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Investors Chronicle: The oil thieves: WHAT RUSSIA AND CHINA ARE TAKING FROM UK INVESTORS

 The Oil Thieves

2-8 March 2007
 
Russia and China are pursuing overtly nationalist policies in their grabbing of oil and mineral assets. An as we explain, Western firms – and shareholders – are losing out.

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In a blaze of publicity over Christmas, the Russian government effectively expropriated from Shell and its Japanese partners a majority share in their flagship Sakhalin Energy liquefied natural gas (LNG) project. At the same time, Chinese state-owned Zijin Mining launched a bid for Alternative Investment Market (Aim)-listed copper miner Monterrico Metals. And then, in January, at the World Economic Forum in Davos, the leaders of global mining firms discussed how best to counter the Chinese investment surge into Africa, which some say is denying opportunities to Western players.

What unites all these developments is the resurgence of economically-justified ‘resource nationalism’ or, to give it its technical name, mercantilism. And its various manifestations around the globe are now challenging the development of a liberal, free market, which seemed assured following the collapse of the Soviet empire. More importantly for investors, this mercantilism is also affecting the share price prospects of Western companies working in the natural resources sector.

Swallowed by the state

In the mining sector, the ongoing bid by a consortium of state-linked Chinese interests for Monterrico Metals is the most recent and obvious manifestation of this trend. It has been led by Zijin Mining, with the aim of controlling the undeveloped Rio Blanco copper project in Peru. It comes on the heels of Zijin itself buying into the Blue Ridge platinum project in South Africa and Sinosteel buying 60 per cent of south-Australian uranium project company PepinNini Minerals. Similarly, Jinchuan Group has bought a minority stake in Australia-listed miner Albidon, as well as buying up all future production from its planned Munali nickel mine in Zambia – and it’s now in talks to acquire some major mines in the Philippines.

The trend can be traced back to 2000, when state-owned China Non-Ferrous Metal Industries Corporation restarted production at an abandoned mine in Zambia’s Copperbelt. It proved to be the outrider for a wave of Chinese investment in the Copperbelt, so overwhelming that Chinese control of the industry even became an issue in the last Zambian general election.

In the energy sector, state-controlled Chinese oil firms have also been making prodigious efforts to widen their global footprint. In 2005, in Kazakhstan, CNPC bought a majority stake in previously Canadian-owned PetroKazakhstan. Then, last year, Citic Group bought up another previously Canadian enterprise operating in the country, Nations Energy. Also in 2006, Sinopec bought 49 per cent of Russian oil company Udmurtneft, and CNOOC bought 45 per cent of a Nigerian offshore block from TotalfinaElf and its state-owned Nigerian partner.

Sinopec and Indian state-owned ONGC even joined forces last year to buy a half-share in Colombian oil company Omimex. Previously, they had been bitter rivals for assets – in fact, ONGC lost out with its rival bids for both PetroKazakhstan and Udmurtneft. Some investors have therefore been worrying about the emergence of an ‘axis of mercantilism’. After all, only a year earlier, an ONGC vehicle teamed up with CNPC to buy PetroCanada’s Syrian assets.

But if there’s one deal that has really highlighted the battle between state-sponsored mercantilism and the free market, it’s CNOOC’s attempted purchase of privately owned US oil firm Unocal in 2005. A furore of objections expressed in US policy circles and by US law-makers caused CNOOC to withdraw its bid before the takeover actually went to an official ruling. The attitude toward the deal expressed by many in the US was neatly summarised by Richard D’Amato, the US senator heading the US-China Economic and Security Review Commission: “The Chinese treat energy reserves as assets in the same way a 19th-century mercantilist nation-state would. Their goal is to acquire and keep energy reserves around the world and secure delivery to China above and beyond any market considerations. To do this, it is willing to pay above-marketplace premium prices in order to gain exclusive control over oil and gas. China believes it can only achieve energy security through direct control of reserves. This hoarding approach directly conflicts with the efforts of the US and other countries in the International Energy Agency to develop fungible, transparent and efficient oil and gas markets.”

Ours, not yours…

The new mercantilism has already had a massive knock-on effect across the natural resources sector. Perhaps the biggest transformation has been in the attitudes of governments of resource-rich countries such as Russia, Kazakhstan, Venezuela and Bolivia. Thanks to the long-term commodity demand being fuelled by China and India, these producer countries have felt the balance of power between themselves and consuming countries shift in their favour. They know that their natural resources have become more valuable both in monetary and scarcity terms. So the governments of all four countries have moved to reassert state control over their natural resources – at the expense of previous contractual norms, which had favoured the private sector and foreign investors. This is, in effect, a move back to the kind of state-sponsored, restrictive monopoly that would ensure profits weren’t shared beyond designated circles, and would allow governments to manage the supply and prices of the commodities in question.

Take, for example, the Kremlin’s expropriation of the Yukos oil company – which came before its expropriation of Sakhalin Energy. Back then, Yukos was a privately-owned Russian company and its downfall, through tax-avoidance charges, was widely believed to have been engineered because of the political ambitions of its now-jailed then-owner, Mikhail Khordorkovsky. However, the Russian government only made its move on Yukos following reports that US oil giant ExxonMobil was negotiating for a minority stake. ExxonMobil is not usually satisfied with just a minority stake in any worthwhile asset, so the prospect of control of Yukos passing to the Americans would no doubt have alarmed the Kremlin. At the time, Yukos owned the biggest and most promising of the East Siberian hydrocarbon fields, seen as the long-term future for Russian energy production. After the Kremlin’s intervention, those assets were vested in state-controlled Russian oil company, Rosneft.

Now, the Russian government is turning its attention to the massive Kovykta gasfield, controlled by BP’s joint venture, TNK-BP. So the expectation is that BP will have to strike some sort of a deal to bring state-owned gas company Gazprom in as a development partner, if it wishes to avoid outright expropriation of the asset.

In fact, this is likely to be last big oil and gas project a UK company can get involved with in Russia. That’s because while the state has been chivvying Shell and BP, the Russian parliament has been endorsing laws that will prevent foreign companies from gaining a controlling stake in any flagship natural resources projects in the future. For so-called ‘strategic’ resources of a particular size, control will be restricted to domestic Russian entities. In the oil and gas sector, this means Rosneft and Gazprom will control everything. They have already been appointed joint co-ordinators of the next generation of offshore and Arctic field developments.

But these controlling stake laws apply equally to the mining sector. For example, in Kazakhstan, the government has passed laws signalling restrictions on foreign investment in strategic hydrocarbon fields. This has forced the private-sector oil-companies in the flagship Kashagan offshore project to let a stake being sold by BG to pass to national oil company KMEG. The private-sector oil companies had originally planned to take ownership of it themselves. KMEG has also been charged with overall strategic direction of hydrocarbon development and has explicit rights over any oil and gas asset being sold by private investors in the country.

Similarly, in Venezuela and Bolivia, the left-leaning governments have both rewritten the terms under which foreign oil companies operate, in favour of the state. Venezuela’s president, Hugo Chavez, has announced the expropriation of majority shares in the Orinoco oilfields, which are the country’s main earner, saying: “The privatisation of oil in Venezuela has come to an end.” BP is among the companies affected. Bolivia is also revisiting the results of privatisations in the mining sector. It has just seized a tin smelter from Switzerland-based commodities trader Glencore.

Free trade vs the state

The peaceful transformation of centrally-planned socialist states into capitalist democracies was supposedly an acknowledgement that wealth creation was best served by unfettered private-sector players. Even China began relentlessly widening its experimentation with private enterprise. In fact, as long as a decade ago, both Russia and China seemed willing to allocate resources to optimise their profits according to the laws of supply and demand – accepting the ‘invisible hand’ of the market. Now ,though, the battle between free-trade and the state seems to have been restarted.

‘Liberals’ – generally identified today as ‘neoliberals’ – see free trade as an unalloyed win-win situation for all. This stems from David Ricardo’s theory of comparative advantage, which argues that even countries that cannot produce any goods at the absolutely cheapest price worldwide should still be able to sell goods that free up other countries to produce higher volumes of higher-value goods. It is a viewpoint in which governments are incidental and private individuals come first. The state is largely viewed negatively for its imposition of tariffs and other barriers restricting trade. But the gains from efficient and free trade are perceived as benefiting a global everyman rather than the citizens of any specific country.

Mercantilists, however, place the preservation and aggrandisement of the state – in particular, their own state – at the centre of all their calculations. They view trade as a zero-sum game where a gain for one party is a loss for another. This notion was inspired by the competition between emerging European nation states for the natural riches of the Americas, Africa and Asia – and for the gold garnered through the trade of these commodities – in the 16th and 17th centuries. All that has happened is that the commodities have changed. Spices, silks and gold have been replaced by the energy and mineral resources needed by modern, industrialised states.

So, with the industrial rise of a resource-hungry China and, to a lesser extent, India, a ‘new mercantilism’ has emerged. The incontrovertible mathematical truth of comparative advantage in free trade means that, in theory, any country is best served by relying on a free market to deliver supplies at the most efficient price. But, in practice, because assured supplies of energy and metals are so central to the development of these countries, they see the risk of market failure as too great. They fear that finite resources of the commodities in question, and ‘chokepoints’ in global supply routes, could threaten their security of supply. So they they conclude that the best way to meet this threat is to increase the share of resources controlled directly by their state or its proxies. They will even pay out-of-market prices to do so. State-controlled Chinese companies, in particular, are scouring the globe for equity stakes in natural resource projects. And they now face competition from state-owned Indian, Malaysian and South Korean companies playing the same game.

Private sector nightmare – or dream?

Clearly, then, the new mercantilism has made life a lot more difficult for UK listed companies in the natural resources sector.

The large oil companies, such as BP and Shell are particularly affected. They are being targeted by national governments as they regain control over their strategically important assets. Not only are these multinationals losing economic rights that they thought they’d already tied up, but the emphasis on national champions in resource-rich countries is also shutting them out of many future opportunities. They had been counting on these for significant production and reserve growth.

For example, Russia snubbed a bevy of top-flight international oil companies, including BP and Shell, by deciding it did not want any of them as partners for the massive offshore Shtokman gas development in the Arctic. At the same time, UK miners are having to take new Russian sub-surface laws regarding domestic control very seriously. BHP Billiton, Rio Tinto and Anglo American are keen to get into Russia in a big way, but they are having to structure their exploration investments as 49 per cent holdings in joint ventures with major Russian miners, most notably Norilsk Nickel.

Even in Africa, where domestic industry is too underdeveloped to restrict projects to national champions, UK listed players now find themselves competing against state-owned companies with deep pockets. Here, the state-owned companies enjoy a far cheaper cost of capital, due to their quasi-sovereign status.

In fact, cost is becoming a major issue. In China, the recycling of state-owned dollar surpluses into spending by state resource companies has been a major driver behind sky-high asset prices. This makes deals hard to justify for companies answerable to ordinary shareholders rather than national governments. And it isn’t just on financial terms that Western firms are outgunned. They are outflanked comprehensively by state-owned companies that can mobilise developmental aid from their respective governments to ‘sweeten’ deals.

For example, recent oilfield licence wins by Chinese, Indian and South Korean state-owned companies in Nigeria and Angola have been tied to developmental aid programmes. This aid has taken the form of soft loans from state-owned financial institutions and infrastructure development for local roads and clinics. Private sector companies simply have no answer to this, except to cry foul. Hence all the newspaper articles and editorials over the past year denouncing Chinese and Indian largesse as undermining Western-led initiatives to rein in African debt, or to attach environmental conditions to project-development loans.

These concerns were behind the so-called ‘governors meeting’ of mining companies that was hosted at the World Economic Forum in Davos. The miners suggested calling on the UN to pressure African governments to resist such blandishments and create a level playing field for all licence bidders. Various high-profile attendees at the meeting, from companies such as Rio Tinto and Anglo American, denied the detail of the press coverage. But they did concede that concerns were expressed over equal treatment of Western and non-Western investors in Africa.

do any uk companies win?

While large multinational companies lose out, there are benefits in the new state of play for smaller private-sector companies.

Companies that have built up valuable reserve or project positions, such as Monterrico, are now prized asset targets. So they’re likely to reap above-market prices for being taken out. As a result, a bidding war for Monterrico could yet erupt. One analyst says that the Chinese offer is now being discussed at board level across the major global mining companies – because they see the Chinese bid as very much an intrusion into what was previously ‘their’ turf in South America.

Premier Oil is another example of a company that may be on the wishlist for the new, deep-pocketed Asian mercantilists. It possesses a good-quality reserve base across both south Asia and the Far East. So it’s not surprising that it has been subject to one failed bid, thought to be from Dubai Energy – a state-owned entity from another developing economy which, despite its location, has no significant hydrocarbon resources of its own. When the approach was first announced, however, speculation was rife that the bidders were state-backed firms from China, India or Malaysia. This is now likely to be the standard response to any rumoured bid for a small-to-mid-cap resources company, for the foreseeable future.

royaldutchshellplc.com and its sister websites royaldutchshellgroup.com, shellenergy.website, shellnazihistory.com, royaldutchshell.website, johndonovan.website, shellnews.net and shell2004.com are all owned by John Donovan. There is also a Wikipedia article.

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