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Simon Watkins

Simon Watkins

Simon Watkins is a former senior FX trader and salesman, financial journalist, and best-selling author. He was Head of Forex Institutional Sales and Trading for…

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China Prepares Its “Nuclear Option” In Trade War

As the trade war with the U.S. continues to escalate, China has re-engaged with Iran on three key projects and is weighing the use of what both Washington and Beijing term the ‘nuclear option’, a senior oil and gas industry source who works closely with Iran’s Petroleum Ministry told OilPrice.com last week.

For the first of these projects - Phase 11 of the supergiant South Pars non-associated gas field (SP11) - last week saw a statement from the chief executive officer of the Pars Oil and Gas Company (POGC) that talks had resumed with Chinese developers to advance the project. Originally the subject of an extensive contract signed by France’s Total before it pulled out due to re-imposed U.S. sanctions on Iran, talks had been well-advanced with the China National Petroleum Corporation (CNPC) to take up the slack on development. As per the original contract, CNPC had been assigned Total’s 50.1 percent stake in the field when the French firm withdrew, giving it a total of 80.1 percent in the site, with Iran’s own Petropars Company holding the remainder. At the same time, Iran was desperate to increase the pace of development of the fields in its oil-rich West Karoun area, including North Azadegan, South Azadegan, North Yaran, South Yaran, and Yadavaran, in order to optimise oil flows ahead of further clampdowns on exports by the U.S.

China, though, which at that time was engaged in just the opening shots of the trade war with the U.S. was loathe to completely disregard all U.S. sensibilities when it came to Iran but equally saw itself as a longstanding partner of the Islamic Republic, not to mention always being cognisant of its need to ensure diversity of energy supply. At that point, China agreed a trade-off with the U.S. that in exchange for it halting active development of SP11 it would be allowed to continue its activities in North Azadegan and would be able to go ahead with its development of Yadavaran – the second of China’s major Iran projects. China told the U.S. that its continued involvement in North Azadegan could easily be justified to anyone else who might be interested – such as the mainstream media – on the basis that it had already spent billions of dollars developing the second phase of the 460 square kilometre field. Similarly, China said at the time, its ongoing activities on Yadavaran could be justified by dint of the fact that the original contract had been signed in good faith in 2007, way before the U.S. withdrawal from the nuclear deal in May 2018 and thus, legally speaking, it had every right to go ahead. Related: Will Shale Rise From The Dead?

The third of China’s major as yet unfinished projects in Iran was the build-out of the Jask oil export terminal, which – crucially, particularly in the current security situation – does not lie within the Strait of Hormuz or even in the Persian Gulf, but rather in the Gulf Of Oman. Even before the new U.S. sanctions, the Kharg export terminal was not ideal for use by tankers as the narrowness of the Strait of Hormuz means that they have to go very slowly through it. With the new sanctions in place and tit-for-tat tanker seizures regularly occurring, China would have little choice but to put at least a couple of its own warships into the Gulf to safeguard their passage or stop buying Iranian oil entirely, neither of which Beijing particularly wants to do.

So, according to the plans, a US$2 billion or so 1,000 kilometre oil pipeline will connect Guriyeh in the Shoaybiyeh-ye Gharbi Rural District, in Khuzestan Province (south-west Iran), to Jask County, in Hormozgan Province (south Iran), with any financing required over and above that provided for Iran to be made readily available  from China. Also to be constructed in Jask is an initial 20 storage tanks each capable of storing 500,000 barrels of oil, and related shipping facilities, at a cost of around US$200 million. Overall, the intention is for Jask to have the capacity to store up to 30 million barrels and export one million barrels per day of crude oil. There are adjunct plans to build a large petrochemicals and refining complex in Jask as well, with the prime market for produced petchems – including gasoline, gas oil, jet fuel, sulphur, butadiene, ethylene and propylene, and mono-ethylene glycol - again being China. According to a recent comment by the director of projects at Iran’s National Petrochemical Company, Ali Mohammad Bossaqzadeh, the project would be built and run by Bakhtar Petrochemicals Holding, although ‘other foreign companies’ may take part. In fact, according to the Iran source, China has also offered to send as many engineers and other professionals required in such a project to Iran for as long as necessary.

Having said that, and aware of the leverage that it had with Iran as one of the very few countries still willing to engage in developing its fields in the midst of increasingly vigorously-imposed sanctions, China has sought deal sweeteners from Iran, and has been given them. In order for it to reactivate its development of SP11, China will get a 17.25 percent discount for nine years on the value of all gas it recovers. “This is the value of the gas as applied to CNPC’s cost-return formula against the open market valuation, and currently the net present value of the site is US$116 billion,” the Iran source told OilPrice.com. For its part, China has agreed to increase the production from its oil fields in the West Karoun area – including North Azadegan and Yadavaran - by an additional 500,000 bpd by the end of 2020. This dovetails with Iran’s plan to increase the recovery rate from these West Karoun fields that it shares with Iraq from the current 5 percent (compared to Saudi Arabia’s 50 percent). “For every one percent increase, the recoverable reserves figure would increase by 670 million barrels, or around US$34 billion in revenues with oil even at US$50 a barrel,” the Iran source said.

If there is any further pushback from the U.S. on any of these Chinese projects in Iran, then Beijing will invoke in full force the ‘nuclear option’ of selling all or a significant part of its US$1.4 trillion holding of U.S. Treasury Bills, with a major chunk of the paper due to be sold in September on this basis. This massive holding of these bonds - through which the U.S. finances its economy and is an important factor both in the value of the dollar and therefore in the health of U.S. international companies especially – has been used as a bargaining chip before by China, especially when it feels threatened. Back in 2007, just before the great financial crisis, a number of senior Chinese figures at various state-run think tanks – through which China often signals its big geopolitical threats – stated that the large-scale selling of this massive Treasury Bill holding would trigger a dollar crash, a huge spike in bond yields, the collapse of the housing market and stock market chaos. Related: The Revival Of A $53 Billion Megaproject

Such a tactic would neatly fit into China’s overall strategy to have the renminbi challenge the U.S. dollar’s status as the key global reserve currency and the prime currency for global energy transactions. “The long-planned sequencing for this was inclusion in the SDR {Special Drawing Rights] mix, which happened in 2016, increasing use as a trading currency, which followed that, use as the key currency of an international energy trading exchange, which has occurred with the creation of the renminbi-denominated Shanghai International Energy Exchange in last year, and the calls from big oil producers and other major trading nations to use the renminbi, which has been happening over the past few years,” the head of a New York-based commodities hedge fund told OilPrice.com. Only recently, Leonid Mikhelson, chief executive officer of Russian oil major, Novatek, said that future sales to China denominated in renminbi is under consideration and that U.S. sanctions accelerate the process of Russia trying to switch away from U.S. dollar-centric oil and gas trading and the damage from potential sanctions that go with it. “This has been discussed for a while with Russia’s largest trading partners such as India and China, and even Arab countries are starting to think about it... If they do create difficulties for our Russian banks then all we have to do is replace dollars,” he said. “The trade war between the U.S. and China will only accelerate the process,” he added.

The trade war with the U.S., though, may be the very reason why this policy is not being pushed right now by China, Rory Green, Asia economist for TS Lombard told OilPrice.com last week. “With the renminbi weakening, and set to reach 7.50 to the [U.S.] dollar level if the U.S. imposes 25 percent tariffs on all Chinese exports, it is more difficult for China to persuade the big oil producers like Russia, Iran, Iraq, Venezuela, to make the switch away from the dollar,” he said. “For China as well, the timing is not quite right, as its use of Eurodollar financing is currently significant, it has a lot of dollar-denominated bonds rolling over shortly, and its balance of payments needs a relatively healthy U.S. demand profile, but China wants to get away from the dollar system and that is the overall direction of travel,” he concluded.

By Simon Watkins for Oilprice.com

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  • Douglas Houck on August 13 2019 said:
    Interesting article and while China has a strong interest in Iran both geopolictically and economically (fossil fuels) I'm not sure that China is going to the ‘nuclear option’ of selling all or a significant part of its US$1.4 trillion holding of U.S. Treasury Bills as it is still too early in the "war" to use such an option.

    Second, I'm not sure about the statement that "China’s overall strategy to have the renminbi challenge the U.S. dollar’s status as the key global reserve currency and the prime currency for global energy transactions." is correct. China wants the yuan (renminbi) to be used within a group/basket of currencies but doesn't want the negative issues (Triffin dilemma) of being the global reserve currency. China currently uses the Euro and local currencies for a lot of transactions.
  • Mamdouh Salameh on August 14 2019 said:
    Despite prevarication by President Trump, he has no alternative but to end the futile trade war he has been waging against China for almost two years.

    The truth of the matter is that President Trump lost his trade war with China and he is finding it hugely difficult to admit defeat, hence the prolonging of the war.

    President Trump has backed himself into a corner, hardly leaving himself a face-saving way to exit the trade war. Only one option is now open to him, namely to call off his trade war against China and negotiate an end to the war on China’s terms.

    And with the trade war escalating rapidly, the hawks in Washington might see their chance to convince President Trump to abrogate the time-honoured agreement the Nixon administration reached with China on the status of Taiwan. Were he to be foolhardy to take such action, he would have crossed a red line after which anything could happen between China and the US.

    One can already suspect the United States’ involvement in the political turmoil which has been taking place in Hong Kong for the last ten weeks. This has been highlighted when China published a photo of an American diplomat meeting members of the Hong Kong opposition. I wouldn’t be surprised if a pro-independence campaign follows soon in Taiwan with US instigation and blessing.

    If, however, President Trump continues escalating the trade war and tries to push China into a corner, he will find that China has very powerful weapons in its arsenal capable of inflicting real harm on the US economy and the dollar. Some of these weapons have been dubbed as China nuclear options.

    The first is for China to retaliate by offloading its holdings of US Treasury bills estimated at $1.3 trillion. That will immediately cause a steep devaluation of the dollar thus leading to a serious exacerbation of both the US budget and US outstanding debts.

    The second weapon is for China to impose an embargo on the supply of rare earth minerals to the United States. That could potentially cripple large swathes of US industry from smartphones, turbines, lasers, missiles, advanced weapon sensors, stealth technology and jamming technology to name but a few. By the time the United States has found alternative supplies, the damage would have been done.

    Then there is the petro-yuan which is already making inroads unto the petrodollar dominance accounting for 32% of all global traded oil and which is capable of nullifying the whole US sanctions regime against Iran altogether.

    The petrodollar system provides at least three immediate benefits to the United States. (1) It increases global demand for US dollars. (2) It also increases global demand for US debt securities and (3) it gives the United States the ability to buy oil with a currency it can print at will. In geopolitical terms, the petrodollar lends vast economic and political power to the United States. Within the next 15 years, the yuan could overtake the dollar as the reserve currency of the world with the petro-yuan becoming the oil currency of the globe.

    Furthermore, China could endeavour to nullify US sanctions against Iran’s oil exports altogether by buying the entire Iranian oil exports and paying for them in petro-yuan. The reason China has so far refrained from such a drastic measure is not to escalate further the vicious trade war with the United States. However, if the US refused to see end this war, China will have no alternative but to do exactly that.

    Dr Mamdouh G Salameh
    International Oil Economist
    Visiting Professor of Energy Economics at ESCP Europe Business School, London
  • Mehrdad Nematollahi on August 14 2019 said:
    Great article!

    Trump policy is based on Saudi politics in the
    Middle East and just pushing Iran to East ( China and Russia).
    Chinese does not have the technology to boost the recovery from 5 percent of the reservoirs in Azadegan and Yadavaran oil fields.
    Trump screw up the contract with TOTAL.
    I wish Trump has a coordinated policy with Europeans and British against Iran , and if he does not care about this issue ,then America and Europe will lose all the things in Iran.
  • Ray Andrews on August 14 2019 said:
    This article misses the boat on several issues.
    First, China needs the US market far more than the US needs cheap Chinese production. Secondly, the Chinese theft of US intellectual property costs the US hundreds of billions of dollars per year and it works to reduce US technological leadership. There will be some short term economic pain for the US, but for China this trade war will be very damaging to their economy.
    The only way the US loses this trade war is if we give in. And I note that the phony gloom and doom from the US and International Trump hating media is doing everything they can to bring about this result.
    Secondly, the so-called Chinese nuclear option is a pipe-dream. There are many options and unintended consequences of China deploying this option. First, if the US wanted to support the price of the US bonds that China holds, the Fed could decide to buy them. China actually holds fewer bonds than the Fed purchased during the various Quantitative Easings during the Obama Administration. But such an effort may not be necessary because if China dumped much of their US holdings, it would create huge uncertainty in the worldwide financial markets and everyone knows that one of the safe havens for the world's investors in an uncertain market is US debt. Therefore, China dumping US debt may have little actual effect on US bond values. Finally, does anyone think that China would like to risk significantly diminishing the value of their hard won hard dollar currency in the form of US debt.
    China is like a guy at a poker game with few high cards. They can bluff and try to force the US to fold, but if we have any sense at all President Trump will see this game through and the US will be solid winners.
  • Webej Webej on August 17 2019 said:
    This argument about China's treasuries holding as the nuclear option has been debunked so many times. It's surprising and tiresome that it keeps resurfacing. The dollar is the bedrock of the monetary system and no matter how much everybody would like to change that (and Trump would like to devalue if, although that will not bring him what he wants, and recession/deflation in the rest of the world will only drive up the dollar), it is not simply a matter of convention and agreement. It will be very hard to scuttle the dollar's status and substitute something else that can take its place.

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