How is "Big Oil" a Lot Like "Big Pharma"?
The economics of uncertainty in large-scale investments
22 Dec 2006 in Regulatory Economics
The pharmaceutical industry and the oil industry have a lot in common besides being the target for criticism. Recent news stories suggest that they have other important economic similarities:
- It takes billions of of R&D dollars to develop new drugs or develop new oil fields.
- Many of their investments don't yield salable products or marketable fuels.
- Both industries operate in regulatory regimes in which success may lead to asset expropriation.
Dow Jones MarketWatch reports that the Russian government (through its state-owned oil and gas company Gazprom) has agreed to pay Royal Dutch Shell $7.45 billion to acquire a controlling interest in the Sakhalin-2 oil and gas project, whose value is reported to be about three times this amount. All news reports characterize the deal as highly favorable to Gazprom and highly detrimental to Shell.
Why would Shell agree to take a substantial loss on the project? Dow Jones implies that Russia is transparently engaging in extortion masquerading as environmental sensitivity:
Most observers haven't taken Russia's environmental concerns seriously, and the government itself has said that it was concerned that cost overruns were diluting the value of its stake in the project.
Dow Jones calls Russia a "bear of a partner" to the multinational oil companies that have invested billions on exploration and development. This is not intended to characterize Russia's negotiating skill and effort at the outset, but rather its willingness and ability to extort concessions after the economic uncertainties of these investments first have been resolved in the companies' favor.
Reuters says that in addition to cash Shell received "a promise of future cooperation," but it's unclear to what extent markets take this commitment seriously. Shell's stock price rallied on the news of the deal but not apparently because of the value of this promise. Rather, the deal "put to rest investors' earlier fears that the company risked being pushed out of the project entirely." In other words, the market predicted that Russia would expropriate an even larger share of Shell's assets.
It is significant that Shell will retain its technical advisory role in the Sakhalin-2 project. Not only is it very hard for Russia to expropriate intangible property such as technical expertise, but it is hard for a newcomer to reproduce Shell's site-specific knowledge. It also belies the claim that Shell committed any genuine environmental harm or that its reported cost overruns reflect any obvious lack of competence.
Other multinational oil companies are experiencing trouble in Russia. In Venezuela, all foreign oil companies have had their assets partially or completely expropriated.
Economic theory predicts that nations which expropriate the assets of multinational firms will experience significant declines in foreign direct investment. Not only do they have to account for exploration investments that fail to produce oil, but they also have to worry about losing the value of investments that succeed. In future negotiations, multinational oil companies can be expected to dramatically increase the price they charge nations like Russia and Venezuela for technical assistance.
The 110th Congress is expected to pass legislation that forces pharmaceutical companies to accept lower prices for drugs under patent. For tactical reasons it won't be advertised as a bill establishing price controls, it will have the same practical effect. If the legislation is limited to new drugs not yet in the development pipeline, it will increase the financial hurdle that prospective drugs must clear before companies will invest in their development. That means fewer drugs will be developed in the future, and in particular, fewer "blockbuster" drugs for which there are few or no therapeutic competitors. It is this class of drugs that has the highest profit potential and also the highest risk of expropriation.
Under a price-control regime, pharmaceutical companies can be expected to demand that the federal government share the financial burdens of drug development. In addition to reducing investment risks, this strategy has other benefits to the pharmaceutical industry. For example, it could reduce the likelihood of an unjustified FDA disapproval. But it also creates a new conflict of interest: once the government becomes an investor in drug development, it has a financial stake in favorable FDA action. In any case, the end result is either higher R&D costs for the same amount of drug development or fewer new drugs.
However, if the legislation establishes explicit or implicit price controls for drugs already in commerce, it will have additional effects analogous to what multinational oil companies experience in Russia and Venezuela. Like oil exploration and development, the vast majority of the cost of a new drug is sunk in R&D. Like the oil companies' experience in Russia and Venezuela, price controls on drugs already in commerce have the practical effect of expropriating the asset value of the pharmaceutical companies' investments that were necessary to bring these drugs to market.
