Energy Investments in Newly Liberalizing Economies:
Opportunities and Risksby
Charles Tooman
Mr. Tooman is a risk management associate with a non-regulated energy marketing company headquartered in Denver, Colorado. He has masters degrees in economics and political science, with an emphasis in international political economy. He retains the copyright of this paper and can be reached at ctooman@aol.com.
Introduction
Economic privatization and political liberalization are the dominant global forces of change as we enter the 21st century. From the former Soviet Union and Eastern Europe to South America and the African Continent, economic and political liberalization are altering the content and character of international relations around the world. These processes of change (encouraged by Western nations and regimes such as the International Monetary Fund [IMF]) have a dramatic impact on international relations insofar as they facilitate a shift away from non-democratic political processes, corporate statism, and the inefficient allocation of resources.
A key element of the reform process is the opening of once closed markets to Western multinational corporations. Reform-minded governments now invite bids on once state-owned assets with regularity-a practice that generates tremendous investment opportunities for Western multinational corporations in liberalizing economies. Indeed, multinational firms are supplementing the efforts of governments and state-owned, regulated companies at a time when many liberalizing nations are approaching their debt limit and have limits on their future borrowing capacity. As a result of this global economic revolution, tremendous opportunities exist for international suitors as well as the governments and industries of liberalizing nations.
Global Energy Investment: Opportunity and Uncertainty
Throughout the community of liberalizing nations, the opportunity for economic partnership and growth is especially prevalent in the energy sector. The need for technological and capital assistance both in upstream and downstream energy operations is critical, as is the need for general infrastructure development throughout the most aggressive developing and liberalizing countries. In fact, economic growth rates have outpaced infrastructure growth in many liberalizing nations, leading to an increase in demand (facilitated by an increase in population and fast-paced industrialization) for low cost energy resources. While this represents a tremendous challenge to regional development associations and multilateral and bilateral economic and finance organizations, as well as the governments of the individual nations, it also represents a tremendous opportunity for private investors. Consider the following recent examples:
- The Thai Cabinet approved a blueprint for the divestment of the government’s stake in about 50 companies, including part of the Petroleum Authority of Thailand. In fact, privatization is a term of Thailand’s $17.2 billion credit arranged by the IMF.
- Nigeria will sell a 40 percent stake in its state-owned oil and electricity companies to private investors. If successful, the sale will be the first major divestiture of state-owned assets by Nigeria and provide the country with much-needed cash infusion to help rehabilitate industry and public works.
- Columbia’s state oil company awarded its first oil exploration contract under new terms intended to attract more investment in exploration and production. The company, Ecopetrol, will offer 13 oil contracts by mid-2000, giving investors a larger share of output and profits.
- A $1.9 billion heavy oil joint venture between Exxon Mobil Corporation and Venezuela’s state oil company began production. This and other heavy oil joint ventures are expected to boost Venezuela’s oil output by up to 700,000 barrels a day.
- Peru recently opened confidential files on a $3 billion Camisea gas project to potential investors.
These examples are indicative of the opportunities available to private corporations in liberalizing markets as economic and political liberalization continues.
However, these opportunities are certainly not risk-free. In liberalizing countries, economic reform and the tremendous opportunity for financial reward are often accompanied by tremendous risk. Specifically, political risk, legal risk, and economic risk threaten the policies of liberalization separately, as well as in combination. Liberalization efforts are at risk from these types of risk in varying degrees, often when the stability of the transition is most tenuous. Political, economic, and legal transition is often laden with Byzantine twists and turns that threaten the possible success of policy change altogether. The following examples from 1998 and 1999 reveal how these types of risk affect the outlook of energy sector liberalization:
- Hunt Oil Company’s Safir oil field in the Ma’areb region of Yemen was hit by a strike that disrupted production at the 160,000 barrels per day field. The workers were striking over salaries, as well as the use of foreign labor.
- The new government of Indonesia is under pressure to renege on energy contracts whose terms (negotiated under ousted President Suharto) Indonesia can no longer afford. While this action would effectively discourage multinational activity in the Southeast Asian country, the political atmosphere is highly charged to exact retribution on multinationals.
- Threats by members of the Nembe community against workers caused the Royal Dutch/Shell Group to stop all oil exports from Nigeria and disrupt additional production. The lost exports equated to approximately 25 percent of Shell’s total oil production worldwide. Members of the Nembe ethnic group threatened to attack workers unless their demands for infrastructure and employment concessions from Shell were addressed.
- Indian rights groups and pressures from environmentalists for cleaner operations have deleteriously impacted the Ecuadorian oil industry. These pressures have hindered the legitimacy of the new government of Jamil Mahaud.
As a result of these and other events, the largest players in the global energy market have re-evaluated their investment strategies. The role of political, economic, and legal risk is thus real, and growing in importance.
Real and Illusory Reform
The introduction of political and economic competition, as well as legal reform, are key elements of reform for some newly liberalizing countries. Yet evidence suggests that even in the absence of political and legal liberalization, the opening of once closed markets has resulted in investment between Western multinational corporations and their liberalizing counterparts (e.g. Myanmar). Therefore, while the introduction of market competition has been the most consistent and primary liberalization process across the globe, the pace and character of political and legal reform has been most inconsistent across liberalizing countries. It is important to note that in these countries, the potential political and legal risks remain high despite the adoption of some market reforms. This risk is relevant and often significant insofar as liberalizing governments often retain full or partial control of privatized companies. (It is no coincidence that as these investment opportunities have increased, so has the interest in political risk insurance among multinational corporations.)
One of the primary difficulties facing reform-minded governments across the globe is the instability caused by the reform process itself. The political, economic, and legal transformation processes in which new governments engage often cause dramatic dislocations, leading to a weakening of the reform effort. Given this, the synergistic relationship between economic, political, and legal risk, as well as the individual impact of these types of risk on the viability of energy sector liberalization must be understood before investment decisions are made.
The following is a checklist of important issues that must be considered when investing in a liberalizing market:
1. Each form of risk must be understood separately, and also in combination.
Risk is most appropriately analyzed as having at least three separate but inter-related factors: economic, political, and legal risk. While a liberalizing nation may pass the test in one area of risk, it may be slow to transform in another. For example, economic reform in Nigeria (aimed at reducing economic risk for private investors) has not been accompanied by effective political or legal reform. In fact, economic reform in Nigeria (including deregulation and a government sell-off) has been undermined by heightened political and/or legal risk. Generally, stable political and legal institutions that provide adequate investment security for foreign investors does not necessarily follow economic reform in liberalizing nations. An analysis that evaluates each form of risk separately (and also in combination) is necessary to correctly evaluate overall investment risk.
2. Attention must be paid to the individual risk-attributes of each nation.
There are few rules regarding economic, political, and legal transformation that are applicable across liberalizing nations. For instance, it is nonsensical to compare the transformation of Ecuador with that of Kazakhstan. It is important to consider that within each liberalizing nation, the pace and magnitude of political, legal and economic reform is different. In general, each liberalizing nation has a particular set of characteristics that define the successes and failures of the overall transformation process. Whether in the form of regional conflict (the Caspian region), civil war (Angola), or ethnic unrest (Nigeria), the risk characteristics of emerging nations are as diverse as the histories, cultures, and institutions of the nations themselves.
3. Transformation is most appropriately viewed as a long, arduous, and unpredictable process.
It is very likely that a reform program will be at best unpredictable, and at worst experience multiple failures along the reform path. For example, Venezuela, which has the largest oil reserves in the Western Hemisphere and is a major oil exporter, especially to the United States, has been experiencing serious political and economic uncertainty over the past two years. Petroleum Intelligence Weekly (PIW) recently reported that three existing projects (Petrozuata, Cerro Negro, and Sincor) in Venezuela's huge, heavy-oil, Orinoco belt are facing construction delays, cost overruns, and limited access to finance. PIW also reported that many companies that had been interested in Venezuela several years ago have now backed off. Also, the credit-rating agency Fitch IBCA expressed concern over Venezuela's "increasingly complex political situation and the low priority assigned to economic reform." Finally, Reuters reported in early September 1999 that foreign oil companies are stepping up their lobbying of the Venezuelan government over concerns that billions of dollars in their investments may be threatened by unpredictable reform policies.
4. The legal institutions of liberalizing economies are often unstable, slow to reform, and particularly susceptible to corruption.
Reforms in liberalizing nations are often undermined by stalled implementation of legal reform and widespread corruption. For example, ambitious plans to develop Russia's petroleum resources have faltered largely due to uncertainties surrounding oil and gas laws and changing tax regimes. Laws intended to entice foreign investment capital (i.e. laws that protect property rights, provide access to foreign markets, liberalize prices, and offer fair taxation) are weak and poorly enforced in Russia. In fact, the lack of confidence of Western multinationals in Russian legal institutions has contributed to the dramatic decline in Russian oil production experienced since 1988.
5. The effects of economic globalization are especially significant in the context of a liberalizing market.
Immature markets in transformation react with greater volatility to global economic events than established and mature markets. For instance, Shell Singapore, a unit of Royal/Dutch Shell Group, slashed output 31 percent in September 1998 at its crude distillation plants because of weak demand amid Asia’s economic slump. In fact, the Asian downturn had a tremendous impact on liberalizing markets across South and Southeast Asia. These events, in conjunction with political and economic uncertainty in Russia, undermined liberalizing markets in the region and across the globe in 1998. The propensity of liberalizing markets to react with great volatility to global economic events must be taken into account.
Going Forward
Generally, much of the growth in energy use will occur in the emerging, liberalizing nations over the next two decades. Specifically, energy consumption in Asia, Africa, the Middle East, and Central and South America is expected to more than double through 2020, with the highest growth rates expected in developing Asia and Central and South America. Indeed, energy use in these nations is projected to surpass that of the industrialized world by 6 percent in 2020-some 16 quadrillion Btu-whereas in 1996 energy consumption in the developing countries was about 40 percent lower than that in the industrialized countries.
These examples not only reflect increased energy usage in emerging nations, but also the need for energy-related infrastructure development-development Western multinationals have an opportunity to participate in extensively. However, as opportunity costs rise in any given emerging nation (as a result of political turmoil, economic disorder, and/or legal corruption), Western multinationals must reassess their ability to participate in certain investment projects. This uncertainty precludes some potential suitors from participating in investment projects in emerging markets altogether.
For instance, BP Amoco has adopted a more cautious attitude towards investment in liberalizing markets. In fact, BP Amoco’s current international focus is on the more stable Organization for Economic Cooperation and Development (OECD) member-nations, with one third investment in the United States, one third in Europe, and one third in the rest of the world, including only 10 percent in Russia.
Evidence suggests that in addition to potentially high capital costs, a company’s risk appetite is an important determinant of investment in emerging markets. The benefits of participating in once untapped markets must be weighed against the potential high costs of economic, political, and legal uncertainty-uncertainty that, as we enter the 21st Century, is unlikely to dissipate.