Russia’s Hydrocarbon Sector Set For Long Term Gains From China’s Energy Crunch

Posted by Written by Bob Savic, Senior Consultant, Dezan Shira & Associates

By Bob Savic, Senior Consultant, Dezan Shira & Associates 

China energy’s crisis has been making global headlines these last few weeks with many Chinese regions, suffering energy deficits. Soaring demand in the aftermath of the global pandemic for energy, from the country’s giant industrial sector and higher-spending households, has collided with tight supplies of imports due to ongoing coronavirus restrictions amid government efforts to cut carbon emissions.

As an immediate term measure, Beijing has ordered its state-owned power companies to secure fuel supplies for winter at any cost.  Much of these energy needs are set to come from the vast expanses of neighboring Russia. Indeed, beyond this crisis, Russia’s Arctic, Siberian and Far East regions are likely to become key centers in supplying China’s energy requirements for decades to come.

Surging Russian energy exports

The prices of all energy commodities appeared to show no sign of easing on the global markets during China’s Golden Week holiday.  Crude oil is up by over 60% since the beginning of this year.  Natural gas has surged by 150% over the same time frame, while in Asia, prices have hit record local levels as China and other major LNG buyers compete for the limited available cargoes to meet demand.

Meantime, coal prices have gone ballistic, climbing by over 230% since the beginning of 2021, even experiencing daily rises of in excess of 10% during Golden Week – an outcome of the large amount of Chinese coal producers which have been ordered to shut down by Beijing in its efforts to meet future climate targets.  Downstream energy derivatives have experienced even greater price inflation with gasoline, heating oil and naptha – all at or near record highs.

Along with rocketing energy prices, Russian energy exports to China have risen in parallel.   Prior to this year, Russia’s exports appeared to be in a structural downtrend as China shifted towards renewable and other sources of energy from global providers.  For instance, Russia exported US$29 billion of oil, gas and coal to China in 2020.  That was down from US$29.5 billion in 2019 and US$41 billion in 2018.  This declining trend looks now like coming to an end.  Over 2021, Russia’s energy exports to China have surged to over US$36 billion in the first eight months of the year alone. Of those, Russian coal exports saw the biggest rise as China’s energy crisis began to bite.

Moreover, China’s imports of Russian oil over the same period expanded by 30.4% in value terms, although physical volume decreased by 7.3% to 53 million tons essentially due to supply bottlenecks. For instance, seaborne crude oil, which makes up the bulk of Russian oil exports, totaled 14 million tons to China, in the first half of this year.  This is down from 19 million tons over same period in 2020, according to shipbroker Banchero Costa. Overall, Russia was China’s second largest oil supplier after Saudi Arabia, which sold 58 million tons to China from January to June 2021.

Russian natural gas, on the other hand, has seen the largest leap in exports to China of any energy exporting nation.  According to China’s customs service, over January to August 2021, Russian piped gas imports grew by 2.7 times over the previous year to 4.7 million tons. Russian LNG exports also rose, reaching 2.67 million tons, even though it only resulted in Russia being the sixth largest LNG exporter to China.   

Alexey Miller, CEO of Gazprom, Russia’s state-owned monopoly piped gas producer, predicted that gas consumption in China will grow faster than any other Asia-Pacific economy.  By end-2021, China’s gas imports will be 160 billion cubic meters, rising to 300 billion cubic meters by 2035.  “Every year the rate of growth of gas consumption simply stuns us and 2021 will be no exception”, he was reported to say.

China requests short-term energy fix from Russia’s Inter RAO

Inter RAO, a diversified energy holding company and the only Russian electricity export-import provider, was requested, on October 1st by China, to increase supplies by about 90% over that originally planned for the month of October.  Both Inter RAO and China’s State Electric Grid Company have been finalizing discussions on the technical possibilities of a significant increase in power supply, with volumes determined on an hourly basis, dependent on demand.

Under a 25-year contract for electricity supplies concluded in 2012, a total 100 billion kWh of electricity is due to be provided by Russia over this period. Currently, Inter RAO exports around 3 billion kWh annually from its plants in the Russian Far East. According to experts, an additional 2 billion kWh can be supplied by year-end, although this is unlikely to resolve China’s energy deficit since demand there rose to 5.5 trillion kWh in the eight months of this year.  This contrasts with China’s entire electricity consumption of 7.5 trillion kWh for all of 2020, whereas Russia’s annual consumption stands at around 1 trillion kWh.

Inter RAO typically purchases electricity from hydroelectric power plants (HPPs) in the Amur region of Russia.  The HPPs, which are mainly operated by RusHydro, a state-owned utility, will be able to produce more power given the significant rainfall this year to have accumulated in reservoirs from which the water will be sourced.

It may even be possible for China to increase imports of Russian coal in the short term, although current logistics constraints may block that approach. According to Russian Railways, China continues to restrict the transfer of goods at land border crossings due to the application of strict pandemic quarantine controls.  As a result, the land-based transport of coal to China dropped by 20% over the January to August period, to 4.2 million tons, even though overall shipments rose by over 30% during that period, to 20.6 million tons.  Still, Russian suppliers managed to increase their market share in the overall volume of coal shipments to China by up to 19% in January-August 2021 from a 12% market share over the same period in 2020.

During the fourth quarter of 2021, it is broadly anticipated that China will have to increase overall imports, including shipments from Russia.  The China Electricity Council, which represents national energy providers has announced that coal fired power companies were currently “expanding their procurement channels at any cost” to secure power for winter heat and other electricity needs. This sudden upsurge in demand for power could be met subject to a relaxation of border quarantine measures, in the near future. These have so far limited the export potential of Russian suppliers in maximizing the rail linkages across the far eastern border areas into the most critically energy-short provinces of Heilongjiang, Jilin, and Liaoning.

Longer term energy supplies coming to fruition

In addition to the Eastern Siberia–Pacific Ocean (ESPO), an oil pipeline which began transporting crude to northeast China in 2011, the large-scale overland supply of energy from Russia to China began in earnest several years ago.  This essentially arose out of a US$400 billion agreement, signed between Gazprom and China National Petroleum Corporation (CNPC) in 2014, and which is scheduled to last 30 years.

During the course of last year plans for overland power supplies from Russia accelerated, as Beijing became increasingly concerned about energy security in a more globally perilous political environment.  Given the vast majority of its imported energy is transported by sea from the Middle East and across a number of countries in Central Asia, in addition to supplies from declared geopolitical rivals such as LNG from the US and coal from Australia, China has begun to gravitate increasingly towards Russia, in securing future energy input.

To this end, China’s President Xi and Russian President Putin agreed to undertake greater cooperation on large scale energy projects arising from a discussion at the end of last year.  In a meeting where both leaders clearly scrutinized the instability of the current global political environment, they appear to have formulated a new energy strategy based on navigating this future uncertainty. According to Xi, “by strengthening strategic cooperation, China and Russia can effectively resist any attempt to suppress and divide the two countries”.

As part of this process both governments set out plans to develop natural gas in the Arctic, expand oil infrastructure across their mutual borders, and to practically double coal exports from Russia to China.

The latter plans could be considered a means of supplanting imports from Australia, following China’s unofficial ban on purchasing the commodity from down under in the wake of a bilateral political disagreement, given that Australia supplied about a quarter of China’s coal imports in 2019.  Coal cooperation with Russia may even be designed to also replace imports from the US.

Russian company, Elgaugol, which operates the Elga mine – the largest coking coal project in Russia – launched a joint venture with China’s Fujian Guohang Ocean Shipping to export coal to China. The Elga project is expected to ship 30 million tons of the raw material to China from 2023 onwards, which would almost double Russia’s total annual coal exports to China of about 33 million tons in 2019.

Russia is also in the early stages of significantly increasing natural gas exports to China over the next five years as additional supply and infrastructure comes onstream. In particular, the China-Russia east route pipeline spans over 8,000 kilometres where it distributes natural gas from Siberia to nine provincial-level regions in China. It began to provide China with natural gas in 2019, starting off with around 3 billion cubic meters (bcm) that year.

This year, 10 bcm of Russian gas will be pumped to China, while the Russian Energy Ministry expects this to rise up to 38 bcm from 2024.  This will be further expanded to 46.5 bcm by 2035.

CNPC and China’s Silk Road Fund both own around 30% of the US$27 billion Yamal LNG project which is majority opened by Novatek, a Russian company licensed to produce and export offshore LNG. Yamal LNG began physically exporting LNG in 2017. A couple years later, in 2019, CNPC and China National Offshore Oil Corporation (CNOOC) took minority stakes in another US$21 billion LNG venture, Arctic 2, also majority owned by Novatek. Recently, it announced plans to export in excess of 3 million tons annually of LNG to China as part of a deal with China’s Shenergy Group over 15 years.

Russia’s hydrocarbon sustainability with China confounds Western sceptics

According to Western think-tank criticisms of Russia’s highly fossil fuel dependent economy, Moscow will have to develop new energy hydrocarbon resources beyond its ability to maintain the current high levels of fossil fuel production for another few years. Some have speculated that if the oil price remained moderate, around US$40 to US70 per barrel, that funding for new investments in the greenfield development of riskier frontier regions would become harder for Russia to raise.

As China moves toward net-zero carbon emissions by 2060, and the developed world by 2050, these critics have claimed that the construction of energy infrastructure in remote regions, to transport new oil and gas supplies having a long lead time that results in low returns on capital, would risk those facilities becoming redundant within a short time frame.  In particular, given the location of Russia’s new oil and gas production in places such as Siberia, the Russian Far East and the Arctic, the challenge for Moscow is whether such costly new export projects would become stranded assets. Accordingly, Western sceptics have predicted that should this happen, it would negatively impact Sino-Russian relations being partly developed on oil and gas, as the two countries’ long-term economic interests diverge.

In light of the current scale of its imports, most of China’s oil and gas supply will continue flowing in across international maritime routes. However, China will seek to balance this with more pipeline imports, especially from Russia, as seaborne cargoes are exposed to geopolitical uncertainties posed by the increasing encroachment of Western naval forces in the seas around China.

An example includes the recent large flotilla of US, UK, Australian and other nations’ warships undertaking maneuvers in the western Pacific as a show force to China.  Overland pipeline trade, for Beijing, therefore, is considered more secure and stable, especially when both buyers and sellers have invested heavily in the infrastructure developed. This is in contrast to Chinese energy traders’ more flexible maritime trade practices having shorter-term contracts and cargoes easily resold.

As the transition from oil and gas, from China’s point of view, becomes crafted more on its geopolitical concerns over the actions of the West in its surrounding waters, oil and gas projects that are viable at US$80 or US$100 per barrel have become more practical.  In particular, exploration and development of new resources in the Arctic region may turn out more prudent to develop.  This would include opening of the Northern Sea Route to reduce the journey time for shipping Russian oil and gas to markets in China.

Moreover, as China continues the longer term objective of shutting down coal-fired plants, which still account for half the country’s electricity production, reliance on the development of renewable resources, even at the most expansive scale and fastest pace of any country in the world, will simply not fully substitute for its rapidly rising demand for power.

China’s energy crunch and its turn towards Russia in immediately plugging some of its energy deficit is certainly a noteworthy event.  But it is essentially more a symbolic turning point highlighting the undercurrents of a strategically close and highly cooperative economic relationship between these two powers. In this regard, Russia’s position as a long term and expanding large scale supplier of hydrocarbon-based energy to China seems to have been already securely drilled into place many meters below ground.

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