Keily Miller
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on : Tuesday, 14 May, 2013
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The Trouble with the B–B Axis

When it comes to oil, Beijing and Baghdad are best friends—for now

With China stepping in to fill the vacuum left by IOCs moving north to Kurdistan, Iraq is left vulnerable to China's inefficient domestic energy market and the fledgling development of its massive shale gas reserves.

China's Jiang Jemin (L), CEO of CNPC, shakes hands with Dia Jaafar, the head of the Iraqi South Oil Company, as Iraq's oil minister Hussein Al-Shahristani (R) and Britain's BP head Tony Hayward (C) stand by following the signing of an oil deal in Baghdad on November 3, 2009. (AHMAD AL-RUBAYE/AFP/Getty Images)

China’s Jiang Jemin (L), CEO of CNPC, shakes hands with Dia Jaafar, the head of the Iraqi South Oil Company, as Iraq’s oil minister Hussein Al-Shahristani (R) and Britain’s BP head Tony Hayward (C) stand by following the signing of an oil deal in Baghdad on November 3, 2009. (AHMAD AL-RUBAYE/AFP/Getty Images)

The fight for Iraqi oil is a story smugly told. Countless observers have remarked on the irony of Western firms’ withdrawal from southern Iraqi oil fields and the flurry of new contracts between Baghdad and Beijing, in what International Energy Agency chief economist Fatih Birol termed “the B–B axis.” Chinese producers from the China National Petroleum Corporation (CNPC), the Chinese National Offshore Oil Corporation (CNOOC), and the China Petrochemical Corporation (Sinopec) have snatched up a giant stake in Iraqi oil fields since Iraq first opened its markets to foreign companies in 2009. (The largest surge of Chinese national oil companies came on the heels of Beijing’s Libya and Angola crises.) With megaprojects in oil fields including Halfaya, with 4.1 billion barrels in reserves, and Rumaila, with 17 billion barrels in reserves, Chinese oil firms have forced their way to the top of Iraq’s oil project index.

China’s growing presence in federal Iraqi oilfields seems to coincide with a movement by international oil companies (IOCs) to move their oil activities northward to Kurdistan. Exxon Mobile and nationally owned CNPC have been in negotiations after Exxon disclosed that it was prepared to sell a portion, if not all, of its 60% stake in major oil field West Qurna 1. The acquisition would give China around half of the total number of contracts awarded to international oil companies for currently producing fields in federal Iraq, marking a new chapter in the Sino–Iraqi relationship. But in Kurdistan, as one Marathon Oil executive put it, “China is completely irrelevant—for now….”

The recent wave of mergers and acquisitions in Iraqi and Kurdish fields is hardly surprising from a commercial standpoint. The ‘going global’ tactic has become fairly standard over the last decade, as corporate- and government-backed entities sitting on dollar mountains have discovered their own vulnerability in the face of currency fluctuations. But China’s way of ‘going global’ is too often misunderstood. When it comes to the activities of its oil companies overseas, the frequent allegations of coddling dictators while targeting the assets of the developing world—the ‘owning Africa’ and ‘owning OPEC’ policies—are entirely unfounded. Despite conspiratorial whispers of political maneuvering from Beijing and balance of power jockeying, the profit-maximizing behavior of US and European firms with a hankering for high-risk exploration rests on precisely the same tactic as Chinese oil companies: asset diversification.

And for this reason, Birol’s B–B axis stands on shaky ground. Without question, Chinese participation in over 50% of Iraq’s oil fields falls in line with a national strategy that includes government stimulus to encourage projects that promote Chinese labor, technologies, and capital abroad; mitigate future domestic shortages through participation in global resource projects; and import innovative technologies and international best practice. And as far as mergers and acquisitions are concerned, Beijing’s interest in strengthening international competitiveness of Chinese firms presents adequate incentive to accelerate (through subsidies or otherwise) their entry into foreign markets. After that, their interests split.

Business as usual

The strategic choices international and national oil companies make in developing their asset portfolio are often distinct. Chinese national oil companies (NOCs) in Iraq fall into a pattern of behavior typical of experienced NOCs competing abroad, as acquisitions such as Sinopec’s acquisition of Addax Petroleum or the China National Offshore Oil Corporations’s majority stake in the Missan Oil Company illustrate. In terms of the legal framework, national companies with experience in developing fields overseas tend to prefer the technical operator–contractor model—often, as in federal Iraq, in the form of a technical service contract in which the IOC provides a defined set of services for a predetermined period of time, in exchange for a fixed fee per barrel produced. IOCs tend to prefer production-sharing agreements, which broadly provide for the sharing of oil produced in predefined proportions. In terms of asset characteristics, NOCs tend go after large, maturing oil fields, steering clear of the highly complex niche fields that have taken up an increasing portion of new projects among large IOCs, and for which most NOCs simply do not have the technology.

This type of behavior relates more to firm structure, cost of capital, and technical expertise than geopolitical influence or incentives for non-commercial gain. NOCs have the access to low-interest capital necessary to finance for the competitive terms they offer. Front-loaded costs under a technical service model tend to far exceed the costs under a production-sharing agreement, since in the first scenario a price-per-barrel fee is included in the terms of the contract and calculated based on a pre-determined plateau rate of production. This type of arrangement incentivizes the negotiating firms to set higher plateau rates, raising initial costs but inflating remuneration fees throughout the project’s two-decade lifespan.

There are several other implications of this type of contract that illuminate why Baghdad’s technical service contract model holds more appeal for NOCs than the high-risk, high-reward production-sharing agreements that Kurdistan’s exploration projects offer. For one, the pre-arranged fee per barrel shields the contractor from oil price volatility—a key concern for NOCs that have to consider currency switching. Secondly, NOCs often have the financial means to offer lower fees and higher project expenditures, including investments in midstream—transport, storage and delivery to market—and downstream activities such as refining. As a result, in projects where feasibility does not depend on innovative, cutting-edge technologies, these types of firms can consistently outbid IOCs. When the world’s largest oil companies are involved in megaprojects, their primary mechanism for market entry is therefore through a joint venture with an NOC, as is the case in the CNOOC–TPAO (Turkish Petroleum Corporation) joint venture at the Missan oil fields, or the pending Eni-CNPC and Exxon-CNPC mergers at Nasiriyah and West Qurna 1 respectively.

Finally, there is the strikingly overlooked issue of production ownership. If resource control were the issue at stake for China, risk-seeking Chinese NOCs would almost certainly be targeting the vast resources of Kurdistan and the production-sharing agreements it offers, where a percentage of the equity is actually controlled by the operating firm. Yet Chinese firms have shown little interest either in controlling oil production at Kurdish fields or even in seeking greater payment in kind from the southern Iraqi fields at which they already operate. This is in large part a regulatory tactic that results from market inefficiencies at home. Chinese imports of Iraqi oil may have increased in 2012, but Chinese producing firms certainly have no interest in being the ones to sell the crude on the Chinese market—especially at the government-set rate of below USD 18 per barrel. In fact, due to China’s regulations on feedstock pricing for crude sold to refineries and percentage of crude that must be sold domestically, the profit margins on the barrels Chinese firms produce are usually much higher if they are sold to refineries near the production site, rather than shipped back home. This also speaks to the level of investment Chinese firms are willing to pour into downstream development in Iraq and elsewhere.

The Chinese conundrum

Based on their contractual preference for the technical service model, then, it is clear that Chinese firms have little interest in owning or controlling the resource itself. With Chinese NOCs consistently acting as profit-maximizing entities, the outlook for Chinese participation in the Iraqi energy sector will therefore be contingent on how quickly Beijing can correct its domestic energy market inefficiencies. Moreover, China is home to the largest reserve of shale gas in the world, boasting a massive 36.1 trillion cubic meters of technically recoverable shale. Once tapped, Iraq will no longer be a key investment strategy for Chinese NOCs, passed up for more lucrative domestic plays. If China can liberalize its domestic market pricing and even open up its massive quantities of Chinese shale gas for development, Baghdad will no longer hold the same strategic value for NOCs, and the future of the Beijing–Baghdad partnership will be drastically altered.

From Baghdad’s position, Chinese companies are attractive partners. Foreign governments outside the Middle East have been sidestepping the whole jurisdictional sovereignty question that ignites each time an oil major signs a contract with the KRG. But if Baghdad’s polemic against commercial partnerships, pitting Kurdish technical service contracts against Iraqi production sharing agreements, escalates to the level of military response, Maliki understands the tendency of Western governments to root for the underdog, and for China’s government to unapologetically preserve its alliance with the kingpin. From Beijing’s perspective, the future decline in the strategic value of its Iraq investments may likely be secondary to the geopolitical implications of its growing alliance with Iraq’s oil sector. The problem for the B–B alliance is that for the national firms that seem to be implementing Beijing’s global strategy, strategic value is all that keeps the “going global” strategy afloat.

Keily Miller

Keily Miller

Keily Miller is a research associate for the Center for Energy Studies at the James A. Baker III Institute for Public Policy. Prior to joining the Energy Forum, she worked as a project manager at business development firm Middle East Consult International. Her research interests include oil and gas markets and geopolitics in the Middle East and North Africa. She graduated cum laude from Yale University with a Bachelor of Arts in Modern Middle East Studies.

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