Strategic Challenges for US China in Global Energy Suppl

By Dave Ernsberger - Editorial Director, Asia

Fudan University, Shanghai - May 17, 2005

In the five years since the turn of the millennium, the world has grown to realize that the defining rivalry of the 21st Century may not be overtly religious or ideological, but overtly economic. It now seems that the definitive competition of the next 100 years will not be between Christianity and Islam, as many had thought in the post Cold War era of the late 20th Century. And it will not likely be between communism and capitalism, at least not as ideologies. The rivalry that will shape the world will likely be between the world's lone super-power, the United States of America, and only nation-state capable of challenging its economic and political supremacy within the next generation, China.

This growing awareness is evident in the popular media, where generous amounts of space in broadcast, print and online media has been devoted to answering the question, "Does The Future Belong To China?" as Newsweek recently put it 1. There are many different ways to answer that question, most of which are beyond the scope of this paper. But one way is to look more closely at the consequences of China's growth for the global energy industry, and in particular on the global oil and gas markets. Since the 1880s, the oil market has acted as a crucible where international relationships have been forged and broken. By examining the international oil markets, it is possible to gain a better understanding of the relationships between the leading actors on its stage--and a better feeling for the rise and fall of nations.

Since the end of the First World War, when industrialized nations shifted from coal to oil as a key transportation fuel in military use, the drive to control oil as a strategic commodity has defined the ambitions of nations. When looking at the strategic challenges for the US and China in global energy supply, it is clear that the most basic challenge of all for both countries will be to find a way to meet their oil and gas demand for at least the next 50 years without creating the conditions for another hydrocarbon-based military conflict.

With demand in 2004 of 20.52 -mil b/d, the US already consumes one in every four barrels of oil produced in the world today 2. Last year's demand represented a strong (and stronger than expected) 2.4% increase from demand in 2003. The increase followed in large part from the US' low interest rate environment, which helped the US economy shake off the impact of high crude oil and gasoline prices. This year, as higher interest rates take hold and the impact of sustained high oil prices begin to be felt, US demand is forecast by the International Energy Agency to rise by a more modest 1.4% to 20.81 -mil b/d.

While trends rarely move in nice flat lines, US demand is forecast by the US Department of Energy 3 to show the same kind of growth for the next 20 years or so. This implies that by 2025, US demand will have reached more than 28 -mil b/d, thanks in large part to strong demand for oil in transportation.

The key statistic is that, these days, the US is lucky if it produces 8-mil b/d of its own crude oil. On average the US produced 7.67 -mil b/d in 2004 4, a figure that will likely rise by 100,000 barrels per day this year if US producers pull out all the stops and crank up production to capture the prevailing high prices for crude oil. With crude oil at $50 or more for most of this year already, owners of US oil fields have had their wildest dreams of the 1980s and 1990s answered--and then some.

With oil prices at their current levels, it has to be assumed that the US is pushing out as much oil as it possibly can, from the small strip wells of east Texas to its massive platforms in the Gulf of Mexico. And it should be remembered that 8 -mil b/d is no small feat. In 2004, only Russia (at 9.23 -mil b/d) and of course Saudi Arabia (at 8.75-mil b/d) produced more oil than the US.

It is often overlooked that the US is the world's third largest oil producer--pushing out more than all of Western Europe combined. Yet this oversight is understandable. A little less than 8-mil b/d of production, however impressive, leaves the US scrabbling for almost 13 -mil b/d of oil on the international markets--about 10 -mil b/d of crude oil and almost 3 -mil b/d of refined products. That was 60% of its total oil requirement for 2004. And by importing 13 -mil b/d of oil, the US was importing more than China and Japan consumed, combined, every single day.

From the point of view of a US energy strategist, this picture does not change much in the next 20 to 25 years. According to the US Department of Energy 5, US crude oil production could rise as high as 9.9 -mil b/d by 2010, and settle back at 9 -mil b/d in a best case scenario combining sustained high oil prices with the efficient tapping of reserves. With more normal circumstances, the DoE expects US oil output to peak at 9.5 -mil b/d in 2010 and settle at around 8.6 -mil b/d by 2025. Even in the most optimistic scenario, the US will only be able to supply 45% of its own needs by 2010, and at best little more than 32% of its needs by 2025.

The implications for US energy strategy from these headline numbers are obvious, and have been for quite some time. The US will need to secure vast amounts of reliable, foreign supplies of crude oil at affordable prices. We will consider the steps it has taken to do so in a moment. The US will also need to pursue energy efficiency and energy diversity initiatives more seriously than it has done in the past if it is to contain demand growth to within forecast parameters. If there are many more years like 2004, without offsetting declines in slow economic cycles, the US will far exceed even the most bullish demand forecasts. The implications for oil prices would be self-evident, of course, and ultimately prices would find a level to correct US demand on their own.

The essential challenges facing China's energy strategists are almost identical, although on a smaller scale. China consumed about 6.38 -mil b/d of oil in 2004, 860,000 barrels a day more than in 2003 6. That growth, which amounted to a stunning 15% increase in demand, established China as the clear number two oil user in the world and shocked the global oil markets--which had been expecting an increase of closer to 10%.

This trend is expected to moderate, but growth in Chinese demand for oil will far outstrip any other single country by a long shot for the foreseeable future. This year, Chinese demand is expected to show an increase of 8% to settle just under 7 -mil b/d, a full 1.5 -mil b/d higher than its increasingly distant regional rival, Japan.

On average, Chinese demand is expected to grow by about 4% per year between now and 2025, ending up at around 12.8 -mil b/d 20 years from now 7. By then, China would be the dominant number two oil consuming nation in the world, consuming more than twice as much as Japan and as much as the whole of Western Europe. This will give China tremendous leverage in the energy world, and indeed China has already enjoyed newfound strength in international energy diplomacy in recent years as the world prepares for the seemingly inevitable rise of China.

Such forecasts may ultimately prove conservative, if China experiences the kind of boom in car use that ultimately catapulted the US into stratospheric oil consumption. According to the International Monetary Fund's latest World Economic Outlook, China could see its vehicle ownership rates jump from 16 vehicles per 1,000 people in 2002 to 267 vehicles per 1,000 people in 2030 8. If the IMF's forecast is correct, China will account for almost one fourth of all new oil demand in the world for the next 25 years, with two thirds of that new demand coming from the transportation sector.

Only 15 years ago, China hardly registered on the global oil map. With little more than 2 -mil b/d of demand in 1990, China at the time languished behind Germany, Russia and Japan, as a distant player in the world energy economy. Fast forward to today, and looking down the line, it is obvious that China's ability to shape its energy destiny will be largely in its own hands, thanks to its unchallenged voice as the US' only significant rival for oil demand. Yet China will need to use this newfound strength wisely to manage its energy requirements effectively.

Chinese oil production shows even less capacity for growth than the US. According to US Department of Energy forecasts, at least, Chinese oil production would peak at 3.7 -mil b/d in 2010--assuming high oil prices persist and reserves are brought to production efficiently 9. By 2025 Chinese production is likely to have moderated back to 3.4-mil b/d. DoE's forecasts don't vary much in a more moderate oil price environment, suggesting--probably rightly--that international oil prices will have little impact on China's ability and desire to bring as much of its own oil as possible to its refiners under any circumstances. Given that Chinese oil reserves are being brought to market by state-run oil companies, it is self-evident that these companies will follow the government's call for "self-sufficiency," or the nearest thing, at almost any production cost.

With such ample demand forecast from the US and China, and such meager domestic production expected to serve it in both countries, it is possible to foresee growing rivalry between the US and China for supply. Today, China and the US together account for about 33% of the world's 84 -mil b/d of oil consumption, and a little more than 13% of its supplies. By 2025, it seems likely that both countries will account for about 34% of total world oil demand, but only 11% of supplies--assuming high oil prices trigger all possible forecast US production. The picture may seem somewhat stable, but the competition for the marginal barrel will be intense, and indeed already is so.

A contributing factor is that policy makers in both countries believe that domestic production is preferable to imports, and the higher the proportion of domestic production relative to demand, the better. Since neither country is willing to curb consumption beyond a few efficiency initiatives and occasional macro-economic tinkering, and since domestic production is both countries will struggle to keep up, the drive for self-sufficiency has spilled over into a notion of establishing "equity production" around the world. For both countries this means establishing long-term supply partners that can be counted on to meet needs, thanks to a complex combination of political, military and economic incentives to do so. For the US, the notion of an "equity" stake in the oil of the Middle East is largely virtual, since stakes are developed by publicly traded multinational corporations that are not, by definition, state-owned. For China, the concept of a Chinese "equity stake" is more concrete, taking shape as it does through equity stakes developed in foreign oil projects by state-run Chinese companies.

There are concerns that this drive for equity in the world's oil resources will bring the two nations into confrontation, particularly as China signs cooperation pacts in lands as distant as Nigeria and South America—and even expresses interest in Canadian projects that lie very close to the center of US' traditional sphere of energy influence. The implications of an armed conflict arising out of this competition are obvious, particularly between two nuclear nations. China and the US will be as keen to avoid military conflict in the first half of the 21st Century as the US and the Soviet Union were throughout the second half of the 20th Century, for many of the same reasons.

The growing economic interconnection between China and the US adds an extra layer of goodwill that acts as an additional deterrent to conflict, beyond the promise of mutual annihilation that nuclear weapons offer. Wal-Mart, the world's largest corporation, employs 1.8 -mil people, and its revenues account for 2% of US Gross Domestic Product. 80% of Wal-Mart's 6,000 suppliers are in China, and they supplied $18 -bill worth of goods to the supermarket giant in 2004. The resulting equation is elegant and simple: the American people need Wal-Mart, Wal-Mart needs Chinese exports, Chinese exporters need Wal-Mart, and the people of China need export markets. The concept of "dependency" ended long ago. The US and China are now in a state of mutual dependence, thankfully for the prospects of future stability in the world.

It is important to remember this co-dependence, and the bright line of nuclear deterrence, when considering how highly US and Chinese energy policy makers will likely prioritize the avoidance of conflict while developing energy policy for this century. The roads that lie ahead for both countries, especially in oil, lead inexorably towards a contest for influence over volatile regions like Africa, South America and, in the final analysis, the profoundly violent Middle East. This makes the task of developing a stable energy policy in both countries both challenging and necessary.

US and Chinese energy policy makers face almost identical problems when satisfying oil demand. In fact, the correlations between US and Chinese oil development are uncanny. By a quirk of geological fate, China and the US have built up a huge dependency on similar grades of crude oil. Both countries have established massive-scale, widely distributed refining industries that are geared towards processing relatively "sweet" low sulfur crude oil, and relatively "light" crude that typically yields a lot of high value products like gasoline or diesel.

The quirk of fate is that the US and Chinese oil industries were built upon ample, domestic supplies of such "top class" crude oil. In the US, major onshore and offshore oil fields in the Gulf of Mexico region have typically provided high-quality crude oil, which allow for relatively easy refining into its key oil products like gasoline and middle distillates. Similarly in China, world class oil fields like Daqing in its northern provinces provided medium sweet crude oil for relatively easy refining into China's major fuels--especially key distillates that support its countryside economy, like diesel.

This means that when China overtook Japan as the world's second largest oil consumer in 2003, its emergence as the second biggest oil consuming nation to the US was more than just symbolic. It rapidly made China a hungry consumer of medium and light, sweet crude oil--the kind of crude oil that the US has long been a traditional consumer of, and exactly the kind of crude oil that is running out in the world relative to higher sulfur, heavier crude oil. In the short term, by which many mean the next one to five years, both the US and China will be drawn into deep rivalry for dwindling supplies of top quality crude oil, because of an historically established "sweet tooth" in both nations.

On the international stage, this rivalry for light sweet crude oil has put immense pressure on the world's oil futures markets, and prices in nominal terms hit historically high levels several times in the fourth quarter of 2004 and the first quarter of 2005. When analyzing these price peaks, it is important to remember that WTI crude oil, and Brent crude oil in the North Sea, are both light, sweet crude oils. Historically high prices for those futures represented, in no small measure, the present and future contest between China and the US for such top quality barrels.

We are therefore likely to see US and China energy policy makers working hard to mitigate the impact of high prices for light, sweet crude oil on their economies. In the next five to ten years, the challenge for policy makes is to establish reliable, and relatively cheap, sources of crude oil. Beyond that horizon, the challenges are manifold. Efforts are underway in both countries to introduce alternative fuels, to lessen each country's dependence on crude oil. In the case of a renewable fuel like ethanol, this effort is already well advanced, though still fraught with certain inefficiencies. Longer-tern solutions like hydrogen as a fuel source will require tremendous effort to implement, so much so that a significant shift into a fuel like hydrogen could be rightly described as an energy revolution.

Where a dependency on crude is inevitable past the ten year horizon, we will likely see both nations make a major effort to retool their refining industries to process more heavy, sour crude. This is a process that has already begun, and has the potential to eventually bring crude oil prices back down towards "historical norms" of closer to $15-30 per barrel, in 2003 dollar terms.

Before discussing longer term policy challenges, let's first turn to the near-term challenges at hand. To put it in its most elemental form, the challenge for Sino-American policy makers will be to find enough room for China in the global oil market, so that China's economic ambitions and resulting energy needs are met without threatening the US' actual security of oil supply.

Perhaps more importantly, Chinese policy makers will be keen to secure the country's its own energy future while avoiding any threat to the US' perceived security of supply. Perceived security of supply is not always the same thing as actual security of supply. When one acknowledges that perceptions can be different from reality, it is a small step to acknowledge that the confusion which may arise from the misapprehension of a threat is equally as dangerous to the world's stability as any intentional threat would be.

The US, in turn, will need to demonstrate tolerance as China seeks out new sources of supply that move closer to its traditional areas of influence than ever before. A unique feature of China's expanding energy hegemony is that China has most often used its growing power and confidence to make overtures to potential suppliers right on the US' doorstep. Additionally, China typically supports the regimes of countries that allow it direct and unfettered access their to oil reserves. Often these have been regimes that the US has marginalized on the global political scene. In some cases these are government that the US has explicitly or implicitly targeted for so-called "regime change."

Typically China's support for new and future suppliers has come in the form of regime support, national financial aid packages and additional infrastructure spending. Ths is not all that different, of course, from how the US supports many of its existing preferred suppliers. The political and financial cost of establishing such relationships has led, from time to time, to the charge that China is over-paying for its oil on the global markets. Relative to an established superpower like the US, that may be so. But the barrier to entry into the world oil markets is prohibitively high for a relative new-comer like China, not least because nations are reluctant to give up their finite reserves of oil cheaply.

The world energy orders created to support superpowers of the past--Britain, the Soviet Union, France, Japan, Germany and, of course, the US--often delineated areas of influence that were later sponsored by, attacked by, and defended by those superpowers as they worked through the usual contortions of war and peace that accompany eras of superpower rivalry.

And so it is with China's emergence to rival the US. Most often China's support has made beneficiary countries less fearful of US-backed trade embargoes and other punitive measures used by the US to exert influence in far flung corners of the world. The establishment of a new world energy order to support China's booming oil appetite is serving as a precursor to the emergence of a new world political order, where countries that have been previously vulnerable to the consequences of US unhappiness are now queuing up to satisfy the oil needs of a new and powerful sponsor--China. A significant challenge for US energy policy makers will lie beyond the establishment of a sustainable and reliable oil supply for the US' own future. US policy makers will also have to tolerate Chinese sponsorship of countries like Sudan, Angola, Yemen and, most crucially, Iran, as they are integrated into China's energy supply plan.

To step back from political theory and examine the facts at hand, it is clear that a loose energy order has already emerged between the US and China, and is in the process of being firmed up. More than 70% of US crude oil imports come from just five countries: Saudi Arabia (18%), Mexico (16%), Canada (16%), Venezuela (12%) and Nigeria (9%). Naturally enough, two of these countries lie on US borders. For all of its anti-US posturing, nearby Venezuela remains a staunch supplier of oil to its northerly neighbor. Only two of the US' top five suppliers lie outside its immediate geographical reach--top supplier Saudi Arabia, and Nigeria.

It must be noted that Saudi Arabia's sheer size and influence as an oil producer--it is the world's largest oil producing national by capacity, and has the lion's share of the world's known reserves--means it has carved out the role of "leading oil supplier" to both the US and to China. Yet this appears to be no threat to the US' energy hegemony over Saudi Arabia. A high-profile visit by Saudi Arabia's Crown Prince Abdullah's to US President George W Bush in April demonstrated clearly that while the world's biggest oil consumer and the world's biggest oil producer share different views on exactly who is responsible for the US' extraordinarily high gasoline prices of the last two years, they remain committed to the de facto supply pact that has kept US energy supply stable through several decades of good economic growth 10.

This relationship is the lynchpin of US energy strategy in the short term. Saudi Arabia has repeatedly demonstrated its commitment to keeping the US well supplied, and in April laid out in detail investment plans aimed at raising its production capacity from 9.5-10 -mil b/d to 12.5 -mil b/d by 2009. Saudi Arabia has also expressed a willingness to raise this to 15 -mil, at its own expense, should demand outstrip forecasts.

The US has an equally powerful long-term energy hegemony established over its neighbors. Declines in US output are expected to be balanced by new production from Canada and Mexico. Canada's conventional oil output is expected to fall by about 500,000 barrels per day over the next 20 years, but an additional 2.5 -mil b/d is expected in non-conventional production, mostly from oil sands projects. Although Mexico has in recent years struggled to maintain and develop its oil industry through national oil company Pemex, the country enjoys a vast resource base of its own. By the end of the decade Mexico is expected to lift production to 4.2 -mil b/d, and by another 500,000 barrels per day by the end of 2025 11.

Finally, the US has established a clear supply cushion should events in any of its major suppliers divert supplies away, particularly in Nigeria, the US' fifth largest supplier of crude oil. Through the US-led invasion of Iraq in 2002 and consequent regime change, the US has laid the groundwork for a virtual right of first refusal on new production from the Middle Eastern country, albeit under ordinary free market conditions. Iraq is now the sixth largest supplier of crude oil to the US, and in 2003 the US received on average 481,000 barrels per day from its former arch enemy--5% of its imports for the year. That reliance will likely be built up in coming years, assuming of course that the new government in Iraq remains favorably disposed towards the US, that some amount of US troops stay in Iraq to ensure that it does, that Iraq can raise production as planned, and that its reserve potential is as high as most prospectors believe it must be.

Outside of its top five suppliers, US import dependency is actually very well diversified among a further 31 countries. And it is these countries, particularly the out-of-favor nations, that China has targeted in its bid to establish elbow room in oil.

China relies on its top five suppliers for 60% of its crude oil 12. As with the US, Saudi Arabia tops the list, accounting for 350,000 barrels per day or 14% of China's 2004 crude imports. But beyond its obvious supplier of first resort--Saudi Arabia (14%)--China's top five list looks very different in composition to the US' supply partners. Oman, a key Gulf supplier of crude oil to the Asia Pacific region, accounts for around 13% of China's imports, or about 335,000 barrels per day. Angola meets a further 13% of China's imports, while Iran (11%) and Russia (9%) round out the top five list. In the case of Russia and Oman, geographical common sense and free market dynamics explain why large amounts of exports from both countries will likely continue to arrive in China as the emerging giant pursues its energy strategy.

China's close cultivation of Angola and Iran as supply sources demonstrate how the country has successfully made space for itself in the global energy scene by carving out areas of influence that have been largely ignored or banned by the US in the last decade. Angola supplies just 3-4% of the US' oil imports, while of course Iranian imports are banned in the US. And China, like the US with Iraq, has been busy grooming major alternative supply sources in case a key supplier changes policy. Most likely China will need to hedge against unpredictable supplies from Russia in the coming ten years, and it appears to have done so with major investments in Iran and Sudan. Sudan was China's sixth largest crude supplier in 2004, with 120,000 barrels per day of exports to China.

China's efforts in Sudan offer an insight into how the country may continue to fashion a substantial virtual oil supply network out of the world's disenfranchised nations and key Middle Eastern oil nations. US investment in Sudan was banned in 1997. The bitter civil war in the country and genocide in western Darfur region mean the ban is unlikely to change soon. China has moved into the investment vacuum, and through state-owned oil giant CNPC, has already invested more than $12 -bill in Sudan's oil industry, including a $600 -mil oil refinery and a long-distance pipeline.

China, the largest foreign investor in Sudan, sent about 10,000 Chinese workers to build the 900-mile pipeline that links the Heglig oilfield in Kordofan province with Port Sudan on the Red Sea 13. CNPC, China's second largest refining company, now relies on Sudan for around half of its own crude oil imports. The bet placed by China seems worthwhile from the point of view of its energy strategy--Sudan has only 563 -mil barrels of proven reserves, but the country's energy ministry estimates that at least 5 -bill barrels will eventually be discovered. China is betting that it will, with Chinese help.

One of the consequences of China's sponsorship is that US efforts to pressure the Sudanese government into making changes to key policies are doomed to falter. This is evident in particular from Security Council voting patterns at the United Nations. And this is where Sino-American energy strategy will butt against the international political order. Making room for China will require that the US accept the end of its ability to create change in all "renegade" countries, all of the time.

While the US may grit its teeth at the protection afforded to Sudan, Washington policy makers are likely deeply alarmed by the impact that China's increased involvement in Iran will have on its declared mission to transform the Middle East into a haven for democratic nations.

Through Sinopec, China's biggest state-owned oil refiner, China signed an extremely significant $70 -bill deal last November to buy liquefied natural gas from Iran in return for rights to develop Iran's Yadavaran oil field. Yadavaran, one of the world's largest undeveloped oil fields, would have a total production capacity of around 300,000 barrels per day and Iran would likely end up exporting half of this volume to China. The deal will boost China's oil security, and of course sets out an important new position for China in natural gas, essentially securing LNG supply from a key new source.

Through investments in Sudan, Angola and Iran, China has demonstrated that it is willing to create space for itself in the global energy markets by filling vacuums created by US foreign policy. The challenge will be for the US to accept that it must trade its ability to carry out change in so-called "rogue" nations in exchange for China backing away from its current primary sources of energy supply. The world is only big enough for Chinese and US oil consumption in the next 10-15 years if the US is prepared to cede control over some portions of it.

Other potential short-term flash points loom in both countries' energy policies that present a challenge to energy strategy. China has secured much of its immediate energy sources largely at the expense of Japan—its fierce regional rival, and equally energy-starved neighbor. The economically-inevitable process of crowding out Japan began in earnest in 2003, when China surpassed Japan as the world's second largest consumer. Yet Japan, by virtue of having minimal domestic oil production, remains even today a larger importer of oil than China.

China put Japan on notice that its era as Asia's center of gravity for oil consumption is coming to an end when, in February 2004, it suspended contractual exports of around 70,000 barrels per day of oil to Japanese refiners. The supply agreement, which dated back to a time when China was a net exporter of oil and in sore need of foreign capital, fell apart amid bitter disputes over pricing terms and volumes. The longer-term damage to Japan from the collapse of the deal was not from the reduced supply--which was in the final analysis relatively small. The key damage was done to its reputation and position as Asia's kingpin oil buyer.

The events of early 2004 strengthened China's hand in negotiations with Russia over which of the two countries a new oil pipeline being built to the east should serve first, by demonstrating China's growing strength as the leading regional energy power. The damage was extended by the Yadavaran agreement, in which China made clear its intention to replace Japan as Iran's single biggest export market for crude oil. Iran, for its part, appeared to acquiesce, with a senior Iranian minister quoted in a Chinese business paper as saying: "Japan is our number one energy importer due to historical reasons (...) but we would like to give preference to exports to China."14

The pressure being placed on Japan represents a challenge to both Chinese and US energy strategy. Japan is a waning force in the global oil market. This is partly by design, as Japan as been very successful in diversifying away from oil as a primary energy resource since 1990. But it is also a symbol of the passing of the Asian economic torch from Japan to China. Like the UK, Germany, or other mature economies, Japan's overall demand has simply reached a natural plateau, as per capita consumption as reached a saturation point. In Japan's case, demand is currently declining gently, and will show only modest periods of growth in the next 20 years.

But Japan will still remain an awkward third power in global oil consumption until India overtakes it sometime in the next 20 years. This means that the country must be comfortably accommodated in the new oil order being established by China and the US. The pressure on Japan recently stepped up to a new level when China asserted sole sovereignty over the Chunxiao gas fields of the east China Sea, much to the alarm of Japan. The eventual resolution of that disagreement is impossible to predict with any certainty, but Japan's angry reaction highlights the danger that regional tensions will rise as China asserts itself as an energy consumer and as a growing force in the world at large. It will be incumbent upon Chinese and US energy policy markers, perhaps most particularly US energy policy makers, to make sure that Japan's demands for energy security are met in oil and natural gas.

A further short-term challenge to energy policy makers will be reconciling China's need to secure its oil trading routes with fears that a growing Chinese military represents a more general threat. No matter how economically justifiable a military build up is, it will be perceived as a threat in some parts Asia, and by many general policy makers in the US.

A naval build up is inevitable as China looks to protect its new oil sources from intentional or accidental disruption. Partly as a result of China's drive to diversify its supply sources into areas forsaken by the US, around 80% of its oil imports now pass through the vulnerable Straits of Malacca and the South China Sea. According to some media reports 15, US government officials have been advised that China's naval build up is more about protecting these oil supplies than preparing to resolve any lingering regional tensions. A challenge for US energy strategy, and overall US strategy, will be to decide that such a build up is justified, and respond non-aggressively.

The Straits of Malacca are vitally important to the energy economies of both the US and China. According to research by Singapore's Institute of Southeast Asian Studies 16 there are as many as six major potential chokepoints along the vulnerable straits outside Singapore. Terrorism, while deemed by the ISEAS to be a relatively unlikely event in the straits for now, could easily close the channel and spark a crisis in world oil markets.

Moroever, piracy is endemic in the area, and is a source of irritation to both the US and China. Collaboration, or at least tacit cooperation, between China and the US on patrolling vulnerable seaborne oil routes in Asia would seem to be a sensible approach to dealing with this shared vulnerability. In the absence of cooperation, China and the US will need to ensure their large and growing navies can adequately protect their energy shipping interests while staying out of each other's way in the increasingly over-crowded shipping lanes of the southeast Asian seas.

Turning to the long-term challenges to US and Chinese energy strategy, both countries will need to address the deep distortions that their common taste for medium-sweet and light-sweet crude oil has caused in the global oil markets. Not only are China and the US slogging it as the number one and two energy behemoths for a finite pool of crude oil resources, but they are rivals for only a small subset of the crude oil being produced in the world today. Around 35% of the crude being produced in the world qualifies as "light, sweet" crude oil, the rest falling somewhere closer to heavy and sour.

The distortion is well measured by comparing spot prices for WTI and Brent crude oil to heavy, sour benchmarks like Dubai and Oman crude oil from the Middle East, Mars crude oil in the Gulf of Mexico, or indeed the basket of crude oils that OPEC uses to measure the intrinsic value of the crude oil it produces. In October 2004 those crudes, which tend to yield more heavy products like fuel oil, traded at wide discounts to the higher quality crude trading as futures in New York and London. The highest discounts traded for a heavy crude oil like Dubai against a premium product like Brent crude oil, were around $14 per barrel--higher even than the outright value of Brent itself only seven years ago.

That discount has narrowed in 2005, partially in response to steps being taken in the US and China to introduce better and more advanced oil refining technologies to handle heavier, high sulfur crude. With refinery utilization rates in both countries regularly topping 92%, and given the two to four year lead time on introducing new refining capacity, both countries need to take immediate action on this issue. So far China has been the more effective in addressing its refining bottlenecks. Chinese officials have stated already this year that refining capacity in the country will rise by 36% to about 373 -mil metric tons per year (7.5 -mil b/d) by 2010 17.

There are major new refinery projects planned or already underway in Qingdao, Huizhou, Chongqing, Dalian and Hainan. The first three of these new refineries look reasonably likely to be completed by 2008, and at last one of them--the 240,000 barrels per day Huizhou refinery--will be tailored to specifically handle heavier, more sour, and more acidic crudes.

China also has a further ten refinery expansions planned or underway, all of which are scheduled to be online by 2010. Expansions at the major Fujian, Zhenhai and Guangzhou refineries seem certain to target heavy sour crude blends, and several investments include equity participation by both ExxonMobil and Saudi Aramco--evidence that China is not only serious about addressing its refining log jam, but is willing to open up participation in its downstream expansions to the cash and experience of Saudi Arabia and oil majors.

China's ambitious and relatively open expansion of its refining sector leaves it light years ahead of the US in its long-term planning. One favorite statistic of oil analysts is that no new refineries have been built since 1976. The impact of this statement is weakened somewhat by the de-bottlenecking that occurred at existing refineries throughout the 1990s, which added to refining capacity. But the de-bottlenecking process is now generally thought to be complete. Burdened by "Not In My Back Yard" issues, even extremely strong refining margins enjoyed by US refiners since 2003 have done little to spur investment in new refining capacity. Instead, to date those strong margins have spurred a merger between the country's leading independent refining companies, Valero and Premcor, and the further consolidation of refining capacity into fewer hands.

In April, US President George W Bush discussed several measures designed to introduce a more stable longer-term policy towards US refining capacity. These included a proposal to encourage the location of new oil refineries on or near old military bases, which are subject to fewer regulatory controls than public sites.

Of course, US oil companies are by and large publicly traded groups, which must seek to meet shareholders' expectations rather than those of the US government--unlike Chinese state-owned giants which are only partially listed. This inevitably makes it more difficult to advance a national energy agenda that require action on the part of the US' oil refiners. US energy policy watchers will be watching closely to see if the measures outlined by President Bush will spur the US' independent refiners or majors into action.

China and the US share several key longer-term initiatives in common designed to move their energy industries away from oil, where neither country looks likely to even be as self-sufficient as they would like to be. Both China and the US have embarked on aggressive, and occasionally contentious, campaigns to introduce ethanol into gasoline mixes in high demand centers. Ethanol as a fuel source for cars is not a new idea. About 100 year ago, Henry Ford designed the Model T to run on ethanol or gasoline. Gasoline eventually won as the fuel of choice, setting in motion the demand trend that defined the next 100 years, but Ford himself was a backer of ethanol 18.

Ethanol's resurrection began in the US during the oil shocks of the 1970s, when in 2003 dollar terms crude oil prices surged to more than $80 a barrel. That period ushered in a series of tax benefits in the late 1970s and early 1980s, which were followed by supportive legislation in the 1990s, and finally a round of state-by-state MTBE bans in gasoline additives in the last few years. In the US, gasoline containing 5% to 10% of the organic fuel, which is derived from corn and other agricultural products like sugar cane, is now in use in major consuming states like in California, Nevada, Arizona, New Jersey, Georgia. Nineteen states have banned MTBE, which has translated into 1.37 -bill gallons of annual ethanol demand. Remaining US states account for about 1.4 -bill gallons of annual demand.

The benefit of including ethanol in gasoline is that ethanol can, of course, be sourced domestically as a fuel source. In 1999, annual ethanol production capacity in the US was about 1.4 -bill gallons. In 2003, production jumped to 2.8 -bill gallons, primarily due efforts to fill the void in gasoline blending created by the MTBE bans. Production for 2004 was around 3.4 -bill gallons.19

On the downside, there have been suggestions that cutting ethanol into the gasoline pool can ultimately reduce gasoline yields at refineries as refiners tweak blendstock compositions to prepare the gasoline for ethanol, which tends to increase volatility ratings in the final product. Moreover, ethanol requires subsidies and tax breaks in both the US and China in order to act as a price-effective component of gasoline.

Nevertheless, the attraction of using more home grown product as a fuel stock has burned brightly in China as well. Ethanol trials began in October 2004 in Heilongjiang and Liaoning provinces. As of April 1, Anhui province was required to sell ethanol-blended gasoline instead of regular grades of gasoline. More than 3,000 service stations were refitted to blend at the pump, and a further 16 ethanol gasoline blending centers were opened to support the move. Ethanol-blended gasoline is expected to completely replace regular gasoline all three provinces by the end of the year 20.

Looking to the future, China's energy strategy could move nimbly to embrace other alternative technologies designed to reduce Chinese consumption of foreign oil--a move that would enhance China's energy security at the same time as keeping China and the US out of conflict. According to BP, which has established one of the largest foreign footholds in China's energy industry, China is gearing up to charge into alternative energy solutions. Describing BP's vision of a "peaceful rise" of China as a new energy superpower, a vice- president from BP recently said the company believes that "China will increasingly be at the forefront of international partnerships to develop and commercialize new technologies."21 BP itself is collaborating with the Chinese Academy of Science, Tsinghua University, and the Ministry of Science and Technology on technologies like coal gasification and poly-generation, hydrogen and future fuels.

Finally, new frontiers lie just over the horizon in LNG and hydrogen fuel cell development. With construction of two LNG import terminals underway, and two more expected to move ahead shortly, China has made it clear that LNG plays a key role in its energy future. The US, with five terminals already running including a terminal off the coast of Louisiana, has shown the same appetite. Time will tell if there is to be enough LNG in the world to meet the demand from both these relative new consumers to the scene--without aggravating long- time consumers Japan and Korea. In the US, the administration has recently signaled its intention to provide $2.5 -bill in grants over the next ten years to support citizens buying hydrogen fuel cell cars, suggesting that the ground work for the US' hydrogen ambitions may be also underway.

The relative merits and prospects for these and other alternative fuel sources lie beyond the scope of this paper, but it is clear that both the US and China see a diversification away from oil, and its inevitable concentration in the Middle East, as important planks of their energy security strategies beyond 2015. In the meantime, it is clear that the new global heavyweights, the US and China, will work hard to make enough room in the oil world themselves without coming into conflict. Understanding the resources that are available, the loose energy order that has already been established, and a mutual desire for relative harmony, it seems that the prospects are good for a new era defined by a deep--but fundamentally peaceful--superpower rivalry in energy. As history as shown, that can only be good news for the world at large.

(1) Newsweek, International Edition, May 9, 2005: "Does The Future Belong To China?"

(2) International Energy Agency "Monthly Oil Report", April 12, 2005, page 42

(3) US Department of Energy, Energy Information Agency's International Energy Outlook 2004, "World Oil Markets", page 30

(4) International Energy Agency "Monthly Oil Report", April 12, 2005, page 43

(5) US Department of Energy, Energy Information Agency's International Energy Outlook 2004, "World Oil Markets", page 213

(6) International Energy Agency "Monthly Oil Report", April 12, 2005, page 40

(7) US Department of Energy, Energy Information Agency's International Energy Outlook 2004, "World Oil Markets", page 167

(8) International Monetary Fund, World Economic Outlook, April 2005, page 165 (http://www.imf.org/external/pubs/ft/weo/2005/01/index.htm

(9) US Department of Energy, Energy Information Agency's International Energy Outlook 2004, "World Oil Markets", page 213

(10) Platts OPR Extra, Volume 83 Number 79, April 26 2005, page 1

(11) US Department of Energy, Energy Information Agency's International Energy Outlook 2004, "World Oil Markets", page 213

(12) PR China General Customs Administration data, released February 22 2005

(13) Daily Telegraph (UK), April 23 2005

(14) China Business Weekly, November 9 2004

(15) Straits Times, May 4 2005

(16) "Maritime Piracy and Piracy: Impact on LNG and Countermeasures," presentation delivered by Graham Gerard Ong, Research Associate, Institute of Southeast Asian Studies, Singapore

(17) " China to add 100-mil mt/year refining capacity by 2010," quoting Tan Zhuzhou of China's Petroleum and Chemical Industry Association, Platts Global Alert, March 28 2005

(18) "Ethanol and the Rest of Us", The Desk, February 2005

(19) "Ethanol and the Rest of Us", The Desk, February 2005

(20) "Ethanol gasoline's fast spread in China," China Oil and Gas Report, April 1 2005

(21) "China's Peaceful Rise -- an energy perspective from BP" delivered by Gary Dirks, Group Vice President, BP Group, at Roundtable Meeting between Bo'ao Forum for Asia and China Reform Forum on April 24 2005

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