Trading political risk
IF YOU CAN measure it, you can trade it. The maxim, often quoted by traders in connection with derivatives contracts in weather and global emissions, suggests political risk could eventually be traded.
Developing a risk analysis and ranking database provided by IHS Energy Group, the Société Générale (SG) equity research team has indexed the political risk of BP, Shell, TotalFinaElf, Eni and Repsol YPF. SG's conclusion, that BP has the lowest overall political-risk ranking for future incremental production and Repsol YPF has the highest, is not as interesting as the implications of the methodology.
IHS started by dividing overall risk into:
Fiscal terms, weighted at 35%;
Exploration and production activity, weighted at 50%; and
Overall political risk, weighted at 15%.
Overall political risk is, in turn, subdivided into political risk (war, unrest, violence or stability), socio-economic risk (economic, energy, environment and ethnic) and commercial risk (investment, repatriation, contract terms).
The political-risk weighting is subjective, based on the analysis of a member of the Department of Political Science in Political Theory and International Relations at the University of Houston. Zero represents a risk-free situation and five a situation of maximum risk.
The analysis, which will be examined in more depth by Petroleum Economist in its October edition, throws up some quirky results. For example, if overall risk is considered, Norway and Nigeria are neck and neck at around 1.7, whereas, if political risk is isolated, Nigeria becomes the riskiest country analysed, with a rating of 3.6, whereas Norway falls to just over 1.0. The UK is more politically risky than, for example, Gabon, largely because of the frequent changes in UK fiscal terms.
SG has built on this analysis by looking at each company's exposure to each country and worked out the resultant risk profile.
SG concludes from a historical analysis of company risk profiles that shareholders' returns do not show a positive correlation with political risk. In other words, exploring in risky areas does not pay the dividends that might be expected.
The value of the analysis presupposes that the subjective evaluation of risk is solidly based and opinions of country political-risk indices will vary from pundit to pundit. The acid test would be if companies were prepared to 'buy or sell countries', based on the quantification of risk. This would involve unbundling political risk from assets and selling unwanted risk to market-makers or to companies prepared to take on additional risk for a fee as a method of raising revenue.
Derivatives contracts in political risk are no more far-fetched than existing derivative contracts in the weather. This raises interesting questions—are you a buyer or a seller of, say, Colombia at 2.6?