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1 Sample Research copying or distributing the information is strictly prohibited September 2013 Russia s pivot east: the growth in energy trade with China Executive summary Russia is shifting its outlook east and engaging with China on a range of huge deals that could see energy trade quadruple by Keen to secure the large volumes of energy that Russia can provide, China is providing finance to underpin much of the infrastructure cost. The combination of a large and growing market and upfront finance has resulted in a strategic re-alignment between Russia and China, with much closer engagement and a growing mutual dependency on energy trade. The construction and expansion of the Eastern Siberia Pacific Ocean (ESPO) pipeline has been a critical piece of infrastructure. In return for guaranteed crude supplies, Chinese finance underpinned the construction of the second stage of the pipeline. ESPO has opened up East Siberia for large-scale commercial oil production, resulting in a significant increase in upstream investment. Now, a wider political realignment is underway, reversing the historical trend of limited engagement between China and Russia. CNPC will acquire a stake in Yamal LNG and purchase at least 3 million tonnes per annum (mmtpa) of LNG. In a highly significant move, CNPC has also been offered equity in several blocks in the Arctic and East Siberia. An MoU was signed in March 2013 for 38 bcm of supply from Russia s East Siberia gas fields, with first delivery scheduled for Negotiating the future terms of cooperation between Russian and Chinese companies will be challenging. If large projects are to be realised, Russia may have to allow deeper Chinese involvement, for which there is little historical precedent. However, both Russia and China have strong incentives to access new sources of growth and develop new energy trade routes. Russia s proximity, the quality and scale of its eastern resource base, and the new willingness of its energy companies to trade, could make it China s most important single energy supplier for some decades to come.

2 Energy trade between Russia and China is developing rapidly As legacy West Siberian oil production declines, Russia is undergoing a period of renewed interest in exploring and developing the energy resources of its Far East and East Siberia regions. Exploiting the mineral and hydrocarbon wealth of these areas allows Russia to diversify markets, maintain energy production levels, develop industry and increase local incomes. Simultaneously, Russia is being forced to accommodate the new realities of the European gas market. Russia has reduced its target price for gas into Europe and is seeking alternative markets for new supply. Russia has also had to shelve plans to send its own LNG to North America. China s precipitous demand growth over the last decade is the third component of Russia s pivot towards the east. China s total oil imports will overtake those of the United States by Its gas market is now the third largest globally. Power demand is also growing at a tremendous rate, and trade with China could make Russia the world s largest electricity exporter by Fears of increased Chinese economic and demographic influence have traditionally limited Russia s willingness to open East Siberia up to direct Chinese investment. Now however, China is beginning to provide capital to finance some of the major infrastructure projects required to unlock Russia s eastern resources. Chinese state financing, through oil for loan deals, supported Transneft and Rosneft in both the wake of the 2008/9 recession and more recently, following the Russian company s US$55 billion acquisition of TNK-BP. There is a rapidly growing mutual dependency between Russia and China. Construction of the ESPO pipeline is the first sign of material progress Russia has historically been reluctant to offer direct access to strategic assets, so the recent farm-in to Yamal LNG, and Arctic and East Siberian acreage marks a significant breakthrough. Together with upfront financing in return for guaranteed supplies, a model for increased cooperation appears to be emerging. The construction and expansion of the Eastern Siberia Pacific Ocean (ESPO) pipeline has been a critical piece of infrastructure. The ESPO pipeline was designed to transport oil from East Siberia to export markets via Kozmino Bay on the Pacific coast. In return for guaranteed crude supplies, Chinese finance underpinned the construction of the second stage of the ESPO pipeline and an additional spur to China. The pipeline has opened up East Siberia for large-scale commercial oil production, resulting in a significant increase in upstream investment. Exploration and appraisal activity has resulted in significant reserves upgrades at existing fields and the discovery of several new plays. Initial challenges over operating in East Siberia are being overcome just as reserves and production are increasing is a breakthrough year Now, a wider political realignment is underway, which is facilitating development and reversing the historical trend of limited engagement between the two countries. On 21 June 2013, at the St Petersburg International Economic Forum, NOVATEK and CNPC announced a framework of cooperation under which CNPC will acquire a stake in Yamal LNG and purchase at least 3 million tonnes per annum (mmtpa) of LNG from the project. In a highly significant move, CNPC was offered equity in several blocks in the Arctic and East Siberia from Rosneft. CNPC s entry into Yamal LNG as a major offtaker provides the project with its first foundation buyer in Asia. This is a significant step in LNG project evolution and gives Yamal LNG momentum. As part of the agreement, Chinese banks will assist in project financing. The capital risk for Yamal LNG is considerable, given both its Arctic location and the scale of development. Chinese support is a crucial step in building a broad-based financial platform for the project. Global Horizons Service Risks Uncertainties Insight - September 2013 Page 2 of 5

3 Trade developments between Russia and China 2004 Rosneft and CNPC sign a 5-year oil deal Gazprom and CNPC sign MoU on 68 bcm of gas supply via two pipelines Sinopec buys stake in Udmurtneft Rosneft and CNPC form Vostok Energy JV 2007 Sinopec farm-in to Sakhalin-3 Veninski block Gazprom s Eastern Gas Programme adopted Russia introduces Mineral Extraction Tax breaks for East Siberian oil projects Russian grid operator establishes JSC Eastern Energy Company to manage power exports to China Rosneft, Transneft and CNPC sign a 20 year oil supply deal via ESPO CNPC and Gazprom sign a gas framework agreement which reiterates 68 bcm of supply 2010 Rosneft and CNPC sign Tianjin Refinery agreement 2011 Oil deliveries via the ESPO spur begin at 15 million tonnes per year Prepayment of US$40 billion for gas deliveries under discussion 2012 Chayandinskoye gas field pre-development work completed Gazprom prioritises eastern gas route to China 25 year contract between JSC Eastern Energy Company and State Power Grid Corporation of China First of 3 transmission lines between Amur Oblast and Heilongjiang Province operational 2013 CNPC and Gazprom sign MoU for gas supply via the Eastern route Rosneft receives US$2 billion loan from China for oil supply CNPC farm-in to Yamal LNG with 3 million tonnes LNG off-take agreed Rosneft, CNPC agree to increase annual oil deliveries by 22 million tonnes Agreement for CNPC to farm-in to East Siberia and Arctic acreage EN+ Group and Shenhua sign cooperation agreement for coal projects with loan from China Russia allocates 50 bn roubles (US$ 1.6 bn) of state budget to RusHydro for Far East power infrastructure development Despite the compelling reasons for Gazprom to agree a pipeline export deal with China, progress has been slow. However, progress has been made in An MoU was signed in March 2013 for 38 bcm of supply from Russia s East Siberia gas fields, with first delivery scheduled for Chinese financing is likely to be a key component of the final deal, with possible equity involvement also figuring in negotiations. Global Horizons Service Risks Uncertainties Insight - September 2013 Page 3 of 5

4 Russia to China energy export growth, Russia to China Exports Coal Electricity Gas Oil Source: Wood Mackenzie China Gas & Power Service; Product Markets Service; Coal Markets Service; Energy Markets Service The energy trade relationship between Russia and China is in its early stages Maintaining cordial relations, and guaranteeing financing over the long term is a key challenge to the developing energy relationship between Russia and China. Negotiating the future terms of cooperation between Russian and Chinese companies will be challenging. While an agreement for gas deliveries was signed in September, pipeline exports from Russia to China have been almost 20 years in negotiation, although we expect a final pipeline agreement within the next two years. Gas developments are on hold until the pipeline agreement and gas sales contract is finalised. Power price deals are also in a very early stage of negotiation. Russian resource nationalism means that Russian companies will want to remain in operational control. Chinese companies have so far been content with accepting minority non-ownership roles in Russian ventures, but frustrations could arise in future if either side becomes dissatisfied with the balance of power and sharing of risk. If large projects are to be realised, Russia may have to allow deeper Chinese involvement, for which there is little historical precedent. The case for further cooperation is fundamentally strong Over the long term, both Russia and China have strong incentives to access new sources of growth and develop new oil and gas trade routes. For Russian companies, China provides an alternative to traditional markets in Europe, and Chinese companies provide long-term financing to help develop capital intensive, high volume low margin projects in Russia. As a large resource holder, Russia is one of many countries that Chinese companies will target to develop longer-term sources of overseas oil and gas production and import networks to China. However Russia s proximity, the quality and scale of its eastern resource base, and the new willingness of its energy companies to trade, could make it China s most important single energy supplier for some decades to come. Global Horizons Service Risks Uncertainties Insight - September 2013 Page 4 of 5

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