from Follow the Money

CNOOC (once again)

June 30, 2005

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The CNOOC bid presumably is motivated by two things.

One, Beijing has plenty of cash, and already holds more Treasuries than it wants, so it wants to diversify its portfolio. As I argued earlier, China’s external portfolio is overweight US treasuries (not a good long-term bet, as the Economist’s Buttonwood notes) and underweight oil. Compare China’s overseas assets with US overseas assets and you’ll see what I mean.

And two, as Joseph Kahn notes, Beijing worries about its increased dependence on imported energy, and believes that greater Chinese participation in oil and gas production would increase its security. (Kahn link -- and much more -- from China matters).

That presumably explains why CNOOC is willing to pay above market for Unocal, helped along by low-cost financing from the Chinese state. Listen to Paul Sankey in the FT:

This is a high-level political decision that makes little sense on a corporate level by western conventions," said Paul Sankey of Deutsche Bank. The deal, he said, would push up CNOOC’s debt-to-equity ratio to 280 per cent. That leads him to believe CNOOC’s decision to bid on Unocal was politically motivated.

CNOOC’s bid consequently raises a host of vexing questions about states and markets and oil, all turbocharged by the fact that China is a future superpower but not democracy or a US ally.

But before going into the broader issues, it is worth noting four things upfront. a) most of Unocal’s key assets are in Asia, not the US -- and CNOOC has indicated it is willing to sell certain pipelines and storage facilities in the US.

b) Japan, Taiwan and Korea -- far more than the US -- may have a "national security" complaint against this deal. Most of the current production of Unocal’s existing Indonesian gas fields is shipped to Japan and some other Asian economies. Japan trusts US companies to sell it oil and gas in a crisis. Would it trust a state-owned Chinese company? c) Large US oil companies can hardly object to the sale of some US assets to a foreign company -- they have long-complained that other countries (notably Mexico) unwisely keep foreigners out of their oil and gas operations.

d) US companies -- and the private equity industry -- also can hardly complain too much about CNOOC’s ability to draw on subsidized credit from the Chinese government to buy up US assets without recognizing that US labor - in certain industries -- has an equally good case that the government of China is tilting the playing field against US labor by spending so much money to keep the RMB from appreciating, and thus keeping Chinese labor "artificially" cheap. The big think question though is the relationship between private companies, great powers and oil -- that most important and strategic commodity. The US has long considered the free flow of oil to be an important national security interest. China -- whose economy is now more energy intensive that the US -- no doubt does too.

However, the US government has never believed that US government itself needs to be involved in the production of oil to secure US national interests. In a sense, though, that was an easy position for the US government to take. For historical reasons -- remember that the US was by far the world’s largest oil producer in the first half of this century -- most of the world’s big international oil companies were American owned. And the US government has not been shy about helping out US oil companies, as Alan Murray notes:

The US government has treated American oil companies as a virtual state industry for decades. How else to explain the lavish tax breaks, the plush to build a Central Asia pipeline, or decades of foreign relations with Saudi Arabia.

Even so, compared to other consuming countries, the US government has historically exercised a relatively light hand. At various points in time, some of the other big international oil companies -- think BP before privatization, think Elf before it got absorbed by Total, think ENI (still owned, I think, by the government of Italy) -- were owned by the state. State ownership hardly makes CNOOC unique in the world oil business. See this factsheet.

However, in the past, the big state-owned international oil production and distribution companies were owned by states that were American allies. Whatever Dick Cheney decides China is (see this article on the divisions inside the Bush Administration), it most certainly is not a friend of freedom.

The "liberal" -- in the European sense of the term, so, Dan Drezner, Sebastian Mallaby, Adam Smith and John Stuart Mills are all liberals -- argument is that ownership of a resource doesn’t matter. Secure access to any resource is guaranteed by the profit motive. Private companies will sell the oil to the highest bidder in an open market place, even in times of scarcity. Available oil will be rationed not be nationality, but by price. And so long as oil is priced (primarily) in dollars, the US has an intrinsic advantage buying oil in the global oil market. The US, even more than most countries, has nothing to worry about.

The security concern -- as I understand it -- is that in times of scarcity, a stated-owned company would choose to (or be forced to) sell to its "home" country, not to the highest bidder. That would take some oil off the global market, and make the market price of the oil that could be freely sold even higher. The concern is not that different from the concern that in the event of a flu pandemic that created a global shortage of flu vaccines, it would be hard for even a close ally like the UK to sell British-made flu vaccines to the US for their "market" price if that meant British citizens could not get the vaccine.

A global oil shortage triggered by an interruption in supply is not that hard to imagine. Think Iran. Think the Kingdom of Saudi Arabia. And that just covers the potential big ones: there is constant strife in smaller oil producing countries in Africa, and a few issues swirling around Venezuela as well.

How much of this is relevant for the CNOOC bid?

Unocal does not produce much oil in the US, and it is hard to imagine that in a time of scarcity, CNOOC truly would take US oil, load it onto a tanker, ship it to China and sell it for less than it could be sold in the US. That simply would never happen.

Unocal’s other assets supply other markets -- the Asian countries that import Unocal’s gas are the ones who have cause for concern. Of course, should CNOOC ever divert Unocal’s gas to the new LNG terminals that China is building, these countries could enter the global market and buy their supplies elsewhere. But even if Asia has a lot of natural gas, I am not sure that kind of transition could be carried out quite as seamlessly as Mallaby assumes.

Moreover, Unocal’s gas contracts seem to expire sometime around 2010 -- freeing up gas production that could be directed toward China. So long as the shift in supply patterns is anticipated, that may not be a huge problem. The Wall Street Journal reported on Thursday that there is no shortage of natural gas in Asia. If CNOOC buys Unocal, other Asian countries will presumably assume that CNOOC will not renew Unocal’s long-term contracts when they expire, and start looking elsewhere for supply sooner rather than later.

Thomas Barnett postulated a world where US capital invests in the oil production and distribution facilities needed to meet growing Chinese demand, creating a community of interest between the US and China. I think he has this relationship wrong though. China has more than enough capital of its own to build or buy the oil production and distribution facilities it needs to supply Chinese markets -- it doesn’t need US capital. And there are no shortage of countries eager for Chinese capital -- look at Ecuador, which seems to think of China as an alternative to both the US and the IMF.

All China needs, in a sense, is for the US government to get out of its way -- and let Chinese companies either buy or build the production and distribution facilities that China needs.

That process though, looks likely to generate constant friction. Think Unocal. Think of China’s interest in Iran’s oil and gas - interest that would only go up CNOOC cannot buy Unocal’s Asian assets. Think of China’s willingness to do "oil" business with other countries that are no friends of freedom. Think of China’s concern that the US navy could cut off its oil and gas lifeline in the event of a crisis, and its desire for overland pipelines linking China to Central Asia.

The US is grown far more comfortable that I think it should be selling large amounts of debt to China, and to others -- the scale of the sale of IOUs required to fund the US current account deficit is scary. The US is far less comfortable selling off US overseas assets, let alone the domestic US operations of US companies.

Yet at the end of the day, China, not the US, will get to decide what types of assets China would prefer to buy. I suspect it will become increasingly clear that China would rather buy more oil companies than more Treasuries.

And it is not as if China really has to choose between oil companies and Treasuries. China has no shortage of spare savings. The combination of a rising current account surplus, ongoing inflows of FDI into China and hot money inflows will allow China to buy either $275 billion or reserve assets in 2005, or $200 billion of reserves and $75 billion of "oil and other" companies. Or whatever other combination China desires, assuming it can find a willing seller. Barring a collapse of the Bretton Woods 2 system, China will have another $300 billion (or more) to spend in 2006, and every year there after.

This is not an issue that is going to go away.

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