Economic Research Forum (ERF)

How to diversify oil-producing economies

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Many oil- and gas-rich countries have either announced or put in place policies to reduce their dependence on oil by diversifying their economies. This column argues that the key is to shift the focus away from the end goal of diversification and towards the transformation process of how to get there.

In a nutshell

The focus on the end goal of diversification has too long kept MENA countries from getting the process right.

Transformative policies should move away from top-down approaches that pick which sectors to develop.

Instead, they must develop an environment that promotes market contestability and changes the incentives of managers and tech-savvy young entrepreneurs, and helps them, their firms and, ultimately, the whole economy to reach their potential.

The collapse in oil prices – which started in 2014 and is expected to be protracted – has put diversification at the forefront of the policy debate in the oil-producing countries of the Middle East and North Africa (MENA). But although many fossil fuel exporters understand the need to diversify, few have successfully done so.

Historically, diversification away from oil extraction has been difficult for such oil-rich countries – in large part because the top-down approach of the state has not given managers and other economic agents the confidence or incentive to embrace new ideas, innovate and take risks.

For example, the incentive structures of state-owned oil companies in many countries around the world, including in MENA, have not consistently encouraged managers and employees to achieve their full potential and adapt to new technology rapidly affecting their industry.

Many state-owned companies embark on missions outside their core activities and competencies, innovate little and struggle to keep talented employees. What’s worse, several state-owned oil companies around the world have a heavy burden of debt, even though they sit on large oil reserves that are relatively cheap to extract.

Shift in focus

But if countries were to shift their focus from the end goal, diversification, to how to get there – that is, to the transformation process – they might find it easier to diversify. The effort involves steps to shift away from the dominant oil and gas sector.

A focus on transformation involves an approach to that dominant sector that can spill over to, and even help foster, sectors outside hydrocarbons. That is, by embracing transformation, countries will focus on getting incentives right for managers and other economic agents and turn into friends the technology and innovation energy markets now see as disruptive enemies. Countries that take this approach are less likely to stumble or resist change.

Technological changes in energy markets can help the sustainability of economies that depend on oil revenues. More agile economic systems with appropriate corporate governance structures – that empower managers and employees – can more easily take advantage of new technology to mitigate risks associated with potential disruptions in energy markets and even create opportunities.

For example, publicly listed companies have tended to fare better than state-owned (or even privately owned) companies. Because these companies are accountable to shareholders, they are more likely to adapt to new circumstances and stay ahead.

At the country level, the lack of government accountability combined with state ownership of the oil sector has exposed countries to considerable risk. The sector is largely resistant to changes in energy-producing and energy-using technologies that can dramatically affect energy markets.

An urgent need 

The decline in oil and gas prices may make transformation imperative. The adage that ‘necessity is the mother of invention’ seems to have a particular resonance for oil-rich MENA countries, which have been shaken by the decline in oil prices and recognise that they must develop economies resilient to the changes in energy markets.

Dubai, for example, facing the depletion of its oil reserves, transformed itself into a global trade hub. Countries and businesses reliant on these markets, and the revenue they generate, must formulate policies to address risks and embrace opportunities presented by transformation.

Institutional factors, such as corporate governance, legal systems, contestable markets – those in which there are no barriers to entry and exit – and patronage spending in state-owned companies affect the attitude toward innovation and openness to new ideas and, therefore, the process of transformation in oil-rich countries.

For example, large public sector employment financed by oil revenues has stifled the impetus for innovation. Economic policies that are not geared toward changing attitudes are unlikely to deliver the needed transformation agenda for oil-rich countries.

Saudi Arabia – the region’s, and perhaps the world’s, most important oil producer – seems aware of the need to augment the long-time source of its riches with non-oil income. As part of its ambitious plan to transform its economy, the country announced a public offering of 5% of the state-owned oil company, ARAMCO. That appears to be a step toward emulating publicly owned Western companies, such as Exxon, which once concentrated on oil, but broadened their focus to become energy companies, balancing their oil assets with other forms of energy.

The focus on the end goal of diversification has too long kept MENA countries from getting the process right. Transformative policies should move away from top-down approaches that pick which sectors to develop. Instead, they must develop an environment that promotes market contestability and changes the incentives of managers and tech-savvy young entrepreneurs, and helps them, their firms and, ultimately, the whole economy reach their potential.

Further reading

Arezki, Rabah (2017) ‘Getting There’, Finance & Development 54(4).

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