The Economics of Trade in Natural Resources

by Paul Collier, Professor of Economics at the University of Oxford, Director of the Centre for the Study of African Economies and Professorial Fellow of St Antony's College 
and Anthony J. Venables, Professor of Economics at the University of Oxford and Director of the Centre for the Analysis of Resource Rich Economies.

Distinctive features of the natural resource sector give rise to non-standard arguments for trade policy and for international rules.

Endowments have fixed locations

For many goods, the possibility of causing (or preventing) the relocation of production is a primary motive for trade policy. Deposits of non-renewable natural resources are immobile, so these motives do not apply. Countries without a resource endowment have no local firms or workers in the sector to protect, and cannot use tariffs to attract production. For these countries user taxes are equivalent to import tariffs. Similarly, for resource producers a resource export tax is equivalent to a subsidy on domestic consumption. While immobility of production reduces the scope for tariff induced production losses, use of domestic taxes (e.g. in fuel importing countries) and user subsidies or export taxes (in fuel exporting countries) support substantial fuel price wedges in different national markets. These create massive efficiency losses from low-value marginal consumption in producing countries and forgone high-value marginal consumption in importing countries. An international policy deal which did not affect the distribution of rents but which eliminated the efficiency losses would be mutually beneficial. Reaching such a deal, in which world prices were gradually harmonized, would be analogous to the mutual de-escalation of tariff wars - a core function of the WTO.

Resources generate rents

Rents belong to the country in which the resource endowment is located. However, investing firms and consumer countries employ a variety of policies to increase their share of these rents. The policy game is primarily about getting rents rather than about relocating production. Manipulation of supply or demand can change the price of the resource, and this is one of the motives for countries to use resource taxes.

Resources are finite and depleting

However, the net effects of supply and demand changes are intertemporal because natural resource extraction depletes a finite resource. Changes in supply in one period have equal and opposite effects in later periods. A limited total supply of a resource sets the long-run average price, so attempts to manipulate the price can only have a small impact on long run average prices. The long-run payoff to cartel power is low or negative, although short-run use of market power can bring temporary efficiency losses.

Extraction is dependent on discovery

Natural resources must be discovered before they can be sold, the incentive for discovery being a share in the rights of extraction. Hence, trade policy is not just about the market for the resource, but also the market for licenses. These arrangements determine the distribution of rent and shape the incentives for depletion and exploration. Most inefficiencies arise in this area, rather than in the market for the resource itself. Projects are long term with high initial sunk costs. As a result incentives to prospect and to develop new sources of supply can be undermined by the process of allocating and enforcing contracts. Contracts leave parties open to an acute ‘hold-up’ problem; government is unable to commit not to renegotiate and investors are deterred by the consequent risk. In some regions there is systematic bias towards under-exploration and over-rapid depletion. Were known reserves increased in these territories to the OECD average, world reserves would increase by around one quarter, allaying fears such as ‘peak oil’. As a near-global organization the WTO has the authorizing space in which to codify rules and standards that might mitigate these political impediments to investment. This would require that renegotiation of contracts be limited through agreed codes of practise or by binding dispute resolution.

Each project is unique

Projects are unique and subject to asymmetric information, with the investor better informed about geology and technology than is government. Extraction rights are commonly sold through secret bilateral negotiations giving rise to social inefficiency due both to the agency problem and to asymmetric information. In conjunction they enable the private capture of rents that should accrue socially, and award contracts to companies on criteria other than efficiency. Because there is no market, secret and bilateral deals do not constitute a breach of the letter of the Most Favoured Nation Clause, even though they breach its spirit. Processes for selling extraction rights are potentially appropriate for regulation by the WTO. The analogue of the MFN clause would be a rule requiring or encouraging open bidding as provided in auctions. Auctions provide equity among bidders, and also overcome the asymmetric information and agency problems noted above. In bypassing international markets, bilateral deals also risk a vicious circle in which, as an increasing proportion of world supply is pre-empted, the residual international market becomes more volatile and so less reliable, inducing further bypass.

Resource extraction is often the dominant activity

Resource projects dominate many economies and so are central to the nation’s development strategy. Since actions in this sector have non-marginal effects on virtually all aspects of the economy, they are quite properly in the realm of public policy. Government will therefore seek to retain control of the rate of extraction and seek to take some part of the rent in terms of local participation, labour training, domestic content requirements and development of local supply. While governments might be well advised to use commercial criteria in their decision taking, simple ‘leave it to the market’ arguments are not valid once the dominant role of the sector is recognised.

Unassigned ownership

Natural assets have no natural owners though by near-universal consensus, ownership is vested in the national governments of the territories in which they are found. Currently no international agency has a clear mandate to negotiate the assignment of rights to resources in international territory. However, this is essential for future exploitation, given the likely development of deep sea and polar resources.