By Terry Hallmark, Instructional Assistant Professor, Honors College
The field of political risk assessment has been in existence for roughly 40 years, and I was a practitioner in the international oil and gas industry for 30 of those, from 1983 to 2013. When I told someone that I was a political risk analyst, the next question was usually “Do you travel?” (not as much as one might expect); and then, “How many countries do you cover?” (90).
Once the preliminaries were over, the conversations usually turned to the risks themselves – all the “shoot ‘em up” stuff folks might come up with if they think about political risks – war, civil unrest, political violence, regime instability and the like. It always came as a surprise, though, when I noted that while international oil companies care about such risks – because they can mess up operations in a big way and the mitigation takes time and money – they’re not the oil companies’ primary concern.
International oil companies are more interested in what might be called commercial risks – opposition to foreign investment, repatriation difficulties and adverse contract changes.
Last year was a busy one for contract changes – 40 countries changed contract terms in 2016, and predictions are that 2017 will be just as busy. That has implications that go beyond a company’s bottom line, potentially even affecting the price of oil.
Opposition to foreign investment can range from a country being completely closed off to foreign oil exploration to protests by environmentalists or indigenous peoples. Oil companies will simply look elsewhere if they can’t get in or if working in a country is too big a hassle. Repatriation of oil earnings can be a problem, too, but it is more an irritant than anything else, since the regulations are either stipulated in the contract or set forth in standing law.
Contract changes – especially adverse contract changes – are a different story. Oil companies expect the contracts they sign to hold, but that’s not always the case. There are three kinds of adverse contract changes – nationalizations, expropriations, and simple, unilateral changes by the government to existing contracts. The first two aren’t contract changes in the usual sense of the word, although tearing up an existing contract surely is a “change.” Nationalizations occur when a government takes over a complete industry; in the oil patch, that typically means establishing a national oil company to run things. Expropriations occur when a country unilaterally seizes control, through extra-legal means, of a project or facility. Both are “oil weapons” in a country’s arsenal that can be used to exert power, gain influence and implement foreign policy.
There have been several nationalizations over the years – the Soviet Union in 1918, Mexico in 1938, Iran in 1951 and Argentina, Egypt, Indonesia, Iraq and Peru in the 1960s. And while most analysts believed that nationalizations were long gone and a thing of the past, Bolivia nationalized the country’s natural gas sector in 2006.
Expropriations are more frequent. For example, Russia took a 50 percent + one stake in Shell’s Sakhalin Island project in late 2006. In May 2007, a subsidiary of Venezuela’s national oil company, PDVSA, assumed control of the Cerro Negro heavy oil project following a decree issued by then-President Hugo Chavez.
Simple contract changes happen all the time. There are two kinds (and this isn’t rocket science): contract changes that are anticipated or known that pertain to new projects and those that are not – contract changes that may come out of the blue and affect existing projects. Wood Mackenzie, a United Kingdom-based oil and gas consulting firm, classifies contract changes as “evolutionary changes” (changes for new projects) and “disruptive changes” (contract changes for existing projects).
Oil companies can generally deal with contract changes that are evolutionary. They simply decide to invest in given country under the terms of the new contract or not.
Disruptive changes can be more problematic in that they can, and frequently do, result in a negative change in cash flow from a given exploration project. However, some disruptive contractual or legislative changes can be positive – i.e. designed to spur exploration activity and investment, such as recent cuts in corporate income tax rates in several countries around the world.
Things have been quite fluid lately, as some 40 countries changed contract terms in 2016. The changes were mostly in response to low oil prices and the subsequent budget shortfalls in oil-dependent countries, which resulted in higher tax rates for foreign oil companies. However, some countries, like the United Kingdom, lowered taxes to help oil companies break even in the low crude oil price environment.
Mexico was the most active country. The United States’ neighbor to the south changed contract terms five times, as it ended more than 70 years of government control of the oil sector. Other contract changes occurred in Russia (which seems to make contract changes constantly), the state of Rio de Janeiro in Brazil and Alaska in the U.S. This year looks to be just as busy as 2106, maybe even busier, as Wood Mackenzie anticipates evolutionary contract changes in Brazil, India, Indonesia, Iran, Mexico, South Africa, Thailand and Trinidad and Tobago; and disruptive changes in Australia, Alaska, Nigeria, Russia and parts of the North Sea. Some of the changes are expected to be positive, others negative, and some are likely to be mixed.
So why does all this matter? Who cares what kind of contract is in effect in a given country or if contract is evolutionary or disruptive or whatever? There are several reasons. At the simplest level, it’s about money. Dealing with an unstable investment climate takes time and trouble, and time is money. Anything that costs major oil companies money has an effect at the pump. Changes in contracts – especially something like a nationalization or a major expropriation – can roil oil markets and drive crude prices through the roof. They can shut a country off from foreign investment altogether.
Further, a host country’s petroleum legislation, and the contracts that flow from it, is instructive, for it says something about how a country views its position in the international oil arena and what it hopes to gain from its oil sector. Is the country trying to maximize its oil earnings by establishing higher tax and royalty rates or is it trying to induce new investment by cutting taxes and royalties or sweetening the pot in other ways? Also, frequent contract changes, especially if they are adverse changes, are an indicator of how a country does business, how it views foreign investment, and perhaps most importantly, how it views the sanctity of law.
Finally, it’s worth reiterating: international oil companies are far more worried about getting into a country, getting the company’s money out of the country and being able to work under the auspices of a stable, signed contract through the life of the project than they are about the political risks in the country. And since contract changes – especially adverse or “disruptive” ones – usually occur unexpectedly, an effort to develop a method perhaps capable of anticipating such changes would seem in order.
That could be a good topic for another blog post down the road.
Terry Hallmark is an Instructional Assistant Professor in the Honors College. He teaches the Human Situation sequence, along with courses in ancient, medieval and early modern political philosophy, American political thought, American foreign policy and energy studies. His current research is focused on the political rhetoric and writings of Will Rogers. Prior to his appointment in the Honors College, Dr. Hallmark worked in the international oil and gas industry, where he had a 30-year career as a political risk analyst. He has been an advisor to international oil exploration and service companies, financial institutions and governmental agencies, including the World Bank, U.S. Department of Defense and members of the intelligence community. He is the Honors College coordinator for the minor in Energy and Sustainability Studies.