China-Russia energy relations: which party holds the stronger hand?

The month of June 2011 has seen two examples of the brittle nature of Sino-Russian energy relations. The first has been the increasing visibility of the dispute between China’s CNPC and Russia’s Rosneft and Transneft concerning the price of oil delivered to China through a branch of the East Siberia – Pacific Ocean (EPSO) pipeline. The second has been the equally visible failure of CNPC and Gazprom to agree a price for gas to be delivered by pipeline from Russia to China.

The China-Russia energy relationship is blessed by a complementarity in resources and demand and by geographic proximity. Russia has the world’s second largest proven reserves of conventional oil outside the Middle East and the world’s largest reserves of natural gas. China is now the largest consumer of commercial energy in the world, ahead of the USA. Energy demand has been growing at 7-10% per year for the last eight years, and imports of oil and gas are set to grow for the foreseeable future. Although the common border is limited, by the juxtaposition of Mongolia, to a small section in the far north-west of China and to a longer segment in the north-east of China, much of Russia’s oil and gas reserves lie within 2,000 kilometres of major population centres in China. This contrasts with the 4,000-6,000 kilometres which separate the oil and gas fields of Central Asia from central and eastern China.

These potentially favourable conditions were recognised nearly twenty years ago. In the early 1990s Sidanko started assessing the giant Kovytka gas field near Irkutsk. BP, CNPC and KOGAS (Korean Gas Corporation) published a detailed feasibility study in 2003 which demonstrated how the gas might be exported by pipeline to north-east China and South Korea. In the late 1990s, Yukos and CNPC started to explore the possibility of building an oil export pipeline from Angarsk to China. An agreement to go ahead with the project design was signed in 2001, at the same time at as a Treaty of Friendship and Cooperation was concluded between the two countries.

Until 2010, the only energy products to cross from Russia to China took the form of oil carried by rail (up to 15 million tonnes per year at its peak),  some more oil passing through pipelines across Kazakhstan, a limited amount of hydro-electricity, and  a small quantity of liquefied natural gas. Only in October 2008 did Russia finally agree to construct an oil export pipeline to China, having been granted US$25 billion of loans by the Chinese. This pipeline was completed in December 2010, but the import pipeline for gas is still under negotiation.

The reasons for these delays lie mainly with the radical re-orientation of Russia’s domestic energy policy which took place after President Putin came to power. The new approach placed greater emphasis on state control over natural resources and energy exports, and on the provision of energy for internal use to support economic development, especially in Siberia. This has involved a more prominent role for the national companies Gazprom, Rosneft and Transneft. These delays stimulated China to seek alternative import routes, including pipelines from Kazakhstan, Turkmenistan and Myanmar, and liquefied natural gas terminals along the coast.

In contrast, the recent disagreements between the two sides relating to oil and gas trade involve pricing. The dispute over the price of oil coming through the EPSO pipeline centres around the pricing formula which was included within the agreement signed by both sides in 2009. This formula sets the price at the Chinese border south of Skovorodino at the same level as that at the port of Kozmino on the Pacific coast of Russia. Yet the distance from Skovorodino to the Chinese border is less than 100 kilometres, whereas the distance from Skovorodino to Kozmino is nearly 2,000 kilometres. Since oil began flowing down the pipeline in January 2011, CNPC has been withholding payments on that element of the freight costs which it believes to be ‘unfair’. Although CNPC is said to have paid a proportion of the outstanding payments, a significant debt still remains and talks on resolving this dispute are said to be stalled.

In contrast to this dispute over oil prices which is new, the failure to agree a price for gas imports is almost an annual occurrence. City gate prices for domestic gas delivered by pipeline within China generally lie in the range US$180-300 per thousand cubic metres, with a maximum of US$360 per thousand cubic metres, depending on the source of supply and the destination. The prices for China’s LNG imports currently span a wide range, from US$150-350 per thousand cubic metres  for some of the older contracts, to as high as US$500 or above for more recent contracts.

Recent reports indicate that CNPC is seeking a border price for Russian gas of about US$250 per thousand cubic metres, which would be consistent with the city gate prices and with LNG from its older contracts. In contrast Russia is seeking a price closer to US$500, well above what it is getting from Europe at present.

These two confrontations over price raise the question as to which party holds the stronger hand: Russia, with all its resources, or China, with its growing demand? At first sight, the resource owner appears to hold the trump cards. But, in my view, this is not the case. China continues to show that it has more choices than Russia, by seeking alternative overseas sources of supply, by exploring the potential for domestic sources of unconventional gas, by trying to reduce its energy intensity, and, if necessary, by rationing energy supply to end-users. If Russia does not appreciate these choices, the negotiations may continue for many more years. The next question is whether Russia is in a hurry to conclude a sales agreement with China. On the current evidence, the answer appears to be negative.

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