Political Risk: An Analysis of the Oil Industry Investment Environment by Denis Parfenov [2002]

Political Risk: an Analysis of the Oil Industry

Investment Environment

by Denis Parfenov

A dissertation prepared in partial fulfilment of the requirements for the

Degree of Masters of Business Studies (in International Business)

The Michael Smurfit Graduate School of Business,

Faculty of Commerce,

University College Dublin,

Ireland

Research Advisor: Dr. John F. Cassidy

July 2002

To my Grandmother

ii

Abstract

Companies diversify geographically and gain entry to traditionally

inaccessible regions. Direct foreign investments allow them to exploit unique

assets and to generate larger profits. Investments in any country entail political

risk. This paper aims to examine the concept of political risk as perceived by

three major oil companies (Exxon Mobile, Royal Dutch Shell, British

Petroleum) with activities diversified around the world. In order to compare

companies strategies, the chosen research sample includes the companies

with interests on Sakhalin island, Russia.

The objective of this dissertation is to analyse the current threats of the

international business environment and the strategies companies employ to

deal with them. The sample of three oil companies is taken, presuming that

the exploration business is a typical example, of where political risk is usually

involved.

When the findings of the secondary research are analysed with regard to the

literature available on the research topic many correlations are found. Most

notable is the finding that in order to achieve long term goals, oil companies

have to undertake tasks with risk and uncertainty. Second, the threat of losing

ownership rights is relatively low at present. Host countries are highly

dependent on foreign investments, technology and managerial expertise. On

the other hand, the risks imposed by forces, which are beyond governments

control, and changes in the international relationship are high. The topic of

dealing with risks caused by forces beyond governments control is under

explored in academic literature. Finally, in spite of high bureaucratic barriers,

the Russian Federation is becoming an investor attractive region. The leading

Western oil companies are actively investing in Russia. The multinationals

practices of dealing with risks in Russia do not differ from their practices in

other countries or to each other.

iii

Acknowledgments

Following a great time at the Michael Smurfit Graduate School of Business, I

would like to thank the following for their help and support throughout the

year:

Dr. John F. Cassidy, thank you for your continued guidance and

advice.

Dr. Anne Bourke, thank you for keeping me focused

My family

My friends

J. ORourke, for a great time.

iv

Table of Contents

Page

Chapter 1: Introduction 1

Chapter 2: Literature Review 5

Section 1: Theory of Internationalisation 5

1.1 FDI 6

1.2 Joint Ventures 8

1.3 FDI in Oil Industry 9

Section 2: Uncertainty and Risk 10

Section 3: Political Risk 11

3.1 Macro Political Risks 14

3.2 Micro Political Risk 16

3.3. Managing/ Minimizing Political Risks 18

Step1: Risk Recognition/Evaluation 18

1.1 Sources of Information (Internal and External) 19

1.2 Technique to Assess Political Risks 21

1.3 Industry Associated / Project Associated Risks 23

1.4 Country Associated Risk 26

Step 2: Developing Pre-investing Planning/

Crisis Planning 30

Step 3: Post-investment Policies/

Crisis Management 32

Section 4: Risk/ Return Trade-off 33

Conclusion 34

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Chapter 3: Research Methodology

Section 1: Introduction in the Case Study Approach 35

Section 2: The Case Study Approach as a Research Strategy 36

Section 3: Sources of Data for This Study and Their Limitations 38

Section 4: The Selection of Cases 39

Section 5: Generalisation 40

Section 6: Boundaries to Case Studies 40

Section 7: Limitations of the Case Studies Approach 41

Section 8: Research Objectives 42

Conclusion 42

Chapter 4: Background- Global Oil & Russia

Section 1: Oil Industry Profile 43

1.1 Uses of Cruel Oil 46

Section 2: Exxon Mobiles Profile 46

Section 3: Royal Dutch Shells Profile 47

Section 4: British Petroleums Profile 47

Section 5: Russian Oil and Gas Sector 48

Section 6: Product Sharing Agreements 51

Section 7: Sakhalin Projects 52

Conclusion 54

Chapter 5: Case Studies 55

Case One: Exxon Mobile

1.1 Exxons Business 55

1.2 Exxon, Chad and Indonesia 56

1.3 Exxon and Sakhalin 1 58

Case Two: Royal Dutch Shell Group

2.1 Shell in Nigeria 61

2.2 Shell and Sakhalin 2 63

Case Three: British Petroleum PLC 65

3.1 BP and Colombian Oil 66

3.2 BP and Sakhalin 4-5 69

Conclusion 70

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Chapter 6: Findings

Section 1: Political Risk and Oil Companies 71

Section 2: Risk Recognition/ Evaluation in the Oil Industry 73

Section 3: Risk Management 74

Section 4: Investing in Russia 77

Chapter 7: Conclusions 79

Future Research Direction 84

List of References a-f

List of Websites g

Appendix I: OLI variables according to Dunning A

Appendix II: Histories of Companies C

Appendix III: World Energy Fuel Shares 1998 2020 F

Appendix IV: Map of Sakhalin Island

G

Appendix V: Sakhalin Projects

H

vii

List of Tables

Page

Table 3.1 Comparing a case with others of its type 40

Table 4.1 Which countries have the worlds largest

proven oil reserves. 43

Table 4.2 Which countries produce the most oil 44

List of Figures

Page

Figure 2.1 Patterns of Political Intervention 13

Figure 2.2 Four types of risk 14

Figure 4.1 Rate of oil reserve renewal, 1990-1999 by country 45

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Glossary of Terms & List of Abbreviations

Barrel - Crude oil is measured in barrels. One barrel equals 42 US gallons,

or 159 litres.

Crude Oil is a naturally-occurring substance found trapped in certain rocks

below the earth's crust. It is a dark, sticky liquid, which, is classed in science

as a hydrocarbon. This means, it is a compound containing only hydrogen

and carbon. Crude oil is highly flammable and can be burned to create

energy. Along with its sister hydrocarbon, natural gas, crude oil makes an

excellent fuel.

Developed Countries are considered for the purpose of this study to be

OECD member countries. Those countries are primarily are the US, Japan,

European countries.

Developing Countries are considered for he purpose of this study to be the

all countries that are not a member of OECD or former centrally planned

economies. Most developing countries are located in Africa, Latin and South

America and Eastern Europe

FDI- Foreign direct investment

FSU- The Former Soviet Union

MNE- Multinational enterprise

NGO- Non-government organisation

OECD- Organisation of Economic Co-operation and Development

OPEC- Organisation of Petroleum Exporting Countries, which was

formed 14th of September, 1960 in Baghdad, Iraq. The current members are:

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Algeria, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia,

the United Arab Emirates (UAE) and Venezuela.

Political Risk- Changes in operating conditions of foreign enterprises that

arise out of political process, either directly through war, insurrection, or

political violence or through changes in government policies that affect the

ownership and behaviour of the firm. or affect in any way the future

profitability of given investment (Jodice, 1980)

PSA- Product Sharing Agreement

UNCTAD- United Nations Conference on Trade and Development

WEC- World Energy Council

World Oil Reserves are estimated at more than one trillion barrels (OPEC,

2002). The 11 OPEC Member Countries hold about 75 per cent and produce

40 per cent of the world total output, which stands at about 75 million barrels

per day.

x

Chapter I: Introduction

Chapter 1: Introduction

As global competition drives corporations into distant, unfamiliar markets,

managers are searching for ways to minimise the uncertainty they have to cope

with. In order to analyse the types of risk most common at present, how foreign

investors manage political risk and how political risk affects their work, the

author takes the case of the three largest oil companies in the world (Exxon

Mobile, Royal Dutch Shell and British Petroleum) which have diversified

interests around the world and at the same time which conduct business in

Russia. This chapter gives the reader the authors reasons for choosing this

topic and states research questions.

Why Political Risk? First, firms operating internationally often have to deal

with dramatic changes in the political, economic and business environments of

host countries. Governments can intervene in the operations of foreign-owned

firms by restricting ownership and control, regulating financial flows and the

employment of foreign management. More radical measures would be

nationalisation, expropriation, or confiscation of assets. Furthermore, civil

disorders, rebellions and revolutions can seriously offset the benefits of

internationalisation. Thus evaluation of political risk and minimising its

exposure can be an important issue for firms operating abroad (De Mortanges

& Allers, 1996). Moreover, besides being subject to political risk, it is also

quite possible that companies miss opportunities because they perceive more

political risk than actually exists.

Second, political risk exists in different forms in all countries and every

investor estimates its presence/degree. However the level is higher in

developing countries than in those which are developed.

Third, international relations more and more influence international business.

Nowadays, trade, political or military sanctions of one government against

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another one can affect the investors decisions and companies growth

strategies.

There are two recent examples of how political risk and relations among

nations affect MNEs business. After September 11, 2001 the U.S. worked hard

to get Pakistan into its anti-terrorist alliance. British Petroleum (BP), which

extracts 60,000 barrels of oil a day in Pakistan, has withdrawn all its overseas

executives from this country. At the same time, Britains Premier Oil, a small

exploration company, announced it was expanding its modest presence in

Pakistan through a US$ 105 million joint venture with a Kuwaiti partner

(Tomlinson, 2001a).

Another example is French oil giant TotalFinaElf. Since 1995, Total has

pursued an aggressive strategy of expanding in the Middle East (mainly in

Libya and Iran), where almost a quarter of the company's oil and gas

production is located. Their exploration and production division accounted for

about seventy per cent of the group's operating income in the year 2000.

Considering that, Total got into an extremely sensitive position following the

attacks against America on September 11 and the vow by the U.S. and its allies

to target nations that harbour or sponsor terrorists. (Tomlinson, 2001b)

To conduct quality research on Political Risk, it is necessary to focus on the

specific sector. According to Shapiro (1981) susceptibility to political risk

depends on the industry, where companies work, size of company, composition

of ownership, level of technology and degree of vertical integration with other

affiliates. Taking into account that, the sample of private oil companies is

chosen.

Why oil? The world lives on oil. It is probably the most important commodity

in the world. Oil is the foundation for the plastics and petrochemical industries.

Oil is fundamental to the welfare of the industrialised world and it is a major

component of the farming industry.

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In the last twenty years most of the discoveries of oil and gas reserves were

made in third world countries, so it has to be explored there. The majority of

these countries are unfortunately extremely uncertain places. Finally, the

exploration of oil and gas is a business which needs huge investments, so the

losses can be very high. Thus risk assertion and management must be very

thorough.

Why companies with interests in Russia? Russia is still an emerging market

and political risk is still quite high in the Russian business environment. This

fact badly impacts the level of needed FDI there.

Moreover, Russia is a unique example due to its history. Beginning in the

nineteenth century the fortunes of Russian oil had a significant impact, when

the development of an oil industry in Azerbaijan (part of Russian Empire)

around Baku broke the Rockfellers Standard Oil monopoly. Furthermore,

Russia is the place where oil companies experienced the first political

interruption caused by the revolution of 1905. Later, the Bolsheviks export

campaign in the 1920s brought about the global price war that led to the

meeting at Achnacarry Castle in Scotland in 1928 and the As-Is agreement.

In the late 1950s the Soviets drive for market share stimulated price-cutting,

and gave a birth to OPEC on September 14th, 1960 (Yergin, 1991).

The Russian Federation possesses abundant deposits of natural resources

including large stocks of fuel minerals. Historically, the country has been one

of the major producers of oil and gas, providing a significant share of the

supply to the worlds markets. The Former Soviet Union (FSU) used to be the

worlds largest oil and gas producer, with output in 1989 more than double that

of Saudi Arabia, and it was the second largest exporter after Saudi Arabia

(Yergin, 1991). Russia is about to do it again.

The Russian oil and gas industry desperately needs foreign investment,

experience and technology to develop its oil reserves, especially offshore ones.

In spite of the increases in output achieved in the last 3-5 years, without FDI,

making further progress seems to be unachievable goal.

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The Russian budget is heavily dependent on export revenues. Oil/gas and

metals have 54 per cent and 17 per cent respectively in the Russian export

profile (Gostomstat, 2002). Thus, the raw material exploration industry is a key

sector in the Russian economy.

Risks differ from one country to another, so the strategy of a company

operating in Chad would be somewhat different to a company doing business

in Colombia. In order to compare how companies handle identical types of

risk, it is necessary to look at their operations in the same environments. Exxon

Mobile, Royal Dutch Shell and BP are all involved in business in Russia.

Moreover, all of them have interests in the same region of Russia, on Sakhalin

Island. This suggests that Russia is a good case study for examining the

behaviour of multinationals.

The research questions of this dissertation are as follows:

1. What kinds of political risk are most common at present?

2. How do firms deal with political risk?

3. Why do firms enter a region with high risk and uncertainty?

4. Do companies investment strategies in Russia differ to other countries

and each others?

In order to eliminate the general by focusing on the particular, a case study

approach will be implemented, since the author does not have the choice of a

great deal of suitable cases to include in the investigation. The following

strategy will be followed: chapter two will examine the academic literature

related to political risk matters. Chapter three will introduce the reasons for

choosing the case study approach as a research strategy and its limitations.

Chapter four will give background information on the worlds oil industry,

companies profiles, the oil sector of Russian economy and issues related to it.

Chapter five will deal with case studies. Chapters six and seven will be

dedicated to findings and conclusions with future research direction.

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Chapter 2: Literature Review


The following chapter outlines the concept of political risk as a part of

internationalisation. The literature included in this section contributed to the

authors understanding of the research issues.

Due the vast range of academic literature regarding the chosen topic, the author

found it appropriate to concentrate on the following strands as the most

important and relevant in regard to dealing with political risk in the context of

the internationalisation process: (Section 1) Theory of Internationalisation,

which examines (1.1) FDI, (1.2) Joint Ventures and (1.3) FDI in Oil Industry;

(Section 2) Uncertainty and Risk; (Section 3) Political Risks looks into (3.1)

Macro Political Risks, (3.2.) Micro Political Risks and strategies of (3.3)

Managing/Minimising Political Risks. The final section (4) is dedicated to

Risk/Return Trade-off.

Section 1: Theory of Internationalisation

The pioneers of the international trade theory are Adam Smith with a theory of

absolute advantage (1776) and Ricardo with a theory of comparative advantage

(1817). These theories state that countries gain, if each devotes resources and

capabilities to the production of goods and services in which it has an

advantage.

However, since these works were written, the world has changed dramatically.

Now international business is not only about trade, but also more and more

about acquiring and placing value creating capabilities and diversifying risks

around the world. The increase in international business activity is mainly due

to: (1) an increase and expansion of technology, (2) a liberalisation of

government policies on cross- border trade, (3) the creation of institutions to

facilitate international trade and (4) the increase in global competition.

1


The International Business channels are: (1) Export & Import; (2) tourism,

transportation, services (consulting, banking etc.); (3) licensing, franchising;

(4) turnkey operations; (5) management contracts; (6) MNE / TNC; (7)

Collaborative agreements; (8) Indirect Foreign Investments (Portfolio

Investment) and (9) Foreign Direct Investment (FDI).

Truitt (1974) points out the difference between indirect foreign investments and

direct foreign investment. Indirect (portfolio) foreign investment is the

purchase and ownership of foreign stock and bonds for the purpose of dividend

as interest payment on return of investment. But in reality, relations among

parent companies and host government can become more involved in business

than in just getting bonuses and thus it is less easily differentiated from direct

foreign investment.

Section 1.1 FDI

Investment implies the acquisition of rights to future income. Alternatively,

transactions that procure such rights may be regarded as forms of investment

(Oman, 1984). Foreign direct investment (Truitt, 1974) can in general be

defined as the acquisition of specific productive capacities abroad, with

entrepreneurial, managerial and technical skills applied to these foreign assets.

The assets may be wholly owned or a part of a joint venture relationship.

According to commonly accepted definitions, any investment worth more than

10 per cent of the total equity of the host organisation counts as direct

investment (Dyker, 2001).

The major part of the literature on FDI relates to the idea of transaction costs.

Simply, this notes that companies involved in so-called oligopolistic

industries which are characterised by technological and financial advantages

produce abroad rather than export or license their technologies. Vernon (1966)

highlighted the importance of location in the theory of FDI in his analysis of

2


the product life cycle and the potential for the firm to exploit a foreign market.

These ideas were summarised by Dunning (2000) (see Appendix I). In

accordance with Dunning (2000) firms invest abroad because they possess

ownership advantages, location factors and internalisation factors (O-L-I),

which may be described as follows:

(O) Ownership advantages: economies of scale, other technological

advantages, or management skills. These ensure or enable the firm to

recover the costs of investing in different assets abroad.

(L) Location factors: these contribute to the decision to employ

ownership advantages to produce abroad (e.g. risks or barriers in export

markets or availability of low cost labour or natural resources)

(I) Internalisation factors: foreign production occurs within the firm

an internal market is created between parent and affiliates to control key

sources of competitiveness or to reduce the risk that the firm might lose

control of knowledge or technology (which would happen through

licensing).

Dunning (1977) proposed three potential advantages of FDI over export-import

strategies. First, MNE should have an advantage derived from ownership of

intangible assets such as brand management, trade secrets, technology, or tacit

management capability, which confers a market or cost advantage. Second,

FDI should give the advantage of being located in the host country resulting in

tariff avoidance, transport cost reduction, low factor prices, or proximity to

customers. Third, the MNE should benefit from internationalising and more

fully controlling its foreign business through FDI; from more fully controlling

its foreign business through FDI to more fully appropriating the profits or rents

generated by its unique assets or capabilities.

Dunning (2000) also insists that OLI theory is applicable to home country and

host country FDI. The country-specific determinant of ownership and

internalisation advantages, and the country specific determinants of location

advantages of the host country, explain that FDI has roots in one country

(because the home country possesses ownership and internalisation

3


advantages), and locates in another (host) country, as the host country

possesses location advantages. The importance of FDI lies in both MNEs and

the foreign host country.

Vernon (1966), in his product life cycle theory, examined the trend for the

production of goods to be concentrated in the developed countries early in the

life of the product, but to move to other developing economies later on. Welch

and Luostarinen (1988) state that there is evidence, that as companies increase

their level of international involvement, there is a tendency for them to change

the method/s by which they serve the foreign markets. There are additional

changes to the shape of companies and the way they conduct business.

1) Operational methods (How?) grow with the increasing commitment of the

investor to FDI (no exporting exporting via agent sales subsidiary

production subsidiary). The future international success of companies will

depend on their ability to master and apply a range of methods of foreign

operations.

2) Sales objects (What?) also progress as companies increase its involvement

in international operations. There is a tendency to offer foreign markets a

mean to deepen and diversify (e.g. expansion within an existing product

line or into new line, or a change to the whole product concept.). The

offering to foreign markets usually begins from the simplest form: goods

and mature further- services systems know-how.

3) Target markets (where?). Companies expanding more distant operations

typically over time in political, economic and physical terms.

Welch and Luostarinen (1988) also noticed the changes in companies

personnel policies, organisational structure and finances with increasing

commitment to internationalisation.

Section 1.2 Joint Ventures

A joint venture (JV) normally applies the sharing of assets, risks/profits and

participation in the ownership (i.e. equity) of a particular enterprise or

investment project by more than one firm or economic group (private

4


corporation, public corporation or even states). The distribution of equity

shares in a joint venture may be determined according to each partners

financial contribution, or it may be based on other forms of capital

contribution, such as technology, management, access to the world markets,

licenses etc.

Daniels & Radebaugh (2001) review the combination of partners, which may

exist in a joint venture:

Two companies from the same country join together in a foreign market

(e.g. Exxon and Mobile in Russia).

A foreign company joining with a local company.

Companies from two or more companies establishing a joint venture in

a third country.

A private company and a local government forming a joint venture

(sometimes called a mixed venture) (e.g. Philips (Dutch) with the

Indonesian Government).

A private company joining a government owned company e.g. BP

Amoco (private UK-US) and Eni (Italian government owned) in Egypt.

Czinkota et alli (2000) argue that: The key to joint venture is the sharing of a

common business objective, which makes the arrangement more than

customer-vendor relationship, but less than outright acquisition. Madura

(2000) states that most joint ventures allow business partners to apply their

respective competitive advantages in a given project. The benefits of the joint

venture as a form of FDI are (Czinkota et alii 2000):

JVs are valuable when pooling of resources results in a better outcome

for each partner than if eachone conducts activities individually.

JVs often permit a better relationship with local government and other

organisations such as labour unions.

JVs allow minimising the risk of exposing long-term investment

capital, while at the same time maximising the leverage on the capital

invested.

5


Typical problems with JVs are as follows: (1) difficulty with selecting a partner

in a host country (Liu & Bjornson, 1998); (2) Different objectives of foreign

partners, which cause disagreements among partners about business decisions

e.g. strategy, accounting and control, marketing policies, management style,

etc. Liu & Bjornson (1998) state that in principle, MNEs seek to maximise

their firm value, consistent with economic efficiency, while local partners may

seek to maximise short-term profit, sometimes at the expense of product

quality or reputation. Other flaws of JVs are:(3) leakage of know-how from

one partner to another and (4) lack of control for investor over joint venture

Section 1.3 FDI in Oil Industry

In the context of a complex and dynamic world, specific companies or groups

of companies in specific countries or regions develop specific capabilities

(Dyker, 2001). Dyker (2001) states that specific FDI decisions are based on the

perception and scope for internalisation, not only of firm-specific advantages,

but also of location-specific advantages. It is not enough for the investing firm

to have something special to offer, but also the host country has to have

something special as well. Since in the context of FDI the investing firm by

definition provides the capital, with attention focusing on the other two main

factors of production, labour and land (including natural resources), FDI in the

developing countries is mainly cheap-labour-seeking and/or land/natural-

resource-seeking.

Furthermore, as products and their marketing become more complicated,

companies need to combine resources that are located in more than one

country. This fact makes business more complex and the companies need a

tight relationship to ensure that production and marketing continue to flow.

One way to help ensure this flow is to gain a voice in the management of one

or more of the foreign operations by investing in it. Vertical integration is a

companys control of the value chain in making its product from raw materials

through production to its final destination. Daniels & Radebaugh (2001) state

that most of the worlds direct investments in the oil industry may be explained

6


by the concept of international vertical integration, as much of the petroleum

supply is located in countries other than those with a heavy demand.

In order to exploit potential sources of competitive advantage gained from FDI,

firms must be able to identify and manage risk in individual foreign markets

(Kashlak, 1998). To examine possible threats the author turns next to

uncertainty and risks.

Section 2: Uncertainty and Risk

The difference between uncertainty and risk is difficult to recognise.

Haendel (1975) argues that some authors have defined risk as uncertainty

concerning possible outcome, so the distinction between risk and uncertainty

would have become a distinction between objective and subjective risk. Risk is

an objective doubt concerning the outcome in a given situation (Haendel,

1975). Uncertainty can be defined as subjective doubt concerning the outcome

during a given period.

More broadly, uncertainty is measured by degree of belief while, risk is a

combination of hazards and is measured by probability. Uncertainty is a state

of mind; risk is a state of the world. Uncertainty imposes cost on society and its

removal constitutes a potential source of gain. Risk is usually associated with

degree of loss (Haendel, 1975).

Country risks can be divided into economic risk, commercial risk, and political

risk.

Economic risk is risk related to the macroeconomic development of the

country, such as the development in interest and exchange rates that

may influence the profitability of an investment.

Commercial risk is risk related to the specific investment, such as the

risk related to the fulfilment of contracts with private companies and

local partners.

7


The third category, political risk, may in many countries be the most

important one. A country is a political entity, with country-specific rules

and regulations applying to the investment.

The next subsection is dedicated to political risk. For perspective within the

overall context of political risk, various definitions of political risk and

summary of empirical efforts to predict political risk will be given. Ways of

managing different types of risks in terms of reducing its exposure will be

examined.

Section 3: Political Risk

There seems to be considerable confusion among authors concerning what

constitutes a political risk event, which has changed over time and still there

is no consensus over this matter. Each author has avoided in some measure the

difficult task of defining precisely what is meant by and what trends are

covered by the term political risk. One of the pioneers in the risk analysis,

Root (1968) focuses on the sources of the international managers judgements

about future political conditions and events in a host country: Political

uncertainty for an international manager refers to the possible occurrence of

political events of any kind (such as war, revolution, expropriation, taxation,

devaluation, exchange control, and import restrictions) at home or abroad, that

would cause a loss or profit potential and/or assets in international business

operations... When the international manager makes a probability judgement of

an uncertainty into political risk (Root, 1968).

Jodice (1980) defined political risk as: Changes in operating conditions of

foreign enterprises that arise out of political process, either directly through

war, insurrection, or political violence or through changes in government

policies that affect the ownership and behaviour of the firm. Political risk can

be conceptualised as events, or a series of events, in the national and

international environments that can affect the physical assets, personnel and

operation of foreign firms.

8


De la Torre & Nectar (1986) define political risk as the probability distribution

that a real potential loss will occur due to the exposure of foreign affiliates to a

set of contingencies that range from the total seizure of corporation assets

without compensation to the unprovoked interference of external agents, with

or without governmental sanction, with the normal operations and performance

expected from affiliates.

Gilligan (1987) maintains, political risk could be defined as the likelihood that

political forces can cause drastic changes in a countrys business environment

in turn affecting the profit and other goals of a business enterprise. It can be

seen to stem from a countrys economic, political and social environments, all

of which are capable of changing dramatically in a short time, particularly in

the traditionally volatile parts of the world.

Czinkota et alli (2000) give a shorter definition: Political risk- the risk of loss

assets, earning power or managing control as a result of political actions by the

host country. The working definition of this dissertation is The political risk

faced by foreign investors is defined as the risk or probability of occurrence of

some event(s) that will change the prospects for profitability of a given

investment in a home or host country.

Politics and the laws of a host country affect international business operations

in a variety of ways. The political risks can be distinguished between (De la

Torre & Nectar, 1986) 1) the real contingences faced by the firm operating in

the foreign country and 2) the sources of the risk.

There are two different contingencies of losses:

1) Macro risk- (the more dramatic one) the involuntarily loss of control

(generally meaning property rights) over specific assets location in

the foreign country, typically without adequate compensation (e.g.,

expropriation, domestication, civil war, terrorism).

2) Micro risk- (the more prevalent one) the loss in the expected value of

a foreign-controlled affiliate due to discriminatory actions taken

9


against it, either because of its foreign nature or as a general

tightening on free market rights often imposed by government in

times of domestic crisis.

The political risks can also be classified as Indirect Intervention (micro risk)

and Direct Intervention (macro risk).

Figure 2.1 Patterns of Political Intervention

Indirect Intervention Direct Intervention

I--------------------------------------------I-----------------------------------------------I

Price controls Domestication Expropriation of

Tax controls assets

Import controls

Labour restrictions

Exchange controls

Market controls

Source: Gilligan, 1987

Another measurement of the exposure to political risks concerns the proximate

cause. It can be differentiated:

a) The actions undertaken by legitimate governments in the exercise of their

national prerogatives, and

b) Those which are the result of actions outside the direct control of the local

government

The source of trouble could be also internal (e.g. political repression) or

external (e.g., dramatic fall in commodity export prices). These forces may

when activated, have very direct impacts depending, greatly, on the maturity

and capacity of national institutions.

The types of most common types of risk facing by foreign investors are

summarised in the Figure 2.2

Figure 2.2 Four types of risk

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Loss contingencies:

An inventory loss of

control over specific

a s s e t s w i t h o u t

adequate

compensation

Type A:

Massive expropriations

Type B:

Selective

nationalisations

Value contingencies:

R e d u c t i o n i n t h e

expected value of the

benefits to be derived

f r o m t h e f o r e i g n

affiliate

Type C:

General deterioration of

the investment climate

Type D:

Restrictions targeted to

key sectors

Macro risks:

S u d d e n c o n v u l s i v e

chances that threaten most

of the population of

foreign direct investors

within the country.

Micro risks:

Interventions generally

motivated by specific

consideration closely

related to the economic

a n d t h e s o c i a l

conditions prevailing at

t h e t i m e , a n d t o

specific industry and

firm characteristic

Source: De la Torre & Nectar (1986)

Section 3.1 Macro Political Risks

Situations such as revolutions in Cuba and Iran produce what is known as

macro risk. In such situations, impacts on a firm are totally determined by

events in the external political environments, and organisational characteristics

such as industrial sector and technology become largely irrelevant. Macro

political risk is the chance that political events in a host country will affect all

foreign firms in a country, without regard to what they do or what industry they

are in. These effects occur simply because they are foreign. Under these

conditions, political events affect all firms in much the same way, and it is

reasonable to talk about the investment environment in a given country

(Kobrin, 1981). Root (1974) defines this type of risk as an ownership control

risk, which is linked to events influencing the owners' ability to control and

manage the investment.

11


The term of expropriation has been used loosely by practising international

businessmen, business journals, and the commercial press to cover a variety of

host government actions ranging from the sudden enforcement of previously

unenforced foreign controls to outright confiscation and physical take-over

(Truitt 1974).

According to Gilligan (1987), the expropriation of assets is the official seizure

of foreign property by a host country whose intention is to use the seized

property for public interest. It is typically seen as a far harsher and less fair

coarse of action, since in many cases the multinationals at best received only

partial compensation.

The concept of expropriation is generally narrower in scope than

nationalisation, but the two do not differ in their legal nature. While an

expropriation usually refers to a singular case of a state taking property, a

nationalisation usually entails a number of individual expropriations.

Expropriation, Truitt (1971) argues, is aimed at a particular company or

companies that are taken over by the host government, while nationalisation is

directed toward a general type of industry or a sector of economy.

Neither expropriation nor nationalisation (Truitt, 1974) is to be confused with

confiscation, which may: (1) Be the pejorative term for any expropriation; (2)

Describe the taking of property without prompt, adequate, and effective

compensation, or no compensation at all (De Mortanges & Allers, 1996); (3)

Describe government seizure of the property of war criminals, illegally

transported goods (such as narcotics or pornography), or property deteimental

to the national security.

Domestication is characterised by the gradual take-over of control and is

achieved most frequently by foreign government imposing certain conditions

on the multinationals and their methods of operation. Gilligan (1987) argues

that most the typical of these include:

The gradual transfer of ownership.

12


The insistence on an increasing number of goods being manufactured

locally rather than simply being imported for local assembly.

Nationals being given priority for promotions.

Nationals being given greater decision- making and veto powers.

Domestication is a less extreme and far more gradual strategy than outright

expropriation or nationalisation. According to Kobrin (1987), while these harsh

macro risks tend to attract considerable managerial attention; their number is

relatively limited.

Section 3.2 Micro Political Risks

Micro-political risk is the chance that political events in a host country will

affect only a specific firm or firms in a specific industry. Examples might be

constraints on petroleum firms that do not apply to foreign firms in other

industries, or constraints on a specific firm because it also does business in a

country unfriendly to the host country. Examples of the latter would be

constraints by Islamic countries against firms doing business in Israel.

Although whilst the macropolitical risk is more dramatic and obvious, micro-

political risks are manifested more frequently in a less obvious way, sustaining

over the long term is such as increased controls and restrictions upon operating

methods. Micro risks generally result from situations that do not involve

political conflict or even a change in regime, but rather a change in policy

(Kobrin, 1981) They represent attempts by host country governments to exert

control over their economies in order to attain national objectives.

Kobrin (1979) points out that, political environments can affect both the

security of assets and the viability of operations; possible contingencies may

include non-discriminatory measures.

Madura (2000) summarises the most common forms of micro political risks

which include:

13


Attitude of the consumers in the host country- a tendency of residents to

purchase only homemade goods (Gilligan, 1987).

Attitude of the host government- various actions of host government

which affect the cash flow. E.g., new pollution control standards, tax increases,

price controls, fund transfer restrictions; partial divestment of ownership, limits

on expatriate employment (Kobrin 1979, Gilligan, 1987).

Blockage of fund transfer- a blockage by host government of fund

transfers from subsidiaries of MNE to the headquarters, which could force

subsidiaries to undertake projects that are not optimal (Kobrin, 1979).

Currency inconvertibility- the home currency cannot be freely

exchanged into other currencies, thus, the earning generated by a subsidiary in

the host country cannot be remitted to the parent through currency conversion

(Gilligan, 1987).

Bureaucracy- this type of political risk can seriously complicate

MNEs business. E.g., Eastern Europe in the early nineties.

Corruption- can adversely affect an MNEs business in a host country,

because it can increase the cost of conducting business or reduce revenues.

Root (1972) lists examples of political risk situations, i.e. examples of events

affecting real investments. Root (1972) distinguishes three types of political

risk: transfer risk, operational risk and ownership control risk.

(1) Transfer risk, which is risk related to the transfer of products and services

across national borders, or the transfer of funds such as payments of

dividends.

(2) Operational risk is risk related to the operation and profitability of an

investment in the host country, such as the operation of an assembly plant.

Examples of operational risk are price controls and possible requirements

that the producer should use sub-standard or expensive local suppliers.

(3) Ownership Control Risk is a risk of losing control over asset and

investments in a foreign country.

14


Section 3.3 Managing/Minimising Political Risks

A direct consequence of the uncertain political environments in many parts of

the world is that there is now a greater need than ever for companies to

recognise that the political environment should no longer been seen as a totally

uncontrollable variable, but rather as a factor upon which effective strategic

management can impact (Gilligan, 1987). The MNEs cannot control political

risk much, but can instead manage its exposure through the structure and type

of investment.

The basic approach to the management of the extreme form of political risk,

such as expropriation, in accordance with Shapiro (1981), involves three steps:

1. Recognition of the existence of political risk and its likely consequences;

2. Developing policies in advance to cope with the possibility of political risk;

3. In the event of expropriation, developing measures to maximise

compensation.

Step1: Risk Recognition/Evaluation

Daniels & Radebaugh (2001) state: As managers evaluate countries as a

potential place to do business and as they struggle to succeed once they have

committed resources, they need to be aware of political risk. However, what

concern the international investor is not political events and processes per se,

but the management contingencies they may generate and the impact that any

externally induced shock may have value on its assets (Kobrin, 1981., De la

Torre & Nectar., 1986).

Kobrin (1981) stated, that compared to most types of economic or business

forecasting, political forecasting remains a very underdeveloped art. However

along with Gilligan (1987), If firms are to avoid or at least minimise the

consequences of risk, it is essential that truly effective techniques of political

risk assessment (PRA) and strategies of risk management be developed.

15


The term country risk analysis describes the activity of predicting future

conditions for the investment in a host country. Robock (1971) and Haendel

(1975) identify four steps in political risk analysis:

1) An understanding of the type of government presently in power, its patterns

of political behaviour and its norms of stability.

2) An analysis of the multinational enterprises own product or operations to

identify the kind of political risk likely to be involved in particular areas.

3) A determination of source of political risk.

4) To project into the future the possibility of political risk in term of

probability and time horizons.

Robock (1971) cited one international company that forecasts political risk via

two projections. One projection is the chance that a particular political group

will be in power during a specific forecast period. The second is of the type of

government interference that each political group can be expected to generate.

Step 1.1 Sources of Information (Internal and External)

A number of studies have concluded that firms rely primarily on internal

sources for information about external environments. The most important

sources of information are (Gilligan, 1987):

a) Managers of overseas subsidiaries are the most important resource of

information available to the international firms (as located around the

world, many of whom are host country nationals).

b) A subsidiarys managers are members of the local elite, and although

that often provides the advantage of direct access to top-level officials

of the current government, it may constrain contact with other

important groups, such as student leaders, labour unions and the

political opposition.

c) Regional managers

d) Managers in HQs with international responsibilities

16


The main flaw of using the internal sources for information is that subsidiary

and regional managers are strongly motivated and therefore tend to

underestimate the potential dangers of the country in which they work.

There are at least three external sources of information that the predictions may

be based on (1) written reports; (2) information deduced from financial

markets; and (3) summary measures like risk indices and ratings. Because it is

often difficult to quantify country risk, all three sources of information used

together are likely to provide the investment analyst with the best estimates.

Written reports usually contain descriptions of possible future developments in

a country. Such reports may be issued by private companies or international

organisations like OECD or the World Bank, the International Monetary Fund,

International Financial Statistics UN; U.S. Commerce Department. Figures

from national accounts may be presented in these reports, but in many cases the

analysis is primarily qualitative and in textual form. Written reports are useful

in providing background information, but may often be too general and give

little guidance to the numerical evaluation. The second source of information is

analyses of prices of assets traded in financial markets.

Moreover many consulting companies and investment banks provide country

and political risk advisory services enabling international investors to identify

and evaluate broad political macro and micro risks in a chosen region from

changes in government legislation and selective discrimination to the impact of

war and terrorism. For example, Deloitte & Touche assesses the likelihood of

more than 40 risks, including:

Currency inconvertibility and capital controls.

Political violence and civil disorder.

Industrial action.

Shareholder action.

Confiscation, expropriation and creeping expropriation.

Adverse tax changes.

Selective discrimination.

Contract frustration or repudiation.

17


Negative investment or trading environment.

Devaluation risk.

According to Mortanges & Allers (1996), while external environments rapidly

change, the data of governmental agencies and international organisations can

create a time lag, which can be crucial. The same can be said in regard to

consulting companies' reports as they are often based on the primary data

which is taken from the governments' resources.

Step 1.2 Techniques to Assess Political Risks

There are various techniques available for implementing country risk

assessment. Some of the most popular are:

Checklist Method - consists of several variables, related to international

cash flows (GNP Growth, GNP/Population, Inflation, Reserves/Imports etc.) or

the balance of payments approach- that are weighted according to their impact

on debt servicing ability, with the weight ranging from 0 to 100. Each variable

in the model is weighted or multiplied by a fixed weight, or coefficient, and the

results are aggregated from the index or composite score. The shortcomings of

this method are the somewhat discriminatory selection of the variables, and

often discriminatory assignment of weight to the variables.

Delphi Method - based on pulling a panel of experts for their estimates of

environmental risks and then aggregating and weighing their responses.

International managers often look to futurists for help in forecasting changes in

their internal and external organisational environments. Futurists use

techniques such as the Delphi method and scenario development to identify

possible futures, often consisting of events and trends, occurring both globally

and within a specific geographical region. The Business Environmental Risk

Index (BERI) and the Business International Index of Environmental Risk (BI)

are based on the Delphi method. Both the BI and BERI indices stress a

description of existing conditions in the host country and are strongly oriented

18


toward short term projections of less than a year, which make then hardly

useful for investors.

Scenarios. As Mortanges & Allers (1996) state, this approach consists of the

formulation of certain possible scenarios for a given country. E.g. the arrival in

power or maintenance in power of a leading political group, defined according

to their attitude towards foreign investment. The next step is to assess

probability of the given scenario coming into being.

Quantitative Analysis. Rather then rely on soft opinion measures (such as

the Delphi method) quantitative measures are based on hard data...

(Haendel, 1975). Quantitative methods are developed to reduce the bias of the

subjectivity of qualitative methods (Mortanges & Allers, 1996). Quantitative

analysis helps a risk analyst to identify characteristics that influence the level

of country risk after the financial and political variables have been measured

for a period of time.

Discriminate analysis is a statistical tool used for this purpose. The general idea

of this analysis is to identify the factors; to help to distinguish between

tolerable risk and intolerable risk countries by examining political and financial

factors of these countries.

Another type of quantitative model was developed by Schollhammer (1978),

uses measures of certain casual factors to forecast political change. He

suggested two types of casual factors: 1) political factors (quantitative

estimates of national riots, armed attacks, death from domestic violence,

government sanctions, defence expenditures and fractionalisation among

parties). 2) The economic factors (e.g. average expenditures, and available food

supply measured in terms of calories per capita) (De Mortanges & Allers,

1996).

The main limitation of these analyses is that they are based on historical data,

which are not always an accurate indicator of the future (Haendel, 1975). The

19


time lag effect of the governmental agencies and international bodies data

can also exist while using the quantitative model for assessing political risks.

Inspection Visits ("grand tours") - involve travelling to a country and

meeting with government officials, firms executives, and/or consumers. Such

meetings help clarify any uncertain opinions the firm has about the country.

The results of this kind of investigation can be very limited, containing only

selective information which does not take into account factors possibly

disastrous for the company (De Mortanges & Allers, 1996). However, when

properly organised, a team of executives can be very useful. Moreover, some

experience with the political environment is better than none. Mortanges &

Allers (1996) suggest supplementing this method with other less subjective

ones.

Company-specific Methods. Shell Oil Company developed the ASPRO-

SPAIR system (De Mortanges & Allers, 1996). ASPRO is short for

Assessment of Probabilities and SPAIR is short for Subjective Probabilities

Assigned to Investment Risk. This approach contains a model of the potential

impact of the political environment on a specific project. Expert analysts are

recruited from a variety of backgrounds to review a set of factors like civil

disorder, sudden expropriation, taxation restrictions, restriction on remittances,

and oil export restrictions. A major disadvantage of this method is that it is very

expensive and appropriate only for large MNEs.

Combination of Techniques. Since each technique has its own pros and

cons, its most appropriate to implement two or more of the techniques

described above (Madura, 2001). An integration of qualitative and quantitative

methods may be a more accurate way to forecast political risks.

There is no consensus as to how country risk can best be assessed. Madura

(2000) suggests dividing the risk evaluation into two steps: 1) the risk

assessment of a country as related to the MNEs type of business

20


(microassessment) and 2) an overall risk assessment of the country

(macroassesment).

Step 1.3 Industry Associated Risk/ Project Associated Risk

Not all events will have similar consequences for different projects. Truitt

(1974) points out that some types of investment are more politically exposed

and sensitive to the threat of expropriation than others. De Mortanges & Allers

(1996) state "the vulnerability and likelihood of an adverse political event

increase when moving from firms producing final goods to those using up

natural resources (e.g. oil) in the host country". The latter are subject to

nationalistic feelings.

Shapiro (1981) and De la Torre & Nectar (1986) declare that companies vary in

their defencelessness in the face of political risks, depending on:

1) Industry Factors (Shapiro, 1981., De la Torre & Nectar, 1986)- different

economic sectors experience different propensity to expropriation and

government intervention in general. Level of risk varies enormously from

one industry to another.

a) Activity/ Economic Sector - as stated by Truitt (1974) and backed up by

Kobrin (1981), De la Torre & Nectar (1986) the areas of highest risk are

perhaps the extractive industries and utilities, with developing countries

demonstrating a strong desire to increase their level of control over

natural resources and infrastructure.

b) Technology (De la Torre & Nectar, 1986) and particularly its level

(Shapiro 1981) - the higher the R&D intensity of the technological

complexity of the business, the less likely it is to be expropriated and

the higher the bargaining power of the foreign investor.

c) Product Differentiation (De la Torre & Nectar, 1986)-highly

differentiated goods require specialised inputs for their sale or service

which often cannot be provided by local firms. Differentiated goods

will be less subject to government intervention as they are more capable

of exercising their bargaining power.

21


d) Competition (De la Torre & Nectar, 1986) - the higher the level of

competition (and consequently, alternative sources of capital and

technology) the higher the probability of government intervention.

2) Corporate factors

a) Size (Shapiro, 1981) - with the smaller firm, the asset gain fails to out

weight the loss of confidence and hostile reaction amongst the worlds

financial community:

b) Nationality (De la Torre & Nectar, 1986)- the nationality of a foreign

investor is relevant to the risk factor, because it is subject to the quality

of the relations which the host country has or has had with the

investors home country.

c) Scope of Activities ( De la Torre & Nectar, 1986) and the Degree of

Vertical Integration with Other Affiliates (Shapiro, 1981) - the nature of

the companys activities and the geographic locations of its affiliates

may have a material influence on the level of risk (e.g. US firm does

business in Israel and Arabic countries)

d) Corporate Image (De la Torre & Nectar, 1986., Daniels & Radebaugh,

2001) - bribery scandals or a history of involvement in the financing of

political subversion can leave the company with a damaged reputation

for a long time.

e) Previous Losses (De la Torre & Nectar, 1986) - the relative bargaining

strength of the company can be assessed from those examples where it

avoided losses while most other firms did not.

3) Structural Factors

a) Contribution to the Local Economy (De la Torre & Nectar, 1986)- to

calculate the perceptible benefits to the local economy resulting from

the foreign firms involvement; the higher the benefits, the lower the

likelihood of government intervention.

b) Intra - corporate Transfers (De la Torre & Nectar, 1986)- the more

closely the affiliate or project is tied to the global network of the parent

company, the lower risk of an expropriation or interference.

22


c) Local Ownership (De la Torre & Nectar, 1986) or Composition of

Ownership (Shapiro, 1981) - the degree of the local ownership in the

foreign subsidiary is both the result of a bargaining process and a major

influence on the risk

d) Environmental Dissonance (De la Torre & Nectar, 1986) - the actual

location of the affiliate can have influence on the risk factor as it affects

the noticeable contribution to national development goals and it

exposes the firm to varying levels of population, ethnic, environmental,

unionisation or guerrilla risks.

4) Management Factors

a) Local Management (Shapiro, 1981., De la Torre & Nectar, 1986.,

Gilligan, 1987)- the use of local management to the largest extent

possible can help to reduce the risk exposure.

b) Corporate culture and Management Philosophy (De la Torre & Nectar,

1986) - the more complex and diversified the operations of the parent

company, the more likely it is that it will have to rely on the judgement

and skills of a managers with international experience, which helps to

reduce political risk explosure.

c) Political Responsiveness (De la Torre & Nectar, 1986). An activist

political role on the part of local management reduces risk. If an MNE

plays an active role in the host country is political life, it can lead to a

better relationship over the long term.

d) Financial Policies (Shapiro, 1981., De la Torre & Nectar, 1986) - the

excessive use of local sources of finance may greatly reduce the risks of

a host government is intervention.

As stated by Truitt (1974), Kobrin (1981) and backed up by De la Torre &

Nectar (1986) the areas of highest risk, traditionally the areas of foreign

investment, which are most vulnerable to expropriation, are natural resource

investments and public utilities. The developing countries demonstrated a

strong desire to increase their level of control over them. Investments in

extractive, export oriented industries and public utilities combine a peculiar set

of characteristics that make them vulnerable:

23


1) remote location, lack of general social responsibility on the part of the

developer, the instability of export prices (that is fluctuating foreign

exchange receipts for the host;

2) a large investment in exploration;

3) the exploitation of irreplaceable natural resources, which has political

significance and general visibility. Some of the largest and most spectacular

expropriations- Mexican Oil, Iranian Oil, and South American power and

communications- have involved natural resources and public utilities.

Step 1.4 Country Associated Risk

There are political risks in every country, however the level and ranges differ

broadly from one nation to another. De la Torre & Nectar (1986) identifies a

total of 22 variables or composite factors that must be monitored on an ongoing

basis, estimates of possible events, their probability of occurrence and the

expected timetable in order to succeed in assessing the countrys associated

risk:

Economic Factors- Internal

a) Population and Income - historical trends in the size of the countrys

population, its economic growth and per capita income provide an

approximation of the national welfare. When viewed against the recent

past, public proclamation about expected growth rates indicate the

potential disparity between the countrys aspirations and its capacity to

provide for its future

b) Workforce and Employment- the size and composition of the countrys

workforce, its sectoral and geographic distribution, its productivity.

Social instability and political risks, especially in developing countries

can result from the polarisation of the population into urban and rural

camps with different problems and priorities.

c) Sectoral Analysis- strengths and diversity of the agricultural sector,

importance of the industrial sector; who controls strategically important

sectors.

24


d) Economic Geography (natural resources)- the more dependent the

economy is on a single source of wealth, the less stable it is.

e) Governmental and Social Services- Are the basic needs (e.g., health

services, education, economic infrastructure, defence, etc.) adequately

covered? If revenues are highly volatile while expenditures consist of

inflexible social programs, any disorder to the revenue stream could

have rigorous political consequences.

f) General Indicators (e.g., price indices, wage rates, interest rates levels,

money supply, etc.)- the objective is not economic analysis per se, but a

search for indicators of trouble.

2) Economic Factors - External

The following set of questions serves to determine to what extent external

limits will determine domestic economic policy. A high degree of dependency

and instability, together with external debt servicing problems, will boost the

risk of host-government-interference with foreign investors in the country, both

in term of expropriation (macro risks) and convertibility (micro risks).

a) Foreign Trade - countrys current account balance and its

composition; price volatility of imports and exports; competitive

conditions; trade in services etc.

b) Foreign Investments - the size and importance of the foreign

sector, its distributions by sectors of industry, its spread by

country of origin.

c) External Debt and Servicing - the level of outstanding foreign debt

relative to GNP and export earnings; its maturity profile; the level

of debt service relative to national income and exports.

d) Overall Balance of Payments- the capital account, level and

changes in a countrys reserves; its liquidity situation.

e) General Indicators- the official and unofficial exchange rates,

their movements over time; the spread and terms which national

borrowers can obtain in international capital markets.

3) Socio-political Factors - Internal

25


a) Composition of Population - ethnolinguistic groups, religious

persuasion, or tribal and class components, their political activism and

the distribution of wealth and power among them.

b) Culture- an analysis of the underlying cultural values and beliefs of the

host society might hold the essential to insight, not so much of potential

instability, but of the probability that foreign influences (e.g., the local

affiliates of MNE) will be the first to suffer the consequences of any

potential disruption to the established regime.

c) Government and Institutions - comprehension of how the host country

system of government and its socio-political institutions work, or are

meant to work, is a key point in the analysis. To establish the principal

features of the constitutional order, the relative functions of the head of

the state, the government (prime minister, cabinet officers, agency

directors and other appointment officers), the legislative bodies and the

legal system, and the nature and structure of bodies, such as the law

enforcement agencies, the armed forces and the political parties and

similar organisations.

d) Power - who are the key decision-makers; their background and

education; their attitudes to critical issues and their relationship to each

other. What is the role of the internal security apparatus? What is the

influence of pressure groups such as trade organisations, labour unions,

army and mafia?

e) Opposition - the problem with assessing the strength of opposition

groups, their sources of support and effectiveness is the access reliable

and balanced information.

f) General Indicators - the level and frequency of strikes, riots or terrorist

acts, the number and treatment of political prisoners, and the extent of

corruption among local authorities.

4) Socio-political Factors - External

a) Alignments - to establish the countrys international position, its

principal political allies, its public position on global issues (e.g., global

terrorism, the Middle East, etc.) and its mutual dependencies. In this

26


context the examination of the United Nations and World Bank Data

may be useful.

b) Financial Support - this includes direct sources of economic support,

such as provision of financial aid, food and military assistance, in

addition to cases of de facto support by important economic and trade

connections.

c) Regional Ties - Border disputes, external military threats, the possibility

of the spill- over effect of nearby rebellious actions, etc. Can have a

profound impact on the domestic composure of government priorities.

d) Attitude Towards Foreign Capital and Investment - many of the rating

services (e.g., the United Nations and World Bank) maintain up-to-date

records of foreign investment flaws and decisions by local authorities,

courts and local chambers of commerce. They also conduct, on a

regular basis, polls on local attitudes toward foreign investors. This

information can be valuable in assessing trends when examining the

country.

e) General Indicators - human rights records as published by international

organisations such as Amnesty International, the existence of formal

and active opposition groups in exile, signs of diplomatic stress

between home and host country, and terrorists acts committed in third

countries etc.

For international firms, however the bottom line is not a comparison of

countries, but rather of investments; of risk and return. In pursuit of high

investment returns, MNEs assume political risk that cannot be accurately

measured but which can be managed (Liu & Bjornson, 1998).

27


Step 2: Developing Pre-investing Planning/ Crisis Planning

Shapiro (1981) points out that, given the recognition of political risk, an MNE

has at least four separate, though not necessarily mutually exclusive, policies

that it can follow:

1) Avoidance (Root, 1968., Haendel, 1975., Shapiro, 1981)- the easiest way

to manage political risks. However because all governments make decisions

which influence the profitability of business, all investments face some

degree of political risk. Therefore risk avoidance is impossible.

2) Insurance (Haendel, 1975., Shapiro, 1981., Madura, 2000) -is an

alternative to risk avoidance. Some governments provide their investors with

insurance programmes or investment guarantee programm, which cover the

risk of inconvertibility of assets, expropriation and war, revolution or

insurrection. For instance, the US government provides insurance through the

Overseas Private Investment Corporation (OPIC), which covers the risk of

expropriation. The US government insurance premiums paid by a firm

depend on the degree of insurance coverage and risk associated with the firm.

Another example is the Japanese government through the offices of the

Ministry of International Trade and Industry (MITI) which insures investing

companies against losses associated with commercial and political risks.

The World Bank has an affiliate called the Multilateral Investment Guarantee

Agency (MIGA) to provide the insurance against political risk for MNEs with

FDIs in less developed countries. MIGAs insurance covers expropriation,

breach of contract, currency inconvertibility, war, and civil disturbances.

Some host governments in order to encourage more FDIs provide their own

insurance programmes. Russia in 1993 established an insurance fund to

protect MNEs against various forms of country risks (Madura, 2000).

3) Negotiating the environment- defining the rights and responsibilities of

both parties, an investor and a host government prior to undertaking

investment. However, when the host government, changes then concession

28


agreements can become resented or unpopular, and may sometimes even

increase political risk (Liu & Bjornson, 1998).

4) Structuring the investment- structuring the investment is a more active

policy of political risk management than previous three. The firm can try to

minimise its exposure to political risk by adjusting (a) its operating policies in

the areas of production, logistics, export, and technology transfer and (2) its

financial policies by borrowing local funds (Madura, 2000)

The key element of the structuring investments strategy is to keep an

affiliate dependent on sister companies for markets and suppliers, one such

strategy is vertical integration (Shapiro, 1981., De la Torre & Nectar, 1986.,

Liu & Bjornson, 1998). Another element is to concentrate R&D facilities and

proprietary technology, or important components thereof, in the home country.

Furthermore, it is possible to establish a global trademark that cannot be legally

duplicated by a host government. Moreover, control of transportation

(shipping, pipelines and railroads) and sourcing production in multiple plants

reduces the governments ability to hurt the MNEs single plant and thereby

changes the balance of power between government and MNE. Finally,

developing external financial stakeholders by raising capital for a venture from

the host and other governments, international institutions and customers can

reduce risks dramatically.

After recognising the possibility of a change in government policy, the firm

must assess its consequences in the context of its investment. Political risks can

be incorporated in several ways, including:

a) Shortening payback period (Shapiro, 1981)- The MNE can maximise cash

generation for the short term.

b) Rising the Discount Rate (Shapiro, 1981., Madura, 2000)- If the perceived

risk is high in the host country, the investor can charge the high discount rate to

adjust project cash flaws. However there is no precise formula for adjusting the

discount rite to corporate country risk.

c) Adjustment of Estimated Cash Flows (Shapiro, 1981., Madura, 2000)- The

idea is to estimate how cash flows would be affected by each form of risk. E.g.

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if there is a 20 per cent probability that the host government will temporary

block funds from the subsidiary to the parent, the MNE should estimate the

projects present value under these circumstances, realising that there is 20 pre

cent chance that this will occur.

Step 3: Post-investment Policies/ Crisis Management

Shapiro (1981) states that once the multinational has invested in a project, its

ability to influence its susceptibility to political risks is greatly diminished but

not ended. He points out five different policies that the MNE can pursue.

1) Planned Divestiture (Shapiro, 1981)- MNE can phase out their ownership

over a fixed time period by selling all or a majority of their equity interest to

local investors. The disadvantages of this policy are: a) a difficulty to satisfying

all parties involved: an investor and a host government; b) if the buy out price

had been set out in advance and the investments were unprofitable, the host

government would probably not honour the purchase the commitment; c)

legislation in certain countries requires local ownership.

2) Short Term Profit Maximisation (Root, 1968., Robock, 1971., Shapiro,

1981)- is an attempt to make maximum profit from the local operation in a

short run by deferring maintenance expenditures, cutting investment to the

minimum necessary to sustain the desired level of production, limiting

marketing expenditures, producing lower quality merchandise. A disadvantage

of this strategy is that it can create a negative attitude in the present and the

future government towards an investor with all its resultant circumstances. An

alternative form of divestiture is to pursue a passive strategy, to do nothing and

believe that the local regime has chosen not to expropriate in case of losing

necessary foreign investments.

3) Adaptation (Root, 1971., Shapiro, 1981) is more a radical approach to

political risk management. This policy entails adapting to potential

expropriation inevitability and trying to earn profits on the firms resources by

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entering into licensing and management agreements. From the economic

perspective, legal ownership of property is essentially irrelevant, but what

really matters is the ability to generate cash flows from that property. Through

contractual arrangements, continuing value can be received from a confiscated

enterprise in at least three ways (Shapiro, 1981): a) handling exports as in the

past but under commission arrangements; b) providing technical and

management skills under a management contract; c) selling raw materials and

components to the foreign state.

These first three approaches relate less to managing the exposure to FDI for the

long term. The forth and fifth approaches relate to how the MNE makes its

investment and generates benefit streams for the host country.

4) Change the Benefit/ Cost Ratio (Shapiro, 1981) is a more active political

risk management strategy. The general idea of this policy is to increase the

benefits to government of not nationalising a firm affiliate and to increase the

costs if it does. In other words, to raising the cost of expropriation by

increasing the negative sanctions would involve control over export markets,

transportation, technology, trademarks and brand names, and components

manufactured in other countries.

5) Developing Local Stakeholders/ Joint Ventures (Root, 1971., Shapiro,

1981) is the strategy of developing local individuals and groups who have a

stake in the business while it continues existence as a unit of the parent

multinational. Potential stakeholders include consumers, suppliers, the

subsidiaries local employees, local bankers, and joint venture partners. This

strategy can substantially increase bargaining power over the government (De

la Torre & Nectar, 1986).

Section 4: Risk/Return Trade-off

Ironically, it is the case that many multinationals recognise that some of the

areas offering the greatest opportunities for growth and development, are also

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those areas in which the level of political risks are likely to be the highest

(Gilligan, 1987).

It is known that the expected returns from the emerging markets can be

impressive and these markets can be a highly risky and volatile (Harvey,

1994a). The return axis may be measured by potential return on assets or return

on equity. The risk may be measured by potential fluctuations in the returns

generated by each project (Madura, 2000). The term efficient project refers

to a minimum risk for a given return.

MNE can achieve more desirable risk- return characteristics form their project

portfolios if they sufficiently diversify among products and markets. For

instance by combining project A with several other projects, the MNE may

decrease its expected return. On the other hand, risks could be also reduced

greatly. Project portfolios outperform the individual projects because of

diversification of risks.

Conclusion

This chapter has had an objective to introduce the reader to the Political risk

related literature. Section one has been dedicated to the Theory of

Internationalisation. Foreign Direct Investments, as one of the alternative ways of

expansion into distant markets, has been reviewed. The benefits and flaws of Joint

Ventures have been discussed. The uniqueness of FDIs in the Oil Industry has been

stated.

Section two has debated the difference in terms between uncertainty and risk.

Section three has dealt with Political Risks. The types of political risk have been

introduced. Ways of minimising political risk exposure (risk recognition /

evaluation, development pre-investment and post-investment policies) have been

analysed. The final section of the chapter has given a brief overview of trade-off

between risk and return.

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From the analysis of International Trade theories, FDI theories and Joint

Ventures as a form of FDI, it is possible to conclude that there are many

reasons and advantages for companies in internationalisation. However, the

risks can seriously offset these benefits. International managers need to identify

and assess the risk they face on the way to internationalisation. Compared to

most types of economic or business forecasting, political forecasting remains a

very underdeveloped art; In spite of that fact there is a possibility to develop

and implement strategies, which allow the company to reduce the likelihood of

losses or at least lessen its amounts. Investors with projects positioned around

the world have to be concerned with the risk - return characteristics of the

project (Madura, 2000).

33



This chapter will outline the research methodology adopted for the purpose of

carrying out the dissertation. It is the authors intention to make it clear to the

reader how the data was collected and analysed. The research approach taken

was that of multiple case studies. These case studies are related to three

companies: Exxon Mobile (Exxon), Royal Dutch Shell (Shell) and British

Petroleum (BP). The objective of this chapter is to detail the research

methodology employed in this study and to give its limitations.

Section 1: Introduction in the Case Study Approach

With the purpose of this study, to attempt to understand the nature of political

risks in international investment environment and how firms deal with different

forms external threats, it was necessary to examine contemporary events and to

collect qualitative information. The research questions involve specific

objectives in examining complex issues of the relationship between foreign

company and business environments in a host county, and also in exploring the

perceptions and attitudes of managers to evaluating and minimising the

political risk exposure to their companies. In this instance a case study

approach was considered appropriate in providing a greater degree of

flexibility than that offered by other research methods in reply to the research

questions.

Furthermore, the subjective interpretation of relationship would not be suitable

for normative, numerically based data gathering and interpretation. Descriptive

and exploratory research was deemed more appropriate because the author is

interested in gaining insights into the general nature of the topic such as

dealing with different kinds of political risks. So, the nature of the topic should

involve the collection of rich qualitative data.

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Moreover, as it has been stated in the Introduction chapter, there is a rationale

in focusing on one industry. The oil industry is chosen. There are only a few

big private players in the extractive industry with interests diversified around

the globe and who at the same time conduct businesses in the same country. In

order to provide a multidimensional picture of a situation with political risk,

its assessment and management; it was decided to base the research on a

small-scale research (three cases).

Section 2: The Case Study Approach as a Research Strategy

The case study approach is one of the several research strategies which can be

Documents

Political Risk: An Analysis of the Oil Industry Investment Environment by Denis Parfenov [2002]