The Time Consistency Problem: Why African Governments are Increasingly Renegotiating Mining Contracts

About two days ago I learnt, from a Financial Times article, of Gabon's intentions to seize Sinopec's oil assets. The authors of the article stress that "this is a sign of Africa’s growing assertiveness as competition intensifies for its natural resources". This assertion is not entirely correct; competition for natural resources is not the core driver of Africa's growing 'resource assertiveness'.

In this post, I will use Paul Collier's research findings (cast within a hypothetical scenario) to discuss the driver of Africa's increasing resource assertiveness; the Time Consistency Problem (which stems from an admixture of demographics, politics and inadequate geological information).

***

In this post, I will discuss: 1) How mining companies bid for prospecting rights; 2) The time consistency problem, and; 3) Ways of eliminating "resource squabbles".



...How Miners Bid for Prospecting Rights

To arrive at the approximate bid price for prospecting rights, miners use the Expected Return concept. The Expected Return of any discrete scenario can be simply approximated by multiplying the return that would accrue to investors, if the scenario eventuated, by the probability of the scenario eventuating. Otherwise put, the Expected Return of any scenario can be computed using this formula:

E(Ri) = Probability of scenario i × the return of scenario i 

Illustration 1, below, depicts the Expected Returns of three independent hypothetical prospecting ventures in Country A, Country B and Country C. In each of the scenarios, the net present value of the sub-soil asset is USD 1 billion.

Illustration 1 (click on illustration to zoom in) **

**Note: For the sake of simplicity, Illustration 1 ignores the downside probabilities and their associated costs


As Illustration 1 shows;

• The probability of discovering a USD 1 billion subterranean asset beneath the Country A Claim is 0.2. Hence, this means that the expected return for the Country A Claim is USD 200 million. If a mining house were to bid for rights to prospect the Country A Claim, it would, ceteris paribus, bid a maximum price of USD 200 million.
• The probability of discovering a USD 1 billion subterranean asset beneath the Country B Claim is 0.4. Hence, this means that the expected return for the Country B Claim is USD 400 million. If a mining house were to bid for rights to prospect the Country B Claim, it would, ceteris paribus, bid a maximum price of USD 400 million.
• The probability of discovering a USD 1 billion subterranean asset beneath the Country C Claim is 0.8. Hence, this means that the expected return for the Country C Claim is USD 800 million. If a mining house were to bid for rights to prospect the Country C Claim, it would, ceteris paribus, bid a maximum price of USD 800 million.

That was the easy part, now to backtrack a little: how do mining companies arrive at the hypothetical USD 1 billion net present value of a claim? An oversimplified answer:

1. They estimate the total quantity of the resource that can be extracted from the claim.
2. They estimate the quantity of the resource that they would need to extract to achieve target levels of capacity utilization and efficiency.
3. They estimate the trajectory of the resource price and the resource quantity that they would need to extract to achieve a target annual return on investment.
4. They estimate the level of political risk of the country that has the resource endowment, and, they add it to the mining house's Weighted Average Cost of Capital. This allows them arrive at the discount rate that would be employed in the valuation exercise.
   

To value each (projected) annual (net) cashflow, Elements 1 to 4 can be plugged into this fomula as follows:

Once the present value of each annual cashflow has been estimated, the cashflows are then aggregated to arrive at the value of the resource endowment to the mining venture. This invariably tends to be much lower than the absolute value of the resource endowment, which is computed as follows:

Total quantity of the resource that can be extracted from the claim * The current unit price of the resource on commodities markets

...The Time Consistency Problem

On the 2nd of January in 2009, the price of gold stood at $874.50 per troy ounce. This implies that a claim with a net present value of USD 1 billion in Country A (refer back to Illustration 1), would hold 1,143,511 troy ounces of untapped reserves.

If the probability of "striking it rich" on such a claim was 0.2 (refer back to Illustration 1), the mining house would have bade no more than USD 200 million (i.e. the Expected Return of the claim) to prospect the claim. Otherwise put, if the mining company "struck it rich", it would have paid no more than a fifth of the net present value of the resource asset.

***

By and large, Country A tends to be an under-developed country which has a youth-heavy demographic structure; i.e. a nation which is enduring the pressure to attract investment (in a bid to create jobs).

Otherwise expressed, Country A tends to be a developing nation that has to implement "pro-growth" policies like; tax holidays and tax rebates. Hence, it is reasonable to assert that the mining venture that struck it rich in Country A in 2009, essentially pays:

• Little-to-no taxes.
• Very little in royalties to the government of Country A.

***

If the-said venture only extracted 900 ounces of gold between 2009 and February of 2012, its net gold reserves would, at February 28 2012 gold prices, amount to 1,142,611 ounces. Hence, the nominal absolute value of the resource asset would lie over USD 2 billion (i.e. double its 2009 nominal absolute value). When this happens, people start to pay close attention and the noise starts:

***

Generally, the trend in most societies is towards greater transparency, egalitarianism, democracy and openness. Thus, with the progression of time, there would be a 'growing awareness' of: the "pittance" that the mining venture paid for prospecting rights; the appreciating absolute value of its resource asset; its growing profitability; its level of Corporate Social Responsibility (CSR), and; its small tax bill and tax optimization practices (e.g.).

In an environment with high unemployment and poverty, this "growing mass awareness" would assume a toxic political dimension and compel the government of Country A to renegotiate its contract with the venture. By and large, the resolve of the government of would strengthen with every uptick of the gold price. Eventually, if the mining venture is headstrong, this pressure would culminate in a fight between the government of Country A and the mining venture, as is shown in Illustration 2 below:

Illustration 2 (click on illustration to zoom in) Adapted From: Index Mundi

Obviously, the odds of winning such a fight are heavily stacked in favour of the government of Country A.

***

From the narrative that precedes Illustration 2, one can conclude, as is shown in Illustration 3, that more information translates into a lower level of commitment to uphold the exploration and mining contract:

Illustration 3 (click on illustration to zoom in)

This is known in economics as the Time Consistency Problem.

To avert it, the government of Country A would need to internalize an approximation of the information that would be available at point c before it enters into a commitment at point a. This would reduce the risk of making uninformed commitments.

For this to happen, the government of Country A would need to unearth, husband and freely dispense information on its subterranean assets [1]. At a fundamental level, this would necessitate public investments in:

1. Country-wide resource exploration endeavours.
2. Databases to organize all available information on subterranean assets.
3. Resource exploration and exploitation analytics. 
4. Channels for dispensing as widely as possible information on subterranean assets.

How, could this four-pronged strategy be operationalized? For the answer to this question, you would need to read Paul Collier's collection of papers and his texts.

Read!

[1] This measure would have the benefit of de-risking the prospecting phase of mining. Otherwise put, the probability of unraveling resource assets, when prospecting, would increase. This would in turn increase the Expected Return of claims / The amount that mining companies bid for prospecting licenses.