4. Governance challenges
Given its relative importance to the economies of many countries, mineral trading needs to be taken seriously by governments across the globe. Yet a number of governance challenges relate to the structure of global trade as a whole, and therefore go beyond the control of an individual country.
In the following, however, only those areas will be highlighted that pose immediate challenges to the management of trading on the national level.
In the world of commodities, it is not unusual over a short period of time for prices to double or even triple, or on the contrary to half. In contrast to other investment forms (stocks, bonds or currencies), commodities tend to have a higher price variance. This can be exemplified by average daily fluctuation rates. Currencies such as the dollar, for example, tend to vary by a maximum of 10% a day, whereas it is not unusual for prices of minerals such as natural gas to fluctuate with a above 30% variance. In addition, price forecasts have traditionally been unreliable, as is displayed in the graph below which compares year by year forecasts of oil prices compared to the actual price movement.
Such market fluctuations therefore pose significant short, medium and long-term risks to all participants involved in the trading of minerals. In the short-term, for example, price fluctuations can create challenges to trading companies when purchase prices at one point in time vary significantly from prices at the time that cargoes have reached the destination market.
In the long-term, on the other hand, producers face the risk of having sunk large sums of capital expenditure into projects that later turn out not to be viable anymore. Given that the production of raw materials usually requires relatively high upfront-investments and a rather long lead time to develop, market conditions might have already significantly changed by the time production commences and not bring the expected margins.
These challenges to producing or trading companies also have knock-on effects to governments, as price volatility might cause governments to fall short of expected revenues. Particularly in resource-dependent countries, changes in commodity prices can lead to what is referred to as boom and busts. In its simplest form, this dynamic can be described by the tendency of governments to commit to high spending during boom years, e.g. via the expansion of state activity, by increasing government staff, or by taking on loans against expected resource revenues. Once there is a sudden price fall, however, a bust cycle might set in that can lead to drastic spending cuts and difficulties to pay back loans or interest.
Given the various factors that determine the economics of minerals -- such as geology, supply and demand, but also available technologies -- companies frequently face higher than anticipated costs to develop or produce a certain kind of mineral, known as cost overruns. Usually such overruns stem from either misplanning, or from having had too little data at the time of when costs were estimated. The later often relates to the hard to predict nature of mineral plays in the ground, or in other words to geology, but overruns can also be caused by technical, economic or political developments that lead to an increase in the required costs for a resource to be produced.
Similarly to issues stemming from price volatility, such cost overruns can significantly impact expected government revenues. Depending on how fiscal regimes and contracts are structured, the government share in the cashflows of mineral projects is often back-loaded, meaning that the gross of benefits are achieved towards the end of a particular resource production. Particularly, so called cost-recovery terms allow companies to offset their investment costs first, before profits are split between governments and companies (e.g. via production entitlements) or income tax is imposed on a company’s revenues. As a consequence, cost overruns can significantly postpone and/or reduce government income.
Transfer pricing and arm’s length
In recent years, the topic of transfer pricing has increasingly entered the world of resource governance. The term itself represents a perfectly legal and necessary process through which related companies determine the price for goods and services sold between them. Yet transfer pricing came under scrutiny as it can also be used as a tool to shift profits and to avoid taxes. Such transfer (mis-)pricing, also referred to as base erosion and profit shifting (BEPS), can be facilitated via a number of different ways, for example by inflating prices for services or goods that a company receives from an affiliate in a particular country, allowing the same company to declare increased costs and to thereby reduce any taxable profits. On the other hand, mispricing can also take place when two related companies choose to undervalue a transaction between each other, such as the sale of a commodity, yet with the same intention to decrease profits in a particular country and usually with the aim to declare profits in a low-tax jurisdiction instead.
A range of national and supra-national initiatives have therefore attempted to regulate the way prices have to be established for such intra-group tradings, such as via the OECD’s transfer pricing guidelines that have been adopted by many countries. While the specifics to regulations vary from country to country, most attempts to deal with profit shifting circle around the so called arm’s length principle. Through it, related party transactions should either be equal to what a seller would charge an independent customer, or to what a buyer would pay for a comparable product on the market.
In order to prevent mis-pricing, tax authorities therefore facilitate frequent tests on the applied prices that are charged between related parties. To do so, they can rely on different methods, such as the so called “best method rule”, the profit-based or the “cost-plus” method. All of these have in common, however, that they specify what prices will be used as reference points to serve as examples for transactions between unrelated parties, against which related party transactions will be measured against. In reality, however, establishing such arm’s length prices can be incredibly difficult, as they rest on a number of different factors (e.g. volume and grade of a commodity, point in time, etc), and often rely on company-provided data that is difficult to falsify.
With revenues of more than $100 billion per year, large trading companies are key actors in the commodity markets and have yet for a long time received very little attention by policymakers. Traders such as Vitol, Glencore and Trafigura however play a crucial role in how minerals find their way from producing countries to end users. They often also interact with governments directly, especially when countries sell their natural resources to the market themselves. Little information is available, however, on the terms of such deals and it is rather anecdotal evidence, that has led to increased public concern over the incredible scale and often secretive nature of such trading.
In many resource-producing countries, minerals trading is handled via the trading arms of national companies, such as the Nigerian National Petroleum Corporation or Angola’s Sonangol. Selling significant portions of a country’s produced commodities, the proceeds from these sales can make up considerable government income. This can be exemplified by the fact mineral exports make up over 77 percent of export earnings in resource-rich countries in sub-Saharan Africa.
Yet the global movement for more transparency in the extractive industries has only recently picked up on trading companies, and initiatives that have led to the disclosure of payments to governments (e.g. via the Extractive Industries Transparency Initiative, or EITI) are yet to enforce the disclosure of mineral sale deals.