Ben Oostdam's story # 498
Three Reasons China is Positioned
to be the Oil Sector’s 
Next Big Profit Play 
By Keith Fitz-Gerald
Investment Director
Money Morning/The Money Map Report 

If you’re looking for the next “Big Oil” play,
bet on Beijing.
As we’ve been reporting for the past several
years, China has been on a global commodities
shopping spree, which includes locking up
every source of oil that it can.
The Red Dragon has cut deals in Africa,
South America Russia and the Middle East -
and won’t stop there.
Even the mainstream news media is finally
becoming aware of this crucial trend.

But here’s the thing.
It’s not enough just to know that this is happening.
In order to profit, an investor really needs to
understand why it’s happening -
and to invest accordingly.
Investors who lack this insight may make the
strategic misstep of betting heavily(or exclusively)
on the Western heavyweights -
Exxon Mobil Corp. (NYSE: XOM), BP PLC (NYSE ADR: BP)
or Royal Dutch Shell (NYSE ADR: RDS.A, RDS.B) -
while ignoring the oil sector’s real growth story,
which is China.

Just this year alone:

•China and Russia have signed a multi-billion-dollar,
 intergovernmental agreement to construct an oil line
 from Russia that will supply oil directly to China.
 Actually seven agreements in one, the terms depict
 a deal worth trillions of dollars - 
 including a 20-year oil contract to pump Russian oil
 to the Chinese market. In return, China has agreed
 to provide a total of $25 billion in loans to Russian
 oil companies Transneft and OAO Rosneft Oil Co.
 China even gets a cut of Rosneft’s production,
 as part of the deal. 

•In Africa, China’s CNOOC Ltd. (NYSE ADR: CEO)
 and Sinopec Shanghai Petrochemical Co. (NYSE ADR: SHI)
 are teaming up to buy a $1.3 billion stake in Angolan
 offshore development rights from U.S.-based
 Marathon Oil Corp. (NYSE: MRO).
 A key point of note: Angola - historically one of
 Exxon’s favorite investment targets - has recently
 overtaken Nigeria as Africa’s biggest oil producer. 

•While noting that it’s hardly a done deal,
 The Wall Street Journal did report earlier this month
 that China National Petroleum Corp. (CNPC) is interested
 in buying all or a part of Argentina’s YPF SA
 (NYSE ADR: YPF) for $14.5 billion. 

•In Africa, China’s CNOOC Ltd. (NYSE ADR: CEO) and Sinopec
 Shanghai Petrochemical Co. (NYSE ADR: SHI) are teaming up
 to buy a $1.3 billion stake in Angolan offshore development
 rights from U.S.-based Marathon Oil Corp.
 (NYSE: MRO). A key point of note: Angola - historically
 one of Exxon’s favorite investment targets - has recently
 overtaken Nigeria as Africa’s biggest oil producer. 

•Reports continue to circulate that CNPC will be taking
 the majority stake in Iraq’s Rumaila oilfield from BP.
 Rumaila is Iraq’s biggest oil field, producing more than
 a million barrels of crude oil per day. 

•And China has become quite chummy with Brazil’s Petroleo
 Brasileiro (NYSE ADR: PBR). Petrobras is developing a huge
 new offshore field - one of the biggest new discoveries
 in decades, in fact - and any deal would include a
 production-supply agreement.
 
This flurry of deals hasn’t been a surprise to Money Morning
readers. Even so, it’s worth taking a moment to look at some
of the key catalysts behind many of these deals.
Let’s look at the Top Three:

•Nervous Reserves: China is sitting on the world’s largest
 pile of cash - more than $2.3 trillion by some estimates.
 With an estimated 70% of that, or about $1.61 trillion,
 in U.S. dollars, there is no question it’s a huge source of
 financial firepower strength at a time when global markets
 are uncertain, if not downright weak. But it’s also a
 liability, too, in that China can’t diminish its
 high-concentration of greenback holdings without pushing
 the dollar off a cliff. So buying oil is a great way for
 China to diversify its reserves without kneecapping
 poor old Uncle Sam. 

•Those Not-So-Free “Free” Markets: China has less faith in
 the “free” markets than the West does.
 Ironically, the United States and other Western powers
 are partly to blame for Beijing’s free-market skepticism.
 For instance, not only did the United States slam the
 door in China’s face when China tried to buy Unocal Corp.
 [now a part of Chevron Corp. (NYSE: CVX)] a few years back,
 but when former U.S. President George W. Bush invaded Iraq,
 the war summarily cut off China’s ability to source oil
 from that Middle East member of the OPEC 12 
 (the Organization of the Oil Producing and
 Exporting Countries).
 Prior to the invasion, Beijing really didn’t consider the
 need to diversify China’s foreign-oil sources so our
 military action prompted their economic reaction.
 Now the genie’s out of the bottle. 

•Peerless Perspective: China’s leaders know that they must
 lock up oil supplies at a time when the Western world can’t
 seemingly be bothered to understand that this is a
 zero-sum game. In other words, China views the global
 financial crisis as an opportunity to be exploited
 for economic gain and the security of its people, not as
 a problem to be solved. China understands the big picture,
 and even though we apparently painted it, the West doesn’t.
 By scouring the earth for oil at a time when the West
 is hamstrung by the global financial crisis, not only is
 China able to strike more favorable deals at more
 favorable prices, but it’s locking up huge supplies of
 commodities for its own use for years, even decades, to come.
 In doing so - and this is the part of the equation so
 many experts don’t get - these resources are no longer
 available for our use here in the United States,
 which has major supply and pricing implications
 for this market.
Bamboozled by the Western media - which has perpetuated the
“global-recession-means-lower-demand” story - it simply hasn’t
dawned on most people here in the West that China doesn’t
care about the major long-term impact this global buying
spree will have on our economy. 
Besides, this whole story thesis is flat out wrong.
While the recession is definitely dampening our use of oil
and gasoline, China’s oil demand is growing by more than 20%
a year. And of the 8 million barrels a day that China 
already uses, half comes from imports. 
Beijing sees those as troubling statistics, which means
that China: 

•Absolutely must lock up as many significant external
 supplies oil as possible right now. 

•And must accelerate its domestic exploration-and-processing
efforts at warp speed.
Nor is this a static situation. China’s auto market is growing
by 50% a year. It’s already the world’s largest,
having passed the United States earlier this year.
In fact, according to some estimates, China will have more
cars on its roads in the next 20 years than all those we
currently have in this country - even if you include the
engine-less “restoration project” your next-door neighbor’s
son has sitting under an oak tree in their back yard.
 
China’s never known high prices and 
its consumers haven’t either.
So they don’t care like we do about what “price” is posted
at the pump. Sure, you can argue as many Western analysts do,
that China’s fuel is highly subsidized, but so what?
That’s a moot point. Consumers who remember what it was like
back when gasoline was 99 cents a gallon aren’t going to
grouse about how it now costs $6 a gallon - 
these newly minted motorists will merely see gasoline
as just part of the cost of having a car.

Because it understands its need for continual economic
progress - as well as the role oil has to play to make
that a reality - China is doing whatever it takes to
guarantee future supplies, including structuring deals in
ways that have caught Western companies by surprise.
For instance, China’s companies are looking at how they can
get a deal done by giving the other party something it
actually needs. Moreover, in a move that’s as frustrating
to Western leaders as it is surprising, many of these deals
come with no strings attached. I suppose you could call
it the “Red Dragon Option” - although Western firms would
do well to embrace these as potential Harvard Business
Review case studies.

After reading this overview, a U.S investor might want
to conclude that China’s already got this one wrapped up
and that “any resistance is futile.”
But that’s not necessarily true. While China’s grown by 
leaps and bounds in terms of its financial sophistication
when it comes to these deals, the country still lacks
the relative exploration-and-production technology to go
after the deep-water reserves and complicated fields
where most of the still-undiscovered oil remains.
Those are also the same kinds of locations where natural
gas may be the better bet.

And that suggests that investments in both sectors -
including deep-water drillers and companies that 
specialize in natural-gas liquification -
may pay off for investors anxious to dine with the
Red Dragon, instead of being listed as an entrée on the menu