Todays Risk eNews
August 15:Commentary - Oil and China

Author: Gary M. Vasey, Ph.D.
Date: 2005-08-15
A significant component of today's record oil prices are related to the increasing energy needs of China. Already the second largest consumer of crude oil behind the United States, China's economy continues to grow at a rapid pace (9.4 percent this year) and even though that growth rate is predicted to slow to 8 percent, it is increasingly in need of overseas oil supply.

A significant component of today's record oil prices are related to the increasing energy needs ofChina. Already the second largest consumer of crude oil behind the United States, China's economy continues to grow at a rapid pace (9.4 percent this year) and even though that growth rate is predicted to slow to 8 percent, it is increasingly in need of overseas oil supply. China's oil imports have doubled over the last five years and grew 40 percent in the first half of 2004 according to TIME Asia1. At the same time, China watchers have noted the capitalist communist country's ambition to have Chinese corporations play a larger role on the world's stage.

For the Chinese, the oil issue is in fact one that is familiar to us all in the West. For many years, China was able to meet its own oil needs with domestic production but as demand has continued to grow at record rates in order to fuel its burgeoning economy and, as its giant field's have gone into rapid production decline, the county is increasingly reliant on oil imports. China 's response has been similar to those in the West as well梙ave its oil company's seek overseas exploration & production opportunities and overseas markets for supply. Similarly, just as the United States and other western nations have sought some insurance against supply disruptions by building and filling strategic petroleum reserves ( SPR ), so are the Chinese readying its own SPR which will eventually contain between 20 and 30 days of supply (approximately 100 million barrels).

Like the United States , China 's energy issues are further complicated by environmental issues. About two-thirds of its current electric power generation is from coal and, like the United States , the country has tremendous coal reserves. However, crude oil is cleaner than coal burning. Besides, oil is needed for other reasons such as to provide gasoline to its growing automobile market and to provide the fertilizers, plastics and other materials that its industry needs.

The Politics of Oil

In entering global oil markets to secure supply, China is faced with some serious issues. Historically, it has not played much of a role in exploration and production outside of the mainland until recently and it has to seek opportunities as it can. As a consequence, the nation finds itself increasingly at odds with western politics and policies as it is forced to seek opportunities in countries and regimes shunned by the west. Its approach to entering these markets and opportunities has been different too梑uilding railways in Nigeria, paying for a port project in Gabon, helping to provide electric power to Angolan slums, investing in a major Sudanese oil company, investing in Iran's largest onshore oil field, funding road projects in Rwanda, and more. According to some sources, China has even used its United Nations Security Council position to "tone down" criticism of some of the regimes that it is involved with to support its need for access to oil. Similarly, China has shown that it is quite prepared to aggressively engage in exploration for and exploitation of politically sensitive areas including the straits of Malacca and by calling for joint exploration in disputed territory near to the Philippines .

In its search for oil supplies, China has also played off of disagreements with U.S. policy in nations on the U.S. 's border. It has taken a $150 million share via CNOOC in the Alberta oil sands and PetroChina has signed a memorandum of understanding with Enbridge Inc. for half of the supply from a proposed $2 billion pipeline project to take oil from Alberta to Prince Rupert in British Columbia . It has even been active in trying to secure supplies in U.S. administration critical Venezuela .

China's Oil Companies

China 's three major oil companies, although national companies, are all quoted on various stock exchanges. They have shareholders outside of the Chinese state. Indeed, in some regards, these companies resemble other national oil companies of a just few years ago such as British Petroleum that historically were also controlled by a major shareholder in the form of a national government. Many of these western national oil companies had access to government "loans" and subsidies, too. In fact, there are still a number of national oil companies that are partly privatized operating in global oil markets today on a par with truly private oil companies, for example Saudi Aramco.

China 's government is seeking to turn these national oil companies into global majors just as the British and French governments did not twenty years ago. In part, that goal supports China 's ability to access overseas markets and opportunities for oil and in part, it is, I would argue, a natural extension of the Chinese movement towards a capitalist but communist system.

A part of this strategy was undoubtedly behind CNOOC's recent attempt to acquire Unocal.

CNOOC and Unocal

On the surface, this was a good offer for Unocal shareholders representing a cash-only deal at a premium over the competing offer. Both Unocal and CNOOC are quoted companies (30 percent of CNOOC was floated to the public in 2001) and Unocal, essentially now a Southeast Asian gas company was a certainly strategic fit for CNOOC. Indeed, CNOOC went to great lengths to satisfy potential concerns over the deal from a political standpoint making commitments to preserve Unocal's U.S. assets and maintaining its workforce (while the competing bid looked for cost savings through job cuts). It pledged to continue Unocal's practice of selling and marketing substantially all of the oil and gas produced from Unocal's U.S. properties in U.S. markets, amongst other promises that could easily have been tested and monitored.

However, there were apparently issues and miscues from the very start of the failed bid. According to a story in TIME Asia2, the 8-person board, which includes four foreigners, had apparently been left largely in the dark about the potential bid culminating in one foreign board member resigning citing health reasons while another recused himself based on a potential conflict of interest issue. Despite that, the $18.5 billion offer went ahead and CNOOC lined up financing from a variety of sources梑oth commercial and "non-commercial" from its parent company (tantamount to a non-payable loan from the Chinese state in some eyes). The political reaction was also apparently something of a surprise to CNOOC who even hired a PR firm to run full-page advertising and built a special website to defend the deal3. Even as CNOOC later pulled out of the prospective deal citing the political environment as its reason for not sweetening the initial bid, sources4 reported that Unocal had in fact preferred CNOOC's bid and that it had been prepared to recommend it, despite political objections.

Analysis of the Failed Bid

If the TIME Asia article is to be believed, it seems paradoxical that the CNOOC bid likely failed in reality due to CNOOC's own evolving capitalist culture. Despite its relative independence from the Chinese state and its public minority ownership, the firm's failure to discuss the potential deal with the board smacked of a centralized decision making process. However, once the board was involved, it was engaged in the process and CNOOC utilized western-style PR and investment banking advice for help. Similarly, CNOOC's funding package was something of a strange mixture of both capitalist and centrally-planned mechanisms and sources!

Perhaps the biggest issue for the Chinese was the response from members of the U.S. government. The center of capitalism and promoter of global free trade baulked at the idea of a Chinese national oil company procuring a U.S. company. That must have been difficult to understand for a country trying to take on the western capitalist value set? At the end of the day, had CNOOC persisted, the deal might have actually gone through, albeit with some delays but it either misread the signals or determined the price was too high.

And what of those Washington political concerns? As usual, one suspects that the politicians really don't understand the energy business in any great detail. After all, Unocal is in all reality a South East Asian company today with around 70 percent of its interest within China 's sphere of influence. As for the argument that dual purpose technologies created a "national defense" threat if passed over to the Chinese, as a geologist, I'd be very surprised if CNOOC didn't already have access to such technologies梐fter all, they are provided by most of the world's larger oil service companies! It might well be that, in the end, the larger threat to national security was actually not to let this deal happen. China remains committed to seeking out new oil supplies but it has just made the logical observation that the normal rules of engagement don't appear to apply to them. Perhaps this will result in China increasing looking to opportunities in areas that are politically off limits to the West?

BP was allowed to purchase U.S. oil company SOHIO in the 1980's despite its U.K. national ownership and has since swallowed up several more besides in the process becoming a truly public company. While it could be argued that the United Kingdom was never a national security threat, it is certainly a parallel in many other respects.

Certainly, the well educated (usually at U.S. colleges) Chinese will now have learned their lessons and will apply them next time. Meanwhile rumors continue to abound about CNOOC's next acquisition target with several other U.S. companies and at least one Australian company named in the media as potential targets. After all, the Chinese have all of those dollars to spend and where better than back in the United States in the form of hard assets? This same concern occurred in the eighties when Japan was buying up U.S. assets. Now Japan 's economy has itself had some tough times.

Finally, Chinese demand for oil will continue to play a role in oil price formation and one suspects, world politics. While Chinese demand growth is certainly not the only factor at work behind today's oil price, it will remain a key factor in global oil markets. Consider this quote from a recent issue of The Economist, "China has accounted for one-third of the increase in global oil demand since 2000 and so must bear some of the blame for higher oil prices. Likewise, if China's economy stumbles, then so will oil prices. However, with China's oil consumption per person still only one-fifteenth of that in America, it is inevitable that as China's energy demands will grow over the years in step with its income. There is currently only one car for every 70 people in China, against one car for every two Americans. That implies a huge increase in oil demand, which could keep prices high for the foreseeable future, because of scarce global spare capacity. China's consumption per person of raw materials, such as copper and aluminum, is also still low, so rising demand will continue to support commodity prices" 5.

It should be noted that the United States Energy Policy Act of 2005, signed into law earlier this week, authorizes an Asian Pacific partnership between the United States , India , China , Japan , South Korea , and Australia on clean development to encourage clean energy technologies throughout the Pacific Rim . This partnership was set up due to the fact that the Pacific Rim is growing faster than other areas and will require massive amounts of energy to sustain economies. What effect it will have on oil remains to be seen.

1 "China's Quest For Oil" - TIME Asia Magazine, Monday, October 18, 2004
2"Uncharted Waters" - TIME Asia Magazine, July 18, 2005
3 http://transactioninfo.com/cnooc/home.php4 "Unocal Says It Favored CNOOC Bid" - L.A. Times July 26, 20055 "How China Runs The World Economy" - The Economist July 20 - August 5, 2005, pp 61-63.

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