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    Political Risks in Global Energy [GGP]

Summary

There are numerous examples of political risk affecting the operations and profitability of oil and gas companies – sometimes very seriously. Stephen O’Sullivan, Senior Visiting Research Fellow at the Oxford Institute for Energy Studies, discusses the three main risks from a historical perspective.

by: Stephen O’Sullivan, Valdai Discussion Club

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Political Risks in Global Energy [GGP]

everyday course of business. These risks include technical, commercial and financial risks, all of which companies attempt to model, analyse and mitigate before taking investment decisions with substantial up-front costs and long-lasting payback periods.

One other important challenge that they face is that of political risk. This has been a feature of the global energy industry since its very beginning – most frequently perhaps in the oil and gas sector.

Many industries are global in nature, with international supply chains spread across the world to improve efficiency and drive down costs. Energy is undoubtedly one of the most global of industries, and energy companies are in a different category from companies which simply sell, for example, consumer goods into a range of countries or perhaps source materials from them for the manufacture of their products. Energy is truly global, for without it there is no supply chain, no consumer demand, no manufacturing output – or certainly a much-reduced level of all these activities. Energy security – or the creation of energy insecurity – can be said to be at the heart of the sector’s political risk, despite the fact that, in most cases, both sides to an agreement benefit from energy security because of their mutual interdependence.

Unsurprisingly, therefore, given its importance, governments have taken a far greater interest in the activities of oil and gas companies both on their own territory and elsewhere in the world. It is this interest – whether positive or negative – that continues to create political risk for the oil and gas sector. As the energy transition continues, those risks are likely to become evident – albeit in different forms – in other parts of the global energy industry.

The most obvious political risk is nationalisation, where a company’s assets are stripped from it, with or without compensation, or unilaterally changed by the host country government. However, changes in the regulations governing the industry, while less dramatic, can have equally significant impacts on the industry. Finally, oil prices may appear at first sight to be a different type of risk and one that companies should mitigate through their commercial operations. However, given the propensity of major oil producers to attempt to manipulate the market, these too are, in effect, a political risk.

There are numerous examples of political risk affecting the operations and profitability of oil and gas companies – sometimes very seriously. Three main risks are discussed below but other risks such as terrorism, wars and secession also often emerge as serious challenges.

Nationalisation – Iran

In 1951 the new government of Iran nationalised the Anglo-Iranian Oil Company’s concessions (which represented the bulk of Iran’s oil reserves and production as well as being described as the United Kingdom’s “single largest overseas asset”). The unexpected loss of its Iranian assets, which dated back to the D’Arcy Concession of 1901, was a significant challenge to both the company and its principal shareholder the British government. A court case failed to resolve the matter since the International Court of Justice determined that it did not have jurisdiction, which shows that negotiated solutions to the political risks which erupt from time to time cannot always be found.

The dispute was resolved both military and politically when the British navy blockaded Iran’s oil ports and the UK government imposed sanctions on the country. In 1953 the Iranian government of Prime Minister Mohammad Mossadegh was toppled in a coup and Mohammad Reza Pahlavi reinstated as Shah. In 1954, the Anglo-Iranian Oil Company renamed itself British Petroleum. In 1979, political risk re-emerged when the Shah of Iran went into exile before the Iranian Revolution took place. Iran subsequently nationalised BP’s assets (which by then were held through Iranian Oil Participants along with those of several other oil companies).

Regulation – Europe

It may not appear to be a risk on the same scale as having in-country assets nationalised or prices collapsing after commissioning a large project with a long payback period, but changes to the regulations governing the operations of oil and gas companies have emerged as major political risks facing the industry as countries and populations reconsider oil companies’ social licence to operate. Here again, unilateral changes to agreements to the disadvantage of the oil and gas company can have serious adverse consequences.

Fundamental changes are taking place in the world’s energy system. Within the energy transition, energy efficiency and renewable energy have moved centre stage in many countries, with Europe being one of the main regions where this shift is underway. Rapidly developing technologies coupled with falling costs have made this change possible. The change is spreading beyond the electricity sector into areas such as personal mobility and buildings. Regulatory initiatives are continually being launched to promote, support and, where necessary, subsidise renewable energy as a way of replacing carbon-based fuels in the energy mix. 

Coal is the obvious first target. Coal consumption in Europe has been declining for the past eight years as the continent switches away from the fuel – a similar decline can also be seen in the US. The decline in European oil and gas use is more recent and more mixed, with European consumption of oil falling for the least three years while gas demand seems to have plateaued. The US picture is slightly different, oil use has risen for the past eight years while gas use has also risen, in this case for the last three years. Two major economies with differing demand profiles for the use of carbon-based energy. The main difference between them is the regulatory framework governing the energy industry and the fact that Europe has taken a conscious decision to embrace the energy transition and promote its advance – a policy absent from the US.

Price – Saudi Arabia

Political risk can arise from unexpected quarters, not simply from host governments nationalising a company’s assets. In the 1980s the world was suffering from an oil surplus because demand had fallen as a result of the sharp rise in oil prices in 1979, which had itself been caused by a combination of the Iranian Revolution and the outbreak of the Iran-Iraq war. New sources of oil production outside the control of OPEC had been developed – including Alaska and the North Sea. OPEC had been cutting its production to maintain prices. However, the decision by Saudi Arabia in 1986 to increase its output, and teach its uncooperative OPEC partners a lesson, led to a rapid collapse in prices.

The decision was entirely political. Saudi Arabia had been producing around 3.5 mbd less than its capacity for some time in an ultimately unsuccessful attempt to balance the oil market. However, then as now, not all of OPEC joined the effort and the Kingdom lost patience with its fellow members. The result was an oil price below $10/bbl at one stage in 1986 and an oil price that did not convincingly move above $20/bbl until 2000.

Saudi Arabia (and, occasionally, other countries) have intervened in markets on numerous occasions, generally in an effort to increase prices. The most recent occasion was the OPEC+ Agreement earlier this year, aimed at reducing output and increasing prices in response to the Covid-19 pandemic, the onset of which led to a rapid and significant collapse in demand. The agreement was concluded after a brief and damaging price war between Saudi Arabia and Russia, which at one point drove US oil prices negative. That price war was a political decision by two oil producers seeking to maximise their market share. Both countries came to the realisation that cooperation rather than confrontation was likely to lead to a better outcome all round – but the damage caused to cashflows and investment risk was, once again, a political choice.

Flashpoints today

Political risk remains an issue today. Clearly the price of oil remains subject to, sometimes benign, manipulation by the OPEC+ grouping. Europe continues to strengthen its environmental regulations and has evidently not been blown off course by the impact of the coronavirus pandemic. There remain traditional areas of political risk. Libya, for example, is being fought over by rival warlords with production down 90% against a year ago. OMV and ENI acquired assets in the country through acquisition and exploration success while Occidental has disposed of some of their assets. Political risk remains high in the country, however, and further currently investment seems unlikely while the conflict continues.

Sanctions imposed on Russia by the United States through the National Defense Authorization Act, principally related to the annexation of parts of Ukraine in 2014, have created issues around the Nord Stream 2 pipeline planned to take 55 bcma of gas from Russia to Germany. The proposed Protecting Europe’s Energy Security Clarification Act potentially extends sanctions to European companies and officials working to complete the Nord Stream 2 pipeline, although the act has yet to become law. Finally, the Countering America’s Adversaries Through Sanctions Act became law in 2017 and imposed sanctions on Russia, Iran and North Korea.

There has been speculation that US opposition to the Nord Stream 2 pipeline is linked to a desire to sell US LNG into Europe, although while a number of European countries, including Germany, oppose the sanctions, not all do, highlighting the threat to Europe’s supply security through overdependence on any one gas supplier. Nevertheless, whatever the reason behind the existing and potential sanctions, both energy companies and engineering contractors are subject to widening political risk in relation to this infrastructure development.

Other parts of the energy sector

The oil and gas sector is well-used to dealing with political risk, whether it likes it or not. But what of other parts of the energy complex – are they likely to face similar risks as they assume greater importance in the global energy system? If we look at the nuclear sector for example, cost overruns and delays would seem to be the major risks facing companies and projects as can be seen from the reactor project at Flamanville in France which has faced serious problems. However, political risk remains a concern in this sector as well, with many governments less keen on nuclear power and balking at the subsidies needed (as in the UK) to ensure the project is sufficiently commercially attractive to its developers.

Wind and solar seem broadly unaffected by political risk since they are largely domestic industries. However, projects whose economics rely too heavily on state subsidies could face issues if government policy were to change in just the same way as oil and gas companies have seen changes to the regulatory framework over time impact their business.

Mitigating risk

In order to reduce the likelihood of, or reduce the impact of, a “creeping nationalisation” or an outright expropriation of assets, oil and gas companies will often negotiate contracts protecting them against, or compensating them for, adverse changes to their operating conditions and include international law and arbitration provisions.

More broadly, companies planning to operate in high-risk areas need to ensure they have a good understanding of a host country’s laws, culture, religion, history – especially as it relates to previous energy activities on its territory – economy and the position of the oil and gas sector within the broader economy. Often local partners are helpful, or even necessary, to improve the likelihood of success but it is equally important that any advice considered when making investment decisions should be independent of vested interests and clearly seen as such.

Summary

For some parts of the global energy industry, political risk is unavoidable. They operate in areas with a range of governance styles, public attitudes to their activities change over time and significant economic actors aim to maximise their own benefit from participating in the energy industry at the expense of other parts of that industry. Other parts are more sheltered from political risk – although in reality, given the importance of the energy sector globally, no energy activities can consider themselves immune from some degree of political risk.

Originally published by Valdai Discussion Club.

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