* Any views expressed in this opinion piece are those of the author and not of Thomson Reuters Foundation.
Extractive companies pay low fees and royalties in Africa in order to offset the political risk of operating there
(John Kemp is a Reuters market analyst. The views expressed are his own)
By John Kemp
LONDON, May 14 (Reuters) - "With Africa's economies riding the crest of the global commodities wave, there is an unprecedented opportunity to convert the region's vast resource wealth into investments that could lift millions out of poverty," former United Nations secretary-general Kofi Annan argued in an opinion piece in the New York Times.
"Seizing that opportunity will require strengthened governance backed by international cooperation to stem the haemorrhage of revenues associated with tax evasion, secret deals and illicit financial transfers," Annan, a Ghanaian, wrote in his capacity as the chairman of the Africa Progress Panel.
But resource extraction has not been a good route to economic development in the past. There is no reason to think it will be a better route out of poverty this time, unless the continent can first address some of its structural problems ("China's booming mineral demand is not a solution for Africa" Nov 2008, http://link.reuters.com/vyt97t).
MISSING REVENUES
Annan and other development campaigners want G8 leaders, meeting in Northern Ireland next month, to help the continent capture "fair value" from its resources by cracking down on tax evasion, aggressive tax planning and transfer pricing ("Stop the plunder of Africa" May 9).
Transfer pricing costs Africa $34 billion a year, according to Annan, twice what the region receives in bilateral aid.
The progress panel highlights problems capturing resource revenues and using them for development in countries as diverse as Guinea, Chad, Equatorial Guinea and the Democratic Republic of Congo ("Equity in extractives: stewarding Africa's national resources for all" May 2013).
Africa has "the potential ... to self-finance transformative development," according to Paul Collier of the Oxford University Centre for the Study of African Economies.
"Harnessing resource wealth requires a chain of decisions to go right, of which the most fundamental is to capture revenues for society," Collier explains in a thoughtful article in the Financial Times ("How we can help African nations to extract fair value" May 12).
But both Annan and Collier confuse symptoms with underlying problems. Africa is not poor because it is unable to capture sufficient value from its mineral resources. Rather the continent is failing to capture more revenue because of the weakness of local institutions - including corruption, poor political leadership and instability.
Transfer pricing, tax avoidance and evasion, and one-sided negotiations over royalties and tax are symptoms of an underlying structural problem.
RENT EXTRACTION
"Mining in frontier conditions is a risky business and so returns should be commensurate. But economics makes a key analytic distinction between profits and rents: whereas profits are a return on capital, rents are unearned," Collier writes. "Although the distinction is lost on accountants who wash rents into profits, it is fundamental to resource extraction."
According to Collier: "Unlike purely productive activities, resource extraction generates rents as well as profits, as inherently valuable assets are lifted from the ground ... Resource extraction companies are given custody of the natural wealth of others: they are analogous to banks not dotcom companies. Spectacular profits from resource extraction are likely to be rent-seeking: companies acquiring the natural assets of poor people."
"Such behaviour demonstrates not exceptionally high business talent but exceptionally low corporate ethics," Collier concludes.
Unfortunately, this analysis is seriously flawed, particularly in its treatment of rents and profits, risks and reasonable returns.
Resources like crude oil and iron ore are not "inherently valuable assets." North Dakota's vast Bakken shale deposits, discovered in 1953, had no value until pioneering companies like Continental Resources <CLR.N> began to apply new horizontal drilling and hydraulic fracturing techniques to unlock crude oil previously trapped in tight rock formations.
Petroleum and mineral reserves are not a gift of nature; they are won by hard work and heavy investment, as Morris Adelman of the Massachusetts Institute of Technology explained ("Genie out of the bottle" 1995).
It is therefore very misleading to speak about mining and oil companies as being mere custodians of the wealth of others.
Resources such as crude oil, iron and copper only become valuable when someone spends money to extract them (including digging and drilling, as well as building all the associated infrastructure for transport, power, sewerage and water supply). Until then they are just useless liquids and lumps of rock.
REASONABLE RETURNS
In theory, resource extraction generates a flow of revenues (net of operating costs such as wages) that can be divided between profits (an adequate risk-adjusted return on capital) and excess revenues (rents). In practice, the division is not nearly so clear cut.
Oil and gas projects require enormous capital expenditures up front on surveying, drilling and constructing pipelines and utilities, running into hundreds of millions of dollars, which must then be recovered from subsequent production of many years.
Big mining projects such as bauxite, iron ore and copper, tend to be even more expensive, as huge amounts of overburden must be cleared, and new railway links, power supplies and water supplies are put in.
Major companies Shell <RDSa.L>, Rio Tinto <RIO.L> and Anglo American <AAL.L> manage their exploration and production activities on a portfolio basis.
Profits from successful oilfields and mining projects must pay for the cost of drilling all the dry holes and pits that have to be abandoned. Looking at capital costs of a project and its revenues in isolation provides a grossly misleading measure of profitability and the potential rent that could be captured.
Companies must commit large amounts of capital years in advance without knowing what price the commodities will fetch when the project finally comes onstream.
POLITICAL RISKS
Returns are also adjusted for risk. Companies develop first the resources which promise the highest returns and the lowest level of risk.
Resource extraction is always risky because most of the costs have to be paid up front while revenues come much later.
Governments around the world compete to attract investment with promises of low royalties and taxes, then change the fiscal terms once the mine or oilfield is operating and prices have risen to capture the "windfall" profits.
Instability in fiscal terms is not confined to Africa. Governments in the United Kingdom and Australia have both been strongly criticised for making ex post changes to fiscal regimes for North Sea oil and mining in Western Australia.
Rightly or wrongly, however, the risk from changing fiscal terms, and the threat of confiscation, is seen as higher in Africa, compounding other forms of political risk. The continent's poor infrastructure makes it doubly expensive to develop new projects as miners must often build their own rail lines and power facilities (e.g. in Mozambique's coal industry).
The perceived riskiness of the continent's mineral resources is the reason why African countries have struggled to attract interest from top tier mining and oil companies. In many of the cases that have attracted most criticism, resources have instead been developed by smaller operators, some of them based in tax havens. These companies are more willing to take high risks in exchange for a much higher share of the revenues, attracting criticisms about corruption and aggressive financial management.
Following a decade of rising commodity prices and discoveries, there are now plenty of known mineral resources. The shortage is capital and technical expertise to extract them all. The result is that countries around the world are competing to attract investment and know-how, generally by offering softer not tougher fiscal terms.
In a risk-adjusted ranking of possible projects, African resources come fairly low, unless they are offshore or in secure enclaves. Even then they are attractive only when companies can deal with reasonably stable governments, and secure very favourable returns by paying minimal taxes and royalties.
The perceived riskiness of Africa's mineral resources is why countries end up negotiating with second and third-tier operators who drive an exceptionally hard bargain.
If African countries want to deal with more reputable operators, and capture a higher share of the value, they must first find ways to strengthen their institutions and reduce risk.
(Editing by James Jukwey)
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