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  1. Home
  2. / Investing
  3. / Energy

Why Oil Investors Gain From Spratly Islands Decision

Among the stocks to watch after yesterday's Hague verdict is CNOOC.
By ALEX FREW MCMILLAN
Jul 13, 2016 | 08:42 AM EDT
Stocks quotes in this article: CEO, SHI, SNP, GNR, FXI

Yesterday's Hague ruling on the Spratly Islands in the South China Sea was an unmitigated disaster for China, as I said yesterday. Yet it may be very good news indeed for investors.

More specifically, investors should watch for a great play on Chinese oil stocks. The most likely result of the strident decision, which ruled against China on every count and essentially said it is an outlaw state, will be talks with the Philippines and the other countries with claims in the South China Sea.

Although China has called the proceedings a "farce" and other nasty names, the conclusion of the arbitration should move forward long-stalled efforts to exploit the area claimed by China, which is about the size of Mexico and contains oil and gas reserves worth around $5 trillion.

China insists the Philippines arbitration has been "plotted and manipulated by certain forces outside the region." That's language we're used to here in Hong Kong from the Umbrella Revolution, where it was interpreted as a reference either to the U.S. in general or the CIA more specifically. China will have firmly underlined and highlighted in its playbook that the lead attorney for the Philippines is an American -- Paul Reichler, a lawyer at Foley Hoag in Washington, D.C.

But that is political bluster. Note China's concluding response: Pending settlement of the claims (which I think is never going to happen), China wants to make every effort "to enter into provisional arrangements of a practical nature, including joint development in relevant maritime areas, in order to achieve win-win results and jointly maintain peace and stability in the South China Sea."

The words "joint development" are the most important part. New Philippines President Rodrigo Duterte has used similar language. "If you want joint ventures, fine, we can get the gas and the oil," he said shortly after being elected. "I believe in sharing."

The stock to watch is China National Offshore Oil Corporation, better known as CNOOC (CEO) . Throw Sinopec (SHI) and China Petroleum & Chemical (SNP) in for good measure.

Why? In 2004, CNOOC and Philippine National Oil signed a deal to conduct seismic tests in the South China Sea. Then in 2005, national oil companies of China, the Philippines and Vietnam signed another deal to work together on seismic tests.

They were supposed to spend three years gathering two-dimensional and three-dimensional seismic lines from around 143,000 square kilometers, to assess the oil reserves there. But despite a 2007 statement that this was a model for future cooperation, the seismic tests have failed to advance.

Testing, exploration and extraction joint ventures now look to be in the cards. China is under pressure to come back to the negotiating table. The Philippines can use the ruling from the Hague to say it has sole rights to explore the Spratlys within reach of 200 nautical miles of its shores, since it has an exclusive economic zone that size, according to the verdict.

China has no claim for a monopoly on the resources under the South China Sea, the arbitration court in the Hague said. The Law of the Sea that went into effect in 1994 "extinguished" its rights, creating the 200-mile exclusive economic zone only around islands. The Spratly Islands are actually rocks, the court said, so they get no protection.

Philippine National Oil is a private state-owned company. Interestingly, China Petroleum climbed 3.15% on Tuesday in U.S. trading, although the performance of CNOOC, up 1.6%, and Sinopec, up 1.49%, mapped the move of China shares. The Shanghai Composite increased 1.8% the day of the verdict, which came after the close of China trading. On Wednesday, in its first response to the verdict, the index closed up 0.37%, which was "Meh."

Unfortunately, there isn't an ETF tracking the natural-resources sector in China, so the best you've got is the SPDR S&P Global Natural Resources ETF (GNR) or a broad China index such as the iShares China Large-Cap ETF (FXI) .

The Philippines, I would venture, will now seek joint ventures with China. It has an ace up its sleeve thanks to the Hague verdict and China already said that's the way it wants to proceed, once the bluster dies down.

What's more, Vietnam may now enter into talks with China about the oil and gas that lies between the two countries. Hanoi has a bitter maritime dispute with China over territorial rights. There were anti-Chinese riots in the Vietnamese capital in 2014 when a Chinese oil rig showed up in the Paracel Islands, much closer to China than the Spratlys but also close to Vietnam.

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At the time of publication, McMillan had no positions in the securities mentioned.

TAGS: Investing | Global Equity | Energy | ETFs | Funds | China | Markets

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