Some time ago, while I was advising on a refinery project in Ecuador, I explained here in Oil & Energy Investor how China’s oil policy was evolving.
The country’s objective used to be controlling oil production abroad, with the aim of transporting that oil back home.
But in 2013, Ecuador, the smallest of the OPEC producers, learned the hard way that this objective had changed. After running out of money, both Ecuador and its national oil company had to rely on loans from China to stay afloat.
In return, Beijing gained control over the revenue flow from Ecuadorian oil exports. The oil was allowed to flow anywhere, as long as the proceeds went back to China (as loan repayments).
Now, several of my sources are telling me that China is about to unleash the next step in its plan to control the world’s oil markets.
Iran and Iraq Have Both Been Given a Free Pass by OPEC
Before we get to China, let me first give you some background.
Low oil prices are hitting hard at two of oil’s central players, both of which are expecting to ramp up production – Iraq and Iran.
While both Iraq and Iran are members of OPEC, neither one has had a monthly OPEC production quota for some time. Those quotas are supposed to determine how much oil each member exports to world markets.
It used to be that OPEC calculated expected global demand and then deducted non-OPEC production. What’s left was called the “call on OPEC,” and was divided among members as a monthly quota.
Of course, there is no way to prevent countries from exceeding those quotas. And the current environment of “every country for itself” has effectively rendered the quotas moot.
Iraq continues to suffer from internal political discord, as well as the threat of Daesh. That’s the more pejorative way of referring to the abhorrence that calls itself the “Islamic State” (or IS), and I refuse to even imply that these monsters have anything resembling sovereignty.
Meanwhile, Iran was until recently under Western sanctions and is intent on returning to its pre-sanction production and export levels, as you’ve seen here in Oil & Energy Investor before.
But Iran’s desired volume – in excess of 4 million barrels a day – will probably be reached as early as June, just in time for the next meeting on capping global production, this one to be held in Moscow.
But those levels cannot be sustained, because of Iran’s significant internal problems in both fields and infrastructure.
Both Baghdad and Tehran require large amounts of investment to overcome growing production crises that will test their ability to obtain the export revenues they both need. But this investment is slow in coming. For Iraq, the upfront problems remain security and political instability – companies are worried that the production goals will be undermined by political discord.
This latter point deserves more emphasis than it has received in the West.
Daesh can never control – or even attack – the primary oil fields in Iraq’s Shiite-dominated south. But by putting pressure on a beleaguered government in Baghdad, they nonetheless accomplish the same objective: they paralyze the central administration, halting attempts to ramp up oil production.
OPEC has given both Iraq and Iran a multi-year delay in the enforcement of oil export quotas. In the current climate of excessive production, the quotas have not been applied.
But they will return in short order, especially if a production freeze is reached at the June meeting in Moscow.
However, the problem for both Iraq and Iran is arising from within…
Both Countries are in Desperate Need of Western Oil Expertise
Low oil prices have produced long delays in payments to providers of field services. In the case of Iraq, that problem is now also affecting the international oil company (IOC) majors running the oil fields.
In the case of Iran, sanctions have prevented foreign involvement – banning the Western technology and expertise Iran needs to keep its oil infrastructure from collapsing. Replacing Western companies with Chinese and even Russian field operators has been a disaster. Virtually all production in Iran is now done using domestic field services. That results in inferior, and sometimes nonexistent, work.
A deeper issue is the way both countries give out contracts. In Iraq, outside companies are provided a fixed payment per barrel extracted above a contracted target amount. The result is more properly to be regarded as a field service contract.
Meanwhile, in Iran the constitution and the law prohibit outsiders from owning either land or raw materials inside the country. This means that foreign companies must operate under very bulky and time-consuming buy-back contracts – in which a company is paid in produced oil according to fixed costs and prices negotiated at the beginning.
In neither case does the resulting contract approach anything resembling a joint venture. That means that
- the fields remain under the ownership of Iraqi and Iranian national oil companies;
- international oil majors (IOCs) cannot place any portion of these oil reserves on their own books.
Both countries have been searching for ways to make the investment more attractive. As you’ve read here before, Tehran has scheduled London meetings with financial sources on three recent occasions, only to have to cancel each time because there was no political consensus back home.
All of this has led to a significant new development – and a new opportunity for China…
This New Financing Approach is Opening the Gates for the Chinese
Baghdad has proposed paying its past due bills with currency bonds rather than cash. The Iraqi Finance Ministry has already begin deploying the paper in the face of an expanding 8%+ budget deficit. These bonds can be traded on the local market, and either cashed in at a discount or used at face value as collateral on loans.
Another approach now under development will apply these bonds to arrearages owed to IOCs. One idea is to use the value of oil reserves in the ground as collateral for these bonds.
It is a move that the IOCs might actually prefer, since it would give them at least some ability to “book” reserve values, albeit indirectly (through the face value of the bonds).
Iran already plays the game of “you pretend to work and we pretend to pay you” with its all-domestic service providers. But Tehran is now considering this bond approach as a possible way of bringing in foreign providers while at the same time avoiding any violations of local “ownership” restrictions.
What would really jumpstart this payment-in-bonds approach would be the ability to utilize the paper in broader local markets, both attracting some value in secondary trading and allowing the face value to work in broader collateral and trading situations. For that to happen, international banks must act as either guarantors of the paper or, in the case of additional issuances, as book runners for the placements.
Here is where the terrain may shift in a seismic way.
Word from several of my sources indicate that Chinese banks (with, of course, the official backing of the government in Beijing) may step in to provide these services.
The move would increase China’s presence in the oil sector on both sides of the Shatt al-Arab (the river separating Iraq and Iran), fund additional Chinese oil imports without actually shelling out hard currency, and take the next step in China’s increasingly sophisticated approach to other people’s oil: gain control over the financing of oil production in both Iran and Iraq.
Chinese national oil companies are already working on entering both the Iraqi and Iranian markets. But the Iraqi-Iranian bond approach will allow China to move ahead one more step in its plan.
Years ago, China would simply buy oil abroad and bring it home. Then, as in Ecuador, it acquired revenues from oil sales in international markets. Now, China wants to gain control over the financing of oil production in other countries.
And it looks like it’s going to work…
This may take geopolitics in the oil sector to a whole new level.
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