China’s New Free-Market Energy Policies

In the past few weeks, Sino-American ties have taken a beating over the Google China fracas, cyberattacks, currency manipulation, U.S. arms sales to Taiwan, and U.S. President Barack Obama’s scheduled meeting with the Dalai Lama. But at the same time, Beijing has done something that could alter its relations with Washington in a profoundly positive way. The centralized communist government has started using the free market to source its energy supplies.

In December, a consortium led by a state-owned Chinese oil company emerged as the big winner of a major oil auction in Iraq. The tender marked a shift from China’s prior policy of securing exclusive state control over its energy supplies, a shift that promises to have far-reaching consequences for what is actually the most serious threat to U.S.-China relations: the shadowy struggle between Washington and Beijing for control of the South China Sea.

Until now, China has pursued a costly zero-sum strategy to guarantee energy for its high-growth economy. Rather than buying fuel from foreign gas or petroleum companies, it has entered into long-term agreements with developing countries (often pariah states like Sudan and Iran), exchanging unlimited access to energy for free infrastructure and preferential trade deals. China has also invested in the maritime capacity to ship and the naval power to secure these supplies. It has bought up port facilities along the sea lanes from the Strait of Hormuz to the South China Sea, developed a navy that could soon rival the U.S. Pacific fleet, and even hinted that it might carve a canal through Thailand’s Kra isthmus to bypass the narrow Strait of Malacca.

Needless to say, the Pentagon has no intention of letting Beijing turn Southeast Asia into a Chinese lake. For years, U.S. surveillance ships have operated inside China’s disputed exclusive economic zone, which extends about 230 miles off the country’s coast and which Beijing declares off-limits to foreign patrols. Last March, Chinese vessels challenged a U.S. spy ship about 75 miles south of Hainan Island in the most serious confrontation since Beijing caught a U.S. spy plane in 2001.*

Pentagon officials fear that China might define its proprietary waters broadly, at the expense of its neighbors and with the help of its growing naval might. So long as China insists on securing its energy shipments, there is always a danger that the United States and its Asian allies might feel the need to challenge Beijing’s interpretation of where international waters begin and where they end, particularly in a region as resource-rich as Southeast Asia.

That is why China’s participation in Iraq’s oil tenders was so significant: It signals a shift away from the proprietary control of reserves toward a market-based approach. At the vanguard of this trend are China’s powerful national oil companies, or NOCs, which have honed their management and engineering divisions to compete and collaborate with global majors. The work paid off in December, when the China National Petroleum Corp. (CNPC) won a contract to develop Iraq’s Halfaya oil field along with Total of France and Malaysia’s state-owned Petronas. Six months earlier, a BP-led group including CNPC got a deal to develop Iraq’s largest oil reserve, at Rumaila.

For much of last year, Sinopec and the China National Offshore Oil Corp. (CNOOC), two other leading NOCs, have aggressively bid for new and existing leases on oil reserves in Africa. In some cases, they are gunning for contracts currently held by big independent oil companies like ExxonMobil and Chevron, an unprecedented case of the once-primitive national oil companies angling to steal the majors’ lunch. And in January, Sinopec announced it was in talks with BP to collaborate in developing large shale gas reserves in China. News of the discussions followed an agreement by Royal Dutch Shell and PetroChina, yet another NOC, to jointly develop a shale gas reserve in Sichuan province.

* Correction: The original version of this article said that China shot down a U.S. spy plane in 2001. In fact, the Chinese intercepted the plane and arrested its pilot. Foreign Policy regrets the error.

In less than a decade, China’s oil companies have gone from parochial stewards of their country’s scant fuel reserves to prominent players on the global energy field. Companies like Shell and BP, faced with severe supply limits — the majors own less than 20 percent of the world’s energy reserves — have concluded the best way to get along in an increasingly competitive market is to work with the arriviste Chinese.

China is not the only developing country that is turning out world-class NOCs, though its huge domestic market and strong connections to emerging markets make it especially attractive as a partner. "The majors want to know about the national oil companies," says Fareed Mohamedi, head of oil market analysis and country risk for PFC Energy, a Washington-based consulting firm. "Who are they partnering with? What are the opportunities? But of course we are particularly bullish on China."

The rise of NOCs, with China’s in the lead, is the most significant trend in the fossil fuels industry today, and it will inevitably outlast Beijing’s outdated zero-sum energy doctrine. This is very good news indeed: As Chinese representation in energy consortia increases, there is little need for Beijing to militarize the sea lanes.

"This is a positive development," says Guy Caruso, an energy specialist at the Center for Strategic and International Studies in Washington. "Speaking from the standpoint of national security, it’s better to have the Chinese in a consortium in Iraq and elsewhere than going off to Sudan and Iran. It also makes nonsense of the argument to build grand canals through Southeast Asia."

China would not be the first oil-hungry industrializing country to transform itself from a zero-sum energy consumer to a net-sum energy player. During the first half of the last century, imperial Britain and France cut deals with pliant governments in the Middle East, which they duly carved up at the end of World War I for control of the region’s oil riches. At the same time, U.S. oil companies won concessions to drill wells in Saudi Arabia and enjoyed de facto control of that kingdom’s vast petroleum reserves as late as the 1950s. Today, the developed world is no longer concerned with actual control of reserves for the sake of energy security. Rather, it buys virtual supplies in the commodities exchanges of Paris, London, and Chicago and puts faith in the market for delivery.

A landmark Pentagon study on Beijing’s energy policies, circulated in August 2004, offered a stark outlook for an age of finite fuel resources and a voracious Chinese economy. Unlike Western countries, content to let the market sort out their energy needs, "Asians generally and Chinese specifically equate energy security with physical possession or control" of reserves, the report said. Faced with uncertainty of supply, the report warned, China might seize oil fields in the Russian Far East. It would exploit a vacuum created by a U.S. withdrawal from Iraq and "establish deep strategic relationships … with Iran, Iraq, and particularly Saudi Arabia."

A minority view represented in the report allowed for a different outcome — that China might accelerate the pace at which it adopts market-based solutions to its energy demands: "The fact that so much of the oil is too far from China for economical delivery will likely increasingly force Chinese oil executives to use swapping and other mechanisms common in the sophisticated world oil market."

Western countries were not always so benign when it came to energy security, nor are "Asians" preternaturally aggrandizing. As events over the last several months reveal, China’s energy companies are turning to the free market, not despite some atavistic or Confucian hoarding instinct, but because it makes sense.