Under the radar

With US$19.5 billion on offer, Aluminum Corp of China’s investment in Anglo-Australian miner Rio Tinto was poised to become a landmark event in Beijing’s quest for natural resources. But over the course of three months, everything fell apart.

Despite Rio’s debt problems, the equity-plus-assets deal faced opposition from the firm’s shareholders and certain elements of the Australian political establishment. A combination of their pressure, regulatory uncertainty, protracted negotiations and rising commodity prices culminated in Rio getting cold feet. Chinalco was left to rue what might have been and ruminate on what went wrong.

It is a situation with which China’s oil and gas companies are all too familiar.

Twice in the last decade, China National Petroleum Corp (CNPC) got caught up in politically charged deals in the former Soviet Union. A bid for a majority stake in Russian oil firm Slavneft in 2002 provoked an outcry in Russia’s parliament; Slavneft was later sold to a domestic firm for a lower fee. Three years later, CNPC’s takeover of PetroKazakhstan only went through after it agreed to sell one-third of the firm to a local player.

Not one to forget

Neither of these incidents, however, generated as much controversy as China National Offshore Oil Corp’s (CNOOC) US$18.4 billion bid for US oil firm Unocal in 2005. Blown sideways by  the fierce political response, a battered CNOOC withdrew its offer. The failure had a lasting impact on the psyche – and approach – of China’s oil majors.

"China’s strategy really changed after the Unocal bid," said Holly Pattenden, a London-based oil and gas analyst at Business Monitor International (BMI).

This change has seen Beijing seek  long-term relationships with resource-rich countries at the government level, while the state oil firms have turned their attention to lower-key and lower-value investments that will not draw political fire.

The sharp decline in oil prices – light sweet crude hovers around US$70, down from a peak of over US$145 in July 2008 – and the pressures of the global financial crisis mean there has been no shortage of potential targets. As of June, Chinese energy and power firms had spent US$6.2 billion overseas, compared to US$10.5 billion for 2008 as a whole, according to Thompson Reuters. This doesn’t include more than US$40 billion extended in credit by Chinese policy banks in exchange for oil and gas resources in 2009.

"Chinese firms will continue with small- to medium-sized deals from an opportunistic viewpoint rather than launching large-scale acquisitions along the lines of the Unocal deal," said Norman Valentine, an analyst with oil and gas consultancy Wood Mackenzie in Edinburgh.

The demand equation

China needs imports in order to feed its oil habit, which has grown in tandem with the country’s economy. The International Energy Agency puts these imports at over 7.8 million barrels per day for 2009, only slightly down from 7.9 million barrels per day in 2008. BMI estimates that China will have to rely on imports for 53% of its oil demand this year. This is expected to grow to 72% by 2020. Natural gas demand came to 80.7 billion cubic meters in 2008, up from 67.3 billion the previous year, although this hike was matched by a similar jump in domestic gas production.

However, China’s energy giants seem divided on how to shore up resources.

CNOOC Chairman Fu Chengyu has said several times this year that he favors joint exploration projects, or purchasing extracted assets directly, to politically risky acquisitions. Aside from a reported US$323 million bid – with China Petrochemical Corp (Sinopec) – for Talisman Energy’s assets in Trinidad and Tobago, CNOOC has been relatively quiet.

In contrast, CNPC, whose general manager Jiang Jiemin has said the financial crisis has opened up M&A opportunities, is forging ahead. PetroChina, the company’s listed unit, purchased a 45.5% stake in Singapore Petroleum in May for US$1 billion, with a view to a full acquisition. It is likely to give PetroChina access to refining capability in a crucial market for determining fuel prices in Asia.

Having lost out in February on a US$400 million deal for Canadian firm Verenex Energy, a CNPC subsidiary took a 50% stake in Kazakhstan’s Mangistaumunaigaz, via a transfer from KazMunaiGas for US$3.3 billion. In addition, the China Export-Import Bank extended a US$5 billion loan to Kazakhstan.

The close ties China’s oil majors enjoy with domestic policy banks is seen as both a strategic advantage and a cause for criticism. The firms have long been accused of dipping into the state’s coffers to overpay for assets, creating an unlevel playing field. A recent Wood Mackenzie report concluded that CNPC has become more willing to pay a "significant premium" for assets. The bids put in for Verenex and Mangistaumunaigaz implied long-term per-barrel oil prices of US$81 and US$110, respectively. Wood Mackenzie’s base case assumption is US$70 per barrel.

Questions have also been raised as to the geographical focus of China’s investments, particularly in Kazakhstan. In 2006, CITIC Resources paid US$1.9 billion for a 50% stake in the Karazhanbas oil field, but it has failed to deliver on expectations. CITIC Resources CEO Sun Xinguo said in April that the field has delivered an average of 36,000 barrels of oil per day. The original goal was 60,000.

Nevertheless, China’s oil majors, regardless of whatever small proportion of their assets are listed, answer to the state – and Beijing’s broader strategy to secure natural resources takes priority over the economics of individual oil and gas fields.

"It’s very difficult to say whether it’s the right approach or the wrong approach. What it is, though, is a different approach from that which a number of multinational oil companies are able to take," said Geraint Hughes, a partner at Clifford Chance, who has worked on several Chinese energy-related deals.

Due to this perceived freedom from market forces, Chinese oil firms are inevitably the subject of rumors. A US$8 billion bid for Switzerland’s Addax Petroleum might seem fanciful if tied to a Western oil giant. If the interested party is an as-yet-undetermined Chinese player, though, analysts see the deal as plausible.

An evolving strategy

Daniel Rosen, a partner at Rhodium Group, a macroeconomic advisory firm in New York, and a visiting fellow at the Peterson Institute for International Economics, sees China’s resources acquisition strategy as characteristic of a nation still experimenting with any variety of innovations and policies. This will eventually crystallize into a set of tactics that maximize the country’s interest, he argues.

Already, versions of deal structures that have proved effective in some parts of the world are now being employed in others. The US$40 billion doled out by China’s policy banks to finance loans-for-oil agreements is a case in point. Wood Mackenzie’s Valentine sees parallels between this and the soft loans strategy Sinopec used to gain access to upstream oil assets in resource-rich but infrastructure-poor Angola in 2004. Infrastructure-for-oil deals were soon struck elsewhere in Africa; now loans-for-oil is in vogue.

"Over the past six months there’s clearly been a shift from infrastructure-for-oil to loans-for-oil," noted Erica Downs, a fellow at the Brookings Institution in Washington DC.

It is a pragmatic switch, analysts say, one that reflects the needs of the recipient nations and the fact that there are few major oil and gas companies or prime assets for sale at present.

Hug the Great Bear

China Development Bank (CDB) in February extended US$25 billion in loans to state-owned Russian firms for a total of 300,000 barrels per day of crude. As part of the deal, Russia will build a spur on its East Pacific Pipeline stretching from Siberia to China. That Russia was willing to begin construction  right away – after 14 years of negotiations – reflects Beijing’s heightened bargaining power amid the financial crisis, according to Lin Boqiang a researcher at Xiamen University’s China Center for Energy Economics Research.

The full impact of these loans may reach beyond Russia into Central Asia, a region seen as a linchpin for China’s long-term energy security. Kazakhstan and Turkmenistan have abundant supplies of oil and natural gas that do not have to reach China via sea lanes largely controlled by the US Navy. China, which in June extended a US$3 billion loan to Turkmenistan for gas field development, must tread carefully here. Central Asian nations are keen to diversify their customer base beyond the Great Bear, but Beijing doesn’t want to upset Moscow.

"One of the biggest obstacles to getting into Central Asia is that this is Russia’s backyard. If [China] can butter up the Russians then they have more access to Central Asia. In some ways it’s a very canny policy," said Jennifer Richmond, director of China analysis at Stratfor, a Texas-based global intelligence company.

Analysts see a similar long-term play in CDB’s US$10 billion loan to Brazil’s Petrobras, which will supply 200,000 barrels of oil per day to Sinopec over 10 years. China hopes these loans will deliver access to Brazil’s large sub-salt oil fields as well as technology transfers. The extraction of sub-salt oil, which lies under layers of rock and salt far below the ocean’s surface, requires deep-water drilling expertise beyond even CNOOC, China’s most adept exploration firm. Petrobras, in contrast, is a global leader in this area.

A flaw in the plan

Clearly, the oil-for-loans deals might pay dividends for China’s oil majors. But whether such state support gives these firms a significant strategic advantage over the large super-majors is up for debate. The obvious caveat to a business model that doesn’t necessarily prioritize the bottom line is that it might impede companies’ ability to build sustainable operations in the long term.

For example, China’s higher tolerance for risk and limited fears of diplomatic blowback facilitate "no strings attached" deal-making with the likes of Sudan, Myanmar and Iran. International oil firms steer clear, aware that their shareholders and home governments might not countenance the human rights abuses often tied to such regimes. Politics aside, Sudan and Myanmar are both unstable and inexperienced at handling foreign investment. It’s difficult for anyone to do business there, as China is discovering.

"Chinese companies are starting to experience the downsides of political risk," said the Brooking Institution’s Downs. "I’m sure they don’t have a lot of experience in risk assessment."

Chinese oil workers have been kidnapped and killed in various countries in Africa, and there are inevitably concerns about investments in Iran and Iraq. Even relatively stable countries present political challenges. In 2007, Ecuador’s government instituted a 99% windfall oil profits tax, highlighting the risk of resource nationalism in South America. Increasingly, China may be learning that there is no such thing as "no strings attached."

Pricing issues

Strict price caps on refined oil products sold domestically further complicate the relationship between the state and the state-owned. Energy price reform is on Beijing’s agenda but it is a long-term endeavor, which leaves China’s oil majors in the difficult position where selling on the international market is more lucrative than selling at home. Keen to maximize their profits, they have in the past neglected the domestic consumers. Research by Daniel Rosen and the Rhodium Group found that in 2006, China had imports of 2.9 million barrels per day of crude, while the maximum amount of crude actually brought home to China stood at only 225,000 barrels per day.

In this context, Damien Ma, an associate with Eurasia Group, a Washington-based political risk consultancy, argues that it is simplistic to view China’s oil and gas companies as mere pawns of the state. "People often miss the growing power of these sub-sovereign actors in China," he said. "CNPC has ministerial rank; people forget how powerful these companies are."

Ma describes the recent buying spree as an "unrehearsed symphony" in which Chinese oil majors have skillfully pitched their desire to expand abroad as being in concert with the Chinese government’s desire to secure long-term energy assets. As such, the firms don’t merely react to government policy, they help shape it.

Rosen adds that the overall policy of energy security doesn’t necessarily come at the expense of others. Chinese investment – wherever it flows – is contributing supply to the global market at a time when other oil firms are cutting back. "I think the US and Europe would need to worry much more if there was not a large flow of Chinese outbound investment into this space worldwide," Rosen said.

Given these dynamics, China’s oil and gas majors may find there is much more common ground between them and their international competitors than with the state, which in turn creates opportunities for cooperation.

There have been plenty of partnerships over the years, but a recently proposed deal by CNOOC and BG Group to convert coal-seam gas to liquefied natural gas (LNG) in Australia represents a novel model of cooperation. Under the terms of the deal, CNOOC would purchase 3.6 million tons of coal-seam gas from BG per year for 20 years and take small stakes in certain BG coal-seam gas and LNG interests.

One source with knowledge of the deal said that while its dollar value was relatively low, it is significant in that it allows CNOOC to build a presence in Australia, a country where many of the plum resources are held by international oil firms. And as the anchor buyer of the assets as well as their upstream and midstream development, CNOOC would be exposed to more of the project’s economic risk, but it could also gain valuable experience in a first-of-its-kind technology.

False dawn?

However, as much as the BG deal is encouraging, it could be argued that its prominence doesn’t reflect positively on the bulk China’s oil-and-gas deal-making. With many of the best assets already taken, companies are scrambling to acquire anything available. This again raises concerns about the long-term sustainability of what China buys.

As Stratfor’s Richmond warns, the current situation won’t last forever. Once other resource-hungry nations get their financial houses in order, Chinese oil firms’ strong balance sheets and state support will no longer be so big an advantage.

"The Chinese are the only ones buying right now," Richmond said. "That’s exactly why China’s pushing at this moment because the window of opportunity for them to operate with little competition is closing."