Chinese Pipe Dreams

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Chinese Pipe Dreams

The Russia-China oil pipeline has been headline news. But is the match of biggest oil producer and largest energy consumer one made in heaven?

The extensive media coverage of the new Russia-China oil pipeline, which became fully operational over the weekend, underscores just how revolutionary the development is.

The pipeline is the first to move crude oil directly from Russia, which was the world’s largest producer of oil in 2009, to China, which in 2010 became the world’s largest energy consumer. Indeed, some analysts note that if added to the existing rail shipments, the volume of Russian oil delivered to China could more than double in a few years. If this happened, it would fundamentally transform the energy relationship between these two Asian great powers, which until now have pursued largely independent, and in some ways competing, energy strategies.

The reality, though, is that Russian oil shipments to China are unlikely to see such a sharp increase anytime soon. The main reason is that although Russia wants to export more oil to Asian customers, this doesn’t necessarily mean the main recipient will always be China.

It wasn’t until 2009 that Russia became even China’s fourth-largest oil supplier, providing 7.8 percent of China’s imports in 2009, up from 6.3 percent in 2008. Such a low figure is perhaps surprising given that the two countries would seem to be natural energy partners given their geographic proximity, Russia’s tremendous energy resources, and China’s rapidly growing demand for energy.

In addition, Russia’s oil and natural gas deposits, some of the largest in the world, lie much closer to China than that country’s more distant energy sources in Africa and the Persian Gulf. This means that whereas oil and gas from these continents can only reach China through international waters vulnerable to interdiction by foreign navies and sea pirates, energy supplied from neighbouring Russia can enter Chinese territory directly by secure land routes.

So why haven’t energy ties been flourishing? Until recently, the key reason was the underdeveloped transportation infrastructure connecting the two countries. For example, most crude oil was sent by railway through the Zabaikalsk-Manzhouli border oil reloading terminal on the Chita-Harbin-Vladivostok railroad, a line with limited capacity and one that’s very costly to run. Not only is rail transport about two and a half to three times as expensive for Russian oil producers as shipments by pipeline, but rail deliveries to China involve the added cost of changing rail cars at the border because of the different gauges of track used by the two countries.

All this means that transporting oil (and gas) via pipeline is significantly more efficient. Yet the two governments have long engaged in divisive negotiations over which pipelines to build, where to locate them, the schedule for their construction, and who will pay to build and maintain them.

So the latest move is significant. Still, it’s important to not make the mistake of some media commentary on this issue, which appears to have conflated the Eastern Siberia-Pacific Ocean (ESPO) pipeline with the new Russia-China pipeline.

When completed in 2013 or 2014, the ESPO will extend more than 4000 kilometres, making it the longest in the world (and at $25 billion, also the most expensive infrastructure project in post-Soviet Russia). But the Russian oil pipeline to China is only a branch line of the larger ESPO.

Week-long Journey

The crude oil that passes through the Russia-China pipeline begins its week-long journey in the Russian town of Skovorodino in the far-eastern Amur region, enters China at the border town of Mohe in Heilongjiang Province, traverses Inner Mongolia, and terminates in northeast China's Daqing City.

Petro China, the operator of the Chinese section of the pipeline, then moves the oil from Daqing's Linyuan Station into the Pipeline Networks of Northeast China, where it proceeds to oil refineries in Dalian, Fushun and other cities.

Although Russian and Chinese officials had been discussing a possible direct oil pipeline for years, it was only recently that they hit upon a scheme that would overcome the fact that Russia’s energy firms lacked the capital and risk tolerance to invest the enormous funds needed to construct the pipelines.

In April 2009, the two governments finalized a $25 billion loan-for-oil deal under which Development Bank of China lent Russia's state-run energy companies the money they needed to build and operate a 67-kilometre branch line from Skovordino to Mohe. The China National Petroleum Corp. (CNPC) also committed to building a 1000-kilometre pipeline from Mohe to the refineries located in Daqing. Russia’s Transneft Corporation then built the branch pipeline, while Russia’s Rosneft energy conglomerate has pledged to pump 300 million metric tons of oil through it over a 20 year period.

Some analysts predict that the pipeline will double the flow of Russian oil to China in the next few years, and there’s no doubt the oil volumes provided by the new pipeline could be enormous. According to their 2009 agreement, Russia will deliver on average 15 million tons of crude oil annually from 2011 to 2030, equivalent to about 300,000 barrels per day for the next 20 years.

Chinese customs officials estimate that, based on current world oil prices, even an additional 15 million tons annually would, everything being equal, add $8 billion each year to the bilateral Russian-China trade volume, with most of these funds flowing to the Russian government directly or through taxes and state control over the Russian energy companies. The Chinese government, meanwhile, will earn up to $1.5 billion from tariffs. But this forecast is extremely optimistic.

The problem with presuming that the volume of Russian oil to China will soon double is that such projections assume that the Russian rail deliveries will continue. In an ironic sense of timing, China began to receive these rail deliveries after the Russian state oil firm Rosneft acquired the largest unit of the Yukos oil firm in 2004. Its owner, Mikhail Khodorkovsky, had run afoul of then Russian President Vladimir Putin, who broke apart his company and put Khodorkovsky and his closest associates in prison.

In return for 48.4 million tons of oil, China loaned Rosneft the $6 billion needed to acquire the remains of Yukos. Although Rosneft bought the Yukos unit at fire sale prices, China didn’t do badly either, effectively prepaying $17 per barrel for the almost 50 million tons of oil.

Now this contract is expiring and Rosneft has declined to extend it due to its low oil sales price, which is now considerably below world market levels. Unless Russia and China negotiate a new arrangement, the large-scale rail shipments of Russian oil to China could therefore soon end.

Although Chinese officials profess they’re happy that they now can import Russian oil via land-based pipelines, in the long run, Russia is likely to benefit most from its new west-east energy pipelines. Although Russia is already the seventh largest oil supplier in Asia, most of Russia's 50,000-kilometre oil pipeline network has been concentrated in West Siberia and has carried oil toward Europe.

For years, therefore, Russian energy managers have been seeking to diversify their energy clients to reduce their dependence on any one market and enhance their bargaining leverage among possible customers. This means the ESPO represents Russia’s key hopes of doing so as it’s designed to send large volumes of oil, produced in West and East Siberia, to Asia-Pacific countries eager to reduce their dependence on Persian Gulf oil exports.

The ESPO is also important in that it won’t require Russia to send all its oil to China — customers in China will have to compete with potential clients in Japan, South Korea, and other East Asian nations, as well as Russian domestic users. This wouldn’t be the first time the Russian government has had an eye on non-market considerations with its energy export policies, and in this case Russian officials might be willing to deliver large volumes of oil at a discount to Japan for concessions over disputed islands, or to North Korea in exchange for concessions over its nuclear and missile policies.

The Chinese, for their part, can’t even console themselves with the expectation that the completion of the long-awaited Russia-China oil pipeline will be complemented by increased Russian supplies of other forms of energy.

Russian government development plans for eastern Russia envisage a resurgence of scientific, technical, and industrial activity that will require the domestic consumption of large quantities of nuclear and hydroelectric power that might otherwise go to China. Even the near-term prospects for large-scale deliveries of Russian natural gas to China look poor.

Russian energy giant Gazprom and the Chinese National Petroleum Corporation (CNPC) have been negotiating possible gas deals since 2004, when they signed a strategic partnership agreement. During Vladimir Putin’s March 2006 trip to Beijing, Gazprom and the CNPC signed a memorandum of understanding about constructing a 6,700-kilometer gas pipeline that would link western Siberia to China’s Xinjiang Province by bisecting the Altai Republic. And, at the June 2009, St. Petersburg International Economic Forum, Kremlin energy czar Igor Sechin said that Russia was prepared to send the Chinese as much natural gas as they wanted.

But during Chinese President Hu Jintao’s state visit in June 2009, Gazprom announced that it wouldn’t be able to begin delivering natural gas to China in 2011 as planned under the Altai pipeline project because Russian and Chinese negotiators couldn’t agree on a price for the gas. Gazprom was supposed to begin building the pipeline in 2008. But without an agreed delivery price, the company is unwilling to commit to construct the pipeline.

When Russian President Dmitri Medvedev visited China in September 2010, the two governments agreed that, beginning in 2015, Russia would provide a total of 30 billion cubic meters of gas to China each year via the planned Altai pipeline. But when Putin met Premier Wen Jiabao in November 2010, Putin acknowledged that a final pricing agreement was unlikely before 2011.

The reality is that the Chinese want a discount for their large volume of purchases in the expectation that world gas prices will fall in future years covered by the contract. But the Russians, noting that their gas could flow westward to Europe as well as eastward to other Asian countries, warn the Chinese they need to pay world market prices. At least, if they want to see large volumes of Russian gas flowing across their joint border anytime soon.