The Strategic Considerations of the Sino-Saudi Oil Deal

China has long recognized its vulnerability toward oil supply disruption and implemented numerous policies to stunt 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, ranking second only after the U.S. (BP Statistical Review of World Energy, 2005). 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 (China Statistical Yearbook, 2005). China’s net increase in oil imports between 1999 and 2004 was one of the key factors driving up international oil prices. Moreover, as about half of China’s crude oil imports come from the politically unstable Middle East, energy security becomes one of Beijing’s top priorities (BP, 2005; China Customs, various years).

The Saudi King’s Visit to Beijing

Saudi Arabian King Abdullah bin Abdulaziz arrived in China on January 22 for discussions on energy, trade and anti-terrorism cooperation. This was the first visit by a Saudi king since the establishment of bilateral relations in 1990. Abdullah, as crown prince, visited Beijing in 1998 before he ascended to the throne last year, and other high-level delegations from both countries have visited their foreign counterparts with increasing frequency in recent years (for a full summary of Sino-Saudi relations, see China Brief, September 27, 2005). The most recent three-day state visit saw the signing of an agreement on oil, natural gas and minerals cooperation, in which Saudi Arabia promised to increase the annual oil and gas exports to China by 39%. As part of the agreement, a 100-million-ton crude oil storage facility is planned for construction in China’s Hainan province. Moreover, Riyadh is likely to build a new petroleum refinery in China to process oil imported exclusively from Saudi Arabia. As Sinopec will soon bring its eight million ton refinery into operation at Yangpu, Hainan in June 2006, Sinopec is likely to become an active participant in follow-up negotiations regarding project details with Saudi Arabia (Nanfang Daily, January 26, 2006).

Mr. Kong Quan, China’s foreign ministry spokesperson, stated during his press conference on January 24 that the Sino-Saudi oil protocol was just one of five agreements signed immediately following a meeting between the king and Chinese President Hu Jintao. The other four agreements cover vocational training; economic, trade, investment and technology cooperation; avoidance of double taxation; and a Saudi loan to fund a development project in China’s largely Muslim region of Xinjiang (Chinese Ministry of Foreign Affairs).

The Strategic Considerations Behind the Deal

Saudi Arabia is the world’s largest crude oil producer and exporter, but its location in a politically-volatile region generates pressures for oil supply diversification from major petroleum consumers. This is especially alarming in terms of the rapid decline of Saudi Arabia’s share of net U.S. crude oil imports from 17% in 2001 to 14% in 2005 (Energy Information Administration, various years). Thus Riyadh is keen to strengthen its position in key emerging energy markets.

With 1.3 billion people, China is undergoing rapid industrialization with real GDP growing at 8-10% annually. In recent years, China’s domestic oil production has only grown moderately, and increasing amounts of imported oil and gas are required to sustain China’s burgeoning economy. This dependence on foreign oil has become a key driver for Beijing to establish close economic and political ties with major oil producing countries, even when the relationship sometimes looks unpleasant to the Western community.

From the perspective of Riyadh, the introduction of a Saudi oil storage base in Hainan could significantly improve its marketing ability not only in China but in the adjacent Asian regions as well. Since the Beijing visit was immediately followed by the king’s trips to India, Malaysia and Pakistan, the whole event not only symbolized Saudi Arabia’s recognition of the resurgent East, but also represents Riyadh’s adjustment of its Western-oriented foreign policy.

After the recent oil price spike, China in 2003 finally realized the importance of the 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 facilities of Sinopec and Sinochem, PetroChina’s Dalian tanks are likely to take more West African crude (China Oil & Gas, 2005). 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 (Port Economy, 2005).

“China is very concerned about a potential market speculation triggered by the signal of establishing large oil reserve bases in China,” says an analyst from Sinopec who prefers to remain anonymous. “Keeping this in mind, you could understand both the statement by a Chinese official that domestic crude oil will be used to fill the petroleum reserve and a similar one that China would not fill the reserve if oil price is too high.”

Since Beijing is eager to establish a strategic oil reserve to lower its risk of fluctuations on the world oil market, Riyadh emerges as the best candidate for providing assistance. Unlike the long frustration of bargaining over the Angarsk-Daqing pipeline with Russia, and the potential risks of importing oil from Iran, Sudan, Libya and Angola, the relations between China and Saudi Arabia evolved smoothly over the past 15 years. According to Kong Quan, the bilateral trade of the two countries in the first 11 months of 2005 enjoyed 59% growth, reaching $14.5 billion, led primarily by Saudi Arabia’s 20.01 million tons oil exports to China.

With the increasingly stringent supply of world oil, it is Riyadh, the swing producer of OPEC, which possesses the greatest potential of producing significant amounts above its OPEC quota to fill Beijing’s strategic petroleum reserve without disrupting the market. China’s daily oil consumption level is about seven million barrels per day; if Riyadh produces an extra half million barrels per day for Beijing, it would only take slightly over three years to build up enough of a reserve to last China three months (BP, 2005).

Historically, China’s petroleum refineries were mostly designed to process domestic sweet crude, which has a low sulfur content, and 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. To expand its oil sales to China, Kuwait, another major player from the Persian Gulf, reportedly intends to invest in three refineries in China (China Arabia Friendship Association, March 30, 2005). Not long after the opening of Kuwait Oil Company’s Beijing office in March 2005, Kuwait, partnering with PetroChina, signed an agreement with the Guangdong provincial government to build a refinery near Guangzhou with a daily processing capacity of three million barrels. According to Sheikh Ahmad al-Fahd al-Sabah, the Kuwaiti oil minister, the refining and petrochemical complex may cost as much as $5 billion and would process crude imported from Kuwait (Gulf Gaily News, December 23, 2005; Guangzhou Daily, December 23, 2005).

Kuwait’s ambitions emphasize the tremendous pressure for Saudi Arabia to compete with other Gulf countries in China, even though Saudi Arabia is apparently unsatisfied with Beijing’s oil pricing system in which domestic oil product prices are manipulated by the State Development and Reform Commission, and are thus currently lower than those on the global market. To attract investment from major international oil players, however, China actually opened its retail markets for refined oil products earlier than the date specified under WTO provisions. As Beijing is due to open its oil products distribution market by December 11, 2006, Saudi Arabia’s active participation along with other major international giants will still be the driving force for Beijing to open China’s highly regulated oil market.

Energy Triangle Dynamics: China, Saudi Arabia, and the United States

Both Riyadh and Beijing understand that stronger ties could upset the U.S., therefore the state visit was kept low profile. For instance, Kong Quan was even unwilling to confirm whether the joint strategic oil reserve project is planned in Hainan during his press conference on January 24. Nevertheless there is a positive message even for the United States: the Sino-Saudi oil deal could reduce China’s oil dependence on some controversial regimes and will eventually increase China’s ability to portray itself as a responsible power.

Although the idea of a forthcoming collision between China and U.S. over precious oil resources may sound intriguing to some analysts, Beijing’s increasing reliance on international trade suggests that the opposite is more likely. While China has become firmly integrated into the world economy since China’s late paramount leader, Deng Xiaoping, spurred the Communist country to open its economy to the world in 1979, China’s interests have been best served by helping the U.S. maintain world order when necessary and simultaneously keeping some distance—rather than inciting direct conflict over access to oil.

In the current international context, Saudi Arabia may be unwilling to highlight its close ties with Washington, which partly explains why the Sino-Saudi relationship has been pushed to the top of Riyadh’s agenda. Nevertheless, considering that the U.S. is a long established superpower and China is just emerging, Saudi Arabia will strike a balance between these two countries and will avoid compromising U.S. interests to please Beijing in the near future.

Since the recent oil protocol is a fairly high-level memorandum of understanding, further negotiations will be required to work out detailed agreements with binding implications. Yet with energy trade at the core of bilateral relations, China and Saudi Arabia are likely to keep extending their ties beyond oil in the areas of education, investment, anti-terrorism and military cooperation in years to come.