EGEE 120
Oil: International Evolution

The Prize Chapter 22: Fifty-Fifty: The New Deal in Oil

PrintPrint

Consider the following questions:

  • What is your view of the ban on alcohol in Saudi Arabia?
  • How did the oil companies balance commercial interests with cultural considerations? How did US foreign policy interact with commercial oil interests?
  • How did US foreign policy interact with commercial oil interests?

Post War National Hunger: Wealth, Power and Pride

In the 1940s and 1950s, the countries hosting American oil companies or subsidiaries wanted more from their foreign visitors and continuously argued about the financial terms of their concessions and “rents.” The central objective of their argument was to shift revenues from the oil companies and the tax receipts of the consuming countries to the exporting countries, as countries, particularly Saudi Arabia, were entrenched in financial crises. Also, the presence of foreign oil investments represented colonialism, and the Nationalists felt as if they were being robbed of wealth due to them from the land. Thus, money was not the only thing at stake, but also power and pride.

Enter image and alt text here. No sizes!
David Ricardo
By Thomas Phillips See Commons:Licensing for more information., Public Domain, Link

David Ricardo was the first to develop and define the concept of economic rent as the amount of profit above and beyond that amount necessary to keep oil in production. Thus, rent represented the difference between the market price and the cost of production plus an allowance for additional costs (transportation, processing, and distribution). It was viewed as a return from nature’s bounty. The question then was who should receive this rent? The oil companies or tenants (that risked the capital, secured the contracts, added value creation where there was none by investing in the expertise to discover, produce, and market the oil), or the consuming countries (that taxed the imported oil), or the host countries or landlords (that had sovereignty over the subsoil, power, status, nationalism issues, influence, significance, etc.).

Enter image and alt text here. No sizes!
John Maynard Keynes
By Unknown See Commons:Licensing for more information., Public Domain, Link

Viewed in another way, the question was: If through a tenant’s risk-taking efforts, the tenant made a discovery that increased the landlord’s property, should the tenant continue to pay the same rent, or should the rent be raised? For the consuming countries, in addition to oil being a strategic commodity central to national strategy, it also provided tax revenue. Clearly, the host countries, oil companies, and consuming countries all had an interest and their own views of the “rent.” As John Maynard Keynes, according to the Prize, once said, “Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.” In the oil business, as we will see in this course, clearly the “practical men” could not only be oil businessmen but also kings, heads of states/governments, and dictators as well as their oil and finance ministers!

The Changing Tenant-Landlord Relationship: Venezuela’s Fifty-Fifty Agreement

Venezuela’s tyrant dictator, General Gomez, died in 1935. Gomez had focused the country’s entire economy around oil, with 90% of export value derived from oil. The “Generation of ’28”- students at the University of Central Caracas group who had been repressed by Gomez in 1928 - assumed power after his death and sought to alter the way oil companies allocated the rent from fields in Venezuela. Both the US government that wanted to avoid expropriation, or another Mexico, and the oil companies that did not want to risk nationalization were forced to accept the shift in power, and all three parties (the oil companies, the Venezuelan government and American government) wanted to work things out.

The two governments, SO of NJ, and Shell eventually agreed on the principle of “fifty-fifty.” Under this policy, taxes and royalties due to Venezuela would be equal to the oil companies’ net profit, theoretically splitting rent equally between the parties. In exchange for the deal, questions about the validity of concessions were overlooked. Venezuela passed the “fifty-fifty” principle into a petroleum law in March 1943. It should be noted that, unlike the majors, some of the smaller companies such as Pantepec Oil Company operated by William F. Buckley were outraged.

In 1945, two years after the agreement, a coup toppled the Venezuelan government, bringing in Romulo Betancourt as the new President and Juan Pablo Perez Alfonzo, who had been the leading critic of the Petroleum Law of 1943, as minister of development.

The new government felt the split was actually a 60-40 split in favor of the companies and instituted revisions in the tax laws to ensure a truly 50-50 split that was accepted by SO of NJ. With these changes, the government’s income in 1948 was six times more than in 1942. Alfonso also wanted revenue from the downstream sector-transportation, refining, and marketing and demanded royalties in actual oil which the Venezuelans then sold on the market themselves.

In a few short years, the oil work force became 90% Venezuelan, and by mid 1940s, Venezuela received 7% more/barrel than paid to Mexico by its nationalized industry, and production was 6 times that of Mexico! Thus, unlike Mexico, Venezuela achieved its national objectives without nationalization. Betancourt was very pragmatic and even invited Nelson A. Rockefeller, a prominent US citizen and grandson of John D. Rockefeller, to establish a corporation for funding the development of projects and businesses in Venezuela.

Map of Mexico and Venezuela
Map Showing both Venezuela and Mexico.
Credit: CIA

American Independents and the Saudi-Kuwait Neutral Zone

The Neutral zone with sovereignty shared between Saudi Arabia and Kuwait was about 2,000 sq. miles created by the British in 1922 to allow Bedouins free movement between the two countries. The US State Department encouraged oil independents to break the power of the majors in the Middle East by encouraging more players to speed up the rate of oil development in the Middle East. It was felt that more oil sources from US firms would lower price to consumers and also counter the potential rise of communists. To placate the strong American left and anti-big-oil, in 1947, a consortium, American Independent Oil Company (Aminoil), made up of independent companies as Phillips, Ashland, and Sinclair was put together to bid for concession in the Neutral Zone. Aminoil won the Kuwaiti portion of the Neutral Zone with a bid that stunned the industry: $7.5 million in cash, minimum annual royalty of $625K, 15% of the profits, and a $1 million yacht for the Amir of Kuwait. This clearly also signified another case of changing landlord-tenant relationship.

J. Paul Getty
J. Paul Getty, circa 1944

The Saudi concession of the Neutral Zone was purchased by another independent, Jean Paul Getty, an eccentric, vain, and insecure person who could not stand to lose in a contest or share authority (i.e., he had to be in control!). A business partner once said, “I had a perfect record with Getty. I had a thousand fights with him and never won a single one.” He married five times and once said, “A man is a business failure if he lets his family life interfere with his business record.” He was so obsessed with his business and oil that he is known to have told one of his wives, “When I’m thinking about oil, I’m not thinking about girls.” Getty always liked to buy low and sell high and was ruthless in his pursuit of getting the cheapest in a bargain. As examples, during the Depression, he fired all his workers and rehired them at a lower salary, and in 1938, he bought the Pierre Hotel in New York for less than a quarter of its value for $2.4 million. He was fascinated with dictators, and had two facelifts & colored his hair reddish-brown to give him a wizened, embalmed look.

Saudi-Kuwaiti neutral zone
The Saudi-Kuwait Neutral Zone (2 December 1922 - 18 January 1970).

With the help of an MIT trained geologist, Paul Walton, who negotiated on Getty’s behalf, Getty Oil won the Saudi concession for $9.5 million upfront, $1 million a year even if no oil was found, and a royalty of 55 cents a barrel. Getty’s 55 cents to Saudi was in stark contrast to the 35 cents of Aminoil to Kuwait and the 16.5 cents of Anglo-Iranian and the Iraq Petroleum Company to Iran and Iraq and the 15 cents from Kuwait Oil Company to Kuwait. By 1953, about 5 years since the concessions to Aminoil and Getty Oil, both groups had spent over $30 million and had no oil to show for it except 5 dry holes. However, in March 1953, Aminoil struck oil. Also, within eight years of the concession to Getty, he had struck oil and become the richest man in America. Then became America's’ first billionaire in 1957 with the 7th largest US oil company. Getty achieved fame as the Billionaire Miser and is known to have installed a pay-phone in one of his castles for guests. He relaxed by reviewing his income and expenses each evening in his 60s. He died in 1976 at age 83, and at his funeral the Duke of Bedford said, “When I think of Paul, I think of money.”

The impact of the independents was summed up by Calouste Gulbenkian’s prophesy, “These groups … offer fantastic terms to local governments who expect similar fantasies from us. The result is trouble all around.” He predicted the wind of nationalization and the spread of other complications.

Thanks to Venezuela and US Tax Laws; Fifty-Fifty extends to Saudi and the Middle East

Recession around the globe caused demand for Saudi oil to drop in 1949 even as their own financial commitments grew, reminiscent of the two previous financial crises in the 1930s and 1940s. For support, they turned to the oil company, Aramco. The Saudis wanted the same deal as Venezuela…but how had they heard of it? In fact, a Venezuelan delegation had been traveling the Middle East, spreading the idea of “fifty-fifty” to encourage the nations of the Middle East to raise their taxes, which in turn would raise their costs. The underlying reason for Venezuela’s action was that the lower-cost higher-volume production in the Middle East was a threat to Venezuela, and Venezuela hoped to raise the Middle East cost in order for Venezuela to be competitive. The closest the Venezuelan delegation, however, got to Saudi was Basra in Iraq, as the Saudis would not let them in because of their vote in the United Nations on Israel.

Interestingly, the Saudis noticed a clause in the American tax laws called “foreign tax credit.” Under this law, American companies that paid taxes to a foreign country could deduct it from their US taxes. Thus, the Saudis realized that they could increase their taxes on Aramco without harming its ability to compete. On December 30th, 1950, Aramco and Saudi Arabia signed a new agreement based on the 50-50 principle. As an illustration of its effect, in 1949, the US Treasury received $43M in taxes, and the Saudis had $39M in royalties. With the new agreement, in 1951, the Saudis received $110M and the US Treasury had $6M (after the tax credit). Thus, while the tax on Aramco remained the same, the payment shifted from the US Treasury to the Saudi government.

The 1950 Saudi agreement sent ripple effects, as neighboring countries moved to make more money off the oil companies they hosted--Kuwait Oil Company, for example, agreed to a 50-50 deal in Kuwait, and in 1952, Iraq also adopted a 50-50 deal. The US agreed with these negotiations due in part to the start of the Korean War in 1950, and the fear of the potential loss of secure access oil, regional instability, and the spread of Communism.

Clearly, a new relationship now existed between the tenants and landlords as the oil companies position now did not just depend upon compliance with laws & payments to governments, but whether the whole concession is perceived as “fair” by the government & public opinion. It was bound to change if it was not perceived as fair. Interestingly and unfortunately, “fairness” and “unfairness” happen to be concepts of emotion and not fixed & measurable economic standards. The 50-50 principle, however, had the right psychological feel of fairness to it.