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Pipeline to Nowhere: The Beijing-Moscow Dance Continues

Negotiating and then building the proposed Russo-Chinese gas pipeline should be an easy win-win. Russia has enormous gas deposits in Western and Eastern Siberia; China has an omnivorous need for energy and the huge capital reserves that would be required to finance the operation. Although there are challenges of topography and other collateral issues, none of them would seem to present insuperable obstacles in getting to yes. Yet despite more than a decade of discussions and negotiations, there is no contract for a pipeline, and the prospect for one in the immediate future is at best uncertain. But that outcome is hardly set in stone. This episode, frustrating to both parties, reveals much about the true state of Russo-Chinese relations while also confirming former Secretary of State Condoleezza Rice’s observations a few years ago about how politics are warping global energy markets.

Despite years of bilateral discussions, the East Siberia–Pacific Ocean (or ESPO) oil pipeline was not opened until 2011 (after decisive Chinese action in lending Russia the money needed for construction). Only then did China gain entrée into Russian energy firms. One reason for China’s earlier failure to gain a foothold in Russian energy was longstanding political opposition from high officials, especially those in the monopoly Gazprom, which will have a major voice in any future gas pipeline and which until now has been allergic to dealing with China. But that new pipeline has not fared well, as it was tied up in the Russo-Chinese equivalent of litigation over fees for much of 2011.

Meanwhile, the natural gas industry, led by Gazprom, remains the most backward sector of the Russian economy, having successfully resisted all efforts to introduce market reforms despite clear evidence that its monopolistic practices injure the growth of Russia’s gas sector and long-term economic development. Since Gazprom controls both upstream production facilities and downstream distribution institutions, it constitutes a major obstacle to consumer choice and market economics. Moreover, it is the monopoly exporter of gas exports and the monopolistic buyer of gas produced by oil companies even as it expands into the electricity and nuclear sectors. Consequently it has consistently failed to invest in new infrastructure and now faces negotiations with China and other Asian nations for new gas pipelines with little actual potential for supplying them with gas anytime soon.

As a monopolist, Gazprom is not content with regulating exports, but also acts to suppress potential rivals. Thus, before 2009 it regularly sabotaged any efforts by rivals like BP and its subsidiary TNK-BP to export natural gas from their project at Kovykta to East Asia until it could buy them out and use the gas strictly for domestic purposes. Similarly, when ExxonMobil announced a readiness to sell China gas from Sakhalin-1 (one of the fields established after gas was discovered on the island of Sakhalin) in 2007, Gazprom ordered it to charge market prices, thus quashing the deal.

While Gazprom was consolidating its monopoly, China initiated its own strategic petroleum reserve in 2003 and began negotiating big deals with Australia, Saudi Arabia, Kazakhstan, and Iran. It concluded negotiations with an international consortium to develop and ship natural gas in the mammoth West-East Pipeline to take gas from Xinjiang to Shanghai, which offered it opportunities for further purchases of equity holdings in Central Asian gas finds and existing fields. Thus China embarked upon a clear strategy of bypassing Russia and “going west” (or “going out”) that continues today.

 

By 2006, the question of oil and gas pipelines to China and other East Asian states had become a key issue for Russian foreign policy. The complicated politics involve not only the rivalries among China and Japan, and to a lesser degree South Korea, for Russian gas and oil. They also include the struggle within the relevant sectors of the Russian government over which pipeline or which gas company would become the primary conduit of energy to East Asia. Indeed, politics as much as economics has driven what has actually happened on the ground regarding those issues.

As Robert Ebel observed at that time in China’s Energy Future:

Energy trade, as it develops between Russia and China is and likely will continue to be a mix of politics and commercial relations. For China, as it is for all importing countries, it is a matter of access to sources of supply. For Russia, unless and until secure and substantial markets can be defined for the crude oil and natural gas resources known to be present in East Siberia, these resources will remain undeveloped, as they did for most of the second half of the twentieth century. Domestic requirements for oil and gas in East Siberia are much too limited, too scattered geographically, to warrant exploitation solely for that purpose.

Since Tokyo and Beijing were already competing from 2003 to 2008 to build the Russian pipeline on routes they favored, Russia could pit those two governments against each other and induce them to offer ever more money while retaining its independent position.

But by 2008 Japan had dropped out of the running as a result of tensions arising from Russian expropriation of Japanese oil firms on Sakhalin-2, the lack of progress on negotiations over the Kuril Islands (seized by Russia in the wake of World War II and contested since 1945), skepticism about investing in Russia, and Moscow’s anger at Tokyo for tightening its alliance with Washington in Asia. Consequently, Moscow now had only one option for oil and gas: China. It moved on oil only when China loaned $25 billion in 2009 to Rosneft and Transneft, the two companies that would find oil, ship it, and build a pipeline. (Russian leaders undoubtedly received personal consideration because the terms of the deal were so favorable to China). Having opened last year, ESPO will provide China with fifteen million annual tons of oil through 2031, at prices well below global market prices once principal and interest payments are figured in and assuming no further disruptions like those that occurred in 2011.

But there was no such progress on the issue of natural gas. In fact, there things seemed to be going backward. By 2007, Gazprom, Rosneft, and Transneft had ousted foreign firms from control of energy projects in Russian Asia. Also by 2007, Moscow had established a blueprint for a unified gas supply system throughout Russian Asia under its control focusing on major energy firms like Gazprom. The results—failure to meet deadines and cost projections, bringing enhanced Chinese and Japanese suspicion of Russian policies—were not long in the offing. Thus China reinforced its push into Central Asia and other sources of energy to bypass Russia. By 2010, China had not only completed a pipeline from Turkmenistan, it had won concessions that mean by 2012 it will be receiving at least forty billion cubic meters (bcm) annually from Turkmenistan with possibilities for sixty to sixty-five bcm in the future. However, China still wants to ensure that its gas supplies do not have to traverse the Strait of Malacca, where they would be subject to US naval interdiction during a crisis.

 

Although a deal between China and Russia was announced in 2009, to date there is still no actual agreement. The 2009 agreement provides for gas to be supplied via two routes, from fields in West Siberia (around thirty bcm a year) and from fields in East Siberia (around thirty-eight bcm). As of 2009, Moscow thought supplies could begin by 2014 or 2015, but this seems unlikely as the parties have still not agreed on price, the main issue. Progress remains stalled because of price disputes. Moscow wants to have the contract signed because this would stimulate its energy sector; however it wants to sell China gas at European prices. China demands a much lower price, and while Beijing wishes to import Russian gas, such imports are not needed for several years because China has ensured gas supplies from Central Asia and other sources such as Australia to strengthen its bargaining position. Moreover, China may have enormous domestic deposits of shale gas that could someday decisively reduce its need for Russian or other foreign gas. And to ensure that it need not depend on Russia, China just bought a thirty-percent share of Gaz de France Suez’s exploitation and production business.

China also is mainly interested in gas supplies from Sakhalin and East Siberia to eastern China, and to a lesser degree in gas supplies from West Siberia to Western China (which is the destination for gas from Central Asia). Gazprom, on the other hand, wants to launch supplies from West Siberia first. Moreover, arrangements are in place under which gas from the Sakhalin-2 project will be purchased for more than twenty years by Japanese and Korean companies (making any potential deliveries to China require the development of new fields). Developing the fields in East Siberia will require enormous investments and costly gas pipelines. China could possibly finance the infrastructure development to a large extent, altough it would probably expect co-ownership of the fields in return, which Russia has objected to.

The pipeline “deal” has several byzantine facets. First, the fact that it was signed before a pricing mechanism was agreed to indicates that Moscow regularly employs it to frighten Europe into believing that Russia has alternative buyers for its gas supplies and therefore can force acceptance of Moscow’s European gas agenda. Second, China is striking at Japan’s, and to a lesser degree South Korea’s, deals with Russia and their mutual interest in a stable energy supply relationship from Russia by pursuing access to Sakhalin-2. Third, by 2009, when the deal was signed, it was already clear that Gazprom would be undercut on its price point by Vladimir Putin’s acknowledgment that China would pay based on an “Asian oil basket” that was much lower than market prices and would cut Gazprom’s profits. But China refused to accept even this Russian concession.

If gas from Sakhalin-2 goes to China rather than Japan and South Korea, not only would their ties to Russia and their own energy plans be confounded, Russia could not then use Sakhalin-2 for Europe, as it claims that it ultimately intends to do. Thus China’s second aim relates to its interest in tying Russia firmly to China as the primary recipient of eastern Siberian and Sakhalin’s gas while striking at Japan and South Korea. Third, while this deal does open up East Siberian gas fields to exploration and supposedly advances Gazprom’s 2007 stalled “Eastern Program,” since Gazprom cannot make the necessary investments due to its earlier improvidence, it has had to open up gas fields in East Siberia to Chinese investment for the first time. Meanwhile, Beijing is not making concessions on price as it did with the 2009 loans for oil. Instead, it fully intends to become Russia’s sole if not primary customer in East Asia, upon whom Moscow’s dependence will grow while it gains ever more equity in Russian energy firms.

Moscow is vulnerable to Chinese negotiating tactics because it cannot afford to wait. Its 2009 energy strategy aims to raise its share of oil supplies to East Asia from three to ten percent by 2016. It plans to increase the number of Asia-Pacific countries to which it exports oil and natural gas ten- and five-fold, respectively, by 2020. Thus the share of Asia-Pacific countries which receive its oil exports will increase to thirty percent by 2020, and natural gas will go from five to twenty-five percent. Obviously these figures depend on implementing both new and developed energy projects, including those in Sakhalin. And in 2006 and 2007, Russia put forward an integrated gas program for eastern Siberia that is still to be implemented. The main obstacles to further developments are a shortage of capital and technology that it can only get by attracting foreign investment. And mortgaging future gas and oil supplies to China does not promote that strategy, to say the least.

 

Until 2008, an analysis of Gazprom’s huge plans for a network of pipelines bringing gas from Eastern and ultimately Western Siberia to Asia in large amounts by 2020 still insisted that Siberia receive priority gas distribution from these gas fields and that Asian consumers pay world market prices. While these authors of the plan wanted foreign countries (e.g., South Korea) to help develop Siberia in return for Gazprom gaining equity in its domestic distribution system, it is clear that the ultimate prize is China. The authors of the plan envisioned Russia building a network of gas pipelines from Russian Asia and liquid natural gas plants from Sakhalin that would allow Russia to dominate China’s gas market by 2030. But instead of concentrating on building pipelines to China, these Russian officials and planners argued that it made more sense to emphasize tying up as much Central Asian energy as possible in Russia’s hands. That Central Asian gas would then go to subsidize Russian domestic consumption, or if necessary to Ukraine, or even Europe.

So if Russia and Europe are the priority markets and Central Asia and Russia the priority construction sites, it is not surprising that energy shipments to China, notwithstanding all these glorious plans, failed to meet their targets. Similarly, Gazprom tried to get out of its plans to sell gas to China. Russia struck out costs associated with designing a gas pipeline from the Sakhalin-1 project budget for 2008 because Russia could not produce enough gas to satisfy its Asian, domestic, and European markets. Under pressure, Gazprom sacrificed China to domestic needs, intensifying suspicions that Russia, under current and foreseeable production levels, cannot satisfy the rising demand of its Asian, European, and domestic customers for energy. Not surprisingly, given Gazprom’s suboptimal organization and huge corruption, as well as its domestic political position, it opted for the domestic and European markets rather than institute market reforms to raise its production or meet Asian demand.

Although Deputy Prime Minister Igor Sechin has said, “Whatever amounts they ask for, we have the gas,” in fact both sides remain bogged down on price. And this remains the case as of the start of 2012 just as it was true in 2009, even though it appeared that China might have to loan Gazprom the money to build the Altai pipeline in return for guaranteed shipments. Gazprom reportedly tried for higher prices but got nowhere, and Russian gas executives were and may still be reluctant to commit to a project they feel gives less than they deserve.

Despite the bureaucratic maneuvering and delay, Russia knows that it is hurt by any lost time. Moscow wanted to settle the long-discussed gas supply deal with China in time for President Hu Jintao’s visit last May. Indeed, right before the visit Russian sources confidently predicted that a deal had been reached and would be announced by both heads of state. However, this apparently was a gambit to force China to accept Russian terms, and Beijing simply brushed it aside. In June 2011, both sides postponed a major deal to supply Siberian natural gas to China due to ongoing price disputes.

Beyond discord on prices, the two sides have also not yet agreed on the source of the gas. As of August 2011, the two sides are about $100 per thousand cubic meter (tcm) apart; agreement is still blocked because Russia insists on charging $352 per tcm (the European price) and China insists on paying $235 per tcm. Unconfirmed reports stated that Russia would lower the price to meet China at $250 per tcm, less than even the EU pays. If true, this development would also show how much Europe loses by failing to unite vis-à-vis Russia.

This ongoing saga of frustration illustrates what happens when political factors like a state-run corrupt monopoly essentially deprive a county of future investment and force it to borrow money from a potential customer, then accede to the customer’s stiff terms. Moscow’s games have ensured that very little Russian gas currently goes to South Korea or Japan, and that it makes very little money, relatively speaking, from those sales. Only China benefits from this situation, which continues to hobble Russia’s overall Asian policy. The saga of the pipeline to nowhere (so far) shows that China increasingly can force Russia to yield to it on major economic and political issues. If, as Bismarck said, alliances resemble the relationship between the horse and the rider, it is clear in this story who is riding whom.

 

Stephen Blank is a professor at the Strategic Studies Institute of the US Army War College. The opinions expressed are his own.

 

Photo Credit: www.kremlin.ru

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