Far Eastern Economic Review - Issue cover dated June 20, 2002

China Mounting Effort To Safeguard Energy Supplies

By DAVID LAGUE IN HONG KONG

IT WAS NEVER MEANT to be this way. More than two decades into China's dizzying economic boom and a steady stream of giant oil tankers riding low in the water sails thousands of miles from terminals in the Middle East to the mainland's booming coastal ports.

Despite a long-standing determination to be energy self-sufficient, demand for oil in China is accelerating far beyond domestic output, and increasingly it is Middle East suppliers, including Iran, Oman, Yemen and Saudi Arabia, that make up the difference.

For industry analysts, this is one key reason why Beijing, in preparing to negotiate its first big offshore energy deal, on April 21 invited bids from Indonesia and Australia, in competition with Middle East producer Qatar, to supply liquefied natural gas (LNG) worth $13 billion over two decades for power plants in southern China's Guangdong province.

"This sends a message to the world that China wants to diversify its energy supplies away from the Middle East," says HSBC oil-and-gas analyst Gordon Kwan from his Hong Kong office. "They have identified targets in Asia than can be stable sources, including Australia and Indonesia ."

Cleaner-burning, if more expensive, LNG also has clear environmental benefits in a country that still relies on coal for 70% of its energy needs. China's major cities are choking under dense clouds of pollution from coal-fired power plants. However, boosting energy security is now a top foreign and economic priority for the Beijing leadership.

To pessimists, this is the early phase of emerging competition for energy in East Asia that has the potential to bring China into conflict with other major energy importers in the region, including Japan and Taiwan, particularly if the United States decides at some time in the future no wind back its security presence. They point out that it was insecurity over energy and rubber that drove Japan to invade energy-rich Southeast Asia in 1941, triggering a disastrous conflict with Britain and the U.S.

Kent Calder, a Japan specialist at Princeton University in the U.S., is probably the leading voice warning of the potential dangers of energy competition among increasingly heavily armed East Asian states.

To others, it is more likely that China's emergence as a major economic and trading power will lead to greater integration and cooperation. In the same way that joining the World Trade Organization is supposed to force China to observe international rules and norms, the argument goes that Beijing will find it must cooperate with energy suppliers and other major importers including the U.S and Japan if it wants to maintain economic growth.

This vulnerability is one reason why some students of international relations believe Beijing would be reluctant to attack Taiwan.

Some oil industry analysts also believe that burgeoning demand from China will have the effect of increasing international exploration and recovery of oil and gas, therefore reducing the potential for friction. The country currently produces only 70% of its oil needs and is searching for more of the fuel and other sources of power.

Whatever the eventual outcome, in the short term it's clear that Beijing is deeply concerned about depending on tankers that must cross the Indian Ocean and navigate narrow and easily-blockaded straits around the Indonesian archipelago before entering East Asia's shipping lanes. Of the 65 million tonnes of oil China imported last year, according to Chinese trade 
figures, about 60% followed this route.

Apart from the political uncertainty of relying on the troubled Middle East, what China most fears is the might of the U.S. Navy. Mindful that Washington has been prepared to enforce economic sanctions against defiant states, Beijing knows that without a blue-water navy it would be unable to counter a U.S. move to interrupt its energy supplies in the event of a serious dispute or conflict.

"The United States is currently the most powerful country in the world and is perceived by many in China as uncomfortable with China's rising power," says a recent study by the U.S.-based Rand think-tank. "As a result, the Chinese government views the United States as the primary threat to China's energy security."

The challenge for China's security planners is that domestic demand is outstripping their efforts to diversify energy sources and the gap is likely to widen, assuming that Beijing can ensure continued economic growth through reforms of its debt-laden banking system and inefficient state-owned enterprises.

The U.S. Energy Information Administration, or EIA, predicts that China's oil consumption is likely to increase from 4.78 million barrels a day in 2000 to 10.5 million barrels a day by 2020. On the way, China will overtake Japan as the world's second-largest oil consumer behind the U.S. Some analysts believe that on current trends, China will need to import about 60% of this projected demand. That will make China a dominant player on world energy markets but also vulnerable to supply disruptions or political manipulation.

Beijing has employed a multifaceted strategy to minimize this exposure. The authorities have launched a drive to boost domestic exploration and recovery in the most promising geological structures, particularly the Ordos Basin in northwest China. Offshore exploration is also a priority, with most activity now concentrated in the Bohai Sea east of the northern port city of 
Tianjin.

"If no effective measures are taken to strengthen petroleum exploration, China will become more dependent on importing petroleum and the risks to oil supply will be greatly increased," Land Resources Minister Tian Fengshan warned at an April 18 energy symposium in Beijing.

China has also invested heavily in foreign oilfields in a bid to guarantee supply. The state-owned China National Petroleum Corp. has negotiated oil deals in Venezuela, Peru, Iran, Iraq, Sudan, Indonesia , Azerbaijan and Kazakhstan. These deals have given China control over an estimated 2.7 billion barrels in foreign oil reserves.

The biggest of these agreements is a $4.6 billion commitment to buy 60% of Kazakh oil company Aktobemunaigaz, with undertakings to assist in development over two decades. This opens the possibility that China could pipe oil from Central Asia to domestic refineries, but the cost of this at current oil prices seems prohibitive to many industry analysts.

Russia's unexpectedly rapid re-emergence as a major player on world oil markets also offers an opportunity for China to minimize its dependence on the Middle East. Beijing and Moscow have been holding extensive talks on the feasibility of pipelines that could supply oil and gas from Siberia and offshore deposits.

Analysts note that there is also strategic risk in depending on Russia, a longstanding rival for influence in East Asia. Beijing's current leadership would well remember the severe energy shortages after the 1960 Sino-Soviet split when Moscow withdrew its experts and support from China's oil industry.

There are also plans to build a strategic petroleum reserve, like other major energy importers including Japan and the U.S., in a bid to buffer its economy against supply disruptions.

Shifting energy demand toward gas is another strategy to boost energy security, with demand for this fuel expected to rise sharply. According to the EIA publication International Energy Outlook 2002, natural gas accounted for 23% of world energy use in 1999 but only 3% of China's consumption. However, demand for gas is expected to expand at a whopping 10% per year over the next two decades until it accounts for almost 10% of consumption.

To meet this demand, Beijing is planning an $18-billion west-to-east pipeline to link Tarim Basin gas deposits in Xinjiang province to the coastal city of Shanghai. The Anglo-Dutch oil major, Shell, signed a nonbinding agreement last year to take a 45% stake in the 3,800-kilometre pipeline that would also pick up additional gas from the Ordos Basin. However, there are serious doubts that the venture can turn a profit because of the size of Xinjiang's reserves.

Even if the pipeline and other projects go ahead, a sizeable proportion of demand will still need to be satisfied from imports, particularly for markets in southern China that are far from domestic gas fields and planned supply networks. That is why China invited British Petroleum's Tangguh oil project in Indonesia , Australia's North West Shelf partners and Qatar's Ras Laffan LNG Co. to put in bids to supply 3 million tonnes of LNG a year from December 2005. There has been speculation in the oil industry press that the size of the order will be increased. Industry analysts report that in negotiations with the bidders, China has been able to drive a hard bargain on price because international LNG capacity currently exceeds demand.

"There is just so much gas out there that needs to find a home, so these companies are highly motivated to do this deal," says Hong Kong-based Salomon Smith Barney oil-and-gas analyst Tom Hilboldt.