Never Underestimate Country Risk


By Marin Katusa, Chief Energy Investment Strategist

Risks abound in investing, with each investment arena offering its own flavors. The risks we face in the world of resource investing, though, are some of the most unpredictable out there. Resource companies navigate risks running from commodity price swings to taxation changes, from geologic uncertainties to the challenges of new technologies, from floods and tornadoes to labor unrest.

Some of those risks and a host of others can be grouped under one heading: country risk. Resource investors share with realtors a focus on location, location, location, and for good reason: the best resource deposit in the world is only worth developing if the payout is greater than the cost. In the wrong location both of those numbers get skewed – government take can shrink payouts to almost nil while a long list of obstacles pushes costs up, up, and away.

Of course, some of the countries with the highest levels of risk are home to fantastic resource potential (oil in Somalia, anyone?). As with all things in life, the decision whether to pursue that potential is a matter of mitigating risks enough so that they are outweighed by the potential for reward.

It would take a Ph.D. thesis to examine country risk in its entirety. Instead, today I want to take you through a few examples of how country risk can create huge headaches for energy companies. Sometimes the headache is absolutely deserved, as payback for bad decisions in the past. Sometimes companies act with the best of intentions, but countries – driven by anything from greed to socialism – pull the rug out from underneath them.

For the investor, the best way to approach country risk is with a truckload of knowledge, a boatload of patience, and a management team with proven risk management skills. If you have decided the potential reward is worth the risk, go for it. But prepare an exit strategy too, because when it comes to country risk situations change very quickly and problems can drag on for decades.

[Editor's note: Marin Katusa, our chief energy investment strategist, will reveal more about mitigating risk in energy investing – as well as resource stocks that he believes offer explosive upside – at the Casey Research Recovery Reality Check Summit. Time's running short, but there are still a few seats available.]

Risk-Reward Mayhem in the Niger Delta

A recent headline sparked the idea for this article: Shell Sued in UK Over 'Massive' 2008 Nigerian Oil Spills. The Nigerian unit of Royal Dutch Shell, Europe's largest oil company, was recently sued in Britain by 11,000 Nigerians who say their land, rivers, and wetlands were spoiled by two oil spills in the Niger River Delta in 2008.

The full story is so much more complicated than the headline implies.

Oil was discovered in Nigeria's Delta region in the late 1950s. The leading multinationals in the play were Royal Dutch Shell and Chevron, who quietly supported the Nigerian government's appropriation of Delta lands to make room for oil development. In fact, a 1979 Constitutional amendment afforded the government full ownership of all Nigerian territory, enabling politicians to distribute lands to oil companies at will.

It was bad enough that their lands were taken, but the people of the Niger Delta also had to face the fact that little if any of the wealth being drilled and piped across their homeland ever returned. In fact, living conditions across the Delta deteriorated through the 1970s, 1980s, and 1990s, as oil spills and rampant development wrecked the lands and waters that had provided so many livelihoods.

By 1992, the first militant group developed in the Niger Delta. Several followed; they all targeted the Nigerian government and Royal Dutch Shell. Violence escalated quickly. In the summer of 1994 a military campaign to end the opposition to oil development razed dozens of villages, killed 2,000 people, and displaced 100,000 to refugee camps.

In 1995, nine Delta activists who had been campaigning against Shell's activities were tried on trumped-up charges, found guilty, and hanged by then-dictator Sani Abacha. Shell claimed that it asked the Nigerian government for clemency toward the nine, but in 2001 two of the "witnesses" who had instigated the false charges admitted that Shell and the Nigerian military had bribed them. Shell later admitted to having given money to the military, which brutally silenced the voices clamoring for justice.

The conflicts of the 1990s collided with increased availability of arms in the 2000s to create an even worse standoff in the Delta. Local and state officials began funding paramilitary groups working to advance one particular agenda or another. In 2005, Shell evacuated its personnel from Nigeria after the most aggressive militant group, NDPVF, declared "all-out war" on the federal government and the oil companies in the Delta.

You see, it's a very complicated story.

The war officially ended in 2009 when the government offered amnesty to militants who turned over their weapons, but rivalries between neighboring communities over their perceived rights to compensation or other oil-related revenues frequently boil over into violent conflict. And two aspects of the war – sabotage and bunkering – continue.

In the seventeen-year war against Big Oil in the Niger Delta, militants routinely sabotaged drills, pumping stations, and pipelines to disrupt production. The frequency of these attacks has lessened since the amnesty program officially ended the war, but some militant groups continue in their quest to push Shell and other foreign companies out of the region. As for bunkering, that's the practice of tapping into pipelines to siphon off crude oil. The diverted oil is loaded onto barges and sold for profit, usually to destinations in West Africa but also abroad. Not only does the practice hurt Big Oil's bottom line, it is also very profitable.

Bunkering is not a thing of the past – oil thefts from pipelines across the Delta remain a major problem for Shell and other companies operating there. Shell's head for sub-Saharan Africa, Ian Craig, said at a conference in Abuja last month that oil companies in Nigeria lose an estimated 150,000 barrels of oil a day to bunkering. Other industry experts peg the number much higher.

With that backdrop in mind, we can return to the headline that started all of this: Shell being sued by Nigerians in London.

The lawsuit was filed by residents of the coastal Bodo community after talks with Shell over two oil spills failed to produce an agreement. The failure is hardly surprising. Shell admitted responsibility for spilling a total of 40,000 barrels of oil in two leaks near Bodo in 2008 and 2009… a reasonably small set of spills. The Bodo claim Shell spilled 600,000 barrels of oil, more than twice the volume of oil spilled from the Exxon Valdez.

The discrepancies between the estimates of the Bodo spills illustrate how difficult it is to get an accurate picture of what goes on in the remote wetlands of the Niger Delta. It is a region where millions of people – the population density in the Delta is among the highest in the world, with 265 people per square kilometer – scratch a living from subsistence farming or fishing and live in mud huts with no electricity.

The poverty of the region stands in sharp contrast to the black gold flowing through its pipelines. Nigeria is the largest oil producer in Africa, producing 2.2 million barrels a day in 2009. The vast majority of that oil comes from the Delta.

From that perspective, it is not surprising that militants and impoverished residents alike are driven to steal oil from those pipelines. It is also not surprising that Delta residents are adamant that Big Oil – and Shell in particular – should pay for the devastating damage inflicted on the Delta over the last 40 years… damage that has eroded their ability to live off the resources of their lands and waters.

The damage is devastating. A UN report released last August says restoring the region would take 25 to 30 years. "The environmental restoration of Ogoniland could prove to be the world's most wide-ranging and long-term oil clean-up exercise ever undertaken if contaminated drinking water, lands, creeks, and important ecosystems such as mangroves are to the brought back to full, productive health," the report stated. UN investigators found at least ten communities where drinking water was contaminated with high levels of hydrocarbons, including the carcinogen benzene.

Shell is willing to pay for the damage it caused, but the company is also adamant that it is not solely to blame. On the contrary: Shell says the vast majority of damage done to the Delta was wrought by Nigerians, who spilled oil every time they sabotaged a line or bunkered oil. In fact, Shell spokesman Jonathan French alleges that some Delta residents spilled oil on purpose, based on "the misguided belief that more oil spilled equals more compensation."

The Bodo peoples retort that Shell uses the same line every time someone accuses them of spilling oil in the Delta. They say bunkering and sabotage are responsible for only 1% of the spilled oil. Shell is to blame, they say, and Shell should pay.

The case is now before London's High Court, marking the first time Shell has faced claims in the UK over environmental damage in another country. The claimants seek hundreds of millions of British pounds in compensation. The case will be watched closely by everyone in the industry, because the ruling could set a precedent that impacts big claims against Western oil companies accused of polluting poor countries. And there are more than a few.

Big Oil Battles in Ecuador and Brazil

Let's briefly visit two other serious legal scenarios involving Big Oil and country risk. The first is also the most famous: the case of Texaco in Ecuador. This case has been going on for 18 years and is still not finalized. But the lesson is apparent: clean up your mess or pay.

In 1964 Texaco (now Chevron) found oil in the remote northern region of the Ecuadorian Amazon, an area known as the Oriente. The indigenous inhabitants of the Oriente lived traditional lifestyles that remained largely untouched by modern civilization. Since no one had ever drilled for oil in the Amazon before, the Ecuadorian government largely trusted Texaco to employ best practices.

It seems the trust was misplaced. Texaco's operations damaged the area so badly that it has been dubbed the "Rainforest Chernobyl." Aware the situation was deteriorating, Texaco left Ecuador in 1982, turning over all of its outdated operations to Petroecuador, which continued to pollute while slowly modernizing the infrastructure. As such, the oil-extraction process caused systematic pollution for almost three decades.

They were caught off-guard when it happened, but by 1993 the inhabitants of the Oriente organized and started fighting back. They filed a class-action lawsuit against Texaco in 1993 in New York; in 2003 they re-filed the case in a Lago Agrio courtroom, after a US judge granted Texaco's request that the case be heard in Ecuador.

In February 2011, Chevron was found guilty of massive environmental crimes in the Amazon and fined upwards of $18 billion. In January of this year an Ecuador appellate court confirmed the $18-billion judgment. The plaintiffs are now seeking to enforce the ruling in countries where Chevron has assets, since the company no longer has any in Ecuador.

The case is unprecedented. It took 18 years, but the decision marks the first time indigenous people have won a judgment against a US company in a foreign court for environmental crimes. Chevron is still trying to wriggle its way out through Ecuador's appeal system, but it seems likely the company will have to pay at least part of the fine.

The Texaco-in-Ecuador case is important for the scale of the damage, the size of the fine, and the endless international legal maneuvering involved. But the situation is also dated, much like the Shell-in-Nigeria situation. Today, we simply expect that oil companies will do a pretty good job of cleaning up after themselves, protecting the environment as much as possible, and taking care of local populations. For the most part, they do. It's all part of the risk-reward balance: by being good neighbors and business partners, oil companies reduce their country risk.

Another good way to reduce country risk? Move offshore, where rigs are better insulated from oil theft and militancy, where there's no need to displace or even work adjacent to local populations, and where the ocean provides a buffer for any accidents. Shell, for example, is trying to sell several of its onshore Nigerian blocks in order to refocus offshore.

Of course, offshore oil developments are far from foolproof. As we've written about before in these pages, Chevron is currently facing two lawsuits in Brazil – one criminal, one civil – related to a spill from its Frade operation off the coast of Brazil. The Chevron spill involved 2,400 to 3,000 barrels of oil, none of which reached the shoreline. The November spill may have been small, but federal prosecutors are determined to make a statement. In December, they laid down an $11-billion civil lawsuit against Chevron and its partners; in March they followed up with criminal charges against 17 Chevron and Transocean executives, charges that could result in lengthy jail terms and significant personal fines.

To put the situation in context, Brazil is working to become one of the world's top oil producers after discovering offshore reserves over the last decade that hold some 50 billion barrels of oil. It is understandable that prosecutors want to ensure that the offshore resources are developed as carefully as possible. But legal charges of this severity over a relatively small spill could easily spook other big, foreign companies away from investing in Brazil, and Brazil certainly can't afford to develop the resource without foreign investment.

To that end, several politicians have spoken out against the charges, including Senator Jorge Viana. In an interview with Reuters, Viana called the charges "excessive" and "irresponsible." He also said the charges "create a climate of insecurity" that could damage badly needed investment in the oil sector. Concluding, he said that if both suits were held up and applied to other polluters, "the industry would shut down."

Finding the Balance

Working in a foreign country is always risky. Sometimes companies create their own risk, as Texaco did in Ecuador when it failed to protect the lands and waters where it worked. Sometimes risk comes out of nowhere, as it did when Brazil announced its lawsuits against Chevron. And sometimes risk and reward both weigh so heavily that it is nearly impossible to find the balance point, as is the case in Nigeria's Delta region.

While much-strengthened environmental oversight should prevent another travesty on the scale of the Texaco-in-Ecuador situation, the rules for country risk still apply. Companies operating in other countries have to be diligent in their risk management. If they are not and if they make mistakes, it will come back to haunt them. For their part, countries have to find a balance as well: they have to balance their desires for oil wealth, social peace, environmental protection, and economic development. It is not an easy balancing act.

For investors, the most important message is: never downplay country risk. Even stable, resource-friendly, First-World countries have made abrupt changes to resource laws that threw companies under the bus. The Canadian province of Labrador, for example, suddenly enacted a moratorium on uranium development in 2008, annihilating the handful of companies exploring the region's reasonably abundant uranium resources.

Every country has its risks and every company has its risk-management methods. As an investor, you have to know your risk tolerance and ascertain whether the company you're considering has what it takes to survive in the country in question. Those equations always involve a lot of variables and unknowns and demand a fair bit of informed guesswork.

It is one of the trickiest aspects of resource investing, but also one of the most important. The potential rewards of resource investing are necessarily paired with these risks, and finding that balance is what I do every day.


Additional Links and Reads

Total Mulls Options to Put Out North Sea Flare (Reuters)

France's Total is consider a wide range of plans, including a helicopter water drop, to extinguish a flare on its Elgin North Sea gas platform that is leaking explosive clouds of gas. The flare was lit as part of evacuation proceedings to relieve pressure in the abandoned rig, but it cannot be turned off remotely and could ignite the gas plumes pumping out of the rig. Authorities have praised Total's handling of the leak, which is one of the biggest in the North Sea in decades. It started on Sunday, March 25 and forced the evacuation of all 238 platform workers. It appears the leak is causing minimal environmental damage.

Japan Easing Limits, Allowing up to 16,000 Evacuees to Visit Homes Inside Nuclear No-Go Zone (Washington Post)

For the first time since the Fukushima nuclear plant disaster, Japanese authorities are allowing up to 16,000 people to visit the homes they were forced to abandon. They won't be allowed to stay overnight, and some will have to wear protective gear, but it is nevertheless a crucial step in the plan to permanently resettle towns within the 20-km zone around the reactor complex. Before the earthquake and tsunami devastated the plant and cause meltdowns in three reactors, the area was home to 100,000 people. It is not clear home many people will return to their homes.

Enbridge Venture Plans Pipes to Gulf as Keystone Blocked (Bloomberg)

Enbridge and Enterprise Products Partners, who co-own the recently reversed Seaway pipeline that now carries crude oil from Oklahoma to the Gulf Coast as well as the Flanagan pipeline connecting Illinois and Oklahoma, have received enough commitment from shippers to start planning an expansion of both lines. With questions still swirling over the Keystone pipeline, Illinois and Oklahoma desperately need new pipes to move crude oil south because increasing production in the Bakken and in Canada's oil sands have swamped the refining and transportation capacity in the oil-hub area. Enbridge and Enterprise are planning to increase Flanagan's capacity to 585,000 barrels per day at a cost of $2.8 billion while doubling capacity on the Seaway line to 850,000 daily barrels.

Iran Sanctions Fuel "Junk for Oil" Barter with China, India (Financial Post)

Iran and its leading oil buyers, China and India, are finding ways to skirt US and EU sanctions on the Islamic Republic by agreeing to trade oil for local currencies and goods, including wheat, soybean meal, and consumer products. Iran is reportedly also seeking to trade oil for wheat from Pakistan and Russia. The tactic works because sanctions target Iran's ability to participate in the global financial system, and barter deals themselves don't violate the sanctions. However, while providing a steady flow of food goods, the bartering situation is leaving Iran short on hard currency to prop up the plummeting value of its currency, the rial. Moreover, Iran can only use so much wheat and soybean meal.

Turkey Cuts 20% of Oil Purchases from Iran (Financial Times)

Turkey is slashing its Iranian oil purchases by 20%, becoming Tehran's last big client to fall in line with US sanctions. Until the announcement, Turkey was the only big buyer of Iranian oil that had not announced a cut in imports. In fact, in recent weeks Ankara has repeatedly insisted that it is not bound by unilateral US sanctions and the announcement came one day after the Turkish prime minister visited Iran, when the two countries reaffirmed their goal of strengthening economic ties. With all of Iran's major customers now having reducing their purchases, oil production in the country has dropped to a ten-year low.

Tapping Oil Stockpiles a Risky Proposition (The Globe and Mail)

Four governments – the US, Britain, France, and Japan – are considering releasing oil from their emergency stockpiles to temper high fuel prices, but most observers agree that the impact of such a move would be short-lived. Moreover, releases would deplete the very stockpiles those countries would need if Iran follows up on its threats to choke off global oil exports by blockading the Strait of Hormuz.

Oil Discovered in Kenya for First Time (The Globe and Mail)

Despite bordering two countries – Uganda and South Sudan – that boast significant oil resources, Kenya had never found oil within its lands… that is, until now. A well being drilled in Kenya near the Ugandan border by partners Tullow Oil and Africa Oil hit 20 meters of net oil pay. The partners will now test a series of other targets nearby. Company spokespeople and Kenyan politicians were careful to emphasize that Kenya still has to travel a long, pot-holed road to become a producer, but the discovery is nevertheless exciting.

Oil Groups to Explore Off Uruguay (Financial Times)

Hoping to discover oil riches like those in neighboring Brazil, Uruguay has awarded eight exploration blocks to BP and BG of Britain, Total of France, and Ireland's Tullow Oil. The companies committed to total exploration investments of $1.5 billion, which will cover extensive seismic and electromagnetic studies, plus at least one deepwater well.

Natural Gas Hovers Near Ten-Year Low (Bloomberg)

Heading for the worst quarter in two years, natural-gas futures have been fluctuating near a ten-year low as record production and a mild winter conspired to push stockpiles to 59% above the five-year average. Speculators are now suggesting prices may have found a bottom.

Apr 03, 2012