Did This Strategy Work Too Well?

Sometimes your actions come back to haunt you, even if you never intended the consequences. Over the past week, I have been learning that lesson the hard way here in Brazil.

Shortly after the breakup of the Soviet Union, my advisory company introduced an approach to provide funding for projects in former republics that were hampered by all manner of fiduciary roadblocks. We “affectionately” began labeling such an effort a “matty,” after the Russian matryoshka nesting doll set in which one is contained within another.

And the device was this: In an economy in which value was dependent upon a number of factors in a difficult market situation, I found it easier to capitalize one extraction project by collateralizing the value of another underlying raw material.

Essentially, “nest” one raw material within another, hence the allusion to the dolls.

The strategy worked, lowering risk and allowing enough working funding to be secured to at least start projects. Thereupon a range of other problems would take over, determining whether profits ever saw the light of day.

However, it appears the “matty” approach may have unintentionally worsened a situation here in Brazil.

Here’s how my strategy may have had an unintended consequence… and how we’ll use the same approach for profit opportunities…

Helping a Timber Harvester in Peru

Several years ago, I negotiated a contract for a client in Peru. The idea was simple enough, although it had not yet been attempted in South America.

The client was harvesting timber in the jungles abutting headwaters of the Amazon. Found in the forested valleys at the foot of the Andes, the product was among the most desired in the world, with high market demand and prospects for very lucrative profits. The problem was prohibitive operational expenses in a region on the wrong side of the mountains and far from access to export by sea.

The timber had a high recovery cost for a reason. The ability of a harvesting company to acquire sufficient working capital was always a problem. Banks would provide some, but the loan terms would quickly escalate. That would make conventional debt utilities very cost-ineffective. And without the carryover from banking lines of credit, investors would shy away.

So I introduced a matty.

Securing the Land’s Mineral Rights in a “Mattty”

I had the company secure the oil and natural gas mineral rights below the surface of where the timber works would be located. While there were also major problems with getting the hydrocarbons from this region, there was no question that this was a valuable find: (1) Seismic testing had indicated the presence of considerable extractable volume; and (2) the oil/gas had a market value even if left in the ground as in situ reserves.

The value of those reserves would have to be heavily discounted to their market price, but access to their ownership still had a worth. That was enough. Folding that negotiated value into the timber funding program provided enough interest to provide bank lines at affordable rates.

The company had no intention of developing the oil and gas, but once it owned the rights they had a market value and could always be sold outright or farmed out. One raw material commodity value had been nested within another.

Working in Peru was also better in other respects. First, we were able to set up a government-approved program to replenish the timber cut through a replanting program. Second, Lima has a special department that represents the interests of indigenous peoples. Those interests sit at the table from the initiation of project negotiations.

As a result, there is no later local opposition to development. The concerns are addressed up front, and the Indians are guaranteed a known portion of the realized government revenue.

Escalating Tensions in Peru’s Neighbors

In Peru’s northwestern neighbor, Ecuador, the situation is different. There, insurgencies among the Indians have brought major projects to a standstill, while damage to the environment in some areas has been massive. The legal fight against Chevron (NYSE:CVX), which began in 1993 as a class action lawsuit over millions of gallons of oil and toxic wastewater released into rivers, streams, and groundwater – one of the biggest ecologically destructive events in recent memory – continues.

Brazil, Peru’s neighbor to the east, takes an approach somewhere in the middle. Yet that seems not nearly enough.

In the last two editions of Oil & Energy Investor, I have discussed significant concerns over developing vast shale oil and gas deposits in the ecologically delicate area surrounding the Iguazu Falls. I also noted that the potential effects of timber projects further upriver have heightened domestic angst.

I decided to see for myself how bad the problem was becoming downstream, in Argentina, where some gas operations are being developed. However, no helicopter pilots would agree to venture that far over the border at any price. Companies seem to have an irritating habit of shooting at anything coming near.

The Matty Approach Is Alive and Well in Brazil

On the other hand, I did find out details on why opposition to the timber trade upstream in Brazil was intensifying. The scarring and deforestation of the land have introduced population and wildlife dislocation, the wiping out of agriculture, massive drainage and flooding problems, increasingly destructive fires, and a rising belief that the ecology is being rapidly undermined and destroyed.

And here is the clincher.

Timber production is increasing rapidly, with the Iguazu River becoming a conduit for logs to market. While the likelihood of developing oil and gas is still up from grabs, the companies are now increasingly acquiring subsurface rights and collateralizing them to provide working capital for the timber projects.

In short, my matty approach as drawn out earlier in Peru is (unfortunately) alive and well in Brazil.

New Opportunities on the Way…

I have no idea whether the Peruvian contract had anything to do with this development. Having spent the last week in this natural wonder, the last thing I would want is for my actions to have anything to do with putting it at risk. But the realization that it might is disquieting to say the least.

Maybe some ideas are best left unacted upon in certain places where the created problems are too severe.

Yet not everywhere, it seems. I am currently looking into other ways of using the matty approach to bridge energy sources. There are now opportunities for lower risk and higher profit moves emerging. Energy Advantage members will shortly be receiving the first of these as the energy market rolls out new ways to make money.

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