Financing in Regards to Exploration and Exploitation of Natural Resources - Coursework Example

FINANCING IN REGARDS TO EXPLORATION AND EXPLOITATION OF NATURAL RESOURCES Introduction As globalisation becomes a very important topical discussion today, it can be asserted that the growth and development of individual states in the world is very important for achieving a global home that is accommodating to all. There are however several factors and conditions that come together to ensure that individual states are able to attain a level of growth and development that is required to make it globally competitive (quote). One of these means is through the efficient and profitable use of natural resources available to the state (quote). As far as the availability of natural resources is concerned, states can be noted to have a right that entitles them to the forms of natural resources found within their territorial boundaries (statutes). As a manner of fact, the state rights and entitlement to natural resources form one of the major categorical bases for defining the sovereignty of nations. This means that each state has the right to use its natural resources for its developmental benefits (quote). But as much as such rights and entitlements are given to nations, sight will not be lost of the fact that to every right is an equal level of responsibility. In this regards, states have an obligation to their people in ensuring that natural resources are not wrongfully used (quote). One of the legal bases that seek to set a clear universal code on state rights and entitlement to natural resources and their obligation to the people is the 1962 United Nations Resolution on permanent sovereignty. The 1962 United Nations Resolution on permanent sovereignty specifically sets out regulations on Permanent sovereignty over natural resources.1 Under the resolution, natural resources are identified as part of the basic constituent of the right to self-determination, which gives nations the right to decide the best ways to utilise their natural resources (quote). Even though the need for encouraging international co-operation in the economic development of developing countries is clearly stated in the resolution, the rights and duties of States as defined under international law put the sovereignty of the countries, whether they are developed, developing or under developed above any international interests. In the light of this, one would expect that through the enforcement of legislative codes and regulations of individual states, there would be much say for countries when it comes to the exploration and exploitation of natural resources. In the wake of mounting tensions between citizens of countries accusing their leaders of unfair distribution of the national cake in terms of equitable use of funds from natural resources,2 the paper seeks to address the issue of financing in the exploration and exploitation of natural resources to establish a relation between the legal mandates in natural resources financing and the financial outcomes that is produced from this to the individual countries, whose sovereignties are protected under the 1962 United Nations Resolution and International Law (quote). This is because if the legal undertaking under the financing of exploration and exploitation of natural resources is done well, the countries should be the direct beneficiaries. 1. Issue of finance and exploration of natural resources. The exploration and finance of natural resources are two important and related issues that are very important to States that want to achieve meaningful use of their natural resources. There have been several studies that have suggested the exploration of natural resources to be a high risk venture, which requires a lot of motivation to go into (quote). For most developing and underdeveloped countries therefore, they would normally leave this task to exploration companies that have track record in successfully undertaking such forms of exploration (quote). This is because exploration often requires a lot of capital injection but its outcomes are not always guaranteed. Meanwhile, most of these countries have very compact national budgets that hardly support the running of the nation. The case is however not the same for most advanced countries as they have their own minerals research and exploration companies that are fully funded by government (quote). For the underdeveloped and developing countries, there are a number of international laws and provisions that make it possible for them to receive assistance from advanced and developed countries, including assistance with technical expertise for exploration of natural resources (statutes). When these advanced countries come in, they have been noted to come in with their own forms of agreements that ensure that they also benefit from the agreement (quote). At other times, due to the need of avoiding the risk with financing exploration and not getting the needed returns, developing countries such as Nigeria often turn to established multinational exploration companies, with whom the government goes into agreement with to undertake exploration. In such cases, it can be said that the government contracts the companies to undertake exploration (quote). When this happens, it is often that there is a public-private partnership for the exploration of natural resources, even though the companies are openly known to be those that take the full cost of the exploration (quote). At other times, government allow the private sector to go into total control of exploration, where government receives its outright benefits ahead of the exploration. What is very unique with all these different instances of exploration is that financial expectations from the companies involved have almost always been the same. This is because whether there is public-private partnership or private sector initiative, companies are expected to show high commitment for their abilities to finance for the exploration (quote). Some governments have been criticised for the extent of demand put on companies in terms of financing (quote) but there are some reviewers who see this as important for avoiding risk on the part of the government. 2. Role of finance in exploration of natural resources. In Nigeria and other developing countries, the role of finance in exploration of natural resources can be said to be the need to avoiding risk associated with the abandoning of exploration projects after they have been started (quote). In the case of the Nigerian petroleum sector, the financing of natural resources take many different forms, depending on the parties involved. Generally, government through the Nigerian National Petroleum Corporation (NNPC) can be said to be a party in the exploration of natural resources. The private sector can also be said to be another party. The financing therefore varies when it is being done by either government or by the private sector (quote). There are however evidence to the effect that greater part of the exploration is done by the private companies. For example, the first discovery of oil in Nigeria in 1956 was as the result of exploration by Shell-BP, which was the sole concessionaire at the time.3 After the successful exportation of oil from the first oil field in 1958, exploration right was opened to more foreign companies in 1960 for both onshore and offshore areas of the Niger Delta.4 Since this period, government have merely become an overseer and facilitator in the exploration of oil. In terms of other natural resources however, government have often taken centre stage in both exploration and exploitation (quote). When government goes into the exploration and exploitation of natural resources as an independent party, there are a number of ways that the financing of natural resources is done. Commonly, government undertakes its own exploration through the ministry of land and natural resources. At other times, government empowers the local industry to go into the exploration and exploitation of natural resources. Through whatever module that is used, government often makes allocation for financing in its annual budget. In Nigeria for example, there is a Mining Sector Support Programme (MSSP) that requires local companies to come on board with their proposals for business in the exploration and exploitation of natural resources (quote). After going through a series of considerations, the best and most befitting proposals are selected and sponsored with government allocated funding. For the government, its major motivation in taking up frontline role in the finance of exploration of natural resource is to ensure that the natural resources that serve as the property for the sovereignty of the nation is well utilised for the benefit of the local people (statutes). This is because governments have always debated that when there is the empowerment of local businesses to go into exploration through the provision of financial assistance, the resulting outcome leads to direct growth and development for the local people who are the true owners of the natural resources (quote). 3. General sources of finance for exploration and exploitation of resources Having noted that government gets most of its financing from State approved budget, it is important to now focus on the major sources of finance for exploration and exploitation of resources by privately owned companies, including those that go into developing countries such as Nigeria. Four major sources of finance may be identified, the first of which is equity. It would be noted that for most of these multinational companies going into mineral exploration and exploitation in developing countries, they already have well established brand equity that makes it possible for them to list on the stock exchange of the local country in which they operate (quote). Consequently, they are able to raise funds by using equity as a source of mineral finance, where they rely on the remaining interest in the company’s assets after there have been the distribution of interest according to individual shareholder’s preferred stock (quote). Using equity as a source of finance for exploration and exploitation of resources have been noted to come with a lot of control for the company because the company depends on its own means in raising funds and thus do not have to worry about such issues as interest rates and inflation (quote). It however requires that companies have very strong balance sheet to do so, and it is considered expensive as it comes only with cost of capital without any leverage (quote). The second source of finance for most other companies in the exploration and exploitation of natural resources is through project finance. Project finance has been explained to be a very special approach to financing where there is limited or non-recourse finance. Such non-recourse finance is often noted to be predicated based on the advantages of the project rather than the credit of the project sponsors (quote). This makes project finance very common in public-private collaboration, where the government’s presence acts as a guarantee for the merits of the exploration being undertaken instead of the credit of the companies involved. The use of project finance has been commonly practiced by local companies rather than multinational companies as these multinational companies are always expected to be financially competitive (quote). There are however some legislatures that guide the use of project finance in most developing countries and even in some developed countries (statutes). Government has not always been the only one sponsoring exploration and exploitation as some non-governmental organisations have also taken up such responsibilities. In any situation, those sponsoring the exploration and exploitation have wanted the beneficiaries to prove or give evidence to the effect that they are a special purpose company that have no other obligations or liabilities than owning the project.5 Another form or source of financing that has been used very often is reserve-based lending. In some quarters, reserve-based lending is also referred to as borrowing base financing, and has largely been used at the tail end of exploration, leading to exploitation (quote). Unlike project financing, the use of reserve based lending involves a non-recourse loan, which is calculated based on defined expected present value of future production from the field where the exploitation is expected to take place (quote). In calculating the expected present value, there are several factors and conditions that are taken into account, including expected minerals price, discount rate, capital expenditure, and price hedging (quote). In Nigeria and even in developed countries, most oil and gas companies and those in other areas of natural resource exploitation have mainly relied on commercial banks for securing reserves based lending. The reason reserves based lending is done towards the end of exploration or at the point of exploitation is because there are regulations that require that in this form of financing, the loan be collateralised with the use of the company’s reserves (quote). Where reserves cannot be guaranteed therefore, collateral cannot be found. With reserves established, repayment is often done with revenues from the sale of field production (quote). The last form or source of finance for exploration and exploitation can be noted to be securitisation. When used as a form of finance, securitisation works in a very technical way, requiring that an illiquid asset of the company involved be transformed into a security through the process of financial engineering (quote). Securitisation in the minerals exploration business have often been based on the use of asset-backed security, given the fact that the risk of this form of financing is considered to be very high. Unlike in the case of exploitation where the presence of mineral resources is often guaranteed, in exploration, the company involved in the exploration has very little to show in terms of guaranteed reserves. Consequently, the need to use any form of reserve based lending is very unlikely (quote). However, by using such asset-backed security as securitisation, there is a minimisation of risk with the financing given. Other ways in which there is minimisation of risk with the financing of exploration through securitisation is to ensure that the seller acquires an up-front lump sum while there is a forward sale of a revenue stream (quote). There have been instances that securitisation have been refused all together because certainty of production and price could not be ascertained.6 4. Financing at the exploration stage Financing at the exploration stage has often been different from financing at the exploitation stag, based on several factors. Referring back to the case of Nigeria’s oil, record has it that it took Shell-BP up to half a century to financially discover oil at Oloibiri in the Niger Delta, which lies in the south-western part of Nigeria (quote). This is because the actual search for oil started way back in 1908 and it was not until 1956 that discovery was made (quote). The indication that this gives is that when it comes to exploration, it takes very long for companies to break even. As a matter of fact, there are instances that companies have not been able to honour their financial obligations because they did not break even at all.7 What is more, at the exploratory stage, it is always very difficult for companies to point to any specific reserve or field based asset that can be used as a direct production based collateral. All that this means to financing at the exploration stage is that the risk associated with the decision to finance companies is very high. In most cases therefore, banks and other financial providers have used mechanisms have been noted to increase financial volatility for companies (quote). To avoid this, the use of equity and project financing has been the most preferred and commonly used often with financing at the exploratory stage. 5. Financing at the exploitation stage At the exploitation stage, the attitude towards financing has often been very different. This is because this is the stage than production stages for most companies and so it is easier for them to use their reserves and fields as collateral in the guaranteeing of loans (statutes). Meanwhile, the minerals exploitation business is known to be one of the most lucrative in the world, where losses are hardly recorded. Using the Nigeria’s oil exploitation as a case study, it is documented that as of the year 2000, oil and gas exports alone in Nigeria accounted for over 98% of export earnings in that country.8 This also contributed to up to 83% of federal government revenue. The mineral’s sector in Nigeria actually supports up to 65% of government budget as it leads to 95% of foreign exchange for the country (quote). These are all indications of how profitable the exploitation of mineral is especially oil and gas. This is because these are values that only represent the quantum of revenue that goes to government, which is often the minority amount. Based on this, companies seeking financing at the exploitation stage have often had the luxury of using such methods of financing including reserve-based lending and securitisation (quote). For all of these, such sources as commercial bank debt, multilateral agency debt, export credit agency, Islamic finance, and bond finance have been used (quote). 6. Contractual terms that should be incorporated in exploration and exploitation agreement There are legal provisions that demand for the inclusion of contractual terms in exploration and exploitation agreements between all parties involved in the mining of mineral resources (statutes). There are four major project documents that are often required for such purposes. The first of this has to do with construction contract, which is often given as a contractual term to the exploration and exploitation company to build asset. The construction contract is often made up of several constituent components including fixed price, completion phases and the payment that comes with these, and liquidated damages (quote). The fixed prices component of the construction contract is often agreed with parties who have gone in exploitation agreements with defined scope of concession, identified field, or a guaranteed reserve to operate from (quote). The completion phases with payment are also used very commonly with exploration agreements to ensure that there are timelines guiding the execution of work (quote). Then also, liquidated damages are included as amount sums that the company going into the exploration or exploitation is designated to honour to defaulted party as compensation when there is a specific breach.9 The second contractual term covered under exploration and exploitation agreement has to do with supply contracts, which seek to over the supply of raw material, power and water (quote). The supply contracts are actually entered into as a way of avoiding cases that have to do with unfair supply terms.10 In both exploration and exploitation, the need to engaging suppliers for various forms of raw materials, power, water, and machinery has always been very necessary. Such engagements have actually been seen to be among both well established mining companies and smaller mining companies who are into small scale mining of mineral resources (quote). At any level that supplies will be needed however, suppliers always ensure that there go into supply contracts with the companies on a long term contractual supply basis. These supply contracts have actually been described to be very necessary and needful for both the supplier and the company going into the exploration and exploitation. For the company, the supply contracts helps in binding the suppliers to fair deal as defined in legislation such as the Supply of Goods and Services.11 For the supplier also, the supply contract entered in long-term basis gives them guaranteed under trade finance.12 Another important component of the contractual terms has to do with offtake arrangements that are often entered into for sale of product.13 By legal provisions, offtake agreements are entered into as a form of negotiation between the company which is the producer of the mineral resource and a buyer, who could be government or any other interested party.14 This offtake agreement is always necessary to guarantee that there is sale for the producer’s future production of the mine that is being explored. The presence of offtake agreements have always been very influential in the financing of exploration and exploitation at all levels, including in developed countries and developing countries. This is because once there is an offtake agreement, it gives lenders much confidence to accept to finance, given the fact that the presence of an offtake agreement means there is a predetermined purchaser of the production to be made.15 Offtake agreements, as much as they can be said to bind purchasers to honouring their promises to make purchases and improves the credit worthiness of producing companies. Offtake agreements are therefore often entered into on the basis of take-or-pay or long term. There is also operation and maintenance agreement that is used as part of contractual terms in exploration and exploitation of natural resources. As far as exploration and exploitation of mineral resources is concerned, operation and maintenance agreement is regarded as a very common form of contract that governs public-private partnership (PPP) agreement (quote). This form of contractual agreement comes in many different forms. In Nigeria and most of other developing countries, the operation and maintenance agreement requires the awarding authority, which is often the government has been required to pay fixed fee to private operators, which are often foreign companies for specific-tasks performed. Operation and maintenance contracts have been noted to come with several advantages to companies, including the fact that the remuneration they receive is not based on the collection of tariffs and the fact that the private companies are not expected to take on the risk of asset condition (quote). Government also gets its share of benefits with this form of contract because the agreement can be performance based, requiring government to demand for high quality of service from these private companies (quote). A typical project contract that may be agreed into between financiers and exploration and exploitation companies may look like what is presented below. Kavanagh and Freehills (2013). 7. Guarantees against borrowing The financing of exploration and exploitation of natural resources is considered by many banks and financial institutions to be a very high risk venture (quote). This is because of the rate of uncertainty associated with this line of business. In order for banks and financial institutions to ensure that those borrowing from them do not default and consequently bring on board the risk of not paying for their debt, guarantees against borrowing is often required under a number of legal requirements and provisions (statutes). A loan guarantee is therefore seen as the commonest form of guarantee against borrowing.16 Under this, beneficiaries are required to bring on board a promising party called the guarantor, who promises through a contract agreement to assume the debt obligation of the borrower in case of a default.17 It is however important to stress that because there are several forms of financing options for exploration and exploitation of natural resources, the guarantee against borrowing takes many different forms, depending on the type of financing that is facilitated. Generally though, there are two major types of guarantees used, which are limited and unlimited guarantees. Under the limited guarantee, the guarantor is made liable for only a portion of the debt that that is financed (quote). Unlimited guarantee however requires that all of the debt that is financed is claimed liable to the guarantor (case). In all instances, the guarantor is made to produce a substantial quantum of proof of their ability to honour the amount financed without fall. 8. Risk minimisation technique in lending money There are a number of ways that parties involved in the financing of exploration and exploitation of mineral resources have minimised risk in lending money. Most of the techniques used in minimising risk are often implemented by the bank or financial institution (quote). For such institutions, they minimise risk largely by enhancing the security involved in the financing. The higher the risk with a piece of financial assistance, the more complicated the security for minimising risk would be. A typical example of this can be noted to be project finance, which is a non-recourse form of assistance and therefore requiring high security over the project assets (quote). Through the use of various forms of security as a way of risk minimisation technique, it is possible to raise defence against creditors who are generally classified to be unsecured. When such a technique as guarantee is used, lenders are assured of much control on a default. Within the exploration and exploitation industry, there are several types and forms of security that may be used, including fixed charge over assets like land and buildings (quote). Other forms of securities used to minimise risk include the use of both fixed and floating charges made over all available assets (quote). Fixed charges over bank accounts of the party contracting the loan is another technique used, as well as share charges and the assignment of benefit of project contracts and insurances.18 In whatever case, the type or source of financing that is sought becomes the major determining factor in the allocation of risk minimisation technique. 9. Types of natural resources contracts and Contractual obligation of the parties 10. Entitlement of damages to the parties. Conclusion The paper has generally sought to explain key thematic issues that come under the financing of natural resource exploration and exploitation in countries. Nigeria was more or less used as a case study with reference to other countries that serve as important benchmarks for the topic. The paper has been useful in establishing that finance is a key issue when it comes to the exploration and exploitation of natural resources. Even though countries act the sovereign owners of the natural resources that are within their territories, most developing countries including Nigeria lack the logistical competence to undertake exploration and exploitation of natural resource on their own (quote). Consequently, these countries are mostly forced to enter into a public-private partnership between government and registered companies in the exploration and exploitation of natural resources. In some cases, some of the natural resources are explored and exploited wholly based on private sector initiative. In such cases, government becomes a facilitator and recipient of monetary benefits through royalties, taxes and duties. The paper has established that in such cases that there is greater involvement of the private sector, the issue of financing becomes very critical because the private companies that come on board are seen as businesses that are present to make their own profits (case). Whiles going into contracts with these businesses therefore, government tries to put in place all mechanisms that ensure that defaulting of payments will be avoided. Government also ensures that there are strict regulations that ensure that companies will show goodwill towards the financing of projects. Even though some policies and requirements of governments have been criticised as being harsh and putting limitation on the financing of exploration and exploitation of natural resources by private institutions (quote), these have also been named to be cautionary measures against possible abandoning of projects.19 For the companies that go into the exploration and exploitation of natural resources therefore, their major area of concern would have to do with ways of avoiding risks and volatility of financing. It for this reason and based on the key findings made through the study that a number of interventions will be recommended to this effect. From the discussions in the paper, it can be noted that volatility with the financing arises when the key financiers of companies, mostly the banks feel that there is higher risk with the financing they perform for companies (quote). To this end, any measure that is put in place to ensure that the financing of companies can be seen as a less risky venture would help in reducing volatility. In other words, the best way to reduce volatility is through the reduction of risks. But for there to be a reduction in risk, companies would have to put in a lot of work when it comes to the research and development (R&D) component of their exploration and exploitation. This is because there are instances where companies have abandoned their projects due to poor feasibility study that made the companies end up running at losses and so not being able to settle their financial assistance (case). Effective R&D is thus recommended to ensuring that companies will always land on resources and exploit them usefully for financial gains. Read More