By Ingilab Ahmadov, Director of the Public Finance Monitoring Center (Azerbaijan) and EITI Board member

It is widely known that a transparent "company-state" relationship is a key factor for resource-rich countries seeking efficient management of their natural resources to benefit current and future generations. Transparency in the extractive industries makes it possible to track resource development and the use of resource revenues. Governments in resource-rich countries are showing increasing enthusiasm for transparency initiatives, and demonstrating a new readiness to embrace accepted international standards. In many countries, there is a new interest in seeking long-term stability for the sake of future prosperity. The sad tradition of leaders hungry to enrich themselves through dubious natural resource deals—leaving behind them only ruin and debt—is gradually passing into history.

The geographic expansion of the EITI is telling evidence of this shift. Now, in even the most remote corners of the world, one can see governments of extractive countries working to join the ranks of open states. There are currently 30 countries on the list of EITI candidates. The list is robust and includes more than half of all the extractive countries in the world.

But, as the on-the-ground experience of EITI has shown, the initiative on its own is inadequate as a tool to ensure full transparency in the extractive sector. The EITI encompasses only a narrow segment of payments and revenues received in extractive countries. A valid complaint by many observers is that even the ideal implementation of EITI principles cannot entirely guarantee the desired level of industry transparency.

The EITI process of documenting company payments to the state is preceded by a no less important step: in which extractive companies obtain licenses and permits, and enter into the relevant contracts that give them the right to extract local resources. Observers of EITI note the great sensitivity of this step and understandably believe that this is the stage where things get interesting: the moment where society's interests collide with corrupt government interests, and lose. But the truth, as with any rigged game, everything interesting takes place before the game begins, when the parties might agree on mutual benefit, when the game itself is at risk of becoming a fiction, when it can be the most difficult to catch the parties as they work behind the scenes to deceive the audience and subvert the fairness of the game itself.

Why is transparency of oil contracts necessary?

First, an outside observer comparing an agreement to a similar contract in other countries, or even to another contract in that same country, needs a way to determine how equitably it was signed, how well it takes society's interests into account. One must note, however, that a contract is a complex document. It cannot be thoroughly assessed in one brief reading, sometimes not even by a specialist. Sometimes only time, and the initial outcomes of a deal, can help one judge its fairness.

Thousands of factors precede and accompany contract implementation. The time factor in particular is relevant. In transparency literature one often sees the comparison of the Azeri-Chyrag-Giuneshli (ACG) contract in Azerbaijan to the Kashagan contract in Kazakhstan. I have repeatedly heard from various experts that the Kashagan takes the interests of the Kazakhstan into consideration far more effectively than the ACG does for Azerbaijan. To be fair, one must say that these statements were made in the late 1990s and early 2000s, when few could foresee so great a delay, or the radical changes in the terms of the Kashagan. Initial observers came to this conclusion on the basis of a familiarity with and a comparison of the terms for splitting profit between the companies and the state, and after analyzing the companies' obligations to the state in both cases.

In reality, one of these contracts (ACG) is turning out to bear genuine fruit, and its work schedule conforms to the contract terms; while for the other (Kashagan), a justified delay in the work schedule has increased the budget more than fourfold and uncertainty remains over when production will begin, making it hard to say anything definite about that contract’s effectiveness. In the case of ACG, one can already talk about the average profit margin and the profit ratio (calculations show that on, average, at a world market price of USD 60/bbl, the state can count on more than USD 200 billion in total income, while the total profit for the companies is no more than USD 40 billion. The share of the state company SOCAR (State Oil Company of the Republic of Azerbaijan) in ACG is 10%.

At present it is hard to judge what the market will be when Kashagan oil production peaks. For all we know, an incredibly high price may replenish the losses, and the country will indeed earn more profit than Azerbaijan has. But events could unfold in either direction. If Azerbaijan manages these revenues wisely, by that time it may have proven the same superiority as it showed in obtaining the revenues.

What do these juxtapositions tell us? To judge the fairness of contracts, one must first have access to them. This is possible in the ACG case, thanks to the legal status of each PSA, but it is harder with Kashagan. There is no open access to this contract. Even though groups such as the Barrows Company, for example, have that ability for commercial purposes. A legal question arises: Why these barriers? Did the government of Kazakhstan really bar public access to the Kashagan contract so that society would not be aware of the comparative unfairness of the contract? If one judges by the terms of the contracts, then, as noted above, the Kashagan contract looked preferable.

So, what is the problem? This situation most likely arose because in Kazakhstan the public nature of oil contracts remains overshadowed by the commercial subcurrent or underpinning. But in Azerbaijan, according to established practice, these contracts, unlike regular commercial transactions, reveal their public nature. And practice has shown that the parties' commercial interests do not suffer from this exposure. To the contrary, both the companies and the government are able to enhance the positive image they so badly need.

Despite these encouraging facts, not everything is clear with oil contracts in Azerbaijan. Even with this instructive history of the openness of PSA contracts, the country has recently tilt toward a lack of openness.

In early 2009, the Azeri parliament ratified the last two PSAs for development of the Kiurovdag, Neftchala, Khylly and Durovdag-Bazanan onshore fields. A distinguishing—and alarming—feature of these contracts was that, for the first time in the history of modern Azerbaijan, they were not signed in public, and the public was not notified about them. Adding to the skepticism around the deal is the fact that the operator for both contracts is Global Energy, an offshore company no one in Azerbaijan had heard of before. As it turns out, the founders of the company are SOCAR and a private individual. At the same time, it was discovered that Global Energy, with its related companies, actually controls 16 existing deposits, which speaks to the seriousness of its intentions.

The process of directly accessing the signed contracts, just as before, has not suffered. Members of parliament had them in their hands, and through them concerned parties then had access to them. The problem in this instance is rather the limit on the public information that preceded parliament's ratification of those contracts, the activity "behind the scenes."

Given Azerbaijan's longstanding and admirable tradition of openness in oil and gas contracts, we can agree that, to put it mildly, this step looks incongruous and illogical. One would like to believe that what happened was an exception and that the state is not straying from its traditional policies of openness in extractive contracts.

But in light of this example, one might unequivocally note that even affluent countries are tending to take the first opportunity to reduce access to contracts and to the procedures that precede their signing.

What is the reason for the parties' great unwillingness to make contracts public to society?

There are several myths that may account for this practice:

Myth 1. Fear among the parties, particularly the government, over unfair criticism by society. The topic of hydrocarbons has always been a sensitive one. Oil contracts are an ideal weapon for opponents to use in a political attack on the authorities.

For the authorities, intrusion into their oil business is treated as a launch into obscenities. Even the most open extractive countries still consider natural resources their patrimony. Ironically, natural resources are also the most vulnerable elements within state policies. But there is a difference between fair and constructive criticism of a government that unwisely manages its resources, and the manipulation of public opinion designed to dump unfounded criticism on the state in order to further a political agenda. Sometimes it is hard even for an insider to tell the first from the second, especially if one is speaking of countries that are not as socially developed. Discord sown for purely political ends might easily shatter the social foundations of society. The result of this abominable tactic, as history shows, is not better resource management, but a power grab. Knowing this, certain governments adhere from the outset to so-called protective tactics so that they later do not have to prove that they are not at fault for poor social conditions. They bar access to contracts from the very beginning. But it is wishful thinking to hope that secrecy actually prevents protest. In fact, public access to contract terms would make it possible to establish an intelligent counter policy and identify the true face of those false politicians who do pursue improper interests. Thus, if there is nothing crooked going on, it is advantageous for the state to open access to contracts.

Myth 2. Glaring local social problems inevitably raise questions over why these problems were not adequately addressed in a contract.

Indeed, practice shows that, in most instances, extractive regions are socioeconomically very weak, and plagued by environmental problems. This situation leads to valid criticisms by local activists. Unresolved social issues, as a rule, provide a weapon for loud criticisms not only against central and local authorities, but also against foreign extractive companies. Out of fairness, we must say that even dozens of contracts will not solve all the unsolved problems. Some of them are fundamental and require huge investments that the contracting parties cannot afford. However, it is also fair to say that closing one’s eyes to existing problems is not the best approach. Especially because these problems are so sensitive. A lack of information about contracts only aggravates tense situations such as these. Wild suspicions arise, such as, "They are pumping out a billion dollars in profit, but all we get is ruin and a bad environment."

Experience shows that the best way to smooth the rough edges is to seek the necessary local feedback so that the contract can reflect the most important and most urgent problems in the form of social investments. Then, when public access to a contract is provided, one can skillfully tell the public how well one is meeting one's obligations. With this approach, the public's attention will focus on the fulfillment (or non-fulfillment) of the obligations instead turning to unfair criticism of the company.

Myth 3. Contract transparency impairs a company's commercial interests and weakens its competitive position.

Much has been written and said to disprove this assertion. Nevertheless, the disputes and speculations have not subsided. It is not difficult to show that fear of information access by competitors is largely groundless. Industry specialists are aware of all or almost all contracts. In the modern world, protection of information, especially about oil, is at best relative. We are not talking about public access, which has little to do with commercial transactions. It turns out that competitors generally know everything or almost everything about one another. Moreover, in the modern, highly capital-intensive oil business, many of them are forced to work together, in part because, to overcome incredibly high costs, they also specialize in certain areas. Given the high level of information technology and the incredibly close cooperation on joint projects, it is unthinkable to maintain "trade secrets" as they existed in the 80s and 90s. Thus, fear over loss of a competitive advantage is ultimately a fiction. More likely, the inclination to protect contracts proceeds from a desire to distract the public, or largely from habit or inertia. It’s simpler that way.

Myth 4. Developed countries need contract transparency, but developing countries are not yet ready for this higher standard.

Indeed, transparency is needed primarily in developing countries. Developed countries already have high standards of management, accountability, responsibility and institutional oversight. Moreover, a well-developed private sector and adequate freedom of speech leave almost no chance for dubious transactions on behalf of the state.

Countries with weak institutions lack this immunity. Consequently, they need transparency first and foremost. The legislative framework for governing energy resources is, as a rule, still evolving. Universal principles of sound accounting and society's rights to natural resources are only now developing. Therefore, it is particularly important that contract terms be available to the public. Under these conditions, some states prefer to improve individual approaches to contracts newly entered into, e.g., the PSAs. Others enhance legislative frameworks and prefer to reinforce universal rules for the long term. A typical example of the first case is Azerbaijan, where to date 30 PSAs have been entered into, each having the status of a law.

Kazakhstan, which recently took a tremendous step forward with its hydrocarbon legislative framework, falls into the second group. Although there is serious criticism of its government due to the frequently changing rules, the country is certainly moving toward the establishment of the desired universal and predictable legislative framework. Clearly, developing countries will long have an acute need for contract transparency and open conditions for hydrocarbon development business, in order to avoid possible errors on this thorny path. Embracing transparency will play a key role.

Myth 5. Transparency can be sought at the payment level, where the Extractive Industries Transparency Initiative (EITI) already excels. Contracts are dry legal clauses that reflect no public interest whatsoever.

Indeed, it is true that transparency is needed first of all to track the movement of money from hydrocarbon sales. But it is also true that, without clear information about contracts, it will be hard to trace the real amount of money that the country should receive. The hydrocarbon business, as we know, includes the following stages:

1. Obtaining permits (licenses) and entering into contracts
2. Developing hydrocarbons, selling them and earning income
3. Managing and disbursing oil and gas revenues

Clearly, of the three stages, only the second—developing hydrocarbons, selling them and earning income—falls within the compass of EITI. An important stage such as obtaining a license and entering into contracts is out of EITI's focus. Without contract transparency, the full effectiveness of EITI is reduced and incomplete. That is the main reason EITI is criticized today—because it does not encompass all aspects of the business cycle and is therefore flawed.

Thus it is not hard to say that contract transparency is an integral component of natural resource management, without which all the current initiatives cannot function at their full force. Contract transparency is a new challenge not only for extractive countries, but also, in the era of globalization—for the entire world community.

http://www.revenuewatch.org/news/091409.php