimited period. This is a quite fundamental
issue in relation to the very long-term prospect for oil
and gas.
Indeed, it raises quite different issues from the
controversy over the prospects for the exploitation of
non-conventional oil as presented above. Such
resources from alternative habitats have been
presented as important volumetric additions to the
availability of conventional hydrocarbons; but also as
additions which only become accessible for use at
generally higher costs. Such an economic restraint on
non-conventional oil and gas production makes for
quite distinctive and contrasting prospects for oil and
gas as organic materials, on the one hand, and as
abiotic occurrences, on the other.
If fields do replete because the origin of the oil and
gas extracted from them is abyssal and abiotic (based
on chemical reactions under specific thermodynamic
conditions deep in the earth’s mantle), then extraction
costs should not rise, as production can continue more
or less undiminished for an indefinite period.
Furthermore, estimates of oil and gas reserves, of
reserves-to-production ratios, and of annual rates of
discovery and additions to reserves do not have any of
the critical importance correctly attributed to them in
evaluating the future prospects of supply in the context
of the organic hypothesis of oil and gas’ derivation. In
essence, the stage on which consideration of the issues
of the future availabilities of oil and gas has hitherto
been played may no longer be appropriate.
If oil and gas were to be accepted as renewable
resources by virtue of their inorganic derivation (in the
same way that geothermal power has come to be
accepted as a renewable, rather than a finite, resource
within the past 30 years), they would establish a set of
alternative carbon energy prospects for meeting global
471
FUTURE SCENARIOS
energy requirements in the Twenty-first century, not
only in scientific and technological terms, but also
from the standpoints of economics and geo-politics.
Thus, the alternative theory of hydrocarbons’
origin seems to be too important to be omitted from
any study concerned with the very long-term prospects
for energy supplies.
The theory ignored to date – is this about
to change?
The clear absence of western-world geologists’ and
other scientists’ attention to the main elements of the
scientific endeavours in the FSU that produced the
abiogenic theory of oil and gas formation, suggests
that this discussion must be put in the political context
of the Cold War between East and West (Kenney,
1996). This produced a consequential near-absence of
effective scientific contact for most of that time. Over
that 40 year period, only one major article on the
subject by a main proponent of the theory, Vladimir B.
Porfir’ev, appears to have been published in a western
journal dedicated to petroleum geology (Porfir’ev,
1974). Even that article was preceded by an
extraordinary and quite abnormal editorial caveat. In
this, any responsibility by the Editors of the article for
the highly controversial views published was robustly
disclaimed: there was little subsequent discussion on
the paper.
The theory was thus, it seems, virtually shut out of
the western world’s consideration of future prospects
for oil and gas occurrence. It was even neglected at the
East-West scientific institution, The International
Institute for Applied Systems Analysis (IIASA),
specifically created in 1972, in Vienna, on the joint
initiative of President Kennedy and Premier
Khrushchev. In a major project on international energy
prospects undertaken at IIASA in the mid-to-late
1970s, a presentation by Academician Professor
Mikhail A. Styrikovich from Moscow, indicating that
“a cautious view of ultimate world oil resources
suggests an availability of 11,000 billion barrels”
(Styrikovich, 1977) was ignored. Instead, the IIASA
study pessimistically concluded that there was a severe
limit on future oil availability (Häfele et al., 1978).
The much larger volumes predicted by Styrikovich did
not, of course, fit in with western estimates based on
oil’s organic origins.
The still-emerging re-globalization of science in
the post-Soviet era is, however, now providing a
window of opportunity for a thorough reappraisal of
the two theories of the origin of oil and gas. In this
process the views of western ‘oil-men’ who are now
being exposed to exploration and exploitation
opportunities in the FSU, are particularly significant.
An ultimate synthesis of the two theories may well
472
emerge, as, indeed, recently suggested by. Thomas
Gold, that hypothesizes (Gold, 1999) an 8 km or more
subterranean microbiological habitat of immense
proportions, through which oil and gas of abiogenic
origin from deep sources pass on their migration route
up to near-surface reservoirs; and in so doing, secure
biological markers of the types found in hydrocarbons.
Such markers were thought to represent a residual
from the original biological debris from which oil and
gas have been created.
At the beginning of the Twenty-first century,
petroleum science thus still has a fundamental issue
to resolve. From such vitally important work, the
long-term prospects for oil and gas could well be
radically changed from the conclusion of this study,
i.e. that there are ‘only’ 55 years remaining to a peak
production of oil in 2060, and 85 years to the peak
production of natural gas. The prospects would
change even more so for the pessimistic claimants of
a world that is ‘running out of oil’ and for a
hydrocarbons’ upstream industry that is ‘mature’, at
best, or ‘declining’, at worst. Oil and gas as
renewable resources would comprehensively
undermine the validity of the existing range of views
which define the industry’s future as severely
constrained.
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ENCYCLOPAEDIA OF HYDROCARBONS
HYDROCARBONS LEGISLATION

10
INTERNATIONAL LAW

11
SUPRANATIONAL LAW

12
NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY

13
CONTRACTUAL REGULATION AND SETTLEMENT OF DISPUTES
 10.1
The sovereignty of states
over their natural resources
10.1.1 The end of the Second World
War and the tendency
of states to extend their
sovereignty
After the end of the Second World War there seemed
to be a marked tendency by states to extend their
sovereignty over their natural resources, both
horizontally and vertically. On the horizontal level – in
so far as reletionship between states is concerned –,
rules of general international law were established that
increased coastal states’ sovereignty over their land
and territorial seas, providing for the exclusive
jurisdiction of states over the exploitation of resources
in their continental shelves, as well as the exclusive
right to exploit those resources located within 200
miles of their coasts. On the vertical level – within
each state –, the powers enjoyed by the states
concerning their own territories, continental shelves
and exclusive economic zones have been specified in
terms of permanent sovereignty over their own natural
resources.
The importance of these phenomena has not
however failed to be balanced out by restrictions
aimed at preventing excesses of creeping national
jurisdiction capable of giving rise to conflicts that
could constitute a threat to peace. Thus, coastal states’
claims over the seabed have been limited according to
the principle that the exclusive powers of such states
over their continental shelves and their exclusive
economic zones cannot be extended beyond a certain
distance from the coasts, that is 200 miles. Beyond
that limit, coastal states must give way – with respect
to the resources of the seabed – to the application of a
regime inspired by the idea of “common heritage of
mankind”, expressed in United Nations General
Assembly Resolution No. 2749-XXV of 17 December
1970 entitled Declaration of principles governing the
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
seabed and the ocean floor, and the subsoil thereof,
beyond the limits of national jurisdiction (Mengozzi,
1971).1 From another point of view, obligations to
protect the marine environment and promote
international trade have been asserted which have
involved different forms of international cooperation,
as well as sometimes complex mechanisms, designed
to facilitate and guarantee respect for those
obligations.
Such phenomena has failed to affect the
hydrocarbon regime, having repercussions on: a) the
extension of states’ exclusive rights of exploration and
exploitation of the maritime areas beyond the
territorial sea; b) the rules governing concessions with
respect to such areas; c) the consequences of accidents
which may arise from the extraction and transport of
hydrocarbons; d ) the way in which each state must
interact with the others as far as the management of
hydrocarbons is concerned.
10.1.2 The powers of coastal states
The exclusive powers of states with respect
to the exploration and exploitation of marine
resources and the criteria for establishing
the boundaries of the areas
The extension of the coastal states’ powers over the
use of the resources in their continental shelves, as
well as the assertion of their right to establish an
exclusive economic zone – leading also to the claim of
permanent sovereignty over the hydrocarbons to be
found therein – have posed the problem of the
delimitation of such areas and the definition of the
1 On the developments that followed with respect to
general international law, see Mengozzi, 1977 and 1980-1981.
477
INTERNATIONAL LAW
relationship between coastal states’ rights and the
maritime freedoms of all other states.
With reference to the first of these two problems it
is worth specifically recalling the judgment of the
International Court of Justice of 20 February 1969 in
the dispute related to the delimitation of the North Sea
continental shelf between the Federal Republic of
Germany on the one hand, and the Netherlands
an Denmark on the other (North Sea Continental Shelf,
Judgment, 1969). In this judgment, the International
Court of Justice held non-applicable the equidistance
criterion, which according to the 1958 Geneva
Convention operates both in the case of states whose
coasts are opposite each other and also in the case of
two adjacent states. The judgment pointed out that
with reference to adjacent states – and the three states
party to the dispute were adjacent to one another – the
application of the equidistance criterion could lead to
an increase in the portion of the continental shelf of
states with a convex coast (as is the case of Denmark
and the Netherlands), as the boundary line tends to
open up towards the open sea whereas, vice versa, it
leads to a reduction in the portion of the continental
shelf of states having concave coasts (as is the case of
Germany). As a result, the Montego Bay Convention
of 10 December 1982 (Byrne and Boyle, 1995)
abandoned the equidistance criterion and stipulates in
art. 83 that the delimitation of the continental shelf
between states with opposite or adjacent coasts shall
be effected by agreement between the states involved.
This is in order to achieve an equitable solution, in line
with numerous other decisions of the International
Court of Justice and arbitration tribunals.
The coastal state’s powers over the exclusive
economic zone and the rights of oil tankers flying
the flag of a foreign state
The question of the relationship to be established
between the coastal state’s rights over its exclusive
economic zone and the traditional maritime freedoms
of the other states, with specific reference to activities
concerning hydrocarbons, was first addressed in art.
59 of the Montego Bay Convention and then by the
International Tribunal for the Law of the Sea in its
decision of 1 July 1999 (M/V Saiga case n. 2, 2000).
Art. 59 of the Montego Bay Convention – in line
with what had been established by the International
Court of Justice in its judgment on the delimitation of
the North Sea continental shelf and specifying the
criteria expressed therein concerning the delimitation
of the continental shelf between states with adjacent
coasts – states “in cases where this Convention does
not attribute rights or jurisdiction to the coastal State
or to other States within the exclusive economic zone,
and a conflict arises between the interests of the
478
coastal State and any other State or States, the conflict
should be resolved on the basis of equity and in the
light of all the relevant circumstances, taking into
account the respective importance of the interests
involved to the parties as well as to the international
community as a whole”.
In the aforementioned case, the International
Tribunal for the Law of the Sea had to establish
whether a coastal state, in its own exclusive economic
zone, could sanction the refueling and sale of fuel by a
foreign ship to other ships by applying its own
customs laws. The International Tribunal decided that
the coastal state could not do so, even though nothing
on this matter is mentioned in the provisions of the
Montego Bay Convention on the freedom of
navigation that must also exist with respect to
exclusive economic zones. To this regard, importance
has been given not only to the functional nature of the
coastal state’s rights with respect to the zone in
question but also to the interests of the “international
community as a whole”.2
10.1.3 Oil concession contracts
and stabilization clauses
While the above-mentioned problems have arisen and
continue to arise with significant acuteness, problems
concerning the rules governing concessions underlying
hydrocarbon activities are certainly no less sensitive.3
Such problems arose in the years following
decolonization, and although less intense now, are still
current.
In particular, it is a matter of defining the value of
the stabilization clauses contained in contracts
establishing such concessions. These clauses are
inserted in concession contracts concluded between
2 For an analogy between what has been enunciated in
the mentioned judgment of the Court of Justice of the
European Communities ruling of 24 November 1992 in Case
C-286/90, paras. 25-26, see Conforti, 2002. In this judgment
the Court of Justice affirmed that a European Community
regulation prohibiting the transport on board by non-
Community ships in the exclusive economic zone of
European Union member States (and in other areas over
which the European Community has jurisdiction) of certain
species of fish caught beyond that very same exclusive
economic zone cannot be applied.
3 For the definition, with reference to the Italian legal
system and in particular to Law No. 613/1967, of publicly
established explanations for the cultivation of hydrocarbons
as well as for prospecting and research as concessions, see
Guglielmi, 1970; for an illustration of the various types of
contracts concluded between host countries and
multinational oil companies, see Smith and Dzienkowski,
1989.
ENCYCLOPAEDIA OF HYDROCARBONS

private enterprises and countries with weak
governmental structures (Jackson, 1990). They are
usually related to the fiscal regime, the regime
governing the transfer of funds abroad and the
repatriation of invested capital. Frequently used in the
1950s and 1960s as a result of some developing
countries, and those which had just gone through a
process of decolonization, wishing to attract foreign
investment, such clauses became much less frequent in
the subsequent period, on account of the spread of the
philosophy expressed in the United Nations
resolutions affirming the permanent sovereignty of
states over their own natural resources. They then
came back into use with the privatizations following
the transformation of the planned economies of the
former Soviet Union and of the states of Eastern and
Central Europe. They were then particularly widely
used in the contracts, through which those countries
stipulated the creation of concessions in favour of
western companies for the exploration and exploitation
of hydrocarbons on account of the great commitment
in terms of time and investment required by these
activities, as well as the political risks they involve.
The companies that undertake initiatives in the
sector need financing. More often than not, the private
and public companies that make the investments by
means of loans press for the inclusion of such a clause
in concession contracts, to the extent that funding is
sometimes on condition of including such a clause
(Wälde and Ndi, 1996). There is a high risk of
unfruitful exploration. However, when it is successful,
the need is felt to prevent the host state from taking
advantage of the positive results by revoking the
concession (Curtis, 1988).
The stabilization provided by the clauses in
question can be achieved in various ways: by the
commitment of the state hosting the activity for which
the concession is granted not to change its legislation
and administrative practices for the entire duration of
the concession; by anchoring the rules governing the
activity for which the concession is granted – and for
the entire duration of the concession – to the rules in
force at the time the concession contract was
concluded; or, still, by means of very detailed contract
terms that can be modified only by agreement between
the parties.
Contracts governed by the law of the host state
Stabilization clauses are of varying importance,
depending on whether or not their regulations and
those of the concession contracts where the clauses are
inserted, are subject to the legal order of the state
hosting the activities for which the concession has
been granted. This being either because those regimes
have been chosen by the parties or because of the
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THE SOVEREIGNTY OF STATES OVER THEIR NATURAL RESOURCES
consequences of the private international law rules
applicable to such contracts.
If a concession contract containing a stabilization
clause is governed by the law of the host state, given
that a contract in itself cannot bind the legislator and
the government, all the more reason that one of its
clauses cannot do so. A contract governed by one
state’s law, however that contract has been drafted,
cannot alter the powers of that state to the extent of
requiring it to renounce its sovereign rights. A foreign
investor cannot invoke legitimate reliance on the
stabilization as foreseen in the concession contract,
since the foreign investor, by exercising due diligence,
can be aware of its invalidity from the standpoint of
the host state’s law. In the same way, legitimate
reliance on respecting the stabilization clause
contained in such a contract cannot be invoked by the
foreign investor, even in the case in which a law of the
country expressly provided for the clause’s validity.
Also, in this case, the state, in exercising its sovereign
rights, could revoke such a rule, while accepting the
possible consequences, such as being obliged to pay an
indemnity (Wälde and Ndi, 1996).
Recourse by the parties to international law
The situation is different if the state and the foreign
investor, in light of the principle of autonomy which is
certainly applicable to international contracts,4 insert
in the concession contract containing a stabilization
clause a provision expressly providing that the contract
be governed by international law. Such a choice is
made in an arbitration clause whereby settlement of
any dispute that might arise will be submitted to an
international arbitration institution or to a person
completely independent of the state granting the
concession. In such a case, if the state authority that
signed the concession contract had the power to insert
such a clause, one can speak of the internationalization
of the contract. This is, at least, in the sense that the
arbitration body that may actually be called upon to
decide on the validity and/or on the legal
consequences of a stabilization clause would have to
proceed on the basis of the application of the rules of
international law (Charpentier, 1956; Mann, 1975).5
4 On the limits the application of this principle
encounters, see Lalive, 1977.
5 For an observation, however, that the
internationalization of a contract can be further consolidated
in the case in which the host state is party to the Washington
Convention for the settlement of investment disputes
between states and nationals of other states, which was
prepared in the framework of the activities of the
International Bank for Reconstruction and Development
giving rise to the establishment of the International Centre
for Settlement of Investment Disputes, see Rosenberg, 1983.
479
INTERNATIONAL LAW
The decision to be taken by such an arbitration
body in this case is not easy. It implies fixing
coordination and equilibrium among the three
principles or rules clearly belonging to the
international legal order: the pacta sunt
servanda principle; the rebus sic stantibus rule;
and the principle of sovereignty.
10.1.4 The principle of permanent
sovereignty of states
over their natural resources
and developing countries
In developing countries and in countries that have just
undergone a process of decolonization, the principle of
sovereignty has gained particular importance. This is
as a result of the emphasis given to the affirmation by
the United Nations’ General Assembly of the principle
of permanent sovereignty of states over their natural
resources. This principle – formulated with reference
to hydrocarbons, as belonging to the category of
non-renewable resources (Elian, 1976) – was first
articulated in the Declaration on the granting of
independence to colonial countries and peoples,
contained in Resolution No. 1514-XV of 14 December
1960 adopted by the United Nations’ General
Assembly. This resolution states that “peoples may, for
their own ends, freely dispose of their natural wealth
and resources without prejudice to any obligations
arising out of international economic co-operation,
based upon the principle of mutual benefit, and
international law”. The theme is picked up again more
strongly in the subsequent Resolution No. 1803-XVII
of 14 December 1962 (Declaration of permanent
sovereignty over natural resources), according to
which “the right of peoples and nations to permanent
sovereignty over their natural wealth and resources
must be exercised in the interest of their national
development and of the well-being of the people of the
State concerned” (Mengozzi, 1967).
These General Assembly resolutions were firstly
followed by the Declaration on principles of
international law concerning friendly relations and
co-operation among states in accordance with the
Charter of the United Nations (United Nations General
Assembly Resolution No. 2625-XXV of 24 October
1970). This was followed by the Charter of Economic
Rights and Duties of States (United Nations General
Assembly Resolution No. 3281-XXIX of 12
December 1974). The former affirmed that “each State
has the right freely to choose and develop its political,
social, economic and cultural systems”. The latter
added that every state has the right to do both “in
accordance with the will of its people, without outside
480
interference, coercion or threat in any form
whatsoever”. It also stated the right to regulate foreign
investment, to nationalize and expropriate foreign
property according to its own domestic laws. It
therefore excluded recourse to international law and
the jurisdiction of tribunals other than those of the
nationalizing and expropriating state to settle any
dispute that might arise (art. 2, para. 2, c).6
The doctrine most careful to interpret the
orientation of developing states and those that have
just undergone a process of decolonization has shown
that both principles – the one affirming that each state
may freely choose its own economic system and the
other proclaiming each state’s permanent sovereignty
over its natural resources – derive from the principle of
sovereign equality of states enshrined in art. 2 of the
Charter of the United Nations. The former specifies
that states have the right to self-determination on the
economic and social level without interference by
other states. The latter specifies the effects over time
of the use of this free choice of the right to
self-determination or re-organization, above all when
foreign economic interests are at play (Giardina,
1980-1981; Abi-Saab, 1991).
With the clear and declared intention of gathering
rules from the assertions contained in the
aforementioned resolutions, that doctrine does not fail
to point out that the absolute and exclusive nature of
the power inherent in internal sovereignty – as well as
the freedom of choice and of action that sovereignty
implies – must be understood as being within the
limits of international law. However, the violation of
the obligations deriving from that law as a
consequence of agreements concluded by one state’s
government leaves sovereignty whole and intact at
domestic level even if it gives rise to an international
responsibility of that state. Indeed, sovereignty is
defined in the aforementioned resolutions as
permanent sovereignty, and subsequently is reaffirmed
as such in art. 2, para. 1 of the Charter of economic
rights and duties of states (adopted by United Nations
General Assembly Resolution No. 3281-XXIX of 12
December 1974).
The logical explanation given to this state of affairs
is deduced from art. 1 of the Covenant on civil and
political human rights of the United Nations,
according to which “the right of self-determination
(à disposer d’eux-mêmes) includes permanent
sovereignty over their wealth and resources”.
According to the doctrine in question “the rights other
States may claim may in no case deprive a people of
6 For the stressing of such characteristics of this
resolution, see Feuer, 1975.
ENCYCLOPAEDIA OF HYDROCARBONS

its own means of subsistence” (Jimenez de Arechaga,
1978). In light of this assertion, the same doctrine
maintains that sovereignty over natural resources is
permanent as it is a fundamental right of the people.
Moreover, it aims to protect that right against the
weakness of state governments and make it prevail
over any agreement governments may have concluded
that might place a significant limitation on that right.
The consequence of this way of viewing things, as
concerns the stabilization clauses in oil concession
contracts, is that a concession concluded for too long a
period of time would be contrary to the permanent
sovereignty of the territorial state (Abi-Saab, 1991).
Furthermore, if a concession is revoked and the
structures built for the purpose of carrying out the
activity for which the concession has been granted are
nationalized, only an indemnity would be due
to the nationalized enterprises. The adequacy of the
indemnity, according to the Charter of economic rights
and duties of states, ought to be determined ”taking
into account its relevant laws and regulations and all
circumstances that the State considers pertinent. The
indemnity could be determined by the judges of the
same State unless it has been concluded in an
agreement, freely signed by the interested State or
States, after the dispute has arisen, to submit the
question to international arbitration or judicial
settlement”.
10.1.5 The pacta sunt servanda
principle in western
literature and in arbitral
case law
Great importance has been given to the pacta sunt
servanda principle not only by numerous western
authors (Weil, 1974; Lalive, 1983) but also by arbitral
awards specifically concerning hydrocarbons and the
stabilization clauses contained in agreements
concerning them.7
The Texaco case
Particularly illustrative of the aforementioned
direction is the award of 12 April 1977 delivered in the
California Asiatic Oil Company and Texas Overseas
Petroleum Company v. Government of the Libyan Arab
Republic case, also known as the Texaco award.
In this case, the Libyan government had proceeded
to the nationalization of the structures of the two
American oil companies that had initiated arbitration
proceedings even though the structures had been
created on the basis of a concession contract that
contained, in art. 16, an intangibility clause and a
stabilization clause (for 50 years) concerning the
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THE SOVEREIGNTY OF STATES OVER THEIR NATURAL RESOURCES
rights granted to the concessionaries. The contract
provided that any dispute between the parties would be
settled by an arbitration tribunal, to the establishment
of which both parties would contribute. Whereas the
companies had appointed an arbitrator of their choice,
the Libyan government refused to do likewise
invoking its permanent sovereignty over its natural
resources and claiming that, in conformity with the
terms of art. 2, para. 2, c, of the 1974 Charter of
economic rights and duties of states, the problems that
had arisen be settled according to Libyan law and only
by a Libyan court. Another provision of the concession
contract was therefore applied whereby, in such a
situation, the President of the United Nations’
International Court of Justice had the task of
appointing a sole arbitrator. Thus Sole Arbitrator
René-Jean Dupuy was appointed.
Since the arbitrator considered himself able to
proceed even though the Libyan government was
absent, Dupuy considered it his duty, in deciding the
matter, to analyse the Libyan government’s arguments
for excluding the applicability of the arbitration clause
contained in the concession contract in the case of the
nationalizations in question. The Sole Arbitrator
admitted that the United Nations Resolutions on the
question of the permanent sovereignty of states over
their own natural resources were meant to have an
important impact on the content of contemporary
international law. Moreover, he said that the
resolutions could contribute to establishing the content
of rules as indicated by doctrine that expresses the
orientations of developing countries and those having
just gone through a process of decolonization.
However he specified that the legal value the content
of each resolution can acquire is not equal to that of
the other resolutions. Its legal value depends on
whether or not there has been consensus on it by a
“large number of States representing the whole of
geographical regions and, at the same time, the whole
of economic systems”. Now, according to Sole
Arbitrator Dupuy, this condition is not satisfied by the
provision of the Charter of economic rights and duties
of states invoked by the Libyan government. It is on
7 Saudi Arabia v. Arabian Am. Oil Co. (Aramco), 1963;
Sapphire Petroleum v. National Iranian Oil Co., 1967;
Texaco Overseas Petroleum Co./California Asiatic Oil Co. v.
Libyan Arab Republic, 1977; BP Exploration Co. (Libya) v.
Libyan Arab Republic, 1979; Alcoa Minerals of Jam.
v. Jamaica, 1979; Libyan Am. Oil Co. (LIAMCO) v. Libyan
Arab Republic, 1981; Kuwait v. American Indep. Oil Co.
(The Aminoil Arbitration), 1982; AGIP Co. v. Popular
Republic of the Congo, 1982; Amoco Int’l Fin. Corp. v.
Islamic Republic of Iran, 1987; Mobil Oil Iran Inc. v.
Islamic Republic of Iran, 1987; Phillips Petroleum Co. Iran
v. Islamic Republic of Iran, 1989.
481
INTERNATIONAL LAW
the other hand satisfied by Resolution No. 1803-XVII
of 14 December 1962, approved by a majority (87
votes in favour, 2 against and 12 abstentions) which
included, in addition to numerous Third World
Countries, many western countries with developed
market economies, including the United States.8
In line with this analysis, the Sole Arbitrator felt
that he could attribute to art. 28 of the concession
contract all the relevance resulting from its content.
Art. 28 reads: “This concession shall be governed by
and interpreted in accordance with the general
principles of the law of Libya common
to the principles of international law and in the
absence of such common principles [...] then by and in
accordance with the general principles of law,
including such of those principles as may have been
applied by international tribunals”. For the purposes of
its application the arbitrator pointed out that according
to the shari’a, the sacred law of Islam, and
according to arts. 147 and 148 of the Libyan Civil
Code, contracts must be respected: contracts can be
terminated or modified only on the basis of mutual
consent or for reasons established by law and must be
performed in good faith (Anderson and Coulson,
1964) and that the pacta sunt servanda principle is a
general principle of law and an essential basis of
international law.9
Consequently the article in question would have
had the effect of making international law and in
particular the pacta sunt servanda rule applicable to
the contract; as the nationalizations in question
contravened that rule, on account of their contrast with
the intangibility and stabilization clauses contained in
the contract concluded by the parties, Libya ought to
have proceeded to a remedy by means of restitutio in
integrum, as this “is, both under the principles of
Libyan law and under the principles of international
law, the normal sanction for non-performance of
contractual obligations and it is inapplicable only to
the extent that restoration of the status quo is
impossible”.
Sole Arbitrator Dupuy added an observation:
according to the arbitration clause contained in the
concession contract (art. 28, para. 5), “In giving a
decision, the arbitrators, the umpire or the Sole
Arbitrator, as the case may be, shall specify an
adequate period of time during which the party to the
controversy or the dispute against whom the decision
is given shall conform to the decisions, and such party
shall not be in default if that party has conformed to
the decision prior to the expiry of the period”.
In his opinion the fact that the arbitration clause
was worded in such a way was in line with a certain
flexibility that, de lege ferenda, legal literature tends to
assign to contracts between states and private parties
482
and had given the party, who had failed to fulfil its
obligations, two possibilities. First and foremost, the
possibility of proceeding to restitutio in integrum as
long as the period of time in which to do so had not
expired and, secondly, the prospect of being ordered to
compensate the damage that, should it be the case,
would have compensated specific performance if,
from the legal point of view, one day non-performance
definitely became a reality.
In reaching this conclusion however Arbitrator
Dupuy had to demonstrate that he was able not to
take into account the decisions rendered with
reference to Serbian and Brazilian loans in which
the Permanent Court of International Justice in a
solomonic way had stated that “any contract that is
not a contract between States acting as subjects of
international law is based on national law”. If he had
been influenced by this precedent, there is no doubt
that Arbitrator Dupuy would have had to take into
account the law of Libya and the Libyan
government’s assertion that the application of
Libyan law and the jurisdiction of Libyan courts was
to be considered imperative. Thus he considered
himself able to overcome that precedent by
considering it outdated. In line with an interpretative
trend concerning the new general international law,
already followed by others (García-Amador, 1959;
Seidl-Hohenveldern, 1975), he declared that
international law had developed over time as a
regime which applies – even if it be with particular
rules that do not coincide with those governing
inter-state relations – also to the relations between
states and entities other than states. Thus, as
particular rules are applicable to relations between
states and international organisations, the same is
also true with respect to relations between a state
and enterprises operative on an international level.
Consequently, when such a state intends to
internationalize its relations with one of these
enterprises and to that end concludes a contract with
it, the state attributes international character to the
enterprise, with a constitutive effect. In this way
such international rules governing their relationship
8 For a comment according to which this United Nations
Resolution is not innovative seeing that long before it the
right of every state to expropriate or nationalize the property
of foreigners had been established, see Verwey and
Schrijver, 1984. For an extensive bibliography on the effect
United Nations Resolutions can have with respect to the
crystallization of the rules of general international law and
the progressive development of them, see Arangio Ruiz,
1972a, 1972b; Treves, 2005.
9 As far as this is concerned, see the arbitration awards
rendered in 1958 in the Aramco case and in 1963 in the
Sapphire case.
ENCYCLOPAEDIA OF HYDROCARBONS

will constitute a system in light of which their
contract will be considered de-localized.
In such a system the pacta sunt servanda rule
– unequivocally strengthened when the contract
concluded contains intangibility and stabilization
clauses such as those occurring in the case in hand –
dominates. In order to establish when a state manifests
this intention to consider an enterprise a subject of
international law and the contract it concludes with
such enterprise internationalized, Sole Arbitrator
Dupuy considered that it might be useful to verify in
the case in hand the existence of three factors: the
intention of the parties (as apparent from the
indication of international law as the most important
source of law governing the contract), the international
character of the arbitration proceedings (shown by the
fact that the parties requested the President of a United
Nations body, the International Court of Justice, to
perfect the process for initiating arbitral proceedings)
and the placement of the contract in question in the
context of economic development agreements
(Verdross, 1959; Bourquin, 1960).
Doubts concerning the Texaco award
and open questions
Although attractive, what comes out of this
complex reasoning cannot fail to leave doubt, at least
for the following two reasons. First of all, on account
of the premise on which the award is based. That is,
the attribution to the will of the state (that makes a
contract with an enterprise at an operating on an
international level) of the constitutive power to
attribute to that enterprise the nature of being a subject
of international law and in turn subject to a particular
(and reduced) series of rules of international law. From
another point of view, particularly important with
reference to the thesis expounded, in relation to the
capability of these rules to confer such a strong value
on intangibility and stabilization clauses, as Arbitrator
Dupuy held, that the state that violates them must, in
principle, proceed to restitutio in integrum.10
In so far as the first point is concerned, even if the
idea is accepted that, in the international legal order,
there are different kinds of subjects governed by
different groups of rules, it cannot be deemed that the
rules according to which an entity can be qualified as
subject are such with reference to one specific state
only and not to all the others. It is not worth adding
anything to the observations contained in important
scientific contributions on this matter, according to
which subjectivity, in the international legal order as in
all other legal orders, is a status that cannot but exist
erga omnes (Arangio-Ruiz, 1951, 1972a, 1972b).
As to the second point, there is no doubt that the
insertion of intangibility and stabilization clauses in a
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
THE SOVEREIGNTY OF STATES OVER THEIR NATURAL RESOURCES
concession contract, especially in the case of
concessions for the prospecting, exploration and
cultivation of hydrocarbons, renders particularly acute
the host state’s traditional obligation to respect the
property and activity of foreign investors. It cannot fail
to bear on the consequences of the exercise of the
power to nationalize arising from the permanent
sovereignty of states over their natural resources and
wealth. If for no other reason because all the rules and
principles of international law, even those that became
particularly firmly established in the wake of the
principles of the Charter of the United Nations, must
be applied bearing in mind the principle of good faith.
This principle is destined to make itself felt – even in
the international order – and is one that must be held
in particular consideration in relations in the context of
cooperation for development.11
Investor protection deriving from the clause in
question cannot however be absolute. This is, above
all, because it is impossible to maintain that the
international law in force can be interpreted in the
terms in which Dupuy interprets it. It is true that, as
Dupuy points out, ”the highest doctrinal authorities”
favour restitutio in integrum (Lauterpacht, 1927; De
Visscher, 1935; Reitzer, 1938; Schwarzenberger, 1945;
Guggenheim, 1954; Reuter, 1961; Jimenez de
Arechaga, 1968; Ténekidès, 1969). However, apart
from the fact that doctrine does not fail to specify that
restitutio in integrum constitutes a remedy preferable
to compensation or to assume that the advantages that
the former presents must be taken into account in
determining the quantum of the latter, the current
content of general international law cannot be
definitely identified with the assumption on which the
doctrine invoked by Dupuy is based. The content of
general international law can be the result only of the
10 For a critique, however, of the idea contained in the
decision according to which the concession would not
violate Libya’s permanent sovereignty over its oil resources
as it would be a concession concerning only a part of such
resources and would be limited in actual time: Verhoeven,
1975. The author stresses that the concession was granted
for a period of 50 years and that at the end of this period the
Libyan oilfields could be close to exhaustion, if not already
exhausted.
11 For a utilization of the principle in question in this
context, see Castañeda, 1974. The author holds that this
principle is applicable with respect to all matters dealt with
in that Charter, including art. 2 thereof (according to which,
concerning the rules governing natural resources, each state
has the right to proceed to nationalize and expropriate
foreign property according to its domestic law, excluding
therefore recourse to international law and settlement of any
disputes that might arise by tribunals other than those of the
state that proceeds to said nationalization and
expropriation).
483
INTERNATIONAL LAW
opinio juris of the states resulting from the practice
that comes about on account of their conduct: in other
words from the usus and from the opinio juris sive
necessitatis.
For some time international case law and
predominating diplomatic practice have recognised
that restitutio in integrum is possible only in
exceptional cases (when pecuniary compensation
appears to be a manifestly insufficient measure).
Moreover, in the majority of cases, the international
responsibility of one state that gives rise to a
nationalization in conflict with a commitment to
stabilize the regime to which an investment is subject,
gives rise only to the payment of pecuniary
compensation (Fatouros, 1962; El Chiati, 1988).
10.1.6 The need for a link between
the pacta sunt servanda
principle and the rebus sic
stantibus rule
On the other hand, even apart from this reality of
contemporary international law, the pacta sunt
servanda principle and the principle of good faith
make up only part of the legal framework in light of
which the action of a state that has concluded a
contract containing a stabilization clause must be
assessed. The social, economic and political
components of the relationship in which such a
contract occurs are sure to change over time and to
have an effect on the related equilibrium. This change
is necessarily destined to acquire relevance because of
the working of the rebus sic stantibus rule that cannot
fail to accompany the application of the pacta sunt
servanda principle and the principle of good faith
(Higgins, 1986; El Chiati, 1988).
To establish that the failure to respect a
stabilization clause is a violation of the legitimate
expectation determined by that clause is not justified
by the operation of the rebus sic stantibus rule in
relation to a contract like that considered by Sole
Arbitrator Dupuy is a sensitive matter.
In theory, one can imagine that this reasoning
could be influenced by the fact that the arbitrator, if an
expert international lawyer was likely to proceed
according to a methodology based on the use of
criteria typically used in public international law cases
or, if not, according to criteria of international trade
law. In the former case the arbitrator can pay attention
to factors external to the contract particularly taken
into account by international law, namely the rules of
the Vienna Convention on the Law of Treaties, whilst
in the latter case, to the text of the contract (Wälde
and Ndi, 1996).
484
In actual fact, however, clauses of this type,
especially if drawn up in a post-colonial period, are
included in contracts concluded in the framework of
cooperation for development. In considering oil
concessions granted on the basis of contracts
stipulated in such context, an arbitrator cannot, in any
case, fail to examine with particular care the content of
the contracts. This is since these contracts typically
place the concession in a balanced ensemble of
commitments that take into consideration: on the one
hand, the enterprise’s need to have a certain financial
equilibrium ensured with respect to the high costs and
risks inherent in the search for and discovery of
resources; on the other hand, the state’s need to obtain
not only fiscally advantageous revenues and the
achievement of social programmes of employment and
training of local personnel which usually accompany
the said concessions (Franko, 1978), but also to meet
needs of a more general nature.
It is also for this reason that, in addition to the fact
that the contracts in question are long-term contracts,
their forecasted stabilization is often tempered by
clauses which, when any difficulties arise, provide for
particular consultation procedures aimed at
overcoming the difficulties bilaterally.12
The consequence of this series of data is that an
arbitrator called on to decide on the violation of a
clause such as the one in question, even if he admits
that the state concluding a concession contract can
terminate it prematurely, will be able to oblige the
state to make compensation that goes well beyond the
emerging damage. The same arbitrator, on the other
hand, cannot fail to grant the host state – in which
exploration and/or extraction activity gives rise to
serious ecological problems that were unforeseen or
could not have been foreseen at the time of conclusion
of the concession contract – the possibility to impose
additional burdens with respect to the provisions of the
contract on the said activities of the company in
question in order to solve those problems.
The assertion made with reference to ensuing
ecological problems cannot fail to extend to other
developments in the situation in which an oil
concession finds itself. Indeed, if it is true that an
arbitrator, in view of the above-mentioned
considerations, has to take into account the financial
12 Point IV of the Papua New Guinea – Bougainville
Copper Co. Agreement of 6 June 1974, for example,
provides that “the parties would meet at intervals of seven
years to consider in good faith whether the Agreement was
operating fairly to each of them and, if not, to use their best
endeavours to agree upon changes to the Agreement as may
be requisite in that regard”; on the practice of inserting
clauses of this sort in the contracts under consideration, see
Asante, 1979.
ENCYCLOPAEDIA OF HYDROCARBONS

balance of the investor – because of which the host
state has managed to obtain the commitment of the
investor with respect to the areas over which the state
has sovereignty and jurisdiction – it is unthinkable that
the arbitrator, in order to achieve contractual balance
(Higgins, 1986), i.e. for the purpose of maintaining the
same “contractual balance desired by the parties”,13
should not also take into account unforeseen
circumstances that diminish beyond any possible
expectation the advantages that the host state could
have legitimately expected to obtain from the
concession.
Even if the so-called théorie de l’imprévision has
been accepted by the legal orders of oil producing
countries with reference to civil law (El Chiati, 1988)
and, in actual fact, in favour of the parties to the
contract obliged to make performance in money, it
cannot be denied that it leads back to a principle,
expressed in the rebus sic stantibus rule, also
applicable to all parties of an internationalized oil
contract. The problem of reconciling – with reference
to a contract of that sort – the possibility of invoking
the théorie de l’imprevision and the rebus sic stantibus
rule with a stabilization clause in it, indeed, consists
only in the problem of keeping such a possibility
within reasonable limits and avoiding abuses. For this
reason it is advisable, if not even fundamental, to
include in such types of contracts, consultation
procedures aimed at overcoming problems that may
arise during performance as well as clauses providing
for international arbitration to be applied in the case in
which settlement cannot be made bilaterally.
That phenomenon, underway in community law
and in the law of individual member states, of
moderating the pacta sunt servanda principle by an
increasingly broad application of the principle of good
faith and of the prohibition of abuse of rights14 must
be held as operative, in the sense indicated, also with
reference to internazionalized contracts, even if the
legal system in which they are considered to be rooted
(enracinés) is international law.
10.1.7 Bilateral joint exploitation
agreements concluded
between coastal states
with reference to common
oilfields or awaiting
definitive delimitation
of the continental shelves
The legal problems raised by the exploration and
exploitation of hydrocarbons are not limited to those
concerning the oil concessions a state grants to private
undertakings. Legal problems also arise on a more
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
THE SOVEREIGNTY OF STATES OVER THEIR NATURAL RESOURCES
traditionally international level. First of all, with
reference to the exploration, cultivation and
commercialization of oil resources located in parts of
the seabed adjacent to the coasts of more than one
state and with respect to which problems of
delimitation arise. Second, with reference to the
carriage by sea of such resources from the place where
they were extracted to where they are destined to be
marketed. Third and last, with reference to the
conditions to be established under which the sale of
such resources is permitted.
The fact that the Montego Bay Convention
followed the International Court of Justice in
endorsing the inapplicability of the equidistance
criterion for the delimitation of the continental shelves
of states with opposite or adjacent coasts –
establishing that such delimitation must be fairly
reached by agreement of the states involved – has
given rise to many disputes concerning the
establishment of a fair delimitation between two or
more states with opposite or adjacent coasts. Some of
these disputes have been brought before the
International Court of Justice. For example, in the case
of the dispute between Libya and Malta (Bundy,
1995).
In other cases, however, forms of cooperation have
been found that over time have been viewed with
ever-increasing favour: the disputed area is identified
and agreement concerning it is reached for joint
exploration and exploitation. This, for example, was
achieved with the treaty between Australia and
Indonesia on cooperation in the Timor Gap Zone
signed in December 1989 and with the treaty
concluded between the United Kingdom and the
Netherlands concerning oil and natural gas fields,
concerning at the same time, the part of the
continental shelf under the jurisdiction of one state and
the part under the jurisdiction of the other state.
It is interesting to note how, after this second
agreement, the governments of the United Kingdom
and of the Netherlands established a joint exploitation
programme of a part of the shelf known as the
Markham field. By virtue of this programme, the two
countries were committed to requesting from the
groups of companies – that had previously obtained
exploration and exploitation licences from each
13 For the use of this other expression see point 42 of the
award rendered by Sole Arbitrator Dupuy in the California
Asiatic Oil Company and Texaco Overseas Petroleum
Company v. Government of the Libyan Arab Republic case.
14 See in community case law, for example, the decision
of the Court of First Instance of 22 January 1997 in the Opel
Austria v. Consiglio case T-115/94, see Mengozzi, 1997;
Mengozzi, 2004.
485
INTERNATIONAL LAW
country – the settling between themselves of an
agreement to regulate the exploitation of that field and
to designate a single licensee to act as Unit operator.
This Unit operator has been given the task of
submitting to the two governments a proposal
concerning the identification of the extension of the
field to be exploited, as well as details on the way in
which the oil should be shared among the two groups
of companies that had previously each obtained its
own licence to exploit in each part of the continental
shelf resulting from delimitation. The governments of
the two countries have retained the power to approve
this proposal, although provision is made for having
recourse to a neutral expert if an agreement between
the two countries is not reached. The sharing of the
quantities of oil or natural gas, resulting from the two
countries’ approval of the Unit operator’s proposal or
from the neutral expert’s determination, is taken by the
agreement as the basis on which taxes and royalties
payable by the licensees to each of the two contracting
parties are calculated.15
A different example of cooperation can be
identified in the agreement concluded between
Thailand and Malaysia concerning an area of the Gulf
of Thailand over which not only Thailand and
Malaysia but also Cambodia and Vietnam claimed
jurisdiction. As Thailand and Malaysia were able to
reach a delimitation agreement concerning only a
limited part of that area, in 1979, they concluded a
Memorandum of understanding, identifying a
triangular area as a joint development area. After
lengthy negotiations the two parties concluded a joint
development agreement in 1990 which resulted in the
establishment of a joint authority.
What appears evident from these two examples is
that, when faced with problems deriving, in the first
case, from deposits extending beyond both sides of the
line of delimitation and, in the other case, from
difficulty in reaching an agreement leading to such a
delimitation, the parties to the two agreements made
reference to the obligation placed on states by art. 83
of the Montego Bay Convention. The fulfilment of this
obligation (namely, to delimit their respective
continental shelves by agreement) was seen by them as
achievable, albeit with difficulty, in harmony with the
other criterion (equitable solution) set out in the same
art. 83 of the Montego Bay Convention, at least in a
transitional stage, through forms of joint development.
In these two cases, does the fact that the obligation
to use the two criteria envisaged in art. 83 has
undoubtedly been considered capable of being
fulfilled by means of the establishment of forms of
cooperation, namely the creation of joint development
zones, mean that a principle of cooperation has
emerged that binds in a general way states and
486
individuals and entities operating at international level
and requires them to seek settlement of their conflicts
of interest by negotiation and agreement?
Such a conclusion may perhaps be excessive. What
can nevertheless be observed is that – as concerns the
specific matter of exploration and exploitation of
hydrocarbons, at the level of relations between states,
thanks also perhaps to the disappearance of the strong
forms of assertion of state sovereignty characteristic of
the cold war period – a principle of cooperation among
states, at least among neighbouring states, is taking
shape. In this regard, one cannot disagree with the idea
that what was provided for in art. 3 of the Charter of
economic rights and duties of states, adopted by the
United Nations General Assembly Resolution of 12
December 1974 according to which “in the exploitation
of natural resources shared by two or more countries,
each State must cooperate on the basis of a system of
information and prior consultations in order to achieve
optimum use of such resources without causing damage
to the legitimate interest of others” is becoming a rule
of general international law (Bundy, 1995).
10.1.8 Cooperation among states:
the Reformulated and
Conventional Gasoline case
With reference to the exploration, cultivation and
exploitation of hydrocarbons, forms of cooperation
have progressively accompanied the claim of
sovereignty. As has been seen, this has occurred at the
bilateral level, as concerns hydrocarbon deposits in the
continental shelves of states with opposite or adjacent
coasts and in the framework of agreements concluded
among several states, in relation to cases of pollution
caused by incidents involving ships carrying such
resources.
One may wonder whether these forms of
cooperation are the expression of the free choices
made by the states which have initiated them or are a
sign of awareness by those states of the emergence on
this matter of a principle sanctioning the obligation to
cooperate.16 No precise reply can be given to this
15 For a precedent to such a solution in the agreement on
the delimitation of the continental shelf concluded in 1965
between the United Kingdom and Norway and in the related
special Agreement on the Frigg Field Reservoir, see
Brownlie, 1979.
16 Specifying, respectively, the way in which art. 83 of
the Montego Bay Convention, illustrated above, must be
applied and the idea according to which ships of all states
must be ensured freedom of maritime transport – including
the freedom to carry hydrocarbons – so that no one must
suffer on account of that freedom.
ENCYCLOPAEDIA OF HYDROCARBONS

question with reference to the specific problems set
out above. One can only affirm that the application of
such a principle in the cases considered is the
manifestation of a trend in international relations. A
reply to a question of this sort, in the second of the two
directions indicated above, can however be given, with
reference to the rules governing the marketing of such
resources. This is in the light of a report by the
Appellate Body of the World Trade Organization
(WTO), which in its opinion revised the report
adopted by a Panel on 29 January 1996 (WT/DS/R,
United States – Standards for Reformulated and
Conventional Gasoline) and which the Dispute
Settlement Body of the WTO adopted on 20 May of
that very year (AB-1996-1, WT/DS2/AB-R) in a
dispute between Brazil and Venezuela, on the one
hand, and the United States, on the other.
The dispute arose following an amendment made
in 1990 to the Clean Air Act of 1955 of the United
States (42 U.S.C., paras. 7401-7671q). By this
amendment the United States Environmental
Protection Agency (EPA) established the so-called
Gasoline Rule. In other words, a rule concerning the
composition and effects of gasoline emissions for the
purpose of reducing pollution in the air in the United
States. The Gasoline Rule permitted the sale only of
treated gasoline (reformulated gasoline) in the most
heavily polluted areas of the country. For the rest of the
country a regime was envisaged that was destined to be
applied to all refineries, blenders and importers
of gasoline in the United States and aimed to prevent the
gasoline marketed from being more polluting than
the gasoline marketed in 1990 (conventional gasoline).
By establishing this regime, the EPA, on the one hand,
required that US refineries that had been operating for
at least six months in 1990 establish an individual
refinery baseline which was to represent the quality of
gasoline produced by that refinery in 1990. On the
other hand, the EPA itself had defined ex officio a
statutory baseline, aimed at representing the average
quality of gasoline sold in the United States in 1990.
This statutory baseline was meant to have been the
reference parameter for the United States refineries
that had not been operative for the required time in
1990, as well as importers and blenders of gasoline.
In the proceedings conducted at the seat of the
WTO, Venezuela and Brazil asserted that the Gasoline
Rule was incompatible, amongst others, with art. III of
the General Agreement on Tariffs and Trade (GATT)
1994, as it led to a discrimination between United
States producers and those from other states (that had
to follow the different baselines established for the
United States producers) and could not be justified by
the exception provided in art. XX of the GATT 1994
establishing that “nothing in this Agreement shall be
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
THE SOVEREIGNTY OF STATES OVER THEIR NATURAL RESOURCES
construed to prevent the adoption or enforcement by
any contracting party of measures […] relating to the
conservation of exhaustible natural resources if such
measures are made effective in conjunction with
restrictions on domestic production or consumption”.
This article must be read in coordination with the
preamble (chapeau) of the same art. XX, which
specifies that the said exception operates “subject to
the requirement that such measures are not applied in
a manner which would constitute a means of arbitrary
or unjustified discrimination between countries where
the same conditions prevail, or a disguised restriction
on international trade”.
Both the Panel and the Appellate Body were aided
in maintaining that the United States had committed a
discriminatory act according to art. III of the GATT
through the sincerity of a United States official of the
EPA who clearly declared under oath in a hearing
before the United States Senate Committee on
Environment and Public Works in April 1994 that the
legislation under attack had also been adopted with the
precise intention of protecting gasoline produced in the
United States (WT/DS2/R, United States – Standards
for Reformulated and Conventional Gasoline, Report
of the Panel, 29 January 1996, para. 3.80).
The Panel, however, had considered that the
discrimination in question could not be justified by the
exception to the application of the general rules of the
GATT, according to art. XX, of which measures
”relating to the conservation of exhaustible natural
resources” can benefit.17 The Appellate Body,
however, held that the exception in question ought
formally to be applied, as the expression relating to
must not necessarily be understood as necessary to
and attention had to be paid to the fact that the EPA’s
measures ought to have been qualified as adopted “in
conjunction with restrictions on domestic production
or consumption” according to the text of art. XX, as
those measures were applicable also to United States
refineries not operating in the United States, for the
required length of time, in 1990. It however concluded,
as the Panel already had, that the US measures were
incompatible with the GATT. This was because the
conduct of that country, although “in the disguise of a
measure formally within the terms of one of the
exceptions provided for in Article XX”, constituted a
“disguised restriction on international trade” and did
so because – and it is this it stressed – it was a
violation of a United States’ duty to cooperate with
Brazil and Venezuela (Nogueira, 1996; Cho, 1998).
17 The air is also one of the natural resources considered
in para. 6. 36 of the Report, but the measures “relating to the
conservation of exhaustible natural resources” must be
understood as only those relating to its protection.
487
INTERNATIONAL LAW
The United States had tried to justify the
imposition of statutory baselines on the oil importers
from these countries on the grounds that the
application of individual baselines to foreign refineries
would have created administrative difficulties. The
Appellate Body rejected this justification pointing out
that the documentation submitted in the proceedings
“did not reveal what efforts the United States may
have made towards cooperating with the governments
of Venezuela and Brazil to mitigate the administrative
difficulties they complained of ”.
It has been said that, by deciding in this way,
the Appellate Body “left a potentially significant
legacy in its analysis: trans-governmental
regulatory cooperation” (Cho, 1998). Even if this
statement is a little too emphatic, there is no doubt
that in today’s interdependent global economy,
problems arising with reference to the search for,
cultivation and marketing of hydrocarbons
increasingly determine the need to reconcile
protection of investments and trade with protection
of the goals of a public nature of states and of the
entire international community.
True, effective cooperation among the protagonists
of the vicissitudes concerning the sector is necessary
because, more than recourse to techniques for
choosing the applicable law and provision for
international arbitration, or at any rate together with
both techniques, it can concretely lead to such
conciliation. It is therefore particularly wise that the
Appellate Body of the WTO stated what has been
indicated above (Baroncini, 2005).
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Paolo Mengozzi
European Court of Justice, Court of First Instance
Luxembourg
Università degli Studi di Bologna
Bologna, Italy
489
 10.2
International law of the sea
and exploitation of the sea’s resources
10.2.1 The various maritime zones
and their evolution
The regime governing the exploration and exploitation
of marine resources varies according to the maritime
zone in which such resources are loca ted and the
marine resources in question.
Maritime zones are areas of the sea, or of the
seabed, for which international law establishes, on the
one hand, limits with respect to space and, on the
other, the rights and obligations of the various states
with respect to those zones. The catalogue of maritime
zones defined by international law has evolved
considerably. While the traditional law that was in
force until about the middle of the Twentieth century
recognized only two zones, the high seas, characterized
by freedom, and the territorial sea, characterized by
the sovereignty of the coastal state, the law today
considers a greater number of zones characterized by
various combinations of the freedom of all states and
the powers of the coastal state.
The definition of the zones recognized today was
reached in two stages, corresponding to two successive
exercises by the United Nations in codifying the law of
the sea. The first stage, corresponding to the work of
the International Law Commission and the First and
Second United Nations Conference on the Law of the
Sea (Geneva 1958 and 1960), resulted in the four 1958
Geneva Conventions on the Law of the Sea, which
came into force between 1963 and 1966.
The second stage, corresponding to the work
of the Third United Nations Conference on the Law of
the Sea (1973-1982), culminated in the opening to
signature, on 10 December 1982, of the United
Nations Convention on the Law of the Sea (the 1982
Convention) which came into force on 16 November
1994 and, as at October 2006, is binding on 151 states
as well as on the European Community, but not yet on
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the United States. The large number of ratifications
and the impact the 1982 Convention undoubtedly had,
even before its entry into force, on the practice of
states, including those states which have not yet
become parties to the Convention, justifies the
conclusion that the Convention can be considered a
reflection of customary law in force. Naturally, this is
not the case when the institutions created on the basis
of the Convention and when dispute resolution
mechanisms are concerned, and it can be challenged
with respect to some specific provisions
or provisions of detail, providing proof of their
merely conventional nature.
Today, in the light of the 1982 Convention,
maritime zones are all measured from baselines. These
baselines correspond to the low-water line but can be
simplified, where the coastline is deeply indented or
along which there is a fringe of islands, by drawing
straight baselines that must not, however, deviate from
the general direction of the coast. Straight lines can be
drawn to close bays, provided that these bays have
certain characteristics concerning form and width
(their mouths cannot exceed 24 nautical miles).
Non-compliance with these requisites is admitted only
in the case of historic bays, whose definition remains
uncertain. The waters inside the baselines are called
internal waters and are subject to the complete
sovereignty of the coastal state.
Starting from the baseline, there are today seven
maritime zones:
Territorial sea. The maximum breadth of the
territorial sea is established at 12 miles within which
the coastal state exercises its sovereignty. Such
sovereignty is limited with respect to the right of
innocent passage to ships of all states and with respect
to more incisive rights of passage (transit passage or
innocent passage that cannot be suspended)
established for navigation in international straits.
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INTERNATIONAL LAW
Contiguous zone. This may extend up to 24 miles
from the baselines within which the coastal state may
exercise enforcement powers to prevent infringement
of its customs, fiscal, immigration or health laws as
well as (according to an innovative provision of the
1982 Convention) the removal of archaeological and
historical objects.
Archipelagic waters. This notion is another
novelty of the 1982 Convention. States wholly made
up of islands can, where certain requisites are met,
establish archipelagic waters within an archipelagic
baseline joining the outermost islands of the
archipelago. The sovereignty of the coastal state, the
so-called archipelagic state, extends to these waters,
except for the right of innocent passage and the right
of archipelagic sea lanes passage, similar to the right
of transit passage in international straits, but limited to
certain sea lanes to be established in cooperation with
the International Maritime Organization (IMO).
Exclusive economic zone. This zone, which states
may establish by specific proclamation, can be
extended to a maximum of 200 miles from the
baselines and comprises the seabed and the
superjacent water column. This, perhaps, is one of the
1982 Convention’s greatest innovations. In the
exclusive economic zone, the coastal state has
sovereign rights for the purpose of exploring,
conserving and managing the natural resources,
whether living or non-living, and with regard to other
activities for the economic exploitation of the sea
(such as the production of energy from the water,
currents and winds). The coastal state also has
jurisdiction with regard to artificial islands,
installations, marine scientific research, and the
protection and preservation of the marine environment
in the exclusive economic zone. However other states
may enjoy, in the exclusive economic zone, the
freedoms of the high seas: freedom of navigation,
freedom of overflight, and freedom to lay submarine
cables and pipelines. They may also exercise other
lawful uses of the seas such as those associated with
the operation of ships, submarine cables and pipelines.
Continental shelf. This maritime zone, codified
for the first time in the 1958 Geneva Convention,
does not require a specific proclamation or actual
occupation by the coastal state. It comprises the
seabed and the subsoil of the submarine areas that
extend beyond the coastal state’s territorial sea. While,
according to the 1958 Geneva Convention, the outer
limit of the continental shelf was determined either by
the isobath of 200 m or by the depth at which the
superjacent waters admit the exploitation of natural
resources, the 1982 Convention states that the
continental shelf of each coastal state extends up to
200 miles from the baseline or up to the outer edge of
492
the continental margin wherever this extends beyond
200 miles. Provision is made, in such a case, for a
complex mechanism (see below) which permits the
coastal state to determine the outer edge of its
continental shelf in a manner which can be opposed to
all. The coastal state exercises its sovereign rights
over the continental shelf for the purposes of
exploration and exploitation of the natural resources
and the rules applicable thereto apply to the seabed of
the economic zone. The concept of the continental
shelf continues to be applied, even after the more
recent concept of the exclusive economic zone, both
in cases where a coastal state has not proclaimed an
exclusive economic zone (as occurs, in particular, at
least with respect to the majority of states in the
Mediterranean) and where the continental shelf
extends beyond the 200 mile limit.
High seas. This is the maritime zone situated
beyond the limits of national jurisdiction and in it the
principle of freedom predominates. This freedom
is exercised by each state by means of ships flying their
flag and is limited only by the requirement of “due
respect” for the interests of other states and, in the few
cases in which interference is admitted with regard to
ships flying foreign flags (at a general level, cases of
piracy, unauthorized broadcasting and the exercise of
the right of hot pursuit; as part of treaty obligations,
fishing and smuggling of drugs). As far as the water
column is concerned, the high seas extend from the
outer limit of the exclusive economic zone or (where
the exclusive economic zone has not been established)
from the outer edge of the territorial sea, taking into
consideration that some freedoms of the high seas can,
as already mentioned, be exercised also in the
economic zone. With regard to the seabed, the high
seas extend beyond the outer edge of the continental
shelf, taking into account however the fact that the
seabed of the high seas is the international seabed
Area.
International seabed Area (Area). This Area
comprises the seabed and ocean floor and subsoil
beyond the limits of national jurisdiction. The Area
and its resources were declared to be the “common
heritage of mankind” by the 1982 Convention. In the
Area, a regime for the exploitation of mineral
resources is in force. Such exploitation is governed
exclusively by the Convention (see below).
Maritime zones different from those provided for
in the Convention are, at times, established by states.
Their lawfulness with respect to the obligations
established by conventions and customary law is to be
assessed not so much on the basis of the denomination
given them as on their extension and the rights
claimed in them. Therefore, fishery zones or zones in
which the marine environment is protected are
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 INTERNATIONAL LAW OF THE SEA AND EXPLOITATION OF THE SEA’S RESOURCES
included within the 200 mile limit because rights are
claimed in them which are included among those
rights coastal states have in the exclusive economic
zone that may not have been proclaimed. Vice versa,
the various cases that still exist of territorial seas
exceeding 12 miles – for example, the defence zone of
50 miles proclaimed by North Korea and the customs
zone of 250 km established by Guinea – cannot
be considered compatible with the international law
in force.
10.2.2 Marine resources
in light of the
1982 Convention
on the Law of the Sea
and of other international
rules
The 1982 Convention does not provide a general
definition of resources nor does it contain an
exhaustive list of the resources it deals with.
Nevertheless, an examination of its various provisions
leads to some useful information. First of all, the
Convention concerns natural resources. Therefore,
resources that are not natural are excluded (among
which historical and archaeological objects and relics,
referred to by special, although incomplete,
provisions). Both art. 56 on the exclusive economic
zone and art. 246 on marine scientific research in the
exclusive economic zone and on the continental shelf
refer to natural resources. They mention living and
non-living natural resources in the English language
version (or biologiques and non biologiques in the
French language version). On the basis of this
distinction other provisions may be mentioned.
Living resources
The numerous rules governing fishing do not
specify the living resources to which they apply. The
rules governing fishing have been drafted clearly
bearing in mind the species of fish but they do not
exclude other species. Arts. 63-67 refer to particular
ichthyic and non ichthyic species. They mention
species which have peculiar characteristics and which
move in the economic zone as well as in the high seas
but do not precisely define the species. Sedentary
species, to which the continental shelf regime, not the
fishing regime, applies are however defined.
Organisms belonging to such species are described
as organisms that “at the harvestable stage, either are
immobile on or under the seabed or are unable to
move except in constant physical contact with the
seabed or the subsoil” (art. 77, which adopts the
wording of the 1958 Geneva Convention on the
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continental shelf). The agreement of 5 December 1995
on Straddling Stocks (species that live straddling the
economic zone and the high seas) and highly
migratory fish stocks, in force since 11 December
2001, include molluscs and crustaceans in the notion
of fish while exempting those belonging
to sedentary species as defined in art. 77 of the
1982 Convention (art. 1).
New living marine resources which the
international community is beginning to discuss are
organisms ranging from microrganisms to organisms
of considerable size that prosper, above all, near
hydrothermal vents found at very great depths on the
seabed. Such organisms have characteristics that
enable them to survive under extreme conditions and
make the study of their genetic mechanisms of great
interest also in view of practical applications, in
particular in pharmacology. Bioprospecting in the sea,
considered as an activity aimed at finding such
resources in order to exploit them, is a new
unregulated activity, to which it is difficult to apply
existing rules. The General Assembly of the United
Nations, which decided to set up a working group in
2004 to study the conservation and sustainable use of
marine biodiversity beyond the zones under national
jurisdiction, seems to have started a very relevant
process.
Non-living resources
As far as non-living resources are concerned, art.
77 of the 1982 Convention on the continental shelf
states that the coastal state exercises sovereign rights
over the continental shelf for the purpose of exploring
it and exploiting its natural resources which include
(in addition to the abovementioned sedentary species)
the mineral and other non-living resources of the
seabed and subsoil. Although not mentioned,
hydrocarbons, whose exploitation is historically at the
origin of coastal states’ assertion of their rights over
the continental shelf, are included among non-living
resources. An example of other non-living resources of
the continental shelf could concern the degree of
difference between the temperature of the seabed and
that of the subsoil, a difference that, like the difference
in temperature between surface waters and deep sea
waters, makes the production of electric energy
possible. Similarly, art. 56, referring to the exclusive
economic zone, mentions activities for the economic
exploitation of the zone, such as the production of
energy from water, currents and winds.
Still on the matter of non-living resources, part XI
of the Convention, concerning the international seabed
Area states in art. 133 that, for the purposes of that
part, the term resources “means all solid, liquid
or gaseous mineral resources in situ in the Area at or
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INTERNATIONAL LAW
beneath the seabed, including polymetallic nodules”,
and that those “resources, when recovered from the
Area, are referred to as minerals”. Polymetallic nodules
are defined in the Regulations on prospecting and
exploration for polymetallic nodules in the Area
adopted by the International Seabed Authority on 13
July 2000. According to art. 1, para. 3, d, “polymetallic
nodules means one of the resources of the Area
consisting of any deposit or accretion of nodules, on or
just below the surface of the deep seabed, which
contain manganese, nickel, cobalt and copper”. The
1982 Convention also mentions “any resource [mineral
resource, in the light of the definition already
mentioned] other than polymetallic nodules” as a
possible subject of future regulations (art. 162, para. 2,
o). Polymetallic sulphides and cobalt-rich
ferromanganese crusts are a first example of such
resources to which the Authority has devoted its
attention. Following an initiative by the Russian
Federation in 1998, the legal and technical Commission
of the Authority completed in 2004 a preliminary draft
on regulations on prospecting and exploration of the
aforementioned mentioned resources.
Other potentially considerable non-living natural
resources, which the international community is just
beginning to focus on, are methane hydrates, a
combination of methane and water, similar to ice,
enclosing an immense quantity of energy. Extracting
these hydrates is extremely difficult and raises problems
regarding the protection of the environment.
Regulations specifically relating to them have not yet
been formulated at domestic level (where they are found
on the continental shelf) or by the International Seabed
Authority (when methane hydrates are on the seabed).
There appears little doubt, however, that they will
become one of the resources to which the international
community will turn its attention in the future.
10.2.3 Outer limits
and delimitation
of the zones under national
jurisdiction
An indispensable requisite for an examination of the
legal regime concerning research and exploitation of
resources in the zones under national jurisdiction is to
determine the limits of these zones, namely, the
territorial sea, the exclusive economic zone and the
continental shelf. The limits to be determined are the
outer limits (within the economic zone or the
continental shelf, as regards the territorial sea and,
towards the high seas, as regards the economic zone
and the continental shelf) or the limits with respect to
States with adjacent coasts or, when there is not
494
enough space for maximum extension outwards, states
with coasts opposite.
As far as the outer limits are concerned, the
maximum breadth of the territorial sea was set at 12
nautical miles by the 1982 Convention. This is the rule
adopted by the majority of coastal states, even though
there are still some cases of states establishing a
narrower breadth (3 or 6 miles) for their entire
coastline or for parts of it. Such measurements are
undoubtedly lawful, while territorial seas broader than
12 nautical miles, some examples of which still exist
today, are to be considered incompatible. The outer
limit of the exclusive economic zone is set at 200
nautical miles, as is also that of the continental shelf
wherever the outer edge of the continental margin does
not extend beyond this limit.
The determination of the outer limit of the
continental shelf, where the outer edge
of the continental margin extends beyond the 200-mile
line, is addressed in the complex provisions of art. 76
of the 1982 Convention, supplemented by annex II
concerning the Commission on the Limits of the
Continental Shelf (see below). Having stated that the
continental margin comprises “the submerged
prolongation of the land mass of the coastal state, and
consists of the seabed and subsoil of the shelf, the
slope and the rise”, art. 76 makes provision for two
alternative methods for determining the outer edge of
the continental margin for the purpose of the coastal
state’s exercising its sovereign rights. One method
maps out a line that joins the outermost points at
which the thickness of sedimentary rocks is at least
1% of the shortest distance from these points to the
foot of the continental slope. The other method
involves having a line joining fixed points no more
than 60 miles from the foot of the continental slope.
The foot of the continental slope will correspond, in
the absence of evidence to the contrary, to the point of
maximum change in the gradient at its base. There is,
however, a limit that both methods cannot exceed: the
fixed points comprising the line of the outer limits of
the continental shelf cannot exceed either 350 nautical
miles from the baseline or 100 miles from the 2,500
metre isobath (except where there are peculiarities in
the seabed).
The complexity and the onerousness of the
research necessary to obtain the data that will permit a
state to support its claim to a continental shelf beyond
200 miles are evident, as is obvious the need for third
states to be able to count on the reliability of the
above-mentioned data. Therefore, the Convention
requires the coastal state to submit the data to an
independent technical entity, the Commission on the
Limits of the Continental Shelf, which will provide
assistance and prepare recommendations concerning
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 INTERNATIONAL LAW OF THE SEA AND EXPLOITATION OF THE SEA’S RESOURCES
the establishment of the outer limit of the continental
shelf. Even though it is the coastal state that
establishes this limit according to its own internal
procedures, an outer limit established on the basis of
the Commission’s recommendations “shall be final
and binding”. By this expression it is understood that
the outer limit will not be susceptible to modification
and that the coastal state will be obliged to respect it.
It seems it could also become opposable to third states.
The Commission, consisting of 18 members elected by
the Meeting of states Parties to the 1982 Convention,
was established in 1997. It has its own Rules of
Procedure and other regulations including scientific
and technical guidelines aimed at assisting coastal
states in the preparation of their submissions. By the
end of 2006 submissions had been made by the
Russian Federation, Brazil, Australia, Ireland, New
Zealand, Norway and, jointly France, Spain and United
Kingdom, while it has been announced that
submissions from other countries will be made by
2009. The submissions already made have given rise to
objections by other states, among which the United
States; however, as the United States is not a party to
the 1982 Convention, its position has, in turn, given
rise to some perplexity.
Obviously, the mechanism of the Commission, on
account of its institutional nature, is not and cannot be
of a customary nature. This will give rise to a sensitive
issue should the United States unilaterally establish the
outer limits of its continental shelf, even if it were to
follow the criteria set out in the Convention before
acceding to it. Nevertheless, it can be held that, at least
in its general lines, the establishment of the outer
limits of the continental shelf indicated in the 1982
Convention has by now become customary law. In this
connection, it is worth recalling that, in the period
between the opening to signature and the entry into
force of the Convention (1982-1994), some states
(Chile, Ecuador, Iceland), drawing inspiration from the
rules of the Convention, proclaimed the outer limits of
their respective continental shelves and that the
objections raised by some states concerned the way in
which the Convention had been applied and not the
principle of such application.
In the delimitation of the maritime zones between
states with coasts adjacent or opposite, the importance
of clearly determining the boundary line is evident for
the purposes of the exploitation of resources. When
mineral resources, in particular, are concerned the oil
companies are reluctant to make commitments by
means of investments in contested maritime zones.
Indeed, some maintain that there is a customary rule
that prohibits the unilateral exploitation of such zones.
In many cases, states with coasts opposite or
adjacent delimit maritime zones by agreement. Even
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the general rules on the matter (arts. 15, 74 and 83 of
the 1982 Convention concerning the territorial sea, the
exclusive economic zone and the continental shelf,
respectively) grant priority to agreements between the
parties. In practice, such agreements are numerous:
there are a couple of hundred. Many delimitations are
however still to be made. States, in determining the
boundary between their maritime zones by agreement,
are obviously free to take into account various
considerations specifically pertinent to maritime
zones, as well as other aspects of their relations. An
examination of the agreements actually stipulated
shows however that the median line, equally distant
from each of the coasts, plays an important part. This
line is, in many cases, the departure point for
negotiators, with respect to which corrections are
agreed to take into account special circumstances,
especially geographical features (such as the presence
of islands) as well as the presence of mineral resources
or fishing banks.
In the agreements, particular solutions are often
found when deposits of hydrocarbons or fishing banks
have been discovered that straddle the boundary line.
Provision can be made for joint exploitation,
exploitation by one party but with the other party
receiving a certain percentage of the product or
profits, etc. sometimes resulting in the creation of a
common development zone that can be crossed by the
boundary line: thus, for example, the agreement
between Saudi Arabia and Kuwait on partition of the
neutral zone of 7 July 1965; the Convention between
France and Spain on the delimitation of the territorial
sea and the contiguous zone in the Bay of Biscay of 29
January 1974; the agreement between Norway and the
United Kingdom relating to the exploitation of Frigg
field of 10 May1976.
In the absence of agreement, concerning the
territorial sea, the 1982 Convention, adopting the
wording of the 1958 Convention, applies the median
line, unless historic title or special circumstances
justify a different boundary line (art. 15). The same
rule concerning the continental shelf is found in art. 6
of the Geneva Convention on the continental shelf.
The identical rules are contained in arts. 74 and 83 of
the 1982 Convention. They omit a reference to the
median line and State that delimitation shall be
effected “by agreement on the basis of international
law, as referred to in art. 38 of the Statute of the
International Court of Justice, in order to achieve an
equitable solution”. Literally, such a rule seems to
constitute only a directive states ought to follow when
stipulating agreements on delimitation. Considering
the liberty states enjoy in concluding their agreements,
its binding content seems minimal as it consists
merely an obligation to negotiate in good faith, an
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obligation already stressed, in the light of customary
law, by the International Court of Justice in its
judgments of 1969 on the North Sea continental shelf.
It is held, however, that the rule is valid also when the
determination of the maritime boundary is entrusted to
a judge or arbitrator. The idea that delimitations should
be effected according to equitable principles had
however already been enunciated in 1969 by the
International Court of Justice in its judgments already
mentioned, in which the equidistance principle was not
considered a rule of customary law even though the
Court admitted that the equidistance method could be
used with, or as an alternative to, other methods,
depending on the area. This judgment undoubtedly
influenced the formulation of arts. 74 and 83 of the
1982 Convention.
In their search for equitable principles on the basis
of rules of customary international law – rules whose
very existence is uncertain – international judges and
arbitrators in the end enjoy notable discretionary
powers accentuated by the diversity of circumstances
which makes each delimitation case unique. Case law,
subsequent to the judgment of 1969, however,
gradually worked out criteria for reaching an equitable
solution. Thus, the idea of proportionality between the
relevant coasts’ lengths (the determination of which is,
however, hardly indisputable) and the extension of the
marine areas assigned to each state was emphasized. It
was then held that certain geographical features had to
be taken into account. Thus the concave form of the
coast on the North Sea led to the correction of the
equidistance line which, if applied, would have left
Germany, squeezed between the projections of the
coasts of the Netherlands and Denmark, too small a
share of the continental shelf. Thus, on several
occasions case law conferred less value (or none at all,
as in the case of the controversial judgment of 1982 of
the International Court of Justice in the case
concerning the important Tunisian island of Jerba;
Tunisia v. Libya) on islands situated close to the coast
of one State. Around islands of one state, situated near
the coast of another but on the wrong side of the
equidistance line between the main coasts, case law
has designated usually rather small enclaves or semi-
enclaves. This was done in the arbitral award of 1977,
rendered in the dispute between France and the United
Kingdom with respect to the Channel Islands which,
although belonging to the United Kingdom, are
situated close to the French coast and, in the dispute
between Canada and France concerning the French
islands of Saint-Pierre-et-Miquelon, located close to
the coast of the Canadian province of Newfoundland
with the addition of a narrow corridor providing
access to the high seas (in the award rendered in
1991). Also Italy and Tunisia decided likewise in their
496
agreement of 1971 concerning the Italian islands of
Pantelleria, Linosa, Lampione and Lampedusa which
are located on the wrong side of the equidistance line
between Sicily and Tunisia. Criteria based on
geomorphological factors had some relevance in the
parties’ pleadings in disputes concerning the
delimitation of the continental shelf but less in the
decisions of judges and arbitrators as long as the
delimitation of the continental shelf was based on the
Geneva Convention and on the concept of the natural
prolongation of the continental mass. Once the 200
mile limit established in the 1982 Convention had
become established, and even before the entry into
force of the 1982 Convention, criteria based on
geomorphological factors ceased to be relevant: this
clearly emerges from the judgment in the case
concerning the continental shelf between the Libya
and Malta of 1986.
Whereas the abovementioned judgment of 1969
concerning the North Sea and the judgment of 1982 in
the dispute between Libya and Tunisia insist in
particular on the irrelevance of the equidistance
criterion, an irrelevance reflected in arts. 74 and 83 of
the 1982 Convention, there seems to have been a
return, in the subsequent evolution of case law, to the
positions adopted in the Geneva Convention on the
Continental Shelf. Recent case law has transformed
the procedure that negotiators of delimitation
agreements have actually followed in many cases into
a delimitation method. Already in 1993, in its
judgment on the maritime delimitation in the area
between Greenland and Jan Mayen Island (Denmark
v. Norway), the Court stressed it was «difficult to point
out a substantial difference» between the application
of art. 6 of the Geneva Convention on the continental
shelf and the application of the rule of customary law
that requires recourse to equitable principles. The most
recent judgments complete this evolution affirming
that “the criteria, principles and rules of delimitation
[…] are expressed in the so-called equitable
principles/relevant circumstances method. This
method, which is very similar to the
equidistance/special circumstances method applicable
in delimitation of the territorial sea, involves first
drawing an equidistance line, then considering
whether there are factors calling for the adjustment or
shifting of that line in order to achieve an equitable
result”. Thus, the judgment of 2002 on the dispute
between Cameroon and Nigeria, repeating previous
Statements.
A further evolution which is common to practice
with respect to agreements and case law is the fact
that, whereas until the mid-1980s problems of
delimitation arose in connection with the territorial sea
as well as with the continental shelf alone, now, as a
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result of claims being made concerning the water
column expressed in the establishment of 200-mile
wide fishing zones and exclusive economic zones,
they are also arising with respect to those zones.
Hence the problem of whether there should be one or
more delimitation lines.
The agreements stipulated in the two subsequent
decades tend to adopt a single line of delimitation of
the seabed, the water column, the continental shelf, the
fishery zone and the exclusive economic zone that
sometimes (above all in the absence of 200-mile
proclaimed zones or when there is only a fishery zone)
is expected to apply also to maritime zones not yet
established. However, agreements establishing
different lines of delimitation of the seabed and of the
water column (for example the agreement of 18
December 1979, in force since 1985, between
Australia and Papua New Guinea) can be cited. In the
many cases in which an agreement for the delimitation
of the continental shelf exists, contracting states have
extended its application to the water column and,
therefore, also to the fishery or exclusive economic
zones established at a later date. This result is obtained
by special agreements. In the light of the judgment of
the International Court of Justice of 1984 in the case
concerning delimitation of the maritime boundary in
the Gulf of Maine Area (between Canada and the
United States), it does not seem right to maintain that
there is a rule of customary law that makes provision
for the automatic “rising to the surface” of the lines of
delimitation adopted for the continental shelf.
As far as case law is concerned, in the majority of
disputes, since the one decided in 1984 concerning the
Gulf of Maine, the parties in their special agreements
request the judge to determine the course of a single
line concerning, for example, the continental shelf and
the fishery zones of the two countries or “all rights
and jurisdiction of the parties recognized by
international law” in the maritime areas belonging to
them (case concerning the delimitation of maritime
areas between Canada and France in the area of
Saint-Pierre-et-Miquelon decided by an arbitral tribunal
in 1992). In the judgment cited above concerning the
Gulf of Maine, the Court decided on the criteria to be
followed for delimitation by a single line. It held that
criteria relevant only to the seabed or to the water
column (for example, the presence of mineral deposits,
fishing banks) must be disregarded in favour of
criteria of a geographical nature that are more neutral.
In its judgment of 1993 on the maritime
delimitation in the area between Greenland and Jan
Mayen, the Court had not been requested to draw a
single line of delimitation even though it had been
called on to draw the line of delimitation that separates
the continental shelf and fishery zones. The Court
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took into consideration the factors pertinent to each of
the abovementioned maritime zones separately and
then concluded that the lines of delimitation of each
zone coincided as, however, the parties had
maintained. The single line, at least within 200 miles
will, in the future, always more frequently be indicated
as the subject of disputes concerning delimitation (as
already occurs in the agreements) in view of the fact
that, as already mentioned, within 200 miles, the
economic zone includes all the economic claims
relating to the seabed and the water column.
It is of considerable interest that international
judges and arbitrators recognize the role played by oil
concession contracts stipulated by states which are
party to a delimitation dispute. Importance was given
to such concessions in the judgment of 1982 in the
dispute between Libya and Tunisia as confirmation of
a previous modus vivendi of the parties. Whereas in
various subsequent judgments importance was not
accorded to oil concessions, in the judgment of 2002,
in the dispute between Cameroon and Nigeria, the
International Court of Justice, in drawing up what it
had enunciated previously, declared that, “although the
existence of an express or tacit agreement between the
parties on the siting of their respective oil concessions
may indicate a consensus on the maritime areas to
which they are entitled [...], oil concessions and oil
wells are not in themselves to be considered as
relevant circumstances justifying the adjustment or
shifting of the provisional [i.e. equidistant]
delimitation line”. Moreover, it is evident that the oil
concessions are more relevant when it is a matter of
delimiting the continental shelf than when a judge or
arbitrator has to draw a single line of delimitation.
This clearly emerges from the Eritrea-Yemen arbitral
award of 1999. The arbitral tribunal, affirming, on the
one hand, that the petroleum contracts entered into by
the parties lent “a measure of support” to a median
line between the main coasts drawn without regard to
the islands, underlined, on the other, that, as it was a
matter of establishing a single polyvalent line, “the
presence of islands requires careful consideration”.
10.2.4 Mineral resources in zones
under national jurisdiction:
the exploration
and exploitation regime
Over the continental shelf “the coastal State exercises
sovereign rights for the purpose of exploring it and
exploiting its natural resources” (art. 77, para. 1, of the
1982 Convention, repeating what the 1958 Geneva
Convention on the continental shelf confirms). It
follows that the shelf is not comparable to the territory
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because the coastal State’s rights are limited
functionally to the exploration and exploitation of the
resources. Such rights are, however, exclusive as only
the coastal State has the right to carry out those
activities and also to curb the corresponding violations
with criminal and administrative penalties. Therefore,
other States can carry out activities of exploration and
exploitation only when authorized to do so by the
coastal State and in conformity with the coastal State’s
legislation, which in turn must conform to the
Convention. This principle is at the base of the oil laws
adopted by many states, making provision for
procedures for opening up sectors of the continental
shelf to exploration, for authorizing national and
foreign companies to carry out activities of
exploration and exploitation and for penalties in cases
of violation thereof.
The sovereign right of the coastal State is
reinforced by art. 81 of the 1982 Convention according
to which, “The coastal state shall have the exclusive
right to authorize and regulate drilling on the
continental shelf for all purposes”. One of the
fundamental activities carried out in connection with
prospecting for and exploring hydrocarbons in this way
falls under the authority of the coastal state even when
it is not the intention of the state conducting the drilling
to explore or to exploit resources. This depends on the
fact that, whatever its purpose in a specific case,
drilling can provide useful information with respect to
resources. This provision, in turn, is completed by art.
246 on marine scientific research in the exclusive
economic zone and on the continental shelf. Art. 246
states that scientific research in such zones can be
conducted only where the coastal state consents it.
Although such consent must normally be granted for
research conducted for peaceful purposes and in order
to increase knowledge of the marine environment for
the benefit of all mankind (so-called pure scientific
research), a coastal State, however, may withhold its
consent at its discretion if, among other things, the
project for which authorization was requested “involves
drilling into the continental shelf, the use of explosives
or the introduction of harmful substances into the
marine environment” or “is of direct significance for
the exploration and exploitation of natural resources,
whether living or non-living” (art. 246, para. 5). In
such cases the pure nature of research is not relevant.
The sovereign rights of the coastal state are not
however unlimited. They “do not affect the legal status
of the superjacent waters or of the air space above
those waters” (art. 78, para. 1). The superjacent waters
belong, in the majority of cases, to the exclusive
economic zone. Where that zone has not been
proclaimed, or when the portion of the continental
shelf situated beyond the 200-mile limit is involved,
498
they belong to the high seas. Above all, “the exercise
of the rights of the coastal state over the continental
shelf must not infringe or result in any unjustifiable
interference with navigation and other rights and
freedoms of other states as provided for in this
Convention” (art. 78, para. 2). This provision does not
entirely coincide with the similar provision in art. 56,
para. 2, according to which, in exercising its rights in
the exclusive economic zone, the coastal state “shall
have due regard to the rights and duties of other states
and shall act in a manner compatible with the
provisions of this Convention”. The failure to mention
the obligation to have due regard to the rights of other
states and to act in conformity with the Convention is
explained by considering that the paragraph cited
basically repeats art. 5, para. 1 of the Geneva
Convention on the continental shelf which was
stipulated at a time when any extension of the coastal
state’s powers beyond the territorial sea was seen as
being exceptional. The wording concerning the
continental shelf would seem to give the freedom of
the high seas in superjacent waters a status superior to
the rights of the coastal state over the shelf, while it is
not possible to speak of this superiority with respect to
the exercise of these freedoms in the economic zone.
The obligation of states to have “due regard” to
freedom of the high seas in exercising the rights
indicated in art. 56, para. 2, reinforced by the mutual
obligation to have due regard to the rights of the
coastal state in enjoying freedom of the high seas (art.
58, para. 3), excludes this superiority. Notwithstanding
the difference in wording, it would nevertheless seem
reasonable to assert that the enjoyment of the freedom
of the high seas is no less limited in the waters
superjacent to the continental shelf than it is in the
exclusive economic zone. The most serious practical
consequences of the principle contained in art. 78,
para. 2, regard installations (see below).
According to art. 208 of the 1982 Convention,
coastal states are obliged to adopt laws and regulations
to prevent, reduce and control pollution arising from,
or in connection with, seabed activities subject to their
jurisdiction and from artificial islands and installations
under their jurisdiction. Such laws and regulations
must not be less effective than those adopted at
international level. It should be pointed out, however,
that in this field few international rules have been
adopted, and even fewer are in force.
10.2.5 Artificial islands,
installations and structures
The coastal state’s sovereign rights over its continental
shelf extend to structures built on it. The usefulness of
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 INTERNATIONAL LAW OF THE SEA AND EXPLOITATION OF THE SEA’S RESOURCES
these structures in the exercise of those rights is
evident. The 1982 Convention lays down detailed rules
concerning artificial islands, installations and
structures (art. 60, to which art. 80 makes reference).
None of these structures possesses the status of an
island, has a territorial sea of its own or affects the
delimitation of maritime zones (art. 60, para. 8).
The coastal state has the exclusive right to
construct and to authorize and regulate the
construction of these structures. This right is
unconditional where artificial islands are concerned.
However, installations and structures must be
for the purposes of exploiting resources or economic
purposes or there is a possibility that they will
interfere with the exercise of the rights of the coastal
state in the economic zone or on the continental shelf.
Some states have eliminated such a restriction by
means of domestic laws or specific interpretative
declarations. Other states have reacted by maintaining
that such laws and declarations are incompatible with
the 1982 Convention.
Not only does the 1982 Convention not provide a
definition of the three types of structures mentioned
but it is also terminologically unclear because a
provision concerning dumping (art. 1, para. 5)
mentions “platforms or other man-made structures”. It
can also be held, however, that on the basis of the
current meaning of the terms, while artificial islands
are characterized by an indefinite permanence both in
terms of placement and length of time, installations
and structures (the distinction between the two is
irrelevant as the two terms are always used together)
connote less permanent structures susceptible to being
removed or dismantled.
The 1982 Convention does not explicitly consider
mobile oil rigs which, even though carrying out their
drilling activities once they have been fixed on the
seabed, are shifted by tugs or are self-propelled. As
can be seen in some national laws (for example, an
Italian decree of 1979 and a Canadian law of 1996),
according to which oil rigs are subject to the regime
for installations and structures when they are fixed on
the seabed but have to be considered ships when they
no longer are fixed to the seabed, can be considered to
conform to the principles of the Convention. The same
may be said of drillships, the ship aspect of which is
prevalent, but which begin to drill once they have been
fixed on the seabed.
The coastal state has exclusive jurisdiction over
these structures on the continental shelf, including
jurisdiction with regard to customs, fiscal, safety and
immigration laws and regulations (1982 Convention,
art. 60, para. 2). Some states have extended their
legislation in general terms to cover structures on their
continental shelves, thereby going beyond what is
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provided in the cited provision which explicitly
indicates the matters to which the exclusive
jurisdiction refers. It seems possible that actual
implementation of such laws and regulations could
give more rise to friction at the international level both
in terms of police and judiciary than to an extension of
sphere of application of laws and regulations.
The Convention governs the compatibility of
artificial islands, installations and structures with
freedom of navigation through detailed rules. The
coastal state must give notice of the construction of
artificial islands, installations and structures and
maintain permanent means to warn about their
presence (art. 60, para. 3). Where necessary, the
coastal state may also establish safety zones around
such artificial islands, installations and structures in
which it may take measures to ensure the safety both
of navigation and of the artificial islands, installations
and structures. The breadth of these safety zones, of
which due notice must be given, must also be
“reasonably related to the nature and function” of the
artificial islands, installations and structures and shall
not, in any case, exceed a distance of 500 m around
them, except as authorized by the IMO (paras. 4 and 5)
and must be respected by all ships (para. 6).
Nevertheless, “artificial islands, installations and
structures can not be constructed and the safety zones
around them may not be established where
interference may be caused to the use of recognized
sea lanes to international navigation” (para. 7).
When installations and structures are abandoned or
cease to be used, problems arise concerning their
removal to ensure compatibility with freedom of
navigation and other rights of other states (the
permanent nature of artificial islands excludes them
from this problem). Whereas the Geneva Convention
on the continental shelf makes provision for the
unconditional obligation of removal, the 1982
Convention, in the light of costs and, in many cases, of
the difficulties involved in removing installations that
can be very large, lays down a more flexible rule.
Abandoned or disused installations and structures
must be removed, but taking into account any
generally accepted international standards established
in this regard by the IMO. This must be done to ensure
safety of navigation, but also having due regard to
fishing, the protection of the marine environment and
the rights and duties of other states; also appropriate
publicity must be given to the position of remaining
elements on the seabed of any installations or
structures not entirely removed (art. 60, para. 3). Only
partial removal has become current practice also in the
light of guidelines adopted by the IMO in 1989. The
guidelines confirm the obligation of entire removal in
cases of abandoned or disused installations near straits
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or important international navigation lanes; at the
same time it foresees exceptions which allow
abandonment or partial removal based on an
assessment of a series of factors concerning
navigation, risks to the environment, costs and risks
involved in the removal and the possibility of other
uses. The decision adopted in 1998 by States which are
party to the Convention for the Protection of the
Marine Environment of the North-East Atlantic (the
OSPAR Convention, 22 September 1992) on the
occasion of the ministerial meeting of the OSPAR
Commission held in Sintra, Portugal, is inspired by
similar approaches but is more precise.
Disposal of the installations once removed is
considered in the perspective of pollution. The 1996
protocol to the 1972 London Convention on dumping
indicates “platforms and other man-made structures at
sea” among the objects that can be dumped at sea on
the basis of an authorization.
10.2.6 Cables and pipelines
As has already been seen, among the freedoms of the
high seas that exist in the exclusive economic zone is
the right to lay submarine cables and pipelines, limited
by the obligation to have due regard to the rights of the
coastal state. This principle which, in view of the
nature of the activity, applies to the continental shelf as
the seabed of the economic zone, is expressed in art.
79 which applies to the continental shelf even when it
extends beyond the 200-mile limit. This article seeks
to specify the terms of co-existence of the
above-mentioned freedom and the coastal state’s
sovereign rights concerning the exploration and
exploitation of the continental shelf’s resources.
It should, however, be stated in advance that as an
effect of the reference to the principles applicable to
the high seas contained in art. 56, arts. 112-115 –
relating to cables and pipelines in high seas – also
apply to submarine cables and pipelines on the
continental shelf. To a large extent, these articles
repeat the provisions of the Paris Convention for the
protection of submarine telegraph cables (14 March
1884) but extend them to include pipelines. Articles
112-115 affirm the principle that in laying cables
and pipelines, due regard must be paid to cables and
pipelines already in position, and the obligation not to
prejudice possibilities of repairing those cables and
pipelines (art. 112, para. 2, with reference to art. 79,
para. 5). Moreover, provision is made for the
obligation to qualify the breaking or damage to these
cables and pipelines by a ship flying the flag of the
state party to the Convention or by a person subject to
its jurisdiction, done wilfully or through culpable
500
negligence, as well as conduct resulting in such
breaking or damage, as a punishable offence under its
domestic laws (art. 113). Where the breaking or
damage is caused by the laying of other cables and
pipelines, there is an obligation to pay compensation
(art. 114).
Where cables and pipelines on the continental shelf
are concerned, the 1982 Convention confirms, on the
one hand, the right of all states to lay cables and
pipelines on the continental shelf and the consequent
obligation of the coastal State not to impede the laying
and maintenance thereof (art. 79, paras. 1 and 2). On
the other hand, this obligation is subordinate to the
coastal state’s right to take reasonable measures for the
exploration and exploitation of the continental shelf
and for the reduction and control of pollution from
pipelines (art. 79, para. 2). A further limit to the
freedom to lay cables and pipelines derives from the
fact that the coastal state, which has the right to
establish conditions for cables and pipelines entering
its territorial sea, also has the right to authorize the
course for the laying of such cables and pipelines
which foreign states intend to lay on its continental
shelf (art. 79, paras. 3 and 4). In order to proceed in
laying cables or pipelines it is consequently necessary
to make known to the coastal state the data which will
enable it to assess both the course and possible
interference with its own economic activites and with
the environment. Negotiation aimed at obtaining
authorization for the course therefore becomes
indispensable. This means that the freedom to lay
cables and pipelines on the continental shelf has a
residual value.
In addition to this, none of the provisions
mentioned prejudice the coastal state’s jurisdiction
“over cables and pipelines constructed or used in
connection with the exploration of its continental shelf
or exploitation of its resources or the operations of
artificial islands, installations and structures under its
jurisdiction” (art. 79, para. 4). These cables and
pipelines are therefore submitted to the regime
applicable to the structures in connection with which
they are used, in particular where customs and safety
laws and regulations are concerned.
10.2.7 The regime of mineral
resources
of the international seabed
In part XI and in annexes III and IV the 1982
Convention dedicates lengthy treatment to the regime
for the mineral resources (as has already been seen in
para. 2, above all to polymetallic nodules, but also
others in perspective) found on the seabed beyond
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 INTERNATIONAL LAW OF THE SEA AND EXPLOITATION OF THE SEA’S RESOURCES
national jurisdiction, namely in the Area. The
prospect of exploiting those resources as the
common heritage of mankind was the topic that
initiated the negotiations in 1968 which led to the
conclusion of the Convention on the Law of the Sea
in 1982. The dissatisfaction with part XI and related
annexes III and IV expressed by the United States
and by other industrialized states involved, through
their investment undertakings, in the exploration and
exploitation of polymetallic nodules, led those states
to vote against or to abstain from voting the adoption
of the Convention. They clearly indicated that the
change in their attitude with respect to the
Convention depended on important modifications to
those provisions. The most heavily criticized aspects
concerned the insufficient importance accorded to
the industrialized states on the Council of the
International Seabed Authority which was being
established, the position, considered too strong,
granted to the international seabed Enterprise (an
operative organ, international in nature) which was
being established, the rules regarding financial
matters and the transfer of technology which were
considered too burdensome. Modest progress was
made in the direction desired by the industrialized
states during the work (1983-1994) of the
Preparatory Commission set up on the basis of the
final act of the Third United Nations Conference on
the Law of the Sea.
Nevertheless, approaching the entry into force of
the Convention, on the initiative of the
Secretary-General of the United Nations, following
special consultations, an agreement was drawn up
concerning the application of part XI of the
Convention and adopted by resolution n. 48/263 of
the General Assembly of the United Nations of 28
July 1994 in which the essential parts of the
industrialized states’ requests were included. This
result was reached partly because, in the experts’
opinion, the industrial exploitation of polymetallic
nodules was still uncertain, and in any case far off,
partly because pre-eminent importance was given to
the facilitation of the deposit of as large a number of
ratifications and accessions to the Convention as
possible in view of the need for the universality of a
Convention that covers two thirds of the terraqueous
globe. This also made the constitution of the
International Seabed Authority, strongly desired by
developing countries, acceptable to industrialized
countries, even though there was no prospect of
industrial activity on the seabed.
The 1994 agreement introduces amendments to
and lays down rules for the interpretation of part XI
of the 1982 Convention. It is an integral part of the
Convention and its provisions, in the case of a
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conflict, prevail over those of the Convention. Since
its adoption, ratification of or accession to the
Convention must be only in conjunction with the
agreement. The majority of states which at that date
were already parties to the Convention ratified the
1994 agreement. In actual fact, also the states that
have not done so follow its provisions, at least those
concerning the functioning of the International
Seabed Authority. Following the 1994 agreement the
majority of industrialized states (including all
member States of the European Communities and the
European Community itself) became parties to the
Convention. The only important exception is the
United States. Notwithstanding the favourable
attitude of the Clinton and Bush administrations,
the Senate of the United States has not yet given
its approval.
The law applicable to the regime concerning the
exploration and exploitation of the international
seabed therefore consists of part XI of the Convention,
including annexes III and IV, as amended by the 1994
agreement as well as by the regulations adopted by the
International Seabed Authority.
The regime provided by the abovementioned rules
seeks to reconcile the fact that the resources in the
Area are the common heritage of mankind and must
therefore be beneficial to all states, with the fact that
only a few developed states, and in many cases their
public or private enterprises, have the technological
and financial capabilities to exploit the resources.
Provision is made for a parallel system under the
regulations and supervision of the International
Seabed Authority (an organization whose seat is in
Kingston, Jamaica, and whose member states are all
parties to the Convention) whereby an attempt is made
to develop, in parallel, mineral sites allocated to
operators from states parties to the Convention (or
their consortia) and the Enterprise which is being
established. At the base of the system is the so-called
banking system by means of which the consortia of the
States parties to the Convention, after having carried
out prospecting activities, submit to the Authority a
proposed contract for exploration (that can then be
transformed into a contract for exploitation)
concerning an area large enough for two mining
operations, indicating also the ways to divide that area
into two equivalent sectors. The Authority stipulates
the contract for one of the portions of the area
indicated and allocates the other to the international
part of the parallel system which finds therefore the
prospecting already completed.
The actual functioning of the international part of
the parallel system has turned out be weakened and
perhaps in doubt in the light of the 1994 agreement.
The international Enterprise will only be established
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INTERNATIONAL LAW
as an autonomous organ in the distant future and will
be able to begin functioning only by means of joint
ventures with developing states or their enterprises.
The financial obligations that would have provided the
Enterprise with means to start its operative activities
have vanished.
Contracts for exploring the seabed are regulated
not only by the Convention but by the regulations on
prospecting and exploration for polymetallic nodules
in the Area of 13 July 2000. These regulations set out
detailed requisites concerning technical and financial
capabilities, submission of data from prospecting, and
marine environmental protection. Applications are
examined by the legal and technical Commission of
the Council of the Authority, a technical organ
composed of 15 members elected by the Council,
which decides by majority. The contract is then
forwarded for final approval to the Council. However,
the Council’s approval is almost automatic as the
contract is considered approved unless disapproved by
a qualified majority decision. This ought to shield a
contract approved by the technical organ against the
possibility of being blocked by a political organ. In
fact, seven contracts were stipulated in 2001 with
enterprises from India, China, Russia, various states
of Eastern Europe, Cuba, the Republic of Korea,
France and Japan.
Concerns were particularly felt during negotiations
about the possible formation of monopolies and about
the situation of states whose mineral resources on land
could suffer from competition from minerals extracted
from the seabed. These concerns became the subject of
detailed provisions of the 1982 Convention and are
still mentioned in the current text. The detailed
provisions on these subjects have largely been
abrogated and, given the industrial inactivity on the
seabed, have no practical relevance. Worries about the
protection of the environment, little considered before
1982, have instead emerged during negotiations for the
regulations of 13 July 2000. These regulations devote
various provisions to this matter, providing among
other things that both the Authority and states that
“sponsor” an activity subject to a contract take the
precautionary approach mentioned in principle 15 of
the Rio Declaration on Environment and Development
of 1992.
At the heart of the regime for exploration and
exploitation envisaged by the Convention lies the
International Seabed Authority. It has authority to
make rules, approve contracts for the exploitation of
the Area’s resources as well as to verify that they have
been performed correctly. The obligations of states
towards the Authority and the abovementioned powers
are the concrete content of the principle that “all rights
in the resources of the Area are vested in mankind as a
502
whole, on whose behalf the Authority shall act” and
that “no state or natural or juridical person shall claim,
acquire or exercise rights with respect to the minerals
recovered from the Area except in accordance with
this part [of the Convention]. Otherwise, no such
claim, acquisition or exercise of such rights shall be
recognized” (art. 137).
The principal organs of the Authority are: the
Assembly, the Council and the Secretariat, as well as
the Enterprise, already mentioned, and a Finance
Committee, not envisaged in the Convention but
established under pressure exerted by industrialized
states. The Assembly is the supreme plenary organ. It
adopts and renders final the decisions proposed by the
Council. The Council is a relatively small organ
composed of 36 members at the heart of the entire
activity of the Authority. It is an organ that makes
proposals to the Assembly; it is a final
decision-making organ with respect to the proposals
for contracts submitted by the legal and technical
Commission, its subsidiary organ, and also enjoys
powers of its own.
The Council’s composition and method of
deliberation are therefore decisive. After the 1994
agreement, while half of the 36 seats are allocated so
as to ensure an equitable geographical distribution of
seats in the Council as a whole as well as a balance
between developed and non-developed countries, the
remaining 18 seats are allocated to four interest groups
forming four chambers. These chambers represent: a)
the most important consumers of metals extractable
from the minerals of the Area; b) the eight states
which have made the largest investments in the
conduct of activities of exploration and exploitation in
the Area; c) the principal producers on land of the
abovementioned metals (in equal numbers developed
states and developing states); d ) developing states
representing special interests. The first three chambers
are composed of four members each, the fourth
chamber of six. The Council makes its decisions by a
two thirds majority. Special interests are however
safeguarded, with respect to possible adverse
decisions, by the rule introduced by the 1994
agreement according to which a decision has been
validly adopted only in the absence of an objection of
the majority within even only one of the chambers.
Moreover, some decisions falling within a limited
number of categories must be taken by consensus.
These are the decisions on measures to protect
developing states from negative effects on their
economies or on the export of minerals extracted from
the Area and on the provisional adoption of rules,
regulations and procedures concerning prospecting,
exploration and exploitation pending approval by the
Assembly.
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 INTERNATIONAL LAW OF THE SEA AND EXPLOITATION OF THE SEA’S RESOURCES
10.2.8 Non-mineral resources
in the economic zone
and on the high seas
Under the 1982 Convention the coastal state has
sovereign rights for the purpose of exploiting and
managing the biological resources in the exclusive
economic zone. According to the provisions on fishing
in this zone, the coastal state must promote the
objective of optimum utilization of these resources.
For this purpose, taking into account the scientific
information available, the coastal state determines the
allowable catch of the living resources and the amount
of the allowable catch it is capable of harvesting. Only
where a portion of the allowable catch is not harvested
by the coastal state, is the coastal state obliged to give
other states access to the surplus of the allowable catch
in its economic zone, and first of all those states of the
region which do not have access to the sea. As
provision must be made for this by means of
agreements, the coastal state’s obligation, therefore, is
to simply negotiate. Corollaries of the coastal state’s
rights are the power to issue laws and regulations
concerning fishing in the economic zone, that must
also be observed by foreign ships, and policing powers
with respect to ships, including arrest at sea and
judicial proceedings. The last mentioned power is
however attenuated by the obligation to release
promptly, upon the posting of reasonable bond,
arrested vessels and their crews and by the exclusion
of penalties or imprisonment and any other form of
corporal punishment that can be inflicted by the
coastal state (art. 73).
On the high seas there is freedom to fish as well as,
however, the obligation to take measures on the basis
of scientific data, applicable to ships and nationals, to
ensure the conservation of the resources and
cooperation with other states. Such cooperation must
preferably take place within the framework of specific
agreements and organizations that already exist or are
to be established.
In the period following the adoption of the 1982
Convention, there was particular interest in the high
sea fishing of straddling stocks (species that occur
between the high seas and the economic zone) and
highly migratory species such as tuna fish. Made the
subject of bare provisions, whose interpretation was
controversial, by the 1982 Convention (arts. 63 and 64,
in relation to art. 116, b), these species had found
themselves at the centre of attention of the fleets on
the high seas, excluded from the exclusive economic
zones, and claimed by the coastal states in difficulty,
on account of the excessive fishing by these fleets
often carried out in their economic zones. Under the
impulse of the 1992 Rio Conference on Environment
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
and Development, on 4 December 1995 an agreement
was reached by th United Nations concerning the
application of the provisions of the 1982 Convention –
relating to the straddling stocks and highly migratory
species – came into force on 11 December 2001. This
agreement combines the approaches of the law of the
sea and environmental law. It includes, for example,
the precautionary principle and, while bearing in
mind the needs of coastal states, adopts forms of
international collaboration, avoiding confirmation of a
preference for indiscriminate freedom or the extension
of the jurisdiction of coastal states. Regional
agreements to implement the 1995 agreement were
concluded in Honolulu, for the Western and Central
Pacific in 2000, and in Windhoek (Namibia) for the
Southeastern Atlantic in 2001.
10.2.9 Dispute settlement
The 1982 Convention, unlike most conventions for the
codification of international law, makes provision for a
settlement of dispute mechanism whose characteristic
is that it is compulsory in the sense that disputes
concerning the interpretation or application of the
Convention can be submitted, at the request of one of
the parties, to decision by a judge or by an arbitrator
whose decision is binding (art. 286).
As far as the body called on to carry out these
compulsory procedures is concerned, the Convention
makes provision for a complex mechanism involving
various adjudicating bodies: the new International
Tribunal for the Law of the Sea, the International
Court of Justice and arbitral tribunals having general
competence or special arbitration tribunals for certain
matters. The competent organ will, in fact, be the one
that both parties to the dispute have chosen in specific
optional declarations. Nevertheless, in the case of
diverging declarations, the choice of arbitration is
presumed, reinforced by the fact that the same
presumption occurs in the case in which one state has
not expressed its preference in a declaration (art. 287).
Indeed, only about thirty states have made the special
declaration, so that the competent adjudicating body as
provided in the Convention in most cases ends up
being an arbitral tribunal with general competence,
governed by the rules contained in annex VII to the
Convention. It should be added that the mechanism of
compulsory procedures envisaged in the 1982
Convention is applied only where no other compulsory
mechanism is applicable to the dispute between the
parties (art. 282).
Not all possible disputes concerning the
interpretation and application of the Convention are
subject to the principle of compulsory adjudication.
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INTERNATIONAL LAW
Some matters are subject to limitations indicated in
art. 297 that apply automatically unless the parties
have decided otherwise in a specific case; others are
subject to the exceptions for which provision is made
in art. 298 that apply only when one state party to the
Convention has, in a special declaration, stated its
wish to take advantage of said exceptions.
The principles just summarily recalled apply to
matters here considered, both as concerns limits and
the delimitation of maritime zones, as well as activities
relating to the exploitation of the resources.
As far as the outer limits of the various zones are
concerned, apart from what has been said concerning
the continental shelf beyond 200 miles, their
determination by the coastal state can give rise, where
incompatibilitiy with the Convention is maintained, to
objections, but hardly to real disputes. These, however,
can actually arise where a coastal state wishes to
exercise powers outside the limits, material or
geographical, provided by the Convention, with
respect to another state. This occurred in the Saiga
case n. 2, decided in 1999 by the International
Tribunal for the Law of the Sea, in which policing
within a customs zone 250 km wide established by
Guinea was held illegal.
Disputes relating to the delimitation of maritime
zones between states with contiguous or facing
coasts are subject to the compulsory procedures for
which the Convention makes provision. states which
are party to the Convention have, however, the
power not to accept compulsory procedures for such
disputes by means of a special declaration for which
art. 298 makes provision. Only about twenty states,
however, have taken advantage of this power. Even
where the exception is applicable, for disputes that
have arisen after the entry into force of the
Convention and in matters not concerning
sovereignty over land territory, recourse to a
conciliation commission is however envisaged at the
request of one of the parties.
Disputes concerning the interpretation and
application of the provisions on the exploitation of the
continental shelf’s mineral resources are not subject to
compulsory procedures as long as they concern the
exercise by the coastal state of its sovereign rights or
jurisdiction; for example, when they concern the
content of laws governing oil-related activities that can
be carried out on the continental shelf. However, such
disputes are subject to compulsory procedures when
they concern conflicts between the exercise by the
coastal state of its rights and the freedoms of
navigation, overflight, the laying of submarine cables
and others granted to all states in the economic zone
by the Convention, or when they concern alleged
violations by the coastal state of specified
504
international rules for the protection and preservation
of the marine environment (art. 297, para. 1, a, b, c).
Disputes concerning the activities of exploration
and exploitation in the international seabed Area are
subject to the compulsory exclusive jurisdiction of the
Seabed Disputes Chamber set up within the
International Tribunal for the Law of the Sea. This
Chamber, composed of 11 members of the Tribunal,
not only has jurisdiction in disputes between states, or
between states and the Authority, concerning the
interpretation and application of relevant provisions of
the Convention, but also in disputes concerning the
interpretation and application of contracts, or pre-
contractual questions or civil liability, to which also
physical and juridical persons may be parties. There is
also the possibility of submitting questions of contract
interpretation to international commercial arbitration,
suspending the decision of the seabed disputes
Chamber that retains exclusive jurisdiction to interpret
the Convention. With respect to the interpretation of
the contract, the Chamber will therefore abide by the
arbitrator’s decision. The mechanism is inspired by
that of the preliminary ruling of the Court of Justice of
the European Union.
Where disputes concerning the exploitation of
living resources in the economic zone are concerned,
principles similar to those illustrated in connection
with mineral resources are observed. The provision on
this matter (art. 297, para. 3) states, however that, in
certain cases excluded from compulsory jurisdiction,
disputes arising from manifest abuses by the coastal
State may be submitted, at the request of any party, to
a conciliation commission.
Disputes concerning the exploitation of living
resources in the high seas come under compulsory
jurisdiction, on account of which provision is not
made for limitations or exceptions. It should be
stressed that, according to the agreement on straddling
stocks and the Honolulu and Windhoek regional
conventions, the rules of the 1982 Convention
governing dispute settlement are applicable to disputes
concerning the application or interpretation of the
provisions of said agreement and regional conventions
even where the states parties to the dispute are not
parties to the 1982 Convention.
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 10.3
Environmental protection
in the petroleum industry
10.3.1 Introduction
The Oil and Gas (O&G) industry, by its very nature, is
environmentally intrusive. Various environmental
problems arise throughout the entire petroleum cycle,
including upstream and downstream phases, but they
especially occur at the stage of O&G Exploration and
Production (E&P) and transportation. The
international petroleum industry is encountering
increasing pressure from governments and civil
society for continued enhancement of its performance
from the point of view of limiting its impact on the
environment.
Posing a serious challenge to the O&G industry
are: a) demands for significant reduction of hazardous
wastes at source; b) more stringent regulation of
discharges and emissions from petroleum production
installations and refineries; c) stricter controls of oil
transportation by ships and pipelines; and d )
rehabilitation of the production sites upon
abandonment and increased energy efficiency. At the
same time, international petroleum companies are
exposed to a rapidly growing body of international and
national regulations, standards and various guidelines,
as well as to risks associated with environmental
litigation.
Three main levels of regulation can be identified
within the complex and intertwined web of
environmental norms and standards that currently
exist: international (global and regional); national; and
corporate self-regulation in the form of industry-wide
or individual company guidelines. The balance
between various levels of regulation and their relative
importance primarily depends on the type and nature
of activity in question. The higher the potential for
international implications – whether in the form of
pollution or any other transboundary effect – the more
prominent the role played by international law. On the
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
whole, the world is witnessing an internationalization
of environmental controls, as international law-making
on environmental matters is becoming more
centralized, thus reducing the room for standard
setting at the individual state level.
International regulations, primarily in the form of
various international treaties, often directly or
indirectly determine (through the process of national
implementation), both the content of national
regulations, and the general conduct of states and the
industry. At the global level, there is a large group of
binding instruments as well as numerous soft law
(non-binding) type documents of relevance to the oil
and gas industry. The most important of these will be
discussed in this paper, which will provide an in-depth
analysis of some selected areas of international
environmental regulation of particular concern to the
E&P activities. This will be followed by a more
general overview of the national environmental legal
frameworks and industry-specific environmental
management practices.
10.3.2 Environmental impact
of the petroleum industry
O&G activities always entail certain environmental
effects, or impacts, at local, regional and even global
level. These impacts vary depending on the type of
activity – petroleum E&P, transportation by ships or
pipelines, refining, processing of crude oil and gas
products and burning of fossil fuels for energy
production, as well as its scale, location (onshore or
offshore) and the nature and sensitivity of the
surrounding environment.
Petroleum E&P activities are accompanied by a
variety of operational discharges, some of which are
more harmful than others. At the E&P stage, most of
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the impact is relatively localized, but may acquire a
transboundary dimension in the case, for example, of
an offshore development. Seismic operations and
exploratory drilling are usually associated with noise,
vibration, various disturbances of the local
environment – including vegetation and wildlife – soil
erosion and changes in surface hydrology. Onshore
activities may require construction of roads and
vegetation clearance over significant territories.
During exploration drilling, discharges are mostly
composed of drilling fluids and cuttings, which may
contain hydrocarbons and surface-active chemicals.
Similarly, produced waters at varying degrees of
salinity are discharged. Disposal of waste, atmospheric
emissions and discharges of effluents, containing oil,
chemicals and other harmful substances is a common
environmental problem. These may also contain
hydrocarbons and residual treatment fluids. Although
impact during this stage of operations is usually
relatively minor and confined in terms of time and
space, it can be substantial in sensitive areas.
Impact becomes more pronounced during
production activities, as this phase involves active
recovery of hydrocarbons from producing formations.
Operations at the development and production stage
often result in increased discharges. This stage is also
characterized by growing risks of accidental pollution
by oil, soil and water contamination from spillage and
leakage.
Rehabilitation, restoration, reinstatement,
reclamation of the petroleum E&P sites – including
the disposal of offshore oil platforms – are among the
most technically and economically serious problems
which face the petroleum industry in the long-term
perspective. As oil fields approach the end of their
productive life, the question of what to do with
existing structures has to be addressed.
Decommissioning covers: a) cessation of well
operations; b) removal of plant and equipment;
c) removal or partial removal of any fixed or floating
structures; d ) removal or stabilization of drill cuttings;
e) decommissioning or removal of pipelines; f ) and
rehabilitation of the seabed, along with any related
onshore activities (e.g. recycling or stabilization of
waste). Although decommissioning, as such, does not
pose serious threats to the environment, abandoned
offshore installations can create obstacles for other
uses of the sea – primarily navigation and fishing
activities – and their complete removal is seen as the
best solution in the majority of cases.
At the transportation stage of oil and petroleum
products, the operational pollution by discharges of
oily waters and drainage from ships, as well as oil
spills resulting from collisions or other accidents
involving oil tankers is of primary concern. On-land or
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submarine petroleum pipelines’ construction and
operation have the potential for a variety of
environmental impacts, from the destruction of
habitats and clearance of vegetation during the
construction, to oil spillages and leakages resulting
from possible pipeline ruptures due to natural and
man-related causes. The impact of thousands of
construction workers on the local environment during
several years of construction can be massive.
Trenching for buried submarine pipelines creates
major impact on the benthos environment and habitats.
Impact on wetlands and surface water bodies may be
particularly serious.
At the stage of processing oil and gas, petroleum
refineries and petroleum distribution systems generate
a series of different kinds of hazardous wastes.
Refining operations produce wastes from each step of
the refining process: both water and sludges
contaminated with petroleum, hazardous waste
containing persistent and toxic contaminants, spent
catalysts (which often contain heavy-metal
constituents), as well as atmospheric emissions such as
benzene, toluene and other toxic air pollutants.
Finally, petroleum processing – especially burning
of the fossil fuels – is the major source of criteria air
pollutants: Particulate Matter (PM), carbon dioxide
(CO2), nitrogen oxides (NOx), carbon monoxide (CO),
hydrogen sulphide (H2S), and sulphur dioxide (SO2).
In particular, these emissions lead to two principal
environmental problems: long-range transboundary air
pollution causing acid rain; and more importantly,
global warming as a result of build-up of the so-called
greenhouse gases in the atmosphere. The latter is a
problem of a truly global proportion, of concern to
both international community and global petroleum
industry.
Thus, the main environmental media affected by
various oil and gas activities include the atmosphere,
aquatic environment (both freshwater and marine),
terrestrial ecosystems – especially
environmentally-sensitive, including wild fauna and
flora. The primary sources of atmospheric emissions
include combustion processes, gas flaring, fugitive
gases from loading operations, and particulates from
other burning sources. Waste streams from E&P
operations, including produced water, drilling fluids,
process and drainage water and so forth affect the
aquatic environment. Potential impact on terrestrial
ecosystems, including soil, plant and animal
communities, arise from construction, contamination
as consequence of spills and solid waste disposal, and
other physical disturbances. Consequently, various
petroleum activities constituting the entire
hydrocarbon fuel cycle are exposed to environmental
regulations – international and national – that deal
ENCYCLOPAEDIA OF HYDROCARBONS

with specific areas of the global environment, such as
water, air, biodiversity and others.
10.3.3 International environmental
legal frameworks relevant
to the petroleum industry
International legal principles
International law plays an increasingly important
role in determining the response to the energy-related
environmental problems by governments, industry and
international institutions. Some basic concepts that
emerged at the international level and that have been
endorsed in numerous global and regional agreements
and accepted at the national level, provide the legal
foundation that individual countries and petroleum
companies have to follow or take into account while
enacting, enforcing or complying with relevant
national legislation. These concepts have crystallized
into a set of legal principles that are governing the
petroleum industry’s operations worldwide.
Sustainable development. This is commonly
defined as “Development that meets the needs of the
present without compromising the ability of future
generations to meet their own needs”. Economic
development and environmental conservation should
be mutually supportive and should be pursued
nationally and internationally. The concept of
sustainable development calls for integrating
environmental considerations into developmental
policies, programmes and specific projects. It implies
that natural resources should be exploited in a wise or
optimal manner. Sustainable development is about
ensuring that the petroleum industry contributes
lasting benefits to society through the consideration of
social, environmental, ethical and economic aspects by
maximizing its broader contributions to society while
minimizing its negative impacts. While a particular
petroleum development may not be sustainable
because the reserves will deplete over time, it can still
make a valuable contribution to a society’s overall
pursuit of sustainable development by creating
employment and paying taxes and royalties that can
contribute to government services. With respect to
non-renewable natural resources, including petroleum,
which are finite by definition, a concept of
quasi-sustainability has been advanced. In essence,
this means, that petroleum development should be
aimed at ensuring the maximum recovery of the
resource while minimizing adverse effects on the
environment. More generally, quasi-sustainability is
understood as a compensating investment in a
sustainable substitute in such a manner as to provide,
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at the end of the life of petroleum resources, an annual
sustainable yield equal to the income portion of the
receipts from petroleum resources (Gao, 1998). The
overall objective of this approach is to save a portion
of the state’s wealth for future generations by, among
other things, creating petroleum trust funds and
similar financial mechanisms.
The principle of prevention. Protection of the
environment is better achieved by preventing
environmental harm than by remedying or
compensating for such harm. Not only is harm
sometimes irreversible, but preventive measures are
usually more effective and less costly than ex post
facto action. They are also most efficient when aimed
at the sources of environmental impact. The preventive
approach is applicable to all actors wherever the
consequences of the activities may be felt. This
principle does not require the prevention of all
possible harm, but rather imposes an obligation to
minimize detrimental consequences of permissible
activities through regulation. The principle of
prevention is usually implemented by means of
application of minimum standards (emission controls,
emission limit values, environmental quality standards
and objectives) or use of the Best Available Techniques
(BATs) or Best Environmental Practices (BEPs). BAT
is understood as the latest stage of development (state
of the art) of processes, facilities or methods of
operation, which indicate the practical suitability of a
particular measure for limiting emissions and waste.
Techniques include both the technology used, and the
way in which the installation is designed, built,
maintained, operated and dismantled. BEP refers to
the application of the most appropriate combination of
environmental control measures and strategies.
Environmental impact assessments are also widely
employed to identify potential threats to the
environment so that preventive measures can be taken.
The precautionary principle. Precaution requires
taking appropriate action, to anticipate, prevent and
monitor the risks of potentially serious or irreversible
environmental harm from human activities, even
without scientific certainty. The precautionary
approach is linked with the principle of prevention, but
is designed to apply to a situation of scientific
uncertainty by reversing the traditional burden of
proof. It calls for action even when there is no full
scientific knowledge about the precise degree of risk
of potentially serious or irreversible environmental
damage. The precautionary principle’s relevance to the
petroleum activities is obvious.
The ‘polluter pays’ principle. The costs of
preventing, controlling and reducing pollution
(harm to the environment) are to be borne by those
responsible for causing such harm and the
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consequential costs. The principle is primarily an
economic one aimed at internalizing the costs of
pollution control, clean-up and protection measures.
Implementation of the ‘polluter pays’ principle is
usually achieved at the national level through the
use of various economic instruments, such as
taxation, charges, insurance, civil liability and
compensation.
The variety of international regulatory instruments
of relevance to the petroleum industry is extremely
broad. Their scope and emphasis differ depending on
the nature of activities regulated, type of the protected
environmental media, geographical reach, number of
the countries involved and so forth. Along with truly
global conventions, especially dealing with protection
of the marine environment, biodiversity and
atmosphere, there are geographically limited regimes
adopted either under the auspices of the United
Nations (UN), such as the UN Economic Commission
for Europe (UNECE), organizations of regional
economic integration, such as the European
Community (EC), or with regard to particular regions
(regional seas or geographically-specific areas, such as
North America).
Some areas of international environmental
regulation that are especially relevant to the petroleum
sector – primarily including the marine environment,
global atmosphere and climate change, as well as
conservation of biodiversity – will be discussed in
detail in the following part of this paper. It is worth
having a brief overview of other important regulatory
regimes which affect international petroleum
operations.
The 1994 Energy Charter Treaty (ECT) is one such
instrument and the first of its kind focusing entirely
and specifically on the energy sector. Although its
geographical scope is currently limited, mostly to
Eurasia (western and central Europe, former USSR,
Japan and Australia), this instrument, in principle, is
open for accession of other states regardless of their
geographical location. Along with provisions dealing
with trade in energy products and investment
promotion and protection, it pays attention to
energy-related environmental issues by encouraging
application of the precautionary principle and of the
‘polluter pays’ principle. An environmental article of
the ECT calls for the minimization of harmful impacts
from all operations within the energy cycle,
environmental integration in energy policy, reflection
of environmental costs in energy price, harmonization
of environmental standards and so forth. A special
protocol on energy efficiency and related
environmental aspects contains more detailed
provisions aimed at reducing environmental impacts of
energy systems and activities.
510
The European Community environmental legal
framework represents probably the most extensive and
comprehensive body of environmental principles,
rules, standards and procedures at the regional level.
While the general objectives and principles of the EC
law are set out in the European Community Treaty, the
Community policy on the environment has been
progressively developed in six action programmes,
addressing among other key areas; a) sustainable
management of natural resources; b) climate change;
c) integrated pollution control and prevention of
waste; d ) reduction in consumption of non-renewable
energy. These policy objectives are reflected in more
than 250 environmental directives, regulations and
decisions, which affect – either directly or indirectly –
the petroleum industry.
Among the most important EC instruments is the
96/61/EC Directive on Integrated Pollution Prevention
and Control (IPPC Directive), which is aimed at
enforcing an integrated approach to controlling
pollution arising from various activities. These include
combustion energy installations, mineral oil and gas
refineries, chemical installations for the production of
simple hydrocarbons, oxygen-containing hydrocarbons,
and sulphurous and nitrogenous hydrocarbons. The
IPPC Directive establishes a mechanism of pollution
control through the system of authorizations and
permits based on the concept of BAT. Under the
1985/1997 EIA Directives (Directives 85/337/EEC and
97/11/EC on Environmental Impact Assessment) both
up and downstream operations and facilities (petroleum
E&P, crude oil refineries, oil and gas pipelines, large
thermal power plants, storage installations, and so on)
are subject to mandatory assessment.
A wide range of the EC legislative instruments
deal with the protection and improvement of various
environmental components, such as air, freshwater
resources, marine environment, nature and
biodiversity, ozone layer, climate change. They also
address specific activities, issues or substances of
concern, such as industrial plants, sulphur dioxide and
nitrogen dioxide, waste disposal and hazardous
substances, etc. Suffice it to mention in this respect
Directive 94/22/EC on the Conditions for Granting
and Using Authorizations for the Prospection,
Exploration and Production of Hydrocarbons, or the
Directive 84/360/EEC on the Combating of Air
Pollution from Industrial Plants.
International protection
of the marine environment
General remarks
There are a large number of global and regional
conventions which are primarily applicable to
ENCYCLOPAEDIA OF HYDROCARBONS

pollution of the marine environment by oil – either as
a result of operational discharges or accidents
involving vessels and offshore platforms. International
legal regime of pollution prevention by oil and other
hazardous substances can be regarded as the most
developed and is based on: the 1982 United Nations
Convention on the Law Of the Sea (1982 UNCLOS);
the 1973/1978 International Convention for the
Prevention of Pollution from Ships (known as
MARPOL 73/78, MARine POLlution); and some
framework regional conventions adopted with respect
to specifically defined maritime areas.
The 1982 UNCLOS is an ‘umbrella’ instrument
whose primary objective is to create a comprehensive
legal regime for the world’s seas and oceans. It aims to
apportion rights and obligations among various
categories of states, and to serve as a basis for further
development of particular rules and standards in
combating marine pollution, including pollution
arising from navigation and seabed activities. The
UNCLOS grants states the sovereign right to exploit
their natural resources pursuant to their environmental
policies, in accordance with their duty to protect and
preserve the marine environment. Part XII of the
UNCLOS specifically deals with the protection of the
marine environment from various sources, including
exploration and production of offshore mineral
resources. It requires states to take measures to
prevent, reduce and control marine pollution from any
source, using the best practical means at their disposal,
and applying generally accepted standards, norms and
recommended practices and procedures.
Many such standards are contained in the
MARPOL 73/78, which is aimed at combating
pollution of the marine environment by discharges of
harmful substances or effluents containing such
substances, including oil. Its primary objective is to
prevent and control the vessel-source marine pollution
but it also applies to certain environmental aspects of
the offshore E&P operations.
Alongside cooperation at global level, regional
approaches have proved to be a popular way of dealing
with environmental problems of common concern.
Frequently, in fact, the appropriate level for
environmental action is the regional one, partly
because this approach offers the opportunity for
custom-built regimes and more stringent legislative
standards – as limited membership often implies a
higher common denominator. The importance of
regional approaches, of course, is recognized in the
law of the sea itself. While the 1982 UNCLOS is
primarily concerned with establishing a global legal
framework governing all aspects of ocean use, it
makes express reference to regional rules, programmes
and cooperation.
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Since the early 1970s a variety of regional treaties
and protocols covering distinct maritime areas have
evolved to deal with various forms of marine
pollution, including pollution from offshore E&P
activities. Currently, there are some 20 conventions
dealing with marine environmental protection on a
regional basis. A regional approach, for example, has
been chosen by the states bordering the north-east
Atlantic, the Baltic, the Mediterranean and the Black
seas, the Persian (Arabian) Gulf, the Red Sea and the
Gulf of Aden, the west and central- African region, the
east-African region, the east-Asian region, the South
Pacific region, the south-east Pacific region, the
south-west Atlantic region and so forth. The United
Nations Environment Programme (UNEP) in
particular, has been instrumental in fostering a
regional identity in combating marine pollution
through its Regional Seas Programme.
Operational pollution from petroleum
E&P operations
The 1982 UNCLOS is the principal global
instrument which deals with prevention and control of
marine pollution, including from land-based sources
and offshore petroleum development. Articles 208 and
214 embrace both aspects of anti-pollution measures:
regulation and implementation. Coastal states are
required to adopt and enforce laws and regulations in
respect of marine pollution arising from seabed
activities. Such laws and regulations are to be no less
effective than international rules, standards and
recommended procedures and practices. Similarly,
states are called upon to harmonize their policies at the
appropriate regional level and to establish global and
regional rules to control and prevent marine pollution
from offshore installations.
In its Agenda 21, the 1992 UN Rio Conference on
Environment and Development (UNCED) expressly
referred to the offshore petroleum activities as
requiring additional measures to address degradation
of the marine environment from discharges and
emissions.
The MARPOL 73/78 applies to discharges from
both vessels and offshore platforms, specifically to
any releases – including “any escape, disposal,
spilling, leaking, pumping, emitting or emptying”.
However, it does not apply to marine pollution directly
resulting from offshore operations, for example, in
connection with the use of oil-based drilling muds or
leakage of oil during well testing.
Annex I of the MARPOL 73/78, which deals with
pollution by oil, applies to machinery space drainage
from drilling rigs and other platforms. As to offshore
processing drainage, production water discharge and
displacement discharge, there are currently no global
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rules or standards applicable to these effluents. Such
discharges are partly dealt with by regional
conventional regimes and partly by national
regulations, which often apply different standards.
Protection of the marine environment against
pollution by garbage is governed by Annex V, which
equally applies to vessels and offshore installations. It
contains special provisions concerning fixed or
floating platforms engaged in the exploration,
exploitation and associated processing of seabed
mineral resources.
Finally, Annex VI on air pollution sets limits on
sulphur oxide and nitrogen oxide emissions from ship
and platform exhausts and prohibits deliberate
emissions of ozone-depleting substances.
While practically all regional conventions establish
general provisions concerning pollution from, or in
connection with, seabed activities, some have been
supplemented by protocols and subordinate
instruments which address the offshore E&P activities.
Certain regional regimes, especially those in the
maritime areas with significant hydrocarbon activities,
current or potential, establish detailed regulations.
These include the Baltic Sea, the north-east Atlantic,
the Persian (Arabian) Gulf and the Mediterranean Sea.
In the 1992 Convention on the Protection of the
Marine Environment of the Baltic Sea Area (Helsinki
Convention), the general obligation to take all
measures to prevent pollution of the marine
environment – resulting from exploration and
exploitation of the seabed and the subsoil or from any
associated activities – is elaborated in Annex VI,
which constitutes an integral part of the Convention. It
sets out relatively detailed procedures and measures to
be realized by states with respect to offshore
petroleum operations conducted in the areas under
their jurisdiction. This procedure addresses a wide
range of issues, including implementation of BAT and
BEP, EIA and monitoring, discharges in the phases of
exploration and exploitation, reporting and exchange
of information, as well as contingency planning and
abandonment. Annex VI contains a number of
provisions regulating operational discharges from
offshore platforms in both the exploration and
exploitation phases which apply primarily to
oil-containing discharges. Provisions of Annex IV,
which deal with discharges of garbage and sewage,
also apply to offshore platforms.
The 1992 Convention for the Protection of the
Marine Environment of the north-east Atlantic (1992
OSPAR, OSlo PARis Convention) has a special Annex
III dealing with the prevention and elimination of
pollution from offshore sources. However, compared
to other similar regional instruments, it does not
provide any technical requirements and standards, but
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rather relatively general rules and concepts, which,
apparently, are to be further developed through the
decisions and recommendations of the OSPAR
Commission, entrusted with development of
programmes and measures for the elimination and
reduction of marine pollution. The regulations adopted
by the OSPAR Commission cover most of the
important aspects of direct operational pollution:
production of oily waters and drilling muds and
drilling cuttings. Much of the regulatory work of the
OSPAR Commission, with regard to the reduction of
discharges of oil from offshore installations, has been
conducted by the Offshore Industry Committee.
Annex III of the 1992 OSPAR Convention
prohibits any dumping of wastes or other matter from
offshore installations, which does not apply, however,
to discharges and emissions. It is provided instead, that
the use in offshore sources, or the discharge or
emission from them, of substances – which may reach
and affect the maritime area – must be strictly subject
to the authorization or regulation by the competent
authorities of state parties. It is evident that the
OSPAR Commission will continue to play the most
important role in developing appropriate standards and
regulations related to offshore activities.
The 1976 Kuwait Regional Convention for
Cooperation in the Protection of the Marine
Environment (1976 Kuwait Convention) has some
general provisions on pollution resulting from
exploration and exploitation of the continental shelf,
and a special protocol concerning marine pollution
resulting from exploration and exploitation of the
continental shelf (1989 Protocol). The latter requires
that measures against marine pollution from offshore
operations should be taken on the basis of “the best
available and economically feasible technology”. The
Protocol contains a broad range of
pollution-prevention measures, from the licensing
system and EIA, to specific regulations of discharges
of oil and oily waters, oil-based drilling fluids,
water-based drilling muds, chemical substances,
garbage and sewage.
The 1994 Protocol for the Protection of the
Mediterranean Sea against Pollution Resulting from
Exploration and Exploitation of the Continental Shelf
and the Seabed and its Subsoil is the most elaborate
document of its kind. The 1994 Protocol sets out
detailed provisions regarding authorization of offshore
exploration and exploitation operations, regulation of
operational pollution, safety measures and emergency
situations, removal of installations, specially protected
areas, and so forth.
To summarize, despite the importance of offshore
hydrocarbon reserves and the growing attention being
given to the environmental impacts of offshore E&P
ENCYCLOPAEDIA OF HYDROCARBONS

activities – particularly as regards waste management
– there is presently no global regime regulating the
entire spectrum of operational pollution from offshore
oil and gas E&P activities. Instead, a combination of
general instruments, both in the form of hard law and
soft law, as well as technical regulations and standards,
supplemented by more specific regional instruments,
represents a constantly evolving legal framework for
controlling and abating this type of marine pollution.
Accidental pollution by oil
Legal instruments which govern accidental
pollution response and cooperation do not, as a rule,
distinguish between various types of potentially
hazardous activities and emergency situations. The
term emergency is generally used to define any
situation which causes, or poses, an imminent threat of
seriously harming the environment or other legitimate
interests of other states or areas beyond national
jurisdiction. Substantial international legal practice has
developed over the last decades to deal with accidental
pollution. The main objective of most of the relevant
international instruments is to harmonize national oil
pollution response policies and procedures, primarily
through unification of state contingency planning and
improving preparedness to emergency situations.
The 1982 UNCLOS addresses the accidental
pollution connected with offshore activities in a very
general manner. The states are required to take
measures in order to minimize – to the fullest extent
possible – pollution from offshore installations, with
particular emphasis being accorded to measures “for
preventing accidents and dealing with emergencies”.
In the area affected by imminent or actual damage,
they should cooperate in eliminating the effects of
pollution and preventing, or minimizing, the damage
through the promotion and joint development of
Contingency Plans (CPs). This is seen as the most
effective means to tackle this type of pollution.
Adopted under the auspices of the International
Maritime Organization (IMO), the 1990 International
Convention on Oil pollution Preparedness, Response
and Cooperation (OPRC), is the only global
international instrument of this kind. Its overall
objective was to create a basis for international
cooperation in responding to pollution emergencies as
well as to enhance existing national, regional and
global capabilities concerning pollution preparedness
and response, to facilitate mutual assistance, and to
develop and maintain adequate organizational and
technical infrastructures. The Convention deals
exclusively with emergencies involving pollution by
petroleum in any form, including crude oil, fuel oil,
sludge, oil refuse and refined products. Offshore
petroleum platforms are covered by the conventional
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regime, in addition to ships and other oil-related
facilities.
Under the convention, states – subject to their
capabilities and availability of relevant resources – are
required to cooperate and to render assistance to
parties that request such assistance in cases of
pollution incidents. The Convention requires that
parties establish national systems for responding to oil
pollution incidents, including, as a basic minimum: a
national CP; designated national authorities; and
operational contact points in charge of oil pollution
response. Parties – either individually or through
cooperation with other states and, as appropriate, other
relevant entities, including the oil industry – are
required to establish:
• A minimum level of pre-positioned oil spill
combating equipment, proportionate to the risk
involved, and programmes for its use.
• Programme of exercises for oil pollution response
organizations and training of relevant personnel.
• Detailed plans and communication capabilities for
responding to oil pollution incidents.
• A mechanism or arrangement to coordinate the
response to oil pollution incidents with, if
appropriate, the capabilities to mobilize the
resources.
In addition, the Convention requires that operators
of offshore units have oil pollution emergency plans,
which are coordinated with the national system for
preparedness and response, and approved in
accordance with established procedures. Those in
charge of offshore installations are to report without
delay about any event on their unit or any event at sea
involving a discharge of oil or the presence of oil to
the coastal state to whose jurisdiction this unit is
subject.
A special role under the OPRC Convention is
assigned to the IMO. The IMO provides general
guidance for states, and oil and shipping industries,
assisting them in creating an organizational framework
and preparing CPs at the local, national and
international levels. The most important condition for
the establishment and sustainable functioning of an
effective oil pollution response system is close
cooperation between the oil and shipping industries
and governments. This interrelationship is reflected in
two planning approaches that currently co-exist in the
international arena: the international industry’s
concept of a tiered response; and governmental
arrangements at the local, national and international
levels.
Tiered response has been accepted as an
operational concept that provides a convenient
categorization of response levels, corresponding to the
severity of the spill, and a practical basis for planning.
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Governmental measures regarding preparedness and
response are grouped as well. Group 1 normally
encompasses the entire national response system with
the national CP as the basic document that defines the
national response policy. Group 2 consists of bilateral
or multilateral response plans or agreements with
other countries as well as with competent regional
bodies. Such multilateral arrangements have already
been developed for the Baltic and North seas as well
as for some maritime regions covered by the UNEP
Regional Seas Programme. Finally, group 3 is the
network of inter-regional plans or agreements. This
includes the operation of the IMO Oil Pollution
Coordination Centre and relationships, both formal
and informal, among the various regional bodies
worldwide.
The importance of effective regional arrangements
and response systems with respect to accidental
pollution is evident, as usually more than one coastal
state suffers from accidental pollution. No country,
regardless of its individual capability, can sustain the
level of equipment and personnel necessary in the
worst-case spill. These arrangements are similar in
many respects. The North Sea and north-east Atlantic
contingency agreements, the contingency measures
with respect to the Baltic Sea and the UNEP regional
seas framework conventions and supplementary
protocols are particularly instructive in this respect.
The 1983 Bonn Agreement for Cooperation in
dealing with Pollution of the North Sea by Oil and
Other Harmful Substances – which replaced an earlier
1969 Bonn Agreement – covers accidental pollution
from offshore installations presenting a grave and
imminent danger to the coast or related interests. It
promotes an active cooperation through a
two-dimensional approach, which combines
preparatory and organizational cooperation as well as
cooperation following the casualty. It was the first
agreement to introduce the principle of allocation of
zones of responsibility, which was eventually
incorporated into other analogous agreements. The
pollution emergency preparedness and response
measures applicable to the Baltic Sea area are very
similar to those related to the North Sea with one
exception: they constitute an integral part of a
comprehensive anti-pollution instrument – the 1992
Helsinki Convention on the Protection of the Marine
Environment. The numerous conventions adopted
within the scope of the UNEP Regional Seas
Programme are almost identical in their approach to
pollution emergencies.
Supplemental protocols dealing with pollution
emergencies are very similar, both in terms of their
structure and the substantive content of their
provisions. They define procedures of information
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exchange and reporting in cases of emergency
pollution as well as providing guidelines for respective
reports. In addition, they call for the maintenance and
promotion of national and, if necessary, regional and
sub-regional plans, providing for mutual assistance of
parties and, in certain cases, determine how and on
what conditions such assistance should be conducted.
Finally, the protocols establish certain institutional
arrangements, including the creation of special
regional mechanisms charged with emergency
communications and collecting and disseminating
information, coordinating of national response
activities, and in some cases, initiating clean-up
operations at the regional level.
Finally, two regional protocols on seabed activities
add considerably to the body of international law
dealing with pollution emergency – the 1989 Kuwait
Protocol and the 1994 Mediterranean Protocol. Among
other provisions, the Protocols contain regulations
specifically tailored to pollution-emergency prevention
and response involving offshore installations. The state
parties are required, inter alia, to ensure that every
offshore installation which is to be used within their
jurisdiction is properly certified for safety, in order to
guarantee that it will not cause accidental damage to
the marine environment. No offshore operations may
begin without a CP approved by a competent national
authority and coordinated with existing national or
local CPs. The respective roles and powers of the
industry and the authorities should be fully understood
before any oil spill emergency arises and explicitly
allocated in the operator’s CP as well as in any local
and national CP. Offshore operators are required at all
times to have available, and in good working order,
“equipment and devices to minimize the risk of
accidental pollution and to facilitate prompt response
to a pollution emergency, in accordance with good
oilfield practice”.
Along with global and regional contingency
arrangements, some maritime areas are covered by
bilateral CPs, based on agreements between the two
coastal states concerned, such as between the United
States and Canada of 1974 and 1977, and between the
US and Mexico of 1980. The number of bilateral
arrangements is relatively small, and they are applied
predominantly to sensitive areas, such as the Arctic, or
to areas intensively used for international navigation or
offshore petroleum production. Not surprisingly, such
CPs are more comprehensive and detailed than their
regional analogies as it is easier to achieve an effective
degree of coordination on a bilateral, rather than
multilateral, level.
Such bilateral CPs include, inter alia, NorBritPlan
between the United Kingdom and Norway with respect
to the North Sea, DenGer between Denmark and
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Germany, ManchePlan between the UK and France, and
the Canada-US Contingency Plan for the Beaufort Sea.
Though adopted with respect to different geographical
areas, these arrangements have similar objectives and
features.
Decommissioning of offshore petroleum
installations
The question of abandonment/removal of
decommissioned offshore installations has turned into
a problem of practical concern with the aging of some
early offshore petroleum production areas. How this
problem is to be resolved will be determined in many
respects by the applicable international legal
framework, based on a number of global and regional
agreements, soft law instruments and relevant state
practice.
The 1958 Geneva Convention on the Continental
Shelf was the first international instrument which
addressed the issue of abandonment. It requires
generally that the exploration and exploitation of the
continental shelf must not result in any “unjustifiable
interference” with other activities in the sea. Whereas
the construction and exploitation of installations are
subject to this general provision, the issue of
abandonment is specifically addressed in art. 5.5,
which provides that “[a]ny installations which are
abandoned or disused must be entirely1 removed”.
The 1982 UNCLOS contains substantially
differing provisions on the same matter in art. 60.3.
Under the new formula, the requirement of a complete
removal is not absolute. In certain cases, partial
removal is permitted, provided that appropriate
publicity is given to the depth, position and
dimensions of the remains. The criteria relevant to
determining the extent of this partial removal include
the obligation to ensure safety of navigation and due
regard to fishing, the protection of the marine
environment, and the rights and duties of other states.
As to the possible conflict of legal obligations
stemming from art. 60.3 of the UNCLOS vis-à-vis the
complete removal requirement of the 1958 Geneva
Convention, the issue must be considered depending
on the ‘participating’ status of states concerned. For
those states which are party to the UNCLOS, the latter
prevails, as between states parties, over the 1958
Geneva Conventions on the Law of the Sea. Given that
the overwhelming majority of states are now party to
the 1982 UNCLOS, provisions of the 1958
Continental Shelf Convention should be seen as
redundant. The post-Geneva development of
international law in the field indicates a major shift in
the state practice, from the requirement of absolute
removal towards a more flexible approach regarding
abandonment.
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This conclusion is supported by the IMO 1989
Guidelines and Standards on the Removal of
Offshore Installations and Structures on the
Continental Shelf and in the Exclusive Economic
Zone (EEZ). Although the IMO guidelines and
standards are not binding, their authority makes them
more than mere recommendations. The IMO
Guidelines reiterate the partial removal approach
embodied in the UNCLOS. The states are requested
to entirely remove all disused installations and
structures, except where non- or partial removal is
consistent with the guidelines and standards. The
removal operation should be performed as soon as is
reasonably practicable after abandonment or
permanent disuse, and the IMO should be notified of
any installations or structures not entirely removed.
A case-by-case approach is promoted in order to
determine such special circumstances which may
allow an offshore installation or part of it to remain in
situ. Evaluation of the following factors is particularly
important:
• Any potential effect on the safety of surface or
sub-surface navigation, or other uses of the sea.
• The rate of deterioration of the material and its
present and possible future effect on the marine
environment.
• The potential effect on the marine environment,
including living resources.
• The risk that the material will shift from its
position at some future time.
• The costs, technical feasibility, and risks of injury
to personnel associated with removal of the
installation or structure.
• The determination of a new use or other reasonable
justification for allowing the installation or
structure or parts thereof to remain on the seabed.
The IMO Guidelines provide for the entire removal
of all abandoned or disused installations standing in
less than 75 metres of water and weighing less than
4,000 tons in air, excluding deck and superstructure.
The same requirement applies to all installations and
structures placed on the seabed on or after 1 January
1998 standing in less than 1,000 metres of water and
weighing less than 4,000 tons.
The complete removal requirement is qualified by
two exception clauses, based on certain factors. The
first allows a coastal state not to remove disused
installations when they will serve a new use if
permitted to remain wholly or partially in place on the
seabed. The second gives a coastal state a right to
determine whether a complete removal of a platform is
technically feasible, extremely costly or likely to
1 Emphasis added by the Author.
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create an unacceptable risk to personnel or the marine
environment. In addition, existing platforms in water
depths of greater than 75 metres or weighing more
than 4,000 tons can be wholly or partially left in place
where it is determined by the coastal state that they do
not cause unjustifiable interference with other uses of
the sea. Importantly, the IMO Guidelines require that
no installations should be placed on the continental
shelf or in the EEZ after 1 January 1998 unless the
design and construction of such an installation permits
its entire removal.
Other requirements of the IMO recommendations
include:
• Adequate maintenance of abandoned or disused
installations or their parts, projecting above the
surface of the sea, in order to prevent their
structural failure.
• Provision of an unobstructed water column (no less
than 55 m) sufficient to ensure safety of navigation
above any partially removed installation that does
not project above the surface of the sea.
• Complete removal (without any exceptions) of any
installations located in approaches to or in straits
or routes used for international navigation.
• Indication of abandoned parts on nautical charts
and their proper marking, where necessary, with
aids to navigation.
Finally, states must ensure that legal title to
installations which have not been entirely removed is
unambiguous and that responsibility for maintenance
and the financial ability to assume liability for future
damages are clearly established.
From a technical point of view, the IMO
Guidelines constitute a well-balanced document
reflecting the best solutions of the problem of
abandonment currently available. From the legal point
of view, however, they do not have the status of
international norms creating obligations for states.
Obviously, nothing can preclude states from adopting
and implementing the IMO Guidelines in their
domestic practice and legislation. However, they
cannot prevail over existing treaty obligations, unless
they are transformed into law through proper legal
procedures or accepted as a rule of general
international law by state practice.
Parallel to these global conventional regimes, the
issue of abandonment has been addressed on a
regional level, particularly in oil-rich maritime
regions. Among numerous conventional regimes, those
related to the north-east Atlantic, the Mediterranean
and the Persian/Arab Gulf regions are of particular
interest in this respect. Additional protocols on
offshore E&P activities, such as the 1994
Mediterranean Sea Protocol, along with other matters,
address the issue of abandonment.
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The 1994 Protocol does not request the complete
removal of abandoned or disused offshore installations
and pipelines. While the operator is in principle
required to remove any installation which is abandoned
or disused, this is qualified by the reference to the
guidelines and standards adopted by the competent
international organization such as IMO. Provisions
regarding disused pipelines are even less stringent: they
can be left in place – abandoned or buried – under the
condition that they neither cause pollution, nor
interfere with other legitimate uses of the sea.
The 1989 Kuwait Protocol only obliges the parties
to empower their competent national authorities with
the right to require the operator of an offshore
installation (platform or other seabed apparatus and
structures) to remove the installation in whole or in
part to ensure the safety of navigation and in the
interests of fishing. In the case of pipelines, the
operators may be requested to flush and remove any
residual pollutants from the pipeline, and to bury the
pipeline, or remove part and bury the remaining parts.
The Protocol calls for the states parties to adopt a
common policy on the removal, but only when they
have a common interest in fishing grounds in the
conventional area. It further requires states, while
determining whether or not installations should be
removed, to take into account any guidelines issued by
their regional organization.
Regulation of the disposal of offshore installations
as a form of dumping
Parallel to the removal regimes, there is a body of
international norms and standards governing disposal
of offshore installations as a form of dumping at sea.
“It is to these rules rather than those on removal that
reference must be made in assessing the legality of
such operations as the disposal of concrete platforms
by towing them to a deep-water dumping site, or the
on-site ‘felling’ of steel platforms in such a way that
no part of them would remain at a height above the
seabed of more than that prescribed by international
standards” (Brown, 1992).
The 1982 UNCLOS deals with the issue of
offshore disposal in a very general manner. It obliges
states to adopt global and regional rules, standards
and recommended practices and procedures as well
as national laws and regulations to prevent, reduce
and control pollution of the marine environment by
dumping and to take other necessary measures in this
respect. Dumping is not to be carried out without the
permission of the competent authorities of states. The
express prior approval of the coastal state is required,
if the dumping is to be carried out within the
territorial sea, EEZ, or onto the continental shelf of
the latter. Dumping includes, among other things,
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any deliberate disposal of platforms or other
man-made structures at sea.
The 1972 London Convention on the Prevention of
Marine Pollution by Dumping of Wastes and Other
Matter (1972 LDC) is another global instrument
directly related to the issue of abandonment. It is
applicable to all marine areas except the internal
waters of a coastal state. The 1972 LDC permits
dumping to be carried out provided certain conditions
are met. The severity of these conditions varies
according to the danger to the environment presented
by the materials themselves and there is a ‘black list’
containing materials which may not be dumped at all.
Although the Convention does not apply to the
dumping of wastes or other matter from offshore
installations, the abandonment of installations at sea,
either total or partial, is clearly covered. Disposal of
the platform requires a prior special permit. This
permit may be issued only after careful consideration
of all relevant factors, including the characteristics of
the dumping site, possible effects of the dumping on
amenities, marine life and other uses of the sea, and
the practical availability of alternative land-based
methods of disposal.
The 1996 London Dumping Protocol, which upon
its entry into force (in March 2006) has replaced the
1972 LDC, represents a major change of approach to
the question of how to regulate the use of the sea as a
depository for waste materials. One of the most
important innovations is the introduction of the
precautionary approach. The 1996 Protocol is much
more restrictive than the 1972 LDC, prohibiting in
principle all dumping. There are a few exceptions to
this which include platforms or other man-made
structures at sea. The contracting parties are required
to designate an appropriate authority or authorities to
issue permits in accordance with the Protocol. The
Protocol recognizes the importance of implementation
and detail compliance procedures.
Among several regional conventions particularly
relevant in this respect is the 1992 Convention for the
Protection of the Marine Environment of the north-
east Atlantic (1992 OSPAR Convention) which
replaced an earlier 1972 Oslo Dumping Convention.
The 1992 OSPAR Convention does not prohibit
dumping, but obliges parties to take all possible steps
to prevent and eliminate pollution by dumping, which
also applies to dumping of offshore installations and
offshore pipelines. However, dumping does not
include the leaving in place – wholly or partly – of a
disused offshore installation or disused offshore
pipeline, provided that any such operation takes place
in accordance with any relevant provision of the
Convention and with other relevant international law.
Annex II, which deals specifically with dumping and
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incineration, does not apply to any deliberate disposal
in the maritime area of offshore installations and
offshore pipelines, referring this matter to Annex III.
The central provision of the latter is art. 5 which
provides inter alia:
• No disused offshore installation or disuse[d]
offshore pipeline shall be dumped and no disused
offshore installation shall be left wholly or partly in
place in the maritime area without a permit issued
by the competent authority of the relevant
contracting party on a case-by-case basis.
• No such permit shall be issued if the disused
offshore installation or disused offshore pipeline
contains hazardous substances which may result in
harm to living resources and marine ecosystems,
damage to amenities or interference with other
legitimate uses of the sea.
• Any contracting party which intends to take the
decision to issue a permit for the dumping of a
disused offshore installation or a disused offshore
pipeline placed in the maritime area after 1 January
1998 shall, through the medium of the
Commission, inform other contracting parties of its
reasons for accepting such dumping, in order to
make consultation possible.
Thus, the OSPAR Convention distinguishes between
the disposal in situ or elsewhere at sea
– considered as dumping – and leaving the installation
in place. However, notwithstanding the fact that it is
defined as a case of dumping, disposal at sea is
excluded from the scope of the Dumping Annex and is
subjected to the same regime as leaving in place. This is
a symptomatic departure from traditional and somewhat
confusing dualistic approach to abandonment
– complete or partial removal vis-à-vis dumping –
towards an all-inclusive model, evidently designed to
avoid the potential for conflicting regulations.
The OSPAR Convention adopts the same
case-by-case approach in determining admissibility of
such a disposal as was introduced in the IMO
Guidelines. Other regional dumping agreements also
apply to the disposal of platforms and other man-made
structures at sea and their equipment, which is not
entirely prohibited but requires a prior authorization
by a special national body in charge of these matters.
Issuance of such permits is dependent upon
consideration of relevant factors, including
characteristics of the matter, of dumping site and
disposal method, as well as possible effects of disposal
on amenities, marine life and other uses of the sea.
Protection of the global atmosphere
One of the negative environmental impacts of the
petroleum industry is pollution of the atmosphere as a
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result of normal E&P operations and more generally
as a consequence of the combustion of fossil fuels and
vehicle exhaust emissions. A number of international
treaties, both global and regional, dealing with these
problems are of concern to the O&G industry. The
major risk to the global atmosphere comes from the
so-called GreenHouse Gases (GHG), namely carbon
dioxide and methane, one of the principal sources of
which is burning of fossil fuels, including petroleum.
The 1992 UN Framework Convention on Climate
Change (FCCC) has as its primary objective to
stabilize concentrations of GHG in the atmosphere.
The Convention sets out a series of general principles
on the protection of the Earth’s atmosphere, such as
the requirement of precautionary measures to be taken
to anticipate, prevent or minimize the causes of
climate change and mitigate its adverse effects. The
FCCC obliges all parties to develop national
inventories of anthropogenic emissions by sources of
GHG. Similarly, parties are to implement national
programmes containing measures to mitigate climate
change by addressing anthropogenic emissions by
sources. Although the FCCC does not provide for
specific requirements applicable to atmospheric
emissions from petroleum activities, it has prompted a
process of review and rule-making regarding GHG
emissions, for example, from gas flaring. Some
countries have introduced carbon taxes to curb energy
use and emissions from oil and gas installations.
An additional 1997 Kyoto Protocol to the FCCC
establishes stronger and more concrete measures,
especially for developed countries, which include
quantified objectives for GHG emissions limitation
and removal by sinks within a specific timescale.
These are intended to ensure that overall emissions
from industrialized nations are reduced to at least 5%
below 1990 levels within the period 2008 to 2012.
The 1985 Vienna Convention for the Protection of
the Ozone Layer and its 1987 Montreal Protocol is
another global regime effectively addressing
production and as a consequence, the releasing into
the atmosphere of ozone-depleting substances. Its
ultimate objective is to significantly reduce and
eventually eliminate production and consumption of
controlled substances by setting firm targets,
timetables for their phase-out and other measures,
such as technical and financial incentives.
At the regional level, protection of the atmosphere
has been dealt with in the context of prevention and
reduction of transboundary air pollution. The 1979
UNECE Convention on Long-Range Transboundary
Air Pollution and its eight Protocols have created the
essential framework for controlling and reducing the
damage to human health and the environment caused
by emissions of a range of air pollutants. Both the
518
Convention and some of the Protocols are quite
important from the petroleum industry perspective.
The 1999 Protocol to Abate Acidification,
Eutrophication and Ground-level Ozone sets emission
ceilings for four pollutants for 2010: sulphur, NOx,
VOCs and ammonia. The Protocol also sets tight limit
values for specific emission sources, including
combustion plants, and requires BAT to be used to
keep emissions down. The 1998 Protocol on Persistent
Organic Pollutants (POPs) focuses on a list of 16
substances that have been singled out according to
agreed risk criteria. The ultimate objective is to
eliminate any discharges, emissions and losses of
POPs by prohibiting the production and use of some
products outright and scheduled elimination of the
others at a later stage. The Protocol includes
provisions for dealing with the wastes of products that
will be banned. The 1994 Protocol on Further
Reduction of Sulphur Emissions uses an effects-based
approach, the critical-load concept, energy savings and
the application of BAT and economic instruments.
Finally, the 1991 Protocol on the Control of Emissions
of Volatile Organic Compounds (VOCs, i.e.
hydrocarbons) or Their Transboundary Fluxes, aims at
reducing emissions of the second major air pollutant
responsible for the formation of ground-level ozone.
Obviously, the legal regime for climate change
established by the FCCC and its Kyoto Protocol is of
particular relevance for the petroleum industry in the
context of atmospheric GHG emissions, mainly as a
result of gas flaring. It may require specific
programmes and measures to be adopted to address
this aspect of petroleum operations. But it may also
have much broader implications for the industry by
increasing pressure to develop sources of energy other
than fossil fuels.
Protection of biological diversity
Similar to the climate change regime, a
comprehensive global legal framework aimed at
protecting biological diversity, natural habitats and
wildlife species may have significant impact on the
petroleum industry by limiting the availability of areas
for exploration and production. Of particular interest
in this respect are the 1972 UNESCO Convention
Concerning the Protection of the World Cultural and
Natural Heritage, the 1971 Ramsar Convention on
Wetlands of International Importance, and especially
the 1992 UN Convention on Biological Diversity (CBD).
The primary objectives of the latter are the
conservation of biological diversity, the sustainable
use of its components and the fair and equitable
sharing of the benefits arising out of the utilization of
genetic resources. Parties to the Convention must
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establish national conservation plans, including
components of biological diversity important for its
conservation and sustainable use. Those activities
which have, or are likely to have, significant adverse
impacts on the conservation and sustainable use of
biological diversity, require proper monitoring. The
CBD promotes in situ conservation through the
establishment of protected areas, regulation or
management of biological resources important for the
conservation of biodiversity and rehabilitation and
restoration of degraded ecosystems. The contracting
parties are required to take measures to implement
environmental impact assessment requirements and
thereby minimize adverse impacts. The Biodiversity
Convention is primarily of contextual relevance to
petroleum E&P operations. It has no operational
provisions. However, it is likely to add to pressures to
ban or, at least, to subject E&P to more stringent
conditions in sensitive areas.
There are also a number of regional nature
conservation regimes in different parts of the world
likely to influence the conduct of petroleum
operations. In the European context, the following EC
directives are of particular importance: Directive
85/337/EEC on the assessment of the effects of certain
public and private projects on the environment and
Directive 92/43/EEC on the conservation of natural
habitats and wild flora and fauna (the Habitat
Directive).
10.3.4 Soft law relevant
to the petroleum industry
Alongside global regulatory instruments (hard law),
soft law plays an increasingly important role in
regulating the oil and gas activities. Soft law consists
of non-binding instruments, such as international
declarations, recommendations and government and
industry guidelines that may potentially evolve into
binding legal standards. From this perspective, soft
law is a valuable addition to hard law, particularly as it
can capture emerging notions of international public
order thus helping to extend the realm of legitimate
international concern to matters of previously
exclusive national jurisdiction.
The soft law type instruments include the 1992 Rio
Declaration on Environment and Development. Soft
law instruments of relevance to petroleum activities
embrace a relatively numerous group of guidelines and
recommendations issued by competent international
organizations. These include IMO and UNEP,
international financial institutions such as the World
Bank and a variety of non-governmental organizations
such as the International Association of Oil and Gas
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Producers (OGP – formerly the Oil Industry
International E&P Forum) and the World Conservation
Union (IUCN, International Union for the
Conservation of Nature and natural resources).
One example is the 1982 UNEP Guidelines related
to offshore mining and drilling – a non-binding
instrument which sets out general directives to be
adhered to by states in their national legislation or
international arrangements. Along with some general
provisions, the Guidelines contain specific
recommendations concerning the authorization of
offshore operations, environmental assessment and
monitoring systems, possible transfrontier
environmental impact and procedures for information
and consultation, safety measures, contingency
planning and implementation measures, as well as
liability and compensation.
The World Bank has prepared detailed EIA
requirements and criteria (in the form of
Environmental Assessment Sourcebook) for
environmental protection in specific industrial sectors,
as well as offshore E&P activities. The World Bank’s
Pollution prevention and abatement handbook 1998
provides guidelines (Oil and gas development –
Onshore) for onshore oil and gas operations (World
Bank, 1998). They establish maximum levels for liquid
effluents, air emissions and noise levels; describe
industry practices and processes used to reduce and
control pollution; and make recommendations for
monitoring and reporting.
In addition to the recommendations of UNEP and
the World Bank, the E&P industry itself provides
guidance to its members. Foremost among the various
oil industry groupings at international level is OGP,
the recommendations of which are particularly
influential. The organization represents the
international O&G industry on technical and
regulatory issues, and has been promoting measures to
improve the environmental record of the industry. As
part of its mandate, OGP disseminates information on
good practice through the development of industry
guidelines, codes of practice, checklists and so forth.
Some of these have been prepared jointly with the
World Conservation Union and UNEP.
To date, guidelines have been prepared on a wide
range of topics such as operations in tropical
rainforests, waste management, decommissioning,
operations in mangrove areas and disposal of wastes
and produced water. OGP has published guidance on
methods for estimating atmospheric emissions from
E&P activities and from operations in Arctic onshore
and offshore areas. These recommendations aim to
establish and disseminate internationally acceptable
standards, practices and procedures on environmental
protection in petroleum E&P activities. To this end,
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they set out requirements for environmental
management systems and planning, and identify
potential impacts and environmental control measures.
For example, they call for the performance of an EIA
prior to commencement of activities. Similarly, OGP
has produced a number of reports and guidelines on the
safety aspects of offshore platform decommissioning
options. It has also issued Health, Safety and
Environmental Management Systems (HSE-MS)
guidelines, which are consistent with the International
Standard Organization (ISO) 14000 Environmental
Management System (EMS) series. These too, have
proved popular with the international E&P industry.
ISO 14000 is a series of international standards on
environmental management. It provides a framework
for the development of an environmental management
system and the supporting audit programme. The main
thrust for its development came as a result of the Rio
Conference on the Environment Development held in
1992. ISO 14001 is the cornerstone standard of the
ISO 14000 series. It specifies a framework of control
for an EMS against which an organization can be
certified by a third party. The ISO 14000 series does
not set binding environmental standards. Rather, it is
designed as a tool to ensure compliance with legal
requirements.
The International Association of oil Geophysical
Contractors (IAGC) has issued environmental
guidelines, which touch upon offshore operations.
Some national oil industry organizations are also
active in promoting best environmental management
practices by adopting their own codes and guidelines.
These include but are not limited to, the following:
American Petroleum Institute (API); American
National Standards Institute (ANSI); American
Society of Mechanical Engineers (ASME); British
Standards Institute (BSI); Catalogue of European
Standards (CEN); Deutsche Institut für Normung
(DIN); (the British) Institute of Petroleum (IP).
For example, the API, through its Environmental
Stewardship Programme, developed Environmental
and Safety Mission and Guiding Principles, which are
binding for all API members. Equally important is the
1995 API Guideline for Onshore O&G Production
Practices for Protection of the Environment.
There is no one single set of internationally
accepted technical standards or norms applicable to
environmental protection in the petroleum industry.
Most of the existing standards and recommended
practices and procedures are usually established and
applied at the domestic level. Although international
practice in this field remains inconsistent, there is a
growing uniformity in terms of the content and
application of environmental standards by the global
O&G industry and individual governments.
520
Notwithstanding the fact that the soft law
instruments are largely recommendations and
qualitative in nature, the various guidelines, especially
those issued by organizations such as UNEP, the World
Bank, OGP and IUCN, are increasingly influential.
While often not compulsory for individual operators,
these instruments are of growing importance
worldwide and, with time, evolve into legally binding
standards through national practice or international
standard-setting. Certain commonly used standards
can be acceptable to, or adopted by, parties to
international agreements or project-specific
arrangements. Some countries, especially developing,
which as yet lack industry-specific standards and
regulations, provide for the application of relevant
international standards in their domestic legislation.
10.3.5 National legal frameworks
Environmental norms and standards applicable to
O&G activities are contained in a variety of national
laws. On the one hand, practically all countries have
general environment protection acts which provide a
broad legal foundation for more specific legislation
dealing with such matters as EIA, planning, pollution,
quality of air and water resources, protection of the
marine environment, conservation of biodiversity,
protected areas, and so forth. These legal acts are
without doubt relevant to petroleum activities and
often impose on such operations – directly or
indirectly – specific conditions, requirements and
constraints. On the other hand, a number of states have
enacted more specific petroleum-related legislation,
often containing provisions addressing environmental
matters and concerns. Although such petroleum acts
rarely contain concrete environmental standards, they
provide a basis for subordinate normative regulations.
In terms of environmental regulation of O&G
activities, three major prevailing regulatory models
have been identified: the statutory approach; the
contractual approach; and the integrated legislative
approach (Gao, 1998).
The first, represented primarily by US and UK
legislation, is characterized by a multitude of statutes
and other normative acts containing relevant
environmental regulations, norms and standards. The
US legal framework for O&G activities, where the
1990 Oil Pollution Act is perhaps the most significant
piece of legislation, is fragmented and does not
constitute a uniform body of environmental regulatory
rules.
The contractual approach is a mode of
environmental regulation through provisions in
petroleum contracts, which is typical primarily for
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developing countries where there is a lack of
comprehensive environmental and petroleum
legislation or where the legal infrastructure is
incomplete. One example where such approach has
been successfully employed is the 1994 Agreement on
the Joint Development and Production Sharing
between the state oil company of Azerbaijan and a
consortium of international oil companies, which was
subsequently approved by the Parliament of
Azerbaijan and acquired the status of national law.
Environmental provisions of this Agreement are very
specific and in effect have an overriding force over
relevant national legislation. They cover the entire
range of environmental aspects of E&P operations,
from the requirements related to the conduct of
operations, emergencies, monitoring, environmental
damage to concrete environmental standards and
practices, including guidelines regarding discharges of
effluents, air emissions, drilling cuttings and fluids,
waste, etc. It can be concluded that with environmental
requirement established through contractual
obligations, such agreements may bear a heavier
responsibility for environmental protection than
national legislation.
Another model, described as an integrated or
comprehensive legislative approach (Gao, 1998), has
emerged as a result of the adoption of framework type
legislation specifically for petroleum activities.
Legislation of some Latin American countries provides
the best illustrations of this model. In a few of them,
this legislation complements general environment
protection acts and national environmental action
plans. This new generation of petroleum-specific
legislation includes, for example, Argentina’s 1992
Resolution on the Protection of the Environment
during Exploration and Exploitation of Hydrocarbons,
the 1993 Regulation on Environmental Protection in
Hydrocarbons Activities of Peru, the 1995 Presidential
Decree on Environmental Regulation Concerning
Hydrocarbon Activities of Ecuador, and the 1996
Environmental Regulation for the Hydrocarbons’
Sector of Bolivia.
The common feature of the industry-specific
regulations is that they set out detailed operational
requirements for the various phases of E&P activities.
This new generation of environmental regulations
represents the beginning of what appears to be a
growing trend towards the creation of an integrated,
industry-specific legislative framework for the oil and
gas E&P sector (Wagner, 1998).
Notwithstanding evident variations in structuring
petroleum-related environmental legal frameworks
in different countries, they have many common
characteristics in terms of both the content of
applicable standards and regulatory and
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management tools employed. These will be briefly
discussed further.
10.3.6 Environmental management
tools
While in the recent past the environment-related
provisions of national legislation and contractual
arrangements mainly relied on traditional concepts
such as good oil field practice, due diligence, or sound
technical and engineering principles, these have been
increasingly replaced by a new generation of
environmental management and control mechanisms.
The new management tools include standards setting
and command control as well as operational
procedures and practices.
Those applicable to the petroleum industry are
usually divided into several categories of technical and
environmental requirements. The first group generally
includes standards dealing with equipment and
product, such as construction requirements for onshore
and offshore platforms, storage tanks, pipelines and
other industrial facilities. The second group deals with
various environmental impacts such as limits on
discharges and emissions, methods of waste disposal,
management of chemicals used in E&P operations,
and so forth. Finally, there are standards and
procedures adopted to assist the petroleum operators
in improving their environmental performance. These
include various environmental management
procedures and systems, such as EIA, EMS,
Environmental Performance Evaluation (EPE),
Environmental Management Plans and programmes
(EMP), Environmental Monitoring and Evaluation
(EM&E), environmental auditing and environmental
reporting, some of which will be considered below.
Environmental impact assessment. This is
generally described as a systematic process of detailed
appraisal of the environmental consequences of the
proposed activities and their alternatives to be used in
guiding decision-making. Increasingly, the EIA
procedure is combined with the assessment of
socio-economic consequences of the planned activity
– the so-called Social Impact Assessment (SIA). The
principal elements of EIA usually include baseline
environmental study, impact prediction, mitigation
measures, Environmental Impact Statement (EIS) or
IEA (International Energy Agency) report, public
participation and review, decision and post-project
analysis. The EIA requirements are contained in
numerous global and regional agreements, such as the
1991 UNECE Convention on Environmental Impact
Assessment in a Transboundary Context, as well as
recommended by the World Bank in its Environmental
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INTERNATIONAL LAW
Assessment Sourcebook and petroleum industry
organizations (e.g. the OGP Principles for Impact
Assessment: The Environmental and Social Dimension).
Environmental management plan. This is another
important instrument, which is usually based on EIA.
Among other things, it identifies the company’s
environmental policy and objectives, provides detailed
information about the operator’s capability and
experience in environmental management. EMP also
specifies environmental personnel, their
responsibilities, training and awareness, emergency
planning, procedures and equipment, incident
reporting and investigation, and review of
environmental performance.
Environmental management system. This is
defined as a means of ensuring effective
implementation of an environmental management plan
or procedures and compliance with environmental
policy objectives and targets. As a management tool,
EMS enables an organization to identify, monitor and
control its environmental aspects. In essence, it is part
of the overall management system that includes
organizational structure, planning activities,
responsibilities, practices, procedures, processes and
resources for developing, implementing, achieving,
reviewing and maintaining the environmental policy.
The model HSE-MS in the petroleum E&P sector,
as outlined by the OGP, consists of the following key
elements:
• Leadership and commitment (addressing top-down
commitment and company culture, essential to the
success of the system).
• Policy and strategic objectives (addressing corporate
intentions, principles of action and aspirations with
respect to health, safety and environment).
• Organization, resources and documentation
(personnel, resources and documentation for sound
HSE performance).
• Evaluation and risk management (identification
and evaluation of HSE risks, for activities,
products and services, and development of risk
reduction measures, including EIA).
• Planning (addressing planning and conduct of
work activities, including planning for changes and
emergency response).
• Implementation and monitoring (addressing
performance and monitoring of activities, and how
corrective action is to be taken when necessary).
• Auditing and reviewing (periodic assessment of
system performance, effectiveness and
fundamental suitability).
• Review (addressing senior management review of
HSE-MS).
The HSE-MS model is compatible with the
requirements of the ISO 14000 series, a global
522
reference point for environmental management
systems, which enables companies to approach the
subject in a systematic and efficient manner. Of
significant relevance in the European context is the EC
1993 Eco-Management and Audit Regulation, which
established the Eco-Management and Audit Scheme
(EMAS).
Environmental performance evaluation. This is
another management tool, which has the aim of
facilitating management control of practices that may
have an impact on the environment. It has been used
globally to improve environmental performance,
provide a basis for performance benchmarking,
demonstrate compliance to regulations and increase
operational efficiency. The ISO standard 14031 (1999)
Environmental Management – Environmental
Performance Evaluation provides guidance in how to
conduct EPE. The essential aspect of EPE is the
selection of meaningful indicators, which may include
Operating Performance Indicator (OPI), Management
Performance Indicator (MPI) and Environmental
Condition Indicator (ECI).
Environmental monitoring and evaluation. This is
used to provide continuous observation and
assessment of effects of development projects and
activities on environmental resources and values in
order to ensure effective protection from the
unforeseen effects of such activities, guide changes of
policy or activity or to detect improvements as a result
of actions taken. EM&E plays an important part in the
development and implementation of pollution control
strategies, and in determining their effectiveness; and
also in the provision of ‘baseline’ information against
which the environmental impacts of certain activities
are gauged. Being applied throughout the life of the
project, it ensures compliance with environmental
regulations and requirements imposed on the project
on the basis of EIA.
Environmental auditing. This is an integral part of
environmental management. It is defined as a process
of systematic, periodical evaluation of a company’s
environmental organization, conduct and systems
against predetermined standards (Wawryk, 2002).
While an important component of an EMS, its role is
not limited only to verifying conformity with
management systems standards. There is a distinction
between an EMS audit and an audit of compliance
with applicable legal regulations. The ISO 14000
series contain standards for environmental auditing.
10.3.7 Conclusions
The rapidly expanding web of environmental
regulations poses a new challenge for the petroleum
ENCYCLOPAEDIA OF HYDROCARBONS

industry. The growing body of international and
national norms and standards has already affected the
O&G activities in various ways.
The industry has been under continuous and
growing legal pressure to address environmental
imperatives by improving its performance. The
introduction of increasingly strict environmental
requirements has led to changes in investment
conditions and capital and operating costs. Corporate
liability for environmental damage has a tendency to
evolve towards greater stringency and higher ceiling of
compensation. Surging environmental fines and taxes
further augment financial burden on the oil and gas
operators.
Environmental considerations affect corporate
structure and operational practices which have to
adjust by introducing environmental management
systems, special personnel and new pollution
abatement and control procedures. Management of
environmental, and associated legal risks, has
become an integral part of corporate strategies.
With the further anticipated expansion of O&G
operations into environmentally sensitive areas,
such as deep-water offshore zones and the Arctic
and Sub-Arctic regions, or to traditional territories
of indigenous peoples, these risks will only
increase.
Bibliography
Birnie P., Boyle A. (2002) International law and the
environment, Oxford, Oxford University Press.
Boesche D.F., Rabalais N.N. (edited by) (1987) Long-term
environmental effects of offshore oil and gas development,
London, Elsevier.
Churchill R.R., Lowe A.V. (1999) The law of the sea,
Manchester, Manchester University Press.
Gavouneli M. (1995) Pollution from offshore installations,
London-den Haag-Boston, Kluwer.
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ENVIRONMENTAL PROTECTION IN THE PETROLEUM INDUSTRY
Glasson J. et al. (1995) Introduction to environmental impact
assessment. Principles and procedures, process, practice
and prospects, London, UCL.
Patin S. (1999) Environmental impact of the offshore oil and
gas industry, East Northport (NY), EcoMonitor.
Sands P. (2003) Principles of international environmental law,
Cambridge, Cambridge University Press.
Skjaerseth J.B., Skodvin T. (2003) Climate change and the
oil industry. Common problems, varying strategies,
Manchester, Manchester University Press.
UNEP (United Nations Environmental Program)/E&P Forum
(1997) Environmental management in oil and gas
exploration and production: an overview of issues and
management approaches, UNEP IE/PAC Technical Report
37, E&P Forum Report 2.72/254.
Worika I.L. (2002) Environmental law and policy of petroleum
development. Strategies and mechanisms for sustainable
management in Africa, Port Harcourt (Nigeria), Anpez
Centre for Environment and Development.
World Bank (1998) Pollution prevention and abatement
handbook, Washington (D.C.), World Bank.
References
Brown E.D. (1992) Sea-bed energy and minerals. The
international legal regime, Dordrecht-Boston (MA), Nijhoff,
3v.; v.I: The continental shelf.
Gao Z. (editor) (1998) Environmental regulation of oil and
gas, London-den Haag-Boston, Kluwer.
Wagner J.P. (1998) Oil and gas operations and environmental
law in Latin America, «Journal of Energy and Natural
Resources Law», 16, 153-185.
Wawryk A.S. (2002) Adoption of international environmental
standards by transnational oil companies: reducing
the impact of oil operations in emerging economies,
«Journal of Energy and Natural Resources Law», 20,
402-432.
Sergei Vinogradov
Centre for Energy, Petroleum and Mineral
Law and Policy
University of Dundee
Dundee, Scotland, United Kindom
523
 10.4
Civil liability
for oil pollution damage
to the marine environment
10.4.1 The evolution
of international rules.
The 1969-71 Convention
system
The progressive increase of maritime transport, and in
particular oil transport, has inevitably increased the
risk of pollution of maritime areas. Indeed, among the
various substances that represent a risk for the marine
environment, oil is the one which may cause serious
pollution most frequently and with particularly
harmful effects. Such a circumstance, so significant as
to leave no room for uncertainty, emerged on the
occasion of the incident involving the oil tanker Torrey
Canyon in 1967. It is not surprising that, as a
consequence of that event, intense action was taken in
order to adopt an international treaty regime aimed at
regulating the various aspects of the phenomenon at
hand, which until then had only been timidly addressed
at an international level.
Accordingly, in the last decades of the Twentieth
century, steps were taken to adopt various measures
aimed at preventing accidents causing oil marine
pollution or at reducing the harmful effects thereof,
and at encouraging and rationalizing forms of
cooperation among states to control oil transport and
to adopt emergency plans in case of pollution. But
above all, uniform law rules on civil liability for oil
pollution damage relating to the marine environment
have been updated. It is mainly the latter aspect which
is dealt with in the following pages.
In this sense, the International Convention on Civil
Liability for Oil Pollution Damage (CLC), whose
original version was adopted in 1969, will first be
considered as well as the International Convention on
the Establishment of an International Fund for
Compensation for Oil Pollution Damage (the so-called
Fund Convention), whose original text was approved
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
in 1971, in order to complete the rules of the CLC.
The purpose of the latter Convention, in fact, is
basically to integrate the amount of compensation
payable to victims of pollution damage caused by oil
transport, in case such victims are not satisfied with
the amounts provided by the CLC and to guarantee, in
any case, the relative payments.
The liability regime contained in these
Conventions is quite simple, being based on the
principle of liability channelling solely towards the
shipowner; the latter, however, is liable only up to a
specific amount for which compulsory insurance is
required. Should that amount be insufficient to cover
the cost of compensation for damage caused by the
incident, it is the Fund established by the
above-mentioned Fund Convention that shall provide
compensation up to the maximum amount determined
by the Fund Convention itself.
Thus, the states who took part in the drafting of the
above-mentioned Conventions intended to adopt a
legal regime able not only to adequately compensate,
with specific guarantees, damage caused by oil
transport, but also to fairly distribute all deriving costs
between the maritime transport industry and the oil
industry. In fact, while the former, on the one hand,
shall cover the costs chargeable to shipowners within
the limits of the strict liability imposed on them, the
latter, on the other hand, shall contribute to the
payment of additional costs incurred in connection
with the functioning of the Fund, as well as damages
not compensated by the shipowner as a consequence
of the operativeness of the limits, especially
quantitative, that are provided by the CLC. In fact,
compensation payable by the Fund is financed only by
the oil import industry’s contributions. Moreover, each
state that is party to this Convention must
communicate to the International Oil Pollution
Compensation Fund – the body provided for by and
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INTERNATIONAL LAW
established on the basis of this Convention – the
names of the oil importing companies registered on its
territory. These companies shall provide the payments
so as to ensure the Fund’s functioning, to be
determined according to the quantity of oil imported
by them on a yearly basis.
It was difficult, however, to achieve a degree of
expansion of the above-illustrated legal regime
throughout an adequate number of states so as to
ensure its significant and certain ambit of application,
which is inter alia necessary for the purpose of
international uniformity as well as for the acquisition
of the basic resources that are needed for the
functioning of the Fund. On the other hand, the
qualitative and quantitative limits originally set forth
regarding both the shipowners’ liability and the
additional compensation payable by the Fund turned
out to be unsuitable, since the first years of application
of the conventional system, to fully satisfy persons
harmed by oil transport incidents. This is evidenced by
the fact that even after the entry into force of the 1969
CLC, the mutual-compensatory system (Tanker
Owners Voluntary Agreement concerning Liability for
Oil Pollution, TOVALOP), created on a voluntary
basis immediately after the Torrey Canyon incident by
companies owning oil tankers, was not discontinued.
This system had originally been set up to address the
incumbent pressure of public opinion calling for an
effective instrument providing for effective pollution
compensation even before the entry into force of the
CLC and, in any case, in situations where the
application of the CLC was excluded (e.g. because the
pollution damage was caused by oil tankers while in
ballast) or with regard to costs that are not included in
the CLC regime (e.g. the costs of preventive measures
taken to avert the threat of pollution damage).
Likewise, the CRISTAL (Contract Regarding an
Interim Supplement to TAnker Liability for oil
pollution) system, adopted on a voluntary basis by the
oil industry, continued to function while waiting for
the entry into force of the 1971 Fund Convention with
the purpose of increasing the compensation limits
provided by the TOVALOP and/or the CLC systems in
cases in which such limits turn out to be insufficient.
CRISTAL was subsequently protracted, even after the
entry into force of the 1971 Fund Convention, until the
compensation limits of the CLC and the Fund
Convention had been adequately increased and both
entities were functioning in a sufficiently large number
of states (in other words, up until May 1996 when the
1992 Protocols entered into force). In fact, the
TOVALOP/CRISTAL system was revoked only as of
February 1997.
As already mentioned, the financial inadequacy
provided for in the original 1969 CLC and 1971 Fund
526
system was immediately perceived. Directly following
its entry into force, negotiations began which aimed to
increase, at least, the quantitative compensation limits
provided therein. Already in 1976, a first Protocol was
approved and entered into force, followed by a second
Protocol in 1984 that aimed to considerably modify
both the CLC and the Fund Convention by increasing
the maximum amount of compensation. However, the
entry into force of the second Protocol was subject to
the condition that the United States agree to comply
with the compensation system. Without any particular
sacrifice on the part of the other participants in the
Fund, the adhesion of this country to the CLC/Fund
system would have made it possible to increase
available financial resources and, consequently, the
limit of compensation payable by it. However, the US
did not accept to enter into this system and decided to
keep pursuing an autonomous policy in this field.
Such policy, confirmed and codified by the unilateral
rules adopted in the interim (in the form of the Oil
Pollution Act of 1990), provided for a liability that
tended to be unlimited on the part of the subject who
caused the pollution. Many aspects of these rules were
even incompatible with those of international uniform
law.
Therefore, contracting states decided to adopt the
1984 Protocols to the CLC and to the Fund
Convention, further integrated, without making their
entry into force subject to the condition of US
participation. These Protocols, updated and approved
in 1992, among other things, provide for a
considerable increase in the quantitative limits
originally set out in the CLC and in the Fund
Convention. This updating did not, however, modify
the original equilibrium of the proportion between the
shipping industry’s contribution and the oil industry’s
contribution to the compensation for damage caused
by incidents during the carriage of oil by sea.
Furthermore, it did not change the principles
underpinning the regime of strict liability imposed on
the owner of the vessel involved in the incident (with
exception of some entirely marginal aspects).
10.4.2 The updating
of the Convention system
The 1992 CLC/Fund system, updated in the
above-mentioned way, came into force in May 1996
and, among other things, led to an increase in the limit
of the shipowner’s liability to: 3 million SDR (Special
Drawing Rights) for ships not exceeding 5,000 units of
gross tonnage; 420 SDR per gross ton (above 5,000 t)
up to 140,000 t; to 59.7 million SDR for ships in
excess of 140,000 units of gross tonnage. Even the
ENCYCLOPAEDIA OF HYDROCARBONS
 CIVIL LIABILITY FOR OIL POLLUTION DAMAGE TO THE MARINE ENVIRONMENT
new limits turned out to be inadequate with respect to
the effects of increasingly serious incidents, which
occurred immediately after the entry into force of the
international instruments that had set out the limits
themselves. As of 18 October 2000, the Legal
Committee of the International Maritime Organization
(IMO) adopted a resolution in conformity with art. 33,
para. 7, of the 1992 Fund Convention. The legal effects
of this resolution were automatically produced on 1
November 2003 as a result of the special mechanism
of tacit acceptance (provided by art. 33, para. 7, of the
1992 Fund Convention and by virtue of the decisions
adopted by the Legal Committee), according to which
the limits indicated in the 1992 Protocols were further
increased by 50%.
Moreover, another Protocol was adopted during the
Diplomatic Conference held on 16 May 2003,
providing for the establishment of a Supplementary
Fund (2003), which entered into force on 3 March
2005. It was designed to operate in cases of marine
pollution caused by the carriage of oil by sea, only in
areas of the sea under the control of industrialized
states or, at any rate, those with highly developed
economies. Indeed, it is reasonable to believe that only
the latter are interested in abiding by the
Supplementary Fund’s rules and shouldering the
consequent burden of the additional financial
contributions (to those required by the 1992 Fund
Convention), required in order to finance the Fund
itself. Only within the ambit of such states’ maritime
areas, as a matter of fact, marine oil pollution damages
did exceed the limits that are compensable by the
Fund. As a result, the value of the Supplementary
Fund was set by the IMO at 750 million SDR, also
including the amounts due under the CLC and the
Fund Convention updated according to the
above-mentioned terms.
It follows that, among other things, the intent was
to reply to the criticism deriving from several quarters
(in particular, the Commission of the European Union)
that the amounts of compensation payable by both the
owner of the ship that caused the incident and by the
Fund were inadequate. At the same time, however,
problems concerning the re-establishment of an
equilibrium between the contributions made by the
shipping and oil industries to compensate for damages
in a way to render it fairer than that determined by the
CLC/Fund system were left unaddressed. Ultimately,
criticism concerning the imbalance and disproportion
between the oil industry’s and shipping industry’s
contribution to compensation for damage was
neglected. This was also the case regarding criticism
of the interdependence of the CLC/Fund system and
the mutual benefit insurance system of the Protection
and Indemnity Insurance (P&I) Clubs, by whose
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characteristic self-imposed rules the CLC/Fund system
continues to be strongly conditioned, although such
criticism has been shared in several quarters and
supported with very consistent arguments.
In this respect, it has been pointed out how the
interdependence between the CLC/Fund system and
the P&I system, and the disproportion between the
costs paid by the oil industry and those paid by the
shipping industry may jeopardize not only the natural
evolution of the criteria adopted for determining
liability, but also their correct application, especially in
relation to the safeguarding of public interest related to
the protection of the marine environment. On the other
hand, greater transparency in the cooperation and
participation of the various economic sectors involved
when an accident occurs has been strongly advocated,
as has the increase in incentives to use ships of better
quality. Moreover, through the operation of the
Supplementary Fund, which for the above-mentioned
reasons is actually financed only by the industrialized
countries, an attempt has been made to reply, at least
partially, to developing countries’ criticism, according
to which it would not be fair to further increase the
compensation paid by the Fund if the parameters for
calculating developing countries’ contributions and for
calculating industrialized countries remain identical. It
has been correctly noted that the criteria for
calculating compensation for damage and the
consequent amounts payable do, in fact, permit a
greater degree of compensation, if such damages have
been caused to the citizens and environments of
industrialized countries than if caused to developing
countries.
At any rate, it is beyond dispute that also the new
regime, in force since November 2003, and the further
integration brought to it by the 2003 Protocol
(Supplementary Fund) do not overcome all the
above-indicated criticism. Indeed, the shipping
industry’s greater share of the costs of compensation
payable by the Fund is counter-balanced by the
additional burden that the Supplementary Fund has
placed on the oil industry. Although the burdens
involved in constituting and operating the
Supplementary Fund are destined to weigh on the
enterprises in industrialized countries, the developing
countries highlighted that the imbalance
disadvantageous to them is not being reduced, but is
simply not being increased. Therefore, the
disproportion with respect to contributions between
the two areas, while not being enlarged, has not,
however, been corrected. Above all, this new regime
leaves serious problems unresolved, such as the rules
applicable to incidents in the maritime areas of states
that do not participate in the CLC/Fund system.
Indeed, their solution remains assigned to voluntary
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INTERNATIONAL LAW
agreements, which largely depend on the decisions by
the P&I Clubs. Often it is conditioned by the
circumstance that the shipowner has no other
resources, or by the fact that the ship flies a flag ‘of
convenience’ and the state involved in the incident has
neither efficient legislative or jurisdictional
instruments nor an administrative apparatus suitable to
obtain payment of adequate compensation, in its
favour and in favour of its own citizens, for the
damage caused by the incident.
As already mentioned, notwithstanding the
amendments to the original CLC/Fund system, the
principles underpinning its functioning remain
substantially unchanged and are based on strict
liability channelled towards the owner of the ship that
caused the incident, who is liable for all the damages
caused by marine pollution. Therefore, the relative
liability has nothing to do with the owner’s fault, as it
depends on the sole circumstance that the pollution
was caused accidentally by the oil carried on a ship
owned by the individual. Only completely exceptional
events allow the owner to be exempted from such
liability. These exceptions, therefore, are admissible
within the strictest limits of the criteria usually
adopted with respect to the other rules of uniform law
inspired by the same principles of strict, channelled
liability. In the system at issue, the only cases able to
constitute a cause for exemption are those in which the
damaging event has been caused by: war, other
situations comparable to war or natural events of an
exceptional, inevitable and irresistible nature;
intentional acts by third parties wilfully to cause the
damage; negligence of government or other authorities
responsible for the maintenance of lights and other
navigational aids.
According to the principles of strict liability, the
sole presence of one of the conditions indicated above
is not enough, in itself, to produce the effects of
exemption. For that purpose, the shipowner must prove
that the circumstance invoked in this connection had
such an important bearing on the matter as to exclude,
with certainty, the causal link between the dangerous
activity of carrying oil and the damaging event.
Therefore, similar proof cannot be considered
adequate if one of the situations exempting the
shipowner of his strict liability was only one
contributing factor causing the damage, becoming part
of a dangerous situation brought about, for example,
by the lack of preventative measures and/or measures
to reduce its effects.
Therefore, one is still faced with a liability regime
that, because of the narrowness of the exempting
events and the strictness of the probative regime
required in order to take advantage of it, makes the
shipowner always liable for the damaging event caused
528
by the carriage of oil. Such is the case even if only
within the above-mentioned quantitative limits, and
subject to the conditions of the sphere of application
of the uniform law that can reduce or even exclude its
functioning (depending on the maritime areas in which
the incident or the resulting pollution occurred). Third
parties that have been harmed can thus take advantage
of this regime, even if only within the limits indicated
herein. Among other things, they are protected by the
corresponding compulsory insurance that the
shipowner is obliged to have and by the possibility of
having their rights respected directly vis-à-vis the
insurers, the only exception being represented by some
marginal cases.
10.4.3 Criticism of the Convention
system and the relevance
of insurance coverage
With respect to such a system of strict liability, the
International Oil Pollution Compensation (IOPC Fund,
i.e. the Fund Convention and its additional Protocols)
steps in, as already mentioned, to integrate liability
limits in all cases in which: the limit to the shipowner’s
liability is quantitatively inadequate with respect to the
entity of damages caused; for whatever reason the
shipowner and its insurer are not capable of meeting
the financial obligations imposed on them by the CLC;
one of the exceptional situations has occurred which
does not permit those involved to take advantage of
the strict liability that the CLC imposes on
shipowners. Criticism of the CLC/Fund system has not
subsided, despite the ever more significant quantitative
increase in the limits of shipowners’ liability and the
certainty of further compensation guaranteed by the
IOPC Fund, integrated by the Supplementary Fund.
Indeed, it has been pointed out that the increases
provided for during recent years have not produced
any real positive effect in terms of reducing the
number of cases of marine pollution and improving
safety with respect to the transport of oil by sea.
Further, it has been observed that the Supplementary
Fund is destined to produce effects that will even clash
with such objectives: while it is true that it accords
greater satisfaction of victims’ claims possible, it is
equally true that the further contribution required is
financed exclusively by the oil industry. Therefore,
this circumstance will enable a further decrease of the
liability of shipowners and of those operating the ships
precisely because they in primis will have to guarantee
that conditions of maximum safety for the carriage by
sea of oil are fulfilled.
In particular, it has been highlighted that the
functioning of the Supplementary Fund actually
ENCYCLOPAEDIA OF HYDROCARBONS
 CIVIL LIABILITY FOR OIL POLLUTION DAMAGE TO THE MARINE ENVIRONMENT
represents a further protection with respect to the
liability and possible fault of shipowners and of
shipping companies in matters concerning the safety
and operating standards of ships. In order to avoid, at
least to some extent, such effects and to preserve a
certain equilibrium between the oil shipping by sea
industry and the oil industry, as far as their
participation in the compensation for oil pollution
damage in connection with the carriage of oil by sea is
concerned, it has been proposed to further raise the
limit of the shipowner’s liability, leaving aside, at least
in part, the ship’s tonnage, or to have the shipping
industry contribute to the costs of the Supplementary
Fund. In this regard, it has been pointed out that such
disproportion is still greater in accidents caused by
small ships, the polluting effects of which are often
comparable or even greater than those produced by
large ships.
On the contrary, the insurance circles of the P&I
Clubs and of the states that are particularly attentive to
the safeguarding of shipping interests (among which,
above all, the United Kingdom) point out that the
actual application of the current regime of the 1992
Protocol has appeared to be, and must be considered to
be, adequate to meet the needs of the practical
requirements and duties of the marine insurance
sector. Any further increase in the liability of
shipowners and shipping companies would cause,
among other things, the depletion of the insurance
market’s available resources, with consequential
devastating effects on its functioning and on the entire
system. Moreover, should the global amounts
concerning shipowners’ liability be further increased,
insurers of the shipowners will have to increase
premiums to such a level as to make the relative costs
practically unsustainable by the shipping industry.
The only constructive solution in the direction that
is indicated by the oil industry has been represented by
the increase of the liability limit (from 4.5 million to
20 million SDR) for small tankers (those not
exceeding 5,000 units of gross tonnage), invocable
only in the case of incidents involving states that have
acceded to the Protocol concerning the Supplementary
Fund. Therefore, this approach is substantially in line
with the content of the Small Tanker Oil Pollution
Indemnification Agreement (STOPIA) proposed by
the P&I Clubs. It provides only that the rules,
originally conceived as contractual in nature, be
incorporated into the body of uniform law rules
thereby guaranteeing greater legal certainty and a
precise sphere of reference. The sole alternative
declared acceptable by the oil shipping industry and
marine insurance circles was the start of negotiations
with a view to updating the 1992 CLC for the purpose
of imposing liability on shipowners up to a determined
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amount, regardless of the size of the tanker involved in
the oil spill, yet still within the maximum limits
currently in force.
Above all, taking due account of the previous
considerations, the essential impossibility of raising
the global limit of shipowners’ liability set out in the
1992 CLC and the subsequent updates, therefore,
remains confirmed. Also, the introduction of forms of
punitive damages (see below) to be paid by
shipowners who fail to fulfil their obligations to
guarantee the seaworthiness and safety of their ships is
to be considered insufficient. Therefore, the original
set-up of the rules on the limitation and channelling of
shipowners’ liability has not been modified, nor can
changes be foreseen within a reasonable period of
time, despite the strong criticism expressed in this
respect in various quarters and, inter alia, shared in the
sphere of the European Union. In particular, the
European Commission, on the basis of economic
analysis of law arguments, did not hesitate to affirm
that the system of limitation of liability, per se, is
discouraging with respect to the adoption of preventive
measures with regard to maritime incidents and/or
measures designed to improve navigational safety. This
system is even considered to clash with the principle
that the individual having caused the pollution should
pay full compensation for damage caused to him.
In fact, it has even been affirmed (in the
Commission’s Communication to the European
Parliament and to the Council of 20 December 2002
following the accident involving the tanker Prestige)
that the CLC/Fund system guarantees true, actual
immunity not only to shipowners but also to those who
in various ways share in the risks of shipping, even
though they are specifically required to fulfil precise
and strict obligations with respect to maintaining the
ship’s safety (for example, charterers, managers, etc.).
Regarding the latter, only the shipowner and the Fund
can claim compensation (CLC, art. 3, para. 5, and the
Fund Convention, art. 9, paras. 1-2). In connection
with the above, some states have declared that
compensation can be claimed, from time to time, on
the basis of criteria that are not always considered
rigorous on account of various circumstances and/or
political assessments, or purely legal considerations.
The latter includes, for example, the limitation period,
uncertainty with respect to the competent court, the
difficulty in collecting adequate information as well as
the time required, the uncertainty and excessive costs
of the relative legal proceedings – the outcome of
which is often rendered irrelevant on account of the
insolvency of the person liable that has come about in
the meantime.
Moreover, it has been observed that unlimited
liability of the shipowner can easily be eluded by
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INTERNATIONAL LAW
means of adequate techniques, such as the normal
practice of constituting a single ship company.
Therefore, the certainty that the shipowner is
financially capable of covering its liabilities must be
dependent on and guaranteed by insurance coverage. It
is to be underlined that the insurance system is also
capable of easily overcoming the legal obstacles posed
by single ship companies, by virtue of the treatment
that these companies receive for insurance purposes.
In fact, according to the rules generally adopted within
the sphere of the P&I Clubs, they are considered as
belonging to a single group and, therefore, a single
fleet when insurance premiums are calculated and
jointly liable for all the obligations they have
individually assumed and/or that can be attributed to
each individually.
The actual fulfilment by the shipowner of its
obligations to pay compensation is thus linked to an
efficient, reliable insurance system. The estimates of
precise quantitative limits are absolutely inevitable in
this perspective. Within such limits, also the proposal
to introduce punitive damages payable by those
responsible for maritime incidents must, therefore, be
placed. In fact, it can operate effectively only by
means of the conventional mechanisms of mutual
benefit insurance. But above all, it has been pointed
out that the system of channelling liability towards the
shipowner only, within precise quantitative limits, is
the only system consistent with the shipowner’s strict
liability as “it would be inconsistent with the concept
of strict liability for a second party to be liable outside
the Convention in addition the statutory party”, as
observed during the preparatory work. Moreover, such
a system has the advantage of avoiding harmful and
possibly contradictory duplications of proceedings
with relative increases, among others, of the legal and
insurance costs.
In the perspective just indicated, however, it is not
surprising that the shipowner’s insurance coverage
used in the transport of oil is considered obligatory
(CLC, art. 7, para. 1) and must be duly certified and
provided by a reliable insurance system. In fact, it
constitutes the only real evidence of the shipowner’s
capacity to pay compensation under the terms of the
CLC. Nor is it surprising that pollution victims are
guaranteed by the possibility of claiming
compensation for the damage they have suffered
directly from whoever provided either the insurance
coverage or the corresponding financial guarantee
(CLC, art. 7, para. 8), the compulsory detailed content
of which is provided for in uniform law regulations
(CLC, art. 7, para. 2). In fact, the purpose of the CLC
regime is to guarantee the payment of the
compensation for oil pollution damage in connection
with the carriage of oil by sea on the basis of strict
530
liability channelled to the shipowner, which is easily
avoided in the absence of adequate guarantees.
10.4.4 The progressive
confirmation of the criterion
of the shipowner’s
strict liability and its limits
The last considerations were also confirmed on the
occasion of the revisions leading to the CLC and Fund
Conventions of 1992 and to their further updates.
They are still being shared, although with greater
uncertainty, which was apparent with the recent
innovations adopted in IMO Resolutions in 2000 and
2003. The critical remarks and objections made in this
connection, briefly recalled above, did not receive on
those occasions adequate response, for prevalently
pragmatic reasons. Therefore, neither doubt nor
uncertainty mars their consistency with the indications
that are currently prevailing in the international
community and interested circles regarding the system
of strict liability channelled to the shipowner. They are
covered by compulsory insurance and completed by
the integrating intervention of the International Oil
Pollution Compensation (IOPC) Fund and of the
Supplementary Fund, based on the principle that
where liability under CLC ends, the IOPC Fund’s
liability begins; moreover, with the specification,
however, that the IOPC Fund and the Supplementary
Fund are obligated to pay compensation also in the
exceptional cases in which the shipowner’s liability is
excluded according to the CLC. This happens, as
already specified, when the damage has been
provoked by war or natural calamity, by the
intentional conduct of a third party or by the
negligence of one or more states in maintaining lights
or other navigational aids.
Greater doubts have been expressed, as apparent
from the above and from the debate both within
Europe and the appropriate international organizations
(above all within the IMO) on: the maintenance of
absolutely unbreakable limits of liability with respect
to shipowners whose behaviour has been seriously
negligent, but not serious enough to violate the rules
currently in force; the possibility for victims to obtain
compensation for damage from other persons who
may be responsible for failing to maintain the ship’s
seaworthiness and its safety; the extension of the
notion of compensable damage with particular
reference to environmental damage. In fact, these are
matters that have always been discussed. At present,
these issues are governed by the consolidated rules of
the 1969 and 1992 CLC, as well as the 1971 and 1992
Fund Conventions, along with a parallel and equally
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 CIVIL LIABILITY FOR OIL POLLUTION DAMAGE TO THE MARINE ENVIRONMENT
significant body of case law that has confirmed, and in
no way marred, the original set-up of the CLC/Fund
system (apart from some appropriate adjustments and
the increase in the amounts of the limits of
shipowners’ liability and of the amount of
compensation paid by the Fund).
With reference to what has been observed under
above, the evolution of the body of rules has
progressively reinforced the substantially unbreakable
nature of the maximum amounts provided with respect
to the shipowner’s liability. In fact, following the
modifications still in force and adopted by the 1992
CLC, it is provided that the limit of the shipowner’s
liability can be increased only through proof that the
shipowner had committed a “wilful or reckless action
or omission”; that is to say, by means of the proof that
the damage resulted “from his personal act or
omission with the intent to cause such damage or
recklessly and with knowledge that such damage
would probably result” (1992 CLC, art. 5, para. 2).
Therefore, the evolution of the body of rules, faced
with the progressive above-mentioned increase in the
quantitative limits of the shipowner’s liability, has led
to the adoption of greater strictness in proving
circumstances that permit such limits to be exceeded.
In fact, it is no longer sufficient to prove actual fault or
privity on the part of the shipowner in order to exclude
the operation of the limit of liability, as under the 1969
CLC. However, it is necessary to prove that the
shipowner’s conduct was intentionally damaging or at
least reckless, with disregard for the potential
consequences even if the damaging event had been
expected. In this regard, attempts to specify and extend
this concept of recklessness, for the purpose of
including at least cases in which the incident is caused
by a structural defect of the vessel, have resulted
completely unsuccessful until now. It seems
unreasonable to consider the current wording of art. 5,
para. 2, of the CLC as permitting a broad
interpretation in the sense indicated herein.
Furthermore, an interpretation aimed at putting the
shipowner to the test in providing negative proof of
such circumstance in order to avoid the accusation of
intentional recklessness does not seem possible.
The system relating to the limit that the 1992 CLC
poses to the shipowner’s liability, to the exceptional
circumstances permitting that limit to be broken and to
the operation of the burden of proof, has therefore
turned out to be a substantially unbreakable limit,
introduced precisely to avoid the risk that broad
interpretations of the notion of actual fault or privity
put forward in some jurisdictions when the 1969 CLC
was in force could have excessively penalizing effects
on the shipowner, and at the same time create
uncertainty and lack of uniform application. Moreover,
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the Fund itself openly admitted the above-highlighted
circumstance in a specific study (containing a
collection of the most important judicial and
administrative practices) conducted as early as the
1980s. Therefore, as already mentioned, it was
preferred to increase, within the possible limits
accepted by the insurance market, the maximum
amount to which the shipowner is liable. At the same
time, the aim was to guarantee greater certainty,
seriousness and uniformity of application with respect
to the subjective situations that permit exceeding the
amount. However, such an evolution has made it ever
more difficult (indeed, practically impossible) to
obtain compensation beyond the quantitative limit
indicated herein since the circumstances that permit
exceeding the limit are increasingly exceptional and
restrictive, and the burden of proof on the victims is
increasingly onerous.
From this perspective, and in order to discourage
the use of inadequately built ships with respect to the
best safety standards, the most reasonable measures
proposed seem to be, rather than the interpretative
efforts aimed at broadening the concepts of wilful or
reckless action or omission that could have negative
effects also with respect to the extension of insurance
coverage, a series of specific actions aimed at
introducing, with reference to some categories of ships
(defined as sub-standard with respect to the optimum
criteria of safety according to objective criteria), not
only greater limits to the liability of their owners but
also greater contributions to both the Fund and the
Supplementary Fund by the cargo owners who have
taken on the risk of using them.
Upon confirmation of the usefulness of the system
of channelling liability to the shipowner alone, any
possible action by victims against other individuals
involved in the management of the ship or in activities
concerning its operation, whose negligence may have
contributed to causing the damage, has therefore been
excluded. The arguments traditionally adduced in
defence of such a system have been repeatedly and
successfully asserted, showing, above all, that liability
channelling, together with strict liability, of the
shipowner constitutes a sufficient and economically
suitable guarantee of certainty, clarity and speed in
obtaining compensation for those who have suffered
damage. In that sense, these considerations have not
been overtaken by the lively and increasingly frequent
criticism of the system.
Indeed, the modifications introduced by the 1992
CLC to the 1969 CLC further strengthened the
underlying principles of channelling liability
exclusively to the shipowner. They extended the
consequent immunity regarding the claims of third
parties that have suffered harm to a wider range of
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INTERNATIONAL LAW
persons liable with respect to what was originally
provided. One should think, for example, of the
individuals who collaborate in various ways with the
ship or provide its services. Originally (in the 1969
CLC), the exemption introduced in this connection, as
regards to any claim for compensation for pollution
damage by third parties who have suffered damage,
was provided only for the servants and agents of the
owner. Subsequently (in the 1992 CLC), however, it
was extended to the benefit of any “person who, not
being a member of the crew, performs services for the
ship” (1992 CLC, art. 3, para. 4, b). Therefore, the
directives originally formulated by the Legal
Committee of the IMO are shared. Those directives are
even more relevant and significant if, as it appears to
be the case, the persons referred to in the provision
cited are understood to include not only natural
persons, but also legal entities who in various
capacities provide services to the ship (as the
provisions of the CLC, and in particular the other
provisions of art. 3, para. 4, already mentioned, seem
to confirm).
Notwithstanding the clarifications just made,
serious uncertainties still remain with respect to its
implementation and to the conditions and limits
according to which such rules can operate. For
example, with specific reference to what has been
indicated in connection with the persons providing
services to the ship, it is still uncertain whether some
of them, in particular ship classification societies, fall
within this category of entities for the purposes of
art. 3, para. 4. Moreover, it is also uncertain whether,
in general, an action of recourse brought against them
can be based exclusively on a contract, with all the
possible limitations and exemptions provided in this
regard, or whether the action of recourse can be of an
extra-contractual type. In favour of the first solution is
the case law of the United States, Spain and the United
Kingdom, which clearly excludes actions of recourse
regardless of whether they are based on a contractual
or at least ‘quasi contractual’ relationship. In
particular, British case law takes an approach that
offers guarantees and is very strict, with specific
reference to the proof of the liability of those
providing services, among them classification
societies. Instead, some decisions on the merits handed
down in France and in Italy adopt a somewhat
different approach.
Therefore, it appears clear how, despite the
progressive elaboration of rules, not only does some
uncertainty still exist with respect to important, even if
apparently secondary, aspects of legislative policy to
be followed at the international level, but there is also
a serious divergence in application of uniform law
rules, as well as significant displays of case law that
532
highlight how substantially identical situations are
treated differently (for example, in the sphere of those
providing services to the ship). This presents the risk
of potential, serious defects in the legislation at stake
also from the constitutional point of view, should such
unevenness of treatment in fact emerge and be
successfully invoked in appropriate instances.
This does not mean, however, that the providers of
services to shipowners can enjoy such a treatment as to
lead to absolute exemption from liability even if their
negligence caused or contributed to causing the
incident. In fact, if that is the case, it is quite true that
third parties who have suffered damage will not be
able to take action against them. Moreover, it is
equally true that the shipowner and the Fund, should it
intervene to integrate the shipowner’s limit of liability,
will be able to bring a recourse action against them
(1992 CLC, art. 3, para. 5).
At any rate, the strict liability of the shipowner
does not operate if such persons or entities had acted
with the intent to cause the damage; the above extends,
in general, also to any other person against whom an
action may not be brought by third parties who have
suffered damage under circumstances that justify the
channelling of liability to the shipowner according to
the Article under consideration. Therefore, they will be
considered liable with respect to third parties who
have suffered damage and who can bring an action
directly against them in the absence of any provision
of the CLC or of the Fund Convention.
10.4.5 The concepts
of compensable damage
and ship for the purposes
of the application of the
international rules
Also with reference to the concept of compensable
damage, the evolution of the 1992 CLC/Fund system
has aimed at better specifying some uncertain
normative contents by progressively amplifying their
material scope of application, in conformity with the
indications put forward.
First of all, in fact, it has been clarified (1992
CLC, art. 1, para. 6) that pollution damage is intended
to refer not only to the ‘physical damage’, caused by
an oil spill, as affirmed by the 1969 CLC, but also
refers to any other type of damage, and in particular
environmental damage, for which the extent of
compensation is limited only to “costs of reasonable
measures of reinstatement actually undertaken or to be
undertaken” and to the “costs of preventive measures
and further loss or damage caused by preventive
measures”. Impairment to the environment has,
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 CIVIL LIABILITY FOR OIL POLLUTION DAMAGE TO THE MARINE ENVIRONMENT
therefore, been included under compensable damage,
even if only limited to the cost of reinstatement
measures of the environment actually undertaken or to
be undertaken according to reasonable criteria and to
the costs of the measures aimed at excluding or
minimizing a serious imminent threat of pollution
damage following an oil spill during transport by sea.
Therefore, with dissatisfaction expressed by several
quarters, additional and more serious damage to the
environment, which cannot be compensated by
reasonable measures aimed at restoring the
environment to its original state, remain excluded. In
fact, attention is drawn to the inadequacy or even
contradictory nature of the 1992 CLC/Fund system,
where it considers biological damage to the marine
environment non-compensable when it is inestimably
important precisely because the damage is irreparable.
As far as economic damages, which are different
than ‘physical’ damages caused by oil spills, it is the
criteria of causation, above all, that shall be used
appropriately in order to bring a given negative
economic effect within the notion of pollution
damage, relevant for the application of the 1992
CLC/Fund system. Thus, in the perspective that has
just been outlined, the meaning of reasonable degree
of proximity between the polluting effect and economic
loss consequent from pollution has been specified. It
shall therefore be demonstrated, on a case-by-case
basis, and in addition to the normal circumstances that
justify compensation for economic loss, the specific
dependence and the geographical connection of the
loss suffered by those who carry out a determined
economic activity with respect to the resulting
pollution. In this connection, it should be taken into
account, for example, the extent to which the business
that has suffered the damage actually relies on using
the specific environmental resources affected by the
phenomenon, and also the impossibility for it to make
use of alternative resources according to reasonable
parameters: in brief, the extent to which the polluted
geographical area in fact constitutes an integral part of
the activity carried out by the one who has suffered the
damage and vice versa.
At any rate, in addition to the aspects mentioned in
the preceding paragraphs with regard to interpretation
having a direct effect on the basic choices made by the
1992 CLC/Fund, many other interpretative problems are
still open or at least have not been completely resolved
with reference to provisions that may appear of lesser
importance, but which in fact produce particularly
significant effects. Among them, for example, the very
notion of ship to be used for the purpose of applying
rules of the convention still remains heavily debated,
even though the 1992 CLC was considerably clearer on
this matter than the 1969 CLC.
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
It is a matter, in particular, concerning cases in
which oil spills come from constructions possessing
all the characteristics of a ship for carrying oil, but are
temporarily used as a floating oil recovery and
separating unit. The position expressed in this
connection by the Fund aims at including these cases
within the concept of ship and, therefore, at extending
to them the rules under consideration, based on a
functional interpretation that permits a broad
application thereof. Thus, the intention is to guarantee
to the greatest extent both the certainty of
compensation for damage to the victims of marine
pollution caused by oil spills, and the payment of
compensation due to those who contributed to prevent
its effects. However, it must be a spill of oil from cargo
tanks that may be used for the transport of oil by sea,
regardless of whether during the oil spill such ships
were being used not for transport, but only as a
receiving and separating unit.
A fortiori, the above-mentioned functional
interpretation is applied in cases of cargo tanks that,
while staying in port and after having terminated the
discharge operations, still contain residues of the
transported oil. In fact, this situation presents even
greater danger of possible effects deriving from the
risk of pollution with respect to those in the carriage
by sea phase. In this case, moreover, the ship is located
in vital and particularly sensitive regions of the marine
environment, such as port areas. Analogous
considerations have been formulated not only by the
Director, but also by the Executive Committee of the
Fund. The latter, precisely on that occasion, recalled in
this connection its function as authoritative (if not
even authentic) interpreter of the international regime
(as recognized by Resolution 8 of May 2003), from
which contracting states, and in particular their courts
and administrative organs, cannot derogate.
10.4.6 The Bunker Convention
The above-mentioned question related to the concept
of ship, relevant for the purpose of the application of
the 1992 CLC, is likely to be superseded to a large
extent when the 1992 CLC system will be shared by
an adequate number of states that are also parties to
the International Convention on Liability for Bunker
Oil Pollution Damage (the so-called Bunker
Convention), adopted by the IMO in March 2001, and
thus permitting its entry into force. In fact, such
Convention governs liability and compensation criteria
for damage caused by oil spills from all ships that do
not adhere to the CLC, according to principles and
criteria analogous to those adopted by the CLC. Thus,
the two Conventions, oriented according to
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INTERNATIONAL LAW
substantially coinciding rules, are mutually exclusive
and complementary. As such, they are suitable to
regulate the effects of any situation of an oil spill from
any type of ship, as well as the consequent liability
based on the same principles adopted in the
corresponding legal rules applicable from time to time
depending on the circumstances of the case.
The Bunker Convention has taken into account the
need to provide adequate rules also in the presence of
legal uncertainty with respect to spills from ships that
are not designed to carry oil (according to the 1992
CLC). In fact, such incidents are much more frequent
and, at least in their globality, just as serious as those
caused by the carriage of oil. Indeed, in some cases, it
has been observed that marine pollution damage
caused by bunker spills is even more serious since, on
account of its physical characteristics, oil used as a
combustible is more resistant to clean-up treatments
than crude oil. In fact, some states have long since
assimilated, by virtue of unilateral rules, the legal
regime governing liability for spills from oil tankers to
spills caused by any other ship (this occurred, for
example, as early as the 1980s in the United States
when the Oil Pollution Act was adopted).
The Bunker Convention confirms, therefore, the
criteria of channelled and strict liability of the
shipowner also with respect to bunker spills caused by
the latter. Moreover, the exceptional causes of
exemption that can be invoked in this regard are
indicated according to particularly strict criteria in the
same logic of the CLC and the analogous uniform
rules on liability for carriage of hazardous goods by
sea (International Convention on Liability and
Compensation for Damage in Connection with the
Carriage of Hazardous and Noxious Substances by
Sea, known as the 1996 HNS Convention).
Therefore, strict liability is not channelled
exclusively to the shipowner (registered owner), but is
extended also to the bareboat charterer, manager and
operator of the ship, according to the position of some
states, who hope that this modification should come
about also in the ambit of the CLC, expecting in this
connection that in all cases in which there are several
persons liable “their liability shall be joint and several”
(art. 3, para. 2). This solution was inspired by the
United States’ model and under European pressure for
a greater involvement in liability for marine pollution
of the persons just indicated. Above all, it has been
justified by the absence of a Convention
complementary to the Bunker Convention, analogous
to the Fund Convention with respect to the CLC.
Moreover, statistically, the damages caused by bunker
spills are more closely linked to the way in which a
ship is operated, in particular by the charterer or
manager, rather than to the structural shortcomings of
534
the ship, for which the shipowner is liable also with
respect to charterers. Therefore, it was natural and
more appropriate not to depart, in favour of the
victims, from the direct involvement of those entrusted
with the ordinary management and daily running of
the ship (namely, operator, charterer and manager of
the ship). It is true that the solution envisaged presents
considerable application disadvantages and can cause
duplication of insurance costs as well as conflicts
among insurers in sharing the compensation. It also
has to be considered that uniform rules do not directly
provide for the application of the joint liability regime,
according to the different situations and degree of
involvement in the pollution of those jointly liable. It
is reasonable, therefore, to maintain that the applicable
rules in this regard will be those established on the
basis of the provisions of the lex fori, though with
evident uncertainty and divergent application.
This diversity, moreover, will potentially occur
also with reference to responder immunity, which, as
already mentioned in connection with the 1992 CLC,
in principle, is destined to operate in favour of those
who intervene during rescue and/or clean-up
operations, and more generally in favour of the
servants or agents of the various persons considered
liable according to jointly channelled, strict liability
criteria. The extent of responder immunity is not,
however, exactly delineated in the uniform law rules.
Therefore, it is reasonable to maintain that, once
again, the domestic rules will have to be applied, and
it is hoped that a specific, express indication is made
in this connection by the different states when
depositing their instrument of ratification, as
expressed in a resolution adopted on this matter
within the IMO.
On the other hand, even greater uncertainty is
caused by the recourse to domestic laws with regard to
the regime instituted by the Bunker Convention, also
with specific reference to the liability limits for those
who must respond for damage caused by a bunker
spill. In fact, the Bunker Convention deliberately
refrains from establishing a specific limitation to
liability, let alone specific values for this purpose. The
Convention’s aim is not to prevent the application of
the liability limits determined according to the
national or uniform legal regime in force in the lex fori
(Bunker Convention, art. 6), as the application of this
regime is explicitly referred to. Such regime can,
therefore, be provided by uniform rules on limitation
of liability for maritime claims (and in particular by
the 1957 and 1976 Conventions), or by the 1992 CLC
in those states that have extended the regime to also
include bunker spills (e.g. the United Kingdom and
Canada), or one specifically providing for an ad hoc
regime for bunker spills (such as the one adopted in
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 CIVIL LIABILITY FOR OIL POLLUTION DAMAGE TO THE MARINE ENVIRONMENT
the United States), or (as in China) a regime in which
there is no limit to compensation for pollution.
It is evident that the Bunker Convention does not
contribute to the establishment of uniform rules
concerning quantitative limits of compensation for
damage caused by bunker spills. It is hoped, as
reasoned within the CLC system, that states will aim
to adopt the same limit for the Bunker Convention as
is provided in the CLC. This would also serve to
guarantee a continuity of rules that would overcome
potential distortions that still exist in the notion of
ship, as mentioned above, which is an important
matter for the purposes of establishing the sphere of
application of the CLC.
This is even more true if one considers that
recourse to the 1957 and 1976 Conventions’ uniform
legislation on limitation of liability with respect to
maritime claims may be inadequate (at least in the
current state of play), since such legislation contains
an exhaustive list of the only claims that can benefit
from the liability regime. In addition, it is not easy to
identify among such claims those that allow all the
various aspects of pollution damage caused by bunkers
spills to be recovered: only compensation for physical
damage and for costs caused by such spills can be
included in the lists provided in the Conventions
indicated herein.
10.4.7 The relationship between
the Bunker Convention
and the rules on limitation
of liability for maritime
claims
At present, there is a risk that, in states that are parties
to the 1957 and 1976 Conventions, pollution damage
caused by bunker spills not included in these categories
must be completely compensated. This risk can only be
eliminated by the entry into force and the effectiveness
in the ambit of the lex fori, of the 1996 Protocol to the
above-mentioned 1976 Convention on Limitation of
Liability for Maritime Claims. In fact, the above
Protocol expressly provides for the limitation of
liability with respect to the various aspects of pollution
damage, even if related to bunker spills.
States are aware of such possibilities; nonetheless,
they have permitted and encouraged recourse to the
general legal regime on limitation of liability for
maritime claims to reduce the constitution of
additional funds to those already provided for in the
1992 CLC/Fund Conventions concerning
compensation for damage. Indeed, the very rules on
limitation of liability for maritime claims in the 1976
Convention and 1996 Protocol provide for the
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establishment of different funds based on the type of
maritime claim, according to the nature of the damage
or the various events that have provoked such damage
in the context of a voyage by sea. In this perspective,
the solution adopted appears reasonable if the Bunker
Convention operates simultaneously or after the entry
into force of the 1996 Protocol to the 1976 Convention
on Limitation of Liability for Maritime Claims; thus,
when both instruments are in force at the same time.
The amounts due, at least within the limits that
have just been indicated, should be accompanied by
adequate insurance coverage or financial security as
established in art. 7, para. 1, of the Bunker
Convention. Only the registered shipowner (and not
the other subjects that are made jointly liable) is
required to have such insurance, to be integrated by a
certificate issued by the state whose flag the ship is
entitled to fly if that state is a party to the Bunker
Convention or, on its own initiative, by a state party
to the Convention (if the state whose flag the ship is
entitled to fly is not party to the Convention), and
such certificate states that insurance or other
financial security is in force (Bunker Convention,
art. 7, para. 2). Thus, it is possible to invoke the
intervention of the state that issued the certificate for
the purpose of correcting situations in which it seems
that the insurer or provider of financial security is not
in a position to fulfil its obligations (Bunker
Convention, art. 7, para. 9).
It goes without saying, the level of liability that
must be secured by insurance or financial security is
the same that is applicable to the limit (and to the
criteria for distributing such a sum with respect to
other possible competing creditors), to be determined
according to the rules in force in the state in which the
damage has occurred, with the uncertainties mentioned
above. Therefore, the relative provisions of domestic
law of the state in which the ship that has caused the
bunker spills is registered will be applicable only in
the case that: the uniform rules on limitation of
liability for maritime claims are not operative, the
rules of lex fori are not applicable and the rules of
private international law refer to the law of the state
whose flag the ship is entitled to fly.
The same model certificate adopted by the
Convention is thus limited to guaranteeing that the
insurance policy is valid and in force, as well as
capable of responding to the characteristics described
in the applicable rules in conformity with art. 7,
para. 1, of the Bunker Convention, while not indicating
a precise amount nor a specific applicable rule. At any
rate, the maximum amount that can be requested from
the insurer or provider of financial security cannot
exceed the value of the specific property fund
provided for in the above-mentioned 1996 Protocol to
535
INTERNATIONAL LAW
the Convention on Limitation of Liability for Maritime
Claims (Bunker Convention, art. 7, para. 1). Moreover,
within the above-mentioned limits and according to
the same principles adopted with respect to the CLC,
victims of damage can make their claims directly to
the insurance company or to the provider of financial
security that has issued the financial guarantee. In that
case, however, said insurance company or financial
security provider can exercise all the defences that the
shipowner can invoke, with the exception of situations
caused by a proceeding for insolvency, brought against
the shipowner, although if the pollution damage was
caused by wilful misconduct, it is possible to exclude
the obligation to pay compensation insured or secured.
10.4.8 Conclusions and prospects
for the evolution
of the system
Notwithstanding the criticism of some aspects of the
relative rules, the legal regime for liability for marine
oil pollution damage created by the uniform law
system described above appears, at present, difficult to
modify, at least with respect to its underlying
principles. This is particularly true since any
modification aimed at exceeding shipowners’ liability
limits in the presence of alleged, grossly negligent
behaviour ought to make provision for insurance
coverage and the relative joint liability (of charterers,
managers, etc.), which inevitably leads to a notable
increase in the price of oil products for consumers.
Clearly, such an effect is hoped to be avoided.
Therefore, it is a matter of preventing incidents in
the ambit of the rules currently in force through
adopting a stricter and truly uniform system to
regulate the market for the carriage of oil by sea, and
in addition to safety and relative controls, to encourage
a sense of social responsibility in all undertakings
involved for any reason in this sector. Furthermore, at
the private law level, appropriate codes of conduct
ought to be adopted and it should be possible
(according to the techniques permitted in the insurance
field) to verify that those codes of conduct are actually
applied by providing sanctions for violations, also by
piercing the corporate veil. To that aim, there should
be an increase in punitive measures and at least
deterrents with respect to shipowners who create
conditions that risk marine oil pollution by not
adopting the best suitable practices. Therefore, the
shipowners’ obligation to acquire adequate insurance
according to the CLC would need a stricter regime for
them as well as insurance premium costs that are more
closely linked to the potential risk created by using
ships which are not the best.
536
From a different perspective, it is also hoped that
the techniques offered by the development of
technology will be used with greater intensity to prove
the shipowner’s wilful or reckless behaviour, and that
the possibilities offered by the insurance system for
piercing the corporate veil of the single ship
companies will be exploited. The use of the techniques
indicated herein appears essential in particular when
holding a specific ship responsible for bunker oil spills
and the relative penalties must be made applicable and
the liability determined.
In any event, in order to complete the system
under consideration, there must also be public
intervention in the direction that has just been
indicated, aimed at guaranteeing and strengthening
the effectiveness of the rules and standards for safe
navigation, on a case-by-case basis, above all by
coastal states or port states. Techniques of moral
suasion with respect to the voluntary adoption of
best practices, according to the opportune
certifications required by the most qualified
organisms, also by virtue of the states’ specific
mandates can be considered equally important.
From this standpoint, it is advisable to provide
incentive for those ships proving to follow best
practices through various privileged treatments, such
as more economic and better operativeness in the
territorial sea and ports in whose markets they are
most interested.
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persone: il problema della risarcibilità del danno alla salute
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Carbone S.M. (2002) Il diritto marittimo attraverso i casi e
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Sergio Maria Carbone
Università degli Studi di Genova
Genoa, Italy
537
 10.5
Bilateral investment treaties
and the North American free
trade agreement
10.5.1 Introduction
The regime of foreign investments is to a great extent
determined not only by domestic legislation in the host
states and by the general rules of customary
international law, but also by the provisions of the
international treaties drawn up by those states.
Provisions in the conventions on this matter are
numerous, detailed and, wherever applicable to a
specific case, constitute a special law with respect not
only to the domestic rules of the host state but also to
international customary rules. It should moreover be
remembered that up until now attempts to adopt a
general multilateral convention governing investment
protection have been unsuccessful. The failure in 1998
of the OECD’s (Organization for Economic
Co-operation and Development) attempt to adopt a
Multilateral Agreement on Investments is of particular
significance in this regard.1 This failure led to great
importance being placed on international bilateral
investment treaties, or on treaties which have been drawn
up by a restricted group of states, in order to determine
which regime actually governs the investments.
The provisions of international investment
conventions should therefore be examined by looking at
two distinct but connected fields: that of Bilateral
Treaties for the Promotion and Protection of Foreign
Investments, and that of the broader bilateral or
multilateral Free Trade Agreements. In both fields the
problems to be examined are similar, particularly with
regard to the comparison between conventions on the one
hand and customary domestic or international rules on
the other. However, the investments regime established by
Free Trade Agreements has a specific character, because
it comes within the wider context of the liberalization of
other sectors, such as services and right of establishment,
which eventually connect with and enrich the body of
rules traditionally pertaining to investments.
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
The provisions of international conventions
governing this area are particularly important with
regard to investments in the sector of hydrocarbon
exploration and production. The considerable size of the
resources needed to carry out related activities, and the
high level of risk involved in such activities, oblige
the private investor to search for the most suitable
instruments to protect investment, which is often made
in countries whose legal systems do not offer particular
protection. The traditional mechanisms provided in oil
contracts (clauses concerning the law to be applied,
international arbitration clauses, stabilization clauses
and the like), being the result of negotiations with state
authorities, cannot always be obtained by private parties
with the necessary degree of completeness. Hence the
importance of the protection offered by bilateral treaties
and other international conventions, not only on account
of the intervention by the state of which the investor is a
national (with the possibility, therefore, that a private
investment dispute may be dealt with at an inter-state
level), but also on account of the consolidated principles
of protection incorporated in such instruments.2
10.5.2 Bilateral investment
promotion and protection
treaties
Origin and development
The number of Bilateral Investment Treaties
(BITs) is particularly high and has been
1 For an indication of the main causes of the failure of
negotiations within the OECD and for further
bibliographical references, see Mauro, 2003.
2 On the two levels of private investment protection
(contractual and that based on international law), see:
Bernardini, 2001a; Carlevaris, 2004.
539
INTERNATIONAL LAW
progressively growing in recent years: from fewer
than 100 treaties in the 1960s, the number rose to
about 170 in the 1970s, about 400 in the 1980s
and about 2,000 by the end of the 1990s
(Sacerdoti, 1997). At present various sources
indicate that about 2,500 BITs have been drawn
up.3 These treaties, with a structure basically
analogous to that of present BITs, were first
drawn up in 1959 (the Agreements between the
Federal Republic of Germany and Pakistan on 25
November 1959 and the Dominican Republic on
16 December 1959). Their precedents were
undoubtedly the classic Treaties of Friendship,
Commerce and Navigation that, commencing
with the Treaty between France and the United
States of 6 February 1778, were regularly drawn
up in the Nineteenth and Twentieth centuries
(Wilson, 1951; Walker, 1956; Preiswerk, 1979),
up to the present definitive victory of the BIT.
The reason for this victory, and for the
subsequent growing number of BITs, is to be
found in the uncertain state of customary
international law governing such investments.
These uncertainties were initially caused by the
impact of new international principles on the
traditional, i.e. general and generic, rules for the
protection of foreign investments. These
principles include that of permanent sovereignty
over natural resources, which was above all
affirmed within the United Nations as early as the
1960s.4 This was followed by preparation within
the United Nations, in the mid-1970s, of the
Charter of Economic Rights and Duties of
States.5 Also significant were certain
international investment disputes concerning the
crucial matter of oil concessions.6
In the context of widespread uncertainty
concerning the customary regime governing this
area, of direct confrontation between opposite
political and ideological concepts behind
scientific reconstructions and the settlement of
individual disputes, recourse to bilateral treaties
between states has proved to be very useful. In
order to encourage and protect investments, these
treaties defined specific rules which were
potentially capable of reducing the margin of
uncertainty and providing the basic framework
for useful collaboration in the future. In this
manner, evidently, special rules were drawn up
that represented an alternative to the general
body of controversial rules, which in any case
were imprecise. Subsequently, the very large
number of these treaties has raised the question
of whether they could make a decisive
contribution to the formation of general
540
customary rules corresponding to those generally
contained in the BITs. The question is still open
to this day. Some recent evolutions of the model
BITs adopted by countries which are particularly
active in the sector of investment promotion and
protection do reopen this whole general set of
problems.
Fields of application
The areas governed by bilateral investment
treaties can, generally speaking, be divided into
various sectors, in particular: the definitions of
investments and protected investors; admittance
of investments and their treatment, with
particular regard to the transfer of profits and
cases of expropriation and nationalization; the
settlement of disputes between contracting states
and, above all, disputes between private foreign
investors and states.
These topics will be outlined below.
Investment
The definition of investment generally adopted
today by the BITs is a very broad one. It includes
not only foreigners’ property but also their rights
and interests. It is by no means an exhaustive
definition, and it indicates by way of example only
some typical categories, which do not therefore
3 For the rapid increase in disputes between investors
and states, which corresponded to the mechanisms provided
in the BITs, see UNCTAD, 2005, which mentions 219 cases
up to November 2005; also Alexandrov, 2005.
4 Starting with the first famous United Nations General
Assembly Resolution n. 1803-VII of 14 December 1962.
See, in this connection, Frigo, 1982.
5 On Resolution n. 3281-XXIX of the General Assembly
of the United Nations of 12 December 1974, see, also for
further references: Picone, 1982; Di Blase, 1996. It is
generally accepted that, with regard to foreign investments,
the Charter denies from the start that international law can
provide criteria for assessing the conduct of states hosting
investments, as it makes no reference, in the case of
expropriation and nationalization, to international standards
of protection, but instead refers to domestic law and to the
courts of the host states. For all, and more recently:
Paulsson, 2000. It should be noted, however, that according
to its Chapter I, the Charter as a whole observed and still
observes some fundamental principles, among which the
“fulfilment in good faith of international obligations”
indicated at letter j) of the list. In this way respect for
international law appears obligatory, even with regard to
expropriation and compensation (Castaneda, 1974).
6 In particular, the three very famous Libyan arbitrations
of the 1970s concerning the British Petroleum, Liamco and
Texaco-Calasiatic cases should be recalled, and more
generally, arbitral case-law concerning state contracts which
have been analysed by, among others, Stern, 1980; Giardina,
1983; Bernardini, 2001b.
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 BILATERAL INVESTMENT TREATIES AND THE NORTH AMERICAN FREE TRADE AGREEMENT
exclude other types and forms of investment not
specifically mentioned.
The five principal forms of investment contained
in Great Britain’s model BIT of the 1990s are an
example of this (Dolzer and Stevens, 1995):
“Investment means every kind of asset, including:
(i) movable and immovable property and any other
related property rights such as mortgages; (ii) shares
in, stock, bonds and debentures of, and any other form
of participation in a company or business enterprise;
(iii) claims to money, and claims to performance under
a contract having financial value; (iv) intellectual
property rights, technical processes, know-how and
any other benefit or advantage attached to a business;
(v) rights conferred by law or under contract to
undertake any commercial activity, including search
for, or cultivation, extraction or exploitation of natural
resources.”
In current and most recent practice, definitions are
more detailed. Expressly indicated are movable and
immovable property and any other related property
rights such as mortgages, usufruct, pledges and
privileges, as well as rights of an economic nature
granted by law or by contract, such as those deriving
from licences and concessions regarding the search
for, cultivation and extraction of natural resources,
including hydrocarbons. In addition, shares in
companies that operate in the host state are explicitly
mentioned as investments. This is in order to overcome
doubts concerning the protection due to the
shareholders themselves as distinct from the
companies in which they are shareholders. Also
important is the explicit mention of industrial and
intellectual property rights, know-how, industrial and
commercial secrets. Rights of this type are well
described and protected in the treaties stipulated by the
United States of America. The income produced by
investments themselves is also generally considered to
be an investment, provided it is re-invested.
Sometimes, in particular in the BITs in the United
States, activities simply connected with the actual
investments are protected as well.
However, given the non-exhaustive nature of the
definitions adopted, there can be a problem as to
whether a determined activity can be considered an
investment and therefore protected by a BIT. In this
regard various, sometimes contrasting, solutions have
been proposed. The only point of consensus seems to
be that sales, and probably any other purely
commercial transaction, are excluded from the concept
of investment.7 Evidently this is a problem of
interpreting which BIT should be applied. Thus the
hermeneutic criteria connected to all international
treaties embodied in the 1969 Vienna Convention on
the Law of Treaties are to be respected. It follows that
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
the treaty’s purpose and scope will be conclusive, as
can be seen from the text as a whole, including the
preamble, and from the context in which the BIT has
been drawn up.
Some of the interpretative elements that may be
drawn from the preambles of the BITs seem
particularly important for the purposes
of contributing to the complete definition of
investment adopted in the texts of the treaties. In the
first place, the parties, by means of a BIT, intend to
promote the investment of resources provided by
individuals or companies from one state in the
territory of another. Secondly, it is apparent that the
flow of private capital promoted by means of a BIT
contributes to the economic development of the
party receiving the investment. At any rate, the
concept of investment should be determined in each
individual specific case by a precise application of
the texts of the treaties involved, taking into account
their purpose and scope and the context in which
they have been drawn up. In this connection the
analysis of the preambles plays an important role. It
should be remembered that all BITs contain a
definition of investment, and that the definitions
adopted have certainly evolved over time, their
breadth and precision growing progressively.
The problem of definition of these treaties is not
as important and serious as it is with respect to the
1965 Washington Convention on the Settlement of
Investment Disputes between States and Nationals
of Other States (ICSID [International Centre for
Settlement of Investment Disputes] Convention).
This convention does not contain an explicit
definition of investment in its Art. 25. Moreover,
from the Preamble of the Washington Convention
and from the arbitral practice of ICSID tribunals,
general criteria of reference are by now normally
deduced which must in every case be verified and
observed.
The criteria generally identified are: a) a certain
length of time of the operation, on the basis of which
instantaneous transactions, such as purchases and
sales, or other transactions that last briefly are
normally excluded; b) the operator’s expectation of
profit on and remuneration from the investment; c) the
risk taken by the investor, which is not the case if the
7 See, however, the observations made below in the text
which stresses that the essential element of the concept of
investment is the contribution to the economic development
of the host state, and how that contribution should
essentially be assessed from the host state’s perspective. For
example, a state could indeed maintain that even a
commercial transaction of considerable value constitutes a
real contribution to its economic development.
541
INTERNATIONAL LAW
host state itself takes on the risk of the investment.
This risk ought, moreover, to be distinguished from the
mere risk of non-performance of the contract by the
other party to the operation; d ) a certain value of the
resources brought in by the investor; e) the
contribution made by the operation to the economic
development of the host state, as indicated by the
Preamble to the Washington Convention.8
Consequently, purely commercial transactions or
those that are of brief duration ought as a rule to be
excluded from the ICSID’s concept of investment. It
should be noted, however, that in a case that aroused
considerable interest, Fedax v. Venezuela (ICSID case
ARB/96/3), an ICSID Tribunal, while fully accepting
the fundamental, general criteria set out above,
qualified a request for payment of bills of exchange
issued by Venezuela in connection with a contract for a
loan concluded between the parties, which was a
typically commercial transaction, as one relating to an
investment. The result was achieved by stressing
Venezuela’s basic public interest in issuing bills of
exchange, in the context of its legislation on public
credit, and the close relation between the transaction in
question and the economic development of the
country.9
By contrast, there can be no doubt as to the
qualification of oil-related activities as an investment,
as they are regulated by the relevant contract with the
state and with the competent state entity, both in terms
of duration and expected remuneration, with the
correlated element of risk and the contribution to the
economic development of the host state.10
In this regard, it should be noted that the need for a
definition of the term investment did not seem
essential in the initial application phase of the
Washington Convention, when the ICSID’s jurisdiction
was based exclusively on an arbitration clause or
agreement to submit to arbitration11 directly and
individually stipulated in the investment contract
between the investor and the state.12 This definition is
of considerable importance when – as in all of the
most recent cases – ICSID arbitration can be based as
follows: on the part of the state, by its adoption of a
domestic law13 or stipulation of a BIT14 and, on the
investor’s part, by direct submission of a request for
arbitration. In this connection, it has been called
arbitration without privity in order to underline this
characteristic initiation of arbitration without the
parties signing an arbitration clause or an agreement to
submit to arbitration at the same time.15
Consequently, the question that currently arises
with increasing frequency is that linked to a possible,
but frequent, definition of investment contained in the
BITs which is broader than the definition resulting
from the general criteria set out in the Washington
542
Convention. Since the BITs constantly refer to the
ICSID as a mechanism for dispute settlement between
states and foreign investors, it is necessary to verify
8 This general reconstruction has today been
authoritatively confirmed by: Schreuer, 2001; Reed et al.,
2004; Rubins, 2004. As to the host state’s need for the
contribution to its economic development, this has already
been indicated by Broches, 1982.
9 For comprehensible critical observations on such
excessive expansion of the concept of investment, see
Horchani, 2004.
10 In confirmation of this, it may be recalled that the
ICSID has recently recorded requests for arbitration
submitted by two oil companies, Wintershall,
in Wintershall v. Argentina (ICSID Case ARB/04/14)
and Mobil, in Mobil v. Argentina (ICSID Case ARB/04/16),
with respect to Argentina and relating to oil contracts based
on the BITs between Argentina and the states of which the
companies were nationals.
11 On the traditional techniques for stipulating
arbitration clauses and the recent evolution of such clauses,
see Bernardini, 2000.
12 The founding fathers and first commentators of the
Washington Convention, in the traditional context described
above, either felt the question of the definition of investment
to be of limited interest (Delaume) or considered it to be
essentially connected to or integrated with the question of
the Centre’s jurisdiction (Broches). The other commentators
always stressed the parties’ wide discretionary powers in this
regard (for all, Tupman). See: Broches, 1966; Delaume,
1966; Tupman, 1986.
13 Two cases are usually recalled. The first is the
so-called Pyramids Case, Southern Pacific Properties (SPP)
v. Egypt (ICSID Case ARB/84/3), decided on jurisdiction in
1985, in which Egypt’s agreement to arbitration by the
ICSID and, therefore, to the Centre’s jurisdiction and the
competence of the Tribunal, were based on Art. 8 of
Egyptian law n. 47/1974 on investments. The second is the
Tradex Hellas v. Albania case (ICSID Case ARB/94/2),
decided on jurisdiction in 1996, in which Albania’s
agreement to arbitration by the ICSID was identified in
Art. 8, para. 2 of Law n. 7764/1993 on investments. On the
latter decision see Mignolli, 2000.
14 With regard to bilateral treaties, the first case in which
a BIT clause providing for recourse to the ICSID was held
capable of establishing the Centre’s jurisdiction following an
investor’s unilateral recourse is the decision rendered in 1990
in the Asian Agricultural Products Ltd. (AAPL) v. Sri Lanka
dispute (ICSID Case ARB/87/3). On the above-mentioned
BIT clauses establishing the jurisdiction of ICSID tribunals,
see, for all: Gaillard, 2003; Sacerdoti, 2004.
15 The expression is Paulsson’s, 1995. See moreover the
critical remarks in this regard by Prujiner, 2005 and
Alexandrov, 2005. To be recalled in this connection is an
interesting case in which the Court of Appeal of Paris, and
then the French Cour de Cassation, annulled an arbitral
award on the grounds of the non-existence of the arbitration
clause, which had not in fact been stipulated by the parties,
but which was, however, supposed to have been concluded
because a bilateral treaty between Romania and Lebanon
made provision directly for ICC arbitration as a means of
dispute settlement. On the decision of the French Cour de
Cassation of 19 March 2002, see Liberti, 2004.
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 BILATERAL INVESTMENT TREATIES AND THE NORTH AMERICAN FREE TRADE AGREEMENT
whether the ICSID has jurisdiction in all those cases in
which the concept of investment adopted by the BIT to
be applied does not, since it is broader, correspond to
that of the Washington Convention. In such a case the
conclusion seems to be that the clause in the BIT
invoking the ICSID mechanism is ineffective when
this mechanism cannot in itself function as there are
insufficient premises (Broches, 1982; Schreuer, 2001).
Protected investors
As to the essential characteristics of protected
investors, all BITs define individual citizens and
companies which are nationals of the contracting
states as such.
For individuals, nationality is commonly
determined and ascertained in conformity with the
law of the state that grants it. Problems arise only
in particular cases, when the investor has dual or
plural nationalities. If the investor is a national of a
third state in addition to being a national of one of
the contracting states, then based on the principle
of effective nationality established by the
International Court of Justice in its decision of
1955 in the Nottebohm case,16 the prevailing
nationality is that of the state with which the
investor has the closest link. Should the investor be
a national of both states which are parties to the
BIT, the solution traditionally accepted with regard
to diplomatic protection of nationals is that the
investor in question is not considered a foreigner
by the host state (Geck, 1987; Mauro, 2003). The
most recent trend emerging from the case-law of
the Iran-United States Claims Tribunal from the
mid-1980s should however be mentioned,
according to which even in this case the criterion
of effective nationality would be applied.17
Going back to the specific matter of
investments, it should lastly be noted how the 1965
Washington Convention, establishing the ICSID, in
Art. 25, para. 2, a) follows the traditional
orientation of the BITs and excludes the Centre’s
jurisdiction should the investor with dual
nationality also be a national of the host state
against whom arbitral proceedings have been
initiated. By contrast, the recent United States
model BIT (2004) adopts the criteria of dominant
and effective nationality of the individuals even
when USA nationality competes with that of the
other state party to the BIT.18
With regard to companies and juridical persons
in general, the starting point for any reconstruction
on this topic according to customary international
law is the decision of the International Court of
Justice in the Barcelona Traction case,19 according
to which diplomatic protection of companies is the
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duty of the state in which the companies have been
set up and have their registered offices, and not
that of the state of which the majority of
shareholders are nationals, provided that
connections with the state in which the companies
have been set up are real and not fictitious.
Article 25, para. 2, b) of the Washington
Convention provides that the Centre’s jurisdiction
shall extend to juridical persons who are nationals
of the state hosting the investment, but that
“because of foreign control” the parties have
agreed they should be treated as nationals of
another Contracting state for the purposes of the
Convention. This provision, which led to a
considerable volume of case-law of ICSID arbitral
tribunals and numerous comments in legal
literature,20 should of necessity be applied in the
case of arbitration under the Washington
Convention. This implies that when an arbitration
is based on a state’s agreement expressed in a BIT
which may adopt definitions different from or
broader than those in the Washington Convention,
ICSID arbitration ought nevertheless to follow its
own criteria for jurisdiction ratione materiae
(subject-matter jurisdiction) and ratione
personarum (personal jurisdiction) as set out in the
16 Liechtenstein v. Guatemala, International Court of
Justice, 1955. For a description of the Court’s decision and
bibliographic references see: Rezek, 1985; Acconci, 2002.
17 This is the case with the decision rendered by the Full
Tribunal in Peru v. Japan, case A/18 of 1984, in Adlam,
1985. On the case-law of the Iran-US Claims Tribunal on
this matter see Mauro, 1999.
18 In the definitions contained in Art. 1 of the USA
model, under the indication “investor of a Party” it is
specified that “a natural person who is a dual national shall
be deemed to be exclusively a national of the state of his or
her dominant and effective nationality”.
19 Belgium v. Spain, International Court of Justice, 1970.
There is a vast amount of legal literature on the topic. See
also with reference to practice and subsequent literature,
Gianelli, 1986; Condorelli, 2003.
20 On the numerous ICSID cases, see Bernardini, 1981
and Mignolli, 1996, up to the most recent cases such as the
important, stimulating case Tokios Tokelès v. Ukraine
(ICSID Case ARB/02/18), a decision on jurisdiction of 29th
April 2004, annotated by Carlevaris, 2004 and Savarese,
2005, also for references to legal doctrine on the question.
With regard to the protection of the investment of a minority
shareholder in a local company, see the ICSID decision of
2003 in CMS Gas Transmission Company v. Argentina
(ICSID Case ARB/01/8), with notes by Zaccaria, 2004 and
Alexandrov, 2005. In general, see Orrego Vicuna, 2005.
Lastly, as to the requirement that the company initiating
arbitration must have the continuous nationality of a
Contracting state, the ICSID decision of 2003 in Loewen
v. USA (ICSID Case ARB/98/3) should be mentioned; see
Acconci, 2004.
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INTERNATIONAL LAW
Washington Convention. The solution could be
different in cases in which a BIT makes provision
for other ways, either judicial or by arbitration, to
settle disputes between investor and host state. In
these cases the BIT’s criteria for establishing
jurisdiction ought to correspond to those of the
chosen mechanisms. Such mechanisms will not, in
general, place limits on the criteria for establishing
subject-matter and personal jurisdiction adopted in
the BITs. For example, this is the case of
arbitration under the UNCITRAL (United Nations
Commission on International Trade Law) rules or
under the rules of the International Chamber of
Commerce, which are also frequently indicated in
bilateral investment treaties.21
Admittance of investments and their treatment
Another topic of great interest relates to the
admittance of investments. The traditional approach of
the BITs has been to leave states considerable freedom
to apply their domestic rules on investments and, in
particular, rules governing concessions for the
exploitation of natural resources such as oil and
hydrocarbons in general. However, the new generation
of bilateral treaties, especially those of the United
States and those inspired by the United States model,
also tend to include the topic of admittance among
those regulated by the treaties (Mauro, 2003).
The technique commonly used in this connection is
not that of formulating a detailed body of rules, but of
using general clauses of reference, such as the
most-favoured-nation clause or the national treatment
clause. The effect of the former is that admission of
investments from the state with which the BIT has
been drawn up is made according to the most
favourable regime applied by the host state to
investments from any other state with which it has
concluded a treaty on the matter. The effect of the
second clause is that no distinction is made, with
respect to admittance and authorization, between
national investments and investments from the other
contracting state to the BIT.
Transfer of profits. This is not the place for a
detailed analysis of the provisions generally included
in bilateral treaties, even the most significant
provisions. However, mention should be made of the
importance of provisions concerning the treatment of
investments, particularly treatment established both in
a general and indirect way by means of the above
most-favoured-nation clause or national treatment
clause. Traditionally, bilateral treaty provisions
concerning the treatment of investments have been
understood in legal writings as an indication of a
minimum international standard which should at all
events be respected by the host state. The
544
above-mentioned attempts made in the mid-1970s to
affirm new principles which were more favourable to
the interests of host states have, however, determined
an evolution of the general formulae used in bilateral
treaties with regard to foreign investments. In the most
recent treaty practice, more general and elastic
formulae have been devised, such as those of fair and
equitable treatment or full protection and security of
foreign investments. These formulae, while less rigid
and schematic than those of the international
minimum standard, guarantee nevertheless a degree of
protection which is now considered adequate by the
countries of origin of the investments (Schreuer,
2005). Finally, the treatment provided for by the BITs
generally consists of obligations on the part of the host
state with respect to the transfer abroad of profits that
might be produced and the repatriation of capital
invested (Mauro, 2003).
Expropriations and nationalizations. Lastly,
provisions in the bilateral treaties concerning
expropriations and nationalizations merit particular
mention. This is not now the place to recall
considerations of legal writers on the related rules of
customary international law, their initial content, their
uncertain and partial evolution and their current
state.22
One of the main raisons d’être for BITs has been
to overcome difficulties caused by uncertainty with
respect to the content of customary rules. Given the
decisive role relating to BITs played by
capital-exporting states, it was held that expropriation
of foreign property and investments can be carried out
only in the public interest, in a non-discriminatory way
and against payment of compensation that must be
adequate, prompt and effective.23
Dispute settlement
In the most recent bilateral treaty practice,
especially the latest models adopted by major
21 For basic references on arbitration by the ICSID,
UNCITRAL and the ICC, see, for all, Bernardini, 2000.
22 Information on practice and the relative bibliography
is extensive. On the distinction between expropriations and
nationalizations see, in general: Carreau and Juillard, 1998,
and Giardina, 1996, with specific reference to the
Guidelines on the Treatment of Foreign Direct Investment,
adopted on 21 September 1992 by the Development
Committee, a joint forum of the World Bank and the
International Monetary Fund. On the evolution of the rules
of customary international law in this connection, also for
references, see: Francioni, 1975; Tesauro, 1976; Dolzer,
1986; Padelletti, 1995; Giardina, 2001.
23 The systematic repetition of this type of provision in
the BITs has led to a common belief that by now customary
law has been formed in this connection. Schwebel, 2004, is
unequivocal in this regard.
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 BILATERAL INVESTMENT TREATIES AND THE NORTH AMERICAN FREE TRADE AGREEMENT
capital-exporting countries, primarily the United
States of America24 and Canada25, amendments to the
traditional rules contained in the BITs have been
introduced above all for the purpose of safeguarding
the states’ right to intervene, possibly even to the
detriment of foreign investors’ interests, to protect
general interests with respect to the environment,
workers’ rights and competition.26 All this seems to
reopen the whole question of basic rules aimed at
guaranteeing foreign investors absolute protection,
rules which are commonly held to be customary and
are generally accepted.27
From the point of view of arbitral proceedings, too,
some changes introduced in the current U.S.A. Model
are rather disruptive with respect to commonly adopted
institutions and procedures. The first change concerns
the so-called fork in the road rule that had been
adopted in the previous Model of 1994 (Art. IX,
para. 3, a) according to which the investor could not
have recourse to arbitration based on the BIT when the
dispute had already previously been submitted to a
different dispute resolution mechanism as provided
contractually. Art. 26, para. 2 of the current Model
provides instead that the arbitration envisaged by the
BIT can in any case be initiated on condition that the
investor waives the right to start or to continue different
proceedings, be they civil, administrative or arbitral.
Another important procedural change is the right
granted to the state of which the investor is a national
to submit written pleadings and to intervene orally in
the arbitral proceedings between investor and host
state on questions of interpretation of the BIT (Art. 28,
para. 2 of the Model). Given that in many
investor-state disputes questions of interpretation of
the relative BIT are likely to arise, there will doubtless
be frequent interventions by the state of which the
investor is a national. Thus the much-stressed
advantage of direct individual-state arbitration,
established by the so-called de-politicization of
disputes compared to traditional inter-state diplomatic
protection, will be lost.
Lastly, Art. 28, para. 3 of the Model BIT provides
that the arbitral tribunal is granted the power to accept
and take into consideration the written and oral
pleadings of persons or entities serving as amici
curiae. In this regard, too, there is no need to point out
that all this is innovative with respect to the
characteristics typical of international arbitration
traditionally conducted in the presence of only the
parties that have stipulated the agreement to submit to
arbitration, and does not permit the intervention of
third parties unless the parties involved in the
arbitration have so agreed.
The procedural changes of the new types of BIT,
added to the substantial changes indicated above,
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appear to herald a new era in the international practice
of bilateral agreements on the promotion and
protection of investments. The characteristics of these
agreements can be deduced from the new BIT models
that are being negotiated and drawn up but whose
import can only be verified in the future, in the light of
solutions to the investor-state disputes relating to the
application and interpretation of these new types of
agreements.
10.5.3 The North American Free
Trade Agreement (NAFTA)
Background
Alongside bilateral investment promotion and
protection treaties, a whole network of bilateral or
multilateral treaties regulating a wider range of
activities has developed. By including investment
matters too, these treaties aim to achieve real areas of
free trade among participating states. These
agreements should be compared and harmonised with
the general rules of the World Trade Organization
(WTO) and, in particular, with the General Agreement
on Tariffs and Trade (GATT) in its original version
(1947) and in its present version (1994). Article XXIV
of the GATT establishes that, provided certain
conditions are met, regional agreements, namely
24 The latest U.S. Model of a Bilateral Investment Treaty
was adopted in November 2004. The text is available on the
web site of the US State Department at
http://www.state.gov/e/eb/rls/othr//38602.htm. For a
comment, see Kantor, 2004. This Model contains Art. 12
entitled Investment and Environment and Art. 13 entitled
Investment and Labor. Typical is the provision contained in
Art. 12, para. 2, according to which “Nothing in this Treaty
shall be construed to prevent a Party from adopting,
maintaining, or enforcing any measure otherwise consistent
with this Treaty that it considers appropriate to ensure that
investment activity in its territory is undertaken in a manner
sensitive to environmental concerns”. In the case of a
dispute concerning the application of the provisions
of Arts. 12-13, however, the only remedy offered by the
Model BIT is inter-state consultation between Contracting
Parties. Investors do not, therefore, seem able to invoke the
violation of these provisions directly in arbitration against
the state hosting the investment.
25 On the Canadian Model Foreign Investment
Protection and Promotion Agreement (FIPA) of 2003, see
McIlroy, 2004.
26 See the references and in-depth examinations of
Kunoy, 2005 and Clough, 2005.
27 The following authors highlight the new
developments, maintaining that they appear to reopen the
whole question of rules that are generally considered
accepted: Kantor, 2004; Rubins, 2005; Schwebel, 2005.
On this case, see also: Marrella, 2003; Fortier and Drymer,
2004.
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customs unions and free trade areas, can lawfully
derogate from the obligation to observe the
most-favoured-nation treatment in force with respect
to all parties to the General Agreement (Fabbricotti,
2001; Picone and Ligustro, 2002). It should be
stressed how the practical application of the GATT
shows a certain tolerance with respect to these
agreements for the liberalization of trade and that,
even though reservations can be expressed with regard
to some bilateral free trade agreements,28 the North
American Free Trade Agreement (NAFTA) is basically
in harmony with the GATT-WTO system.29
NAFTA was signed on 17 December 1992 by the
United States, Canada and Mexico, and entered into
force on 1 January 1994 (Art. 2203). It is accompanied
by two complementary Agreements on environmental
co-operation and on labour co-operation, which also
entered into force on 1 January 1994. These were
motivated not only by the understandable need for
protection at a time when increasing economic activity
was expected, above all in Mexico, but also by the
desire to avoid the danger of dumping, to the detriment
of the United States and Canada, on account of lower
costs in Mexico, given the lesser degree of
environmental and labour protection in that country
(Beviglia Zampetti, 1996).
Characteristics
Abolition of customs and other restrictions on trade
The first characteristic of a free trade area is the
abolition of customs and other restrictions on trade
within that area. This must come about, according to
Art. XXIV of the GATT, for substantially all the trade
and within a reasonable time. With regard to all trade,
the requisite appears to have been respected even with
the adoption of special regimes for agricultural goods,
textiles, automobiles and energy resources. As to the
period necessary for the complete achievement of the
free trade area, the rule tends to prevent an
over-lengthy transitory phase from transforming the
planned free trade zone (which is permitted) into a
preferential agreement (which is not). NAFTA
provides that, in the transitory period for tariff
elimination, 60% of customs duties will be phased out
within five years of the entry into force of the
Agreement. Tariffs and quotas on agricultural products
will be completely eliminated within fifteen years. For
the majority of products, traditional quotas, which are
initially transformed into extremely low tariff rate
quotas, will also be abolished within a maximum
period of fifteen years. Lastly, it should be observed
that during the transitory period states will still be able
to introduce protective measures when imports of
certain goods, which have benefited from tariff
546
reductions provided for in the Agreement, have risen
to the extent that they damage the corresponding
industry in the importing state.
As in all free trade areas, in NAFTA, too, only
goods originating in the Contracting states can
circulate freely. Otherwise, given the absence of a
common external tariff in the zone, there would be
distortions in movement to and from those member
states whose tariffs and trade regulations are more
favourable to outsiders. The consequent problem of the
definition of the origin of goods, peculiar to each free
trade area, is settled by NAFTA’s basic rule that the
country of origin of the goods is the country in which
the goods have undergone the last transformation that
makes it possible to change the customs heading. This
is the case independently of the importance, quality
and quantity of the transformation which has caused
the change with respect to the previous customs
heading. Special, more restrictive rules apply to some
products such as textiles, automobiles and automatic
data processing goods.
Investments, services and related issues
Part Five of NAFTA governs and liberalizes
investments, services and related issues. With regard to
services, the principles adopted are those of
most-favoured-nation treatment and of national
treatment. In addition, residence or establishment in a
country are no longer considered indispensable
requisites for the provision of services in that country.
The general principle of freedom of establishment,
which the United States had in the course of
negotiations considered of fundamental importance,
has been introduced (De Mestral, 1998). National
measures, at federal, state and provincial level, which
conflict with NAFTA’s liberalizing rules that states
wish to maintain, are specifically listed in Annexes to
the Agreement. All other measures are to be abolished.
The majority of services, in particular financial
services, have therefore been liberalized on the basis
of the special rules set out in Chapter XIV on
insurance services and procurement. Moreover there
are rules on competition, monopolies and state
enterprises (Arts. 1501-1505).
Article 1139 of NAFTA, containing definitions of
terms used in Chapter XI, adopts an extremely broad
definition of investment, though it does expressly
28 To be mentioned, for example, are the free trade
agreements stipulated by the United States and Singapore on
6 May 2003 and by the United States and Chile on 6 June
2003. See the observations thereon by Mauro, 2006.
29 For a general description of the structure and content
of NAFTA, compared to those of GATT, see, above all:
Abbott, 1995; Marceau, 1997; De Mestral, 1998.
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 BILATERAL INVESTMENT TREATIES AND THE NORTH AMERICAN FREE TRADE AGREEMENT
exclude some forms. In this way NAFTA contributes a
clarity that the ICSID Convention does not provide
and places some limits on the very broad definitions
adopted in the BITs. In particular, the following have
been excluded from the concept of investment: claims
to money that arise solely from commercial contracts
for the sale of goods or services; the extension of
credit in connection with a commercial transaction,
such as trade financing, other than a loan already
considered to be an investment;30 any other claims to
money that do not involve the kinds of interests
already considered to be investments.31
As far as the obligations concerning treatment are
concerned, the basic principles are still the traditional
principles of the most-favoured-nation treatment and
national treatment. In this connection it should be
noted that treatment also includes the right of
establishment of foreign investors and, therefore, their
admittance. Some sectors have nevertheless been
excluded (Art. 1101, Annex III), namely, the natural
gas and petroleum sectors with regard to Mexico,32 the
air transport sector with regard to the United States
and the publishing and audiovisual sectors with regard
to Canada.
There are also rules on the treatment of
investments themselves. The general formula adopted
in Art. 1105, paragraph 1 merits attention as it imposes
a “treatment in accordance with international law,
including fair and equitable treatment and full
protection and security”. It is very broad and
protective. Some additional indications nevertheless
legitimate conduct of a host state that might have a
negative effect on the ample protection which should,
in general, be provided to foreign investors. These
limitations and additional indications concerning the
treatment of foreign investments contained in NAFTA
seem to have been the spring-board for developments
incorporated in the new USA and Canadian Model
BITs (see above; Legum, 2004).
A first specification is that contained in Art.
1105, paragraph 2, affirming the obligation to treat
investors and investments of other member states in
a non-discriminatory manner with regard to
measures adopted or maintained relating to losses
suffered by investments in its territory owing to
armed conflict or civil strife. Even more important is
the specification concerning environmental
measures. Article 1114 states in this connection that
nothing in Chapter XI on investments can prevent a
member state from adopting, maintaining or
enforcing any measure it considers appropriate to
ensure that investment activity in its territory is
undertaken in a manner sensitive to environmental
concerns. Moreover, states recognise that it is
inappropriate to encourage foreign investments by
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derogating from or relaxing the application of
existing health, safety or environmental measures.
On the specific matter of expropriations, including
indirect expropriations and nationalizations, there are
special rules requiring not only that expropriation be
for a public purpose and on a non-discriminatory basis
but that it also be in accordance with “due process of
law” (Art. 1110, para. 1, c). Compensation shall be
equivalent to the fair market value of the expropriated
investment at the date of expropriation and shall not
reflect any change in value occurring because the
intended expropriation had become known earlier. The
criteria for assessment are indicated in the following
formula: “Valuation criteria shall include going
concern value, asset value (including declared tax
value of tangible property) and other criteria, as
appropriate to determine fair market value” (Art. 1110,
para. 2). Interest on the amount of compensation shall
be due at a commercially reasonable rate for that
currency from the date of expropriation until the date
of actual payment thereof (Art. 1110).
Settlement of investor-host state disputes
The last topic to be addressed relating to
investments in the sphere of NAFTA is the settlement
of investor-host state disputes.33 The rules of NAFTA
in this regard permit interesting, constructive links
with the observations expressed above concerning the
mechanisms provided by BITs and the general ICSID
mechanism.
30 A business loan is considered an investment when the
business is linked to the investor, when the original loan
expires at least three years afterwards and does not include a
loan to a state enterprise whatever its duration.
31 Here the reference is to goods and interests expressly
qualified as investments under letters a) to h) of the
definition of investment.
32 Mexican constitutional law prohibits foreign
ownership of the country’s natural resources. Maintaining
this principle also within the scope of NAFTA, Mexico is
exempt from a great number of the obligations concerning
sources of energy envisaged in the North American
Agreement: see De Mestral, 1998.
33 This is not the place to describe the mechanisms for
dispute resolution between states, which are obviously
included in NAFTA, as in all other international agreements
and in particular BITs. See the thorough description in:
Johnson, 1994; De Mestral, 1998. Such typically inter-state
mechanisms do not interfere with those available to settle
disputes between private investors and host states; it should
only be taken into account that the possible non-enforcement
by a state of an arbitral award in a dispute between private
individuals and a state constitutes a violation of the
obligation contained in the BIT or NAFTA, to execute
arbitral awards. Non-compliance can therefore give rise to
an autonomous dispute between states concerning the
non-enforcement of an arbitral award obtained by a private
individual against a state.
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INTERNATIONAL LAW
First of all a general rule concerning expiration
should be recalled: the investor can take action to
assert its personal right on condition that more than
three years have not elapsed since it knew of the
wrongful act or the harm it had suffered; or assert, still
within the same time-limit, the rights of an enterprise
which has suffered a wrongful act or sustained harm.
When an investor makes a claim on behalf of a
company and an investor or a non-controlling
shareholder makes a claim on a personal basis with
reference to the same events, the subsequent actions
ought to be decided by the same arbitral tribunal
established under the general rule contained
in Art. 1120.
Of interest is the provision in Art. 1119, which
states that the investor must deliver to the state notice
of intention to submit a claim to arbitration at least 90
days before the claim is submitted, indicating the key
elements set out in its claim and, in particular, the
factual basis for the claim, the NAFTA provisions the
claimant considers to have been violated and the
amount of damages claimed. The requirement for
submission of the claim to arbitration is that the
investor who makes a claim on its own behalf, on
behalf of a company or a directly or indirectly
controlled entity waives, and has its waiver submitted
by the company or the entity on whose behalf it is
claiming, the right to initiate or continue proceedings
before any administrative tribunal or court under the
law of any member state or to have recourse to other
dispute settlement mechanisms. The agreement to
arbitration envisaged by NAFTA and the waiver of any
other possible method of dispute settlement must be in
writing and must be submitted together with the claim
for arbitration.
The North American Agreement thus provides a
remedy to those difficulties and conflicts that
frequently arise where there is competition between
dispute settlement mechanisms.
As to the type of arbitration chosen by NAFTA,
Art. 1120 indicates three alternative solutions from
which the investor can choose. They are: the ICSID
Convention, provided that both the state of which the
investor is a national and the host state are parties to
that Convention; the Additional Facility Rules of the
ICSID, provided that only one of the two
above-mentioned states is party to the ICSID
Convention; and the UNCITRAL Arbitration Rules.
The first and third alternatives are rather common and
are, at any rate, typical of the BITs. The reference to
the Additional Facility Rules of the ICSID is due to the
fact that Canada is not a contracting party to the
Washington Convention, and therefore the true ICSID
mechanism cannot be applied with respect to Canada
and Canadian nationals.34
548
Conclusions
The description and analysis can be concluded by
stressing that NAFTA, especially in the investments and
services sectors, gave rise to interesting and significant
disputes that have above all drawn a comparison
between the rights of investors and service providers
and the law of the host states for the protection of public
interests with regard to the environment, labour and
public health.35 This shows how international disputes
relating to investment protection in general are
nowadays those undoubtedly more complex disputes
that oppose the above-mentioned interests and values,
rather than the traditional cases of expropriation and
nationalization of foreign property.
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35 This occurred right from the first cases, namely the
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Rome, Italy
ENCYCLOPAEDIA OF HYDROCARBONS
 10.6
The Energy Charter Treaty
of 1994
10.6.1 Introduction
The Energy Charter Treaty was signed in Lisbon
on 17 December 1994 by fifty-two contracting
parties, including the European Community and all
the member states at that time, Russia (which
provisionally applies the Treaty) and the states of
Eastern Europe, other European states, states of the
former Soviet Union, Turkey, Japan and Australia
(which has yet to deposit its instrument of
ratification).
The Treaty, together with the Protocol on
Energy Efficiency and Related Environmental
Aspects annexed to it, entered into force on 16
April 1998, once the first thirty ratifications had
been reached.1
Essentially, the Energy Charter Treaty
constitutes a re-assertion, in a precise and
binding legal form, of the general principles
affirmed a few years previously at a general
political level in the European Energy Charter
signed at The Hague on 17 December 1991 by
the European Community and its member
states.
The Charter also aimed to stimulate the
development of Eastern European countries by
means of investments from Community countries,
and to ensure that the Community states had a
stable supply of and secure access to the energy
resources (oil, natural gas and electricity) of those
countries.
As the purpose of the Charter was to create an
open, competitive market within the entire energy
sector, two objectives were of particular
importance: the supply and transport of energy
products to the Community territory and
subsequently the free use of those resources within
the Community.2
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
10.6.2 Trade, transit,
the environment and energy
efficiency, and competition
The main sectors governed by the Energy Charter
Treaty are those concerning trade, transit of energy
products, energy efficiency and related
environmental questions, and the investment
sector. Provision is made for dispute settlement
mechanisms and an institutional structure, centred
on the Energy Charter Conference, and a
Secretariat based in Brussels.
The sector of trade in energy products
With regard to trade, the original provisions of the
Treaty were based on the GATT rules in force at the
time, and were modified by the Trade Amendment,
which was adopted in April 1998 when the Treaty
1 For an up-to-date list of the contracting parties, the
state of ratifications of the Treaty, the Protocol on Energy
Efficiency and Related Environmental Aspects and the 1998
amendment to the trade-related provisions of the Treaty, as
well as the states which provisionally apply these
instruments, see the internet site www.encharter.org. The
bibliography on the Treaty is very large. See in particular:
Brazell, 1994; Babadji, 1996; Touscoz, 1996; Wälde, 1996a;
Schaeffer, 1998 (a work primarily dedicated to questions of
free circulation of imported energy products and
competition within the European Community); Happ, 2002;
Wälde, 2004.
2 The Energy Charter Treaty, part of the concluding
document of the Hague Conference on the European Energy
Charter, was signed by fifty-one contracting parties,
including the European Communities, countries of Eastern
and Western Europe, member states of the former Soviet
Union, the United States of America and other
non-European member states of the OECD, namely Japan
and Australia. The text of the Charter is reproduced in the
publication of the Energy Charter Secretariat, 2004.
551
INTERNATIONAL LAW
entered into force.3 The purpose of the amendment
was to harmonize the Treaty rules with World Trade
Organization (WTO) practice and provisions. The
principles common to and constituting the basis of
both systems are non-discrimination, transparency of
decisions and commitment to the progressive
liberalization of trade in the energy products covered
by the Treaty. The amendment expands the Treaty’s
scope to also cover trade in energy-related equipment
and instruments. It also sets out a mechanism for the
future introduction of a legally-binding standstill on
customs duties and restrictions for energy-related
imports and exports.
For those signatory states which were not, or are
not yet, members of the WTO (the Russian Federation
and other former republics of the USSR) the Treaty
provisions as amended represent an instrument that
encourages the application, albeit in one particular
sector, of principles and rules conforming to those of
the WTO,4 thereby in effect also favouring their future
participation in the WTO.
Transport and transit of energy products
Rules concerning the transport and transit of
energy products, contained in art. 7 of the Treaty, are
particularly important. Oil and natural gas are often
transported by public companies which operate as
monopolies, especially in the countries of Eastern
Europe, thereby hindering the creation of any form of
market in that sector. On the other hand, the countries
of Western Europe seek to ensure a safe and stable
energy supply and to avoid both dependence on
exclusive suppliers and any risks that might be
created by transit countries which, on account of
their own possible need for the products in transit
over their territory, or of disputes with producer
countries, can hinder the supply or render it
unreliable. The problems of this nature that occurred
in Western Europe, and particularly Italy in the
winter of 2006, are well known. These followed a
dispute between Russia and the Ukraine over the
price of Russian supplies of natural gas to the
Ukraine, and the price to be paid to the Ukraine for
the transit of natural gas destined for European
consumption over Ukranian territory .
The contracting parties undertake in particular to
facilitate the transit of energy products and materials
by applying the general principle of freedom of transit
without discrimination based on the origin, destination
or ownership of the products and materials in question,
and in particular with no discrimination relating to
prices based on the same criteria (art. 7 of the Treaty).
In the case of disputes, a transit state must not
interrupt or reduce the flow of products and materials
over its territory until the contractual mechanisms or
552
other mechanisms envisaged for the settlement of
disputes have been used and exhausted. In every case,
a contracting party involved in the dispute can appeal
to the Secretary General, who will appoint a
conciliator in order to achieve an agreed solution. If
agreement cannot be reached within three months, the
conciliator shall recommend a solution to the dispute,
or a mechanism for dispute resolution, and at the same
time shall set the provisional rates and other conditions
to be applied to the transit until the dispute has been
settled.
With regard to transit, the contracting parties, in
order to improve the content of the Treaty provisions
and to facilitate its application, are preparing a Transit
Protocol, negotiations for which began in 2000.
However, no final results have yet been achieved. In
addition, in 2003 two trans-border model agreements
were adopted: the Inter-Governmental Model
Agreement (IGA) and the Host-Government Model
Agreement (HGA).5
Environmental issues
Art. 19 of the Treaty contains general provisions
concerning the environment. In pursuing sustainable
development and respecting international obligations
regarding environmental protection, each contracting
party shall seek to reduce, in an economically efficient
manner, the negative environmental impact of the so-
called energy cycle. This commitment relates to
consequences both within its own territory and outside
its territory. It concerns all the operations in the energy
chain, from prospecting for and exploring resources, to
production, stockpiling, transport, distribution and
consumption of the products. Also included are the
activities of waste disposal and plant suspension and
closure. In their operations the contracting parties
should adopt precautionary measures aimed at
avoiding environmental deterioration. They should in
every case cover the costs of the pollution caused,
including cross-border pollution, having regard to the
public interest without causing distortions in
investments and international trade.
3 On 3 May 2006 the amendment was ratified by thirty
states. Fourteen states apply it provisionally. Seven states
have not yet applied it. Among these are: Australia (which
does not even apply the Treaty yet), Romania, Norway,
Japan and Russia (which provisionally applies the Treaty).
4 For the text of the amendment and of the Final Act of
the Energy Charter Conference that adopted it, see Energy
Charter Secretariat, 2004.
5 On the negotiations for the adoption of the Transit
Protocol and on the IGA and HGA Model Agreements, see
the Energy Charter Secretariat, 2005; for the texts of the
agreements, see the website mentioned above in note 1. The
present texts are now being re-negotiated and revised.
ENCYCLOPAEDIA OF HYDROCARBONS

The (Energy Charter) Protocol on Energy
Efficiency and Related Environmental Aspects,
PEEREA, which entered into force in 1998, was
signed at the same time as the Treaty.6 The Protocol
obliges contracting parties to strengthen their energy
efficiency policies on the basis of the following
general principles: the setting of prices which
correspond to real energy and environment costs;
transparency of regulatory mechanisms; dissemination
and transfer of technology; adoption of programmes
for improving energy efficiency; and promotion of
investment in this last sector. In order to promote and
monitor the application of the Protocol, a working
group has been set up, which has examined the
programmes adopted, or to be adopted, by numerous
member states, especially Eastern European states.
The group also deals with topics of general interest,
including the key question of the connection between
energy efficiency and renewable energy sources.7
Competition
Another Treaty provision deserving mention is art.
6 on competition, according to which the contracting
parties agree to take steps to reduce obstacles to
competition with regard to economic activities in the
energy sector. Each party shall ensure that it enforces
on its territory such laws as are necessary and
appropriate to address unilateral and concerted
anti-competitive conduct in economic activities in the
energy sector. Contracting parties with experience in
applying competition rules shall give full
consideration to providing assistance on the
development and implementation of these competition
rules to other contracting parties. Should a dispute
arise between contracting parties concerning
anti-competitive activities carried out on the territory
of one of the parties, the provision provides for the
mutual exchange of information and co-operation
between the parties or their respective competition
authorities. In addition to this mechanism, disputes
can be submitted exclusively to general arbitration
between contracting parties as established by art. 27 of
the Treaty, described below. The form of individual
recourse available to investors of one contracting party
against the other as concerns investment matters is
therefore excluded.
10.6.3 Investment promotion
and protection
In consideration of the general purposes of the Treaty,
great attention is paid to the matter of investments and
the relative mechanisms for dispute settlement. A
specific part of the Treaty, Part III, is devoted to
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
THE ENERGY CHARTER TREATY OF 1994
investment promotion and protection. Moreover,
further various provisions of the Treaty contribute to
formulate the set of rules governing the sector, namely
art. 1, containing definitions (for example, of the
terms investment and investor), as well as art. 18,
concerning sovereignty over natural resources.
In line with the tradition in bilateral investment
agreements too (see Chapter 10.5), the definition of
investment adopted is very broad and means “every
kind of asset, owned or controlled directly or indirectly
by an Investor”. The definition expressly includes
tangible and intangible property, and any property
rights such as leases, mortgages, liens and pledges; a
company or shares, stocks, or other forms of equity
participation in a company, bonds and other debt of a
company or business enterprise; claims to money and
claims to performance pursuant to contract associated
with an investment; intellectual property and returns
from a business enterprise; any right conferred by
contract or by virtue of any licences and permits
granted pursuant to law to undertake any economic
activity in the energy sector. The provision states that
the protection accorded by the Treaty applies not only
to investments made after the Treaty entered into
force, but also to investments made before it came into
force provided that they relate to matters which arose
after the date of entry into force.
The definition of investor is also a broad one, as it
too is in harmony with the tradition of the bilateral
agreements. With respect to a contracting party,
investor means: a natural person having the citizenship
or nationality of or who is permanently residing in one
of the contracting parties in accordance with its
applicable laws; and a company or other organization
organized in accordance with the law applicable in that
contracting party. This definition is also applicable to
natural persons and legal entities of third states. In this
connection, however, one of the decisions that
constitutes Annex 2 to the Final Act of the Energy
Charter Conference should be recalled. According to
this declaration, an investment made by an investor of
a contracting party which is not party to an Energy
Investment Agreement (EIA) or a member of a
free-trade area or customs union shall be entitled to
treatment accorded under such EIA, free-trade area or
customs union, provided that the investment has its
registered office, central administration or principal
place of business in the territory of a party to that EIA
or member of that free-trade area or customs union; or,
6 The protocol constitutes Annex 3 to the final act of the
Energy Charter Conference of 1994. The text is reproduced
in the Energy Charter Secretariat, 2005.
7 For the activities of the working group, see the Energy
Charter Secretariat, 2005.
553
INTERNATIONAL LAW
should it only have its registered office in that
territory, has an effective and continuous link with the
economy of one of the parties to that EIA, free-trade
area or customs union. The declaration therefore
demonstrates the contracting parties’ caution in
attributing the treatment envisaged by the Treaty to
investments of investors whose only link to the
relevant territory is the registered office of the
company they have set up.
Sovereignty over natural resources is a general
principle of international law confirmed in numerous
resolutions of the General Assembly of the United
Nations and in international instruments8. The Treaty
could not fail to acknowledge the importance this
principle merits, and does so in art. 18. The manner
and extent to which the principle is expressed,
however, highlight how the main interest protected by
the Treaty is that of investment.
In the first place it is stressed that sovereignty and
sovereign rights over natural resources are to be
exercised with respect for and subordinate to the rules
of international law. The indication is undoubtedly
correct and acceptable, but it constitutes a clear
specification with respect to the discussions and
doubts raised on the matter by the text of the 1974
Charter of Economic Rights and Duties of States9.
Subsequently it is stated that the Treaty shall in no way
prejudice the rules in contracting states governing the
system of ownership of energy resources, without,
however, affecting the objectives of promoting access
to and exploitation of energy resources on a
commercial basis.
The contracting parties undertake to facilitate
access to energy resources by allocating in a
non-discriminatory manner, and on the basis of criteria
which are made public, authorizations, licences,
concessions and contracts relating to energy resources.
art. 18, para. 3 states that each state shall continue to
enjoy the right to decide the geographical areas in
which development of energy resources is permitted,
the rate of that development, and taxes and duties due
for the development itself. Each state has the right to
regulate the environmental and safety aspects of
operations carried out in the sector, as well as the right
to participate in the operations either directly or
through its public enterprises.
The main obligations regarding treatment of
investments are dealt with by the Treaty in the precise,
detailed indications that are in essence included in Part
III, arts. 10-17. art. 10, para. 1 provides, in brief, the
framework and general characteristics of the rules.
Each contracting party is required to encourage and
create stable, equitable, favourable and transparent
conditions for investors of other contracting parties. In
each case investments shall be accorded fair and
554
equitable treatment (Happ, 2002; Wälde, 2004);
investments shall also enjoy the most constant
protection and security and shall in no way be
impaired in their management, maintenance, use,
enjoyment or disposal by unreasonable or
discriminatory measures. In no case shall such
investments be accorded treatment less favourable than
that required by international law, including treaty
obligations.10 Moreover, each contracting party shall
observe any obligation it has entered into with an
investor or protected investments (umbrella clause).11
In particular, the treatment accorded to protected
investments shall be no less favourable than that which
a contracting party accords to its own investors or to
investors of any other contracting party, or a third
state, whichever is the most favourable (art. 10, para. 3).
Undoubtedly of interest, as they are innovative
compared to the traditional rules of bilateral
investment treaties (see Chapter 10.5), are the
provisions concerning the entry of foreign investments
(Tucker, 1998). Making of investments is defined (art.
1, para. 8) as establishing new investments, acquiring
all or part of existing investments or moving into
different fields of investment activity. In this
connection art. 10, paras. 5 and 6 establish that each
contracting party shall endeavour to limit to the
minimum the exceptions to the most favourable
treatment described in art. 10, para. 3, and
progressively remove existing restrictions affecting
8 The best known resolution is United Nations General
Assembly Resolution n. 1803 (VII) of 1962. See Frigo,
1982.
9 United Nations General Assembly Resolution n. 3281
(XXIX) of 1974. For all further references to this
Resolution, see Di Blase, 1996.
10 It should be observed that among the contracting
parties’ understandings of the various provisions of the
Treaty included in the Final Act of the Energy Charter
Conference, and preceding the text of the Treaty itself,
understanding No. 17 concerning arts. 26 and 27 clarifies
the reference to treaty obligations contained in art. 10 para.
1 and does not include the decisions adopted by
international organizations – even though they are legally
binding – or treaties which have entered into force before 1
January 1970.
11 See in this connection the considerations and
arguments of Wälde, 2004, on individual obligations with
respect to the treatment of investments from other
contracting parties. In particular pp. 381 et seq. on national
and non-discriminatory treatment; pp. 385 et seq. on fair and
equitable treatment; pp. 392 et seq. on respect for the treaty
obligations vis-à-vis investors (in connection with the latter
see also note 13); pp. 400 et seq. on no less favourable
treatment than that required by international law, including
conventional international law; p. 402 on measures whose
effect is equivalent to an expropriation. In this last
connection see recently Schreuer, 2005, in the section
devoted to breach of contract and expropriation.
ENCYCLOPAEDIA OF HYDROCARBONS

investors of other contracting parties. Furthermore, a
contracting party may at any time declare to the
Energy Charter Conference, through the Secretariat,
its intention not to introduce new exceptions to the
making of investments with respect to the more
favourable treatment described in art. 16, para. 3.
Lastly, a contracting party may, at any time, make a
voluntary commitment to accord to investors of other
contracting parties as regards the making of
investments the more favourable treatment described
in art. 10, para. 3. This commitment, notified to the
Secretariat and listed in Annex VC, shall be binding
under the Treaty.
Other important provisions concerning the
treatment of investments are those governing
compensation for losses and expropriation. With
regard to compensation for losses other than those
deriving from expropriation, art. 12 states that for
losses owing to war or armed conflict, state of national
emergency, civil disturbance, or other similar events,
an investor of another contracting party shall be
accorded the most favourable treatment that the
contracting party hosting the investment accords to its
own investors or investors of another contracting party
or of a third state. The above refers to restitution,
indemnification, compensation or other settlement. In
every case the investor, whose investment is totally or
partially requisitioned by the forces or the authorities
of the host contracting party, or totally or partially
destroyed by the same forces or authorities although
not required by the necessity of the situation, shall be
accorded restitution or compensation which shall be
prompt, adequate and effective.
The rules governing expropriation are particularly
detailed and contain some specific characteristics.12
First of all it should be noted that the concept of
expropriation (used in art. 13) also includes
nationalization and any other measure having the same
effects as those of expropriation and nationalization. It
is specifically clarified that expropriation also
includes those situations where the assets of a
company or enterprise in which an investor has an
investment, including through the ownership of shares,
are expropriated (art. 13, para. 3). Expropriations
cannot be made with respect to a protected investment
unless they be for a purpose which is in the public
interest, non- discriminatory, carried out under due
process of law and accompanied by the payment of
prompt, adequate and effective compensation. It is
specified in this connection that compensation shall
correspond to the fair market value of the investment
at the time immediately before the expropriation.
Such fair market value shall, at the request of the
investor, be expressed in a freely convertible currency
on the basis of the market rate of exchange on the date
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THE ENERGY CHARTER TREATY OF 1994
of expropriation, and shall include interest at a
commercial rate established on a market basis from
the date of expropriation until the date of payment.
Lastly, the investor affected shall, under the law of the
expropriating party, have a right to prompt review – by
a judicial or other competent and independent
authority of that party – of its case, of the valuation of
its investment, and of the payment of compensation, in
accordance with the principles of the Treaty.
To conclude the analysis of the contracting parties’
rights and obligations, it is worth stressing the
importance of the final provision of Part III of the
Treaty, art. 17, according to which each contracting
party reserves the right to deny the advantages of Part
III in two particular cases that involve a third state.
The first case is that of a legal entity owned or
controlled by citizens or nationals of a third state - if
that entity has no substantial business activities in the
area of the contracting party in which it is organized.13
The second is that of an investment that the denying
contracting party establishes to be an investment of an
investor of a third state with which that party does not
maintain a diplomatic relationship, or towards which
the denying contracting party adopts or maintains
measures that prohibit transactions with investors of
that state, or measures that would be violated or
circumvented if the benefits of Part III were accorded
to investors of that state or to their investments.
10.6.4 Dispute settlements
between
investors and states
and between states
With regard to dispute settlement, specific rules have
been provided for disputes between an investor and a
contracting party and for disputes between contracting
parties. The first type of dispute is governed by art. 26,
12 See Schreuer’s description of the topic and
reasonings, Schreuer, 2005.
13 The ICSID Arbitral Tribunal constituted under art. 26
of the ECT in the Plama Consortium Ltd v. Republic of
Bulgaria case dealt with this exception. In its award on
jurisdiction of 8 February 2005, the Arbitral Tribunal
decided that the Bulgarian declaration could not have
retroactive effect, and that therefore it would have had the
effect of denying the investor the substantial benefits
awarded to it under Part III of the ECT only from the date of
issuing and not for the previous period. Moreover, the
declaration itself can have an effect only on the investor’s
substantive rights and not its procedural rights, namely the
right of recourse to international arbitration (in this case
ICSID arbitration) available to investors under art. 26 ECT.
The text of the award is reproduced in the Energy Charter
Secretariat, 2005.
555
INTERNATIONAL LAW
which has been the subject of numerous doctrinal
comments as it is undoubtedly of interest.14 First of all
it establishes that any dispute of this type concerning
the application of Part III of the Treaty shall, if
possible, be settled amicably. If settlement cannot be
reached amicably within a period of three months from
the date on which such a request is made, the investor
may choose to submit the dispute for resolution as
follows: to the courts or administrative tribunals of the
contracting party which is party to the dispute; in
accordance with any applicable, previously agreed
dispute settlement procedure; or in accordance with
the procedure indicated in art. 26. By ratifying or
acceding to the Treaty, each contracting party gives its
unconditional consent to arbitration or conciliation as
set out in art. 26. Excluded are the contracting parties
indicated in Annex ID15 that have not given their
unconditional consent where the investor has
previously submitted the dispute in accordance with
the first two mechanisms indicated above. The
contracting parties indicated in Annex IA (Australia,
Canada, Norway and Hungary) do not give their
consent with respect to disputes concerning the last
sentence of art. 10, para. 1 which provides that each
contracting party shall observe any obligations it has
entered into with an investor (umbrella clause).16
Should an investor choose the mechanism provided
in art. 26, such investor shall give written consent for
the dispute to be submitted for settlement by one of the
three mechanisms listed in art. 26, para. 4. These
mechanisms are: the International Centre for
Settlement of Investment Disputes (ICSID) in
Washington if the requirements concerning nationality
and membership of the ICSID are met, or if they are
not, in accordance with the ICSID’s Additional Facility
Rules; arbitration under the Arbitration Rules of
UNCITRAL; or an arbitral proceeding under the
Arbitration Institute of the Stockholm Chamber of
Commerce. Any arbitration under art. 26 shall, at the
request of any party to the dispute, be held in a State
that is a party to the 1958 New York Convention on the
Recognition and Enforcement of Foreign Arbitral
Awards. Moreover, claims submitted to arbitration shall
be considered to arise out of a commercial relationship
for the purposes of art. 1 of that Convention.
A tribunal established under art. 26, para. 4 shall
decide the issues in dispute in accordance with the
Energy Charter Treaty and the rules and principles of
international law.17 Awards of arbitration shall be final
and binding on the parties to the dispute. An award of
arbitration concerning a measure adopted by a local
government authority or other local body shall provide
that the contracting party to the dispute may pay
monetary damages in lieu of any other settlement that
has been decided. Each contracting party shall carry
556
out without delay any such award and shall adopt
measures for the effective enforcement on its territory
of such awards.
With regard to disputes between contracting parties
concerning the interpretation and application of the
Treaty, art. 27 establishes that such disputes shall be
settled through diplomatic channels.18 If, on the other
14 For all, see Wälde, 1996b, in particular pp. 442 et
seq.; Tucker, 1998; Hober, 2003.
15 Contracting parties which do not, as in the two cases
referred to in the text, allow an investor to have recourse to
international arbitration under art. 26 of the Treaty are quite
numerous (24). Among them are the European Communities
and some of their member states, including Italy. It should
be noted in this connection that the declaration was made by
some states which have not yet completed the process for
the ratification of the Treaty, as well as Canada and the
United States, who have not even signed the Treaty.
Concerning this possible reservation to the Treaty see, in
particular, Vandevelde, 1996, pp. 415 et seq., who observes
that the reservation allows states to prevent a decision by its
own courts from being overturned or superseded by a
subsequent international arbitral award. However, at the
same time such a reservation discourages investors from
having recourse to the host State’s domestic courts. See,
moreover, Cremades, 2005.
16 Art. 10, para. 1 of the Treaty obviously raises the
problem of establishing which types of contract violations
amount to violation of the Treaty. Indeed, not all of the very
numerous contracts that states draw up with foreign
investors are significant in this regard. It has been rightly
pointed out (Happ, 2002, in particular pp. 345 et seq.) that if
art. 10, para. 1 is invariably interpreted in the light of the
entire Treaty then the conclusion is that contracts thus
protected are only those that directly concern investments
and establish the conditions for investment (investment
agreements or state contracts) and that violation by a state of
its contractual obligations cannot represent a simple breach
of contract, but the exercise of power by a government or at
any rate a public entity. This would seem to be a wholly
convincing argument.
17 For general reasons requiring awards made in the
same manner as the Treaty mechanisms to be in conformity
with international law, as is the case with ICSID and
NAFTA awards, see Giardina, 2003, in particular pp. 655-
661. In effect, the state of which the investor is a national
cannot provide diplomatic protection for its citizen against
the contracting party hosting the investment while one of the
arbitral proceedings envisaged in art. 26 are ongoing and
regard the Party who has complied with the arbitral award.
This waiver of diplomatic protection is not made clear,
unlike art. 27, para. 1 of the ICSID, but may be implied from
art. 27 of the Treaty according to which no action taken by a
contracting party against another contracting party can be
successful if the latter party has respected and behaved in
conformity with the Treaty. Indeed, with regard to the
enforcement of arbitral awards, art. 26, para. 8, last
sentence, explicitly states the obligation to fulfil the terms of
the award and ensure it is effectively enforced.
18 On the mechanism for settling disputes between
contracting parties see above all: Vandevelde, 1996; Wälde,
1996b.
ENCYCLOPAEDIA OF HYDROCARBONS

hand, a dispute has not been settled through diplomatic
channels within a reasonable period of time, each
party may, upon written notice to the other party,
submit the matter to an ad hoc arbitral tribunal
constituted in accordance with the same art. 27. The
Secretary General of the Permanent Court of
International Arbitration at The Hague shall act as
appointing authority. Unless the contracting parties
come to a different agreement, the Tribunal shall apply
the arbitration rules of UNCITRAL and sit in The
Hague. This tribunal too, like those which settle
disputes between investors and states, shall decide the
issues in dispute in accordance with the Energy
Charter Treaty and applicable rules and principles of
international law.
Lastly, leaving aside disputes between contracting
parties which have not yet arisen and which are
unlikely to arise, it is worth mentioning that until now
there have not been many disputes between investors
and states. In two cases, awards were made on the
merits of the dispute, in another case an award was
made on jurisdiction,19 and three cases are pending.
The scarcity of disputes is certainly due to the recent
entry into force of the Treaty, but it also seems to
demonstrate that the contracting parties are essentially
committed to perfecting the Treaty’s implementing
instruments and to developing and amplifying the
obligations assumed under the Treaty itself.
References
Babadji R. (1996) Le Traité sur la Charte Européenne de
l’Énergie, «Annuaire Français de Droit International», 2,
872.
Brazell L. (1994) The draft energy charter treaty: trade,
competition, investment and environment, «Journal of
Energy & Natural Resources Law», 12, 299-341.
Cremades B.M. (2005) Arbitration under the Energy Charter
Treaty and other investment protection treaties: parallel
arbitration tribunals and awards, «Transnational Dispute
Management», 2.
Di Blase A. (1996) La Carta dei diritti e doveri economici
degli Stati, in: Giardina A., Tosato G.L., Diritto del
commercio internazionale, Milano, Giuffrè, 147.
Energy Charter Secretariat (2004) The Energy Charter
Treaty and related documents, Bruxelles, Energy Charter
Secretariat.
Energy Charter Secretariat (2005) Annual report,
Bruxelles, Energy Charter Secretariat.
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THE ENERGY CHARTER TREATY OF 1994
Frigo M. (1982) La sovranità permanente degli Stati sulle
risorse naturali, in: Picone P., Sacerdoti G., Diritto
internazionale dell’economia. Raccolta sistematica dei
principali atti normativi internazionali ed interni con testi
introduttivi e note, Milano, Franco Angeli, 245.
Gaillard E. (2005) Energy Charter Treaty: international
center for settlement decision, «New York Law Journal»,
66, 1-2.
Giardina A. (2003) Clauses de stabilisation et clauses
d’arbitrage: vers l’assouplissement de leur effet obligatoire?,
«Revue de l’Arbitrage», 3, 647-666.
Happ R. (2002) Dispute settlement under the Energy Charter
Treaty, «German Yearbook of International Law», 45, 331-
362.
Hober K. (2003) Investment arbitration in Eastern Europe.
Recent cases on expropriation, «The American Review of
International Arbitration», 14, 377-446.
Schaeffer E. (1998) Le Traité sur la Charte de l’Énergie et
l’accès des produits énergetiques des pays de l’Est aux
marchés de l’UE, in: Hafner G. (edited by) Liber Amicorum
Professor Ignaz Seidl-Hohenveldern in honour of his 80th
birthday, den Haag, Kluwer, 593.
Schreuer C. (2005) The concept of expropriation under the
Energy Charter Treaty and other investment protection
treaties, in: Investment arbitration and the Energy Charter
Treaty. Proceedings of the conference, Stockholm, 9-10
June.
Touscoz J. (1996) Le Traité de la Charte de l’Energie. Aspects
juridiques, «Revue de l’Énergie», 481, 494-498.
Tucker A.E.L. (1998) The Energy Charter Treaty and
‘compulsory’ international state/investor arbitration,
«Leiden Journal of International Law», 11, 513-526.
Vandevelde K.J. (1996) Arbitration provisions in the BITs
and the Energy Charter Treaty, in: Wälde T.W., The Energy
Charter Treaty. An East-West gateway for investment and
trade, London, Kluwer, 409.
Wälde T.W. (editor) (1996a) The Energy Charter Treaty. An
East-West gateway for investment and trade, London,
Kluwer.
Wälde T.W. (1996b) Investment arbitration under the Energy
Charter Treaty, «Arbitration International», 4, 429-467.
Wälde T.W. (2004) Energy Charter Treaty. Based investment
arbitration, «The Journal of World Investment & Trade»,
3, 373-412.
Andrea Giardina
Università di Roma ‘La Sapienza’
Rome, Italy
19 See references in note 13. For a presentation of the
decision, see Gaillard, 2005. See also references to the other
pending or resolved cases.
557
 10.7
Organization
of the Petroleum Exporting Countries
(OPEC)
10.7.1 Introduction
and background
The Organization of the Petroleum Exporting
Countries (OPEC) is a permanent intergovernmental
organization, presently comprising eleven oil
producing and exporting countries (Lugo, 1997).
Membership is spread across three continents – South
America, Asia and Africa – and the members are:
Algeria, Indonesia, the Islamic Republic of Iran, Iraq,
Kuwait, the Socialist People’s Libyan Arab Republic,
Nigeria, Qatar, Saudi Arabia, United Arab Emirates
and Venezuela.1
These countries have a combined population of
about 525 million and in almost all of them – with the
exception, currently, of Indonesia – oil is the main
foreign exchange earner. As the vital key to
development – economic, social and political, in
OPEC member countries, oil revenues are used not
only to expand their economic and industrial base, but
also to provide jobs, education, health care and a
decent standard of living for their peoples.
The objectives of OPEC are encapsulated in art.
2 of the Statute of Organization2 thus: to
co-ordinate and unify the petroleum policies of the
member countries and to determine the best means
for safeguarding their individual and collective
interests; to seek ways and means of ensuring the
stabilization of prices in international oil markets,
with a view to eliminating harmful and unnecessary
fluctuations; and to provide an efficient economic
and regular supply of petroleum to consuming
nations and a fair return on capital to those
investing in the petroleum industry.
The OPEC Statute stipulates that: “Any country
with a substantial net export of crude petroleum,
which has fundamentally similar interests to those of
member countries, may become a full member of the
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
Organization, if accepted by a majority of
three-fourths of full members, including the
concurring votes of all founder members”.
Three categories of membership are provided for
under OPEC’s Statute: founder members, full
members and associate members. Founder members
are those countries which were represented at OPEC’s
first conference, held in Baghdad, Iraq, in September
1960, and which signed the original agreement
establishing OPEC (OPEC Statute art. 7 para. A). Full
members are the founder members and those countries
whose applications for membership have been
accepted by the conference (art. 7, para. B). Associate
members are the countries which do not qualify for
full membership, but which are nevertheless admitted
under such special conditions as may be prescribed by
the conference (art. 7, para. D). Table 1 below is
illustrative of the geographical distribution of OPEC
membership including the date of entry of each
member country.
In the area of international energy law, OPEC is the
international organization with, perhaps, one of the
greatest impacts on the oil sector. Its influence extends
to energy and energy-related environmental questions,
and not only on production and trade, but also on
investment. OPEC countries currently control about
75% of the world’s oil reserves and 40% of oil
production.3 What is more, most low-cost oil is
produced by OPEC countries. The implication of this
is that a prolonged slump in prices will tend to
1 Ecuador (1972-92) and Gabon (1975-94) were once
Members of the OPEC.
2 OPEC Resolution No. II.6/1961.
3 Strictly speaking, OPEC is about oil, not gas (though
the term petroleum technically includes hydrocarbon gases).
For some OPEC countries (i.e. Iran, Algeria), their gas
potential may gradually dominate or coexist with their oil
559
INTERNATIONAL LAW

continue to play well into the future, or at least until

Table 1. Geographical distribution such a time (if and when), market forces and
of OPEC Membership technology combine to reduce the strategic
significance of oil relative to other energy sources.
Date
Country Location
of Entry

Algeria 1969 Africa

10.7.2 History and structure
of OPEC
Indonesia 1962 Asia
Brief history
Iran 1960* Middle East OPEC was created as a permanent
Iraq 1960* Middle East intergovernmental organization in conformity with
the resolutions of the Conference of the
Kuwait 1960* Middle East representatives of the governments of Iran, Iraq,
Kuwait, Saudi Arabia and Venezuela, held in
Libya 1962 Africa
Baghdad from 10 to 14 September 1960.7 The
Nigeria 1971 Africa Organization, therefore, started as a treaty among
five sovereign nations seeking to assert its Member
Qatar 1961 Middle East Countries’ sovereign8 rights in an international oil
Saudi Arabia 1960* Middle East market dominated, at the time, by the Seven Sisters
multinational companies (Sampson, 1975).
United Arab Emirates 1967 Middle East

Venezuela 1960* South America

* Founder Members.
enhance OPEC member countries’ market shares.4
High-cost producers also tend to deplete their reserves
much more rapidly. This means that the lower the
price, the greater the enhancement of future OPEC’s
market share. Geo-political tensions and an unusually
high demand clearly strained existing capacity in 2004
and 2005, causing the price of oil to sky-rocket. Only
OPEC member countries’ spare capacity met what
would have otherwise been a global shortfall in
supply.5 All of these factors point to the increasing role
that OPEC could play in the foreseeable future.
This article examines OPEC’s role in the
development of international energy law and policy
and, in the process, demonstrates the growing
synergies between international energy law and other
branches of international law,6 that are partly due to
OPEC’s role.
The article sets out in five major parts: an
introduction and background in Part 1; OPEC’s history
and structure in Part 2; its role in the international oil
market in Part 3; OPEC in the evolution of
international energy laws in Part 4; and a concluding
section that summarizes the major findings, in Part 5.
While noting that the Organization has been the
subject of intense criticism, especially in the Western
oil-consuming nations, this article attempts to put
things in proper perspective and, in the process,
highlight the crucial role the Organization is playing in
stabilizing the international oil market and would
interest. Gas producers are often in a somewhat different
situation than oil producers: transit by pipeline is their main
challenge. There is now a Gas Exporting Countries Forum
(GECF), including both OPEC and other countries (Norway,
Russia, Malaysia, Turkmenistan). Their first meeting was in
Tehran in 2001 and then subsequently in Algiers. One
cannot exclude the possibility that this very soft and loose
consultation mechanism coalesces into something harder
and tighter. That would appear logical, at least from OPEC
and its member countries’ perspective. Most major oil
producers are, or are likely to become, major gas exporters.
There is reportedly an OPEC gas committee, but little is
known about its activities. OPEC has always kept a low
profile. In the early 1970s, some studies were done on gas
pricing, but OPEC was then overwhelmed with the major
challenge of its declining oil market share, mounting excess
capacity, keeping a tab on production management among
its members and the end of price-setting around 1985.
4 Low oil prices will also tend to increase the efficiency
in high-cost areas (e.g. North Sea). Significant results in
terms of lowering production cost have been achieved, e.g.
by the UK CRINE (Cost Reduction Initiative for the New
Era) initiative. This incentive for efficiency is not present in
the Mid Eastern low-cost producers. But the difference
between, say, North Sea and Saudi production cost is still
very large.
5 Recent events in 2005, during which hurricanes
Katrina and Rita devastated the refinery industry in the U.S.
Gulf Coast, saw OPEC responding positively by making
spare capacity available.
6 Several other branches include: a) international trade
law; b) international economic law; c) international
environmental law; d ) international competition law; e) and
policy and the international law on sustainable development.
7 OPEC was registered with the United Nations
Secretariat on 6 November 1962 (UN Resolution No.
6363/1962).
8 See, for example, UN Resolution No.1803-XVII/1962.

560 ENCYCLOPAEDIA OF HYDROCARBONS


In general, initial activities were of a low-profile
nature as OPEC set out its objectives and established
its Secretariat in Geneva, Switzerland, where the first
meeting of the OPEC Board of Governors (BoG)
convened in May 1961. In April 1965, the OPEC
Conference decided to move the headquarters to
Vienna.
The historical antecedents of the respective
member countries of OPEC vis-à-vis the Seven Sisters
multinational oil companies prior to the advent of the
organization clearly reveal that the establishment of
OPEC was a reaction against the anti-competitive
practices of the Seven Sisters at the expense of the
producer countries. The Seven Sisters were complete
monopolies at the time, controlling not just production,
but price and marketing outlets for crude oil.
Subsequent resolutions of the General Assembly
(Resolutions 1803 and 1820, for instance) of the
United Nations supported the rights of peoples and
nations to permanent sovereignty over their natural
wealth and resources asserting amongst others that,
“The exploration, development and disposition of such
resources, as well as the import of the foreign capital
required for these purposes, should be in conformity
with the rules and conditions which the peoples and
nations freely consider to be necessary or desirable
with regard to the authorization, restriction or
prohibition of such activities”. Relying on these, and
more particularly on the UN General Assembly
Resolution No. 2158-XXI/1966, OPEC took necessary
steps and articulated, amongst others, the mode of
development, participation, relinquishment and posted
prices for its member countries’ hydrocarbon
resources. Other issues considered in OPEC’s
resolution include the need for a limited guarantee of
fiscal stability, a renegotiation clause, accounts and
information, conservation, settlement of disputes and
other ancillary matters.
In 1968, the Organization took steps to enhance its
international standing by issuing a Declaratory
statement of petroleum policy in member countries.
As endorsed by the United Nations, this referred to the
inalienable rights of all countries to exercise
permanent sovereignty over their natural resources in
the interests of their national development. It said that
the exploitation of OPEC’s indigenous and exhaustible
resources should be aimed at securing the greatest
possible benefit for its member countries. This could
best be achieved if the countries themselves directly
undertook the exploitation of these resources.
In the 1970s, OPEC rose to international
prominence as its member countries took control of
their domestic petroleum industries and acquired a
major say in the pricing of crude oil on world markets.
There were two oil pricing crises that resulted in oil
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
ORGANIZATION OF THE PETROLEUM EXPORTING COUNTRIES (OPEC)
prices rising steeply: one was triggered by the Arab oil
embargo in 1973 and the second by the outbreak of the
Iranian Revolution in 1979. Both were fed by
fundamental imbalances in the market.
In 1974, OPEC entered into an international
treaty with Austria.9 The treaty, now generally
referred to as the OPEC Headquarters Agreement,
governs OPEC’s status and rights under Austrian
law. Arguably, the Headquarters Agreement is both a
treaty under international law and a legislation
approved by the Austrian Parliament, having been
made part of Austrian law and published in the
Austrian Official Gazette.10 At various times,
Austria, like the United States, Switzerland and the
Netherlands, entered into headquarters agreements
with other international organizations, including the
United Nations, containing substantially similar
provisions. Generally, headquarters agreements
bestow certain privileges and immunities to
international organizations, which are recognized
under international law. Under the OPEC
Headquarters Agreement, OPEC has a distinct legal
personality. Its member countries are, therefore, not
responsible for any possible liability of OPEC.
The first Summit of OPEC Sovereigns and Heads
of State was held in Algiers in March 1975. Amongst
others, this summit adopted a solemn declaration
reaffirming the sovereignty and inalienable right of all
countries to the ownership, exploitation and pricing of
their natural resources. This concept was embodied in
the proposal for a New International Economic Order,
aimed at promoting a more equitable global economic
system; there was particular emphasis on alleviating
poverty and other injustices affecting developing
countries by encouraging greater interdependence
among nations from the North and the South. The
declaration appealed for “North-South dialogue”
between developed and developing countries on
cooperation and concerted action to solve the major
problems affecting the world economy.
A direct result of the OPEC summit was the
establishment, in Vienna in 1976, of the OPEC Fund
for International Development: a specialist multilateral
development finance institution to help the poorer,
low-income countries in pursuit of their social and
economic advancement. The Fund has gone from
strength to strength and to date has made total
financial commitments of 7.4 billion dollars,
two-thirds of which has already been disbursed. Well
9 Headquarters Agreement between Austria
and OPEC (effective 10 June 1974) with amendments
(effective 1 October 1985).
10 Austrian Official Gazette BGBL 382/74 of 11 July
1974 and BGBL 379/85 of 13 September 1985.
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INTERNATIONAL LAW
over 100 of the word’s most underprivileged countries
have benefited from this assistance. In addition, on an
individual basis, OPEC member countries have
provided considerable assistance to other developing
countries in need. One of the solemn declarations of
the Conference “reaffirmed the natural solidarity
which unites OPEC countries with other developing
countries in their struggle to overcome
underdevelopment”, and called for measures to
strengthen cooperation between these countries.11
OPEC held its second summit in Caracas,
Venezuela, in September 2000 on the occasion of the
Organization’s 40th anniversary. After making an
in-depth review of the modern-day energy industry, the
OPEC sovereigns and heads of state signed a solemn
declaration reaffirming their commitment to OPEC’s
long standing principles and objectives “to aim at the
preservation and the enhancement of the role oil would
play in meeting future world energy demand”. Their
actions took into account “the rapid pace of change in
economic, political, technological and environmental
developments, and the challenges and opportunities
created by globalisation and liberalisation”.
Prices peaked at the beginning of the 1980s, before
beginning a dramatic decline which culminated in a
collapse in 1986 – the third oil pricing crisis. Prices
rallied in the final years of the decade, without
approaching the high levels of the early 1980s, as
awareness grew of the need for joint action among oil
producers if market stability with reasonable prices
was to be achieved in the future. Environmental issues
began to appear much more forcefully on the
international agenda in this decade.
In the beginning of the 1990s, a fourth pricing
crisis was averted. This occurred when an outbreak of
hostilities in the Middle East caused a sudden steep
rise in prices on panic-stricken markets but was
moderated by output increases from OPEC members.
Prices then remained relatively stable until 1998, when
there was a collapse, in the wake of the economic
downturn in Southeast Asia. Collective action by
OPEC and some leading non-OPEC producers brought
about a recovery. As the decade ended, there was a
spate of mega-mergers among the major international
oil companies in an industry that was experiencing
sizable technological advances. For most of the 1990s,
the ongoing international climate change negotiations
threatened heavy decreases in future oil demand.
Since its inception, OPEC has had to face many
formidable challenges in the constantly evolving
international oil market, impacting the entire pricing
spectrum and compounded by factors far removed
from simple market economics. Additionally, recent
and emergent developments in international trade law,
more particularly, its focus on free trade and
562
liberalization either at the World Trade Organization
(WTO) or in the Energy Charter Treaty (ECT) has
thrown up new and formidable challenges to OPEC.
Simultaneous with the move towards globalization is
regionalization, in the form of trading blocks, such as
the EU and the North American Free Trade Agreement
(NAFTA), with new rules governing interstate
commerce as well as with their respective member
states. Needless to stress is the increasing influence of
environmentalism encapsulated in the global climate
change regime and its implications for OPEC. All
these, no doubt, pose new regulatory challenges for
OPEC and its member countries.
Structure
Representatives of OPEC member countries
(Heads of Delegation) meet at the OPEC Conference
to coordinate and unify their petroleum policies, in
order to promote stability and harmony in the oil
market. They are supported in this by the OPEC
Secretariat, directed by the BoG and run by the
Secretary General and by various bodies including the
Economic Commission and the Ministerial Monitoring
Committee. The Conference is the supreme authority
of the Organization, and consists of delegations
normally headed by the Ministers of Oil, Mines and
Energy of Member Countries. It generally meets twice
a year, in March and September, and in extraordinary
sessions whenever required. It operates on the
principle of unanimity and ‘one Member, one vote’. It
is responsible for the formulation of the general policy
of the Organization and the determination of the
appropriate ways and means of its implementation. It
also decides upon applications for membership of the
Organization, and on reports and recommendations
submitted by the BoG on the affairs of the
Organization. It approves the appointment of
Governors from each member country, elects the
Chairman of the BoG as well as the Secretary General.
Moreover, the Conference directs the Board to submit
reports or make recommendations on any matter of
interest to the Organization, and considers and decides
upon the Organization’s budget, as submitted to it by
the Board.
The BoG may be compared to the board of
directors of a commercial organization. The BoG is
composed of Governors nominated by member
countries and confirmed by the Conference for two
years. The Board directs the management of the
Organization; implements resolutions of the
Conference; draws up the Organization’s annual
budget and submits it to the Conference for approval.
11 See http://www.opecfund.org/about/about.aspx.
ENCYCLOPAEDIA OF HYDROCARBONS

It also decides upon any reports submitted by the
Secretary General and submits reports and
recommendations to the Conference on the affairs of
the Organization (OPEC Statute art. 20).
The Economic Commission is a specialized body
operating within the framework of the Conference and
supported by the Secretariat, with a view to assisting
the Organization in promoting stability in the
international oil market. The Commission is composed
of a Commission Board, National Representatives, and
a Commission staff. The Commission Board consists
of the Secretary General, the National Representatives
appointed by the member countries, and a
Commission Coordinator (who is ex-officio the
Director of the Research Division).
The Ministerial Monitoring Sub-Committee
(MMSC) was established in February 1993 by the 10th
Meeting of the Ministerial Monitoring Committee in
order to monitor oil production and exports by
member countries. The MMSC comprises three heads
of delegation and the Secretary General.
The OPEC Secretariat functions as the
Headquarters of OPEC. It is responsible for carrying
out the executive functions of the Organization, in
accordance with the provisions of the Statute and
under the direction of the BoG (arts. 25 and 26). The
Secretariat consists of the Secretary General – who sits
in on Management Committees, Board of Governors
Meetings and presides over the ECB, Economic
Commission Board (art. 27) – and the Research
Division (art. 33 para. A), headed by the Director of
Research, and comprising the Petroleum Market
Analysis, Energy Studies and Data Services
Departments. Other functions include the Public
Relations and Information Department (art. 33, para.
C), the Administration and Human Resources
Department (art. 33, para B), and the office of the
Secretary General. The Senior Legal Counsel and the
Internal Auditor report directly to the Secretary
General. The Secretariat was originally established in
Geneva, in 1961, as mentioned before, but it was
moved to Vienna in 1965. The 8th (Extraordinary)
OPEC Conference approved the Host Agreement with
the Austrian Government in April 1965,12 prior to the
opening of the OPEC Secretariat in Vienna on 1
September, 1965.
10.7.3 OPEC and the international
oil market
The OPEC Statute requires OPEC to pursue stability
and harmony in the petroleum market for the benefit
of oil producers, consumers and investors alike (art. 2
paras. A, B, C). To this end, OPEC member countries
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respond to market fundamentals and forecast
developments by coordinating their petroleum policies
with a view to promoting stability in the international
oil market. Production limits are simply one possible
response. If demand grows, or some oil producers are
producing less oil, OPEC increases its oil production
in order to prevent a sudden rise in prices. At other
times it reduces its oil production in response to
market conditions in order to counter falling prices: a
delicate balancing act against the backdrop of
common, divergent and sometimes conflicting
interests, forces and objectives.
Currently, it is estimated that at least 75% of the
world’s oil reserves are in OPEC member
countries.13 OPEC member countries produce about
40 per cent of the world’s crude oil and 16% of its
natural gas. However, OPEC’s oil exports represent
about 55% of the oil traded internationally.
Therefore, OPEC does have some influence on the
oil market, especially if it decides to reduce or
increase its level of production. This is not, however,
at the exclusion of all other variables: market
fundamentals, geo-political tensions, climate and the
activities of speculators.
OPEC seeks stability in the oil market and
endeavours to deliver steady supplies of oil to
consumers at fair and reasonable prices. The
Organization has achieved this in a number of ways:
sometimes by voluntarily producing less oil, and at
other times, by producing more when there is a
shortfall in supplies (such as during the Gulf Crisis in
1990, when several million barrels of oil per day were
suddenly removed from the market).
It could have been valid in the early 1970s to the
mid 1980s to contend that OPEC set crude oil prices.
But, this is no longer the case. No doubt, OPEC’s
Member Countries do voluntarily restrain their crude
oil production in order to stabilize the oil market and
avoid harmful and unnecessary price fluctuations,
which is inimical not just to OPEC member countries
but to consuming nations and investors alike.
In today’s complex global markets, the price of
crude oil is set by movements on the three major
international petroleum exchanges, all of which have
their own Websites featuring information about oil
prices. These exchanges are: the New York Mercantile
EXchange (NYMEX),14 the International Petroleum
12 On the Headquarters Agreement between Austria and
OPEC, see footnotes 9 and 10.
13 At the end of 2003, OPEC had proven oil reserves
of 891,116 million barrels of crude oil, representing
78.3% of the world total of 1,137,550 million barrels.
See OPEC, 2003.
14 http://www.nymex.com.
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INTERNATIONAL LAW
Exchange in London (IPE),15 and the Singapore
International Monetary EXchange (SIMEX).16
The impact of OPEC output decisions on crude
oil prices should be considered separately from the
issue of changes in the prices of oil products, such
as gasoline or heating oil. There are many factors
that influence the prices paid by end consumers for
oil products, besides crude oil prices. In some
consuming countries (mainly EU countries) taxes
comprise over 70% of the final price paid by
consumers, so even a major change in the price of
crude oil might have only a minor or negligible
impact on final consumer prices. Bottlenecks in the
downstream sector, more particularly, the lack of
adequate refining capacity, can also translate into
higher gasoline prices. Even the climate, such as in
bitterly cold winters, or summer driving seasons,
have been known to put pressure on heating oil or
gasoline prices respectively. Needless to stress,
geo-political tensions, notably in the Middle East,
and occasional labour crisis, even in non-OPEC
member countries such as Norway, have had
contributory roles in the ultimate prices of crude oil.
10.7.4 OPEC and international
energy law
Member countries natural interest to increase
and stabilize revenue
OPEC’s current role in the evolution of
international energy law is marked by two key
issues. First, the organization was founded on
building up its member countries’ natural interest
to increase and stabilize revenue, i.e. its ‘mineral
rent’ from its sovereignty over oil and gas resources.
That is still its raison d’être. Admittedly, there has
to be a delicate balancing between short-term
optimization through price and volume, and
long-term strategies. These long-term strategies are
centred on market share for OPEC oil and gas
versus non-OPEC competitors and non-
hydrocarbon alternatives. Here, there is,
presumably, a divergence of interest between OPEC
policy and high excise taxes of Western
Governments, and in particular, those of the EU.17
In the UK, for example, high excise taxes, up to
four times or more the price of gasoline, are said to
have an environmental justification in that they
internalize external costs to the environment and by
road traffic.18 But they are also a convenient cover
for achieving a sizeable tax income to compensate
for the more visible lowering of income tax rates.
Within this context, it is possible to perceive
tensions between OPEC, on the one hand, and
564
major consuming countries, on the other, as not
about a higher price for petroleum-based energy,
but who gets what from oil (OPEC, 2004). The EU
and the US have tried to deflect political blame for
high gasoline prices on to OPEC with some
success.19 Hitherto, they were reluctant to accept
OPEC’s interest in stabilized oil prices and a ‘fair’
OPEC share of the mineral rent on a formal
negotiating agenda (European Union, 2001).
Recently, there has been a noticeable change in the
EU’s posture.
Second, others argue that OPEC is naturally
disinclined to view with favour the use of Western,
very much currently EU government policy, to use
heavy pressure to move away from hydrocarbons in
favour of renewable energy sources as this would
devalue its reserves. Undoubtedly, however, such
policies could go hand-in-hand with a price and
production-based supply restriction.
Certain commonalities, however, exist on both
sides, i.e. producers and consumer states. All states
with substantial petroleum production (US, UK,
Norway, Russia and other non-OPEC producers)
and exports have an interest in not seeing the oil
price decline as dramatically as it did in 1985 and
1998, a fact which is often ignored. The
consequences were: a) a deterioration of the
position of high cost, non-OPEC production as well
as non-conventional energy; b) reduced trade with
OPEC Member countries due to their abruptly
collapsing purchasing power; c) disruptions in the
world financial system; d ) greater economic
volatility; e) and greater emission of greenhouse
gases due to cheaper petroleum (Alhajji, 2001).
15
http://www.ipe.uk.com.
16 http://www.simex.com.sg. The websites of the
Paris-based International Energy Agency (IEA,
http://www.iea.org) and the US Energy Information
Administration (EIA, http://www.eia.doe.gov), also have
extensive historical information on oil prices.
17 OPEC estimates that in 1996 the G-7 nations (i.e.
United States, Canada, Japan, Germany, Italy, United
Kingdom and France) obtained oil tax incomes totalling 270
billion dollars, while OPEC Petroleum Export Revenues
were 160 billion dollars.
18 See Transport at
http://europa.eu.int/comm/environment/env-act5/chapt1-
3.htm. It is instructive that these excise taxes do not apply to
coal, another, and, perhaps, far more polluting fossil fuel in
the same way.
19 See for example, “US Commission blames OPEC for
high oil price” at
http://www.redtram.com/go/8611125/; “OPEC’s symbolic
move” at
http://www.economist.com/agenda/displayStory.cfm?story_i
d=4077933; “Oil Price History and Analysis” at
http://www.wtrg.com/prices.htm.
ENCYCLOPAEDIA OF HYDROCARBONS

Volatile oil prices – the benchmark for all energy
pricing – will undermine the economic viability of
much of the current drive towards a
non-hydrocarbon, energy-efficient and
renewable-based energy scenario. The very high oil
price and perception of possible impending scarcity
in 2005 had to do with a decade of
under-investment by the international oil companies
(and the relative closure of most OPEC countries to
foreign investment). Expectations of future price
volatility have probably been the major factor for
such under-investment, as oil companies do
naturally not want to invest in a period of high
prices and high costs, and then experience new
capacity to come on stream in a period of declining
oil prices.
Both groups may also have an interest in
capping petroleum prices as this would, otherwise,
lead to inflation (a problem for consuming
countries) and an accelerated substitution of
petroleum (a problem for OPEC countries). In
theory, there could be a possible deal between
consumers and producers to stabilize oil prices
within an acceptable range, to reduce volatility of
little interest to anyone but oil traders and include
some sort of monetary coordination to make oil
prices responsive to high-growth and recession
situations.20 Such a negotiating agenda might also
contain quid pro quo in the area of free access of oil
and oil-based products to EU and US markets and
some principles on sharing mineral rent, i.e.
between consumer excise taxes and producer
royalties.
Climate change itself is not a midterm threat to
OPEC countries if production (based on
investment) is kept in balance with demand. Up
until very recently, OPEC has been accused of
fostering a policy of implicitly keeping controls on
investment and explicitly keeping controls on
production. Paradoxically, that policy was quite
compatible with the more extreme anti-hydrocarbon
positions taken by Non-Governmental
Organizations (NGOs) such as Greenpeace: exiting
from hydrocarbons by restricting supply (Mitchell
et al., 2001). OPEC policy can be interpreted not
only as that of price stabilization, but also as a
conservation policy, in the sense of art. XX (g)
General Agreement on Tariffs and Trade (GATT).21
In consonance with the saying ‘once bitten, twice
shy’, current Western thinking is not favourable to
the use of regulatory instruments (trade, investment
and pricing rules) to smooth pricing volatility. The
history of the largely-failed commodity stabilisation
instruments of the 1970s and 1980s does not
encourage new tinkering with similar instruments.22
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ORGANIZATION OF THE PETROLEUM EXPORTING COUNTRIES (OPEC)
Country-based income stabilization is another
matter. In a volatile industry, it makes sense to skim
off surplus in rich years and add to invested funds
to increase income in lean years. Many OPEC and
Western producing countries (e.g. Alaska, Norway,
Kuwait, Abu Dhabi, Venezuela) have developed
different types of oil income funds. These are now
being proposed or have been established for new,
developing country producers.23 In essence, income
is stored away and made more difficult to access
except in cases of emergency or severe budget
pressures due to historically low oil prices. Such
income stabilization may not make oil prices less
volatile, but would make low price periods much
more tolerable.
Issues for discussions between OPEC
and producer countries
These are issues for an agenda of discussions
between OPEC and the producer countries with the
20 OPEC, over the last years, seems to have given some
attention to the impact of oil prices on economic growth.
But such feedback (much like Central Bank monetary policy
relying mainly on interest rate setting) could be enhanced
and be part of a consultative process. In essence, oil prices
should be lower in recession periods (and therefore add
purchasing power) and higher in boom periods (therefore
taking off purchasing power). The 121st Meeting of the
OPEC Conference made reference to the monetary policy
implication of OPEC’s then reference basket price band
(22-28 dollars per barrel).
21 Article XX (g) provides that: “Subject to the
requirement that such measures are not applied in a manner
which would constitute a means of arbitrary or unjustified
discrimination between countries where the same conditions
prevail, or a disguised restriction on international trade.
Nothing in the agreement shall be construed to prevent the
adoption or enforcement by any contracting party of
measures […] (g) Relating to the conservation of
exhaustible resources if such measures are made effective in
conjunction with restrictions on domestic production or
consumption”. See also Desta, 2003b.
22 Though one could argue that OPEC countries, in
particular, Saudi Arabia, with the ability to increase or
decrease production at relatively short notice and possessing
large reserves in the ground, act in not too dissimilar a way
from a commodity producers’ association with a large
stockpile (i.e. exploitable reserves). This includes a common
production policy and a quota for each producer, plus some
element of investment control through restriction on
foreign investment. It cannot be said though, that there is
currently any restriction on investment in OPEC member
countries; Alhajji and Huettner, 2000.
23 Norway, Alaska, Alberta, Kuwait, Oman, Venezuela,
Colombia, Azerbaijan, Chad, Iran, United Arab Emerites;
McPherson, 2002. The World Bank is engaged in a project
on the use of oil revenues. IMF (International Monetary
Fund) experts are critical, naturally, as the traditional
finance ministry approach is always opposed to special
revenue vehicles; Davis et al., 2001.
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INTERNATIONAL LAW
International Energy Agency (IEA) and the EU as
the main interlocutors. Such a dialogue was
attempted in the 1980s and in a low-profile way
again more recently.24 While OPEC is currently the
major international petroleum organization, it is not
necessarily the most important influence in
prospective negotiations with consumer states on
oil price stabilization. It is, also, not a major
influence, apart from playing the role as a critic and
observer, in the Kyoto-based climate change
negotiations. Perhaps there is less a role here for
formal international law than for quiet diplomacy in
significant bilateral relations (e.g. US-Saudi
Arabia) that impact national policies towards oil
and gas.
The Western world has largely tried to suppress
the existence of OPEC psychologically25 or been
attempting, albeit unsuccessfully, to destroy it. US
external energy policy since September 2001 has
been an implicit attempt to free itself from its
overwhelming and inevitable dependence on oil
supplies from the Middle East. Its strategies, which
are now emerging, engrave themselves into the now
30 year tradition of anti-OPEC policies. These
strategies are: entente with Russia, build-up of the
Kazakh producers, accelerated expansion in West
Africa and attempt to distance Nigeria, Indonesia
and Venezuela from OPEC (Goldwyn, 2002) and
prospect that a regime-change in Iraq will bring
about a more US friendly government. It is
suggested that a policy of active and formal
constructive engagement with OPEC might have
been more fruitful. Only in relatively very recent
times, have there been such dialogue between
OPEC and the IEA representing major producers
and consumers.
OPEC’s facilitative role in bringing together a
concert of producer countries’ production policies
has been at various times subject to scrutiny from
an anti-trust perspective. On the face of it, a
privately organized association that sets production
quotas would contravene national competition law
such as art. 81 of the European Community (EC)
Treaty26 or the Sherman Act 1890;27 both rules
forbid agreements in restraint of trade. The fact that
such concert occurred outside US or the EU
territory is not relevant, as both now assume
extraterritorial jurisdiction over conduct outside
their borders with an appreciable effect on
competition within their borders.
US anti-trust law was applied, for example, in the
litigation against the uranium cartel organized outside
the US, but with an effect on prices within the US.28
So far, there have been private efforts to litigate in the
US against OPEC, none of which has been
566
24 Saudi Arabia, in 2000, called for the establishment of
a permanent secretariat for the International Energy Forum
(IEF). A Forum secretariat has now been established in
Riyadh following a producer-consumer meeting in 2002 in
Osaka. The IEF and IEF Secretariat reflect a change in
EU-OPEC dialogue that was launched on 9 June 2005.
25 The qualification as the ‘OPEC Cartel’ and the
omission in most EU or IEA studies to face squarely the
existence and the need to negotiate with OPEC indicates
some sort of taboo. The Hague Joint Conference on
Contemporary Issues of International Law (2005), and
examined international institutional reform. The Conference,
jointly sponsored by the American Society of International
Law (ASIL), and Nederlandse Verenigning voor
International Recht, amongst others, considered most major
international organizations, including an international
organization of wine sellers, as worthy of discussion, but not
OPEC. This is rather ironic considering the crucial role
OPEC plays in the international oil market.
26 Art. 81 EC Treaty provides that: “The following shall
be prohibited as incompatible with the common market: all
agreements between undertakings, decisions by associations
of undertakings and concerted practices which may affect
trade between member states and which have as their object
or effect the prevention, restriction or distortion of
competition within the common market, and in particular
those which: a) directly or indirectly fix purchase or selling
prices or any other trading conditions; b) limit or control
production, markets, technical development, or investment;
c) share markets or sources of supply; d) apply dissimilar
conditions to equivalent transactions with other trading
parties, thereby placing them at a comparative disadvantage;
e) make the conclusion of contracts subject to acceptance by
the other parties of supplementary obligations which, by their
nature or according to commercial usage, have no connection
with the subject of such contracts. Any agreements or
decisions prohibited pursuant to this Article shall be
automatically void. The provision of para. 1 may, however, be
declared inapplicable in the case of: any agreement or
category of agreements between undertakings; any decision
or category of decisions by associations of undertakings; any
concerted practice or category of concerted practices, which
contributes to improving the production or distribution of
goods or to promoting technical or economic progress, while
allowing consumers a fair share of the resulting benefit, and
which does not: a) impose on the undertakings concerned
restrictions which are not indispensable to the attainment of
these objectives; b) afford such undertakings the possibility
of eliminating competition in respect of a substantial part of
the products in question”. For a consolidated version of the
text of the EC Treaty see Official Journal of the European
Communities C 325, 2002
27 Section 1 of the Sherman Act 1890 (15 U.S.C. §§1-7)
provides that: “Every contract, combination in the form of
trust or otherwise, or conspiracy, in restraint of trade or
commerce among the several states, or with foreign nations,
is declared to be illegal. Every person who shall make any
contract or engage in any combination or conspiracy hereby
declared to be illegal shall be deemed guilty of a felony, and,
on conviction thereof, shall be punished by fine not
exceeding $10,000,000 if a corporation, or, if any other
person, $350,000, or by imprisonment not exceeding three
years, or by both said punishment, in the discretion of the
court” (1994 and Supp. IV, 1998).
28 See Rio Tinto Zinc v. Westinghouse (1978) 1 All. ER 434.
ENCYCLOPAEDIA OF HYDROCARBONS

successful.29 Either the courts assumed that OPEC had
sovereign immunity or that its actions were acts of
state outside the jurisdiction of US courts or that
service to OPEC was not possible. OPEC’s members
were equally held to enjoy sovereign immunity, as
their action within the OPEC process was considered
sovereign action rather than commercial action. In
International Association of Machinists & Aerospace
Workers v. OPEC (1979) Court of District of
California,30 a labour union filed an anti-trust suit
against OPEC and its member countries claiming
damages and injunctive relief for violating US
anti-trust laws. The court dismissed the claim for
damages on the grounds that the plaintiff was, at best,
an indirect purchaser of oil from OPEC member
countries, a condition that precludes damages under
US law. The claim for injunctive relief was similarly
dismissed for lack of jurisdiction under the Foreign
Sovereign Immunities Act 1976.31 This was based on
the ground that the defendants’ practice of setting
conditions for the exploitation of their valuable natural
resources was a sovereign function for which they
enjoyed full immunity, and that it could not qualify for
the commercial activity exception. The Appeal Court
affirmed the lower court’s judgment, but on the
alternative ground of act of state doctrine.32
Opinions are divided on the extra-territorial
application of US anti-trust laws to an
intergovernmental organization such as OPEC. Some
have argued that OPEC actions are of a commercial
nature, influencing the oil price in international
markets, and are implemented not by state agencies,
but by private and at least organizationally separate
state oil companies.33 There is also the submission that
the international oil companies are associated with the
implementation of OPEC production and pricing
policies, and in fact, benefit from it. Clearly OPEC
poses peculiar legal barriers for the Sherman Act
(Ukpanah, 2002).
While it is true that the nature of the action within
the framework of OPEC is not cast in stone, it is
instructive that in the instances when OPEC was sued,
the matter was resolved one way or the other in
OPEC’s favour. For example, in April 2000, the owner
of a gasoline station in the US, Prewitt Enterprises,
Inc., sued OPEC, on the basis that “OPEC’s
price-fixing activities violated US anti-trust laws”. The
suit was brought to the Federal District Court of
Alabama, which issued a default judgment against
OPEC in March 2001. OPEC member countries,
although not directly involved as defendants, were
seen to be co-conspirators with OPEC itself and other
non-OPEC oil exporting countries (specifically
Mexico, Russia, Norway and Oman), and that the
supply restriction agreements they entered into were
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
ORGANIZATION OF THE PETROLEUM EXPORTING COUNTRIES (OPEC)
commercial in nature for which there could be no
sovereign immunity.
After the default judgment, the Organization
decided to participate in the case and was successful in
having the default judgement vacated, and requested to
have the case dismissed on numerous grounds. One of
the arguments presented, which the Court agreed to
consider first, was the validity of the service. OPEC
sustained that the way chosen to serve OPEC was
prohibited by Austrian Law and that it is subject to
immunities under the headquarters agreement signed
with Austria. Various third parties including OPEC
member countries and non-member states filed amicus
curiae briefs in support of OPEC’s position. In August
2002, the Court decided to dismiss the case for
inadequate service of process, taking into consideration
that, as the headquarters agreement is “an integral part
of Austrian law”, the Plaintiffs’ attempted service by
certified mail was defective and prohibited under
Austrian law. The dismissal, however, was granted
“without prejudice”, meaning that the Plaintiff has the
right to pursue an alternative means of effective service.
Prewitt Enterprises, Inc., filed a motion to amend
the judgement invoking the judge’s discretion to order
service. In March 2003, the District Court denied
Prewitt’s motion to order service on OPEC by some
alternate method, regardless of Austrian law, and
Prewitt appealed the District Court’s dismissal of its
complaint. On 18 December 2003, the eleventh Circuit
Court confirmed the decision taken by the District
29 Note, The Applicability of the Antitrust Laws to
International Cartels Involving Foreign Governments,
{*24} 91 YALE L.J. 76 Prewitt Enterprises, Inc., On Its
Own Behalf And On Behalf Of All Others Similarly Situated
v. Organization of the Petroleum Exporting Countries
(2001). Civil Action Number CV-00-W-0865- United States
District Court for the Northern District of Alabama,
Southern Division 2001 US. Dist. LEXIS 4141; 2001-2
Trade Cas. (CCH) P73,246; the litigation ended when the
US courts determined that service to OPEC was not possible
without the cooperation of the Austrian government which
was not forthcoming, reported in «Middle East Economic
Survey», 2002.
30 477 F. Supp. 553.
31 28 U.S.C. §§ 1602-11.
32 Appellate court decision in International Association
of Machinists and Aerospace Workers v. OPEC and member
countries (1981), Supreme Court of the United States, 649
F.2d 1354. The 9th US Circuit Court of Appeal held that
OPEC’s action was to be considered an act of state and it
could not interfere in the actions of a sovereign. This is
approved by Seidl-Hohenveldern, 2001, who also refers to
the secondary justification to prevent the depletion of scarce
resources.
33 Note the recent court action against OPEC in the US
Federal District Court of Alabama in 2001 (Prewitt
Enterprises v. OPEC). See also the arguments made by
Rueda, 2001; Udin, 2001.
567
INTERNATIONAL LAW
Court. In early January 2004, Prewitt petitioned all of
the judges sitting on the Eleventh Circuit to reverse the
decision issued on 18 December by the three-judge
panel. On 2 March 2004, the United States Court of
Appeals for the eleventh Circuit rendered a decision
denying Prewitt’s motion for rehearing by the same
court. Prewitt then elected to petition the United States
Supreme Court to take the case. That petition became
due beginning June, and was served on OPEC, which
equally filed its brief in opposition by 28 June, 2004.
On further appeal by Prewitt to the US Supreme
Court, the Supreme Court declined to hear the matter
without giving any reasons. Against this backdrop, it
may well be that anti-trust issues concerning OPEC
can better be resolved by diplomatic means rather than
through an adversarial judicial mechanism.
It is, though, a core principle of both US and EU
competition law that the law aims at conduct by
private companies and not by governments nor at
private conduct if under clear (and not contrived)
government compulsion. To use the cartel prohibition
against OPEC in the EU, the EU would have to prove
amongst others that OPEC is an undertaking under art.
81. Secondly, that OPEC actions affect trade between
member states of the EU and lastly, whether OPEC
can be exempted from the province of art. 81, para. 1,
on the basis of economic efficiency criteria envisaged
under art. 81, para. 3, EC Treaty. US anti-trust law
would therefore have to argue the commercial
character, overcome the argument of government
compulsion and, under international law, deal with the
recognition of permanent sovereignty over natural
resources.34
If these objections could be overcome and,
intergovernmental conduct subjected to national law,
many governmental initiated, sponsored and backed
economic activities (e.g. common regimes of
agricultural production constraint or restructuring of
specific industries) would be subject to anti-trust
law.35 This is probably not what Western governments
would want or accept. Anti-trust scrutiny is good for
others, but not if turned against themselves.36
OPEC’s actions, and those of member states, have
also been subject to legal scrutiny in times of low oil
prices. Taxes (in particular royalties) that are below
those which private landowners would charge (mainly
in the US) have been argued to constitute a measure of
state subsidy.37 These might, under US and WTO trade
law, justify retaliatory import tariffs to balance out the
amount of subsidy alleged to be inherent in the
producer country tax system.38 This issue, which is
quite similar to the US complaint over ‘artificially
low’ stumpage fees (royalties) on Canadian softwood
imported to the US, is most difficult to prove.39 There
is no international rule on minimum production
568
34
UN General Assembly 1962 No. 1802 – XVII and art.
18 – energy sovereignty – of the Energy Charter Treaty
Mexico included a reference to sovereignty over natural
resources in its accession to the WTO (UNCTAD, 2000).
35 The desire to subject OPEC to US anti-trust law has
not been lost on the US Congress, which has attempted
several times, beginning from 2000 to 2005, to bring OPEC
within the ambit of anti-trust extraterritorial jurisdiction. See
e.g. H.R. 4731. Foreign Trust Busting Act 2000, 106th Cong.
2d Sess., allowing lawsuits against foreign energy cartels; H.
Con. Res. 276 (13 Mar 2000), strongly urging the President
to file WTO complaint against OPEC member nations for
unlawfully imposing quantitative restrictions in petroleum
exports; H.R. 3822, Oil Price Reduction Act 2000, 106th
Cong. 2d Sess. (2 Mar 2000); SRS 263, 106th Cong. 2d Sess.
(28 Feb 2000) S 665. No Oil Producing and Exporting
Cartels (NOPEC) Act 2005, 109th Cong. 1st Sess. S 555,
which sought to amend the Sherman Act to make oil
producing and exporting cartels illegal. It would appear that
in all these various attempts reason prevailed over passion.
36 It is useful here to examine closely the former
Norwegian mandatory gas sales syndicate’s investigation by
the EU Competition Directorate General. It was recently
disbanded (and the EU investigation in consequence closed)
(EU press release, 17 July 2002). Here, companies could
make and probably have made the argument of government
compulsion. On the other hand, Norway itself was under
pressure, notably through its obligation (transposed from EU
law by the European Economic Area agreement it had
accepted) from art 86 para. 2 of the EU Treaty (restriction
on state-established monopolies) and the freedom of trade
under the Treaty (arts. 29, 30). These obligations, while
applicable now directly to Norway, are not applicable to
OPEC countries. Nevertheless, it is not impossible to
envisage the conclusion of Economic
Cooperation/Association Agreement between the EU and
OPEC member states, which would make EU competition
law applicable. An agreement with Algeria has reportedly
already been negotiated; it includes reference to EU
competition law. The issue requires further examination than
can be done here. The EU press release of 17 July 2002 also
makes reference to Gazprom’s willingness to drop restrictive
conditions in future long-term gas sales contracts to the EU.
Also: Press Release, 06 October 2003, European
Commission Reaches Breakthrough With Gazprom and Eni
on Territorial Restriction Clauses.
37 During the oil price collapse of the late 1990s, US
domestic oil producers petitioned, although unsuccessfully,
the US International Trade Administration for the imposition
of anti-dumping and countervailing duties on crude oil
imports coming from such countries as Venezuela, Saudi
Arabia, Iraq and Mexico. See Smith, 2000. For further
discussion see Desta, 2003b.
38 The issue here is lower production taxes
(royalties-stumpage fee) in the producing country, not an
exemption of oil exports from export taxes; this seems not to
be actionable under item (g) of the Annex I (illustrative list
of export subsidies) in the Agreement on Subsidies and
Countervailing Measures (SCM).
39 The recent 27 September 2002 WTO panel decision in
the Canada v. US Softwood Lumber case raises such issues,
i.e. if a lower-than-normal royalty (here, stumpage fee)
could be considered a subsidy. In this case, the US claim
was denied because stumpage fees in public Canadian
forests were not clearly lower than a Canadian
market-comparative fee. See Benitah, 2002.
ENCYCLOPAEDIA OF HYDROCARBONS

taxes;40 the fact that the US legal tradition is of private
rather than state ownership of subsurface minerals
cannot be used to impose the US average or standard
landowner’s lease’s royalty on the rest of the world.
Additionally, it is usually very difficult to disentangle
precisely the fiscal relationship between a state
petroleum company and the taxing (but also
subsidising) state. There are developments in EU law
on state aids which may encompass a reduction of
taxes in a specific industry. Lower taxes on export oil
may therefore come to be viewed as an illicit state aid
under both national and the WTO anti-subsidies’ rules.
But in most cases, taxes on exported oil are higher, not
lower, than the tax regime applicable to domestic oil
consumption; probably in all OPEC countries,
domestic oil consumption is privileged, not penalized,
in comparison with exported oil.
WTO law
It is possible that the role of OPEC will come
under scrutiny from WTO law (Desta, 2003c); several
significant OPEC members are now in the process of
accession (see Table 2) (Botchway, 2001).
GATT/WTO obligations do not apply to OPEC,
which will not be a WTO member, but to its member
states. Production quotas such as the ones currently
used are ‘export quotas’ under art. XI GATT.41 One
justification may be under art. XI (2) (b) – measures
“necessary for international marketing of
commodities” (UNCTAD, 2000) the next defence can
be found in arts. XX and XXI of the GATT. The
Table 2. WTO membership status
of OPEC member countries
OPEC member Status of membership
countries of WTO
Algeria Negotiating terms of accession
Indonesia Member
Iran Not a member
Iraq Not a member
Kuwait Member
Libya Not a member
Nigeria Member
Qatar Member
Saudi Arabia Negotiating terms of accession
United Arab Emirates Member
Venezuela Member
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
ORGANIZATION OF THE PETROLEUM EXPORTING COUNTRIES (OPEC)
question is justifiability under art. XX, mainly (g),
conservation of exhaustible natural resources or (h),
pursuance of obligations under any intergovernmental
commodity agreement which conforms to criteria
submitted to the WTO parties and not disapproved by
them.
Acceptance as a legitimate measure under an
international commodity agreement might be one
way, but it is unlikely that governments, without
that a comprehensive deal is struck with OPEC,
would approve such arrangements at present. Some
would argue that OPEC quotas are intended
primarily to maintain and increase price levels.
Others would contend that it has a conservation
function considering the exhaustibility of oil.
Conservation is certainly the effect of a higher
price and government-induced limitation on
production or vice versa. It does not seem, at
present, a primary rationale for these measures,
and may therefore be seen as a secondary
justification. But the condition is that such
conservation measures must be applicable equally
to domestic production. That this is done currently
is not clear, and needs more in-depth investigation.
While the conservation argument would not seem
credible during periods of high oil prices when
members are producing at optimum capacity, the
fact that there is a lack of spare capacity equally
exposes the contention that OPEC quotas are
intended primarily to maintain and increase price
levels. OPEC countries would also rely on the
national security exception (art. XXI, GATT;
Hahn, 1991); acceptance of this is far from certain,
but the concept has been interpreted by major
trading countries (US, EU) very widely.
The dependency of OPEC countries on oil
production, not comparable to the role of oil in
other countries, would be an argument. GATT does
not include any formal reference to ‘permanent
sovereignty over natural resources’ (UN General
Assembly Resolution No. 1801/1962) or ‘energy
sovereignty’ (art. 18 ECT, 1994). But this principle
could be seen as controlling or at least influencing
the interpretation of the national security and
conservation exceptions (art. XX of the GATT),
40 Except directives issued in EU law, which sometimes
set minimum taxes, e.g. VAT (Value Added Tax) or
minimum excise taxes on automotive gasoline: Williams,
1998. The book, surprisingly, does not even mention the
most relevant and controversial 1997 draft directive for a
carbon tax. Same for: Terra and Wattel, 1997. See also
Dibout, 1996, and Price 1999.
41 Very early GATT reports leave no doubt that export
restrictions used to avoid price competition among exporters
and maintain export prices (WTO, 1995).
569
INTERNATIONAL LAW
either directly as customary international law or
indirectly as a result of GATT interpretation for
maximum compatibility with customary
international law. Accession negotiations and
conditions could carve out an exception for
participation in OPEC export quota schemes.42
However, accession to the WTO is now subject to
increasingly restrictive conditions, and therefore,
the earlier a country’s accession, the less such
constraints they have to live with.
In 1948, the WTO may have been primarily
about access to manufacturing goods, with little
interest in energy security. But this has changed for
the influential blocks in the WTO. There is and will
be more and more of an effort to extract
concessions favouring US and EU energy security
concerns from the resource-owning countries
requesting membership. For example, in the case of
Russia, the dual energy price (i.e. higher export
price, lower domestic prices for both energy exports
and pipeline tariffs) is currently a stumbling block,
as is the prohibition on Trade-Related Investment
Measures (TRIMs). Nevertheless, the legal
instruments for a deal are available, but it needs
political will and some creativity to identify the
contours of a proposal that improves the situation of
both sides.
WTO law would also be relevant for OPEC
member rules obliging foreign and national
companies with export quota, by restricting their
production, if otherwise the quota would be
exceeded. This might be considered a TRIM, which
is, in principle, incompatible with the WTO
agreements. The same applies to obligations to
refine or otherwise process oil and gas extracted in
the producer country or to give preference
(including minimum quota) for domestic
procurement of goods and services. It is interesting
to note that the WTO does not prohibit the use of
export duties to discourage exports. If OPEC
countries would shift from production quotas to a
uniform export tax system (equivalent to royalties),
that would be compatible with the GATT rules
(Desta, 2003a and 2003d; Zarilli, 2003).
It is noteworthy that in over 40 years, there has
not been any formal procedure against OPEC
member countries for alleged contravention of
GATT obligations. This may be seen as a tacit
acceptance of the OPEC export restriction system.43
If a comprehensive deal were to be negotiated
between OPEC and consuming countries, then such
a deal could be translated into the GATT by either
approving OPEC as a commodity organization or
by negotiating an understanding. Such an
interpretative understanding would define
570
acceptable forms and terms of production or export
limitation under the OPEC system. An
understanding could possibly44 limit the
applicability of art. 26 on investment arbitration
during a transition period and be modelled on the
various Norwegian exceptions to this provision.
Hypothetical membership of the OPEC
countries in the ECT (Wälde, 1996) would raise the
same questions as those for the WTO, as the ECT
provides for non-GATT members application of
GATT provisions with some qualifications. Unlike
the GATT, however, the ECT, in art. 18, explicitly
recognizes energy sovereignty and the
“optimalization of [resource] recovery and the rate
at which they may be depleted or otherwise
exploited”. Arguably, ECT membership therefore
poses fewer problems for OPEC countries than the
GATT, though the GATT/WTO includes several
OPEC members and others in accession
discussions, while the ECT does not. There may,
however, be soft-law disciplines under the ECT for
‘export taxes’ on oil45 and under art. 6 (competition
law) as well as under the art. 5 prohibition on
TRIMs.
Some of these issues could be solved through
understandings negotiated by countries requesting
accession (or, in the case of Russia, before
ratification). Such understandings could include: a
limitation or long transition process for the TRIMs
42 United Arab Emirates, Nigeria, Qatar, Venezuela,
Indonesia, and Kuwait, are WTO members; Algeria and
Saudi Arabia are in accession negotiations; Iran and Libya’s
applications for accession are explicitly being blocked by the
US; Iraq is not a member nor involved in accession
discussions for status:
http://www.wto.org/english/thewto_e/acc_e/workingpart_e.h
tm. Another issue for examination is if the OPEC quota, an
export restraint, does or does not constitute a ‘financial
contribution’ under the definition of subsidy in art. 1 of the
SCM Agreement; the recent WTO panel in US Canada
(measures treating export restraints as subsidies) suggested
that export restraints do not constitute subsidies, WTO Doc
WTIDs1941R., panel report circulated on 29 June 2001.
43 Again, one needs to appreciate that while some OPEC
producers have been WTO members for quite a while,
others, including the major ones (Saudi Arabia, Iran, Iraq,
Libya), have not. One needs also to bear in mind that a WTO
dispute about the OPEC production coordination may
definitively keel these oil producers out and compel the
existing OPEC members to leave OPEC. Would this be in
anyone’s interests?
44 The problem is to what extent an Understanding can
exceed the normal scope for interpretation and in effect
change the Treaty: an issue debated with respect to the 2001
North American Free Trade Agreement Commission
restrictive interpretation on Chap. XI. See Weiler, 2002.
45 Art. 29, para. 4, “states shall ‘endeavour’ not to
increase, export levies”.
ENCYCLOPAEDIA OF HYDROCARBONS

obligation (art. 5); a recognition of OPEC
production control (limiting any argument about the
competition law, art. 5); or an understanding that
the ECT does not affect issues that are controversial
between the EU and energy exporters (e.g. Russia,
Algeria), such as destination clauses and initial
access to new infrastructure such as pipelines.
OPEC countries face another tension between
the implicit or explicit tendency to exclude, or at
least control, foreign investors with free access
provisions in some modern bilateral treaties and,
should they consider joining, multilateral treaties,
such as the ECT. While most OPEC countries have
entered into Bilateral Investment Treaties (BITs),46
it is doubtful (though not impossible) that they have
accepted non-discriminatory free access regimes
without a carve-out for the upstream oil industry.47
The NAFTA provides such an example: it
excludes free access for the sector in order to
maintain the current Mexican oil and gas upstream
state monopoly. No OPEC country has yet joined
the ECT, though there have been discussions. Saudi
Arabia (but also Algeria, Kuwait, United Arab
Emirates, and Venezuela) find discussions easier to
obtain in the ECT (where there is no US presence)
than in the WTO. The soft-law free access (art. 10)
‘best efforts’ obligation does not, at this time,
constitute a binding obligation to provide non-
discriminatory free access to foreign, treaty-state
investors. Even if a supplementary treaty as
originally planned gets accepted, it is unlikely that it
would modify or override the treaty’s energy
sovereignty provision (art. 18). On the other hand,
membership in the ECT (as in many modern-type
BITs) would require OPEC states not to
discriminate between foreign and national investors
(i.e. state companies) when opening up acreage for
licensing (art. 10; art. 18, para. 4), albeit this is still
a soft-law obligation. Norway, it is interesting to
note, has, under the impact of the EEA (European
Economic Area) agreement, had to accept the 1994
EU licensing directive (Directive 94/22/EC).
This set of EU-wide rules on licensing of
upstream oil and gas acreage prohibits
discrimination between national and foreign
companies, and requires an objective and
transparent system of rules to govern licensing.
Another question is whether OPEC countries could
move towards a more harmonized structure of
taxation for oil extraction, something that was
considered in the 1960s.
The investment arbitration provision (art. 26) is,
so far, apparently the major deterrent. OPEC
countries may not be very familiar with the
international accountability of their actions and thus
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
ORGANIZATION OF THE PETROLEUM EXPORTING COUNTRIES (OPEC)
emphasize sovereignty. The fact that most of them
have already accepted investment arbitration under
bilateral investment treaties, and are seeking to
accept the interstate dispute settlement system for
the WTO disciplines may gradually change that.48
There is no international or national competition
law which would oblige OPEC states (so far, in the
main, seen as immune from US or EU competition
law) to refrain from production and export quota.49
10.7.5 Conclusions
OPEC, as an international organization and forum
which facilitates collaboration among the major oil
and gas producing countries, is now increasingly
being pulled into the institutional structure of the
global economy with myriad intricate international
economic law rules traversing the energy sector.
There will have to be give-and-take on both sides
(consumers and producers alike) to conclude a
successful harmonization in tandem with national,
regional and global economic imperatives.
OPEC fulfils, unlike the more hostile
sentiments in the 1970s, a silently important
function for both domestic producers and
international oil companies by being the
organization most keen, and most potent, to assist
in stabilizing prices by helping producers to
manage production. If this ability, which was not
evident in the 1980s and 1990s, is maintained or
will fade again is beyond our ability to forecast.
Sustainable development would require,
amongst others, greater application of energy
efficiency, minimization of emissions harmful for
the global (and localized) climate and possibly
restrictions on the supply, and use, of hydrocarbons.
Such policies, eagerly pursued by mostly Western
46 See http://www.worldbank.org/icsid.
47 This is an issue that would require more
detailed
investigation and study.
48 This is discussed at length in my study for OPEC on
the implications of the ECT for OPEC, in Wälde, 2004.
49 The competition law prohibition against cartels
(including the new term of ‘hard core’ cartel being
mentioned in the 2002 Doha WTO conference) – art. 81 EC
Treaty, US Sherman Act – applies to private producers, but
not governments. Governments are immune from anti-trust
jurisdiction – except (under US law at least) if operating in a
commercial role. There is therefore no possible OPEC or
OPEC Member States’ liability under anti-trust law – as
there is none for the US, or the EU, with respect to, for
example, jointly reducing agricultural production or
encouraging a reduction of production capacity of an
industry in crisis (e.g. steel or semiconductors).
Seidl-Hohenveldern, 2001.
571
INTERNATIONAL LAW
NGOs and the EU, for example, are unlikely to
succeed if proper account is not taken of OPEC, the
major international organization of the major oil
producing countries. This analysis suggests that
there may be more compatibility than meets the eye
or which is intuitively implicit in the conventional
reference, however right or wrong, to the OPEC
cartel.
We suggest that an overall deal is possible, but
requires a more active and creative effort at
identifying commonalities of interest and much
stronger leadership with the political will in
pursuing and negotiating them on both sides. An
arrangement could require some concessions by
OPEC in terms of managing the oil price as a
contribution to a stabilizing world monetary
policy (e.g. lower prices in a recession, higher in a
boom). It would require better guarantees of
security of supply to concerned parties (e.g. US,
EU, China) as well as security of demand to major
oil producing countries. Surely, the world cannot
justifiably require major oil producing countries to
divert development funds to increasing their spare
capacity when the major consumers are heavily
investing in alternatives to oil. Oil prices could
also be linked to import prices for the producing
countries.
In exchange, there could be some examination
of the very high excise taxes on gasoline and some
other developed country policies affecting the
producer states. A higher price for oil together
with a discipline on supply could be in the interest
of the OPEC countries, the environmentalist
community and consumer countries’ long-term
interests in a stable and secure oil supply. An
unfettered global oil market is probably not in the
interests of anybody – contrary to recurrent
allegations, or conventional thinking, particularly
in the US.
Historically, an unfettered oil market without
political influence never existed, even in the US’
domestic petroleum industry. On the international
scene, it would drive down oil prices to very low
levels, close down most non-OPEC production
(including in the US), counter current Kyoto and
energy efficiency objectives, discourage
development of renewable energy and would very
likely result in extreme and therefore, for the global
economy, detrimental, swings of the oil price.
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Schlemmer-Schulte S., Tung K.-Y. (edited by) Liber
Amicorum Ibrahim F.I. Shihata, den Haag, Kluwer, 727, 7.
Smith W. (2000) Save Domestic Oil, Inc.’s crude oil market
dumping petition: domestic and international political
considerations, «Tulsa Journal of Comparative and
International Law», 8, 147-175.
Terra B., Wattel P. (1997) European tax law, den Haag,
Kluwer.
ENCYCLOPAEDIA OF HYDROCARBONS

Udin A. (2001) Slaying Goliath: the extraterritorial application
of US antitrust law to OPEC, «American University Law
Review», 50, 1321-1373.
Ukpanah E. (2002) OPEC as a cartel: can US antitrust laws
be applied extraterritorially?, «Center for Energy, Petroleum
and Mineral Laws and Policy», 6, 1-20.
UNCTAD (United Nations Conference on Trade And
Development) (2000) Trade and development report, New
York, United Nations.
Wälde T.W. (editor) (1996) The Energy Charter Treaty. An
East-West gateway for investment an trade, London, Kluwer.
Wälde T.W. (2004) Legal and policy implications of a
relationship of two international treaties in natural energy
resources: OPEC and the ECT, in: «Oil, Gas and Energy
Law intelligence», 2, 5.
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ORGANIZATION OF THE PETROLEUM EXPORTING COUNTRIES (OPEC)
Weiler T. (2002) Articulating new standards of regulatory
treatment in international economic law, «Business Law
International», 143.
Williams D. (1998) EC tax law, Harlow, Longman.
WTO (World Trade Organization) (1995) Guide to GATT law
and practice. Analytical index, Génève, WTO, 2v.; v.II, 325.
Zarilli S. (2003) Domestic taxation of energy products and
multirateral trade rules: is this a case of unlawful trade
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Thomas W. Wälde
Centre for Energy, Petroleum
and Mineral Law and Policy
University of Dundee
Dundee, Scotland, United Kindom
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 10.8
The International
Energy Agency (IEA)
10.8.1 Overall profile
The IEA – an autonomous agency within the
OECD (Organization for Economic Co-Operation
and Development) – is an international
organization that has been of interest in particular
to energy specialists.1 In essence, it combines the
role of an intergovernmental energy policy
think-tank or research institute with the role of
administrator of an emergency oil-sharing
programme. It is less in the public light than
OPEC (Organization of Petroleum Exporting
Countries), its counterpart. Different from OPEC,
it is hard to blame the IEA for driving oil and
petrol prices up. The anti-globalization and ‘civil
society’ movements have not as yet discovered
the IEA as a scapegoat for the various ills of
globalization; it may to some extent also be
covered by the OECD. Its relationship with the
OECD shades between, on one side, an
independent international agency with an
administrative support arrangement with the
OECD, and on the other, an autonomous and
specialized part of the OECD group.
The IEA’s raison d’être has diversified away
from its earlier focus – Western solidarity in the
face of OPEC-faced threats – towards
energy-focused research and market intelligence,
i.e. a type of work that could also be carried out
by academic institutions, consultancy and
investment firms. In developing this role – which
was not absent when the IEA was created – it also
filled a vacuum, in particular as the transfer of
the OECD’s energy policy functions left the
OECD, the natural vehicle for such applied
research, without its own energy arm. The IEA
advantage or difference is that it is publicly and
internationally funded; it therefore has more
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historical continuity and financial stability, and
less dependence on markets, clients and national
budgeting processes, than private or
nationally-based public energy research institutes.
While still in charge of the OECD countries’
emergency oil-sharing system, it now fulfils a
function of centralized research and intelligence
quite similar to the role of national energy
institutes or the pooled research and intelligence
function of international business associations.
Focused on something that is seen as strategic,
particularly during times of high energy prices
and possible supply disruptions, and insulated
from the questioning of national agencies of that
type by its character as an international
organization, it may have to justify its continuing
usefulness by defining the ‘public good’ it
delivers and its distinctive comparative cost and
quality advantage over private, more
market-driven organizations.
At its origin, the IEA was conceived primarily
as a response to OPEC’s then – in 1974 –
increasing control over oil production, prices and,
implicitly, investment (Mommer, 2002). In
essence, it was designed to be an instrument of
solidarity and mutual-help of the Western
1 The main study on the IEA, with all original
documents included, is Scott (1994, also available for
downloading from the IEA website); the most recent
academic comment is by: Steeg (2001), former executive
director of the IEA, Miehsler (1983), Bamberger (2004,
available from www.iea.org). I am grateful for critical
comments to Craig Bamberger, former legal counsel; Nancy
Turck, at present legal counsel; Malcolm Keay, formerly of
the IEA and now with the Oxford Energy Institute; and to
Aloysius Gng, my research assistant. I should, however,
point out that I have the sole responsibility for this text and
the opinions expressed therein.
575
INTERNATIONAL LAW
oil-consuming countries in times of politically
created supply shortages; this would involve an
element of minimum oil stock requirements, to
tide over short-term and localized supply crises,
an element of demand restraints and, finally and
most impressively, an element of sharing of oil
supply. The IEA therefore set up essentially a club
of oil consumers who promised to help each other
in times of crisis. That was meant in particular to
counter the 1973 Arab oil embargo which tried to
divide oil-consuming countries by distinguishing
between unfriendly, neutral and friendly
consuming countries. Set up as, in law and theory,
a purely intergovernmental oil cooperation
programme, without direct effect in domestic law,
it has nevertheless developed a system of
concertation with the (Western) oil companies;
such concertation is essential for the proper
functioning of the oil emergency sharing system.
The oil emergency sharing mechanism is one
of the most impressive, and little noted,
achievements of intergovernmental cooperation
since the Second World War. It brings together
such diverse countries as (most of) the European
Union (EU) countries, North America and Japan;
it creates a rapid-decision system in coordination
between the executive director and the board; and
it obliges nations to act against their normal
pattern of conduct and political instinct – sharing
the impact of a crisis rather than “each going for
itself ”. In this regard, the proper comparison for
the IEA agreement is probably rather in the area
of nuclear crisis management. There is no other
agreement or international organization which
sets up a comparably effective energy solidarity
mechanism – e.g. United Nations (UN) or Energy
Charter Treaty (ECT).2
The emergency sharing mechanism has never
been fully tested in actual crisis practice
throughout the last 40 years, though stand-by
arrangements have been set up repeatedly. Energy
security supply remains a sensitive topic for most
consuming countries. At present, most EU
countries (including, increasingly, the United
Kingdom), Japan, the United States, but also the
major industrializing countries (China, India,
Brazil and other Asian countries), are heavily
dependent on oil and gas imports. These carry an
often under-appreciated price in adding political
dependencies to oil/gas supply dependencies, e.g.
in particular the EU with respect to Russia or
everybody with respect to the Middle Eastern
countries.
The very high petroleum prices in 2005-06,
the prospect of security risks in the major
576
oil-producing countries in the Middle East,
Nigeria and Venezuela, or the risk of a
fundamental political re-alignment of Russia, all
exacerbate the security risk. The risk is more
pronounced in the field of gas supplies, which are
predominantly based on fixed pipelines and
heavy front-end capital investment, and often
transit through politically volatile zones. Non-
conventional and renewable energies are desirable
in terms of energy security, diversification of
supply sources, energy efficiency and climate;
but at present they look unlikely to prevent a
further concentration of oil and gas supply from
politically more stable to politically more
vulnerable and volatile countries. The emergency
sharing programme – as minimal as it may be –
remains therefore both a most sensible response
and a policy instrument that should be reviewed
to identify political and technical feasibility of
expansion; in particular it should look towards
building a more extensive energy community
with both the now most dynamically growing
consuming countries (China, India) and the
producing countries (mainly those in OPEC, but
also Russia and the Central Asian producers).
The IEA has evolved mainly from an oil-
supply crisis response system, with features of
‘war economy’ management, to the world’s major
think-tank, energy policy research institute and
professional link between the public agencies in
member states dealing with energy policy. In
response to public perception and governmental
interests, it now carries out consultative energy
policy research in most of the relevant areas of
current concern – climate change, environment,
security, gas, pipelines, non-conventional and
renewable energy. This is a welcome contribution
to the international community as there is no UN
‘World Energy Agency’; the existing major
international agencies (World Bank, UN,
International Monetary Fund or IMF, OECD, EU
Commission, regional institutions) deal with
energy, but it does not constitute their major
focus. In particular, security of supply is not a
major concern of any of these international
agencies. The only other somewhat comparable
institutions are, first, OPEC, and then the Energy
Charter Secretariat, with a much smaller policy
2 Some elements of intergovernmental
commodity-sharing schemes existed earlier, notably in the
European Community for coal and steel, and possibly to a
much more limited extent at least in the concepts of the
UNCTAD (United Nations Conference on Trade and
Development)-initiated UN commodity agreements.
ENCYCLOPAEDIA OF HYDROCARBONS

and economic research programme.3 A proper
World Energy Agency is still absent, though in
my judgement desirable.
10.8.2 Origin
The concept of the IEA as a Western,
consuming-countries’ mutual-help and solidarity
oil-sharing ‘programme’ was presented by US
Secretary of State Henry Kissinger in 1974 at the
Intergovernmental Conference on Energy. It was
a reaction to the OAPEC (Organization of Arab
Petroleum Exporting Countries) 1973 oil
embargo, which aimed at dividing the Western
consuming countries into good, bad and
indifferent countries, and tried to steer supply
selectively to the friendly countries only.4 One
should perhaps bear in mind that the most
significant supply disruptions in the EU came
about not because of OPEC and Middle Eastern
conflict, but because of resistance to another
round in gasoline tax increases by the British and
other EU governments in October 2000. In
September 1974, the OECD Energy Coordinating
Group approved the draft International Energy
Programme (IEP) – without France at that time;
the OECD Council adopted the decision to set up
the International Energy Agency. The Agreement
on the International Energy Programme was
ready for signature in November 1974 and
became effective in January 1976. Together with
the OECD Council Decision, the IEP is the
constitutive document of the IEA.
10.8.3 Autonomy or
integration: IEA relations
with the OECD
The relation between the OECD and the IEA has
never been absolutely clear. On one hand, the
IEA was meant to be “autonomous” – different
from the much more OECD-integrated “Nuclear
Agency” which, arguably, would rather find a
logical home in the IEA proper than the OECD.
There are elements indicating and supporting
autonomy: a) separate name; b) separate chief
executive entitled executive director (though
itself a slightly ambiguous term also compatible
with an integrated but autonomous view); c)
separate funding and decision-making
mechanism, though linked to OECD criteria and
administrative management within the OECD
structure; d ) area focus; e) organizational
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THE INTERNATIONAL ENERGY AGENCY (IEA)
foundation in an instrument that can be viewed
as a full-fledged intergovernmental agreement –
the Agreement on the International Energy
Programme, i.e. the IEA’s constituent instrument;
and f ) separate membership (though OECD
membership is necessary, it is not by itself
sufficient; the IEA functions as an OECD ‘core’
energy group).
All these criteria are somewhat ambiguous.
This is the natural result of a compromise
between autonomy on one hand, and practical
reasons and OECD-organizational interests for
greater subordination and integration on the
other. The use of the term “program” suggests
rather a specific activity within the OECD; the
use of the term “Agreement on the International
Energy Programme” rather than “Agreement on
Establishment of an International Energy
Agency” suggests integration. Such ambiguity
– which is likely to be seen more as integration
from the OECD side and more as autonomy from
the IEA side5 – is not unusual with international
organizations, e.g. with the UN proper and its
specialized agencies and autonomous but
organizationally more or less-integrated
programmes.
The staff of the IEA are formally OECD staff
(and are employed under the OECD’s conditions
of employment) though they report to the IEA
executive director. Tensions between formal
employment and substantive lines of reporting
can therefore arise. The IEA executive director is
appointed by the IEA governing board with the
concurrence of the secretary-general of the
OECD.6 Most of the IEA staff are employed
under fixed-term contracts;7 often, they are
seconded, mainly from member governments,8
sometimes also from companies. Fixed-term and
seconded staff provide for mobility and
flexibility – and also create an informal network
linking the IEA, member countries and often
3 For profiles on OPEC (see section 10.7)
4 One should note that at the time of this writing
– January 2006 – similar statements were made by the
Iranian President.
5 See The IEA as an Autonomous Agency of the OECD,
in Scott, 1994, Vol. I, and Steeg, 2001 (both authors were
with the IEA).
6 Art. 7 of the council decision – not in the IEP, Art. 59.
Arguably, the IEP supersedes the council decision. Practice
seems to be to maintain the OECD secretary general’s
role: Steeg, 2001.
7 It is true that the normal pattern is three and two-year
contracts, a pattern one also finds with other organizations.
8 Seconded civil service staff with reintegration rights
constitute about 20% of current IEA staff.
577
INTERNATIONAL LAW
also energy companies. On the other side,
institutional memory can be affected,9 no logical
career path is available and long-term investment
in specialized expertise is not a core professional
development incentive. The IEA shares this
relatively short-term outlook feature in personnel
policy with, for example, OPEC or the Energy
Charter Treaty (ECT) secretariat (it is also being
considered for the OECD). Employment with
such organizations therefore can sometimes be
seen as a research sabbatical rather than as a
solid career move. One can debate if the
advantages – linkages with member states and
the likelihood that ‘dead wood’ will move on –
are compensated by the shortcomings. It has
been pointed out to me that IEA staff have to
demonstrate some achievement during their time
at the organization, in order to get their next job
– something that is less pronounced in
international organizations with staff that cannot
be dismissed.
IEA staff are clearly distinguished from
OECD personnel, so the executive director should
have full power to contract and supervise its staff;
one cannot exclude that the formal integration
within the OECD allows OECD interference
through reliance on the formal rules; rigid formal
rules can easily be relaxed or applied with full
vigour, with an element of underlying personnel
strategy and institutional politics (Bamberger,
2004). Its staff is about 160, compared to 100 or
so at OPEC and about 30 at the Energy Charter
Secretariat.
10.8.4 Budget
The IEA has its own budget, fed by member
contributions based on the OECD scale of
contributions. The IEA has the authority to
change this scale of member-state contributions.
Formally, however, this budget is a ring-fenced
part of the overall OECD budget. While the IEA
governing board has ultimate power over
financial matters, for practical purposes the
agency follows the OECD financial regulations.
It is thus a separate IEA budget but placed
within the larger OECD budget. The IEA uses
the OECD’s administrative, financial and audit
services. The justification for this integration –
that can easily lead to frictions – has been to save
on administrative overheads. It is always difficult
to verify if such organizational integration
reduces administrative costs or not; it is
characteristic of an older model or organization
578
that saw efficiencies automatically produced by
economies of scale. The IEA has authority (Art.
65) to carry out “special activities” outside the
budget, fed by general, mandatory and
scale-based member-state contributions; this
authority – comparable to the “sole risk” clause
in petroleum joint ventures – allows a group of
like-minded countries to use the IEA machinery
to carry out special activities (e.g. technological
research). Apparently, the IEA has not engaged
to a significant extent in technical assistance
apart from the energy policy reviews in
non-member countries, but Art. 65 should
provide a financial and organizational structure
for technical assistance, externally funded and
IEA-executed research or technical assistance
projects.
10.8.5 Governance
The main organ of the IEA are the governing
board and the secretariat, headed by the executive
director. There are several “standing groups”,
advisory groups and the IEA dispute-settlement
centre (for commercial disputes arising out of an
oil supply transaction under an emergency
situation).10
The governing board – the ministers
responsible for energy or their delegates – is the
central decision-making organ of the IEA. The
most interesting features are: in taking decisions,
the application of a system of weighted voting,
based on oil consumption; qualified-majority
decision as the rule, with special voting
requirements for the application of the
emergency-sharing system and unanimity for in
particular adding new obligations not
contemplated in the IEP.
Weighted voting and unanimity is rare in
international organizations. It usually indicates a
greater degree of integration (e.g. EU) and/or a
greater need for rapid decision-making in a more
narrow and specialized context (e.g. World
Bank). Of particular interest is the interplay
between the executive director – who makes
finding of the oil supply emergency (Art. 19 IEP)
– and the governing board, which then confirms
the finding and thus activates the
emergency-sharing mechanism. Again, there are
9 Some senior staff have been, apparently, in the IEA for
much longer periods; that would help to create a more solid
and informal institutional memory.
10 Miehsler, 1983.
ENCYCLOPAEDIA OF HYDROCARBONS
 THE INTERNATIONAL ENERGY AGENCY (IEA)

elements of war economy11 and

‘international-crisis management’ Table 1. OECD member countries
decision-making structures which do not appear
to have been fully explored as yet.12 Helga Steeg Country Date of accession
(2001), the former IEA executive director, reports Australia 7 June 1971
that apart from one instance in 1994, decisions
Austria 29 September 1961
were always taken by consensus. That does not,
however, devalue the significance of the Belgium 13 September 1961
weighted-majority voting system of the IEA: Canada 10 April 1961
consensus is that much easier to achieve, in fact
in most cases automatic, if the voting-weight Czech Republic 21 December 1995
minority realizes that it is outnumbered. Denmark 30 May 1961
Member states have to implement decisions Finland 28 January 1969
that were taken within the IEP rules and
procedures. Given the intergovernmental nature France 7 August 1961
of the IEP Agreement, implementation is in the Germany 27 September 1961
main by national implementing legislation and
Greece 27 September 1961
not by direct effect – the indication, usually, of a
much closer integration as in the case of certain Hungary 7 May 1996
types of EU legislation (EC Treaty, regulations, Iceland 5 June 1961
immediately effective directives without space for
Ireland 17 August 1961
national implementing discretion). IEA
cooperation is therefore in essence Italy 29 March 1962
intergovernmental, different from the much more Japan 28 April 1964
intensive style of integration within the EU. One
Korea 12 December 1996
should, however, assume that for the
emergency-sharing system, a complete set of Luxembourg 7 December 1961
mutually related arrangements by the IEA, with Mexico 18 May 1994
and within the member states, and with the oil
Netherlands 13 November 1961
companies subject to member state legislation,
has already been worked out and periodically New Zealand 29 May 1973
tested, so that the decision to activate the IEA Norway 4 July 1961
emergency-sharing system is instantly and quite
automatically implemented down to the corporate Poland 22 November 1996
and commercial level (Steeg, 2001). Portugal 4 August 1961
The standing committees deal with the Slovak Republic 14 December 2000
various objectives (including emergency sharing)
of the IEA. Advisory groups have been set up, Spain 3 August 1961
first with the major oil companies (Industry Sweden 28 September 1961
Advisory Board) and the Industry Supply
Switzerland 28 September 1961
Advisory Group, for operational issues of the
emergency-sharing mechanism.13 Turkey 2 August 1961
United Kingdom 2 May 1961
United States 12 April 1961
10.8.6 Membership
IEA membership is only open to OECD members 11 Scott, 1994, Vol. II, also Steeg (2001) refer to the
(see Table 1). There is therefore a double precedents in the war economy effort of the First World War
threshold: first, OECD membership and then IEA allies managed by Royal Dutch Shell and Standard Oil of
membership (with accession requiring New Jersey (now EXXON). See also: Yergin (1991);
signature/ratification of the IEP, acceptance of the Howarth (1997); Barudio (2001).
12 A comparison between the IEA emergency sharing
subsequent acquis and a majority decision by the
system’s decision structure and comparable structures within
IEA governing board); new members have to be the EU and under the IAEA (International Atomic Energy
willing and able to meet the requirements of the Agency) auspices appears called for.
Energy Programme (see Table 2). It is noteworthy 13 See e.g Bamberger, 2004.

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INTERNATIONAL LAW
Table 2. IEA member countries
(January 2006)
AUSTRALIA JAPAN
AUSTRIA REPUBLIC OF KOREA
BELGIUM LUXEMBOURG
CANADA THE NETHERLANDS
CZECH REPUBLIC NEW ZEALAND
DENMARK NORWAY*
FINLAND PORTUGAL
FRANCE SPAIN
GERMANY SWEDEN
GREECE SWITZERLAND
HUNGARY TURKEY
IRELAND UNITED KINGDOM
ITALY UNITED STATES
* Participates in the Agency under a special agreement.
that, so far, only the Czech Republic, Hungary
and the Republic of Korea have become IEA
members, though Mexico,14 Poland and the
Slovak Republic are by now OECD members.
Poland and the Slovak are officially both
candidate countries for IEA membership.
Negotiations about accession with Mexico,
started in 1994, have come to an end. The IEA
governing board decides, by majority, on
accession.
Norway – in a special situation as Europe’s
major petroleum exporter, with no need for and
little interest in emergency sharing – is not an
IEA member; it participates in all other matters in
a role that is equivalent (including financial
contribution) to a full IEA member. The
agreement with Norway provides that it may
– but is not obligated to – participate in the
emergency-sharing mechanism by oil demand
restraint measures and by activating available
standby oil production capacity.15 The decision to
participate is exclusively Norway’s. That means
that in terms of technical and operational
preparedness, Norway is presumably integrated
into the emergency planning mechanism, but has
the option to participate or not. The Norwegian
position in the IEA mirrors its position in the
ECT: Norway signed, but has not ratified the
treaty. It reflects the country’s insular – in
attitudinal and legal terms – position towards
580
European integration. It wishes to sit at the table
but not to have to share its oil wealth.
The IEA does not, it seems, have a highly
institutionalized role for formal ‘observers’ – a
role that has been activated for a number of
OPEC and other countries in the case of the
Energy Charter Treaty process. I wonder if the
creation of such a role – maybe possible under the
IEA statutes – would not be a vehicle to foster a
more institutionalized involvement of major
producing (e.g. OPEC countries, OPEC itself,
Russia) and consuming countries (e.g. China,
India and Brazil).16 There are, however, less
formal and more ad-hoc-oriented ways to let
non-members participate in specific activities;
this tendency seems to be on the increase.
The European Commission also participates
in the work of the IEA17 but not as member; it is
without voting power and without contribution.
Art. 72 of the IEP allows accession by the
European Communities.18 It is not quite clear if
this means that a request by the EU to accede
would be sufficient for the EU (or European
Communities) to acquire membership or if a
majority decision by the governing board could
block accession, presumably because of a dispute
over the compliance of the EU with the IEP and
the subsequent acquis. That may be a sensitive
issue and not much is publicly known about the
reasons for the EU not to accede to the IEP. With
general knowledge of EU politics and attitudes, it
is probably safe to surmise that, with respect to
energy policy, there are not insubstantial
inter-organizational tensions between the EU and
the IEA. While in the past EU membership meant
OECD membership, that is not so in 2005/06;
with the accession of many East European
countries (and more to come), EU membership
no longer automatically overlaps with OECD
membership. There are some underlying political
issues which are unresolved: the EU, in particular
14 There have been discussions with Mexico (which
originally applied for membership). But in the meantime
Mexico has withdrawn its application. Note Abramowski
(1995).
15 Detailed discussion: Scott, 1994, Vol. I.
16 For a discussion of the institutional issues of
relationships with non-member countries: Scott (1994), Vol.
I, highlighting the reluctance to create a formal full observer
status; Bamberger (2004) indicating a cautiously more
welcoming approach.
17 See also Scott, 1994, Vol. I.
18 EU accession would not per se convey any voting or
other rights that the treaty confers upon “participating
countries”.
ENCYCLOPAEDIA OF HYDROCARBONS

Germany and all Eastern members, are heavily
dependent on gas and oil supply from Russia and
increasingly Central Asia. This dependency may
translate itself into a political attitude towards
Russia which may be substantially different from
an IEA position, where in particular the US,
along with other countries, may have more
legroom to be concerned over energy dependency
leading to political dependency.
10.8.7 Accession
The IEA membership structure creates
considerable obstacles to accession; first, the
OECD unanimity requirement for membership
has to be satisfied, then the IEA majority
requirement. Non-OECD countries are therefore
easily blocked. Even OECD countries – such as
Mexico – find it apparently difficult to reconcile
the IEA emergency-sharing structure with their
own priorities. Otherwise, major energy
consumers – i.e. countries that are heavily
dependent on supply disruptions, such as China,
India or Brazil – might well have an interest in
participating. It is difficult to forecast if these
countries will in the future be ready to meet the
double-threshold requirements for IEA
membership or if they will develop the political
desire and interest to set up regional energy
sharing systems of their own.
The most flexible instrument of working with
the IEA seems therefore to be the model adopted
by Norway. As far as I can see, it does not require
prior OECD membership; it promises a seat at the
table and even includes participation in the
emergency sharing programme; it should also
only require an IEA governing board majority
rather than the otherwise preceding OECD
unanimity. On this model, there seem to be no
legal obstacles for energy-producing countries
(e.g. OPEC countries) or energy-consuming
countries (e.g. China and India) to negotiate a
form of participation in the IEA that is both of
interest to them and the existing IEA member
states.
10.8.8 Emergency response
mechanisms in the IEA
In the words of the IEA itself: “The IEA’s
emergency response mechanisms were set up
under the 1974 Agreement. The IEP Agreement
requires IEA countries to hold oil stocks
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equivalent of at least 90 days of net imports of the
previous calendar year and to release oil stocks,
restrain demand, switch to other fuels, increase
domestic production and, if necessary, share
available oil, in the event of an oil supply
disruption of 7% or more to the IEA or individual
countries”.19
The IEA also has a complementary set of
measures known as Co-ordinated Emergency
Response Measures (CERM). These provide a
rapid and flexible system of response to actual or
imminent oil supply disruptions of any size.
The IEA emergency measures are kept in
constant readiness through periodic tests
involving administrations and the oil industry.
They have been mobilised on several occasions
over the years, making a significant contribution
to restoring market stability in times of
uncertainty.
The instruments used for the operation of the
emergency sharing mechanism are:
Oil stocks. These are to be managed by
member states to sustain consumption for at least
90 days of net oil impacts. This commitment can
also be accommodated by an ability to switch fuel
(e.g. from fuel oil to coal) or stand-by oil
production. This obligation applies generally
– without specific emergency situation (Art. 2
IEP). The emergency reserve by 90 days net
import stocks should not be visualized as a
state-owned storage farm – rather as a system
whereby private and/or public reserves in total
amount to the 90 days import equivalent
(Bamberger, 2004).
The 90 days reserve capacity is quite
substantial. Under normal circumstances, one
should not expect a total disruption, but rather a
partial disruption of some import flows. A 90
days reserve, in particular when combined with
voluntary or government-imposed restraints on
domestic consumption, should provide a
sufficiently long forward coverage of essential
supplies so as to give time for political measures
and other measures to diversify and enhance
supplies. One also needs to realize that the
– different from 1974 – competitive and
well-functioning markets in oil and oil products
will provoke an additional level of demand
19 “The 90-day stock commitment cannot as a practical
matter be accommodated by an ability to switch fuel or by
stand-by oil production, because the governing board has
never taken the decisions that would be necessary to make
that possible” (Scott, 1994, Vol. I, IV.B. 5 (a), and Vol. II,
sec III.B.1).
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restraint by sometimes dramatically raising prices
for oil and oil products. While some components
of oil demand are relatively inelastic, and thus not
very responsive to price rises, dramatic price rises
seen as more than just temporary price spikes will
lead to consumption declines – if only by
throttling economic growth, the main driver for
consumption. It is also important to realize that
the IEP emergency sharing system is focused on
oil. Oil was – as in recent war economy
management – the main fuel for transport, in
particular in 1974. While it is still – though with
prospects of gradual change – the main driver for
transport, the role of oil for production of electric
power has been declining, with the primary role
mainly assumed by gas. Gas is not part of the
IEA emergency sharing programme, though its
importance for power production in most
European countries (except perhaps nuclear-
based French electricity) has been growing and is
destined to grow further. That raises a new aspect
of energy supply security not addressed in the
1973-designed IEP system – and one for which
there is likely to be much less possibility of
political will, US-leadership capacity and
political coordination 32 years later.20
Demand restraint. The second level of
emergency action is demand restraint. This will
already ensue as reaction to substantial price
increases, which in turn are likely to be market
reactions to a perception of impending scarcity.
Mandatory measures can both increase political
acceptance of market-triggered restraints (greater
equality in sharing the burden of supply crises),
but also deal with demand which is not very
price-responsive. IEA member states must have a
programme of “contingent oil demand restraint
measures” readily available, which falls under the
jurisdiction of the Standing Group on Emergency
Questions. The coexistence between market
reactions – less appreciated in 1973 than now –
and state-led command-control measures is not
addressed in the IEP and requires further study. In
most recent situations where a supply crisis
loomed on the horizon, prices have risen
considerably.
The sharing of oil supplies between countries.
This is the core of the emergency-sharing system.
The idea is that after the other measures have
been taken and if there are still supply shortfalls
in some countries, oil will be redirected from
other countries in a comparatively better situation
to those in a comparatively worse situation. That
is the essence of the IEA’s “solidarity
mechanism”. It is, for sovereign countries ruled
582
by politicians subject to domestic political
pressures, usually with little regard for other
countries, a major feat. Re-direction must take
place mainly by re-direction of oil tankers or by
the more difficult restructuring of oil pipeline
flows. Such re-direction is likely, first, to be a
voluntary response by oil companies embedded in
the IEA emergency sharing planning and, second,
backed-up by redirection powers under national
law. Special legislative measures had to be
undertaken to ensure that inter-company
cooperation under the auspices of the IEA could
not be assailed on competition law grounds.21
The decision process. This process for
triggering the emergency situation and
administering the IEP rules relies on a strong role
of the technically-oriented and staffed secretariat,
with monitoring by the Standing Group and the
Management Committee of the Governing Board
of the IEA. The mechanism has been periodically
tested, adapted and refined.22
The world of oil and of energy has, however,
not stood still since 1973. First, as already
pointed out, gas has been taking up a major part
of oil’s role for electric power supply. It operates,
different from oil, in a less flexible system based
on gas pipelines and LNG transport systems
(dispatch facility, LNG tanker, reception
facilities).
Second, the system essentially relies on
international oil companies carrying out, by
voluntary compliance or government fiat, the
redirection of oil supplies. This world of
international oil has, however, substantially
changed. While the traditional oil majors still
dominate transport and refining, they have been
shut out from the major oil-producing areas in the
Middle East; as other oil provinces gradually
20 The alternative to oil stocks are fuel-switching
capacity and stand-by oil production (Art. 3). There is
unlikely to be any readily available oil-production reserves
throughout the IEA countries (unlike, still, Saudi Arabia),
though at least in the middle-term oil production can be
encouraged by direct persuasion of oil companies to rather
accelerate than maximize production, and by the lifting of
environmental rules and the fiscal burden. Such measures
would, however, not work within a short term, say six
months’, horizon. Switching capacity, on the other hand, is
likely to exist, mainly between fuel oil on one hand and coal
or gas on the other (with gas being accompanied by its own
security of supply issues). Some member countries may
have non-operating nuclear power plants, but these can only
be brought back to operation under a longer time horizon.
21 Details: IEA, 1995; Steeg 2001; Scott, 1994, also on
US and EU antitrust/competition law exemptions.
22 In detail: Bamberger, 2004.
ENCYCLOPAEDIA OF HYDROCARBONS

become depleted, the role of precisely these
countries (Saudi Arabia, Gulf countries, Iraq and
Iran) is growing. Not only do the producing states
control the upstream stage – production – they
also control, through their state companies and
via contractual links, an increasing part of
shipping. With new, non-IEA countries moving
up into the prime rank of consumers (most visibly
China and India) 23, these nations now compete in
an increasingly significant way with the IEA
countries for supplies. They also expend
significant efforts to create direct
intergovernmental and politically dominated links
with the main producing countries. China and
India, through their state oil companies operating
with governmental support, have also been
replacing international oil companies in countries
where Western ‘civil society’ no longer allows the
large Western oil companies to operate.
Oil (and gas) supply from the other major
producing province – Russia in particular – is, as
of 2006, again coming under very politicized
state dominance, with the role of private oil
companies in what seems to be terminal decline.
The January 2006 Russian gas squeeze on
Ukraine illustrates for the first time in gas the
close nexus between energy supply and politics –
both external and domestic. The IEP sharing
system still may hold together; however, without
ever being tested in serious circumstances, it
looks increasingly frazzled on the edges. A
scenario can now be envisaged quite easily where
political alliances (say China, India and Russia)
can create their own preferential supply area
where the role of the (Western) international oil
companies as the effective agents of supply
redirection is stymied by the oil and
gas-producing countries. These factors do not
have to be applied in reality; their impact is
sufficiently strong by the very fact that such
combination is possible and thus adds political
leverage to the major players outside the IEA
scheme.
Several decisions of the governing board – in
1984 and 1995 in particular – have tried to
enhance the effectiveness of the sharing
mechanism. Priority should be given to drawing
upon available stocks (i.e. national mechanisms)
but with IEA-wide consultation. Also, the
growing role of relatively well-functioning oil
markets was recognized by trying to fine-tune the
emergency-sharing systems to work in tandem
with market reactions. Voluntary action should be
encouraged over command-control (including
price control) regulation (Steeg, 2001).
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
THE INTERNATIONAL ENERGY AGENCY (IEA)
The first steps of the IEA emergency scheme
were tested in the Kuwait/Gulf War crisis of 1991.
The key feature of the response – since developed
further by the governing board – was the closer
coordination of IEA-initiated action with markets.
Markets, as is known, operate as much as by
perception of the future (which can be influenced) as
by facts (which can be partly influenced by
IEA-initiated action such as a stock draw-down
policy). In 1991, the IEA countries carried out a
coordinated stock draw-down, as much intended to
increase the oil supply as to work on and against the
perceptions of future supply scarcity which move the
markets. There has been an ongoing discussion over
the potential consequences, in terms of oil
production and oil supply, of political events – wars,
large-scale terrorist attacks – natural disasters, or
mainly market-driven events. The Katrina hurricane
in September 2005 had a severe impact on oil
production and, in particular, on supply of refined
products in the US; the collective IEA action
– from September to December 2005 – consisted
mainly of a much-publicized stock draw-down to
both add real supply and “calm the markets”.24
The IEA has so far not taken similar action
with respect to mainly market-driven supply
challenges, expressed primarily through rapidly
escalating prices; however, individual countries
– mainly the US – have used their strategic oil
reserve both to add marginal supplies and to send
a signal to the markets to counter perceptions of
impending scarcity. It is in my view an
unresolved issue that is unlikely to be determined
clearly one way or the other: markets – driven by
perception but also by the factual context
influenced by politics as well as by mainly
23 On January 12, 2006, the two countries signed a
Memorandum for enhancing cooperation in the field of oil
and natural gas, published in the Financial Times.
24 See IEA press release: 26/12/2005 Paris - “IEA
Executive Director Claude Mandil today announced that the
collective action taken by IEA member countries in response
to the interrupted oil supplies in the Gulf of Mexico, caused
by Hurricane Katrina, was successfully concluded on
December 22nd. This decision was made in consultation
with all 26 IEA member countries, which agreed that the
impact of Hurricanes Katrina and Rita had been successfully
addressed by a combination of the IEA collective action,
lower than expected demand, worldwide refinery flexibility
and additional efforts by producer countries. The collective
action was launched on 2 September 2005, when the IEA
member countries agreed to make available to the market the
equivalent of 60 million barrels of crude oil and oil
products. Nearly all of the barrels were provided to the
market through the use of stocks and increased indigenous
production. Moreover, demand restraint measures brought
additional relief to the market”.
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economic factors – work on a combination of
facts and perception. Very high oil prices – high
in terms of the speed of the increase, of historical
comparators and in terms of the expectation of
consumers and market participants – can be a
purely market-related event which are eventually
corrected by the market itself. But very high oil
prices can also reflect – sometimes correctly,
sometimes not – the markets’ predictions of
supply shortages. Markets can also directly create
supply shortages25 if oil supply is no longer
affordable for economically, socially and
politically pressing purposes. The IEA’s
emergency-sharing programme should therefore
not exclude action against serious market
disruptions, but it should also not become an
attempt, most likely futile, to steer the oil market
and to suppress the economically essential
price-signalling effect. Such “dirigiste” thinking
was part of the largely failed UNCTAD (United
Nations Conference on Trade and Development)
commodity fund ideas of the 1970s. Very high oil
prices essentially signal existing or possible
supply/demand imbalances, lack of investment in
exploration, development, transport, refining and
distribution, or demand that develops beyond the
longer-term payment capability. Responsiveness
to the oil markets (both physical and forward
markets as well as paper and derivatives-based
markets) and management of physical shortages
can therefore not be completely divorced from
each other. The IEA members have been moving
away from primary reliance on sharing. The
emergency-sharing system has now become, in
essence, a measure of last resort. The primary
emphasis is on coordinated measures involving
the timely draw-down of strategic stocks,26
supplemented by demand restraint, oil production
and fuel-switching measures.
10.8.9 External relations
(relation with
“non-member countries”)
Chapter VIII of the IEP indicates that as early as
1974 – when the relationship with the Middle
East-producing countries in particular was very
confrontational – the negotiators envisaged the
IEA as an instrument to carry out systematic
consultation and even cooperation with other
consuming and producing countries. In the IEA
tradition, that is categorized as “relations with
non-member countries” and was always considered
as an important dimension of IEA work.
584
A 1983 comment27 suggests that cooperation
with OPEC “will never” materialize; “never” is a
word that should not be employed. OPEC, the
main counterpart to the IEA, sees itself as an
organization representing countries which are
major oil exporters and whose well-being
depends almost solely on oil export. While it is
interested in prices on the higher range of what
markets generate, it also has a long-term interest
in protecting the role of oil against competing
energy resources; several steep and lasting
declines in oil prices have brought serious
economic and social disruption to the major oil
exporters, mainly in 1985 and then again in
1998/99. The fact that such long and steep
declines have occurred and have badly hurt the
producing countries (and the oil companies) is
easily ignored in a time of high prices. It is very
likely that such price cyclicality will continue.
OPEC has as a result of these experiences
developed a more long-term view of the mutual
benefits of stable prices and a steady supply of oil
to consuming nations (Wälde, 2003 e 2006).
OPEC’s interest in fair or remunerative –
essentially higher-range, but not highest-range –
prices is very similar to the anti-oil and
pro-conservation positions taken by the more
radical NGOs (Non-Governmental Organization)
such as Greenpeace; OPEC’s conservation
objective – to maintain oil as the OPEC
countries’ major industry for a long term rather
than exhausting it rapidly against a low price or
against a high cash flow they cannot absorb – is
probably not different from the interest of the
IEA consuming countries. A too-low oil price
would discourage development of alternative,
non-conventional and renewable energy
technologies and energy efficiencies. There have
been, since 1976, several efforts at systematic
consultation between OPEC and the IEA (and a
much stronger consultation between the US and
25 Shortage is to be defined in this case as the
unavailability of oil at an affordable cost for particular
purposes and people.
26 These issues can only be dealt with here in summary
fashion; for a much more detailed discussion: Bamberger,
2004 (especially on the declining level of member country
stock protection).
27 Miehsler, 1983, p. 1141: “So far cooperation between
the IEA and OPEC has not materialised and it is unlikely
that it ever will”. If one interprets “cooperation” in the sense
of the emergency sharing system of the IEA or the
production-control system of OPEC, then the prediction is
more plausible (though even deals combining both systems,
even now perhaps anathema to the main players, should
never be considered as utterly impossible).
ENCYCLOPAEDIA OF HYDROCARBONS

Saudi Arabia on a continuous informal basis);
currently, there is a Riyadh-based
consumer-producer dialogue institution
(International Energy Forum).28 On 28 April
2004, OPEC and the IEA have held a series of
workshops on areas of common interest so that
the 1983 commentator’s “never” has already been
formally disproved.
The ‘external relations’ dimension of IEA work
includes both consultations – with other
consuming and the main producing countries – and
technical and policy-related studies which are
discussed under the next heading. While the IEA
accession process is difficult (see above), Art. 48
(2) opens up the door to more formal
agreement-making. Based on Art. 48 (2), “the
management committee may make proposals on
appropriate cooperative action regarding these
matters to the governing board which shall decide
on such proposals”; based on the principle that an
international organization is vested with the powers
that are necessary to give effect to its legitimate
objectives, that article, together with Art. 63 (“the
Agency may establish appropriate relations with
non-participating countries, international
organizations, whether governmental or non-
governmental, other entities and individuals”),
provides for extensive powers to establish formal
relations (including agreements with rights and
obligations) for the IEA.29 The IEA countries have
therefore considerable flexibility, without the need
for a fundamental change of the IEP Agreement, to
develop as a coordinated group their relations with
other relevant groups (primarily its mirror-image
OPEC), Russia and the Central Asian oil producers
and, with India and China, the major emerging
oil-consuming economies. Both its freedom to
negotiate appropriate agreements and the
association model with Norway provide the
appropriate institutional vehicles to organize such
cooperation. These possibilities seem to merit more
exploration. Similarly, the IEA and the Energy
Charter Treaty Conference, an organization with
cognate objectives, but at present in the main
focused on the vital area of energy investment,
could develop a formally much closer relationship,
though their constituencies are only partly
overlapping.30 Since sufficient oil supply can in the
longer-term not be assured unless enough acreage
is available under reasonable terms for exploration
and development investment, it would seem logical
for the two organizations to consider a much closer
relationship – up to partial integration (Bamberger,
2004).
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
THE INTERNATIONAL ENERGY AGENCY (IEA)
10.8.10 Policy and technical
research and
consultation
At the origin of the IEA stood the Western,
consuming-countries’ effort to provide a system
of solidarity against attempts by Arab
petroleum-producing countries to divide them by
political preference. That historical experience is
embodied in the surviving – and in its core idea
not obsolete – oil emergency-sharing system.
However, the IEA has in the meantime developed
much further into the world’s pre-eminent
institution for applied energy policy research,
with a natural predilection for the issues most
relevant to the consuming countries – energy
efficiency, energy forecasting, analysis of energy
data (in particular the respected “Oil Market
Report”), climate change and other
environmental implications, as well as analysis of
the factors giving concern for energy security and
subsequently possible energy-security enhancing
countermeasures. This reflects the fact that the oil
emergency-sharing system has never been put
into full use; it is difficult to continue to obtain
funding and keep an organization morally and
intellectually alive without it being more than just
a system for emergencies that might – but in 40
years never have – occurred. It also reflects the
fact that the OECD – the larger ‘house’ for the
IEA – has become mainly a government-funded
and government-staffed think-tank in matters of
economic policy; the IEA has in this context
(without that there seems to be a complete
division of labour) become the Western countries
main think-tank and applied energy
policy-research institute.31 The IEA produces
authoritative reports on oil markets and other
statistical information on the oil industry.
28 Note here the recent press releases on the IEA
website. The permanent office of the IEF was inaugurated in
November 2005. Its main focus is at present greater oil
industry data transparency.
29 See also Scott, 1994, I, pp.144-147.
30 See Wälde, 1996.
31 Recent publications reflecting the core of the IEA’s
daily work deal with: a) lessons from liberalized electricity
markets; b) learning from the blackouts; c) prospects for
hydrogen and fuel cells; d ) energy policies of IEA countries
- Norway; e) act locally, trade globally; f ) biofuels for
transport; g) energy statistics manual h) investment in coal
supply and use – An industry perspective on the IEA World
energy investment outlook i) key world energy statistics; j)
reducing greenhouse gas emissions – The potential of coal;
k) World energy outlook 2005; l) projected costs of
generating electricity; m) resources to reserves
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These are often quoted as “authoritative”
information in a way that work by other
institutions in the field – academic institutes,
governmental energy institutions, NGO reports or
industry research facilities – is not. The value of
the IEA publications derives from a technically
expert and industry-focused professional culture,
which one does not find in the more universal
UN-related organizations. There are also formal
and, through the network of IEA alumni, informal
networks with industry, the member states and
non-member states, which feed information into
the IEA processes which do not exist in this form
and intensity elsewhere. A more privatization-
and market-oriented approach would suggest that
some of these activities could be outsourced and
left to the more flexible and possibly
open-minded research processes with academic,
NGO and industry-research institutions. It seems
that to this date a proper (and independent)
assessment of the alternatives, of either focusing
intergovernmental energy-policy research in the
IEA or contracting it out to a more
network-oriented research activity has not been
undertaken.
10.8.11 Energy research
and technology
The IEA also runs an Energy Technology
Collaboration Programme under the Committee
on Energy Research and Technology. The
programme has focused on the following areas
considered strategic for energy policy: a)
renewable energy technologies; b) energy end-use
technologies; c) fusion power; d ) electric power
technology; e) R&D priority setting and
evaluation; f ) energy efficiency and technology
reliability; g) reducing environmental impact of
energy activities; h) and cooperation with non-
member countries.
These research activities are carried out by
IEA-sponsored expert groups and they use the
instrument of ‘Implementing Agreements’.
Essentially, the IEA provides the framework for
collaborative research, often with extensive
in-kind contributions. Non-state actors, e.g.
companies, other private sector entities and
associations, also participate. The instrument
would seem to be suitable for the IEA to act as a
‘general contractor’ and provider of a fundraising
vehicle for research. There seems to be potential
for initiative by developing research projects with
non-state actors – e.g. industry associations or
586
respected NGOs (e.g. IUCN, the International
Union for the Conservation of Nature and natural
resources) – active in the field. It is perhaps
illustrative that the 2004 Bonn Conference
promoting renewable energy had little if any
substantial IEA inputs and relied in the main on
NGOs.32
I am not aware of any systematic and
independent evaluation of the continued
usefulness of these activities apart from the
projects’ own reports. A cursory review suggests
that the research priorities appear to be mainly
those that appeal to the ‘technocratic’ view within
national governments. The IEA is less, or almost
not at all, exposed to NGO campaigning and thus
has not developed, for better or for worse, the
extensive accommodation of NGO-emphasized
themes as has, for example, the World Bank.
10.8.12 Conclusion
The IEA has established itself in the specialized
field of energy policy studies as one of the key
players, with a reputation for prudence, solidity
and reliability rather than for innovation, and as a
think-tank driving forward imaginative policy and
institutional initiatives. That is undoubtedly due
to its structure, which is exclusively
intergovernmental, run by committees staffed by
member-state ministries dealing with energy and
with staff and leadership employed in the main
with short-term contracts. Some institutional
conditions, enabling leadership in terms of policy
initiatives requiring a longer lead time, are
therefore not utterly favourable. It is the
organizational vehicle for the time and still an
impressive emergency-sharing mechanism; it has
in recent oil-market history influenced the
markets several times, and it provides reassurance
to markets and governments – though the IEA has
n) renewables information 2005; o) energy policies of IEA
countries - Turkey; p) European refinery industry under the
EU Emissions Trading Scheme; q) deploying
climate-friendly technologies through collaboration with
developing countries; r) variability of wind power and other
renewables; s) experience with energy efficiency policies
and programmes in IEA countries; t) offshore wind
experiences; u) open bulletin; w) monthly oil survey;
x) monthly natural gas survey; y) monthly oil prices survey;
z) monthly electricity survey.
32 See my own input report on the role of institutional
arrangements for renewable energy, done through IUCN and
in co-authorship with Prof Bradbrook and the IUCN Director
General Achim Steiner, published on Wälde et al., 2003.
ENCYCLOPAEDIA OF HYDROCARBONS

never been fully tested in the crucible of a serious
supply crisis. As commendable as the oil
emergency-sharing system is, it is still subject to
age – the energy supply challenges of 2006 are
not identical to the oil-supply challenges of 1973.
The advent of China and India as the most
dynamically growing major consuming countries,
the re-concentration of oil supply in the
politically volatile Middle East, political risk in
other oil producing countries and the
re-politicization of oil and gas industries in
Russia (and in neighbouring countries subject to
Russian energy and political influence) require a
fundamental rethinking of global, regional and
national energy security. The most serious
challenge seems to come, in a 2006 perspective,
from developments in Russia, where markets and
companies are pushed back while a strong
authoritarian state with great-power ambitions
emerges; furthermore, the main consuming area,
the EU, does not seem to have the political will,
wisdom or muscle to diversify its growing
dependence on Russian energy. With the advent
of gas as the major imported energy resource to
fuel power stations, have come new
dependencies, both of a commercial and a
political nature. The link between political and
energy dependency with respect to supply of
Russian gas to Europe has often been raised, but
never been taken seriously in a form that would
have led to serious action; such action would
entail a full debate on nuclear industry together
with continuing and stable support for renewable
energy, plus publicly guaranteed investment into
gas supply – by pipeline or LNG tanker – from
Central Asia, the Middle East and Africa.
A serious rethinking of the oil focus of the
IEP is therefore warranted, but given the nature of
politics unlikely, before gas dependence has been
directly felt in terms of shortages.33
One can question if the extensive immunity
the IEA has enjoyed from NGO attention has
been good or bad for it. On the positive side, it
has been able to maintain its technical
competence and reputation without being
compelled into a centrifugal dilution of its key
competencies. On the negative side, it has not
been forced to enter into a serious debate – which
may also have had an educational influence on
energy-interested NGOs, for example on the link
between climate change, energy security and
nuclear power.
The IEA is in a curious situation. A child of
the oil agitation of the 1970s, it may find itself in
a quest for re-justification of its role and future
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
THE INTERNATIONAL ENERGY AGENCY (IEA)
directions. With the realization that the
oil-exporting states have been as much dependent
on export as the import states on import (at least
over the last 30 years), the fact that the
emergency programme has so far never been
activated can be more easily explained. With oil
itself declining in the energy mix – substituted in
part by gas, possibly again coal and now, under
the signs of Kyoto change, the new push towards
renewable energy resources, its oil focus requires
re-thinking. Energy security is now no longer
exclusively a matter of oil supply, but also of gas,
coal, uranium and electricity supply. Energy
security for the IEA member countries, in
particular the EU, means a favourable investment
situation in producing countries, favourable legal
and institutional conditions for transport and
transit of energy resources – and electricity – and
physical infrastructure (plus a regulatory
framework maximising its use) such as pipelines,
interconnectors and storage facilities. It also
means that energy efficiency is taken seriously as
one of the easiest ways to reduce dependency on
oil imports from afar.
While the IEA has dealt with such issues in
various studies, it has no operational, policy or
policy-advisory role. Also, its character as a
strictly Western, OECD-type of organisation
may be in question as globalization, and the
forces now triggered, call rather for universal
organizations with an ability to conduct a global
dialogue with all relevant stakeholders, conduct
globally focused research and prepare globally
relevant policy studies corresponding in
coverage with the globalization of energy
markets. This was brought home starkly to the
OECD when it tried, unsuccessfully, to negotiate
(in its club atmosphere) a multilateral
investment code (Multilateral Agreement on
Investment, MAI) that was mainly relevant and
intended to be ultimately applied to non-OECD
countries.
There does seem to be a case for the
usefulness of a truly universal energy agency, as
energy continues to be the mainstay of the global
economy. One way would be to maintain the
emergency-sharing system of oil (which does no
33 There have been a number of IEA studies focusing on
gas supply security. Gas-sharing schemes are more difficult
to design – as compared to the oil sharing scheme, partly
because of the absence, up to recently, of anything like a
global gas market. Gas security therefore also involves
different forms of response mechanisms (e.g. interruptible
contracts and fuel switching).
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harm and provides some risk insurance), but to
expand the organization’s focus on all energy
sources, expand membership (perhaps in
associate form) to all countries wishing to join
and put more emphasis on developing
energy-related technical assistance. The IEA’s
non-member countries’ and its research contract
areas would seem to provide a nucleus for such
expansion.
The IEA is no substitute or alternative for a
truly ‘international’ world energy agency. But
perhaps its research and policy part could be the
nucleus for one. One might envisage an IEA
consisting of two components – an
emergency-sharing, OECD-based side and a
universal, all-energy-based side. Either with or
without the IEA, there is a case for a policy
recommendation for a truly global World Energy
Agency (WEA). The energy industries are
coalescing into a truly globalised industry. This
means there is a need for the research institute-type
of work of the IEA, the market stabilizing
influence of OPEC and the proto-regulatory work
of the OECD, but involving, on an equal level, all
stakeholders: governments, companies (for
example in the way they are involved in the ILO,
International Labour Office, procedures), other
international agencies (IEA, OPEC, OECD, World
Bank, UN agencies) and non-state actors such as
industry, professional associations and NGOs. As
the EU Commission recently noted, energy in
developing countries is an orphan without a parent
international organization.
There is currently no push for such an
organisation and nobody with the authority of
Henry Kissinger to advocate its establishment.
Most other agencies involved in energy would be
jealous, for turf and competitive reasons. But the
interesting challenge to create such a new
international energy organisation would be to
identify an organizational design that does justice
to the much greater role of non-state actors
(companies, associations and NGOs). A modern
WEA would embody and institutionalize the
modern ways of stakeholder consultation now
being designed and employed.
The EU Commission has raised in a quite
oblique way the need for a WEA. It might be a
comparatively well-placed international
organisation to promote it, in particular since it
has probably the best ability to speak with every
significant stakeholder, including OPEC and the
OPEC countries, Russia, the large and in the
future most-significant Asian consumers (India,
China), the US and ‘civil society’. Much of the
588
current mandate, activities and staff of the IEA,
the ECT Secretariat (infra), the energy activities
of the World Bank and the UN, but also a part of
the research and dialogue activities of OPEC,
APEC (Asia-Pacific Economic Cooperation) and
OLADE (Latin American Energy Organization),
could be consolidated into the proposed WEA.
Such modernization of the international
institutional set-up for energy policy would
evidently have to strengthen, both in content,
linkages and name, the incorporation of
sustainable development. A proper World Energy
Agency could also further develop the provision
of reliable energy market data; energy market
data are currently studied by the IEA, by OPEC,
industry associations, international financial
institutions and by many banks, traders, hedge
and investment funds dealing either with oil and
energy trading or the longer term impact of
energy prices for investment and trading
strategies. From a survey of experts, it seems that
the “BP Statistical Review of World Energy” is
still considered the most useful source. Lack of
reliable energy-market data is regularly raised at
energy policy gatherings.
References
Abramowski J. (1995) Mexican energy laws, «Journal of
Energy & Natural Resources Law», 13, 29.
Bamberger C. (2004) IEA. The first 30 years. The history of
the International Energy Agency 1974-1994. Supplement
to volumes I, II & III, Paris, Organization for Economic
Cooperation and Development/IEA.
Barudio G. (2001) Traenen des Teufels. Eine Weltgeschichte
des Erdoels, Stuttgart, Klett-Cotta.
Howarth S. (1997) A century in oil. The Shell transport and
trading company 1897-1997, London,Weidenfeld &
Nicolson.
IEA (International Energy Agency) (1995) Oil supply
security. The emergency response of IEA countries,
Paris, Organization for Economic Cooperation and
Development/IEA.
Memorandum for enhancing cooperation in the field of oil and
natural gas (2006), «Financial Times», 12 January.
Miehsler H. (1983) International Energy Agency, in:
Encyclopedia of international law, Heidelberg, Max Planck
Institute for comparative public law and international law,
1981-1990, 5v.; v.II, 1137-1142.
Mommer B. (2002) Global oil and the nation state, Oxford,
Oxford University Press.
Scott R. (1994) IEA. The first 20 years. The history of the
International Energy Agency 1974-1994, Paris, Organization
for Economic Cooperation and Development/IEA, 3v.
Steeg H. (2001), in: Roggenkamp M.M. et al. (edited by) Energy
law in Europe. National, EU and international law and
institutions, Oxford, Oxford University Press, 3.133-3.179.
ENCYCLOPAEDIA OF HYDROCARBONS

Wälde T.W. (editor) (1996) The Energy Charter Treaty. An
East-West gateway for investment and trade, London,
Kluwer.
Wälde T.W. (2003) International organizations in the energy
sector, OPEC, «Oil, Gas & Energy Law intelligence»,
1, 2.
Wälde T.W. et al. (2003) 2004: year for renewable energy,
«Oil, Gas & Energy Law intelligence», 5, 1.
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
THE INTERNATIONAL ENERGY AGENCY (IEA)
Yergin D. (1991) The prize, the epic quest for oil, money and
power, New York, Simon & Schuster.
Thomas W. Wälde
Centre for Energy, Petroleum and
Mineral Law and Policy
University of Dundee
Dundee, Scotland, United Kindom
589
 11.1
European Union
and the liberalization
of the energy market
11.1.1 Introduction
The impact of European Union (EU) law on the
hydrocarbons sector has differed considerably
between oil and gas. The oil market is global in
character and has long been subject to competition.
Legal action to promote liberalization in EU oil
markets has therefore been deemed unnecessary.
There are two exceptions to this. Firstly, in the
market of petroleum products, the European
Commission (hereafter ‘the Commission’) used its
powers under art. 31 of the EC Treaty1 to pursue the
dismantling of ‘oil products monopolies’ in France
and Greece during the 1980s.2 This pre-dated the
current drive for an Integrated Energy Market (IEM)
that began with the White Paper of 1988,3 and,
though taking a very long period of time, was
largely successful. The second exception was the
hydrocarbons licensing legislation, which is
examined below. This formed part of the IEM
programme and was one of the first legal measures
that it introduced.
For the gas sector the situation is more complex.
Firstly, the sector has an international character with
the bulk of supplies coming from non-EU countries
on the basis of long-term contracts, though it is
much less exposed to competition in pricing than the
oil sector. Secondly, there are elements of natural
monopoly in the high-pressure pipeline network that
impose limits on the scope of competition. Finally,
gas operations have a vertically integrated character
from production to consumption (the so-called gas
chain). This means that regulatory action in one
segment of the chain can easily have an impact on
other segments. When the IEM programme began in
1988, the gas sector came under scrutiny by the
Commission mainly because of the exercise of
monopoly power in the transmission and distribution
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
segments of its operations. However, legislation
designed to liberalize these segments has usually
had significant implications for the upstream
activities of exploration and production as well.
The sections below examine firstly the EU
Hydrocarbons Licensing Directive (EC) 94/22/ and
secondly the rules introduced for the gas sector
through Directive CEE 2003/55/, which provided
common rules for an internal market in gas and
replaced earlier legislation on the subject. The
supplementary rules introduced for network access
through the gas regulation are also discussed.4
Finally, there is a brief examination of the impact of
primary EU law on the hydrocarbons sector, where
the rules of competition law have increasingly
played a complementary role to the Directives in the
liberalization process.
11.1.2 Hydrocarbons licensing
Directive 94/22/EC
The conditions for access to hydrocarbons and
their management are governed by Directive (EC)
1 Art. 31 requires member states to progressively adjust
state monopolies of a commercial character through which a
member state supervises, determines, or appreciably
influences imports or exports between member states. This
is enforced by the Commission.
2 Sixth Report on Competition Policy (1977), points
268-269 (France); Commission v. Greece (1990) Court of
Justice of the European Communities, case C 347/88, ECR
4747.
3 The internal energy market, COM (1988) 238 final, 2
May 1988.
4 Regulation (EC) No. 1775/2005 of the European
Parliament and of the Council of 28 September 2005 on
conditions for access to the natural gas transmission
networks, OJ L 289/1, 3.11.2005.
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SUPRANATIONAL LAW
94/22/CEE (the Hydrocarbons Licensing Directive
and from now on to be referred to as ‘Directive’).5
This framework Directive has its roots in the
widespread use of discriminatory provisions by
member states to limit access by foreign companies
on the one hand, and a lack of transparency in
hydrocarbons licensing procedures on the other. For
many years there had been mandatory landing
obligations and rights of first refusal to produced
hydrocarbons, which were frequently enjoyed by
state monopolies in exploration and production.
However, because of the uneven distribution of
hydrocarbons in the EU, these practices were evident
in only a few of the member states – usually those
with offshore petroleum deposits. Although this use
of discriminatory provisions appeared to be in
decline by the late 1980s, it was nevertheless clearly
inconsistent with the framework of rules being
developed for the IEM. The Directive was adopted
on 30 May 1994.
The objectives
The declared objectives of the Directive are to
set up common rules to ensure that: procedures for
granting authorizations to prospect or explore for
and produce hydrocarbons are open to all entities
that possess the necessary capabilities;
authorizations are granted on the basis of objective,
published criteria; the conditions under which
authorizations are granted are known in advance by
all entities taking part in the procedure.
Transparency and non-discrimination are central
to the achievement of these objectives.
The Directive rests on a careful balance between
respect for the member states’ rights based on
sovereignty and the Community interest in the way in
which those rights are exercised. It avoids the path of
detailed regulation in favour of establishing a
framework of general principles to which the rules
made by member states must conform. In line with the
principle of subsidiarity, each member state remains
free to choose or to maintain the rules that it considers
most appropriate to its natural and operational
circumstances, as well as its national policies on
resource management. The approach taken by the
Directive involves the establishment of common rules
but in a way that is quite distinct. It resembles the
focused approach followed by the Directives on public
procurement contracts, rather than the broader
approach of the two Directives on common rules for
the electricity and natural gas sectors. This reflects its
origins in an attempt to achieve its aims through the
public procurement arrangements provided for under
art. 3 Utilities Directive (EEC) 90/531/CEE, since
repealed by Directive 2004/17/EC.6
592
The provisions of the Directive do not directly
affect the sovereignty or sovereign rights of member
states over hydrocarbon resources within their
territory. Member states retain their rights and
responsibilities with respect to the management of
hydrocarbons, including revenues that arise from
their development. In particular, they retain the right
to decide: a) which areas must be opened for
exploration and production; b) the level and the rates
of tax, royalties and other revenues such as those
arising from state participation; c) who the licensees
will be; d ) how their activities are to be monitored.
The Directive expressly gives member states the
right to be involved both in areas of public policy –
including the central one of depletion policy – and
in the protection of the member state’s financial
interest (art. 6.2).
Common rules
Award of licences
It is required that the procedures for
authorization applications be publicized. Three
conditions are set out to ensure that procedures are
transparent and objective (arts. 3 and 4): firstly,
decisions must be based on objective,
pre-established criteria, published in advance.
Secondly, all general conditions and obligations
imposed on undertakings must be established and
made available to entities before applications are
submitted. Thirdly, criteria, conditions and
obligations must be applied in a non-discriminatory
way.
The kind of procedures that are permitted
include the concession or licensing system
(authorizations granted administratively or by
auction after the member states have published a
notice in the Official Journal), and the open door
system (authorizations granted on a permanent basis
for a pre-declared territory). Individual awards are
also possible.
5 Council Directive (EC) 94/22/CEE on conditions for
granting and using authorizations for the prospection,
exploration and production of hydrocarbons, OJ L 164/3, 1994.
6 The Directive of the European Parliament and of the
Council of 31 March 2004 coordinating the procurement
procedures of entities operating in the water, energy,
transport and postal services sectors, OJ L 134/1, 30.4.2004.
This measure applies to the exploration and exploitation of
both oil and gas: see art. 7(a) and Annex VII. Also relevant
is Commission Decision 2005/15 on the detailed rules for
the application of the procedure provided for in art. 30 of
Directive (EC) 2004/17/CEE of the European Parliament
and of the Council co-ordinating the procurement
procedures of entities operating in the water, energy,
transport and postal services sectors, OJ L 7/7, 11.1.2005.
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 EUROPEAN UNION AND THE LIBERALIZATION OF THE ENERGY MARKET
Some examples of member states’ efforts to
comply with these provisions include the following:
• The United Kingdom made an announcement of
an out-of-round offer of blocks for on-land
territory summarizing the conditions.
• Germany made a formal declaration in
accordance with art. 3.3 stating that the entire
area of Germany (except where there are
individual authorizations) was available for
licensing within the meaning of art. 3.3.
• Ireland published a notice stating that all areas of
the Irish offshore were permanently available for
licensing (with a large number of exceptions
listed by block number).
• France issued a notice defining the geographical
areas available for hydrocarbons prospecting and
setting out the procedure to apply for a
prospecting licence.
The principles of transparency, objectivity and
non-discrimination must be met in the criteria on
which decisions on applications for authorizations
are made (art. 6). The criteria must be based on the
financial and technical capability of entities and on
the manner in which they propose to prospect,
explore and bring into operation the area in
question. They must be published in the Official
Journal. Denmark obtained a derogation from this
provision in connection with an authorization with a
50-year term that had been granted in 1962 (art. 13).
State participation
The aim of the detailed provisions on state
participation is to ensure that if a member state
wishes to link the grant of a licence to state
participation, it may do so. It may also manage
such participation, directly or indirectly. However,
the member state is required to ensure that the
principles set out in the Directive, especially those
of transparency, non-discrimination and equality of
treatment are respected (art. 6).7 Participants other
than the state should not be subject to undue
pressure. The state is required not to be party to
information nor exercise any voting rights on
decisions regarding sources of procurement for
entities. Moveover, it shall not exercise majority
voting rights on other decisions. In addition, the
state – or its legal representative – shall not prevent
the management decisions of the licensee company
from being taken on the basis of normal commercial
principles. Voting by the state or its legal
representative must also be based on transparent,
non-discriminatory and objective principles. Much
of the above, set out in art. 6.3, subpara. 2, was
designed to meet the Danish insistence on a
continued state presence in the exploration and
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
production of hydrocarbons while ensuring that the
Directive’s principles were respected. By contrast,
an earlier United Kingdom (UK) experiment with
state participation had been abandoned by this time.
Another member state, the Netherlands, had
concerns that the state should be able to influence
depletion policy and to protect the state’s financial
interests. This led to art. 6.3, subpara. 3 which
provides that the state – or its legal representative –
may oppose a decision by the licence holders if such
a decision does not respect the conditions and
requirements on these matters as they are set out in
the licence.
The state as the public authority may also impose
conditions and requirements on the exercise of
licence activities based on specific public interest
reasons such as national security, public safety,
public health, security of transport, protection of the
environment, protection of biological resources and
of national treasures possessing artistic, historic or
archaeological value, safety of installations and of
workers, planned management of hydrocarbons
resources (depletion rates or optimizing recovery) or
the need to secure tax revenues (art. 6.1).
The final subparagraph of art. 6.3 concerns the
situation where the state company is also a licence
holder. It was developed to meet the demands of
Norway, which was present as an observer in
anticipation of its future accession to the EU (this
plan was subsequently withdrawn, following a
domestic referendum result in 1994). While
rejecting a proposal to divide the Norwegian state
hydrocarbons company, Statoil, into two separate
parts, it accepted a provision to create a division or
‘chinese wall’ between its business activities and its
role as manager of the state’s participation interest.
In particular, it required that no information should
flow from the part responsible for the management
of the state’s participation share to the part that holds
licences in its own right. This could be
circumvented, however, if the manager of the State
participation share engages the part of the licence
holder as a consultant. In such cases, information
necessary to carry out such consultancy activities
may be handed over.
Article 6.4 imposes a general constraint upon the
monitoring of licensees by member states. This is
limited to what is necessary to ensure compliance
with the conditions, requirements and obligations
following the grant of a licence. The thrust of this,
however, is concerned with avoiding any
7 See generally on the British National Oil Company:
Cameron, Property rights and sovereign rights: the case of
North Sea oil, London, 1983, pp. 138-171.
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SUPRANATIONAL LAW
requirement to provide information on actual or
intended sources of procurement.
Article 7 requires member states to abrogate
legal, regulatory and administrative provisions
reserving the right to obtain authorizations in a
specific geographical area within the territory of a
member state to a single entity. Such exclusive rights
conflict with the principle of equal access to
resources and were to be abolished by 1 January
1997. Essentially, this article addresses a specific
problem faced by Italy over authorizations held by
the then state-owned entity, Eni.
The Commission is required to monitor the
treatment of EU entities in third countries to
ascertain whether they receive treatment comparable
to that which is granted to entities from the same
third countries in the EU (art. 8). The Directive lays
down a procedure for evaluating this situation and, if
the need arises, for initiating negotiations with third
countries to establish reciprocal rights.
Links to other legislation: procurement
The Directive establishes a link in art. 12 with
the relevant public procurement legislation. A
member state is automatically allowed to utilize the
alternative regime in relation to upstream markets in
that legislation, once it has implemented the
Hydrocarbons Licensing Directive in its national law
(that is, implemented in national law by 1 July
1995). The relevant legislation has been modified
during the life of the Hydrocarbons Directive.8
Under the current arrangements there is a
general procedure allowing for exemption of sectors
directly exposed to competition. This has to be
without prejudice to the four Commission Decisions
that grant special exempted status to the exploitation
of geographical areas in the Netherlands, the UK,
Austria and Germany.9 If a member state has
implemented and applied the Hydrocarbons
Directive, access to a market is not deemed to be
restricted,10 and contracts in the hydrocarbons sector
may be subject to special arrangements. However,
member states are required to ensure that any entity
operating in the hydrocarbons sector observes the
principle of non-discrimination and competitive
procurement in respect of the award of supplies, as
well as works and service contracts. This is
especially with regard to the information which an
entity makes available to economic operators
concerning its procurement intentions. These are
admittedly vague notions and there is no definition
in the Directives or other guidance of what exactly
they should entail. Such entities also have to
communicate to the Commission information
relating to the contracts that they award.
594
Implementation
Member states were required by art. 14 of the
Directive to adopt the necessary legal, regulatory or
administrative measures to comply with it by 1 July
1995, and to inform the Commission of the fact. The
Directive’s operation was the subject of some
scrutiny in 1998.11 The conclusion was that its
provisions were being implemented correctly. In
four years of operation, no reciprocity problem had
been detected, not least because the Directive was
operating in a context of progressive international
opening-up of hydrocarbons exploration and
production. Neither the oil companies nor the
entities in the member states reported any
discriminatory treatment and no entity had
complained directly to the Commission. All of the
member states except Finland and Luxembourg
– which have no commercial hydrocarbon deposits –
had transposed the Directive into national law.
Norway, acting through the European Economic
Area (EEA) Agreement, has also transposed its
provisions into national law.
The Directive was adopted after the Treaty of
European Union entered into force and was
therefore made subject to the co-decision
procedure with Parliament for the last stages of its
passage. The inclusion of natural gas in this
Directive (being subject to similar physical,
technical and legal conditions as oil) ensured that
the first Gas Directive on common rules for the
natural gas sector (under discussion at that time)
would be limited in scope and would exclude
production. This approach was continued with the
second Gas Directive.
8 Originally, this was art. 3 Directive (EEC) 90/531/CEE,
then Directive 93/38/CEE, now repealed by Directive (EC)
2004/17/CEE of the European Parliament and of the Council
of 31 March 2004 co-ordinating the procurement procedures
of entities operating in the water, energy, transport and
postal services sectors, OJ L 134/1, 30.4.2004. This applies
to the exploration and exploitation of both oil and gas: see
art. 7 (a). Also relevant is Commission Decision 2005/15/EC
on the detailed rules for the application of the procedure
provided for in art. 30 Directive 2004/17/EC of the
European Parliament and of the Council co-ordinating the
procurement procedures of entities operating in the water,
energy, transport and postal services sectors, OJ L 7/7,
11.1.2005.
9 Commission Decisions 93/676/EC, 97/367/EC,
2002/205/EC and 2004/73/EC. See art. 27 and recital 38
Directive (EC) 2004/17/CEE.
10 Directive 2004/17/EC, art. 30.3 and Annex XI of that
Directive. For gas transport and distribution see Annex I.
11 COM (1998) 447 final: Report from the Commission
to the Council on Directive (EC) 94/22/CEE on the
conditions for granting and using authorizations for the
prospection, exploration and production of hydrocarbons.
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 EUROPEAN UNION AND THE LIBERALIZATION OF THE ENERGY MARKET
The Directive in question was an early example
of pan-European co-operation on energy legislation,
as countries linked to the EU by the EEA
participated in its development. The involvement of
Norway was of great importance to the final result.
Essentially, liberalization of hydrocarbons
licensing has proved relatively painless to all entities
established in the EU, including subsidiaries of
non-EU companies. Since the Directive was
adopted, the Commission has become more active in
the supervision of hydrocarbon exploration and
production, for example, with respect to competition
aspects of joint marketing of gas (discussed below),
and certain areas of environmental management -
such as the decommissioning of oil and gas
installations12 as well as impact assessment.13
11.1.3 Gas
Directive 2003/55/EC
The principal legislation aimed at establishing
common rules for an internal market in natural gas is
Directive (EC) 2003/55/CEE (the ‘Gas Directive’),14
which was adopted by the European Parliament and
Council on 26 June 2003. Its structure and many of
its provisions were built upon similar provisions in
the preceding Gas Directive (EC) 98/30/CEE,15
which it repealed. Each member state had to
transpose it into national law by 1 July 2004. It is
supplemented by a regulation that sets out basic
principles and implementation measures for Third
Party Access (TPA).16
The aim of the Gas Directive is to establish
common rules for the transmission, distribution,
supply and storage of natural gas. It lays down rules
relating to the organization and functioning of the
natural gas sector, access to the market, criteria and
procedures applicable to the granting of
authorizations for transmission, distribution, supply
and storage of natural gas and the operation of
systems (Gas Directive, art. 1). The scope of the
Directive extends to Liquefied Natural Gas (LNG).
It also extends to other gases provided that they may
be technically and safely injected into and
transported through a natural gas network or facility.
The Directive has two principal aims: firstly, to
increase quantitative market opening and bring
about full liberalization (understood as ‘market
opening’) by 2007, and secondly, to enhance
qualitative regulation and bring about more
uniformity and co-ordination of national regulation.
It was decreed that by July 2004 there was to be full
freedom of choice for non-household customers, and
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
indeed, all customers are to enjoy this right by 1 July
2007. In practice, a number of member states have
already opened up their markets entirely to
competition ahead of the 2007 deadline. Derogations
are possible but these are tightly defined. To ensure
that the measures are effective, the Directive
provides for monitoring and reporting requirements
for member states and the Commission. A principal,
but not the sole instrument to achieve this end is an
expanded use of the benchmarking reports to meet
the reporting requirements envisaged in art. 31 of
the Directive. Building upon established practice,
such reports are to be published on an annual basis
from the end of 2004, covering the issues listed in
the Directive. A detailed coverage of public service
issues is required every two years through art. 28.3,
and a detailed assessment of the market prior to full
market opening had to be produced before the end
of 2005.
The Gas Directive differs from its predecessor in
two important ways, namely, its clear advocacy of
regulated TPA and the regime on unbundling. The
first is intended to promote network access to new
market entrants more effectively than either the
negotiated form of access or the weak form of
regulatory access contained in the first Directive,
while the second addresses the barriers to
competition created by corporate structure. In both
cases, practical success depends upon institutional
enforcement by National Regulatory Authorities
(NRAs), which have a minimum set of competences
outlined in the Directive. The NRAs have an
advisory role on implementation and further steps
through a newly-established body called the
European Regulators Group for Electricity and Gas
(ERGEG).
Gas Regulation
Like the Electricity Regulation, the Gas
Regulation17 provides a set of principles to be
respected, with detailed minimum requirements on
access conditions outlined in lengthy guidelines
12 COM (1998) 49 final: Communication on the removal
and disposal of disused oil and gas installations.
13 Directive (EC) 97/11/CEE, Annexes II and III.
14 Directive 2003/55/EC of the European Parliament and
of the Council of 26 June 2003 concerning common rules
for the internal market in natural gas and repealing Directive
(EC) 98/30/CEE, OJ L 176/57, 15.7.2003.
15 Regulation (EC) No. 1775/2005 of 28 September 2005
on conditions for access to the natural gas transmission
networks, OJ L 289/1, 2005.
16 Gas Regulation, Common Position approved 5/2005.
17 See note 4 above.
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SUPRANATIONAL LAW
annexed to it. The scope goes beyond cross-border
issues, however, covering not only interconnectors
but also gas networks within the member states.
Its aim is to complete the provisions of the Gas
Directive. While the Directive defines the objectives
of TPA as the principal instrument for opening the
market and for introducing competition, the
Regulation aims at providing minimum conditions
to be satisfied with respect to this central element if
the Directive is to be successful. The assumption is
that the internal market cannot work effectively in
the gas sector if access conditions to the networks do
not correspond to certain minimum standards on key
aspects of TPA. For this reason, a set of guidelines
were included in an annex to the Regulation. These
guidelines on good practice were adopted by the Gas
Regulatory Forum (the so-called Madrid Forum) at
its meeting on 24-25 September 2003 after extensive
discussions with the gas industry and the NRAs. The
set of guidelines annexed to the Regulation covers
six main areas:
• The criteria according to which charges for
access to the network are determined, to ensure
that they fully take into account the need for
system integrity and effectively reflect incurred
costs.
• A common minimum set of TPA services – for
example concerning the duration of
transportation contracts offered and on an
interruptible basis.
• Common rules regarding contractual congestion
of networks that balance the need to free up
unused capacity with the rights of the holders of
the capacity to use it when necessary.
• Information on technical requirements and
available capacity.
• Rules ensuring that transmission system
operators use balancing systems in a manner
compatible with the internal market.
• Common basic requirements regarding the
trading of primary rights to capacity.
The objective of the guidelines is for customers
to have potential access to a varied portfolio of
available primary sources of gas. To achieve this, a
well-developed network is required which operates
according to coherent rules on a European scale. A
principal aim of the Regulation is to ensure that the
new guidelines are fully applied by all Transmission
System Operators (TSOs) across the internal EU
market for natural gas. The rules and principles
contained in the guidelines form the core of the
Regulation itself to ensure the highest level of
compliance. However, the Regulation also contains
enforcing provisions that spell out the underlying
principles concerning: a) charges for network
596
access; b) TPA access services; c) capacity
allocation mechanisms and congestion management
procedures; d ) transparency requirements;
e) balancing and imbalance charges, and secondary
markets.
Finally, the Regulation is equivalent to and
procedurally the same as the one already adopted for
cross-border exchanges in electricity. The instrument
is one that does not require implementation in the
way that directives do. It is directly applicable. The
legal regime is based on the European Commission’s
(EC) competence to adopt measures for the
harmonization of national standards to complete the
single market (art. 95. 1). Similarly, these
supplementary rules are viewed as having an
evolutionary character, requiring additions on issues
such as the alleviation of contractual congestion.
The Regulation therefore provides that the rules in
the annex may be modified according to a
`comitology’ procedure for the exercise of
implementing powers granted to the Commission.18
However, as a result of Council amendments to the
proposal, this version of regulatory evolution by
committee is weaker than that found in the
Electricity Regulation and, in addition, any such
modifications are not to be permitted before 1
January 2007.
The following sections consider the principal
subjects treated in the Gas Directive: access to
pipeline networks – including upstream pipeline
facilities and exemptions; regulation; unbundling;
public service obligations; cross-border trade;
and derogations – including those arising from
take-or-pay commitments and uneven market
development. Where relevant, provisions of the
supplementary measures in the Regulation are
noted. The first section however summarizes the use
of transmission and distribution in the Directive.
Key Terms
Transmission
Transmission is defined in the Directive as the
transport of natural gas through a high-pressure
pipeline network other than an upstream pipeline
network with a view to its delivery to customers, but
not including supply (art. 2.3; Regulation, art. 2.1).
A general duty is imposed on transmission, storage,
and LNG undertakings to operate, maintain, and
develop a secure, reliable, and efficient transmission
network, storage facilities and, if appropriate, LNG
18 Regulation (EC) No. 1775/2005, art. 14. The
procedure is based on arts. 5 and 7 of Council Decision
1999/468/EC, OJ L 184/23, 17.7.1999.
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 EUROPEAN UNION AND THE LIBERALIZATION OF THE ENERGY MARKET
facilities. They are required to do so under economic
conditions and with due regard to the environment
(art. 8.1). These undertakings must not discriminate
between system users or classes of system users,
especially in favour of their related undertakings.
They are placed under an obligation to provide any
other transmission, storage or distribution
undertaking with sufficient information to ensure
that the transport and storage of natural gas takes
place in a manner compatible with the secure and
efficient operation of the interconnected system. The
confidentiality of commercially-sensitive
information obtained in the process of carrying out
the business must be preserved (art. 10). In
particular, transmission undertakings must not abuse
commercially-sensitive information obtained from
third parties in the context of providing or
negotiating access to the system.
Distribution
The provisions on distribution and supply as set
out in arts. 11 to 15 of the Directive are almost
identical to those applicable to arts. 7 to 10 on
transmission, storage and LNG. The definition of
‘distribution’ provided in art. 2.5 is given as the
transport of natural gas through local or regional
pipeline networks with a view to its delivery to
customers. Note that this does not include supply.
Each distribution undertaking must operate,
maintain and develop under economic conditions – a
secure, reliable and efficient system, with due regard
to the environment (art. 12.1). No discrimination
may take place between system users or classes of
system user – especially in favour of its related
undertakings. Each distribution undertaking must
provide any other distribution undertaking and/or
transmission and/or storage undertaking with
sufficient information to ensure that the transport
and storage of natural gas may take place in a
manner compatible with the secure and efficient
operation of the interconnected system.
Confidentiality requirements on information are
imposed on distribution undertakings in art. 14.
Each distribution undertaking is to preserve the
confidentiality of commercially-sensitive
information obtained in the course of carrying out
its business. Further, distribution undertakings are
prohibited from abusing commercially-sensitive
information obtained from third parties in the course
of providing or negotiating access to the system.
Access to pipeline networks
At the core of the Directive are the provisions on
system access. Member states are required to ensure
the implementation of a system of TPA is provided
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
to the transmission and distribution networks and
LNG facilities on the basis of published and
regulated tariffs (art. 18). However, this general rule
is subject to a number of exceptions. Firstly, for
storage facilities (including line pack, which is a
means of gas storage that relies on compression of
the gas in the transmission and distribution
systems), access is to be either on a negotiated or
regulated basis or both (Gas Directive, art. 19.1). For
access to upstream pipeline networks the regime
continues to be separated out to give member states
discretion over the arrangements adopted (Gas
Directive, art. 20). Finally, exemptions from TPA
may be granted for major new gas infrastructure
investments such as international interconnectors,
LNG and storage facilities (Gas Directive, art. 22).
The general requirements of regulated TPA are set
out below, followed by an examination of the three
aforementioned exceptions.
Regulated TPA in gas
Member states are required to ensure that the
system of TPA implemented is based on published
tariffs, is applicable to all eligible customers and is
applied objectively and without discrimination
between system users (Gas Directive, art. 18.1). This
concerns both transmission and distribution. The
role of the NRAs is underlined by the requirement
that tariffs or the methodologies underlying their
calculation are approved prior to their entry into
force. These tariffs or the methodologies once
approved by the NRAs are also to be published prior
to their entry into force. The rationale behind this
promotion of the regulated TPA option over the text
of the first Gas Directive is to secure competition in
the wholesale market, not in the retail market.
Refusal of access by a Transmission System
Operator (TSO) or Distribution System Operator
(DSO) is still possible where there is no available
capacity (Gas Directive, art. 21.1). The reasons for
this refusal have to be substantiated, taking any
public service obligations into account. Where
appropriate and where there has been a refusal,
member states are obliged to ensure that the TSO or
DSO provides relevant information on measures that
would be necessary to reinforce the network.
Three notable features of this form of TPA
concern long-term transportation contracts and
cross-border transmission. Firstly, the
implementation of the TPA provisions must not
prevent the conclusion of long-term contracts in so
far as these comply with European Commission
(EC) competition rules (Gas Directive, art. 18.3).
Secondly, a refusal of TPA may be made on the
ground that it would give rise to serious economic
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SUPRANATIONAL LAW
and financial difficulties with take-or-pay contracts
(Gas Directive, art. 21.1).19 However, in such (and
other) cases of refusal, the member state may take
the necessary measures to ensure that the natural gas
undertaking which refuses access makes the
necessary enhancements to the pipeline network, as
far as it is economical to do so or when a potential
customer is willing to pay for them (Gas Directive,
art. 21.2). By contrast, in the Electricity Directive 20
the refusing party is only required to provide
information on measures that would be necessary to
reinforce the network. Finally, and partly in order to
facilitate cross-border transmission of gas, those
TSOs that need to transmit across borders shall have
access to the network of other TSOs (art. 18.2).
The above provisions are supplemented by the
common rules contained in the Annex to the Gas
Regulation. The additional technical rules cover
network access and TPA services, congestion
management procedures, transparency requirements,
balancing, as well as the trading of primary capacity
rights.
Choice for access to storage
In contrast to electricity, the optimal functioning
of a gas system is heavily dependent on the
existence and use of storage facilities. The Gas
Directive therefore includes provisions that address
the issue of access to storage facilities (art. 19).
Member states have a choice with respect to the
access regime for gas storage facilities, line pack
and ancillary services. It may be either negotiated or
regulated TPA or both (Gas Directive, art. 19.1).21
Irrespective of the system chosen, it has to be
operated in accordance with objective, transparent
and non-discriminatory criteria. Such access is
important for new market entrants since storage is
an important flexibility tool. It may assist market
actors in using the opportunities of spot markets to
reduce the price of electricity and gas, and for power
generators, access to storage may enhance continuity
of supply.
The differences between this provision and its
predecessor may seem insignificant, but the
definitions are wider and the goal is more ambitious.
The guiding principle is that experience gained with
the first Gas Directive in developing an internal
market requires the current measure to act as a step
towards clarification of the provisions for access to
storage and ancillary services (Gas Directive, recital
20).22 This idea is less evident in the Directive itself
than in the ‘Interpretation Note’ issued subsequently
by the Commission.23
The thrust of the Commission’s interpretation
(which is neither legally binding nor considered to
598
be binding on the Commission itself) is to limit
exemption from the Directive’s access provisions to
those storage facilities that are exclusively reserved
to TSOs for carrying out their functions and the
portion of storage facilities used for production
operations. TSOs should be required to provide a
justification to the national authorities for their
exclusion of facilities from the scope of the
Directive’s access provisions. This may be done by
the use of historical data. Moreover, since the
Directive requires the establishment of storage
system operators, they will have to act in accordance
with the Directive’s provisions on system operators,
which include a requirement to provide information
to system users for efficient access to the system. In
the Commission’s view, the latter would include the
following: information on available firm and
interruptible capacities in relevant storage facilities
over a specific time period; information on access
conditions including tariffs; and information on
services available.
For the operation of storage access, the criteria in
the paragraph above are relevant, but so is the
criterion in the Directive stating that access is
restricted to circumstances when it is technically and
economically necessary for the supply of customers.
When it cannot be proved that a request for access is
linked to the supply of customers, it is not to be
treated as justified.
There is sufficient agreement that the Gas
Directive needs to be supplemented in some way for
action to be taken within the framework of the Gas
Regulatory Forum (the so-called Madrid Forum, in
which the key players discuss the development of
guidelines and codes of practice to improve the
working of the internal market legislation).
19 The provisions of art. 27 (derogations in relation to
take-or-pay commitments) and the alternative chosen by the
Member State according to art. 27. 1 have to be taken into
account here. Refusals of access to storage facilities on
grounds of lack of capacity must satisfy certain
preconditions: refusal due to a need to meet take-or-pay
obligations is not regarded by the Commission as one of
these (DG TREN Interpretation Note on TPA to Storage
Facilities, 16.1.2004: available on DG TREN website).
20 Directive (EC) 2003/54/CEE of the European
Parliament and of the Council of 26 June 2003 concerning
common rules for the internal market in electricity and
repealing Directive (EC) 96/92/CEE, OJ L 176/37, 15.7.2003.
21 Member States are also allowed to designate a
separate system operator for storage (art. 7).
22 Long-term LNG storage can be included within its
scope as a means of transmission support as well as
linepack.
23 DG TREN, Third party access to storage facilities,
16.1.2004. The following paragraphs relate to the text in this
document.
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 EUROPEAN UNION AND THE LIBERALIZATION OF THE ENERGY MARKET
However, storage and access to storage facilities do
not fall within the scope of the Gas Regulation, and
are addressed separately, in guidelines laid
down under art. 9. 1 of the Regulation or as amended
under art. 9. 2 of the Regulation. A set of detailed
and clear rules was adopted on a voluntary basis on
23 March 2005, with a similar level of detail as that
in the Good Practice Guidelines for Third Party
Access. The Guidelines on Good Third Party Access
for Storage System Operators are eventually to be
incorporated into the Annex to EC Regulation
No. 1775/2005.
Access to upstream pipeline networks
The Gas Directive contains a special regime for
upstream pipeline networks, defined as ‘any pipeline
or network of pipelines operated and/or constructed
as part of an oil or gas production project, or used to
convey natural gas from one or more such projects
to a processing plant or terminal or final coastal
landing terminal’ (Gas Directive, art. 2.2). They
constitute an important part of the gas chain and are
therefore relevant to the general aim of achieving a
competitive market in natural gas.
Member states are required to take measures to
ensure that natural gas undertakings and eligible
customers can access these networks, but the form
of such access is to be determined by the member
state itself (Gas Directive, art. 20).24 In doing so,
member states have to observe some requirements
such as the objectives of fair and open access, and
the establishment of dispute settlement
arrangements, so that disputes may be settled
expeditiously by an authority independent of the
parties with access to all the relevant information.
Several considerations are listed that may be taken
into account and which give some protection to the
interests of the owner or operator of the upstream
pipeline. In effect, a negotiated access regime is
retained for upstream pipeline networks.
Member states must apply the overall objectives
of the Gas Directive, namely: fair and open access;
achieving a competitive market in natural gas and
avoiding any abuse of a dominant position - while
taking into account security and regularity of
supplies; capacity which is or can reasonably be
made available; and environmental protection. Other
areas in which the Directive’s provisions may be
relevant to implementation measures for upstream
operations include the establishment of technical
rules to ensure inter-operability and interconnections
in relation to upstream gas facilities, as well as rules
on information exchange and the publication of
technical rules for access to these pipelines. The
following specific considerations may be taken into
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
account by member states in their implementation
procedures: a) the need to refuse access where there
is an incompatibility of technical specifications
which cannot be reasonably overcome; b) the need
to avoid difficulties which cannot be reasonably
overcome and could prejudice the efficient, current
and planned future production of hydrocarbons,
including that from fields of marginal economic
viability; c) the need to respect the duly
substantiated reasonable needs of the owner or
operator of the upstream pipeline network for the
transport and processing of gas as well as the
interests of all other users of the upstream pipeline
network or relevant processing or handling facilities
which may be affected; d ) the need to apply their
laws and administrative procedures, in conformity
with Community law, for the grant of authorization
for production or upstream development.
These considerations will be of more relevance
to gas producing companies than to eligible
customers. Most of them relate to the capacity
available in the upstream pipeline networks and
related facilities.
When establishing the detailed rules, member
states must take into account which additional
capacity can reasonably be made available in case of
capacity constraints. Consideration a) above relates
to the refusal of access where there is a technical
impossibility. It might, for example, create serious
technical problems due to incompatibility of gas
qualities; b) is designed to safeguard current and
planned production against serious difficulties that
could have been caused by the implementation of
the Directive. Operational considerations such as
those that may act to hamper access to upstream
pipeline networks must be fully substantiated and
justified; c) refers to existing commitments and
needs of current users that must be respected in the
same way as with downstream pipeline networks.
The assumption here is that access must be provided
only to the extent that uncommitted capacity is
available; d ) refers to the need for balance between
national laws and EU legislation as well as the
interface between the Gas Directive and other
legislation such as the Hydrocarbons Licensing
Directive (see above). The measures taken must be
reported to the Commission (art. 20.1).
To deal with any possible disputes, member
states are required to have in place an authority
which is independent of the parties and which has
access to all relevant information (art. 20.3). The
24 Compare the wording of art. 23 of the first Gas
Directive, which has wording that is almost identical.
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SUPRANATIONAL LAW
aim is to settle such disputes relating to access to
upstream pipeline networks expeditiously, taking the
above criteria into account as well as the number of
parties that may be involved in negotiating access to
such networks. Where the disputes have a cross-
border character, the arrangements for settlement for
the member state with jurisdiction over the upstream
pipeline network that refuses access must be applied
(art. 20.4). Consultation between member states is
necessary where more than one member state has
jurisdiction over a network and a cross-border
dispute arises. The aim is to ensure that the
provisions of the Directive are applied consistently.
Exemptions
The general rules for TPA in gas may be waived
in specific cases involving new major infrastructure
projects and significant increases in capacity in
existing interconnectors (Gas Directive, art. 22).
There are detailed criteria for grant of an exemption.
The investment proposed for an exemption must
contribute to competition in supply (and in the case
of gas infrastructures, must enhance security of
supply), and not be detrimental to the functioning of
the internal market. Importantly, the level of risk
attached to the investment must be such that
investment would not take place unless an
exemption is granted.
The rules on exemptions are to be applied (and
monitored) very carefully.25 They do not apply to
existing infrastructure. That is, if the main financial
commitment to construction was taken before 15
July 2003 (the date of publication of the Gas
Directive). No block exemptions may be applied for
specific types of infrastructure, and exemptions are
to be granted on a case-by-case basis, with
applications assessed on their merits. Exemptions
cannot apply where the result would create or
reinforce a dominant position or where it would
reduce the scope for diluting existing dominant
positions.
Applications for exemptions are made to
the NRA but member states may elect to require the
NRA to submit an opinion on the application
to the relevant body in the member state. The
decision has to be duly reasoned, published and
communicated to the Commission with all the
relevant information. Crucially, the Commission
may request that the NRA or member state
concerned amend or withdraw the decision to grant
an exemption. This must be done within a
two-month period. The absence of express criteria
by which the Commission might reject the NRA
decision is a source of uncertainty, compensated
only slightly by the publication of information in an
600
interpretation note.26 It appears that the Competition
Directorate of the Commission would also be
closely involved in any Commission decision to
accept an exemption in this context.
It may be noted that none of the above prejudices
the power of the NRA to choose specific rules for
specific pieces of infrastructure – both existing and
new – including the grant of incentives to develop
specific types of investment.
The Gas Regulation also contains a provision
specifically directed at this subject. In art. 16, on
Derogations and Exceptions, the Regulation sets out
to establish consistency of application of EU law in
this area. It does not go beyond the scope of the
derogations already laid down in the Directive, but
grants a member state with a derogation under art. 28
of the Directive the right to apply for a temporary
derogation from the application of the Regulation,
subject to the approval of the Commission.
Regulation
Member states are obliged to charge one or more
competent bodies with the function of regulatory
authority (art. 25.1; Cameron 2005). The
requirement is more precise than in the previous Gas
Directive.27 However, it may be noted that regulatory
functions may be spread over several authorities if
that is deemed appropriate by the member state, and
thus there may be, say, local or regional regulatory
bodies, but also a combination of NRA, ministry and
say, a competition authority. The independence of the
regulatory authority (or authorities) is obligatory but
is defined in relation to the interests of the gas
industry rather than in relation to existing
government structures. Nonetheless, those member
states with state-owned utilities may have to develop
mechanisms to separate the regulatory authority
from the ministerial body that supervises the
state-owned energy utility. In addition, member
states are required to take measures to ensure that the
regulatory authorities are able to carry out their
duties in an efficient and expeditious manner
(art. 25.7).
25 DG TREN Interpretation notes, Exemptions from
certain provisions of the third party access regime,
30.1.2004; Security of supply provisions for gas, 16.1.2004,
pp. 5-7.
26 Id.
27 Compare the wording in art. 22 of the first Gas
Directive: “Member States shall create appropriate and
efficient mechanisms for regulation, control and
transparency so as to avoid any abuse of a dominant
position”. In practice, however, the competences of many
NRAs have usually gone far beyond this. This wording
reappears in the new Directive as art. 25.8.
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 EUROPEAN UNION AND THE LIBERALIZATION OF THE ENERGY MARKET
In addition, while member states continue to set
out the functions, competences and administrative
powers of the NRAs, a minimum set of functions
and competences is outlined in the Directive in the
interest of harmonization.28 In particular, the NRAs’
supervisory role over network access and the setting
or approval of network tariffs (or at least the
methodologies underlying the calculation of the
tariffs) has been given a basis in European law. An
additional development of importance is the
enhanced European co-operation and co-ordination
that the Directive and supporting measures
provide.29
What the regulator must do
The Directive sets out three general
responsibilities for the NRAs: to ensure
non-discrimination, effective competition and the
efficient functioning of the market.
More specifically, there is a list of eight activities
that constitute the minimum that the NRAs shall
monitor. Each item listed has to be included in an
annual report on the outcome of monitoring. These
activities are:
• The rules on the management and allocation of
interconnection capacity (in conjunction with the
regulatory authority or authorities of those
member states with which interconnection
exists).
• Any mechanisms to deal with congestion on the
national electricity or gas network;
• The time taken by transmission and distribution
system operators to make connections and carry
out repairs.
• The publication of appropriate information by
transmission and distribution system operators
concerning interconnectors, grid usage and
capacity allocation to interested parties, taking
into account the need to treat non-aggregated
information as commercially confidential.
• The effective unbundling of accounts to ensure
that there are no cross subsidies between
generation, transmission, distribution and supply
activities (as well as storage and LNG in the case
of gas).
• The terms, conditions and tariffs for connecting
new producers of electricity to guarantee that
these are objective, transparent and non-
discriminatory. In particular taking full account
of the costs and benefits of the various renewable
energy sources technologies, distributed
generation and combined heat and power. In the
case of gas, this activity is defined as the access
conditions to storage, line pack and other
ancillary services.
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
• The extent to which TSOs and DSOs fulfil their
tasks in accordance with the Directive’s
provisions, and
• The level of transparency and competition.
Tariff supervision
In addition to the monitoring functions, the
Directive charges the NRAs with the responsibility
of fixing or approving – prior to their entry into
force (ex ante) – at least the methodologies
used to calculate or establish the terms and
conditions for the connection and access to
national networks. This includes transmission and
distribution tariffs.30 These tariffs, or
methodologies, are to allow the necessary
investments in the networks to be carried out in a
manner that allows these investments to ensure the
viability of the networks. In addition, the NRAs
are to be responsible for fixing or approving the
methodologies used to calculate or establish the
terms and conditions for the provision of balancing
services.
This regulatory power on the fixing or
approving of tariff methodologies may be limited,
since art. 25.3 provides that member states may
require the NRAs to submit the tariffs – or at least
the methodologies – for formal decision to the
relevant body in the member state. In such cases,
the relevant body may have the power to either
approve or reject a draft decision submitted by the
regulatory authority. These tariffs or methodologies
or modifications relating to them are to be
published together with the decision on formal
adoption. Any formal rejection of a draft decision
is also to be published together with the reasons for
its decision. Both TSOs and DSOs (as well as LNG
operators in the case of gas) may be required to
modify their terms and conditions, tariffs, rules,
mechanisms and methodologies by the NRAs, to
ensure that they are proportionate as well as being
applied in a non-discriminatory manner (Gas
Directive, art. 25.4).
28 Gas Directive, recital 13. There are also some
requirements imposed by the Directives on member states
that they may elect to devolve to NRAs, such as those on
providing tendering procedures for additional capacity in the
interest of security of supply and ensuring that reliable
information is provided to customers about the energy
sources for the electricity supplied.
29 Gas Directive, recital 14. Commission Decision of 11
November 2003 on establishing the European Regulators
Group for Electricity and Gas, 2003/796/EC.
30 For the general context see, the DG TREN
Interpretation Note, The role of the Regulatory Authorities,
14.1.2004.
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SUPRANATIONAL LAW
Dispute settlement
Any party with a complaint against a TSO or a
DSO on the matters set out in the preceding sections
may refer the complaint to the regulatory authority
(Gas Directive, art. 25.5).31 In such circumstances,
the NRA will act as a dispute settlement authority
and issue a decision within two months after receipt
of the complaint. Extensions to this deadline of a
further two months (and longer with the consent of
the complainant) may be granted where additional
information is sought by the NRA.32 The final
decision is binding, unless and until overruled on
appeal. Appeals may also be made against certain
decisions by the NRAs and against a decision to
refuse to grant an authorization.33 This does not
preclude any complaint under rights of appeal
according to Community and national law. The
procedure is deliberately intended to facilitate
speedy decision-making when a complaint is made,
in contrast to the approach in cases brought under
competition law.
With respect to cross-border disputes, the
deciding regulatory authority is to be the authority
that has jurisdiction in respect of the system operator
which refuses use of, or access to, the system
(art. 25.10).
Co-ordination among regulators
The NRAs are required to contribute to the
development of the internal market and a level
playing field by cooperating with each other and
with the Commission in a transparent manner.34 To
facilitate this, the Commission established an
independent advisory group called the European
Regulators Group for Electricity and Gas
(ERGEG) in November 2003. Its membership
comprises the heads of the competent NRAs in the
member states, with the EEA (European Economic
Area) countries participating as observers. Its aim
is to facilitate consultation, coordination and
cooperation between the regulatory bodies in
member states and between these bodies and the
Commission, to consolidate the internal market
and to ensure the consistent application in all the
member states of the Gas and Electricity Directives
and the Electricity and Gas Regulations.35 The
group tenders advice to the Commission and
assists it in the preparation of draft implementing
measures in electricity and gas. It acts either at its
own initiative or at the request of the Commission.
Under art. 4 of the Decision, the ERGEG is
required to “consult extensively and at an early
stage with market participants, consumers and
end-users”. However, this does not mean that it
will supplant the Forum processes established for
602
electricity and gas. Indeed, it is intended to draw on
the results of deliberations in those settings among
all players from government, NRAs and industry.
The establishment of this advisory body was
strongly supported by the European Parliament
during the debates on the Directives. It mirrors the
roles of similar bodies already established in the
telecommunications and financial services
sectors.36 According to its rules of procedure, the
ERGEG will submit an annual report of the
Commission, which will then be transmitted to the
Parliament and Council.37 The Chair will report to
the Parliament when requested to do so.
Unbundling
The provisions on unbundling are an attempt to
address structural constraints on the creation of an
IEM. They apply to network businesses if these are
part of a vertically-integrated undertaking.38
There are three kinds of unbundling: legal,
functional and accounting unbundling. The first
separates the TSO and DSO from other activities not
related to transmission and distribution.
Transmission and distribution are to be carried out
by a separate network company, with a legal form
chosen by the vertically-integrated company.39 The
second involves a separation of the TSO and DSO to
ensure its independence from the
31 This includes the possibility of appeals against
decisions or proposed decisions by the NRA on the
methodology.
32 The deadlines may be extended by the NRA beyond
the two month period with the agreement of the
complainant.
33 Gas Directive, arts. 25.6 and 4.3.
34 Gas Directive, art. 25.12.
35 Commission Decision of 11 November 2003 on
establishing the European Regulators Group for Electricity
and Gas, 2003/796/EC, Recital (6); Regulation (EC) No.
1228/2003 of the European Parliament and of the Council of
26 June 2003 on conditions for access to the network for
cross-border exchanges in electricity, OJ L 176/1, 15.7.2003.
36 The ERGEG is in practice (if not formally) an
offshoot of the Council of European Energy Regulators
(CEER). It shares a common chairperson and members, and
ERGEG relies on the CEER for funding and expertise. The
CEER is a voluntary association that includes most of the
EU energy regulators, and has been highly active in the
Electricity and Gas Forums since its establishment in March
2000. It has a number of working groups.
37 Rules of Procedure, art. 9 (Accountability).
38 Discussion of how the terms vertically integrated
undertaking and control are understood by the Commission
in relation to Council Regulation (EEC) No. 4064/89
(merger control), is contained in the DG TREN
Interpretation Note, The unbundling regime, 16.1.2004.
39 For TSOs: see Gas Directive, art. 9; for DSOs: see
Gas Directive, art. 13.
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 EUROPEAN UNION AND THE LIBERALIZATION OF THE ENERGY MARKET
vertically-integrated undertaking (Gas Directive,
arts. 9.2 and 13.2). The third form of unbundling
focuses on company accounts (Gas Directive,
art. 17, paras. 1-4). The guiding principle is that
separate accounts have to be maintained for network
activities relating to electricity and gas. These
provisions are largely unchanged from those in the
first Directives but the companies affected by them
are far fewer. Under the new regime they affect
mainly those DSOs that are not legally unbundled.
Accounting unbundling is the minimum separation
requirement to be observed by every network
operator. No derogations are possible from this
requirement, unlike the other forms of unbundling.
NRAs are expected to monitor this form of
unbundling by ensuring that there is an accurate
application of accounting principles, and therefore
no cross-subsidies between generation and supply on
the one hand and transmission and distribution on
the other.40
The most radical change is the emphasis upon
legal unbundling. Gas TSOs that are part of a
vertically-integrated undertaking are to be
independent – at least in terms of their legal form,
organization and decision-making – from other
activities not related to transmission (Gas Directive,
arts. 9.2 and 13). Both Directives, however, are
careful to distinguish between this and ownership
unbundling (Gas Directive, recital 10). No change of
ownership of assets is implied, so no company will
have to sell off its transmission and distribution
arms. It is also limited to the network business as a
natural monopoly; all other activities may continue
to be operated in a single company or group of
companies. The caution here reflects amendments
made during the debates on the draft Directives, but
the provisions are to be revisited for the distribution
sector in 2007. Nonetheless, the independence of
decision-making by the TSOs and DSOs over assets
necessary to maintain, operate and develop networks
has to be guaranteed when those assets are owned
and operated by vertically-integrated entities.
Independent management structures have to be put
in place.
In national legislation, member states may
provide for exemptions for DSOs from the legal
unbundling requirements if there is the possibility
that they lead to a disproportionate financial and
administrative burden on small distribution
companies (Gas Directive, art. 13 and recital 11).
The exemptions for smaller DSOs are not limited in
time but for larger ones (those serving more than
100,000 customers) the requirement for legal
unbundling may only be postponed until 1 July 2007
(Gas Directive, arts. 13 and 33.2). An analysis of the
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functioning of legal unbundling must be included in
the progress report to be produced by the
Commission before 1 January 2006 (Gas Directive,
art. 31.3).
Compliance
In both Directives there is provision for a
compliance programme, to be established by the
TSO, the DSO and/or a combined system operator
(Gas Directive, art. 9. 2 (d) (TSOs), art. 13. 2 (d)
(DSOs) and art. 15 (d) (combined operators). This
will include details of measures taken to ensure that
discriminatory conduct is excluded and ensure that
observance of the unbundling requirements is
properly monitored. It has to set out specific
obligations of employees in this respect. The person
or body responsible for monitoring this programme
is required to submit an annual report to the NRA
and ensure that it is published. This report will set
out the measures taken.
Public service obligations
The provisions on consumer protection and
public service have been considerably expanded
from the previous Directive. They may be divided
into three broad groupings.
Firstly, there are Public Service Obligations
(PSOs) imposed upon the member states. These
include the obligation to ensure that electricity and
gas companies respect the Directives’ requirements
and do not discriminate; protect consumers in
various ways; notify measures taken to achieve
PSOs; publish PSOs; and ensure that eligible
customers can easily switch supplier. There is also a
positive duty to protect final customers – especially
vulnerable ones. Secondly, there are objectives to be
pursued by the member states: environmental
protection, security of supply, protection of final
customers (especially vulnerable customers and
those living in remote areas) and social and
economic cohesion. Member states may also
monitor and if necessary intervene in markets in the
interests of security of supply.41 Finally, there are
options available to member states, such as the
establishment of a supplier of last resort for
customers connected to the gas network, and the
40 DG TREN Interpretation Note, p. 20. Incentive-based
regulation of network access charges is expressly
encouraged to reduce the risk of cross-subsidization.
41 Gas Directive, arts. 5 and 26; see also the DG TREN
Interpretation Notes: Measures to secure electricity supply,
and Security of supply provisions for gas, both dated
16.1.2004. The Commission has also brought forward a
proposal for a directive on Infrastructure and Security of
Supply, COM (2003) 764.
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SUPRANATIONAL LAW
protection of remote customers who are connected
to the gas system.
Article 3.2 sets out the specific obligations that
shall be included in the category of public service.
The obligations that a member state may impose on
a natural gas undertaking relate to: security,
including security of supply (possibly including
long-term planning); regularity; quality of supplies;
price of supplies; and environmental protection.
PSOs must be clearly-defined, transparent,
non-discriminatory and verifiable. They must also
be published and notified to the Commission by
member states without delay. The idea behind
publication is to make the terms of the obligations
available to third parties who may be interested. On
receiving notification, the Commission examines its
compatibility with the Gas Directive and the Treaty
and will verify whether it represents the least
distorting measure necessary to achieve the
objective in question.
When imposing PSOs on natural gas
undertakings, member states must have full regard
to the EC Treaty provisions with special attention to
art. 86 (art. 3.2). Recital 27 expressly refers to the
need to have regard to the interpretation of the
relevant rules on a national basis but subject to
observance of EC law.
Finally, in contrast to the member states’ powers
not to apply the access provisions, a natural gas
undertaking must be allowed to refuse access to its
transmission/distribution system if the granting of
access would prevent it from carrying out its PSOs
referred to in art. 3.2. However, in that event, duly
substantiated reasons must be given for such a
refusal.
Cross-border trade
The first Gas Directive had almost nothing to say
about cross-border trade, and neither does the
second one. Instead, the intention is to include
provision for increasing competition in cross-border
trade in a different way, by establishing the principle
that an internal market directive may be elaborated
by means of a regulation that sets out in detail the
basic principles and implementation measures for
certain key issues related to internal market goals.42
A first attempt has been made in the electricity
sector, where the regulatory measure addressed the
conditions for access to the network for cross-border
exchanges in electricity.
In contrast to the electricity sector, there has
been a substantial flow of natural gas across borders
of member states for many decades. Attempts to
render cross-border trade in gas compatible with the
internal market aims have therefore had a different
604
focus. For this reason, the regulation is directly
concerned with cross-border trade only to a very
limited extent. The scope of the regulation goes
beyond that, to focus more on the avoidance of a
distortion of competition and discrimination
throughout gas networks and not only with respect
to interconnectors.
Derogations
The Directive allows member states to apply for
derogations in a number of highly-specific
circumstances. There are derogation possibilities in
cases arising from take-or-pay commitments, and
where the systems are either emerging or are
relatively isolated (Gas Directive, arts. 27 and 28).
While the provisions on the former are substantially
the same as those in the first Gas Directive
(Cameron, 2007), those dealing with the latter differ
slightly. For gas transmission infrastructure, a
derogation may only be granted if no gas
infrastructure has been established or if it has been
established for less than ten years. The temporary
derogation may not be granted for longer than ten
years from the date at which gas is first supplied in
the area. However, for distribution infrastructure, the
duration of any derogation may be longer: a
maximum of twenty years from the time that gas is
first supplied through the system in the area. Other
potential derogations are the exemption of integrated
undertakings serving less than 100,000 connected
customers (Gas Directive, art. 13.2),43 and the
non-application of art. 4 with respect to distribution
companies through art. 3.5.
Take-or-pay
The bulk of European gas supplies are contracted
under long-term contracts that contain so-called
take-or-pay clauses. Under such arrangements, gas
buyers will agree to take delivery of not less than a
minimum quantity over a specified period (such as a
year), or, if they do not, pay for the shortfall from
the agreed minimum. In this way, the buyer bears the
market risk, while the gas producer takes the
production risk. By assuring a regular cash flow over
a period of many years, such contracts reduce the
42 This has already been done through the Regulation
(EC) No. 1228/2003 of the European Parliament and of the
Council of 26 June 2003 on conditions for access to the
network for cross-border exchanges in electricity, OJ L
176/1, 15.7.2003. The set of guidelines have since been
further developed by the ERGEG to provide more detail on
the general provisions of the Regulation on co-ordination
between TSOs, transparency and maximising available
capacity, and the treatment of congestion rents.
43 This threshold is subject to review under art. 31. 1 (b).
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 EUROPEAN UNION AND THE LIBERALIZATION OF THE ENERGY MARKET
risk for producers and facilitate their ability to
finance the infrastructure of their projects.
The duration of such contracts has typically been
for between 15 and 25 years, and could cover the life
of the project. They have played a key role in
bringing the European gas market into existence.
However, long-term gas contracts were concluded at
a time when the member state gas markets were
organized around national and regional monopolies
of supply and distribution as well as an absence of
competition in supply.
The benefits of long-term contracts to buyers
diminish with the growth of a competitive market in
gas, unless the contract provides for some price
adjustment to reflect market changes. Specifically,
natural gas purchased under existing contracts will
not always be able to compete – in terms of price –
with gas that becomes available in the competitive
gas market, following on from the Gas Directive.
A transitional regime is therefore included in
arts. 21.1 and 27 to mitigate the effects of the
transition to a liberalized gas market on the
performance of take-or-pay contracts entered into by
transmission or distribution system companies. If a
natural gas undertaking encounters, or considers it
will encounter, serious economic and financial
difficulties because of the take-or-pay commitments
it has accepted in one or more of its gas purchase
contracts, an application may be made for a
temporary derogation from the access provisions of
art. 18. This is intended as a last resort measure for
exceptional cases in which a company may face the
prospect of bankruptcy. However, it may be noted
that, in principle, an undertaking may refuse access
to an applicant company before it has experienced
serious economic and financial difficulties and
before it has applied for a derogation. This system of
derogations in the Directive is important due to its
potential for delay and frustration of the objectives
of the Directive. The system is essentially equivalent
to the transitional regime established for stranded
assets under the Electricity Directive but the
treatment of criteria for the grant of derogations is
more detailed than its counterpart in the electricity
sector.
Procedures for granting a take-or-pay derogation.
Applications for derogations are made on a
case-by-case basis. There is a two-stage procedure
for dealing with applications which involves:
submission of an application to the member state of
the applicant or to its designated competent
authority (e.g. the Bundeskartellamt in Germany);
and notification and review by the Commission of
any decision by a member state or its designated
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competent authority to grant a derogation. The
Commission has the final say.
Member states are allowed, under art. 27.1, to
give the natural gas undertaking the choice of
presenting its application either before or after
refusal of access to the system. In cases where a
natural gas undertaking has refused access to the
system, the application for a derogation must be
presented without delay. The Commission has stated
that the maximum delay in this respect is one
week.44 All applications must be accompanied with
information relevant to the nature and extent of the
problem and also the efforts of the gas undertaking
to solve the problem. If there are no reasonable
alternatives available to the company, a derogation
may be granted by the member state or designated
competent authority.
Once a derogation has been granted, either by the
member state or by its designated competent
authority, the Commission must be notified of the
decision without delay (art. 27.2). All relevant
information must be submitted to the Commission,
in an aggregated form if appropriate, so that the
Commission may reach a well-founded decision.
Within four weeks of receiving notification, the
Commission may request that the member state or
designated competent authority amend or withdraw
the decision to grant a derogation. Failure to comply
with the Commission’s request for amendment or
withdrawal within a period of four weeks will lead
to a final decision being taken expeditiously under
procedure I of art. 2 decision 87/373/EEC.45
Throughout, the Commission must preserve the
confidentiality of commercially-sensitive
information. Derogations granted must be properly
substantiated and published in the Official Journal.
Decisions on requests for derogations concerning
contracts concluded before the Directive entered
into force should not create a situation in which it is
not possible to identify alternative outlets that are
economically viable (art. 27.3). The Commission
will not consider problems as serious difficulties
unless: sales of natural gas fall below the level
of minimum off-take guarantees contained
in gas purchase take-or-pay contracts; the relevant gas
purchase take-or-pay contract cannot be adapted; or
the gas undertaking is not able to identify alternative
outlets for the gas. This provision appears to
enhance the possibility of obtaining derogations in
44 European Commission Discussion Note, Take-or-Pay
contracts, 22 October 1998.
45 Council Decision of 28 June 1999 laying down
procedures for the exercise of implementing powers
conferred on the Commission, 1999, OJ L 184/23.
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respect of contracts in existence before the Directive
entered into force, but also sets criteria which must
be satisfied to obtain a derogation for such a
contract.
In cases where a gas company has not been
granted a derogation by the member state under
art. 27 of the Directive, the company can no longer
refuse access to the system because of take-or-pay
commitments that have been accepted in a gas
purchase contract. Member states must ensure that
the provisions on system access are then complied
with. The unsuccessful applicant may then rely on
the mechanisms for appeal in the member state.
In circumstances where the Commission requests
the member state to withdraw a decision and the
member state fails to do so, a consultative
committee will advise the Commission on
subsequent steps. This committee will be composed
of representatives of the member states and will be
chaired by a representative of the Commission.
Three steps follow from this:
• The Commission representative submits to the
Commission a draft of the measures to be taken.
• The committee delivers its opinion on this draft
within a time limit set by the chair. That opinion
is recorded in the minutes. Each member state is
entitled to ask to have its position recorded in the
minutes.
• The Commission takes its decision, drawing on
the opinion and informing the committee of the
decision, as well as how the opinion has
influenceed it.
The operation of art. 27 is subject to a review to
be carried out within five years of the Directive
entering into force. The findings of this review will
be reported to Parliament and Council, which may
then consider whether amendments are needed.
Criteria for grant of derogations
Derogations may not be granted unless and until
nine criteria listed in art. 27 are considered by the
member state and the Commission. These are as
follows, the: a) objective of achieving a competitive
gas market; b) need to fulfil PSO and to ensure
security of supply; c) position of the natural gas
undertaking in the gas market and the actual state of
competition in this market; d ) seriousness of the
economic and financial difficulties encountered by
the natural gas undertakings and transmission
undertakings or eligible customers; e) dates of
signature and terms of the contract or contracts in
question, including the extent to which they allow
for market changes; f ) efforts to find a solution to
the problem; g) extent to which, when accepting the
take-or-pay commitments in question, the
606
undertaking could reasonably have foreseen, having
regard to the provisions of the Gas Directive, that
serious difficulties were likely to arise; h) level of
connection of the system with other systems and the
degree of inter-operability of these systems; and
i) effects that the grant of a derogation would have
on the smooth functioning of the internal natural gas
market.
This is not an exhaustive list and may therefore
be supplemented by criteria relevant to the specific
case in question. More importantly, the criteria are
not necessarily listed in order of importance (and do
not indicate the weight a court might give them in
the event of a dispute). A different order of priority
would probably be adopted by an applicant for a
derogation. Such a practice order of the nine criteria
would probably take the following form (retaining
the above numbering): beginning with criterion art.
25.3 e, then a, b, c, h, g, f, a and finally i.
Irrespective of their order of priority, the
individual criteria require some comment, given
their broad formulation in the Directive itself.
They are considered below in the ‘practice’ order
and not in the order presented in art. 25.3 of the
Directive text.
Dates of signature and terms of contract(s),
including extent to which they allow for market
changes (previously e). From a practical point of
view the most important criterion will concern the
dates when the contract or contracts were signed.
This allows for distinctions to be made between
existing and future contracts. This was designed to
give market operators a clear signal that prudence
should be exercised when signing future
take-or-pay contracts to take account of the
changing market circumstances. It was also
designed to ensure that any take-or-pay contracts
entered into or renewed after the entry into force of
the Directive would make a prudent allowance for
changes, resulting from a more competitive gas
market so as not to hamper a significant opening of
the market.
The relevance of the date of signature is that it
gives an indication of the extent to which legislative
changes could and should have been taken into
account when signing a contract. However, no date
is expressly mentioned in the Directive. In the
original proposal submitted by the Commission in
February 1992, only contracts signed before 1 July
1991 were covered. This date was retained in the
amended proposal of early 1994 but prior to
conclusion of the present text, it seems that a
possible cut-off date was 25 July 1996. For contracts
signed after the adoption of the Gas Directive
(10 August 1998) the matter is easier.
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 EUROPEAN UNION AND THE LIBERALIZATION OF THE ENERGY MARKET
Seriousness of economic and financial
difficulties encountered by natural gas undertakings
and transmission undertakings or eligible customers
(previously a). This criterion concerns the economic
and financial difficulties faced by the players. Since
art. 27.1 expressly refers to derogations being
considered if a company encounters “or considers it
would encounter” serious difficulties, this criterion
implies that preventive action may be considered
before the serious problems have in practice
occurred. Such problems must of course have their
origins in the entry into force of the Gas Directive
and not in any other cause. The economic and
financial implications for the eligible customers
should be taken into account since they face their
request for access being denied as a result of the
grant of a derogation. The seriousness of the
problem should be reflected in a proportionate
manner with access refusal tailored according to a
percentage of the requested TPA volumes. It seems
that a comparative analysis would be carried out
between the member states when assessing a request
for derogation to obtain input from concrete
examples and actual experiences, if available, where
serious economic and financial problems have in
fact faced gas companies in take-or-pay situations.
Need to fulfil public service obligations and
ensure security of supply (previously b). Although
this criterion concerns PSOs and security of supply,
the main provision for the protection of PSOs is in
fact art. 3, not art. 27. Art. 17. 1 takes art. 3.2 into
account and should therefore be seen as the principal
vehicle for protection of PSOs rather than art. 27.
Position of natural gas undertaking in the gas
market and actual state of competition in the market
(previously c). This criterion refers to the position of
the natural gas undertaking in the gas market and the
actual size of competition in this market. The
position of the gas undertaking can be taken to
include inter alia:
• Size of the company, including area of operation,
balance sheet, assets, marketshare, and turnover.
• Role of the company in international gas trade.
• Supply and sales portfolio of the company.
• Extent of infrastructure owned – including
storage; ownership in other energy/gas
companies – whether upstream or downstream.
• Rights and obligations of the company, including
PSOs.
The market conditions referred to in the criterion
are also open to interpretation. They could be
regional, national, or wider within the EU. An
analysis of the state of competition would include an
assessment of the level of market-opening in the
area concerned in terms of both the eligible share of
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the market and the share of the market that actually
benefits from competition. It would also include a
consideration of the number of suppliers competing
in the market and the impact of competition on
market shares, prices and profits. The general level
of competition in the market may also be considered,
not only the level of gas-to-gas competition.
Level of connection of the system with other
systems and degree of inter-operability (previously
h). Although the pace of network integration is fast,
there remain regional and national gas networks that
are not well-integrated into the European gas grid.
Technical aspects may hamper inter-operability with
other systems and in such areas gas companies may
face difficulties to sell gas outside their traditional
supply area in the event of serious take-or-pay
problems.
Extent to which, when accepting take-or-pay
commitments, the undertaking could reasonably
have foreseen, with regard to the provisions of the
Gas Directive, that serious difficulties were likely to
arise (previously g). This applies to take-or-pay
contracts signed after the entry into force of the
Directive. It turns on the prudence that an
undertaking has shown when taking on the take-or-
pay commitments at issue and whether the resulting
difficulties could reasonably have been foreseen. If
they could have been foreseen or were in fact
foreseen, there is no basis for an expectation that a
grant of derogation may be made to solve the
difficulties that have followed.
Efforts to find a solution (previously f ). This
criterion for derogation from the access provisions
of the Gas Directive is focused on the efforts made
to find a solution to the problem. Derogation should
be adopted only as a last resort when all other
attempts by the operators involved have failed to
identify an alternative solution to the problem. Such
efforts may include efforts to sell the gas elsewhere
or attempts to re-negotiate the contract or to increase
company efficiency.
Achieving a competitive gas market (previously
a). This criterion is likely to be influential at the
Commission stage. It relates to the overall objective
of the Directive: market-opening, largely by means of
TPA. Whatever decision is taken with respect to
refusal of access must be balanced and justified
against this principal objective of the Directive,
which is to provide for the opposite.
Effects the grant of a derogation would have on
achieving smooth functioning of the internal natural
gas market (previously i). Finally, there is the
criterion that is based on the effects of a grant of
derogation on the smooth functioning of the internal
gas market. By implication, this emphasizes that any
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grant of a derogation would have a restrictive effect
on the operation of an internal gas market in the EU.
The criteria should therefore be applied by Member
states and the Commission in a cautious manner and
balance any derogations against the overall objective
of a smooth-functioning internal gas market and a
significant degree of market-opening.
Uneven market development
The wide differences in the penetration of gas in
the energy markets of member states are taken into
account in several places in the Directive. In
particular, it makes special provision for: member
states that are not yet fully linked to the European
gas system and have a high degree of dependence on
a single external supplier; for member states
classified as emergent markets; and for those areas
or regions within some member states seeking to
encourage investment in transmission infrastructure.
The term emergent markets, used in art. 28 is used
and defined in the Directive. It means “a member
state in which the first commercial supply of its first
long-term natural gas supply contract was made not
more than ten years earlier” (art. 2.31). It therefore
applies to Greece and Portugal, where the first
supply commenced between 1996 and 1997.
Art. 28 provides for the grant of derogations to
member states that experience the effects of one of
three categories of uneven market development
listed below:
Lack of system connection. The article treats
those member states that are not directly connected
to the interconnected system of any other member
state and have only one main external supplier. Such
a supplier should have a market share of more than
75 per cent. In those cases, art. 28.1 permits those
member states to derogate from arts. 4, 9, 23 and/or
24 of the Directive. However, such derogations
expire automatically from the moment that at least
one of these conditions is no longer fulfilled.
Emergent markets. Art. 28.2 provides for a
similar derogation for those member states that are
emergent markets and which would experience
substantial problems as a result of the
implementation of the Directive. They may derogate
from the same provisions of the Directive as
member states in the first category but such
derogations expire once they cease to be classifiable
as ‘emergent markets’. Substantial problems may
not be associated with take-or-pay commitments.
Note that in both these aforementioned
categories, such derogations must be notified to the
Commission.
Risk to investment in infrastructure. The third
category in art. 28.4 is the most complex. It
608
concerns the interplay between investment in new
transmission capacity and implementation of the
Directive. For a member state that foresees that
implementation of the Directive would cause
substantial problems in a geographically-limited
area of its territory, an application for a temporary
derogation is possible. This applies especially where
the development of transport infrastructure is
involved and where a competitive market as
envisaged by the Directive might inhibit new
large-scale investment or undermine recent
investment. In other words, the infrastructure
investments would not be economically viable
within the area in question without the grant of a
derogation. Temporary derogations may be granted
by the Commission for developments within such an
area. The derogation may be from art. 4, art. 7,
art. 8, paras. 1 and 2, art. 9, art. 11, art. 12. 5, art. 13,
art. 17, art. 18, art. 23. 1 and/or art. 24. However,
such derogations may only be granted if no gas
infrastructure has yet been established in the area or
where one has been in operation for less than ten
years. The temporary derogation may not exceed a
period of ten years from the time that gas is first
supplied in the area concerned. The procedure for
the grant of derogations in this category is different
from that in the previous two. Once an application
for a temporary derogation has been submitted to the
Commission by a member state, it may grant a
derogation only after taking into account at least six
criteria.
The list in art. 28.5 is not exhaustive but
includes the following, the: a) need for
infrastructure investments, which would not be
economical to operate in a competitive market
environment; b) level and pay-back prospects of
investments required; c) size and maturity of gas
system in the area concerned; d ) prospects for
gas market concerned; e) geographical size
and characteristics of the area or region;
f ) socio-economic and demographic factors.
It is certain that the Commission will seek to
apply the above criteria in a restrictive manner, and
that derogations for investments in the transport of
gas through local or regional pipeline networks to
final consumers are unlikely to be accepted.
At present, the Gas Directive provides a legal
regime for a transition to a fully-liberalized market,
which has not yet been achieved. Nevertheless, the
Directive (and supplementary Regulation) will
provide important momentum to the enforcement
role of the NRAs with respect to the Directive’s
provisions. It will also provide a more secure basis
for unbundling and for a workable form of TPA -
applied across the EU in an even-handed manner. It
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 EUROPEAN UNION AND THE LIBERALIZATION OF THE ENERGY MARKET
should be noted however that the Directive is only a
framework law which provides common rules for the
member states. In providing substance to this
framework there remains a risk that some member
state actions will undermine its efforts to bring
about a level playing field.
11.1.4 The complementary role
of competition law
Competition policy had to be adapted to meet the
specific challenges presented by the transition to a
liberalized market in gas. Competition law had
always been seen by the Commission as an
important instrument in achieving the aims of the
IEM programme. However, after the first and second
Gas Directives entered into force from 1998
onwards, it became important to identify the precise
areas in which it could be used to greatest effect and
tested in specific cases. This process of reviewing
competition policy with a view to aligning it to the
liberalization of the energy sector is a continuing
one, with a further, comprehensive review of the gas
and electricity sectors initiated in 2005.46
In general terms, the broad aim of competition
policy has been to complement the Directives and
ensure that the market players operate on a level
playing field. The principal instruments used have
been the competition rules in arts. 81, 82 and 86 EC
Treaty, the Merger Regulation and the state aid rules
in arts. 87 and 88 EC Treaty. The thrust of policy has
been to prevent private arrangements or practices
that restrict the emergence of competition or that
foreclose national markets against new entrants. An
important consideration has been that incumbent
players in the gas markets might anticipate a
competitive market in ways that were potentially
anti-competitive (e.g., by entering into long-term
supply or transportation agreements). Below are two
areas in which legal action has been taken against
anti-competitive practices in the upstream gas
industry.
Joint marketing of gas
The sale of gas by gas companies through joint
selling arrangements has attracted scrutiny from the
Commission. These horizontal arrangements have
been a traditional practice on the part of gas
producers but have attracted the criticism that they
artificially reduce the number of independent
players. Although this practice had been tacitly
permitted for some time, it came under new scrutiny
in the late 1990s and was deemed to be in breach of
art. 81. 1 EC Treaty. Two cases illustrate this.
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
Following a complaint from the gas company
Marathon, the Commission took action against the
arrangements used in the sale of gas from Norway to
EU gas companies, under art. 81 EC Treaty and art.
53. 1 EEA Agreement (to which Norway is a
party).47 The Norwegian gas sales consortium, the
GFU, a statutory body established in Norway, had an
exclusive negotiating right for all sales of
Norwegian gas. This automatically precluded the
non-Norwegian licence interest holders from
negotiating or participating in the negotiation of
their own sales. It also fixed the price, volumes and
all other trading conditions and severely limited the
choice of EU consumers to negotiate with
Norwegian gas producers. The result was that the
Government of Norway suspended the GFU from
1 June 2001 and abolished it entirely as of 1 January
2002. However, the effects of this measure were
unlikely to be felt for many years due to the fact that
most of the gas sold by the GFU was already
contracted under arrangements that had up to 25
years to run.
A second instance in which joint marketing was
reviewed, concerned plans for the marketing of gas
from a newly discovered gas field in Ireland called
Corrib.48 The licensee companies, Enterprise Energy
Ireland, Statoil and Marathon, applied to the
Commission for an exemption under art. 81. 3 EC
Treaty to market the gas jointly for the first five
years of production. They argued that joint
marketing was necessary to balance the
countervailing purchasing power of the incumbent
Irish energy companies, Bord Gais Eirean – the
state-owned gas company and the Electricity Supply
Board – the state-owned electricity company. The
companies withdrew their application after the
Commission raised objections on competition
grounds, and agreed to market their gas individually.
The Commission argued that the ongoing
liberalization process would create an increasing
number of eligible customers, including power
generators and energy-intensive industrial
consumers. Moreover, it agreed that the net effect
would be to expand the customer-base in the power
market and offer potential sales outlets to gas
suppliers. The case confirmed that there is now a
46 European Commission Press Release, IP/05/716:
Competition: Commission opens sector inquiry into gas and
electricity, 13 June 2005.
47 European Commission Press Release, IP/01/1170:
Commission insists on effective access to European
pipelines for Norwegian gas, 2 August 2001.
48 European Commission Press Release, IP/01/578:
Enterprise Oil, Statoil and Marathon to market Irish Corrib
gas separately, 20 April 2001.
609
SUPRANATIONAL LAW
policy of not tolerating the joint selling of gas,
unless compelling reasons are provided as a
justification.
The outcome of the Corrib case provided an
interesting contrast to the Britannia case of only a
few years earlier.49 The Commission cleared an
agreement notified to it by the companies
participating in the development of the Britannia gas
field in the UK. The agreement did not affect trade
between member states and so was outside the scope
of the EC’s competition rules. It affected joint
selling operations between February 1992 and the
end of 1994. However, the conclusion was based on
the absence of any pipeline system between the UK
and any other member state that could have
managed the volumes of gas to be produced by this
field. At the end of 1994 the interconnector pipeline
agreement between the UK and the continent was
signed, and this argument in support of joint selling
was no longer justified. This appears to have been
behind the outcome of the Corrib case.
Long-term contracts: destination clauses
In 2001 the Commission began a series of
investigations into territorial sales restrictions in gas
supply contracts between non-EU gas producers and
EU gas wholesalers/importers. The so-called
destination clauses in long-term gas supply
contracts prohibit the resale of purchased gas to
consumers outside of the traditional supply area of
the importer - being usually the member state in
which the importer is located. These clauses were
included in contracts made between the Russian gas
utility Gazprom, and Italian companies SNAM (the
gas distribution unit of Eni), Enel and Edison,
involving some 20 billion cubic metres of gas a year.
They were also found in contracts involving
Sonatrach of Algeria and the Nigerian national LNG
supplier. In the former case, they also prohibited
Gazprom from selling to other companies in Italy.
Such clauses were deemed by the Commission to
hinder the creation of an IEM.
The origin of this clause appears to lie in an
attempt to protect the market value principle in the
pricing of gas. In this way, gas is priced differently
according to the alternative energy sources that are
available to gas buyers in each member state. The
practice is for the producers to discount from the
market value price the costs of transporting their gas
to the country of consumption (the net-back
principle). The producers therefore have an interest
in maintaining the market value principle.
The procedure adopted by the Commission has
not involved the notification of formal charges (with
one exception), but rather the negotiation of
610
solutions with the parties concerned. The initial step
of the Commission was to send a statement of
objections to the parties, including the non-EU
parties, noting the incompatibility of the destination
clause with art. 81 EC Treaty. The cases involving
the supply of Russian gas to Eni/SNAM (Italy),
OMV (Austria) and E.ON/Ruhrgas (Germany) were
settled after the companies deleted the restrictive
clause from their existing gas supply contracts. ENI
and OMV also committed themselves to taking a
number of pro-competitive measures that promoted
gas-to-gas competition in the EU, including an offer
to sell significant gas volumes of Russian gas in
Italy or elsewhere in the EU as well as the
development of the TAG (Trans-Austrian Gas)
pipeline. Gazprom is no longer contractually
prevented from selling its gas to competitors of ENI
or even from entering the Italian gas market itself.50
It has also agreed not to introduce new destination
clauses or similar contractual mechanisms in the
future. As part of the settlement of its case with the
Commission, the Nigerian supplier of LNG also
agreed not to introduce such clauses in its contracts
in the future.
The single exception to the negotiated procedure
above concerned Gaz de France (GdF), as a
transporter, and again Eni and Enel, as users of the
GdF pipelines in France. The contracts for the transit
of gas that these companies had concluded with GdF
all contained a clause that could be linked to
destination clauses. Specifically, the clauses in the
contracts which established that the gas – as the
object of the transit contract – was destined for
marketing downstream from the delivery point at the
French border. The case was subsequently closed by
the Commission after ascertaining that these clauses
had been eliminated by GdF, Eni and Enel.
The wider policy context of this ongoing
investigation is, as indicated above, that there are
already very few suppliers of gas on the market so
that efforts should be made by the Commission to
ensure that the suppliers are not further reduced
(Albers, 2005). Such actions therefore fit with the
overall aim of increasing the amount of gas available
on the EU market. If SNAM, for example, is
prevented by a non-EU supplier from exporting the
gas it purchases, then a consumer based in another
EU member state cannot approach SNAM as a
potential supplier. Such practices are targeted for
removal. The fact that the Commission chose to
49 European Commission Press Release, IP/96/1214,
The Commission clears a notified agreement concerning the
Britannia Gas Field, 19 December 1996.
50 Commission Press Release IP/03/1345, 6.10.2003.
ENCYCLOPAEDIA OF HYDROCARBONS
 EUROPEAN UNION AND THE LIBERALIZATION OF THE ENERGY MARKET
raise this matter with non-EU and non-EEA
suppliers is a novel development in the application
of EU law in the energy sector.
11.1.5 Conclusions
There has been a considerable expansion in the body
of EU law relating to the hydrocarbons sector in
recent years. This has taken the form of Directives
and other forms of EU legislation, but has also been
accompanied by a more assertive approach from the
Commission to the application of primary law,
especially the antitrust rules.
In spite of this, the process of energy market
liberalisation has proved slower than expected,
perhaps testifying to the limits of what may be
achieved by means of EU law alone. In this context,
the future path would seem to be one in which an
increasingly robust implementation of EU law
becomes evident, as well as a growth of legislation
on matters of detail, perhaps through instruments
such as regulations.
However, the legislation has provided a
framework in which law-making within the
member states by a number of actors, especially
NRAs, will play an ever-larger role. One result of
this is a need to ensure that the many regulatory
bodies (including competition authorities) act with
a measure of co-ordination in their efforts at
promoting competition and liberalization in the EU
hydrocarbons markets.
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
Finally, it is noteworthy that the Gas Directive
contains many provisions on consumer protection
and security of supply. This highlights a trend
towards questioning the benefits of the market
orientation of energy liberalisation. In this context, it
can be expected that justifications for this
orientation will increase, as will their legal
expression in provisions such as these, which seem
designed as much to provide a level of political
assurance as to give additional legal protection in an
area in which it is already very extensive.
References
Albers M. (2005) The new EU directives on energy
liberalization from a competition point of view, in: Cameron
P.D. (edited by) Legal aspects of EU energy regulation.
Implementing the new directives on electricity and gas
across Europe, Oxford, Oxford University Press, 41-58.
Cameron P.D. (1983) Property rights and sovereign rights.
The case of North Sea oil, London, Academic Press, 138-
171.
Cameron P.D. (2005) The internal market energy: hernessing
the new regulatory regime, «European Law Review», 30,
631-648.
Cameron P.D. (2007) Competition in energy markets. Law
and regulation in the European Union, Oxford-New York,
Oxford University Press, 188-194.
Peter D. Cameron
European University Institute
Robert Schumann Centre for Advanced Studies
Firenze, Italy
611
 12.1
United States of America
and Canada
12.1.1 Preliminary remarks
The United States of America and Canada are
constitutional federations in which control over
natural resources is divided between the federal
Governments and their component units. In the US
these component units are states; in Canada they
are Provinces. The division of legal authority over
natural resources between the Canadian federal
Government and the Provinces is not identical to
the division between the US federal Government
and the states. Moreover, each state and each
Province has developed its own legal regime, and
these are not identical within the two federations.
The presence of Native American tribes, with some
level of control over natural resources within their
tribal areas, adds another layer of complexity.
There are broad similarities in the legal regimes
of the two federal Governments, Provinces, and
States but there are also significant differences.1
Because of the multiplicity of jurisdictions and the
somewhat differing legal regimes, the legal
doctrines governing hydrocarbon development in
North American will be described generally, with
the laws of certain Provinces, states or the federal
Governments used as illustrative examples of
specific provisions; where such occur, laws will be
used to identify significant differences among legal
doctrines as well.
12.1.2 Ownership
of hydrocarbon resources
Hydrocarbon resources in the United States and
Canada may be owned by the respective central
Governments, the component federal units, Native
American tribes, and private persons, including
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
privately owned corporations. Private ownership of
oil and gas rights, which is virtually unique to the
two countries, derives from the English common
law principle cuius est solum, eius est usque ad
coelum et ad inferos.
The identification of the owner for a specific
hydrocarbon resource depends upon a variety of
factors, including: whether the mineral resource is
located onshore or offshore; the time when the state,
Province, tribal group or private person established
its rights to the land at issue; and the statutory and
constitutional mineral regime then in effect. Because
of different governmental policies, common law
traditions and constitutional provisions, the US and
Canada have allocated ownership of mineral
resources among the several ownership categories in
many various ways. It is, however, possible to make
some generalizations. As the subsequent material
explains, private ownership of oil and gas in situ is
far more widespread in the US than in Canada,
although in both countries the principal owner of
hydrocarbon resources is a governmental entity. In
the western onshore US, that entity is the federal
Government. In onshore Canada, it is the Canadian
provincial Governments. In offshore Canada and the
US, it is the respective federal Governments,
although the coastal states and Provinces also enjoy
significant rights of ownership and control over
adjacent seabed areas, perhaps more so in the US
than in Canada.
The rule of capture
One of the most significant doctrines of
Canadian-American oil and gas law is the rule of
1 For a brief description of the similarities and differences
between the two federations, see Smith et al, 2000.
613
NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
capture. Because a variety of individuals, private
companies and government entities may own oil
and gas rights in an area, it is not uncommon for
rights in an oil and gas reservoir to be divided into
many discrete portions owned by different legal
persons. Once drilling and production begins on
one tract, the oil and gas beneath other tracts
begins moving toward the well and, in doing so,
often cross ownership boundaries. This situation
gave rise to one of the earliest legal questions
presented by the oil industry in the United States
and Canada: does the owner of a portion of the
reservoir that is being drained have any legal
recourse against the owner of the well that is
causing the drainage? The courts answered the
question in the negative.2 Under this judicially
formulated doctrine, which came to be known as
the rule of capture, a person owns all of the oil and
gas produced by a well bottomed beneath his tract,
regardless of the original location of the
hydrocarbons, and regardless of the fact that the
well is draining oil and gas from beneath land
owned by someone else. Because the owner of the
tract being drained usually lacks an administrative
or judicial remedy, he can protect his interest in the
underlying hydrocarbons only by drilling off-set
wells to prevent the drainage. The rule of capture
illustrates the importance of judge-made law in the
development of the legal regimes governing
ownership rights in oil and gas in Canada and the
United States.
There are some limitations to the rule of
capture. One limitation is contained in the
definition of the rule: the draining well must be
bottomed beneath the tract of the owner of the
well. If the well is bottomed beneath a
neighbouring tract, the neighbour can enjoin any
further production from the well and recover the
value of all oil and gas produced from the well. A
second limitation is the requirement that the well
be properly drilled and operated. Neighbouring
landowners have a cause of action for the value of
the oil and gas drained from their land by the well
under certain circumstances: if the well is drilled or
produced in violation of administrative regulations;
if negligent drilling results in a blow-out that drains
and dispels oil and gas from adjacent land; or if the
owner of the well intentionally wastes production
(Smith and Weaver, 1998-2005). In several
instances, statutes and administrative regulations
have further restricted the rule of capture. These
include statutes that require small tracts to be
pooled to form a single drilling and production unit
composed of all tracts presumptively drained by a
well, and statutes that authorize all tracts within a
614
field to be united and developed as a single unit
(Kuntz, 2004). Except in some situations where
federally-owned land is involved, these statutes are
applied and administered by the oil and gas
conservation agency of the state or Province where
the land is located.
Ownership of onshore hydrocarbon resources
The right to explore for and produce from
onshore hydrocarbon resources may be entrusted to
the federal Government, a state or Province, or a
private person or corporation.
The United States
The common law principle that the owner of
land owns the mineral resources beneath the land is
firmly entrenched in the law. Conveyances of land
by the sovereign are deemed to automatically
include mineral rights beneath the land granted,
unless the minerals are specifically reserved, or the
grant is governed by an express statutory provision
limiting the grant to the surface. This was true both
of British Crown grants to the original thirteen
colonies that joined to form the United States and
of grants by the United States itself. During the
Nineteenth century, the federal Government
acquired ownership of almost all of the land
currently within the US that is west of the original
thirteen colonies. To encourage the settlement of
this huge area, the US Congress enacted a series of
laws under which individuals or families who
farmed or raised livestock for a specified number
of years received their homestead land for a
nominal sum. Grants made under the earliest
homestead laws were not limited to the surface but
included all mineral rights beneath the land.
Private ownership does not extend to the beds
of navigable lakes and streams nor, in most
instances, beyond the mean high tide mark. These
areas are subject to a federal navigational
servitude; but the underlying land and mineral
resources are owned by the state where they are
located. Each state holds title to its stream and
lake beds and tidelands in trust for the public
benefit.
The practice of conveying mineral rights along
with ownership of the soil began to change under
2 For Canada, see: Borys v. Canadian Pacific Railway
(1953) Privy Council 2 D.L.R. 65; Berkheiser v.
Berkheiser (1957) Supreme Court of Canada 7 D.L.R. (2d)
721. For the US, see: Barnard v. Monongahela Natural
Gas Co. (1907) Supreme Court of Pennsylvania 65 Atl.
801; Bender v. Brooks (1910) Court of Civil Appeals of
Texas 127 S.W. 168.
ENCYCLOPAEDIA OF HYDROCARBONS

US homestead laws enacted in the late Nineteenth
and early Twentieth century. The latter usually
reserved the minerals or specific substances, such
as coal, for the federal Government.
Beginning in 1802, new states that were
created out of federal territory were given grants of
federal land to provide a source of funding for
public schools, colleges and other institutions.
Although a few of the new states sold their land
along with the underlying mineral rights to private
persons, most states kept their land or sold only the
surface. Texas was an exception to this system. It
had enjoyed the status of an independent nation
and retained millions of acres of public land when
it joined the union (Smith and Weaver, 1998-2005).
Neither the surface nor the minerals in much of
the land in the western United States was ever
transferred into private ownership or to the states.
This retained land is still owned by the federal
Government and is classified as public domain.
Although concentrated in western states such as
Alaska, Utah and Nevada, this vast area of
federally-owned land comprises approximately
30% of the entire onshore area of the United
States. The hydrocarbon reserves beneath this land
are owned by the federal Government.
Some additional land is owned by Native
American tribes, who hold the land for the benefit
of all living members of the tribe. Some land is
also owned by individual Native Americans whose
ancestors received allotments of specific tracts.
Whether Native American land includes the
underlying mineral resources depends upon the
terms of the treaty or statute that set aside the land.
Whether owned by the tribe or individuals, Native
American land ownership differs from other types
of land ownership in several important respects.
Recognized Native American tribes are “domestic,
dependent nations” with limited “attributes of
sovereignty over both their members and their
territory” (Rocky Mountain Mineral Law
Foundation, 2001). As a sovereign, a tribe can
impose taxes and controls on mineral development.
Tribal councils can also authorize oil and gas
Exploration and Development (E&D), but that
right is subject to the Trust Doctrine. This
judicially-formulated doctrine imposes a duty upon
the federal Government to act as guardian of
recognized tribes and individual Native Americans,
and makes sure that all actions affecting them,
including mineral development, are in their best
interest. Additionally, there are federal statutes
regulating the sale of Native American lands and
requiring federal approval for any mineral
development agreements entered into either by a
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
UNITED STATES OF AMERICA AND CANADA
tribe or an individual Native American owner of
allotted lands (Rocky Mountain Mineral Law
Foundation, 2001).
Canada
In a very broad sense, the history of mineral
ownership in Canada parallels that of the United
States, but the allocation among the central
Government, the Provinces, Native Americans and
private owners is much different. As in the US, the
earliest grants by the British Crown and the
Crown’s representatives, i.e. the federal and
provincial Governments, included mineral rights.
Since Canada was settled from east to west, most
of these grants were in the eastern portions of the
country. Commencing in 1887, the federal
Government began retaining mineral rights, and
persons acquiring land under the federal
homestead laws received only the surface (Ballem,
1999).
By the late Nineteenth and early Twentieth
century, however, each individual Canadian
Province, rather than the federal Government, had
come to own virtually all of the public land and the
underlying mineral resources within its borders,
including all waterways shoreward of the “low-
water line along the coast”.3 This transfer of
ownership began with the 1867 Constitution,
which gave each of the original four Provinces –
Ontario, Quebec, Nova Scotia and New Brunswick
– all of the public land within its individual
boundaries. From 1870 to 1949, six additional
Provinces were created. Either by the terms of
admission or through subsequent legislation, each
new Province received ownership and control of
the land and underlying mineral resources. As a
result of these transfers of ownership to the
Provinces, virtually the only remaining onshore
land and hydrocarbon resources owned by the
federal Government are located in the Yukon, the
Northwest Territories, Nunavat, and Sable Island.
The Yukon is in the process of acquiring provincial
status, and a relatively recent act of the Canadian
Parliament has conferred administrative control
over public property and oil and gas within the area
to the Yukon Commissioner.4
The Canadian Provinces have not taken a
uniform approach to private ownership of mineral
resources. As early as 1880, the Province of
Quebec began reserving mineral rights beneath the
land that it granted (Ballem, 1999). Several other
3 Oceans Act S.C. 1996 c. 31, subs. 5.1.
4 Yukon Act S.C. 2002 c. 7, subs 45.1.
615
NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
Provinces have enacted legislation that vests all
mineral rights within their borders in the provincial
Government. Others have recognized private
ownership, but generally on a far more restricted
basis than exists in the US.5 As a result of these
developments, the various provincial Governments
own the mineral rights in and beneath much of
Canada.
The Canadian legal regime applicable to native
peoples is somewhat similar to that of the United
States. The federal Government has set apart land
for various Native American tribes and holds these
lands in reserve for them. In addition, Canadian
Supreme Court decisions interpreting the 1982
Canadian Constitution Act have held that native
people may have rights to use land or have title to
land used or occupied before certain dates.6 The
Native American land and underlying oil and gas
reserves are administered for the benefit of the
tribes by the Minister of Indian Affairs and
Northern Development, acting under federal
regulations and in consultation with Native
American representatives from the tribes. Royalties
from oil and gas development on these lands are
held by the federal Government in trust for the
benefit of the tribes.7
The legal classification of rights in hydrocarbons
There are two principal approaches to the legal
classification of oil and gas in the ground, with
relatively minor variations among different
jurisdictions. The two theories are usually referred
to as the ownership theory and the non-ownership
theory. In the United States, the legal nature of real
property interests, including rights of hydrocarbons
in situ, is a matter of State law and may vary in
accordance with the legal doctrines of each
particular state. In Canada, the legal classification
of mineral rights has been established by the
Supreme Court.
In the US, several jurisdictions, including
Texas, make no distinction between the ownership
of hydrocarbons and the ownership of solid
minerals, such as coal and iron ore. Under this
ownership theory, a landowner has the same title to
the underlying hydrocarbons as he does to the
surface and to the solid minerals. Rather illogically,
the rule of capture is nonetheless applied in
“ownership” jurisdictions. As a result, a person’s
title to oil and gas is lost if it is drained to adjacent
land (Anderson et al., 2004) Other states,
including California, Oklahoma and Louisiana
have taken the position that oil and gas are not
susceptible to ownership while still in the ground
because they may migrate beneath property
616
boundary lines (Anderson et al., 2004). The
Canadian Supreme Court has also stated that oil
and gas are not susceptible to ownership while still
in situ.8 In these jurisdictions a person may acquire
ownership to oil and gas only after it is produced.
In the words of the Canadian Supreme Court: “The
proprietary interest becomes real only when the
substance is under control, when it has been piped,
brought to the surface and stored”.9
Regardless of legal classification, rights in
hydrocarbons in situ can be separated from title to
the surface. This is true not only in the more
obvious situations where the federal Government, a
state or a Province has conveyed the surface and
retained the hydrocarbons, but also with respect to
private rights in hydrocarbons. In states and
Provinces such as Alberta, Texas, Louisiana and
Oklahoma, which have a long history of
hydrocarbon development, mineral rights have
often been separated from surface ownership, with
one private person owning the surface and another
private person having exclusive rights to the
underlying hydrocarbons. In an ownership
jurisdiction, the effect of a severance is to create
two separate and distinct titles within the same
tract of land. One person has title to the surface
and the other to the underlying minerals, including
the oil and gas. Such a division is also possible in
non-ownership jurisdictions. In the states that
follow this view, and in Canada, a grant of oil and
gas rights gives the grantee an exclusive right to
search for and produce oil and gas (Anderson et
al., 2004). Under English common law, such an
interest is usually termed a profit à prendre or an
easement. In Louisiana, which is a civil law
jurisdiction, the grantee’s interest is treated as a
servitude.
In both ownership and non-ownership
jurisdictions, a private person or a governmental
entity who owns the mineral interest has the
exclusive right to authorize E&D of the
hydrocarbons. Authorization for the E&D of tribal
lands usually requires participation or approval by
a federal governmental agency.
5 Crown Minerals Act R.S.S. 1984 c. C-50.2, s. 23.
6 R. v. Delgamuukw v. British Columbia (1997) Supreme
Court of Canada 3 S.C.R. 1010; R. v. Van der Peet (1996)
Supreme Court of Canada 2 S.C.R. 507. See also: Carpenter
et al., 2001; Rankin, 2004.
7 Indian Oil and Gas Act R.S. 1985 c. 1-7, s.3, subs. 6.1.
8 Berkheiser v. Berkheiser (1957) Supreme Court of
Canada 7 D.L.R.(2d) 721.
9 Berkheiser v. Berkheiser (1957) Supreme Court of
Canada 7 D.L.R.(2d) 721 at s. 10.
ENCYCLOPAEDIA OF HYDROCARBONS

Ownership of offshore hydrocarbon resources
There has been extensive litigation over
whether the US states’ and Canadian Provinces’
ownership and control over their internal mineral
resources extends to offshore areas. The first case
to reach the US Supreme Court was United States
v. California (1947),10 in which the federal
Government disputed California’s claim to title to
the seabed and mineral resources for three nautical
miles seaward of the ordinary low tide water mark.
California relied on the fact that it, like almost all
other States, had been admitted to the Union on the
same basis as the original thirteen colonies. The
State argued that after the colonies gained
independence from Britain, each colony succeeded
to the entire area within its boundaries that had
been claimed by the British Crown, including a
three-mile wide territorial sea, and that each
colony continued to own this area when it joined
with the other colonies to form a new federal
union. The Court rejected this argument. The
controversy arose over whether California or the
federal Government could authorize development
of petroleum reserves in the area. The Court
reasoned that these reserves “might well become
the subject of international development and
dispute” and that the protection of the seaward
areas and promotion of international commerce
were responsibilities of the central Government,
rather than individual state Governments, which
were “not equipped in our constitutional system
with the powers or the facilities” for exercising
such responsibilities.11 The same result was
reached in a later case involving Texas, which was
admitted to the Union as an independent country
and recognized as such by several European
countries. The Court conceded that Texas once had
sovereign rights to a territorial sea, but reasoned
that by coming into the Union, Texas had
necessarily relinquished a portion of its
sovereignty, including its claim to its seaward
area.12 Attempts by states to extend their control
beyond the traditional territorial sea and into the
outlying continental shelf have been similarly
unsuccessful.13
The Canadian Supreme Court, when faced with
similar claims, reached the same result. In
Reference re Offshore Mineral Rights (British
Columbia),14 the Court rejected British Columbia’s
claim to lands beneath the adjacent territorial sea
and continental shelf. The Court did, however, rule
in a later case that the straits and the underlying
seabed between the mainland and Vancouver Island
were part of British Columbia.15 The ruling in
Offshore Mineral Rights is presumably applicable
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UNITED STATES OF AMERICA AND CANADA
to all other Canadian Provinces, with the possible
exception of Newfoundland, which presents a
unique situation. Before joining the Canadian
union in 1949, Newfoundland had essentially the
same legal status within the British
Commonwealth as Canada and Australia. It had,
moreover, adopted legislation dealing with its
territorial sea and seabed. Relying on these factors,
the Newfoundland Court of Appeals held that the
boundaries of Newfoundland include its territorial
sea.16 Whether the Canadian Supreme Court,
which has yet to rule on this issue, will agree with
the decision is an open question. However, both
that Court and the Newfoundland Court of Appeals
have held that Newfoundland does not have control
over its continental shelf.17
The Courts of the US and Canada have
established that their respective federal
Governments have ultimate ownership and control
over their entire offshore area to the furthest extent
recognized by international law, with the exception
of: certain tidelands and straits, offshore
Newfoundland, and potential claims to offshore
areas by some Canadian Indian groups. The extent
of Canada’s offshore rights is set out in the Oceans
Act.18 It vests ownership in the seabed beneath
Canada’s 200-mile wide Exclusive Economic Zone
(EEZ) in the federal Government and provides for
federal rights to the seabed of the Canadian
continental shelf. The continental shelf is
“determined in the manner under international law
that results in the maximum extent of the
10 United States v. California (1947) Supreme Court of
the United States 332 US 19.
11 United States v. California (1947) Supreme Court of
the United States 332 US 19 para. 36.
12 United States v. Texas (1950) Supreme Court of the
United States 339 US 707.
13 United States v. Maine (1975) Supreme Court of the
United States 420 US 515; United States v. Maine (1986)
Supreme Court of the United States 475 US 89.
14 Reference re Offshore Mineral Rights (British
Columbia) (1967) Supreme Court of Canada S.C.R. 792; 65
D.L.R. (2d) 353.
15 Canada v. British Columbia (1984) Supreme Court of
Canada 8 D.L.R. (4th) 161.
16 Reference re Mineral and Other Natural Resources of
the Continental Shelf (1983) Newfoundland Ct. App. 145
D.L.R. 3d 9.
17 Reference re Mineral and Other Natural Resources of
the Continental Shelf (1983) Newfoundland Ct. App. 145
D.L.R. 3d 9; Reference re Newfoundland Continental Shelf
(1984) Newfoundland Ct. App. 5 D.L.R. (4th) 385. For a
history of the controversies between the provinces and
federal government over offshore areas and description of
the accords, see Lucas and Hunt, 1990.
18 Oceans Act 1996 S.C. c. 31.
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
continental shelf of Canada, the outer edge of the
continental margin being the submerged
prolongation of the land mass of Canada consisting
of the seabed and subsoil of the shelf, the slope and
the rise, but not including the deep floor with its
oceanic ridges or its subsoil”.19
Nonetheless, political pressures and possible
constitutional concerns have led the legislative
bodies of both countries to enact statutes ceding
some portions of their offshore rights to states and
Provinces. In 1987 and 1988 respectively, the
Canadian federal Government entered into accords
with the Provinces of Newfoundland and Nova
Scotia, where most offshore production is currently
taking place. The accords deal with jurisdictional
and revenue issues and were subsequently
implemented into legislation by the Canadian and
provincial parliaments. The statutes establish a
programme for offshore licensing that is similar to
the system governing licensing of onshore federal
land and provide for monitoring by oversight
boards staffed by federal and provincial civil
servants. The revenue generated by the licences is
divided between the federal Government and the
Provinces (Lucas and Hunt, 1990).
There is also potential for petroleum production
in the seabed offshore of British Columbia; but
because of environmental, constitutional and
political concerns the federal and the provincial
Governments have imposed moratoria on such
development. Whether there will be a legal regime
for petroleum development in this area in the near
future depends in part upon whether the British
Columbia Offshore Oil and Gas Team, which was
created in 2003, is able to formulate a regulatory
plan that will address the concerns of
environmental protection and native peoples while
remaining satisfactory to industry.
The US Congress enacted the Submerged
Lands Act 1953,20 which transferred title to the
seabeds and underlying resources to a distance of
three miles to each coastal state. The Act further
provided that states adjoining the Gulf of Mexico
could claim an even further extension if such an
extension could be supported by prior historic
claims. Florida and Texas, as former colonies of
the Kingdom of Spain, successfully invoked this
provision and established title seaward within the
Gulf to a distance of nine nautical miles.21 Each
coastal state has authority to grant E&D rights of
hydrocarbon resources within its seaward area. The
federal Government has the exclusive right to
control mineral development within the remainder
of its continental shelf, which the US claims to a
distance seaward from its shores of 200 miles. This
618
claim is consistent with arts. 55 to 75 of the U.N.
Convention 1982 on the Law of the Sea, but is
based upon the Presidential Proclamation 1983 No.
5030 asserting sovereign claims to a 200-mile
EEZ. E&D of federal offshore areas are governed
by the Outer Continental Shelf Lands Act 1953.22
12.1.3 State participation
and state companies
Neither the US nor Canada has a state oil
company. The same is true of the Provinces and
states. With some exceptions for geophysical
exploratory activities, especially in offshore areas,
northern Alaska, and other limited areas, the
various governmental units in the two countries
rely upon private oil and gas companies for
exploration, development and production. The
governmental units participate in these operations
only in the sense that they authorize private
companies to explore, develop, produce and sell
mineral resources in strict accordance with statutes
and regulations and receive various financial
payments in exchange. Although the leases and
licences executed by the governmental units
usually contain an option for payment of royalty in
kind, in most instances, the federal, state and
provincial Governments elect to receive monetary
payments rather than a portion of production.
12.1.4 Form and nature
of exploration and
development agreements
The type of agreement most commonly used to
transfer development rights to an oil and gas
company is the oil and gas lease.23 As will be seen
subsequently, the term is misleading, for the nature
of the agreement and the relationship of the parties
bear little resemblance to traditional agricultural,
business or residential leases between landlords
and tenants. The provisions of leases covering
resources owned by the US or Canadian federal
19 Oceans Act 1996 S.C. c. 31 para. 17(1)(a).
20 43 USC. paras. 1301-1315.
21 United States v. States of Louisiana, Texas,
Mississippi, Alabama and Florida (1960) Supreme Court of
the United States 363 US 121.
22 43 USC. paras. 1331-1356.
23 Oil and gas lease is US terminology. In Canada the
instrument is known as a petroleum and natural gas lease.
For convenience, the shorter US term will be used
throughout this chapter.
ENCYCLOPAEDIA OF HYDROCARBONS

Governments, and by states or Provinces are
controlled primarily by statute; whereas the
provisions of oil and gas leases entered into by
private owners are determined partially by statute
and by common law, but principally by
negotiations between the parties. Nonetheless,
most of these agreements, whether privately
negotiated or prescribed by statute, have the same
basic structure and contain similar provisions.
This section will first describe the basic terms
and structure as they are found in typical private
leases, and then go on to describe the most
significant ways in which federal, state and
provincial leases and licences differ.
Leases on privately owned oil and gas resources
Privately negotiated leases almost invariably
begin with a model form lease, such as those
developed by the Canadian Association of
Petroleum Landmen (CAPL), the American
Association of Professional Landmen (AAPL),
other professional groups, or oil companies. Such
model forms are often tailored to meet the specific
legal requirements of each oil and gas producing
Province or state.
Rights granted to the oil and gas lessee
The rights granted by the oil and gas lease are
set out in the granting clause. The CAPL 1991
model lease designed for use in Alberta is
reasonably typical. It “grants and leases exclusively
unto the Lessee all the leased substances [...]
within, upon, or under said [leased] lands [...];
together with the exclusive right and privilege to
explore for, drill for, operate for, produce, win,
take, remove, store, treat and dispose of the leased
substances and the right to inject substances into
the said lands for the purpose of obtaining,
maintaining or increasing production from the said
[leased] lands, the pooled lands or the unitized
lands and to store and recover any such substances
injected into the said lands.” Leased substances are
defined as including petroleum, natural gas and all
substances produced in association with petroleum
and natural gas, including substances in reservoir
water. US leases contain somewhat similar
language, but typically also grant specific
incidental rights that are necessary to conduct
operations on the land, such as rights of ingress
and egress, laying pipelines and building roads.
Under traditional US and Canadian common
law, rights of surface use that are reasonably
necessary to effectuate the purpose of the grant
will be implied, even though they are not
specifically set out in the lease (Lucas and Hunt,
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1990; Smith and Weaver, 1998-2005). In US
transactions involving private landowners, an oil
and gas company’s implied rights have been held to
include such matters as ingress and egress;
conducting geophysical exploration, locating drill
sites and facilities at the most desirable site for
mineral production and development; building
roads, storage tanks, transport facilities and other
structures; using water on the premises for drilling
and secondary recovery operations and sand and
gravel for road building (Lowe et al., 2002; Smith
and Weaver, 1998-2005). Such rights will not, of
course, be implied if there is a lease clause
specifically negating a particular right of surface
use or specifying where roads or structures can be
located.
Legislation in several Canadian Provinces and
US states has abolished or significantly modified
the common law doctrine of implied surface rights.
Alberta’s Surface Rights Act 200024 is fairly
typical of the provincial statutes. Under this act, an
oil and gas lessee may enter the leased premises
only for the purpose of determining where drilling
and production operations will be conducted, and
may make such an entry only after a reasonable
attempt to notify the surface owner.25 Language in
a petroleum and natural gas lease granting the right
to come on the premises and actually conduct
drilling and production operations is legally
insufficient to authorize an entry for such
purposes. In order to enter the land to drill,
produce or conduct other related operations, the
lessee must negotiate a separate surface lease
agreement with the landowner and pay
consideration for this Surface Lease, in addition to
that given for the Petroleum and Natural Gas
Lease.
A typical surface-use agreement leases a
specific described area to the oil and gas
company for the purpose of exploring,
developing and producing oil and gas. There are
provisions governing the construction of roads,
fencing of the lessee’s facilities, restoration of the
land upon termination of the agreement, and
other such matters. The agreement usually
provides for annual rentals and is for twenty years
or some other specified period. It may contain a
24 Surface Rights Act R.S.A. 2000 c. S-24 (hereinafter
the Alberta Surface Act).
25 Alberta Surface Act subss. 14(1), (2). Seismic
exploration is not contemplated by this provision. An
agreement must be reached with the surface owner before
seismic exploration may be carried out and other statutes
must be complied with as well, see Lucas and Hunt, 1990.
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
clause authorizing renewal for one or more
similar periods.
If the surface owner and the oil and gas lessee
are unable to reach a negotiated surface lease
agreement, the lessee may apply to the Alberta
Surface Rights Board for a right of entry order.
Upon a showing of the most recent offer made to
the surface owner, and after providing evidence
that the offer was refused, the operator may
receive an order from the Board to grant the
lessee a right of entry based upon a forced
settlement. The forced settlement will require
payment of a stipulated amount to the surface
owner.26 Several states in the US have enacted
Surface Damage Acts that contain provisions
somewhat analogous to those in the provincial
acts (Kuntz, 2004).
Some US jurisdictions, such as Texas, adhere to
the traditional common law doctrine of implied
rights, including the doctrine that an oil and gas
lessee has no obligation to compensate the
landowner for use of the surface or injury to the
surface. Payment is required only if the operator
negligently damages the land or uses more of the
surface than is reasonably necessary for oil and gas
operations. In these jurisdictions it is incumbent
upon the surface owner to include within the oil
and gas lease express clauses providing for
compensation and stipulating where operations can
take place. The principal protection afforded a
landowner who fails to negotiate for such
provisions is the accommodation doctrine. This
common law principle requires oil and gas
operators to accommodate surface uses if it is
reasonable to do so (Smith and Weaver,
1998-2005). In most states the doctrine applies
only to existing uses. An operator is not required to
locate roads, drill sites or other facilities in a way
that will accommodate the landowner’s proposed
future uses of the surface.
Duration
An oil and gas lease is divided into two
durational periods: a primary term, which is a
fixed number of years, and a secondary term,
which continues for an indefinite period thereafter.
The purpose of the primary term is to give the
lessee a period during which it can conduct seismic
or other exploratory operations to determine if it
should engage in drilling and development
operations. The duration of the primary term in
private leases is a matter of negotiation. In the US,
the duration is typically within a one to five year
range. In Canada, a primary term of one to two
years is the current norm.
620
There are three principal variations of the
primary term. Traditionally, the most common type
has required the lessee either to drill or to pay a
rental for the privilege of deferring drilling
operations until the following year. If the lessee
does not drill and fails to pay the rental at the end
of the year, the lease automatically terminates.
These requirements continue throughout the
primary term. If the lessee has not obtained
production, it must either commence drilling
operations or pay the delay rental every year during
the primary term or lose the lease.
A second type of primary term provides that
the lessee must either drill or pay a delay rental. If
the lessee fails to do either, the lessor has a cause
of action for unpaid rent. This variation of the
primary term is not widely used in US leases, but
two successive versions of the CAPL model form
leases contain primary terms of this type. The 1988
and 1991 CAPL form leases impose a duty upon
the lessee to make rental payments every year
during the primary term if the lessee has not
commenced drilling operations. Under these leases
the lessee may avoid this financial obligation to
future, unaccrued rentals by giving notice to the
lessor that it is surrendering the lease.
A third type of primary term does not provide
for periodic rental payments. A payment is made
when the lease is entered into, and the lease
continues for the number of years set out in the
primary term. This type of lease is often referred to
as a paid up lease and is especially appropriate for
leases with a short primary term. It is increasingly
used in both the US and Canada. The 1988 and
1991 CAPL leases can be converted into paid up
leases under an option that allows a lessee to pay
all of the delay rentals in a lump sum, at the time
the lease is executed, if the lessee and the lessor so
agree. The most recent CAPL lease, which was
promulgated in 1999, is entirely a paid up lease
and makes no provision for rentals during the
primary term.
To continue the lease after the primary term the
lessee must meet the conditions stipulated in the
instrument. The typical form of US leases provides
that the lease will continue after the primary term
“as long thereafter as oil and gas or other
hydrocarbons are being produced from said land or
land with which said land is pooled hereunder”.
Although, a few states, including Oklahoma, have
held that the discovery of oil or gas is sufficient to
satisfy this requirement, a significant majority have
26 Alberta Surface Act ss. 15, 19, 25.
ENCYCLOPAEDIA OF HYDROCARBONS

concluded that production requires the actual
removal of the hydrocarbons from the ground.
There is, however, virtual unanimity of agreement
between both groups of states that a slight amount
of oil or gas is insufficient. In order to maintain the
lease, the well must either be capable of producing
in paying quantities or, where actual production is
required, that production must be in paying
quantities (Anderson et al., 2004). The phrase
paying quantities means that the value of the oil or
gas produced exceeds operating expenses. The
judicial rationale is that the oil and gas lease is
entered into in order for both parties to receive
income from oil and gas production, and not to
allow the oil and gas lessee to speculate on future
value of the mineral resources. So long as the
operator is receiving income that exceeds
expenses, and thus at least recouping initial capital
expenses, the lease continues. If income falls
below expenses and continues at this low level for
a long enough period that a reasonably prudent
operator would no longer anticipate making a
profit, the lease automatically terminates unless
maintained by some other provision within the
lease. Other activities that will maintain the lease
after the primary term are drilling, or operations
preparatory to drilling.
Some Canadian oil and gas leases provide for a
second term in language that is very similar to that
used in US leases, stating that the lease will
continue after the initial term “so long thereafter as
the leased substances or any of them are produced
from the said lands or the pooled lands [...]” Most
recent leases, however, follow the language of the
various CAPL model leases, which provide that
operations will extend the lease after the primary
term and maintain it during the secondary term.
The term operations is defined in the leases as
production, drilling, reworking, injection,
repairing, and other drilling-associated tasks that
are incidental to the listed operations. The issue of
whether a minor level of production will maintain
a lease has not been judicially determined in
Canada (Greenfield and Tadesco, 2004). However,
a respected commentator on Canadian oil and gas
law has stated that it is “highly unlikely that the
words would be expanded to include any economic
or volume conditions. If an operator is prepared to
physically produce a well, regardless of profit or
loss, it is submitted that a Canadian court would
hold that the ‘are produced’ test had been met”
(Ballem, 1999). Under most Canadian leases, as in
a minority of US states, a lease will not
automatically terminate so long as there is a well
capable of producing the leased substances, even
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UNITED STATES OF AMERICA AND CANADA
though there is no actual production and the lessee
is not conducting operations. The landowner may,
however, have a claim for damages for breach of
contract in some situations.
In addition to the basic provisions governing
duration, both US and Canadian oil and gas leases
contain clauses that will allow the lessee to
maintain the lease in the absence of production or
operations in certain specified situations. Leases
typically contain at least three provisions, referred
to as savings clauses, that are designed to deal with
these situations. One type is the force majeure
clause. The CAPL lease forms provide that a lease
will not terminate if production is interrupted
because of force majeure, and give the lessee 30
days to recommence operations after the force
majeure has ended.
A second widely used savings clause is
commonly referred to as the shut-in well clause.
This clause was originally designed to deal with
gas wells that could not be produced because of
lack of pipeline facilities, but has also been used
where gas wells are voluntarily shut-in because of
low gas prices. The clause typically provides that if
a gas well is shut-in, the lessee will nonetheless
pay a royalty. This payment is usually the same
amount as the rental paid during the primary term.
In the few US states that define production to
mean merely that a well is capable of production,
this clause is a covenant. The lessor can sue for the
shut-in royalties if the lessee fails to make
payment. However, most US states require actual
production; otherwise the lease automatically
terminates. In these jurisdictions the clause
stipulates that if a gas well is shut-in the lease can
be maintained by the payment of shut-in royalties.
Failure to make the payment results in lease
termination.
In the US, shut-in provisions were traditionally
not thought to be necessary with respect to crude
oil, which can almost always be produced and
stored or transported by trucks even if there are no
easily available pipeline facilities; but some more
recent leases now allow either oil or gas wells to be
maintained through payment of a shut-in royalty.
Older Canadian leases also differentiate between
oil and gas wells, but more recent leases allow a
lessee to shut-in either an oil or gas well for any
reason, so long as the well is capable of producing
and shut-in well payments are paid to the lessor.
A third savings clause deals with a well that
was never physically capable of producing initially
or has stopped producing. The cessation of
production clause gives the lessee a specified
amount of time, such as 60 days, in which to
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
commence new drilling, reworking or repair
operations. This situation differs from the
preceding one, where a lessee has either never
commenced production because of lack of pipeline
facilities or has chosen to stop production because
of a depressed market for natural gas. A similar
result is reached under the CAPL leases, which
provide that the lessee can keep the lease in effect
after the primary term so long as operations are
being conducted. Because operations are defined
as including reworking and repairing, a well that
stops producing will not result in lease termination
as long as the lessee is carrying out repair or
reworking operations.
Financial payments to the lessor
Oil and gas leases typically provide for four
types of financial benefits that may be payable to
the lessor. Two have already been discussed: the
rental, which is paid during the primary term, and
the shut-in royalty, which is payable if a well
capable of production is voluntarily shut-in. The
third financial benefit is a monetary sum referred
to as the bonus. The bonus is a payment for
entering into the oil and gas lease. It is typically
calculated by multiplying an agreed-upon dollar
sum by the number of acres covered by the oil and
gas lease. The amount paid per acre is a matter for
negotiation between the parties to the lease and
depends upon whether the land is in or near
proven, producing wells or whether it is in wildcat,
i.e. undrilled territory. In both the US and Canada
the lessee’s obligation to pay the bonus is usually
delayed for several days after the lease is executed,
in order to give the lessee sufficient time to obtain
title assurances. Either as a result of express
contractual language or common law doctrine, the
lease will normally be deemed invalid if both the
lessor has good title to the underlying
hydrocarbons and the bonus is not paid (Ballem,
1999; Smith and Weaver, 1998-2005).
The fourth financial benefit is the royalty,
which is a right to a specified fraction or
percentage of production, less certain expenses.
Typical US and Canadian leases do not
automatically terminate if the operator fails to
make timely royalty payments. The lessor’s remedy
for nonpayment of royalties by the lessee is an
action for damages for breach of contract (Ballem,
1999; Anderson et al., 2004; Smith and Weaver,
1998-2005).
Throughout much of the Twentieth century, the
royalty on US leases was almost invariably set at
12.5%, but in more recent private leases it is likely
to range from 16.67% to 25%. Primarily, for
622
historical reasons, the royalty on oil is payable in
kind, whereas the lessee is deemed to own all of
the natural gas produced and pays a royalty based
on the sale price or market value of the natural gas.
In practice, of course, few private landowners have
the facilities to take their royalty share of oil in
kind. They authorize the lessee to sell it on their
behalf and receive a payment in cash.
Two principal legal issues have arisen in the US
in connection with the calculation of royalty on
natural gas. The first relates to the expenses that
can be deducted from the sale price or value of the
natural gas if it is sold at a point past the wellhead.
Courts in some states have held that unless there is
language in the oil and gas lease to the contrary,
royalty is free of capital investment costs and
production expenses. Yet, it is subject to a
proportionate share of all post-production costs
incurred to transport, process or otherwise put the
natural gas into a marketable condition. Other US
jurisdictions have concluded that the lessee has an
obligation to obtain a marketable product and that
the royalty is free not only of capital and
production costs, but all additional costs that are
necessary to obtain a marketable product
(Anderson et al., 2004).
The second legal issue in the US relates to the
determination of market value. Many oil and gas
leases provide that if natural gas is sold off of the
leased land, the royalty is based on ‘market value at
the well’ rather than the lessee’s sale price.
Controversy over the determination of market
value is most likely to arise if the gas is sold to an
affiliate or subsidiary of the operator, or if the sale
is under a long-term contract containing pricing
provisions that vary from current market prices. As
with many other issues, US state Courts have
reached different conclusions with respect to
whether a sale to an affiliate should be disregarded
or considered as evidence of market value. They
have also differed on whether market value should
be determined at the time a contract is entered into,
in which event the prices provided for in the long-
term contract will usually hold, or at the time gas is
delivered to the purchaser, in which event the
pricing provisions of a long-term contract are not
determinative as to what constitutes market value
(Anderson et al., 2004).
Most of the legal issues related to the
calculation of royalty on natural gas can be
resolved by express contractual provisions in the
oil and gas lease. Some very recent US leases and
most Canadian leases executed over the last 20
years have done this. The Canadian leases
promulgated by the CAPL do not differentiate
ENCYCLOPAEDIA OF HYDROCARBONS

between oil and gas royalties, and provide for a
royalty on both based on “the current market value
at the wellhead”.27 The problem of affiliated sales
is dealt with by providing that if the lessee does not
engage in an arm’s-length sale of the production,
“current market value at the wellhead [...] shall be
deemed to be the average market price [...] as and
when produced in the area in which the Lands are
located less all expenses permitted to be deducted
hereunder”.28 The CAPL leases list the expenses
that can be deducted from royalty. The 1999 CAPL
lease authorizes a deduction for “any reasonable
expense incurred by the lessee (including a
reasonable rate of return on investment) for water
disposal and for separating, treating, processing
and transporting Leases Substances beyond the
wellhead”.29
Other types of financial benefits can, of course,
be negotiated by the lessor. Surface use
agreements, which are required by statute in most
Canadian Provinces and in several US states, have
already been mentioned. Minimum royalty clauses,
which require a lessee to pay any difference
between a stated minimum sum and the royalties
owed on actual production, are also found with
some frequency. Far less common are provisions
for net-profit payments and other forms of
payment in addition to a standard royalty.
Federal, provincial and state leases and licences
Whereas oil and gas companies or their agents
acquire leases on privately owned land through
negotiations with the landowners, leases on
federal, provincial and state lands are usually
granted through a competitive bidding process.
This process and its requirements differ among the
various US and Canadian jurisdictions. The
regulatory regime governing the leasing of US
federal offshore lands, while not necessarily
typical, is illustrative of the procedures.30
The Outer Continental Shelf Lands Act 195331
directs the Department of the Interior to prepare
successive five-year plans for the sale of leases on
offshore lands subject to federal control. One step
in developing a plan is the identification of areas
of hydrocarbon potential, a process that depends,
in part, upon recommendation from oil and gas
companies. The plan, once finalized, describes
lease location, size and timing of lease sales.
Competitive, sealed bidding commences after a
formal notice of sale has been published in the
Federal Register.
The Mines and Mineral Service (MMS),
which is an agency within the Department of the
Interior, is authorized to use any of the following
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bidding methods: a) bids based upon a cash
bonus with a fixed royalty of no less than 12.5%;
b) bids based upon royalty percentage under a
lease with either a fixed work commitment or a
fixed cash bonus; c) bids based upon either a cash
bonus or a work commitment under a lease with a
sliding scale royalty; d ) bids based upon a cash
bonus under a lease with a fixed net profits share
of no less than 30%; and e) a variety of other
options. In practice, bidding is usually based
upon a single lease term, which is either the cash
bonus or the royalty.
With one principal exception, leases are
awarded to the “highest responsible qualified
bidder”. To meet this standard, a corporate bidder
must be organized under US law and be financially
capable of fulfilling lease obligations. The
principal exception is that the bid does not violate
US competition laws. This is a significant
exception because several companies often submit
joint bids that must be reviewed for potential
antitrust violations. Companies with a daily oil
production of over 1.6 million barrels, or its
equivalent in natural gas, during the preceding six
months are prohibited from participating in joint
bidding arrangements.
US offshore leases and most other leases
granted by government units have the same basic
format and structure as private leases. US leases on
federal and Native American lands are standard
forms that contain statutorily-required provisions.
The length of the primary term is set by statute or
regulation, but in some instances may be varied to
take into account special conditions. For example,
US federal regulations provide that leases shall
have a primary term of five years, but authorize
primary terms of up to ten years for offshore leases
in deep water or where there are other adverse
conditions. If drilling operations are commenced
during the primary term on an onshore lease and
are being diligently continued at the end of the
primary term, the primary term is extended for two
additional years. The lease continues into a
secondary term that is typically for as long as oil or
gas is produced in paying quantities, or for as long
27 C.A.P.L. 99 Alberta Petroleum and Natural Gas Lease
and Grant, para. 4(a).
28 C.A.P.L. 99 Alberta Petroleum and Natural Gas Lease
and Grant, para. 4(e).
29 C.A.P.L. 99 Alberta Petroleum and Natural Gas Lease
and Grant, para. 4(a).
30 For a fuller description of the statutory and regulatory
scheme governing US offshore and onshore leasing, see
Lowe et al., 2002.
31 43 USC. paras. 1331-1356.
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
as approved drilling or reworking operations are
being conducted.
There are important differences between private
leases and leases on resources on lands owned by
the US and Canadian federal Governments, states
and Provinces. Under these leases the operator
usually agrees to be bound by existing regulations
and those that may be subsequently promulgated.
The agreements also require that E&D be
conducted in accordance with a plan that has been
approved by a specified agency, such as the US
Bureau of Land Management (BLM), which is an
agency within the Department of the Interior.
Federal and some state and provincial leases can be
cancelled if the lessee violates any important lease
provision or relevant laws and regulations. The
leases also often provide for suspension of
production. On offshore US leases, production can
be suspended, either by the MMS or at the request
of the lessee, for a wide variety of reasons. These
include the need to construct production or
transport facilities, to enter into sales contracts, to
comply with environmental regulations, to install
safety equipment and to obtain necessary
government permits. Because of the extensive
suspension provisions and their approximate
equivalents in Canadian governmental leases and
licences, the savings clauses that play an important
role in private leases are not usually found in
federal leases.
Other differences between private and
governmental leases can be found in the
provisions of the Canadian federal government’s
accords with Newfoundland32 and Nova Scotia33
and of the Canada Oil and Gas Operations Act
1985.34 The Operations Act is the federal
legislation regulating oil and gas exploration on
federal onshore property as well as some offshore
federal resources. These legislative enactments
provide for three levels of permits: an exploration
licence, a significant discovery licence, and a
production licence. Like their US counterparts,
they generally require that operations be
conducted in accordance with an approved plan.
Where the activities take place in the areas
offshore of the coastal Provinces, the operations
are monitored by oversight boards composed of
federal and provincial civil servants.
The types of financial benefits paid in
connection with state, provincial and US and
Canadian federal leases are similar to those in
private leases, but often include additional sums,
such as application fees and bidding fees.
Governmental leases commonly include special
provisions dealing with valuation of production for
624
the purposes of computing royalty. One especially
significant provision in US federal and Native
American leases is the express authority given to
the MMS to issue regulations establishing the
value of oil and gas production for the purpose of
calculating royalty payments. The basic concept is
embodied in the express lease provision that the
value “shall not be deemed to be less than the
gross proceeds accruing to the Lessee from the sale
thereof ”. The term gross proceeds means the total
consideration received by the lessee, including
such things as reimbursements by the purchaser for
state or taxes and other expenses paid or incurred
by the lessee. A related requirement is the lessee’s
obligation to pay royalty on a finished marketable
product, without deducting any processing
expenses. There are regulatory exceptions for the
cost of transporting production for sale to a distant
point and for some processing expenses of gas
containing heavy hydrocarbons, such as ethane and
propane. The gross proceeds method of valuation
is used when the sale is an arm’s-length transaction
between the lessee and a non-affiliated entity. If
the purchaser is an affiliated company, the MMS
may look to the affiliate’s resale price as the
amount used for calculating royalty.
Similar to leases on US privately owned land,
US federal leases and many state leases authorize
the Government to take royalty in kind. Federal
statute provides that if this option is exercised, the
Department of the Interior may either sell the
production through a competitive bidding process,
keep the production either for use by such agencies
as the Department of Defense or storage in the
Strategic Petroleum Reserve (SPR), or sell it to
small refineries that lack access to adequate crude
oil supplies. The Government can also require the
lessee to sell up to 20% of the total crude oil,
condensate, and natural gas liquids to small or
independent refiners at market value.
By statute, in the US, revenue from federal
onshore leases is shared with the state where the
lease is located. The revenue generated by offshore
Canadian federal licences is also shared by the
provincial and federal Government in accordance
with a legislative scheme. With some exceptions,
there is generally no revenue sharing between the
federal and state Governments for US federal
offshore leases.
32 Canada-Newfoundland Atlantic Accord
Implementation Act S.C. 1987 c. 3.
33 Canada-Nova Scotia Offshore Petroleum Resources
Act S.C. 1988 c. 28.
34 R.S.C. 1985 c. O-7.
ENCYCLOPAEDIA OF HYDROCARBONS

Nature of interest created
There is no unanimity of agreement with
respect to the legal character of oil and gas leases
in the US and Canada. Leases granted by the US
federal Government are viewed as binding
contracts. If the lessee breaches its agreement by
failing to pay or calculate royalties correctly, the
US has an action in damages. The Government can
terminate the lease only for reasons specified in
the agreement. If the Government wrongfully
cancels the lease or breaches a contractual promise
to follow certain stipulated procedures, the lessee
can treat the agreement as having been repudiated
and recover its initial bonus payment.35 Leases
granted by federal and provincial Governments of
Canada may be viewed as having more of the
characteristics of licences. Indeed, some provincial
leases contain explicit language stating that the
lessee must abide by new statutory or regulatory
requirements promulgated after the agreement is
entered into.
The nature of private and state-granted leases in
the US is determined by the laws of individual
states where the land is located, and these laws
vary significantly (Walker, 1929; Anderson et al.,
2004). A few states treat the oil and gas lease as a
lease of the land for mining purposes, as distinct
from a lease of the land for residential, agricultural
or other business purposes. As such, it may be
subject to special regulatory requirements, but is
otherwise governed by the same rules of law that
apply generally to landlord-tenant agreements. A
different position is taken by states, such as Texas,
that view the oil and gas lease as conveying full
title to the underlying oil and gas that lasts for the
duration stated in the instrument.36
A third and somewhat more widely held
position is that the oil and gas lease does not
transfer any interest in the underlying oil and gas
to the lessee. Instead, the oil and gas lessee
receives an irrevocable right to go on the land to
search for and produce oil and gas. In common
law, this type of interest is called a profit à
prendre. The right is irrevocable and the grantor
cannot interfere with its exercise by the grantee.
The grantee, however, acquires no interest in the
oil or gas until they are actually produced. One
common rationale for this position is the rule of
capture. Since oil and gas may be drained from
their original location and produced by some
other landowner, they cannot be susceptible to
ownership while still in the ground. This is the
position taken by the Courts in Oklahoma and
California as well as several other states. It is also
the position taken in Canada, where private oil
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UNITED STATES OF AMERICA AND CANADA
and gas leases are also categorized as profit
à prendre.37
Under all of these disparate legal categorizations,
an oil and gas lease is viewed as the transferring
of an interest in land and so must be executed in
accordance with all of the formalities required
for such transfers. In Canada, for example, an oil and
gas lease must be executed under seal.
12.1.5 Investment protection
Constitutional and contract law protection
in the US
The US and Canada differ in the level of
protection afforded to investments in
hydrocarbons.
The Fifth Amendment to the US Constitution,
which is binding on the states as well as the federal
Government, provides that private property may
not be taken for public use without due process of
law and payment of just compensation.
The Due Process Clause, as this constitutional
provision is called, applies in two types of
situations. The first is where the Government
directly expropriates land for its own use. This
most commonly occurs where the federal
government, a state or local Government acquires
land for a road, school or other public use and is
unable to reach an agreement with the owner over
the value of the land. In this situation, the
condemning governmental agency is required to
pay the fair market value of the property. This
value is typically determined by a board of
appraisers. If either the landowner or the
government disagrees with the appraised value, the
decision can be appealed to the courts. It is,
however, generally upheld, unless there is clear
evidence that the appraisers reached an arbitrary
result as to its value.
Interests in oil and gas reserves have rarely
been acquired by the Government in this manner.
The few exceptions that have occurred were either
when the land was needed for some other,
non-petroleum-related purposes or in time of war.
In such instances the governmental body acquiring
the property was required to pay fair value.
35 See, e.g. Mobil Oil Exploration & Producing
Southeast, Inc. v. United States (2000) Supreme Court of
the United States 530 US 604.
36 Cherokee Water Co. v. Forderhause (1982) Supreme
Court of Texas 641 S.W. 2d 522.
37 Berkheiser v. Berkheiser (1957) Supreme Court of
Canada 7 D.L.R. (2d) 721 s. 12.
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
The second situation to which the Fifth
Amendment applies is referred to as a regulatory
taking. A regulatory taking occurs when federal or
state governmental regulations require property to
be used for public purposes, or when the property
is deprived of so much of its value that the
regulatory regime can be deemed tantamount to an
actual appropriation of the property. The earliest
judicial decision38 concerning the doctrine
involved land in which ownership of the minerals
had been severed from surface ownership. A coal
company executed a deed that granted the surface
but reserved the right to remove all coal beneath
the land, and also provided that the grantee
assumed the risk of surface subsidence and waived
any claims for damages as the result of such
subsidence. A subsequently enacted statute
required the company to leave enough coal in place
to provide support for the surface. The US
Supreme Court held that the statute was
unconstitutional because it violated the protection
of property rights guaranteed by the Fifth
Amendment.
Later decisions have established more
specific criteria for regulatory takings under the
Fifth Amendment. Physical appropriation or
occupation of the property by the Government
constitutes a categorical taking of property.39 A
regulation that deprives property of all value is
also a categorical taking of property.40 Under
this doctrine, a municipal ordinance that
prohibited all oil and gas development within
the city and so deprived a severed mineral
interest of all its value would be presumptively
unconstitutional. Such an ordinance would
either be ruled invalid or the Municipality would
be required to pay the fair market value of the
severed mineral interest.
In less extreme cases, determination of a
regulatory taking depends upon a consideration of
three factors: the economic impact of the
regulation; the extent to which the governmental
action approximates a physical occupation of the
property; and the extent to which the
governmental action interferes with “distinct,
investment-backed expectations”.41 The final
factor, especially if coupled with a showing of a
sharp decline in value, provides significant
constitutional protection for companies or
individuals investing in hydrocarbon resources. It
should be noted, however, that the doctrine of
regulatory taking has never been successfully
invoked against sharp increases in taxes on profits
from mineral development. The principal example
of such a tax in the US was the windfall profits
626
tax enacted on oil company profits during the late
1970s. Although the US Supreme Court has stated
on at least one occasion that it might invalidate a
confiscatory tax, it has never found a tax to be so
high as to be confiscatory.
In addition to constitutional protections,
investments in oil and gas receive significant
protection through the application of traditional
Anglo-American contract law. US Supreme Court
decisions have established that contracts between
the US Government and private persons, including
corporations, are governed generally by the same
law that applies to agreements between private
persons. The court applied that principal in Mobile
Oil Exploration & Producing Southeast, Inc. v.
United States (2000),42 where it held that the
Government had wrongfully repudiated an oil and
gas lease by refusing to approve an exploration
plan.
Investment protection in Canada
From a legal standpoint, protection of
investments in hydrocarbons is less assured in
Canada than in the US: Canada has no
constitutional equivalent of the takings clause of
the US Constitution. Although its 1982
Constitution contains a Charter of Rights and
Freedoms, there is no clause in the Charter
guaranteeing the enjoyment or protection of private
property. The Canadian Bill of Rights 1960,43
which does include “the right of the individual to
life, liberty, security of the person and enjoyment
of property and the right not to be deprived thereof
except by due process of law”, is statutory, rather
than constitutional, and applies only to the federal
Government.
The Bill of Rights does not purport to bind the
Provinces. In some instances Provinces have
modified oil and gas leases on provincial lands by
legislation enacted after the agreements took
effect. Some provincial leases expressly provide
that the lessee must comply with provincial
38 Pennsylvania Coal Co. v. Mahon (1922) Supreme
Court of the United States 260 US 393.
39 Loretto v. Teleprompter Manhattan CATV Corp.
(1982) Supreme Court of the United States 458 US 419.
40 Lucas v. South Carolina Coastal Council (1992)
Supreme Court of the United States 505 US 1003.
41 Penn Central Transportation Co. v. City of New York
(1978) Supreme Court of the United States 438 US 104.
42 Mobile Oil Exploration & Producing Southeast, Inc.
v. United States (2000) Supreme Court of the United States
530 US 604. See also United States v. Winstar Corp. (1996)
Supreme Court of the United States 518 US 839.
43 Canadian Bill of Rights S.C. 1960 c. 44; R.S.C. 1985.
ENCYCLOPAEDIA OF HYDROCARBONS

enactments, presumably including subsequent
legislation that modifies contractual provisions.
Other provincial leases contain clauses expressly
permitting the Province to change the royalty by
legislative enactments.
There is, moreover, some question about the
level of protection afforded property by the Bill of
Rights at the federal level. At least one Canadian
Court has held that protection of property, as
provided in the Bill of Rights, refers only to
procedural and not to substantive protection. In R.
v. Bryan (1999)44 the Manitoba Court of Appeals
rejected an argument by a wheat farmer that the
federal law prohibiting him from exporting wheat
without an export permit violated the Bill of Rights
because it deprived him of property without due
process of law. That Court concluded that since the
Parliament had observed proper procedures in
passing the statute and the statute was not ultra
vires, there could be no violation of the Bill of
Rights.
In enacting such legislation, “Parliament can
interfere with the right of the individual to
enjoyment of property”.45 The statement that
Parliamentary enactment of a statute automatically
satisfies the due process requirement of the Bill of
Rights has been criticized by at least one other
Court as not in accordance with prior cases.46
The absence of express constitutional
protection of property, the judicial disagreements
over the scope of the protection offered by the Bill
of Rights, and the apparent legal right of Provinces
to change contractual terms of leases on provincial
land through subsequent legislation lead to the
conclusion that the legal protection of investment
in oil and gas reserves in Canada is lower than that
given to equivalent investments in the US.
12.1.6 Fiscal and currency
regulation
US taxation
US and Canadian fiscal policies have
traditionally encouraged investment in oil and gas
resources. Tax codes are a principal mechanism
used to effectuate this policy.
The basic scheme of taxation in the US is as
follows: private individuals, including both citizens
and resident aliens, are subject to graduated tax
rates on income that, in some instances, can exceed
40%. Unless there is a tax treaty to the contrary, a
foreigner’s US source income is taxed at a rate of
30%, and this amount must be withheld from the
recipient’s income and paid to the US Internal
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UNITED STATES OF AMERICA AND CANADA
Revenue Service (IRS). Corporate net income is
taxed at graduated rates of up to 35%.
Foreign corporations with income that is
effectively connected with a US trade or business
are also subject to this tax and subject to
essentially the same regulations governing
computation and reporting of income as domestic
corporations. Corporate profits that are distributed
as dividends are viewed as income to the individual
shareholder receiving them, and taxed a second
time.
Within this general scheme of taxation there are
several doctrines designed to encourage oil and gas
exploration, development and investment by
providing tax benefits not available to other
industries (Anderson et al., 2004). Three
provisions are of particular importance.
Deductible intangible drilling costs
The first is the option given to taxpayers to
deduct intangible drilling costs from income in the
year in which they are paid or incurred. Such
intangible costs do not include payments for
tangible materials that have some salvage value,
such as drilling tools, pipe, casing, and machinery.
They do include payments to drilling and other
service contractors, transport and labour costs,
expenses connected with constructing derricks,
cost of drilling from floating rigs and payments
made in connection with designing, constructing,
transporting and installing drilling platforms.
These expenses typically represent between 25%
and 40% of well-drilling costs. If the same tax
rules applied to oil and gas apply to other forms of
investment, such intangible costs would have to be
treated as capital expenses and amortized over the
projected life of the investment, which in this case
is the well. The special treatment given drilling
costs has been described as “an energy policy
incentive to encourage capital investment in the
development of oil and gas properties by providing
for an immediate deduction that effectively
reduces[s] the after-tax cost” of many oil and gas
investments (Anderson et al., 2004).
Depletion allowance
A second tax provision is the depletion
allowance, which permits small producers and
44 R. v. Bryan (1999) Manitoba Ct. App. 170 D.L.R. (4th)
487.
45 The Court cites W.S. Tarnopolsky, The Canadian Bill
of Rights, McClelland & Stewart, Toronto, 1975.
46 Authorson v. Canada (2002) Ontario Ct. App. 215
D.L.R. (4th) 496.
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
royalty owners to deduct from the taxpayer’s gross
income 15% of the taxpayer’s income from
production. The significance of the depletion
allowance is that, unlike traditional methods of
depreciation, it is not tied to or limited by the
taxpayer’s capital investment in the property. The
taxpayer can continue to take a depletion allowance
even after the taxpayer has recovered his entire
investment. In all other industries, the depreciation
or amortization that a taxpayer is permitted to take
in connection with a wasting asset is tied to, and
limited by, the taxpayer’s investment and
terminates when that investment has been
recovered through depreciation. The depletion
allowance creates a significant incentive for
individuals to invest in oil and gas properties in
preference to investments that are otherwise
equally attractive.
The pool of capital doctrine
The third tax regulation of special importance
in promoting investment in oil and gas E&D is the
pool of capital doctrine. Under this doctrine the
IRS treats an investor who contributes equipment
and services for E&D, in exchange for an interest
in the minerals, as establishing a pool of capital for
the oil and gas enterprise. In all other industries or
businesses, such a contribution of capital in
exchange for an interest in the business would be a
taxable transaction for both parties. The investor
would be treated as having sold the equipment or
services for an amount equaling the value of the
interest in the business venture, and the transferor
of that interest would be deemed to have sold the
interest for the value of the equipment or services.
Taxation in Canada
Canadian tax provisions applicable to oil and
gas production contain several provisions that are
analogous to those employed by US tax code. For
example, 100% of exploration expenses, including
intangible costs incurred to determine the
“existence, location, extent or quality” of an oil or
gas reservoir, are deductible as expenses. Others
are less favorable: 30% of intangible drilling
expenses related to development can be deducted
on a declining balance basis, compared with 100%
deductibility in the year they were incurred in the
US.
On the other hand, the basic corporate tax rate
is lower than that of the US. In 2003 the
Government proposed a series of tax reforms to
make investment in the oil and gas sector more
competitive with those of the US, including a
reduction in the corporate tax rate applicable to
628
income from resource extraction from 28% to 21%
over a five year period.
The US currency regulations of potential
significance to oil and gas companies and private
investors are the reporting requirements for
transfers of currency. Banks and other financial
institutions are required to file reports on all
deposits, withdrawals, and exchanges of currency
of more than $10,000. Several transactions for less
than $10,000 each, but totaling more than that
amount, are also subject to the reporting
requirements if they take place within a specified
time period. These requirements were instituted
because of concern that US banks were being used
to conceal illegally obtained funds or income that
was not being reported to the IRS.
Regulations also require reporting of any
transport of domestic or foreign currency in excess
of $10,000 into or out of the country. Violations of
both types of regulations can result in heavy fines
or prison sentences.
12.1.7 Operating conditions
Contractual provisions in the oil
and gas lease in the US
Operating conditions may be imposed by
contractual provisions in the oil and gas lease and
by regulations. In the vast majority of older private
oil and gas leases in the US and Canada no
conditions were expressly imposed.
In the US, Courts and commentators attributed
the absence of such clauses to the impossibility of
determining reservoir conditions in advance of
exploration and discovery (Walker, 1993; Smith
and Weaver, 1998-2005). To fill the resulting gap,
US Courts have implied such covenants as the
parties presumably would have intended, had they
known ab initio the nature of the reservoir, market
conditions, and similar matters. Because
prospective royalties are the principal
consideration for executing an oil and gas lease,
Courts have held that the lessee has an implied
obligation to develop the leased premises with
reasonable diligence once oil or gas is discovered.
The lessee must also protect the premises
against drainage to other portions of the reservoir
and seek a reasonable price for production
obtained from the premises. The standard to
which the lessee is held under these and other
implied duties is that of the reasonable prudent
operator. This standard incorporates the concept
of a profit motive; hence, a lessee is not required
to engage in operations, such as drilling a well to
ENCYCLOPAEDIA OF HYDROCARBONS

prevent drainage, unless there is a reasonable
expectation that the income from the well would
repay the capital costs and yield a reasonable
profit.47 These rather amorphous requirements,
although essential to providing protection to
private lessors, have resulted in extensive
litigation.
Although most private leases still in effect in
the US are subject to the implied covenant
doctrine, more recent leases are likely to contain
express provisions governing the number of wells a
lessee is required to drill, the time period in which
the drilling must be done, the circumstances under
which the premises must be protected against
drainage, and the criteria for determining market
value of production. Under traditional rules of
contract interpretation, an express contractual
provision is deemed to negate any implied terms
dealing with the same subject matter.
Contractual provisions in the oil
and gas lease in Canada
In contrast to US Courts, Courts in Canada
generally construe oil and gas leases in strict
accordance with their express terms and have been
disinclined to imply covenants or other terms in
such instruments. As a leading commentator on
Canadian oil and gas leases has commented, “the
common theme that runs throughout all the
judgments is that of strict attention to the actual
wording of the particular lease itself, and a
determinedly literalistic application of that
language” (Ballem, 1999).
Possibly because of this judicial approach,
Canadian leases usually contain lengthy and
detailed conditions dealing with drainage, such as
the provision in the various CAPL leases setting
out the circumstances under which the lessee must
protect the premises from drainage. It details the
methods to be used and provides that until the
required action is taken, the lessee must pay a
royalty on production from the draining well
“proportionately equivalent on an acreage basis to
such royalty as would have been payable to the
lessor if the leased substances produced from the
[draining] well were actually being produced from
a well”48 on the leased premises.
There are usually no express conditions in
Canadian leases dealing with other matters that are
dealt with in US leases by implied covenants or,
more recently, by express conditions. These
include: the duty to develop the premises, to
market production with reasonable diligence and at
a reasonable price, and to manage and administer
the leasehold in a proper manner.
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However, a development or exploration
covenant may be unnecessary in most Canadian
leases because of the size of the typical lease in the
western Provinces. Such leases commonly cover
160 acres, which is also the size of most drilling
units in those Provinces (Ballem, 1999). Because
only one well can be drilled on such a lease, the
requirement that the lessee drill in order to
maintain the lease past the primary term may be a
de facto condition of full development. Moreover,
it is at least arguable that most other obligations
implied in US leases are contained in the conduct
of operations clause that requires the lessee to
“conduct all operations in a diligent, careful and
workmanlike manner and in compliance with
regulations [...]”.49
One view of US implied covenant jurisdiction
is that the covenants are merely specific
expressions in commonly occurring situations of
the lessee’s overall duty to conduct operations in a
reasonable and prudent manner, taking into
account the interests of both parties to the
transaction (Weaver, 1981; Lowe et al., 2002). The
express obligation in Canadian leases to conduct
operations in a diligent and workmanlike manner
can reasonably be interpreted to mean much the
same thing.
Federal, state and provincial leases also
contain express contractual provisions dealing
with lease operations. Although leases on state-
owned lands often contain detailed conditions
analogous to the Canadian provisions dealing
with drainage to wells on adjacent lands, US
federal leases typically contain broadly stated
conditions, such as the requirements that the
lessee “shall exercise reasonable diligence in
developing and producing and shall prevent
unnecessary damage to, loss of or waste of leased
resources and shall conduct operations in a
manner that avoids or minimizes adverse
environmental impacts”.50
Similarly general conditions are found in the
Canadian Oil and Gas Operations Act 1985,51
which controls the content of federal leases.
47 For discussions of the nature, effect and classification
of implied covenants, see Anderson et al., 2004; Kuntz,
2004.
48 C.A.P.L. 91 Sask. Petroleum and Natural Gas Lease,
para. 8 (d).
49 C.A.P.L. 99 Alberta Petroleum and Natural Gas Lease
and Grant, para. 8.
50 US Dept. of Interior, Bureau of Land Management
Form 3100-11 (Oct. 1992) Offer to Lease and Lease for Oil
and Gas Sections paras. 4-6.
51 R.S.C. 1985 c. O-7.
629
NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
Operators are required to “produce oil or gas from
a pool or field in accordance with good production
practices to achieve the maximum recovery of oil
or gas”.
The details of the manner in which operations
must be conducted in US and Canadian federal
governments are typically set out by regulations or
specific regulatory agreements between the lessee
and governmental agency, rather than in
contractual language.
Federal leases typically require that E&D be
conducted in accordance with plans that have been
approved by the relevant agency or agencies.
Production may be similarly controlled. The Oil
and Gas Operations Act stipulates that production
must be “at the applicable rate consistent with the
rate specified in the approved development plan
relating to the pool or field”.
Federal regulation
Federal regulation can be illustrated by the
requirements applicable to US federal offshore
leases (Lowe et al., 2002). The operator’s proposed
plan of exploration must contain: a schedule of
proposed exploratory activities; a description of the
equipment to be used; the location of all proposed
exploratory wells; and any other pertinent
information requested by the Department of the
Interior.
As described subsequently, the plan is subject
to the National Environmental Policy Act 1969
(NEPA)52 and therefore to an environmental
assessment that could result in a requirement for an
environmental impact study. The plan is also
subject to the requirement that it be consistent with
the adjacent state’s coastal zone management plan.
The Department of the Interior has thirty days in
which to approve or reject the plan. If the plan is
rejected, the lessee may revise the plan and the
running of the lease term may be suspended during
the revision period.
Somewhat analogous provisions apply to US
Federal Onshore Leases. Before drilling, the lessee
must file an application for permit to drill with the
Bureau of Land Management. The application
must set out the operator’s proposed surface
operations and provide details of the proposed
drilling. If the land is managed by another federal
agency, such as the US Forest Service or Fish and
Wildlife Service, that agency also must review and
approve the drilling proposal. The development
phase of a federal oil and gas lease is subject to
plan-approval requirements similar to those
imposed during the exploratory phase. A lease can
be cancelled or suspended if the lessee violates
630
lease requirements or relevant laws and
regulations.
With some exceptions, federal regulations of oil
and gas drilling and production govern operations
only on land owned or controlled by the respective
federal Governments. The US states and the
Canadian Provinces have primary authority to
regulate the extraction and use of natural resources
within their own territories. Under the US
Constitution, the federal Government has only the
powers delegated to it. These powers do not include
control over the extraction of resources not directly
owned by the federal government.53 Under this
system, the development of all hydrocarbon
resources within a state, other than those owned by
the federal Government or Native American tribes,
is regulated in accordance with the mineral law
regime of that state.
In Canada, the right of each Province to
manage its own natural resources was broadly
suggested by its 1867 Constitution, and later made
specific in section 92A of the 1982 Constitution.
That section provides that each provincial
legislature “may exclusively make laws in relation
to exploration for non-renewable natural resources
in the Province [and the] development,
conservation and management of non-renewable
natural resources [...] including laws in relation to
the rate of primary production”.
In accordance with this constitutional authority,
the US states and Canadian Provinces have
enacted conservation regimes designed to lessen or
eliminate the waste and reservoir depletion that can
occur as a result of the rule of capture. Under that
doctrine, persons owning land over a common
reservoir have a strong economic incentive to drill
as many wells as possible near their property lines
and to produce the wells as rapidly as possible
because each operator will own all of the oil or gas
produced, including that drained from
neighbouring land. Such competitive drilling and
production not only results in excessive and
uneconomic capital investments in the reservoir,
but also in the excessively-rapid depletion of
reserves and reservoir pressure, with the end result
that hydrocarbons that might have otherwise been
produced are left in the ground.
52 42 USC. paras. 4321-4335.
53 See, e.g. Cities Service Gas Co. v. Peerless Oil & Gas
Co. (1950) Supreme Court of the United States 340 US 179;
Thompson v. Consolidated Gas Utilities Corp. (1937)
Supreme Court of the United States 300 US 55; United
States v. DeWitt (1869) Supreme Court of the United
States 76 US 41; 19 L.Ed. 593 (US 1869).
ENCYCLOPAEDIA OF HYDROCARBONS

These practices also negatively impact the
environment. US state Legislatures and Canadian
provincial Governments have attempted to remedy
these problems by authorizing state and provincial
oil and gas conservation agencies to promulgate
drilling, well density and well production
regulations that must be followed in order to secure
a permit to drill and operate a well.
The oil and gas producing US states and
Canadian Provinces do not have identical
procedures for issuing permits and regulating well
production. Moreover, statutes in the Provinces
where oil and gas ownership has been vested
entirely in the provincial Government provide for
slightly different procedures for issuing permits
than in the Provinces where private ownership is
recognized. However, the regulatory processes that
are concerned with the conservation of oil and gas
resources are similar, and in any event, the overall
procedures are similar enough that the regulations
in Alberta, which is the major oil and gas
producing Province, can be looked to as illustrative
of the regulations both in the Canadian Provinces
and the US states.
Alberta’s regulatory regime
Alberta’s regulatory regime is based on the
Province’s Oil and Gas Conservation Act 2000.54
The stated purposes of the legislation include: a)
preventing waste of the Province’s oil and gas
resources; b) providing for the efficient
development of such resources; c) providing that
each owner of rights in oil and gas in situ has the
opportunity to produce his share of oil and gas; and
d ) controlling pollution. The Act designates the
Alberta Energy Resources Conservation Board (the
Conservation Board) as the principal regulatory
agency and gives it jurisdiction over all wells
within the Province that are intended to produce oil
and gas or are associated with oil and gas
production or processing. An operator must obtain
a licence from the Conservation Board before
making preparations to drill, conducting drilling
operations, producing oil or gas or undertaking
injection operations. The licence specifies the
well’s location and the well must be drilled at the
designated site.
The Conservation Board is authorized: a) to
require operators to provide deposits or other
forms of security to guarantee the proper and safe
suspension, abandonment and reclamation of
wells; b) prohibit drilling with specified distances
of roads, buildings and other private and public
facilities; c) establish well spacing units; d )
prescribe measures to be taken before and during
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UNITED STATES OF AMERICA AND CANADA
drilling to conserve any gas, oil or water
encountered cases; and e) establish well production
allowables, maximum production rates, and
penalties and remedies for overproduction.
Like the conservation statutes of virtually all oil
and gas producing states and Provinces, the
Alberta Conservation Act addresses the problem
of fragmented mineral ownership. It gives the
Conservation Board authority to require lessees to
pool leases to form a standard-sized drilling and
production unit. This power is exercised when
mineral rights beneath several small tracts are
owned or leased by different persons. The act
allows an oil and gas lessee of a tract within a
spacing unit to petition the board to force-pool the
other lessees or mineral owners within the unit.55
The applicant for the forced-pooling order must
show that an agreement with the other mineral
owners “cannot be made on reasonable terms”.56
This latter requirement is similar to that of the
Texas Mineral Interest Pooling Act 1977,57 which
requires the applicant to show that it made a “fair
and reasonable” offer for voluntary pooling, which
was rejected. In most US states, however, such a
showing is not necessary.
Whereas US statutes typically allow the state
conservation agency to compel several tracts to be
pooled into a single, standard-sized drilling unit, they
rely upon voluntary agreement to achieve unitization,
whereby all or virtually all of a reservoir is developed
by a single operator. Typical state statutes require a
voluntary agreement to a unitization plan by the
owners of 75% of the interests in the reservoir before
the state agency can force the non-consenting owners
into unitized operations. Forced unitization under
such statutes is limited to plans for enhanced
recovery and pressure maintenance operations. It is
not available for primary recover operations
(Anderson and Smith, 1999; Kuntz, 2004).
Although federal lands are not subject to state
pooling and unitization laws,58 the Department of
the Interior can require both onshore and offshore
lessees to engage in unitized operations.
Unitization of federal lands is not limited to
enhanced recovery operations, but can also be
required for the primary recovery stage and for
exploration. Exploratory units include all federal
leases overlying a common reservoir, whose limits
54 R.S.A. 2000 c. O-6.
55 R.S.A. 2000 c. 0-6 subs. 80(1).
56 R.S.A. 2000 c. 0-6 para. 80(2)(c).
57 Tex. Nat. Res. Code Ann. paras. 102.001-102.112.
58 Kuntz (2004), para. 70.3, suggests that there may be
minor exceptions to this rule.
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
are determined on the basis of inferences from
geological and geophysical information.
Exploratory wells must be drilled at specified
intervals, and the unit is normally dissolved if oil
or gas is not discovered within five years; if there
is a discovery, those parts of the unitized area
‘reasonably proven to be productive of unitized
substances’ share in the production.
12.1.8 Environmental issues
Environmental regulations:
lack of a single statutory regime
Most oil and gas leases on government lands
contain general contractual requirements that
stipulate that operations be conducted in a manner
that are environmentally sound. US leases on
onshore federal lands provide an example. These
leases require the lessee to minimize the
environmental impact of its operations and provide
that the Department of the Interior can prescribe
necessary measures to assure compliance with this
contractual requirement, including “modification
to siting or design of facilities, timing of
operations, and specifications of interim and final
reclamation measures”. In most instances,
however, the specific details of environmental
protection are established by statute or regulation.
Neither the US nor Canada has a single
statutory regime that is applicable to oil and gas
production. With a few exceptions, such as the US
Oil Pollution Act 199059 and the state well
plugging statutes, most environmental legislation
applies broadly to all industries and, in some
instances, to all persons. Many states and
Provinces have legislation covering the same
subjects as the federal statutes, and the state and
provincial statutes may have broader coverage and
impose more stringent requirements than federal
statutes. The result is an overlapping system of
requirements and enforcement of environmental
regulations by a confusingly large number of
federal, state and provincial agencies.
The most frequently encountered
environmental regulations are those requiring
initial environmental assessments of proposed
activities, prohibiting operations that may pollute
protected waters or waterways, protecting specified
forms of wildlife, and mandating abandonment and
reclamation procedures.
Enviromental assesments
The basic purpose of environmental assessment
requirements is to alert the decision-maker to the
632
potential impact of proposed operations upon the
human and natural environment and to provide
them with alternatives to consider that may have
less serious deleterious effects. In the US, the
NEPA 196960 requires an assessment of the
environmental impact of a proposed activity only
when a federal agency or federal lands are involved
and the actions may have a significant effect on the
environment. Oil and gas companies are subject to
NEPA requirements when undertaking operations
on federal lands or offshore areas subject to federal
control. A federal agency must undertake an initial
study of the potential environmental impact of
decisions: a) to offer oil and gas leases on public
lands of offshore areas; b) to approve drilling plans
on leased lands; c) to consent to major revisions of
such plans; and d ) similar matters. A company that
has a lease on federal land, is seeking such a lease,
applying for a drilling permit, or is otherwise
planning a project that needs federal agency
approval is necessarily closely involved with this
study.
The study typically results in an initial
document called an Environmental Assessment
(EA). Based upon the EA, the agency may
determine that the proposed action has no
significant impact on the environment and that no
additional studies are needed. Alternatively, the
agency may conclude that the potential effect of
the proposed action is great enough that a further,
more detailed study is required. Such a study leads
to the formulation of an Environmental Impact
Statement (EIS). This document, which is
generally prepared after a series of public hearings
and comments by scientists, agency staff, the
affected company, interest groups, environmental
organizations, and the public, contains a detailed
statement of the positive and negative
environmental and economic effects of the
proposal, the possible alternatives, and a suggested
course of action. Although NEPA requires strict
adherence to this procedure, the statute has no
substantive force. If an agency complies with the
requisite process, it can choose any of the
alternative courses of action, even if the alternative
chosen has strongly negative environmental
consequences. However, this is rarely done.
Private persons and states are not subject to
NEPA when authorizing development of their own
lands, unless there is some significant level of
federal agency involvement. A few states have,
59 33 USC. paras. 2701-2761.
60 42 USC. paras. 4321-4335.
ENCYCLOPAEDIA OF HYDROCARBONS

however, enacted statues modelled after NEPA. In
these states the state environmental assessment
requirement may apply to oil and gas development
of private and state lands.
Environmental assessments may also be
required for oil and gas operations in Canada.
Provincial statutes, such as Alberta’s
Environmental Protection and Enhancement Act
1992,61 often provide for two levels of
environmental assessment that are analogous to the
EA and EIS requirements of NEPA.
Operations on Canadian offshore areas are
subject to environmental assessments by both the
federal Government and the Governments of the
coastal Provinces. The federal environmental
assessment is carried out under the provisions of
Canadian Environmental Assessment Act, and the
provincial programmes are carried out under the
specific statutes or accords of British Columbia,
Newfoundland and Nova Scotia. Both the federal
and provincial legal regimes require an assessment
of potential adverse environmental impacts of
offshore operations, an examination of possible
alternatives to the proposals, and a consideration of
measures that will mitigate the negative
environmental effects of the proposed operations.
Since the federal and provincial programmes are
administered separately, some attempts have been
made to eliminate redundancies within the dual
system.
Protection of water and waterways
A principal focus of the environmental regimes
of Canada, the US and their constituent units is the
protection of oceans, waterways and underground
water sources from pollution.
In the US, virtually all operations that may
result in waterway and underground water
contamination are subject to complex permitting
requirements under a variety of statutes and by
different governmental agencies at both the federal
and state level. One of the most important of these
statutes is the Clean Water Act 1948 (CWA),62 a
broad-reaching statute that applies to almost all
levels of oil and gas activities, including selection
of sites for drilling, road building and erecting
structures necessary to support drilling, production
and storage operations.
The provision that is primarily relevant to site
selection is the section limiting operations in
wetlands (Hanson and Feldman, 1992; Pierce,
1999). The regulations promulgated under this
section apply to all land, regardless of ownership or
the involvement of federal agencies. The purpose
of this regulatory regime is to reduce pollution of
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the country’s waterways. Wetlands adjacent to open
water filter and purify water flowing across them;
further, by slowing surface run-off after heavy
rains, they prevent flooding and erosion.63
The CWA, and regulations issued under it,
prohibit dredging or filling navigable waters of the
US without a permit from the Corps of Engineers.
The term navigable waters is defined quite broadly
to include all waters of the United States: any
source of surface water that could affect interstate
commerce in such waters and wetlands adjacent to
such water sources or their tributaries.
Wetlands, in turn, are defined as including
“those areas that are inundated or saturated by
surface or ground water at a frequency and
duration sufficient to support […] the prevalence
of vegetation typically adapted for life in saturated
soil conditions”.64 Under this definition wetlands
include not only swamps and marshes, but also
low-lying areas that are merely moist and are
characterized by moisture-dependent vegetation. A
company proposing to raise the level of any such
low-lying area in order to construct a drill site,
build a road, put up a storage facility or erect other
infrastructure must determine whether the area
falls within the regulatory definition of wetlands. If
it does, the company must obtain a permit in order
to carry out its project. Usually the applicant must
show that no site other than the wetland can be
used for its purpose and that it has planned its
operations in such a way as to minimize their
impact upon the area. The company may then
receive what is known as a section 404 permit.
Issuance of the permit may be conditioned on
mitigation. The form of required mitigation varies
with the circumstances. The company may be
required to formulate a mitigation plan that
involves either creating new wetlands or restoring
an existing, degraded wetland.
An alternative method of mitigation is the
purchase of mitigation credits. Private businesses
have created or restored wetlands in order to sell
mitigation credits to companies that are required to
mitigate in order to get a section 404 permit. This
option, if acceptable to the permitting agency, has
the advantage of relieving the companies of long-
term maintenance commitments since the work is
done by the business entity that is selling the
mitigation credits. There is a similar advantage to
61
S.A. 1992 c. E-12.
62 33 USC. paras. 1251-1387.
63 United States v. Riverside Bayview Homes (1985)
Supreme Court of the United States 474 US 121.
64 33 CFR para. 328(3)(b).
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
another method of mitigation, which is to make
payments to a recognized environmental
organization, such as the Nature Conservancy, that
has an established programme for acquiring and
preserving natural areas, including wetlands. The
payment is made in lieu of constructing or
restoring a wetland. Determining which of the
various options is acceptable and the requisite size
of any mitigation effort of payment is done through
consultation with the permitting agency.
Even if the company’s operations are not within
a wetland, it may be subject to regulations and
permitting requirements designed to prevent or
control the contamination of surface water run-off
from rains or snow melt. The permit will be
required if construction activities involve clearing
and grading a large area, as is usually the case with
erecting a drill site and the road to the drill site; or
if its exploration, production, processing or
transport facilities may result in surface water run-
off coming in contact with materials or waste
products on the site.
Extensive regulations also govern the
discharge of potentially contaminating substances
used or generated by drilling operations. These
regulations also apply to water that is produced
along with oil and gas. Because of its volume,
produced water is usually the most significant
substance that an operator must dispose of.
Produced water is frequently highly saline. It, and
other waste oilfield fluids, have traditionally been
temporarily disposed of in pits. This practice has
declined as a result of federal regulations. Where
still used, such saltwater pits are regulated by State
agencies that require a permit and a showing that
the bottom of the pit has an impervious cover
(Smith and Weaver, 1998-2005). Disposal of
oilfield fluids into waterways is subject to the
provisions of the Clean Water Act. It requires a
permit before any pollutants can be discharged
into US surface waterways, their tributaries, and
connected wetlands. The permit imposes specific
limits on the quantity and rate of discharge and on
the permissible concentrations of chemical and
biological contaminants. These restrictions, which
are established by the Environmental Protection
Agency (EPA), differ according to specific
categories of activities.
Because of the limitations imposed upon the
use of saltwater pits and the discharge of
contaminants into waterways, most produced water
is injected underground. These injections are
governed by the terms of the Safe Drinking Water
Act 1974 (SDWA),65 which applies to the
underground injection of virtually all substances,
634
except natural gas injected for storage purposes.
The Act covers injection wells used for enhanced
recovery operations, such as water flooding, as
well as injection wells used for disposing of waste
drilling and production fluids. Injections that may
endanger drinking water sources are prohibited.
Other injections require permits. The EPA has
established the standards for water quality and
injection control, but the appropriate
environmental agency of the state where the fluids
are to be injected is authorized to issue injection
permits. The state’s quality and injection control
requirements must be the same or higher than
those established by the EPA.
Disposal of oilfield wastes offshore is subject
to the Marine Protection, Research and Sanctuaries
Act 1972,66 which prohibits using ocean waters for
the disposal of industrial wastes, including wastes
from refineries and processing plants, unless a
permit has been obtained from the EPA. In
deciding whether to issue a permit, the federal
agency must consider factors such as the
environmental effects, alternative means of
disposal of the wastes, and whether the disposal
will “unreasonably degrade or endanger human
health, welfare or amenities, or the marine
environment, ecological system, or economic
potentialities” (Conine, 1991).
Actual or potential pollution of water and land
from oil spills is dealt with under the Clean Water
Act 1948 and the Oil Pollution Act 1990. Oil spills
must be reported immediately to the National
Response Center by the owner or operator of the
vessel or facility responsible for the spill. The
company responsible for the spill is liable for
clean-up costs and for damages resulting from
injury to natural resources, property and
livelihood.
Liability may also be imposed by private
persons for the loss of profits and by governmental
entities for the increased cost of public services
and for the loss of tax and other revenues. Because
prevention and remediation of oil spills are major
statutory goals, facilities and vessels that might
discharge oil in harmful quantities are required to
have a specific plan to prevent spills and a plan for
responding in the event of a spill. Several states
also have legislation dealing with oil spill
prevention and liability.67
65
42 USC. paras. 300f-300j.
66 33 USC. paras. 1401-1445.
67 See, e.g. Alaska Stat. paras. 46.03.740-46.03.850;
Tex. Nat. Res. Code Ann. paras. 40.001-40.053; Smith and
Weaver, 1998-2005.
ENCYCLOPAEDIA OF HYDROCARBONS

Protection of wildlife
Canada and the US have extensive statutory
and regulatory provisions designed to protect
certain wildlife species. From the standpoint of oil
and gas operations, four of the most important are
the Endangered Species Act 1973 (ESA),68 the
Migratory Bird Treaty Act 1917,69 the Species At
Risk Act 2002 (SARA)70 and the Migratory Birds
Convention Act 1994.71 The first two are US
provisions, and the latter two are Canadian. It
should be noted, however, that both countries have
other wildlife-protective statutes, such as the US
Marine Mammal Protection Act 197272 and the
Canada Wildlife Act 1985,73 that may be relevant
to oil and gas companies in certain situations.
The United States’ ESA is of special
importance to an oil and gas company because the
presence of a protected species may preclude
operations in a certain area and subject the
company to fines and penalties if a species is killed
or harmed. The ESA authorizes the Department of
the Interior, acting through specific agencies under
its jurisdiction, to list species in immediate danger
of extinction i.e. endangered species, and species
that may become endangered i.e. threatened
species.
There are two principal provisions of the ESA74
that provide substantive protection to listed species.
The first is section 7, which applies to all
federal agencies. Any federal agency that plans to
undertake any project or authorize any action that
may further jeopardize the existence of a
threatened or endangered specie must consult with
the Fish and Wildlife Service (FWS), which is the
agency charged with primary responsibility for
administering the ESA.75 During this consultation
period no resources may be committed to any part
of the proposed project that may adversely affect
the threatened or endangered specie. The
consultation period terminates when the FWS
issues its biological opinion. If the FWS concludes
that the project will not jeopardize a listed species,
the project can go forward; otherwise, the project
must be abandoned or conducted in accordance
with one of the alternatives set out in the biological
opinion. Because section 7 is applicable only to
federal agencies, federal public lands, federal
funding or other direct federal participation, this
regulatory process usually applies only to a
company seeking a lease, an exploration permit or
a drilling permit on federal land or the continental
shelf beyond the point of state jurisdiction.
The second principal substantive provision of
the ESA is section 9, which is not limited to
federal agencies or federal land, but applies to all
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persons “subject to the jurisdiction of the United
States”, including corporations proposing to carry
out oil and gas operations on privately owned land.
Section 9 makes it unlawful to take any species of
fish or wildlife listed as endangered, but does not
extend its protection to threatened species or to
endangered plants, other than prohibiting their
trade or sale. The term take is statutorily defined as
meaning “to harass, harm, pursue, hunt, shoot,
wound, kill, trap, capture, or collect, or to attempt
to engage in any such conduct”. Recognizing that
habitat loss is one of the major reasons for
endangerment, the FWS has issued regulations
defining harm as including “significant habitat
modification or degradation where it actually kills
or injures wildlife by significantly impairing
essential behavioral patterns”.76 Because of this
regulation, an oil and gas lessee risks incurring
civil and criminal penalties if it destroys the habitat
of an endangered animal species in order to drill
and install roads, storage facilities or other
infrastructure. Equally likely, the company would
be subject to a preliminary injunction against
clearing the site.
If there is no other feasible site for the proposed
operations, there is a possibility that the company
may be able to obtain a special permit from the
FWS. Section 10(a) of the ESA authorizes a permit
for a taking of an endangered specie if the taking
“is incidental to, and not the purpose of, the
carrying out of an otherwise lawful activity”.
Under this provision, an oil and gas lessee may be
permitted to destroy habitat if the destruction is
merely incidental to a lawful purpose, such as
drilling for oil. Such a permit is not automatically
granted, however, and if granted, a usual condition
is that the applicant mitigate the impact of the
68 16 USC. paras. 1531-1544.
69 16 USC. paras. 703-712.
70 S.C. 2002 c. 29.
71 S.C. 1994 c. 22.
72 16 USC. paras. 1361-1421h.
73 R.S. 1985 c. W-9.
74 The section numbers of the Endangered Species Act
used in the text are those used by judges and lawyers to refer
to the original section numbers prior to codification of the
ESA in volume 16 of the United States Code. As codified,
section 7 is para. 1536, section 9 is para. 1538, and section
10(a) is para. 1539(a).
75 The National Marine Fisheries Service, which is an
agency within the Department of Commerce, has
responsibility for marine species.
76 50 CFR para. 17.3. See Babbitt v. Sweet Home
Chapter of Community for a Greater Oregon (1995)
Supreme Court of the United States 515 US 687 upholding
application of the regulation to logging activities.
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
incidental taking. The applicant may be required to
designate or acquire some other area as protected
habitat for the affected species and provide funds
for the continued maintenance of the designated
area as a proper habitat.77
The potential adverse impact of oil and gas
development on rare, threatened or endangered
species is also an environmental issue in Canada.
The federal Government enacted the Species At
Risk Act 2002 (SARA). The act is administered by
the Minister of Fisheries and Oceans, the Minister
of Canadian Heritage and the Minister of the
Environments, whose responsibilities depend upon
the type of species involved and their location.
SARA establishes a procedure for listing species,
similar to that of the ESA.
Unlike the ESA, with the exception of
migratory fowl and aquatic species, SARA applies
only to listed species on federal lands and relies
primarily on the provincial and territorial
Governments to provide protection for listed
species within their territories. However, it
authorizes the Minister of the Environment to
recommend an extension of the Act’s protections
upon a finding that a Province or territory has not
effectively protected a listed species or its habitat.
The protections afforded by SARA are similar to
those found in the ESA.
Sections 32 and 33 make it an offence to kill,
harm, harass, capture or take a listed species or to
damage or destroy the den, nest or other place that
is habitually occupied during all or part of the
species’ life cycle. SARA also provides for the
identification of the habitat that is critical to a
species’ survival or recovery and authorizes the
relevant minister to formulate regulations
specifying what actions can or cannot be taken
within these areas if they are not otherwise
protected. Destruction of a species’ critical habitat
is an offence under section 58 of the statute. This
protection may be extended to critical habitat on
private or provincial lands if the habitat is not
otherwise protected by stewardship agreements or
provincial laws.
The effect of these environmental protections
upon an oil or gas company’s proposals for
exploration or drilling is analogous to that of the
ESA in the US. The company must consider the
potential impact of its proposed operations on
listed species and the species’ critical habitat and
develop alternatives that will either avoid such
areas or mitigate their impact. In some areas oil
and gas operations will be absolutely prohibited.
In addition to the ESA and SARA, the US and
Canada have statutes implementing the Migratory
636
Bird Treaty Act 1917, which the countries entered
into to provide protection to migrating birds from
excessive hunting pressure. The US statute78
provides that “it shall be unlawful, by any means
or in any manner, to pursue, hunt, take, capture,
kill, attempt to take, capture, or kill […] any
migratory bird”. Federal Courts are divided on the
scope of the Act. In several cases the Courts have
pointed to the original purpose of the underlying
treaty and concluded that the statute applies only
to hunting, trapping and other similar activities
that are intended to harm or exploit birds.79 Oil
companies cannot safely rely on these decisions,
however, for other Courts have ruled differently.80
Oil and gas companies have been prosecuted
under the statute for deaths of migratory fowl that
have been poisoned by oil field wastes or have
become coated with oil and died after landing in
pits filled with oil-field sludge. The FWS, which
is charged with enforcing the statute, imposes
penalties of up to $10,000 per bird and up to six
months in prison for deaths of certain birds. State
agencies also participate in enforcement of the
Migratory Bird Treaty Act by promulgating
standards for open pits and tanks, such as a
requirement that an operator must cover or place
nets over any storage tank or pit that is 8 feet or
greater in diameter.
Although it appears not to have been as broadly
interpreted as the US statute, the Canadian
Migratory Birds Convention Act also imposes
penalties for wrongfully killing migratory fowl. A
1994 revision to the Act, which was originally
passed in 1917, significantly strengthened the
enforcement and penalty provisions.
Well plugging and reclamation issues
All states, Provinces and the federal
Governments require that any well that has been
completed as a dry hole or that has ceased to
produce must be plugged within a specified
period. This period is typically one year, although
extensions may be granted. The plugging must be
done in accordance with detailed regulatory
77
See, e.g. Friends of Endangered Species, Inc. v.
Jantzen (1985) Supreme Court of the United States Ninth
Circuit 760 F.2d 976.
78 Migratory Bird Treaty Act, 16 USC. paras. 703-712.
79 E.g. Mahler v. US Forest Service (1996) United States
District Court S.D. Indiana 927 F.Supp. 1559, 1579.
80 E.g. United States v. Moon Lake Electric Ass’n, Inc.
(1999) United States District Court D. Colorado 45
F.Supp.2d 1070 (holding electric co-op strictly liable for
killing migratory birds that were electrocuted when landing
on its power poles).
ENCYCLOPAEDIA OF HYDROCARBONS

requirements. The purpose of the well plugging
regulations is to prevent environmental and safety
hazards that may arise from escaping gases and to
prevent contamination of underground fresh water
sources from substances that may migrate from
the abandoned well bore through the unplugged
well. Most jurisdictions require an operator to post
a bond or provide some other form of security to
assure compliance with this requirement. In some
jurisdictions a lessee that acquires an oil and gas
lease from a prior operator may be held
responsible for plugging wells on the leased
premises that the earlier operator abandoned or
failed to plug properly (Smith and Weaver, 1998-
2005).
Many, but not all, jurisdictions require that the
well site be reclaimed. Reclamation may be
especially costly if, with respect to hazardous
materials, they are not disposed of in accordance
with statutory and regulatory requirements.
The clean-up responsibilities imposed by the
US Comprehensive Environmental Response,
Compensation and Liability Act 1980
(CERCLA)81 are especially onerous. They are not
limited to hazardous wastes generated by the
operator. The statute authorizes the EPA to order a
wide range of persons to remove hazardous
substances. These persons include not only the
owners and operators of the property at the time
the hazardous substance was disposed of, but also
current and prior owners and operators who knew
of the contaminated condition of the property but
failed to disclose this information when selling the
property.
Enforcement of CERCLA is not limited to the
EPA. The statute also authorizes state
Governments, Native American tribes and private
parties to sue to recover costs that they have
incurred to protect the public health and
environment by removing or taking other remedial
action with respect to the contaminants. CERCLA
contains a petroleum exclusion that specifically
exempts “petroleum, including crude oil or any
fraction thereof ” and “natural gas, natural gas
liquids, liquefied natural gas, or synthetic gas
usable for fuel” from its requirements. However it
does not exempt wastes generated by the drilling or
production processes.
Under this statutory scheme, a company that
acquires an oil and gas lease on a site containing
hazardous wastes may incur enormous liabilities
for cleaning up the site. In one well-known
instance a company that paid $1,800,000 for
property incurred remedial costs of over
$11,000,000.82 In such a situation the purchasing
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UNITED STATES OF AMERICA AND CANADA
company may be able to recover clean-up costs
from the prior owner or operator that was
responsible for depositing the wastes, but only, of
course, if that party is financially responsible.
Other enviromental issues
An oil and gas lessee may encounter a variety
of other environmental issues and requirements at
different points in its operation. This is especially
likely if operations are conducted in an urban area
(Pierce, 1984; Kuntz, 2004).
In the US there are several highly productive oil
and gas reservoirs that underlie towns and cities.
The affected Municipalities commonly enact
ordinances banning exploratory activities, drilling
and storage, except in designated locations, and
require permit approvals before any such
operations can begin within the designated area.
These permits are in addition to any permits
required by state or federal agencies. An oil and
gas lessee may be required to submit a detailed site
plan that sets out the proposed location for drilling,
its impact on vegetation, streams and other
topographic features, its distance from buildings,
and the company’s plans for fencing, landscaping
or otherwise shielding the site from the
surrounding urban area. Location in an urban area
with a significant amount of smog, ozone or other
air pollutants may also subject oil and gas
operations to regulation by a state agency or by the
EPA under the federal Clean Air Act 1955,83 which
imposes more stringent requirements for areas that
fail to meet specified ambient air quality standards
than are generally applicable to air-quality
attainment areas.
Another form of environmental regulation
applies to certain types of pollutants, such as
service company wastes, that are associated with
oil and gas development. Companies using or
generating such pollutants are subject to detailed
record-keeping requirements under the Resource
Conservation and Recovery Act 1976,84 and may
dispose of the substances only at licenced waste
treatment, storage and disposal facilities. Although
many waste products generated by exploratory and
production operations are specifically exempt from
these federal requirements, the substances may be
subject to stringent state regulations governing
transport and disposal.
81
42 USC. paras. 9601-9675.
82 Amoco Oil Co. v. Borden, Inc. (1989) Supreme Court
of the United States Fifth Circuit 889 F.2d 664.
83 42 USC. paras. 7401-7671q.
84 42 USC. paras. 6921-6939e.
637
NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
12.1.9 Dispute settlement
In the US, and to a somewhat lesser extent in
Canada, litigation is the usual and expected
method of dispute resolution. In the US
litigation involving private leases and leases
executed by a state are adjudicated in the state
where the leased land is located. This litigation
is normally in the state Court, and most States
have three levels of judiciary: a trial Court,
which initially hears the case; an intermediate
Court of Appeals; and a state Supreme Court,
which frequently has discretion whether to
accept a case from the Court of Appeals. If the
federal government is involved the suit is in
federal Court.
Similarly, if there is diversity jurisdiction, i.e. if
the parties are not both citizens of the same state or
incorporated in the same state, the suit may be
brought in federal Court. As in most states, there
are three levels of federal Courts. The initial trial is
typically in the federal district Court that has
jurisdiction over the area where the leased land is
situated. There may then be an appeal to the federal
Court of Appeals that has jurisdiction over the area.
In very rare instances, the US Supreme Court will
grant a petition to hear a case based upon diversity
jurisdiction. It is not uncommon, however, for the
Court to hear disputes involving claims by the
federal Government.
There are three principal situations in which a
method of dispute resolution other than litigation is
used.
Leases on private lands. The first is the
increasing use of mediation for disputes
involving leases on private lands. It is relatively
common in the US for a Court to require
mediation before proceeding to litigation.
Mediation frequently results in an agreed-upon
settlement by the parties. The parties can also,
of course, agree to arbitration. Such agreements,
when entered into, are rarely based upon
provisions of the lease. For it is quite unusual to
include a clause providing for arbitration in
private oil and gas leases. Such clauses are,
however, relatively common in farm outs and
joint operating agreements.
Tribal lands. The second situation is where
tribal lands are involved. Tribal leases are not
subject to the US Administrative Procedure Act,
and the tribes, as sovereign entities, are immune
from suit. Unless the lease contains an express
waiver of sovereign immunity or a dispute
resolution clause providing for arbitration or some
other method of settlement, disputes will be
638
resolved in tribal courts under tribal customs
and laws.
Leases on government land. The third situation
is where the dispute involves leases on government
land (Kuntz, 2004). A lessee adversely affected by
an agency decision is frequently required to seek
an administrative hearing before a designated
hearing examiner or hearing board, and to comply
with a detailed regulatory and statutory procedure.
The procedure may require one or more levels of
administrative appeals if the decision at the
administrative hearing is unfavourable.
The lessee must exhaust these administrative
remedies and obtain a final decision by the highest
hearing panel of the agency before it can seek
judicial relief. The US Administrative Procedure
Act provides for judicial review of an agency
decision, but only after it has become final at the
highest level.
12.1.10 Conclusions
To an observer from outside the North American
legal systems there are several especially striking
features of the US and Canadian legal regimes
applicable to oil and gas:
• One such feature is the existence of private
ownership of mineral resources everywhere
except in a minority of Canadian Provinces.
• A second feature is the reliance throughout
most of the states, Provinces and by the federal
Governments upon judicial decisions to
establish much of the content of their legal
regimes. Case law has often been more
important than statutory and regulatory law,
especially with regard to establishing private
rights and interpreting private leases.
• Third, of course, is the multiplicity of legal
regimes. The federal structure and
constitutional provisions of both countries have
resulted in the development of separate
regulatory schemes based upon differing
statutory provisions in each state and each
Province as well as in the respective federal
Governments.
To the extent that there are basic similarities
within all of the North American systems, the
similarities can be traced to the common legal
background of all the jurisdictions – except
for Quebec in Canada and Louisiana in the
US – and to the willingness of all the
jurisdictions to rely on the experience of other
jurisdictions in developing their own regimes of
hydrocarbon law.
ENCYCLOPAEDIA OF HYDROCARBONS

References
Anderson O.L., Smith E.E. (1999) The use of law to promote
domestic exploration and production, in: Proceedings of
the 50th annual Institute on oil and gas law and taxation,
Dallas (TX),18-19 February.
Anderson O.L. et al. (2004) Hemingway oil and gas law and
taxation,West Publications, Scarborough (UK).
Ballem J.B. (1999) The oil and gas lease in Canada, Toronto,
University of Toronto Press.
Carpenter S. et al. (2001) Oil and gas development in Western
Canada in the new millennium: the changing legal
framework in the Northwest Territories, the Yukon and
offshore British Columbia, «Alberta Law Review», 39,
1-33.
Conine G.B. (1991) Environmental issues in offshore
exploration and production activities, in: Proceedings of
the 42nd Institute on oil and gas law and taxation, Dallas
(TX), 22 February.
Greenfield D., Tadesco J. (2004) Fundamental aspects of
oil and gas revisited, «Alberta Law Review», 42, 75-112.
Hanson B.R., Feldman M.D. (1992) Developing natural
resource projects in wetlands: charting a course through
troubled terrain, in: Proceedings of the 38th Rocky Mountain
mineral law annual institute, Monterey (CA), July 1991.
Kuntz E. (2004) A treatise on the law of oil and gas, Cincinnati
(OH), Anderson, 2v.
Lowe J.S. et al. (edited by) (2002) Cases and materials on oil
and gas law, St. Paul (MN), West Publishing.
Lucas A., Hunt C. (1990) Oil and gas law in Canada, Toronto,
Carswell.
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UNITED STATES OF AMERICA AND CANADA
Pierce D.E. (1984) Municipal development of oil and gas,
«Tulsa Law Journal», 19, 337.
Pierce D.E. (1999) Assessing thirty years of federal
environmental regulation of upstream oil and gas activities,
in: Proceedings of the 50th annual Institute on oil and gas
law and taxation, Dallas (TX), 18-19 February.
Rankin T.M. (2004) Offshore oil and gas and coastal British
Columbia: the legal framework, «The Advocate», 62, 497,
502.
Rocky Mountain Mineral Law Foundation (edited by)
(2001) Law of federal oil and gas leases, New York, Matthew
Bender.
Smith E.E., Weaver J.L. (1998-2005) Texas law of oil and
gas, Carlsbad (CA), Lexis Law, 3v.; v.I.
Smith E.E. et al. (edited by) (2000) Materials on international
petroleum transactions, Denver (CO), Rocky Mountain
Mineral Law Foundation, 271-275.
Walker. A.W. Jr. (1929) The nature of property interests
created by an oil and gas lease in Texas, «Texas Law
Review»,7, 539.
Walker A.W. Jr. (1933) The nature of property interests
created by an oil and gas lease in Texas, «Texas Law
Review», 11, 399.
Weaver J.L. (1981) Implied covenants in oil and gas law,
«Vanderbilt Law Review», 24, 1473.
Ernest E. Smith
School of Law
The University of Texas at Austin
Austin, Texas, USA
639
 12.2
Argentina, Brazil, Mexico
and Venezuela
12.2.1 Introduction
In Argentina and Brazil, as well as in other countries
in Latin America, a major drive of legal
developments in the oil industry during the 1990s
marked the opening up to private investment, in the
context of liberalization and policies aimed at the
creation of enabling environments for investment.
While Brazil notably allowed for private
participation following a radical constitutional
amendment in 1995, Argentina went the furthest in
the trend towards liberalization, fully privatizing its
State-owned company and reinstating the use of the
concession system to grant exploration and
exploitation rights to private investors. At the other
end of the spectrum, Mexico has retained ownership
of its state-owned company as well as control over
the industry. Since the late 1990s, Venezuela has
shown a countervailing trend to the one prevailing
earlier that decade, with legal instruments allowing
for more State participation.
The countries in the region have generally
opened up – to different extents – to private
investment in the upstream of natural gas, and all of
them, without exception, have liberalized the
downstream (transportation and distribution) of
natural gas (Campodónico, 2004). In the current
context, one can witness different expressions of
states seeking to assert increased control over their
hydrocarbon resources.
The legal forms used to allow for private
participation in the hydrocarbons industry in the
countries under study are basically the concession
system (granting ownership over the hydrocarbons
extracted) on one hand, and contractual approaches
(particularly service contracts) on the other.
This section focuses on the analysis of the
legal framework for the hydrocarbons activity
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
– particularly on the upstream – in Argentina, Brazil,
Mexico and Venezuela. It will focus on the
description and analysis of a range of issues under
each legislation, including: a) ownership of
hydrocarbon resources underground; b) state
involvement in the industry; c) legal forms; d ) rights
and operating conditions; e) unitization provisions if
relevant; f ) environmental regulation; g) fiscal
structure and government take; and h) price
mechanisms and dispute settlement. It will also
describe the provisions on investment protection,
including a broader reference to the general foreign
investment regime.
It is relevant to point out that there is a
significant range of processes and initiatives of
integration in Latin America (See Inter-American
Development Bank, IADB website). These include
MERCOSUR (MERcado COmún del SUR) – of
which Argentina, Brazil, Paraguay and Uruguay are
members, and Bolivia and Chile have signed
economic complementation agreements – and the
CAN (Comunidad Andina de Naciones), of which
Bolivia, Colombia, Ecuador, Peru and Venezuela are
members. Mexico is a member of NAFTA (North
America Free Trade Agreement). There has been a
number of regional integration initiatives for the
energy sector in recent years, including those within
the emerging CSN (Comunidad Sudamericana de
Naciones) created in 2004.
It is noteworthy that Venezuela stands as the
major Latin American oil and gas producer. It ranks
seventh world-wide vis-à-vis the estimate of proven
reserves of crude oil, and ninth in the estimate of
proven reserves of natural gas (Campodónico,
2004). Mexico is a major oil producer, being
thirteenth in the ranking of countries according to
the estimate of proven reserves of crude oil, and
thirty-fourth in the estimate of proven reserves of
641
NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
natural gas (Campodónico, 2004). Brazil ranks third
in the estimate of oil reserves in the region, after
Venezuela and Mexico. While still an importer of
oil, the gap between supply and demand has
decreased significantly in recent years. For natural
gas reserves, Brazil stands fifth in the region.
Following a governmental decision to increase the
use of natural gas, its importance has steadily
increased, although Bolivia supplies about half of
Brazilian demand (Campodónico, 2004). In terms of
estimated proven oil reserves, Argentina stands
fourth in Latin America, after Venezuela, Mexico
and Brazil. Although energy supply is dominated by
crude oil and natural gas, Argentina depended rather
heavily on imported oil for a long time, until a
radical change in oil and gas legislation allowed the
flow of private investment into the industry and the
privatization of the sector. As to reserves of natural
gas, Argentina ranks fourth in the region after
Venezuela, Mexico and Bolivia. It ranks first as
producer and second as consumer of natural gas in
the region, having developed the industry back in
the 1940s (Campodónico, 2004).
12.2.2 Argentina
Ownership and title to resources underground
The Argentine nation has adopted a federal
representative republican form of government, as set
forth by the constitution (art. 1 of the National
Constitution of the Republic of Argentina 1853, as
amended in 1994).
For most of the Twentieth century, the
hydrocarbon industry of Argentina was dominated
by a state company (Sociedad del Estado)
Yacimientos Petrolíferos Fiscales (YPF), created in
1922. Hydrocarbon exploration and production were
carried out either by, or on behalf of YPF. Over time,
a range of contractual forms were used to allow for
private participation, including the risk contracts
introduced under Law No. 21778/1978 and those of
the Houston Plan provided under Decree No.
1443/1985. Law No. 17319/1967 (Hydrocarbons
Law), which is the core legal statute of the legal
framework for hydrocarbons in Argentina and which
provides for exploration permits and exploitation
concessions, was rarely used for granting
concessions up until the launching of the Argentina
Plan in the early 1990s.
During the 1990s, in the framework of the
overall liberalization of the economy and opening up
to private investment, and as set out under the State
Reform Law No. 23696/1989 (State Reform Law),
the government encouraged competition, reliance on
642
market mechanisms and the privatization of YPF.
The Argentina Plan was launched by Decree No.
2178/1991, which also provided the regulations for
the implementation of the Hydrocarbons Law 1967,
and followed the enactment of three decrees. These
decrees, among other provisions, established new
rules for the upstream sector and reinstated the
application of the concession system stipulated
under the Hydrocarbons Law 1967 (Decree No.
1055/1989); deregulated downstream activities
(Decree No. 1212 /1989), and granted companies
involved the right to freely sell and dispose of
hydrocarbon production (Decree No. 1589/1989).
Furthermore, Decree No. 2411/1991 authorized YPF
to negotiate with the parties the contracts executed
under Law 21778 and under the Houston Plan, the
contracts’ conversion into exploration permits or
exploitation concessions pursuant to the
Hydrocarbons Law. At present, the Argentina Plan is
still in force and in effect. However, for the past
years, and mainly due to the increased involvement
of provinces in the bidding system, there are
virtually no bids at the federal level.
A recent modification to the Hydrocarbons Law
by virtue of Law No. 26197 (Short Law), introduced
significant changes to the legal framework for
hydrocarbons in Argentina. As from the enactment
of the Short Law, the provinces will assume the
administration of the hydrocarbons fields located in
their respective territories and in the bed and subsoil
of the territorial waters along their coastlines.
Moreover, all exploration permits and hydrocarbons
exploitation concessions and any other type of
hydrocarbons exploration and/or exploitation
agreement granted or approved by the Federal State
in exercise of its powers, are transferred to the
respective province.
Before the enactment of the Short Law, a
transitory regime for the exploration and
exploitation of some specific areas was in force.
According to Law No. 24145/1992 (Hydrocarbons
Federal Law), Presidential Decree No. 1955/1994
and Presidential Decree No. 546/2003, ownership of
hydrocarbons would be subsequently transferred to
the provinces (Areas under Transfer). Provinces
were entitled to grant new oil and gas exploration
permits and exploitation and transportation
concessions within its respective territory over those
Areas under Transfer and over those defined by their
relevant competent local authorities in accordance
with their exploration and/or exploitation plans and
the Hydrocarbons Law.
Apart from constitutional provisions and the
above-mentioned Hydrocarbons Law 1967, the State
Reform Law 1989 and the Short Law, statutes of the
ENCYCLOPAEDIA OF HYDROCARBONS

current legal framework for hydrocarbon activities in
Argentina include Law No. 24076/1992 (Gas Law).
The natural gas statutory framework is based on the
Hydrocarbons Law for exploitation and production,
and the Gas Law for transmission and distribution.
Both laws are regulated by several decrees and
resolutions.
Upstream operations are regulated by the
granting authorities, while the national gas regulator,
ENARGAS (Ente NAcional Regulador del GAS), an
independent agency created in 1992 by the Gas Law,
regulates the transportation and distribution of
natural gas. It is also the arbitrator for disputes
within the downstream gas sector.
As from the enactment of the Short Law, the
provinces, as enforcement authority, will exercise
counterpart functions in relation to the exploration
permits, exploitation concessions and hydrocarbons
transport subject to transfer. They will be entitled,
among other things, to: a) fully and independently
exercise the control and audit activities of the
mentioned permits and concessions, and of any
other type of hydrocarbons exploration and/or
exploitation agreement granted or approved by the
Federal State; b) demand the fulfilment of all
statutory and/or contractual obligations applicable as
to investments, rational exploitation of resources,
information, and payment of fees and royalties; c)
determine the extension of statutory and/or
contractual terms; and d ) apply the penalty regime
set forth in the Hydrocarbons Law and its regulatory
provisions (fines, suspension of records,
termination, and any other penalty provided for in
the bidding terms and conditions or in the
agreements). The national executive branch is
responsible for the creation of energy policies at
federal level.
According to art. 1 of the Short Law, liquid and
gaseous hydrocarbons fields located in the Republic
and in its continental platform belong to the Federal
State or to the Provincial State, according to the
territory where they are located.
Those hydrocarbon fields located within 12
marine miles measured from the baselines and up to
the external limit of the continental platform, belong
to the Federal State.
Those hydrocarbon fields located within
provincial territories belong to the Provincial States,
including those located at the sea adjacent to their
shores until a distance of twelve 12 marine miles
measured as from the base lines.
State involvement in the petroleum industry
Until 1993, YPF was the Argentinean state-
owned company responsible for the exploration and
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
ARGENTINA, BRAZIL, MEXICO AND VENEZUELA
exploitation of oil and gas, and the transportation
and distribution of gas. Following the full
privatization of YPF S.A. and the liberalization of
the industry, these activities are now performed by
local and foreign companies. The transmission and
distribution system is also owned and operated by
private companies. Additionally, other companies
hold sub-licenses for export transmission.
With a view to reducing the foreign dominance
of the sector and amid a controversial debate, a new
state oil company – ENARSA (ENergía ARgentina
Sociedad Anónima) – has been created, as approved
by Law No. 25943/2004. Pursuant to art. 5 of this
law, 53% of ENARSA’s shares will belong to the
Federal State, 12% to the provinces, and the
remaining 35% will be listed on the stock market.
The purpose of ENARSA is the appraisal,
exploration and exploitation of hydrocarbons, as
well as their transportation, storage, distribution,
trade and industrialization, the provision of public
transportation and distribution services of national
gas, and the generation and trade of electricity in
domestic and foreign markets (art. 1). ENARSA has
full powers to operate in the oil, natural gas,
electricity, coal and nuclear sectors, as well as in
regard to non-conventional energy sources.
The new oil company will also hold title over the
exploration permits and concessions in maritime
areas which are not already subject to permits or
concessions on the date of entry into force of the law
(art. 2). Circular 2004 No. 67, enacted by the
Secretariat of Energy, eliminates offshore areas that
were previously put up for private bid from the
Argentina Plan.
Concessionary regime and/or contracts
According to art. 2 of the Short Law, the Federal
State and the Provincial States will exercise their
powers as Granting Authority pursuant to
Hydrocarbons Law and its regulatory provisions and
pursuant to the Federal Hydrocarbons Agreement
(Acuerdo Federal de los Hidrocarburos).
It should be noted that the federal system
basically establishes a concession system. Article 4
of the Hydrocarbons Law entitles the executive
power to grant exploration permits and temporary
exploitation concessions (with the Short Law this
power is now vested in the provinces with respect to
hydrocarbons located in their territories, the federal
executive power keeping the concession power over
fields located in federal jurisdiction), as well as
concessions for the transportation of hydrocarbons
(see discussion infra), pursuant to the requirements
and under the conditions set forth by this law. At the
provincial level, and as of the enactment of the Short
643
NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
Law, provinces have been using risk service-type
contracts over those Areas Under Transfer.
In regards to transport concessions, art. 3 of the
Short Law provides that within a term of 180 days
from its enactment, the National Executive Branch
and the provinces shall agree the transfer, to
domestic jurisdictions, of all those transport
concessions related to the hydrocarbons exploitation
concessions transferred by virtue of the new regime.
The National Executive Branch will be the
Granting Authority of all those hydrocarbons
transport facilities comprising two (2) or more
provinces or of those which are directly aimed at
exportation. All those transport concessions which
begin and finish within a same provincial
jurisdiction and which are not directly aimed at
exportation will be transferred to the provinces. The
aforementioned agreement and transfer process is
pending.
Bid process
Exploration permits and exploitation and
transportation concessions are awarded by means
of public bids. The term of the relevant exploration
periods (see below) are important from the
standpoint of the exploration bid mechanism. All
bids for exploration must include a minimum
amount (K) of 150 work units, where each unit is
valued at 5,000 dollars. Thus, the minimum work
commitment for any block is 750,000 dollars worth
of exploration. In general terms, these minimum
work units may be completed during any of the two
(or three) basic periods, but a permit holder may
only extend its permit into the second period by
committing to drill at least one exploration well.
Similarly, the permit holder must undertake to drill
at least one exploration well in the third period
(Decree No. 2178/1991, Annex II, art. 5.1,
subpara. 3).
Exploration bidders are required first of all to
present an ‘Envelope A’, which must contain such
financial and operational information as will allow
the Secretariat of Energy to qualify the applicants as
competent bidders, as well as the bid guarantee in
the amount of 100,000 dollars (Decree No.
2178/1991, Annex II, art. 4). After confirmation of
qualification, consideration is given to the bidders’
Envelope B. Envelope B should specify the bidders’
pledged work units in excess of K; the time (T) in
which such commitments will be carried out; and
agreements to drill at least one exploration well if
the agreement extends into the second or third
period (Annex II, art. 5). The work performance
guarantee is provided within thirty days after the
award of the exploration permit (Annex II, art. 10.1).
644
Awards, which are made relatively quickly, are
confirmed by Resolution of Chief Staff (Annex II,
art. 7.3).
As of the enactment of the Short Law, and as
more areas became subject to provincial jurisdiction,
provincial authorities defined areas for exploration
and/or exploitation, using their own bidding
systems. With the enactment of the Short Law, this
trend is reinforced and the use of a diverse range of
bidding systems is likely to be consolidated.
Right to prospect, explore, develop,
produce and dispose of petroleum resources
At the Federal Level, and pursuant to the
Hydrocarbons Law, the successful applicant may
either acquire exploration permits or exploitation
concessions. Exploration permits (Hydrocarbons
Law, arts. 16-26) grant the holder the exclusive right
to perform all operations needed to explore for
hydrocarbons within the area specified in the permit,
as well as the right to convert the permit into an
exploitation and transportation concession, once a
commercial discovery is made.
Exploitation concessions (Hydrocarbons Law,
arts. 27-38) grant the exclusive right to fully produce
all productive reservoirs in the concession area.
Article 6 of the Hydrocarbons Law establishes that
the permit or concession holders own the extracted
hydrocarbons. As a consequence, they have the right
to transport, commercialize and industrialize these
hydrocarbons. They also have the right to their
by-products. They are bound to the relevant
technical and economic regulations which take into
consideration the domestic market needs and lead to
the development of the exploration and exploitation
of hydrocarbons. Additionally, the concessionaire is
entitled to construct all such facilities, including
pipelines, which may be necessary for the
commercial exploitation of the reserves (arts. 30-31).
Construction and operation of transmission
facilities may be obtained: under the Hydrocarbons
Law; under the Gas Law, by companies that apply
for concessions to ENARGAS; and under the Gas
Law, as part of the extension of the existing
concessions.
Argentine onshore exploration blocks have a
maximum area of 10,000 km2. Blocks over the
continental shelf have a maximum area of 15,000
km2 (Hydrocarbons Laws, arts. 24-25). Although the
Hydrocarbons Law provides that no person or legal
entity may simultaneously hold more than five
exploration permits or five exploitation concessions
(art. 34), Decree No. 2178/1991 specifies that
limitations apply fairly narrowly to the same entity.
The Hydrocarbons Law allows for a “basic period”
ENCYCLOPAEDIA OF HYDROCARBONS

consisting of three subsequent terms (four years,
three years, and two years each) and an “extension
period”; each basic term in offshore areas can be
extended for an additional year; once the basic
period has elapsed, the exploration permit can be
extended by up to five further years (art. 23).
Decree No. 2178/ 1991 – regulating the
Hydrocarbons Law – entitles the holder to the right
to “use in advance” a fraction of the five year-
extension period by extending the second or third
exploration term for three years (or two years to the
end of the second term if there is no third term).
Decree seems to envisage that the permit holders
may be able to extend their exploration periods (with
permission from the Secretariat of Energy), by a
further one year (in the case of three-term permits)
or a further two years (in the case of two-term
permits). In any event, with just one exception, no
exploration permit may be extended by more than an
aggregate of four years (Annex II, art. 9.2).
At the end of the basic exploration terms, the
permit holder is entitled to hold the area for further
extended terms in the following situations: the
operator has made a discovery but is investigating
commerciality (extension not exceeding one year);
the operator has made a predominantly gas
discovery or discoveries, but there is a lack of a
market for the gas (extension not exceeding five
years, but subject to extension at the option of the
Secretariat of Energy in instances of continuing lack
of a market). This is according to Decree No.
2178/1991, Annex II, art. 9.3.
Regarding relinquishment obligations, the
Hydrocarbons Law requires the surrender of 50% of
each exploratory block at the end of the last two
basic exploration periods (art. 26). Generally
speaking, the permit holder is required to give up the
whole remaining exploratory area (25% of the
original block) at the end of the third term.
The standard term for exploitation concessions is
twenty five years, subject to a possible further ten-
year extension (art. 35). Permits and concessions can
be assigned prior to executive approval (art. 72).
At the provincial level, service type-contracts in
place tend to regulate these matters pursuant to the
Hydrocarbons Law.
Operating conditions
At the Federal Level, holders of exploration
permits are required to carry out exploration
activities with due diligence and in accordance with
efficient techniques, as well as to invest minimum
amounts (Hydrocarbons Law, arts. 16, 19 and 20)
and to inform the enforcement authority of any
discoveries made within 30 days. Following field
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appraisal, and a ‘commerciality statement’
– whereby the permit holder requests the granting
of an exploitation concession upon determination of
commercial viability of the field – a concession will
be awarded within 60 days (arts. 21-22). Within
90 days from the date of declaration of
commerciality, the concessionaire must prepare
a development plan and list of investment
commitments (Hydrocarbons Law, art. 32).
At the Provincial level, service type-contracts in
place tend to regulate these matters pursuant to the
Hydrocarbons Law.
Unitization
Hydrocarbons Law (art. 36, part 2) provides that
the Secretariat of Energy should control that the
holders of exploration or production rights do not
cause damage to neighbour exploration permit
holders or concessionaires. Should a problem arise
between the holders of adjoining concessions or
exploration permits, and in the case of no agreement
being reached between such parties, exploitation
conditions in the bordering zones of the concessions
may be imposed by the Secretariat of Energy. This
regulation would be the legal basis of starting a
process of so-called unitization or unification, if it
became necessary. There are no other specific legal
rules regarding unitization and there is very little
experience in this matter in Argentina.
Environmental protection
The 1994 constitutional amendment to the
Constitution of Argentina has adopted the concept of
human development and the principle of
inter-generational equity in art. 41, which grants any
inhabitant the right to enjoy a healthy and balanced
environment, suitable for human development. This
provision incorporates the environmental dimension
into the decision making of any development
project. Such provision is also a source of
obligations both for individuals (who have the “duty
to preserve the environment”), and for the state,
which “will provide for the protection of this right,
the rational utilization of natural resources, the
preservation of natural and cultural heritage, and
biological diversity, and environmental information
and education […]”. The Federal State must
establish minimum standards for protection, while
the provinces have the right to establish
supplementary regulations to these minimum
standards.
At a national level, the General Law of the
Environment No. 25675/2002, provides these basic
standards for attaining an “adequate and sustainable
management of the environment, the preservation
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and protection of biological diversity and the
implementation of sustainable development”. Law
No. 24051/1992 sets forth the minimum standards
for environmental protection related to the
management of hazardous waste, while Law No.
25612/2002 provides the same for the management
of industrial waste. Most oil and gas producing
provinces have established supplementary
regulations to these national minimum standards.
With respect to the oil industry, and with a view
to facilitate the national supervision of hydrocarbon
activities, the Secretariat of Energy entered into an
agreement with the producing provinces by which
the latter would accept and implement the federal
regulations. Various resolutions of the Secretariat of
Energy are applicable, including Resolution No.
29/1991, setting forth technical and operating norms
for hydrocarbon activities pursuant to the
Hydrocarbons Law; Resolution No. 105/1992 which
requires oil companies to present certain
environmental studies; Resolution No. 252/1993,
which sets guidelines and recommendations for the
performance of environmental studies and the
monitoring of the works and tasks specified in the
Resolution No. 105/1992.
Fiscal structure and government take
Upstream and downstream activities are subject
to some of the municipal, state and federal taxes and
contributions for commercial activities, but are
exempt from certain special taxes that also apply to
the distribution of fuels. These include gross
income, tax over assignment of fuel, gas oil
contribution, hydro infrastructure contribution,
valued-added tax, income tax, stamp tax, real state
tax, and import duties among others.
Regarding royalties, at the Federal Level, the
holder of exploitation concessions is subject to a
12% royalty due either to the appropriate provincial
government or to the Federal Government. The
Central Government has authority to reduce royalty
down to a base of 5%, determined by economic and
operational considerations (Hydrocarbons Law, arts.
59 and 62, and Decree No. 2178/1991, Annex II, art.
9.9). Royalties are calculated on the basis of the
price of hydrocarbons at the wellhead. In other
words, transportation costs to the point of
commercialization are deductible (Hydrocarbons
Law, art. 61), up to the value of 3% of total
production. At the Provincial Level, service type-
contracts in place tend to regulate these matters
pursuant to the Hydrocarbons Law.
According to art. 2 of the Short Law, the
hydrocarbons royalties corresponding to exploration
permits and hydrocarbons exploitation concessions in
646
force upon the entering into effect of said law, will be
calculated pursuant to the provisions of the relevant
titles (permits, concessions or rights) and shall be paid
to the jurisdictions to which the fields belong.
There is also a small surface fee (canon)
obligation which is different for exploration permits
and exploitation concessions (Hydrocarbons Law,
arts. 57 and 58 and Decree No. 2178/1991, Annex
II, art. 9.5), at the Federal Level; at the provincial
level, as in other matters, service type-contracts in
place tend to regulate these matters pursuant to the
Hydrocarbons Law.
Under Decree No. 310/2002, the national
government established a 20% export duty on
crude oil and a 5% duty on most of its by-products.
Resolution 337/04 of the Ministry of Economy
increased the export duty to 25%. Finally,
pursuant to resolution No. 532/2004 of the
Ministry of Economy, the export duty was
maintained at 25% for the cases where the oil
price equals or is less than 32 dollars per barrel.
But, if the West Texas Intermediate (WTI) exceeds
32 dollars per barrel, the export duty percentage
should be increased by the following percentage
points: 32.01-34.99 $/bbl: 3%; 35.00-36.99 $/bbl:
6%; 37.00-38.99 $/bbl: 9%; 39.00-40.99 $/bbl:
12%; 41.00-42.99 $/bbl: 15%; 43.00-44.99 $/bbl:
18%; 45.00 $/bbl: 20%.
Pursuant to resolution No. 534/2006, a 45%
export duty on gas exportations is in force.
Moreover, resolution No. 776/2006, established
several export duties on gas, crude oil and by-
products from Tierra del Fuego, Antártida e Islas del
Atlántico Sur, Special Customs Area (Area Aduanera
Especial). It should be noted that exports and
imports from and to this Special Custom Area have
always been duty free.
Fixing the price of oil and gas
There is no mandatory price setting regime for
crude oil or crude-oil products, although this is
subject to certain exceptions when local production
cannot satisfy the domestic demand.
In these cases, the executive branch has the power
to condition oil exports on the prior satisfaction of
domestic demand and to regulate internal oil prices
during a period when local demand cannot be
satisfied.
In the case of gas, prices for pipelines services
are based on the Gas Law, on licences, and on the
ENARGAS regulation concerning the price cap
system. Prices of the distribution services are set as
tariffs based on the price cap system. These general
principles are described in the Gas Law and defined
in the licences and ENARGAS’ regulations.
ENCYCLOPAEDIA OF HYDROCARBONS

To ensure market competition, companies
transporting natural gas cannot produce or distribute
the product, and are prohibited from discriminating
between clients. Pipelines are common carriers,
earning revenue through transportation tolls for
shipping gas but not taking ownership of the
volumes. Distributors sell the product to final users,
buy gas from producers, and pay tolls to
transportation companies. Their tariffs are regulated
by ENARGAS. Large gas users are entitled to
directly negotiate gas contracts with producers and
can be connected to the truck gas pipelines.
Customers of gas distribution services (industrial,
commercial and residential) pay tariffs on their gas
consumption. The terms of services are described on
the licences and cannot be changed without the
approval of ENARGAS. Tariffs of the distribution
service contain components such as the pass-
through of their gas purchasers to gas producers and
the cost of the transmission service.
Foreign investment
Argentina has a very open foreign investment
system. Article 20 of the National Constitution
guarantees foreigners the enjoyment of all the civil
rights of nationals, including the right to operate
any industry, trade and commerce, and to own,
buy and sell real property. Property is protected
under constitutional provision (art. 17).
Accordingly, the Foreign Investment Law No.
21382/1976 and its subsequent amendments, as
well as regulatory Decree No. 1853/1993, adopted
high standards for investment protection, such as
equal treatment of both foreign and domestic
investment and net profits remittance. Foreign
companies are allowed to enter the Argentine
market through the most appropriate Argentine
corporate, or other commercial vehicle.
While foreign investors are not generally
required to obtain prior authorization to undertake
investment in Argentina, certain registration
conditions apply to all private companies – domestic
or foreign – in the hydrocarbons sector, including
registration with the Secretariat of Energy. Foreign
oil companies do not need to associate with
domestic private companies. Foreign oil companies
operating through Argentine shell companies are
required (by administrative fiat of the Secretariat of
Energy) to put up a parent company guarantee in
support of their exploration and/or production
activities, as well as to provide very specific and
sometimes cumbersome corporate information by
the Argentine Office of Corporations.
To provide an understanding of the general
framework for foreign investment, it is noteworthy
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that Argentina has concluded around 51 Bilateral
Investment Treaties (BITs) and joined the
International Centre for Settlement of Investment
Disputes (ICSID) in 1994. Typically, BITs guarantee
most-favoured-nation treatment, double taxation
avoidance and transfer of investment-related
payments, as well as for international arbitration in
case the investor is subject to discriminatory
treatment or non-fulfilment by the Argentine state of
the conditions granted to the foreign investor.
Nevertheless, the scope of their application is being
questioned by the current central government.
Recently, by virtue of Law No. 26154 of 2006,
promotional regimes – tax incentives – were created
within the framework of the Hydrocarbons Law. All
provinces are invited to adhere to said regimes. In
order to enjoy the benefits granted, the interested
parties are required to associate with ENARSA.
The following are the tax incentives:
• Value Added Tax: credit or reimbursement on the
expenses and investments made during
exploration and exploitation periods.
• Income Tax: amortization in three equal and
consecutive annual installments, of all capital
expenditure and investments made during the
exploration and exploitation periods.
• Assumed Minimum Income Tax: exclusion from
the imposition basis for assets belonging to
permit holders and exploitation concessionaires.
The regimes are as follows:
• Promotional Regime for Hydrocarbons´
Exploration: includes areas granted to ENARSA
with its creation (maritime areas not already
subject to permits or concessions) and areas with
geological potential over which there are no third
parties´rights granted by the Hydrocarbons Law,
in jurisdiction of the provinces that adhere to this
regime. This regime classifies areas in the
Continental Platform, areas in Sedimentary
Basins without production and areas in
Sedimentary Basins with Production. The
duration of the benefits varies depending on the
area: ten to fifteen years from the acquisition of
the corresponding permit.
• Exception Regime for Exploration Areas in
Concessions granted by the Hydrocarbons Law.
Permit holders and exploitation concessionaires
may adhere to this regime subject to the following
classification: subdivided areas in production-in
continental platform; subdivided areas in
production-on land. In both cases, the permit holder
and exploitation concessionaires request the
subdivision of their area so that a new area is
formed. The duration of the benefits varies
depending on the area: twelve to ten months running
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
as from the acquisition of the proper exploration
permit, subject to extension.
Currency regulation
Regarding currency regulation, Argentine
currency is fixed in pesos, but large transactions are
usually convened in US dollars. In general terms, the
inflow and outflow of foreign currency is allowed,
although certain restrictions are in force and effect.
Concerning the oil and gas activity, Decree No.
1589/1989 granted crude oil producers free disposal
of hydrocarbon proceeds in sales – either in the
domestic or the international market – and in a
percentage not higher than 70% of the value of each
transaction.
Due to other general regulations in force and
effect during the 1990s, producers were not obliged
to surrender the foreign exchange proceeds out of
exports of crude oil or by-products resulting from
the processing of crude oil. Moreover, they could
dispose 100% of those proceeds as they deemed fit.
However, after the devaluation crisis which occurred
in late 2001, the National Executive Power issued
Decree No. 1601/2001, under which the obligation
of surrendering proceeds of exports was restated, by
virtue of applying the old Decree No. 2581/1964.
This led to a big controversy between the industry
and the government as to whether the contracts
executed under the scope of the above mentioned
Decree No. 1589/1989 were reached by Decree No.
1601/2001. Industry representatives argued that
those contracts enjoyed the benefit of a special
foreign exchange regime and therefore, the rule
contained in Decree No. 1601/2001 only affected
30% of the proceeds. Decree No. 1638/2001 was
issued by the executive power days later, clarifying
that those activities which enjoyed a special foreign
exchange regime were out of the scope of Decree
No. 1601/2001. Notwithstanding this last rule and
further Presidential Decree No. 2703/2002, which
entitles oil and gas producers to freely dispose of
70% of their proceeds from export oil, gas and their
by-products, the matter is currently still under
debate.
Settlement of disputes
Operational disputes are not likely to occur
under the dominant concession regime, as the
private companies are entirely in control of upstream
operations. With respect to legal disputes, the
Hydrocarbons Law provides that permits and
concessions may provide for arbitration on nullity
and termination issues and with respect to specific
technical matters. Otherwise, the federal jurisdiction
shall hear all disputes related to the interpretation
648
and/or execution of the Hydrocarbons Law. The
Hydrocarbons Law does not specifically mention
what kind of arbitration panel would hear such
cases. However, it says that each party will choose
one arbitrator with a third one being selected upon
the agreement of both arbitrators or in case of
disagreement, by the president of the National
Supreme Court. One could expect that this type of
arbitration might involve domestic experts (from one
to three), as old service contracts provided (i.e.
Houston Plan). The Hydrocarbons Law does not
have a specific provision stating what the applicable
law in case of controversies is, but if these refer to
the Hydrocarbons Law or regulating legislation
thereof, Argentine law will prevail.
At the Provincial Level, amicably settlement
prior to any judicial claim seems to be the tendency
in service type-contracts in force.
12.2.3 Brazil
Ownership and title to resources underground
Brazil is a federative republic, formed by the
indissoluble union of states and municipalities, as
well as the Federal District (art. 1 of the Constitution
of the Federative Republic of Brazil 1988, with
amendments).
The opening of the Brazilian petroleum industry
was formally launched with the approval of the
Constitutional Amendment 1995 No. 9, which
amended the Federal Constitution 1988. By allowing
for the participation of private investment in
hydrocarbon activities, Petroleo Brasileiro S.A
(PetroBras), the Brazilian state-owned company
founded in the 1950s to run the state monopoly over
those activities, is exposed to competition.
The relevant laws applicable to the hydrocarbons
sectors are Law No. 9478/1997 (Petroleum Law);
Decree No. 2705/1998 (Participation Decree,
concerning government participation calculations
and collection guidelines for the Petroleum Law);
Decree No. 2455/1998 (concerning the National
Petroleum Agency); Decree No. 3520/2000
(concerning the National Council for Energy
Policy); and associated laws and regulations. Draft
laws on a specific regulatory framework for gas
activities are under discussion.
The Conselho Nacional de Politica Energetica
(CNPE) is created by art. 2 of the Petroleum Law.
This body is presided over by the Ministry of Mines
and Energy and is responsible for proposing and
advising national policies and measures relating to
the energy sector to the President of Brazil,
including those related to the promotion of the
ENCYCLOPAEDIA OF HYDROCARBONS

rational use of energy resources and their supply.
Article 7 of the Petroleum Law also creates a
new regulatory agency for Brazil, the Agencia
Nacional do Petróleo, Gás Natural e
Biocombustíveis (ANP), which is linked to the
Ministry of Mines and Energy, but operates under a
special autarchic regime. The role of the ANP is set
out in art. 8 of the Petroleum Law and is generally to
promote the regulation, contracting and inspection
of economic activities related to the petroleum
industry (see also amendments introduced by Law
No. 11097/2005). More specifically, its functions
include: a) implementing the national oil, natural
gas and biofuels policy; b) coordinating the data
necessary to delimit blocks for exploration; c)
managing the bidding process for concessions for
exploration, development and production, and
executing the relevant contracts; d ) authorizing
refining, processing, transportation, and import and
export activities; e) inspecting/monitoring (either
directly or through agreements with other state
entities) the operation of the petroleum industry; and
f ) applying penalties provided for in law, regulation
or contract.
The Constitution of Brazil art. 20, para. IX sets
forth that mineral resources, including those of the
subsoil, are owned by the Union (federal
government). Article 176 of the Constitution
confirms this principle and states that property over
mineral resources is separate from that of the soil.
Exploration and exploitation rights are granted by
means of exploration authorizations and
concessions.
Article 3 of the Petroleum Law states that the
Union owns all oil, natural gas and other fluid
hydrocarbons reservoirs existing in the national
territory (which includes onshore areas, territorial
waters, the continental shelf and the exclusive
economic zone) regardless of whether the same are
located in private or public land.
State involvement in the petroleum industry
As mentioned earlier, PetroBras is the state-
owned Brazilian company which exercises the
entrepreneurial function of the state in the petroleum
industry. The Brazilian state owns 55.7% of voting
stock in the company. PetroBras draws its power
from Law No. 2004/1953, which authorized the state
to set up a state-owned oil company to run it’s
monopoly in the oil and gas industry. PetroBras was
eventually founded on 12 March 1954 and the
government approved the founding on 2 April 1954
in Decree No. 35308/1954.
The Petroleum Law revoked Law No. 2004/1953
and all matters relating to PetroBras’ specific
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performance are defined and supported by the new
law. Arts. 61 to 68 of the Petroleum Law make
provision for PetroBras, stating its objective as the
exploration, exploitation, refining, processing,
commerce and the transportation of oil (and its
products) from wells, oil shale or other rocks, of
natural gas and other fluid hydrocarbons, as well as
other similar activities. According to art. 61,
PetroBras must carry out its economic activities in
free competition with other enterprises (so when
PetroBras wishes to engage in upstream exploration
and production, it must bid for concession contracts
in the same way as any other entity). Moreover, it is
authorized to form consortia with either domestic or
foreign enterprises and it also has the power to
establish subsidiaries. Thus, unlike the parallel case
in Venezuela, for example, there is no requirement
of mandatory participation by PetroBras in joint
ventures.
Concessionary regime and contracts
Constitutional Amendment 1995 No. 9 caused a
sweeping change in the legal framework of the oil
and gas industry in Brazil. Previously, art. 177 of the
Constitution of Brazil 1988 had provided that the
state (which acted through PetroBras) had a
monopoly on certain oil and gas related activities: a)
exploration and exploitation of deposits of oil and
natural gas or other fluid hydrocarbons; b) the
refining of domestic or foreign oil; c) the import and
export of oil and gas products and by-products
deriving from the activities listed in a) and b); d )
transport of domestic oil by ship, and transport of oil
and gas through pipelines. The 1995 amendment to
art. 177 s. 1 established that these activities could be
carried out by state and private companies as agreed
with the Union.
On this constitutional basis, art. 4 of the
Petroleum Law still provides that the state has a
monopoly over the activities in a) to d ) above, but
art. 5 stipulates that private sector operators
(which must be enterprises established under
Brazilian law with headquarters and management
in Brazil) may engage in these activities by way
of concession or authorization. Upstream
exploration and production activities work under
a concession regime which in all cases requires
the granting of a concession contract, as
explained below. Article 21 confirms that all
rights to oil and natural gas exploration and
production in the national territory belong to the
Union and shall be administered by the ANP.
Article 23 states that private sector operators may
carry out oil and natural gas exploration,
development and production activities, by way of
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
concession contracts. The ANP shall define the
blocks subject to the concession contracts.
In regard to the refining of oil and the processing
of natural gas, arts. 53-55 provide that private sector
operators may build and operate oil refineries, as
well as natural gas processing plants and storage
facilities, subject to an authorization issued by the
ANP. Arts. 56-59 of the Petroleum Law allow private
sector operators to engage in the transportation of
oil, oil products and natural gas, and finally, art. 60
provides for authorizations for private entities to
engage in the import and export of oil (and its
products), natural gas and condensate.
With regard to the execution of geological and
geophysical services for petroleum prospecting
aimed at gathering technical data, the ANP is
entitled to provide authorizations which are intuitu
personae to data-gathering companies. These are
defined as companies with expertise in the
acquisition, processing and interpretation of data
regarding exploration and production of oil and
natural gas (ANP Ordinance 1998 No. 188, as
amended by ANP Ordinance 1999 No. 35).
Bid process
Arts. 36 to 42 of the Petroleum Law deal with
the bidding process for the granting of concession
contracts. The bid announcement should attach the
model concession contract and include such
requirements as: the block and duration of the
concession; the minimum work programme and
investments; the minimum governmental
participation, as well as the participation of surface
rights owners; the criteria to assess the relevant
technical and financial requirements as well as the
technical and economic-financial viability of the
proposal; and relevant documentation. The bid
announcement should also include some further
requirements if the participation of companies under
consortium is allowed (art. 38) and for foreign
companies participating in the bid, either on its own
or in consortium, including the commitment that
they will set up a company pursuant to Brazilian
laws and headquartered and administered in Brazil if
they win the bid (Petroleum Law art. 39; ANP
Ordinance No. 84/2000).
The winning bid will be identified on the basis
of the objective criteria established in the bid
announcement, in accordance with principles of
legality, impersonality, morality, publicity and equal
standing of the participants. The general work
programme, as well as the governmental
participations, are essential in the selection of the
winning bid. The ANP Ordinance 1999 No. 174 sets
forth regulations for the bid procedures, and
650
establishes that bids will be conducted by a special
bid commission in six stages: prequalification;
qualification; publication of the public
announcement; bid award; bid ratification; and
execution of the concession contract.
CNP Resolution No. 8/2003 sets forth certain
guidelines for ANP to implement a policy of
expansion of oil and gas production, with a view to
achieve self-sufficiency and further exploration to
increase reserves. These comprise the inclusion of
blocks or areas in mature areas, and the requirement
that in the process of assessment of the bid
applications, the ANP will set out criteria to
encourage exploration programmes.
Right to prospect, explore, develop, produce
and dispose of petroleum resources
Unlike the data-gathering companies referred to
above, concessionaires are not required to request
authorization for data-gathering activities.
Nevertheless, they must inform the ANP about any
transaction related to the acquisition of data, either
by themselves or by a data-gathering company, with
whom there is a contractual relationship for that
purpose (art. 6 of ANP Ordinance 1998 No. 188).
Concessionaires have a right and a duty to
explore for oil and natural gas at their own expense
and risk, in a particular block, and, where successful,
to produce oil or natural gas. Concessionaires have
the property in the goods produced, subject to the
relevant charges and state participation (Petroleum
Law, art. 26).
Operating conditions
Private operators must comply with the
technical, economic and legal requirements of the
ANP before they may obtain a concession to explore
for and produce oil and natural gas. The operating
conditions for concessions are partly set out in the
Petroleum Law and partly in the Model Concession
Agreement.
The Petroleum Law provides for the
concessionaire’s general duties to explore for oil and
natural gas – at its own expense and risk – in a
particular block and, where successful, to produce
oil or natural gas. Where a concessionaire is
successful in the exploration stage, it must submit its
plans regarding the development and production of
the block to the ANP for approval. The ANP must,
within 180 days, make a decision on whether the
plans submitted are to be approved. The Petroleum
Law sets out two other conditions worthy of note.
First, when the concession is extinguished, the
concessionaire must remove any equipment which is
not subject to reversion to the state, repair any
ENCYCLOPAEDIA OF HYDROCARBONS

damages arising out of the activities, and carry out
any environmental recovery directed by the relevant
entities. Second, the transfer of concession contracts
is permitted, provided that the contractual conditions
are preserved and the new concessionaire conforms
to the technical, economical and legal requirements
established by the ANP.
Arts. 43 and 44 of the Petroleum Law set out
what must be included in concession contracts as
operating conditions. These are: a) the definition of
the block subject to the concession; b) the term and
the conditions for its extension; c) the work
programme and expected investment required; d )
state participations; e) the guarantees required to be
provided by the concessionaire of compliance with
the contract; f ) the rules on relinquishing areas; g)
procedures for inspecting the operations and
auditing the contract; h) the obligations on the
concessionaire to provide data to the ANP; i)
procedures relating to the transfer of the contract; j)
dispute resolution procedures; k) the possibilities for
cancellation/extinction of the contract; and l)
penalties for breach of contract.
Article 44 sets out more general duties of the
concessionaire that must be included in the contract.
These include obligations regarding: a) conservation
of reservoirs, safety, and preservation of the
environment; b) the immediate reporting of
discoveries; c) the evaluation of discoveries,
including potential commerciality; d ) the
submission to the ANP of development plans for
fields discovered to be commercial; e) its
responsibility for its agents; and f ) the adoption by
the concessionaire of petroleum industry best
practices.
We will take as an example the model
concession contract released by ANP in 2004.
Clause 4.2 of that document gives the term of the
contract as the period starting from the date it comes
into effect, until 27 years after the declaration of
commerciality. The declaration of commerciality is
at the sole discretion of the concessionaire,
according to clause 7.1.1. Also of interest is clause
20, which provides for minimum local content in the
goods and services utilized by concessionaires in the
performance of the contract. The ANP has also
provided for minimum requirements of using local
workers.
The transport of oil, natural gas, and oil products
in Brazil is made through pipelines – via seas and
rivers, roadways, and railways. Pursuant to the
Petroleum Law, any company or consortium of
companies that meets the provisions of such law
may receive authorizations from ANP to build
facilities and carry out any type of oil and gas
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product transportation, whether for domestic supply
or for import and export. It should be noted that the
Petroleum Law treats differently activities relating to
transfer of oil and transport of oil depending on
whether the oil, its by-products and natural gas are
owned by the concessionaire of the facilities, or are
in the public domain.
In order to obtain authorization from the ANP
for the construction, extension works and operation
facilities for transport or transfer of oil, its
by-products and natural gas, the interested party
must comply with the provisions of the Petroleum
Law and ANP Ordinance 170/98.
Unitization
Article 27 of the Petroleum Law establishes that
in the case of reservoirs extending on neighbour
blocks held by different concession holders, these
shall enter into an agreement for the
individualization of production.
Clause 12 of the ANP model concession contract
2004 contains unification provisions. Where a
concessionaire discovers that a reservoir extends
beyond the concession area, it must immediately
inform the ANP. If the adjacent area is also under a
concession, the ANP must notify all parties involved
so a unification agreement can be negotiated and
signed (the ANP may request to be present as an
observer at the relevant negotiations). Exploration
activities may be suspended while the unification
agreement is pending. The ANP can, within a certain
timeframe, request amendments to the unification
agreement. Once the ANP approves the unification
agreement, a new concession agreement, valid for
the unified area, must be signed. Where the adjacent
area is not the subject of a concession, the ANP may
– at its discretion – ensure the continuity of
operations. It is noteworthy that experiences in
unitization in Brazil are just emerging and they are
likely to increase due to the features of oil reservoirs
and the more recent adoption of cell system, with
small blocks for concessions.
Environmental protection
Brazil’s environmental laws are rather
advanced, having introduced the environmental
dimension into law and policy earlier than other
countries in Latin America, such as Colombia and
Mexico (Acuña, 1999). The Federal Constitution
1988 devoted an entire chapter to protection of the
environment; it establishes a series of obligations
applicable to the public authorities and community
at large. Law No. 6938/1981 (Federal Law) is
Brazil’s framework environmental law, which
defined a National Environmental Policy and
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created a national environmental council known as
CONAMA (CONselho NAcional do Meio
Ambiente). Balancing environmental objectives
and economic development policies is one of the
key objectives.
There is an entire system of federal agencies
designed to enforce environmental legislation in
Brazil. The Brazilian environmental system,
SISNAMA (SIStema NAcional do Meio Ambiente),
comprises the Brazilian environmental council
(CONAMA, the normative, consulting, and
decision-making agency); the IBAMA (Instituto
BrAsileiro do Meio Ambiente e dos Recursos
Naturais Renováveis, the Brazilian Environmental
and Renewable Natural Resources Institute, the
executive agency). SISNAMA also includes other
agencies of the federal administration, public
foundations that deal with environmental protection,
and entities of both state and municipal executive
branches (state and municipal environmental offices,
environmental agencies – such as the Companhia de
Tecnologia de Saneamento Ambiental, or CETESB,
the Fundação Estadual de Engenharia do Meio
Ambiente, or FEEMA, the Conselho de Política
Ambiental do Estado de Minas Gerais Câmara de
Bacias Hidrográficas Conselheiro, or COPAM,
among others), in their responsible jurisdictions.
Article 8, para. IX, of the Petroleum Law includes
among the functions of ANP, the enforcement of
best practices for the conservation and rational use
of petroleum, as well as environmental preservation.
The Environmental Management Coordinating Unit
(Coordenadoria de Meio Ambiente) was created to
coordinate the environmental and operational safety
aspects relating to ANP (ANP Ordinance 2004 No.
160).
As per Law 6938, art. 9, instruments of national
environmental policy include inter alia
environmental impact assessments, licenses,
environmental standards, planning, incentives,
protected areas, national environmental information
system, penalities and compensations.
The Environmental Crimes Law, Law No.
9605/1998, regulated by Decree No. 3179/1999, sets
out criminal offences against the environment. It
includes the possibility of jail sentences of up to
four years for individuals responsible for pollution,
and introduces liability for corporations for
environmental offences. Other sanctions include
fines and restrictions of rights.
As per CNPE Resolution No. 8/2003, the
relevant governmental agencies publish specific
environmental guidelines for the areas to be offered
for bidding. In general terms, petroleum-related
activities must comply with environmental licenses
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(CONAMA Resolutions No. 23 of 1994, No. 237 of
1997 and No. 350 of 2004); reclamation of areas
under concession in the exploration phase that have
been relinquished (ANP Ordinance No. 114 of
2001); procedures for abandonment of petroleum
wells (ANP Ordinance No. 25 of 2002), as well as a
range of obligations related, inter alia, to the
prevention of oil spillages; reporting and standards
for transportation, and those specified under the
relevant concession contract.
Fiscal structure and government take
Oil and gas activities are subject to general
federal, state and municipal taxes. These include the
federal income tax; the tax on distribution of goods
and services (ICMS, Imposto Sobre Circulação de
Mercadorias e Serviços), which is a Brazilian state
responsibility; the tax on services; the contributions
for the profit participation programme and the social
security financing contribution in it (PIS/COFINS,
Programa de Integraçao Social/COntribuição para o
FINanciamento da Seguridade Social), which are
federal matters and payroll deductions.
We must point out the REPETRO (Dispõe sobre
a aplicação do regime aduaneiro especial de
exportação e importação de bens destinados às
atividades de pesquisa e de lavra das jazidas de
petróleo e de gás natural), Special Customs System
for Export and Import Goods Intended for
Prospecting and Drilling of Oil and Natural Gas
Deposits, created by the federal government.
REPETRO exempts – from all federal import duties
(II – Import Duty – and IPI – Tax on Manufactured
Products in its Portuguese acronym) – imports under
the temporary admission system of certain products
relating to oil and natural gas, prospecting and
drilling activities. The REPETRO benefits include
special customs systems which are effective up to 31
December 2020.
Articles 45 to 52 of the Petroleum Law provide
for state participations in the form of signature
bonuses, royalties, special participations and fees for
the occupation or retention of areas (see also Decree
No. 2705/1998).
The signature bonus, according to art. 46, shall
be paid on execution of the concession contract and
its minimum value shall be established in the
bidding announcement.
Royalties are payable monthly in domestic
currency from the start of commercial production of
each field and shall correspond to 10% of the
production of oil or natural gas. Reduction of the
royalty to a minimum of 5% is possible given the
geological risks, production expectations, and other
relevant factors. The criteria for the computation of
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the value of the royalties shall be established by
Presidential Decree. Arts. 48 and 49 set out precisely
how the royalties from a particular block are to be
distributed amongst the state(s) where production
occurs, the relevant municipalities, the Ministry of
Science and Technology, and other government
institutions. This precision should help to eliminate
the uncertainty of distribution found in other
countries that can lead to contradictory claims being
made on the operator by different levels of
government.
Special participations, set out in art. 50 of the
Petroleum Law, are only possible for operations of
large production volumes or great profitability, and
are further regulated by arts. 21 to 27 of the
Participation Decree. ANP Ordinance 1999 No. 10
sets forth the procedures to be adopted in the
calculations. These provisions set out what the rate
of special participation will be, depending on the
location of the block (for example, whether it is
onshore or offshore), the year of production as well
as the level of production. The rate can be as high as
40%. The manner of distribution of special
participations is also provided for in great detail in
the Petroleum Law.
The bid announcements and the concession
contract shall set out the yearly payments to be made
for the occupation or retention of the block, on a
km2 basis. Where the relevant block is onshore, the
concessionaire must also make a monthly payment
to the surface owner of the property, which will
consist of 1% of the value of the oil or natural gas
production (ANP Ordinance No. 143 of 1998).
Fixing the price of oil/gas
Pursuant to the Petroleum Law, the prices of oil
by-products are free to be set by the market.
Nevertheless, CNP, by means of Resolution No.
4/2002, established that, in the event of there being
evidence that predatory prices are being practised, or
that there are circumstances affecting proper pricing,
ANP may take such action necessary as to remove
the disruption, including setting ceiling prices.
Foreign investment
Foreign investment is governed by art. 171 of the
Federal Constitution, as amended by Constitutional
Amendment 6, and 172, as well as by varying
federal and state statutes and regulations. Chief
amongst these are Investment Law No. 4131/1962
and Law No. 4390/1964, both regulated by Decree
No. 55762/1965.
Investment activities in Brazil are overseen by
the FIRCE (Department of Foreign Capital of the
Central Bank of Brazil). Foreign capital investment
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is accorded a similar legal treatment to that
applicable to national capital, in identical conditions.
Any distinction not sanctioned by law is prohibited.
A few sectors are exclusively reserved or partially
restricted for the state. Other economic activities are
open to foreign capital under certain conditions. In
addition to restrictions in the petroleum sector
(illustrated above), other restrictions on foreign
investment in certain areas, including inter alia,
energy, health services, media, rural property
acquisition, fishing, mail and telegraph, aviation and
aerospace, remain in effect. Mining on areas within
the national border strip (an area of 150 km width
along the surface borders) is also restricted: the
majority of capital (51%) must lie in the hands of
Brazilians and two thirds of workers have to be
nationals; and exploration and exploitation activities
are subject to additional authorization from the
National Defence Council.
According to art. 170 of the Federal
Constitution, anyone may freely engage in any
economic activity. Thus, no authorization from
government agencies would be needed except in the
cases provided for by law. One example is the
requirement that all investment or reinvestment must
be registered with the FIRCE to provide for the
remittance of profits, capital repatriation and
registration of profit reinvestment. In addition,
foreign investors have to comply with nationality
quota restriction imposed by Decree No. 5452/1943
regulating foreign investment whereby two thirds of
the labour force must be Brazilian.
Article 5 subpara. 4 of the Federal Constitution
establishes protection for property rights. Thus
expropriation is only permitted in cases of necessity
or public utility and upon the payment of fair
compensation. On a more general aspect, Brazil has
not joined ICSID and BITs signed have not entered
into force.
Currency regulation and settlement of disputes
Protection against foreign exchange losses has
been reduced in recent times in Brazil. The Brazilian
Central Bank used to guarantee that the original
amount invested could be repatriated tax free, but
this is no longer the case. This change is mitigated to
a certain extent by the fact that under certain
situations, Brazilian companies engaging in oil and
gas activities are able to maintain a US dollar bank
account in a Brazilian bank.
Art. 43 para. X of the Petroleum Law provides
that the concession contract must set forth the rules
for dispute settlement related to the contract and its
execution, which can include conciliation and
international arbitration.
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The ANP model concession contract 2004, in
clause 31, requires parties to attempt to resolve their
disputes amicably and if this is not possible, to
submit the dispute to ad hoc arbitration using the
International Chamber of Commerce (ICC)
Arbitration Regulations.
Law No. 9307/1996 governs arbitration in
Brazil. It is chiefly fashioned on the UNCITRAL
(United Nations Commission on International
TRAde Law) conceived as a model law, though the
new Brazilian law does not distinguish between
domestic and international arbitration (Bosco Lee,
2002), except for the requirement of recognition of
the foreign award by the Superior Court of Justice.
The law allows the enforcement of arbitral awards
(including foreign arbitral awards) in court. Where
there are issues arising from the arbitration that need
to be resolved by a court, or where one party seeks
to enforce the arbitral award in court, the ANP
model concession contract 2004 provides that the
parties submit to the jurisdiction of the courts of the
city of Rio de Janeiro. Brazil became a party to the
New York Convention 1958 with the enactment of
Decree No. 4311/2002. The ANP Model Concession
Contract 2004, according to clause 31.1 of that
document, must be executed, governed and
construed in accordance with Brazilian law.
12.2.4 Mexico
Ownership and title to underground resources
Mexico is a representative, federal and
democratic republic, comprised of states which are
free and sovereign as regards to their own regimes,
but united in a federation pursuant to constitutional
principles (art. 40 of the Political Constitution
of the United states of Mexico, the Mexican
Constitution).
Article 27 of the Mexican Constitution sets the
definition and status of ownership of the Mexican
nation over its petroleum and other hydrocarbons, as
well as the scope, principles and modalities of the
legal regime for their development. Pursuant to arts.
25 and 28, petroleum and other hydrocarbons are
considered as strategic areas, which are entrusted
exclusively to the public sector. The state manages
these areas by means of agencies or enterprises
which are controlled by the Federal Government
(see also the Foreign Investment Law 1993, art. 5).
From this constitutional basis, the core legal
framework for hydrocarbons is comprised of: the
Regulatory Law of Constitutional Art. 27 in the
Field of Petroleum and its Regulations (the
Petroleum Law), as well as of the Natural Gas Law
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1995 (the Gas Law); the Law of Public Works and
Related Services of 2000 (the Procurement Code);
the Law of PEtróleos MEXicanos 1992 (the PEMEX
Charter) and other relevant laws and regulations.
The Federal Government has exclusive jurisdiction
over the oil and gas industry.
Following the expropriation of the assets of
petroleum companies by the Decree of 18 March
1938, the main actor in the Mexican petroleum
industry has been PEtróleos MEXicanos (PEMEX).
This is a decentralized public entity created by the
Decree of 7 June 1938, whose purpose is to conduct
the strategic activities of the state in the petroleum,
other hydrocarbons and basic petrochemicals
industry (PEMEX Charter, arts. 1 and 2). The
upstream sector is virtually closed to private
companies, so the focus of this section is somewhat
different to that of most countries in Latin America.
There is no possibility for private investors to
acquire title to petroleum, and the only way they can
participate in the upstream sector is by way of
service contracts issued by PEMEX. With the aim of
developing a market for domestic consumption,
private investment can participate in downstream
activities (transportation, distribution and storage) of
natural gas. More recently, PEMEX-Exploration and
Production developed the Multiple Services
Contract (MSC), a new contractual scheme whereby
several services are performed by a single
contractor, which allowed the participation of both
national and international companies in the
exploitation of natural gas.
Pursuant to art. 27 of the Mexican Constitution,
the nation retains direct ownership (dominio directo)
of petroleum and all hydrocarbons located in the
national territory, including the continental platform.
Ownership is defined as inalienable and non
prescriptive. Only the nation can carry out the
exploitation of such resources in accordance with
the terms of the Petroleum Law. This Law reiterates
the constitutional provision and further defines the
scope of the term petroleum as comprising all
natural hydrocarbons – whatever their physical
condition (Petroleum Law, arts. 1 and 2).
State involvement in the petroleum industry
Only the nation may carry out all the activities in
the petroleum industry (Mexican Constitution, arts.
25, 27 and 28; and Petroleum Law, art. 2). The exact
extent of the petroleum industry is defined in art. 3
of the Petroleum Law. It includes: all exploration,
exploitation, refining, transportation, storage,
distribution and first hand sales of oil (and products
derived from oil refining); the exploration,
exploitation, preparation (including the
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transportation/storage related to those activities) and
first hand sales of gas; and the preparation,
transportation, storage, distribution and first-hand
sales of derivatives from oil and gas that might be
used as basic industrial raw materials and which
constitute basic petrochemicals.
PEMEX and its subsidiary companies have been
entrusted to act on behalf of the nation to carry out
the activities in the petroleum industry described in
art. 3 (Petroleum Law, art. 4,). PEMEX and its
subsidiaries are “decentralized public entities”
(PEMEX Charter, art. 2), meaning that they have
their own legal existence and equity but that the
state retains ownership and control over them
(Mexican Constitution, art. 25). Due to their public
nature, PEMEX and its subsidiaries are subject to
the special legal regime established by the PEMEX
Charter and other applicable statutes and regulations
which have implications for their contractual
practices. They are also bound by normal
commercial laws.
PEMEX is a vertically integrated company, and
is divided into the following subsidiaries: a)
PEMEX-Exploration and Production, whose
purpose is the exploration and exploitation of
petroleum and natural gas; b) PEMEX-Refining,
which is responsible for industrial processes of
refining; elaboration of petroleum products and
petroleum derivatives; c) PEMEX-Gas and Basic
Petrochemical, which processes natural gas,
liquefied natural gas and synthetic gas; and d )
PEMEX-Petrochemical, which is responsible for
processing petrochemical industrial products
constituting part of the basic petrochemical industry.
In all cases, these entities are also in charge of the
transportation, storage and marketing of their
products (PEMEX Charter, art. 3).
PEMEX-International Trade is the commercial arm
of PEMEX in the international market, dealing with
crude oil imports and exports.
It follows that direct participation in the
upstream petroleum sector in Mexico is closed to the
private sector, and that, in the downstream sector,
only certain gas-related activities, principally those
involving transportation and storage not related to
the upstream sector, and distribution, are open to
private participation (Petroleum Law, art. 4.2).
However, according to art. 6 of the Petroleum
Law, PEMEX may engage individuals or companies
on a work or service contract basis to help it to
conduct its activities, but such contractors must be
paid in cash and may not take percentages or
participations in the production. Likewise, art. 4 of
the PEMEX Charter states that PEMEX and its
subsidiaries may, in accordance with their relevant
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purposes, enter into all types of acts, agreements or
contracts and issue credit instruments with
individuals or companies. In any case, neither
PEMEX nor any of its subsidiaries has a right of
ownership in Mexico’s domestic hydrocarbons.
Turnkey drilling contracts have been the most
common form of private participation in Mexico’s
petroleum industry.
Contracts
The principal avenue for private sector
participation in the Mexican oil industry is entered
into with PEMEX by way of service contracts –
typically for drilling and other forms of exploration,
in accordance with art. 134 of the Mexican
Constitution, the Law of Public Works and Related
Services (the Procurement Code), and associated
statutes and regulations. The Procurement Code (art.
3) mandatorily applies to contracts for, among other
things, the following activities: a) exploration,
geotechnics, location and drilling works; b) integral
or turnkey projects where the contractor is obligated
from the design of the work to its total completion,
including, when applicable, transfer of technology;
c) exploration, location and drilling works other than
oil and gas extraction; improvement of soil and
subsoil; disassemble; extraction and the like, the
purpose of which is the exploitation and
development of natural resources located in the soil
or subsoil; and d ) installation of artificial islands
and platforms directly or indirectly used in the
exploitation of natural resources.
As can be seen from the above, the service
contracts may extend only to exploration and
appraisal of oil and gas reservoirs; any production
has to be undertaken by PEMEX itself.
The contracts can be unit price contracts (where
compensation is based on the completion of units of
work), lump sum contracts (where compensation is a
fixed aggregate amount) or alternatively a mixture
of the two. Turnkey drilling contracts are usually
lump sum contracts. Article 46 of the Procurement
Code sets out thirteen basic terms which must be
included in the contract. These are: a) authorization
of the budget to pay the contract; b) indication of the
procedure by which the contract was awarded; c)
contract price; d ) term of the contract, which obliges
the contractor to finish the works by a certain time;
e) procedure for payment; f ) requirement of a
performance guarantee (including a guarantee for
any advance payments), which must be provided
within 15 days of the day the notification of the
award of the contract (art. 48 of the Procurement
Code deals with the performance guarantee); g)
details of payments for already performed works; h)
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penalties for delays in the works, which may not
exceed the amount of the performance guarantee; i)
method for reimbursing any excess payments
received; j) cost adjustment procedure; k)
circumstances in which PEMEX may terminate the
contract; l) detailed description of the works to be
performed; and m) dispute resolution procedures.
The actual content of these clauses is for the parties
to negotiate.
The Procurement Code prevents the assignment
of contracts awarded (art. 47). It is possible for the
contractor to receive advance payments prior to the
date for starting the works in a particular year (up to
30% of the approved budget allocation) in order to
cover upfront capital expenditure, though these
payments must be included in the performance
guarantee (Procurement Code, art. 50).
As the contract is performed, the contractor
must, at least once a month, submit to PEMEX an
estimate of the performed works (Procurement
Code, art. 54). PEMEX should, where appropriate,
approve the estimate within fifteen days after its
submission and then make the necessary payment
within twenty days after approval is given. Where
economic circumstances occur which are not
provided for in the contract, and result in a change to
the cost of the works, arts. 56, 57 and 58 of the
Procurement Code allow for cost adjustments to be
made.
As described below, the Ministry of Public
Function (the Ministry) has an important
supervisory role to play in respect to the provision of
the services under the contract, including a right to
inspect in situ the services being provided to
determine if they are being performed in accordance
with the terms of the Procurement Code (art. 75).
PEMEX must deduct a certain percentage from the
contractor’s invoices in order to pay this Ministry for
performing its role. If the Ministry decides that the
relevant contract needs to be annulled for reasons
attributable to PEMEX, the latter must reimburse the
contractor for any non-recoverable expenses it has
incurred.
Once the works are complete, the contractor is
liable for any hidden defects that may appear in the
works, and, pursuant to art. 66 of the Procurement
Code, must provide a guarantee for a term of twelve
months in case any such defects occur. Such a
guarantee can either be a bond amounting to 10% of
the value of the works, a letter of credit for 5% of
the value of the works, or else, funds amounting to
5% of the value of the works placed in a trust.
PEMEX has full power to temporarily suspend a
contract at any time with justified cause, and to
terminate it early where there are general interest
656
reasons for doing so or where the contractor has not
complied with the terms (Procurement Code, arts.
60 and 61). Where early termination is attributable
to PEMEX, the latter shall pay for the contractor’s
performed works and non-recoverable expenses.
In 2002, PEMEX-Exploration and Production
developed a new contractual scheme that allows the
participation of both national and international
companies. This was with a view to promoting
natural gas projects in areas with geological
potential, increasing the internal supply of such
resources, and strengthening project, technology and
financing capabilities.
As explained before, this is the MSC, a form of
service contract which brings together into one
single contract the type of services that are usually
performed for PEMEX under several contracts, for a
fixed fee. A draft generic form of MSC was
available for the first bidding round in 2003. This
scheme was under revision at the time of writing.
The MSC has been criticised in parliamentary
discussion by those who argue that pursuant to the
constitution, only PEMEX can undertake activities
aimed at the exploitation of natural gas and hence,
they cannot be granted to private companies.
Tender process
With a few exceptions, the service contracts
must be awarded by public tender (Procurement
Code, arts. 27 and 28), and the Procurement Code is
very detailed about how the tender process should
occur. All participants in the tender must be treated
equally and have the same access to information.
The tender will only be open to Mexican
participants, except where the terms of treaties or
the provision of external credit demand international
participation; no proposals were submitted in the
course of a Mexican-only tender; or else an
investigation has shown that Mexican contractors
lack the necessary skills or capacity (art. 30). The
Procurement Code sets out what tender proposals
must contain, how the terms of a call for tender may
be modified and the procedure for the delivery,
opening and evaluation of tender proposals.
In certain cases, the public tender requirement
may be dispensed with, and PEMEX may award a
contract through either an invitation to bid to at least
three persons or a direct award to a person
(Procurement Code, art. 42). The circumstances in
which public tendering is not required include
where: a) a person holds exclusive rights which are
required for the performance of the contract; b)
there is some sort of emergency or disaster which
precludes a public tender process; c) potential losses
or costs justify the alternative procedures; d ) there
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have been two unsuccessful public tender
procedures.
Right to prospect, explore, develop,
produce and dispose of petroleum resources
Activities in the petroleum industry as defined in
art. 3 of the Petroleum Law are carried out by
PEMEX, and will be performed by way of
assignments of lands granted to PEMEX by the
Energy Secretariat either at PEMEX’s request or as
considered convenient by the Federal Executive
branch (Regulation to Petroleum Law, art. 5). Each
assignment – the number of which is unlimited –
can cover up to 100,000 ha and has a 30-year term,
renewable at PEMEX’s request (Regulation to
Petroleum Law, art. 6). PEMEX cannot assign,
transfer, sell or by any means compromise the
assignments.
Reconnaissance and surface exploration require
prior authorization from the Energy Secretariat (art.
7) at PEMEX’s request. The Petroleum Law and its
Regulation set out a procedure for access to land in
case of opposition by the landowner or landholder,
or, in certain cases, by legal representatives of ejidos
or communities (Petroleum Law, art. 7 and
Regulation of Petroleum Law, art. 8), as well as for
temporal occupation or expropriation of land and for
compensation (Regulation of Petroleum Law,
chapter X). In any case, the overarching principle is
that of public utility of the petroleum industry,
whereby the use of land for this industry takes
precedence over any other land use (Petroleum Law,
art. 10).
As for the downstream gas-related activities in
which the private sector may participate pursuant to
art. 4.2 of the Petroleum Law, terms, conditions and
related matters (including the issuing of permits) are
regulated by way of the Natural Gas Regulation as
set out in art. 14 of the Petroleum Law. Permits may
be granted to private entities and to PEMEX and
other decentralized agencies of the energy sector
(Natural Gas Regulation, art. 14). They shall be
granted by the Energy Regulatory Commission
either on the basis of application (Natural Gas
Regulation, arts. 32 to 37) or public bidding (arts. 38
to 46). Permits shall be for a 30-year term,
renewable for additional terms of 15 years each
(Natural Gas Regulation, arts. 19 and 53).
As far as operating conditions in this section are
concerned, see operating conditions in service
contracts above.
Environmental protection
The petroleum industry is subject to the rules
and procedures set out in the General Law of
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Ecological Balance and Environmental Protection
1988 (amended 2005; i.e. the Environmental Law).
This law’s purpose is to promote sustainable
development and set the basis for, inter alia,
ensuring the right of every person to live in an
environment adequate for their development, health
and well-being (Environmental Law, art. 1). The
petroleum industry is under federal jurisdiction (art.
5), and the competent authority is the Secretariat of
the Environment, Natural Resources and Fisheries
(the Environmental Secretariat; art. 6). The
Environmental Attorney General also has
supervisory powers in order to protect the
environment. PEMEX must comply with these
environmental provisions. The Procurement Code,
art. 20, requires that contractors consider the effect
on the environment that the works may cause, and
prior to commencing the project, undertake an
environmental assessment in accordance with the
Environmental Law.
The Environmental Law defines environmental
impact assessment as the procedure whereby the
Environmental Secretariat sets forth the operating
conditions for works and activities subject to
compliance, with a view to avoiding or minimizing
their negative environmental impact. The petroleum
industry is one of the industries in Mexico which
requires prior authorization from the Environmental
Secretariat, in so far as the environmental impact of
its activities (art. 28) is concerned. It must submit an
environmental impact statement (art. 30) which is to
be made available to the public. Public consultation
can be carried out by the secretariat at the request of
any person from a relevant community (art. 34). In
addition, those conducting activities classified as of
high-risk pursuant to art. 147 of the Environmental
Law and associated regulations must submit an
environmental risk study and provide an
environmental risk guarantee (art. 147 bis). The
Environmental Law includes a definition of
hazardous wastes, which are identified, classified
and characterized by Mexican Official Standards,
specifically by NOM-052-SEMARNAT-93.
The secretariat can approve, authorize subject
to certain conditions, or reject the submitted
statement (art. 35). The Environmental Law
provides for the use of economic instruments
(arts. 21 and ff.) and coordination with voluntary
processes of environmental self-regulation and
auditing (arts. 38 and ff.). It relies on
administrative mechanisms (from fines to
temporary and definite shutdown, administrative
detention up to 36 hours, and suspension or
revocation of the relevant concession, license,
permit or authorization) to enforce compliance
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
(art. 171). Transgressors are also subject to civil
and criminal liability under the relevant regimes.
Fiscal structure and government take
Main taxes and applicable fees to the
petrochemical industry include income tax,
value-added tax, special production and services tax,
oil earnings tax, import taxes, oil extraction fee,
extraordinary oil extraction fee, oil extraction
additional fee and hydrocarbon fee (Basham, et al.,
2000).
PEMEX’s tax regime is established under art. 7
of the Income Law of the Federation. PEMEX is
exempted from paying the Income Tax, but is subject
to the payment of: a) the oil extraction fee which is
due per each petroleum extraction region; b)
extraordinary oil extraction fee; c) additional oil
extraction fee; d ) oil earnings tax; e) hydrocarbons
fee; f ) special production and services tax; g) value
added tax; h) import duties and export taxes; and i)
fees for exceeding earnings, as well as other generic
fees (Income Law of the Federation for 2005;
Basham et al., 2000).
PEMEX does not have either economic or
financial autonomy. Its budget has to be approved by
congress as part of the budget of the republic, hence
macroeconomic objectives might prevail over the
company’s investment strategies and decisions. A
comprehensive tax reform has been discussed in
congress over the past few years, but the issue has
not yet been resolved (Campodónico, 2004).
Fixing the price of oil/gas
The gas price is fixed in accordance with art. 8
of the Gas Act. The maximum price for first hand
sales of gas by PEMEX shall be set in accordance
with directives issued by the Energy Regulatory
Commission. The price calculation methodology
shall reflect gas opportunity costs, competitive
conditions in international markets, and the place
where the sale is made. The maximum price of gas
shall not affect the right of the purchaser to negotiate
more favourable conditions in the purchase price.
Foreign investment
The Foreign Investment Law of 1993 repealed
the Law to Promote Mexican Investment and
Regulate Foreign Investment of 1973. A list of
restricted areas exclusively reserved for the state is
mentioned in art. 5 of the Foreign Investment Law.
These include oil and other hydrocarbon activities,
as well as electricity, broadcasting, and postal
services. According to art. 6 of the Foreign
Investment Law, several activities are exclusively
reserved for Mexicans or Mexican firms with a
658
clause excluding foreigners. Such restriction can be
of a limited effect since once an investment is made
through an enterprise registered in accordance with
Mexican laws, it is deemed a Mexican enterprise
with the guarantees that this provides.
The administrative authorities chiefly comprise
of the Secretariat of Commerce and Industrial
Development, the National Foreign Investment
Commission and the National Foreign Investment
Registry created under the Foreign Investment Law
1993. Investors must register their investment within
40 days of establishing their activities. In order to
renew their investment, investors are further
required to report their economic and financial
activities to the National Registry.
Under the general foreign investment regime,
foreign investors have the same procedural recourse
as national investors. Special recourse for foreign
investors is envisaged only in the dispute settlement
sections of the free trade treaties to which Mexico is
a party. Mexico is not a member of ICSID, however,
the country is a member of UNCITRAL, and has
enacted an arbitration law fashioned in UNCITRAL
Model Law pattern (von Wobeser, 2002).
Mexico has been a NAFTA member since
1993. Chapter 11 of the agreement permits
investors of a member state to arbitrate any
investment dispute against a hosting member state.
The country has also signed free-trade agreements
with a number of Latin American states and the
European Union (EU). These treaties usually
provide for arbitration relating to investment
disputes. The current legislation pertaining to
arbitration is found in various domestic and
international instruments. These include the
national Commercial Code, the Federal Code of
Civil Procedure as well as various states’ civil
procedure laws. Other related laws include the
federal laws relating to consumer protection,
copyright and telecommunications (von Wobeser,
2002).
On our specific area of study, investment
protection is based on the Procurement Code and is
discussed above. If a service contract is prematurely
terminated for reasons not attributable to the
contractor, the contractor has the right to claim
payment for its performed works and compensation
for its expenses.
Currency regulation and settlement of disputes
Since production sharing and concessions are not
possible for private investors in Mexico’s oil and gas
sector, the only relevance of currency regulation is
the currency in which service contract fees are paid.
According to the Monetary Law of Mexico,
ENCYCLOPAEDIA OF HYDROCARBONS

international service contract fees can be
denominated in either foreign currency (usually US
dollars) or Mexican pesos. Where a US dollar
contract is payable in Mexico, it may be paid in
pesos, subject to the conversion rate set out in the
contract or else the official Banco de Mexico rate. In
the event that proceedings are brought in Mexico
seeking performance of any of the parties
obligations in Mexico, pursuant to the Mexican
Monetary Law, the relevant party may discharge its
payment obligations denominated in a foreign
currency by paying any such sums, in Mexican
currency at the rate of exchange prevailing in
Mexico on the date when payment is made.
Disputes are provided for in arts. 83-91 of the
Procurement Code. Disputes involving the
contracting procedure may be notified to the
ministry, which may investigate the dispute and
request further information from the parties. Where
the ministry finds that the contracting procedures set
out in the Procurement Code have been breached, it
may issue a resolution suspending the contracting
procedure. Such a resolution may be appealed to the
relevant courts.
For disputes that involve non-compliance with
the terms of service contracts, the parties may file
complaints to the ministry, which shall hold a
conciliation hearing to determine the matter. If the
parties reach an agreement pursuant to the
conciliation, it shall be binding on them. If not, they
may still pursue a remedy through the courts.
Article 15 of the Procurement Code deals with
arbitrations in respect of matters under the
Procurement Code, and limits arbitrations to those
matters set out by the Ministry, and agreed on by the
Ministry of Finance and Public Credit and the
Ministry of Economy.
In most cases, Mexican law is the applicable
law. The Procurement Code (art. 16) provides that
the service contract should be governed by the law
of the place of execution of the contract, and that
where a contract is awarded on the basis of a
public tender and the works or services under it
are to be performed in Mexico, the contract should
be executed in Mexico. Article 15 of the
Procurement Code provides that disputes
concerning contracts executed in accordance with
the Procurement Code must be referred to the
Mexican federal courts.
It should be borne in mind that while the
Procurement Code must apply to the service
contracts, it is not the only law that can apply. In
1993, the PEMEX Charter was amended so that, for
contracts with an international element, PEMEX
could agree to an applicable law other than that of
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Mexico, if it were convenient (PEMEX Charter, art.
14). Thus, the possibility exists that the law of other
jurisdiction applies as well as the Procurement
Code. Importantly, PEMEX is not able to claim
sovereign immunity in Mexico, according to art. 14
of the PEMEX Charter.
As a matter of public policy, under art. 4 of the
Federal Code of Civil Procedure of Mexico (Código
Federal de Procedimientos Civiles), attachment prior
to judgment or attachment in aid of execution will
not be enforced by Mexican courts against property
of PEMEX and its subsidiaries. This provision is
included in every agreement in which a public entity
is a party and it has been accepted by the
international financial community.
12.2.5 Venezuela
Ownership and title to underground resources
The Bolivarian Republic of Venezuela is a
democratic and social state (Constitution, art. 2); it
has a decentralized federal structure (Constitution,
art. 4).
The legal framework for hydrocarbons in
Venezuela has evolved over different periods,
coloured by diverging paradigms of development
and attitudes to private investment. The period of
use of concession agreements lasted for most of the
Twentieth century, until the nationalization of the
hydrocarbons industry occurred. Nationalization
was gradually implemented in the early 1970s and
culminated with the enactment of the Organic Law
Reserving the Hydrocarbons Industry and Trade to
the state (the Nationalization Law) in 1975. This
law established the state monopoly over
hydrocarbon exploration, production, refining,
marketing and exporting, and set up the basis for
the creation of a state-owned company to
administer and manage these activities. Petróleos
De Venezuela Sociedad Anònima (PDVSA) was
formed later that year. In the early 1990s, the
government launched the opening of the oil
industry to private investment. This was
implemented by different modalities of association
with PDVSA: the exploitation of marginal fields
through operating agreements; strategic
associations (for the development of extra heavy oil
projects in the Orinoco belt); and association
agreements for the exploration at risk of
non-traditional areas and production of
hydrocarbons under a profit-sharing scheme.
This state of affairs would see radical changes
with the administration of Hugo Chávez-Frías in the
late 1990s. President Chávez supported the
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
enactment of a new constitution (the Constitution of
1999) which strengthens the legal implications
derived from the “social state clause” (art. 2) and
reaffirms resources ownership and state control over
oil and gas activities. The core principles and
modalities of the current legal regime of
hydrocarbons are set forth in the Venezuelan
Constitution of 1999, the Organic Law of
Hydrocarbons of 2001 (the Hydrocarbons Law)
which was partially modified in 2006, and the
Organic Gaseous Hydrocarbons Law of 1999 (the
Gas Law).
Since President Chávez passed the Hydrocarbons
Law and the Gas Law, the hydrocarbons industry in
Venezuela has been governed by two fundamentally
different legal regimes. The gaseous hydrocarbons
regime is designed to attract private investors – with
a view to increase gas consumption – as is the
petroleum regime with respect to downstream
activities. However, whilst not fully closed to private
sector investment, upstream petroleum activities are
now much less open than they were before 2001.
The Hydrocarbons Law, enacted after the Gas
Law, did not make it entirely clear how the two
pieces of legislation were to fit together. For
instance, while the Gas Law excluded upstream
activities related to associated natural gas, the
Hydrocarbons Law did not expressly state that it
covered such activities. On the contrary, art. 2 of the
Hydrocarbons Law provided for a general statement
in virtue of which activities associated with gaseous
hydrocarbons were to be governed by the Gas Law.
The ambiguity in the determination of the applicable
law to upstream activities of associated natural gas
was finally cleared up by art. 2 of the 2006
amendment to the Hydrocarbons Law which
submitted those types of activities to the provisions
of the Hydrocarbons Law.
The competent authority for the administration
of hydrocarbons, with the capability of inspection of
activities and monitoring operations is the Ministry
of Energy and Petroleum, (the Ministry;
Hydrocarbons Law, art. 8, Gas Law, art. 6). The
national gas entity ENAGAS (Ente NAcional del
Gas) is responsible for the supervision and police
functions of the transportation and distribution of
gaseous hydrocarbons (Gas Law, art. 36).
According to art. 12 of the Venezuelan
Constitution 1999, all hydrocarbon deposits that
exist within the territory of Venezuela, including the
territorial sea, the exclusive economic zone and the
continental platform, are “the property of the
Republic, are of public domain, and therefore
inalienable and imprescriptible”. This article is the
basis of the Hydrocarbons Law and the Gas Law,
660
and has been used by the government to justify
requiring all upstream petroleum activities to be
conducted under the control of the state (as is
described below).
Ownership and title to petroleum and gas
reservoirs underground vests with the state, as per
art. 12 of the Venezuelan Constitution 1999. This is
reaffirmed by art. 3 of the Hydrocarbons Law and
art. 1 of the Gas Law.
The following summary deals for the most part
with petroleum and gas resources separately.
Petroleum is used to refer to liquid hydrocarbons
and associated gases, and gas is used to refer to
hydrocarbon gases.
State involvement in the hydrocarbons industry
Petroleum
The state participates in the petroleum industry
directly via PDVSA, the state oil company, PDVSA’s
subsidiaries or other entities provided for in arts. 27-
32 of the Hydrocarbons Law. This gives the National
Executive the power to create companies solely
owned by the state or to agree on incorporated joint
ventures with private investors for the execution of
hydrocarbons activities. PDVSA is subject to the
rules of private law but it is also a state company.
According to art. 303 of the Venezuelan Constitution
of 1999, the state must retain all shares in PDVSA,
though this does not apply to its subsidiaries and
affiliates. In accordance with the Hydrocarbons Law
(art. 29) PDVSA’s actions must follow government
policy implemented through the Ministry, and it is
subject to the supervision of the National Executive
through the Ministry (Hydrocarbons Law, art. 30).
The Ministry’s objectives include coordination,
supervision and control of the activities of state-
owned companies and private entities performing in
the hydrocarbons sector, throughout all stages
including exploration, production, refining,
commercialization, transport and any other
hydrocarbons-related activity.
Gas
Article 22 of the Gas Law states that the various
activities in the Gas Law may be carried out by
private persons with or without state participation,
or directly by the state. Since state participation is
not essential in gaseous hydrocarbon ventures, the
provisions relating to state companies in the Gas
Law are not as crucial as those in the Hydrocarbons
Law. Articles. 43-46 of the Gas Law provide for
state companies, and allow the National Executive to
create corporations which are solely owned by the
state.
ENCYCLOPAEDIA OF HYDROCARBONS

Contracts and licences
Petroleum
Article 302 of the Venezuelan Constitution of
1999 reserves petroleum activity to the state, for
reasons of national interest. Based on this article of
the constitution, the state has specifically reserved to
itself – in art. 9 of the Hydrocarbons Law – certain
activities associated with the search for petroleum:
exploration; production; gathering; and initial
transport and of storage. These are called primary
activities.
Primary activities may only be performed
directly by the state, by 100% state-owned
companies or by incorporated joint venture
companies in which more than 50% of the shares are
held by the state. These companies performing
primary activities are operating companies
(Hydrocarbons Law, art. 22). The fact that
exploration cannot be carried out by companies in
which the state holds less than a 50% stake may
restrict the level of upstream activity in Venezuela,
since this requires significant investment and risk
exposure for the state in every new venture.
Moreover, a company in which the state holds more
than 50% of the shares is deemed to be a state-
owned company (Organic Law on Public
Administration, art. 100). Indeed, for this same
reason, the company shall be subject to a number of
laws and regulations applicable to public entities
only, that in practice might result in hindrances, as
delays affecting the day-to-day operations
(borrowing of funds, acquisitions of goods and
services, etc).
Per art. 24 of the Hydrocarbons Law, the
National Executive, may transfer by decree to
operating companies, the right to carry out the
primary activities, as well as the property of
movable or immovable assets vested in the private
domain of the state which might be instrumental for
performing those activities efficiently.
Regarding the contracts entered into under the
previous regime opening up the oil industry which
was implemented in the early 1990s, in April 2005
the Ministry ordered the conversion of the 32
operating agreements into incorporated joint
ventures (empresas mixtas) arguing the illegality of
such agreements and the need to adapt such ventures
to the terms of the Hydrocarbons Law.1 This was
part and parcel of President Chavez’s Full Petroleum
Sovereignty Policy, which also comprised a new
package of tax burdens over the oil sector.
In March 2006, the Venezuelan National
Assembly approved the conditions for the new joint
ventures2, and weeks later the law for the
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regularization of private participation in the primary
activities referred to in the Hydrocarbons Law.3 The
main purpose of these laws was to declare the
illegality and extinction of the operating agreements
executed during the 1990s and to establish the
conditions of the new joint ventures.
As a result, almost all former partners4 in the
operation agreement assented to the conversion into
incorporated joint ventures. Nevertheless, some
fields were returned to PDVSA: B2X68/79
(formerly operated by Hocol), Maupa (formerly
operated by Inemaka), Sanvi-Güere (formerly
operated by Teikoku), Guárico Occidental (formerly
operated by Repsol) and Quaimare-La Ceiba
(formerly operated by Repsol). Therefore 22
incorporated joint ventures were constituted with a
state stake above 51% in accordance with the
Hydrocarbons Law (Table 1).
The new incorporated joint ventures (or
empresas mixtas) have the following features: a) the
property of the fields is not transferable and the state
maintains sovereignty over them; b) the state,
through its company Corporación Venezolana del
Petróleo (CVP) has a participation stake of not less
than 51% in the joint venture; c) oil production must
be sold to PDVSA and its commercialization is an
exclusive right of the state (PDVSA); d ) as
discussed below, the incorporated joint ventures are
subject to a new tax regime.
The Strategic Associations were joint ventures to
upgrade extra-heavy oil into synthetic crude from
the Orinoco basin which is located along the
Orinoco River in the south-east of Venezuela.
Between the years 1993 and 1997, PDVSA entered
into four Strategic Associations (Boyaca, Junin,
Ayacucho and Carabobo; Table 2).
Under the full petroleum sovereignty policy
these association agreements as well as the
associations for exploratory risks and profit
sharing of Paria Este, Paria Oeste, la Ceiba and
Orifuels Sinovensa, are also bound to shift into
incorporated joint ventures with PDVSA or any
of its affiliates holding a majority stake of at
least 60%.
1 See speech of the Ministry to the National Assembly,
available from:
http://www.mem.gob.ve/noticias/prensa/English_version.pdf.
2 Official Gazette of the Bolivarian Republic of
Venezuela No. 38410, dated 31 March 2006. Conditions of
the shareholders’ joint ventures that will rule the terms of
the joint venture companies (empresas mixtas).
3 Regularization Law of private Participation in the
Primary Activities in Decree No 1510 per Crjanic
Hydrocarbons Law.
4 Except Eni of Italy and Total of France.
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY

and by-products as indicated by the National

Table 1. Stake distribution of the incorporated Executive may only be commercialized by the
joint ventures Venezuelan state-owned companies. Other products
may be commercialized by either state-owned
Fields PDVSA Investor companies, joint ventures or private entities as long
Kaki 60% Inemaka (40%)
as they hold a permit issued by the Ministry (art.
61). However, the state has the right to reserve such
Cabimas 60% Suelopetrol (40%) activities to 100% state-owned companies. Supply,
Onado 60% CGC (40%) storage, transportation and distribution of petroleum
by-products also may not be continued except by
Guárico Oriental 70% Teikoku (30%) way of a ministry permit (art. 61).
Mene Grande y Quiriquire 60% Repsol (40%)
Gas
Boscán 60% Chevron (40%)
Article 302 of the Venezuelan Constitution of
LL-652 75% Chevron (25%) 1999 refers specifically to “petroleum activity”, and
Falcón Este y Falcón Oeste 60% VINCCLER (40%)
as a result non-associated natural gas is not subject
to the state reservation which is applied to the
Casma-Anaco 60% OPEN (40%) petroleum industry. The Gas Law (art. 2) expressly
Colón 60% Tecpetrol (40%) allows private entities, whether foreign or national,
to engage in the exploration for and exploitation of
Urdaneta 60% Shell (40%) reservoirs of non-associated gas, as well as the
Acema 60% Petrobras (40%) gathering, storage, utilization, processing,
industrialization, transport and domestic/foreign
La Cconcepción 60% Petrobras (40%)
marketing of natural gas, be it associated or non-
Mata 60% Petrobras (40%) associated. These activities may, of course, also be
carried out by the state. The Gas Law equally applies
Oritupano Leona 60% Petrobras (40%)
to non-hydrocarbon elements of gaseous
Pedernales 60% Perenco (40%) hydrocarbons and liquid hydrocarbons which can be
Ambrosio 60% Perenco (40%) extracted from natural gas. The activities set out in
art. 2 of the Gas Law may only be conducted by
B2X70/80 80% Hocol (20%) private persons where the person receives a licence
Monagas Sur 60% Harvest (40%) or a permit to do so from the Ministry (art. 22).
Caracoles y Intercampo 75% CNPC (25%)
Right to prospect, explore, develop,
D.Z.O. 60% BP (40%) produce and dispose of petroleum resources
We refer here to the above mentioned possibility
Boquerón 60% BP (25%)
to transfer by decree the right to carry out the
Source: PDVSA (Petróleos De Venezuela Sociedad Anònima). primary activities to operating companies
(Hydrocarbons Law, art. 24).
In accordance with the rules for the migration The National Executive will set the boundaries
of the Orinoco Belt joint ventures and other profit of the geographical areas in which the primary
sharing joint ventures into new incorporated joint activities are to be performed by operating
ventures (empresas mixtas),5 investors are meant companies into blocks of up to 100 km2 each
to keep ownership of the infrastructure, transport (Hydrocarbons Law, art. 23). Petroleum activities
services and converters (art. 3) and the use of are of public utility and social interest, and take
these facilities will be compensated by the new precedence over other land uses. Those authorized to
joint venture pursuant to further negotiation. perform these activities are entitled to request the
Refining (distillation, purification and temporary occupation or expropriation of assets, as
transformation of natural hydrocarbons) and the well as the constitution of servitudes. Arts. 38 and ff.
commercialization of the products obtained may be of the Hydrocarbons Law provide for the rules and
carried out by the private sector (Organic Law of procedures to get access to land, including
Hydrocarbons, art. 10). The right to carry out
refining activities is subject to obtaining a licence
(art. 12), and those engaged in refining activities 5 Presidential Decree No. 5200 of 26 February 2007
must be registered (art. 14). Natural hydrocarbons (published in Official gazette of same date No. 38632).

662 ENCYCLOPAEDIA OF HYDROCARBONS


Table 2. Strategic Associations into which PDVSA entered between 1993 and 1997
Strategic Asociations Stakeholders
PDVSA
Junin (formerly Petrozuata)
ConocoPhillps
PDVSA
Boyaca (formerly Sincor) Total
Statoil
PDVSA
Ayacucho (formerly Hamaca) ChevronTexaco
ConocoPhillips
PDVSA
Carabobo (formerly Cerro Negro) ExxonMobil
Vebaoil
Source: PDVSA (Petróleos De Venezuela Sociedad Anònima).
notification to landowners and rules for expert
appraisal and compensation.
Operating conditions
Petroleum
The operating conditions under which joint
venture companies may perform the primary
activities set out in art. 9 must be approved by the
National Assembly of Venezuela, acting on the
advice of the Ministry through the National
Executive (Hydrocarbons Law, art. 33). The
minimum conditions, which are set out in art. 34 of
the Hydrocarbons Law and in the Venezuelan
National Assembly resolution of March 2006,6
are: a) a twenty-five year maximum term, renewable
for not more than fifteen years; b) indication of the
location, orientation, extension and shape of the area
where the activities are to be carried out; c) an
obligation to maintain the lands and permanent works
(including the facilities, accessories and equipment,
and any other equipment acquired for the performance
of the activities) in good condition and to hand these
over to the state at the end of the term; and d ) any
disputes that cannot be settled in a friendly way
(including by arbitration) shall be decided by
Venezuelan courts.
Article 15 of the Hydrocarbons Law deals with
the operating conditions for refining activities. The
licences granted regarding refining activities must
contain the provisions described in c) and d ) above.
Article 66 sets out the penalties for violations of the
Hydrocarbons Law, including fines and suspensions.
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Participation (%) Production (bbl/d)
49
130
51
38
47 200
15
30
30 170
40
41.67
41.67 120
16.67
Gas
The licences by which private persons may
conduct exploration and exploitation of non-
associated natural gas must contain certain
minimum terms (art. 24) which are not unlike the
minimum conditions under which joint ventures may
conduct primary activities for petroleum: a) a
description of the project, including the destination
of the gas; b) a thirty-five-year maximum term
which may be extended for not longer than thirty
years (the extension must be applied for after
completion of half the initial period and not later
than five years before the end of the initial period);
c) a maximum period of five years (part of the initial
period) during which the exploration (and any
further work specified by the Ministry) must be
carried out, subject to additional conditions which
may be specified in gas regulations; d ) an indication
of the extent, manner, location and technical
demarcation of the area subject to the licence; e)
special considerations required to be made in favour
of the state must be specified; f ) conditions in c)
and d ) described above in respect of petroleum
primary activities also apply to gas.
Gas regulations may establish other conditions
which apply to the exploration and exploitation of
non-associated natural gas. Permits issued by the
Ministry for activities other than exploration and
6 Official Gazette of the Bolivarian Republic of
Venezuela No. 38410. Dated 31 March 2006. Conditions of
the shareholders’ joint ventures that will rule the terms of
the joint venture companies (empresas mixtas).
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
exploitation must contain the same terms as for
licences, with the exception of c) and d ) set out
above. Article 51 of the Gas Law sets out the
penalties for non-compliance with licence and
permit conditions, including fines of up to 10,000
tax units (approximately US$ 175,000 at current
values for tax units) and suspensions of up to six
months. According to art. 25 of the Gas Law,
licences for the exploration and exploitation of non-
associated natural gas may be repealed by the
Ministry for: a) non-compliance with an exploration
programme; b) not completing exploration within
the initial five years; c) not making any special
payments required by the state; d ) assigning the
licence without prior approval; and e) and valid
reasons set out in the licence itself. Similar causes
for repeal for licences issued for activities other than
exploration and exploitation exist under art. 27 of
the Gas Law.
Unitization
Petroleum
Unitization of reservoirs is dealt with in arts. 42
and 43 of the Hydrocarbons Law. Where a
hydrocarbon reservoir extends over different
production areas, the parties must enter into a
unitization agreement for its production, to be
approved by the Ministry. If the parties are unable to
come to an agreement, the Ministry is to establish
the provisions governing production. For reservoirs
that extend into the territory of neighbouring
countries, a unitization agreement must be entered
into with the neighbouring country. The National
Executive has the power to act to protect the
interests of the state. In a Memorandum of
Understanding of 2003, Venezuela and Trinidad and
Tobago agreed to unitize their cross-border fields
and in March 2007 both countries subscribed to the
Framework Treaty relating to the unitization of
hydrocarbons reservoirs that extends across the
delimitation line between the Republic of Trinidad
and Tobago and Venezuela.
The main features of this treaty are: a) the
implementation of the Treaty is by a joint
Ministerial Commission (agreement by consensus),
a Steering Committee and working groups as
considered necessary; b) the parties may jointly
consult experts in the determination of the allocation
of the reserves of each cross-border hydrocarbon
reservoir (art. 3.3); c) main operating decisions
about the unit operator, the unit area, the
development plan and the inter-licensee unit
operating agreement require the approval of both
states; d ) re-determination of the reservoir volumes
664
to each state on the hydrocarbons initially in place
seems to be possible at any time and at the sole
request of any of the parties; e) profits, gains and
capital are taxed in accordance with each state’s laws
and are explicitly based on the agreed allocation to
which they are entitled (art. 7.2); f ) parties are
jointly and severally responsible for ensuring the
implementation of preventive measures in order to
avoid environmental damages (art. 9); g) access to
pipelines shall be set in accordance with the
applicable laws of each party and in light of
reasonable, transparent and non-discriminatory
terms (art. 10.2); h) decommissioning plans and
provisions for the creation of final decommissioning
and disposal of installations is also required (art.
10.5.1); i) dispute resolution of the interpretation or
application of the treaty is by consultation or
negotiation by the Steering Committee in the first
instance or subsequently by the Ministerial
Commission and the parties, while disputes over
technical issues such as the allocation of the
reserves are subject to joint consultation with
experts (art. 21); and j) the treaty does not establish
an explicit duration, but it can be terminated by
either state with a one-year written notice to the
other party by means of diplomatic channels.
Gas
Articles 20 and 21 of the Gas Law cover
unitization, in similar terms to those in the
Hydrocarbons Law. Agreements unitizing gaseous
hydrocarbon reservoirs across international
boundaries must be approved by both the Ministry
and the state Congress.
Environmental protection
Articles 127, 128 and 129 of the Venezuelan
Constitution of 1999 provide for environmental
protection. It is the right and duty of each generation
to protect and maintain the environment, and the
state also has a duty of environmental protection
(art. 127). Article 129 imposes an obligation to
conduct environmental impact studies before
commencing an environmentally dangerous activity.
While both the Hydrocarbons Law (art. 5) and
the Gas Law (art. 3) provides for environmental
protection in very broad terms, Venezuela has two
pieces of environmental legislation in place,
applicable to the industry: the Organic Law of
Environment 1976; and the Penal Law of the
Environment 1992. The Organic Law of the
Environment is the basic framework law for the
protection of the environment in Venezuela, and lays
down general principles for the conservation,
protection and improvement of the environment for
ENCYCLOPAEDIA OF HYDROCARBONS

the benefit of the quality of life. It sets down its own
guiding principles, such as the principle of
sustainable development, and also recognizes
principles set out in international instruments. It
authorizes the government to oversee and control
environmentally dangerous activities; for
hydrocarbon production, this control is exercised by
the Ministry. It stipulates administrative civil and
criminal sanctions for violation of standards
established under decrees regulating this law. The
Penal Law of the Environment creates specific
environmental offences (being acts which violate
legal provisions on the protection of the
environment) and establishes criminal sanctions for
these offences. It also creates obligations to conduct
environmental audits for existing installations, and
to complete environmental impact studies for future
activities. Environmental licences, permits or
authorizations must be obtained for each phase of oil
and gas operations. The law can also require
environmental restitution or clean-up.
Hydrocarbon activities are also subject to a
myriad of regulations stipulating technical standards
and limits to control activities with a negative
impact on the environment, including regulations on
hazardous waste, water effluents and atmospheric
emissions, as well as specific regulations for the
preparation of environmental impact assessments.
Fiscal structure and government take
Petroleum
Article 44 of the Hydrocarbons Law provides for
a 30% royalty for the state,7 with reductions possible
to 20% (for mature or extra-heavy oil reservoirs)
and 16.66% (for bitumen blends) but only where
production would otherwise not be economically
feasible. Where reductions are allowed, the state has
the power to increase the royalty back to 30% where
economic feasibility would allow it. The royalty may
be requested by the National Executive in kind or in
cash (art. 45).
Five additional taxes are applicable to petroleum
activities (art. 48). First, there is a surface tax levied
on the granted area that is not being produced. This
is equal to 100 tax units (with each unit being
around US $1,750) per km2 per year, and shall
increase annually by 2% during the first five years
and by 5% during subsequent years. Second, there is
a fuel consumption tax, applicable to hydrocarbon
by-products produced and consumed as fuel. The
rate is 10% per m3 of gaseous product consumed.
Third, there is a general consumption tax levied on
each litre of hydrocarbon by-product sold in the
internal market. The rate is fixed by the Budget Law
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each year, but will be between 30% and 50% of the
final price paid by the consumer. This tax is paid by
the consumer and must be withheld by the supplier
and paid monthly to the National Treasury. Forth,
there is a general extraction tax of 1/3 of the value of
all the hydrocarbons extracted by the operators. This
tax has to be paid on a monthly basis and operators
are allowed to deduct due payments for royalties.
Fifth, a 0,1% tax for export registry. This tax levies
hydrocarbons export from any port of the National
Territory.
While the ordinary income tax rate in Venezuela
is 34%, in accordance with the Income Tax Law
(2007 - arts. 11 and 53b) all upstream operators are
currently taxed at 50%. Operators developing
activities related to non-associated gas (downstream
hydrocarbons activities, exclusively or the upgrade
of extra heavy crude oil) are levied at 34%, as
discussed below. With the payment of 30% in
royalties and 50% in Income Tax, along with other
taxes, the government take is approximately 82.5%.
The Hydrocarbons Law does not definitively
rule out the application of state or municipal taxes to
hydrocarbon activities (unlike art. 7 of the former
Nationalization Law, which did) but based on a
Venezuelan Supreme Court decision of 17 August
1999 (File No. 812-899) and the wording of art.
156.12 of the Venezuelan Constitution of 1999, the
better view appears to be that these taxes do not
apply.
Gas
Article 34 of the Gas Law provides for a flat
20% royalty for the state on the volume of gaseous
hydrocarbons extracted from a reservoir and not
re-injected, which represents a rise in royalty rates
compared to previous regimes. It is noteworthy that
there is no provision in the Gas Law enabling the
government to reduce the royalty rate as an incentive
for development as it is the case for liquid
hydrocarbons (see above). This royalty may be
demanded by the National Executive, through the
Ministry, either in kind or in cash. As per art. 35 of
the Gas Law, producers of gaseous hydrocarbons
must pay taxes on such hydrocarbons when they are
used as fuel, though these taxes are to be set in laws
other than the Gas Law. The Law of Partial Reform
7 The Operation Agreements were levied with a 16,67%
rate since 2002 and before that with 1%. In the extinguished
Operating Agreements (of the Rounds I and II) it was
established that PDVSA had to pay the Royalty. In the
Operation Agreements of Round III, the royalty should be
directly deducted from PDVSA’s payments to the contractors
(partners).
665
NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
of Income Tax Law 1999 (last amended in February
2007), signed into law on the same day of 1999 as
the Gas Law, sets a maximum tax rate of 34% for all
activities relating to non-associated gas (previously,
companies involved in the exploration and
production of natural gas were obligated to pay
income tax of 67.7% in most instances). In addition,
this new Income Tax Law creates a major tax credit
for new gas investments and gives the President the
power to partially or totally exonerate certain classes
of taxpayers from income tax liability. On the whole,
the new income tax regime has a positive effect on
the gas regime in Venezuela.
Fixing the price of oil/gas
Petroleum
Article 60 of the Hydrocarbons Law gives the
National Executive, through the Ministry, the power
to establish hydrocarbon prices for the Venezuelan
domestic market. These prices may be fixed in
bands or using any other applicable system.
Gas
Article 12 of the Gas Law allows the Ministry to
fix the price of gaseous hydrocarbons for the
Venezuelan domestic market, taking into account
principles of fairness. The rates for end consumers
are set jointly by the Ministry and the Ministry of
Production and Commerce. The bases for
establishing the prices must be prepared by the
National Gas Entity.
Foreign investment
The Hydrocarbons Law contains no provisions
which exempt existing contracts or guarantee
protection of investment. Article 24 of the
Venezuelan Constitution of 1999 stipulates that
retroactive application of legislation is forbidden.
For some, this should provide some level of
protection; for others, a law can affect the future
effects under a given contract that was executed
before the law came into force. Article 54 of the Gas
Law provides that agreements for the sale and
purchase of natural gas, entered into prior to the date
the Gas Law came into effect shall remain in force
for the specified term.
On the general foreign investment regime, this is
regulated by various legal instruments, including art.
190. 10 of the Constitution of 1999, and Sole article,
para. 3 of the Law Approving the Cartagena
Agreement 1969. Other instruments relate to
Decisions 1991 No. 291 and 292 of the Commission
of the Cartagena Agreement, Decree No. 2095/1992
and Decree No. 356/1999, Law of Promotion and
666
Protection of Investment (the Investment Law).
Foreign investment in Venezuela is overseen by the
Superintendency of Foreign Investment (SIEX,
Superintendencia de Inversiones EXtranjeras). It
was originally attached to the Ministry of Finance
(Art. 9 of Decree 2095); from 1997 to the Ministry
of Industry and Commerce - Decree No. 1667/1996
- (which later became the Ministerio de Industrias
Ligeras y Comercio). Decree No. 369/1999
establishing the functions of its Ministry attributed
all matters related to national and foreign investment
to the SIEX, as attached to the latter Ministry.
All investment is thereby required to be
registered in SIEX within 60 days following
constitution. There are also some labour restrictions
on foreign investment in the terms of art. 27 of the
Organic Labour Law, whereby foreign employees
shall not exceed 10% of all workers in companies
employing 10 or more workers. Further, art. 20
provides that certain posts (chief of personnel,
captains of ships or airplanes for instance) shall only
be occupied by Venezuelans.
Several economic sectors are either restricted or
closed to foreign and private investment. In addition
to the exclusion on the petroleum activities (as
illustrated above), several instruments and
regulations place variable restrictions on customs
and tax services, maritime and air transportation.
Property rights are constitutionally guaranteed
under Chapter V of the Constitution of 1999.
Expropriation is allowed only on grounds of public
benefit and social interest and by final judgment and
after the payment of fair compensation (Constitution
of 1999, art. 101). The Law of Expropriation for
Public and Social Utility of 2002 sets forth the
requirements and procedure for this kind of
expropriation.
Thus, limitations on economic activities are only
allowed on circumstances provided in the
Constitution or established by law for reasons of
safety, health or others of social interest (art. 96).
Article 15 of the Constitution of 1999 provides for
equality between foreign investors with nationals.
Both shall enjoy the same duties and rights with
such limitations or exceptions as are established by
the Constitution or by law. Likewise, pursuant to
relevant legislation, the treatment granted to the
foreign investor and the investment is the national
treatment. In addition, most favoured nation
treatment is also granted in several investment
promotion and protection agreements.
Foreign investment in Venezuela used to face no
restrictions on the transfers of investment, remittances of
capital, benefits, debt services or other remittances
derived from foreign investment. At present, there is a
ENCYCLOPAEDIA OF HYDROCARBONS

currency exchange regime that allows for remittances
derived from foreign investment, dividends and others,
once the investor fulfils the required administrative
procedures (Exchange Covenant No. 1 of 2003).
Venezuela has concluded 26 BITs (country specific list
of BITs in United Nations Conference on Trade and
Development, UNCTAD, Web site). In so far as
international settlement is concerned, Venezuela is a
member of ICSID as of 1995, the United Nations
Convention on the Recognition of Foreign Arbitral
Awards 1958, the Multilateral Investment Guarantee
Agreement (MIGA), and the Inter-American Convention
on International Commercial Arbitration 1975.
Settlement of disputes
Disputes related to the constitution of joint
ventures and the performance of primary
hydrocarbon activities, as well as to the licences of
exploration and exploitation of non-associated gas
hydrocarbons must be resolved by the courts of
Venezuela (Hydrocarbons Law, art. 34 and Gas Law,
art. 24).
Article 151 of the Constitution of 1999
establishes that in “public interest contracts, and
unless inapplicable by reason of the nature of such
contracts, a clause shall be deemed enclosed, even if
not expressly, whereby any doubts or controversies
related to such contracts which cannot be amicably
resolved by the parties shall be decided by the
competent courts of the Republic and in accordance
with its laws, and shall not on any grounds or reason
give rise to foreign claims”.
The exception included in this article (“unless
inapplicable by reason of the nature of such
contracts”) has not been construed unanimously.
On one hand, the exception included in the
article has been construed as applying to contracts
between sovereign states or between a sovereign
state and an institution of public international law
only, and/or contracts of an industrial or commercial
nature. This was the interpretation of the Supreme
Court in a judgment dated 17 August 1999 where it
was held that, despite the fact that the Oil
Association Agreements were contracts of public
interest, such contracts could be subject to the
exception of art. 151 because the exception refers to
contracts between sovereign states; between a
sovereign state and an institution of public
international law; or to contracts of an industrial or
commercial nature. The judgement stated that the
term nature should not be construed by reference to
the commercial nature of the contracts only; hence,
the Venezuelan administration would be able to
include an arbitration clause in other cases as it sees
fit. Therefore, if the Venezuelan administration
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considers that it is in the country’s best interest to
include an arbitration clause in a public interest
contract, then this would be a relevant factor for
consideration.
On the other hand, another line of
interpretation has argued that these kinds of
contracts – referred to activities of national
security, with high impact in the economy, and
subject to extraordinary requirements for their
execution (i.e. Congress prior approval) – are to be
considered as of public interest, and therefore, in
accordance with art. 151 of the Constitution,
submitted to the exclusive jurisdiction of the
Venezuelan Courts. In the same sense, one of the
senior judges in the referred judgment of the
Supreme Court, concluded that all the clauses of
the Oil Association Agreements were of public
interest, thus rendering the whole contract not
amenable to arbitration. He also argued for the
application of art. 3 of the Arbitration Law, which
states that disputes directly pertaining to the
powers and functions of the state, or of persons or
entities of public law shall remain excluded from
arbitration.
In light of this position, the incorporation of
international arbitration clauses in this kind of
contract – if considered as of national public interest
– must be then submitted to the prior approval of the
President of the Republic according to the Decree,
Internal Rule, No. 4, for the “Review of the draft
national public interest contracts to be executed by
the Republic”.
The position favouring the use of arbitration in
this type of contract would see these as subject to
the comprehensive Law of Commercial Arbitration
enacted by Venezuela in 1998 (Arbitration Law), and
arbitration as part and parcel of the system of justice
of the Republic, as other forms of alternative dispute
settlement (art. 253 of the Constitution of 1999 and
Supreme Court Decision of 14 February 2001).
Article 258 of the Constitution of 1999 encourages
the use of arbitration, conciliation, mediation and
other forms of alternative dispute settlement. The
Arbitration Law made no distinction between
domestic and international arbitration. Prior to the
enactment of the 1998 Law, international arbitral
tribunals were not always recognized to have
exclusive jurisdiction even if parties contracted to
arbitrate their dispute before them (Weininger &
Lindsey: 2002).
For this position, arts. 22 and 23 of Investment
Law of 1999 would be applicable. These provide that:
in case there is an investment treaty between the home
state of a foreign investor and the state in which the
investment is made, or in case of disputes on which
667
NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
provisions of the MIGA or ICSID apply, there is
recourse to international arbitration; and at the
investor’s choice, any dispute related to the application
of the Investment Law can be subject either to national
courts or to a Venezuelan arbitral tribunal, once the
administrative procedure has been exhausted.
Recent developments in the Venezuelan
hydrocarbon sector have also provided grounds for
new approaches to this realm of dispute resolution.
The forum selection clause contained in the
conditions for the new joint ventures approved by
the Venezuelan National Assembly in March 2006,
provides that the Venezuelan Courts are the
exclusive forum for the settlement of disputes
between PDVSA or its affiliates (CVP) and the
international oil companies without expressly
providing for arbitration. Nevertheless, a more
detailed examination of the clause could lead to a
different thought in this regard.
The joint venture model approved by the
Venezuelan Assembly provides for a forum selection
clause in the following terms: “Applicable Law and
Jurisdiction. This contract will be construed by and
interpreted according to the laws of the Republic, and
any dispute or controversy that might arise regarding
the said [contract] and that could not be amicably
settled between the parties, must be exclusively
submitted to the decision of the competent courts of
the Republic. Before initiating any [action before
courts] the parties shall explore, in good faith and
within the scope of the Hydrocarbons Organic Law,
the possibility of using mechanisms to amicably
resolve the disputes of any nature that might arise,
including the possible request of opinions on
technical matters, to independent experts appointed
by mutual agreement […]”.8
From the literal analysis of this clause, it is clear
that the disputes that “must be exclusively submitted
to the decision of the competent courts of the
Republic” are those which would not been capable
of prior amicable settlement by the parties.
Therefore, it does not provide for an automatic
submission of the disputes to the Venezuelan courts
and, on the contrary, the clause seems to establish a
condition precedent to the jurisdiction of the
Venezuelan Courts. This condition is the exhaustion
of amicable dispute settlement mechanisms by the
parties “before initiating any [action before courts]”.
Nevertheless, despite some broad references to what
could be those “amicable mechanisms”, the joint
venture model’s forum-selection-clause neither
defines nor limits such mechanisms. Instead, when
exploring for suitable “amicable mechanisms”, the
clause compels parties to do so in good faith and
“within the scope of the Hydrocarbons Law”.
668
The Hydrocarbons Law sets out the minimum
conditions that must be adopted in a joint venture.
Article 34 9 establishes that:10 “[…] 3. In the
conditions (of the joint ventures) there must be
included, and when not expressly shown they will be
deemed as incorporated in them, the following
clauses: […] b. The doubts and disputes of any nature
that could arise due to the execution of activities and
that could not be amicably settled by the parties,
including the arbitration11 in the circumstances
allowed by the law that rules the matter,12 shall be
adjudicated by the competent Courts of the Republic,
in accordance with it’s laws and shall not on any
grounds or for any reason give rise to foreign claims”.
This clause, whilst establishing certain mandatory
minimum conditions to the joint ventures (which are
8 It continues: “It is understood that any important
dispute, including for example, disputes regarding the
Business Plan, work programs, development plans and
related budgets, shall be addressed to the highest executives
of both parties, who shall then meet to try to resolve the
differences. In case that said dispute is not settled within
sixty (60) days following the meeting held for such purpose,
they shall inform the details of said [dispute] to the
Ministry”.
9 Section III in regards to the joint venture companies
(empresas mixtas), “Terms and Conditions for the creation
and functioning of the joint venture companies”.
10 Referring to art. 33 of the Hydrocarbons Organic Law
that states that: “The incorporation of joint venture
companies and the conditions that will rule the development
of the primary activities will require the prior approval of
the National Assembly, to which effect the National
Executive, through the Ministry of Energy and Mines, shall
inform [the National Assembly] of all the pertinent
circumstances to said incorporation and the conditions,
included the special advantages provided for the Republic.
The National Assembly may modify the proposed conditions
or establish those which might consider suitable […] The
joint venture companies will be ruled by the present Law
and, in each particular case, by the terms and conditions
provided for in the Agreement that in accordance with the
law be enacted by the National Assembly […]
Supplementary, the rules of the Commerce Code and other
applicable laws”.
11 Arbitration is also recognized and promoted by the
Venezuelan Constitution when establishing in its art. 258
that: “[…] The law shall encourage arbitration, conciliation,
mediation and any other alternative means for resolving
conflicts”.
12 “[…] including the arbitration in the circumstances
allowed by the law that rules the matter” If the term “the
matter” is related to the joint ventures and their conditions,
the Hydrocarbons Law would be “the law that rules the
matter”. This would be a redundant and futile statement of
the law. On the contrary, if “arbitration” is “the matter”, the
applicable law would be the Venezuelan Commercial
Arbitration Law and hence, there would be enough legal
bases to incorporate arbitration agreements in the joint
ventures.
ENCYCLOPAEDIA OF HYDROCARBONS

applicable despite the will of the parties) provides also
for a hierarchy among the dispute mechanisms
referred to therein. In first instance, parties are bound
to exhaust amicable procedures (i.e. negotiation,
mediation, etc.) including arbitration. Subsequently, if
the disputes are not capable of being settled by means
of those amicable procedures, the parties are entitled
to resort to local courts.
However, despite the fact that art. 34 of the
Venezuelan Hydrocarbons Law provides for the set
of mandatory minimum conditions applicable to the
joint ventures, the Venezuelan National Assembly
approved a joint venture model lacking arbitration,
hence, preventing parties from agreeing upon it
when negotiating joint ventures.13 If this is the case,
it seems that there could be grounds for investment
disputes against the Venezuelan state on the basis of
violations to the investors’ rights by preventing their
use of arbitration in the joint ventures as provided
for in the Hydrocarbons Law.
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670
Elizabeth Bastida
Centre for Energy, Petroleum and
Mineral Law and Policy
University of Dundee
Dundee, Scotland, United Kindom
Carlos Valiente Noailles
Partner Bazán, Cambré & Orts Law Firm
Buenos Aires, Argentina
The authors gratefully acknowledge the substantial contribution
of Richard Khoe, as well as of María Constanza Larramendi,
Jairo Ching Castillo and Tariq Bakheit in the preparation of this
manuscript. We would like to thank Prof Edmilson Santos, João
Santos Coelho, Mauricio Gárate, José Ignacio Moreno, Mauricio
Berrizbeitía and César Mata-García for very helpful comments
on some of the sections on Brazil, Mexico and Venezuela.
ENCYCLOPAEDIA OF HYDROCARBONS
 12.3
Russian Federation
12.3.1 Sovereignty
Russia remains one of the largest mineral producers in
the world, and Russian mineral resources constitute an
important component of the country’s wealth. Russian
oil deposits comprise approximately 13-15% of the
world’s global mineral deposits. Moreover, the country
has the world’s largest gas reserves, and the second
largest oil reserves (after Saudi Arabia), with an
estimated value of between 270 and 300 trillion
dollars.
The extraction and production of hydrocarbons
are the most significant industries in the Russian
economy. Hydrocarbon production is the backbone
of the economy as well as its most rapidly
developing sector, generating a substantial portion
of the gross national product and providing a large
part of budget revenues and hard currency earnings
for the country.
Russia is one of the major oil exporting countries.
According to official reports, the country’s combined
onshore and offshore proven and probable
hydrocarbon reserves have been estimated at
approximately 100 billion tonnes of oil equivalent.
Russia has the largest recoverable crude oil reserves in
the Okhotsk and Caspian Sea regions.
The main feature of the resource base of the
country’s gas industry is that the gas reserves are
predominantly associated with oil, oil and gas, and oil
and gas condensate fields, having 30-50% of world
industrial gas reserves.
In the territories and water areas of Eastern Siberia
and the Far East, the initial recoverable resources of
hydrocarbons equal 85-90 billion tonnes of reference
hydrocarbons. This includes 20-22 billion tonnes of
oil, 1.5-2 trillion cubic metres of associated gas, 58-61
trillion cubic metres of non-associated gas and 3-5
trillion cubic metres of condensate.
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The explored reserves (category ‘proven’ in
international classification) in these regions comprise
605.1 million tons and 303.1 million tons (including
those on shelf) respectively.
The types of oil in the regions under examination
are characterized by high quality, exceeding in basic
parameters the Russian export standard Urals. These
are basically light crude.
The majority of oil resources of Eastern Siberia
and the Far East (86,1% and 68,2% respectively) has a
density of less than 0.87 g/cm, while about 50% of
reserves, concentrated in Eastern Siberia and about
78% in the Far East, have a sulphur content of less
than 0.5%.
Russian ability to obtain the full benefits of these
estimated reserves depend on a number of factors,
including expanding existing, and building or gaining
access to new oil export routes, reaching agreements
with neighbouring states as to various commercial
aspects of oil and gas extraction, transport and
refining.
12.3.2 Ownership and title
to the underground
petroleum resources
General principles for the use of natural resources can
be found in the Russian Federation Constitution,
which provides that natural resources can be held in
private, state, municipal and other forms of ownership
(art. 9), and guarantees to the owners free use and
disposal of the respectively owned natural resources
(art. 36) with a corresponding obligation to preserve
the environment from destruction and damage
(arts. 42 and 58).
The Russian Federation Constitution establishes
joint competence of the Russian Federation and its
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
constituent subjects over the issues of use of natural
resources and environmental protection (arts. 71 and
72), which means the Russian Federation is entitled to
provide general legislative regulation, while the
subjects of the Federation have the right to further
develop their regulation in that respect.
In addition to environmental rules established
by the federal and regional authorities, certain
rights to regulate these relationships are provided
to local (municipal) bodies of self-administration
(Law On General Principles of Establishing Self-
Administration in the Russian Federation No. 122
FZ/2004, art. 13).
The Subsoil Law amendments have eliminated the
traditional federal/regional ‘two-key’ government joint
control regime in favour of a new ‘one-key’ sole
federal control regime. Exclusive power is now in
federal hands (the Ministry of Natural Resources, and
the Russian Federation Government itself) at the
expense of the regional Governments.
12.3.3 Structure of the petroleum
legislation
Public relationship
Public relationship concerning the use of subsoil
resources is mainly regulated by the Federal Law on
subsoil resources (SUBsoil Law, SUBL No. 2395-1,
adopted in 1992, restated in 1995 and amended in
1999 and 2000). The SUBL specifies that all subsoil
resources are the subject of state property of the
Russian Federation and corresponding subjects of the
Federation where the reserves of subsoil resources are
located (arts. 1-2) and divides competence and
authority of the Russian Federation, subjects of the
Russian Federation and municipalities (arts. 3, 4 and 5
respectively). Except for the resources of the
continental shelf, all subsoil resources fall under the
joint competence of the Federation and its subjects.
Under the SUBL, the subsoil resources are divided
between those “widely available” and the others.
According to the SUBL, procedures for providing
“widely available” resources for use are established by
the subjects of the Federation (art. 4), while
procedures for granting rights to use of all other
subsoil resources are established in the federal
legislation and by federal authorities within their
competence. In their respective regional legislation,
subjects of the Federation can only develop and adjust
further federal rules and procedures. All subjects of
the Russian Federation have adopted such regional
laws on use of subsoil resources, tariffs for the use of
natural resources and programmes of geological
survey, etc. Some of the regions adopted more
672
complex acts. For example, the Republic of
Bashkortostan adopted a Code of subsoil resources.
The use of hydrocarbon resources is jointly
regulated by the Russian Federation and its subjects
within the framework established by the federal
legislation, and controlled by the federal authorities.
The relationships involved in the use of
hydrocarbon resources – which have complex effects
on the environment – are regulated by corresponding
laws and regulations, and require confirmation of the
right to use the natural resources concerned by each
particular user of subsoil resources. This is because
geological survey, exploration and development of any
oil and gas field require access to the land, water
resources, almost always forestry resources, and
involve air pollution.
The procedures for granting the rights to use
subsoil resources are closely tied with the procedures
for granting the rights to use land plots, forest and
water resources, including underground water
resources.
By virtue of state ownership of the subsoil
resources, the only legitimate way to use them is to
obtain a special administrative permit or licence. An
exception to this rule is only made for the use of
certain “widely available” subsoil resources by the
owners (users) of land plots within the established
limits (not more than 50,000 cubic metres per year or
deeper than 5 metres).1
The same principle applies to the use of all other
natural resources, except for the land, where the
relationships are based on private ownership or civil
law contracts with the landowners.
Licences for the use of the subsoil resources are
granted in accordance with the Regulations on
Procedures for Licensing of Use of Subsoil Resources
No. 3314/1/1992, which has been further commented
by the responsible federal authorities.2
Legal regimes for the development
of subsoil resources
As far as legal regimes are concerned, there are
two main options for the development of subsoil
resources in the Russian Federation: either to enter
into a Production Sharing Agreement (PSA) with
the state, or to obtain a licence under the SUBL.
Most Russia-registered companies choose the
SUBL regime for the exploration and the
1 See arts. 18 and 19 of the SUBL.
2 This was formerly the Committee
on Geology and the
Use of Subsurface Resources of the Russian Federation
(Roskomnedra, Russian Subsoil Committee). Later this
function was transferred to the Ministry of Natural
Resources.
ENCYCLOPAEDIA OF HYDROCARBONS

development of subsoil resources. Therefore, the
procedure for the issuance of licences under the
SUBL is more established in practice than that for
entering into a PSA. Foreign companies, however,
seek to enter into a PSA more frequently than
Russian companies. This preference may be based
on the availability of additional guarantees
for investors operating under the Federal Law
on PSAs No. 225 FZ/1995 (the so-called
Production Sharing Agreements Law, PSAL).
While the PSAL and the SUBL regime have much
in common, there are some significant differences
which are the deciding factors for investors. The most
significant differences between the two regimes appear
to be the following. Despite certain specific
characteristics of a PSA, it is an agreement which is
generally regulated by civil legislation, except in those
cases which are covered by special legislation on
PSAs. Under the SUBL, the investor is granted by the
state the right to explore subsoil resources pursuant to
an administrative decision of the state. Therefore,
under the PSAL regime, the investor operates within
the general framework of civil law as distinguished
from the investor under the SUBL regime, who
operates within the framework of administrative law.
The difference between these two branches of law is
significant.
Under the civil law regime, there is the possibility
of negotiating the terms and conditions of the PSA and
agreeing with the state on various issues pertaining to
the development of subsoil resources. Since a PSA is a
civil law agreement, the investor under the PSA has
the ability to obtain additional contractual guarantees
from the state, while under the SUBL regime, no
guarantees are available in addition to those set forth
in the SUBL itself and other laws as applicable to all
investors.
Administrative law, on the other hand, does not
provide the parties with the possibility to negotiate the
terms and conditions of their relations, such terms and
conditions being the same for all investors. One party
(the state) dictates what the other party should do and,
as a general matter, the state must treat all investors
equally and cannot grant any special rights or
privileges to a particular investor. A right to
exploration and production of petroleum resources is
granted either on the basis of a SUBL licence or the
PSA with the state.
A licence for the use of underground resources – to
use the land plot for the purposes of geological
research, exploration and production of underground
resources – is issued only upon obtaining the
preliminary permission of the local land resources
authority or owners of the land plot (SUBL, art. 11).
The documents certifying allotment of the land plot
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should be attached to the licence. The land plot should
include the territory required for the research,
exploration and production works, as well as for
construction of any facilities required for such works.
Plans for the land plot should be attached to the
licence and the licence itself should specify the
boundaries of the land plot.
Procedure for obtaining rights
Obtaining the rights to use subsoil resources under
the SUBL regime is much easier and less complicated
than that under the PSAL regime. Due to a number of
reasons (including still existing gaps and uncertainties
in the legislation on PSAs, lack of experience of
governmental agencies in this sphere, general negative
attitude towards PSAs of certain politicians), the
procedure for obtaining the rights to use underground
resources under the PSAL regime is more complicated
than that under the SUBL.
The overall approach of the legislature to granting
rights under the PSAL regime is stricter than when
granting licences under the SUBL regime. For
example, in order to enter into a production sharing
agreement under the PSAL covering certain fields,
unlike the SUBL, it is necessary to adopt a law on
inclusion of the field into a special list of fields – for
which usage rights can be granted to investors – and in
some cases, a law approving the agreement. A lower
level of governmental agency may grant rights under
the SUBL rather than under the PSAL. The number
and level of decisions required in order to obtain rights
to use subsoil resources pursuant to a tender is
illustrated below.
SUBL regime: a) inclusion by the Ministry of
Natural Resources of the field into the programme of
licensing; b) adoption by the Government of the
Russian Federation of a decision on conducting a
tender; c) based on the results of the tender, adoption
by the Government of the Russian Federation of a
decision on granting the right to use underground
resources; d ) issue of a licence by the Ministry of
Natural Resources; e) registration of the licence with
the Federal Geological Archive.
PSAL regime: a) adoption by the state Duma of
the federal law on inclusion of the field into the list
of fields which may be developed under the PSAL
regime; b) creation of a commission or
appointment of a governmental agency authorized
to conduct a tender; c) based on the results of the
tender, appointment by the Government of the
Russian Federation of a commission for
negotiating the PSA; d ) negotiating of the terms of
the PSA and adoption of a decision on execution of
the PSA by the Government of the Russian
Federation and the executive body of the respective
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
constituency of the Russian Federation; e)
execution of the PSA; f ) approval of the PSA by
federal law, in certain instances; g) issue of the
licence; h) registration of the licence.
Under the SUBL regime, the investor operates
within the framework of administrative law and has
little possibility to choose or agree the terms and
conditions of the use of subsoil resources. Although
pursuant to the SUBL, the investor has the possibility
– but is not required – to enter into a special
agreement with the state, which would elaborate on
the terms and conditions of the use of underground
resources set forth in the licence (so-called “licensing
agreement”), such agreement appears to be a pro
forma and is totally dictated by governmental
agencies. The licensing agreement is drawn up by the
state before issuing a licence and is attached to the
licence as its indivisible part. In general, the terms and
conditions of the licensing agreement may be divided
into two groups:
• Terms and conditions predetermined by the state
and included in the draft licensing agreement
provided by the state – such terms are usually
similar in all licensing agreements. As a matter of
practice, the licence and the licensing agreement
also usually include the provisions directly set
forth by the SUBL and other normative acts.
• Terms and conditions based on the tender results
and presented by the tender participants in their
tender proposals (when preparing the tender
package, the state leaves a blank space in the draft
licensing agreement for investors to fill in such
terms). These provisions usually vary depending on
the field (e.g. volumes of production, exploration
and development, climate conditions, regional
regulations, etc.).
The investors may not change these terms and
conditions either during or after the tender unless the
tender makes provision for such changes. Except for in
the latter case, this does not leave much flexibility for
the investor to negotiate the terms and conditions of
such licensing agreement and to set forth contractually
(by analogy with the PSA) at least some rights of the
use of underground resources. Any change in tender
terms and conditions in the course of negotiations with
the winner of the tender, or acceptance of the bid
providing for terms which differ from tender terms
may be deemed by other participants of the tender as a
violation of tender rules. This situation can also give
rise to claims for invalidation of tender results – based
on the unequal conditions for tender participants –
assuming that the tender did not make provision for
such changes. As a result, most licensing agreements
look very much alike and do not differ much in their
terms and conditions.
674
Execution of the PSA does not mean that the
investor under the PSAL regime is totally exempt
from application of administrative law. It remains
subject to various normative acts of
administrative law which relate to such matters as
safety of works and environmental protection, etc.
These acts apply to investors operating under any
regime. In case of violation of such acts, the
investor under the PSA may be held liable
pursuant to administrative law. In addition, the
investor may be held contractually liable in the
event of breach of the PSA. In this case, the state
will be entitled to use any remedies provided by
the Civil Code. If the investor objects to
contractual remedies imposed by the state, such
contractual remedies may only be obtained
through the court.
The specific nature of the licensing agreement is
also evidenced by the fact that violation of the
licensing agreement by the licensee may be deemed a
violation of the licence and result in early termination,
suspension or limitation of the licence. This is what
happens in general, rather than entailing consequences
envisaged by the Civil Code with respect to violations
of civil law contracts (SUBL, art. 20). Although, as a
matter of fact, violation of the terms of the PSA may
also, by the terms of the PSA, give rise to its
termination.
The ‘selling’ of licences
It is possible to create a joint venture company
with a company which is interested in acquiring the
licence. While requiring that the initial licensee should
hold at least a 50% stake in such a joint venture, the
SUBL does not specify for what period of time the
initial licensee should hold this stake. Therefore, upon
expiration of some time following the transfer of the
licence, the initial licensee may transfer the remaining
50% interest in the joint venture to another company.
This can be done by creating a 100%-owned
subsidiary and transferring the licence to such a
subsidiary. The shares in such a 100% subsidiary are
then sold to a company interested in the licence; or
such a subsidiary is then merged/consolidated with the
company; this will result in the initial licensee holding
a stake in the new licensee in the latter case, while the
former case will lead to the complete withdrawal of
the initial licensee.
In theory, the above-mentioned transactions may be
qualified as sham transactions under art. 170 of the
Civil Code. However, Russian legislation is of a
relatively formal nature and if all the legally required
procedures were observed when performing such
transactions, in practice it would be almost impossible
to prove that a sham transaction took place.
ENCYCLOPAEDIA OF HYDROCARBONS

12.3.4 Operating conditions
Terms and extension of the term of the licence/PSA
In accordance with art. 10 of SUBL, the subsoil
plots can be chartered for: geological survey, for a
term up to 5 years; and mining operations, for the term
of the development of mineral deposits. Note that the
term is calculated according to the technical and
economic feasibility of exploitation of resources,
providing rational use and protection of subsoil.
The term of use of a subsoil plot can be prolonged
by the initiative of the subsoil user where there is the
necessity to terminate a search and assessment or
mining, provided that there is no violation of the
licence by the subsoil user. The period of use of a
subsoil plot under the conditions of a PSA is
determined by the aforementioned agreement. The
period of use of subsoil plots dates from the moment
of state registration of licences for the exploitation of
these subsoil plots.
Under the PSAL regime, the term of the PSA – and
therefore the term of the licence issued pursuant to the
PSA – may be extended at the request of the investor
for the term required for economically justified use of
the deposit. This is provided that the investor fulfills
its obligations under the PSA (PSAL, art. 5).
Early termination, suspension and limitation
of the rights of the licensee
Both under the PSAL regime and under the SUBL
regime, the right to use underground resources may be
terminated early. Under the SUBL, termination
(suspension, limitation) of rights to use underground
resources is effectuated through termination
(suspension, limitation) of the licence. Under the
PSAL, it is the PSA itself which may be terminated
early. In addition, under the SUBL regime, the
grounds and the procedure for early termination,
suspension or limitation of rights are set forth in the
SUBL (art. 20), while, under the PSAL regime,
grounds for early termination, suspension or limitation
should be provided in the PSAL (art. 21).
The right to subsoil exploitation is terminated:
upon the expiry of the validity period of the licence;
by the waiver of the licence holder of his rights for
subsoil exploitation; upon occurrence of a certain
condition provided in the licence as a reason for
termination of the right of subsoil use, such as in the
case of licence re-issuance violating conditions set in
SUBL (art. 20).
The right to subsoil exploitation can be
pre-terminated, suspended, or limited by the licensor in
the case of: a) instant threat to life and health of
people who work or live in affected areas connected
with subsoil exploitation; b) violation of substantial
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licence conditions by the subsoil user; c) systematic
violations of authorized rules of subsoil exploitation;
d ) emergency situations (natural disasters, military
actions, etc.); e) the subsoil user during the licence
validity period not having begun subsoil exploitation
in specified quantities; f ) liquidation of the company
or other economic agents that were granted subsoil for
exploitation; g) under the licensee’s initiative; h)
failure to submit reporting as required by the Law of
the Russian Federation; i) under the initiative of
subsoil user and his notification.
In case of disagreement of subsoil user with the
decision about the termination, suspension or
limitation of rights to subsoil exploitation, he can
challenge the decision in administrative or juridical
procedures.
In case of subsoil exploitation in accordance with
thePSA, the right to use subsoil can be terminated,
suspended, or limited under the conditions and terms
stated in the mentioned agreement.
In case of withdrawal of the licensee from the
right to subsoil exploitation, he must declare it
with written notification to the licensor no later
than six months before the declared term of the
licence (SUBL, art. 21).
The subsoil licence holder must fulfill all
obligations mentioned in the agreement in case of
anticipated withdrawal from the rights to subsoil
exploitation. In case of his non-execution of the
mentioned obligations, licensors have the right to
claim the amount of damage in the manner required by
SUBL.
In case of elimination of circumstances and
conditions which caused suspension or limitation of
the right to the use of subsoil, this right can be restored
in full. The period of suspension, in case of absence of
fault from the subsoil user, is not included in the total
licence period.
In the case of subsoil exploitation in accordance
with the PSA, the conditions and manner of
pre-termination of the right to the use of subsoil are
defined by the mentioned agreement.
Reserves classification
There have also been recent reports that the
Ministry of Natural Resources now supports Russian
oil and gas companies’ conversion from the country’s
own traditional to generally accepted international
standards. The latter essentially refers to the United
States of America Securities and Exchange
Commission (SEC) standards (the most conservative,
required for securities regulation purposes), and the
Society of Petroleum Engineers (SPE) standards. The
stated reason is the need for greater clarity as to the
level of Russian companies’ real economically
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
recoverable reserves, for general
investment/development purposes in today’s world. It
is said that even by SPE (let alone the stricter SEC)
standards, many Russian companies’ recoverable
reserves would be reduced to about 70% of what is
reported under the Russian A⫹B⫹C1 standard,
because Russia’s system still does not sufficiently take
into account the ‘economic’ aspect of recoverability.3
Some major Russian companies have already begun
using one or the other international standards in any
event.
12.3.5 State control
and participation
The state control of relations in subsoil use is
performed via managing, licensing and controlling.
The tasks of the state control include: a) definition of
volumes of production of the basic types of mineral
resources for the current and long-term periods in the
Russian Federation as a whole and in regions; b)
provision of the development of mineral resource base
and preparation of reserve subsoil plots used for
building of underground constructions which are not
connected with mining operations; c) provision of
geological survey of the territory of the Russian
Federation, its continental shelf, the Antarctic region
and the bottom of the World Ocean; d ) setting of
quotas for the shipping of extracted mineral resources;
e) introduction of taxes and other payments connected
with subsoil use, as well as adjustable prices on
particular types of mineral resources; f ) setting of
standards (norms, regulations) in the area of
geological studies, use and protection of subsoil,
secure conduct of operations connected with subsoil
use as well as rational use and protection of subsoil
(SUBL, art. 35).
The federal body for governing of the state subsoil
fund and its regional bodies cannot perform the
functions of governing the economic activity of
enterprises that perform exploration and mining
operations or building and exploitation of underground
construction which are not connected with mining
operations. Neither can they take part in business
activities.
Authorized body
There are certain differences between the level and
mechanisms of governmental control under the PSAL
and the SUBL. The PSAL endeavours to reduce the
number of controlling agencies and streamline the
procedure for exercising state supervision over the
activities of the investor by establishing a management
committee (PSAL, art. 7.7). However, this approach
676
has not been adhered to even in the PSAL itself. Art.
19 of the PSAL provides that federal governmental
agencies together with the governmental agencies of
the respective constituencies of the Russian Federation
should supervise the activities of the investor under the
PSA. This destroys the one-stop shop arrangements
and welcomes any governmental agencies having
jurisdiction over the activities of the investor to
interfere with its activities under the PSA and carry
out numerous checks.
The Government of the Russian Federation
appointed the Ministry of Economic Development and
Trade as the governmental agency in charge of all issues
associated with PSAs (except for a number of most
important issues which were left within the competence
of the Government of the Russian Federation).
However, this attempt made little clarification, also a
number of other governmental agencies are empowered
to have control over the investors’ activities.4
Furthermore, any construction and other works subject
to state examination will also require participation of
authorized governmental agencies.
The SUBL does not contain summarized
provisions on governmental agencies authorized to
inspect investors’ activities under the licence (licensing
agreement). The SUBL itself talks about various types
of supervision.5 All other forms of supervision that are
not mentioned in the SUBL but are applicable to any
type of business activity are also carried out by various
governmental agencies within the scope of their
competence (including, inter alia¸ tax control and fire
protection).
According to data, state participation in the biggest
Russian petroleum companies – Gazprom and Rosneft
– is estimated respectively as 100% and approximately
50% of its share capital.
12.3.6 The price of oil and gas
For the purpose of taxation, the oil and gas prices are
calculated by tax authorities every quarter. The
3 On the other hand, there is some conjecture in the
industry that any new Ministry of Natural Resources push to
introduce international standards may be tied to a possibly
planned “resources tax” initiative.
4 For example, the Ministry of Energy, the Ministry of
Taxation, the Ministry of Finance, the Ministry of Natural
Resources, the Ministry of Property, the Ministry of
Antimonopoly Policy and Support of Entrepreneurship, the
State Customs Committee and the Federal Agency on
Mining and Industrial Control.
5 Geological supervision, supervision over resource
conservation, protection of resources (SUBL, art. 36)
supervision over safety of works (SUBL, art. 37).
ENCYCLOPAEDIA OF HYDROCARBONS

calculation is based on the recent world prices and the
ruble/dollar currency exchange rate. This calculation is
used for the main fiscal payments such as rentals
– so-called NDPI (from the Russian Nalog na
Dobychal Poleznykh Iskopaemykh, tax on the
extraction of useful minerals) – and export tax.
The oil and gas price is fixed for the federal
budgeting every year. In 2006 it was set at
approximately 28 dollars per barrel.
Fiscal structure
Payments for the right to use natural resources
– and specifically hydrocarbons – are set forth in
several legislative acts of which the main one is
the SUBL (arts. 39-48). These are followed by
regional acts of the subjects of the Russian
Federation and municipalities within their
competence.
Compulsory payments for subsoil use are set forth
in art. 39 of the SUBL and include: a) regular
payments for subsoil exploitation in case of
occurrence of special events mentioned in the licence
agreement; b) regular payments for subsoil
exploitation; c) payment for geological information
about subsoil; d ) submission fee for the auction; e)
licence-issuing fee.
NDPI
This was introduced in 2002. In accordance with
art. 26 of the Tax Code of the Russian Federation (Law
No. 146 FZ/1998), mineral extraction tax is given in
rubles per extracted tonne of mineral resource. Tax is
calculated as a certain fixed base multiplied by a
correction factor. NDPI basic rate is fixed by the
government yearly. Correction factor is attached to the
world oil price and dollar/ruble exchange rate. In
2005, the basic rate was 400 rubles per tonne. And the
correction factor (K) is:
P ⫺8
K⫽ 121 ⫻(R : 31.5)
8
where P is one month average Urals price in
Rotterdam and Mediterranean oil market at the
relevant period of extraction (dollars per barrel); R is
one month average dollar/ruble exchange rate set by
the Russian Central Bank; 8 is the current minimum
level of oil price for the aims of NDPI taxation.
Export fee
The export fee on oil also depends on the
two-month average price of Urals in the
Mediterranean and Rotterdam markets. The tax
formula is similar to the formula of NDPI. World oil
price is the only differential factor for the tax rate.
Since April 2006 (when world oil price was set at
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58.13 dollars per barrel) the export fee has been set at
186.4 dollars per tonne.
PSA scheme
By the year 2006 only three PSAs had been signed,
comprising less than 1% of the total Russian oil
production. Sakhalin-1, Sakhalin-2 and Khar’jaga are
all three-step traditional PSAs. Compensating oil in
those projects was fixed between 85% and 100%, and
royalty (so-called NDPI) at 6-11%. Government takes
in the mentioned PSAs are 15-70% in Sakhalin-1,
10-70% in Sakhalin-2 and 47.7-73.8% in Khar’ jaga.
Investor’s profit oil is subject to the corporate
32-35% income tax. All of the agreements were signed
before the adoption of PSAL was introduced. There
are three types of PSAs according to the law. The first
one is the so called three-step traditional PSA (with
compensating oil, government take and income tax);
the second is the two-step direct sharing (with
corporate income taxation and no compensating oil);
and the last is the one-step direct sharing (without
corporate income taxation and compensating oil).
12.3.7 Contracting for goods
and services
In so far as the “Russian content” obligations (i.e.,
obligations to use Russian goods and services in the
course of carrying out works under the SUBL
licence/PSA) are concerned, the SUBL regime and the
PSAL regime differ significantly. As is the case with
the rights to geological information, the SUBL rule
with respect to “Russian content” appears to be more
investor-friendly than under the PSAL regime.
Under the SUBL regime, there are no special
provisions requiring that the licensee buys Russian
goods/equipment or services rendered by Russian
companies. The investor is not required to purchase
goods and services through tenders, but may do so at
its own discretion (Civil Code, art. 448). Sometimes
the analogue of the “Russian content” rule (although
in a more lenient form) is set forth in the licensing
agreements or particular tender rules. The licensing
agreement may set forth not just a “Russian content”,
but a “respective constituency of the Russian
Federation content” rule. For example, the licensing
agreement may require that the licensee contracts or
subcontracts to companies registered in the territory of
the respective constituency of the Russian Federation.
This is if such companies offer the same services on
the same conditions as foreign or any other companies.
However, even in such a strict form, this rule in the
licensing agreements appears to be much more relaxed
than that set forth in the PSAL. In addition to
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
requiring that privilege is given to Russian companies
providing the same goods and services on the same
conditions as proposed by foreign companies, the
PSAL also requires that a certain percentage of
Russian goods and services be purchased. As the
SUBL, at present, does not contain requirements for
the subsoil user as regards Russian content, any
demand by the state to include such requirements in
the licence would be illegal and could be disputed in
court. However, from a practical point of view, there
would be no violation of legislation if, under particular
tender rules, the state provides that participants’
proposals regarding Russian content would influence
the choice of the winner.
Under the PSAL regime, the PSA should provide
for the use of Russian services and goods/equipment
in the amount stipulated by the PSA, but not less than
that set forth in the PSAL (art.7), i.e. employment of
not less than 80% of Russian nationals, ordering not
less than 70% of goods and equipment from Russian
companies, pre-emptive right of Russian companies to
carry out works for the project, and purchase of
Russian-made technological equipment. At the same
time, there are no guarantees that the SUBL provisions
will not be revised in the future to be analogous with
art. 7 of PSAL. However, in our opinion, this is
unlikely considering Russia’s plans to enter the World
Trade Organization (WTO) and the constant criticism
of the provisions contained in art. 7 of PSAL.
12.3.8 Investment protection
The rights and obligations granted to Russian
nationals by the Constitution generally also apply to
foreign citizens and individuals without citizenship,
unless otherwise provided in the federal law or
international treaty (art. 62). These constitutional
provisions create the legal basis for involving foreign
citizens and their legal entities into the use of natural
resources in Russia, including subsoil resources.
Art. 9 of the SUBL expressly provides that foreign
citizens and legal entities can be users of subsoil
resources and can enter into agreements on production
sharing, unless certain limitations are imposed by the
federal laws.6
Under the legal regime, both foreign citizens and
legal entities shall enjoy the same rights and have the
same obligations in relation to subsoil use as citizens
and legal entities of the Russian Federation. This is
unless otherwise stipulated by legislative acts. Foreign
investors from countries with which Russia has
Bilateral Investment Treaties (BITs) – such as the
United States, United Kingdom and France – which
amount to around 150 BITs in total, have even greater
678
investment protections under these BITs. Most of
these treaties provide more favourable clauses than are
provided for by Russian law, especially with respect to
the clauses related to dispute resolution and
expropriation.
Russia is also a signatory to the International
Convention on the Settlement of Investment Disputes
between States and Nationals of other States of 1965
(ICSID Convention) as well as the Energy Charter
Treaty. At the moment, both the ICSID Convention
and the Energy Charter Treaty have not been ratified
by the Russian Federation so it is not yet a party to
these Conventions but could be considered as a
prospective one. However, parties deriving from BITs
may refer their disputes to the international
arbitrations including ICSID as they are the subject of
an agreement between the foreign investor and the
state. No such dispute has been known to be the
subject of the settlement in ICSID so far.
Stabilization clauses
The SUBL does not contain any specific clauses
on stabilization. Therefore, under the SUBL regime,
only general stabilization clauses apply which are set
forth in the Civil Code of the Russian Federation and
in the Federal Law On Foreign Investments. Unlike the
PSAL stabilization clause, FIL, CIL and Civil Code
stabilization clauses only protect investors against
unfavourable changes in federal legislation and are
incapable of interfering with local legislation.
It appears that the investor will not be able to expand
guarantees from unfavourable changes in the legislation
by agreeing on such guarantees with the state.
While there are some stabilization clauses available
to the investor under the SUBL regime, these clauses
appear to provide less protection and be narrower in
scope than those provided in the PSAL. In addition, as
the PSA is an agreement between the state and the
investor, the parties thereto may agree on certain
additional stabilization guarantees. One of the most
important differences between the SUBL regime and
the PSAL regime appears to be the difference in
stabilization clauses.
12.3.9 Environmental protection
The major legislative act regulating the environmental
policy is Law No. 7 FZ/2002, on Environmental
Protection (EPL).
6 See para. 4 of art. 9 of the Law, which limits users of
subsoil in connection with radio-nuclear containing
elements only by legal entities registered in the Russian
Federation.
ENCYCLOPAEDIA OF HYDROCARBONS

EPL as a general environmental law creates the
main legal framework for use of natural resources and
contains fundamental principles of environmental
protection which are further reflected and developed in
the specific laws and regulations concerning the
affairs in the sphere of use of particular natural
resources. Such specialized laws adopted on the
federal level are: a) Land Code No. 136 FZ/2001; b)
Water Code No. 167 FZ/1995; c) Forest Code No. 22
FZ/1997; d ) Law on Subsoil Resources (SUBL), on
continental shelf of the Russian Federation No. 187
FZ/1995; e) as well as several other laws oriented
towards protection of atmosphere, fauna, health
conditions for the population, etc.
As a basic regulating act, the EPL determines the
authority of state agencies, sets out licensing
procedures and requirements, provides for state
monitoring and expertise of environmental and natural
resources, and establishes environmental rights and
duties of individuals and legal entities.
The SUBL establishes the main environmental
requirements applicable to subsoil usage. These
include: a) protection of subsoil by using special
methods of developing deposits; b) prevention of man-
caused desertification; c) prevention of wind erosion
of soil; d ) prevention of depletion and pollution of
underground waters; e) use of non-toxic reagents; f )
cleanup of spills of drilling fluids, fuels and lubricant
materials by ecologically safe methods. The
aforementioned general requirements are further
specified in a number of other rules and regulations,
which govern the conduct of petroleum operations.
The Ministry of Natural Resources must approve
the subsoil use licence prior to its execution. The
general ecological requirements must be included in
all subsoil use licences as well as specific
environmental provisions, depending on the type of
subsoil use operation.
The SUBL provides increased obligations in the
area of environmental protection, including provisions
concerning the liability of subsoil users whose
activities result in environmental pollution and
reclamation, etc.
Companies conducting work in oil and gas fields
in Russia must obtain a number of permits and
approvals. In addition to the aforementioned approvals
of subsoil use licence, the user must obtain a wide
range of other permits, including permits for plant
water and solid waste discharge, permits for gas
flaring, permits for re-injecting natural gas into wells
to maintain the intra-strata pressure, permits for
constructing and assembling drilling equipment at the
sea, and permits for construction and exploitation of
pipelines. These permits are issued by the Ministry of
Natural Resources and other state agencies.
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RUSSIAN FEDERATION
The authorized agencies of the Ministry of Natural
Resources annually establish pollution limits and
quotas and calculate the rates for environmental
pollution and approve them with the heads of local
administration. The tax agencies and the subsoil users
are notified of the approved rates through official
publications. Each year, companies must apply for a
permit to create emissions at the then-current rates.
The user exceeding the approved limits pays
substantially higher fees. Furthermore, under Russian
law, subsoil users responsible for unauthorized
pollution are liable to pay compensation for the
damage caused.
12.3.10 Currency regulation
The exchange regulations were considerably
liberalized by Law No. 58 FZ/2004 “about exchange
regulations and exchange control”.
In accordance with art. 10 of the mentioned Law,
non-residents have the right to perform limitless
foreign currency transactions from bank accounts
(from deposits) beyond the territory of the Russian
Federation to bank accounts (bank deposits) in
authorized banks; or from bank accounts (bank
deposits) in authorized banks to the accounts
(deposits) in banks beyond the territory of the Russian
Federation, or in other authorized banks.
Nevertheless, there are still limitations in
regulations concerning the obligatory sale of part of
the currency earnings in Russia’s internal exchange
market (art. 21). In accordance with regulations, it is
obligatory to sell a part of currency earnings of non-
residents at the rate of 30% unless the Central Bank
fixes another rate. The Central Bank has the right to
fix another rate of obligatory sale of part of currency
earnings of the residents but no more than 30% of its
sum. The object of obligatory sale is the currency
earnings of residents such as currency proceeds due
and payable to residents from non-residents for the
deals concluded by residents or in their name. These
deals provide the transfer of goods, execution of work,
rendering of services, transfer of information and
results of intellectual activity, including exclusive
rights on them in favour of non-residents, but with
several exceptions.
Besides, in cases established by the law, both
residents and non-residents must fulfill the demand
about the reservation (art. 16) in accordance with the
order established by the Central Bank of the Russian
Federation. The body of exchange regulations cannot
establish more than one requirement for reservation
relating to one currency operation. Both residents and
non-residents deposit the sum for reservation, at the
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
rate and for the period defined by the body of
exchange regulations in accordance with the current
Federal Law, to a separate account in the authorized
bank. The sum of money used for reservation is
deposited in the currency of the Russian Federation.
Calculation of the sum for reservation is performed for
the day of depositing. The calculation of the sum for
reservation for the exchange operation in foreign
currency is performed in accordance with the official
rate of exchange, established by the Central Bank for
the day of depositing of the sum for reservation.
The currency and foreign exchange rules differ
depending on the residency of the licensee. If the
licensee is a Russia-registered company, it must
transact all business with other resident entities in
rubles save for certain exceptions. Foreign currency
may be used by Russian resident companies in
cross-border transactions, subject to legal restrictions.
All the above restrictions do not apply to foreign
investors registered outside of Russia. A foreign
investor is free to receive and pay in foreign currency.
However, unlike a Russia-registered company, the
foreign investor is subject to certain limitations with
respect to payments in rubles. The foreign investor
opening ruble accounts in Russian banks is subject to
special rules as to the use of such accounts. Goods and
services provided in Russia may be paid for abroad, by
a foreign investor or by a Russia-registered licensee, if
the company which provided goods or rendered
services is a foreign resident.
12.3.11 Applicable law
The licence, as well as any terms and conditions of
activities of the licensee, are regulated by Russian law
(SUBL, art. 1). The licensing agreement, if concluded
by the parties, is also governed by Russian law (Civil
Code, art. 1213).
Before 1 March 2002, the possibility to choose
foreign law as the governing law of the PSAL was
considered by foreign investors to be one of the most
important advantages of the PSAL regime in
comparison with the SUBL regime. However, pursuant
to Part III of the Civil Code of the Russian Federation
(art. 1213.2) which came into force on 1 March 2002,
“agreements associated with land plots, underground
resources, separate water bodies and other immovable
property situated within the territory of the Russian
Federation are subject to Russian law.” While art.
1213.1 of the Civil Code of the Russian Federation
establishes the general norm to determine which law
should be applied regarding immovable property,
regardless of its location, art. 1213.1 contains the
mandatory requirement that Russian legislation
680
applies to immovable property (including the subsoil),
located on the territory of the Russian Federation.
The PSAs, being agreements associated with the
use of underground resources, are subject to Russian
law and the parties cannot change the governing law
by their agreement. As the Civil Code allows the
parties to choose different governing laws for different
provisions of their agreement (Civil Code, art. 1210.4),
the parties may try to separate those provisions
of the PSA which are associated with the use of
underground resources from the other provisions of
the agreement, and agree on the foreign law as the
governing law for the latter part of the PSA. However,
it is not clear whether Russian courts will agree with
such an approach, because art. 1213 specifically refers
to the ‘agreement’ rather than ‘provisions of the
agreement’.
12.3.12 Dispute settlement
The SUBL provides that financial, property and other
disputes, as well as claims contesting the wrongful
acts and actions of governmental agencies should be
considered by a regular court or an Arbitrazh court
(SUBL, art. 50). Arbitrazh courts in Russia are
branches of state courts specifically created to resolve
commercial disputes. Despite their name – arbitrazh:
arbitration – they are institutions for litigation rather
than arbitration.
However, the SUBL also provides that property
disputes may be referred by the parties to
arbitration, subject to agreement between the
parties. The SUBL does not set forth a division
between property and non-property claims. The
criteria of the property nature of the claim is set
forth in the Federal Law No. 226 FZ/1995 On State
Dues. This Law contains several examples of non-
property claims, which may give a general idea of
which claims are considered to be non-property (e.g.
claims on acknowledgment of rights, on awarding
specific performance, etc.). Using these criteria,
most non-property claims under the SUBL appear to
be claims contesting actions or documents issued by
governmental agencies. Such claims usually arise
where the investor is contesting actions and
documents adopted by governmental agencies
relating to its investments (e.g. refusal to issue or
extend the licence) – but does not have contractual
relations with the state – which is usually the case
under the SUBL regime. In addition, disputes
associated with establishing the terms of using
underground resources in the licence etc., also
appear to be non-property disputes and are subject
to litigation in the Russian Federation state courts.
ENCYCLOPAEDIA OF HYDROCARBONS

Those disputes, which may be classified as property
disputes, include claims for compensation of
damages and wrongful use of geological
information.
The parties to the PSA may refer certain disputes
under the PSA to arbitration, including international
arbitration (PSAL, art. 22). However, the language of
the PSAL appears to be somewhat restrictive, allowing
the parties to refer to arbitration only those disputes
which arise in connection with implementation,
termination or invalidation of the PSA. Therefore, any
other disputes should be subject to litigation in the
Russian Federation state courts. However, as most
disputes arising under the PSA are based on
commercial relations, despite this restrictive language
of the PSAL, we believe that a general rule may be
applied which allows to refer any commercial disputes
(including those in which the state is a party) to
arbitration, if both parties agree. Those disputes which
do not relate to implementation, termination or
invalidation of the PSA will, most probably, be of a
non-commercial nature (e.g. issuance of the licence
under the concluded PSA) and, thus, will be altogether
non-transferable to arbitration pursuant to the Russian
procedural legislation.
Investors from countries that have entered into a
BIT with Russia may rely on provisions contained
therein which provide for international arbitration even
in the absence of an arbitration agreement. As
mentioned above, the Russian Federation is not a party
of the Energy Charter Treaty and the ICSID
Convention.
Russia has formally joined the New York
Convention of 1958 regarding the enforcement of
foreign arbitral awards. However, local courts are not
universal with respect to the understanding and
application of this Convention and the enforcement of
foreign arbitral awards is often problematic.
Investor’s liability
Under administrative law, the violating party
should always be held liable by the state and the scope
of liability cannot be changed by the agreement of the
state and the violating party. As a general matter,
administrative law remedies may be imposed by the
authorized governmental authorities on a violating
party without reference to a court (except for certain
cases, e.g. confiscation of property). The list of
administrative law remedies is quite narrow and
primarily includes imposition of fines, revocation of a
special permission/licence and deprivation of certain
rights.7 Strictly speaking, by their nature, the
administrative law remedies are more a punishment
than remedy. As is the case with the tort liability of the
state discussed above, if the investor operating under
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
RUSSIAN FEDERATION
the SUBL performs a tort, the state may claim
damages caused by such tort to the state (Civil Code,
art. 1064).
The limitation period for imposition of
administrative law remedies (e.g. imposition of fines)
is shorter than the limitation period within which the
party to a civil law agreement may sue the other party
for the breach thereof. The limitation period within
which the governmental agencies may impose
administrative law remedies is two months (or a year,
depending on the violation) from the date of violation
(Code on Administrative Offences, art. 4.5).
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1984.
Jakovlev V.F. (1999) O vsaimodejstvii publichnogo i chastnogo
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Novikova E.V. (1999) Chastnoe pravo i èkologicheskoe
zakonodatel’stvo: vlijanie i sootnoshenie, Moskva, Jurist’.
Novikova E.V. (1999) O znachenii juridicheskoj techniki dlja
formirovanija èkologicheskogo zakonodatel’stva, «Zhurnal
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Novikova E.V. (1999) Veshchnoe pravo na zemlju kak ob”ekt
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problemy zemel’noj i agrarnoj reformy v stranakh
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i drugikh stranakh SNG, gosydarstvakh Baltii. Tezisy
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Novikova E.V. (2003) O neobkhodimosti reformirovanija
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3-8.
Novikova E.V. (2004) O vozmozhnostjakh tretejskovo
rassmotrenija sporov v sfere nedropol’zovanija, «Neft’,
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Novikova E.V. (2004) Ob èkologo-pravovykh riskakh v
dejatel’nosti nedropol’zovatelja. Materialy vtorogo
atyrausskogo pravovogo seminara, Atyrau, Tengizshevrojl,
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Novikova E.V. (2004) O novykh podkhodakh k formirovaniju
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Novikova E.V. (2004) Problemy pravovogo obespechenija
èkologicheskoj bezopasnosti kaspijskovo regiona i
vozhmozhnaja strategija ikh reshenija. Sbornik dokladov
po atomnomu pravu, Moskva.
7 See Code of the Russian Federation on Administrative
Offences No. 195 FZ/2001, effective as of 1 July 2002.
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Novikova E.V. (2004) Environmental payments under
the subsurface use contract and stability of the investor’s
position (guaranteed rights). Legal analysis, in: Bantekas I.
et al. (editors) Oil and gas law in Kazakhstan. National and
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sredy: metod dolzhnogo ucheta i drygie sposoby
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Sukahnov E.A. (1992) Zemlja kak ob”ekt grazhdanskogo
prava, «Vestnik Moskovskogo Universiteta», 5.
Sulejmenov M.K. (1997) Pravo nedropol’zovanija kak
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Elena V. Novikova
Russian Academy of Sciences
Moscow, Russia
ENCYCLOPAEDIA OF HYDROCARBONS
 12.4
Kazakhstan
12.4.1 Introduction
The extraction and production of hydrocarbons are the
most significant industries in the Kazakh economy. So
much so that hydrocarbon production can be defined
as the backbone of the economy of Kazakhstan and its
most rapidly developing sector, generating a
substantial portion of the gross national product and
providing a large part of budget revenues and hard
currency earnings for the country.
Kazakhstan ranks as the 12th nation in the world in
terms of proven reserves of oil and gas condensate,
and it is rated 23rd in the listing of the world’s leading
oil producing countries. According to official reports,
Kazakhstan’s combined onshore and offshore proven
and probable hydrocarbon reserves have been
estimated at approximately 29 billion barrels.
Kazakhstan possesses the Caspian Sea region’s largest
recoverable crude oil reserves.
Apart from the Caspian shelf reserves,
Kazakhstan’s explored natural gas resources total 1.8
billion m3. Over 95% of the gas reserves are
concentrated in 142 fields (in free and dissolved
form), located in the territories of Atyrau, Aktyubinsk,
western Kazakhstan and Mangistau regions.
The main feature of the resource base of the
country’s gas industry is that the gas reserves are
primarily associated with oil, oil and gas, and oil and
gas condensate fields. There are 66 fields in the
Republic with industrial gas reserves, of which only 7
small fields are stand-alone gas fields. The initial
sources of stand-alone gas fields total only 4.2 billion
m3, which is no more than 1.5% of the total initial gas
reserves of the country.
Kazakhstan’s ability to obtain the full benefits of
these estimated reserves will depend on a number of
factors, including expanding existing oil export routes
and building or gaining access to new routes, reaching
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
agreements with neighbouring states as to various
commercial aspects of oil extraction (notably over the
Caspian Sea), transportation and refining.
12.4.2 Petroleum legislation
Under Kazakhstan’s Constitution, mineral resources,
including petroleum resources, in their natural
condition in the subsoil are the sole and exclusive
property of the state. As pointed out below, the right to
exploration and production of petroleum resources is
granted on the basis of a contract with the Ministry of
Energy and Mineral Resources. The owner of the
petroleum lifted to the surface shall be defined in the
contract. Unless otherwise stipulated in the contract,
the owner shall have the right to dispose of the
petroleum brought up to the surface.
The primary legislative acts regulating the
petroleum industry in Kazakhstan are: a) the Law on
subsoil and subsoil usage adopted in January 1996
(the Subsoil Law); b) the Law on petroleum adopted in
June 1995 (the Petroleum Law); c) the Law on
Production Sharing Agreements (PSAs) for
conducting offshore petroleum operations adopted in
July 2005 (the PSA Law); d ) the Code on taxes and
other obligatory payments to the budget adopted in
June 2001 (the Tax Code).
The Subsoil Law lays the basic framework
governing both oil and mining operations in
Kazakhstan, while the Petroleum Law addresses only
petroleum operations and overlaps in various respects
with the Subsoil Law. The Subsoil Law and the
Petroleum Law are to be applied together, in harmony
where possible. The PSA Law regulates Production
Sharing Agreements only for the offshore oil blocks of
Kazakhstan. Any relations that are not regulated by the
PSA Law shall be regulated by the Subsoil Law and
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
the Petroleum Law. However, the rules of the PSA Law
shall prevail over the rules of other legal acts of
Kazakhstan in the event that such acts establish any
rules for concluding, implementing or terminating
agreements differing from those stipulated by the
PSA Law.
Only the Tax Code, as stated in the Tax Code itself,
may establish provisions concerning the payment of
taxes and levies relating to subsoil operations in the
Republic of Kazakhstan. Hence, the tax provisions of
subsoil use contracts are governed by the Tax Code.
Kazakhstan’s legal regime governing the
development of natural resources has evolved
significantly over the years. There were important
amendments introduced to the Subsoil Law and the
Petroleum Law in 1999, 2004 and 2005. The 1999
amendments brought greater clarity to the rules on
subsoil operations and changed the legal regime for
subsoil use rights, while the 2004 and 2005
amendments strengthened the government’s control
over any direct or indirect transfers of subsoil use
rights and introduced a concept of the state’s
pre-emptive right. As a result of the 2004 and 2005
amendments to the Tax Code, a new tax regime was
introduced, which significantly moved the balance of
risk and reward in favour of the state.
12.4.3 The subsoil use contract
The subsoil use right to conduct petroleum operations
may be granted to Kazakh and foreign individuals and
legal entities. Under art. 13.4-1 of the Subsoil Law,
subsoil use rights may be granted to several subsoil
users without requiring them to form a legal entity or
other project vehicle to represent the interest.
Members of such joint ventures are deemed joint
holders of the subsoil use right. Subsoil users in a joint
venture bear joint responsibility and liability for
obligations arising under their subsoil use contract.
The right to subsoil use may be assigned or granted to
an entity directly by the state.
Granting subsoil use rights by the state
Procedure for granting subsoil use rights
The subsoil use right may be granted by the
competent authority either by way of conducting a
tender or by way of conducting direct negotiations.
Under art. 41.1 of the Subsoil Law, the right to
negotiate and enter into a subsoil use contract
(excluding offshore hydrocarbon PSAs) for
exploration and/or production of hydrocarbons is
pursuant to the results of an investment tender held by
the competent authority, which is the government
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agency designated under the subsoil and petroleum
legislation to serve as the state’s contractual
representative in subsoil deals with investors.1
Exceptions to this tender rule may occur when the
competent authority grants the subsoil use right on the
basis of direct negotiations to the National Oil
Company (NOC) for the exploration and/or production
of hydrocarbons. Another possible exception may exist
when the competent authority grants the right for the
production of hydrocarbons to an entity who is
exclusively entitled to obtain the subsoil use right in
connection with a commercial discovery made on the
basis of the exploration contract.
Investment tenders may be either open, in which an
announcement pertaining to the planned tender is
published beforehand, or closed, in which an
announcement is delivered to selected participants.
Each year, the Kazakh government approves a list of
blocks which will be tendered for granting the subsoil
use right for the exploration and/or production of
hydrocarbons. The government may also approve a
second, separate list of blocks to be offered at tenders
for which, however, participation is conditioned by a
minimum 50% participatory share of the NOC.
Those who wish to participate in a tender must
submit an application to the Ministry of Energy and
Mineral Resources. The winners of tenders are
selected on the basis of a number of factors, including
proposed investment obligations, payments to the state
‘budget,’ compliance with the requirements of subsoil
and environmental legislation and estimated
profitability of a particular project. The regulations on
granting subsoil use rights issued on 21 January 2000
provide a detailed explanation of the procedures for
granting subsoil use rights.
The procedure for granting the right to enter into
an offshore hydrocarbon PSA set forth by the PSA
Law is different from the procedure set forth by the
Subsoil Law. Under art. 12 of the PSA Law, the right
to enter into a PSA shall also be provided to all
potential contractors (excluding NOC) on the basis of
1 Prior to August 1999, subsoil use rights were granted
based on a license issued by the government, and a subsoil
use contract signed with the competent authority. The
process of obtaining a license and then negotiating a
contract was a lengthy, costly and time-consuming
procedure. The 1999 amendments introduced a new legal
regime. Since August 1999, contractors may receive the
right to engage in subsoil use operations by simply
executing a subsoil use contract with the competent
authority (currently, the competent authority is the Ministry
of Energy and Mineral Resources). Licenses and contracts
which were issued and executed before August 1999
continue to be effective up to the expiration of their
stipulated terms, including periods of extension provided
under the legislation in effect at the time of their issuance.
ENCYCLOPAEDIA OF HYDROCARBONS

open or closed tenders. However, if there are more
than two bidders, the tender shall be two-staged.
Parameters for evaluating tenders
The winner of a tender shall be determined on the
basis of a combination of the following principal
parameters: a) the beginning and intensity of the
exploration; b) the initial date of production and the
attainment of its economic and technical potential,
including the maximum coefficient in the extraction of
useful minerals; c) proposed amounts of initial and
subsequent ‘budget’ payments; d ) investments,
deadlines and terms of financing the project as well as
capital investments in the development of the
contractual territories with all its social repercussions;
e) compliance with the requirements associated with
the protection of the subsoil and the environment as
well as the safe performance of operations in
accordance with the Kazakh legislation; f ) obligations
regarding the hiring of Kazakh personnel as a
percentage of the total number of employed personnel.
Proposals concerning the financing, training and
retraining of Kazakh personnel; g) obligations
undertaken with regard to the purchase of goods,
works and services of Kazakh origin as a percentage
of the total value of goods, works and services
required for the performance of investments in
facilities under the contract and which are in
compliance with national and/or international
standards; h) proposals concerning the development
and use of high technologies, new and current
processing production facilities, main pipelines and
other pipelines, construction and joint use of
infrastructure items and other facilities.
Types of subsoil use contracts
The Subsoil Law and the Petroleum Law provide
that the winners of tenders may execute the following
types of subsoil use contracts with the competent
authority: a) concession agreements – exploration
contracts, production contracts and combined
exploration and production contracts; b) PSAs; c)
service contracts; d ) contracts for construction and/or
operation of underground storage and oil pits (this
type of contract is granted by the competent authority
on the basis of direct negotiations).
Contract negotiations and execution procedures
Contract specifications are agreed upon between
the parties involved in accordance with applicable
laws and the model subsoil use contract.2
The Ministry of Energy and Mineral Resources
provides assistance in concluding contracts with
subsoil users and assists in the preparation and
execution of these contracts.
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Prior to execution, draft contracts must be reviewed
by a number of ministries and agencies (the Ministry
of Economy, the Ministry of Finance, the Ministry of
Environmental Protection, the Ministry of Justice, the
Ministry of Healthcare, and the Emergency Situations
Agency).
Upon finalization, the subsoil use contract must be
registered with the Ministry of Energy and Mineral
Resources which also maintains the state registry of
subsoil use contracts. A subsoil use contract will be
effective upon its registration unless a later date is
specified in the contract.
Transfer of subsoil use rights
Under Kazakhstan’s petroleum legislation, subsoil
use rights may also be acquired from another user (as
opposed to acquiring subsoil use rights from the state).
No tenders are conducted in this case; however, the
subsoil user must obtain permission from the
competent authority in order to transfer its subsoil use
rights to a third party.
Article 53.1 of the Petroleum Law requires the
competent authority’s consent for the transfer of a
subsoil use right by a subsoil user to another party and
for the transfer of shares (interest) in a company that
holds the right to conduct petroleum operations.
Furthermore, art.14.1 of the Subsoil Law states: “The
transfer of a subsoil use right by a subsoil user to
another party, whether on a paid basis or free of
charge, including contributions to the charter capital of
a legal entity, except in case of a pledge of the subsoil
use right, shall be conducted only with the permission
of the competent authority”. Under art.14.5 of the
Subsoil Law, failure to obtain permission from the
competent authority will result in the invalidity of such
subsoil use rights transfer.
The competent authority may withhold its consent
to transfer the subsoil use right if:
• The proposed transferee is unable to meet the
subsoil user’s obligations under the contract in
whole or in part (if the right to use subsoil is
transferred in part).
• The subsoil user has deliberately provided false
information to the competent agency.
• The transfer of the right to subsoil use will entail
non-compliance with the national security
requirements of the country, including ‘the
concentration of rights’ for conducting subsoil use
operations.
‘The concentration of rights’ ruling, which
includes the “concentration of rights under a
2 This is the model contract for conducting subsoil
use operations approved by Government Resolution
No. 108/1997.
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contract”3 and the “concentration of rights to conduct
subsoil use operations”4 was introduced to the Subsoil
Law in October 2005 to prevent a concentration of
direct or indirect rights to Kazakhstan’s strategic
mineral resources by “one person” or by a “group of
persons from one country.”
As a result of the 2004 and 2005 amendments to
the Subsoil Law, the state is authorized a pre-emptive
right in matters of direct or indirect transfers of subsoil
use rights. Specifically, art. 71 of the Subsoil Law
provides the state a pre-emptive right in the following
cases: a proposed transfer of an interest in a subsoil
use contract; a sale of shares in a subsoil user or a
parent company (or the ultimate parent company) of a
subsoil user if such parent company (or ultimate
parent company) has control over the subsoil user (i.e.
can determine or affect the business decisions of the
subsoil user), and the main business of the parent
company (or ultimate parent company) involves
subsoil use in the Republic of Kazakhstan.
As the government has not adopted implementing
procedures concerning the state’s pre-emptive right,
the procedures for requesting a waiver of this right are
currently unknown.5 It is also unclear whether this
right applies to all types of alienations or just certain
types and, if so, which types. Article 71 refers to the
“acquisition” of shares “being alienated”. The terms
acquisition and alienation in the Russian language
encompass transfers of property rights from one
person to another (with or without consideration)
and, as such, they cover a broad range of share
transfers. No exemptions are contained in art. 71. On
the other hand, Kazakh law clearly recognizes that not
all transfers are by alienation.
Notwithstanding the above, the state can be
arbitrary in its enforcement of legislation, particularly
where the legislation is unclear. Thus, a certain degree
of practical risk must be accepted when concluding
that a particular alienation of subsoil rights or shares
of a subsoil user is exempt from the state pre-emptive
right. We note that under recently amended art. 45.2-1
of the Subsoil Law, the competent authority has the
right to unilaterally terminate a subsoil use contract
which has been assigned (or where control of the
subsoil user has been changed) with no prior offer to
the state.
Pledge of subsoil use rights
A pledge agreement on subsoil use rights also
requires the consent of the competent authority and
becomes effective only upon its registration with the
competent authority. The government has not yet
defined the procedure for foreclosure on pledged
subsoil use rights nor taken action in this regard. The
absence of procedures for foreclosure on pledged
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subsoil rights creates uncertainties when banks are
required to proceed to such a foreclosure.
12.4.4 State participation
and key regulatory agencies
The Ministry of Energy and Mineral Resources is the
main state agency with which an investor interested in
acquiring subsoil use rights will work. As mentioned
above, the Ministry of Energy and Mineral Resources
is the competent body authorized to execute subsoil
use contracts on behalf of the state. As the competent
body, this is the only ministry with the authority to
suspend and terminate subsoil use contracts. The other
agencies which subsoil users will work with include
the State committee on geology and subsoil use, the
Ministry of Environmental Protection and its territorial
environmental committees, local governments, and the
tax authorities of the Ministry of Finance.
The National Oil Company
Joint Stock Company (JSC) KazMunayGas is a
100% state-owned National Oil Company (NOC)
involved in a full cycle of operations and services for
hydrocarbon exploration, development, production,
processing, transportation and marketing.
As mentioned above, the NOC may obtain the right
to enter into all types of subsoil use contracts on a
basis of direct negotiations. In addition to this, the
NOC has the right to be a sine qua non partner (with
at least 50% of the total interest) in all offshore PSAs
and in exploration and/or production contracts for
blocks listed in the mandatory NOC participation list.
Under the Petroleum Law, the NOC is entitled to
perform the monitoring and control of compliance by
3 The “concentration of rights under a contract” is
defined as a share held by one of the consortium participants
under contract with the Republic of Kazakhstan, which
allows such participant, at its sole discretion, to make
decisions on the subsoil user’s operations under the contract.
4 The “concentration of rights to conduct subsoil use
operations” is defined as a share held by one person or a
group of persons originating from the same country having
subsoil use operations within the territory of the Republic
of Kazakhstan, or an ownership interest in the charter
capital of subsoil use companies in the Republic of
Kazakhstan, which may create or has created a threat to the
economic interests of the Republic of Kazakhstan.
5 We note that the wording of art. 71 refers to both new
and “previously signed” subsoil contracts. This appears to
violate certain provisions in Kazakhstan’s legislation
prohibiting retroactivity of new legislation. But, until the
courts declare such retroactivity to be a violation of the law,
the government appears intent on applying the state’s pre-
emptive right to subsoil contracts entered into before such
right became effective.
ENCYCLOPAEDIA OF HYDROCARBONS

subsoil users with their subsoil use contracts.
Specifically, art. 7.1 of the Petroleum Law provides for
the following functions of the NOC: a) participation in
forming strategies for the use of rates of recreation and
to further increase petroleum resources;
b) representation of the state’s interests in contracts;
c) participation in the organization of tenders
for petroleum operations; d ) preparation and
implementation of new oil projects.
The authorized body
Under PSA Law, in addition to the competent
authorities and other state agencies, an authorized
body (the Authorized Body) will also carry out the
monitoring and supervision of compliance with PSA
provisions. This authorized body also has the
mandatory right to participate in the management
committee of the PSA. Although the PSA Law
provides that the authorized body does not exercise
control over a project or the supervisory functions of
state bodies, it does not clearly separate which
responsibilities lie with the competent authorities and
which with the authorized body, nor does the PSA
Law spell out the authorized body’s function in the
management committee.
Under art. 11 of the PSA Law, the government may
appoint the NOC or any state agency or legal entity
registered in Kazakhstan as the authorized body. As
noted above, the NOC will be a 50% participant of
many if not most PSAs. Should the government
appoint the NOC as the authorized body, NOC’s
participatory interest must be transferred to one of its
subsidiaries or sold to a third company. However, the
transfer to a subsidiary does not cure the serious
conflict of interest issue.
The authorized body will not be appointed to PSAs
in cases where the NOC’s share is more than 50% and
the NOC’s subsidiary is the operator under the PSA.
Although the idea of an authorized body was
introduced to Kazakhstan’s subsoil use legislation for
the first time in 2005, it has already existed in practice
for several years. The NOC of Kazakhstan is
appointed as an authorized body in two Kazakhstan
PSAs such as the North Caspian Sea PSA and
Karachaganak PSA, both signed in 1997.
12.4.5 Contract duration
Exploration contracts are valid for up to six years.6
The duration of an exploration contract may be
extended twice for up to two years. Production
contracts have a duration of 25 years (45 years for
hydrocarbon deposits with more than 100 million tons
of crude oil and/or more than 100 billion m3 of natural
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gas).7 A combined exploration and production contract
is concluded for the combined terms for the duration
of both the exploration contract and the production
contract.
The duration of PSAs for hydrocarbon production
contracts stipulated in art. 6 of the PSA Law is similar
to the duration of production contracts set forth by the
Petroleum Law. However, the duration of PSAs for
combined exploration and production works cannot
exceed thirty-five years. In addition, art. 6.1 of the
PSA Law sets forth different rules for extending the
duration of the executed production sharing
agreement. Unlike the Subsoil Law and the Petroleum
Law which state that following the approval of the
extension application, the contractor will continue to
operate under its existing contract (with whatever
amendments the parties agree upon when negotiating
an extension), the PSA Law states that following the
competent authority’s approval of the contractor’s
extension application, the parties will negotiate a
completely new production sharing agreement that
will govern the period of the agreed extension.
12.4.6 General structure
of a subsoil use contract
The details of a contract are agreed upon between the
parties in accordance with applicable laws and the
model subsoil use contract. Every subsoil use contract
must reflect the conditions of the model subsoil use
contract (albeit the so-called model subsoil use
contract is neither very detailed nor sophisticated).
But, since the model subsoil use contract is merely the
legal basis for a particular type of agreement, it may
be modified to meet the specific requirements of the
transaction.
Contract area
The contract must specify the contractual territory
(i.e. the area allocated under the contract to carry out
exploration and/or production activities, to be defined
by geographic coordinates). The contractual territory
may include one or a number of adjacent blocks. The
contractual territory may be limited to a given depth.
Work programmes
All contracts must contain a work programme
defining the conditions for exploration and/or
production over the contract period. Two types of work
programmes are described under the Petroleum Law.
6 See art. 43 of the Subsoil Law, and art. 26 of the
Petroleum Law.
7 Petroleum Law, art. 26.2.
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The minimum work programme defines the
contractor’s obligations for exploration activities
conducted in the contract time period and territory.
The competent authority can release the contractor
from all or part of the work programme if it is proven
that its fulfilment would be unreasonable due to
circumstances beyond the contractor’s control.
The second type of work programme is the annual
work programme, which defines the contractor’s
annual obligations during both exploration and
production. It includes exploration and production
programmes, detailed descriptions of planned
operations and minimum and maximum levels of
production.
Compliance with the approved work programmes
is essential, since failure to do so may result in the
competent authority suspending subsoil use operations
or terminating the contract, should such breaches not
be cured within the specified time period.
Local content requirement
Subsoil use contracts also contain so-called local
content provisions: contractors are required to use
local materials, goods, works and services where such
services are competitive with international services.
As a matter of practice, there is a growing amount of
pressure to increase local content.
Article 41 of the Subsoil Use Law now requires
subsoil users to identify in their tender proposal their
commitment to hire local personnel, as well as to
specify the percentage of local content in their works,
goods and services (subject to compliance with local
and/or international standards). The tender proposals
must also specify the user’s commitments to the
infrastructure and other economic and social
developments of the relevant regions of the country.
In the event of repeated violations of the local
content requirement, the competent authority has the
power to suspend the subsoil use operations for up to 6
months, and then to terminate such rights if the
violations are not cured in the manner prescribed by
the competent authority.
12.4.7 Tax regime of hydrocarbon
contracts
Under the Tax Code, there are two types of tax regimes
applicable to subsoil use (hydrocarbon) contracts:
Model 1 and Model 2. The Model 1 tax regime is
applicable to subsoil use contracts in a type of
concession agreement (exploration and/or production
contracts), and the Model 2 tax regime is applicable to
production sharing agreements (PSAs).
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Model 1
In this regime, the subsoil user is responsible for
the payment of all taxes and other obligatory payments
that would generally apply to ordinary taxpayers in
Kazakhstan (corporate income tax, social tax, property
tax, land tax, VAT, rent tax on crude oil export, excise
on crude oil and gas condensate, environmental fees,
etc.). In addition, the following specific taxes are
applicable to mineral extraction activities: bonuses,
royalties, and excess profit taxes.
A subsoil use contract will establish all taxes
applicable to the subsoil user over the term of the
contract, either directly or by way of reference to the
Tax Code in effect on the date the contract is signed.
Special subsoil taxes are discussed in more detail
below.
Bonuses
Bonuses are fixed payments required of subsoil
users. The subsoil users are expected to pay two types
of bonuses8: a signature bonus and a commercial
discovery bonus.
The signature bonus is a lump-sum payment by
subsoil users for the right to use the subsoil. The initial
amounts of signature bonuses are defined by the
government based on the volume of hydrocarbons and
the economic value of the field. The final amount of a
signature bonus is established by a commission at the
conclusion of a tender held to award the subsoil use
right. This amount is included in a contract taking into
account the economic value of the contract area, but it
cannot be lower than the initial amount set by the
government. The signature bonus must be paid to the
budget no later than 30 days from the date when the
subsoil use contract comes into force. The tax return is
to be filed by the 15th day of the month following the
month the payment is due.
The commercial discovery bonus is a fixed
payment that is paid by subsoil users when a
commercial discovery is made in the contract area9.
The basis for calculation of the commercial discovery
bonus is defined as the value of the extractable
hydrocarbon reserves duly approved by the competent
state authorities. The value of the hydrocarbon
reserves is determined using the market price
established at the International (London) Exchange, in
8 In the past, many contracts established production
bonuses that were payable when certain production levels
were reached. These are no longer included in taxes
applicable to contracts negotiated after July 1, 1998, as the
production bonuses are essentially no different than
royalties, and were deleted by legislative changes.
9 Under exploration contracts that do not envisage
subsequent production, the commercial discovery bonus is
not paid.
ENCYCLOPAEDIA OF HYDROCARBONS

accordance with the information sources approved by
the Government of Kazakhstan on the day the bonus
payment is made. When a market price for
hydrocarbons is not established, the value of
extractable hydrocarbon reserves is determined based
on the planned costs of their extraction adjusted by the
planned profitability as indicated in the work
programme approved by the competent authority.
Currently, the rate of the commercial discovery bonus
is fixed at 0.1% of the value of proven extractable
resources. Previously, the rate of the commercial
discovery bonus was not fixed; i.e. it could vary
depending on the specific conditions of subsoil use
operations but could not be lower than 0.1%.
Royalties
Royalties are payments for the right to use subsoil
under Model 1 contracts. Ordinarily, the royalty is paid
in cash, but the government may require payment in
kind. If payment is to be in kind, the mechanism
should be specified in an additional agreement with
the competent authority. Cash royalty payments will
usually be calculated by multiplying the production by
a netted back price and applying the appropriate
royalty rate.
Royalties are calculated on the value of the
produced hydrocarbons. The value is calculated on the
basis of the average selling price of hydrocarbons in
the reporting period, exclusive of indirect taxes, and
reduced by the actual transportation expenses to the
place of sale (shipment).
Royalties are paid on a sliding scale as a
percentage determined on the basis of the volume of
cumulative production of oil, including gas condensate
for each calendar year of operation (Table 1).
For purposes of royalty calculations in the case of
the extraction of associated gas hydrocarbons, such
gas hydrocarbons should be converted to their crude
oil equivalent at the ratio of 1,000 m3 to 0.857 tonnes
of crude oil. Moreover, gas hydrocarbons are also
valued in the case of free-of-charge transfers for
further processing. If gas hydrocarbons are re-injected
into the subsoil, such gas hydrocarbons are exempt
from royalty.
Excess Profit Tax
Subsoil users operating under a Model 1 contract
are subject to Excess Profit Tax (EPT) in accordance
with the procedures and at the rates established below.
The EPT will start to apply once the ratio of
cumulative aggregate income to cumulative tax
deductions (as calculated for corporate income tax
purposes) exceeds 1.2. Under the current regime, the
tax base is the net income of a subsoil user in excess
of 20% of tax deductions. A net income for the
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Table 1. Progressive royalties percentage with regard
to the annual hydrocarbon production
Volume of annual
Percentage
oil production (t)
Up to 500,000 2%
From 500,000 to 1,000,000 2.5%
From 1,000,000 to 1,500,000 3%
From 1,500,000 to 2,000,000 3.5%
From 2,000,000 to 2,500,000 4%
From 2,500,000 to 3,500,000 4.5%
From 3,500,000 to 4,500,000 5%
From 4,500,000 to 5,000,000 5.5%
Over 5,000,000 6%
purposes of EPT is defined as the difference between
taxable income and corporate income tax (plus branch
profits tax where applicable).
The tax base can be adjusted for the
expenditures actually incurred for the education of
the Kazakh work force and/or an increase of fixed
assets but this adjustment cannot exceed 10% of the
taxable amount. The tax rates are established on
a sliding scale ranging from 0% to 60% and depend
on the ratio of accumulated income to accumulated
expenses of a subsoil user. The EPT is calculated
by multiplying the tax base by the rates established
in Table 2.
The EPT tax period is a calendar year, and the tax
is payable by April 15 of the year following the
reporting year.
Model 2
The fiscal regime known as Model 2 (production
sharing agreements) differs from the Model 1 regime
in that, under PSAs, a subsoil user is obligated to share
production with the Republic of Kazakhstan in
accordance with a special formula. In addition to
sharing production, the subsoil users must pay a
so-called top-up tax and other taxes and levies that are
applicable to the Model 1 regime, excluding, however,
the following: a) royalty; b) excise tax on crude oil
and gas condensate; c) excess profit tax; d ) rent tax on
export of crude oil and gas condensate; e) land tax;
f ) property tax.
The Tax Code specifically provides for the
following provisions which must be included in a
PSA: a) determination of the volume and monetary
value of total production; b) determination of the
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percentage of total production to be used for cost
recovery, i.e. to reimburse the costs incurred by the
subsoil user (known as cost oil); c) determination of
the share in total production to be shared after
deduction of the cost recovery production between the
subsoil user and the Republic (known as profit oil); d )
the shares (percentages) of the share of the Republic
and the subsoil user’s share in profit oil; e) the
procedure for determining the share of the Republic in
profit oil in accordance with the Tax Code.
The Republic of Kazakhstan’s share of profit oil
In accordance with the Tax Code, the procedure for
the calculation of the share of the Republic and a
subsoil user’s share in profit oil is unified for all PSAs
concluded after January 1, 2004.10 The Republic’s
share of the profit oil produced under a PSA contract
may vary, depending on how the contract is negotiated,
the degree of risk, and the expected costs.
The share of the subsoil user in profit oil is the
lowest of three percentage values as determined by the
following three factors: R-factor (profitability index) –
the ratio of the subsoil user’s accumulated income to
the accumulated expenditure under the project;
internal Rate of Return (IRR) of the contractor – the
discount rate when the net real discounted income
(presumably net present value) reaches its zero value;
P-factor (price factor) – the ratio of the subsoil user’s
income to the total production volume during the
reporting period.
The value of the extracted production is
determined as a product of the physical volume of the
extracted production in tonnes as measured at the
point of sharing (to be determined by a specific PSA)
and the average sales price at the point of sharing for
the tax period in question. The average selling price of
production is determined as the total sale income for
Table 2. Progressive EPT percentage with regard
to the ratio of profit to accumulated expenses
Ratio of profit
Percentage
to accumulated expenses
Up to 1.2 0%
From 1.2 to 1.3 10%
From 1.3 to 1.4 20%
From 1.4 to 1.5 30%
From 1.5 to 1.6 40%
From 1.6 to 1.7 50%
More than 1.7 60%
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the reporting period less indirect taxes and sales
expenses divided by the corresponding physical
volume sold. The selling price is also subject to
transfer pricing control under the Kazakhstan transfer
pricing legislation.
The Tax Code provides for the lists of expenses
that are recoverable and specific expenses that are
not cost recoverable for subsoil users operating
under a PSA. Recoverable expenses are defined as
justified expenses of a subsoil user actually borne
during the execution of the work programme and
without any uplift. There is no definition of
‘justified,’ but clearly issues such as whether the
expense is part of an approved work programme,
and whether it is supported by proper documentation
are important. The share of production allocated to
cost recovery may not exceed 75% prior to payback
and 50% post payback.
Recoverable expenses of a subsoil user are reduced
by the amount of operating income related to receipt
of rent payments for rental of property created or
acquired under the contract, after deduction of related
expenses, and the amount of other income (penalties,
interest, etc.) received from the activity under the
contract.
Top-up tax (or additional payment under a PSA)
The top-up tax constitutes the additional payment
of subsoil users operating under a PSA to the state
budget to ensure that the total state’s take will be
between 5-10% prior to the project’s payback and 40%
in the periods thereafter.
It can be inferred that the tax burden stemming
from the PSA type tax regime may be greater. In
reality, the payment burden will differ if the economics
of a project is more or less favourable than what was
originally anticipated when the project was negotiated.
Other taxes
Subsoil users are also bound to the payment of
other taxes.
Economic rent tax on exported oil
and gas condensate
The economic rent tax on exported oil and gas
condensate is paid by all legal entities and individuals
exporting crude oil and gas condensate for sale. As
noted above, subsoil users under PSAs are exempt
from it with respect to production from their own
contract areas. The tax base is determined by the value
of the exported crude oil based on the market price
10 Prior to this date, these issues were subject to
negotiation and the procedure could be established in a PSA.
ENCYCLOPAEDIA OF HYDROCARBONS

netted back for transportation costs and for oil quality.
The procedure for determining market prices for oil
and gas condensate will be fixed by the government of
Kazakhstan in a separate legal act, which is still to be
adopted. The tax rates applied to exported crude oil
and gas condensate is set forth by the Tax Code on a
sliding scale basis.
Environmental fees
For purposes of environmental legislation, users of
hydrocarbons are liable for the payment of two types
of environmental fees: fees for the use of certain
natural resources, and fees for pollution of the
environment. The taxable base and rates for the above
environmental fees vary depending on the nature of
subsoil user’s activities, the volume of used natural
resources, the volume of pollution, etc. Generally, the
above fees are different from taxes in that they may
vary not only from contract to contract but from one
taxable object to another. In addition, some of the fees
are subject to negotiation with approval by an
authorized government body. Below is a description of
the three environmental fees most relevant to a
subsoil user.
Fee for the use of a plot of land. It is collected for
the state’s provision of the plots of land for the
temporary, onerous use of land (a lease). The
procedure for this kind of provision is established by a
legislative act of the Republic of Kazakhstan. The fee
rates are determined in accordance with the land
legislation of the Republic of Kazakhstan and cannot
be lower than those of land tax. The amount of the fee
is calculated on the basis of agreement for the
temporary, onerous use of land by the local executive
body. The fee is paid to the ‘budget’ where the plots of
land are situated.
Fee for the use of water resources from surface
sources. It is collected for all types of special water
use from surface sources regardless of whether that
use involves the drawing of water from those sources
or not. Special water use is carried out on the basis of
a permit issued by the authorized body for the
management of water resources. The types of water
use are established by the water legislation of the
Republic of Kazakhstan. The object of taxation will
vary depending on the actual use of water. The fee
rates are established by the local administrative
representatives of an oblast’ (province, capital or major
city of the Republic). The fee is paid to the ‘budget’ at
the location of the special water use as specified
in the permit.
Fee for pollution of the environment. It is paid
to the ‘budget’ at the location of the source (object)
of pollution as indicated in a permit, with the
exception of movable sources of pollution for
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which payments are made to the ‘budget’ at the
place of their state registration. The object of
taxation is the actual volume of emissions within
or in excess of the established limits, and
discharges (including accidental) of pollutants and
of the disposal of production and consumption
waste. The fee rates are established by the local
administrative representatives based on and no
lower than the calculations made by the
environmental protection authorities.
Ring-fencing
Subsoil users operating under more than one
subsoil use contract or having activities outside the
scope of subsoil use contracts are required to maintain
separate records of their tax liabilities for each
contract or activity, unless otherwise stipulated in the
subsoil use contracts. Consolidation of such income
and expenses is prohibited unless the contract
explicitly grants permission to do so. This means that
unless the contract explicitly renounces ring-fencing, a
subsoil user may not deduct costs incurred under one
contract from revenues earned from another (but note
that the ring-fence applies to the contract, not to
individual geological structures within a
contract area).
In addition, when several taxpayers carry out
subsoil operations under one subsoil use contract, the
tax regime established in the contract applies equally
to each taxpayer. For fiscal purposes, all such
taxpayers are required to maintain consolidated
accounts for activities carried out under one subsoil
use contract and to pay taxes in accordance with this
contract. However, correctly structured arrangements
will not necessarily preclude individual liability of
subsoil users operating under PSAs, for example for
corporate income tax, which may be important for
double taxation relief. The principle of a separate
liability for tax violations is also provided by the
PSA Law.
Mandatory supply of crude oil
to domestic refineries
Due to the limited capacity of the Kazakh
pipeline network, the government tends to exercise
strict control over the export of oil and oil products
from Kazakhstan. The oil export restrictions are
also imposed to insure continuous and stable
operation of the three domestic refineries. Thus,
the government imposes a requirement on most
new subsoil use contracts for the mandatory supply
of crude oil by Kazakh oil producers to the
country’s three refineries. The government also
imposes seasonal restrictions on the export of
certain oil products.
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12.4.8 Environmental protection
Environmental protection law
The major legislative act regulating environmental
policy is the Law on environmental protection, dated
July 15, 1997 (the EP Law). As a basic regulating act,
the EP Law determines the authority of state agencies,
sets out licensing procedures and requirements,
provides for state monitoring and expertise of the
environment and natural resources, and establishes
environmental rights and duties of individuals and
legal entities. In addition to the EP Law, the Land
Code, the Subsoil Law, the Petroleum Law and several
other legislative acts contain additional specific
environmental protection provisions.
The Subsoil Law and the Petroleum Law establish
the main environmental standards applicable to subsoil
use operations. These include: a) protection of subsoil
by using special methods of developing deposits; b)
prevention of man-caused desertification; c)
prevention of wind erosion of soil; d ) prevention of
depletion and pollution of underground waters; e) use
of non-toxic reagents; f ) cleanup of spills of drilling
fluids, fuels and lubricant materials using ecologically
safe methods. The aforementioned general
requirements are further specified in a number of
other rules and regulations, which govern the conduct
of petroleum operations.
As mentioned above, the Ministry of
Environmental Protection must approve the subsoil use
contract prior to its execution. The general ecological
requirements must be included in all subsoil use
contracts signed in Kazakhstan although some
flexibility is permitted given that, at the time the
contract is signed, the exact environmental issues that
may confront the developer are not known.
Depending on the type of subsoil use operations, a
particular contract may contain specific environmental
provisions. The Petroleum Law, for example, provides
for the special treatment of offshore operations. Under
Kazakhstan’s offshore regulations, oil and gas
operations in the sea must be conducted in accordance
with the highest international standards and with
minimal risk of contaminating the sea. Permission to
begin drilling offshore is granted only if a contractor
has conducted all necessary geophysical and seismic
studies, calculated the risks associated with drilling,
and obtained a number of licenses, permits, and
approvals (e.g., drilling license, permit to install the
necessary equipment, approval of the projected
drilling plan). Kazakhstan’s Petroleum Law prohibits
the construction and operation of any type of oil
storage facilities offshore. The construction and
operation of offshore pipelines are also subject to a
number of special permits and approvals from various
692
state agencies. Contractors operating offshore are
responsible for preparing and obtaining approval of
special programmes for preventing and responding to
emergencies which may arise in the course of subsoil
use operations. Contractors operating offshore must
have a sufficient amount of special equipment and
materials on their drilling barges (and on any other
type of equipment installed in the sea) for the
immediate localization and clean up of potential oil
spills or any other contamination of the sea.
In addition to the standard set of requirements
generally imposed on contractors operating offshore,
the Subsoil Law contains specific offshore
requirements. For example, the Subsoil Use Law
requires contractors operating in the sea to organize
state inspections of their offshore equipment at their
own expense.
The Subsoil Law includes additional obligations in
the area of environmental protection. Article 48.1 of
the Subsoil Law contains detailed provisions
concerning the liability of subsoil users whose
operations result in the pollution of the sea. Under art.
64.3-6 of the Subsoil Law, upon termination of a
subsoil use contract, a subsoil user must take action to
conserve the site for exploration or production, and
dismantle and remove all equipment and other assets
from the contract territory.
Companies conducting oil and gas operations in
Kazakhstan must obtain a number of permits and
approvals. In addition to the above-mentioned
approvals of subsoil use contracts and working
programmes, contractors must obtain a wide range of
other permits, including permits for plant, water and
solid waste discharge, permits for flaring gas, permits
for re-injecting natural gas into wells to maintain the
intra-strata pressure, permits for constructing and
assembling drilling equipment at sea, and permits for
construction and exploitation of pipelines at sea. These
permits are issued by the Ministry of Energy and
Mineral Resources, the Ministry of Environmental
Protection and other state agencies and committees.
The Ministry of Environmental Protection annually
establishes national pollution limits and quotas. The
territorial agencies of the ministry annually calculate
environmental pollution ceilings and approve them
with the heads of the local administration. The tax
agencies and the subsoil users are notified of the
approved limits through official publications. Each
year, companies must apply for a permit to create
emissions at the then-current rates.
Companies exceeding the approved limits pay
substantially higher fees. In addition, under Kazakh
law, subsoil users responsible for unauthorized
pollution are liable to pay compensation for the
damage caused.
ENCYCLOPAEDIA OF HYDROCARBONS

Exploration and production of natural gas
Under art. 30.4 of the Petroleum Law, in the event
of a commercial discovery of natural gas, a contractor
must immediately begin exploration to the extent
required for commencement of production, unless
otherwise stipulated by the subsoil use contract.
However, a subsoil user is under no obligation to begin
production of natural gas prior to the conclusion of
transactions on the supply of natural gas from the
field. The subsoil user is given a one-year period to
conclude a deal on the supply of natural gas. If the
subsoil user does not conclude a supply contract
during this period, then the competent authority may
determine a third party with whom the subsoil user
must enter into the supply contract.
Flaring gas
In December 2004, the Petroleum Law was
amended to strengthen the gas utilization
requirements. Under art. 30.5 of the Petroleum Law, a
commercial development of oil and gas fields is
prohibited without full utilization of gas. Flaring gas is
allowed only in emergency situations (when flaring is
necessary to safeguard human health and
environment), or, upon obtaining a special permit, in
exceptional cases of well testing or production testing.
However, as a result of the 2005 amendments to
the Petroleum Law, the restrictions on flaring gas and
the gas utilization requirement do not apply to
companies whose gas utilization programmes were
approved by the relevant state agency by December 1,
2004 (during the completion period of their respective
utilization programmes) and to companies whose gas
utilization programmes were not approved by
December 1, 2004 but were approved by July 1, 2006.
Surface rights
Under Kazakh law, the granting of subsurface
rights does not afford the subsoil user an automatic
right to the corresponding surface land. The subsoil
user must obtain its surface rights separately from the
local governmental authority in the province (oblast’)
or district in which the contract territory is situated.
However, art. 44.4-1 of the Subsoil Law stipulates that
a subsoil use contract serves as the basis for the
prompt granting of land plots by the local executive
bodies, thus compelling the local authorities to provide
the necessary quantity of surface land.
Permitting offshore operations
Under art. 36.1-7 of the Petroleum Law, a subsoil
user may not commence construction or installation of
offshore facilities without obtaining a written permit.
Under art. 36.2-2 of the same law, a subsoil user may
not commence offshore drilling of wildcat,
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KAZAKHSTAN
exploration, or production wells, nor of any other
wells, without a permit. Discharge and waste burial
during offshore petroleum operations are prohibited by
art. 36.6-1 of the Petroleum Law.
Under art. 36.3 of the Petroleum Law, a subsoil
user may commence construction and operation of
offshore oil and gas pipelines only upon written
permission, while art. 36.4-1 prohibits the construction
and operation of offshore oil storage. Article 36.5-1
stipulates that the creation, operation and use of
artificial islands, dams, facilities and installations
intended for conducting petroleum operations,
offshore and scientific research, as well as for other
purposes, are the exclusive right of the government.
Site inspections by state authorities
Article 36.1-6 of the Petroleum Law states that
subsoil users who perform offshore petroleum
operations are required to organize, at their own
expense, transportation of state authorities conducting
inspections at offshore facilities owned or used by said
subsoil users.
12.4.9 Insurance, governing law,
stabilization
Subsoil use contracts must also contain insurance
provisions. The Petroleum Law requires subsoil users
to insure themselves against the risks associated with
the conduct of petroleum operations although, in many
cases, this insurance requirement is not satisfied as no
detailed regulations have been issued to identify what
specifically needs to be insured.
Under art. 53.1-1 of the Petroleum Law, relations
associated with the conducting of petroleum
operations on the territory of Kazakhstan and offshore
are governed exclusively by the laws of the Republic
of Kazakhstan.
Article 71 of the Subsoil Law and art. 57 of the
Petroleum Law provide protection to the subsoil user
against adverse changes in legislation. Hence, any
legislative amendments which deteriorate the subsoil
user’s position are not applicable to subsoil use
contracts signed prior to such amendments.
Based on this principle, all subsoil licenses issued
prior to the adoption of the August 1999 amendments
remain in force up to their expiration, including
extensions, in accordance with the legislation that was
in effect at the time of the issuance of such licenses.
The suspension, termination and revocation of subsoil
licenses issued prior to the August 1999 amendments
must be carried out in accordance with the applicable
rules of the Subsoil Law which existed prior to the
August 1999 amendments.
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However, there are certain exceptions from the
above stabilization guarantee. This guarantee is not
applicable to changes in the sphere of national
defense, environmental safety and health protection.
The Tax Code of Kazakhstan, as discussed below,
sets forth a different stabilization provision. The tax
provisions of subsoil use contracts are subject to the
rules established by the Tax Code.
Beginning January 1, 2005, all subsoil use
contracts (as opposed to solely PSAs) to be signed
between negotiating parties must undergo an
obligatory tax expert evaluation. This provision also
applies to amendments and additions introduced into
existing contracts. The tax regime agreed upon as the
result of a tax review must be included in the final text
of the contract.
The stability of the tax regime, as established by
tax expert evaluation, is incorporated into subsoil use
contracts and must be consistent with the tax
legislation effective on the date when the contracts are
signed. Where there are changes to the tax legislation,
during the period following review of the contracts but
before their signing, the relevant tax regimes shall be
subject to an additional tax review to incorporate any
changes before the contracts are concluded.
Currently, the tax regime of Model 1 contracts
(PSAs) established after January 1, 2004 are stabilized
from changes within Kazakh legislation. However, the
tax regime of Model 2 contracts provides that taxes
and other obligatory payments are calculated and
remitted to the ‘budget’ in accordance with the tax
legislation in effect on the date the relevant tax
liabilities arose. Nevertheless, both Model 1 and 2
contracts entered into before January 1, 2004 are
grandfathered.
The amended Tax Code states that the tax regime
will be maintained and kept valid for the entire period
established for the contract’s validity for any subsoil
use contract between the government (or competent
authority of Kazakhstan) and a subsoil user, provided
the contracts duly pass the mandatory tax review.
However, it is unclear whether contracts concluded
prior to 1996 (i.e. prior to the introduction of the
mandatory review clause) will be grandfathered.
Additional provisions concerning the stability of
subsoil use contracts are contained in art. 285.1 of the
Tax Code, which reads as follows:
• Where changes to tax legislation occur, the
taxation conditions established in PSAs may be
amended upon mutual agreement of the parties.
• Where changes to tax legislation result in benefits
to subsoil users, the taxation conditions established
in PSAs shall be amended in order to restore the
original economic interests of the Republic of
Kazakhstan.
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At present, the general view is that the first
paragraph of the above article constitutes the main
rule, i.e. that renegotiation of the taxation conditions
of a given PSA will only take place with the voluntary
consent of both parties, and that the second paragraph
is a simple statement of the desired aim of the
voluntary renegotiation.
An additional provision related to the stability of
PSA contracts is contained in art. 285.2. This
provision suggests that if the Republic of Kazakhstan
repeals any tax or levy envisaged in the PSA, the
subsoil user shall continue to pay the said tax or levy
until such time as the tax provisions of the PSA
contract are renegotiated.
It would also be logical to infer, from the
wording in art. 285.1 above, that changes in tax
laws favouring the taxpayer shall not
automatically result in the renegotiation of the
PSA contract, i.e. the consent of both parties is
necessary. Overall, the issue of the stability of
tax regimes is probably satisfactory, albeit not as
clear as it might be, due to the fact that the issue
is dealt with in several different provisions which
are not entirely consistent with one another.
Accordingly, stability still remains a key issue
for subsoil users.
12.4.10 Suspension
and termination of subsoil
use contracts
Petroleum rights may be suspended or prematurely
terminated only in the circumstances prescribed by the
Subsoil Law. Furthermore, the Subsoil Law sets out an
exhaustive list of instances where petroleum rights can
be suspended or terminated.
The competent authority may suspend petroleum
operations for a period of up to six months, if the
subsoil user has breached the terms of the contract
and/or has regularly violated the legislative
requirements of the Republic of Kazakhstan relating to
local content, subsoil and environmental protection,
and safe operations. In addition, the competent
authority may suspend petroleum activities when, due
to circumstances beyond the subsoil user’s control,
they may cause damage to human life or the
environment.
The competent authority may unilaterally terminate
a subsoil use contract should the subsoil user fail to
cure the breaches identified by the competent
authority in a timely and proper manner, should a
material breach of the subsoil use contract be
identified, and should the subsoil user be declared
bankrupt.
ENCYCLOPAEDIA OF HYDROCARBONS

The Subsoil Law allows petroleum companies to
challenge any orders and/or actions of the competent
authority in court.
12.4.11 Dispute settlement
Under the Petroleum Law, the parties involved in the
subsoil use contract may settle their disputes in
connection with the performance or termination of the
contract by way of negotiation or in accordance with
dispute resolution procedures, if any, as stipulated in
the contract. Disputes which are not settled by these
means may be submitted to either the Republic’s
judicial authorities for resolution, or to local or foreign
arbitration if an agreement or contract to arbitrate has
been agreed upon prior to the dispute.
However, investors from countries which have
entered into a bilateral investment treaty with
Kazakhstan or which are signatories, such as
Kazakhstan, to the Energy Charter Treaty may rely on
provisions contained therein which permit
international arbitration even in the absence of an
arbitration agreement.
In spite of the above, although the Republic has
formally acceded to the 1958 New York Convention
regarding the enforcement of foreign arbitral awards,
local courts are not universal with respect to the
understanding and application of this Convention and
the enforcement of foreign arbitral awards is often
problematic.
12.4.12 Protection
of investments under
international treaties
Under both the Petroleum Law and the Subsoil
Law, foreign citizens and legal entities, as well as
stateless persons, shall enjoy the same rights and
have the same obligations in relation to subsoil use
as citizens and legal entities of the Republic of
Kazakhstan unless otherwise stipulated by Kazakh
legislative acts.
Foreign investors from countries with whom
Kazakhstan has Bilateral Investment Treaties, BITs
(i.e. United States, UK, France, and China), have even
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KAZAKHSTAN
greater investment protection under these BITs. Most
of these treaties provide more favourable clauses than
are provided for by domestic law, especially with
respect to what entails an investment or investor, as
well as clauses related to dispute resolution and
expropriation.
As noted above, Kazakhstan is also a signatory to
the 1965 Convention on the Settlement of Investment
Disputes between States and Nationals of Other States
(ICSID Convention) which establishes the
International Centre for the Settlement of Investment
Disputes (ICSID). Pursuant to the ICSID Convention,
ICSID provides facilities for the conciliation and
arbitration of disputes between member countries and
investors who qualify as nationals of other member
countries. Recourse to ICSID conciliation and
arbitration is entirely voluntary. However, once the
parties have consented to arbitration under the ICSID
Convention, neither can unilaterally withdraw its
consent. Some BITs (e.g. the US-Kazakhstan BIT)
contain provisions which permit ICSID arbitration,
even in the absence of an arbitration agreement.
12.4.13 Currency regulations
The foreign exchange regulations are substantially less
restrictive for non-residents. For foreign currency
purposes, foreign individuals, branches and
representative offices of foreign entities, as well as all
legal entities that do not fall under the definition of
‘residents’ are deemed non-resident. Non-residents
may open offshore bank accounts without restriction
and deposit their funds offshore. Non-resident legal
entities may purchase foreign currency on the
domestic foreign currency market for routine currency
operations and in other cases as stipulated by
legislative acts.
There are also no restrictions on foreign investors’
repatriation of their investments abroad. Unlike other
CIS countries, Kazakhstan has no mandatory
conversion into local currency.
Gulmira Utegenova
Senior Associate, Baker & McKenzie
Law Firm
Almaty, Kazakhstan
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 12.5
Norway
12.5.1 Sovereignty over the
petroleum resources
In Norway, all oil and natural gas resources, mainly
petroleum, are located on the continental shelf. On 31
May 1963, Norway declared its sovereign rights to
explore for and exploit the petroleum resources on its
continental shelf, as provided for in the Convention on
the Continental Shelf 29 April 1958 which came into
force on 10 June 1964 (the Geneva Convention, art. 2).
Agreements on dividing the North Sea in
accordance with the median line principle (the Geneva
Convention art. 6.1) were reached between Norway
and the United Kingdom in March 1965, and between
Norway and Denmark in December 1965.
Subsequently, the Norwegian Continental Shelf south
of 62oN (the North Sea) was divided into thirty-seven
quadrants, each comprising twelve blocks covering
fifteen minutes of latitude and twenty minutes of
longitude. On average, the blocks in the North Sea are
about 500 km2 in size. The same division into blocks
has subsequently been made for the Norwegian Sea
and the Barents Sea. Due to the curvature of the earth,
the size of the blocks is gradually reduced towards the
north. In the Barents Sea, the size of each block is
about 250 km2.
12.5.2 Ownership and title
to the underground
petroleum resources
The Act of 21 June 1963 No. 12 relating to exploration
for and exploitation of submarine natural resources
stated that the property rights to petroleum resources
are vested in the Norwegian State. This provision was
also included in a subsequent Petroleum Act of 1985
and in the Petroleum Act applied today, which is Act
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19 November 1996 No. 72 pertaining to petroleum
activities (known as the Petroleum Act). It states: “The
property rights to subsea petroleum deposits and the
exclusive right to resource management is vested in
the Norwegian State” (the Petroleum Act s. 1-1).
The rights of the Norwegian State under the
Petroleum Act are vested in the Ministry of Petroleum
and Energy. Issues related to HSE (Health, Safety and
[work] Environment) are the responsibility of the
Ministry of Social Affairs and Labour, while the
Ministry of Environment is responsible for
environmental issues related to petroleum activities.
The Ministry of Finance is responsible for petroleum
taxation.
Main principles on which the Norwegian
petroleum policy and legislation have been based are:
• The petroleum resources are managed for the
benefit of society as a whole.
• The petroleum activities are governed by the
Norwegian State.
• Both national and international oil companies are
invited to carry out the activities, with a view to
achieving a plurality of geological ideas, the best
technological competence, a good financial basis
for the activities, and good checks and balances.
• The mapping and exploration of the continental
shelf are carried out at a moderate pace. This
process has been obtained through a phased
opening of areas for petroleum activities on the
continental shelf, and through the award of a
limited number of blocks in each licensing round.
Today, Norway is the seventh largest producer of
oil and gas in the world, and the third largest oil and
gas exporter. The main aims for the Norwegian
petroleum activities are that:
• The petroleum activities render the highest
possible value creation to society and to the
companies.
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
• The Norwegian petroleum industry is
internationally competitive and works towards an
ever higher degree of internationalization.
• Norway combines its position as a significant
petroleum producer and exporter, with
environmental concerns in the forefront.
12.5.3 Structure of the petroleum
regulation
The right to prospect for petroleum resources
No petroleum activities may be conducted in
an area before it has been formally opened to
petroleum activities (the Petroleum Act s. 3-1).
Such opening is made by decision of the Storting
(Norwegian Parliament) on the basis of an impact
assessment carried out by the Ministry of
Petroleum and Energy.
To prospect for petroleum resources on the
Norwegian Continental Shelf, a reconnaissance
licence is required (the Petroleum Act s. 2-1). The
licence is granted by the Norwegian Petroleum
Directorate, which is the technical branch of the
Ministry. This licence gives the holder the right to
geological, petrophysical, geophysical,
geochemical, and geotechnical activities,
including shallow drilling, as well as operation
and use of a facility to the extent it is used for the
purpose of prospecting.
The licence is non-exclusive and is normally given
for a three-year period. There is no limitation in the
Petroleum Act as regards the area that may be covered
by such licence. In practice, the licence covers a fairly
large area. According to the Petroleum Regulations
(Regulation to the Act of 27 June 1997, s. 6, pertaining
to petroleum activities, established by Royal decree),
the holder of the reconnaissance licence is required to
submit copies of all data, registrations and other
results from the activity to the Petroleum Directorate
within three months after the prospecting activity has
been carried out. This requirement ensures that
Norwegian authorities constantly have access to and
knowledge of the most recent geological data from the
continental shelf.
The right to explore for, develop, and produce
the petroleum resources
Production licence
The right to explore for, develop, and produce
petroleum resources requires a production licence.
The licence is formally awarded by the King in
Council (the Petroleum Act s. 3-3, para. 1). This
licence is exclusive and gives the licensees the right
698
to explore for and produce any oil and gas that is
discovered within the licence area (the Petroleum
Act s. 3-3, para. 3).
The award process is carried out by the Ministry of
Petroleum and Energy. The Norwegian system for the
award of a production licence is discretionary. The
Ministry of Petroleum and Energy decides if, when,
where, to whom, and on what conditions a production
licence is awarded. In this process, however, Norway
as a party to the Agreement on the European
Economic Area (EEA) is part of the European internal
market and is thus obliged to adhere to relevant EU
legislation, most importantly the EU licensing
directive of 1994 (94/22/EC).
Production licences are normally awarded in
dedicated licensing rounds, which are carried out by
the Ministry approximately every second year. The
licensing round begins with the Ministry inviting all
companies active in Norway to nominate blocks they
would like to see licensed. Such nominations are
purely advisory. Based on the nominations, the
Ministry consults with the Petroleum Directorate, the
Ministry of Fisheries and Coastal Affairs, and the
Ministry of Environment on which blocks to put up for
licensing. An agreed proposal for blocks is submitted
to the Cabinet for acceptance.
Any limitations to the periods during which
drilling will not be permitted for environmental
reasons or due to fisheries concerns have to be
included in this proposal to ensure that such
limitations are known to applicants when they apply
for the award of a block. Subsequently, as provided for
in the Petroleum Act (s. 3-5) and the Petroleum
Regulations (s. 7), an invitation to apply for blocks on
the continental shelf is announced in the National
Gazette and in the European Journal.
Applications
Applicants will have at least ninety days to submit
their applications (the Petroleum Act s. 3-5, para. 2).
Applicants have to pay to the Ministry a handling fee
of Norwegian Kroner (NOK) 60,000 (Petroleum
Regulations s. 9, para. 5).
The required contents of an application are stated
in the Petroleum Regulations s. 8. Applications may be
received from natural persons domiciled within the
EEA. In practice, no natural person has ever applied
for a production licence, either from single joint stock
companies or groups of such companies registered
within the EEA. In other words, the majority of
companies being awarded a participating interest in a
production licence is a joint stock company registered
in Norway. There is no limitation in Norwegian
legislation regarding the nationality of the owner of
such joint stock companies.
ENCYCLOPAEDIA OF HYDROCARBONS

Awards
Based on the received applications, the Ministry
conducts negotiations with all applicants, normally
arranging possible work commitments and the term of
the licence. Subsequently, the Ministry puts forward a
proposal to the Cabinet as to which blocks to award in
each production licence, which companies should be
awarded the licence in question, the size of their share
in the licence, and who should be appointed operator
(Petroleum Act s. 3-7).
The criteria for awarding a production licence are
mainly the financial strength, geological competence,
technological capacity, and general experience of the
applicant as an oil company (the Petroleum
Regulations s. 10).
To ensure that all applicants are in fact qualified to
be a licensee or an operator, all newcomers on the
continental shelf are recommended to seek pre-
qualification from the Ministry and the Petroleum
Directorate before they apply for a licence or for the
consent of the Ministry to a farm-in agreement.
When the proposal for the award is accepted by the
Cabinet, the Ministry makes an offer to the relevant
companies and gives them a ten-day time limit to
accept or decline the award of the production licence.
Also included in this offer are all relevant conditions
for the award (Petroleum Act s. 3-3).
Such conditions foresee the obligation for the
group of licensees to form a joint venture within thirty
days of the licensee being awarded the licence by
entering a Joint Operating Agreement and an
Accounting Agreement. These agreements are model
agreements formulated by the Ministry. They regulate
the relationship between the licensees and how costs
related to petroleum activities should be paid and
divided among licensees. The appointed operator
carries out his responsibility on a no-loss-no-gain
basis. The Joint Operating Agreement contains, among
others, voting rules for decision-making in the joint
venture.
The voting rules are formulated by the Ministry
and imply that a defined combination of the
number of licensees in the licence group and the
size of their participating interest is needed to
make a decision. This way of formulating the
voting rules also ensures that companies with a
smaller share in the licence group will have a voice
when decisions are made.
Another condition for the award of a licence is the
obligation to undertake a work commitment as defined
by the Ministry and the term of the licence. As
appropriate, specific environmental conditions and
limitations of the period in which exploration drilling
is permitted are due to fisheries’ interests and
environmental concerns.
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Awards in predefined areas
Recently, a new practice for annual awards of
production licences in mature areas has also been
implemented: namely, Awards in Predefined Areas.
Under this system, blocks in areas on the
continental shelf defined as mature (i.e. where the
geology is well known), are put up for licensing in the
beginning of January each year, with the time limit for
applications set on 1 October each year. Any acreage
that is relinquished within such predefined area during
the year is automatically included in the predefined
area. Awards under this system take place before
year-end. This timeframe ensures a quick circulation
of acreage in mature areas. The process for the award
itself is the same as the one described above for a
dedicated licensing round.
Plan for development and operation
If a discovery is made within the licence area,
and the licensees deem the discovery to be
commercial, they must submit a PDO (Plan for
Development and Operation) for the field to the
Ministry of Petroleum and Energy for approval
(Petroleum Act s. 4-2, para. 1).
The PDO consists of two parts: the plan for
development and operation tout court, and an impact
assessment. The plan contains an account of
economic, resource, technical, safety-related,
commercial and environmental aspects, as well as
information concerning how a facility may be
decommissioned and disposed of when the petroleum
activities have ceased.
The impact assessment states reasons for the
effects that the development may have on commercial
activities and environmental aspects, including
measures to prevent and remedy such effects. The
impact assessment is carried out by the licensees on
the basis of an assessment programme that has been
submitted to and approved by the Ministry after having
been on a public consultation (the Petroleum
Regulations s. 22).
The impact assessment itself is also submitted to
the Ministry and is subject to public consultation,
normally for a three-month period (the Petroleum
Regulations s. 22a). Also, included in this provision
are more detailed requirements for issues that are dealt
with in the impact assessment. These requirements
reflect EU legislation on impact assessments that
Norway is obliged to adhere to as a party to the EEA
Agreement.
If the area that is to be developed is already
covered by a regional impact assessment or an existing
PDO, upon examination the Ministry may exempt the
licensees from the requirement to carry out a new
impact assessment or to submit a new PDO (the
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
Petroleum Act s. 4-2, para. 6 and the Petroleum
Regulations s. 22a, para. 3).
Until a PDO has been approved by the Ministry,
the licensees may not enter into costly contractual
obligations for the development without specific
consent by the Ministry (the Petroleum Act, s. 4-2,
para. 5).
In addition, if the field in question extends across
blocks covered by a production licence with different
licensees, or across the median line of another State,
no PDO will be approved until the field has been
united. Thus, the Petroleum Act s. 4-7 states that the
licensees in such situation are obliged to try to reach
agreement on the most efficient way to conduct the
petroleum activities in connection with the petroleum
deposit, and on how the field shall be divided between
the blocks or States in question. An agreement
reflecting this is then submitted to the Ministry for
approval.
If the licensees of the relevant licences are unable
to reach agreement within reasonable time, the
Ministry has the authority to determine the conditions
for such joint petroleum activities, including the
apportionment of the petroleum deposit between the
groups of licensees. If the field extends across the
median line of another State, a treaty for the
development between Norway and the State in
question will also have to be agreed upon before the
PDO may be approved.
The approval itself is not given until the King in
Council or the Storting, as appropriate, has accepted
the development of the new field. The cost of the
development decides whether it will be put before the
King in Council or the Storting for acceptance. If the
cost of the development is less than 10 billion NOK,
the proposal is presented to the King in Council. If the
cost is more than 10 billion NOK, the Storting must
consider the development before it can be approved by
the Ministry. This condition is due to the fact that in
1972 the Storting decided that any development of
large fields on the continental shelf must be put before
the Storting for consideration.
In addition, if there is State participation in the
field in question, the Storting may also need formally
to approve the development in order to ensure that
sufficient economic resources are channelled through
the State budget to cover the State’s share of the cost
of the development.
When the development of the new field entails
construction of a pipeline from the field to transport
the oil and/or gas production, or a facility for
utilization of the oil and/or gas produced, the
construction of such pipeline or facility may be
considered as part of the PDO if the pipeline/facility is
only meant to transport or process petroleum from the
700
field in question to shore or to a larger trunk pipeline
on the continental shelf.
If, however, the licensees foresee that the pipeline
or facility may also be used for the transport or
utilization of oil or gas from other fields in the future,
the construction of such pipeline/facility must be
described in a separate PIO (Plan for Installation and
Operation) (Petroleum Act s. 4-3).
The PIO, like the PDO, consists of a plan for
installation and operation of the pipeline/facility, and
of an impact assessment (the Petroleum Regulations
s. 28). The requirements for an impact assessment are
the same for a PIO as for a PDO (Petroleum
Regulations s. 28, para. 1).
Pipeline for transport of petroleum
or facility for utilization of petroleum produced
In accordance with the Petroleum Regulations s.
28, para. 3, at the time of granting a licence to install
and operate a pipeline for transportation of petroleum
or a facility for utilization of petroleum produced, or at
a later stage, the Ministry may:
• Stipulate tariffs for use of the pipeline/facility, with
respect to both the licensee’s own petroleum and a
third party petroleum.
• Decide that the pipeline/facility is tied in with
other pipelines/facilities, i.e. the capacity is
increased, and/or the pipeline/facility is modified
to be able to transport or process other types of
petroleum than those for which it was originally
built. Such decision must not, however, imply that
costs are unduly raised or that the use of the
pipeline/facility is unreasonably impeded as
compared to the use that has been assured by the
(former) approval of the Ministry. The Ministry
further decides the costs of implementation of
these decisions that are borne by the party or
parties in whose favour the decision was made, or
are taken into account when the tariff is stipulated.
• Decide which petroleum shall be transported in a
pipeline. This decision may indicate that new
petroleum is transported instead of petroleum
which has already been assured transport in the
pipeline from former approval by the Ministry.
The Ministry authorizes the anticipated rate of
production when the PDO is approved. In addition, the
licensees are required to apply to the Ministry for a
production permit when production actually starts, and
thereafter annually. Production permits for gas are
given for a longer period, which are stipulated in each
production permit.
The right to dispose of the petroleum produced
The licensee becomes the owner of his share of any
petroleum produced (the Petroleum Act s. 3-3, para.
ENCYCLOPAEDIA OF HYDROCARBONS

3). The title to such petroleum passes from the State to
the licensee at the well-head. Oil and gas are marketed
by each licensee on an individual basis. Crude oil is
either transported through pipelines to shore or, most
commonly, loaded on tankers offshore. Gas is
transported through pipelines to onshore locations in
Norway, the European continent (Germany, Belgium,
France) or Great Britain.
The upstream gas transportation system (around
6,000 km in length) is organized in a joint venture
called the Gassled, which is owned by all the largest
producing companies. Gassled is operated by the
100%-State-owned company Gassco, which has also
been given the task of administering the regulated
access regime that applies to Gassled (the Petroleum
Act s. 4-9 and the Petroleum Regulations chapter 9).
Under this regime, Gassco sees that all companies
with a duly substantiated, reasonable need to transport
gas from the Norwegian Continental Shelf are ensured
the right to do so on non-discriminatory and objective
terms. The tariffs for the use of Gassled are regulated
in the Tariff Regulations, laid down by the Ministry on
1 January 2003. These regulations state that the
owners of Gassled are ensured a profit on their
investment of around 7%.
12.5.4 Operating conditions
Term
A production licence is awarded for an initial
period (exploration period) and a prolongation period.
The duration of both is stipulated at the time of award
(the Petroleum Act s. 3-9). The initial period, in which
the licensees are expected to carry out the work
commitment they accepted as a condition for the
award, may be maximum ten years. Normally, it is
stipulated at five or six years. If the licensees find that
they need more time to carry out their work
commitment, they may apply to the Ministry for a
prolongation of this period. The Ministry may then
prolong the initial period within the time limit of ten
years. An initial period may be prolonged several
times within this ten-year time limit.
The prolongation period is set individually for each
production licence, but as a main rule it covers thirty
years. It may, in particular cases, be set at fifty years
(the Petroleum Act s. 3-9, para. 2).
According to the Petroleum Act s. 3-9, para. 5, the
Ministry may, in particular cases and on the basis of an
application from the licensees, prolong the licence
period for one or more periods after the expiry of the
first prolongation period. Such application in this case
must be submitted to the Ministry no later than five
years before the expiry of the licence period. The
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Ministry in these cases is free to decide the length of
the new prolongation period, and to set any necessary
conditions for it.
Area
A production licence may cover one or several
blocks or parts of blocks on the Norwegian
Continental Shelf (the Petroleum Act s. 3-3, para. 2).
The Ministry decides the number of blocks to be
awarded in each licence. In mature areas, a production
licence may cover several blocks, in certain cases
between ten and twenty. Normally, however, a
production licence covers one or two blocks.
Licensees may also apply to the Ministry for a
geographical division, including a horizontal division
of the area of a production licence (the Petroleum Act
s. 3-10 and the Petroleum Regulations s. 15, para. 2).
In such case, the conditions applying to the original
licence will also be applied to the new production
licence covering the area that has been separated from
the original one. Consequently, this geographical
division of the area of a licence is not considered to be
a new award.
Rentals
There is no obligation to pay a fee during the initial
period of a production licence. The reasoning behind
this lack of fee is that Norwegian authorities want the
companies to use their financial resources to map the
continental shelf and explore it, and not as cash
payments to the Norwegian State.
However, after the expiry of the initial period, the
licensees are obliged to pay an area fee (the Petroleum
Act s. 4-10 and the Petroleum Regulations s. 39). The
area fee is calculated per square kilometre and is
primarily meant as an instrument to make the licensees
relinquish acreage where they have no activities.
The fee for the first year is 7,000 NOK per km2.
Thereafter, the fee increases by 7,000 NOK per square
kilometre per year until it has reached 70,000 NOK
per km2. Subsequently, the fee shall be 70,000 NOK
per km2 per year for the remaining duration of the
production licence. However, this increase of the fee
does not apply to production licences awarded in the
Norwegian part of the Barents Sea. Thus, to stimulate
activities here, the area fee continues to be 7,000 NOK
per km2 for the whole prolongation period.
Relinquishment
The prolongation of the licence period after the
expiry of the initial period is a right conferred upon
the licensees under the Petroleum Act (the Petroleum
Act s. 3-9, para. 3).
However, the right to require a prolongation of the
licence is subject to fulfilment of two conditions: the
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
licensees must have carried out the work commitment
they accepted as a condition for the award of the
licence, and a defined part of the acreage originally
awarded must be relinquished.
As a main rule, half the acreage of the production
licence is relinquished upon prolongation of the
licence period (the Petroleum Act s. 3-9, para. 3). The
exact percentage to be relinquished is stipulated in the
licence at the time of award. This issue is negotiated
between the Ministry and potential licensees as part of
the award process.
During the initial period, the licensees may at
any time, and on three months’ notice, relinquish
their production licence in whole or in part (the
Petroleum Act ss. 3-14 and 3-15 and the Petroleum
Regulations s. 15).
In the prolongation period, the licensees may
relinquish their production licence in whole or in
part at the end of each calendar year, and on three
months’ notice. The Ministry may require that all
obligations that have been accepted by the
licensees be fulfilled before any relinquishment
takes place. The form and size of the licence area
after relinquishment is subject to approval by the
Petroleum Directorate.
Work and/or expenditure commitments
As a condition for the award of a production
licence, the licensees must accept to carry out a
work commitment during the initial licence period
(the Petroleum Act s. 3-8 and the Petroleum
Regulations s. 13).
The work commitment is formulated by the
Ministry as an obligation to carry out a certain amount
of work in the licence area within a stipulated time
limit. Expenditure commitments are not used in
Norway because the best geological mapping and
exploration of the continental shelf is believed to be
obtained through clearly defined work commitments.
The work commitment is often formulated so as to
oblige the licensees to carry out a defined seismic
activity and to drill a defined number of exploration
wells. This drilling obligation may be for the drilling
of a number of firm wells, or for the drilling of one or
more firm wells and one or more wells that are
conditional upon the result of the previously drilled
exploration well.
In mature areas, the work commitment may also be
formulated so that the licensees get a defined number
of years to decide whether or not they want to take on
a drilling obligation. If they then decide not to take on
this obligation, the whole area of the licence must be
relinquished at once.
In such areas, the work commitment may also
state that the licensees must submit a PDO for a
702
field before the expiry of the initial period. If no
PDO is submitted to the Ministry within the set
time limit, the whole licence must be relinquished.
If a PDO is submitted within the set time limit, the
licensees may keep the area surrounding the field
in the prolongation period. The rest of the acreage
must then be relinquished. The reasoning behind
these types of work commitments is to guarantee
that acreage in mature areas is circulated between
companies fairly quickly, thereby ensuring that
acreage is considered from many different
geological angles and at an active pace.
Royalty and bonuses
The licensees are not obliged to pay royalty on
production. Such an obligation existed in the early
years of petroleum activities in Norway, but was
repealed for production from fields for which the
PDO was approved after 1 January 1986. Today,
the payment of royalty is being phased out
altogether as unnecessary. Nor are the licensees
obliged to pay any signature bonus for the award of
a licence (reconnaissance licence, production
licence or a licence to install and operate a
pipeline).
12.5.5 State participation
through a state oil company
or otherwise
State participation in the Norwegian petroleum
activities started by the establishment of the
100%-owned, joint-stock company Statoil in 1972.
Statoil was to have a 50% participating interest in all
production licences awarded after 1973.
However, due to the numerous discoveries that
were made in the subsequent years, the Storting
saw that this policy would result in Statoil growing
to enormous proportions within a very short time.
Thus, in 1984 the Storting decided that Statoil’s
50% share in all joint ventures was to be divided in
an underlying relationship between Statoil and the
State. One part (on average: 20%) was to continue
to be owned directly by Statoil, and one part (on
average: 30%) was to be owned directly by the
Norwegian State. The State’s underlying part of the
Statoil share was not to be a company; it was
simply a stream of money going out of and into the
State. The share was called the State Direct
Financial Interest – the SDFI. All costs and
revenues connected with the SDFI were covered
directly by the Norwegian State. Statoil continued
formally to be the licensee for the whole 50%
share. Thus, Statoil was the manager of the SDFI
ENCYCLOPAEDIA OF HYDROCARBONS

on behalf of the State. This role implied that Statoil
voted on all commercial matters in the joint
ventures on behalf of the SDFI. Further, Statoil
marketed the oil and gas produced from the joint
shares together with its own production.
In 2001, Statoil was partly privatized and its shares
were listed on the Oslo and New York Stock
Exchanges. At the same time, the existing arrangement
concerning the SDFI was changed. A
100%-State-owned company, Petoro AS (Petoro), was
established for the sole purpose of managing the SDFI
portfolio. Its tasks and responsibilities are regulated in
a new chapter eleven of the Petroleum Act. As
manager of the SDFI, Petoro is formally the licensee
for the SDFI share in all joint ventures (production
licences, pipelines and other facilities, as appropriate).
Petoro is not to become an operator of a joint venture,
and its activities are to be solely on the Norwegian
Continental Shelf unless otherwise decided by the
King in Council.
When the Norwegian State decides to reserve a
share for itself in a new production licence (the
Petroleum Act s. 3-6 and the Petroleum
Regulations s. 12), Petoro becomes the manager of
the new share as well. Petoro does not apply for
production licences in licensing rounds. Statoil has
been obliged by the State to continue to market the
State’s share of petroleum produced, together with
its own petroleum. The State has at the same time
obliged Petoro to monitor Statoilì’s marketing
activities on behalf of the State.
12.5.6 Fixing the price of oil or gas
for tax and other purposes
Within fifteen days after expiry of each quarter, details
of the quantities of petroleum which have been sold
during this period, to whom they have been sold, and
at what price are submitted to the Ministry (the
Petroleum Regulations s. 49).
The Regulations laid down on 25 June 1976 on the
fixing of norm prices stipulates that norm prices on
petroleum (in practice: crude oil) may be fixed for tax
purposes. The norm price corresponds to the price the
crude oil could have been traded for between
independent parties in a free market. The norm price is
fixed retroactively for each quarter. The Ministry has
authorized a Petroleum Price Council to fix the norm
price.
The Council is chaired by a Supreme Court
Justice. Companies have the right to file a
complaint to the Ministry regarding the Council’s
decision on the norm price for a specific kind of
crude oil. The Ministry may set aside the norm
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price in question on the basis of the complaint or, if
it for some reason becomes clear that the norm
price is wrong, on its own account.
As regards gas, the Petroleum Regulations s. 19
requires that all gas sales contracts are subject to
approval by the Ministry. Thus, profits from gas sales
are taxed on the basis of the obtained price.
12.5.7 Fiscal structure
The Norwegian government petroleum tax system
consists of a company tax (28%), a special petroleum
tax (50%), a CO2 tax, area fees, the revenues from the
SDFI and dividends from Statoil (the State’s share of
the company is presently 70.9%).
The tax provisions are laid down in the Petroleum
Tax Act 13 June 1975 No. 35. Profit tax is paid by all
companies earning revenue from the conduct of
petroleum activities in Norway, irrespective of their
country of registration. As previously mentioned,
however, the Petroleum Act states that production
licences may only be awarded to companies registered
within the EEA. Thus, all licensees on the continental
shelf are subject to taxation in Norway.
The taxation system is so structured that there is
full consolidation of income and expenses (no ring
fencing). All expenses incurred by a licensee from the
petroleum activities are tax deductible. Investments are
depreciated at a high rate (six years), and financial
costs may be deducted against both the corporation tax
and the special petroleum tax.
The special petroleum tax is paid when companies
earn their income from the petroleum activities.
Licensees are allowed an uplift against the special
petroleum tax, implying that they may deduct 30% of
the investment (7.5% each year over four years).
Losses may be carried forward with a risk free
interest, which is reimbursed if activities cease.
Companies which are not in a position to pay the
special petroleum tax may each year claim
reimbursement of the tax value of exploration
expenses from the government.
The Act of 21 December 1990 No. 72 pertaining
to fees on discharges of CO2 in the petroleum
activities obliges the licensees to pay a fee to the
State on discharges of CO2 resulting from the
burning of petroleum and from natural gas
discharged to the air as part of the petroleum
activities on the continental shelf. This fee, called
the CO2 tax, is to be paid retroactively every six
months and is a cost that can be deducted against the
corporate tax and the special petroleum tax. The rate
of the fee for 2005 has been set at 0.78 NOK per
litre petroleum or Sm3 of natural gas.
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12.5.8 The petroleum contract
and the parties thereto
Concession
Petroleum activities in Norway may only be carried
out by other bodies than the Norwegian State if they
have been awarded the necessary licence (the
Petroleum Act s. 1-3). Exploration, development and
production require a production licence. This is a kind
of concession awarded by the Norwegian State to
qualified oil companies (foreign or national). As a
condition for the award, licensees are required to enter
into two agreements between them: a Joint Operating
Agreement and an Accounting Agreement. These
agreements are model agreements formulated by the
Ministry of Petroleum and Energy.
Companies may also carry out prospective work
under a reconnaissance licence, and they may install
and operate pipelines and facilities for the utilization
of petroleum under a specific licence granted to them
by the Ministry for this purpose.
Production sharing agreements, risk and non-risk
service contracts and technical assistance contracts are
not used in the petroleum activities in Norway.
Investment protection
In Norway, petroleum activities are regulated by
public law, mainly the Petroleum Act, the Petroleum
Taxation Act 13 June 1975 No. 35 and the Public
Administration Act 10 February 1967, which apply to
all decisions made by Norwegian authorities and
which affect companies undertaking petroleum
activities.
No legislation applicable to the petroleum
activities differentiate between nationals and
foreigners. All investors and investments in the
petroleum activities are treated equally, irrespective of
nationality. As part of the EU internal energy market,
Norway is also obliged to apply the principles of
transparency, objectivity and non-discrimination as
regards nationality to all authority decisions made
concerning petroleum activities.
The State has a right to take over a facility on the
continental shelf when a licence expires, is
surrendered or revoked, or when the use of such
facility has been permanently terminated (the
Petroleum Act s. 5-6, para. 1). If a licensee’s onshore
facilities are expropriated by the State, the licensee is
fully compensated (the Norwegian Constitution s. 105
and the Petroleum Act s. 5-6, para. 3).
Environmental protection
Environmental protection in the petroleum
activities is regulated by the act pertaining to
protection against pollution and on discharges (the
704
Pollution Act 13 March 1981 No. 6), under the
responsibility of the Ministry of Environment and its
subordinate body, the State Pollution Control
Authority (SPCA).
As a main rule, any activity in Norway that may
result in pollution is subject to a permit from the
SPCA (the Pollution Act, s. 11). Thus, petroleum
activities are subject to a specific permit. Such
permit is given, upon application from the licensees,
for the relevant kind of pollution that may result
from the petroleum activities, including discharges
into the sea and the air. The environmental
authorities may stipulate any necessary conditions
when such permit is given. This system of integrated
pollution control is in accordance with the European
directive on Integrated Pollution Prevention Control
(IPPC) 96/61/EC.
According to the Petroleum Act chapter seven,
liability for pollution damage in the petroleum
activities may only be claimed in accordance with the
Petroleum Act. As a main rule, the licensee is strictly
liable for any pollution damage that occurs from the
petroleum activities (s. 7-3).
In the act, pollution damage is defined as
damage or loss caused by pollution as a
consequence of petroleum leakage or discharge from
a facility, including a well. It also includes costs of
reasonable measures to avert or limit such damage
or loss, as well as damage or loss as a consequence
of averting measures. Damage or loss incurred by
fishermen as a consequence of reduced possibilities
for fishing may also be subject to compensation
from the licensees.
Claims for pollution damage are initially directed
to the operator. If the claim is left unpaid in whole or
in part, the other licensees of the joint venture are
directly responsible for the full payment of the claim
(the Petroleum Act s. 7-3, para. 2).
Currency regulation
There is no currency regulation in Norway.
This lack of regulation implies that Norwegian
Kroner may be freely converted into any foreign
currency and vice versa, without any restriction as
to the amount.
However, certain acts have been passed for the
purpose of preventing and controlling whitewashing of
profits resulting from illegal transactions: see for
instance the Act of 20 June 2003 No. 41 pertaining to
measures against whitewashing of profits resulting
from illegal actions. This act obliges relevant legal
persons and institutions, such as banks, insurance
companies and finance institutions, to report
suspicious transactions to the police for further
investigation.
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12.5.9 Applicable law
All petroleum activities in Norway are regulated
and carried out under Norwegian law. This
practice also follows from the Petroleum Act s.
1-5, where it is stated that any relevant
Norwegian laws and regulations other than the
Petroleum Act shall be applied in the petroleum
activities, as appropriate.
Further, a condition for the award of a
production licence and a licence to install and
operate a pipeline or other facilities is that the
relationship, and any disputes between licensees
and their contractors, be regulated by Norwegian
law. This condition, among others specifically
stated in the Joint Operating Agreement and the
Accounting Agreement, requires licensees to enter
into a relationship between themselves upon the
award of a production licence.
As a consequence of this requirement, licensees
must see to it that all contracts for deliveries of goods
and services necessary for the performance of
petroleum activities under licence are also regulated by
Norwegian law.
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12.5.10 Dispute settlement
Disputes between two licensees in a group of licensees
(joint venture), or between two or more groups of
licensees are settled, as a rule, by arbitration and in
accordance with Norwegian law. This condition is
stipulated in the model Joint Operating Agreement that
is entered into by the licensees as a condition for the
award of a production licence.
However, if the parties to the dispute so agree, the
dispute may be brought before the Norwegian courts of
law. The same will apply to a joint venture owning and
operating a pipeline on the Norwegian Continental Shelf.
A dispute between the Ministry of Petroleum and
Energy (or another Ministry, as may be appropriate)
and the licensees concerning, for instance, a decision
according to the Petroleum Act, will normally be tried
before the ordinary courts of law. This is a three-tier
system, with City or District Courts, Appellate Courts
and the Supreme Court.
Mette Gravdahl Agerup
Ministry of Petroleum and Energy
Oslo, Norway
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United Kingdom
12.6.1 Introduction
The development of UK oil and gas law
Under the Petroleum Act of 1998, all rights to
the nation’s petroleum resources belong to the
Crown. However, the Secretary of state for Trade
and Industry has the power to grant licences to
private entities which give them exclusive rights to
“search and bore for and get” petroleum over a
limited area and for a limited period. This system
of state granted licences applies to onshore oil and
gas as well as to oil and gas located under the
territorial sea and the UK sector of the Continental
Shelf (UKCS). Northern Ireland operates the same
licensing system with regard to its offshore waters
but issues its own licences independently.
This licensing regime was motivated by the fuel
demands of the First World War, although it was
not until 1935 that the first licences were issued.
The then governing body, the Ministry of Power,
issued the first offshore licence, P001, in 1964, and
its successor, the Department of Trade and Industry
(DTI), issued the one-thousandth licence in 1999.
Following the conclusion of boundary
agreements with neighbouring states, the
designated area of the UKCS has been refined over
the years by a series of designations under the
Continental Shelf Act of 1964.
Role of the state
In the early 1970s, major new oil discoveries in
the northern sector of the North Sea, combined
with a dramatic increase in oil prices, focused the
attention of the state on its oil revenues.1 A number
of changes were made, principally the bolstering of
corporation tax as it relates to the revenues of oil
exploitation, the introduction of Petroleum
Revenue Tax (PRT), and the creation of the
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state-owned British National Oil Corporation
(BNOC), into which the state’s existing interests in
the oil sector were consolidated. At the same time,
it became a condition to the granting of all new
production licences that BNOC be given a 51%
interest, and BNOC sought to negotiate
participation agreements in respect to discoveries
under existing licences. Throughout the rest of the
1970s, BNOC pursued an active policy of
expansion, to secure for the state proprietary rights
to Britain’s oil resources. However, the 1980s saw a
shift in state policy by a conservative government
now committed to privatization. BNOC’s
participation agreements with oil companies were
phased-out and its assets transferred to Britoil plc,
the shares of which were then sold by the
government.
Privatization was even more dramatically
pursued in the gas industry where, under the Gas
Act of 1986, British Gas was privatized en-masse.
It was kept as a single undertaking and retained its
monopoly in the small customer market. However,
new entrants were allowed to compete for those
customers who required more than 25,000 therms
annually. True competition in the industrial market
did not get underway until 1990, during the time of
the ‘dash’ for gas-fired power stations, and the
commencing of the gas release scheme instituted
by the then Director General of Gas Supply
(DGGS), Sir James McKinnon. In 1993, the DTI
formally rejected a policy of divestment, opting
instead for the complete separation of the transport
and trading businesses of British Gas, and
contemporaneously announced that British Gas’
1 This and the following section on regulation draws
heavily upon the House of Commons Research Paper 98/19
entitled Regulating Energy Utilities.
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
tariff monopoly was to come to an end in April
1996.
In line with this decision, British Gas demerged
on 17 February 1997, creating two separate
companies, Centrica plc and BG plc Centrica, (which
trades as British Gas in the UK), took over gas sales,
services, and retail together with certain UKCS gas
production activities. BG included UKCS
exploration and production activities, international
activities, and the operations of Transco, the gas
transport and storage business.
In October 2000 a second demerger of BG
resulted in two companies, BG Group (the
international gas business) and Lattice Group plc
which was given responsibility for Transco.
On 21 October 2002 Lattice Group plc and
National Grid Group plc merged to form a new
company, National Grid Transco plc. This merger
united the gas and high voltage electricity
transmission businesses. National Grid Transco’s
gas transmission business transports and stores gas
for its customers through a UK-wide gas pipeline
network, under the standard conditions of a public
gas transporter’s licence. These standard conditions
include a requirement to prepare a document called
the ‘network code’, which sets out the terms and
arrangements for providing an economic
and efficient transport system and for securing
effective competition between relevant shippers
and suppliers. It also incorporates a market-based
mechanism for ensuring that inputs of gas into the
system are in balance with offtake volumes. In
2005, National Grid Transco sold four of its eight
regional gas distribution networks (which connect
to its high pressure national transmission system) to
independent operators. These regional distribution
networks also operate under gas transporter
licences.
Regulation of the gas industry
The Gas Act of 1986 established the Office of
Gas Supply (OFGAS), headed by the DGGS. Both
the Secretary of state and the DGGS were given
general duties (section 1 of the Gas Act of 1995) to
secure that all reasonable demands for gas are met,
to secure effective competition in the gas industry,
and to protect consumers both in terms of prices and
quality of services. Section 2 of the Gas Act of
1995 places further duties on both the DGGS and
the Secretary of state with respect to safety. Some
of these responsibilities are discharged by the
DGGS through issuing or modifying licences
related to the transport, supply, and shipping of
gas. Of particular significance are the price
controls which are imposed by the DGGS on the
708
monopoly areas of the gas industry (now
principally Transco). In cases of disputes with the
gas industry, the DGGS was given powers to make
referrals to the Competition Commission to
determine the issue.
Today the regulation of the gas market is
undertaken by the Office of Gas and Electricity
Markets (OFGEM) since OFGAS was combined
with the Office of Electricity Regulation in 1999.
OFGEM is headed by a board, the Gas and
Electricity Markets Authority, in place of an
individual DGGS.
OFGEM also has concurrent powers with the
main competition authorities (the Office of Fair
Trading in the UK, and the European Commission)
to enforce competition law in the energy sector.
This remit complements OFGEM’s regulatory
functions, as market competition has been
introduced to replace pre-privatization monopoly
structures in the industry. In particular, OFGEM
has powers to apply the Competition Act of 1998
and arts. 81 and 82 EC Treaty. The Competition
Act applies to activities which have an effect on
UK markets, and arts. 81 and 82 EC Treaty apply
where the activities concerned affect trade between
EU member states. This legislation may therefore
be relevant to both onshore and offshore activity.
The legislation prohibits anti-competitive
agreements and arrangements between parties.
This prohibition may, for example, apply to aspects
of joint projects involving cooperation between
competitors. The legislation also prohibits
anti-competitive behaviour by companies with a
dominant position in the market. Owners and
operators of significant infrastructure, in particular,
may be required to avoid conduct which exploits
customers or excludes competitors, for example,
by preventing third party access. Separate
competition legislation, applying to all economic
sectors, provides for review by the competition
authorities of merger and acquisition activity,
meaning that in some cases such transactions will
require prior notification and clearance by the
competition authorities.
12.6.2 The structure
of petroleum regulation
Most petroleum exploration and development
licences follow a standard format. Whilst the DTI’s
official policy is to be flexible and ready to
consider adapting licences to suit special cases, in
practice there is very little, if any, room for
negotiation. What the DTI has done however is to
ENCYCLOPAEDIA OF HYDROCARBONS

create a range of different licence types (see
below).
The Secretary of state has discretion in the
granting of licences, and the key policy driver is
ensuring maximum exploitation of the hydrocarbon
resource. There are other considerations that he
must also take into account, however, such as the
protection of the environment and the interests of
other users of the sea.
Licences take the form of a Deed, and can be
held by a single company or by several companies
working together, but in legal terms there is only
ever a single licensee, however many companies
that may include. All the companies comprising
‘the licensee’ share joint and several liability for
operations conducted under the licence.
Each licence carries an annual charge, called a
rental, which generally falls due each year on the
licence anniversary. Rentals are charged at an
escalating rate on each square kilometre that the
licence covers at that date.
As well as an added source of revenue for the
state, rentals also help to concentrate the minds of
licensees on the acreage they hold and encourage
them to surrender acreage they do not want to
exploit, freeing it up for others who do.
Types of licence
Offshore
Production licences. The main type of
offshore licence is the seaward production
licence, of which the DTI and its predecessors
have now granted more than a thousand. The
name is somewhat misleading as production
licences do not cover just production, but the full
life of a field from exploration to
decommissioning. They cover relatively small
areas (typically no more than a couple of
hundred square kilometres). In an effort to be
more flexible in its licensing arrangements,
recently the DTI has issued licences in three
variations of the traditional production licence:
the promote licence, the frontier licence and
licences specially drafted to cover the
redevelopment of a decommissioned field (such
as Argyll/Ardmore).
Exploration licences. Some companies wish to
carry out exploratory surveys over wide areas of
the offshore sector. Production licences would be
impractical and prohibitively expensive for such
activities and, in any event, these companies do not
require exclusive rights to undertake such
activities. To meet this need, the DTI issues
exploration licences. Exploration licences run for
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UNITED KINGDOM
three years at a time, and allow exploration
anywhere on the UKCS except on any area that is
covered at the time by a production licence. If the
holder of an exploration licence wants to explore
acreage covered by a production licence, it will
need the agreement of the licencee. Production, or
any drilling deeper than 350 m, is not permitted
under an exploration licence.
Onshore
Licences for onshore areas are called Petroleum
Exploration and Development Licences (PEDLs),
but they are similar in form to offshore production
licences, with model clauses and a three-term
lifetime. Completion of the agreed exploration work
programme in the six-year initial term is a
precondition for entry into the second, and approval
of a development plan in the five-year second term
is a precondition for entry into the third. Before
1996, the DTI issued a sequence of separate
licences for each stage of an onshore field’s life:
an exploration licence, an appraisal licence, a
development licence, and a production licence.
PEDLs were introduced at the eighth licensing
round to reduce the bureaucratic burden of issuing
a series of licences.
Terms (periods)
Seaward production licences and petroleum
exploration and development licences are valid for
a sequence of periods, called terms. These terms
are designed to follow the typical lifecycle of a
field: exploration, appraisal and development and
production. Each licence expires automatically at
the end of each term, unless the licensee has made
sufficient progress.
Relinquishments/surrenders
The DTI expects companies to work their
licences. In recent years, the amount of acreage
left untouched, and unexploited, has raised
concern. In an attempt to address this issue, Pilot
(a collaboration of government departments,
industry representatives, and trade unions)
initiated the Fallow initiative. Licensees are
entitled to ‘determine’ (i.e. surrender) a licence,
or part of the acreage covered by it, at any time
(unless the licence is still in its initial term and
the work programme has not been completed).
The Pilot scheme attempts to stimulate activity on
fallow (unused) acreage by drawing up a list of
those areas it considers fallow, and encouraging
owners either to pursue any viable opportunities
for exploiting the area or to relinquish the
acreage.
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
There are also compulsory relinquishment
requirements. Under the Petroleum Licensing
(Exploration and Production; Seaward and Landward
Areas) Regulations 2004 (Statutory Instrument 2004
No. 352), which set out model clauses to be
incorporated into exploration and production licences
resulting from the twentieth licensing round and
beyond, licences are awarded for an initial term of
four years after which 50% of the licensed area must
be surrendered. This is intended to encourage
companies to act promptly following the grant of a
licence so they can decide which is the correct area
to relinquish after four years.
Partial surrenders, however, are subject to
restrictions on the complexity of the area
relinquished. The DTI’s concern is that it does not
wish to have areas handed back that are so
irregular in shape that they would be unattractive to
other companies and therefore difficult to
re-licence.
Multiblock licences
For regulatory purposes, the UKCS has been
divided by a grid into blocks averaging 25 km2.
Many licences cover more than one block. The
term multiblock licences has come to refer to
offshore licences which cover blocks that are
scattered across a wide geographical area. This
causes both administrative and regulatory
difficulties and the DTI has undertaken not to issue
any more licences covering scattered areas, and
also to work with industry to find a way of splitting
existing multiblock licences.
Onshore licences and landowners
The Secretary of state issues landward
production licences under powers granted by the
Petroleum Act of 1998. They confer the right to
search for, bore for, and get hydrocarbons under
that legislation, but they do not confer any
exemption from other legal or regulatory
requirements.
Thus, licencees will still need to obtain
access rights from landowners, satisfy applicable
health and safety regulations, and even obtain
planning permission from relevant local
authorities. The Secretary of state has very little
power to assist licencees. In particular,
surprisingly, he is unable to confer any right to
enter on or interfere with land. This position is in
stark contrast with that of electricity generators,
where the Secretary of state has the power to
require private landowners to grant wayleaves to
such generators to run transmission lines across
their land.
710
Hydrocarbons Licensing Directive Regulations
of 1995
In 1994, the EU laid down strict rules that
member states have to follow when issuing
petroleum licences, covering such things as the
factors that may (and may not) be taken into
account when deciding whether or not to issue a
licence, and the minimum amount of public
consultation.
These rules were contained in the
Hydrocarbons Licensing Directive 94/22/EC,
which was implemented in the UK, in 1995, by
means of the Hydrocarbons Licensing Directive
Regulations of 1995 (Statutory Instrument of 1995
No. 1434).
Licensing rounds and out-of-round applications
The DTI issues licences through competitive
licensing rounds and is committed to a regular
timetable of one onshore and one offshore
licensing round each year.
Although the vast majority of seaward
production licences or onshore petroleum
exploration and development licences are
issued in licensing rounds, particular cases may
present compelling reasons to issue a licence
outside a round. It rests with the company
seeking an out-of-round licence to make a case
to the DTI that it should invite out-of-round
applications.
12.6.3 Operating conditions
The regulatory framework
and departmental policy2
The powers of the Secretary of state, in relation
to the development of and production from
offshore oil and gas fields, were first set out in full
in model clauses scheduled to the Petroleum and
Submarine Pipelines Act of 1975. Similar clauses
are incorporated into every onshore licence. The
Petroleum (current model clauses) Order of 1999
(Statutory Instrument of 1999 No. 160) includes
the full text of all current model clauses. The
licences prevent licencees from installing facilities
or producing hydrocarbons without the
authorization of the Secretary of state. In
particular, a licencee wishing to develop a field
must prepare a field development plan for approval
by the Secretary of state.
2 From the DTI’s Guidance notes on procedures for
regulating offshore oil and gas field developments.
ENCYCLOPAEDIA OF HYDROCARBONS

Key objectives
In reviewing field development plans, the DTI’s
overall aim is to maximize the economic recovery
of UK oil and gas resources whilst avoiding
unnecessary competitive drilling. The DTI will also
take into account the environmental impact of
hydrocarbon development and the need to ensure
secure, diverse and sustainable supplies of energy to
UK businesses and consumers at competitive
prices.
The Secretary of state will consider this aim in
assessing proposals and, more specifically, will
consider the following policy objectives: ensuring
the recovery of all economic hydrocarbon reserves;
ensuring adequate and competitive provision of
pipelines and facilities; and taking proper account
of environmental impacts and the interests of other
users of the sea.
Transport
Ensuring adequate and competitive provision
of pipelines and facilities
The provision of infrastructure (processing
facilities and pipelines) is seen as crucial to
maximizing economic recovery, particularly for
gas. Many UKCS fields do not contain sufficient
reserves to justify their own infrastructure, and are
economic only as satellite developments utilizing
existing facilities. There is, therefore, a national
interest in ensuring that there is sufficient
infrastructure constructed. For example, it may be
in the national interest to oversize pipelines beyond
the immediate needs of the fields concerned in
order to create the capacity for future tie-in
developments.
Pipeline provision
In reviewing field development programmes
which have implications for future pipeline
applications, the DTI will seek to:
• Avoid the unnecessary proliferation of oil and
gas pipelines. Whilst new pipelines, particularly
those connecting with existing systems, may
enhance competition, the security of supply and
the pace of development, an additional pipeline
may interfere with the rights or established
practices of other users of the sea on the
pipeline’s route and may also have an impact on
the environment. These, sometimes conflicting,
considerations must be balanced.
• Aid, where feasible, future field developments,
including those outside the licence area. The
DTI’s role will normally be to advise and
encourage interested parties to cooperate in
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UNITED KINGDOM
constructing and sizing lines according to future
potential and making provision for tie-ins and
risers for their mutual benefit. Licensees will
also be encouraged to consider the needs of the
onshore petrochemicals industry when
evaluating development options.
• Ensure that those building and operating
pipelines and other infrastructure compete on a
level playing field and that the method of
marketing oil and gas employed promotes open
and competitive markets.
Subject to these aims, the evacuation route and
destination of petroleum are essentially matters for
the commercial judgement of the licensees. Where
oil or gas is to be exported to another country by
means of a new pipeline, the pipeline will be
subject to the negotiation of appropriate agreements
between the governments concerned.
Third party access to offshore infrastructure
The evolution of offshore infrastructure on the
UKCS has been characterized by companies
developing pipelines for sole usage, followed by
ullage (i.e. spare capacity) progressively being
made available for use by third parties on payment
of a tariff (i.e. a payment for transport and
processing services). If requested by a would-be
user, the Secretary of state has powers (currently
under the Petroleum Act of 1998), having
considered the interests of all parties, to impose a
solution to problems of pipeline sizing,
connections, or tariffs.
As part of the EU drive to create a competitive
and liberalized energy market, the requirements of
the EU Second Gas Directive 2003/55/EC have
been transposed into English law by amendments to
the Gas Act of 1986, through the Gas (Third Party
Access) Regulations 2004 Statutory Instrument
2004 No. 2043. This new legislation introduces a
system of regulated third party access to
interconnectors and Liquefied Natural Gas (LNG)
import terminals. The third party access must be
based on published, globally available, non-
discriminatory and cost-reflective tariffs. The
tariffs, or at least the methodology underlying their
calculation, must be approved by OFGEM prior to
coming into force.
The current legislation provides for major new or
expanded LNG facilities to be exempted from third
party access in certain circumstances and subject to a
set of conditions. Essentially, the developer of an
LNG facility must convince OFGEM that the facility
would not be built if it was subject to the formal third
party access regime, and establish also that the lack
of third party access does not have a seriously
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
detrimental effect on competition in the gas market.
The exemptions must be proportional in scope and
duration to the need to secure the investment of the
individual project.
Section 19 C of the Gas Act of 1986 sets out the
criteria to be satisfied before OFGEM may give an
exemption:
• The facility or (as the case may be) the
significant increase in its capacity will promote
security of supply.
• The level of risk is such that the investment to
construct the facility, or (as the case may be) to
modify the facility to provide for a significant
increase in its capacity, would not be or would
not have been made without the exemption.
• The facility is or is to be owned by a person
other than the gas transporter who operates or
will operate the pipeline system connected or to
be connected to the facility.
• Charges will be levied on users of the facility or
(as the case may be) the increase in its capacity.
• The exemption will not be detrimental to
competition, the operation of an economically
efficient gas market, or the efficient functioning
of the pipeline system connected or to be
connected to the facility.
• The European Commission is or will be content
with the exemption.
In a joint consultation document issued by
OFGEM and the DTI in June 2003, the following
three additional criteria were identified as minimum
requirements for an exemption to be granted for
interconnectors and LNG facilities:
• Effective capacity allocation in terms of an
initial offer of capacity to the market.
• Effective mechanisms to ensure that capacity is
not hoarded (i.e. ‘use it or lose it’ arrangements).
• Information provision requirements relating both
to the regulator and potentially also the market.
A voluntary industry Offshore Infrastructure
Code of Practice was introduced in January 1996.
This seeks to streamline and facilitate the timely
application of the processes of seeking, offering,
and negotiating third party access to offshore
pipelines, processing facilities and onshore
terminals and ensuring that access is easy and fair,
with terms offered on a negotiated, non-
discriminatory basis.
12.6.4 Pipelines
Legislation
The principal legislation relevant to
cross-country pipelines is listed below in
712
chronological order with a brief summary of the
requirements in each case. Unless the contrary is
stated, all references below to ‘the Act’ are to the
Pipelines Act of 1962 and section numbers refer to
sections of that Act.
Coast Protection Act of 1949. Under section 34
of this Act, the consent of the Secretary of state for
Transport is needed for work connected with
pipeline construction which causes or might result
in obstruction or danger to navigation. Thus a
separate application has to be made to the marine
division of the Department of Environment,
Transport and Regions for consent to construct any
part of a cross-country or local pipeline which is to
lie between high and low water marks or across
bays, estuaries, etc.
Pipelines Act of 1962. Section 1 of the Act
creates a ‘one-stop-shop’ authorization procedure
for the construction of cross-country pipelines
exceeding or intended to exceed 16,093 km in
length. This procedure therefore removes the need
for the company constructing such a pipeline to
seek separate planning consents from each local
authority whose jurisdiction the pipeline is to cross
through, thus greatly increasing administrative
efficiency. These benefits have been further
increased under changes made by the 1999
Deregulation (Pipelines) Orders (see below).
For the purposes of the Act, a pipeline means a
pipe together with any apparatus and works
associated with it and includes associated
equipment such as pumps, compressors, valves,
pipe-work, data transmission and control
equipment, instrumentation systems, cathodic
protection equipment, and pipe supports. This
definition therefore includes, for example, the
mechanical components of a compressor station
but not any building, fences, etc. around it, for
which planning permission in the normal way will
need to be sought.
The Act applies to pipelines in land which
includes the foreshore (the land between high and
low water marks) and partially enclosed areas of the
sea such as bays, estuaries, and harbours. The precise
limits of its applicability are the baselines defined in
the Territorial Waters Order in Council of 1964.
The Electricity and Pipeline Works
(Assessment of Environmental Effects)
Regulations of 1990 (Statutory Instrument of 1990
No. 442). These regulations lay down the general
manner in which environmental impact
assessments for oil and gas pipelines should be
prepared.
The Pipeline Safety Regulations of 1996
(Statutory Instrument of 1996 No. 825). These
ENCYCLOPAEDIA OF HYDROCARBONS

regulations apply, inter alia, to all pipes requiring
authorization under section 1 of the Act. They
impose requirements regarding the design,
construction, operation, maintenance, and safety
management of pipelines.
The Deregulation (Pipelines) Order of 1999
(Statutory Instrument of 1999 No. 742). This order,
which came into force on 3 April 1999, makes
major changes to the Act, the effects of which are
as follows:
• Local pipelines (i.e. those 16,093 km long or
less) no longer need to be notified to the
Secretary of state.
• Pipeline diversion authorization from the
Secretary of state is no longer required for the
diversion of an existing pipeline unless the
length of the diversion outside the limits of
deviation exceeds 16,093 km in length (which
is the same as applying for a pipeline
construction authorization under section 1).
• A proposed pipe which is to be connected to
another pipe now requires authorization under
section 1 only if the proposed new pipe exceeds
16,093 km in length. If it is 16,093 km long or
less, it is subject to a grant of planning
permission.
• The introduction of a written representations
procedure means that unresolved objections to
an application for a pipeline construction
authorization can (with the agreement of the
objectors and the applicant) be dealt with
without recourse to a public inquiry or hearing.
12.6.5 UK oil and gas taxation
regime
There are two taxes (corporation tax and the
supplementary corporation tax charge) which
apply generally to profits derived from production
of oil or gas on the UK mainland and offshore
within UK territorial waters or the UKCS. A third
tax (petroleum revenue tax) also applies to some
older UK and UKCS fields.
Corporation tax
Corporation tax is the normal tax which applies
to companies, whether they are UK tax resident
companies or non-UK companies earning profits
from a UK business. Broadly, it is charged at the
rate of, currently, 30% (on profits above 1.5
million £), the taxable profit being based on the
profits as shown in the company’s commercial
accounts but subject to a number of statutory
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adjustments. The principal adjustment is that,
instead of the depreciation charge in the company’s
accounts in respect of capital investment, there is a
special system of capital allowances. These
provide for an allowance in the year in which
certain capital expenditure is incurred and/or
annual allowances according to the type of asset on
which the expenditure is incurred and other
factors.
Corporation tax is modified to ensure that
profits from upstream oil and gas production from
the UK and the UKCS are subject to corporation
tax, without any relief for losses and expenditure
related to other activities outside a ‘ring fence’
which is placed around UK and UKCS oil and gas
production and related activities. This means that
relief for losses incurred by the same company or
other group companies on non-ring fence activities
cannot be relieved against ring fence profits
(although ring fence losses can be relieved against
profits from non-ring fence activities), and relief
for interest against ring fence profits is only
available in relation to borrowings used for ring
fence activities. Corporation tax which applies to
companies in respect of UK and UKCS oil and gas
production and related activities is generally
referred to as ‘ring fence corporation tax’.
The capital allowances regime for ring fence
corporation tax is more favourable than it is for
normal corporation tax. In the case of expenditure
on plant and machinery, a 100% allowance is given
in the year the expenditure is incurred (except
where the equipment has a useful life of 25 years
or more, in which case a 24% first-year allowance
is given, with 6% per annum straight-line
allowances thereafter). A full deduction is normally
also available for decommissioning costs incurred
in connection with ring fence activities. Capital
expenditure on mineral exploration and access for
a ring fence trade normally qualifies for a 100%
allowance. Expenditure on research and
development generally qualifies for an immediate
full deduction whether or not incurred for a ring
fence trade.
The after-tax profits of a UK company can be
paid to its shareholders without any withholding
tax being applied to dividends; and a non-UK
company can remit its after-tax profits to its
overseas head office without any additional branch
profits tax.
Supplementary corporation tax charge
on ring fence trades
In addition to ring fence corporation tax, a
company which has activities within the ring fence
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
is required to pay a supplementary corporation tax
charge of an amount equal to, currently, 10% of its
profits as computed for ring fence corporation tax
purposes but without any deduction for financing
costs. For this purpose, financing costs include not
only interest on debt finance but also the interest
component in finance lease rentals and the costs of
any other transaction which is treated as a
financing transaction under UK GAAP (Generally
Accepted Accounting Principles).
Petroleum revenue tax
In the case of fields for which development
consent was granted before 16 March 1993, PRT is
also payable. PRT is a field-based tax which is
charged at the rate of, currently, 50% on the
cumulative excess of the proceeds or value
of production (less an allowance of PRT-free
production) over the costs of developing and
operating the field. Tariffs received in respect
to the use of field assets by other fields (for
example, the use of pipelines to transport oil to the
mainland) are also brought into account. No relief
is given for financing costs, but a special
supplement (of, currently, 35% of certain
qualifying expenditure) is given in place of relief
for financing costs. A ‘safeguard’ applies to ensure
that, broadly, PRT does not reduce the annual
return from a field to below 15% of the cumulative
capital expenditure on the field.
Where PRT is payable, it is taken into account
as a cost in computing profits which are subject to
corporation tax.
12.6.6 Joint venture
management
Operating agreements
When several companies are party to a licence,
they usually make an agreement among themselves
governing future operations. Such an agreement is
commonly called a Joint Operating Agreement
(JOA). Creating or amending a JOA commonly
entails the apportionment of at least some of the
rights granted by the production licence governing
the area in question. As such, it requires the
consent of the Secretary of state.
Where a field crosses several different licence
areas, a further operating agreement will be required
to manage the interrelations between the different
interests in that field. Such agreements are usually
called Unit Operating Agreements.
In theory, all operating agreements require
approval of the Secretary of state; however, to reduce
714
the burden of this, the DTI has issued the Open
Permission (Operating Agreements), which grants
prior approval to most instances of the creation,
amendment or novation of operating agreements.
The Open Permission is an approval that the
Secretary of state has issued covering a whole class
of regulated acts. It is not issued to any particular
person or company and can be relied upon by
anyone at any time. If a company is satisfied that
the Open Permission describes the act that it is
proposing and that it will comply with any
conditions and restrictions on its use, then it can go
ahead and perform the act under the Open
Permission, and does not need any further
individual permission. It is, however, the
responsibility of any person proposing to use an
Open Permission to satisfy itself of all its
provisions, and that they are all complied with.
The Open Permission only covers the
apportionment of rights granted by the licence and
relating to petroleum won and saved, and any
proceeds of its sale. Any particular agreement may
be subject to other regulatory provisions (including
other controls imposed by the model clauses). If
this is the case, it remains the responsibility of the
licensee to comply with those provisions. In
particular, nothing in the Open Permission has any
effect on controls on licence assignments, the
appointment of an operator, or the Petroleum Act’s
decommissioning provisions.
Unitization and cooperative development
Where a field development programme is
proposed for a field which extends into the area
covered by a neighbouring licence, the Secretary of
state has powers to require a unitization between
licensees. The grounds for the use of this power are
that unitization is needed in the national interest in
order to secure the maximum ultimate recovery of
petroleum and avoid unnecessary competitive
drilling.
The Secretary of state will not necessarily
refuse to grant development consent to a particular
group of licensees who have not concluded a
unitization agreement with the licensees of an
adjacent block. The focus will be on whether the
economic recovery of oil and gas is being
maximized.
In order for the licensees to understand what
constitutes a field for both unit development and
tax purposes, the DTI will issue a proposed field
determination at an early stage in the field
development programme approval process,
utilizing the geological information that is
available to it at that time.
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12.6.7 Safety at work
Since the Piper Alpha disaster in 1988 (when a
massive explosion and resulting fire claimed the
lives of 187 men on the Piper Alpha oil production
platform in the North Sea) and the resulting report
by Lord Cullen in 1990, the entire offshore safety
regime has been restructured. A requirement to
establish safety cases has been introduced for all
installations, as well as workforce safety
committees with appointed representatives. This
period of change has also seen the total rewriting
of the relevant regulations. A key effect of the
report has been a shift in the overall focus of health
and safety regulation away from detailed rules
specifying standards for compliance, towards a
goal setting approach, placing the onus on
individual duty holders to develop appropriate
measures to control hazards and manage risk, and
keep health and safety documentation up to date.
However, the offshore industry is, like other
‘higher hazard’ industries, subject to a
‘permissioning regime’ under which the start or
continuation of particular work activities are
conditional upon acceptance of a safety case by the
health and safety regulator.
Safety cases were brought into being through
the Offshore Installations (Safety Case)
Regulations of 1992 (Statutory Instrument of 1992
No. 2885), which made them mandatory for
operators of all offshore installations, both old and
new, fixed and mobile. In essence, they involve the
identification and assessment of the hazards
involved in all stages of a project’s life, from
conception through operation to final
decommissioning and abandonment. Each hazard
must then be addressed with the appropriate
controls in order to minimize risks to personnel. A
key feature of the recommendations of the Cullen
Report was that adequate provision be made for the
possibility of a major emergency, including
provisions for the temporary refuge of personnel,
and their safe and full evacuation and rescue.
Safety cases must be in place at least six months
before the commencement of operation, and must
also be periodically updated (at least every five
years, or sooner if required by a major change in
circumstances).
Following Lord Cullen’s recommendations, the
regulatory body was also changed. Previously, this
role had fallen under the remit of the Department
of Energy, but it was felt that the Health and Safety
Executive (HSE) would be more appropriate.
Therefore, on 1 April 1991, the Offshore Safety
Division (OSD) of the HSE was established as a
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dedicated regulatory body and, after numerous
re-shuffles, ministerial responsibility was
eventually given to the Department for Work and
Pensions. One of the key roles of the OSD is the
acceptance of safety cases under the 1993
Regulations. No installation can operate until such
approval has been given.
The principal legislation covering health and
safety is the Health and Safety at Work etc. Act of
1974. This does not apply outside Great Britain as
a general rule but the Offshore Safety Act of 1992
extended the 1974 Act, and a number of others,
important to onshore safety, to cover persons
employed on offshore installations, or associated
pipeline works.
The next stage of implementation of the Cullen
Report was the development of regulations whose
focus is on setting goals and targets for safe
practice, with the detail being contained in
non-mandatory guidance notes setting out how
such targets can be met. An example of this style
of statutory instrument is the Offshore Installations
(Prevention of Fire and Explosion, and Emergency
Response) Regulations of 1995 (Statutory
Instrument of 1995 No. 743). These replaced a
number of over-prescriptive regulations which had
been the subject of criticism in the Cullen Report,
with more general provisions supplemented by an
approved Code of Practice and Guidance.
The offshore safety regime was reviewed again
recently following an industry-wide consultation
on reform to improve the regulation and control of
major hazards offshore carried out by the Health
and Safety Commission. The review resulted in the
Offshore Installations (Safety Case) Regulations
2005 (Statutory Instrument of 2005 No. 3117)
which came into force in April 2006. These new
regulations introduce a number of changes,
reflecting the changing nature of the offshore
industry, but the central requirement remains the
same – an offshore installation must have a safety
case accepted by the HSE in order to operate in
UK offshore areas.
12.6.8 Environmental regulation
Pollution
High priority is given to the prevention of oil
pollution from pipelines and facilities. In addition
to the Petroleum Act of 1998, other legislation (for
example the Prevention of Oil Pollution Act of
1971) puts additional controls on the discharge of
oil or any mixture containing oil. The Offshore
Petroleum Activities (Oil Pollution Prevention and
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
Control) Regulations of 2005 (Statutory
Instrument of 2005 No. 2055) which came into
force in August 2005, introduce a permitting
system for oil discharge.
The Merchant Shipping (Oil Pollution
Preparedness, Response and Co-operation
Convention) Regulations of 1998 (Statutory
Instrument of 1998 No. 1056) provide that harbour
authorities and operators of offshore installations
and pipelines must prepare an oil pollution
emergency plan.
The Offshore Combustion Installations
(Prevention and Control of Pollution) Regulations
of 2001 (Statutory Instrument of 2001 No. 1091)
implement Council Directive 96/61/EC on
Integrated Pollution Prevention and Control and
cover any offshore facility which has a thermal
input of over 50 MW. All new facilities, as well as
existing facilities which undergo substantial
change, will require a PPC permit. Operators of
existing facilities which do not undergo substantial
change will need a PPC permit after 30 October
2007.
Applicants for PPC permits will need to
demonstrate that they have employed Best
Available Techniques (BAT) in designing and
operating combustion installations.
Operators of offshore facilities should have
regard to the Offshore Petroleum Activities
(Conservation of Habitats) Regulations of 2001
(Statutory Instrument of 2001 No. 1754) which
concern the protection of designated conservation
areas in the UKCS. These regulations implement
Council Directive 92/43/EC on the Conservation of
Natural Habitats and of Wild Flora and Council
Directive 79/409/EEC on the Conservation of Wild
Birds.
Gas flaring
The DTI recognizes that, during the appraisal,
commissioning, and production phases of a
development, the flaring and venting of some gas
is unavoidable. It does require however that it is
kept to the minimum that is technically and
economically justified. Flaring and venting is also
undesirable on environmental grounds.
The DTI controls gas flaring in the UKCS
through the requirement for licensees to apply for
consent to flare gas emitted by their oil and gas
fields. The main purpose of this requirement is to
ensure that gas is conserved where possible by
avoiding unnecessary wastage during the
production of hydrocarbons.
The UK’s agreed target reduction for
greenhouse gases under the Kyoto Protocol is
716
12.5%. The UK has gone beyond its Kyoto
commitment however, with a further domestic
target to reduce carbon dioxide emissions by 20%
from 1990 levels by the year 2010. The
government is therefore keen to ensure that
industry makes every endeavour to help reduce
emissions, with an overall aim of reducing gas
flaring on an annual basis.
Environmental impact assessments
The Offshore Petroleum Production and
Pipelines (Assessment of Environmental Effects)
Regulations of 1999 (Statutory Instrument of 1999
No. 360) implement Council Directive
85/337/EEC on the assessment of the effects of
certain public and private projects on the
environment, as amended by Council Directive
97/11/EC insofar as it relates to the effects on the
environment of certain offshore oil and gas
projects. An environmental study, known as an
environmental impact assessment, must be carried
out for most developments. A document describing
the study, an environmental statement, is submitted
to the Department for Trade and Industry as a
necessary part of the project approval process.
12.6.9 Transfer of interest:
licence assignments
Background
The Secretary of state’s consent is required
before any transfer (‘assignment’) of licence
interest can be made. This restriction arises from
the model clauses attached to each licence. It
applies equally to assignments between sister
companies, within a single company group, as to
assignments between unrelated companies. Until
1994, any company seeking approval of an
assignment had to submit pre-execution drafts of
all the relevant legal documentation, including the
Deeds of Assignment and novations of relevant
agreements, all of which had to be examined by the
DTI lawyers. Now, however, the procedure has
been greatly streamlined by the introduction of
standard form documentation (see below).
DTI policy
The following is a list of the key issues for the
DTI when considering whether to allow an
assignment:
Technical and financial capacity of the
licensee. The DTI will need to be satisfied that the
proposed new company is capable of discharging
its licence obligations.
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Decommissioning costs. Financial capacity will
be an even greater concern if significant
decommissioning costs are likely to be incurred by
licensees in the near future.
New entrants to the UK. The DTI places great
reliance upon the assignee’s previous track record.
If an assignee company is new to the UK however,
the DTI will take account of any overseas
experience.
Effect on operatorship arrangements. The DTI
will not approve any assignment if it would result
in a licence having no approved operator. When an
operator seeks to leave a licence, it will need to
ensure that its remaining partners have agreed a
replacement operator and that the DTI is ready to
approve their choice.
Offshore Pollution Liability Association Ltd
(OPOL). The DTI requires all operators to be
members of OPOL and to register each off its
separate operatorships.
Execution
Any consent granted by the Secretary of state
will be made conditional on the Deed of
Assignment conforming substantially to a draft
approved by the Secretary of state. Departures
from the agreed form may only be made in such
ways as do not materially alter its effect (for
instance, by moving company names to a
schedule). The DTI recommends use of the Master
Deed procedures (see below).
Use of the approved drafts is not compulsory;
but a different draft would have to be submitted to
the DTI in advance for approval.
The United Kingdom Offshore Operators
Association (UKOOA) Master Deed
The Master Deed was developed by UKOOA’s
Progressing Partnership Working Group (PPWG),
the DTI, and a number of other interested
organizations. It greatly expedites the transfer of
offshore licence interests and other agreements
relating to associated assets and infrastructure; and
introduces a standard pre-emption regime to give
confidence to incoming companies.
The offshore oil industry has given the Master
Deed broad support, with 178 companies, holding
99% of licence interests, having signed up already.
Under former practice, a deal could be
significantly delayed by the need to get a range of
signatures on many documents, even when all
parties were content with it. Under the Master
Deed, licensees have appointed an Administrator to
act as their attorney for the execution of pro forma
documents. The Administrator is a specially-
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created subsidiary of UKOOA called UKCS
Administrator Limited.
Use of the new transfer arrangements is
voluntary for the party disposing of its interest. If it
does not wish to use them, it is free to stay with the
traditional arrangements.
New pre-emption arrangements
A number of new entrants have expressed concerns
to the DTI about the risk of being pre-empted even
after extensive (and expensive) negotiations
to conclude a deal. The standard new arrangements
replace any previous pre-emption arrangements
(though they do not take effect where there had been
none before).
When informed of a proposed licence
assignment, companies on a licence will have an
initial seven-day period in which to waive or
reserve their rights to pre-emption; and then, if
they have reserved their rights, a 30-day period in
which to decide whether or not actually to exercise
their pre-emption right. Failure to meet either of
these deadlines will result in the pre-emption right
being lost.
12.6.10 Abandonment
and decommissioning
Overview
The decommissioning of offshore oil and gas
installations and pipelines is regulated by the
Petroleum Act of 1998, and the DTI’s Offshore
Decommissioning Unit is the applicable regulatory
body. Under the 1998 Act, the Secretary of state is
empowered to serve notice on a wide range of persons
(in the first instance this would include parties to
JOAs, in respect of installations, and owners in
respect of pipelines) which either specifies the date
by which a decommissioning programme
for each installation or pipeline is to be submitted or, as
is more usual, provides for it to be submitted on or
before such date as the Secretary of state may later
direct.
Government policy and the UK’s international
obligations
International obligations
The UK’s international obligations on the
decommissioning of offshore installations have
their origins in the United Nations Convention
1982 on the Law of the Sea. The Convention
entered into force in 1994 and was ratified by the
UK in 1997. Art. 60.3 includes the following:
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
“Any installations or structures which are
abandoned or disused shall be removed to ensure
safety of navigation, taking into account any
generally accepted international standards
established in this regard by the competent
international organization”.
The competent international organization for
this purpose is the International Maritime
Organization (IMO) which, in 1989, adopted the
IMO Guidelines and Standards setting out the
minimum global standards for the removal of
offshore installations.
In 1992, a new Convention, the Convention
for the Protection of the Marine Environment
of the North-East Atlantic (known as the
OSPAR Convention), was agreed upon. The OSPAR
Convention came into force in 1998, and has since
been updated and amended.
In July 1998, at the First Ministerial meeting of
the OSPAR Commission, a new regime for the
decommissioning of disused offshore installations
was established under the new Convention.
Ministers adopted a binding Decision (OSPAR
Decision 98/3) to ban the disposal of offshore
installations at sea.
The main features of OSPAR Decision 98/3
Under the terms of Decision 98/3, which
entered into force on 9 February 1999, there
is a prohibition on the dumping or leaving
wholly or partly in place of offshore
installations. The topsides of all installations
must be returned to shore. All installations
with a jacket weight less than 10,000 t must
be completely removed for re-use, recycling,
or final disposal on land.
The Decision recognizes that there may be
difficulty in removing the ‘footings’ of large steel
jackets weighing more than 10,000 t and in
removing concrete installations. As a result, there
is a facility for derogation from the main rule for
such installations. It has been agreed that these
cases should be considered individually to see
whether it may be appropriate to leave the
footings of large steel installations or concrete
structures in place. Nevertheless, there is a
presumption that they will all be removed entirely
and exceptions will be granted only if the
assessment and consultation procedure, which
forms part of the OSPAR Decision, shows that
there are significant reasons why an alternative
disposal option is preferable to re-use or
recycling or final disposal on land. Any
installations emplaced after 9 February 1999
must be completely removed.
718
Decommissioning obligations
under the Petroleum Act of 1998
Section 29 of the 1998 Act enables the
Secretary of state to serve notices requiring the
recipient to submit a costed decommissioning
programme for his approval at such future time as
he may direct. The programme (referred to in the
1998 Act as an ‘abandonment programme’) should
contain the measures proposed to be taken in
connection with the decommissioning of an
installation or pipeline. Equivalent notices served
under previous legislation will continue to be valid.
For installations, notices may be served not
only on the licensee but also on the persons having
the management of the installation (usually the
operator) and the parties to a JOA or similar
agreement. These will be the entities to which
section 29 notices will initially be served.
However, notices may also be served much more
widely: for example, on any person owning an
interest in the installation or on parents of licensees
or on other associated companies. The option of
serving more widely is reserved for those cases
where it is judged that satisfactory arrangements,
including financial arrangements, have not or will
not be put in place to ensure a satisfactory
decommissioning programme is carried out.
By this process, the obligation to submit a
decommissioning programme, on or before such
date as the Secretary of state may subsequently
specify, is placed upon each of the JOA parties or
other qualifying persons. The notice also advises of
the requirement to carry out consultations with
specific parties, including fishermen’s
organizations and other interested bodies, when
preparing a programme.
Once the decommissioning obligation has been
fixed by means of the section 29 notice, it remains
so, unless it is withdrawn by the Secretary of state.
If a party disposes of its interest in the installation(s)
or pipeline(s) on a field, the Secretary of state may
consider exercising his discretion under section 31
subs. 5 to withdraw the notice. Under normal
circumstances, subject to any representations
received, the notice will be withdrawn. This does not
necessarily mean that the party will have no
decommissioning responsibilities in relation to the
field. In accordance with section 34 of the 1998 Act,
a party may, in certain circumstances and following
the approval of a programme, be placed under a duty
to carry out that programme even though he
has previously been released by a notice under
section 31 subs. 5.
Given the difficulties involved in ensuring that
there is always an entity liable for
ENCYCLOPAEDIA OF HYDROCARBONS

decommissioning costs (particularly, as over time
many will cease to exist), the DTI is considering
whether it might be possible to make appropriate
insurance-based arrangements to address residual
liability. The government will be willing to
consider any scheme which is proposed.
Pipeline decommissioning
The Petroleum Act of 1998 also provides a
framework for the orderly decommissioning of
offshore pipelines, and the Pipeline Safety
Regulations of 1996 (Statutory Instrument of 1996
No. 825), administered by the HSE, provide further
requirements for the safe decommissioning of
pipelines. There is little international regulation in
this area. The provisions of OSPAR Decision 98/3
do not apply to pipelines, and there are no
international guidelines on the decommissioning of
disused pipelines.
Decommissioning proposals for pipelines
should be contained within a separate programme
from that for installations. The following are some
of the key tests applied by the DTI when
considering such programmes: a) decisions will be
taken in the light of individual circumstances, and
all feasible decommissioning options should be
considered including removal, burial or trenching
to adequate depths or leaving in place; b) any
removal or partial removal of a pipeline should be
performed in such a way as to cause no significant
adverse effects upon the marine environment;
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c) any decision that a pipeline may be left in place
should have regard to the likely deterioration of the
material involved and its present and possible
future effect on the marine environment;
d ) account should be taken of other uses of the sea.
The serving of a section 29 notice for pipelines
follows the same procedure as for installations.
Notices are issued to all owners of a pipeline at the
time production starts or once a pipeline is in situ.
Residual liability
The persons who own an installation or
pipeline at the time of its decommissioning may be
subject to residual liability. In addition, those with
a duty to secure that the decommissioning
programme is carried out will remain responsible
for complying with any conditions attached to the
Secretary of state’s approval of the
decommissioning programme.
Any remains of installations or pipelines will be
subject to monitoring at suitable intervals as specified
in each decommissioning programme and may require
maintenance or remedial action in the longer term.
Any claims for compensation by third parties,
arising from damage caused by any remains, will
be a matter for the owners and the affected parties
and will be governed by the general law.
Michael Taylor
Partner, Norton Rose Law Firm
Milan, Italy
719
 12.7
Algeria, Libya and Tunisia
12.7.1 Algeria
Sovereignty over national resources
With Law 05-07 of 28 April 2005, Algeria has seen
a thorough reformation of its hydrocarbon legislation.
The oil research and production organization has gone
through different phases, namely, the 1958 Saharian
Code – enacted after Algerian independence; the 12
April 1971 Order defining the framework within
which foreign companies’ activities are carried out in
the field of liquid hydrocarbons research and
exploitation –; and the modified Law 86-14 of 19
August 1986, reorganizing oil activities through the
introduction of new legal instruments such as the
Production Sharing Agreement (PSA), the services
agreement and various forms of gas partnership.
The principle of sovereignty over national oilfield
resources is stated in art. 17 of the 1996 Algerian
Constitution as follows: “Public property is an asset
which belongs to the national collective […] It
comprises the subsoil, mines and quarries, natural
energy sources, mineral, natural, and living resources
of the different national maritime domain zones”. This
is reiterated in art. 3 of the 05-07 Law concerning
hydrocarbons which states that all hydrocarbon
resources, “discovered or not discovered, localized in
the soil and subsoil of the national territory and
maritime areas pertaining to the national sovereignty,
are the property of the national collective, of which the
state is the emanation”.
Moreover, in art. 5 of the law, a definition of what
is meant by ‘maritime area’ is given as: “territorial
waters and the exclusive economic zone”.
The 05-07 Law
The object of the 05-07 Law concerning
hydrocarbons is more extensive than that of the
previous Law 86-14 of 19 August 1986, the only
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object of which was “prospecting, research,
exploitation and pipes transport activities”.
Activities
The law defines the legal status applicable to
different activities, including those upstream and
downstream. These mainly concern the activities
which were previously under the national state
companies’ monopoly, such as Naftec (refining),
Naftal (distribution), and Sonatrach Spa (pipeline
transportation).
The upstream activities concern research,
exploration, development, pipeline transportation and
open access to Third Parties’ activities concerning
already discovered and operating oilfields. The
downstream activities concern the freedom to carry
out hydrocarbon refining and transformation activities
(art. 77), including those linked to implementing the
storing, marketing and distribution of hydrocarbon
products (art. 78), as well as building infrastructures
allowing the carrying out of such activities (arts.
77-79).
The law recognizes the principle of access to oil
products’ storing and transportation facilities for third
parties (art. 79).
Institutional framework
The Law 05-07 determines the institutional
framework by separation of the public prerogatives
from the economic and commercial activities
previously carried out by Sonatrach. It also redefines
the mission of this company. Indeed, Sonatrach Spa
will only be charged with commercial activities
and will have the same role as that of any given partner.
The law extends the prerogatives and objectives
of the Minister in charge of Hydrocarbons who is
endowed with the optimal valorization of national
hydrocarbon resources. It has created two new
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
corporate bodies: the hydrocarbon regulation
authority (l’Autorité de Régulation des
Hydrocarbures) and the national agency for the
valorization of hydrocarbon resources (Agence
Nationale pour la Valorisation des Resources en
Hydrocarbures, ALNAFT).
Upstream organisation
The regulation authority plays the role of any
classic regulation authority. It regulates, defines and
implements technical standards. This authority has a
normative power in matters of security, hygiene,
industrial security and environment safety. It
establishes the specifications for implementing
transportation and storing facilities, processes
applications for transport licences and the open access
to transportation.
ALNAFT is partially charged with the following
missions, previously entrusted to Sonatrach: a) setting
up of a hydrocarbon research and exploitation data
bank; b) launching and evaluation of calls for tenders;
c) conclusion of agreements; d ) granting of research
and exploitation perimeters; e) follow-up and
supervision of agreements which are carried into
effect; f ) delivery of prospecting permits; g) levying
and transfer taxes and h) a general objective of
investment promoting and developing of the
concerned activity.
With regard to gas, ALNAFT is also entitled to
keep and update a reserves account and periodically
determine the reference prices, taking into
consideration the highest among the following prices:
the price prevailing under each agreement, and the
reference price of the previous period. It also watches
over the domestic market supply.
ALNAFT should keep in full confidentiality all
pertinent information which it might have received
from Sonatrach.
The law also defines the rights and liabilities of
persons exerting one or more activities referred to
above. By ‘persons’ it intends, in art. 5, “any foreign
corporate body, as well as any Algerian private or
public corporate body, possessing the financial and/or
technical means required by the present Law and
regulations referred to for its application”. With regard
to retail trade activities, the notion of “person”
includes natural persons.
The legislator has extended to Algerian private or
public corporate bodies the possibility to intervene and
act in the different upstream and downstream
activities.
The mining domain is divided into four zones – A,
B, C and D – subject to a regulatory law. Each zone is
subdivided into parcels, the number and geodesic
coordinates of which will be regulated by law. The
722
purpose of this classification is to determine the
applicable fiscal system.
The prospecting permit
and research and/or exploitation agreement
A distinction should be made between the
prospecting permit on the one hand, and the research
and exploitation agreement on the other. The former is
issued by ALNAFT to any entity which has applied for
the implementation of hydrocarbon prospecting works.
The prospecting permit may relate to one or several
perimeters and is granted for a maximum period of two
years. The conditions and modalities of granting the
permit will be established by a regulatory text (art. 20).
The prospecting permit will not, in any case, be granted
over a parcel which has previously been granted
under a research and/or exploitation agreement. The
parcel which has previously been granted a research
and/or exploitation agreement is systematically
excluded from the one or several perimeters of
prospecting (art. 21).
The entire set data and results obtained by the
operator, during the carrying out of prospecting works,
will necessarily be at the disposal of ALNAFT.
Procedures relating to the communication of the
said data and results will be fixed by a regulatory text
(art. 22).
The mining claim, on the basis of which research
and/or exploitation activities are carried out, is put at
the state’s disposal by ALNAFT. The conditions of
such a procedure will be ruled by a regulatory text.
This agreement recognizes an exclusive right over
the contractual perimeter of carrying out research and
exploitation activities. As for the exploitation
agreement, it can be entered into only if the oilfield is
declared to be commercially profitable. This permit
does not give any right of property over the land. It is
signed by the party contracting with ALNAFT and is
approved by presidential decree at the Ministers’
Council session.
Procedure of calling for tenders
It is subsequently concluded through a call for
tenders, the procedures of which will be fixed via
regulatory channels.
Research and/or exploitation agreements are
concluded after calls for tenders. A distinction is made
between a research and exploitation call for tenders,
and an exploitation contract call for tenders.
The choice is made according to the following
general criteria: the minimum works programme for
the first research phase; the non-deductible amount for
bonus; and the proposed taxes ratio.
The call for tenders procedure takes place in two
phases – a technical phase and an economic phase.
ENCYCLOPAEDIA OF HYDROCARBONS

The evaluation criteria in the technical phase are:
reclaiming ratio; production optimization; production
facilities capacity; duration and minimum investment
costs.
In the economic phase, the evaluation criteria are
the proposed licence fee, the level of which should be
higher than the minimum level fixed by law, or the
bonus amount; this amount being non deductible for
tax purposes. The opening of bids related to the
economic phase takes place publicly. However, the
Minister in charge of Hydrocarbons may depart from
this procedure “on a motivated and detailed report […]
for general interest purposes”.
Research and exploitation phase. Guarantees
A classical distinction is made between the
research period and the exploitation period.
A research period of seven years is divided into
three phases; three years duration for the first period;
and two years duration for the second and the third
period.
The exploitation period lasts twenty-five years, i.e.
for an already discovered oilfield, the exploitation
contract period is twenty-five years. If the concerned
field is a dry gas field, the period is extended to thirty
years.
In the event of the discovery being declared
commercially profitable before the research period
expiry date, the remaining years will be added to
the exploitation period, up to a maximum sum total
of thirty-two years.
The contractor should have the technical and
financial capacities necessary for hydrocarbons
research and exploitation activities. He should also
deposit a bank warranty of good execution “payable in
Algeria on simple request from ALNAFT, covering the
minimum works to be carried out by the contractor
during each research phase”. This warranty will be
released proportionally to the carrying out of the
different phases.
The termination will take place ipso iure if the
contractor has not declared the oilfield to be
commercially exploitable.
The contractual perimeter is reduced to 30% on the
first phase expiry and 30% on the second phase
expiry.
The excluded area concerns any surface excluded
by the contractor from the exploitation perimeter.
In so far as renunciation is concerned, the
contractor may release all his rights and liabilities if,
within the framework of the contract, he has met his
minimum liabilities for the research period.
Land use and easements are warranted to the
operator by art. 7 of the Law through land acquisition
and expropriation for public utility purposes. They
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pertain to the regulating authority to introduce the
necessary procedures and formalities when it concerns
activities pertaining to hydrocarbons and notably those
linked to transportation concession, and to ALNAFT
when it relates to research and/or exploitation
contracts.
Technical aspects and anticipated production
Technical aspects cover oilfield preservation,
recovering, gas flaring and un-utilization.
It is compulsory to maintain optimal preservation
of the oilfields (art. 49). Each oilfield developing
programme should indicate the liabilities and
expenditures. Injection of drinking water or of water
suitable for irrigation, when used for recovering needs,
is subject to tax payment. In this way, ALNAFT can
control the water quantities used, and the development
programme before authorizing it.
Gas producers should participate in meeting the
needs of the Algerian domestic market on request from
ALNAFT. Their participation is proportional to gas
production subject to taxation (art. 51).
Gas flaring is forbidden, except if previously
authorized by ALNAFT, subject to paying a royalty of
8,000 DA/Nm3 (Algerian Dinars per Normal cubic
metre) (art. 52).
All the facilities should be repaired and adapted to
the new standards within a period of seven years.
When an oilfield is declared commercially
profitable and extends over at least two perimeters –
each one being the object of a separate contract – the
concerned contractors should set up a joint programme
for developing and exploiting the oilfield. This should
be done after ALNAFT has notified this need to each
contractor. This programme, called unitization
program, should be submitted to ALNAFT for
approval.
In the event of the contractors failing to come to
any agreement within six months after receipt of
ALNAFT notification or if ALNAFT does not approve
the said unitization programme, the latter will appoint
(at the contractors’ expenses), an expert selected on
the contract annexed list in order to establish another
unitization programme. The unitization programme
established through expertise will be enforced as soon
as it is ready.
In the event of the deposit which is declared
commercially exploitable extending over one or
several perimeters which are not subject to any
contract, ALNAFT should proceed to a call for tenders
in order to conclude an exploitation agreement
regarding this deposit extension.
Subject to ALNAFT’s prior consent, the
contractor may benefit from an anticipated
production during a twelve-month period, with the
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
purpose of fixing the deposit development
programme. The contractor shall submit to ALNAFT
for approval a development programme comprising
of cost evaluation, budget, exploitation perimeter
delimitation and indications of measuring points
(that is to say the determination of the hydrocarbons
volume used for reckoning taxation).
For long-term strategy purposes, inherent to the
domestic energetic policy, limitations of deposit
production are liable to be applied. Those limitations
are established by decree of the Minister in charge of
Hydrocarbons who assesses quantities, duration and
effective date (art. 50).
State participation
The contractor is not bound to be associated or to
associate in advance with Sonatrach. The latter enjoys
the right to opt for a participation of 20-30%. This
option should be exercised within a period of thirty
days following ALNAFT’s approval of the
development programme. Sonatrach will not be able to
transfer and/or yield the acquired participation before
the expiry of a period of five years.
The agreement to be concluded between Sonatrach
and the contractor will obligatorily contain a provision
of joint marketing gas abroad (art. 48), subject to
meeting the following requirements: reimbursement of
research costs; payment of future costs and definition
of either Parties’ rights and liabilities.
Sonatrach is bound to take charge of, in proportion
to its participation, the investments related to the
development programme.
This agreement, entitled operations agreement, is
submitted to ALNAFT and approved by Decree at the
Minister’s Council Session.
Specific provisions applied to Sonatrach
Whereas the state enjoys participation in the
hydrocarbon activities via Sonatrach, the latter,
according to arts. 103 and following, is bound to:
• Address to ALNAFT the delimitation of research
and exploitation perimeters over which it operates
within a period of thirty days after the constitution
of ALNAFT itself, provided that: the perimeters
which are not preserved by Sonatrach be subject to
competitive bidding; and the perimeters which are
preserved by Sonatrach be subject to contracting
between this latter and ALNAFT within ninety
days following Sonatrach’s decision to preserve or
renounce the said perimeter.
• Submit to ALNAFT a developing programme
related to the exploitation perimeters as well as the
financial means necessary to its implementation.
In the event of Sonatrach and ALNAFT not coming
to an agreement over the development programme
724
within a period of three-hundred-and-sixty days
following the effective date of the agreement, the
dispute will be submitted to the Minister in charge of
Hydrocarbons, subsequent to the expertise within the
delay previously mentioned.
Transitory provisions
These provisions govern the relationship between
ALNAFT and Sonatrach, but present an interest for
the contractor.
Article 101 states that the autonomy of the parties’
will be upheld as well as the legal intangibility and
continuity of partnership. All contracts and additional
clauses signed before the promulgation of the Law
05-07 will remain enforceable in the agreed terms, and
remain so until their expiry date.
However, within ninety days a parallel contract will
have to be concluded between ALNAFT and
Sonatrach for each existing partnership contract. In the
context of this parallel contract, Sonatrach shall return
to the Minister in charge of Hydrocarbons the
concerned mining claims, in order that the same be
granted to ALNAFT.
Sonatrach will continue to exert the same
prerogatives pursuant to the previous law, up to the
signing of the parallel contract. ALNAFT will take over
the said prerogatives as soon as the contract is signed.
Determination of gas and oil prices
The selling price of oil is duty-free. It should
include the crude oil price before refining, refining
fees, road and pipeline transportation fees, storage and
distribution fees, as well as reasonable net profit from
each activity.
The price of crude oil before refining is calculated
using the average price of crude oil for export over the
last ten calendar years on the basis of the export crude
oil price statistics recorded and published by the
Minister in charge of Hydrocarbons.
The selling price of gas on the domestic market
should include: production costs; costs of
infrastructures necessary and specific to meeting the
domestic market needs; exploitation costs of
infrastructures used to meet the domestic market
needs; and reasonable margins for each activity.
The selling price of gas on the international market
is periodically determined by ALNAFT and approved
by decree of the Minister in charge of Hydrocarbons
(art. 61).
The reference price is calculated as the highest
price deduced from the price of each enforced contract
and the reference price of the preceding period. This
price should not be lower than the ratio of the Sahara
Blend FOB (Free On Board) medium price of the
previous quarter.
ENCYCLOPAEDIA OF HYDROCARBONS

The FOB medium price is the price published by a
specialized magazine which is authorized to act as a
reference. As to the percentage, it is fixed and
readjusted by the Minister in charge of Hydrocarbons
according to the gas market.
Transport
Within the framework of the transport activity
(arts. 68-76), the Law permits the implementation,
investment and pipeline construction (excluding
exploitation). This activity is officially recognized
through granting a maximum period of fifty years (art.
71). Free access to existing or future transport
facilities is recognized to third parties.
A distinction is made between the concession for
transport requiring the carrying out of facilities to
convey the quantities produced within the framework
of a research an/or exploitation agreement and a
transport concession contract.
Any concession claim is examined in advance by
the Regulation Agency. Sonatrach may also, within the
framework of any transport concession, make recourse
to its participation option if need be.
The various technical criteria, competitive bidding
procedures, pricing, principle of free access and the
different technical standards will be subject to further
regulations. In order to deal with the transport
adjustment fees, a pipeline transport fund is set up.
Property transfer
Property transfer (arts. 80-82) for the state’s
benefit is exempt from any charges. It will take
place at the expiry date of the research and/or
exploitation contractual period as well as at
the expiry date of the pipeline transport concession.
Three years before the contract expiry date, the state
should opt either for the transfer or the repair of the
site. Works and facilities to be transferred should be
in a good operational state.
During the contract or the concession period, the
contractor will constitute a deposit in an escrow
Table 1. Surface tax calculation
Research Period (years)
Zones 1 to 3
4 and 5
inclusive
Zone A 4,000 6,000
Zone B 4,800 8,000
Zone C 6,000 10,000
Zone D 8,000 12,000
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account to cover costs resulting from abandonment
and/or repairing of the site. The deposit amount is
fixed by ALNAFT’s appointed expert(s) with regard to
the research and exploitation agreement, and by the
Regulation Agency for concessions.
With regard to the agreement of research and
exploitation, the control of the site abandonment and
repair is a joint liability of ALNAFT and the Ministry
in charge of Environment. As to Concession, it is the
joint liability of the Regulation Agency and the
Ministry in charge of Environment.
The fiscal system
A deep recast of the oil fiscal system has been
introduced by Law 05-07 (arts. 83-99). The fiscal
provisions of this law are not applicable to contracts
and additional clauses concluded before its
publication. The new fiscal system is characterized by:
a non-deductible surface tax payable to the Treasury; a
royalty paid monthly to ALNAFT (arts. 25-26); an
income tax on hydrocarbons payable monthly to the
Treasury; an additional tax payable yearly
to the Treasury; and a land tax on real estate other than
those related to exploitation.
To these, the following specific-purpose taxes are
to be added: a) 1% for transfer of rights (art. 31); b)
8,000 DA/Nm3 for gas flaring (art. 52); c) 80 DA/Nm3
for water assisted recovery (art. 53); d) tax on use,
transfer or release of greenhouse exhaustion credit (tax
to be defined by a regulatory text) (art. 67).
Surface tax
Surface tax (art. 84) is payment in proportion to
the occupied surface, in km2, and its allocation is
calculated on the basis of: the period of research,
retention and exploitation (Table 1).
The royalty (arts. 85 and 26) is levied on all
quantities of extracted hydrocarbons and is calculated
at the measuring point, that is the “location chosen
within the exploitation perimeter where the decided
quantities of hydrocarbons will be extracted”.
Retention Period
as defined (art. 42) + Exploitation
6 and 7 Exceptional Period Period
as defined (art. 37)
8,000 400,000 16,000
12,000 560,000 24,000
14,000 720,000 28,000
16,000 800,000 32,000
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
Table 2. Surface tax for a production up to 100.000 boe/d
Quantity produced Zone A
00 to 20,000 boe/d 5.5%
20,001 to 50,000 boe/d 10.5 %
50,001 to 100,000 boe/d 15.5%
The following hydrocarbon quantities are excluded
from reckoning: consumed by the production direct
needs; those lost prior to the measuring point; and
those re-injected within the deposits. These exclusions
take place in proportion to “technically acceptable
quantities” (art. 26).
The tax is determined monthly for the
hydrocarbons quantities extracted from the
exploitation perimeter (art. 85). The applicable ratios
vary according to zones and daily produced quantities.
A distinction is made between the produced quantities
inferior or equal to 100,000 barrel oil equivalent
(boe)/d and a production superior to 100,000 boe/d
(see Table 2).
As for the hydrocarbons quantities superior to
100.000 boe/day determined on the basis of a monthly
average, the tax ratio provided for in each contract –
applicable to the whole production – may not be
inferior to the levels indicated in the Table 3.
The tax is deductible from the additional income
tax (Impôt Complémentaire sur le Revenu, ICR) and is
paid monthly, every tenth day, to ALNAFT. In case of
failure to pay in due time, a penalty of 1‰ for each
overdue day is required from the operator (art. 92).
Tax on hydrocarbon income
The tax on hydrocarbon income (Taxe sur le
Revenu Pétrolier, TRP) is payable monthly by the
operator (arts. 86-87). It is equal to the annual
production value of each exploitation perimeter
from which the transport fee is deducted, that is
to say: between the measuring point and the
Algerian port; between the measuring point and the
exploitation land boundary; between the measuring
point and the selling point in Algeria (art. 91).
The following items are deducted from the TRP
(art. 86): a) the royalty; b) annual portions of
Table 3. Surface tax for a production greater
than 100.000 boe/day
Zone A B C D
Minimum tax rate 12.5% 14.5% 17% 20%
726
Zone B Zone C Zone D
8% 11% 12.5%
13% 16% 20%
18% 20% 23%
exploitation investment; c) annual portions of research
investment; d) provisions for abandonment/restoration;
e) training costs; f ) gas buying price for assisted
recovery operations. The TRP is deductible from the
basis of calculating ICR and is paid in twelve
provisional instalments on the 25th day of each month
(art. 94) (Table 4).
Additional tax based on results or income
The additional tax on results or on income, also
called ICR (art. 88) is calculated according to the
Corporate Income Tax rate (Impôt sur le Bénéfice des
Sociétés, IBS). It is due, at the latest, on the expiry
date of the period fixed for filing the annual financial
statement (art. 95). As to the payment terms, they will
be defined by a regulatory text.
A 1‰ penalty is imposed for each overdue day
(art. 95).
Exemptions
In so far as exemptions are concerned (art. 89),
research-exploitation activities are exempt from VAT
(Value-Added Tax), tax on professional activity (Taxe
sur l’Activité Professionelle, TAP), customs duties and
taxes on imported goods and equipments linked with
the listed activities, and any other charges.
Transport activities (art. 97) are exempt from VAT,
duties taxes and customs duties on imported goods,
equipment, materials and products allocated and used
exclusively for that activity. A regulatory text will
define and establish the list of goods and equipment to
be exempted.
Article 55 makes a distinction between a resident
and a non-resident person. Any person who has a
head-office located abroad is considered as being a
non-resident. The non-resident person participates in
the capital as well as in all the expenditures during the
exploitation period in foreign currencies. It should
address to ALNAFT a quarterly report of its currency
imports. Free currency transfer is guaranteed.
Investment protection and environment protection
Guaranties granted to the contractor relate first to
the approval of the research and/or exploitation
agreement by Presidential decision taken in the
ENCYCLOPAEDIA OF HYDROCARBONS

Table 4. Rates used to calculate TRP
Selling Price Expressed in 109 DA as provided by art. 86
Tax on Hydrocarbons Income Ratio
Council of Ministers session and published in the
Algerian Gazette.
A specific protection is afforded by recourse to
international arbitration as a method of settling out
disputes between the state or state-owned entities and
the private investors under the different types of
hydrocarbons agreements provided by the law.
Law 05-07 of 28 April 2005 related to
hydrocarbons provides in its art. 18 that any entity
or operator should prepare and submit to
the hydrocarbons regulating authority an environment
impact survey, and an obligatory environment
management programme, comprising the description
of measures for managing prevention and
environmental risks associated with research and/or
exploitation activities.
The hydrocarbon regulating authority is entitled to
jointly coordinate those surveys with the Ministry of
Environment and obtain the corresponding agreement
of the concerned contractor and operator.
The environment impact survey should, as
a minimum, contain the following elements:
a) a statement on the activity to be carried out; b) a
description of the site initial state as well as its
environment which might be affected by the activity to
be carried out; c) a description of the potential impact
on environment and human beings’ health related to
the activity to be carried out and suggestions about
alternative solutions; d ) a statement of facts on the
cultural patrimony that may be affected by the activity
to be carried out and its repercussions on the socio-
economic conditions; e) a statement on measures
allowing to reduce, remove and, if possible,
compensate for the harmful effects on environment
and health.
Besides these requirements, gas flaring is prohibited,
unless previously authorized by ALNAFT, and subject
to payment of a tax of 8,000 DA/Nm3 (art. 52).
The repair and adaptation of installations to the
new standards should be implemented within a period
of seven years.
Applicable law settlement of disputes
Thanks to the modifications introduced to the
previous law, in the event of any disputes arising from
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First level L1 70
Second level L2 385
First level L1 30%
Second level L2 70%
the carrying into effect of research and exploitation
agreements, a recourse to international arbitration is
provided for the settlement of such disputes.
In case of failure of the conciliation procedure, art.
58 of the Law 05-07 clearly states that the dispute may
be submitted to international arbitration, in conformity
with the arbitration clause of the research and/or
exploitation agreement, so as to permit the settlement
of disputes in the manner chosen by the two
contracting parties. However, when Sonatrach is the
only party, the dispute is settled by arbitration of
the Minister in charge of Hydrocarbons. The law to be
applied is the Algerian Law 05-07 relating to
hydrocarbons and the texts issued for its application.
12.7.2 Libya
Sovereignty on the oil resources and property
and titles of them
The 1955 Hydrocarbons Law No. 25 states in art. 1
that hydrocarbons found in their natural state in the
subsoil layers of Libya are regarded as state-owned
property.
This sovereignty of the state over hydrocarbon
resources intends to preserve – to the best of its ability
– the wealth of the country for the Libyan people’s
profit and to promote oil activity as a catalyst of the
Libyan economy.
To this end – and to achieve the state’s goals – the
opening of the country to foreign companies is the key
to success. This policy can, in no case, be in
contradiction with the principle of the state’s
sovereignty over the oil resources. It constitutes a
means of reinforcing the state’s presence and its major
concern which is to develop the country.
This principle is underlined in the contracts of
exploration and production sharing, concluded with
the Libyan National Oil Company (NOC). A
provision, integrated in this type of contract, stipulates
that the contract signature does not give to the
contracting state company any right of ownership on
in situ hydrocarbons, extracted within the perimeter
covered by the exploitation and production sharing
contract.
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
The underground oil resources are the property of
the state which disposes freely of them for its citizens’
profit.
From the reading of Law No. 25/1955 it can be
seen that exploitation of oil resources is carried out
according to three titles: prospecting licence; contract
of privilege; and contract of exploration and
production sharing, provided for by Decree 10/1979 of
5 August 1979, supplementing the Hydrocarbons Law
of 25 November 1955. These titles are granted to any
oil company wishing to carry out activities in the
hydrocarbons sector in the territory of Libya (the
‘holder’).
Structure of hydrocarbon regulation
The prospecting licence
Any hydrocarbon activity is subject to prior
agreement of the state through its Council of
Ministers.
The 1955 Hydrocarbons Law distinguishes
between the prospecting licence and the contract of
privilege.
Prospecting is subject to an application to the
Ministry of Oil which reserves the right to give
favourable advice to this application. The acceptance
by this competent authority will be materialized
through the granting of a licence for specified zones
for a limited duration. As a counterpart of this grant,
the holder will have to pay a tax of 500 Libyan dinars.
In no event does the prospecting licence give the
right to its holder to carry out drilling and/or research
activities. Any contrary step will result in depriving
the holder of the right to prospect, and make the
aforesaid granted licence subject to cancellation by the
Ministry.
The contract of privilege
In so far as the activities such as drilling, research
and others are concerned, these must be subject to a
contract of privilege. In this case, the Ministry for Oil
publishes – through local and international press – an
official statement relating to the oil zones eligible for
an application for a contract of privilege. The contract
of privilege gives its holder the right to carry out
geological and geophysical prospecting, research,
drilling works and to extract hydrocarbons from the
perimeter defined by the contract. Moreover, the
holder will have the right to carry out the transport of
the extracted hydrocarbons by pipes or other means
and, in general, to carry out their refining, storage,
export and use.
In order to bring the contract of privilege
operations to a successful result, the contract holder
will have to carry out investments in the project and
728
make sure that the execution of its contractual
liabilities is in conformity with the standards and uses
on the matter, namely: extract hydrocarbons in
sufficient and reasonable quantities, subsequent to
their discovery, by taking into account the world
demand and the oil resources economic use within the
contractual perimeter.
The contract of exploration and production sharing
The contract of exploration and production sharing
is concluded between NOC and a foreign company
operating in the hydrocarbon sector and carrying out
its activity in the Libyan territory. The contract of
exploration and production sharing is concluded in
accordance with the provisions of Law No. 25/1955
which lays out that all hydrocarbons located in Libya’s
territory are the state’s national wealth. As to NOC, the
company holds the exclusive right and authority to
develop and produce hydrocarbons within and beyond
the contractual perimeter.
The contract of exploration and production sharing
concluded between NOC and the foreign company
must be approved by the General Popular Committee
of the Libya Jamahiriya. The object of the contract
relates to the hydrocarbons exploration and production
sharing within the contractual perimeter. The contract
does not give any right of ownership to third parties on
the hydrocarbons located within the contractual
perimeter. Moreover, in addition to the determination
of the hydrocarbons produced and reserves quantities,
the exploration and production sharing contract also
takes care of the financing of the operations led within
the contractual perimeter, as well as the nature of the
operations and the conditions under which those will
have to be carried out.
The contract of exploration and production sharing
has two phases – a first phase of exploration and a
second of exploitation. At the expiry of the exploration
period, the holder will preserve only the lots having
given commercially exploitable results.
During the exploitation period, the contract holder
– as long as it has carried out the work programme as
well as the minimum expenditure programme – can
proceed to the cancellation at any time – provided that
NOC has been notified with one year’s notice prior to
the cancellation date. The exploitation perimeter
contract will thus be considered as legally terminated.
Any amount due on account of the perimeter
exploitation will consequently be due and payable on
the contract cancellation date.
During the notice period, the holder will continue
to enjoy the totality of the rights which were granted to
him by the contract of exploration and production
sharing and will have to carry out all its obligations
without limitation, including the budgetary
ENCYCLOPAEDIA OF HYDROCARBONS

expenditures and/or those approved by the Committee
of Management. The contract holder’s withdrawal can,
in no case, discharge it from its contractual liabilities
towards NOC, nor exempt it from the execution of any
obligation or responsibility which would be
attributable to it and which were not identified or
could not have been identified before the holder’s
withdrawal from the exploration and production
sharing contract.
The contract of exploration and production sharing
provides for the setting up of management committees
in charge of the control and supervision of the
operations carried out within the framework of the
contract. These committees, which are made up of four
members (two members appointed by NOC, and two
by the holder), must be set up within a period which
should not exceed one month following the effective
date of the exploration and production sharing
contract.
The Committee of Management has the power to
take any important decision relating to the
hydrocarbon operations including, without limitation,
the approval of the programmes of works as well as the
relevant budgets. The decisions of the aforementioned
committee are unanimously made. The Committee of
Management is the body charged to declare a
commercial discovery. When the Committee
of Management declares that a hydrocarbon discovery
is commercially exploitable, the contracting parties
conclude a shareholders’ agreement: according to its
terms, a company, which should act as operator, will
be set up and will take charge of the operations of
development and exploitation under the name and on
behalf of the contracting Parties. This is in accordance
with an agreement related to the carrying out of
operations concluded between the same parties.
The operator will have to carry out its activity
within the framework of the laws and regulations in
force in Libya. It should be noted that in a company of
Libyan law, created in accordance with the contract of
exploitation and production sharing, the operator, by
all means, engages its responsibility towards the
shareholders in case of loss, damage or complaints of
any nature. The operator is not, in any case,
responsible for the indirect effects related to any loss
or damage. The operator will have to submit a
programme of work for the Management Committee’s
approval, as well as a budget for each year of the
exploration period. Moreover, he will have to submit
for approval a programme of work, as well as a cost
report for the next four years during the exploitation
period. The operator will be charged to carry out the
work programme and budget submitted to the approval
of the Committee of Management, and will not be able
to launch or to carry out any operation which would
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not appear in such a programme, except for the cases
which will be stated in the contract and submitted to
the authorization of the Committee of Management.
In all cases, the foreign party of the shareholders’
agreement will have to pledge a minimum of
exploration work in order to support the programme
of exploration.
In the contrary case, it will have to pay to NOC
compensations and allowances due to the fact that the
exploration programme was not completed.
The operator will have to present a detailed report
of the discoveries carried into effect within the
contractual perimeter and declared commercially
exploitable, for the approval of the Committee of
Management. Moreover, before marketing any
quantity of hydrocarbons produced, the operator will
have to submit a programme to the Committee of
Management.
The contract of exploration and production sharing
envisages the setting-up of the Committee of
Management in charge of hydrocarbons production
control to assess the yearly quantities the operator
would have estimated and delivered to the parties for
the period beginning with the commencement of the
production marketing.
Each party has the right and the obligation,
jointly or separately, to proceed with the sale of its
production share and to freely dispose of it.
The production sharing will be carried out in
accordance with the provisions and terms agreed upon
in the exploration and production sharing contract.
It should be noted that all expenditure related to
the production operations are the exclusive
responsibility of the contract holder. The exploration
and production sharing contract is governed by the
Libyan law.
Operating conditions
The operation of the oil activity, such as it is stated
by Law No. 25/1955, has to meet a certain number of
conditions, as follows.
Surface area. For the purpose of the application of
the 1955 Hydrocarbons Law provisions, the Libyan
territory is divided into four oil zones: section 1 covers
all the provinces of Tripoli and the Western mountain,
the az-Zawiyah, Homs and Misratah; section 2 covers
the provinces of Benghazi, the Green hill and Darna,
located at the North of parallel 28; section 3 covers the
provinces of Benghazi, the Green hill and Darna
located at the South of the parallel 28; and section 4
covers the provinces of Sebha and Oubari.
Renunciation. The holder of the contract must
reduce 75% of the initial surface of the contractual
perimeter within five years as from the date of the
contract enforcement. A second reduction of 50% of
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
the initial surface will have to be operated within eight
years, starting from the aforementioned date.
Moreover, a third reduction of 30% of the initial
surface is envisaged for the perimeters situated
between zones 1 and 2, and 25% of its total surface for
the perimeters situated between the zones 3 and 4 and
within 10 years from the contract enforcement date.
The contract holder will have to notify a written
advise to the Ministry of Oil one month prior to any
renunciation relating to the perimeters to be given up.
The contract holder can, at any time, give up the
totality or half of the contractual perimeter, provided
that it communicates this to the Ministry of Oil by
addressing a written notice at least three months prior
to any renunciation.
The contract holder is free to choose the surfaces
which it will renounce, in the cases quoted above,
respecting the following conditions. First, the surface
– object of the renunciation – consists of one whole
piece. The pieces forming the area object of the
renunciation can be two if the surface of the
contractual perimeter exceeds 12,000 km2. This is
unless the Minister in charge of Oil stipulates
otherwise, in conformity with the legal provisions.
Second, the surface subject to renunciation is
delimited by the lines mentioned on the official chart,
established by the ministry and attached to one or
several pieces of the contractual perimeter, unless the
Minister in charge of Oil stipulates otherwise in
conformity with the legal provisions.
The notification of renunciation will have to be
accompanied by an official chart established by the
Ministry of Oil of a detailed plan indicating the
surfaces which the holder intends to give up, while
specifying those that it wishes to keep.
The contract of privilege holder continues to enjoy
the rights and advantages granted to him over the
contractual surfaces which it did not give up. The
rights and advantages concerning the surfaces which
the holder gave up will cease to exist. It is the same
for the applicable liabilities, except those relating to the
holder’s claims to those surfaces which he did not yet
give up.
Programme of works
In conformity with the law, the holder of the
contract of privilege must, within eight months as
from the date of granting the privilege, carry out
hydrocarbon prospecting works within the contractual
perimeter. Moreover, it must promptly implement the
work imposed by the contract, in accordance with the
requirements of the applicable code of practice and the
related technical precepts, and by adopting the
adequate scientific processes. In order to achieve the
goals mentioned in the contract of privilege, the holder
730
will have to carry out the programme of minimum
expenditures provided for by the contract, whether
these expenditures are made in Libya or outside its
territory. The aforementioned expenditures cannot, in
any case, be lower than the sums mentioned below
(see further), relating to the minimum programme of
works. Such programmes mainly concern prospecting,
research and drilling works, including expenditures
relating to these works and to the general and
administrative organizational costs, as well as other
general expenditures.
These expenditures are distributed as follows.
For the contracts of privilege granted in zones 1
and 2: an average of 1.50 Libyan dinars per annum,
per km2, during the first five years, and involving the
totality of the surface of the piece granted in the
concerned zone; an average of 3.50 Libyan dinars per
annum, per km2, during the following three years, and
involving the totality of the surface of the piece
granted in the concerned zone; an average of 6.00
Libyan dinars per annum, per km2 for each five-year
period. This tariffing is applied to the totality of the
piece surface of the concerned zone.
For the contracts of privilege granted in zones 3 or
4, an average of 1.50 Libyan dinars/year per km2
during eight years for the totality of the piece surface
in the concerned zone; an average of 3.50 Libyan
dinars/year per km2 during the following four years
and covering the totality of the piece surface in the
concerned zone; an average of 6.00 Libyan dinars
/year per km2 for each of the five-year periods. This
tariffing is applied to the totality of the surface of the
piece in the zone concerned.
The whole sum spent by the holder during each
work period concerned which exceeds the minimum
amount fixed for the aforementioned period will be
carried forward with the companies’ profit, in
accordance with the exchange regulations in force for
any such period.
If it appears to the Ministry of Oil after expiry of
half of one of the above-mentioned work periods, that
the contract of privilege holder failed in its obligations
in an oilfield zone, the Ministry can require the holder
to present an insurance under the form of financial
titles or banking guarantees for an amount which will
not exceed the total of the sums which it was
committed to spend in the aforementioned zone.
At the end of the aforementioned period, a
requisition of this insurance can be made by the
Ministry for Oil, as to the amount of expenditure
which the contract of privilege holder failed to spend.
State participation
The Libyan state takes part in the oil activity
through NOC.
ENCYCLOPAEDIA OF HYDROCARBONS

Indeed, the NOC plays an important part in the
hydrocarbons sector of Libya. Any foreign company
wishing to carry out an activity in the sector of
hydrocarbons must – besides its registration as a
foreign subsidiary company by the General
People’s Committee of Foreign Relations and
International Cooperation – be recorded at the Office
For Foreign Companies at the NOC.
The wide nationalization programme of the oil
companies sector, launched by the Libyan authorities
in 1972 and 1973, made it possible for the NOC to
acquire 51% of each company operating in the
hydrocarbons sector in Libya at that time.
The participation of the state, through the NOC,
has developed even more thanks to the concession of
exploration commonly called round of exploration,
for which all the agreements of hydrocarbons
exploration are signed between the foreign oil
companies and NOC. The latter makes it possible for
the Libyan state to follow and exert control over
foreign companies operating in Libya. Indeed, NOC is
given the responsibility of choosing the companies
which may be authorized to operate in Libya. NOC’s
choice is made on the basis of a meticulous
examination of the registration file.
Oil and gas pricing
The price for Libyan crude oil is fixed on the basis
of the open market price for full cargo individual
commercial sales, and takes into account
the contractual provisions concluded between the
Ministry for Oil and the contract of privilege holder.
However, if there is not an open market for the
commercial sales for full Libyan crude oil cargo, the
prices will be equitably fixed by agreement between
the Ministry and the contract of privilege holder.
In the absence of an agreement, crude oil prices
will be calculated in terms of class and quality
practised by other open markets, while making the
necessary adjustments for loading and insurance
expenses.
In the event of any change in the conditions or
bases for fixing crude oil and by-product prices in
the market, the Minister for Oil can decree the
fixing of crude oil and by-product prices, while
observing market rates as well as the advantages of
the Libyan crude oil. In such a case where the
contract holder disagrees with the approach adopted
by the Libyan authorities in order to fix prices, the
government will be able to proceed with the selling
of the crude oil and its derivatives to any other
purchaser. Therefore, the contract holder will record
its income resulting from the exported oil crude
or its derivatives, according to the prices fixed by a
decision of the Minister for Oil.
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ALGERIA, LIBYA AND TUNISIA
The tax structure
The Hydrocarbons Law No. 25/1955 also foresees
the payment of taxes, rents and royalties. The contract
holder must, for each contract governed by the
provisions of the Law No. 25/1955, pay the following
taxes, rents and royalties:
• A tax of 100 Libyan dinars for each km2 of the
contractual perimeter and a corresponding amount
for the period of the granted privilege contract.
• An annual rent for 100 km2 of the contractual
perimeter and a corresponding amount, in the
following way: a) for pieces in zones 1 and 2: 10
Libyan dinars, for each of the first eight years of
the contract; 20 Libyan dinars for each of the seven
following years. However, if the contract holder
makes a hydrocarbon discovery in commercial
quantities during the above 15 years, the amount of
the rent is immediately raised to 2,500 Libyan
dinars/year for the remaining period. This same
rent amount is calculated for the year of discovery;
b) for pieces in zones 3 and 4: five Libyan dinars
for each of the first eight years of the contract; 10
Libyan dinars for each of the seven following
years. However, if the contract holder discovers
hydrocarbons in commercial quantities during the
aforementioned 15 mentioned, the rent is
immediately raised to 2,500 Libyan dinars/year for
the remaining duration of the contract. This same
rent amount is calculated for the year of discovery;
c) 3,350 Libyan dinars for each of the five year
periods, starting from the end of the fifteenth year
up to the end of the twentieth year of the granted
contract; d ) 5,000 Libyan dinars for each
remaining year of the contract.
• A royalty equal to 16.67% of the total value of
the natural gasoline field which the privilege
contract holder obtains in the contractual
perimeter as well as the oil (except for natural
gas) extracted and preserved on the oilfield site,
after separation of water and deduction of the
quantities of oil, petroleum products and natural
gasoline used by the contract holder when
executing his works programme in accordance
with the contract provisions. The royalty ratio of
natural gasoline and oil (except for crude oil
and natural gas) is calculated according to
guidelines occasionally modified by the Ministry
for Oil and the contract holder. With regard to
the natural gas extracted within the contractual
perimeter that the contract holder sells and
delivers in Libya, a royalty of 16.67% of the
selling price – from which will be deducted the
costs of transport starting from the well – will be
paid by the contract holder and will not be
reimbursed by the purchaser.
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
• A royalty equal to an amount of 16.67% of the
price of the natural gas extracted within the
contractual perimeter and exported from Libya by
the contract holder.
In that case, the natural gas price is fixed according
to the price of the selling place, after deduction of any
taxes, interests, and transport charges from the wells,
paid by the contract holder and which will not be
reimbursed by the purchaser.
The Ministry for Oil has the right to the royalty for
each year in cash – in whole or in part – provided that
it will address a written notice to the contract holder to
that effect. Each quantity of oil or natural gas that the
Ministry for Oil decides to allot to itself must be
delivered by the contract holder aboard ship at the
navigational limit point in Libya.
The amount of royalty due for the perimeter object
of the contract of privilege for each year is offset by
the amount of the yearly rents paid for the
aforementioned year, provided that these rents are not,
in any case, lower than 2,500 Libyan dinars for each
100 km2 surface.
All taxes, land rents, royalties and additional taxes
pursuant to the Hydrocarbons Law of 1955, as well as
income tax, are payable to the Treasury, through the
Ministry for Oil.
The amount of income due to the Ministry for
Oil and any other Libyan governmental authority
or to the communes or other authorities, central or
local, resulting from production, industrialization,
collaboration in the hydrocarbons field, as well as
the related rights such as transport, sales, exports,
loadings, the yielded profits and their sharing, and
that of the crude oil produced or sold in Libya or
exported from it by the privilege contract holder
will be equivalent – for each complete commercial
year – to the sum the Libyan government has the
right to cash in yearly, calculated in accordance
with the privilege contract, taking into account any
modification in accordance with Hydrocarbons
Law No. 25/1955. However, an exemption from
certain taxes on imported and exported goods is
granted.
The licensee or the contract of privilege holder
(akin to his collaborators) are authorized to import
without payment of customs taxes the following items:
apparatus, machines, materials and products; and
goods according to their designation, in agreement
with the Customs Code. The exemption from customs
taxes is applicable, provided that the aforementioned
imported materials and equipment are intended for
their use in Libya within the framework of
hydrocarbons prospecting, research, drilling,
extraction, transport and filtering or any other related
operation.
732
This tax exemption is not applicable for the
equipment which is already in Libya, and the price of
which approaches and/or does not exceed the actual
value. Thus, at the time of comparing the prices, it is
necessary to add to the goods prices such as the
customs tax, as well as the other overheads until their
point of destination in Libya.
The other goods, which are subject to customs
duties, in accordance with the Customs Code, may not
be exonerated from the taxes in question. Any person
wishing to sell imported goods, free of customs taxes,
in accordance with para. 1 quoted above, or transfers
its property, will be liable to present a declaration to
customs before selling or transferring the property in
question. Moreover, if import taxation is required
according to the Customs Code, such persons will
have to pay a tax fixed by the Customs General
Manager. This is unless the property sale or transfer is
operated for the benefit of a licensee or a contract of
privilege holder enjoying the aforementioned
exemption.
The oil and its derivatives extracted in Libya,
as well as the goods imported which are exempt
from customs duties, in accordance with para. 1
quoted above, can be exported exempt from
customs duties and obtain an import export
licence. This is in accordance with the state’s
general policy related to importation, without
derogating from the legislative restrictions
required by the state on production in case of
wars and other major events.
The oil agreement
Authorizing one or more companies to carry out an
oil activity in Libya is subject to a contract of privilege
signed between the Ministry for Oil and the applicant
company/ies.
The Ministry for Oil grants contracts of privilege
which state the oil activity control procedures. Details,
such as the additional interests and advantages offered
by the applicant can be added, as long as they make it
possible to reduce the rights, interests and advantages
in terms suitable for the Ministry for Oil in conformity
to Hydrocarbons Law No. 25/1955.
Before granting the contract of privilege, the
Ministry for Oil will require the applicant to make a
statement of honour, committing him to abstain from
any political activity in Libya. The Ministry for Oil
(before granting the contract of privilege) can require
from the applicant guarantees in the form of banking
titles or warranties of a specified amount, not
exceeding the sum of 50,000 Libyan dinars, in order to
guarantee the good execution of the obligations
stipulated in all the contracts of privilege delivered in
Libya.
ENCYCLOPAEDIA OF HYDROCARBONS

The aforementioned sum is fixed for the duration
of the contract of privilege. The General Manager of
the Customs will have to keep this sum as a necessary
guarantee, as provided for in the Customs Code.
The contract of privilege is issued for the duration
fixed by the applicant in his request, provided that it
does not exceed fifty years. This duration can be
extended but cannot exceed sixty years.
In conformity with the provisions of the
Hydrocarbons Law No. 25/1955, no contract of
privilege can be issued for a perimeter included in
another granted contract of privilege. The Ministry of
Oil can grant contracts of privilege which bring
together joint areas, located in two or more of the oil
zones.
The limits of the zone object of the contract of
privilege – delivered in accordance with the provisions
of the Hydrocarbons Law No. 25/1955 – should
conform to the boundaries indicated in the chart
established by the Ministry for Oil.
The maximum number of contracts of privilege
and surface areas the holder is authorized to gather
together in one time is as follows: three contracts of
privilege in zones 1 and 2; four contracts of privilege
in zones 3 and 4, while knowing that the Ministry of
Oil can issue contracts of privilege exceeding the
authorized number. Thus, it must carefully examine
the requests which are addressed to him and the
perimeters object of the contracts of privilege.
The perimeters which contain oil and gas wells are
not taken into account when calculating the maximum
limits: 30,000 km2 in the zones 1 and 2 and 80,000
km2 in zones 3 and 4.
The contract of privilege holder is allowed to
penetrate the non-granted areas located at the
contractual perimeter borders; that is those areas not
having an owner. The holder can occupy them without
financial compensation with an aim to carry out his
work, provided that they are not legally occupied by a
third party.
However, if the contract of privilege holder does
not conclude a friendly arrangement with the owner of
the ground or his legal occupant, on the conditions
allowing him to occupy this real estate, the contract
holder must inform the authority.
In the event of the occupation of this real estate
being for a period which does not exceed one year, the
authority will be able to authorize its occupation
temporarily, provided that the contract of privilege
holder has given to the Ministry for Oil a sum of
insurance – the amount of which is to be estimated by
the authority. This insurance will be regarded as
financial compensation for the owner or the legal
occupant of the real estate in the event of
non-utilization or the suffering of damage.
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
ALGERIA, LIBYA AND TUNISIA
If the occupation of the real estate exceeds a period
of one year, the Ministry for Oil will be able to
authorize the contract of privilege holder to occupy the
real estate, provided that it has paid the fixed
allowance amount due to it.
The Ministry for Oil will have to take all necessary
steps to make it possible for the contract of privilege
holder to take possession of the real estate in
accordance with the provisions of the law in force. In
this case, the company’s deeds would be considered
similar to the public interest deeds.
If litigation arises on the nature of the right of
people over this real estate or over the compensation
amount that the contract of privilege holder must pay,
the Ministry for Oil will submit the litigation to the
competent jurisdiction in order to evaluate the amount
allowance. The Ministry for Oil will pay the sums
fixed by the court.
The contract of privilege does not give any right to
its holder to carry out works on the reserved
cemetery areas, the spot of specific places of prayer and
archaeological sites. All the artistic and archaeological
parts, discovered by the contract of privilege holder
are subject to the controls set out in the Hydrocarbons
Law No. 25/1955.
Drilling operations as well as dangerous works, at
a distance of less than 50 m from public places or
buildings cannot be authorized without the Director’s
agreement and after having taken all precautions
required in this matter.
Investment protection
and environmental protection
The hydrocarbons sector constitutes the engine of
the Libyan economy. It benefits from the
Hydrocarbons Law No. 25/1955, which highlights the
interest and importance attached by the Libyan state to
this sector and the efforts it deploys to protect the
investment in this field.
The distinction between the hydrocarbons sector
and other activities as it appears from the provisions
relating to investments, allows to note that the oil
activity is the main anchoring point of foreign capital.
The Libyan state, conscious of this importance and the
determining role that the oil industry plays in the
development of the country, has been able to
attract, thanks to the Oil Law, several foreign investors
through rounds of exploration.
For all these reasons, the Hydrocarbons Law No.
25/1955 was promulgated with the aim of attracting
the foreign investors in offering them many
possibilities of investment and development.
The provisions of the Hydrocarbons Law, No. 25,
suggest that the legislator took care of the foreign
investments protection by: exonerating the contractor
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
from certain taxes on imported and exported goods;
granting oil transport facilities by pipeline; granting
the possibility to the contractor to build a factory for
refining its extracted oil.
As a complement to these advantages, one must
add the increasing desire of Libya to dynamize oil
exploration by proposing blocks to foreign companies,
through the means of ‘round of exploration’, for which
contracts of Exploration and Production Sharing
Agreement (EPSA) are signed with NOC.
The characteristic of the Round of Exploration, is
that the costs of exploration are refunded by the
production. The production costs are shared between the
alien company and NOC (oil cost), and the sales products
are given on the basis of a variable scale (oil profit).
The provisions for environmental protection can be
seen in the guise of a certain number of measures that
the company holding the contract of privilege must
respect.
The measures imposed by the 1955 Hydrocarbons
Law concern only what must be taken care of after,
and not before, the undertaking of activities. It
essentially concerns site repairing, draining and
closing of all the drilling points and wells before their
abandonment.
Regulations regarding currency exchange
The company is subject to the exchange control
system in force in Libya as follows:
• Within the limit where amounts exceed the
company’s needs for its activities in Libya, the
company has the right to keep abroad any sum
available to it, including the receipt of the sales.
However, the company must present at the Office
of Central Exchange of Libya its currencies
account statements or its Libyan oil sales assets.
• The company can transfer the exceeding sums
which it will not use within the framework of its
activities in Libya to the countries from which it
received these sums for its activities, provided that
this transfer takes place in the currency of these
countries.
• The company has the right to sell or buy any
currency, be it Libyan or other, at suitable rates of
exchange, through authorized exchange offices.
This will make it possible for the company to
undertake its activities in Libya and carry out the
transfer quoted above.
• No restriction is required for the company’s
currency import, with an aim of carrying on its
activities related to the contract implementation.
The applicable law and settlement of disputes
The Libyan government makes sure that oil
operations are controlled well, as it has multiple oil
734
contracts with oil companies. It therefore takes all
necessary measures to guarantee the company’s
contractual rights. These contractual rights, clearly
stipulated in the contract, cannot be modified without
prior agreement of the two parties.
However, during the contractual period, the
interpretation of the contract will be made in
accordance with the provisions of the Hydrocarbons
Law No. 25/1955, and the regulations promulgated
during the contract validity.
No modification or cancellation of these
regulations will be applied to the company’s
contractual rights without its prior written
agreement. The Libyan law will be that applicable
to the contract.
Litigations opposing the Libyan state to the holder
arising out of the interpretation and/or execution of the
contract provisions or its appendices, or the rights and
obligations of one of the contracting parties, for which
the amicable settlement has failed, will be made
subject to arbitration.
Two arbitrators will be designated; one by
each of the parties. The latter will choose a
President. In the event of disagreement, as for its
designation, and within sixty days from the date
of the nomination of a second arbitrator, each
party will be able to file a recourse to the
President of the International Court of Justice or
its representative (if the President is Libyan or
citizen of one of the countries in which the
company was created) to designate it.
The arbitration procedure will begin after deposit
of a written request for arbitration by one of the
parties, in which the object of the arbitration as well as
the name of the arbitrator designated by this party will
be mentioned.
The other party upon receipt of a copy of this
request by its counterpart will have ninety days from
the date of its receipt to designate an arbitrator,
under the penalty that the other party will request the
President of the International Court of Justice to carry
out the designation of only one arbitrator. The latter’s
decision will be binding for both parties.
The President of the Arbitration Board, or the
single arbitrator can in no case be a Libyan citizen or a
citizen of the country in which the holder was
incorporated or a citizen of the country of the
company which controls it.
In the event of the two party-appointed arbitrators
not coming to an agreement regarding the decision
of the dispute within six months from the beginning of
the arbitration procedure, the President of the
Arbitration Board will intervene in this procedure. The
parties will be bound either by its decision or by that
of the single arbitrator.
ENCYCLOPAEDIA OF HYDROCARBONS

12.7.3 Tunisia
Sovereignty over hydrocarbons resources
All hydrocarbon deposits localized in the Tunisian
subsoil territory and in the Tunisian off-shore territory
form part of the Tunisian state’s public domain as
national wealth. This is stipulated in art. 4 of Law
99-93 of the 17th August 1999, relating to the
promulgation of the Hydrocarbons Code.
The introductory text of the Tunisian Republic
Constitution stipulates that the exploitation of wealth
should be carried out for the benefit of the nation. This
principle can be interpreted in a way that wealth is not
the direct and absolute ownership of Tunisia but that
its exploitation by third parties should be carried out
for the benefit of the Tunisian nation.
However, sovereignty of the Tunisian state over
oilfields is made less stringent by the fact that
prospecting, research and exploitation activities, in
addition to their being undertaken by the state, can
also be undertaken by foreign private undertakers
(the ‘undertaker’), provided that the latter possesses
the financial and technical resources to implement the
activities.
The impact of the Tunisian sovereignty over its
oilfields appears clearly in the order of priority use of
the natural gas produced in Tunisia. Thus, art. 65 of
Law 99-93 mentions that gas use is subject to the
following order of priority: its use by the holder of the
permit; meeting the Tunisian domestic market needs;
and export.
Ownership and title to hydrocarbon resources
Pursuant to the Tunisian legislation (Law 99-93
relating to the promulgation of the Hydrocarbons
Code), the hydrocarbons mining titles are: a) the
authorization of prospecting; b) the permit of
prospecting; c) the permit of research; d ) the
concession of exploitation; e) the production sharing
contract.
Any hydrocarbons research, prospecting and
exploitation activity undertaken in Tunisia cannot be
initiated without prior granting by the authority, and
obtention by the operator, of one of the
aforementioned titles.
Prospecting authorization
The authorization of prospecting is governed by
art. 9 of the Hydrocarbons Code. It allows the holder
to implement preliminary prospecting works,
excluding all seismic surveys drilling operations. In
the event of the authorization holder proceeding with
works other than those for which it has a right,
the prospecting authorization can be cancelled by the
granting authority.
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
ALGERIA, LIBYA AND TUNISIA
The prospecting authorization is granted by the
Minister in charge of Hydrocarbons, and is issued for
a period not exceeding one year. The granting of the
prospecting authorization is not exclusive. Indeed, in
the same prospecting area, the authorization can be
granted to several applicants. Moreover, the
prospecting authorization may be subject to the
granting of an area covered by other titles, notably by a
prospecting permit or a research permit.
When the validity period of the prospecting
authorization expires, the holder of the authorization
or the applicant must submit to the granting authority
– namely the Minister in charge of Hydrocarbons – a
full copy of all the surveys carried out and the
information collected by the works done in the
relevant area.
The failure to respect the obligation by the
applicant to provide surveys and tests carried out
during the validity period of the prospecting
authorization will lead to penalties for the applicant. In
this case, the applicant will not be able to obtain either
a prospecting permit or a research permit, nor will the
applicant be able to hold shares in valid permits or
concessions.
The prospecting permit
The permit of prospecting is governed by art. 11 of
the Hydrocarbons Law and is granted by the Minister
in charge of Hydrocarbons by means of a decree, after
consulting and receiving corresponding advice from
the Hydrocarbons Consultative Committee. This is
delivered for a period of two years. This duration can
be extended for twelve months by decree of the
Minister in charge of Hydrocarbons when
the application is made by the permit holder and the
Hydrocarbons Consultative Committee grants its
favourable advice to the extension of the prospecting
permit duration.
The prospecting works could be carried out by the
Tunisian state itself, but the prospecting permit may
also be delivered to Tunisian or foreign public or
private companies which own the financial and
technical resources necessary to carry out prospecting
works in the best conditions.
Contrary to the prospecting authorization, the
prospecting permit cannot be issued for the carrying
out of prospecting works within an area already
covered by a prospecting permit, a research permit
and/or an exploitation concession which are prior in
time to the prospecting permit.
The works authorized by the prospecting permit
are geological or geophysical works, excluding drilling
operations. The whole prospecting works should be
carried out exclusively within the limits of the area
defined by decree of the Minister in charge of
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
Hydrocarbons. The failure to respect the provisions
related to the nature of works authorized by the
prospecting permit may involve the cancellation
of the prospecting permit. The Minister in charge of
Hydrocarbons issues a decree of cancellation of the
prospecting permit after having heard the holder
thereof on the infringements imputable to him and
after receiving the Hydrocarbons Consultative
Committee’s advice.
The prospecting permit is granted with the aim of
implementing prospecting works for the whole
elementary perimeters, stipulated in art. 13.2 of the
Hydrocarbons Code as being perimeters of square
form, each one having a surface of 4 km2. The
elementary perimeters sides are oriented according to
the North-South and East-West directions, composed
of portions defined by parallels and meridians. As to
summits of the elementary perimeters, they are
defined by marks, fixed case by case by Decree
published in the Tunisian Republic’s Gazette.
In addition, an application for a prospecting permit
is receivable only in the event of it relating to a surface
constituted by a whole number of elementary
perimeters. However, if the application of the
prospecting permit relates to an area delimited by an
international frontier constituted, partly, of elementary
perimeters, the holder of the prospecting permit has to
deliver to the granting authority (on the date of expiry
of the permit validity period) a copy of the seismic
surveys and all the information and data records which
might have been collected by it during the carrying out
of the prospecting works authorized by the permit.
The prospecting permit can, on request by his
holder, be transformed in a research permit provided
the holder applies to the granting authority, i.e. the
Minister in charge of Hydrocarbons, two months
before the expiry of the prospecting permit.
The research permit
The research permit is delivered by Decree of the
Minister in charge of Hydrocarbons, after consultation
and favourable advice of the Hydrocarbons
Consultative Committee. The said Decree is published
in the Tunisian Republic Gazette. The research permit
is granted for a period of five renewable years.
The research permit is granted by the authority
only to the applicants owning a real or elected
residence in Tunisia or, failing this, which have
previously appointed a representative residing in
Tunisia. This implements the Tunisian state’s will to
allow the execution of research tasks only to entities
equipped with certain means and established in Tunisia
in one form or another.
The research permit application is accepted only
when it is related to a surface constituting a whole
736
number of elementary perimeters. However, as it is the
case for the prospecting permit, the research permit
application is also receivable when the area, object of
the research permit, is delimited by an international
boundary and constituted by portions of elementary
perimeters.
When filing the research permit application, the
applicant commits itself to carry out a programme of
research work, in particular drilling and geophysical
works. The importance of the work programme is
related to the fact that the research permit is granted
on the basis of the financial and technical capacities of
the applicant of the research permit as well as the
nature and significance of the work programme
presented by him.
In the Tunisian legislation (Law No. 99-93 related
to the promulgation of the Hydrocarbons Code), the
research permit delivered by decree of the Minister in
charge of Hydrocarbons is governed by the Specific
Convention regulated by arts. 19-22 of the
Hydrocarbons Code.
The Specific Convention authorizes research and
exploitation of oilfields. This convention regulates the
whole operations related to the research permit
undertaken by the holder, and which are, directly or
indirectly, related to the research permit and the
concessions which are liable to be authorized at the
research works termination. The Specific
Convention will last as long as the research works
implementation will last, and in the case where these
research works happen to be profitable, its duration
will be extended for the time needed for issuing the
exploitation concession.
In accordance with the Specific Convention, the
research permit holder shall carry out a certain amount
of works on the perimeter applied for during the
period of the permit validity. The Specific Convention
confers to the holder the exclusive right to carry out
research works within the perimeter indicated in the
research permit, as well as the exclusive right to obtain
a concession following the carrying out of the works.
The Tunisian Law allows the holder of the research
permit to renounce the permit at any moment during
the permit validity period. Just as the holder has the
right to renounce the research permit, the granting
authority also has the right to cancel the research
permit in cases where the holder: a) does not meet the
financial and technical capacity required for granting
the permit; b) has purposely delivered false
information or inaccurate data in order to be granted
the research permit; c) has failed to carry out its
obligations relating to the research programme on
the perimeter applied for; d ) has not conformed to the
provisions of arts. 31, 34 and 61 of the Hydrocarbons
Code; e) has refused to take over the responsibilities of
ENCYCLOPAEDIA OF HYDROCARBONS

the rights and duties of one or several of the permit
co-holders who have withdrawn without yielding the
said rights and duties under the terms provided for
in the Hydrocarbons Code; f ) refuses to
communicate information in conformity with
arts. 63-64 of the Hydrocarbons Code, as completed
and defined by the Specific Convention; g) refuses
to conform to the measures which have been
prescribed by the head of the hydrocarbons services
(arts. 133-134 of the Hydrocarbons Code).
In order to meet the domestic hydrocarbon
consumption needs in Tunisia, the granting authority
has the right to buy, in priority, a portion of the liquid
hydrocarbon production extracted by the holder, or any
other third party acting on his behalf in the Tunisian
territory. Deliveries carried out for the benefit of the
conceding authority are considered domestic sales and
paid in Tunisian dinars, without prejudice to the
holder’s right to transfer the surplus quantity (as
provided in art. 182 of the Hydrocarbons Code).
The authority is also empowered to pronounce the
expiration, cancellation or renunciation of the permit
without releasing the holder from its liabilities related
to the exploitation. However, the Tunisian
Hydrocarbons Law grants the holder a preferential
right to carry on the exploitation in the same
conditions which have led the authority to decide to
accord the concession to third parties.
The holder is bound to carry out an impact
environment survey in conformity with the legislation
and regulations in force in Tunisia. This survey should
be approved in advance, at each phase of the research
and exploitation works. The holder should take all
appropriate measures to protect the environment and
respect the liabilities undertaken in the impact survey
as approved by the competent authority.
When a research permit expires (for any reason),
or in the event where the holder of an exploration
permit decides to put an end to the exploitation
activities in conformity with the provision of art. 118
of the Hydrocarbons Code, the holder of a research,
prospecting and/or exploitation concession is bound to
repair the surfaces returned and the abandoned
exploitation works in such a way that no prejudice will
affect third parties or the environment and the natural
resources.
The hydrocarbons selling price to be taken into
consideration for the calculation of the taxable profits
is equal to: the normal selling price, as defined by the
Specific Convention, for hydrocarbons to be exported;
and the real selling price for hydrocarbons sold on the
domestic market.
Moreover, the Specific Convention should contain
the provisions under which the operating concession
has been granted and notably: the rules that the
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licence-holder has to respect in order to
allow the delimitation of the conceded perimeter;
and the applicable procedures according to which
the licence-holder is liable to continue exploration
on the concession granted to it.
The Specific Convention should also determine the
cases of termination of the concession.
It is to be reminded that the Specific Convention is
signed, on the one hand, by the authority represented
by the Minister in charge of Hydrocarbons and by the
duly appointed representative of the research permit
holder, on the other hand. However, in the case of a
PSA, the Specific Convention is signed, on the one
hand, by the Minister in charge of Hydrocarbons and
by the titular state company and the undertaker
represented by duly appointed persons on the other
hand.
The Specific Convention is approved by Decree
published in the Tunisian Republic’s Gazette.
The holder of the exploration permit can apply for
its renewal, only if it has incurred totally the
expenditures and the works schedule provided for in
the Specific Convention.
If it has failed to do so, it may claim the renewal of
the permit to explore only after having paid to the
authority the amount representing the difference
between the amount of minimum expenditures to be
incurred or the amount necessary to the
implementation of works as provided by the Specific
Convention and the amount actually spent.
Pursuant to art. 30 of the Tunisian Code
of Hydrocarbons, the role of the Minister in charge of
Hydrocarbons is very important as to the exploration
permit. Thus, the Minister in charge of Hydrocarbons,
may extend the period of validity and/or the area of a
valid research permit on advice of the Hydrocarbons
Consultative Committee. The Minister is also endowed
with the power to extend that renewal for one year.
Moreover, he is entitled to authorize the holder to
modify the programme of works to be carried out
during the period of the exploration permit validity.
Following the advice of the Hydrocarbons
Consultative Committee, the Minister in charge of
Hydrocarbons lays down all these acts in a Decree to
be published in the Tunisian Republic’s Gazette.
The legal nature of the licences of exploration
and prospecting permits
These deeds are deemed to be movable and
indivisible according to the provisions of art. 33 of the
Hydrocarbons Code. Thus, the total or partial
alienation of the rights and liabilities issuing from the
exploration or prospecting permit is forbidden by
the Hydrocarbons Code, except when specifically
authorized by the authority.
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
The exploration and prospecting permits cannot be
granted, partially or totally, other than to a company
which fulfils all the criteria and conditions required by
the permit, and this following the authorization by the
Minister in charge of Hydrocarbons and conform
advice of the Hydrocarbons Consultative Committee.
In the case of a transfer of a permit to an affiliated
company, the granting authority should be notified.
The latter might require from the assignor or from the
parent company a covenant warranting the carrying
into effect of the licensee’s liabilities, notably with
regard to the implementation of the minimum works
commitment. The transfer of the exploration or
prospecting permits, under whatever form, should
forcibly be subject to a transfer deed established
between the assignor and the assignee.
In the case of a partial or total transfer of the
permits of exploration or prospecting, the permit
transferee should assume all the assignor’s covenants
related to the said permit(s), and will benefit from all
rights pertaining to the conceded surface, since the
date of the transfer coming into effect.
The transfer is authorized by a decree of the
Minister in charge of Hydrocarbons, which is
published in the Tunisian Republic’s Gazette.
Should the holder of an exploration permit wish to
reduce the surface it has been granted, it should notify
the authority of its intention to proceed by clearly
indicating the elementary perimeters which it intends
to abandon. In this case, the Hydrocarbons Code
provides that surfaces to be kept, for each renewal, are
not reduced due to the deliberate reduction of the
perimeter of exploration. Thus, minimum works and
expenditures incurred do not undergo any
modification in the course of each period of validity.
Moreover, the holder is authorized to operate
modifications related to the duration/ validity of the
exploration permit having the right to proceed freely to
the reduction of the relevant area, provided that it will
notify such reduction to the authority and will respect
the minimum works and expenditures to be incurred.
The surface and the remaining period of the permit
validity are fixed by decree of the Minister in charge
of Hydrocarbons.
The holder of the exploration permit may, at any
time, deliver a written statement of renunciation,
provided that it has fulfilled its obligations with regard
to the minimum works and expenditures during
the period of validity of the permit. This not being the
case, the holder may renounce the exploration permit
if it pays a compensation allowance equal to the
difference between the minimum amount of works and
expenditures to be carried out during the exploration
period and the amount which the holder had
undertaken to invest.
738
The exploration permit may be subject to
cancellation by the Minister in charge of
Hydrocarbons, after formal notice addressed to the
holder. This can occur in the instances where the
holder: a) does not fulfil the terms of the financial and
technical means required during the exploration permit
period; b) has deliberately provided false information
in order to obtain the exploration permit; c) does not
fulfil the requirements relating to the minimum works
and expenditures he has subscribed to; d ) has not
conformed to the liabilities regarding the starting-up
of the works, the concession of the exploration permit
and the surface repairing; e) as refused to take over, at
its own expenses, the rights and liabilities of one or
more co-holder of the exploration permit withdrawn
without yielding the rights and liabilities provided for
by the Hydrocarbons Code; f ) refuses to communicate
information of geological, geophysical, hydrological,
drilling and exploitation nature in his possession as a
quarterly and an annual report relating to the activities
and expenditures carried out within the framework of
the budgets and programmes communicated in
advance to the authority; g) refuses to conform to the
procedures set by the hydrocarbons Heads of
Divisions.
In the case of the exploration permit being subject
to cancellation, the permit holder must pay the
authority a compensating allowance similar to that
pertaining to the renunciation of the exploration
permit.
After expiration, cancellation or renunciation to the
exploration permit, the holder cannot claim to recover,
directly or indirectly, rights over the perimeters
concerned by the permit until the expiry of a period of
three years, starting from the expiration, cancellation
or renunciation date. This period can be reduced to six
months by the Minister in charge of Hydrocarbons, on
request of the holder, and subject to the conformed
opinion of the Hydrocarbons Consultative Committee.
The exploitation concession
The exploitation concession is granted to the
holder who, during the validity period of his permit of
exploration discovers an economically exploitable
hydrocarbons oilfield within his perimeter.
In conformity with the provisions of the Specific
Convention, a company possessing the necessary
technical and financial means may be authorized by
the Tunisian state to operate a returned, abandoned or
forfeited concession of exploitation, in conformity
with the terms already defined by the Specific
Convention.
Moreover, the Tunisian state is entitled to grant,
within the same framework, and according to the
provisions defined in advance, an exploitation
ENCYCLOPAEDIA OF HYDROCARBONS

concession relating to a discovery situated outside a
zone covered by a permit of exploration, prospecting
or a concession of exploitation to any company
owning the financial and technical capacities
necessary to the exploitation.
When the exploration or prospecting works result
in the discovery of a potentially exploitable
perimeter, and the holder has presented conclusive
production tests to the authority, the same is bound
– prior to any application for a concession of
exploitation – to carry out an appraisal programme
during a period which does not exceed three years as
to liquid hydrocarbon discoveries and four years as to
gaseous hydrocarbon discoveries. These periods start
from the date, notified to the Minister in charge of
Hydrocarbons on which the discovery is considered
as being potentially exploitable.
At the end of the appraisal works, and in case the
discovery is held to be economically exploitable by
the permit holder, the latter will have the right to be
granted a concession of exploitation relating
to the discovered oilfield.
Moreover, when the holder proves that the
discovery is not economically exploitable on its own,
its regrouping with other discoveries situated in one or
several permits of the same holder may be authorized
by the authority. The authority may authorize, for the
same reasons, the regrouping of discoveries situated
on permits granted to different holders.
The holder’s application for a concession of
exploitation cannot but concern a perimeter
constituted by a whole number of elementary
perimeters, which are all in one block, containing the
discovery and situated wholly within the perimeter to
which the concession belongs. However, an
application for a concession of exploitation is
receivable when its perimeter is delimited by an
international frontier and, therefore, by portions of
elementary perimeters.
At the risk of being declared void, the application
for a concession of exploitation introduced by the
permit holder should comprise: a) a covenant to
develop the hydrocarbons field covered by the
perimeter applied for; b) development programme
containing a geological and geophysical study of the
oilfield with an estimate of the existing reserves
and the proved recoverable reserves; c) a study
comprising the production methods considered and
the expected production profile; d ) an exhaustive
study concerning the installations necessary for
hydrocarbons production, processing, transport
and stocking; e) an economic study with a detailed
estimate of development and exploitation costs
setting out the economic value of the discovery;
f ) study on the staff needs including a training and
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recruitment programme of the local staff; g) a study
of the valorization of the liquid hydrocarbons
by-products and notably dissolved or associated gas,
Liquefied Petroleum Gas (LPG) and condensates;
h) study of security measures to be taken for the
staff, the protection of installations and the
population and environment protection, as well as the
plan for the carrying out of development works.
The concession of exploitation is granted by decree
of the Minister in charge of Hydrocarbons for a period
of thirty years starting from the date of its publication
in the Tunisian Republic’s Gazette.
The holder of the concession of exploitation enjoys
the exclusive right to undertake exploitation activities
within the surface of the perimeter of the concession.
Moreover, it is authorized to carry out exploration
activities of geological horizons other than those
which have given the right to the concession of
exploitation, such as appraisal works carried out in
order to check the extension of an oilfield before or
after its production start-up.
The exploitation concession holder shall freely
dispose of the hydrocarbons extracted; notably those
for export. It is subject to the payment of a royalty
proportional to the quantities of hydrocarbons
produced, in cash or in kind, according to the
authority’s choice and to the terms provided for by the
Specific Convention. The proportional royalty rate is
determined according to the net accrued income share
of each co-holder and related to each exploitation
concession.
Moreover, the holder is bound to contribute
to the supply of the Tunisian market in order to meet
the needs of the domestic consumption. In this
case, the authority has the right (with priority) to buy
part of the liquid hydrocarbons production extracted
by the concession holder. The amount destined
to the Tunisian market, to be bought by the authority,
is calculated as being 20% of the production from
each concession.
In the event of the authority exerting its priority
right of buying the concession holder’s production, the
latter is bound to assure the deliveries in question
according to the terms set by the notification and the
modalities defined by the Specific Convention. This
sale is carried out in Tunisian dinars, without prejudice
of the holder’s rights to transfer abroad the surplus
after its local needs have been met.
It should be noted that a concession of exploitation
granted in conformity with the provisions of art. 53 of
the Hydrocarbons Code, is considered movable and
indivisible. Thus, partial or total transfer of the rights
held by either of the co-holders of an exploitation
concession is forbidden, except by preliminary
authorization from the authority.
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
Total or partial transfer of the exploitation
concession can be carried out subject to the
preliminary authorization of the Minister in charge of
Hydrocarbons on corresponding advice from
the Hydrocarbons Consultative Committee. The
affiliated companies are exempted from this
authorization, but they are subject to an advance
notification of the transfer to the authority.
In the event of a transfer made subject to the
authority permission, the state company Entreprise
Tunisienne d’Activités Pétrolières (ETAP) will benefit
from the pre-emptive right to acquire the interest,
which is the object of the transfer. In this case, the
state company should (under penalty of preclusion)
notify the transferer of its decision to exert or not to
exert this right, within a period of thirty days
following the filing of the application of transfer by
the holder.
In the case of the exploitation concession being
granted to several holders, the withdrawal of one or
several among them does not involve the cancellation
of the exploitation concession.
The exploitation concession holder can, at any
time, reduce its area and notify its decision to abandon
the concerned elementary perimeters to the authority.
It can also give up the exploitation concession in its
entirety.
In the case of expiration, renunciation or
cancellation of an exploitation concession, the latter
returns to the granting authority, without discharging
the holder from its obligations. However, at the
expiration of the exploitation concession, the holder
will benefit from the preferential right to carry on the
exploitation according to the provisions and conditions
similar to those the authority would grant to third
parties.
Production sharing contract
The Tunisian state company can, within the
framework of its hydrocarbons prospecting, research
and exploitation activities, conclude service contracts
provided for in art. 97 of the Hydrocarbons Code
under the name of contracts of production sharing.
However, the state company has to obtain the
approval of the authority as to the appropriate time to
conclude a contract of production sharing. The same
procedure will be applied regarding the approval of
any modification of the contract of production sharing.
In order for a production sharing contract to be
concluded between the Tunisian state company and a
private company (the ‘undertaker’), the same will have
to be concluded on the basis of the following
principles: a) the research permit as well as the
exploitation concessions be granted to the state
company; b) the state company, in its capacity of
740
holder, concludes a production sharing contract with
an undertaker having proved evidence that it owns the
financial resources and technical experience necessary
to carry out research and exploitation activities; c)
the undertaker finances, at its own risk, the totality
of the research and exploitation activities for the
account and under the control of the state company;
d ) in the case of hydrocarbons production, the state
company delivers to the undertaker a certain quantity
of that production within the limit of a ratio fixed in
the production sharing contract, in order for the
undertaker to recover the expenditure it has carried out
within the framework of the contract; e) the state
company delivers to the undertaker, besides this, as
remuneration, a percentage of the remaining
production as agreed in the production sharing
contract.
State contribution
ETAP is the national petroleum company in
Tunisia through which the Tunisian state contributes to
the exploitation of hydrocarbon resources.
ETAP plays a determining role in the exploitation
of hydrocarbons in Tunisia. When filing an
application, any request for a permit of hydrocarbon
exploration in Tunisia must offer to ETAP an option to
participate in any exploitation concession ensuing
from such permit.
As to the exploration permit, this cannot be
granted to the applicant company except in the case of
a partnership with ETAP. The partnership quota of the
latter is determined between the parties in the Specific
Convention. However, the prospecting and exploration
works are at the exclusive expense of ETAP’s partner.
ETAP’s participation can be carried out in the form
of ETAP participation in the capital of a Tunisian
joint-stock company with its head-office in Tunisia, or
in any other possible form of participation. The deeds
related to ETAP’s participation as well as the
procedure and the conditions of its application are
submitted to the prior approval of the authority, under
penalty of cancellation. The said deeds are provided
for in art. 93 of the Hydrocarbons Code as ‘particular
agreements’. The particular agreements are approved
by decision of the Minister in charge of Hydrocarbons.
In the event of an exploitation concession, ETAP
has the right to opt for participation in a percentage
decided by itself, if this is within the limit of the rate
agreed upon in the specific contract. The option of
participation must be exercised by ETAP within six
months of filing the exploitation concession
application, or at any time agreed upon by the parties
in the specific contract.
Expenditures for exploration and/or prospecting
and appraisal carried out under an exploitation
ENCYCLOPAEDIA OF HYDROCARBONS

concession in which ETAP has exercised the option
of participation are borne by its partners. In
addition, in the event of ETAP participating in the
complementary development of the exploitation
concession, it will reimburse its share of the
expenditures already incurred, in conformity with
the specific contract. The reimbursement of ETAP’s
share in the aforementioned expenditures is made by
the exchange-value of a percentage of its production
quota, in conformity with the provisions defined in
the specific contract.
Moreover, when the state company carries out
prospecting research and/or exploitation hydrocarbon
activities, whether for its own account, in partnership,
or otherwise, it benefits from all rights and submits
itself to all the covenants provided for by the
Hydrocarbons Code and the regulatory texts issued in
implementation thereof.
The fiscal structure
The fiscal system applicable to the holder of a
permit or a concession covers rates, duties and taxes of
general application and rates, duties and taxes relating
specifically to hydrocarbons.
The holder of a research, prospecting or
exploitation concession, as well as the subcontractors
to whom he had recourse during the carrying out of
the hydrocarbons research, prospecting or exploitation
concession works in Tunisia, are subject to: the
provisions of the specific concession; the provisions of
the specific production sharing contracts; the
provisions of the contracts of supplies, works and
services related to the whole of the holder’s activities
carried out within the framework of the specific
concession or production sharing contract, and relating
to the hydrocarbons research and exploitation
activities.
The following are also applied:
• Payments to the Tunisian state, local authorities,
public or private companies and public services
licence-holders, in remuneration of the holder’s
direct or indirect use of various roadway systems,
networks and other components of the public or
private domain, in accordance with the conditions
of use defined in the specific contract.
• Taxes on the establishments of industrial,
commercial or professional status for the benefit of
local communities.
• Taxes on constructed buildings.
• Customs duties and taxes. The amount paid for
these matters is considered as a deposit on profit
taxes, and the tax due for the automatic import and
export information processing.
• Duties and taxes paid on suppliers of services,
goods, equipments, materials, products and raw
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materials or consumables comprised in the buying
price, except for the value added tax.
• Taxes on transport and exploitation vehicles, and
the single tax on insurances.
In addition to duties, taxes and rates of general
application, the holder shall pay taxes, duties and rates
specific to hydrocarbons and to his research,
prospecting and exploitation hydrocarbons activities in
Tunisia. In this context, the holder is subject to the
following payments:
• A fixed tax, equal to as many times the minimum
hourly inter-professional warranted salary of an
unskilled workman, as the perimeter comprises
entire elementary perimeters; and anytime the
holder of the contract applies for the institution,
renewal or extension of hydrocarbons title-deeds
areas, except for the prospecting authorization.
• A fixed tax per hectare of land included in the
exploitation concession equal to as many times the
minimum hourly inter-professional warranted
salary of an unskilled workman, and thus at the
latest by 30 June of every year. This tax is
established by decree of the Minister in charge of
Hydrocarbons, and is equal to five times the
minimum hourly inter-professional warranted
salary of an unskilled workman per hectare for the
inactive or unexploited concessions.
• With regard to the exploitation concession, the
holder should provide, at the latest by 31 March of
every year for the previous year, an annual
statement containing all the information on
hydrocarbons production and sales as well as the
exploitation expenditures. Any delay in payment
involves the application of delay penalties
applicable in terms of income-tax and corporate
taxes. A royalty proportional to the quantities of
hydrocarbons produced by the holder is applied to
the exploitation concession. The proportional duty
can be paid in cash or in kind according the
authority’s choice, and in conformity with
the provisions of the specific contract. The annual
production taken into account for the
determination of the proportional duty does not
include the quantities of consumed hydrocarbons
for the exploitation needs or injected into the
oilfield. The measurement procedures of the said
quantities are defined by the specific contract.
As stated previously, the proportional duty is
determined according to the Ratio (R) of the net
income, accrued to the total accrued expenditures of
each co-holder and respectively related to each
exploitation concession and to the research permit
from which the same was issued. The rate of the
proportional duty is variable according to the Ratio
(R) as previously defined (Table 5).
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
Table 5. Rate of proportional duty according
to the Ratio (R)
For liquid hydrocarbons:
R inferior or equal to 0.5: 2%
R superior to 0.5 and inferior or equal to 0.8: 5%
R superior to 0.8 and inferior or equal to 1.1: 7%
R superior to 1.1 and inferior or equal to 1.5: 10%
R superior to 1.5 and inferior or equal to 2.0: 12%
R superior to 2.0 and inferior or equal to 2.5: 14%
R superior to 2.5: 15%
For gaseous hydrocarbons:
R inferior or equal to 0.5: 2%
R superior to 0.5 and inferior or equal to 0.8: 4%
R superior to 0.8 and inferior or equal to 1.1: 6%
R superior to 1.1 and inferior or equal to 1.5: 8%
R superior to 1.5 and inferior or equal to 2.0: 9%
R superior to 2.0 and inferior or equal to 2.5: 10%
R superior to 2.5 and inferior or equal to 3.0: 11%
R superior to 3.0 and inferior or equal to 3.5: 13%
R superior to 3.5: 15%
In cases where ETAP does not participate in a
given exploitation concession, the rate of the
proportional duty applicable to that concession cannot
be inferior to 10% for liquid hydrocarbons and to 8%
for gaseous hydrocarbons.
The holder should pay a tax on profits at a variable
rate according to the Ratio (R) previously determined
(Table 6).
In the event of ETAP participating in a given
exploitation concession at a rate equal or superior to
40%, the tax rate on profits coming from the said
concession is fixed to 50%.
The payment of the profit tax excludes, in
conformity with the provisions of art. 103.5 of the
Table 6. Tax on profits according
to the Ratio (R)
For liquid hydrocarbons:
R inferior or equal to 1.5: 50%
R superior to 1.5 and inferior or equal to 2.0: 55%
R superior to 2.0 and inferior or equal to 2.5: 60%
R superior to 2.5 and inferior or equal to 3.0: 65%
R superior to 3.0 and inferior or equal to 3.5: 70%
R superior to 3.5: 75%
For gaseous hydrocarbons:
R inferior or equal to 2.5: 50%
R superior to 2.5 and inferior or equal to 3.0: 55%
R superior to 3.0 and inferior or equal to 3.5: 60%
R superior to 3.5: 65%
742
Hydrocarbons Code, the payment, for that purpose, of
any due advance under the terms of the legislation in
force in matter of income-tax of individuals and
corporate tax, excepting deductions at the source
relating to the said taxes which constitute advances on
the quarterly payments or on the final tax.
In the case of a contract of production sharing, the
Tunisian legislator has instituted a production sharing
fiscal system.
Tax related to production sharing contract is
defined in proportion to the production share due to
ETAP, after deduction of the quantities delivered to the
Undertaker as a recovery of its expenditures and as its
remuneration relating to the given fiscal year. The
undertaker is supposed to have paid the profit tax.
The said tax is fixed – as oil and gas relating to the
concerned fiscal year – for each fiscal year on the
value of the production quantities drawn by the
undertaker. The production will be valued according to
the selling price provided for in the specific contract
or at the actual selling price of hydrocarbons sold on
the domestic market.
The holder is in any case subject to the duties and
taxes pertaining to its activity.
Loan interests related to the expenditures of the
initial development and to the complementary
development investment of a given exploitation
concession, and for an amount equivalent to 70% of
the said expenditures amount will be recovered by the
undertaker within the limit of the rates applicable to
the exploitation concession.
Research expenditures carried out on an
exploitation concession will be recovered by the
undertaker by way of quantities of oil or gas recovery
within the limit of the rates applicable to the
exploitation concession.
Profits resulting from the production, stocking and
transport of hydrocarbons for the exclusive account of
the holders are submitted to the fiscal system of
general application.
Liability reserve
The holder of an exploitation concession has to
constitute a liability reserve for repairing the
exploitation site in the event of its withdrawal.
This liability reserve should be established by the
holder in the course of the last five fiscal years for an
offshore site, and in the course of the last three fiscal
years for a land site. However, the holder can be
allowed by the authority to constitute the liability
reserve for repairing the exploitation site over a longer
period during the last years of the concession.
The holder can be discharged from the obligation
of repairing the site in the event of its withdrawal from
exploitation for reasons of renunciation of the
ENCYCLOPAEDIA OF HYDROCARBONS

exploitation concession or termination at the
concession expiry date, on condition that the duration
of the still remaining exploitation concession –
economically profitable – is for a minimum of five
years for an offshore and three years for a land
exploitation. This, provided that the carrying on
of the exploitation of the oilfield during the residual
period will cover the whole costs, including fees for
repairing the site and securing a reasonable profit.
In the opposite case, in the event of the conditions
previously mentioned not being met, the authority can
require from the holder (at the latter’s choice) either to
contribute to the repairing of the site or to carry on the
oilfield exploitation.
At any moment, the authority is entitled to request
a warranty from the holder covering the abandonment
and repairing of the exploitation site. In no case does
the said warranty release the holder from its liabilities
related to the abandonment and repairing of the
exploitation site.
Legislation in matters of exchange
The holders of hydrocarbon claims or the
undertakers can be either resident or non-resident
corporate bodies in Tunisia.
The holder or the undertaker operating within the
framework of Tunisian rules of general application,
whose registered capital is held by Tunisian or foreign
non-residents and constituted by imported convertible
currencies superior or equal to 66% of the registered
capital, is considered as being a non-resident.
Any participation of residents in the registered
capital of the non-resident holder’s or undertaker’s
company should be carried out within the strict respect
of the exchange regulations in force in Tunisia.
Additionally, companies registered in Tunisia in the
form of corporate bodies having their head-office
abroad, are considered as non-residents with regard to
the exchange regulations. Therefore, the endowment
of these companies’ offices in Tunisia should be
subject to a financing by convertible currencies
imported to Tunisia.
The holder or the undertaker non-resident in
Tunisia is liable to conform to the Tunisian regulations
in matter of exchange as well as to the specific
contract and the provisions provided for by the
Hydrocarbons Code.
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ALGERIA, LIBYA AND TUNISIA
As to the residents, the Tunisian Code on
Hydrocarbons provides that, during the exploitation
phase, the holder or the undertaker is allowed to keep
abroad the yield of the exported hydrocarbons but
remains liable to repatriate monthly to Tunisia an
amount equal to that due to the Tunisian state for
taxes, fees and expenses if it does not own the
necessary resources in Tunisia.
Moreover, the non-resident holder or undertaker
is permitted to use freely, in Tunisian dinars, the
yield of its extracted gas sales during a concession
exploitation for the supply of the domestic gas
market, and this for its expenditures under the
exploitation concession.
In order to allow the non-resident holders and
undertakers to benefit freely from their income (in
Tunisian dinars) of the gas supplied to the domestic
market, the intermediary banks are allowed to carry
out, without any restriction, any transfer pertaining
to the expenditures incurred in foreign currency within
the framework of the exploitation concession.
Holders and undertakers which are residents are
also allowed to freely carry out currency transfers
related to prospecting, research and exploitation
activities in conformity with the exchange system
annexed to the specific contract.
Disputes settlement and applicable law
Litigation resulting from the implementation of the
different permits and licences granted by the Tunisian
authorities are settled through arbitration procedures
by third parties who will determine, as provided
in the specific contract, the arbitration procedures
and the terms for implementing the settlement through
arbitration.
The Hydrocarbons Code provides that the different
permits, licences and titles are governed by the
provisions of the same code and that rights, duties and
obligations mentioned therein are also governed by the
Hydrocarbons Code. Moreover, Tunisia has issued a
‘convention-type’ which conforms with the provisions
of the Hydrocarbons Code and which has been
approved by decree.
Mohammed Chemloul
Sonatrach
Algiers, Algeria
743
 12.8
Egypt
12.8.1 Introduction
The word Egypt visualizes in the mind pictures of the
pyramids, grand temples and mummies, all evidence
of the inception of one of the first civilizations in the
world. However, this is only the tip of the iceberg.
Egypt, located on the far northeast corner of the
African continent, is blessed with the most abundant
natural resources.1 Furthermore, it controls the
strategically and economically important Suez Canal,
with the Mediterranean Sea marking its northern
boundary, the Red Sea bordering it from the east,
Sudan stretching from its southern border and Libya
lying west of its borders. Recent discoveries have
shown that Egypt has plenty of natural gas. Not only
enough to keep its local market supplied for the
foreseeable future, but enough to have it enter into the
lucrative natural gas export market as well. The
number of international petroleum companies
currently operating in Egypt and the investments made
in the Egyptian Liquefied Natural Gas export plans on
the part of these companies supports this view.2
In this paper, the authors will attempt to give a
comprehensive explanation about the legal regime that
regulates the exploration and exploitation of
hydrocarbons in Egypt.
12.8.2 Sovereignty over
petroleum resources
The recognition of sovereignty of the Egyptian State
over its natural resources and its rights to nationalize
property is inserted in the Egyptian law. Under art. 3
of Law No. 86/1956 concerning Mines and Quarries,3
all petroleum found in Egypt and its territorial waters
is considered the property of the state. Furthermore,
under the Egyptian Concession Agreement (ECA), the
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
Petroleum Company (PC) is granted the right to
explore for petroleum and exploit the discovery in a
certain area covering the potential field. This right
seems to be the norm in any ECA granted to a PC.
Under the ECA, the PC (although designated in the
ECA as a contractor, as explained later in this paper) is
a creditor entitled to a payment in kind, but cannot lift
or take its share of petroleum directly.
In this perspective, the ECA is a Production
Sharing Agreement (PSA), whereby the PC operates
with the legal status of a contractor on behalf of the
mining-rights holder, the Egyptian General Petroleum
Corporation (EGPC). The share of production received
by the PC under the ECA is, from a legal standpoint, a
payment effected by EGPC to the PC. Any other
interpretation, would be contrary to the principle of
the permanent sovereignty of the Egyptian State over
its natural resources as provided by Egyptian law.
12.8.3 Ownership and title
to underground petroleum
resources
Before petroleum is discovered, the problem regarding
the rights to the petroleum seldom arises in Egypt. As
1 This paper is prepared by Dr. S. Elatfy in collaboration
with Dr. M. Badran. The views expressed herein by the
authors’ are their personal views. They are not necessarily
shared by those they may represent.
2 A number of international petroleum companies are
currently operating and investing in Egypt in the upstream.
These include American, British, Spanish, Canadian, Italian,
and Malaysian companies, i.e. Apache, British Petroleum,
British Gas, Edison, Eni, Shell, Centurion, Petronas, etc.
3 Law No. 86/1956 on Mines and Quarries, in addition
to s. II (Raw Combustibles) of Law No. 66/1953 on Mines
and Quarries form the legislation that regulates petroleum
exploration and exploitation operations in the Country.
745
NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
a rule, no property right, whether in rem or ad rem,
exists on an unidentified object, such as petroleum
prior to a successful exploration well.
Once petroleum is discovered, the situation
becomes different. At this point in time, there comes
into existence an identifiable object, located in an
identified trap called the reservoir. To this end, under
the ECA, both the reservoir and the petroleum trapped
therein are considered immovable and belong to the
Egyptian State.
On the other hand, the products to be extracted
from the reservoir by wells drilled from the surface are
considered movables by anticipation. The point at
issue here is to determine the time at which transfer of
ownership of the oil and/or gas has been effected.
Under the Egyptian civil code, the rule is that title is
automatically transferred with respect to a thing
determined by its kind, when such a thing is identified.
Accordingly, the question raised with regard to oil and
gas, is how and when such identification is effected in
the ECA.
Under the Egyptian civil code, it is held that in
respect of sale of goods to be measured, weighed or
counted (which is the case for oil and gas), the
identification takes place in either of the following
cases: at the time and place agreed upon between the
parties; according to the usage if there is no agreement
between the parties; when the thing or the goods are to
be delivered if there is no usage. Therefore, with that
in mind, and reading through the ECA, in particular
the clause regarding the PC right to take its share of oil
and gas, the PC operation should be characterized as a
sale en bloc (i.e. sale of unascertained things which
need to be measured, counted or weighed) rather than
a sale of a thing in general au poids (i.e. a sale by tract
without regard to quantity). Thus, title will be
transferred by delivery, unless agreed otherwise
between the parties.
12.8.4 The right to explore,
develop, produce
and dispose of petroleum
resources
Granting the ECA
From time to time, normally about once or more
during the year, EGPC invites PCs to bid for blocks of
acreage pre-selected by EGPC. Any interested PC
submits a bid to EGPC indicating the terms it is
prepared to offer, i.e. how much money will be spent
on exploration operations, how many wells will be
drilled, how much signature and production bonuses
will be paid, what percentage of any petroleum
produced will be set aside for cost recovery, and what
746
the split will be between the Government and the PC
of the remaining petroleum produced.
Sometimes, EGPC will award a block subject to
the PC bidder agreeing to improve one or more of the
terms. Once an agreement is reached on the basic
terms, a draft ECA is prepared by the PC, based on the
latest model form of EGPC ECA.
When all the terms are agreed, EGPC and the PC
will initial the draft ECA that will be submitted for
formal approval by the EGPC’s Board of Directors.
Following EGPC approval, the draft ECA is then sent,
for review and approval, to the State Council, the
Council of Ministers and finally the People’s
Assembly. If the People’s Assembly approves the draft
ECA (without amending any of its terms), a law is
passed authorizing the Minister of Petroleum to sign
the ECA on behalf of the Government.
The authorization of the People’s Assembly to the
Minister of Petroleum to sign the ECA seems to be a
sort of administrative monitoring process from the
Legislative Authority on the Executive Authority. The
reason for issuing such an authorization in the form of
a law is due to the fact that the Legislative Authority,
as a practice, expresses its will through the form of a
law.
Legal nature of the ECA
Article 123 of the Egyptian Constitution 1971 (as
amended) states that the law shall determine the rules
and procedures pertaining to the grant of an ECA.
Although the Constitution itself did not contain any
substantive rules with respect to the grant of petroleum
concessions, it referred to the law with regard to the
rules and procedures regulating the exploitation and
exploration of hydrocarbons in Egypt.
The law does not lay out the rules and procedures
for the granting of exploration and exploitation
permits on the basis of a PSA. However, by virtue of
arts. 50 and 52 of Law No. 86/1956, it was possible for
the Minister of Petroleum to enter into an ECA that
incorporates special conditions that differ from the
ones set out in the law.
On the basis of these articles an ECA between the
Egyptian Government, EGPC, and the PC is: enacted
by a special law; is considered a PSA; contains several
conditions that override Law No. 86/1956 in
particular, and the Egyptian laws in general. Thus, the
local general laws, except to the extent that they
conflict with the terms of the ECA – which itself is
issued by a special law – govern the exploration and
exploitation operations in Egypt.
As a rule, where the ECA is silent, the general laws
of Egypt will apply. For example, the ECA overrides
the general laws on such matters, which include but
are not limited to customs, operating company
ENCYCLOPAEDIA OF HYDROCARBONS

organization, although it remains subject to the general
laws on most matters including the local petroleum
regulations (i.e. requirements for the conservation of
petroleum, spacing of wells, abandonment of wells,
location of facilities, and the protection of the
environment and antiquities).
12.8.5 Exploration and production
terms, and expenditure
commitments and bonuses
Exploration duration
The ECA usually states that the exploration period
varies between four and twelve years with exploration
operations commencing no later than six months after
the effective date of the ECA in question. The current
norm under the ECA is for an initial exploration
period of three years, that may be extended by the PC
for two successive extension periods of three years.
However, these extensions are subject to the PC
fulfilling the expenditure of its minimum exploration
obligations, and satisfying the drilling obligations as
set out in the ECA.
Relinquishment during exploration
The ECA usually requires the PC, at the end of the
third year after the effective date, to relinquish to the
Egyptian Government a total of 25% of the original
area, which will not be covered by a development
lease agreement. The effective date is typically defined
in the ECA as the date on which the text of the ECA is
signed by the Egyptian Government, EGPC, and the
PC after the relevant law is issued.
At the end of the sixth year after the effective date,
the PC is required to relinquish again an additional 25
% of the original area, which will not be covered by a
development lease agreement.
At the end of the ninth year of the exploration
period, the PC shall relinquish the remainder of the
area not then converted to a development lease
agreement. In all events, voluntary relinquishments
may take place by the PC at the end of any period,
provided that the PC has fulfilled its exploration
obligations under the relevant ECA.
Exploration obligations
Under the ECA, exploration is defined to include
geological, geophysical, aerial and other surveys as
may be contained in the approved work programmes
and budgets, and the drilling of such shot holes, core
holes, stratigraphic tests, holes for the discovery of
petroleum or appraisal of petroleum discoveries and
other related holes and wells, and the purchases or
acquisition of supplies, materials, services and
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EGYPT
equipment therefor, all as may be contained in the
approved work programmes and budgets.
The PC, according to the ECA, is obligated to
carry out certain financial and physical tasks during
the exploration periods. These work obligations are
generally expressed in terms of both physical work
(that is, wells required to be drilled) and money
expenditure.
The PC may spend more than the minimum
amount required to be expended or drill more wells
than the minimum required to be drilled during the
initial three-year exploration period, or during any
period thereafter. In this case, the practice is that the
excess may be subtracted from the minimum amount
of money required to be expended by the PC or the
minimum number of wells required to be drilled
during any succeeding exploration period(s).
On the other hand, under-expenditure by the PC in
any exploration period may trigger an obligation to
pay the deficiency to EGPC.
Production duration
The right to produce petroleum and retain a part of
the area beyond the exploration phase for this purpose,
is conditioned on the making of a commercial
discovery during the exploration period.
Under the ECA, a commercial discovery is defined
as a discovery worthy of being developed
commercially, taking into consideration the
recoverable reserves, production, pipeline, and
terminal facilities required, estimated petroleum
prices, and all other relevant technical and economic
factors.
As stated in the ECA, the commercial discovery
may consist of a single reservoir or a group of
reservoirs. However, this is clearly a flexible standard,
and the PC cannot unilaterally declare a commercial
discovery. The latter must persuade EGPC to concur in
the existence of a commercial discovery. This
normally requires several steps according to the ECA.
Once the PC discovers a commercial oil or a
commercial gas deposit, it must conduct an appraisal
programme by drilling one or more exploration
appraisal wells (unless EGPC and the PC agree that
this is not necessary). As soon as the PC concludes
that the discovery is worth developing, the PC notifies
EGPC of the existence of a commercial discovery and
proposes a development plan.
In the case of an oil discovery, the notice of
commercial discovery must be given upon completion
of drilling of the second appraisal well and, in any
event, not more than 12 months after the test
confirming the commercial well. In the case of a gas
discovery, this notice must be given within 24 months
after the test confirming the commercial well. If the
747
NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
PC does not believe that a discovery is commercial, or
fails to give notice of commercial discovery within the
prescribed time limit, the area of the commercial
discovery may be set aside for sole risk operations by
EGPC.
Following PC’s notice, EGPC and the PC shall
meet and agree on the existence and the area of the
commercial discovery, on the basis of the technical
and development plan presented by the PC. EGPC and
the PC then will jointly apply to the Minister of
Petroleum to obtain approval on the development
lease. The latter shall consist of a number of
rectangular blocks covering the area considered to be
capable of production. Under the ECA, development
blocks currently measure 1⫻1 minute on the
International Grid System, or approximately 3 square
kilometers. After the approval of the Minister of
Petroleum on the development lease, operations must
start in accordance with the development plan.
Expenditure commitment
Development is typically defined in the ECA as
including, but not limited to, all the operations and
activities, pursuant to approved work programmes and
budgets under the ECA with respect to: the drilling,
plugging, deepening, side tracking, redrilling,
completing, equipping of development wells, the
changing of the status of a well; design, engineering,
construction, installation, servicing and maintenance
of equipment, lines, systems facilities, plants and
related operations to produce and operate said
development wells, taking, saving, treating, handling,
storing, transporting and delivering petroleum,
recycling and other secondary recovery projects;
transport, storage and any other work or activities
necessary or ancillary to the activity specified in the
first two points above.
In most ECAs, commercial production in regular
shipments (not defined in the ECA) must be established
from each development block comprised in the
development lease (either directly or through drainage)
within 3-5 years of the date of the Minister’s approval,
or the non-producing blocks must be surrendered.
Following the Minister’s approval with regard to a
development lease based on a gas discovery, EGPC is
required to seek internal markets for production and
must buy the gas under long-term gas sales
agreements. Thus, development obligations are
deferred, pending location of a market for the gas.
Should EGPC as buyer fail to enter into a long-term
gas sales agreement with EGPC and the PC as sellers,
within a certain period (typically 4 years) from the
notice of a commercial gas discovery, EGPC and the
PC as sellers shall have the right to take and freely
dispose of this quantity of gas by exporting it.
748
Under the ECA, the PC right to produce oil and
associated gas according to the development lease will
run for 25 years starting from the date of the oil
discovery, and from the date of the first deliveries for
non-associated gas.
Bonuses
In the ECA, the PC has the obligation to pay a
number of different negotiable bonuses. Such bonuses
are classified as signature, production, and extension
of the gas development lease bonuses. They are not
treated as a recoverable cost. Signature bonuses under
the ECA commonly vary between US$ 100,000 and
US$ 500,000, although they can be higher.
On the effective date of the ECA the PC pays the
signature bonuses in question, and another different
signature bonus is paid upon the approval of each
development lease agreement. Production bonuses are
payable, varying as to amount, according to the level
of production.
Terms for recent ECA have stated that a production
bonus is paid when the total average daily production
reaches the rate negotiated and agreed upon between
the parties. Production bonuses under the ECA
commonly vary between US$ 500,000 and US$
1,500,000, although they can be higher.
Furthermore, an additional production bonus is
payable when the total average daily production
reaches the rate negotiated and agreed upon between
the parties. The sum that triggers such additional
production bonus, commonly used under ECA, is
25,000 bbl/d.
Finally, a bonus is payable upon the Egyptian
Government approval for the PC to enter into an
extension period with regard to the original
development lease agreement for a gas discovery. Such
bonus, commonly paid under some ECA, is in the sum
of US$ 100,000.
12.8.6 State participation
in the Egyptian Concession
Agreement
Within the executive branch of the Egyptian
Government, the Ministry of Petroleum is responsible
for the management of Egypt’s petroleum resources.
Affiliated with the Ministry of Petroleum is EGPC,
which was initially created by Law No. 135/1956, and
which was entirely repealed in the same year by Law
No. 332/1956.
According to the law that has created EGPC, the
latter is a public establishment endowed with a legal
personality, and has an annual budget to be run
according to the rules followed in commercial
ENCYCLOPAEDIA OF HYDROCARBONS

enterprises. However, due to the many defects in the
initial laws that created EGPC (mainly Law No. 332),
these were replaced by Law No. 167/1958, which was
repealed (although part of its provisions are still in
force) by Law No. 20/1976.
Until 1976, EGPC was referred to in the ECA and
the Egyptian laws as ‘Moassassa’, which has been
changed to the name ‘Haya’. EGPC is wholly owned
and controlled by the Egyptian Government. One of its
duties is to recommend the general planning of the
country’s petroleum policy. Thus, it has often been
called an official arm of the Egyptian Government.
The Chairman of EGPC board of directors is
appointed by a decree from the President of Egypt,
and the remaining board members are appointed by a
decree from the Prime Minister on the
recommendation of the Minister of Petroleum.
Resolutions of the EGPC board must be forwarded
to the Minister of Petroleum for ratification,
amendment, or cancellation. Notwithstanding these
close ties to the Egyptian Government, EGPC has an
independent budget similar to a commercial budget, and
it is subject to Egyptian income tax. EGPC funds bear
the oxymoronic label ‘privately owned State funds’.
Except for certain reserves, its after tax surplus (if any)
each year is turned over to the public treasury. In the (as
of yet hypothetical) event there were a deficit, the
treasury would be responsible for it. In other words,
EGPC has a financial autonomy and a separate budget.
This budget is approved by the People’s Assembly and
promulgated by law like the budget of the state.
EGPC is always wearing two hats in respect to
each particular ECA. On one hand, it has
administrative powers of control and supervision of all
petroleum activities and, on the other hand, is a partner
with the PC in every ECA. This dual role can be
clearly seen in the procedure for obtaining a
development lease. EGPC role on one side is as
regulator and on the other side is as participant. As
regulator, EGPC must be satisfied with the existence
and the area of the commercial discovery claimed by
the PC, and with the adequacy of the development
plan. As participant, EGPC joins in the application for
Minister’s approval of the development lease.
This dual role carries over into the development
stage through EGPC’s participation in the management
and economic returns of the operating company.
Under the ECA, an operating company between EGPC
and the PC is created upon a commercial discovery in
accordance with it’s preinserted articles of association
set out in the ECA. As a rule, the operating company
is a non-profit private sector company, with its board
members representing EGPC and the PC.
Although an operating company has the legal form
and appearance of a company, it is better to think of its
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EGYPT
role under the ECA as that of a joint operating
committee (with technical sub-committees) for EGPC
and the PC. The charter of the operating company is
very clear on the latter’s role as an agent for the two
principals rather than as entity acting for itself. Thus
the operating company does not own any interest in
the ECA, has no financial or work obligations under
the ECA, can spend only the money advanced to it by
the principals, receives income only for the principals,
and can only act in accordance with their decisions. It
is also worth mentioning that the operating company
charter typically inserted in the ECA states that its
shares are 50/50 owned between the principals. This
indicates equal control rather than equal investment or
equal entitlement to production.
12.8.7 Pricing oil and gas
under the Egyptian
Concession Agreement
Pricing of oil
As far back as 1963, EGPC policy seems to have
been consistent in valuing the oil price on the basis of
the weighted average prices realized by either EGPC
or the PC, whichever higher. Thus the ECA issued in
the 1960s contained wording in art. 12 s. (c) reflecting
this understanding.4 The status given to the price
realized by EGPC, when higher, was colloquially
referred to at the time as ‘the keep honest clause’. In
the 1970s, when EGPC adopted the new form of PSA,
it continued the same policy of determining the value
of the oil on the same basis of weighted average prices
realized by either EGPC or the PC.5 The Government
entrusts this same basis of valuation in all the ECAs
4 The Pan America (currently BP) Western Desert
Concession (1963), and the Pan America (currently BP)
Gulf of Suez Concession (1964) stated in Article 12 (c) the
following: “Subject to the preceding paragraph (b), EGPC
and the CONTRACTOR each shall have the right freely to
export and sell its portion of all petroleum which is
produced and saved hereunder. The CONTRACTOR will be
allowed to export and sell its share of the oil produced and
saved under this Agreement for the best prices that it can
obtain from non-affiliated companies in the light of
prevailing marketing conditions; provided, however, that if
EGPC is obtaining a higher price for its share of the oil for
comparable quantities and conditions of sale, then such a
higher price will be deemed received by the
CONTRACTOR. One of the relevant conditions of sale shall
be the marketing conditions prevailing at the times the sales
contracts were executed”.
5 See art. 7 (c) (1) of the South Gharib ECA issued by
Law No. 60/1974 on March 21, 1974, the South Ghara ECA
issued by Law No. 148/1974 on December 14, 1974, and the
South Belayiam ECA issued by Law No. 150/1974 on
December 16, 1974.
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that have been granted from 1974 to the present date,
which is reflected in the ECA under art. 12 s. (c) of
EGPC ECA Model.
Art. 12 s. (c) of the EGPC ECA Model provides
that the cost recovery crude oil to which the PC is
entitled shall be valued by EGPC and the PC at the
market price for each calendar quarter.
Under the ECA, market price is defined to mean
the weighted average prices realized from sales by
EGPC or the PC during the quarter, whichever is
higher. It is provided that sales to be used in arriving at
the weighted average(s) shall be sales of comparable
currency from FOB (Free On Board) point of export
sales to non-affiliated companies at arm’s length under
all crude oil sales contracts. Excluded are crude oil
sales contracts involving barter and:
• Sales, whether direct or indirect, through brokers
or otherwise, of EGPC or the PC to any affiliated
company;
• Sales involving a quid pro quo other than payment
in a freely convertible currency, or motivated in
whole or in part by consideration other than the
usual economic incentives for commercial arm’s
length crude oil sales.6
The ECA Model addresses the situation in which
either EGPC or the PC considers that the market price,
as determined under the ECA in question, does not
reflect the prevailing market price or in the event
EGPC and the PC fail to agree on the market price for
any crude oil produced for any quarter. The process
here is that any party may elect to submit to a single
arbitrator the question on what single price per barrel,
in the arbitrator’s judgment, best represents for the
pertinent quarter the market price for the crude oil in
question. The arbitrator shall be appointed and shall
carry out the arbitration process in accordance with
terms agreed upon in the ECA.7
Pricing of natural gas
EGPC policy seems to have been in the direction of
utilizing natural gas both as a source of energy and as a
feedstock. This, in line with gas discoveries in the
Western Desert, offshore the Mediterranean north of the
Nile Delta and Sinai, pushed EGPC to introduce a new
gas clause in its ECA Model. The new gas clause’s
intent was to: a) encourage the PC to explore for and
develop natural gas; b) provide for the right of the PC to
own the natural gas; c) create a dedicated market for the
natural gas; d) provide a fair price for the natural gas.
To this end, the sales of the discovered natural gas
in all current ECA are set according to a price formula
that applies to the PC (except small variations found in
older ECA and very recent ones). The formula is based
on 85% of the Gulf Of Suez Mix oil price (GOSM) in
calorific value (the calorific value is the heating value
750
of the burnt hydrocarbon). The GOSM has a price of 2
US$ below the Brent oil price.8 It should be noted that
the gas price clause stating the above formula has been
amended in the most recent ECA.
To this end, art. 7 (c) (2) (i) of the EGPC ECA
Model has been deleted in its entirety and replaced by
a new clause.9
12.8.8 The fiscal structure
under the Egyptian
Concession Agreement
Cost recovery
The EGPC ECA Model currently in force in Egypt
is based on the ‘production sharing system’. In fact,
6 See art. 7 (c) of the ECA between EGPC and BP,
issued by Law No. 82/2003.
7 See art. 7 (c) (v) of the ECA between EGPC and BP
Exploration (Delta) Limited issued by Law No. 82/2003 in
East Morgan Area, Gulf of Suez, Arab Republic of Egypt,
and the same article of the ECA between EGPC and Lukoil
Overseas Egypt Ltd. issued by Law No. 83/2003 in West
Geisum Area, gulf of Suez, Arab Republic of Egypt.
8 E.g. when Brent ⫽ 42 US$/barrel, then GOSM ⫽ 40
US$/barrel.
9 According to Law No. 157/2004 issued to amend the
gas pricing provisions under the ECA issued by Law No.
18/1995 between EGPC and BP Egypt Company in East
Tanka Marine Area Gulf of Suez, Arab Republic of Egypt; it
stated that: “art. 7 (C) 2-(i) Gas and LPG of the Concession
Agreement shall be deleted in its entirety, and shall be
replaced by the following: a) The Cost Recovery and
production sharing of Gas subject to a Gas Sales Agreement
between EGPC and CONTRACTOR (as sellers) and EGPC
(as buyer) entered into pursuant to art. 7 (e) shall be valued,
delivered to and purchased by EGPC at a price determined
monthly according to the following formula: PG ⫽ F x H.
Where: PG ⫽ the value of the Gas in US dollars per
thousand cubic feet (MCF); H ⫽ the number of British
thermal units (Btu) per thousand cubic feet (MCF) of Gas; F
⫽ a value in US dollars per million British thermal units
(Btu) determined monthly according to the following table:
Price of Brent (US$/barrel) ⫽ F (US$/mmBtu), less than or
equal to 10 ⫽ 1.50, greater than 10 but less than 14 ⫽
(0.1625x Brent) less 0.125, equal to or greater than 14 but
less than 17 ⫽ 2.15, equal to or greater than 17 but less than
20 ⫽ (0.1667x Brent) less 0.6833, equal to or greater than
30 ⫽ 2.65. Where Brent is the monthly average price
expressed in US dollars per barrel for Brent (Day To Day,
DTD) quoted in ‘Platt’s Oilgram Price Report’ for ‘Spot
Crude Price Assessment – international’ for the month in
question. In the event that the value of F cannot be
determined because Platt’s Oilgram Price Report is not
published at all during a month, the parties shall meet and
agree the value of Brent by reference to other published
sources. In the event that there are no such published
sources or if the value of Brent cannot be determined
pursuant to the forgoing for any other reason, the parties
shall meet and agree a value of Brent”.
ENCYCLOPAEDIA OF HYDROCARBONS

Egypt was the first country after Indonesia to adopt
the concept of the PSA. To this end, in May 1970 a
typical Indonesian PSA form was finalized in Egypt
between EGPC and a Japanese company named the
North Sumatra Oil Development Corporation.
Starting from July 1973, EGPC has concluded a
great number of ECAs based on the PSA system.
Under this system:
• The PC funds 100% of the expenditures for
exploration, development and operations, including
those incurred by the operation company, which
means that none of the initial exploration or
development risk is taken by EGPC.
• The petroleum is divided between EGPC and the
PC according to a formula tied to production levels
and the PC’s accumulated expenditures.
• EGPC pays all royalties and taxes owed to the
Egyptian Government by the PC in respect of the
PC share of production. It is this obligation by
EGPC that eliminates for the PC the political risk
of a change in the Egyptian tax or royalty rates, as
EGPC will bear any increased costs.
Classification of costs
A fundamental principle of all PSA is the right of
the PC to recover costs and expenses of the operations.
To this end, the ECA has classified the costs to be
recoverable. As a rule, costs and expenses under the
ECA fall under three categories: the exploration
expenditures, the development expenditures and the
operation expenses.
Depending on the ECA in question, a certain
percent (around 30%) of all the petroleum produced
will be used for satisfying these expenditures.
Operating expenses under the ECA are those costs,
expenses, and expenditures made after the initial
commercial production.10 They specifically include
workovers, repairs, and maintenance of assets.
However, they exclude sidetracking, redrilling and
changing of the status of a well, replacement of assets
or part of an asset, additions, improvements, renewals
or major overhauls that extend the life of the asset.
Great care, therefore, needs to be taken in framing
work authorizations, for example for changes in pipe
diameter and power requirements. This is because the
periods of cost recovery vary according to the type of
expenditure. Once an expenditure is classified as an
operating expense, it is recoverable in the tax year in
which such expenditure were incurred and paid or in
the tax year in which the initial commercial production
occurred, whichever is the later date.
Exploration expenditures under the ECA are those
costs and expenses for exploration, and the related
portion of indirect expenses and overheads.
Development Expenditures under the ECA, on the
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other hand, are those costs and expenses for
development (with the exception of operating
expenses) and the related portion of indirect expenses
and overheads. Exploration expenditures are typically
recovered over four years and development
expenditures over eight years. The periods vary from
concession to concession. This makes the correct
classification of expenditures of utmost importance.
The PC interests lie in recovering expenditures as
soon as possible, i.e. to the extent possible in treating
expenditures as operating expenditures or exploration
expenditures. EGPC interests, on the other hand, lie in
deferring the PC cost recovery, i.e. by classifying
expenditures as development expenditures to the
extent possible, thereby increasing EGPC share of
profit oil. In the most recent ECAs, it was evident that
exploration and development expenditures are
recovered over the same period, thereby making
classification between those categories no longer
relevant for cost recovery purposes.
Production Sharing
Crude Oil
Under the ECA, total production is divided into
cost oil (a portion taken for the recovery of costs
incurred by the PC) and the balance profit oil. The
profit oil is divided between EGPC and the PC
according to a formula tied to the production levels
and the PC accumulated expenditures. This formula is
negotiated at the time each ECA is granted, on the
basis of exploration risk and prevailing industry
standards. The splits vary significantly from
concession to concession. The PC shall have the right
and the obligations to separately take and freely export
all of its costs recovered and profit oil shares.
However, the ECA clearly states that priority to the
requirements of the local market from the PC’s profit
oil share should be given. Thus, EGPC shall have
preferential right to purchase such profit oil from the
PC. The price shall be calculated according to an
agreed formula inserted in the ECA in question, and in
US dollars or in any other freely convertible currency
remittable by the selling PC.11
Gas
The provisions governing the sale or the
disposition of gas produced in the ECA are scattered
in several articles within the EGPC ECA Model. A
10 The date of the initial commercial production is
normally linked in the ECA with the date on which the first
regular shipment of crude oil, or the first deliveries of gas,
are made.
11 See Note 7, art. 7 (a) (1) (iii).
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
reading of these provisions collectively helps reach a
comprehensive understanding of the requirements and
conditions for the disposition of gas under a particular
ECA.
Under the EGPC ECA Model, art. 3 (e) typically
lays out the method for disposition of gas.12 Pursuant
to this article, disposition of gas takes place either
through a gas sales agreement, a scheme to dispose of
gas for export or otherwise. However, art. 7 (e) (2) (I)
of the EGPC ECA Model typically provides that
priority is to be given to the requirements of the local
market as determined by EGPC.
A gas sales agreement is defined in the EGPC
ECA Model as a written agreement between EGPC
and the PC (as sellers) and EGPC and the Egyptian
natural holding GAS company (EGAS, as buyers).13
This agreement, based on the concept of take or pay,
contains the terms and conditions for the gas sales
from a development lease entered into pursuant to the
relevant ECA.
A period of notice (around four years), starting
from the date of the commercial gas discovery, is
reserved for a gas sales agreement to be concluded.
Such agreement must take into consideration the
relevant technical and economic factors to enable a
commercial contract, including: a sufficient delivery
rate; delivery pressure to enter the National Gas
pipeline Grid System at the point of delivery;
delivered gas quality specifications not more stringent
than those generally applied in Egypt. In the event
EGPC (and/or EGAS) fails to buy the gas within the
reserved period, the PC shall have the right to take and
freely dispose of its gas share by exporting it.
12.8.9 The parties of the Egyptian
Concession Agreement
In February 1957, the Egyptian Government, through
its national company arm EGPC, entered into the first
participation agreement in the world with the
International Egyptian Oil Company (IEOC), a
subsidiary of Eni.14
Starting in 1970, the Egyptian Government
decided to switch from state participation agreements
to PSA, and was represented in the ECA by EGPC. To
this end, in each ECA certain parties must sign. These
parties are as follows:
• The Egyptian Government which owns all minerals
found under the land and the seabed of Egypt.
Thus, the Egyptian Government, represented by the
Minister of Petroleum, grants the right to exploit
these minerals in return for a royalty and the right
to collect taxes on the profits of the operations.
• EGPC which has a dual role. One as representing
752
the Egyptian Government in the ECA granted to
the PC. And the other, as a partner in the
management of the operations within the operating
company.
• The PC (Either Egyptian /or non Egyptian) which
is referred to in the ECA as the ‘Contractor’. The
term ‘Contractor’ in the ECA reflects the PC role
as provider of technical services to explore for and
develop any petroleum discoveries. However, the
role of the Contractor under the ECA cannot be
compared to that of the contractors used to drill
wells or construct platforms, or even the role of a
general contractor. Unlike those contractors, the
PC in the ECA invests its own capital in the ECA
operations, has a management voice (with EGPC)
in the conduct of operations, and has a direct
economic interest in the results of operations,
namely the right to share in petroleum produced
from the concession. Thus, though the PC is called
Contractor under the ECA, the PC shares an
ownership interest in the ECA with EGPC.
• EGAS which is a further party introduced in the
EC, starting from 2003.
12.8.10 Investment protection
for exploration,
development,
and production operations
in Egypt
In general, Egypt provides a number of guarantees to
encourage investment in the sector of exploration for
and exploitation of petroleum. These guarantees
include, but are not limited to legislative enactment
granting special protection to investors, and
comprehend some protective clauses in the ECA
entered with the PC. The assessment of the
effectiveness for said guarantees is a function of the
Egyptian law and the forum having the right to settle
disputes between the parties of the ECA, whether
12 Ibid. see art. 7 (e) (2) (1).
13 EGAS is a governmental wholly owned holding
company formed by the Prime Minister Decree No.
1009/2001 (as amended) with the purpose to carry out
exploration and production operations with regard to natural
gas. It is subject to Law No. 203/1991 (as amended)
concerning Public Enterprise. This Law was issued as a first
step towards the privatization of public sector organizations
in Egypt. One of the main aspects of this Law is that it
allowed the shares of the subsidiary companies to be traded
on the Stock Exchange. Previously, the shares of public
sector companies could not be traded on the Stock Exchange.
14 Eni has been present in Egypt since 1954 and is the
leading international oil and gas Company in the country
through its subsidiary IEOC.
ENCYCLOPAEDIA OF HYDROCARBONS

before the local Courts or an international arbitration.
In general, local Courts and arbitrators with regard to
ECA controversies will settle a dispute according to
two counteracting concepts: the autonomy of the will
of the ECA parties and the sovereignty of state.
A PC that wishes to invest in Egypt in the
exploration for and production of petroleum is not
limited to finding the prospective area and the
favourable economic terms which ensure the viability
of the project, and the rate of return commensurate
with the risks involved. The PC also considers the
legal preconditions that need to be satisfied in order to
preserve the stability of the ECA. Of course, the
balance between the gain of the project versus the
associated risks will have to be assessed by the PC.
Generally speaking, most PC investing in Egypt
insist on obtaining the legal guarantees for the
protection of their investments. Egypt offers a number
of guarantees with regard to a PC wishing to invest in
the exploration, exploitation and production of
hydrocarbons. These guarantees combined with
Egypt’s history of no litigation disputes in the
petroleum sector have resulted in gaining a high level
of trust that is evidenced by the large number of
petroleum companies investing in this country in all
areas of the petroleum sector.
With that in mind, we list part of these guarantees:
The Egyptian Constitution
The 1971 Constitution (as amended) is based upon
respect for individual freedoms and for the ‘rule of
law’. For private sector development, the Constitution
contains provisions, which safeguard any PC wishing
to invest in the Arab Republic of Egypt. Art. 29 states
that property, shall be under the protection of the state.
Art. 34 states that private ownership shall be
safeguarded and may not be put under sequestration,
except in the cases defined by the law and in
accordance with a judicial decision. In fact, ownership
may not be expropriated except for a public purpose
and in association with a fair compensation, in
accordance with the law. Article 35 states that
nationalization shall not be allowed except in case of
public interest, by means of a law and for a
compensation. Finally, art. 36, which states that
general confiscation of property shall be prohibited,
and special and limited confiscation shall not be
allowed unless there is a judicial decision.
Legislative protection
A special law formalizes the ECA in Egypt. This
applies to any ECA granted in Egypt. The usefulness
of the formalization of the ECA by a law is to
safeguard any PC wishing to invest in the area of
exploration and exploitation of oil and gas. It has been
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the norm for a number of years, and has been tested in
a case submitted to the Egyptian Courts.15
Stabilization clause
Behind the great diversity of stabilization clauses
lies a one and sole objective; to preclude the
application to an agreement of any subsequent
legislative (statutory) or administrative (regulatory) act
issued by the government or the administration that
modifies the legal situation of the PC (El Chiati,
1988). Thus, stabilization clauses are a tool for any PC
to protect its investment in a particular country, it
wishes to invest in. To this end, the ECA includes clear
wording regarding the stabilization concept.16
15 Egyptian State Council, Administrative Court, Case
No. 541 for the Juridical Year 38, Agypetco v. Minister of
Petroleum, (1984, unpublished). According to the terms of
the ECA in this case, the PC was obligated to start the first
regular shipment of oil with respect to the development lease
agreement within a period of three years. Failing that, the PC
must have surrendered the block. In order to retain the block,
the PC wanted to transport the crude oil to the export point
by trucks. However, the Ministry of Petroleum insisted on
the construction of a pipeline, the cost of which in the
opinion of the PC was not guaranteed by the small discovery.
As the dispute could not be resolved amicably, the Minister
of Petroleum issued a decision prohibiting the transportation
of crude oil by trucks. As a consequence, the PC could not
achieve commercial production within the three-year period.
Hence the PC was compelled to surrender the block. When
the PC brought the matter to the Court (and started
arbitration procedures), in a particularly noted decision, the
Court annulled the Minister’s decision and ordered the
restitution of the block to the PC. The Court founded its
decision on the fact that the concession agreement did not
determine the manner of transporting the crude oil and gas.
In view of the fact that the ECA is issued by a special law, it
is not permissible for a lesser authority to modify the status
of the parties and the rights arising from the ECA, unless by
an instrument having the same dignity (a law).
16 See Note 7, art. 19 which reads as follows: “In case of
changes in existing legislation or regulations applicable to
the conduct of exploration, development, and production of
Petroleum, which take place after the effective date, and
which significantly affect the economic interest of the
agreement in question to the detriment of the PC or which
imposes on the PC an obligation to remit to the Arab
Republic of Egypt the proceeds from sales of the PC
petroleum, the PC shall notify EGPC of the subject
legislative or regulatory measure. In such case, the Parties
shall negotiate possible modifications to the agreement in
question designed to restore the economic balance thereof,
which existed on the effective date. The Parties shall use
their best efforts to agree on amendments to the agreement
in question within ninety days from the said notice. These
amendments to the agreement in question shall not in any
event diminish or increase the rights and obligations of the
PC as these were agreed on the Effective Date. Failing
agreement between the parties during the period referred to
above in this art. 19, the dispute may be submitted to
arbitration, as provided in art. 24 of this agreement”.
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
Although named in the ECA ‘Stabilization’, it is
identified with adaptation wording.
It is a fact that the intention of the stabilization
article is to maintain the integrity of the ECA articles.
It achieves this purpose by creating a rule in the ECA
for the parties to readjust and/or re-establish the
financial equilibrium of the ECA in the event any act
imputable to the authorities adversely affects that
equilibrium. Thus, the stabilization article founded in
the ECA imposes on the Egyptian Government an
obligation to act in good faith and gives rise to an
obligation to compensate the PC.
12.8.11 Environmental protection
In any ECA granted after 2002, new wording
regarding the environment is included. According to
this wording, the PC, in carrying out its operations
under the ECA, is subject to: the provisions of the Law
No. 4/1994 concerning the Environment; and any laws
or regulations concerning the protection of the
environment, which are consistent with the provisions
of the ECA.17
In brief, air, water, and land pollution, specification
for environmental impact assessment, duties of
environmental police force, and the national
emergency plan for dealing with major environmental
disasters (i.e. oil spills), are among the main topics
dealt with in Law No. 4/1994.
For a PC that is going to carry out exploratory
drilling operations, the environmental impact
assessment must include a description of the proposed
project, a description of the existing environment, a
summary of anticipated wastes and proposed treatment
methods, and a review of potential environmental
effects. On the other hand, for offshore operations, the
same assessment requirements will apply as for the
onshore operations, although additional information is
required with regard to the existing environment (i.e.
physical oceanography, water quality etc), and the
potential environmental effect (i.e. oil spill response
plans etc). During the petroleum operations, the PC is
obligated to keep a register of the impact of discharges
and emissions on the environment. Furthermore, oil
and gas flaring is permitted during well testing
provided it is carried out according to the world
standards approved by the competent authorities. The
PC is prohibited from exceeding the maximum
permitted limits for sound intensity. The authorities
shall observe that the total permitted noise emissions
from the PC fixed sources in one area are within the
limits permissible for that zone. The authorities shall
also ensure that the PC has applied for the purchase
and usage of machines and equipment that will
754
guarantee compliance with permitted maximum noise
levels. Operational discharge standards for exploration
and production operations in the Egyptian waters are
defined in Law No. 4/1994.18 Although Law does
prohibit the disposal of solid wastes in the marine
environment,19 there is no specific legislation
concerning the withdrawing, the clean up or the
restoration of areas after completion or abandonment
of petroleum operations. In practice, decommissioning
requirements are defined on a case by case basis.
Under existing ECA, there is no wording that
obligates the PC to dismantle any facilities created
within a concession upon its expiration, and the
facility will typically belong to EGPC according to the
cost recovery process. However, if a facility is
abandoned during the term of a ECA, and
dismantlement is considered part of the prudent
operation of the field or of the ECA, then EGPC may
request dismantlement (e.g. to replace a damaged
platform, or for safety reasons in case of a threat to
navigation), the costs of any such dismantlement
would be paid by the PC, and cost recovered pursuant
to the cost recovery provisions of the ECA. If the PC
has insufficient production through which the
dismantlement costs could be recovered, then, as it
seems, the PC may have to incur most of the costs.
12.8.12 Applicable law
to the Egyptian Concession
Agreement
Arguing from the principle of autonomy of the will, a
PC wishing to invest in Egypt may want to seek to
designate as governing law a law other than the
national law of Egypt. The PC may also claim that its
ECA should, because of its special nature, be governed
by extra-state laws. However, no sovereign state allows
submission of its petroleum agreements to a foreign
law, and Egypt is no exception.
Accordingly, the ECA states that the PC shall be
subject to Law No. 66/1953 (as amended by Law No.
17 See Note 7, art. 18 (b). Furthermore, in addition to
Law No. 4/1994, there are a number of other laws regarding
the environment that affect the petroleum operations, i.e.
Law No. 66/1953 concerning mines and quarries, Law No.
86/1956 concerning mines and quarries, Decree No.
1051/1958 concerning the continental shelf, Law No.
143/1981 concerning desert lands and its Executive
Regulations No. 198/1982, Law No. 48/1982 concerning
protection of the river Nile and waterways from pollution
and its Executive Regulations No. 8/1983, and Law No.
12/1984 concerning coastal zone management.
18 See Note 4 of Law.
19 See Note 4 of Law.
ENCYCLOPAEDIA OF HYDROCARBONS

86/1956) provided that no regulations, or modification
or interpretation in such law are contrary to or
inconsistent with the provisions of the ECA.20
The ECA also states that Egyptian law shall apply
to the dispute between the parties although, in the
event of any conflict between the Egyptian laws and
the ECA, the provisions of the ECA shall prevail.
Reading through the provisions of the ECA, it seems
that the laws regulating the ECA shall be in the
following order: first, the articles inserted in the ECA
in question; second, Law No. 66/1953 (excluding art.
37) as amended by Law No. 86/1956; and, third, the
Egyptian law.
On the other hand, and since Egypt is one of the
countries that belong to the civil law system family,
there are two systems of law, the administrative law
and the civil law. So, in the event of a dispute
regarding the ECA, the question that will be raised is
whether the dispute will be transferred to the
administrative Courts, thus subject to administrative
law, or to the civil Courts, thus subject to the civil law.
The main effect on the ECA, as a result of the two
different laws, is related to the fact that, according to
the administrative law, EGPC (as a state company) and
the state will not be on equal legal status grounds with
the PC. This said, it seems that such difference
between the two laws is only a theoretical problem, in
light of the wording inserted in the stabilization clause
of the ECA, since such wording typically states that
any exceptional legal rights granted to EGPC and the
state by virtue of the administrative law will not be
enforceable by the latter unless accepted by the PC.
12.8.13 Dispute settlement under
the Egyptian Concessions
Agreement
Under the EGPC ECA model, any dispute,
controversy or claim arising from or relating to a
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particular ECA or the breach, termination or
invalidity of it, if raised between the PC and the
Egyptian Government, shall be referred to the
jurisdiction of the appropriate Egyptian Courts,
and shall be finally settled by such Courts. On the
other hand, if the same disputes arise between the
PC and EGPC in the same ECA, they shall be
settled by arbitration in accordance with the
Arbitration Rules of the Cairo Regional Centre
for International Commercial Arbitration. The
award of the arbitrators shall be final and binding
on the parties.
The ECA includes wording on the number of
arbitrators, the process of how the arbitrators are
appointed, and the location on where the
arbitration will take place. The award of the
arbitration will be final and conclusive. Judgment
on the arbitral award rendered may be entered in
any Court having jurisdiction, or application may
be made in such Court for a judicial acceptance
of the award and for the enforcement, as the case
may be.
References
El Chiati A.Z. (1988) Protection of investment in the context
of petroleum agreement, in: Recueil des Cours de l’Académie
de Droit International de la Haye, Dordrecht, Nijhoff,
v.204, 115.
Sherif El Atfy
Exxon Mobil
Cairo, Egypt
Mohamed M. Badran
Cairo University
Cairo, Egypt
20 See Note 7, art. 24 (h).
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 12.9
Nigeria
12.9.1 Introduction
The main elements of Nigerian law relating to the
exploration and production of oil and gas are to be
found in Twentieth century legislation. Such
legislation is exemplified by the following major
statutes, the principal effects of which are
summarized below:
• The Petroleum Act (Laws of the Federation of
Nigeria 1990, Cap. 350) came into force on 27
November 1969 and has since undergone
several amendments. Its main purpose is to vest
in the state the property in petroleum existing in
its natural condition in strata in Nigeria.
In addition, it seeks to provide a legal
framework to enable persons to search for and
obtain such petroleum. The following
regulations are subsidiary to the Petroleum Act:
Mineral Oils (Safety) Regulations, Statutory
Instrument 1963 No. 45; Petroleum (Drilling
and Production) Regulations, Statutory
Instrument 1969 No. 69; Crude Oil
(Transportation and Shipment) Regulations,
Statutory Instrument 1984 No. 1984. These
regulations deal with various matters which
concern the search for, obtaining and disposal
of petroleum in connection with licences. In
particular, the regulations set out model clauses,
which are incorporated in such licences unless
modified or excluded in specific cases.
• The Oil Pipelines Act 1956 No. 31 (Laws of the
Federation of Nigeria 1990, Cap. 338) came into
force on 4 October 1956. It provides for the
issuance of permits to survey routes for oil
pipelines as well as the awarding of licences for
the establishment and maintenance of such
pipelines incidental and supplementary to
oilfields. The Oil and Gas Pipelines Regulations,
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Statutory Instrument 1995 No. 14, which is
subsidiary legislation, are ostensibly geared at
augmenting the Oil Pipelines Act and bringing it
in line with current industry practices.
• The Oil Terminal Dues Act 1969 No. 9 (Laws
of the Federation of Nigeria 1990, Cap. 339)
came into force on 1 January 1965. Its purpose
is to provide for the levying and payment of
terminal dues on any ship evacuating oil
at any terminal in any port in Nigeria. Most
importantly, it incorporates the Convention on
the continental shelf signed in Geneva on 29
April 1958, thereby making it part of Nigerian
municipal legislation. The subsidiary
legislation passed pursuant to the Oil Terminal
Dues Act relates to the establishment of the oil
terminals now in operation in Nigeria.
• The Deep Offshore and Inland Basin Production
Sharing Contracts Act 1999 No. 9 (as amended)
was passed on 23 March 1999 with retroactive
effect from 1 January 1993 and is the first piece
of Nigerian legislation recognizing the
dichotomy between the onshore and offshore
exploration regimes. It provides legislative
recognition and support for the Production
Sharing Contract (PSC) arrangement, which had
hitherto existed and been conducted purely
under contractual terms, since its inception in
1973 and its substantial revision in 1993. It also
modifies existing provisions (particularly
royalties and duration of grants) of the
Petroleum Act as well as the Petroleum Profits
Tax (PPT) Act for the purpose of deep water and
inland basin exploration, conducted ostensibly
under the PSC.
• The PPT Act 1959 No. 15 (Laws of the
Federation of Nigeria 1990, Cap. 354) came
into force on 1 January 1958 and has since
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
undergone several amendments. Its purpose is
to provide for the assessment and imposition of
a tax upon the profits of enterprises engaged in
the development of petroleum in Nigeria.
• In relation to the development of and disposal
of natural gas, statutory intervention has been
less regular. The Associated Gas Re-injection
Act 1979 No. 99 (Laws of the Federation of
Nigeria 1990, Cap. 26) came into force on 28
September 1979 and along with its subsidiary
legislation, the Associated Gas Re-injection
(Continued Flaring of Gas) Regulations 1979
(as amended) represents the only direct piece of
composite Nigerian legislation to date
concerning the exploration and development of
natural gas. Other provisions appear as sections
within the Petroleum Act and PPT Act.
In order to understand the content of this
legislation, we need to understand the influences
and factors which gave rise to it, as well as those
which have since shaped the legislator’s work.
The first factor is the pre-independence
legislation which was based on British colonial
influence and extensive experience in seeking oil
abroad in such places as the United States
and the Middle East. In this way, a licensing
regime was developed, drawing on leasing
practices in the USA and the experience of state
concessions in the Middle East.
The second factor is based on the common
heritage of the law of the sea and international law.
The third factor has been prompted by Nigeria’s
alignment and subsequent membership of the
Organization of the Petroleum Exporting Countries
(OPEC) in the 1960s and 1970s. This brought to
the fore Nigeria’s desire to assure state
participation interests in petroleum as a basis for
the effective regulation of oil and gas exploration
and production, as well as an appropriate return
from such activity.
The fourth factor has been the laws and policies
of deregulation and indigenization, born out of the
inherent limitations of state participation policies
coupled with the realization of the vast potential of
offshore petroleum exploration and production.
Such deregulation and indigenization policies are
now having a profound impact on the sector.
The fifth factor – instigated by the
environmental consciousness prevalent over the
past 30 years – has given rise to legislative reforms
in respect of the environmental aspects of oilfield
practice leading, amongst other things, to the
encouragement of gas development and utilization.
An outline of the history of Nigerian oil and gas
law since the beginning of the 20th century shall
758
now be provided, demonstrating the effect these
various influences have had on the current regime.
12.9.2 Development of Nigerian
oil and gas law
1900-50: creation of the licensing regime
Although it is believed that grants for the
exploration and exploitation of oil and gas date
from the late Nineteenth century, municipal
legislation governing such grants did not come into
existence until the turn of the Twentieth century.
This is exemplified by the promulgation of the
Mining Regulation (Oil) Ordinance 1907 No. 12
and thereafter Ordinance 1909 No. 19 (Laws of
Southern Nigeria 1909, Cap. 130). The Mineral
Oils Ordinance 1914 No. 17 (Laws of the
Federation of Nigeria 1958, Cap. 120) was passed,
repealing Ordinance 1909 No. 19, with the aim of
regulating the right to search for, obtain and work
mineral oils.
The first record of active exploration was the
pioneering work in 1908 of the Nigerian Bitumen
Company, a German entity whose activities
abruptly ceased upon the commencement of the
First World War in 1914. In 1921, oil exploration
rights were granted to two British companies,
namely D’Arcy Exploration Company and
Whitehall Petroleum Co. Ltd in the Niger Delta,
but little or no commercial activity was recorded.
In 1937, the Shell D’Arcy Company, a consortium
of the Royal Dutch Shell Petroleum Company
and the D’Arcy Exploration Company,
commenced exploration work and were
granted exclusive exploration and production rights
in the whole of Nigeria.
The advent of the Second World War equally
interrupted exploration activity and in 1946, upon
resumption of its activities, the Shell D’Arcy
Company re-emerged in partnership with British
Petroleum as Shell-BP, assuming the position of
the pioneer oil and gas exploration company in
Nigeria.
Exploration activity after both the First and
Second World Wars was conducted under the
authority of the Mineral Oils Ordinance 1914
which provided under section 6(1)(a) that,
“no lease or licence shall be granted except to a
British subject or to a British company registered
in Great Britain or in a British colony, and having
its principal place of business within her Majesty’s
dominions, the chairman and the managing
director (if any) and the majority of the directors of
which are British subjects”.
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The effect of this provision was to fortify Shell-
BP’s premier position over lands to which leases
and licences for the exploration of oil had been
granted. Although the primary motive behind the
passage of the legislation as a whole was to further
consolidate British influence in new economic
activity in Nigeria at the time, it is postulated that
an equally important consideration arose from the
need to avoid unrestricted competitive drilling in
what was at the time a largely unregulated sphere
of activity.
Again, drawing from its experience in the
United Kingdom in the 1920s and 1930s, where it
claimed that the search for petroleum had been
unduly hampered by uncertainties as to the rights
of property and having experienced similar
difficulties in Nigeria, the British colonial
government secured the passage of the Minerals
Ordinance 1946 (Laws of the Federation of Nigeria
1958, Cap. 121). The principal purpose and effect
of this was to vest in the Crown the property in all
petroleum (mineral oils) in situ. It provided that,
“the entire property in and control of all minerals
and mineral oils in, under or upon any lands in
Nigeria, and of all rivers, streams and watercourses
throughout Nigeria is and shall be vested in the
Crown save in so far as such rights may in any case
have been limited by any express grant made
before the commencement of this Ordinance”.
Such vesting of rights were subject to the
condition under s. 6(1)(b) of the Mineral Oils
Ordinance 1914 that the grantee of the lease or
licence pay compensation to any person in lawful
occupation of the land for disturbance of surface
rights or as determined by the Governor General of
Nigeria. However, no provision was made for
compensation in the event that exploration showed
the presence of substantial deposits under one’s
land, on the basis that no compensation could be
due for the loss of something the landowner never
had. To this day, this concept continues to underpin
the framework of Nigerian oil and gas law. The
nature of the current compensation system has
been a contributory cause for much of the conflict
between the oil producing communities and the oil
corporations.
1950-70: the discovery of oil
The first commercial discovery of oil in Nigeria
was made at Oloibiri in the Delta State (today
Bayelsa State) in 1956 by Shell-BP which since
1937 (as the Shell D’Arcy Company) had been sole
concessionaire in Nigeria. In January 1958, the first
oilfield came on stream, producing about 5,100
barrels per day and in the same year, s. 6(1)(a) of the
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Mineral Oils Ordinance 1914 was repealed by s. 2 of
the Mineral Oils Amendment Ordinance 1958 No. 5,
thus extending the grant of exploration rights to
other foreign, non-British corporations. Shell-BP
was constrained to relinquish its interests in areas of
its grant in the first instance to Mobil Oil which was
the first non-British entity to enter the field in 1962
and thereafter, when Shell’s concession areas were
further reduced to the most promising areas and
other corporations began exploration activities in
Nigeria.
The PPT Ordinance 1959 No. 15, the last major
piece of oil and gas legislation of the
pre-independence era, came into force in 1958,
introducing a 50% tax on chargeable profits from
petroleum operations, thus giving the government a
share, albeit indirectly, of the profits from such
petroleum activities.
As the new multinationals began to increase
their exploration activity in the 1960s, so the
Nigerian government sought to increase its level of
involvement in oil and gas exploration. The latter
had been involved, as an observer, in the
deliberations of the OPEC since 1964 (four years
after its formation in 1960). Moreover, in keeping
with the resolutions of the United Nations, it had
sought steadily to increase its control over oil
production. This was further hastened by the
increase in exploration and production activity in
the decade of the 1960s (save for the interruption
of the Nigerian Civil War 1967-1970). It was soon
realized that the Mineral Oils Ordinance of 1914
(with amendments) was no longer adequate in
regulating oil and gas activity, and this led to the
promulgation of the Petroleum Act in 1969, which
repealed the Mineral Oils Ordinance 1914, whilst
preserving the validity of licences and leases
issued under the said Mineral Oils Ordinance.
The Petroleum Act also pronounced in s. 1(1)
that the entire ownership and control of all
petroleum, “[…] in, under and upon any lands to
which this section applies shall be vested in the
state […]”. This provision, coupled with s. 2(2),
which provided that licences or leases may be
granted only to citizens of Nigeria or companies
incorporated in Nigeria under the Companies Act
1990 No. 1, fully subordinated exploration and
production activity as well as the entities engaged
in it under Nigerian legislative authority. The
Petroleum Act (Cap. 350) for the first time in the
Nigerian oil and gas sector, established a
comprehensive statutory regime for the grant of
rights to search for and obtain oil in Nigeria and
remains the basis for the regulatory system in
operation today.
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1970-90: evolution of state participation
In 1971, Nigeria became a member of OPEC,
and in line with OPEC resolutions passed in the
late 1960s immediately set about steadily
increasing both its control over and the degree of
competition within the Nigerian petroleum sector.
The alignment with OPEC and the subsequent
direct involvement of the government in
exploration activity must be contrasted with the
pre-1970 position where oil corporations in
Nigeria enjoyed, through pre-1969 grants, virtual
ownership and control of petroleum from
extraction to disposal. At the time, the Nigerian
Government’s interests were confined to nominal
ownership of the petroleum in situ, taxation,
royalties and lease rentals. The government’s
interests were overseen by the Petroleum
Resources Department. At the time this was a
department under the Federal Ministry of Mines
and Power in 1970 (responsible for the
enforcement of regulations governing oil field
operations) and the Petroleum Section of the
Ministry of Finance, which was responsible for
ensuring compliance with the fiscal obligations
pertaining to petroleum operations.
The rapid rise of oil production revenues in the
1970s (the ‘oil boom era’) hastened the realization
of the government policy of implementing OPEC
resolutions calling on member states to participate
more actively in oil operations. This in turn led to
the establishment of the Nigerian National Oil
Corporation (NNOC) by Act 1971 No. 18. The
NNOC operated alongside the Ministry of
Petroleum Resources (MPR) with separate and
distinct functions. The MPR continued the
functions of the Petroleum Resources Department
as regulator of petroleum operations of the oil
corporations, while the NNOC in 1971
commenced the process of acquisition of the assets
and liabilities of the existing foreign oil
corporations on behalf of the Nigerian
Government. The Nigerian National Petroleum
Corporation (NNPC) came into existence on 1
April 1977 pursuant to Act 1977 No. 33. It
embodied a merger between the NNOC and the
MPR: the NNPC fully succeeded the NNOC in all
aspects, assimilating the MPR’s regulatory
functions under a Petroleum Inspectorate
Department.
In 1979, the NNPC completed the process of
acquisition of the majority interests in the
operations of the oil corporations then engaged in
exploration and production of oil in Nigeria, which
up until then were 100% wholly owned by those
corporations. It should be noted that the NNPC
760
acquired participation interests in the petroleum
operations as opposed to the equity holdings within
those corporations. Such acquisitions resulted in
the creation of what is termed the Traditional Joint
Venture (TJV) as presently exists in the oil and gas
sector. The acquisition of each interest was to be
formalized by the simultaneous signing of heads of
agreement with participation agreements and,
thereafter, the Joint Operating Agreement (JOA).
This process, however, suffered protracted
periods of delay and stalemate, principally due,
aside from bureaucratic factors, to the deep-seated
disagreements between the oil companies and the
government over the valuation of interests. Such
delays not only resulted in the non-execution of
participation agreements until 1984 but also
accounted for the non-existence of JOAs long after
the federal government had effected its
acquisitions. An anomalous situation therefore
arose whereby from the period of acquisitions to
the signing of the JOAs in July 1991 – apart from
off/take scheduling and lifting of crude oil –
operation of joint venture business was conducted
on the basis of an informal understanding.
As aforementioned, the NNPC had, in
succeeding the NNOC during the course of these
acquisitions, subsumed the functions of the
Ministry of Petroleum Resources under the
Petroleum Inspectorate Department within the
NNPC. However, in 1986, the Petroleum
Inspectorate, responsible for regulation and policy
formulation, was detached from the NNPC and re-
created as the Department of Petroleum Resources.
The NNPC was thus left to engage in the
commercial aspects of oil and gas activity through
the NAtional Petroleum Investment Management
Services (NAPIMS).
These activities are conducted mainly on the
basis of the TJV arrangements concluded between
the NNPC and the foreign multinational oil
corporations which currently operate in Nigeria
through a variety of locally registered subsidiary
companies, usually linked to a specific project or
operational function. NAPIMS, on behalf of the
government, controls a majority stake in the six
TJV operations alongside the Nigerian subsidiaries
of the Royal Dutch Shell Group, ExxonMobil,
ChevronTexaco, Eni/Agip and TotalFinaElf, which
account for the majority of Nigeria’s total
production. The Shell TJV is currently the largest
of the joint venture operations. The oil
corporations, which have undergone worldwide
mergers over the past decade, continue to discharge
their functions as partners to the NNPC and
operators to the joint venture, through the
ENCYCLOPAEDIA OF HYDROCARBONS

corporate entities which existed before the mergers
occurred. All daily decisions are taken through
their management, and all operating costs of each
joint venture are financed jointly between the joint
venture partners, in accordance with their equity
interests, and by a system of monthly cash calls.
The contractual relationship between the NNPC
and the joint venture partners is subject to a
Memorandum Of Understanding (MOU), designed
to provide attractive fiscal incentives to the
participating oil corporations in exchange for
increased investment and efficient operations. In
principle, the MOU is subject to regular review in
order to adjust to ruling cost, production and oil
price regimes. The operational basis for the joint
venture and the MOU is the joint operating
agreement, which: a) designates the operator of the
joint venture; b) specifies each partner’s share in
the cost of petroleum operations; c) indicates PPT
and royalty obligations; and d ) outlines various
commercial principles, among other
considerations. The JOA permits the NNPC to
reserve the right to become the operator in any
joint venture undertaking. However, a lack of
sufficient indigenous expertise and, more
importantly, financing continues to constitute an
impediment to the realization of such a right. With
most of the major oil and gas projects focusing on
the joint venture operations in which NNPC is the
major shareholder, matters of joint venture funding
and cash calls continue to be of paramount concern
to state participation policy within the sector.
12.9.3 Current structure
of the Nigerian
oil and gas sector
With the following major sedimentary basins in
Nigeria, namely Anambra, Bida, Sokoto, Chad,
Benin/Dahomey, Benue basin/trough and the Niger
Delta, seismic records have over time overwhelmingly
testified to the level of proven reserves; and these
principally in the Niger Delta, therefore making it the
focal point for exploration and production
development. Thus, all oil production to date has
occurred in the Niger Delta basin.
Although the majority of the oil is to be found in
relatively simple sub-surface geological structures,
operating conditions in the Niger Delta basin have
always been acknowledged as challenging. The
onshore terrain of exploration ranges from mangrove
jungles, marshes and swamps to the shallow water
continental shelf and requires significant
commitment in terms of human skill and financial
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resources, with logistics and ecological dangers
largely contributing to discovery and development
costs. Major discoveries and the demonstration of
huge proven oil and gas reserves compensate for
substantial investments. However, difficulties of such
onshore exploration are compounded by the
perennial incidents of community instability, attacks
on installations and sabotage of oil and gas-related
facilities.
The petroleum industry has nevertheless
provided a highly profitable foundation for
extensive participation by a wide range of oil
service contractors in Nigeria. These extend over a
broad field from seismic exploration, rig
construction, drilling, well finishing and
completion, to the logistics of pipeline installation
and complex project management. Although major
global operators in the oil service sector operate
joint ventures with Nigerian partners and have
been closely involved in developing skill, capacity
and competence among their partners, local
involvement, however, remains low. The emergent
local content policy, which is another facet of the
indigenization of the upstream oil sector, seeks to
balance the need to attract and retain foreign
capital and technology, as well as to increase
indigenous participation in the oil service sector.
1990s to the present: the movement offshore,
modification of state participation
and indigenization
The developments of 3 dimensional (3D)
seismology and deep drilling technology have
made the deep seas a very attractive proposition for
oil exploration. It was in response to this
overwhelming potential that the Nigerian offshore
exploration, deepwater development programme
commenced through the licensing round 1990-91.
The government, which had already begun re-
evaluating its involvement in its TJVs, offered for
bidding a number of new concessions in the deep
outer shelf of the Niger Delta area. In 1993, deep
offshore blocks in water depths of between 200 m
and 3,000 m were awarded to foreign oil
corporations such as Royal Dutch Shell,
ChevronTexaco, ExxonMobil, TotalFinaElf and
Eni/Agip. These corporations were mandated to
incorporate new subsidiary entities under the
production sharing contract arrangement.
Such contractual arrangements have since become
the contractual vehicle of choice between the
NNPC and oil corporations for offshore
exploration and production of oil and gas. In
March 2000, the government opened competitive
bidding on 22 new oil blocks, including 11 in the
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
Niger Delta deep and ultra-deep offshore, in which
46 oil companies participated, and in 2005, the
government made available a further 43 oil blocks.
The emergence of the offshore regime also
resulted in the entrance of new foreign oil
corporations into Nigeria, including Exxon (now
ExxonMobil), Conoco (now ConocoPhillips),
Canadian Occidental (now Nexen Petroleum),
Statoil/British Petroleum Alliance, Jerez Energy,
Marathon Oil, Trans Atlantic Petroleum
Corporation, Ocean Energy, as well as BP Amoco -
which had until the latter part of the 1990s also been
involved but subsequently withdrew its interests in
the country. However, despite the current dominance
of onshore/shallow water exploration and production
to date (where major new discoveries continue to be
made), since the beginning of the offshore
exploration and development campaign in 1995, a
number of sizeable discoveries have been made in
the offshore area. The major commercial finds
are Erha (Oil Prospecting Licence, OPL 209),
Bonga (OPL 212), Agbami (OPL 216), and Akpo
(OPL 246). Despite the aforementioned, the
competitiveness of the Nigerian deep water regime
in comparison to other deep water basins such as the
Gulf of Mexico is yet to be established and this will
doubtless have an impact on the contractual and
fiscal arrangements, which will govern it in the near
to medium-term future.
The 1990s also witnessed the articulation of an
‘indigenous policy’, which resulted in the
emergence of indigenous oil producers in Nigeria,
hitherto largely stultified by the dominance of
foreign oil investment interests and the financial
and technical requirements necessary for
participation in oil and gas exploration. Since the
1990s, the indigenous producers have become a
growing presence. Their role in the industry, in the
context of increased opportunities, for direct
investments and joint venture relationships has
been promoted and facilitated by policy directives
of the state in 1989 – by the Ministry of Petroleum
Resources and particularly, under the Petroleum
(Amendment) Act 1996 No. 23, which gave a
legislative underpinning to the marginal fields
regime.
The Nigerian government held a special
licensing round to offer marginal fields to local
firms and in June 2002, pre-qualified 71
companies out of 150 that submitted bids. The
licensing round, which was held in November
2002, was to allow for more participation by
indigenous oil companies in Nigeria’s upstream oil
exploration and production activities. 24 marginal
fields, which had been relinquished by Shell,
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ChevronTexaco and TotalFinaElf, were distributed
to 31 of the 71 companies pre-qualified prior to the
licensing round. The government has identified
about 116 fields in the Niger Delta, which it
categorizes as marginal. They are located within
existing Oil Mining Leases (OML), which
according to the government have substantial
collective reserves and have not been developed
under the TJV arrangements between the
multinational oil corporations and the NNPC.
These have been proposed for allocation in future
marginal field licensing rounds.
The indigenous oil companies are essentially
sole risk operators and generally enter into
partnerships – either of the nature of a PSC or joint
venture relationship – with foreign oil
corporations. Production caps imposed on
indigenous producers to ensure the OPEC quotas
are not exceeded make it clear that indigenous
operators are more at risk and more vulnerable
than the multinational oil corporations to oil
production policies of the state.
12.9.4 State participation
Structure
State participation in Nigeria was defined in
the pre-independence era through the concession
system. In the immediate post-independence era,
namely, the early 1960s, where oil and gas
production expertise and capability in the domestic
sector was virtually non-existent, it seemed logical
to continue with the concession system to make the
maximum call on the resources of the worldwide
private oil industry.
State participation continued (through the
1970s and 1980s) within a modified framework of
governmental partnership with private enterprise
involvement. To date, such participation has been
manifested through the present mode of state
control and involvement in the exploration and
production activities of the multinational oil
corporations. The TJV arrangement, the PSC and
the RSC (Risk Service Contract) are common
contractual devices by which the Nigerian
government has implemented its policy of direct
participation in oil exploration and production.
Nigerian National Petroleum Corporation
The prevailing policy of direct state
participation has been exemplified by the
mandatory intervention of a wholly-owned state
enterprise to achieve: a measure of control over the
licensee’s operations; physical control of vast
ENCYCLOPAEDIA OF HYDROCARBONS

quantities of oil; the acquisition of information and
know-how about the industry.
The emergence and growth of the NNPC is
thus intrinsically linked with such policy
objectives. The acquisition by the NNPC of
majority participation rights under existing
concessions was thereon fortified by Federal
Government Notice 1972 No. 311, which vested all
unallocated acreages and reversions in leased
sedimentary blocks, onshore and offshore Nigeria
in the NNOC then, and now the NNPC. The NNPC
was also given powers and operational interests in
refinement, petrochemical processing and product
transport as well as marketing, in addition to its
exploration and production activities. Between
1978 and 1989, the NNPC constructed refineries in
Warri, Kaduna and Port Harcourt and took over the
Shell refinery established in Port Harcourt in 1965.
The NNPC, headquartered in Abuja (Federal
Capital Territory), Nigeria, now stands as a
monolithic corporate entity headed by a Group
Managing Director with six directorates. The first
five directorates listed below are each headed by
Group Executive Directors, while a General
Manager heads the sixth directorate. The
directorates are: a) Engineering and Technology;
b) Refineries and Petrochemicals; c) Commercial
and Investments; d ) Exploration and Production;
e) Finance and Accounts; f ) Corporate and Legal
Services. There is also a Public Affairs Division
headed by a General Manager.
The NNPC has ten subsidiary companies; two
joint ventures and about ten affiliated companies,
which are engaged in a variety of upstream and
downstream activities. Within the Exploration and
Production Directorate, the NAPIMS monitors and
supervises all aspects of the government’s
investments in the TJVs, PSCs, RSCs and other
allied contractual arrangements in the upstream
sector of the industry.
The NNPC’s subsidiaries are:
• Nigerian Petroleum Development Company
(NPDC) Limited – a sole operator, subsidiary
of the NNPC, engaged in exploration and
production of crude oil from acreages, wholly
owned by NNPC in contrast to the joint venture
interests to which NNPC is a non-operator
partner.
• Pipelines and Products Marketing Company
(PPMC) – an entity responsible for the
transportation of NNPC’s crude oil to refineries
in Nigeria. It also imports, distributes and
markets refined products through its pipelines.
• Kaduna Refinery and Petrochemicals Company
(KRPC) Limited.
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• Eleme Petrochemicals Company (EPCL)
Limited.
• Port Harcourt Refinery Company Limited
(PHRC).
• Warri Refinery Petrochemicals Company
(WRPC) Limited.
• Integrated Data Services (IDSL) Limited – an
entity providing seismic data acquisition,
processing and interpretation services to the oil
and gas sector generally.
• National Engineering and Technical COmpany
(NETCO) – an entity providing engineering
services to NNPC’s direct exploration
operations, with a technical affiliation to
Betchel Corporation of the United States.
• Nigerian Gas Company (NGC) Limited – this
entity was established in 1988 from the former
Gas Division of the oil and gas section of
NNPC. NGC is responsible for the
development of a gas industry to serve the
domestic energy needs and provide industrial
feedstock requirements through a national
integrated pipeline network. The company is
also established to participate in the
international natural gas market, particularly
the West African sub-region through the export
of the gas and its derivatives.
• Duke Oil Services (UK) Limited – a company
established in the United Kingdom for purposes
of international trading of NNPC crude oil and
petroleum products.
The NNPC has two downstream joint ventures:
• Nigerian Liquefied Natural Gas (NLNG)
Company is an incorporated joint venture made
up of the NNPC (49%), Shell Gas B.V.
(25.6%), Cleag (a subsidiary of Elf now
TotalFinaElf; 15%), Agip International B.V.
(10.4%), with Shell as technical partner. The
NLNG Company is responsible for the
liquefaction of non-associated and associated
natural gas for export.
• HYdrocarbon Services Of Nigeria (HYSON) is
an incorporated joint venture with Calson
(Bermuda) for the purpose of supplying
petroleum products from Nigeria’s refineries to
sub-Saharan Africa.
The Department of Petroleum Resources
The Petroleum Inspectorate within the NNPC
structure, responsible for regulation, was detached
in 1986 and recreated as the Department of
Petroleum Resources (DPR). The DPR is headed
by a Director General who is responsible for
setting standards for the effective control of the
petroleum industry. The DPR’s general
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
responsibilities and objectives are to ensure:
compliance with petroleum laws and regulations
through the monitoring of the operations of the
exploration companies; the full development of
Nigerian petroleum resources; the protection of all
oil and gas investments (foreign, local, public and
private).
The previous objectives have been expanded by
the DPR in enumerating its stated functions in the
upstream oil and gas sector to be: a) the supervision
of petroleum industry operations carried out under
licenses and leases; b) collaborating in this regard
with other government agencies such as the Ministry
of Finance, Central Bank of Nigeria and the
Nigerian Customs Service; c) ensuring conformity
of oil and gas operators with technical and safety
regulations and ensuring conformity of operations
with national industry standards and practices; and,
further to this, d ) maintaining records of petroleum
industry operations, such as petroleum reserves,
production, exports, licences and leases. Note that in
this regard, part of the functions of the DPR in
seeking to enforce technical/operational standards
essentially converge with the functions of the
NAPIMS in maintaining the efficiency of the
government’s investments within the upstream
sector.
Furthermore, the DPR processes all
applications for licences from all entities seeking
to carry out business in the oil and gas sector. In so
doing, it regulates and certifies by way of
guidelines, the prerequisites for all registration
requirements and/or bid submissions in the sector
on behalf of the Ministry of Petroleum Resources.
It also advises the MPR on technical and policy
matters under the following enabling and
subsidiary legislation: a) Petroleum Act; b)
Petroleum (Drilling and Production) Regulations;
c) Mineral Oils Safety Regulations; d ) Oil
Pipelines Act; and e) Oil and Gas Pipelines
Regulations.
Ministry of Petroleum Resources
The Ministry of Petroleum Resources is the
government ministry charged with the formulation
and implementation of government policy and
general management of the operations of the
petroleum industry. The MPR has as its sub-unit,
the DPR, and discharges a number of duties
including representing the government at domestic
and international level. Such international fora
include representation of the government at OPEC
meetings (particularly at quota negotiations).
In the domestic context, the MPR formulates
domestic industry policy as well as oil and gas
764
resource management policy (on the DPR’s
recommendation), particularly through oil
production reserves generation and the issuance of
licences to operators engaged in any petroleum
activity. Ancillary to the aforementioned is the
MPR’s duty of collation of economic, commercial
and technical data on the oil and gas industry, and
generally ensuring the compliance of all entities
operating under licences, with legislation and
regulations in the sector.
From May 1999 to July 2005, the office of the
Minister of Petroleum Resources was vacant and
the responsibilities of the position – particularly
with regard to representation of the government at
domestic and international level, attendance of
OPEC deliberations, and formulation of domestic
industry policy and resource management – have
been jointly discharged by the office of the
Special Adviser to the President of Petroleum
Affairs and the Group Managing Director of the
NNPC. However in July 2005, a Minister
of Petroleum Resources was appointed who has
resumed the proper discharge of the roles
aforementioned.
12.9.5 The impact of the law
of the sea on Nigerian oil
and gas law
Risks of pollution and environmental
degradation
The Convention on the Territorial Sea and
Contiguous Zone of 1958 and the Convention on
the Continental Shelf of 1958, which were
superseded by the United Nations Convention on
the Law Of the Sea (UNCLOS) 1982, all represent
important sources of international law from which
Nigerian oil and gas law has thus far developed
and continues to develop.
The scope of Nigerian oil and gas legislation
has been progressively extended to its territorial
waters, Continental Shelf and Exclusive Economic
zone, by various legislative enactments, which arose
principally from developments of international law
and in anticipation of the movement of exploration
activity from onshore to offshore. However, despite
the likelihood of conditions radically different from
those obtained on land, after the promulgation of
the Petroleum Act in 1969, a separate legal
framework for offshore exploration has not been
deemed necessary. No attempt has thus far
been made to devise an original system of legal
regulation for offshore activity. The landward
regime has simply been extended to all areas
ENCYCLOPAEDIA OF HYDROCARBONS

outside Nigerian territorial waters in which
international law recognizes the rights of a coastal
state with respect to the seabed and subsoil as well
as their natural resources.
Recent deepwater discoveries have underscored
the overwhelming importance of offshore
exploration since the first deepwater licensing
rounds 1990-91. As international agreements are
also forged between Nigeria and other countries
for the exploration and exploitation of oil and gas in
the Gulf of Guinea, the continued focus on
deepwater exploration and the development of
international law will doubtless affect the pace and
direction of Nigerian oil and gas legislation.
Current legislative provisions regarding the
scope of ownership of oil and gas are to be found
in the following legislative provisions:
• Section 1 of the Petroleum Act which states:
“(1) The entire ownership and control of all
petroleum in, under or upon any lands to which
this section applies shall be vested in the state.
(2) This section applies to all land (including
land covered by water) which – a) is in Nigeria;
or b) is under the territorial waters of Nigeria; or
c) forms part of the Continental Shelf or d)
the Exclusive Economic Zone. (3) In this
section, references to territorial waters are
references to the expression as defined in the
Territorial Waters Act”.
• The Constitution 1999 of the Federal Republic
of Nigeria further restates this position under
s. 44(3) which provides that, “Notwithstanding
the foregoing provisions of the section, the
entire property in and control of all minerals,
mineral oils and natural gas in, under or upon
any land in Nigeria or in, under or upon the
territorial waters and Exclusive Economic Zone
of Nigeria shall vest in the Government of the
Federation and shall be managed in such
manner as may be prescribed by the National
Assembly”.
The law of the sea has also enabled Nigeria to
enter into maritime treaties for the exploitation of
its continental shelf. A major example of this is the
Treaty 21 February 2001 between Nigeria and the
Republic of São Tomé and Principe – which
established the Joint Development Zone (JDZ), in
respect of an overlapping area of the states’
respective maritime boundary claims – and created
a Joint Development Authority (JDA) as the sole
body to promote and supervise petroleum and
other activities in the JDZ. The JDA reports to a
Joint Ministerial Council (JMC), which has overall
political responsibility for the JDZ. The Treaty
outlines the principles for joint development as
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well as the general regime for petroleum-related
activities through the creation of a specific
regulatory and tax regime in the JDZ. All
petroleum development activities in the JDZ shall
be embodied in a zone plan, which will be
reviewed periodically.
The JDA is empowered to supervise all activity
related to the exploration and production of
petroleum resources in the JDZ. The JDA is
divided in four departments: a) Monitoring and
Inspections Department; b) Commercial
and Investment Department; c) Non-Hydrocarbon
Resources Department; d ) Finance and
Administration Department.
The Monitoring and Inspection Department
assumes similar functions to that of the Ministry of
Petroleum Resources and the Commercial and
Investment Department assumes a role similar to
that of the NNPC, both representing the states with
regards to all issues relating to exploration and
production in the JDZ. The JDA is vested with the
proprietary rights to all acreages in the JDZ on
behalf of the states and no petroleum activity can
be undertaken in the JDZ except pursuant to the
permission of the JDA and in accordance with the
Petroleum Regulations 2003. The JDA is governed
by a board and headed by a Chairman. It is
headquartered in Abuja, Nigeria.
The JMC comprises Ministers and related
personnel who, as mentioned before, retain overall
political responsibility for the JDZ. The JMC
receives reports and recommendations from the
JDA and is responsible for approving operational
aspects of the zone, such as the Guidelines for
Investors, Petroleum Regulations, Tax Regulations
and the Model PSC. The JMC reports directly to
the governments of the states.
12.9.6 The licensing of oil
and gas exploration
and production
The Petroleum Act which sets out the legal
framework for persons to be enabled to search for
and obtain such petroleum as well as the scope of
such rights, viz., from land to the Continental Shelf
and Exclusive Economic Zone, also empowers the
Minister to grant to such persons as he thinks fit,
licences and leases to explore, prospect, search for,
obtain, carry away and dispose of petroleum.
Section 2 of the Petroleum Act provides: “(1)
Subject to this act, the minister may grant: a) a
licence, to be known as an oil exploration licence
to explore for petroleum; b) a licence, to be known
765
NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
as an oil prospecting licence, to prospect for
petroleum; and c) a lease to be known as an oil
mining lease, to search for, win, work, carry away
and dispose of petroleum. (2) A licence or lease
under this section may be granted only to: a) a
citizen of Nigeria; or b) a company incorporated in
Nigeria under the Companies and Allied Matters
Act, or any corresponding law. (3) The provisions
of the First Schedule to this act shall, in so far as
they are applicable, have effect in relation to
licences and leases granted under this section”.
The Nigerian licensing regime, first formalized
in 1914 by the Mineral Oils Ordinance, has
evolved into the Petroleum Act 1969, and is based
on the principle of the proprietary rights of the
state. What this means in terms of the nature of
rights conferred by the licence and concomitantly
those obtained by the licensee will be examined
later in the chapter. Thus the state, having been
vested with the entire ownership or control of all
petroleum in accordance with s. 1 of the Petroleum
Act Cap. 350, was and is at liberty to decide how
petroleum is to be exploited or even whether it
should be exploited at all. It could therefore
undertake exploration and production itself,
through a wholly-owned entity of the state or by
joint venture (incorporated or unincorporated) or
by employing oil companies as contractors either
through production sharing contracts or through
Service Contracts (SCs) etc. to get the oil on its
behalf. Therefore, anyone who seeks to explore for
petroleum in a way other than under a licence or
contractual grant by the state is interfering with the
property rights of the state.
The licence serves to establish the rights of the
licensee in substances produced from the licensed
area and to regulate the manner in which
operations under the licence are conducted. It also
provides an instrument of governance for direction
of exploration efforts into particular areas and for
control of the rate of depletion of resources.
Licences are issued under the Petroleum
(Drilling and Production) Regulations, which the
Minister is empowered to make by virtue of s. 9 of
the Petroleum Act. These regulations lay down
conditions for application for licences. The
invitation for applicants in a licensing round is
provided for by way of guidelines or guidance
notes for the particular bidding or licensing round,
which lists the blocks on offer and indicates
application procedures.
Types of licence under the Petroleum Act
The powers conferred under the licence granted
pursuant either to a discretionary allocation or
766
bidding/licensing round constitute wide discretion
which is constrained by the provisions of the first
schedule to the Petroleum Act. These form part of
the parent legislation and the provisions of the
Petroleum (Drilling and Production) Regulations,
which are subsidiary legislation and are, by
operation of such legislation incorporated into the
licences and leases as model clauses unless waived
by the minister. These provisions also subject
licensees and lessees to regulatory requirements of
various types such as the Mineral Oils (Safety)
Regulations, Oil Pipelines Regulations and the
Crude Oil (Transportation and Shipment)
Regulations as well as other environmental laws,
regulations and guidelines.
Oil exploration licence
The Oil Exploration Licence (OEL) is usually
granted by the Minister in respect of an area of
undetermined potential on which a premium has
not been placed by the Minister. The licence
confers upon the licensee non-exclusive rights
subject to the surface rights of the owners or
occupiers of the area of the licence, to explore for
petroleum by geological and geophysical methods.
The OEL permits the licensee to erect temporary
structures necessary for operations, which may
thereafter be dismantled and removed and does not
preclude the grant of another oil exploration
prospecting licence or oil mining lease over part of
or the whole of the same area. The OEL has to all
intents and purposes fallen into disuse, although it
remains on the federal statute books. The present
practice is that the state engages the services of a
seismic data gathering service company and
such seismic information is available for perusal by
oil companies from the Department of Petroleum
Resources upon payment of set fees.
Oil prospecting licence
The Oil Prospecting Licence (OPL) conveys an
exclusive right to explore and prospect for
petroleum within the area of the licence. Its
duration cannot exceed five years including
renewals, and the grantee is entitled to carry away
and dispose of petroleum obtained during
prospecting operations subject to fulfilment of
special terms imposed under the Petroleum Act, the
PPT Act or any other law imposing taxation in
respect of petroleum.
Oil mining lease
The Oil Mining Lease (OML) is granted to the
holder of an OPL who has satisfied conditions
imposed either on the licence or on him by the act
ENCYCLOPAEDIA OF HYDROCARBONS

and who has also discovered oil in commercial
quantities. For these purposes, oil shall be deemed
to be discovered in commercial quantities by the
OPL holder if the Minister is satisfied with the
licensee’s evidence that the licensee is capable of
producing at least 10,000 barrels per day of crude
oil from the licensed area. The OML is an exclusive
right within the leased area to conduct exploration
and prospecting operations and to obtain, get, work,
store, carry away petroleum in or under the leased
area. The term of the OML shall not exceed 20
years but may be renewed under the Act.
12.9.7 Impact of environmental
protection laws
Risks of pollution and environmental
degradation
The risks of pollution and environmental
degradation are almost inevitable corollaries of oil
exploration, development and production. Nigeria
has not escaped these threats. Indeed, due to the lack
of a rigorous regime enforcing international
standards of good oil-field practice amongst its joint
venture partners, oil exploration and production
operations in Nigeria were subject to several oil spills
on variable scales, between the mid-1970s and the
late 1990s. The effects of flaring natural gas, which
the government now seeks to curtail and eliminate,
have also added significantly to the environmental
threats through the emission of vast quantities of
greenhouse gases and deforestation.
In particular, careless and unmonitored onshore
oil production, combined with peculiarities of
terrain where ecological damage can be rapid and
devastation of local flora and fauna long-lasting,
has resulted in severe strain on both agriculture and
fishing as well as jeopardizing the economic
stability of a vast number of local communities in
the Niger Delta. The installation of pipelines
running through numerous farmlands continues to
cause the destruction of vast areas of agricultural
land, ground-water sources, wildlife habitats and
ecosystems. Of all the identified causes of onshore
oil spillage, ruptured pipelines arising from
obsolete and or inadequate pipeline delivery
infrastructure, together with poor monitoring and
reporting, account for 70% of the incidents. The
remaining 30% are caused by engineering errors,
poor maintenance and sabotage.
Rural land in Nigeria represents a fundamental
safety net for a great number of people who
traditionally depend on their narrow range of crops
for subsistence agriculture and various indigenous
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medicines. Oil exploration activities have eroded
the livelihoods and incomes of most families who
previously relied on hitherto fertile homelands. A
further distorting factor has been the large amount
of displacement occurring within the rural
communities through expropriation of land during
the course of oil exploration and production
activities. Furthermore, the promulgation of the
Land Use Act 1978 No. 6 and its consequences of
vesting direct control and management of land in
the state Governor resulted in major oil
communities losing their farmlands to claims on
areas for oil production and transportation without
adequate compensation. Allied to this
expropriation of farmlands was further
displacement resulting from area pollution from oil
wells and flow stations.
Up until the late 1980s, regulatory measures
within the existing petroleum statutes had not
resulted in any substantial changes in the conduct
of oil exploration, with the operations of Shell (in
view of their exploration rights over vast acreages)
featuring prominently in the majority of the
instances of oil pollution.
The model clauses in the legislative enactments
and contractual provisions under the joint venture
arrangement, requiring that operations be conducted
with “good oil field practice” leave considerable
room for interpretation of what is practical or
possible in terms of environmental goals. Some
commentators have suggested that fundamentally the
willingness by the state over the past 30 years to
endure the effects of environmental damage in
respect of onshore and shallow water operations
indicated a financial dimension to the problem of
pollution, namely that the government frequently
sought to attract foreign investment by neglecting to
enforce environmental standards in general.
Development of regulatory framework
Background
The 1972 Stockholm Conference on the Human
Environment, which was attended by Nigeria,
ignited the consciousness of the Government on the
need to evolve a holistic rather than sectoral
approach to environmental protection. Thereafter,
the issue of controls on environmental degradation
was made the subject of Nigerian constitutional and
legislative provisions, in consonance with
international endeavours under the auspices of the
United Nations Environment Programme (UNEP)
and the International Maritime Organisation (IMO).
During the late 1970s and 1980s, there were
sectoral environmental regulations with various
767
NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
responsibilities relating to environmental
protection and improvement. There were also
commissions with an advisory capacity in
environmental matters and non-governmental
organizations dealing with environmental matters.
The Department of Petroleum Resources
endeavoured with limited success to adopt
remedial enforcement tools. These included
compliance monitoring within the context of the
Petroleum Act and model clauses incorporated into
the licence pursuant to the Petroleum (Drilling and
Production) Regulations.
Equally, environmental issues were not given
sufficient prominence until the dumping of toxic
wastes of Italian origin in Koko Port, Bendel State
(now Delta State), in May 1988 under a purported
private arrangement with the local inhabitants of
Koko. This represented the catalyst for environmental
enforcement and in reaction to widespread public
condemnation of the event, the government
immediately promulgated the Harmful Waste
(Special Criminal Provisions) Act 1988 No. 42 (Laws
of the Federation of Nigeria 1990, Cap.165), which
came into force on 25 November 1988.
An institutional framework was nevertheless
needed to deal with existing and anticipated
problems of the environment and the Federal
Environmental Protection Agency (FEPA) was
established by Act 1988 No. 58 and came into
force on 30th December 1988. It was amended by
Act 1992 No. 59 pursuant to which FEPA was
given responsibility for control over the
environment and development of processes and
policies to achieve its objectives. In addition to its
contributions to the National Policy on the
Environment (NPE) in 1989 it published other
sectoral regulations including the National
Environmental Protection (Pollution Abatement in
Industries and Facilities Generating Wastes)
Regulations, Statutory Instrument 1999 No. 9.
The Environmental Impact Assessment Act
(EIA) 1992 No. 86 established FEPA as the overall
regulator and made the EIA mandatory for all
development purposes (with specific exceptions).
State and local government councils were also
encouraged under Act 1992 No. 86 to establish
their own environmental protection agencies.
Under the authority of the same Act, FEPA
published the EIA procedural guidelines in 1995.
Current regulatory framework
Apart from the provisions of current petroleum
statutes, the current key regulatory framework is
outlined below:
Harmful Waste (Special Criminal Provisions,
768
etc.) Act (Cap. 165). This Act prohibits and
penalizes the carrying, dumping and importing of
harmful wastes (without lawful authority) on land,
territorial waters, the Contiguous Zone and the
Exclusive Economic Zone of Nigeria. Breaches of
the Act attract civil liability as well as criminal
penalties.
The FEPA Act (Cap. 131). This Act creates the
FEPA and pursuant to section 4, endows it with
the responsibility of prescribing the
environmental criteria and standards for
protecting Nigeria’s environment. Section 23 of
the FEPA Act provides that the Agency shall
cooperate with the Ministry of Petroleum
Resources through the DPR for the removal of oil
related pollutants discharged into the Nigerian
environment. The Act also states that the agency
should provide support to the MPR (DPR) as it
may from time to time request. As part of the
government’s efforts towards integrating
environmental concerns into development, the
guidelines and standards set in the FEPA Act prior
to the United Nations Conference on Environment
and Development (UNCED) were reviewed
through the enactment of the FEPA (amendment)
Act 1992 No. 59. Not only was FEPA’s mandate
expanded by an amendment to section 4 of the
FEPA Act, but it was made an integral part of the
presidency even though it is subject to the
direction (under the principal Act) of the Minister
for the Environment. The amendment also
empowered the Director General of the Agency to
make regulations for the purposes of the Act
prescribing standards for water and air quality,
effluent limitations, atmospheric protection,
ozone protection, noise control as well as control
and removal of hazardous substances.
The EIA Act 1992 No. 86. This Act seeks to
infuse environmental considerations into
development project planning and execution, by
providing that it shall be obligatory for an EIA
study to be conducted on any project likely to have
a significant impact on the environment. Such a
study is to be prepared at an early stage, before the
project is undertaken and directed to the FEPA for
approval. The EIA Act prescribes guidelines for
EIA studies, outlines project areas and sizes of
projects requiring EIAs in all areas of national
development as well as the restrictions on public or
private projects which were undertaken without
prior consideration of their environmental impact.
State legislation. In line with the FEPA Act,
some of the states, which make up the Federation,
including the three major oil producing states,
namely Rivers State, Delta State and Bayelsa State,
ENCYCLOPAEDIA OF HYDROCARBONS

have enacted the following pieces of environmental
legislation: Rivers State Environmental Protection
Agency Law 1994 and Rivers State Pollution
Compensation Tax Law 1994; Delta State
Environmental Protection Agency Law 1997 No. 5
and Delta State Pollution Compensation Law 1995;
Bayelsa State Environment and Development
Planning Authority Law 1996 and Bayelsa State
Pollution Compensation Tax Law 1998.
Applicable environmental instruments and
subsidiary legislation. The following instruments
of intervention in pollution control outline specific
offences, requirements and penalties for
contravention namely: a) the National Guidelines
and Standards for Environmental Pollution Control
in Nigeria; b) the National Environmental
Protection (Effluent Limitation) Regulations in
Statutory Instrument 1991 No. 8, which make it
mandatory for industrial facilities generating
wastes to retrofit or install at commencement of
operations anti-pollution equipment for
detoxification of effluents and chemical
discharges. The regulations also outline industrial
categories, crucial parameters and their limits in
effluents or emissions and prescribe penalties for
their contravention; c) the National Environmental
Protection (Pollution Abatement in Industries and
Facilities Generating Wastes) Regulations
Statutory Instrument 1991 No. 9, which provides
for, inter alia, the restriction on the release of
hazardous or toxic substances into the ecosystem,
pollution monitoring requirements for industries,
strategies for waste reduction, requirements for
environmental audits and penalties for
contravention; d ) the Management of Solid and
Hazardous Wastes Regulations Statutory
Instrument 1991 No. 15, which sets out a
comprehensive list of dangerous and toxic wastes,
contingency plans and emergency procedures.
These regulations also prescribe the guidelines for
ground water prevention, a toxic waste tracking
programme, and environmentally sound
technologies for waste disposal.
Environmental guidelines and standards for the
petroleum industry in Nigeria. The lack of detail
and enforcement mechanisms within petroleum
statutes, as well as the growing concern for adverse
environmental impact and damage arising from
oil-related pollution, prompted the need to control
new installations and projects within the oil sector
with the capacity to degrade the environment. This
compelled the Department of Petroleum Resources
pursuant to the Minister’s powers under the
Petroleum Act to issue Environmental Guidelines
And Standards for the Petroleum Industry in
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Nigeria (EGASPIN) in 1991, which were revised
and updated in 2002 in the light of advances in
pollution control technology. The EGASPIN
represent a comprehensive working document
covering environmental control of the six stages of
petroleum operations in Nigeria, namely
exploration, production, terminal operations,
hydrocarbon processing plants, oil and gas
transportation and marketing. Specifically, the
guidelines deal with monitoring, handling,
treatment and disposal of effluent. They prescribe
tentative limits of waste discharges into fresh
water, and offshore areas of operation, where
established, as well as focussing on the
characteristics of gaseous, liquid and solid wastes
generated. The guidelines are subject to periodic
review.
12.9.8 Development
of natural gas
The prospects for the commercialization of natural
gas, principally through liquefaction for export,
and in the more efficient use of gas for domestic
industrial energy generation, coupled with the
imperative to end flaring gas for compelling
environmental reasons, resulted in a significant
shift commencing in the 1980s through the 1990s
towards natural gas as the basis for Nigeria’s future
hydrocarbon industry.
The execution of the Associated Gas Framework
Agreements (AGFA) in 1992 provided a foundation
for a series of incentives and inducements that were
re-enacted into legislation under the Petroleum Act as
well as the PPT Act and in turn resulted in the
establishment of a wide range of gas utilization
projects, some of which began to come on stream at
the end of the 1990s. Such domestic utilization
projects, which have been directed at improving the
quantity and reliability of energy generation, were
undertaken by the NNPC’s natural gas subsidiary, the
Nigerian Gas Company, in order to improve the
efficiency of the state-owned National Electrical
Power Authority (NEPA).
Other significant investment endeavours by
Independent Power Producers (IPPs) have been
encouraged, including power-generating projects
sponsored by ExxonMobil, Agip, Siemens, Asea
Brown Boveri (ABB). Equally, gas gathering,
transmission and delivery projects have also been
undertaken by dedicated gas-related companies
formed by major oil companies such as Shell and
Chevron Nigeria Limited in order to realize natural
gas utilization programmes. In this regard, the
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
Nigeria Liquefied Natural Gas (NLNG) project,
conceived in 1989, and the Chevron multi-phase
Escravos gas project, conceived in 1992, are the
most prominent of such gas utilization projects to
date. There is further illustration of this through
regional initiatives such as the West African Gas
Pipeline (WAGP) project, which is at its final
planning stages and seeks to establish a natural gas
transmission pipeline to supply Nigeria’s
neighbouring states with gas, principally for power
generation. Also significant is the West African
Power Pool (WAPP) which is a long term (15-20
years) plan for the integrated utilization of gas in
power generation by the Economic Community Of
West African States (ECOWAS).
12.9.9 Taxation of oil and gas
Government take in the Nigerian oil and gas sector
is derived presently from four principal sources: a)
direct taxation under the Petroleum Profits Tax Act
and the Companies Income Tax (CIT) Act;
b) oil and gas field levies such as rents and
royalties; c) licence bonuses or premiums and fees;
d ) miscellaneous levies under petroleum statutes
and other enactments; e) indirect taxation.
The nature of PPT
The PPT Act was passed into law as Ordinance
1959 No. 15 on 23 April 1959 with retroactive
effect from 1 January 1958. The PPT Act is the
main body of legislation on petroleum profits tax
and is now contained in Laws of Nigeria 1990 Cap.
354. It imposes a tax and provides for the
assessment and collection of such tax from the
winning of petroleum in Nigeria and in this regard,
it takes precedence over other tax laws. It
comprises 11 parts and 4 schedules and its
provisions are administered by the Federal Board
of Inland Revenue (FBIR), established and
constituted under s. 1 of the CIT Act. Furthermore,
the Board is deemed to have been established and
set up with all constituent powers and duties as set
out in s. 3 of the PPT Act.
Petroleum profits tax applies to the chargeable
profits for a given accounting period at the rate of
85% (effective from 1 April 1975). There is,
however, a reduced rate of 65.75%, payable within
the first five years of operations, allowing for all
pre-production capitalized expenses to be fully
amortized. The profits of any company engaged in
petroleum operations as expressed in the definition
section of the PPT Act are wholly subject to the
PPT Act and are, by s. 19 (h) of the CIT Act,
770
exempt from tax imposed by the CIT Act. Equally,
s. 55 of the PPT Act further restricts the scope of
the Income Tax Management Act 1969 No. 81
(Laws of the Federation of Nigeria 1990, Cap.173),
now repealed and replaced by the Personal Income
Tax Act 1993 No. 104, which regulates the taxation
of the income of persons other than companies. It
also provides that no tax shall be charged under the
provisions of the Income Tax Management Act or
under any other Act in respect of any income or
dividends paid out of any profits which are taken
into account under the provisions of the PPT Act in
the calculation of chargeable profits (upon which
tax is charged, assessed and paid).
Application of the Companies Income Tax Act
The specific scope of application of the PPT Act
means that its provisions do not extend to the many
and varied activities of oil service contractors,
which include such services as exploration, drilling,
construction, pipeline production, equipment
supply, consultancy services, laboratory services,
marine transportation, pressure testing, calibration,
diving and dredging services etc. This is premised
on the fact that such activities do not involve such
entities in the “winning or obtaining and
transportation of petroleum or chargeable oil for
their own account”. Therefore, such entities will be
taxed in accordance with the provisions of the CIT
Act. Likewise, should the oil exploration and
production companies become additionally engaged
in activities which do not come within the ambit of
petroleum operations and where such activities
cannot be classified as operations incidental to such
petroleum operations, they must be taxed under the
CIT Act.
The assessable tax for any accounting period
under the CIT is 30%. However, a full exegesis of
the CIT Act is not within the scope of this work
and some basic knowledge of the CIT regime is
therefore assumed. There are, however, certain
aspects of the CIT regime, which are either
relevant or applicable to the PPT regime. The most
significant are the administration as well as the
principle of ascertainment of profits based on
expenses incurred “wholly, exclusively, necessarily
and reasonably” so that tax liabilities are based on
book profits of the company which are then
adjusted to arrive at the taxable profits. In this
regard, the most significant adjustments are the
reliefs given by way of capital allowances.
Accounting period
The taxation of a company engaged in petroleum
operations is applied for an accounting period.
ENCYCLOPAEDIA OF HYDROCARBONS

According to the definition section of the PPT Act,
this means, “a period commencing 1 January and
ending 31 December of the same year or (a) shorter
periods commencing the day the company first
makes a sale or bulk sale of chargeable oil under a
programme of continuous production and sales and
ending on 31 December of the same year or (b)
commencing on the 1 of January and ending when
the company ceases to engage in petroleum
operations”. Such date of cessation is to be
determined by the Minister of Petroleum.
PPT payable
Since the enactment of the PPT Act, percentage
rates of PPT have been reviewed in the following
manner: 50% with effect from 1 January 1958;
55% with effect from 20 March 1971; 60.78% with
the effect from 1 October 1974; 65.75% with the
effect from 1 December 1974 and 85% with effect
from 1 April 1975. The Act provides that the
assessable tax for any accounting period shall be
an amount equal to 85% of the chargeable profits
for the period. However, where the company is yet
to commence sale or bulk disposal of chargeable
oil under a programme of continuous production
and sales and has not fully amortized all its
pre-production capitalized expenditure, its
assessable tax shall be 65.75% of chargeable
profits for the period.
Laws applicable to oil and gas
The laws applicable to oil and gas transactions
are essentially determined by the common law rules
of private international law in Nigeria. These rules
provide that the “proper law of the contract” shall be
the law of the country in which the contract is
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NIGERIA
created, the lex loci contractus and performed, the
lex loci solutionis.This very often, is Nigeria.
However the concerns of foreign investors are
primarily based on the uncertainy as to the limits of
the state’s power as well as the uncertainties due to
delays and possible unfairness of the Nigerian legal
system. These concerns have been partially
addressed by provisions within the licence, joint
venture agreement and production sharing contracts
which provide for arbitration in accordance with the
United Nations Commission on International
TRAde Law (UNCITRAL) rules.
A foreign investor’s rights are generally
protected from expropriation by provisions in oil
and gas laws. These however do not extend to
changes in the governing law by the state, which
adversely affect the economic interests of the
investor. An investor’s rights are also protected by
Bilateral Investment Treaties (BITs) and
Multilateral Investment Treaties (MITs) such as the
ECOWAS Energy Protocol (modelled on the
Energy Charter Treaty) and the Washington
Convention which created the International Centre
for Settlement of Investment Disputes (ICSID).
Such investment protection instruments are
increasingly being employed in the Nigerian oil
and gas sector to protect foreign investors’ rights
under licenses and exploration and production
contracts. This trend will continue for the
forseeable future as offshore financing plays an
increasingly vital role in the development of the
Nigerian oil and gas sector.
Adedolapo Akinrele
F.O. Akinrele & Co. Law Firm
Lagos, Nigeria
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 12.10
The United Arab Emirates
12.10.1 Introduction
The United Arab Emirates (UAE) is an old and large
oil producer in a major producing area, the Arabian
Gulf. It is a member of both the Organization of the
Petroleum Exporting Countries (OPEC) – Abu Dhabi
joined the organization in 1967 and the Federation
took over this membership in 1974 – as well as the
Organization of Arab Petroleum Exporting Countries
(OAPEC) since 1970. The UAE possesses extensive
reserves of oil and gas, and enjoys a comfortable
production capacity. In effect, oil is the cornerstone of
its economy.
Oil was first discovered in Abu Dhabi in 1958.
Production began in 1962 from the offshore areas,
then followed in 1963 with onshore fields. The oil
sector was developed very quickly. Abu Dhabi began
exporting crude in 1963 and soon became a major oil
exporter worldwide. In Dubai, oil in commercial
quantities was discovered in 1966 and the first cargo
was shipped in 1969. Oil was subsequently discovered
in Sharjah in 1972, with exports commencing in 1974.
Ràs Al Khaymah was the fourth Emirate to find and
exploit oil in 1983. Of the seven Emirates comprising
the Federation, Abu Dhabi is the largest oil producer
with the most abundant oil reserves (over 90% of the
Federation’s oil and gas reserves, estimated at 92.26
billion barrels – as against 4.0 billion for Dubai, 1.5
billion for Sharjah, and 0.1 billion for Ràs Al
Khaymah).
The UAE has neither a unified federal oil policy
nor a federal petroleum legislation under which the
conditions governing grants for exploration and
development permits are fixed in advance.
In accordance with the UAE Constitution, certain
matters are left to the jurisdiction of the individual
member Emirates, such as petroleum affairs. Each of
the oil producing Emirates has a Petroleum
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Department, the most important is that of Abu Dhabi.
It should be noted that since 1988, the Petroleum
Department in Abu Dhabi has been replaced by the
Supreme Petroleum Council of the Emirate of Abu
Dhabi. These Departments grant exploration permits
and oil concessions, concluding various oil
agreements, defining the petroleum policy of each
Emirate, and exercising the other functions of public
authority in the field of petroleum.
As Abu Dhabi is the most profitable and largest oil
producing Emirate, with the biggest oil reserves and
the longest history of relationships with foreign oil
companies, it is appropriate to concentrate on its legal
framework for the development of petroleum resources
as representative of the UAE in this respect.
12.10.2 Sovereignty over
petroleum resources
The concerted efforts of underdeveloped countries in
the post-war period led to the issuance of a series of
United Nations Resolutions on the question of
permanent sovereignty over national natural resources.
The first Resolution was passed in 1952. Host
countries were advised, by exercising their permanent
sovereignty, to secure the maximum exploration of
natural resources by the accelerated acquisition of full
control over production operations, managing and
marketing.
The producing countries of the Middle East,
equipped with this new chart of economic rights
endorsed by the highest international forum, pursued
their efforts to improve the terms and conditions of the
existing concession agreements in light of the dictates
of their permanent sovereignty.
The model of the joint venture agreement was
conceived in order to provide a compromise of
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
maintaining permanent sovereignty over natural
resources, while developing these resources at the
same time. The first model of this form of
agreement was introduced to the area when the
Italian national oil company ENI (now Eni), under
the late Enrico Mattei, signed two joint venture
agreements with Egypt and Iran in 1957.
Abu Dhabi did not adopt that form of agreement,
but continued its efforts to introduce improvements
in the two main existing oil concessions – ADPC
(Abu Dhabi Petroleum Company) concession
onshore and ADMA (Abu Dhabi Marine Areas)
concession offshore – and to conclude new
modernized oil concession agreements with better
terms and conditions on the acreage available. A
first set of improved concession agreements was
concluded in the period 1967-71. A second set was
completed during the period 1980-81, bearing
further improvements.
Towards the end of 1972, a radical change
occurred in the oil scene in the Middle East with the
introduction of a new concept: participation of the
host Governments in the existing oil concessions. A
general agreement on participation was signed in
December 1972 between the Governments of various
oil producing countries in the region (i.e. Saudi
Arabia, Abu Dhabi, Qatar and Kuwait) and the oil
concessionaires in the respective countries. The initial
share of participation granted to the Government was
25%. In 1974, however, the Governments concerned
succeeded in convincing the oil companies to raise
their participation share to 60%. In the case of Abu
Dhabi, two agreements were concluded in September
1974, both with the major concessionaires, ADPC
onshore and ADMA offshore, raising Abu Dhabi’s
participation to 60%.
The Participation Agreement 1974 was brief and
contained only general principles, stipulating that an
implementing agreement was to be concluded to
provide detailed arrangements and procedures. In Abu
Dhabi, two implementing agreements were concluded:
one with ADMA in 1977, and the other with ADPC in
1978. A brief description of the participation
agreements as implemented in Abu Dhabi will be
provided further.
Through these agreements and arrangements,
the Government of Abu Dhabi believes to have
attained sovereignty over its petroleum resources
and also to have realized its basic objectives:
effective control of the production phase of the
industry (levels of production and allowables are
determined by a unilateral decision of the
Government, and crude oil prices in accordance
with OPEC resolutions); true participation
in the decision-making process; gaining experience
774
and training for its nationals, while securing
the contribution of the foreign partners through
know-how and expertise.
12.10.3 Ownership and title
to underground petroleum
resources
Underground petroleum resources as well as other
natural resources belong to the state: art. 23 of the
United Arab Emirates’ Constitution stipulates, “the
natural resources and wealth in each Emirate shall be
considered to be the public property of that Emirate.
The Public Authority shall be responsible for the
protection and proper exploitation of such natural
resources and wealth for the benefit of the national
economy”.
Art. 1206 of the UAE Civil Transaction Code
states: “Minerals found under the ground shall be the
property of the State even if they are found in a
privately owned land”.
It is worth mentioning that the natural resources
belong to the state, according to the majority of
Islamic schools. The state grants concessions to
investors in consideration of certain payments. In
Islam, a person only owns what one has produced
or developed by one’s own efforts (El Malik,
1993). This has been the trend of most Muslim
countries in the Twentieth century (Saudi Arabia,
Kuwait, Iraq, UAE, Egypt, etc.). Other Middle
Eastern states, not mentioned above, follow the
same pattern of state ownership of minerals. Art. 1
of the Mining Code of Saudi Arabia clearly
articulates this principle: “All natural deposits of
minerals, in any form or combination either in soil
or subsoil, belong exclusively to the state. This
includes both land and sea territories comprising
the continental shelf ”.
12.10.4 The structure
of petroleum regulations
and the operating
conditions
The structure of petroleum regulations and operating
conditions will be best presented together in view of
the particularity of the legal framework for the
development of petroleum resources in Abu Dhabi.
In the Emirate of Abu Dhabi, no comprehensive
petroleum legislation exists under which the terms and
conditions governing the granting of petroleum
exploration and development permits are fixed in
advance. However, certain aspects of the petroleum
ENCYCLOPAEDIA OF HYDROCARBONS

industry are covered by specific legislation. Three
pertinent laws may be cited in this respect:
Abu Dhabi Income Tax Decree 1965, as amended;
Law No. 8/1978 on Conservation of Petroleum
Resources; and Law No. 4/1976 on Emirate of Abu
Dhabi’s Ownership of Gas.
The legal framework for the development of
petroleum resources is therefore determined by the
terms and conditions of the individually negotiated oil
agreements concluded between the Government and
the respective foreign oil companies. These
agreements have developed through various stages
since the time of granting the original old-style
concessions.
A broad outline and the main phases of the general
evolution of the Abu Dhabi oil agreements will be
addressed below.
The original old-style concession agreements
and their evolution
As in other oil producing countries of the
Middle East, the development of petroleum
resources in Abu Dhabi was governed by the
old-style concession agreements from the discovery
of oil until the early 1970s when the participation
arrangements were concluded. The basic common
features of the old-style concession form of
agreement are well known.
Abu Dhabi’s first concession agreement between
the Ruler of Abu Dhabi and the Trucial Coast
Petroleum Development Company, owned by the Iraq
Petroleum Company (IPC) shareholders, was signed in
January 1939. The name of this company was changed
to Abu Dhabi Petroleum Company (ADPC) in 1962.
The duration of the concession was 75 years and it
covered the entire onshore and offshore areas of Abu
Dhabi. Following preliminary exploration after the
Second World War, this company relinquished the
offshore areas and kept all the onshore areas.
Production of oil started under this concession in
1963.
Abu Dhabi’s second concession was granted in
1953 to Abu Dhabi Marine Areas (ADMA), covering
all of the Emirate’s offshore areas for a total of 65
years. Production of oil started under this concession
in 1962.
The exploration and exploitation of oil in Abu
Dhabi was thus governed – until the advent of the
participation era in the 1970s – by these two main
concessions, which followed the well-known model of
the old-style concessions, as described above. They
also followed a similar pattern of evolution. In 1966,
the Government and the two concessionaires agreed to
replace the fixed royalty of three rupees per ton by a
royalty of 12.5%. In addition, the two companies
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THE UNITED ARAB EMIRATES
agreed to submit to the Income Tax Law 1965 and to
pay an income tax at the rate of 50%, raised to 55% in
1971. This improvement in financial terms continued
until the OPEC formula was effected in 1974.
Concessions agreements from 1967-81
Like the other oil producing countries in the
Middle East, while the Government of Abu Dhabi was
exercising every effort to improve the terms of the
existing old-style concessions and making use of every
opportunity to revise them, it also aimed to conclude
new agreements with better terms and conditions
covering the acreage relinquished by the major
concessionaires.
Starting in 1967, Abu Dhabi concluded a number
of new agreements, maintaining the legal form of the
concession system, but with better terms and
conditions. A first set of these improved agreements
was concluded in the period 1967-71. A second set
was completed between 1980-81 with still further
improvements. Starting in late 1980, the Government
of Abu Dhabi awarded a number of new concessions
to foreign companies. Six such concessions were
awarded between 1980 and 1981.
These new concessions deserve special
attention as they constitute the most up-to-date
model of oil agreements concluded by the
Abu Dhabi Government. It is to be noted that no
other oil concessions have been granted by the Abu
Dhabi Government after the concessions of
1980-81. These agreements follow a standard
prototype with standard basic terms and conditions.
They are clearly examples of what oil experts label
modernized concession agreements. The Deminex
Agreement, concluded on 3 May 1981, is
representative of the latest model of concession
agreement adopted by Abu Dhabi.
The term of this Agreement shall be a period of
thirty-five years from and after the effective date
(art. 4).
Art. 3, entitled Ownership of Natural Gas,
stipulates that “all natural gas that may be discovered
or produced in the concession area in association with
crude oil or independently shall be subject to the
provisions of Law No. 4/1976”. Law No. 4/1976
established Abu Dhabi Emirate’s sole ownership over
all its associated and non-associated gas.
Art. 6 indicates the work obligations of the
concessionaire and specifies the minimum sums of
money to be spent on drilling and development in each
of the first eight years, the sums of which gradually
increase from $2.5 million in the first year to $8
million in the eighth year.
Art. 10 provides for bonus payments: an initial
bonus of $2 million, $2 million upon commercial
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
discovery, $5 million after regular exports of crude oil
have reached an average of 100,000 barrels a day, and
$10 million after regular exports have reached 200,000
barrels a day.
Art. 11 provides for annual rentals and art. 12
covers relinquishment. The company shall relinquish
to the Government not less than 25% of the non-
productive portion of the concession area within three
years from the effective date, another 25% of that
portion within five years, and another 25% within
eight years.
Art. 13 deals with royalty payments and
adopts the concept of a progressive or sliding
scale royalty: the company shall pay to the
Government a (fully expensed) royalty equal to
12.5% of the posted price of crude oil produced
each year. If the production during the calendar
year reached an average rate of 100,000 barrels
a day, the company shall pay a royalty of 16%.
The royalty will increase to 20% if the
production reaches an average rate of 200,000
barrels a day.
Art. 17 addresses taxation and adopts a sliding
scale of income tax: it stipulates that the company
shall pay a basic income tax at 55%. However, if the
production of crude oil during a calendar year reaches
an average of 100,000 barrels a day, then the company
shall pay income tax at 65%. If the production reaches
an average of 200,000 barrels a day, the company shall
pay an income tax at 85%.
For the assessment and payment of income tax, the
company shall be subject to the provisions of the Abu
Dhabi Income Tax Decree 1965, as amended,
supplemented by the provisions of art. 17 of the
Agreement.
After having determined the taxation to which the
concessionaire is subject, the Agreement in art. 18
adds that no other or higher taxes, duties, fees or
charges shall be imposed upon the company.
Art. 35 treats arbitration and provides for an
internationalized arbitration procedure guided
generally by relevant rules of procedure of the
International Court of Justice, and stipulates that the
governing law should be “the principles of law
normally recognized by civilized states in general
including those which have been applied by
international tribunals”. Art. 35 (Arbitration) will be
revisited when dealing with the topic of settlement of
disputes below.
Art. 38, entitled Better Terms, provides for a kind
of adaptation clause or a ‘most favoured nation
clause’.
Art. 44 provides for Government’s option to
acquire, at any time after the discovery of oil in
commercial quantities, a participating interest of up to
776
sixty percent (60%) in all rights and obligations under
this Agreement.
These are the main features of this new set of
concessions awarded by the Abu Dhabi Government in
the early 1980s.
Legal framework for gas development
The old-style concession agreements conferred
disproportionately favourable rights and privileges on
the guest concessionary companies operating in the
Middle East. They used to grant such companies the
exclusive right to explore, develop and dispose of
petroleum, which was defined to include both liquid
and gaseous hydrocarbons. Consequently, the host
countries had no control over the disposition of any
gas associated with the production of oil.
Under this type of concession agreement, the
flaring of associated gas by concessionary companies
in the Middle East became and remained for a long
period one of the major complaints of the host
countries.
In order to provide a basic remedy for this
problem, Abu Dhabi decided to promulgate Law No.
4/1976 as well as launch some projects for the fruitful
exploration of its gas.
Law No. 4/1976 established the Abu Dhabi
Government’s sole ownership over its associated and
non-associated gas resources located within the
Emirate. It provides that the Government, through the
Abu Dhabi National Oil Company (ADNOC), has
complete control over the exploitation of gas within its
territory.
ADNOC has been implementing major
programmes to expand gas gathering, processing,
liquefaction and export capacity.
In the field of gas development, from the outset
ADNOC’s policy has been aiming to recover the
wasted gas that has been flared, meeting local needs,
and producing LNG (Liquefied Natural Gas) and LPG
(Liquefied Petroleum Gas) for export.
In the field of gas processing, ADNOC owns
and independently operates certain gas processing
plants, and has concluded two joint ventures with
foreign partners for the establishment of two major
processing plants. One of these is the Abu Dhabi
Gas Liquefaction Company (ADGAS), for the
liquefaction of offshore gas, in which ADNOC
retained a 51% equity interest until December 1997
when its equity interest was raised to 70%. The
remaining equity is distributed among Mitsui
Group, BP and Total. The second plant is Abu
Dhabi Gas Industries (GASCO), for the
exploitation of the onshore associated gas, in which
ADNOC holds a 68% equity interest, CEP (Total)
and Shell each 15%, and PARTEX 2%.
ENCYCLOPAEDIA OF HYDROCARBONS

12.10.5 State participation through
a State oil company
or otherwise
Reference has already been made to the General
Agreement on participation signed in December 1972
between the Governments of some oil producing
countries in the region (including Abu Dhabi) and the
oil concessionaires in those countries, and to the two
Participation Agreements concluded in September
1974 between the Government of Abu Dhabi and the
two major concessionaires – ADPC onshore and
ADMA offshore – which raised Abu Dhabi’s
participation in the existing concessions to 60%.
‘Participation’, an interesting model of successful
participation arrangements, is a major event not only
for Abu Dhabi but also for the other oil producers in
the region, and continues to play an important role in
the Abu Dhabi oil industry. In view of its importance,
a summary of the main features of the participation
arrangements as implemented in Abu Dhabi will
follow. The ADMA Arrangements are taken as an
example.
ADNOC, on behalf of the Government, and
ADMA shareholders are each entitled to raise in each
quarter its participation share of the crude oil available
(i.e. 60% to ADNOC and 40% to the other ADMA
shareholders). The parties established a Joint
Management Committee (JMC) composed of the
parties’ representatives. The JMC is responsible for
determining all major policy matters relating to
management.
ADNOC has the right to 60% of the votes and the
companies to the remaining 40%; however, decisions
of the JMC are made by 75% of the total voting rights.
Operations are conducted on behalf of the parties
by an OPerating COmpany (referred to as OPCO) to
be ‘incorporated’ in Abu Dhabi under Abu Dhabi law.
Its capital is held by ADNOC (60%) and by ADMA
shareholders (40%).
The OPCO has a Board of Directors to manage its
affaires composed of five members; in the case of
ADMA-OPCO, two are nominated by ADNOC and
each of the three shareholders in ADMA nominates
one member. The Chairman of the Board as well as the
General Manager of the company are chosen from
among ADNOC’s candidates. The resolutions of the
Board are taken by a simple majority of three,
including the two members from ADNOC.
Each participant has the right to receive its
proportionate share in the production and to dispose of
it. Each party is responsible for the payment of the
applicable income tax and royalty on its share.
The implementing agreement is governed by Abu
Dhabi law and disputes are settled by arbitration,
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taking place in Abu Dhabi in accordance with the ICC
(International Chamber of Commerce) rules and
regulations.
Establishment of Abu Dhabi National
Oil Company
ADNOC was established towards the end of 1971
(by Law No. 7 /27 November 1971), when the cult of
participation in the producing countries of the region
was at its peak.
ADNOC’s activities today are vast and diversified.
They cover almost all phases of the petroleum
industry, including exploration, development and
production of oil and gas, processing and refining,
local distribution of refined products, marketing of oil
and gas abroad, marine transportation, intensive
involvement in the field of petroleum services and
many industrial projects based on oil and gas.
First and foremost among ADNOC’s activities
today is its involvement in the production of oil and
gas, which can be considered the cornerstone of its
overall integrated operation. How ADNOC achieved
this objective of securing its own source of oil and gas
production will now be addressed.
ADNOC’s involvement in the sector of oil and gas
production first came through the participation
arrangement and its acquisition, on behalf of the
Government, of a 60% ownership interest in the two
major concessionary ventures in the country. Until
ADNOC’s Upper Zakum field came on stream in
1983, over 90% of Abu Dhabi’s oil production came
from the fields exploited by these companies. The
other channels through which ADNOC became
involved in the field of exploration and production
include: the development of the Upper Zakum field in
which ADNOC holds 88% of the petroleum rights; in
the case of natural gas, the promulgation of Law No.
4/1976 regarding Abu Dhabi’s ownership of all
associated and non-associated gas; and the decision of
the Government in 1979 to grant ADNOC alone
certain prospecting licences.
In addition to its activities in the field of oil and
gas production, as outlined above, ADNOC realized
that the other complementary activities had to be
carried out by the national company for various
reasons and considerations.
ADNOC decided that some of these activities
should and could be undertaken solely by ADNOC.
These activities include: marketing its oil, refined
products and gas; local distribution of refined
products through a wholly owned subsidiary;
refining through its two independently-owned
refineries; marine transportation through its
wholly-owned subsidiary Abu Dhabi NAtional
Tanker CO. (ADNATCO).
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
For other activities, ADNOC thought they could be
accomplished preferably in co-operation and through
joint ventures with specialized foreign partners. These
joint ventures cover, on the one hand, certain industrial
projects (mainly gas projects: ADGAS, GASCO,
FERTIL) and, on the other hand, various petroleum
services organizations.
12.10.6 The price of oil and gas
Oil price
The old-style concession agreements stipulated
payment of royalty on each ton of oil produced,
regardless of its sales price or the profit realized from
it, so that Governments were not really interested in
the prices at which the oil was sold. In the period
1950-51, various oil producing countries of the Middle
East (Saudi Arabia, Iraq and Kuwait) adopted the
profit-sharing principle. Abu Dhabi adopted the same
principle in 1966. In that year, the Government and the
two concessionaires agreed to replace the fixed royalty
of three rupees per ton by a royalty of 12.5%, and to
pay an income tax at the rate of 50% based on the
posted price. According to this principle, the host
Government’s take moved from a fixed royalty per unit
of production or exports to 50% of the net company
profit based on posted prices. When the new financial
arrangement was adopted, the host countries became
directly affected by the post price, which was a tax
reference price used for the calculation of the
companies’ profits and did not always reflect market
realities. In that period (and until the early 1970s), the
posted prices of crude oil were determined by the oil
companies alone, without any consultation with the
host countries.
In February 1959, the oil companies decided,
without prior consultation with the Governments
concerned, to cut the price of Middle Eastern oil by
about 18 cents per barrel. In spite of the uproar that
the companies’ action provoked in oil exporting
countries, the companies decided to cut prices again in
August 1960 by an average of about 9 cents per barrel.
It is generally recognized that these unilateral cuts
in oil prices by the major oil companies were directly
responsible for the creation of OPEC in September
1960. In other words, OPEC was founded as a direct
response to the challenge posed by the multinational
oil companies in arbitrarily and unilaterally reducing
the posted prices of crude oil in February 1959 and
again in August 1960. Oil prices were the main reason
behind the creation of OPEC in 1960.
One of the principal aims of OPEC was to stabilize
oil prices. Art. 2B of OPEC’s Statute states: “The
Organization shall devise ways and means of ensuring
778
the stabilization of prices in international markets with
a view to eliminating harmful and unnecessary
fluctuations”.
The first success achieved by OPEC on the price
front was the freezing of oil prices at the post-August
1960 level. As regards royalties to be paid by the oil
companies, since 1962 OPEC began advising its
member countries to increase the royalty rate and to
adopt the principle of royalty ‘expensing’. According
to the 50-50 profit sharing formula introduced in the
area in 1950-51, royalties, which amount usually to
12.5% of the posted price multiplied by the number of
barrels produced, were considered a credit towards the
50% income tax liability of the companies instead of
being treated as an expense. Although OPEC failed in
its attempts to attain an increase in the royalty rate of
12.5%, it succeeded in getting royalties expensed. The
settlement that was reached in 1964 with the
companies provided for acceptance of the principle of
royalty expensing.
Oil prices remained frozen from the Second World
War until 1971, when the Tehran Agreement was
signed. As already mentioned, oil prices were reduced
on two occasions by the oil companies, in 1959 and
1960. These prices were determined by the companies
alone until 1971, when the OPEC countries succeed in
participating with oil companies in setting the price of
their oil.
After the outbreak of the October 1973 Arab-
Israeli War, the Arabian Gulf Oil Ministers met in
Kuwait on 16 October 1973 and decided to fix oil
prices themselves unilaterally. In other words, they
decided to substitute legislation for negotiation. They
seized the initiative to formulate their own oil policy in
pricing and settling production levels. Since that day, a
new principle has been established in the oil industry:
oil pricing must be decided upon by the host countries,
not by the oil companies operating therein. At that
meeting, the posted price of the Saudi 34 degree
marker oil (Arabian light), FOB (Free On Board) Ràs
Tanura, was raised from $3.001 to $5.119 per barrel.
The price of Abu Dhabi Murban 39 degrees had thus
moved up from $3.144 to $6.045. On 22-23 December
1973, the Ministerial Committee of the Gulf Member
Countries met in Teheran and decided to raise posted
prices to a much higher level, in view of later
developments in the oil market. They set the new
posting for the Saudi marker crude at $11.651,
effective 1 January 1974. Since that time, it has been
the policy and practice of the OPEC member
countries, including Abu Dhabi, to fix the price of
their oil independently, for tax purposes or otherwise,
but not in an arbitrary manner. Oil prices are
determined by market forces through supply and
demand.
ENCYCLOPAEDIA OF HYDROCARBONS

One of the main aims of OPEC’s pricing strategy is
to ensure the stability of the oil market. OPEC’s
Economic Commission Board used to meet on a
quarterly basis to determine and recommend to the
member countries posted prices for each quarter,
taking into account all relevant factors. Since the
mid-1980s, each member country followed a practice
of determining the posted prices of its oil in light of
the market conditions.
Gas price
Commercial realities hold particular relevance
in relation to gas price. A fixed price in gas
contracts would not allow the contracts to respond
quickly and effectively to the constant changes in
the market. Gas contracts have evolved to include a
price formula that accounts for many factors. Since
the markets for LPG and LNG are so different, the
prices relating to each will be discussed separately.
However, the involvement of ADNOC and its
partners in the gas joint ventures in gas marketing
will be addressed first. As already mentioned,
ADNOC is involved in two major gas projects:
ADGAS and GASCO.
Through ADGAS, for the liquefaction of offshore
gas, ADNOC retained a 51% equity interest until
1997, when its equity interest was raised to 70%.
ADGAS directly markets its products and the
shareholders are not responsible individually for
marketing their shares. Since the plant commenced
operation in 1977, the LNG and LPG have been
delivered to Tokyo Electric Power COmpany (TEPCO).
The arrangements concluded between ADGAS and
TEPCO for the sale and purchase of ADGAS output
will be referred to later.
Through GASCO, for the exploitation of the
onshore associated gas, ADNOC holds a 68% equity
interest (the other shareholders are Shell, Total and
Partex). GASCO is not entrusted with the task of
marketing its products (mainly LPG). Each
shareholder, including ADNOC, receives its share in
the output and is responsible for its marketing and for
the payment of the applicable taxes.
The price for each of the LPG and LNG will
follow in brief.
LPG
LPG is normally co-produced with crude oil and,
as a result, production cannot be easily adjusted to
meet LPG demand. LPG must be refrigerated or
pressurized, making storage costly and the holding of
surpluses impractical. While LPG is produced in
conjunction with crude, there is clearly a distinct LPG
market, as evidenced by the fluctuating demand in the
spot market.
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For the purpose of determining the taxable income
of each GASCO partner from the sale of its share in
GASCO’s LPG output, the following provisions of the
gas tax regime apply as related to gas price.
“Each participant shall declare its gross income
(which shall be open to audit by the Government)
based upon:
i) in respect of sales of products FOB Ruwais, the prices
actually received or receivable by it; provided, however,
that all such sales shall be at arms-length prices;
ii) in respect of all sales of products for export other
than sales FOB Ruwais, prices in conformity with the
prices under (i) above for approximately contemporary
sales of similar quantities of similar products on
similar terms to similar markets [...]”.
LNG
While LNG price formulae have responded to the
market, the contractual response has not been a
modification of price, but a guarantee of demand. The
producers cannot be subject to all of the vagaries of
market demand and require a contractual commitment
of a specified minimum volume in order to ensure
required levels of cash flow. This contractual
commitment is referred to as take-or-pay and works in
the manner indicated by its title. Take-or-pay
obligation is of paramount importance to producers as
it effectively shifts the demand risk to the buyer of
LNG. It is for this reason that take-or-pay provisions
may be viewed as relating to pricing and may
influence the LNG pricing scheme. Producers might
otherwise prefer a fixed LNG price to guarantee a
certain minimum level of cash flow.
Current LNG pricing practice provides for a
floating price tied to some form of indicator, designed
to fluctuate to changes in market price for the
competing fuel. Today, most LNG prices are linked to
crude oil.
In Abu Dhabi, as already mentioned, since ADGAS
liquefaction commenced operations in 1977, the LNG
(and LPG) have been delivered to Tokyo Electric
Power COmpany (TEPCO).
According to the most recent method of fixing the
price of ADGAS LNG, a formula was adopted that
was generally in line with the formula being used by
certain other projects selling LNG to Japan. One basic
element of the formula linked the price of LNG to a
basket of crude imported into Japan, commonly
known as the Japanese crude cocktail.
12.10.7 Fiscal structure
The original old-style concession agreements
(including the Abu Dhabi two major concessions:
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
ADPC, onshore-1939, and ADMA, offshore-1953)
provided for the payment to the host Government of an
extremely low royalty made at a fixed rate per ton (in
the Abu Dhabi agreements, three rupees or 75 cents
per ton or about 10 cents per barrel), regardless of the
oil’s sale price or the profits realized by the
concessionaire.
In 1966, Abu Dhabi succeeded in adopting the
50-50 profit sharing formula and concluded an
agreement, to this effect, with each of the major
concessionaires, ADPC and ADMA. According to this
formula, the Government’s take moved from a system
of fixed royalty per unit of production to 50% of the
net company profit based on posted prices. The two
companies agreed to submit to the 1965 Income Tax
Decree and pay an income tax at the rate of 50%. At
the same time, the fixed royalty per ton was replaced
by a royalty of 12.5% of the posted price of the oil
produced or exported.
However, according to the original 50-50 profit
sharing formula, royalties (amounting to 12.5% of the
posted price multiplied by the number of barrels
produced) were considered a credit towards the 50%
income tax liability of the companies, instead of being
treated as an expense to be borne by the enterprise and
deducted from gross profits, like other expenses, to
arrive at the net income. One of the first efforts
deployed by OPEC was its effort to convince the
concessionaires to ‘expense’ royalty payments. It was
not until 1964 that OPEC succeeded in getting
royalties expensed. In Abu Dhabi, an amendment to
the tax decree came in 1966, providing for the
‘expensing’ of royalty. The two concessionaire
companies agreed to submit to this amendment, which
came into force on 1 January 1966.
Since that time, when royalty was expensed, the
Government’s revenue consisted of royalty and income
tax. However, both the rates of the royalty and the
income tax were raised gradually, as will be seen.
There is no special tax legislation applicable to the
oil industry in Abu Dhabi. Income tax is imposed by
the Abu Dhabi Income Tax Decree 1965, as amended.
This Income Tax Decree was not promulgated as a
special petroleum tax legislation, but rather as a
corporate tax law of general application, although the
Decree contained certain provisions related to the oil
operations.
In practice, however, the above-mentioned Decree
is presently applicable only to companies “dealing in
petroleum” (according to the terminology of the
Decree), that is, dealing with production and export of
petroleum, and to petrochemical companies and
branches of foreign banks. The tax rate provided for in
the Decree varies according to the level of taxable
income, but the rate applicable to income deriving
780
from oil activities was initially fixed at 50%. It was
raised to 55% in 1971, which was considered then as
the minimum income tax rate of oil operations. This
rate was later increased, as will be seen. However, the
specific rate applicable to a concessionaire is usually
agreed upon between the Government and the
concessionaire on an ad hoc basis through negotiations
in each specific case, and stipulated in the agreement
concluded with the concerned concessionaire,
provided that the rate is not fixed below 55% (i.e. the
base rate since December 1970).
In 1974, OPEC members decided to increase the
rate of income tax applicable to the ‘major’ oil
concessions to 85% (and to increase the royalty to
20%), which henceforth became known as the OPEC
formula. In Abu Dhabi, this formula applied to ADPC
and ADMA concessions.
It is worth mentioning that for the smaller
concessions the rate of income tax (and royalty) varies
from one concession to another. In effect, the Abu
Dhabi authorities have accepted the idea that the
smaller high-cost oilfields, particularly offshore,
require some relief from the standard OPEC rate,
which was designed for large-scale ventures.
When reviewing the small concessions granted in
the period 1967-71, it will be noted that, for example,
the Abu Dhabi Oil Company (Japan) paid 55% tax and
12.5% royalty, Total Abu Al Bukoosh paid 75% tax
and 20% royalty, Al Bunduq Company paid 75% tax
and 20% royalty, Amerada Hess paid a tax of 55%, but
a royalty at a sliding-scale from 12.5 to 16%,
depending on the level of production.
The new model of concession agreement,
concluded in 1980-81, has generally adopted an
income tax rate on a sliding scale basis from 55 to
85% as the volume of production rises. A sliding scale
royalty is also generally applicable rising from 12.5 to
20% as the level of production increases.
A brief description of the fiscal regime applicable
to the industrial projects based on gas will now be
provided.
For the industrial projects based on gas (ADGAS,
GASCO and Fertil), a special fiscal regime has been
conceived that is much more favourable to them than
the general system applicable to the oil producing
companies, in order to encourage the exploitation of
natural gas resources, to attract the heavy investments
required and to take into account the particular hazards
in this field. In essence, what is provided for by this
particular regime is described below.
The gas company is subject to Abu Dhabi Income
Tax Decree 1965, as amended, but enjoys a tax holiday
during the first five years from the commencement of
commercial production. Thereafter, “the Company
shall be liable for Abu Dhabi income tax at a rate of
ENCYCLOPAEDIA OF HYDROCARBONS

55% of profits” (with the possibility of carrying
forward any loss incurred for not more than 5
consecutive years from the end of income tax year in
which such loss is incurred). Other than income tax, as
aforesaid, no other taxes are imposed on the company
or its shareholders. However, the agreements provide
for a formula of gas payment to the Government
on the gas utilized in the project, if the profits
exceed a certain defined target operating income
(e.g. 15% after tax).
In 1979, the concept of a fixed margin of profits
for ADPC and ADMA (subject to an income tax at the
rate of 85% and a royalty of 20%) was introduced in
Abu Dhabi to ensure the profitability of carrying out
their operations in Abu Dhabi and to assure the
shareholders of both ADPC and ADMA of the
competitiveness of dealing in Abu Dhabi oil as
compared to their other sources. This fixed margin
was initially fixed at 22 cents per barrel after payment
of tax. It was gradually increased, and in 1988 it
reached the amount of one dollar per barrel.
12.10.8 The petroleum contract
and the parties thereto
Abu Dhabi has known only one form of petroleum
contract, the concession. Abu Dhabi has never
concluded any other form of petroleum contract for
the exploitation of its petroleum resources, such as the
production sharing agreement, the risk and non-risk
service contract, etc. However, the concession
agreements concluded by the Abu Dhabi Government
have gone through different stages of evolution since
the time of granting the original old-style concessions.
The broad outlines and main phases of the general
evolution of the Abu Dhabi agreements have already
been traced briefly above.
From the original old-style concession agreements
(ADPC, onshore-1939; ADMA, offshore-1953) and
the very few, mainly financial, improvements in their
terms and conditions (through the set of concession
agreements concluded in the period 1967-71), better
terms and conditions were established as compared to
the original concessions. This culminated by the
adoption of the concept of participation in the early
1970s; the participation of the Government in the
existing major oil concessions ushered a radical
change in the relationships between the Government
and the concessionaires. The latest set of concession
agreements had been concluded in the period 1980-81.
As already mentioned, these new concessions
constitute the most up-to-date model of an oil
agreement concluded by the Abu Dhabi Government.
No other oil agreement has been granted by Abu
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Dhabi after the concessions of 1980-81. These
agreements follow a standard prototype with standard
basic terms and conditions. The main provisions of
one of these agreements, the Deminex Agreement of
May 1981, were outlined above. These concession
agreements are clear examples of what is being
labeled by oil experts as modernized concession
agreements.
As concerns the parties to the concession
agreement, the concession is a licence granted by the
Government. In Abu Dhabi, the parties to the
concession agreement are therefore the Government
and the foreign concessionaire. The concession
agreement is usually signed by the Ruler or Deputy
Ruler of the Emirate of Abu Dhabi. ADNOC is not
party to the concession agreement: it was established
towards the end of 1971 (by Law No. 7/ 27
November 1971) and was intended to be the arm
of the Emirate of Abu Dhabi for the implementation of
the Emirate’s overall petroleum policy, established
by the competent authorities in the Government (this
role is presently and since 1988 exercised by the Abu
Dhabi Supreme Petroleum Council) and eventually
intended to hold the Government’s share in the
operating companies and to play the role of national
partner under the participation arrangements and
joint ventures.
12.10.9 Investment protection
There is no law in the UAE or the Emirate of Abu
Dhabi concerning foreign investment protection.
However, the UAE has concluded a number of
agreements for the “promotion and protection of
investment” with a number of countries: the United
States, United Kingdom, France, Italy and other
European countries, and almost all of the Arab
countries.
Among other things, these agreements contain
provisions dealing with the expropriation of foreign
assets in the contracting country. Art. 6 of the
Agreement between the Government of the UK and
the Government of the UAE concluded on 8 December
1992, which deals with the subject of expropriation,
states: “Investment of investors of either Contracting
Party shall not be nationalized, expropriated or
subjected to measures having the effect of
dispossession, direct or indirect, or having effect
equivalent to nationalization or expropriation
(hereinafter referred to as ‘expropriation’) in the
territory of the other Contracting Party except for a
public purpose related to the internal needs of that
Party on a non-discriminating basis, under the process
of law, not being contrary to any contractual obligation
781
NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
undertaken by a Contracting Party in favour of an
investor, and against prompt, adequate and effective
compensation”.
Art. 8 of the same Agreement provides for the
reference of all disputes between a contracting party
and an investor of the other contracting party to the
International Center for Settlement of Investment
Disputes (ICSID).
The other agreements concluded between the
Government of the UAE and other countries have
similar provisions as arts 6 and 8 of the Agreement
with the UK.
In 1981, the UAE adhered to the International
Center for Settlement of Disputes between a
contracting state and the nationals of other countries.
Later, in 1993, the UAE adhered to the Convention
Establishing the Multilateral Investment Guarantee
Agency (MIGA Convention).
12.10.10 Environmental protection
It is well known that the old-style oil concession
agreements concluded between the oil companies and
the producing countries of the Middle East were
generally silent on matters related to environmental
protection in the oil exploration and production
operations. The old-style oil concession agreements
concluded by the Government of Abu Dhabi (in 1939
for the onshore areas and in 1953 for the offshore
areas) were no exception to this general lack of
environmental awareness, and contained no provisions
concerning environmental protection and resource
conservation.
This situation has not improved under the more
recent set of concessions granted by Abu Dhabi in the
period 1967-71, which contained a timid reference, in
broad terms, to the reasonable precautions the oil
companies should take in conducting their petroleum
operations.
The most recent oil concession agreements,
concluded in the period 1980-81, did not introduce
improvements in the field of environmental protection.
In view of the increased worldwide awareness
regarding environmental issues, environmental
protection and sustainable development, which
have become some of the most important global
concerns of this era, both the federal Government
of the UAE and the Government of the Emirate of
Abu Dhabi began preparing and promulgating the
necessary legislation and regulations in this
respect.
At the federal level, Federal Law No. 7/1993
established the Federal Environmental Agency. In
1999, the Federal Law for Protection and Development
782
of Environment (Law No. 24/1999) was promulgated.
This law is a modern, comprehensive law containing
one hundred articles, covering all aspects of this
important subject.
The petroleum industry has, of course, its own
environmental problems and cannot be other than
greatly concerned with issues related to protection of
the environment and the conservation of resources.
The oil industry of Abu Dhabi is no exception.
Prompted by its keen awareness of environmental
protection in the different phases of the oil operations
as well as its deep concern towards the sustainable
development of petroleum resources of the Abu Dhabi
Emirate, ADNOC, on behalf of the Abu Dhabi
Supreme Petroleum Council, took the initiative to
prepare, adopt and implement an effective and
comprehensive “Health, Safety and Environment
(HSE) Management System” for the oil industry in
Abu Dhabi.
ADNOC felt that in order for the HSE
Management System to be effective, it must apply to
the whole oil industry in Abu Dhabi and be adopted
and implemented by the industry. This system has
been styled after the guidelines proposed by the Oil
Industry International Exploration & Production
Forum (otherwise known as the E&P Forum).
The E&P Forum groups a large number of the
international oil companies. This shows the high
quality and the international standard of the HSE
Management System adopted by the ADNOC Group.
12.10.11 Currency regulation
There is no currency exchange control in the UAE or
in the Emirate of Abu Dhabi. Therefore, oil companies
(like any other company or individual operating or
working in the country) enjoy the freedom of
transferring their income out of the country or
repatriating their capital investment, as well as the
freedom to import any currency needed for their
operations. There is no restriction on their right to
import or export any currency.
However, to avoid doubt and as a precaution for
any future imposition of currency control or
restriction, the agreements usually contain a provision,
in this respect, which confirms this lack of restriction
on the operating companies’ right to import or export
currency.
12.10.12 Applicable law
The original concession agreements did not contain
any provision concerning the law governing the
ENCYCLOPAEDIA OF HYDROCARBONS

concession agreements, the applicable law to the
agreement.
In the Agreement concluded on 19 September
1965 between the Ruler of Abu Dhabi and Abu Dhabi
Petroleum Co. (ADPC), which amended the 1939
Concession Agreement by introducing the 50-50 profit
sharing formula, the applicable law was specified for
the first time as follows below.
Art. 13.9 stipulates: “The Amended Agreement
shall have the force of law. It shall be given effect and
shall be interpreted and applied in conformity with the
principles of Law normally recognized by civilized
states in general including those which have been
applied by International Tribunals”.
A similar provision is to be found in the Abu Dhabi
Marine Areas (ADMA) revised Agreement of 10
November 1966 (art. 12).
In the concession agreements granted by Abu
Dhabi in the period 1967-71, a standard provision on
the applicable law was adopted: “This Agreement shall
have the force of law. It shall be given effect and shall
be interpreted and applied in conformity with the
principles of law normally recognized by civilized
states in general including those which have been
applied by International Tribunals”.
The most recent concession agreements concluded
in the period 1980-81 adopted also a standard
provision on the applicable law identical to the one
adopted in the concession agreements of 1967-71, as
already quoted above.
12.10.13 Settlement of disputes
As a general rule, oil concessions in the Middle East
provide that disputes between the concessionaire and
the producing country which are not settled by
negotiation or mutual agreement shall be resolved by
arbitration.
Since the original old-style concessions,
through the set of concession agreements granted
in the period 1967-71, and up to and including the
most recent concessions of 1980-81, arbitration
has been adopted as a method of settlement of
disputes with certain changes through the
successive concession agreements in the drafting
of the arbitration clause.
The oil concession agreements of the period
1980-81 adopted an arbitration clause similar to the
established standard clause under the 1967-71
agreements. The appointing authority is the President
of the International Court of Justice and the arbitration
procedure shall be determined by the referee being
guided by the rules of procedure of the International
Court of Justice.
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THE UNITED ARAB EMIRATES
No concession agreements were concluded in Abu
Dhabi after 1981. It is not known for certain how the
arbitration clause would have been drafted in such
concession agreements, if and when concluded.
However, a most interesting development in the
Abu Dhabi oil industry is noted concerning the
question of the settlement of dispute methods as
reflected in certain recent agreements concluded
between, on the one side, ADNOC, and on the other
side, either a group of oil companies operating in Abu
Dhabi, including some of the majors, or one of these
companies separately. Although they are not of the
nature of concession agreements, some of these
agreements have an important object (such as
joint-venture arrangements), and others the focus of
technical or management services, etc. A standard
arbitration clause has been drafted and adopted,
through discussions and mutual consent between the
concerned parties, and inserted in the agreements
referred to. This standard arbitration clause runs as
follows: “The Parties shall use their best efforts to
settle all disputes or claims arising out of or in relation
to this Agreement or any breach thereof. Should any
difference or dispute of any kind arise between the
Parties in connection with or arising out of this
Agreement which cannot amicably be resolved within
three hundred and sixty (360) days, then such
difference or dispute shall be settled finally by
arbitration in Abu Dhabi under the procedural rules of
the Abu Dhabi Commercial Conciliation and
Arbitration Center (ADCCAC) by three (3) arbitrators,
one to be nominated by each party and the third to be
agreed by the two nominated arbitrators and failing
such agreement, the third arbitrator to be appointed by
the Secretary General of ADCCAC from the
international panel of arbitrators maintained by
ADCCAC. All arbitration proceedings shall be in
English and the award of the arbitrators shall be in
accordance with the laws of Abu Dhabi and the United
Arab Emirates. The award shall be final and binding
upon both parties”.
When comparing this arbitration clause with the
previously cited art. 35 of the Deminex Concession
Agreement of 1981, one does not fail to notice the
major improvements introduced in the new clause,
whether concerning the procedural rules and
regulations under which the arbitration is to be
conducted, the venue of arbitration, the appointing
authority, or the applicable law on the substance. The
adoption of this new arbitration clause in the recent
agreements between the national company and its
foreign partners reflects, in our view, a radical change
in the climate of the relationship between the foreign
companies and the host country or its national
company, and indicates a real spirit of confidence on
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
the part of foreign oil companies in the local legal
infrastructure and institutions of the host country.
Bibliography
Abu Dhabi National Oil Company and its group of companies
(2005), Abu Dhabi, ADNOC.
Al Otaiba M.S. (1975) OPEC and the petroleum industry,
London, Croom Helm.
Al Otaiba M.S. (1977) Petroleum and the economy of the
UAE, London, Croom Helm.
Al Otaiba M.S. (1982) The petroleum concession agreements
of the United Arab Emirates, London, Croom Helm.
Arab Petroleum Research Center (2005) Arab oil and gas
directory 2005, Paris, Arab Petroleum Research Center.
Bentham R. (1984) Arbitration and the petroleum industry,
in: International arbitration. A practical study with specific
reference to the petroleum industry. A collection of papers
presented by the Section on energy and natural resources
law at the International Bar Association’s 20th biennial
conference, Wien, 2-7 September.
Blinu K. et al. (1986) International petroleum exploration
and exploitation agreements, New York, Barrows.
Cattan H. (1967) The evolution of oil concessions in the
Middle East and North Africa, Dobs Ferry (NY), Oceana.
Cattan H. (1967) The law of oil concessions in the Middle
East and North Africa, Dobs Ferry (NY), Oceana.
Kosheri A. (1998) Contemporary approach in the contracts
of exploration of energy in the Arab World, in: Seminar on
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arbitration in oil and energy contracts, Abu Dhabi, 13-14
October.
Mughrabi M.A. (1966) Permanent sovereignty over oil
resources. A study of Middle East oil concessions and legal
change, Beirut, Middle East Research and Publishing Center.
Shihata I. (1995) The settlement of disputes under oil and gas
exploration and development agreements: the relevance of
ICSID and the World Bank Group guidelines, in: The World
Bank in a changing world, Dordrecht, Nijoff, 1991-2000,
3v.; v.II, 497-509.
Stevens P.I. (1976) Joint ventures in the Middle East oil,
Beirut, Middle East Economic Consultants.
Suleiman A. (1995) Certain aspects of the gas experience of the
UAE, «Journal of Energy and Natural Resources Law», 13.
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References
El Malik W.H. (1993) Minerals investment under the Shari’a
law, London, Graham & Trotman.
Atef Suleiman
Partner, Emirates International Law Firm
Abu Dhabi, United Arab Emirates
ENCYCLOPAEDIA OF HYDROCARBONS
 12.11
Iran
12.11.1 Introduction
Iran is situated in South-West Asia. Northern Iran
borders the Republic of Armenia, the Republic of
Azerbaijan, the Caspian Sea and Turkmenistan.
Eastern Iran borders on Afghanistan and Pakistan.
Southern Iran borders on the Sea of Oman and the
Persian Gulf, and Western Iran borders on Iraq and
Turkey. The territory of Iran comprises an area of
1,648,000 km2, including about 6,000 km of land
borders and 2,700 km of sea boundaries.
Khouzestan Province is the major centre of the
petroleum industry in Iran. Presently, there are over 30
oil-producing fields in the country. Iran’s major
onshore oilfields include Gachsaran, Aghajari, Marun,
Asmari and Bangestan. There are also offshore fields
such as Doroud, Norouz, Abuzar, Salman and Soroush.
Over half of the oil is exported as crude to various
countries and the remainder is used for national
consumption.
Iran is the second largest producer of the
Organization of the Petroleum Exporting Countries
(OPEC). According to Iranian officials, Iran’s crude
oil reserves are estimated to total 137 billion
barrels, and to account for 11.6% of the world’s
total oil reserves; the country also has about 29,000
billion m3 of gas, amounting to 15.3% of the
world’s total gas reserves.1 Iran’s oil export
revenues account for about 80% of the country’s
total export revenue and form a substantial part of
the national budget.
The above figures clearly reflect the role that oil
revenues play in the economic development of the
country and any related economic development plan.
There is a direct link between an increase in oil
revenue through the development of petroleum
resources and the achievement of national economic
development targets.
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
The development of vast resources of petroleum
would require a large amount of investments.
However, from 1979 until the 1990s, Iran maintained a
policy of self-reliance in terms of investment, and
foreign investors did not participate in the exploration
and production activities in Iran’s petroleum industry.
This policy was in line with Iran’s constitutional
restrictions on foreign investment and on the
involvement of foreigners in the development of
natural resources. In the early 1990s, for a number of
reasons, Iran started to consider allowing foreign
investment to contribute to exploration and production
activities.
Iran’s crude oil production level before 1979 was
about 6 million barrels per day. However, the
production level fell sharply during subsequent years.
Oil field and installation damage directly resulted
from the 8 year long Iran-Iraq war. Furthermore,
depleted oil wells accounted for the loss of 250,000 to
300,000 barrels per day of production.
There have been new discoveries of oil and gas in
vast quantities. For instance, the Azadegan oil field,
which was discovered in 1999, has been Iran’s largest
oil discovery in many years, with proven crude oil
reserves of 26 million barrels. Similarly, there have
been a number of large gas discoveries in Iran. For
example, the giant, South Pars, non-associated natural
gas field is the largest of its kind in the world. The
development of this field, which is the country’s
largest energy project and has been divided into 28
phases, requires extremely large investments.
The need for investment in the downstream sector
is also manifested particularly in the refinery section.
1 News report by the Islamic Republic News Agency
(IRNA), Iran’s official news agency quoting Hadi Nejad-
Hosseinian Iranian Oil Ministry Deputy for International
Affairs on 4 October 2005 (Exclusive […], 2005).
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
Although Iran is a major oil-producing country, due to
its shortage of refining capacity, a large amount of
foreign exchange is necessary in order to import the
refined products needed to meet the ever-increasing
demand of its domestic market. In order to increase
refining capacity, new investment in the refinery
sector is also an objective that requires both capital
and technology.
All of the above factors contributed to the
recognition of, on the one hand, the need for capital,
technology and know-how in order to raise the
production level of oil and, on the other hand, the role
that foreign capital and technology can play in this
respect. Based on this recognition and because of
various legal and political considerations, new
measures were introduced. For example, the
introduction of buy-back agreements was considered
and subsequently created as a vehicle of cooperation
between international oil companies and Iran in order
to increase the production level. The level of
investment that has been provided with respect to the
above-mentioned framework has, to some extent,
contributed to a rise in production.
Other channels of cooperation with foreign
partners have also been explored in order to increase
the production level. The flurry of multibillion-dollar
energy deals with major Asian economies is an
example of a further step that has been considered to
entice foreign players by linking upstream
development to the downstream Liquified Natural Gas
(LNG) deal. Furthermore, Iran has offered to develop
parts of the nearby Azadegan oil field in order to
generate investment in the LNG facilities that would
be linked to the development of natural gas from
South Pars.2
In addition to the introduction of buy-back
operations as a new contractual framework of
cooperation with foreign investors, there have been
other legal developments which have, to some extent,
contributed to the promotion of a more favourable
environment for foreign investment in Iran. These
legal developments include the introduction of the
2002 Foreign Investment Promotion and Protection
Act (FIPPA), the 1992 Law on International
Commercial Arbitration, and the adoption of the New
York Convention on Recognition and Enforcement of
Foreign Awards of 1958.
12.11.2 Sovereignty
over petroleum resources
Iran exerts sovereignty over its natural resources
including petroleum. Art. 153 of the Iranian
Constitution imposes a general prohibition on foreign
786
control over natural resources in the following terms:
“Any form of agreement resulting in foreign control
over natural resources, economy, army, or culture of
the country, as well as other aspects of national life, is
forbidden”.
More specifically, according to the terms of the
1987 Petroleum Act (hereinafter referred to as “the
Petroleum Act” or “the Act”), petroleum resources
have been declared public property. Art. 2 of the
Petroleum Act provides that such resources “are part
of the public domain (properties and assets) and
wealth and according to art. 45 of the Constitution are
at the disposal and control of the Government of the
Islamic Republic of Iran and all installations,
equipment, assets, property and capital investments
which have been made or shall be made in the future
within the country and abroad by the Ministry of Oil
and its affiliated companies, will belong to the people
of Iran and remain at the disposal and control of the
Government of the Islamic Republic of Iran […]”. Art.
45 of the Constitution refers to the above as public
wealth and specifically refers to mineral deposits. It
provides that “public wealth and property, such as
uncultivated or abandoned land, mineral deposits, […],
shall be at the disposal of the Islamic government for it
to utilize in accordance with the public interest. Law
will specify detailed procedures for the utilization of
each of the foregoing items”.
According to the terms of the latter part of art. 2 of
the Petroleum Act, the Government of the Islamic
Republic of Iran (hereinafter also referred to as “the
Government”) and, through regulation, the Ministry of
Petroleum have the authority to exercise sovereignty
over petroleum resources. This position is further
reinforced by art. 81 of the Constitution, which
provides that “the granting of concessions to
foreigners for the formation of companies or
institutions dealing with commerce, industry,
agriculture, services or mineral extraction is absolutely
forbidden”.
12.11.3 Ownership and title
to underground petroleum
resources
Article 44 of the Iranian Constitution provides for the
public ownership of minerals and prohibits any private
ownership of such, both domestic and foreign. It
stipulates that “The economy of the Islamic Republic
of Iran is to consist of three sectors: state, cooperative,
and private, and is to be based on systematic and
2 «Petroleum Economist», 2004.
ENCYCLOPAEDIA OF HYDROCARBONS

sound planning. The state sector is to include all
large-scale and mother industries, foreign trade, major
minerals, banking, insurance, power generation, dams
and large-scale irrigation networks, radio and
television, post, telegraph and telephone services,
aviation, shipping, roads, railways and the like; all
these will be publicly owned and administered by the
State […]”.3
More specifically, the terms of the Petroleum Act
expressly provide that petroleum resources shall be
owned by the Government. Art. 2 of the Act provides
in part that “[…] ownership of petroleum resources
and installations is vested in the Government of the
Islamic Republic of Iran which on the basis of the
regulations, rights and powers prescribed in this Act
shall be undertaken and executed by the Ministry of
Petroleum in accordance with the general principles
and policies of the country”.
12.11.4 The structure of petroleum
regulations: the right to
prospect, explore, develop,
produce and dispose
of petroleum resources
Petroleum regulations are primarily set forth in
the Petroleum Act and in statutes pertaining to the
relevant national company (i.e. the National Iranian
Oil Company, NIOC). The terms of the Petroleum Act
provide that the Petroleum Operation, which includes
the exploitation of petroleum resources (such as
research, survey, geodesy, geological studies,
exploration, drilling, operations, exploitation and
production) shall be carried out by the companies that
have been established for these purposes. Such
companies act according to their respective statute,
which has been approved by Parliament (Petroleum
Act, arts. 1 and 4). The Petroleum Act sets forth
provisions relating to investment in the petroleum area,
and, in principle, bans foreign investment. According
to art. 6 of the Act, “All capital investments shall be
proposed through the Ministry of Petroleum on the
basis of the budget of the operational units and shall
be included, upon approval of the General Assembly,
in the General State Budget. Foreign investment in
these operations in any manner shall not be allowed
whatsoever”. However, as provided by the relevant
budget laws, noted below, a particular framework of
foreign involvement in petroleum activities (i.e.
buy-back agreements) is permitted.
Operating conditions
In view of the Petroleum Act’s prohibition and the
relevant constitutional restrictions on the involvement
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
IRAN
of foreigners in petroleum activities, the only way in
which foreign companies can participate directly in the
upstream petroleum sector is through buy-back
agreements. The 2004 Budget Law (2004-05) allows
the formation of such agreements. This allowance can
also be inferred from the relevant provisions of Iran’s
2002 Fourth Five-Year Economic, Social and Cultural
Development Plan (2005-10). Buy-back agreements,
as are referred to in detail below, are basically service
contracts and, as such, they do not provide for rental
area, royalty or bonuses. The term and scope of work
of buy-back agreements are set forth in the terms of
the agreement.
12.11.5 State participation through
a state oil company
or otherwise
Established in 1979, the Ministry of Petroleum is in
charge of Iran’s oil and gas sectors. It controls the state
companies that are involved in the oil, gas and
petrochemical sectors, including NIOC, the National
Iranian Gas Company (NIGC), the National
Petrochemical Company (NPC) and the National
Iranian Oil Refining and Distribution Company
(NIORDC). According to the terms of art. 4 of the
Petroleum Act, these and other similar companies have
been established to execute and carry out petroleum
operations and exploitation throughout the country, the
continental shelf and the marine areas.
NIOC was established in 1952 when the Iranian
Government nationalized the oil industry. NIOC
performs all upstream operations of the oil and gas
industry, as well as refining, transportation, sale and
distribution of oil and gas. NIOC can, while subject to
the relevant laws and regulations, enter into
exploration and development and other types of
agreements with foreign companies.
NIOC has six regional companies and a number of
functional subsidiary companies. The Petroleum
Development and Engineering Company (PEDEC),
for example, is an important subsidiary of NIOC and
is in charge of buy-back projects.
The Iranian Constitution bans foreign ownership of
Iranian gas reserves. NIGC is primarily responsible for
the provision of natural gas to the domestic market.
The Ministry of Petroleum and NIOC and its
subsidiaries are responsible for gas exploration,
production, refining and transport. As more
gas-producing plants become operational, the prospect
of extremely large gas production approaches.
3 Emphasis added.
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
In order to manage and coordinate gas export
activities, the National Iranian Gas Export
Company (NIGEC) was recently established. It is
responsible for Iran’s gas exports, a number of
pipeline projects and the LNG and Gas-To-Liquid
(GTL) projects. The Iran-Pakistan-India pipeline is
amongst the more ambitious future projects for
which NIGEC is responsible. Furthermore,
Memoranda of Understanding have been signed in
relation to natural gas exports to Greece and to
Austria via Turkey.
NPC, a subsidiary of the Ministry of Petroleum,
is in charge of the petrochemical sector in Iran,
and is also responsible for a large number of companies
that produce petrochemicals. The petrochemical
industry is mainly concentrated in two areas of
Mahshahr and Assaluyeh; on the whole, NPC has
worked hard to increase the output capacity of
petrochemicals. In terms of foreign cooperation, NPC
favours the Build-Operate-Transfer (BOT) and BOOT
(Build Own Operate and Transfer) projects with
foreign partners. A number of petrochemical
companies have been or are being privatized. It is
estimated that by 2010, half of the NPC’s projects will
be owned by the private sector.
The National Iranian Oil Refining and
Distribution Company, established in 1992,
is in charge of transferring crude oil to refineries
and export points, building new refineries and
distributing oil products.
12.11.6 Buy-back agreements
As noted above, the compelling factors that
contributed to the recognition of the need for foreign
capital and technology include: the lack of sufficient
investment in the oil industry after 1979, the depletion
of wells, the need for new technology together with the
discovery of new fields, and the need to exploit
common fields with adjacent countries. The need for
foreign capital and technology in petroleum
exploration and production is often satisfied through
some kind of cooperation with International Oil
Companies (IOCs). Various legal frameworks are used
to formalize this cooperation, such as concessions,
licences, Production Sharing Agreements (PSAs),
service contracts, technical assistance agreements, etc.
However, there are certain limitations imposed by the
Iranian Constitution and other laws, which limit the
choice of contractual frameworks that are available to
Iran’s petroleum industry. As noted above, the Iranian
Constitution does not allow foreign ownership of its
oil and gas resources. Furthermore, based on past
experience as well as constitutional restrictions, there
788
is a sense of resentment towards production-sharing
contracts.4
The concept of foreign sources for the purpose of
development was first introduced in the First Five-Year
Economic, Social and Cultural Development Plan
of 1990 (1990-95). However, it was the Second
Five-Year Economic, Social and Cultural Development
Plan of 1994 (1995-2000) that introduced the so-called
buy-back contract. The buy-back method of
transaction has now become a feature of the Iranian
economy. To a great extent, this method is supported
by successive governments as a way of attracting
foreign capital, services and know-how, while
reducing foreign exchange expenditures.
The Iranian buy-back contract has been described
as “a short-term Risk-Service Agreement between
NIOC and an International Oil Company, IOC, or
group of IOCs, jointly constituting Contractor. The
IOC Contractor provides certain E+P services in
return for which his costs, and a reward, are
reimbursed out of a share of project revenue” (Bunter,
2003). The operation of the field is transferred to
NIOC as soon as development is completed and
production has commenced. According to the terms of
these agreements, contractors recover their costs at a
fixed rate and bear the risk insufficient production in
order to fully recover their costs.
According to the terms of buy-back contracts, the
contractor undertakes to provide the necessary funding
to carry out development activities and for all related
machinery, equipment, technology and skills. In
return, the contractor recovers the costs and a
remuneration fee, which is normally paid out of the
production funds associated with the project. The
scope of each project is set forth in the terms of the
Master Development Plan, which includes technical
data such as project plans, including project schedules,
seismic plans, reservoir development and management
plans, platforms, pipelines and facilities, design and
construction plans, and production rates. It also
includes schedules of estimated costs pertaining to the
development of the contract area. The amount of costs
to be incurred and the remuneration fee is a matter of
negotiation or competitive bidding. Moreover, any
change in the terms of the Master Development Plan is
only possible upon the consent of NIOC.
According to the terms of the cost recovery and the
remuneration scheme set forth in buy-back contracts,
the contractor is entitled to recover all capital and
operating costs and bank charges together with interest
4 See comments made by Mr. Hosseini, a high-ranking
NIOC official, in the interview regarding Iran’s experience
with PSAs (Exclusive […], 2005):
www.payvand.com/news/19/may/1146.html.
ENCYCLOPAEDIA OF HYDROCARBONS

at an agreed rate, which is normally determined at the
London Inter-Bank Offered Rate (LIBOR), plus an
agreed percentage. These costs are amortized over a
fixed, agreed number of years starting on the date of
first, or additional, production of the field. If the cost
that is incurred is higher than that provided in the
terms of the original Master Development Plan (i.e. it
exceeds the contract’s cost ceiling), then the contractor
shall bear such extra cost.
In addition to cost recovery, the contractor is
entitled to receive a remuneration fee of a
contractually agreed amount, which is payable to the
contractor during the amortization period of cost
recovery. Such fee has generally reflected between
30% and 70% of the capital cost of the project,
depending on the cost recovery schedule and
remuneration.
The terms of the contract also provide that if any
agreed, additional work is performed and the terms of
such work are not set forth in the original Master
Development Plan and such work results in an
increase in the capital cost, then the contractor will be
entitled to a proportionately higher remuneration fee.
On the other hand, if, as a result of an approved change
in the scope of work, the incurred capital cost
decreases, then there will be a proportionate decrease
in the contractor’s remuneration fee.
The buy-back contract regime provides that
petroleum costs and remuneration fees will be paid
to the contractor in the form of crude oil and/or gas.
Such payment will be an agreed percentage of the
field’s production. It is to be noted that NIOC
reserves for itself a certain percentage of the field
production as “priority percentage right”. However,
any costs or remuneration fees not recovered from
the remaining share of revenues are carried forward
and recovered with interest in following periods. The
important feature of the buy-back contract regime is
that all payments that are due to the contractor, as
provided for in the terms of the contract, are subject
to the achievement of the development operations’
objectives as set forth in the terms of the original
Master Development Plan. Therefore, the contractor
bears the risk of non-recovery of its costs and
remuneration fees if such objectives are not
achieved.
As far as the question of levies, charges, fees and
taxes is concerned, the buy-back contract regime
provides that such taxes that are imposed on NIOC,
including any Iranian corporate income tax, social
security charges, required payments to the Iranian
Training Fund, or other levies, charges or fees, will be
paid by the contractor. Such levies, charges, fees and
taxes that are imposed on the contractor will be paid to
the contractor by NIOC.
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Buy-back contracts contain an Iranian content
provision by which the contractor pledges to supply a
minimum (often 30%) of services, equipment and raw
material through domestic manufacturing, which also
includes engineering services. For instance, with
regard to the contract for the development of the
Soroosh and Norooz fields in which the contractor was
Shell Exploration Corporation, 29.4% of the project
had been given to Iranian companies prior to the
completion of the project (Mashal, 2003).
The first buy-back agreements were short-term
agreements that lasted between five and seven years.
This duration gave rise to criticism that the contractor
had no reason to employ advanced technology for a
prolonged period of production because it would not
have access to crude oil beyond the terms of the
contract (Varzi, 2002). However, it has been argued
that if the level of production is maintained, the
contractor may try to secure a series of successive
buy-back agreements in a way that “maximum return
of the previous project guarantees the stream of
investment dollars into each succeeding
project”(Bunter, 2003). Yet, there is no guarantee that
the contractor will be granted further successive
contracts by NIOC. In any event, the longer terms of
more recent buy-back agreements have, to some
extent, resolved the problem. Furthermore, the terms
of more recent buy-back agreements contain
incentives to increase performance above the agreed
level.
So far, there have been major buy-back agreements
between IOCs and NIOCs including the following
offshore agreements: a) Sirri A and E, Total and
Petronas; b) South Pars phase 1, Petropars; c) South
Pars phases 2-3, Total Petronas and Gazprom;
d ) Balal, Total, Bow Valley and Agip; e) Doroud,
Total and Agip; f ) South Pars phases 4-5, Agip
and Petropars; g) South Pars phases 6-8, Statoil and
Petropars; h) South Pars phases 9-10, POGC;
i) Nosrat and Farzam, PetroIran; j) Forouzan and
Esfandiar, PetroIran; k) Salman, PetroIran; l)
Soroosh-Nowruz, Shell. In so far as onshore
agreements are concerned: a) Darkhovin, Eni
and NIOC; b) Masjid-e-Soleiman, Sheer Energy and
NESCO; c) Azadegan, Inpex; d ) Cheshmeh Khosh,
CIOFC; e) Bangestan, PetroIran. The Petroleum
Development and Engineering Company (PEDEC),
a NIOC subsidiary, is in charge of all buy-back
projects that are in operation, study or negotiation.
It is noted that some buy-back agreements have
been entered into by Iranian companies. Moreover,
NIOC itself has become more active in terms of
participation in projects.
Major buy-back contracts have been largely used
in the field of development. Exploration buy-back
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
contracts are not very popular because they do not
automatically lead to granting the contract for the
development of the field to the contractor. This issue
has been and is being, to some extent, remedied by
extending the scope of cooperation between the
contractor and NIOC into the development phase.
It has been argued that “the life of the buy-back
project is short: this encourages the IOC to attain
quickly a peak of production so as to recover its costs
and achieve a guaranteed return, but not to invest for
an enhanced plateau rate over many years after it has
handed the project back to NIOC” (Bunter, 2003). As
noted above, NIOC has taken notice of this criticism in
more recent agreements in which a longer project life
has been agreed.
There have been complaints by foreign contractors
regarding the lengthy negotiation process pertaining to
buy-back agreements and the “excessive application of
bureaucracy in the administration” of these projects
(Bunter, 2003). NIOC has been continuously updating
buy-back contracts in order to address the issues that
have been raised by foreign contractors and to make
these contracts more attractive in comparison to other
contractual forms that have been used in upstream
petroleum activities.
12.11.7 Investment protection
Foreign investment protection is primarily regulated by
the 2002 Foreign Investment Promotion and Protection
Act (FIPPA), which was passed by the Iranian
Parliament (the Majlis) in March 2002. It was
introduced to promote the attraction of foreign
investment by providing safeguards for
such investments. Furthermore, it has streamlined the
process of admitting foreign investment into the
country. The Implementing Regulations of FIPPA have
also been published and act as a source of guidelines
for the implementation of FIPPA.
Art. 1 of FIPPA defines foreign investor as
“non-Iranian natural and/or juridicial persons or
Iranians using capital of foreign origin”. Therefore, the
factor that determines “foreign investor” is foreign
origin of the capital rather than the nationality of the
investor.
According to the terms of art. 3 of FIPPA, there
could be two categories of investment: Foreign Direct
Investment (FDI) in areas where private sector activity
is permitted (as provided above, the Constitution
defines these areas); and Foreign Investment in all
sectors within the framework of “civil participation”,
“buy-back” and “Build-Operate-Transfer” schemes
where the return on capital and profits that have been
accrued emanates solely from the economic
790
performance of the project in which the investment is
made, and such return of capital and profit is not
dependent upon a guarantee by the Government or
government companies and/or banks.
The terms of art. 5 of FIPPA provide for the
creation of the Organization for Investment, Economic
and Technical Assistance of Iran (hereinafter referred
to as the Organization), which is the sole official
authority for the promotion of foreign investment in
the country and for the investigation of all issues
pertaining to foreign investment. The terms of art. 6 of
FIPPA provide for the establishment of the Foreign
Investment Board (hereinafter referred to as the
Board), which is in charge of investigation and
decision-making with respect to applications for
admission, importation, utilization and repatriation of
capital. The chairpersons of the Board are the Vice
Minister of Foreign Affairs, the Vice President of the
State Management and Planning Organization, the
Vice Governor of the Central Bank and vice ministers
of relevant ministries, as the case requires.
The footnote to art. 6 of FIPPA provides a
timetable applicable to the review of the applications
by the Board. According to the timetable of the
footnote, the Organization, after receiving an
application, has 15 days in which to conduct a
preliminary review. Then the Organization must send
the application and its recommendation to the Board.
Thereafter, the Board has one month to review the
application and notify the applicant of its final
decision.
The criteria to be employed in relation to the
admission of foreign investment by the Board are
those referred to in art. 2 of FIPPA. In addition, the
Centre for Foreign Investment Services (hereinafter
referred to as the Centre) is set up as part of the
Organization as provided in the terms of Chapter 4 of
the Implementing Regulations of FIPPA. The Centre is
in charge of: the provision of information and advice
to foreign investors; the coordination required with
regard to securing necessary licenses and permits, to
the issue of visas and work permits, to address issues
such as registration of joint venture companies, import
and repatriation of capital, and customs and tax
affairs; and the coordination of various departments of
the agencies that are represented in the Centre and
monitoring the results of the decisions that are made
with regard to foreign investment.5
Chapter 2, art. 2 of FIPPA sets forth the general
conditions applicable to the admission of foreign
investment, which includes:
• The investment shall contribute to growth, promote
5 The Implementing Regulations of FIPPA, art. 20.
ENCYCLOPAEDIA OF HYDROCARBONS

technology, enhance the quality of products, and
increase employment opportunities and exports.
• The investment shall pose no threat to national
security, public interest, the environment, and the
production of local investments.
• The investment shall not entail grants of
concessions that are defined as special rights
which place foreign investors in a monopolistic
position. This condition is based on the
constitutional ban on concessions.
• The ratio of the value of the goods and services by
foreign investment shall not exceed 25% in each
economic sector and 35% in each subsector (field).
Foreign investment for the production of goods and
services for export purposes, other than crude oil,
shall be exempt from the aforementioned ratios.
The exception of crude oil could be due to the
crucial importance of oil to the economy and
security of the country, and the desire to avoid
dependence on a limited number of foreign firms
in this area (Sabahi et al., 2004).
Chapter 4 pertains to guarantees for foreign
investment. The terms of art. 8 embody the principle
of national treatment and provide that “Foreign
Investments under FIPPA shall equally enjoy all rights,
protections, and facilities available to local
investment”. The terms of art. 9, however, constitute
the main guarantee against expropriation. It states,
“Foreign investment shall not be subjected to
expropriation or nationalization, unless for public
interests, by means of legal process, in a
non-discriminatory manner, and against payment of
appropriate compensation on the basis of the real
value of the investment immediately before the
expropriation”.
Therefore, expropriation of foreign investment is
permitted by FIPPA to satisfy public interest, through
a legal process, and in a non-discriminatory manner.
The provisions of art. 9 also provide for the payment
of “appropriate compensation”, which, when read with
the rest of the article and other provisions of FIPPA,
appears to be in convertible currency and to represent
the value of the business as a going concern before the
decision to expropriate is made public (Sabahi et al.,
2004). International law allows for expropriation that
is non-discriminatory and for public purposes.
The terms of Chapter 5 of FIPPA set forth
provisions, among others, for the repatriation of
foreign capital and accrued profit.
With regard to settlement of disputes, art. 19 of
FIPPA provides that “disputes arising between the
Government and Foreign Investors with regard to their
respective mutual obligations within the context of
investment under FIPPA, if not settled through
negotiation, shall be referred to domestic courts,
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unless the law ratifying the Bilateral Investment
Agreement with the respective government of the
Foreign Investor provides for another method for
settlement of disputes”. Therefore, in principle, it
appears that domestic courts will be competent to
adjudicate investment disputes between the
Government and the foreign investor. However,
international arbitration is available when there is a
Bilateral Investment Treaty between the respective
government of the foreign investor and Iran. There are
a number of such treaties in force.
12.11.8 Environmental protection
NIOC considers environmental protection of the
utmost importance and it seeks the contractors’
compliance with the high international standards set
forth in this respect. In the terms of its contracts,
NIOC insists on the application of such standards in
order to satisfy the requirements of the relevant
international and Iranian laws and regulations. Iran has
well-developed laws concerning the protection of the
environment. These laws are of general application
and naturally apply to foreign companies operating in
Iran. Furthermore, NIOC has its own regulations
concerning matters of Health, Safety, and the
Environment (HSE). In a circular dated October 2004,
addressing health, safety and the environment, the
Managing Director of NIOC underlines the
importance of these matters and emphasizes that
consideration of environmental issues, among others,
is a highly relevant factor in the process of accepting
competent contractors. The terms of the circular
provide that the contractor must furnish documents
that demonstrate that the contractor maintains a clear
strategy and management systems concerning
environmental issues, among others, relevant to the
subject matter of any specific contract to which the
contractor is a party.
The Directive concerning health, safety, and the
environment dated Autumn 1381 (2002) provides in
the terms of art.1-1 that a low-priced bid from a
contractor with an unacceptable HSE record should
not be a factor to be considered to accept the bid.
Furthermore, the directive requires that contractors
and subcontractors must have a health, safety, and
environmental system that is appropriate for their type
of activity. Particular emphasis is being placed upon
environmental pollution. Contractors are required to
report the existence of such pollution to NIOC’s HSE
representative.
The terms of art. 1-7 provide, in principle, that no
contract will be concluded unless it complies with
NIOC’s standards concerning, among others, the
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
environment. The terms of art. 2 provide that the
contractor’s and NIOC’s responsibilities concerning
safety, health and the environment shall be clearly
specified in the terms of the contract. NIOC has the
duty to stop the activities of the contractor when such
activities are in breach of environmental requirements.
It is in the contractors’ interest to be sensitive to
the HSE requirements, in general, and the
environmental issues, in particular, since
a bad environmental record can adversely influence
further involvement with contractors in both
current and future projects that such contractors
may seek to secure.
12.11.9 Currency regulation
The terms of Chapter 5 of FIPPA exempt foreign
investors from being subject to foreign exchange
regulations, as well as introduce provisions concerning
transferability and convertibility of foreign capital that
is imported for the purpose of investment. The terms
of art. 11 of the FIPPA set forth the forms of foreign
capital that may be imported into the country,
including cash and non-cash items. Non-cash items
should be valued by the competent authorities. The
terms of art. 12 address the question of convertibility
and provide that the rate of conversion of foreign
exchange, if there is a single exchange rate, will be the
official rate; otherwise, the free market rate, as
confirmed by the Central Bank of Iran, will apply. The
terms of art. 13 of FIPPA set forth the principle of free
repatriation of capital and profit. It states, “The
principal of the Foreign Capital and profits therefrom,
or the balance of capital remaining in the country, after
fulfilment of all obligations and payment of legal dues
and upon approval of the Board and confirmation by
the Minister of Economic Affairs and Finance, shall be
transferable abroad subject to a three-month prior
notice submitted to the board”.
The terms of art. 17 set forth the ways in which
foreign exchange for the transfer of foreign capital can
be procured, including foreign exchange that is
purchased from banking systems, foreign exchange that
is earned from the project and foreign exchange
that is earned through the export of permissible goods
as specified in the list that has been approved by the
Council of Ministers for implementation. Note 2 of
this article provides that, with regard to investment and
subject to art.3(b) – i.e. civil partnerships, buy-back
agreements, and BOT contracts –, “if as a result of
enactment of legislation or a Cabinet decree, the
execution of the financial agreements approved
within the framework of FIPPA is prohibited or
interrupted, the resulting losses up to the maximum of
792
instalments at maturity, shall be provided for and paid
by the Government”. The terms of note 3 to art. 17
impose a duty on the Central Bank to secure and make
the foreign currency equivalent available to the foreign
investor for amounts transferable when the banking
system is used to carry out the transfer. The need for
the Board’s approval, the confirmation of the Minister
of Economic Affairs and other requirements of transfer
have been considered somewhat to be the downside to
repatriation of capital as they, among others, have been
viewed as “heavily bureaucratic” (Sabahi et al., 2004).
12.11.10 Applicable law and
settlement of disputes
The scheme of buy-back agreements provides for the
applicability of Iranian law. Iran’s legal system in the
areas of commercial, contract, agency, pledges,
investment protection, trademarks, patents, and
property is well developed. The well-established Civil
and Commercial Codes cover most of the above areas
of law.
The NIOC model buy-back contract provides for
international arbitration as a means of dispute
settlement between the contractor and NIOC.
However, there have been arguments with regard to
constitutional restrictions under which NIOC may be
subject to certain limitations in submitting its
disputes with foreign parties to arbitration. The
relevant law is art. 139 of the Iranian Constitution,
which states: “The settlement of claims relating to
public and state property or the referral thereof to
arbitration is in every case dependent on the approval
of the Council of Ministers, and the Assembly must
be informed of these matters. In cases where one
party to the dispute is a foreigner, as well as in
important cases that are purely domestic, the
approval of the Assembly must also be obtained. Law
will specify the important cases intended here”.
Therefore, it may be argued that an agreement or
referral of NIOC’s disputes with foreign contractors
to arbitration would be dependent upon the
permission of Parliament (Majlis).
The imposition of restrictions and various other
aspects of the terms of art. 139 of the Constitution
have been the subject of scrutiny by a number of
arbitration tribunals. In the Gatoil case, NIOC’s
competence to submit or refer its disputes with its
foreign contractual counterparts to arbitration was
questioned and specifically addressed by the
arbitration tribunal.6 In this case, NIOC as the
6 Unpublished case, reproduced from Panah (2003).
ENCYCLOPAEDIA OF HYDROCARBONS

claimant had claimed the recovery of the price of the
oil that it had sold and delivered to Gatoil. The
contract had provided that “Any dispute between the
parties arising out of this Contract shall be settled by
arbitration in accordance with the laws of Iran […]”.
Gatoil argued that according to the terms of art. 139 of
the Iranian Constitution, NIOC could not refer the
dispute to arbitration without the specific permission
of the Iranian Parliament (Majlis). NIOC, in turn,
argued that the article related to “claims relating to
public and state property” and that it did not concern
NIOC’s transactions since, although NIOC’s shares
belonged to the state, it operated under the
Commercial Code and its property was separate from
that of its shareholders. Furthermore, NIOC argued that
the terms of art. 139 do not prescribe an absolute
prohibition to submit disputes to arbitration. What it
imposes is a requirement of Parliament approval that,
in the case of NIOC, has been granted through the
NIOC statute. NIOC further relied on the Guardian
Council Opinion of 14 June 1986, which provides
that a referral to arbitration by the state (or its entities)
was not dependent upon obtaining a special
permission. The arbitration tribunal rejected Gatoil’s
objection and decided that NIOC could refer the
dispute to arbitration.
A further challenge of the tribunal’s decision (in a
French Court, the seat of arbitration being in France),
made by Gatoil on the basis of its conflict with
French international public policy, failed. The French
Court maintained that in cases of arbitration where
party autonomy prevails, the arbitration clause is
valid. Had NIOC tried to rely on local law
restrictions to reject the arbitration clause, the result
would have been contrary to international public
policy. In view of the above, it appears that NIOC
may legally agree to arbitration in its contracts with
foreign parties as indeed it has done in buy-back
agreements with foreign contracting parties.
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
IRAN
In recent years, Iran has adopted two important
pieces of legislation in order to promote
international arbitration. The Law of International
Commercial Arbitration of 1997, which is based on
the UNCITRAL Model Law of International
Commercial Law of 1985, provides for a modern
legal framework of international arbitration in Iran.
Iran has also acceded to the New York Convention
on the Recognition and Enforcement of Foreign
Awards of 1958, which allows, among others, the
enforcement of awards in Iran that have been made
in other member countries of the New York
Convention. Furthermore, Iran has negotiated a
number of bilateral investment treaties with foreign
countries which provide for arbitration as a means of
settling investment disputes.
References
Bunter M.A.G. (2003) The Iranian buy back agreement, «Oil,
Gas & Energy Law intelligence», 1, 2.
Exclusive interview: Mehdi Hosseini, National Iranian Oil
Company deputy managing director speaks up (part one)
(2005), «Iran Energy Focus», 19 May.
Mashal K. (2003), «Public Utilities Fortnightly», 9.
Panah S.A. (2003) Iran’s accession to the New York Convention,
Qom, Mofid University, LLM dissertation.
«Petroleum Economist» (2004), December, p. 35.
Sabahi B. et al. (2004) Foreign investment in Iran in light of
the passage of the ‘Foreign Investment Promotion and
Protection Act’ (FIPPA 2002), «Oil, Gas & Energy Law
intelligence», 2, 1, p. 5; p. 10.
Varzi M. (2002) Importance of opening up Iran’s oil and gas
sector in the long term, in: Iran energy forum. Upstream
and downstream. Proceedings of the conference, London,
27-28 May.
Msoud Vafakish Sistani
Ministry of Petroleum
Teheran, Iran
793
 12.12
Iraq
12.12.1 Introduction
On 28 May 1901 the Persian Atabeg, the Prime
Minister (acting on behalf of the then Shah of the
Persian Empire, now the Islamic Republic of Iran) and
William Knox D’Arcy, an English private citizen,
signed into effect the first of the great petroleum
concessions that were to change the entire Middle
Eastern world. The legal precedent set by the
Anglo-Persian petroleum concession is of enduring
legal importance for Iraq and for all of the other
oil-producing countries of the Arabian Gulf.
The Shah, the Moslem monarch of the Persian
empire of the time, was exercising his legal
prerogatives as its ruler, drawing his authority as
delegated from Allah, God. Nevertheless the former
should not be granted the honorific of sovereign as
this is reserved only for the deity himself. The Shah
was taking as a legal precedent the practice of the
Prophet Muhammad nearly thirteen hundred years
before in awarding private concessions in minerals and
in land to some of his closest followers. Not only that,
Muhammad himself was a trader and of a merchant
family in Mecca and so the Islamic Sharia law
specifically approves of private property and of
commerce provided that it is lawfully carried out,
hallal.
12.12.2 The Islamic law
and the early petroleum
concessions
in the Middle East
In the very early days of Islam the first Moslem
empire was established with its capital at the western
Arabian city of Medina, which means the City of the
Prophet, and as its Head of State the Prophet himself.
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
At that time Muhammad awarded some of his closest
followers with concessions in land and also the right to
work and to benefit financially from certain gold
mines. These gold mining concessions, iqta, were
for mines located in the hills bordering the Red Sea
in what is now western Saudi Arabia.
The legal validity in the Islamic law of the later
petroleum concessions of the Twentieth century – those
awarded in Iran, then Iraq and later on in Bahrain,
Kuwait, Saudi Arabia and Oman – depended on the
legal precedents that had first been set by the Prophet
in those early land and mineral transactions and also
by the lawful authority held by the Islamic monarchs
of the Arabian Gulf as delegated by God. At the time
that the early Twentieth century petroleum concessions
were awarded, they were judged to be perfectly lawful
in both the Shia and in the Sunni forms of the Islamic
law. The religious authorities of the time, the ulama,
the doctors of the law, raised no objections to these
grants of rights in petroleum at the time, nor to the fact
that the rights had been awarded to foreign and to non-
Moslem corporations.
First of all, in Iran a new petroleum company was
created, the First Exploration Company, later to be
incorporated in England as the Anglo-Persian Oil
Company (APOC). This was then to become the
Anglo-Iranian and after that British Petroleum (BP).
This first Middle Eastern petroleum concession
obliged the First Exploration Company to issue a large
number of shares of stock to the Shah in what must
have been one of the earliest forms of state
participation. More than twenty years later this same
company, APOC, with its partners, was to sign a
similar agreement with King Feisal I of Iraq, the
Islamic monarch of that country, but this time no
direct state participation was envisaged. This oversight
was to have an important and dire political
consequence later on: it had the effect of distancing
795
NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
the economic objectives of the host country from those
of its foreign concessionaire.
12.12.3 Sovereignty over,
and the ownership
of petroleum resources
and reserves
The Iraq Constitution presently in force and which will
certainly be subject to change after the elections of 30
January 2005, is the one that was adopted in 1991
under the Saddam Hussein regime. It prohibits the
private ownership of ‘national resources’ and ‘the
basic means of production’ (art. 13). It also forbids the
foreign ownership of ‘immobile’ property (art. 18),
presumably land, buildings and the like, except as
provided by law. The bar on private ownership of the
minerals and petroleum in the subsurface is common
to all of the Arab lands and descends from the legal
precedents established under the Ottoman empire.
In 1888 and 1889 the Ottoman sultan Abdul
Hamid, the legal suzerain over the Ottoman empire
which included Iraq-Mesopotamia (the land between
the two rivers Tigris, Dijlah, and Euphrates, Furat),
had transferred by special firmans into his civil list the
petroleum and mineral rights in his empire (Shwadran,
1959). In the meantime, following an instruction from
the Ottoman sultan and caliph, the civil servants and
learned Islamic scholars of the Ottoman empire
embarked upon a codification of the Sharia law which
was intended to be binding throughout the sultan’s
domains. Ahmad Jaudat Pasha, chief of the judicial
diwan, presided over a legal commission which was
established in Istanbul in 1869 and which concluded
its mission seven years later (El-Ahdab, 1999). The
articles of the Ottoman version of the Sharia, known
as the Medjella, followed the Hanafi school of the
Islamic law and were derived from the science of the
fiqh, from legal academic writing and from case-law.
Later on, after the arrival of the Young Turk
Movement, the petroleum rights of the empire were
removed from the imperial civil list and placed within
the Turkish Ministry of Finance. These incidents are
important for a number of reasons:
• They established in law for the successor Iraqi state
the rights to petroleum in situ and superceded any
private land-owner rights that might exist to the
minerals in the subsurface.
• In the Sunni school of the Islamic law adopted by
the Ottomans, which is named the Hanafi, the
landowner is permitted to own the subsurface
rights in situ in petroleum and other minerals much
as in the English common law. These petroleum
rights might be exercised by the private landowner
796
himself or might be granted to third parties. The
Hanafi is the dominant school of law in force
amongst the Sunnis of Iraq but for the Shi’i
majority the Islamic legal system follows the
Ja’afari (Imami) legal school. In practice however,
all Moslem nations vest the beneficial ownership
of the petroleum and minerals in situ in the state.
• The Ottoman Medjella, even today, forms an
important component of the legal framework
within Iraq (see below). This form of law does not
rule out the recourse of a non-Moslem to the
Islamic courts nor to arbitration for the resolution
of a dispute between a foreign corporation and a
Moslem, although there are some difficulties with
the latter as will be seen.
• They introduce for us an awareness of just how
complex are today’s petroleum rights-holdings in
Iraq. Certain Turkish sources quite recently have
suggested there may exist residual Turkish rights in
Iraq as a result of the former sovereignty of the
Ottoman sultan and also as a result of certain
treaties entered into after the First World War
(Mahmud, 2003).
Blinn, Duval, Le Leuch and Pertuzio, in their
discussion on the Islamic law of petroleum and
minerals, declare that the “natural resources of the
subsoil” always belong to the state (Blinn et al., 1986).
This is because the latter acts in its capacity as
custodian of the inalienable community property.1
Despite the restrictions on absolute sovereignty
placed on earthly rulers by the Islamic law this does
not mean that the independence of the Moslem state
is compromised in any way as it is understood in
international law. No Islamic country would ever
concede that it is a subject of any other power, either
foreign or earthly. Therefore, the Iraqi state is
sovereign in law over all matters within its
competence including the mineral and petroleum
resources in its landward and seaward territory as
limited by its national boundaries. So far as the
ownership of petroleum in situ is concerned, all
Arab nations are agreed that the bounty of God, in
the form of petroleum in the ground, is considered to
be the natural patrimony of the people and may
not be alienated into private ownership. What does
this have to say about the grant of rights in reserves,
at the wellhead (in the old Concession Agreements)
or at the delivery, export, nomination point (in the
Contractor Agreement, production sharing)? The
position is rather confusing and will be explored
further below.
1 It is fair to point out that not all authors agree with
these opinions.
ENCYCLOPAEDIA OF HYDROCARBONS

In October 2004, after the Saddam Hussein regime
was supplanted, the then Iraqi Planning Minister Mr.
Mehdi Al Hafedh announced that certain government
policy recommendations had been put to the newly
formed Oil and Gas Council (Oweis, 2004a). The
interim Prime Minister Mr. Iyad Allawi suggested that
discussion between Iraq and the International Oil
Companies, the IOCs, might begin but that at the same
time they must balance the need for foreign investment
against Iraq’s national interests. The proposed
contractual arrangements are rather unclear since a
Production Sharing Agreement (PSA) is mentioned as
the model, but then the reports go on to say that this is
consistent with a guaranteed profit to the IOC even
though the oil price might weaken. This seems to be
keeping much more with the Iranian buy-back type of
agreement than any PSA. The former does guarantee a
rate of return, usually about 18% in a production
agreement, not for full cycle E & P (exploration and
production), but does not permit the IOC to gain title
to reserves.
In January 2004, much new light was shed on this
matter in a paper published in the «Oil and Gas
Journal» by lawyers Andrew Derman and Scott
Hounsel. These authors relate that in 1990 the then Iraqi
Oil Ministry adopted the ‘curious position’ that its
contracts with foreign companies did not entitle them to
any claim on Iraqi oil. If correct, this implies that the
IOCs could not gain title to Iraqi crude, and that
therefore their status would be as service contractors
without gaining any lifting rights, apparently equivalent
to their position in the Iranian buy-back agreement. The
Iraqi Oil Minister Mr. Thamir al-Ghadbain is quoted as
saying, “the Ministry has been studying investment
models for years, including service contracts used by
countries such as Iran, and production sharing.”
The Iranian buy-back agreement has recently
been examined in detail by the Iranian writer
Jahangir Amuzegar some years after it was
first mooted (Amuzegar, 2001). He points out the
defects in the system but acknowledges the
constitutional constraints in which it operates. First of
all, he observes that the name is misleading since no
purchase or sale of crude or gas is involved. The
contract is short-term but ‘generously’ compensates
the IOC for the use of their capital and expertise. In its
development-production form the buy-back transfers
commercial risk from the IOC to the Iranian state.
Moreover, no transfer of technology takes place. The
structure of the agreement tends to encourage the IOC
to maximize production in the early years after
exploitation commences. For the IOCs the buy-back
offers fewer incentives than the conventional contractor
agreement (production sharing) since the IOC gains no
title to the reserves produced (see below).
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
IRAQ
12.12.4 Iraqi petroleum rights
By the end of the Nineteenth century several European
groups of investors as well as one non-European group
were competing for petroleum rights in the eastern
(Mesopotamian) marches of the Ottoman empire.
These were the German-owned Anatolian Railway
Company, the English-owned APOC, the Anglo-Dutch
Anglo-Saxon Oil Company (Royal Dutch/Shell,
advised by the famous Calouste Gulbenkian) and the
American Chester group. At that time Great Britain
and the other Europeans were determined to keep the
Americans out of the Middle East and so negotiations
continued between the Sublime Porte and the British
and German governments. The Turkish Petroleum
Company (TPC) was formed with a shareholding
divided between the Anglo-Persian Oil Company
(controlling interest), the Anglo-Saxon Oil Company,
the Deutsche Bank who owned the Anatolian Railway,
and 5% for Mr. Gulbenkian, also known as Mr. Five
Percent. TPC was incorporated in England on 19
March 1914 and five days later the ambassadors of
Great Britain and Germany requested that the Turkish
grand vizier grant a concession to explore for and
exploit petroleum in the vilayets of Mosul and
Baghdad to the new company. On 28 June 1914, only a
month or so before the outbreak of the First World
War, the Grand Vizier responded with a letter that
referred to: the grant of petroleum rights in the
vilayets of Mosul and Baghdad to the TPC; the right of
the Turkish government to take a future decision as to
Turkish government participation in the company; the
obligation of the TPC to indemnify any other
rights-holders in the areas cited.
During the First World War the Turks began
drilling for oil near Baghdad on a structure known as
Qaiyarah. On 10 March 1917 the British, advancing
northwards from Basra, reached Baghdad.2 A little
time later they constructed a small refinery to exploit
the oil produced at Qaiyarah which was used for Army
motor lorries (Owen, 1975). There matters remained
until after the Armistice of November 1918.
After the Turkish and German defeat in the great
world conflict, the victor powers began to take charge
of matters in the former Ottoman empire and these
matters included the oil rights in Mesopotamia.
Strictly speaking this name only applies to the land
between the two rivers, Tigris and Euphrates, but it
was also the common name for what is now Iraq. The
United States, not having participated in the desperate
fighting against the Ottoman empire, was not
2 The British were to advance to Baghdad again some
eighty-six years later.
797
NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
consulted, although, later on it managed to insert itself
into the Iraq concession when it was finally granted.
Meanwhile the Allies busied themselves with carving
up the rotting corpse of the Ottoman empire and the
various mandates of Palestine, Trans-Jordan, Syria and
Iraq were awarded to Great Britain and France. Emir
Feisal, son of the Hashemite King Hussein of the
Hejaz and Mecca, was appointed to the throne of Syria
and then of Iraq. His brother Abdullah was appointed
to the vacant throne of the Trans-Jordan.
At any rate, after some inter-allied hard-bargaining
the Germans were ejected from the TPC and their
share was awarded to the newly created French state
oil company, Compagnie Française des Petroles (CFP),
Total. Iraqi politics soon stepped in. Some three years
after its liberation by British troops the newly-created
Iraq erupted into rebellion. In 1920 the Shia majority
raised the black flag of revolt and it was suppressed at
the cost of 8,450 Iraqi lives and 2,200 British. As a
result, the ambitions of the Shia majority were firmly
curbed in favour of the Sunni minority and on 23
August 1921 the Sunni King Feisal ascended the
throne of a nominally independent Iraq.3
This event is important. Feisal was of the House of
Hashem in the Hejaz, which is of the same tribal
lineage as the Prophet thus conferring on him a
legitimacy (so it was thought) in the eyes of the Shia
as well as the Sunni. At the same time there was a
defense agreement with Great Britain according to
which British soldiers would garrison British bases
and, besides, the men in Whitehall felt it best that
British capital should develop the Iraqi oilfields. The
parallels between the Iraqi situation of the 1920s and
today’s world are quite striking, as the issue of foreign
military bases in the country is ongoing.
In 1922 there was a border dispute over the
northern border between the newly independent
Kingdom of Iraq and the new Republic of Turkey. The
dispute centred upon the situation of the vilayet of
Mosul and of the Kurdish peoples within it. The
clauses of the subsequent agreement of June 1926
between the Turks, Iraq and Great Britain are
important because they provided that there were to be
boundary adjustments that would finally satisfy all
parties, and for twenty-five years Iraq was to pay
Turkey a 10% royalty from the oil from the area of
Mosul or, in lieu, a £500,000 quit claim (Shwadran,
1959). Mahmud declares that this agreement is
fulfilled since the quit claim has been paid (Mahmud,
2003).
Meanwhile, the geologists of the various
shareholders in the TPC began work in the field under
circumstances of great difficulty. However, no
agreement had been secured as to the petroleum rights
in Iraq and there existed only the pre-war letter of
798
intent between the Ottoman vizier and the European
parties in the TPC. This matter was to be speedily
rectified but great power diplomacy intervened. The
Americans were fearful of running out of oil and
belatedly decided to venture into international
exploration. They soon realized that their position in
Iraq had been undermined by their failure to ratify the
Treaty of Versailles but, even so, they insisted that all
of the victor powers should be treated equally in the
post-war settlement and that American oil companies
be admitted to the TPC. This new policy was to be
known as the Open Door. However, as Henry
Longhurst was to point out, when the petroleum rights
in Saudi Arabia were involved, the Door was to swing
in one direction, that is, as it does today, only in
United States favour (Longhurst, 1959).
Meanwhile, the new kingdom of Iraq was busying
itself with other matters. On the 21 March 1925, the
country adopted a constitution that established a
constitutional monarchy in which Islam was declared
to be the official religion of the country. However, the
civil, criminal, and other secular courts were to
co-exist with the various religious jurisdictions.
Sovereignty was declared to reside with the people,
and also, the Parliament was to consist of a Chamber
of Deputies and a Senate. On 24 March 1925 the
concession was signed which granted the TPC full
petroleum rights over parts of the vilayets of Mosul
and Baghdad.
Even though not ideal, the Iraqi constitutional
monarchy was representative in its own way. The last
free elections in Iraqi history (before the present series
of 2005) took place in 1953. Later on, after the
overthrow of the monarchy in 1958, a republican form
of constitution was adopted in 1965, then another in
1990 and yet another in 1995. The latter established
the dominant ruling power of Saddam Hussein, his
immediate family, and their more distant relations.
Currently, the country is governed by an interim
constitution. No doubt mindful of its very mixed
ethnic and religious composition, Iraq has never
adhered to a fully Islamic legal framework (see
below), instead, it adopted a mix of secular,
commercial, and other laws drafted according to
circumstance.
Other important events were taking place as well.
The sixth well to be drilled by the TPC, the Baba
Gurgur no. 1, located on the Kirkuk anticline located
in the vilayet of Mosul in what is now declared by
some to be Kurdish territory, spudded on 30 June
1927. On reaching the Miocene ‘Main Limestone’ (the
3 At that time Iraq was ruled by Great Britain as a
mandated territory on behalf of the League of Nations.
ENCYCLOPAEDIA OF HYDROCARBONS

same geological horizon as the Asmari producers in
Iran) on 14 October 1927, the well blew oil over the
crown block and came in flowing at an estimated
90,000 barrels per day. Despite this financial bonanza
the Anglo-Dutch-French shareholders in the TPC kept
to their word, and through the subsequent Red Line
Agreement the Americans were admitted to the TPC
on 31 July 1928.
In 1929 the name of the company was changed to
the Iraq Petroleum Company (IPC) and later it was
awarded all of the land east of the Tigris river, together
amounting to some 46,000 square miles. Later still, all
of Iraq, including the vilayet of Basra, was conceded
to the IPC under a series of new and amended
concession agreements. This vast concession area was
to trouble relations between the host government and
the IPC and has had a material effect on the drafting of
modern petroleum agreements today.
12.12.5 The Iraq Petroleum
Company (IPC) concessions
The concession is a rather ancient legal instrument
found both in the English common law and in the
French civil code tradition, although satisfactory
definitions are not easy to find. The website of the
New Zealand Government is useful in this regard,
since it provides an informal but broadly applicable
definition of the concessions which might be awarded
by one of their departments for any commercial
activities on public lands. “A Concession is an official
authorisation to operate in an area managed by the
Department. It may be in the form of a lease, licence,
permit or easement.”
The website goes on to declare that concessions are
required, inter alia, for the exploration and
exploitation of minerals. It further states that
concessionaires are required to pay concession fees for
the privilege of obtaining commercial or other benefits
from public land. These fees will be the result of
negotiations and may be charged as a percentage of the
gross revenue, a per hectare or fixed fee or a
combination of these. Sometimes concession
opportunities are publicly offered (tendered) but most
concessions are initiated by an individual or firm
approaching the department seeking permission to run
a particular business. The concession thus awarded
provides: the legal right to carry on the proposed
business activity on land managed by the department;
a definition of the formal relationship between the
concessionaire and the department so that both parties
are aware of their obligations; security of tenure for
the term of the concession, provided that the
concessionaire complies with its conditions.
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
IRAQ
All of these definitions and remarks can be
applied directly to the early petroleum concessions
granted in the Middle East although the latter appear
to be much wider in scope (see below). At the time
of the signature of the 1925 agreement in Iraq there
existed no petroleum legislation to give effect to the
transaction, although a new constitution had just
been adopted. Shwadran declares that the Iraqi
Government (sic) signed the agreement with the
TPC for the grant of petroleum rights and so it is to
be assumed that the agreement thereby took on the
force of law.
While this was going on, certain arrangements had
been made for the exploitation of any oil which was
found in territories that had been transferred from Iran
to the Ottoman empire in a border rectification
(Bunter, 2004). Great Britain succeeded in obtaining
recognition from Turkey that the Anglo-Persian
concession in Iran actually covered these transferred
territories as well. Therefore, on 30 August 1925 an
agreement between the Iraqi government and APOC
was concluded. This provided that a subsidiary of
APOC, to be known as the Khanaqin Company, had an
exclusive petroleum concession over 684 square miles
in the transferred territories, quite separate from that
of the TPC-IPC group, for thirty-five years. A refinery
supplying products for all of Iraq was to be built which
was to be supplied with oil from the Naft Khaneh field
discovered there, which was capable of producing
some 3,000 barrels per day.
Later on, an affiliate marketing company, the
Rafidain Oil Company, was established in order to
supply petroleum products, mainly petrol or motor
spirit or gasoline, also paraffin or kerosene and diesel,
to the Iraqi market. Owen states that by the 1950s both
of these enterprises were in Iraqi state ownership;
furthermore, both of these companies still operate
quite separately from the Iraq National Oil Company
(INOC), of which more later (Owen, 1975).
Legally, the famous Red Line Agreement is of
great interest. It provides an early example of what
has now come to be called a Joint Operating
Agreement (JOA), in which two or more IOCs, often
of widely differing nationalities, come together in an
informal business grouping to carry out the
petroleum operations. This loose grouping is not at
all the same as a true partnership in the sense of the
English common law.4 Nevertheless, this name is
widely used in an informal sense although it is by no
means fit-to-purpose. In the JOA, the IOC ‘partners’
come together in a non-profit group in order to
4 Nef used the much better word co-partnery in
connection with similar arrangements in the English coal
industry (Nef, 1932).
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
jointly finance and conduct the petroleum E & P
operations.5 They often bind themselves not to
compete with each other within a defined Area of
Mutual Interest (AMI). In this case the AMI area
was defined by the ‘red line’ actually drawn by
Calouste Gulbenkian on a map within which, as he
understood it at the time, the pre-war suzerainty of
the Ottoman sultan was generally recognized under
international law.6
So useful was the IPC grouping that it was used by
its member companies for their E & P activities in
other countries of the Middle East, with the group
later taking up petroleum concessions in Palestine,
Syria, Oman and the United Arab Emirates, some of
which are still in effect. The shareholding in the IPC
group was to become Anglo-Persian 23.75%, Royal
Dutch-Shell 23.75%, Compagnie Française des
Petroles 23.75%, Calouste Gulbenkian 5% and the
American Near East Development Corporation
23.75%. The latter was itself owned by Atlantic
Refining Company 16.66%, Gulf Oil Corporation
16.66%, Pan American (Standard Oil of Indiana,
Amoco) 16.66%, Standard Oil of New Jersey (Esso) 25%
and Standard Oil of New York (SOCONY-Mobil)
25%. Anglo-Persian retained an over-riding royalty of
10% on production reflecting its senior position in the
partnership.
The petroleum agreements between the
government of Iraq and the IPC, and those that were
previously and subsequently in force in Iran, Bahrain,
Kuwait and Saudi Arabia were undoubtedly lawful
under the Islamic law since no objection was raised to
them by the ulama at the time. However, they had a
number of unfortunate defects which have led to the
way in which all modern petroleum agreements are
now shaped. They were exclusive grants and covered
territories that were extremely large and the
concessions were in force for very long periods of
time.7
The fiscal reward for the government was payable
as a royalty; so many gold shillings per ton of oil. This
payment was independent of the oil price, however,
later on, any taxable profit depended on the posted
price for oil, a quantity which tended to be fixed by
the IOCs (Vernon, 1976).
Despite the precedent set by the 1901 Persian
concession there was, for the most part, only an
ambiguous commitment to any form of state
participation.
There were no relinquishment provisions so that
the IOC, having made his discovery, could exploit it
without the need to carry out further exploration in the
remainder of his very large concession area. This
meant that government budgets which were derived
largely from the revenues from the concession area
800
were dependent on the present-day business needs of
the IOC.
This latter defect will always be present to an
extent in any extractive minerals agreement.
However, in modern petroleum contracts the acreage
awarded is generally much smaller than in the early
concessions. Moreover, the IOC is obliged to carry
out an agreed upon work programme for its
exploration operations within a short period of time,
and after that, it must relinquish to the government
all of its acreage that is not subject to a production
licence. The latter may then re-license to third parties
all surrendered acreage.
The ownership of petroleum under the old
concessions also seems rather unclear. Even though
the Islamic monarch was able to grant rights over
petroleum in the subsurface to the foreign
concessionaire there is an implied limitation to those
rights. Blinn et al. (1986) declare that under the
Islamic law hydrocarbon deposits, presumably they
mean the Oil and Gas In Place (usually capitalized)
may in no manner become the object of private
acquisition. Their exploitation by a third party may
be undertaken only by means of an exploitation
agreement for a fixed term and within the limits of a
conceded area. They go on to state that the IOC may
not become the owner of the deposit and that its
rights are limited to the acquisition of the mineral at
the wellhead. However, they do not explain if this
concept was also held by the IOCs at the time of
signature of those early petroleum agreements. This
view may not be consistent with the interpretation of
the meaning of the Arabic word for concession, iqta,
as presented by el-Malik in 1996 (see below).
Moreover, the Indonesian lawyer Kusumaatmadja, in
his examination of the old mining concessions in the
Netherland’s East Indies, was also of the opinion
that the rights exercised by the foreign
concessionaires were extensive and included
5 In the case of the IPC the group was rather more than
informal since it was actually incorporated in England as a
limited company. Nowadays, such a partnership should be
called an incorporated joint venture.
6 Interestingly Gulbenkian did not include the state of
Kuwait within this Red Line Area which suggests that the
Iraqi claim to Kuwait, now sundered, was tenuous at best.
7 Despite the special pleading of some authors this was
not a specific defect of the petroleum concessions granted in
the Arabian Gulf and North Africa at the time. In the 1970s
an exclusive petroleum concession was granted to one
company over a very large portion of the Danish offshore.
After the UK Petroleum (Production) Act had been assented
in 1934 an onshore UK Mining License was granted for 75
years, extendible for another fifty. In the Netherlands, until
quite recently, oil and mineral concessions were granted in
perpetuity.
ENCYCLOPAEDIA OF HYDROCARBONS

property which could be mortgaged, being in rem
rather than ad rem (Kusumaatmadja, 1974).
12.12.6 Modern geopolitics
and the legal situation
of Iraqi oil
Around the world there are many highly successful
nation-states which have composed themselves from
widely differing ethnic and religious groupings.
Perhaps the most successful example of these is the
Helvetic Confederation (Switzerland) probably the
best-governed nation on earth. Therefore there is no
particular reason why Iraq, although composed of
many different ethnic and religious tendencies, should
not come in time to enjoy a similar enviable stability.8
In the 1920s and 1930s, as a nation newly-formed
from the debris of the Ottoman empire, the Kingdom
of Iraq was always fractious. Jewish immigration into
Arab Palestine, then under the British mandate,
certainly affected Iraqi politics as well. Although the
Prime Minister of the time, Nuri es Said, was strongly
pro-British, the Iraqis were not in love with the British
presence in their country. However, for the partnership
in the IPC, such a presence was extremely valuable
since it not only provided a welcome sense of security
for all of the investors in the group, it actually involved
for the non-British partners an effective
security-guarantee financed by the British tax-payer.
For the ordinary Iraqi citizen there was a tendency to
conflate the presence of British troops, bases, clubs
and cantonments with the overwhelming influence of
the British government and of the British IPC. Not
surprisingly, groups of disaffected Iraqi army officers
began to acquire a sense of grievance and also a sense
of Iraqi nationalism.
By 1941, the complaints of the Iraqis had
expanded into open revolt and a group of senior Iraqi
army officers, going under the name of the Golden
Square, initiated a coup. This was speedily put down
by British soldiers and seamen but the damage was
done. The relationship between the British and the
Iraqis never recovered, and, in 1958, the pro-British
monarchy was overthrown by a group of army officers,
amongst them the Shia General Qassem. Law 12
December 1961 No. 80 removed from the IPC
concession all of its land area excepting that
immediately surrounding its producing fields.
Prior to the coup of 1958 the Iraqi economy was
principally agrarian although oil revenues played an
increasing role. The Iraqi ruling class was dominated
by a small group of land-owning magnates. There were
4.4 million landless peasants in the country whilst
3,600 landlords owned over 80% of the cultivable
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IRAQ
land. It was the same in many of the Arab territories.
To an extent the Iraqi government had determined to
utilize the nation’s oil to further its aims of national
development. In 1950 it created the Iraqi Development
Board (IDB) to oversee the expenditure of Iraq’s share
of oil revenues (Tanzer, 1969). This group was initially
to receive all of Iraq’s share. However, similar to many
other petroleum contracts at the time, the Iraq-IPC
concession was amended in 1952 so that there was to
be 50-50 government-IOC profit-sharing. At that time
Iraq’s share of oil revenues had increased substantially
so that the IDB share was reduced to 70% with the
remainder going to the ordinary government budget
for current expenses.
Following the dissolution of the Iraqi monarchy in
1958, and the later take-over of the IPC, other Arab
lands as well as Iraq began to embark on an extended
period of secular nationalism with a pronounced
socialist tinge. This was inspired by the example of
Gamal Abdel Nasser of Egypt and also of the Syrian
Arab Christian Michel Aflaq, the founder of the Arab
Ba’ath (Renaissance) Party which had established
underground branches in Syria and Iraq. Nasser had
already nationalized the Egyptian Shell subsidiary
Anglo-Egyptian Oilfields, and so throughout the Arab
world the state domination of the commanding heights
of the economy seemed to be becoming the natural
order of things. In 1952, in Iran, Mossadeq
nationalized the Anglo-Persian, now Anglo-Iranian,
but he forgot that oil has to be sold into a market to
realize its value. Nationalization in Iraq, in Kuwait, in
Saudi Arabia, in Libya, in Algeria and elsewhere was
just around the corner but first the great oil producers
had to seize control of the oil-pricing mechanism from
the IOCs.
In 1960 the Organization of Petroleum Exporting
Countries (OPEC) was formed at a meeting in
Baghdad of the five largest oil producers in the world
excepting the USA and the Soviet Union. These five
were Iraq, Iran, Venezuela, Kuwait and Saudi Arabia
and it is no coincidence that all of these countries
could be considered to lie amongst the ranks of the
‘less-developed’. Later they were to be joined by many
others, including Indonesia, Libya, Algeria and
Nigeria.
In Iraq an extended period of political instability
had succeeded the relatively quiet years of Nuri es
8 The reader should be aware that, although Moslems are
in the distinct majority in Iraq and the Shia are a 60-65%
majority of the whole Iraqi population, there are also
substantial populations of Assyrian and Chaldean Christians,
as well as other more heterodox Islamic groupings. Jews,
once a large minority, are no longer resident in significant
numbers.
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
Said and of the constitutional monarchy. Coup
followed coup and in one of them the young Ba’athist
Saddam Hussein had barely escaped with his life. In
1963, General Qassem, who was at the head of the
Revolutionary Command Council and the erstwhile
ruler of Iraq, was murdered. In 1964 a briefly
constitutional government of the day created the
INOC, and in 1967, the INOC was granted sole
petroleum rights over most of the national territory of
Iraq. In 1968 the company began petroleum operations
for its own account and in that same year the Arab
Ba’ath Party seized power in Iraq, never to relinquish
it voluntarily. In some ways this was an unmitigated
disaster for the Iraqis but it also ushered in a period of
national development and of personal prosperity for
many.
12.12.7 State participation
and the nationalizations
of the 1970s
After its inception in 1960 the new organization OPEC
remained quiescent until 1969, when in Libya the
phenomenon of Colonel Muammar al Ghaddafi
exploded into the world of oil. Ghadaffi, like the
ruling circles in Iraq, Algeria and Egypt, was an Arab
radical and was insistent on increasing the role of the
Libyan state in the petroleum sector. He picked off the
weakest of the IOCs in Libya, the rather small
Occidental Petroleum (Oxy), knowing that Oxy had
contracts to supply crude oil to its customers but had
only limited sources of supply. He unilaterally cut
Oxy’s production but then restored it in return for an
increase in the government’s share of revenues. The
other IOCs fell into line and the control of production
rates by the host governments replaced the old posted
price system. By this time another demand had been
made; the host governments insisted that they wanted
to ‘participate’ as equity partners in the operations of
the IOCs in their countries. These two demands of the
1960s and the 1970s, first control of the oil price
through government-dictated production quotas and
then actual equity participation, marked a massive
shift of power away from the IOCs into the hands of
the host governments.
At about the same time the General Assembly of
the United Nations adopted resolutions which assured
a nation’s permanent sovereignty over its mineral
resources. As a result the State Oil Companies (SOCs)
were created in the major oil producing nations. In
1972, in Iraq, the IPC was nationalized partially
(actually a participating percentage was granted to
Iraqi state interests) but not into the ownership of the
INOC, but instead into a separate Iraqi state oil
802
company. This was the Iraqi Company for Oil
Operations (ICOO), which was established
immediately after nationalization.9
This process of state participation is very
characteristic of the Iraqi oil sector. There is in the
country a multiplicity of small to medium sized
upstream, midstream and downstream state-owned
petroleum enterprises, each having different defined
functions and areas of operations (see below). Whether
these will survive in their present form with the return
of sovereignty to the Iraqi people is quite unclear. In
1973, during the Arab-Israeli (Ramadan) War, the Iraqi
government nationalized completely the shares of the
remaining American partners in the IPC: Standard Oil
of New Jersey, Mobil Oil, Royal Dutch, and the
Gulbenkian family. This left the British and French as
the only foreign partners in the IPC and in 1975 these
last foreign shares in the IPC were nationalized
completely.
International law recognizes an Act of State, where
the sovereign may carry out some act such as
expropriation or nationalization, provided that proper
compensation is offered. Some prominent Moslem
scholars appear to have questioned the lawfulness in
the Sharia law of the nationalizations of the petroleum
concessions, iqta, in the Middle East in the 1960s and
1970s. According to the Islamic jurist Al Maududi,
“no state or legislature has the right arbitrarily to
deprive the people of their rights or to take over or to
interfere with the properties legally valid except
against any right justifiable”.
In Islamic law the term right justifiable refers to
cases of pressing need, such as war or starvation,
which can hardly be said to apply when the properties
were nationalized in Iran, Saudi Arabia, Kuwait and
Iraq. Any unlawful deprivation of property
lawfully-held is considered to be a ghasb, an
usurpation, and any transfer of such property to a third
party results in that party having gained illegitimate
possession, yad mubtila. If the petroleum concessions
as granted were adjudged to be essentially an
administrative right to extract the minerals, that is iqta
istighlal, then the concessionaire has gained no
ownership rights to the minerals in the ground, and
cannot claim compensation for these rights even if his
concession was nationalized. However, he may claim
restitution of his property for any minerals extracted
before the nationalization event, but not for any
extracted after it. If however the concession were
adjudged to be iqta tamleek, that is a property right
9 One wonders what would have happened to Iraq if the
Iraqi participating percentages in the IPC had been granted
to the individual citizens of Iraq for their personal benefit
instead.
ENCYCLOPAEDIA OF HYDROCARBONS

over the minerals in the ground, then the
concessionaire may also call for compensation for any
of the minerals extracted by others after the act of
nationalization (El-Malik, 1996).
By 1975 the IPC operation in the vilayets of Mosul
and Baghdad had been granted to the new SOC,
ICOO. The IPC operation in the vilayet of Basra had
been handed over to the INOC, and the much smaller
operations in the transferred territories belonged to the
national enterprises of the Khanaqin and Rafidain Oil
Companies. By 1975 the country was producing a
total of 2.248 million barrels per day. By this time, due
to political difficulties, petroleum exports from
northern Iraq through Syria had almost ceased and
those through Israel had long come to an end. A
southern pipeline export system had been built to the
Shatt al Arab and, later on, another was built through
Iraq’s southern border with Saudi Arabia and into the
Saudi pipeline system.
Despite its strongly socialist hue, Iraq was by no
means averse to foreign investment in its petroleum
sector and, between 1968 and 1972, awarded to the
IOCs three full cycle E & P Risk Service Agreements.
In these, the foreign IOC became a service contractor to
the Iraqi SOC but assumed all of the risk in the E & P
phases. If a commercial discovery was made the IOC
had the right to recover its costs and would be rewarded
for its risk by a negotiated share of production, which
was paid in cash. Alternatively, the IOC was permitted
to purchase its share of production with the cash earned.
It is not known if there was any level of direct state
participation. The first of these agreements was initiated
with the French Elf-Erap and covered an area in the far
east of the country hard by the border with Iran. There,
the French discovered three fields, two of which had
reserves in the billion barrel class. In 1972 the INOC
entered into a Risk Service Contract with Braspetro and
in 1977 the latter discovered the Majnoon field with
reserves of twenty billion barrels. In 1973 the INOC
entered another similar agreement with the Indian Oil
and Natural Gas Corporation (ONGC) but in 1977
these rights ceased. In 1978 and 1979 the rights of the
Elf and Braspetro groups ceased as well.
12.12.8 The Iraqi legal system
El Ahdab summarized the legal system that prevails to
this day in Iraq recognizing that it has been heavily
influenced by the following legal traditions: a) the
Ottoman version of the Islamic law and fiqh, otherwise
the Medjella; b) English law dating from the British
occupation in the late 1910s and 1920s; c) Egyptian
law because of the strong influence of Egyptian
institutions and law throughout the Arab world; d )
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Socialist law following on the economic and social
thinking of the Arab Ba’ath Party (El-Ahdab, 1999).
The influence of the tribal customary law or laws,
and the common law should be added to this list as
well. Despite the overwhelming weight of Great
Britain in the political affairs of the Arabian Gulf and
of the Middle East in general, at least prior to the
1950s, rather surprisingly other legal influences are
dominant. Most of the legal framework for these
countries has been heavily influenced by the Egyptian
civil code and by the French civil law which to an
extent informs it. Egypt has always occupied a central
role in Arab politics and in economic life which was
only briefly interrupted by the Sadat apertura to the
State of Israel in the 1980s.
By the nineteenth century the Egyptian sultanate,
although nominally subject to the Sublime Porte in
Istanbul, had become a de facto independent state
under a viceroy, khedive (pronounced khudaywee). In
Egypt, until 1875, the Sharia co-existed with various
versions of European law applied by the consular
courts and then by the Egyptian mixed courts. In that
year numerous legal codes were issued under the
authority of the khedive and these followed French
law: its Civil Code, Commercial Code, Maritime
Code, Code of Civil Procedure and Code of Criminal
Procedure. This process of law-giving was adopted in
many of the Arab lands thereafter, including Iraq.
Other decisive influences on Iraqi law are the
doctrines and practices of Arab socialism, in
particular, those adopted by the Arab Ba’ath Party. It is
not easy to unravel the beliefs adopted by the
founding-fathers of the Ba’ath, although the actual
history of the party is fairly well-documented
(Mansfield, 1978). Recall that in the 1930s and 1940s
the whole world seemed to be polarized between two
political extremes; socialism/communism on the one
hand and the various forms of fascism on the other.
Liberal democracy appeared to be waning and Islam as
a political force was barely apparent. For the
subjugated colonial peoples of the Middle East and
Africa the example of Soviet Russia and of socialism
as a political means to national liberation was
overwhelming. In Syria in 1944 the Arab Christian
Michel Aflaq and a few like-minded souls laid down
the beginnings of the Arab Ba’ath Party. Mansfield
opines that Aflaq’s writings, although romantic and
idealistic, are far from lucid. Aflaq declared that the
three-fold mission of the Arabs was ‘freedom, unity
and socialism’ which to him meant political,
cultural and religious freedom as well as liberation
from colonial dominance; an ambition not altogether
realized in any of the Arab lands.
Other formative influences a short time later were
the Free Officers of Egypt and, in particular, the
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
almost talismanic hold of Gamal Abdel Nasser on the
Arab masses in the 1950s. Nasser intended the Arab
Socialist Union (ASU) to be the ruling power in Egypt
and later in the Arab lands. His insistence on the
public ownership of the means of production, the
distribution, and the exchange was of decisive
importance in the development of the Arab political
economies, not least of all in Iraq. The national flags
of many of the Arab lands, including that of Iraq,
follow directly from the red, white, black adopted in
Egypt after the 1952 revolution in that country (Ahad,
2004).
Nasser’s Egypt was one of the first to nationalize
the foreign oil companies operating in the land,
and the Ba’ath, although to an extent a rival to the
ASU, enthusiastically adopted its economic policies.
After the economic and political template set by
Nasser and the Ba’ath, the recently liberated lands of
Asia and Africa entered a phase of economic
nationalism which endures to this day. For this reason
it seems that the recent foreign clamour for the
privatization of parts or all of the Iraqi oil industry is
most misplaced. All of the various historical
influences on the Arab and Iraqi legal systems that
have been discussed are of decisive importance given
the elections of 30 January 2005 in the latter country
and will, no doubt, colour its economic and political
development for years to come.
Finally, there is likely to be an equally, if not an
even more, decisive influence on the Iraqi legislative
system and that is from the growing weight of the
Islamic Sharia law. Although it does not enjoy the
overwhelming prestige conferred upon the Arabian
peninsula by its possession of the two holy places,
the region of Iraq does occupy an important but
secondary position in the respect of the world
Moslem community, the ummah. The power base of
the fourth of the Rashidun (the “rightly-guided
caliphs”), Ali the cousin of the Prophet, was in
southern Iraq and there he and his son Husayn are
buried. Not only that, in the eighth century AD the
Abassid dynasty shifted the caliphate from
Damascus to Baghdad where they established that
city as possibly the most important in the world at
the time. Here the caliphs established a great centre
of learning and attracted to it a glittering assembly of
academic talent. Here as well as in Medina the great
Islamic scholars, amongst them Abu Hanifa and his
followers, began the work of the inscription of the
principles, the fiqh, of the Holy law. The Hanifi
school of the Islamic law is still in effect amongst
the Sunni community of Iraq.
For the Shia the territory of Iraq is even more
important. The split in Islam after the death of Ali and
the martyrdom of Husayn, which was occasioned by
804
the assumption of the caliphate by the Umayyads,
made southern Iraq a place of special esteem in the
minds of the partisans of Ali, Shiatu Ali, the Shia. In
the two southern cities of Najaf and Kerbala,
especially the former, are sited the most important
seminaries in Shia theology, whose learned scholars,
the ulama, are entitled to interpret the law. In Islam
there is no distinction between the observance of
religion and the observance of the law, therefore, it is
clear that the position of the Shia ulama attracts great
deference. Unlike the Sunni ulama, the Shia clergy are
organized into hierarchical grades at whose pinnacle
are those entitled to style themselves ayatollah. The
Grand Ayatollah Ali al-Sistani is at the head of the
leadership of the Shia community and is supported by
the seven other members of the marja’iyah, a marja
being a recognized Shia jurisprudent. This group of
respected clerics is entitled by the Islamic law to
appoint judges to hear particular civil and criminal
suits submitted to their jurisdiction. Not only that,
their political influence appears to be very powerful.
As a consequence of the different legal ancestries
prevailing in the country, El-Ahdab has declared the
main Iraqi laws to be: a) the Baghdadi Criminal Act
issued on 21 November 1918 which is of Ottoman
origin but with several modifications according to
Egyptian and English influence; b) the Baghdadi Code
of Criminal Procedure issued on 15 November 1918
and influenced by Sudanese, Indian, Ottoman and
English laws; c) the Companies Act which is the same
as the Indian Companies Act and was enacted in 1919
but was modified in 1957 and again in 1981; d ) the
Commercial Code which was first enacted in 1943 and
modified in 1959 and its later expressions; e) the Code
of Civil and Commercial Procedure which was issued
on 25 August 1956.
In 1933 the Iraqi government, by this time free of
the restraints imposed on the internal laws of the
country by the occupying British, formed a legal
commission to draft a modern civil code. Matters
dragged on for a while until in 1936 a new group was
commissioned under the leadership of Dr. Abdul
Razzaq Al-Sanhuri, who was Dean of Legal Studies at
Baghdad University. The final draft of the new civil
code was approved by the National Assembly on 4
June 1951 and came into effect on 9 September 1953.
The explanatory memorandum attached to this civil
code explained that it had been the intention to
establish a general legal framework for Iraq consistent
with the general principles of the Sharia and the
Moslem fiqh, but that it awaited a more general Arab
civil code. At the time Pan-Arab politics were heavily
influenced by ideas of Arab unity.
Apparently all Iraqi laws are publicly reported in
the Iraqi Official Gazette al Waqaa i al Iraqiyya.
ENCYCLOPAEDIA OF HYDROCARBONS

However, depending on the sources consulted, the
legal situation of Iraqi commercial law is rather
unclear. It appears that the Civil Code, Law 1951 No.
40, became effective in 1953 but was amended by the
Companies Law, Law 1997 No. 21. However the
principal piece of commercial legislation appeared as
Law 1984 No. 30. The Civil Procedures Code, Law
1969 No. 83, enforces the judicial procedures to be
adopted in cases of civil and commercial dispute.
Despite the relative modernity of the Iraqi legal system
it is clear that major and much more ancient legal
influences are at work. The legal reasoning behind the
various pieces of modern commercial law are heavily
influenced by the Islamic law, thus: a) Contract Law
(offer and acceptance, validity, dissolution and breach
of contract, unpredictable events and force majeure,
damages, debt/interest although the payment of
interest is not ruled out in Iraqi law usury is forbidden);
b) Companies Law (registration, domestic companies,
foreign companies, branches of foreign companies);
c) Agencies; d ) Trade Laws (exporting, importing,
standards, private property rights, intellectual property
rights, patents, copyright). It appears that there
may not be any Iraqi laws concerning competition
or anti-trust.
The Iraqi court system is divided into the civil
courts, courts of personal status and the criminal courts.
Each of these three court systems falls into a hierarchy
of courts of first instance, courts of appeal and
courts of cassation. The full bench of the Court of
Cassation is the highest judicial authority in the land.
Any person, whether Iraqi or foreign, may bring suit in
Iraqi and may hire an Iraqi lawyer. Even though Iraq is
not a party to the New York Convention on the
Recognition and Enforcement of Foreign Arbitral
Awards, it permits access to other foreign dispute
resolution mechanisms. However, there appear to be
severe legal limitations to this.
12.12.9 The Iraqi legal framework
of the petroleum sector
As far as petroleum operations are concerned, the first
Iraqi statute law to directly affect the petroleum sector
was Law 1961 No. 80. The original Iraq Concession
Agreement of 1925 was given the force of law by the
Iraqi legislature of the day without the benefit of
specific petroleum legislation. The new law of 1961
deprived the Iraq Petroleum Company and its affiliates
of all of their acreage not subject to production
operations. Law 1961 No. 80 is only two pages long,
and its title, Defining the Areas of Exploitation of Oil
Companies in the Iraqi Republic, conceals its legal and
historical significance. After the enactment of the cited
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law no further concessions of the old type were
awarded in the Arab lands although very lengthy
petroleum grants covering very large areas were still
made in some European countries.
Wälde discusses in some detail the question of the
remaining rights, if any, of the original shareholders in
the IPC consortium (Wälde, 2003). International law
and resolutions of the General Assembly of the United
Nations passed in the 1960s recognize the rights of
states to nationalize foreign and domestic enterprises
against the payment of just compensation. Walde has
examined any residual IOC rights under the heading of
Old Title (sic) and whether or not compensation for
deprivation of assets was properly paid. However, he
finds that this issue is probably only of historical
importance.
In 1964, the enactment of Law 1964 No. 11 caused
the establishment of the INOC, whose statutes of
incorporation were amended by Law 1965 No. 88. In
that same year the government took steps to improve
its control of the gas resources of the country by Law
1965 No. 74. In 1967 the INOC was permitted to
operate in most of the Iraqi national territory including
its territorial waters and also in the Iraqi share of the
then Saudi-Iraqi neutral zone. The exclusive
operations of the INOC, which began in 1968,
presumably excluded the acreage in the charge of the
state-owned Khanaqin and Rafidain Oil Companies
which operate to this day. Law 1970 No. 229,
Preservation of Oil Wealth and Natural Hydrocarbons,
brought into effect a number of detailed regulations for
the conduct of E & P operations within the national
territory. This law was signed by one Ahmad Hassan
Al Bakr, who some will recognize as predecessor in
presidential office to his cousin Saddam Hussein. The
areas of competence of the INOC was modified yet
again by Law 1971 No. 83.
By the early 1970s, the political climate in the
lands of the Arabian Gulf had shifted decisively in the
direction of state control of their domestic oil
industries. On 1 June 1972 the operations of the IPC
were nationalized completely by the enactment of Law
1972 No. 69 and art. 2 established the Iraqi Company
for Oil Operations (ICOO), and vested the Iraqi
operations of the former IPC into the ICOO, not the
INOC. Art. 3 of Law 1972 No. 69 addressed the
question of compensation for the assets of the IPC.
Money restitution was payable to the shareholders of
the company less any taxes, fees, wages and other
sums which must have given rise to some
opportunities for differing interpretations of the
language.
In 1968 the Iraqi Republic adopted a provisional
constitution which was subsequently modified by
presidential decree. The head of state was to be an
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executive president who was also prime minister
whilst there were two vice presidents. A parallel body
was the Revolutionary Command Council (RCC), an
executive and policy group common to many of the
more radical Arab regimes. Subordinate to the
presidency and to the RCC was the council
of ministers in which were found three deputy prime
ministers and a suite of ministries one of which was
the Ministry of Oil. However, in 1987 the Ministry of
Oil and the INOC were merged and it became unclear
whether or not the Ministry and its nominally
subordinate state oil company, INOC, ever had an
existence independent from each other. Also the extent
to which the Ministry was able to exercise any
regulatory supervision over the INOC or to operate a
separate licensing regime for the grant of petroleum E
& P rights is quite unclear. Therefore it seems more
than likely that, for the present, the technical experts
of the Ministry and of the INOC will exercise the
functions of: a) establishing and implementing Iraq’s
upstream to downstream petroleum policy; b)
operating an E & P company; c) regulating to an
extent upstream, midstream and downstream
operations in the country; d ) negotiating E & P
agreements with the IOCs.
At this time, the INOC operated for its own
account or in cooperation with the IOCs in legal
associations, which took the form of service contracts.
The latter gained the status of contractor to the INOC.
Later on the INOC was able to assume in toto the
functions of the ICOO. By the 1990s the company was
a fully integrated E & P company but it did not appear
as a holding company. Associated with the INOC were
a number of other upstream, midstream and
downstream companies, all state-owned but apparently
under a separate reporting line: a) Iraq Drilling
Company; b) Iraq Oil Tankers Company; c) The
National Company for the Distribution of Oil Products
and Gas; d ) National Company for Oil and Gas
Exploration; e) Northern Petroleum Company,
which was carrying out petroleum operations in
northern Iraq; f ) Southern Petroleum Company,
which was carrying out petroleum operations for
southern Iraq.
In addition, there are the Rafidain and Khanaqin
Oil Companies as well as several other bodies: the
State Enterprises for Oil and Gas Industrialization in
the South, the State Enterprise for Petrochemical
Industries, the State Establishment for Oil Refining in
the Central Area, the State Establishment for Oil
Refining in the North and also the State Enterprise for
Pipelines. The ongoing status of these bodies at this
time is not known although recent English press
reports suggest that many of them are still in existence
and working at their difficult tasks.10
806
12.12.10 Modern Iraqi draft
petroleum agreements
and contracts
Following is a review of two modern Iraqi draft
petroleum agreements which date from 1998 and
2001, from just before the fall of the Saddam regime.
There is little or nothing contained within them that
will not be familiar to students of modern international
contractual practice. They take the form in the first
case of a full cycle E & P Contractor Agreement
(production sharing) and in the second case of a
Contractor Agreement (production sharing) intended
to be used when the foreign IOC-contractor was
involved in the exploitation of an existing field.
Although, of course, no longer legally providing any
sort of model for the petroleum operations of the
future, it seems more than likely that these two drafts
could provide some guidelines for the broad structure
of future contracts. Also provided is some information
about a full cycle E & P agreement whose terms and
conditions are discussed in the annual report of the
Irish independent oil company, Petrel Resources.
The parties to the 1998 and 2001 contracts are
the same. On the one hand is the Ministry of Oil, not
the INOC, representing the Iraqi state, and on the
other the IOC or partnership of IOCs as contractor,
but the definitions of the latter are slightly different.
Neither contract has the accounting principles
attached nor the text of any draft bank or parent
company guarantee. It is unclear to what extent the
individual clauses of either contract were considered
to be negotiable.
It is worth pausing and pointing out that in the
Arabian Gulf at the present time there are three
countries that are in active negotiations with the IOCs:
these are Iran, Saudi Arabia and Kuwait, while Iraq
appears set to follow suit. Despite the signature on a
number of petroleum agreements in the two former
countries, it appears that in no case has an IOC yet
been able to gain title to reserves of oil or gas.11 As yet
the Iraqi model contracts appear to place no limits on
the ability of the IOC to take delivery of crude or to
acquire the title to it. Nevertheless, the rulings of the
Ministry of Oil in 1990 (see above) appear to
contradict these words. This question is obviously in
10 Will they remain as they are for some time or will
they be disbanded and reconstituted in some other form?
11 This important lacuna is directly contrary to the legal
position of reserves in oil and gas in the old concession
agreements and in the more modern Contractor Agreements
(production sharing) as in Indonesia, Egypt, Angola and
other countries. In the latter the IOCs have been able to book
reserves.
ENCYCLOPAEDIA OF HYDROCARBONS

need of further legal clarification by the competent
Iraqi authorities.
The first Iraqi petroleum agreement that will be
discussed is a model Production Sharing Contract
(PSC), for exploration and development in the western
desert, dated April 1998. Only the contractual points
worthy of special comment will be referred to. The
first of the usual recitals declares, “The Republic of
Iraq is the sole owner of all natural resources within its
territory and offshore areas and has the exclusive right
to explore, develop, extract, exploit and utilise
the natural resources therefrom”, and the second, “The
Ministry of Oil is the Governmental (capitalized in
the original) body concerned with exploration,
development and production of petroleum etc”.
Art. 1 defines the delivery point at which the
contractor’s entitlement to crude is delivered. Art. 2
provides for joint and several liability of the entities
constituting the contractor. Whilst art. 3 permits an
exploration period of five years, three plus two with a
possible two year extension. Art. 5 stipulates that after
the first phase, a relinquishment of 60% is due. After
the approval of the development plan, the contractor is
permitted to enter a three-year development period
after which production must commence, but the
production period is negotiable; art. 4 provides for the
payment of a negotiable signature bonus, a discovery
bonus and a production bonus. Art. 6 discusses the
negotiable work programme. Art. 8 provides the usual
reasons for termination, namely: failure to carry out
the work programme, material false statements,
qualified bankruptcy etc. but permits a period to
remedy defaults.
Art. 9 refers to Law 1985 No. 84 in respect to the
conduct of petroleum operations and also enjoins good
oilfield practice. This law has the effect of a set of
petroleum regulations rather than a true piece of legal
enactment. Art. 9 makes reference to “the general
supervision and control” of a Joint Management
Committee (JMC), referred to also in art. 13. After the
contractor has recovered a negotiable percentage of his
costs, art. 9.10 obliges him to establish, together with
an Iraqi entity, a joint operating company. A copy of
the charter for such a company is supposed to be
attached to the contract.
Art. 10.1 is a gas clause which provides that the
associated and non-associated gas are the property of
the government subject to subsequent articles. Flaring
is not permitted except in compliance with Law 1985
No. 84. However, the contractor is entitled to seek to
commercialize a non-associated gas discovery but this
right lapses after two years. The contractor then has
four years to develop such a commercial gas field. Art.
10.20 enjoins the establishment of a Natural Gas
Production Sharing Agreement (NGPSA), but which is
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IRAQ
not defined. Art. 17 states, “title to export oil,
delivered to contractor, shall pass to contractor at the
delivery point”, whilst art. 18 makes provision for the
pricing of crude according to international prices, less
certain deductions for transport etc.
Art. 19 concerns cost recovery and profit sharing.
The amounts of cost oil and the amount of profit oil
accruing to the contractor are negotiable. A
mechanism for the pricing of gas is provided in art.
19.5 subpara. (i) although this is subject to mutual
agreement. Art. 21 permits the contractor to retain the
proceeds of sale of crude oil or gas offshore. Art. 23
provides for tax-exempt status for the contractor as
well as for non-Iraqi sub-contractors. Duty-free import
status is also permitted.
Art. 27 obliges the contractor to enter into a JOA
such that an unnamed Iraqi entity gains a 25%
participating interest in the contractor and becomes
one of the commercial bodies actually comprising the
contractor. The mechanism for funding the Iraqi
entity’s share of costs appears to take into account the
value of assets already existing in the contract area.
Art. 39 permits international arbitration of disputes in
Geneva in English according to the rules of the ICC.
The second agreement of 2001 is entitled “Iraq,
Model Production-Sharing Contract”. On the first
page the parties are defined as the Ministry of Oil, the
IOC-contractor and the Iraqi entity, which becomes
part of the contractor. Art. 2 states that the contract is a
production contract and art. 9 defines the scope of the
operations within the contract area which seem to be
limited to production operations. It does not appear as
if pure exploration rights are ruled out within the
contract area (new pool wildcat) and the contractor is
obliged to “appraise the field”. Unless otherwise
stated the two contracts appear to be almost identical
although article numbers and detailed wording may
change.
Art. 18 concerns cost recovery and production
sharing. The cost oil percentage is negotiable and the
remaining crude oil (which is not specifically
designated as profit oil) is also shared according to a
negotiable formula. Art. 23 assures tax-exempt status
for the contractor and his non-Iraqi sub-contractors.
However, this agreement is materially different from
the one previous, in that recourse to international
arbitration is not provided. Only arbitration in
Baghdad is allowed and the language of arbitration is
to be Arabic.
At present, one company appears to be ready to
proceed with a full cycle E & P project in Iraq. Petrel
Resources is an Irish independent that entered into
discussions with Iraqi officials pre-war for E & P
acreage in the virtually unexplored western desert;
they have also begun discussions about rights in
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discovered oilfields (Aldrick, 2004). The Petrel annual
report provides much up-to-date technical, legal and
fiscal information on the latest type of Iraqi petroleum
agreements (Teeling, 2004). In March 2002 Petrel
concluded a contractor agreement with the oil
exploration company of the Iraqi Ministry of Oil for
full cycle petroleum E & P in contract area (block) six
of the Iraqi western desert. The Petrel block is located
about one hundred kilometres south-east of the Akkas
gas discovery. The Petrel report mentions another
state-owned oil company, the State Company for Oil
Projects, but it seems that the structure of the Iraqi
government oil sector is unclear.
The Petrel report confirms that IOCs should not
expect to gain title to reserves of oil or gas but
explains that costs are recovered from cost oil. After
cost recovery the remaining oil is designated profit oil
and is presumably split between the contractor and the
Iraqi government entity according to a pre-arranged
formula. No details are available in the Petrel report of
any signature bonus, work programme or dollar
commitment. However, the Petrel contract envisages a
Rate Of Return (ROR) of about 20%. In certain
circumstances however there is a bonus arrangement
which may permit the IOC to achieve a ROR of 40%
with some form of access to crude oil.
12.12.11 Arbitration in Iraqi law
Prior to 1956 the Iraqi concepts of arbitration followed
the rulings given in the Ottoman Medjella, which in
turn, derived from the Hanafi school of the Islamic
law. Perhaps it is worthwhile to pause for a moment
and examine the thinking that lies behind the Moslem
concept of arbitration. The words of the Quran provide
two interpretations of the status of arbitration and both
of these are to be found within Sura 4, an-Nisa: the
Women. The first of these, verse 35, relates to
arbitration in the event of a dispute between a husband
and wife and prefers to liken the process to one of
conciliation, close to our ideas about amiable
composition. The second Quranic verse in the same
Sura, verse 58, lays the ground-work for a legal
process which may be likened more to a judicial
resolution. However, El-Ahdab cautions us against
applying European ways of thinking to the Moslem
concepts of arbitration. He points out that there are
differences in thinking even within the various Islamic
madhab, the schools of Islamic law, and is clearly
advising others to seek counsel’s opinion from the
learned ulama themselves.
Iraqi Law 1956 No. 88 repealed the provisions of
the Medjella and in 1956 the new civil code laid
down special provisions concerning arbitration.
808
However, these were later judged to be ambiguous
and were redrafted in Law 1969 No. 83. The first
article of the new Iraqi civil code declares that, in
the absence of a particular ruling, the jurist should
look to Iraqi customary, that is to say tribal law, for a
resolution and that failing that, the Sharia should be
the guide. However, there is no compulsion to follow
any particular school of the Sharia thus
accommodating the different religious traditions in
the country. Art. 15 provides that contracts must be
performed according to their content and in a
manner complying with the requirements of good
faith. The arbitration provisions of Law No. 83 are
given in arts. 251 through 276.
El-Ahdab declares that in Iraq there are two kinds
of arbitration: optional arbitration which may be
likened to our amiable composition or to an arbitration
proper, national or international; and compulsory
arbitration.
Without going into detail about the two different
kinds of arbitration in Iraq, El-Ahdab raises some
issues which must give rise to serious concerns in the
mind of any foreign investor. Whilst not ruling out a
foreign corporation in Iraq having recourse to
international arbitration, El-Ahdab believes that such
an act might be construed as hostile and moreover
contrary to public policy. Art. 32 of the Iraqi civil code
says, “one cannot apply the provisions of a foreign
law […] if these provisions are contrary to public
order or Iraqi good morals” which might possibly be
interpreted to be a hold-out of Iraqi Socialist law.
However, art. 69 of the same civil code contradicts
this rule by providing that disputes should be
submitted to arbitration without insisting on either the
domestic or international forms. Moreover, another
authority quoted by El-Ahdab declares that as there is
no express prohibition contrary to arbitration there is
no reason why an arbitration might not be held outside
Iraq, provided that such arbitration was not contrary to
public order or morals. The reader is now referred to
El-Ahdab’s lengthy twenty-four page exposition of the
matter of arbitration within and without the Iraqi
jurisdiction since the matter now takes on an
increasing level of legal complexity.
One development of great interest and which is
covered in some detail in El-Ahdab’s excellent work is
the creation of the Arab Centre for Commercial
Arbitration in Rabat in the 1980s. A group of Arab
jurists observed the volume of judicial arbitration
generated by commerce in the Arab lands and that had
been settled under the auspices of this or that
non-Arab arbitral forum and wondered why there was
not a corresponding Arab venue for the resolution of
investment disputes. Accordingly, the Council of Arab
Ministers of Justice agreed to create a permanent
ENCYCLOPAEDIA OF HYDROCARBONS

organization for commercial arbitration and on 14
April 1987 the final text of the Arab Convention on
International Arbitration was signed in Amman by
twelve Arab countries: Jordan, Tunisia, Algeria,
Djibouti, Sudan, Syria, Iraq, Lebanon, Libya,
Morocco, Mauretania and Yemen. The Convention
applies to commercial disputes between natural or
legal persons of any nationality bound by a
commercial transaction with one of the member
countries or one of the persons of such a country or
which has its main place of business in one of those
countries.
Another inter-Arab legal convention is the Riyadh
Arab Convention on Judicial Cooperation. This legal
instrument, signed on 6 April 1983 by twenty Arab
states, including Iraq, attempted to impose unity of
judicial process amongst the Arab states and also
contained a mechanism for the enforcement of
judgements and arbitral awards. However, Denman
and Hounsel, 2004, point out that Iraq is not a party to
the 1958 New York Convention on the Recognition
and Enforcement of Foreign Arbitral Awards. This
means that it could be difficult to enforce an arbitral
award against the Iraqi government; however future
Bilateral Investment Treaties (BITs) could provide for
mutual recognition of rights.
12.12.12 The legal status of the
petroleum transactions
negotiated
by the Saddam regime
Before the invasion of Iraq took place in March, 2003,
Prof. Thomas Wälde of the Centre for Energy,
Petroleum, Mineral Law and Policy at the University
of Dundee in Scotland had already speculated on the
likely outcome of regime change in that country
(Wälde, 2003). First of all, he examined the
implications of a change in government on the oil
sector and then turned his attention to the legal status
of the previous agreements in the petroleum sector that
had been entered into in the country. These are of two
types: the old title of the former concessionaire, IPC,
and the transactions of various kinds that several
newcomers (mainly Russian companies but also
French and Chinese) had entered into since the 1990s
with the Saddam regime.
Walde agrees that the arrangements negotiated by
the newcomers, although not implemented due to UN
sanctions, have some implications for today’s world.
He points out that human rights obligations and
notions of good governance play a greater role in
limiting the sovereignty of governments than they did
a century ago. Breach of peremptory international law
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IRAQ
principles (permanent sovereignty over mineral
resources, respect for key human rights principles) can
be invoked to limit the power of government (to enter
into binding legal agreements).
On 22 May 2003 the United Nations passed
Security Council Resolution 2003 No. 1483 which
lifted economic sanctions on Iraq and accepted the
Coalition Provisional Authority (CPA) as the de jure
authority in Iraq (Kirgis, 2003). The rights, duties,
obligations and liabilities of the occupying forces
under the laws of war have been clearly established
over many centuries of the development of
international law (Paust, 2003).The authority of the
CPA was then extended to the Iraqi Interim
Government, which took office at the end of June
2004, and its successors, to be mandated by elections
which should have taken place on 30 January 2005.
The American lawyers Derman and Hounsel
examined the issue of the petroleum transactions
entered into by the former regime and now the
lawyers wonder whether the ‘contracts’ between
foreign companies and the old regime will be
honoured (Derman and Hounsel, 2004). First of all,
these two authors point out that an otherwise valid
contract is not invalidated by a change of regime, no
matter how unpleasant it was: pacta sunt servanda.
As precedent they cite the legal survival of the
contracts entered into by a dictatorial regime in Costa
Rica, the Tinoco Granados adjudication, even after
the regime had been overthrown. Certainly in the
thirty years or more of its existence there was never
any doubt of the legitimacy of the Saddam regime.
Derman and Hounsel argue that once the Iraqi
Ministry of Oil signed a deal, it became legally
binding after its ratification by the Revolutionary
Command Council. Another legal authority, Mr. Peter
H.F. Bekker, points out that any property interests,
including in the form of contracts, that foreign parties
once negotiated with Iraq, should not be affected
merely by the ouster of Saddam and a change in
government (Bekker, 2003). Of course, this somewhat
begs the question of whether or not the rights enjoyed
by the oil companies include property. UN Resolution
2003 No. 1483, which recognized the status of the
foreign occupation of the country, did not declare null
and void any contracts previously entered into.
The political and security uncertainties of Iraq
appear to have imposed a profound sense of
‘wait-and-see’ on most foreign investors. A
spokeswoman for Total declared that any participation
in Iraq by the company is likely to be at least five
years away (Batt, 2003). M. Thierry Desmarest, the
Chairman of the company has called for the rules of
transparency to be at work in Iraq as in any other
country of the world. This may be a plea for a formal
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bidding system to be instituted for the grant of
petroleum rights. In September 2004 the Interim Prime
Minister Iyad Allawi, in London for talks with Tony
Blair, appealed for Russian and French economic and
diplomatic support in the reconstruction of his
country.
There are other complications at work as well. In
1998 the Kurdish administration declared that of their
autonomous areas in the north of Iraq the Northern
Iraqi Federative Administration (NIFA) owned the oil
within their territory. According to Derman and
Hounsel the Sulaymaniyah Regional Governorate, a
sub-federal dependency of the NIFA, then went on to
execute a Contractor Agreement (production sharing)
with a Turkish private company (for details of further
petroleum agreements in Kurdistan see Bunter, 2005).
12.12.13 Future developments
We cannot tell how events will turn out much beyond
the return of constitutional authority to the Iraqi
people on 30 June 2004 and the elections which took
place in January 2005. After the latter there has been a
vigorous process of political negotiation leading to the
formation of a transitional government and then a
process of constitutional consultation. This will be
followed by the presentation to the Iraqi people of a
draft constitution and its ratification or rejection by
them (see below). We cannot be sure what form such a
future constitution might take, although, it seems as if
the Kurds will be satisfied by nothing less than federal
status for their lands and the Shia may also be equally
insistent upon some form of autonomy for their
southern area (Howard, 2004). Most Kurds seem to
have voted for a legislature which is to be part of a
united democratic federative Iraq (Loyd, 2005a,
2005b). How this will affect petroleum rights or the
operations of the devolved state oil companies is quite
unclear although there are already some developments
which suggest that degrees of local autonomy are
already being asserted in this respect.
To be sure, the law of unforeseen consequences is
in effect in Iraq and as Trotsky was to put it, “war is
the locomotive of history” (Kochan, 1962). It is clear
that certain political and difficult tasks will need to be
carried out by the Iraqi people so that personal
development and economic progress can be made,
including: a) the construction of a legitimate and
democratic government with defined levels of central
and devolved government and representation for all
faiths and peoples; b) the rapid establishment of the
constitutional convention to decide upon the future
structure of the Iraqi state and its legal basis: unitary
republic, kingdom, or a federal or confederal polity; c)
810
the division, if any, of the oil and mineral ownership
and revenues amongst the constituent parts of the new
Iraqi state; d ) a resolution of the claims of the various
Russian, French, Indian, Chinese oil companies and
others in respect of undertakings entered into by the
previous (Saddam) Iraqi government; e) the status of a
future Ministry of Oil (still working despite bomb
attacks) and of the Iraqi National Oil Company and its
sister companies, the functions of which some could
be divided amongst the various sub-federal
jurisdictions; f ) the status of the Islamic law and of
the various confessional groups in the country, the
Moslems (Sunni and Shia), the Christians and the
other faiths; g) the role that foreign enterprise will
come to play in the development of the national
economy including the oil sector: upstream, midstream
and downstream.
According to the «New York Times», on 12
September 2003 officials from Pertamina, the
Indonesian state oil company, had visited Baghdad as
early as August of that year and had already been in
contact with Iraqi management. They received
approval from Iraqi officials to begin exploration and
development work in an oilfield south of Baghdad that
they had originally contracted in April 2002. Other
companies, some with connections to pre-war
transactions, have been in discussion with Iraqi
officials since that time.
What does the future hold for petroleum
agreements in Iraq? It will be very difficult for the
Iraqis to get too far out of line with the contractual
arrangement entered into with their powerful
neighbours Saudi Arabia, Kuwait and Iran and so a
form of Iranian Buy-Back Agreement will probably be
rather attractive to the Iraqis. This means that the IOCs
will not be able to gain title to reserves. But this is not
an insuperable barrier to investment. Lord Browne, the
Chief Executive of BP recently declared, “we [the
IOCs] have migrated from direct ownership [of
resources in the ground in the old concessions],
[from] taxes and royalties [in the newer concessions]
to Production Sharing Contracts [contractor
agreements] and there is bound to be further migration.”
On being questioned as to whether the concept of
‘booking reserves’ was outmoded, Lord Browne
replied: “I think that it has a role but it is not
necessarily the exclusive role. After all, we do not
book reserves in our retail business, or in our refinery
business. They are very valid businesses, they make
good rates of return and there can be businesses of all
sorts in a portfolio like BP’s” (Report [...], 2004).
It has been suggested that, at least in the oil-rich
nations of the Arabian Gulf, the traditional Contractor
Agreements and the concessions may have had their
day (Bunter, 2005). It seems that if the host
ENCYCLOPAEDIA OF HYDROCARBONS

governments are prepared to grant E & P rights to the
IOCs, and in Kuwait this event seems quite far off,
then these will be in the form of Service Agreements.
In March 2004, Adnan Al-Janabi published a
useful review of future oil policy options for Iraq. First
of all, he points out that the country is amongst the
low-cost producers of the world, if not the lowest-cost
producer of all. His opinion is that increasing Iraq’s
daily production by one million barrels from existing
oil fields will require a capital expenditure of not more
than $2.5 billion. This is a relatively modest sum given
the huge capital requirements of today’s oil industry,
even while taking into account the pipeline sabotage
and violence plaguing the country (Al-Janabi, 2004).
In April 2004, Dr. Farouk Al-Kasim gave his views
on Iraq’s future upstream petroleum policy in an
article in the Middle East Economic Survey (Al-Kasim,
2004). For eleven years Dr. Kasim worked for the Iraqi
South Oil Company and later on assumed high
positions in the Norwegian oil industry, and so his
opinions can be considered authoritative. Al-Kasim
believes that it would have been preferable to enact a
permanent (new) constitution for Iraq with a
petroleum law and regulations before entering
negotiations for major contracts. However, he should
have realized that contractual security does not depend
wholly on the existence of this kind of legislation,
although, it would be much improved by it. At the time
of the fall of the Soviet Union in October 1991, the
petroleum-rich republics of the Soviet Empire were
faced with the same dilemma: how to provide
contractual security to the numerous oil companies
seeking deals in the absence of up-to-date petroleum
legislation? The solution was relatively simple: to
provide the petroleum contracts with the force of law
by permitting ratification by the legislature.
Dr. Al-Kasim goes on to review other aspects of
Iraq’s petroleum policy and advocates a system where
state enterprises will compete and co-operate with
private domestic and foreign companies in the E & P
sector. This is to introduce much-needed efficiencies.
However, he also recommends a ‘differentiated
approach’ to investment. For low-risk petroleum
projects he suggests state companies taking the lead
role. For high-risk projects, full cycle E & P contracts,
Dr. Al-Kasim believes that the IOCs should assume
most or all of the operations, and for medium-risk
projects he recommends a mixture of both. There is a
danger that the IOCs will regard such an approach as
inherently discriminatory. Dr. Al-Kasim also advocates
licensing rounds, which would be organized by an
independent licensing agency, to allocate upstream E
& P licences. However, he does not recognize the
federal dimension that may have irrevocably entered
Iraqi politics and which would make the creation of a
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IRAQ
centralized petroleum licensing agency quite
impractical. A degree of devolution to sub-federal
institutions in petroleum licensing seems inevitable.
So far as petroleum contracts are concerned, press
reports indicate that the following transactions have
recently taken place: BP and Shell have been awarded
consultancy agreements with the Iraqi Ministry of Oil
in connection with technical support for the
redevelopment of the Rumaila and Kirkuk fields
(Klinger, 2005); a Canadian company Group (Oil and
Gas International, OGI), believes that it has won a
tender to develop the Himrin Field (Oweis, 2004b); a
Turkish-British-Iraqi group appears to have won a
contract to redevelop Khurmala Dome (Francis, 2005).
Of course the ratification of these agreements will
be needed after any change of government following
the January 2005 elections.
12.12.14 The elections
of 30 January 2005
Certainly the behaviour displayed by the various
occupying forces could not have done more to turn
Iraqis against ‘the West’. Recently, news has emerged
that foreign troops may have seriously damaged one of
the world’s most precious archaeological sites, the
Babylon of Nebuchadnezzar, even though Saddam in
his day made efforts at its restoration and preservation
(Treasures […], 2005). Only time will tell whether or
not these actions and the terrible loss of priceless
human life will have prejudiced the entire Iraqi people
against foreign involvement in the oil sector. Even the
CIA has admitted that the world has now become a
more dangerous place since the invasion of 2003
(Reid, 2005). Some prominent Iraqi authorities such as
Gailan Ramiz, who was killed since the liberation,
have declared that the long night of Saddam had
“demonized the Iraqi soul”. It would be wrong to
anticipate stereotypical behaviour of this kind
(Hilsum, 2004).
At any rate, and despite much violence and
murder, the elections for the 275-seat Iraqi
Transitional National Assembly, TNA, took place
successfully on 30 January 2005. Actually, there were
three separate elections taking place at the same time
using a system of proportional representation. The
most important was for the National Assembly, but at
the same time voters were asked to select members of
municipal councils. In Kurdistan the voters were also
asked to select members of the Kurdish regional
assembly. The turn out was 58% of the registered
electorate. More than 8,000 candidates stood on more
than 400 lists of candidates which were sponsored by
111 separate political parties. The ballot papers
811
NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
recognized the following major political groupings
with the following results, seats won, in rough order:12
• The United Iraqi Alliance: 140 seats won; the most
powerful Shia grouping led by Abdul Aziz Al
Hakim with VicePresidents Ibrahim Ja’afari and
Ahmed Chalabi. This affiliation of parties now has
a slender majority in Parliament but will need to
form alliances with other groups to push its
policies and its preferred candidates forward. The
leadership is drawn from the Supreme Council for
the Islamic Revolution in Iraq (SCIRI) and also
another but rival Islamic grouping, Dawa. The
alliance had 225 candidates mainly from southern
and central Iraq, representing 111 parties, all of
whom take their lead from the politico-religious
leadership of the Grand Ayatollah Ali Al Sistani,
the Shia marja. This group is actually an informal
alliance of southern Shia moderates and is in
favour of an early American withdrawal from their
country.
• Kurdistan Alliance: 75 seats won out of 165
candidates, leader Jalal Talabani of the
Patriotic Union of Kurdistan, promotes
autonomy for Kurdistan and insists that Mosul
is a Kurdish city. This group also includes
supporters of Masoud Barzani of the Kurdistan
Democratic Party.
• The Iraqi List: 40 seats won out of 258 candidates,
a Shia group but more secular in orientation than
the United Iraqi Alliance and supporting the group
surrounding Interim Prime Minister Dr. Iyad
Allawi.
• Iraqis Party: 5 seats won out of 80 candidates,
supports the Sunni minority and the former Interim
President Ghazi Al Yawer.
• Alliance of Independent Democrats: 1 seat won out
of 78 candidates, leader Adnan Pachachi, former
foreign minister prior to seizure of power by
Saddam, mainly Sunni and exile-based, secular and
liberal.
• National Democratic Party: 48 candidates, also
mainly Sunni, secular and liberal.
• Mashaan Al Jebouri Liberation and Unification
Gathering: 37 candidates, Sunni.
• National Democratic Alliance: secular and liberal.
• Independent Nationalist Cadres and Elites: 3 seats
won, a Shia grouping owing allegiance to the
radical minor cleric Hojatolislam Moqtadr Al Sadr,
has supporters in slums of Baghdad.
• Iraqi Turkmen Front: 3 seats won, representing one
of Iraq’s smaller ethnically-based interests.
• People’s Union: 2 seats won out of 275 candidates,
a communist-led grouping that represents a
political tendency formerly of great importance in
the Middle East.
812
• Kurdistan Islamic Group: 2 seats won, a part of the
Kurdish Alliance.
• Islamic Labour Movement: 2 seats won, a Sunni
grouping.
• National Rafidain List: 1 seats won, representing
Assyrian Christians.
• National Reconciliation: 1 seat won, a Sunni
group;
• Iraqi Republican Alliance: anti-American and
Sunni Arab nationalist in orientation, well-funded,
in favour of a unified Iraqi state.
• Constitutional Monarchy: headed by a scion of
Hashemite family, Sharif Ali bin Hussein, London-
based merchant banker and cousin of the late king.
• Iraqi Hashemite Alliance: also a constitutional
monarchical grouping.
• Movement of Free Officers and Civilians:
Nasserite and associated with ideas of Abdul
Karim Qasem, first president of post-monarchical
Iraq.
• Other religious and ethnic minority groupings.
The ending of the initial elections in January 2005
by no means concluded the political process.
On 15 February 2005 the TNA met to select a
president, the Kurdish Mr. Jalal Talabani, and two
vice-presidents who now form a three-man presiding
council. Within fifteen days the latter selected an
executive Prime Minister, the Shia Mr. Ibrahim al-
Jaafari, by a two-thirds majority. The presiding council
and the PM will now have to select a cabinet of
ministers also by a two-thirds majority but this is now
experiencing some delays (AFP, 2005).
The TNA will then appoint a committee to begin
the work of drafting a new constitution for Iraq. By 15
August 2005 the TNA will finish the draft which will
then be submitted to popular referendum on 15
October. If three provinces out of eighteen reject the
draft then the constitution will fail.
On 15 December 2005 there will be elections for a
new government under the new constitution.
Already the hard political debate has started. The
Kurds have insisted that the Kirkuk oilfield, the first
to be discovered in Iraq and the country’s largest, should
be used to provide a special income for Kurdistan.
By 31 December 2005 a new Iraqi government
will be in power but this will be only the beginning of
a long process of political reconciliation between all
parties. Major issues will include the status of the
petroleum agreements entered into with the former
regime and the extent of the application of the Sharia
law in the petroleum sector. Finally, the
implementation of any new and federal legal
12 As reported by «The Times» (Farrell, 2005).
ENCYCLOPAEDIA OF HYDROCARBONS

arrangements, if any, which could affect the status of
Iraq’s state oil companies will take much hard
bargaining. The disarmament of the citizenry must be
a high priority. Major upstream petroleum investment
seems a long way off as yet.
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Patel M. (2004) The legal status of coalition forces in Iraq
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Hilsum L. (2004) Obituary of Gailan Ramiz, «The Guardian»,
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Kirgis F.L. (2003) Security Council Resolution 1483 on the
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Klinger P. (2005) BP and Shell establish new toehold in Iraqi
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Michael A.G. Bunter
B and R Co. Petroleum Consultants
Conwy, North Wales, United Kindom
813
 12.13
Qatar
12.13.1 Introduction
Oil was discovered in Qatar in 1939, and since the
1950s, when commercial production started,
Qatar’s economy has been based primarily on oil
revenues. However, starting in the early 1990s,
Qatar began developing its extensive natural gas
reserves in the North Field. Today, the rapidly
expanding natural gas sector is leading the
country’s economic diversification efforts and is
reshaping the economy
Qatar conducts its principal oil operations through
the state-owned Qatar Petroleum (QP), which manages
Qatar’s oil, gas, fertilizer, petrochemicals and refining
enterprises in Qatar and abroad. According to QP,
Qatar’s oil reserves have substantially risen over the
past five years, from 3.7 billion barrels in 1999 to 14.5
billion barrels in September 2004.
Gas constitutes Qatar’s principal hydrocarbon
resource. Discovered in 1971, the North Field,
which extends over an area of approximately
6,000 km3 predominantly underlying the territorial
waters of the State of Qatar, is the largest
non-associated gas field in the world. It has
proven reserves currently estimated at over
9⫻1014 ft3, the equivalent of about 162 billion
barrels of oil. These reserves translate into 15.3%
of the world total and would be sufficient to
support the planned production of natural gas for
over 200 years. Associated gas reserves are
currently estimated at 15⫻1012 ft3.
Qatar’s rapid economic growth has enabled the
country to reach the top ranks of the wealthiest
countries in the world, through the measure of per
capita income. Qatar’s Gross Domestic Product (GDP)
per capita was estimated at 31,897 dollars in 2003 and
36,476 dollars in 2004. It is expected that the GDP per
capita will grow further in the coming years. The share
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
of the oil and gas sector in the overall GDP stood at
57% in 2002, 59% in 2003, and an estimated 62% in
2004, the increase being mainly due to the rise in oil
and gas prices and production.
12.13.2 Petroleum legislation
Despite the fact that petroleum activities represent the
backbone of the economy in Qatar, there is limited
legislation that directly relates to such activities.
Below is a brief survey of the main pieces of
legislation:
Decree Law No. 10/1974. Concerning the
establishment of Qatar Petroleum. Other than
establishing QP and regulating its management and
functioning, the decree entrusts certain rights to QP,
including the right to:
• Assume alone the exploration for oil, natural gas
and other hydrocarbon substances.
• Represent the state in negotiating and concluding
agreements concerning exploration for and
exploitation of hydrocarbon resources.
• Establish and incorporate special purpose
companies – alone or with others – to carry out
specific projects.
Decree Law No. 4/1977. Concerning the
preservation of petroleum wealth. The stipulations of
this decree apply to all types of petroleum operations
taking place in the territory of the state of Qatar. The
decree requires all operators to conduct their
petroleum operations prudently, using safe and
technically sound methods in keeping with
technological advancements in this field. In particular,
it requests that operators:
• Utilize the best reservoir management techniques.
• Take safety precautions to protect lives, assets and
the environment.
815
NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
• Use only tools and equipment that meet
international standards.
• Submit regular reports to the government regarding
the progress of their operations. The decree
prohibits operators from engaging in or carrying
out any petroleum operations without obtaining the
necessary approvals. Finally, the decree outlines
punishments which may be imposed on those
parties who violate its provisions.
Law No. 8/2004. Concerning the protection of oil
and gas offshore installations. This law is designed to
assure the safety of oil and gas offshore installations
by prohibiting floating means of transport from sailing
in close proximity to such fixed or movable
installations. The law levies heavy penalties, including
fines and imprisonment, on violators.
There is other legislation of general application
which is relevant to petroleum operations. Chief
among the provisions is Decree Law No. 30/2002 on
the issuance of the environment protection law and its
executive regulations.
In June 2005, the permanent Constitution of the
state of Qatar came into effect. Under the
Constitution, the state has sovereignty over its entire
territory. Art. 2 of the Constitution provides that the
state shall practise its sovereignty on its territory and
shall not give up its sovereignty on any part of its
territory. Art. 29 of the Constitution provides that
natural wealth and resources are the property of the
state and that the latter shall preserve these and
maintain their optimal utilization in accordance with
the provisions of the law.
12.13.3 Structure
of operating conditions
In relation to developing its oil and gas resources,
Qatar has, in many ways, been a regional trend-setter.
Its initiatives to engage foreign participation, which
started in the 1980s, have proven to be a huge success
for both the country and for its foreign partners to the
extent that many countries in the region have followed
suit, whilst others are still trying to learn from its
example.
In the absence of comprehensive legislation,
operating conditions relating to petroleum operations
are regulated by the individual contracts entered into
between the state, represented by QP, and the
operator(s). Although certain terms may vary from one
contract to another, depending on the prospects of the
delineated area and whether the state wishes to
participate or not, there are many prevalent features
found in most contracts. These will be discussed in the
following two sections.
816
Sole risk petroleum operations:
terms of arrangement between the state
and foreign partners
Where there is no government participation, the
arrangement between the state and its foreign
partner(s) takes the form of an Exploration and
Production Sharing Agreement (EPSA) where there
are no proven reserves, or a Development and
Production Sharing Agreement (DPSA) where there
are proven reserves to be exploited. A typical
EPSA/DPSA will contain the following terms.
Grant of rights: The contractor is given the
exclusive right to explore for, appraise, develop and
produce crude oil and non-associated gas from a
designated contract formation in a designated contract
area. This right includes the right to store, transport
and export for sale, or otherwise deal with or dispose
of, the crude oil and non-associated gas. Nevertheless,
the state reserves unto itself certain rights and
easements that will allow it to exercise its sovereign
powers.
Term: A typical term of an EPSA/DPSA is 25
years. Such a term may be extended for one or more
terms of 5 years each.
Exploration phase: Depending on the potential of
the contract area, the exploration phase is given for a
duration of 5-8 years, usually divided into two
exploration periods. The contract outlines the
minimum work commitments to be carried out by the
contractor during the exploration period(s). The
minimum work commitment includes: acquisition,
processing or reprocessing, and interpretation of
2D/3D seismic data; drilling of a number of
exploratory wells and conducting studies of the
various data acquired during such phases to assess the
hydrocarbon potential of the contract formation and
area. The contract also outlines the minimum
expenditure the contractor is expected to make during
each phase. If the exploration phase is divided into two
periods, the contractor will not be allowed to move to
the second period unless it has met its obligations
during the first period.
Appraisal and development: When a
discovery of crude oil or non-associated gas
occurs as a result of exploration activities, the
contractor will be required to submit, usually
within 6 months from the discovery, an appraisal
programme for approval, specifying the number
and location of appraisal wells. The government
has a period of time, usually not exceeding 6
months, to review and approve the proposed
appraisal programme. Upon completion
of the appraisal programme, the contractor has a
period of 6 months to declare whether the
discovery is commercial or not. In the event of a
ENCYCLOPAEDIA OF HYDROCARBONS

commercial discovery, the contractor will be
required to submit a development plan.
Relinquishment: The contractor is expected to
progressively relinquish the non-prospective/
non-producing areas. The first relinquishment if
any, takes place after the first exploration period,
and usually applies to no less than 20% of the
contract area. At the end of the second exploration
period, the contractor is expected to relinquish any
part of the contract area which has not been
designated as a producing, a development or an
appraisal area.
Cost recovery and production sharing: Petroleum
costs are defined as all costs and expenses incurred by
the contractor under the contract, but exclude certain
expenses such as taxes, rentals and bonuses paid, as
well as interest paid on financing. The contract sets
aside a certain percentage, normally 40%, of the net
crude oil or non-associated gas production for cost
recovery of petroleum costs incurred by the contractor.
In the event that the production is not sufficient for
cost recovery of petroleum costs in any given period,
the balance will be carried forward. If the production
set aside for cost recovery exceeds the petroleum
costs, the balance will be shared between the
government and the contractor, usually at a ratio of
90/10, respectively. The balance of the net crude oil or
non-associated gas production will be divided between
the government and the contractor on the basis of a
pre-determined sliding scale which takes the potential
of the area into consideration.
Annual work programme and budget: When the
contractor goes into the production phase, it is
required to prepare and submit, before the beginning
of each year, a work programme and budget for the
following year for review and approval.
Management committee: The contract would
state that the contractor must share its plans with the
government and ultimately obtain its approval
thereof. Therefore, a short while after the ratification
of the contract, the parties involved, i.e. the
government, represented by QP, and the contractor
are required to establish a management committee
comprised of an equal number of members for each
party in order to facilitate joint reviews and
approvals. The committee members have full power
and authority to represent and bind each party to the
contract on the matters reserved for its decisions.
Typically, matters reserved for the management
committee include reviewing and making decisions
with respect to: the annual work programme and
budget, including any revisions thereto; exploration,
appraisal and/or development plan and budget;
lifting procedure; and establishment of other
committees and their relevant procedures.
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
QATAR
Pricing: The price for the crude oil is generally set
at the market price, which refers to the maximum
weighted average price obtained on the market through
arm’s-length transactions during any given period.
Conduct of petroleum operations: The contract
outlines a few principles which the contractor is
expected to abide by, including:
• Conducing the petroleum operations in a diligent
and workmanlike manner and in accordance with
good petroleum industry practices, including those
concerning oil and gas field conservation.
• Compliance with local laws, rules and regulations.
• Procuring and maintaining insurance.
• Keeping the government fully informed as to the
progress and results of all related petroleum
operations and studies and preserve such data.
• Giving the government’s representatives access to
operations.
• Obtaining government approval in respect of any
plans to construct or locate any permanent or
temporary installations including pipelines,
platforms and other major installations inside or
outside the contract area.
• Producing crude oil and non-associated gas at the
maximum efficiency rate consistent with good
petroleum industry practices.
The contractor is required to conserve associated
gas to the maximum extent possible in the
circumstances and in the best possible manner.
Associated gas may only be flared to the extent that on
the one hand such flaring is consistent with good
petroleum industry practices, and on the other the
government’s prior written approval has been secured
by the contractor. If the associated gas is not used by
the contractor, it shall be delivered to and shall
become fully owned by the government at the point of
gas separation from oil.
Bonuses and rentals: Usually an EPSA or DPSA
provides for the contractor paying a signature bonus. A
contract also provides for the contractor paying to the
government production bonuses. The first such bonus
is paid upon the first export of production and
subsequent bonuses are paid upon reaching certain
production levels. The contract also provides for the
contractor paying certain rental amounts for the
contract area.
Taxes: At present, Qatar has only one form of
taxation, namely, tax on income realized by foreign
entities operating in Qatar. The contractor is subject to
the income tax law, including, but not limited to, the
requirements with respect to the filing of tax
declarations, the assessment of tax and the keeping of
records for review by authorised persons. Assets are
depreciated on a straight line basis over a period of 10
years. The income tax rate applicable to the contractor
817
NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
is 55%. However, the government usually assumes,
pays and discharges out of its share of the production
the income tax otherwise payable by the contractor.
The contractor is required to pay customs duties.
Title to assets: Usually, all title to and interest in
fixed and movable assets passes to the government on
the day on which the relevant cost thereof has been
recovered by the contractor. Nevertheless, the
contractor enjoys the full and exclusive use of such
assets for its petroleum operations for the duration of
the contract.
Accounting: The contractor is required to
maintain accurate accounts and records of all
petroleum operations and petroleum costs, which
shall be available to the government. The government
has the right to audit such accounting records at all
reasonable times. Accounting records are usually
maintained in United States dollars, which is the
currency of the contract.
Currency: The contract provides that the contractor
and its personnel have the rights to freely maintain and
operate bank accounts in any currency as well as to
freely retain and dispose of any funds therein,
including funds from the sale of the contractor’s share
of crude oil and gas; to freely import into and export
from the state any currencies; and to freely exchange
such currencies into other currencies, including into
and from the local currency.
Termination: Both parties in the contract retain the
right to terminate it for a specific reason and can do so
after a notice and cure period. Reasons for termination
by the government include failure of the contractor to
make payments or meet other obligations stated in the
contract. Usually, given the amount of investments
involved, such contracts do not permit termination for
convenience.
Governing law and dispute resolution: EPSA/DPSA
contracts are usually governed by Qatari law. Although
some contracts provide for dispute resolution before
Qatari courts, others provide for dispute resolution
through local or international arbitration.
Equilibrium: The contract provides that in the
event of the government enacting a new law or decree
which demonstrably has a material adverse effect on
the contractor’s fiscal position with respect to the
petroleum operations, the government will take steps
to restore the fiscal benefit contemplated to be enjoyed
by the parties in the contract.
12.13.4 Petroleum operations with
government participation
Qatar has taken an active interest in engaging foreign
participation in major capital-intensive projects,
818
particularly those relating to developing its natural gas
resources from the North Field. In this regard, QP has
developed major Liquefied Natural Gas (LNG)
projects with foreign shareholders for export in the
form of LNG. The two main projects are Qatargas
and RasGas, which are being expanded rapidly
through RasGas II, Qatargas II, RasGas III, and
Qatargas III to meet additional export opportunities. In
addition, Qatar is pursuing the first gas export pipeline
in the Gulf Cooperation Council (GCC), which will, it
is to be hopcd, pave the way for the creation of a GCC
gas grid originating in Qatar.
A typical project which is concerned with
developing a grass-roots LNG project requires a
matrix of contractual documentation between the
government, QP and the foreign participant(s). For the
purposes of this article, only two typical agreements
will be discussed in some detail, namely: the
development and fiscal agreement and the technical
services agreement.
Development and Fiscal Agreement (DFA)
Parties: the parties of the DFA are the government
represented by QP, QP as a participant and the foreign
participant(s).
Grant of rights: The government grants QP and the
foreign participant(s) the right to enter into a joint
venture and to establish in the State of Qatar a joint
stock company to produce certain quantities of LNG
for export. The government also grants the participants
an exclusive right to explore for, appraise, develop and
produce non-associated gas from a designated contract
formation in a designated contract area. This includes
the right to process, liquefy, store, transport and export
for sale, or otherwise deal with or dispose of, the
non-associated gas. Despite the aforementioned, the
state reserves unto itself certain rights and easements
that will allow it to exercise certain sovereign powers
inside the contract area. The grant specifically
prohibits the participants from exploiting other
materials discovered in the contract area. If it becomes
apparent that the non-associated gas reserves in the
contract area are insufficient to meet the project’s
requirements, consideration will be given to allocate
additional reserves.
Development obligations: The government also
grants to the participants the right to construct and
operate all facilities necessary for implementing the
project.
Term: Given the economics of the LNG industry,
agreements are typically concluded for durations of 20
years or more, with the possibility of renewal.
Conduct of petroleum operations: The DFA
outlines a few principles which the participants are
expected to abide by, including:
ENCYCLOPAEDIA OF HYDROCARBONS

• Conducting the petroleum operations in a diligent
and workmanlike manner and in accordance with
good petroleum industry practices, including those
concerning gas field conservation.
• Compling with local laws, rules and regulations.
• Procure and maintain insurance.
• Keeping the government fully informed as to the
progress and results of all petroleum operations
and studies related thereto and preserve such data.
• Giving the government’s representatives access to
operations.
• Obtaining government approval in respect of any
plans to construct or locate any permanent or
temporary installations including pipelines,
platforms and other major installations inside or
outside the contract area.
Royalty: The participants pay to the government a
royalty on each million British thermal unit (Btu) of
gas delivered to the inlet of the LNG Plant. The
participants also pay to the government a royalty on
condensate produced and sold by the project equal to a
certain percentage of the sale proceeds.
Taxes: The participants are subject to the income
tax law, including, but not limited to, the requirements
with respect to the filing of tax declarations, the
assessment of tax and the keeping of records for
review by authorized persons. Assets are depreciated
on a straight line basis over a period of 10 years.
However, the government will typically grant the
participants a tax holiday for a certain period of time
not exceeding 10 years.
Accounting: The participants are required to
maintain accurate accounts and records of all
petroleum operations and petroleum costs, which shall
be available to the government. The government has
the right to audit such accounting records at all
reasonable times. Accounting records are usually
maintained in United States dollars.
Currency: The participants, the project company
and their respective personnel are free to maintain and
operate bank accounts in any currency and to retain
and dispose of any funds therein; to import into and
export from the state any currencies; and to exchange
such currencies into other currencies, including into
and from the local currency.
Title to assets: The project company has title to all
assets.
Termination: The parties of the contract retain the
right to terminate it for specific reasons and can do so
after a notice and cure period. Reasons for termination
by the government include the failure of the project
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
QATAR
company to make payments or meet other obligations
under the contract. Usually, given the amount of
investments involved, the DFA does not permit
termination for convenience.
Governing law and dispute resolution: The DFA is
usually governed by Qatari law. Although some
contracts provide for dispute resolution before Qatari
courts, some of them provide for dispute resolution
through local or international arbitration.
Equilibrium: The DFA provides that in the event of
the government enacting a new law or decree which
demonstrably has a material adverse effect on the
participant’s fiscal position with respect to the project,
the government will take steps to restore the fiscal
benefit contemplated to be enjoyed by the parties
under the DFA.
Technical Services Agreement (TSA)
Parties: The parties of the TSA are the joint
venture company on the one hand and each of the
participants on the other.
Object: the object of the TSA is to facilitate the
provision of certain services by the participants of the
joint venture company. Such services include
providing project personnel, training services and
other services of technical nature.
Provision of project personnel: The participants
are required to provide highly-qualified personnel
to assume key positions in the joint venture
company organization, particularly during the early
phases when the project is undergoing
implementation.
Provision of training services: The participants are
required to make available their training resources and
facilities to train personnel engaged with the joint
venture company.
Other technical services: These may include
providing the joint venture company with technical
services such as technical advice, engineering data,
simulation programmes and other information which
is required for the design, engineering, construction,
operation and maintenance of the project. Such
services are rendered through short-term visits or
assignments.
Remuneration: The participants are remunerated by
the joint venture company for the services they
provide based on agreed rates.
Sultan M. Al-Abdulla
Qatar General Petroleum Corporation
Doha, Qatar
819
 12.14
China
12.14.1 Sovereignty over
petroleum resources
China (also termed herein the State or People’s
Republic of China, PRC) recognizes the significance
of a strong mineral industry on its economic future
and that domestic supplies of necessary mineral
commodities have failed to meet the requirements of
economic expansion (Ziran, 1998). China has made
sustainable development of mineral resources a
national strategy and the protection of those resources
an important part of this strategy (Information office
of the State Council of the People’s Republic of China,
2003). The PRC Constitution vests the ownership of
all mineral resources with the state. The PRC
Constitution further provides that the state shall ensure
“the rational use of natural resources” and that
“appropriation or damaging natural resources by any
organization or individual by whatever means is
prohibited” (art. 9).1
During the recent past, measures have been
attempted to ‘reformulate’ China’s mineral policy
system to promote mineral development in order to aid
the achievement of its national economic and social
development objectives (Information Office of the
State Council of the People’s Republic of China,
2003). However, and generally speaking, as yet,
China has no integrated oil and gas legislation or legal
administration.
In 1949, China had just over 300 properly
developed mines, producing annually about 120,000
tonnes of crude oil, among other resources. In 1982,
China began to open its oil and gas industry to outside
investment by using foreign capital and technology to
prospect and exploit oil and gas resources
(Information Office of the State Council of the
People’s Republic of China, 2003). China became
self-sufficient in oil production in the 1960s upon the
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
discovery and development, with the Soviet Union’s
assistance, of the giant Daqing oil field in
Heilongjiang Province, eventually exporting 80% of
its domestic crude oil production from 1978 to 1985.2
Daqing accounted for 54% of the national output of oil
in 1975 (US Central Intelligence Agency, 1977).
In 1999, China produced 160 million tonnes of
crude oil and 25 billion m3 of natural gas. However,
since the 1990s, its consumption of oil has nearly
doubled (Tiejun, 2003). By 2002, China had
established a large supply system for energy, mineral
products, and other raw and processed materials, with
the successful construction of large oil and gas fields,
such as Daqing, Shengli and Liaohe, among other
resource production facilities, producing 167 million
tonnes of crude oil and 32.7 billion m3 of natural gas.
By 2003, China’s production of crude oil ranked fifth
in the world. Through further prospecting for offshore
oil and gas resources, in cooperation with foreign
companies, a number of new oil and gas fields have
been discovered (Information Office of the State
Council of the People’s Republic of China, 2003). At
the same time, China’s oil consumption rate has been
increasing at an annual rate of 4.9% since 1990, while
crude production has grown at an annual rate of only
1.7%.3 China has been a net importer of oil since 1993
1 This paper is presented to provide general information
regarding the oil and gas laws of the People’s Republic of
China and is not meant to constitute legal counsel. The
reader is cautioned to seek his or her own legal counselling
regarding application of any laws to specific situations.
2 New discoveries needed for China’s soaring energy
demand (2004), realtimenews@SPE,
http://www.rigzone.com, September 30.
3 Haiying L. (2004) Patching the oil pricing, China
OGP, http://www.chinaogp-online.com, June 29.China’s
reliance upon imported oil is projected to rise from 23% in
2000 to 40% by 2010.
821
NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
and is now the world’s second largest oil importer after
Japan and could become the second largest consumer,
after the United States, within a relatively short period.4
12.14.2 Ownership and title
to the underground
petroleum resources
As stated above, the PRC Constitution vests the
ownership of all mineral resources with the state.
State-owned mining enterprises used to be the
principal organizations involved in mining mineral
resources. Provincial, autonomous regions, and
municipal governments, in conjunction with the local
departments of the State Ministry of Land And
Resources (MOLAR or the Ministry), were, and still
are, responsible for supervising and administering
exploration and mining.5 Now, however, collective-
owned, private-owned, and other ownership enterprises
(via Hong Kong, Macau and Taiwan or foreign
investment) have entered this industry.6
12.14.3 Structure of the petroleum
regulation
The right to prospect for the petroleum resources
Discussion of oil and gas or petroleum resources is
presented by the state in the context of mineral
resources, and not pursuant to a separate oil and gas,
or petroleum statutory regime. The Chinese
government reports that a “framework is being
established to implement drastic change to China’s
mining sector, which will facilitate business and
investment opportunities and generate unprecedented
prosperity” (Tiejun, 2003). The Chinese government
intends, as national policy, to depend mainly on the
exploitation of its own mineral resources to guarantee
that the needs of its modernization programme are
met. In addition, the government plans to encourage
the exploration and exploitation of its mineral
resources, to increase domestic capability of resource
supply, by importing foreign capital and technology to
help Chinese mining enterprises and mineral products
enter international markets (Information Office of the
State Council of the People’s Republic of China,
2003).7
Drafting of the first mining law for China began in
1979 (Tiejun, 2003). Seven years later, in 1986, the
first law regarding Chinese mineral resources was
adopted to work in conjunction with the PRC
Constitution to establish basic principles for
a mining regime (Kwauk, 2004). In 1994,
the Ministry of Geology and Mineral Resources
822
(now the Ministry of Land and Resources)8 began
drafting the Proposed Amendments to the Mineral
4 New discoveries needed for China’s soaring energy
demand (2004), realtimenews@SPE,
http://www.rigzone.com, September 30; Contra, China
further opens up oil markets to private companies (2005),
Xinhua Financial News, http://www.rigzone.com, January 6.
5 The scope of this paper is the law regarding mining
rights in China, principally oil and gas minerals, as well as
laws of particular interest to mineral investment interests.
There are a number of other related laws that may be of
interest to the reader with investment interests in the
mineral, energy, petroleum or other industries, not covered
here, such as the following: Regulations on Collection and
Management of Mineral Resources Compensation (royalty);
Provisions on the Administration of the Collection of the
Mineral Resources Compensation (royalty), Regulation of
the PRC on Resources Tax; and Income Tax Law of the
PRC; Provisional Regulations of the PRC on Value Added
Tax and on Enterprise Income Tax (both effective 1 January
1994); and Income Tax Law of the PRC, concerning
Enterprises with Foreign Investment and Foreign Enterprises
(effective 1 July 1991). See also the discussion below at
section 12.14.7, regarding the Petroleum Contract which
makes reference to a foreign entity’s tax liability. Additional
laws and regulations regarding royalty and taxation
involving oil and gas production in China include:
Regulations on the Payment of Royalty for the Exploitation
of Offshore Petroleum Resources (effective 1 January 1989),
Notice on the Payment of Royalty for the Exploitation for
Sino-Foreign Cooperative Exploitation of Land Oil
Resources (effective as amended on 1 January 1996), Notice
on the Payment of Royalty for the Exploitation for Sino-
Foreign Cooperative Exploitation of Land Crude Oil
Resources (effective as amended on 7 April 1999), and
Provisional Regulations of the People’s Republic of China
on Resources Tax (effective 13 December 1993), Detailed
Rules for the Implementation of the Provisional Regulations
of the People’s Republic of China on Resources Tax
(effective 30 December 1993), Notice on Reduction and
Exemption Measures for Using Fees of Exploration Rights
and Mining Rights (effective 6 June 2000), and Notice on
Reduction and Exemption Measures for Using Fees of
Exploration Rights and Mining Rights in Short Supply
(effective 21 September 2000).
6 There are 140,000 established, state-owned mining
enterprises, including 132 with investment from Hong
Kong, Macau, and Taiwan businesses; and an additional 160
with foreign investment (Information Office of the State
Council of the People’s Republic of China, 2003).
7 As of 2003, over 92% of China’s primary energy, 80%
of its industrial raw and processed materials, and more than
70% of its agricultural means of production come from
mineral resources.
8 MOLAR, established in March 1999, under the
Reorganization of the State Council’s Agencies Program, is
one of the member departments making up the State
Council and is in charge of the planning, management,
protection and rational utilization of land resources, mineral
resources and marine resources, all constituting
natural resources. 1st Session of the 9th National People’s
Congress, and State Council Notification on the
Establishment of the Organizational Structure.
ENCYCLOPAEDIA OF HYDROCARBONS

Resource Law, which come into effect on 1 January
1997. These new amendments included recognition of
a right to transfer mining rights.
The PRC Constitution provides that all mineral
resources are owned by the state. The Mineral Resource
Law, the principal mining law of the state, along with
implementing rules and regulations, establishes the
regulatory process for oil and gas exploration and
exploitation. China’s other major oil and gas laws and
regulations are composed principally of two State
Council onshore and offshore regulations, discussed in
more detail below. These regulations are for exploiting
onshore and offshore petroleum resources in
cooperation with foreign parties or entities, and related
administrative regulations and regulative documents
promulgated by the State Council and related
ministries.9 The legally designated Chinese Oil
Companies (the China National Petroleum Corporation,
CNPC, and the China Petroleum & Chemical
Corporation, Sinopec) and China National Offshore
Oil Company (CNOOC) are responsible for cooperating
with foreign parties for the exploitation of onshore and
offshore oil resources, respectively.10
The PRC Constitution (arts. 62, 89 and 100)
establishes a tiered structure, whereby the National
People’s Congress, State Council, and local
governments regulate the exploration and exploitation
of oil and gas resources. At the top of this hierarchical
structure is the National People’s Congress, which
enacts national legislation (art. 62). The State Council
implements national legislation through the enactment
of administrative rules and regulations, as well as
issuing decisions and orders.11 Local regulations may
be adopted by the people’s congresses of provinces
and municipalities and their standing committees.12
Administrative rules and regulations cannot
contravene the PRC Constitution or legislation enacted
by the National People’s Congress.13 Similarly, local
regulations cannot contravene those established by the
Constitution, the National People’s Congress, or the
State.14
The Mineral Resources Law of the PRC, adopted
19 March 1986, amended on 29 August 1996
(amendments) and effective as amended 1 January
1997 (after passage of the 21st Session of the Standing
Committee of the 8th National People’s Congress on
29 August 1996), is the principal natural resources law
of China. The Mineral Resources Law consists of
seven major chapters.
As set forth in Chapter 1, the purpose of the Law is
to promote the exploration, development, utilization,
and protection of mineral resources and to ensure that
the present and long-term requirements of socialist
modernization are met.15 Chapters 1 through 4 provide
the bases from which regulations for exploration and
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
CHINA
exploitation are promulgated. Chapter 2 establishes a
unified registration system for mineral exploration
and exploitation. Chapter 3 sets forth the manner
in which exploration and, specifically, regional
geologic surveys shall be carried out. Chapter 4
specifies the requirements a mining enterprise must
meet prior to mineral exploitation, specifies the
manner in which the exploitation must occur, and
mandates that the exploitation occur in an efficient,
economic, hygienic, and safe manner, while also
preventing pollution of the environment.
On 26 March 1994, the State Council promulgated
rules in accordance with the Mineral Resource Law.
Additionally, on 12 February 1998, the State Council
issued three sets of regulations (“items of regulations”)
to further implement the Amendments to the Mineral
Resources Law. Each of these is summarized below.
The Rules for Implementation of the
Mineral Resources Law are divided into chapters and
organized to parallel the Mineral Resources Law.
Chapter 1 provides valuable general information
explaining the regulatory scheme as a whole. Chapter 1,
art. 2, defines mineral resources as follows: “[...] natural
resources with value for utilization, which are formed
through geologic function and exist under solid, liquid
or gaseous state. The varieties of the mineral resources
and their classification are listed in the Catalogue of
Mineral Resources attached to these Rules.16 The
department in charge of geology and mineral resources
under the State Council shall report discovery of the
new varieties of the mineral resources to the State
Council for approval, and then make publications”.17
9 See footnote number 10, and section 12.14.6.
10 State Council, Exploitation of Onshore Oil Resources
in Cooperation with Foreign Parties Regulations (Revised)
(State Council Onshore Regulations), art. 7, and State
Council, Exploitation of Offshore Oil Resources
in Cooperation with Foreign Parties Regulations (Revised)
(State Council Offshore Regulations), art. 6.
11 PRC Constitution, art. 89 (1); Mineral Resources
Law, art. 9.
12 PRC Constitution, art. 100; Mineral Resources Law,
art. 9.
13 PRC Constitution, art. 89 (1).
14 PRC Constitution, art. 100. See also, State Council
Onshore Regulations, art. 10.
15 Mineral Resource Law, art. 1.
16 The Catalogue of the Mineral Resources includes:
“(1) Energy mineral-coal, coal-related gas, stone coal, oil
shale, petroleum, natural gas, oil sand, natural bitumen,
uranium, thorium, geothermal resources”.
17 Rules for Implementation of the Mineral Resources
Law of the People’s Republic of China, art. 2. See also,
where applicable, Measure for the Administration of
Invitation to Bid, Auction, and Quotation Concerning
Mineral Prospecting Right and Mining Right (for Trial
Implementation) (effective 11 June 2003).
823
NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
Explore, develop, produce, and dispose
of the petroleum resources
Chapter 1 of Rules for Implementation of the
Mineral Resources Law of the People’s Republic of
China further provides that the state shall adopt a
licensing system for the exploration and exploitation
of mineral resources (art. 5). Essentially, anyone who
intends to explore or exploit mineral resources in
China must: apply for registration in accordance with
the law; draw the exploration licence; and obtain an
exploration or mining right (art. 5).
An exploration right is defined as the “right to
explore the mineral resources within the scope
provided by the exploration licence which is legally
obtained” (art. 6). Individuals or units that obtain
exploration licences are called exploration licensees
(art. 6). Similarly, a mining right means the “right to
exploit the mineral resources and to own the mineral
products within the scope provided by the mining
licence which is legally obtained” (art. 6). Individuals
or units that obtain a mining licence are called
concessioners (art. 6)
The Rules further provide that the State Council’s
department in charge of geology and mineral resources
is responsible for the supervision and administration
of mineral resources exploration and exploitation
(art. 8). As discussed above, the People’s Governments
of provinces, autonomous regions, and municipalities
shall also have similar authority in their respective
administrative areas (art. 8).
As described in greater detail below, Chapters 2
and 3 of the Rules set forth in general terms the
licensing process and the rights and obligations of an
exploration licensee and concessioner. Chapter 5
provides that the state shall protect the lawful rights
and interests of and exercise supervision and
management over the collectively-owned mining
enterprises, privately-owned mining enterprises, and
individual miners pursuant to law. Chapter 6 discusses
potential legal liabilities for failure to comply with
applicable laws.
The State Council enacted regulations for the
exploration of mineral resources for the purpose of
strengthening the administration of mineral resources
exploration, safeguarding the lawful rights and
interests of exploration licensees, maintaining the
exploration order, and promoting the wise
development of the mining industry (Regulations For
Registering To Explore For Mineral Resources Using
the Block System, art. 1). These regulations provide
that the state shall adopt a ‘block system’ or a Unified
Block Registration System, based on a grid pattern in
which the basic unit block is longitude 1° x latitude 1°
(approximately 848 acres) for determining the
resource areas to be explored.18 The Regulation sets
824
forth the maximum number of blocks for which
exploration permits can be issued, which is dependant
upon the mineral resource to be developed. For
example, an exploration permit for oil and gas is 2,500
basic unit blocks (art. 3).
All oil and gas exploration activities “shall be
examined and approved by the organization designated
by the State Council, and registered and licensed by the
department in charge of geology and mineral resources
under the State Council” (art. 4). Regulations establish
the procedure an exploration investor shall follow when
applying for an exploration licence as well as
procedures for the licensing authorities when
processing an investor’s application (arts. 5 and 6).
In addition to the general regulatory requirements,
the regulation sets forth specific requirements related
to obtaining a licence to explore for oil and/or gas
(arts. 6, 7, 8). A licensee is required to begin work
within six months after an exploration licence is issued
(art. 18). Generally, an exploration licence for oil and/or
gas is valid for up to seven years, but may be extended
for a period of typically no greater than fifteen years
(art. 10). When an economic deposit is discovered,
under certain conditions, the licensee may apply and
receive a reservation of the exploration rights for a
maximum period of four years (art. 21). Among the
obligations under the permit are scheduled minimum
exploration expenditures,19 reporting requirements
(art. 18), and scheduled rental payments.20 While the
licensee receives a preferential right to obtain a mining
licence as a concessioner, his preferential right is not,
apparently, a “guarantee” (Kwauk 2004).21
12.14.4 Operating conditions
Prior to actual mining of mineral resources, a mining
project shall be “examined, approved, registered, and
18 The acreage calculation is based on 1,151 statutory
miles per nautical mile and 60 nautical miles per 1º of
latitude (Regulations For Registering To Explore For
Mineral Resources Using the Block System, art. 3).
19 2,000 RMB (renminbi) per square kilometre in the
first year, 5,200 RMB in the second year, 10,000 RMB each
year thereafter (Regulations For Registering To Explore For
Mineral Resources Using the Block System, art. 17).
20 100 RMB per square kilometre per year for the first
three years, increasing by 100 RMB per square kilometre in
each succeeding year, the highest rate not to exceed 500 RMB
per square kilometre per year. An additional reimbursement
fee may be required for “any blocks containing mineral
deposits discovered at the state’s expense” (Ziran, 1998).
Regulations For Registering To Explore For
Mineral Resources Using the Block System, art. 12.
21 Discretionary decision-making processes in China are
frequently “political and opaque”.
ENCYCLOPAEDIA OF HYDROCARBONS

licensed by the department in charge of geology and
mineral resources under the State Council”
(Regulations for Registering to Mine Mineral
Resources, art. 3). Similar to the procedures for
obtaining an exploration licence, the Regulations for
Registering to Mine set forth the application
procedures and regulatory requirements for a
concessioner to obtain and maintain a permit to mine,
some of which requirements are specific to the
exploitation of oil and/or gas (art. 3).
A concessioner’s licence term runs from ten to
thirty years, based on the magnitude of a mining
project. If the size of a mining project is large, the
maximum term of the mining licence is thirty years,
and scaled down from there to as low as ten years for a
small mining project. The concessioner may extend the
term of a mining licence with an application thirty
days prior to expiration of the term (art. 7). Again, a
concessioner must meet certain reporting requirements
and must pay rent to the state.22
Both exploration and mining rights are transferable
under certain circumstances and in accordance with
the applicable law as provided by the Regulations for
Transferring Exploration Rights and Mining Rights
(arts. 2, 5, 6, 7, 8). The State Council’s department in
charge of geology and mineral resources and the
people’s government of provinces, autonomous regions
and municipalities must examine and approve the
transfer (art. 4). Upon transfer of the right(s), the
assignee assumes whatever time remains on the
original licence (art. 13).
Regulation of royalty for offshore exploration
occurs through Regulations on the Payment of Royalty
for the Exploitation of Offshore Petroleum Resources
(approved by the State Council on 5 December 1988
and promulgated on 1 January 1989). Art. 3 sets
different tiers of payment and states that “royalty shall
be computed and paid on the basis of the Annual
Gross Production of Crude Oil or Natural Gas of each
oil or gas field at various rates”.
Concerning the signature bonus, according to the
fourth round model contract for offshore cooperation
in China, Chinese law has the following general terms:
“the Contractor shall pay CNOOC a signature fee of
$1,000,000”. Such signature fee shall be paid in three
installments: the first $250,000 shall be paid by the
Contractor within thirty days from the date of
commencement of the implementation of the contract;
the second $250,000 shall be paid by the Contractor
within thirty days of the date of the Contractor’s election
exercised under either art. 6.3 (a) or art. 6.3 (b) of the
contract; and the remaining $500,000 shall be paid by
the Contractor within thirty days of the date of
approval of the overall development programme for
the first oil field or gas field within the contract area.
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CHINA
12.14.5 State participation through
a state oil company
or otherwise
Most mineral exploration or exploitation in China is
carried out by state enterprises or Chinese foreign
joint ventures. Three large natural oil companies are
given the power to purchase operating rights, to lease
ownership rights overseas, and to establish subsidiaries
to undertake overseas oil exploration. These
companies are CNPC (an oil production company),
Sinopec (a refining company), and CNOOC.23
The State Council onshore and offshore
regulations, referenced above, grant the two Chinese
Oil Companies and CNOOC, respectively, the
authority to negotiate, execute, and perform under
cooperative or petroleum agreement (collectively
hereinafter, Petroleum Contract) with foreign
enterprise entities, or foreign contractors, for the
exploitation of onshore or offshore oil and/or gas
resources.24 Prior to the 1996 amendments to the
Mineral Resources Law, the law did not provide any
specific measures for foreign investment in mineral
resources. The state allowed foreign entities
and individuals to invest in mineral exploration and
exploitation under the Mineral Resources Law, subject
to all other laws (art. 7). A variety of measures have
been undertaken to improve mineral investment
conditions within China, to promote domestic mineral
development, and simultaneously, to encourage the
introduction of foreign capital and advanced
technology (Ziran, 1998). The introduction of foreign
capital and advanced technology is intended to achieve
certain objectives, including: augmenting mineral fuel
and raw material supplies, increasing government
revenues, improving the mining technology base, and
increasing employment opportunities in Chinese
mining (Ziran, 1998). To achieve these and other
goals, the government hopes to encourage foreign
exploration and exploitation into the mineral project
categories (Groups) discussed below.
22 See e.g., Regulations For Registering to Mine Mineral
Resources, arts. 8, 9.
23 State Council Onshore Regulations and State Council
Offshore Regulations. Only twenty-two years ago, in China,
there were 260,000 domestic companies competing in the
mining industry, creating boundary disputes and vast
inefficiencies. State policies since that time have resulted in
approximately 95% fewer mining companies operating in
China (Tiejun, 2003).
24 State Council Onshore Regulations (for the Chinese
Oil Companies) arts. 7, 8; State Council Offshore
Regulations (for CNOOC), arts. 6, 7, both pursuant to
approval and filing with the Chinese Ministry of Foreign
Trade and Economic Cooperation (MOFTEC).
825
NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
Projects for potential foreign investments
On 11 February 2002, the state promulgated
Provisions on Guiding the Orientation of Foreign
Investment (to be called Foreign Investment
Provisions, or Provisions).25 Significantly,
these Provisions provided that the State Development
Planning Commission, the State Economic Trade
Commission, and the Ministry OF Foreign
Trade and Economic Cooperation (MOFTEC) shall
formulate a Guidance Catalog of Industry with
Foreign Investment (Guidance Catalog) and a Catalog
of Dominant Industries with Foreign Investment of
Mid-west Regions (art. 3).
The Foreign Investment Provisions are applicable
to projects of investment and establishment of Chinese
foreign equity joint ventures, Chinese foreign
contractual joint ventures and foreign-capital
enterprises (hereinafter referred to as enterprises with
foreign investment), and projects with foreign
investment in other forms (hereinafter referred to as
projects with foreign investment) (art. 2). All projects
for potential foreign investment fall into four
categories: a) encouraged; b) permitted; c) restricted;
d ) and prohibited (art. 4). Projects that are categorized
as encouraged, restricted, or prohibited are listed in the
Guidance Catalog. All other foreign investment
projects are categorized as permitted projects, but are
not set forth in the Guidance Catalog (art. 4).
The following paragraph sets forth examples of
encouraged, restricted, and prohibited projects.
Encouraged projects include those “being of new
agriculture technologies, agriculture comprehensive
development, or energy, transportation, and
important raw material industries” (art. 5). A project
which is “adverse to saving resources and improving
the environment” or engages in the “prospecting and
exploitation of the specific types of mineral
resources to which the state applies protective
exploitation” is considered restricted (art. 6). By
contrast, a prohibited project is one “polluting the
environment, damaging natural resources or
harming human health” (art. 5).
These Provisions further provide that the Guidance
Catalogue may specify that an enterprise with foreign
investment can be “limited to joint venture, contractual
venture, with Chinese party at the holding position
or with Chinese party at the relatively holding
position” (art. 8). However, a project that engages in
the construction and operation of energy,
transportation, municipal infrastructure, under certain
circumstances, may request organizational expansion
of “their relevant business scope” (art. 9).
Projects with foreign investment shall be examined
and approved, and ‘put on record’ by various state
departments, and, in some circumstances, the
826
departments of the people’s governments of the
provinces, autonomous regions, or municipalities.
Additionally, the contracts and articles of association
of enterprises with foreign investment shall be
examined and approved by the applicable departments
of the state. Numerous other examination and approval
processes may apply dependant upon the type
of project being proposed (art. 12).
Overall foreign investment in China has increased
sharply, to $50 billion in 2002. Of 180,000 mines in
China, 324 are supported by foreign investment
(Tiejun, 2003). China has been actively participating
in the exploitation of oil and gas resources outside the
country in recent years (Information Office of the
State Council of the People’s Republic of China,
2003). While China opened its oil and gas industry, in
1982, to outside investment with money and
technology, in 1993 they first allowed exploration
activities on the ground, in the western China Tarim
Basin’s natural gas reserves.26 The total value of
China’s foreign trade has been increasing at a rate in
excess of 10% for the last several years. Mining is
responsible for 6% of China’s entire industrial output,
15% of its total foreign trade, and 30% of its Gross
Domestic Product (GDP) (Tiejun, 2003).
As mentioned, part of China’s energy strategy is for
its domestic companies to explore and develop natural
resources overseas. As such, China is increasingly
looking offshore to satisfy its demand for energy, and
the CNPC, for example, has signed forty-eight
investment and cooperation contracts overseas with
twenty different countries.27 CNOOC plans for sixteen
new development projects between 2005 and 2006,
and a net production volume offshore of China in 2005
of 19% over 2004.28
China is attempting to strengthen its assured
supply, for example, by moving forward with a
pipeline linking China and oil rich Kazakhstan,
designed to deliver up to 20 million tonnes of Caspian
Sea crude oil annually to western China, and a deal
between China Petrochemical Corporation and
Petrobras, Brazil’s largest state-owned oil company, to
25 Five forms of business entities are possible for foreign
investment in Chinese mineral resources, as follows: equity
joint ventures, contractual joint ventures, foreign capital
enterprises, companies limited by shares with foreign
investment and investment companies by foreign investors,
each entity regulated by its own applicable law and
implementation rules and/or other regulations (Ziran, 1998).
26 China […], 2000.
27 Energy hungry China boosts oil resources by 25% in
2004 (2005), Xinhua Financial News,
http://www.rigzone.com, February 1.
28 CNOOC targeted 19% YOY offshore production
growth in 2005 (2005), http://www.rigzone.com, February 2.
ENCYCLOPAEDIA OF HYDROCARBONS

jointly explore and develop offshore areas of China
and Brazil.29
However, not all of China’s foreign oil and gas
development efforts have gone smoothly. China’s
aggressive permitting of natural gas areas in offshore
waters of the East China Sea have triggered harsh
responses from Japan. Japan considers the area its
exclusive economic development zone.30 In addition,
proposed pipeline deals to deliver gas from eastern
Siberia to northern China and oil from western Siberia
to Daqing have not been consummated.31
China has considered expanding its resource
supply by looking overseas. The China National
Overseas Mineral Development Fund was established
to support Chinese mining corporations that are
operating overseas and seeking opportunities in the
exploration and exploitation of mineral resources
there. The three principal national oil companies –
CNPC, Sinopec and CNOOC – have been given the
power to purchase operating rights and lease, and other
ownership rights overseas. These companies also have
the ability to establish subsidiaries to undertake
overseas oil exploration (Chen, 2004). Chinese
investment in western producing entities is also being
pursued.32
China will likely see continued oil and gas production
growth in the near future, both domestically and from
offshore operations by Chinese companies.33 For 2004,
CNPC reported finding 520 million tonnes
of oil, Sinopec reported finding 328 million tonnes of
oil, and the two companies reported discovering a
combined 422 billion m3 of natural gas.34
Private company development is beginning to see
activity on the domestic side as well. A group of more
than ten private firms, including fuel oil trader
Shanghai Pengdum Petrochemical, have government
approval to set up a 10 billion yuan oil and
petrochemical venture, competing with the larger state
entities: oil producer CNPC, refiner Sinopec, and
offshore producer CNOOC.35 The venture, called
China Great Wall Petroleum United, was founded by
members of the privately-funded China Chamber of
Commerce for Petroleum Industry, an event which
may indicate a lessening of state control over the
industry.36 This venture is the first association of
private oil firms in China that has been established to
protect small and medium-sized private oil firms in
both the domestic and international oil markets.37
In June 1998, to begin moving its oil pricing
function from the state to the market, facilitating
anticipated entry into the World Trade Organization
(WTO), China moved to link its domestic crude price
to the international market, publishing crude oil
prices monthly based on the Singapore Free On Board
(FOB) price.38
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
CHINA
In June 2000, China furthered its oil and gas
pricing reform by floating the price of refined
petroleum products on the market, referencing the
Singapore spot market price, with the State
Development and Planning Commission (SDPC)
adjusting the prices monthly by a set formula.39
12.14.6 Fiscal structure
The State Council onshore and offshore regulations
(again, in differing language) each provide for
exportation of oil and repatriation of revenues, in
accordance with state law (such as taxation and mining
royalties) and in accordance with the Petroleum
Contract.40 Branch offices for the foreign contractor
are required in China,41 and ultimate ownership of all
“assets” (presumably tangible assets) remaining after
compensation of the foreign contractor, automatically,
at the end of production, become the property of the
Chinese Companies or CNOOC, as applicable.42
The Chinese government has undertaken a
number of measures in recent years to improve the
29 China does not leave oil resources to chance (2004),
Insight, http://www.rigzone.com, October 29.
30 Japan to again ask China to stop drilling operations
in disputed waters (2005), AFX News Limited,
http://www.rigzone.com, May 26.
31 China does not leave oil resources to chance (2004),
Insight, http://www.rigzone.com, October 29.
32 CNOOC […]; see also China looks offshore to satisfy
booming demand (2005), Greenwire,
http://www.rigzone.com, May 6.
33 China’s annual crude oil output may maintain at 180
million tonnes per year through 2020. Offshore, Western oil
to sustain China’s oil output growth (2005), Xinhua News
Agency, http://www.rigzone.com, May 25.
34 Energy hungry China boosts oil resources by 25% in
2004 (2005), Xinhua Financial News,
http://www.rigzone.com, February 1.
35 China further opens up oil markets to private
companies (2005), Xinhua Financial News,
http://www.rigzone.com, January 6.
36 Ibid.
37 Chamber for private oil companies launched (2005),
China Bureau, Dow Jones Newswire, Odj, ODJ Select via
COMTEX, http://www.rigzone.com, January 13.
38 Haiying L. (2004) Patching the oil pricing, China
OGP, http://www.chinaogp-online.com, June 29; oil pricing
is published by SDPC.
39 Ibid.
40 State Council Onshore Regulations, arts. 15 and 16;
State Council Offshore Regulations, arts. 9 and 10. See also,
footnote 5 above regarding taxation regulations. Said
Regulations were revised in 2001, as set forth below.
41 State Council Onshore Regulations, art. 17; State
Council Offshore Regulations, art. 15.
42 State Council Onshore Regulations, art. 19; State
Council Offshore Regulations, art. 20.
827
NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
climate for foreign investment in the oil and gas
industry. The first measure has been through issuing
certain policy directives: in August 1999, the
Opinions on Further Encouraging Foreign
Investment at Present; in June 2000, the Catalogue
of Dominant Industries for Foreign Investment in the
Central and Western Regions; and in March 2002,
the revised Directory of Industries for Foreign
Investment (or Industrial Catalogue). The second
measure has been adopting a ‘One Window’ policy
for cooperation with foreign oil companies in the
field of oil and gas resources. This policy is based
on production sharing contracts, committing China
to annulling administrative statues and departmental
rules incompatible with WTO rules, and giving
national treatment to foreign investors in
prospecting and exploitation (Information Office of
the State Council of the People’s Republic of China,
2003; Tiejun, 2003).43 Further, with regard to oil and
gas resources, in September 2001, the State Council
of China issued the revised Regulations on the
Exploitation of Offshore Oil Resources in
Cooperation with Foreign Enterprises, hereinafter
the State Council Offshore Regulations, and the
Regulations on the Exploitation of Onshore
Oil Resources in Cooperation with Foreign
Enterprises, hereinafter the State Council Onshore
Regulations (Information Office of the State
Council of the People’s Republic of China, 2003).
Upon entering the WTO in December 2001, China
was required within three years of accession to fully
open its import/export, retail, and wholesale industries
to foreign investment (Turnacliff, 2004).
Requirements to open up its markets to global
competition pursuant to its admission to the WTO are
seen to be fueling efforts by the State-owned Assets
Supervision and Administration Commission to create
Chinese entities that can better compete with foreign
oil multinationals.44
12.14.7 The Petroleum Contract
and the parties thereto
The State Council Onshore and Offshore Regulations
provide that the foreign contractor shall bear all
exploration costs and risks of investment and that the
foreign contractor and the Chinese Companies (in
the case of onshore petroleum fields) or CNOOC
(in the case of offshore petroleum fields) will share in
the field development costs, the foreign contractor
recovering its initial investment and expenses and,
ultimately, receiving its compensation/remuneration out
of production from the developed field, otherwise in
accordance with the terms of the petroleum contract.45
828
The typical petroleum contract contains familiar
western terminology for natural resources joint
venture agreements, including: work commitments,
minimum exploration expenditures, management
organization and function, designation of operator,
recruitment of personnel, work programmes, and
budgets.46 Extension provisions are set forth for
accounting procedures and preferential employment of
Chinese personnel. The provisions of these regulations
as set forth are reflected, generally, in the Petroleum
Contract reviewed here.
In China, the Petroleum Contract and the
Production Sharing Contract or Agreement (PSC) are
two names for the same document, but PSC is a term
more familiar in other countries such as Indonesia. In
China it is officially called the Petroleum Contract
which is an English translation of a Chinese official
name for the contract; in Chinese there are no
Production Sharing Contracts. Under the Petroleum
Contract, once a commercial oil field is found, then
the foreign company has to submit an Overall
Development Program (ODP) for the Chinese
government to approve before development; and upon
development and production of the oil field there is an
oil field operating company to be formed by the
operator, by means of a subcontracted. The Petroleum
Contract is the master contract from which all these
other contracts and arrangements are ‘splinted off’.
12.14.8 Investment protection
For such cooperative exploitation of petroleum
resources,47 the State Council onshore and
offshore regulations each contain language
providing for the protection of foreign investments,
43 The Ministry spent recent years rescinding a number
of cumbersome and inefficient laws and regulations,
resulting in a significant reduction in government
interference in resource allocation.
44 China plans to restructure PetroChina, CNPC to
create a global player (2004), AFX News Limited,
http://www.rigzone.com, October 26, reporting that
China planned to restructure its biggest oil producer,
PetroChina, and its parent entity, State-owned CNPC.
45 State Council Onshore Regulations, arts. 13 and 14;
State Council Offshore Regulations, art. 8.
46 Authors review of a standard petroleum contract
between a foreign entity and CNOOC, dated 2004, the
Petroleum Contract.
47 Oil in art. 28 of the State Council Onshore
Regulations and petroleum in art. 26 of the State Council
Offshore Regulations are both defined as crude oil or natural
gas. The authors use petroleum herein to mean crude oil
and/or natural gas, as does the Petroleum Contract
referenced above.
ENCYCLOPAEDIA OF HYDROCARBONS

profits, and other lawful rights.48 Each set of
regulations has an additional provision securing,
apparently, foreign investment from expropriation
without compensation, although the precise
language is different between the two sets of
regulations.49 However, as set forth above, regarding
preserving an exploration discovery, the foreign
investor/licensee receives a “priority” or preferential
to obtain a concession, but realization of an
exploration investment is not assured.50
Two trade laws were passed by the Central
Government in 2004 – a new trade and
distribution law and a new foreign trade law –
which allow, for the first time, foreign investors to
own 100% of their entities engaged in trade,
wholesale, or retail industries, thereby affording
equal treatment under Chinese law to all
companies operating in China, regardless of the
nationality of the shareholders/owners (Turnacliff,
2004). This new regulation was made effective as
of 1 July 2004 for trading to foreign investors, and
as of 31 December 2004 for retail and wholesale
business; however, development of formal
procedures for foreign investors to open trading
companies and other detailed regulations have not
been issued (ibid.).51
In conjunction with its accession to the WTO,
China’s policy for mineral resource development
continues to evolve to encourage more
foreign investment, as evidenced in the foreign
investment industrial Guidance Catalog (Kwauk,
2004). Additionally, Chinese statutes, rules, and
regulations also impose restrictions and provide
specific direction for foreign investment.52
12.14.9 Environmental protection
China recognizes that mineral resource development
continues to encounter certain problems, such as:
a) rapid economic growth and resource consumption
creating a supply and demand gap; b) serious waste
and environmental pollution created from the
exploitation and utilization of mineral resources;
c) varying development of mineral resources between
regions; and d ) needed improvement with resource
exploration and development in responding to market
conditions (Information Office of the State Council
of the People’s Republic of China, 2003). Briefly,
China’s targets for the utilization and protection of its
mineral resources in the early Twenty-first century
are to increase the supply of mineral resources to
support its national economy, to promote
improvement in environmental protection during
resource development, and to provide a more
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
CHINA
attractive investment and marketing climate
(Information Office of the State Council of the
People’s Republic of China, 2003).
The basic laws in China governing
environmental protection in the mineral industry
sector of the economy are the Environmental
Protection Law and the Mineral Resources Law
(Ziran, 1998). The Guidance Catalog, noted above,
expressly prohibits projects that pollute the
environment, damage natural resources or harm
human health.53 The State Council Onshore and
Offshore Regulations each contain references to
environmental protection,54 providing for the
protection of natural resources and the prevention of
pollution, as does the Petroleum Contract.55 In
addition, the MOFTEC and the State Environmental
Protection Agency issued provisions in 1993 on
environmental protection management with regard
to foreign investment (MacBride Jr. and Bei, 2001).56
48 State Council Onshore Regulations, art. 4; State
Council Offshore Regulations, art. 3.
49 State Council Onshore Regulations, art. 5; State
Council Offshore Regulations, art. 4.
50 Han, 2005. The “privileged priority” status of the
explorationist needs to be addressed.
51 It is interesting to note that a convention to trade
exploration and mining rights was held in Qingdao,
Shandong Province, in August 2004, with 339 companies
and various foreign government delegations attending, and
resulting in 40 projects becoming subject to trading
agreements. China mining and mineral commodities market
newsletter (2004), Infomine, 8, http://www.infomine.com,
September 14.
52 The authors recommend that readers interested in
foreign investment review the Guidance Catalog and the
Catalog of Dominant Industries with Foreign Investment of
Mid-west Region. These documents will provide additional
detailed information which space does not allow to be set
forth herein.
53 Provision on Guiding the Orientation of Foreign
Investment, art. 5.
54 State Council Onshore Regulations, art. 22; State
Council Offshore Regulations, art. 22.
55 The Petroleum Contract above provides for its parties
being subject to environmental and safety protection laws, as
well as the use of “best efforts” and “reasonable endeavors”
to protect personnel and natural resources” from harm and
pollution, with particular measures for fishing areas.
56 Additional laws and regulations regarding safety,
conservation, and environmental protection involving oil
and gas production in China include: Law of the People’s
Republic of China on Conserving Energy (effective 1
November 1997), Law of the People’s Republic of China on
the Prevention and Control of Atmospheric Pollution
(effective as amended on 29 April 2000), Law of the
People’s Republic of China on the Administration of Sea
Areas (effective 1 November 1997), and Regulations of the
People’s Republic of China Concerning Environmental
Protection in Offshore Oil Exploration and Exploitation
(effective 29 December 1983).
829
NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
12.14.10 Currency regulations
Currency in China is denominated as yuan
(historical) or people’s currency (renminbi or RMB).
Recent exchange rates (prior to July 2005) were
about 8 RNB per $1. It is prohibited to take Chinese
currency out of China pursuant to the 6 March 1951
measures forbidding state currency to cross the
border. The basic legislation governing the Chinese
foreign exchange central system is the Regulations
of the People’s Republic of China in Foreign
Exchange, effective 1 April 1966, and revised 14
January 1997. Recent news that China will stop
pegging it’s currency to the dollar, moving the yuan
from a fixed to a flexible exchange rate, and the
issue of whether China will let the yuan rise against
the dollar, could have far-reaching impact on world
markets.57 This action may not be responding to the
more critical underlying problems, a weak Chinese
banking system (Han, 2005), with, apparently, weak
banking regulations.
12.14.11 Applicable law and the
settlement of disputes
On 26 October 2002, a special investigative report was
issued by the Central Government reviewing the
implementation of the Mineral Resource Law (Tiejun,
2003). This report identified seven issues or problems
confronting China’s mining industry, as follows:
a) regulatory disorder in certain areas of the country;58
b) inefficient mining practices that fail to reach
maximum productivity; c) pollution from mining
operations;59 d ) inadequately funded state mineral
administration; e) lack of modern mining technology;
f ) insufficient structure for minerals commodity
markets;60 and g) insufficient diversity and restraints
on mining rights transfers (Tiejun, 2003). As
mentioned above, laws meant to alleviate these
problems may be some time in coming. However, a
spokesman for the Ministry has reiterated that it is
China’s policy goal to continue to use foreign
investment in mining resources to support the
country’s ‘grand plan’.61
Although China is clearly focused on advancing
its economic agenda, in part, by continued revisions
of the Chinese mining laws, these revisions may not
be readily forthcoming. Ministry representatives
have estimated five to seven years for laws to be
implemented which will guarantee security of land
tenure, protect the environment, enact land use
planning, and improve the mining tax regime.62
Despite recent production records and economic
advances, two-thirds of China’s provinces had too
830
little power at the end of 2004, and energy shortages
are projected as a major “bottleneck” in 2005.
Chinese domestic demand for mineral resources is
continually increasing as China progresses from a
developing country into a major economic power
(Tiejun, 2003).
In the areas of legal recourse and dispute
resolution, of considerable concern for western natural
resources companies desiring to operate in China in
the 1990s were the State Council Onshore and
Offshore Regulations, each containing provisions for
dispute resolution between the foreign contractor and
the state entity (either one of the Chinese Companies
or the CNOOC, as applicable).63 Again, in differing
language, each set provides for initial consultation
(commonly a negotiation or conciliation activity) and,
failing that, submission to arbitration, by agreement of
the parties.64 Additionally, and in the event of an
adverse change in a foreign contractor’s “economic
benefits” due to the subsequent promulgation of new
laws or regulations, the Petroleum Contract may
57 Kirchhoff, 2005, per actions of the People’s Bank of
China.
58 Concerns that the priority rights of exploration
licensees do not guarantee rights to exploit discovered
mineral resources are being addressed by the Ministry. For
example, officials of the Ministry and other governmental
officials have committed that exploration companies in
Yunnan Province will be granted the priority mining rights
to their discoveries, so long as the other provisions of the
mining licence are met (Kwauk, 2004).
59 Despite its recognition of environmental degradation
problems, China is clearly pursuing a “growth first” policy
for energy development, as pronounced by SDPC (Zhang,
1999).
60 China’s oil pricing mechanism continues to be
plagued by problems: speculation at the expense of
producers, direct impact of international price fluctuations
on the domestic economy, and current pricing mechanisms
not reflecting domestic market supply and demand realities;
and Chinese refiners, such as Sinopec and PetroChina, have
been prey to speculators; the domestic economy has no
buffer to international oil fluctuations, during an increasing
reliance on overseas oil (Haiying L., 2004, Patching the oil
pricing, China OGP, http://www.chinaogp-online.com, June
29). Various theories are posed as to how China should
adopt measures to stabilize domestic oil prices; however, it
is generally agreed that domestic market conditions should
be leveraged into the pricing formula.
61 Kosich, 2004.
62 Ibid.
63 State Council Onshore Regulations, art. 25; State
Council Offshore Regulations, art. 24.
64 State Council Offshore Regulations, art. 24. The
Petroleum Contract under review contains a fairly elaborate
consultation and arbitration provision, of eleven clauses,
including arbitration to be conducted pursuant to the rules of
the United Nations Commission on International Trade Law
(UNCITRAL).
ENCYCLOPAEDIA OF HYDROCARBONS

provide for adjustments or revisions to its terms so that
a contractor’s “normal economic benefits” can be
maintained thereafter.
References
China to open metals, minerals sectors to foreign companies,
«Soon» (2000), 24 April.
CNOOC may bid for Unocal (2005), «China Daily», 10 May.
Han M. (2005) China’s role in the global natural resources
economy, in: Proceedings of the 51st annual Rocky
Mountains mineral law institute, Portland (OR), 21-23 July,
Paper 1.
Information Office of the State Council of the People’s
Republic of China (2003) China’s policy on mineral
resources (White Paper), Beijing, New Star, 23 December.
Kirchhoff S. (2005) First step: China will stop pegging yuan
to dollar, «USA Today», 22 July.
Kosich D. (2004) Chinese mining law reform may take 5 years,
«Mineweb», 12 March.
Kwauk B. (2004) The law in China, «Mining Journal», 16
July.
MacBride W.L. Jr., Bei W. (2001) Chinese mining law
overview, «Journal of Energy & Natural Resources Law»,
19, August.
Tiejun W. (2003) Changing mining environment in China, in:
Proceedings of the Prospectors and Developers Association
of Canada convention, Toronto, 11 March.
Turnacliff B. (2004) Letters from Shanghai, «The Shanghai
Lawyer», 3, 27 July.
US Central Intelligence Agency (1977) China oil
production prospects, ER 77-10030U, June.
Zhang C. (1999) Recent development in China’s greenhouse
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
CHINA
gas emissions and assessment: a trip report, Palo Alto
(CA), Stanford University, Center for International Security
And Cooperation, 6 January.
Ziran Z. (1998) Overview of national mineral policy in China
opportunities and challenges for mineral industries, People’s
Republic of China, Ministry of Geology & Mineral
Resources.
William L. MacBride Jr.
Partner, Gough, Shanahan,
Johnson & Waterman Law Firm
Helena, Montana, USA
Dana L. Hupp
Associate, Gough, Shanahan,
Johnson & Waterman Law Firm
Helena, Montana, USA
Zhang Chunhe
Ministry of Land and Resources
Beijing, China
The authors would like to express their gratitude to the law
firm Gough, Shanahan, Johnson & Waterman and to the
Ministry of Land and Resources for the generous donation
of time and resources to the production of this paper, to Ms.
Min Chen, Legal Consultant for Blake, Cassals & Graydon
LLP, for her generous input and to Dr. Zhong Ziran, Director
of the Department of Geological Exploration for the
Ministry, for the generous input he has provided in the past.
Gratitude is expressed to Ms. Kim McTyeire, Ms. Shannon
Messina and Ms. Susan Irish, legal secretaries with the firm,
and to Mr. Eli Z. Clarkson, an associate of the firm, for their
valuable assistance in the editing of this paper.
831
 12.15
Indonesia
12.15.1 Introduction
In considering the system of regulation of
hydrocarbons in Indonesia, the starting point is the
Indonesian Constitution of 1945, year of the country’s
Declaration of Independence, which states: “Land and
water and natural riches shall be controlled by the state
and used for the greatest possible prosperity of the
people”.1 The Indonesian archipelago is resource rich.
Control of the exploitation of these resources has the
potential to be a politically sensitive issue.
In 2001, a new Indonesian Oil and Gas Law was
introduced, Law No. 22 of 2001 (2001 Law). This law
plays a pivotal role in the current system of regulation of
this sector in Indonesia. Although it may have been
assumed that the above provision of the Constitution was
simply a general expression of intent of little ongoing
relevance to the shape of the law, this assumption was
challenged in late 2004 in a case heard in the
Constitutional Court.2 The current system of regulation
based around the 2001 Law amounted to a fairly
far-reaching reform and reshaping of the system. Persons
opposed to the 2001 reform argued to the Constitutional
Court that the 2001 Law was unconstitutional being in
violation of various provisions of the 1945 Constitution.
In all material respects, the challenge was unsuccessful
and the 2001 reforms were confirmed to be
constitutional. Nevertheless, the Constitutional Court
was required to measure the provisions of the 2001 Law
against the guiding principles of the Indonesian
Constitution, including that stated above.
12.15.2 Indonesian legal system:
an overview
Before discussing the system of regulation, it is worth
commenting briefly on the nature of Indonesia’s legal
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
system. Indonesia’s legal system follows key aspects
of the civil law tradition. Thus, the rules of the system
are to be found in legislative sources. Previous court
decisions, which are not systematically published or
readily accessible, do not offer any binding precedents
as to the manner in which these sources should be
interpreted and applied. In addition, legislation is often
expressed as relatively general principles or concepts,
rather than the detail and minutiae more often seen in
common law systems.
There is a hierarchy of legislative sources in
Indonesia starting from the 1945 Constitution.3
Currently, the 2001 Law is the primary specific source
relating to the regulation of hydrocarbons. Further to
that there are Government Regulations enacted under
the 2001 Law.
Primary legislation, in this case the 2001 Law,
usually acts as a framework and leaves a significant
amount of detail to be filled in by implementing
regulations. These implementing regulations often
follow some years after the primary legislation. In
relation to the 2001 Law, the key implementing
regulations were enacted only in 2004. Therefore, at
the time of writing, the application of various aspects
of these implementing regulations remains to be
tested.
An issue that can sometimes cause difficulties in
Indonesia is the inconsistency between rules contained
in different sources. It is not uncommon that new rules
1 Indonesian Constitution 1945, Chapter XIV (Social
Welfare), art. 33 subpara. 3. Please note that Indonesian
laws and regulations are enacted in the Indonesian language.
English translations of the wording of Indonesian laws and
regulations contained in this Article are unofficial.
2 Constitutional Court No. 002/P44-I/2003 dated 15
December 2004.
3 Law No. 10 of 2004 concerning Legislation, art. 7.
833
NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
are enacted without expressly addressing the status of
previous rules, which may not be directly
contradictory, but deal with matters in the same area.
In addition, as discussed further below, additional
powers have been granted in recent years to regional
governments in Indonesia under legislation providing
for a system of regional autonomy. The operation of
these powers in the oil and gas sector has led to
complaints of a lack of coordination in the regulatory
position.
In Indonesia, an Official Elucidation is published
together with legislation, and can provide additional
information on the meaning of principles often
expressed in general terms.
The 2001 Law was a relatively far reaching reform
and reshaping of the system of regulation of
hydrocarbons in Indonesia. The system in force prior
to the 2001 Law was based on laws and regulations
mostly dating from the 1960s and 1970s,4 which
marked the start of modern, commercial oil and gas
exploitation in Indonesia.
The 2001 Law broadly divides the oil and gas
industry into upstream and downstream business
activities (as defined in the 2001 Law), and reshaped
the system for regulation of both. Previously, in
upstream activities, Pertamina, Indonesia’s national oil
and gas company, had regulated and controlled
exploration and production in a quasi-governmental
role.
In particular, Pertamina had acted as the
government party in oil and gas mining concessions in
the form of production sharing contracts. The 2001
Law removed that role and provided that a new
government agency would be created to deal with
these matters. Downstream business activities had
been a state monopoly in the hands of Pertamina. The
2001 Law was the first piece of a new regulatory
system for downstream business activities, enabling
private companies to participate in processing,
transportation and trading.
Under a Government Regulation of June 2003,5
Pertamina became a state-owned limited liability
company (or Persero). This change had been provided
for in the 2001 Law.6 Previously, Pertamina had been
deeply involved in regulatory and policy aspects of the
oil and gas industry in Indonesia. Pertamina’s role is
being transformed by establishing new regulatory
bodies, removing Pertamina as the government party
in production sharing contracts, and removing its
monopoly position in downstream activities. In due
course, it is intended that Pertamina will simply be one
commercial operator in the sector.
The 2001 Law establishes the framework for a
regulatory system in downstream activities. The law
had not previously contemplated private investment in
834
this area. The new system is based on government
granted business licences for the carrying on of
downstream activities. Whilst Pertamina continues
substantially in the position of an incumbent in
downstream businesses, it is starting to feel the impact
of competition in its market. As the most visible
example, Shell has now started trading from various
petrol retail sites in and around Jakarta.
The 2001 Law was enacted in the years following
the collapse of the previous long-standing political
regime in Indonesia under General Suharto. The
collapse of that regime gave new life to the political
ambitions of the various regions within the massive
Indonesian archipelago. The 2001 Law followed
relatively soon after certain laws,7 which became
effective on 1 January 2001, aimed to address these
ambitions. These laws provided for greater regional
autonomy and greater sharing of tax and revenue
between central and regional governments. These
developments were particularly relevant to the oil and
gas industry, since many of the oil and gas fields are in
outlying areas; the changes are recognized in the 2001
Law.
Under the 2001 Law, regional governments are
granted various consultation and other rights in
relation to upstream activities in their area, and the
Chapter of the 2001 Law on state Revenues8 provides
for revenues to be payable to regional governments as
well as central government. As discussed below, this
has been a contentious issue, which has not yet fully
played out, and remains an issue of concern for
investors in the industry.
12.15.3 Supervision of the oil
and gas sector
Under the 2001 Law, three principal government
institutions are to be involved in supervising the oil
and gas sector in Indonesia.
Directorate General of Oil and Gas, a section of
the Department of Energy and Mineral Resources.
While many of the functions previously held at this
level have now been transferred to BPMIGAS (Badan
Pelaksana Minyak dan Gas Bumi, see below), the
government, through this Directorate General (Migas),
4 In particular, Law No. 44 of 1960 on Oil and Natural
Gas Mining; Law No. 15 of 1962 on Domestic Market
Obligations; Law No. 8 of 1971 on State Oil and Natural
Gas Mining Companies.
5 Regulation No. 31 of 2003.
6 Law No. 22 of 2001, art. 60.
7 See note 53.
8 Law No. 22, Chapter VI of 2001.
ENCYCLOPAEDIA OF HYDROCARBONS

retains certain high level functions and broad
responsibility for policy and coordination in the sector
(where the 2001 Law refers to the Minister, these
matters are in practice carried out through this body).
In upstream activities, the Minister is still stipulated as
the source of various decisions and approvals, which
include determining and offering working areas,
approving the initial plan of development for a
working area and giving government approval for the
transfer of interests in production sharing contracts by
contractors, as well as having a broader supervisory
function.9 In downstream activities, the Minister
retains a general regulatory function.
Implementing body for upstream business activities
or BPMIGAS. This is a state-owned, non-profit agency
set up by Government Regulation in July 2002,10
based on the provisions of the 2001 Law
contemplating the creation of such a body. BPMIGAS
now has an extensive role in the regulation of
upstream activities. These include acting as the
government party to production sharing contracts,
supervising the implementation of production sharing
contracts,11 and input to various ministerial decisions.
Regulatory body for downstream business activities
or BPHMIGAS. BPHMIGAS (Badan Pengatur Hilir
Minyak dan Gas Bumi) is a government institution set
up by Presidential Decree in December 2002,12 based
on the provisions of the 2001 Law. Its remit is
based around the regulation and supervision of national
fuel-oil supply, important in the Indonesian domestic
context (fuel-oil is described as fuel derived or processed
from crude oil, including gasoline, diesel and
kerosene),13 and distribution and transportation of natural
gas by pipe. Responsibilities include ensuring availability
of fuel-oil throughout Indonesia, as well as increasing
domestic use of gas.14 To some extent, these are two
sides of the same coin given that Indonesia is currently
engaged in a push to diminish reliance on oil in favour of
an increased use of gas. The increased transportation and
use of natural gas is a looming challenge for Indonesia.
Today, the network for the transportation of gas by pipe
in Indonesia is not extensive.
12.15.4 Upstream business
activities
Definitions
Upstream business activities are defined in the
2001 Law as business activities focused or based on
exploration and exploitation. Exploration is defined as
activities aimed at obtaining information about
geological conditions to find and obtain an estimate of
the oil and natural gas resources in a specific working
area. Exploitation is defined as a series of activities
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aimed at producing oil and natural gas from a specific
working area, consisting of well drilling and
completion, the construction of facilities for the
transportation, storage and processing through
separation and purification of oil and natural gas in the
field, and other supporting activities.15
In October 2004, the provisions of the 2001 Law in
relation to upstream activities were supplemented by
the enactment of Government Regulation No. 35 of
2004 concerning Oil and Natural Gas Upstream
Business Operations (Upstream Regulations). The
remainder of this section discusses the principal
features of the upstream activities regime under the
2001 Law and Upstream Regulations.
Oil and natural gas remain assets controlled by the
state through the government as the holder of the
mining authority.16 Exploration and exploitation of
these assets by other parties (i.e. upstream business
activities) are therefore to be conducted through
concessions in the form of “Co-operation Contracts”17
with BPMIGAS, a body established by the
government in its capacity as the holder of the mining
authority. Under the 2001 Law, co-operation contracts
can take the form of a Production Sharing Contract (or
PSC) or other form of co-operation contract that meets
the requirements of the 2001 Law, including the
requirement that it be “beneficial to the state” and
“maximize the people’s prosperity”.18
Since its introduction in the 1960s, the PSC has
formed the basis for upstream activities in Indonesia.
As elsewhere, PSCs were perhaps felt to offer
advantages in the political context, both for the
government, as they recognized Indonesia’s permanent
sovereignty over its assets, and for an industry worried
about unpredictable change in a less stable political
environment. Furthermore, it provided a contractual
document with the government setting out the “law
between the parties” (to use the basic description of
the effect of contracts contained in the Indonesian
Civil Code),19 and thus, in theory, isolated from shifts
in the general legal regime.
9 Government Regulation 2004 No. 35 (“GR 35”),
arts. 5, 95, 86 et seq.
10 Government Regulation 2002 No. 42.
11 GR 35, arts. 24 and 91.
12 Presidential Decree 2002 No. 86.
13 Law No. 22 of 2001, art. 1.4 and Government
Regulation No. 36 (“GR 36”) of 2004, art. 76.
14 GR 36, art. 7; Law No. 22 of 2001, art. 46.2; see also
Government Regulation No. 67 of 2002.
15 Law No. 22 of 2001, art. 1 paras. 7, 8 and 9.
16 Law No. 22 of 2001, art. 4.
17 Law No. 22 of 2001 art. 11.
18 Law No. 22 of 2001, art. 1.19.
19 Indonesian Civil Code, art. 1338.
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
Under the regime in force prior to the enactment of
the 2001 Law, in some cases, contractors were granted
rights under forms of contract other than PSCs. These
contracts were derived from PSCs and linked to
Pertamina’s position with respect to its own fields
(rather than those for which it simply acted as a
representative of the government). Depending on the
circumstances, these comprised joint-operating
agreements (and joint-operating bodies), technical
assistance contracts, and enhanced oil recovery
contracts. The PSC is the mainstay of upstream
activities and, although other forms of contract could
be accommodated by the 2001 Law, it is expected that
PSCs will be the universal or near-universal model. A
number of examples of the other forms of contract
referred to above remain in force. However, for the
purposes of this Chapter, reference is made only to
PSCs.
Existing PSCs (i.e. those in place prior to the
2001 Law taking effect) are expressly confirmed by
the 2001 Law to remain in force until the expiration
of the relevant contracts.20 The principal of sanctity
of contract is observed, and the terms of the
existing PSCs remain unchanged (save that rights
and obligations of Pertamina are transferred to
BPMIGAS).21 This means that some of the changes
brought about by the 2001 Law, such as the
extension of domestic market supply obligations to
gas as well as to oil, are not thought to apply to
existing PSCs. However, as discussed elsewhere,
where an extension to a PSC is sought, which is an
increasingly common occurrence, the terms and
conditions of the extension appear likely to take
into account developments and changes in the
regime.
For PSCs created after the enactment of the 2001
Law, both the law itself and now the Upstream
Regulations stipulate a list of matters to be addressed
in PSCs22 and a number of specific positions to be
reflected in certain provisions of PSCs. Except where
specified, for the purposes of this Chapter, PSCs
should be taken to mean PSCs reflecting the 2001 Law
and Upstream Regulations. It should be recalled,
however, that PSCs for existing, producing fields in
Indonesia will have been entered into under the
previous regime. Most of the core provisions are
largely the same, although the standard terms of PSCs
have been altered from time to time historically to deal
with policy or legal changes, and to give effect to
government incentive packages for oil and gas
investment.
PSCs are an important tool in the government’s
control of upstream activities, ensuring it can control
such activities through contractual conditions, as well
as through applicable laws and regulations.23 A brief
836
summary of some key aspects of PSCs under the 2001
Law and Upstream Regulations follows.
Production Sharing Contracts (PSCs)
Parties
A PSC is entered into by a contractor with
BPMIGAS. A contractor can be either an Indonesian
incorporated entity, which can in theory include a
foreign owned Indonesian company although this is
not an option used in practice to date, or an entity
incorporated in another jurisdiction. A contractor can
have an interest in only one working area, and thus
separately incorporated entities are needed to hold
interests in several working areas under common
control.24
Validity period, extension and relinquishment
A PSC has a maximum period of (and is normally
granted for) thirty years. This comprises an initial
exploration period of six years (extendable on one
occasion only for a maximum of an additional four
years, provided that the contractor has fulfilled the
minimum requirements to date), and the exploitation
period. At the end of the exploration period, the
working area is relinquished and the PSC terminates if
the contractor has not discovered oil and/or natural gas
in quantities that can be produced commercially. If
such discoveries have been established, the contract
will continue into the exploitation period.25
A PSC can be extended for up to twenty years in
each extension. The application for extension is made
to the Minister through BPMIGAS. This application
can be made at the earliest ten years and at the latest
two years before expiry of the PSC.26 The need to
secure extensions significantly in advance of expiry
has been an issue in certain projects that require large
amounts of funding, in particular the large Tangguh
LNG project. Perhaps partly in recognition of this, the
limit on the earliest date to apply for an extension
(i.e. ten years before expiry) is excluded if the
contractor is bound by a natural gas sale and purchase
contract.27 Whether this exception will prove to be
suitably expressed as the LNG market and natural gas
market in Indonesia change remains to be seen.
20 Law No. 22 of 2001, art. 63 s. c).
21 Law No. 22 of 2001, art. 63 s. a).
22 Law No. 22 of 2001, art. 11.3; GR 35, art. 26,
art. 24.2.
23 Law No. 22 of 2001, Official Elucidation to art. 11.
24 Law No. 22 of 2001, art. 13.
25 GR 35, art. 27; also Law No. 22 of 2001, Official
Elucidation to art. 15.
26 GR 35, art. 28.
27 GR 35, art. 28.6.
ENCYCLOPAEDIA OF HYDROCARBONS

Another issue with PSC extensions is the terms
and conditions that will apply. Although not specific
on this particular point, the Upstream Regulations
provide that the provisions or form of contract in the
extended contract “should remain profitable for
the state”.28 This provision is not specific about
where the line will be drawn, but suggests that as part
of an extension the government may require changes
in the terms and conditions reflecting more recent
developments, notwithstanding the terms of the
existing PSC. This appears to have been the
government practice.
A PSC will provide for specified percentages of
the working area allocated initially to be relinquished
in stages.29 This is aimed at reducing the problem of
contractors ‘sitting on’ assets that are not used.
Commonly, at the end of the relinquishment schedule,
the contractor will hold only a fraction of the initial
area.
Domestic Market Obligations (DMO)
In accordance with the 2001 Law and Upstream
Regulations, a contractor is obliged to provide a
maximum of 25% of its share of oil and natural gas to
meet domestic demand.30 Under PSCs entered into
prior to the 2001 Law, the domestic market supply
obligation does not extend to natural gas. At the time
of writing, the future impact of DMO remains unclear
and an issue of potential concern to investors. Under
the 2001 Law, it is stated that the implementation of
DMO will be further regulated by Government
Regulation; the Official Elucidation states that this
will cover “basic matters” including “provisions on
price and the policy of providing incentives”.31 It is
unclear whether the provisions in the Upstream
Regulations on DMO are intended to represent these
Government Regulations on DMO referred to in the
2001 Law. The provisions of the Upstream Regulations
related to DMO contain little regarding specifics. In
particular, they contain no stipulation on price. The
picture is further confused by the Constitutional Court
ruling referred to in the opening section of this
Chapter.
Although it upheld the main provisions of the 2001
Law, the Constitutional Court did identify several
provisions of the 2001 Law, which it considered did
not meet the requirements of the 1945 Constitution.
Perhaps the most significant provision was the
reference to DMO being based on a maximum of 25%
of production. The Constitutional Court felt that a
maximum without a minimum did not guarantee
sufficient benefit for the state and thus prescribed the
deletion of reference to “a maximum”. Therefore, it
appears that the 2001 Law would then provide for a
flat 25% to be caught by DMO.
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It is not an established role of the Constitutional
Court to amend a law in this way (as opposed to
striking down provisions), and subsequently it has
been indicated that the Indonesian Parliament may
amend the 2001 Law to deal with the Constitutional
Court’s finding. At the date of writing, no such
amendment appears to have been enacted. It would
seem arbitrary to provide a flat percentage for DMO
that may not match reality. Indeed, if DMO were to be
applied to major new gas projects in Indonesia, in the
current circumstances, infrastructure to accommodate
the gas supplied may be insufficient.
A PSC will stipulate expenditure for a fixed work
programme for the initial years of the exploration
period.32
Ownership of oil and natural gas remains with the
government until it passes the point of delivery, and
sharing of production is effected at this point.33 This is
distinct from the approach sometimes taken under
licence based systems whereby ownership is held by
the licensee even before mining.
PSCs can be in Indonesian or English, and are
commonly in the latter. PSCs are subject to Indonesian
law.34
Handling of Production
As the name suggests, the provisions of PSCs
dealing with how the oil and natural gas produced is to
be allocated comprise an important part of the system.
These provisions are also relatively complex and
affected by numerous variables. What follows is an
attempt to summarize common elements of the basic
approach. The 2001 Law and Upstream Regulations
refer to the general concepts involved, but also contain
few specifics in this area. The detail is found mainly in
the terms and conditions of the PSC and, to some
extent, the practices of BPMIGAS. The basic scheme
for the allocation of production under a PSC will be
along the lines of the following.
First tranche petroleum. Before deduction for
recovery of investment credits and operating costs, a
percentage of production – typically 20% in previous
cases – is taken as first tranche petroleum. In the past,
this first tranche petroleum had been split between the
contractor and the government party (now
BPMIGAS), in accordance with their relevant sharing
28GR 35, art. 28.2.
29GR 35, art. 7.1; also Law 2001 No. 22, art. 16.
30Law No. 22 of 2001, art. 22; GR 35, art. 46.
31
Law No. 22 of 2001, art. 22.2 and Official
Elucidation, art. 22.2.
32 GR 35, art. 31.
33 Law No. 22 of 2001, art. 6.2; GR 35, art. 55.
34 GR 35, arts. 37 and 38.
837
NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
splits. In more recent rounds of PSCs signed, there
have been examples of PSCs in which first tranche
petroleum is taken entirely by BPMIGAS, and is thus
part of the state’s revenue – effectively a form of
royalty.
Cost recovery. After first tranche petroleum, the
contractor is entitled to recover its operating costs
from production. Operating costs recoverable in a year
comprise of current-year non-capital costs,
current-year depreciation for capital costs, and any
recovery permitted for unrecovered costs of previous
years. Only certain categories of costs will be
permitted as recoverable, and amounts are linked to
approved budgets and work plans. Costs related to oil
and costs related to natural gas are treated separately.
The implementation of the cost recovery regime is
overseen by BPMIGAS, and is one of the key areas in
which contractors deal with BPMIGAS on an ongoing
basis. Ultimately, amounts to be recovered must be
agreed with BPMIGAS. Alongside cost recovery, as
part of various previous incentive packages designed
to encourage investment in oil and gas assets, the
contractor may also be entitled to take amounts
representing certain investment credits. These are
defined percentages of identified capital investment
costs.
Remaining production. After cost recovery, the
remaining production is split between BPMIGAS and
the contractor, according to specified sharing splits or
equity shares. The application of these splits depends
on a number of variables, including the nature of the
field and the level of production. A standard sharing
split for conventional areas (i.e. not for frontier
production) to date would be for oil: BPMIGAS 85%,
contractor 15%; for gas: BPMIGAS 70%, contractor
30%.
These percentages reflect the position after tax, the
contractor being subject to Indonesian income tax. The
precise pre-tax percentages, specified in the PSC, will
differ accordingly and, therefore, will show the
contractor as receiving a somewhat greater percentage.
DMO. As noted above, the contractor may be
required to make a percentage of its share available to
satisfy domestic market obligations. This will be taken
from its equity sharing split of remaining production.
Where it is applied, DMO will operate differently to
the other parts of the production sharing mechanism,
since it will in fact comprise sales of oil and/or natural
gas by the contractor from its share. It will,
nevertheless, affect the return of the contractor and the
production available to it for its own purposes.
Production bonuses. For completeness, over the
course of the PSC, the state may also receive certain
bonuses based on the achievement of specified
cumulative production levels.
838
The sharing of production is effected at the point of
delivery.35 As standard practice, BPMIGAS can
appoint the contractor to sell the state’s share of oil
and/or natural gas. In that case, the contractor is
authorized to transfer ownership of the state’s share at
the point of delivery.36
Transfer of interests in PSCs
Under the Upstream Regulations, a transfer of part
or the whole of a contractor’s rights and obligations –
or “participating interest” – under a PSC requires
approval from the Minister.37 In practice, obtaining
this approval is dealt with through BPMIGAS and, in
accordance with the Upstream Regulations, takes into
account the considerations of BPMIGAS. In addition,
the terms of the PSC itself will require BPMIGAS’s
consent, as a party to the PSC, for such a transfer.
Notably, there is no requirement for consent from the
Minister or BPMIGAS regarding the change of control
of a PSC contractor.
Since PSC contractors are commonly special
purpose vehicles (indeed, the 2001 Law stipulates
that an entity can have an interest in only one
working area), in substance, a transfer of ownership
of the contractor itself can provide an alternative
means to transfer a participating interest. The
Upstream Regulations also introduce a new, and
potentially restrictive, provision in this area. Where
a contractor transfers the whole of its participating
interest to a non-affiliated company (not further
defined), and that is not currently a partner in that
working area, the Minister may request the
contractor “first to offer to national companies”.38
No further details are provided as to how such an
offer will occur. This provision, to the best of our
knowledge at the date of writing, remains to be
tested in practice.
Approval of first development plans
The approval of a development plan for the first
production from a working area has particular
significance for a number of reasons.
First, approval of the first development plan is
sometimes viewed as important to ensure that a PSC
continues into the exploitation period after the
exploration period. Although there is no reference to
the approval of the first development plan as a
condition of the PSC continuing beyond the end of the
exploration period – the reference, as noted above, is
simply to the discovery of commercial quantities of oil
35 GR 35, art. 55.
36 GR 35, art. 100.
37 GR 35, art. 33.
38 GR 35, art. 33.2.
ENCYCLOPAEDIA OF HYDROCARBONS

or natural gas39 – there is no other formal
confirmation of this continuation, and approval of the
first development plan can be viewed as ensuring that
this requirement has been satisfied.
Secondly, the first development plan needs
approval from the Minister – subsequent development
plans for a working area are approved by BPMIGAS.40
Thirdly, the Upstream Regulations (and typically the
PSC itself) provide that as of the approval of the first
development plan, the contractor shall offer a 10%
participating interest to a “Regional Government owned
business enterprise” and, failing take up of that offer
within sixty days, to “national companies”.41 Again,
there is no detail on the operation of this provision
although requirements for Indonesian participation have
been part of PSCs in the past. This is expected to be an
area of increased activity in coming years.
Role of the operator and taxation
In many PSCs, more than one contractor holds a
participating interest. Each of the contractors will hold
a percentage of the entire interest. In that case, one of
the contractors will be the operator of the asset. It is
worth noting that in these cases, BPMIGAS, in
administering the regulatory system, will generally
deal only with the operator. Therefore, for example,
where one of the other contractors needs to obtain
consent to transfer its participating interest, the
process of obtaining this consent will be dealt with
through the operator.
Taxation is beyond the scope of this Section.
Nevertheless, a few general comments in this area can
be made. Where a contractor is foreign incorporated,
by entering into a PSC it becomes a permanent
establishment taxable in Indonesia. A contractor is
obliged to pay taxes as part of its obligation to pay
state revenues.42 Historically, a largely special tax
regime has been applicable to upstream oil and gas
activities. Currently, greater emphasis is being placed
upon the application of general tax laws and
regulations for upstream activities, although this
remains a contentious area.
The 2001 Law and Upstream Regulations specify
that state revenue in the form of tax comprises “taxes,
import duties and other levies on import and excise
and regional taxes and regional retributions”.43 The
latter item remains an area of some difficulty as
discussed further below.
Notably, contractors now have the option under the
2001 Law and Upstream Regulations to stipulate in the
PSC that the obligation to pay taxes will be determined
in accordance with either the provisions of the tax laws
and regulations prevailing at the time of execution of
the contract or the provisions of prevailing tax laws
and regulations.44 The aim is to allow contractors
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flexibility to make their own assessment for the
purposes of business feasibility given the nature of
upstream activities as a long term investment,
involving commitment of significant capital and
significant risk.45 This concept provides a specific
example, embedded in legislation, of the sanctity of
contract principle for PSCs: the contractor can choose
to fix in the PSC the tax regime that will apply for the
duration of the contract.
12.15.5 Enviromental law
and regional autonomy
Environmental Law
Clearly, many areas of the general law in Indonesia
will apply to the oil and gas industry as to other
industries. Although this Chapter does not aim to
cover all areas of the general law relevant to upstream
oil and gas operations in Indonesia, at the current time
it would seem incomplete to review the regulation of
upstream activities without briefly covering two
particular areas of concern, environmental law and the
impact of regional autonomy.
The primary law in Indonesia relating to
environmental matters is Law No. 23 of 1997 on
Environmental Management (Environmental Law).
There are a number of related laws and regulations in
place, including some regulations made under previous
environmental laws, which have not been repealed and
are applied in practice to the extent not directly
contradicting the Environmental Law. This is an area
where precisely identifying the prevailing legal position
can be difficult for the reasons outlined above.
The Environmental Law deals with a number of
requirements regarding specific issues affecting the
environment. These include: obligations to treat waste,
a specific regime for hazardous and toxic wastes, and
requirements to meet discharge and environmental
quality standards in water and air.46 Each of these will
be of relevance to an upstream oil and gas project.
39 See note 25.
40 GR 35, art. 95, art 90 s. d).
41 GR 35, arts. 34 and 35.
42
Law No. 22 of 2001, art. 31.1 and 2; GR 35, art. 52
paras.1 and 2.
43 Law No. 22 of 2001, art. 31.2; GR 35, art. 52.2.
44 Law No. 22 of 2001, art. 31.4; GR 35, art. 53.
45 Law No. 22 of 2001, Official Elucidation to art. 31.4.
46 National standards for water and air are contained in
Government Regulation No. 82 of 2001 and No. 41 of 1999
respectively. Requirements for various types of emissions are
set in a number of other specific regulations. Regional
Governments have also enacted environmental standards that,
if more strict, may supersede the national standards.
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NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
An overarching element of the regime in the
Environmental Law is the use of the environmental
impact analysis process (AMDAL, an acronym based
on the Indonesian). AMDAL comprises preparation of
terms of reference and, on the basis of the terms of
reference, an environmental impact assessment,
an environmental management plan, and an
environmental monitoring plan. Only business
activities considered to have a significant impact on
the environment need to go through the AMDAL
process. Suffice to say, oil and gas upstream
operations are required to comply with the AMDAL
process.
The purpose of the AMDAL is to arrive at a
specific set of requirements for that business which
will ensure compliance with applicable environmental
standards. The fulfillment of the AMDAL process,
comprising of each of these elements, must be
approved by the central or regional government.
Allocation of responsibility in this area depends on the
application of recent changes to the regional autonomy
regime, the implementing regulations for which have
not been enacted at the date of writing. The prevailing
view, at least in central government, is that this
remains a matter for central government.
In oil and gas projects, performance in accordance
with the AMDAL is monitored,47 a task carried out by
an office of the Ministry of Energy and Mineral
Resources or the regional government (depending on
the allocation of responsibility as referred to in the
preceding paragraph). This comprises supervision of
the implementation of the environmental management
plan and monitoring plan, as comprised within the
AMDAL.
Of note in this context is the regime for treatment
of hazardous and toxic waste – the so-called ‘B3’
wastes – contained in separate Government
Regulations.48 Oil and gas upstream operations are
identified in these regulations as a source of particular
categories of B3 waste (drilling mud, oil sludge, used
active carbon, other sludges and drill cuttings). This
regime sets out particular requirements for
management of these types of waste.
As an industry-specific supplement to these
matters, a Regulation of the Ministry of Mines dating
from 1973,49 which still appears to be in force,
expressly prohibits discharge of oil, drilling mud, or
other toxic mud into the sea. This also requires that an
oil and gas project have in place an emergency plan,
approved by the Director General of Mining,
containing mitigation measures to address pollution
issues arising from activities. It can be assumed, in any
event, that such discharges and pollution would breach
other provisions of current environmental laws and
regulations in Indonesia. In mid-2006, hot and foul
840
smelling mud started to erupt from near the site of an
exploration well being drilled onshore in East Java. It
is alleged that this is the result of an incident and loss
of control during drilling. The impact on the
surrounding area and population has been enormous,
displacing thousands of people and disrupting
business and industry. There is no sign yet of the mud
flow abating and the story looks like having several
yeas to run. Both in the short term and longer term it
can be anticipated that this may give rise to changes in
regulation and practice in these areas.
In recent years, the environmental issue of
abandonment of installations has attracted significant
attention in other jurisdictions. In Indonesia, the legal
position of contractors with respect to abandoned
installations remains somewhat piecemeal. The
ultimate ownership of oil and gas installations rests
with the government.50
Neither the 2001 Law and Upstream Regulations
nor the Environmental Law, that spell out an obligation
of contractors to deal with installations after their
operations. Under the current system, the existing
obligations appear more likely to arise under the terms
of the PSC. The Upstream Regulations provide that a
contractor should allocate funds for post-operation
activities and that the procedure for use of this fund be
stipulated in the PSC.51 Both in the Upstream
Regulations and the 2001 Law, post-mining operation
obligations are listed as one of the items for inclusion
in a PSC.52 Neither the Upstream Regulations nor the
2001 Law specify exactly what the post-operation
obligations of the contractor should be.
Notably, the standard form of PSC used since 1995
contains provisions in this area. It allows for
accumulation of funds for post-operation activities and
sets out several post-operation obligations to be
fulfilled. These are expressed in somewhat general
terms and focus on obligations to prevent further
damage to the environment from old wells. They do
not go so far as to spell out an obligation to remove or
otherwise deal with disused installations, although this
may be implied. Given the periods involved, the
application of these provisions has not yet been tested.
Further developments may be needed in this area in
due course to provide greater clarity about the
obligations falling on contractors. It can also be
47 Law No. 23 of 1997, art. 22; see also Government
Regulation No. 27 of 1999.
48 Government Regulation No. 18 of 1999 concerning
Management of Hazardous and Toxic Waste Materials.
49 Ministry of Mines Regulation
No. 04/PM/pertamb/1973 of 1973.
50 GR 35, art. 78.
51 GR 35, art. 36.
52 Law No. 22 of 2001, art. 11.3; GR 35, art. 26.
ENCYCLOPAEDIA OF HYDROCARBONS

queried whether it will be appropriate on an ongoing
basis to try to deal with an issue of this magnitude,
which has attracted public attention in other
jurisdictions, in what is ultimately a private contractual
document.
Regional autonomy
Two important regional autonomy laws were
enacted in 1999, which were relevant to the regulation
of upstream oil and gas activities.53 These came into
effect on 1 January 2001. Following amendments in
2004, the relevant laws are now Law No. 32 of 2004
on Regional Autonomy; and Law No. 33 of 2004 on
Fiscal Decentralization.
The Regional Autonomy Law grants authority to
regional governments to deal with a variety of
consultation and other rights in connection with
upstream oil and gas investments made within their
regions. Under the 2001 Law and Upstream
Regulations, there are various rights provided to
regional governments, such as consultation rights in
relation to the determination of working areas to be
offered,54 and with respect to approval of the first
development plan in a working area.55
The Upstream Regulations also contain some
generally expressed provisions concerning the
obligation of contractors with regard to the
development of the local community.56 These
provisions refer vaguely to potential aspects, such as
“improving the residential environment of the
community so as to bring about harmony between the
contractor and the surrounding community”,57 and
benefits “in-kind in the form of physical infrastructure
and facilities”.58 There is no detailed discussion of
what is needed to fulfill requirements in this area. The
Upstream Regulations provide that in activities to
develop the local community, a contractor
“co-ordinates with the Regional Government”.59 In
some cases, regional governments, apparently under
the aegis of this provision and the Regional Autonomy
Law, have negotiated directly with contractors with
regard to benefits for the locality.
The Fiscal Decentralization Law contains
provisions for increased tax and revenue sharing
between Indonesia’s central government and the
regional governments. Again, this principle is
recognized in the 2001 Law and Upstream
Regulations. Part of the contractors’ obligation to pay
state revenues comprises regional taxes and
retributions.60
The operation of these aspects of regional
autonomy has been a key concern in recent years for
investors in the oil and gas sector. Investors are now
required to deal with regional governments as well as
central government. The regional governments, de facto,
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INDONESIA
have the ability to restrict or impede their operations.
Investors are concerned by the lack of coordination
of the overall position. Consultation and other rights
(and in particular, the right to levy taxes and
negotiate other local benefits) can be exercised in an
apparently haphazard and inconsistent way. Indeed,
the central government has reportedly revoked
numerous over-reaching regional government
bye-laws over recent years in an effort to improve
this aspect of the investment climate. At present, the
problem remains.
12.15.6 Downstream business
activities
Background
Downstream business activities are defined in the
2001 Law as business activities focused or based on
the following:
Processing. Activities of refining, obtaining
derivatives, enhancing the quality and increasing the
added value of crude oil and or natural gas, excluding
field processing.
Transportation. The activity of transferring crude
oil, natural gas and/or the products of their processing
from the working area or from the collection and
processing area, including the transport of natural gas
through transmission and distribution pipelines.
Storage. Activities of receiving, collecting,
gathering and/or releasing crude oil and/or natural gas.
Trading. Activities aimed at purchasing, selling,
exporting or importing crude oil and/or the products of
its processing, including the trading of natural gas
through pipelines.61
In October 2004, provisions of the 2001 Law were
supplemented with the enactment of Government
Regulation No. 36 of 2004 concerning Oil and Natural
Gas Downstream Business Operations (Downstream
Regulations).
Downstream activities in oil and gas were
previously the exclusive preserve of Pertamina as a
government monopoly. The 2001 Law, now
supplemented by the Downstream Regulations,
introduced a new regulatory system based on the grant
53 Law No. 22 of 1999 on Regional Autonomy and Law
No. 25 of 1999 on Fiscal Decentralization.
54 Law No. 22 of 2001, art. 12; GR 35, art. 3.2.
55 Law No. 22 of 2001, art. 21.1; GR 35, art. 95.2.
56 GR 35, Chapter VIII.
57 GR 35, art. 74.2.
58 GR 35, art. 77.
59 GR 35, art. 76.1.
60 Law No. 22 of 2001, art. 31.2; GR 35, art. 52.2.
61 Law No. 22 of 2001, art. 1 paras. 10, 11, 12, 13 and 14.
841
NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
of business licences for specific downstream activities.
There are opportunities now for private participation
in downstream activities although lack of or limited
precedent is still tending to slow the bureaucratic
process farther. Private companies are gradually
having an impact, however, most visibly retail petrol
stations in an around Jakarta mentioned above,
although there remain structured impediments in the
broader retail market.
In many respects, the rules and regulations
applicable to downstream activities are those
generally applicable to business activities in Indonesia
(many or most of which involve the grant of business
licences for the relevant activities). Certainly,
downstream activities are not regulated by the special
PSC-based system as described for upstream activities
or any equivalent.
Downstream business activities can only be carried
on by business entities incorporated in Indonesia,
pursuant to a business licence issued by the Minister.62
As with upstream operations, the Minister is, in
practice, represented by the Directorate General of Oil
and Gas. Although only Indonesian incorporated
entities can hold such licences, these can be
Indonesian subsidiaries of foreign investors.
Regulation and supervision
Regulation and development of downstream
activities are overseen by the Minister with input from
BPHMIGAS and other related agencies, and
downstream activities generally are supervised by the
Minister.63 BPHMIGAS is responsible for regulation
and supervision of fuel-oil supply and distribution, and
transportation of natural gas by pipe.64 As these activities
are part of the general scope of downstream
activities, they are to be carried out by entities holding
business licences granted by the Minister.
A business licence will only cover one type of
downstream activity (except in certain cases where
transportation or storage, or, in more limited cases,
trading are considered as a continuation of or support
to another activity, in which case they will also be
covered by the relevant licence for that principal
activity).65 A single business entity can be granted
more than one downstream business licence.66 An
entity that is a contractor in a PSC cannot also hold a
licence for downstream activities.67 The regulation of
processing to produce lubricants and petrochemicals is
done jointly by the Minister of Energy and Mineral
Resources (through the Directorate General of Oil and
Gas) and the minister in charge of industry.68
Distribution and transportation of natural gas
Increased domestic use of natural gas is an
officially acknowledged target in Indonesia. At
842
present, there is very limited gas infrastructure in
Indonesia. It is hoped that the ability of private
companies to carry on the business of gas
transportation as part of downstream activities may
play a role in developing this infrastructure. A number
of special provisions in the 2001 Law and Downstream
Regulations relate to the distribution and
transportation of natural gas.
In order to transport natural gas by pipe, a business
entity must hold a “Special Right” as well as a
business licence.69 A Special Right is granted by
BPHMIGAS and gives the recipient the right to carry
out transportation of natural gas by pipe in an
identified area of a transmission network or
distribution network.70 These areas will form part of
the “National Natural Gas Distribution and
Transmission Network Master Plan”, expressly
provided for in the 2001 Law and the Downstream
Regulations. This is established by the Minister and is
an evolving document, which is envisaged to change
over time.71
A business enterprise transporting natural
gas by pipe must give access to other parties to
use the facilities it owns to transport natural
gas “with due regard to technical and
economic aspects”.72 The tariff, which can be
levied, is to be determined by BPHMIGAS
with “due regard to the economic calculation
of the business enterprise’s, users’ and
consumers’ interests”.73
Although some of the relevant concepts
appear to be contemplated, these provisions do
not provide the level of detail that has been
necessary elsewhere to successfully establish
and operate open-access gas transmission and
distribution networks. At the date of writing, it
remains to be seen whether these provisions
can be used successfully in the development
and operation of gas distribution and
transmission networks in Indonesia.
62 Law No. 22 of 2001, art. 23; GR 36, arts. 2 and 13.
63 GR 36, arts. 3, 4 and 6.
64 GR 36, art. 7, Presidential Decree No. 86 of 2002,
art. 4; Government Regulation No. 67 of 2002, art. 3.
65 Law No. 22 of 2001, art. 23.2; GR 36, art. 16.1,
art. 18.1 and art. 19.1.
66 Law No. 22 of 2001, art. 23.3.
67 Law No. 22 of 2001, art. 10.
68 GR 36, art. 25.
69 GR 36, arts. 9.1 and 27.
70 GR 36, art. 1.14; Presidential Decree No. 86 of 2002,
art. 6; Government Regulation No. 67 of 2002, art. 5.
71 Law No. 22 of 2001, art. 27.1; GR 36, art.1.11,
art. 34.2.
72 GR 36, art. 31.1.
73 GR 36, art. 33.
ENCYCLOPAEDIA OF HYDROCARBONS

Availability and distribution of fuel-oil
Prices
The 2001 Law acknowledges fuel-oil as a “vital
commodity which affects the livelihood of many
people” in Indonesia.74 A chapter of the Downstream
Regulations is concerned with ensuring availability
and distribution of fuel-oil.75 This provides that trading
of certain types of fuel-oil should be based on the
categorization of different areas: those where
a market mechanism is already in effect, those where a
market mechanism is not yet in effect, and ‘isolated
areas’, being those difficult to reach and/or with
limited transportation infrastructure involving a high
distribution cost.
BPHMIGAS is to establish joint utilization of
transportation and storage facilities in supply, and
distribution of certain types of fuel-oil “particularly
for areas where a market mechanism is not yet in
effect and for isolated areas”.76 The government can
determine a limit to retail prices in areas where a
“mechanism of healthy, fair and transparent business
competition is not yet and/or unable to be established”
based on inputs from BPHMIGAS.77
The 2001 Law stipulates that, generally, prices for
fuel-oil and natural gas be left to a “mechanism of
healthy and fair business competition”.78 It goes on to
note that this pricing policy does not reduce the
government’s social responsibility to certain groups of
society.79 The Official Elucidation states that the
government may provide special assistance to replace
subsidies to certain consumers for the utilization of
certain fuel-oil, and that the government determines
the natural gas pricing policy for household and small
consumers and certain other uses.80 The Downstream
Regulations reflect these provisions.81
The provisions in this area were another aspect of
the 2001 Law with which the Constitutional Court was
not happy in its decision in December 2004, referred to
above. The Court felt that the government needed
broader control over prices of these products. A key
concept behind the Constitution was national unity. The
Court was sceptical about a market mechanism
operating effectively throughout the enormously varied
Indonesian archipelago. National unity would, therefore,
require a more general pricing control. Whatever the
rights and wrongs of this decision, in the current
environment it remains an academic debate. There was
and is, for practical reasons as much as anything, no
immediate prospect of a competitive market for supply
of fuel-oil or natural gas in Indonesia.
Crossover between downstream and upstream
Notwithstanding the distinction drawn in non-
specific terms in the 2001 Law, as a general principle,
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INDONESIA
it appears open to upstream contractors to carry on, as
an extension of their upstream activities, activities that
would otherwise be downstream.82 In that case, these
activities will not fall within downstream, and a
separate business licence will not be required.
In addition, the costs associated with these
activities can form part of the contractor’s operating
costs, which can potentially be recovered by the
contractor from its cost recovery share of production.
For major investments in, for example, LNG plants,
the preference of investors, for the time-being at least,
would appear to be for these to remain part of the
special PSC regime for upstream projects. For the
relevant facilities to be an extension of upstream
activities, they should be used for the contractors’ own
purposes, and must not be developed with the
intention of profiting from these activities alone. This
will not be the case if the facilities are to be used to
earn profits by charging fees for use by other parties.83
12.15.7 Settlement
of legal disputes
For foreign investors in any jurisdiction, confidence
in their ability to obtain transparent resolution of
legal disputes and enforcement of legal rights is an
issue of concern. Foreign court judgments are not
directly enforceable in Indonesia. If judgment is
obtained in a foreign court, the case must be
contested again on the merits in Indonesia, and a
foreign court’s decision will be given such weight as
the Indonesian court considers appropriate. The
perceived ability and willingness of domestic
interests to exploit weaknesses in the court system to
their own advantage have caused foreign investors to
wish to avoid the courts in Indonesia.
As a result, many foreign investors seek to have
their disputes settled by arbitration. In August 1999,
the law in this area was overhauled and a new
framework was put in place with the enactment of Law
No. 30 of 1999 regarding Arbitration and Alternative
Dispute Resolution (Arbitration Law).
74Law No. 22 of 2001, art. 8.2.
75
GR 36, Chapter XI; Presidential Decree No. 86 of
2002, Chapter II; Government Regulation No. 67 of 2002,
Chapter II.
76 GR 36, arts. 67 and 68.2.
77 GR 36, art. 68 paras. 3 and 5.
78 Law No. 22 of 2001, art. 28.2.
79 Law No. 22 of 2001, art. 28.3.
80 Law No. 22 of 2001, Official Elucidation to art. 28.3.
81 GR 36, art. 72.
82 Law No. 22 of 2001, art. 26.
83 Law No. 22 of 2001, Official Elucidation to art. 26.
843
NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY
The Arbitration Law is not perfect and some
difficulties remain, including the readiness of local
parties to contend that a dispute relating to an
agreement containing an arbitration clause should be
heard by the courts as, for example, a claim in tort.
Nevertheless, the Arbitration Law represents a
significant step forward, and it sets out positively and
clearly some key principles, the application of which is
becoming more consistent and predictable over time.
Centrally, the Arbitration Law provides that parties
to an existing or potential dispute may enter into an
agreement to arbitrate.84 When entering into a
contract, this will take the form of an arbitration clause
as part of that contract. The courts have no jurisdiction
to adjudicate disputes between parties who have made
an arbitration agreement.85 There are certain
formalities and contents required in order to form a
valid arbitration agreement, particularly if the dispute
has already arisen.86 It is worth the effort to ensure
that a valid arbitration agreement is created. The
arbitration provided for can be institutional or ad hoc,
and, in the former case, through a domestic or
international body.
The Arbitration Law provides a procedure both for
the recognition and enforcement in Indonesia of
foreign arbitral awards and Indonesian awards.
Indonesia ratified the New York Convention 1958 in
1981, and there have been regulations dealing with
enforcement of foreign awards since 1990.87 However,
this remained a troublesome area, and the new law acts
to update and, in some respects, to centralize the
procedures.
The Arbitration Law now unequivocally provides
for foreign arbitral awards to be enforceable on the
basis of an exequatur from Central Jakarta District
Court, provided that the award was given in a country
bound by a bilateral or multilateral treaty with
Indonesia regarding enforcement of foreign awards,
and that the award is not contrary to public order and is
considered within the scope of ‘commercial law’ (only
disputes relating to commercial law and thus dealing
with the private rights of parties can lawfully be the
subject of resolution by arbitration in Indonesia).88
Notably, the contractual concessions under which
upstream oil and gas operations in Indonesia are
carried out provide, in their standard form, for disputes
to be subject to arbitration in accordance with the rules
of the International Chamber of Commerce.
12.15.8 Currency controls
In essence, there is currently no regulation or
restriction of exchange or movement of foreign
currency reserves in Indonesia. There are restrictions
844
on the transfer of Indonesian Rupiah by and to
non-resident parties. This is, however, a relatively rare
objective foreign investors will wish to achieve.
Indonesian Rupiah can be converted into dollars
through the banking system in Indonesia. Parties in
Indonesia making or receiving foreign currency
payments over a prescribed threshold are required to
provide certain information to their bank relating to
those payments in order for their bank to make
administrative reports to Bank Indonesia.
If an Indonesian borrower (which would include an
Indonesian company owned by a foreign investor)
enters into a loan agreement with an overseas party, a
report must be made to Bank Indonesia, and a copy of
the loan agreement must be filed with Bank Indonesia.
Failure to do so within ten days results in a penalty,
which accumulates for each further day of delay.
As a matter of domestic law in Indonesia,
investment protection for foreign investors is part of
the system under which foreign investment (or PMA,
by its Indonesian abbreviation) companies are set up.
Under that regime, investors in such companies must
obtain approval of a specified government agency to
make the investment, and are then given certain basic
protections: a guaranteed right of repatriation of
invested capital and after tax profits, and a guarantee
of “fair compensation” in the event of nationalization
of the investment.89
In the oil and gas sector, foreign investors who
operate through Indonesian incorporated foreign
investment companies will benefit from these
protections. This will apply to foreign investors in
downstream activities, where such an entity is required
but it is a rare practice in upstream activities. In
upstream activities, foreign investors can, and
normally do, participate through foreign incorporated
entities. In that case, the foreign investment approval
regime will not apply and the investor will need to rely
on its contractual rights against the government under
its concession for oil and gas operations.
An area of international law of which investors
are increasingly aware is the protections provided
under either bilateral investment treaties or
multilateral treaties. A discussion of these treaties
84
Law No. 30 of 1999, art. 2 et seq.
85 Law No. 30 of 1999, art. 3. Note also art. 11, which
states that parties waive their right to have their dispute
resolved by a national court when they agree to arbitration
and also restricts the rights of the courts to intervene.
86 Law No. 30 of 1999, arts. 4 and 9.
87 See generally Law No. 1 of 1967 as amended by Law
No. 11 of 1970.
88 Law No. 30 of 1990, art. 66.
89 See generally Law No. 1 of 1967 as amended by Law
No. 11 of 1970.
ENCYCLOPAEDIA OF HYDROCARBONS

lies beyond the scope of this Chapter. Notably,
Indonesia, as part of the Association of South East
Asian Nations (ASEAN), is party to the ASEAN
multilateral treaty called the Agreement for the
Protection and Promotion of Investments. Indonesia
has also entered into forty-five bilateral investment
treaties (although not all of these have so far come
into force).
While each treaty needs to be considered for its
own specific terms, as a broad generalization, they
afford protection to private investors based in the
jurisdiction of one treaty party from undue
interference, or expropriation, at the hands of the
government of another treaty party. The
host government need not be directly party
to the investment in order for an investor to invoke the
protection. Expropriation can cover steps that are less
direct than classic nationalization but deprive the
investor of the value of its investment. However,
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needless to say, this can leave scope for debate and
interpretation.
Importantly, most of the relevant treaties provide
for international arbitration as the preferred method for
dispute settlement, often under UNCITRAL
(United Nations Commission on International Trade
Law) rules, or ICSID (International Centre for
Settlement of Investment Disputes) rules. Thus,
these treaties may well give a foreign investor, who
feels aggrieved by government action, the ability to
take the issue outside the Indonesian courts (and
instead to international institutions with credibility
in the international community) and the benefit of
indirect policing by bodies such as the IMF and
World Bank.
Mark Newbery
Partner, Herbert Smith Law Firm
London, United Kingdom
845
 13.1
Contractual regulation
with respect to exploration for
and production of hydrocarbons
13.1.1 The oil contract
The oil contract is one of the most significant examples
of a particular type of contract characteristic of
international trade, the so-called state contract (in
French contrat d’État). It is in fact a contract, concluded
between a state (or a public entity) and a private person
(sometimes a physical person but more frequently a
legal person), the content of which is the carrying out
by the private party of a particular activity in the oil
sector, that is the exploration for and production of
liquid and gaseous hydrocarbons as well as the
downstream activities of transport and refining. Such
activities are carried out on the basis of an agreement
with the entity (the state or a public entity) that retains
ownership of, and the right to exploit, natural oil
resources. In return for the assignment of such rights, in
the ways and to the extent envisaged in individual
contracts, the private party assumes the obligation to
carry out the oil-related activity in conformity with the
terms and conditions agreed with the other party, and
agrees to invest the economic, technical and managerial
resources necessary for the best development of the oil
resources referred to in the contract.
As practical experience shows, also historically, this
type of contract is concluded for various reasons. Among
these, at least in an initial phase, is the absence of a set of
relevant rules in the contracting state or the circumstance
whereby the domestic legal system itself requires that the
oil-related activity be carried out on the national territory.
This can be achieved on the basis of a contractual
relationship with the state or with the public entity that
has been put in charge of the activities in this sector by
the state. On the other hand, in the more evolved legal
systems, both civil and common law, exploration for and
production of hydrocarbons are carried out by private
persons on the basis of a title (licence or mining title, an
administrative act) granted by the local authority to the
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private person on the basis of the laws governing
hydrocarbons or mines in general. The present
contribution aims at considering only the first situation
described, namely one featuring the presence of a
contractual relationship between a state (or a public entity
of a determined state) and a private person.
From the oil contract’s characteristics mentioned
above derives the connection between the type of
contract under consideration and the subject of private
investment in developing countries as well as the
protection of such investment. In fact, a characteristic
of the oil contract is the great size of investments
needed on account of the high level of risk involved in
the exploration for hydrocarbons; hence the need for
effective protection of the private party’s investment.
The oil contract, as such, fully falls within the
broader category of investment contracts, a matter
analysed in the international literature with particular
regard to the problems of protecting private investment
as well as of the bilateral and multilateral international
instruments implemented by different states to ensure
such protection.
As, in actual fact, with a view to the economic
development of the country on whose territory the
activity is carried out, the oil contract has been
included in the category of economic development
agreements. Legal writings of the 1960s dedicated
particular attention to this type of contract above all
with regard to the problem of the applicable law on
account of the particular characteristics of the contract
in question (Hyde, 1963).
13.1.2 Legal regulation
Nature
The nature of the legal rules governing oil
contracts is of particular importance. It varies
847
CONTRACTUAL REGULATION AND SETTLEMENT OF DISPUTES
according to the legal system of the state on whose
territory the related activity is carried out, as well as to
the characteristics of the individual contract. In
relation to these factors the applicable rules have been
considered, on a case by case basis, either as part of
the state’s public law or as private law, depending on
whether the state is party to the contract iure imperii
(i.e. in the exercise of its sovereign prerogatives in
the pursuance of the public interest) or iure gestionis
(i.e. as if it were acting as a private party).
In consideration of the fact that under an oil
contract a natural resource which is the heritage of the
state is being put at the disposal of a private party and
rights are granted to exploit that resource, it seems that
this type of contract, as concerns various aspects,
cannot escape the application of the public law
whereby the state regulates fundamental sectors of its
economy. The inequality of the parties to this type of
contract derives precisely from the fact that the state
(or the public entity delegated by the state) intervenes
as a party to the contract in the capacity of defender of
the public interest.
Hence, the need to distinguish between the
contractual regulation governing the parties’ rights and
obligations and the state’s power to safeguard the
public interest underlying the oil contract when
considering that through such contract a natural
resource, which is property of the state, is exploited.
Such a distinction, although not easy to draw in view
of the diversity of national legal systems, is of utmost
importance in establishing the extent to which the oil
contract (as any other contract concluded with a state),
being an administrative contract, is subject to the
principles of public law.
The administrative contract
The category of administrative contracts, as public
law contracts, has mainly developed in the French
legal system. The French model, which was adopted in
Egypt following the work of the great jurist al-Sanhuri
(1948), was subsequently introduced via this country
in many Arab states (Iraq, Syria, Libya, Qatar, Kuwait,
United Arab Emirates, Algeria, Sudan, Lebanon,
Yemen, Tunisia, Morocco and still others). The
Egyptian Civil Code governs a special category of
contracts, the concession of services of public utility,
subject (as are other contracts having the same
characteristics) to special rules and to the jurisdiction
of a special court (the Conseil d’État in France, Egypt
and other states whose legal culture is French; the
Administrative Law Chamber in other Arab states).
The conditions according to which each legal
system recognizes that specific contractual
relationships are in the nature of a public law
contract depend largely on each system’s concept of
848
public interest and the guarantees it provides to
safeguard it. From a general point of view, the
notion of public contract in the various legal systems
indicates the state’s power to adopt unilateral
measures whenever the protection of public interest,
as interpreted by the state, so requires. Among such
measures is the power to modify contractual terms
on account of supervening changed circumstances,
according to the principle of changing circumstances
recalled in the Resolution No. 16 of 25 June 1968,
para. 90 of the Organization of the Petroleum
Exporting Countries (OPEC; see below) and even
the extreme measure of revocation of the contract in
the presence of specific conditions.
In consideration of the possible subjection of the
oil contract to the principles of the contracting state’s
public law, the private party has attempted to provide a
series of contractual conditions and guarantees aimed
at reducing the risk of intervention by the state in the
exercise of its regulatory powers to protect public
interest (see below).
13.1.3 Contractual regulation
Characteristics
The most significant characteristics of the
contractual regulation regarding oil contracts can be
summarized as follows:
• One of the contracting parties is a state, a Ministry
or a state-controlled entity that, while formally
autonomous, is acting on behalf of its country’s
government. This is the case of the numerous state-
owned companies that have been created, since the
1950s in oil-producing countries, such as the
Egyptian General Petroleum Corporation (EGPC),
the National Iranian Oil Company (NIOC), the
Iraqi National Oil Company (INOC), Sonatrach in
Algeria, the Nigerian National Petroleum
Corporation (NNPC), the Libyan National Oil
Company (LNOC), Pertamina in Indonesia,
Yacimientos Petrolíferos Fiscales (YPF) in
Argentina, the Pedevesa (PDVSA, Petróleos De
Venezuela Sociedad Anónima), the CNOOC in
China and others.
• The object of the contract consists in an activity to
be conducted in a specified area of the state’s
territory for the exploration for and development of
hydrocarbons together with the activities of
transportation, stockpiling, refining, exporting and
marketing connected to the primary activities.
• Essential to carrying out the activity envisaged in
the contract is the investment in the territory of the
state, both in terms of capital as well as technology,
goods, services and managerial capacity.
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 CONTRACTUAL REGULATION WITH RESPECT TO EXPLORATION FOR AND PRODUCTION OF HYDROCARBONS
• A long-term relationship is established between the
parties lasting, in an initial phase, about fifty to
sixty years and more recently lasting not less than
thirty years.
• The regulation envisaged by the contract tends to
be complete: the private party, in fact, attempts to
regulate its relations with the state in the contract
as much as possible, in order to limit possible
interference by domestic laws.
• Particular clauses relative to the law applicable to
the contract and the rules for settling disputes by
arbitration are regularly found in order to provide
the private party the best protection against
interference by domestic laws and courts.
Given their importance, both in the framework of
contractual instruments for the protection of
investments and for the evolution of the contractual
relations between the parties, the matters of applicable
law and arbitration deserve particular consideration.
The applicable law clauses and the arbitration
clauses
Among the instruments developed by the oil
contracting practice designed to guarantee adequate
protection for foreign investment in the sector of
exploration for and production of hydrocarbons, the
applicable law clause and the arbitration clause have
always constituted conditions for a positive outcome of
negotiations between the private party and the state
recipient of the investment. They are two contractual
provisions related to one another because, as
demonstrated by relevant arbitral awards (see Chapter
13.3), an international arbitrator has systematically
applied the parties’ choices of law even where, in
contrast with the principles regulating conflicts of
laws, a-national rules have been chosen instead of
domestic legal systems (to which the state conflicts
systems usually refer). In addition to these two
protective measures widely adopted in oil contracting
practice there is a series of further contractual
provisions (see below).
The traditional principle with respect to the
applicable law, affirmed by the Permanent Court of
Justice (today the International Court of Justice) in the
case concerning Serbian and Brazilian loans in 1929
is, as is known, that contracts between states and
private parties are subject to the laws of the state party
to the contract. This also in relation to the fact that
such contracts, among which oil contracts are
included, are normally performed on the territory of
the state. Therefore, the conflict rule lex loci
executionis applies.
The intervention of the law of the state recipient of
the investment could not, however, satisfy the private
party’s need to guarantee its contractual relationship
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with the state, an adequate degree of stability of the
conditions stipulated and predictability as to their
application over time. It was therefore necessary for
the private party to remove what French doctrine so
effectively refers to as l’aléa de la souveraineté, i.e.,
the risk that the state party to the contract may resume
the role of sovereign state during the course of the
relationship in order to modify its legal regime,
altering to its own advantage (although by taking
measures of a general nature) the contractual terms
freely agreed with the private party.
Hence the search for techniques for formulating
applicable law clauses aimed, in some cases, at
internationalizing the contractual relationship by
subjecting it to international law and, in others, at
denationalizing it by means of a reference to “the
general principles of law recognized by civilized
nations” (Statute of the International Court of Justice,
art. 38, para. 1, c), or to the principles of law common
to both the state party to the contract and to the state
of which the private party to the contract is a national
(the tronc commun, in the words of the contract
between Agip Mineraria and the National Iranian Oil
Company, of 1958) or, lastly, by freezing the law of the
state on the signature date of the contract (a technique
which was adopted in the contract between Agip and
Tunisia in the 1970s).
In this context of denationalization of the oil
contract, the choice of law is to be considered as
contained in the oil concession agreements with Libya
(before the revolution of 1969), according to which
“The Concession shall be governed by and interpreted
in accordance with the principles of law of Libya
common to the principles of international law and in
the absence of such common principles then by and in
accordance with the general principles of law,
including such of those principles as may have been
applied by international tribunals” (ICCA, 1979). In
view of the complexity of its formulation, it is not
surprising that such reference has been the subject of
diverging interpretations in the three arbitral awards
rendered after the Libyan nationalizations of 1970 (see
Chapter 13.3).
The choice of international arbitration as the sole
method for settling disputes arising from oil contracts
has historically been of substantial relevance. As in the
case of the choice of a legal system different from that
of the state party to the contract, the exclusion of the
jurisdiction of domestic courts has raised sensitive
issues in view of the state’s consequent abstention
from exercising sovereign prerogatives.
In addition to the tenacious resistance put up in this
regard by the states of Latin America in the name of
the doctrine elaborated in the second half of the
Nineteenth century by the Argentine jurist Carlos
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CONTRACTUAL REGULATION AND SETTLEMENT OF DISPUTES
Calvo, known as the Calvo doctrine (according to
which disputes must be submitted to the exclusive
jurisdiction of domestic courts), states have invoked
international law principles concerning their immunity
from jurisdiction. Alongside the progressive
re-dimensioning of such principles with the
acceptance of so-called restricted immunity (restricted,
that is, to the exercise of sovereign prerogatives,
excluding acts performed iure gestionis by the state),
over time it has been held that immunity from
jurisdiction can be waived, even implicitly, and that a
state’s acceptance of arbitration implies such a waiver.
On the other hand, for the private investor
international arbitration represents a condition that
cannot be renounced not only to avoid disputes arising
from oil contracts being decided by domestic courts,
which are perceived as being subject to political
influence by the contracting state, but also to
guarantee the actual enforcement of applicable law
clauses referring to a-national rules, which are usually
accepted by the international arbitrator, where the
same reference would have not foreseeably had the
favour of the state’s judge.
Other contractual provisions
Among the further contractual provisions aimed at
strengthening the protection of the private party with
respect to the regulatory power of the state party to the
oil contract, are:
• The clause according to which the contract has the
force of law of the state (Petroleum Concession
Agreement, art. 34.4, concluded in 1975 by the
Ruler of Sharjah, one of the United Arab
Emirates).
• The intangibility clause, whereby the state
undertakes not to modify contractual terms unless
by mutual agreement (contract between Agip
Mineraria and the Iranian NIOC, of 1958, art. 39;
Mozambique model production sharing agreement
of 2000, art. 30.7, d and e).
• The stabilization clause, whereby the state assumes
the obligation not to enact laws or regulations
contrary to the content of the oil contract or, at any
rate, not to apply them to the detriment of the
private party to the contract and not to derogate
from specific contractual guarantees such as those
concerning taxation, customs, currency and the
like. In some cases the law itself makes provision
for the stabilization of contractual conditions, as
evident in the Oil Law of Kazakhstan (Law
No. 2350/1995, art. 57), the Nepalese model
production sharing agreement 1994 (art. 70.1), the
Petroleum Code of the Côte d’Ivoire (Law
No. 669/1996, art. 18, lit. m). Stabilization clauses
in oil contracts present a wide variety of
850
formulations concerning the time limitations for
such guarantees and the matters covered by those
guarantees as well as the reciprocity in favour of
the state (Montembault, 2003).
• The obligation to renegotiate the contractual
conditions in case of a change in circumstances,
with the possibility of submitting any
disagreements that might arise to international
arbitration for settlement, according to what has
been provided by some national laws (the Russian
Oil Law on production sharing contracts of 1999,
art. 18.2) or by the various national model
production sharing agreements (the Ivorian model
of 1997, art. 36.2; the Chinese model of 1992,
art. 28.2; the Angolan model of 1997, art. 37.4)
or by concession (the Egyptian model of 1998,
art. 19; Bernardini, 1998).
Bilateral treaties for the protection of investments
The oil contract is therefore of fundamental
importance in creating the conditions necessary to
avoid its subjection to the legislating power of the state
in which the activity is being carried out. Forms of
protection are provided in the bilateral treaties for
the protection of investments concluded by the great
majority of states having most diverse political, social
and legal systems. Their number had, by the end of
2005, exceeded 2,400. These Bilateral Investment
Treaties (BITs) make provision for direct access by
private investors (in this case the oil companies) to
mechanisms for settlement by arbitration of disputes
with the state in case of violation of the guarantees
agreed in the BIT with the investor’s state.
Such guarantees reflect commonly recognized
standards of treatment: fair and equitable treatment;
non-discrimination; most favoured nation treatment; as
well as a series of further guarantees such as those
relating to the use of freely convertible currencies, the
freedom to transfer them abroad and the compensation
due in case of nationalization or expropriation of the
private investment.
13.1.4 The evolution
of the oil contract
The development over time of the contractual relations
between states and private persons with respect to oil
has been influenced particularly by the evolution of
the contracting parties’ relationships with respect to
the strength of their positions. There are three phases
in which in a completely conventional manner this
evolution may be distinguished: the phase of the oil
concession; the phase of participation by the state; the
phase of the new generation of oil contracts.
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 CONTRACTUAL REGULATION WITH RESPECT TO EXPLORATION FOR AND PRODUCTION OF HYDROCARBONS
The oil concession
In an initial phase, which may be identified in the
period culminating at the end of the 1950s, the
disparity of positions between the two parties from a
legal point of view (on the one hand a sovereign state,
even though it may often lack a developed legal
system and, on the other, an oil company of the
industrialized world) was counterbalanced by the
economic power of the oil companies, the famous
‘seven sisters’: British Petroleum (BP), Exxon
(formerly Standard Oil of New Jersey), Gulf, Mobil,
Royal-Dutch Shell, Standard Oil of California
(SOCal) and Texaco, which were often sustained by
the state to which they belonged (as made evident by
the case of the Anglo-Iranian Oil Company, for whose
protection against Iran Great Britain brought an action
before the International Court of Justice in the early
1950s).
The ‘legal container’ in which the different
positions of the two parties to the contract (on the one
side, a state with limited sovereignty; on the other, a
private entity with full powers) are fully expressed is
the petroleum concession. As evidenced by its name,
by means of the corresponding contract (the petroleum
concession agreement), the state, as owner of the
subsoil resources, grants the private entity the
exclusive right to explore, appraise, develop and
produce hydrocarbons, for a period of more than fifty
years, on a vast area of the national territory, as well as
the right to store, transport, treat and sell the
hydrocarbons produced, in consideration of the
compensation set out in the contract. The most
important legal effect consists in the transfer of the
state’s ownership of hydrocarbons to the private
concessionaire at the well head, i.e. at the place where
the product which has been found is physically taken
over. As will be seen, from the point of view of the
state’s sovereignty, this moment in which ownership is
transferred is less acceptable than the point of export
indicated in the Production Sharing Contract (PSC;
see below).
Investment obligations
Limited obligations concerning investment
(expressed as sums to be invested in the various
periods of the exploration phase), work (expressed as
the number of wells to be drilled in the period) and the
release of the area covered by the concession
characterize the relationship in this phase. It is up to
the concessionaire, in compliance with the obligations
concerning investment and work, also to draw up
annual programmes and budgets, without any
interference by the authority granting the concession.
Even the obligation to use local human resources
(essential for the acquisition of the necessary
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professionalism) is normally subordinate to the
priority need to conduct oil operations efficiently. The
obligation to train staff (training) is deferred to the
commercial production phase and made subject
nevertheless to various limitations. Complete freedom
is guaranteed with respect to currency as the
concession agreement grants the concessionaire the
right to open and maintain in the country accounts in
any currency and to export freely the profits made as a
result of its activity. Equal freedom is granted to the
concessionaire and its contractors with respect to
imports, free from customs and similar duties, of all
material required to carry out oil operations and their
re-export. The same applies also to the exportation of
the oil produced.
In return for the set of rights and privileges granted
under the petroleum concession, at least in an initial
phase, the concessionaire is required only to pay a
quota of production, in cash or in kind, as a royalty.
Only subsequently, on the initiative of Venezuela
(1943), the payment of income tax was added to the
payment of a royalty. This income tax was normally
limited to 50% of the income calculated on the basis
of a posted price in conformity with the principle of
equal profit sharing. This price is determined, in this
phase, by the concessionaire company and
corresponds to the price at which the concessionaire
company is prepared to sell the crude oil produced.
The amount of the royalty constitutes a deductible cost
for the purposes of calculating the income tax, the
latter being set at an overall rate of 50% of the income
calculated as indicated above.
The absence of any control by the state over the
concessionaire’s activities and over the hydrocarbon
production, as well as the concessionaire’s exclusive
responsibility for the downstream activities of
marketing, transport and refining characterize this
phase of the relationship, defining the petroleum
concession contract as a real enclave in the legal
system of the state granting the concession, made
almost impenetrable by an impressive apparatus of
protective contract terms (see above).
For many decades the control of oil resources in
the Middle East has been exercised in a practically
exclusive way by the oil companies as a result of
contracts concluded since the early 1900s. These
companies, also known as majors, holders of the most
important petroleum concessions in the Middle East,
have provided the capital, technology and managerial
capacity necessary for the exploration for and
production of hydrocarbons, bringing into being
sophisticated relationships for the marketing and
supply of hydrocarbons on the markets of
industrialized countries. However, in the view of many
oil-producing countries, the activities carried out by
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CONTRACTUAL REGULATION AND SETTLEMENT OF DISPUTES
the concessionaires have seriously limited the
sovereign prerogatives of the state, hindering the full
integration of the oil industry into the national
economy (From concession [...], 1973).
Participation of the state
The independence of the colonies
The point of departure of the second phase of the
evolution of relations between oil producing countries
and the oil companies is determined by the
achievement of independence of numerous states,
which had formerly been colonies of the western
powers, and by the coordinated action of various oil
producing states.
The first phenomenon embraces a time span of
more than five years from 1956 to 1962, with the
independence of Morocco (1956), Tunisia (1957),
Belgian Congo, French Congo, Côte d’Ivoire, Gabon,
Ghana, Madagascar, Nigeria, Upper Volta (today
Burkina Faso; 1960), and Algeria (1962). The
intervention of these new states significantly altered
the equilibrium of power within the international
organizations as they had been granted voting power
equal to that of industrialized countries. Through the
position taken in these organizations and the treaties
they stipulated, the new states brought about a
profound revision of the traditional principles of
international customary law (such as the pacta sunt
servanda principle), considered to be expressions of
the old international economic order and functional to
the interests of the old colonial powers.
The new principles were formulated in various
resolutions of the General Assembly of the United
Nations in the 1960s and early 1970s. Particularly
relevant among these are those that solemnly affirm
the “permanent sovereignty over natural resources”
(Resolutions of 14 December 1962, No. 1803-VI and
of 25 November 1966, No. 2158-XXI) or those
concerning the establishment of a new international
economic order (Resolutions of 1 May 1974, No. 3201,
S-VI and No. 3202, S-VI), or those defining the
economic rights and duties of the states in the
so-called Charter of Algiers (Resolution of
12 December 1974, No. 3281-XXIX), which was
adopted notwithstanding the opposition of the
industrialized countries, as well as the Resolution on
development and international economic cooperation
(19 September 1975, No. 3362, S-VII).
The above principles also decisively affirm, among
others, every state’s inalienable right to its own natural
resources and its right to adopt measures of
nationalization for the complete recovery of such
resources, as well as the jurisdiction of domestic
courts to judge on the basis of their own laws disputes
852
concerning nationalization measures. The affirmation
of such principles served the purpose to recover the
sovereignty, which had in part been restricted by
instruments, such as the petroleum concession, which
were considered an expression of the old economic
order. The newly independent states’ awareness that
they had at their disposal energy producing resources,
first of all oil resources, upon which the development
and well-being of the industrialized world depended,
favoured the affirmation of the above-mentioned
principles.
The action of oil producing countries
In addition to developing countries’ capacity to
exert pressure in this way, there was the action of oil-
producing states united in the OPEC, which was
created at the beginning of the 1960s. OPEC, in its
Declaratory Statement of Petroleum Policy in Member
Countries (Resolution of 25 June 1968, No. 16.90),
sets out the basic principles of a common petroleum
policy, prevalent among them being those relating to
the participation of states in the ownership of
concessionaire companies, to the renegotiation of the
financial conditions of the oil contracts and to the
settlement of disputes by regional courts (not,
therefore, by international arbitration).
The above-mentioned Resolution, after recalling
the inalienable right of each state to exercise
permanent sovereignty over its natural resources (a
universally recognized principle of public law, as
repeatedly stated by the resolutions of the General
Assembly of the United Nations) set, among others,
the goal of attaining reasonable participation in the
ownership of the concessionaire company on the basis
of the principle of changing circumstances.
By means of the General Agreement on
Participation, signed in New York on 20 December
1972, various states of the Middle East obtained a
25% participation in the concessions that had been
granted in the past to the oil companies operating on
their territories and, at the same time, the commitment
of those companies to transfer, within the following
ten years, up to 51% of their participation in those
concessions. This agreement marked, on a formal
level, the end of the exclusive control the companies of
the sector had over the oil resources and the entry
on the scene of the state as co-participant
associated in the planning and management
of oil-related activities. In fact, the attainment of
participation by the oil producing countries of the
Middle East ought to have given rise to a joint venture
with the oil companies for the joint management of
oil-related activities without, however, modifying the
formal instrument (the oil concession) through which
such activities are carried out.
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According to the intentions of the producing
countries, from this participation, with the association
form it would create, would derive the power of the
state-owned company of the producing state to share,
on account of the quota thus acquired, the rights,
obligations and profits involved in oil-related
activities, as well as the power to co-manage such
activities by means of the participation in mixed
committees (of management, technical and operative)
composed of representatives of both parties in the
relationship, with decision-making powers
proportionate to their quota of participation.
The state-owned company becomes in this way the
instrument that enables the state to acquire
progressively the professional, technical and
managerial competence and experience it needs to
exercise control over oil-related activities in order to
ensure that such activities are directed to pursue public
utility or, at least, do not exclusively serve the private
party’s interests. While this was one of the goals of
governmental participation set by OPEC Resolution of
25 June 1968, No. 16. 90, it is a goal that has been
achieved only in minimal part. Apart from a few
exceptions, in fact, the state-owned companies’ lack of
staff having technical experience and managerial
capacity has impeded them from fully taking
advantage of these new opportunities. Oil companies
that have deliberately kept their governmental partners
in the dark as to the geological, financial and
commercial information relevant to oil-related
activities have therefore continued for a long time to
exercise wide decisional powers and full control over
the activities.
This hardly satisfying result came about also by the
fact that private companies were permitted to continue
to establish operative programmes and budgets as
operators of the joint venture. The role of the entity in
which the state was represented ended up, therefore,
being limited merely to approving such programmes
and budgets with the result that if approval was not
given, the entity would be unable to approve alternative
programmes and budgets without the assistance of the
operator of the joint venture. Precisely in the light of
these aspects an arbitral award of 1975 rendered in
Anaconda Company v. Overseas Private Investment
Corporation (OPIC), in the Chilean copper sector,
affirms that, notwithstanding the restructuring of the
relationships by means of joint ventures actual
decision-making rested with the Western head
companies; consequently, operations continued to be
conducted by Anaconda as in the past “through
substantially the same practical chain of control as
before” («International Legal Materials», 1975).
The experience of joint ventures, has therefore
turned out to be disappointing and does not, at any
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rate, respond to the states’ need for a more complete
recovery and actual exercise of that permanent
sovereignty over its natural oil resources, that was so
strongly proclaimed in the resolutions of the General
Assembly of the United Nations.
The new generation of oil contracts
The search for other instruments capable of better
satisfying the above-mentioned needs and the goal of
obtaining greater profits from the oil-related activities
carried out on a state’s territory stimulate the search
for and preparation of new contractual formulae. To
this third phase of evolution of the relationships
between oil companies and producing countries, which
started in some states at the end of the 1960s and
developed later during the 1970s, contributes the
processes of nationalization or the revocation of oil
contracts taking place in various states (Libya, Algeria,
Kuwait, Iran, Iraq, Venezuela), dissatisfied with
OPEC’s action – considered too moderate and slow –
to recover complete control over oil resources.
This evolution is marked by the progressive
abandonment of the oil concession in favour of other
types of contractual relations in which the state, by
means of the public enterprise designated for that
purpose, becomes an active party to the activities of
exploration for and development of hydrocarbons.
Even though the concession contract continued to be
used in various countries (Sharjah, Abu Dhabi,
Brazil, Egypt were still concluding this type of
contract as late as the 1970s and 1980s), this process
of transition led to the progressive adoption of new
contractual schemes in which the mining title, held
fully and exclusively by the state-owned company,
has become the point of reference and the raison
d’être for the association of private companies with
oil-related activities. Indeed, the private company
still has access to the financial, technical and
managerial resources the state needs in order to
better exploit its oil resources. A change in the oil
company’s role followed: no longer a concessionaire
in relation to the host state but a contractor, i.e. a
contractor of works and services on behalf of the
state-owned company. The most significant new
contractual formulae are: the production sharing
contract; the service contract, with or without risk;
the technical assistance agreement.
It is worth examining the characteristics of these
different contractual formulae, referred to in legal
writings as the “new generation of petroleum
agreements” (Maniruzzaman, 1993), and how they
differ from traditional oil concession agreements, in
order to assess the extent to which they have enabled
states to actually recover sovereignty over their natural
oil resources.
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CONTRACTUAL REGULATION AND SETTLEMENT OF DISPUTES
The production sharing contract
Among the new contractual formulae, a
particularly important one, also because it is so widely
used, is the production sharing contract. By stipulating
a production sharing contract a foreign company
associates itself exclusively with the oil-related
activities to be conducted in the contract area but not
with the title to the mineral resources. That title rests,
together with the exclusive right to explore for and
produce hydrocarbons and to carry out activities
related to such rights, with the state-owned company
competent in the oil sector. The oil company,
contractor on behalf of the state-owned company, takes
on the risk that hydrocarbons might not be found. The
contractual relationship being set up in this way, it
follows that both the ownership of the hydrocarbons
found and responsibility for carrying out the related
activity rest with the state-owned company.
The newest element introduced by the PSC that
characterizes the scheme is the provision that
management of operations is in the hands of the
state-owned company (the so-called management
clause). The formula adopted in this connection in one
of the first Indonesian contracts concluded with
Pertamina in 1968, the state entity for hydrocarbons,
reads: “Pertamina shall have and be responsible for the
management of the operations and contractor shall
be responsible for the execution of the works
program”. The purpose of the clause is to allow the
public party to be trained, an objective to be achieved
by close interaction between Pertamina and the
contractor. Such a provision, however, involves the
need to harmonize the powers the state-owned
company has been granted in order to recover
sovereignty through public control over the oil-related
activities carried out on the national territory and the
contractor’s contractual responsibility to conduct
operations in the field. As has been stressed, “If not
handled wisely and carefully, such a structure may
lead to immense frustration on the part of the foreign
partner” (Machmud, 2000).
The duration of the PSC is normally much shorter
than that of the oil concession (about 30 years). It
usually starts with an exploratory phase (4 or 6 years,
renewable), followed by a phase of development and
production in case of a commercial discovery (20
years, extensible for another 10 years on the
contractor’s option). The contractor’s minimum
obligations with respect to expenditure and operations
to be carried out (seismic and minimum number of
wells) are established for the exploratory phase.
As concerns the availability of financial resources,
the PSC requires the contractor to provide all the funds
necessary to carry out operations and to assume the
risk of losing its investment should the activity not
854
lead to the discovery of a marketable quantity of
hydrocarbons. Where operations lead to a
commercially viable discovery, as defined in the
contract, as from when commercial production starts,
the contractor will have a right to two different quotas
of the available production, one of which will serve to
reimburse the costs of exploration and development
incurred for the conduct of the operations, often
including interest that has accrued on the investments
for development (so-called cost oil), and the other to
provide the contractor a return on his investment
(so-called profit oil).
The quota recognized as a profit is intended to
remunerate also the risk the investor has taken in the
exploration and development phase. Ownership of the
quota of hydrocarbons due to the contractor is
transferred at the point of export, thereby qualifying
the contractor’s rights not as mineral rights (as in the
case of the concession) but only as economic rights.
Each of the two parties has available, and markets
without restraint, its own quota of the total production.
Ownership of all goods imported for the purpose of
conducting operations passes to the state-owned
company, the relative cost being one of the items to be
reimbursed by the cost oil.
In the Indonesian scheme taxes and royalty are not
due from the contractor precisely on account of the
absence of profits in the country and of ownership of
hydrocarbons at the well head as, on the contrary, is
envisaged in the oil concession contract. As of 1976,
in order to satisfy the need of the companies of the
United States to provide their fiscal authorities with
documentation as to the income tax paid abroad, the
Indonesian PSC requires that Pertamina’s quota of
production shall include the sums the latter has paid
on behalf of the contractor as taxes and a receipt is
issued for this purpose. The PSC concluded on 18
November 1997 between the Republic of Kazakhstan
and a consortium of international companies (one of
which was Agip) makes provision for a 30%
withholding at the source as a profit tax.
Defined in its structure by the President of
Pertamina (formerly called Permina), Ibnu Sutowo,
and inaugurated in 1966 with a contract concluded
with the consortium IIAPCO (Independent
Indonesian American Petroleum COmpany), the
contractual formula in question has been used in
many other states since the 1970s. The PSC
concluded in Indonesia by Agip in 1968 provides
that the contractor will receive annually a quota of
production equal to 40% as cost oil and a quota
equal to 35% of the remaining 60% as profit oil. The
PSC concluded by Exxon in Angola in 1998
provides for a 50% quota as cost oil and the sharing
of profit oil: 80% for Sonangol and 20% for the
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 CONTRACTUAL REGULATION WITH RESPECT TO EXPLORATION FOR AND PRODUCTION OF HYDROCARBONS
contractor. Other PSCs provide for a different
percentage sharing of production in relation to the
mining prospects in the contract area and to the
ability and negotiating power of the private investor.
Thus, in some of these contracts the production
quota due to the state increases in relation to the
increase of the contractor’s pre-tax rate of return, as
provided in the form of contract appended to Law
1982 of 26 March of the Republic of Liberia.
The Indonesian PSC has represented the model oil
contract adopted in Malaysia and in China. In all three
countries the respective governments actively
participate in carrying out oil-related operations in
order to control and optimize the benefits deriving
from the development of a resource considered to be
of strategic importance for these countries. All three
countries have very well-structured state-owned
companies for hydrocarbons thanks to which each
national oil industry is active in both upstream and
downstream activities. This has been the result of
using the PSC, both as an instrument for professional
training of staff so as to consent an effective control
over oil-related activities and as a source of significant
capital investments.
While the Indonesian and Malayan models are
similar, the Chinese PSC contains various elements of
differentiation. Thus, with regard to the management
clause, the Chinese model provides for a joint
management committee that closely follows the
carrying out of operations rather than just merely, as in
other models, setting generic guidelines. The Chinese
PSC represents a hybrid formula to the extent that the
royalty and taxes are an integral part of the contract in
contrast to the typical scheme. Moreover, in both
Malaysia and China, the state-owned company tends to
participate in the contract, transforming itself from a
partner without risk to co-adventurer under the PSC
(Machmud, 2000).
At present the PSC is the prevalent model of
contract in many Asian states (Bangladesh,
Burma – today Myanmar, China, the Philippines,
India, Indonesia, Laos, Malaysia, Mongolia, Nepal,
Pakistan, Sri Lanka, Vietnam), in countries formerly
members of the Soviet Union (Azerbaijan,
Kazakhstan, the Russian Federation, Turkmenistan,
Ukraine, Uzbekistan), in states of the Middle East
(Jordan, Iraq, Israel, Oman, Qatar, Syria, Yemen), in
Central and South American states (Netherlands
Antilles, Colombia, Cuba, Ecuador, Peru, Trinidad and
Tobago) and in some European states (Albania,
Croatia, Malta, Romania) and African states (Algeria,
Angola, the Republic of Congo, Côte d’Ivoire, Eritrea,
Ethiopia, Ghana, Guinea, Kenya, Liberia, Libya,
Mozambique, Nigeria, Sudan, Tanzania, Togo, Tunisia,
Uganda, Zambia).
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Some of these states provide, as alternative
formulae, the concession contract and the service
contract. Other states (Thailand, Nicaragua) still
continue to adopt the model of the concession
contract. With respect to the original PSC scheme,
many states have introduced variations in order to
satisfy some national aspirations and to harmonize this
new type of contract with their respective legal
systems. Finally, in other states, still unsatisfied with
certain contractual terms, the revision of such terms is
under discussion (as in the Russian Federation with
regard to the PSC in force for the Sakhalin area).
The flexibility of the contractual formula and the
fair balancing of the positions of the two parties in the
relationship are among the reasons for the PSC’s
success. This explains why the same formula could be
adopted for projects in the oil sector not limited to
exploration and production of liquid hydrocarbons, but
also for the construction and operation of plants. Such
is the case of the contractual relations whereby Royal
Dutch Shell and Exxon, two of the majors, have
agreed to collaborate with Qatar to develop and put
into production large reserves of natural gas.
According to information published in the
specialist press, Shell’s project envisages the
construction of the largest plant ever built for the
production of Gas To Liquids (GTL) at Ras Laffan
(Qatar) on the basis of an integrated development and
production sharing agreement. The project calls for an
investment by Shell of about 5 trillion dollars to
develop natural gas reserves and to build a GTL plant
capable of supplying 140,000 barrels of GTL products
per day. The agreement concerns both upstream as
well as downstream aspects of the project, with Shell’s
commitment to comply with strict directives for
safeguarding the environment, health and safety. The
sharing of production between Qatar, owner of the
natural resources, and Shell, the contractor, is
considered by both parties to be fair and to provide
satisfactory returns.
Also Exxon’s project in Qatar, which also concerns
GTL products, is being implemented on the basis of a
PSC concluded in 2004. Exxon’s investment is
estimated at 7 trillion dollars for the production of
154,000 barrels per day.
The service contract
By the service contract the state-owned company
retains exclusive ownership of the mineral rights for
the contract area and ownership of the hydrocarbons
found and produced in the area. The private company,
either directly or through a company it controls, acts as
a general contractor in the name, and on behalf, of the
state-owned company and, in that capacity, carries out
all operations necessary for the exploration for,
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development and production of hydrocarbons, on
payment of a flat fee or a sum commensurate with the
quantity of production in the reference period. The fee
can be graded according to the size of the discovery,
the amount of risk capital invested and other factors.
The private party does not, therefore, have the
capacity, prerogatives and rights of a concessionaire or
of an associate, its role being limited to that of a
contractor. It follows that programmes and budgets for
the activity to be developed in each year of the life of
the relationship, even if drawn up by the contractor,
must be approved by the state-owned company.
Two types of service contract can be distinguished
in practice: those with risk and those without risk. In
the case of a service contract with risk the contractor is
required to finance entirely the exploration for
hydrocarbons and subsequently the development of
deposits found in the contract area. This financing
consists of assuming the risk of failure to find
hydrocarbons (usually crude oil) in commercially
viable quantities. Only in the latter case, indeed, the
sum of all the costs sustained up to that date is
considered a loan granted by the contractor to be
reimbursed by the state-owned company.
Reimbursement is normally made in money, and it is
the contract that establishes the amount and the date
(normally every three months) of each instalment.
Production costs are, instead, reimbursed directly by
the state-owned company in the local currency, on
issuance of an invoice. In addition to reimbursement
of costs, the contractor has the right to receive, for
services rendered, additional sums calculated
according to the terms of each service contract.
Various service contracts provide for the contractor’s
right to quantities of crude oil, assessed at market
price (set out in the contract), instead of payments in
money by the state-owned company.
The ‘with risk’ formula was adopted in the 1960s
and 1970s in service contracts concluded, among
others, in Iran, Iraq, Nigeria and Venezuela. In a
subsequent stage this contractual formula permitted
some states to obtain more favourable conditions: this
is the case of the service contracts concluded in Iran
and Burma, as well as in Brazil on the basis of the
1976 Petrobras model contract.
The distinction between the PSC and the service
contract with risk is not an easy one to make, also in
view of the variations each country introduced in the
different schemes. It lies essentially in the method of
payment of the amount due to the private party to the
contract. While the PSC makes provision for direct
access to a quota of production in kind, in the service
contract the contractor is paid in money, unless the
contractor has opted for taking a quantity of crude oil
of an equivalent value.
856
Other service contracts are ‘without risk’ because
the contractor is not obliged to finance at its own risk
hydrocarbon exploration and development, and is
remunerated by a pre-established sum. On the basis of
this contract the private company places at the disposal
of the state-owned company qualified staff, its own
experience and know-how in order to conduct
hydrocarbon exploration, development and production
on the basis of programmes and budgets set by the
state-owned company. Also in this type of contractual
relationship the contractor can have access to
determined quantities of production, usually on the
basis of a separate sales contract.
Various service contracts have been concluded in
recent years by companies of the Italian Eni group.
The most significant of these are the following.
Buy back service agreements. They are contracts
stipulated in Iran with the NIOC between the late
1990s and the beginning of 2000, for a 4-5 year
duration for the development phase and a 6-7 year
duration for the hydrocarbon extraction phase.
Programmes and budgets are approved by a Joint
Management Committee (on which both parties are
represented) that decides unanimously (except for
mechanisms aimed at overcoming a possible
deadlock). Reimbursement of investments (up to a
determined amount) and a fee are paid out of the
returns generated by the sale of a quota (up to 60%) of
hydrocarbons produced, while reimbursement of
operating costs and income tax is made directly. The
contractor is also granted the right to purchase from
the NIOC a quota of production.
Service contract. It was concluded in 2000 with the
Nigerian Petroleum Development Company, holder of
oil petroleum licence n. 91 and of subsequent oil
mining leases. It provides for the development of two
fields that had already been discovered. The relative
investments were financed by the available crude oil
or, if that was insufficient, by funds provided by the
contractor. The entire production is owned by the state,
but the contractor’s own costs (both capital and
operating costs) are reimbursed from a quota of the
cost oil and the contractor is remunerated for services
rendered out of the residual production profit oil on
the basis of percentages established in the contract.
Operations are conducted under the direction of a Joint
Management Committee that decides unanimously
(except in the case of disagreement when an
independent expert intervenes). As concerns taxation,
the state-owned company pays the petroleum profit
tax, as well as the royalty, while the contractor pays
income tax.
Operating agreement. This contract, concluded in
1997 with Corpoven in Venezuela, provides that the
Eni company, as operator, shall make available
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 CONTRACTUAL REGULATION WITH RESPECT TO EXPLORATION FOR AND PRODUCTION OF HYDROCARBONS
investments and provide the know-how needed to
carry out the project for the rehabilitation of certain
basins of hydrocarbons, as well as the development,
production, transport and refining of production on the
basis of a master development plan approved at the
time the contract was stipulated. Investments made,
including interest, are reimbursed in money, in
addition to the payment every three months of a
service fee. The entire production is owned by the
state-owned company.
The technical assistance contract
As its name suggests, this type of contract
stipulates the services to be rendered by the foreign
partner, often limited to specific phases of oil-related
activities, in return for the payment of predetermined
sums of money and without the contractor bearing the
risk of not finding hydrocarbons.
The position taken by the state-owned companies in
the management of natural oil resources constitutes one
of the most significant innovations introduced by the
new contractual formulae. Even though many of the
terms agreed in the new schemes reflect those typical of
the oil concession contract, the circumstance that the
state-owned company signs the contract and not the state
leads to important legal effects with respect to the
protection of private investment. The state cannot, in
fact, be called on to be directly responsible in the case of
breach of contract nor can it attribute to the intangibility
and stabilization clauses contained in the contract the
same legal value deriving from the assumption of the
related obligation by the state (see above).
In order to hold the state contractually liable for
possible breach of contract by the state-owned
company or for any interference by the state in the
performance of the contract, there are various forms of
guarantee that the state can have issued on conclusion
of the contract. Among these is the approval of the
PSC by law, according to the provisions of some legal
systems such as that of Azerbaijan (Bati, 2003). On
the other hand, useful effects, which in terms of
economic equilibrium might be derived from a
stabilization clause accepted by the state, are achieved
by the inclusion, in various contracts, of a clause
concerning the public party’s obligation to compensate
the contractor for the economic consequences of
measures adopted by the state in violation of
guarantees for the contractually agreed stabilization
(this is the case of contracts concluded with
state-owned companies by states formerly members of
the Soviet Union).
The aspect characterizing the most recent evolution
of contractual relations with respect to the activities of
exploration, production, refining and marketing is
provided by the position taken by many states when
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granting mining rights regarding hydrocarbons. A
widespread practice is that whereby the company
wishing to obtain a contract for exploration for and
production of hydrocarbons on the territory of specific
states must submit a secret offer to the competent
authority declaring acceptance of the model contract
established for this purpose by the host state.
The prospects of success in obtaining the contract
are based solely on the commitments concerning
investment and execution of works made on the
occasion of the tender, with the possible addition, if
requested, of the payment of sums of money (bonuses)
at established time-limits. The model forms for the
various types of contracts (PSC or service contracts)
are by now widespread in countries from the most
varied geopolitical areas and diverse legal cultures.
An example of the most recent evolution is the
tender whereby the Algerian Sonatrach, in 2004,
invited offers for the execution of an integrated project
(to be carried out in association with Sonatrach) to
explore, develop, liquefy and market natural gas from
fields located in the Gassi Touil region, on the basis of
a PSC, non-negotiable, for the duration of 30 years.
The contract envisages a phase for the development
and production of hydrocarbons financed for 65% by
the contractor and for 35% by Sonatrach, as well as
two phases of exploration for new fields financed for
100% by the contractor. Decisions are unanimously
taken by a management board on which the two parties
are equally represented, with a third person being
called on to settle any possible disagreements.
The activity of liquefying natural gas and
marketing the LNG (Liquefied Natural Gas) are
carried out by two different companies in which
Sonatrach and the contractor participate with different
quotas depending on the company. The contractor is
reimbursed the costs incurred and is remunerated for
its investments and for the activity carried out by a
quota of production of crude oil, LNG, natural gas or
other products of the refining process, the remaining
part of production being property of Sonatrach.
The contractor’s income tax on the remuneration
stipulated in the contract is paid by Sonatrach, who is
also charged with the royalty on the production of
hydrocarbons. The contract is governed by Algerian
law, and disputes are settled by international
arbitration on the basis of the Rules of Arbitration of
the United Nations Commission on International
TRAde Law (UNCITRAL).
13.1.5 Conclusions
Joint ventures, production sharing contracts and
service contracts represent respectively stages of a
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process whereby developing states have sought to
attain broader control over their natural resources and
greater profits from oil-related activities, recovering at
the same time complete sovereignty over their oil
resources that the granting of concessions had
seriously limited. Moreover, unlike what normally
occurs with respect to oil concession (see above), the
new types of contracts are as a rule subject to the
domestic law of the state on whose territory the
oil-related activity is carried out, thereby satisfying
one of the objectives of the states’ action aimed at
recovering sovereignty.
Some new international instruments, first of all the
1965 Washington Convention on the settlement of
investment disputes between states and nationals of
other states, refer to the law of the host state as
regulating the private investment. Legal writings refer in
this connection to the re-localization of the applicable
law in the legal system of the host state. However,
international arbitration continues to constitute the
normal method of dispute resolution between the
parties also by means of the above-mentioned
Washington Convention on investments. Despite these
corrections, it cannot be affirmed that the goal of actual
control by the state over the development of its
resources is always and everywhere achieved. Such
control depends, indeed, largely on the state’s ability to
make available professionally suitable resources as a
result of the implementation of serious training
programmes for its staff.
However, from the point of view of the private
party the new contractual schemes may prove
acceptable (as, after all, their diffusion demonstrates),
to the extent that the investment is reasonably
protected and access is allowed to a quota of
858
production of hydrocarbons at an acceptable cost in
order to ensure continuity of supply on its own outlet
market.
References
Bati A. (2003) The legal status of production sharing
agreements in Azerbaigian, «Journal of Energy and Natural
Resources Law», 21, 153-167.
Bernardini P. (1998) The renegotiation of the investment
contract, «ICSID Review. Foreign Investment Law Journal»,
13, 411-425.
From concession to participation: restructuring the Middle
East oil industry (1973), «New York University Law
Review», 774, 788-789.
Hyde J.N. (1963) Economic development agreements, in:
Recueil des Cours de l’Académie de Droit International
de La Haye, Leiden, Sijthoff, 105, 267-374.
ICCA (International Council for Commercial Arbitration)
(1979) Yearbook commercial arbitration, Deventer (The
Netherlands), Kluwer.
«International Legal Materials» (1975), 14, 1237.
Machmud T.N. (2000) The Indonesian production sharing
contract. An investor’s perspective, den Haag, Kluwer.
Maniruzzaman A.F. (1993) The new generation of energy
and natural resource development agreements: some
reflections, «Journal of Energy and Natural Resources
Law», 11, 221-247.
Montembault B. (2003) La stabilisation des contrats d’État
à travers l’exemple des contrats pétroliers. Le retour des
dieux de l’Olimpe?, «Revue de Droit des Affaires
Internationales-International Business Law Journal», 6,
593-643.
Piero Bernardini
Counsel, Ughi e Nunziante Law Firm
Università LUISS - Guido Carli
Roma, Italy
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 13.2
Import contracts
and transport of gas
13.2.1 Introduction
This chapter considers a number of common legal and
commercial matters which may arise in the
arrangements for the import and transport of gas. In
particular, issues relating to the contractual
arrangements for production of natural gas and
transport by pipeline to the point of delivery, and the
liquefaction, transport and regasification of Liquefied
Natural Gas (LNG). This article is written by reference
to examples of a number of pipeline and LNG
developments and seeks to identify and examine some
of the principles of more general application.
Many developments of natural gas have been
carried out to supply local markets and, over recent
times, pipeline developments have become regional
and LNG developments have, for some, become
global. This article develops some of the more usual
legal and commercial themes which may arise in
arrangements for the transport of gas produced in one
state to a purchaser or consumer in another state, often
through the medium of an intervening state or states.
The developments will have regard to the contractual
arrangements for production of gas and transport (by
pipeline or tanker) to the point of delivery. These
arrangements have traditionally been structured as
long-term contractual arrangements in the context of
certainty of supply and guaranteed markets. But
movements towards liberalized markets in many
consuming areas are now militating against those
traditional structures and their associated, inflexible,
debt financing arrangements. Similarly, the move
towards privatization or some lesser separation of state
interests and private or commercial interests have led
to a more sophisticated approach to the granting of
rights by a state, on the one hand, and its commercial
participation in projects, on the other. Recent years
have seen considerable growth in the making of
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agreements or treaties among states for transnational
developments and the making of implementation
agreements or host government agreements between
individual states and the sponsors of projects.
While major oil and gas companies have
traditionally participated in both pipeline
developments and the LNG business, those two sectors
have remained broadly independent of each other.
However, the development over recent years of
transparent and liquid markets for the trading of gas in
the United States and North West Europe have
contributed to a closer alignment of these previously
separate sectors. The import-dependency of North
West Europe has led to many recent developments of
cross-border pipelines and new LNG regasification
facilities. The traditional supplies to these markets
have tended to be on long-term inflexible contracts,
while new supplies tend to be for shorter periods and
on terms which are influenced by the requirements of
the prevailing regulatory regimes, competition laws
and the market prices arising from gas-to-gas
competition.
Following a period where the main aim of
politicians and regulators was to achieve rights of
access for all potential users of existing facilities,
recent times have seen a change of emphasis where it
has been recognized as necessary to create
circumstances in which new investment will be
assured. The commercial and regulatory circumstances
for the encouragement of new investment for the
creation of cross-border pipelines and LNG facilities
are not necessarily those of liberalized markets and the
uncertainty of project development has been
exacerbated by regulatory consideration of each new
development on a case by case basis. These recent
movements have led some to consider that North West
Europe may soon be the venue for a realignment of
gas markets similar to that which took place in the
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United States take-or-pay wars of the mid 1980s or in
the United Kingdom in the mid 1990s during the
restructuring of the former British Gas and the gas
industry in the United Kingdom. But, whereas those
realignments took place in relation to pipeline gas, the
circumstances of North West Europe suggest that
realignment may apply both to pipeline gas and to
LNG. The circumstances of the United States and the
United Kingdom were local, whereas those of North
West Europe are primarily cross-border, and the
position of international contracts for the sale and
purchase of pipeline gas or LNG will be those which
export towards Western Europe (where the enactment
of the Energy Charter Treaty, ECT, played a major
role), more recent potential developments have looked
towards the East, with the prospective export of
natural gas from Russia, Kazakhstan and Turkmenistan
towards Asia.
As of 2005, there were about forty-five existing
LNG import terminals and some twenty existing
liquefaction plants. Liquefaction plants exist in Asia,
Africa, Australia, the Middle East and the Americas.
Regasification plants have been developed in North
Asia