Profit In The South China Sea

For centuries, China and Japan have fought for territory, resources, and affluence in the Pacific sphere. The years of warfare and strife have left these nations in a constant political tug-of-war in which each side maneuvers for clout and influence in this economically significant portion of the world. As always, the maneuvering of world superpowers provides profit opportunities for the nimble investor.

A Battle for Wealth

On November 23rd, 2013, the Chinese military designated an Air Defense Identification Zone in the East China Sea which requires intruders to notify the Chinese authorities of incursions into their air space. The Chinese claim that this Air Defense Identification Zone has been put in place to slow the Western incursion into the Pacific theater. I believe that underlying driver of this move is not political, but rather it is purely based upon economics.

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The South China Sea is the region stretching from Singapore to the Straits of Malacca and it is considered to be one of the most important trade routes in the world. Whoever gains dominance of this region will be able to exert influence on trade patterns and strategic partnerships in the entire Asian-Pacific region. After reading these statistics, you will understand exactly why China is seeking influence and asserting power in this region.

1. More than 50% of the world's annual merchant fleet tonnage travels through the Straits of Malacca, the majority of which continues through the South China Sea


2. Over 14 million barrels of crude oil travel through this region per day (roughly 33% of all global oil movement)


3. Around 190 trillion cubic feet estimated natural gas reserves ($750 billion worth at today's market price)


4. Estimated 11.2 billion barrels of crude oil reserves (Over $1 trillion worth at market prices)

The energy reserves of the region are perhaps the largest driver of aggression in the South China Sea. China is attempting to exert authority in the area in order to lay claim to its vast resources. The recent incursion represents a victory for China.

China: An Energy Importer

China is a significant energy importer. According to data gathered from the EIA, China imported over 1.3 TCF of natural gas per year. Assuming the shale-depressed Henry Hub price of $3.95/MMBTU, this means that China ran a natural gas deficit of $4.6 billion dollars in 2012. Influence in the South China Sea provides China the opportunity to retain these funds for internal development and job creation. The problem is readily apparent in the two following graphs.

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Since 2006, China has operated at an energy deficit. This is significant in that funds are constantly flowing from China to other nations in an accelerating fashion as seen in the chart below:

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Not only is China bleeding funds through gas deficits, but the picture is even starker when examining crude oil. China has consumed more crude than it has produced since 1993. As of last year, China was losing an estimated $201 billion each year through crude oil deficits.

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China is engaged in a dangerous battle to secure energy resources in the South China Sea. Not only is it seeking these resources, but Japan, Brunei, Cambodia, Indonesia, Malaysia, Philippines, Taiwan, Thailand, and Vietnam are all battling as well. The war has been ongoing for decades and the end is nowhere in sight, but the nimble investor can profit from the regional volatility resulting from this conflict.

Profit from Uncertainty

In such a complicated region, a simple thesis such as "buy this stock" simply does not exist. However, through event-driven investments, we can best position ourselves to profit. The complexity of the issue allows profit in a myriad of investments and markets.

CNOOC

The investment which will most directly benefit from the South China Sea territorial dispute is this China National Offshore Oil Corporation (CEO). CNOOC, the third largest petroleum company in China, stands to benefit greatly in that it is already producing and exploring the South China Sea. As China extends its reach, CNOOC will be able to legally access greater quantity of reserves boosting revenues. I believe that the best investment is a long term call option. Volatility is a major component in option pricing and I believe that the volatility resulting from the coming years of action in this region will greatly benefit holders of these derivatives.

Petro China

A slightly more complicated beast, Petro China (PTR) will also profit from this Chinese incursion. Petro China is not only involved in exploration and production, but also refining. Refining is a complicated creature in that the absolute price of crude oil or refined products is nearly irrelevant. What matters to a refinery is the difference in value between crude oil and the products it produces. Since Petro China engages in this field, its benefit from additional energy resources will be unknown on its refining side, but beneficial to its exploration and production departments. Net-net, I believe that an outright long position in PTR will benefit in the long run as China gains greater access to energy resources.

WTI

West Texas Intermediate is the global benchmark for crude oil prices. The majority of all global oil trades on a basis to this important contract. Interestingly enough, even though WTI is almost never processed at a foreign refinery, world events greatly impact the price of this instrument. The South China Sea conflict is interesting from a pricing standpoint in that since several countries are fighting over this region, the majority of the crude oil remains locked beneath the sea. I believe that China's incursion into the region will unlock more resources placing downward pressure on WTI prices as global output increases. The most profitable way to play this will be either a time-trade in futures contracts or shorting an oil ETF (USO) or (OIL).

Foreign Exchange

In 2012, China sold more than $200 billion worth of yuan to purchase dollars necessary to buy energy for its economy. China's territorial gain means that it will need to convert fewer Yuan to dollars to fund its deficit. This is where we investors profit. As China sells less Yuan and purchases fewer dollars there will be profit potential in both of these currencies. Dollar demand will decline by over $200 billion per year, generating profits in short positions of (UUP) and long positions of (UDN). Yuan sales will decrease by $200 billion equivalent, potentially rewarding (CYB) and (CNY) holders as supply of offered Yuan diminishes.

The South China Sea dispute will probably not be resolved in the coming months or years. Nations have fought over this region for many years and as drilling techniques have improved, the desperation of energy deficient nations has increased. I believe that a final solution is centuries in the making but for now, we can profit from short term political gains and losses in the region. Specifically, I believe that China's recent gains allow the nimble investor the potential to profit in a variety of instruments and markets.

Source: Profit In The South China Sea

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)

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