About David Anderson

David Anderson is head of credit & political risk for Zurich.
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Water Scarcity Risk: Not Just a Local Political Issue

mining-and-water
There are few issues as politically charged as water, not only because people’s survival depends on it, but also because it is a critical component of so many industries. Agriculture, food and beverage manufacturers, refineries, paper and pulp companies, electronics manufacturers, mining operations and power plants—are of these rely on a continuous and reliable water supply.

When companies move into markets with weak infrastructure or questionable rule of law, drawing on these resources can quickly bring them into conflict with local citizens and, sometimes, the host government. Because of its vital importance, however, water scarcity has become much more than a local issue for businesses.

Water shortages can lead to conflict as competition grows for diminishing resources, as any scarce resource on which people depend is likely to become political at some point in time. One scenario that repeatedly unfolds is as follows: A mining operation depletes local water resources or has a tailings dam accident that contaminates a local river, a protest ensues and the host government intervenes in the project. Hydroelectric power projects can create a number of similar political risks and some different ones, including relocation of local villages.

In recent years, however, awareness has grown about how water scarcity risk affects political risk at the national and international levels, requiring a different type of analysis. The depletion of rivers, lakes and streams has led to more dependence on below-ground water. More than two-thirds of groundwater used around the world is for irrigating crops, and the rest of below-ground water is used to supply cities’ drinking water.

For centuries, below-ground water supplies served as a backup to carry regions and countries through droughts and warm winters that lacked enough snowmelt to replenish rivers and streams. Now, the world’s largest underground water reserves in Africa, Eurasia and the Americas are under stress, with many of them being drawn down at unsustainable rates. Nearly two billion people rely on groundwater that is considered under threat.

What makes the problem particularly difficult to solve in the emerging markets is that small, often subsistence, farmers are doing the drilling for water. The U.S. military called climate change, including reduced access to water, a “threat multiplier,” potentially threatening the stability of governments, increasing inter-state conflict, and contributing to extremist ideologies and terrorism.

It is always difficult to establish causality with something as complex as politics, but there certainly is circumstantial evidence that water scarcity was a factor in the Syrian uprisings that led to the country’s civil war. In Yemen, some hydrologists warn the country may be the first to actually run out of usable water within a decade, and combatants are making a bad situation even worse by using water and food as weapons against opposing villages. In Sudan, desertification and water scarcity have been cited as having a strong link to the Darfur conflict.

Since water does not respect political borders, the conflicts can become international.  One of the most high-profile disputes has been Ethiopia’s damming of the Nile River for hydroelectric power, potentially threatening Egypt’s ancient water source. In 2013, Egypt’s then-president said he did not want war but he would not allow Egypt’s water supply to be endangered by the dam. Fortunately, in 2015, Egypt, Ethiopia and Sudan signed an agreement allowing dam construction, provided that it did not cause “significant harm” to downstream countries. But the studies into how much harm it could do have not even been completed yet, and the dammed water could be diverted to uses other than power. Thus, the political risk surrounding the Nile River is far from over. Since 1975, Turkey’s construction of dams for irrigation and power have cut water flow into Syria by 40% and into Iraq by 80%, setting off disputes there.

Companies are accustomed to building water into their business plans in developing countries. Environmental impact assessments and proactive community relations programs can bring potential problems to the surface before they start, helping companies manage water in an environmentally and socially prudent manner. The geopolitical risks around water scarcity can be more difficult to manage, however. In this area, companies should consider building water scarcity into their political risk management and forecasting frameworks, factoring it in when making investment and supply chain decisions. If governments cannot find ways of sharing this limited resource, political violence risk may become even more of a factor for international businesses to consider.

This article previously appeared on Zurichna.com.

Oil and Politics: Brazil’s Petrobras Scandal

PetrobasLast month, we focused on Mexico and specifically the state-owned oil company Pemex as a risk for companies selling or investing into Latin America. We saw that Pemex represents a drag on Mexican fiscal accounts and is imposing losses on suppliers and investors. This month, we turn our gaze to Brazil: it is similar to Mexico in that it has a dominant, politically charged state-owned oil company, but different because the scale of the crisis is much more severe, as are the risks to suppliers and investors.

Brazil is undergoing a major economic and political crisis, and its state-owned oil company, Petróleo Brasileiro S.A. (Petrobras), is right at the center of the trouble. Petrobras shares some of the same challenges as Pemex: It started as an entirely state-owned firm, was used as an instrument of government policy from inception and took on enormous quantities of debt in recent times, exemplified by its $11 billion debt issue in 2013—the largest on record for emerging markets.

Brazil, however, recognizing earlier than Mexico the necessity of foreign investment for a viable oil industry, opened up the sector in 1997 and eventually reduced the government shareholding to 64% (direct plus indirect). Petrobras expanded into deepwater areas in Angola and the Gulf of Mexico and became one of the few national oil companies able to equally compete with companies such as Royal Dutch Shell and Total.

In 2014, information about the extent of corruption between Petrobras board members, various politicians and business executives not only came to light, but also sparked official investigations and arrests. President Dilma Rouseff has been temporarily removed from office pending a trial by the Senate. The official charge against her is manipulating the federal budget by directing state banks to support spending programs. She was the chair of Petrobras when the corruption allegedly occurred, however, and she and her party (Partido dos Trabalhadores or PT) are perceived by many as at least partly responsible for the scandal.

It is likely that Rouseff will be permanently removed from office within six months, but the uncertainty does not end there: As of this writing, two cabinet ministers have been removed from office, and six more are under investigation. Dozens of politicians and executives have been convicted in connection with the scandal, and prosecutors have recovered $795 million in stolen money. The economy of Brazil shrank 3.8% in 2015 and is projected to shrink another 3.5% in 2016. Moody’s downgraded Petrobras to Ba2 in December 2015, and S&P cut the sovereign rating to BB with a negative outlook in February. With the Zika virus now causing a global health emergency and the Olympics beginning in August, one wonders how many more stresses Brazil can take before serious political unrest breaks out.

Like with Pemex, the Petrobras crisis is increasing risks to suppliers already: There are trade credit insurance claims stemming from suppliers to Petrobras, and the wider Brazilian economic downturn (combined with the commodity price trough) is giving rise to other credit losses. But the Brazilian crisis goes well beyond trade credit risk. Brazil is a $2.2 trillion economy and one of the largest bond issuers in the emerging markets. As a result, this crisis has global implications: Eurasia Group has Brazil as one of its top 10 global risks for 2016.

Mexico and Brazil are not the only countries dependent on state-owned oil (or other natural resource) companies that are facing major challenges: Venezuela, Ecuador, Nigeria, Angola, Russia—the list goes on and on. In Brazil, however, there are some mitigating circumstances that reveal a silver lining. First, 85% of Brazil’s sovereign debt is held domestically, meaning it is less affected by currency depreciation and is easier to reschedule. Provided Brazil takes on some painful fiscal reforms, the country can dig itself out of the economic crisis. Secondly, so far, officials have been able to investigate and prosecute some of the parties responsible, despite the defendants being some of the more powerful people in Brazil.

There is hope that Brazil’s institutions will emerge all the stronger for being able to correct wrongdoing, which may set the stage for a more just Brazil and a better investment and credit risk environment in the long run. In the meantime, we are likely to see severe market and political volatility. It is a good idea to closely monitor your exposure in Brazil and in other countries dependent on highly indebted state-owned natural resource companies.

Mexico’s Pemex Illustrates Trade Credit Risks in Latin America

With all the focus on the Middle East and Europe, it is easy to lose track of Latin America as a region with major risk issues. Companies investing and selling to Latin America have become accustomed to viewing its largest economies—Mexico and Brazil—as relatively low-risk countries with promising growth prospects. That perception has recently changed, however, largely because of a common ingredient: large state-owned oil companies on which the government depends.

With a $1.26 trillion economy and population of 122 million, Mexico is a key market for the United States and Canada, particularly since the advent of the North American Free Trade Agreement. Some $535 billion in trade occurred between the U.S. and Mexico in 2014. From 2000 through 2012, U.S. foreign direct investment into Mexico totaled $291.7 billion.

With a monopoly (until recently) on oil production and fuel distribution, Petróleos Mexicanos (Pemex) is a colossus—the largest company in the country, representing about one-third of all government tax revenues and approximately 5% of Mexican exports. From its origin in 1938, Pemex has also been a political entity, as it was nationalized at a time when foreign companies dominated the oil sector. Since then, it has become enmeshed in Mexican politics and patronage, suffering from frequent allegations of corruption.

However, in the early 2000s, Mexico’s political leadership recognized a problem: oil production was falling and Pemex lacked the resources to invest in new fields to reverse the trend. Clearly, foreign investment was going to be needed to keep Mexico competitive in world oil markets. So, in August 2014, Mexico passed the laws necessary to open up the oil, gas, and power sectors to private companies, including foreign ones. Unfortunately, with oil prices taking a serious downturn, the timing of the opening was awful. Pemex was losing its monopoly at the same time its revenue was dropping and home currency was depreciating against the U.S. dollar, after it had accumulated enormous foreign currency debt.

Not surprisingly, in November 2015, Moody’s downgraded Pemex’s credit rating from A3 to Baa1, with a negative outlook. Without the sovereign support, the rating was put at a lowly Ba3. And Pemex’s problems have directly drained the central government: this month, the Mexican government announced over $4 billion in aid for the company.

Pemex has serious cash-flow problems and is not able to pay its suppliers on time. In late 2015, citing low oil prices, it announced that it would unilaterally extend payment terms on all contracts to 180 days from the previous 60-90. For suppliers dependent on short payment terms who were already under cash-flow stress from general industry conditions, these payment delays could cause serious financial problems, including bankruptcies. Accordingly, the trade credit insurance industry—which covers buyers’ failure to pay contractual trade obligations on the due date—is already seeing claims related to Pemex and its suppliers.

Except for people who remember the early 1980s, when Mexico defaulted following the high oil prices and debt run-up of the 1970s, Pemex’s problems were unthinkable just a few years ago. This is an example of the difficulty of predicting how commodity markets, politics and financial management can mix for any given country. However, while Pemex’s problems are serious for its suppliers and represent a drag on the economy, Mexico is still forecasted to grow 2.6% in 2016 and no wide political crisis is currently underway. Many other countries dependent on oil are not so lucky. Next month we will look at one with much more serious problems and risks to investors and suppliers: Brazil.