Creating a National Oil Company in East Timor: Building on the Experience of Other Producers

Valrie Marcel Dubai School of Government and Chatham House

January 2011 Working Paper Series No. 11-02

Creating a National Oil Company in East Timor: Building on the Experience of Other Producers

Creating a National Oil Company in East Timor: Building on the Experience of Other Producers
Valrie Marcel Dubai School of Government and Chatham House

The Dubai School of Government Working Paper Series is designed to disseminate ongoing research of potential interest to individuals and institutions interested in the development of public policy in the Arab world. Working papers are not formal publications of the Dubai School of Government. Circulation is designed to stimulate discussion and comment, often leading to further revision prior to formal publication. Findings and conclusions are solely those of the authors, and should not be attributed to the Dubai School of Government.

Valrie Marcel is an Associate Fellow at Chatham House and the author of Oil Titans; National Oil Companies in the Middle East.

Correspondence: valerie.marcel@gmail.com

An earlier version of this paper was presented at the International Studies Associations Annual Convention in New Orleans, LA, February 18, 2010.

Dubai School of Government Working Paper 11-02

Abstract
East Timor has decided to create a national oil company, in keeping with best international practice. As a new country with a nascent democracy and acute development needs, its priorities concern national control over the resources and leveraging oil and gas development for greater economic prosperity. What can East Timor learn from the trial and error of other producers? This paper will examine governance challenges in the sector and draw from international experience to find solutions to these. We will focus on the relationship between the national oil company and the state and the governance mechanisms that would both enable the company and ensure adequate state control over the sector.

Creating a National Oil Company in East Timor: Building on the Experience of Other Producers

We want to create a national oil company and we want to do it right from the start. We need to ensure that we have strong participation from society and that we have in place the right mechanisms to ensure good governance. Secretary of State for Natural Resources, Mr. Alfredo Pires Workshop Setting up an NOC in Timor-Leste, Dili, 28 May 2009

1. Introduction
East Timor is a new country and a relatively new gas producer. Its also one of the latest to decide to create a national oil company (NOC), in the footsteps of over fifty countries most of which created their national oil company in the 1960s and 70s. Based on the experience of other established producers, Timor-Leste is aware of the potential fallout of poor governance of this cash intensive sector; notably the risk of corruption and failing to capture all the benefits of petroleum wealth. Timor-Leste has committed itself to setting up its NOC in keeping with best international practice and wants to learn from the experience of other producers. As a young country with a nascent democracy, weak state institutions and acute development needs, its priorities concern national control over the resources and leveraging oil and gas development for greater economic prosperity. What can East Timor learn from the trial and error of other producers? This paper will examine potential weaknesses in Timor-Lestes planned institutional set up for governing the oil and gas sector and draw from international experience to find solutions to these. We will first focus on the relationship between the national oil company and the state, and the governance mechanisms that would both enable the company and ensure adequate state control over the sector. The papers broader ambitions on this point will be to clarify tradeoffs involved in designing various petroleum sector governance structures, a first step in elaborating a theory of oil sector organization. We will then discuss what contribution the NOC should be expected to make in other words, what objectives it should be given and to what extent can it count on local capabilities to support its efforts. a) Policy background In May 2009, a workshop was hosted by the Secretaria de Estados dos Recursos Naturais (SERN) in Dili to review relevant country and NOC experience from around the world and discuss potential applications in the Timor-Leste context. National oil company representatives came to come tell their story, detailing lessons learned from previous challenges. Participants included a wide-ranging selection of stakeholders of Timor-Lestes petroleum sector, including members of parliament, district administrators and civil society. 1 These discussions clarified national objectives for the sector and parameters for establishing a national oil company in Timor-Leste. Most important, Timor-Leste should strengthen its petroleum expertise in order to avoid dependence on international oil companies and allow national
See http://www.chathamhouse.org.uk/events/view/-/id/1277/ for details of the workshop, summary notes and presentations from NOC participants and Chatham House.
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Dubai School of Government Working Paper 11-02

control over the sector; governance mechanisms must be put in place to ensure the accountability of the NOC and prevent it from growing into a state within the state. A clear preference was expressed for a governance system with a strong ministry of energy (which is, in the Timor context, the Secretaria de Estados dos Recursos Naturais or SERN) rather than a strong national oil company. This paper therefore does not discuss how to establish a corporatized NOC model 2, which would involve the NOC acquiring a higher degree of legal, managerial and financial autonomy from the state. Recent research on how governance systems affect performance has correlated systems that give the NOC greater decision-making autonomy and rely on monitoring operations with improved financial performance (Hults, forthcoming). However, states do not only pursue financial objectives when governing the oil and gas sector. As our discussion will show, Timor-Lestes government and civil society are united, for somewhat different reasons, in wanting to put in place strong mechanisms to control the decisions of the NOC. b) Theoretical framework For an optimal benchmark of good governance 3 in the oil and gas sector, this paper draws on the framework devised by Chatham Houses project on Good Governance of the National Petroleum Sector. Beginning in 2005, Chatham House and the Centre for Energy, Petroleum and Mineral Law Policy (CEPMLP) at Dundee University facilitated a dialogue between participants primarily from government and national oil companies from 23 developing and developed oil- and gas-producing countries. 4 Working parallel to a series of international workshops, an editorial group (led by the author) drafted documents which were reviewed by an Advisory Committee composed of representatives from the oil and gas producing countries. The main conclusions are summarized in Good Governance of the National Petroleum Sector: The Chatham House Document. 5 This document presents 5 universally applicable principles and 40 benchmarks to help producers assess their systems of governance. 6 The more detailed Good Governance of the Petroleum Sector Report provides examples from country case studies and offers contextspecific checklists and guidance for the petroleum sector policy- or strategy-maker. 7 The project focused on the relationship between NOCs and their governments, which is key to successful management of petroleum resources. In light of exporting countries dependence on volatile oil revenues, another key focus was on how petroleum activities can be leveraged to stimulate the non-petroleum economy.
G. Lahn, V. Marcel, J. Mitchell, K. Myers & P. Stevens (2007). Report on Good Governance of the National Petroleum Sector, Chatham House, London, April, p. 13. 3 Petroleum sector governance refers to the system for making and implementing decisions concerning the exploitation of a nation's oil and gas resources. It includes the structural and hierarchical organization of the sector, its decision making and communication processes, the policies and objectives governing its activities and the regulation of those activities. 4 The projects team included Professor Paul Stevens, John Mitchell, Dr Keith Myers, Willy Olsen, Glada Lahn, Pedro Gmez, Professor Isabelle Rousseau and the author. 5 http://www.chathamhouse.org.uk/files/9761_ggdoc0407.pdf 6 The Norwegian Agency for Development Cooperation (NORAD) drew on these benchmarks to develop a comprehensive and detailed checklist to help producers and the Oil for Development programme assess the state of petroleum-related governance in a given country in relation to the ideal. Further details on this can be found at: http://www.norad.no/en/Thematic+areas/Energy/Oil+for+Development/OfD+Information+Package/Good+ Governance 7 http://www.chathamhouse.org.uk/files/9762_ggreport0407.pdf
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Creating a National Oil Company in East Timor: Building on the Experience of Other Producers

These concerns, which are of particular interest to the producers, are reflected in the articulation of all five universal principles of good governance: 1. Clarity of goals, roles and responsibilities - Because of its special importance to national politics and economics in many countries, the petroleum industry can be prone to competing agendas and attempts to control decision making for the sector. For each policy, strategy or operational decision, there has to be clarity on the intended outcome of the decision, who will be involved in making it and how. 2. Sustainable development for future generations - As a capital-intensive, rather than people-intensive, industry, dependent on finite resources, sustainability must be at the heart of petroleum sector policy making. Sustainable development policies aim to meet the needs of the present without compromising the well-being of future generations. 3. Enablement to carry out the role assigned - For optimum performance, each actor must have access to the necessary means in terms of authority, financial resources, information, human capacity (skills, knowledge, experience etc.) and supporting processes. 4. Accountability of decision making and performance - Accountability of decision making and performance provides assurance to society that decision-makers (individuals and institutions) are identified, and that their performance is assessed objectively. 5. Transparency and accuracy of information - Whatever the precise mechanisms of governance and accountability in a particular national context, their effectiveness depends on reliable and timely information. Though these principles might be universal, practice depends on the national context and the state of development of the sector. There cannot be a detailed, one-size-fitsall model for good governance of the petroleum sector. Each country has a unique geological, economic, political and social context that will influence the environment in which the petroleum operators exist. The national context evolves over time, and petroleum sector governance has to adapt in response. Identifying and understanding the national context is therefore a first step in developing strategies for improvement of governance in the petroleum sector. The present paper discusses what oil sector organization can support the realization of the five principles of good governance within the parameters of the existing national context in Timor-Leste. The paper is structured around the main national context indicators that are relevant to the establishment of an NOC: 1) The political system: Identifying with which state institutions the NOC will have to interact; determining whether roles and responsibilities are clearly distributed within the system and the level of stability of the political system in which the NOC will operate 2) The economy the extent to which the national economy can support and benefit from the activities of the NOC and the degree of dependence on petroleum resources

Dubai School of Government Working Paper 11-02

The table below shows Timor-Lestes scores on some of the key national context indicators. Each indicator is rated on a simple spectrum of high and low. 8
Chart 1 Assessing the national context in Timor-Leste NATIONAL CONTEXT THE POLITICAL SYSTEM Centralization of institutional power Government dominance over the NOC Clear division of roles & responsibilities THE ECONOMY Level of economic development Development of a national vision Contribution from petroleum Size of reserves Dependence on petroleum CAPABILITIES & SKILLS Competence of NOC State capacity Human capital/local content potential Possibility to learn from foreign partners Support of population for the sector
HIGH LOW

X X X X X X X X X X X X

The paper draws extensively on the literature produced by the project on Good Governance of the National Petroleum Sector, which is comparative and policyoriented, as well as the data collected by the author during the policy workshop held in Dili, which provided invaluable insight into policy and public debates on the energy sector in Timor-Leste. A number of secondary sources also provided valuable information on Timor-Leste. 9

2. The Political System

Timor-Leste was largely a Portuguese colony until 1975. Nine days after declaring its independence from Portugal, it was invaded and occupied by Indonesian forces. A protracted struggle ensued over the next two decades. Estimates of the numbers killed during Indonesian occupation range between 100-200,000, a quarter to onehalf of the population at that time. 10 In 1999, a UN-supervised popular referendum resulted in a large majority voting for independence from Indonesia. However, in the following month and before the arrival of multinational peacekeeping forces, Indonesian-backed Timorese militia engaged in a large-scale scorched-earth campaign of retribution. Approximately 70% of the countrys economic infrastructure and 100% of the electrical grid were destroyed. 11 The Australian led peacekeeping forces deployed in the country in September 1999 and brought the violence to an
As defined by local stakeholders during discussions at the May workshop and otherwise, by the authors assessment 9 Paul Stevens, Elisa Cassinadri (2008) and others in the bibliography. 10 East Timor, Oxford Economic Country Briefings, Oct 2, 2009 11 CIA World Factbook, Timor-Leste, https://www.cia.gov/library/publications/the-world-factbook/geos/tt.html, accessed 4/02/2010.
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Creating a National Oil Company in East Timor: Building on the Experience of Other Producers

end. On May 2002, Timor-Leste was internationally recognized as an independent state. In April 2006, a near breakdown of law and order followed a military strike led by the petitioners. International and UN peacekeeping forces restored stability, allowing the first Timorese-run presidential and parliamentary elections to take place in 2007. In February 2008 a rebel group attempted a (poorly organized) coup against the president, which was thwarted. Since the attack, peace and stability has been maintained. Timor-Leste is emerging as a genuinely competitive multi-party system, albeit with tensions in the ruling coalition government and regional-ethnic cleavages.

a) Centralization of institutional power Broadly speaking, a fragmented political system can be detrimental to the petroleum sector if it cannot provide it with clear and consistent direction. Conversely, a centralized system may involve limited transparency and accountability processes. Centralization or fragmentation of the political system can be assessed in the relationship between the executive and legislature and the dominance of certain institutions or individuals in decision making for the sector. Parliamentary and congressional systems offer greater decentralization, and with it greater accountability of the executive, but also, sometimes fragmentation. TimorLeste has a unicameral parliamentary system based on the Portuguese model12; however, the existence of a parliament in Timor-Leste has not involved a decentralization of institutional power over the petroleum sector, as it has done in Iran, Kuwait, Mexico and Norway, for instance. In Timor-Leste, information and capacity pertaining to the petroleum sector are concentrated within the executive government. While the legislature could increase the accountability of executive decisions surrounding the sector and its performance, at present, the parliaments potential for balancing executive power is limited by the fact that it has no specific role in the petroleum governance system as of yet and by the low level of expert knowledge in the legislature. Increasing the role and capacity of Parliament in Timor-Leste would bring potential advantages and possible pitfalls. The involvement of parliament in matters of local content or health, safety and environment (HSE) standards in the NOCs operations has had a positive impact in several countries. The parliament can also attract public attention to important issues affecting the sector, bring about dialogue between state institutions (and the public) regarding the most appropriate goals and objectives for the sector, and thus increase the legitimacy of the decision taken. 13 That said, a broad role for parliament is not usually the most conducive for enabling the NOC to pursue its strategic objectives. In some countries, the involvement of multiple institutions in the decision-making process has led to incoherent policy and strategy directives and unclear lines of responsibility. This is the case in Kuwait, where the NOCs investment plans and draft contracts, for instance, must be submitted to the
President Jose Ramos-Horta was elected in 2007. The head of states role is largely symbolic but he or she has the right to veto legislation, dissolve Parliament and call national elections. The Prime Minister, Kay Rala Xanana Gusmao, heads the government since 2007. A distinctive feature of the Timorese political system is the separation of the legislature and the executive. Ministers do not need to be members of parliament, and any MPs subsequently appointed as members of the executive government are replaced in the legislature per party lists (Leach, 2009). 13 See section Clear division of roles and responsibilities, p. 10, for further discussion on the role of parliament.
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National Assembly after they have been approved by the companys board, the oil ministry and the Supreme Petroleum Council. Parliamentary involvement has also led in some cases to lengthy approval processes for setting objectives and targets for the oil and gas sector, as seen in the Iranian and Kuwaiti parliaments opposition to the terms of foreign investment terms. Objectives for the oil companies and NOC may be entangled with other political issues: parliaments have opposed the commercialization of the NOCs goals (e.g., the Iranian Majlis has opposed the removal of subsidies on gasoline and the Kuwaiti parliament has opposed removing restrictions on the use of non-Kuwaiti crudes in the NOCs international refineries). In fact, David Hults recently correlated financially performing NOCs with governance systems that are highly unified, as opposed to fragmented. While Hults acknowledges that fragmented authority may have a beneficial impact on the NOCs autonomy, the advantages of policy coherence outweigh those of autonomy. In concert with our proposition that active parliaments can lead to multiple and conflicting objectives for the NOC and unclear governance roles, Hults found that the best performing NOCs were governed by states that have centralized authority over the companies (Petrobras, Petronas, Saudi Aramco, Sonangol and Statoil). We note that two of these cases have Parliaments - Statoil and Petrobras; however, in Norway and Brazil the energy ministries hold primary governance authority as opposed to Iran, Kuwait, India, Nigeria and Mexico, where competing interests in the executive and legislative branches maintain separate lines of NOC authority and sometimes wrestle with one another over oil policy. That said, not all NOCs operating in a system of centralized authority perform well (e.g., Venezuelas PDVSA under Chavez and Russias Gazprom). 14 The reason for this could be that in such cases the leadership or regime in power has an insecure grasp on power that prompts it to press their NOC for short-term political gains or rely on cronyism to maintain power. 15 Part of the recipe for success in the unified governance systems includes the ability of the institution responsible for the sector to take a long-term view of its needs (and therefore also depends on the political permanence of that institution). Clearly, the Timorese political direction of the sector will be highly centralized. The institution responsible for oil and gas sector policy making and overseeing the NOC is the SERN. There are no other governing councils involved, nor are other government bodies interests formally represented (except in the Cabinet meetings), and this degree of centralization is greater than that of other centralized governance systems. In Saudi Arabia and Abu Dhabi, for instance, proposals regarding the oil and gas sector are debated on the NOCs Board and in a higher governing council (Supreme Petroleum Council or SPC). While decision making in petroleum matters in these centralized political systems is hierarchical and dominated by a strong political actor, such as the minister of petroleum on the board in Saudi Arabia and in both cases the ruler of the country on the SPC, other actors tend to be involved in decision making through membership on the relevant governing bodies. For instance, the minister of finance and the minister of planning are usually represented, and in some cases there may be representatives from civil society (such as the chamber of commerce or a university dean) represented on the Board.
We can also add to these cases, Indonesias Pertamina during the Suharto era. David Hults, Hybrid Governance, in Oil and Governance: State Enterprises and the World Energy Supply (forthcoming), Cambridge University Press.
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Creating a National Oil Company in East Timor: Building on the Experience of Other Producers

The Saudi Aramco board includes retired executives from private oil majors, in order to provide non-political input. The presence of multiple political actors in the governing bodies provides a forum for consensus building and allows greater policy coordination. Timor-Lestes comparatively extreme centralization reflects its limited human capacity and a relatively immature institutional development. The country has a simplified institutional framework because the hydrocarbons sector is new and small. The focus across the political spectrum is on establishing strong institutions that can keep a firm grip on the NOC and avoid corrupt practices within the NOC. And all indications are that the SERN (and the newly created regulator, National Petroleum Authority/ANP) are seen as suitable candidates to concentrate this institutional power over the future NOC. But further institutions need to be created to provide inputs into the decision-making process and also checks to balance the SERN, whilst maintaining the strong and consistent direction of the sector. To this end, broader government, legislative and civil society influence will have to brought to bear on the SERN to involve other actors in decision making. The Timorese could introduce a board to oversee the new national oil company and above it a governing body, like a petroleum council. These bodies would involve other ministries and perhaps members of civil society. A petroleum council can hold the NOC to account and oversee its strategic plans (presumably these would first be approved by the NOCs Board of Directors), leaving SERN to focus on policy (devising objectives, laws and regulations) and overseeing the regulatory agency. Determining which responsibilities fall on a petroleum council depends on what lines of accountability the state wishes to strengthen. A petroleum council can be responsible for some of the following: 1. Reviewing and/or approving the strategic plans of the NOC 2. Reviewing and/or approving regulations and policy (though this can be done by Parliament) 3. Overseeing the performance of the NOC (The National Petroleum Authority/Autoridade Nacional do Petrleo (ANP) would actually monitor the performance) The composition of a petroleum council can be more bureaucratic, if its primary purpose is to encourage input from the various civil bureaucracies affected by the energy sector (e.g., SERN, ministry of finance, treasury, the petroleum fund, ministry of labor, ministry of commerce, ministry of education). A council of this type is less useful in a political system where the cabinet already plays a strong role. Alternately, the council could include trade unions, representatives from institutions of higher learning, and even non-governmental organizations. Including these representatives in the decision-making body reinforces the principle of participatory development. However, it is more common for non-governmental members to be included in the Board of Directors, rather than the petroleum council. 16

16

For examples of the composition of petroleum councils and boards in various countries, see the Good Governance Report, op. cit., pp. 59-60.

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Another point to raise in regards to the centralization of power in Timors petroleum sector is that a handful of officials act in numerous capacities, representing the state or SERN on all relevant commissions and boards. The dominance of individuals in decision making can give the sector the vision and direction to get things done. Many other producing countries have concentrated decision making in the hands of a single individual and sometimes to good effect. Minister of Energy and Mines, Chakib Khelil, in Algeria spearheaded a controversial reform of the hydrocarbon sector. To accomplish this he strengthened his grip over personnel decisions in Sonatrach and ensured he was the single driving force of the national energy sector. In Malaysia, former Prime-Minister Mahathir bin Mohamad was closely involved in the affairs of national company Petronas and his office relied on Petronas funds to finance development projects. 17 The President of Libyas NOC, Chokri Ghanem, a reformer with close ties to the leader, was able to orchestrate an opening of the petroleum sector to foreign companies. In many such cases, the strong man of the sector derives his or her influence from support from the leader (or, indeed, is himself the leader, as in the Malaysian case). However, a sector dependent on one or two persons falls into disarray when changing political or personal circumstances lead them to be replaced. Moreover, a more personalized system does not tend to promote free flow of ideas or checks and balances. Graft or corruption can go undetected more easily in a system dominated by one personality unless he or she stands against such practices. Institutionalizing power, by granting seats on various commissions and boards to individuals on the basis of their institutional affiliation, is a sign of a mature political system. In new country with weak institutions and limited skills individuals to oversee the sector, extending the representational role to a greater number of institutions (and officials) would educate more officials (and by extension the institution they represent) on how business and policy is conducted in the energy sector. b) Government dominance of NOC (Top-Down process) A clear priority expressed by stakeholders at the workshop was to have strong and consistent government direction of the sector. In other words, government should decide what the NOC does, have access to information about the NOCs operations and be able to hold the NOC to account for its performance. A strong direction of the sector implies a top-down process. A consistent direction of the sector implies it rests on policy guidelines and processes that survive the change of government. The Timorese civil society groups and Parliamentarians represented at the workshop demonstrated a mistrust of oil companies that extended even to the national oil company they wished to create. This is not unique of course, as we saw from Chavez supporters in Venezuela or from Kuwaiti MPs, weary of both government and NOC, but it is not the norm. In many producing countries the NOC embodies nationalistic aspirations and is the custodian of the resources, protecting them from foreign control, and a provider of public goods. But the Timorese struggle for independence was not carried by the national oil company, as occurred in a number of producing countries during the 1970s era of nationalization. Consequently, they
17

Interviews with the author in Malaysia, 2004.

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Creating a National Oil Company in East Timor: Building on the Experience of Other Producers

wish to ensure that the future national oil company would not have the means to develop into an overly powerful organization a state within a state, which would not be acting in the interest of the people but in the pursuit of its corporate interests. Interestingly they had greater trust in their young government to protect their interests. 18 The Timorese have therefore entrusted the SERN with a great deal of power. It will likely be able to provide the NOC with clear and firm direction satisfying the objective expressed at the workshop to keep a strong government grip on the NOC, but it could have an adverse effect on the NOCs capacity to develop its skills and capability to a high industry standard. Here our discussion turns to the question of whether the governance of the sector will allow the enablement of the national oil company to carry out the role assigned to it. There is a temptation for a strong ministry or secretariat to interfere in day-to-day NOC operations, rather than restrict itself to its responsibilities for dictating policy guidelines and overseeing the sector. If the company runs like an extension of the ministry rather than as a business, this can result in a bureaucratic corporate culture with a lack of entrepreneurial drive amongst NOC employees. This is likely to translate in efficiency losses. The NOC may have more difficulty in attracting and retaining high caliber staff. Also, with less autonomy, the NOC may not have the space in which to develop its managerial competence. As a consequence, the NOC may not develop into a trusted partner for government, which is able to make sound recommendations to government about what is needed to develop the sector. This has occurred in other countries, such as Trinidad and Tobago, where the NOCs voice is muted by stronger government forces and in Iran, where the NOC has difficulty attracting the best local talent. Without challenging the basic (and legitimate) policy choice to have a top-down system with a dominant ministry, some provisions can be made to limit such negative fallouts. For instance, directives can limit interaction between the NOC and government representatives (as well as non-government representatives) to Board of Directors meetings. In such cases where the board becomes the sole interface between government and NOC, strategies and budgets are approved at the board level. 19 In Saudi Aramcos case, for instance, the King has forbidden any direct contact with the managers of the NOC outside the Board meetings. This has ensured that the NOC is not pressed for special favors or subject to the pressure of special interests (for appointments or local contracts for instance). By contrast, the Kuwait Petroleum Corporation is not ring fenced and the managers have been frequently pressured to hire nationals by way of family connections.
Views expressed by local stakeholders at the workshop in Dili are borne out by a more systematic and comparative survey: In the World Economic Forums ranking of Public Trust in Politicians, Timor-Leste scored a high ranking of 52nd out of 139 countries. See The Global Competitiveness Report 2010-2011, p 369. Respondents asked how they would rate the level of public trust in the ethical standards of politicians in their country.
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Timor-Leste can choose to have a government- or company-dominated Board, though the composition of the board is not necessarily reflective of whether the NOC is under the firm control of government. To avoid the multiplication of informal government contacts with the NOC, it may be advisable to have the key government figures represented on the board. Another option is the Statoil board model, which was dominated neither by the company nor by government figures, but by external experts representing different segments of society. The Minister was the shareholder and had ultimate decision-making power in a general assembly.
19

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Financially also, plans are to maintain a firm grip on the NOC. The preferred financial structure for the proposed NOC is a budget allocation from government. There are a variety of systems in which the NOC basically surrenders its operating revenues (to the treasury and/or to a petroleum fund) and is refunded or retains cash for its capital programme (e.g., Iran and Mexico under the former system). A risk inherent to a budget allocation system is that the NOC can end up inflating costs. This is because this is in fact a cost plus system and the NOC will deduct its operating costs from the operating revenues transferred to the state. Financial incentives and performance incentives can be introduced to encourage the NOC to generate profits. Of course, auditing expenditure is also essential, though some countries have erred to excessive, over-detailed financial scrutiny that paralyzes operations. A second risk with this system is that the company wont be given enough capital to commit to its development plans. This is likely to occur when oil/gas prices dip and the government budget becomes strained and other development priorities of government (education, healthcare) take precedence over capital expenditure programmes. The National Iranian Oil Company (NIOC) and Petrleos Mexicanos (PEMEX) are examples of cash strapped NOCs with annual budgets that are part of the governments annual budget (which must be approved by Congress). While PEMEX posts positive pre-tax profits, it generates post-tax losses and has been forced to depend on debt to finance its capital projects. Similarly, the Nigerian National Petroleum Corporation (NNPC) had to borrow funds last year to pay the governments joint venture share of the costs to develop Nigerias onshore fields. Companies with uncertain capital expenditure budgets (largely because their budgets are not protected from government pillaging) have found other ways of raising capital, such as bond markets (PEMEX, PDVSA, PetroChina, CNOOC, Qatar Petroleum) and export credit agencies (PEMEX, Sonangol). They can also secure capital from foreign investors and loan markets. Chinese state oil companies have high access to capital and have in the past shown willingness to partner with financial institutions to extend loans to producing countries (often in exchange for future production). Some companies have also mitigated the impact of fluctuating budgets thanks to accumulated cash reserves or a reserve fund. This helps the NOC make long-term planning. 20 However, until Timor can boast commercially proven reserves in its exclusive territorial waters, it will be difficult for a new NOC to raise capital. c) Division of roles and responsibilities There is often confusion between the ministry of petroleum and the NOC over responsibility for policy and strategy making and what the difference is between the two. Public policy typically comprises a set of objectives, laws, plans, political actions and standards of behaviour that aim to achieve goals in the national interest. In addition to policy specific to the petroleum industry, broader public policy may impact on the oil and gas sector. This could

20

Valerie Marcel, The National Oil Company Investment Challenge, KPMG International, 2009.

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Creating a National Oil Company in East Timor: Building on the Experience of Other Producers

include for example, measures to encourage private sector involvement, protect the environment, or increase the employment of nationals. The strategy function concerns how the oil and gas sector will deliver national policy objectives (e.g. the pace and means of oil and gas development, the programmes to build local capacity; priorities for the use of scarce resources, responses to uncertainty etc.). The distinction between policy and strategy functions is important, but is often unclear. 21

The regulatory and policy-making functions are admirably clear in Timor-Lestes system: the SERN will be responsible for policy making and the ANP for monitoring operators. The NOCs role will be limited to operations. It will be accountable to the SERN (as is the ANP, the regulatory agency). However, the boundaries of SERNs prerogatives are not yet clearly laid out with respect to strategy-making. The state will need to determine which body is responsible for elaborating the NOC strategy and which body will review and approve this strategy. Also, the state will need to specify the role of Parliament and clarify its relationship with the NOC. Parliament can approve the strategic direction of the NOC, but it should not be involved in reviewing its day-to-day operations and decisions. In order to enable the NOC financially, it is preferable that the Parliament is not responsible for approving the NOCs budget; but it should be informed of the budget (and can be tasked with determining equity capital for the NOC). Among other potential responsibilities, Parliament can approve field development plans, highlight issues of concern, review and amend bills and prepare an annual white paper summarizing events, policies and activities.

3. Economy
The economic background in Timor-Leste is a critical element of national debates about the creation of a national oil company. East Timor is a low capacity producer in terms of human, industrial, state administrative and sectoral capacity. 22 Expectations are high about the NOCs future contribution to national capacity-building and stimulation of the economy. However, the NOCs real means to impact the economy and capacity levels will be limited. Our discussion will center on what the NOC can realistically accomplish in Timor. a) Development of a national vision In a rush to develop the resources and bring economic and development benefits to the population, many countries have ended up with haphazard policies, duplication of efforts or NOC strategies that conflict with government goals. In order to avoid wasting critical human capital and resources, it is beneficial to develop an overarching guiding strategy for national development and delineate the role the energy sector should play in this strategy. Such was the experience of Trinidad and
The Chatham House Report on Good Governance of the National Petroleum Sector, April 2007, p. 15 Policy choices faced by low capacity producers are discussed at length in a forthcoming paper by the author and Patrick Heller, Institutional Design in Emerging Oil Hotspots: Optimal Governance Functions of New and NonOperating NOCs.
21 22

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Tobago, which developed Vision 2020 in a large grassroots exercise to identify the future direction of the industry and to rally educational, public policy and private sector efforts behind the same goals. Timorese interest in Trinidads experience is high and a delegation of Timorese government officials visited the country in the fall of 2009 to learn more about their master plan for the energy sector. A national vision can be developed thanks to public participation (town hall meetings) or through committees (or both). Involving the public presents the advantage of educating the population on the ways in which the energy sector can contribute to development and prosperity. It also helps to raise public support for the national energy sector. A committee driven effort will be more concrete and detail-oriented. It can help build consensus among various political interest groups if the composition of the committee reflects a broad political spectrum (and includes non-governmental groups). Both public and committee processes would be beneficial in East Timor. The public consultation can foster nation-building, while the committee exercise can broaden support for the AMP coalition. Key issues that can galvanize various groups include how to leverage foreign investment in the energy sector to stimulate the domestic private sector. However, Michael Leach has argued that policy debate in East Timor is stunted by alliance politics, heavily centered on leaders personalities and regional loyalties. There is therefore a risk that a consultation could become lost in a bargaining game between regional governing parties trying to satisfy local patronage networks. That said, the Timorese authorities have experience in public consultations. They prepared the National Development Plan in 2002, thanks to a broad-based consultative process which solicited input from 38,000 people in 980 public meetings. The plan outlined a long-term development vision and strategy through to 2007, which was discussed in a workshop with stakeholders, amended to incorporate workshop results and then approved by Parliament (IMF, 2005). 23 A key factor in the applicability of a development vision is its grounding in a fair assessment of realities on the ground e.g., the countrys economic potential in terms of its hydrocarbon reserves, non-hydrocarbon resources, geographic location, education level, the estimated size of the petroleum windfall and its potential to support the economy. This is particularly important in Timor-Leste, where the population holds unrealistic expectations about the transformative potential of the oil and gas activities. 24 A good understanding of the resource base is necessary to lay out appropriate policy for the long-term development of the sector and ancillary sectors, and for determining NOC strategy. A long lead time is needed to build up this infrastructure and service industry. This was Trinidad and Tobagos success story, as it built up a whole industry to support its upstream gas activities over 20 years. On the basis of the estimated operational requirements at various stages of development, it anticipated these needs by creating local capacity through education, fostering businesses and calling on the local capital markets, as well as

The key action areas of this plan are: improving governance (strengthening the administrative structures of the state, the justice system and the security forces), service delivery for poverty reduction, and job creation (IMF, 2005: 8-9). 24 The IMF explains that, if well harnessed, Timor-Lestes petroleum wealth can offer its citizens a more prosperous future. But there are many challenges, such as the limited capacity of public institutions to execute budgetary public investment (IMF, 2005: 8). Prosperity has so far eluded the Timorese, as the non-oil GDP remained broadly flat up until 2007, in spite of the onset of oil and gas production in 2004. Poverty remained pervasive (IMF, 2009: 7, 15).
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Creating a National Oil Company in East Timor: Building on the Experience of Other Producers

shoring up institutions and the regulatory framework. 25 The idea was to have goods, services and skills on the ready when they would be required by operations. This careful planning and execution is surely a model for producing countries. However, the Trinidadians had some aces in their hand: they knew they had significant gas reserves and their population was already well educated. In Timor-Leste, the potential to develop a value chain is greatly constrained by the fact that the private sector is underdeveloped, education levels are poor and oil and gas activities are offshore and the resources are then brought to Australia. b) The size of petroleum reserves Available data on Timor-Lestes reserves are limited. According to the CIA World Factbook, proved oil reserves as of January 2008 are of 553.8mnb, placing TimorLeste near Bolivia and Turkmenistan in world proved reserves ranking. Its proved natural gas reserves are 200 billion cu m (1 January 2006 estimate), ranking TimorLeste 44th worldwide among gas reserve holders, after Syria and Papua New Guinea. 26 As such, Timor-Lestes hydrocarbon resources are modest by international standards but massive compared to the small size of its economy. The IMF put Timor-Leste among the most petroleum dependent countries in the world, as measured by its ratio of petroleum revenue to non-oil GDP (IMF, 2009: 4). And the resource base may grow significantly: exploration activities in Timors (hitherto largely unexplored) waters are being carried out by foreign companies and there are high hopes locally of major finds (Stevens, 2008: 8). 27 Production currently is from the gas-condensate Bayu-Undan Field in the Joint Petroleum Development Area, operated by ConocoPhillips and producing since 2004. Revenues are divided between Australia and Timor-Leste. The next field likely to be developed is Kitan, which is estimated to contain 30-40 million barrels of oil and could come into production in 2010-11 (IMF, 2009: 5). The much larger Greater Sunshine Field, a gas-condensate field, which is operated by a consortium led by Australias Woodside Petroleum, contains an estimated 240 million barrels of light oil and 5.4 trillion cubic feet of natural gas. It was expected to come into production in 2013, but the project has faced repeated delays and a development plan has yet to be agreed upon. The most recent delay for the Greater Sunshine project stems from disagreements about where the natural gas should be piped for processing. Sharing control and revenues from this and other fields in the Joint Petroleum Development Area has been a major source of tension between Timor-Leste and Australia. The geographic location of future discoveries will be critical in order to gain wider economic contribution from petroleum resources. However, Lao Hamutuk, the Timorese NGO, has wisely warned that piping gas to Timor is not a sufficient condition for economic development and that other weaknesses must first be addressed: the fragility and inexperience of state institutions, lack of human resources and inability to execute the budget (Lao Hamutuk, 2008).
Anthony Paul, presentation at the NOC workshop in Timor-Leste, Dili, 28-29 May 2009, Natural Gas for Sustainable Development, available at http://www.chathamhouse.org.uk/event/file/download//id/1277/doc/14529 26 CIA World Factbook. 27 Timor-Lestes hydrocarbon resources lie in 3 areas: sovereign onshore, sovereign offshore and the joint petroleum development area (JPDA). The sovereign areas are administered by the Directorate of Oil and Gas, while the JPDA is administered by the Timor Sea Designated Authority.
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Dubai School of Government Working Paper 11-02

c) Potential for economic linkages with the petroleum sector In the 3 years following the arrival of peacekeeping forces in 1999, a massive international programme led to substantial reconstruction, but the country remains severely underdeveloped in terms of infrastructure, with weak state institutions, and high unemployment (estimated between 20% 28 and 50% 29). In 2003 World Bank estimates of the proportion of the population living below the poverty line were fortytwo percent. With adult illiteracy at 40%, 30 the NOC will not be able to draw on a large pool of local candidates for recruitment. While training, education, and secondment with international oil companies are the priority programmes for SERN and ANP, plans are to recruit foreign talent until competent nationals are able to fill these posts. As pertains to the business environment, Timor-Leste suffers from a combination of relatively high wages and energy prices, poor communications and high administrative costs of doing business (IMF, 2005: 13). Fiscal, administrative and regulatory changes are underway to increase the ease of doing business in the country. Large-scale and long-term state programmes for poverty reduction, education and infrastructure development are needed to raise the countrys human capital. Since 2005, the development of offshore oil and gas has greatly shored up government revenues and the major policy challenge is how best to leverage the oil and gas wealth to stimulate the non-petroleum sector and to reduce poverty. The petroleum fund, established with income from the Bayu Undan field already in development, is the governments principal source of revenues. 31 Hopes are pegged on the development of the larger oil and gas field, Greater Sunrise, to provide greater revenues and transform the economy. As it stands presently, Timor-Leste is highly dependent on its petroleum revenues to finance the government budget (oil and gas account for 95% of government revenue and approximately 73% of GDP) (Stevens, 2008: 5). 32 The high inflow of oil revenues has the potential to alleviate the high rates of poverty and unemployment, but overspending can bring a severe resource curse. The private sector is extremely weak in Timor-Leste. 33 The non-oil economy is very limited (largely to subsistence agriculture) and there is little domestic industry to support the upstream gas activities. As Mitchell and Stevens have argued, with its comparatively small population of 1.1 million, Timor-Leste does not have the domestic purchasing power that have allowed Indonesia and Iran to diversify economically. Therefore, access to international markets is key. Mitchell and
CIA World Factbook, Timor-Leste Stevens and Cassinadri, op.cit., p.3. 30 IMF, 2005: 7. 31 In 2005, the National Parliament unanimously approved the creation of a Petroleum Fund. The Fund receives all petroleum revenues. The Fund is prudently managed and has been praised for operating in a transparent manner. This has helped cement the publics trust in how petroleum resources are managed by the state (IMF, 2009: 15). The agreed spending level has been calculated at 3 percent of petroleum wealth, which for 2008 is estimated to be $294 million (Stevens, 2008: 6). 32 It is estimated that when the Greater Sunshine Field comes on-stream, the sector will account for 89% of GDP and 94% of government revenue (Mitchell & Stevens, 2008: 28). 33 Skilled personnel has been largely absorbed by the public sector. Competition for the small pool of skilled personnel has pushed wage levels upwards, making it more difficult for the private sector to compete (Mats Lundahl; Fredrik Sjlholm, 2009)
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Creating a National Oil Company in East Timor: Building on the Experience of Other Producers

Stevens have sought to identify the necessary conditions for the development of the non-hydrocarbon economy in petroleum dependent countries: 1) First and foremost, investing in developing human capital through education in concert with private sector needs, 2) Developing and maintaining infrastructure, 3) Making capital available to the private sector 34, 4) Good institutions and governance that allow the state to provide services, 5) Entrepreneurship supported by a favourable business climate, and 6) Effective management of the petroleum revenue windfall (to avoid the resource curse) (2008: 30-35). At present, there is little potential for the petroleum sector to support the development of the private sector and the non-oil economy through its regular operations until the service and manufacturing industries develop and the banking sector matures. Policy initiatives are required to strengthen the regulatory environment. An overhaul of the Investment Law and Land and Property Law will also be beneficial to the private sector. Efforts to bolster education levels will also ultimately increase the pool of candidates for recruitment. Even in the case of diversified economies, the hydrocarbon sector can provide only limited economic linkages to the economy because it is a capital-intensive industry. In Timor-Leste, the potential contribution from the sector is further limited by the fact that production facilities are offshore and the gas is piped to Australia. The government of Timor-Leste is advocating the establishment of an LNG facility on Timor-Lestes coast. Public expectations will have to tempered regarding the NOCs potential impact on the economy through its supply chain, as the main economic stimuli will first come from government policies and spending. d) Building NOC competence and State capacity Enablement is a major governance issue for producers. Delegating decision-making authority and reinforcing capacity are the first steps in the process of enablement. As the governments capacity grows, it should normally take over most infrastructure, welfare and education programmes of the NOC so that the NOC can focus on optimizing resource development. The NOC, for its part, needs to provide reliable information and transfer knowledge to government to enable government to choose best policies for the petroleum sector. It goes without saying that the NOC will have very low competence levels when it is first created. It will be a small team with a lot on its plate. Unfortunately, state institutions will not be able to offer support for its first deployment, considering the weak state capacity. Indeed, delivery of public services is not impeded by a lack of financial resources, but rather by limited human resources and embryonic institutions (IMF, 2005). Stevens and Cassinadri point out that in the 2004/05 budget only $40mn out of the planned expenditure of $90mn was spent. The administration is slowed by bureaucratic hurdles for instance, any spending over $100 (sic) requires approval by the Ministry of Planning and Finance (Stevens, 2008: 6). It remains to be seen whether the NOC will be given greater spending autonomy than the civil bureaucracy. It has been suggested that creative partnerships with civil
In resource rich countries, the revenue accrues to government and the financial sector is institutionally weak and unable to provide the private sector with capital in an efficient manner.
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society, the church and the private sector could support the governments efforts to deliver services to the population (IMF, 2005: 9). The new NOC could initiate similar local partnerships (in addition to partnerships with international companies). Because the petroleum sector in Timor-Leste is open to foreign investment there are opportunities to learn from foreign partners operating there. This was an important ingredient in competence building and commercial success for several NOCs, such as Statoil and Petrobras. Many other NOCs (Sonatrach and Kuwait Petroleum Corporation, for instance) had to suddenly learn the business because of nationalization of IOC assets in their country. Conversely, NOCs which were able to gradually fill the shoes of the IOCs operating in their country tend to have a stronger competence level (e.g., Saudi Aramco). 35 The Timorese model PSC requires contractors to give preference to local job seekers and locally sourced goods and services, provided they are competitive, but they demand little in terms of training and helping to create local goods or service companies in Timor-Leste (Price et al, 2008: 15). Oil service companies and contractors can offer important opportunities for learning skills and technology. In many countries, they work on the ground with the NOC, even where the IOCs are not present. In the joint development zone, the Clough AMEC service contract for the Bayu-Undan field stands out with innovative dispositions for training Timorese nationals and fostering companies to provide goods and services needed for operations. 36 However, some obstacles limit potential benefits to the Timorese economy: there is no downstream activity in Timor and the Australian Clean Customs clause restricts the transport of goods between the offshore platform and TimorLeste, inhibiting the opportunities for developing the value chain onshore. In the medium- and long-term, the NOC itself will have an important role to play in developing national capacity. As directed by its national mission, it can support local companies, employ nationals (though government should stress to society the limited support the NOC can give to employment), and train Timorese. Local content policies can also prompt international oil company action, thought they must be based on a realistic assessment of available resources locally. IOCs will face difficulties in abiding by the local content policies if they are too expensive to justify, if partnering with a local company leads to lower technical and environmental standards or if they involve corrupt practices. 37 In 2005 Nigeria introduced ambitious local content requirements in its licensing process, requiring bidding operators to partner with Nigerian companies and train them through the consortium. However, insufficient time and information was given to companies to carry out due diligence on potential partners and some abstained from bidding. Others abstained because the availability of quality local partners was insufficient. And others still brought on board shell companies that brought little competence to the project but gave an appearance of local content. Indeed, the risk with local content policies is that they
Valerie Marcel, Oil Titans, Chapter 1. Chatham House Working paper, Resource Depletion, Dependence and Development: Timor- Leste, Paul Stevens and Elisa Cassinadri, November 2008. 37 For a discussion of some of the issues related to local content provisions in licensing rounds, see the presentation by Willy Olsen, The Nigerian bidding round 2005; An observers reflections on the transparency issues, at the Sept. 2005 Chatham House Good Governance workshop: http://www.chathamhouse.org.uk/research/eedp/current_projects/ggws/
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Creating a National Oil Company in East Timor: Building on the Experience of Other Producers

give underqualified companies an easy ride and provide local interests with opportunities for corruption. Some producers have taken a new course to avoid these pitfalls. For instance, in Saudi Arabia, if the NOC finds that services are not available locally, it can engage the local private sector to start up a company to provide the goods or services, train them to meet the standards of the industry and within an agreed timeline, divest from that company (Sonatrach and Sonangol have similar programmes). Once the company is a stand alone firm, the NOC should not be obliged to contract it. The company must be competitive to win the NOCs contract. This last point is crucial to develop a competitive goods and services sector around the industry and minimize the room for corrupt or nepotistic award of contracts and for a complacent industry. Clearly, in Saudi Arabia and elsewhere, it is particularly difficult for a national oil company to maintain these higher standards in subcontracting to local firms because they fall under pressure domestically to favour these companies.

4. Conclusion: How far, how soon?

Participants at the NOC workshop in Dili highlighted the following priorities for the new NOC: 1. Ensure national control of resources 2. Respond to the needs of Timor-Leste & develop Timorese capacity 3. Develop infrastructure as required by its operations 4. Remain strongly directed by the people and the state 5. Develop into an international NOC, once the capacity is acquired It is unlikely that as a young NOC, the company would be able to pursue, let alone fulfill all the objectives described above. The capacity of the NOC to effectively control national resources will initially be limited because it will have a small staff and little experience (even of its own resource base). National control of resources is generally understood to mean that the NOC is charged with ensuring implementation of the governments resource policy, including the legitimate right for the state to appropriate as much rent as possible. In practice, that aspect of the national control objective will be in the remit of the ANP during the first phase of the NOCs life. However, from the start, the NOC should seek to understand the resource base, acquire and assess data and manage a database, in order to later fulfill the objective of national control. The objective of national control may also include ensuring greater national independence from foreign companies. This would only be a longterm objective in Timor-Leste and certainly would not be the focus on the newly created NOC. Given the priority placed on development and national control, the NOCs initial focus will likely be dual: first to build up the competence of the NOC, working on its processes and people, and second, to contribute in the capacity building of the country. This includes training of nationals and to the extent it is possible, procurement of Timorese goods and services and employment. It can engage in infrastructure development as required by its business once it is clear that the industry will develop onshore. 38

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The NOC and government may benefit from finding a common user basis for infrastructure start-up companies, because the needs of the operators will not be large enough to support these firms.

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Dubai School of Government Working Paper 11-02

Creating a national oil company will satisfy the Timorese desire to participate in the development of their natural resources - and to no longer be passive observers. This will give the Timorese pride in and a sense of ownership of the sector. It can focus national efforts towards building skills for a new employer and providing products and services for a new contractor. But the general public will need to have realistic expectations of what the NOC can concretely contribute in its first years. There is so much to do to raise the country out of poverty. The government has demonstrated a strong commitment to following best practice in this sector and its willingness to have the public participate in the process. The biggest challenge for policy-makers and the public will be to proceed gradually and with measured expectations when so much is at stake.

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Bibliography
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Valerie Marcel (2009). The National Oil Company Investment Challenge, KPMG International, available at http://www.kpmg.com/Global/en/IssuesAndInsights/ArticlesPublications/Pages/Natio nal-oil-company-investment-challenge.aspx Valerie Marcel (2006). Oil Titans: National Oil Companies in the Middle East, Washington D.C.: Brookings Institution & Chatham House; Contribution from John Mitchell. John V. Mitchell and Paul Stevens (2008). Ending Dependence: Hard Choices for Oil-Exporting States, Chatham House Report, July; available at (last accessed 24 March 2010): http://www.chathamhouse.org.uk/publications/papers/view/-/id/645/ NORAD (2009). A check-list for the state of petroleum-related governance in OfDcountries; available at: http://www.norad.no/en/Thematic+areas/Energy/Oil+for+Development/OfD+Informati on+Package/Good+Governance Willy Olsen (2005). The Nigerian bidding round 2005; An observers reflections on the transparency issues, Presentation at the September 2005 Chatham House Good Governance workshop; available at: http://www.chathamhouse.org.uk/research/eedp/current_projects/ggws/ Oxford Economic Country Briefings (2009). East Timor, Oxford, Oct 2. Anthony Paul (2009). Natural Gas for Sustainable Development, presentation at the workshop Setting Up a National Oil Company in Timor-Leste, Dili, 28-29 May; available at: http://www.chathamhouse.org.uk/event/file/download//id/1277/doc/14529 Dr Gareth Price and Tamara Lynch (2008). Commentary on Timor-Leste, Chatham House Working Paper, April; available at (last accessed 24 March 2010): http://www.chathamhouse.org.uk/research/eedp/current_projects/rddd/cc/ Jeremy Sarkin (2008). Achieving Reconciliation in Divided Societies: Comparing the Approaches in Timor-Leste, South Africa and Rwanda, Yale Journal of International Affairs, Spring | Summer, available at (last accessed 24 March 2010): http://yalejournal.org/article/achieving-reconciliation-divided-societies-comparingapproaches-timor-leste-south-africa-and Paul Stevens, Elisa Cassinadri (2008). Resource Depletion, Dependence and Development: Timor-Leste, Chatham House Working Paper, November.

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