China, Russia and the waning demand for Canadian oil

After closing gigantic supply deals with Russia, does China still need Canadian production?

August 06, 2014

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The international oil trading business with its complex contractual underpinnings, expensive infrastructure requirements and protracted time horizons has never been for the faint of heart. Required is not only imagination, perseverance, immense cash reserves, and co-operative governments, but also no small measure of luck in timing. More to the point: oil markets are, by definition, constantly shifting targets. Last year’s $270-billion oil deal sealed by Russia and China is only trumped by this year’s $400-billion gas deal. These mammoth transactions between former Cold War allies, economic rivals and now co-operative energy partners exemplify this high stakes game.

Canada has professed to have a dog in this hunt, but in a world where only results count, the country has been unable to deliver on the promise of stable, competitively priced crude oil supplies for Pacific export – not for a lack of trying, and not because of overestimated reserves. Owing to regulatory delays and political obstructionism holding back Northern Gateway, Keystone XL and other projects, Canada just can’t create tidewater access ahead of determined rivals. Meanwhile, international markets keep moving and won’t wait for non-performers.

 

Everyone used to think demand from North America was insatiable. This was led by the U.S., of course, with its car culture, restless electricity expansion and greenback as the world’s reserve currency. Quietly though, the oil consumption party has moved elsewhere. U.S. energy demand has flattened overall and even fallen in some regions. The word “export” has begun to be uttered in polite conversation. Painfully aware of the wide web of capital investments in landlocked, cross-border infrastructure with the United States, Canada has been compelled to assess those few bands of Pacific coastline that might afford tidewater access for its own oil exports. Sending hydrocarbons to Asia with its deep, booming markets looked secure. It looked endless.

The center of mass of the world’s energy markets – including associated geopolitical alliances and tensions – has been shifting inexorably to the Pacific. In its commercial and defense strategies, the United States under the Obama administration has clearly developed a strategic regional pivot toward the Asia-Pacific, signalizing America’s recognition of the magnitude and direction of change there. The fundamental changes in the Asian energy market, led by China but underpinned by Japanese and Korean demand, have made a China-Russia oil alliance possible, with predictable fears of exclusion and energy security at the top of their political agendas.

One source of fears is the possibility of Russia entering into hostilities with the United States and its allies over Ukraine. Another is the potentially explosive disputes arising around territorial claims and counterclaims in the South China Sea between China and other Asian countries like Japan, the Philippines, Vietnam and Taiwan. The economic giants China and Russia are thus reaching out to find friends, even as far as Africa, in order to offset the West’s geopolitical influence in Europe and the Pacific. After all, you need friends to trade in world energy markets and, at the end of the day, your enemy’s enemy may prove a valued friend.

 

Beyond possible incompatibilities from distinct core ideologies, there really are only manageable obstacles to diplomatic agreements between Russia and China. These countries aren’t fighting over territory, and both can claim relatively equal military strength. Belligerence remains oratorical. Most of China’s geopolitical difficulties occur in regions to the south or east. The economics of the oil and gas trade create comparative advantages for both sides. Russia needs new, stable and diverse export markets for its vast oil and gas reserves. China needs to secure supplies that avoid the long distances, high transit costs and security issues associated with Middle Eastern oil and gas.

Other developments driving the transformation of Asian energy markets are equally compelling. China is quietly building up buffers against oil price spikes and supply disruptions. According to the International Energy Agency, it imported a record high volume of 6.81 million barrels per day of crude oil in April – and that in spite of slow growth in the steel industry and a construction downturn. The IEA estimated that 1.4 million bpd of the imported volume was being directed into the country’s storage system, a volume change that highlights the speed and urgency of China’s rising oil import demand.

Last year’s $270-billion oil deal sealed by Russia and China is only trumped by this year’s $400-billion gas deal.”

On the Russian side, even absent the Ukraine crisis, Russia can see that having a single European customer puts it at risk with its oil and gas export capacity. As a result, it faces a constant stream of price disputes, right-of-way tensions with transit countries, shifting European demand and unpredictable shifts in European energy policy. New pipelines for transporting Russia oil eastward to China will require major investment. In Russia’s case, the status quo is insupportable, politically and economically.

The infrastructure involved in the current Russia-China relationship is at a logical limit. Building new capacity though won’t happen unless investors see long-term stable demand ahead. They get that with the new oil and gas agreements. Russia exports nearly all of its hydrocarbon energy from east to west through pipelines built in the 1960s and 1970s. This stands in contrast to how the greater part of the world’s traded energy flows from west to east owing to robust Asian industrial growth and increasing supplies of unconventional oil and gas from the U.S.

On the flip side, China has significant reasons to import more energy from Russia, starting with security of supply. China’s navy is not strong enough to prevail in maintaining sea lane access should a dispute arise with the U.S. and its Asian pivot partners. Partnering with Russia is the answer to a maiden’s prayer. The arrangement cuts the volume of oil arriving via vulnerable transit routes. It also confers greater deal-making leverage with old partners in the Persian Gulf and new partners in Australia.

 

Last year’s $270-billion oil deal not only essentially doubles Russia’s export volumes to China, with Rosneft to supply 365 million tons of oil to China over 25 years (293,000 bpd) but reflects the determination to create a broad hedge of energy supplies from oil to natural gas to solar electricity. The deal supplements the estimated 15 million tons per year (300,000 bpd) of oil traveling to China annually via the East Siberia Pacific Ocean pipeline that opened in 2009, a volume that constitutes only two per cent of Russia’s 518 million tons in annual oil output (10.4 million bpd) from the region.

The oil deal was years in the making, and the engineering, procurement and construction of the requisite infrastructure build-out will not occur overnight. Importantly, the contracts bind the parties together in a way that effectively excludes outsiders from entry – not because they are forbidden to play, but because the facilities, from ports and pipes to storage and upgrading, won’t be economically attractive for those who anticipate following in this new market after physical supplies begin to move.

This all must give the Canadian proponents of the Northern Gateway project cause for reflection. In a stroke, what once seemed like a leisurely walk in the park, albeit with a variety of obstacles such as aboriginal opposition, intractable politicians and difficult terrain, might now be an arduous trek. Western Canadian Sedimentary riches, in particular the oil sands, begin to look increasingly like stranded capital assets. Now we must face the possibility that, although projects to the British Columbian tide line could work flawlessly on paper, they might fail simply because the boat to China already sailed from Russia – or even from more nimble competitors as far as away as Pakistan.

China has been developing strategic, long-term infrastructure plans for over a decade. These plans include collaborative agreements involving finance to port and pipeline construction as well as partnerships with countries whose diverse interests and political ideologies range from the United Kingdom to Iran. Any pipeline project that increases supplies from Iran via Pakistan also increases access to Iraqi reserves and ultimately oil reserves throughout the Gulf Kingdoms via an overland rather than marine system.

“China is quietly building up buffers against oil price spikes and supply disruptions.”

China’s diversification strategy is, of course, based on an expectation that future domestic demand could outstrip import capacity as well as the export capacity of co-operating countries. Future key links will focus on improvements to coastal ports and pipeline systems such as the West-East Pipeline Project and a future link to Pakistan.

Pakistan represents the new icon of complex and interrelated geopolitical arrangements to secure long-term oil supplies. As part of its $12-billion commitment to an economic corridor extending from coastal Balochistan to the border in Gilgit, China would finance at Gwadar Port a $4-billion, 400,000 bpd refinery configured for Iranian crude. This investment reflects China’s desire to eliminate the “Malacca Dilemma” understood as the risk of having 83 per cent of its total crude imports pass through the strategically precarious sea lanes between the Malay Peninsula and Sumatra. Avoiding this route would reduce transport distance by 12,000 miles and costs by 25 per cent.

In the future China will also have a stake in the Turkmenistan-Afghanistan-Pakistan-India Pipeline (TAPI) project that could start operating by 2015. Strategically, this system could be extended to China, further enhancing access to regional supplies.

 

The unsettling upshot: China may eventually need our oil less than our petroleum industry needs China. In the end, it’s all about timing and political self-interest. Vladimir Putin has said, “China is our reliable friend,” in an interview before a conference in Shanghai. “To expand co-operation with China is undoubtedly Russia’s diplomatic priority.”

The enormity and significance of the Russia-China energy deals should force Canadian stakeholders to face up to the new, jarring reality: Be ready to respond quickly when the customer knocks or lose out to flexible, price-cutting rivals. As they build out their trade and diplomatic relationships, Russia’s and China’s growing community of interests is a hallmark of the energy realpolitik of the 21st century. It is unlikely we are witnessing a temporary or accidental marriage. This is particularly unlikely on the energy front, where the world’s largest net energy exporter is matched with the second largest net energy importer with which it incidentally shares a 4,300-kilometer border.

Does this deal mean Canada has lost the opportunity to export oil to China and the Pacific Basin? Not likely. Asian energy markets are too large and growing too fast for that. On the other hand, Canada’s opportunity to be a key and pivotal supplier to Asian markets has probably slipped away. And this opportunity grows ever more elusive as not only other producing countries sign onto long-term supply contracts but also, more importantly, dedicated pipelines, pump stations and storage facilities are built, thereby cementing alternative trade routes and transfer points.

 

We might then feel prone to ask, at least from a Canadian point of view: What happened? Were we sidelined by a process that simply demanded more speed, commitment and capital investment than we were prepared to make? More likely, policy-makers in Canada misread the signals and information about energy market transformations that were in play throughout Asia. Only time will tell, of course, but the game board of the international oil trade has been fundamentally altered, and it may be difficult if not impossible to set the pieces back to where we achieve greater advantage if we don’t quickly.

Losing the Pacific Basin marketplace may not be the end of the game for future oil and gas export opportunities though, if Canada looks hard at the remaining options, and acts strategically to exploit them. Using the Jordan Cove LNG project as a model, finding pipeline access that serves U.S. export terminals may provide important economic opportunities, as might the cross-Canada Energy East pipeline with future access to Europe. These are hard choices and will leave an ache when producers and policy-makers reflect on what might have been. That may not matter in the new reality. That was then, and this is now.

More posts by Michal C. Moore

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Comments

2 Responses to “China, Russia and the waning demand for Canadian oil”


  1. snert says:

    “jarring reality: Be ready to respond quickly when the customer knocks or lose out to flexible, price-cutting rivals.” Ha! That’s turning into a bigger pipe dream than the pipelines themselves.

  2. J West Hardin says:

    Our legal obstructionist hurdles should be suspended by enacting eminent domain legislation immediately for the good of the country. Or….we can soon say hello to 100% taxation in order to support the status quo. If liberal anti government protestors can’t imagine their comfy pensions being suspended in the future…they should think again. And the Greens should know that after The Tides Foundation, Farrallon Capital and The Rockefeller Foundation has closed Canada for business….they will leave nothing behind….and then all the Greens and their children will have for a future is welfare.