Political risk insurance as an instrument to reduce oil and gas investment risk and manage investment returns

Abstract

New oil and gas supply projects are increasingly taking place in non-OECD countries, where the rule of law and the sanctity of contracts are often not as well developed as in OECD countries. The oil and gas industry faces increasing political risk at the same time that oil prices have become more volatile and project costs have escalated, sometimes squeezing margins. The exceptionally high capital intensity of the oil and gas industry makes companies particularly vulnerable to political risk. MIGA, the Multilateral Investment Guarantee Agency of the World Bank, in its World Investment and Political Risk 2011 report, broadly defines political risk as ‘the probability of disruption of the operations of companies by political forces and events, whether they occur in host countries or result from changes in the international environment. In host countries, political risk is largely determined by uncertainty over the actions not only of governments and political institutions, but also of minority groups and separatist movements’. The essence of this definition focuses on the risks arising from the adverse actions—or inactions—of governments. Political risk includes, for example, currency convertibility and transfer restrictions, expropriation, civil unrest, war and terrorism, breach of contract and non-honouring of sovereign financial obligations. Energy investors are understandably concerned that returns on projects in emerging markets could suffer as a result of political changes or instability in the host country. In 2010, a survey of the US Energy Industry conducted by the Aon Corporation, a leading global provider of risk management services, insurance and reinsurance brokerage, ranked political risk among the top five challenges facing the industry. The survey also revealed that most companies are not properly prepared to assess and mitigate political risk. Political risk insurance (PRI) is a relatively recent innovation in positioning companies to reduce oil and gas investment risk. This article explores how PRI can be used to mitigate risks in the oil and gas sector when conducting business across borders, thus helping to manage investment returns. The article discusses a comprehensive case study of the Chad–Cameroon Petroleum Development and Pipeline Project to highlight the various facets of political risk and how these can be mitigated.