Twenty-five percent of Exxon’s annual oil production came from Saudi Arabia in 1972. By 1980, it was gone. Saudi Arabia nationalized its oil fields and put them into a newly formed company called Saudi Aramco.
Companies that produce natural resources in most cases do not own the resource they produce until they produce it. Someone else owns the resource as it exists in the ground. Sometimes that someone is a government. Sometimes it is a private person.
The production company and the owner of the resource enter into a contract. That contract dictates the terms of who gets what and who pays for what.
The production company generally spends the capital required to find and develop the resource and then shares either the product itself or the proceeds from selling the product with the owner. In virtually every case, the production company spends capital to develop the resource first and then relies on its split of the proceeds down the road in order to generate a return on the capital spent.
The production company becomes instantly vulnerable once it spends the capital to develop the resource. The resource along with the associated production and processing facilities reside within the jurisdiction of the owner. The owner as a result has the leverage to tell the production company to go stuff it.
The one lever the production company has is offering some sort of future value, like spending more capital or somehow increasing future production. Generally, though, the production company is at a disadvantage. The go-stuff-it leverage possessed by the owner of the resource trumps the future-value leverage possessed by the production company.
Therein lies a major risk of investing in natural resource companies. The producers of commodities rely heavily on stakeholders to give them the right to conduct business. The business requires heavy upfront investment. The production company is vulnerable to stakeholders changing the terms of the deal once the capital has been spent.
We believe this type of stakeholder risk increases significantly in commodity bull markets. The economic benefit to the stakeholder, first of all, rises with the commodity price. Higher prices increase the economic incentive for the owner of the resource to change the nature of the deal.
A second and much more consequential factor that increases stakeholder risk for the production company during commodity bull markets has to do with public sentiment towards the producer. Public sentiment sometimes turns against the commodity producer as commodity prices rise. What is revenue to the producer is an expense for the public at large. When commodity prices increase, the public feels the pain. The production company meanwhile sees increasing profits. The highly visible connection between the expense and the profit is sometimes too much for the public to take; they forget of course that it is the producer that has spent the capital, discovered and developed the resource, and delivered it in some usable form to the consumer. That is forgotten when prices rise. The producer turns into the villain.
It is this change in public sentiment that is so costly for natural resource producers. It gives politicians, owners, and other stakeholders the opportunity and political cover to change the terms of the deal and essentially swipe value when commodity prices rise.
Chile nationalized its copper industry in phases between 1969 and 1971. Bolivia nationalized its tin industry in the 1950s. Saudi Arabia nationalized its oil industry in phases between 1974 and 1980. In all cases, the companies that spent the capital to develop the resource took massive economic hits. In all cases, the nationalizations had broad public support, especially in the host countries.
Stakeholders even in so-called “safe” jurisdictions find ways to swipe value when commodity prices rise. The U.S. enacted the Crude Oil Windfall Profit Tax in 1980. That tax targeted a specific industry for a specific reason: legislators believed the U.S. oil industry was making too much money. With oil back over $100 per barrel, we again hear rumblings of targeted taxes against oil producers.
When commodity prices rise, stakeholders get greedy. That risk is very real. It is also a one-way street: commodity producers don’t receive much sympathy or support when commodity prices plummet.
Oil prices increased 10-fold between 1972 and 1980 yet Exxon’s stock price in real terms was essentially flat. During that period, Exxon’s stakeholders swiped value from the company. The most notable example is Saudi Arabia nationalizing its oil industry.
