Streetwise Professor

August 30, 2011

Old Commie Habits Die Hard

Filed under: Commodities,Economics,Politics,Regulation,Russia — The Professor @ 7:08 pm

A couple of wonderful stories today about contractual fidelity, Chinese style.

First, in 2008, when dry bulk shipping prices skyrocketed, Chinese national champion shipping company Cosco chartered large numbers of ships under long term deals at sky-high prices.  Today, prices are far lower, and Cosco has reneged on numerous contracts–thereby setting up ugly legal battles.  Fortunately, the shipowners believe they have a very strong case, and are threatening to take Cosco to court.  Cosco is counting that the prospect of the loss of future business will lead the shipowners to swallow their pride and cut the charter rates.  But who wants to do business with someone who views a forward contract as a free option?

At the same time, there is a risk that Cosco’s reputation, built up over 40 years, could suffer serious damage. Shipowners are unlikely to feel the same eagerness in future to let Cosco charter their ships to Australia.

Funny thing, reputation.  40 years to make.  40 seconds to break.

And here’s a doozy.  Back in 2009 I predicted that no sooner would the Russia-China oil pipeline get built, than there would be a contractual battle.

Sho’ nuff.

According to the 2009 Russian-Chinese intergovernmental agreement, oil deliveries to China through the Eastern Siberia-Pacific Ocean pipeline are made under contracts among Russian oil company Rosneft, Russian state-owned pipeline monopoly Transneft, and the China National Petroleum Corporation (CNPC) for 15 million tons a year over two decades. In exchange for guarantees of long-term oil deliveries China provided Transneft and Rosneft with loans of $10 billion and $15 billion respectively.

But at the beginning of 2011 the CNPC started underpaying for Russian oil, as China demanded a revision of the price formula. It currently includes the price of transporting oil along ESPO’s entire route to the port terminal in Kozmino. But as the branch to China begins at the point of Skovorodino, 1,271 miles from Kozmino, China is insisting that the pricing formula must be revised and that the cost of transportation from Skovorodino to Kozmino must be subtracted from it, with Beijing originally estimating the difference at $12 a barrel, underpaying accordingly.

Accordingly, China’s debt as calculated by Moscow is now approximately $85 million. In a telling comment on the validity of both Russia and China’s court systems, Rosneft and Transneft have begun consulting with lawyers about the possibility of initiating a lawsuit against the CNPC at the London Court of Arbitration. Earlier this month Transneft sniffed that if the case goes to court, it is prepared to return to China the $10 billion received in 2009 and to stop transporting Russian oil to China, unilaterally abrogating the 20-year contract.

Switching gears, China is upping the stakes to begin discussions at the governmental level to resolve the impasse. Chinese negotiators have invited Russian Energy Minister Sergei Shmatko to participate in the next round of talks, which is to take place in Beijing starting at the end of August, when it was originally assumed that only Rosneft and Transneft representatives would be participating in the discussions.

Konstantin Simonov, general director of the National Energy Security Foundation, is convinced that China is indulging in a bit of good old fashioned “provokatsiia,” to use a Soviet word, telling reporters, “The statement by the Chinese customs is of a provocative nature: The Chinese are endeavoring to show that Russia is not fulfilling its contract obligations and is casting doubt on the development of energy relations with China as a whole.”

Two-sided opportunism, writ large.

The original pricing in the deal was very opaque (and still is), but given Russia’s palpable desperation in early-2009, my surmise was–and is–that the pricing terms were very generous to the Chinese.  I figured that Russia would try to find any pretext to break the deal, so this doesn’t surprise me: “Earlier this month Transneft sniffed that if the case goes to court, it is prepared to return to China the $10 billion received in 2009 and to stop transporting Russian oil to China, unilaterally abrogating the 20-year contract.” But the Chinese are feeling their oats too, and no doubt they are trying to squeeze even more out of a specific asset.

Thus, given the two parties involved, no doubt each is attempting to hold-up the other.  So the Arbitrage Court should have loads of fun dealing with this one. Is “a pox on both” an allowable verdict in an arbitration?

Keep these kinds of things in mind whenever anybody talks about “capitalist” China.  Only fools would have any such illusions about Russia, and it is just as foolish to harbor such thoughts about China.  It is capitalist/rule of law when capitalism suits it, and statist/above the law when it doesn’t.  The country still has many miles to go before it is a truly reliable and law-based trading and contracting party.  When the stakes are big enough–as is apparently the case with Cosco and the ESPO pipeline–it will treat contracts like toilet paper.  (Which they need in a lot of places in China.)

In other words: seller (and investor) beware.

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  1. So was if the original deal was very favorable to China (according to you, that is; at the time, I pointed out there was no evidence for that) why on Earth is it specifically China that is trying to revise it at a time of high-again oil prices?

    If your logic were true, it would be Russia trying to squeeze out of that contract now.

    Comment by Sublime Oblivion — August 30, 2011 @ 7:37 pm

  2. […] China can’t help flaking on […]

    Pingback by FT Alphaville » Further reading — August 31, 2011 @ 1:15 am

  3. Fail to see that this is really any different from the ‘strategic default’/voluntary renegotiations engaged in by a wide swathe of companies during the financial crisis

    Comment by Tim — August 31, 2011 @ 1:41 am

  4. Ahme, SO, we know you need remedial reading classes, but the article clearly states the Chinese are trying to drive the price even lower, while the Russians are trying to wheedle out.

    Comment by Andrew — August 31, 2011 @ 2:20 am

  5. @Sublime Oblivion – you are assuming rational behavior. There are any number of reasons why the Chinese think it is a good idea to give the Russians an opening to abrogate that contract on their part even though common sense should tell them to stay away from that (assuming that Streetwise Professor’s assumption is correct about the deal being favorable to China). One is dealmaking taken to the extreme, i.e. they see one part of the contract seemingly unfair to them without looking at the full balance. I’d say this is common especially among negotiators who have little experience, or who are used to always get their way.

    And a lot of thanks to Streetwise Professor for highlighting these dealings. I guess we all understand that such a behavior is not exclusive to businesses or state-owned organizations in Russia and China however these days. We may all long back to those days where you could trust a contract (and a word) even though those days may never even have existed. Contract and litigation law firms will continue to have a bright future, living off of the inability of the contract parties to see their overall best interest on balance.

    Comment by Mondo — August 31, 2011 @ 2:27 am

  6. You were spot on Professor.

    Comment by pahoben — August 31, 2011 @ 6:11 am

  7. What’s new. Go back 20 odd years – they have done the same in a whole range of products from copper, to scrap, to corn, to soybeans. On any major fluctuations in proces given their new arrgoance and aggression we should expect to see even more events such as these

    Comment by simon hunt — August 31, 2011 @ 11:13 pm

  8. So what next for the Russians? Start threatening to sell oil and gas to Europe if the Chinese don’t play ball?

    Comment by Tim Newman — September 1, 2011 @ 2:06 pm

  9. […] Interesujący tekst o chińskim podejściu do zasady ‘umów należy dotrzymywać’, przede wszystkim w kontekście polskiej ‘afery’ z Generalną Dyrekcją Dróg Krajowych i Autostrad oraz chińskim konsorcjum COVEC w roli głównej. Okazuje się, że chińskie firmy mają w zwyczaju wycofywać się z umów, które stają się niekorzystne wskutek zmiany sytuacji rynkowej. COSCO, chiński lider transportu morskiego, wycofuje się z długoletnich umów na charter statków transportowych, które zostały zawarte na szczycie cenowym w 2008 roku. To kolejny przykład ilustrujący jak daleko jest chińskiej gospodarce do standardów wolnorynkowych. […]

    Pingback by » Do przeczytania: 18.09.2011 Niezależny Blog Finansowy — October 5, 2011 @ 9:58 am

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