Russia, China Reportedly Near Major Loan Deal to Back Pipeline Construction, New Oil Supply Agreement

A Supply Deal, and a Pipeline to Deliver

In advance of Chinese premier Wen Jiabao's meeting with officials in the Russian capital Moscow today, Reuters reported that Russia and China have agreed on a long-term oil supply deal that has been in the works for several months. In support of the supply agreement, which will be carried out by state-run Rosneft on behalf of Russia and the China National Petroleum Corp. (CNPC) from the Chinese side, Reuters reported that officials have agreed on a loan from China to Russia that could provide up to US$25 billion in funds for Russia to pump into construction of a new cross-border pipeline from its Eastern Siberia-Pacific Ocean (ESPO) pipeline to northern China. The loan, which would be backed by the oil export deal, would also provide the necessary funds for Russian oil companies to sort out immediate financing needs in the face of the twin blows of the financial crisis and a sharp contraction in crude oil prices.

Rosneft and CNPC have been looking to negotiate a new oil supply agreement to underpin construction of the planned pipeline branch from ESPO to northern China, but the Russian state oil giant has been holding out, seeking better terms than an existing 2004 export-backed loan deal with CNPC. Under that agreement, which runs through 2010, Rosneft agreed to supply 48 million tonnes of oil to China over a six-year period as part of a US$6-billion loan deal. Rosneft arranged the last-minute loan in order to finance its US$9.37-billion acquisition of Yuganskneftegaz, the 1-million-b/d former Yukos production unit that was sold at a controversial auction in December 2004. However, Rosneft has been unhappy with the pricing terms of that deal (not surprisingly, given the urgency of Rosneft's need for the loan at that time), and has made it clear that it would not renew the supply deal as it currently stands.

However, with the financial crisis limiting Russian oil companies' access to credit in the midst of a liquidity freeze, and the recent oil price contraction drying up the flow of export revenues available for investment in long-term projects, China once again finds itself in a strong financial position relative to Russia. Yet, with the Russians playing coy about plans to build a cross-border link from the phase-one ESPO terminus at Skovorodino to Daqing, and China seeking a commitment from Russia to fulfil its earlier promise of an increase in oil exports, Russia has retained some bargaining leverage over China. Thus, it appears that "breakthrough" in talks on an oil supply deal that Wen mentioned last week are a decision by China to offer loans to Russian companies to follow through with construction of the branch pipeline.

Reuters reported that the 70-km branch pipeline from Skovorodino to the Russian-Chinese border (presumably CNPC will finance and build the Chinese section of the pipeline from the border to Daqing) will cost an estimated US$800 million, with the rest of the funds under the reported loan going to support Transneft's onward construction of phase two of ESPO, as well as to aid in Rosneft's immediate financing needs. Sources close to the talks told Reuters that Transneft would get 40% of the funds under the export-backed loan, while Rosneft would get the other 60%. The oil supply deal would commit Rosneft to exporting 300 million tonnes of oil to China via the cross-border pipeline over the next 20 years. Funds from the loan would help Rosneft deal with the current liquidity squeeze, help it to refinance its debts, and provide financing for long-term investment projects—such as boosting production in Eastern Siberia to ensure sufficient supplies to fulfil the terms of the supply deal with CNPC.

China's Motivation

China is prepared to provide the loan in order to push the pipeline project forward, and increase its bargaining position with regard to construction of the Skovorodino–Daqing spur, which will divert crude from the main Russian trunkline to its major oil-producing region. From Daqing the pipeline will probably run to supply major urban centres in the east of the country. China hopes that the loan and the forthcoming agreement will help ensure that the Russian presidential administration (the Kremlin) does not act on previous threats to divert the whole of the pipeline's supplies to consumers such as Japan from its eastern Pacific coast if it is not satisfied with the terms of an agreement, although whether Russia would really have been prepared to sacrifice access to the largest oil market in Asia over import pricing issues appears unlikely. China's willingness to provide the loan indicates its wish to push the oil supply agreement with Rosneft forward, which would account for around 4% of China's current annual oil demand. Given the size of this agreement (the biggest ever between Russian and Chinese oil firms), China is indeed more than willing to provide the funds given the strategic benefit to its own oil import supply security. Indeed China is extremely keen to increase oil imports from Russia to offset its dependence on oil imports via tanker through the Strait of Malacca, which are vulnerable to supply disruptions from, for example, collisions in the Strait, congestion, attack by pirates, or even a naval blockade by a hostile foreign power.

Outlook and Implications

The export-backed loan deal, assuming it is finalised, will represent a win for Russia and China individually, as well as a victory for the two countries together in expanding their economic ties and strengthening their co-operation. For Russia, the loan will provide much-needed financing to cope with the duel effects of the financial crisis and the oil price slump, as well as providing additional incentives to push on with ESPO construction, the tie-in branch pipeline to China, and funds for exploring and producing the oil in eastern Siberia to send to China via the Skovorodino-Daqing pipeline. Construction of the cross-border pipeline and implementation of the oil supply deal will allow Russia to diversify its export markets as well, marking a major splash for Russia into the Asian oil market.