Risk Outlook Q3 2021

Executive summary

Commodity price rallies, fragile supply chains, shortages of workers in some industries and layoffs in others, and massive pandemic-related state spending programs are fuelling political instability –the effects of which may hinder economic growth and trigger dramatic developments in several emerging markets. Latent unrest, upcoming elections, and sudden changes in the legal framework, threaten investor participation in several geographies, from the low-risk to already-perilous markets.

The recovery of advanced economies is due to substantial public and private investments, as well as a restoration of business confidence that has gone hand in hand with vaccine rollouts. By contrast, a number of emerging countries, particularly in the southern hemisphere, continue to contend with problems that pre-date the pandemic, and therefore appear unwillingly bound to an unintended reset of their social and economic systems.

The political risk implications of a wide range of issues, from the transition to more sustainable practices in the power sector, to the vulnerability of supply chains of soft commodities (such as sugar and wheat), are impacting investors, traders, and payments. Assessing and proactively covering risk to protect strategic assets and investments, while premiums are still low and capacity is available, can be a timely move.

Table of contents:

• Power struggles and political risk implications in uncharted territories
• Oil and gas: Power competition increases tensions in the Asia-Pacific (APAC) region
• Ushering in an era of change
• Political risk clouds mining sector prospects
• High prices induced by legislation, fragile supply chains, and bottlenecks
• Mining sector developments in Chile, Sub-Saharan Africa, and the Philippines
• Soft commodities: Food, water, and conflict
• Ukraine and Argentina 
• The Indian crisis
• Central Asia 
• Summary: When it comes to commodities, risk is always as big as the planet

1. Power struggles and political risk implications in uncharted territories

Oil majors worldwide are under internal and external pressure to advance the green transition which is leading some to divest parts of their portfolios. The effect of this on national economies is likely to be mixed. Capital outflows will leave some governments and national companies with less liquidity and exposure to debt solvency. In other cases, however, commodity dependence and the very viability of strategic trade routes may leave some countries in a vulnerable position.

Potential threats:

• Interstate war
• Contract alteration
• Expropriation
• Non-payment

1.1 Oil and gas: Power competition increases tensions in the Asia-Pacific (APAC) region

The crude oil price plateaued in the first half of 2021, reaching a level three times that of early 2016. However, capital expenditure in the first quarter was 28% lower than in the corresponding quarter of 2020, and the second lowest amount for any quarter since 2016. Several reasons may have cooled investor interest in the sector, starting with a reduced appetite for fossil fuels. The green transition, whether ordered by national courts (as in the case of Shell) or encouraged by institutional investors and public opinion, has received a boost from rising oil prices. This allows companies to resist a drop in oil prices by reduced costs, while higher prices lead to positive cash flows (see chart below) and better returns for shareholders. On the other hand, capital expenditure remains subdued with possible long-term effects on crude oil future availability and prices.

One more traditional, and perhaps underestimated, cause is that extractive activity can attract a higher degree of political risk, often stirring latent territorial disputes. This has occurred in the Middle East and Africa, and also in South America, where there have been recent disputes over drilling for oil near the Falkland Islands. In recent months, however, developments in both US and Chinese foreign policy have unveiled an increasing level of political risk in Southeast Asia, a region that has been less affected by such perils in recent times. Not only is the territory a leading source of energy demand, it is also where the largest investment has been made since 2000.

In Southeast Asia, growing government and investor interest in climate change could mean that borrowers, whose green credentials are lacking, may be challenged by greenhouse gas policies and constraints on credit availability. The physical risks stemming from climate change, such as typhoons, floods, and bushfires, have increased. However, policy risks, stemming from the imposition of environmental policies by governments, and financing access risk, such as lenders and investors receding from high carbon industries, remain elevated. Technology issues, such as chip shortages, could impact issuers' operations in the short term, and their business models, in the long term. Meanwhile, the US-China strategic confrontation is persisting, with the latter seeking to use regional control as a crucial facet of its grand strategy.

Tense confrontation is increasing in the South China Sea, together with growing disturbances in coastal states’ domestic environments. These developments suggest that while the much of the world focused on the pandemic, the South China Sea became a flashpoint for the region, as Beijing sought to impose its “nine-dash line,” an unrecognised boundary drawn around 85% of these waters, through which US$3.4 trillion of goods pass each year.

Development of the Kasawari gas field, first discovered in 2011, serves as the origin of recent tensions. Located 4.3 nautical miles north of another gas field, both feed into the Malaysia LNG project at Bintulu. China Coast Guard (CCG) vessels frequently run excursions also in the Luconia Shoals, and are often deployed there for months. In June, CCG vessels challenged the start of Malaysian oil and gas operations near the Sarawak coast. Malaysia’s accusations indicated discontent at what they perceived as a disregard of international law by their Chinese counterparts. The tensions brought about by the presence of CCG ships, therefore, increases the scope of contract repudiation. The simultaneous deployment of air support demonstrates Beijing’s willingness to leverage parallel escalation and raises concerns about possible unintended consequences.

1.2 Ushering in an era of change

The oil and gas sectors in APAC countries are also undergoing what could be important changes. The region is moving away from a resource-based governance model – whereby resource owners are permitted to leverage their own tools in extraction – to a model where infrastructure takes center stage. In accordance with this model, economic capital is sourced from a diverse range of resource owners, using a tolling system.

The challenges surrounding global oil prices have also expedited the need to modify vertically-integrated ownership, as oil companies look to dispose of non-core assets. This has led non-traditional investors to engage with the hydrocarbon sector, buying up assets sold at heavily discounted rates. Accessing these assets will permit them to leverage the disruption of the ownership framework, and allow such investors to acquire specialist knowledge of the oil and gas sectors.

Despite the upsides of this sector, there are challenges to navigate. Due to the specialist knowledge required in upstream production, it is crucial that the operational risks associated with hydrocarbon projects are understood and managed. Governance, reputational, and environmental risks are intrinsically part of the oil and gas sector, while at the same time, the industry’s exposure to workplace hazards is high. In terms of operations, new investors will also require extensive negotiation skills should they look to adjust commercial arrangements to better align with their risk appetite. Environmental, social, and governance (ESG) issues are increasingly key considerations as the industry looks for more sustainable means of generation.

Confidence in regulations is vital too, as certain countries in the APAC region, can prove to be challenging to navigate for foreign direct investment. This is principally driven by the fact that state-owned oil enterprises are obliged to operate oil and gas infrastructure for the government. As investment shifts towards upstream infrastructure, the difficulties increase, as there is a marked discord in investments in offshore platforms, when compared to an onshore pipeline system. The cost associated with developing and operating offshore fields, and the need for processing crudes into value-added products, are common concern for investors. Furthermore, Southeast Asia is experiencing increased rates of urbanisation and greater reliance on electricity, which can be drivers for social unrest and civil commotion as higher demand and peak hours might affect availability and accessibility.

The growing middle class is likely to drive the demand for liquefied natural gas in the long term. As a result, governments in the region are pivoting towards an infrastructure-led economic recovery, post pandemic. The convergence of interests, with investors looking to acquire stable assets while resource owners seek to scale down their operations, has stimulated a market with great potential, and an investment environment that has the potential to become more viable for external actors.

2. Political risk clouds mining sector prospects

The mining industry is increasingly addressing ESG issues as a matter of urgency, as protection of natural resources continues to shape the global business agenda. According to the International Energy Agency, assuming a trajectory until 2040, consistent with meeting the Paris Agreement objectives on climate change, global demand for copper will rise by more than 40%, nickel and cobalt by 60-70%, and lithium by almost 90%. However, the mining sector is facing a number of controversial measures by national governments, increased sensitivity among the public, and demands from local communities, that might restrain the appetite of investors and raise concerns among lenders.

Potential threats:

• Strikes, riots, and civil commotion
• Contract repudiation
• Creeping expropriation

2.1 High prices induced by legislation, fragile supply chains, and bottlenecks

Prices for metals, such as iron ore and copper, reached all-time highs in the first half of 2021. This was due to the strong economic recovery, driven by government stimulus packages in many advanced economies, vigorous spending on infrastructure, and power generation in several emerging markets, as well as the resurgence of trade and economic activity. Prices are expected to remain strong in the second half of the year, as suppliers struggle to keep pace with the demand, and are challenged by stranded supply chains and transportation bottlenecks as COVID impacts continue to be felt globally.

In several countries there have been clashes over the use of subsoil and resources. At a time when the pandemic has widened the social and economic gap, and in an environment of mistrust of institutions, rising prices could be perceived as another failure to redistribute wealth. Strikes and roadblocks in key Latin American countries have slowed down activity in ports. The action has spread to other work forces, with unions demanding improved economic, social, and environmental conditions.

Most of the geographies with large-scale mining production, such as copper, share high susceptibility to the risk of strikes, riots, and civil commotion (see chart below). Chile, the Democratic Republic of Congo (DRC), Mexico, and Peru produce 54% of the world’s copper, and have 44% of its reserves. Their correspondent risk ratings for strikes, riots, and civil commotion is between 5.5 and 6.5 out of 10 – the highest risk – signalling the potential for policy unpredictability, contract frustration, and changes in legislation. Economic inequality, uneven access to welfare programs, and lack of trust in institutions are common traits that have worsened in the latest 18 months. These factors could ignite social unrest and spark additional tensions in countries that require macroeconomic stability, independence of supervisory bodies, and policy predictability in order to accommodate new investments.

2.2 Mining sector developments in Chile, Sub-Saharan Africa, and the Philippines

The National Congress of Chile is currently examining several opposition-led bills that could potentially affect the mining sector. The bills include the introduction of additional royalties on copper sales to finance social programs, and a limit on mine operations near glaciers. The national mining company, Codelco, has said the latter could put 40% of its copper output at risk. In the country, many large mining companies currently pay a flat or invariable royalties rate on copper, regardless of its price, under agreements that run through 2023. These contracts may be reviewed after the general election in November, with newly-elected authorities beginning their terms in March 2022.

Chile’s Constitutional Convention, whose members were elected in May 2021 in the middle of protests that shook the country, will also deal with access and exploitation of natural resources. Chile’s key mining regions, Antofagasta and Atacama, chose independent candidates that advocate sustainable mining and protection of natural resources. Mines located in these areas, include Escondida, the world’s largest copper mine, and Chuquicamata. Even if the present law prevents governors from reviewing contracts or cancelling concessions, they are likely to become more vocal against mega-mining activity, should it be perceived as hazardous for the environment or water supplies. This also increases the likelihood of appeals at a local court level and popular opposition.

In 2010, when President Sebastian Pinera was serving his first term, miners were persuaded to accept a temporary tax hike in exchange for the extension of tax stability agreements, after the country was devastated by an earthquake and tsunami. This time, there is a general lack of cohesion within the government at the moment to allow a cohesive approach to achieve equally productive negotiations with miners, and to address mounting pressure from the population.

As a consequence, contract repudiation risk in Chile is increasing, as is creeping expropriation in the Latin American region as a whole, particularly in Peru and Mexico. In Peru, despite the uncertainty caused by the electoral contention between Pedro Castillo and Keiko Fujimori, and related concerns regarding possible expropriations in the sector, the energy and mines ministry reported that mining investment grew by 8.3%, totalling US$ 1.7 billion, between January and May (compared to 2019).

Latin America will likely remain prone to political clashes and their spillover effects on the investment environment, but further turbulence may also occur in Sub-Saharan Africa and Southeast Asia, threatening agreed contracts and investment returns.

In June, Democratic Republic of Congo anti-corruption groups estimated that obscure deals in the mining sector, could amount to US$4 billion in lost revenue for the country. The government has initiated a round of terminations of contracts, to redress unfavorable economic conditions, agreed under previous administrations. Rising prices for commodities, such as copper and nickel, are likely to encourage governments to look to impose new royalties, but these are unlikely to impact production.

In the Philippines, the second-largest producer of nickel, a reform of the mining sector is set to enlarge mineral reservation areas, lift the ban on new permits, and impose additional costs for mining operations. The government is seeking to raise revenue, to address a widening budget deficit, which is forecasted at 9.4% of their GDP in 2021. In 2020, mining firms contributed to the national budget with an amount equivalent to 0.2% of the GDP. Similar developments may be replicated by governments in other countries in the area, in order to finance current spending and avoid undermining their popularity through tax increases.

3. Soft commodities: Food, water, and conflict

Price hikes in soft commodities and uncertainties on the supply side may affect the macroeconomic environment. A reduction in purchasing power is feeding anti-establishment discontentment, with some governments taking steps backwards, in terms of economic diversification, and diplomatic relations. Political risk arising from the ongoing conflict in the Black Sea and contract renegotiation in debt-distressed countries may have indirect consequences on other businesses.

Potential threats:

• Strike, riots and Civil commotion
• Legal and  regulatory risk
• Interstate War
• Legal and Regulatory Risk

3.1 Ukraine and Argentina

Political decisions and military escalations will shape the trading environment in highly remunerative and risky markets, such as Argentina and Ukraine. The free trade agreement between Ukraine and the EU has been in place for five years, contributing to the shift in destination markets, from Russia to Western Europe. Meanwhile, the Chinese appetite for Ukrainian crops has boomed in recent years, and the country is currently China’s top supplier of wheat, sunflower oil, and sunflower meal, which have overtaken metals and ores, as the main export products.

The start of a limited, long-awaited sale of farmland in July, is expected to boost Ukrainian harvest yields, just as food prices reach their highest point in almost a decade. Ukrainian citizens will be able to buy and sell up to 100 hectares a year. Trade by corporations could start in the near future. However, public opinion polls indicate low support for farmland sales to foreigners, a step that is to be decided by a referendum after 2024. The oligarchs’ influence on the market, as well as the regulator’s resolve to prevent consolidation of the land into large estates, are still to be tested. Delivering a healthy land market will be crucial for the country’s turnaround into an advanced, EU-oriented economy. Large investments are expected to have significant effects on prices, multiply international initiatives in the country, and challenge the slow and controversial judicial system. In addition, tight credit conditions and the limited (often zero) track record of local companies as long-term borrowers, expose the agribusiness sector to the dynamics of alternating periods of high and low levels of economic activity, which Ukraine is still subject to.

Shifting from metals to soft commodities has helped maintain a balance in Ukraine’s current account, but has done little to reduce the country’s trade reliance on maritime chokepoints. The entry of western, mainly Anglo-American, ships into the Black Sea increased after April 2021. However, in the days leading up to the NATO summit held on June 13-14, a US destroyer, Dutch frigate, and the British destroyer, HMS Defender, passed through the straits of the Dardanelles and the Bosporus on their way to the Ukrainian port of Odessa. On June 23, the Russian military fired cannonballs and warning bombs at HMS Defender, as it sailed close to the Crimean coastline. President Vladimir Putin subsequently signed a decree in July, granting Russia’s armed forces the right to block the Kerch Strait, connecting the Black Sea and the Azov Sea. The arrival of western ships symbolically marked the start of preparations for Exercise Sea Breeze, a multinational maritime exercise held every year since 1997. Warships from a record 32 nations attended this year’ gathering, which ended on July 10. Skirmishes near Ukraine could lead to a slowdown in the country's development plans, by diverting expenditure from long-term support to logistics and infrastructure, economic pluralism, and military reforms. Infrastructure is already under construction in the western coastal area of the Black Sea, so what appear to be ongoing threats in the Azov Sea, can be circumvented. The presence of so many navies in the area undoubtedly exposes Ukraine to the risk of unforeseen escalations, which could increase arrears, claims arising from pre-shipment guarantees, advance payments, and short-term credits. This situation could subsequently affect other coastal economies, such as Turkey.

Meanwhile, in Argentina, policy developments may put the maritime sector and trade at risk. The government has decided to sub-contract the dredging of the Parana River – the country's key grain export superhighway – for one year, while it prepares a longer-term concession. The decision raised concerns from private grain industry leaders, who opposed an increased role for the state, in the country's main logistics system. About 80% of the country's agricultural exports are loaded at Rosario ports, sent on cargo ships down the Parana River, before arriving at the shipping lanes of the Atlantic Ocean. The Parana River has made Argentina one of the world's most efficient food exporters. Cargo ships loaded directly at Rosario avoid using inefficient barges and trucking that delay shipping in Brazil and the US. However, recent protests by port construction workers in Argentina's key grain hub Rosario have snarled exports, with roads blocked at some of the key terminals. Protests have also taken place in 2021, in solidarity with workers laid off in related industries because of the recession, and as a consequence of the lack of access to vaccines. Several strikes started in March, May, June, and July, paralyzing exports, which brought into question the capabilities of the government to properly respond to these demands.

3.2 The Indian crisis

India’s move to expand ethanol blending in gasoline, as a way to reduce pollution and decrease oil import costs, could result in the biggest shakeup of global sugar production in the last 12 years.

By 2025, Czarnikow Group forecasts India will be making 27 million metric tons of sugar, down from 33 million metric tons. With domestic consumption today at around 25 million metric tons, and likely to grow in future, India would no longer be a leading surplus sugar producer and exporter. These developments could exacerbate further tensions over food prices in the country, require additional investment in already distressed areas of the agricultural sector, and increase global price volatility.

Forecasts indicate that GDP may rebound in 2021, following the largely unexpected 8% contraction in 2020, primarily driven by pandemic-induced measures. However, as COVID-19 infections continue to rise, the Indian economic recovery is likely to be compromised. The slow dissemination of vaccines, compounded with mutations of coronavirus, could dampen business sentiment as the fragile healthcare system contributed to the country’s inability to combat domestic outbreaks. The financial pressures in provincial households, poor rates of productivity, and an ever more stressed job creation environment combine to reduce the rate of economic expansion. Non-banking financial institutions have come under pressure recently, leading to increased scrutiny in retail lending and weaker consumption.

3.3 Central Asia

Lawmakers in Uzbekistan, Tajikistan, and Kyrgyzstan, are still negotiating the demarcation of borders, in what has proved to be a prolonged process. Crude oil, natural gas, and mineral wealth account for the majority of contested resources – although each nation also competes to access and control the rivers and canals in the region. Despite positive demographics and, in some cases, better-than average economic prospects, water scarcity is core to Central Asian diplomacy. Water related disputes have the potential to threaten long-term stability in the region.

Uzbekistan relies heavily on water for its agriculture sector that is primarily driven by cotton production. On the other hand, both Kyrgyzstan and Tajikistan have constructed multiple dams along the rivers flowing into Uzbekistan as they try to secure a reliable source of electricity. This is a long-standing policy position of both countries, that currently only produce around 10% of their hydropower potential.

Uzbekistan and Liechtenstein are the only countries in the world that are doubly landlocked. This means Uzbekistan needs harmonious relations with its neighbours, in order to be able to trade abroad and supply goods to its population, which is the largest in the region and 1.8 times that of Kazakhstan, a much larger territory.

Tajikistan and Kyrgyzstan produce around 90% of their electricity from hydropower. The Amu Darya and Syr Darya rivers, both of which are tributaries emanating from Kyrgyzstan and Tajikistan, are sensitive to seasonal droughts, while blackouts are commonplace in these upstream countries. 

In April 2021, a border conflict erupted near Vorukh, a Tajik enclave located within Kyrgyzstan. Both sides had laid claim to a reservoir and pump station, situated by a river. The conflict resulted in over 50 deaths and the displacement of more than 40,000 people. In March, Uzbekistan signed an agreement with debt-distressed Kyrgyzstan to retain control over some important irrigation infrastructure, and limit further development of water infrastructure that would divert flows. The Orto-Tokoi reservoir was recognised as Kyrgyz territory, but Uzbeks will be able to make free use of it to irrigate their fields. A peaceful management of these disputes will help Uzbekistan prevent its economy from overheating, at a time of large investments and growing public debt, which has doubled in two years and is expected to surpass 40% of GDP in 2021. Conversely, it is likely that an escalation of local quarrels could be used by neighbouring countries as a means of putting pressure on Tashkent and of getting access to additional economic aid. 

When it comes to commodities, risk is always as big as the planet

Climate change, adhesion to ESG standards, and policy developments increase the risk environment for commodities. These factors interlink political risk at all levels.

The main political risks in the short- and mid-term are sudden and arbitrary changes in both tax and operational regulation, expropriation, transfer and convertibility, and political violence. An escalation of personal violence, flash mobs and riots into internal conflict, institutional crisis, or conflict, is therefore likely.

Meanwhile, trade bottlenecks and cyberattacks on physical infrastructure leave policymakers and enforcement agencies with little capability for prevention or intervention. Fragile supply chains are also being addressed through import-substituting industrialisation, as took place in countries subject to international sanctions, resulting in impacts on global production and supply of certain materials, components, and trade flows at large.

Production and trade bottlenecks may lead to an increase in credit risks, such as non-payment, requests to extend maturities, and an overall deterioration of the customer base. Financial facilities could be introduced, requiring additional pre-shipment and advanced payment protection to shield businesses from logistical disruption.

The probability and global impact of these developments levels the playing field when it comes to risks. When it comes to commodities, the potential butterfly effect from unexpected disruption in distant countries is worth covering at an accessible price.