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Eurasia Group Global Trends Quarterly

Free Markets Versus State Capitalismin Oil and Gas

eurasia groupDefining the Business of Politic

Executive summary

Over the last decade, state-owned national oil companies (NOCs) have become

increasingly important in the global oil and gas sectors. Their rise is also a key part of

the trend toward state capitalism in many emerging markets. While NOCs generally

lack capacity in some of the industry’s cutting-edge technologies, in many cases

they have the advantages of low-cost capital from state-controlled banks and strong

backing from their home governments. This environment challenges the dominance of

privately held Western international oil companies, but presents opportunities for these

firms to partner with NOCs on projects of mutual interest.

Second Quarter 2012


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1 eurasia groupDefining the Business of Politic

Second Quarter 2012

OverviewOver the last decade, state-owned national oil compa-nies (NOCs) have become increasingly important in theglobal oil and gas sectors. Teir rise is also a key part of thetrend toward state capitalism in many emerging markets(EMs). Several NOCs have become top-tier competitorsin the acquisition and development of new hydrocarbonsreserves. While NOCs generally lack capacity in some ofthe industry’s cutting-edge technologies, in many cases theyhave the advantages of low-cost capital from state-controlledbanks and strong diplomatic backing from their home gov-ernments. Tis environment challenges the dominance of

privately held Western international oil companies (IOCs),but presents opportunities for these IOCs to partner withNOCs on projects of mutual interest. Te industry willtherefore feature an increasingly complex mix of competi-tion and cooperation between IOCs and NOCs.

Analysis

NOCs expand their overseas natural resource acquisitions

Te reasons for NOCs to expand beyond their home mar-

kets and compete with IOCs vary. Some NOCs are drivenby domestic energy security policies that prioritize owningand controlling natural resources abroad. Te main ChineseNOCs, CNPC/PetroChina, Sinopec, and the China NationalOffshore Oil Corporation (CNOOC), are good examples ofthis. Other NOCs, such as Malaysia’s Petronas, were focusedon developing resource reserves in their home markets, buthave been compelled to seek opportunities elsewhere due todeclining production and limited prospects at home.

Many of the competitive advantages that NOCs enjoyderive from relatively easy access to capital from state-controlled nancial institutions that governments have

directed to support overseas acquisitions to meet nationalenergy security goals. Te Chinese NOCs are the stron-gest nancially, but they are hardly alone in benettingfrom state-backed capital. Tis support does not meanthat NOCs are indifferent to good returns on capital orare systematically overpaying for assets, but they are moretolerant of risk than many IOCs would be.

Oil

In the oil sector, state nancing has been crucial, as hasthe ability of NOCs to carry out relatively simple techno-logical projects using lower-cost labor and supply chains.In buying up key assets, CNPC has beneted hand-ily from its access to nancing from state-owned banks;

while CNPC does not always overpay for assets, it doessometimes try to outbid rivals for strategic investments.CNPC’s access to state-backed nancing was particularlyhelpful in its acquisition of the Athabasca oil sands stake inearly 2009. At the time, Western rivals were mired in thedepths of the global nancial crisis and had limited accessto both credit and bond-market nancing. Tis pattern islikely to continue, with China’s inherent nancial strengthenabling CNPC to be more aggressive than its rivals inacquiring assets and taking on higher-risk projects. China’s$20 billion in soft loans to Venezuela in 2010 is anotherexample: Te loans made Chinese NOCs’ bids for assets inthe Orinoco heavy-oil belt more competitive.

On the cost advantage side of the equation, a goodexample is the Rumaila oileld redevelopment project inIraq, where CNPC has a 29% stake. Despite the fact thatBP is the operator, CNPC actually has a much larger staff,and the project relies overwhelmingly on CNPC’s supply

chain, which sources equipment from low-cost CNPC-affiliated suppliers of the relatively low-tech equipmentneeded for the project.

In a few cases, though, the wealth of opportunities athome has discouraged NOCs from venturing abroad, asthey look to secure privileged spots in their home marketsinstead. A prime example of this is Petrobras: Brasilia re-cently gave the company the right to be sole operator of newacreage awarded in Brazil’s deepwater pre-salt offshore elds.aking on this role has stretched Petrobras’s capabilities,causing it to pull back from much of its overseas activity.

Gas

China’s NOCs have made signicant investments in overseasgas markets and will continue to do so. Tis push, which isdriven mainly by technology and knowledge acquisition,has been showcased in the North American gas plays. In2010 alone, Chinese NOCs invested $10 billion in naturalresources abroad, more than half of which involved oil sandsand shale gas reserves in Canada. China’s sovereign wealth


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2011, to shore up the country’s energy security. Of the totalamount, Kogas will invest $7.8 billion, and the companysaid in January that it will invest $3 billion of that amount

in overseas LNG projects. Kogas sold 33.57 million tons ofLNG at home last year, up 7.6% from 2010. Te companyalready has gas and LNG assets in exploration and produc-tion in Qatar, Oman, Yemen, Australia, and Indonesia, andis involved in major projects in Iraq and Mozambique thatcould translate into future LNG supply. US LNG exports

will reinforce Kogas’s sourcing diversication. Indeed, withSouth Korea poised for free trade with the US, Kogas willbe able to buy US LNG from planned projects that havereceived export licenses from the US Department of Energyfor exports to FA nations.

In reaction to these state-owned companies locking upsupplies with state funds, the Japanese government is struc-turing a new natural resource acquisition strategy that willallocate funds to the country’s utilities in order to enhancesupply security and compete with foreign NOCs. Acquiringcheaper, more secure gas supplies will depend on two pillars:

increasing competition within Japan’s domestic gas marketand encouraging Japanese offtakers to form consortia to buyupstream equity in LNG liquefactions projects abroad. Te

government is ready to double its assistance budget to inducecompanies to buy equity stakes in export projects. In this way,

Japanese companies will be able to insert themselves through-out the supply chain—from production to consumption—thereby boosting supply security and increasing exibilityin volume and destination. Beyond the LNG projects that

Japanese trading and production companies already partici-pate in, Japanese utilities will become increasingly involvedin new projects to bring supply back home. Planned invest-ments include Nigeria’s Brass LNG, for which LNG Japan,Itochu Corporation, and Sojitz Corporation might arrange aloan in exchange for equity shares. Another promising project

is Kitimat LNG in Canada’s British Columbia, for which the Japanese trading house Mitsubishi has teamed up with Shell. And a consortium of Japanese companies called Japan FarEast Gas—including Japan Petroleum Exploration, Itochu,Marubeni, Inpex and Itochu Oil Exploration—will buy eq-uity and capacity in Russia’s planned Vladivostok LNG proj-

Japan’s investments in planned LNG projects

Country Project Status Shareholders/Japanese companies

TotalJapanese

participation Venezuela Delta Caribe on hold Itochu, MIMI (Japan Australia LNG is a 50-50 joint

venture between Mitsubishi and Mitsui)NA

Nigeria Brass LNG FID expectedin 2012

Japanese companies could help financing byarranging a loan in exchange of equity shares (LNGJapan (4%), Itochu Corporation (3%) and SojitzCorporation)

7%

Indonesia Donggi-SenoroLNG, Sulawesi

FID taken in Jan.2011, start-upexpected in 2014

Sulawesi LNG Development 59.9% (joint venturebetween Mitsubishi 75% and Kogas 25%)

50%

Abadi LNG start-up 2016 Inpex (60%) 60%

Papua New Guinea PNG LNG start-up 2014 JX Nippon Oil & Gas Explorat ion

Australia Gorgon LNG start-up 2014 Osaka Gas (1.25%), Tokyo Gas (1%), Chubu Electric(0.417%)

2.67%

Pluto LNG 2012 Kansai Electric (5%) Tokyo Gas (5%) 10%

Ichtys LNG Inpex (76%) 76%

Canada KM LNG 2017 Mitsubishi NA

Russia Vladivostok LNG 2017 Japan Far East Gas Co (a joint venture betweenJapan Petroleum Exploration Co. (32.5%), Itochu(32.5%), Marubeni (20%), Inpex (10%) and by ItochuOil Exploration Co. (5%))

NA

Mozambique Mozambique LNG Mitsui (20%) 20%

Source: Eurasia Group Research


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ect. In Mozambique, meanwhile, Mitsui is partnering with

Anadarko to develop an LNG venture and potentially ship 5million tons of LNG back to Japan.

Forming alliances between IOCs andNOCs to increase technology transfers

In addition to their nancial strength, many of the NOCsseeking to expand internationally hope catch up with theIOCs’ technological prowess. Tis desire has driven severalNOCs to set their sights on projects that provide accessto key technologies, which presents both opportunitiesand challenges for the IOCs: NOCs can be key sources ofcapital and risk-sharing, but may also become more tech-nologically competitive over the long term, particularly inunconventional oil and gas. Indeed, in some cases, IOC-NOC partnerships allow the NOC to gain experience

with unconventional oil and gas or deepwater production.In some other cases, NOCs grant IOCs access to home-market exploration, acreage, or reserves that the NOCs donot have the capacity to develop themselves, in exchangefor technology transfers.

Oil

Te largest number of these partnerships has involvedNOC capital owing into backing projects, which requireIOC expertise in unconventional oil, or NOCs paying toacquire a major stake in such projects once they are pro-ducing. Chinese NOCs have made extensive acquisitionsin recent years, motivated by technology acquisitions morethan concerns about energy security. CNPC and Sinopechave both bought major stakes in oil sands projects in Al-berta that offer experience in heavy-oil extraction. CNPC’s2010 acquisition of acreage in Venezuela’s Junin-4 block,

which is due to begin producing this year, marks the be-ginning of CNPC’s ability to apply steam-assisted gravity

drainage (SAGD) technology independently. As noted,CNPC was aided in its bid for the acreage by soft loansfrom Beijing—an important advantage.

Sinopec and CNOOC have been by far the most activeNOCs in pursuing deepwater expertise, initially by acquir-ing minority stakes in overseas projects. Sinopec has extensiveinterests in deepwater offshore projects in Angola and Brazil,for example. And Beijing’s provision of loans to Petrobras tosupport the company’s ambitious investment program was,

again, an important competitive advantage for Sinopec; the

company obtained contractual provisions committing Petro-bras to extensive deepwater technology transfers.

One example of a technology-driven strategic allianceowing in the opposite direction is the strategic partner-ship and equity-swap deal that Russia’s Rosneft and Exx-onMobil announced in August 2011. In this case, the Rus-sian side offered access to reserves it could not develop byitself, particularly in the Arctic, in exchange for technologytransfers. While the long-term focus is squarely on explo-ration of the Russian Arctic, in the short term, Rosneft

will benet from technologies that enable it to attenuatethe decline rates at mature onshore elds, a key concernfor the company. Trough the new partnership, Rosneft

will be able to reduce its spending on service providerssuch as Schlumberger for browneld work. Accordingto company data, omskneft, one of Rosneft’s three coreproducing subsidiaries in Western Siberia, has four elds

with a water cut of 80%. Russian insiders believe that 7.5billion barrels of additional reserves can be accessed usingexisting technology.

Gas

Gas developments and export projects to unlock untapped

resources will increasingly be located in unfriendly envi-ronments with harsh weather (such as the extreme coldof the Barents Sea, the Arctic, and Siberia), challengingtechnological requirements (for deep offshore and un-conventional resources), or unsafe surroundings (due to

wars and terrorist attacks on facilities and personnel). Asa result, successful partnerships between IOCs and NOCs

will be critical to unlocking those new energy supplies, byapplying breakthrough technologies and effectively man-aging safety and environmental risks.

As in the oil sector, there are several cases of technology-

driven strategic alliances in the gas sector. Russia’s plannedShtokman project, with reserves in the Barents Sea and well within the Arctic, is a joint venture of Gazprom, o-tal, and Statoil. otal has been producing LNG offshore atSnohvit in the Barents Sea, and the group has operationsin cold regions of Kazakhstan and Canada as well, givingit experience with very low temperatures (below negative50 degrees Celsius), logistics in remote sites (includingovercoming storms and icebergs), and difficult-to-exploitresources. otal has also joined the Novatek-led Yamal


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LNG project in Russia’s Western Siberia, with a 20%stake. Although Novatek is an independent gas producer,it is backed by the Kremlin and benets from special tax

treatment. Tis partnership will benet from the com-bined experience and technology of the two companies.

Te traditional equal partnership framework for IOC-NOC ventures needs to be revisited, however, as demon-strated by the failed cooperation in 2008 between BP andNK-BP in Russia (differing interests between the Westernand Russian partners led to disputes over corporate gov-ernance). Te host country also needs to offer sufficientrisk-reward opportunities and a predictable regulatory en-vironment in order to satisfy investors. One illustration ofa fruitful partnership is that between Qatar’s state-ownedcompanies (Qatar Petroleum, RasGas, and Qatargas) andExxonMobil. By participating in two Qatargas joint ven-tures and three RasGas joint ventures, ExxonMobil hassecured interests in 12 liquefaction trains. Tis partnershipis the result of a welcoming business climate, as well as poli-cies established by Qatari government that make it possiblefor investors, scientists, and engineers to collaborate andexecute capital- and technology-intensive projects.

Another accelerating trend in IOC-NOC cooperationis partnerships in third countries as a result of decliningresources in NOC home countries and their need for

technology transfers. Petronas, which has historically beena large gas producer, is considering importing gas intoMalaysia as output from its aging elds declines and do-mestic demand for power generation rises. Te companyis hoping to secure LNG imports by building import in-frastructure at home and forging long-term supply agree-ments overseas; it is investing in upstream gas ventures allaround the world, including Canada, Mozambique, and

Australia, where Petronas is part of the GLNG joint ven-ture along with Santos, otal, and Kogas to develop theGladstone LNG project. (First gas is expected to come online in 2015.)


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Photo credit: Reuters

This material was produced by Eurasia Group in collaboration with PricewaterhouseCoopers. This is intended as general background research and is not intended to

constitute advice on any particular commercial investment or trade matter or issue and should not be relied upon for such purposes. © 2012 Eurasia Group

Second Quarter 2012

Business implications

NOCs are trying to catch up withIOCs technologically, and many are thereforefocusing on projects that will give them access tokey technologies—particularly horizontal drillingand hydraulic fracturing—in order to developunconventional resources at home. Despite ChineseNOCs’ aggressive acquisitions of overseas stakes toincrease their exposure to unconventional plays,Beijing remains concerned about its NOCs’ capacityfor innovation. And these rms’ ability to digestforeign technology could be limited by Western

service providers’ concerns about intellectualproperty rights. Indeed, IOCs may have reasonto worry that the trend toward technologicallysophisticated NOCs could render IOCs’ competitiveadvantages less relevant.

Tere is a growing risk that IOCs couldbe sidelined by increasingly technologically savvyoil service companies as demand for the latter’sservices grow. NOCs are asking oil service rmsto provide many of the services traditionally

supplied by IOCs. One of the competitiveadvantages that oil service companies enjoy is thesimple nature of their partnerships with NOCs:Te NOCs remain in full control of their reserves.(In contrast to oil service companies, IOCs arekeen to hold reserves to support their share-pricevaluations.) Tat said, oil service companies areinsufficient substitutes for IOCs on high-riskprojects, given IOCs’ experience with capital-intensive and technologically challenging ventures.

o ship LNG out ofthe recently planned Arctic LNG projects (in Alaska,Canada, and Russia), a new type of icebreaker thatcan resist multi-year sea ice will have to be built,and the shipping industry is gearing up to meetthe challenge. For example, South Korea’s SamsungHeavy Industries has built three icebreakers ableto endure 1.5 meters of ice for Russia’s Sovcomotshipping company, which used them to ship oilfrom Lukoil’s Varandey terminal on the shores of thePechora Sea to Murmansk, from where the oil is sentto international markets.

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