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Environment Magazine September/October 2008

 

June 2007

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Searching for Oil: China’s Initiatives in the Middle East

In a world in which the supply of oil is limited by geology and politics, China’s determination to fuel its rapidly growing economy is seen by many as a looming source of conflict. It is not simply the geographic breadth of China’s initiatives that cause anxiety in Western capitals but also its willingness to enter into economic arrangements with “rogue” states. Critics believe that China, unfettered by concerns about human rights and willing to link oil investments with foreign policy goals, has been able to gain an unfair advantage in the competition for oil and regional influence. They point to China’s relationship with nations such as Angola, Sudan, and Iran.

Is this concern warranted? Do China’s recent initiatives augur a future replete with tensions over access to oil? What motivates Chinese oil policy? Are its policies inevitably in conflict with Western long-term interests? Unfortunately, the answers are complicated, clouded by incomplete data and conflicting signals. One can find evidence to support almost any particular argument. A number of factors influence Chinese policy, and these are often uncoordinated and sometimes in conflict. China’s relationship with the Middle East illustrates how the interaction of political and commercial factors shape China’s oil policy. Definitive conclusions and simple paradigms may be beyond the reach of a single discussion, but a nuanced assessment of China’s oil investment may provide a better understanding of these initiatives and therefore broaden and enhance the debate.


China’s Growing Appetite for Oil


China is the world’s largest country with a population of 1.4 billion people. Its economy has grown at a pace unprecedented in modern history: more than 9 percent per year between 1978 and 2005. Energy is critical to service this growth, but despite building 199,300 megawatts (MW) of new electricity generating plants over the last five years, increasing its coal consumption by 21 percent over the same period,1 and initiating one of the world’s most aggressive campaigns to increase energy productivity, China continues to be plagued by localized energy shortages. Frustrated by inadequate electricity supplies, many industrial and commercial consumers have been forced to rely on small, inefficient diesel-fueled generators to meet their production schedules. This increase in oil demand is mirrored by a dramatic increase in motor vehicle sales and modal shifts in the movement of freight to truck and barge transportation.2 Overall, China’s reliance on imports as a percent of total energy remains low (approximately 8 percent), but as China becomes more urbanized and its demand for transportation services grows, this situation will change.3 Between 2000 and 2005, China’s oil consumption increased from 4.7 million barrels per day (bpd) to almost 7 million bpd; in 2005, 43 percent of this consumption was derived from imports.4 In 2004, China’s annual growth in oil demand approached 800,000 bpd, accounting for one-third of the world’s incremental increase and 70 percent of the growth in the Asia-Pacific region.

Despite its vastness, China has never discovered large oil reserves. Its traditional fields in and around Daqing and Shengli are old and their production is either flat or declining, while its newer discoveries in the Junggar and Tarim basins are modest on a global scale and are far from China’s population centers on the coast. To meet its projected demand, most Chinese officials agree that the country must aggressively venture into the global oil market. In fact, the International Energy Agency (IEA) predicts that China’s oil imports will grow from 1.5 million barrels in 2000 to approximately 10.9 million barrels in 2030, when China will be importing about 77 percent of its crude oil with more than half of its imports coming from the Gulf States.5


China’s Oil Import Strategy


China began to pursue oil supplies outside its borders in the early 1990s. By 1997, it was negotiating billions of dollars in oil investments throughout Asia, Africa, the Middle East, and even South America. While the geographic scope of its efforts was broad, the strategies and structures underlying these initiatives were far from homogeneous. Even under the best of circumstances, countries (and for that matter international oil companies) are forced to adjust their strategies to the policies and political environments in which they are operating. These differ from one country to the next. There are several factors, though, that are particular to China’s oil initiatives. First, the structure of China’s oil industry is unique. The government simultaneously strives to retain control of the industry while encouraging its state oil companies to be aggressively entrepreneurial. Second, China is a new entrant in the global market, and this creates advantages and disadvantages. Finally, while China worries about its vulnerability to future oil disruptions, the character of its concern is different than that of its Western counterparts.

An Oil Industry in Transition

In the mid-1990s, China’s leaders reluctantly accepted reality; complete oil independence was financially and technically unrealistic. China needed to build the capability to participate in global oil markets. In response, it restructured its preexisting state oil and gas enterprises into two major companies: the China National Petroleum Corporation (CNPC) and the Chinese National Petrochemical Corporation (Sinopec).

In the 1980s and early 1990s, one could think of Sinopec and CNPC as arms of the state. But in 1998, as China’s economic policies became more market-oriented, the companies and associated ministries were reorganized to respond more to commercial than social goals. These changes, however, only went so far. The result is a mixture of investment strategies, some exclusively driven by commercial opportunity and others evidencing strong government intervention. Because there is little transparency, it is not always clear which of these is operational.

The profitability of the state oil companies is critical to China’s efforts to meet its long-term energy security goals while supplying a significant percentage of the total revenues realized from the struggling state sector.6 China’s government may leave the management and many of the investment decisions to professional executives, but clearly it has the legal means to intervene if it so decides. Further, the boards of all of its oil companies consist of senior government officials, and there is a revolving door between the corporate boards and senior political positions. This makes it difficult for the companies to ignore “requests” made by the central government: Failure to respond could jeopardize future promotions. This is not to suggest that government intervention is not costless. In fact, the costs could be high, since international investors will raise the cost of capital in reaction to a perceived increase in political risk.

China’s government structure and  decisionmaking processes are notoriously stove-piped. One agency is often unaware of what the other is doing. This often results in investment and initiatives that seem internally inconsistent. If these inconsistencies are sufficiently serious or visible, they are adjusted, but if not, they are left alone to puzzle outside observers.

Recognizing these structural problems, the government recently established the National Energy Leading Group (NELG) as a part of the State Council, the highest decision body in China. The group is chaired by the prime minister and includes the heads of the twelve relevant ministries and commissions, including Defense. To staff this body, NELG created the National Energy Office, which will be responsible for developing policies and programs for NELG consideration and for insuring the group’s decisions are implemented.7

This reorganization will not eliminate all the inherent tensions in the system. As they become more profit-motivated, China’s oil companies will be less willing to sacrifice their bottom line to achieve political goals. Authority is still fragmented with multiple agencies or commissions with some statutory responsibility for energy, but over time the asymmetry of information between the government and its oil companies will decrease, insuring that China’s oil strategies will be more coherent.
 
Late to the Party

In the mid-1930s, the fledgling U.S. oil industry and its government confronted a world in which the largest known oil reserves outside North America—Iraq, Southeast Asia, and Iran—were tied up by British and European interests. Hence, the companies looked for potential resources outside the European sphere of influence. Some of these were in neighboring countries, but others were in regions that heretofore had been ignored by the established industry, such as Saudi Arabia. Although the stated U.S. policy was to achieve oil self-sufficiency, corporate and government officials understood the long-term strategic value of foreign oil. To compete with the European companies, the U.S. government granted its companies generous tax credits and subsidies to invest in oil production outside the United States. These efforts were actively supported by the U.S. Department of State and eventually the U.S. military.

Over the past 55 years, U.S., Japanese, and European companies have forged relationships with key producing countries. The Chinese perceived these partnerships as entrenched and felt compelled to find alternative sources of oil. They focused on three sources: neighbors, such as Russia and Kazakhstan; countries where entrenched Western energy interests were less prominent, such as Yemen, Oman, and several African nations; and producing countries in which the government had severed most of its historical ties to European and U.S. interests, such as Sudan and Iran. These three categories were all targets of opportunity, some more so than others.

There are risks inherent in each. Neighbors may have significant supplies and shorter and more secure transportation routes, but centuries of border conflicts often have resulted in distrust that must be overcome if a future partnership is to become sustainable. In cases where private multinational oil companies ignored certain producing countries, it is often because that country’s resources are perceived as small or its governance and industrial infrastructure inadequate. Finally, countries where the government repudiates the contracts signed by its predecessors are also countries where the government can change again, throwing out present relationships and contracts.
In an ideal world, China would like to secure long-term concessions, but such an option is limited in today’s market. Approximately 85 percent of the oil traded is controlled by producing governments. Concession agreements, which used to be common, are now rare. Instead, producing states prefer to contract with foreign oil companies for expertise, technical services, and investment dollars but not to take ownership of the oil. In a recent report, the U.S. Department of Energy (DOE) assessed China’s success in “hoarding” equity oil (that is, oil owned by the producer, not purchased in the market): “By early 2005, China’s cumulative overseas investment in oil and gas supply was $7 billion, averaging less than $600 million per year. The total equity oil secured is around 400 thousand barrels per day, equivalent to roughly 15% of China’s total crude imports or 6% of China’s current oil consumption.”8

U.S. DOE goes on to compare China’s “hoarding” to the activities of the three largest U.S. companies: ExxonMobil, Chevron, and ConocoPhillips. These three companies produce 3.9 million bpd of equity oil—almost 10 times the volume owned by the Chinese companies.9

China recognizes that the availability of equity oil is limited under the best of circumstances and insufficient to meet its future needs. To address this shortfall, China has attempted to incorporate oil into a broader trading regime. Countries that were reluctant to sell China equity oil welcomed Chinese expertise, purchasing efforts, and investment dollars. Therefore, Chinese companies developed a strong technical and service capability that could be exported. More significantly, China also offered ancillary trading arrangements. Often these were oil related, such as rights to construct downstream facilities in China, but in other cases they involved the sale of non-energy Chinese goods, including, in some instances, weapons.

These bilateral arrangements have a more pronounced government-to-government flavor than the U.S. and European oil strategies, which have relied on multilateral market approaches. For example, ExxonMobil does not offer grain sales as a means to cement an oil concession.

What concerns Western governments is not so much the expanded scope of these equity arrangements as the fact that some of them have been consummated with “rogue states” that are openly hostile to the United States (Iran) or have shown a marked disdain for human rights (Sudan). This concern has two elements, which are slightly contradictory. The first is that China is taking advantage of the international embargos that prohibit Western oil companies from investing in these states. Instead of joining the West and condemning these rogue states, China, from the perspective of the United States, is taking advantage of international sanctions to reap competitive benefits. The second concern is that China’s actions are aiding and abetting bad regimes, which, because of Chinese investments and technical assistance, are able to stay in power longer and continue their record of belligerence and abuse.

The first of the two charges does not survive close scrutiny. In fact, a strategy of entering into oil concessions with rogue states may actually turn out to hurt China’s long-term interests. Rogue states are often characterized by an autocratic leadership, lack of long-term civil stability, and corruption.10 Governments that fit this description usually do not have workable legal or civil institutions; thus, contracts depend on the disposition of a few government leaders. When these leaders are replaced or significant factional struggles occur, there is no guarantee that agreements will be honored as negotiated. Relying on oil deals from rogue states is risky and may not be economically sustainable over the long term.

The second objection is more valid. Certainly in a situation in which the international community is refusing to invest in a rogue state, Chinese investments and trade will increase the host government’s coffers, giving it the ability to buy more arms.

In a world in which Chinese oil companies feel that they have few other options, the benefits of having relatively uncontested access to oil supplies may be worth the short-term political costs, but going forward, these costs will rise as China becomes a larger player in the international market. In future years, a strategy based on international cooperation may look more attractive than one that relies on special arrangements with a few rogue states.

Oil Security: The Chinese Perspective

While Chinese officials may differ on the character of the oil security threat and what to do in response, all are focused on the question posed by Shen Dingli, a professor of international relations at Fudan University, “If world oil stocks were exceeded by growth, who will provide energy to China?”11 Under these circumstances, would the United States and Japan be willing to share oil? Most Chinese leaders are skeptical. Recognizing that future economic growth requires a continual flow of oil and that future demand can only be met by going outside traditional Asian markets, Chinese officials are fully aware that they must venture out into an international marketplace—a marketplace they believe is controlled by Western interests. In an excellent paper, University of Michigan political scientist Kenneth Lieberthal and Asian energy security expert Mikkal Herberg argue that

[Chinese] distrust of energy markets is aggravated by the perception that these markets are dominated by the United States, a perception that overlaps with concerns that the United States is out to exploit China’s energy weakness. Based upon strategic dominance in the Persian Gulf, the U.S. Navy’s control over critical energy transport sea lanes, and enormous power in the global oil industry and institutions, many [in China] believe that the United States exerts a powerful influence on global oil prices and flows. The projection of U.S. power into the Persian Gulf and Central Asia in the wake of September 11 has further aggravated these fears. Strident rhetoric during the 2005 CNOOC-Unocal episode has strongly reinforced these perceptions.12

Eighty percent of China’s imported oil passes through the Straits of Malacca.13 If a war over Taiwan breaks out, the Chinese leadership fears the United States will attempt to cut the flow of oil to China. Without involving third parties, disrupting neutral shipping, or declaring an all-out war on China, a U.S. oil embargo is not likely to be effective.14 Still, China is investing time and effort to counter the threat. It has begun to build  domestic strategic oil storage reserves and port facilities along Asian sea lanes to reduce its vulnerability.

Finally, China shares its western borders with several countries threatened by Islamic fundamentalism, including Afghanistan. It is concerned that unrest in these regions will spread to its oil-producing, majority-Muslim Xinjiang Uighur Autonomous Region.15 It also realizes that the overland flow of oil via pipeline from Central Asia will traverse thousands of miles of territory primarily populated by Muslims. Unrest or insurgency jeopardizes these pipelines. Thus it is not surprising that  China did not oppose the U.S. invasion of Afghanistan in 2001. As China’s reliance on Middle Eastern oil grows, these concerns will grow more, not less acute.


China and the Middle East


Barring stunning discoveries elsewhere, the Middle East will continue to have the largest oil reserves and the lowest production costs. Sixty-four percent of proven oil reserves are located in the Middle East, and 42 percent are in the Gulf Cooperation Council (GCC) countries.16 The U.S. Energy Information Agency (EIA) predicts that global oil production will be increasingly concentrated in the region.17 Gulf oil production, currently at 24 million bpd, is predicted to reach 35 million bpd by 2020.18 Much of this growth will be targeted toward Asian markets, which already receive a majority of their imports from the Middle East.19 Adnan Shihab-Eldin, former acting secretary-general of the Organization of the Petroleum Exporting Countries (OPEC), points out that the dollar value of GCC oil to Asia increased from $100 billion to $240 billion between 2000 and 2004.20

If China only needed to import two to three million bpd, it might be able to cobble together a portfolio of oil purchases from neighboring countries, such as Russia and Kazakhstan, and Asian countries, such as Indonesia and Malaysia, supplemented by purchases from smaller Middle Eastern and African nations. But with import levels predicted to double in the next decade, China must look to the Persian Gulf and, more specifically, Saudi Arabia, Iran, and perhaps at the end of the next decade, Iraq. These three countries sit on top of 70 percent of the region’s oil.21

Recognizing this reality, China has gradually developed partnerships with key Middle Eastern countries. In 1992, China imported approximately 37 percent of its crude oil from this region compared with 59 percent from Asian-Pacific countries, but by 2004, Asian-Pacific imports had fallen to no more than 12 percent and Middle East imports had risen to 45 percent.22 In 2004, 30 percent of China’s Middle East imports came from Saudi Arabia and 23 percent from Iran23 (see  Figure 1).

Figure 1

Chinese trading companies initiated business ventures in the Gulf region as early as 1979, and by 1983, CNPC’s construction division was active in Kuwait. During the 1990s, Chinese oil companies signed service and technical contracts with GCC states worth more than US$10 billion.24

Realizing that it did not have the historical linkages with key Gulf countries enjoyed by U.S. and European multilateral companies, China had to approach the Middle East not simply as an oil resource base but as part of a larger interdependent trade relationship. Economists in China see moderate GCC states as an entry point for Chinese goods and services. In 2004, trade with these countries reached US$20 billion, a remarkable statistic considering  GCC exports to China remain small relative to those to Western countries.25 In its relationships with Gulf countries, China has deliberately avoided a singular focus on oil supplies. Its goal is to create a level of economic interdependence that produces economic benefits for China as well as their trading partners in the Gulf.

A closer look at China’s interaction with specific Middle Eastern countries and Sudan illustrates this strategy—one that the United States has been reluctant to mirror, especially after the 9/11 attacks.

Saudi Arabia

In 1999, China’s President, Jiang Zemin, visited Saudi Arabia. At the conclusion of the visit, he announced the inauguration of a “strategic partnership” with the kingdom. This partnership created a cross-investment environment where Saudi Arabia agreed to open up select portions of its upstream market (excluding equity oil) to China, and China agreed to open up its refining and marketing sectors to the Saudis. While this agreement was driven by mutual strategic benefits, it was also catalyzed by the need to resolve a major technical obstacle.

China realized that if it was to be able to meet its projected import levels, it needed to be able to access Saudi crude. However, in the last 20 years, much of the oil from newer Saudi reserves (including the offshore fields) is heavier and sourer (and therefore more difficult to refine) than those produced from its older reserves. China’s oil refining industry has been unable to keep up with growing demand, creating a short-term need to import more oil products. Chinese oil refineries are limited in their capacity to process heavier and sourer crudes, and therefore China is committed to making significant investments in its domestic refining sector over the next five years.26 From the Saudi perspective, to penetrate China’s markets, it will need to insure that its crude oil can be refined into useful products. Aramco, the Saudi national oil company, could build refining capacity in Saudi Arabia and export products to China. Such a scenario is not acceptable to China, which seems determined to build domestic capacity sufficient to meet its demand for oil products. Alternatively, Saudi Arabia can invest in China’s refining industry and upgrade the capacity to handle Saudi crude oil. Not only will this give China priority access to Saudi crude, it also will give Saudi Arabia a direct entry into the downstream sectors in China, one of the fastest growing markets in the world.

In 2001, after several years of negotiations, Aramco signed an agreement with Sinopec for a 25 percent share in a US$3.5 billion expansion of an existing refinery in Fujian province, coupled with a new, large ethylene production facility. The plant is due to be complete by 2008.27 China agreed to allow the partners in this deal to open and manage 600 gas stations throughout the province. In return, China received a 30-year supply contract for 30,000 bpd of Saudi crude.28

Aramco is now negotiating to build a second refinery in Qingdao. It would be the largest in China with an initial capacity of 200,000 bpd to be expanded to 400,000 at a later date. The facility would be designed to handle Arab heavy crude oil. The refinery would be operated by Aramco, but Sinopec will have an ownership interest.29 These two projects together require investment totaling more than US$6 billion.

To win over Sinopec and prevent opposition to the Qingdao project, the Saudi government granted the company a US$300 million concession to explore and produce natural gas in Saudi Arabia. Under this arrangement, Sinopec will own 80 percent of a special purpose company and Aramco will own 20 percent. This partnership is part of the Saudi government’s effort to salvage its gas initiative. In many ways it is a symbolic deal, since Sinopec has little experience in natural gas production. But if China were to open up its refinery market, it needed a reciprocal concession by the Saudis—specifically a toehold in Saudi Arabia’s upstream markets.

The advantage for Saudi Arabia is clear. It obtains a market for its sour crude oil, access to China’s refining and petrochemical industry, and reduces its political and economic reliance on the United States. China gains long-term contracts for crude oil, greater economic interdependence, and, with its greater security of supply, a flow of investment dollars. It also gains limited access to certain Saudi upstream markets.

While cross-investment seems mutually beneficial and logical, Aramco and the Saudi government have expressed concern about China’s policy to control the price of refined products—a policy designed to maintain domestic economic and political stability, a top priority for the Chinese leadership. When world oil prices increase, Chinese regulators shield consumers from higher fuel costs. While it is unclear whether the refineries or the retailers must absorb the cost increases, Aramco is purchasing an interest in both sectors. Hence, it wants the Chinese government to amend its price control regime prior to completing its proposed downstream investments.

Despite its initiatives elsewhere, China recognizes that its reliance on Middle Eastern and, more specifically, on Saudi Arabian oil will grow. At the same time, Saudi Arabia realizes that world oil demand is shifting and that much of the growth over the next 10 years will be in Asia, with China as the largest market. While oil trade is at the core of this emerging partnership, China has been careful to expand the relationship to include a range of goods and services as well as opening its downstream petroleum sector to significant Saudi investment. This strategy contrasts with that of the United States, which has been reluctant to open either its upstream or downstream industries to foreign ownership. This attitudinal difference does not go unnoticed in Riyadh or Beijing.

Iran

Sino-Iranian trade dates back 2,000 years when the Parthians served as a bridge between China and the Mediterranean world. There are geographic and historical links that make a partnership with Iran a logical extension of Chinese energy policy. Iran sits on enormous supplies of oil and gas, and it is technically feasible to link Iranian supplies with China by building a connecting line to the Sino-Kazakh pipeline. Thus, energy trading can occur overland or by sea. Furthermore, barring some new discoveries, the Saudis have no natural gas for export, while Iran has significant volumes. Finally, U.S. sanctions on commercial trade with Iran provide China with limited competition in this market, because U.S.-based companies are prevented from doing business in  Iran. Iran provides a tremendous opportunity for China. It has supply, it has a need for markets and capital, which China can supply, and it is strategically located along traditional trading routes through Central Asia.

Yet Sino-Iranian trade is only 0.6 percent of China’s total, and through 2003, China was Iran’s sixth-largest trading partner.30 China’s imports from Iran have hovered in the range of 200,000–300,000 bpd, significantly less than those from Saudi Arabia.31 Despite negotiations around several liquefied natural gas deals, not one cubic foot of Iranian gas has reached China. The obvious question is, if Iran is such an obvious target of opportunity for China, why has there been so little to show for it?

Several factors seem to have complicated Sino-Iranian oil and gas relationships. These include the character of earlier Iran-China sales, the limitations of Iranian contracting practices, a lack of capital on the Iranian side and, most importantly, caution on the Chinese part due to an unwillingness to trigger a confrontation not only with the United States but also with GCC countries, especially Saudi Arabia, that are uneasy about Iranian intentions.

In the 1990s, China expanded its economic interactions with Iran in many areas. Today Chinese manufacturers have facilities in Iran, and a Chinese firm is building the Tehran subway. Sinopec and CNPC have become more involved in discussions around various pipeline and refinery projects, but the Chinese companies have been constrained in those negotiations by the difficulties of coming to mutually beneficial arrangements with the Iranians and the desire not to come into conflict with the United States and Saudi Arabia. Sinopec’s withdrawal from the Neka-Tehran pipeline project and its on-again, off-again discussions around the development of the Yadavaran field are indications of the challenges of doing business with the existing Iranian regime.

It is very difficult for a foreign petroleum company to enter into a mutually attractive arrangement with the Iranian government. The Iranian constitution prohibits production-sharing agreements or outright concessions, thus the Iranians have relied on “buyback” contracts in which foreign companies act as contractors for the National Iranian Oil Company (NIOC). The foreigners provide technology and capital and receive a preset payment in the form of oil supplies plus an agreed-upon fee. Once the foreign firm is paid, all the oil reverts to NOIC. The Iranians are very leery of granting foreign firms generous terms. Thus, negotiations surrounding proposed projects often become stalled. Sinopec and CNPC evaluate possible Iranian projects—not solely along national strategic lines but in comparison with other investment opportunities. Chinese oil companies have made it clear that if Iranian projects do not allow them to make attractive commercial returns they will stay on the sidelines. If one adds this reality to the political concerns surrounding U.S. sanctions, Iran’s poor relationship with Saudi Arabia, and the ongoing controversy around Iran’s nuclear ambitions, it is not surprising that Chinese companies have walked away from several major Iranian projects and not pursued others.

In the longer term, however, the fundamentals in favor of closer Sino-Iranian oil and gas trade are strong, and if the present Iranian policies become less antagonistic to China’s short-term strategic interests, trade should expand. When it does, it is likely to take the same form as the present arrangement with the Saudis—emphasizing Iranian investments in downstream facilities in China and Chinese investments in new oil and gas fields in Iran. These would be coupled with a range of investments by both countries in non-energy projects.

Other Middle Eastern Countries

China has also entered into contracts with Iraq, Kuwait, Oman, Yemen, and Syria. In 2004, the total volume imported from these five countries (minus Syria) was 526,000 bpd.32 More than 62 percent of the imports were from Oman, and another 19 percent were purchased from Yemen. While three of China’s oil companies are active in Oman, almost all of the country’s oil is produced by Petroleum Development Oman (PDO), of which the Omani government owns 60 percent. Chinese companies only provide technical assistance.

The situation with Yemen is not much different. Sinopec is the only Chinese company licensed to import Yemeni crude.33 In recent years, Yemen has been more willing to open up its reserves to foreign investment, and Sinopec has acquired a 37 percent interest in Block S2, which may produce up to 32,000 bpd by the end of 2009.34 But this would not appreciably change the nature of Yemen’s relationship with China, because almost 90 percent of the oil exported to China will continue to be produced and marketed by the Yemen government or one of its subsidiaries.

In neither Oman nor Yemen is there any evidence that China is locking up and hoarding significant reserves. Oman and, to a lesser extent, Yemen, export a vast majority of their crude oil to Asia. Thus China perceived these countries as less linked to Western interests and a more secure source of supply.

Iraq sits on huge oil reserves, but because its government lacks any semblance of stability, foreign oil companies are reluctant to invest there, believing that any contract has limited sustainability. China was active in Iraq in the 1990s, but since the U.S. invasion, its activities have been limited to purchasing a small amount of oil for import.

The history of Sino-Kuwaiti ties illustrates that China’s lack of political baggage is not permanent and that China has paid economic costs for political moves. China’s abstention from the UN resolution condemning Iraq’s invasion of Kuwait crippled bilateral trade. After the war, Kuwait cancelled $300 million in loans to China.35 China hit back in 1997 by threatening to vote against continued UN sanctions on Iraq—unless Kuwait undid the slight by buying $300 million in Chinese artillery.36 Between 1997 and 2003, several Sino-Kuwaiti oil service projects failed, and oil trade was a paltry 23,000 bpd.37

Recently, Kuwaiti-Chinese relations have begun to thaw. In 2003, both countries pledged to increase trade.38 This January, Kuwait committed to doubling exports to China to 80,000 bpd.39 However, as with Saudi Arabia’s crude, Kuwaiti crude oil is high in sulfur and thus cannot be handled by China’s existing refineries. Thus, China is attempting to interest Kuwait in a cross-investment arrangement similar to that pursued with Saudi Arabia but smaller in scope. While such an arrangement makes economic sense, it has proven difficult to achieve. Like Saudi Arabia and Iran, Kuwait has constitutional limits on foreign oil investment. The state-owned Kuwait Petroleum Corporation has invested in China since the 1980s and has sought a refinery deal since March 2005. A proposal to build a $5 billion refinery in Guangzhou is pending. It has been jeopardized by China’s price control regulations, which threaten the venture’s profitability.40

China’s reliance on imports from Iraq, Kuwait, Oman, Yemen, and Syria is unlikely to grow rapidly, due more to domestic limitations than China’s lack of interest. There have been no opportunities to hoard equity oil, because China has been unable to acquire such oil and is unlikely to be able to do so in the future. Cross-investment policies, where the producing government invests downstream in China, and China invests upstream in that country, are seen as an attractive means to promote greater interdependence and enhance long-term oil security. However, China has not made appreciable inroads in establishing such relationships with these five countries. Kuwait may prove to be an exception, but not for another few years.

Sudan

When critics accuse China of hoarding equity oil, partnering with rogue states, and ignoring human rights, most point to Sudan. There are multiple examples of each, but from a short-term, strategic, and commercial perspective, Sudan provided China with a unique opportunity to obtain a dominant position in one of the few remaining underdeveloped oil regions in the world. While the short-term benefits have been significant, there are signs that China’s initiatives in their present form may not be sustainable over the long term.

As much as 52 percent of China’s equity oil comes from Sudan.41 While Sudan is clearly of major importance to China, the reverse is also true. China is of critical importance to Sudan, because 65 percent of its exports go to China.42 The number of Chinese workers in Sudan has tripled since the early 1990s and reached 24,000 in 2006.43 Chinese non-oil investments are significant and include hydroelectric facilities, a new airport for Khartoum, and several textile plants. China also operates the vast bulk of Sudan’s oil production and has a 50 percent stake in the nation’s only major refinery in Khartoum.

To understand the factors that induced China to make these commitments, it is helpful to put them in a historical context. Chevron USA began exploring for oil in 1974 in the Muglad Basin in southwestern Sudan. But when civil war broke out for the second time in the mid-1980s, Chevron abandoned investments exceeding US$1 billion and sold its interests to a Canadian firm, which formed the Greater Nile Petroleum Operating Company (GNPOC). In 1997, the firm sold a 40 percent share to CNPC. The goal of the newly formed company was to develop oil fields in south-central Sudan and build a 1500-kilometer pipeline to a coastal port facility at Marsa al-Bashair, near Port Sudan.

When China initiated its negotiations with Sudan, its petroleum resources were undeveloped and most of its territory unexplored. Although oil was first discovered there in the early 1970s, it was not until 1999 that Sudan actually exported a barrel of oil. It was one of the few areas in the world that geologists felt might still hold large unexploited resources. While proven reserves remain low, some geologists estimate that investment in exploration and development could allow Sudan to produce more than 600,000 bpd in the near future.44

Hence from China’s perspective, Sudan had enormous upside potential. Further, U.S. and European companies had left the region, insuring virtually no competition for access to the country’s oil resources.

By 1997, Sudan was in desperate financial straits. Its debt was 250 percent of its gross domestic product (GDP). Interest payments were US$4.5 million per day, and each day the civil war was draining another $1 million from its treasury. Rural areas were devastated, undermining its agricultural economy. GDP was in free-fall. The only escape from this financial death spiral was to increase oil revenues. Western companies had left, and China was the only country prepared to fill this vacuum. To attract investment, Sudan agreed to give China generous concession terms. For example, there are no restrictions on profit reparation, and the Sudanese government exempts CNPC from all domestic taxes on exported oil (although CNPC does pay royalties). Further, the concession acreage is significantly larger than that awarded by other countries. These terms are among the most generous in the world. Thus, from a purely commercial basis, investments in Sudan were almost too good to turn down, especially given China’s perception that most other producing regions were tied to U.S., European, and Japanese interests and might be less receptive to Chinese overtures.

The character of China’s involvement in Sudan is shaped by the domestic political context in which it found itself. Sudan has been racked by civil wars since the 1950s. While there are multiple axes of conflict, historically the key issue has been tension between the Christian and animist southern districts and the Muslim northern districts. Northerners have controlled the Khartoum government for the last half-century, and the south sought either independence or greater autonomy. In 1989, Colonel Omar Hassan al-Bashir, backed by the National Islamist Front, overthrew the elected government and escalated military actions against Sudan People’s Liberation Army Movement in the south. By the time this civil war ended, more than two million people had died and four million were displaced.

While a campaign to convert the southern population to Islam was the public issue that split the two sides, oil played a significant role. Sudan’s oil reserves are located in the south. Initially, all oil revenues went to the autonomous southern government, but this was during a period in which reserves estimates were quite small. When it became clear that Sudan might be sitting on major supplies, the northern faction reasserted control. It created a new province—Benitiu—that primarily consisted of the existing oil fields. Concerned about security of supply, it decided to locate the country’s only refinery near Khartoum, more than 1,000 kilometers away, and build a pipeline from the oil fields to the refinery. This allowed the north to control all the oil revenues, which were used to fund the army and various militia groups. China supplied the technical expertise to develop these reserves. It also helped finance the development and provided the workers necessary to expand, construct, and operate the oil fields, the pipeline, and the refinery. In other words, China served as a total turnkey contractor, while Malaysia’s national oil company, among others, supported GNPOC financially.45

Given that oil revenue was essential to the Khartoum government’s ability to fight the war, militia forces from the south targeted the oil facilities. Conversely, the government spent considerable resources defending the infrastructure. China was caught in a difficult position. With thousands of its citizens at risk, it was under pressure to protect its workers and the facilities that they had built. China had three choices: withdraw from Sudan and abandon its investments; send security personnel to protect their managers and workers; or provide technical assistance and equipment to the Sudanese army so that it could protect its workers. While the details remain sketchy, it is clear that the Chinese chose some combination of the second and third option.46 Although there is no hard evidence that Chinese troops were present in Sudan, from the perspective of the rebel forces in the south, the Chinese had clearly sided with the government in Khartoum.

After years of bitter fighting, the two sides finally signed a peace treaty on 9 January 2005. Under the terms of the Comprehensive Peace Agreement, the south began a six-year period of autonomous self-rule, to be followed by a vote on secession.47 If the country votes to stay together, the oil revenues will be split, as will the jobs in the industry. Southern Sudan has formed its own oil company, Nilepet, and disputes are already emerging about which side has the rights to grant concessions for future oil exploration. To no one’s surprise, the new government in the south has no interest in dealing with the Chinese. Meanwhile, the Khartoum government is expressing concern that the concession terms given to CNPC in the late 1990s were overgenerous. In a world of high oil prices, the lost opportunity cost of these agreements is becoming politically uncomfortable to the Khartoum government, which has suggested that renegotiation is the only fair way to proceed. In addition, Khartoum has initiated negotiations with the Indian Oil and Natural Gas Corporation with the intent to sell a portion of its stake in the Greater Nile Petroleum Operating Company and unofficially agreed to sell two new blocks—one to the Romanian company, Rompetrol, and the other to the Algerian national oil and gas company, Sonatrach. It seems that China’s position of relative exclusivity is rapidly disappearing.

China has been repeatedly criticized for not condemning the conduct of the Khartoum regime. China’s response is that it does not get involved in domestic political affairs and that its activities in Sudan are commercial in nature. But this explanation seems hollow to much of the international community, since Chinese investments were essential to the financial viability of the al-Bashir government and its military operations.

Has China benefited from its experience in Sudan, and is it likely that the benefits will be sustainable into the future? The answer to the first question is not clear. Certainly China’s CNPC was able to acquire a significant amount of equity oil, which is a scarce commodity in today’s world, and they were able to gain a large foothold in a country located in one of the last relatively unexplored oil and gas frontiers. However, China has invested substantial sums up front, with the expectation that over a longer period of time it will get this money back plus a generous rate of return. If these concessions are renegotiated or expropriated by the Sudanese government or its successors, China may find that the net present value of its returns, which looked so good four years ago, may be far lower than anticipated.

While one cannot foresee the future with certainty, the probability that China’s concessions will be sustainable in their present form is quite low. Governments of rogue states often rest on the authority of one man or at best a small cadre of individuals. When a regime falls, the companies and constituents that benefited from their generosity are often distrusted by the new regime. Secondly, an autocratic government, especially one that has waged a bloody civil war, has enemies—and those enemies will be decidedly uncooperative with those favored by the previous government. With most of the reserves and potential oil resources located in the south, this takes on an added dimension. If Sudan splits into two countries, the southern regime will gain a greater role in selecting which companies will operate, build and perhaps own the oil facilities. Given the history of China’s partiality to the Khartoum government, it is unlikely that the authorities in the south will look favorably on Chinese companies.

Dealing with an unstable autocratic government has long-term liabilities that China may have undervalued in its rush to take advantage of what they saw as a unique commercial and strategic opportunity.


Conclusion

In the first quarter of 2006, China demanded 7.15 million barrels of oil per day but only produced 3.85 million bpd—a differential of 3.3 million barrels that had to be made up by imports.48 If one assumes very conservative projections, China must double its imports within 10 years to meet its growing demand. It will have to do so in a market in which most of the world’s oil will be owned by state petroleum companies. Seeking and purchasing equity oil outside China’s borders is an option that is fast disappearing. Hence the fear that China will be able to control and hoard large volumes of foreign oil, insuring that those supplies are not available to the West, is not realistic in tomorrow’s oil market.

China may prefer equity oil and state-on-state arrangements, but it is more likely that Chinese oil companies will be forced to compete for oil in the international market in the same way ExxonMobil or British Petroleum buys supplies.

While the future is fraught with uncertainty, there are several factors that will characterize the Middle East. First, as world consumption increases, a greater proportion of the world’s oil will originate from the region. Unless major new oil reserves are discovered elsewhere, China will inevitably have to compete to purchase supplies from Middle Eastern producers.Second, there is no guarantee that state-run petroleum companies will synchronize their investments with the projected increases in global demand. In many instances, this underinvestment may not be a deliberate effort to manipulate the market but rather an inevitable result of inefficiencies common in some state-owned enterprises. Hence Chinese companies and other multinational oil companies will be periodically competing for supplies in a constrained marketplace.

Finally, the Middle East remains a tinder box of instability and unrest, and thus the threat of disruptions is always in the background, lurking like a specter in a Greek drama. From China’s view this vulnerability is compounded by the fear, whether realistic or not, of a U.S. Navy-enforced oil embargo that disrupts China’s access to Asian sea lanes.
As China’s demand for oil continues to rise, the Chinese know they cannot eliminate their vulnerability to future disruptions, and thus their only option is to develop strategies that will reduce the probability of the impacts.

China has shown a sophisticated understanding of the Gulf countries’ desire to be seen as strategic trading partners. A partnership built around a portfolio of needs and interests is likely to forge stronger bonds than one that focuses only on oil. China also realizes that for many Gulf countries, it is becoming politically uncomfortable to be too reliant on the United States. Building new partnerships with China and its oil companies will provide Gulf countries with greater political flexibility and independence. China is not attempting to replace the United States in this region; rather, it is focusing on shifts at the margin. However, as oil and gas exports to Asia, particularly China, grow, the relationship between the two regions will increase in mutual importance.

China recognizes that it has a large stake in fostering stability and not provoking unrest. The experiences with Sudan have taught it important lessons, and many of its recent actions are characterized more by caution than aggressive opportunism. Pundits point out that although Iran could play a very important role in its long-term energy strategy, China has been careful not to provoke the United States by aggressively pursuing certain oil and gas arrangements. It has also been careful not to endanger its growing connections and relationships on the other side of the Gulf. As it gains more experience, China will become more sophisticated in the diplomatic and strategic intricacies of oil geopolitics.

China’s future oil strategy will be influenced by the growing strength of its oil companies. CNPC, Sinopec, and CNOOC may not be on a par with the first tier of private multinational oil companies, but they are becoming more expert in participating in the international marketplace, accessing capital markets and competing for supplies in every corner of the globe. At the same time, these companies are new to the market and inevitably they will sometimes miscalculate the financial and strategic risks and rewards to their own detriment. They are trying to learn the complex ropes of the international marketplace.

Nurturing its industry and helping its companies increase their asset values and their credibility in the international marketplace will be as valuable a step in enhancing China’s oil security as any programmatic initiative. It also plays into China’s strength, since its brightest and best energy minds are working in these companies. Further, in dealing with the political minefields that characterize the Middle East, there is strategic value in separating the government-to-government negotiations from the commercial discussions while retaining the ability and willingness on both sides to complement each other’s interest. This type of dual structure is what has allowed the United States and its oil companies to build successful partnerships in the Gulf over the past half century.

The United States and China have a choice: They can enter into an aggressive and hostile, politicized competition for oil supplies, or they can cooperate with each other on strategic issues vital to each other’s national interests, while agreeing to compete commercially in the energy marketplace. Politicizing the search for oil will lead to increased tensions, as each country attempts to capture its “fair share” of the world’s oil. Evidence from the Middle East suggests that in the world of a global energy market, if anyone wins in such great power competition, it is the oil producers themselves. Importers rarely “win” anything of value.

It is difficult to extrapolate from a limited sample of events and projects in one region. But if China’s experiences in the Middle East are representative of the strategies it will adopt in the future, China is already making its selection and will follow the second route, not because it prefers it, but because it may not have any other choice if it is to meet its oil demand over the next two decades.

Henry Lee is the Jassim M. Jaidah Family Director of the Environment and Natural Resources Program within the Belfer Center for Science and International Affairs at Harvard’s John F. Kennedy School of Government, faculty co-chair of the School’s International Infrastructure Program, and a lecturer in public policy. He has served on numerous state, federal, and private boards and advisory committees on energy and environmental issues and has worked with private and public organizations, including the InterAmerican Development Bank, the State of São Paulo, the U.S. Departments of Energy and Interior, the Intercontinental Energy Corporation, General Electric, and the U.S. Environmental Protection Agency. His recent research interests focus on environmental management, geopolitics of energy, China’s energy policy, global climate change, regulation of electric and water utilities, and public infrastructure projects in developing countries. Dan A. Shalmon is a student in the Security Studies Program at Georgetown University’s Edmund A. Walsh School of Foreign Service. He presently works for a Washington, DC–based defense contractor on counter-terrorism and counterinsurgency issues. From 2005 to 2006, he was a research associate at the Environment and Natural Resources Program at the Belfer Center for Science and International Affairs, the research arm of the John F. Kennedy School of Government at Harvard. Previously, he was assistant director of Northwestern University’s Debate Society, where he was responsible for energy policy research efforts that led the society to a national championship title.
The authors would like to express deep appreciation to the many individuals who helped us with this paper: Bill Hogan, Joe Nye, Ed Cunningham, and Yuan Wu read drafts and made helpful and insightful comments; Iain Johnston, Taylor Fravel, Bernard Cole and Erica S. Downs, who took the time to discuss China’s energy security policies and foreign policy more broadly; and Amanda Swanson, who deserves a special thanks for helping proofread, format, and produce this paper. The views expressed in this paper are those of the authors. Publication does not imply endorsement by the Environment and Natural Resources Program, the Belfer Center for Science and International Affairs, the John F. Kennedy School of Government, or Harvard University.


NOTES

1. British Petroleum (BP), BP Statistical Review of World Energy, 2006 edition (London: BP, 2006), accessible via http://www.bp.com.
2. In the first months of 2006, 5.8 million cars were sold in China, an increase of 26 percent over the same period in 2005. “The Fast and the Furious: Carmaking in China,” The Economist, 29 November 2006.
3. G. Zhang, “How Can Energy Shortage Be Blamed on China,” People’s Daily, 21 September 2005, accessible via http://english.peopledaily.com.cn.
4. BP, BP Statistical Review of World Energy, 2006 edition.
5. International Energy Agency (IEA), 2006 World Energy Outlook (Paris: Organisation for Economic Co-operation (OECD)/IEA, 2006), 34 and 145. In addition to crude oil imports, product imports are also increasing, especially for aviation fuels. The Gulf States include Iran and the Arab countries surrounding the Persian Gulf.
6. D. Pietz and C. Ellsworth, Fueling China: Oil and Gas Demand to 2010 (Wakefield, MA: Energy Security Analysis, Inc, January 2000), 17.
7. U.S. Department of Energy (DOE), Energy Policy Act of 2005 Section 1837: National Security Review of International Energy Requirements (Washington, DC, 2006), 12. The National Energy Office has a staff of only several dozen employees.
8. DOE, ibid., page 28. DOE does not include loans to third parties for oil exploration and production projects. Also, China sells a portion of its equity oil to other parties and does not import all of it to China.
9. DOE, note 7 above, page 28.
10. Defining a “rogue state” is tricky. Oil producers such as Iran (and Iraq prior to 2003) are considered “rogue states” subject to unilateral U.S. sanctions but have sizeable trading relationships with other countries, including U.S. allies.
11. P. Goodman, “Big Shift in China’s Oil Policy,” The Washington Post, 13 July 2005.
12. K. Lieberthal and M. Herberg, China’s Search for Energy Security: Implications for U.S. Policy (Seattle: National Bureau of Asian Research, 2006), accessible via http://www.nbr.org/programs/energy/index.html (accessed 13 April 2007), 16.
13. P. Han, “Kazakhstan Oil Pours into China through Crossborder Pipeline,” Xinhua, 25 May 2005, http://news.xinhuanet.com/english/2006-05/25/content_4600061.htm.
14. B. Cole, Chinese Naval Modernization and Energy Security (Washington, DC: National Defense University, 2006), http://www.ndu.edu/inss/symposia/pacific2006/colepaper.pdf (accessed 13 April 2007), 7.
15. L. Jin, “Energy First—China and the Middle East,” Middle East Quarterly 12, no. 2 (2005), http://www.meforum.org/article/694 (accessed 13 April 2007).
16. A. Shihab-Eldin, “GCC-Asia Strategic Relations: Development, Opportunities and Challenges,” background paper for the International Monetary Fund/World Bank Program of Seminars 2006, 16–18 September 2006, Singapore, http://wbln0018.worldbank.org/pos/poscal.nsf/e43c00e6f7cd1e4085256d78007bfd46/
c34e4ce88430f1cc852571a8008078f1/$FILE/Shihab-Eldin_Background%20paper.pdf
(accessed 13 April 2007), 2.
17. U.S. Energy Information Agency (EIA), Persian Gulf Oil and Gas Exports Fact Sheet, September 2004, http://www.eia.doe.gov/emeu/cabs/pgulf.html (accessed 13 April 2007).
18. OPEC database, 2006.
19. Shihab-Eldin, note 16 above.
20. Shihab-Eldin, note 16 above, page 7.
21. EIA, note 17 above.
22. Chinese Customs Statistical Review, 2000.
23. S. Dale and S. Tam, “China’s Wide Reach,” International Oil Daily, 4 February 2005.
24. X. Xu, “China and the Middle East: Cross-Investment in the Energy Sector,” Middle East Policy 7, no. 3 (2000), http://www.mepc.org/journal_vol7/0006_xu.asp (accessed 13 April 2007).
25. B. Daragahi, “China Goes Beyond Oil in Forging Ties to Persian Gulf,” New York Times, 13 January 2005. In 2000, China exported $5.36 billion in merchandise to Middle Eastern countries. In 2005, it exported $16.1 billion in merchandise to Middle Eastern countries.
26. Reuters, “Asian Refinery Upgrade and Construction Plans,” 9 November 2005. China had 580,000 barrels per day of new refining capacity under construction.
27. ExxonMobil bought a 25 percent interest in this facility. Bloomberg News, “Exxon Joins China Project with 2 Others,” The New York Times, 9 July 2005.
28. J. Calabrese, “China and the Persian Gulf: Energy and Security,” Middle East Journal, 52, no. 3 (1998): 351–66.
29. The Qingdao refinery is included in China’s latest Five Year Plan. Jin, note 15 above.
30. Jin, note 15 above.
31. Dale and Tam, note 23 above.
32. Dale and Tam, note 23 above.
33. “Yemeni Delegation Discusses Investment,” China Daily, 12 May 2004.
34. “OMV Targets Yemeni Output Later this Year,” Energy Compass, 13 January 2006.
35. Calabrese, note 28 above.
36. J. Lancaster, “U.S. Role as Arms Merchant to Kuwait Faces Challenge by China,” The Washington Post, 15 July 1997.
37. K. Teo and R. Husari, “Kuwait Looks to Plant Deeper Roots in Key Chinese Oil Market,” International Oil Daily, 30 July 2004.
38. Calabrese, note 28 above.
39. R. Husari, “Kuwait’s New Outlook,” International Oil Daily, 19 January 2007.
40. “OPEC’s Progress Might Be Delayed by China’s Hesitations on Oil Reform,” China Energy Weekly, 23 December 2005; F. Tan, “Kuwait’s KPC Wants Cracker in China Refinery JV,” Chemical News & Intelligence, 27 March 2007; and S. Knell, “Final Approval of Kuwait Downstream JV in China Now Pending,” Global Insight, 16 March 2007.
41. “China’s CNPC Targets Overseas Integration Deals,” Petroleum Intelligence Weekly, 23 January 2006.
42. EIA, Sudan Energy Data, Statistics and Analysis, March 2006, http://www.eia.doe.gov/emeu/cabs/Sudan/Full.html (accessed 13 April 13, 2007).
43. “Friend or Forager?” Financial Times, 23 February 2006, 15.
44. EIA, note 42 above.
45. “After Caspian Rebuff, China Seduces Sudan,” Petroleum Intelligence Weekly, 22 May 2003.
46. China built several munitions factories for the Sudanese government, in part to avoid being accused of exporting arms to Sudan.
47. “Sudan’s New Peace,” The Middle East, February 2005, 353.
48. EIA, International Petroleum Monthly, August 2006, http://www.eia.doe.gov/ipm/ (accessed January 2007).

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