One of the things that doesn't get a lot of discussion in the press is the under-the-table relationship Iran and China have had when it comes to oil. At first glance, they wouldn't seem to have a lot in common. One is a theocracy with a radical view of non-believers and the other is probably the only example of a successful communist dictatorship since this form of government was created. But, if you look a little deeper they have a couple of things that align their mutual interests strongly. The first is they are both absolute dictatorships, meaning the institutions of government and national policies can be changed at the whim of those at the top. The second thing they have in common, and this is the main takeaway, both countries have serious geopolitical issues with the United States.
Iran suffers from years of sanctions imposed primarily by the U.S. to compel them to comply with U.N. resolutions regarding their atomic program. China views this century as the one in which they displace America as the world's dominant Super Power. The place where these two authoritarian government’s worldviews align is in their opposition to the U.S.
It's worth noting China's apparent success has been funded by western economies over the last 75-years, thanks to our desire to buy everything as cheaply as possible. In that time, China has become the manufacturing center for the world and amassed immense wealth in doing so. The pandemic has caused a rethinking of the wisdom of outsourcing strategic commodities to despotic regimes, but for now, if you buy something other than food odds are it was made in China.
What interests us primarily is the extent to which China and Iran have found common ground in thwarting the U.S. sanctions on Iranian oil sales. Many countries have fallen in lock-step with the American sanctions and have refused to do business with Iran. A few have not, and notably among them China. One of the few countries which can flout U.S. edicts with relative impunity, China has opened their ports wide to tankers carrying Iranian crude thus dulling the effect of the sanctions. A win-win for each country on a number of fronts.
China and Iran in modern times
As Dr Mamdouh G Salameh details, the Iran-China strategic relationship is based on three pillars.
The first is their enmity to the United States.
The second is their geopolitical ambitions and
the third pillar is crude oil.
The three pillars are linked to both the United States and oil.
The two countries have a multi-decade history of finding commonality when it comes to heading off U.S. interests. Beginning in the late 1980s when Iran first began to flex its military muscles outside its own borders, China has supplied the regime with ship-killer Silkworm missiles to enable it to directly threaten U.S. fleet movements through the straits of Hormuz. Over the decades, China has often been Iran's backstop in the geopolitical theatre, and now the two countries have embarked on an ambitious partnership that could lead to a vastly expanded commercial and military Chinese presence in Iran. The New York Times is quoted as saying-
“The partnership, detailed in an 18-page proposed agreement obtained by The New York Times, would vastly expand Chinese presence in banking, telecommunications, ports, railways, and dozens of other projects. In exchange, China would receive a regular - and, according to an Iranian official and an oil trader, heavily discounted - supply of Iranian oil over the next 25 years.”
And there you have it. China has secured a steady supply of Iranian oil for the foreseeable future. We will now discuss some possible implications that might emerge over the next few years in the oil and geopolitical arenas.
China's Iranian oil buying binge
China, whose economy had largely recovered from the virus by the spring of 2020, has been on an oil buying rampage to meet the demands of its restarting economy. That isn't really news. What is news is how the two countries have collaborated to help Iran evade U.S. sanctions. Sanctions which if we are honest, have not delivered on their intent-compelling the rogue Islamic country to turn away from its nuclear ambitions. Perhaps now we see why.
In an article carried in World Oil's March 11th issue, Bloomberg delved into the full extent of China's oil buying from Iran.
Chinese imports of Iranian crude will hit 856,000 barrels a day in March, the most in almost two years and up 129% from last month, said Kevin Wright, a Singapore-based analyst with Kpler. His figures take into account oil that’s undergone ship-to-ship transfers in the Middle East or in waters off Singapore, Malaysia, and Indonesia to obscure their origin.
China buys a lot of oil, almost 12 mm BOPD from a variety of sources to meet its incredible demand of over 30 mm BOPD. So makes sense that it distributes its business among a number of suppliers. What has made Iranian oil purchases particularly compelling is the discounting the rulers of Iran have applied to cargoes, in times when oil prices have been rising dramatically. The Bloomberg article noted that cargoes from Iran are priced $3-5/bbl less than typical benchmarks like Brent. When you are buying the quantities that Beijing is, that turns into real money very quickly.
But, there are deeper implications in this rabid consumption of oil.
China is building storage tanks at a break-neck pace
China is stockpiling oil at a pace unrivaled in the developed world. An example of this tank building spree was discussed in a Reuters article. In a marked dichotomy with the U.S., China is building oil inventories by design. And in another shift from tradition, private firms are playing a lead role in what is estimated to be a 100 mm bbl addition in 2021 to China's oil storage capacity.
Reuters Satellite image showing new tank construction in a commercial oil storage facility in Rizhao.
China's oil buying helped stabilize the market in 2020 when prices crashed. This activity also gave them access to huge volumes of crude at discounted prices.
As China imports about 75% of the oil it uses it just makes sense for it build inventories. This is particularly true given its belligerent stance regarding the U.S. presently. A stance that may in some measure be a subliminal message to America to back off. In 2019 the U.S. sanctioned Cosco shipping, China's primary oil tankering company for transporting Iranian oil. Sanctions that were partially reversed not long after in trade negotiations with China.
Having a huge inventory of crude gives China a buffer if oil shipping lanes are shut down for any lengthy period of time.
Putting all of this together
China announced to the world in 2013 that it would embark on an ambitious plan, called the "Belt and Road" (BRI) initiative to vastly expand its influence across dozens of Middle Eastern and Asian countries. This was a signature mark of the then newly installed Chinese President Xi Jing Ping, (who now seems to be "President for Life.")
Introduced with a lot of pomp and circumstance, the BRI was couched in language that recalled the "Silk Road" trade routes of yesteryear, a parallel goal, but really provided a shield for China's true intentions. That being filling a void left by waning American influence in these regions and promoting their Chinese Century ambition in which they displace the U.S. as the reigning global economic and military power. An article published by the Council of Foreign Relations- a think-tank that publishes position papers on global topics, summarized the BRI concerns for affected countries in a few words.
United States shares the concern of some in Asia that the BRI could be a Trojan horse for China-led regional development and military expansion.
Singling out Iran for special emphasis fits neatly into China's global strategy to project its power across the economic and geopolitical spectrum. What better way for the Asian superpower to announce to the world its arrival on the world stage than to thwart key UN resolutions on the country? Resolutions primarily enforced and supplemented by the country it is determined to displace from the top, The United States of America.
Taiwan: A possible trouble spot that could be the spark
The U.S. and China Alaska talks last week yielded a lot of fiery rhetoric amid grandstanding on both sides. The U.S. came to lecture China on human rights issues, its aggressive posture with a close neighbor-Taiwan, and repression of democracy in Hong Kong, and cyberattacks in the U.S. mainland.
China wasn’t hearing it and served it right back to America’s senior diplomatic officials, calling out its foreign interventionism, notably in Iran and Venezuela (Another country China has backstopped against U.S. geopolitical edicts.), race relations in the U.S., and the apparent decline in domestic confidence in U.S. democracy. This was summed up by China’s foreign policy official coming out of the meeting, and quoted in the Wall Street Journal-
“Mr. Yang, a member of the party’s ruling body, channeled that sentiment in responding to Mr. Blinken on Thursday. “The United States does not have the qualification to say that it wants to speak to China from a position of strength,” Mr. Yang said. He accused the U.S. of being condescending and waved his finger at Mr. Blinken and Mr. Sullivan.”
Paramount in the U.S.’ concerns was China’s increasingly hostile rhetoric vis a vis Taiwan, a country China refers to as a province of the mainland. The U.S. and Taiwan have mutual defense agreements in place that call for one to come to the aid of the other in the event of an attack. For its part, China has made it clear since Henry Kissinger first flew to Beijing 50-years ago, to meet with China’s then Premier, Zhou Enlai, that it had no more important foreign policy imperative than the reincorporation of Taiwan with the People’s Republic of China, PRC.’
“No matter what other issues Kissinger raised — Vietnam, Korea, the Soviets — Zhou steered the conversation back to Taiwan, “the only question between us two.” Would the U.S. recognize the People’s Republic as the sole government of China and normalize diplomatic relations? Yes, after the 1972 election. Would Taiwan be expelled from the United Nations and its seat on the Security Council given to Beijing? Again, yes.”
In modern times China through President Xi Jing Ping has made it clear that this remains a prime objective for the country.
“It is for this reason, above all others that Xi has presided over a huge expansion of China’s land, sea, and air forces, including the land-based DF-21D missiles that could sink American aircraft carriers.”
There is an opinion among analysts that the ongoing upgrade by the U.S. of Taiwanese defensive armament may present a closing window to China, impelling them to act precipitously to achieve their aims.
In that event, China’s strategy of stockpiling oil for the inevitable interdiction of oil tankers toward its ports in response makes perfect sense. Some military strategists see this scenario playing out as early as 2025.
What might this mean for the tightening oil markets in 2021?
One of the things that we have to realize is that oil is a globally traded commodity. The gasoline that you burn in your car may have partially come from a barrel of crude produced in Saudi Arabia, Canada, or a host of other countries.
By and large, the supply line that moves oil around the world consists of massive vessels that can carry one to two mm barrels at a time. These vessels and the installations to which they sail, are particularly vulnerable to piracy, and military interdiction. In recent years both have been on the rise, sometimes for cash, but often as an expression of geopolitical intent. The point here is that the global distribution network is extremely fragile and subject to the whims of extreme factions in countries like Yemen.
A place where a rebel group called the Houthis that are backed by Iran in a struggle with Saudi Arabia, recently have launched drone and missile attacks on Saudi oil infrastructure. Attacks that appeared to be ineffective as not much damage was done, thanks in part to Patriot missile batteries that knocked them out of the air before they reached their targets. Just the same the subtle message was received by the oil markets which spiked sharply on the initial reports before settling lower in a few days as the news cycle moved on to renewed virus fears, slowing inventory drawdowns, and a strong dollar.
As shown in the EIA graphic above, oil is forecast to be in a very tight balance between supply and demand this and next. Meaning that any interruption in global shipments could adversely affect importing countries, of which the U.S. is one. While we produce about 11 mm BOEPD, we consume almost twenty. That other 9 mm BOPD comes to us from across increasingly dangerous waters, as potentially bellicose actors like Iran and China exert their influence geopolitically.
Summing it all up
I have felt for a long time that U.S. and Canadian companies do not get the full value for the relative security that comes from having the bulk of their production located within respective national boundaries. I don't know how exactly to calculate that value as over the last few years, many of these companies have struggled to show relevance in a world that increasingly wants to use "green energy." Having just passed through a period of massive oversupply these companies are focused on repairing their wounded balance sheets and restoring damaged investor confidence. Expansion of their production base is about the last thing on their corporate minds at present.
There are a few things I can say with confidence though is that if any of the scenarios I posit in this article come to pass.
The first is that China will be a primary beneficiary of Iran's oil output. The country has the capacity to produce 3.5-4.0 mm BOEPD. Iran newly emboldened by the change of administration in the U.S. and under the protective blanket of its Chinese partner has begun to ramp production back up. Iran has also shown to be very cagey about shipping its oil under sanctions, leaving port at night, and turning off tracking transponders. The odds are heavy that China will have the most favored nation status if oil shipments become problematic.
The second is the likelihood of some type of oil shortage is becoming increasingly likely. Production in the U.S. is on a modest downward trajectory, as is the production in many OPEC countries from under-investment by the major IOCs the last few years. Add in the geopolitical ambitions of Iran and China, with the increase in tensions with the U.S., and you have a tinder box, that only needs a spark. As discussed, a likely spark is Taiwan in the near future.
Finally, the introduction of a war premium to oil prices will cause a commensurate re-evaluation of oil equities in non-belligerent countries.
The modern economy runs on petroleum products and derivatives, and will for many decades.