Integration Of Sudden Expropriation Risk Into Project Economics
Authors: Mustafaoglu Mike M. 
Published: December 2007

The evaluation of international petroleum investments requires the assessment of economic impact of political risk events on project profitability in political risk events on project profitability in addition to other conventional risks such as the geologic, price, and cost uncertainties.

An applied procedure is presented in this paper that utilizes the discounted cash flow theory and the concept of expected present worth under uncertain timing to arrive at an expropriation risk adjusted present worth. The use of expropriation risk adjusted present worth. The use of expropriation risk adjusted present worth in decision making is illustrated within present worth in decision making is illustrated within the portfolio and utility theories. A hurdle rate that, in practice, most often is arbitrarily assigned by managers is derived based on the expropriation risk adjusted present worth. Finally, the ranking of projects, the strategic options (such as the cost of projects, the strategic options (such as the cost of political risk insurance and unconventional financing political risk insurance and unconventional financing modes) are explored using the expropriation risk adjusted present worth. A real life example that illustrates the concepts iterated above is given also.

Introduction

Sudden expropriations have been the culminating events in the efforts of countries whose substantial natural resources were controlled by foreign companies in asserting their economic self-determination. Starting with the Mexican takeover of the U.S. oil companies in 1938, the American natural resource companies operating overseas have been subject to a series of expropriations in the recent past. Lately, the most significant development has been the achievements of the Organization of Petroleum Exporting Countries (OPEC). OPEC's success not only has given its members a tremendous influence in world politics, but it also has made it possible the politics, but it also has made it possible the achievement of national economic goals previously beyond reach. Having seen this dramatic change, a multitude of less-developed countries now envision the control of their natural resources as a precondition to economic independence. Thus, the evaluation of international petroleum investments must explicitly take into account the risk of sudden expropriation along with the geologic and economic (prices, costs, etc.) risks that have been evaluated traditionally. Although the immediate impact of expropriations without or partial compensation is the write-off of the company's equity in the foreign venture, a far more important impact generally is the loss of future profits. For these reasons, the risk of expropriation without or partial compensation should be one of the partial compensation should be one of the determining factors in foreign investment decisions.

Despite the usefulness of political risk forecasting and analysis, there has not been rigorous research done on the subject. Stobaugh used event trees to analyze political risk. However, his methodology suffers from forced oversimplification since it would require probability estimates difficult to provide, to obtain a probability tree that represents a comprehensive set probability tree that represents a comprehensive set of risk events affecting a project. Also, no guidelines are provided for handling the time dependencies between events.

Van Agtmael, Blasch and Cummings, and some service publications advocated the use of a checklist methodology in assessing political risk. In this approach the factors that can affect the project profitability, such as domestic stability, project profitability, such as domestic stability, remittability of earnings, inflation rates, material supply, infrastructure, and bureaucratic red tape, are listed and assigned judgmental weights, thus resulting in an index for each country. The checklist methodology suffers from several drawbacks. It has no theoretical justification for the inclusion or exclusion of variables into the list. The scaling and measurement process is arbitrary. Also, the checklist does not have a time dimension; thus, it is static. A checklist approach presents a standard procedure for evaluation of political risk. For this reason, it can impair the creativity of the analyst and the decision maker. The resulting country risk index involves a large element of arbitrary subjectivity, and generally does not take into account specific project factors. So, the index cannot be a substitute for in-depth environmental and economic analysis.