China's super smart acquisitions strategy

August 27, 2012 | 00:00

How Beijing is targeting physical assets to maximise leverage over global energy prices

China's super smart acquisitions strategy

Just when you thought it was a good time for summer vacations, China has been busy rewriting the upstream acquisitions script, and doing so on an entirely new level. The Chinese do not limit themselves any longer to investing in far-flung and exotic locations, they're taking key stakes right inside OECD countries, with the clear intention of hedging their international price risk exposure. China is deliberately targeting North America (WTI) and North Sea (Brent) plays, alongside sinking major investments into North American LNG export facilities, to be able to dictate what happens on the trading markets.

Cheniere LNG plant at Sabine Pass (c) WSJ.com

The latest in a string of thirsty dragon stories hitting international headlines over the summer, was China Investment Corporation's (CIC's) decision announced on 21 August to sink $1.5 billion into Cheniere's LNG export plants at Sabine Pass, the poster-boy of American LNG potential sitting on the Gulf coast. As a passive investor (Blackstone group has been putting a larger deal together with Singapore as the other partner), CIC wants to make sure that surplus gas from America makes its way onto international markets. A stake in Sabine Pass is the perfect way of cajoling the US in the right 'export led' direction. Add that to Sinopec's rumoured White Knight bid for $14 billion of US energy company Chesapeake's ailing assets (not to mention multiple stakes China has in Canadian LNG projects), and it's clear that China is going to be a serious player enhancing the North American natural gas scene. Given that China can globally source gas wherever it wants, the strategic resonance of these US investments shouldn't be lost. Beijing knows better than anyone that American LNG exports are absolutely pivotal to globalising the 'golden age of gas' by enhancing global liquidity, and more importantly, feeding spot market dynamics to ground gas prices on the basis of gas fundamentals, rather than relying on expensive oil indexed contracts of old.

Perfect opportunity

Physical US assets will have a profound effect on globally traded gas dynamics. If China can push the US towards international exports, it will be able to source all its external gas supplies on a far cheaper (or at the very least, cost reflective) basis between the Atlantic and Pacific Basins - renegotiating contrasts with Russia, Central Asia, Middle East and Australasian providers as they go along. Beijing has the perfect opportunity to capture the US market, especially because the entire American shale sector has left itself overexposed. Reserves have all been overbooked; key companies seriously overleveraged. Far from being the answer to all of Washington's 'supply side dreams', US shale is becoming an economic nightmare across the States. Without Chinese strategic investment helping producers to shift US shale onto international consumers, it's highly unlikely America will attract further international capital into shale plays. Unless Henry Hub prices magically lift, nobody is going to have any problems with the colour of Chinese money. Take it, or go bust. There is no choice, even for vociferous US politicians that might think otherwise.

Move over to liquid oil, and a similarly Sino-centric view is emerging in North America.
The flagship deal involved is the friendly $15.1 billion acquisition of Canada's Nexen by China's CNOOC. If accepted by Nexen’s shareholders on 20th September, the transaction will mark the largest ever offshore acquisition by a Chinese company – boosting CNOOC’s crude production from 1.3% to 3.5% of China’s import balance. CNOOC’s portfolio will also see a significant uptick, adding 900 million barrels to the 3.3 billion barrels of proved reserves CNOOC currently holds.

Looking at the assets involved, commentators usually focus on Canadian oil sands, and the technology involved in heavy oil plays of Long Lake. CNOOC is offering a handsome price, just as they did for OPTI’s technological know-how in 2011. The national flags involved in Nexen's (approximately) 200 exploration blocs in the Gulf of Mexico haven't been missed either. But this isn't about Chinese ensigns on a US flag pole - not at all. This is about making sure increasingly large amounts of Canadian tar remain 'commercially viable' by finding their way onto international markets, rather than slowly trickling their way towards Texas via the US Midwest. The Nexen deal could be the first serious step (alongside $18 billion piecemeal minority Chinese stakes in Canadian energy assets) to breaking American shackles on Canadian crude and getting broken WTI benchmarks back towards international price realignment. China clearly intends to play an instrumental role in steering things that way.

North Sea angle

This is certainly where the North Sea angle comes in for CNOOC. Alongside promising developments in West of Shetland waters, the Nexen deal gives the Chinese major strategic control of the Buzzard fields, the UK’s biggest (220,000 barrels a day) oil field, which more importantly, provides the bulk of Forties blends (the cheapest of the blends in the so-called BFOE basket) setting Brent prices. The North Sea remains by far the most important price marker for global oil, accounting for 65% of reference points. But just as WTI has serious bottlenecks starving international markets of marginal oil, the North Sea is littered with creaking and ageing infrastructure, not to mention playing host to some of the least attractive fiscal regimes in the world. Not surprisingly, maintenance concerns have put Brent into backwardation of late, (i.e. forward prices trading above spot prices) with output falling to a mere 774,000b/d in August - the lowest on record.

The combination of uncertainty and asset sweating has put Brent under considerable pressure as a credible global benchmark. It therefore comes as no surprise that China is looking to remedy such problems again through a direct physical stake, precisely because it already imports 27% of its oil priced from Brent. Stable prices mean stable import bills for China - a development that’s all the more critical given Beijing’s 1.5 million barrels a day Brent exposure is set to grow in West Africa in future. Asian national oil companies (NOCs) have been the most prominent buyers of West African bounty lately, and you’ve guessed it, Nexen just happens to hold valuable Nigerian stakes as well.

We could reel off more numbers and more stakes Chinese NOCs are building up, but the key point is that wherever you look, China Energy Inc. is linking physical assets to virtual trades, both for WTI and

These are strategic acquisitions being made at the very highest levels, not random resource hunts made up as the PRC goes along
Brent. These are strategic acquisitions being made at the very highest levels, not random resource hunts made up as the PRC goes along. It’s hardly a coincidence that Sinopec tabled a bid for Talisman’s North Sea assets on the same day CNOOC made its move for Nexen. Tiny volumes on a global scale yes; but vital assets as far as global price implications are concerned. China, while not ‘setting’ dated Brent, will at least be an important part of its physical make-up. That’s clearly worth bearing in mind for Urals and Middle East Dubai assets down the line as well.

Very good news

Should we be worried? Not really. Much of this is mere arithmetic. Even with Nexen’s help, CNOOC would only have covered 8.5% of China’s 2011 oil consumption, compared to the 7% it managed on its own. And despite impressive production figures for Sinopec and PetroChina (the latter now produces more oil than Exxon Mobil on a daily basis), the three big Chinese national oil companies (NOCs) won’t satisfy China’s 9.9 million barrels a day demand. Beijing has no choice but to step up equity deals on a global basis, both for security of supply - and far more importantly - to hedge its price risk exposure.

The good news for everyone else is that these international acquisitions have a domestic angle for Chinese majors as well. One important point is that China will apply international lessons they’ve learned from unconventional oil (and gas) to develop its 14.5 billion barrels of oil sands at home. But the pricing angle shouldn’t be overlooked either. Under current arrangements, Chinese domestic oil production goes to domestic customers, mainly CNOOC Oil and Petrochemicals (a sister company of CNOOC), Sinopec and PetroChina. Take-off is benchmarked against Tapis, Daqing, and Duri prices for light crude, medium crude and heavy crude, respectively, and tends to push averaged realised oil prices well below international levels – at least in the case of CNOOC’s competitors. The fact that CNOOC managed to cut the spread between international benchmark and realised prices from nearly 9% in 2007 to 1.4% in 2011 suggests that China’s ‘domestic consumer discount’ doesn’t merely reflect the below-par quality of Chinese crude, but that Chinese NOCs are making the best of their ability to sell overseas oil onto international markets. It’s no accident that Gunvor (a leading energy trading house) is now one of CNOOC’s key external customers. Just like their IOC counterparts, Chinese majors are increasingly motivated by profit and competition. When CNOOC claims it wants to become of one the world’s 15 largest oil firms by 2030, we should take them deadly seriously. If they prove to be the most profitable as well, they’ll not only set the pace for their Chinese counterparts, but start acquiring far larger Western IOCs along the way.

As far as WTI and Brent is concerned that’s all very good news - Chinese investments will dilute the significance of the 'main' international spread to optimise its energy stake, while keeping oil as a

Either way you look at it, Chinese commercial interests will inevitably turn the geo-strategic tables, where the West simply no longer holds all the physical aces that dictate the traded energy world
fungible and elastic commodity. No doubt the PRC will have to keep pushing their national champions to thrive, and domestic price reform will clearly be crucial to that effort, but just as importantly, US and British politicians need to recognise a good thing when they see it from China. Either way you look at it, Chinese commercial interests will inevitably turn the geo-strategic tables, where the West simply no longer holds all the physical aces that dictate the traded energy world.

The transformation of oil and gas markets will accelerate in step with the expansion of China Inc's international presence and portfolio diversification. For now, that's to be welcomed, especially if Chinese NOCs nudge North America Energy Inc. out of its regional shelter. We all know that blurring physical assets with the traded energy world is the holy grail of any commodity house worth its salt. Let's just hope China doesn't learn all the tricks of the trade too quickly.

 

About the authors

Matthew Hulbert is a specialist in energy security & political risk, and a regular contributor to EER.

Christian Brutsch is a professor of international relations and diplomacy at the Geneva School of Diplomacy, Switzerland.


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