Can Anyone Save This Marriage: Russo-Chinese Energy Relations

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Blank: The Russian-Chinese relationship has three parts. There is the strategic part—the military exercises, the Shanghai Cooperation Organization, the approach to North Korea and Iran—there is the ideology—including a shared vision of international relations—and there is the economic relationship. This is the weakest part of the relationship, because Russia is a backward economy. China is generally unhappy with the quality of Russian goods and Russia dominates the Chinese market only in arms.

This relationship is suffering from increasing problems, which gives the U.S. an opportunity to secure its own interests. The Russian-Chinese energy relationship is driven not by market economic forces, but by politics and power, specifically the domestic Russian bureaucracy and Russia’s foreign policy interests.

The China-Japan pipeline struggle provides a good example because it mirrored a struggle within the Russian bureaucracy. Transneft wanted a pipeline to Japan because Japan was willing to put up a lot of money, plus Semyon Weinstock owned land adjacent to the pipeline route. Other bureaucracies wanted the pipeline to China and pressed China to raise its offered price. The political nature of the energy relationship means both domestic politics and geopolitics play a part.

China is looking everywhere for energy. It is nervous because the U.S. Navy controls the sea lanes, particularly in the Persian Gulf. Some in the Pentagon worry that the Chinese navy is seeking to build force projection capability to compete for these lanes. Moreover China feels it must own energy from the wellhead to the consumer. It will not rely on cash, U.S. goodwill, or Russian supply, opting instead for a global strategy. This dictates involvement in the Persian Gulf, even if Russia delivers on its commitments.

Ultimately Russia and China are rivals. We can see this in Central Asia. Russia sells hydrocarbons to Europe, Asia, and the domestic market. All are large and growing. Given the capital scarcity and inefficiency, infrastructure problems, and pressure on foreign companies in the Russian energy industry, its growth may plateau within four or five years. Russia can only keep pace with its supply commitments if it dominates Central Asia. This means the Russian bureaucracy cannot survive without keeping the Central Asian countries backward. These nations and China all know and resent this, so they have begun to make bilateral deals like the Kazakhstan-China oil pipeline. Now there is talk of a gas pipeline that would deliver supply from Uzbekistan, Turkmenistan, and Kazakhstan to China. There is already real Russian-Chinese rivalry.

Meanwhile there is an anti-market logic in both countries. For Russia energy is the main instrument of foreign policy. To this end the government is creating monopolies and increasing state control. This leads to opacity and inefficiency. Russia lacks the capital to build necessary infrastructure, but policy keeps foreign direct investment (FDI) and foreign technology out. China wants oil and gas below the market price and Russia naturally objects.

In March Russian President Vladimir Putin promised two gas pipelines to China, one from West Siberia and one from East Siberia. The East Siberia gas pipeline has been discussed for ten years. Supply would come from Kovykta, a field controlled by BP-TNK and RUSIA Petroleum. Gazprom has long sought to take over the field, sending the Kovykta gas to the Russian domestic market and using other fields to supply China. BP has been mauled again in Moscow and will sell the field to Gazprom. The East Siberia pipeline has still not been built. The West Siberia “Altai” pipeline is nowhere near becoming reality. There is no sign of agreement on the price for gas or pipeline financing.

The story is similar in oil. One of the many reasons for the Yukos case was the company’s desire to build a pipeline to Daqing, China. Such a pipeline, with only one customer, allows the customer to dictate price. The Kremlin did not want this, nor did it want Yukos effectively playing a role in foreign policy. The pipeline to Nakhodka, on the Pacific, would instead enrich Transneft and allow Russia to supply multiple customers, including China, Japan, South Korea, and even the US. Russia would have control of price. Japan was prepared to bankroll the Nakhodka pipeline, but the cost has ballooned from $11 billion to $18 billion.

The China-Japan bidding war over the route of the oil pipeline helped Russia, but angered China. So Russia made a side deal to deliver oil to China by rail. This is extremely inefficient but geopolitically necessary—Russia would need a relationship with China whether it had Jeffersonian democrats or Ivan the Terrible ruling in Moscow.

In 2005 Putin announced the pipeline would go to the Pacific. Then in March 2006 he announced a branch line would go to China. But nobody knows how much oil there is in East Siberia, which may actually be better suited to gas exploration.

The Russian-Chinese energy relationship is much more complex and dysfunctional than it seems. Robert Jervis and Richard Betts have long argued that a Russian-Chinese alliance is the biggest potential threat to U.S. security. Energy is the Achilles’ heel of that relationship. The energy dynamic will not improve because it’s driven by the domestic politics of the two countries, and both see energy in political terms. Moreover they’re rivals in Central Asia.

If the U.S. approached China with the idea of a league of energy consumers—which would share best practices and gasified coal technology—it could help secure supply and force a wedge between Russia and China. The U.S. needs to do this because if the Pentagon is right, China will increasingly challenge the U.S. in the Persian Gulf.

Chow: The Russian-Chinese interaction is less a relationship than a series of dates. Slavneft was a bad date. There have been a few one-night stands, like the Yugansk bridge loan. There is no marriage here.

The oil and gas business is cyclical and very slow. The distribution of risk alone can take years to negotiate. People think the oil business is about all kinds of things, but ultimately it’s about money. The Russian-Chinese energy relationship is severely overhyped. In a business where projects take 20 to 40 years, riding on political winds is the worst thing to do. In 2003 I was in St. Petersburg at the U.S.-Russia energy summit. The U.S. attempt to develop an energy relationship with Russia has borne no fruit so far. Why should China be any different?

Everything is distorted by $70 oil. Governments can do many silly things, like blocking FDI or building uneconomical pipelines. As for these pipelines to the Far East, somebody must be willing to bear the burden: either the producer with a ship-or-pay contract, or Japanese refiners sharing risk, or Chinese refiners subsidizing the project. For refiners the reference point is the Persian Gulf spot price with adjustments for quality and transport cost. They won’t guarantee a price, except relative to a market index.

For a long-haul pipeline you need a big supply and a big market. In this case it would be best to have a pipeline that serves China, Japan, and South Korea. China shouldn’t care where the pipeline goes—it will pay the market price in any case. Nobody does long-term fixed-price contracts anymore. So the hype on the Russian-Chinese energy relationship is unwarranted.

Mr. Blank is right; Russia and China do need a strategic relationship. Their trade in energy and arms is natural. It’s normal that these two countries want to be global players and the U.S. shouldn’t worry about that. For now Russia is a regional player because it has pipelines only to Europe and no deepwater ports. It’s only natural for both Russia and China to diversify. I agree the U.S. should be inclusive in its energy policy. Seventy dollar oil isn’t all the result of Chinese demand. It also comes from U.S. demand and political uncertainty for which the U.S. is partly responsible. To this day I don’t understand why India and China are not in the International Energy Agency. If the U.S. tries to be the only global player, Russia and China will do things that seem threatening. Basically the U.S. can choose integration or competition.

Q&A
Q: Both speakers have case doubt on Putin’s “energy superpower” strategy. Has the market, with $70 oil, made aggressive or imperialistic behavior more possible?
Chow: Putin has presided over a huge price increase. Usually when this happens to a politician, at first he thinks he’s lucky. Then after a while he thinks he’s really good, and this will go on forever. There are some rigidities in the oil market, but these just prolong the cycle. When the fall comes it will be harder. This may be more dangerous for Russia than a stable price.
Blank: China is conserving and creating reserve supplies. The U.S. will eventually do the same. Russia has not used its energy wealth to revive other economic sectors. Instead the reaction has been to kill the golden goose, for example with Yukos. Monopolies in energy and elsewhere are strangling growth. When the crash comes there will be a hell of a lot of wreckage.

Q: Who is winning in Central Asia? Can the U.S. do anything to interfere or play a more important role in light of Vice President Cheney’s recent visit to Kazakhstan?
Blank: Russia had been able to keep China out before 2003. Lukoil even sued to try to block the PetroKazakhstan deal. China is taking Uzbekistan seriously, by the way. They’ve even considered an Iran-China pipeline. They fear the influence of the American or perhaps the Indian navy in the Persian Gulf. As for the U.S., it is finally getting a Central Asia policy. Kazakhstan is its main partner. The U.S. wants them in BTC [Baku-Tbilisi-Ceyhan] and that will require a Trans-Caspian pipeline. The TAP [Turkmenistan-Afghanistan-Pakistan-India] pipeline would help put Central Asia in the Indian, rather than the Russian or Chinese, orbit. The rivalry in Central Asia will grow.
Chow: The U.S. is way in the lead in the Caspian oil race. Chevron has a vastly larger share of Tengiz than Lukoil does. It was a mistake to exclude SINOOC from Kashagan, as the Western players wound up with the Kazakh government as a partner instead. The U.S. should not worry so much.
Blank: Kazakhstan is not going to choose the U.S. over Russia or China. We can do business there, but Kazakhstan’s neighbors will always be more important.

Q: As a high-cost producer, Russia needs a high price. China needs a low one. A Putin advisor told me a long Iranian crisis actually benefits Russia by keeping the price high. So when we talk about Russia, are we talking about the whole country or a small circle of people? If there is a small circle of oligopolists, naturally they want low supply and high prices. So first, do you see a fundamental contradiction in Russian and Chinese interests? And second, are Russian decision-makers interested in high prices?
Blank: As I said, China and Russia are already arguing on price. Yes, if people are benefiting, they want the high price to continue. Russian politics depends on patronage and guys want rents to distribute. But economic policy is undermining future growth. At some point Russia will lose customers to other suppliers, conservation, etc.

Q: This discussion assumes a strategy. One could see Russian oil and gas as a series of crony capitalist decisions with little regard for state interest. Could you comment?
Chow: I agree generally. If you want a good oil and gas strategy, invite FDI when the price is high, because you will get the best terms. Don’t wait for the price to fall. This is especially true in Russia, where there is such a need for investment. But Russia isn’t doing this. They’re waiting until they really need the money. Remember Russia is a price taker; OPEC is the price setter. Russia has no cushion.

Summary prepared by Matthew Gibson, Junior Fellow with the Russian and Eurasian Program at the Carnegie Endowment for International Peace.