North American equity traders barely had time for their coffee to cool on the morning of Oct. 5 when shares of Calgary-based PetroKazakhstan Inc. plunged nearly 5 per cent. Investors were selling on word that the government of Kazakhstan was threatening to halt a $5-billion takeover by China's biggest energy producer.
A day earlier, the Kazakh parliament voted to approve a law that would give it the final say on sales involving foreign oil companies operating in their country. It didn't matter that the acquisition plan was announced two months earlier and was green-lighted by PetroKaz shareholders this week.
What did matter was that the former Soviet republic and recently independent country of Kazakhstan did not feel it was properly consulted on a matter that affected its own natural resources. Theories for the sudden stance are plentiful in the world of Eastern European politics. Most are directed at the cozy joint venture partnership between the government of Kazakhstan and Russian-based OAO Lukoil, which claims to hold a right of first refusal on the PetroKaz-owned oil field in question.
It is a political world and managing political risk isn't exclusively for seasoned investors. Mutual fund unitholders may not realize they're exposed to events in remote parts of the world through holdings in their funds. Many companies making headlines because of political conflict abroad could be part of their retirement portfolios. Natural resources, gold and currencies tend to attract the most political risk because of their ties to a country.
For retail investors, that means politically risky assets can be found in just about every Canadian equity, international or hedge fund. How to balance and manage that risk is critical to boosting long-term returns.
Two week's before the kerfuffle in Kazakhstan, for example, and on the other side of the globe, Venezuelan President Hugo Chavez threatened to cancel all mining licences and stop issuing new ones to foreign companies. The announcement sent a chill through capital markets over fears the leftist leader was considering a nationalization campaign that would transfer foreign-owned assets to the government. Toronto-based Crystallex International Corp., which is developing a gold deposit in the country, got caught in the political crossfire and shares lost more than 25 per cent of their value in a single day.
"The Crystallex experience speaks for itself," says Erik Nilsson, Bank of Nova Scotia's senior international economist.
Mr. Nilsson says most political risk is not that obvious and spotting it is not as simple as determining whether a government has a left- or right-wing political agenda. He says it often has more to do with political and economic stability, which puts places such as Indonesia, many Latin American countries and former Soviet satellites in the running. "In some cases, a government's motive could be a bluff to get more money out of the private sector," he says.
"The stans are a problem," he adds, referring to the term used to describe the former Soviet Republics that end with "stan." In many cases, old Cold War communist cronies occupy key private and public sector positions, and private property rights are a mere suggestion.
Mr. Nilsson says spotting a potential political pitfall anywhere is not easy. He advises that investors keep an eye on government policy statements and state of the union addresses. "You need to look for the tone of candidates during election campaigns. If they win, that will be what their supporters expect," he says.
As head of the management team at Sentry Select Capital Corp., Glenn MacNeill knows about the political risk involved with oil stocks. His background is in oil and gas and that's why he keeps a close eye on Sentry's $213-million Strategic Energy Fund.
"Political risk is just something you have to incorporate into your risk model," he says. The biggest political influence on oil stocks lately is acts of terrorism, or the threat of terrorism because the largest portion of the world's oil supply comes from the volatile Middle East. Mr. MacNeill identifies other political hot spots as the former Soviet Union, China, Venezuela and Nigeria.
When determining political risk, Mr. MacNeill looks at how a government has treated a company, and the sector, in the past. Regardless, he prefers domestic oil companies in his portfolio -- and if he's going to buy a foreign company, there better be a payoff. "We expect a much better return from foreign investments than domestic investments," he says.
Hedge fund managers tend to gravitate toward risk, and from an investment perspective political risk is just one of those things that must be dealt with.
"When you look at the situation you have to look at the risk and rewards -- and politics is just part of the risk," says Jean-François Tardif at Sprott Asset Management. Mr. Tardif owned PetroKaz for a period about two years ago in his Sprott Opportunities Hedge Fund. He says he was aware of the risk of doing business in Kazakhstan but couldn't resist its value.
"The stock was so cheap and generated a lot of cash flow," he says. He eventually took his profits when it wasn't so cheap, but says it wasn't politics that motivated the sale.
Hedgers such as Mr. Tardif tend to keep their cards close to their chests when it comes to strategy, but one simple political hedge he suggests is buying shares in a company he likes and simultaneously taking a short position in a similar company in the same country. The strategy works in principle but he admits it's far from a perfect hedge because the company with the long position could be singled out by the government. He points to OAO Yukos.
Yukos was once Russia's largest privately owned oil company until it was partly nationalized by the government of President Vladimir Putin last year. Company founder and president Mikhail Khodorkovsky was sentenced to eight years in a Siberian prison on tax and fraud charges he claims were politically motivated.
But you don't need to travel to the other side of the world to find political investment risk. In Canada, income trusts have been taking a beating from investors since last month when Ottawa announced it was merely reviewing the income trust tax structure. Trade disputes with the United States over lumber and steel duties have dealt a blow to those sectors and sent chills through nearly every importer and exporter.
Wherever risk is found, it's Bob Tebbutt's job to manage it on behalf of his institutional clients. As vice-president of corporate risk management for Peregrine Financial Group Canada Inc., he takes a fundamental approach to determining political risk by gauging economic indicators.
"Political risk is measured in the value of a currency and the value of the economy," he says. His most effective hedging tools for political situations -- ranging from a coup in the developing world to a minority government in Canada -- are long positions in gold and the U.S. dollar.
"Any political hedge will increase the value of movable objects like gold and currencies," he says. "Before you hedge you must first accept the fact that there is going to be a better or worse situation in the near future."
But a better or worse situation is relative to the investor and the investment. With greater risk comes the potential for greater reward, and there will always be investors who can make the best of any situation.
Dale Jackson has been a producer at Report on Business Television since its launch in September, 1999.
Few investments have the political risk of Russian oil company Yukos, whose former president has begun serving an eight-year prison sentence in Siberia. But politically risky assets can be found in just about every Canadian equity, internal or hedge fund.
The risk: Government of Kazakhstan threatened to halt a $5-billion takeover of PetroKaz by China's biggest energy producer. Calgary-based company's shares fell after Kazakh parliament voted to approve a law that would give it a final say on sales involving foreign oil companies in their country.
Crystallex International Corp.
The risk: Venezuelan President Hugo Chavez threatened to cancel mining licences and stop issuing new ones
to foreign companies. Toronto-based miner, which is developing a gold deposit in the country, got caught up in the political crossfire and the shares lost more than 25 per cent of their value in a single day.
The risk: Oil company was partly nationalized by the government of President Vladimir Putin. Company founder and president Mikhail Khodorkovsky was sentenced to eight years in a Siberian prison on tax and fraud charges he claims were politically motivated.
The risk: You don't need to travel to the other side of the world to find political investment risk. In Canada, the income trust sector has taken a beating since Ottawa announced last month that it was merely reviewing the income trust tax structure.
SOURCES: THOMSON DATASTREAM
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