In countries with weak institutions, the enforcement of contracts is challenging. This is particularly so when one of the contracting parties is the government itself. Historically, firms in the developed world resorted to their own governments' use of force to protect their investments abroad. For instance, when the Iranian government attempted to renegotiate the contract with the Anglo Persian Oil Company (nowadays BP) in 1953, the US and the UK sent military ships to the Persian Gulf to restrict Iranian’s exports and their intelligence agencies assisted a successful coup d’etat in 1953 (Abrahamian 2013).1 Other examples of military enforcement of contracts include the 1956 attempt to expropriate the Suez Canal Company controlled by France and the UK (Marston 1988) or Haiti’s foreign control of the banking system, recently spotlighted by the New York Times (2022).
This era of coercive enforcement of contracts ended by the early 1970s, bringing about an increased threat of expropriation in countries with weak property rights. The factors that would make such an expropriation threat realise have drawn substantial attention (Guriev et al. 2008, Stroebel and Benthem 2012). Instead, in this column we focus on the reverse question: what can firms do to reduce the risk of being expropriated when formal contract enforcement is absent?
In new research (Paltseva et al. 2022), we argue that firms responded to this increased threat of expropriation by establishing an informal relationship with the government. These informal relationships have the advantage of being self-enforcing, that is, prospective future rents (rather than a court) prevent the parties from behaving opportunistically. A large body of theory (Ray 2002)2 has suggested that such relationships must exhibit a delay in rents given to the government. This comes in the shape of delayed investment, production and payment of taxes and is known as contract backloading. The underlying rationale is as follows. By pushing the government’s rents towards later periods of the relationship, firms make their exit from the country following an expropriation more damaging for the government such that the incentive to expropriate decreases.
In line with these insights, we show that firms indeed responded to the removal of military enforcement by backloading their contracts in countries with weak institutions relative to their contracts in countries with strong ones (which were court-enforced throughout this period). We demonstrate it by using the oil and gas sector. This is the perfect laboratory to test this hypothesis for at least three reasons: it is the capital-intensive industry making expropriations particularly tempting, firm-government relationships last decades allowing us to study the dynamics of their contracts, and petroleum-rich countries vary significantly in their quality of institutions and hence in the need for contracts to be backloaded. We use micro-level data from Rystad Energy that contain information on physical, geological, and financial features for the universe of oil and gas fields.3 We focus on all the fields worldwide owned by the oil majors (BP, Chevron, ConocoPhilips, Eni, ExxonMobil, Shell, Total) which started production between 1960 and 1999, leaving us with a total of 3494 fields. We differentiate between countries with weak and strong institutions using the measure of the constraints on the executive from Polity IV.
The transition to a new world order
Our identification strategy relies on the global transition to a new world oil order, in which expropriations become more feasible, or in the words of Eaton et al. (1983): “decolonisation and the general postwar weakening of the OECD members as political and military actors is an experiment where expropriation is first viewed as impossible and then becomes possible.” This change affected the probability of expropriations in countries with weak institutions while leaving countries with strong institutions unaffected. The change took place gradually between 1968 to 1973 and was driven by the increased political costs of using military enforcement of international contracts. The cost rose due to both international and domestic pressure. First, the idea of countries’ sovereignty over their natural resources, brought by the decolonisation wave of the 1950-60s, had been gaining prominence and eventually shifted the international opinion against the use of military interventions by the Western world.4 Second, there was a growing domestic resistance to military interventions, such as the anti-war protests in the US during the Vietnam War leading to the election of Nixon in 1968 and a complete US withdrawal in 1973.5
The evolution of OPEC provides a good illustration of this change in the oil world order. OPEC was created in 1960, but its influence on the oil market was rather limited until 1968 (for example, OPEC's attempt to use oil as a weapon in the embargo during the 1967 Six-day War largely failed). However, from 1968 on, its power gradually increased. For example, expropriations by OPEC members, Libya in 1970, and Algeria in 1971 were tolerated by the Western world. This gain in power became apparent in 1973 when the Arab-Israeli Yom Kippur War unfolded. The US supported Israel and the OPEC countries responded with an oil embargo, which in turn did not trigger any military response. At this point, it became common knowledge that the era of military enforcement had ended.
Indeed, the transition to a new world order was marked by a substantial increase in the numbers of expropriations since 1968 (Figure 1). However, Kobrin (1980) finds that even during this wave of expropriations, fewer than 5% of all foreign-owned firms in developing countries were expropriated. We suggest that this is, at least partly, thanks to avoidance of expropriation by firms by using self-enforcing and hence backloaded contracts.
Figure 1 Expropriation in all industries
Note: Data on expropriation on all industries from Kobrin (1984).
To test our hypothesis, we estimate a difference-and-difference specification where the countries with weak institutions represent the treated group, countries with strong institutions represent the control group, and our treatment period starts in 1968. We measure backloading by comparing the timing of accumulation of production over a period of 40 years of the field life.6 Our hypothesis suggests that, prior to 1968, there should be no differences in contract dynamics between treatment and control since contracts are enforced either by courts (in countries with strong institutions) or by the threat of military involvement (in countries with weak instructions). However, (gradual) disappearance of military enforcement post 1967 would lead to an increase in backloading in countries with weak instructions but not in countries with strong institutions, where contracts continue to be court-enforced.
The results are in line with the hypothesis. In countries with weak institutions, fields starting production after 1968 take approximately five more years to reach two thirds of cumulative production, relative to fields in countries with strong institutions (Figure 2). A similar delay is observed for tax payments and investment.7
Figure 2 Delay in production in countries with weak relative to strong institutions
Note: Vertical axis measures the difference in the number of years until 2/3 of the cumulative production is reached between the fields in weak and strong institutions countries. Baseline year: 1967. Standard errors clustered by country and start-up year. Only includes 37 (out of 49) countries that do not change institutions in this time period.
The omnipresence of a credible military threat in response to an expropriation served as a substitute for local formal enforcement and eliminated the need for contracts to be self-enforced and backloaded in countries with weak institutions. Once this threat disappeared, agreements had to be backloaded to diminish the temptations of being expropriated. For the period 1974-2019, we find that the average delay is two years. Our back-of-the- envelope calculation suggests that the average country loses around $120 million per year due to the delayed production and the respective tax payments.
While this loss is large, it is important to emphasise that, in the absence of such backloading, oil majors would often choose not to invest in the first place, since they would anticipate the severe commitment problems (Cust and Harding 2020). Thus, as a second-best solution, the cost of the backloading may be seen as marginal when compared to the value-added generated from trade when oil majors are willing to invest in countries with weak institutions and questionable property rights.
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1 As the British officials at the Ministry of Fuel and Power put it in September 1951: “If we reached settlement [...], we would jeopardise not only British but also American oil interests throughout the world. We would destroy prospects of the investments of foreign capital in backward countries. We would strike a fatal blow to international law. We have a duty to stay and use force to protect our interest.” (Abrahamian 2013).
2 For example, see Lazear (1981), Harris and Holmstrom (1982), and Fong and Li (2017) for a labour setting; Albuquerque and Hopenhayn (2004) for a financing setting; Acemoglu et al. (2008) for a political economy setting; and Thomas and Worrall (1994) for an investment setting.
3 A field may be thought of as containing at least one production well, operated by at least one firm with the initial property right being owned by at least one country.
4 See, for instance, the UN General Assembly (1973) resolution on sovereignty over natural resources.
5 Daniel Yergin (1993) summarises concisely this transition: “The postwar petroleum order in the Middle East had been developed and sustained under American-British ascendancy. By the latter half of the 1960s, the power of both nations was in political recession, and that meant the political basis for the petroleum order was also weakening. [...] For some in the developing world [...] the lessons of Vietnam were [...] that the dangers and costs of challenging the United States were less than they had been in the past, certainly nowhere near as high as they had been for Mossadegh, [the Iranian politician challenging UK and US before the coup d’etat in 1953], while the gains could be considerable.”
6 We conduct the analysis on the field level which allows us to control for a large number of confounding factors and rule out several alternative explanations for the contract backloading.
7 Our results are robust to the use of different cumulative production thresholds (½, ⅔ and ¾ of cumulative production), an alternative measure of institutional quality (Polity IV or OECD membership), and the exclusion/inclusion of outliers. Please, see the paper for more details.