TESTIMONY OF

Dean P. Girdis

Director, PFC Energy

Energy Market Developments in China and Implications on Energy Security and Policy

Before the U.S.-China Economic and Security Review Commission Hearing on China’s Energy Needs and Strategies October 30, 2003

 

Good afternoon.  Distinguished members of this Commission, it is a pleasure to come before you today to address such a timely and critical issue.  My name is Dean Girdis and I am a Director with PFC Energy.  PFC Energy is a strategic advisory firm in global energy, based in Washington, DC.  We work with international and state-owned companies in the global petroleum industry on various htmects of their international oil and gas investments and market strategies.

Energy Market Development in China

The main objectives of this testimony are to:

China’s energy markets continue to transform through the mechanisms of government sector reform and restructuring, expanding investment by domestic and foreign energy companies, and the resulting transition to competitive markets.  The Chinese government continues to push through reform and industry restructuring measures in order to encourage the necessary investment needed to meet energy demand growth.  Concurrent with these initiatives is the focus on improving energy security. Energy, and hence energy security, is seen by the Chinese Government as an essential input to the economy and a requirement to sustain economic growth, to generate employment and thus to provide for social and political stability.

This is particularly true for oil and gas: oil is vital to support the growth of the transportation sector and gas will serve to meet growing residential energy demand and to displace the more polluting coal and oil plants in urban areas in coastal provinces.  China recognizes that to improve energy security it: (1) must increase the use of coal, particularly through the application of improved technology, (2) introduce efficiency measures through the country and sectors, and (3) import more oil and gas from a variety of sources to meet demand growth and improve supply diversity.  The focus of this testimony is oil and gas demand growth, as this is the most critical in terms of geopolitical impact of China’s energy demand growth and on the US-Sino relations. 

Within this context, there are several issues that are intertwined and dominating China’s energy markets and that are in turn impacting government policy including:

Security of Supply – China’s Growing Oil and Gas Supply Gap

With China’s robust economy forecast to grow 8% per annum to 2010, energy demand will continue to rise, if not increase above forecasts, leading to a growing reliance on imported oil and gas.  Even with lower economic growth or increased domestic reserves of oil and gas, domestic production will not be able to meet demand growth. Increased utilization of alternative energy sources, such as China’s vast coal reserves or hydropower, will be insufficient to meet energy demand growth.  This is due to the structure of energy demand growth – increased demand for transport fuels for automobiles and natural gas for power and heat needs and to improve environmental quality in cities.  China’s status as a net importer of crude oil and natural gas will only grow. 

Reflecting the decline in the ratio of energy to real GDP in China, the elasticity of energy demand in China has consistently been much lower than the energy elasticity in other markets – regardless of stage of development. By way of comparison the usual rule of thumb in forecasting energy demand in emerging markets is about “1” or a bit higher, implying that a 1% increase in real GDP will generate at least a 1% increase in primary energy demand. The energy elasticity of the Republic of Korea and other East and South East Asian emerging markets has consistently been about this level. The rule of thumb for industrial countries is about 0.3 to about 0.5 implying that a 1% increase in real GDP will generate about a third to one half percent increase in energy demand.

The sharp decline in the ratio of energy to GDP in China and the low elasticity of energy demand are important because if continued they would imply that China’s economy can continue to grow quite rapidly while not requiring the same order of magnitude increase in energy that would be expected were the economy to grow as rapidly in any other country – regardless of the state of economic development. On the other hand if these trends are temporary, the likely increase in China’s energy requirements could pose some serious challenges for China and the world.

However, despite a comparatively lower elasticity, China continues to focus on the development of domestic oil and gas resources throughout the country.  Increased oil and gas exploration and development activity is moving west and is a primary target of government and foreign operators, including Shell and ExxonMobil, in an effort to fill the major West-East gas pipeline.  However, a combination of unattractive exploration terms and China’s thus far unimpressive geology is unlikely to produce substantial additions to oil reserves though additional finds of gas are more likely.  At the same time, currently producing oil fields have been on the decline for over a decade.  As a result of these facts the domestic supply of oil and gas will be insufficient to meet demand forecasts.

There will be an increasing reliance on imported oil and gas moving forward.  Oil and petroleum product imports first began in the mid-1990s and the supply gap will grow as the demand for transportation fuels grows.  According to recent analysis, imports are expected to rise from 1.7 mb/d in 2001 to 4.2 mb/d in 2010 and 9.8 mb/d in 2030. 

The country of origin of imported crude is an important consideration. Although China has signed a recent agreement with Russia, and the Chtmian has significant supplies, most crude will need to be imported from the Middle East.  By increasing its reliance on the Persian Gulf, China will experience a similar dependency that the US and Japan experience. China in part has acknowledged this situation through its pre Gulf War II commitment to invest in Iraq’s oil industry once sanctions were lifted and its ongoing diplomatic efforts in Iran for joint exploration and production activities.  An important factor impacting the origin of imported crude is the limitation of China’s refining industry to process low quality sour crudes from Iran, Iraq, Saudi Arabia, and Kuwait.  Some refinery upgrades are now underway.

In terms of gas, a similar picture is emerging.  Ongoing production from the Sichuan and Shaanxi Basins will increase to meet growing regional demand in Sichuan and Beijing. New production is likely from Tarim and Ordos’s basin.  However, gas demand will outpace domestic supply leading to rising imports of piped gas from Russia and LNG from Asia and possibly the Middle East.

China will continue to experience a growing reliance on Middle East sources of crude oil, as Japan experienced in the 1970s and 1980s.  It may be difficult for China in the near term to break this relationship as most available crude supplies are from the Middle East.  Almost concurrently, China has sought to strengthen its ties to the Middle East, through discussions/investments with both Iran and Iraq, and to diversify them, via building relationships in other regions of the world.  It is unlikely China will be able to reduce this dependency on foreign oil.  And it is this fact that raises fears in Beijing that China will compete with the US for international energy (oil) supplies - thus, indirectly tying China’s economic growth to US geopolitical positioning and the recent pro-active use of the US military.  Regarding gas, China will be less dependent on the Middle East as most supplies will come from Russia and Asia Pacific.

As a result of this growing dependence on imported energy, the security of oil and gas supplies for China becomes important for several reasons including:

 

Sufficient Oil and Gas Supplies are Available in World Markets

In terms of oil, the five year supply outlook is reassuring to oil consumers, as it is clear there will be plenty of new production in the market from OPEC and Non-OPEC sources.  Russia should be able to continue to raise exports by 300,000 b/d - 500,000 b/d each year while deepwater production growth accelerates.  Some notable supply areas will enter decline in this period, most notably the North Sea, while numerous mature areas will continue to decline, such as eastern onshore China, the US onshore, and conventional Canadian onshore.  In these mature areas, price volatility can have a significant impact on the rate of decline.  As prices fall, companies have less money to invest, and scale back first in lower return mature areas.  Without continuous drilling, mature areas decline quickly, and while production may stabilize after prices recover, output rarely recovers to previous levels, as seen in the United States in 1998 and 1999.  Despite the expected oil demand growth in China and other parts of the world production will grow sufficiently to meet demand.

For LNG, global demand has grown significantly in the past two decades.  Base load markets in the Asia-Pacific – Japan, Korea and Taiwan – have been the main driver of global LNG demand growth, with Japan leading the way as the largest, and most dependent, LNG buyer.  LNG consumption grew from 35 bcmpa to 150 bcmpa in the last 2 decades.  Much of this growth was driven by Japan as well as the emergence of Korea as a major LNG consumer provided an important step in the region’s demand for LNG. 

Going forward, LNG penetration in China and India will be key factors in regional LNG demand growth.  However, there would appear to ample potential gas resources to service LNG demand in the region over the next 10-15 years.  Expansions from existing projects complemented by plans for new Greenfield LNG developments should ensure these markets are well supplied. 

 

Demand growth for oil and gas in China will not have a major impact on prices as sufficient gas and oil is available in world markets.  Saudi Arabia has sufficient spare capacity to meet demand growth and other countries are aggressively developing oil export projects.  As noted above sufficient gas is available as well.  The oil and gas demand growth in China will have little impact on the US economy.  Concurrent, the Chinese government has taken a proactive stance at improving the environmental quality through encouraging efficient use of oil and gas resources as well.

Growing Sense of Energy Supply Insecurity by Political Establishment

China’s political establishment has a growing sense of supply insecurity driven by the reality of its growing oil imports and need for additional gas resources.  Despite some coordinated and impressive efforts to improve infrastructure and to identify new sources of oil and gas, the Chinese Government has not formulated a long-term comprehensive strategy to address energy security.  If China cannot successfully address both the long-term and short-term issues associated with energy security it will be unable to meet the challenge of rising energy demand.  

It is becoming increasingly evident worldwide that political relationships with exporting countries are key to securing upstream access to oil and gas reserves and second, for securing oil and gas export projects.  This is particularly true within the current environment in Asia Pacific where there is increasing competition amongst Japan, South Korea and China over access to oil and gas reserves both within and outside of the region.  Access to the oil and gas reserves of Russia is a key focal point of this competition.

The increased reliance on imported oil is of concern to the Chinese Government for two principal reasons.  First, given that the Middle East will be the most likely source of crude, this places China within the scope of US influence in the Middle East.  China does not feel comfortable with the ability of the USA to exert pressure in this part of the world.  This is because China views the USA as a potential barrier to China’ s goals of achieving greater economic and political power.  Second and more importantly, the Middle East is a relatively unstable region of the world.  Beyond the Middle East sufficient alternative sources of crude are not readily available. And those areas with potential, such as the Chtmian, are not an easy solution technically, commercially or politically.

Regarding natural gas, China has some yet undefined potential in Western China. As well, given the lower fungibility of gas, China has better access to both imported piped gas and LNG from within the Asia Pacific region.  Russia has extensive gas reserves that are most easily monetized by exporting to China.  Chinese officials also appear relatively comfortable working with Russia via bilateral agreements and by accessing LNG sources within the Asia Pacific region.

The impact of rising or high prices for both oil and gas is not a major issue in China as energy is one element of industrial production.  This past year has seen high oil prices in world markets and Chinese markets with negligible impact on energy consuming industries in the country.  Natural gas currently produced in China is sold at prices comparable to markets in Europe and future gas from the West-East Pipeline and imported LNG will be sold at western prices.  Moreover, in coastal provinces of China, where most export industries are located, current power, gas or oil prices are comparable to those in the US or Europe.

 


Role of the Chinese National Oil Companies (NOCs)

Ongoing reform and partial privatization of the state oil companies was a much-needed first step in improving the ability of these companies to operate under commercial principles.  A second benefit from improved commercial operations is that Chinese NOCs will be able, in part, to serve as vehicles to improve China’s energy security. The Chinese Government is doing so by supporting and promoting investment in overseas oil and gas assets by the state energy companies - Sinopec, CNPC/PetroChina, and CNOOC.  Such support is created through both high-level political delegations to countries with significant energy resources and indirectly through capital infusions.

For some time, the Chinese NOCs, with government support, have pursued investment overseas in a number of countries.  By examining this mix of pre and post NOC investment activities it is clear that the Government, and by extension, the Chinese NOCs, did not and have not formulated a clear investment strategy.  However it is important to note that the three Chinese NOCs are increasingly pursuing strictly commercial investment strategies that may not fully take into consideration broader objectives of energy security for China. 

China’s Leverage of its Bilateral Relations and Geopolitical Dynamics

The Chinese Government generally takes a proactive approach to pursuing and building bilateral relations – this applies to the energy sector as well.  Consideration of geopolitics and their impact on such activities is often a key consideration.  However, in some instants China has failed to fully integrate nuances of geopolitics, particularly in regard to its activities in the Middle East, Russia and the Chtmian.  There are several issues that the Chinese Government have taken into consideration when pursuing bilateral relationships and include:

China’s ability to leverage its political and market strength
 
China has international political clout, given its size and its role as permanent member of the UN Security Council.  However, the greatest leverage China has is tied to the interrelationship of its political clout with its commercially attractive energy market.  Chinese officials are never tired of saying “China is a market with a billion consumers”. Although this may be an overstatement, China has used the argument that it is the most attractive developing country market given its size, growing economy, increasing market transparency, recent membership to WTO, and positive balance of payments to attract foreign investment.  In terms of the energy sector, no developing market compares particularly when consideration is given for the growing energy import gap and the current cost of energy in coastal provinces – equivalent in many instances to that of the markets in Europe and USA. 
Role and use of Chinese military

China has used its military to address territorial disputes, such as the Spratly Islands dispute in the South China Sea, and as a means of barter for energy imports.  China has traditionally limited the use of its military in direct territorial conflicts, though it has flexed its muscle with Taiwan.  China has demonstrated however that it will use its military in territorial disputes to protect its rights of access to undeveloped oil and gas acreage.  Second, China has pursued a strategy of tying foreign investment to military exports in a number of countries.  For example, once it has secured access to foreign oil and gas properties it has at times used arm sales and cross investment to reduce China’s energy import bill with Iraq, Iran, Sudan, Angola, and Nigeria. There is scope to apply such a strategy to the Middle East or possibly Asia as imports rise from these regions.

Political support for marginalized countries
 
China pursued support of politically marginalized countries, such as Iran, Iraq, Libya, Sudan and Angola, for economic interests – specifically in these cases for access to their domestic oil and gas resources.  Interestingly, a state visit by Premier Zhou Jiaming in 2002 included all the countries noted above. This visit was immediately followed by a visit from several Chinese NOCs.  The pursuit of such a strategy is quite logical as the targeted countries welcome access to Chinese capital (via Chinese NOCs) for investment in their respective oil and gas sectors.  In particular, China has been strategically building its relationships and involvement with Iran over the past few years.  Less directly, it has supported Sudan and Angola during their internal conflicts.

Accessing Global Energy Resources

China is seeking to diversify it’s oil and gas supply sources as a means of reducing the potential impact of supply disruption.  The main concern in this regard is in terms of oil – given most available supply is not within East Asia and China’s sphere of influence.  In terms of gas, China more readily access reserves located in the Far East including Indonesia, Malaysia and Australia, for example.

Middle East

There is no more important region for accessing oil and gas reserves than the Middle East (defined as those countries in West Asia).  The oil resource endowment of this region is unparalleled.  The geographical location is ideal, being located between two major oil and gas consuming areas.  Moreover, the ability of some of the countries in the region to maintain excess production capacity allows them to play a unique role in balancing global supply with demand.  The gas reserves—and the transport competitiveness—of the Middle East are much less pronounced than is the case with oil, the region nonetheless plays an important role as supplier to the industrialized world. 

In the long run, China will not be able to avoid increasing its dependence on Middle East oil due to supply availability.  As a result the Chinese Government and the Chinese NOCs have focused activities in the recent past on Iraq (pre-Gulf War II), Iran and most recently Saudi Arabia.  The only means of mitigating this dependence will be by controlling the growth in Chinese oil demand.  In terms of gas, China will be able to look to the Middle East as one of number of diversified sources, and to use competitive pressures in the global gas business, especially in LNG, to drive a hard bargain between Middle Eastern and Asian suppliers.  These gas purchases could also be leveraged to gain Middle East access for China’s other industries and products.

Russia

The Putin administration favors closer trade links to China in general, and enhanced energy sales in particular.  The economic basis for this policy is self-evident; the trade overwhelmingly favors Russia, for which China is already an important market for weapons sales.  Oil and gas exports would tilt the balance even more in Russia’s favor, while drawing in substantial Chinese investments at the same time. 

Strategic and security considerations also count in favor of closer ties, although here the picture is more mixed.  The Russian government certainly shares Beijing’s reservations about the extent of American power, and has sometimes worked with the Chinese government in attempts to restrain the US, for example through the UN Security Council.  At the same time, however, neither country is willing to antagonize Washington by creating anything like a formal alliance to oppose American interests.  This is probably more true of Russia, whose relations with the US are actually quite good.  Moreover, the Russian government and Russians in general worry about the ‘demographic threat’ China represents to its own declining population, particularly in the lightly inhabited Russian far east.  This consideration cuts both ways, however, as the development of a vigorous energy trade with China could provide a vital economic boost for east Siberia.

Russian oil firms have vigorously defended their home turf, rebuffing most attempts by Chinese companies to acquire upstream assets.  The most striking recent case of this behavior was the privatization of Slavneft in late 2002.  Petrochina expressed a strong interest in bidding but was essentially forced to withdraw, with Slavneft eventually going at auction to Sibneft for a price well below the government’s target.

Similar complications have dogged China’s efforts to reach agreement with Russian partners on pipeline construction and long-term supply contracts.  The history of plans for an Angarsk – Daqing pipeline shows the complexity of the bargaining this has involved.  Russian president Vladimir Putin appeared to give his government’s consent to the deal during an official visit to Beijing in December 2002, but within days the state-owned pipeline monopoly Transneft had announced plans for its own pipeline to the Russian Pacific port of Nakhodka.  Even though China substantially secured approval for Daqing most recently Japan has lobbied hard and secured the makings of an agreement that could negate the planned pipeline to Daqing.

Kazakhstan

Kazakhstan offers similar opportunities for China to arrange stable and secure supplies of oil and gas, but the geographic obstacles present a greater challenge than they do with Russia.  However most of Kazakhstan’s oil and gas reserves are located in the northwest of the country, 6,000 kilometers from the nearest centers of population and industry in China.  Yet the completion of the domestic West – East gas pipeline would reduce the distance by half. 

If such a line is ever built, it will likely be because China saw a need for it on strategic and security grounds.  In the meantime, China is seeking greater participation in Kazakhstan’s upstream sector, and would certainly expect this as a quid pro quo in any deal for a pipeline and long-term supply contract.  China’s experience in this regard has been mixed so far.  CNPC has recently raised its stake in Aktobemunaygas to 100%, but Sinopec and CNOOC were frustrated in their attempt to buy British Gas’s interest in the Kashagan consortium.  In the latter case it was reportedly the foreign partners of the consortium who blocked the bid, but the government of Kazakhstan itself is thought to have mixed feelings about a larger Chinese presence in the upstream sector. 

Establishing a Strategy to Reduce Energy Insecurity

A comprehensive energy strategy that addresses both demand and supply issues is required to effectively manage the rising energy insecurity in China.   In order to accomplish this, clearly defined objectives must be established, implemented and coordinated by the Chinese Government. These objectives can only be realized through development of a comprehensive energy security strategy, with accompanying policies. 

There are several options and strategies that the Chinese Government could pursue:

·         Reduce energy demand growth through efficiency and DSM investments

·         Increase domestic oil and gas output

·         Diversify energy sources, CBM

·         Pursue source diversification by investing in other regions of the world

·         Reduce impact of supply disruptions and price volatility through creation of strategic petroleum reserve.

Chinese Government Responses to Improving Energy Security

There are a number of options that the Chinese government will likely examine and implement to improve its energy security including:

Establish an Integrated and Comprehensive Government Energy Security Policy

China will need assess and formulate its energy strategy and policy objectives with consideration for both reducing and managing domestic demand for oil and gas while concurrently improving its access to international oil and gas assets.  A range of domestic policies will be required to address demand management whereas international relationships and bilateral agreements are required for gaining access. 

Reduce oil demand

Design an energy policy that reduces oil dependence in general to a minimum. Structurally, oil usage, especially a transport fuel, will grow.  Therefore, China should foster transport technologies, such as the use of hybrids, higher mpg requirements, taxation of particular cars and trucks that meet these requirements among others, and fuel taxes that flatten the crude oil demand curve despite the structure pressures. 

Leverage bilateral relationships

China is pursuing this strategy with only a moderate degree of success to date.  The most success it has achieved to date is working with the Russian Government – however, private energy companies in Russia, particularly oil companies, have resisted China’s actions.  It is also important to note that the Chinese Government may need to change the manner in which it attempts to leverage its position. 

Identify Key Middle East suppliers

Since the terrorist activities in the USA of 2001, the power brokers of Washington have politically marginalized the Middle East.   As a result these countries believe their long-term position of secure energy supplier to the USA may be partially jeopardized – and of greatest concern is the potential loss of political leverage.  In response, the USA has pursued a process of building closer ties to Russia and has positioned itself in West Africa in an attempt to reduce crude oil import dependency on the Middle East.  The Middle East needs new, or alternative, markets for its energy resources and China presents an attractive export market.  There is a high degree of complementary – China needs oil and some counties in the Middle East, more than others, need markets and capital. This argument is particularly true for a country such as Saudi Arabia and Iran.

Build stronger ties with Russia

Russia and China complement one another.  Managing political and economic linkages are almost impossible to separate from an energy security perspective. This is particularly true for China and Russia where there is a strong case for interdependency between the two countries – Russia needs China’s hard currency to meet government budgetary requirements and China needs Russia’s oil and gas to meet demand growth. As well, each is seeking stronger ties with each other to counterbalance growing US political and military projection worldwide.

Work with international financial institutions

The role of international organizations in improving energy security via reform of energy markets has been important and will continue.  The World Bank, in particular, has played a critical role in guiding power sector reform and restructuring and in encouraging transparency in the oil and gas sectors.  There has been significant multilateral lending in energy sector though increasingly the level of cooperation is focused on improving sector operations and efficiency and on introducing better energy policies.

Conclusions

China recognizes the growing importance of secure oil and gas supplies for maintaining economic growth, generating employment and securing social and political stability.  This position is central to China’s actions and policies in terms of its bilateral relationships, geopolitical positioning and in the activities of its NOCs.  The US can play a greater role in the Chinese energy sector and possibly by influencing policies through increased cooperation at both the government and commercial level.  However, despite external pressure, the Chinese government will pursue policies and strategies that will meet energy demand growth in China and they will guard against any attempts that are seen as endangering their ability to accomplish this goal.



Source: China Energy Outlook, IEA/SDPC (2002) and PFC Energy Analysis



Source: PFC Energy Analysis