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China-Middle East Dialogue
in the Age of Rising Energy Demand in East Asia*
Deng Xiaoping encapsulated China’s new international strategy in the early 1980s with the slogan “peace and development.” This phrase embodied a decisive break with Mao Zedong’s “international line” of “war and revolution,” and shifted Chinese efforts towards developing a peaceful, stable international environment. While Mao presided over a high-risk and high-cost confrontational approach to international affairs that sought to revolutionize both China and the international order, Deng’s approach was to avoid ideological conflicts, and not to involve China in matters unrelated to its own immediate interests.1 In recent years, China has followed a pragmatic set of foreign policies – in particular maintaining relations with capitalist countries like the United States and those in Western Europe, and at the same time preserving ties with Third World countries. This has not been easy as, on occasion, the interests and priorities of these two relationships will clash.
Geopolitically, China is an island. To the east are the South and East China Seas. To the northeast is Siberia, thinly inhabited and to a great extent uninhabitable. To the direct north is Mongolia. To the southwest, standing like the Great Wall, are the Himalayas. In the southeast, there is Indochina. In theory, China could expand there, but the last time there were land-based skirmishes, in 1979, Vietnam beat the Chinese soundly. Jungles and mountains stretching from eastern India to the South China Sea make that region almost impassable. Finally, there are the western approaches into Central Asia, through Kazakhstan. This has been the traditional, and in some ways only, route for Chinese trade and diplomacy. China is certainly deeply involved in Central Asia, but its own region of Xinjiang is both Muslim and hostile to Beijing. So, China is either bordered by hostile climate and geography, or hostile/unhappy neighbors – India, Tibet, Indochina, and its own province of Xinjiang
For these reasons, China must be viewed as one of the most insular great powers in the world. It has occupied most of the terrain that is accessible to it; what remains is inaccessible, undesirable or quite able to defend itself. China’s great interest, therefore, should be the oceans. Over the past 20 years, China has become a major exporter and thus should have a great interest in securing its sea lanes.2
On instruction from their political masters, in the past few years military leaders have organized the People’s Liberation Army (PLA) into combined-arms battle groups based on a doctrine which has been labelled “active defence.” The PLA is being organized and equipped to fight its battles deep inside an enemy’s territory, rather than on the periphery or in the Chinese hinterland as envisioned by the “people’s war” theory, which Mao himself acknowledged tended to mean the destruction of a large amount of infrastructure.3 These changes have, in part, been made in order to secure China’s energy needs.
What is China?
China is the world’s most populous country. It is currently governed – as it has been since 1949 – by the Communist Party. In March 2003, a long-expected transition in China’s political leadership took place. Hu Jintao assumed the country’s presidency, as well as chairmanship of the ruling Communist Party. Wen Jiabao became the new premier. In March 2005, Hu Jintao replaced former President Jiang Zemin as chairman of the Central Military Commission, completing the leadership transition.
China has a mixed economy, with a combination of state-owned and private firms. A number of state-owned firms have undergone partial or full privatization in recent years. The Chinese government has encouraged foreign investment – in some sectors of the economy and subject to constraints – since the 1980s, creating several “special economic zones” in which foreign investors receive preferable tax, tariff and investment treatment.
With China’s entry into the World Trade Organization (WTO) in November 2001, the Chinese government made a number of specific commitments to trade and investment liberalization which, if fully implemented, will substantially open the Chinese economy to foreign firms. In the energy sector, this will mean the lifting or sharp reduction of tariffs associated with imports of some classes of capital goods, and the eventual opening to foreign competition of some areas of commerce, such as retail sales of petroleum products. Despite moves toward privatization, however, much of China’s economy remains controlled by large state-owned enterprises (SOEs), many of which are inefficient and unprofitable. The large SOEs have had some negative repercussions in the economy in general and many Chinese banks have had to write off large debts accrued by them. Restructuring of the SOE sector, including the privatization of some enterprises, is a major priority of the government, as is restructuring of the banking sector.
The most important matter to note about China is the economic growth that has occurred in the past decade. China’s real Gross Domestic Product (GDP) grew at a rate of 9.5% in both 2003 and 2004, and 9.9% in 2005. Real GDP for the first quarter of 2006 was up 9.5% year-on-year. Although most observers expect this to slow in coming years – real GDP growth is forecast to drop to 7.8% in 2006 – the Chinese economy will still continue to grow. Much of the increase in the GDP growth rate has come from excessive spending on capital goods and construction, particularly in the state sector. In an effort to cool an economy seen as overheating, the Chinese government took a number of steps in 2004 designed to counter this trend, including tightening bank lending policies.
Inflows of foreign direct investment (FDI) into China have grown as well. In 2004 FDI totalled $57.0 billion (US)(all figures in US$), a new record, but up only modestly from the 2003 figure of $53.5 billion. In addition, China’s merchandise trade surplus rose in 2004 to $32.6 billion, from $25.3 billion in 2003. It increased to a remarkable $102 billion in 2005. Imports increased by 35.8% in 2004, largely capital goods being acquired to refurbish outdated industrial facilities. Exports increased by 35.4% in 2004.4
While economic growth is desirable, it can have negative repercussions. Thus China’s society is suffering from different social and political disorders. The economic growth has been incredible but economic development has occurred unevenly, with urban coastal areas, particularly in the southeast, experiencing more rapid economic development than in other areas of the country. The one-party system in which all political networks are under the control of the Communist Party is facing unrest among ethnic groups, social disparity, violation of human rights, corruption and unemployment. One of the biggest challenges facing the Chinese government is protecting an environment that is rapidly being despoiled and polluted. According to a report by the World Health Organisation (WHO), seven of the world’s 10 most polluted cities are in China. How China fares in the future is related how the government deals with these challenges.
In the past, the Chinese goods have not necessarily been of good quality, but they were very cheap. Compared with European, Japanese and even Korean consumer goods, the Chinese had the lowest prices. But in recent years, all Chinese industrial niches are trying to manufacture high-quality goods with lower price than US or European ones. Chinese companies are rapidly outgrowing their image as a source of cheap products, and are threatening the reputation of the US, Western European and South Asian capitals as the ‘go-to’ resource for higher-end technology and large-scale project support. China will soon be able to meet virtually any civilian or military need for high-technology goods as its productive capacity serves more and more foreign companies. Indeed, China has taken control of several technology market leaders such as the purchase of IBM’s laptop business by Lenovo. Many Western companies have already opened research and development facilities in China, and China is seeking to acquire Western companies, particularly those which consumers identify with quality products. In China duplication has actually expanded into a guild-like methodology for industrial training and growth, because of the lack of concern over intellectual property rights. In the future, few Western technologies will remain unmatched by China in both the commercial and military spheres.5
Energy in China
Despite of the fact that 80% of the demand for oil is in the developed countries of North America, Japan, Europe, and two developing Asian countries – China and India; only 10% of proven oil reserves is to be found in these countries. Unlike oil, gas is widely available in Asia, with untapped fields across the region including western China. The main source of energy in China, however, is coal. Coal makes up 65% of the country’s primary energy consumption, and China is both the largest consumer and producer of coal in the world. But because of the serious negative effects on the environment caused by burning coal, China has decided to look at fossil energies and renewable energy sources. Also China has been attempting to move to clean coal.6
China’s electric power industry experienced a serious oversupply problem in the late 1990s, due largely to demand reductions following the closure of inefficient state-owned industrial units, which were major consumers of electricity. The Chinese government responded to the short-term oversupply in part by implementing a drive to close down small thermal power plants and by imposing a moratorium (with a few exceptions) on approval of new power plant construction, which ran through 1 January 2002.
Projected growth in net electricity consumption is most rapid among the economies of countries that are not members of the Organization for Economic Cooperation and Development (OECD), with annual average growth of 3.9% from 2003 to 2030, compared with 1.5% for OECD economies. China leads the growth in annual net electricity consumption with increases of 4,300 billion kilowatt hours, over the projection period. China leads the world in coal-fired capacity additions in the period, adding 546 gigawatts. Strong growth in natural gas-fired capacity is projected to push coal’s share of total capacity down to 63% in 2010, but it is expected to rebound to 72% in 2030.
In recent years, China has shown fairly strong growth in oil-fired electricity generation because peak electricity demand continues to outpace on-grid electricity generation and Chinese industry has had to rely on diesel generators to cope with annual summer power shortages. That situation is expected to continue in the short term, but as planned capacity fuelled by natural gas, coal, nuclear and hydroelectric power comes on line and the country’s national electricity grid matures, the use of oil to generate electricity is expected to moderate. China has ambitious plans to increase hydroelectric capacity, including completion of the 5.4-gigawatt Longtan hydroelectric project by the end of 2007 and the 18.2-gigawatt Three Gorges Dam project in 2009.7
But we are interested in oil in this chapter. With the massive economic growth in the country, China is now consuming much more oil than it did even a decade ago. The demand for oil is projected to increase rapidly in years to come. In the early years of this millennium, total demand was around 6.5 million barrels per day (bpd), but these numbers are rapidly changing. China’s oil demand is projected by the International Energy Agency (IEA), an energy advisory organization based in Paris, to reach 14.2 million bpd by 2025, with net imports of 10.9 million bpd. As the source of around 40% of the growth in world oil demand over the past four years, with year-on-year growth of 1.0 million bpd in 2004, Chinese oil demand is a key factor in global oil markets.
China has long recognized its vulnerability toward oil supply disruption and has implemented a number of policies to slow the rapid growth of its oil consumption. Yet efforts so far have met with little success. China currently accounts for more than 8% of global oil consumption, and has become the world’s second largest consumer of petroleum products (after the United States), after it surpassed Japan for the first time in 2003.8 In 1993, after decades of energy self-reliance, China’s domestic oil supply was unable to meet its fast growing demand and the country became a net oil importer. Since then, China’s crude oil imports have increased at an astonishing rate of 13% annually from 1994 to 2005.9 The increase in oil imports by China between 1999 and 2004 was one of the key factors driving up international oil prices. Figure 1 shows China’s oil production and consumption.
Figure 1. China’s Oil Production and Consumption, 1980-2005 (thousand barrels per day)
China’s petroleum industry has undergone major changes over the last decade. In 1998, the government reorganized many state-owned oil and gas assets into two vertically integrated firms – the China National Petroleum Corporation (CNPC) and the China Petrochemical and Chemical Corporation (Sinopec). This reorganization created two regionally focused firms – CNPC in the north and west, and Sinopec in the south – although CNPC is still tilted toward crude oil production and Sinopec toward refining. The other major state sector firm is the China National Offshore Oil Corporation (CNOOC), which handles offshore exploration and production and accounts for more than 10% of China’s domestic crude oil production. These three – Sinopec, CNPC and CNOOC – are the largest Chinese oil and gas firms. All three successfully carried out initial public offerings (IPOs) of stock between 2000 and 2002, bringing in billions of dollars in foreign capital.
In early 2000, CNPC separated out most of its high-quality assets into a subsidiary called PetroChina, and carried out its IPO of a minority interest on both the Hong Kong and New York Stock Exchanges in April 2000. The IPO raised over $3 billion, with British Petroleum (BP) the largest purchaser at 20% of the shares offered. Sinopec carried out its IPO in New York and Hong Kong in October 2000, raising about $3.5 billion. Like the PetroChina IPO, only a minority stake of 15% was offered. About $2 billion of the IPO was purchased by the three global energy giants – ExxonMobil, BP and Shell. CNOOC held its IPO of a 27.5% stake in February 2001, after an earlier attempt in September 1999 was cancelled. Shell bought a large block of shares valued at around $200 million.
In 2002, Chinese oil companies began to look at separating out some of their business units into subsidiaries. CNPC has set up subsidiaries for drilling services and geological survey work, and plans to eventually spin them off through international IPOs. CNOOC also has created an oilfield services unit – China Oilfield Service, Ltd. (COSL) – which was listed on the Hong Kong Stock Exchange in November 2002. Sinopec was planning to buy TNK-BP’s Udmurtneft in Russia in 2006 and sell a 51% stake in it to Rosneft while retaining the remaining 49% for itself. The deal would give Beijing its first stake in Russian oil and pave the way for a strategic partnership with Rosneft.10
As about half of China’s crude oil imports come from the politically unstable Middle East, energy security has become one of Beijing’s top priorities. After an oil price spike in 2003, China finally realized the importance of a strategic oil reserve to its energy security and started to fund the establishment of four strategic reserve bases at Zhenhai (Ningbo), Daishan (Zhoushan), Xingang (Dalian) and Huangdao (Qingdao). While crude from the Middle East would fill the Sinopec facilities, PetroChina’s Dalian tanks are likely to take more West African crude.11 When completed in 2008, China’s petroleum reserves will be able to hold the equivalent of one month’s national oil imports; by 2015, Beijing plans to expand that capacity to the equivalent of three months’ net oil imports.12
Historically, China’s petroleum refineries were mostly designed to process domestic sweet crude, which has low sulfur content. The refineries are not capable of handling large amounts of heavy and sour crude, which has higher specific gravity, more sulfur content and is difficult to process. Since heavy and sour crude dominates Middle Eastern production, the lack of suitable refining capacity remains a major entry barrier for Middle Eastern oil producers seeking to penetrate China’s oil market.13 The imported oil form Central Asia and Caspian Sea also has the same high sulfur and needs desulphurization installations.
With the expectation that dependence on oil imports will grow in the future, China has been acquiring interests in exploration and production abroad. CNPC has acquired oil concessions, and in some cases signed exploration or production deals, in Azerbaijan, Canada, Kazakhstan, Venezuela, Nigeria, Sudan, Indonesia, Iraq and Iran. This new activity has raised eyebrows internationally, particularly because China has gotten involved in some countries that are seen as bad international citizens or unfriendly to the West (Sudan, Iran, Venezuela), and in countries that have traditionally been in the US ‘orbit’ (Canada, Saudi Arabia, Nigeria). It is ironic that there is international disapproval whether China talks to Western enemies or Western friends.
In addition, Russia’s Far East is seen as a potential source of crude oil imports. The Russian and Chinese governments have been holding regular discussions on the feasibility of pipelines to make such exports possible. One proposed plan is a pipeline which would carry as much as 1 million bpd of crude oil from Anagarsk in Russia to join the existing Chinese pipeline network at Daqing.
Chinese oil companies have been active in other countries. CNOOC paid $2.3 billion for a 45% stake in a Nigerian oil field – the Akpo oil field – in its first major investment since its failed bid to take over California-based Unocal in 2005. The deal adds to a multibillion-dollar string of foreign acquisitions by Chinese oil companies, which are aggressively pursuing energy supplies to fuel China’s booming economy. The agreement, which requires approval from the Nigerian and Chinese governments, covers a deep-water area of the oil-rich Niger Delta Region. The Scottish consulting firm Wood Mackenzie has estimated Akpo’s recoverable oil reserves at 620 million barrels and natural gas at 2.5 trillion cubic feet.14
In China’s biggest foreign deal to date, its leading state-owned oil company, China National Petroleum Corp., agreed in 2005 to pay $4.2 billion for a producer in the neighbouring Central Asian republic of Kazakhstan.
But it does not end there. In January 2006, CNPC and the Indian firm, ONGC, set aside their rivalry and agreed to jointly acquire oil production rights in Syria in their first collaborative venture. And in mid-2006 visiting Bolivian President-elect Evo Morales invited China’s state energy firms to help develop his country’s vast gas reserves after his government carries out plans to nationalize them.
Despite efforts to diversify its sources of supply, however, roughly half of China’s imported oil still comes from the Middle East, with Saudi Arabia alone accounting for 17% in the first quarter of 2005.
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