The Fuse

The Presource Curse: Why Major Oil Discoveries Can Lead to Economic Distress

by Nick Cunningham | December 06, 2017

Countries that become overly reliant on the production of natural resources often tend to exhibit slower economic growth, more corruption, and poorer development outcomes than other nations, a scenario called the “resource curse.” While abundant reserves of oil, gas or minerals would appear to bless a country with massive wealth, commodity-dependent nations often suffer from chronic underdevelopment.

Symptoms of the resource curse can often arise even before natural resources are produced.

But the symptoms of the resource curse can often arise even before natural resources are produced, according to new research from the International Monetary Fund (IMF). The enticement of potential riches can tempt governments into making imprudent decisions that lead to disappointment, particularly in nations with weak institutions. The IMF says that governments need to be more cautious when they find large oil or gas discoveries and not “fall prey to an overly optimistic response.”

The ‘presource’ curse

The problems arising from a tidal wave of revenues from resource extraction have been noted by economists for years, and it is not just confined to less developed countries. The Netherlands gave a nickname to this phenomenon—”Dutch Disease”—when it suffered from poor economic performances after discovering large natural gas reserves in the North Sea. A sudden and substantial appreciation of a country’s currency can make non-commodity sectors of the economy less competitive, wiping out export industries and leaving the nation even more dependent on resource extraction. Countries with weak institutions also have to contend with worsening corruption, flagging democratic norms, slow growth, and often an uptick in poverty.

The “presource curse” is economic malaise that can hit a country in the brief window of time after discoveries are made but before any resources are produced.

But the IMF now says that these problems can “set in much earlier than conventionally thought,” before any drop of oil is even produced. The IMF defines this situation the “presource curse,” or economic malaise that can hit a country in the brief window of time after discoveries are made but before any resources are produced. The excitement generated after a large discovery can lead to wasteful spending, debt, and corruption.

The IMF points to Ghana, which made large offshore oil discoveries in 2007 and 2010, as a prime example. At the time of the discoveries, Ghana’s GDP was above average, and it was weathering the global financial crisis better than others. But several years on from the first oil discovery—a field aptly named “Jubilee”—the excitement has faded away. Ghana reported economic growth of 4 percent between 2014 and 2016, significantly lower than the 7 percent the IMF had forecast.

The Fund says that the oil discoveries were to blame for lower growth. “The oil discovery and the financial windfall it promised appeared to usher in an era of economic imprudence: heavy borrowing, profligate spending, and exposure of the economy to the oil price crash of 2014,” the IMF wrote in a new report. Ghana was able to save $484 million in savings from oil revenues, but that was dwarfed by the $4.5 billion in new debt issued.

Mozambique is another example. Large natural gas discoveries in East Africa have sparked a lot of interest from international companies that hope to build LNG export terminals to export gas to Asia. For example, ExxonMobil paid Italian oil giant Eni $2.8 billion earlier this year to take a 25 percent stake in gas fields in Mozambique. Eni and Exxon are trying to keep pace with Royal Dutch Shell, which has emerged as one of the world’s largest LNG exporters. “This strategic investment will enable ExxonMobil’s LNG leadership and experience to support development of Mozambique’s abundant natural gas resources,” ExxonMobil CEO Darren Woods said in a statement in March 2017.

However, like Ghana, the results for Mozambique have been below expectations. The IMF expected the East African nation to grow at an annual rate of 7 percent, but growth dipped to just 3 percent by 2016 “as the disastrous consequences of enormous off-budget borrowing unraveled,” the IMF said. The Fund suspended its support for Mozambique in wake of the scandal.

Avoiding the presource curse

Ghana and Mozambique are only two examples and “are not aberrations,” the Fund wrote. There have been 236 giant discoveries (greater than 500 million barrels) since 1988 across 46 countries. The IMF has consistently raised growth forecasts after such events, assuming that new oil discoveries would expand GDP. But after surveying all of these cases, the IMF concludes that growth, on average, “systemically lags IMF projections and, for some countries, falls.” Not every case is the same. Countries with weak institutions fare much worse, and often post lower GDP growth rates than before the discovery was made. Countries with stronger institutions or prudent policymaking can avoid the presource curse. For instance, Tanzania also discovered large natural gas reserves, a year after Mozambique. But unlike its southern neighbor, Tanzania’s GDP actually increased from 6 to 7 percent after the discoveries, which the IMF attributes to low levels of debt and a “commitment to fiscal sustainability through legislating a fiscal rule.”

IMFPresourceCurse

Missing growth estimates laid out by institutions like the IMF has real-world consequences. “[G]overnments and the private sector rely on forecasts to plan and make decisions,” the IMF wrote, while “the media and voting public can also be influenced.” The psychological effect of expecting a windfall can lead to poor policymaking, with government officials pressured into even more counterproductive decisions in an effort to please the populace.

Moreover, growth forecasts affect the cost of capital, and since many countries expect large revenues from newly discovered oil fields, they issue high volumes of new debt to make investments in infrastructure and other projects, expecting to pay back that debt with resource revenues that might never come. At the same time, artificially low interest rates could incentivize over borrowing, the IMF says.

Countries can avoid the pitfalls of the presource curse by ensuring projects move forward on time and implementing budget constraints.

Avoiding these pitfalls is possible. “The presource curse, like the resource curse, is not preordained,” the IMF said. The report advises governments to “approach discoveries more cautiously,” including focusing attention on pre-production to ensure projects move forward on time. Moreover, rather than trying to decide what percentage of resource revenues should be saved, governments should implement budget constraints to avoid borrowing and spending well beyond their means. If the oil and gas projects are delayed or fail to materialize, governments that proceed with caution can prevent a fiscal calamity.

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