A three-year bull market for metals, combined with a scarcity of mineral deposits in stable countries, has encouraged domestic mining companies to take risks and look further afield for the next big discovery. As a result, many investors who loaded up on Toronto Stock Exchange-listed mining companies that have set up operations in areas with political turmoil have reaped the rewards while others have been reminded why such investments have traditionally been so risky.

“If you look at where resources and reserves and exploration activity are taking place, it’s not in what we call AAA-grade countries such as Canada and Australia,” says Alex Gorbansky, managing director of Frontier Strategy Group, a Boston-based risk-management firm that specializes in the resources industry. “Most of the massive finds are now being sought in very challenging and risky environments, in places such as the Democratic Republic of the Congo [and] parts of Latin America and Central Asia.”

And judging from the share performance of some companies working in these former no-go zones, many investors are no longer applying a political risk discount to these mining investments. Take the companies operating in the DRC, for instance. Although the country is considered the second-worst place in the world to invest (after Zimbabwe) — according to a 2005 survey of mining and exploration companies conducted by the Fraser Institute in Vancouver — shares of companies mining there have soared in price recently.

For example, Toronto-based gold explorer Banro Corp. — whose gold property was expropriated during the DRC’s civil war in the late 1990s, then returned in 2002 — is trading at about $11 per share, up from $3.50 in June 2005. And Perth, Australia-based Moto Goldmines Ltd., another gold explorer, is trading at about $8 per share, up from $3 as recently as November.

One investor willing to take those risks in exchange for the substantial rewards the DRC has to offer is Terry Bell, vice-president of global mining for Salida Capital Corp. , a private investment firm in Toronto. He says the country is blessed with world-class copper and gold deposits. And, he says, the example of Vancouver-based First Quantum Minerals Ltd., which has been mining copper in the country without major incident, proves that success can be had in mining there.

Shares of First Quantum, which fetched less than $20 each in early 2005, have jumped to the $35-$40 range. The company’s market capitalization is more than $2 billion, and it recently made a $190-million takeover bid for Adastra Minerals Inc., a TSX-listed but London-based company that holds a 65% stake in the DRC’s Kolwezi copper/cobalt tailings project.

Bell holds several companies in his BTR Global Prospector Fund that are exploring or operating in the DRC, including Adastra, Banro, First Quantum and Moto.

Other rewarding investments in politically risky locales include Vancouver-based Greystar Resources Ltd., trading in the $8-$9 range as it develops its Angostura gold/silver deposit in northeastern Colombia, and UrAsia Energy Ltd., also of Vancouver, with its uranium properties in Kazakhstan. UrAsia has almost doubled in price to $2.80 since listing on the TSX in November.

However, recent moves by some foreign governments demonstrate how quickly things can turn sour, which could heavily affect many mining companies’ stock prices, hurting investors in the process.

In 2004, share values of mining companies operating in the northeastern African country of Eritrea were slashed in half within a day following the government’s announcement of a moratorium on exploration while the country reconfigured its mining code. Shares of Nevsun Resources Ltd. and Sunridge Gold Corp., both based in Vancouver, dropped from $4 and $2, respectively, to $2 and less than $1 per share.

Last year, Venezuelan President Hugo Chavez threatened to cancel all existing mining licences with foreign companies and to stop issuing new ones. Investors interpreted the move as a leadoff to nationalization of the country’s resources and bailed out of companies operating there. Shares of Toronto-based Crystallex International Corp., which is developing a gold deposit in the country’s Bolivar state, lost more than 25% of their value in one day. Bolivar Gold Corp. — also of Toronto, but with an advanced gold exploration property near Crystallex’s — was another casualty. Its shares dropped from $2.90 to $1.70.

And even though there are signs of improvement in the DRC — home to one of the richest deposits of metals in the world, but plagued by years of civil war — the future remains cloudy as the country heads toward its first democratic elections later this year.

@page_break@“There has been a significant increase in valuations for companies doing business in the [DRC] because the view is that things are going to improve in the long term,” says Frontier Strategy’s Gorbansky. “There is no question that it has turned a corner, but there is still a huge amount of uncertainty in terms of the future trajectory of the government and the regulatory business environment.”

Meanwhile, Salida’s Bell is cautiously optimistic about the DRC’s prospects. He says the United Nations’ recent stationing of 15,000 troops there suggests there is a strong international will to establish peace: “If the [DRC] is stable and developing, it’s going to pull up everyone else around it. There is a lot of finance available for these projects for the same reason.”

With these tempting but potentially hazardous investments before them, how can your clients shield themselves from political risk? Bell relies on due diligence plus an ongoing dialogue with companies working in the area and other local sources to make investment decisions. To minimize the risk even further, companies with a higher political risk profile are given an accordingly lower weighting in his fund.

Decisions should also take into account the particulars of the company. Bell likes Banro, for instance, because the management has a track record in Africa and an understanding of how to adapt to local conditions; in addition, its property in the DRC has significant exploration upside.

Another way to factor in political risk is to apply a discount — as much as 15% for countries such as the DRC — to assets in risky areas.

There are also organizations that track political risk, such as the Fraser Institute and Berlin-based Transparency International, which publishes an annual corruption perception index that ranks more than 150 countries in terms of perceived levels of corruption. These can be used to weed out some of the riskiest hot spots.

Meanwhile, Frontier Strategy divides “above-ground” risk into four major categories: geopolitical, regulatory and business climate, environmental and social. The firm then evaluates several parameters within each category to determine an overall risk rating for each country.

This technique attempts to answer questions such as: what is the government’s attitude toward foreign investment; how much corruption is there; what are the environmental compliance costs; and what level of community opposition is associated with the mining areas?

“These are the key questions investors need to be asking as they look at a company or specific project, but, unfortunately, they are not,” says Gorbansky.

Frontier Strategy is particularly concerned about growing risk in Latin America, where Canadian mining companies have substantial investments. The firm will be keeping a close eye on elections in Peru this year. If a new government is elected that is either hostile to, or covetous of, foreign mining projects, Frontier Strategy believes that the outcome, combined with socialist leanings in Venezuela and Bolivia, could have a negative impact on investments in the whole region.

The other danger is that as competition for resources projects grows (China and India are aggressive newcomers), governments will gain increasing leverage to negotiate better and, potentially, more nationalistic terms for themselves.

According to Frontier Strategy, the best places to invest in 2006, from an above-ground risk perspective, are Australia, Canada and Chile. The worst places are Venezuela, Uzbekistan and Ukraine. Countries at risk include Ghana, which has increasing corruption and no clear successor to President John Agyekum Kufour, and Mongolia, where mining laws are untested at a time in which there is a frenzy of exploration activity.

“Political risk is becoming one of the big three categories of risk facing companies, along with commodity price risk and exploration risk,” says Gorbansky. “And investors need to figure out how to capture that in their valuations.” IE