Loan-for-resource agreements are complicated, but there are positives if rules are heeded

Erdenes Tavan Tolgoi LLC, a state-owned enterprise, owns Tavan Tolgoi, which is one of the world's largest untapped coal reserves and is located in Mongolia.

ETT reached a deal in July 2011 with Aluminum Corp of China, known as Chalco, to secure a long-term supply of coal from the eastern parts of Tavan Tolgoi. Under the deal, Chalco gave a $350 million (260 million euros) loan to ETT, Mongolia's biggest coal producer. ETT in exchange would repay the loan with Tavan Tolgoi coal at undisclosed terms.

But ETT has reportedly halted coal exports to China and is demanding a renegotiation of the agreement in order to raise prices and lower its "payback" of coal. To date, ETT has repaid nearly two-thirds of the loan.

This deepening disagreement shows that loans-for-resources deals - in oil, natural gas or coal - are not without risk. Changes in government, for example, increase the likelihood that a loans-for-resources contract could be voided or renegotiated. The fact that the ETT management team, appointed last fall by the newly elected Mongolian government, wants to change the language in the contract to reflect fluctuating market prices for coal clearly illustrates this.

Resource-rich countries are at risk of failing to comply with an agreement. They may not provide the quantity they promised to supply. And because oil, natural gas or coal is not used as collateral, if borrowers threaten to cut off their supply, lenders cannot seize the resource or revenue from the sale of resources to compensate for potential losses. Therefore, deals that hinge on loans for resources are not preferred.

Good quality assets are, however, rarely for sale these days, and even if they were, China's state-owned companies might not be able to fairly win bids because foreign governments have recently blocked attempts by Chinese SOEs to buy oil and other resource-rich fields. Given these constraints, loans-for-resources deals are, unfortunately, the next-best strategy.

Deals that hinge on loans-for-resources to secure long-term supplies were not invented in China. Japan gave China loans for its oil as early as the 1970s. This type of deal is not new for China and has been used by Chinese national oil companies for years. In 2004, China National Petroleum Corp loaned the Russian oil producer Rosneft $6 billion for 180,000 barrels of oil a day through 2010.

Five years later, a bigger deal was struck. In 2009, China Development Bank gave a $25 billion loan to Rosneft, Russia's biggest oil producer, and Transneft, its oil pipeline operator. In exchange, Russia would provide China with an additional 15 million tons of crude oil a year between 2011 and 2030 (or nearly 7 percent of China's 2009 volume of oil imports) through a new pipeline.

Another notable deal was the $10 billion loan agreement in 2009 with the Brazilian oil giant Petroleo Brasileiro SA, known as Petrobras. It is the biggest deal in Central and South America. Under the terms of the 10-year loan from the CDB, Petrobras will supply Sinopec 150,000 barrels per day in 2009. In 2010, that figure rose to 200,000 barrels per day through 2019.

At first glance, a loan-for-oil deal and a loan-for-coal deal look very similar. But why does a loan-for-oil deal work, while most coal deals turn sour? This boils down to a difference in pricing mechanisms built into these loans-for-resources deals.

Many outside observers assume that oil deals based on loans grant Chinese oil companies a discount. Under this assumption, borrowers simply sell a fixed quantity of oil to China during the contract period at a predetermined price to pay back the loan. The perception is that borrowers lose out while China captures windfall gains as oil prices rise. This is a complete misunderstanding. Chinese oil companies cannot bargain on prices and all the deals are linked to market prices, not quantities of oil. Russia, Brazil and Venezuela sell their oil to China at market prices.

Chinese oil companies, however, with the support of the Chinese government and Chinese policy banks, did take advantage of foreign companies who suffered in the global financial crisis and reached otherwise unlikely deals for long-term supplies of oil and gas. In fact, China and Russia have been discussing a cross-border pipeline for crude oil since the early 1990s. Leveraging its financial strength at a time when many other major economies were in a recession, China struck its long-awaited loan-for-oil deal with Russia in 2009.

Moreover, these oil deals based on loans, backed by the CDB, often required borrowers to buy and hire from China to mitigate loan risks. The agreement with Petrobras stipulates that $3 billion of the $10 billion loan must be used to purchase oil equipment from China. China's $10 billion loan to Argentina in 2010 is to buy Chinese trains, which actually became a credit line for Chinese railway companies to invest in 10 separate rail projects in Argentina, with the money effectively staying in China. Half of the $20.6 billion loan the CDB granted to the Venezuelan Economic and Social Development Bank is denominated in Chinese yuan, which locks Venezuela into buying Chinese equipment and hiring Chinese firms.

In addition to securing oil supplies, these deals also serve the Chinese government goal of creating new export markets. They also reduce their exposure to default risks and a borrower's potential for corruption. Borrowers find purchase requirements attached to Chinese loans less objectionable because they seek to build up their energy, mining, infrastructure, transportation and housing sectors inexpensively using Chinese input and equipment.

But the pricing mechanism, the key element in these oil deals that are based on loans, is market-based. Market-based arrangements will ensure the delivery of oil because there would be a strong temptation to default on contracts if the market price were to rise above a negotiated price.

This is the case for the ETT deal. ETT wants to alter the contract to reflect fluctuating market prices for coal. Chalco claims ETT is still able to turn a profit from the current contract. This may well be the case. But ETT believes it is losing out as coking coal prices rise above their negotiated mark and it wants to benefit from the market price. Given that China's state-owned resource giants often compete with each other in securing overseas deals, resource-rich countries are taking advantage of the rivalries. ETT is reaching out to Shenhua, China's largest coal producer, and are betting on a rivalry between Chalco and Shenhua to stoke a renegotiation of an increasingly untenable deal to its advantage.

The Chinese government needs to discipline these Chinese SOEs because competing with each other in securing deals abroad often leads to outrageous payments and the risk of incurring huge losses. Given that these SOEs can cover overseas losses through their capital at home, this has created a perception that these SOEs are irresponsible users of state funds.

Because of confidentiality arrangements, the pricing mechanism in the ETT deal is unknown. The Wall Street Journal reported that the price was capped at $70 a metric ton. But Chalco said that a price was set based on a formula combining reference prices plus an adjustment for price fluctuations. If that is the case, the deal's parameters sound like they are in line with China's power tariff system. But neither of the reported pricing mechanisms is fully market-based. Thus, it should come as no surprise that ETT is accusing Chalco of taking advantage of a moment when the Mongolian government badly needed funding to secure a deal that would be unacceptable under normal international trade settings. This is why ETT wants to renegotiate the terms of the deal.

This major flaw in the deal is the cause for the current impasse. In contrast, market-based loan-for-oil deals work smoothly, which illustrates the point that market-based pricing mechanisms work for most energy deals.

Indeed, evidence suggests that market-based energy contracts work over the long term and prevail over ideological differences or politically motivated actions. Under market-based contracts, the former Soviet Union exported natural gas to Western Europe virtually unimpeded even during the Cold War era. The point is that brothers can get into a conflict if one does not follow market rules.

The author is chairman and a professor of School of Economics, Fudan University, Shanghai. The views do not necessarily reflect those of China Daily.

(China Daily 02/22/2013 page8)