By Katherine Young
April 15, 2007

With resources in so-called 'safe' countries becoming increasingly scarce, and pressure from growing economies increasing the demand for commodities, resource companies, including juniors, are forced to look further afield for the next big thing. In the current economy, situations and environments that may have seemed too risky in the past have to be considered.

Katherine Young of the Resourcex Investor spoke to Stephen Bailey, Senior Vice President of Frontier Strategy Group - a global research and advisory firm that specializes in analyzing above-ground risks in natural resources industries - about what juniors can do to reduce political risk to their projects.

Resourcex Investor: What are the key factors a junior resource company should consider in assessing the political risk to their project?

Stephen Bailey: The first issue that should be considered is macro stability in terms of the safety of its workers both on the exploration side as well as the operations side. Is this the type of country where we feel safe, where we feel confident our workers could be safe?

Once that threshold is crossed then junior companies should consider other issues such as can we do business here while also maintaining sound legal and moral practices with respect to issues such as corruption, as well as issues such as the use of security forces to maintain the safety of assets and workers.

In a lot of environments it's important for companies, and in particular junior companies, to think, given my size, what type of leverage can I bring to bear to ensure that I can be successful here even if conditions in the country deteriorate from a political perspective? Are there partnerships I can develop with NGOs and important government actors or international institutions that would help me to continue to operate if things were to deteriorate?

RI: You mentioned some key strategies like partnering with NGOs and developing relationships in governments. What would you outline as the other main strategies for reducing political risk?

SB: Before you can do anything, an essential prerequisite is to have a very firm understanding of where the environment you are operating in is likely to head"¦so what I mean by that is: if you're in a country where there's been significant civil conflict, like for example the Democratic Republic of the Congo, developing signposts such as: What is the percentage of members of the military that have been demobilized that continue to be armed? How have the elections played out and what have those elections meant for the positions of the key opposition leaders? By tracking those types of variables and signposts you are able to get a sense of where the environment is likely to head over time so that you can be on the proactive side rather than the reactionary side.

RI: What do you think junior companies can do to maximize leverage that they may have?

SB: The most important thing you can do to maximize leverage is, first from a governmental relations perspective, identify the key actors within the government who are likely to maintain their influence over time, those actors being technocrats or individuals within the government who are very well-respected [and are] unlikely to ever lose influence within the country.... Because if one administration is toppled by another or one administration is ushered out, you don't want to be in a position where the administration that's coming into power ushers you out in an attempt to remove any vestige of influence that the previous administration might have had.

The other thing is, in the communities where you operate it's very important for junior mining companies to create very strong partnerships with NGOs both at the local and national levels - or I should say international levels - to make sure that their presence is sustainable by the people who are most affected by it. Through those partnerships, [junior companies are] able to extend and expand on a limited amount of resources [they] have to devote to these social issues. It's really outsourcing some of the responsibility that you have in a way that allows your presence to be sustainable and politically popular.

RI: If a company was going to join with a joint venture partner as a strategy to reduce political risk, what are some of the downsides of that strategy?

SB: Joint venture partnerships comprise different types: partnerships with western companies that largely share your values, your operational practices and your interests; partnerships with other actors that are likely to have influence in a particular country or geography"¦.

The main challenge comes with respect to the latter group, where those companies might not necessarily share the same legal obligations that western companies have and also might have different interests than western companies have, and in those cases it's very important to recognize the reputational challenges that exist. If those companies do engage in corruption, or if their labour practices or environmental practices are not sound, part of that responsibility is ultimately going to be transferred to you as a joint venture partner.

It's also important to recognize that the security of your assets is something that has to be protected. If you partner with a Russian or a Chinese company in an area where you don't have influence it's important to understand how you can maintain a long term alignment of incentives between the joint venture partner and yourself. It's not enough just to bring money or technical skills to the table, because once that money and technical skill has been transferred to the joint venture partner you no longer have any use to them. So coming up with ways to maintain your leverage throughout the joint venture partnership [is important] and if you can't do that, don't enter the partnership.

RI: You suggested earlier that having another project in another country where the partner doesn't have close ties, and you do, might be a good way to create incentive for the partner.

SB: Exactly. I think it's very important for western companies to think outside of the box in terms of the joint venture projects of the future. When you're operating in an area where you partner with [for example] a Chinese or a Russian company, the rules that apply to traditional partnerships with western companies may not apply. You have to be very creative in terms of creating an alignment of incentives, and one way to do that is by entering a more grand strategic partnership in which you give access in a country where you have significant influence in exchange for access in a country where they have significant influence. The benefit of that is that the country you partner with is less likely to expropriate or impair your asset because they recognize that would have ramifications for them in the country where they have less leverage.

RI: A balance of power.

SB: Exactly.

RI: How effective is political risk insurance?

SB: It's really difficult to talk about it in broad terms. It really needs to be done on a case by case basis. In some countries it probably would be something that's essential, in other countries it's probably in the range of optional, and a lot of it depends on what type of risk an individual company is willing to bear.

If a company wants to have a greater upside it might forgo political risk insurance because the premiums are going to decrease their annual return rate. It's also important to remember that there are other tool kits that companies have to limit their exposure, such as non-recourse debt financing that provides the company with capital foreign investment but does not leave them on the hook for those loans if the political situation deteriorates.

So, political risk insurance, non-recourse debt-financing, and joint-venture partnerships that spread risk across the partners are options you can use that limit your exposure. But it's hard to talk about which ones should be used without talking about a particular environment.

RI: Are there any downsides to partnering with the World Bank?

SB: I think the World Bank is an excellent organization to partner with. One place where things can go wrong is if a company thinks that a partnership with the World Bank can solve all its problems. It's important to have a broad array of partners on the national political level, the local level and the international level that minimize geopolitical risk exposure no matter what direction the country takes. If you put all your eggs in the World Bank basket, and the country decides they are going to take money from the Chinese [for example], then kicks the World Bank out, suddenly you're left without a significant partner with influence in the country. So while it's important to use the World Bank as a resource and a very important point of leverage in a lot of countries, it's also essential that you diversify your partnership base to allow you to succeed no matter how the environment changes.

RI: One last question: if there's a mine operating in a given country and they've run into problems either on the government level or the community level, and then another company wants to open a similar mine in that country, how can that second company protect itself from the problems the first company encountered and perhaps created?

SB: That's a very good question and once again, it's difficult to talk about that in generalities. Sometimes it's because it's not possible to operate there. For example a company could end up getting kicked out because the government has a new policy of nationalizing all assets and in that case it doesn't really matter which company you are, it's going to be difficult to come in"¦I think cases where there has been a company that has been essentially kicked out because the government has decided it wants to nationalize the asset, or is unhappy with western investors, the best thing you can do, or really the only chance you have of success, is to provide the government or the community or both with a new and long-term economic incentive to accommodate your presence. And that can be through partnering with the national company of the government such that they have a vested interest in having you operate there if they don't have the technical skills to do it themselves, or one very innovative method that's been used by some companies is to provide the community or the government, oftentimes the regional government or sometimes the national government, with an equity stake in the project and then to publicly float an entity as the subsidiary of the main company such that if the government does anything to impair the asset then it's also going to be impairing the value of the equity that you've given to the government so it creates a clear long term alignment of incentives.

RI: Does that work on the small scale as well for junior companies?

SB: Absolutely. Let's say you're a company that only has one asset, if you're open, and this is obviously on a case-by-case basis, but if you're open to making the junior entity public and you give the government some stake in that public entity the same principle applies-to the extent that they do anything to impair your asset, the market value of whatever stake they have is going to be impaired as well.

Katherine Young writes for Resourcex Investor, an internationally distributed newsletter specializing in identifying as-yet-undiscovered resource companies representing the best in their class. For more information, visit the website www.resourcexinvestor.com.