The decision by the Chinese National Offshore Oil Corporation (CNOOC) to offer US$18.5bn cash for a California based oil company, Unocal, is the first of what is likely to be a constant stream of Chinese bids for US companies. The deal signals that China's central bank has become fed up with its policy of recycling the dollars produced by the country's exports to the US through the US bond markets. Instead of financing the US current account deficit by buying US Treasury bonds, the Chinese will now buy US companies. 

CNOOC moved smartly, on 23 June, just as Chevron Texaco was about to snap up Unocal for US$16.4bn in cash and shares. If the CNOOC deal goes through, it will be the biggest foreign investment by a Chinese company. CNOOC is China's third-biggest oil company. It is offering 11% more per share than Chevron. Although CNOOC's shares are listed on both the Hong Kong and New York Stock Exchange's the company is not including equity in its offer.

Chevron issued a sharp statement claiming that CNOOC's deal was fraught with regulatory implications. Indeed the US Commerce Secretary, Carlos Gutiérrez, said that CNOOC's bid would certainly be looked at from the point of view of national security. Unocal, however, obtained Chevron's permission to talk to CNOOC about CNOOC's offer. The Unocal board reaffirmed its recommendation that shareholders should accept the Chevron offer: the Unocal directors said that there was no guarantee that the CNOOC deal would go through. 

Unocal's board has plenty of ways of warding off CNOOC if it decides that the deal is unwanted. Among the so-called "poison pills" to ward off unwanted bids, the Unocal board can make it very expensive for a bidder to buy more than 15% of the company. The board also has staggered terms, which means that an unwanted bidder could not replace the board immediately. 

National security considerations are unlikely to derail the bid: most of Unocal's producing assets are outside the US. The bulk of them are in Southeast Asia. CNOOC is also being advised by top US investment banks, suggesting that CNOOC had taken preliminary soundings of US policymakers before making the offer. One base that the investment banks may not have covered is the reaction of the Thai and Indonesian governments to having strategic parts of their energy industry placed in Chinese hands. 

The CNOOC line is that the deal is strictly business and raises no national security issues for anyone. Few analysts swallow this view. China's hurtling rate of economic growth is stretching the energy industry: brown-outs are increasingly common. China fears that the US's twitchiness about its interest in securing supplies of raw materials, particularly energy from South America, threatens its economic well-being and thus its security. Analysts claim that China views securing energy resources as a matter of national security. 

The CNOOC said that by taking over Unocal it would double its annual output of oil and gas. It would also increase its oil reserves by 80%. The deal poses a tricky question for the US authorities. If they bar the take over (though analysts say that they will be hard pressed to find a good reason), relations with Beijing will take a turn for the worse. The US is already unhappy with the threat China poses to what remains of its textile industry and the refusal of the Chinese authorities to contemplate a revaluation of the yuan. 

The deal is likely to be reviewed by the Committee on Foreign Investment in the US (Cfius). This is chaired by the US Treasury Secretary and other cabinet minister, notably the secretaries for Homeland Security, Defense, Commerce, Justice and the US Trade Representative all sit on it. The Cfius has reviewed 1,560 deals since it was set up in 1988 but investigated the implications of only 25. Its most recent major veto was Hutchison Whampoa's attempt to buy Global Crossing in 2003. The initial Cfius ruling will be in 30 days. If the ruling is negative, there will be a further 45-day investigation. 

The Chinese foreign ministry spokesman, Kong Quan, said that contacts between CNOOC and Unocal are "normal commercial activities between enterprises and other people should not be surprised and try to interfere on political grounds." The CNOOC chairman and chief executive, Fu Chengyu, wrote in a letter to the US Congress on 27 June that the company is eager to have the US government scrutinise the national security implications of the deal. He implied that any objective analysis would conclude that the security issues were negligible: Fu said Unocal's oil and gas production amounts to less than 1 percent of US consumption. 

The macro issues
There are economic as well as strategic implications to the deal. The macro-economic implications of the bid are manifold. In 2004 China ran a US$160bn trade surplus with the US. So far this year, (first four months) the US trade deficit with China is US$57bn. For the last few years China has been lending these dollars back to the US by buying US Treasury bonds: there are signs, however, that Chinese and Asian interest in building up the central banks' holdings of US T-bonds is waning. 

The problem for the world economy is that if the Asians stop buying US bonds, it is not clear who will. If the US cannot borrow at current rates it will either have to pay more or reduce its borrowing. Either way US consumption will drop, cutting its demand for Chinese (and Asian) imports. There is a third option: China changes the form in which it finances the US current account deficit. Buying Treasury securities and buying US companies both rank as capital account transactions and thus finance current account deficits. 

Foreign direct investment by Chinese and Hong Kong companies at the end of 2002 stood at US$8bn. The biggest foreign direct investors in the US are Switzerland, which has US$878bn invested there, and Japan which has put in US$431bn. The early involvement of US investment banks in the CNOOC deal suggests that they too have seen the opportunity for increasing Chinese FDI in the US. The same sort of thing happened a generation ago when the Arab oil exporters were running huge trade surpluses after jacking up the price of oil in the early 1970s. By the 1980s Arab oil exporters were switching to buying real, rather than financial assets. Kuwait brought downstream oil assets such as petrol stations while other oil exporters (notably Libya) bought stakes in Italian and German companies. 

The first oil boom also prompted Venezuela's state oil company to buy downstream assets in industrialised countries. It bought Veba Oel in Germany and Citgo in the US. Citgo is the biggest independent petrol refiner and retailer in the US with a market share of about 5%. Other emerging market countries have been active in the US. In 2000 Cementos Mexicanos paid US$2.8bn cash for Southdown. The deal made Cemex the biggest cement producer in North America. The deal was so successful that four years later Cemex was able to bolster its European presence by buying RMC for US$5.8bn in cash. This deal was the biggest-ever foreign acquisition by a Mexican company. The deal makes Cemex one of the world's largest building materials companies with annual sales of US$15bn.

The fundamental reasons
There is also a fundamental reason for CNOOC to buy Unocal. China is a major importer of oil. Unocal is the US's ninth-largest producer of oil and gas. As oil prices increase, China wants to its secure supplies. It may be that China views (as Chevron clearly does) Unocal's proven reserves of 659m barrels as a better bet than investing in oil exploration on its own account. 

Back of the envelope calculations show that valuing Unocal just for its oil reserves, CNOOC is paying US$28 a barrel (US$18.5bn for 659m barrels). In fact the gas, pipelines, refineries and processing assets mean that CNOOC is probably paying around half that headline price for the oil. This sort of price (US$14 to US$15 a barrel) is the hurdle rate big oil companies still set to evaluate the viability of projects. 

Big oil companies have yet to raise their hurdle rates substantially to take into account the surge in oil prices. Although some senior oilmen say that high prices are here to stay, others are less sure. What is clear is that the current spike in oil prices is led by demand rather than by controls on output. The only country where output could probably be higher is Venezuela.

China and the US are mutually responsible for the global surge in oil demand. Oil demand from China grew by about 15% in 2004. China's oil imports are running at about 2.1m bpd. China accounts for about a third of the overall growth in world oil demand. There is little sign of higher prices deterring Chinese demand for oil. The IMF economic model assumes that higher oil prices will have an effect on China's growth: the IMF reckons that China will lose 0.4 of a percentage point in annual growth for each US$5 rise in the annual average price of crude oil over US$40 a barrel. There is no sign of this happening. 

The bulk of Unocal's oil reserves are still in North America (the US and Canada) though the bulk of its gas reserves are in Asia. Its proven gas reserves are 6.57trillion cubic feet. The company's average oil production in 2004 was 159,000bpd. The US and Canada accounted for 70,000bpd; Asia for another 70,000 bpd and 19,000bpd came from elsewhere in the world. As for gas production, the US produced 495m cubic feet a day for Unocal in 2004; Canada produced 83m but Asia produced 912m. The company's total output was 1.51bn cubic feet a day. 

In Asia, Unocal's most important area is the Gulf of Thailand. The company has three concessions in the Thai part of the Gulf. It sells the gas it produces there to local Thai electricity companies. The company produces around 35,000bpd of oil from its Thai fields. It also has an important stake in a natural gas field in the Myamar portion of the Andaman Sea. It also owns almost 30% of the pipeline which takes this gas to Thailand where it is used by power stations. 

Although the company has 12 production-sharing concessions in Indonesia, only four of them really matter. The company produces 35,000bpd of oil from these fields and 136m cubic feet of natural gas. The company has been active in Indonesia since 1968 and discovered Indonesia largest oil and gas field, Attaka, in 1970. Unocal has had a long association with the Indonesian state oil company, Pertamina. Indonesia has been the company's main focus of operations: between 1998 and 2001, Unocal drilled 100 exploration wells in Indonesia and found commercial quantities of oil and gas in eight of them. 

Unocal has some technology which the Chinese want, notably its ability to drill deepsea wells. It has drilled the deepest well in Indonesia: at a depth of 6,772 feet in the Makassar Strait. Besides the deepwater technology, Unocal has also drilled horizontal wells; three D seismic exploration and modelling for deepwater oil structures. This and other technologies enabled Unocal to recover additional oils from fields that had been classed as exhausted by the state oil company. Unocal also has been involved in liquefying natural gas for transportation on to users in North Asia. It also has experience in using natural gas a feedstock for producing fertilisers.