Natural resources and finance

Developing natural resources, whether rare earths or oil, gold or coal, requires significant financial resources. There may still be a few prospectors roaming remote lands with a pick and pan seeking riches, but finding and developing natural resource deposits today requires a modern financial system.  

Unfortunately, many jurisdictions rich in natural resource deposits are poor in rule of law.  

As a result, financial centers around the world play a crucial role in helping to develop resources. As Prof. Roger Meiners notes in this issue, the “natural resource curse” is in part the curse of political competition for control of resources.

Financial centers’ roles are not uncontroversial, with some arguing that they facilitate corruption and theft from natural resource rich jurisdictions. To put both sets of arguments in context, let’s consider four significant problems involved in natural resource development and the role financial centers play.

Financing development / governance 

Before anyone benefits from a natural resource deposit, it must be developed. This takes time and money. As a result, such activities are economically vulnerable with little protection against political risks (expropriation, for example) to the large amounts of capital that must be tied up for extended periods. Locating a new mineral deposit typically costs hundreds of thousands of dollars and determining whether to proceed with a site may cost a half a million to a million more, even before any extraction begins.

If we think of exploring for natural resources as akin to buying a lottery ticket, the combination of political risk and capital-intensity makes the analogy something like buy a ticket and leave the ticket in an unlocked room for a decade before seeking to cash it in if it is a winner.

Given the investment requirements and development time, natural resource ventures require sophisticated finance and governance structures. Investors will want to diversify their investments across possible sites (buying more tickets) and will be wary that the technically sophisticated operators will renege on bargains, as well as concerned that the governments controlling the area where exploration and development are underway may decide to expropriate directly or indirectly.

Putting governance under rules in jurisdictions with sophisticated legal systems is thus important to reducing risks. Using a Canadian stock exchange or NYSE traded company is not sufficient, of course, since the resources remain located in a territory where the government may renege on any bargains (e.g. Venezuela) but such actions can help manage risks.

Controlling fraud 

Natural resources and fraud seem to go together like peanut butter and jelly. Some of these frauds are relatively unsophisticated, others exhibit considerable cleverness. “Salting” ore samples to throw off laboratory tests has a long history.

One 19th century account describes how, after buyers of a mine had gone to great lengths to collect an ore sample and bring it to the surface themselves, a drunk stumbled up to the mine mouth, tripped, and dropped his whiskey bottle down the shaft where it smashed in the rising ore bucket filled with the samples. The whiskey had plenty of gold particles in it and the “drunk” successfully salted the sample.

More recently, the 1990s Bre-X fraud involved samples left in an Indonesian warehouse, where they appear to have been salted, with investors distracted by the use of a high quality laboratory for the testing. The scale of the fraud grew – by some estimates Bre-X was a $6 billion fraud – but the story was essentially the same.

Fraud is a particular problem where investments involve projects far away, with complex technologies and data that are hard for investors to evaluate. Bre-X claimed to have found a massive gold deposit in a remote part of Indonesia where no one had previously looked for gold (for good reason, it turned out). Once a major mining company with technical expertise was brought in by the Indonesian government (a part owner of the project), the scam quickly unraveled.

As long as investors have sought quick riches, fraudsters will be drawn to mineral scams.  The rules of finance can operate to limit such opportunities, if given sufficient scope to operate. Market pressures by contrarians have helped unravel major financial scandals, as short sellers did with Enron’s overstated profits. Stock exchange rules can – but do not always – force disclosures that limit fraud. More importantly, those with legitimate investment opportunities in natural resources (and other things) seek ways to distinguish themselves from fraudsters by using financial instruments and markets that offer guarantees for investors.  Encouraging financial innovation can thus help prevent fraudulent schemes from succeeding.


The vast sums available to those with control of natural resources invite corruption. One dramatic example is Angola, where the combination of oil and diamonds, and what Tony Hodges termed “Afro-Stalinism” under Jose Eduardo dos Santos, led to massive corruption.

As Hodges summarized in his book “Angola: Anatomy of an Oil State,” under dos Santos, “Oil wealth provides the presidency with enormous resources to buy off opponents and build alliances, while the lack or non-enforcement of transparent rules and procedures for the allocation of resources [whether diamond concessions, state contracts, privatization of state assets, land titles or business licences] gives the head of state an array of mechanisms with which to dispense favors.”

Some financial center critics blame financial centers for facilitating this corruption. For example, Corruption Watch U.K. pointed to the use of Swiss and Isle of Man entities in a Russian-Angolan transaction that the NGO estimated cost the Angolan and Russian governments $750 million, rather than the alleged corruption of Russian and Angolan officials (who structured the transaction using those entities) as evidence of a problem with finance.

Routing the proceeds of corrupt transactions through multiple entities in different jurisdictions undoubtedly makes it harder (but by no means impossible) to trace the transactions. But the fundamental problem was not the availability of Swiss and Manx entities to bad people.

It was not even the – predictable – existence of people seeking illegitimate gains in Russia and Angola, or even Switzerland and the Isle of Man. The key problem was the structure of the Angolan economy as described by Hodge – an economy where favors are doled out to buy loyalty.

Finance, and financial centers, cannot solve the problems of corruption created by political control of vast resources. But they do help. Modern accounting grew in part from the needs of American railroads to reassure European investors that the railroad owners were not making off with the investment funds.

It was far from perfect – there were plenty of railroad scams during the 19th century – but accounting and financial markets both facilitated the construction of a north American rail network that required more capital than was locally available and gradually restrained corruption. Finance can play a similar role in restraining corruption in natural resource investments if it is allowed to do so.

Particularly when combined with controls on politically exposed persons’ use of the financial system, as modern AML systems attempt to do, this can check many abuses.

Integrating profits into the world economy 

The vast wealth generated from natural resources needs to find productive uses in the world economy. Financial centers have played key roles in assisting in this process. The “recycling” of petro-dollars into the world economy in the 1970s would not have been possible without London’s financial markets, operating with the aid of various offshore centers. Indeed, petro-dollars played a major role in the expansion of the Eurocurrency markets in the early 1970s, which in turn led to major growth in many offshore financial centers.

Today, sovereign wealth funds of major natural resource states from Norway to Kuwait are significant market actors that make use of financial centers’ services. As a result, these funds are invested in economies from America to Asia, improving the world economy. Without tax neutral platforms in jurisdictions with high quality courts and laws, these funds would find it much more difficult to flow to productive investments.

Where are we headed? 

One way to think about the world is as a static system, focusing on division of resources. In such a world, finance has only an insignificant role to play and the main question is who is getting what. The alternative and more realistic way is to remember that the world is a dynamic system. The stock of natural resources is not static since what matters is the known stock of resources.

The development of fracking, the recent discovery of vast gas fields off Egypt, and the promise of additional resource discoveries mean that our natural resource endowment can grow if we can invest resources in finding and developing resources. Finance – and the world’s financial centers – have a significant role to play in expanding the resource base upon which the world economy can grow.


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Andrew P. Morriss

Andrew P. Morriss, Chairman, is the D. Paul Jones, Jr. & Charlene Angelich Jones – Compass Bank Endowed Chair of Law at the University of Alabama School of Law. He was formerly the H. Ross & Helen Workman Professor of Law and Business at the University of Illinois,Urbana-Champaign. He received his A.B. from Princeton University, his J.D. and M.Pub.Aff. from the University of Texas at Austin, and his Ph.D. (Economics) from the Massachusetts Institute of Technology. He is a Research Fellow of the N.Y.U. Center for Labor and Employment Law,and a Senior Fellow of the Institute for Energy Research, Washington,D.C., as well as a regular visiting faculty memberat the Universidad Francisco Marroquín,Guatemala. He is the author or coauthor of more than 50 scholarly articles, books, and bookchapters, including Regulation by Litigation (Yale Univ. Press 2008) (with Bruce Yandle and Andrew Dorchak), and is the editor of Offshore Financial Centers and Regulatory Competition (American Enterprise Institute Press 2010).

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