Stratford - Mexico, iraq y algeria by Roberto García

BUSINESS-RISK ASSESSMENT: Mexico, Iraq and Algeria

Oct. 20, 2010

STRATFOR 700 Lavaca Street, Suite 900 Austin, TX 78701 Tel: 1-512-744-4300 www.stratfor.com

BUSINESS-RISK ASSESSMENT: Mexico, Iraq and Algeria Editor’s Note: The following is an assessment of the political, economic and security risks associated with investing in business operations in Mexico, Iraq and Algeria and how those risks may change over the next six months. The specific focus is on the energy sector in each country, including its current state and pace of development and the regulatory environment. Our conclusions overall are that Algeria currently offers the most promising investment climate, while Mexico offers the possibility of an improved climate over the next two or three years and Iraq will remain the least promising until a durable and sustainable government can be formed.

Mexico Political Environment Mexico’s political environment can be summed up in one word: stagnation. Ironically, the political paralysis Mexico has experienced over the past decade is the result of a radical political transformation. The center-left Partido Revolucionario Institucional (PRI) lost its 71-year monopoly on power in the 2000 presidential election when it was defeated by the center-right Partido Accion Nacional (PAN). Since the 2006 presidential election, the PAN has retained executive authority through Mexican President Felipe Calderon, while the legislature has been divided among the PRI, PAN and the far-left Partido de la Revolucion Democratico (PRD), which split from the PRI in the late 1980s. The PRI and PRD are strongest in Mexico’s central and southern states while support for the PAN is concentrated in the northern and central states. Traditionally, power in Mexico had been concentrated in the executive branch. Political reforms in the late 1990s and the turnover to the PAN in 2000 created a situation in which the Congress was strengthened at the expense of the executive, but this also opened the way to more competition in a body that lacked experience in consensus-building. The result, unsurprisingly, has been severe political gridlock on nearly all fronts. Also, a major issue complicating Mexico’s political system is the existence of single-term limits for politicians, a relic of the Mexican Revolution, when revolutionaries sought to prevent despots from holding power indefinitely. As a result, Mexican politicians enter office already searching for their next job, there is little accountability for their policy decisions and they have little incentive to move ahead with political or economic reform. There has been discussion of removing the single-term limit, but no such reform can be expected in the near future, particularly with elections approaching. Electoral Landscape Ahead There are two elections on the horizon: the 2011 gubernatorial elections and the 2012 presidential election. The PRI is eager for a comeback now that Mexico has undergone two terms of stagnant PAN rule and has seen the level of violent crime in the country skyrocket since December 2006, when Calderon declared war on the drug cartels. However, the PRI now faces a more strategically, though not ideologically, unified opposition. After a contentious showdown in the 2006 presidential election, alliances formed between the conservative PAN and the left-wing PRD during 2010 municipal elections, though the results from these alliances have been mixed. The PRI held constant, winning a total of three seats from the PAN and PRD while losing three seats to the alliance. The PRI’s losses, however, were more significant than its wins; it yielded the strongholds of Sinaloa, Puebla and Oaxaca, which the party had held for eight decades. More recently, the PAN and PRD began formally discussing allying with each other in 2011 gubernatorial elections, raising suspicions that the unlikely partners would maintain their alliance for the 2012 presidential race. The gubernatorial races in Guerrero, Nayarit, Michoacán, Baja California Sur and Estado de Mexico (aka Edomex, short for “State of Mexico”) may prove a good test for the

viability of the alliance in the race for the top office. A key race to watch in determining the trajectory of the 2012 election is the upcoming gubernatorial race in Edomex, where the current governor is PRI member Enrique Peña Nieto. The charismatic Peña Nieto is widely believed to be a front-runner for the presidency and enjoys a wide base of popularity. A PAN-PRD alliance would aim to unseat the PRI in one of its key strongholds and undermine Nieto’s popularity ahead of national elections. Anticipating such an alliance for the national elections, Nieto is finding new, more creative tactics to break up this rival pact. The state legislature on Sept. 15 voted in favor of abolishing a law that allowed multiple parties to put forward a common candidate. This move will help Nieto undermine a PAN-PRD agenda to unseat him in upcoming gubernatorial elections. The political scene remains in flux as PAN and PRI heavyweights compete for PRD votes. Meanwhile, the PRD itself is experiencing internal tension, with firebrand politician Andres Manuel Lopez Obrador, who barely lost the presidential election in 2006, condemning his PRD colleagues for aligning with the PAN. Also, PRD founder Cuauhtémoc Cárdenas also has spoken against PAN-PRD alliances, saying the parties have contradictory goals. Ultimately, the PRD and PAN do share one political goal -- preventing the PRI from dominating the political scene as it did until 2000. Regardless of who emerges as president in 2012, the next Mexican government is unlikely to break free from its current paralysis. Neither the PRI nor PAN is expected to win a large majority in the Senate, the Chamber of Deputies or more than half of Mexico’s state legislatures, where critical reforms could be pushed forward. Hence, the potential for political instability lingers. Obrador, in particular, is prone to resort to widespread blockades and protests to contest election results as he did during his 2006 presidential run in his home state of Tabasco, a stronghold for the PRI and PRD. Obrador has a history of organizing “civil resistance” movements when he loses in elections and has led groups of supporters to block the entry to several oilrigs and other Pemex facilities in Tabasco for several months. He also has staged demonstrations and protest caravans to Mexico City. Though Obrador gained a lot of visibility through these actions, his support base has weakened since the 2006 election fallout. Challenges to the Country’s Leadership Currently, the political agenda in Mexico is dominated by violent crimes associated with the government’s war with the drug cartels, declining oil production and a narrowing tax base (discussed further in the Economic Environment section below). With the possible exception of the cartel war, there is little reason to expect much movement on these issues at least for the next two years. While pitching policy proposals of its own to appear constructive, the PRD will use its current majority position in Congress to block legislation on key issues and try to portray the PAN-led government as ineffectual in the lead-up to national elections. In looking at the path to the 2012 presidential race, it is important to note that Calderon must bring down the level of cartel violence well before voters go to the polls if he wants the PAN to have another chance at the presidency. Mexicans are, by and large, worn down by the war and do not see the struggle as having been worth it. Much of this has to do with a general abhorrence of the war’s violence, but there is also a critical economic factor to consider. An estimated $25 billion to $40 billion flows into Mexico annually from the sale of narcotics, most of which are sold in the United States. This estimate is likely quite low, but it is still a staggering amount when considering the enormous profit margins made on each sale. This money makes its way into the Mexican financial system, providing valuable liquidity. Indeed, Mexico was one of the few countries during the global financial crisis in 2008 that was able to continue making loans for commercial real estate. It follows, then, that the Mexican leadership has little appetite for sustaining high levels of violence or stemming the flow of drug money into the economy. This is the time for Calderon to shape a political exit strategy from the cartel war (to be discussed in the Security Environment section below).

Economic Environment With a large and growing population and a massive market across the border in the United States, Mexico boasts the world’s 13th largest economy in nominal gross domestic product (GDP). Mexico’s ongoing recovery from the 2008 global recession is tightly linked to that of the United States. Mexico’s current GDP growth has been averaging 4.6 percent but month-to-month growth remains weak, with the biggest declines in construction and mining. Foreign direct investment (FDI) fell to $12.52 billion at the end of 2009, down from $23.68 billion in 2008. Throughout the crisis, Mexico acquired ample foreign exchange reserves ($103 billion through July 2010) to help cushion itself against further volatility in the markets and, as a precaution, obtained a $47 billion credit line from the International Monetary Fund that has been renewed until April 2011. Mexico’s export economy relies heavily on manufacturing (80.9 percent of 2009 export earnings), followed by oil (14.8 percent) and agricultural products (3.6 percent). Since the signing of the North American Free Trade Agreement (NAFTA) in 1994, the Mexican economy has become tightly linked to that of the United States, with most U.S. FDI flowing into the manufacturing sector. Challenges and Constraints Mexico faces a persistent problem with capital shortages. This is not due to lack of foreign investment but is more of a reflection of constraints in the political system, entrenched corruption, structural limitations in public finances, declining oil revenues and a narrow tax base. Slow internal development has fueled migration from Mexico to the United States, making remittances a critical part of the Mexican economy. Remittances average around $20 billion annually, but there is a serious question as to whether that money is being reinvested in a productive manner in Mexico. Mexico’s tax base, which stands at 10 percent of GDP, remains critically low because long overdue tax reforms have stalled in Congress. The country’s highly distorted tax system also allows ample room for evasion, undermining the country’s fiscal stability. Some reforms have been passed under Calderon to widen the tax base, including a move to give states more power to raise local revenue and increasing transparency and accounting in the tax system. A value-added tax (VAT) of 16 percent applies to the sale of goods and services, while a reduced 11 percent VAT applies to the sale of goods and services within 20 kilometers of Mexico’s borders with the United States and Guatemala. Exports are exempt from the VAT. The Impuesto Empresarial a Tasa Unica (IETU) law created a business flat tax (now at 17.5 percent) to try and simplify the tax system and remove special tax regimes, but taxpaying in Mexico is still very cumbersome. Since the IETU runs parallel to an existing 28 percent corporate income tax, businesses have to pay the higher of the two taxes. The government has introduced an electronic payment system for payroll, property and social security taxes as well as for company registrations. Mexico’s energy and power sectors also impact its economic health. The world’s sixth-largest oil producer, Mexico depended on oil income for roughly 31 percent of total public revenue and for 14.8 percent of export revenues as of 2009, making the country extremely vulnerable to global price shocks in the oil market. Oil production peaked in 2005 and is now steadily declining, which means Mexico’s biggest challenge is creating new sources of revenue. National oil company Pemex is not financially capable of offsetting this decline, and delayed energy reforms have hampered private and foreign investment in the energy sector to increase the exploration and development of deepwater offshore oil reserves in the Gulf of Mexico. Energy reforms passed in 2008 created a new tax regime that sets different tax rates for oil fields depending on risk, exploration and production costs. The reforms also legalized incentive-based service contracts and allowed Mexican citizens to buy Pemex bonds to help finance the company’s operations. After considerable delay, Pemex has recently submitted three models of incentive contracts to the Chamber of Deputies for approval, although movement on these reforms could face further delays as the PRI continues to object to the legislation (it has even taken the case to the Supreme Court). Mexico has been slow to encourage investment in the offshore fields. Pemex has drilled only 10

offshore wells at depths exceeding 500 meters. Catamat-1, at 1,230 meters, has been the deepest well drilled to date by the company, while drilling evaluations continue for tapping reserves at Catamat-1, Leek-1 and Tamil-1. Instead, Pemex is focused on mature and (severely) underperforming onshore fields, particularly the Chicontepec project in the states of Puebla, Hidalgo and Veracruz. Pemex announced Sept. 29 that it would reduce drilling operations at Chicontepec by 60 percent from 1,250 to 499 oil wells. The move will squeeze out smaller, local contractors and make room for companies like Halliburton and Schlumberger, who have the technological skill to improve production in these fields, which have consistently missed their production output targets. To help move along Pemex’s stated plans to issue up to 14 incentive-based contracts by the end of 2010 and increase production efficiency, U.S. Export-Import Bank has granted Pemex a $1 billion loan to finance the purchase of U.S. goods and services for oil and natural gas production and exploration. The government is trying to improve Pemex’s financial position and thus the financial position of the government by giving more tax breaks to compensate for peso appreciation, lower output and higher input costs, but these half-measures will do little to reverse the energy sector’s decline or provide greater funding to the state. The power sector is also in poor shape, as years of low private investment have hampered development even along the U.S.-Mexico border, while electricity demand continues to outpace supply. Private companies must still sell their electricity output to the highly inefficient state-owned Federal Electricity Commission. Struggling to attract the investment needed to install 16.3 gigawatts of capacity by 2016 under current regulations, the government has relied more heavily on natural gas for power consumption (further depressing energy revenues) and has considered importing lighter crude and blending it with Mexico’s heavier crude to aid in the refining process and reduce fuel imports. Investment and Regulations The 1993 Foreign Investment Law guarantees equal legal treatment to foreign and local investors. Foreign investors are not allowed to own property within 100 kilometers of Mexico’s borders or within 50 kilometers of its coastlines, but they can use bank-administered trusts to obtain property in the restricted zones. The Secretariat of Environment and Natural Resources, which steadily increased its rate of inspections from 2,597 in 2008 to 3,468 in 2009, has shut down 247 business operations that it deemed in violation of environmental regulations. Companies are advised to accept voluntary audits to avoid inspections; self-audits are typically granted to larger multinational corporations (MNCs) with approved audit certification. Mexico also has become more safety-conscious regarding its deepwater drilling operations since the BP spill and has postponed drilling at the deepwater Maximino well (expected to commence in the fourth quarter of 2010). The National Hydrocarbons Commission, born out of the 2008 energy reforms, is limited to making recommendations to the Energy Ministry, but it is calling for regulations on par with those of the United States. One such proposed regulation is the “double key” standard, in which more than one Pemex worker would make final decisions on drilling procedures. Other regulatory factors to consider include the government’s introduction in June of new regulations to make it more difficult to exchange U.S. dollars for pesos at local banks due to the high rate of money laundering by Mexican drug cartels, a move that has greatly irritated the business community. Upper limits of $7,000 in cash per month for businesses and $4,000 per month on accounts for Mexican nationals have been imposed, while foreigners are allowed a maximum exchange of only $1,500 per month. Labor Force Mexico’s average per-capita GDP in purchasing power parity was $15,570 in 2009, above the $11,000 average in Latin America. The country of 111.2 million people hosts a large and active labor force of roughly 46.2 million, with an unemployment rate averaging around 5.7 percent, with the most job losses from the global recession occurring in manufacturing and construction. Most laborers are unskilled due to the country’s poor education system and work in the informal sector, which employs some 12.5 million workers and is largely a result of strict labor laws that make hiring and firing

workers costly. Under NAFTA regulations, at least 90 percent of a company’s total workers must be Mexican citizens. The Mexican Congress has been debating labor law reforms that would allow more flexibility in hiring and firing and allow for seasonal employment as well as internships. The labor reforms also call for reducing the work week from 48 hours to 40 hours in all industries, prohibiting the employment of minors under age 16 who have not completed basic education and increasing overtime pay for work on Sunday (political stagnation in the lead-up to elections will likely delay a decision on this). Most companies provide their own training due to lack of skilled workers in the labor force. Labor unions are powerful and have strong political ties, although they have been divided in recent years, a situation that is not expected to change within the next three years. The Confederation of Mexican Workers (CTM) is the largest union, with 5 million claimed members, followed by the Revolutionary Worker and Peasant Confederation with 4.5 million members and the National Workers Union with 1.2 million workers. The PRI has the most influence with the unions, particularly the CTM, with which the party has had a longstanding relationship. The PRI could use its links to labor to apply pressure on the PAN government, as the PRI has done before through labor strikes in the power sector. Mexican workers hold the constitutional right to strike. If they are granted permission by the government, management is restricted from entering company premises and from hiring replacement workers and must cease operations until the strike is resolved. If they are refused permission, the employees are required to return to work within 24 hours or face termination. However, unionization in the manufacturing sector is low, as are average wages, and there is little job stability or access to social security benefits. The frequency of strikes depends on location. They are more frequent in Oaxaca and most of the southern states but are extremely rare in Querétaro, Guanajuato and Nuevo León. Strikes have decreased overall (likely out of job insecurity) during the recent recession.

Security Environment The escalating cartel war in Mexico, which has created the most severe security crisis that the country has seen in nearly a century, consists of three fronts: the government’s battle against the drug cartels, the battles among the various cartels themselves and the violence being inflicted by the cartels and other criminal groups against the civilian population. The campaign President Calderon launched against the cartels in December 2006 has steadily escalated over the last four years, and while there is no denying that the government is making progress in fracturing the largest and most powerful cartels, one result has been a steadily deteriorating security situation nationwide. Ongoing turf battles among rival criminal groups have only intensified and increased over the past several years, particularly along the U.S.-Mexico border, where many multinational corporations operate. Territorial disputes among drug cartels have long been the norm in Mexico, but Calderon’s offensive against the country’s most powerful cartels has severely disrupted the criminal balance of power, leaving power vacuums other criminal groups seek to fill. This conflict is especially visible in border cities such as Ciudad Juárez, Monterrey, Reynosa and Nuevo Laredo, which the cartels use as drug-smuggling corridors into the United States. But the conflict also affects other parts of Mexico that fall along the drug supply chain, such as ports in southwestern Mexico and areas along the Guatemalan border. This cartel power struggle is far from over, and until a lasting balance of power has been solidified, the bloody warfare will continue and perhaps even worsen. Foreign businesses must thus conduct daily operations in an increasingly volatile environment, threatening their employees’ safety and the profitability of their business operations. The threat of violence has forced some companies to close their doors and others to develop exit strategies should the violence become too intense. The Sinaloa Federation is the largest and most powerful cartel at present, with operations primarily along Mexico’s west coast, but their influence reaches from Chihuahua to Chiapas. The main opposition to the Sinaloa Federation is the Los Zetas organization, which operates largely along the eastern half of the country from Tamaulipas to Chiapas along the Gulf coast, although their influence reaches all

the way to the western Pacific states. Los Zetas and the Gulf Cartel maintain the largest presence and have the most influence in Nuevo León and Tabasco states. However, since the rupture in relations between the two in January 2010, Los Zetas’ dominance has waned in places like Tamaulipas and Nuevo León as the Gulf Cartel has aligned itself with the Sinaloa Federation and La Familia Michoacana against Los Zetas. The conflict between these two regional powers has yet to spread to Tabasco state, but anywhere the two organizations’ operations overlap the potential for violent conflict between the two exists.

Criminal Threat in Nuevo León and Tabasco The general crime threat in Mexico is at a critical level and has been for more than a decade. Changes in the security landscape over the past year, however, have led to an expansion of criminal threats in the country. Three factors in particular are contributing to this growing problem: Mexico’s rampant corruption, pressure on the cartels to seek other forms of revenue, and a general breakdown in law and order that has created an environment in which criminal organizations unrelated to the drug trade can operate with impunity. The corruption problem is not one that can be resolved easily. The billions of dollars Mexican drug cartels make each year mean they have plenty of cash to bribe government officials. The most noteworthy official so far has been the country’s drug czar, Noe Ramirez Mandujano, who allegedly disclosed classified information to the Beltran Leyva Organization (BLO) for monthly payments of $450,000. Moreover, the low education requirements and poor salaries of police officers have traditionally made law enforcement a career of last resort. Given this reality, few police officers would refuse a bribe, especially when the alternative is death. Moreover, there is also a historical culture of

graft in Mexican police departments whereby street cops are expected to pay bribes to their superior officers. Being poorly paid, the street cops must get the money to pay their superiors from somewhere, hence their corruptibility. Los Zetas and the Gulf Cartel have heavily penetrated local and state authorities in Nuevo León and Tabasco. Several state and local officials have been arrested for working for, or having links to, these organizations. The Public Security Director for Paraíso, Tabasco, was arrested Oct. 14 on allegations of working for Los Zetas. In Monterrey, Nuevo León’s largest city, elements of the Gulf cartel assassinated several members of the Monterrey Municipal Police in March and April for their collaboration with Los Zetas in the Gulf campaign against the Zetas support structure in the area. All of these issues mean foreign businesses in Mexico are forced to deal with security on their own, since the local authorities have proven unreliable (and at times malicious) partners. In addition, the tendency to employ retired Mexican law enforcement or military personnel in corporate security positions elevates the risk to businesses. In these cases, it is important to pay close attention to vetting procedures, which requires additional time and resources from both security and human resource departments. The second factor contributing to the increase in criminal threats is that many drug-trafficking organizations (DTOs) have begun to turn to other criminal activities to supplement their incomes. Previously, drug traffickers generally focused their attention solely on the lucrative drug trade. This meant drug traffickers rarely crossed paths with civilians not associated with the drug trade. Due to the government offensive against the cartels and U.S. efforts to interdict drug shipments from South America over the past two years, however, cartel turf battles have intensified, as have feuds within the organizations. As a result, many drug traffickers are becoming increasingly involved in crimes such as extortion and kidnapping for ransom. It is important to note that accurate statistics regarding the kidnapping and extortion threats in Mexico do not exist, since the vast majority of kidnappings are not reported to authorities. One inquiry by a Mexican legislative committee estimated there are some 4,500 kidnappings per year in Mexico, only one-third of which are reported to police because families fear reprisals from the kidnappers and because the police often are involved in such crimes. Nevertheless, statistics available from the Mexican Public Security Secretariat show reported cases of kidnappings in Mexico rose by 40 percent from 2008 to 2009, increasing from 838 to 1,181 incidents. While these reports should not be considered comprehensive, they do provide a useful baseline for gauging the threat level. The kidnapping and extortion threat has increased exponentially over the course of the past four months in Nuevo León due to the conflict between Los Zetas and the Gulf cartel. Los Zetas have experienced several organizational and operational setbacks during this time period, particularly in Nuevo León. The organization has lost five of its Monterrey regional leaders in the past four months to Mexican security operations, which also have resulted in the detention of numerous operational assets and the seizure of large arms-caches. There also has been a corresponding increase in kidnapping and extortion reports from the Monterrey metropolitan area, including attempts on high net worth individuals and members of their families. This has prompted the U.S. State Department to ban diplomatic personnel from bringing children into the city. Los Zetas have not experienced the same losses in Tabasco state and thus have not resorted to kidnapping or extortion in this region. Tabasco does, however, lie on the primary transit route for Central American immigrants headed north towards the United States. Los Zetas often kidnap these Central American immigrants, transport them to the border and hold them for ransom before taking them across. The hiring of security personnel with Central American backgrounds could draw unwanted attention from Los Zetas given the lucrative nature of human smuggling in the region.

Los Zetas have also been known to be involved in fuel theft from Pemex facilities. The fuel is often sold on the black market to stations in Mexico or just across the border in the United States, and according to a Pemex report released at the end of 2009, Los Zetas were responsible for up to $1 billion in losses from siphoning operations. Due to their involvement in this type of criminal activity, there are portions of Pemex property in Tamaulipas state Los Zetas have taken over altogether, prompting Pemex employees to refuse to work in these areas. To maintain their grip on this market, Los Zetas have been known to kidnap Pemex executives to ensure their complicity in Los Zetas operations. In the first six months of 2010, Los Zetas members kidnapped six Pemex executives throughout Mexico, including an executive from Pemex’s Exploration and Production unit in Tabasco. The threat of further action from Los Zetas has prompted Pemex officials to ask the Mexican military to provide additional security for their executives and operations. This threat will likely continue for at least the next two to three years, although it could remain focused on refined products, not drilling or extraction operations, since criminal groups can sell the finished products more easily than crude. The third factor contributing to the crime increase is the distracted security apparatus. With Mexican military forces and police agencies tied down in the cartel battle, common criminals not involved in the drug trade have flourished. Car theft, robbery, mugging and pick-pocketing have long been staples in the Mexican crime scene, and such crimes have increased throughout the country in recent years. Indeed, these more common crimes are much more likely to affect multinational corporate operations and personnel in Mexico than the cartel-related violence dominating the headlines. The obvious risk associated with these developments is that, while the government continues to make it difficult to traffic drugs, very capable DTOs and other criminal groups will continue to target businesses and citizens throughout Mexico for kidnapping and extortion. These trends can be expected to persist at least for the next two to three years until the country’s security situation stabilizes.

Impact on Business Operations The deteriorating security situation in Mexico presents a range of security implications for multinational corporations operating in Mexico. As organized-crime groups expand their targeting, it seems all but inevitable that multinational corporations’ personnel and facilities will become part of that growing target set. Executives and employees who have not received protective services may begin to demand them for themselves and their families. Expenses related to these services, which may include armored vehicles and armed security personnel, can quickly add up. And while executives are perhaps most at risk during their workday routine, the deteriorating security situation in many parts of the country could make it necessary for some companies to provide personal protection during business travel, also at a considerable expense. The host of threats facing multinational corporations in Mexico will require many corporate security teams to reassess their security programs. Increasing protective services for employees, for example, not only would require hiring executive protection teams but also could require employing additional corporate security managers to oversee enhanced programs. These security managers would also find themselves busy addressing and updating related programs, such as reliable communications systems, business-travel protocols and contingency plans. Many of these security measures certainly pose difficult financial decisions for many companies already operating or looking to expand operations in Mexico. At the same time that companies search for ways to reduce costs, they must now address whether to increase spending on security measures (assuming they have or can obtain the funds to do so). But while these costs may be uncomfortable, many companies will find them necessary to maintain business operations and ensure employee safety. Security Forecast As we look ahead two to three years, which is the time it will take for the Mexican government even to begin to stabilize the security situation, Mexico will continue to face some extraordinary challenges. The current cartel conflict has led to unprecedented levels of violence that the Mexican government has been unable to control. The government has exhausted vast amounts of national resources to try to reduce the violence to politically acceptable levels, but violence has continued to increase steadily throughout the country. While it is difficult to forecast the security environment for a particular city or region, indicators of broader trends in violence in Mexico lead STRATFOR to believe there is hope. The fact is that violence in Mexico is reaching a saturation point politically and socially. As politicians try to save face and citizens fed up with the violence become more vocal, Mexico is reaching a point where something must change. And something certainly will; it is just the form of that change that remains uncertain. As we see it, there are two possible scenarios. One is the eventual involvement of the United States in the conflict. There is mounting pressure for Mexico’s northern neighbor to take a more active role in counternarcotics efforts, but political and social sensitivities in Mexico have prevented a significant U.S. presence on the ground in Mexico. Indications are emerging, however, that this sentiment is beginning to change. The president of the Mexican War College recently said Mexico cannot handle the cartel problem on its own. Even more indicative of this changing sentiment was the recent decision to embed U.S. intelligence analysts and operatives in the Juárez Intelligence and Operations Fusion Center to better facilitate information-sharing. However, STRATFOR believes the trigger for a dramatic increase in U.S. involvement will be the targeting of a U.S. elected official or high net worth individual on U.S. territory by Mexican drug cartels. With an increase in U.S. involvement, the situation in Mexico could become similar to the situation in Colombia, where U.S. advisers trained and sometimes led Colombian troops and law enforcement personnel in countercartel operations as part of Plan Colombia. It would also mean an increase in aid to Mexico in addition to the $1.4 billion Merida Initiative already in place, in which U.S. federal drugenforcement agents provide equipment and limited training to their Mexican counterparts. A significant increase in U.S. assistance, including more hands-on involvement by U.S. advisers in conjunction with the ongoing Merida Initiative, would give Mexican security forces a distinct advantage in combating

cartel power throughout Mexico. Once Mexican security forces are able to reduce drug-related violence to politically acceptable levels with more direct U.S. assistance, Mexican security forces could then divert excess resources to focus crimes such as kidnapping, extortion, cargo theft and other more common crimes that permeate the security landscape throughout Mexico, affecting both Mexican nationals and foreign business operations. The second scenario would be to restore the balance of power among the cartels and the Mexican government, an equilibrium that could be achieved over the next two or three years. In order for this to happen, an agreement must be reached between the cartels and the Mexican government that does not necessarily involve President Calderon shaking hands with Sinaloa cartel leader Joaquin “El Chapo” Guzman. A unified DTO able to consolidate and prevent itself from fracturing would be the most likely candidate to enter into such an agreement. It is not unreasonable to assume that sometime between now and the end of 2012, one cartel will have co-opted and/or destroyed most of its competitors and emerged as the dominant DTO in all of Mexico’s embattled regions. Currently, the Sinaloa cartel appears to be the most likely choice, given the geography it controls and the upper hand the organization seems to have in various conflicts throughout Mexico. The Sinaloa cartel is engaged in just about every region of Mexico, giving it a geographical advantage compared to more isolated organizations like La Familia Michoacana, which controls only the state of Michoacán. While many of the regions the Sinaloa cartel is engaged in are considered disputed territory, the cartel is often on the winning side. The New Federation, an alliance between the Sinaloa, Gulf and La Familia Michoacana cartels, is a testament to how the Sinaloa cartel might coopt willing organizations while destroying rivals like Los Zetas. Going forward, if the Sinaloa cartel were able to consolidate its power and gain hegemony in the world of Mexican drug trafficking, the cartel would be able to divert some of it enforcement resources to quell the activities of other criminal organizations that have risen up in the chaos. This is not to say that crime in Mexico would disappear, only that the crime that did occur would run the risk of Sinaloa blowback or be heavily regulated by the cartel. However, this kind of transition would take time, and the security situation in many parts of the country would remain chaotic. Should the Sinaloa scenario play out, businesses operating in Mexico would likely have to deal with the cartel in some form or fashion, and whether this would involve extortion payments is not entirely certain, although it is likely. In both scenarios, the level of violence would get much worse over the next two or three years before it improved. Both situations represent a single entity essentially taking over control of geography presently controlled by multiple actors. STRATFOR has always maintained that the cartels will defend their turf ferociously. The eventual domination of the geography by a single entity, however, will force the weaker groups to move away from traditional methods of generating income, primarily drug trafficking, to other criminal activities. We already have begun to see indications of this in the current conflict. Overall, if multinational corporation can persevere through the next two to three years of continuing turmoil in Mexico, it could be rewarded with a more secure and predictable operating environment.

Iraq Political Environment Despite the challenges in the years since the dismantling of the Baathist state structure, Iraq has developed a rudimentary democratic political system. This post-Baathist order, with all its weaknesses and flaws, serves as a framework within which the country’s various political stakeholders and their respective international backers continue to compete for power. At least this has been the case thus far. Given that this framework has been held together by a large U.S. military force that is now withdrawing, its structural integrity is uncertain. The U.S. military presence in-country is now down to a little less than 50,000 troops, all of which have to be withdrawn by the end of next year (unless the current agreement can be renegotiated). Complicating the situation is the complex and fragmented political landscape, where all three principal ethno-sectarian groups (Shia, Sunni and Kurds) have been significantly divided at the intra-communal level. This situation has made it difficult for the external players with interests in Iraq (the United States, Iran, Saudi Arabia, Turkey and Syria) to achieve their preferred balance of power. The most glaring example of the fragmentation is the fact that the four major blocs that won the most seats in parliament in the March 7 election have been unable to form a coalition government, which, given the election results, means that we are not just looking at a new government but an entirely new power-sharing agreement. The old one, which gave birth to the first constitutional post-Baathist government led by Prime Minister Nouri al-Maliki, held office for four years and is now merely a caretaker administration because of significant shifts in the Iraqi political landscape. Unlike the previous two votes (in January and December of 2005), the Sunnis participated en masse this time around, and the Shia participated in the form of two rival blocs. This realignment of political forces manifested in the March 7 election has created a situation where the country’s majority Shiite community (backed by its Iranian patrons) is facing a challenge to its domination of the country, which it has enjoyed since the foundations of the post-Baathist republic were laid in mid-2003. The Sunnis overwhelmingly put their weight behind the centrist, non-sectarian al-Iraqiya bloc led by former interim Iraqi Premier Iyad Allawi, which also picked up a considerable amount of votes in Shiite and ethnically mixed provinces and secured the largest number of seats (91). The Shiite vote was divided between al-Maliki’s State of Law (SoL) bloc with 89 seats and the Shiite Islamist Iraqi National Alliance (INA) with 70 seats (this bloc is led by Tehran’s main Iraqi proxies, the movement of radical Iraqi Shiite leader Muqtada al-Sadr and the Islamic Supreme Council of Iraq led by Ammar al-Hakim). The Kurdish vote was also much more fragmented than in the past, but the two main Kurdish groups were able to form a post-electoral alliance with the smaller groups to create the unified Kurdistan Blocs Coalition (KBC) in order to sustain the strength of the 53 seats they held in the previous Parliament. In order to prevent the Sunni-backed al-Iraqiya from leading the next government, the two rival Shiite groups also engaged in a post-vote merger to form a unified Shiite bloc called the National Alliance. This super-Shiite bloc, with a combined strength of 159 seats, was formed in late May or early June but has not been able to agree on a prime ministerial candidate, with the INA opposing al-Maliki’s bid for a second term. While the Shia continue to sort out their internal differences, they have also been engaged in talks with the Sunnis on how to share power. Iran is trying to iron out the differences among its Shiite proxies so that they can agree on al-Maliki remaining as prime minister. The United States has also put its support behind an al-Maliki premiership -- the result of a back-channel understanding of sorts with Iran. While the lingering intraShia disputes over al-Maliki continue to bog down the formation of a new government, the key issue is

the sectarian balance of power between the Shia and the Sunnis, which is at the heart of the U.S.Iranian struggle. The Iranians want to limit the Sunni share of power while the United States and its regional allies (largely Arab) want to ensure a sufficient Sunni presence in Baghdad. Tehran wants to ensure that Iraq will not pose a future threat and will instead serve as a launch pad for wider Iranian regional ambitions. The United States and its regional allies would like to see a significant Sunni stake in the Iraqi government that, together with Shiite disunity, could form a bulwark against Iranian efforts to project power in the Persian Gulf region. Any negotiated settlement that translates into a government will have to be seen by both sides as an acceptable outcome, and there are signs that such a government (in a preliminary form) will likely emerge before the year is out. A new power-sharing formula would be only a beginning, since any such government would be very fragile, especially since it would have to shoulder increasing responsibility for internal security as the Americans withdraw and its various factions try to work together. The Shia will try to hold onto their dominant position in the government while the Sunnis work to increase their share of power. The Kurds will be using the sectarian tensions to enhance the autonomy they currently enjoy in their northern region. A new government also would not settle all the issues that stand between the United States and Iran, chief among them the nuclear issue. The Americans and Iranians would both like to see the remaining 50,000 U.S. troops leave the country, which would require an agreement between the two. Tehran will want security guarantees, the end of sanctions and recognition of its sphere of influence in the region while Washington will demand that Iran not exploit the vacuum created by the departure of U.S. forces. In other words, there is a lot that can go wrong and a lot that can have significant security implications for Iraq and the region.

Economic Environment Political uncertainty and the security risks stemming from it are the main hurdles in the path toward Iraq’s overall economic improvement. Investors are daunted, above all, by the lingering militant threat against Iraq’s oil facilities. Nevertheless, many investors are willing to take some risks to make substantial profits once the country gains a certain level of lasting stability. Although the overall business climate in Iraq is murky for the moment, some investors are interested in getting a foothold in the country now to consolidate their future presence. Headway has been made in infrastructure and oilfield development, and incremental steps are likely to continue. A continually improving political and security environment would have a positive effect on other sectors, such as retail, but again this depends on the strength of the future Iraqi government. The oil-rich southern port city Basra seems to be the current target of investors, who are pumping in money for robust development projects despite militant threats. The fact that more and more foreign consulates are being opened there shows an increasing interest by other countries in the city and province. But again, the Shiite south as a whole is vulnerable to Iranian interference. The Iraqi economy already is -- and will become even more -- dependent on the oil and gas sector, as indicated by the difference between GDP numbers for 2009 (when oil prices declined sharply) and forecasts for 2010-11. The International Monetary Fund estimates that Iraqi GDP will grow by 2.5 percent in 2010 and 11.5 percent in 2011, since OPEC recently decided to maintain output to keep the price of oil between $70 and $80 a barrel. Given that 95 percent of the Iraqi government’s budget relies on oil revenue, Iraq’s preliminary budget proposal for 2011 is 102 trillion dinars ($86.4 billion), based on a world oil price of $70 a barrel, according to a statement by the country’s deputy finance minister in September. Vigorous economic growth is also likely to continue in the Kurdish region to the

north, but its relationship with the central government in Baghdad -- the Kurdistan Regional Government is involved in Iraqi government talks and will be a part of any coalition deal -- will affect the speed of this economic growth. While there are many investors willing to take the risks, political instability and the security situation are still preventing many MNCs from investing in Iraq despite lucrative deals offered by the Iraqi government. Those that have invested work away from the cities in isolated desert areas. Few if any major housing, agricultural or food companies have invested in the country, since it would involve a presence near urban areas, where the potential for militant activity remains significant. Ultimately, the uncertainty surrounding the political and security situation in Iraq as well as regional geopolitics will prevent the new political system from maturing. Iraqi factions have yet to evolve from a basic state of political survival to a level from which they can engage in meaningful governance and produce important legislation. What this means is that the central government, while it has established its writ in raw form, has yet to develop the institutional mechanisms and procedures necessary to provide real business opportunities in the country. Energy Potential As far as Iraq’s energy potential is concerned, the country is in a position to rival Saudi Arabia and Russia in terms of oil production and export. According to estimates, production can increase from the current 2.4 million barrels per day (bpd) to 10 million to 12 million bpd over the next decade and a half. But as is evident from the political stalemate and precarious security situation, the country remains far from achieving the conditions necessary for maximizing crude production and emerging as one of the world’s top three oil producers. In addition to the struggle over political power and control of security forces, influence over energy resources is a key point of contention among Iraqi factions. There are three core reasons for this: 1) Most oil and gas reserves are located in either the Shiite south or the Kurdish north, putting the Sunnis at a serious disadvantage. 2) Kurdish autonomy in a federal Iraq further complicates this picture, since the Kurds believe they deserve authority over energy-related policies in their region. 3) The status of the oil-rich region of Kirkuk remains disputed between Kurds and Arabs (the Shia and Sunnis). For these reasons, Iraq has not been able to make any headway toward enacting a national hydrocarbons law, which, in addition to the uncertainties over the political and security situation, remains an obstacle to substantial outside investment in the country’s energy sector. There has been some interest on the part of international energy firms seeking development contracts. Initially, this interest was limited to the northern Kurdish enclave, where security has been better than it has been in the rest of the country. Recently, however, as many as 10 different multinational consortiums have won contracts to increase production at fields in the Shiite south and central Sunni parts of the country. Iraq held an auction for three major natural gas fields Oct. 20. Because the next government will have more than a token Sunni presence and the Kurds will drive a hard bargain with the Shia for their share of the political pie, disagreements over energy issues will be the subject of bargaining long after a new government is in place. But implementation of these sought-after contracts will likely be stymied, as they have in the past, by the political stalemate and questions about the future of country -- and region -- in light of U.S.-Iranian tensions and the American withdrawal from Iraq. Another key issue is the link between development of Iraq’s energy sector and the status of Iran’s energy sector, given the influence Iran has over its western neighbor and the sanctions imposed on Iran. The Islamic Republic is not interested in Iraq emerging as a major oil producer at a time when its own oil and natural gas production is suffering from sanctions, especially with the decades-long sanctions regime being tightened. Even in a scenario where Iran -- as part of a settlement with the United States -- is able to get out from underneath the sanctions and embark upon a major drive to

revitalize its energy sector, it will want to ensure that any development of the Iraqi oil and gas industry does not undermine Iranian interests. In a strange way, Iranian interests intersect with those of Saudi Arabia and the other petroleum states in the Persian Gulf. Arab states also have an interest in containing the extent to which the Iraqis are able to develop their energy sector. Backing Sunnis in an effort to counter Iranian influence in Iraq will also help create the conditions in which the Iraqi energy sector could suffer from arrested development, since sectarian tensions must be reduced, not sustained, for a stable government and energy development to be fully realized. Investment and Regulation Security has long been the chief concern for investors wanting to do business in Iraq. In the past two or three years, with the collapse of the Sunni and Shiite insurgencies, the lack of a robust regulatory environment -- despite an otherwise investor-friendly attitude on the part of the country’s political stakeholders -- has become the main hurdle. The improved security situation has created an opportunity for the Iraqis to focus on improving the investment climate in the country, but issues having to do with political survival, disputes among the three ethno-sectarian groups and the lack of meaningful legislation have prevented any substantive movement in this direction. However, some basic work has been done to attract foreign investors. This includes creation of the National Investment Commissions (NICs) and Provincial Investment Commissions (PICs) and an amendment to the National Investment Law to clarify issues having to do with land use. The hallmark of improvements to the investment climate was the licensing round in December 2009, in which 10 international consortiums were awarded contracts to develop Iraqi oil fields. The overall investment climate remains quite difficult, especially for small- and medium-sized investors. There are significant costs associated with maintaining security, complexities in obtaining business visas and registrations, long delays in securing government payments on certain contracts and uncertainty surrounding dispute-resolution procedures. Then there’s the corruption and inefficiency stemming from decades of central planning. Heavy state procurement and subsidies distorting market prices are the legacies of Baathist rule under Saddam Hussein. This situation will take a long time to undo, and investors still have to deal with demands for bribes and kickbacks at various levels of the state bureaucracy. Even today, Iraq ranks 178 out of 180 on Transparency International’s Corruption Perception Index. This combination of factors led the World Bank, in its 2010 report, to rank Iraq 153 out of 183 in ease of doing business. In 2009, the Iraqi government approved revisions to the 2006 National Investment Law (NIL) that provide a rudimentary framework for a modern legal system that could protect foreign and domestic investors. One such amendment to the NIL allows limited foreign ownership of real estate development projects. Still, a large number of licensed investment projects remain stalled due to lingering confusion over land-use responsibility both at the national and provincial levels. Though created in keeping with the 2006 NIL as “one-stop shops” that could provide information, facilitate the signing of agreements and assist with the registration of foreign and domestic investors, the NICs and PICs are still in the embryonic stage. Commissioners from both entities suffer from a lack of clear lines of authority, budget constraints and a dearth of regulations and standard operating procedures. Members of both the NICs and the PICs are still learning how to develop and adopt a regulatory regime that would be favorable to international investors. Because of the absence of any legislative clarity regarding the NIL and the government deficiency in coordinating infrastructure development, most of the investment projects that have received NIC approval have yet to be implemented. There is also the fact that both the federal government and the regional government in Kurdistan have the authority to regulate investment, with a key difference being that the Kurdish government allows foreigners to own land.

On the issue of expropriation, Article 23 of the constitution clearly prohibits the practice unless it is “for the purpose of public benefit in return for just compensation.” Such a process is supposed to be regulated by law, but the necessary legislation has yet to be enacted. Likewise, Article 12 of the NIL also guarantees non-seizure or nationalization of an investment project unless a final judgment has already been issued, but there are factions within the Iraqi government that dispute this law, and the judiciary has yet to rule on such a case. This means that international investors can enjoy protection from expropriation only if further domestic legislation is enacted to guide implementation of Article 12 or if there is a treaty between Iraq and the investor state. Currently, the United States does not have a bilateral investment treaty with Iraq. There are also issues regarding international arbitration, which Iraqi law does not support. Baghdad has not signed or adopted two key legal instruments pertaining to international commercial arbitration: the U.N. New York Convention on Regulation and Enforcement of Foreign Arbitral Awards and the attendant rules and procedures codified by the U.N. Commission on International Trade Law. There are problems with other provisions in the NIL pertaining to both domestic and international investors qualifying for incentives, having the right to take capital and dividends out of the country and receiving exemptions from taxes and fees. Uncertainty surrounding such provisions is due largely to a lack of precedent and implementing regulations. Given the complexity of existing Iraqi laws, regulations and administrative procedures, even if the NIL were fully implemented, potential investors would still face considerable obstacles to establishing and operating a business. More than 170 companies have filed for investment licenses but few have moved to the implementation stage. Further ambiguity is created by the lack of competition and consumerprotection laws, which are essential for leveling the playing field and which remain in the drafting stage. Investors lack any legal defense against unfair business practices, e.g., price-fixing, bid-rigging and abusing market dominance. Without a consumer-protection law, both investors and consumers have no standard definition of unfair business practices. In promulgating regulations, the Iraqi government operates in a very opaque manner, which allows it to apply regulations arbitrarily. Regulations imposing duties on citizens or businesses are supposed to be published in an official gazette, but internal ministerial regulations are not. As a result, bureaucrats can create internal requirements and procedures that are beyond oversight, thereby creating an additional burden for investors. Labor laws also remain in a very nascent stage and are not strong enough to promote a flexible employment environment conducive to the promotions of business. An old Saddam-era law still on the books alludes to working conditions for expatriate workers, allowable working hours and nonsupportive benefits but has no mechanism for enforcement. A law drafted with the help of the International Labor Organization has been under review in Parliament, but it is unclear when it will be sent to the Cabinet for further action. Iraqi law says all employers must provide some measure of transportation, accommodation and food allowances to their employees but does not specify the amounts. According to the NIL, priority in employment and recruitment has to be given to Iraqi nationals, and foreign employers are expected to help provide training to their employees as a way of enhancing skills, capabilities and efficiency. There are also certain labor requirements that govern the hiring of Iraqi and foreign workers, but these requirements have not been codified into law. Not only is Iraq’s post-Baathist legal system still in its formative stages, it is also more complex than many such systems because it is a hybrid of many different codes -- Islamic, European and Iraqi, among others. Following the ouster of the Baathist regime, the American-controlled Coalition Provisional Authority (CPA) tried to liberalize the business climate and enacted certain regulations and dispensed with others in a rushed effort to create a system more in compliance with international standards. The interim Iraqi government and subsequent constitutional government also passed new

laws and piled them on top of existing Hussein-era and CPA statutes, making an already convoluted system even more so. The result has been that the enforcement of laws -- especially those put in place by the CPA -- has been irregular, and many laws remain largely untested in the judicial system. There are certainly no provisions at this time that recognize and enforce civil judgments or arbitrations for non-Arab foreigners. The U.S. government advises companies to proceed with great caution prior to entering into a lease agreement in Iraq, especially a long-term one, and to solicit the help of qualified and experienced legal professionals before doing so. Regarding the tax regime, the CPA imposed a flat 15 percent tax on all income earned by foreign or Iraqi companies and on profits transferred overseas. It also suspended the 25 percent levy on company profits. A number of tax incentives are still available, depending on the type of economic activity a foreign investor is engaged in. For example, in the manufacturing sector there are exemptions from income and other taxes for five years from the date on the company’s registration certificate. Foreign tax credits are also offered in order to alleviate double taxation. Investors, however, should remember that the country’s taxation system is not fully functional and should navigate this landscape accordingly. Because of these issues, U.S. Undersecretary of Commerce Francisco Sanchez led a mission composed of top executives from 14 American companies to Baghdad in early October to assess the business climate. During the visit, Sanchez remarked that Baghdad had a long way to go in its efforts to improve the country’s business climate and that the regulatory environment continues to be a major challenge for international companies. The core problem is a political system still struggling to emerge as its various players deal more with matters of political survival than actual governance and institution-building, which are the basic ingredients of an atmosphere conducive to entrepreneurship.

Security Environment Until the completion of the U.S. drawdown of forces to 50,000 troops in late August, security in postBaathist Iraq had been held together by a large U.S. military force. American military power was able to shape a new political system (albeit still a work in progress) and create a completely new national security structure from scratch. The ability of Iraqi forces to maintain the peace achieved so far depends on a sustainable agreement among the country’s political principals and their international backers over shared control of these new security forces. The key to this is to make room for Sunnis in security forces dominated by Shia and Kurds. This was the key aspect in the deal between U.S. Gen. David Petraeus and the Sunnis when the latter agreed to end their insurgency in 2007. The minority community has embraced the political system, as is evident by its participation in the provincial elections in January 2009 and the March 2010 parliamentary elections. But the Sunnis have yet to achieve their share of power, which at this stage is all about a stake in the control of security forces. Even though some 100,000 Sunni militiamen agreed to lay down their arms, Shiite resistance to their integration into the state security apparatus has left 80,000 former insurgents waiting to be included. The army, police and intelligence services, due to demographics as well as the manner in which the majority Shiite community sought to take advantage of the fall of the Saddam Hussein and Sunni opposition to the new system, are dominated by Shia and Kurds. It remains to be seen if or how the power-sharing arrangement currently being negotiated will resolve this issue. In terms of effectiveness, Iraq’s new armed forces have demonstrated some ability to discharge their security responsibilities, but they remain untested in a post-American environment. That test has begun with the American drawdown and will become even more intense when most of the remaining 50,000 U.S. troops are withdrawn, most likely by the end of 2011.

An organized Sunni and Shiite insurgency is almost non-existent, but jihadists and other forces on both sides of the sectarian divide continue to stage periodic attacks. The security situation is nowhere near as bad as it was two or three years ago, but it could deteriorate, especially if Iran feels the need to pressure the United States or if a U.S.-Iranian military conflict emerges in which the Iranians are able to activate Shiite militias and encourage Sunni militants. It is also important to note that, in sharp contrast to the Hussein era, Iraqi security forces do not constitute an autonomous establishment that can step in and take charge of matters in the event of a breakdown among political factions. Developed under the oversight of a single government led by alMaliki, the armed forces also are not accustomed to the changes in political leadership brought about by periodic elections. Thus, there are questions of loyalty in the armed forces in addition to their untested effectiveness. Because the Iraqi military is a manifestation of the ethno-sectarian-political divisions that define the country, the ultimate fear is that, in a worst-case scenario, it will devolve into competing forces under the control of different factions. The disproportionate amount of Iranian influence in the country also affects day-to-day business operations. This is especially the case in the south, where political and militant groups are engaged in activities to further Iranian interests in the country. Key to this effort are organized-crime syndicates. Given that official channels are still not completely up and running, foreign investors must conduct business through informal channels managed by regional tribal, political and economic elites. Southern Iraq is where an American investor could run into oil lobbies that are paid for by the Iranians. Indeed, a foreign company doing business anywhere in Iraq will likely need to circumvent the central government and invest time, money and human resources to establish contact with local tribal and provincial authorities. This means spending a great deal of time in country, drinking lots of tea and attending meetings late into the night. There are a number of U.S. firms in Iraq that can help facilitate such dealings. The biggest thing to be cautious about in negotiating deals at this level is getting caught in sectarian politics. One way to avoid this is to partner with a foreign firm, such as a Turkish company, that will know its way around Iraqâ&#x20AC;&#x2122;s business landscape. While security in the south has greatly improved since the 2007-08 period, when the al-Sadrite militia was forced to stand down, there is no shortage of dormant militias or organized criminal elements. Any potential investor in the region must factor in the cost of security, especially since U.S.-Iranian relations remain tense and Tehran could unleash its henchmen in Iraq at any time. Foreign workers can also be potential kidnapping targets and can be indirectly used by the Iranians as bargaining chips in negotiations with the United States.

ÂŠ 2010 STRATFOR Austin, TX 78701 Tel: 1-512-744-4300 www.stratfor.com

Algeria Political Environment Algeria’s current political system is a fairly recent development, following a decade-long (1992-2002) civil war between Islamist militias and the secular army that claimed 150,000 to 200,000 lives. Before that, a single-party socialist republic had existed since the country gained its independence from France in 1962. During the 10-year insurgency, the army was engaged in a complex struggle on three fronts: It was fighting militant Islamists, containing political Islamists through negotiations and creating a controlled multi-party political system with a strong presidency. The army held presidential elections in 1995, instituted a new Constitution in 1996 and held parliamentary elections in 1997. The current president, Abdelaziz Bouteflika, was elected in 1999, and under his leadership Algeria was finally able to bring an end to the decade-long insurgency and move toward a new era of political stability. Re-elected in 2004, Bouteflika was the architect of the Charter for Peace and National Reconciliation approved in a 2005 national referendum, which provided amnesty to those individuals who laid down their arms and compensation for the families of people killed by security forces. The insurgency hasn’t completely died down but it has been greatly reduced, with the lone surviving insurgent group, the Groupe Salafiste pour la Prédication et le Combat (GSPC) eventually morphing into the regional node of al Qaeda (more on that in the Security Environment section below). In the 2009 election, President Bouteflika secured a third five-year term, after the parliament amended the Constitution and removed the two-term limit. There have been three parliamentary elections under the new system (1997, 2002, and 2007), producing coalition governments involving the Front de Libération Nationale (FLN), the army-created Rassemblement National Démocratique (RND) and the moderate Islamist Mouvement de la Société pour la Paix (MSP), which won the bulk of seats in all three elections. The FLN controls the presidency and has alternated with the RND for control of the prime minister’s post. The current prime minister, Ahmed Ouyahia, who is the leader of the RND, held the premiership on two previous occasions during the crisis years (1995-1998 and 2003-2006). Though voter turnout has consistently decreased from a high of 59 percent in 1991 to 35 percent in 2007, the current ruling FLN-RND-MSP coalition doesn’t face any challenges from any political force. However, there are tensions between the civilians and the army-led security establishment, which, in the process of trying to further stabilize the country with a civilian political system in the 1990s, has seen a loss of influence. There are also concerns about political continuity, given Bouteflika’s age (he is 73) and the fact that he has been almost solely responsible for the stabilization of the country and has grown powerful enough to contain the power of the armed forces.

Economic Environment Algeria has proven oil reserves of 12.27 billion barrels and 4.51 trillion cubic meters of natural gas reserves, the 10th-largest natural gas reserves in the world. Algeria also is the third-largest exporter of liquefied petroleum gas, the fourth-largest exporter of liquefied natural gas (LNG) and the ninthlargest exporter of oil. Oil and gas account for 97.5 percent of the country’s export earnings, and state energy firm Sonatrach is the biggest employer in Africa, with 120,000 employees. Indeed, the energy sector constitutes the core of the Algerian economy, accounting for 60 percent of budget revenues and nearly 30 percent of GDP. Most of Algeria’s oil and gas exports go to Italy, Germany, France, the Netherlands, Spain, the United Kingdom and the United States. Algeria supplies about a fifth of Europe’s gas needs. For the longest time, however, the Algerian oil and gas industry has been held back from any major development. Its socialist political economy limited outside investment, which was the case until the

late 1980s. But when the system was opened up for reform, the country was rapidly hurled toward civil war, which lasted well into the early 2000s. It has only been in the last eight years that Algeria has achieved a level of political stability, and in many ways the process is still under way. Having obtained this stability, the Algerians have been examining ways to attract investments that can enhance their energy sector, which, as the main source of income for the country, is the key guarantor of stability. Thus far, the focus has been on enhancing output from existing oil and natural gas fields, but as recently as last month, Sonatrach announced that it will seek to double its exploration efforts over the next three years. No details have been provided on how the Algerian government intends to achieve this objective. Algeria faces the problem of lackluster interest on the part of international energy firms, largely because of the perception that the prospects are not attractive enough and the financial terms are unfavorable. In two previous bidding rounds, in 2008 and 2009, very few international companies expressed interest in the offerings, which the government said was due to the economic downturn. Oil companies, however, said that the terms demanded by Algiers were simply not worth the risk. Sonatrach is in charge of 80 percent of Algeria’s crude output and more than 90 percent of its natural gas supplies and owns and operates the country’s refining and fuel-distribution system. There is quite a bit of international oil company (IOC) involvement, done in collaboration with the government in the form of production-sharing contracts, but production rights have declined in recent years due to changes in those contracts. Another key issue plaguing the country’s energy sector is a power struggle between Bouteflika and the security establishment, which recently resulted in a purge of top energy managers in the Cabinet and in Sontrach. In December 2009, the national intelligence service, Département du Renseignement et de la Sécurité (DRS), which is controlled by the Defense Ministry, launched an investigation of the company’s senior management for alleged corruption and irregularities in awarding contracts. This purge has undermined the decision-making process at a time when the country’s energy sector is trying to revitalize itself. Sonatrach President and CEO Mohamed Meziane and his top executives were all dismissed and Meziane, his two sons and former Sonatrach vice presidents Belkacem Boumediene and Benamar Zenasni are now in jail on embezzlement charges. Also fired was Energy and Mines Minister Chakib Khelil. These men are all allies of President Bouteflika, who is sparring with the leadership of the army and the DRS. Bouteflika has been trying to limit the authority of DRS chief Mohamed Mediene, a long-time political opponent of the president, in an effort to overhaul the security service as a counter against the military. What is happening is that the political system created by the generals has matured and it is trying to limit the influence of its creators, the men in uniform. Conversely, the armed forces are trying not to lose their position as the praetorian guards of the state. It is unlikely that this spat will result in a major political crisis, since both sides realize the need to consolidate on the gains made since the end of the insurgency and that the country needs to attract investments. Regarding the latter, it is not clear if the new energy minister, Youcef Yousfi, and Sontrach chief Nourredine Cherouati will introduce any radical changes in the way the country has been conducting its energy business. Reports suggest that international energy firms are waiting to see what oil and natural gas blocks are offered in the next bidding round, which is scheduled to be held March 3, 2011. Interested firms are supposed to have meetings with Algerian energy officials ahead of the bidding, for which some 70 firms, including Exxon Mobil, Royal Dutch Shell, Total, Gazprom, BP, Repsol and ENI, have been pre-qualified. After the failure of the first two bidding rounds, the Algerians are hoping the third round will be more successful. In the 2008 round, only four bids were received for 16 blocks offered while in the 2009 round only three out 10 licenses were awarded. The government blamed the global economic downturn for the poor showing, but the energy firms said that the low interest was due to the enactment of investment-prohibitive legislation.

Algeria is also trying to reach an understanding with Russia over natural gas exports to Europe. During Russian President Dmitri Medvedev’s recent one-day visit to Algeria on Oct. 6, there was some reported progress regarding energy matters, but no specific deals have come to light. The Kremlin’s natural gas behemoth, Gazprom, has announced it plans to bid on hydrocarbon exploration and production in Algeria. After winning rights to the area in 2008, Gazprom is exploring the El Assel field with Sonatrach, the only joint project announced since the two companies signed a memorandum of understanding in 2006. Meanwhile, TNK-BP, a venture between a group of Russian billionaires and BP, is interested in acquiring BP assets in Algeria. TNK-BP shareholder and interim chief executive Mikhail Fridman accompanied Medvedev in his Oct. 6 visit and examined BP’s Algerian assets. Fridman remarked that TNK-BP has the financial and technical resources to develop the fields in which BP may sell stakes. BP owns 33.15 percent of two gas fields in In Salah and 25 percent of the In Amenas field. Sonatrach co-owns the fields and operates them jointly with Norway’s StatoilHydro, with an average annual output of 18 billion cubic meters (bcm). Sonatrach and TNK-BP are both interested in BP’s Algerian assets, and TNK-BP could offer the Algerian state oil company a swap to obtain them. During the Medvedev visit, Russian Energy Minister Sergei Shmatko said no deal was expected within the next one to two months. The decision-making process is expected to be a long one, and TNK-BP Deputy CEO Maxim Barsky, who also accompanied Medvedev on Oct. 6, said Prime Minister Vladimir Putin sent a letter to his Algerian counterpart asking him to approve the sale of BP’s Algeria assets to the Russian oil firm. Barsky estimated that BP’s gas assets in Algeria are worth up to $3 billion and his company would be able to finance an outright purchase. Russia’s interest in Algerian energy sector is part of Moscow’s agenda to establish a stake in energy resources that Europe relies upon at a time when the continent is trying to use North African countries like Algeria and Libya to diversify away from Russia. As is evident from Medvedev’s visit (which didn’t produce any deals), and the fact that many Western firms have been prequalified for the next bidding round, Algeria prefers to do business with Western energy companies. Still, the Algerian desire to acquire technology could steer them toward greater diversification. Algeria has naturally experienced some budgetary shortfalls due to the 2008 financial crisis and weakening global energy demand, but from the looks of the 2010 budget, the state appears committed to high levels of capital expenditures. The government intends to invest $286 billion in public projects over the next five years, which will add to the country’s growing budget deficit of $13 billion (based on an oil price of $37 per barrel). This high level of spending can be sustained due in large part to the country’s low level of public debt (around 21 percent of GDP) held by domestic banks. The government is also likely to tap into its oil stabilization fund, which currently holds around $60 billion, to help finance these projects. Investment and Regulation As Algeria tries to modernize its energy sector and deal with the effects of the global downturn on its economy, it will seek to diversify the economy by attracting foreign and domestic investment outside of the energy sector. But the government appears to be making little progress in making the country attractive for foreign investors. Indeed, decisions taken by the Algerian political elite have had the opposite effect, such as the recent stipulation that contracts must first be offered to domestic firms. From 1999 through 2005, Algiers introduced significant reforms to its investment laws. These included a 2001 revision that facilitated the entry of investors into the country and a 2004 hydrocarbons law that allowed IOCs to hold a majority stake in exploration and development projects. By 2006, however, it had become clear that those elements who favored greater state control over the economy had prevailed. That year, an amendment to the energy legislation granted Sonatrach the majority stake in all exploration and development projects and mandated a tax on oil production if Brent crude prices rose above $30 a barrel, with the applied rate between 5 and 50 percent of production. Levying this new

windfall tax, the government raked in an extra $4.3 billion in 2008. Two years later, after Bouteflika said the foreign investment regime and privatization scheme were the primary cause of Algeria’s lack of economic growth, Prime Minister Ouyahia conducted a review of government policies, a process that gave rise to even tougher investment regulations. After a July 2008 speech by President Bouteflika in which he spoke out against alleged large-scale profits from foreign investments being repatriated abroad, the tax law was amended to make it mandatory for investors, within four years, to re-invest the amount of tax benefits they received. In 2008 and 2009, Algeria announced several economic policies that would strengthen government control over foreign investment projects. In July 2009, the country adopted a “complementary finance law,” which imposed new restrictions on foreign investment, importing and domestic consumer credit. The law requires a minimum of a 51 percent Algerian partnership in new foreign investment projects, a 30 percent Algerian partnership in all foreign import companies and payment of all imports by letters of credit opened by Algerian banks. Moreover, the central bank stipulates that all invoices must mention a due date for payment and that invoices which fail to include a date or exceed 360 days won’t be paid. The 2009 law does give a number of incentives to investors -- principally having to do with a value-added tax and tax exemptions for time durations that are contingent upon the type of investment and the nature of the deal agreed upon by the investor and the National Agency for Investment Development (ANDI). Even though foreign investors can repatriate their profits via transfers or liquidation, it can take a long time to obtain permission from the central bank to make transfers or payments or to get a local bank to issue the transfer. These hurdles are the result of a heavily bureaucratized and inefficient banking system. However, here again, U.S. firms generally are able to secure faster payments because of the mandatory letter of credit. Essentially, there are three different government departments that oversee foreign investment in Algeria. ANDI is in charge of creating the conditions conducive to investment and issuing tax exemptions. A second entity, the National Investment Council (CIN), spells out investment strategies, sets priorities and is authorized to approve special investment incentives in the various sectors. A third, the Ministry of Industry and Investment Promotion, is responsible for enunciating investment policies and furthering privatization. The Algerian regulatory system, transparent for the most part, is very opaque when it comes to identifying the locus for decision-making. The various ministries regulate business in their respective spheres according to different rules and have regulatory bodies overseeing their application. As in any Third World country, navigating Algeria’s bureaucratic maze can be a challenge, with the top bureaucrats for various departments unreachable and guaranteed delays if the paperwork is not complete. Though not as big of a problem as it is in other parts of the Third World, there have been corruptionrelated issues in Algeria, including the 2009 arrest of a number of Cabinet-level officials and executives of state-owned firms. There haven’t been too many complaints from international firms about officials requesting bribes, though there have been reports of bribery used by foreign investors to circumvent bureaucratic hurdles. Customs officials have reportedly demanded bribes in exchange for speeding up the release of materials stuck in ports. Plans to privatize Algeria’s local banks, the national telecommunication firm and the country’s principal airline have not been implemented. A U.S. firm was able to acquire a majority share in an industrial unit in 2008, which is likely the result of Algerian officials wanting to secure the involvement of American firms in business opportunities in their country. Despite this, American non-energy investment in Algeria is confined to a pharmaceutical plant, a desalination facility, a bottling factory and a cable-making industrial unit.

It is important to note that Algiers has not made any expropriation moves against a U.S. firm. However, a U.S. firm was involved this year in a tax dispute over contracts with Sonatrach, in which the U.S. firm argued that the tax was imposed after the firm had long been doing business in the country. After lengthy talks and binding arbitration, the dispute-resolution process is still in play and could take up to 24 months to be completed. For the most part, real estate in Algeria is controlled by the government, and conflicting claims of title ownership have made the purchase and financing of property very difficult. One American investor who was interested in building a factory in the country spent two years trying to get approval from a local governor to buy land for the facility and reportedly did not succeed. Algeria has a labor force of a little over 10 million, out of population of 36 million. The government maintains that unemployment is in the neighborhood of 13 percent, but international organizations say it could be as high as 25 percent. American firms have been able to hire technical staff, though recruiting and retention is difficult because skilled Algerian workers prefer the higher salaries offered in the Persian Gulf region. And because Arabic and French are the two main languages in the country, it is difficult to find English speakers. Authorities have placed no limits on how many expatriate personnel a company can hire, but getting proper documentation can be a cumbersome process. Visas must be applied for with the Ministry of Employment and Social Solidarity. Work permits have to be obtained from the Ministry of Labor. Finally, a residency card has to be acquired from the local police office in the district where the worker will be physically employed. A number of additional regulations were announced this year. Among them is the requirement for investors residing abroad who hold shares of Algerian companies to tell the government each year who their representatives are in Algeria. Furthermore, property that has been nationalized cannot be sold to foreign investors. Another new regulation gives the Algerian state the right to pre-empt a business transaction if a foreign investor wants to sell Algerian assets. Loosening the Rules Just two weeks ago, in what is being described as a sign the government is moving toward economic nationalism, the new energy minister said that Algiers will step up pressure on oil majors to share technology with the country instead of simply taking oil and gas out of the ground. “There is a need for a bigger partnership in industry, a partnership in manufacturing equipment and the transfer of technology, not the partnership of a seller and a buyer,” the official APS news agency quoted Yousfi as saying. “This is a requirement which we are going to impose more and more.” It was Yousfi’s first public statement since becoming minister, made during a meeting with Canadian business leaders in Montreal. Algerian energy officials argue that they need foreign expertise and technology to discover and develop many of the country’s deposits, which often have challenging geology. It is not clear if more technology transfer will be included as a requirement in the next oil and gas licensing round. Algeria relies on foreign know-how to extract a large part of its energy output. Companies currently operating oil and gas concessions in Algeria include BP, Total, Eni, Gazprom and Anadarko. In the 2009 licensing round, the National Agency for Valorization of Hydrocarbon Resources, known by the acronym ALNAFT, reportedly demanded that international companies offer assets abroad as part of any deal, a requirement that was later set aside following company complaints. Another example of Algeria’s tendency toward inflexibility is the recent statement by Ali Hached, a principal adviser to the country’s Ministry of Energy and Mines, who said that Algeria isn’t supplying natural gas to spot markets and doesn’t favor renegotiating long-term supply contracts to add spot pricing. Algeria is resisting pressure from buyers to renegotiate long-term contracts because it wants higher prices to pay for the development of new gas fields. Hached explained that the country is building two LNG trains that are costing it a fortune, which can only be financed by long-term

contracts on a fixed price. The energy ministry adviser stressed that the government had already engaged in risky investments and could not cross certain red lines due to its “quasi long-term portfolio.” In yet another development highlighting foreign-investment issues in the non-energy sector, the Russian president was unable to get his Algerian counterpart to agree to have Russian telecom operator VimpelCom take over Djezzy, Algeria’s biggest cell phone company, which is a unit of Egypt’s Orascom. Algerian law gives the government the right to block any sale of a firm to a foreign firm, and through this law it is holding up VimpelCom’s plans to become the world’s fifth-largest cellular operator by buying control of Orascom assets. Under an agreement to combine assets announced Oct. 4, VimpelCom had planned to take a 51.7 percent stake in Orascom, which is involved in a dispute with Algeria over taxes and the ownership of its Algerian operations. Talks between Orascom and MTN Group Ltd. over a possible merger failed in June after the Algerian government blocked the sale of Djezzy and said it would make an offer for the company instead. It is now looking for banks to assist in the purchase of Djezzy by helping with the acquisition and finding an international operator to invest in the company. Earlier, in November 2008, the government imposed a $600 million tax readjustment on Orascom. In 2009, Djezzy, along with other operators, was hit by a 5 percent sales tax on credit recharges and a 42 percent lowering of its interconnection rates. Then in August of 2010, a new monthly tax on cellcompany revenues was imposed, costing Djezzy $4.6 million on annual revenue of $1.82 billion. Djezzy’s problems underscore the uncertainty of the regulatory environment in Algeria and how it can have adverse effects on foreign investors. This case is an example of the state first intervening in a private deal between the Russian firm and the Egyptian firm that owns Djezzy and then asserting its intent to take over the firm itself. The details of the Djezzy case highlight the potential complexities that international companies can find themselves mired in while doing business in Algeria. It could be argued, however, that in the Djezzy case, Algeria is taking liberty with a firm owned by a fellow Arab state and is unlikely to behave in such an aggressive manner with a Western firm, especially an American one. Nevertheless, Algeria has been reluctant to loosen its laws governing business dealings with international firms. Political stability and a greatly improved security situation make the country an attractive place for investments, but it needs to deregulate if it wants to move forward with its plans for the energy sector, which is the lifeline of the country. There is some evidence of slow movement in that direction. In September, Sonatrach awarded a $920 million contract to the French firm Technip to overhaul the Algiers refinery. Around the same time, the Italian firm Saipem said it had clinched an engineering, procurement, and construction contract to build an oil and gas separation plant at Hassi Messaoud. It is therefore plausible that momentum toward deregulation could increase between now and the third bidding round scheduled for March.

Security Environment Despite the significant weakening of the jihadist movement in Algeria, the country remains home to al Qaeda’s regional node in North Africa, called al Qaeda in the Islamic Maghreb (AQIM). Founded in 2006, AQIM is the successor to the host of groups that waged war against the state in the 1990s, including the GSPC, Groupe Islamique Armeé, Armée Islamique du Salut, Mouvement Islamique Armé, Mouvement pour un Etat Islamique, Takfir wa al-Hijra and Algerian veterans of the Afghan war against the Soviets. Since AQIM’s founding, most of its attacks have produced low casualty counts. More lethal attacks have been restricted mostly to Algiers, with a few just east of the capital against security forces. However, the number of violent attacks and threats of attack against foreign targets in Algeria have increased significantly since the spring of 2008. Still, this trend has not made AQIM any more

than a low-intensity threat, since the group remains torn between two conflicting theaters of operation -- its home turf in Algeria and the wider North African region. Most of the IOCs are located in the desert near the energy fields in the south. These areas are isolated and better secured, and there are very few attacks against facilities located there. Also, travel between these areas and the northern part of the country is done by air, which makes it hard for jihadists to target IOC employees. Though it portrays itself as a force active in the wider region, AQIM has not demonstrated the ability to carry out attacks in the other Arab countries of North Africa (Morocco, Tunisia and Libya). Even in the Sahel region (which includes parts of Senegal, Mauritania, Mali, Burkina Faso, Algeria, Niger, Nigeria, Chad, Sudan, Somalia, Ethiopia and Eritrea), AQIM has done little more than abduct Westerners. Nor has AQIM posed a serious security threat to the European continent, despite its geographic proximity to Europe and its connections with the North African immigrant populations in European countries like France and Spain. The post-9/11 global atmosphere, the decline of Islamism as a political force in Algeria and the horrors of the jihadist insurgency in Algeria throughout the 1990s, all have steered the country away from Islamist militancy. Non-violent Islamists retain a substantial but fragmented presence in the country, but it is highly unlikely that AQIM or any successor group will be able to revive the militancy to any serious level.

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