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A Mess In Africa Highlights A Challenge To Resource Companies
Half a world away, a messy situation in a resource-rich land is offering up a lesson in caution to investors who seek out smaller mining companies. Canadian miner First Quantum once thought it had a valuable resource and a valid contract in its Kolwezi copper project in the Democratic Republic of Congo. Since then the company has seen the government of the RDC seize the project, sell it to another party, and now has seen the asset sold yet again - this time to mining company Eurasian Natural Resources. All the while, international law has more or less stood behind First Quantum.
Investors in natural resource stocks have always contended with a higher level of risk and volatility relative to broader stock market indices, and those who invest in small miners (also called "juniors") take on even greater risks. In addition to the uncontrollable commodity price cycles, there are a host of production issues and dangers, as well as the risk that a project does not contain as much mineral wealth as the company hoped.
Political risk has often been an element of the overall risk profile in this sector. But with more and more companies turning to Africa as the last source of readily available minerals and resources, this is a story that could play out again in the future. Unfortunately for investors, there are not a lot of options to avoiding this.
IN PICTURES: 5 Tips To Reading The Balance Sheet
Corruption and Renegotiation
It is no great secret that corrupt governments have historically given favorable natural resource extraction deals to multinational companies in exchange for certain "gifts" or "consulting fees". While the legality of such inducements is highly questionable and countries like the United States and Canada tend to prosecute such cases, it still happens and companies often look at it as a cost of doing business.
What happens, though, when there is a regime change? Back in the 1980s, Peru decided that prior agreements signed under a former government were not fair or proper and needed renegotiation. Occidental Petroleum (NYSE:OXY) decided to play ball and renegotiated the deal on terms that were worse for the company, but still profitable. Other companies stood their ground and saw their deals canceled or nationalized.
A similar situation is now occurring in the RDC, and this is where First Quantum found itself in a mess. Starting in 2005, the government began to reexamine prior mining deals and took a harsh tone with many miners. In the case of First Quantum, this has resulted in the aforementioned seizure and cancellation, as well as a $12 billion fine handed down by a court in Congo. On the flip side, the much larger American company Freeport McMoRan (NYSE:FCX) and South Africa's AngloGold Ashanti (NYSE:AU) have found the government more willing to engage in discussion and negotiation and they have kept their own negotiations low-key.
What is the lesson here? Well, it might be that larger companies are less likely to get pushed around, or perhaps that it is by showing a willingness to discuss new terms that companies stave off unilateral actions from a government. In either case, a sweet contract may not be worth anything only a few years later.
Nationalization
In cases like Venezuela, sometimes there is no pretense of renegotiation. Many times during Chavez's administration, the Venezuelan government has announced the seizure of various companies and assets. In exchange, the government has offered what often constitutes only token amounts of compensation.
Swiss cement company Holcim and French company Lafarge simply chose to sell to the government and get out; Mexico's Cemex (NYSE:CX) has put up more of a fight and taken the matter to arbitration. One wonders, though, exactly how the company imagines that arbitration will be enforced. Likewise, ExxonMobil (NYSE:XOM), ConocoPhillips (NYSE:COP), and Tidewater (NYSE:TDW) have taken Venezuela to arbitration over expropriated assets worth billions of dollars, but there is little that even the World Bank's International Center for Settlement on Investment Disputes can do to enforce its own rulings.
What is an Investor to Do?
Unfortunately for investors, there are some risks that are just inescapable - including the grabbing hands of politicians. Even Brazil and Australia are guilty to some extent, as Brazil's government has changed the rules on Petrobras (NYSE:PBR) investors from time to time and Australia is implementing a brand new mining tax that will impact even giants like Rio Tinto (NYSE:RTP) and BHP Billiton (NYSE:BHP).
The Bottom Line
Even with these risks, some investors will stick by the mining sector. An unexpected gold strike in Turkey or a new rare earth mine in Australia can be worth hundreds of millions (if not billions) of dollars and propel a tiny company into a multi-bagger investment success. Simply put, a lot of investors will take the risk of a total wipeout to get those big winners. The best an investor may want to hope for, then, is to diversify across resource types and locations and be suspicious of contracts that seem a little too good to be true, particularly after a change in government. (For more, see Strike Gold With Junior Mining.)
Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!
Investors in natural resource stocks have always contended with a higher level of risk and volatility relative to broader stock market indices, and those who invest in small miners (also called "juniors") take on even greater risks. In addition to the uncontrollable commodity price cycles, there are a host of production issues and dangers, as well as the risk that a project does not contain as much mineral wealth as the company hoped.
Political risk has often been an element of the overall risk profile in this sector. But with more and more companies turning to Africa as the last source of readily available minerals and resources, this is a story that could play out again in the future. Unfortunately for investors, there are not a lot of options to avoiding this.
IN PICTURES: 5 Tips To Reading The Balance Sheet
Corruption and Renegotiation
It is no great secret that corrupt governments have historically given favorable natural resource extraction deals to multinational companies in exchange for certain "gifts" or "consulting fees". While the legality of such inducements is highly questionable and countries like the United States and Canada tend to prosecute such cases, it still happens and companies often look at it as a cost of doing business.
What happens, though, when there is a regime change? Back in the 1980s, Peru decided that prior agreements signed under a former government were not fair or proper and needed renegotiation. Occidental Petroleum (NYSE:OXY) decided to play ball and renegotiated the deal on terms that were worse for the company, but still profitable. Other companies stood their ground and saw their deals canceled or nationalized.
What is the lesson here? Well, it might be that larger companies are less likely to get pushed around, or perhaps that it is by showing a willingness to discuss new terms that companies stave off unilateral actions from a government. In either case, a sweet contract may not be worth anything only a few years later.
Nationalization
In cases like Venezuela, sometimes there is no pretense of renegotiation. Many times during Chavez's administration, the Venezuelan government has announced the seizure of various companies and assets. In exchange, the government has offered what often constitutes only token amounts of compensation.
Swiss cement company Holcim and French company Lafarge simply chose to sell to the government and get out; Mexico's Cemex (NYSE:CX) has put up more of a fight and taken the matter to arbitration. One wonders, though, exactly how the company imagines that arbitration will be enforced. Likewise, ExxonMobil (NYSE:XOM), ConocoPhillips (NYSE:COP), and Tidewater (NYSE:TDW) have taken Venezuela to arbitration over expropriated assets worth billions of dollars, but there is little that even the World Bank's International Center for Settlement on Investment Disputes can do to enforce its own rulings.
What is an Investor to Do?
Unfortunately for investors, there are some risks that are just inescapable - including the grabbing hands of politicians. Even Brazil and Australia are guilty to some extent, as Brazil's government has changed the rules on Petrobras (NYSE:PBR) investors from time to time and Australia is implementing a brand new mining tax that will impact even giants like Rio Tinto (NYSE:RTP) and BHP Billiton (NYSE:BHP).
The Bottom Line
Even with these risks, some investors will stick by the mining sector. An unexpected gold strike in Turkey or a new rare earth mine in Australia can be worth hundreds of millions (if not billions) of dollars and propel a tiny company into a multi-bagger investment success. Simply put, a lot of investors will take the risk of a total wipeout to get those big winners. The best an investor may want to hope for, then, is to diversify across resource types and locations and be suspicious of contracts that seem a little too good to be true, particularly after a change in government. (For more, see Strike Gold With Junior Mining.)
Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!
by
Stephen D. Simpson, CFA
Stephen D. Simpson, CFA, is a freelance financial writer, investor, and consultant. He has worked as an equity analyst for both sell-side and buy-side investment companies in both equities and fixed income. Stephen's consulting work has focused primarily upon the healthcare sector, while he has also written extensively for publication on topics pertaining to investments, security analysis, and healthcare. Simpson operates the Kratisto Investing blog, and can be reached there.
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