The Start of a Beautiful Friendship? Russia begins exporting oil through the Pacific port at Kozmino

by Greg Shtraks

A week ago the Russian government released a comprehensive energy report entitled “Energy Blueprint for 2030”. The crux of the report lies in the realization that the western Siberian oil fields have peaked and that substantial domestic investment in the East Siberian fields will be necessary in order to increase domestic output to the desired level of 530-535 million tons of crude oil annually (up by 8.6-9.7 percent from 2008).

The report also clearly outlines the projected shift in oil exports away from Europe and toward Northeast Asia as the share of the Asia Pacific region in Russian exports will grow from 8% in 2008 to 25% in 2009. This change in direction is partially out of necessity as transporting oil from East Siberia to Europe is both costly and difficult, but the shift also reflects China’s insatiable thirst for oil – a demand that is expected to equal that of the United States by 2030. In fact, the beginning stages of the energy blueprint are already being enacted. On Wednesday, December 9, top Russian leaders attended the loading of tankers at Kozmino in a pompous ceremony designed to announce the opening of the ESPO pipeline linking Russia with Asia. Today, such an event seems to be an obvious part of the natural progression in the unstoppable rise of China, but only two years ago the fate of the East-Siberian Pacific Ocean Pipeline was still far from certain.

A potential pipeline from Russia to East Asia was first proposed by Boris Yeltsin in the mid-1990’s and was eagerly seized upon by the Russian oil giant Yukos which wanted to construct a pipeline from Angarsk to China. Meanwhile, the quasi-state owned giant Transneft proposed an alternative pipeline running from Taishent in East Siberia to the Pacific Port of Nahodka. By 2004 Mikhail Khodorkovsky, the founder and CEO of Yukos, was awaiting trial, his company was being dismantled, and the plan for the pipeline to China was shelved until further notice.

The main question in Moscow was not whether such a pipeline needed to be built, but rather where the ultimate destination would be. Moscow tried hard to play Tokyo and Beijing off each other in order to get the best investment possible and, initially, this strategy seemed to be a success. Tokyo was willing to pay a higher price for the oil and to provide substantial investment to develop the East Siberian oil fields under the condition that the pipeline connected Siberia with Nahodka. China, on the other hand, insisted that the pipeline be built to the Inner Mongolian Petrochemical Center in Daqing. Russian leaders dithered on a final decision as the economic and the security apparatuses in Moscow clashed with each other regarding the potential geopolitical consequences of the proposed pipeline.

Analysts at the Russian Department of Energy and of Commerce pointed to the need for Chinese capital to finance the exploration of East Siberian reserves. Security personnel, however, feared that the Far East would become “an energy appendage” for China. Finally, in 2005 Moscow decided on a compromise that would integrate the two variants by building a pipeline from Taishent in East Siberia to both Nakhodka and Daqing. Russian oil giant Rosneft constructed an oil refinery in Nakhodka and built a new port in near-by Kozmino. Still, as the world oil prices reached astronomical heights, Russia delayed the construction of a pipeline that would have provided oil to China and Japan at discounted prices. The global financial crisis changed all that.

In February 2009 oil prices dropped to $25 per barrel and Russian oil giant Rosneft and pipeline operator Transneft were on the brink of collapse. Bejing, sensing that a unique opportunity was at hand, made an offer that Moscow could not refuse. The Chinese Development Bank offered loans to Rosneft and Transneft of $10 billion and $15 billion, respectively, as part of a $25 billion dollar investment that would accelerate the construction of the pacific pipeline. As part of the agreement, Russia would develop further fields, build the ESPO leg for Daqing from Skorovodino to the Chinese border, and supply China with at least 300,000 barrels per day.

Beyond the border, in the Chinese interior, Beijing would construct a domestic pipeline approximately 600 miles long to Daqing. The Chinese loan would be made at 6% interest and would require that price of Russian oil be an extremely advantageous $22 per barrel. In February, many analysts assumed that Russia would negate the deal as soon as the price of oil rebounded to it’s natural course. However, the ceremony at Kozmino indicates that, at least in the short term, Russia intends to go through with the deal.

The reasons for Russian acquiescence are two-fold. First of all, according to Brookings Institution analyst Shoichi Itoh, the East Siberian oil reserves are geographically dispersed and vastly untapped. According to Russian estimates an investment of $102 billion is required to extract the 600 million barrels on untapped reserves. However, even during the era of high oil prices and despite substantial tax breaks offered by the Russian government, Russian oil companies were unable to adequately develop East Siberia. As such, Russia will require a sustained investment from all the countries in North East Asia in order to develop East Siberia.

In fact, last week Russia’s government began to scrap export duty for crude oil produced at 13 East Siberian fields, including the giant Verkhnechonskoye field. Russia’s reputation as a dependable partner in oil excavation is already in ruins and a negation of the deal with China would make cooperation extremely difficult. Secondly, China has worked hard to diversify their supply of oil. Chinese exploits in Africa, Latin America, and the Middle East are will known. On Friday Hu Jintao also visited Kazakhstan and Turkmenistan and participated in the opening of a new natural gas pipeline linking Turkmenistan with China – the first such project in Central Asia. Furthermore, a potential oil pipeline linking Kazakhstan with China was discussed during Hu’s meeting with his Kazakh counterpart Nursultan Nazarbayev. China is far from creating a monopsony on oil, but such a variety of sources allow China to be very aggressive in negotiating the price. The ESPO pipeline will completed within a year but I highly doubt that it will remain the only pipeline linking East Siberia with the Pacific.