China's Changing Oil Strategy and its Foreign Policy Implications

Section 1: Basic Tendencies of Oil Supply and Demand

Western estimates of future Chinese oil supply and demand show relative consonance.

These estimates are based on an average economic growth rate of 7 percent and exclude extreme scenarios in economic policy and performance. In the coming decade, the growth rate of the gap between China's demand and domestic supply will continue to increase. Chinese dependence on oil imports could grow to 30-35% of its total consumption in 2005, reaching almost 45% in 2010.

The specialists at the James Baker III Institute for Public Policy have estimated China's future oil demand according to three possible scenarios of economic performance. Their conclusion is that even in the most conservative of these scenarios—where an average GDP growth of only 2.5% would occur over the coming decade—China would require substantial oil imports. Inability to meet these requirements "will invariably interrupt the development process."

It is impossible to consider China a "have-not country" in terms of oil reserves. It was a moderate oil exporter during the 1980s, but now, its three main oil producing zones—Daqing, Shengli and Liaohe, situated in the northern and north-eastern parts of the country—are considered to be nearing depletion, and can sustain their current level of production only with additional, sound investments. The growth of the domestic supply of oil is primarily associated with the development of oilfields in Xinjiang province in western China, and the exploitation of offshore oil ranges in the East China Sea. By most estimates, both these sources—though they will probably increase output in the years to come—will fail to meet the growing demand. In Xinjiang's basins—Tarim, Jungar and Tu-Ha—the main problem is considered to be the complex geological structure of the oilfields and the need for sophisticated oil extracting technology. These factors make both the investment risk and production cost of the oil very high. Generally speaking, the reserves and potential capacities of these basins and of all Chinese onshore oilfields are currently viewed more modestly than in the late 1970-s, when they were sometimes compared to the oilfields of Saudi Arabia.

The capacity to extract offshore oil in the East China Sea, which is much more costly to extract than any onshore oil, is also below earlier expectations. Offshore oil production represents less than 7% of total Chinese production.

Until very recently, the Chinese government, had actually excluded the possibility of such a growing reliance on imported energy from its strategic and security considerations. This orientation stemmed from the premise that because of the sheer magnitude of its energy demands, China could hardly afford to not be self -reliant. However, with regard to oil and gas, the potential reserves of which are not as high as coal and will not be able to match the growing demand in the very near future, the situation is obviously changing. The evolving "oil pinch" has made many Chinese experts admit that increased reliance on oil imports is becoming "unavoidable." Facing the real possibility of importing almost half of its oil requirement—nearly 3 million barrels per day in 2010—experts began pressing the government to conceptualize and develop an "outward-looking oil economy."

In 1997, four years after China became an oil importer, Li Peng, himself an energy expert, clearly promoted a shift in the government's approach. He pointed out in his article that "as the economy develops and people's living standard rises, demand for oil and gas is certain to increase by large margins. While striving to develop our own crude oil and natural gas resources, we have to use some foreign resources."

During the last few years, several indicators have begun to show that China's oil strategy is moving in this direction.

Import statistics are the first and most convincing sign. Beginning in 1993, China's imports of crude oil grew at an average rate of 9.1% annually. Though imports dropped substantially in 1998, presumably as a result of the Asian economic crisis, the total volume of imports in 1998 was 27 mt (520 kilobarrels per day).

This totaled more than 15% of China's total consumption in 1998. In recent years (1993-1998) China's main oil import partners have been Oman, Yemen, Iran, Saudi Arabia, Russia, Indonesia and Angola.

On the basis of economic reasoning, China's growing reliance on the world oil market may be considered a reflection of the current unfeasibility of domestic production. The average production cost of Middle Eastern oil is still under $2 per barrel.

The average production cost of Chinese onshore oil is reported to be between $9 and $23 per barrel, depending on the oilfield.

Given the temporary low price of oil, and forecasts that these prices will not increase drastically in the coming five years, Chinese investment in troublesome domestic oilfields is economically unfeasible.

Other indicators of a shift in oil strategy were the serious realignments in the oil industry and the reform of domestic oil prices that took place between 1994-1996. One of the aims of these realignments was to create financially robust, strong and flexible oil companies capable of aggressive import policies and overseas investment. As result of such measures, three leading Chinese state oil companies—The China National Petroleum Corporation (CNPC), The China National Offshore Oil Corporation (CNOOC), and The China National Petrochemical Corporation (Sinopec) were promoted to the ministerial level and placed under the State Economic and Trade Commission. Along with this promotion, the companies were delegated the power to purchase operating rights and rental rights overseas, and to establish subsidiaries to undertake overseas oil exploration. The government also gradually increased the state-controlled price of crude, and thus bolstered the oil producing companies with substantial financial resources for overseas exploration and development.

Beginning in that period, the overseas activity of Chinese oil companies became very visible. At a relatively rapid pace, they purchased small to medium oilfields in Canada and Peru and bid on projects in India, Indonesia, Papua New Guinea, Russia and Venezuela. In 1995 China's leading Oil Company—CNPC—signed an agreement with the Japanese Marubeni corporation for downstream joint ventures in third states.

That same year, CNPC entered a joint venture with an American partner and bought 98 old oil wells in Texas. The most fruitful year for Chinese oil purchases was 1997. Within a short period of time, China announced that it was arranging large-scale oilfield development deals with Kazakhstan, Venezuela and Iraq totaling $5.6 billion. Though all three oilfields were considered to be potentially very rich and consistent with the serious geographical priorities of China's oil strategy, the Kazakhstan deal was considered the most important and most promising.

Section 2: Geopolitics of Oil Security: Challenges and Choices

What security challenges might be imminent for China after it becomes less self-reliant in terms of its oil supply? Perhaps more importantly, what geopolitical choices are now under consideration as remedies to these vulnerabilities?

There are two main trends that are of primary importance. First is the visibly growing relative importance of the Middle East as the world's dominant oil producer. For the coming decade, there will be no other substantial inflow of oil to the world market comparable to flows from the Middle East.

For the Middle East (plus Venezuela), total share of world oil production is forecast at 45.4 % in the year 2010.

The second important trend is the significantly increasing oil flow from the Middle East to the Asian Pacific region, with China, Japan and Korea the main consumers. According to the chart, almost every second barrel of crude oil produced in the Middle East in 2010 will head to consumers on the other side of the Strait of Malacca.

As a result of these trends, the Middle East's share of China's oil imports, fluctuating roughly about 50%, could conceivably grow to 80% or more in the year 2010. Henceforth, with such a heavy dependence on the Middle East for oil, U.S. strategic domination over the entire region, including the whole lane of sea communications from the strait of Hormuz, will be perceived as the primary vulnerability of China's energy supply. It would not be an exaggeration to say that the key objective of China's oil strategy will be to avoid this strategic vulnerability.

While addressing this multifaceted notion of "vulnerability," energy security experts often point out one of its very important dimensions—the ability of the state to accumulate the necessary resources to pay for imported energy.

In the case of China's export-oriented economy, it means that China will be confident in its energy security only if it has unlimited access as an exporter to the world market. This interdependence of China's posture on the world energy and world trade markets should not be underestimated. Even with the current low prices of crude, China's energy bill could amount to roughly $20 billion in 2010.

From this perspective, China's friction with the West over entering the world market, and its non-admission to WTO could logically be perceived by its leaders, as an infringement on its energy security.

Another challenge that China is facing in entering the world oil market as an importer is the growing regional competition among East Asian countries for crude oil. The situation in the global oil market is now rather beneficial for consumers. This is a result of low prices caused by an abundance of oil due to obvious over-capacity among the Middle East producers, and investments and technology being utilized to meet the growing demand. At the same time, there remains a very real possibility that the amount of oil entering to the world market will gradually be outpaced by soaring demand—especially in East Asian countries. This tendency will continue to progress, given the obviously low pace at which countries such as China will be able to restructure their energy mixes. In the period when the supply of oil will rapidly diminish, there is a very real and politically relevant possibility that Japan and China, as the greatest consumers of oil in East Asia, will become competitors.

This is forcing Japan to seriously consider China's energy future. To a certain extent, its own political and energy security is closely related to whether or not China will be satisfied or belligerent in terms of energy. Consequently, Japan's understanding lays the ground for the shared interests of both countries' energy strategies.

There is another factor that could also exacerbate the competition for oil between China and other East Asian states. Chinese oil refineries are primarily set up to process oil with a low to medium sulfur content. Because the volume of this type of oil is gradually declining in the world market, China's competition with Japan, Indonesia and South Korea is increasing. Facing the need to adjust itself to the increasing volume of Middle East oil with high sulfur content, China needs sound investment in its refinery sector. Both these factors are placing additional pressure on China's energy industry.

When analyzing China's developing oil strategy—the geographical and security choices being made—it must be considered that this strategy is still not developed, mature, or well conceptualized. Many other future economic and political uncertainties are obscuring China's energy priorities.

However, some priorities are quite visible and quite understandable. They include:

The geographic scope of Chinese oil development contracts expanded significantly after 1995. It has grown to include the potentially rich oilfields in Iraq and Venezuela along with fields of moderate to small capacity in Peru, Canada and the United States

However, given the scale of China's oil demand and security considerations, the solution to China's problem of dependency on Middle Eastern oil could be found in two possible places-Russia and Central Asia. There are many reasons to forecast that many serious developments in China's energy field will be oriented in these two directions.

Russia as Supplier

Russia is the world's third largest oil producer and has the largest reserves of natural gas. Given the similarities the two countries share in their free-market oriented reforms, and even more so in their respective approaches to global affairs, it seems very natural for Russia to become China's stable, if not primary, energy donor. Although in political terms the pieces of the puzzle seem to fit, the economic aspect is much less encouraging. Russia's oil industry is currently experiencing a deep depression. It has experienced a nearly 50% slump over the last ten years, which, combined with decreasing oil prices, served as one of the main reasons for Russia's default in 1997. Moreover, the crisis in Russia's oil industry should be viewed as systemic rather than simply as a symptom of current transitional difficulties. This is primarily because the majority of oil wells in the European part of the country and western Siberia have been in operation since the early 1970s, and are now substantially depleted. They require serious and costly technological renovation in order to resume output equal to the previous level. According to western estimates, in the mid-1990s Russia would need an initial investment of $25 billion and annual injections of $6 to $7 billion if it is to re-attain former production levels.

The other serious obstacle is that the Russian oil and gas industry, traditionally oriented toward the country's western market, lacks the necessary transport and refinery infrastructure in Eastern Siberia and Far Eastern Russia. The bottlenecks this causes lead to energy shortages within the Russian Far East. Meanwhile, many experts consider the production cost of the new oilfields in Siberia—namely the West Sakha oil basin—far above any reasonable level. Given all these considerations, one could assume that Russia cannot be a serious consideration in terms of supplying China with oil in the near future. Furthermore, Chinese investment in Russian oilfields is very unlikely.

However, there is another equally, or perhaps even more important consideration that prevents China from being oriented—both financially and strategically—to the Russian energy base. This is the fact that China is reluctant to add energy dependency to its already existing political and security linkages with Russia.

At present, Russia and China are considering only one substantial energy deal—the extraction and transportation of gas from the Kovytkinskoye gasfield in the Irkutsk oblast of Eastern Siberia. The project includes plans to build a 3000-kilometer pipeline running through Mongolia all the way to the eastern coast of the Shandong province of China. The pipeline project was supposed include Japanese and Korean firms as participating investors, with the terminus of the pipeline in Japan and Korea. Although no substantial progress on investment has been achieved recently, the project is supposed to provide for almost 40 percent of China's total demand for natural gas. Notwithstanding this substantial share, this plan could be considered strategically safe, given the relatively small proportion of natural gas in China's total energy consumption.

Central Asian Supplies

Compared to Russia, Central Asian oil resources seem more promising for China. The estimated oil reserves of the Caspian Basin are quite substantial—possibly as great as 200 billion barrels—though most industry analysts support a more conservative estimate of 90 billion barrels.

China's deal with Kazakhstan—in which the CNPC outbid Russian and U.S. competitors, including Texaco and Amoco—is remarkable in many respects. Under the terms of the contract, China will acquire the right to develop two oilfields (Aktuibinsk and Uzen) in exchange for its commitment to build a 3,000-kilometer pipeline from the oilfields to the Xinjiang province of China, and a 250-kilometer pipeline to the border of Iran (via Turkmenistan).

Many experts speculate over the true intentions of the Chinese in participating in these pipeline projects. The uncertainty over the real capacity of the Kazakhstan oilfields, as well as the tremendous cost of the project, which is estimated at $9 billion, are the main reasons for such speculation.

Recent information regarding Chinese plans for this project is rather encouraging. According to Wu Yaowen, vice president of CNPC, the 482 kilometer-long domestic section of the Kazakhstan pipeline—from Korla to Shanshan in Xinjiang—has already been completed. Furthermore, construction of the pipeline from Shanshan to Luoyang in Henan province, and Pengzhou in Sichuan province, is in full swing. The CNPC official also said, "when completed in eight years, the pipeline is expected to transport 25 mt (480 kilobarrels/day) of crude from Kazakhstan to China annually."

However, progress on the construction of what is strategically the most important part of the pipeline—the section extending from Shanshan to the Kazakhstan border—has not yet been reported.

When viewed from a long-term perspective, indications of the priority China places on finishing this project with Kazakhstan are quite visible. First, the projected pipeline to Kazakhstan is well matched with the long awaited pipeline network to be built inside China. It is hoped that this network will help solve the chronic infrastructure bottlenecks in China's energy system—primarily the gap between the Xinjiang oil and gas bases in western China and the main consumers in the country's eastern and maritime provinces.

The energy experts also point out another, even more farfetched consideration, concerning China's participation in the Kazakhstan project. The key geopolitical difficulty with the Central Asian suppliers is establishing a stable transportation system by which to deliver energy to the final destinations in the Middle East and Europe. Although currently pursuing different approaches, sooner or later Russia, Turkey, Iran and other involved parties will solve the transportation problem. By connecting to the Central Asian transportation system in the near future, China will eventually gain strategic continental access to the Middle East through the future Central Asian networks.

With these two pivotal links from the Middle East to Central Asia, and from Central Asia to China, China could position itself at the center of a "Pan-Asian Global Energy Bridge" that will connect existing and potential suppliers to Asia (i.e., the Middle East, Central Asia, and Russia) with the key Asian consumers (China, Japan and Korea).

China could certainly benefit from such a pivotal geostrategic position. First and foremost, with all the possible suppliers interlinked on a continental base, the stability and diversity of China's oil supplies will be enhanced. Second, China is reasonably confident that its involvement in an international pipeline network would facilitate Japanese and Korean investment in China's internal pipelines. These pipelines, while connecting Xinjiang with the eastern provinces, would eventually become an important link in the overall chain. Third, China's position at the center of the "Pan-Asian Global Energy Bridge" would provide a very important advantage in the refining process, with China's coastal regions serving as the refining link between Middle Eastern and Central Asian crude oil, and the Asian-Pacific markets.

It goes without saying that constructing such interdependence within the structure of international energy flow appears to be the ideal solution to China's energy vulnerabilities. Of course, the idea of an "energy bridge" can only be considered a long-term future scenario with many economic and political "ifs" along the way. From the narrow, energy-focused view, this type of Pan-Asian network will require huge investments in pipeline infrastructure and in China's coastal refineries.

Section 3: Implications for China's Foreign Policy

Within the general framework of China's growing energy requirements, oil strategy still faces many domestic and external uncertainties. Domestically, these uncertainties are related primarily to China's future economic performance—the real volume of aggregate energy and oil demand, sufficient technological ability to allow for significant shifts in the structure of China's energy mix, the growth of consumerist tendencies that might trigger an increase in individual energy consumption, and developments in the ecological situation. Externally, these uncertainties are influenced by possible tendencies of the future energy market, the price of oil and gas, the general climate of international relations, the prevailing tendencies for either confrontation or interdependence in the world, and the level of China's integration into the world economy.

China, as a net energy consumer, also operates within an uncertain and turbulent geopolitical context. The Middle East remains unstable, with a continued risk of interrupted energy flows. Concurrently, the Central Asian states, including China's main partner Kazakhstan, remain in search of their national identities, leaving potential output of its oil and gas reserves unclear. Russia is engulfed in economic depression and political turbulence, making investment in its vast Siberian energy resources very risky.

Given all these uncertainties, it is obvious that China must postpone any long-term energy strategy decisions. Ultimately, these critical decisions will concern the level of Chinese dependency on the foreign energy market, and consequently, the volume of investment in domestic oil production, the selection of long-term oil suppliers, and the feasibility of the Central Asian pipeline. The important decisions relating to the modernization of Chinese refinery facilities and the infrastructure for transportation and storage of oil are also pending. Supposedly, China is not yet ready to make substantial long-term investments and commercial commitments in the Middle East, Central Asia or Russia—the three global energy bases that could potentially satisfy its long-term energy needs. However, in the interim, the Chinese government is securing future access to all three zones for a time when investment will eventually be possible. Additionally, expansion of current Chinese overseas oil development is not yet necessary, because these projects are still able to meet the relatively small current Chinese aggregate oil demand. However, many of them, such as the oilfields in Venezuela, are exploratory in nature and will very likely be expanded in the future.

With regard to its foreign policy, China is interested in building the necessary political climate for such future options. A variety of diplomatic instruments is being used for this purpose in China's interaction with its "energy-related" partners. These instruments include general political and diplomatic support of countries such as Iraq and Iran, whose position seriously conflicts with that of the major powers. China uses its position and influence in international organizations to lobby for the interests of such states. Beijing's role in the United Nations Security Council and also its position in the UN bodies dealing with sanctions, were of exceptional importance to progress on its energy deals with Iraq.

The other instrument used to create the necessary political atmosphere for its "energy-related" ties, is arms sales. Many states selling oil or oil concessions to China—Iraq, Iran, Sudan, Angola and Nigeria—are buyers of Chinese weapons. The purchase of weapons by these countries is viewed by Beijing not only as the construction of close "special" ties with the states, but also as an instrument by which to decrease its energy import bill.

Manifestations of China's oil-related interests were visible in its active support of Kazakhstan's accentuated steps to demonstrate and strengthen its Asian identity. Beijing's compromising and conciliatory approach to the settling of the border disputes with Kazakhstan was also obviously dictated by energy priorities.

The other evident example of similar motivations may be seen in China's relations with Angola and Sudan. China supported both regimes politically and militarily during their conflicts with their African neighbors.

China's current oil situation, characterized by a lack of substantial overseas investment in oil production, and growing import flows from the Middle East, is favored by current energy market tendencies. At present, the relatively low price of Middle Eastern oil makes huge investments in development in both domestic and overseas non-Middle East oilfields unfeasible. However, such a situation will not last long. According to estimates, maintaining stable oil supplies with a volume higher than two million barrels a day is impossible without long-term trade commitments and access to the production of oil. China is very likely to surpass this two-million-barrel barrier in the coming five years.

Making such long-term commitments is a serious geostrategic consideration for China. There are many indications that suggest that its choice will ultimately favor Central Asia—likely the primary focus of Chinese investment in oil production and transportation. The biggest share of China's oil will still come from the Middle East, but given the limited capability of the Chinese navy and the relative geographical proximity and accessibility of Central Asian oil via surface transportation, Central Asia appears to be China's most natural choice as an energy supplier. More importantly, by investing in Central Asia, China will avoid the danger of becoming energy dependent on Russia or the United States. The latter would be the case if Beijing continues to rely heavily on oil imports from the Middle East.

Realistically, the possibility of any serious Chinese financial participation in oil exploration and development in either the Middle East or in Russia is much lower. In the case of the Middle East, Western and Middle Eastern oil companies already tightly control those oilfields outside of Iran and Iraq—namely those in Saudi Arabia, Kuwait and the United Arab Emirates. Chinese access to open competition for the exploitation of promising oilfields in these countries is very unlikely. In the case of Russia, considering the Western and Northern Sakha oilfields China's most probable option, extraction and transportation costs will remain economically unfeasible.

Choosing Central Asia as the primary region for long-term energy investments, China will certainly continue to maintain strong interest in the development of oilfields in Iran and Iraq. These two countries will continue to receive special consideration from China, because the eventual lifting of the oil embargo on Iraq will return its oil to the world market, effectively making these two energy partners a type of insurance measure. This insurance will be necessary if the actual output of Central Asian oil turns out to be no more than the minimum level expected. Nonetheless, if that were the case, the enormous investment in the pipeline grids to Central Asia would not be considered a failure. Their simple extension to Iran would continentally link China to the Middle East.

The short pipeline from Kazakhstan to Iran, part of the Chinese oil exploration package with Kazakhstan, is an obvious component of China's overall strategy. Another confirmation of Chinese intentions is visible in the Chinese effort to expand its involvement in the Iranian energy infrastructure. According to information circulating among western energy experts, though the Chinese are still denied access to Iranian oil fields, Chinese construction companies are currently bidding on the proposed Iranian pipeline from the Caspian Sea to Tehran. Their chances of winning the contract for this so-called "Nekka pipeline" are considered very high.

In fact, China has its own vested interest in obtaining a pipeline link from the Caspian to the Middle East via Iran. Given the challenges China will continue to face with regard to its energy supply, this solution, in line with the concept of the "Pan-Asian Global Energy Bridge" seems to be the most beneficial to the country's overall energy interests. It would leave China in the least vulnerable position with respect to both oil reserve depletion and transportation risks.

From the political perspective, this new route for such a significant energy flow could have a significant impact on international relations in Asia. By drastically shifting the most important and busiest energy artery in the world from the Strait of Malacca to a line across mainland China, the creation of new geopolitical tendencies inside Asia would be inevitable.

One possible tendency might be growing economic and security cooperation between China, Japan, and Korea. It is clear that all three countries have strong a strategic interest in the benefits of continental access to Middle Eastern and Central Asian energy reserves. The compatibility of all three countries' interests in this energy route is obvious. It has already brought Japanese companies—regardless of their anxieties over transportation dependency on China—to jointly participate with the Chinese in Central Asian energy projects. On the Chinese side, enthusiastic interest in Japanese and Korean financial participation in costly pipeline projects is highly visible. The necessity of such cooperation provides justification to overcome the legacies of the past and suspicions of regional hegemony.

Another possible development stemming from these events, as well as from the decreasing importance of the sea-routes in the Indian and Pacific Oceans, could be the eventual reshaping of the basic security arrangement between the United States and Japan. Japan, feeling that the sea-routes of the Asia Pacific are less vulnerable, while relying to a greater degree on the stability of its ties with China, might be interested in a less binding set of military commitments in its alliance with the United States.