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Sanctions on Russian energy open the door for China

Western sanctions have tipped the balance of Russia's energy relations with China in Beijing's favour, an advantage that the Chinese side is pressing to win trade deals on its terms and gain direct access to some of Russia's largest oil and gasfields.

In May, the Gazprom and China National Petroleum Corporation (CNPC) finally signed a long-negotiated 30-year gas trade deal that Gazprom's chief executive Alexei Miller valued at $400 billion, but only after Russia appeared to make major concessions on price. The Putin government had wanted China to agree to oil-linked prices similar to those paid by its European customers, while  Beijing wanted to pay less, in line with the tariff it pays for Central Asian gas. 

Top dog

Details of the pricing have not been disclosed, but it seems clear that  China came out on top. "We believe this is a good deal for PetroChina as this Russian gas price appears to be competitive with its imports from Turkmenistan," said Gordon Kwan, an analyst at Nomura, an investment bank. 

CNPC is expected to make a prepayment of at least $20bn to provide Gazprom with much-needed financing for the development of the East Siberia gasfields and pipeline infrastructure, although the terms have not been finalised. The deal was only signed on the last day of a major summit meeting between presidents Vladimir Putin and Xi Jinping, with some of the terms still under negotiation, leaving observers wondering whether Russia was desperate to leave China with a deal in hand in the face of increasing pressure from the West. Just days before, CNPC had signed another major gas agreement , this time with Russian independent Novatek to buy 3 million tonnes per year (t/y) of liquefied natural gas (LNG) from the Yamal LNG project. 

CNPC owns 20% of  the project . Novatek has 60% and French major Total 20%. The development, which will help Russia raise  gas exports to China and elsewhere in Asia, is a high priority in Moscow, so much so that regulators broke Gazprom's gas export monopoly to pave  the way for the project. 

China's role in Yamal LNG  has grown in importance since sanctions cut off the project's access to long-term funding and technology transfers. "The sale of a 20% stake in Yamal LNG to CNPC in early 2014 is particularly important for the progress of this very complicated project at a time when Western bank financing has been largely put on hold to Russia, and US and Japanese corporations have assumed a cautious approach to all cooperation, including technical," says Julia Pribytkova, a senior analyst at Moody's, a credit ratings agency. In September, Total acknowledged that Yamal LNG was looking to Chinese banks to secure non-dollar funding. 

As it has done elsewhere, China is likely to push for its construction and engineering firms to win  more work at the project in exchange for the funding. China Offshore Oil Engineering has already secured a $1.64bn contract at Yamal LNG, beating out the much more experienced South Korean firm Hyundai Heavy Industries. This model, in which China plays a vital role at nearly every stage of a project, from financing to owning a stake in the field to engineering and construction, even purchasing, is one that China will try to replicate.

Russia has historically closely guarded its energy business from outside influence, only allowing foreign companies into the county to provide technology or cash that domestic companies lack. 

Changing role

China has historically had little to offer Russia in either respect, so it has not played much of a role developing Russian resources, even as its importance as an export market has grown. But now US and European companies are being forced to pull back from the country. 

ExxonMobil has had to pause its major Arctic offshore exploration campaign with Rosneft after the companies drilled their first well. Shell has reportedly halted a joint exploration programme in the Bazhenov shale with Gazpromneft. And Schlumberger has withdrawn many of its expat staff from Russia.

That leaves Russia with little choice but to turn to China, especially as sanctions come at a particularly vulnerable time for the energy sector. Russia's Soviet-era oilfields are in decline, and the country's energy future hinges on its ability to ramp up investments in new, more complex and expensive projects. "Thanks to its easier oil deposits in West Siberia, Russia has been able to invest much less in the upstream than the global average," Kwan says. "However, another period of flux is under way in Russian energy with investment needs growing rapidly, which is where PetroChina could come in. As West Siberia's big oilfields deplete, the Arctic, tight oil and LNG will be the new drivers of Russian energy. Capex in those three areas alone will be more than $100bn by 2025."

Closer energy relations between Russia and China were always in the cards. China needs more energy to fuel its economy and it has one of the world's top three producers next door. At the same time, Russia is keen to reduce its reliance on Europe as a customer and has turned its attention to Asia. Before sanctions were imposed, the countries weren't always enthusiastic in negotiating energy deals with each other. But sanctions  are pushing Russia to accept China's terms.

Nomura's Kwan reckons PetroChina can gain favourable terms as the preferred partner for Russia. "Instead of merely being a buyer of Russia's oil and gas, PetroChina, with the firm's proven experience in operating the fabled Daqing oil field, could potentially secure stakes in Russia's oil and gas exploration projects," he said. 

The change in tone from Russia has been swift. After years of rebuffing China's efforts to own stakes in its oil- and gasfields, Putin said in September that China could play a direct role in developing the - Vankor oilfield, one of Russia's largest and most important deposits. "Vankor is one of the biggest production operations today and very promising. Overall, we take a cautious approach to letting in our foreign partners, but we of course set no restrictions for our Chinese friends," Putin said during a visit by China's vice premier, Zhang Gaoli. 

Sanctions have hit Russian plans to expand output at the field, which is one of Rosneft's largest. "Rosneft is planning to double Vankor's production ahead by developing a cluster of nearby fields and Chinese oil capital could help amidst western banks' financial sanctions," said Kwan. Nomura estimates PetroChina could pay around $1bn for a 10% stake in the field.

The increased cooperation is unlikely to end there. China may yet get a stake in the huge undeveloped East Siberia gas and condensate fields that will feed into the Power of Siberia pipeline, says Laban Yu, a senior analyst at Jefferies, an investment bank. "We believe the Russia-China gas pipeline deal includes an equity option that PetroChina will exercise by the end of the decade," Yu said in a recent note to investors. 

Many (Chinese) oil service companies see Russia as a big opportunity since the US and EU put sanctions on the country

That may be the first of many more gas deals. The countries are also already negotiating a follow-on agreement  that would revive the previously proposed pipeline from West Siberia through the Altai mountains into western China. 

Russian energy officials have preferred this route all along because it would allow them to supply China from some of the same fields it supplies Europe, reducing costs and giving it a stronger hand in negotiations with its European customers. China had initially preferred a supply route to the east, where most of the country's population and industry is located.  But with a deal for an eastern pipeline  now signed, China is now also pressing ahead with the Western supply route, China's vice foreign minister Cheng Guoping said this month. "The PetroChina and Gazprom deal will only provide around 10% of China's total gas consumption in 2020. We believe there is clear scope for more China-Russia gas deals ahead," Kwan says. China could also push for a role in developing Russia's major new unconventional and Arctic projects. 

PetroChina, Sinopec and China National Offshore Oil Corporation (Cnooc) have all invested heavily in the US and at home to acquire and develop unconventional oil and gas technologies. And in March this year, Cnooc signed a deal for offshore Arctic exploration in Iceland. 

Russia hopes to be producing 1m barrels a day of tight oil from the Bazhenov shale by 2020 but will need help, meaning it could look to China's oil companies and service firms to provide expertise. "Many (Chinese) oil service companies see Russia as a big opportunity since the US and EU put sanctions on the country. Russian oil companies are allowing the Chinese to bid for work domestically," says Scott Darling, an analyst at JP Morgan . 

China's oilfield service companies have been busy building their unconventional capacity, largely through partnerships with Western companies such as Schlumberger, ahead of an expected boom in drilling in China. It could also now find new opportunities in China. For now though, Chinese companies' capacity for developing frontier projects still lags far behind their Western counterparts. While the turn to China could help Russia plug important funding gaps caused by sanctions, it carries significant risks for Russian energy policy and the profitability of its energy companies. 

Russian policymakers will be concerned about becoming overly reliant on China. Gazprom hopes to defray this risk in East Siberia by using major undeveloped gasfields to also supply an LNG project in Vladivostok, which will ship gas to Japan and South Korea. However those countries are strong allies of the US, so the project is unlikely to make any progress as long as sanctions are in place.

China's hard bargaining also presents a risk to Russia, as the size and scale of the capital spending involve big risks in terms of construction and cost overruns, says Pribytkova of Moody's. "The size and the scale of capital expenditures under the Chinese deals carry significant implementation and cost overrun risks and will require strict financial discipline from the state companies involved in order to make them profitable," she adds.  

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