from Follow the Money

Is oil always sold to the highest bidder?

July 14, 2005

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I suspect that the US is not prepared for the implications of a world where China’s reserves are rising fast enough to allow China to finance the purchase of one Unocal every month. I also would bet that the US is not prepared for a world where Chinese demand for energy -- and Chinese demand for energy-producing assets -- is set to rise rapidly.

Who knows, China’s new interest in a range of oil fields may be one unintended consequence of the US invasion of Iraq. On the other hand, the US invasion of Iraq may have just accelerated a process that was bound to happen in any case.

China, after all, has no shortage of savings available to finance investment abroad. It hardly should be a shock that Chinese capital wants to try to profit from the increase in global demand for oil created by Chinese growth. CNOOC -- it seems -- does not intend to get outbid.

China now imports around 1/3 of the oil it uses -- and that share is rising fast. The US import about ½ is oil consumption. But as Keith Bradsher points out, citing the boutique energy consultancy PIRA, about 70% of the crude produced by the top three US energy firms is produced overseas, while overseas crude produced by Chinese firms accounts for 10% of Chinese production.

The Chinese oil giants are belatedly following a well-trodden path - one that France, Italy and Britain have taken - to build national players that can secure access to the globe’s energy resources. But the Chinese companies have had the misfortune of trying to build overseas empires at a time of steeply rising prices and renewed nationalism among the governments of oil-producing nations. Their combined overseas reserves remain a tenth of the reserves of a single big Western multinational like BP.

Cnooc, with 93 percent of its reserves in China, is the exact opposite in globalization from BP, with 93 percent of its proven reserves outside of Britain. PetroChina, the giant of China’s oil industry, will still have 95 percent of its reserves in China even after the consolidation of a wide range of overseas holdings being transferred by its parent, the China National Petroleum Corporation, or C.N.P.C.

The PIRA Energy Group, a New York-based oil consultancy, estimates that China’s top three companies now control 300,000 to 400,000 barrels of oil production a day outside of China, or 10 percent of their domestic production. ... By comparison, crude production outside the United States for the three largest American oil companies amounts to 70 percent of their total output.

A quick aside: both Bradsher and Kahn have done excellent reporting on the CNOOC bid.

My views on CNOOC’s bid for Unocal should be pretty clear by now: the sale of Asian gas fields that currently supply the energy needs of Thailand, Taiwan, Japan and Korea is not a national security threat to the US; the fact that the US needs to sell 40 Unocal’s a year to finance a current account deficit of $800 billion should be a concern to all Americans, and is a long-term threat to the United States global position.

But even though I don’t think there is much of a case that the sale of Unocal to CNOOC really threatens US national security, that doesn’t mean that I agree with every part of every argument that has been put forward to defend CNOOC’s bid.

One argument in particular seems sometimes to a bit overstated -- the argument that oil and gas is always sold to the highest bidder, so the market always guarantees sufficient energy supplies.

The argument is basically right. Oil usually is sold to the highest bidder. Just not always.

Nor for that matter are oil companies always sold to the highest bidder. Just listen to Chevron’s case against Unocal ...

Look at the retail price of gasoline in major oil producing states, states like Russia, Iraq, Saudi Arabia and Iran. The retail price of gas in these coutnries almost always is well below the world market price. Fair enough - the oil in these countries is the property of the country’s citizens. Rather than paying the global market price at the pump and getting a dividend check back from the national oil company, these countries have, in a certain sense, opted to take part of their "oil windfall" in the form of cheap gas - in part because the citizens of many oil producing countries don’t really trust their government, and don’t trust the government to use the profits from the state oil company for the long-term benefit of all of the country’s citizens. Norway is the exception, not the rule. But the result is that the state oil company makes less money that it could if it sold its oil and gas to the highest bidder.

These kinds of policies have broader implications. Keeping local prices keeps local demand up. In a world where global oil production is now close to global oil demand, the resulting increase in oil consumption in oil producing countries effectively reduces the oil available to supply the global market. These kinds of policies may consequently help to push up the global market price of oil. Exceptionally low prices in oil producing countries also rather clearly create strong incentives for a country’s citizens to take local oil and smuggle it out of the country. That, for example, seems to be the basis of much of the Iraq’s economy.

It is not just the world’s oil producing countries that keep retail gasoline prices artificially low. Some oil consuming countries also are currently subsidizing - rather than taxing - local oil consumption. That usually comes about because the government has fixed the local price of gas, and hesitates to pass on higher global oil prices to local consumers. That has been the case in Thailand - and as a result, Thais have had little incentive to scale back their oil consumption. The result: a big surge in Thailand’s current account deficit, and growing fiscal cost to the government. (UPDATE: it seems the costs got a bit too big; Thailand seems to be getting rid of its subsidies)

China also controls the the retail price of gasoline, and Chinese domestic gasoline prices have increased far less than the global oil price. But for some reason, at least in 2005, low domestic prices and strong growth do not seem to have led to a surge in Chinese oil consumption. That is one of the many Chinese mysteries.

The Chinese state oil firms still seem quite profitable, so the Chinese government does not need to offer them a fiscal subsidy. But the longer China resists increasing its domestic gasoline price, the higher the probability that China’s state oil firms are selling their domestic oil production for a bit less than they could on the world market.

There is a second case where oil and gas is sold for less than the current market price - namely when a producer sells its oil and gas in advance as part of a long-term contract, and the spot price moves well above the contract price. In those circumstances, producing countries are often tempted to break the contract - or at least to try to renegotiate the contracts terms. Reputation matters, of course - but in a world of limited supply, it may not matter all that much.

Is this relevant for CNOOC? Perhaps. If CNOOC buys Unocal, it will inherit a bunch of long-term contracts to supply Indonesian LNG to a set of other Asian economies. No doubt, in most circumstances CNOOC would honour those contracts - though in the longer-term, CNOOC may decide to let the contracts expire and instead use Indonesian gas to supply the LNG infrastructure it is building in China.

But suppose there was an interruption in the global oil and gas supply chain a few years and the spot price of gas and oil surged. Say something happened in Iran. All consuming countries would be scrambling to find enough oil and gas to meet their domestic demand. Would CNOOC be tempted to break the long-term contracts it inherited from Unocal? After all, in those circumstances, it could sell Indonesian gas at a higher price in China than it could to Japan, at least so long as it honoured its existing contract ...

CNOOC would have to chose whether it wants to try to become a global supplier of energy to all markets, in which case its reputation for supplying all markets and honouring all contracts in times of stress matters, or whether it simply wants to be a long-term supplier of energy to the Chinese market. In the second case, its reputation as a reliable supplier to China may matter more than its reputation as a reliable supplier to the world.

This scenario is no doubt a bit far-fetched. But I think it raises a serious point. Those who worry about the security of energy supplies worry about the availability of supply in the worst case scenario, not just the availability of supply in times of plenty. They worry about times when the market, in a sense, starts to break down.

Saudi Arabia no longer as spare capacity available to bring on line to offset a supply interruption elsewhere, so the risk of a market disruption is rising. With less spare capacity in the world’s oil producing countries, all of the world’s oil consuming countries may start to worry more about the security of their energy supply. I suspect that China’s rising demand for a scarce commodity - and for oil and gas producing assets -- will reverberate throughout East Asia, not just inside the US.

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