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

“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.”

- Zhuge Liang, Chinese military strategist

Introduction

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 America’s Chevron, which offered
$16.5 billion in a combination of cash and Chevron stock (Foss). However, given the climate of
rising oil prices and America’s 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 public’s 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 Washington’s 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 world’s 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 nation’s 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
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 D’Amato, 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 which
market 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 alone
cannot 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 Ghana’s 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 for
oil, 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 Unocal’s reserves, CNOOC Ltd.
just would not have enough oil to make a dent in the flow of oil into the United States.
 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
D’Amato 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, China’s 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 D’Amato’s 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 sober
policies.

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 Unocal’s 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)

Pelosi’s 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
Pelosi’s comments indicated the true reason behind the political backlash of CNOOC Ltd. bid for
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 (“China’s Defense Budget”).
Given China’s 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 People’s Republic of China. And in every year,
the report has grown grimmer; China’s 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 China’s military
buildup have reached the New York Times best seller list: Red Dragon Rising and Showdown:
Why China Wants War with the United States. 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. And
both books frequently cite the Defense Department Report, The Military Power of the People’s
Republic of China.

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 China’s 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 Xiaoping’s words, “to be
rich is glorious”, it seems China has just about every incentive to avoid war.

In examining The Military Power of the People’s 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 China’s military build-up is no more alarming than South Korea’s. China, the report
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 China’s, and amount to 4% of its GDP. In absolute terms, the
region’s 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 report’s own words, China’s
“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 government’s priorities.

It can be reasonably concluded that China’s 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 CNOOC’s Bid”, 2)

Like most of China’s 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 China’s large state-owned corporations after
the market reforms. CNOOC remains the holder of the company’s pre- market reform debt, and
has very little day-to-day control of CNOOC Ltd.’s operations (“Is CNOOC’s 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 one’s 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).
But to portray CNOOC Ltd. as being heavily subsidized would be an insult to CNOOC Ltd - the
company’s 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 CNOOC’s $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 CNOOC’s Bid”, 4). Considering that CNOOC’s 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
Prisoner’s Dilemma”). In other words, rational countries, including the United States, will reach
individual 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 the
government 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.
 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), the
American public was uncomfortable with an Arab firm running its ports. In a remarkable case of
déjà 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
Unocal fiasco, vociferously sent the message to the world that a foreigner’s investment is not
welcome in America’s 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 barriers
of protectionism from fear of the world catching up to its economic might? Economic
isolationism has destroyed empires. Ming Dynasty China, the height of China’s 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 USSR’s
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 America’s economy is strong and robust, the personal savings rate is 0%
(Marks). To feed America’s insatiable consumption, both public and private, 80% of the world’s
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 world’s 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 America’s 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, and
Washington 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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