The Lehmkuhl Lecture 2013

The fund’s origins

23 December 1969 brought a Christmas present hardly anyone still dared hope for: it was clear that oil had been struck off the coast of Norway. Not only that, Ekofisk was the largest offshore oilfield yet found anywhere in the world. “I can cover the North Sea from here to the North Pole with oil,” drilling supervisor Ed Seabourn on the exploration platform Ocean Viking told his superiors at Phillips. The years that followed brought further major discoveries, and the immense value of these deposits in the North Sea soon became clear. The revenue would transform Norwegian society.

The foundations of the Norwegian oil model were laid as far back as 14 June 1963, when the Gerhardsen government proclaimed Norwegian sovereignty over the Norwegian continental shelf. Domestic and foreign companies would be granted licences to explore and exploit its deposits on specific terms. The course that was set 50 years ago was rooted in close government control, but unlike some other oil-producing nations Norway did not succumb to the temptation of nationalising the oil industry. To begin with, there was little choice – we were reliant on foreign companies to get started on exploration and production, and it was Esso that drilled the first exploration well on 19 July 1966.

In a parliamentary report dated 14 June 1971, the year that production began on Ekofisk, the Storting formulated the first guidelines for Norwegian oil policy, which came to be known as the Ten Commandments. One fundamental principle was that “oil policy should be developed with a view to natural resources on the Norwegian continental shelf being exploited in such a way as to benefit the whole of Norwegian society”. National supervision and control needed to be ensured, and importance was attached to industrial development, the coordination of all Norwegian interests, the landing of oil in Norway and the formation of a state-owned oil company. One important goal was to build up a strong oil industry domestically. The following year, on 14 June 1972, the Storting decided to create a petroleum directorate and a state-owned oil company, Statoil. The aim was to draw a clear line between political, administrative and commercial roles – a key feature of the Norwegian model.

The idea of an oil fund was first floated by the Tempo Committee, chaired by Hermod Skånland, in 1983. It proposed setting up an equalisation fund, to which government revenue from the oil sector would be transferred. The committee’s confidence in the government’s ability to save was limited: “The political bodies must decide for themselves whether building up such a fund to avoid a future decline in revenue is realistic,” it wrote. “The committee for its part chooses not to make this assumption.” The thinking behind the fund was to save money for future generations, a concept that gradually matured during the course of the 1980s. The Willoch government approved the creation of such a fund in 1986, and the Government Petroleum Fund Act – now the Government Pension Fund Act – was first passed on 22 June 1990. The act rules that all government revenue from petroleum activities must be transferred to the fund, and that the fund’s capital may only be used for transfers to the government budget as resolved by the Storting. In other words, the government’s non-oil deficit is to be covered by an annual transfer from the fund via the so-called budgetary rule, and the fund may not be used routinely for other purposes.

Many doubted whether any oil money would actually ever be put aside, and some questioned the very existence of the fund. Forecasts also indicated that Norwegian oil production would peak in the early 1990s. To begin with, the fund was indeed merely an accounting exercise. Government petroleum revenue flowed into the fund, but the entire amount was then clawed back to cover parts of the non-oil deficit. But the Norwegian economy would pick up, and the first transfer proper to the fund took place in 1996. Today the fund has nearly 5 trillion kroner invested in global capital markets, equivalent to almost a million kroner for every Norwegian citizen. Few would have believed this when the fund was set up in the depths of recession with high unemployment and budget deficits.

Norway joined the elite of oil-producing nations when the Statfjord field came into production on 24 November 1979. At their peak, the three platforms on the field accounted for more than half of Norway’s oil production and 80 per cent of Statoil’s operating earnings. After just over 40 years of oil production, we have now recovered some 6 billion standard cubic metres of oil equivalents since oil was first produced in 1971. This includes just over 26 billion barrels of oil, condensates and natural gas liquids, and 1.7 trillion standard cubic metres of gas. Norway has accounted for around 2.5 per cent of global oil production during this period, and around 2 per cent of global gas production. In 2012 Norway was the world’s third-largest gas exporter behind Russia and Qatar.

The total value of oil production to date on the Norwegian continental shelf is up at 11 trillion kroner in today’s money.¹ That is five times the output of the mainland economy in 2012. Around 37 per cent of this revenue has gone towards exploration costs, investment and operating costs to get the oil out. The government’s net cash flow from petroleum activities through to the end of 2012 was around 5.2 trillion kroner in 2012 money, or 48 per cent of total production revenue. Since the first payment to the fund in 1996, just over 3 trillion kroner has been transferred to it, or 3.4 trillion in 2012 money. This is equivalent to about 30 per cent of total production revenue on the Norwegian continental shelf.²

Over the past 40 years we have recovered about 40 per cent of estimated recoverable reserves on the Norwegian continental shelf. These reserves are currently believed to total 13.6 billion standard cubic metres of oil equivalents, including oil and gas already sold and delivered, which means that the current estimate of remaining recoverable reserves is 7.6 billion standard cubic metres of oil equivalents. Forecasts for the government’s future net cash flow from petroleum activities and future transfers to the oil fund are associated with considerable uncertainty. This uncertainty relates not only to remaining reserves and future production levels, but also to production costs and future oil and gas prices. All the indications are that Norway has reached peak production, but new technology means that more and more oil and gas deposits are becoming recoverable.

Oil and gas are non-renewable resources. By transferring revenue from petroleum activities to the fund, wealth in the form of oil and gas in the seabed is converted into diversified financial wealth invested in foreign securities. The oil fund is the core of the Norwegian oil model: our natural resources are to benefit the whole nation, they belong to the people, not just a select few who grow rich on shared resources, and not just the current generation but future generations too.

The fund’s investments

The first transfer to the fund, of 2 billion kroner, was made on 31 May 1996 after the central government accounts for 1995 showed a surplus. At the end of 1996 a further 45 billion kroner was transferred, equivalent to the estimated surplus on the central government budget for that year. At this time, the fund did not take the form of a separate account at Norges Bank, and the capital attracted a return equal to that on the foreign exchange reserves. An investment strategy for the fund was established in the national budget for 1998 whereby 40 per cent would be invested in equities and the remaining 60 per cent would continue to be invested in government bonds. Norges Bank was given the task of managing this capital, and a separate management organisation was set up at the bank from 1 January 1998. The first purchases of shares were made in the first half of that year. Starting out as an equity investor just before the turn of the millennium was a challenge. The first ten years of the new millennium have been dubbed the stock market’s lost decade, and culminated in the worst financial crisis for many decades.

If we are to safeguard the fund’s long-term international purchasing power, we need to generate a return that at the very least matches growth in the global economy, and we need to invest in asset classes that are sufficiently large given the size of the fund. Since 1998 the fund’s return after inflation, tax and management costs, or its real return, has been 3.5 per cent for the very first krone transferred to it. The return in average money has been slightly higher.³ The fund’s real return has been below the long-term forecast of 4 per cent, but in line with growth in the global economy. By way of comparison, real growth in the countries in which we have actually invested has been just 1.9 per cent during this period. Historically, growth in the global economy has been higher, 3.2 per cent since 1980.⁴ The OECD is predicting annual growth of 3.7 per cent through to 2030, but it is worth noting that its long-term projections for 2030 to 2060 are as low as 2.3 per cent.⁵ So, despite the fund’s brief history including both a lost decade in the stock market and the greatest financial crisis for many decades, its purchasing power has still increased. The annualised nominal return in dollar terms has been 6.5 per cent since 1998,⁶ and almost a third of the fund’s value today stems from returns.

Historically, only shares have been able to offer a sufficient return to justify the expectation of a 4 per cent real return on the fund. A historical review of real returns since 1900 shows that US government bonds have returned 2 per cent, while shares have returned 6.3 per cent.⁷ Although stock market returns have been good historically, this is no guarantee of what will happen in the future. Returns have fluctuated considerably from year to year and from decade to decade. Investors will price equity investments on an expectation of a stronger return in this asset class, but we have to assume that the forecast of a real return of 4 per cent is uncertain, including in the long term.

In July 2007 the Ministry of Finance decided to increase the fund’s allocation to equities from 40 per cent to 60 per cent. A few weeks later, on 9 August 2007, we saw the first signs of a financial crisis developing when French bank BNP Paribas suspended withdrawals from three of its funds because their investments were “impossible to value”.⁸ Stock markets nosedived during the course of 2008 and the first quarter of 2009, and the fund produced a negative return for 2008 of 23.4 per cent, or 633 billion kroner. Between the financial crisis erupting in autumn 2007 and the early summer of 2009, the fund invested 1 trillion kroner in equities. By way of comparison, the fund’s first decade through to the end of 2006 saw total equity purchases of just 500 billion kroner. The markets then rapidly recovered, and the losses turned to gains. The financial crisis left us not with record losses on equity investments but substantial profits, and the story of how a small country with less than 0.1 per cent of the world’s population acquired more than 0.5 per cent of the world’s listed companies in less than two years. Downturns in the markets can be unappetising, but they can also offer opportunities for investors with a long-term perspective.

The fund’s investment strategy focuses on long-term returns rather than short-term gains and means that the fund needs to be able to ride out temporary fluctuations in prices. Our long-term horizon puts us in a position to act as a countercyclical investor. In periods of falling stock prices, the fund’s equity share will fall, and if the changes are sufficiently large, the fund will be rebalanced back to its original weights. This means that the fund buys when prices are low, and sells when they are high. When share prices are tumbling and uncertainty is rife, buying shares and so increasing the level of risk is a leap of faith. Experience, however, shows that it is profitable to do so. We have carried out full rebalancings only twice in the fund’s history.⁹ The rebalancing in spring 2009 has singlehandedly increased the annual return on the fund from inception by about half a percentage point.

Norges Bank’s main aim in the management of the fund is to safeguard and build wealth for future generations. We do this by developing investment strategies spanning multiple asset classes to ensure the best possible return given a moderate level of risk. We aim for a good return with acceptable risk, but we cannot avoid the uncertainty inherent in our investments. Investments are made for the future, and the future is uncertain. The fund’s investment strategy seeks to protect its capital for future generations while also safeguarding its international purchasing power through a real return in excess of growth in the global economy. This means that we have to expect substantial fluctuations in the value of the fund.

The mandate we have from the fund’s owners requires a strategy where we spread the risk. This means that we aim to diversify investments at every level. First, we invest in different asset classes. In 2011 the Ministry of Finance gave the go-ahead for investments in real estate as well as equities and fixed income, and the fund is now to consist of 60 per cent equities, 35-40 per cent fixed-income securities and up to 5 per cent real estate. In time, it will also be natural to allow investment in other asset classes. Risk-free interest rates are record-low. Returns in the bond markets are weak and look set to remain so for a long time to come. The safest investment currently produces a return after inflation of close to zero.

Second, we diversify geographically and have invested worldwide. In its first decade the fund had more than half of its investments in Europe, but we now aim to have roughly a third in each of the main regions: Europe, the Americas and Asia. We want to claim a share of global output, so we need to be invested where value is created. We will therefore also be stepping up investment in emerging economies as their capital markets mature. This is a continuous fine-tuning of the fund’s strategy to preserve the international purchasing power of our oil.

Third, we spread our investments across large numbers of companies, bonds and, increasingly, properties. We are invested in more than 8,000 companies in more than 70 countries.¹⁰ Being such a large fund, we naturally invest mainly in large companies, but we also invest in many smaller companies with the potential to grow into large ones. More than 4,000 of the companies we are invested in have a market value of less than 10 billion kroner.

Fourth, we use a number of different investment strategies by delegating investment mandates to different managers. We have more than 100 investment mandates with internal and external managers operating in different areas of global financial markets. The external mandates invest primarily in small companies and emerging markets where we are unable to build up the necessary expertise in-house. The internal mandates specialise in different industries, sectors and market segments. Common to all of them is that we aim to have an in-depth knowledge of what we are investing in and try to use this knowledge intelligently and systematically in our investment strategies. We manage but one fund, but have over 100 mandates and invest in thousands of different companies in all countries with functioning capital markets.

Although the fund’s returns in recent years have been favourable, we have to be prepared for future periods with heavy losses. In 2008 we returned a negative 23.4 per cent. Looking at the biggest downturns since the year 1900, we see that variations of this magnitude have occurred roughly once every 30 years. But it will not necessarily be another 30 years before we have another year like that. The slide in the fund’s value in 2008 did not go unnoticed, but the conclusion was that the fund’s strategy should stand and that we have to accept that the fund will fluctuate in value. With 5 trillion kroner in the fund and the current asset mix, a year as bad as the worst year of the past century would bring a drop in value of almost 30 per cent, or nearly 1.5 trillion kroner. A year like 2008 would reduce the fund’s market value by close to 1.2 trillion kroner, which is equivalent to the entire annual government budget. This says a great deal about how special 2008 was by historical standards, but also about what we have to be prepared for in the future. When our grandchildren come to use the returns on the fund at some point in the future, the fluctuations in the fund’s value in kroner during the financial crisis will pale into insignificance, because it is these big variations in returns that underlie the expectation of a healthy long-term return on the fund.

Investing is all about the future – and there is much about the future that we do not know. Future returns are therefore uncertain, and fluctuations in value from year to year will be considerable. We cannot eliminate this uncertainty – it will always be there. To ensure the best possible return while also limiting risk in the long term, we have spread our investments across several asset classes, across most countries with developed financial markets, and across companies with small holdings in most listed companies. Our investments are diversified to reduce risk, but we cannot eliminate it entirely. Norway has come a long way in turning oil wealth into financial wealth. It is important to stress that what we refer to as oil revenue is actually only the retrieval of wealth. This financial wealth highlights the huge amounts involved, but this in itself does not make us any richer. It also highlights the considerable fluctuations involved, but does not increase the overall variation in the nation’s wealth.

The fund’s management

We manage the fund for the Norwegian nation – those of us living here today and our kuhl

. We are therefore dependent on the confidence of the Norwegian people if we are to be able to do our job. Besides generating good returns, our management must be carried out responsibly and transparently.

History has shown that owners are rewarded better than lenders. Our investments in equities and real estate make us owners, while our investments in bonds make us lenders. So, for two-thirds of the fund’s investments we are owners. Although it is likely that we will get a better return for the fund as owners than as lenders in the years ahead, we also know that ownership presents challenges.

Today it is 158 years since the father of the school, Kristofer Lehmkuhl, was born. Lehmkuhl was very keen for students to learn about morality in business, and business ethics were very important to him. Good business ethics are also a cornerstone of our ownership activities. Active ownership protects shareholders’ rights and provides a basis for profitable commercial activity. Responsible investment safeguards the value of investments. In this respect, there are fundamental parallels between Lehmkuhl’s vision and the management of the oil fund. As a long-term investor in more than 8,000 companies, we encourage high standards of corporate governance. We do so because it will be profitable and produce good returns in the longer term.

As the oil fund is so large, it wields more influence than its percentage holdings in individual companies would warrant in themselves. We are therefore in a better position than many other investors to influence markets and individual companies. We are keenly aware of the responsibility that goes with our large holdings in some companies. Voting and dialogue are the most important instruments available to us. We aim to vote at all general meetings of companies in which the fund has shares, and to have a rewarding dialogue with the boards of the largest companies in our portfolio. It is rarely a better option to pull out of a company than to try to improve its corporate governance.

The management of the investment portfolio must build on the goal of the highest possible return. A good long-term return on the fund depends on sustainable economic, environmental and social development and well-functioning, legitimate and efficient markets. We need to act responsibly when exercising our ownership rights, because the fund’s investments are about the future and belong to future generations. Our large holdings bring not only rights but also responsibilities.

The fund has identified a number of focus areas for responsible investment. First, we aim to defend our rights by ensuring equal treatment of all shareholders, safeguarding shareholders’ rights and making boards accountable to shareholders. We also aim to promote well-functioning, legitimate and efficient markets, on which we depend as a large investor. As a fund for future generations, we also focus on children’s rights, and we have identified climate change as another natural focus area for an oil fund. We have published expectations for how we think companies should manage the risks associated with children’s rights, climate change and ever scarcer water resources. Each year we assess the extent to which companies in industries with high exposure to these risks meet these expectations. We then contact the companies and encourage them to improve their reporting in these areas.

The fund needs to be a respected, open and responsible manager if it is to retain the confidence of the Norwegian people. Transparency is also important for the fund’s investments abroad. The authorities in some countries are sceptical about sovereign wealth funds, making openness about our investments important in building trust. We need to ensure the legitimacy of our investments in different host countries as our global presence grows. It must be clear to the companies and countries in which we invest that we have a common interest in long-term value creation. As a minority shareholder, we adopt a principles-based approach based on internationally recognised standards of corporate governance, and we lend support to companies’ boards to further our shared interest in long-term profitability.

The objective of good corporate governance is good returns. We want the companies we invest in to take responsibility for the impact their operations can have on the environment and on people, and so on the long-term return on the fund. Good corporate governance, as well as good management of our capital, must build on responsibility and transparency.

Large oil reserves do not necessarily translate into prosperity. Rich natural resources are a blessing, but in most countries they have equally been a curse. Countries with extensive natural resources rarely get richer. There are two main factors that can be problematic. One is if oil riches benefit only a select few, and the other is if the use of this wealth undermines existing industry and so the country’s growth capacity – known as Dutch disease. The oil fund can be seen as an institutional response to prevent this. In other words, the oil fund has two main purposes. One is to ensure that all of us, not just in this generation but also in future generations, stand to benefit from the country’s oil revenue. The other is to ensure stability and retain a competitive industrial sector in the mainland economy.

The oil fund has given us considerable financial capital, but pales into insignificance next to the value of our human capital. The most important thing for us as a nation is to build knowledge and skills. The most important investments we make are in people – and that includes future generations. Human capital creates value when we promote knowledge, competition and creativity. One goal in building up the oil fund has been to stop the spending of oil money from displacing existing and future industry. For as long as knowledge, competitiveness and creativity remain the basis of industry, it goes without saying that we need to be on our guard against allowing our natural riches to contribute to a decline in knowledge-based, competition-driven and innovation-dependent industrial activity.

The Norwegian oil model is often held up as an example for others. The main feature of the model is that oil and gas resources belong to the people and must benefit the nation as a whole. We must also ensure that the Norwegian oil and gas story is made an epoch, not just an episode. The idea has not been to get all of the oil out as quickly as possible, but to take time to recover these resources, and it has been important to develop skills and technology. Recognising this has made the Norwegian continental shelf a world leader in recovery technology and recovery rates. The average recovery rate here is 46 per cent for oil and 70 per cent for gas. By way of comparison, the global average for oil is just 22 per cent. Back in 1972, the planned recovery rate for the Ekofisk field was 17-18 per cent, but this has now risen to 52.5 per cent. In other words, Norway has increased its oil wealth by building national expertise and thinking long-term. The Norwegian oil industry has proved to be technologically advanced and globally competitive.

Kristofer Lehmkuhl worked tirelessly to raise skills levels in Norwegian industry. In the same way, the oil fund is keen to recruit financial skills and expertise, and contribute to a strong financial research arena in Norway. It is in this context that the Norwegian Finance Initiative (NFI) came about. The NFI aims to support our work to safeguard and build financial wealth for future generations by strengthening financial research and education in areas relevant to the long-term management of the oil fund. The NFI co-finances professorships and guest speakers, awards grants to doctoral students and supports research in financial economics. We hope, of course, that in the longer term this will contribute to greater expertise in asset management in Norway, benefiting the stewardship of our shared financial wealth.

An active and knowledge-based investor with an in-depth understanding of the underlying and long-term value of our investments is essential for taking care of the wealth in the fund. We aim to do this by building expertise in asset management both at Norges Bank and in Norway as a whole. When the fund started out, the whole of its equity portfolio was managed externally, but 96 per cent of the fund is now managed internally. The management organisation has been built around a will to succeed, where acceptance of risk and an ability to get results are prized. We have built a cost-effective, flexible and change-ready organisation. Our investment management is part of an extremely competitive global market and demands people with a high degree of integrity, a willingness to learn and a focus on results.

The story of Norwegian oil is often described as a fairytale, but it could have gone very differently, and we need to protect what we have achieved. The management of the fund needs to ensure that future generations too benefit from Norway’s oil wealth. The oil fund is in many ways the core of the Norwegian oil model: it retains national control of the country’s wealth and aims to distribute this wealth equally between the Norwegians of today and tomorrow.

The establishment and management of the oil fund have been a great success, and many countries envy our economic freedom. The important thing is to manage this financial wealth in such a way that the recovery of our non-renewable natural resources is not seen as a lost opportunity.

We have managed to achieve our two main aims: we have safeguarded this wealth for future generations, and we have ensured stability in the mainland economy. Just under half of our oil and gas has been recovered, and a third of the value of this has been saved in the oil fund. It was not a given that we would manage to save such a large share of our oil revenue in the fund. As managers, we can promise only one thing – we will do our best to safeguard this wealth for future generations.

Thank you for your time.

Notes

¹ From 1971 to 2012, total revenue from oil and gas production was just under 11 trillion kroner in 2012 money, according to calculations by the Ministry of Finance.

² From 1971 to 2012, costs in the Norwegian oil and gas sector totalled 3,989 billion kroner, while the state’s net cash flow from petroleum activities was 5,197 billion kroner. Source: FACTS 2013, 2012 National Accounts, Statistics Norway, Ministry of Petroleum and Energy, NBIM. Own calculations.

³ Real return measured as time-weighted and money-weighted return.

⁴ Figures from the IMF for 1980-2012.

⁵ The OECD’s estimates for global growth are 3.7 per cent for 2011-30 and 2.3 per cent for 2030-60.

⁶ As at 26 September 2013.

⁷ Source: Elroy Dimson, Paul Marsh and Mike Staunton: Credit Suisse Global Investment Returns Scorebook 2013.

⁸ Source: Bloomberg article of 9 August 2007: “BNP Paribas Freezes Funds as Loan Losses Roil Markets”.

⁹ The first was in the first quarter of 2003 and involved equity purchases of 4 billion kroner. The second was in the first quarter of 2009 and involved equity purchases of 136 billion kroner.

¹⁰ The fund had investments in 7,427 companies in 72 countries at the end of 2012.