Oil for money, China style

Oil deal between China and Brazil’s Petrobras and Russia’s Rosneft and Transneft, ensure supply of oil for China in exchange for liberal amounts of money to help develop hydrocarbon finds in the two countries.
What happens when cash-strapped oil companies and cash-rich countries meet? It doesn’t take much imagination to realize that innovative deal-making is the likely result.
The cash-rich country in question is China and the companies in adversity are Brazil’s Petrobras and Russia’s Rosneft and Transneft. The deals will ensure supply of oil over the next two decades for China in exchange for liberal amounts of money to help develop hydrocarbon finds in the two countries. What is interesting about these deals is that they are not only about securing oil rights, but that they make innovative use of adverse economic conditions to advance China’s long-term interests.
As reported by the Financial Times, China signed a landmark deal with Brazil’s state-owned oil company, Petrobras, on Thursday. Under the deal, Petrobras will get $10 billion to develop oil finds and, in exchange, will supply 100,000-160,000 barrels of oil a day to Unipec Asia, a subsidiary of China Petroleum and Chemical Corp. (Sinopec). It will also supply oil to another Chinese company, PetroChina.
Last week, on Tuesday, China Development Bank signed a $25 billion deal with Russian oil company Rosneft and monopoly oil pipeline operator Transneft for supply of oil from east Siberian oilfields.
These deals are innovative, for they solve two problems in one go. On the one hand, they provide cash to companies that otherwise have few options to secure it from global financial markets. On the other, they secure hydrocarbon resources for China by a different route. Instead of such resources being bid up in a competitive process with many players trying to garner them, the deals have occurred in a barter-like fashion.
To be sure, this sort of deal-making is unusual. More than anything else, it requires a virtual freeze in the world’s financial markets so that efficient allocation of resources becomes difficult, if not impossible.
At the same time, the equation was completed by China’s future needs. China’s actions are consistent with its medium and long-term energy security requirements. In 2006, its reserves-to-production (RPR) ratio for oil stood at 11.6 years. In 2007, this dipped slightly to 11.34 years. Thus, it makes good sense for China to firm up supply contracts of the kind it signed with Brazil and Russia. These will ensure that it faces no discontinuity or demand-supply mismatch in the years to come.
The question to be asked is why India, which also has a tidy pile of cash, did not make use of this opportunity as China did.
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Oil Prices: Are we at a multi-decade bottom?

Oil has been one of the predominant stories for 2008. Characterizing the first half with its meteoric rise and capturing the second with a spectacular free fall, market chatter has swung from talk of $150 per barrel of crude to $35 per barrel in the span of a few months.

As with any commodity, the price of oil is decided by demand and supply. In the past few years, while on the demand side North America remained one of the largest consumers, incremental growth in demand has come from China, West Asia, India and countries of the former Soviet Union. Oil demand from the Organisation for Economic Cooperation and Development nations has registered tepid growth since 2000 and their share has fallen by almost 5%.
In the first half of 2008, demand for India and China was forecast to grow by around 10%. The high estimates argued that these countries would exhibit price inelasticity in their blistering path of growth, leading to fears of spare capacity exhaustion. Spare capacity as a percentage of demand has been coming off its peak of 14% in 1987 to an anaemic 3% in 2007. Hoarding by select nations added to the general level of panic, causing markets to bid oil contracts higher.
Through the summer the US saw a decline in demand—highway miles driven fell for the first time in 29 years, toll booth receipts dropped and several airlines grounded fleets. With the biggest consumer weaning off its addiction, oil started faltering. The final blow was dealt with worse-than-expected numbers coming out of China. While part of the price decline was funds flowing out of the commodity spectrum and the US dollar strengthening in a recessionary environment—in line with prior recessions—the crux of the matter is a fixation with the near-term demand.
In earlier recessions, developed nations would largely contribute to the growth in oil demand at the cusp of a recovery. However, over time, developed nations have lost share to emerging nations and hence any recovery in oil demand will now be led by these countries.
Estimates assume acceleration in demand growth in the second half of 2009. That might prove overly optimistic, with China’s economic growth undoubtedly set to slow further.
China’s reliance on exports and any prosperity thereof feeds into oil consumption.
Exports to developed countries have dramatically slowed and are hardly a self-starter in light of the severe downturns in these countries. While internal domestic growth could be a driver, we have severe doubts about China’s announced fiscal pump-priming.
Incremental demand was also registered from West Asia. With large infrastructure and development projects being rolled out, these cash-rich nations were once touted as self-sustaining and hence consumption-based economies. But as this levered story came unhinged, any incremental demand in oil from these nations is now suspect.
While in the near term the pull back in consumption is more than certain, we believe this will lead to an overcorrection in the price of oil.
The Organization of Petroleum Exporting Countries (Opec) faces one of the largest drops in global oil demand since the 1980s and will aggressively cut production. As demand overcorrects, so will supply.
A pull back in the price of oil will also put new projects on hold as it is no longer as profitable to spend capital in generating a commodity that can’t seem to bottom.
New expensive upstream projects such as oil sands and deep-water exploration will likely be delayed, thereby postponing any incremental supply additions.
Turning to existing supply, the picture is bleak. Mature oil fields are seeing accelerating decline rates, and outside of Opec, the supply is characterized mainly by mature fields. New discoveries are yielding much smaller fields, not to mention some fields trapped in geopolitical strife.
All this will eventually contribute in setting a floor to the price of oil. Additionally, China has pledged to build strategic reserves to service 180 days, demand over the next decade. As oil gets cheaper, nations will strengthen their strategic reserves, bringing natural buyers to the market.
The world will be weaned off oil only in the face of a major technological shift towards, say, battery cars or biofuels, or an increase in supply. However, the former will take a long time to become mainstream and the latter is highly unlikely.
Although oil prices have plummeted, the prospect of an economic recovery at some point in the future isn’t unreasonable. Neither is it unreasonable to consider the pressures of rising population on a shrinking natural resource.
As oil pulls back, we are likely sitting on a multi-decade bottom.

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