Political risk: when diversification isn't enough.

• Author: Cohen, Fred L.
• Position: Risk management

This year, 2006, is proving to be one of the more challenging, politically-charged years in recent history. Global events have repeatedly threatened to impact multinational business operations--from presidential elections in Mexico, Brazil and Nigeria, to avian flu and rising oil prices sparked by political tensions in the Middle East. Even companies that don't have international operations face some level of political risk simply because chances are good that their customers, suppliers or joint venture partners operate globally.

[ILLUSTRATION OMITTED]

Business leaders realize that to survive, they have to find the most effective ways to work with partners abroad, compete internationally and manage the risks associated with these ventures. The politics of foreign governments and societies touches almost every aspect of business for companies operating globally, from strategic selection of markets to issues such as intellectual property, human resource management, taxation, environmental programs, currency management and more.

As companies expand globally, especially in developing countries, having a formal approach to political risk management becomes critical. In the past, companies assumed that a balance of risk and return could be generated through a diversified portfolio of global operations. Overseas investments in most industries were narrower in size and scope compared with today, and multinational expansion was mostly confined to developed countries or regions.

Companies occasionally experienced reductions in revenue or operating losses resulting from political risks associated with regime change, social unrest, debt defalcation or currency devaluations. In these situations, political risk was a cost of doing business that sometimes occurred in limited ways but rarely proved catastrophic, and could be mitigated through political risk insurance or early identification and use of mitigation techniques.

With today's reliance on international growth--which is often pursued in new and unfamiliar markets--there has been a shift to larger, more uncertain investments that require a more systematic approach to global portfolio management. Systematic political risk management, in contrast to traditional views of country risk, looks beyond, for example, how short-term currency fluctuations and security concerns affect general market conditions to how political conditions influence a specific company's longer-term prospects and volatility in its markets and across the globe.

Portfolio Trends and Challenges

Energy companies' response to tightening in the crude oil market is indicative of the portfolio trend. High oil prices and the efforts of consumer nations to secure future supplies have heightened the stakes, pushing private oil companies to reconsider their portfolios of petroleum reserves. With the run-up in crude oil prices, national oil companies--for example, the Chinese oil companies--have the money and political backing to acquire smaller, more inaccessible fields and larger stakes in existing fields.

As a result, smaller oil-producing states such as Chad, Sudan, Ecuador and Kyrgyzstan can position their production to a single buyer rather than the broader market. In an exceptionally tight market, these small, less stable states...