Forming a comprehensive energy partnership with Beijing – helping the government meet its economic, energy and environmental requirements – is the best strategy for investment in China, says Boston Consulting Group*
OVER the last decade, international energy companies have marvelled at China's economic growth. Many have developed entry strategies in an attempt to benefit from rapidly rising industrial and consumer demand, only to see the Chinese government counter with restrictive regulations. As a result, most businesses have experienced disappointing financial returns and early investors have absorbed significant losses. Investments based on a better understanding of the country's energy-policy challenges may lead to more profitable projects both for China and for its potential investors.
China's rapid industrial development has created an insatiable appetite for all types of energy. To continue this growth, China must increase its imports of crude oil, refined products, petrochemicals, coal and natural gas; it must also make large capacity additions in refining, chemicals production and power generation. At the same time, the government must balance competing demands: it must secure energy supply from diverse sources; attract foreign investment and technology; improve energy affordability and efficiency; and protect the environment.
Recently, many energy companies have evaluated opportunities in China on the basis of the economics of a single project, hoping to negotiate favourable terms with the government. But this approach has often led to disappointing results. BCG's research suggests a comprehensive energy partnership – one that helps the government meet its economic, energy and environmental challenges – is likely to yield better results and may afford companies advantageous competitive positions.
Since 1980, China has achieved the fastest economic growth the modern world has ever witnessed, averaging a 10% compound annual growth rate for real GDP and a more than sevenfold increase in disposable income. This growth has been fuelled by exports of labour-intensive finished goods that are produced from domestic and imported raw materials such as petrochemicals feedstocks. The growth has been concentrated in the country's eastern provinces, where there is abundant low-cost, skilled labour and easy access to export facilities.
Rapid industrial growth, increasing disposable income and the advantages of low-cost country sourcing have attracted interest from around the world. Many companies from a variety of industries have invested in China hoping to gain a competitive advantage from low-cost labour, whereas others have banked on the growth of domestic consumer retail industries as the Chinese increase their standard of living. Most international companies have evaluated strategies to capitalise on the China opportunity as either a source of labour, as a market, or both.
The Chinese government is facing economic, environmental and energy issues that have caused it to impose internal price controls and strict regulations on foreign investments.
When it comes to economic issues, the government is carefully subsidising energy prices to ensure sustained economic growth. Disposable income in China's industrial east is $3,600 a year compared with only $400 a year in the agrarian west. This disparity has the potential to create social unrest and encourages the government to pursue policies that hold down domestic prices of energy and staples to ensure the economy grows and new job creation continues. Social disruption and riots have increased in China over the last 10 years, but the government continues to rely on economic prosperity as the glue holding the social fabric together.
The government is also struggling to solve the serious environmental problems associated with growth. The increasing use of cars and the resultant pollution is a case in point. Air and water quality are significant problems and these will be exacerbated by the creation of new refineries, chemicals plants and coal-fired generation facilities. Of the 20 most polluted cities worldwide, 16 are in China.
Towards energy self-sufficiency
The biggest problem China faces, however, is energy self-sufficiency. The government is concerned about the security and diversity of energy supply. Restrictions on the growth of imports and bids for foreign supply have had limited success. Tight regulatory controls on foreign energy investments have three dimensions:
- Ownership restrictions on exploration and production (E&P), refinery and wholesale investments require that foreign companies undertake joint ventures with national oil companies (NOCs);
- Quotas limiting or controlling imports of crude and refined oil products apply only to non-state importers and are announced annually by the National Development and Reform Commission (NDRC); and
- Price regulation of both wholesale and retail prices of refined products permits domestic industries to grow even when crude prices are high.
These regulatory policies are designed to protect domestic industries and to ensure continued economic growth and job creation. For example, when the price of international crude rises, the government regulates prices to protect domestic industry. As a result, only conventional E&P, export-oriented petrochemicals ventures and compressed natural gas (CNG) are truly attractive investments for international oil companies (IOCs). Refining, some petrochemical products and most retail businesses are not attractive investments during times of high energy prices.
China's economic growth is being threatened by an energy shortage and the country has begun to rely on imports to meet the supply gap. China began importing crude in the mid-1990s and imports have grown at 15% a year since 2001 (see Figure 1). Although reserves additions are reported to have averaged about 1bn barrels during this period, domestic production has remained steady at about 3.4m barrels a day.
This gap is compounded because almost all of China's refining capacity has been designed to run heavy, very sweet crude oil, which is rapidly declining in production in the region. As a result, China has been forced to import large and increasing quantities of sweet west African crude at a substantial price premium. In 2004, imports met around 40% of demand; by 2015, they are expected to top 50%.
Gas imports in the form of liquefied natural gas (LNG) are also growing. Gas accounted for about 4bn cubic feet a day of total energy consumption in 2004 and gas demand is expected to triple by 2015 (see Figure 2). Imports will probably meet around 25% of this projected demand. Electricity is also in short supply. In 2004, the power supply gap was 130 terawatt hours (TWh). At present growth rates, this supply gap is expected to widen to about 800 TWh by 2015 (see Figure 3).
To reduce dependence on imports and to ensure reliable supply, Chinese NOCs have tried, with limited success, to acquire international reserves and to create joint ventures with resource holders. Acquisition efforts have fallen short of expectations, however, and China is also overpaying for overseas reserves. Several recent efforts to acquire E&P rights have been unsuccessful, including:
- Attempted acquisition of Unocal. In 2005, China National Offshore Oil Corporation (CNOOC) made an $18.5bn bid for Unocal and was forced to withdraw under political pressure from the US, which feared such a deal could threaten national security;
- Loss of Talisman Energy's stake in Sudan's Greater Nile Petroleum Oil Company (GNPOC). In 2003, China National Petroleum Corporation (CNPC) waived its shareholder pre-emption right after being outbid by India's Oil and Natural Gas Corporation (ONGC), which acquired Talisman's 25% stake in GNPOC for $0.72bn; and
- Loss of stake in Kazakhtan's Kashagan oilfield. In 2003, CNOOC and Sinopec attempted to buy an 8.3% stake in the Kashagan oilfield from BG Group, but BG's partners pre-empted the deal and exercised their rights to buy the stake.
Recent deals in which China overpaid for reserves include:
- PetroKazakhstan (PK) acquisition. In 2005, PetroChina bought PK with a bid of $4.18bn ($55 a share) – about 20% higher than PK's market value of $3.4bn;
- Shell Angola stake. In 2004, CNPC beat off competition from ONGC to buy Shell's 50% stake in Angola's offshore Block 18, paying $0.62bn, coupled with a $2bn aid offer; and
- Sudan acquisition. In 2003, CNPC acquired Block 3 in Sudan at a price that was 17% higher than ONGC had offered.
The potential solution
The government will have to look to foreign investment, technology and capabilities to ensure there is sufficient energy to fuel economic growth. Investors that continue the traditional approach of negotiating a single energy project will probably fail. However, a comprehensive approach that helps the Chinese government solve energy-policy issues is likely to generate superior returns and to provide companies with access to all parts of the energy-value chain. Some examples from the cement, airline and refining industries serve as a guide to this approach:
Cement-Manufacturing Joint Venture – in Sichuan, the joint venture, which was initiated in 2000 with a large European cement manufacturer, constitutes the largest foreign direct investment in western China. It was designed to develop China's vast but forgotten western provinces, address China's cement-supply shortage and uncompetitive domestic manufacturing, boost manufacturing efficiency and improve environmental protection in the industry. The result was an exclusive contract between the international cement manufacturer and the Yunnan government.
Refining and petrochemicals joint venture – an international oil company partnered with Sinopec and Saudi Aramco in this venture. The project included a long-term crude-oil supply contract from Aramco that helped China address its policy goal of a secure energy supply. The venture was also designed to transfer technology and expertise so that China could increase efficiency through improved refinery operations. To offset losses that would be incurred if it had to sell at the prices set by Chinese regulators, the international oil company got the right to sell at import parity – at world market prices. Initially, the import parity agreement was for the lifetime of the project, but with oil prices above $70 per barrel, the terms were shortened to three years. Even so, over the life of the project, overall returns to the international oil company are projected to be significantly above the cost of capital.
Single-aisle aircraft – an international aircraft manufacturer set up the first large-scale foreign aircraft-manufacturing plant in China and committed to buying more than $200m-worth of spare parts per year in China. The venture will alleviate the shortage of adequate transportation in China; support passenger and cargo growth of 10% and 30% a year, respectively; and boost the local economy through large-scale foreign direct investment and job creation. With its win of an order for 150 planes, the aircraft manufacturer has secured more than $10bn in sales.
You scratch my back
Major oil companies and large international utilities are best equipped to help China, given their capabilities across the energy value chain and their ability to invest in large, capital-intensive projects. The overriding issue for China is securing a reliable supply of crude oil and refined products.
Therefore, all large energy deals that are approved will probably involve the provision of assistance to improve the efficiency of domestic E&P operations, the development of unconventional resources, such as shale oil and tar sands, and LNG and refinery expansions. Investments such as these will help solve China's energy-policy problems and may be attractive to oil companies if they are granted special economic terms by the government.
China has large reserves of unconventional resources that could be developed domestically with technology and investment from major oil companies. Several E&P projects and the associated refinery capacity needed to convert the shale oil and tar sands into refined products would reduce crude and products imports, while bolstering supply security. Unconventional reserves are 16 times greater than traditional reserves. If these unconventional reserves of tar sands and shale oil are developed, they could produce as much as 1.8m b/d of crude oil by 2015.
Improvements in traditional E&P could also help to reduce imports. In 2004, only 6% of China's crude production involved IOCs. But recent technology-sharing contracts with IOCs have resulted in marked improvements per well compared with production by NOCs alone. Well productivity could be improved by as much as 61%, which could be worth up to 2m b/d to China.
In return for helping solve China's energy-policy issues, international energy firms could negotiate terms that rival returns in other parts of the world and receive privileged access to other parts of the value chain where China's growth will lead to profitable businesses.n