Oil Price Volatility Increases Political Risk and Opportunity
In risk management, dealing with change is a constant challenge and that challenge increases when change is unexpected or is greater and occurring more rapidly than anticipated. This last is the definition of volatility, and it accurately describes the current state of geopolitical risk. . One of the main drivers of political risk at the moment is volatility in commodity prices and, particularly, in the price of oil. Other commodities contribute to political and economic uncertainty, but oil plays a determinant role in the economies of some of the largest emerging markets.
The price of oil per barrel varies, largely because of the different types produced worldwide. Futures and options contracts on two predominant grades are among the most actively traded instruments and provide a consistent basis for comparing the global price of oil. West Texas Intermediate Crude oil is now about $48 a barrel. One year ago, its price was nearly $60. Two years ago, the price for WTI Crude was more than $100 a barrel. Brent Crude, produced in the North Sea, is priced slightly higher per barrel. The U.S. Energy Information Administration’s Short-Term Energy Outlook forecasts that WTI Crude will average about $40 a barrel in 2016 and $50 in 2017, while Brent Crude will be about a dollar higher.
The EIA notes that the current contract values for oil suggest high uncertainty in the pricing outlook. In spite of the recent rally, market fundamentals suggest that oil prices are likely to remain subdued due to excess supply. At a meeting of the Organization of Petroleum Exporting Countries (OPEC) in April 2016 in Doha, Qatar, OPEC members could not agree on a production freeze to bring global oil supply more in line with demand. In addition, Iran has resumed producing oil after the removal of sanctions. As a result, excess oil production is continuing to put downward pressure on pricing.
The ill effects of low prices are most apparent in countries whose economies rely heavily on oil exports. Two such countries that pose especially worrisome political risks are Venezuela and Nigeria. Venezuela is facing the possibility of a debt default and the threat of uncontrollable domestic chaos. Amid hyperinflation and government-imposed price controls, Venezuelans face empty store shelves and hours-long waits for basic goods. Nigeria, the most populous country in Africa, with more than 183 million people, is one of the continent’s largest oil producers. Oil accounts for about 75% of Nigeria’s government revenue and 90% of its exports. Attacks on oil infrastructure by militants have disrupted oil production, further straining the country’s ability to pay its obligations and paradoxically causing fuel shortages as the country cannot efficiently refine its own oil. Other sub-Saharan oil-producing countries, such as Angola, the Republic of Congo and Ghana, also are facing severe challenges from oil price volatility.
Under highly volatile market conditions, one sign of a country’s potential for opportunity is how it reacts when its budgeted revenues fall due to the price of oil, or indeed any other commodity on which its economy relies."
Rapidly changing and deteriorating conditions in a given country or an entire region, can create an environment of uncertainty and increasing risk of financial loss for businesses, lenders and investors. Political risk and trade credit insurance is a valuable tool to help mitigate these challenges and protect investments in less stable yet potentially profitable markets.
It would be easy to look at these countries and dismiss the idea of operating in or investing in them as too risky. As a leading underwriter of political risk and trade credit insurance, XL Catlin embraces the notion of finding opportunity in risk, rather than risk avoidance.
Under highly volatile market conditions, one sign of a country’s potential for opportunity is how it reacts when its budgeted revenues fall due to the price of oil, or indeed any other commodity on which its economy relies.
Ghana, for example, has been aggressive in its response to declining oil revenues. It negotiated a loan arrangement with the International Monetary Fund to provide funding to stabilize its economy and resist further shocks. That has made Ghana more attractive to bond investors and enabled the country to continue to invest in infrastructure. Like many countries, Ghana needs more investment in essential infrastructure such as power plans, roads and electricity distribution networks. That need—and the accompanying investment opportunities—isn’t going away.
Political risk and trade credit insurance can provide crucial support to multilateral and government development agencies looking to back infrastructure investment, businesses seeking growth opportunities as well as banks that want to preserve their lending capabilities in countries confronting heightened instability. Political risk and trade credit insurance capacity has grown over time, and there continues to be strong interest in buying it. Even though clients’ reasons for purchasing political risk insurance can vary, uncertainty over a country’s economic and political stability remains a prime reason to seek coverage.
Save for a handful of countries, today, there is less fear of outright confiscation or expropriation of assets. On the other hand, businesses are more concerned about political violence and nonpayment by sovereign or government-related entities. Nonpayment is a significant risk for organizations with exposure to the governments of Venezuela or Mozambique, for example, or for businesses with credit exposure to private sector entities in Brazil.
Although at manageable levels, claim activity in political and trade credit insurance is occurring now and we can expect it to rise, particularly in short-term credit coverage given the deteriorating credit environment for non-investment grade, or high-yield, risks. While not always linked to the price of oil or other commodities, trade credit risks should nevertheless be a serious consideration for any business operating across borders.
Managing political and trade credit risk is a matter of clearly understanding the many components of a risk, especially for coverage of transactions with long durations(). XL Catlin’s underwriters and risk analysts live and breathe geopolitical risk and are focused on the confluence of country, industry and credit risk on one hand and opportunity on the other. Using this deeper understanding, XL Catlin can offer coverage on tenors of up to 15 years on political risks and up to seven years on trade credit risks. We are looking to partner with companies and institutions that have staying power globally and, like XL Catlin, see risk as an opportunity.
About the Author
Rafael Docavo-Malvezzi is global head of risk and Americas regional product lead for Political Risk & Trade Credit Insurance at XL Catlin. Before joining the company in 2011, he was a risk manager at other insurance organizations. His career experience includes strategic planning and operations and risk consulting in financial services as well as analysis and research for the Council on Foreign Relations in New York and the Organization for Economic Cooperation and Development in Paris.