Yesterday I had a speaking engagement at the Energy Risk USA 2007 conference in Houston, Texas.
My brief talk was entitled “The New Calculus of Political Risk,” and focused on how rule of law, property rights, and democracy are damaged and discouraged by energy investors’ seemingly endless appetite for political risk. With so many calculator-toting quantitative risk analysts filling the conference, I confess that I was like a fish out of water – yet in some ways I think that advisors on political risk will soon learn that they must combine the results from their complicated algorithms with qualitative intelligence, local expertise, and a much more comprehensive understanding of geopolitics. (no offense to any of my quant friends!) Many of my comments were drawn from an article I authored for the magazine last October (titled “Risking it in Russia,” which can be downloaded here), in which I argue that in Russia there is a disturbing gap between the academic measure of risk and the financial estimates – in other words, too many energy firms have a distorted sense of the risk vs. reward, and are going to find themselves much more exposed than they originally had estimated. I wrote the following in this article: There exists a new reality in risk management for Russian energy investment. A new inverted risk calculus is already being used by some groups, which have concluded that the quality of a political relationship with the local government and state-owned firms is just as important as the financial details of a potential deal. Because of the flexible and discretionary approach to property rights and contract law in Russia and the ever-weakening rule of law, the risk manager is not likely to have an accurate degree of certainty of what the risk actually is. The pricing is no longer dispositive, and some banks and finance groups are already adapting to this enlarged role of geopolitical risk, which goes far beyond simple elections to include a measurement of active cooperation in helping the government and national champions secure their objectives. In my speech yesterday, I expanded this theory and contrasted it against different cases. In Russia, Venezuela, and Nigeria, I discussed the different strategies implemented by Yukos, Royal Dutch Shell, BP, ExxonMobil, Chevron, and China’s big three state-owned firms when faced with government harassment or political instability. My comments on the Russian cases can be found in other entries on this blog. However, it is with the Venezuelan case that some interesting contrasts can be found. These days, everyone generally thinks of Venezuela as an international pariah that you would never put an investment dollar near, but many people forget that Hugo Chavez’s re-nationalization of the oil sector was a gradual process, accompanied by many promises that “this is the last time” or “it’s a one-off experience” or “OK, sure, we’re going to take this away from you, but I promise you can keep X, Y, and Z.” In other words, Venezuela in the late 90s and early 00s became the instruction manual for the Kremlin. Look at this quote from a 1999 press release from Richard Matzke, then president of Chevron Overseas Petroleum Inc., following Chavez’s election:
“We feel as good about the potential of Venezuelan oil right now in ’99 as we did back in ’46 when Chevron discovered the Boscan oil field! Except today the outlook for growth is even more rosy, thanks to Venezuela’s development of its people resources, its decision to reopen the oil industry to both international expertise and international funding, its import of cutting-edge technologies, and the renewed interest of the international investment community.”
Now fast-forward to May 1, 2007, as Hugo Chavez celebrates the final takeover of the last private oil fields in the much-desired Orinoco Belt oil fields. Naturally Chevron was far from alone when it lost its investments in Venezuela (ConocoPhillips, ExxonMobil, Chevron Corp., Total, Statoil and BP Amoco PLC previously controlled the projects), but it was ExxonMobil who consistently had the strongest (and best reaction) to Chavez’s interventionism: they stick to their guns and demand that contracts be respected. In summary, the Venezuelan experience is a lesson in how to not trust a resource nationalist. The poverty of skepticism shown by Chevron and others in Venezuela early on came back to haunt them – and right now this poverty of skepticism is hurting multinational energy firms in Russia – and further contributing to the distortion of energy risk. (However, it is very interesting to note who is still winning in Venezuela – the answer is Russia, whose LUKoil and Gazprom are snapping up Orinoco licenses. It is difficult for Shell and ConocoPhillips to compete with an energy company that can throw a fleet of fighter jets into the deal).
China’s state-owned firms such as CNOOC are thriving on political risk in Nigeria, and seem willing to put up with corruption, violence, and kidnapping for access to resources
The experience in Nigeria is less one of resource nationalism and more a story of political corruption, democratic collapse, and human rights tragedies – though important parallels can still be drawn. For several years now the political situation has been rapidly deteriorating in the oil-rich Niger Delta, and many international oil companies are shutting down stations and evacuating hundreds of employees to protect them from rampant violence and kidnappings. Recently Shell took a major hit in Nigeria, while Chevron suffered another kidnapping of its staff on May 1 (the same day that Chavez completed his plunder of their Orinoco fields). Because of this instability, oil exports have fallen by 25% over the past year. Despite this dismal outlook and at a time in which most investors are pulling back from Nigeria, Chinese state firms are thriving (and India is not far behind). Last year, CNOOC Ltd. outbid Indian state rival ONGC for a 45% stake in a major oil production site, and then more recently Chinese state firms were awarded the lion’s share of auctions for oil licenses in a poorly attended process that many say was rigged. Then, just weeks later, the outgoing government of President Olusegun Obasanjo held one of the most fabulously corrupt and fraudulent elections in recent African memory (and that’s saying something). In less than a month since the elections, there have already been 30 kidnappings of expatriate oil workers. In Venezuela, oil companies presumed regularity and were punished. In Nigeria, China is so desperate to participate in production projects that the government has no reason to reform or democratize – the capital will keep coming no matter what they do. All around the world, energy producing states are rushing toward resource nationalism and rent-seeking because the rewards are greater and because investors have lost their ability to correctly measure political risk. So what are the lessons to be drawn from the experiences of energy risk in Russia, Venezuela, and China? My unifying theory, somewhat basically illustrated in the diagram below, is that increased appetite for risk is creating increasingly unfavorable outcomes for energy investors, consumers, and citizens of petro-states. Tentatively, I am calling it “The Self-Perpetuating Cycle of Resource Nationalism and Energy Risk.” We can generally agree that geopolitical instability, be it the war in Iraq or conflicts elsewhere, is driving up prices to record highs. With the price of crude at this level, many governments, such as Russia, believe that they were cheated by private investors when the prices were lower and now want a bigger piece of the pie. In other countries, the high prices bring forward an irresistible temptation for rent seeking and corruption. The result in both cases is increased resource nationalism. However, it’s no secret that state-run energy firms are wildly inefficient – just look at Gazprom misdirecting all of its earnings away from production, causing a potential gas shortage, or the declining production experienced under PDVSA in Venezuela. This falling production, due to state control, drastically increases the pressure on multinational firms to secure access in production projects at almost any price, raising their tolerance for political risk. The glut of liquidity and the diversity of global portfolios have also helped investors seek more and more exposure. It is my contention that this willingness to take on almost endless risk for access to energy is helping to encourage further resource nationalism, which damages rule of law, democracy, and human rights, and helps breeds lawless regimes that powerfully contribute to geopolitical instability – back to point one – further holding up high prices. Naturally, I haven’t yet completed exhaustive empirical research to link each of these phenomena, but early indications are supportive. Many political and international finance experts agree with me that energy is the next great topic to guide international relations, and taking steps toward understanding “the big picture” of what motivates regime decision-making will be a key aspect of maintaining and managing global stability.