The Energy Context behind China’s Drilling Rig in the South China Sea

On May 3 China placed the Haiyang Shiyou 981 deep water semi-submersible drilling rig 119nm off the coast of Vietnam and 180nm from Hainan Island. The rig lies 17nm from Triton Island, part of the Paracel islands that China occupied by force from then South Vietnam in 1974. Vietnamese and international condemnation was swift and strident. Vietnamese Foreign Minister Pham Bing Minh called the move a violation of Vietnamese sovereignty and the U.S. State Department described the move as “provocative”. Chinese Foreign Ministry (FMPRC) Spokesperson Hua Chunying said the rig was normal part of regular offshore resource exploration activities China is entitled to conduct in its territorial waters off of the Paracel islands (FMPRC press conference, May 6 and 12). The move is in fact a deliberate Chinese escalation of its territorial and maritime dispute with Vietnam. This marks the first time that any claimant has unilaterally explored for hydrocarbon resources in a disputed part of the South China Sea, although Chinese officials maintain the activity in question is a decade old, and claimants have previously granted concessions to international energy companies to explore disputed areas (FMPRC press conference, May 14).

From a messaging standpoint, the timing of the move seemed counterproductive. China clearly intends to keep the pressure on its rival claimants through a series of moves that sit below its rivals’ threshold for the use of force, but against which a weaker state has little recourse. But this move broke a year of relative calm in the Sino-Vietnamese relationship on the eve of a summit of the Association of Southeast Asian Nations (ASEAN), and seemed to undermine the message of regional cooperation and shared security that Xi delivered later in the month at the Conference on Interaction and Confidence-Building in Asia (Xinhua, May 21).

However, the move was not a sudden decision, but the realization of a years-long effort to develop acquire deep-water technology and deploy it to the region. China deployed the Haiyang Shiyou 981 when it did because it was when it could. The move supports China’s ultimate goals both by asserting China’s ability to tap resources in the disputed area, and by discouraging international companies from working with Vietnam and other claimants. Nevertheless, despite considerable advances in deep water drilling technology, China lacks the capability to produce natural gas so far from its shores, suggesting that the move is driven as much by strategic considerations as by energy considerations.

Why Now?

China’s maritime capabilities are growing rapidly, including maritime law enforcement, military power projection and offshore drilling. China has invested considerably in becoming a “maritime power,” as called for by former President Hu Jintao. The 12th Five Year Plan calls for the national maritime economy to compose 10 percent of China’s total GDP. In addition to naval modernization, China is developing the capacity to enforce its considerable maritime claims with lightly-armed civilian enforcement vessels. These vessels enforce China’s claims to the Senkaku/Diaoyu islands and have enforced China’s claims against fishermen from the Philippines and Vietnam.

China has also made considerable investments in offshore rig technology. The stated-owned China National Offshore Oil Corporation (CNOOC) seeks to increase offshore production dramatically, with an emphasis on the deep waters of the South China Sea. Wholly-owned CNOOC subsidiary China Oilfield Services Limited (COSL) allocated 62 percent of its capital to acquiring new rigs in 2013 (Platt’s Oilgram News, February 1, 2013). COSL is constructing two semi-submersible rigs capable of drilling in waters of 1500 metres. This is still only half the depth limit of the Haiyang Shiyou 981, but deep nonetheless (Platt’s Oilgram News, February 1, 2013). COSL also bought Transocean’s Richardson deep water rig in a surprise move in mid-2013 after the Haiyang Shiyou 981 demobilized due to damage related to steel fatigue or welding quality (Petroleum Intelligence Weekly, August 19, 2013). The Haiyan Shiyou 981 is clearly the most capable rig in the fleet. Constructed by China National Shipbuilding Corporation, COSL took possession of the $900 million rig in May 2012. It first operated in the Pearl River Delta before beginning operations near the Liwan gas field in the South China Sea, 198nm southeast of Hong Kong (Platt’s Oilgram News, May 9 2012). When the Haiyang Shiyou 981 was launched in 2012, the Petroleum Economist reported that Liu Feng, of the National Institute of South China Sea Studies, had suggested that “with Chinese drilling technology improving, it is just a matter of time before CNOOC pushes into the central and southern sectors of the South China Sea” (Petroleum Economist, September 2012).

Finally, deep water resource exploitation is a long term goal that China is rapidly approaching. China operates one of the world’s most capable deep water submersibles, the Jialong, which can descend to depths of 5000m. China is one of the most active states in the world at the International Seabed Authority in Jamaica, which issues licences for deep water mining surveys on the seabed beneath the high seas. The pursuit of deep sea drilling technology was widely suspected to be a motive in CNOOC’s generous offer for Canadian oil company Nexen in 2012. COSL’s investments in drilling capability are a product of CNOOC’s stated goal to produce 1 billion barrels of oil equivalent per day in deep water by 2020 (Petroleum Economist, December 2012). Earlier this year, CNOOC announced a mid-sized find in the Lingshui 17-2 area of the Qiongdongnan basin in its first independent deep water drilling operation. According to the Oil & Gas Journal (March 19), the find was made in 1450 meters of water at a depth of 3510m beneath the seabed. The basin is located south of Hainan and north of the Paracels in waters not claimed by Vietnam.

The economics of this effort are driven by domestic supply shortfalls, high gas prices in the Asia-Pacific and the premium China places on supply security. From CNOOC’s perspective, deep water exploration in the South China Sea is integral to the company’s future. Its Bohai Bay fields are beginning to peak and its East China Sea sites are locked in a perpetual freeze due to the maritime boundary dispute with Japan (Platt’s Oilgram News, April 17, 2012). Reliable natural gas production in the South China Sea supports China’s energy security objectives in three ways. First, it supports the diversification of energy source away from coal towards other hydrocarbons. Second, it adds indigenous production that further diversifies China’s sources of gas (as does the recent natural gas deal inked with Russia). Finally, the gas would not be imported by sea, which alleviates Chinese anxieties about imports that arrive on ships that travel through American policed sea lanes.

Discouraging the Competition

As a function of its growing capabilities, CNOOC’s interests and the political importance of the South China Sea to Beijing, China’s objective is to ensure that any economic activity in a Chinese-claimed part of the South China Sea occurs on Beijing’s terms. The economic rationale outlined above is coloured by political and security concerns. In 2012, for the first time, CNOOC released blocks for bidding in two separate rounds. The first round was composed entirely of blocks off the coast of Vietnam that had been licenced by Hanoi to foreign oil companies in partnership in PetroVietnam. This was undoubtedly a political move as China held a more wide-ranging round of bids later that summer, which included blocks in the Yellow Sea, the East China Sea, the Pearl River mouth basin and the South China Sea.

By deploying the rig in Vietnamese-claimed waters, China is escalating tensions in waters adjacent to those currently being explored by international oil companies. Vietnam lacks advanced deep water drilling technology and is beholden to foreign partnerships, although PetroVietnam is trying to develop a deep water drilling rig in a joint venture with a Russian company (Platt’s Oilgram News, July 21 2011). By raising the political risk for foreign companies operating off Vietnam, Beijing can prevent Vietnamese drilling while building its own capacity to explore disputed areas unilaterally. China does not yet seem prepared to try to remove foreign oil companies already operating off the Vietnamese coast, although it has pressured foreign majors not to enter into such contracts with Vietnam in the past. ExxonMobil is developing the Ca Voi Xanh gas field in blocks 117, 118 and 119, which are west of the area in which the rig is deployed.

China’s determination to deter unilateral drilling in the South China Sea is further evidenced by its posture towards Philippine efforts elsewhere in the South China Sea. Block SC 72, near the Reed Bank, was offered by the Philippines in 2011, but China warned foreign oil companies against making bids. Chinese vessels interrupted Forum Energy’s efforts to explore the area. Discussions between Forum’s partners and CNOOC were subsequently held to develop a workable solution. In March 2014 Philippine media reported that these talks had stagnated.

Chinese belligerence regarding Vietnam is currently limited to the South China Sea. There is no sign that Beijing seeks to revisit the delimitation of the Tonkin Gulf with Vietnam. PetroVietnam and CNOOC signed a memorandum of understanding on exploration and production in the disputed area in 2006, and the geographic area covered by the agreement was expanded in the summer of 2013. Beijing may be of the view that the Tonkin Gulf is settled in a favorable way, unlike the South China Sea.

Limits to China’s Ambition?

There may be practical limits to China’s ambition. Despite its growing capabilities, China still confronts considerable limits on its ability to commercially produce oil and gas resources far from its shores. In the current case, even if the Haiyang Shiyou 981 makes a significant discovery, the commercial viability of that discovery hinges on getting the product to market. These costs increase dramatically with distance and the technological challenges associated with laying pipelines in deep water. The nearest Chinese gas pipeline network is on Hainan island, and water depths would make accessing that network very costly. The most sensible market for the product is Vietnam, which would be loath to pay China for resources it views as its own. These conditions suggest that China’s intent, in addition to exercising its jurisdiction in claimed waters, is also intended to dictate the terms of the “joint development” it so often purports to seek.

Furthermore, the Haiyan Shiyou 981 itself may be less impressive than first advertised. As noted above the rig spent part of 2013 undergoing considerable repairs. Consequently, the rig may not be able to operate during the typhoon season of July to September as was originally intended, which casts doubt on Beijing’s claim the rig will remain off the coast of Vietnam until August (Petroleum Intelligence Weekly, August 19 2013).

However, it is likely that China will persist in the face of these challenges. For instance, due to the reluctance of foreign majors to partner in the development of disputed areas Beijing seems prepared to proceed independently. Chinese domestic rig capacity continues to be less than that required, yet Beijing insists that foreign operators use Chinese-registered rigs. Foreign operators face considerably higher costs when trying to partner with Chinese firms, due to a 6 percent import tax and 17 percent value added tax added to the cost of operating semi-submersible rigs not registered in China (Platt’s Oilgram News, May 25, 2012). Although this slows the exploration process considerably and reduces the commercial viability of discoveries, it is a cost China seems prepared to bear to control offshore activity in its claimed waters.

Conclusion

Western analysts should note the importance of Chinese capabilities. China is now more capable than ever in the exploitation of disputed maritime areas. Moreover, despite the limits noted above and the immense costs CNOOC confronts, Beijing is prepared to pay a premium for energy security. It stands to reason that it is similarly prepared to pay a premium to exploit resources in Chinese claimed maritime areas as this fulfills both economic and political objectives.

On balance, strategic explanations of the timing of the deployment of the rig may hide a more simple truth: that the move was a function of Chinese resource development plans in the South China Sea. The conclusion that the move was “poorly” timed because increased international opprobrium against China assumes that Beijing’s South China Sea strategy is concerned with regional and international opinion. On the contrary, Chinese leaders may have decided that international condemnation is a small price to pay for leveraging their growing maritime capability to ensure that resource development in waters claimed by China occurs with Beijing’s blessing and under Beijing’s rules.