3.4 Convergence of Mining and Hydrocarbons?

Box 3.4 Convergence of Mining and Hydrocarbons?

■ Mining companies go to increasingly remote places to develop mines, requiring ports, power stations, and railway lines, so the upfront costs of getting established are rising, in line with oil. ■ Mining companies are having larger impacts on the local economy. Examples are mining projects in Guinea and in Mongolia, increasing the size of local GDP hugely. ■ Technology advances in oil and gas are making them closer to mining in the way they operate (shale bringing oil and gas on-land and with greater geographical dispersion). ■ The recovery process from shale and tar sands resembles mining in economics and technologies more than the traditional extraction from deep underground wells; margins look more like mining due to higher cost. ■ There is increasing similarity in the political challenges they face, especially in the impact of resource developments. Policy makers see similarities, too (as in discussions about Extractive Industries Transparency Initiative—see chapter 8).

Source: Humphreys 2014.

Companies in the EI sector routinely buy and sell their interests through mergers and acquisitions (M&As), usually on a friendly rather than a hostile basis. In the hydrocarbons sector, it is common for the buyers to be cash-rich NOCs from countries with insufficient domestic resource bases, such as China and India. Near the peak of the last commodity cycle, in 2011, the disclosed value of exploration and production M&A activity increased by almost 70 percent to reach US$317 billion (Ernst & Young 2011).11 Cash-rich NOCs from China and Korea played an important part in that activity. By contrast, in 2015 comparable M&A activity in hydrocarbons had fallen to US$71 billion once the giant merger between Royal Dutch Shell Group and BG is removed from the equation (Ernst & Young 2016, 6); it is US$153 billion when this transaction is included. Chinese and Asian NOCs were scarcely visible, with total NOC transactions declining to US$6.1 billion in 2015 from almost US$122 billion in 2012. The strong correlation between M&A and the commodity price environment means that with the substantial price fall, M&A activity has been in decline for several years (as, for example, equity valuations fall and demands grow for returns of capital to shareholders). In a downward cycle, companies face limits on their M&A aspirations by uncertainty about the prospect of a commodity price recovery and (or alternatively) constraints on their balance sheets. Further, cross-border (as distinct from domestic) M&A has become increasingly challenged by the need for regulatory approvals to meet competition concerns by governments and even by what may be called cultural differences.

For an international oil company (IOC), this kind of sale to an NOC (or other) buyer can be a way to raise funds for new projects. It can also be a way to generate a return from selling an asset that has been created by identifying commercially viable reserves. Its market value is derived from its future production potential. As the project matures, the share value increases, and a sale follows. This kind of IOC has a different business model from that of the better-known integrated oil and gas companies. (Exxon Mobil and Shell are examples of such companies.) Instead of producing oil from a successful exploration and generating a stream of cash to return to shareholders as dividend payments, it sells the asset at an early stage. In this way it avoids the complexity of bringing a large find into production, which requires significant upfront investment and often requires a JV structure to finance the development. Other IOCs may choose to produce discovered reserves themselves and may acquire other projects in order to gain access to the reserves they contain, thereby increasing the volume of reserves under their control (with or without having discovered them).

A similar trend is evident in the mining sector, where the level of spending on M&As tends historically to be greater than that on exploration and development. However, here too there has been a reaction to the M&A transactions carried out in the years when commodity prices were high, with a severe decline in the volume and value of M&A transactions amid large impairment charges or write-downs of asset values that have followed these early deals. Separately, regulatory hurdles are a challenge for cross-border mining transactions, with governments reluctant to allow a transfer of ownership of resources to foreign companies, and a growing concern about loss of tax revenue that may follow from their approval.

When M&A occurs, such activity reflects a transfer of ownership of the present stock of mines and associated processing facilities. Inevitably, its value is significantly higher than the value of annual additions to that stock, which derives from exploration and development. Just as in the

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hydrocarbons sector, junior companies will expect to gain their rewards by selling any discoveries to larger mining companies for exploitation.

It should already be clear that the business models of companies in EI activities are far from uniform and need to be understood by governments and their advisers in designing policies for this sector. There are in the EI sector companies that can be classified as large integrated IOCs, junior or “independent” IOCs, and NOCs, which can operate internationally, regionally, or simply nationally. The company that is likely to sell its asset in the event of an exploration success is also usually one with a higher than average appetite for risk, and that can have advantages to governments looking for a first-mover to generate interest in their territory.

Policy effects

Policy needs to take into account the real differences among types of companies and the M&A dynamic arising from the maturity of prospects from exploration to extraction. It also needs to account for a shift that commonly occurs from junior to more major producers. This is particularly evident in the petroleum sector, where the investment returns on successful projects tend to be higher and payback periods tend to be shorter than in mining. Decisions need to be made about the kind of companies that a government wishes to see as investors within its borders. Many years ago, the Norwegian government policy was organized around a preference for the larger, integrated companies in its emerging hydrocarbons sector, while its North Sea neighbor, the United Kingdom, favored the entry of a diverse range of companies into offshore exploration. These decisions affect policy at the beginning of the value chain (the award of rights) but also have impacts at later stages, with M&A activity being prevalent throughout. This is to some extent the lifeblood of a healthy industry, but it is a flow that governments should keep a close eye on. In particular, governments should ensure that the environmental conditions associated with the license to operate are carried over to the new company.

South-south investment

A significant change in recent years has been the growing role of EI companies from the emerging economies, especially in low-income countries. In this group, Brazil’s, China’s, and India’s national or private companies have made the most notable impacts on the international EI scene. Russia also provides a home to new corporate players, even though it is not located in the South. Companies from other countries such as Malaysia and Thailand (hydrocarbons), Peru (silver), South Africa (platinum), and Botswana (diamonds) have made significant impacts on global EI markets in recent years. Countries in this group are taking a much larger share of global spending on exploration in the mining sector, amounting to 60 percent, according to one study (Humphreys 2009, 2).

Much of the literature on the development implications of EI has focused upon the impacts of foreign direct investment from OECD or other developed countries, or NorthSouth flows. However, the rise of players from emerging economies, and the so-called BRICs (Brazil, Russia, India, and China) in particular, raises questions about how SouthSouth flows will affect established patterns. It is still too early to answer. As David Humphreys (2009, 21) notes in a study of such companies in the mining sector:

[I]nvestors from these countries sometimes bring a rather different set of perspectives to their overseas investments, emphasizing, on the one hand, raw material security of supply considerations along with the commercial prospects of a mining project and, on the other hand, the benefits of such investments taking place within the context of a broader government-togovernment financial and cooperation agreement.

Oil and gas dynamics

Large, integrated companies operate internationally at all stages of the petroleum cycle: exploration, production, transportation, refining, and marketing. These are usually known as the IOCs, are privately owned for the most part, and are based in the United States and Europe. The six companies commonly attributed to this group are BP, ExxonMobil, Shell, Chevron, ConocoPhillips, and Total. Sometimes called “super-majors,” these companies account for about two-thirds of the world’s exploration and production investments, with the balance being made by NOCs. They are especially prominent in deepwater exploration and development and liquefied natural gas (LNG) projects; their size and resources allow them to manage and finance such projects more easily than other companies and to face the risks that these projects entail.

National oil companies are common among resourcerich states, with around 90 percent of the world’s oil and gas reserves and 75 percent of the production under their control. The largest is Saudi Aramco (Saudi Arabia).

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Some of these NOCs have become increasingly active beyond their home base, competing with the IOCs for access to new or existing petroleum reserves. Examples of companies that have ventured outside their national territory are China’s CNOOC, CPNC, and Sinopec; India’s ONGC; Brazil’s Petrobras; Russia’s Gazprom; and Malaysia’s Petronas. NOCs are also used by their home states as vehicles to secure much-needed energy resources for domestic industries’ needs.

Junior companies, sometimes called independents, do not have the high overhead costs of the IOCs. Their size can vary considerably, with the smaller ones typically hoping to significantly profit from the sale of promising prospects, sometimes to other, larger independent companies. They are usually prepared to accept high risks at the exploration stage, both in terms of the hydrocarbons they target and in terms of the countries in which they explore. For this reason, they often dominate in initial exploration, especially in frontier settings. They tend to respond quickly to current demand and change their exploration focus rapidly. For the most part, they operate with funds raised from individual investors and equity finance, often in provincial stock markets such as those in Canada and Australia, making their expenditure highly volatile.

Oil service companies are usually confined to the provision of services and supplies to the operating companies that manage exploration and production on behalf of their consortium partners. Drilling wells and oilfield management are frequently outsourced by operators to specialized service providers. The larger service companies, like Halliburton or Schlumberger, are capable of becoming involved in preexploration, exploration, and production, but they may choose not to pit themselves competitively against their oil company clients and therefore refrain from such activities.

Within the industry, three business stages are commonly distinguished: (1) upstream, meaning the exploration, development, and production activities; (2) midstream, meaning the storage, trading, and transportation of crude oil and natural gas; and (3) downstream, meaning refining and marketing. Some companies, such as ExxonMobil, Shell, and BP, perform activities in each of these segments. However, many of the thousands of firms in the oil and gas industry are specialists or niche players; further, some carry out different activities within one or more of the above segments. In the EI Value Chain that is used in the Sourcebook, the upstream activities fall within the first and fifth chevrons, while some of the activities in the midstream and downstream segments are treated in the second chevron, “sector organization.” The market for crude oil is shaped by many players: refiners, speculators, commodities exchanges, shipping companies, IOCs, NOCs, independent companies and the Organization of the Petroleum Exporting Countries (OPEC). For the most part, the Sourcebook focuses on the upstream activities.

Natural gas is commonly found in association with oil. The techniques for discovery are the same. Hence, the larger oil companies are often also among the largest producers of natural gas. Some companies have started out, however, as gas companies and moved into oil: Encana (Canada), ENI (Italy), BG (UK), and ELF (France) are examples. Gas is very much like oil in the upstream segment and very different from it in midstream. However, important and distinct characteristics of gas differ from those of oil in the upstream segment: gas processing and natural gas liquefaction. In the midstream segment, transporting natural gas is more complex and much more challenging than transporting crude oil, albeit with fewer environmental risks. Constructing and operating pipelines to bring natural gas from remote locations to markets raises complex issues of cross-border regulation (see chapters 5 and 6). However, transportation of gas has become significantly easier over the past decade with the expansion of the LNG industry, dominated by the largest IOCs. It offers significant opportunities to countries along the coast of Africa and the Aceh province of Indonesia, where large gas deposits have been found far from the main consumer markets. This, of course, comes with infrastructure implications for emerging gas producers, which the Sourcebook takes note of (see chapters 5, 6, and 9).

Mining dynamics

Large, international, multiproduct mining companies are relatively few in number. Typical examples would now include Anglo American, BHP Billiton, Rio Tinto, Vedanta, and Glencore. They are involved in every stage of the industry value chain and typically have an interest in several types of minerals. The rationale behind this diversification of activity and products in the minerals sector is to spread the risk of activities and achieve a higher average rate of return than would be achieved with a single product such as gold, coal, or iron ore. When one commodity is down in price another should be up—that is the assumption. Looking at the largest companies more closely, many are much less diversified than at first appears. If one focuses on the larger companies, six have more than 50 percent of their work in iron ore, four are copper producers, and three are gold producers (Ericsson 2012, 8). The dependence on iron ore is

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mostly a product of timing; 2011 was the peak of the iron ore price cycle. For the most part, then, they are dependent on one metal for more than 50 percent of their production. These companies tend to be diligent in their approach to environmental and social performance standards and social investments. They commonly adhere to international standards and reporting requirements, through, for example, the International Council on Mining and Metal’s Sustainable Development Principles, and the International Finance Corporation’s performance standards.

National resource companies are fewer in number and much less influential in mining than their counterparts in hydrocarbons. Even so, Burnett and Bret put their number at around 80, varying according to size, commodity focus, geographic reach, and degree of independence from the State (Burnett and Bret 2016, 11, 16). Typically, they focus on a limited number of minerals and sell them on the international market. Early efforts at state ownership and control included significant failures in Africa, such as the nationalization of copper mines in Zambia, and in the state companies established in centrally planned economies, largely in Eastern Europe and parts of Asia where, for a long time, it was associated with a heavy industry development model. The Zambian effort was part of a wave of nationalizations of foreign mining companies in developing countries in the late 1960s and early 1970s. During the 1960s there were 32 expropriations of foreign mining companies; between 1970 and 1976 the number reached 48 (UNCTAD 2007, 108). Governments retreated from state control in the 1990s, but the practice remains high in many metals, partly due to the growth of state-controlled mining in China. Some Chinese companies are becoming quite prominent outside China: Chinalco, MMG, China Molybdenum, and CNMC, for example. In the diamond industry there are examples of successful state holdings in Botswana and Namibia, both of which have formed joint venture companies with De Beers (RMG 2011, 10). An example in copper is Codelco, the Chilean producer. In iron ore there is the Indian mining company National Mineral Development Corporation. Some of the large “national” mining champions, such as Vale in Brazil or Norilsk Nickel in Russia, also enjoy a close relationship to government. In Vale’s case, the Brazilian government holds a golden share, which could be used to block a foreign takeover.

Junior mining companies are typically medium- or small-sized companies focused on exploration activities in one country or region or a specific mineral or group of minerals. They may be owned by domestic entrepreneurs or international firms, sometimes backed by venture capital or private equity.12 There are about 1,700 such companies (Burnett and Bret 2016) and they make up the majority of mining companies in business today. Indeed, many mineralrich countries have a group of such companies of differing sizes, sometimes each operating in only one mine. Examples, can be found in Chile, Mexico, and Peru. They will usually have local ownership and staffing. Such companies can accept higher risk than the larger ones, both in terms of the type of mineral target sought and the countries in which they explore. They also “tend to seek the products that are presently fashionable, and they can and do change their exploration focus quickly” (Crowson 2008, 118). For companies that focus solely on exploration, they are likely to recoup their capital not by developing the reserves themselves (by which stage their interests are likely to be diluted significantly), but by selling most, if not all, of their discoveries to larger companies with the technical, financial, and marketing skills and access to the capital markets. Sometimes the larger companies provide the junior ones with the capital to support operations and an assurance of a market for their discoveries if successful. At the peak of the cycle, in 2006–8, junior mining companies accounted for over 50 percent of total mineral exploration, and the majors 30 percent. Ten years later, those proportions had reversed. Juniors are volatile because they generally depend on equity markets for their funding, and so are susceptible to cycles. The principal markets for risk capital for juniors are largely limited to Australia, Canada, and London.

Small-scale miners and artisanal workers play a key role in mining, and this has no parallel in the hydrocarbons sector. Their work may take on a corporate character, with workers employed to mine, but this is generally on a very small scale. The subsector is the equivalent of subsistence agriculture and is labor intensive, employing on a conservative estimate as many as 30 million people around the world. They always operate informally and sometimes also illegally.13 These companies and workers usually account for minor shares of global mining production. They tend to concentrate on high unitvalue products, such as gold and gemstones, and are widely found in developing countries. Health and safety conditions among such miners are often poor; these operations tend to employ women and children, and they often cause significant environmental damage. The benefits to a host country of such mining are unlikely to be reflected in any tax returns, and mining codes and tax systems are usually not responsive to this kind of activity. This sector is on the increase, with impacts on the sensitive or protected ecosystems and biodiversity and encroachment on World Heritage Sites. (Largescale mining also can have such impacts.) It is relatively insulated from the rise and fall of commodity prices

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