ABOUT TDM
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Managing Political Risk in the Oil and Gas industries
I. Introduction
In today’s increasingly global marketplace every investor has to consider particular risks involved in expanding its operations. Risk is a constantly present factor in business decision making process, and determining appropriate ways to manage and mitigate risks is crucial to the ultimate success of any new investments or expansion of already existing business operations.
Risk management is of paramount importance to the economic consequences of investments in oil and gas industry where such investments can exceed US$1 billion, and many years to complete.[1]
The general types of risk faced by all businesses can be grouped into five broad categories:
1) market risks, such as unexpected changes in interest rates, exchange rates, stock prices, or commodity prices;
2) credit/default risks;
3) operational risks, such as equipment failure, fraud;
4) liquidity risks, such as inability to pay bills, inability to buy or sell commodities at quoted prices; and
5) political risks.[2]
The key test for whether a risk can be covered by political risk insurance is determining whether the occurrence was caused by a government action (a "political" risk) or was the result of a commercial activity. Insurers make a distinction between these two types of risk because a political risk is presumably not within the control of the investor, and a commercial risk is.[3]
Due to the extreme volatility of energy commodity prices it has long been considered that businesses operating in the petroleum, natural gas, and electricity industries are particularly susceptible to market (price) risks and other commercial risks. However, political risk management in the energy industry plays an increasingly important role since the world’s oil and gas production pattern is directly related to the geopolitical location of reserves. As shown in the table below major oil reserves are located in the regions of the world characterized by an unstable political environment.
|
Middle East |
65.7% |
|
Commonwealth of Independent States and Eastern Europe |
5.9% |
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Western Europe |
1.6% |
|
Latin America |
12.3% |
|
North America |
3.9% |
|
Asia and Pacific |
4.4% |
|
Africa |
6.1% |
Table 1. Distribution of oil reserves[4]
It has to be noted that traditional commercial risk management approaches, such as diversification, long-term contracts, inventory maintenance, etc. do not work well, however, for managing political risks. This paper defines the political risks threatening the well-being of the oil and gas industry, provides the description of current political risk management tools and techniques, and determines areas of their practical application.
II. Defining Political Risk in the Oil and Gas Industry
One of the major considerations inherent in any international investment is the political risk represented by the host country. This is particularly true in industries such as the oil and gas or energy industries, which are high profile and often controversial in almost every country in which the energy industry has been privatized or in which private upstream petroleum operations exist. When evaluating a prospective investment in a foreign country, the investor must also evaluate and manage the potential political risk in addition to the geological and market risks. In other words, an oil company must be able not only to find hydrocarbons, it must also be able to develop and produce those hydrocarbons at a reasonable profit over time. An agreement signed with the host government is likely to have a term that will be for a longer period of time than the current government will remain in office. A future government may be less disposed to western companies and adopt a more nationalist policy for their national resources.
Once the geologists have made their assessment of the geologic potential of a particular area, and the economists have evaluated the fiscal regime that the host country is offering, it is up to company management and their advisors to assess the political risk inherent in a particular new venture and determine if that risk can be managed in an acceptable way, given the returns that are likely to result if the first two assumptions are correct.
Political risk does not result from the type of political system in place in the host country. For example, western companies have operated successfully under all types of political systems, be they Marxist, capitalist, nationalist, socialist, monarchy, or democracy. Political risk usually stems from changes to the political and socio-economic conditions of the host country from those that existed at the time the agreements in question were originally entered into. Examples of this are the problems that Belco Petroleum Corp. faced in Peru in the 1980s and that Enron Corp. faced in India in the 1990s. In both cases, a change in the local ruling party resulted in a new government that adopted an anti-foreign investment attitude that differed significantly from that of the predecessor government (or in the case of Enron in India, a regional government that adopted a policy different from that of the national government).
Furthermore, political risk is not confined to the third world. At various times, developed countries such as the UK, France and Italy have raised concerns about nationalization. If you broaden the definition of political risk to include "creeping expropriation" which stems from changes in legislation that affect the industry such as taxes, labor, environmental regulations and other economic measures, the United States itself may be considered to present somewhat of a political risk.
Therefore, the way the political power is exercised in particular country may have considerable effect on the investing firm’s financial performance. Sometimes subtle political changes can greatly affect the investment climate. Accordingly, it is very important to identify the types of political risks in order to determine whether a particular government action poses a threat to the investment.
The first distinction that must be made is between firm-specific political risks and country-specific political risks. Firm-specific political risks are risks directed at a particular company. The example of firm-specific risks can be the risk that a government will nullify its contract with a given firm or that a terrorist group will target the firm's physical operations. Firm-specific risks, therefore, are by nature discriminatory. By contrast, country-specific political risks are not directed at a firm, but are countrywide. Examples include a government's decision to forbid currency transfers or the outbreak of a civil war within the host country.[5]
Investors may be able to reduce both the likelihood and impact of firm-specific risks by incorporating strong arbitration language into a contract or by enhancing on-site security. However, firms usually have much less control over the impact of country-level political risks on their operations. Sometimes the only sure way to avoid country-level political risks is to stop operating in the country in question.[6]
A second distinction to be made between types of political risk is the distinction between government risks and instability risks. Government risks are those that arise from the actions of a governmental authority, whether that authority is used legally or not. Instability risks, on the other hand, arise from political power struggles. An example of such risk could be conflicts between members of a government fighting over succession, or mass riots in response to deteriorating social conditions.[7]
The distinctions between different categories of political risks are summarized in the table below.
| Government Risks | Instability Risks | |
| Firm Specific Risks | ||
| County Level Risks | ||
Table 2. Categories of political risks.[8]
The degree of willingness to accept political risk varies from company to company. What one company finds acceptable, may be too risky for another company. In addition, there is usually a direct correlation between the degree of political risk that a company is prepared to accept, and the degree of geological potential of the proposed contract area.
In assessing[9] the degree of political risk in a particular country, the company will look to many indicators, e.g., the current activity in the host country that is affecting or is likely to affect the stability of the government (insurrection, rebellion, criminal activity), prospect for change of national or local government, past history of nationalizations/expropriations, experience of other companies in the country, political activity and trends in the region, the overall economic condition of the country, etc.
“When assessing political stability, the focus should be on the legitimacy of state authority, the ability of that authority to impose and enforce decrees, the level of corruption that pervades the system of authority, and the degree of political fractionalization that is present. Where economic policy is concerned, the focus would be more along the lines of the degree of government participation in an economy, the government's external debt burden, and the degree to which interest groups can successfully obstruct the decision-making process. Effective political risk management requires distinguishing developments that pose true risks—a well-defined threat to corporate performance—from political events that are merely dramatic.[10]
III. Political Risk Management
It is important to emphasize that the there are a number of ways to protect the investing company against political risks, and the decision regarding the political risk mitigation measure to be taken has to be made after the careful assessment and evaluation of the factors the can potentially influence the company’s financial performance in the host country.
Assuming that a petroleum company determines that the geological potential is attractive given the fiscal terms being offered, how does the company manage the political risk? Political risk can be managed in two ways: either through actual political risk insurance, or through what I like to refer to as de facto insurance. De facto insurance may be described as the protection that results from strategic partnering and/or planning. Actual political risk insurance is aimed not at preventing a loss, but rather at assuring the investor that compensation will be received for all or part of the investment if a loss does occur. De facto political risk insurance is aimed at trying to prevent a loss from occurring in the first place. Obviously, it is more effective against certain risks such as expropriation or nationalization, and less effective against others, e.g., currency inconvertibility, war risk, etc. These two methods are not mutually exclusive. They complement each other and in many instances are, used in tandem.
IV. Types of Political Risk Insurance
Actual political risk insurance can be obtained either through private companies such as Lloyds, AIG, etc. or through national or multilateral government insurance programs e.g., OPIC or MIGA. Countries offering some form of political risk insurance to their nationals include Australia, Belgium, Canada, Denmark, France, Germany, Japan, the Netherlands, Norway, Sweden, United Kingdom and the United States. The extent and scope of coverages offered will vary by country.
It can be emphasized that unlike multilateral agencies, bilateral agencies (known as Export Credit Agencies, or ECAs) are designed to promote trade or other interests of an organizing country. They are generally nationalistic in purpose and nationalistic and political in operation. Funding for bilateral agencies generally comes from their organizing governments.[11] This distinction is important in making the decision about the type of political risk insurance to be obtained by the investor: many of the projects financed by ECAs have serious social, political, cultural and environmental impacts and this factor may influence the investment climate in some developing countries.
The two major U.S.-based ECAs are Overseas Private Investment Corporation (OPIC)[12] and Export-Import Bank (USEx-Im).[13]
The United States Overseas Private Investment Corporation ("OPIC"),[14] is probably one of the best known of the national government companies. OPIC is an agency of the executive branch of the U.S. government. It is widely known for its political risk insurance program, in which it covers losses attributable to certain political risks in oil and gas projects such as expropriation including losses caused by material change in project agreements, confiscation of tangible assets and bank accounts, interference with operations. OPIC insurance covers up to $250 million per transaction or project and can be obtained for up to 20 years.[15]
USEx-Im operates as independent U.S. agency. According to its governing statutes it has three guiding principles: support United States exports through financing, attain a reasonable assurance of payment, and provide financing support where commercial finance cannot do so. In addition, the USEx-Im guarantee program provides credit support for private sector loans made to foreign buyers to protect against repayment risks. The host government and USEx-Im must have in place a bilateral agreement. This agreement must give USEX-Im recourse to the government if a political risk event occurs, and results in a default.[16]
In addition to the national companies, which only offer protection to their own citizens (for example, in the case of OPIC, a corporation must be 50% or more owned by United States citizens, or if a foreign corporation, it must be at least 95% owned by a qualified United States entity), the Multilateral Investment Guarantee Agency ("MIGA"), which is an agency of the World Bank, offers protection to corporations which are incorporated and have their principal place of business in a country which is a member country, or which is majority owned by nationals of member countries. Approximately 97 countries have signed the MIGA Convention and of those approximately 71 have ratified the convention. Ratification is required in order to participate in MIGA's programs.
V. Types of Coverage and Measure of Loss
Two of the most important sections of a political risk insurance policy are those which set forth the events that give rise to a loss i.e., what constitutes an event of loss, and the measure of damages in the event a loss occurs. The determination of when an event of loss occurs, and the measure of damages will be a function of the type of coverage that is being purchased. It is important, therefore, to understand the types of political risk insurance coverages that are available.
Political risk insurance coverages generally include expropriation, currency inconvertibility, war and civil disturbance, trade disruption and breach of contract, each of which will be examined more closely.
1. Expropriation coverage protects against partial or total loss of the investment as a result of actions by the host government which may reduce or eliminate the insured's ownership of, control over, or the exercise of its rights with respect to its investment. Coverage can also be obtained against so-called "creeping" expropriations i.e. a series of actions which, over time, have the effect of depriving the investor of its ownership, control or rights to its investment. The amount of the loss is generally the net book value of the insured investment.
