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Venezuela’s ‘Shell’ Game

Raymond Fisman02.11.09, 03:46 PM EST

Hugo Chavez turns to Big Oil.


Hugo Chavez has lost some of his bluster.

For years, the Venezuelan president railed against the evils of global capitalism; for foreign oil companies operating in Venezuela this has meant 16-fold tax hikes and, in some cases, threats of nationalization for refineries and oil fields.

Now, without the steady cash flow from sky-high oil prices, Chavez is quietly cozying up to these same corporate giants whose investments he needs to keep his economy afloat and to shore up support in advance of a Feb. 15 referendum on his right to run for re-election.

Chavez isn’t the only one who would benefit from more investment in rigs and refineries–a steadier supply of oil and other commodities would help to iron out some of the wild price gyrations that create budgeting nightmares for U.S. households and businesses.

The stakes, however, are far greater for the millions living in poverty throughout the developing world–Chavez’s Jekyll-and-Hyde act helps explain not only the volatility in oil markets but also why many resource-rich countries remain so mired in poverty. The reason is that potential investors, who need to finance infrastructure projects in countries like Venezuela, fear getting taken advantage of by fickle dictators after their money has been spent.

Both countries and individuals become rich by investing. A farmer produces a richer harvest when he trades in his shovel for a tractor, and a deliveryman distributes many more parcels with a truck than with his old horse and buggy. Understanding why some countries are poor and others are rich is the same as figuring out why some places attract investors and others don’t.

How does the farmer decide whether to buy a tractor? He’ll incur this upfront cost if he expects that the resulting boost to his income will offset the initial cost. Similarly, Shell will invest in a billion-dollar pipeline in Venezuela if it expects a billion-dollar payoff down the road.

For Shell, this requires a leap of faith–a pipeline can’t be taken apart and reassembled in Texas or Alaska if things don’t work out under Chavez. It’s in Venezuela for good, unlike a truck that can be driven across the border to deliver packages in Colombia or Peru instead. Once the expense has been incurred, or the investment has been made, what’s to stop Chavez from sending in troops to nationalize Shell’s assets, or jacking up the royalty fees that Shell pays to the government?

The answer is that the Venezuelan government has signed a contract that spells out the terms under which Shell is to make its investment. This includes the royalty rate–say 1% of Shell’s revenues from the project–and a host of other conditions: Must they hire local employees? Does Shell lease or own the land the pipeline is built on? Are local investors given an ownership share in the project?

But the world is a complicated, unpredictable place, so despite thousands of pages of lawyerly text outlining the agreement, there will always be a way for Chavez to put the squeeze on Shell. For example, who would have foreseen the massive run-up in oil prices last year? Should the contract be renegotiated as a result?

And this is all assuming that Chavez chooses to honor the contract in the first place–in Venezuela, Chavez’s word is the law, so he can (and has) changed agreements with oil companies on a whim. One percent royalties? Why not make it 16% instead? Shell has already spent its billions, so from the company’s perspective going forward, a smaller share of revenues is better than no revenues at all. For Chavez, the storyline of fighting against the pillaging ways of foreign investors always plays well to the masses.

But now go back a step–given that Shell knows Chavez isn’t as good as his word, why should they invest in the first place? They’re willing to do so at the agreed-upon 1% royalty fee, but not the 16% rate they fear for the future.

As a result, Shell doesn’t make what could have been a profitable investment, and Venezuelans don’t get the investments they need to get rich, all because their government can’t commit. This is what economists refer to as the hold-up problem–Shell is “held up” by Chavez after making irreversible investments.

Nations that have solved this hold-up problem–by honoring contracts and showing concern for their future reputation among potential investors–have attracted investment and gotten rich. The ones that haven’t remain poor. In 1970, people in Finland and Venezuela earned about the same on average. Now a Finn earns three times (ppp) to six times (nominal) more than his Venezuelan counterpart.

What then are we to make of Chavez’s newfound affection for Big Oil? Investors have recently been burned by governments like Russia and Bolivia, so they’ll naturally be wary of promises from Chavez and others. But the risks are even greater this time around.

We’re facing a global slowdown that is being blamed in large part on the perils of free markets and globalization. A backlash is very much on the horizon, and this only intensifies the hold-up paradox. Poor nations like Venezuela desperately need investment to escape their dire economic circumstances–hence the sales pitches from Chavez and others. But at no point in recent history are these promises less likely to be believed by the CEOs and financiers that need convincing.

Raymond Fisman is the author of Economic Gangsters: Violence, Corruption and the Poverty of Nations (with Edward Miguel), and the Lambert family professor of social enterprise at Columbia Business School.


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