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How China is Beating the United States in the Global Oil Game

Oct 16, 2008
Iraq, Keith Fitz-Gerald, Oil

By Keith Fitz-Gerald
Investment Director
Money Morning Investment News/The Money Map Report

Iraq recently signed its first oil deal in 35 years with a foreign company.

And – quite surprisingly to many observers – the company wasn’t one of ours.

Not surprisingly, the U.S. news media barely acknowledged the deal – even though the agreement was major news throughout the rest of the world.

According to reports from Baghdad, the 22-year deal between the Iraqi government and the China National Petroleum Co. involves $55 billion, or 87% of Iraq’s current total revenue at a conservative long-term estimate of $100 a barrel.

The deal is actually a renegotiated version of a 1997 agreement between China and a Saddam Hussein-led Iraq. That original deal included production-sharing rights, but under the new contract China will be paid for its services, but will not share in profits,
The New York Times reported. The payments will be made in cash – and won’t be “in kind” payments of crude oil, the newspaper said.

While this deal, on its face, appears to be just another global oil-services contract, it’s actually a very significant development in the hunt for long-term energy supplies. In fact, it actually demonstrates that – when it comes to nailing down those long-term oil supplies – China is an expert, and is playing a very deep game. And the outcome of that game will certainly have substantial long-term implications for consumers and investors both here in the United States, and in markets abroad. Here’s why:

  • With estimated reserves of 115 billion barrels, Iraq is tied with Iran for the world’s No. 2 position, trailing Saudi Arabia, which has estimated reserves of 264 billion barrels, according to estimates from the Energy Information Administration.
  • In a country where electricity is in short supply, the oil produced from the Ahdab Oil Field will help fuel a planned power plant that would be one of the largest in Iraq. By helping Iraq with this key initiative, China can expect to gain a solid foothold in one of the most oil-rich nations in the world, analysts say.
  • At the end of the day, the deal clearly highlights something that most U.S. investors haven’t focused on yet – namely that the eventual winners in this game may not be such well-known giants as Chevron Corp. (CVX), ExxonMobil Corp. (XOM), or other household names. Deals like this one and the host of others that are undoubtedly close behind suggest that tomorrow’s winners may have names most English-speaking investors can’t pronounce, since they’ll be distinctly Arabic or Chinese in nature. [Two recent installments of Money Morning’s popular new “Buy, Sell or Hold” feature have focused on Chevron. Take some time to peruse the original story, as well as the update.]

China’s Shrewd Long-Term Oil Plan

The important thing for investors to understand now is that oil ownership, as I have said for many years, is an illusion. It does not guarantee price, nor profit. What really matters in the end is having secure supply lines and sources from the Middle East (and other parts of the world).

Under this new contract, CNPC will provide technical advisors, oil workers and equipment to help develop the Ahdab oil field southeast of Baghdad, said Assim Jihad, a spokesman for Iraq’s Oil Ministry.

While China won’t participate in the profits from the oil it helps pump, it is shrewd enough to realize there will be long-term benefits. Analysts who see the bigger picture here agree with our view.

“There are some political profits for China,” Ibrahim Bahr al-Ulum, a former Iraqi oil minister, told The Times. “They need access to Iraq, and when they need oil, at least the Iraqi people will feel that China has done something for them.”

And that’s not all. Before 2003, Iraq had oil agreements with China, Russia, Indonesia, India and Vietnam – three of which included production-sharing agreements, The Times reported. But the big jump in oil prices, the new government and a myriad of other changes that have taken place since that time prompted Iraq to reconsider the terms of those deals, Iraqi officials said.

Iraq continues to negotiate other service contracts with ExxonMobil, Royal Dutch Shell PLC (ADR: RDS.A, RDS.B), Total SA (ADR: TOT), BP PLC (ADR: BP), Chevron, and some smaller oil companies. The deals have been reduced in length from two years to one after Iraq took a lot of flak for not putting the contracts out for competitive bidding.

But China’s contract was the first major one to be completed – and for one simple reason, Jihad, the Iraqi Oil Ministry spokesman, said. CNPC had “wide experience in this field,” and because many foreign oil companies were not willing to come to Iraq.

China has apparently learned how to play the global oil game with a pro’s touch. Ironically, it was the United States that crystallized this vision.

By invading Iraq, the United States dealt China’s central planning commission an embarrassing wakeup call when the second Gulf War summarily wiped out China’s oil interests in Iraq.

When that happened, China’s central planners realized two things:

  • The status quo in the global oil game had changed.
  • And China’s double-digit economic miracle could not be sustained with only a few oil suppliers.

What China fears most is that there will not be enough oil to go around in the very near future and that a U.S.-dominated supply chain could effectively “strangle” China’s growth.

So, it has done what the United States and other great powers have done at other times in history and gone on a buying spree from Darfur to Peru that’s turned heads and ruffled feathers all across the world.

What’s been especially frustrating for hapless Western leaders who do not understand that their actions caused this in the first place, is that China’s not afraid to do business with rogue nations like Iran, Sudan and Burma. It has even gotten chummy with Venezuela and Russia – much to the consternation of our present administration.

It’s a virtual certainty that China will maintain this policy going forward. My contacts in China and Africa have told me point blank that China’s leaders “don’t care about human rights or nukes or hostile governments. What matters is anyone who provides oil to China no matter what the rest of the world thinks.”

So, in as much as the U.S. media has dismissed this deal as only one in a long string of recent Chinese oil purchases, it’s arguably the most important deal yet. The reason: It suggests that China will go to extraordinary lengths to obtain the oil it wants and needs.

To add to its stable of captive oil suppliers, China will pay far more money, endure limitless criticism for ignoring human-rights issues and endure harsher business conditions than our companies can or will undertake. While U.S. firms must worry about sanctions, bad publicity or simply security, China worries about one thing, and one thing only – getting oil.

It’s a lesson initially learned from us. Then they refined it. Perhaps it’s time we re-learned this lesson from China.

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To the Members of Congress: The Only Three Moves That Will Stop the Oil Price Advance

May 22, 2008
Keith Fitz-Gerald, Main Essay, Oil

By Keith Fitz-Gerald
Investment Director
Money Morning/The Money Map Report

An Open Letter to Congress:

First there was the trillion-dollar pork fest for energy.

Then there was the decision to go with corn-based ethanol.

Now, Congress has voted to stop adding oil to the national Strategic Petroleum Reserve (which was created in the 1970s to smooth out pricing disruptions and supply problems).

Talk about missing the point!

Sure you could argue that by putting less into the strategic reserves we could take some of the pressure off price… and by implication help bring it down from its record level at more than $130 a barrel.

I mean it sure sounds good in theory, especially in an election year. But in reality the strategic petroleum reserves would last only 2 months, even if we cut off all imports tomorrow. So there’s simply not enough volume to make a dent in recent price hikes.

Nor can we drill or refine our way out of this mess, as President George Bush seems to favor. In a recent interview with Yahoo! News, the president suggested both as alternatives when in reality we can do neither.

For one thing, refiners are the ultimate middlemen and they’re pinched at these prices. They simply can’t make money as they try to refine an increasingly expensive product and sell it to users who are chaffing at $4 a gallon. That’s why stocks like Western Refining Inc. (WNR), Tesoro Corp. (TSO), and Valero Energy Corp. (VLO), for example, have fallen by nearly 30-40% in recent months. Their margins get worse with each up-tick in oil prices from here on out now that we’ve reached a point where high prices are beginning to dampen demand.

For another, drilling and refining our way out of this assumes we have oil to begin with… we don’t. And even if we turn the Alaskan Tundra into Swiss cheese, the demand reduction we’re seeing here in the United States is being dramatically offset by developing countries that are guzzling gasoline at unprecedented rates.

In fact, those are precisely the reasons that I’ve been predicting for years that oil prices were headed skyward and why I’ve just recently boosted my target price for crude oil to $225 a barrel.

For what it’s worth, here’s my simple three-step plan.

  1. Encourage people to use less. This is not rocket science, guys, and I have no idea why our leadership can’t understand this but apparently logic doesn’t apply inside the Beltway. Our current fuel standards literally date to the 1970s and pre-date the emergence of both mini-vans and gas guzzling SUVs. They average 25 mpg when we all know damn well that manufacturers around the world are fully capable of building 40-50 mpg cars and are doing so for other markets like Europe and Asia where…taa daa…they sell a ton of small, zippy, gas-efficient vehicles.
  2. Create incentives for this to happen. Instead of providing pork laden tax breaks to the oil industry and stimulus packages that are simply nothing more than a glorified handout, why not shift the money to the consumers who need it? Seems to me that once people figure out they have a meaningful and lasting way of saving money, they’ll not only make it happen, but line up immediately to get started.
  3. Reward those that develop alternatives. We have some of the best brains in the world in places like Silicon Valley and our University System. The fact that they’re not working overtime on this issue suggests to me that they’re not being prodded in the right place. We would easily jump start this process and conservation by rewarding alternative development and usage.

Call me crazy, but there’s a reason why they call it "supply and demand."

The bottom line is that if we demand less, prices will come down.

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One Sure-Fire Sign That Gas Prices are Heading Higher

Apr 11, 2008
Keith Fitz-Gerald, Main Essay, Oil

By Keith Fitz-Gerald
Investment Director
Money Morning/The Money Map Report

The U.S. Energy Department said earlier this week that it expects average monthly gasoline prices to peak at $3.60 a gallon this spring, since the high prices will serve to curb demand.

For investors who are tired of feeling like they’ve been mugged every time they fill up at the corner gas station, this forecast had to nurture a feeling of relief – as well as a belief that pump prices will finally start to decline.

That may well happen in the short term (although even the Energy Department report said that before prices level off there could be interim price spikes that will take pump prices up over the $4 a gallon level).

But for the long haul, after looking at this prediction, we can’t think of a more powerful indicator – or surefire sign – that prices at the gas pump are headed higher … much higher.

Here’s why.

First and foremost, governments have had an unbelievable record of making bad decisions using bad data. And that record goes back centuries. Unfortunately, it’s the taxpayer who usually ends up dealing with the consequences of these ill-advised government "predictions" after these civil-servant prognostications lead to such maladies as inflationary spirals, taxation cycles, recessions, monetary-policy miscues.

Why should this time be any different?

History suggests it won’t be.

When it Doesn’t Compute

Economic forecasters – especially those employed by the government – have a spectacular history of getting little, if anything, right. Not only that, but according to a study conducted by Societe Generale (OTC: SCGLY), financial analysts lag reality badly and change their minds only when there is irrefutable proof they are wrong.

William A. Sherdan, author of the book, "The Fortune Sellers: The Big Business of Buying and Selling Predictions," notes that "economic forecasters have routinely failed to foresee turning points in the economy, the coming of major recessions and the starts of recoveries."

As if that weren’t bad enough, University of Chicago Professor Victor Zarnowitz – a leading global expert on business cycles and forecast evaluation – specifically analyzed the U.S. Federal Reserve, the President’s Council on Economic Advisors and the Congressional Budget Office to assess the error rates associated with their predictions. His work found that 46 of 48 predictions made by this bunch missed major economic turning points including – most notably, the severe recession beginning in 1974.

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Don’t expect their marksmanship to get better anytime soon, either. Data we’re familiar with suggests that conventional governmental forecasting is actually getting worse over time – not better.

Which makes us all the more suspicious of the $3.60 per gallon price point, particularly since it flies in the face of nearly everything we here at Money Morning know about global gasoline demand – which is accelerating dramatically even as long-term supplies are slowly being squeezed.

We’d love to say that’s a surprise, but there’s evidence of more government meddling here, too.

A Streetcar Named … Greed

Today, few investors remember the Great American Streetcar Scandal, but it helped set the fuel pinch we’re feeling today in motion decades ago. In case you’re not familiar with it, the scandal was a joint effort between General Motors Corp. (GM), Firestone Tire, Standard Oil Corp. and Phillips Petroleum (COP) to acquire streetcar systems nationwide … after which this anti-streetcar syndicate ripped out the municipal trolley systems in order to force the mass adoption of the automobile. This all took place between 1936 and 1950.

Long story short, GM was fined a whopping $5,000 and its executives charged $1 each for conspiracy, but the damage was done. Throw in the Interstate Highway System – which came into existence at about the same time, not coincidentally – and one can easily imagine the links between higher demand and bad decision making, even if only in retrospect.

Which brings us back to the present day…

Gasoline prices are indirectly tied to oil and, as such, the $3.60 line the government drew in the sand stands directly in the face of everything we know about "peak oil" and global demand.

Originally proposed by Shell Oil geophysicist M. King Hubbert in the 1950s, the concept of peak oil refers to the point in time when the maximum rate of petroleum production is reached, after which this production rate endures an irreversible decline.

Originally, it was a highly controversial theory. But in an era where we’re burning reserves four times faster than they’re being replaced by new discoveries, it’s increasingly being accepted as a reality. The sharper experts are no longer asking "if" we’re going to run out of oil; now they’re trying to predict "when."

It’s certainly a vexing question, and we don’t pretend to know the answer.

But we do know this: It’s likely to be sooner than the world thinks, if for no other reason than global demand is accelerating at a record pace at a time when worldwide inventories are generally declining.

That’s why investors can expect more days like Wednesday, when the disclosure that U.S. oil inventories were "lower than expected" torpedoed U.S. stock prices and sent oil futures soaring to a new intraday record of $112.21 a barrel.

The latest Energy Information Administration data suggests that world wide consumption will increase 37% by 2030, which puts demand at staggering 118 million barrels a day. For some perspective: Daily oil consumption in 2006 was 86 million barrels.

Not surprisingly, the lion’s share of new demand is coming from the developing world, with China and India leading the way. China, which imports 55% of its oil, is on track to double consumption within 10 years, while India is expected to triple its oil usage in the same period to more than 5 million barrels a day.

Where this gets really interesting is that any number of factors that would reduce supply don’t appear to be included in any of the generally accepted equations. For instance:

  • The growth rates in both China and India alone are fast enough and the countries large enough that they could potentially negate any savings we see in this country from higher prices.
  • Oil-exporting countries are becoming increasingly likely to "hold back" oil from the international export markets, opting to keep it at home literally to fuel domestic growth.
  • Several major oil suppliers – most notably Saudi Arabia – may not be accurately reporting their reserve capacity.

Which brings us full circle.

Why I Believe Oil Will Reach $187 a Barrel

I’ve been projecting energy prices for well over a decade. And I’ve always made sure to include all the potential catalysts in my forecasts. That’s why my projections have been on the mark.

Back in early 2002, when oil was trading at less than $20 a barrel, I conservatively predicted that oil prices would reach $100 a barrel within 10 years. As we now know, it happened in a shorter period than that.

Where do we go from here?

Late last year, when oil was trading in the range of $90 a barrel, I first publicly predicted that crude would trade as high as $187 a barrel in the next three years. In the middle of March, just days after I reiterated that prediction and provided some potential related investment opportunities in an edition of Money Morning, Wall Street giant Goldman Sachs Group Inc. (GS) issued a report predicting crude oil prices would reach $175 in the next few years.

Real pricing changes and the altered behavior that flows out of such stressful stretches can only take place when prices are high and when shortages become apparent. Without the benefit of all the information uncovered by such a volatile environment, forecasting can be a fool’s game.

As I’ve demonstrated, whenever I’ve made price projections, I’ve always made sure to factor in as many variables as possible. But it’s clear to me that the Energy Department did not do the same.

Therefore, as much as we’d love to believe that gasoline prices will stop their incredible ascent at $3.60 a gallon this spring, we can’t. Not only does the government’s price point seem to be little more than another guess in a long line of baseless predictions, it’s even contradicted by the saga that’s unfolding on the global economic stage.

Absent the introduction of proven alternatives to gasoline, we’re entering an era in which a pump price of $3.60 a gallon is going to be looked back on as a bargain.

And while it’s going to be a painful period, investors who view this as an opportunity may well find ways to take the sting out of escalating energy prices. Check out these Money Morning investment research reports:

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Why the President’s Push for Lower Oil Prices is Nothing But a Pipe Dream

Jan 16, 2008
Keith Fitz-Gerald, Main Essay, Oil, President George Bush

By Keith Fitz-Gerald
Investment Director
Money Morning/The Money Map Report

Every president has a defining moment when the American people, and indeed the world, recognize that he’s badly out of touch with some aspect of reality.

I can’t help but think that President George W. Bush ["Dubya"] has just had his moment as I watch him muddle around an unsympathetic Middle East this week, pushing for lower oil prices.

The market just isn’t going to let this happen.

Turning on the petroleum spigots as he’s requesting isn’t going to solve the problem. Indeed, we don’t even believe that a solution exists.

Here’s why.

The oil markets right now face a situation known as "backwardization." This theory holds the future prices of a commodity will tend to rise over the life of the contract. The upshot: Near-term contracts trade at a higher price than the longer-term contracts. With oil, that means that near-month delivery contracts are priced more expensively than distant-month contracts. When this happens, market sellers have every incentive to sell as much as they can as soon as they can to maximize profits, since they know that future prices will be lower.

What this suggests is that no matter how much pushing, prodding or – in this case – begging Bush does, the markets are still likely to push prices higher in search of profits. The Saudis will want to sell all the oil they can at the current high price, and will do nothing to risk sending prices lower.

That means: No production increase.

Let’s walk through an example to illustrate how this works.

The February 2008 oil contract closed Tuesday at $91.65 per barrel, while the December 2008 contract settled $2.90 a barrel lower, at $88.75. Accordingly, the markets are telling oil sellers that it’s better to sell oil now than it is to sell it later.

At the same time, however, the market also is telegraphing to buyers that they can risk purchasing later at lower prices. But – and here’s the important part – the discounted price could push far higher as the delivery month draws closer.

When the markets exist in this state, it is in the seller’s interest to sell as much oil as they can as soon as they can, which makes what Bush is asking all the more absurd.

In 2006, Saudi Arabia produced 10.72 million barrels of oil per day. For purposes of illustration, let’s assume they sell it for February delivery. At $91.65 a barrel, that sale would result in a staggering $982.5 million in revenue. If they waited and sold it at the December 2008 contract price of $88.75, they’d receive $31.1 million less per day, or $951.4 million for their efforts.

You can do the math as easily as we can. Over the course of a year, that would net out to an "opportunity loss" of $31.1 million a day, or a net revenue shortfall of $11.3 trillion per year if the Saudis elected to sell later.

This means that by asking the Saudis to increase production in an effort to lower oil prices, President Bush is effectively suggesting that they shoot themselves in the proverbial foot to the tune of trillions of dollars in lost revenue – which is why we think there’s a not a snowball’s chance in Hades that anything other than a short-term reprieve might be possible.

But, just to play devil’s advocate for a minute, let’s assume that the Saudis decided to play ball.

Could they?

We don’t think so.

The massive Golar oil field, along with many of their fields, is in decline, and anecdotal evidence suggests that the Saudis have already reached their peak. Not only are they pumping massive amounts of salt water into their oil fields to sustain production, they’re also drilling enough wells in the region to make it look like a giant piece of Swiss cheese from the air. Add in the fact that the Saudis haven’t had a major new discovery in half a century, and we have all the ingredients for still-higher-higher prices – and that’s assuming they actually have what they say they do in the way of reserves.

However, there’s an increasing body of evidence suggesting that the Saudis have falsified their reserve counts since the 1970s, a scenario that author Matthew R. Simmons outlined in his book, "Twilight in the Desert: The Coming Saudi Oil Shock and the World Economy."

We’ve been talking for years about how this reality would ignite upward pricing pressure in the petroleum markets, but the possibility that the Saudis might not have been telling the truth and may actually be unable to meet global demand is something that the masses have only recently started to consider.

And trust us, when they do, the fear that there may not be as much oil as previously thought will send it up to the high-$100 price point I’ve been predicting faster than you can blink. And the price may go even higher than that.

Then there’s the Organization of the Petroleum Exporting Countries (OPEC). The Saudis risk upsetting the apple cart if they move in a direction contrary to other decidedly anti-U.S. OPEC members who want prices as high as possible for as long as possible. Many people think of OPEC as one big happy family. But the truth is that it’s often no better than a den of thieves who would just as soon cut one another’s throat as cheat on production quotas in search of still more profits.

So the bottom line is that Bush can saber-dance his way through the Middle East all he wants, but his machinations are likely to be viewed within the context of history as too little, too late. Perhaps he could have done something about this the last time he met with Saudi’s King Abdullah, and oil was still at $50 a barrel.

But now that oil is north of $90… forget it.

The Saudis, like other OPEC nations, have gotten used to higher oil prices and the global wealth that goes with it. They’ve also finally figured out that oil can be as much a political weapon as it is an economic one. For them, controlling the petroleum flow is better than having an army to field when it comes to assuming a more-important place on the world stage.

That makes it even less likely that they’ll lower oil prices out of the goodness of their hearts.

And that spells higher oil prices for years to come… even if by some stroke of luck we actually do find that snowball in Hades, and get a temporary respite.

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Investors Will Benefit From New Plan to Have the United States and China Cooperate in Curbing Oil Speculation

Jan 10, 2008
China, Keith Fitz-Gerald, Main Essay, Oil

By Keith Fitz-Gerald
Investment Director
Money Morning/The Money Map Report

Here’s a headline investors probably never expected to see: The United States and China have agreed to cooperate on the management of the two countries’ strategic oil reserves.

We don’t know whether to find this story – first reported by China’s state-run Xinhua News Service – amusing, or downright terrifying.

So for now we will think logically about the possible reasons why such an unlikely alliance would be formed, and ponder what we should do about it.

Let’s talk about the why first.

Ostensibly, this agreement is about curbing oil speculation in the international markets. By including China, the consortium of international members who report their oil-reserve plans through the International Energy Agency in Paris, not only get a look at China’s current inventory, but also at that country’s potential future energy needs.

Considering it’s the United States that’s shepherding China through the admissions process, we suspect this is what’s really driving the agreement.

China’s growth is unprecedented. But as a Communist nation, its workings are all too often closed off to the rest of the world. Having international disclosure of China’s oil reserves and future stockpiling plans will theoretically provide advanced notice to other nations of higher oil prices in the event one or more nations makes a run on the markets.

Knowing how secretive Chinese traders can be – and the potential competitive advantages they are giving up in the interest of international cooperation – we’re more than a bit stunned over the prospects of a China that would be willing to disclose this information.

As for how we might use this agreement to create bigger profits in the years ahead, that’s a crucial point to consider.

Our sources suggest that China is slated to spend between $300 billion and $500 billion in the next five years on energy conservation and environmental protection equipment. And that’s in addition to the $1 trillion or more that nation already has apportioned to energy production and other petroleum-related matters. Therefore, any storage and demand figures can conceivably be utilized to develop better investment intelligence on where it plans to spend its money and in what order.

Indeed, now that the OPEC crowd has finally conceded that the global supply outlook for petroleum is nowhere near as serene as they’ve tried to have us believe for years, this kind of market intelligence becomes all the more valuable to investors.

And given that $300 billion to $500 billion represents nearly 30% of the total global market for such conservation and protection equipment, this could be a powerful indicator when it comes to future profits. With regard to energy production, that’s more of a wildcard. But since oil remains priced in U.S. dollars, the potential demand figures carry a highly correlated relationship to the strength – or weakness – of the greenback.

Moreover, given that much of this equipment – as well as China’s reserves – come from the United States, China’s participation in the IEA consortium could serve as important political antacid when it comes to reducing China’s trade surplus, which has been a major point of controversy in Washington.

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