Oil Is Like Milk; China Has No Need to Buy Cows: Andy Mukherjee

July 27 (Bloomberg) -- If your life depended on drinking a glass of milk every day, would you buy a cow?

That's the question Chinese planners must ask themselves as they evaluate their push to buy energy assets from Sudan and Angola to Iran, an effort that has prompted the country's state- owned oil companies to spend $15 billion in the past five years.

Agreed, the world's second-biggest auto market after the U.S. needs every drop of oil it can get. And China isn't the only country that has begun to equate energy security with physical possession of oil-producing assets.

On July 18, I wrote about a copycat drive by India.

Whereas the Chinese have bought more than 100 oil fields and companies in the past five years, the Indians have been largely unsuccessful in their quest. In the past year alone, state-owned Indian oil companies have lost at least five deals to their Chinese and Korean counterparts.

The issue, however, is more complex than who's succeeding and who's not. What needs to be considered is whether it makes sense for any Asian nation to make the purchase of energy- producing assets a cornerstone of its foreign policy when the economics of this global oil-hunt may itself be dubious.

According to three McKinsey & Co. consultants, if China manages to keep domestic production from its aging fields at the current level, it will need to buy 3 percent of the world's proven petroleum assets -- more than the combined reserves of BP Plc, Chevron Corp., Exxon Mobil Corp., Royal Dutch Shell Plc and Total SA -- to meet projected demand until 2025.

``Even if it were possible to buy all the reserves China is likely to need, the investment probably wouldn't be a smart one,'' Ivo Bozon, Subbu Narayanswamy and Jonathan Woetzel wrote in a special China edition of the McKinsey Quarterly.

Paying Premium Prices

``A much more efficient and less costly strategy would be to reform the state-controlled petroleum sector, open it to foreign investment, and integrate the country into the global system that supplies Japan, the U.S. and other big energy consumers,'' Bozon, Narayanswamy and Woetzel said.

According to the McKinsey consultants' estimates, Chinese national oil companies pay at least a 10th more than their international rivals for foreign reserves.

Why are they paying this premium? How does buying oil fields in Sudan -- and risking relations with the U.S. in the bargain -- secure China's energy supplies?

Of what use would China's overseas investments be if, say in the event of a world war, its enemies gained control of the Straits of Malacca, the chokepoint through which four-fifths of the oil used by China passes?

Value and Vulnerability

Even if China were promised home delivery of all the overseas crude it needed, where would it receive the commodity and how would it be refined?

``To keep up with surging demand, the country needs to build a large, technologically world-class refinery every year for the next 15 years, at a cost of about $2 billion apiece,'' the McKinsey researchers said.

Energy security isn't merely about extracting the crude. It extends to transportation, storage, refining, trading and retail. Things could go wrong at any stage.

After Hurricane Katrina halted refinery operations in Louisiana and Mississippi last year, crude-oil prices shot up even though global inventories were adequate. Prices rose because of limitations in the infrastructure required to divert petroleum product supplies from Europe to the U.S.

Real Security

For Asian nations, buying oil assets is a political project. Perhaps politicians have a sharper assessment of future security risks than the market. Or, what's more likely, they are just being overanxious and bidding up prices of even marginal assets.

China's quest for energy security must begin at home by dismantling arbitrary and non-transparent control on pump prices. Since March 2005, the government's guidance price for standard unleaded gasoline has risen 30 percent to about $2 a gallon, compared with a 37 percent surge in international crude prices.

As in many other Asian countries, artificially low energy costs in China have been a key plank of a strategy to keep inflation in check and avoid raising interest rates. This strategy does more harm than good.

For one, it militates against efforts at energy conservation and adds to pollution, already a serious threat to China. Second, such arbitrary price caps depress investment in everything from exploration to refining.

Global Network

China's refinery output in the first six months of this year was 85 million tons, 7 percent less than domestic crude-oil production, according to a report this month by Xinhua, the official news agency. In that period, China imported 12 million tons of refined oil products, on top of 70 million tons of crude.

The world has invested significant resources in creating a global energy network that makes oil a traded commodity.

There's nothing to be gained in bypassing the network, even if it could be done. The idea should be to find the most efficient way to embrace it.

If you need milk every day, you should buy a refrigerator. A cow in the backyard would be too much.

(Andy Mukherjee is a Bloomberg News columnist. The opinions expressed are his own.)