Political risk in oilfield minerals investments in MENA

Published: Friday, 20 December 2013

Many countries in the MENA region are taking steps to diversify their economies away from almost sole reliance on oil and gas production and to pay greater attention to their reserves of metals and minerals. Dr Elizabeth Stephens, JLT Consulting,* looks into the political risk in MENA

Production of metals and industrial minerals are already a significant contributor to the economies of Iran and Turkey, while metal production is a factor in the nonfuel economies of Bahrain, Oman, Qatar, Saudi Arabia, and the UAE.

Abundant natural gas supplies, particularly within Iran and the GCC and the ease of ocean transportation provide a solid basis for the region’s development of energy-intensive mineral industries to produce aluminum (primary and secondary), crude steel, direct-reduced iron (DRI), fertilisers, petrochemicals, and rolled steel. These industries are essential for the economic diversification efforts in the region, especially in the countries that depend heavily on hydrocarbon exports to sustain economic growth.

While the governments of many states in the region retain majority ownership of the companies that operate in their mineral sector, some, like Saudi Arabia are actively encouraging private investment in mineral projects and are expected to remain attractive to domestic and international investors. Yet behind these potentially lucrative investment opportunities a range of political risks lie.

Artifical stability

In those territories most severely impacted by the Arab uprisings, rulers had provided investors with stability at the expense of the rule of law, individual rights and political participation. Under these circumstances investors should consider the long term political risks associated with their trades and investments. From an actuarial perspective, if stability is dependent on a dictatorial ruler, even without a revolutionary uprising, the leader will pass away at some point, potentially ushering in an era of instability. Qatar’s preemptive handover of power from the 61-year-old modernising emir, Sheik Hamad bin Khalifa, to his 33 year old son, is an exception to the rule of succession in the regions hereditary monarchies. Ailing monarchies in other territories are clinging tenaciously to power and are reluctant to pass the reigns to the younger generation.

Through fair means and foul, the Arab world’s remaining eight monarchies have so far managed to head off popular pro-democracy revolutions that erupted in January 2011 and ousted the dictators of Tunisia, Egypt, Libya and Yemen and embroiled Syria in conflict. Despite this, King Mohammed VI of Morocco, King Abdullah of Saudi Arabia, King Abdullah II of Jordan, Sultan Qaboos bin Said of Oman and the various sheiks of the Persian Gulf are less certain of their grip on power than a decade ago and the monarchies of Jordan, Bahrain and Saudi Arabia face particular challenges.

The sovereign credit ratings of all these territories reflect this potential for instability, with agencies penalising them by around four notches for a lack of democratic institutions and the separation of powers.

Heightened risk?

It is inaccurate to say that the entire MENA region is a riskier investment destination due to the Arab uprisings. The region is complex, multifaceted and the risk profile of every country differs to that of its neighbour. Continued violence in Syria, the troubled political environment in Egypt, lawlessness across broad swathes of Libya and the real risk of Iraq being engulfed in civil war, creates the impression of a tumultuous region in which business opportunities are scarce.

Following the uprisings, investment sentiment towards the MENA soured and those companies less familiar with the region began to pull out, even from countries relatively insulated from the unrest. Those who stayed and maximised the opportunities available found themselves in a better position as competition diminished.

Political risk management strategies

Investing in MENA is far more complex than the television images of protests and violence which can act as a deterrent. There is rarely such a thing as a ‘good’ or ‘bad’ country. In reality it is more appropriate to think in terms of a good or bad risk. While historically, management of political risk by corporations was considered an oxymoron, today we recognise that companies change and influence the political risk environment they operate within. As such, there are several startegies companies can adopt to manage and mitigate the impact of political risk on their investments.

The first step is to understand that all risk is local and that an integral part of the due diligence process is to review the specific environment in the specific region of the country for their specific project. A review of security on the ground, legacy issues, reputational risk, social impact, environmental impact and relations with the current and potentially future political decision-makers in the host country is essential. In Syria, international oil companies had developed such strong relationships with local communities that they were able to continue operating for many months into the conflict, with communities defending installations against rebel forces.

The second step to reduce country risk is to identify the range of stakeholders and their respective interests. Stakeholders are not limited to those entities that finance the project and include the host government, local government, community groups or tribes, project sponsors, lenders, offtakers and NGOs. Western oil companies operating in Libya behaved in an exemplary manner when the uprising took hold in Libya. While political violence forced them to abandon their assets, they did not abandon their local workers and continued to pay them throughout the crisis. By maintaining good relations with local communities the transition back to operating within the country at grassroots level has been smoother.

The third step is to ensure equitable reward sharing between project sponsors, the host government and other participants. A major driver for resource nationalism has been perceived inequality in returns when commodity prices rise. One way to address this is to link government royalties to profitability and commodity prices. Direct government equity participation in projects can also be a risk management tool and may be an alternative to the royalty structure.

The fourth step is to engage with non-governmental stakeholders. Many operational NGOs are more appreciative of the developmental benefits of investing in the resources sector and are willing to work with foreign investors. Their local expertise may prevent the project company from inadvertently creating new risks and, for example, in developing local infrastructure can advise on balancing the interests of competing tribes, employing from across ethnic groups and sensitivities to such things as religious and historical sites.

The fifth step is to consider the benefits engagement with multinationals may bring. As a preferred sovereign creditor, the World Bank wields considerable influence in the event of contractual disputes and defaults with emerging governments. This influence is reinforced by the World Banks’s role as a key source of liquidity when a country is in turmoil.

The sixth step is to consider recourse under bilateral investment treaties (BITs) which have long provided a valuable source of risk mitigation and valuable safety net to counter the worst excesses of government behaviour.

The seventh step is to provide adequate protection for personnel. There is a direct correlation between the security vacuum that emerges following the overthrow of an authoritarian government and the prevalence of kidnap incidences. Kidnap rates have risen in all terrirotires impacted by the Arab uprisings. In conjunction with ensuring operational continuity, companies owe a basic duty of care to their employees and must ensure that suitable security plans are implemented and regularly reviewed to minimise the risks of an incident occurring. Risk cannot be completely removed from a project and should an event happen the company needs to have an effective crisis plan in place, which will include access to specialist third party service providers for medical or political evacuation or kidnap response.

The eighth step in the risk management process is to insure these risks. Political Risk Insurance (PRI) can insure against loss to foreign lenders, investors, suppliers and traders with mining companies. There are a range of perils that these risk participants may be exposed to depending on the specific project, the basis on which it trades, the location and associated contractual agreements.

PRI and political risk

A key issue that is often misunderstood when looking at political risk in the minerals sector is the idea that the key asset to be insured is the mineral reserves.

In the private sector the asset is in fact the right to explore for and receive a share of the revenue derived from natural resources, not an ownership right in those resources. This means that the fundamental peril for investors in and lenders to resources projects is often the repudiation of the operating agreement by the host government and not the confiscation of the mining assets.

This is a crucial in an era where government action may take different forms that are not of the character of expropriation as has been traditionally understood but do constitute a repudiation of existing operating agreements, often through a process of ‘creeping expropriation’.

The private PRI market, comprising of nearly 50 syndicates and companies, has theoretical capacity for a single project in excess of $1bn. Securing this capacity and agreeing conditions and a competitive price is most successfully achieved by demonstrating clear identification of the underlying perils and appropriate risk management.

Political risk underwriters of resource projects pay careful attention to due diligence and do distinguish between the qualities of similar projects in the same territories.

PRI won’t fix a bad deal or contract but when a project is well structured and the correct PRI coverage purchased, PRI effectively neutralises country risk and provides an effective safety net for your MENA investments.

*Elizabeth Stephens is head of credit and political risk analysis at JLT Specialty Ltd