from Follow the Money

China’s Resource Buys

February 20, 2009

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Note: This post is by Rachel Ziemba of RGE Monitor (where this first appeared) thanks again to Brad for letting me fill in while he’s on vacation.

note: I’ve made a slight update to the discussion on the price Russia will pay for its loan.

China development bank must be busy.... Over the last few weeks, loans worth over $50 billion have been confirmed with the oil companies of Russia, Brazil and the Australian mining company Rio Tinto, all of which have found themselves with financing issues in light of the collapse in commodity prices and credit crunch. While $50 billion is a relatively small in terms of China’s foreign exchange liquidity, this is a significant investment on China’s part in the resource sector, and shows that it is trying to get higher returns on its capital – while coming to the rescue of those who cannot tap the still relatively frozen international capital markets. And given some of the dire predictions for energy sector investment (including warnings from the IEA) might avoid a severe drop off in investment, allowing some of these countries and China to get more bang for the buck as global deflationary trends lower costs.  Most significantly, it increases the share of oil supplies that are pre-contracted, perhaps a desire from both China and its suppliers to have a somewhat more predictable price environment for at least some of its supplies. And given the financing needs, China may be able to push for lower prices.

Leaving aside Rio Tinto, to which I’ll return in a bit, these indicate an increase in long-term oil supply deals between customers and producers both of which are state-backed enterprises, bankrolled by the government backed development bank. It thus increases the role of governments and may trigger greater concerns if not from the recipient countries then from others. It further reinforces the increased role of government and quasi-government influence in the energy and resource sectors as state-backed resource companies have an increasing role in the energy sector in terms of production and supplies. Several of these companies have some private funding but ultimately governments have a key influence on decisions, backstopping decisions.

Russia and Brazil will repay China’s loans in oil. In the case of Russia, estimates from uob kay hian suggest that given an interest rate of 6%, Chinese companies are getting access to supplies at approx $22/ barrel.  This seems low, even at today’s prices given the long-term oil prices that most of these companies assume.  Other estimates seem to suggest that that the price is closer to $70 a barrel, which presumably is the notional value of the loan. But much will depend on the interest rate which is apparently between 5-5.5% according to other sources and pegged to libor, which leaves Russia vulnerable to further libor volatility.  Update: Based on a helpful commentator, it seems that the loan will buy access to oil but not oil itself, with the price being obtained monthly from Argus and Platts quotes.

China has already had oil supply deals with Venezuela and Japan signed a 5 year 120,000 barrel a day deal with Abu Dhabi’s ADNOC these deals are somewhat larger. Russia has promised the equivalent of 300,000 barrels per day or almost as much as china imports from its largest supplier, Saudi Arabia.

Speaking of Saudi Arabia, Hu Jintao just visited the kingdom and left with contracts to build the train to Mecca, an extension of a natural gas joint venture, another joint effort on two refineries, in which Chinese companies will provide assistance but will not own a stake. The natural gas cooperation is of particular interest to both countries. Saudi Arabia (and most of its neighbors except Qatar) are short on natural gas and in recent years the fuel has attracted more exploration activity than oil given its role in power generation and as a feedstock in petrochemical production, a key growth industry aiming at the Asian market. Most of Saudi Arabia’s natural gas is found with oil, making it more difficult to exploit. In fact, Jadwa notes that natural gas demand might actually restrain further and sustained oil production cuts.  In Saudi Arabia, Chinese companies already operate much of the construction in Saudi Arabia and China is the largest source of imports for Saudi Arabia. However, Aramco remains relatively flush despite the Saudi spending increases and revenue declines, raising capital in recent years to fund its expansion.

But the Russian oil companies and Petrobras clearly need funds.

Russian oil companies, like Russian banks, borrowed heavily abroad when credit was cheap. In the case of the oil companies,  the Russian tax structure, especially export taxes limited profits with the government itself taking most of the revenues above $25/barrel. Oil and Gas companies went cap in hand to the government some months ago asking for funds to maintain their investment plans and refinance their debt. Russia’s oil companies had previously insisted that maintaining production required well over $70 a barrel oil.

In exchange for $25 billion over 20 years Russian oil companies, Rosneft and pipeline operator Transneft have agreed to supply China with around 300,000 barrels per day in oil and build a pipeline extension to China. The oil supplied would be equivalent to 8% of China’s daily oil imports (and 4% of daily oil demand).  FT’s Lex suggests that Rosneft’s $15bn share of the $25bn loan package will comfortably cover its $8.5bn debt maturing this year, 60% of which is owed to foreign banks half due in Q2 and allow it to make the investment increases to meet the needs of its supply deal with China. With its share of the funds, Transneft, the pipeline monopoly, will finance new pipeline spur to China which had been held up on price discussions as well as US$5.5–7.3bn capex in 2009, part of its future mid-term investments, including the US$3.6bn on the Baltic pipeline. Furthermore ING notes that the inflows associated with such a loan could relieve some of the pressure on Russia’s finances. Despite a very sharp contraction in imports (preliminary data suggest an almost 40% decline of imports from non-CIS countries in January) Russia’s current account surplus is likely to shift to deficit this quarter. Inflows from China could offset some of the growing financing gap depending on when it is delivered.

Brazil: CDB will loan Petrobras $10 billion helping the company continue its investment plan, especially relating to pre-salt oil and to aid in refinancing its outstanding debt. Details of the loan have not yet been released but will be finalized before a May visit to China by the Brazilian prime minister. Petrobras agreed to sell as much as 100,000 barrels of oil this year to Sinopec and increase it over time.     Petrobras is planning to invest well over  $100b over five years as it develops the pre-salt finds announced last year. The company has been seeking alternatives to international bank lending and bonds to finance its spending plan in the face of an international credit crunch. Petrobras already sells a some oil and products to China and signed a cooperation agreement with Sinochem in 2004 and CNPC in 2005

Petrobras has repeatedly stated that pre-salt production is still feasible even with a lower oil price. Yet, statements suggest the pace of development of pre-salt production could be slowed and that associated projects, such as plans to build two new refineries for export, could be put on hold. Collectively this means Petrobras is more reliant on its joint venture partners – Global Insight suggests that Petrobras may be able to keep diversifying its funding sources. But since Petrobras’ shares have come under such pressure, and financing terms at home and abroad are costly while the cost of hiring rigs  has not softened very much, Chinese funds could keep investment in the pre-salt area on course. Doing so supports the economic development and political goals of the Brazilian government.

In Australia, Chinalco, the Chinese largest state-owned company, financed by the China Development Bank, agreed to lend Rio Tinto $20b through a convertible bond to help it pay off its debts (it has $9b coming due in Oct2009 and $10b in 2010, mostly accrued during its purchase of Alcan). Chinalco will buy $7.2bn in convertible bonds, eventually increasing its stake in Rio from 9% to 18% and invest $12.3bn in strategic partnerships in Rio’s copper, aluminium and iron ore divisions. In exchange for providing capital as a very competitive rate Chinalco should get access to these prime assets for a key rate. The convertible bond structure was likely chosen to avoid restrictions on equity purchases.  Perhaps it is not a surprise that the Australian treasury is planning to change legislation to treat debt as equivalent to equity, possibly blocking the transaction.

Although Australia has been receiving an increased amount of investment from China with an estimated 10b in Australian dollars approved in 2008 (on top of an existing stock of A$6.2b according to Mark Thirwell.) Trade with China rose to 13% of Australia’s total. This is the first major test of of a new investment review process Australia introduced last year which clearly distinguishes between state and non-state investors meaning all state-backed investors are subject to increased review. Chinalco, a state-backed company will prompt significant scrutiny especially given the fears it will aquire the most profitable of Rio’s assets and increased bargaining power at price discussions. If regulators were concerned about the pricing power of a joint Rio Tinto/BHP Billiton, the Chinese funded Rio may also shake up the market. However unlike the oil deals, the investment in Rio is not explicitly linked to a supply deal with iron ore pricing still in progress.

For China, these investments seem to be a relatively efficient way to use its financial resources given the likely long-term appreciation of resource prices and uncertainty about financial assets. Like other cash-rich investors, it can set the terms and may provide the opportunity for its energy companies to really enter the global stage even if it may limit their intermediary role and tie them into their domestic political structure. It may also suggest that China can take advantage of the nascent reversal of resource nationalism that seems to be underway. When oil prices rise, so does the uncertainty of fiscal regimes in the sector and vice versa. For those receiving the funds, it provides a way to get cheaper loans than possible though other means. However in some cases, it may undermine the rights of existing shareholders – such concerns are more obvious in the case of Rio Tinto where existing shareholders may be disadvantaged when the new shares convert. Furthermore its joint interests as a shareholder and one of Rio’s largest customers may counteract

However, China may be getting access to supplies, but aside from some limited joint ventures, its companies are not getting access to reserves but to guaranteed end product. Over all,  the desire to lock up supplies may reflect a shift away from China’s policy of seeking out investment opportunities in a range of oil projects wherever they could be found, mostly in unstable states in Africa.  Erica Downs notes that the early go global efforts of China’s national oil companies left them with a range of investments in many countries a portfolio that was difficult to manage efficiently – now they may be trying to concentrate. There were other costs too.  Raghuram Rajan noted that buying stakes in opaque companies in poorly governed foreign countries might not be the best way to go. The security of a country’s ownership of oil assets in poorly governed foreign countries likely diminishes when the oil price rises. While China did not face nationalism pressures per se given their often minority stakes, events of recent years including attacks on Chinese workers in Nigeria have illuminated the economic costs of the production.

Most of the Chinese oil production abroad was sold on global markets with the profits used to cross subsidize losses on domestic refining segments given fixed prices. In fact only about 10% of Chinese oil imports are supplied through the equity stakes that China has in oil projects abroad. Instead China imported oil from a range of countries in Africa which supplies 1/4th of China’s oil (especially Angola) and the middle east, which supplies 50% (mostly Saudi Arabia, Iran and to a lesser extent Oman.)

It also increases the amount of oil that is officially locked up for long-periods of time which will boost predictability for some producers and consumers even as it raises costs for others. Already the Asian market tends to have more long-term contracts than in other regions, because of the long transportation time and need of Asian countries for imported oil unlike other locations where the spot market is more developed. Longer term supply contracts may not only provide a more stable source of energy but may provide more opportunity for joint venture for somewhat lower costs, increasing the ability to plan given that most new production remains expensive by historical averages. Yet deferring investment in new resources would surely boost the price for all, including China.

Two more side notes (digressions) as this has been a big week in energy politics. Not only is a country like China trying to diversify their suppliers but some exporters are trying to diversify their customers. Russia trying to boost oil exports to china, it is trying to boost and diversify its natural gas exports to Asia by opening up a LNG plant on the east coast. The first cargos from Sakhalin-2 began to be loaded earlier this week. Most (65%) of the pre-contracted cargos are bound for Japan, which is the largest demander of LNG. Russian supplies may help to partly offset the decline in supplies from Indonesia which is consuming more at home. The rest of the LNG supplies are bound for other Asian countries, with a small amount going to a regassification plant in Mexico for the Latin American market. Given the obstacles in shipping, the reduction in distance and transport time, might reduce prices in Asian LNG market. However in both oil and gas, diversification of partners may divert supplies from existing customers, especially in Europe. Russia in particular is facing constraints in increasing supplies given relative under investment. Russian domestic natural gas exports have been on the decline for some years as domestic demand grew. While 2009 will likely prove a short reversal, the cheap power and gas prices will keep domestic demand high, meanwhile oil production is falling as fields mature.

Given that the focus of this note has been bilateral producer consumer deals, it seems apt to conclude with the energy ’deal’ that President Obama and Prime Minister Harper announced yesterday. Details are still uncertain but the two countries have pledged to co-invest in technologies that will reduce the environmental impact of energy sources like coal and the bitumen harvested from Canada’s oil sands. In part it reflects the producer, Canada taking seriously the concerns of its largest customer – Canada is the largest supplier of energy to the U.S.. It takes the funds already allocated in the recent U.S. and Canadian fiscal packages to carbon sequestration and other clean energy investments (much more expansive in the US than in Canada). The economic incentives of finding cheaper, more efficient technology are clear. With California and other states moving ahead to seek cleaner fuels, the carbon footprint of the oil sands is a major burden. And given that the U.S. government now has a political consensus around a new climate change deal, as Annette Hester notes, it is in Canada’s interest to start making the changes that will make sure its supplies are not priced out of the carbon market which will eventually come.  the same goes for U.S. based refiners who were counting on Canadian refined crude. Given the regulatory changes relating to emissions, the high costs of production given that the swarm of producers into Alberta led to sky-rocketing prices (now reversing) oil sands projects have been frozen or deferred. This is a case where the government can create the incentives for the private sector to invest - and can best signal the direction of the developing new climate regime.  Given that the oil sands are often cited as one of several examples of more expensive supplies that will provide a price floor for oil production, it may be important development to watch.

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