Sino-Russian Energy Relations: A Match Made in Heaven?

Edward Chow

After four decades of unprecedented economic growth, China has the second largest economy in the world and is the biggest energy consumer. Production of oil and gas in China is far short of burgeoning demand, and in 2013 it replaced the United States as the largest oil importer. Overreliance on domestic coal as the primary energy source severely damages the environment and the health of the Chinese population in ways that are increasingly unsustainable and politically unacceptable.

Even with growth in demand slowing from the economic transition to the less energy-intensive service sector, China’s oil and gas import dependence continues to worsen. Import dependency for oil has reached a dangerously high level of 70 percent. Most of China’s imported oil comes from distant sources and is transported through maritime routes over which China as yet has little control.

Russia is the world’s largest exporter of oil and gas combined. The rapid rise of global oil prices after 2000, driven largely by booming Chinese demand, helped the post-Soviet Russian economy recover. At the peak, oil and gas represented half of Russian federal government revenue and two-thirds of export earnings. Control of the petroleum sector is a major instrument of state power, both domestically and internationally.

Russia is highly dependent on Europe as the destination for its oil and gas exports for reasons of geology, geography, and history. Europe is much closer to Russia’s traditional oil- and gas-producing regions, and infrastructure was built during the Cold War to transport Russian oil and gas to markets in Europe. However, European demand for oil and gas will decline for economic, demographic, and climate change policy reasons. The development of new Russian producing areas, such as eastern Siberia and the Arctic region, depends on finding new markets where demand for oil and gas is still growing.

It serves both Russia’s and China’s interests to diversify, respectively, their oil and gas export markets and supply sources. Since the largest oil and gas exporter and importer share a common border, it is natural that they should turn to each other. The need for diversification became more urgent for Moscow in 2014, when Western economic sanctions were imposed over the conflict in Ukraine. At the same time, heightened concerns in the West over China’s rise and increasingly assertive behavior abroad caused Beijing to reassess its reliance on the international market for its oil and gas supplies.

Economic Feasibility

The dream of shipping Siberian oil and gas to China took shape during Soviet times, but it was never realized because of simple industry economics. The Chinese market was and is far away from Western Siberia. Industry fundamentals call for pipelines to be built to places where producers can gain the highest price after subtracting the cost of transportation. Western Europe was closer, overly reliant on oil imports from the Middle East or otherwise politically motivated (in the case of Germany to pursue Ostpolitik), and willing to provide financing for pipelines. China did not become a net oil importer until 1993, when the infrastructure for Russian oil and gas exports to Europe was already in place.

Shipping Russian oil and gas to China over three times the distance when compared to Europe via expensive infrastructure that does not yet exist requires a high commodity price and complicated commercial negotiations to distribute the financial risks of investments costing tens of billions of dollars. Oil pipeline deals are easier than gas deals to conclude, as transportation costs represent a smaller portion of the end value and oil is more easily traded to other buyers.

The idea of an oil pipeline from Siberia to China was revived in the mid-1990s. Negotiations were difficult and circuitous, partly because of distrust on both sides. A deal was eventually concluded in 2009, with China providing $25 billion in loans to Transneft, the Russian state-owned oil pipeline monopoly, and Rosneft, the majority state-owned Russian oil producer. Oil from the pipeline started flowing directly to China in 2011 and almost immediately an oil price dispute broke out, illustrating the commercial complexities of such deals. The pipeline was further extended to the Pacific Coast in 2013 for Russian oil to be sold to other Asian markets. Its capacity can be expanded from 1 million barrels per day to 1.6 million with smaller incremental investments. Diversification has a cost, but if state-owned and controlled companies are able and willing to pay the high price, then strategic projects can be realized.

The Eastern Siberia–Pacific Ocean (ESPO) pipeline provided real benefits to Russia and China, and to the Asian oil market as a whole. The arrival of a major new crude supply reduced the so-called Asian premium charged by Persian Gulf producers to Asian buyers. Today Russia and Saudi Arabia compete to be China’s largest oil import source, as both countries recognize China as the premium growth market, particularly when compared with the less friendly West.

The success of ESPO allowed Russia and China to proceed with a more economically challenging gas pipeline project. The Power of Siberia contract was signed in Shanghai in May 2014 under the watchful eyes of presidents Vladimir Putin and Xi Jinping. This deal took ten years to negotiate and was concluded partly due to Russia’s need to show it could not be isolated following the imposition of Western sanctions over its annexation of Crimea. The cost of Russian investments in two gas field developments in eastern Siberia and the pipeline to Northeast China is estimated at $55 billion. Interestingly, there was no offer of Chinese loans this time, only a guarantee to purchase up to 38 billion cubic meters per year of natural gas under an agreed pricing formula.

It is difficult to assess Power of Siberia commercially, since not all of the elements included in the package agreed by the two presidents are known. Around the same time, China agreed to be the first foreign purchaser of Russia’s most advanced S-400 missile defense system. Gazprom, the Russian state-controlled gas champion, understood that its giant Chayanda and Kovykta gas fields would not be developed unless it first secured a market in China. Development of these east Siberian fields for export is critical for linking the infrastructure of eastern Siberia and the Russian Far East, a national priority.

Given the financial risks, Gazprom hoped China would pay a price for gas comparable to what it received in Europe. Power of Siberia started transporting a small volume of gas to China at the end of 2019. At the same time, international oil and gas prices plummeted, even before the global recession caused by the coronavirus pandemic. Oversupply of liquefied natural gas (LNG) meant that China has the alternative of buying spot LNG cargoes without committing to additional long-term gas imports.

It is too early to judge the commercial attractiveness of this thirty-year gas deal. However, the Power of Siberia story does reveal the inherent risks in such deals: they take a long time to negotiate, finance, and complete; project costs and financial risks are high; market conditions will change in a notoriously cyclical industry; and political guidance may make deals easier to conclude, but does not guarantee commercial success. Yet Gazprom is already heralding a second and third major gas pipelines to China, presenting the Chinese market as a future equivalent to its large gas exports to Europe. The Chinese side is largely silent on this prospect, as it believes that time and negotiating leverage are on its side.

Competition from Central Asia

It is telling that neither the Russian oil pipeline nor gas pipeline projects went forward until after China first built pipelines from Central Asia. The Kazakhstan to China oil pipeline was completed in 2005 with a further extension finished in 2009. The first gas pipeline from Turkmenistan through Uzbekistan and Kazakhstan to China was completed in 2009, with two additional lines built in quick succession.

For China, the big difference is that Kazakhstan and Turkmenistan welcomed Chinese equity investments in oil and gas fields, whereas Russia resisted granting upstream ownership rights to Chinese companies, preferring instead long-term supply contracts and loans. In Central Asia, China was given opportunities in the more lucrative part of the petroleum business. In Russia, it was merely a purchaser of oil and gas. For Central Asian countries, China represented an alternative to reliance on Russia as their only export route. In fact, for Turkmenistan, China replaced Russia as the offtaker of almost all its gas.

Competition between Russian and Central Asian oil and gas favors China. It is able to drive advantageous bargains with Central Asian countries seeking financing and options to balance Russian dominance. Those contracts in Central Asia allow China to wait for the right commercial deals with Russia. Initially, Russia was rather complacent about Central Asian oil and gas going to China, even participating in the building of the Kazakhstan–China oil pipeline. The thinking was that it was better that such flows head east than west, where they would be rivals on Russia’s prime European market.

With Asia (including India) the targeted market today, it will be interesting to see if and how Russia asserts its influence in Central Asia when the Kashagan oil field in Kazakhstan and the Galkynysh gas field in Turkmenistan—two world-class projects—are fully developed. Tensions may emerge between Russia and China over conflicting interests in Central Asian oil and gas.

Chinese activity in Central Asian oil and gas long preceded President Xi Jinping’s 2013 announcement in Kazakhstan of China’s policy for the New Silk Road, subsequently renamed One Belt One Road, and now Belt and Road Initiative (BRI). Oil and gas are resources in which China needs and wants to invest in Central Asia, Russia, and elsewhere. To the extent that oil and gas projects are profitable, they help pay for others in the BRI with marginal economic returns, while income from oil and gas allows countries to buy more Chinese goods and services.

Strange Bedfellows

Russia belatedly made large upstream opportunities available for Chinese investment. In 2016, however, when Rosneft offered a major stake in its new east Siberian producing field Vankor, the asking price was too high for Chinese companies, which were given the first look. Ultimately it was Indian companies that accepted Rosneft’s price.

In 2013, China National Petroleum Corporation (CNPC) bought 20 percent of the $27 billion Yamal LNG project, majority-owned and operated by the “independent” Russian gas company Novatek. When an additional 9.9 percent stake became available the next year, a Chinese policy bank, the Silk Road Fund, stepped in to purchase the interest. Yamal LNG shipped its first cargo in 2017. In 2019, Novatek and partners made the final investment decision on a separate $21 billion LNG project named Arctic 2. CNPC and China National Offshore Oil Corporation (CNOOC) each own 10 percent of Arctic 2 to pursue a classic strategy of major LNG buyers to integrate upstream.

It may also indicate a preference for dealing with private Russian companies with the same profit motivation and interest in cost control as they have. No doubt the presence of a major European oil company, Total, and Western contractors in both projects gave additional comfort. National champion companies such as Gazprom and Rosneft tend to have their own peculiar modus operandi and are assessed differently by their majority owner, the state.

Chinese national champion companies have to be internationally competitive to prosper, and they have learned from bitter experiences in places like South Sudan and Venezuela. They spread their economic interests in other oil- and gas-producing countries in the Persian Gulf, Africa, and South America. China continues to cement strategic relationships with Russia’s competitors in Saudi Arabia and Iran, which hold the world’s largest oil and gas reserves combined.

Nevertheless, the presence of national champion oil and gas companies—Gazprom, Rosneft, and Transneft on the Russian side and CNPC, CNOOC, China Petroleum & Chemical Corporation (Sinopec), and others on the Chinese side—makes it easier to impose a decision when senior political leaders command it. Economic value creation and profit maximization can be judged secondary to strategic national objectives.

Tailwinds to Headwinds

Oil went through a supercycle of rapid price increases from 2000 to 2014 (with one interruption for the 2008–2009 global financial crisis) from around $20 per barrel to well above $100. The start of this supercycle coincided with Vladimir Putin’s rise to power in Russia, and in many ways informed his rule. It also drove China’s search for international oil and gas supplies to fuel its booming economy, and affected the quality of oil and gas deals China was willing to accept.

By 2014, the world of oil had seen a dramatic change from concerns over scarcity to plentiful supply. In 2016, Russia was forced to join OPEC in reducing production in order to prop up the price of oil. Instead of peak supply, the oil world is now consumed by the notion of peak demand due to climate change policy, transition away from fossil fuels, and other causes beyond the cyclical nature of the petroleum business. Oil prices are unlikely to rise above $60 per barrel in the short to medium term as global recovery is expected to be weak and slow, given the massive fiscal and monetary stimuli just to forestall economic collapse after the COVID-19 pandemic.

Oil and gas projects that are viable at $80 or $100 per barrel make no economic sense at today’s price of around $50. Exploration for and development of new resources in the Arctic region, for example, are no longer prudent to pursue. From an energy standpoint, the opening of the Northern Sea Route to shorten the voyage for transporting Russian oil and gas to markets in Northeast Asia is more important than Arctic exploration.

Russia may be able to maintain its high level of production for another few years, but beyond that new resources will have to be developed. If the oil price remains moderate, the capital for new investments in greenfield development in riskier frontier areas will be difficult to find. If the developed world really does move toward net-zero carbon emissions by 2050, building long lead-time and long-lasting infrastructure to transport new oil and gas supplies risks those facilities becoming obsolete halfway through their useful life.

Dreams of Different Futures

China has made a similarly ambitious pledge of net-zero carbon emissions by 2060 and is at the forefront of the energy transition. It is the largest producer of renewable wind and solar energy, the largest manufacturer of electric cars, and the largest builder of new nuclear power plants. As part of its innovation strategy, it invests heavily in the research and development of new energy technologies, from clean coal, carbon capture and sequestration, batteries, and other energy storage, to supergrids for energy distribution, advanced materials, artificial intelligence, and computing power for energy applications.

China does this partly but not solely because it recognizes its overdependence on oil and gas imports and the security vulnerability this causes. As far as energy transition is concerned, China has the advantage of economic scale in a manner no country has enjoyed since post-World War II United States. China’s dream is to be the standard-bearer of the new global economy, post-oil and gas.

Russia wants the oil age to last for as long as possible. Not only is petroleum the key sector of the country’s economy, it helps Russia to punch above its economic weight internationally. Russian leaders dream of oil and gas prices surging again, just as they did a couple of years after the global financial crisis of 2008–2009. However, what Russia really needs may be to diversify its economy away from overreliance on oil and gas.

Although China and Russia’s energy interests converge today, they may well diverge in the longer term. If the global economy moves beyond fossil fuels, the Russian and Chinese economies will have much less to offer each other. Russia would have little to sell to China and less money to buy from China. A diversifying Russian economy might turn more naturally to Europe for a partnership in modernization.

Sino-Russian relations may be a marriage of convenience arranged by oil and gas, but arranged marriages have a way of lasting. Over time, the spouses get used to each other’s annoying habits and understand the other person better. They also become attached to the progeny that issues from the relationship. It is particularly helpful if there is a common enemy, such as an overbearing West.

Both Putin and Xi have declared the current state of the bilateral relationship the best in history. More than ever, their citizens are learning each other’s language, exchanging visits, and studying and doing business together. There are also other fruitful areas of cooperation, such as military technology. Energy trade facilitates the deepening of their relationship, if for no other reason than it generates money for other activities.

The transition from oil and gas will almost certainly follow a glide path rather than suddenly drop. Given the scale of its imports, most of China’s oil and gas supply will continue to come by sea. However, China seeks to balance this with pipeline imports from Russia and Central Asia, as seaborne cargoes are exposed to interdiction by a hostile navy. Pipeline trade tends to be more stable and longer term, with both sellers and buyers invested in the infrastructure built when compared to more flexible maritime trade with shorter-term contracts and cargoes easily resold. Given the location of its oil and gas production, the challenge for Russia is whether costly new export projects will become stranded investments in ten or twenty years if the petroleum age is really coming to an end. Such disruption will also impact Sino-Russian relations, built in part on oil and gas, as the two countries’ long-term economic interests diverge.

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