China's Economic Opportunity

While western commodity giants rethink investment strategies in light of commercial constraints, China will continue to use the downturn as a 'perfect storm' to invest on strategic grounds to fuel long term domestic growth, Matthew Hulbert writes for ISN Security Watch.

The contrast could not be starker: Governments and companies across the developed world are in a state of financial shock, desperately trying to reel themselves back from overextended positions. Although China has belatedly shared in this shock once the myth surrounding economic "decoupling" was debunked, rather than licking what will inevitably remain open wounds, Chinese leaders and CEOs have been much busier touring the Middle East, Australasia and Latin America in search of vital natural resources to sustain China's longer term economic growth. This is a smart move on a number of levels.

Economic Woes Open Opportunity for China

For one, most analysts expect that once the world economy rebounds (or merely shows signs of recovery) commodity prices will soar once more as supply-demand fundamentals rapidly close in due to a lack of investment in the lean times. China will be well placed to lay claim to a greater share of the world's natural riches once this happens – not least because its own track record of turning concessions into production has been circumspect.

Secondly, with a number of resource rich emerging markets being badly affected by credit constraints and weakening fundamentals, China has been able to buy political capital by drawing on some of its US$2 trillion reserves to throw crucial financial capital at oil and gas producers ranging from Venezuela, Iran, Russia and Brazil in exchange for long-term supply deals. In metals and mining Beijing has been even bolder; forget long term supply agreements, Beijing has maneuvered itself to buy direct stakes in zinc, iron and steel producers in Australia while closing in on copper producers in Chile. 

For those au fait with international energy and commodity markets, such developments are not entirely new, but what is striking is the degree to which credit has been made available to overseas M&A and resource acquisitions from China - not only in terms of its national champions - but also through investment vehicles such as the China Investment Corporation. This is not because domestic demand has picked up in China (far from it), but because Beijing is interested in investing in its longer term interests.

Cheaper assets and dwindling resource nationalism across producer states as economic panic sets in are both useful breeding grounds for China to incubate its natural resource portfolio. If anyone needed confirmation, the fact that Chinese aluminum company Chinalco has been able to acquire a strong stake in mining company Rio Tinto underlines the fact that  the commodities game, like global finance, is being changed by state interests as much as those of the market.

Picking Off the Easy Fruit First

Unsurprisingly, Caracas and Moscow have both gladly accepted US$12 billion and US$25 billion in loans from China in return for long term oil supplies heading "East." Their current account balances couldn't really allow for much else. 

In Venezuela this included extended credit lines first made available to Chavez in 2007, topped up with a fresh US$12 billion amid ongoing lending from China's Development Bank to the Venezuelan development bank, Bandes. In return, Petroleos de Venezuela (PDVSA) is to sell China between 80,000 barrels per day (bpd) and 200,000 bpd of crude to cover the loans and underpin the credit line. Sinopec and China National Petroleum Corporation (CNPC), two major Chinese petroleum companies, will be the gleeful recipients.   

Yet this deal was easily topped by a long-awaited US$25 billion oil export-backed loan agreement with Russia to help state-run entities Rosneft and Transneft supply 300,000 bpd of crude to China over 20 years. The deal starts in earnest in 2011 once the East-Siberia Pacific Ocean pipeline is completed, but it still constitutes the largest trade financing agreement between the two countries and alleviates the massive refinancing needs of Russia's energy giants in the midst of the credit crisis.

Although the project could well be subject to delays, it clearly underlines strengthened energy links between Russia and China and is unlikely to be dogged by the same political risk factors that taint Russian supplies to European markets. If anything, Russia could start to put a premium on ensuring Chinese supplies at the expense of its European custom to 2010-2011; Chinese consumption is simply too important for Moscow to let slip.

Eyeing New Prizes

But China has not confined its efforts to states deemed to be on the "critical list" of resource mismanagement.  Chinese leaders also dropped in on Brazil, where they signed a memorandum of understanding with Petrobras for a US$10 billion  loan to help the company finance its US$174.4 billion five-year strategic plan in return for 60,000-100,000 bpd of oil for Sinopec and 40,000-60,000 bpd  to be delivered to CNPC.

Mexico also featured on Beijing's destination in the Americas, while in Africa, Mali, Senegal and Tanzania were among the latest string of states where China is looking to increase its presence beyond pre-existing strongholds in Sudan, Angola and other commodity producing states.  

Yet what will come of most concern to western players are China's latest overtures to the Middle East. Beijing signed a US$1.7 billion oil deal with Iran (bypassing international sanctions on the nuclear issue) to develop part of the North Azadegan oil field between CNPC and National Iranian Oil Company (NIOC) in January 2009.

CNPC is due to produce 75,000 bpd  over a four-year period with options to develop the second phase of the field, a deal with follows on from Sinopec's US$2 billion  contract in 2007 to develop the enormous Yadavaran oil field with initial outflow of 85,000 bpd by 2012.  The Iranian economy certainly needs a shot of adrenaline ahead of the presidential elections in June 2009; China remains the most obvious source to provide it as the electoral clock ticks down. 

Even Saudi Arabia has come onto the Chinese radar alongside Egypt, Yemen and Syria. Although energy deals inked with Riyadh in February were general in nature by pledging greater future cooperation, this builds on a steady stream of agreements signed between the two countries since 1999 designed to forge closer linkages between the energy value chain in terms of upstream development in Saudi Arabia (notably the Empty Quarter) and downstream refining capabilities in China.

Completion of the Qingdao refinery (in which Aramco, Saudi Arabia's state-owned oil company, holds a 25 percent stake) should see the Saudi company provide 1 million bpd, mirroring broader trends of allowing Middle East national oil companies to invest in downstream refining and marketing in China for greater Asian security of supply. This is a relationship that will continue to grow stronger, not only within oil, but broader trade, infrastructure and defense linkages across China and the Middle East to ensure that oil supplies increasingly flow east. Similarly, few analysts would bet against Chinese players being the first to raise the stakes in Iraq by signing whatever options Baghdad put before them.

A Rising Challenge: To Whom, From Whom?

This is not to say that western oil and mineral majors have seen a growing Chinese presence as a long-term threat for a number of years, but the key difference was that Beijing had previously spent vast sums of money (around US$7 billion) while only netting around 400,000 bpd on the oil front. For some, China's interest in new and marginal producers in Africa and Latin America was even seen as beneficial to boosting energy and commodity production while satisfying greater global demand in areas where western companies couldn't credibly venture due to operational risks. China National Offshore Oil Corporation (CNOOC) operations in Somalia offer the most obvious of many possible examples.
 
Yet this narrative is rapidly changing, and it is changing as a result of the economic downturn. China is not only looking toward marginal producers now, but is increasingly gaining stakes in the world's largest commodity producing countries and companies which, depending on the longevity of the economic downturn, will continue to put them at a strategic advantage to the West as boardrooms fail to leverage balance sheets and keep pace with Beijing's acquisitions policy.

If anything, China's greatest competition for resources in the short-to-medium term is unlikely to come from Washington, Brussels or indeed Moscow, but from other emerging market economies such as India who are similarly trying to invest in natural resources for the longer term by supporting national champions such as Oil and Natural Gas Corporation (ONGC). India has never quite worked out whether they share a cooperative or antagonistic relationship with China in pursuit of natural resources, nor indeed have Southeast Asian players.

Mutual Cooperation vs Mutual Antagonism

However, given that demand for commodities will continue to slacken across the OECD for the foreseeable future alongside greater rhetorical emphasis being placed on renewable forms of energy, resource contestation from developed and emerging markets is unlikely to hit the headlines any time soon. But international oil companies are already painfully aware that one of their greatest difficulties is that they are only able to vie for around 10 percent of global reserves due to heavy concentration of proven reserves residing in a handful of countries.

Once the global economy picks up, they may find that this percentage has shrunk even further as the energy and commodities balance of power incrementally shifts to the East. If this proves to be the case, governments will be similarly quick to sharpen their attitude toward resource contestation in the Middle East, Central Asia, Latin America and Africa.

Indeed, resource contestation and international relations has always been a combustible mix; the economic downturn may have extinguished the "western fuse" for now, but at the same time, it has acted as a catalyst for Chinese engagement that see the economic downturn as a crucial window of opportunity to invest in global resources.

Once global demand picks up, western players will undoubtedly rejoin the race, but China will similarly redouble their efforts. Whether this dynamic will play toward mutual cooperation or antagonism remains to be seen, but one thing is for sure, it will continue to rewire international relations away from the role of the market towards that of the state for those who want to sit at the top of the resource acquisition tree. 

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