Ever feel weighed down by the burden of excess riches? Tainted by the moral hazard of an unexpected windfall? No? Then you’re probably not Norwegian.
In a fascinating address at the 1st Nordic Investment Conference in Copenhagen, Knut Anton Mork of Norwegian University of Science and Technology shared his insights into the foundation, growth, and future of the Norwegian Oil Fund, arguably the largest sovereign wealth fund on the planet.
It all started in disappointment. Phillips Petroleum, now ConocoPhillips, held a license to prospect the promising Ekofisk field of the North Sea. By 1969, they had failed to turn up anything significant and were looking to cut their losses and leave. That would have meant returning their license to the Norwegian government.
But the government refused to accept an end to the license and forced Phillips to keep prospecting. As is the way with such things, on 23 December 1969, Phillips struck oil, the largest ever find at sea.
From then on, there were two concerns:
- That oil revenue was somehow dirty money and, as an unearned source of income, was likely to taint those who used it.
- Avoiding the so-called Dutch Disease: The Netherlands had experienced a similar windfall with the discovery of the Groningen natural gas field in 1959 but suffered a subsequent decline in the non-natural resources industrial sector because strengthening domestic currency reduced the international competitiveness of these other industries.
Norway’s solution, as proposed by the Skånland Commission of 1983, was to separate the oil revenues from spending. The extraction of oil was to be left to oil companies, and the taxation of corporate profits (at the rate of 58%!) would be used to secure the state’s share. These tax incomes would then be deposited in a state fund, the oil fund, to preserve wealth for future generations. Since the first deposit in 1996, the fund has grown to around 10 trillion Norwegian kroners, or over US$1 trillion.
Investments are made according to the following principles, which have been amended and revised over the years:
- An open process of asset management
- Investment primarily in listed securities (with real estate a more recent addition)
- Largely index investing
- No investments in Norwegian stocks or bonds
- Ethical considerations to be part of the process (i.e., no coal or tobacco)
- Not to be an instrument of Norwegian foreign policy
But, in the midst of such riches, problems remain. Mindful of the preservation of capital, the fund has adopted a fiscal spending rule of payouts equal to the expected real return, which since 2018 has been set at 3%. But if asset valuations are volatile, then a fixed spending rule puts at risk the real value of the fund, essentially taking from future generations. The fund’s allocation has risen from 0% equity at inception to 70% today with real estate included, so fluctuating market values are a significant concern.
This is compounded by the state’s reliance on payouts. Currently 15% of government spending is paid for by the fund, so there is considerable pressure to maintain a consistent flow of funds. If funding levels are not smooth, politicians may be faced with the unenviable task of identifying which (admittedly generous) public services to cut.
Inevitably, there is a tension between payout consistency, payout level, asset allocation, and the ability to preserve the real value of assets for the benefit of future generations.
There has been some luck: In 2008, falling values of overseas assets in US dollar terms were counterbalanced by a falling NOK. But such good fortune cannot be expected to last forever.
Mork anticipates two significant problems that will need to be addressed:
- Management Model: The asset management process remains in the hands of the Norges Bank, Norway’s central bank. Given its responsibility for monetary policy, it may not be best placed to run so significant an investment fund. This is to be addressed in a new act in 2020.
- Fat Cats: One in five working age Norwegians currently claim some kind of state-funded benefit. This worrying statistic is compounded by the limited life of the fossil fuel derived income. New deposits to the fund will likely dry up just as an aging population will need to rely on state support. The Norwegian government predicts a 2060 budget shortfall of 5%–6% of GDP.
What to do? There is no easy answer. But having a trillion US dollars and time to think may give rise to some creative solutions. These are nice problems to have.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image courtesy of CFA Society Denmark