No.

12

Petroleum Sector Briefing Note

June - July 2008

Petroleum Revenue Funds Part 1

Some petroleum revenue funds have been upheld as models for successful nonrenewable resource
management. But international experience with petroleum revenue funds has been mixed. Where they
have failed, oil funds have arguably contributed to the adverse effects of oil and gas revenues. This note,
first in a series of four, discusses arguments for and against funds and what they are intended to achieve.

he Extractive Industries Transparency Initiative

(EITI) aims to ensure that petroleum income is
properly accounted for [13]. But if the payments received are poorly spent, or worse, misused,
the country would still not benefit fully from its petroleum resources. To address potential problems associated with petroleum income, a number of hydrocarbon-dependent governments have set up petroleum revenue funds. These funds can range from separate independent institutions to little more than a line item in
the budget. Many new petroleum funds have been established during this decade. All of these funds are designed to save petroleum revenues, often with accumulation and withdrawal rules that vary with the fund
objective, so that not all income is spent in the year
received.
International experience with petroleum revenue
funds has been mixed. Whether and to what extent
these funds can help mitigate various potentially harmful aspects of petroleum revenue (see [4]) has been
hotly debated. This note provides background information on what problems petroleum revenue funds are
intended to address, fund objectives, arguments for and
against establishing a fund, and a brief overview of
funds from around the world.

Potential Problems to be Addressed

Petroleum revenues have several unique characteristics: they are unpredictable, volatile, and in due
course decline to zero as petroleum reserves are depleted. Price volatility is an important source of revenue volatility, but even if oil prices were stable, petroleum revenues would still be volatile. These revenues
may start with a large inflow in the form of signature
bonus, followed by a period of little revenue until production starts. The revenues then build up to a peak,
possibly with dramatic acceleration once costs have

been fully recovered. This introduces a high degree of

volatility into the revenue stream even before production decline sets in. In countries with a high degree of
dependence on petroleum revenues, spending all income
in the year received could lead to wildly fluctuating
government expenditures.
As an illustration, shown in Figure 1 in triangles is
the annual petroleum revenue received by the government of Norwaythe worlds fifth largest oil and third
largest natural gas exportersince 1995 when the country activated its petroleum revenue fund. Oil export volumes and oil prices are also shown for reference. The
annual revenue varied from a low of less than US$6
billion in 1999 to a high of more than US$55 billion in
2006, this when there was no marked variation in the
export volume of oil. Shown in squares is the annual net
transfer to the petroleum revenue fund, subtracting the
expenses incurred in fund management. The government
has historically transferred as much as 99 percent of the
petroleum revenue to the fund. The amount of petroleum revenue spent varied from less than US$0.5 billion
in 2001 to more than US$10 billion in 2004 and 2006.
There are several reasons why a government might
not want to spend all its petroleum revenue in the year
received.
Capacity to spend the extra revenue well Suppose government launches a massive school building
program during an oil boom. If there is a sudden surge
in demand for building materials, construction workers,
and teachers, domestic capacity to manufacture cement and other building materials may not be sufficient,
adequate import infrastructure may not exist and takes
time to develop, and there may not be enough construction workers and teachers. Under these circumstances,
the wages and costs of construction materials may rise
steeply, while school classrooms may be filled with pupils but with too few teachers.

Petroleum Sector Briefing Note

June - July 2008

would lead to a fall in exports with harmful effects beyond the sectors directly affected over time in a phenomenon known as Dutch disease.

Government Response

High costs of large adjustments to government

expenditures. Staying with the school building program,
many new teachers will have to be hired, who will take
years to train. But even if skills and materials shortages
could be overcome, if the world oil price were to suddenly collapse and the government petroleum revenue
halved or worse, many school buildings might be left
unfinished and teachers might not be paid. Half-finished
projects are costly to the economy, while a massive firing of teachers to keep the government budget manageable would not only be damaging to education but politically very difficult. The government could borrow money
to continue the projects, but running a large fiscal deficit
could be costly and even unsustainable in the long run.
Preparing for the eventual depletion of petroleum reserves. Petroleum reserves are finite, and in
time they will be depleted. A government budget that
relies heavily on petroleum revenues will have an enormously difficult time adjusting to having no petroleum
revenue. To continue to provide income after oil and
gas production ceases, several governments have set
up funds for future generations by saving revenue
now with the objective of spending income later.
Impact on the exchange rate. Large fluctuations
in foreign earnings that are spent on the domestic market could result in large currency fluctuations. A sudden increase in government expenditures from foreign
exchange income might lead to significant strengthening of the local currency, making imports cheaper but
exports more expensive and less competitive. This

The key to tackling the foregoing problems is fiscal

policythat is, the governments spending and taxation policy. To the extent that it makes sense, government spending should be smoothed out so that the government budget does not merely mirror the booms and
busts in the world oil market. To limit appreciation of
the local currency, one option is to save foreign earnings outside the country and bring in foreign income
only gradually over time.
These policies can be pursued without setting up a
separately managed petroleum revenue fund. And establishing a fund does not guarantee spending restraints
and sound savings. There are many instances in which
the existence of a fund did not stop the government from
overspending during booms, only to be caught by a serious budget squeeze during price downturns. This could
happen, for example, when the fund is outside the national budget. Accumulating money in the fund in times
of high petroleum revenue is no solution to the problem
caused by revenue volatility if the government borrows
against the fund assets and increases spending.

Fund Objectives
Petroleum revenue funds have been set up with the
following objectives.
1. Smooth government spending by saving when revenues are high and withdrawing from the fund when
revenues fall.
2. Save for the time when petroleum resources are
exhausted.
3. Save abroad to slow down currency appreciation.
4. Save for unforeseen events.
5. Save until such a time as when the country has
adequate absorptive capacity (skills and other resources to spend the extra revenues productively).
These objectives are not mutually exclusive. For
example, income can be saved abroad (objective 3) under any one of the four other objectives. Many funds
have more than one objective.
In addition, large revenue flows tend to invite political interference and attempts to divert them for private gain or launch unproductive projects. Setting up a
separate petroleum revenue fund with stringent rules
governing it is seen by some governments as a means
of controlling such tendencies.

June - July 2008

Petroleum Sector Briefing Note

Smoothing spending

Arguments For and Against Funds

Expenditure smoothing is one of the most common

objectives of petroleum revenue funds. The purpose is
to lower the costs of stop-go government spending that
would otherwise result in the face of revenue volatility.
The key to smoothing expenditure is delinking fiscal
policy from petroleum revenue. Not letting government
expenditures fluctuate with ups and downs of petroleum revenues would also help avoid large swings in
exchange rates, provided that savings are not all invested in the domestic market.

Funds can help create greater transparency. When

coupled with the EITIwhereby payments made by
petroleum companies are compared and reconciled with
payments received by governmenta fund can help
citizens track oil revenues from receipt to expenditure.
However, it is important to recognize the challenges
facing efficient management of a fund.

Saving for future generations

For an economy dependent on hydrocarbons, the
prospect of eventual exhaustion of oil and gas presents
a challenge. Some governmentsincluding Alberta,
Alaska, Kuwait, Norway, Oman, So Tom and
Prncipe, and Timor-Lestehave chosen to put aside
a portion of petroleum revenues to share with all citizens, both current and future who might not enjoy comparable petroleum income. One approach, adopted in
Alaska, is to spend only realized fund investment earnings, adjusted for inflation. In this way, the funds capital is fully preserved, and oil income can be enjoyed
into perpetuity in principle.

Saving Abroad
Also referred to as sterilizing, saving oil income
abroad can mitigate the adverse impact of a sudden
increase in domestic spending on the economy. Kuwaits
Future Generation Fund invests outside of Kuwait.

Unforeseen events
Following the aftermath of the invasion of Kuwait
by Iraq in 1991, Kuwait used its fund resources for
reconstruction. Recent examples include funds in
Azerbaijan and Timor-Leste.

Absorptive capacity
Low-income countries may have many needs, including universal provision of primary health care, education, safe water, and other basic services. This might
argue for an expenditure profile that is high at the beginning and gradually declines over time. That said, if
the country cannot implement the spending program
productivelyif there are not enough teachers, nurses,
doctors, engineers, and construction workersit might
still be better to phase in these projects gradually, even
in the face of pressing needs.

The issue is not even how much and on what the

government is spending petroleum revenue (the fund
addresses primarily the first), but rather the overall
stance of the governments spending program. Not
having a unified budgetnot integrating the oil fund
fully into the budget, allowing the fund to have its
own spending program, or saving petroleum income
in the fund but in parallel using fund assets as collateral to borrow money for higher spendingcould
even worsen, rather than improve, fiscal management.

Fund administration is another challenge. A suitable

mechanism to manage the fund needs to be established, including professional management of fund
investments and reporting to the central bank or a
board. In countries with limited skills, fund management might compete with other pressing needs requiring scarce specialized skills.
Stringent withdrawal rules to prevent raiding may
have costs, such as inability to withdraw from funds
in times of genuine emergency. And a fund can always be raided. Venezuelas earlier Investment
Fund changed savings rules after only two months of
fund operation. More recently, Ecuadors Constitutional Assembly in April 2008 approved a new law
that in essence abolishes existing oil funds, gives added
authority to the government over the spending of an
extra US$1.5 billion of oil money, and directly boosts
the revenue side of the budget [5]. A growing fund
balance in the face of many unmet needs would provide an added political impetus to raid the fund.

Petroleum Revenue Funds from Around

the World
Table 1 gives an overview of petroleum funds that exist today. The list is not intended to be exhaustive, but
main funds are captured in the table. Not shown are
general investment authorities that derive a significant
portion of their income from petroleum revenue, such
as the Abu Dhabi Investment Council, Brunei Invest-

Petroleum Sector Briefing Note

ment Agency, Libyan Arab Foreign Investment Company, Qatar Investment Authority, and Saudi Arabian
Monetary Agency.
Long-standing oil and gas producers that established
funds only recently include Algeria, Mexico, and Trinidad
and Tobago in 2000; and Angola, Nigeria, and the Russian Federation in 2004. The Stabilization Fund of the
Russian Federationthe worlds second largest oil exporter, sometimes surpassing Saudi Arabiaaccumulated more than US$150 billion in four years.
Some funds do not have regular reporting. Despite
being mandated by law, the formal balance sheet of the
Iranian Oil Stabilization Fund has never been submitted
to parliament by its board of trustees or published [6],
and conflicting account balances have been cited by
different government officials. OthersAlaska, Alberta,
Azerbaijan, Norway, and Timor-Lestepublish fund
accounts on the Internet.
The next briefing note will discuss what to consider in setting up a fund.

June - July 2008

References
[1] World Bank. 2007. Extractive Industries Transparency Initiative. Petroleum Sector Briefing
Note No. 4, June.
[2] World Bank. 2007. Country Experience with EITI
Part 1. Petroleum Sector Briefing Note No. 5, July.
[3] World Bank. 2007. Country Experience with EITI
Part 2. Petroleum Sector Briefing Note No. 6, August.
[4] World Bank. 2007. Oil and Gas: A Blessing or A
Curse? Petroleum Sector Briefing Note No. 2, April.
[5] Global Insight Daily Analysis. 2008. New law grants
Ecuadors government extra oil revenue. April 3.
[6] www.mees.com/postedarticles/oped/v48n475OD01.htm.
For more information contact:
Mr. Bun Veasna
Infrastructure Officer
Email: [email protected] or
Masami Kojima
Lead Energy Specialist
Email: [email protected]