2. Key risks and factors guiding investment
The following provides a summary of some of the key factors guiding investment and illustrates how these may differ depending on the product under consideration.
Key factors guiding investment in the oil and gas and mining industries:
Hydrocarbons: Threat of cash subsidies, cash optimisation, social licence to operate, mine closure
Aluminium: Sustaining capital, innovation and productivity improvement and access to energy
Copper: Price and currency volatility, access to energy and water, resource nationalism
Gold: Price and currency volatility, switch to growth, innovation and productivity development
Iron ore: Innovation and productivity improvement, price and currency volatility, capital allocation
Lead/Zinc: Switch to growth, pipeline shrinkage, price and currency volatility
Nickel: Price and currency volatility, resource nationalism, capital allocation
Platinum Group Metals (PGM): Price and currency volatility, innovation and productivity improvement, social licence to operate
Potash: Price and currency volatility, capital for projects, productivity improvements
Silver: Price and currency volatility, lack of supply, productivity improvements
Uranium: Threat of substitutes, price and currency volatility, rising regulations
Steel: Over supply, price and currency volatility, threat of substitutes
Attracting Exploration and Production (E&P) in the petroleum sector
Many countries wishing to attract more investments in their territory have decided in favour of a pro-active exploration policy and strategy supplemented by a plan of action for E&P licensing, rather than waiting for applications to be made by companies at their initiative.
Deciding on such a plan of action is important for a country, as illustrated by the positive experience in the US Outer Continental Shelf (OCS), in the provinces of Canada, in the federal OCS of Australia, in Brazil, in Norway and the UK. Nearly all countries are trying to attract E&P investments. To maximise their chances of success, each country must adopt a fit-for-purpose exploration and licensing plan of action, and then implement it in a consistent manner and update it when justified.
Explore the Extractives Hub topic on Petroleum Licensing & Contracting.
Therefore, more awards of Subsoil User Rights (SUR) take place under well-prepared and planned Competitive Licensing Rounds. The open-door policy is continuously being restricted to selected acreage previously opened and not yet licensed.
A plan of action for licensing new blocks would generally include the following steps to be decided by the country:
- Delineation of the areas of interest to be opened to exploration, and establishing priorities in the allocation of acreage and exploration areas (“blocks”) for each of the future planned rounds. Rounds may take place periodically at dates to be decided upon by the ministry, for example on an annual basis or, as in most countries, every two or three years. The optimal schedule depends on the exploration policy and the size and number of the available remaining E&P exploration opportunities.
- Acquisition of geological and geophysical (Geodata) data in a timely way, prior to each round, so that the ministry or the Contracting Authority (CA) may provide sufficient data and information to potentially interested companies. Often such data packages are sold to such companies, the price depending mainly on the exploration policy and prospectivity of the region.
- The ministry or CA to carry out a geological survey regarding the areas to be opened to assess their prospectivity and help in the delineation of the respective exploration blocks to be offered and subsequently in their international promotion.
- Selection of the blocks to be opened for the round and definition of the size of each opened block.
To help in such a selection, some countries ask potentially interested companies to nominate in confidentiality their blocks of highest interest and the priorities they attach to each of them, without any commitment to follow their suggestions when making applications (this process is called “block nomination” in Norway).
It is also important to establish a framework for determination of the specific terms of reference for the round, including the applicable fiscal and contractual terms and conditions as well as the detailed rules and instructions for submission of applications and for their evaluation, ranking and selection of the winning bidder.
Some key considerations in the licensing process include:
Confidentiality of data gathered
Reimbursement of Subsoil User Rights costs incurred for geological survey
Data ownership and confidentiality
These issues are explained in more detail overleaf.
Confidentiality of data gathered under an Exploration and Production (E&P) Contract
Regulation (or the E&P contract) should ideally detail the confidentiality rules for E&P data. The duration of confidentiality is becoming shorter than before, and is often limited to three or four years from the date of data acquisition. The reason for this is to provide earlier access to data to all explorers and so encourage exploration activities within the country and reduce risks or errors when data is kept confidential for too long.
With the same goal, confidentiality will typically end in cases where the area related to the data is surrendered, even if the confidentiality period is not over. In cases of surrender or relinquishment, the State is and remains the owner of the data, which can be used for further promotion of the acreage and preparation of Data Packages.
Reimbursement of Subsoil User Rights (SUR) Costs Incurred for Geological Survey
Generally, the costs of the geological survey (GS) performed by the State are not directly reimbursed to the State by the selected SUR-holders. Indeed, they are often considered as a country long term infrastructure investment justified by the promotion of new Exploration and Production (E&P) acreage. The reward for the country is the signing of new E&P contracts which may generate large government petroleum revenues in the event of significant discoveries, rather than the reimbursement of costs.
Data Ownership and Confidentiality
This is an extremely contentious area. Investors consider both the ownership and confidentiality of the data they generate or acquire as vital to their commercial interests. Host states, on the other hand, see ownership as critical to building a national data repository to inform their decisions on extractive industry sector issues. The government’s interest includes the right to release data as essential to the promotion of exploration and development interests. Contractual provisions, outside of a few industrialised states, now assign ownership to the host state while allowing the investor to retain copies of paper or electronic data and samples of physical data, subject to confidentiality requirements.
Constraints and context
In designing and/or conducting a licensing round, government authorities will face several external and internal constraints. Geology and price expectations, critical to investor interest, tend to fall into the first category and there is not a great deal that the authorities can do about them. However, some actions are possible. If uncertainty about geology is a factor, governments can, and good practice would encourage, the preparation of comprehensive data packages based on existing data and the possible acquisition of limited new data.
New data, such as seismic or aeromagnetic data might be acquired at the government’s expense, through donor support, or on a speculative basis by private investors acting on the government’s behalf and reimbursed through data sales. Depending on its nature and value, this data might be made freely available to potential investors, sold to interested parties, or its purchase may in some cases be made mandatory as a condition for participation in the licensing round.
With respect to price expectations, governments may, if circumstances will allow flexibility on timing, choose periods of rising resource prices to launch a licensing round. Such periods are, however, likely to be periods of maximum competition among states for investor interest.
Internal constraints (such as matters over which the government might be expected to have control) will also have a major bearing on licensing prospects and include issues of macroeconomic and political stability as well as the types of legal, contractual, regulatory, institutional, and fiscal regimes a government chooses to adopt.
Conditions for success
An extractives project is commonly contracted under a long-term contractual arrangement. To be effective, these agreements require a contemporary risk anticipation and mitigation mechanism to be developed. This arises because projects are subject to a variety of risks during the project life cycle, including price fluctuation, technical, political, and potential environmental hazards. The contract therefore needs to be predictable but also flexible enough to adapt to future uncertainties without endangering the relationship between the parties.
Turning from contractual considerations to the licensing process itself, several conditions have been demonstrated to be critical to its success. The first of these is an environment where there is competition among potential investors. If this can be achieved, it can potentially result in the best outcome for the state.
Competition among potential investors can also help offset some of the asymmetry regarding access to information that tends to disadvantage governments in the licensing process. Investors are very often better informed than their government counterparts as to a state’s geological prospects. This is particularly true in the early stages of extractives sector development, when data sharing requirements have yet to be established. While problematic in the case of one-on-one bilateral negotiations over contract awards, this informational disadvantage is largely nullified when informed investors are made to compete against each other.
A second condition critical to success is institutional capacity. Properly preparing a licensing round, and evaluating potential investors and their contract proposals are activities that require sophisticated professional technical, legal, and commercial skills. These skills need to be acquired by host government authorities responsible for the contract award process. Pending their development, the authorities are generally encouraged to engage support from outside experts.
The objective in designing the award process is to find the best candidate (for example, the most efficient explorer and developer), maximise the potential revenues from the award, and avoid any distortion of incentives to perform. Transparency is at the core of good practice when it comes to award procedures. Whether acting individually or as participants in a competitive bidding round, license applicants should – on a non-discriminatory basis – be made fully aware of the procedures to be followed. They should also be provided access to all available data, whether on a free or purchase basis, and be informed of all applicable legal and fiscal regimes (including model contracts). Documentation should also provide assurances that areas offered for licensing are currently unlicensed and that proper authority exists for their licensing. With the possible exception of specific technical data, this information should be available in the public domain.
It is desirable, and now increasingly common practice, that applications for awards should be prequalified. Bidders are prequalified to ensure that that they have the financial and technical capacity to undertake a substantial exploration or development programme. Where geological information is limited or not immediately encouraging, governments may decide to adopt an open door, first-come-first-served licensing procedure or direct negotiation with a limited number of prequalified companies. Where significant geological data is available and investor interest is high, a competitive auction is generally considered the best option.
Transparency and accountability
There is no indicator that host countries’ compliance with international transparency and accountability standards, such as complying with the Extractive Industries Transparency Initiative (EITI), attracts private investment. However, compliance with the EITI in a host country would mean only that those investors who are prepared to abide by the standard will invest there, which increases the overall sector excellence, rather than increasing the volume of potentially poor or average quality investment.
Criteria for Award
Once the credentials of potential investors have been established, good practice favours setting a limited number of clearly specified criteria for the award of a license. Arguably, the most important of these is the investor’s work commitment which should be specified in both physical terms and financial (or minimum) expenditure terms.
The successful discovery of natural resources requires significant effort at the exploration stage. It also requires the application of sophisticated exploration and exploitation technology. To attract foreign investment, a host government should try to limit information uncertainties and asymmetries associated with its resource endowments.
Many developing states often lack the geoscience information (geodata) necessary to undertake detailed land-use planning. Faced with budget constraints and pressures to provide critical services to their citizens, many governments find it difficult to justify the collection of geodata when the payoffs are generally long-term in comparison with the country’s immediate spending needs.
Geoscience information can be collected on an ad hoc basis, resulting from a ‘lucky’ discovery by artisanal miners to more systematic, complex, and large-scale efforts. The quantity of this information (whether it is produced by a state or private investor) depends ultimately on the benefits and costs perceived by either party.
If all the benefits are not internalised, or alternatively, if the returns associated with the collection of geoscientific data are prohibitively difficult to calculate (due to high perceived levels of political, technical, or security risks), a sub-optimal amount of geoscientific information may be produced. Therefore, the primary aim should be to identify those policies required (if any) to ensure that an efficient amount of geodata is produced.
A minimum quantity and quality of geoscience information will be a prerequisite for ensuring that a host state earns an equitable portion of its natural resource wealth and that private investors can assess the geological prospects of a license area. In these situations, the state does not need expertise in assessing the value of the license area since the competitive tension created by a properly managed auction process should ensure that the license is valued fairly. For example, the government of Papua New Guinea is skilled at utilising such data collection to promote investment.
In petroleum contract awards, the work programme is generally considered to be controlling and it must be performed even if resultant expenditures exceed the minimum. In mining contracts awards, it is not always possible to be very specific about the work to be performed and therefore giving priority to work programmes may not be appropriate. In most petroleum licensing procedures, the work programme and expenditure commitments are combined with financial and fiscal variables (such as bonuses, royalties, or production shares).Sometimes a third variable may be added, but where awards are based on more than one variable, applicants or bidders need to be told the relative weights the authorities have assigned to each variable for selection purposes. Ideally, the variables selected should be relatively easily assessed, not only by the authorities but also by observers of the award process. Adding variables related to contributions to local infrastructure and or local content – whether by direct participation in the award or through commitments to local suppliers – can make bid evaluation difficult even if the potential political and developmental appeal of such variables is strong. This may however be an obvious or attractive variable for governments in typically developing, and specifically African resource rich countries, as they strive to balance local participation. Most countries have or are developing local content legislation (Kenya, for example). In the 2006/2007 licensing round, Brazil had a local content variable. Angola included a contribution to social projects of 20% in the 2005/2006 licensing round.
Key risks and factors guiding investment – Mining and minerals
Foreign Direct Investment (FDI) is channelled into productive sectors of the economy. In resource-endowed states, it is the extractives sector, including mining and metals that attracts most of such inflows. Classically and as shown in the chart below, the key determinants that go into investing in the mining and metals sector are as follows:
The diagram below is a flow chart explaining the determinants of Foreign Direct Investment in the mining sector in more detail, and is a useful guide.
These determinants can, however, be refined to include the security of the investment, captured through the political stability, fiscal regime and flexibility of the host government to accommodate investor requirements to create an enabling environment and protect both investors and home government activities. In short, these factors determine the risk profile of a potential investment. They can vary significantly over time and according to commodity.
A key point in the mining sector is that governments compete for investment and hence even a world class mineral deposit may not attract investment if it is in a high-risk environment. Some of the common factors that have an impact on the investment climate include political instability, conflict and governance.
The Fraser Institute in Canada publishes an annual report with country rankings based on an assessment of their attractiveness as a destination for mining sector investment. Their reports can be accessed through the topic library and at the Fraser Institute https://www.fraserinstitute.org/categories/mining.
Large-scale and long-life mineral deposits are commercially the most attractive for mining companies and the average term of investment is long, requiring a stable investment environment. Different minerals also have different conditions. Deep level mines typically require more investment than open cast operations and therefore longer payback periods.
Another issue relevant to developing countries is the associated infrastructure. A country may have a world class deposit, but without infrastructure to transport minerals, the investment is unlikely to prove attractive.
For mining companies, accessing funding can be challenging in periods of low prices. During cyclical downturns, the capacity of mining companies to finance exploration and expansion projects is therefore constrained and projects are often cancelled. For host states, it is important to understand how these pressures translate into the current situation where mineral development follows a cycle that lags prices.