Property rights, instability and FDI

If a country wants to attract foreign investment it must have political stability and good property rights. So goes the neo-liberal orthodoxy.
But it seems to be flatly  contradicted by Shell and Repsol's deal to develop an Iranian gas field.
The thing is, Iranian law forbids foreign companies from owning mineral rights or taking equity stakes in joint ventures. Shell and Repsol will merely get a cost-plus return on the project. This return is likely to be a little over 12% - which seems small given the risks  surrounding the project, one of which is the threat of US sanctions*.  Oil companies have for years been critical of such arrangements.
Which raises the question: why is Shell doing such a deal? There are three possibilities:
1. It's hungry for growth. Though this deal won't raise their reserves, it will boost production after 2011. For a firm that's made a habit of missing production targets, this is a relief.
2. The opportunity cost of the deal is low. Property rights may be bad in Iran, but they're no better in Bolivia or Russia.
3. Shell is buying a call option on policy change. By being in Iran, it's well placed to benefit if the government  relaxes its limits on foreign ownership. The more unstable the Iranian regime is, the greater is the value of this option, as the greater are the chances of such change.
And this raises a nice possibility - that political instability can be good for investment. This paper (pdf) gives more evidence for this counter-intuitive notion.
* The threat of a US attack on Iran - which has a roughly 25% probability this year - is less of a problem; think what it would do to oil prices.

Comments

[dearieme]

The proposition that "stability" matters, irrespective of the state of affairs that is being stable, seems pretty fatuous.

[Cleanthes]

Dearieme,

If that was what was being said, I would agree, but it isn't, so I don't.

It is "political stability AND GOOD PROPERTY RIGHTS".

That seems an important qualification.

[Mark Wadsworth]

Fascinating stuff. But all business is about taking risks, for which you expect a risk adjusted return. 12% seems low, but what sort of return do they get on similar projects elsewhere? If Shell will do the same deal for 6% elsewhere, then Iran has conned itself out of some money and so on.

[Chris]

Shell's net ROA is around 10-11%, so 12% is not much out of line.

1. seems the most likely explanation.

As for the paper you quote, saying instability=high investment is the same as saying instability=high saving, which makes more sense!!

[dsquared]

4) the 12% return is being earned on an inflated regulatory asset base and on the basis of costs in Iran inflated by transfer pricing, so the actual return is substantially more than 12%.

[Glenn Athey]

Are you saying that neoliberal orthodoxy just doesn't make sense in the real world?! can't say I am too shocked, but then the same is true of a lot of economic theories and models - they contain partial truths, but not many can explain all decisions or outcomes.

If its the fundamental business of, the enterprise to extract, refine and sell oil, and said oil is in unstable countries, then that's fairly rational.

Natural resources are a prime attractor of foreign direct investment - plenty of evidence to support that. Most of China's outward FDI is aimed at securing natural resources. Its a given, really.

[Glenn Athey]

Are you saying that neoliberal orthodoxy just doesn't make sense in the real world?! can't say I am too shocked, but then the same is true of a lot of economic theories and models - they contain partial truths, but not many can explain all decisions or outcomes.

If its the fundamental business of, the enterprise to extract, refine and sell oil, and said oil is in unstable countries, then that's fairly rational.

Natural resources are a prime attractor of foreign direct investment - plenty of evidence to support that. Most of China's outward FDI is aimed at securing natural resources. Its a given, really.

[ChrisA]

Orthodoxy doesn't say that there will be no international investment, it says it will be reduced compared to other areas where there are good property rights and stable economies. And that is exactly what is happening, I mean compare FDI in Iran versus, say, the UK.

Shell's deal is puzzling to me because of the US sanctions issue, they must have been given a wink and a nod by the US authorities surely. But I bet the deal is a lot more than 12% if you could get hold of a copy of the internal Shell model.

[Mark Wadsworth]

Maybe instability is good for FDI, as the a ) people on the ground have less money to invest (their government has squandered it all) and b) if they do have any money, their best strategy is to get money out of the country to prepare for their eventual flight.

Leaving a vacuum to be filled by FDI.

Thanks for additional figures on Shell's IRR. I suppose one way of explaining this is that "markets know best", whether you can understand how or why is neither here nor there.