The Ghost of Oil's Future

In 1928, Henry Ford constructed a town in the Amazon Rainforest called Fordlandia. Initially devoid of inhabitants, this “ghost town” aimed to dramatically cut production costs so Ford could access cheap and abundant natural rubber resources. The Brazilian government saw the agreement as an opportunity to realize economic benefit from utilization of its natural resources, and cultivate the beginnings of an economy. Despite the promising strategy, the emergence of synthetic rubber as a superior alternative to natural rubber ultimately resulted in Fordlandia’s failure. Known primarily for revolutionizing manufacturing operations, Mr. Ford developed a unique market entry strategy with Fordlandia, in which a firm could collaborate with a country in order to gain access to natural resources. This strategy has recently been given new life by Chinese state-owned firms.

To satisfy growing resource demands, China has increased its in- vestments in Africa at an annualized growth rate of 33.5% since 2000. State-owned China International Trust and Investment Corporation (CITIC) revived the ghost town strategy in 2009 for its Kilamba project. A contract with the Angolan government called for CITIC to construct several commercial and residential developments, hous- ing up to half a million people at a cost of $3.5B. In return, CITIC would receive access to Angola’s natural resources and be able to establish a symbiotic relationship with the Angolan government.

The Viability of Ghost Towns

The ghost town strategy is best suited for multinational oil firms seeking to gain access to oil reserves in underdeveloped countries. These firms would construct a ghost town, which includes key infrastructure components such as a hospital, retail space, roads, water mains, and a power grid. Upon completion of the ghost town, the host nations would gain possession of the infra- structure while the oil firm continues to manage the system operations. Prior to construction, the firm and government would agree to a discounted royalty rate. Royalties are taxes on oil and gas sales generally ranging from 10% to 30% of revenues.

From the firm’s perspective, costs saved through reduction of the royalty rate offset the initial required investment of building the town. The ghost town strategy is predicated upon the idea that oil and gas companies will exchange a large capital expenditure and energy development expertise in return for reduced royalty rates on hydrocarbon extraction. The infrastructure will foster growth independent of oil production, making ghost towns desirable for a developing country aiming to decrease its dependence upon natural resource extraction, and move towards a modern economy.

The Implication for Firms

Multinational oil and gas firms are facing an increasingly competitive bidding process for extraction rights as conventional oil fields are depleted, and state-owned enterprises (SOEs) – which currently have access to 80% of the world’s oil reserves – continue to grow. As accessible conventional reserves become scarcer, producers have been shifting focus to unconventional, and quite commonly expensive, oil fields. For example, Canadian oil sands mining projects have seen C$55B of capital expenditures over the past ten years despite a production cost 6x higher than the conventional field. Firms would be willing to accept higher political risk to access a conventional oil field because they would profit off the comparatively lower operating expenses. Royalty reduction strategies, albeit to a lesser extent, are already used in the industry. Often, oil and gas companies will sign production-sharing agreements in which corporations finance the host country’s portion of the oil and gas infrastructure. In return they accept payment via a reduction of royalties until all financing costs are covered.

Surprisingly, the ghost town strategy can also help mitigate risks associated with the extraction process. Oil and gas projects with large, immobile fixed assets in unstable political climates face a significant risk of nationalization. If states choose to nationalize the oil field, multinational firms and their employees – who control, operate, and maintain key infrastructure – will leave the country rendering the ghost town infrastructure use- less. While it is possible that a state could regain this functionality, it could take years to train and develop the personnel necessary to understand and operate complex infrastructure systems.

State Urgency and Benefits

Many states with a diminishing supply of oil are strained to parlay oil and gas revenues into diversified economic and social development. One such example is Equatorial Guinea, where President Obiang recently initiated a Social Development Fund and expressed a desire for rapid urban development, stating “there need[s] to be a vision for the future, we [need] to develop Equatorial Guinea and build its infrastructure… the oil will not last forever.”

Due to aforementioned considerations, states are warming to the notion of a reduction of royalty rates in exchange for construction of public infrastructure. This aggressive approach quickly provides necessary infrastructure, an essential ingredient in states’ efforts to foster economic development, at the expense of long-term royalty cash flow. The ghost town model also allows states to utilize private corporation expertise, capturing the benefits of exploring and developing the oil fields without having to invest the technical expertise themselves. From a sovereignty perspective, multinational corporations are more desirable than SOEs. Angola’s willingness to allow CITIC to take such a significant development role, despite the sovereignty concerns associated with a Chinese SOE accessing its natural resources, indicates how appealing the ghost town energy development strategy can be to host countries.

Potential Locations

There are four criteria used to evaluate the optimal atmosphere for implementation of the ghost town strategy:

• Political stability is essential. No corporation will invest unless they are confident the royalty agreement will remain in place and unaltered by transitioning governments. Political stability can be expanded to include factors such as civil unrest, revolutions, and the rule of law.
• Ease of doing business is an indicator of potential success of foreign direct investment.
• A large and accessible oil reserve is significant from a revenue generating perspective for the corporation; neighboring reservoirs will open the opportunity for continued collaboration between both parties.
• The presence of developed energy infrastructure, particularly oil and gas facilities, is extremely important. Refineries, pipelines, and ports are essential to process crude oil and move it to market.

With such stringent requirements Equatorial Guinea appears to be the only country that currently satisfies the identified criteria. Exhibiting a stable government, Equatorial Guinea has expressed clear intentions to collaborate with a foreign entity to rapidly develop a diversified economy. In addition, Equatorial Guinea has a strong commercial judicial system, ranking 61st of 190 in the “enforcing contracts” ranking. As Africa’s third largest oil exporter, Equatorial Guinea has the significant reserve potential and the associated industry-specific infrastructure. The country’s current environment is primed for a collaborative effort with a multinational investor to implement the ghost town strategy.

Financial Analysis

This financial analysis is predicated on a multinational oil and gas firm identifying an oil field with an internal rate of return (IRR) of roughly 40%. This IRR is required to account for the significant political risk of entering a potentially volatile country and the technological risk associated with developing an oil and gas field. Assuming this requirement is met, the following analysis studies the incremental royalty savings and infrastructure expenditures associated with the ghost town oil strategy:

To determine the town’s construction cost, the CITIC project in Angola can be used as a scalable proxy to construct a town in which 50,000 inhabitants could live. Revenues are based off of Equatorial Guinea’s Alba oil field and a long-term oil price outlook of $94 per barrel. In this scenario, the oil field equipment investment would be 13x greater than the ghost town component. For the ghost town strategy, the target IRR for royalty savings minus capital expenditures is 20%. The required IRR is lower than the hurdle rate for the oil field equipment because the ghost town mitigates the nationalization risk of the oilfield equipment investment As a result, one can view the ghost town as both an entrance strategy into a large production play and as a hedging strategy to protect the investment in oil field infrastructure.

This illustrative example predicts that a royalty reduction of 6%, after tax shield implications, would be required to meet the 20% IRR target. As a result, the royalty rate for Equatorial Guinea would be reduced from its current 15% to 9%. It is difficult to definitively state what a government would be willing to accept in terms of royalty discount, but the cost to the government of financing a ghost town project through its own long- term bonds can be compared to the lost revenue from the royalty rate decrease. In the case of Equatorial Guinea, the cost of debt is assumed to be the central bank’s discount rate of 8.5%. Foregone royalty revenues, when discounted by this rate, equal a net present value of $338M, compared to the required cash outflow of $350M for an infrastructure investment. Clearly, this project is within the realm of financial feasibility and is something that both parties should consider given the long-term strategic benefits.

Recommendation

The ghost town strategy is an aggressive undertaking; however, decreasing conventional reserve options has necessitated riskier oil development strategies. The ghost town model is an entry and hedging strategy that multinational oil firms can use to access reserves in the developing world. It is also clear that states are open to this type of arrangement, given the Kimbala project’s development despite the obvious sovereignty concerns.

Equatorial Guinea would be the most advantageous location for a company like Royal Dutch Shell, who is well poised to execute on the ghost town strategy. Shell has the ability to finance the project at a low cost of 8.2% and has significant experience working in Africa, as 31.5% of its 2011 revenues come from the continent. Shell also has not experienced volume or reserve growth over the past two years, making it well positioned for new reserve opportunities.

With their backs to the wall, private companies are confronted with increasingly high risk or high cost opportunities. If they do not jump into the fray with the ghost town strategy, private corporations will be forever haunted by their hesitation.