Crude Games: China, Iran and Oil (Part 2) (USO, FXI, FXE, CHIE, XLF)

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oil Crude Games: China, Iran and Oil (Part 2) (USO, FXI, FXE, CHIE, XLF)By Ryan Landon Swanson

Note: This article is the second of a two-part series on Sino-Iranian oil relations.  Click here to read part one of Sino-Iranian Oil Relations.

While Iran faces an oil (NYSEARCA:USO) embargo and financial sanctions from the US and the European Union (NYSEARCA:FXE), Chinese (NYSEARCA:FXI) companies have the opportunity to buy up the oil that Western countries will soon reject.  But this choice would come at a cost: if Chinese companies decide to replace the losses, they will likely have to renounce legal ties to the US financial system (NYSEARCA:XLF).  The US Secretary of State, Hillary Clinton, has already banned Zhuhai Zhenrong, a Chinese state-owned oil trading company, from holding a US export license—that is, that company can no longer legally sell oil to the US.  Similarly, the State Department also revoked the export licenses of oil companies from Singapore and the United Arab Emirates for doing business with Iran.

Beginning in 2010, Zhuhai Zhenrong had filled the vacuum of lost gasoline sales to Iran, as many Western countries had halted their sales due to US sanctions.  The US State Department claimed that Zhuhai Zhenrong had sold over $500 million of gasoline to Iran between July 2010 and January 2011.  Mark Dubowitz, director of the Foundation for Defense of Democracies, claimed the recall of Zhuhai Zhenrong’s export license was a “shot over the bow,” as the company was not predicted to have significant business exposure with the US and would not make a significant impact on China’s oil sector (NYSEARCA:CHIE).  While the recall has been largely symbolic, it does send a warning signal to China’s state-owned oil giants that they could meet similar consequences for dealing with Iran.

Because Chinese companies may face the prospect of being banned from US and European markets, they now must make the difficult choice between buying discounted oil (NYSEARCA:USO) from desperate Iran or maintaining friendly trade relations with Western countries.  To hedge its bets, China’s government has sought to strengthen its energy relations with Saudi Arabia over the past few weeks.   In November of 2011, Saudi Arabia’s oil production reached a 30-year high of 10 million barrels per day and the Saudis have hinted that they will sell more oil to Asian consumers who cease to buy oil from Iran.  In light of Saudi Arabia’s robust production and good standing with Western governments, China’s Sinopec signed agreements with Saudi Aramco, including investment in a $10 billion refinery in the port city of Yanbu.

Saudi Arabia is also China’s largest supplier of oil, which makes it reasonable to assume that the Chinese government is taking cautious measures not to stress its relations with the Saudis.  Erica Downs, a China energy expert at the Brookings Institute, explains Saudi Arabia’s concern with Iran:

Saudi Arabia regards Iran’s nuclear program as a threat to its national security.  Prince Turki al-Faisal, who previously served as Saudi Arabia’s intelligence chief and ambassador to the United States, recently stated that Iran’s quest for—and Israel’s presumed possession of—nuclear weapons might prompt Saudi Arabia to follow suit.

Thus, threats of nuclear weapons development in both Iran and Saudi Arabia hold huge energy security implications for China (NYSEARCA:FXI).  Chinese oil companies must navigate through these conflicting expectations and loyalties of its Middle East suppliers.  Thus far, China has not replaced European buyers of Iranian oil—a decision that the Saudis surely approve of—, but Chinese officials have also denounced the US and Europe’s embargo, claiming that the sanctions on Iran are not constructive for eliciting Iran’s compliance with the International Atomic Energy Agency.  However, it is only matter of time before China’s ride-the-fence approach will have to favor one side more than the other.

There are two more points to consider.  First, Iran has threatened to cut off its sale of crude oil before the European Union embargo takes effect on July 1st.  This poses a stark dilemma for the already stressed economies of Greece, Spain, and Italy—which all receive a disproportionately higher share of Europe’s imported Iranian oil.  Nasser Soudani, a member of the Iranian Parliament’s energy committee, contended that the Europeans had no choice but to renounce the embargo as “abandoning Iran’s oil would mean the extinguishing of the candles of their economic lives.”  Hence, it is possible that not all European countries will be able to find alternative oil suppliers to effectively implement the sanctions.

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