The Attraction of FDI to Conflicted States: The Counter-Intuitive Case of US Oil and Gas.

Author:Skovoroda, Rodion

1 Introduction

Countries characterized by extreme forms of political risk and conflict--including political violence, intra and inter-state war, and terrorism--are generally considered to be undesirable destinations for foreign direct investment (FDI) (Busse and Hefeker 2007; Driffield et al. 2013). This is attributed to potential losses associated inter alia with political instability, regulatory unpredictability, and expropriation risk (e.g., Holburn and Zelner 2010; Jensen 2003).

More recent studies, however, point towards a degree of sectoral heterogeneity in the response of FDI to conflict: in particular, the relative insensitivity of resource-seeking FDI to political conflict (Witte et al. 2017). Furthermore, Biglaiser and DeRouen (2007) reported findings that seem counter-intuitive, with societal conflict found to have a significantly positive influence on general FDI inflows.

This paper addresses important research questions, as follows. In general, how does a host country's political instability and conflict influence inward FDI and its ownership commitment? Can theory explain any sectoral heterogeneity in FDI responses to instability? Is FDI by resource-seeking firms attracted to nations with societal conflict, and if so, can this effect be fully explained by the availability of the resource? Answers to these questions would respond to a recent plea for further contextualization of the conflict/FDI relationship (Bailey 2018).

This paper addresses these research questions in the context of the US Oil and Gas industry. It begins with a review of the relationship between general country and conflict risks and inward FDI in theory and practice in general across all industries, and then for resource-seeking firms in particular. This is followed by an analysis of ownership mode and foreign entry. A 'Methods' section explains our choice of US Oil and Gas as a focal industry, and subsequent sections follow the usual sequence of results, discussion and conclusions for theory, practitioners and policy.

2 FDI Location Decisions

Dunning's eclectic OLI internationalization paradigm still dominates IB thinking regarding influences on the destination of FDI. Recent comprehensive reviews include Nielsen et al. (2017) and Bailey (2018). FDI is expected to flow to any location that offers the MNE a suitable combination of OLI advantages.

Here, (0-) ownership-advantages "refer to a firm's tangible and intangible resources [...] that a firm may exploit internationally" (Nielsen et al. 2017, p. 65).

On the other hand, (L-) location advantages include lower production costs and favorable institutional and political environments (which may be modified by conflict risks).

(I-) internalization advantages are rooted in transactions-cost analysis (TCA) which identifies behavioral downside risks, involving technological spillovers and brand protection, and favoring operations within the firm to market transactions, e.g. licensing to host country incumbents.

When all three OLI advantages favor direct investment, inward FDI is predicted.

This prediction is strongly supported by a raft of empirical studies. For example, political stability, democracy, and rule of law (Bailey 2018), together with well-developed formal political and legal institutions, attract inward FDI (Nielsen et al. 2017). An institutional environment conducive to 'good' corporate governance attracts foreign investments (Biglaiser and DeRouen 2007). The presence of these strong institutions in the host country supports market exchange (Ahsan and Musteen 2011). It follows that negative influences, institutional voids (Khanna and Palepu 2005) and high country risks in general should have adverse consequences for inward FDI via L-advantages. This is confirmed by the meta-study of Bailey (2018), by Driffield et al. (2016), and by Goswami and Haider (2014); who find FDI was discouraged by such factors as corruption, tax rates and cultural distance.

However, slightly different conclusions apply to one specific category of country risk--violent political conflict. This ranges from the risks of civil war and terrorism, and terrorism events, to war between nations: all studied below in relation to US Oil and Gas. Consistent with OLI theory, decades of research (Chen 2017; Dai et al. 2013; Li and Vashchilko 2010; Nigh 1985) have associated political violence negatively with overall inward FDI. Mancuso et al. (2010, p. 787) report "a general consensus in the literature that increases in terrorist activity or risk reduce the inflow of FDI". However, while Witte et al. (2017) support this 'general consensus' overall, they note the insensitivity of resource-related FDI to political conflict. This they attribute to the high profitability of natural-resource extraction and to the geographic constraints on location choice. As noted above, Biglaiser and DeRouen (2007) report a positive, counter-intuitive relation between societal conflict and FDI for fifteen Latin American countries, 1980-1996. This they attribute to natural resource discoveries in Colombia, Mexico, and Peru.

Resource-based firms and industries as possible exceptions in relation to political conflict and FDI raise a new possibility. Rather than being attracted only to countries offering 'good' governance, resource-extractive firms may have developed capabilities that enable them to survive and thrive in hostile, 'bad' governance environments (Frynas and Mellahi 2003).

3 Resource-Based FDI and Political Conflict

This 'bad' governance hypothesis can be explained by real options and corporate governance theories. OLI theory views country risk negatively as a cost and deterrent to FDI that can be reduced overall by international diversification (Chung et al. 2013). In contrast, a real option approach (1) emphasizes the valuable "sequential flexibility with which a productive resource or asset can be designed, acquired, utilized, improved or scrapped" (Driouchi and Bennett 2011, p. 206). Firms can use this flexibility strategically to limit downside risk and exploit emerging upside potential under uncertainty. The upside potential in the form of opportunities for international entrepreneurship may indeed be significant in unstable and risky countries that are characterized by market dislocations and disequilibria (Di Gregorio 2005). In this respect, a real option perspective accords with the literature on entrepreneurship which views risks as two-sided opportunities. Consequently, Trigeorgis and Reuer (2017) identify five types of real option: options to defer (or stage), grow, change scale, switch or abandon. In particular, growth options are created at market entry and facilitate "enlarging a new foreign subsidiary by subsequent investment" (Fisch 2011, p. 517). It is argued below that growth options have the greatest significance for resource-seeking firms.

Oil supply is often flexible upwards and downwards, often depending on the resource's price. Unlike other industries where downsizing is costly, however, reduced resource extraction often leaves resources 'in the ground'. These assets may even increase in value when left alone. It is difficult to judge the value of these unrecovered minerals and energy resources, since most national accounting conventions for extractive firms exclude from balance sheets the potential value of resources acquired by subsidiaries until they are extracted or processed (e.g., Securities and Exchange Commission 2010). Nevertheless, in the USA the SEC does require Oil and Gas companies to disclose the volume of their reserves in supplementary documents, suggesting that unrecovered reserves represent valuable assets for oil and gas firms. For example, the annual report of the USA's biggest oil and gas company, ExxonMobil, shows that in 2017 it possessed proven Oil and Gas reserves representing 21 billion barrels of oil equivalent. Disregarding the costs of extraction for this rough estimate, these barrels valued at over US$73 would imply a total value of reserves of $1,533,000 million. These reserves dwarf ExxonMobil's total book assets, worth 'only' $348,691 million in 2017. Regardless of accounting conventions, regardless of the current market conditions and the current levels of oil price, unrecovered reserves could be extremely valuable to most extractive firms as they convey the opportunity to undertake positive net present value projects in the future.

From a real option perspective, the acquisition of reserves by resource-seeking MNEs is more likely to confer growth options and pre-emptive, first-mover options on subsidiaries, thus increasing the value of investments beyond any values obtained through classical investment appraisal (e.g. Discounted Cash Flow) methods. Of course, the above ground assets (e.g. facilities engaged in drilling, transferring and refining oil) of resource-based foreign subsidiaries could be vulnerable to terrorist attacks and destruction, but the most valuable assets may be non-lootable, and safely deep underground. Nevertheless, specialist articles on the security of Oil and Gas assets are mainly focused on threats to above-ground assets (c.f. Bajpai and Gupta 2007). Underground assets may continue to appreciate in value even after surface installations have been attacked or destroyed. In other words, downside risks may be limited in extractive industries, and upside risks with positive real option values may be more important than negative pull-out risks, thus encouraging inward FDI, despite political conflict.

Of course, expropriation (rather than the destruction of assets) may still be a major risk where predatory states prevail, but non-lootability may again prove to be important. To the extent that political conflict and violence reduce the capacity of state-controlled domestic firms to operate expropriated assets and businesses, the incentives of the state to expropriate technologically superior FDI could be lower and FDI could...

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