|
China: US Dollars vs. Oil One of the great lessons I’ve learned over the years is to pay more attention to what people do rather than what they say. For example, I always found it peculiar when the CEO of a subprime mortgage lender, home builder or technology company protested in the media that business was “improving” or “bottoming” while selling shares like mad. Politicians are just as bad about saying one thing and doing another. Conversely, I have always admired people who do what they say they will do. The leaders in China have made it clear to the world that they are very nervous about the future of the US dollar (USD) and are diversifying their holdings away from America’s currency. Apparently many recent purchasers of US Treasuries do not believe Chinese leaders will do what they say they will do or they would not have rushed to buy Treasury notes in recent months at ridiculously low yields. In the not too distant future, China’s promise to diversify into hard assets, especially oil, is going to severely pressure the US dollar and therefore the value of US Treasury notes. In this article I will examine how China’s accelerating diversification away from the USD into hard assets, such as oil, is essential to protect the value of the country’s reserves and provide access to resources essential for further economic development. US Trade Balance with China
*Source: US Census Bureau, Foreign Trade Division, Data While many China observers believe the country’s large foreign reserve holdings are a huge benefit to the country, history tells us this not always the case. According to Richard Duncan, author of the book The Dollar Crisis: Causes, Consequences, Cures, large trade surpluses or extraordinary capital inflows will lead to excessive credit creation, over-investment and an unsustainable surge in asset prices. Mr. Duncan also explains how accelerated economic activity as a result of trade surpluses nearly always ends in a severe recession, a systemic banking crisis, and drastically higher debt (page 23-24 “Dollar Crisis”). The two examples Mr. Duncan examines in detail in the book are Japan and Thailand. The experiences of Japan in the 1980’s and Thailand in the 1990’s are eerily similar to what China is experiencing currently. However, unlike Thailand and Japan, who invested their reserves in unnecessary additional production capacity and real estate baubles, China is actively taking steps to secure vital resources while mitigating the impact of the flood of US capital that has entered the country. Despite its efforts, China is going to eventually suffer the consequences of economic overheating. Probably the most important commodity to China’s future economic development is oil. As China’s domestic production can no longer come close to supplying the country’s needs, overseas oil investments are becoming increasingly common for Chinese oil companies. No company is more active in this area than China’s largest oil company, China National Petroleum Corporation (CNPC). According to a Bloomberg article dated July 17, 2009, CNPC had overseas oil output of 229.44 million barrels of oil in the first six months of 2009 along with 374.27 million barrels of oil of domestic production during the same period. The article also stated that according to the official Xinhua News Agency, the company plans to double its annual oil and gas production to 2.9 billion barrels of equivalent within the next eight to ten years. I expect nearly all of this increase to come from overseas investments. One way CNPC and other Chinese oil and gas companies secure foreign hydrocarbon assets is to form joint ventures with host countries that are in need of development capital and expertise. According to the Eurasia Group, China began investing in overseas oil assets in 1993 when the country first became an oil importer. The first few years the companies made only a few small investments but today the Chinese oil companies operate in over two dozen countries. The largest overseas hydrocarbon producing investment for CNPC is its 40% ownership in the Greater Nile Petroleum Operating Company (GNPOC). GNPOC was founded in 1997 with the purpose of developing hydrocarbons in Sudan and is jointly owned by CNPC (40%), Petronas of Malaysia (30%), ONGC of India (25%) and Sudapet of Sudan (5%). CNPC is the operator of the project which currently produces approximately 300,000 barrels of oil per day (bopd) according to GNPOC’s website. Since forming in the late 1990’s, the company’s most important achievement is its development of the very prolific Muglad Basin in southern Sudan and the building of a 1,540 kilometer export pipeline to Port Sudan. What is most remarkable about CNPC’s investment in Sudan is that it came during one of the world’s worst civil wars in modern history and with a historically unstable political regime. However, CNPC’s gamble in Sudan appears to have paid off handsomely. For CNPC’s approximately $5 billion investment in Sudan, it has gained access to billions of barrels of reserves and increased oil imports. Sudan, which exports between 50% and 80% of its crude oil production, accounts for 7 to 9% of China’s crude oil import needs. Given the success of CNPC’s investment in Sudan to date and the huge opportunities that remain, I expect the company to be active for many years in Sudan. Another way CNPC secures foreign oil assets is through the outright purchase of exploration and production companies. The first large corporate transaction undertaken by CNPC was the 2005 purchase of Calgary-based PetroKazakhstan Inc. for $4.18 billion. At the time of purchase in August 2005, PetroKazakhstan was producing 150,000 barrels of equivalent per day (boed) and had proved and probable reserves of 535 million barrels of equivalent. While Kazakhstan is a very difficult place to operate, CNPC’s purchase price of less than $10 per barrel of proved and probable reserves to accompany PetroKazakhstan’s significant established production base has paid large dividends to date. It should be noted that CNPC’s purchase came on the heels of China National Offshore Oil Company’s (CNOOC) failure to purchase US-based Unocal Corporation for approximately $18 billion, despite outbidding ChevronTexaco. I believe the political opposition to the purchase of Unocal, which had more than half of its production and reserves in Asia, was a turning point for how the Chinese viewed their ever-increasing mountain of US dollars. Up until the summer of 2005, it would have seemed reasonable to think that the Chinese government would be able to trade US dollars for US-based commodity producers. However, once the uproar over of a Chinese state-controlled oil company purchasing a US-based entity got underway, it quickly became clear to the Chinese that they could sell Homer Simpson dolls to the US but could not use the proceeds to purchase anything of strategic value. After the Unocal purchase busted, Chinese oil companies went on the warpath – doing everything in their power to secure oil and gas reserves. In addition to the previously discussed PetroKazakhstan purchase, state-controlled Sinopec purchased Tanganyika Oil Company Ltd. for $2 billion in December 2008. At the time of purchase, Tanganyika was producing approximately 6,700 barrels of heavy oil from two concessions in Syria. More recently, in June Sinopec announced the purchase of Addax Petroleum for approximately $8 billion. Addax is active in West Africa, the Middle East and recently signed a concession to develop a field in the Kurdistan region of Iraq. Addax currently produces approximately 135,000 boed. The above is just a sampling of the larger transactions Chinese oil companies have undertaken over the last sixteen years. As the world’s supply of non-OPEC reserves continues to dwindle, look for the pace of acquisitions to accelerate in coming years. The final way China is trading it dollars for oil is through the expansion of its strategic petroleum reserve (SPR). According to a July 21, 2009 Energy Tribune article by Lee Geng and Michael Economides, China started its SPR program in 1993 however the country did not start building tank farms until 2003. The above ground facilities under construction are expected to hold 100 million barrels of crude when completed later this year, or approximately 16 days of consumption. According to the article, the SPR program is only in its first phase. The second phase calls for building a storage facility in the northwestern city of Chongqing with a capacity of 50 million barrels. Should the country decide to build a 90-day supply, similar to other countries that maintain SPRs, it would need to stockpile 700 million barrels. It has become increasingly clear that China is going long oil and is carrying out its promise to reduce its exposure to the US dollar. Investors, especially American investors or those with significant exposure to the US dollar, should consider following the lead of the Chinese by increasing their exposure to oil related investments, since hiding in cash or US Treasuries is a recipe for disaster as the greenback circles the drain.
CONTACT INFORMATION
Bill Powers | Editor | Powers Energy Investor |
