China's Foray Into Artic Oil

According to estimates by the U.S. Geological Survey, the Arctic may account for roughly one-fifth of global undiscovered oil and gas reserves and may also contain sizable mineral deposits -- possibilities that have piqued the interest of companies around the world.

Initially, exploration activity in the Arctic was confined primarily to Western oil majors. But recently, the China National Offshore Oil Corporation, better known as CNOOC , became the first Chinese oil company to make a play for Arctic oil. Let's take a closer look at why China has become increasingly interested in the Arctic frontier's vast resource potential.

China's bid for Arctic oil
Earlier this month, CNOOC, the state-owned oil giant, teamed up with Eykon Energy, a small Icelandic energy company, to bid for an exploration license off the northeast coast of Iceland. CNOOC's move comes shortly after the two countries strengthened their ties in April, when Iceland became the first European nation to sign a free-trade agreement with China.

A handful of important business deals between the two nations have also recently been inked, including a confidential cooperation agreement between Arion Bank, one of Iceland's largest lenders, and China Development Bank, a large state-owned financial institution. And further bolstering its increasing interest in the region, China was recently inducted as a permanent observer at the Arctic Council, the chief decision-making entity in the region.

Discouraging precedents
CNOOC's play for Arctic oil may seem surprising to some, given the recent spate of delays and shelved projects in the region. Most recently, Royal Dutch Shell announced that it will "pause" drilling activities for the year in Alaska's Beaufort and Chukchi seas, after its $5 billion oil campaign was beset with challenges including harsh weather, equipment failures, and regulatory uncertainty.

Similarly, ConocoPhillips recently said it is suspending plans to drill in Alaskan waters in 2014 because of regulatory, permitting, and other uncertainties, while Statoil announced last year that it will postpone drilling in the American Arctic until 2015. To be sure, these companies have good reasons to be hesitant in their Arctic ambitions.

Risks in Artic drilling and the bottom line
That's because Arctic drilling faces several major risks, including the threat of an environmental backlash, regulatory uncertainty, and the constant threat of harsh weather. Tax policy can be another deterrent, since large tax increases can significantly diminish the profitability of marginal projects.

Take Statoil, for instance, which recently decided to delay developing its Johan Castberg oilfield in the Barents Sea because of an unexpected tax increase that would meaningfully increase the project's break-even cost of development.

But despite the Western oil majors' negative experiences in the Arctic, China's CNOOC appears undeterred. It even recently announced that it will set up a new Arctic research center in Shanghai, a move suggesting thast China's thirst for Arctic oil is far from quenched. Let's see if it can avoid the pitfalls that led some of the Western oil majors astray.

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