the downward flow - a business perspective of the failed cnooc unocal deal

8/14/2019 The Downward Flow - a Business Perspective of the Failed CNOOC Unocal Deal

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If your will is not strong, if your thought does not oppose injustice: you will fritter away, stuck in

the commonplace, silently submitting to the bonds of emotion, forever cowering before

mediocrities, never escaping the downward flow.

The Downward Flow: A Business Perspective of the Failed CNOOC-Unocal Deal

- Zhuge Liang, Chinese military strategistIntroduction

In the summer of 2005, CNOOC Ltd., a subsidiary of the Chinese state owned oil

company CNOOC, offered $18.5 billion in an all-cash bid for the California-based oil

conglomerate, the Unocal Corporation. The bid beat out Americas Chevron, which offered

$16.5 billion in a combination of cash and Chevron stock (Foss). However, given the climate of

rising oil prices and Americas increasing concerns over the realties of a growing China in a more

globalized world, the ostensibly routine business transaction proved politically sensitive. Amid

the American publics uproar and voices from Congress calling for the deal to be nixed, the

Senate sent the proposed acquisition to the Committee on Foreign Investment in the United

States (CFIUS), a rare invocation of the Exon-Florio provision of the Defense Production Act

(governing that the legislature cannot get involved in a business deal unless the terms are a

threat to national security). In addition, Congress overwhelmingly passed an energy bill that

would require CNOOC Ltd. to face an additional 120 days of investigation in CFIUS. (Chen)

Facing months of congressional hearings and regulatory risk, Unocal shareholders opted

instead for the lower Chevron bid. In the wake of this decision, CNOOC Ltd. abandoned its

efforts, declaring Washingtons reaction regrettable and unjustified (White). Indeed, Congress

was required to justify its involvement on a various number of rather dubious national security

issues due to the specific language in the Defense Production Act. Yet in an objective analysis of

the sale, it remains clear that the potential acquisition was not a matter of national security,

posing no threat to the American economy (or even gas prices) as well. The deal fell through

due to the political climate of paranoia Congress and the American people showed the

international community that even the worlds largest and most robust economy can succumb

to the sophomoric dogma of economic nationalism.

Was the acquisition of Unocal by CNOOC a threat to Energy Security?

Many of those in Congress, both conservative and liberal, argued fiercely that the

purchase of Unocal was a threat to the national security of the United States on the basis that it

harmed the nations energy security (in other words, made the United States more dependant

on imported oil). To accept this line of thinking, one must first believe that a lack of energy

independence is indeed a matter of national security. Many politicians, unfamiliar with basic

economics, regard oil as a strategic commodity. At first glance, this makes intuitive sense: oil is


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needed to run everything, especially a military. If one cannot control any energy, one surely

cannot hope to run an army. As a strategic commodity, states would scour the globe in search

of oil, and keep tight control of their energy exports as to minimize the potentiality of its rivals.

Richard DAmato, the chairman of the US-China Economic and Security Commission, is quoted

as saying that the CNOOC Ltd. acquisition of Unocal was not a business transaction at all []

the Chinese government is going after these energy supplies to control them and lock them up.

(Ding, 5).

Yet this model of the oil industry is completely baseless. If oil actually is a strategic

commodity, as uranium is widely accepted to be currently, then blocking foreign corporations

from owning our oil companies would certainly seem understandable. But in the discussion of

oil, it is important to remember that unlike uranium, oil is a fungible (interchangeable)

commodity traded on the open market. Oil drilled out of the ground from an American

company such as Exxon-Mobil or Unocal does not exclusively head back home to the American

market. Indeed, it would be poor business. The fundamental purpose of a corporation is to

make a profit, not be agents of nationalism, so it is the local price that determines to whichmarket a company sells its product (this local price is in turn determined by supply and

demand). The nationality of the company never seems to enter the equation: Exxon-Mobil sells

to Europe, BP sells to Australia, Citgo sells to the United States, et cetera.

The obvious fear is that CNOOC Ltd. would discontinue selling oil to the United States

and focus solely on their home market of China. So what if CNOOC Ltd., for political reasons,

decided to not sell to the United States? It is common sense to assume that the price of oil

would increase due to a decrease of supply, just as the OPEC embargo caused in the late 1970s.

But the OPEC embargo was a special situation due to the fact that it was an entire cartel of

countries that enacted the embargo, not just an individual corporation. One company alonecannot control the supply for a fungible commodity like oil. The oil supply in a particular market

is usually determined by how extensive the infrastructure is in that given market. More oil

reaches the United States than Ghana, because the United States has pipelines, highways, and

other methods of transporting the commodity that simply makes it cheaper for oil to reach our

market than Ghanas market. On a micro level, if the transport costs are lower, especially for a

high-volume commodity like oil, a particular company can afford to transport more oil to the

United States at a lower price. At the same time, the United States has the largest demand for

oil, by far, of any country in the world America consumes over 20 million barrels of oil per day,

over three times the amount of China (second in the world in oil consumption) (Energy

Statistics). Given the United States extensive modern infrastructure and insatiable demand foroil, it makes the United States the most attractive market for selling oil in the world. So, if for

some peculiar reason, CNOOC Ltd. decided not to sell to the American market, because oil is

fungible, another company would certainly sell in their place. The result would be a shift in

neither supply nor demand, and thus no shift in price. Even with Unocals reserves, CNOOC Ltd.

just would not have enough oil to make a dent in the flow of oil into the United States.


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Because CNOOC Ltd. is a corporation driven by profit, it seems unlikely that CNOOC Ltd.

would not sell oil to the United States for petty political reasons. However, Congressman

DAmato is certainly correct in saying that China wishes to lock up energy supplies, yet it is a

bit more accurate to say that the Chinese government is simply looking to create a strategic

energy reserve. This is nothing out of the commonplace - most industrialized nations dependent

on oil imports have such reserves, including the United States. They were created in the wake

of the OPEC embargo to keep oil refiners from suffering setbacks from temporary supply shocks:

refiners typically hold 10 to 30 days of crude oil, but the promise of crude oil in the case of

emergency allows refiners to hold less working capital and produce more efficiently. (Strategic

Energy Reserves)

In addition, Chinas buying spree of oil is dwarfed by the United States. China is in the

process of stockpiling a planned 100 million barrels of crude oil, in which they are about one

third complete. The United States, on the other hand, is nearly complete its 700 million barrel

stockpile. By Congressman DAmatos rationale, if any government is looking to to lock up and

control energy supplies, it seems to be our own. (China)

There has been many misunderstandings and much misinformation in regard to the oil

industry. The industry is probably the most politically sensitive in American business, given its

size and geopolitical reach. It also seems to be a lightning rod for those in a constant state of

trepidation regarding an American economic collapse: after all, oil touches nearly every sector,

from farming to finance. The CNOOC Ltd. bid for Unocal is most likely the best example of this

permeation of misconceptions and misleading information, as CNOOC Ltd.s potential ownership

of Unocal would not have remotely affected the American economy or its energy security. It

appears that Congress has no interest in dispelling these foolish notions of how the economy

works, else the raucous rhetoric in Washington would have surely given way to more soberpolicies.

Fear and Loathing in Washington D.C.: was CNOOC a threat to national security?

In the debate over the 2005 energy bill, House of Representatives Democratic minority

leader Nancy Pelosi demanded loudly on the house floor that the CNOOC Ltd.-Unocal deal not

go through, because China would gain access to Unocals cavitation technology (used for drilling

oil in deep water). This would allow China, Pelosi reasoned:

to do nuclear tests underground and to mask them so we would not ever be

able to detect them. [] this coupled with their military buildup and

authoritarian systems, China becomes a threat. That's enough to block it on

national security grounds. (Ding, 4)

Pelosis argument, however, was somewhat irrational. China is already a nuclear power, and the

Chinese government could simply buy cavitation technology if they so desired. Yet perhaps

Pelosis comments indicated the true reason behind the political backlash of CNOOC Ltd. bid for


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Unocal - maybe the undoing was not due to ignorance of the oil market, but because of petty

politicians swept up by China alarmism. After all, China is expanding and modernizing its

military, increasing their military budget at more than 10% per year (Chinas Defense Budget).

Given Chinas growing geopolitical clout, the American government, in particular the Pentagon,

is keeping a close eye on this sleeping dragon.

Every year for the past four years, Congress has required the Defense Department to

issue a report entitled The Military Power of the Peoples Republic of China. And in every year,

the report has grown grimmer; Chinas military build-up increasingly ambitious. The result of

these reports has contributed to the widespread perception that China is hoping, in time, to

dominate militarily not only the Taiwan Strait but also East Asia in its entirety. Since the

ominous reports first came out in 2002, two books trumpeting the threat of Chinas military

buildup have reached the New York Times best seller list: Red Dragon Rising and Showdown:

Why China Wants War with the United States

Yet for those that have studied China, the conclusions seem somewhat illogical. If China

were to launch a lengthy military campaign in Taiwan, it would most certainly destroy the

economic infrastructure of the island, which is mainland Chinas largest source of foreign

investment. Any hot war with the United States would assuredly eliminate the largest market

for Chinese exports, as well as obliterating the returns of their American investments. If one

views the situation logically and rationally, there seems no reason why China would want war

with either the United States or Taiwan. For a nation embracing Deng Xiaopings words, to berich is glorious, it seems China has just about every incentive to avoid war.

. Both of these books reach the conclusion that

China is in essence throwing the gauntlet at the United States for military supremacy in the

region; both books conclude that China is preparing for military action with Taiwan, soon. Andboth books frequently cite the Defense Department Report, The Military Power of the Peoples

Republic of China.

In examining The Military Power of the Peoples Republic of China, it seems clear that

the initial objective of the report is to shock and inspire fear in the reader. According to the

report, China is undergoing a massive military build-up not seen since Germany in the 1930s:

[China is] in the process of long-term transformation to a more modern force

capable of fighting short duration, high intensity conflicts against high-tech

adversaries, [] reforming military institutions and personnel systems,

improving exercise and training standards, and acquiring advanced foreign

(especially Russian) and domestic weapon systems, [] modernizing nuclear

forces, land- and sea-based access denial capabilities, and emerging precision-

strike weapons have the potential to pose credible threats to modern militaries

operating in the region. (United States, 5)

All in all, at first glace the report raises some serious alarms. Yet in an objective examination, it

seems that Chinas military build-up is no more alarming than South Koreas. China, the report


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states, spends roughly 1.5% of its GDP on military expenditures (United States, 15). While

certainly a hefty sum, it pales in comparison to the United States military expenditures, which

are fifteen times larger than Chinas, and amount to 4% of its GDP. In absolute terms, the

regions other major economic powers, South Korea and Japan, both spend more on military

expenditures than does China (Kaplan, 2). At the same time, in the reports own words, Chinas

growth [in] defense expenditures has lagged behind the growth of overall government

expenditures [since 1990]. (United States, 15) So, in other words, the military is not at the top

of the Chinese governments priorities.

It can be reasonably concluded that Chinas military does not pose an immediate

national security threat to the United States. So how does CNOOC Ltd. pose a national security

threat to the United States simply by owning an American oil company? There could be grounds

for the CFIUS involvement could if the production of F-16s or the SALT-II were being outsourced

across the Pacific, but Unocal is an oil company. They produce a homogeneous commodity, with

roughly 1% of their assets within the territory of the United States. (Foss)

Why do we have a WTO? Economic Domination and unfair business practices

By far the most credible argument against the sale of Unocal to CNOOC Ltd. came from

the business community. In the words of Wharton business professor Marshall Meyer, CNOOC

is ultimately government owned and in some respects can choose to use government powers if

it wants to [those powers including] unlimited government credit. (Is CNOOCs Bid, 2)

Like most of Chinas major corporations, the government holds a majority share: CNOOC

Ltd. is 70% owned by the Chinese government (Chen). The relationship, however, is complex:

CNOOC Ltd., officially the company looking to acquire Unocal, is a subsidiary of CNOOC, which is

100% government owned (in essence a government entity). CNOOC Ltd. was spun off from

CNOOC in 1995 as a market entity, as is common in Chinas large state-owned corporations after

the market reforms. CNOOC remains the holder of the companys pre- market reform debt, and

has very little day-to-day control of CNOOC Ltd.s operations (Is CNOOCs Bid, 3). Today,

CNOOC functions mostly as a bridge between the Chinese government and CNOOC Ltd. For a

Chinese business, it is extremely important for the company to be intricately intertwined with

the government: in the absence of the rule of law, guanxi(social relationships) is the only way to

ensure the government enforces laws and regulations in ones area of business. In China,

government ownership does not necessarily equate to government control.

Many in the west, however, are unfamiliar with such an atypical relationship between

business and government. Western corporations controlled by the government have historically

been wasteful bureaucratic nightmares that can only stay competitive with a reliance on

inefficient government policies and subsidies. Because of this premonition, USCC commissioner

Carolyn Bartholomew, in a letter to the President echoing many other business and government

leaders, stated that the CNOOC Ltd. bid for Unocal was not a free market transaction because in

her view, the company was heavily subsidized by the Chinese government (Bartholomew).


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But to portray CNOOC Ltd. as being heavily subsidized would be an insult to CNOOC Ltd - the

companys return on equity (one of the most fundamental indicators of the efficiency of a

business) is a staggering 38.98%, one of the leaders in the independent upstream oil and gas

market (CEO). In addition, CNOOC Ltd.s net income is growing at an average rate of roughly

47.5% a year in the last few years (CEO). As a business, they are well run, profitable, and

growing rapidly.

However, if one looks closer as to the financing of CNOOCs $18.5 billion all-cash bid, the

claim of unfair business practices suddenly appears legitimate. Of the $18.5 billion bid, CNOOC

Ltd. used $3 billion of its own cash, and $9 billion was borrowed at commercial rates from

Goldman Sachs, J.P. Morgan, and the Industrial and Commercial Bank of China. The remaining

$6.5 billion was borrowed in two sums, both from CNOOC: $4 billion was borrowed at the

extremely low rate of 3.5% from CNOOC with no timetable for repayment, and $2.5 billion was

interest free (Is CNOOCs Bid, 4). Considering that CNOOCs equity is entirely financed by the

Chinese government, it would seem as though the bid was indeed unfair due to indirect

subsidies from the Chinese government.

However, this sort of government intervention is hardly uncommon. Especially in

international business, countries constantly subsidize various industries in order for their local

companies to gain a strategic advantage. It is an idea coined strategic trade, and is a huge

hurdle for international institutions. The difficulty lies in that each country has an incentive to

give subsidies to their home companies, but if all countries engage in this form of trade, it

destroys the efficiency of international markets and simply turns into a competition of which

government can spend the most. This phenomenon is studied extensively by game theorists,

who view the natural equilibrium for international trade agreements as Pareto-suboptimal(The

Prisoners Dilemma). In other words, rational countries, including the United States, will reachindividual decisions regarding trade policy that do not produce the most mutually optimal

outcome.

So while China did give CNOOC Ltd., indirectly, $6.5 billion in subsidies, the United

States government, in the hopes of keeping the price of oil low, subsidizes its oil companies as

well. While it is difficult to obtain precise numbers for direct subsidies to individual corporations

in developed countries since the advent of the World Trade Organization, the domestic oil

industry received $11.6 billion in raw subsidies in 2005 alone (Salient). In addition, there are

countless numbers of indirect subsidies in the form of low interest loans, bids for government

projects, and so forth. Estimates have pegged the amount of indirect subsidies flowing from thegovernment to the oil industry at roughly $35 billion yearly (Salient). So while CNOOC Ltd. did

receive some government funds, it is impossible to tell just how much their competitor in the

Unocal bid, Chevron, benefited from United States government protectionist tendencies as

well.


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There are mechanisms in place, however, to judge the fairness of international business

transactions marred by strategic trade, both international and domestic. On the domestic side,

each merger or acquisition involving an American company goes to the Justice Department for

review as to whether the transaction will limit market competition. If indeed the proposal is

deemed unfair, the Justice department strikes it down due to anti-trust violations.

Internationally, the World Trade Organization was created in 1994 as an extension of the GATT

agreements to form an organization dedicated to breaking down trade barriers and creating fair,

multi-lateral trade agreements. At the World Trade Organization, states can file grievances

about specific foreign tariffs or subsidies that they consider unfair, and the WTO then judges

whether the disputed trade barriers are justified or if they stifle international competition. For

instance, in the aeronautics industry, Airbus and Boeing have been in an ongoing dispute in the

WTO over the last decade. Boeing argues that the massive amounts of direct subsidies Airbus

has received from a pool of European countries created unfair competition, and Airbus has

argued that Boeing has received even more in indirect subsidies in the form of American

defense contracts (Boeing and Airbus).

If the United States truly felt that the CNOOC Ltd. bid was anti-competitive, they should

have filed a grievance with the World Trade Organization, rather than grand-standing on a

perceived Chinese threat to American prosperity and invoking a rare provision from a law

designed to protect national security. While there are certainly credible arguments against the

CNOOC Ltd. bid on the grounds of unfair business practices, it is an ingoratio elenchi to block the

transaction on the grounds of national security. If the deal should not have gone through due

only to unfair government subsidies, there is no question that Congress overstepped its bounds

and encroached on the duties of the Justice Department and the WTO. Yet the fact that these

options were not explored suggest the notion that the relatively small amount of indirect

subsidies that CNOOC Ltd. benefited from, in conjunction with the fact that Chevron too

receives government subsidies, would not have been sufficient for the World Trade Organization

to block the acquisition.

Where do we go from here? The perils of Economic Nationalism

In February 2006, a Dubai-based port management company, Dubai Ports World,

acquired a British port management company, Peninsular and Oriental Steam Navigation

Company (P&O). A controversy erupted because P&O held some American assets; P&O

managed ports up and down the Atlantic coast, from New Jersey to Miami. Even though a port

management company has no role in port security (which is managed by the coast guard), theAmerican public was uncomfortable with an Arab firm running its ports. In a remarkable case of

dj vu, Congress invoked the Exon-Florio provision of the Defense Production Act and the deal

was sent to examination by CFIUS. Ultimately, Dubai Ports World (a world renowned ports

management company that runs some of the highest-security ports in the world in Hong Kong

and Singapore) promised to sell the American assets to a different corporation (Dubai). It was

an unnecessary display of bravado from Congress the failed deal, in conjunction with the


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Unocal fiasco, vociferously sent the message to the world that a foreigners investment is not

welcome in Americas markets.

And so the United States is at a point of time where it must choose its future: will

America confront the economic challenges of a more open, globalized world with poise and

innovation? Or will America retreat into its own insular backwaters, hiding behind the barriersof protectionism from fear of the world catching up to its economic might? Economic

isolationism has destroyed empires. Ming Dynasty China, the height of Chinas economic and

technological power, decided to close its borders from the world and eventually became a

colonial afterthought. France, once the economic and cultural capital of the Europe and the

world, has steadily retreated into the second tier of nations after decades of misguided

protectionist policy. The United States has ran into challenges in the past, from the USSRs

launching of the Sputnik to the unprecedented economic rise of Japan in the 1970s and 1980s,

but has continued to lead the world due to its entrepreneurial spirit and the flexibility of its

economic system.

But now we have reached a point in our history where our leaders are choosing flight

over fight. While Americas economy is strong and robust, the personal savings rate is 0%

(Marks). To feed Americas insatiable consumption, both public and private, 80% of the worlds

savings are invested in our capital markets (Roach). As long as this trend continues, foreign

investors will want to continue to diversify their American assets from simple government debt

and corporate bonds into the stock market, and indeed, into owning entire US companies. The

answer for Americans is not to pout and blame this trend on the perceived mal-intentions of an

Arab or a Chinaman, but to save and invest - curbing domestic consumption, from households to

the halls of Congress.

America can continue to be the worlds preeminent economic superpower, but it

requires vigilance. It requires an openness to new ideas and technology, and the free flow of

information and capital into and out of its borders. The American public is scared: scared of

their job being outsourced to a lower-cost location, and scared of their country being stalled in

economic quagmire. It is up to our leaders to educate the public that it is protectionism that

leads to stagnation, and that the success of the American system has always been its openness.

If we discourage investment, if we deter foreigners, if we detest competition, it will lead to the

slow demise Americas leadership. If America continues down the road of economic

nationalism, it will be the death sentence to the American superpower. The death of the

CNOOC-Unocal deal is indicative of a paranoid public on the brink of outright xenophobia, andWashington has found itself wanting to exploit this fear rather than quelling it. This trend must

be stopped. The public must be vigilant, and its will must be strong; else as the eminent Zhuge

Liang warns, America will be silently submitting to the bonds of emotion, forever cowering

before the mediocrities, never escaping the downward flow.


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Works Cited

Bartholomew, Carolyn. United States. State Department. U.S.-China Economic and Security

Commission Annual Report

"Boeing and Airbus."

. 14 July 2005. 11 July 2006.

The Economist

"CEO: Summary of CNOOC Ltd."

. 30 Nov. 2004. 11 July 2006

.

Yahoo Finance

Chen, Wing-Gar, and Loretta Ng. "Cnooc Drops $18.5 Bln Unocal Bid Amid U.S. Opposition."

. 09 July 2006

.

Bloomberg

"China's Defense Budget."

02 Aug. 2005. 11 July 2006

.

Global Security

"China to Have Strategic Oil Reserve Soon."

. 11 July 2006

.

China Daily

"China to Have Strategic Oil Reserve Soon."

10 July 2005. 08 July 2006

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China Daily

Ding, Genevieve. "The CNOOC Bid for Unocal and US National Security:." Duke University. 09

July 2006 .

10 July 2005. 08 July 2006

.

"Dubai Company Gives Up on Ports Deal." MSNBC

"Energy Statistics."

09 Mar. 2006. 13 July 2006

.

Nationmaster

Foss, Brad. "Experts Say Security Threats Not Clear in CNOOC Bid for Unocal."

. 10 Jan. 2005. 12 July 2006

.

The Associated

Press

"Is CNOOC's Bid for Unocal a Threat to America?"

28 June 2005. 07 July 2006

.

Knowledge@Wharton

Kaplan, Fred. "The China Syndrome."

. 21 Nov. 2005.

University of Pennsylvania. 11 July 2006

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Slate 26 May 2006. 17 June 2006

.


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Marks, Alexandra, and Ron Scherer. "Spendthrift Nation." Christain Science Monitor 03 Aug.

2005. 13 July 2006 .

Military Power of the People's Republic of China

Roach, Stephen. "The Day After Tomarrow."

. Department of Defense. Washington D.C.:

Office of the Secretary of Defense, 2006. 13 June 2006

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Global Economic Forum

Salient D. Jonathon "U.S. Oil Industry's Lobbying Pays Off."

. 01 Nov. 2005. Morgan

Stanley. 13 July 2006 .

Bloomberg

"Strategic Energy Reserves."

27 July 2005. 09 July 2006

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Howstuffworks

"The Prisoner's Dilemma." University of Texas. 16 Aug. 2006 .

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United States. Office of the Secretary of Defense. Department of Defense. Military Power of the

People's Republic of China

"Unocal Backs $17 Billion Chevron Bid."

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MSNBC

White, Ben. "Chinese Drop Bid to Buy U.S. Oil Firm."

20 July 2005. 11 July 2006

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Washington Post 02 Aug. 2005. 15 Aug.

2006 .

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