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The Russia-China Gas Deal: Implications and Ramifications

Until recently, inadequate transportation infrastructure, along with rancorous arguments about price and a general atmosphere of mutual suspicion have kept Chinese purchases of Russian energy at relatively low levels. But now, with the historic May 21st agreement, the China National Petroleum Corporation (CNPC), the country’s largest integrated energy company, and Russian energy giant Gazprom, which controls Russia’s export gas pipelines, finally signed a thirty-year, $400 billion deal that will see as much as thirty-eight billion cubic meters (bcm) of Russian gas go to China annually from around 2018 to 2047. Gazprom will send gas pumped from its Kovyktin and Chayandin fields in eastern Siberia to the Beijing-Tianjin-Hebei metropolitan area in the north of China and the Yangtze River Delta in the east. The deliveries, which may take a few years to reach full capacity, will provide China with more than one-fifth of its present-day annual consumption of some one hundred and seventy bcm, although Chinese demand for natural gas is expected to rise above two hundred bcm by then.

The final negotiations took place in Shanghai, on the sidelines of the Conference on Interaction and Confidence Building Measures in Asia, a security forum attended by senior Russian and Chinese leaders, including Russian President Vladimir Putin and Chinese President Xi Jinping. CNPC and Gazprom only completed their negotiations at four in the morning on the last day of Putin’s short stay in the city.

The Russian government, which relies on oil and gas revenue to generate rents to pay key domestic and foreign stakeholders as well as for general public services, has been eager to send more gas and oil to Asia. Despite the West’s reaction to events in Ukraine, Russia continues as a major energy player in Europe, which accounts for seventy percent of its exports. But opportunities for further growth there are constrained by economic and political factors, as Putin acknowledged in a speech shortly after the announcement of the Sino-Russian gas deal at the St. Petersburg International Economic Forum. “We have to admit that energy consumption in Europe is growing slowly due to low economic growth rates, while political and regulatory risks are increasing,” he said. “Given these circumstances, our desire to open up new markets is natural and understandable.”

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Of these new markets, Russian officials and energy firms have clearly prioritized potential sales to the faster-growing Asian energy markets, especially in China. Demand for energy in Asia is projected to grow at an annual rate of two and a half percent through 2035, a level that is almost double that of the rest of the world. Obtaining a large share of this rapidly developing regional market would give Moscow considerable funds and geopolitical influence. China is willing to provide loans or make prepayments that provide Russia’s often debt-ridden energy companies with ready cash to start building pipelines and modernize their production at low financial risk.

Many of Russia’s new and untapped hydrocarbon fields are situated in eastern Siberia and the Russian Far East, closer to China than the older fields that now provide energy primarily to consumers in Russia and Europe. Their proximity means that Russian oil and gas can enter Chinese territory directly without having to pass through international waters or third-party countries. China already derives large quantities of oil and gas from its recently built energy pipelines with Central Asia, but Chinese analysts question the stability of these suppliers given the upheavals in other Muslim countries and the vulnerability of Central Asia to adverse developments in Afghanistan.

Although oil trade between Russia and China has been taking place for years, Gazprom had postponed building an expensive state-of-the-art pipeline because Chinese and Russian negotiators were unable to agree on a price formula for the deliveries. In essence, Russian negotiators wanted Beijing to pay the same high price as the European customers, whose long-term contracts link gas to oil prices, as a means of helping Gazprom defray the high costs of developing new gas fields and constructing new pipelines from them to China. Chinese negotiators, on the other hand, sought to buy the gas at the lower prices that Chinese utilities are allowed to charge their domestic consumers, having lost billions of dollars on earlier gas imports because of state price controls.

 

The financial details of the Sino-Russian gas deal still remain murky. Gazprom CEO Alexei Miller has said that the gas deal is worth about $400 billion. Although Miller declined to specify details, the price China will pay looks to be around $350 per thousand cubic meters, which is on the lower end of what European consumers pay for Russian gas under discounted long-term contracts tied to world oil prices. For now, the volume China will receive is only one-fourth of the amount of gas Gazprom now sells to Europe. Still, the deal would provide Gazprom with sales equivalent to sixteen percent of its current exports, make China the company’s second-largest national customer after Germany, and generate $13 billion in additional annual revenue starting in 2018. Gazprom could spend approximately $55 billion, and the CNPC $22 billion, to construct the pipelines and related transportation and storage infrastructure associated with the deal. A CNPC prepayment of $25 billion could help Gazprom meet this burden as well as develop the two new fields.

Whatever the specific financial terms, in agreeing to build the expensive and immovable pipelines connecting Russian gas with Chinese importers, the two parties have fundamentally committed to a long-term gas partnership. Moscow acceded to Beijing’s demand to abandon other gas pipeline routes and construct the one being called “Power of Siberia” along a more direct path to China—through Siberia to Vladivostok, on the Pacific, with several possible connecting points with the Chinese border.

This mega-gas deal builds on earlier oil sales agreements between the two countries. In April 2009, China and Russia finalized a deal in which the China Development Bank lent Russia’s state-controlled energy companies Rosneft and Transneft $25 billion to build and operate the sixty-seven-kilometer Skovorodino-Mohe branch line, extending from the Skovorodino refinery on the East Siberia–Pacific Ocean (ESPO) oil pipeline to the Russian-Chinese border town of Xing’an. In return, Rosneft pledged to send three hundred thousand barrels per day of oil to China for twenty years.

Last year, the China Development Bank agreed in principle to lend Russia’s Rosneft more money in return for twenty-five years of additional guaranteed oil deliveries worth an estimated $270 billion at current exchange rates. Rosneft aims to triple its oil shipments to China to about fifty million tons by 2018 and, in partnership with the CNPC, construct a refinery in Tianjin in northern China with a capacity to process up to sixteen million tons of crude each year. China’s large prepayment of perhaps $60 billion to $70 billion played a crucial role in helping Rosneft manage its large corporate debt.

Despite these deals, if the two countries had not reached their recent mega-agreement, doubts that they were truly close partners would have reduced their leverage with third parties. Moreover, Presidents Xi and Putin had a personal stake in the deal after they announced at the Sochi Games in February that they would reach an agreement this year. Beijing and Moscow both face serious conflicts with other countries which would have tried to exploit perceived strains in their relationship. Western governments have been imposing sanctions and pursuing diplomatic initiatives to isolate Moscow for its military adventures in Ukraine, while China has had its own territorial clashes with Japan and other East Asian neighbors over islands thought to be surrounded by potential undersea energy and mineral deposits.

But now, Russia and China have strengthened ties and established a unique “win-win” model for developing their energy partnership: China loans Russian firms the money, often in the form of large advance payments, they need to develop new energy supplies and transport them to China. Russian energy firms in turn pledge to deliver guaranteed volumes of energy to China.

The Kremlin has also been allowing Chinese firms to assume a larger role in the Russian and Central Asian energy markets in return for providing the capital to help Russia and its allies develop new energy production. Although China has eroded Russia’s previously dominant economic presence in Central Asia, Chinese investment and trade with Russia’s southern neighbors is helping to promote stability in a region that could present a grave security threat to both countries if it should ever undergo the Asian equivalent of an Arab Spring.

Yet for all the justifiable euphoria about the new energy deal between the two countries—a deal some observers believe has a secondary motive of diminishing US power—there are still ambiguities in the relationship that the West can exploit.

For example, despite initial suggestions that the payments or the recent gas deal would be in the Chinese or Russian national currencies, which would have substantiated claims that Beijing and Moscow were indeed aiming to create a new world financial order, Russian officials have since confirmed that the Chinese will pay for their gas in dollars. Notwithstanding the complications introduced by Western financial sanctions on Russia following the onset of the Ukraine crisis, Beijing does not want to devalue its enormous dollar reserves by challenging the use of petrodollars in global energy transactions.

Chinese energy managers want to obtain Russian oil and gas but will continue to strive to limit their dependence on any single external energy source. Policymakers in Beijing do not consider Russia a reliable long-term energy supplier. They see how Russia has manipulated oil and gas exports in its dealings with Ukraine and other European countries, how it delayed constructing pipelines to China as long as possible to keep open alternative export options, and how it has attempted to leverage competing Asian and European energy customers to pressure Beijing to soften its stand in bilateral negotiations. Beijing is aware that Russian suppliers are reluctant to transfer their best energy technologies to China, especially regarding nuclear energy, for fear that they will be copied, allowing lower-cost Chinese manufacturers to displace Russian exports to third-party markets. In addition to a general strategy of avoiding overdependence on any one energy supplier, Chinese energy managers complain about quality problems with Russian nuclear energy products and services.

For its part, Russia has sought to limit its dependence on China by developing energy ties with other Asian consumers, although so far with limited success. Russia’s sole major energy deal with Japan has been that with Osaka Gas, which agreed to purchase liquefied natural gas (LNG) from Russia’s Sakhalin Energy company. However, many Japanese companies still see Russia as an unreliable partner with a poor investment climate. The Russia-Japan territorial dispute has also constrained bilateral energy ties.

On the Korean Peninsula, security and economic obstacles have impeded Russian plans to construct a trans-Korean pipeline to ship gas directly from Russia to East Asian clients, including South Korea. North Korea has demanded excessive transit fees, while South Korean investors are concerned about the risks of Pyongyang’s ability to disrupt the pipeline. As a result, Russia has been unable to secure substantial South Korean high-technology investment in its energy sector.

Partnerships between Russian and Vietnamese companies now account for more than a third of Vietnam’s oil production. In 2012, to Beijing’s annoyance, Gazprom and PetroVietnam signed an agreement to cultivate energy blocks in the contested waters of the South China Sea. But Moscow is now unlikely to risk relations with China to secure a much less economically and strategically valuable partnership with Vietnam.

The implications of the Sino-Russian energy relationship for other Asian countries are mixed. On the positive side, Moscow’s decision to expand its oil and gas shipments to Asia should help to dampen regional energy prices, especially for natural gas. The region has some of the highest LNG prices in the world; paying for LNG imports has resulted in Japan’s running a trade deficit for the first time in decades. Even if most of Russia’s deliveries go to China, that still reduces the volume of gas and oil that China buys from other sources, reducing the price for those hydrocarbons that other Asian countries buy. Lower energy costs in Asia would generally raise regional growth rates and could alleviate energy-driven territorial conflicts.

On the negative side, the confidence gained from closer Sino-Russian ties could embolden Beijing to more aggressively challenge neighbors over territorial disputes. Closer energy ties with Beijing could also decrease Moscow’s inclination to resolve its dispute with Tokyo over ownership of the islands the Russians call the Kuriles. In addition, the more Asian countries rely on Russian energy supplies, the less willing they will be to challenge Moscow’s policies regarding Ukraine and other issues. Already Japan and especially South Korea have lagged behind the United States and Europe in imposing sanctions on Russia over its actions in Ukraine.

 

Looking ahead, the recent gas deal will likely intensify Russian efforts to rebalance the terms of their trade with China, with Russians pressing to broaden their bilateral trade beyond hydrocarbons to include more high-value products such as industrial and high-technology goods. Moscow is also seeking more Chinese investment in such industries as biotechnology, nanotechnology, and aviation manufacturing. Meanwhile, Chinese energy companies want to invest in Russia’s upstream energy projects, including in Eurasia, and may demand that future deals give China’s energy companies a role in the production of Russian oil and gas—something Russian firms and officials have generally resisted.

In short, Moscow’s energy resources are far from being in China’s pocket. With its Soviet-era “brownfield” oil and gas fields experiencing stagnating production, Russia’s future oil and gas must increasingly be extracted from places that are colder, deeper, and generally less accessible. Chinese capital can help Russian energy companies develop these deposits, but unlocking the vast potential of Russia’s unexploited “greenfield” oil and gas deposits in remote Pacific and Arctic fields with challenging geophysical characteristics (e.g., offshore locations under frozen tundra) and substantially higher costs will require advanced technologies and experienced personnel possessed only by a few major Western multinationals.

Richard Weitz is the director of the Hudson Institute’s Center for Political-Military Analysis, an adjunct senior fellow with the Center for a New American Security, and an expert with Wikistrat. He would like to thank the Smith Richardson Foundation for supporting his research on China-Russia relations.

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