A risk associated with complex contracts is that the true market value of the contract may be better understood by the oil companies than by the government. For instance, if oil prices are highly volatile, and there is no due diligence clause for development; getting an oil lease is simply getting an option on the price of oil, and the price of the lease should reflect that option. A contract with a compulsory development clause would presumably lower the value of the lease – the contractor is forced to develop the lease at some time other than they would have chosen – but one needs to compare the extra development benefits with the loss of revenues. Contracts can be written that are sufficiently complicated so that it may be hard to tell whether there was a material breach; or provisions can be included that lead to breaches by both sides, making a determination of the fair resolution even more difficult.

There is a tension between these concerns. Simple contracts, with few contingency clauses, are more likely to encounter circumstances in which there will be pressure to renegotiate. Of use would be the development of a set of standard contracts, not written by the oil companies but by the oil producers, reflecting their experiences and attempting, in the best way they can, to guard against the various ways in which they have been cheated.

1)     Evaluate contracts on the basis of the incentives they generate and their performance under different scenarios

Over the years, there have been a series of fads in extracting oil and other natural resources. There have been, for instance, various forms of contracting for the services provided. The general theory of contracting provides a lens through which these arrangements can be assessed – whatever the names attached to the arrangement – and calls attention to the fact that, so long as the information is imperfect and contracts incomplete (that is, always) issues of agency arise. Once the contract is specified, analyse payments in each of a different set of contingencies, and identify incentives and actions to which they lead. In short, in principle, ascertain the fraction of the potential value of the resource that accrues to the government for a range of different price, quantity or quality scenarios.

2)     Make the timing of payments a function of the ability of the state to bear risk

Different contractual terms provide money to the government at different times – and with different risk. As should be noted, most bonus bidding puts money upfront and imposes risk on the oil companies. For oil companies dealing with the advanced economies, this is foolish and expensive: The developed country can borrow far more cheaply than even the best of the oil companies, and it can diversify its risks far better. The implicit risk and time discount factors disadvantage the government. This pattern may be reversed when it comes to a large oil company dealing with a new oil-producing country such as Guyana.

3)     Insure against oil risk

Long-term oil markets, extending decades into the future, do not effectively exist. As a result, countries may wish to maintain their real reserves as a form of asset protection – long-term risk management. This argument carries some weight in countries such as Guyana regarding decisions concerning the speed with which to develop a field.

Modern welfare economics has provided the tools with which can be used to assess alternative tacks for developing a country’s natural resources – the impact on “social welfare”. This is an approach which integrates the impact of natural resource extraction on the environment, on different groups within the country, as well as on subsequent generations. It incorporates macro- and micro-economics. It entails trade-offs, for example, trade-offs between the magnitude of the agency problems, the risks of resource diversion, and exposure to risk. However, for many applications, its comprehensiveness is matched by its cumbersomeness.

There are two simplified alternatives. One is to focus on how much the public has benefited from the sale, measured, for instance, by the present discounted value of revenues to the government. The second is to measure the present discounted value of the change in the country’s Gross Domestic Product (GDP) – green GDP, of course, not GDP as conventionally measured. Both of these are, of course, inadequate: The first because it puts no weight either on what happens outside the public sector or on what the government itself does with the money; and the second because it puts no weight on concerns about distribution (median incomes might go down even as total income goes up). But each is useful in highlighting the various abuses that can occur.

Inevitably, in the contractual arrangements between a country and those who have the knowledge and skill to take the oil out, there arise a large number of agency problems. Additionally, the form of the contractual arrangements may make some of the problems worse, while it mitigates others. Full privatisations – bonus bid, long-term leases to private companies with no government stake – have been marked by some of the worst abuses, with governments getting the worst deal (for example payments as a value of the oil).

For countries with high-quality public management, and where there are not particularly difficult extraction problems (such as those associated with deepwater extraction), the route taken by such countries as Malaysia seems desirable. For others, the answer is less clear. They face the difficult choice of trying either to improve public sector management or to rely on an imperfect and possibly corrupt public sector to define relationships with a private sector whose goal runs counter to that of the public interest – minimizing payments to the public. Where possible, the path set forth by Malaysia is desirable – while initially relying on the private sector, a key objective should be the transfer of technology, skills, and understanding of organizational structures to enable the creation of an honest and efficient public sector extractive industry (Stiglitz 2006).

Whatever the approach, the following principles should guide the government:

1. Transparency: Open and transparent agreements, openly arrived at. Any oil firm not willing to disclose all terms of the contract, volumes extracted, and prices sold, should be barred from operating within the country. Business secrecy is too often simply a cover for bad behaviour. By the same token, when there are adjustments to the terms of the contract, they should be made in an open and transparent manner.
2. Ownership: The developing country should remain the ultimate owner of the natural resource. This means that residual rents and residual control rights should reside with the country. Of course, it may be in the interests of both parties to specify as clearly and extensively as possible what happens in various contingencies, but no contract can be fully complete.
3. Fairness: Natural resource rents belong to the country; foreign oil companies should get only a fair rate of return, adjusted for the risks they face. This means that the contracts should provide that increases in the price of oil or gas should go disproportionately to the developing country.

Some of the principles which should guide the auction process should include a strong presumption for royalty bidding, with the results of pre-bidding exploration publicly disclosed. When there is only one (or a few) bidder(s) on a tract, there should be a real concern that the country will not receive fair value for its resources. In some cases, it may be desirable to have bidding for particular services, rather than leasing the tract.