Profit from the government grab for oil and commodities
Big oil companies and miners are under pressure from tax-hungry governments. But this is creating opportunities for smart investors, says James McKeigue.
Last month, the small town of Rustenburg in South Africa erupted in angry protest. Throughout February, miners had been complaining about pay. But suddenly the protesters turned violent and attacked local mines with axes, burning tyres and rocks. They were joined by neighbouring villagers, who are unhappy with high unemployment and low living standards.
Why did they target the mines? Because while the poverty above ground is all too obvious, beneath the soil the region has vast riches. South Africa is home to the world's greatest mineral wealth worth an estimated $2.5trn at present prices which several local and multinational mining companies are busy extracting. That's what annoys the protestors. They feel that mining corporations are taking natural wealth that belongs to South Africa and not giving back enough in return.
They're not the only ones. The sentiment is shared in resource-rich countries across the globe. The rebound in the price of most commodities since 2009 has boosted the profits of the private-sector companies that extract and process them.
Subscribe to MoneyWeek
Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE
Sign up to Money Morning
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
It hasn't taken long for governments to decide that they want a larger share of those profits. In a recent report, Ernst & Young highlighted resource nationalism' as one of the biggest threats to the mining industry. It also found that in the past 18 months, 25 countries have either said that they plan to increase mining-related taxes, or have done so already.
Resource nationalism is also growing in the energy sector, where governments feel they haven't benefited enough from rising oil prices. They have responded by raising taxes and royalties and supporting national oil companies (NOCs).
The increase in resource nationalism is, of course, making life difficult for miners and oil companies. But like any disruption, it is also creating opportunities for nimble investors.
A long history of nationalisation
Resource nationalism is nothing new. The earliest example in the oil industry came in the 1920s, when the Bolsheviks nationalised the Russian holdings of the Nobel family. A few decades later, Mexico followed suit when it ejected Western companies and seized control of its own oil fields in 1938. Yet neither example encouraged much faith in nationalisation.
In the years following Mexico's move, Venezuela's socialist government came under pressure to nationalise its oil industry. But President Romulo Betancourt refused, shrewdly noting that his government made more per barrel of oil by taxing an efficient private industry than Mexico did from owning everything.
In the 1960s, international oil companies still controlled the majority of global oil reserves and production. But as demand increased and the oil market tightened, prices rose and governments in producing countries began to renegotiate contracts. Rising demand also meant that the oil companies could no longer threaten to close markets to countries that bargained too hard. There would be a buyer for oil, regardless of whether a particular company marketed it or not.
Eventually, the combination of regional politics and rising prices led to the nationalisation of the Middle East's oil reserves in the mid-1970s. Unlike previous nationalisations, this changed everything. It proved that resource-rich countries didn't need to rely on Western firms to handle production.
Of course, big oil companies still had plenty of technical know-how to sell to the Middle East, but if companies wanted to top up their reserves, they had to look elsewhere. So they went off and found new oil, though none was as abundant or easy to harvest as that found in the Middle East.
With the low oil prices of the 1980s and 1990s, resource nationalism went out of fashion. However, now largely buoyed by a decade of rising prices it is starting to re-emerge.
The first indication came in Russia in 2006, when President Vladimir Putin forced private companies to sell discounted stakes in lucrative projects to newly empowered NOCs. Then in 2010, Brazil revealed a new oil framework that gave its NOC, Petrobras, the operating rights for all fields in oil-rich pre-salt area.
Given their booming economies and rising confidence, it is perhaps unsurprising that Brazil and Russia felt they could change the rules of the game. But now lots of other oil producers appear to be following suit and that would leave private oil companies which now control less than 20% of the world's oil with nowhere else to go.
According to risk analysis firm Maplecroft, almost half of global oil production takes place in countries with a high risk of resource nationalism. The firm's associate director, James Smither, says the trend is increasing, because commodity prices are generally high at a time when many governments are strapped for cash.
The Arab Spring' has also encouraged resource-rich countries in the Middle East to spend more on social programmes. Even countries that have always welcomed oil firms are trying to claw back more tax. For example, last year Chancellor George Osborne raised taxes for producers in Britain's part of the North Sea.
Another factor is the changing perception of commodities, says US energy analyst Gregor Macdonald. "Issues surrounding resource nationalism are not new. What is new is scarcity rent' the growing awareness among sovereigns that the resources are scarce. As [they] become increasingly aware that their gold and oil and copper is not merely trading at higher levels, but rather, will be trading at or above those levels from now on, that will change their dealings with resource extractors."
Big oil is facing hard times
All of this makes life more difficult for private-sector oil firms. If the government in question decides to go down the Osborne route' and raise taxes or royalties, it cuts profit margins for oil companies and hits investors. If, instead, the government opts to build a NOC, it creates another problem for the largest firms, known as supermajors' or big oil'. In some cases the NOCs are inefficient or corrupt, and working with them is a blow to profits. Or, even worse, the NOCs become serious competitors.
"They have pockets deeper than any well," says The Economist. "And after years of working with the supermajors, their technical expertise is growing. Norway's Statoil is a match for almost anyone. Brazil's Petrobras is developing its own technologies to exploit ultra-deep water. Both are forming partnerships with other state-backed firms."
These new NOCs are happy to work with oil firms, but given that they now control 80% of the world's reserves, they do so on their terms. Because NOCs focus on the biggest projects, they are more of a challenge to the supermajors than the smaller oil firms, known as juniors or independents, that are left to develop smaller, less glamorous fields.
The growing clout of service firms is also eating into big oil's market share. A spate of mergers, acquisitions and listings have created large oil services groups that can offer many of the services that were once the preserve of big oil. Many service firms are less exposed to resource nationalism because they are paid on a contract basis for the work they do, whereas supermajors invest huge sums in the beginning and then wait ten or 20 years for it to pay off.
Many industry watchers feel that the traditional model of a large integrated oil company that can boost its reserves is coming to an end. "This renders big oil to the role of banker, the unwitting provider of capital who certainly has production skills to offer but mostly is looking to obtain a royalty. This is further pressured by the fact that there simply are no more large projects anywhere, that are easy to invest in, at a time when big oil is essentially in liquidation as it cannot replace its own reserves," says Macdonald.
Resource nationalism is also putting pressure on mining companies. Every year Ernst & Young surveys the 30 largest miners to gauge their perception of the largest threats facing the industry. In recent years, resource nationalism has risen from ninth place to become the top worry.
Perhaps surprisingly, one of the first countries to act was mining-friendly' Australia, announcing plans to raise mining taxes in 2010. One of the biggest producers of many minerals, Australia has traditionally attracted the huge amounts of investment needed to develop its resources by creating a stable tax regime for miners.
But a strong run in commodity prices meant that the government's share of mining profits fell to 15% in 2008-2009 from 40% in 2001-2002.
Australia's move sent a strong signal to other mining countries. For example, Anglo American is currently locked in a legal dispute with Chilean state miner Codelco. Codelco is insisting that Anglo sell a 51% stake in the world's fifth-largest copper mine. Meanwhile, in South Africa, there are calls from more radical members of the ruling ANC party to nationalise the industry. A recent report commissioned by the government advised against full nationalisation, but suggested a 50% windfall tax on super profits and a 50% capital-gains tax on the sale of prospecting rights.
Many other African countries are also weighing up changes to their tax and royalty system, and some recently sent delegations to Australia to learn about its mining tax. That's a worry for miners. Ernst & Young says seven of 2011's biggest mining deals took place in Africa, and the continent is widely believed to have the greatest remaining mineral potential. Even if miners go elsewhere, they are unlikely to receive a better reception. For example, just last week Indonesia, the world's largest exporter of thermal coal and tin, announced it would force foreign firms to sell at least 51% of their domestic projects to local firms.
The mining industry is defiant. Cynthia Carroll, Anglo American's chief executive, has warned that "mining companies simply will not invest if they cannot be assured that the assets they create will be secure. In ignoring this truth, the false prophets who argue for nationalisation are advocating the road to ruin".
But given the widespread nature of the trend, it is hard to see how a large miner with a big project portfolio can avoid it. Luckily, it's easier for investors to move their money than for companies to move a mine. We go through the best ways to play resource nationalism below.
The best ways to play resource nationalism
Many countries are now less willing to share their reserves with oil firms. As a result they prefer to get their own national oil companies (NOCs) to work alongside oil-service firms who ask for cash payment, rather than a share of reserves. The percentage of oil and gas production in such countries, which is under service contracts, has grown from 0.1% in 2000 to 4% in 2010 and is expected to hit 11% by 2020.
One beneficiary of this trend is UK-listed oilfield services firm Petrofac (LSE: PFC). It designs and builds oil and gas infrastructure wells, pipelines, processing plants etc and also operates and maintains assets.
The group has a strong focus on servicing NOCs and last year appointed ex-BP executive Andy Inglis to head up a new energy services division to win more business with them. It has also won favour with NOCs by creating a division to offer training and technology transfer to local workers.
The firm now has contracts with government oil firms in Latin America, Asia and the Middle East, which helped to drive sales up 33% in 2011, and profits up by 25%. "Petrofac is better at winning contracts with NOCs than its competitors," says Fox Davies Capital analyst Paul Singer. "The constant repeat business with NOCs is driving profits." With a $10bn order backlog, the company's prospects look bright. On a forward p/e of 12.4, it is cheaper than many of its peers and offers a good way to play the rising power of the NOCs.
If you don't want to expose yourself to the risk of investing in one company, you can gain exposure to a basket of oil-service firms through an exchange-traded fund (ETF). Market Vectors' OIH ETF tracks the Oil Services Index (OSX) a group of 18 American oil-service firms. With a 0.47% expense ratio it offers a cheap way to invest in service firms, but bear in mind that it's listed in dollars so you are directly exposed to currency risk.
Many private investors may not like the rise of the NOCs but, as the old adage goes, if you can't beat them, join them'. As we mentioned last week, we like Norway's NOC, Statoil. Another promising option is Chinese firm CNOOC (HK:883).
The state owns 64% of the company, with the rest listed on exchanges in Hong Kong and New York. It is the smallest of China's three state-owned energy outfits, but has exclusive rights to develop the country's offshore oil resources.
International firms are allowed to prospect for oil and gas in offshore China but CNOOC has the sole right to acquire at no cost a 51% stake in any successful discovery. Will Riley, co manager of Guinness Asset Management's Global Energy Fund, is a big fan of the stock. "The South and East China Seas have massive oil and gas potential. They have not been fully exploited and should yield major discoveries."
The firm is also active outside of China. It is one of the largest producers of Indonesian offshore oil and has also bought stakes onshore in Canada and Argentina.
The danger with state-owned firms is that they are directed by politics, not what's best for shareholders. Yet in this case, the interests of both coincide, as the Chinese government is eager to boost production.
Moreover, teaming up with Beijing has its advantages. China's growing might means that its operations in other countries, such as Indonesia, are unlikely to come under pressure from resource nationalism in those countries. Considering the massive upside potential of a discovery in China's offshore sector, CNOOC looks cheap on a forward p/e of 9.2.
China's stranglehold over the global production of rare-earth metals' is another form of resource nationalism. The US, Japan and Europe have banded together to complain to the World Trade Organization about the country's restriction of exports of these crucial metals.
Yet this is a huge opportunity for rare-earth miners outside China. Take Australian miner Lynas Corp (ASX: LYC). Over the last few years the stock has soared and slumped as the miner worked to establish a rare-earths mine and processing centre.
It is now on the brink of opening the world's first new integrated supply source of rare earths outside of China. Its main asset is the Mount Weld mine, the richest rare-earth deposit in the world. Production has started and the first batch is ready to be shipped to the processing centre that is being built in Malaysia.
Unsurprisingly, customers have already been lined up to take delivery of its production. Clearly, investing in companies that have not started full-scale production yet is a risk, yet Lynas is very close, and assuming there are no more hitches, and with China unlikely to back down over rare earths, Lynas looks worth a punt.
Sign up to Money Morning
Our team, led by award winning editors, is dedicated to delivering you the top news, analysis, and guides to help you manage your money, grow your investments and build wealth.
-
Review: The Store, Oxford – purveyors of excellence
MoneyWeek Travel The Store is a luxurious, new hotel in Oxford that has set up shop in a former department store in the heart of the city
By Chris Carter Published
-
Seven ways the Budget could hike inheritance tax or capital gains tax at death
Chancellor Rachel Reeves could target death taxes by raising IHT and/or levying CGT on inheritances. We look at some potential moves in the Autumn Budget
By Ruth Emery Published