Norway’s trillion-dollar oil problem

January 16, 2014, 5:14 PM UTC

Norway’s Prime Minister, Erna Solberg, is contemplating her country’s far-off future. She is sitting in her Oslo office, just three months after Norwegians swept her Conservative Party into power (ousting the more leftist Labor government), and talking about the fate of her country — specifically, when the oil that has brought huge benefits to this nation runs dry. “Long-term revenues are important to us,” Solberg, 52, tells Fortune. “We are harvesting a natural resource, and it is not sustainable, even if it lasts for a long time. We have to survive [beyond] the oil age.”

Solberg isn’t being alarmist. Indeed, she’s quite measured as she lays out her concerns about a Norwegian economy that’s overly dependent on oil, and whose productivity and competitiveness, she says, lags those of other rich countries. But such comments, and the changes Solberg is seeking, are sure to reverberate loudly around the world, especially in financial centers such as New York, London, and Hong Kong. You see, Solberg isn’t just plotting a course for her relatively small country (pop. 5 million); she’s also signaling how she may spend the proceeds of nearly a trillion U.S. dollars (yes, trillion with a t) held by Norway’s Government Pension Fund Global, widely known as the oil fund.

The fund was established in 1990 to hold Norway’s surplus oil income, which comes from the high taxes on oil and gas companies drilling off the coast, and the government’s 67% stake in petroleum giant Statoil. It is now the world’s largest sovereign wealth fund, with assets around $830 billion — 20% more than Saudi Arabia’s SAMA Foreign Holdings. But with the booming oil industry continuing to supply the state with surpluses, plus the fund’s own steady returns, Government Pension Fund Global could close in on $1 trillion.

While Qatar and the United Arab Emirates have made headlines plowing billions of their citizens’ wealth into soccer clubs and TV networks, Norway’s oil fund has invested hundreds of billions almost without notice. Norway now owns about 1.2% of all stocks in the world and an average of 2.3% of every listed company in Europe. Its portfolio includes about $146 billion of U.S. stocks (including $3.3 billion in Apple shares); $56 billion in U.S. Treasury bonds; and prime real estate in New York, London, Paris, Berlin, Frankfurt, and Zurich.

The oil fund presents Oslo with the sort of challenges any government would love to have: How should Norway spend the giant surplus, and how should it manage its growing wealth going forward? The fate of the sovereign wealth fund and its riches is a source of heated debate inside Norway and huge envy abroad, with economists and business leaders such as Bill Gates chiming in with all kinds of advice for Norway. Solberg and her supporters want to invest more of Norway’s petroleum riches in R&D centers, better education, and roads to prepare for a post-oil economy. Tightfisted rivals feel the country should continue to save its money for a rainy day. By law, the government is prohibited from spending more than 4% of its oil revenue each year. And the previous government spent only 2.9% of its allotment, or about $22.9 billion, in 2013, giving Solberg billions more to spend this year without blowing her legal limit.

Then there’s the fund itself. Heavily invested in equities, it rose about 15% last year, according to financial analysts. But its benchmark is a tepid annual return of about 4%. That’s by design, says Yngve Slyngstad, CEO of Norges Bank Investment Management, which runs the fund for Norway’s central bank. “It is important for everyone to understand the way we are managing the fund, that it is based on long-term stability,” he says. Some economists believe the fund has grown plodding and inefficient because of its size and advocate splitting it up with different managers and different investment goals. “We need a more industrial approach,” says Øystein Noreng, an oil economics professor at the BI Norwegian Business School in Oslo. “The larger the fund, the greater the risk.” The government is conducting a major review of the fund and will release its findings in the spring.

One thing is certain: Norway’s trillion-dollar problem isn’t going away anytime soon: Norway has proven reserves of about 5.32 billion barrels of oil and about 70.9 trillion cubic feet of natural gas, ensuring a continued flow of revenue into the oil fund for decades to come.

In January the central bank confirmed that if the oil fund were divided evenly, every Norwegian would be worth more than 1 million kroner (about $164,000). Norwegians are not conspicuous about their wealth. Yes, there are gleaming new buildings, such as the Oslo Opera House, which opened in 2008 on the city’s glassy fjord. But the fund’s biggest advantages aren’t visible. Every Norwegian attends school and university entirely free; women give birth at top-notch hospitals for free, with a year of paid maternity leave guaranteed by law. At 65, Norwegians can begin claiming state pensions of up to 80% of their salaries for the rest of their lives. “I don’t have to worry about leaving my kids money,” says Marianne Røiseland, a board member of Norway’s TV2 channel and a close friend of Solberg’s.

Hard as it is to believe, the country was once a basket case. When big oil began flowing in the early 1970s, economists warned Norwegian officials they ought to set aside the profits in preparation for an inevitable fluctuation in oil prices. Politicians ignored the advice, spending freely and leaving Norway deep in debt when oil prices plummeted. “Norway’s position was bad,” Noreng, the economics professor, says. The government borrowed heavily to fund Statoil when it was a newcomer in the oil industry, and national debt soared. Norway recovered, repaid its debts, and then again blew its oil revenues during the 1980s. “When the oil price collapsed again in 1986, we were caught with our pants down,” he says.

After that, Norwegian officials vowed not to repeat their boom-and-bust mistakes. When they created the oil fund, they set for the first time strict limits on government spending. Solberg’s Conservative Party won over voters in the fall, gaining 18 seats, and formed a governing coalition with its right-wing coalition partner, the Progress Party. They won partly by promising more spending on big projects. (That’s right, the conservative politicians in Norway advocate more government spending.) The coalition contends that the public sector needs to improve the quality of education and research institutions, infrastructure, and health care facilities, or it won’t be able to attract diverse industries, as Sweden has done, for example, with its booming high-tech startups. “We know we need to make some changes,” says Siv Jensen, 44, Norway’s new finance minister and leader of the Progress Party. “We have to increase our productivity and competitiveness.”

Jensen says her political heroine is the late Margaret Thatcher, and she’s seeking to emulate some of the former British Prime Minster’s strategy of privatizing state-run industries and cutting taxes. Jensen thinks privatization will lead to better education and health care in Norway; she also wants lawmakers to repeal estate taxes, and she wants a lot more money spent on infrastructure like roads. Jensen and Solberg insist that for now at least, they will keep the oil fund’s rules intact and spend within their 4% allowance. But old-timers like former trade minister Trond Giske fear the new leaders will “mess with the Scandinavian model,” which stresses heavy state involvement. “That’s been the recipe of our success.”

How might all these potential changes affect the oil fund’s investment strategies? On paper there is plenty of money. But big domestic projects like infrastructure and schools could someday force officials to push for a greater share of the oil fund’s holdings. And that could translate into fewer kroner for Apple and Nestlé and its other investments. Already the oil fund has a unique wrinkle: In 2004 the government formed an ethics council that advises the Finance Ministry on companies it thinks Norway shouldn’t invest in. They include any business using child labor or producing land mines, nuclear weapons, or tobacco.

Some outsiders are pushing the oil fund to take a more “activist” approach. In November, Bill Gates flew to Oslo to meet Solberg. He implored her to invest more Norwegian money in Africa (where the fund has few holdings), arguing that it would bolster the continent as well as bring good returns. Solberg listened but says she remains unconvinced. “Bill Gates can do whatever he likes with his money,” she says. “This is the Norwegian people’s money.”

How Solberg’s government decides to spend the people’s money will play out over the course of the next several months. If Solberg eventually succeeds in attracting new industry, she will not only transform the economy but also diversify the money flowing into the government coffers, beyond oil profits. Perhaps Norwegians may even someday have a whole other wealth fund to call their own.

This story is from the February 3, 2014 issue of Fortune.