Managing Globalization: How Diversification Can Act as a Hedge

When Evo Morales was elected president of Bolivia in December, he pledged to take over the country's natural gas industry - yet the stock prices of the foreign companies that extract the gas barely moved.

Two weeks ago, when he made good on his promise, investors still weren't spooked. With hundreds of millions of dollars worth of assets in play, the question is, why? It's not that investors don't care. Rather, multinational companies have found a variety of ways to protect themselves against political risks in the countries where they do business.

The first of these is one that anyone with a portfolio will know: diversification. Globalization has allowed energy companies (as well as other multinationals) to expand into places that many investors probably couldn't find on a map, but that very process helps to spread out their risks.

Petróleo Brasileiro, the Brazilian energy giant, has operations in 16 countries, said its chief financial officer, Almir Guilherme Barbassa. Bolivian gas is an important resource for Brazil, but it's not such an important source of Petrobras's profit, probably just a few percentage points.

And if anything, geographical diversification is slightly more difficult for energy companies than for other multinationals.

"You can't easily pick and choose where you go," said Roddy Kennedy, a spokesman for BP, which also has assets in Bolivia.

Companies like BP, he said, can go only where they have opportunities to extract the raw materials they need. Still, BP has also diversified through expansion.

"In the 1980s, we had two sources of oil, which were Alaska and the North Sea," Kennedy said. "We've now got six major profit centers around the world."

South America is one of them, but Bolivia is a relatively small part of it.

Of course, even with diversification it's still worth trying to protect your assets. You might think that the most straightforward way to do that would be to buy insurance. It's not quite so simple, though. "Energy companies like us are probably bigger than most insurance companies, and it would be too expensive for us to contemplate insuring everything," Kennedy said.

Instead, energy companies tend to insure themselves. Self-insurance works like a medical savings account or a rainy day fund: You contribute to it over time, and you dip into it when you need it. Barbassa said Petrobras did this when figuring the cost of operating in a new place.

"When we are going to evaluate a new project in a country, we add to the capital cost we expect from that project some basis points or some additional cost of capital to cover the political risk," he said.

The company structures its financing so that if one particular investment goes sour, the creditors would have no recourse to Petrobras's other assets.

"We get loans from the financial system to the country specifically," Barbassa said. "We use them to transfer part of the risk."

To estimate the extra financing that might be necessary to cover political risk, Petrobras looks at how a country's sovereign debt is rated, said the company's executive manager for risk management and planning, Jorge Nahas. Petrobras also plans its entire business around conservative assumptions to ensure that a threat to one part of its operations won't leave it strapped.

"This can assure that we will have enough funds to support our investment plan," Nahas said. "When you have a case like what's happening in Bolivia, we are sure that we are going to have enough cash to face this problem."

Multinational companies can also use the financial markets to protect themselves explicitly, for example by using derivatives. Securities contracts can be based on virtually any events that might happen, including the seizure of assets or profits. But Kennedy said BP used derivatives mainly to protect its ability to supply energy, rather than to protect specific assets.

"We try and protect ourselves as a user of product," he said. "We don't go out and do it in a speculative sense. We try and protect our daily requirements for refining, for instance."

Kennedy added that like many multinational companies, BP protected itself from country-specific risk by hedging currencies. Fluctuations in exchange rates can change how costs within a foreign country affect a company's bottom line back home, especially in the case of energy companies that sell their products outside the countries where they extract the raw materials. For example, a German company that grows mushrooms in Poland but sells them in Germany would be hurt by a gain in the zloty's value; costs would rise without any compensating change in the value of sales.

To the extent that exchange rates have moved in Bolivia, it may actually have helped the energy companies. Since Morales's election, the boliviano has lost about 14 percent of its value against the Brazilian real and almost 8 percent against the British pound. Inflation in Bolivia has been similar to Britain's and slower than Brazil's, so the changes have probably had real effects.

For the companies invested in Bolivia's gas industry - they also include BG Group of Britain, Exxon Mobil of the United States, Total of France and Repsol YPF, a Spanish-Argentine concern - the situation is still changeable. They have six months to negotiate new contracts with the Bolivian government. Investors will undoubtedly be watching, but they won't exactly have their hearts in their mouths.