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Introduction - The dragon breathes fuel China is endowed with many things: a rich history, a strong tradition of governance, and a vast population and large territorial footprint at the center of the worlds largest continent. its economic growth over the past decade has proven that it can mobilize these resources to grow its productive capacity and move on from a long period of underdevelopment. One endowment it lacks, however, is hydrocarbon energy and specically the amount requisite to continue its resource-intense development trajectory. As its demand for resources has grown, its need to look outward to secure them has grown as well. The Chinese national oil companies (NOCs) have been key actors in this going out process, but as resource needs grow and Chinas demand constrains world markets, it is uncertain how the NOCs will work to secure the supply that Chinas growth is demanding.

China has not always found itself in this import-dependent situation. Less than thirty years ago China was a net exporter of oil and other commodities as its underdeveloped local market used its commodities to service Japanese growth. Now, China is the worlds second largest consumer and importers of oil and annual demand growth is higher than all the rest of the world combined. This demand from China has been an important contributor Chinas Contribution to Global Demand Growth

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International Energy Agency, 11

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Chinas Largest Oil Suppliers 2009

Chinas Largest Oil Suppliers by region 2009

Middle East Africa Asia Russia South America .2

9% 5%

5%

55%
26%

Saudi Arabia 22% Angola 27% Iran Russia 6% 17% Sudan 7% Oman 8% 12% Others

to unstable and constantly increasing global oil prices.3 Now, demand is outpacing supply and the modest drop in demand from developed economies has not offset Chinas extraordinary consumption growth. In fact, Chinese demand growth has been the most important driver of global demand growth for some time, a trend that will not soon abate. Chinas NOCs audacious investors The resource agenda of Chinas NOCs is closely connected to the governments broader goal of energy security. In pursuit of this goal, the Chinese government has broadened its strategy from pure equity and joint-venture investments to shoring up better trade relationships, offering foreign aid and installing transportation and telecom infrastructure to support their investment goals. This strategy is one that emanates from the government as a whole and not just the NOCs, with the National Development and Reform Commission requiring Chinese NOCs to invest in upstream energy suppliers overseas.4 Traditionally, Chinese companies have plied traditional supply routes in Russia, the Middle East and Southeast Asia for oil supply, but they are increasingly looking further aeld to Africa, North and South America for diverse supply sources.5 This voracious demand for

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ChinaOilWeb data report, 2010 Blas (Financial Times), full text United States USCC Report, 4 Chart and information from Moran, 10

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Chinas Largest Natural Resource Procurement Cases -

oil has led it to some of the worlds most hostile production environments, both technologically and politically. From purchasing exploration rights in Iran to competing with domestic oil companies for concessions in Russia, Chinese companies appear to have a risk appetite that exceeds that of other NOCs and supermajors like ExxonMobil and Shell. Although a large part of this risky business comes from the sheer growth in demand that the

Chart credit: Moran, page 10

companies have !

experienced in

a very short period of time, part of this appetite may derive from the lack of Chinese NOC experience in hostile environments.

In the Western Hemisphere the approach has been more guarded and, despite headline successes and failures, the risk prole has been more measured. The focus of this essay is to explore three brief case studies in the Western Hemisphere of Chinese NOC involvement in the energy sector and understand Chinese motivation for nding oil supplies in unconventional places. Also, given the sometimes hostile regulatory environment throughout the region, not just in Latin America but also in the United States and Canada, the essay also explores the question of how China reacts to political risk and sovereign challenges to its energy interests.

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Chart credit: Center for American Progress (2010)

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CASE STUDY 1 PetroChina and EnCana - Wasted time leads to a failed push for an important asset Conducive as North America may seem to foreign investment in comparison with the rest of the hemisphere, Chinas oil companies have faced their most serious challenges and defeats in the U.S. and Canada. Chinas most famous war story came when CNOOC submitted an unexpected, all-cash bid for Unocal in the midst of a takeover by Chevron. The generous offer, however, was famously rebuffed by the U.S. Congress, who considered the transaction an undue incursion by China in an area of U.S. national security.

A more interesting case, however, is the failed bid by PetroChina to invest US$5.5bn to establish a full partnership with Encana in the challenging Athabasca Oil Sands in Northern Alberta. After a year of negotiations and assurances of success from both sides, talks broke down and the deal was scuppered. Both sides ascribed the breakdown to a lack of a comprehensive agreement on terms, and for such a large stakeeffectively a 50% interest in the particular developmentthe failure was surprising and disappointing to both parties and observers alike. The deal, had it been successful, would have been the largest Chinese investment in Canadian energy. And the CEO of Encana expressed condence in the deals prospects up until the very end, when he had to announce a lack in substantial alignment in the interests of both sides.6 As a result, The Financial Post concluded that this deal would likely poison the well for other Chinese deals in the country for years to come.

While the Canadian government is, like the U.S. government, supportive in principal to foreign investment in the countrys resource sector, major foreign acquisition plans for
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Cattaneo (Financial Post - Canada), full text

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resource companies have failed in the past several years. The most notable was Australian-based BHP Billitons attempted takeover of the Potash Corporation of Saskatchewan, which was blocked ultimately over reasons of national interest. According to Canadas respected Financial Post, the federal government twice delayed approval of the PetroChina/Encana transaction and, in order to avoid another BHPBilliton debacle, may have quietly set transaction conditions that neither PetroChina nor Encana could accept.7

Still, the Chinese have successfully invested (and received government approval) in part of ConocoPhillips oil sands interests, but did so at a premium of nearly 100% of the assessed value.8 The government, with terms like this, would have a difcult time demonstrating the deal did not bring economic benet to Canada. But given failures elsewhere it appears they may be demanding some premium from Chinese companies that want to operate incountry. Whether this is to compensate for the political ramications or the uncertainty of how to deal with Chinese NOCs in one of Canadas most precious energy assets is unclear. Regardless of the reason why substantial alignment could not be attained, the Canadian government has been rm on its attitude towards national interest in large foreign resource acquisitions, and Chinese NOC investments have not been given on par treatment with those from elsewhere.

CASE STUDY 2 Sinopec and Petrobras 2009 - Cooperation but no equity In early 2009, the China Development Bank agreed to lend Petroleos Brasileiros (Petrobras) US$10bn to assist in its efforts to exploit the Santos pre-sal offshore basin off the coast of Southern Brazil. The deal set off speculation that the Chinese state oil
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Simon (Financial Times), full text Hatcher (Houston Chronicle), full text

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companies was planning to buy up a percentage of the production of Brazils newlydiscovered deep sea reserves, but in reality the deal just guaranteed 100,000 barrels per day delivery of crude to Sinopec for 10 years at market prices.9 Given the estimated investment in developing the eld will clock in close to US$200bn, a loan guarantee equal to 5% like the one Sinopec is making certainly does not constitute market-cornering practice. Also, unlike the attempted CNOOC acquisition of Unocal in the U.S., the Petrobras deal did not involve any equity stake. Additionally, the promised crude supply was not even planned to come from the new production, rather from existing Brazilian elds. The loan-for-oil agreement, though, was not to be the end of the story and Sinopec continued in negotiations with Petrobras to take a larger role in the exploration and production of the elds. By mid-2011, Sinopec was already in advanced negotiations to acquire two blocks of the Santos basin production. And ahead of the mid-year visit of President Dilma Rousseff to China, Petrobras announced that Sinopec would join the Brazilian company on-site to develop the offshore oil elds. What this strategy reects is a growing tendency for the Chinese oil companies to avoid the high-prole equity investments or partial takeovers that they had attempted in the past decade. Instead of taking major stakes, the Petrobras deal shows that they are using their inuence and capital to slowly build relationships in areas of political and economic interest like Brazil. Also, given that these are deepwater exploration projects, Chinese oil companies will be very interested in understanding Petrobras already-advanced technology. With oil being discovered by supermajors and neighboring NOCs in the South China Sea, the goodwill generated by the loan-for-oil agreement may result in a very valuable engineering lesson for Sinopec.

Ausick (24/7 Wall Street), full text

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CASE STUDY 3 CNOOC and Chesapeake - Finally, an equity success story In early 2011, CNOOC and Chesapeake Energy (the U.S.s largest shale gas exploration company) announced that CNOOC would take a 33% stake in Chesapeakes assets in two U.S. shale plays. The deal, worth in total more than US$2 billion, provided an outlay of US $570 million for 800,000 acres of drilling leases in Colorado and Wyoming and an additional commitment to fund two-thirds of Chesapeakes share of the costs that would be repaid over a period of three years. The deal has a clear benefit for Chesapeake: a major investment in a time of weak American capital markets and a view into the world of conducting a joint partnership with a Chinese NOC. CNOOC, however, has even more to gain from a fruitful alliance, and that is experience and expertise to exploit similar resources at home.10 China has an estimated 36 billion cubic meters of shale gas reserves (twelve times the countrys conventional deposits) but heretofore has not possessed the technology to effectively exploit their resource. This investment gives CNOOC a front row seat to the most advanced techniques in hydraulic fracturing, or fracking, and how to manipulate wellheads in order to extract the maximum amount wells without contaminating its environs.11

After the disastrous experience of CNOOCs bid for Unocal, it is remarkable that the company has been able to make such a substantive bid in one of the U.S.s leading energy companies. Clearly, what makes this deal different is a much worsened U.S. domestic investment climate in 2011 than in 2006 and a Congress that had more pressing issues to address. But the nature of the stakeshale gas versus oilmight also be an important distinction to make.
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CNOOC, full text Nicholson (New York Times DealBook), full text

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Why is investment so problematic in some places and so successful in others? NOC Strategy for Expanding Abroad - IEA Analysis

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One simple theory for why Chinese companies have had so many issues in Western Hemisphere investments was advanced by Professor Bo Kong in his recent book Chinas International Petroleum Policy. In his analysis, he posits that Chinese companies have a short history of dealing with political and legal risk. Using this line of logic, Chinese NOCs until recently failed to understand the types of risks inherent in political systems that differ from theirs. At the same time, he concludes that China has neither the resources nor the intent to lock up foreign oil.13 Contracts such as the oil-for-loan contracts with Venezuela and Brazil, and the difculty of Chinese NOCs in making equity investments that it can reinvest into their business, can lead to a different conclusion. Perhaps Chinese oil companies are not locking up supply but they certainly are negotiating outside the traditional connes of supermajor contractual behavior in many jurisdictions. Doing so predominantly in political and corporate environments that neither practice international standards of transparency nor consistent application of contract law can lead to questionable practices.

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International Energy Agency, 13 Kong, 151

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Zha Daojiong, a professor of international political economy at Peking University in Beijing, was less condent that they were just inexperienced investors. He believes that Chinese outward investment in the energy sector is motivated by more practical reasons. His take was that investments in countries with high political risk and a chance of expropriation were just testing grounds for bigger things. The goal is not to make absolute prots or be able to claim a foothold in an important market. Instead, Chinese NOCs that are struggling from decades of technical inferiority are using these opportunities to learn from more sophisticated exploration and drilling methods. Given the vast amount of excess liquidity oating around the central governments budgets, it is easy to make investments and walk away if they are not productive so long as some innovation or learning to Chinese engineers comes from it.14

In the oil space, this may be expertise on the how to drill in offshore wells. In the gas space, this may involve nding new ways to turn a drill head multiple times so as to extract more gas from the same tight spaces. Either way, according to Professor Zha, Chinese joint ventures are looking for more than just prots in their investments overseas. He also believes minor and moderate losses will be written off as trial and error experiments in the greater going out strategy. In certain cases, like in the case of CNOOCs investment in Chesapeake, Chinese NOCs will extract as much expertise and innovation as possible in order to modernize processes and exploration technique in more favorable surface environments.

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Personal Interview, Zha Daojiong

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Will Chinese NOCs have to become more like their peers or will peers become more like them? Estimated Chinese Share of Overseas Equity in Oil-Exporting Countries

Chart credit: International Energy Agency

Given the number of headline investments abroad that have failed, one might conclude that Chinese NOCs are committing vast amounts of political and economic capital to projects before properly vetting them. Certainly in the cases like PetroChinas failed bid for Encana assets are illustrative. On the surface, it may seem that resource investment xenophobia is rearing its head in parts of the hemisphere. But another interpretation that observers can make from these experiences is that, while Chinas resource investment record in the developing world has been largely successful, it has struggled in countries with more transparent governments and stronger institutionalization.

And in these countries, like in the aforementioned purchase of ConocoPhillips assets in Canada, companies and governments have demanded China pay a healthy premium to play. Perhaps this happens because resource nationalism in places like the U.S. and

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Canada has regulatory teeth, whereas in less-developed political systems large companies can have a greater inuence on the approval process. Perhaps also advanced countries and oil companies understand that Chinese companies are not just paying for the underlying asset but also the expertise and intellectual capital they can gain from these partnerships.

On the whole, the most successful joint ventures and resource-based investments of Chinese NOCs in the oil sector have, with few exceptions, taken place in non-OECD jurisdictions and with companies that are not fully market-driven. Where they have failed has been in those with fully transparent vetting processes in more advanced economies. And although there could be a selection bias with Chinese companies unwilling to get involved in areas where they know they will face challenges, the message state companies are sending is clear. Even if it is not credible, investee governments like Canada and the U.S. believe Chinese NOCs do not operate best where local standards of governance, monitoring and accountability in joint ventures are superior to Chinas own. In Canada, PetroChina could not convince the Canadian government that a lucrative deal was in the national interest. Even in Brazil, Petrobras has not yet agreed to any equity participation in its burgeoning oil production. Likewise, investors in these same jurisdictions are demanding premiums for Chinese participation, possibly pricing in the loss of intellectual capital and future revenue possibilities in China from proprietary knowledge.

The gas sector is different, though, and the deal with Chesapeake demonstrates that Chinas NOCs are bullish about the potential to develop shale gas resources at home and are willing to put up large sums of money to develop that expertise. Governments understand that the gas will most likely be sold locally, and companies understand that given the nature of shale, their expertise will likely be demanded even when the Chinese

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NOCs return home to drill. It also suggests that the localized nature of the gas industry (that gas production is not as easily commodied and exported as oil) may not rouse the same resource nationalism as oil. Finally, it demonstrates the types of compromises and concessions Chinese NOCs are willing to make to work towards domestic production and greater energy security at home.

The new phase of this going out strategy of the Chinese NOCs could simply be one of diversication. Or perhaps the focus on the Western hemisphere may come from a recognition that their traditional sources of supply in the Middle East are much more vulnerable to political turmoil than they once thought. At the same time, recent moves into the Brazilian energy sector may show a new strategy in the hemisphere, namely one of cautious and long-term relationship building. This may be, in part, due to a maturing Chinese view of the world and understanding of where their investments will fall under more or less scrutiny. It also may come from the realization that companies Petrobras does not work under fully market-scrutinized terms, and that the operating structure has important commonalities with Chinese NOCs.

This is also why Latin America, more so than North America, stands at an important crossroads between the two types of investment China has been making abroad. With few exceptions, Latin American countries have much stronger institutions and more stable governments than other recipients of Chinese inward investment. At the same time, there is enough leeway in Latin American political and economic systems (including the presence of large, state-owned resource companies) to broker deals with Chinese companies without much external participation or democratic legitimacy.

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But clearly Chinas energy foray into the Western Hemisphere could dissipate as quick as it materialized. Energy imports from the region account for only 5% of its total oil imports, and this supply gap could easily be absorbed by production in the Middle East and Southeast Asia. Still, as prices rise and supply is constrained by political instability and a lack of investment in upstream exploration, China is likely to continue exploring unconventional sources of supply.

Chinas interest and continued investment in risky projects will continue as long as it needs to secure upstream oil supply at prices acceptable to the market. But it appears that Chinese NOC interest in Western Hemisphere oil and gas production, then, is less a play to gain short-term access to vast new sources of production to displace traditional providers. Rather it looks more like a testing ground for developing new technology to use at home and a platform for boosting ties for an uncertain energy future. For oil and gas companies, and the governments that regulate them, Chinese capital has been an important source of investment at broadly favorable terms. Given these complementaries, and the contrast to the political and economic environments in traditional suppliers closer to home, Chinese NOCs may well nd the hemispheres storied resource nationalism less risky than the systemic turmoil elsewhere.