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Russia To Offer Oil Shares: What Are The Risks?

Russia's intent to privatize (or at least sell shares in) oil company Bashneft has raised eyebrows around the world as industry executives consider gaining access to some prime resources and others worry if the risk of further interference by either national or local governments is too high to make such an investment attractive. Although to most people, political risk is like pornography to Potter Stewart, they'll know it when they see it, it is worth thinking about what precisely constitutes political risk in different environments.

The first lesson is that despite all the talk about how "the easy oil is gone" and the industry must move into ever-riskier areas, political risk is nothing new in the oil industry. In the early days in the U.S., the threat of local action against your operations was very real. Indeed, oilman Charles Lynch in West Virginia, famously faced legal action when, in defiance of a local zoning board, he had some high school football players lay a pipeline across a road in the dead of night, the court ultimately deciding it was a fait accompli. (To be honest, Charles Lynch was my grandfather, and the story is only famous in my immediate family.)

But John D. Rockefeller faced a hostile government, and the Standard Oil Trust was judged a monopoly and broken up (after he retired), although the value of the subsequent components rose, suggesting that the management had become overly centralized (at least investors thought so). And in Russia in 1905, the Nobles faced labor unrest led by Ioseb Besarionis dze Jughashvili, whom readers probably know by his more familiar nom de guerre, Joseph Stalin. Vladimir Putin might be autocratic, but his power pales in comparison.

Political risk can be counterintuitive, especially given only superficial analysis. My favorite example is the situation in 1975. You consider two countries for investment: one is run by a revolutionary government, led by Marxist guerillas who have just taken power, with no history of a free legal system or rule of law. The other is part of the British Commonwealth, with a constitution and legal system of long-standing, as well as a decades-old private oil sector. Which seems the lesser risk?

The two countries are Angola and Canada, and the former proved to be quite friendly to its foreign oil companies, maintaining a stable fiscal system and encouraging investment. Canada, on the other hand, became run by Pierre Trudeau who taxed oil in order to fund the creation of a national oil company, restrained natural gas exports to the U.S., and urged banks to loan money to Canadian companies to buy out their American counterparts.

The operative difference between the two countries: financial needs. Angola was impoverished after years of colonial rule and an independence war and in dire need of money, as well as technical expertise. Canada, on the other hand, had a large non-oil sector and could afford to adopt economically counterproductive policies. The secondary factor was the late-1970s oil price increase, which convinced the Canadian government that energy was a "seller's market" and they could make more egregious demands, what is now known as resource nationalism. Again, not a new phenomenon, just a new name.

Political risk derives from three sources: ideology, financial needs, and rule of law.

Trends in ideology seem irrelevant, but can be very important in providing a philosophical rationale for political action. During the 1930s, for example, many thought capitalism was a failed system, and the creation of national companies seemed logical. And in the 1960s, the newly-independent states in Africa and Asia generally associated capitalism with colonial oppression, and so were disinclined to pursue a free-market, foreign-investment friendly, resource policy.

Thus, left-wing politicians like Pierre Trudeau and Hugo Chavez no doubt believed fervently that they were doing the right thing, out of a mix of ideological conviction and ignorance of economics-and history. (Terry Karl described the disastrous policies of one of Chavez' predecessors, which Chavez almost precisely mirrored.) Any given leader can be expected to pursue an economic policy almost independent of the current political and economic environment, but it helps if global politics are leaning left. In the 1990s, the "Washington Consensus" and Thatcher/Reagan Revolution encouraged the reduction in resource nationalism, while the economic problems in many countries in the 2000s moved the needle in the other direction. Now, the failures of leftist policies in countries like Argentina and Venezuela seem to be reducing resource nationalism.

The second important factor is the country's fiscal and economic situation. A wealthy country like Canada or Norway can afford to take more policy risks and alienate investors than a poor country like Angola (or Egypt, Chad, and many others). And obviously, the lower the price of oil, the more an oil producer's economy is strained. (The inverse is obviously true, as higher oil prices encourage governments to demand more of private oil companies.)

Finally, the rule of law can be crucial. Governments are less likely to take egregious action if their own judicial system won't back them up. Canada didn't seize American companies' assets in the 1970s because its courts wouldn't allow it. More recently, contracts have required impartial arbitration in international courts, and in the case of Hugo Chavez' nationalization of some foreign oil assets, damages were awarded. Even so, companies (and other investors) have often found it hard to collect when a government refuses to acknowledge judgments against it, as the long battle by Argentinian bond holders showed.

So, how does the case of present-day Russia and the offer of shares in Bashneft stack up in terms of political risk? Not well, I'm afraid. Only in the factor of financial needs is there an implied element of safety, as the country currently can't afford to alienate investors given the drop in oil and gas export prices and the effect of sanctions. On the other hand, whatever ideology drives the Russian government these days doesn't seem to include any elements of free-market capitalism; many Russia specialists use kleptocracy to describe its ethos. Not socialist, but hardly an improvement.

And the rule of law seems conspicuous by its absence. Although the focus of the press is now on the infringement of political rights of the regime's opponents, in the past, the legal system has been used to seize assets in ways that wouldn't pass a garbage truck driver's smell test. Claiming tax evasion or environmental damage, authorities have moved against domestic and foreign companies, acting more or less by fiat.

Nothing in the current situation suggests that the regime has experienced an epiphany as opposed to seeking some easy cash. Of course, the industry has a long track record of rushing in to countries after an apparent change in heart, or at least investment policy, from Libya to Iran, and there will no doubt be some who convince themselves that "this time is different," rather as some people return to problem spouses again and again. But recognizing the inherent risks should come first.

Source: Forbes