by Michael D. Celock, Featured Contributor
[su_dropcap style=”flat”]I[/su_dropcap]T HAS BEEN A BUSY YEAR in the Arctic. In April, the United States assumed the chairmanship of the Arctic Council for a two-year term. Shell Oil announced that it was suspending Arctic operations. President Obama became the first U.S. President to visit the Arctic. The Chinese, who have taken to referring to themselves as a “Near Arctic State,” sent several warships on a summer excursion through U.S. territorial waters on their way to the Arctic. This in turn was followed by the Russian announcement that they expect to be in the position of maintaining a permanent military presence in the Arctic by 2018. These events in combination with the long standing predictions of global warming and new developments in deep-water oil, LNG and mineral exploration have sparked renewed interests in the viability of Arctic investment.
The Arctic presents an interesting combination of geopolitics and natural resource development. For investors, the region will present a unique blend of both traditional risk exposure normally associated with emerging and frontier markets as well as its own brand of region specific risk.
Due to the rapid climatic changes occurring in the region, the Arctic is experiencing a paradoxical transformation. Many investors envision the effects of global warming as a way of effectively transforming the region from Arctic tundra to one of the last remaining frontier growth markets. There is no denying that the Arctic offers investors significant economic opportunity. However, before anyone decides to pack their snowshoes, they need to evaluate the cold reality of the challenges that they face.
Investing in Arctic development opportunities requires an innovative and robust investment strategy that should take into account the complex and challenging nature of the Arctic region. The extreme climate in combination with geopolitical factors and the evolving concerns over environmental risk are all things that must be taken into account. Investors will need to determine if much of their risk and liability exposure can be effectively mitigated through an application of well-designed and diversified investment strategies coupled with the incorporation of proactive best practices.
Prior to making financial commitments, it would be prudent for a potential investor to engage in comprehensive risk and due diligence assessments designed to fully evaluate their environmental, reputational and operational risk exposure in relationship to potential returns on their investment. A significant complicating factor that needs to be recognized and addressed is that in many instances the various operational risks may become intertwined. This in turn results in the magnification of potential risk exposure thus increasing the difficulty of its successful mitigation.
The opening of profitable new sea lanes in combination with the region’s significant deposits of natural resources will provide the catalyst for Arctic development opportunities. World-wide investment in the Arctic as an emerging market has the potential to attract investment of upwards of $100 Billion over the next decade.
By current estimates, the Arctic is warming at least two three times as rapidly as the rest of the earth. At that rate, it is projected that the Arctic sea lanes will be navigable during the summer months. This will result in the unlocking of both the Northwest Passage (NWP) through waters claimed by Canada and the Northern Sea Route through Russian controlled waters. This in turn will have the effect of reducing Arctic sea passage transit time by approximately forty percent. This reduction in travel time will translate into substantial logistical savings over the currently used Panama and Suez Canals. At the end of the day, this offers the Arctic the potential of becoming both a luxury tourist destination as well as an efficient trans-shipping route.
The Arctic also possesses significant deposits of natural resources. It is currently estimated that the Arctic could yield an estimated fifteen percent of the world’s untapped oil – the equivalent of ninety billion barrels. LNG deposits are calculated at thirty percent – the equivalent of 1,669 trillion cubic feet. The Arctic is also estimated to have in place forty percent of the world’s palladium, twenty percent of the world’s diamonds as well as significant amounts of gold and other in-demand minerals, and an abundance of fish and fresh water.
Like Russia, China’s Arctic interests are both economic and geopolitical. The recent summer cruise by Chinese warships traversing through U.S. territorial waters on their way to the Arctic was China’s not so subtle way of announcing their intention of endowing itself with extraterritorial jurisdiction in the region. In order to provide the legal justification for their overall world-wide expansion, China has enacted new laws that are not only deliberately vague, they include a rather broad definition of what constitutes national security and state secrets. China’s reliance on the overly broad national security interpretation of their laws in relationship to their state-controlled enterprises will present challenges for U.S. companies hoping to develop a working relationship or joint venture with Chines entities. The proliferation of Russian SOE’s in combination with the current sanctions imposed on Russia heightens the importance for U.S. corporations to have in place comprehensive corporate compliance procedures. When dealing with SOE’s operating in the Arctic the importance of engaging in comprehensive due diligence particularly FCPA, due diligence of the SOE’s and relevant third parties cannot be overstated.
The Northwest Passage is gaining strategic importance as an economic sea route from the Atlantic to the Pacific. As a result of the climatic changes underway in the region, the Canadian government is experiencing renewed challenges to their authority over the Northwest Passage.
Canada has recently chosen to become more vocal when exercising their sovereignty claims over the NWP and surrounding waters. It is Canada’s position that they possess full sovereignty and complete control over the NWP. The U.S. and a number of other countries have adopted the position that the NWP is an international waterway.
Unlike many emerging markets, the Arctic is bordered for the most part by countries with a well-developed rule of law. For investors, this means that their Arctic risk exposure will center around the operational and logistical risks normally associated with the Arctic environment, as well as traditional corporate governance, reputational and regulatory risk rather than any immediate geographical risk.
While geopolitical risk in the Arctic is currently low and likely to remain that way for the near future, it is not nonexistent. The single most important contributing factor to any possible Arctic geopolitical confrontation will center on the geographical layout of the region and the rather inequitable natural distribution region’s natural resources. Currently, those areas of the Artic that are currently unclaimed are being vigorously contested by the bordering countries
Currently, geopolitical risk in the Arctic is primarily centered around the actions of Russia and China and to a limited extent the interaction between the United States and Canada. Of the countries that make up the Arctic Council (United States, Canada, Russia, Denmark, Finland, Iceland, Norway, Sweden and Greenland), natural resources are rather unevenly distributed between the United States, Canada and Russia. The U.S. and Canada control the largest proportion of the undiscovered oil at approximately sixty-five percent. Russia in turn possesses the largest amounts of natural gas and palladium. This unequal distribution of natural resources has the potential for the development of any potential conflict dependent on the inter-relationship of the various countries. In 2001, Russia proclaimed their sovereignty over half the Arctic sea floor. In 2007, they rather boastfully planted a flag on the sea floor. While Russia’s Arctic interests are at times congruent to the national interests of the United States both countries have on occasion adapted a pragmatic and practical working relationship. Also any areas of the Arctic that are currently unclaimed are being hotly contested by the bordering Arctic countries.
Currently, only Norway and Russia operating in cooperation with China have achieved any significant economic advancement in the region. Russia is intent on both exploiting the region’s natural resources as well as militarizing the region. Along with their military expansion, Russia in cooperation with the French energy company, Total, is constructing the Yamal LNG Facility in the Ob River estuary. The LNG produced there is destined to be shipped to China via a joint Russian-Chinese pipeline. China is expanding its cooperation not only with several other Russian controlled companies, it is also involved in joint development operations with other nations as well. Both India and Japan are looking to exert some measure of control in the Arctic as well.
Among the most significant non-geopolitical factors complicating Arctic development is the iconic stature of the region, the lack of a clearly defined and articulated regulatory framework as well as the massive capital outlays required due to the harsh Arctic climate. In the Arctic, these significant individual challenges combine to create a complex web of interconnected obstacles and risk factors that must be addressed and successfully overcome.
The inadequate infrastructure is directly attributable to the harsh and unpredictable Arctic climate as well as by the geopolitical uncertainties in the region. In turn, the lack of infrastructure in combination with the extreme cold contributes to the reluctance of many companies to invest in the Arctic. Without financial commitments there exists little incentive to improve the infrastructure. For oil, LNG and mining industries, the excessive cold requires the development of custom designed machinery, technology and operating techniques designed for polar and deep water operations. In order to justify the massive investment in infrastructure there must exist a significant return on investment to make any project commercially viable.
The Arctic also currently lacks dependable GPS and sophisticated satellite communication systems. In turn, the lack of dependable communications and GPS capabilities hinders both Arctic navigation and the ability to provide a coordinated response to any potential environmental or emergency situation.
While the Arctic sea lanes are becoming more navigable due to global warming, they remain highly unpredictable and dangerous. The current limitations on adequate and dependable GPS and communications magnifies the potential for an accident.
For companies engaged in Arctic operations, particularly for those companies engaged in deep-water oil exploration and trans-shipping, the environmental consequences of any disaster in the Arctic will certainly present greater consequences than anywhere else in the world.
The sheer size and harsh conditions in the Arctic contribute to the logistical challenges when attempting to mobilize a rapid response effort. Also contributing to the increase in environmental liability exposure is the limited window of opportunity to initiate any environmental clean-up operation. The colder water would take any oil loss through a spill significantly longer to dissipate. Also if the spill were to occur towards the winter months, it would be almost impossible to remove oil trapped under the ice.
For those investors and companies seeking to operate in the Arctic, their internal corporate compliance, risk and crisis management procedures need to take into account the complex compliance challenges unique to the region. Companies whose operations involve dealings with foreign state-owned organizations must focus on conducting comprehensive due diligence on those organizations. Under the FCPA and other anti-corruptions laws, a company can be held responsible for any corrupt practices of the third party if it leads to a business advantage for the contracting company. Employees of these SOE’s are viewed as foreign officials for purposes of the FCPA.
In order to successfully address the inherent environmental and geopolitical risks associated with Arctic exploration, investors need to recognize that some investment opportunities are simply unsustainable unless any potential risk can be mitigated to an acceptable level. Given the challenges and the ever changing dynamics associated with Arctic development projects, companies should have in place a well thought out exit strategy designed to mitigate their risk exposure.
Companies that ultimately succeed in the Arctic will be those that are knowledgeable in assessing and mitigating their liability exposure, recognize the need to consult and work with the Arctic communities, and take environmental concerns seriously.
