The visible hand of China has been extremely active in Latin America lately.
The most remarkable aspect of activity over the last couple of years is the amount of money that China has put to work. According to a report put out by the United Nations Economic Commission for Latin America and the Caribbean (UN-ECLAC) earlier this year, Chinese firms had roughly US$23 billion worth of transactions in Latin America that had either closed in 2011 or were in the process of closing. Most of these investments related to natural resources. The study further points out that in 2010, China put US$15.3 billion to work in Latin America, becoming the region's third-largest investor. The numbers are significant and show how quickly China’s perception of Latin America is changing. By way of contrasting the large sums of money invested over the past few years, consider that between 1990 and 2009 - a span of nineteen years - the sum of all Chinese investments in Latin America only amounted to US$7.3 billion. What has changed? Well, China has changed. With support from Beijing, Chinese firms have been rapidly acquiring equity stakes in natural resource companies, extending low-cost loans to mining and oil firms, and writing long-term off-take agreements. Latin America is the latest part of this effort.
The rationale behind natural resource deals is straightforward; China needs to grow, if it doesn’t, the country implodes socially and politically. One of the ways China grows is by increasing the productivity of its citizens. Urbanization is a catalyst for productivity. Since the year 2000, China has grown its population of urban citizens by 20 million people per year, yet there are still 700 million people living in rural areas. Their migration to cities shows few signs of slowing. This is a crucially important issue that affects global mining companies, agriculture firms, and of course any investor that is seriously looking at these sectors. The day China stops (or seriously slows) its growth in urbanization, I expect that the natural resources industry as a whole will crater. Natural resources firms are tied to global GDP growth. And prices for resources have tumbled in recent months due to concerns (rightly so) over Europe. However, I argue that despite anemic growth in Europe and the U.S. over the coming years, the China factor essentially puts a floor on the prices of most commodities. Barring a domestic catastrophe in China - which I doubt but many pundits think is likely - China will for decades continue to be the world’s most important investor in the resources sector.
Today, most rural Chinese are not integrated to the global economy. They grow crops and consume them; most survive on less than US$2/day. But when these individuals move to cities their commodity footprint increases exponentially. Consider the purchase of a simple white good: a refrigerator. The appliance is made from commodities (steel, aluminium, plastics), everything inside of the refrigerator is a commodity (perishable food), and the refrigerator uses commodities for power. It is plugged into a power outlet in a country where over 80% of the generating assets are coal-fired and transmitted on cables that use six tons of copper per kilometer. Multiply the purchase of a refrigerator by the millions of people moving to cities annually and the numbers begin to add up quickly.
Yet the China story is more than about white goods. The world is witnessing a tectonic shift in wealth, economic growth, and individual empowerment in a country with 1.4 billion people that lacks almost every industrial natural resource.
What does China need?
Despite having a large land mass, China is critically short of economically extractible minerals, including copper, iron ore, manganese, lead and zinc.
China consumes more than 6 million tons of refined copper annually, but produces only 1 million domestically. For this reason Chinese firms seek to invest in copper mines globally. While China has made copper investments in Africa, Southeast Asia, Australia, and even Afghanistan, it is now focusing seriously on Latin America. The China copper deficit in absolute and per-capita levels shows no sign of abating.
While copper is perhaps the most important industrial mineral in demand in China today, zinc is not far behind. Our interviews with Chinese mining investors shows a growing concern for future zinc prices. The general conclusion is that many of the world’s largest zinc mines in Australia, Canada and Africa are reaching the end of their useful lives. This fact, coupled with increased demand for zinc emanating from China, and relatively few new zinc mines being developed, has led Chinese investors to seek high-quality junior zinc miners in Peru and in other parts of Latin America.
In addition to copper and zinc, Chinese firms are scouring the globe for other minerals including nickel, cobalt, molybdenum and manganese. Lithium, used in laptop batteries and hybrid cars is also in high demand, as China is the world’s largest battery maker and consumer electronics manufacturer. Precious metals are also in high demand in both consumer and investor terms. China owns roughly US$1 trillion worth of US dollar denominated debt. It is growing increasingly alarmed about the value of its holdings if the dollar continues to devalue relative to the Chinese yuan.
Our firm's analysis shows that from 2005 to date, the vast majority of mining transactions were equity stakes, of which 83% were control equity positions or complete buyouts. Chinese firms have also purchased minority equity stakes in mining companies, however these have tended to be much smaller deals in early-stage junior exploration companies.
Chinese firms are adapting quickly and deal structures are getting more creative. A notable example is 2009’s Sinopec/China Development Bank’s US$10 billion loan to Brazil’s Petrobras. The Brazilian firm found world-class offshore oil deposits and needed large amounts of capital to finance the extraction. Unlike other transactions, the deal did not involve an equity stake in Petrobras. It was structured instead a standard off-take agreement. The Chinese will get 150,000bbl/d of oil in year one and 200,000bbl/d of oil for nine additional years. In return, Petrobras gets a low-interest 6.5% loan of US$10 billion. According to the contract, the oil will be sold to Sinopec at ‘market prices’ and paid for in cash. While Chinese national oil companies show a strong interest in loan-for-oil deals, Chinese mining investors are employing other types of creative approaches. In the mining industry, these approaches include:
- Project joint ventures: the Chinese partner, over a set number of years, performs and pays for all exploration and feasibility studies at a project level plus pays the Latin American concession holder a certain amount per year. When a production decision is made, the Chinese side owns a nominal percentage of the project and the Latin partner the remainder. Construction and working capital costs are split on ownership percentage. Sometimes this is accompanied by an equity stake in the Latin American mining firm.
- Equipment-for-equity: Chinese firms produce concentrator plants, smelters, crushers and beneficiation plants will consider ‘bartering’ these items in return for equity stakes in mining companies.
- Farm-in agreements: Chinese firms invest a nominal amount in a junior miner initially with a call option to purchase additional shares at a pre-agreed upon price if certain conditions are met (for example discovery of certain amount of minerals)
- Listing: The Hong Kong stock exchange is positioning itself to become one of the world’s largest and most liquid markets for natural resources companies. Many Chinese firms leverage the liquidity and investor demand for resource companies by acquiring overseas mining companies and injecting them into Hong Kong shells. Many of these shells have raised hundreds of millions of dollars to develop their Latin American mining projects. A notable example is Honbridge Holdings, a firm that acquired a Brazilian iron-ore asset in 2010.
Despite China’s immense need for minerals, doing deals between China and Latin America is difficult.
Parties face significant obstacles, and Latin American firms should be prepared for a process that could last 18 months or more. One of the greatest barriers to the globalization efforts of Chinese companies is a lack of employees with the right amount of international experience. As a result, Chinese companies face difficulties in both negotiating deals and operating their overseas acquisitions. There are other enormous obstacles including time zone differences, language barriers, and long flight times. Chinese State-owned enterprises (SOE’s) have other challenges including a cumbersome and laborious decision making process. Privately-held companies operate with much more flexibility but still face the common obstacles of language, cultural and geographic barriers. In all cases, Beijing must be consulted on transactions larger than a certain amount, and the approval process can take anywhere from a month to several months depending on the complexity of the transaction.
For all of the differences between China and Latin America, one aspect of the two cultures is similar: the importance of relationships. Unlike societies such as North America and Europe which operate with contracts and a functioning legal system, we have found that China and Latin America favour relationships over contracts. Instinctively both sides understand this but geography and language create significant barriers to building lasting relationships. These barriers can be best overcome with the realization that any China-Latin American transaction will not be easy.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.